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ISA, Grade 12 Economics Standard and Higher Level, March 2014

SECTION 4: DEVELOPMENT ECONOMICS


4.8 The Balance between Markets and Government
Intervention
Worksheet Strength and Weaknesses of
Market-oriented policies and Interventionist policies
Learning objectives:
Define the following terms: market-oriented policies, trade liberalisation, capital
flows, liberalisation of trade flows, privatisation, deregulation, dual economy,
interventionist policies, infrastructure, human capital, social safety net, good
governance;
Know that examples of market oriented policies are: trade liberalisation, liberalisation
of capital flows, privatisation and deregulation.
Discuss the positive outcomes of market oriented policies including a more efficient
allocation of resources and economic growth;
Discuss the negative outcomes of market-oriented strategies including market failure,
the development of a dual economy and income inequalities.
Know that examples of interventionist policies are: the provision of infrastructure,
investment in human capital, the provision of a stable macroeconomic economy and
the provision of a social safety net;
Discuss the strengths of interventionist policies which would the potential to create
economic development through better infrastructure, more skilled labour force, the
predictability of the economy;
Discuss the limitations of interventionist policies including excessive bureaucracy,
poor planning and corruption;
Explain the importance of good governance to create economic development;
Discuss the view that economic development may be best achieved through a
complementary approach, involving a balance of market oriented policies and
government intervention.
Also see:
Economics Course Companion 2nd edition, Jocelyn Blink & Ian Dorton, chapter 33
The balance between markets and intervention, pages 401 - 404;
A classic example of evaluation in development economics is the debate to what extent
the government should intervene to create economic growth and development. This is
similar to the discussion we say earlier regarding demand and supply-side policies.
However, now rather than focusing on whether demand or supply-side policies would be
preferable, you need to consider to what extent a government or market forces could
create a higher standard of living. You need to remember that macroeconomic
government intervention in the supply-side of the economy is to be divided into:
1. Market oriented policies

2. Interventionist policies
In general supply side policies aim at positively affecting the production side of an
economy by improving the institutional framework and the capacity to produce. Both
types of supply-side policies aim to increase the long-run aggregate supply which is
illustrated by a shift to the right of the LRAS curve on a AS / AD diagram. This would
create potential economic growth as the potential output increase.
The institutional framework of an economy includes:
education system
health care
use of appropriate technology
financial system including access to credit and micro-credit
position of women
legal system including protection of property rights
transparency of government (degree of democracy and level of corruption)
distribution of income
quality of infrastructure
level of political (and macroeconomic) stability
effective taxation system
Capacity to produce (or the potential output, or production capacity) depends on:
quantity of factors of production
quality of factors of production
Earlier we looked at examples of interventionist supply-side policies. As the government
intervenes in the macroeconomy, the spending in the economy will increase. This will
increase AD, but more importantly it will increase the LRAS. Examples of interventionist
supply-side policies include:
Investment in human capital through education and training
Investment in new technology through encouraging research and development
Investment in infrastructure
Targeting specific industries through policies including tax cuts /breaks, tax
allowances and lending at lower interest rates
The above policies can have great impacts on a domestic economy which could create
economic development, such as:
Provision of infrastructure
Better human capital
Providing a stable macro-economy creating predictability and encouraging
enterprise and FDI
Provision of a social safety net

At the same you need to be aware that behind these policies, greater government
intervention can also bring about large disadvantages such as:
Excessive bureaucracy (and the increased production time and costs this creates)
Limitations due to the inability to plan successfully for the entire economy in
advance
Increased levels of corruption.
The above makes clear that interventionist policies have strengths and weaknesses. How
successful these policies will be depends on the particular conditions in a country. If a
government is able to target essential industries successful without creating more
bureaucracy, dependency and corruption then this policies can be powerful in creating
economic development.
Economists which support the more new-classic way of thinking will argue that marketoriented policies will be more likely to create economic growth and development.
Market-based policies can be separated into 3 groups:
1. policies which encourage competition
2. labour market reforms
3. incentive-related policies
Policies which encourage competition are:
trade liberalisation
liberalisation of capital flows
privatisation
deregulation
anti-monopoly regulation
Reforms which can be done in the labour market aim to make the labour market more
flexible. In many low-income countries, the flexibility of the labour market is not the
main problem. A larger problem is likely to be the low skilled labour force unable to
quickly respond to changes in the demand for labour or the very high level of
unemployment or employment in the informal sector. Still, for countries which have
made the jump to the middle or high-income groups of countries, it is possible that the
following labour market reforms could have a positively impact on the labour market and
therefore the macro-economy as a whole:
reducing the power of labour unions
reducing unemployment benefits
abolishing minimum wage
A third group of market-based supply-side policies are those policies which relate to
incentives. There are two incentives which could have a great positive impact on
economic development. These are the incentive to work and to invest. In low-income
countries, it is less appropriate to look at the incentive to work as no work in a country
without a social safety net means starvation and living in slum conditions. Also, reducing

the tax base in a country with low tax revenues will further limit the governments ability
to provide capital spending and transfer payments to low-income households.

However, incentives to invest either by domestic firms or foreign multinational


corporations could provide the necessary injections into the economy. Cuts in corporate
tax and the tax on capital gains (profit) could stimulate the factor of production
entrepreneurship and so create more economic growth and development.
In summary, the most appropriate market oriented policies for low-income countries
would be those that stimulate competition in specific industries, make the domestic
economy more competitive internationally, provide incentives for domestic and foreign
direct investment and to attract more capital flows (in the form of portfolio investment).
However as market-oriented policies assume that market forces work perfectly, it is easy
to imagine that such policies will have several weaknesses too. Market forces do not
always create an equilibrium at the socially optimum level of output. Market failure has
many causes and in the context of low-income countries you could imagine that negative
externalities of production, the overexploitation of common access resources and the
abuse of monopoly power are the most likely causes of market failure.
Also, those with a higher income and more opportunities are more likely to be able to
participate in the economy and so are more likely to gain for economic growth. This
could then increase the income inequality in the country or the development of a dual
economy.
A dual economy refers to the economy consisting out of a more traditional sector and a
more modern sector. The growth and development in the more modern part of the
economy is likely to be higher and therefore those employed there may enjoy a higher
standard of living. Those in the more traditional sector of the economy may suffer under
poor working conditions, trapped in a poverty cycle, unable to gain for the growth and
development in other sectors / regions.
Government policies however, can only work well when there is good governance and
strong leadership. Governance according to the World Bank is defined as the manner in
which power is exercised in the management of a countrys economic and social
resources for development. Unfortunately, there are too many examples of government
leaders who have mismanaged their countries resources and in this way have hurt the
economic development of their country.
If a country is to truly fight extreme poverty, create a more equal distribution of income
and generate sustained economic development, then strong leadership and good
governance is needed. Luckily there are examples of such good leaders too. The late
Ethiopian Prime Minister Meles Zenawi for example focused on development, improved
food security and reduced poverty. The same could be said for a number of Ghanaian
presidents. This has enabled Ghana to implement a successful development strategy
focused on building the private sector, developing human resources and implementing
good governance. In Brazil, President Lula revolutionised the fates of millions by
adopting a set of policies designed to channel resources directly to people at the bottom
of the income pyramid.

The Ibrahim Index of African Governance


Established in 2007, the Ibrahim Index of African Governance (IIAG) is a collection of
quantitative data on governance in Africa. It provides an annual assessment of
governance in every African country. The IIAG provides a framework for citizens,
governments, institutions and business to assess the delivery of public goods and
services, and policy outcomes, across Africa.
The data are classified within four categories:
1. Safety & Rule of Law
2. Participation & Human Rights
3. Sustainable Economic Opportunity
4. Human Development.
The Ibrahim Prize for Achievement in African Leadership celebrates excellence in
African leadership. It is awarded to a former Executive Head of State or Government
by an independent Prize Committee composed of eminent figures. Both in 2012 and
2013, the price was not awarded as the committee did not feel that any candidate was
suitable. This is a strong comment on the quality governance in the continent.
For more information: www.moibrahimfoundation.org/
In 2011 Forbes magazine compiled a top 10 of worst dictators in the world (are there ever
good dictators from a development point of view, anyway?). Although since then several
political changes have taken place several of the mentioned leaders are still in power or
handed over power to a like-minded leader and continue to hurt the economic growth and
development of their countries.
1. President of Zimbabwe Robert Mugabe.
2. Syrias president Bashar Al-Assad
3. North Korean Supreme Leader Kim Jong-Il, who has been followed up by his son
in December 2011 Kim Jong-Un and likely to be again in the top 10
4. Libyian Head of State Moammar Qaddafi. Since June 2013, the head of state is
now Nouri Abusahmain. It is not clear how the political situation in Libya will
evolve.
5. Burmas Senior General Than Shwe, succeeded in 2011 by Senior General Min
Aung Hlaing
6. Uganda President Yoweri Museveni (recently signed into law a bill toughening
penalties for gay people)
7. Venezuelan President Hugo Chavez, succeeded in 2013 by President Maduro after
Chavez died
8. Cubas Fidel Castro, although his brother Raoul effectively leads the country now.
9. Russian Prime Minister Putin (Crimea situation)
10. Iranian Supreme Leader Ayatollah Ali Kha
ARTICLE 1: ANC to debate role of state in economy

1. Debate is intensifying about how South Africa can tackle some of the worlds deepest
inequalities and highest youth unemployment, causing the ruling African National
Congress to reassess the role of the state in the economy and search for a more
effective model to deliver jobs. The findings of a team commissioned to look into the
merits of greater state intervention and the experiences of 13 nations ranging from
Norway to Venezuela are due to be discussed at a two-day meeting of the ANC
national executive committee that begins on Thursday.

2. The International Monetary Fund last week said it expected the South African
economy to grow by just 2.5 per cent in 2012, a 1.1 per reduction on its projection
last September. This contrasts with forecasts of 5.5 per cent growth for sub-Saharan
Africa as a whole and 7 per cent growth the government says it needs to create the 5m
jobs it wants to by 2020 to address youth unemployment now at 50 per cent.
3. The ANC meeting also comes against a backdrop of calls for the nationalisation of
mines by Julius Malema, the militant leader of the partys youth league. Few believe
such a move is likely or viable. But the outbursts by Mr Malema suspended by a
party disciplinary hearing have unsettled investors and put the spotlight on whether
the mineral riches that built Africas most advanced economy merely benefit a small,
predominantly white, elite. We may disagree with them (the youth league) on the
conclusion, says Enoch Godongwana, the ANCs economy policy chief. But I
subscribe to the view that the resource is not used to the benefit of South Africans as a
whole in the manner to achieve our development goals.

4. Mr Godongwana says the ANC will not follow a particular model, but instead
consider different aspects of other nations experiences. The focus is likely to be on
strategic sectors, such as minerals that could be used to support an ailing
manufacturing industry.

5. Where Mr Godongwana says there is little doubt is the belief that the government
should be more active in mining. A state-owned company, the African Exploration
Mining and Finance Corporation, was launched last year. Mining executives say they
are comfortable with that, provided it competes on a level playing field. The ANC
will also look at sectors where there are deemed to be monopolies or oligopolies
operating, such as steel.

6. Businessmen agree on the need to accelerate job creation and boost the economy but
say policy uncertainty is hampering investment and worry about potential shifts to
more populist polices.

7. But as the debate rumbles on, fears exist that faster-growing African nations, such as
Nigeria, could steal the limelight. South Africa has got a very limited window in
order to be able to capitalise on the innate advantages which it still has and
emphasis on the word still, says Michael Power, strategist at Investec. But if it
doesnt move reasonably quickly to capitalise on those advantages its going to be,
not superseded by any one country but superseded by this country in this particular
field and that country in that particular field.

8. The immediate priorities for business include addressing infrastructure bottlenecks,


labour market inflexibilities, and, crucially, poor quality education and skills. While
there has been significant policy rhetoric since the Zuma administration took office,
there is little evidence of implementation I dont believe its going to be different
for the next two years, says another business executive, who asked to remain
anonymous.
Source: The Financial Times, published 1 February 2012, written by Andrew England, http://www.ft.com/intl/cms/s/0/7823d9664b37-11e1-a325-00144feabdc0.html#axzz1lKTwryHG

It is important to release that there is no perfect answer to the question, how economic
development may be best achieved, apart from using what is called a complementary
approach. This means that a balance needs to be found between market-oriented policies
and government intervention, but also between FDI, trade and development assistance.
Trade for aid can be very useful for the least developed countries which are not ready to
compete internationally due to poor infrastructure, weak international representation, low
skilled labour forces and limited competition in the domestic market. However, aid does
also pose the risk of increasing debt.
For middle-income trade for aid may no longer be most effective and increased
participation in international trade could be beneficial then. At the same time,
international trade can only be really successful when the domestic economy is as strong
as possible and there is no risk that a dual economy will be created which may not
increase overall standard of living.
FDI can fill savings and investment gaps which can break the poverty cycle, but will only
create to sustainable development when exploitation of resources including natural
resources and labour is provided and long-term relationships are constructed without the
need to grant large tax incentives to MNCs which will repatriate their profit.
In short: there is no easy answer and the more aspects you can consider in your answer,
the stronger your balanced judgment will be.
ARTICLE 2: World Bank warns China on growth fears
1. China must urgently implement sweeping economic and political reforms if it is to
maintain growth of even half the level it managed over the past three decades, the
World Bank said in a report released Monday. China has now reached a turning
point in its development path, Robert Zoellick1, World Bank president, said in
Beijing on Monday. As Chinas leaders know, the countrys current growth
model is unsustainable.
2. The report warned China faces the prospect of being ensnared in a middleincome trap if it does not address a wide range of pressing issues, from
government interference in the economy to social inequality, weak rule of law and
terrible environmental pollution.
3. After three decades of averaging 10 per cent annual growth, China is the worlds
second-largest economy and the largest exporter of goods but there is growing
evidence that its export-dependent, investment-led growth model is running out of
steam.

Current president is Dr Kim.

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4. The World Bank report supports that assessment and predicts that even if Beijing
implements steady reforms and avoids any major shocks to the economy, annual
growth will decline to 5.9 per cent by 2021 and to just 5 per cent by 2026. Even at
that lower rate, China would still replace the US as the worlds biggest economy
by 2030 and its influence in the global economy would be comparable to that of
the UK in 1870 or the US in 1945.
5. However, postponing urgently needed reforms risks the possibility of an
economic crisis in the future, and also raises the likelihood of serious social
unrest, said the report, called China 2030: Building a modern, harmonious and
creative high-income society. It identified broad reforms to help stave off
stagnation or worse, including strengthening the fiscal system, promoting green
growth, expanding social security, reducing inequality, fostering innovation and
integrating the Chinese financial sector into the global financial system.
6. The World Bank hopes its prescriptions will be used as a blueprint for reform but
many analysts are sceptical that the next crop of Chinese leaders will have the
power or inclination to implement many of the suggestions. Probably the most
contentious suggestion in the report was the call for Beijing to redefine the role of
government by pushing privatisation of state enterprises and making governance
more responsive and inclusive. Although the word democracy did not appear
anywhere in the report, it argued strongly for greater political participation by
Chinas citizens.
7. The expanding middle class is increasingly vocal in its demand to participate in
the discussion of public policy and the government should grant rights to
individuals, households, enterprises, communities, academia and other nongovernmental organisations through clear rules that encourage broad
participation, the report said.
8. It also warned that the main obstacle to the reform proposals would be opposition
from vested interests, such as state enterprises that enjoy a monopoly in key
markets or powerful companies and individuals with special privileges in the
current power structure. In order to push through the reforms, the World Bank
proposed the establishment of a high-level reform commission with the full
support of the most senior ranks of government.
Adapted after: The Financial Times, published 27 February 2012, written by Jamil Anderlini,
http://www.ft.com/intl/cms/s/0/88141132-6140-11e1-a738-00144feabdc0.html#axzz1ni8gZCSf (accessed 28 February 2012)

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ARTICLE 3:
China Approves Income Plan as Wealth Divide Poses Risks
1. Chinas State Council approved an income-distribution plan intended to tackle the
nations wealth gap. The 35-point blueprint targets boosting minimum wages to at
least 40 percent of average salaries, loosening controls on lending and deposit rates
and increasing spending on education and affordable housing. State-owned
enterprises should contribute more to the treasury, according to a statement yesterday
on the governments website.
2. The gap between rich and poor poses risks for a new Communist Party leadership,
headed by Xi Jinping, thats seeking to sustain the nations expansion by boosting
domestic demand. The key question is how effectively the government implements
the policies, according to analysts. Its a good plan that came a little bit late, Yuan
Gangming, a researcher with the governments Chinese Academy of Social Sciences
in Beijing, said in a telephone interview.
3. The income gap in China is so big now that it brings huge risks of derailing China
from its growth path. The nations Gini coefficient was 0.474 in 2012, statistics
bureau data showed last month, above the 0.4 level used by analysts as a gauge of the
potential for social unrest.
4. The plan, under development for several years, was most recently due to be released
by the end of 2012. Caijing magazine reported in December that the government
couldnt reach a consensus on a draft by the National Development and Reform
Commission. Deepening reform of income distribution is a very huge and
complicated project, and it cant be done in one step, the government said. Policy
makers aim to raise pay for the poor and rural residents and tackle hidden and illegal
income, according to the statement.
5. The blueprint also calls for capping salaries of senior managers at state-owned
enterprises and says their pay growth should be lower than that of the average wage
of workers. The plan reiterated previously announced goals including doubling percapita income from 2010 to 2020 and expanding a property-tax trial. HSBC Holdings
Plc estimates the income target would signal real growth of about 7 percent a year.
6. The property tax is indeed a very important way to redistribute from the wealthier to
low income families, said Shen Jianguang, chief Asia economist at Mizuho
Securities Asia Ltd. in Hong Kong. At the same time, the resistance to this new
property tax is furious, so how it will be designed and implemented is a big question
mark, Shen said.
Source: http://www.bloomberg.com/news/2013-02-05/china-approves-income-plan-as-wealth-divide-poses-risks.html (accessed 14
February 2013), By Bloomberg News - Feb 5, 2013

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DATA RESPONSE 1 (N08/3/ECONO/HP3)


Study the extract and data below and answer the questions that follow.
Nigeria
1. Nigerias economy depends heavily on the oil sector, which contributes 95 % of
export revenues, 76 % of government revenues, and about a third of gross domestic
product (GDP). Oil prices rose considerably in 2005. With its large reserves of human
and natural resources, Nigeria has the potential to build a prosperous economy, reduce
poverty significantly, and provide the health, education, and infrastructure services
its population needs.
2. GDP per capita is about US$400. Despite the countrys relative oil wealth, poverty is
widespread about 37 % of the population lives in extreme poverty.
3. Government efforts in the fight against corruption are improving the countrys
international image. The government is also trying to ensure that public money can
only be used for approved investment projects.

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(Question continued)
(a)

Define the following terms indicated in bold in the text:


(i) infrastructure (paragraph 1)
[2 marks]
(ii) investment (paragraph 3).
[2 marks]

(b)
Using information from paragraph 1 and table 1, explain why
there is evidence that the demand for oil was price inelastic in 2005.
[4 marks]
(c)
Using an AD/AS diagram, explain the effect that the changing
current account
balance is likely to have on inflation.
[4 marks]
(d)
Using information from the text/data and your knowledge of
economics, evaluate
possible measures that the Nigerian
government might employ to promote
economic development.
[8 marks]

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DATA RESPONSE 2 (M10/3/ECONO/HP3)


Study the extract below and answer the questions that follow.
Vietnams changing economy
1. Vietnam has achieved an impressive turnaround in its agricultural sector. Whereas in
the mid-1980s the country was on the verge of famine, today it is the second-largest
rice exporter in the world. In addition, it produces and exports a variety of farm,
fishery and forest goods, though these activities are not always consistent with
sustainable development.
2. Important factors behind the success of Vietnams agriculture were privatization of
farms and equitable distribution of land ownership, stabilization of the economy in
the mid-1980s, liberalization (freeing) of farm prices and its policies based on free
trade.
3. Vietnams economic transition is often measured in terms of the declining share of the
agricultural sector in Gross Domestic Product (GDP) and the corresponding increase
in the shares of the industrial sector and the service sector. Where the primary sector
(agriculture, forestry and fisheries) used to provide over two-thirds of all jobs 10
years ago, now it provides only about half of all jobs.
4. Until recently, the government and international agencies were advising Vietnamese
farmers to diversify their production, partly by moving towards non-farm industries,
and partly by diversifying crops within agriculture. An example of the diversification
suggested is the development of craft industries producing simple homespun goods
and tourism that would bring rich tourists who would buy these goods. However, in
recent months there have been rapid increases in rice commodity prices due to
increases in world demand for rice. This would provide large benefits for rice farmers.
The government is now concerned that diversification has gone too far, as some rice
farmers have already switched out of rice production.
5. In the long term, Vietnam may face a far more serious danger. Scientists predict a rise
in the sea levels along its coast that by the year 2100 could submerge one-eighth of its
land area, as well as give rise to extreme weather conditions. As most of Vietnams
agricultural land and population are near the sea, such developments would be highly
destructive to the country and its economy.
[Source: The Economist Newspaper Limited, London (24 April 2008)]

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(Question continued)
(a)

Define the following terms indicated in bold in the text:


[each definition is worth 2 marks]
(i)
(ii)
(iii)
(iv)
(v)

privatisation (paragraph 1)
liberalization of prices (paragraph 1)
free trade (paragraph 1)
diversification (paragraph 4)
commodity (paragraph 4)

(b) Using the concept of income elasticity of demand, explain the


change in relative
importance of the agricultural sector in
comparison to the industrial and the
service sectors in Vietnam
(paragraph 3).
[4 marks]
(c)
Using an appropriate diagram, explain the likely long-term
impact of a rise in sea levels on the productive capacity of the
Vietnamese economy (paragraph 5).
[4 marks]
(d)
Using information from the text/data and your knowledge of
economics, evaluate
diversification as a policy option for improving
export performance in Vietnam.
[8 marks]

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Producer Inflation
Posted: 20 Mar 2013 02:56 AM PDT
Another guide to inflationary pressures is the producer price index (PPI).
Producer inflation measures the price of goods produced by manufacturing firms. This is sometimes referred to as factor gate prices

In the year to February 2013 the output price index for home sales of manufactured products rose 2.3%. In the same period the total input
price index rose by 2.5%.

Narrow measure of producer prices


The narrow measure of producer prices excludes industries which tend to be more volatile. This volatile industries included food, beverages,
tobacco and petroleum industries. Excluding these industries, the producer price inflation has been lower during this period.

Input prices
Input prices are the cost of raw materials used in the manufacturing process. This will involve the cost of metals, plastic, oil and other raw
commodities.

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Again, there is a narrow measure of input prices, which excludes the more volatile industries of food, oil, tobacco, beverages and petroleum.
This graph shows the quite significant input price inflation during 2011.

Leading indicators
Producer and input prices are known as leading indicators. This is because they will tend to influence future inflationary pressures. If input
prices rise, firms will put up their producer prices, and in turn, this is likely to translate into higher consumer retail prices.

Cost-push inflation in UK
In 2010 and 2011, we can see a rise in input prices and producer prices. This caused a rise in CPI, suggesting that the rise in inflation was
due to cost-push factors.

Forecasting future inflation


Producer and input prices are a key factor in determining future inflation. For example, at the start of 2013, CPI is higher than producer and
input prices. This suggests that in 2013, there will be downward pressure on the inflation rate from the lower producer inflation rate.
However, if producer prices rise throughout 2013, this will contribute to higher CPI inflation.

Factors causing producer price inflation?

Depreciation in exchange rate. If there is a depreciation in the exchange rate, then the price of imported raw materials will
increase. If the Pound appreciates, the cost of inputs will decrease and producer price inflation will fall.

Commodity prices. Rising commodity prices (e.g. speculation on price of oil) will push up the broader measurer of producer
prices.

Strong demand. If there is a high rate of economic growth, this will cause rising demand for raw materials and will tend to push
up prices. In a recession, we would expect lower demand and more limited producer inflation.

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Supply of raw materials. Shortages of key raw materials will push up input prices. Similarly, a glut in supply of metals, food or oil,
would push prices down.

Labour costs. Labour costs and labour productivity will affect producer prices. Rising unit labour costs will increase the cost of
production and cause firms to seek to increase prices.

Why do producer prices tend to be more volatile than headline


inflation?
These graphs suggest input prices are more volatile than producer prices, and producer prices are more volatile than consumer prices. Why?

Input prices can be very volatile because of factors affecting supply (e.g. a crop failure, leads to sharp rise in price)

Demand for input prices tends to be more price inelastic. An increase in supply of oil, leads to a significant fall in price. Demand
for retail goods tend to be more price elastic. It is harder to pass on price increases to consumers for retail products.

Producers will absorb some of the input prices to keep prices more stable. Firms dont want to keep changing costs for
psychological reasons and the menu costs involved. It is the same with retailers, there are benefits to keeping prices stable and
not changing prices every time raw material prices change.

Raw materials are only a % of final price. If coffee beans increase in price 50%, it will have a significant effect on the price of
coffee produced by a firm like Nescafe. However, coffee beans may only account for about 2% of the total price of a coffee on the
High street (see: Price of a Starbucks). Even if the price of coffee beans doubles, the price of a Starbucks may only increase 5p.

Relationship between producer prices and exchange rate

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From Sep 2011 to May 2012, there is an appreciation in the Pound Sterling. During this period there is a fall in the producer price inflation.
(Bear in mind several factors will affect producer inflation apart from exchange rate. Also, there may be time lags, with delays between an
appreciation and receiving lower import prices.

Related

Producer Price Index at ONS

The post Producer Inflation appeared first on Economics Blog.

Pros and Cons of Capitalism


Posted: 19 Mar 2013 11:54 PM PDT
Capitalism is an economic system characterised by:

Lack of government intervention

Means of production owned by private firms.

Goods and services distributed according to price mechanism (as opposed to government price controls)

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Pros of Capitalism

Economic freedom helps political freedom. If governments own the means of production and set prices, it invariably leads to a
powerful state and creates a large bureaucracy which may extend into other areas of life.

Efficiency. Firms in a capitalist based society face incentives to be efficient and produce goods which are in demand. These
incentives create the pressures to cut costs and avoid waste. State owned firms often tend to be more inefficient (e.g. less willing
to get rid of surplus workers and less incentives to try new innovative working practices.)

Economic growth. With firms and individuals facing incentives to be innovative and work hard this creates a climate of
innovation and economic expansion. This helps to increase real GDP and lead to improved living standards. This increased
wealth, enables a higher standard of living; in theory, everyone can benefit from this increased wealth, and there is a trickle
down effect from rich to poor.

There are no better alternatives. As Winston Churchill, It has been said that democracy is the worst form of government except
all the others that have been tried. A similar statement could apply to capitalism.

Cons of Capitalism

Monopoly Power. Private ownership of capital enables firms to gain monopoly power in product and labour markets. Firms with
monopoly power can exploit their position to charge higher prices. See: Monopoly

Monopsony Power. Firms with monopsony power can pay lower wages to workers. In capitalist societies, there is often great
inequality between the owners of capital and those who work for firms. See: Monopsony exploitation

Social Benefit Ignored. A free market will ignore extenalities. A profit maximising capitalist firm is likely to ignore negative
externalities, such as pollution from production. This can harm living standards. Similarly, a free market economy will underprovide goods with positive externalities, such as health, public transport and education. This leads to an inefficient allocation of
resources. Even supporters of capitalism will admit that government provision of certain public goods and public services is
essential to maximise the potential of a capitalist society.

Inherited Wealth and Wealth inequality. A capitalist society is based on legal right to private property and the ability to pass on
to future generations. Capitalists argue that a capitalist society is fair because you gain the rewards of your hard work. But, often

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people are rich, simply because they inherit wealth or are born into a privileged class. Therefore, capitalist society not only fails to
create equality of outcome, but also fails to provide equality of opportunity.

Inequality creates social division. Societies which are highly unequal create resentment and social division.

Diminishing marginal utility of wealth. A capitalist society argues it is good if people can earn more leading to income and wealth
inequality. However, this ignores the diminishing marginal utility of wealth. A millionaire who gets an extra million sees little
increase in economic welfare, but that 1 million spent on health care would provide a much bigger increase in social welfare.

Boom and Bust cycles. Capitalist economies have a tendency to booms and busts with painful recessions and mass
unemployment. See: Boom and bust economic cycles

A Note on Different Types of Capitalism


All types of capitalism implies that the economy is market based However, within the broad term of capitalism, there are different varieties
which can have profoundly different outcomes. For example, unregulated capitalism sometimes termed turbo capitalism will see greater
problems associated with inequality, under-provision of public services and greater inequality. A primarily capitalist society with some
regulation on inequality, environment and monopoly power can create a very different outcome to a pure capitalist society.
See: different types of capitalism
When people talk about capitalist societies, e.g. US, there is actually significant government intervention in areas such as education, health
care and transport. US government accounts for around 35% of GDP.
Even a country like France, where the government spend 50% of GDP has an economy which may be considered to be primarily free
market. There is no clear cut point when an economy stops being capitalist and becomes a mixed economy.

Supply Side Economics Pros and Cons


By Tejvan Pettinger on September 12, 2011 in economics

Readers Question: What are the benefits of supply-side economics, particularly for the working class, the middleclass if you will?

Supply side policies encompasses a range of different policies that seek to reduce tax rates and government
intervention in the economy. In the US, supply side economics became synonymous with the Laffer Curve theory
and the Reagan tax cuts of the 1980s. It is also referred to as trickle down economics.

Examples of free market supply side policies include:

Privatisation selling state owned assets to private sector

Deregulation opening state owned monopolies to competition.

Reducing power of trades unions

Reducing minimum wages

Reducing income / corporation taxes

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Greater labour market flexibility e.g. easier to hire and fire workers.

see also: supply side policies

As an economist it is daunting to try and give an overall assessment of supply side policies because it really
depends on the policy and how it is implemented.

For example, privatisation and deregulation can have benefits for lower income workers. Some inefficient state
owned industries have benefitted from private ownership and increased competition. This has been a factor in
lower telecom prices and lower electricity prices. But, at the same time, privatisation can create private monopolies
which exploit the consumer even more than inefficient state owned monopolies. Rail privatisation in the UK has led
to increased fragmentation and higher prices for consumers (though also some benefits on some services).

Greater labour market flexibility can be a mixed blessing for workers. On the one hand, it can lead to a more
productive economy which creates more jobs. On the other hand, it can lead to greater wage inequality and higher
job insecurity.

In the late 1970s, British unions were very powerful, many days were lost due to strikes, Britains competitiveness
suffered as a result. To some extent, reforms to unions did help create a more flexible economy in the UK.

However, the Conservative government grossly overestimated the impact of their supply side miracle. In the
Lawson boom, they allowed the economy to grow by 5% a year, thinking there had been a supply side miracle.
But, actually there was no miracle. The UKs long run trend rate was stuck at 2.5% and the lawson boom led a bust
and recession of 1991.

On the other hand, the US labour market has gone to the other extreme. Workers have very little protection,
minimum wages are low and there has been a widening of inequality, with little evidence of a trickle down effect to
workers.

Europe has much greater labour market protection. This helps minimise economic pain in a recession, but is also a
factor in Europes higher level of structural unemployment.

Supply Side Economics and Tax cuts


The strongest supporters of Supply side economics argue that cutting income tax rates can boost labour supply,
increase economic growth and even increase government revenue. (though tax rates fall, because more people
work, overall tax revenue increases). Needless to say it become a popular policy.

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Some argue the Reagan tax cuts for high earners showed that lower income tax rates could increase labour supply
and help increase tax revenue (supporters of supply side economics)

Others dispute the extent to which tax cut actually increases labour supply. A study by Randall Mariger, an
economist at the Federal Reserve Board, found that tax rates cuts increased the labor supply by less the 1%
between 1985 and 1986. In other words labour supply is quite inelastic. However, you could find studies which
suggest labour supply is more elastic in the long term.

Empirical evidence suggests, the 1993 Clinton increase in the top marginal tax bracket to 39.6% had no effect on
the labor supply of the rich. The tax increase wasnt a barrier to a strong period of economic growth. Combined
with fiscal restraint, it also led to one of the few US budget surplus in recent decades.

However, it depends on the marginal tax rate. For countries like Sweden with an 80% marginal tax rate or the
marginal tax rates which were a legacy of WWII in US and UK, there is a much stronger case that these kind of
marginal tax rates do create disincentives to work.

I would say the Bush tax cuts for the high income earners was a poor choice of policy. It cut tax for those who
needed it the least. It contributed to the long term deficit and gave little if any benefit in terms of increasing
productivity. There was very little trickle down effect from this tax. It would have been better to have kept the taxes
as they were meaning the US would have more scope for fiscal expansion when they faced the recession of
2009-2011.

Definitely, you can find economists who will say supply side economics are marvellous and are essential for
creating jobs.

http://www.economicshelp.org/blog/3176/economics/supply-side-economics-pros-andcons/
In all the hand-wringing about capitalism and globalisation, one statistic tends to be
forgotten. Thanks largely to economic growth, nearly 1 billion people have been lifted
out of extreme poverty in 20 years. Between 1990 and 2010 the poverty rate fell from
43% of the population of the developing world to 21%. Our cover leader in most editions
argues that the world has a real chance of lifting another 1 billion out of destitution by
2030. In Britain, however, we celebrate another unnoticed success: classical liberalism, of
the sort that The Economist has trumpeted for 170 years, is popular again with the young.

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N09/3/ECONO/HP3/ENG/TZ0/XX
8809-5103

10
5. Study the extract below and answer the questions that follow.
Growers hurt by the low price of tea
The world produces so much tea that British people are paying far
less for their favourite drink
than they did 30 years ago.
Global overproduction, supermarket price wars and a weak dollar
mean that the price is less
than a penny a cup. The real price of a cup of tea is actually a quarter
of what it was in 1977,
industry research has revealed.
The figures are good news for the worlds second-biggest per capita
tea-drinking nation,
but bad news for the 36 tea-growing countries, which last year
produced 3.5 million tonnes
of tea, of which 160 000 tonnes were shipped to Britain.
Tea is grown in some of the poorest countries in the world and is
often a primary source
of income; for Uganda, for example, it is the third-largest export
earner. For many growers
and pickers it is their only source of income.
A tea consultant said: continuing low prices and deteriorating terms
of trade mean that planned
investment in infrastructure has to be postponed or cancelled and
this is likely to result in a
less than expected rate of economic growth. This impacts on the
individual small farmers and
puts more pressure on their day-to-day existence.
British tea importers argue that many countries, led by Bangladesh
and Vietnam, are planting
and growing far more tea bushes than the world needs, under pressure
from poor local farmers
desperate to make a living.
The chairman of the UK Tea Council, said: there is too much being
grown in some countries,
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and producers need to balance supply with demand.


Some in the industry believe that Britain is not paying enough for
the 165 million cups it drinks
every day, and that a slightly higher price would benefit farmers
without hurting consumers.
Cafdirect, Britains largest ethical tea and coffee wholesaler
(distributor) which deals only in
fair trade products, said: we are the only major brand to guarantee a
minimum price for tea,
and this year announced an increase of 8 %.
[Source: adapted from The Times, 25 July 2007]

(This question continues on the following page)


(Question 5 continued)
(a) Define the following terms indicated in bold in the text:
(i) infrastructure (paragraph )
(ii) minimum price (paragraph ).
[2 marks]
[2 marks]
(b) Using an appropriate diagram, explain the main reason for the
change in the real
price of tea since 1977 (paragraph ). [4 marks]
(c) Explain why falling tea prices may result in deteriorating terms of
trade for
countries where income from tea is the primary source of income. [4
marks]
(d) Using information from the text/data and your knowledge of
economics,
evaluate two possible measures which might be used to improve the
standard of
living of tea farmers. [8 marks]

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