Understanding Basic Economics PDF

UNDERSTANDING
ECONOMICS
Kuala Lumpur Klang Ipoh Seremban Johor Bahru Bangkok Bank Muar Sungai Petani Kuantan
Petaling Jaya Melaka Penang Kuala Terengganu Kota Bharu Kota Kinabalu Kuching
UNDERSTANDING ECONOMICS
Advisor : Dato’ Idrus Mohd. Satha
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Introduction to Understanding Economics
Economics is the study that deals with the best allocation of scarce resources. It is a
common academic discipline offered by most of the colleges and universities for the
relevant curriculum. The major topics discussed in economics are production, market,
income, wealth and welfare.
Understanding Economics is fundamental to design and implement economic policy. It

helps us to understand how resources are to be used optimally and how households and
firms interact to meet the demand and supply.
This understanding is required at both the individual (micro) and the aggregate (macro)
levels. Economic theories discuss both static (dealing with output, employment, income,
trade and finance) and dynamic (dealing with innovation, technical progress, economic
growth and business cycles).
The study of Economics requires an understanding of resources, agents, institutions and

mechanisms. Moreover, since virtually no economy operates in isolation, it is important
that these phenomena are studied in an international context.
Course Objectives
On completion of this course, student will be:
• Able to demonstrate knowledge of the core principles of economics.

• Able to understand those core principles that relates to economic problems and
issues.
• Exposed to a more detailed knowledge and understanding of an appropriate
number of specialized fields of economics (e.g. money creation).
• Able to understand the knowledge of quantitative techniques appropriate to the
study of economics.
• Exposed to the power of abstraction to focus on the essential features of an
economic problem and to provide a framework for the evaluation of the effects of
policy.
• Able to analyze an economic problem or issue using an appropriate theoretical
framework.
• Able to have an understanding of appropriate concepts in economics that may be
of wider use in decision–making context (e.g. opportunity cost).
• Able to demonstrate a facility in numeric and other quantitative techniques, such
as correctly interpreting graphs.
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Academic Planner
The following is a guideline for lecturers to plan the number of lecture hours per chapter
based on the content available and its importance. Lecturers are to adjust these hours
according to the length of the semester:
Week Topics Chapter Hours
1 Introduction to Economics 1 3
2 Factors of Production 2 3
3 Demand and Supply 3 3
4 Demand and Supply 3 3
5 Price Determination and Elasticity 4 3
6 Consumers’ Behaviour 5 3
7 Production and Production Costs 6 3
8 Production and Production Costs 6 3
9 Market Structures 7 3
10 Market Structures 7 3
11 Role of Government and Economic Growth 8 3
12 The Banking System, Money and Inflation 9 3
National Income and Theory of Income

13 10 3
Determination
14 International Trade 11 3
14 weeks 42 hours
iv
Table of Contents
Table of Contents
Table of Contents .................................................................... v 4.2 Case Study .............................................................87
1 Introduction to Economics.......................................... 1 4.3 Summary................................................................89
1.1 Introduction to Economics....................................... 2 4.4 Exercises ................................................................90
1.1.1 What is economics all about? 2 4.4.1 Answer the following question 90
1.1.2 Scarcity 3 5 Consumers’ Behaviour ..............................................92
1.1.3 Microeconomics and Macroeconomics 5.1 Consumers’ Behaviour...........................................93
4 5.1.1 The Marginal Utility Theory 93
1.1.4 Economic Systems 6 5.1.2 The Law of Marginal Utility 95
1.1.5 Mixed Economy 7 5.1.3 The Indifference Curve and the Budget
1.1.6 Planned Economy 8 Line 97
1.1.7 Market Economy 9 5.1.4 The Properties of Indifference Curves:
1.1.8 The reasons why the government needs to 98
intervene in the market economy 11 5.1.5 Budget Line 98
1.1.9 Traditional Economy 14 5.2 Case Study ........................................................... 100
1.1.10 Allocation of Resources 15 5.3 Summary.............................................................. 102
1.1.11 Economic Concepts 15 5.4 Exercises .............................................................. 103
1.1.12 Production Possibility Frontier 17 5.4.1 Answer the following questions 103
1.1.13 Production Possibilities Curve 17 6 Production and Production Costs ........................... 106
1.1.14 Opportunity Cost 20 6.1 Production and Production Costs ......................... 107
1.2 Case Study............................................................. 23 6.1.1 The Production Theory 107
1.3 Summary ............................................................... 25 6.1.2 Cost and Inputs 108
1.4 Exercises................................................................ 27 6.1.3 Short-Run Cost 109
1.4.1 Answer the following questions 27 6.1.4 Production in the short-run: The Law of
2 Factors of Production................................................ 31 Diminishing Marginal Returns 109
2.1 Factors of Production............................................. 32 6.1.5 Short-Run Cost Curves 110
2.1.1 Land 33 6.1.6 Marginal Cost and Average Cost 111
2.1.2 Labour 33 6.1.7 Long-Run Cost 114
2.1.3 Capital 35 6.1.8 Production in the Long-Run: The Scale of
2.1.4 Entrepreneur 37 Production 114
2.2 Case Study............................................................. 39 6.1.9 Economies of Scale (EOS) 115
2.3 Summary ............................................................... 41 6.1.10 Diseconomies of Scale (DOS) 115
2.4 Exercises................................................................ 43 6.2 Summary.............................................................. 117
2.4.1 Choose the correct answer 43 6.3 Exercises .............................................................. 118
3 Demand and Supply .................................................. 45 6.3.1 Answer the following questions 118
3.1 Demand and Supply............................................... 46 7 Market Structures.................................................... 122
3.1.1 Definition of Demand 46 7.1 Market Structures................................................. 123
3.1.2 Demand Curve and Demand Schedule 7.1.1 Perfect Competition 124
47 7.1.2 Short-Run Equilibrium in Perfect
3.1.3 Quantity Demanded (Qd) 48 Competition 125
3.1.4 The Law of Demand 50 7.1.3 Long-Run Equilibrium in Perfect
3.1.5 Changes in demand versus changes in Competition 126
quantity demanded 51 7.1.4 Entry and Exit 127
3.1.6 The Exceptional Demand Curve 54 7.1.5 Monopolistic Competition 128
3.1.7 Definition of Supply 56 7.1.6 Short-Run and Long-Run Equilibrium in
3.1.8 Supply Curve and Supply Schedule Monopolistic Competition 129
56 7.1.7 Perfect Competition versus Monopolistic
3.1.9 Quantity Supplied (Qs) 58 Competition in the Long-Run Equilibrium
3.1.10 The Law of Supply 58 131
3.1.11 Changes in supply versus changes in quantity 7.1.8 Monopoly 132
supplied 59 7.1.9 How Monopoly Arises 132
3.2 Summary ............................................................... 62 7.1.10 Monopoly in the Long-Run and Short-
3.3 Exercises................................................................ 63 Run 132
3.3.1 Answer the following questions 63 7.1.11 Perfect Competition versus Monopoly
4 Price Determination and Elasticity .......................... 66 133
4.1 Price Determination and Elasticity ........................ 67 7.1.12 Oligopoly 134
4.1.1 Price Determination 67 7.1.13 Comparison of the Market Structures
4.1.2 Market Equilibrium 67 135
4.1.3 Price Ceiling and Price Floors 70 7.2 Case Study ........................................................... 137
4.1.4 Price Elasticity of Demand (PED) 7.3 Summary.............................................................. 138
73 7.4 Exercises .............................................................. 139
4.1.5 Calculating PED 74 7.4.1 Answer the following questions 139
4.1.6 Factors Affecting the Price Elasticity of 8 Role of Government and Economic Growth
Demand 78 (Macroeconomics) .................................................... 142
4.1.7 Income Elasticity of Demand 79 8.1 Role of Government............................................. 143
4.1.8 Cross Elasticity of Demand 80 8.1.1 Economic growth and development
4.1.9 Price Elasticity of Supply 81 143
4.1.10 Factors Determining Elasticity of Supply 8.1.2 Government revenue and expenditure
83 145
4.1.11 Applications of the Concept of elasticity 8.1.3 Areas of government intervention
84 147
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8.1.4 Differences between developing and 10.1.3 Methods of Calculating National Income
developed countries 149 191
8.1.5 Problems faced by developing countries in 10.1.4 Why GDP equals to aggregate expenditure
achieving economic growth 151 and aggregate income 196
8.2 Case Study........................................................... 152 10.1.5 The Circular Flow of National Income and
8.3 Summary ............................................................. 156 Expenditure 197
9 The Banking System, Money and Inflation 10.1.6 Uses of National Income Statistics
(Macroeconomics).................................................... 158 198
9.1 The Banking System, Money and Inflation.......... 159 10.1.7 Why GDP is important? 199
9.1.1 Money 159 10.1.8 Problems in Calculating National Income
9.1.2 The Earliest Money and Barter Trade 200
159 10.2 Case Study ..................................................... 201
9.1.3 Types of Money 161 10.3 Summary........................................................ 203
9.1.4 Banking System 162 10.4 Exercises ........................................................ 205
9.1.5 Classification of Banks 163 10.4.1 Answer the following questions 205
9.1.6 Powers of the Central Bank 164 11 International Trade (Macroeconomics).................. 210
9.1.7 What is Monetary Policy? 164 11.1 International Trade ......................................... 211
9.1.8 Consumer Price Index (CPI) 166 11.1.1 Distinction between Domestic and
9.1.9 Inflation 167 International Trade 212
9.1.10 Measurements of Inflation 168 11.1.2 Advantages and Disadvantages of Trade
9.1.11 Demand-Pull Inflation and Cost-Push 214
Inflation 170 11.1.3 Absolute Advantage versus Comparative
9.1.12 Unemployment 172 Advantage 214
9.1.13 Business Cycle 176 11.1.4 Terms of Trade 216
9.2 Case Study........................................................... 178 11.1.5 Protectionism 218
9.3 Summary ............................................................. 180 11.1.6 Balance of Payments 219
9.4 Exercises.............................................................. 182 11.1.7 Foreign Exchange 221
9.4.1 Answer the following questions 182 11.2 Case Study ..................................................... 223
10 National Income and Theory of Income 11.3 Summary........................................................ 225
Determination (Macroeconomics) .......................... 188 11.4 Exercises ........................................................ 227
10.1 National Income and Theory of Income 11.4.1 Answer the following questions 227
Determination...................................................... 189
10.1.1 Definition of National Income
Accounting 189
10.1.2 Gross Domestic Product (GDP) 189
vi
1 Introduction to Economics
Introduction to Economics
Objectives
What is economics all about?
At the end of this chapter students should be able to:
Scarcity
Microeconomics and Macroeconomics • Define economics and distinguish between

microeconomics and macroeconomics
Economic Systems
Mixed Economy • Explain the three big questions of
Planned Economy microeconomics
Market Economy
Traditional Economy
• Understand the types and functions of economic
systems
Allocation of Resources • Explain how the economy can produce a limited
Economic Concepts
amount of resources and a certain level of
technology by using the production possibility
Production Possibility Frontier curve
Production Possibility Curve
• Understand the concept of opportunity cost
Opportunity Cost
1
1.1 INTRODUCTION TO ECONOMICS

1 What can you understand by the word “economics”?
The word ‘economics’ is derived from the

Greek word, “Oikonomikus”, which
means skilled in household management.
The Economist’s Dictionary of Economics

defines economics as “The study of the
production, distribution and
consumption of wealth in human
society.”
One can also view economics as the

science that deals with the production,
allocation, and the use of goods and
services.
It is important to study how resources can be best distributed to meet the needs of the greatest
number of people. The fact is that economics affects our daily lives and creates an awareness
of local, national and international economic issues: whether it be price increases, interest
rate changes, fluctuations in exchange rates, unemployment, economic recessions or balance
of payments problems.
The ultimate objective of economics is to make a feasible decision which solves the
problem of limited resources to meet the need of human beings.
1.1.1 What is economics all about?
Economics also examines how we make choices - college tuition or a new car; more
hospitals or more highways; more free time or more income from work? It gives us a way of
understanding how to make the best use of natural resources, machinery, and people’s work
efforts.
Briefly, economics is the study of making choices. In other words, economics is
concerned with how people make decisions in a world of scarcity. In analysing the economic
facts, a few core questions would help economist to solve problems and ensure optimal
utilization of limited resources.
In economics we study:
• How we decide what to produce with our limited resources.
• How we ensure stable prices and full employment of our resources.
2
• How to provide a rising standard of living both for ourselves and for future generations?
Is economics concerned with money? Yes, economics has a lot to do with money – how it is
made, lost, used and misused.
1
One important idea in economics is that of needs and wants. This would include the
need for food, clothing, shelter, health care, and etc.
Wants are what people desire or wish to

have or to experience, such as getting a car,
watching movies or receiving medical
attention.
One may need clothes, but one may not

need a dress designer. Needs are the goods
or services which are essential or basic to a
person’s life such as food, clothing and a
place to stay.
Why economics is considered a social science

It is the study of human behaviour in the context of how society allocates scarce resources
with competing uses to satisfy unlimited wants.
Since it deals with human behaviour, its laws and theories are not the same as
scientific laws; it cannot be verified under experimental conditions, but is based on empirical
observation.
1.1.2 Scarcity
The concept of scarcity is important to the definition of economics because scarcity forces
people to choose how they will use their limited resources in an attempt to satisfy their
unlimited wants and desires.
Economics is sometimes called the study of scarcity because an economic activity
would not exist if scarcity did not force people to make choices.
Scarcity means that there are not enough, or there can never be enough goods, and
services to satisfy the needs of individual, families and societies.
Scarcity requires choice. People must choose what they desire for; they will either be
satisfied or otherwise. A decision of consuming more of a good or service will lessen the
consumption of others because of limited resources.
3
1 Scarcity refers to the fact that people’s wants are

more than what is available, as neither goods nor
services are often enough.
As a society, limited resources (such as

manpower, machinery, factors of production, and
natural resources) fix a maximum on the amount
of goods and services that can be produced.
For example, an individual wants a big house and

cars. And the need for personal computers is
more important than that for video cameras. This
means that every resource needed is limited in
amount and a choice has to be made.
When there are scarcity and choice, there are costs. Central to the decision-making process is
the value of the best alternative foregone.
Economists call this opportunity cost. Making choices in a world of scarcity means
we have to pass up some goods and services to obtain those that we want.
What do we mean when we talk about cost? For example, the cost of reading is passing up
the opportunity of sleep. Because of scarcity, whenever you make a choice, you must pass up
another opportunity; you must incur an opportunity cost. We will study opportunity cost at
the end of this chapter.
When our economy does well, we, as a nation, do well. But when our economy is in
crisis or doesn’t do well, the nation suffers and we will not get the goods and services we
need or either they will be in shortage. Therefore it is important that all citizens be informed
about the economy.
The study of economics involves many subdivisions of the entire systems and the two major
ones are:
• Microeconomics
• Macroeconomics
1.1.3 Microeconomics and Macroeconomics
Some economists believe that in order to really understand macroeconomics, you must fully
understand microeconomics.
How does microeconomics relate to macroeconomics? Let us look at the differences
between microeconomics and macroeconomics.
4
Microeconomics Macroeconomics
1
• Microeconomics is the study of • Macroeconomics is the study of the
individual decision-making units and entire economy in terms of the total
markets within the economy. amount of goods and services produced,
total income earned, the level of
• It looks at decision-making and how it employment of productive resources, and
influences the behaviour of individual in the general price level.
businesses and households.
• It is concerned with the economy as a
• It focuses on the specific expenditure and whole. It is the branch of economics that
decisions of individual consumers and the studies the overall level of prices, output
forces (tastes, prices, incomes) that and employment in the economy
influence those decisions. inclusive of the following:
• Microeconomics is the components of the ¾ Inflation

larger economy - the details of
macroeconomics. ¾ Recession
• The key questions about ¾ Balance of trade

microeconomics:
¾ Unemployment
• How to utilize resources most
efficiently? • The key questions about
macroeconomics:
¾ What goods and services to
produce? ¾ What determines the standard of
o What will be the demand living?
and supply?
¾ What determines the cost of
¾ How are goods and services living?
produced?
o Where to get the ¾ Why does our economy fluctuate?
resources? Is it scarcity or
otherwise? • Macroeconomics can be used to analyze
o The resources that how best to influence policy goals such as
businesses use to produce economic growth, price stability, full
goods and services are employment and the attainment of a
from the factors of sustainable balance of payments.
production such as land,
labour, capital and
entrepreneur.
¾ For whom are goods and services

produced?
o Who gets the goods and
services?
o Land earns rent
5
o Labour earns wages
1 o Capital earns interest

o Entrepreneurship
profit
earns
• How to allocate the goods and services

that are produced?
¾ Where there is consumer demand

and producer supply, in a market
economy, goods and services are
allocated based on the ability to
pay.
Chapter 2 will cover the area on Factors of Production, and Macroeconomics, from Chapter 8
to 11.
1.1.4 Economic Systems
An economic system is the way in which an economy is organized to make the basic
economic decisions. It can be said as a mechanism which deals with the production,
distribution and consumption of goods and services in a particular society.
An economic system is composed of people, institution, and their relationship to
resources, and it addresses the problems of economics such as the allocation and scarcity of
resources. It is a way of answering these basic questions. Different economic systems answer
them differently.
The main economic decision-makers are households, with firms, governments, and the rest
of the world serving as supporting actors.
Households are considered to be the lead actors since they supply resources used in
the production, and demand goods and services produced by other actors.
Firms, governments, and the rest of the world are supporting actors because they
demand the resources that households supply and use them to produce and supply the goods
that households demand.
How these basic economic questions are answered determines which sort of economic system
will be followed. The most basic and general economic systems are:
• Mixed economy • Market economy
6
• Planned economy • Traditional economy

Let’s take a look at Figure 1-1 which shows the three key questions of microeconomics and
ends up with the concept of various economic systems. 1
Figure 1-1 Shows how scarcity is created and how the answers to the three basic economic questions
(what, how and who) lead to philosophically different economic systems
1.1.5 Mixed Economy
Mixed economy is an economic system with some combination of market and centralized
decision making. In this economy the government and the private sector jointly solve
economic problems. Thus, most of the real-world economies are a mixture of the two
systems.
The government will not intervene in all but four areas:
• The business sector • Output market

• The household sector • Input market
Even countries, like US, which practices more

enthusiastically the free market or capitalist
approach, still have substantial levels of
government activity in the public goods and
services, and the regulation of markets.
7
1 As for China, it is theoretically a

communist economy, yet they are now
developing into private enterprises.
Malaysia is a good example of a mixed

economy since government intervention
in market is almost equal. Economic
policies are mostly made in a mixed
fashion including partial intervention.
Free market is a market in which the government does not intervene.
1.1.6 Planned Economy
Planned economy is also termed as “command economy” in which the basic economic
decisions are made by the planners rather than by private individuals and businesses. In this
economy, everything is controlled by the government and there is no private sector.
In this economy a government planning office decides what will be produced, how
it will be produced, and for whom it will be produced.
Consumers have no choice but to accept what has been decided by the government or
the central authority. Such planning is complicated. The planned economy is usually
associated with the socialist or communist economic system, where land and capital are
collectively owned.
• Communism – Planned economic system in which the government owns and operates all
major sources of production.
• Socialism – Planned economic system in which the government owns and operates
selected major sources of production.
However, countries like China, Cuba,

North Korea and those countries from the
Soviet Bloc have a large measure of central
directions and planning.
The state owns factories and land, and
decisions are made by them about what
people should consume, how goods should
be produced, and how people should work.
8
Imagine that you had to run by command

in the city which you live – the food,
1
clothing, and housing allocation decisions
you would have to make! It means that
consumers have no choice but to accept
what has been decided by the government.
A fundamental problem with this economy is that it is impossible to plan for everything, so
lots of things fall between the cracks. This economy usually suffers a shortage of spare parts,
because no one plans for machine break downs. Secondary effects, such as environmental
impact, are often ignored.
Furthermore, planners do not have control of the purchase of goods, so they have to
guess what consumers really want. Individuals have little incentive to address these problems,
because on meeting planned targets they would be rewarded, not on improving the overall
system.
Table 1-1 Strengths and Weaknesses of Planned Economy
(Source: Patrick J Welch & Gerry F Welch, 2004)
1.1.7 Market Economy
A market economy (also known as free market economy and free enterprise economy) is
an economic system in which the production and distribution of goods and services take place
through the mechanism of free market guided by a free price system rather than like a
planned economy.
9
1 It refers to the study of an economy in which

the basic economic decisions are made by the
individual buyers and sellers in markets using
the language of price.
It also refers to the study of business

decisions based on decision makers’
knowledge of the external environment.
Also called a price system market; one in which buyers and sellers communicate through
prices in markets.
Before we proceed, every student should know what a market means
• A market is defined as a place or situation in which buyers and sellers of a product

interact for the purpose of exchange.
• The distinguishing characteristics of each of the market models are centred on three areas,
that is: number of sellers; product type; entry and exit.
These three areas are important for determining the type and amount of competition that
exist in a market.
For example, Mc Donald’s is trying to sell

Big Macs by making them available at a
particular price, and students tell Mc
Donald’s that they want Big Macs by paying
the price asked. The exchange of the burger
is made because the price is suitable to both
the buyer and seller.
Market economy may be practical, but it also depends on the fundamental principles of
individual freedom:
• Freedom as a consumer to choose among competing products and services.
• Freedom as a producer to start or expand a business and share its risks and rewards.
• Freedom as a worker to choose a job or career, join labour union, or change employers.
It is possible for a market economy to have government intervention in the economy.
10
1.1.8 The reasons why the government needs to intervene in the

market economy
1
In a market economy, the private sector is not willing to supply public goods such as street
lights, road signs, defensive device and etc. There will be problem of free riders where
people who want to make use of goods but refuse to pay for them. This is the reason why
public goods have to be provided by the government.
The government has to curb the power of the monopoly both from economic and
political viewpoints.
What is monopoly? The term “monopolist” is a sole trader who is the only one seller
of a good but there are many buyers. The monopolist or the sole trader tends to exploit the
consumer by charging higher prices and lower output.
The government can attempt to ensure an equitable income distribution in the economy. They
will impose high direct taxes on the rich and give subsidies to the poor.
In the market economy there are no provisions made for the disabled, the
unemployed, the elderly or even children living in poverty. So, when the government
intervenes there will be a protection for such people.
Now let us look at Figure 1-2 illustrating the Circular Flow Model - the real and
money flows between households and businesses in output – product, markets and input –
resource and markets.
This model shows how business

(firms) and households relate to
one another as buyers and sellers.
Firms choose the quantities of the
various goods and services to
produce.
Households choose the quantities

of labour, land, capital and
entrepreneurship to sell or rent to
firms in exchange for wages, rent,
interest, and profit.
Households then spend their

incomes on consumption of
goods, in taxes paid to
governments and on assets that
flow through the financial sector
and are then used to buy
investment and other goods. Figure 1-2 Circular Flow Model
11
Households as resource suppliers:
1 • Use limited resources: labour, capital, land and entrepreneurial ability to satisfy unlimited
wants.
• Use these resources to produce goods and services in the home.
• Sell these resources in the resource market to earn income.
Households as demanders for goods and services:
• Households spend over 70% of their income on consumption of goods which include:
¾ Durable goods – automobiles, refrigerators, etc.
¾ Non-durable goods – food, clothing, etc.
¾ Services – medical care, haircuts, travel, etc.
As mentioned in the planned economy, the government’s economic planners, production

experts, and political officials establish production levels for goods and designate which
factories will produce them.
They will also establish the prices for the shirts and blouses, as well as the wages for
the workers who make them. Predictably, the products are limited and sell out quickly,
disappearing from store. Why? It is because factories fail to meet their production quotas.
This phenomenon doesn’t happen in the market economies, because that kind of
economic system works in a very different way. Economic decisions on what, how and who
are handled by the business (management) itself.
No ministry decides how many shirts or blouses to manufacture, or styles and colours.
Any one individual or company can decide to produce and sell shirts and blouses, and many
will do just that if they believe they can sell these products at prices high enough to cover
their production costs.
The market economy and the free price system make goods from around the world
available to consumers. It also gives the largest possible scope to entrepreneurs, who risk
capital to allocate resources so as to satisfy the future desires of the mass of consumers as
efficiently as possible.
The Malaysian economy is a small and relatively open economy. In 2005 Malaysia was the
33rd largest economy by purchasing power parity where its gross domestic product (GDP)
for 2005 was estimated to be RM290 billion. Some of the visible projects from that period are
Putrajaya, Kuala Lumpur International Airport (a new international airport), a hydroelectric
dam (Bakun dam), the Petronas Towers and the Multimedia Super Corridor.
12
Kuala Lumpur’s Landmark, The Kuala Lumpur Tower

The Petronas Twin Towers
Table 1-2 Strengths and Weaknesses of Market Economy
13
1.1.9 Traditional Economy
1 Traditional economy relies largely on tradition, custom or ritual when making the basic
economic decisions. The decisions such as the who, how, what and for whom questions are
all made on the basis of custom, beliefs, religion, habit, etc.
Some economists view economies in Saudi

Arabia, parts of Pakistan and India, Iran, Iraq,
Afghanistan, Native Americans, South
America and Africa as examples of
economies that maintain some elements of
traditional economies. Their people are still
making clothing and shelter exactly the same
way as they did in the past.
Example: “This is what my grandfather did

and what his grandfather did…..” Boys tend
to take up the occupations of their father,
while girls stay at home with their mother.
There may be little room for freedom,
innovation, or change.
It is very hard to say that this system is not for the most part, market driven. Even Saudi
Arabia produces and markets its oil using some element in traditional system thus it is
market driven.
Table 1-3 Strengths and Weaknesses of Traditional Economy
14
1.1.10 Allocation of Resources
Allocation of resources is an apportionment of productive assets among uses. The aim is

always to allocate resources in such a way as to obtain the maximum possible output from a
1
given combination of resources.
Resource allocation is important in economics because the resources of a society are
in limited supply, whereas human wants are usually unlimited.
The allocation is determined by the three key words:
• What to produce? Consumers have the purchasing power to dictate the types of goods.
• How to produce? It depends on the cheapest method of production, where the producer
will use the least input to produce a given level of output.
• For whom to produce? Those having the purchasing power will eventually get the goods
that have been produced.
Factors of production/resources – these are those elements that a nation has at its disposal to
deal with the issue of scarcity. How efficiently these are used determines the measure of
success a nation attains.
Factors of Production consists of:
• Land and raw materials – natural

resources, etc
• Capital – investment monies
• Labour – human capital, the work force;

size, education, quality, work ethic
• Entrepreneurs – inventive and risk

taking spirit
We will cover in details the area on Factors of Production in Chapter Two.
1.1.11 Economic Concepts
Every economy, in order to produce and consume, needs to address basic issues such as the
following:
• The goods and services that should be produced and in what quantities.
15
• The scarce resources such as labour and capital should be allocated to produce goods and
services.
1 • The availability of supplies of goods and services that should be distributed across the
population.
• The price that should be charged for goods or services.
Fundamentals of Economic concepts (microeconomic level):
• Scarcity. The result of not enough goods and services to satisfy all wants and needs.
• Choice. Scope of making your own choice.
• Supply. The different amounts of a product that a seller wish to sell at different prices in a
given time period.
• Demand. The different amounts of a product that a buyer wishes to purchase at different
prices over a given period.
• Consumers. Emphasizes consumers as individuals and household members.
• Producers. Who creates utility or helps bring it into existence which supports human life.
The earth, of course, is the real producer. For example, the crops and livestock produced
in the agriculture sector become food products in the manufacturing sector, and then
moved to households through the wholesale and retail trade.
• Natural resources. Land, fish, wildlife, air, water, groundwater, drinking water supplies,
and other such resources are included in natural resources. Natural resources are
renewable.
• Money. Generally accepted means of payment for delivery of goods or settlement of debt.
It is the medium of exchange.
• Pricing. Measurable value to measure the flow of supply and demand.
• Markets. Composed of firms selling products and competing for the same group of
buyers.
• Specialization of labour. Allow a nation to produce more with its supply of labour and
resources.
• Barter trade. Barter trade has a medium of exchange. Goods are swapped for other goods.
• Public goods. A good or service that has the features of non-rivalry and inexclusiveness
and as a result would not be provided by the free market. Examples are street lighting,
flood-control dams, pavement, public drainage, lighthouse, and public services such as
defence and law enforcement.
16
1.1.12 Production Possibility Frontier
The production possibility frontier (PPF) is the boundary between those combinations of
goods and services that can be produced and those that cannot. It is the simplest way to
1
represent the basic production decision: “How much of each good should be produced?”
The entire production system is represented by two alternative goods. Any combination (or
mix) of these two goods can be produced, within the limitations of existing resources and
technology.
The PPF is a curve depicting all maximum output possibilities of two or more goods
given a set of inputs (resources, labour, etc). The PPF assumes that all inputs are used
efficiently.
1.1.13 Production Possibilities Curve
The production possibilities curve is a simple model designed to show the production
capabilities of an economy given current resources. Three factors to consider:
1. an increase or improvement in technology
2. the employment of migrant workers (that is, an increase in labour force)
3. an increase in population
Figure 1-3 shows the production outside the curve is unattainable, given existing resources
and technology.
Production inside the curve is attainable (inefficient), since resources (including
labour) and/or technologies are under-utilized. The economy is not efficient and the resources
are not fully utilized or optimally used. In other words, unemployment exists (unemployment
is a condition where some available resources are not being used in the production of goods
and services).
Production on the curve (efficient) represents all of the possible mixes of maximum
output for both goods. Here all resources and technologies are fully and efficiently used.
17
Figure 1-3 The Production Possibilities Curve
What can shift the PPF?
• Economic growth – is reflected by an outward shift in the PPF.
• Changes in resource availability – people working longer hours, wars.
• Capital stock – more capital goods produced during this period results in an outward shift
of the PPF in the next period.
• Technology – discoveries that will employ resources more efficiently.
Example:
Under what conditions is it possible to increase production of one good without decreasing
production of another?
An economy can produce more of one good without sacrificing production of other goods if it
is operating inside its PPF. The economy is inside the PPF when some resources are idle or
when they are allocated efficiently. Therefore, production can be increased by using more of
the idle resources or by allocating resources more efficiently.
The PPF model is commonly used to illustrate the optimal mix between security and food
referred to as “Guns and Butter”. We must give up some guns to get more butter or give up
some butter to get more guns.
Let us look at the example shown in Figure 1-4 .
18
Figure 1-4 shows some combinations of the

quantities of butter and guns that can be
produced.
1
The x-axis shows the quantities of butter
produced, and y-axis shows the quantity of
guns produced.
Because PPF shows the limit of production,

we cannot attain the points outside the
frontier. They are points that describe wants
that cannot be attained.
We can produce all the points inside the

Figure 1-4 The PPF Model of Guns and Butter PPF and on the PPF- they are attainable
points.
Let us look at another example of PPF shown below.
This boundary (Figure 1.5) is what we can attain and what we cannot attain and it is
defined as trade-off. Every choice along the PPF involves a trade-off – we must give up
something to get something else.
Trade-off arises in every imaginable real world situation. By using our available
technologies, we can employ the factors of production (land, labour, capital and entrepreneur)
to produce goods and services. But we are limited in what we produce.
Figure 1-5 illustrates some combinations

of the quantities of Product A (y-axis) and
Product B (x-axis) that can be produced.
As indicated point A, B, and C represent

the points at which production of good A
and good B is most efficient.
The line passing through these points (A-

C) is the PPF. It separates the attainable
(X) from the unattainable (Y).
Point X demonstrates the point where

resources use are inefficient, or are not
being used in the efficient production of
both goods.
Point Y demonstrates an output that is Figure 1-5 The PPF Model of Product A, B, and C
unattainable with the given inputs.
19
Examples of trade-off are:

1 • When your parents say that you should study more, they are suggesting a trade off: more
study time for less leisure or sleep.
• When doctors say that we must spend more on AIDS and cancer research, they are
suggesting a trade off: more medical research for less of some other things.
• When the Prime Minister says that he wants to spend more on education and health care,
he is suggesting a trade off.
All trade-offs involve a cost – known as opportunity cost.
1.1.14 Opportunity Cost
Opportunity cost can be defined as the next best alternative foregone. It is the cost or decision
measured of any choice options that a person gives up.
For example, if you give up the option of playing a computer game to read this text,
the cost of reading this text is the enjoyment you would have received rather than playing the
game.
One can view that the cost of choosing an option as the sacrifice involved in rejecting
the other choice (which are the benefits one loses when one rejects the other choice).
Opportunity cost can also be known as the real cost of the goods.
• Example of opportunity cost for the

individual:
¾ To work or waste time or leisure
¾ Present consumptions or savings
¾ Doing homework or playing games
• Example of opportunity cost of a government:
¾ Civilian goods or military goods
¾ Foreigners or local
20
• Example of opportunity cost of a producer: 1

¾ Labour
¾ Capital
Opportunity cost also relates to the cost of pursuing one alternative versus another. When
economists refer to the “opportunity cost” of a resource, they mean the value of the next
highest value alternative use of that resource.
If, for example, you spend time and money going to a movie, you cannot spend that time at
home reading a book, and you can’t spend the money on something else. If your next best
alternative to seeing the movie is reading the book, then the opportunity cost of seeing the
movie is the money spent plus the pleasure you forego by not reading the book.
Technically, the opportunity cost is not limited to the cost of investing the money, but also
includes any other opportunity you could spend the money on (investing, buying something
else, saving the money, etc).
Example 1.
If you were going to spend RM500 on a new bike, the opportunity cost would be that you
would not be able to buy anything else with or invest that RM500. For the purpose of
financial planning, you should look at the cost versus the benefit of each decision you make.
In this case, you would spend RM500 on the bike or you could invest the RM500 in a savings
account. In five years, the bike will be worth RM25 and the RM500 investment will be worth
RM650 (including interest). The opportunity cost of buying a bike is the long-term benefit
21
that you will receive if you did not buy the bike and invested it instead.
Example 2.
When governments subsidize college education, most students still pay more than half of the
cost. Take a student who pays RM2,000 in tuition at a college. Assume that the government
subsidy to the college amounts to RM5,000 per student. It looks as if the cost is RM7,000 and
the student pays less than half. But looks are deceiving. The true cost is RM7,000 plus the
income the student foregoes by attending school rather than working. If the student could
have earned RM15,000 per year, than the true cost of the education is RM7,000 plus
RM15,000. Of this RM22,000 total, the student pays RM17,000 (RM15,000 plus RM2,000.)
Both of the examples have powerful implications on the opportunity cost.

What about the cost of room and board while attending school? This is not a true cost
of attending school at all, because whether or not the student attends school, someone must
pay for room and board.
Opportunity cost is expressed in relative price, that is, the price of one choice relative
to the price of another.
For example, if milk costs RM4 per gallon and bread costs RM2 per loaf, then the relative
price of milk is 2 loaves of bread. If a consumer goes to the grocery store with only RM4 and
buys a gallon of milk with it, then one can say that the opportunity cost of that gallon of milk
was 2 loaves of bread (assuming that bread was the next best alternative).
22
1.2 CASE STUDY

1
The opportunity costs of studying economics
What are you sacrificing?
You may not have realised it, but you probably consider opportunity costs many times a
day. The reason is that we are constantly making choices: what to buy, what to eat, what
to wear, whether to go out, how much to study and so on. Each time we make such
choice, we are in effect rejecting some alternative. This alternative foregone is the
opportunity cost of the action we chose.
Sometimes the opportunity cost of our actions are the direct monetary costs we incur.
Sometimes it is more complicated.
Take the opportunity costs of your choices as a student of economics.
Buying a textbook costing RM69.96
This does involve a direct money payment. What you have to consider is the alternatives
you could have bought with the RM69.95. You then have to weigh the benefit from the
best alternative against the benefit of the textbook.
1. What might prevent you from making the best decision?
Coming to classes
You will be paying tuition fees. Thus there is no extra (marginal) monetary cost in
coming to classes once the fees have been paid. You will not get a refund by skipping
classes!
So are the opportunity costs zero? No: by coming to classes you are not working in the
library; you are not having an extra hour in bed; you are not sitting drinking coffee with
friends, and so on. If you are making a rational decision to come to classes, then you will
consider such possible alternatives.
2. If there are several other things you could have done, is the opportunity cost the sum
of all of them?
Choosing to study at university or college
What are the opportunity costs of being a student in higher education? At first it might
seem that the cost would include the following:
• tuition fees
23
1 •
•
books, stationery and so on
accommodation expenses
• transport
• food, entertainment and other living expenses.
But adding these up does not give the opportunity cost. The opportunity cost is the
sacrifice entailed by going to university or college rather than doing something else. Let
us assume that the alternative is to take a job that has been offered. The correct list of
opportunity costs of higher education would include:
• tuition fees
• books, stationery and so on
• additional accommodation and transport expenses over what would have been
incurred by taking the job
• wages
3. Why is the cost of food not included?
4. Make a list of the benefits of higher education.
5. Is the opportunity cost to the individual of attending higher education different from
the opportunity costs to society as a whole?
(Source: Sloman & Norris, 2005)
24
1.3 SUMMARY
The subject of economics is usually divided into two main branches:

1
• Microeconomics deals with the activities of individual units within the economy: firms,
industries, consumer, workers, etc.
• Macroeconomics deals with aggregate such as the overall levels of unemployment, output
growth and prices in the economy.
Economics is all about:
• What goods and services are going to be produced and in what quantities?
• How are things going to be produced, given that there is normally more than one product?
• For whom are things going to be produced?
Scarcity means that there are not enough, or there can never be enough goods, and services to
satisfy the needs of individual, families and societies.
Mixed economic systems combine elements of market and centralized (planned) decisions.
Mixed economies arise in respond to planning and market failures.
Modern economies are mixed, relying on the market but with a large dose of government
intervention.
In planned economy, government planners make the basic economic decisions. Planned
economies can allow societies to achieve non-economic goals more easily than in market
economies, can limit unemployment, and can provide for a more equal distribution of
goods/services if that is the goal of society.
In a market economy, buyers and sellers communicate their wants and needs in markets, and
the language they communicate are the prices.
A market economy will only produce goods and services if buyers demand them at a price
that allows sellers to produce them at a profit.
Economists use a circular flow model to illustrate the basic structure of a market economy.
The circular flow of goods and incomes shows the interrelationships between firms and
households relate to one another, as buyers and sellers in output and input markets. The
circular flow model also identifies where government can intervene in the market economy to
correct problems or improve conditions.
The central economic problem is that of scarcity. Given that there is a limited supply of
factors of production, it is impossible to provide everybody with everything they want. These
factors of production are of three broad types:
25
• Labour – human resources
1 • Land and raw materials – natural resources
• Capital – physical assets – factory, machinery, management
Economic concepts:
• Scarcity
• Choice
• Consumers
• Producers
• Natural resources; human resources; capital resources
• Pricing
• Markets and etc.
The Production Possibility Frontier (PPF) shows the possible combinations of two goods that
a country/business can produce in a given period of time.
It shows the maximum amount of one good that can be produced given the output of the other
goods. It depicts the trade-off or menu of choices for society in deciding what to produce.
Resources are scarce and points outside the frontier are unattainable. It is sufficient to
produce within the frontier.
The boundary shows in the PPF on what we can attain and what we cannot attain is defined
as trade-off. Every choice along the PPF involves a trade-off – we must give up something to
get something else.
The opportunity cost of a good is the quantity of other goods sacrificed to make an additional
unit of the good. It represents the slope of the PPF.
26
1.4 EXERCISES
1
1.4.1 Answer the following questions
1. The science that deals with the production, allocation, and use of goods and services,
and how resources can best be distributed to meet the needs of the greatest number of
people is ________________.
a. Biology
b. Psychology
c. Economics
2. The study of the entire system of economics is ____________________.
a. Macroeconomics
b. Microeconomics
c. Finance
3. The study of how the economic system affects one’s business or the study of parts of the
economic system is __________________.
a. Microeconomics
b. Macroeconomics
c. Business organization
4. Goods and services that are necessary for living such as food, clothing, and shelter are
_____________________.
a. needs
b. wants
c. advertising
5. Goods and services that are not necessary for living such as toys, games, and
entertainment are ___________________.
a. needs
b. wants
c. advertising
6. This is an important part of economics that helps to ensure people’s needs and wants are
met.
a. Scarcity
b. Advertising
c. Distribution
27
7. A time when there are not enough goods and services to meet people’s need and wants is
_____________________.
1 a. scarcity
b. advertising
c. distribution
8. A person who supports a centrally planned economy would most value ____________.
a. competition
b. cooperation
c. individuality
d. materialism
9. The production possibilities frontier illustrates the _________________________

_______________________________.
a. resources the economy process, but not its level of technology.

b. limits to people wants.
c. maximum combinations of goods and services that can be produced.
d. goods and services that people want.
10. In order for Malaysia to grow more durians, textile production must decrease. This
situation is an example of _________________.
a. a free lunch
b. opportunity benefit
c. a trade off
d. zero opportunity cost
11. A recession, during which unemployment increases, will place an economy

________________________________________.
a. outside its production possibilities frontier.

b. on the production possibility curve but moved a little upwards.
c. on the production possibility curve but moved a little downwards.
d. inside its production possibility frontier.
12. Which economic feature often results from the use of the other three features?
a. profit
b. labour
c. land
d. capital
13. Why does a nation experience increasing opportunity cost?
a. Resources are not equally efficient in producing different kinds of goods and
services.
b. As the nation moves from a production point within the PPF to one on the PPF,
opportunity costs increase.
28
c. As the nation moves from a production point within the PPF to another point also
within the PPF, opportunity costs increase.
d. When the amount of resources increases, the opportunity cost of all goods and
services increases.
1
14. A country has a comparative advantage in the production of a good if it can
_______________.
a. produce more of the goods than another country.

b. trade-off producing the goods for another good.
c. produce the goods at the lowest opportunity cost.
d. produce more of the goods most efficiently.
15. In the circular flow diagram, if Ringgit payments flow to businesses, what flows back to
households?
a. labour
b. labour and other resources
c. goods and services
d. payments to factors of production
16. What can you understand by opportunity cost, and give an example.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
17. What is production possibility curve (PPC)?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
29
30
2 Factors of Production
Factors of Production
Objectives
Land
Labour
Capital • Understand the factors of production

• Understand and define land
Entrepreneur
• Understand and define labour
• Understand and define capital
• Understand and define entrepreneurship
31
2.1 FACTORS OF PRODUCTION
Factors of production are also called productive resources. Factors of production are the
resources used in producing goods and services to meet human wants. Economic resources
2 are relatively scarce to the infinite needs and wants of people and businesses operating in the
economy. It is important to use these resources efficiently in order to maximize the output.
Productivity is a measure relating a quantity or quality of output to the inputs
required to produce. For example, labour productivity, which can be measured by quantity of
output per numbers of worker.
Production refers to the transformation of inputs (labour, land) to outputs (any
product) by firms in order to earn profit.
In a market economy, entrepreneurs combine land, labour, and capital to make profit.
In a planned economy, central planners decide how land, labour, and capital should be used
to provide for maximum benefit for all citizens.
Economists make a distinction between four types of resources:
• Land – naturally-occurring goods such as soil and minerals that are used in the creation
of products. The payment for land is rent.
• Labour – human effort used in production which also includes technical and marketing
expertise. The payment for labour is wage or salary.
• Capital – human-made goods (or means of production) which are used in the production
of other goods. These include machinery, tools and buildings. In a general sense, the
payment for capital is called interest.
• Entrepreneurship – skill of organizing and operating economic activities such as profit

making business initiatives. Usually entrepreneurs are risk takers to start and manage
business activities.
Consider labour and entrepreneurial ability: both are people, a person who represents
labour today might be willing to take a risk and organize production tomorrow, becoming
an entrepreneur. Labour and capital: capital is production factor of production, but some
labour is also produced through education and training - some labour is actually capital,
human capital attached to people. Human capital - the skill and knowledge of people, it
comes from education, on the job training, and work experience.
32
2.1.1 Land
Land is a kind of factor of production which is natural and provided only by nature: e.g.,
unimproved land and mineral deposits (oil and gas, iron ore, coal, copper) in the ground.
Other raw materials or primary product such as agricultural crops, forest products,
fisheries products and so on are also produced using land as input.
2
• Land has the following characteristics:
¾ It is a durable asset
¾ It is limited in supply
¾ It is a gift of nature
¾ It is said to be immobile
¾ It is owned by people but can be

rented out
2.1.2 Labour
The terms labour and human resources have essentially the same meaning and often used
synonymously. The human inputs (including technical and marketing expertise) are involved
in production.
A simple definition of labour is all forms of human input, both physical and mental, in
current production. Labour is also limited as a factor of production.
There are two important points to remember about labour as a factor of production:
• A housewife or a keen gardener produce goods and services, but she/he does not get paid
for them. She/he is producing non-marketed output and the her/his output is not included
in GDP (Gross Domestic Product which means the total production of an economy in a
year. GDP will be discussed elaborately in the macroeconomic section).
• Not all labour is of the same quality. Some workers are more productive than others
because of their education, training and experience.
33
The manufacturing, construction, transport and communication and service sectors utilize
human resource in skilled or unskilled form. Labour force and quality of labour are basic
issues in strengthening national economy.
•
2 Labour has the following characteristics:
¾ A labourer offers his services
¾ Labour services cannot be kept or

stored
¾ Labour has greater mobility than land
¾ Labour is not homogeneous product

(different people have different skills
and attitude)
The value of labour like all the factors of production is determined by a few factors such as:
• Total supply
• Elasticity of supply
• Elasticity of demand for product using factors; and
• Physical productivity of factor
Malaysia has a population of approximately 23.8

million. The economy grew 8.3 percent in 2000, but
slowed in 2001 to a growth rate of 0.4 percent
growth. Malaysian’s services and manufacturing
accounted for 49.6 percent and 31.5 percent of the
GDP. The unemployment rate was approximately
3.6 percent in 2001.
Over recent years there has been a sustained

increase in the employed labour force – providing
more labour resources with which to increase total
outputs (GDP – Gross Domestic Product). The
Malaysian economy maintained its momentum
growing 7.1% (real GDP) in 2004, after expanding
5.3% in 2003. The better than expected expansion in
2004 was fuelled primarily by the continuing
strength of the manufacturing sector, particularly
the electronics and chemical industries.
34
2.1.3 Capital
Capital refers to the machines, factories, tools and so on which are used as input in producing
other goods and services. It is something owned which provides ongoing services.
In the national accounts, or to firms, capital is made up of durable investment goods,
normally summed up in units of money. Broadly: land plus physical structures plus
equipment. The idea is used in models and in the national accounts. 2
The wages for workers as well as any machinery and equipment, computers, office furniture
and all other goods that are used in the production of good and services. Capital makes labour
more productive.
• Capital has the following characteristics:
¾ It is a durable asset
¾ It is owned by people but can be

rented out
¾ Capital factor and services are

generated over a production period
¾ Capital goods first have to be

produced
• There are three types of capital:
¾ Fixed capital
¾ Working capital
¾ Social capital
35
• Fixed Capital
¾ Fixed capital is a physical asset or durable which does not vary as the level of
output varies. It will not change in the production process even if the output is
zero.
2 ¾ Fixed capital is sometimes known as supplementary, indirect or overhead factor.

Examples are machinery, plant and equipment, new technology, factories and
buildings – all goods designed to increase the productivity potential of the
economy in the future.
¾ We can include the social capital created from Government investment spending,
i.e. the building of new schools, universities, hospital and spending on expanding
the national road network.
• Working Capital
¾ Working capital is the stock of goods that vary with the level of output. When
output increases, the working capital also increases. When output is zero, the
amount of working capital will be zero also.
¾ Working capital includes stocks of finished and semi-finished goods

(components) that will be either consumed in the near future or will be made into
finished consumer goods.
¾ Working capital is the amount we need to pay for the day-to-day operating costs
of our business.
36
• Social Capital
¾ Social capital is normally provided by the government. It includes educational,

medical, housing and recreational centre.
¾ Social capital is not directly related to production of goods and services, but to
increase the productivity of the general workers, that is labour force of the
country.
2
2.1.4 Entrepreneur
There are a variety of definitions of the concept of entrepreneurship. Most commonly, an

entrepreneur is a person who has skills of creative decision-making, risk-taking or starting a
business venture.
The Entrepreneurial skills of an entrepreneur help in organizing or bringing other
factors together and the entrepreneur takes the risk of success or failure. Without an
entrepreneur’s efforts, a new business ventures does not occur. Understanding the factor of
entrepreneurship is an important part of understanding the dynamics of the market economy.
The entrepreneur can be an individual or a group. It is the entrepreneur who sees new
opportunities to satisfy a demand and who finds new, better way or less-costly ways to use
resources. An entrepreneur also finds new ways to meet consumer demands in order to earn a
profit.
37
Give an example of the factors of production as inputs in the production process.
1. List the inputs involved in the supply of cakes by a confectionery.
2. Classify these inputs according to the four factors of production.

2 Solution:
• Land – shop space, eggs. Land may be regarded as any input provided directly by nature.
We may classify eggs as land in the sense that it derived directly from nature too. The
physical building which forms the shop should be classified as capital since it is man-
made. However, we may regard the space it occupies as land.
• Labour – baker, cashier, sales assistant.
• Capital – oven, flour, baking powder, cream, sugar, egg-beater, and tray.
• Entrepreneur - confectionary owner.
38
2.2 CASE STUDY
Green Economics
Taking account of factors of production 2
People have become concerned by a number of environmental problems in recent years.
These include the following:
• Land and river pollution. The tipping of toxic waste into the ground or rivers can
cause long-term environmental damage. Soils can be poisoned; rivers and seas can
become polluted. It is not just industry that is to be blamed here. Sewage pollutes
rivers and seas. Nitrogen run-off and slurry deposits from farming are also major
pollutants.
• Acid rain. This is caused by sulphur and nitrogen emissions from power stations,
industry and cars. An irresponsible company has been blamed for forest death and the
contamination of many lakes and streams, with the death of fish and plant life.
• The greenhouse effect. This is caused by carbon dioxide and other gases emitted
again by power stations, various industries and cars. The fear is that these gases will
cause a heating of the Earth's atmosphere. This will lead to climatic changes which
will affect food production. It will also lead to a raising of sea levels and flooding as
part of the polar ice caps melts.
• Nuclear radiation. The fear is that accidents or sabotage at nuclear power stations
could cause dangerous releases of radiation. The disposal of nuclear waste is another
environmental problem.
It was not until the late 1960s and early 1970s that the environment became more firmly
part of the political agenda in most industrial countries. The government realised that if
economic growth was to be sustained then environmental damage could grow at an
alarming rate.
The problems that the government has encountered in attempting to change attitudes and
economic strategies have been equally pressing. The costs of pollution ignorance are
high, especially in the short-run. As long as these short-run costs are greater than the
perceived costs of continuing pollution, the industry and government will continue to
incur them. The consequences of this, however, could be irreversible and are far more
costly in the long-run, in both a financial and an environmental sense.
What can economists say about the causes of these environmental problems? They have
three common features:
• Ignorance. It is often not till many years later that the nature and causes of
environmental damage are realised.
39
• The polluters do not pay. The costs of pollution are rarely paid by the polluters.
Economists call such costs as the external costs. Since polluters rarely pay to clean
up their pollution or compensate those who suffer, they frequently ignore the
2 problem.
• Present gains for future costs. The environmental costs of industrialisation often build
up slowly and do not become critical for many years. The benefits of
industrialisation, however, are more immediate. Thus the government, consumers and
industries are frequently prepared to continue with various practices and leave future
generations to worry about their environmental consequences. The problem then is a
reflection of the importance people attach to the present relative to the future.
Environmentalists recognise these problems and try through the political process and
various pressure groups, to reduce people’s ignorance and to change their attitudes.
They stress the need for clean technologies, for environmentally sound growth and for
greater responsibility by industry, consumers and government alike. Policies, they argue,
should prevent problems occurring and not merely be a reaction to them once they are
nearing a crisis point. If growth is to be sustainable into the long-term, with a real
increase in the quality of life, then current growth must not be at the expenses of the
environment.
The environmentalist’s claim is that far too little is being done. The cost of coping with
environmental degradation will continue to grow, even if the current international
agreements are implemented.
Discuss the mentioned case study
1. Should all polluting activities be banned?
2. Could pollution ever be justified?
3. Will the environmental problems be improved by using modern technology?
Explain your answer in relation to the four types of resources.
(Source: Sloman and Sutcliffe, 2003/2005)
40
2.3 SUMMARY
Factors of production are also called productive resources.
The four types of resources are:
• Land (natural resources)

2
• Labour (human resources)
• Capital (man-made)
• Entrepreneur (individual or group)
The concepts of production refer to:
• Manufacturing of goods
• Distributing the goods produced
• Providing services
Natural resources are not human made, but it is a gift of nature.
In economics, land includes natural resources such as soil, water, plants and minerals
available for production.
In economics, labour refers to human inputs, that is, services and rewards received.
Labour is not a homogeneous product. Different people have different skills, some with
experience, education and training, and some vice versa.
Capital in economics means investment in goods that can produce other goods in the future.
Capital makes labour more productive. Without capital, production would be done by hand.
All capital is wealth, but not all wealth is capital.
There are three types of capital:
• Fixed capital – physical assets which do not vary as the level of output varies.
• Social capital – created from government investment spending, such as educational,

hospital, housing and road network.
• Working capital – stocks of goods that vary with the level of output.
An entrepreneur can be an individual or a group.
41
His functions is to organize or bringing other factors together and taking the risk of success or
failure.
An entrepreneur coordinates the factors of production (land, labour, capital) to satisfy

demand and to maximize profits.
2 An entrepreneur is always concerned with research and development, in order to be more

competitive than his rivals.
42
2.4 EXERCISES
2.4.1 Choose the correct answer
1. In the production of automobiles, the factory and assembly lines are examples of
________________.
2
a. labour
b. land
c. capital
d. property
2. Why is the availability of labour often a minor consideration in locating an industry?
a. New industry will usually pay low wages to workers.

b. People will usually move to areas of new industry.
c. People will usually have to be retained for jobs.
d. New industries usually only hire skilled labour.
3. There are many steps involved in the production of a product before the product is sold.
First, an entrepreneur comes up with an idea for a product and makes plan for its
production. A factory must then be built (or rented) and equipped with the proper
machinery. Raw materials needed to produce the product are bought, workers are hired
and production begins. The owner must then transport and sell the items to consumers.
Only then does the owner begin to receive a return (profit) on his investment. Which step
in the production process described represents “land” as a factor of production?
a. Buying the raw materials needed

b. Hiring workers to produce the item
c. Equipped the factory with machinery
d. Transporting the products to market
4. Which economic feature often results from the use of the other three features?
a. Land
b. Profit
c. Labour
d. Capital
5. One characteristic of a model market economy is that____________________________.
a. businesses are guaranteed a profit

b. society’s production is shared equally
c. government regulates competition
d. property is privately owned
6. Which definition is basically a definition of an entrepreneur?
43
a. a person who develops new inventions

b. a person who invests in the stock market
c. a person who lends money to new businesses
d. a person who risks a loss to make a profit
7. The income approach to GDP includes all of the following items, except _____________.
2 a. wages of workers
b. self employed income
c. interest income
d. Corporate profits
e. Investment spending
8. The relationship between real GDP and the quantity of labour employed when all other
influences on production remain the same is the ________________________________.
a. aggregate supply
b. supply of labour
c. production possibilities frontier
d. production function
9. All of the following factors influence labour productivity except ___________________.
a. Technology
b. Capital
c. Human capital
d. Wage rate
10. To increase in the supply of labour will lead to a ________________________________.
a. no change in the position on the production function and no shift in the production
function.
b. movement along the production function.
c. rightward shift in the production function.
d. leftward shift in the production function.
44
3 Demand and Supply
Definition of Demand
Objectives
Demand Curve and Demand Schedule
Quantity Demanded (Qd) At the end of this chapter students should be able to:
The Law of Demand
Changes in demand versus changes • Explain the influences on demand
in quantity demanded • Understand the law of demand
The Exceptional Demand Curve
• Explain the influences on supply
Definition of Supply • Understand the law of supply
Supply Curve and Supply Schedule • Explain how demand and supply determine
Quantity Supplied (Qs) prices and quantities bought and sold
• Use demand and supply to make predictions
The Law of Supply
Changes in supply versus changes in about changes in prices and quantities
quantity supplied
45
3.1 DEMAND AND SUPPLY
3.1.1 Definition of Demand
Demand can be defined as the amount of a particular good or service that a consumer or
group of consumers will want to purchase at a given price during a specific time, ceteris
paribus (the Latin phrase that means all other things remain constant).
3 It is an economic event of consumer’s desire and willingness to pay for a good or

service. If there is no ability (means or affordability) or no desire (will or want) to have a
good or service, there would not be any demand for the good.
For example, Mr. Safa wants to buy an apple and he agrees to pay a specific price at
a particular time. There is a demand for an apple from Mr. Safa. If he does not want to spend
any money on it but he wants to buy an apple is not a fact of demand. Or, if he wants to spend
money on it but does not want to have it also is not a fact of demand.
Thus, means and desire are the two basic elements of demand. Demand is illustrated
by the demand curve and the demand schedule.
Demand, Wants and Needs are not the same. Wants and needs were defined earlier
in the first chapter. Wants and needs have no basic elements to be fulfilled whereas demand
has ‘means’ and ‘desire’ to be fulfilled.
For example, Anthony has some money and he

demands for a music cassette by saying that he is
willing and able to buy 3 music cassettes a month at
RM19.90 per cassette.
Another example, how many six packs of Orange juice

will people buy each month if the price is RM4? What
if the price is RM2 or RM6?
The answers reveal the relationship between the price

of Orange juice and the quantity purchased. This
relationship is called the demand for Orange juice.
46
Demand and Supply
3.1.2 Demand Curve and Demand Schedule
Demand can be expressed as a demand schedule or curve. A Demand curve is a graph

showing the relationship between the price of a product and the quantity of the product
demanded over a given period of time. The price is measured on the vertical axis; whereas
quantity demanded (Qd) is measured on the horizontal axis (Refer Figure 3-1)
The demand curve shows the relationship between the quantity demanded (Qd) of a
product and its price (P) when all other influential factors to consumer buying intention
remain the same.
A demand curve can be different in shape, a straight line, a concave curve, or a
convex curve. It must be observed that the slope of the demand curve also depends on the
scale used.
3
Figure 3-1 Demand Curve
Figure 3.1 shows the demand curve usually slopes downwards from left to right – the
lower the price, the more of commodity goods we are willing to buy. The demand curve
slopes downward, reflecting the law of demand: price and quantity demanded are inversely
related, other things being constant.
A Demand schedule is a table showing the quantities of a product a consumer is willing and
able to buy at varying prices in a given period of time, when all other influences on prices of
related goods, expected future prices, income, population and etc – remain the same (ceteris
paribus).
Figure 3.2 shows an example of a demand schedule for mangoes in Village X. At a
price of RM1.40, 10 thousands a week are demanded; at a price of 80 sen per piece, 40
thousands a week are demanded. As price decreases, the Qd increases. For a given price, the
demand curve tells us the quantity people plan to buy. For a given quantity, the demand
curve tells us the maximum price that consumers are willing and able to pay. For example,
the maximum price that a consumer will pay is RM1.00.
47
A demand schedule for mangoes

per day in village X
3
Figure 3-2 Demand Schedule
3.1.3 Quantity Demanded (Qd)
Before discussing the Law of Demand, ‘quantity demanded’ is required to be discussed for
the easy understanding of demand.
If you demand for something, it means you want it, you can afford it, and you plan to buy it.
It reflects the decision about getting something that satisfies you.
Therefore quantity demanded (Qd) is the amount of goods that people are willing
and able to buy at a particular price, during a specific time period. Qd does not refer to what
people would simply like to consume. The term Qd is illustrated by a point of the demand
curve – the Qd at a particular price.
The Qd is measured as an amount per unit of time.

For example, suppose that you drink a cup of tea at a Mamak stall a day. The quantity
of tea that you demand can be expressed as 1 cup per day, 7 cups per week, or 365 cups a
year. Without a time dimension, we cannot tell whether the quantity demanded is small or
large.
Figure 3-3 and 3-4 shows the examples.
48
Demand and Supply
3
Figure 3-3 The Demand Curve
Figure 3-3 shows that any point on the demand curve represents a single price: quantity
demanded relationship PER UNIT OF TIME.
To distinguish between shifts in and movements along demand curves, it is usual to

distinguish between a change in demand and a change in quantity demanded (Qd).
A shift in demand is referred to as a change in demand, whereas a movement along
the demand curve as a result of the change is referred to as change in quantity demanded (Qd)
due to a change in price.
Other variables that may affect the demand and make an upward or downward
movement of the entire demand curve include: the money income of consumers, prices of
related goods, consumer expectations, number of consumers, and consumer tastes.
Figure 3-4 Quantity Demanded (Qd)
Figure 3-4 shows that Qd is a flow variable (measured over a period of time – a week,
month or a year) rather than a stock variable (measured at a point in time).
A change in Qd is represented by a movement along the existing demand curve.
49
3.1.4 The Law of Demand
As the price of a product falls, people tend to purchase more of it, but when the price
increases, the demand will fall.
Think of buying soft drinks. You go into the market. A six-pack sells RM6.50. You buy a given
number, say, two packs. Next week there is a sale, the price is RM4.90 a six-pack. You stock
up and buy five six-packs! The following week, the price has risen to RM7.50. This is just too
expensive; you don’t buy any at all! The result is familiar to anyone who shops for anything
regularly.
The above example is referred to as the law of demand, where as the price of the product
rises (falls), the quantity demanded of the product falls (rises).
It shows the inverse or negative relationship between the price of goods and Qd. The
reasoning behind the law of demand goes back to the fundamental problem of scarcity and
choice. The root of scarcity problems is that people have limited resources to satisfy their
unlimited wants and needs.
The law of demand holds that other things remaining the same, the Qd will rise as the
price decreases and will decrease as the price rises. Or other things remaining the same, the
higher the price of a good, the smaller is the Qd.
For example, people who promote films want to fill

the movie theatre with screaming fans. But fans have
limited income and desires for other goods.
Normally, fans will buy tickets depending on the
price. If the promoter sets a high price for the ticket,
there will be lots of empty seats in the theatre. If the
price is too low, the promoter may lose potential
sales revenue. What the entire promoter needs to
know is what price will induce a Qd that conforms to
the number of seats available. By constructing a
demand curve, the promoter might get the solution of
the correct price evidently
50
Demand and Supply
The inverse relationship between the price and the Qd can be represented graphically by a
downward sloping demand curve. The amount of a good that buyers purchase at a higher
price is less because as the price of a good goes up, so does the opportunity cost of buying the
good.
Let’s look at the demand relation curve on Figure 3-5.
Figure 3-5 shows that the curve is a

downward slope, why?
A, B, and C are points on the demand

3
curve. Each point on the curve reflects a
direct correlation between Qd (Q) and price
(P).
So, at point A, the Qd will be Q1 and the

price will be P1, and so on. The demand
relationship curve illustrates the negative
relationship between price and Qd. The
higher the price of a good the lower the Qd
(A), and the lower the price, the more the
good is demanded (C).
Figure 3-5 Demand Relation Curve
3.1.5 Changes in demand versus changes in quantity demanded
A rise in demand is signalled by a rise in price – the quantity supplied (Qs) rises. A fall in
demand is signalled by a fall in price – the Qs falls.
The five factors that can influence a change in demand are as follows:
1. Prices of Related Goods: –
• A substitute is a product that can be used to replace another product and fulfils
the same purpose. Rightward shift.
For example, a bus ride is a substitute for a train ride. Demand for bus ride can
be substituted for train ride. Thus, the demand for one ride will affect the other.
The demand for coffee will depend on the price of tea. If the price of tea increases,
the demand for coffee will rise too.
51
• The substitute effect of price change.
¾ Caused by a change in the relative price of a good. If the price of one

product falls relative to the price of the other related product, consumers
tend to substitute that product for the other one.
• A complement is a product that is used in conjunction with the other product

(consumed together). Leftward shift.
For example spaghetti and mince meat, cars and petrol, CDs and CD players.
3 2. Expected future prices – the price of future goods is expected to rise, therefore the
opportunity cost of obtaining the goods for the future is lower today than it will be
when the price has increased.
For example, suppose your paddy field is hit by a flood and it damages the fields. So
you purchase more rice from other states throughout the next six months. Therefore
your current and future demand for rice have decreased. However, people expect the
price of the rice not to increase but still it does.
Paddy field affected by floods
3. Income – consumers’ income influences demand. When income increases,

consumers buy more of most goods, and when income decreases, consumers buy less
of most goods. This means that it does not lead to the increase in demand for all
goods.
• A normal good is one for which demand increases as consumer’s income

increases. An example of a normal good is air travel or sea travel (luxury goods).
• An inferior good is one for which demand decreases as consumer’s income

increases. An example of an inferior good is cheap margarine, coconut, and etc.
• The income effect of a price change:

This is caused by a change in consumer’s real income. If the price of a product
falls, other things constant, the consumer’s purchasing power (real income) rises,
increasing his ability to purchase more of the good in question and more of the
other goods.
52
Demand and Supply
4. Population – demand also depends on the size and the age of the population. The
larger the population, the greater is the demand for goods and services and vice versa.
5. Preferences – are an individual’s attitudes towards goods and services (choices).

For example, a lady worker would prefer to take a train rather than be caught in the
congested traffic. Another example is a rock music artiste would prefer to use a CD
rather than a tone-deaf techno phobic.
For example, what happens when there is a demand for sugar? 3
Table 3-1 Changes in Demand
Change in demand occurs which can be seen by an upward or downward movement of a

demand curve, if a determinant of demand other than price changes. An increase in demand
will shift the demand curve upward and vice versa.
For example, if income increases the demand for mandarin oranges will increase, and
therefore the demand curve for mandarin oranges will shift upward. On the other hand, a
change in Qd refers to a movement along a demand curve.
53
Figure 3-6 shows when the price of the

goods changes, there is a movement
along the demand curve shown by the
black circle on demand curve D0.
3 When some other factors such as

income, a substitute good or
complementary good, influence
buyers’ decision, the demand curve
shifts upward or downward
An increase in demand shifts the

demand curve upward (from D0 to D1).
An decrease in demand shifts the
demand curve leftward (from D0 to D2)
Figure 3-6 A Change of The Quantity Demanded
versus a Change in Demand
3.1.6 The Exceptional Demand Curve
There are exceptions which can explain exactly the price-quantity relationship according to
the law of demand. Thus, the law that says the demand tends to fall when prices rise and
tends to rise when prices fall does not hold good always. Under certain circumstances and for
certain people, the reverse applies. For example:
• A fall in prices leads to a fall in demand.
• A rise in prices leads to a rise in demand.
54
Demand and Supply
Let’s look at the Figure 3-7 which illustrates the normal demand curve showing that when the
price increases, the Qd falls and when price decreases, the Qd rises. However, there is an
exception to this law. This occurs when a price increase leads to an increase in the Qd and
similarly when the price decreases, the Qd also falls. When price at Po, quantity demanded is
Qo, and when price increases to P1, quantity demanded also increases to Q1.
Figure 3-7 The Demand Curve and The Exceptional Demand Curve
These exceptions arise under the following situations:
1. Inferior goods (Giffen goods)
• Giffen foods are normally of poor quality. They are bulky but not nutritious.
Examples are cheap margarine, poor quality of salt, salted fish and etc.
• If the price of basic foodstuffs such as bread, corn, potatoes, salted fish, broken
rice and margarine rises, the real income (purchasing power) will fall.
• The reason is that as price rises, the higher price makes it impossible for
consumers to purchase better quality foodstuffs.
2. Veblan Goods (when we judge quality by price)
55
• When we relate price to quality, definitely what comes in mind is that the
expensive goods are of better quality.
• If the price of jeans, textiles, shirts is higher, the Qd will rise because it provides a
means of displaying superior wealth or worth.
3. Festive Seasons and Crisis Situations
• Demand for certain goods still increases and price will increase mainly because of
traditional celebration/festive season.
3 • During a crisis or an emergency situation, prices of certain basic goods such as
rice, sugar, oil will rise but the demand for them will also increase.
• No matter how expensive they are, there will be a demand for them.
3.1.7 Definition of Supply
Supply represents how much the market can offer. It indicates how many product producers
are willing and able to produce and offer for sale over a range of prices and quantity.
For example, how many pairs of jeans you would be willing to supply, i.e., offer for
sale?
We can define supply more precisely as the amount of the goods or services which is
offered for sale at a given price per unit of time. It is always supplied at a certain price.
The correlation between price and how much of a good or service is supplied to the
market is known as the supply relationship. Supply is illustrated by the supply curve and
the supply schedule.
3.1.8 Supply Curve and Supply Schedule
A supply curve shows the relationship between the price of a good and the quantity supplied
of that good at a specified period of time. The price is measured on the vertical axis;
whereas the quantity supplied is measured on the horizontal axis.
Not all supply curves will be upward sloping (positively sloped). Sometimes it can be
vertical, horizontal or even downward sloping.
56
Demand and Supply
Figure 3-8 Supply Curve 3

Figure 3-8 shows the supply curve usually slopes upwards from left to right - showing
the higher the price, the greater the amount offered for sale – reflecting the law of supply.
A supply schedule is a table showing the different quantities of goods that producers are
willing and able to supply at various prices over a period of time. It is the list of all possible
prices, along with the quantity supplied at each price.
A supply schedule can be for an individual producer or group producers, or for all
producers (the market supply schedule).
There are two reasons producers offer more goods for sale when the price rises. First,
as the price increases, other things constant, a producer becomes more willing to supply the
good. A higher price will insist producers to be more able to increase Qs.
Price usually is a major determinant for the Qs. For a particular good with all other
factors held constant, a table can be constructed of price and Qs as shown in Figure 3-9
below. The table below demonstrates the upward slope of the supply curve.
The law of supply states that the higher the price, the larger the Qs, all other things remain
constant.
Figure 3-9 Supply Schedule
57
3.1.9 Quantity Supplied (Qs)
Before proceeding with the Law of Supply, it is important to know about the concept of
quantity supplied (Qs). The quantity supplied (Qs) refers to the total amount of goods that all
firms are willing and able to sell, at a given price, during a given time period.
The Qs refers to the amount of certain goods producers are willing to supply at a
certain price. And it also refers to the number of units of goods sellers are willing and able to
produce and offer to sell at a particular price.
For example, producer Firoz wants to sell 10 units shirt at RM 50 per unit at the
3 beginning of the year.

Supply and the Qs relationship:
• A change in the Qs = a Movement along the supply curve
¾ Price.
• A change in supply = a Shift in the supply curve
¾ This can happen for many reasons.
3.1.10 The Law of Supply
The Qs is usually directly related to its price, other things being constant. The higher the
price, the greater is the Qs, the lower the price, the smaller are the Qs, other things remain
the same. Clearly the law of supply is the opposite of the law of demand which can be
stated as-if the price of goods increases, quantity supplied will increase.
For example, according to the law of demand, consumers will buy more as the price
drops since they want to pay as little as they can. On the other hand, according to the law of
supply, sellers will be willing to produce more and sell more as the price goes up to
maximize their profit.
The law of supply demonstrates the quantities that will be sold at a certain price. But
unlike the law of demand, the supply relationship shows an upward slope.
58
Demand and Supply
Figure 3-10 shows that the curve is an

upward slope, why?
A, B, and C are points on the supply curve.

Each point on the curve reflects a direct
correlation between Qs and price (P).
So, at point B, the Qs will be Q2 and the price

will be P2, and so on. 3
This means that the higher the price, the
higher the Qs. Producers supply more at a
higher price because selling a higher quantity
at a higher price increases revenue.
Figure 3-10 Supply Relationship
A price change that is caused by demand will be in

a temporary or permanent basis.
For example, if there is a sudden increase in the

demand and price for rain coats in an unexpected
rainy season; suppliers may simply accommodate
demand by using their production equipment more
intensively.
If, however, there is a climate change, and the
population will need rain coats all the year-round,
the change in demand and price will be expected to
be long-term; suppliers will have to change their
equipment and production facilities in order to meet
the long-term levels of demand
3.1.11 Changes in supply versus changes in quantity supplied
A rise in supply is signalled by a fall in price – the Qd rises. A fall in supply is signalled by a
rise in price - the Qd falls.
There are five factors that can influence a change in supply. They are:
59
1. Prices of productive resources (production cost) – The higher the cost of

production, the less profit will be made at any price. At costs rise, firms will cut back
on production, probably switching to alternative products whose costs have not risen
so much. For example, if the wages or the price of raw materials to produce compact
discs increases, the supply of CD will decrease.
2. Prices of related goods produced – If a product which is a substitute in supply

becomes more profitable to supply than before, producers are likely to switch from
the first good to this alternative. Supply of the first good falls. For example, if the
3 price of carrots goes up, or the cost of producing carrots comes down, farmers may
decide to produce more carrots. The supply of potatoes is therefore likely to fall.
3. Expected future price – If price is expected to rise, producers may temporarily

reduce the amount they sell. Instead they are likely to build up their stocks and only
release them on to the market when the price does rise.
4. The number of suppliers – more suppliers will results in more supply, shifting the
supply curve to the right.
5. Technologies – New technologies create new products and lower the costs of
producing existing products. It influences the change in supply.
Figure 3-11 shows when the price of the

goods changes, there is a movement along
the supply curve, shown by the black circle
on the S0 supply curve.
When any other factor influences producer’s

decision on supply, there is a shift of the
supply curve and a change in supply.
An increase in supply shifts the supply

curve rightward (from S0 to S1, and a
decrease in supply shifts the supply curve
leftward (from S0 to S2).
Figure 3-11 A Change in the Quantity

Supplied versus a Change in Supply
Changes in price of a good → change in Qs → movement along supply curve. Such a shift
results in a change in Qs for a given price level. If the change causes an increase in the Qs at
each price, the supply curve would shift to the right; refer to Figure 3-11.
60
Demand and Supply
3
Figure 3-12 Quantity Supplied versus Price
Figure 3-12 illustrates that while changes in price result in movement along the supply curve,
changes in other relevant factors cause a shift in supply, that is a shift of the supply curve to
the left or right.
Change in non-price determinants of supply → change in supply → shift of supply curve.
61
3.2 SUMMARY
Demand is the quantity that buyers are willing to buy at each price other things being equals.
The lower the price the higher the quantity demanded.
When the price of a good rises, the Qd per period of time will fall. This is called the law of
demand. It applies both to individuals demand and the whole market demand.
The law of demand is explained by an increase of substitute goods or decrease in the price of
3 a complement goods and will raise the Qd at each price.
The relationship between price and Qd per period can be shown as a demand schedule or a
graph plotted. On the graph, price is plotted on the vertical axis and Qd on the horizontal axis.
Demand curves slope down (negatively slopped).
If price changes, the effect is shown by a movement along the demand curve and this is called
a “change in the Qd”.
Supply is the quantity of goods a seller wishes to sell at each price other things being equal;
The higher the price, the higher the quantity.
When the price of goods rises, the Qs per period of time will also rise. This is called the law
of supply. It applies both to the individual producer’s supply and the whole market supply.
The law of supply states that the higher the price, the larger the Qs, all other things constant.
Not the same as demand relationship, however, the supply relationship is a factor of time.
Time is important to suppliers because they must, but cannot always, react quickly to a
change in demand or price.
The relationship between price and Qs per period of time can be shown in a schedule or as a
graph. On the graph, the price is plotted on the vertical axis and Qs on the horizontal axis.
Supply curves slope upwards (positively slopped).
If price changes, the effect is shown by a movement along the supply curve and this is called
a “change in Qs”.
If the demand for goods exceeds the supply, there will be a shortage and will lead to a rise in
the price of the goods.
If the supply of goods exceeds the demand, there will be a surplus and will lead to a fall in
the price of the goods.
62
Demand and Supply
3.3 EXERCISES
1. When the price of the goods rises, the quantity demanded per period of time will fall. This
is known as ________________________.
a.
b.
c.
quantity demanded
the law of demand
quantity supplied
3
d. the law of supplied
2. If the price changes, the effect is shown by a movement along the demand curve. We call
this effect as a _________________________.
a. change in the quantity demanded

b. change in the quantity
c. change in the law of demand
d. quantity demand curve
3. If the price changes, the effect is shown by a movement along the supply curve. We call
this effect as a ________________________.
a. supply demand curve

b. change in the law of supplied
c. change in the quantity supplied
d. quantity supplied
4. The cost of pressing DVDs has fallen. This will cause __________________.
a. an increase in demand
b. an increase in quantity demanded
c. an increase in supply
d. an increase in quantity supplied
5. If the price of a good or service is below its equilibrium level, a shortage will develop, so
what will happen to the price?
a. The price will automatically decrease toward equilibrium

b. The price will fall drastically
c. The price will automatically increase toward equilibrium
d. The price will increase automatically
6. If chocolate is discovered to have positive health benefits, would this lead to a shift in the
demand curve or a movement along the demand curve?
63
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
7. Distinguish between the substitution and income effects of a price change. If the price of
a piece of goods increases, does each effect have a positive and negative impact on the
quantity demanded?
3 ________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
8. For each of the following pairs, indicate whether the goods are substitutes, complements
or unrelated:
a) Private and public transportation
________________________________________________________________________
b) Peanut butter and jelly
________________________________________________________________________
c) Coke and Pepsi
________________________________________________________________________
d) Alarm clocks and automobiles
________________________________________________________________________
e) Golf clubs and golf balls
________________________________________________________________________
64
Demand and Supply
65
4 Price Determination and Elasticity
Price Determination
Market Equilibrium
Objectives
Price Ceiling and Price Floors
Price Elasticity of Demand (PED)
Calculating PED
• Understand price determination and market
Factors Affecting the Price Elasticity of equilibrium
Demand
• Define, calculate and explain the factors that
Income Elasticity of Demand influence the price elasticity of demand
Cross Elasticity of Demand
• Define, calculate and explain the factors that
influence the price elasticity of supply
Price Elasticity of Supply • Define, calculate and explain the factors that
Factors that Determine Elasticity of
influence the cross elasticity of demand and the
Supply income elasticity of demand and the income
elasticity of demand
• Understand why government intervene in price
control
66
Price Determination and Elasticity
4.1 PRICE DETERMINATION AND ELASTICITY
4.1.1 Price Determination
In a market economy, prices are determined in the marketplace, by consumers and producers.
If consumers demand more goods, the price will rise and encouraging more production. If the
product is overstocked, prices fall, encouraging more sales.
Prices coordinate the decisions of producers and consumers in a market. Prices are
the balance wheel in the market mechanism.
The price of the goods regulates the Qd and Qs. If the price is too high, the Qs exceeds
the Qd. If the price is too low, the Qd exceeds the Qs. We are now going to see how prices
coordinate the plan of buyers and sellers and achieve equilibrium.
4
4.1.2 Market Equilibrium
Equilibrium in a market occurs when the price balances the plans of buyers and sellers.
The equilibrium price is the price at which the Qd equals the Qs.The equilibrium quantity
is the quantity bought and sold at the equilibrium price. It is not necessary that market price is
equivalent to the equilibrium price.
Equilibrium prices and equilibrium quantity are where demand equals supply; a
simple way to understand equilibrium is all sellers can find buyers. In equilibrium there is no
pressure on the market to produce or to consume more than is being sold because for each
period the same amount will be produced and sold.
67
4 For example: What happens to the equilibrium price and quantity of ice cream in response
to: concerns the rise about the fat content in ice cream, simultaneously, the price of sugar
(used to produce ice cream) increases.
The answer: Fat concerns shift demand left, equilibrium price falls and equilibrium quantity
falls. Increase in price of sugar lead to leftward supply shift, equilibrium price rises,
equilibrium quantity falls. In the end, equilibrium quantity will fall but impact on price is
unclear.
By now, we are familiar with graphs of supply curves and demand curves. To find market
equilibrium, we combine the two curves into one graph. Let’s look at Figure 4-1
The point of intersection of supply curve

and demand curve marks the point of
market equilibrium.
Unless interfered with, the market will

settle at this price and quantity. Why is
this?
At this point of intersection, buyers and

sellers agree on both price and quantity.
For instance, in the graph shown (Fig. 4-1),
we see that at the equilibrium price p*,
buyers want to buy exactly the same
amount that sellers want to sell.
Figure 4-1 Market Equilibrium
68
If the price is higher, however, we can see

that sellers would want to sell more than
buyers would want to buy.
Likewise, if the price is lower, quantity

demanded would be greater than quantity
supplied.
The graph shows (Figure 4-2), the

discrepancy in supply and demand if the
price is higher than the equilibrium price:
Note that the quantity that sellers are

willing to sell is much higher than the Figure 4-2 Price Higher than Equilibrium Price
4
quantity that buyers are willing to buy.
What happens if both curves shift? Will we end up at the same equilibrium point? In this
model, it is not possible to reach the same equilibrium: either the price or the quantity can be
the same as the previous equilibrium, but not both, unless the curves shift back to their
original positions. Let’s look at the illustration in Figure 4-3 below.
To illustrate why this is true, consider the

graph shown.
The initial equilibrium, between supply

curve S1 and demand curve D1, has price
p* and quantity q*. If supply shifts to
supply curve S2, both equilibrium price
and quantity change.
It is now possible to change back to our

original price by shifting the demand
curve to position D2 or it is possible to
revert to our original quantity by shifting
the demand curve to position D3.
Note that we cannot reach the original

equilibrium point unless we move the
Figure 4-3 Shift in Supply and Demand
curves back to their original points.
For a real world example, consider the market for oil (still referring to Figure 4-3). The initial
supply and demand curves would be at position 1 (p1). When the suppliers decide to
collaborate and supply less oil for every price, this causes a backwards shift in the supply
69
curve, to supply curve S2. This cuts the quantity supplied from quantity 1 (q1) to quantity 2
(q2) and raises the price paid for oil along demand curve D1.
We can either shift the demand curve (D1) in to curve D2, maintaining previous price
levels, but decreasing consumption even more, or we can shift the demand curve to curve D3,
maintaining previous levels of consumption but raising prices. Since there is a trade-off
between having steady prices or steady consumption, the consumers have to make a decision
about which is more important to them.
In the short-run they will probably decide to pay the higher prices to keep
consumption steady (that is, they will shift out to curve D3), but if the prices stay high for a
long time, they will start finding ways to economize, (thereby shifting in to curve D2).
4.1.3 Price Ceiling and Price Floors
Sometimes government steps into certain markets and interfere with free pricing by setting up
the following two prices:
This topic could be important to student; because it will highlight on how and why the
interference of government on the prices in the markets.
• Price Ceiling or Upper Price Limit
¾ A government sets the maximum price that can be charged for a good or service;
if the equilibrium price is above the price ceiling, a shortage will occur.
¾ Figure 4.4 shows an example of when the equilibrium price for a product is below
its upper price limit, the price ceiling has no effect on the market; but when the
equilibrium price for a product is above its upper price limit, the price ceiling
takes effect and a shortage occurs. (A shortage forces the price up).
For example:
Suppose more people want to borrow money, the demand
curve will shift to the right. The new interest rate will be
14%. But the interest rate can rise only up to 12% (rather
than increase from 10 to 14%). At the 12%, the borrower
would like to take up a loan of RM16 million, but lenders
would only provide RM12 million of funds. Therefore at the
12% interest limit, there would be a shortage of funds
borrowing amounting to RM4 million. Thus the equilibrium
price is above the ceiling price, and a shortage occurs.
70
Let’s illustrate the example above by plotting two different graphs at two different interest
rate limits.
Equilibrium price is below the ceiling: Equilibrium price is above the ceiling:
Ceiling does not take effect Ceiling takes effect
Interest
Rate 20%
D S
12
Interest
Limit
10
4
S D
0 10 22
Millions of Ringgit of loans per week Millions of Ringgit of loans per week
Figure 4-4 Effect of a Price Ceiling in a Market
(Source: Patrick J Welch, 2004)
• Price Floor or Lower Price Limit
¾ A government sets the minimum price that can be charged for a type of goods or
service; if the equilibrium price is below the price ceiling, a surplus will occur.
¾ Figure 4-5 shows an example of when the equilibrium price for a resource or a
product is above its lower price limit, the price ceiling has no effect on the
market; but when the equilibrium price is below its ceiling, the ceiling takes
effect and a surplus occurs (A surplus forces the price down).
For example:
Suppose the minimum wage law sets the minimum hourly payment of workers earn, and
government guaranteed agricultural prices and ensure that farmers will receive at least a set
of minimum price on particular crops. The free market will not be affected if the equilibrium
price of goods is above its price floor. The equilibrium wage of RM6 is greater than minimum
wage and there is no impact on the market. Let’s say the government rises from RM5 to RM7
per hour, the minimum wage will take effect. That means business buying this type of labour
will have to pay RM7 per hour and the number of workers demanded falls to 1,000. And the
number of workers willing to work rises 1,200. The price floor has created a surplus of 200
workers who cannot get a job in this market. Thus the free market equilibrium price is below
the government imposed floor, a surplus occurs.
71
Let’s illustrate the example above by plotting two different graphs at two different minimum
wages.
4 Equilibrium price is above the floor:

Floor does not take effect
Equilibrium price is below the floor:
Floor takes effect
Number of workers Number of workers

Figure 4-5 Effect of a Price Floor in a Market
(Source: Patrick J Welch, 2004)
Another example: The government imposes a maximum price of rice for RM1 per kg. What is
the effect of this?
Solution: The equilibrium is at RM2 that is where demand is equal to supply. If rice is fixed
at RM1 per kg, then there will be a shortage of 30 kg.
72
4.1.4 Price Elasticity of Demand (PED)
Price elasticity measures buyers and sellers’ sensitivities to changes in the price of a product,
ceteris paribus.
Elasticity is important because it provides a measure of how sensitive the quantity of a
type of goods supplied or demanded is to changes in variables influencing the demand or
supply of the goods.
For example:
Suppose a store manager wants to run a sale.
Should he lower the price of a given item? And,
if yes, by how much?
The answer will depend on whether the increase

4
in purchases by customers will be larger than the
price decrease. This change in purchases by
customers is what elasticity is intended to
measure.
Another example: Would the price elasticity of

demand for electricity be more elastic over a
shorter or long period of time?
The answer is demand is more elastic over a

longer period of time since adjustments, for
example installing energy saving devices, can be
made.
General formula for a price elasticity:
¾ P = the current price of a product

¾ Q = the Qd.at the price
¾ ΔP = small change in the current price
¾ ΔQ = small change in the Qd
(In the formula, the Greek letter delta (Δ) stands for “change in” and %Δ stands for
“%change in”)
73
For example, let’s look at Figure 4-6, which shows the slope of the Demand curve, where
• ΔP = small change in the current price (ΔP < 0)

• ΔQ = small change in the Qd
• Slope = ΔP/ΔQ
Figure 4-6 Price Elasticity of Demand
The response of consumers to a change of price is measured by the price elasticity of demand
(PED). If demand is elastic (E > 1), a small change in price induces a large change in Qd.
4.1.5 Calculating PED
Price elasticity of demand measures the responsiveness of demand to a given change in price
and is found using the following formula.
Price elasticity of demand refers to the percentage change in Qd divided by the
percentage change in price (ceteris paribus).
Price elasticity = % change in Qd…

of demand (PED) % change in price
(To ignore any negative sign)
To use this formula we need to know the Qd at difference prices when all other influences in
the buyers’ plans remain the same.
What we want to compare is the size of the change in Qd with the size of the change
in price and they are measured in different units. Therefore we can use the percentage or
proportion changes.
74
For example, if the price decreases from RM5 to RM4 and Qd increases from 60 to 70 units,
the price elasticity would be:
Price elasticity = % change in Qd

of demand (PED) % change in price
% change in quantity = 10 x 100 = 17%

60
% change in price = 1 x 100 = 20%

5
Therefore 17 = 0.825 (inelastic)

20
4
Another example, if a 40% rise in the price oil causes the Qd to fall by a small 10%, the price
elasticity of oil would be:
-10% / 40% = -0.25 (ignore negative sign)
What happen if a 5% fall in the price of sugar caused a 15% rise in the Qd, the price
elasticity of demand for sugar would be:
5% / -5% = -3 (elastic)
This means that sugar has a more elastic demand than oil. In other words, it is the percentage
or proportionate increase in price that we look at in deciding how big a price will rise.
75
There are five responses of price elasticity of demand:
• Elastic demand (ε > 1 (fairly))
• Inelastic demand (ε < 1 (fairly))
• Unit elastic demand (ε = 1)
• Perfectly elastic (ε = ∞)
• Perfectly inelastic (ε = 0)
If the PED is greater than one, the demand is price elastic (Refer Figure 4-7 & 4-8).
Demand is responsive to changes in price.
4 If for example a 15% fall in price leads to a 30% increase in Qd, the price elasticity = 2.0
(ε > 1 (fairly)).
If the PED is less than one, the demand is price inelastic (Refer Figure 4-7 & 4-8). Demand
is not very responsive to changes in price.
If for example a 20% increase in price leads to a 5% fall in Qd, the price elasticity = 0.25
(ε < 1 (fairly)).
Figure 4-7 Relatively Elastic and Relatively Inelastic
If the PED is equal to one, the demand has unit elasticity.
For example, when there is a change of price by 50 per cent, the change in the amount
demanded will also change by 50 per cent. (Let say the actual price is RM10 and then reduce
to RM5). Therefore a 50 per cent fall in the price has brought about a 50 per cent rise in the
amount demanded. The percentage change in Qd is equal to the percentage change in price.
Demand changes proportionately to the price change. (ε = 1).
76
If the PED is equal to zero, the demand is perfectly inelastic.
For example, when the price is RM3, the amount demanded is 20 units. When the price rises
to RM5, the amount demanded is still 20 units. A change in price will have no influence on Qd
(ε = 0).The demand curve for such a product will be vertical as shown in the figure below.
Figure 4-8 Perfectly Inelastic Demand
If the PED is infinity, the demand is perfectly elastic. Any change in price will see Qd fall to
zero.
For example, when price is at RM2, the Qd would be 40 units. When the price increases to
RM2.50, there will be no demand at all. When the price falls to RM1.80, there will be an
infinite change in the Qd. It means that when demand is perfectly elastic, a small change in
price will lead to a change in Qd from zero to infinity (ε = ∞). This demand curve is
associated with firms operating in perfectly competitive markets.
Figure 4-9 Perfectly Elastic Demand
77
4.1.6 Factors Affecting the Price Elasticity of Demand
There are several factors affecting the price elasticity of demand. They are:
• What will happen if there is an availability of substitutes?

The more possible substitutes, the greater will be the elasticity. To note that the number
of substitutes depends on how broadly the product will be.
For example, if buyers can switch to similar or

alternative products when prices rise, they will
respond more elastically to the price change. If
4 there is a rise in the price of chicken, customers

can switch to beef or mutton or even to fish. On the
other hand, if prices increase, buyers may have
little choice but to buy at higher prices, and this is
a price-inelastic response. Even if the price of
textbooks increases, students have no choice but to
buy them.
• Are goods or services a necessity or a luxury?

Luxury products will tend to have greater elasticity. Some products with a low degree of
necessity are habit forming and can become necessities to some consumers. Necessities
tend to have a more inelastic demand.
For example, regardless of how much emergency medical care costs, parents will still take
their sick children to the doctor. It is a lot easier to cut back on holiday plans than
medications.
• Time Period
Demand tends to be more elastic in the long run rather than in the short run.
78
For example, after the two world oil price shocks of the 1970s - the "response" to higher oil
prices was modest in the immediate period after price increases, but as time passed, people
found ways to consume less petroleum and other oil products. This included measures to get
better mileage from their cars; higher spending on insulation in homes and car pooling for
commuters. The demand for oil became more elastic in the long-run.
4
• The proportion of income spent on a particular product.
The greater the proportion of income spent on a particular product, the more elastic is the
demand for it, other things remaining the same.
Let’s take this as an example. If the price of chewing gum doubles, you consume almost as
much gum as before, so your demand for gum is inelastic, right? If apartment rents double,
you will tend to look for more students to share with your accommodation. Your demand for
housing is more elastic than your demand for the gum. Why should there be difference?
Housing takes a large portion of your budget, and a gum is not that much, right? But your
income spent will be more on the housing that puts your budget on the increase.
4.1.7 Income Elasticity of Demand
Income elasticity of demand (YED) can be defined as the measurement of the

responsiveness of demand to a given change in income of the consumers, ceteris paribus.
79
The YED is calculated by using the formula:
YED = __Percentage change in Qd__

Percentage change in income
For example, if a 2% rise in income causes an 8% rise in the demand for the product’s
demand, then its income elasticity of demand would be:
8% / 2% = 4 (elastic)
The major determinant of income elasticity of demand is the necessity of the goods that are
needed.
4 YED can be negative or positive and fall under three categories (Refer Figure 4-11):
• Greater than 1 (normal goods, income elastic).
• Positive and less than 1 (normal goods, income inelastic). Consumers use an increase in
income to buy more of the goods.
• Negative (inferior good). People use an increase in income to buy less of this type of
goods and more of a superior substitute.
4.1.8 Cross Elasticity of Demand
Cross elasticity of demand (XED) measures the responsiveness of demand for one type of
product A to a given change in the price of a second product B:
XED = Percentage change in quantity demanded of good a

Percentage change in price of good b
If product B is a substitute for product A's, demand will rise as b’s price rises. For example,
if the demand for butter rose by 2% when the price of margarine (a substitute) rose by 8%,
the cross elasticity of demand for butter with respect to margarine would be:
2% / 8% = 0.25
If product B is complementary to product A’s, demand will fall as b’s price rises and as the
quantity of b demanded falls. For example, if a 4% rise in the price of bread led to a fall of
3% demand for butter, the cross elasticity of demand for butter with respect to bread would
be:
-3% / 4% = -0.75
80
The major determinant of cross elasticity of demand is the closeness of the substitute or
complement. If XED is positive, then the two goods are substitutes. If XED is negative
then the two goods are complements. XEP normally focus on the links between changes in
the prices of substitutes and complements. Figure 4-10 shows the XEP through diagrams.
With substitute goods such as corn or washing powder, an increase in the price of
one type of goods will lead to an increase in demand of other goods. XEP will be positive.
With goods that are in complementary demand such as demand for DVD players
and videos, where that is a fall in the price of DVD players we expect to see more DVD
players bought, and will lead to market demand. When there is no relationship between two
products, the XEP is zero.
Figure 4-10 Comparison of Substitute and Complements Price
4.1.9 Price Elasticity of Supply
Price elasticity of supply (PES) measures the responsiveness of supply to a given change
in price.
PES = Percentage change in quantity supplied

Percentage change in price
81
For example, if a price fall of 6% causes a fall of 3% in the Qs, what is the elasticity of
supply equal to?
Elasticity = 3%
6%
= 0.5 (inelastic)
4 Another example, if a 10% rise in price causes a 25% rise in Qs, the price elasticity would
be:
25% / 10% = 2.5 (elastic)
And if a 10% rise in price causes only a 5% rise in the quantity, the price elasticity of
supply would be:
5% / 10% = 0.5 (inelastic)
Unlike the PED, the figure is positive because price and quantity supplied change in the same
directions.
Illustrating price elasticity of supply (Refer Figure 4-11)
• When supply is perfectly inelastic, a shift in the demand curve has no effect on the
equilibrium quantity supplied to the market.
Examples include the supply of tickets for sports or musical venues, and the short run
supply of agricultural products (where the yield is fixed at harvest time) the elasticity of
supply = zero when the supply curve is vertical.
• When supply is perfectly elastic a firm can supply any amount at the same price.
• When supply is relatively inelastic a change in demand affects the price more than the
quantity supplied. The reverse is the case when supply is relatively elastic. A change in
demand can be met without a change in market price.
82
4
Figure 4-11 Price Elasticity of Supply
Table 4-1 The Different Features of Price Elasticity of Demand and Supply
4.1.10 Factors Determining Elasticity of Supply
The major factors that affects the price elasticity of supply are:
• Time period – Momentary supply or immediate time period is unlikely to be able to

increase supply considerably immediately. Supply is highly inelastic.
83
• Long run supply – refers to the response of sellers to a price change when all
technologically feasible adjustments in production have been made. Therefore it is likely
to be elastic.
• Short run supply – refers to the response of sellers to a price change after some of the
technologically feasible adjustments in production have been made.
4.1.11 Applications of the Concept of elasticity
What is Elasticity?
• Measurement of the percentage changes in one variable that result from a 1% change in
another variable.
4 • When the price rises by 1%, quantity demanded might fall by 5%
Different Types of Elasticity
• Price elasticity of demand: how sensitive is the quantity demanded to a change in the
price of the goods.
• Price elasticity of supply: how sensitive is the quantity supplied to a change in the price of
the goods.
Demand Elasticity
• When the price of oil rises by 1% the quantity demanded falls by 0.2%, so oil demand is
not very price sensitive.
• Price elasticity of demand is -0.2
• When the price of gold jewellery rises by 1% the quantity demanded falls by 2.6%, so
jewellery demand is very price sensitive.
• Price elasticity of demand is -2.6
84
Supply Elasticity
• When the price of Da Vinci paintings increases by 1% the quantity supplied doesn't
change at all, so the quantity supplied of Da Vinci paintings is completely insensitive to
the price.
• Price elasticity of supply is 0
• When the price of chicken increases by 1% the quantity supplied increases by 5%, so the
chicken supply is very price sensitive.
• Price elasticity of supply is 5
Leonardo Da Vinci’s paintings
Inelastic Economic
• When an elasticity is small (between 0 and 1 in absolute value), we call the relation that it
describes inelastic.
• Inelastic demand means that the quantity demanded is not very sensitive to the price.
• Inelastic supply means that the quantity supplied is not very sensitive to the price.
Elastic Economic
• When an elasticity is large (greater than 1 in absolute value), we call the relation that it
describes elastic.
• Elastic demand means that the quantity demanded is sensitive to the price.
• Elastic supply means that the quantity supplied is sensitive to the price.
85
Size of Price Elasticity
• Inelastic: price elasticity is less than 1
• Unit elastic: price elasticity is equal to 1
• Elastic: price elasticity is greater than 1
Figure 4-12 An example of the Elasticity in Pricing
Other than increasing sales, elasticity concepts will be useful to determine tax burden and
to identify the market structures that the business is in (for information only).
86
4.2 CASE STUDY
Advertising and its effect on the demand curve

How to increase sales and price
When we are told that brand X will make us more beautiful, enrich our lives, wash our
clothes whiter, give us get – up and – go, give us a new taste sensation or make us the
envy of our friends, just what are the advertisers up to? ‘Trying to sell product,’ you may
reply. In fact there is a bit more to it than this. Advertisers are trying to do two things:
•
•
Shift the product’s demand curve to the right
Make it less price elastic
4
This is illustrated in the figure below.
D1 shows the original demand curve with

price at P1 and sales at Q1. D2 shows the
curve after an advertising campaign. The
rightward shift allows an increased
quantity (Q2) to be sold at the original
price. If the demand is also made highly
inelastic, the firm can also raise its price
and still have a substantial increase in
sales. Thus in Figure A, price can be raised
to P2 and sales will be Q3 – still
substantially above Q1. The total gain in
revenue is shown by the shaded area.
How can advertising bring about this new

demand curve?
Shifting the demand curve to the right
This will occur if the advertising brings the product to the attention of more people and if
it increases people’s desire for the product.
Making the demand curve less elastic
This will occur if the advertising creates greater brand loyalty. People must be led to
believe (rightly or wrongly) that competitors’ brands are inferior. This will allow the firm
to raise its price above that of its rivals with no significant fall in sales. There will only be
a small substitution effect because consumers have been led to believe that there are no
close substitutes.
87
1. Think of some advertisements which deliberately seek to make demand less elastic.
2. Imagine that Dorina margarine, a well – known brand, is advertised with the slogan,
‘It helps you live longer.’ What do you think would happen to the demand curve for a
supermarket’s own brand of Dorina margarine?
3. Consider both the direction of shift and the effect on elasticity. Will the elasticity
differ markedly at different prices? How will this affect the pricing policy and sales of
the supermarket’s own brand?
4 (Source: Sloman and Norris, 2005)
88
4.3 SUMMARY
It is important to understand that in a market economy, prices are determined in the

marketplace, by consumers and producers.
Prices coordinate the decisions of producers and consumers in a market. Prices are the
balance wheel in the market mechanism.
At the equilibrium price, Qd equals Qs. At prices above equilibrium, there is a surplus and the
price falls. A surplus forces the price down. At prices below equilibrium, there is a shortage
and the price rises. A shortage forces the price up.
Price elasticity measures buyers and sellers’ sensitivities to changes in the price of a product,
ceteris paribus. 4
Demand or supply is price elastic when Qd or Qs changes by a greater percentage than the
price changes.
Price elasticity of demand or supply is calculated by dividing the percentage change in Qd or

Qs by the percentage change in price. If the resulting number is greater than one, demand or
supply is price elastic. If the resulting number is less than one, demand or supply is price
inelastic. And if the resulting number is equal to one, demand or supply is unitary elastic.
When the response by buyers to a price change is elastic, total revenue moves in the opposite
direction of the price change. When the response by buyers to a price change is inelastic, total
revenue moves in the same direction as the price change.
Elasticity of demand is affected by whether the product is a luxury or a necessity, the

availability of substitutes, and the price of the product relative to the buyer’s income.
Cross elasticity of demand (XED) measures the responsiveness of demand for one type of
goods to a given change in the price of a second type of goods.
The income elasticity of demand (YED) measures the sensitivity of Qd to changes, in income,
holding constant the prices of all goods.
The concept of elasticity would be:
• The different types of elasticity
• Supply and demand elasticity
• Inelastic and elastic economic
• Price elasticity
89
4.4 EXERCISES
4.4.1 Answer the following question
1. What is price elasticity of demand and supply?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
4 2. There are five responses of price elasticity of demand. Name and explain them.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
3. Why is the demand for some products price elastic while others are price inelastic?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
4. What happen to the change of equilibrium price and equilibrium quantity if:
a) The price of motorcycles goes down.
________________________________________________________________________
________________________________________________________________________
b) Buyers decide that a product that has been a fad is now out of style.
90
________________________________________________________________________
________________________________________________________________________
c) Fans become more supportive of a local football team because it has a winning season.
________________________________________________________________________
________________________________________________________________________
d) Automobile prices increase.
________________________________________________________________________
________________________________________________________________________
e) Local movie theatres raise their prices.

4
________________________________________________________________________
________________________________________________________________________
f) Several new stores selling mountain bikes open in town.
________________________________________________________________________
________________________________________________________________________
5. _______________________________ of demand measures the responsiveness of

demand to changes in consumer income, holding constant the prices of all goods.
6. _______________________________ of demand measures the impact of a change in the

price of one good on the demand for another good.
7. Demand is __________________________ if the demand elasticity is – 1.
8. Demand is _________________________ if the price elasticity is more negative than –1.
9. The quantity supplied equals the quantity exchanged, even though the quantity demanded
at prices __________________________ equilibrium will ________________________
the quantity supplied.
10. The income elasticity of demanded measures, for a given price, the
___________________ in quantity demand divided by the ________________________
income from which it resulted.
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5 Consumers’ Behaviour
Consumers’ Behaviour
Objectives
The Marginal Utility Theory
The Law of Marginal Utility
The Indifference Curve and the Budget • Describe the preferences using the concept of
Line utility and distinguish between total utility and
The Properties of Indifference
Curves marginal
Budget Line • Explain the marginal utility theory of consumer
choice
• Use marginal utility theory to predict the effects
of changing prices and incomes
• Describe a household’s budget line and show
how it changes prices or income changes
• Make a map of preferences by using
indifference curves and explain the principle of
diminishing marginal rate of substitution
• Understand the indifference curve and the
budget line
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5.1 CONSUMERS’ BEHAVIOUR
Human beings have unlimited wants but limited resources. Can we get more out of our
resources if we spend more on some goods and services and less on others? We try to spend
our incomes in ways that get the most out of our scarce resources.
Consumers’ behaviour involves the ‘use and disposal of products’ as well as the
study of how they are purchased. Product use is often of great interest to the marketeer,
because this may influence how a product is best positioned or how we can encourage
increased consumption.
5
In this section, you will be looking at ways to measure consumer satisfaction and response.
There is no scientific way to measure consumer satisfaction; however, economists attempt to
provide some types of analytic tools so that certain statements can be formed.
With elasticity, economists show the relationship between price and the strength of their
purchase.
As a rational consumer he will try to maximize his choice and satisfaction or
achieve consumer equilibrium with a given level of income. In order to achieve equilibrium
the consumer will follow the marginal utility theory.
5.1.1 The Marginal Utility Theory
Marginal utility is defined as the increase in utility as a result of consuming one more unit of
the goods – additional satisfaction gain from extra unit consumption.
Marginal utility is the change in total utility resulting from a one unit change in the
consumption of a type of goods.
For example, if you were really thirsty you will get a

certain amount of satisfaction from a glass of water. This
satisfaction would probably decrease with the second
glass, and then even more with the third glass. The
additional amount of satisfaction that comes with each
additional glass of water is marginal utility.
93
Utility refers to the degree of benefit or satisfaction that a person gets from the consumption
of goods and services. Total utility refers to the total satisfaction as a result of consuming
goods and services. More consumption generally gives more total utility – aggregate sum of
satisfaction.
Although total utility usually increases as more of a type of goods is consumed,
marginal utility usually decreases with each additional increase in the consumption of a
type of goods. This decrease demonstrates the law of diminishing marginal utility.
Since there is a certain threshold of satisfaction, the consumer will no longer receive
the same pleasure from consumption once that threshold is crossed. In other words, total
utility will increase at a slower pace as an individual increases the quantity consumed.
For a start, we look at the cokes and burgers example in terms of utility. Let's suppose
that Harun is going for lunch, thinking of eating burgers and drinking cokes. Here, is the
example of Harun’s utility numbers for cokes and burgers.
Looking at Table 5-1, we see the quantity of burgers or

cokes in the column, and the total utility gained from
consuming that quantity of burgers in the second
5 column, and from that quantity of cokes in the third
column.
There is a hidden simplifying assumption here. We are

assuming that the utility of burgers doesn't depend
directly on the consumption of cokes, and vice versa.
That's unrealistic, of course, but making the example
realistic, we will go ahead with the simplifying
assumption.
With that in mind: suppose that Harun consumes two

burgers and three cokes. (OK, Harun is really hungry!)
How much utility would that give him? The burgers
give 150 units of utility and 3 cokes give 80 units of Table 5-1 Total Utility of burgers and
utility, for a total of 230 units of utility. But Harun can coke
do better than that.
The idea is that people act "as if" they were maximizing the utility they get from spending
their limited income on burgers and cokes. In other words, they try to "allocate" that limited
income between burgers and cokes efficiently in such a way as to give the greatest utility.
We remember that "marginal" approaches have a lot to do with efficient allocation
and maximizing anything. So, we will want to figure the marginal utilities of burgers and
cokes.
In order to "maximize," our rational consumer will need to get the most out of every
Ringgit spent. So we will also compute the quotient of marginal utility divided by price, that
is, the marginal utility per Ringgit spent on burgers and cokes. We will assume that a coke
costs $1 and a burger costs $2.
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5.1.2 The Law of Marginal Utility
The Law of Marginal Utility states that the additional satisfaction which a person derives
for every additional unit consumed will diminish (decrease) as he consumes more.
For example: Some restaurants offer “ALL YOU CAN EAT” meals. How is this practice
related to diminishing marginal utility? What restrictions must the restaurant impose on the
customer in order to make a profit? 5
The solution is the marginal utility derived from each additional plate of food will diminish
as you become full. The marginal utility will continue to decrease until it reaches zero or
becomes negative. Food shows diminishing marginal utility after certain amount has been
consumed. The restaurant impose that the consumer should not take food home in a doggy
bag and that the consumer should not share the meal with others at the table.
This illustrates a general principle that has much wider application in economics. In
economics, we speak of a law or principle of diminishing marginal utility.
The Law of Diminishing Marginal Utility refers to for any goods or service, the
marginal utility of that type of goods or service decreases as the quantity of the goods
increases, ceteris paribus. In other words, total utility increases more and more slowly as
the quantity consumed increases.
A short statement of the law is, as the amount of goods consumed increases, the
marginal utility of those goods tends to diminish.
It is possible for marginal utility to be negative while total utility is positive because total
utility rises as long as marginal utility is positive. When total utility starts to drop, marginal
utility becomes negative.
95
Total utility is still positive as long as the negative marginal utilities are not sizable enough to
completely offset the positive marginal utilities on earlier units of consumption.
Figure 5-1 shows that total utility will

increase initially, reach a maximum and
finally fall.
The law states that as consumption

increases, marginal utility will always fall.
(Marginal utility declines as consumption
increases).
If the consumer is rational, he will only

consume up to the point where marginal
utility is at zero or when total utility is at its
maximum.
5
Figure 5-1 The Law of Marginal Utility Graph
You will eat and drink until you do not want to do so anymore. That is until marginal utility
of each additional drink falls to zero. Your consumption is determined not by prices or
income but simply by your tastes.
I would like to illustrate another example by empirical psychologists of the last century.
Suppose you blindfold a boy and ask him to hold out his hand, palm up. Now place a weight
on his palm; he certainly will notice it. As you add more units of weights, he notices their
addition too. After his palm is seen carrying a good deal of weight, you can add just as big a
weight as you have done in the beginning, and yet this time he will reply that he his not
conscious of any addition. In other words, the greater the total weight he is already carrying,
the less will be in effect of an extra or marginal unit of weight.
96
5.1.3 The Indifference Curve and the Budget Line
Indifference curves show various possible combinations of two goods (x, y) which will yield
the same level of satisfaction or utility to the consumer (Figure 5.2).
The indifference curve will shift upwards and higher as the level of satisfaction
increases. It is negatively sloped downwards from left to right. It cannot be vertical or
horizontal.
The curves are convex to the origin as a result of diminishing marginal utility. Indifference
curves do not intersect. An indifference map refers to successive indifference curves where
each entails a different level of utility.
If one moves away from the origin on the map the level of utility increases. The
consumer’s utility-maximizing combination of two goods will occur on the highest attainable
indifference curve. That is where the budget line is tangent to an indifference curve, which is
the highest attainable level of utility.
The following figure 5-2 shows an indifference map of three indifference curves.
The slope of an indifference curve is

known as marginal rate of substitution
(not constancy). It shows the rate at which
consumers are willing to give up one type
of goods in exchange for more of the other
goods.
The consumers would rather be on 13 than

12, and would rather be on 12 than 11, but
does not care they are on each indifference
curve.
A line intersects each higher indifference

curve, reflecting more of both goods. Figure 5-2 The Indifference Curves/Map
If you, our customer, were given your choice between any two points on it (as the above
graph), you would not know which one to choose. All would be equally desirable to you, and
you would be indifferent as which curve is received.
97
5.1.4 The Properties of Indifference Curves:
A particular indifference curve reflects a constant level of utility, so the consumer is

indifferent about all consumption combinations along a given curve. Combinations are
equally attractive.
If total utility is to remain constant, an increase in the consumption of one type of
goods must be offset to decrease the other good, so each indifference curve slopped
downward.
Consumer preferences:
• Indicate what the consumer is willing to buy.
• Sloped downward: is convex.
• Law of diminishing – marginal rate of substitution – is the amount of goods A that a

consumer is willing to give up to get one more unit of goods B declines as the
consumption of B increases.
5 • Higher indifference curve represent higher levels of utility.
• Indifference curves do not intersect.
5.1.5 Budget Line
Budget line shows various combinations of two products which can be purchased with a
given level of income and knowledge of the prices of the two products. An increase in
income shifts the budget line outward to the right; a higher level of utility will be attainable.
The budget line can be defined as a line that shows all combinations of two goods that
can be purchased at given prices with a given amount of income.
Let us illustrate the example below and plot the budget line (Refer Figure 5-3).
Janet has only RM100 to spend on her two passions of life: buying books and attending
movies. If all books cost RM5 and all movies cost RM2.50 (this is only an assumption to make
the problem easier), Figure 5-3 shows the options to Janet.
98
The budget line is a frontier showing what Janet can attain. The budget line limits a choice
that is due to scarcity. The cost of a book is RM5 or two movies. Spending money on a
product means that money cannot be used to purchase another product. In the case of books
versus movies, the trade off is a straight line because one more book always costs two
movies, regardless of how many books Janet has already.
Figure 5-3 Budget Line
You should be able to see that the slope of the budget line depends only on the price of books
relative to the price of movies. If either book gets cheaper or movies get more expensive, the
budget line in the graph above will get steeper.
If this is not immediately obvious, compute the possibilities open to a person with $100 to
spend if books and movies both cost $5.00 (a case of more expensive movies), and the
possibilities open to a person with $100 to spend if books and movies both cost $2.50 (a case
of cheaper books). Graphing the possibilities open to a person with only $50 to spend but
with books costing $5.00 and movies $2.50 gives you a line that is to the left of the line in the
graph above, but parallel to it, which means that it has the same slope. The amount of money
available to spend does not determine the slope of the budget line; only the ratio of prices
does that.
The indifference curve indicates what you are willing to buy. The budget line shows what
you are able to buy.
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5.2 CASE STUDY
Getting satisfaction
The relationship between marginal utility and the demand curve
When you buy something, it’s normally because you want it. You want it because you
expect to get pleasure, satisfaction or some other sort of benefit from it. This applies to
everything from chocolate bars, to bus journeys, to CDs, to jeans, to insurance.
Economists use the term ‘utility’ to refer to the benefit we get from consumption.
Clearly, the nature and amount of utility that people get varies from one product to
another and from one person to another. But there is a simple rule that applies to virtually
all people and all products. As you consume more of a product, and thus become more
satisfied, so your desire for additional units of it will decline.
5 Economists call this rule the principle of diminishing marginal utility. For example, the
second cup of tea in the morning gives you less additional satisfaction than the first cup.
The third cup gives less still. We call the additional utility you get from consuming an
extra unit of a product the marginal utility. So what the rule is stating that the marginal
utility will fall as we consume more of a product over a period of time.
There is a problem, however, with the concept of marginal utility. How can it be
measured? After all, we cannot get inside each other’s heads to find out just how much
pleasure we are getting from consuming a product! One way around the problem is to
measure marginal utility in money terms; in other words, the amount that a person would
be prepared to pay for one more unit of a product. Thus if you were prepared to pay 80
sen for an extra packet of potato chips per week, then we would say that your marginal
utility from consuming it is 80 sen. As long as you prepared to pay more or the same as
the actual price, you will buy an extra packet. If you are not prepared to pay that price,
you will not.
We can now see how this relates to a downward sloping demand curve. As the price of a
type of goods falls, it will be worth buying extra units. You will buy more because the
price will now be below the amount you are prepared to pay (i.e. price is less than your
marginal utility). But as you buy more, your marginal utility from consuming each extra
unit will get less and less. How may extra units do you buy? You will stop when the
marginal utility has fallen to the new lower price of the good: when MU = P.
1. How will your marginal utility from the consumption of electricity be affected by the
number of electrical appliances you own?
100
2. How will your marginal utility from the consumption of butter depend on the amount
of margarine you consume?
3. If a type of goods is free, what would your marginal utility be from consuming it?
(Source: Sloman & Norris, 2005)
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5.3 SUMMARY
Human beings have unlimited wants but limited resources. As a rational consumers they will
try to maximize their choice and satisfaction or achieve consumer equilibrium with a given
level of income.
Marginal utility is defined as the increase in utility as a result of consuming one more unit of
the goods – additional satisfaction gained from extra unit consumption.
Utility refers to the degree of benefit or satisfaction that a person gets from the consumption
of goods and services.
Total utility refers to the total satisfaction as a result of consuming goods and services. More
consumption generally gives more total utility – aggregate sum of satisfaction.
The law of marginal utility states that the additional satisfaction which a person derives for
every additional unit consumed will diminish as he consumes more.
5 The Law of Equi-Marginal Utility is an extension to the law of diminishing marginal utility.
The paradox of value which is also known as diamond-water paradox can be solved by
distinguishing between total utility and marginal utility.
Consumer’s surplus can be expressed as the difference between what the consumer is willing
to pay and what he actually pays.
Consumer surplus can be understood as the difference between the total

value of a quantity of some goods purchased, and the total value of the
money paid for the whole quantity.
An indifference curve shows the various possible combinations between two goods (x, y) that
will give the consumer the same level of satisfaction. As the level of satisfaction increases,
the indifference curve will shift upwards and higher.
Consumer tastes can be represented by a map of non-intersecting indifference curves. Along

each indifference curve, utility is constant.
Indifferent curves exhibit a diminishing marginal rate of substitution.
Since the consumer prefers more to less, he will always select a point on the budget line. The
consumer has a problem of choice. Along the budget line, more of one type of goods can be
obtained only by sacrificing some of the other goods.
Utility-maximizing consumers choose the consumption bundle at which the highest reachable
indifferent curve is tangent to the budget line.
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5.4 EXERCISES
1. A household’s consumption possibilities are constrained by its income and by the prices
of goods and services. Some combinations of goods and services are affordable, and some
are unaffordable.
(True/False)
2. Consumer’s preference can be described by marginal utility.
(True/False)
3. When a consumer maximizes utility, he/she is using resources inefficiently.
(True/False) 5
4. Your tastes determine the (marginal / utility) you derive from consuming a particular
good.
5. As long as the marginal utility is positive, total utility is downward / rising.
6. The law of diminishing marginal utility states that as an individual consumes more of a
certain goods during a given time period, other things constant, total utility increases /
decreases by smaller / bigger amounts.
7. The price elasticity of the demand for food is negative. The demand for food is inelastic.
A higher food price rises spending on food. Higher food price implies less is spent on all
other goods. The Qd of each of these other goods falls. Discuss each statement. Are they
all correct?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
8. Suppose that marginal utility of Good X = 100, the price of X is RM10 per unit, and the
price of Y is RM5. Assuming that the consumer is in equilibrium and is consuming both
X and Y, what must the marginal utility of Y be?
103
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
9. What is diamonds-water paradox, and how is it explained? Use the same reasoning to
explain why bottled water costs so much more than tap water.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
5 ________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
10. Name two predictions of marginal utility theory.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
104
105
6 Production and Production Costs
Production and Production Costs
Objectives
The Production Theory
Cost and Inputs At the end of this chapter students should be able to:
Short-Run Cost
Production in the short-run: The Law • Distinguish between the short-run and the long-
of Diminishing Marginal Returns run
Short-Run Cost Curve
Marginal Cost and Average Cost • Derive and explain a firm’s short-run cost
curves
Long-Run Cost
Production in the Long-Run: The
• Understand total fixed cost, total variable cost,
Scale of Production marginal cost, and average cost
Economies of Scale (EOS) • Explain the relationship between a firm’s output
Diseconomies of Scale (DOS)
and costs in the long-run
• Derive and explain economies and diseconomies
of scale
106
6.1 PRODUCTION AND PRODUCTION COSTS
Central to our analysis is production. Production is the process by which inputs are
combined, transformed, and turned into outputs.
For example, an automobile plant uses labour, machines, steel, plastic, electricity and
countless other inputs to produce cars
It is important to understand that production and productive activities are not confined to
private business. Households also engage in transforming factors of production (labour,
capital, natural resources and so on). 6
For example, a gardener will combine land, labour, fertilizer, seeds and tools (capital) to
produce vegetables which he eats and the flowers he enjoys.
The relationships between inputs and outputs (the production technology) expressed
numerically or mathematically are called a production function.
6.1.1 The Production Theory
By now we should already understand that the basic economic system’s problems (what to
produce and how much to produce) have been solved by demand and supply theory and the
theory of price.
107
And now we are moving on to the next problem – how to produce? As a producer we
should be able to understand the production and production costs in order to maximize profits
and minimize costs.
The production function identifies the maximum quantities of particular goods that
can be produced per time period with various combinations of resources, for a given level of
technology. It refers to the relationship between inputs and outputs.
The production function can be divided into two efficiencies:
• Economic efficiency refers to the cheapest method of production in terms of Total Cost
(TC) to produce a given level of output.
• Technology efficiency refers to the minimum number of inputs used to produce a given
level of output.
6.1.2 Cost and Inputs
A firm’s cost of production will depend on the factors of production it uses. The more
factors it uses the greater the cost will be. This relationship depends on two elements:
• The productivity of the factors – the greater the productivity, the smaller will be the
6 quantity needed to produce a given level of output, and the lower will be the cost of the
output.
• The price of the factors – the higher their price, the higher will be the costs of
production.
The decisions about the quantity to produce and the price to charge depend on the type of
market in which the firm operates. But decisions about how to produce a given output do not
depend on the type of market in which the firm operates. These decisions are similar for all
types of firms in all types of markets.
Let us study the relationship between a firm’s output decision and its cost, and what the
production function implies for Short-Run and Long-Run Costs.
108
6.1.3 Short-Run Cost
The short-run is a time frame in which at least one of a firm’s resources is fixed. Fixed
resource is an input that cannot be varied in the short-run (for example, the size of the
building).
Output can be changed in the short-run by adjusting variable resources, but the size,
or scale of the firm is fixed in the short-run. Labour is usually the variable input, so to
produce more output, a firm has to hire more labour and operates its production over time.
Short run decisions are easily reversed. The firm can increase or decrease its output
in the short-run by increasing or decreasing the amount of labour it hires. Workers have a
chance to develop skills and better utilize the fixed resources.
6
6.1.4 Production in the short-run: The Law of Diminishing Marginal
Returns
Production in the short-run is subject to diminishing returns. You may well have heard of
the law of diminishing in Chapter 5.
This law states that as more of a variable resource is combined with a given amount of
a fixed resource, the marginal product will decline.
For example, diminishing marginal returns arise

from the fact that more and more workers using
the same capital and working in the same space.
As more workers are added, there is less and less
for the additional workers to do that which is
productive. As a firm uses more of a variable
input, with a given quantity of fixed inputs, the
marginal product of the variable input will
diminish. Marginal returns are diminishing.
109
The Law of Diminishing Marginal Returns is the most important feature of production in
the short run.
Increasing Marginal Returns occur when the marginal product of an additional
worker exceeds the marginal product of the previous workers. The marginal product of the
second worker is greater than the marginal product of the first worker. Marginal returns are
increasing.
6.1.5 Short-Run Cost Curves
In the short-run, some factors are fixed in supply. Their Total Costs (TC) is fixed – do not
vary with output. Total cost includes the cost of a land, capital and labour, and
entrepreneurship.
There are 2 types of Total Costs (TC):
• Total Fixed Cost (TFC) (indirect cost) – is the cost of the firm’s fixed inputs. Since the
quantity of fixed input does not change as output changes, TFC does not change as
output changes. Fixed cost refers to any production cost that is independent of the firm’s
rate of output.
• Total Variable Cost (TVC) (prime cost or direct cost) – is the cost of the firm’s variable
6 inputs. Since to change its output, a firm must change the quantity of variable inputs,
TVC changes as output changes. Variable cost refers to any production cost that
changes as the rate of output changes.
TC measurement would be: TC = TFC + TVC
Let’s look at the illustration on the total cost and marginal cost curves in Figure 6-1 and 6-2
below.
In Figure 6.1, since FC does not vary with

output; the FC curve is a horizontal line at
RM200 level. Variable cost starts from O
and increases slowly as output increases.
When the variable resource generates

diminishing marginal returns, variable cost
begins to increase more rapidly.
Total cost is the vertical sum of fixed cost

and variable cost.
Figure 6-1 Total Cost Curve
(Source: McEachern, William, 2006)
110
In Figure 6.2, marginal cost first declines,

reflecting increasing marginal returns, and
then increases, reflect diminishing marginal
returns.
Notice that the TC curve has a backward S

shape, due to the result of combining
marginal return above.
Figure 6-2 Marginal Cost Curve
(Source: McEachern, William, 2006)
What is the difference between fixed and variable costs? Do both of the cost have an effect
on the short-run marginal cost?
FC is a short run phenomenon. It does not vary as output varies, and the firm must pay FC in
the short-run even if output is zero. VC is associated with the firm’s variable resources. As
6
output varies, usage of variable resources varies. Thus variable cost rises as output rises and
falls as output falls. If output is zero, VC is zero. Since MC measures the change in TC as
output changes by one unit, it is affected by variable cost only.
6.1.6 Marginal Cost and Average Cost
Marginal Cost (MC) is the extra cost of producing one more unit; that is the rise in TC per
one unit rise in output.
MC measurement is: MC = ΔTC

ΔQ
(Where Δ means ‘change in' or ‘rise in’)
For example, say a firm is currently producing 1,000,000 boxes of matches a month. It now
increases its output by 1,000 boxes (on another batch) therefore,
the ΔQ = 1,000
Let us understand first what is meant by the Marginal Product (MP). It is the additional
output that can be produced by adding one more unit of a specific input, ceteris paribus.
111
According to the law of diminishing returns, when additional units of a variable input
are added to fixed inputs after a certain point, the MP of the variable input will decline.
Average product (AP) is the average amount of product produced by each unit of a
variable factor of production.
For example, you have sat for six exams and that your average score is 86. If you score 75
for the next exam, your average score will fall, but not all the way to 75. In fact, it will fall
only to 84.4. If you have a score of 95 instead, your average will rise to 87.3.
MC indicates how much TC will increase if one more unit is produced or how much TC will
drop if production declines by one unit (Refer to Figure 6-1).
6 Average Cost (AC) is cost per unit of production. AC corresponds to VC and to TC.
AC measurement is: AC = TC
Q
Table 6-1 relates the amount of labour employed to the amount of output produced. Labour is
measured as one worker for one day (labour employed ranges from 0 to 8 worker-days).
Total product - output is measured in tons of furniture being moved per day at each
level of employment. The marginal product of each worker is the amount by which the total
product changes with each additional unit of labour.
Let’s look at the relationship between Table 6-1 and Figure 6-3.
112
Table 6-1 The Short Run Relationship between Units of Labour and Tons of Furniture Moved
Figure 6-3 illustrates the relationship between total product and marginal product, using data
from Table 6-1.
6
Because of increasing marginal returns,
marginal product in (b) increases with each
of the first three workers.
With marginal product increasing, total

product in (a) increases at an accelerating
rate.
But once decreasing marginal returns set in,

which begins with the fourth worker,
marginal product declines.
Total product continues to increase but at a

decreasing rate. As long as marginal product
is positive, total product increases.
Where marginal product turns negative, total

product starts to fall.
Figure 6-3 The Total and Marginal Product
(Source: Mc Eachern, William, 2006)
113
The total and marginal production summarizes:
• increasing marginal returns,
• diminishing but positive marginal returns, and
• negative marginal returns.
• These ranges for marginal product correspond with total product that:
¾ increases at an increasing rate,
¾ declines.
6.1.7 Long-Run Cost
The long-run is a time frame in which all resources under the firm’s control are variable.
Variable resource is any resource that can be varied in the short-run to increase or decrease
production (no resource is fixed).
The length of the long-run differs from industry to industry because the nature of
production differs. To increase output in the long-run, a firm is able to choose whether to
6 increase to change its plant (for example) as well as whether to increase the quantity of the
labour it hires.
Long-run decisions are not easily reversed. Once a plant decision is made, the firm
usually must live with it for some time.
6.1.8 Production in the Long-Run: The Scale of Production
In the long-run, all factors of production are variable. A firm can build a new factory at any
time, to install new machines, to use different techniques of production and in whatever
quantities in output it chooses.
The word ‘scale’ means that all inputs increase by the same proportion.
Decreasing return to scale is therefore quite different from diminishing marginal returns.
How does a firm’s cost vary with output over the longer term? We can distinguish by looking
at two possible situations:
114
• Economies of Scale
¾ Forces that cause a reduction in a firm’s long-run average cost as the scale of
operation increases.
• Diseconomies of Scale
¾ Forces that cause an increase in a firm’s long-run average cost as the scale of
operation increases.
6.1.9 Economies of Scale (EOS)
Like short-run average cost curves, the long-run average cost curve (LRAC) is U-shaped.
A firm experiences economies of scale if costs per unit of output fall as the scale of
production increases. Consider some sources of economies of scale. A larger size often
allows for larger, more specialized machines and greater specialization of labour.
EOS features a firm’s technology that leads to falling long-run average cost as output
increases. The LRAC curve slopes downward.
EOS are said to exist when the AC declines as output increases over a range of output.
If AC declines as output increases, so must the MC (the cost of the last incremental unit of
output). EOS are not limited to manufacturing; marketing, R&D, and other functions can
realize economies of scale as well. The relationship between AC and MC can be summarized
as follows: 6
MC < AC = Economies of scale
MC = AC = Constant returns to scale
MC > AC = Diseconomies of scale
6.1.10 Diseconomies of Scale (DOS)
Diseconomies of scale result from a larger firm size, whereas diminishing marginal returns
result from using more variable resources in a firm of a given size. The main source of DOS
is the difficulty in managing a very large enterprise.
DOS are features of a firm’s technology that lead to a rising long-run average cost as
output increases. The LRAC curves slopes upward.
Diseconomies of scale can sometimes occur for the following reasons:
• A specific process within a plant cannot produce the same quantity of output as another
related process. For example, if a product requires both screw A and screw B,
diseconomies of scale might occur if screw B is produced at a slower rate than screw A.
• As output increases, costs of transporting the good to distant markets can increase enough
to offset any economies of scale. For example, when a firm has a large plant capable of
115
producing a large output located in one location, the more the firm produces, the more it
needs to ship to distant locations.
• Up to output level A, LRAC falls as the

firm’s experiences EOS.
• Output level A is the minimum efficient

scale - the lowest rate of output at which
the firm takes full advantage of EOS.
• Between A and B, the average cost is

constant. Beyond output level B, long-
run average cost increases as the firm’s
experiences DOS.
6 Figure 6-4 The Long Run Average Cost (LRAC)
If when a firm increases its labour and capital by 10 per cent, output increases by more than
10 per cent, its average TC falls. EOS is present. If when a firm increases its labour and
capital by 10 per cent, output increases by less than 10 per cent, its average TC rises. DOS is
present.
What distinguishes a firm’s short-run period from its long-run?

In the short-run, at least one of the firm’s resources is fixed, usually the size of the firm. In
the long-run, all the resources are variable. That is, the quantities of all resources can change
to alter the firm’s level of output, including the size of the firm.
116
6.2 SUMMARY
By considering the relationship between production and production costs, we have developed
the foundation for a theory of firm behaviour.
The relationship between inputs and outputs expressed numerically or mathematically is

called a production function.
Production in the short-run is subject to diminishing returns, which explains why marginal
cost and average cost eventually increase as output expands.
Total cost can be divided into total fixed cost and total variable cost. Total variable cost will
tend to increase less rapidly at first as more is produced, but then, when diminishing returns
set in, it will increase more rapidly.
Marginal cost is the cost of producing one more unit of output. It will probably fall at first,
but will start to rise as soon as diminishing returns set in.
Average cost, like total cost is divided into fixed and variable cost. Average fixed cost will
decline as more output is produced. Average variable cost will tend to decline at first, but
once marginal cost has risen above it, it must then rise.
In the long-run, all inputs under the firm’s control are variable, so there is no fixed cost. 6
The firm’s long-run average cost curve is an envelope formed by a series of short run
average total cost curves.
A long-run average cost curve indicates the lowest average cost of production at each rate of
output when the size or scale of the firm varies.
A firm’s long-run average cost curve, like its short run average cost curves, is U-shaped.
As output expands, the average cost at first declines because of economies of scale – a larger
plant size allows for bigger and more specialized machinery and a more extensive division of
labour.
Average cost may be constant over some range. If output expands still further, the plant may
encounter diseconomies of scale as the cost of coordinating resource grows.
Economies and diseconomies of scale can occur at the plant level and the firm level.
The LRAC curve can be downward sloping, upward sloping or horizontal, depending in turn
on whether there are economies of scale, diseconomies of scale or neither.
117
6.3 EXERCISES
1. Distinguish between the short-run and long-run in the theory of production.
________________________________________________________________________
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________________________________________________________________________
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6 ________________________________________________________________________
2. Identify whether the following are fixed costs or variable costs.
a) The depreciation of machinery used in production
________________________________________________________________________
b) Interest charges on a bank loan
________________________________________________________________________
c) Utility bills of a management consultancy office
________________________________________________________________________
d) Electricity and water bills paid by a car-wash firm
________________________________________________________________________
e) Cost of cement and bricks used to build houses
________________________________________________________________________
f) Wages of production operators employed by a textile factory
________________________________________________________________________
118
3. The production function of a firm is given by:
Q = 400 KL -5 KL²
Where Q is the output,
L is the number of workers employed
K is the quantity of capital employed in units
The quantity of capital is fixed in the short-run at 10 units.
a) What is the output if the firm employs 20 workers?
________________________________________________________________________
________________________________________________________________________
b) What is the marginal product of the 21st worker?
________________________________________________________________________
________________________________________________________________________
c) Write an equation for the marginal product of labour in the short-run. 6

________________________________________________________________________
________________________________________________________________________
d) How many workers must the firm employ to maximize its output?
________________________________________________________________________
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e) What is the maximum output in the short-run?
________________________________________________________________________
________________________________________________________________________
f) Write an equation for the average product.
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________________________________________________________________________
4. What effect would each of the following have on a firm’s short-run marginal cost curve
and its total fixed cost curve?
119
a) An increase in the wage rate
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b) A decrease in property taxes
________________________________________________________________________
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c) A rise in the purchase price of new capital
________________________________________________________________________
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d) A rise in energy prices
________________________________________________________________________
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6 5. What type of changes could shift the long-run average cost curve? How would these
changes also affect the short-run average total cost curve?
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120
121
7 Market Structures
Market Structures
Objectives
Perfect Competition
Revenue Curves of Perfect At the end of this chapter students should be able to:
Competition
Short-Run Equilibrium in Perfect
Competition • Define perfect competition
Long-Run Equilibrium in Perfect • Explain how price and output are determined in
Competition
Entry and Exit perfect competition
• Explain why firms shut down temporarily and
Monopolistic Competition
Short-Run and Long-Run
lay off workers
Equilibrium in Monopolistic • Explain why firms enter and leave the industry
Competition • Explain how monopoly arises
Perfect Competition versus
Monopolistic Competition in the • Compare monopoly with perfect competition
Long-Run Equilibrium • Explain how price discrimination increases
Monopoly
profit
How Monopoly Arises • Define and identify monopolistic competition
Monopoly in the Long-Run and • Explain how output and price are determined in
Short-Run
Perfect Competition versus a monopolistically competitive industry
Monopoly • Define oligopoly
Oligopoly
Comparison of the Market Structures
122
Market Structures
7.1 MARKET STRUCTURES
The concept of market structure is central to both economics and marketing. Each discipline
takes a different methodological approach towards problem-solving.
Economics is concerned with the market competition and fair pricing as well as
firm pricing strategies. Marketing, on the other hand, is more concerned on the market
structure analysis.
Market Structure describes the important structure of the market, such as:
• The number of suppliers – are they many or few?
• The product degree of uniformity – do firms in the market supply any identical product,
or are there any differences among the firms?
7
• Entry into the markets – can a new firm enters easily or is entry blocked?
• How much competition does a firm face – do firms compete based only on price, or do
they also compete through advertising and product differences?
A firm’s decision about how much to produce or what price to charge depends on the
structure of the market.
Of the four (4) market structures, each represents an abstract (generic) characteristic of
a type of real market. Let’s take note on the abstract individually.
• Perfect Competition
• Monopolistic Competition
• Monopoly
• Oligopoly
123
7.1.1 Perfect Competition
What is the difference between making things right and making the right things?
And what is so perfect about perfect competition?
To answer these, let us examine our first market structure – perfect competition, sometimes
known as pure competition.
Perfect Competition is an industry in which:
• There are many firms
• There is freedom of entry into the industry
• All firms produce an identical product
• All firms are price takers
The very large number of firms in perfect competition implies that each individual firm is
very small in comparison to the total market. So each firm buys or sells only a tiny fraction of
the total amount exchanged in the market.
7 For example, in the milk production segment of

agriculture, farms are usually small. They are
especially small compared to the size of the entire
market for milk. We should know that the milk
distributors are occasionally large, but not the
productive farms.
The production in perfect competition is said to be standardized or homogeneous (no

branding or advertising). They are identical. The consumer cannot differentiate whether the
good comes from producer A or B or C. No advertisement done in this market.
For example, milk is a uniform and homogeneous

product. It is not possible to make a distinction between
the milk of one farm and another. The government has
in fact set standards of quality, fat content and
cleanliness.
124
Market Structures
The firms which are in perfect competition have no power over price; they have to sell
whatever is quoted in the market price. Price is determined by market demand and supply.
The firms which are in perfect competition are said to be price takers. (Price taker is a firm
that cannot influence the price of goods or service).
Lowering the price is not necessary, because customers would not buy from the firm
as they could get the same product from other firms.
A perfectly competitive firm is so small relatively to the size of the market - that the firm’s
choice about how much to produce has no effect on the market price.
There are no barriers to ‘entry’ or ‘to exit’ (freedom of entry) from a market in
perfect competition. This condition assures that no firm will dominate the market and evict
other firms and they remain large.
Producers and consumers have perfect knowledge of the market. That is, producers
are fully aware of prices, costs and market opportunities. Consumers are fully aware of price,
quality and availability of the product.
7.1.2 Short-Run Equilibrium in Perfect Competition
What is short-run under perfect competition? It is the period during which there is too little
time for new firms to enter the industry.
To determine the market price and the quantity bought and sold in a perfectly
competitive market, we need to study how market demand and market supply interact.
Industry demand and industry supply determine the market price and market output.
Let us examine the determination of price, output and profit in perfect competition as shown
in the Figures 7-1.
Let’s say the industry supply curve is S.

Demand is D1, and the price is RM20.
At this price, each firm produces 8 shirts a

day and the industry produces 8,000 shirts
a day.
So, under perfect competition, the firm’s

supply curve entirely depends on
production costs. This demonstrates why
the firm’s supply curve is upward sloping.
Equilibrium
125
In part (b), when demand increases to D2,

the price rises to RM25 and each firm
increases its output to 9 shirts a day.
Industry output is 9,000 shirts a day. When

demand decreases to D3, the price falls to
RM17 and each firm decreases its output
to 7 shirts a day. Industry output is 7,000
shirts a day.
Change in Equilibrium
Figure 7-1 Short Run Equilibrium
(Source: Parkins, Michael, 2003)
7.1.3 Long-Run Equilibrium in Perfect Competition
In the short-run equilibrium, a firm might make an economic profit, or incur an economic
loss, or make normal profit (break-even). But in the long-run, an industry has to adjust the
equilibrium by entering or exiting an industry.
Long-run equilibrium occurs in a competitive industry when the economic profit is
zero or when firms earn normal profit. No firm has an incentive to enter the industry or to
7 leave it.
All factors of production in the long-run are variable. If a typical firm is making
supernormal profits, new firms will be attracted. Likewise, if existing firm can make
supernormal profits by increasing the scale of operations, they will do so.
So, in the long-run equilibrium in a competitive industry, firms either enter or exit
the industry and old firms neither expand nor downsize. Each firm earns normal profit.
Let us examine the long-run equilibrium in Figure 7-2 below.
Figure 7-2 Long Run Equilibrium
126
Market Structures
An industry starts out in the long-run competitive equilibrium. Part (a) shows the industry
demand curve is Do, the industry supply curve is So, the equilibrium quantity is Qo, and the
market price is Po.
Each firm sells its output at price Po, so its MR is MRo (part b). Each firm produces qo and
makes normal profit.
Demand decreases permanently from Do to D1 (part a). The equilibrium price falls to P1, each
firm decreases its output to q1 (part b), and industry output decreases to q1 (part a).
In this new situation, firms incur economic losses and some firms leave the industry. If so,
the industry supply curve gradually shifts leftward from So to S1.
This shift gradually raises the market price from P1 back to Po. While the price is below Po,
firms incur economic losses and some firms leave the industry.
Once the price has returned to Po, each firm makes a normal profit. Firms have no further
incentive to leave the industry.
Each firm produces qo, and industry output is q2.
(Source: Parkins, Michael, 2003)
7.1.4 Entry and Exit
Entry and exit of firms to the industry influence price, the quantity produced, and
economic profit. The immediate effect is to shift the industry supply curve. If more firms
enter an industry, supply increases and the industry supply curve shifts rightward. If firms
7
exit an industry, supply decreases and the industry supply curve shifts leftward.
As new firms enter an industry, the price falls and the economic profit of each
existing firm decreases. As firms leave an industry, the price rises and the economic loss of
each remaining firm decreases.
Let’s see what happens when new firms enter, and when firms leave an industry.
127
Figure 7-3 Entry and Exit
When new firms enter the industry the supply curve shifts rightward, from S1 to S0.
Let’s say the equilibrium price falls from RM23 to RM20, and the quantity produced
increases from 7,000 to 8,000.
When firms exit the industry, the supply curve shifts leftward, from S2 to S0. The equilibrium
price rises from RM17 to RM20, and the quantity produced decreases from 9,000 to 8,000.
In the long-run, regardless of whether demand increases or decreases, the price returns to its
original level. It is impossible for the long-run equilibrium price to remain the same, rise or
fall. You have seen how a competitive industry adjusts toward its long-run equilibrium.
7
7.1.5 Monopolistic Competition
You have studied perfect competition where a large number of firms produce identical goods,
there is no barrier to entry, and each firm is a price taker. In the long-run, there is no
economic profit.
Each supplier of monopolistic competition is a price maker. Barriers to entry are low
and firms can enter or leave the industry in the long-run. Sellers also behave competitively.
Monopolistic competition is a market structure with many firms selling products that
are close substitutes and firm entry is relatively easy.
Monopolistic Competition is an industry like perfect competition in which:
128
Market Structures
• There are many firms
• There is freedom of entry into the industry
• Each firm produces a differentiated product
• Firms have some control over their price
7.1.6 Short-Run and Long-Run Equilibrium in Monopolistic

Competition
As we know that many firms are selling substitutes, any firm that raises its price can expect to
lose some customers, but not all, to rivals. Recall that the availability of substitutes for a
given product affects its price elasticity of demand. A firm’s demand curve will be more
elastic, the more substitutes there are the less differentiated its product is.
Figure 7.4 shows the price and quantity combinations that maximize and minimize the short
run equilibrium.
(a) Maximizing Short Run Profit (b) Minimizing Short Run Loss
Figure 7-4 Monopolistic Competition in the Short Run
The monopolistically competitive firm produces the level of output at which MR equals MC
(point e) and charges the price indicated by point b on the downward sloping demand curve.
In (a) the firm produces q units, sells them at price P, and earns a short run economic profit
equal to (b – c) multiplied by q.
In (b) the average TC exceeds the price at the output where MR equals MC. Thus the firm
suffers a short run loss equal to (c – P) multiplied by q.
(Source: McEachern, 2006)

In the short-run, the monopolistic competitive firm can earn three types of profits:
129
(Refer to Figure 7-4)
• Supernormal profits or economic profits
• Normal profits
• Subnormal profits or minimizing losses
A monopolistic competitor maximizes profit just as a Monopolist (next topic) does: the profit
maximizing quantity occurs where MR equals MC; the profit maximizing price for that
quantity is found up on the demand curve (as in Figure 7-5).
Figure 7-5 shows if firms earn a profit, new

firms will enter the industry in the long-
run.
This entry reduces the demand facing each

firm. In the long-run, the demand curve
shifts leftward until MR equals MC (point
a) and the demand curve is tangent to the
average total cost curve (point b).
The Economic profit is zero at output q.

With zero profit no more firms will enter,
7 so the industry is in long run equilibrium.

Figure 7-5 Long-run Equilibrium of the firm under
Monopolistic Competition
(Source: McEachern, 2006)
The same long-run outcome will occur if firms suffer a short-run loss. Firms will leave until
their remaining earns becomes a normal profit, but not economic profit.
Because of the ease of entry into the market, monopolistic competitive firms earn zero
economic profit in the long-run. Monopolistic competitive firms spend large amounts on
advertising, which contributes to an increase in average costs.
Figure 7-5 shows the long-run equilibrium for a typical monopolistic competitor. In
the long-run, entry and exit will alter each firm’s demand curve until economic profit
disappears – until each price equals average total cost.
And now we understand that monopolistic competition is like monopoly in the sense
that firms in each industry face demand curves at downward slope.
Monopolistic competition is like perfect competition in the sense that easy entry
and exit eliminate economic profit or economic loss in the long-run.
130
Market Structures
7.1.7 Perfect Competition versus Monopolistic Competition in the

Long-Run Equilibrium
Figure 7-6 compares the long-run equilibrium position of two firms. The perfectly
competitive firm faces a demand curve that is horizontal at market price. It will produce an
output of q, at price of P.
The other is under monopolistic competitive and thus faces a downward sloping
demand curve. It will produce a lower output at Q2 at the higher price of P2.
A crucial assumption here is that a firm would have the same long-run average cost (LRAC)
curve in both cases.
By producing more, firms would move to a lower point on their LRAC curve.
Therefore firms under monopolistic competition are said to have excess capacity as shown in
Q1 – Q2. Excess capacity (under monopolistic competition) is the output at which average
total cost is a minimum (at the bottom of U-shaped) – LRAC.
Given the following example as in the Figure 7-6, monopolistic competition has the
following disadvantages:
• Less will be sold and at a higher price
• Firms will not be producing at the least-cost point.
Figure 7-6 Long Run Equilibrium of the Firm Comparison with Perfect Competition
131
7.1.8 Monopoly
What happens when there is only one firm in the market? Do we, as a consumer suffer?
A monopoly from Latin word monopolium – Greek language monos, one + polium, to sell.
A Monopoly exists where there is only one firm in the industry. A Monopoly is similar to
those under Oligopoly (next topic), where the size of barriers will vary (arbitrary) from
industry to industry.
For example, a textile company may have a monopoly on certain types of fabric, but it
does not have a monopoly on fabrics in general.
For a firm to maintain its monopoly position there must be barriers to the entry of new
firms. One way to prevent new firms from entering into the market is to make entry legal.
7 7.1.9 How Monopoly Arises
There are two key functions on how a monopoly arises:
1. No close substitute – Monopolies are constantly under attack from new products and
ideas that substitute for products produced by monopolies.
• If goods have a close substitute, even though only one firm produces it, that firm
effectively faces competition for the producers of substitutes. For example, the
satellite dish has weakened the monopoly of cable television companies.
2. Barriers to entry – This refers to a legal or natural constraint that protects a firm
from potential competitors.
• Legal barriers to entry create a legal monopoly - market in which competition and
entry is restricted by the granting of government license, patent, or copyright.
Most monopolies are regulated in some way by government agencies.
7.1.10 Monopoly in the Long-Run and Short-Run
132
Market Structures
The distinction between short-run and long-run in monopoly markets is less important. In the
short-run, monopoly is limited by a fixed factor of production, as competitive firms are.
What will happen to the monopoly in the long-run? If the monopoly is earning
positive profit, nothing will happen. In addition, because we assume that a monopoly is a
profit maximizing firm, it will operate at the most efficient scale of production. It will neither
expand nor contract in the long run.
It is impossible for a profit maximizing monopolist to suffer short run losses. Total
revenue is sufficient to cover variable cost but not the total cost.
If a monopoly is insulated from competition by high barriers that block new entry,
economic profit can persist in the long run.
7.1.11 Perfect Competition versus Monopoly
Monopolists will produce a quite different output and price from a perfectly competitive
industry because they face a different type of market environment.
7
Let us compare the two of them. By looking at Figure 7-7, we can analyze that the
monopolist demand curve slopes downward, the MR curve also slopes downward and is
beneath the demand curve (a).
A Monopolist restricts output to Qm and sells that output to Pm (a). Consumer surplus
under perfect competition is the large triangle (b). Under monopoly, consumer surplus
shrinks to the smaller triangle (a).
Consumers lose partly by having to pay more for the goods and partly by getting less
of it. Part of the original producers is also lost (b).
The monopolist earns an economic profit equal to the shaded rectangle. By comparing
the situation under monopoly with that under perfect competition, you can see that the
monopolist’s economic profit comes entirely from what was consumer surplus under perfect
competition.
The monopolist takes the triangle A and creates a “deadweight loss” which is part of
the consumer surplus under perfect competition. This “deadweight loss” results from the
inefficiency arising from the higher price and a reduced output of monopoly.
133
Monopoly Perfect Competition
Figure 7-7 Perfect Competition and Monopoly
(Source: Parkin, 2003)
7.1.12 Oligopoly
What happens if there are just a few firms that dominate the market?
7 The final structure we examine is Oligopoly, a Greek word meaning “few sellers” – a market
dominated by just a few firms.
Oligopoly occurs when just a few firms between them share a large proportion of the
industry. Each firm produces a differentiated product. Oligopoly is similar to those under
monopoly, where the size of barriers will vary from industry to industry.
134
Market Structures
Let us look into this as an example. Suppose you operate one of the three gas station in a
small town. If you cut your petrol price and your two competitors do not cut theirs, your sales
increase, and the sales of the other two firms decrease. With lower sales, the other firms will
most likely cut their prices too. If they do cut their prices, your sales and profits will tumble.
So before deciding to cut your price, you must predict how the other firms will react and
attempt to calculate the effects of those reactions on your own profit.
(Parkins, 2003)
Oligopoly are therefore said to be interdependent, and the behaviour of any particular firm
is difficult to predict.
Monopolistic competition is like a golf tournament, where each player strives for a
personal best. Oligopoly is more like a tennis match, where each player’s action depends on
how and where the opponent hits the ball.
7.1.13 Comparison of the Market Structures 7

Types of Number of Freedom of Ability to set Nature of
market Firms Entry Price Product/Examples
Homogeneous or
standardized /
Examples:
1. Agricultural – wheat,
Unrestricted corn, livestock
Perfect Very large / (free to None 2. Basic commodities –
Competition many enter and (price takers) gold, silver, copper
exit) 3. Traded stock and
market for foreign
exchange
Unrestricted
Monopolistic Many /
(free to Some Considerable or
Competition several
enter and differentiated /
135
exit) Examples:
Bus and taxi service,
manufacturing shampoos
and shoes. Plumbers and
restaurateur
Restricted Considerable or no close

or substitute /
completely Examples:
Monopoly One / single Unique
blocked Local phone, post, gas,
(Barriers to electricity, water
Entry) authorities
Differentiated or
standardized /
Restricted Examples:
or partial (Dominates local market)
Oligopoly Few / small Some
(Barriers to Gas station/retailer, video
Entry) rental store, cement
industry, banks and cars
producers
136
Market Structures
7.2 CASE STUDY
Oligopoly or Monopolistic Competition

Big firms and little firms: the case of bakeries
Despite barriers to entry of other large-scale firms, many oligopolies face competition at
the margin from many small firms. The reason for this is that the small firms often
produce a specialist product or serve a local market. These small firms are in a position
somewhat like monopolistic competition: they produce a differentiated product and face
few if any entry barriers themselves.
A good example of this is bakers. Two giant producers, A Bakeries and B Bakeries,
produce bread for a nationwide market, with 34 per cent and 32 per cent respectively of
the Malaysian market in 2001. But then there are thousands of small bakeries, often
where the bread is baked in the shop. Their bread is usually more expensive than the
mass-produced bread of the two giants, but they often sell a greater variety of loaves,
cakes, etc., and many people prefer to buy their bread freshly baked.
In the 1950s and 1960s, the giant bakers gradually captured a larger and larger share
of the market. This was due to technical developments that allowed economies of scale:
developments such as mechanical handling of bread, processes that allowed rapid large-
scale proving of dough, and bulk road tankers for flour. Also, with the development of
supermarkets where people tended to shop for the week, there was a growth in large-
volume retail outlets where there was a demand for wrapped bread with a long sell-by
date. These presented real barriers to the small baker.
7
But then in the 1970s, the rise in oil prices and hence the rise in transport costs gave a
substantial cost advantage to locally produced bread. What is more, some of the technical
developments of the 1960s were adapted to small-scale baking. Finally there was a shift
in consumer tastes away from mass-produced bread and towards the more individual
styles of bread produced by the small baker.
The effect was a growth in the number of small bakers, who now found that entry
barriers were very small.
1. Explain the concept of oligopoly and monopolistic competition in this case study.
2. Are the large oligopolistic bakers and the small bakers catering for the same market?
Explain your study.
(Source: Sloman and Sutcliffe, 2003/2005)
137
7.3 SUMMARY
Market structures describe important features of the economic environment in which firms
operates. These features include the number of buyers and sellers in the market, the ease or
difficulty of entering the market, difference in the product across firms, and the forms of
competition among firms.
There are four alternative market structures under which firms operate; they are perfect
competition, monopolistic competition, monopoly and oligopoly.
The assumptions of a perfect competition are a very large number of firms, complete freedom
of entry, a homogeneous product, and perfect knowledge of the good and its market by both
producers and consumers.
Firm in perfect competition are said to be price takers because no firm can influence the
market price. The market price in perfect competition is determined by the intersection of
demand and supply.
Monopolistic competition occurs when there is free entry in the industry and quite a large
number of firms operating independently of each other.
In the short-run, monopolistic competitors that can at least cover their average variable costs
will maximize profits or minimize losses by producing where marginal revenue equals
marginal cost.
7 In the long-run, easy entry and exit of firms ensures monopolistic competitors earn only a
normal profit, which occurs where the average total cost curve is tangent to a firm’s
downward sloping demand curve.
A monopolist is the sole supplier of a product with no close substitutes; its demand curve is
also the market demand curve.
Since a monopolist that does not price discriminate, he can sell more only by lowering the
price for all units, MR is less than the price.
Price discrimination is where a firm sells the same product at different prices in different
markets and it allows the firm to earn higher revenue from a given level of sales.
To increase profit through price discrimination, the monopolist must have at least two
differentiable groups of customers, each with a different price elasticity of demand in a given
price, and must be able to prevent customers charging the lower price from reselling to those
being charged the higher price.
An oligopoly is an industry dominated by a few sellers, some of which are large enough
relative to the market to influence the price.
Since an oligopoly consists of just a few firms, each may react to another firm’s changes in
quality, price, output, or services. No single approach characterizes all oligopolistic markets
because they are interdependent.
138
Market Structures
7.4 EXERCISES
1. Define market structure. What factors are considered in determining the market structure
of a particular industry?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
2. Determine whether each of the following is a characteristic of perfect competition,

monopolistic competition, oligopoly, and/or monopoly:
a) A large number of sellers
________________________________________________________________________
b) A homogeneous product
7
________________________________________________________________________
c) Advertising by firms
________________________________________________________________________
d) Barriers to entry
________________________________________________________________________
e) Firms that are price makers
________________________________________________________________________
3. a.) Why does the demand curve facing a monopolistically competitive firm slopes
downward in the long-run, even after the entry of new firms?
________________________________________________________________________
________________________________________________________________________
139
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
b.) Do the firms in an oligopoly act independently or interdependently? Explain your

answer.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
4. Cool Air’s Mineral Springs, a single price monopoly, faces the demand schedule and has
the following total cost.
7 Price
(RM per bottle)
Quantity
Demanded
(bottles per
Quantity
Produced
Total Cost
(RM)
(bottles per hour)
hour)
10 0 0 1
8 1 1 3
6 2 2 7
4 3 3 13
2 4 4 21
0 5 5 31
You are required to:
a) Calculate Cool Air’s total revenue schedule.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
140
Market Structures
b) Calculate its marginal revenue schedule.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
c) Calculate the marginal cost of producing each output in the table.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
d) Calculate the profit maximizing output and price.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________ 7
________________________________________________________________________
e) Calculate the economic profit.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
f) Does Cool Air’s use resources efficiently? Explain your answer.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
141
8 Role of Government and Economic Growth
(Macroeconomics)
Role of Government
Objectives
Economic growth and development
Government revenue and expenditure
Areas of government intervention
• Examine the sources of government revenue
Differences between developing and • Understand government expenditure
developed countries
Problems faced by developing • Define tax
countries in achieving economic • Understand the purpose of taxation
growth
• Understand the differences between developing
and developed countries
142
Role of Government and Economic Growth (Macroeconomics)
8.1 ROLE OF GOVERNMENT
How much can we rely on governments?
First, governments must have the will to protect the environment. But governments are also
accountable for their improvements in economies of the country and must often appease
various pressure groups, such as representatives of big business.
Governments may provide goods and services directly. These could be in the
category of public goods or other goods where the government feels that provision by the
market is inadequate. Governments may also provide information in cases where the private
sector fails to provide an adequate level.
Governments try to achieve high rates of economic growth over the long term. It
means that growth that is sustained over the years and is not just a temporary phenomenon.
The Government is always avoiding recessions and excessive short-term growth that cannot
be sustained. 8
8.1.1 Economic growth and development
Economic growth refers to the increase in national income whereas economic development
relates to changing economic structures from primary to secondary sector (Sloman, 2005)
Economic growth is defined as the percentage change in GDP over the previous
year. It is a quantitative measure of output or production which is also equivalent to national
income.
GDP changes over time when the output of goods and services changes, and when the
prices of these goods and services change. Economic growth occurs when the total output of
goods and services increases.
143
There are three causes of economic growth:
• Actual growth. Is the annual increase in national output or GDP (in %). It means the rate
of growth in actual output produced.
• Potential growth. It is the speed at which the economy could grow. It is the annual
increase in the economy’s capacity to produce. The two main factors that contribute to
potential growth/output are:
1. An increase in resources – natural resources, labour and capital
2. An increase in efficiency – advances in technology, improved labour skills

or improved organization
• The effectiveness of fiscal policy
1. A country can produce more of both goods – x and y without having to

forego the production of another – by using the shift of the PPC outwards
(remember!)
2. The government can encourage technological development by offering

8 subsidies to companies in research and development.
3. The accuracy of forecasting – reliability of forecasts to aggregate demand
4. The extent to which changes in aggregate demand successfully affect

output, employment, inflation and the balance of payments.
Since we have covered most of the chapters, now let’s look at an example of the recent
development of Malaysian economy that we can link the situation with the previous chapter.
The Malaysian economy recorded an expansion of 5.9% in the second quarter of 2006, year-
on-year, exceeding the 5.5% growth (revised) in the first quarter of 2006. For the first half of
the year, the economy posted a 5.7% growth over the same period of last year. On the
production side, the services and manufacturing sector continued its encouraging
performance by recording an increase of 6.0% and 8.4% respectively.
Let us illustrate what is contained in Table 12-1 (just for your information only).
144
P
Gross Domestic Product / 2005
P 2006 2006 P
st nd
Gross National Income 1 Quarter 2 Quarter
Gross Domestic Product (GDP):

495,239 129,499 133,815
Current Prices
(RM million)
Gross Domestic Product (GDP):

262,175 66,348 68,212
Constant 1987 Prices
(RM million)
GDP Growth Rate Constant 1987:

5.2 5.5 5.9
Prices (%)
Gross National Income (GNI):

Current Prices
471,331 124,908 ..
(RM million)
Per Capita GNI:

18,040 18,891
Current Prices (RM)
Table 8-1 Gross Domestic Product and Gross National Income
(Source: Department of Statistic Malaysia, Sept 2006)
The government will manipulate the magnitude and direction of revenue as well as
government expenditure to attain economic growth, achieve full employment, equity and
stabilize the economy, both internally and externally.
8.1.2 Government revenue and expenditure
Government revenue refers to the income of a government from all sources appropriated for
8
the payment of the public expenses.
145
Government sources of revenue include:
1. Tax. This is a compulsory contribution of wealth levied on a person or corporation or

organizations by the government to raise revenue to finance expenditure on public
goods and services. Developed countries depend mainly on direct taxes while
developing countries depend mainly on indirect taxes.
Direct Tax
Scope of Taxation in Malaysia (Inland Revenue Malaysia)
I. For Resident Individual. A resident individual is assessed on income derived

from sources in Malaysia and income received in Malaysia from outside
Malaysia. With effect from Year of assessment 2004, income remitted into
Malaysia from overseas by a resident individual, a trust body, and a
cooperative is exempted from income tax.
II. For Non-Resident Individual. A Non-Resident individual is assessed only on

income derived from sources in Malaysia.
III. For Resident Company. A Resident company is assessed on income derived

from Malaysia and income remitted to Malaysia from sources outside
Malaysia.
a) Starting from Year of Assessment 1995 onwards, only income

derived from Malaysia is taxable.
b) Banking, insurance, shipping and air transport businesses are taxed

on world income scope. The Imputation System is applicable.
IV. For Non-Resident Companies. A Non-Resident company is liable to

Malaysian tax when it carries on a business through a permanent
8 establishment in Malaysia and is assessed on income derived only from
sources within Malaysia.
Income Chargeable To Tax:
1. Gains or profits from a business for whatever period of time carried on
2. Gains or profits from an employment
3. Dividends, Interests or Discounts
4. Rents, Royalties or Premiums
5. Pensions, annuities or other periodical payments not falling under any of the
foregoing paragraphs
6. Gains or profits not falling under any of the foregoing paragraphs
7. Special classes of income
146
Indirect Tax includes:
I. Custom duties which are taxes on imported goods
II. Excise duties which are taxes on locally-produced goods
III. Entertainment tax such as cinema tickets and nightclubs
2. Treasury bills, bonds and loans. These are sold by the government to financial
intermediaries to raise revenue for projects.
3. Income from investment. This is the form of wholly-owned government industries

that have government equity participation. Examples are Malaysian Airline System,
Tenaga Nasional , etc and any source of investment that is joint venture with foreign
governments or foreign investors.
4. Sale of goods and services. Examples are health, education and postal services.
Government expenditure consists of government purchases, transfer payments, or

government’s borrowing. It is considered to be one of the major components of GDP.
8
8.1.3 Areas of government intervention
The government intervenes by:
1. Provide infrastructure that is too costly and extensive for the private sector.
2. Improvising the value-added growth in the manufacturing sector – electronic and
electrical segment, chemical, petroleum and rubber products.
And the improvement in the construction-related industries – lend support to the

expansion of the sector. Government will have to maintain and promote economic stability or
growth, and also to avoid exploitation of pricing of goods and services.
The government of Malaysia’s expenditure was budgeted at RM134.7 billion,
representing a moderate increase of 5% from the actual 2005 expenditure (2005: +6.8%). The
2006 budget projections were broadly in line with the government fiscal policy (BNM, 2005).
147
There are four strategies (under the fiscal policy) that have been extended in the 2006
Budget. Shown below is the brief measures announced in the 2006 Budget.
1. First Strategy. Implementing Proactive Economic Activity.
• Improving further the government’s delivery and procurement systems. For example,
expanding the use of ICT to facilitate dealings between the public and government and
expediting the issuance of visas for experience and professional workers in the field of
ICT and financial services.
2. Second Strategy. Providing a Business-Friendly Environment
• Reducing cost of doing business
• Strengthening the capital market. For example, the merging of the financial sectors.
• Modernising the agricultural sector
• Developing ICT and biotechnology sectors, etc
3. Third Strategy: Developing Human Capital
• Extending the scope of individual tax relief
• Extending disable child relief, etc
4. Fourth Strategy: Enhancing the Well-Being and Quality of Life of the Rakyat
• Reducing financial burden of Malaysians and others

8 • Increasing tax rate on liquor and cigarettes
• Reducting road tax by 40% for private diesel vehicles
(Source: BNM, 2005)
148
8.1.4 Differences between developing and developed countries
A developed country enjoys a relatively high standard of living through a strong high-
technology diversified economy. Most countries with a high per capita GDP are considered
developed countries.
Some countries, however, have achieved a (usually temporarily) high GDP through
natural resource exploitation without developing the diverse industrial and service-based
economy necessary for developed status.
8
A developing country is a country with a low income average, a relatively backwards
infrastructure and a poor human development index when compared to the global norm.
• *The term developing country refers mainly to countries with low levels of economic
development, but this is usually closely associated with social development, in terms of
education, healthcare, life expectancy, etc. The term generally implies an inferiority of the
developing countries.
• *Another term synonymous to developing country is less developed country (LDC) or

less economically developed country (LEDC). LEDC is a term used by modern
geographers to portray the countries classified as developing countries more accurately,
specifying that they are less economically developed, which usually correlates best with
other factors such as low human development.
*Development entails a modern infrastructure (both physical and institutional), and a move
away from the low-value added sectors such as agriculture and natural resource extraction.
Developed countries, in comparison, usually have economic systems based on continuous,
149
self-sustaining economic growth in the tertiary and quaternary sectors and high standards of
living.
*The application of the term developing country to all of the world's less developed countries
could be considered inappropriate: a number of poor countries are not improving their
economic situation (as the term implies), but have experienced prolonged periods of
economic decline.
*Countries that have the more advanced economies among the developing nations but have
not yet fully demonstrated the signs of a developed country are grouped under the term
Newly Industrialized Country.
(*Source: Wikipedia, the Free Encyclopedia)
Features Developed countries Developing countries
Economics
GNP per capita Above US$8,000 below US$8,000
(very arbitrarily determined)
Growth in per cent Stable growth usually around 3% Flunctuating, usually around
GNP per capita 1 per cent or even negative
Inflation rate Well - controlled Inflation rate around

Mild inflation around 2 per cent 4 - 10 per cent
Unemployment rate Usually full employment Unemployment rate relatively high
Economic structure Mainly secondary and tertiary Dominantly primary sector

sectors
Current account Surplus Deficit
8 Reserves
Demographic
Surplus Deficit
Infant mortality Low High
Population Growth Around 0.6 - 1 per cent Usually 2 - 3 per cent
Life expectancy 70 years and above 50 - 70 years
Urban population 95 - 100 per cent 60 - 70 per cent
Social
Number of people per doctor Less than 500 Ranges from 2000 - 7000
Literacy rate In some cases, usually Low literacy rate

95 - 100 per cent Ranges from 30 - 70 per cent
Number of people per telephone Around 1 - 2 persons Ranges from 10 - 100 people
Table 8-2 Differences between Developed and Developing Countries
150
(Source: Hashim Ali, 2000)
8.1.5 Problems faced by developing countries in achieving

economic growth
• Inflation
• Unemployment
• Rapid population growth

• Huge foreign debt
• Income inequality
• Underdeveloped primary sector
• Rural urban migration
151
8.2 CASE STUDY
Case 1
Shall we put up our price

Competition, price and revenue
When you buy a can of drink on a train, or an ice-cream in the cinema, or a bottle of fresh
orange in a restaurant, you may well be horrified by its price. How can they get away
with it?
The answer is that these firms are not price takers. They can choose what price to
charge. We will be examining the behaviour of such firms, but here it is useful to see how
price elasticity of demand can help to explain their behaviour.
Take the case of the can of drink on the train. If you are thirsty, and if you haven’t
brought a drink with you, then you will have to get one from the train’s bar, or go without
it. There is no substitute. What we are saying here is that the demand for drink on the
train is inelastic at the normal shop price. This means that the train operator can put up
the price of its drinks, and food too, and earn more revenue.
Generally, the less the competition a firm faces, the lower will be the elasticity of
demand for its products, since there will be fewer substitutes (competitors) to which
consumers can turn. The lower the price elasticity of demand, the higher is likely to be
the price that the firm charges.
8 When there is plenty of competition, it is quite a different story. Petrol stations in the
same area may compete fiercely in terms of price. One station may hope that by reducing
its price by 1p or even 0.1p per litre below that of its competitors, it can attract customers
away from them. With a highly elastic demand, a small reduction in price may lead to a
substantial increase in their revenue. The problem is, of course, that when they all reduce
prices, no firm wins. No one attracts customers away from the others! In this case it is the
customer who wins.
1. Why might a restaurant charge very high prices for fresh orange and bottled water
and yet quite reasonable prices for food?
2. Why designer clothes are labelled so much more expensive than that of similar “own
brand” clothes from a chain store, even though they may cost a similar amount to
produce?
Explain your answer.
152
Case 2
Adjusting to Oil Price Shocks

Short-run and long-run demand and supply curves
Between December 1973 and June 1974, the Organization of Petroleum Exporting
Countries (OPEC) put up the price of oil from $3 to $12 per barrel. It was further raised
to over $30 in 1979. In the late 1980s the price fluctuated, but the trend was downward.
Except for a sharp rise at the time of the Gulf War in 1990, the trend continued in the
early 1990s. By 1996, the price was fluctuating around $16 per barrel: in real terms (i.e.
after correcting for inflation), roughly the level prior to 1973.
The situation for OPEC deteriorated further in the late 1990s, following the recession
in the Far East. Oil demand fell by some 2 million barrels per day. By early 1999, the
price had fallen to around $10 per barrel – a mere $2.70 in 1973 prices! In response,
OPEC members agreed to cut production by 4.3 million barrels per day. The objective
was to push the price back up to around $18–$20 per barrel. But, with the Asian economy
recovering and the world generally experiencing more rapid economic growth, the price
rose rapidly, reaching over $35 in late 2000. The effect was to trigger protests around the
world, with pressure on governments to cut fuel taxes.
The price movements can be explained using simple demand and supply analysis.
The initial rise in price
OPEC raised the price from P1 to P2. To prevent a surplus at that price, OPEC members
restricted their output by agreed amounts. This had the affect of shifting the supply curve
to S2, with Q2 being produced. This reduction in output needed to be only relatively small
because the short-run demand for oil was highly price-inelastic: for most uses there are
no substitutes in the short-run.
153
Long-run effects on demand
The long-run demand for oil was more elastic. With high oil prices persisting, people
tried to find ways of cutting back on consumption. People bought smaller cars. They
converted to gas or solid fuel central heating. Firms switched to other fuels. Less use was
made of oil-fired power stations for electricity generation. Energy-saving schemes
became widespread both in firms and in the home.
This had the effect of shifting the short-run demand curve from D1 to D2. Price fell back
from P2 to P3. This gave a long-run demand curve of DL: the curve that joins points A and
C.
The fall in demand was made bigger by a world recession in the early 1980s.
Long-run effects on supply

8 With oil production was so much more profitable, there was an incentive for non OPEC
oil producers to produce oil. Prospecting went on all over the world and large oil fields
were discovered and opened up in the North Sea, Alaska, Mexico, China and elsewhere.
In addition, OPEC members were tempted to break their "quotas" (their allotted output)
and sell more oil.
The net effect was an increase in world oil supplies. This is shown by a shift in the supply
curve to S3. Equilibrium price thus fell back to P1 (point D). Note that the supply curves in
these diagrams are all short-run supply curves, since each one shows supply for a
particular number of oil fields.
Drawing a long-run supply curve is more difficult: it depends when in the story we start
and what assumptions we make.
We could draw a long-run supply curve linking points E and F. The reasoning is as
follows.After the limiting of supply to S2, OPEC members would have supplied at point
E, had the price remained at P1. After some years with the price set at P2 or thereabouts,
154
more suppliers enter the market. The supply curve shifts to S3. Had the demand curve not
shifted, equilibrium would then have moved to point F: the intersection of S3 and the
original demand.
A long-run supply curve thus links points E and F.
Back to square one
By the late 1990s, with the oil price are as low as $10 per barrel, OPEC once more cut-
back supply. The story had come full circle. This cut-back is illustrated in diagram (a).
The trouble this time was that the world was recovering from recession. Demand was
shifting to the right. The effect was that the price rose above the $18–$20 per barrel
OPEC target. In September 2000, OPEC agreed to increase its production in order to
bring the price down to around $25 from the $35 mark it had reached. In other words,
they agreed to shift the supply curve back to the right somewhat.
8
1. Give some examples of things that could make the demand for oil more elastic.
2. What specific policies could the government take to make demand more elastic?
155
8.3 SUMMARY
Governments must have the will to protect the environment. Governments are also
accountable to their improvements in the economies of the country and must often appease
various pressure groups, such as representatives of big business.
Governments may provide goods and services directly.
Economic growth refers to the increase in national income whereas economic development
relates to changing economic structures from primary to secondary sector.
Three causes of economic growth:
• Actual growth
• Potential
• Effective of fiscal policy
Government revenue refers to the income of a government from all sources appropriated for
the payment of the public expenses.
Government sources of revenue include direct tax and indirect tax.
Government expenditure consists of government purchases, transfer payments, or

government’s borrowing. It is considered to be one of the major components of GDP.
A developed country enjoys a relatively high standard of living through a strong high-
technology diversified economy.
156
157
9 The Banking System, Money and Inflation
(Macroeconomics)
Money
The Earliest Money and Barter Trade
Objectives
Types of Money
Banking System
Classification of Banks
Powers of the Central Bank • Understand the roles and functions of banks
• Describe the tools used by the central bank to
What is Monetary Policy?
conduct monetary policy
Consumer Price Index (CPI) • Explain how central bank influences interest
Inflation
rates
Measurements of Inflation • Define inflation
Demand-Pull Inflation and Cost- • Explain how demand-pull inflation and cost-
Push Inflation
push inflation is generated
Unemployment • Explain the effects of inflation
Business Cycle
• Understand what is unemployment
• Explain the cycle of booms and recessions –
business cycle
158
T h e B a n k i n g S ys t e m , M o n e y a n d I n f l a t i o n ( M a c r o e c o n o m i c s )
9.1 THE BANKING SYSTEM, MONEY AND INFLATION
9.1.1 Money
What is Money?
The economic definition emphasizes that money is the medium of exchange, or what we use
to buy things with. As one type of goods becomes generally accepted in return for all other
goods, that type of goods begins to function as money.
Money fulfils three important functions:
• A medium of exchange – anything that is generally accepted in payment for goods and
services (for example - barter trade).
• Unit of account or measure of value – is an agreed measure for stating the prices of
goods and services. For example, the price of a movie is RM7 and the price of a cup of
coffee is RM3.50, so the opportunity cost of a movie is 2 cups of coffee (RM7 / RM3.50).
• Store of value – anything that retains its purchasing power over time. If money were not
a store of value, it could not serve as a means of payment. Money can be kept and later
used to buy goods and services. (There are further explanations below in regards to the
money functions).
9
Money is desired not for its own sake, but for the goods it can purchase.
9.1.2 The Earliest Money and Barter Trade
In the beginning, money was not used as a payment for goods. If money cannot be exchanged
for goods it is of no use. Before the invention of money, goods and services were paid in
kind, i.e., exchanged directly for other goods and services. This simple direct form of
exchange is called barter.
Barter depends on a double coincidence of wants, which occurs when one trader is
willing to exchange his or her product for something another trader offers (a medium of
exchange).
159
For example, Chong has some bananas and wishes to exchange them for a fishing net. Maybe
there are many people who want his fruits but not one of them has a net to give in exchange.
In this case there is only a single coincidence of wants. But if the people are also willing to
exchange bananas for a fishing net, there is a double coincidence of wants.
Money guarantees a double coincidence of wants because people with something to sell will
always accept money in exchange of it.
Barter does not provide a good store of value. There are many goods which cannot
keep long – they lose their freshness and other intrinsic qualities and may even go out of use.
Therefore, it is difficult to hold wealth in these forms.
9 For example, goods such as fruits, vegetables, fish and eggs are easily perishable, as they
spoil or deteriorate. In the process of looking for the right buyer and seller to exchange for
the goods, the goods to be exchanged may have perished.
Barter lacks a common measure of money. Some goods cannot be divided into smaller
units as this would destroy those particular goods. There is no common measure of value,
everything is exchanged for money. Money thus becomes the standard unit, and common
denominator of value. Money acts as lubricant that smoothes the mechanism of exchange.
Money has grown increasingly more abstract over time, moving from commodity
money (such as gold) to paper money (pieces of paper not redeemable for anything or Fiat
money).
160
9.1.3 Types of Money
As we know, different societies have quite different types of money systems. The major
historical types of money system are:
• Commodity moneys – These are moneys that have value in non-monetary uses
equivalent to the monetary value of the commodity. Any commodity used as a medium of
exchange is commodity money. Well-known examples are gold, copper and silver metals,
but sea-shells (that is, cowrie shells) tobacco, and cigarettes have all been used.
Historically, copper, gold and silver coins have been used the most in European and East
Asian societies.
¾ Metallic coin
An example could be gold and silver coins that have values roughly equal to the price
the metal would command as jewellery.
¾ other commodities
As we have seen, seashells have been used as money, as have tobacco and, perhaps,
oxen.
• Fiat money or paper money (pronounce “fee at” in Latin “so be it”) or representative
money. Fiat money is a monetary standard (usually paper money) that people are required
by law to accept as a medium of exchange and/or a standard of deferred payment. Fiat
money is declared legal tender by the government, meaning that you have made a valid
and legal offer of payment of your debt when you pay with such money. In Singapore,
money is issued by the Commissioner of the Currency Board. In Malaysia, it is issued by
Bank Negara, the Malaysian Central Bank.
9
• Fiduciary money – Whenever bank issues credible promises to pay in some other form
of money, and the promises are transferable, they can circulate as money. Bank money is
also called "fiduciary money," since it is based on the trust people have that the bank will
keep faith (fides) and pay as promised. Fiduciary money may be based on promises to pay
in commodity money (gold coin, for example) or in fiat money.
We will go into much more detail later, because modern monetary systems are largely
fiduciary. Two major instances of fiduciary money are:
¾ bank notes
These are bills issued by banks. They were widely used in the nineteenth century and
are still used in some countries.
161
¾ checking accounts
In our society, checks are acceptable as money, so by the definition of money - a
commodity or token that serves as a medium of exchange - checks are money, just as
real as any other kind of money.
Both fiat money and fiduciary money are tokens, of course, as distinct from commodity
moneys. These token moneys are usually much the most important kinds of money in the
modern world.
• Supply of Money:
¾ Narrow definition (M1): consists of coins and notes in circulation and demand
deposits
¾ Broad definition (M2): comprises coins and notes in circulation and demand
deposits plus savings and fixed deposits
¾ Very broad definition (M3) refers to coins and notes in circulation, demand
deposit and all ‘near money’.
In September 2006 referring to Malaysia M1, or narrow money, continued to expand at a

higher rate of 11.5% (Aug: 10.2%), while broad money, M3, increased at a lower annual
rate of 7.9% (Aug: 8.3%) (BNM, Sept 2006).
9.1.4 Banking System

9 In financial economics, a financial institution acts as an agent that provides financial services
for its clients. Many different types of institutions make up the financial sector. They are
jointly known as financial intermediaries.
Financial intermediaries have the common function of providing a link between those
who wish to lend and those who wish to borrow. As financial intermediaries they act as the
mechanism whereby the supply of funds is matched to the demand of funds.
A financial institution generally falls under financial regulations from the government
authority. The main type of financial intermediaries is commercial banks, savings and loans,
life insurance companies, mutual funds and pension funds.
Banks are financial intermediaries. Banks attract deposits from savers to lend to borrowers,
earning a profit on the difference between the interest paid by depositors and the interest
charged to borrowers.
162
9.1.5 Classification of Banks
The Central Bank is a bank owned and controlled by the government.

It is a non-profit institution and its main function is to control money
Central Bank
supply in the economy. In Malaysia this central bank is known as Bank
Negara Malaysia.
Commercial Banks are most active in terms of economic contribution.

Commercial bank borrows money from the public, crediting them with
Commercial
a deposit. The deposit is a liability of the bank. It is money owed to
Bank
depositors. In turn the bank lends money to firms, households or
governments wishing to borrow.
Savings Bank previously functions mainly to encourage small savers.

Savings Bank They accept deposit but do not give loans. For example, Post Office
Savings Bank.
Agricultural / Co-operative Banks give loans to farmers, both short

Agricultural / Co-
term and long term loans. For example, Bank Pertanian Malaysia or the
operative Bank
Agricultural Bank of Malaysia.
Offshore Bank / Offshore Banks / Exchange Banks deal with the buying and selling of
Exchange Bank foreign currencies. For example, Labuan Offshore Bank.
Merchants Banks are very specialized agencies which deal with

Merchants Bank Discount Houses and Acceptance Houses, in underwriting of securities
and corporate finance
163
9.1.6 Powers of the Central Bank
• To exercise general supervision of banks (government banker)
• To issue bank notes and coins
• To buy and sell government securities
• To extend loans to member banks
• To clear checks (clearing houses)
• To require member banks to hold reserve requirements
• To act as a lender of last resort
9.1.7 What is Monetary Policy?
How does the central bank implement a monetary policy?

And how do they control the money supply?
A monetary policy refers to the regulations of the money supply and interest rate by a
central bank. The new money systems are roughly divided into two main problems that can
be studied as independent theories, and they are:
• The theory of credit that deals with responsibilities and limits of loans, to process the
aspect of the money’s value;
• The theory of value standards and exchange markets that defines the agreement on how
the money is supposed to be worth.
The term monetary policy refers to the actions undertaken by a central bank to influence the
availability and cost of money, and credit, as a means of helping to promote national
9 economic goals.
164
If the central bank wants to increase the supply of money, it creates more reserves, thereby
freeing banks to create additional deposits by making loans. If it wants to decrease the money
supply, it reduces reserves. All this depends on the economic conditions of the country.
The aims of Monetary Policy:
• To maintain stability of internal prices
• To achieve higher rates of economic growth
• To eliminate fluctuations in production and employment
• To achieve full employment of resources
Three tools are available to the central bank for changing the money supply:
• Open Market Operations. The buying and selling of government securities and treasury
bills in the open market in order to expand or contract the amount of money in the
banking system. To increase the money supply, the central bank carries out open market
purchase (purchase of bonds by central bank). To reduce the money supply, the central
bank carries out an open market sale (sale of bonds by central bank). The discount rate
and reserve requirements are also used.
In the case of Malaysia and Singapore, open market operation is not effective – the public
holds very little government securities (< 3%), because of the low interest, only 5¾%)
(Hashim Ali, 2000).
• Bank Rate (Discount Window Lending). This is important as the other rates of interest,
especially on loans, depend on it. Lending to depository institutions directly from their
central bank’s lending facility (the discount window), at rates set by the central bank and
approved by the Board of Governors. Banks borrow from central bank to satisfy their
reserve requirements.
• Reserve Requirement (Required Reserve Ratio). This is the amount of money and
liquid assets that the commercial banks must hold in cash or on deposit with the central
bank. Requirements regarding the amount of funds that depository institutions must hold
in reserve against deposits made by their customers.
This is the most important tool in controlling money supply in Malaysia and Singapore.
9
Using these tools, the central bank influences the demand for and supply of balances that
depository institutions hold on deposit at central bank and thus the interest rate charged by
one depository institution on an overnight sale of balances at the central bank to another
depository institution.
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9.1.8 Consumer Price Index (CPI)
Price indexes are used to measure overall price levels. And the most popular fixed-weight
price index is Consumer Price Index (CPI) which is also known as headline inflation.
The CPI is calculated to measure the average price movements of goods and services
purchased by households throughout the country. It reflects changes of the cost of purchasing
goods and services in a fixed market basket, but is not designed to measure changes of the
cost of living attributed to changes in the consumption structure of households.
CPI is used to measure changes in the cost of living, the money that must be spent to
purchase the typical bundle of goods consumed by a household such as transportation,
shelter, clothing, food and medical care.
CPI is a measurement of weighted average of changes in general price level from the
base year to the current year. The quantities of each type of goods in the bundle that are used
for the weights are based on extensive surveys of consumers.
Changes in the CPI are calculated monthly and announced to the public. These
monthly changes must be compounded to arrive at an annual figure for comparison.
Let us look at an example on the constructing the consumer price index (CPI). To
determine an annual percentage change in price between two consecutive years, 1 and 2 in a
price index, we can use the following equation.
Current year price x 100 = Current Year Index

9 Base year price
Year 2000 All items (goods) = 172.2

Year 2001 All items (goods) = 177.1
177.1 – 172.2 x 100 = 2.85%

172.2
Therefore the general price level has increased by 2.85% from the base year to the
current year.
CPI is one of the most frequently used statistics for identifying periods of inflation or
deflation. This is because large rises in CPI during a short period of time typically denote
166
periods of inflation and large drops in CPI during a short period of time usually mark
periods of deflation.
Table 9-1 The Strengths and Weaknesses of CPI
9.1.9 Inflation
Inflation is an increase in the overall price level. It happens when many prices increase
simultaneously. Inflation can be defined as a sustained increase in the price level.
Inflation is an increase in the price of a basket of goods and services that is
representative of the economy as a whole. If the rate at which the general level of prices for
goods and services is rising, and subsequently purchasing power is falling.
Inflation does not mean that the prices are high, but rather that they are
increasing. Since inflation refers to an increase in the general level of prices, the price for
every piece of goods and service need not increase.
The following are two different degrees of inflation: 9

• Hyperinflation or galloping inflation. Extremely high inflation where the value of
money is persistently falling – an out of control of economy.
• Deflation. It is the opposite of inflation where general falling level of prices and rising
real income. A sustained decrease in the general level of prices. This does not mean that a
few items decrease in price, or that there is a decrease for a short period of time.
To understand how this works, imagine a world that has only two commodities. For example,
167
Oranges are picked from orange trees, and paper money, printed by the government. In a
year where there is a drought and oranges are scarce, we'd expect to see the price of oranges
rise, as there will be quite a few Ringgit chasing very few oranges. Conversely, if there's a
record crop or oranges, we'd expect to see the price of oranges fall, as orange sellers will
need to reduce their prices in order to clear their inventory.
These scenarios are inflation and deflation, respectively, though in the real world inflation
and deflation are changes in the average price of all goods and services, not just one.
Inflation is an upward movement in the average level of prices. Its opposite is deflation, a
downward movement in the average level of prices. The boundary between inflation and
deflation is price stability.
As inflation rises, every ringgit will buy a smaller percentage of goods. For example,
if the inflation rate is 2%, then a RM1 pack of flour will cost RM1.02 in a year.
Most countries’ central banks will try to sustain an inflation rate of 2 – 3%.
9.1.10 Measurements of Inflation
The main challenge in measuring inflation as the change in level of prices is establishing
9 which prices to use for the calculation. The government usually measures various inflation
rates, each focusing on the prices of a collection of goods and services important to a
particular segment of the economy. These are:
• Consumer price index (CPI), which measures the change in retail prices purchased by
typical consumers/households.
• Product price index (PPI), which measures changes in the wholesale price of goods at
'the factory door' – producer. It focuses on production inputs purchased by businesses.
• A Gross Domestic Products (GDP) price index which measures price changes in the
economy as a whole. The use of the index will be discussed in chapter 10.
• Commodity price index (RPI), or so-called ‘crude goods’ price index, which measures
commodity price inflation.
168
To measure inflation rate, we calculate the annual percentage change in price level. For
example, if this year’s price level is 126 and last year’s price level was 120, the inflation rate
is,
Inflation rate = 126 – 120 x 100

100
= 5 percent per year
This equation shows the connection between the inflation rate and the price level.
9
For example in Malaysia, the headline inflation, as measured by the CPI, remains
unchanged at 3.3% in September 2006. The rate of increase in the prices of food and non-
alcoholic beverages moderated further to 3.1% (Aug: 3.2%), mainly on account of the slower
price increases for both food taken at home and food taken away from home.
The rate of increase of the Producer Price Index (PPI) moderated to 7.5% in August from
8.1% in July 2006 (BNM, Sept 2006).
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9.1.11 Demand-Pull Inflation and Cost-Push Inflation
Inflation occurs where there is:
• an increase in the money supply
• a Cost-push or supply side inflation
• a decrease in the aggregate supply of goods and services
• an increase in the aggregate demand of goods and services – demand-pull inflation
Inflation can result from either an increase in aggregate demand or a decrease in aggregate
supply. These two sources are called demand pull and cost push.
The types of inflation, as part of what John Maynard Keynes, 1920, the eminent British
economist calls ‘the triangle model’ - include:
• Demand-pull inflation. Has a tendency to occur when the economy is close to or at full
employment. A demand pull inflation arises from increasing in aggregate demand such
as:
¾ An increase in the quantity of money
¾ An increase in government purchases
¾ An increase in exports
¾ It is categorized by the four sections of the macro economy: households,

businesses, governments and foreign buyers. When these four sectors concurrently
want to purchase more output than the economy can produce, they compete to
purchase limited amounts of goods and services. Buyers in essence bid prices up,
again, causing inflation. This excessive demand, also referred to as “too much
money chasing too few goods”, usually occurs in an expanding economy.
9 ¾ An aggregate demand is the total demand for goods and services in the economy.
The aggregate demand decreases as the price level increases. Refer to Figure 9-1
illustrates that the price increases are combined with increases in aggregate
demand.
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Figure 9-1 Demand – Pull Inflation
• Cost-push inflation or supply side inflation. Inflation caused by an increase in costs. The
two main sources of increases in costs are:
¾ An increase in money wage rates
¾ An increase in the money prices of raw materials
¾ Aggregate supply is the total volume of goods and services produced by an

economy at a given price level. When there is a decrease in the aggregate supply
of goods and services stemming from an increase in the cost of production, we
have a cost-push inflation. A cost-push inflation basically means that prices have
been “pushed up” by increases in the costs of any of the four factors of
production (labour, capital, land or entrepreneurship) when companies are
already running at full production capacity.
¾ With higher production costs and productivity maximized, companies cannot

maintain profit margins by producing the same amount of goods and services. As
a result, the increased costs are passed on to consumers, causing a rise in the
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general price level (inflation).Refer to Figure 9-2 illustrates that the price
increases are associated with decreases in aggregate output.
Figure 9-2 Cost – Push Inflation
The government is using at least three instruments of economic policy to control inflation,
and they include:
• Monetary policy – the tools to control the quantity of money in economy (particularly
influencing interest rates and credit condition through setting the money supply).
¾ In the short-run, the monetary policy affects the economy by influencing interest
rate.
¾ In the long-run, changes in the money supply affect the price level.
• Fiscal or budget policy – decision on taxes and government spending. The government
collects taxes from households and firms and spends these funds to bring the economy out
9 of inflation. It also helps determine the overall level of spending and influences aggregate
demand.
• Direct controls – increase output of production, restrictive import and export policy,
controlling prices, and rationing scarce goods.
9.1.12 Unemployment
Is unemployment a state where everyone is without a job? The answer is clearly no, since we
will not include children and pensioners and exclude those who are not looking for work,
such as parents who choose to stay at home looking after their children.
When we talk about unemployment, what comes to mind is labour force and
unemployment rate. The labour force is those 19 years of age and older who are either
172
working or looking for a job, whereby unemployment rate is the number unemployed as a
percentage of the labour force.
The most usual definition that economists use for the number of unemployed is the labour
force which consists of the people in the adult population, and they are:
• Those in employment plus those unemployed.
• Those of working age (19 years of age) who are without work, who want to work and
who are available for work or are looking for work.
• Since the labour force are those in employment and unemployment, thus if 10 million
people were employed and 0.5 million people were unemployed, the unemployment rate
would be:
0.5 x 100 = 4.76%

10.0 + 0.5
Hence, the unemployment rate is reported monthly, equals the number of

unemployed divided by the number in the labour force.
Let’s take a look at the example below.
For example:
9
The unemployment rate is the number unemployed divided by the number in the labour force.
In this problem, there are 65 people interviewed, but many are not in the labour force:
children, the retired, and those not actively looking for jobs.
Here, this means we must exclude:

10 children under 16
10 retired workers
5 full-time homemakers
5 full-time students
2 disabled workers
1 who would "like a job" but is not actively searching
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The labour force in this example is 65 - 33 = 32.

Of these, 30 have jobs (25 full-time, 5 part-time) and are counted as employed.
Two do not have jobs despite an active search and are counted as unemployed.
Hence the unemployment rate in this group is 2 / 32 = .0625 or 6.25 percent
The unemployment rate measures the percentage of those in labour force who is unemployed,
that is people without jobs who are looking for work - divided by the number in the labour
force.
By now we can explore the two macroeconomic problems; unemployment and
inflation. Not all unemployment or all inflation harms the economy.
Let us study the performance of employment in Malaysia as shown in the Figure
below. This is to show the trend of economic performance on employment, production, and
wages is important in every industry, particularly in Malaysia.
Overall Performance
The sales value and salaries & wages paid out for the first eight months of 2006 as well as
the number of establishments and employees as at the end of August, 2006 (with
comparative figures for the corresponding period of the preceding year) are as shown below:-
For this period, the Manufacturing sector recorded an increase of 10.9% in sales value, 8.9%
in salaries & wages paid and 9.0% in the number of employees engaged compared to the
corresponding period of 2005. The average sales value per employee during the first eight
months of 2006 went up by 1.8%, compared to the same period in 2005.
174
Number of Employees
There were 22 industries (20.6%) each engaging more than 10,000 employees as at the end
of August, 2006. A total of 750,676 persons were engaged in these 22 industries, which saw
an increase of 9.7% or 66,503 persons as compared with 684,173 persons employed for the
same period of the preceding year. This accounted for 69.3% of the total employees reported
by the establishments in August, 2006.
The number of employees engaged in the Manufacturing sector in August, 2006 rose from
9.0% or 89,069 persons to 1,083,170 persons as compared to the corresponding month in
2005. This number was also higher by 0.2% or 2,389 persons when compared to 1,080,781
persons employed in July, 2006.
Salaries & Wages

The total salaries & wages paid in August, 2006 increased by 10.2% or RM174.4 million to
RM1,882.0 million from RM1,707.6 million paid out a year ago. The total amount paid in
August, 2006 was 1.7% lower compared to RM1,913.8 million recorded in the previous
month.
(Source: Department of Statistics, Malaysia, Aug 2006)
Students: Discuss your view on the unemployment pertaining to the above Figure.
Unemployment also varies by occupation. Professional and technical workers experience

9
lower unemployment rates than blue-collar workers. Construction workers face high
unemployment because business is both seasonal and subject to wide swings over the
business cycle (McEachern, 2006).
There are four sources of unemployment: frictional, seasonal, structural, and cyclical.
• Frictional unemployment. It is a state of unemployment that comes from people moving

between jobs, careers, and locations.
For example if a person quits his job as an economics researcher to try and find a job in
the music industry, we would consider this to be frictional unemployment.
• Structural unemployment. This is a state of unemployment that comes from there being
an absence of demand for the workers that are available. Structural unemployment is
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often due to changes in tastes, technological, taxes, and competition which reduce the
demand for certain skills and increase the demand for other skills.
For example if the introduction of DVD players causes the sales of VCRs to plummet, many
of the people who manufacture VCRs will suddenly be out of work.
• Cyclical unemployment. This occurring when the unemployment rate moves in the
opposite direction as the GDP growth rate. So when GDP growth is small (or negative)
unemployment is high.
When the economy goes into recession and workers are laid off, cyclical unemployment
will occur.
• Seasonal unemployment. This is unemployment caused by seasonal changes in labour

demand during the year. Examples of seasonal changes are like the changes of the four
weather seasons. Policy makers are not concerned with the seasonal unemployment.
The economy is viewed as operating in “full employment” if there is no cyclical

unemployment (but with some frictional, structural and seasonal unemployment).
When economists talk about full employment, they do not mean zero unemployment
but low unemployment, with ranging from 4 to 6 percent. Unemployment fluctuates with the
business cycle.
9.1.13 Business Cycle
9 Business cycle or economic cycle or trade cycle is a cycle of booms and recession. The
business cycle is the periodic but irregular up-and-down movements in economic activity,
measured by fluctuations in real GDP and other macroeconomic variables.
A business cycle is not a regular, predictable, or repeating phenomenon like the swing
of the pendulum of a clock. Its timing is random and, to a large degree, unpredictable.
A business cycle is identified as a sequence of four phases:
1. The upturn. In this phase, a stagnant economy begins to recover, and growth in
actual output.
2. The expansion. During this phase there is rapid economic growth; the economic is
booming.
3. The peaking out. During this phase, growth slows down or even ceases.
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4. The slowdown, recession or slump. During this phase there is little or no growth or
even decline in output.
Let us illustrate the diagram shown in Figure 9-3 below.
Figure 9-3 The Business Cycle
• A high level of output is not a high rate of growth.
• The level of output is highest in phase 3.
• The rate of growth in output is highest in phase 2, where the curve is steepest.
(Source: Sloman and Norris, 2005)
In this business cycle, the economy is expanding as it moves through no.2 to the peak – no.3.
When the economy moves from a peak down at no. 4, the economy is in recession.
The period at the bottom of the cycle to a peak is called an expansion (boom) –
9
output and employment growth. The period from a peak down is called a contraction
(recession or slump) – when output and employment fall.
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9.2 CASE STUDY
Do people volunteer to be unemployed?

The distinction between voluntary and involuntary unemployment
A distinction made by some economists is that between voluntary and involuntary

unemployment. Many economists would regard equilibrium unemployment as voluntary.
If people choose not to accept a job at the going wage, even though there are jobs
available, then in a sense they could be said to have voluntarily chosen to be unemployed.
Disequilibrium unemployment, according to these economists, would be classed as
involuntary. Workers want to work at the current wage, but there are not enough jobs
available.
Some economists would also include classical unemployment as voluntary. If people,

through their unions, have chosen to demand a higher wage than the equilibrium wage,
then they could be said to have collectively ‘volunteered’ to make themselves
unemployed. According to these economists, then, only demand-deficient unemployment
would be classed as involuntary.
Some economists go even further and argue that all unemployment should be classed
as voluntary. If the cause of disequilibrium unemployment is a downward stickiness in
real wage rates, then workers, either individually or collectively, are choosing not to
accept work at a lower wage.
Other economists would go to the other extreme and claim that all disequilibrium
unemployment and most equilibrium unemployment are involuntary. Structural
unemployment, for example, results from changes in demand and/or supply patterns in
the economy and a resulting mismatching of unemployed workers’ skills to the person
specifications of vacant jobs. Workers can hardly be said to have volunteered for these
changes in demand. True, people can be retrained, but retraining takes time, and in the
meantime they will be unemployed. Similarly with frictional unemployment, if the cause
9 of some people being unemployed is initial ignorance of job opportunities and hence the
time it takes to search for a job, they cannot be said to have volunteered to be initially
poorly informed.
The terms ‘voluntary’ and ‘involuntary’ unemployment are not only ambiguous, they
are also unfortunate because they have strong normative overtones. ‘Voluntary’
unemployment tends to imply that the blame for unemployment lies with the unemployed
person and not with ‘market forces’ or with inadequate government policies. While in
one sense, at a low enough wage rate there would probably be a job for virtually any
unemployed person, the unemployed cannot be said to be voluntarily unemployed if they
are choosing to turn down jobs at pitifully low wages.
Although the concepts of voluntary and involuntary unemployment are commonly

used, for the above reasons we shall avoid them.
178
1. If I offer a job to someone to clean my house at 50 sen per hour, and unemployed
people choose not to take the job, should they be classed as “voluntary
unemployed”?
Explain the reason for your answer.
179
9.3 SUMMARY
Money is anything that is generally accepted as a medium of exchange, or what we use to buy
things with.
The evolution of money: example is barter trade, which are goods which are traded directly
for other goods.
Problems of barter trade:
• Problems of double coincidence
• Problems of perishability
• Problems of divisibility
Types of money:
• Commodity money
• Fiat money or paper money
• Fiduciary money
Supply of Money:
• Narrow definition (M1): consists of coins and notes in circulation and demand deposits
• Broad definition (M2): comprises coins and notes in circulation and demand deposits plus
savings and fixed deposits
Financial depository institutions, such as commercial banks, savings banks, merchant banks,
and offshore banks play a critical role in the economy because they create money through
9 their loan-making activities.
Basically there are two ways of creating credit:
• By giving loans – direct loans, overdraft, and discounting bills of exchange.
• By investing – purchase of shares and government securities.
There are three tools available to the central bank for changing the money supply.
• To increase the money supply the central bank carried out open market purchase. To
reduce the money supply the central bank carried out open market sale.
• Lending to depository institutions directly from central bank’s lending facility (the
discount window).
180
• Reserve requirement regarding the amount of funds that depository institutions must hold
in reserve against deposit made by their customers. Malaysia and Singapore are practicing
this requirement.
Price indexes are used to measure overall price levels. And the most popular fixed-weight
price index is Consumer Price Index (CPI) which is also known as headline inflation.
The CPI is calculated to measure the average price movements of goods and services
purchased by households throughout the country.
CPI is one of the most frequently used statistics for identifying periods of inflation or
deflation. This is because large rises in CPI during a short period of time typically denote
periods of inflation and large drops in CPI during a short period of time usually mark periods
of deflation.
Inflation is a situation refers to:
• Prices are rising
• Cost of living increases
• Persistent fall in the value of money
• Too much money buying too few goods
Inflation that results form increases in aggregate demand is known as demand-pull inflation.
The price increases are combining with increases in aggregate output.
Inflation that results from decreases in aggregate supply is known as cost-push inflation. The
price increases are associated with decreases in aggregate output.
Gross domestic product (GDP) is the market value of all final goods and services produced
by factors of production within a given period of time.
The unemployment rate is the number of people looking for work divided by the number in
the labour force. 9
181
9.4 EXERCISES
1. A person trades in a car when buying another. Is the used car a medium of exchange? Is
this a barter transaction? Please explain your reasons.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
2. Initially gold coins were used as money but people could melt them down and use the
gold for industrial purposes. What must have been the relative value of gold in these two
uses? Explain the circumstances in which gold could become a token money, and
disappear from monetary circulation completely.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
3. What are the three (3) functions of money?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
4. Match the terms in the box with the items listed below.
9 Fiat Money Commodity Money Near Money
Deposit Money Not considered as money
a) a VISA credit card
________________________________________________________________________
b) an ATM card
________________________________________________________________________
182
c) rice and livestock used by a primitive tribe as a means of payment
________________________________________________________________________
d) 1, 000 Malaysian Airline shares
________________________________________________________________________
e) A 90 sen coin
________________________________________________________________________
f) A fixed deposit account with HSBC bank
________________________________________________________________________
g) A current account deposit with AM Bank
________________________________________________________________________
h) Gold
________________________________________________________________________
i) A savings deposit with Post Office Savings
________________________________________________________________________
j) A RM100 note
________________________________________________________________________
5. How would the following affect the demand for money?
a) an increase in the rate of interest
________________________________________________________________________ 9
b) an increase in nominal national income
________________________________________________________________________
c) an increase in the general price level
________________________________________________________________________
d) expectation of a rise in interest rate
________________________________________________________________________
183
e) people become more cautious and decide to save more in the bank
________________________________________________________________________
6. Why do people dislike inflation?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
7. Determine the impact on each of the following if 2 million formerly unemployed workers
decide to return to school full time and stop looking for job:
a) the labour force participation rate
________________________________________________________________________
________________________________________________________________________
b) the size of the labour force
________________________________________________________________________
________________________________________________________________________
c) the unemployment rate
9 ________________________________________________________________________
________________________________________________________________________
8. Determine whether each of the following would be considered frictional, structural,

seasonal, or cyclical unemployment:
a) A part-time employee who was hired for the Hari Raya season is laid off after the
Hari Raya.
________________________________________________________________________
b) A worker who is laid off to reduce aggregate demand in the economy.
________________________________________________________________________
184
c) A worker in a video rental store becomes unemployed as video-on-demand service

becomes more popular.
________________________________________________________________________
d) A new college graduate is looking for employment.
________________________________________________________________________
9. Assumes that the economy’s real GDP is growing.
a) What will happen to money demand over time?
________________________________________________________________________
________________________________________________________________________
b) If the central bank leaves the money supply unchanged, what will happen to the
interest rate over time?
________________________________________________________________________
________________________________________________________________________
c) If the central bank changes the money supply to match the change in money demand,
what will happen to the interest rate over time?
________________________________________________________________________
________________________________________________________________________
d) What would be the effect of the policy described in part (c) on the economy’s stability
over the business cycle?
________________________________________________________________________
________________________________________________________________________ 9
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
10. Suppose you never carry cash. Your pay check of RM1,000 per month is deposited
directly into your checking account, and you spend your money at a constant rate so that
at the end of each month your checking account balance is zero.
a) what is your average money balance during the pay period?
________________________________________________________________________
185
b) How would each of the following changes in assumptions affect your average
monthly balance?
i.You are paid RM500 twice monthly rather than RM1,000 each month?
_____________________________________________________________________
_____________________________________________________________________
ii.You are uncertain about your total spending each month.
_____________________________________________________________________
_____________________________________________________________________
iii.You spend a lot in the beginning of the month (e.g., for rent) and little at the end of
the month.
_____________________________________________________________________
_____________________________________________________________________
iv.Your monthly income increases.
_____________________________________________________________________
_____________________________________________________________________
186
187
10 National Income and Theory of Income
Determination (Macroeconomics)
Definition
Accounting
of National Income
Objectives
Gross Domestic Product (GDP) At the end of this chapter students should be able to:
Methods of Calculating National
Income
Why GDP equals to aggregate • Define national income
expenditure and aggregate income • Understand the various ways and uses of
The Circular Flow of National
Income and Expenditure measuring national income
• Know how to measure consumer price index
Uses of National Income Statistics
Why GDP is important?
• Explain why GDP equals aggregate expenditure
Problems in Calculating National and aggregate income
Income • Understand the circular flow of national income
and expenditure
188
National Income and Theory of Income Determination (Macroeconomics)
10.1 NATIONAL INCOME AND THEORY OF INCOME

DETERMINATION
10.1.1 Definition of National Income Accounting
To study macroeconomics, we need data on total output, total income, total consumption, and
the like. Much of the macroeconomics data is from the components of national income.
National Income is defined as the value of final goods and services that are available
to the residents of a country as a result of their own economic activities over a period of one
year.
In other words national income is the total income earned by the factors of production
owned by a country’s citizen. The key concept in the national income is gross domestic
product (GDP).
10.1.2 Gross Domestic Product (GDP)
Gross domestic product (GDP) is the market value of all final goods and services produced
by factors of production within a given period of time. It means that GDP is not the market
value of total final sales during a period, but it is the market value of total production.
Because GDP is an important concept, we need to understand what is meant by final
goods and services produced by factors of production. Many goods produced in an economy
are not classified as final goods, but intermediate goods instead. Intermediate goods are
10
produced by one firm for use in further processing by another firm.
We do not use the value of total sales in an economy to measure how much output has
been produced. It is also important to understand that GDP measures goods and services
produced, not sold.
Let us examine two examples:
189
1) Market value.
To measure total production, we must add together the production of apples and oranges,
computers and kitchen utensils. For example, which is the greater total production: 100
apples and 50 oranges, or 50 apples and 100 oranges? GDP answers the question by valuing
items at the market values that means at the prices at which each item is traded in markets. If
the price of an orange is 20 sen, the market value of 100 oranges is RM20. By using market
prices to value production, we can add the apples and oranges together. The market value of
50 apples and 100 oranges is RM5 plus RM20, or RM25.
As mentioned earlier, many goods produced in the economy are not classified as final goods,
but instead as intermediate goods.
An intermediate type of goods (or service) is an item that is produced by one firm,
bought by another firm, and used as a component of a final good or service. The value of
intermediate goods is not counted in GDP.
2) Final goods and services.
For example, in producing a car, Proton pays RM200 to Goodyear for tyres (among other
components) to assemble a car, which it sells for RM24,000. The value of the care (including
10 its tyres) is RM24,000, not RM24,000 + RM200. The final price of the car already reflects the
value of all its components.
In calculating GDP, we can either sum up the value added at each stage of production or we
can take the value of final sales. We do not use the value of total sales in an economy to
measure how much output has been produced.
190
10.1.3 Methods of Calculating National Income
National Income - The market value of all final goods and services produced in a year within
the country, regardless of who owns the resources.
Measures of national income and output are used in economics to estimate the value of goods
and services produced in an economy. Some of the more common measures are Gross
Domestic Product (GDP), Gross National Product (GNP), Net National Product (NNP), and
Net National Income (NNI).
GDP is a better measurement of the state of production in the short term. GNP is a better
way when analysing sources and uses of income.
• National income can be measured by two different approaches:
1) The Income Approach
2) The Expenditure Approach
• The two approaches are meant for every payment (expenditure) by a buyer is at the
same time a receipt (income) for the seller.
(1) The Income Approach (Refer to Table 10-1)
¾ The measurement of income approach is: calculating GDP by adding up

expenditures on all factors income earned by the suppliers of the resources used to
produce the total output during the year.
¾ The components are:
a) wages and salaries of all employees – the largest item in income approach 10
b) interest and dividends from shares – net interest paid by business
c) rental income – a minor item, is the income received by property owner in the
form of rent
d) profits (undistributed profits) - corporate profits – the second largest item in

income approach
191
e) income of self employed workers (proprietors’ income)
f) taxes – such as sales tax, custom duties and etc
g) Net business transfer payments – includes pensions, scholarship, unemployment

benefit, and interest on the national debt. Transfer payments are not included in
national income.
h) Domestic and national income:
o Domestic income is income earned through the factors of production,

within a territorial or geographical boundary. Include income earned by
foreign workers.
o National income refers to income earned by nationals excludes all

incomes of foreign workers.
(2) The Expenditure Approach (Refer Table 10-1)
¾ The measurement of expenditure approach is: calculating GDP by adding up

expenditures/monetary value of all final goods and services produced during the
year.
Expenditure categories are:
¾ Personal consumption (C): This is the largest part of GDP - household spending
on consumer goods. There are three main components in C:
o Durable goods – automobiles, furniture, and household appliances (used

up in a long time)
o Non-durable goods – food, clothing, gasoline, and cigarettes (used up

fairly quickly)
o Services – include expenditures for doctors, lawyers, and educational

institution
¾ Gross private domestic investment (I) or total investment in capital by the

private sector: spending by firms for their own final use, and they are part of final
10 sales and counted in GDP.
o The two main categories of investments:
Inventory investment - increase or decrease (disinvestment) in the

value of the stocks of inventories that businesses have on hand.
Think of an inventory of a new car dealer or of a clothing store, or
stocks of newly produced but unsold – all these have value.
192
Gross investment – the total value of all newly produced capital

goods such as new plants, equipment, commercial buildings, and
residential structures.
GDP includes newly produced capital goods but exclude capital
goods consumed in the production process.
¾ Government Spending and gross investment (G) – include government

consumptions such as school buildings, military salaries, school teachers’ salaries,
and etc. G is excluding transfer payments (Refer income approach (f)).
o Gross investment is the expenditure on new construction, equipment and

changes in stock.
o Net investment is gross investment minus depreciation.
¾ Net exports: exports minus imports (EX - IM). Exports (produced domestically
but sold to foreigners) - Ringgit in, goods out. Imports (produced by foreigners
but purchased by domestic consumers) – Ringgit out, goods in. The net export is
included in the GDP.
10
Figure 10-1 Gross Domestic Product (GDP) Formula
As mentioned earlier the key concept in the national income and product is gross domestic
product (GDP). Since GDP is such an important concept, we need to take some time to
explain it.
Let’s look at an example on Expenditure and Income approach to GDP in Table 10.1
193
8,214.3 70.0
Durable goods 987.8 8.4
Nondurable goods 2,368.3 20.2
Services 4,858.2 41.4
1,928.1 16.4
Nonresidential 1,198.8 10.2
Residential 673.8 5.7
Change in business inventories 55.4 0.5
2,215.9 18.9
Federal 827.6 7.1
State and local 1,388.3 11.8
-624.0 -5.3
Exports ( EX ) 1,173.8 10.0
Imports ( IM ) 1,797.8 15.3
_______ _____
11,734.3 100.0
(Source: Case and Fair, 2006)
Table 10-2 Example of National Income
10 (Source: See Table 10-1)
National income is the total income of the country that is the income of the country’s
citizens not the income of the residents, therefore minor adjustment should be made.
Not all of GNP is available to produce final goods and services - part of it represents
output that is set aside to maintain the nation's productive capacity.
Capital goods, such as buildings and machinery, lose value over time due to wear and
tear and obsolescence. Depreciation measures the amount of GNP that must be spent on new
capital goods to offset this effect.
194
In the Income Approach:
• Net National Product (NNP) is GNP minus depreciation
• Net National Income (NNI) is NNP minus indirect taxes
• Personal Income (PI) is NNI minus retained earnings, corporate taxes, transfer payments,
and interest on the public debt.
• Personal Disposable Income (PDI) is PI minus personal taxes, plus transfer payments.
To convert from GNP to GDP you must subtract factor income receipts from foreigners that
correspond to goods and services produced abroad using factor inputs supplied by domestic
sources.
To convert from GDP to GNP you must add factor input payments to foreigners that
correspond to goods and services produced in the domestic country using the factor inputs
supplied by foreigners.
Plus: Receipts of factor income from the rest of the world +415.4
Less: Payments of factor income to the rest of the world -361.7
Equals:
Less: Depreciation -1,435.3
Equals:
Less: Statistical discrepancy -76.9
Equals:
Table 10-3 GDP, GNP, NNP and National Income
(Source: See Table 10-1)
For developed countries, national income is greater than domestic income, perhaps because
there are many foreign companies in the country than those of the local investors.
10
195
10.1.4 Why GDP equals to aggregate expenditure and aggregate

income
A relationship between aggregate income and aggregate expenditure that determines, for a
given price level, where the amount people plan to spend equals the amount produced.
We can apply the same meaning as GDP equals aggregate expenditure and equals
aggregate income as follows:
• Aggregate income is the sum of all income earned by resource suppliers in an economy
during a given time period. It includes:
¾ Compensation of employees – wages
¾ Interest
¾ Rental income
¾ Profits
o Corporate profits
o Proprietor’s income
¾ Indirect business taxes net of subsidies (if any)
¾ Depreciation
Calculations for Aggregate Income:
Wages + interest + rental income + profit + (indirect business taxes net of subsidies, if any) +
depreciation = GDP
• Aggregate expenditure is total spending on all production of final goods and services.
• Aggregate expenditure (in the opinion of Keynes) is the key to economic activity. That is,
the household, business and government plan to buy will be determined of what firms
10 will eventually produce.
196
For example, when a family is planning to buy a car or put new appliances in the house, that
would be a carefully thought out decision which considering the long term situation of the
family. Such purchases are key items of aggregate expenditure.
We can use the symbols for consumption (C) investment (I), government expenditures (G),
and net exports (X-M), to express total expenditures (GDP) as the sum of these four
components.
Formula for Aggregate Expenditure:
AE = C + I + G + (X-M)
(Refer Figure 10-2)
10.1.5 The Circular Flow of National Income and Expenditure
GDP can be determined in two ways:
• By the total expenditure on goods and services
• By the total income earned on producing goods and services
Let’s illustrate the diagram below (Figure 10-2). The total expenditure – aggregate
expenditure is the sum of the whole circle.
• Aggregate expenditure equals consumption expenditure plus investment, plus

government purchases, plus net exports.
10
• Aggregate income earned through producing goods and services is equal to the total
amount paid for the factors of production used – wages, interest, rent, and profit.
• The two flows of incomes and of expenditures are equal: all expenditures on products are
ultimately someone's income, and every bit of total income is also expended in some way.
197
(1) Production
(2) Incomes (3) Expenditure
Figure 10-2 The Circular Flow of National Income and Expenditure
In Figure 10-2, firms use factors of production (1) provided by households. Land, labour,
capital and entrepreneurship are used by firms to produce a type of goods or services. The
firms pay households a reward for using these factors (2).
Note also that Expenditure (3) is now made up of two items. Households spend money with
firms for goods and services and these we now call consumption (C) and firms spend money
with other firms (investment). Expenditure is therefore equal to consumption plus investment.
E = C + I.
Households (house) in this model are required to pay taxes. When the government receives
these taxes they then spend them (government spending) on building roads, paying soldiers,
and teachers and so on. In this four sector model the total amount of expenditure is equal to
consumption plus investment plus government spending. E = C + I + G.
Finally, for this simple open model we can see that expenditure is equal to consumption plus
investment, plus government spending, plus exports. However, because the model is now
open to the outside world domestic spending on goods and services which originate outside
the economy must be subtracted. Therefore imports (M) have to be subtracted. So, E = C + I +
G + (X - M).
10 10.1.6 Uses of National Income Statistics
The computation of national income is done annually by every country in the world. Even a
poor country is also involved in this computation.
The following are the reasons why we must compute national income:
• To find out the distribution of national income
• To calculate the rate at which the economy is growing
198
• To find out the contributions of different sectors
• To indicate the general standard of living of the people
• To assist the government in planning the economy
• To monitor the national planning
• To compare between countries and over time
10.1.7 Why GDP is important?
Gross Domestic Product (GDP) is one measure of economic activity, the total amount of
goods and services produced in a year. It is calculated by adding together the market values
of all of the final goods and services produced in a year.
It is a gross measurement because it includes the total amount of goods and services
produced, some of which are simply replacing goods that have depreciated or worn out.
It measures current production because it includes only what is produced during the year.
It is a measurement of the final goods produced because it does not include the value
of a piece of goods when sold by a producer, again when sold by the distributor, and once
more when sold by the retailer to the final customer. We count only the final sale.
Changes in GDP from one year to the next reflect changes in the output of goods and
services and changes in their prices. To provide a better understanding of what actually is
occurring in the economy, real GDP is also calculated. In fact, these changes are more
meaningful, as the changes in real GDP show what has actually happened to the quantities of
goods and services, independent of changes in prices.
There are often a number of different measures of GDP reported. Nominal GDP, or
simply GDP, is total output in current prices. Real GDP is total output with prices held
constant. Real GDP per capita is the real GDP per person in the economy and is the best
measure of well-being of all the others.
10
199
10.1.8 Problems in Calculating National Income
There are two major problems encountered in calculating national income:

(Source: Hashim Ali, 2000)
• Practical Problems
¾ Lack of expertise – Shortage of professionals such as statisticians, researchers,

programmers, and etc that is needed to present the national income data. They are
mostly from the most developing countries.
¾ Lack of sophisticated machinery – Technical aspect to compute the massive

volume of data is equally important. Developing countries like India, Indonesia
and Peru face the problem of technical know-how.
¾ Not accessible – There are certain areas in the poor countries that are remote and
isolated. These areas are usually inhabited by the poorest section of the
population. Their economy is still based on the barter trade – where this activity
must be estimated and included under national income accounting. Without such
data national income will not be accurate.
¾ False information – Business man and other self-employed people usually

underestimate their earnings to avoid paying high taxes. These people are
normally from developed rather than developing countries.
¾ Problem of illiteracy – Governments of the third world countries like Indonesia,

Myanmar, India, Bangladesh, and many African nations having difficulties in
getting information on the data collection for the calculation of the national
income.
• Conceptual Problems
¾ Problems of estimation – The estimation of depreciation of machinery can be

different due to obsolete and losses of its value. For example, in Singapore, cars
over 10 years old are considered as obsolete, and that can cause the depreciation
to differ.
¾ Imputed rent – Some owner-occupied houses may overestimate and some may
underestimate their imputed rent. This could cause the estimation of the actual
10 national income not accurate.
¾ Problem of double accounting – it has been explained earlier on.
200
10.2 CASE STUDY
The Keynesian Revolution

In the long-run we are all dead!!!
Keynes rejected the classical remedies (treatment) for unemployment. According to

Keynes, they were more than just useless: they actually made the problem worse. So what
were the classical remedies? And why would they make unemployment worse?
‘People should be encouraged to save. This would reduce interest rates and encourage
more investment, more growth and more jobs’. But if people save more, they spend less.
Firms will therefore sell less. They will thus have idle capacity and will lay off workers.
Unemployment will rise. What is more, firms will be discouraged from investing. After
all, what is the point in installing extra machines when you are not using all of the
existing ones?
Keynes called this the paradox of thrift. If the nation becomes thriftier, it will thereby
become poorer.
‘People should be prepared to take wage cuts. This would reduce firms’ costs and allow
them to take on more labour.’ But workers are also consumers. If people are paid less,
they will spend less and firms will sell less. Firms will thus want to employ fewer
workers, not more.
‘The government should attempt to balance its budget. If the government is currently
running a budget deficit, then it should attempt to eliminate it. This would release
resources for private-sector investment. More investment would lead to more
employment.’ But if the economy is in recession and unemployment is already high, the
budget deficit may be quite large. There are two reasons:
a) The government will be spending a lot of money on unemployment benefits;
b) If incomes and consumption are low, tax receipts will be low.
To eliminate the deficit then, the government would either have to raise taxes or have to
reduce its expenditure, for example by reducing the level of benefits. Either way,
aggregate demand would fall and firms would sell less. This would merely encourage
them to lay off more workers. Unemployment would rise, not fall.
‘Reduce the supply of money. This would reduce prices. This in turn would make British 10
goods more competitive overseas and thus lead the export industry to recovery.
Employment would rise.’ But reducing the money supply would raise interest rates and
reduce investment. The economy would slide further into recession and unemployment
would rise.
So if all these classical remedies are wrong, what is Keynes’ answer? That is simple.
There must be more spending, not less. Aggregate demand must be boosted,
201
either directly through a programme of public works, or indirectly by giving tax cuts and
thus encouraging more consumer expenditure. Either way it would mean a policy of a
deliberately unbalanced budget. According to Keynes, therefore, budget deficits were
highly desirable in recessions.
1. How would you / or the classical economist reply to each of Keynes’ critics?
2. Would each of the above classical policies be suitable if there is a problem of excess
demand and inflation?
(The General Theory of Employment, Interest and Money, John Maynard Keynes, 1936)
10
202
10.3 SUMMARY
The key variable of data in the macroeconomics is the national income. National Income is
defined as the value of final goods and services that are available to the residents of a country
as a result of their own economic activities over a period of one year.
GDP is the key concept in national income accounting. Gross domestic product (GDP) is the
market value of all final goods and services produced by factors of production within a given
period of time.
GDP excludes intermediate goods to avoid double counting and an overstated value of
production.
Measures of national income and output are used in economics to estimate the value of goods
and services produced in an economy. Some of the more common measures are Gross
Domestic Product (GDP), Gross National Product (GNP), Net National Product (NNP), and
Net National Income (NNI).
GDP can be measured by two different approaches:
a) The Expenditure Approach
b) The Income Approach
The measurement of income approach is: calculating GDP by adding up expenditures on all
factors income earned by the suppliers of the resources used to produce the total output
during the year.
The measurement of expenditure approach is: calculating GDP by adding up

expenditures/monetary values of all final goods and services produced during the year.
Aggregate income is the sum of all income earned by resource suppliers in an economy
during a given time period. An aggregate income earned through producing goods and
services is equal to the total amount paid for the factors of production used – wages, interest,
rent, and profit.
Aggregate expenditure is total spending on all production of final goods and services.
Aggregate expenditure equals consumption expenditure plus investment, plus government
purchases, plus net exports.
10
The circular flow model summarizes the flow of income and spending through the economy.
Spending on consumption remains in the circular flow and is the biggest aggregate
expenditure.
Uses of national income statistics:
• To find out the distribution of national income
• To calculate the rate at which the economy is growing
203
• To find out the contributions of different sectors
• To indicate the general standard of living of the people
• To assist the government in planning the economy
• To monitor the national planning
• To make comparisons between countries over time
Why GDP is important?
• It measures current production because it includes only what was produced during the
year.
• It is a measurement of the final goods produced because it does not include the value of a
type of goods when sold by a producer, again when sold by the distributor, and once more
when sold by the retailer to the final customer. We count only the final sale.
Problems in calculating national income:
• Practical problems such as lack of a expertise and sophisticated machinery, false

information and problems of illiteracy.
• Conceptual problems such as the estimation criteria of depreciation of machinery that can
be differed due to obsolete and losses of its value.
• Problems of double counting.
According to Keynes, it is not prices and wages that determine the level of employment, but
the level of aggregate demand for goods and services instead.
Keynes believes that the government could intervene in the economy and affect the level of
output and employment – to lift the economy out of recession.
10
204
10.4 EXERCISES
1. Define national income
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
2. What are the three approaches to measuring national income?
___________________________________________________________________________
3.
gross domestic product gross national product
national income net national product
a) The value of final output of goods and services produced by factors of production
owned by residents of a country, irrespective of the location of theses resources.
_____________________________________________________________________
b) The value of final output of goods and services produced by residents of a country
form resources owned by them after allowing for depreciation.
_____________________________________________________________________
c) A country’s net national product valued at factor cost
_____________________________________________________________________
d) The value of final output of goods and services produced within the territory of a
country. 10
_____________________________________________________________________
4. Identify the component of aggregate expenditure to which each of the following belongs
to:
a) A businessman’s purchase of a new car manufactured in Japan.
_____________________________________________________________________
205
b) A household’s purchase of one hour of legal advice.
_____________________________________________________________________
c) Construction of a new house.
_____________________________________________________________________
d) An increase in semiconductor inventories over last year’s level.
_____________________________________________________________________
e) A government’s acquisition of 10 new police cars.
_____________________________________________________________________
5. How do we know that calculating GDP by the expenditure approach yields the same
answer as calculating GDP by the income approach?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
6.
gross domestic product government consumption market value
intermediate goods gross investment net exports
gross national product expenditure approach personal income
national income
a) ___________________________is the key concept in national income accounting.

10 GDP is the total _____________________________of all final goods and services
produced within a given period for factors of production located within a country.
b) __________________________ is the market value of all final goods and services

produced during a given period by factors of production owned by a country’s citizen.
c) GDP excludes all transactions in which money or goods change hands but in which no
new goods and services are produced. GDP excludes _________________________.
d) The ______________________________ to GDP adds up the amount spent on all

final goods and services during a given period.
206
e) __________________________ and ______________________ include expenditures

by state, federal and local governments for final goods and services. The value of
___________________________ equals the differences between exports and imports.
f) _________________________ is the total amount earned by the factors of production

in the economy. ______________________ is the total income of households.
7. The CPI is a fixed-weight index. It compares the price of a fixed bundle of goods in one
year with the price of the same bundle of goods in some base year.
Prices
Good Quantity Consumed 2001 2002 2003
RM
X 100 1.00 1.50 1.75
Y 150 1.50 2.00 2.00
Z 25 3.00 3.25 3.00
Calculate the price of a bundle containing 100 units of good X, 150 units of good Y, and
25 units of good Z in the years 2001, 2002, and 2003. Convert the results into an index by
dividing each bundle price figure by the bundle price in year 2001.
Calculate the percentage change in your index between 2001 and 2002 and again between
2002 and 2003. Was there inflation between 2002 and 2003?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
8. Explain the two approaches to calculating GDP.
___________________________________________________________________________
___________________________________________________________________________
10
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
9. Why does money go round and round from firms to consumer and back again? What
model should be used?
207
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
10. What are the problems in calculating national income? Answer in your own words.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
10
208
10
209
11 International Trade (Macroeconomics)
International Trade
Objectives
Distinction between Domestic and
International Trade At the end of this chapter students should be able to:
Advantages and Disadvantages of Trade
• Describe the trends and patterns in international
Absolute Advantage versus Comparative trade
Advantage
• Explain comparative advantage and explain why
Terms of Trade all countries can gain from international trade
Protectionism
• Explain why international trade restrictions
reduce the volume of imports and exports and
Balance of Payments reduce our consumption possibilities
Foreign Exchange
• Explain the arguments that are used to justify
international trade restrictions
210
International Trade (Macroeconomics)
11.1 INTERNATIONAL TRADE
If you walk into a supermarket and are able to buy South American bananas, Brazilian coffee
and a glass of Arabica coffee, you are experiencing the effects of international trade.
Political changes in Asia, for example, could result in an increase in the cost of labour,
thereby increasing the manufacturing costs for an American sneaker company based in
Malaysia, which would then result in an increase in the price that you have to pay to buy the
tennis shoes at your local mall. A decrease in the cost of labour, on the other hand, would
result in you having to pay less for your new shoes.
International trade is the exchange of goods and services between countries. This type of
trade gives rise to a world economy, in which prices, or supply and demand, could either be
affected or otherwise by global events.
International trade allows us to expand our markets for both goods and services that
otherwise may not have been available to us. It is the reason why you can pick and choose
from Japanese, German and American cars. As a result of international trade, the market
offers greater competition and therefore more competitive prices, and this brings a cheaper
product back to the consumer.
Why do countries trade with each other and what do they gain out of it?
11
• This will allow them to gain economies of scale and exploit their entrepreneurial and
management or labour skills.
211
• Specialization – means a nation which specializes in the production of goods and

services. Specialization occurs on an international level when countries concentrate their
productivity efforts on the goods and services they are best at producing, and trade in
goods and services that are most costly to produce. For example, a student may select
economics as her major, a doctor may specialize in surgery; and Johore is known for its
pineapples.
• Principle of absolute advantage. A country has an absolute advantage in the production

of goods if it can produce them with fewer resources than other countries.
• Comparative advantage. A country has a comparative advantage in the production of a

product if that product can be produced at a lower cost in terms of other goods.
11.1.1 Distinction between Domestic and International Trade
When a domestic business firm crosses its national borders to do business in other countries,
it enters a riskier and more complex environment.
This will allow the firm to gain economies of scale and to exploit its entrepreneurial
and management or labour skills.
International trade is the buying and selling of goods and services among different countries.
It affects the following:
• Levels of production
• Employment
• Prices in the trading countries
Below are some of the main distinctions between domestic and international trade.
1. Different units of currencies. International business transactions are
11 denominated in foreign currencies at different values. The factors that tend to

decrease the supply or increase the demand for currency will raise the value of
that currency – and this will result in foreign exchange risks.
2. Size of the market. International trade is obviously wider than domestic trade.
Comparative advantage will differ - where the individual country should
specialize in the product where it has the lower opportunity cost. If the
212
opportunity cost for both countries is equal or similar, then either country will not
gain from trade.
3. Documentation. International trade involves lots of documentation than in the

ease of domestic trade. Many bureaucratic routines will have to be channelled
through before clearance. This includes the processing of international documents
such as bills of exchange / lading, import / export permits, travellers’ cheques, etc.
4. Composition of goods. Refers to goods that cannot be produced locally. For

example, in Singapore, rice, wheat and butter are imported. Second will be goods
that are too expensive to be produced locally and is cheaper when imported. For
example, Singapore imported cars and watches.
Let’s look at the simple model to demonstrate trade.
There are two countries producing two different goods - foods and clothing – Country R and
Country P.
PPF (can you still remember what PPF is?)
With x resources, Country R can make: 20 units of clothing or 200 units of food
With x resources, Country P can make: 10 units of clothing or 150 units of food
Absolute costs of production are cheaper in Country R. Yet both countries can benefit from
trade, because of differences in relative (opportunity) costs of production.
Opportunity Cost
Country R: Opportunity cost of 1 unit of clothing = 10 units of food

Opportunity cost of 1 unit of food = 1/10 unit of clothing
Country P: Opportunity cost of 1 unit of clothing = 15 units of food

Opportunity cost of 1 unit of food = 1/15 unit of clothing
Trading Possibilities
Country R has comparative advantage in producing clothing.

Country P has comparative advantage in producing food.
Both countries will be better off if they trade separately.
Basis for Trading
If Country P sells 100 units of food to Country R, Country P gets 10 units of clothing. (If
Country P used those resources to make clothes, Country R would only get 6.67 units). 11
If Country R sells 100 units of clothing to Country P, Country R gets 1500 units of food.
(Would only get 1000 units if Country R used those resources to produce food).
213
11.1.2 Advantages and Disadvantages of Trade
Advantages of international trade:
• Consumers: more goods, lower prices
• Domestic firms (in export industries): bigger markets, more profits, more jobs.
• Differences in demand.
For example, if people in country A like beef more than lamb, and people in country B
like lamb more than beef – than A using resources better suited for lamb to produced
beef, and B using resources better suited for producing beef to produce lamb. It will
benefit both to produce beef and lamb and to export the one they like less in return for the
one they like more.
Trade can benefit both countries if demand conditions differ.
Potential disadvantages:
• Import competition – threat to some domestic firms and jobs.
• Balance of payment problems (trade deficit might reduce aggregate demand).
11.1.3 Absolute Advantage versus Comparative Advantage
Countries have different endowment (gift) of factors of production. They differ in population
density, labour skill, climate, raw materials and so on. Therefore, the ability to supply goods
differs from country to country. The relative cost will definitely vary from country to country.
At this stage we need to distinguish between absolute advantage and comparative advantage.
• Absolute advantage – refers to a country that can produce a type of goods with fewer
resources than another country.
• Comparative advantage – refers to a country that has a comparative advantage over

another in the production of goods if it can produce them at a lower opportunity cost than
in other countries.
Let’s take a look at the following example which shows the comparison of absolute and
comparative advantage.
11
214
David Ricardo, working in the early part of the 19th century, realised that absolute advantage
was a limited case of a more general theory. Consider Table 5-1. It can be seen that Portugal
can produce both wheat and butter more cheaply than England (i.e. it has an absolute
advantage in both commodities). What David Ricardo saw was that it could still be mutually
beneficial for both countries to specialise in trade.
Country Wheat Butter
Cost Per Unit in Man Hours Cost Per Unit in Man Hours
England 15 30
Portugal 10 15
Table 11-1
In Table 11-1, a unit of butter in England costs the same as to produce 2 units of wheat.
Production of an extra unit of butter means foregoing production of 2 units of wheat (i.e. the
opportunity cost of a unit of butter is 2 units of wheat). In Portugal, a unit of butter costs 1.5
units of wheat to produce (i.e. the opportunity cost of a unit of butter is 1.5 units of wheat in
Portugal). Since relative or comparative costs differ, it will still be mutually advantageous for
both countries to trade even though Portugal has an absolute advantage in both commodities.
Portugal is relatively better at producing butter than wheat: so Portugal is said to have a
COMPARATIVE ADVANTAGE in the production of butter. England is relatively better at
producing wheat than butter: so England is said to have a comparative advantage in the
production of wheat.
Table 11-1 shows how trade might be advantageous. Costs of production are as set out in
Table 11-2. England is assumed to have 270 man hours available for production. Before trade
takes place, it produces and consumes 8 units of wheat and 5 units of butter. Portugal has
fewer labour resources with 180 man hours of labour available for production. Before trade
takes place, it produces and consumes 9 units of wheat and 6 units of butter. Total production
between the two economies is 17 units of wheat and 11 units of butter.
Production
Country Before Trade After Trade
Wheat Butter Wheat Butter
England 8 5 18 0
Portugal 9 6 0 12 11
Total 17 11 18 12
Table 11-2
215
If both countries now specialise in production, Portugal producing only butter and England
producing only wheat, total production is 18 units of wheat and 12 units of butter.
Specialisation has enabled the world economy to increase production by 1 unit of wheat and
1 unit of butter.
(Source: David Ricardo, an Economist, Principles of Political Economy and Taxation)
The simple theory of comparative advantage outlined above makes a number of important
assumptions:
• There are no transport costs.
• Costs are constant and there are no economies of scale.
• There are only two economies producing two goods.
• The theory assumes that traded goods are homogeneous (i.e. identical).
• Factors of production are assumed to be perfectly mobile.
• There are no tariffs or other trade barriers.
• There is perfect knowledge, so that all buyers and sellers know where the cheapest goods
can be found internationally.
11.1.4 Terms of Trade
The ratio or the price index at which a country can trade domestic products for imported
products is the terms of trade. The terms of trade determine how the gains from trade are
distributed among trading partners.
11 The terms of trade are defined as:
The average price of export x 100

The average price of imports
216
Express as an index, where price is measured against a base year in which the terms of trade
are assumed to be 100. When the terms of trade is greater than 100, it is said to be favourable
terms of trade. But if less than 100, than it is an unfavourable term of trade. When the terms
of trade is 100, it refers to a balanced terms of trade. Thus, if the average price of exports
relative to the average price of imports has risen by 20% since the base year, the terms of
trade will now be 120.
Let’s refer to an example on Hashim, 2000’s measurements.
1. Price of exports increases while price of import decreases – favourable
2. Increases in price of exports are greater than the increase in price of imports –
favourable
3. The increase in price of exports is less than the increase in price of import –
unfavourable
4. Price of exports remains constant while price of import increases – unfavourable
5. Price of exports increases while price of import remains constant – favourable
Table 11-3 shows the terms of trade of the following years.
Table 11-3 Terms of Trade

11
217
11.1.5 Protectionism
Protectionism refers to the philosophy that it is in the best interest of a country to restrict free
trade. Protectionism is the alternative to free trade. Protection is the practice of shielding a
sector of the economy from foreign competition. Action will be taken by a government to
prevent imports from destroying domestic producers.
Protectionist policies include:
• Imposing tariffs – taxes on import. The price of goods will rise and the demand for
imported goods will fall.
• Imposing quotas – quantity limits on imports. By limiting the quantity of goods that can
be imported or exported, residents would have to buy the locally made products.
• Export subsidies such as payment made to local producers/domestic firms by the

government. By doing so, it will cause a fall in the production and prices of local foods.
• An embargo which is outright bans on trading a product or on trade. Banned goods

which are not allowed to be imported into the country. Embargo goods are drugs, certain
livestock, pornographic, etc.
Protection results in higher prices. Even if there is government intervention to protect certain
parts of the economy, restricting trade is not the only solution to the problem, since it
involves side effect costs.
Classical economist, Adam Smith, preferred free trade since the 17th century, i.e. trade with
11 no restrictions at all. He believes that free trade will bring about benefits and greater
specialization. His idea was supported by the Comparative Advantage Theory suggested by
David Ricardo (an economist mentioned earlier).
218
Other arguments for protection (Case and Fair,2006):
• includes that cheap foreign labour makes competition unfair;
• that some countries engage in unfair trade practices;
• and that protection safeguards the national security;
• discourages dependency;
• Act as shield to infant industries.
Despite these arguments, most economists prefer free trade.
Protection results in higher prices. Countries may make a partial movement towards free
trade by the adoption of preferential trading system. This involves free trade members, but
the restrictions on trade are imposed on the rest of the world.
11.1.6 Balance of Payments
The Balance of payments (BOP) refers to the records of a nation’s transactions in goods,
services, and assets with the rest of the world. It reflects all payments and liabilities to
foreigners (debit) and all payments and obligations received from foreigners (credits).
The balance of payments is also the record of a country’s sources (supply) and uses
(demand) of foreign exchange. The BOP includes the trade balance, foreign investments and
investments by foreigners. It may be used as an indicator of economic and political stability.
For example, if a country has a consistently positive BOP, this could mean that there is
significant foreign investment within that country. It may also mean that the country does not
export much of its currency.
The balance of payments is divided into two major accounts:
• The Current account – the difference between a nation’s total export of goods, services
11
and transfers, and its total imports of same. Current account balance calculations exclude
transactions in financial assets and liabilities. This account is also called balance of trade -
the difference between the value of exports and imports.
219
Exports result in an inflow of money (credit). Import result in an outflow of money

(debit). A surplus is when exports exceed imports. A deficit is when imports exceed
exports.
• The Capital account – Investment can be in the form of buying shares or bonds in other
countries. These accounts include investment in the form of treasury bills and other short
term investment by private individuals or officials. It also consists of net transfer of
money of a capital nature. For example, the transfer of funds by people moving into or out
of the country.
These are shown in Table 11-4 which provides data on the balance of accounts.
2005e
Item
+ - Net
RM million
Goods 536,931 410,476 126,455
Trade account 533,788 434,010 99,778
Services 72,202 82,452 -10,249
Balance on goods and services 609,133 492,928 116,205
Income 20,469 41,937 -21,470
Current transfers 1,131 18,094 -16,963
Balance on current account 630,734 552,960 77,772
% of GNP 16.4
Capital account -
Financial account -41,952
Direct investment 2,711
Portfolio inverstment -11,881
Other investment -32,782
Balance on capital and financial account -41,952
Errors on omissions of which: -23,000
Foreign exchange revaluation gain (+) or loss (-) -15,496
Overall balance 12,820
Bank Negara Malaysia international reserves, 266,334
net USD million equivalent 70,483
Note: Numbers may not necessarily add up due to rounding.
11 e Estimate
Table 11-4 Balance of Payments
(Source, BNM Annual Report 2005)
220
What is the distinction between the balance of payments and a balance sheet?
• A balance sheet for a firm or a country measures that entity’s stock of assets and
liabilities at a moment of time.
• The balance of payments, by contrast, measures the flows, usually over a period of a
month, a quarter, or a year.
Despite its name, the balance of payments is not a balance sheet.
11.1.7 Foreign Exchange
What causes exchange rates to change?
If you want to go abroad, of course you will need to change your Ringgit to the currency and
foreign exchange rate of that particular country.
Where does the supply of foreign exchange come from?
It is simple. For example, Malaysian earns foreign exchange when it sells products or
services to another country. We also earn foreign exchange when tourists visit Malaysia. The
United States earns foreign exchange when the Asians come to the States to visit Disney
World.
Similarly, when Proton sells cars to other countries, it increases the supply of foreign
exchange.
Exchange rate is the price of one country’s currency in terms of another country’s currency;
the ratio at which two currencies are traded for each other. The exchange rate is a price – the
price of one country’s money in terms of another country’s money. Similar to all prices,
demand and supply determine the exchange rate.
11
The equilibrium exchange rate occurs when the quantity demanded of a foreign
currency market equals the quantity of that currency supplied in the foreign exchange market.
221
The determination of exchange rates between a nation’s monies can be done either through:
• a fixed exchange rate system,
• A flexible or floating exchange rate system. The purpose is to maintain a country’s

currency value within a narrow band. It is also known as pegged exchange rate.
The Revolution of Ringgit Malaysia.
• The currency of Malaysia which was established on 26 Jan 1959 is regulated by BNM,
the central Bank of Malaysia.
• The Malaysian Dollar (M$) was created on 12 June 1967.
• On 25 June 1972, M$ was linked to USD with a fluctuating Effective Rate ranging from
RM2.76 and revised the following year.
• In 1975 The M$ was officially renamed the Ringgit.
• In 1978 the exchange rates for all other currencies were determined on the basis of
Ringgit – US Dollar (MYR/USD) – sustained until the mid of 1997 – where Ringgit
started to depreciate because of Asian Financial Crisis.
• Effective from 2 September 1998 – pegged at the rate against the USD at RM3.80 per
unit USD. This pegged rate is still maintained till today.
The purpose of a fixed exchange rate system is to maintain a country's currency value within
a very narrow band. Fixed exchange rate is also known as pegged exchange rate. Fixed rates
provide greater certainty for exporters and importers.
11 This also helps the government maintain low inflation, which in the long run should
keep interest rates down and stimulate increased trade and investment.
222
11.2 CASE STUDY
Income Elasticity of Demand and the Balance of Payments

A problem for certain developing countries
When people are poor, they have to spend a large proportion of their income on basic
goods such as food. As they get richer, they can afford to buy an increasing proportion of
luxury goods. This means that the income elasticity of demand for basic goods is likely to
be low: their demand only rises slowly as incomes rise. The income elasticity of demand
for luxury goods, on the other hand, is likely to be high.
This has important implications for international trade. If a country exports basic
goods with a low income elasticity of demand, and imports luxury goods with a high
income elasticity of demand, it is likely to run into long-term balance of payments
problems.
As it grows richer, its demand for imports is likely to grow rapidly. As the rest of the
world grows richer, however, the demand for the country’s exports is likely to grow
slowly.
This has been one of the problems facing many developing countries. As exporters of
commodities such as rice, sugar and tea, they have found that the demand for their
exports has grown relatively slowly. As importers of manufactured products, however,
their imports have grown relatively rapidly.
This affects their terms of trade. The terms of trade are the average price of a
country’s exports divided by the average price of its imports. If the demand for exports
grows only slowly relative to imports, so the price of exports is likely to fall relative to
imports: the terms of trade will deteriorate. More will have to be exported to buy the
same quantity of imports.
Between 1980 and 2000, the price of (non-fuel) commodities fell by 51 per cent,
compared with world prices generally. The price of manufactured products imported
from the major industrialised countries, by contrast, rose by 40 per cent. This represented
a substantial deterioration in the terms of trade for many developing countries.
A word of caution: income elasticity of demand is the only one factor influencing the
level of a country’s imports and exports, and it is also the only one factor determining its
terms of trade.
11
223
1. Would you expect the demand for a developing country’s raw material exports to
grow more rapidly or slowly over time?
2. Does their growth give a good indication as to their income elasticity of demand?
11
224
11.3 SUMMARY
An international economy deals with the economic relationships among countries.

International trade is concerned with the exporting and importing of goods and services and
is important because it affects production, employment, and price in the trading countries.
Trade enables countries to move beyond their previous resource and productivity constraints.
Specialization occurs on an international level when countries concentrate their productive

efforts on the goods and services they are best at producing, and trade for the goods and
services that are most costly to produce.
Comparative advantage is practised when a country produces those goods and services in
which it has a cost advantage in comparison to other countries, and trades for what it is less
adept at producing.
The advantage in the production of a product enjoyed by one country over another when that
product can be produced at a lower cost in terms of other goods than it could be in the other
country.
When countries specialize in producing whatever goods, they have a comparative advantage;
they combined output and allocate their resources more efficiently.
Absolute advantage means a country is the lowest cost producer of those goods.
The advantage in the production of a product enjoyed by one country over another when it
uses fewer resources to produce that product than the other country does.
Some distinctions between the domestic and international trade:
• Differences in units of currencies
• Size of the market
• Documentation
• Composition of goods
Gains from trade also arise from decreasing costs (economies of scale), differences in
demand between countries, increased competition from trade and the transmission of growth
form one country to another.
According to David Ricardo in the 19th century, the theory of comparative advantage holds
that specialization and free trade will benefit all trading partners, even those that may be
absolutely less efficient producers.
11
The terms of trade should be the price of exports relative to the price of imports which is
expressed in the form of an index, where the base year is 100.
225
Protection results in higher prices. The resulting loss in consumer surplus is not fully offset
by the gain in profits to domestic firms. Even if there is government intervention to protect
certain parts of the economy, restricting trade is not the only solution to the problem, since it
involves side-effect costs.
The balance of payment account records all payments to and receipts from foreign countries.
The current account records payments for the imports and exports of goods and services. The
capital account records all transfers of capital to and from abroad. The whole account must
balance, but surpluses or deficits can be recorded on any specific part of the account.
Foreign exchange is all currencies other than a domestic currency of a given country.
The exchange rate will depreciate (fall) if the demand for the domestic currency falls or the
supply increases. The opposite in each case would cause an appreciation (rise).
11
226
11.4 EXERCISES
1. What are the primary reasons for international trade?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
2. What benefits can a country derive from international trade?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
3. What is meant by terms of trade?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
4. a) Explain the meaning of a country’s balance of payments
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
b) Explain why the overall balance of payments always balances or equals zero? 11
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
227
________________________________________________________________________
________________________________________________________________________
5.
protection trade barriers trade deficit
trade surplus trade
a) __________________________ prevents a nation from reaping the benefits of

specialization, pushes it to adopt relatively inefficient production techniques and
forces consumers to pay higher prices for protected products than they would
otherwise pay.
b) Other arguments for ______________________ hold that cheap foreign labour makes
competition unfair; that some countries engaged in unfair trade practices and shield
infant industries.
c) The situation when a country imports more than it exports is known as

___________________________. The situation when a country exports more than it
imports is known as ____________________________.
d) __________________________enables both countries to move beyond their previous

resource and productivity constraints.
6. What is the difference between a depreciation of the Ringgit and a devaluation of the
Ringgit?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
7. a) For what purpose would foreigners demand a country’s currency?
________________________________________________________________________
________________________________________________________________________
b) For what purpose would the residents of a country demand currency?
11 ________________________________________________________________________
________________________________________________________________________
8. Explain what is absolute advantage and comparative advantage?
228
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
9. Under the floating exchange rate system, a surplus in the balance of payments will cause
the exchange rate of a country’s currency to (appreciate / depreciate). If the country is
under a fixed rate regime, the same surplus would lead to a (rise / fall) in the country’s
money supply as the monetary authorities (buy /sell) the country’s currency in the foreign
exchange market to maintain the exchange rate
___________________________________________________________________________
___________________________________________________________________________
10. Suppose Malaysia ran a balance on goods and services surplus by exporting goods and
services while importing nothing.
a) If the level of Malaysia production does not depend on the balance of goods and
services, how would running this surplus affect our current standard of living?
________________________________________________________________________
________________________________________________________________________
b) What is the relationship between total debits and total credits in the goods and
services balance?
________________________________________________________________________
________________________________________________________________________
c) When all international economics transactions are considered, what must be true
about the sum of debit and credits?
________________________________________________________________________
________________________________________________________________________
11
229

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UNDERSTANDING

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Coordinator : Chow Mee Ling

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Editor : Khadijah Haidi Khalid

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web site: http://www.cosmopoint.com.my

Understanding Economics is fundamental to design and implement economic policy. It

The study of Economics requires an understanding of resources, agents, institutions and

On completion of this course, student will be:

• Able to demonstrate knowledge of the core principles of economics.

Week Topics Chapter Hours

3 Demand and Supply 3 3

4 Demand and Supply 3 3

5 Price Determination and Elasticity 4 3

7 Production and Production Costs 6 3

8 Production and Production Costs 6 3

11 Role of Government and Economic Growth 8 3

12 The Banking System, Money and Inflation 9 3

National Income and Theory of Income

 Microeconomics and Macroeconomics • Define economics and distinguish between

1.1 INTRODUCTION TO ECONOMICS

The word ‘economics’ is derived from the

The Economist’s Dictionary of Economics

One can also view economics as the

1.1.1 What is economics all about?

• How we decide what to produce with our limited resources.

• How we ensure stable prices and full employment of our resources.

Wants are what people desire or wish to

One may need clothes, but one may not

Why economics is considered a social science

1 Scarcity refers to the fact that people’s wants are

As a society, limited resources (such as

For example, an individual wants a big house and

1.1.3 Microeconomics and Macroeconomics

• Microeconomics is the components of the ¾ Inflation

• The key questions about ¾ Balance of trade

¾ For whom are goods and services

o Labour earns wages

1 o Capital earns interest

• How to allocate the goods and services

¾ Where there is consumer demand

1.1.4 Economic Systems

• Mixed economy • Market economy

• Planned economy • Traditional economy

1.1.5 Mixed Economy

The government will not intervene in all but four areas:

• The business sector • Output market

Even countries, like US, which practices more

1 As for China, it is theoretically a

Malaysia is a good example of a mixed

Free market is a market in which the government does not intervene.

1.1.6 Planned Economy

However, countries like China, Cuba,

Imagine that you had to run by command

Table 1-1 Strengths and Weaknesses of Planned Economy

(Source: Patrick J Welch & Gerry F Welch, 2004)

1.1.7 Market Economy

1 It refers to the study of an economy in which

It also refers to the study of business

Before we proceed, every student should know what a market means

• A market is defined as a place or situation in which buyers and sellers of a product

For example, Mc Donald’s is trying to sell

Microeconomics and Macroeconomics • Define economics and distinguish between