Tragakes Economics IB Diploma Coursebook PDF

Ec mic
f e IB D a
COURSEBOOK
E e T aga e
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A
D :E
K &R F
1I E
1.1 U de a d g e a e f ec c
1.2 T e ee ba c ec c e : e ce a ca a d / c ed b
1.3 U de a d g e db e f de
1.4 T e e d f ec c
1.5 A b ef f ec c g : e g f ec c dea
2M
2 C :D
2.1 I d c c e e a e
2.2 De a d
2.3 S
2.4 C e e a e e b : de a d a d
2.5 T e e f e ce ec a a d a e eff c e c
2.6 C e f e a g be a fc e a d d ce (HL )
3 E
3.1 P ce e a c f de a d ( ED)
3.2 I c eea c f de a d ( ED)
3.3 P ce e a c f ( E )
4 G
4.1 G e e e e a e
4.2 P ce c
4.3 I d ec a e
4.4 S b de
5 M I: C
5.1 T e ea g f c e ce
5.2 Ma e fa e a d e e a e : d e g g aea d c a be ef a dc
5.3 Nega e d c e e a e
5.4 Nega e c e e a e
6 M II: P , ,
6.1 P e d c e e a e
6.2 P ec e e a e
6.3 Ma e fa e a d b c g d
6.4 A e c f a (HL )
6.5 E ed b f c e a d ea (HL )
7 M III: M (HL )
7.1 I d c f , d e a d a e c e
7.2 P f a a b e a a d ce
7.3 Pe fec c e
7.4 M
7.5 M cc e
7.6 O g
7.7 G e e e e e e ab e f a e e
3M
8
8.1 Ec c ac
8.2 Mea e f ec c ac
8.3 Ca c a ba ed a a c e acc g
8.4 T eb e c ce
8.5 Na a c e a c a d a e a e ea e
9 A
9.1 Agg ega e de a d (AD) a d e agg ega e de a d c e
9.2 S - agg ega e a d - e b e AD-A de
9.3 L g- agg ega e a d g- e b e ea / e ca ca
de
9.4 Agg ega e a de b e Ke e a de
9.5 S f g agg ega e c e e e g e
9.6 I ca f e Ke e a de a d e e a / e c a ca de
10 M I: L ,
10.1 L e e
10.2 L a d ab e a e f fa
10.3 E g e ea be ee e e a d fa
11 M II: E ,
11.1 Ec cg
11.2 S a ab e e e f g e e deb (HL )
11.3 P e a c f c be ee ac ec c b ec e
12 E
12.1 I e a
12.2 P e
12.3 Ca e f ec c e a a d e
12.4 T e ac f c e a d ea e a
12.5 P ce ed ce c e a d ea e a e a d e
13 D - -
13.1 I d c ac ec c ce
13.2 De a d a age e a d ea c
13.3 De a d a age e a d f ca c
13.4 T e Ke e a e (HL )
13.5 F e c e e a d Ke e a ec c e (S e e a ae a
ec e ded f HL O )
13.6 S - de ce
13.7 E a a f de a d- de a d - de ce e e e ,
a d ab e a e f f a a d ec cg
4 G E
14 I :P I
14.1 T e be ef f e a a ade
14.2 F ee ade: ab ea dc a a e ad a age (HL )
14.3 T e f ade ec : e c f ee ade
15 I :P II
15.1 A g e f a d aga ade ec
15.2 Ec c eg a : ad g b c
15.3 Ec c eg a : ea
15.4 W d T ade O ga a
16 E
16.1 F a ge c a ge a e
16.2 C e e ce f c a ge e c a ge a e : a e a a
16.3 G e e e e
16.4 T e ba a ce f a e
17 F (HL )
17.1 H e c e acc a d e f a c a acc a e e a ed e c a ge a e
17.2 C a ga dc a g e c a ge a e e
17.3 E a a g ea
17.4 U de a d g c e acc def c a d e
18
18.1 S a ab e de e e
18.2 Mea g de e e
19 B
19.1 P e c ce ( a )
19.2 Ec c ba e
19.3 P ca a d c a ba e
20
20.1 I e a a ade a eg e
20.2 D e f ca a d ca e e e
20.3 Ma e -ba ed ce
20.4 I e e c e : ed b a d f e g d
20.5 F e g d ec e e a d a a c a (MNC )
20.6 F eg ad
20.7 M a e a de e e a a ce
20.8 I a c a ge
20.9 S e g a d a fg e e e e e a e- e ed a ac e
20.10 P ge a d ee g e ec ed S a ab e De e e G a
F
A e i , A e , K ia
Abo he a hor
Ellie T agake ha a BA f m C l mbia Uni e i , MS cSc f m he Uni e i f Bi mingham and
PhD f m he Uni e i f Ma land. She ha ked in he a ea f ec n mic de el men f
ag ic l e in ec n micall le de el ed c n ie , financial e ice and heal h em , in e e al
na i nal and in e na i nal gani a i n , incl ding he W ld Bank and W ld Heal h O gani a i n. She
i a highl e e ienced a h , i h n me fe i nal blica i n . Man f he e a e in he a ea f
heal h em financing and ef m in an i i n ec n mie , and ha e been an la ed in e e al
lang age incl ding R ian and Chine e. She i al a highl e e ienced eache and e amine , ha ing
a gh f man ea in he Ec n mic De a men a he Ame ican C llege f G eece and al ha ing
e ed a IB Ec n mic Chief E amine . She c en l e e a IB Seni E amine and Managing
Di ec f Hellenic Ag ic l al En e i e .
Ackn ledgemen
A h
I would like to express my deepest gratitude to Peter Rock-Lacroix for his detailed, thorough and
exhaustive review of the entire book, including the materials accompanying the digital version. In
addition to offering most insightful and creative suggestions for improvements and catching errors, Peter
was a continuous encouraging and supportive presence throughout the entire writing process.
I am also grateful to Dimitris Doulos, Roma Kaur and Charles Wu for their valuable comments on the
first three chapters of the book that helped set guidelines for the remainder of the writing.
In addition, I would like to extend my sincere thanks to many friends and colleagues around the world
who contributed to the previous two editions of the book. They include Henry Tiller, former IB
Economics Chief Examiner, and Emilia Drogaris, both of whom commented extensively on the second
edition, and Julia Tokatlidou for her extensive review of the first edition. I would also like to express my
gratitude to Tibor Cernak, Simon Foley, Hana Abu Hijleh, Kiran Asad Javed, Jane Kerr, Pat Lasonde,
James Martin, Peter Rock-Lacroix, Sachin Sachdeva, Vijay Peter D Sou a, Charles Wu, Lar Lun,
Constantine Ziogas for their comments and suggestions for improvements.
My warmest thanks also go to K.A. Tsokos for the guidance and inspiration that his book, Ph sics for the
IB Diploma, provided for me.
A h and bli he
The author and publishers acknowledge the following sources of cop right material and are grateful for
the permissions granted. While ever effort has been made, it has not alwa s been possible to identif
the sources of all the material used, or to trace all cop right holders. If an omissions are brought to our
notice, we will be happ to include the appropriate acknowledgements on reprinting.
UN Sustainable Development Goals from https://www.un.org/sustainabledevelopment/sustainable-
development-goals/ 2019 United Nations, reprinted with permission of the United Nations
Thanks to the following for permission to reproduce images:
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H e b
Th o gho hi book o ill find lo of diffe en fea e o help o lea ning.
CONCEPTUAL UNDERSTANDINGS
The e a emen in od ce he ke concep of he ni .
LEARNING OBJECTIVES
A b lle ed li a he beginning of each ec ion clea l ho he lea ning objec i e of he ec ion.

The e objec i e link o he a e men objec i e and o come in he IB economic g ide.
TEST YOUR UNDERSTANDING

Te o nde anding q e ion appea a he end of e e opic, and help o e ie he lea ning
objec i e of he ec ion. The can be ed a he ba i fo cla di c ion o home o k
a ignmen . If o can an e he e q e ion , i mean o ha e nde ood he impo an poin of
a ec ion.
REAL WORLD FOCUS

Real o d foc fea e help o ela e he heo o a e lea ning o p ac ice in eal life. The e a e
follo ed b q e ion in ended o foc o a en ion on impo an heo e ical idea and hei
ele ance o eal o ld i a ion .
Ke poin , ch a impo an la , concep , defini ion and concl ion , a e highligh ed in an

o ange bo . Thi help o foc on he impo an ma e ial in a chap e and can facili a e e ie ing.
EXAM STYLE QUESTIONS

Yo can find q e ion in he le of IB e am in he 'Digi al co ebook: E a ma e ial' ec ion.
BEFORE YOU START

Thi ho ec ion of a emen and q e ion ill help o o eflec on p io lea ning, check ha
kno ledge o ill need fo he chap e and p o oke o o n ho gh abo he opic.
D be ee c e a d g e e e ae a
The book i di ided in o co e and highe le el ma e ial. A e ical line n do n he ma gin of all
highe le el ma e ial, allo ing o o ea il di ing i h highe le el f om co e ma e ial.
THEORY OF KNOWLEDGE
Theo of kno ledge fea e enco age o o hink c i icall abo economic a a ocial cience,
he na e of economic kno ledge, diffic l ie in ol ed in acq i ing economic kno ledge, h
economi di ag ee, he ole of al e , lang age, e hic , belief and ideolog in he de elopmen of
economic kno ledge. Each fea e end i h q e ion in ended o im la e f he hinking and
di c ion on he e impo an heo of kno ledge i e .
INQUIRY AND REFLECTION

The e q e ion appea a he end of each chap e and enco age o o eflec on he de elopmen of
o kill p oficienc and o p og e again he objec i e . The a e in ended o enco age o
c i ical hinking and inq i -ba ed lea ning.
Ke e m a e highligh ed in a ge b d fon a hei fi appea ance in he book o o can

immedia el ecogni e hem. A he end of he book, he e i a glo a ha define all he ke e m .
Digi al c eb k: E a
a e ial
Thi digi a c eb c ai a be f fi e ha a e i e ded a i a d g ide a e
hi c eb . The digi a c eb fi e a e a f :
I d ci IB Ec ic a e e :E a a e a d
i e al a e e
He e i fi d a e a a i f a he IB e a a e i eed e a e f , i c di g
i f ai ea i g b ec i e i h c e di g a e e b ec i e ha a ea a he
begi i g f each ec i a d b ec i f he b , c a d e ha a ea a he begi i g f
e a e i , he d a i f each e a a e a d he e ce age f each i he a IB c e, ef
gge i he ihe a ,a da e a ai fi e a a e e .
Checkli fi a ic hel ga i e he
c eb k a e ial
Checkli : Real ld i e a d ke c ce
Each f he h ee ai i f he b (Mic ec ic , Mac ec ic a d The G ba Ec )
i di ided i ec i headed b a real- orld issue. The e a e i ea - d i e , each f c i g
a b ad, ge e a e i i d ci g he ai ic f he b e e cha e . I addi i he e a e
i e ke concepts i g h gh ec ic c e. I hi chec i i fi d gge i
h i he e c ce he ea - di e .
Checkli : Mea e f ec ic ac i i , ell-bei g, ec ic i e ali a d

e
The e a e e e a a e a i g ea e f he e i a ec ic a iab e . The a e a i ed
he e i h a a defi i i f each, he di i g i h be ee he a d a id c f i .
Checkli : Calc la i a SL a d HL
The IB Ec ic ab ide de ai ed i f ai a ca c a i ha h d be ab e
ef , a b h SL a d HL. Thi chec i i a he e ca c a i ha ca ea i g h gh
he a e e ha de a d ha he a e a d chec he ff a g h gh ac ice
e e ci e . Y i fi d e ac ice e e ci e i he Te Y U de a di g e i i he
b .
Checkli : P licie f Pa e 3 (HL l )

O e f he e i i Pa e 3 a de ec e da ic i de add e a a ic a
i e. Thi chec i i c de a icie ha a e i c ded i he IB Ec ic ab , a g i h he
cha e he e he ic i di c ed. B g i g h gh hi i ca ea i chec ff ha ae
fa i ia i h a he icie ha a be e i ed ec e d i Pa e 3. Y i fi d e
e i eai g icie i he Te Y U de a di g e i a e a i I i a d
Ref ec i ac i i ie . I addi i eache a gi e ic e i f he eache e ce.
I a diag a ih i h e he
The IB Ec ic ab ide a de ai ed i f a diag a ha eed de a d a d d a .
He e i fi d a he e diag a e d ced a d ga i ed b cha e a d ic i hi each cha e ,
iha e if he diag a i HL . I addi i f each diag a he e i a i ha h d be
ab e i aeb e f he diag a i e i .Y eache ca gi e ac ice e i ih
diag a f he eache e ce.
Q a i a i e ech i e
Thi ec i c ai a he a i a i e ech i e eed de a d i de e ce i IB
Ec ic c e. I e ab e e ie e e hi g f e ce age a d e ce age cha ge
de a di g he e e ia f e a i hi be ee a iab e , a d i e e i g a d c ci g
diag a a d g a h .
Pa e 1 (HL a d SL)
He e i fi d a e e i f hi a e a SL a d HL, c e di g each cha e i he
b , c e i g a he cha e . Y eache ca ide ih a che e ha a e i c ded i he
eache e ce.
Pa e 2 (HL a d SL)
He e i fi d c e e Pa e 2 e i . G i g h gh he e ca ef i ide ih
a g d idea f he c e f hi a e . Y eache ca ide ih a che e ha a e
i c ded i he eache e ce.
Pa e 3 (HL l )
I hi a i fi d c e e Pa e 3 e i . G i g h gh he e ca ef i a
de a d h hi a e i c ed. Y eache ca ide i h a che e ha a e
i c ded i he eache e ce.
S le e a a e ial
Thi i a e e i f he a e ia i he b . I i c de a be f ic ha a e e i ed
a e ia , b ha a be f i e e de h d i e gai a dee e de a di g f e
i e i ec ic .
Table of contents for
digital material
Introduction to IB Economics assessment: Exam papers and internal assessment
Checklist: Real world issues and key concepts
Checklist: Measures of economic activity, well-being, economic inequality
and poverty
Checklist: Calculations at SL and HL
Checklist: Policies for paper 3 (HL only)
Important diagrams with tips on how to use them
Quantitative techniques
Paper 1 (SL and HL)
Paper 2 (SL and HL)
Paper 3 (HL only)
Supplementary material
1 Economics for the IB Diploma - Tragakes © Cambridge University Press 2020

T K d a
1.1 Ref a i , cie ce a d h
1.2 Wh d ec i f e di ag ee?
2.1 The ea i g a d i ica i f a i cia e fa e
2.2 A i , e ce i f fai e a d e f-i e e ed beha i f a i a ec ic
deci i - ake
2.3 H i a a e he c i ici f fi a i i a i a he fi ai g a ?
4.1 A ca i e efficie c : i i ea a e-f ee?
5.1 Ec ic hi ki g ai abi i a d E i O , i e f he 2009 N be P i e
i Ec ic
5.2 The e hica di e i f ai abi i a d e e i g he g ba c i a e
6.1 I e ai i eai a ke fai e: he ibi i f a i cia i he
e e ce f e e e i e a i ie
7.1 Pe fec c e i i a d he ea d
8.1 The b i e c c e, ac a a d e ia : i g a iab e ha ca be
b e ed
8.2 The GDP c ce
9.1 C f ic i g ec ic e ec i e a d he e f ec i i ica be ief a d
ide g
10.1 Wha i a a ab he a a a e f e e ?
10.2 Ch i g be ee e e a d i f a i : he e f i ic a d ide g
i ec ic ic
11.1 The c f ic be ee ec ic g ha d ai abi i
12.1 Ab ea d eai e e
12.2 P i ci e f e i f a a i
13.1 Pa adig hif i ac ec ic
15.1 I he e a a a ec i he ec ic a g e i fa f f ee ade?
18.1 The a e f ec ic de e e
19.1 The a e f ed ca i
20.1 M a i e f ade ibe a i a i i de e i g c ie
Unit 1
Introduction to
Economics
1 Economic i a ocial cience in hich here i in e dependence be een people ho

in erac i h each o her o impro e heir economic ell-being, and ho are
infl enced and empo ered b heir al e and na ral rro nding .
2 The economic orld i d namic and bjec o con in o change.
3 Economic heorie are fo nded on he principle of logic complemen ed b empirical
da a, ed o b ild model ha r o e plain o r comple economic orld.
Indi id al and gro p of indi id al di pla mo i a ion and beha io r ha are
comple and aried. Their nder anding i facili a ed b he con rib ion of e eral
di cipline ha in erac i h economic , ch a p cholog , philo oph , poli ic and
hi or .
4 Economic deci ion-making i cen ral o de ermining he rela i e economic ell-being
of indi id al and ocie ie .
5 The ke problem of economic deri e from ca ci , hich nece i a e choice. Thi
in rn lead all economie o confron rade-off , oppor ni co and he challenge
of ainabili .
6 Economic hinking face a n mber of deba e . Among he mo impor an of he e i
he deba e be een economic gro h and e i , and he deba e be een free marke
(and heir efficienc ) and go ernmen in e en ion.
7 Unlimi ed economic gro h ba ed on he e of fini e re o rce canno con in e
indefini el . E abli hed heorie and approache o he i e of economic gro h are
being challenged b ne model and ocial mo emen i h a ie o rede igning he
econom o ppor long- erm pro peri .
Man rgen i e in o r orld oda , ch a po er , poll ion, he en ironmen , economic

gro h, andard of li ing, nemplo men , infla ion, echnolog , in erna ional rade and
man more, in ol e economic .
The objec i e of economi i o e plain, anal e and nder and i e ch a he e in he
hope of finding a o deal i h hem o a o bring abo impro emen in he ell-being
of people e er here.
Marrake h, Morocco. Woolen handmade ha for ale in he marke q are of he old ci
_______________________________________________________________________
C a 1
T da c c
BEFORE YOU START
As ou begin this course, ou ma alread have an idea of economics .
What do ou think the subject is about?
Sciences like ph sics, biolog and chemistr are e amples of natural sciences .
Anthropolog , ps cholog and economics are e amples of social sciences .
In hat a s do ou think natural and social sciences are similar and in hat a s are the
different?
What do ou think the purpose of government should be in societ ?
Chapter 1 of this book is an introduction to the social science of economics. We ill discover the
meaning of economics, and ill discuss ke concepts forming the basis of the economic perspective of
the orld. We ill see ho economists use models and theories to anal se economic problems, and ill
also learn about the organising principles of market, planned and mi ed economies. The chapter ill end
ith an account of famous economists ho made important contributions to economic thought.
1.1 U
LEARNING OBJECTIVES
After stud ing this section ou ill be able to:

define all the terms appearing in in the te t (AO1)
e plain the social nature of economics (AO2)
distinguish bet een microeconomics and macroeconomics (AO2)
e plain the nine central concepts that run through our course in economics (AO2)
e plain the meaning of scarcit (AO2)
as unlimited human needs and ants met b limited resources
in relation to sustainabilit
identif and e plain the four factors of production (AO2)
e plain the meaning of opportunit cost and its relationship to choice and free goods (AO2)
T
The are academic disciplines that stud human societ and social relationships. The are
concerned ith discovering general principles describing ho societies function and are organised. The
social sciences include anthropolog , economics, political science, ps cholog , sociolog and others.
Economics is a social science because it deals ith human societ and behaviour, and particularl those
aspects concerned ith ho people organise their activities and ho the behave to satisf their needs
and ants. It is a social science because its approach to stud ing human societ is based on the scientific
method, hich e ill consider belo .
M
The stud of economics breaks do n the economic orld into t o levels. One of these is like looking at
the economic orld through a microscope, hile the other is like looking at it through a telescope.
The micro level, called , e amines the behaviour of individual decision-making
units in the econom . The t o main groups of decision-makers e stud are consumers (or
households) and firms (or businesses). Microeconomics is concerned ith ho these decision-
makers behave, ho the make choices, hat are the consequences of their decisions and ho their
interactions in markets determine prices. (Micro comes from the Greek ord μικ or micr ,
meaning small)
The macro level, called , e amines the econom as a hole to obtain a broad or
overall picture of the econom . Macroeconomics uses aggregates, hich are holes or collections
of man individual units, such as the sum of consumer behaviours and the sum of firm behaviours,
and total income and output of the entire econom , as ell as total emplo ment and the overall
price level. (Macro comes from the Greek ord μάκ ο or makros, meaning large.)
The ideas and principles that are developed in microeconomics and macroeconomics are the building
blocks that economists use to stud man specific areas of economics. Some of these areas are studied at
the micro level, such as market failure (Chapters 5 7) and others at the macro level, such as
unemplo ment and inflation (Chapter 10). In addition, the ideas and principles developed in
microeconomics and macroeconomics are applied to the stud of man other areas, such as International
economics and Development economics, hich ou ill discover in Unit 4 of this book.
K
The concepts listed belo ill be discussed in a number of different conte ts in our stud of
economics. While economists agree on the definitions of each of these, there are debates over ho some
of these concepts should be interpreted or applied, especiall in connection ith formulating appropriate
economic policies to address important economic objectives. You ill encounter man of these as ou
read this book.
S
One of the most important concepts in economics, , refers to the idea that resources are
insufficient to satisf unlimited human needs and ants. In fact, it is said that if there ere no scarcit ,
there ould be no social science of economics. This is because economics is the stud of ho our scarce
or limited resources can best be used in order to satisf the unlimited needs and ants of human beings.
C
In a ver important sense, economics is the stud of . Since resources are scarce, it is not possible
for all human needs and ants to be satisfied. This means that choices must be made about hat ill be
produced and hat ill be foregone (not produced and therefore sacrificed). Economics studies ho
different decision-makers make choices bet een competing alternative options, and anal ses the present
and future consequences of their choices.
E
E refers to making the best possible use of scarce resources to avoid resource aste. In vie of
the scarcit of resources, it is important to use these in a s that ensure the are not asted. In part,
efficienc means using the fe est possible resources to produce goods and services. But, in addition, it
requires that scarce resources are used to produce the goods and services that mostl satisf societ s
needs and ants. This is kno n as , used as a benchmark or standard to determine
the appropriateness of economic actions from the point of vie of minimising resource aste.
E
E is the idea of being fair or just. Equit is not the same as equalit , hich is the sameness of
treatment or outcomes for people or groups of people in a societ . Fairness is a normative concept (to be
discussed later) because ideas of hat is fair var according to beliefs, value judgements and ideologies.
In economics, the ideas of equit and inequit are usuall identified ith equalit and inequalit , and are
used mostl in connection ith equalit in the distribution of income, ealth and human opportunit . In
all economic s stems, these kinds of inequities or inequalities are present both ithin and bet een
societies, and are significant issues, as man people cannot meet their basic needs and lack opportunities.
There is much debate among economists on ho much and hat t pes of government intervention in
markets are appropriate in order to address these issues effectivel .
E -
E - is a concept that has several different dimensions. It refers to levels of prosperit ,
economic satisfaction and standards of living among the members of a societ . Economic ell-being
includes:
securit ith respect to income and ealth, having a job and housing
the abilit to pursue one s goals, ork productivel and develop one s potential
the abilit to have a satisfactor qualit of life, hich includes numerous factors such as health,
education, social connections, environmental qualit , personal securit
the abilit to maintain all of the above over time.1
There are ver significant variations in levels of economic ell-being both ithin nations and bet een
nations.
S
S refers to the long-term maintenance or viabilit of an particular activit or polic . In
economics, it is most commonl used to refer to the abilit of the present generation to satisf its needs
b the use of resources, and especiall non-rene able resources, ithout limiting future generations
abilit to satisf their o n needs. The problem arises because the present generation at an moment in
time engages in man economic activities of production and consumption that too often destro or
degrade (lo er the qualit of) the environment and non-rene able resources. The result of such
activities is that future generations ill be penalised. Therefore the issue is ho to develop methods of
production and patterns of consumption that ill not result in such environmental and resource
destruction and degradation.
C
Panta rhei is a famous sa ing b the Greek philosopher Heraclitus, that means ever thing flo s .
Heraclitus taught that is an essential part of life. This idea is ver important in economics, here
much of hat e stud is in a continuous state of change. In economics, e can distinguish bet een the
idea of change: (i) in economic theor and (ii) in real- orld events. In economic theor , economists ver
often stud change bet een one situation and another situation that has been caused b a change in one
or more variables. It is important to bear this in mind in our stud of economics as ou ill often be
asked to anal se and evaluate this kind of change in a large variet of conte ts. Regarding the stud of
real- orld phenomena, the orld is characterised b continuous change in the institutional,
technological, social, political and cultural environments in hich economic events occur.
I
I refers to the idea that economic decision-makers interact ith and depend on each
other. Such interdependence occurs on all levels, from individuals, to communities, to nations and to
groups of nations. Interdependence arises from the fact that no one is self-sufficient, requiring ever-
increasing degrees of interactions and interdependence. Consumers, orkers, firms, governments and all
other individuals or groups of individuals depend on one another for the achievement of their economic
goals. With increasing globalisation ( hich refers to the interactions and integration of economies orld-
ide), interdependence increases. In a highl interdependent orld, events in one part give rise to man
and possibl unintended consequences in other parts, ith outcomes that cannot al a s be predicted or
discovered b looking at the constituent parts in isolation. Economists must therefore take into
consideration both intended and unintended consequences of economic decisions and events hen there
is a high degree of interdependence.
I
In economics, t picall refers to government intervention, meaning that the government
becomes involved ith the orkings of markets. While markets offer numerous advantages as a a to
achieve important economic objectives, it is generall recognised that markets on their o n often cannot
achieve important societal goals, such as the goals of equity, sustainability, economic well-being or
efficiency. When this occurs, hether at the micro or macro levels, there ma be good reason for the
government to intervene in order to correct for the market s deficiencies. Ho ever, economists and
polic -makers often disagree idel on the need for, degree and method of intervention that is necessar .
A ke debate that ou ill repeatedl encounter in our studies of economics involves the advantages
and disadvantages of free markets versus government intervention.
T :
T
The term economics is derived from the ancient Greek e pression o kov v iv (oikon nemein), hich
originall meant one ho manages and administers all matters relating to a household . Over time, this
e pression evolved to mean one ho is prudent in the use of resources . B e tension, economics has
come to refer to the careful management of societ s scarce resources to avoid aste. Let s e amine this
idea more carefull .
Human beings have ver man needs and ants. Some of these are satisfied b ph sical objects and
others b non-ph sical activities. All the ph sical objects people need and ant are called goods (food,
clothing, houses, books, computers, cars, televisions, refrigerators and so on); the non-ph sical activities
are called services (education, health care, entertainment, travel, banking, insurance and man more).
The stud of economics arises because people s needs and ants are unlimited, or infinite. Whereas
some individuals ma be satisfied ith the goods and services the have or can bu , most ould prefer
to have more: more and better computers, cars, educational services, transport services, housing,
recreation, travel and so on; the list is endless.
Yet it is not possible for societies and the people ithin them to produce or bu all the things the ant.
Wh is this so? It is because there are not enough . Resources are the inputs used to produce
goods and services anted b people, and for this reason are also kno n as . The
include things like human labour, machines and factories, and gifts of nature like agricultural land and
metals inside the earth. Factors of production do not e ist in unlimited abundance: the are scarce, or
limited and insufficient in relation to unlimited uses that people have for them.
S is a ver important concept in economics. It arises henever there is not enough of something
in relation to the need for it. For e ample, e could sa that food is scarce in poor countries, or e could
sa that clean air is scarce in a polluted cit . In economics, scarcit is especiall important in describing
a situation of insufficient factors of production, because this in turn leads to insufficient goods and
services. Defining scarcit , e can therefore sa that:
S is the situation in hich available resources, or factors of production, are finite, hereas
ants are infinite. There are not enough resources to produce ever thing that human beings need and
ant.
W
The conflict bet een unlimited ants and scarce resources has an important consequence. Since people
cannot have ever thing the ant, the must make choices. The classic e ample of a choice forced on
societ b resource scarcit is that of guns or butter , or more realisticall the choice bet een producing
defence goods (guns, eapons, tanks) or food: more defence goods mean less food, hile more food
means fe er defence goods. Societies must choose ho much of each the ant to have. Note that if
there ere no resource scarcit , a choice ould not be necessar , since societ could produce as much of
each as as desired. But resource scarcit forces the societ to make a choice bet een available
alternatives. Economics is therefore a stud of choices.
The conflict bet een unlimited needs and ants, and scarce resources has a second important
consequence. Since resources are scarce, it is important to avoid aste in ho the are used. If resources
are not used effectivel and are asted, the ill end up producing less; or the ma end up producing
goods and services that people do not reall ant or need. Economics must tr to find ho best to use
scarce resources so that aste can be avoided. Defining economics, e can therefore sa that:
E is the stud of choices leading to the best possible use of scarce resources in order to best
satisf unlimited human needs and ants.
As ou can see from this definition of economics, economists stud the orld from a social perspective,
ith the objective of determining hat is in societ s best interests.
TEST OUR UNDERSTANDING 1.1

1 Think of some of our most important needs and ants, and then e plain hether these are
satisfied b goods or b services.
2 Outline h economics is a stud of choices. Describe its relationship to scarcit . Outline ho
scarcit is related to the need to avoid aste in the use of resources.
3 E plain h diamonds are far more e pensive than ater, even though diamonds are a lu ur
hile ater is a necessit ithout hich e cannot live.
S
T
Economic activities in man (if not most) countries are often achieved at the e pense of the natural
environment and natural resources. Economic growth, hich involves increases in the amount of goods
and services produced, ver often results in increased air and ater pollution, and the destruction or
depletion of forests, ildlife and the o one la er, among man other natural resources. Increasing
a areness of this issue has given rise to the concept of sustainable development, defined as
development hich meets the needs of the present ithout compromising the abilit of future
generations to meet their o n needs .2
Sustainable development occurs hen societies gro and develop ithout leaving behind fe er or
lo er-qualit resources for future generations. If e, in the present, use up resources at a rate that leaves
fe er or lo er-qualit resources behind, e are satisf ing our needs and ants no at the e pense of
people in the future, ho ith fe er or lo er-qualit resources ill be less able to satisf their o n
needs and ants. If e change the global climate and use up clean air, seas and rivers, forests and the
o one la er, e put future generations at a disadvantage and even in danger.
Using the definition of sustainable development, e can see that sustainability or sustainable resource
use involves using resources in a s and at rates that do not reduce their quantit or qualit over time.
As a rule, this term is used ith reference to rene able resources, or those kinds of natural resources that
are able to reproduce themselves (such as forests, fish and sea life, air qualit , the fertilit of the soil).
Sustainable resource use does not mean that these kinds of natural resources should not be used at all,
but rather that the should be used at a rate that gives them enough time to reproduce themselves, so that
the can be maintained over time in terms of quantit and qualit and not be destro ed or depleted.
It is clear that the issue of sustainable use of resources arises from the fact that these resources are
scarce. If the ere not scarce, it ould not matter at all ho fast e used them or destro ed them as
there ould be plent more.
S refers to maintaining the abilit of the environment and the econom to continue to
produce and satisf needs and ants into the future; sustainabilit depends cruciall on
, referring to the preservation of the environment over time. The problem of
sustainabilit arises because resources are scarce.
Threats to sustainabilit do not onl result from high-income production and consumption patterns that
rel strongl on polluting fossil fuels as ell as other activities that destro the environment. In addition,
in ver poor societies, threats to sustainabilit often arise from povert itself, hich drives ver poor
people to destro their natural environment as the make efforts to survive. E amples include cutting
do n forests, overgra ing, soil erosion and man more. In all these cases, there ma be an unsustainable
use of resources, as fe er and lo er-qualit resources are left behind for future generations.
While virtuall ever one toda agrees on the importance of sustainabilit , there is vast disagreement
about hat this means from a practical point of vie , and ho this can be achieved in practice. We ill
discuss the issue of sustainable resource use and policies to achieve this in Chapter 5.

1 E plain the relationship bet een scarcit and sustainabilit .
2 Consider the follo ing: Dangerous levels of industrial air pollution in India reduce life
e pectanc b seven ears for 40% of its population. This refers to the people living in the states
of the Indo-Gangetic plain, here pollution has increased b 72% in a period of 18 ears. The
population of Delhi faces an average loss of 10.2 ears. The public is outraged. The government
has begun to respond to this public health emergenc .3
Research an e ample of a challenge India faces and outline ho it is a threat to sustainable
development.
Describe ho India s rapid economic gro th impacts its future generations.
R
We have seen that resources, or all inputs used to produce goods and services, are also kno n as factors
of production.
T
Economists group the factors of production under four broad categories:
L consists of all natural resources, including all agricultural and non-agricultural land, as ell
as ever thing that is under or above the land, such as minerals, oil reserves, underground ater,
forests, rivers and lakes. Natural resources are also called gifts of nature .
L includes the ph sical and mental effort that people contribute to the production of goods
and services. The efforts of a teacher, a construction orker, an economist, a doctor, a ta i driver or
a plumber all contribute to producing goods and services, and are all e amples of labour.
C , also kno n as physical capital, is a manmade factor of production (it is itself produced)
used to produce goods and services. E amples of ph sical capital include machiner , tools,
factories, buildings, road s stems, airports, harbours, electricit generators and telephone suppl
lines. Ph sical capital is also referred to as a capital good or investment good.
E (management) is a special human skill possessed b some people, involving the
abilit to innovate b developing ne a s of doing things, to take business risks and to seek ne
opportunities for opening and running a business. Entrepreneurship organises the other three factors
of production and takes on the risks of success or failure of a business.
O
The term capital , in the most general sense, refers to resources that can produce a future stream of
benefits. Thinking of capital along these lines, e can understand h this term has a variet of different
uses, hich although are seemingl unrelated, in fact all stem from this basic meaning.
P , defined above, is one of the four factors of production consisting of man-made
inputs that provide a stream of future benefits in the form of the abilit to produce greater quantities
of output: ph sical capital is used to produce more goods and services in the future.
H refers to the skills, abilities and kno ledge acquired b people, as ell as good
levels of health, all of hich make them more productive. Human capital provides a stream of
future benefits because it increases the amount of output that can be produced in the future b
people ho embod skills, education and good health.
N , also kno n as environmental capital, refers to an e panded meaning of the factor
of production land (defined earlier). It includes ever thing that is included in land, plus additional
natural resources that occur naturall in the environment such as the air, biodiversit , soil qualit ,
the o one la er and the global climate. Natural capital provides a stream of future benefits because
it is necessar to humankind s abilit to live, survive and produce in the future.
F refers to investments in financial instruments, like stocks and bonds, or the funds
(mone ) that are used to bu financial instruments. Financial capital also provides a stream of
future benefits, hich take the form of an income for the holders, or o ners, of the financial
instruments.

1 Outline h resources are also called factors of production .
Identif the four factors of production.
2 Outline ho ph sical capital differs from the other three factors of production.
3 Describe h entrepreneurship is considered to be a factor of production separate from labour.
4 Identif the various meanings of the term capital .
Outline hat the have in common.
S , :
O
Opportunity cost is defined as the value of the ne t best alternative that must be given up or sacrificed in
order to obtain something else. Ever time e choose to do something, e give up something else e
could have done instead. For e ample, our decision to read this book no means ou have given up a
different activit , such as sleeping, atching TV or visiting a friend. If our best or favourite alternative
to reading this book is atching TV, the TV time ou have sacrificed is the opportunit cost of reading
this book. Opportunit cost in this case rises from the fact that time is limited or scarce; if it ere
endless, ou ould never have to sacrifice an activit in order to do something else.
When a consumer chooses to use her $100 to bu a pair of shoes, she is also choosing not to use this
mone to bu books, food or an thing else; if books are her favourite alternative to shoes, the books she
sacrificed (did not bu ) are the opportunit cost of the shoes. Note that if the consumer had endless
amounts of mone , she could bu ever thing she anted and the shoes ould have no opportunit cost.
The concept of , or the value of the ne t best alternative that must be sacrificed to
obtain something else, is central to the economic perspective of the orld, and results from the
scarcit that forces choices to be made.

1 Define opportunit cost.
2 E plain ho scarcit and choice relate to opportunit cost.
3 Think of three choices ou have made during the past eek and describe the opportunit cost of
each one.
F
Based on the concept of opportunit cost, e can make a distinction bet een free goods and economic
goods (note that the term good is used here in a general sense to include goods, services and resources):
A is an good that is not scarce, and therefore has a ero opportunit cost. Since it is not
limited b scarcit , it includes an thing that can be obtained ithout sacrificing something else. An
economic good is an good that is scarce, either because it is a naturall -occurring scarce resource (such
as oil, gold, coal, forests, lakes), or because it is produced b scarce resources. All economic goods have
an opportunit cost greater than ero.
Free goods are rare. Sometimes a good can be a free good in certain situations and an economic good in
others. For e ample, arable land in America before European colonisers arrived as a free good because
it as so abundant; as the colonisers gre in numbers it became increasingl scarce and therefore an
economic good. Salt used to be a free good that has become an economic good. O gen in the open
unpolluted countr side can be a free good; in a room ith no indo s that is cro ded ith people, it
becomes an economic good. Unobstructed sunshine is also a free good in man situations.
It is important to distinguish free goods from goods or resources that are available free of charge to their
users. There are t o categories of goods that are available free of charge, but hich do have opportunit
costs and are therefore economic goods:
goods provided b the government, such as the road s stem, public parks and pla grounds, free
education, free health care services; all these are economic goods produced b scarce resources, and
are paid for out of ta revenues (see Chapter 6);
certain natural resources, such as clean air, forests, rivers, lakes and ildlife, that are not o ned b
an one (the are called common pool resources; these are also economic goods because the are
scarce, and are becoming increasingl scarce due to overuse and depletion (see Chapter 5).

1 E plain the difference bet een a free good and an economic good.
2 Identif hich of the follo ing goods are free goods and e plain h :
public parks
sand in the Sahara desert
garbage collection
free health care services
ildlife.
3 Wh do ou think free goods are rare?
1 OECD Frame ork for Statistics on the Distribution of Household Income, Consumption and Wealth, Chapter 2
Economic ell-being, OECD 2013.
2 Brundtland Commission (World Commission on Environment and Development) (1987) Our Common Future,
O ford Universit Press
3 Pollution: From Punjab to Bengal, 48 crore people ma die 7 ears earl but all is not lost
Dirt air: ho India became the most polluted countr on earth

1.2 :
/
LEARNING OBJEC I E
After stud ing this section ou will be able to:

define all the terms appearing in in the text (AO1)
identif and explain the three basic economic questions (AO2)
distinguish between the role of markets and government intervention in designing and proposing
solutions to the basic economic questions (AO2)
distinguish between economic s stems: the free market econom , planned econom and mixed
econom (AO2)
: / ,
Scarcit forces ever econom in the world, regardless of its form of organisation, to answer the
following three basic questions:
/ . All economies must choose what particular goods and services and
what quantities of these the wish to produce.
H . All economies must make choices on how to use their resources in order to
produce goods and services. Goods and services can be produced b use of different combinations
of factors of production (for example, relativel more labour with fewer machines, or relativel
more machines with less labour), b using different skill levels of labour, b using different
technologies or b using different raw materials, for example, plastic or wood.
F . All economies must make choices about how the goods and services
produced are to be distributed among the population. Should ever one get an equal amount of
these? Should some people get more than others? Should some goods and services (such as
education and health care services) be distributed more equall ?
R /
The first two of these questions, what/how much to produce and how to produce, are about resource
allocation, while the third, for whom to produce, is about the distribution of output and income.
R refers to assigning available resources, or factors of production, to specific uses
chosen among man possible alternatives, and involves answering the what/how much to produce and
how to produce questions. For example, if a what/how much to produce choice involves choosing a
certain amount of food and a certain amount of weapons, this means a decision is made to allocate some
resources to the production of food and some to the production of weapons. At the same time, a choice
must be made about how to produce: which particular factors of production and in what quantities (for
example, how much labour, how man machines, what t pes of machines, etc.) should be assigned to
produce food, and which and how man to produce weapons.
If a decision is made to change the amounts of goods produced, such as more food and fewer weapons,
this involves a reallocation of resources. Sometimes, societies produce the wrong amounts of goods
and services relative to what is sociall desirable. For example, if too man weapons are being produced,
we sa there is an overallocation of resources to production of weapons. If too few sociall desirable
goods or services are being produced, such as education or health care, we sa there is an
underallocation of resources to the production of these.
The third basic economic question, for whom to produce, involves the distribution of output and is
concerned with how much output different individuals or different groups in the population receive. This
question is also concerned with the among individuals and groups in a
population, since the amount of output people can get depends on how much of it the can bu , which in
turn depends on the amount of income the have. When the distribution of income or output changes so
that different social groups now receive more, or less, income and output than previousl , this is referred
to as .
E O R NDER ANDING 1.6

1 State the three basic economic questions that must be addressed b an econom .
2 Explain the relationship between the three basic economic questions, the allocation of resources
and the distribution of income or output.
3 Consider the following, and identif each one as referring to output/income distribution or
redistribution; or to resource allocation, reallocation, overallocation or underallocation (note that
there ma be more than one answer).
Evidence suggests that over the last two decades in man countries around the world the
rich are getting richer and the poor are getting poorer.
In Bra il, the richest 10% of the population receive 48% of total income.
Whereas rich countries t picall spend 8 12% of their income on providing health care
services to their populations, man poor countries spend as little as 2 3% of their income.
Man developing countries devote a large proportion of their government budget funds to
spending on universit level education, while large parts of their population remain
illiterate.
If countries around the world spent less on defence, the would be in a position to expand
provision of social services, including health care and education.
Pharmaceutical companies spend most of their research funds on developing medicines to
treat diseases common in rich countries, while ignoring the treatment of diseases common
in poor countries.
A
Countries around the world differ enormousl in the wa s the make allocation and distribution
decisions. At the heart of their differences lie the methods used to make the choices required b the
what/how much, how and for whom to produce questions. There are two main methods that can be used
to make these choices: the market method and the command method.
In the market method, resources are owned b private individuals or groups of individuals, and it is
mainl consumers and firms (or businesses) who make economic decisions b responding to prices that
are determined in markets (we will see how this happens in Chapter 2). In the command method,
resources (land and capital in particular) are owned b the government, which makes economic decisions
b commands. In practice, commands involve legislation and regulations b the government, or in
general an kind of government decision-making that affects the econom .
In the real world, there has never been an econom that is entirel a market econom or entirel a
command econom . Real-world economies combine markets and commands in man different wa s,
and each countr is unique in the wa s the combine them. Economies ma lean more toward the
command econom (as in planned economies of communist s stems), or more toward the market
econom (as in highl market- oriented economies). Whatever the case, in the last 40 or so ears, there
has been a trend around the world for economies to rel more and more on the market and less on
commands.
When the government makes decisions that affect the econom , this is known as government
intervention, because the government intervenes (or interferes) in the workings of markets. Examples of
government intervention include provision of public education, public health care, public parks, road
s stems, national defence, flood control, minimum wage legislation, restrictions on imports, anti-
monopol legislation, tax collection, income redistribution and man more.
Whatever the reasons for and t pes of government intervention in the market,
changes the allocation of resources (and distribution of output and income) from what
markets would have achieved working on their own.
The market econom offers important benefits that we will discover in Chapter 2. Yet it does not alwa s
produce the best answers to the what/how much, how and for whom questions for man reasons to be
discussed in later chapters. Therefore, a market econom cannot operate effectivel without some
government intervention.
Whereas practicall ever one agrees that some government intervention in markets is necessar ,
economists disagree widel over how much governments should intervene and how the should
intervene. There are two broad schools of thought on this issue. One focuses on the positive aspects of
markets, while the other focuses on the imperfections of markets.
According to the first perspective, economists argue that in spite of imperfections, markets are able to
work reasonabl well on their own, and can produce outcomes that generall promote societ s well-
being. Markets can achieve a reasonabl good allocation of resources, answering the what/how much to
produce and how to produce questions quite well. Government intervention changes this allocation of
resources, and often worsens it, giving rise to resource waste. Therefore, while some minimum
government intervention ma be needed in certain situations, this should not be ver extensive.
According to the second school of thought, markets have the potential to work well, but in the real world
their imperfections ma be so important that the make government intervention necessar for their
correction. This means that markets, working on their own, do not do a ver good job of allocating
resources in societ s best interests. The purpose of government intervention, therefore, is to help
markets work better and arrive at a better pattern of resource allocation and distribution of income and
output.
E : , ,
It is suggested that ou reread this section after reading Chapters 2 and 4 7, as ou will then be better
able to understand it.
The market and command methods to answer the basic economic questions discussed above can be
thought of as two ideal t pes of economies: a based on the market approach and
a based on the command approach. An ideal t pe is an abstract idea that does not
claim to represent the real world, but rather contains some characteristics that serve as a standard for
comparison of real-world situations. (Note that an ideal t pe is not ideal in the sense of perfect or
excellent.) As we also discussed above, real-world economies combine markets and commands in man
different wa s, resulting in .

1 Identif some more examples of command methods (government intervention) in market
economies.
2 Outline the main source of the disagreement between those who argue there should be little
government intervention in the econom and those who argue that government intervention
should be more extensive.
The ideal-t pe free market and planned economies are distinguished from each other on the basis of
three criteria.
Re ce e hi : blic i a e ec Ownership of societ s resources can be public or
private . The public sector refers to the parts of the econom that are under the ownership of the
government (whether national, regional or local). The government is also sometimes referred to as
the state . The private sector includes the parts of the econom that are under the ownership of
private individuals or groups of individuals; these include consumers (households), firms
(businesses) and resource owners, as well as organisations such as NGOs (non-governmental
organisations) and interest groups (for example, consumer protection organisations). The free
market econom has private sector resource ownership, and the planned econom has public sector
resource ownership.
Ec mic deci i -maki g Economic decisions and choices regarding the what/how much, how
and for whom questions can be made b the public sector, i.e. the government, or b the private
sector. There are man private decision-makers, as noted above, but the most important of these are
consumers (households), firms (businesses) and resource owners. The free market econom has
private sector economic decision-making and the planned econom has public sector economic
decision-making.
Ra i i g em
The term 4 can be defined as a method used to apportion or divide something up between
its interested users. In economics, it refers to the method used to make resource allocation and
output/income distribution decisions. There are two kinds of rationing s stems: price rationing and
non-price rationing.
The free market econom uses price rationing to make resource allocation and output/income
distribution decisions. This means that all economic decisions relating to what will be
produced, how it will be produced, and who will receive the output are made on the basis of
prices of goods, services and resources that have been determined in markets.
The planned econom uses non-price rationing to make resource allocation and output/income
distribution decisions. This means that all decisions relating to what/how much will be
produced, how it will be produced, and who will receive the output, are made b use of
methods that have nothing to do with prices determined in markets. Non-price rationing results
when there are no markets, or when governments interfere in markets, in which case the
government acts as a central authorit and makes economic decisions b commands.
Both price rationing and non-price rationing will become much clearer to ou after ou have studied
Chapter 2.
In the free market econom households and firms (the private sector) are the main owners of resources,
as well as the economic decision-makers who make bu ing and selling decisions, and who are linked
together in product and resource markets. As we will see in Chapter 2, product and resource markets
determine prices of goods, services and resources, which act as the basis of price rationing.
The planned econom is characterised b the absence of markets or the limited operation of markets. As
the owner of resources and economic decision-maker, the government makes all allocation and
distribution decisions through non-price rationing. This is called a planned econom because the
government authorit makes detailed plans of all economic activities, on the basis of which it directs and
coordinates economic decisions through commands. There remain ver few countries in the world that
are still highl centrall planned; these include North Korea and, to a lesser extent, Cuba. Most other
countries have begun to introduce major reforms intended to strengthen the role of markets.
In the real world, virtuall all economies combine elements of both markets and commands. Differences
between actual economies lie mainl in the wa s the two are combined and in the degree to which one
predominates. For this reason, most economies in the world toda are mixed economies.
Increasingl , mixed economies are becoming mixed market economies. That is, most economic activit
is market-based based rather than centralised, and price rationing is more common than non-price
rationing.
In mixed market economies, public or private sector ownership and decision-making often go together.
For example, privatel owned firms usuall make decisions about what and how the will produce and
sell, while the government makes decisions about economic activities that fall under its ownership (such
as public health services, public road s stems, public parks, defence facilities and man others).
However, the government s decision-making role in the mixed market econom is not limited to
activities falling under its ownership; it also extends into private sector activities. For example, the
United States, one of the more market-oriented countries in the world, has government decision-making
that affects the private sector in numerous areas such as minimum wage legislation, subsidies for
agricultural products, tariffs on imports, regulation of private sector activities, anti-monopol legislation,
tax collection, income redistribution and man others. All mixed market economies, in fact, have
government involvement with the private sector that is either a response to the failure of the market
mechanism to work well, or in response to the demands of politicall powerful interest groups. We will
examine government intervention in the market extensivel for both these sets of reasons in later
chapters.
Government involvement in the private sector varies widel from countr to countr in extensiveness.
For example, the free market pla s a more prominent role in the United Kingdom and the United States
compared to France and Japan. Also, government involvement in the private sector varies in the form
that it takes. For example, in the Nordic countries (Denmark, Finland, Iceland, Norwa and Sweden),
there is extensive government intervention in income redistribution; in Japan, extensive government
intervention takes the form of planning and coordinating private sector activities.
In mixed market economies, both price and non-price rationing can be observed, but with price rationing
predominating. In general, price rationing arises in situations where there is a market for resources,
goods and services. If there is no market (or if markets are not free because of government intervention),
then some form of non-price rationing occurs. For example, when governments in market economies
provide national defence, public health care s stems, public road s stems and flood control, the do not
rel on price rationing to determine resource allocation and output distribution, and the role of the
government agencies that plan and provide these services is similar to the role of the central planner.
Consider the case of national health s stems, where the government, through tax financing, undertakes
to provide health care services that are made available to the entire population free (or nearl free) of
charge. Since there is no price charged to the consumer who receives a service, some mechanism other
than price, i.e. non-price rationing, must be used to distribute the service among its users. The most
commonl used non-price mechanism is the waiting line or waiting period (queue).
There have been significant changes over time in the relative prominence of private versus public sector
activities. During much of the 20th centur , man countries throughout the world saw major increases in
government participation in economic decision-making. Since the 1980s, there has been a shift once
again in the direction of less public sector involvement and a corresponding growth in private sector
activities. In man countries around the world, including both more developed and less developed ones,
the increasing importance of market-based activities has been due to the growing popularit of man
suppl -side economic policies (to be discussed in Chapter 13), as well as a recognition of the limitations
of central planning. Table 1.1 provides a summar of the three criteria as the appl to each t pe of
econom .

1 Identif the basic economic questions that must be answered b
free market economies,
command economies, and
mixed economies.
2 Use the criteria appearing in Table 1.1 to compare and contrast the main characteristics of the
market and command economies.
3 Outline wh the command econom is also referred to as a centrall planned econom .
4 Compare and contrast the methods b which allocation and distribution choices are made in the
market econom and the command econom .
5 Define and explain the difference between price rationing and non-price rationing.
Describe the functions of these two rationing mechanisms.
Identif the kind of economic s stem in which each one predominates.
6 Describe examples of command practices in mixed economies.
7 Outline wh most economies in the world toda are mixed market economies.
C F P M
( ( (
) ) )
R private sector public sector public and private sectors
E - private sector public sector public and private sectors
R price rationing non-price price rationing and non-price

rationing rationing
1.1: Free market, planned and mixed economies
E
( )
The interested student ma explore this topic in the 'Digital coursebook: Extra material' section.
4 Will be introduced in Chapter 2 as a s llabus term.
1.3
LEARNING OBJEC I ES
After studying this section you will be able to:

• define all the terms appearing in in the text (AO1)
• identify and explain the relationships illustrated in the production possibilities curve model PPC
(AO2)
• use the PPC model to explain opportunity cost, scarcity, choice, unemployment, efficiency, actual
growth and growth in production possibilities (AO2)
• draw a diagram to explain all the above concepts in the PPC model (AO4)
• distinguish between increasing versus constant opportunity cost in the PPC model (AO2)
• draw a diagram to illustrate the difference between increasing and constant opportunity cost in the
PPC model (AO4)
• identify and explain the interdependent activities of decision-makers in the circular flow of income
model: households, firms, the government, banks and the financial sector, and the foreign sector
(AO2)
• explain the role of leakages and injections in the circular flow of income model (AO2)
• draw a diagram to identify and explain the relationships illustrated in the circular flow of income
model including leakages and injections (AO4)
Everyone is familiar with the idea of a model. As children, many of us played with paper aeroplanes,
which are models of real aeroplanes. In chemistry at school, we studied molecules and atoms, which are
models of what matter is made of. A is a simplified representation of something in the real world; it
represents only the important aspects of the real world being investigated, ignoring unnecessary details.
This way it allows us to focus on important relationships. Models are used a lot by scientists and social
scientists in their efforts to understand or explain real-world situations.
I
Consider a simple hypothetical economy producing only two goods: microwave ovens and computers.
This economy has a fixed (unchanging) quantity and quality of resources (factors of production) and a
fixed technology (the method of production is unchanging). Table 1.2 shows the combinations of the two
goods this economy can produce. Figure 1.1 plots the data of Table 1.2: the quantity of microwave ovens
is plotted on the vertical axis, and the quantity of computers on the horizontal axis.
If all the economy s resources are used to produce microwave ovens, the economy will produce 40
microwave ovens and 0 computers, shown by point A. If all resources are used to produce computers, the
economy will produce 33 computers and 0 microwave ovens; this is point E. All the points on the curve
joining A and E represent other production possibilities where some of the resources are used to produce
microwave ovens and the rest to produce computers.
P M C
A 40 0
B 35 17
C 26 25
D 15 31
P M C
E 0 33
1.2: Combinations of microwave ovens and computers
For example, at point B there would be production of 35 microwave ovens and 17 computers; at point C,
26 microwave ovens and 25 computers, and so on. The line joining points A and E is known as the
d c b e c e (PPC) (or d c b e f e , PPF).
In order for the economy to produce the greatest possible output, in other words somewhere on the PPC,
two conditions must be met:
• A . This means that all resources are being fully used. If there
were unemployment of some resources, in which case they would be sitting unused, the economy
would not be producing the maximum it can produce.
• A . Specifically, there must be efficient resource use. The term
efficiency in a general sense means that resources are being used in the best possible way to avoid
waste. (If they are not used in the best possible way, we say there is inefficiency .) Efficiency in
production means that output is produced by use of the fewest possible resources; alternatively, we
can say that output is produced at the lowest possible cost. If output were not produced using the
fewest possible resources, the economy would be wasting some resources.
The ( ) represents all combinations of the maximum amounts

of two goods that can be produced by an economy, given its resources and technology, when there is
full employment of resources and efficiency in production. All points on the curve are known as
.
F 1.1: Production possibilities curve
What would happen if either of the two conditions (full employment and efficiency) is not met? Very
simply, the economy will not produce at a point on the PPC; it will be somewhere inside the PPC, such as
at point F. At F, the economy is producing only 15 microwave ovens and 12 computers, indicating that
there is either unemployment of resources, or inefficiency in production, or both. If this economy could
use its resources fully and efficiently, it could, for example, move to point C and produce 26 microwave
ovens and 25 computers.
However, in the real world no economy is ever likely to produce on its PPC.
An economy s ac a , or the quantity of output actually produced, is always at a point inside the
PPC, because in the real world all economies have some unemployment of resources and some
inefficiency in production. The greater the unemployment or the inefficiency, the further away is the
point of production from the PPC.
The production possibilities model is very useful for illustrating the concepts of scarcity, choice and
opportunity cost:
• B , PPC. With its fixed quantity and
quality of resources and technology, the economy cannot move to any point outside the PPC, such as
point G on Figure 1.1, because it does not have enough resources (i.e. there is resource scarcity).
• B ,
. Assuming it could achieve full employment and efficiency, it must decide at
which particular point on the PPC it should produce. (In the real world, the choice would involve a
point inside the PPC.)
• B , . If the economy were at any point on the
curve, it would be impossible to increase the quantity produced of one good without decreasing the
quantity produced of the other good. In other words, when an economy increases its production of
one good, there must be a sacrifice of some quantity of the other good. This sacrifice is the
opportunity cost.
Let s consider the last point more carefully. Say the economy is at point C, producing 26 microwave ovens
and 25 computers. Suppose now that consumers would like to have more computers. It is impossible to
produce more computers without sacrificing production of some microwave ovens. For example, a choice
to produce 31 computers (a move from C to D) involves a decrease in microwave oven production from
26 to 15 units, or a sacrifice of 11 microwave ovens. The sacrifice of 11 microwave ovens is the
opportunity cost of 6 extra computers (increasing the number of computers from 25 to 31). Note that
opportunity cost arises when the economy is on the PPC (or more realistically, somewhere close to the
PPC). If the economy is at a point inside the curve, it can increase production of both goods with no
sacrifice, hence no opportunity cost, simply by making better use of its resources: reducing unemployment
or increasing efficiency in production.
In Figure 1.2(a) the PPC s shape is similar to that of Figure 1.1, while in Figure 1.2(b) it is a straight line.
When the PPC bends outward and to the right, as in Figure 1.2(a), opportunity costs change as the
economy moves from one point on the PPC to another. In part (a), for each additional unit of computers
that is produced, the opportunity cost, consisting of microwave ovens sacrificed, gets larger and larger as
computer production increases. This happens because of specialisation of factors of production, which
makes them not equally suitable for the production of different goods and services.
As production switches from microwave ovens to more computers, it is necessary to give up increasingly
more microwave ovens for each extra unit of computers produced, because factors of production suited to
microwave oven production will be less suited to computer production. By contrast, when the PPC is a
straight line (as in Figure 1.2(b)), opportunity costs are constant (do not change) as the economy moves
from one point of the PPC to another. Constant opportunity costs arise when the factors of production are
equally well suited to the production of both goods, such as in the case of basketballs and volleyballs,
which are very similar to each other, therefore needing similarly specialised factors of production to
produce them. As we can see in Figure 1.2(b), for each additional unit of volleyballs produced, the
opportunity cost, or sacrifice of basketballs, does not change.
F 1.2: Production possibilities curve with increasing and constant opportunity costs
E refers to increases in the quantity of output produced in an economy over a period of

time. What are the causes of growth? We can find the answer to this question in the production
possibilities model.
We have seen that any economy is most likely to be actually situated at some point inside its PPC, as it is
very difficult for an economy ever to be fully efficient and have maximum employment of all resources.
The further away an economy is situated from its PPC, the greater its resource unemployment and
inefficiency. Therefore, by reducing unemployment and increasing efficiency, a country moves closer to
its PPC and increases the actual quantity of output produced. It follows that ed c e e
a d c ea e eff c e c a e fac ha ca ca e g h f ac a . In Figure 1.3(a), the
movement from point A to point B illustrates ac a g h.
However, reduction of unemployment and inefficiencies can only result in a limited amount of economic
growth. As the economy moves closer to its PPC, the ability to achieve more growth is exhausted, and
more growth can only occur if there is g h d c b e , illustrated by an outward shift of
the PPC. An outward shift of the PPC means the economy can produce more of both goods (X and Y),
shown in Figure 1.3(b) by the shifts from PPC1 to PPC2 to PPC3. In this figure, the growth in production
possibilities is accompanied by outward movements of the economy s points of actual production, from A
to B to C.
The factors that lead to outward shifts of the PPC, or growth in production possibilities are:
• increases in the quantity of resources (factors of production) in the economy
• improvements in the quality of resources (for example, through more educated labour)
• technological improvements.
As its production possibilities grow, unemployment must be kept at low levels and inefficiencies should be
reduced to ensure that actual output continues to grow along with production possibilities, as in Figure
1.3(b). For example, an increase in the size of the labour force will do little to increase actual output
produced if much of this labour remains unemployed (in this case the economy could remain stuck at
point A even as PPC1 shifts to PPC2). Similarly, the discovery of major oil reserves may do little to
expand actual output if these reserves remain unexploited, or if their exploitation is undertaken
inefficiently.
It is important to distinguish between ac a g h, which involves a movement from one point inside
the PPC to another point closer to the PPC, and g h d c b e involving an outward
shift of the PPC. A is caused by reduction in unemployment and increases in efficiency in
production. G is caused by increases in the quantity of resources,
improvements in the quality of resources and technological improvements.
F 1.3: Using the production possibilities model to illustrate economic growth
The PPC can also shift inward, indicating a decrease in production possibilities, or that less of the two
goods can be produced, as shown in Figure 1.3(c). This results from a decrease in the quantity of resources
or deterioration in resource quality.
An outward or inward shift need not be parallel; this is illustrated in Figure 1.3(d). For example, a
technological change favouring the production of one good (X) increases the production of that good
proportionately more. Similarly, an influx of unskilled workers into a country results in a larger
proportionate increase in the production of goods using relatively more unskilled labour.
ES O R NDERS ANDING 1.9

1 Consider the production possibilities data in Table 1.2 and Figure 1.1. If the economy is initially at
point A and moves to point B, computer production will increase by 17 units.
Calculate the opportunity cost of the increase in computer production.
If the economy moves from D to C, calculate the gain and its opportunity cost.
If it moves from point C to B, calculate the gain and its opportunity cost.
2 Use the concept of opportunity cost to explain why the following two statements have the same
meaning:
efficiency in production means producing by use of the fewest possible resources
efficiency in production means producing at the lowest possible cost.
3 Distinguish between output actually produced and output on the PPC.
Outline why an economy s actual output is most likely to be located somewhere inside its
PPC.
4 Say an economy is initially at point F, producing 15 microwave ovens and 12 computers (Figure
1.1). State what would be the opportunity cost of moving to a point on the production possibilities
curve, such as point C, where it would be producing 26 microwave ovens and 25 computers.
5 Using diagram(s), distinguish between actual growth and growth in production possibilities.
List the factors that can give rise to each of these.
6 Use the production possibilities curve model and diagrams to show how the following can result in
actual growth or growth (or decrease) in production possibilities:
a discovery of new oil reserves
firms hire more workers
a vaccine for contagious diseases is invented
firms improve how they manufacture and lower their costs of production
the widespread use of a new technology
a violent conflict destroys a portion of a country s factories, machines and road system
large cuts in government spending on education and health care lower levels of education and
health in a population
an increase in the quantity of capital goods
an improvement in the level of education and skills of workers
industrial pollution destroys the environment.
7 Using diagrams, distinguish between increasing and constant opportunity costs.
8 Using the production possibilities model, explain the relationship between scarcity, choice and
opportunity cost.
The is a simple model that illustrates some economic concepts and
relationships that will help us understand the overall economy. In its simplest version, shown in Figure
1.4, the model illustrates a c ed ec , meaning it has no links with other countries (it is closed to
international trade), and is also a model of an economy with no government and no banks or financial
market.
It is assumed that the only decision-makers are (or consumers) and (or businesses); both
are shown in square boxes. Households and firms are linked together through two markets: product
markets and resource markets, shown in diamonds.
Households are owners of the four factors of production: land, labour, capital and entrepreneurship. Firms
buy the factors of production in resource markets and use them to produce goods and services. They then
sell the goods and services to consumers in product markets. We therefore see a flow in the clockwise
direction of factors of production from households to firms, and of goods and services from firms to
households.
In the counterclockwise direction, there is a flow of e used as payment in sales and purchases. When
households sell their factors of production to firms, they receive payments taking the form of e (for
land), age (for labour), e e (for capital) and f (for entrepreneurship). These payments are the
c e f h eh d . The payments that households make to buy goods and services are h eh d
e e d e (or consumer spending). The payments that firms make to buy factors of production
represent their c f d c , and the payments they receive by selling goods and services are their
e e e . All payment flows, known as e f , are shown in Figure 1.4
F 1.4: Circular flow of income model in a closed economy with no government
This model demonstrates an important principle: the c e f involving the money that goes from
firms to households is equal to the e e d e f from households to firms, which is the money that
households spend to buy things from firms. In other words, the household incomes coming from the sale
of all the factors of production equals the expenditures by households on goods and services. This is the
c c a f f c e.
In addition, these two flows must be equal to the value of goods and services, or the value of total output
produced by the firms, known as the a e f f . The reasoning of this is as follows: if each good
and service is multiplied by its respective price, we obtain the value of each good and service, and adding
them all up we arrive at the value of total output. This value is the same as consumer expenditure, since
spending by consumers is equal to each item they buy multiplied by its price. Therefore:
The shows that in any given time period (say a year), the value of output
produced in an economy is equal to the total income generated in producing that output, which is equal
to the expenditures made to purchase that output.
A
The real-world economy is more complicated than this simple model suggests. We arrive at a closer
picture of the real world by adding and (also known as hd a a ) to the money
flow of Figure 1.4. To understand what these are, consider a pipe with water flowing through it, as in
Figure 1.5. As water flows through the pipe, some leaks out (the leakages), while new supplies of water
are injected in (the injections). It is the same with the flows of money in the circular flow model.
F 1.5: Leakages and injections
Leakages and injections are paired together so that what leaks out of the flow can come back in as an
injection. The most important pairs are the following:
saving investment
taxes government spending
imports exports
S
Saving is the part of consumer income that is not spent but rather is saved. Investment is spending by
firms for the production of capital goods, which is one of the four factors of production. This is why
capital goods are also known as investment goods. How are saving and investment linked together as
leakages and injections?
When households save part of their income, this represents a leakage from the circular flow of income
because it is income that is not spent to buy goods and services. Households place their savings in
financial markets (bank accounts, purchases of stocks and bonds, etc.). Firms obtain funds from financial
markets (through borrowing, issuing stocks and bonds, etc.) to finance investment, or the production of
capital goods. These funds therefore flow back into the expenditure flow as injections. This process is
shown in Figure 1.6, which, in addition to the money flows of Figure 1.4, shows the three
leakage/injection pairs. (For simplicity, Figure 1.6 contains only money flows.) Leakages appear in the
left-hand side of the figure, and injections on the right. We can see that saving leaks out of the flow of
consumer expenditures (saving is money that is not spent), and after passing through financial markets is
injected back into the expenditure flow as investment.
F 1.6: Circular flow of income model with leakages and injections
Taxes and government spending are connected to each other through the government. Households pay
taxes to the government; this is a leakage because it is income that is not spent to buy goods and services.
The government uses the tax funds to finance government expenditures (on education, health, defence,
etc.) and this spending is an injection back into the expenditure flow.
I
I are goods and services produced in other countries and purchased by domestic buyers. E
are goods and services produced domestically and purchased by foreigners. When an economy has
international trade with imports and exports, it is known as an e ec . Imports and exports are
linked together through other countries . Imports are a leakage because they represent household
spending that leaks out as payments to the other countries that produced the goods and services. Exports
are an injection because they are spending by foreigners who buy goods and services produced by the
domestic firms.
In the real world, leakages and injections are unlikely to be equal, and this has important consequences for
the size of the circular flow. If a leakage is greater than an injection, then the size of the circular flow
becomes smaller. Suppose saving (a leakage) is larger than investment (an injection). This means that part
of the household income that leaks as saving into financial markets does not come back into the flow as
investment. The result is that fewer goods and services are purchased, firms cut back on their output, they
buy fewer factors of production, unemployment increases (since firms buy a smaller quantity of labour)
and household income is reduced.
If a leakage is smaller than an injection, the size of the circular flow becomes larger. Suppose spending on
exports is greater than spending on imports; then the expenditure flow increases since the injection is
larger than the leakage. Foreigners demand more goods and services, firms begin to produce more by
purchasing more factors of production, unemployment falls (as firms buy a larger quantity of labour), and
household income increases. To summarise, leakages from the circular flow of income (saving, taxes and
imports) are matched by injections into the circular flow of income (investment, government spending and
exports), though he e eed be e a each he .
In the c c a f f c e de if injections are larger than leakages the size of the flow increases;
if leakages are larger than injections the size of the flow shrinks.

1 Identify the two markets shown in the circular flow of income model. Using examples,
outline what is exchanged (bought and sold) in each of these.
Identify the three flows shown in the circular flow model.
2 The circular flow of income model shows that households and firms are both buyers and sellers
simultaneously. Explain how this is possible.
3 Use the simple circular flow of income model to:
show the circular flow of income
show the equivalence between factor income flow, household expenditure flow and the value
of output flow.
4 Define leakages and injections in the circular flow of income.
Use the circular flow of income model to illustrate how the three pairs of leakages and
injections are linked together.
5 Distinguish between a closed economy and an open economy.
6 Describe what happens to the size of the income flow when:
leakages are larger than injections
injections are larger than leakages.
The circular flow of income model is a simple model that de c be basic economic relationships, bringing
together and showing how microeconomics and macroeconomics relate to each other.
(Microeconomics and macroeconomics were introduced at the beginning of this chapter. We can see in
this model that the basic decision-making units, c e and f , are interdependent; they are linked
together through their buying and selling activities which occur in markets. We will study the behaviour of
consumers and firms in c ec c . These buying and selling activities, when added all up, lead to
flows of income, output and spending, which are also interdependent. We will study these under
ac ec c.
1.4 T
LEARNING OBJECTIVES

distinguish between positive and normative economics (AO2)
explain the use of logic, hypotheses, models and theories in positive economics (AO2)
explain the role of the ceteris paribus assumption (AO2)
explain the roles of empirical evidence and refutation in positive economics (AO2)
explain the role of value judgements in policy-making in normative economics (AO2)
distinguish between equity and equality (AO2)
E
Economists think about the economic world in two different ways:
One way of thinking tries to describe, explain and predict economic events; this is called positi e
economics. It is based on positi e statements, which are about something that is, was or will be.
Positive statements are used to describe, explain or predict economic events by use of hypotheses,
theories and models. Positive statements:
may describe something; for example, the unemployment rate is 5% and industrial output
grew by 3% are two statements describing the level of unemployment and growth of
industrial output
may be statements in a hypothesis that tries to e plain something; for example, the statement
a higher price of apples results in fewer apples purchased is a statement that provides an
explanation of why fewer apples are purchased
may be statements that predict a future event; for example, unemployment will increase next
year predicts what will happen to unemployment next year.
The other way of thinking deals with how things in the economy should or ought to be; this is
called normati e economics. It is based on beliefs or value judgements about what should happen,
about hat is good or bad, about hat is right or rong. It is used in making economic policies.
Examples include the following:
The unemployment rate should be lower is a statement based on a belief or value that high
unemployment is not a good thing.
Health care should be available free of charge is a statement about a value that everyone in a
society should have access to free health care.
The government should spend more money on building schools is a policy recommendation
about what the government should do.
See Table 1.3 for more examples of positive and normative economics. Note that statements in positive
economics may be factually correct or they may be false. For example, we may say that the
unemployment rate is 5%; if the unemployment rate is 5%, this statement is correct; but if the
unemployment rate is actually 7%, the statement is false.
Statements in normative economics, by contrast, cannot be true or false. They can only be assessed
relative to beliefs and alue judgements. Consider the normative statement the unemployment rate
should be lower . We cannot say whether this statement is true or false, though we may agree or disagree
with it, depending on our beliefs about unemployment. If we believe that the present unemployment rate
is too high, then we will agree; but if we believe that the present unemployment rate is not too high, then
we will disagree.
P N
Incomes have fallen by 7%. Incomes should be increased.
Free university education will increase There should be free university education.
government spending by 3%.
Income inequality is increasing. Income inequality has increased too much.
Women are often paid less than men for the same Women and men should receive equal pay for the
work. same work.
Higher taxes will result in lower disposable Taxes are too low and should be increased.
incomes.
T 1.3: More examples of positive and normative economics

1 Which of the following are positive statements and which are normative?
It is raining today.
It is too humid today.
Economics is a study of choices.
Economics should be concerned with how to reduce poverty.
If household saving increases, there will be a fall in household spending.
Households save too little of their income.
2 Explain the importance of making a distinction between positive and normative statements in
economics.
T
In economics, as in other social (and natural) sciences, our efforts to gain knowledge about the world
involve the formulation of hypotheses, theories, laws and models. All of these are based on the use of
logic. All of these lie within the realm of positive economics.
T
As we have seen above, positive economics involves thinking about the economic world in order to try
to describe, explain or make predictions about economic events. Positive economic thinking is used to
describe and explain in a systematic way why economics events happen the way they do, and attempts to
predict economic events that are likely to occur in the future.
This type of thinking is based on the use of , a Greek word ( or logiki) which means reason. It is
a method of reasoning, which involves making a series of statements each of which is true if the
preceding statements are true. For example:
1 When it rains there are clouds in the sky.
2 It is now raining.
3 Therefore there are clouds in the sky.
The truth of the third statement is based on the truth of the previous statements. Therefore, we can say
that the third statement is logical, as it is based on logic.
Economists use logical thinking to acquire knowledge of the economic world. Since economics is a
social science, economists acquire knowledge by use of the scientific method (you may already be
familiar with this from your study of the natural sciences like physics, biology and chemistry). The
scientific method is based on the use of logic.
T
A is an educated guess, usually indicating a cause-and-effect relationship about an event.
Hypotheses are often stated as: if . . ., then . . .
In order to formulate a hypothesis, economists make observations of the world around them and identify
a question they would like to answer. Let s consider an example from economics. We observe that
people living in the city of Olemoo buy different amounts of oranges per week at different times in the
year. We want to answer the question: why are more oranges bought in some weeks and fewer in others?
We then identify variables that we think are important to answer the question. A variable is any measure
that can take on different values, such as temperature, or weight or distance. In this example, the
variables we choose to study are the quantity of oranges that residents of Olemoo buy each week, and the
price of oranges.
Our next step is to make a h pothesis about how the variables are related to each other. We have seen
that a hypothesis is an educated guess about an if . . . then . . . relationship. Our hypothesis is the
following: if the price of oranges increases, he the quantit of oranges Olemooans ant to bu each
eek ill fall. Notice that this hypothesis indicates a cause-and-effect relationship, where price is the
cause and the quantity of oranges bought is the effect . The hypothesis also involves a prediction,
because it claims that changes in the price of oranges will lead to a particular change in the quantity of
oranges Olemooans buy.
T
If our hypothesis is to make sense, we need to also make assumptions. An assumption is a statement that
is supposed to be true for the purposes of building the hypothesis. In our example, an important
assumption is this: the price of oranges is the only variable that influences the quantity of oranges that
Olemooans want to buy, while all other variables that could have influenced their buying choices do not
play a role. This is called the ceteris paribus assumption. Ceteris paribus is a Latin expression that
means other things equal . Another way of saying this is that all other things are assumed to be constant
or unchanging.
Why is this assumption important? Our hypothesis stated that the quantity of oranges that will be bought
is determined by their price. Surely, however, price cannot be the only variable that influences how many
oranges Olemooans want to buy. What if the population of Olemoo increases? What if the incomes of
Olemooans increase? And what if an advertising campaign proclaiming the health benefits of eating
oranges influences the tastes of Olemooans? As a result of any or all these factors, Olemooans will want
to buy more oranges.
This complicates our analysis, because if all these variables change at the same time, we have no way of
knowing what effect each one of them individually has on the quantity people want to buy. We want to
be able to isolate the effects of each one of these variables; to test our hypothesis we specifically wanted
to study the effects of the price of oranges alone. This means we have to make the assumption that all
other things that could affect the relationship we are studying must be constant, or unchanging.
More formally, we would say that we are examining the effect of orange prices on the quantity of
oranges people want to buy, ceteris paribus. This means simply that we are studying the relationship
between prices and quantity on the assumption that nothing else happens that can influence this
relationship. By eliminating all other possible interferences, we isolate the impact of price on quantity, so
we can study it alone.
In the real world all variables are likely to be changing at the same time. The ceteris paribus assumption
does not say anything about what happens in the real world. It is simply a tool used by economists to
construct hypotheses, models and theories, thus allowing us to isolate and study the effects of one
variable at a time. We will be making extensive use of the ceteris paribus assumption in our study of
economics.
T
Now we are in a position to test our hypothesis to see if its predictions fit with what actually happens in
the real world. To do this, we compare the predictions of the hypothesis with real-world events, based on
. Empirical evidence refers to real-world information, observations and data that we
acquire through our senses and experience (empirical comes from the Greek word or empeir a
meaning experience).
Here, the methods of economics differ from those of the natural sciences. Whereas in the natural
sciences it is often (though not always) possible to perform experiments to test hypotheses, in economics
the possibilities for experiments are very limited. Economists therefore rely on a branch of statistics
called econometrics to test hypotheses. This involves collecting data on the variables in the hypothesis,
and examining whether the data fit the relationships stated in the hypothesis. In our example, we must
collect data on the quantity of oranges bought by Olemoo s residents during different weeks throughout
the year, and compare these quantities with different orange prices at different times in the year.
(Econometrics is usually studied at university level, and is not part of IB requirements.)
We are now in a position to compare the predictions of our hypothesis with real-world outcomes. If the
data did not fit the predictions of the hypothesis, the hypothesis would be rejected, and the search for a
new hypothesis would begin. In our example, this would happen if we discovered that as the price of
oranges increases, the quantity of oranges Olemooans want to buy each week also increases. Clearly, this
would go against our hypothesis, and we would have to reject the hypothesis as invalid. If, on the other
hand, the data fit the predictions, the hypothesis would be accepted. In our example, this would occur if
our data show that as the price of oranges increases, Olemoo s residents buy fewer oranges. We can
therefore conclude that according to the evidence, our hypothesis is a valid one.
T
We have seen that a hypothesis is an educated guess about a cause-and-effect relationship in a single
event. A is a general explanation of a set of interrelated events, usually (though not always) based
on several hypotheses that have been tested successfully (in other words, they have not been refuted, or
disproven, based on evidence; see the discussion below on refutation). A theory is a generalisation about
the real world that attempts to organise complex and interrelated events and present them in a systematic
and coherent way to explain h these events happen. Based on their ability to systematically explain
events, theories attempt to make predictions.
Referring to the example of oranges, the relationship between the price of oranges and the quantity of
oranges residents of Olemoo buy at each price was a hypothesis. This kind of hypothesis has been
successfully tested a great many times for many different goods, and the data support the presence in the
real world of such a relationship. However, this relationship is not a theory, because it only shows how
two variables relate to each other, and does not explain anything about h buyers behave the way they
do when they make decisions to buy something.
To explain this relationship in a general way, economists have developed utility theory and
indifference curve analysis based on a more complicated analysis involving more variables,
assumptions and interrelationships. These theories try to answer the question as to h people behave in
ways that make the observed relationship between price and quantity a valid one. (Utility theory will be
examined at HL in Chapter 2).
T
A la , in contrast to a theory, is a statement that describes an event in a concise way, and is supposed to
have universal validity; in other words, to be valid at all times and in all places. Laws are based on
theories and are known to be valid in the sense that they have been successfully tested very many times.
They are often used in practical applications and in the development of further theories because of their
great predictive powers. However, laws are much simpler than theories, and do not try to explain events
the way theories do.
For example, the simple relationship between the quantity of a good that people want to buy and its
price, while not a theory, has the status of one of the most important la s of economics: it is the la of
demand. This law is a statement describing an event in a simple way. It has great predictive powers and
is used as a building block for very many complex theories. We will study the law of demand in detail in
Chapter 2 and we will use it repeatedly throughout this book in numerous applications, and as a building
block for many theories.
T
In your study of economics, you will encounter many theories and some laws. Your study of both
theories and laws will make great use of economic models. Models are sometimes used to illustrate
theories (or laws) and sometimes to describe the connections between variables.
Whereas sciences like biology, chemistry and physics offer the possibility to construct three-dimensional
models (as with molecules and atoms), this cannot be done in the social sciences, because these are
concerned with human society and social relationships. In economics, models are often illustrated by use
of diagrams showing the relationships between important variables. In more advanced economics,
models are illustrated by use of mathematical equations. (Note that both diagrams and mathematical
equations are used to represent models in natural sciences, such as physics, as well.)
Models are often closely related to theories, as well as to laws. A theory tries to explain h certain
events happen and to make predictions. A law is a concise statement of an event that is supposed to have
universal validity. Models are often built on the basis of well- established theories or laws, in which case
they may illustrate, through diagrams or mathematical equations, the important features of the theory or
law. When this happens, economists use the terms model and theory interchangeably because in
effect they refer to one and the same thing. For example, in Chapter 9, different models of the
macroeconomy will be used to illustrate alternative theories of income and output determination.
However, models are not always representations of theories. In some cases, economists use models to
isolate important aspects of the real world and show connections between variables but without any
explanations as to h the variables are connected in some particular way. In such cases, models are
purely descriptive; in other words, they describe a situation without explaining anything about it. For
example, the production possibilities curve model presented above in Section 1.3 is a simple model that
is very important because of its ability to describe scarcity, choice and opportunity cost. Similarly, the
circular flow of income model, also presented in Section 1.3, describes how decision-makers are related
to each other in the economy and introduces the concepts of output, income and spending. In the case of
both models, there is no theory or explanation involved.
Yet descriptive models that are not based on a theory are in no way less important than models that
illustrate a theory. Both kinds of models are very effective as tools used by economists to highlight and
understand important relationships and phenomena in the economic world. In our study of economics,
we will encounter a variety of economic models and will make extensive use of diagrams.
T
The concept of is very important in economics (as in any social science or science). To refute
something means to contradict it, disprove it or show it to be false. Refutation in the sciences and social
sciences is the idea that it must be possible to refute or dispro e a hypothesis or a theory. It must be
possible to subject it to empirical testing, where the data or empirical observations can disprove it if it is
false or invalid. In other words, if a hypothesis or theory cannot be refuted or disproven by empirical
testing, then it is not scientific. Refutation is also known as falsifiabilit , because if something is refuted,
it is falsified, in other words it is shown to be false.
You may note that our hypothesis about Olemooans is refutable or falsifiable. The hypothesis is if the
price of oranges increases, then the quantity of oranges Olemooans want to buy each week will fall . We
could collect data on quantities and prices of oranges, and if the data do not fit the hypothesis, the
hypothesis would be refuted, in other words it would be falsified or disproven.

1 The relationships between hypotheses, theories, laws and models described here apply generally
to all the social sciences and sciences based on the scientific method. Yet they may differ
between disciplines in the ways they are used and interpreted. As you study economics, you may
want to think about the following: How are theories and laws used in economics as compared
with other disciplines? Do they play the same role? Are they derived in the same ways? Do they
have the same meaning?
2 Explain the scientific method. Outline the steps it involves.
3 Distinguish between hypotheses, theories, laws and models.
4 Explain why it is important to compare the predictions of a hypothesis with real-world
outcomes.
Explain the role of empirical evidence and refutation in the scientific method.
5 Describe how models help economists in their work as social scientists.
6 Consider the statement, If you increase your consumption of calories, you will put on weight.
Explain why this statement is not necessarily true.
Rephrase the statement to make it more accurate. (Hint: What might happen to your weight
if at the same time that you consume more calories you also began an intensive exercise
programme?)
THEOR OF KNO LEDGE 1.1

R ,
We have seen how hypotheses are tested using the scientific method. If the data support the
predictions of a hypothesis, the hypothesis is accepted. However, this does not make the hypothesis
necessarily true . The only knowledge we have gained is that according to the data used, the
h pothesis is not false. There is always a possibility that as testing methods are improved and as new
and possibly more accurate data are used, a hypothesis that earlier had been accepted now is rejected
as false. Therefore, no matter how many times a hypothesis is tested, we can never be sure that it is
true .
But by the same logic, we can never be sure that a hypothesis that is rejected is necessarily false. It is
possible that our hypothesis testing, maybe because of poor data or poor testing methods, incorrectly
rejected a hypothesis. Testing of the same hypothesis with different methods or data could show that
the hypothesis had been wrongly rejected.
If our results from hypothesis testing are subject to so many uncertainties, how can economic
knowledge about the world develop and progress? Economists and other social and natural scientists
work with h potheses that ha e been tested and not refuted (not falsified or disproven). While the
possibility exists that the hypotheses may be false, they use these hypotheses on the assumption that
they are not false. As more and more testing is done, and as unfalsified hypotheses accumulate, it
becomes more and more likely that they are not false, though e can ne er be sure.
This way, it is possible to accumulate knowledge about the world, however, this is done on the
understanding that this knowledge is tentative and provisional; in other words, it can never be proven
to be true.
T
Is it possible to ever arrive at the truth of a statement about the real world based on empirical
testing?
Even assuming that testing methods could be perfected and data vastly improved, can there ever
be complete certainty about our knowledge of the social (and natural) worlds?
T
V -
It was noted earlier that normative economics is based on beliefs and alue judgements about what
should happen, about what is good or bad, or about what is right or wrong. Value judgements are
opinions; they are subjective judgements rather than factual statements.
Note that statements based on normative economics are not refutable or falsifiable. They cannot be
shown to be false. One can only agree or disagree with them depending on one s own beliefs and value
judgements.
Value judgements in normative economics are important for economic policy-making. They identify the
important economic problems that should be addressed and recommend policies to solve them.
Economic policies are government actions that try to solve economic problems. Examples of economic
policies are government actions to lower unemployment, lower inflation, protect the environment,
improve the quality of education, reduce levels of poverty, provide free health care services and many
more. When a government makes a policy to lower unemployment (the number of people who are
looking for work but can t find a job), this is based on the value judgement that high unemployment is
not a good thing. If a government pursues a policy to make health care available to everyone free of
charge, this is based on a value judgement that people should not have to pay for receiving health care
services.
Positive economics and normative economics, while distinct, often work together. To be successful, an
economic policy aimed at lowering unemployment (the normative dimension) must be based on a body
of economic knowledge about what causes unemployment (the positive dimension). The positive
dimension can provide guidance to policy-makers on how to achieve their economic goals.
P is the study of economics based on the scientific method, used to arrive at

knowledge about the economic world. It includes descriptions, models, hypotheses, theories and laws.
N forms the basis of judgements about what economic goals and economic
policies ought to be. It is based on value judgements, because it identifies important economic
problems that should be addressed and prescribes what should be done to solve them.
E
An important concept from normative economics that you will encounter in this book is equit , which
refers to the idea of being fair or just. The idea of equity, or fairness is a normative concept because
fairness depends on people s beliefs or value judgements, which differ from person to person.
Equalit , on the other hand, is the state of being equal with respect to something. For example, equality
with respect to income would mean that each member of a society receives exactly the same income.
Equality is a positive concept, since two or more things are either equal or not equal based on a measure.
The idea of equality in income distribution may or may not be equitable, depending on how equity is
interpreted. If it is believed that income distribution is equitable or fair if income is distributed equally,
then equity in income distribution means income equality. However, if it is believed that it is equitable or
fair for people s income to be in proportion to their work effort (a different equity principle), this would
give rise to income inequality, since not everyone s work effort is the same.
In spite of different possible interpretations of the meaning of equity, in most countries around the world,
the pursuit of equity is usually interpreted to refer to government policies that try to reduce inequalities
in income, wealth and opportunity. This is because of the widely shared belief or value judgement that
the free market without government intervention results in highly unequal income and wealth
distributions that are considered to be unfair. For this reason, we often find writers referring to a more
equitable or more equal distribution of income or wealth to mean the same thing. Both expressions are
correct, provided it is understood that in these cases, equit in income distribution is interpreted as
greater equalit (or less inequalit ).
E means fairness while means being the same. While the two concepts have different
meanings, in economics is most often interpreted to mean , while equity is
interpreted to mean equality.
Note that the pursuit of equity in the sense of equality does not refer to efforts to achieve complete
income or wealth equality, but rather the reduction of inequalities that are considered to be unfair.
You should also note that the ideas of equity and equality in distribution involve answers to the for hom
to produce basic question of economics (see Section 1.2). The other two questions, hat/ho much to
produce and ho to produce are answered by use of positive economics.

1 Suppose the government of Country X implements a series of policies to reduce income
inequalities. Identify possible value judgements that may have led to this policy.
2 Distinguish between equity and equality.

?
As you will discover in the course of reading this book, there are many areas of economic theory as
well as policy on which there are major disagreements and debates among economists. Why do
economists disagree so much? It would seem that use of the scientific method in economics, by
forcing hypotheses to undergo tests, and allowing the real-world evidence to sift through valid and
invalid hypotheses, would eliminate much disagreement. Why do economists continue to disagree in
spite of their use of the scientific method? To try to answer this question, we should consider the point
mentioned earlier on the difficulties of testing hypotheses due to the inability of economists to
perform controlled experiments.
The scientific method, as we have seen, involves relating evidence to educated guesses about cause-
and- effect relationships between variables to see if they match. Economists face some difficulties in
this effort. First, the inability to perform controlled experiments means that economists collect data
about real-world events that are the result of many variables changing at the same time. To test
hypotheses, economists devise complicated econometric models that try to isolate the interfering
effects of numerous variables, and try to link causes with effects. Sometimes, economists have to deal
with incomplete or unreliable real-world data. In some cases, they may even be faced with variables
that are not measurable and have no data, in which case they must use substitute variables (called
proxy variables) or substitute relationships between variables. As a result of these difficulties, it is
not unusual for two or more economists to be testing the same hypothesis and to come up with
conflicting results.
For all these reasons, while the testing methods of economists do produce some useful results, these
are sometimes not as accurate and as reliable as the results of experiments in other disciplines
performed under controlled conditions. This means it may be more difficult for hypothesis testing in
economics to refute (reject) invalid hypotheses. If the evidence does not reject a hypothesis,
economists hold on to it and may continue to use it in their work (possibly until further testing in the
future). However, this does not mean that the hypothesis is a valid one. It may be invalid, but the
evidence just has not been discriminating enough to reject it. This has important implications for
economics. It means that there may be several conflicting hypotheses that economists are holding on
to and working with, not all of hich are alid h potheses, and some of which may be false.
Moreover, economists may use these hypotheses to build theories. A theory was described earlier as
being based on several hypotheses that have not been rejected, based on evidence. This means it is
possible to have theories built on invalid hypotheses, which simply have not (yet) been shown to be
invalid. But if the hypotheses on which theories are built are invalid, then surely the theories
themselves are also invalid. This explains one possible reason why we sometimes see several
conflicting theories being used at the same time. Maybe only one of them (or even none of them) is
valid. Whatever the case, as economists usually prefer to support one theory over another, this may be
an important reason why they sometimes disagree.
As we will see in Theory of knowledge 9.1 (Chapter 9), the inability of empirical evidence to
effectively discriminate between competing theories allows much room for value judgements and
ideologies to enter into one s individual preference for one economic theory over another.
T
As you read this book and learn more about economics, you may want to keep the following questions
in mind:
Can you think of other possible reasons why economists often disagree?
What other social sciences/sciences cannot test hypotheses by performing controlled
experiments?
Do you think economists disagree more or less than (or the same as) other social and natural
scientists?
Do you think the difficulties of economics are due to its being a young social science that will
slowly mature and resolve these difficulties as econometric methods and the quality of data
improve? Or are they due to problems that are inherent in the nature of the subject and therefore
cannot be easily resolved?
Do you think these difficulties seriously affect the progress and development of new economic
knowledge? Or can economics continue to progress in spite of these difficulties?
1.5 A :
LEARNING OBJEC I ES

e plain the major schools of thought from the 18th centur to the present: (AO2)
18 :
Adam Smith and laisse faire
19 :
utilit theor in classical microeconomics
the concept of the margin
Sa s La in classical macroeconomics
the Mar ist critique of classical economics
20 :
the Ke nesian revolution
the emergence of macroeconomic polic
the monetarist/ne classical counter-revolution
21 :
behavioural economics and the dialogue ith ps cholog
gro ing a areness of the interdependence bet een the econom , societ and the
environment, and the need to move to ard a circular econom
The histor of economic thought is a fascinating account of ho economic ideas have evolved over the
ears. Man of the economic ideas and theories ou ill learn about in our stud of economics can be
traced back to the contributions of famous economists ho lived and orked decades, and even
centuries, ago. Although economic thinking has developed and progressed over time, leading to a deeper
understanding of economic events, man of these contributions still lie at the heart of economics that e
stud toda .
I i gl ec mme ded ha ead hi ec i agai af e c m le i g he e f hi b k. It is
onl then that ou ill be able to appreciate the richness of the ideas of these famous economists,
because onl then ill ou be able to recognise in their ork our o n understanding of economics.
Until about the 18th centur , there ere no distinct disciplines as e kno them toda . Investigation of
events and phenomena in the social orld ere part of hat as kno n as m al hil h , hile
investigation of events and phenomena in the natural orld ere part of hat as kno n as a al
hil h .
In the area of hat e no kno as ec mic , scholars and philosophers since the time of the ancient
Greeks, t o and a half thousand ears ago, have concerned themselves ith ideas that tr to e plain
economic events, but no one had attempted to provide a theor e plaining the econom in a s stematic
a . The first scholar to do this as Adam Smith.
18 :A S
F 1.7: Adam Smith, Scottish philosopher and political economist, often considered to be the
Father of Economics , author of A I i i he Na e a d Ca e f he Weal h f Na i (the
Weal h f Na i for short)
A S (1723 1790) as a Scottish philosopher ho is often referred to as the Fa he f

Ec mic . Adam Smith studied moral philosoph at the Universit of Glasgo and at O ford
Universit , eventuall ending up back at the Universit of Glasgo , here he taught moral philosoph .
He is best kno n for the ideas e pressed in his book The Weal h f Na i ,5 published in 1776.
The Weal h f Na i is considered to be a masterpiece that has influenced economics for generations
up to the present da . Although it borro s heavil from the ideas of various scholars of the time, it
represents the first attempt ever to set forth a comprehensive theor of ho an econom can hold itself
together, functioning in a harmonious a , and ho such an econom can gro over time.
Adam Smith lived at a time hen the traditional rights of rulers to impose authoritarian controls and
restrictions on their subjects in Europe as coming more and more under attack. Smith believed that
strong, repressive governments ere not essential to the orkings of an econom . He therefore set out to
sho ho an economic s stem ithout government could not merel function, but could moreover
thrive and prosper to the great benefit of its citi ens.
In this task, Smith borro ed heavil from the ideas of the natural la s set forth b Isaac Ne ton (1642
1727), the great mathematician, ph sicist, astronomer and theologian. Just as Ne ton discovered natural
la s that govern the ph sical orld ith harmonious regularit , so Smith believed he as uncovering
the natural la s of the social orld that govern economic relations ith that same regularit .
Smith begins ith the idea of a market and the behaviour of individuals in a market that ill produce
beneficial results for the hole of societ . He sho s ith painstaking detail and numerous e amples in
The Weal h f Na i that if individuals behave in a self-interested a , so that each person tries to do
the best for herself or himself, there ill result a greater good for societ . In a famous quote from The
Weal h f Na i , Smith rites:
I i f m he be e le ce f he b che , he b e e , he bake , ha e e ec di e , b
f m hei ega d hei i ee .
Such behaviour gives rise to c m e i i , hich regulates the behaviour of people acting in their self-
interest. Competition is ver important because it keeps people s self-interest in check. Suppose, for
e ample, that a producer of shoes raises price to a high level e pecting more personal gain. Other
producers of shoes ho also ant to sell their products ill sell them at a lo er price, so the high-price
seller ill be forced to lo er the price. This process continues until the price of shoes falls to the lo est
possible level.
Similarl , competition ill lead to the production of those goods and services that are mostl anted,
because self-interest ill lead producers to make those goods that the ill be able to sell. In the same
a , occupations that are difficult or dangerous ill command higher ages because orkers ill onl
be illing to take on such jobs if the ages are high enough to compensate them for the hard ork and
risks.
These ideas gave rise to the famous e pression the i i ible ha d f ma ke , hich refers to the
presence of thousands or millions of individual decisions made b individual decision-makers that are
self-regulated through interactions in markets, ithout the presence of a government deciding hat/ho
much to produce. The invisible hand results in a more efficient use of resources.
This is also kno n as a econom (from French, meaning le i d ) hich refers to a free
market ithout government intervention. It is not necessar to have a government telling people hat to
do or ho to do it, because the market orking on its o n can do a much better job of this.
Ho ever, Adam Smith did foresee a role for government as ell. Governments in his vie have three
important functions: to take care of national defence, to oversee securit and a s stem of justice, and to
provide public infrastructure (roads, bridges, canals and so on), hich are essential to the proper
functioning of an econom and therefore should be financed from ta ation.
The idea of competition, being central to Smith s ideas, as carried further. Smith as ver concerned
about the possible gro th of firms to become large corporations or monopolies, hich ould restrict
competition. He as keenl a are of the po er of large firms to raise the prices to high levels and keep
them there due to the absence of competition. As he rote:
The ice f m l i e e cca i he highe hich ca be g . The a al ice,
he ice f f ee c m e i i , he c a , i he l e hich ca be ake .
Smith believed that competition ould ensure that monopolies and large corporations ill not be able to
arise.
The Weal h f Na i also presents a theor of economic gro th. Economic gro th is seen to depend on
the division of labour (the separation of processes into man different tasks, each one performed b
different orkers) hich permits eciali a i of labour to take place. Specialisation of labour involves
the pursuit b orkers of a particular task involving skills appropriate to the task in question. If orkers
specialise in particular activities that the can perform best, then more output ill be produced and this
ill lead to economic gro th.
Smith e tended the idea of specialisation be ond hat takes place ithin countries to international trade
bet een countries. He is responsible for the idea of ab l e ad a age of a countr in international
trade. According to this idea if each countr produces the goods it can produce at the lo est cost and
trades them for goods produced at a lo er cost in other countries, then all the countries involved ill be
better off. Therefore, Adam Smith as an advocate of free trade (trade ithout restrictions). The theor
of absolute advantage ill be discussed in Chapter 14 (at HL onl ).
Whereas Smith rote that self-interested behaviour leads to the beneficial invisible hand of the market,
he did not rite that people s actions are determined onl b self-interest. In an earlier book, The The
f M al Se ime (1759), Smith argued that people have the abilit to put themselves in the position
of another person, in other ords to empathise. This makes them behave in a s that create happiness
for other people, because doing so gives them pleasure. This is important because in later ears Smith s
ideas ere misinterpreted to mean that people behave onl selfishl and ith greed.
The concepts of demand, suppl and markets that ou ill read about in Chapter 2 are e tensions and
elaborations of Adam Smith s thinking.
Adam Smith is best kno n for the idea that the self-interested behaviour of decision-makers ithout
government intervention results in competitive markets that give rise to a more efficient use of
resources and greater output, thus benefitting societ . This is kno n as the i i ible ha d f he
ma ke .
19
The economic ideas that developed during the 19th centur are kno n as .
Economic thinking as modified and refined considerabl since the time of Adam Smith. The main
economists of the time ere concerned ith issues like the process of economic gro th and the
distribution of income. A number of scholars made important contributions, such as David Ricardo ( ho
e ill encounter in Chapter 14), and Jerem Bentham and John Stuart Mill ho e ill briefl discuss
belo .
Jerem Bentham (1748 1832) and John Stuart Mill (1806 1873) ere British philosophers ho also
made contributions to economics. Jerem Bentham as the founder of ili a ia i m, a philosoph of
ethics (a philosoph about hat is right and rong) hich taught that an action is right if it promotes the
most happiness for the largest number of people. Bentham s theor of ethics is based on the idea that:
i i he g ea e ha i e f he g ea e mbe ha i he mea e f igh a d g.
Therefore actions are right or rong according to the consequences the have on the happiness of other
people.
John Stuart Mill furthered Bentham s ideas b blending them ith human rights, including the rights of
minorities and omen. He as a fervent believer in human freedom and as opposed to forcing people
to do things against their ill. Mill s theor of ethics can be summarised in his statement that:
ac i a e igh i i a he e d m e ha i e , g a he e d d ce he
e e e f ha i e .
The idea of the greatest happiness is based on the concept of ili , hich Bentham defined to be:
ha e i a bjec , he eb i e d d ce be efi , ad a age, lea e, g d,
ha i e . . . . . . e e he ha e i g f mi chief, ai , e il, ha i e .
Similarl , Mill defines happiness as pleasure and the absence of pain.
Utilit , the central concept in the philosoph of ethics of utilitarianism, evolved to become a central
concept of economics that underlies economic theories up to the present da .
Classical economists developed the philosoph of ethics kno n as ili a ia i m, according to hich
an action is right if it promotes the most happiness for the largest number of people.
Classical economists ere concerned about the concept of al e, specificall hat gives things their
value and hat determines their price. One theor that as popular at the time as the labour theor of
value, according to hich the price of a good as determined b the quantit of labour that as
necessar to produce it.
It so happened that three economists, orking independentl of each other, came to use the concept of
ili in order to arrive at a theor of ho prices are determined. The ere Stanle Jevons (English,
1835 1882), Carl Menger (Austrian, 1840 1921) and L on Walras (French, 1834 1910). Although the
differed idel in the methods the used, the all agreed on t o fundamental points:
the concept of ili , or satisfaction or pleasure derived from consuming something, is central to an
idea of value that helps determine prices, and
hat matters is not the total utilit of consuming something but rather the e a or addi i al utilit
of consuming one more unit of the good, kno n as ma gi al ili .
Suppose that utilit can be measured in units of il (imaginar units that measure satisfaction).
According to Amandla s tastes and preferences, eating one ice cream provides her ith 5 utils of
satisfaction. If she eats a second one, she receives a total utilit for the t o ice creams of 9 utils; her total
utilit has increased b onl 4 utils because she enjo ed the second ice cream less than the first. Hence,
her marginal utilit is 4 utils. As she enjo s each successive ice cream less than the previous one, her
marginal utilit keeps falling.
Some ears later, in the earl part of the 20th centur , Alfred Marshall (English, 1842 1924) used these
ideas to come up ith the la of demand and the demand curve that e are familiar ith toda . If
Amandla gets less and less marginal utilit from consuming more ice creams, she ill onl be illing to
bu more if their price falls, hence the la of demand. The entire anal sis of demand and suppl and
market equilibrium that e stud toda is attributable to Alfred Marshall.
The concept of ma gi al is ver important in economics. It ill be encountered several times (Chapters
2 and 7, at HL onl ).
In the 19th centur , the concept of , underl ing utilitarianism, referring to the satisfaction
derived from consuming something, as combined ith the concept of , meaning e tra or
additional, leading eventuall to as the basis of a theor of value that determines
prices of goods and services. It forms the basis of rational consumer behaviour that is used to the
present da in microeconomics.
S
Whereas e refer here to classical microeconomics and macroeconomics, these terms did not e ist at the
time, as there as no distinction during the 19th centur bet een the micro and macro levels of anal sis.
As e ill see belo , macroeconomics as a distinct branch of economics as born in the 20th centur .
The classical economists of the 19th centur believed that the problem of unemplo ment could not arise
under normal circumstances. While there could be occasional disturbances in an econom due to such
events as ars, droughts or other major disruptions, ordinaril unemplo ment could not arise for
e tended periods because it as thought that the econom ould keep on producing as much as is
required in order to keep orkers full emplo ed.
This idea came to be kno n as Sa La , after the French economist Jean-Baptiste Sa (1767 1832).
Sa as strongl influenced b Adam Smith, and as an advocate of free markets and laisse faire. The
la that as named after him stated ver simpl that l c ea e i dema d. What this means is
that overall spending in an econom cannot fall enough to prevent all the output produced from being
bought.
We can see hat this means ver clearl b e amining the circular flo of income model presented in
Section 1.3. Firms produce goods and services, and the pa households for providing them ith the
resources. The households receive this income and spend it to bu the goods and services. Therefore
l c ea e i dema d; the output that firms produce provides households ith the income the
need to bu that output. Therefore, orkers ill keep on orking to produce that output and there ill
be full emplo ment.
This simple idea came to be ver seriousl questioned during the Great Depression of the 1930s, hich
sa falling output and ver high unemplo ment rates in man countries. These events gave rise to the
birth of macroeconomics as a distinct branch of economics and the development of ne theories to
e plain unemplo ment.
According to S L , suppl creates its o n demand, a theor that claims that the econom tends
to ard full emplo ment in the absence of an government intervention.
F 1.8: Karl Mar , German philosopher and political economist, hose theories formed the basis
of modern communism, author of Ca i al: C i i e f P li ical Ec m (Da Ka i al for short)
K M (1818 1883) as a German philosopher ho had a profound influence on the course of

global events during the 20th centur , as man of his ideas formed the ideological basis for the
establishment of communist regimes around the orld. In addition to being a philosopher, Mar as an
economist, historian, political theorist, sociologist and linguist.
Mar produced a huge amount of ritten ork but perhaps the best kno n is his book Ca i al: C i i e
f P li ical Ec m (for short Da Ka i al in German, 1867), hich as ritten over eighteen ears. In
this book, Mar presented hat he considered to be a scientific account of the la s of capitalist
development, hich ould eventuall result in the do nfall of capitalism. (Ca i ali m is the free market
s stem, based on private o nership of the means of production, and driven b the desire to make
profits.)
Mar s anal sis is based on a version of the labour theor of value, hich as noted earlier as the
standard e planation of value in the 19th centur , until the appearance of marginal anal sis. The value of
a good as determined b the amount of labour that as used to produce it. Ho ever, Mar observed
that the price actuall paid for a good as usuall far greater than the value of labour that as put into
producing it, measured b the ages paid to labour. The difference bet een the t o, or the price of the
good minus the value of labour to produce it, as termed l al e b Mar , and corresponded to
profit made b the o ners of the factories.
Surplus value represented e ploitation of orkers b the o ners of factories. The factor o ners had an
incentive to pa orkers as little as possible, forcing them to ork under appalling conditions, so that
the could make the surplus value and hence their profits as large as possible. It is be ond doubt that
conditions in 19th centur factories in England, here Mar as living at the time, ere trul appalling,
as the ritings of authors such as Charles Dickens clearl sho .
As a historian, Mar sa economic s stems being transformed over time in a particular order. Feudalism
had been replaced b capitalism, and according to the historical la s he claimed to have discovered,
capitalism as going to be replaced in the future b communism. This ould happen because of the
innate instabilit of capitalism. Competition ould force capitalists (the o ners of factories) to keep
investing in ne machiner in order to reduce labour costs and hence beat their competitors. But b
using machines in place of labour, the capitalists ould reduce the surplus value of labour that gave rise
to their profits. Therefore the result ould be declining profits for the capitalists.
At the same time that capitalists profits ere e pected to fall, orkers ould become increasingl
unemplo ed and povert -stricken as the ere replaced b more machines. Workers ere e pected to
become more and more pitted against capitalists. The capitalist s stem ould eventuall be overthro n,
to be replaced b communism here the means of production (the factories) ould be o ned
collectivel b the people.
Mar did not at an time describe his visions of communism in a s stematic a , but it is clear from his
ritings that the s stems that came into being in the 20th centur ere not based on his ideas. His
predictions have not materialised, since capitalist profits do not appear to be falling. While capitalism
does periodicall undergo crises, such as the Great Depression of the 1930s and the global financial
crisis of 2008, it does not appear to be on the verge of collapse. The communist s stems that came into
being in the 20th centur ere not the result of capitalism s collapse, but rather the result of force.
Yet Mar continues to be highl influential because he had keen insights into the orkings of capitalism
hich are still highl relevant toda . These include the recurrence of crises, hich is similar to hat is
kno n toda as the business c cle, the impoverishment of the middle class as income inequalities gro
rapidl , the lack of gro th in real ages over decades in man developed countries (related to the
gro th in income inequalities), increasing job insecurities and the risks of gro ing unemplo ment due
to rapid technological change. Moreover, Mar has had a profound influence in other social sciences,
including sociolog , anthropolog and political science.
Karl Mar is still idel read toda , and there has been a gro ing interest in his ork since the onset of
the global financial crisis in 2008. Interestingl , a search on Ama on UK ields more results for Karl
Mar than for Adam Smith.
Karl Mar developed a theor according to hich ca i ali m ld be e e all e laced b

c mm i m because of the market s stem s internal contradictions that ould lead to its collapse.
While this has not materialised, Mar is still highl regarded for his numerous insights into ho
capitalism orks.
20
K
F 1.9: John Ma nard Ke nes, British economist, hose theories replaced classical economics,
author of The General Theor of Emplo ment, Interest and Mone (The Ge e al The for short)
It as noted earlier that in the 19th centur , it as believed that, in accordance ith Sa s La , suppl
creates its o n demand. In this a of thinking, it as not possible to have e tended periods of
unemplo ment. Therefore hen the Great Depression of the 1930s occurred, bringing ith it ver
significant declines in output along ith high unemplo ment in man countries, economists ere at a
loss to e plain ho this had occurred.
J M K (1883 1946), an e tremel influential British economist, set forth an economic
theor that entirel replaced the classical theor and Sa s La . Ke nes is best kno n for his book The
Ge e al The f Em l me , I e e a d M e (for short, The Ge e al The , 1936).
Ke nes argued that the state of full emplo ment in an econom as onl a special case that could not
occur all the time. If spending decreased, there as nothing to ensure that an econom ould return to a
situation of full emplo ment on its o n. Classical economists thought that if overall demand decreased
and there as a fall in spending, then prices ill fall, hich ill cause spending to increase again, so
output and emplo ment ill once again go to the full emplo ment level. Also, classical economists
thought that if there as a decrease in spending so that output fell, then there ould be some temporar
unemplo ment that ould cause ages to fall, making emplo ers increase the number of orkers the
hire. This ould also bring emplo ment back up to the full emplo ment level once again.
But according to Ke nes, ages ere stick , meaning the could not fall easil . In addition, falling
ages meant that orkers ould have less mone to spend, hich ould cause overall demand and
spending to fall further. But stick ages meant stick prices, because producers could not lo er their
prices if the had to go on pa ing the same levels of ages. As a result, the economic s stem could not
on its o n go back to full emplo ment.
Ke nes argued that a situation like this requires government intervention in the form of increased
government spending, hich ould give the econom the push it needed to get it going again. Using the
idea of the m l i lie , he sho ed that if the government increased its o n spending on such things as
building roads or schools, there ould be a multiplied spending effect in the econom . This ould help
the econom to get out of its state of lo output and unemplo ment.
Ke nes thoroughl dismissed the laisse faire econom of the 19th centur and provided a justification
for government intervention that is urgentl needed to avoid prolonged recessions (negative gro th) and
high unemplo ment. We ill discuss Ke nes contribution in Chapter 9.
One of the important contributions of John Ma nard Ke nes is the idea that a ec m lef i
ill ece a il lead f ll em l me , thus requiring government intervention in order to
ensure that full emplo ment ill be achieved.
Macroeconomic polic as inspired b the ork of John Ma nard Ke nes discussed above. The term
macroeconomics, as a field of economics distinct from microeconomics, did not even e ist until 1945
hen it as coined b Jacob Marschak.6 According to the thinking of the classical economists, there
as no need for macroeconomic polic since the econom as assumed to correct itself automaticall
through market forces in the absence of government intervention. We ill discuss macroeconomic
policies in detail in Chapter 13.
/ -
In the earl 1970s, the global econom e perienced cost-push inflation, also kno n as stagflation, on
account of the first oil price crisis. Ke nesian economics, ith its focus on aggregate demand, as
unable to provide a solution to inflation of this t pe. These events paved the a for the emergence and
gro ing popularit of t o schools of thought: and .
Monetarism, attributed to the Nobel Pri e inning economist Milton Friedman (1912 2006), emphasises
the role of mone in the econom . It is argued that changes in the mone suppl have major effects on
output in the short run, and on the price level in the long run. Ne classical economics, associated partl
ith another Nobel Pri e inning economist Robert Lucas (born 1937) emphasises the importance of
individuals rational e pectations of inflation and government polic actions.
While these t o theories are quite different from each other, e are considering them together because
the share a unif ing principle regarding he le f ma ke i b i gi g he ec m back a i a i
he e he e i f ll em l me ih a g e me i e e i . In fact, according to these t o
schools of thought, it is government intervention itself, in such areas as minimum age la s and the
operation of trade unions, that leads to stick ages that do not fall, thus preventing the automatic
adjustment of the econom back to full emplo ment. If all ages and all prices could respond freel to
the forces of demand and suppl , markets on their o n ould achieve high levels of output and full
emplo ment.
It is clear from the above that this approach involves a rejection of Ke nesian economics, hich requires
government intervention for the smooth functioning of an econom . It advocates a return to the classical
idea of automatic full emplo ment through the orkings of a laisse -faire econom ; hence the use of the
term e cla ical.
The monetarist/ne classical approach has been the inspiration of market-based suppl -side policies. We
ill discuss this model and its implications for polic in Chapters 9 and 13.
According to the monetarist/ne classical schools of thought, government intervention prevents the
econom from reaching a state of full emplo ment on its o n, hereas a free market econom
ithout the government intervening ill tend to ard full emplo ment.
21
B
Since the earl part of the 21st centur , there has been a gro ing dialogue bet een economists and
ps chologists, resulting in a ne field of economics kno n as . Behavioural
economics questions the idea that marginal utilit underlies demand and rational consumer behaviour
( hich e discussed earlier). It is argued that consumers do not have the necessar information
available, but also and most importantl the human mind orks in a s that are not rational in the a s
the theor presupposes.
Rather than rel on a theor that e plains the behaviour of consumers, behavioural economics relies on
e periments and the accumulation of evidence about ho consumers behave under a broad variet of
different circumstances. This information is then used to formulate economic policies that ill
encourage consumers to behave in a s that are held to be sociall desirable.
The gro ing importance and influence of behavioural economics is evidenced b the fact that, in a span
of 15 ears, three Nobel Pri es have been a arded to scholars dealing ith this subject. The include
Daniel Kahneman (2002) for his ork on human judgement and decision-making under uncertaint ;
Robert J Shiller (2013) for his anal sis of asset prices in the area of behavioural finance; and Richard
Thaler (2017) for his ork sho ing that people are predictabl irrational in a s that contradict
economic theor . (Behavioural economics ill be studied at HL in Chapter 2.)
, ,
Earlier in this chapter e discussed the issue of sustainabilit , hich arises from conditions of scarcit of
resources. We learned that sustainabilit refers to the maintenance of resource quantities and qualit over
time. Until recentl , economists carried out their ork in isolation, ithout taking into consideration the
interrelationships and interdependencies that e ist bet een the econom , societ and the environment. In
recent ears there is increasing a areness of the need to consider three pillars of sustainabilit together:
the econom , societ and the environment, sometimes abbreviated as profit, people, planet.
In addition, it is imperative to move a a from the traditional e tractive take-make-dispose model,
hich characterises our current approach to producing products and disposing of aste. This approach
involves e tracting resources, making them into products and then thro ing them out. The imperative of
achieving sustainable development requires that e adopt a . The idea behind a
circular econom is that goods should be produced in such a a that the can be repaired rather than
thro n out. In addition, the ould be made out of biological materials so that once discarded the can
go back to the biosphere and prevent pollution of the planet. According to London s Waste and
Rec cling Board:
A ci c la ec m i a m e efficie a d e i me all d al e a i e he adi i al
li ea ec m . I i e i hich e kee e ce i e f a l g a ible, e ac he
ma im m al e f m hem hil i e, he ec e a d ege e a e d c a d ma e ial a he
e d hei life. 7
We ill stud the problem of sustainable resource use in Chapter 5.
Novel thinking in the 21st centur includes: (i) the contributions of ps cholog to economics, hich
offer alternative a s of understanding ho consumers make decisions, ith a vie to influencing
consumer choices to ard sociall desirable outcomes; and (ii) the development of ne models
regarding sustainabilit that focus on the close interdependencies bet een the econom , societ and
the environment, and the concept of a circular econom .

1 Referring to the concept of laisse faire, e plain Adam Smith s main contribution to economics.
2 Outline the three phases of macroeconomic thought on the need for government intervention in
the econom for the purpose of achieving full emplo ment, from the 19th centur to the late 20th
centur .
3 E plain ho perceptions regarding the concept of ili have evolved from the 19th centur to
the present.
4 Outline the meaning of a ci c la ec m and its importance to sustainable development.
5 Select a famous economist ou are interested in and present his/her ork, either individuall or
in a group.
E AM S LE Q ES IONS
You can find questions in the st le of IB e ams in the 'Digital coursebook: E tra material' section.
5 The full title of the book as A I i i he Na e a d Ca e f he Weal h f Na i .
6 The other- orldl philosophers
7 London Waste and Rec cling Board (LWARB)

2
M
Mic ec ic i c ce ed i h he beha i fc e , fi a d e ce e ,
h a e he i a ec ic deci i - ake i a a ke ec . We i d
he de f de a d a d , hich f he ba i f he a ke ec a di e f
he i a a a ica i ic ec ic . We i ea ab he be efi f
f ee a ke a e a hei i e fec i i a a ie f i ai he e he fai ee
i a ec ic bjec i e . We i a e a i e he e f g e e . We i ee
ha effec g e e ha e he he i e fe e i a ke a e a h he ca he
achie e be e cia c e he a ke fai ef e .
The e i de e i ic ec ic a e i a beca e he ide a
i igh i he ki g f he a ke ec ,a di he effec f diffe e e f
g e e i e e i . I addi i , he f he ba i f addi i a ic e i d i
ae a f hi b k.
Rea d i e 1: H a e ch ice ade b

c e a d d ce he he ee hei
ec ic bjec i e ?
CONCEP AL NDE ANDING
1 The ec e ce a e a ca ed (a ig ed) he d ci f g d a d
e ice i e ded ee eed a d a ai h gh he i e ac i f
c e a d d ce i a ke .
2 The ch ice ade b c e a d d ce a e he e fc e deci i -
aki g.
3 The achie e e fa ca i e efficienc ea ha e fa e i a i i ed ( ade he
g ea e i ca be).
4 C i change gi e i e d a ic a ke .
The e ic a e add e ed i Cha e 2 a d 3. I Cha e 2 e i di c e he ba ic

b i di g b ck f ic ec ic : de a d, a d a ke . We i e a i e h
c e a d d ce i e ac i a ke a d e i ee i e de ai ha Ada
S i h ea b he i i ib e ha d. We i a e a i e e ece de e e ha ffe
a e ai ee a ai fc e a d fi beha i .
Cha e 3 i i d ce a e c ce , ha f e a ici , hich ea e h c e
a d fi e d cha ge i ice , a d a be e de a d he ki g f
a ke .
A b ge i g ch ie
________________________
Chapter 2
Competitive markets: Demand and

supply
BEFORE YOU START
O er time, ou see prices of goods and ser ices change. Wh do ou think sellers of goods and
ser ices change their prices?
When ou bu goods and ser ices, do ou think our choices are al a s in our best self-
interest?
Ho do consumers and producers make choices in tr ing to meet their economic objecti es?
In this chapter e e amine hat lies at the heart of e er market-based econom : the forces of demand
and suppl . We ill then see ho the interactions of demand and suppl arri e at equilibrium market
prices, and e ill stud the special qualities of free competiti e markets. This chapter ill also
e amine some recent de elopments in the fields of consumer and producer beha iour that pro ide no el
e planations on ho these fundamental decision-makers make choices.
2.1 I d ci c eii e a ke
LEARNING OBJECTIVES
Af e d i g hi ec i ill be able :
defi e all he e m a ea i g i a ge b d i he e (AO1)
li e he mea i g f a c eii e a ke (AO1)
Ma ke
The a e f a ke
A ma ke igi all a a lace he e e le ga he ed b a d ell g d . S ch ma ke ill e i
da , f e am le ca le ma ke , fi h ma ke , f i a d ege able ma ke a d flea ma ke , i l i g a
h ical mee i g lace he e b e a d elle mee face face.
The e m a ke ha i ce e l ed i cl de a ki d f a a geme he e b e a d elle f

g d , e ice e ce a e li ked ge he ca a e cha ge.
The ma ke ma be i a ecific lace ( ch a a ege able ma ke ), i ma i l e ma diffe e

lace ( ch a he il ma ke ). B e a d elle ma mee ( a , i a h ), he ma e e mee ,
c mm ica i g b fa , h e, i e e , cla ified ad , a he me h d hich all hem c e
i f ma i ab ice, a i a d ali .
A ma ke ca be l cal, he e he b e a d elle igi a e f m a l cal a ea; i ma be a i al, i
hich ca e he b e a d elle a e f m a he e i hi a c ; i ma be i e a i al, i h
b e a d elle f m a he e i he ld. F e am le, mall eighb h d bake ie d ce a d
ell b ead a d he baked g d f he l cal c mm i hi i a l cal ma ke . L cal akea a
e a a al d ce f he l cal ma ke . The lab ma ke , he he ha d, e d be m l a
a i al ma ke . B c a , he ld il ma ke i cl de il d ce i diffe e c ie , a d
b e f il i all e e he e i he ld, a ell a h le ale , e aile a d he i e media ie
i l ed i b i g a d elli g il a d he ld.
G d a d e ice a e ld i d c ma ke , hile e ce (fac f d ci )a e ld i
e ce ma ke (fac ma ke ).
TEST YOUR UNDERSTANDING 2.1

1 Wha i a ma ke ?
2 S gge m e e am le f l cal, a i al a d i e a i al ma ke .
The ea i g f a c eii e a ke
C e i i i ge e all de d be a ce i hich i al c m e e i de achie e me
bjec i e. F e am le, fi m ma c m e e i h each he e h ill ell he m ,
c me ma c m e e e h ill b a ca ce d c, ke c m e e e h ill ge he
be j b i h he highe ala ie , c ie c m e e e hich ill ca e he bigge e ma ke .
Be d hi e e da e e, c m e i i i mic ec mic cc he he e a e ma b e a d
elle ac i g i de e de l , ha e ha he abili i fl e ce he ice a hich a d c i
ld. Thi h ld be c a ed i h ma ke o e (al k a mono ol o e ) hich efe he
c l ha a elle ma ha e e he ice f he d c i ell . The g ea e he ma ke e , he
g ea e i he c l e ice. O he he ha d, he g ea e he deg ee f c m e i i be ee elle ,
he malle hei ma ke e , a d he eake i hei c l e he ice.
I hi cha e e ill d c e i i e a ke c m ed f la ge mbe f elle a d b e
ac i g i de e de l , ha e i di id al elle mall g f elle ha he abili c l
he ice f he d c ld. I ead, he ice f he d c i de e mi ed b he i e ac i f ma
elle a d b e , h gh he f ce f dema d a d l .
2.2 D
LEARNING OBJECTIVES

e plain the la of demand (AO2)
dra a demand curve (AO4)
e plain the relationship bet een individual demand and market demand (AO2)
anal se the non-price determinants of demand as causes of demand curve shifts (AO2)
using diagrams distinguish bet een movements along the demand curve and shifts of the demand
curve (AO4)
e plain the assumptions that underlie the la of demand (HL onl ) (AO2)
the la of diminishing marginal utilit
the income and substitution effects
U
D is concerned ith the behaviour of bu ers. Consumers (or households) are bu ers of goods and
services in product markets, hereas firms (or businesses) are bu ers of factors of production in resource
markets. In our anal sis of demand and suppl e ill focus mainl on product markets and therefore on
the behaviour of consumers as bu ers (though the same general principles described here appl also to
the behaviour of firms as bu ers in resource markets).
I
As bu ers, consumers are demanders of those items the ish to bu .
The of an individual consumer indicates the various quantities of a good (or service) the
consumer is willing and able to bu at different possible prices during a particular time period, ceteris
paribus.
A consumer s demand for a good can be presented as a demand schedule, or as a table listing quantit
demanded at various prices. Table 2.1 sho s a consumer s demand schedule for chocolate bars. When
the price of chocolate bars is $5, the consumer is illing and able to bu t o chocolate bars in a eek.
When the price is $4, the consumer is illing and able to bu four chocolate bars in a eek, and so on.
P ($) Q (
)
5 2
4 4
3 6
2 8
1 10
T 2.1: Demand schedule for a consumer
F 2.1: Demand curve for an individual consumer
Willing means the consumer ants to bu the good; able means that the consumer can afford to bu
it. (You ma ant to bu a Ferrari, but can ou afford it? If not, our desire to bu one ill not sho up
as demand for Ferraris. Or, ou can afford a Ferrari but ou have no desire to o n one; again ou ill
not have an demand for Ferraris.)
Ceteris paribus means that all things other than price that can affect ho much the consumer is illing
and able to bu are assumed to be constant and unchanging (see Chapter 1, and Quantitative techniques
chapter in the 'Digital coursebook: E tra material' section). In fact, the consumer s demand is affected
not onl b price, but also b man other things, like income, tastes and prices of related goods. For the
moment, e ignore all these and concentrate onl on the relationship bet een the quantit of a good and
its price.
The information contained in the demand schedule can be plotted as a graph, sho n in Figure 2.1. The
price of chocolate bars is plotted on the vertical a is and quantit of chocolate bars on the hori ontal
a is. The curve in Figure 2.1 is a . Note that even though this is a straight line, it is
referred to as a curve .
The demand schedule and demand curve do not tell us an thing about ho man chocolate bars the
consumer ill actuall bu and hat price the consumer ill pa . This information ill be given to us
later through the interaction of demand ith suppl . The demand information onl tells us ho man
chocolate bars the consumer ould be prepared to bu if the price ere $5, or $4, and so on.
T
The demand curve plotted in Figure 2.1 illustrates a ver important relationship: as the price of a good
falls, the quantit of the good demanded increases. When t o variables change in opposite directions, so
that as one falls, the other increases, the are said to have a negative (or indirect ) relationship. This
relationship is a causal one, because changes in price cause changes in quantit demanded. The
negative relationship bet een price and quantit demanded is kno n as the la of demand.
According to the , there is a negative relationship bet een the price of a good and its
quantit demanded over a particular time period, ceteris paribus: as the price of the good increases,
quantit demanded falls; as the price falls, quantit demanded increases, ceteris paribus.
The la of demand is most likel to be consistent ith our e perience. The higher the price of a good,
the less of it ou are probabl illing and able to bu .
F
So far e have considered the demand for a good of one individual consumer. Market demand sho s the
total quantities in the market for the good consumers are illing and able to bu at different prices
(during a particular period of time, ceteris paribus). Market demand is the sum of all individual demands
for that good. Figure 2.2 sho s ho the quantit demanded b consumer A is added to the quantit
demanded b consumer B, and so on until all the quantities demanded b all consumers of chocolate
bars are added up. (Note that consumer A has a different demand for chocolate bars than consumer B,
indicating different preferences). For e ample, at the price of $4, e add the four bars demanded b
consumer A to the five bars demanded b consumer B, and so on to all the quantities demanded b other
consumers, to arrive at the sum of 6000 chocolate bars per eek. This sum is a point on the market
demand curve Dm. When e add individual demands in this a for each of the possible prices, e
derive the entire market demand curve Dm, sho ing the total demand in the chocolate bar market.
F 2.2: Market demand as the sum of individual demands
M is the sum of all individual demands for a good. The market demand curve
illustrates the la of demand, sho n b the negative relationship bet een price and quantit
demanded.
N -
T -
The - are the variables other than price that can influence demand.
The are the variables assumed to be unchanging b use of the ceteris paribus assumption.
Changes in the non-price determinants of demand cause shifts in the demand curve: the entire demand
curve moves to the right or to the left. In Figure 2.3. note that the vertical a is is labelled P , standing
for price, and the hori ontal a is is labelled Q , standing for quantit . Suppose the original demand
curve is given b D1. If price is P1, then the demand curve D1 indicates that quantit Q1 ill be
demanded. If the demand curve shifts to the right, to D2, at the same price P1 a larger quantit , Q2, ill
be demanded. If, on the other hand, the demand curve shifts to the left, from D1 to D3, then a smaller
quantit , Q3, ill be demanded at the same price P1.
A right ard shift of the demand curve indicates that more is demanded for a given price; a left ard shift
of the demand curve indicates that less is demanded for a given price. A right ard shift of the curve is
called an increase in demand; a left ard shift is called a decrease in demand.
F 2.3: Shifts in the demand curve
The non-price determinants of market demand include:

I . A good is a hen demand for it increases in
response to an increase in consumer income (demand for the good varies directl ith income).
Most goods are normal goods. Therefore, an increase in income leads to a right ard shift in the
demand curve, and a decrease in income leads to a left ard shift.
I . While most goods are normal, there are some goods here
the demand falls as consumer income increases; the good is then an (the demand for
the good varies inversel ith income). E amples of inferior goods are second-hand clothes, used
cars and bus tickets. As income increases, consumers s itch to more e pensive alternatives (ne
clothes, ne cars and cars or aeroplanes rather than travelling b bus), and so the demand for the
inferior goods falls. Thus an increase in income leads to a left ard shift in the demand curve and a
decrease in income produces a right ard shift.
P . If preferences and tastes change in favour of a product (the good becomes
more popular), demand increases and the demand curve shifts to the right; if tastes change against
the product (it becomes less popular), demand decreases and the demand curve shifts to the left.
P . T o goods are ( ) if the satisf a similar
need. An e ample of substitute goods is Coca-Cola and Pepsi . A fall in the price of one (sa ,
Coca-Cola) results in a fall in the demand for the other (Pepsi). The reason is that as the price of
Coca-Cola falls, some consumers s itch from Pepsi to Coca-Cola, and the demand for Pepsi falls.
On the other hand, if there is an increase in the price of Coca-Cola, this ill result in an increase in
the demand for Pepsi as some consumers s itch from Coca-Cola to Pepsi. Therefore, for an t o
substitute goods X and Y, a decrease in the price of X produces a left ard shift in the demand for Y,
hile an increase in the price of X produces a right ard shift in the demand for Y. In brief, in the
case of substitute goods, the price of X and demand for Y change in the same direction (the both
increase or the both decrease). Other e amples of substitute goods are oranges and apples,
Cadbur s and Nestl chocolate, and milk and oghurt.
P . T o goods are ( ) if the
tend to be used together. An e ample of complementar goods is computers and computer soft are.
In this case, a fall in the price of one (sa , computers) leads to an increase in the demand for the
other (computer soft are). This is because the fall in the price of computers results in a bigger
quantit of computers being purchased, and the demand for computer soft are increases. Therefore,
for an t o complementar goods X and Y, a fall in the price of X leads to a right ard shift in the
demand for Y, and an increase in the price of X leads to a left ard shift in the demand for Y. In the
case of complementar goods, the price of X and the demand for Y change in opposite directions (as
one increases, the other decreases). More e amples of complementar goods are shoes and shoe
laces, tennis shoes and tennis rackets, and table-tennis balls and table-tennis rackets. Note that most
goods are not related to each other; these are called independent goods. For e ample, pencils and
apples, cars and ice cream, telephones and books are unrelated to one another, and the change in the
price of one ill have little or no effect on the demand for the other.
T . If there is an increase in the number of consumers (demanders),
demand increases and therefore the market demand curve shifts to the right; if the number of
consumers decreases, demand decreases and the curve shifts to the left. This follo s simpl from
the fact that market demand is the sum of all individual demands.
F 2.4: Movements along and shifts of the demand curve
M
It is important to distinguish bet een movements along a demand curve, and shifts of a demand curve.
Whenever the price of a good changes, ceteris paribus, it leads to a movement along the demand curve.
In Figure 2.4(a), if the price falls from P1 to P2, the quantit of the good demanded increases from Q1 to
Q2. A movement along the demand curve from A to B has occurred; this is referred to as an increase in
quantit demanded. An increase in price gives rise to a decrease in quantit demanded, resulting in a
movement from B to A.
B contrast, an change in a non-price determinant of demand results in a shift in the entire demand
curve, as sho n in Figure 2.4(b); this is called a change in demand. For e ample, if there is an increase
in the number of bu ers, the demand curve shifts right ard from D1 to D2; this is called an increase in
demand, sho n in Figure 2.4(b). A decrease in the number of bu ers causes a left ard shift of the
demand curve from D1 to D3; this is called a decrease in demand. To summarise:
An change in price produces a change in quantit demanded, sho n as a movement on the demand
curve. An change in a non-price determinant of demand leads to a change in demand, represented b
a shift of the entire demand curve.

1 Define demand .
State the la of demand.
E plain hether the la of demand sho s a negative or positive relationship.
Sho the la of demand in a diagram.
Describe the relationship bet een individual demand and market demand.
Distinguish bet een a change in demand and a change in quantit demanded and
e plain the cause or causes of each.
Ho ould ou sho the difference bet een a movement along the demand curve and a
shift of the demand curve in a diagram?
Identif the non-price determinants of demand.
2 Using diagrams, sho the impact of each of the follo ing on the demand curve for product A.
The number of consumers in the market for product A increases.
Consumer income increases and product A is an inferior good.
Consumer income decreases and product A is a normal good.
A ne s report claims that use of product A has harmful effects on health.
The price of substitute good B falls.
The price of complementar good B increases.
A (HL )
T
The la of diminishing marginal utilit is based on a simple theor of consumer behaviour that
e plains the negative relationship bet een price and quantit demanded, or the la of demand.
U is the satisfaction that consumers gain from consuming something. It is a subjective concept,
because satisfaction is something that depends entirel on personal tastes and preferences, hich var
from person to person.
Utilit cannot be measured, but for the purposes of developing the theor , e assume that utilit is
quantifiable (it can be measured in terms of numbers of units), and the unit that e use is the util.
Utils do not e ist in actual fact, ho ever e assume the e ist for the purposes of building the theor .
Total utilit is the total satisfaction that consumers get from consuming something, hile marginal
utilit is the e tra satisfaction that consumers receive from consuming one more unit of a good. Table
2.2 sho s ho total utilit and marginal utilit are related to each other. You can see that both total
utilit and marginal utilit are measured in utils.
Table 2.2 sho s Anna s preferences hen she bu s T shirts. The first T shirt provides her ith 15
utils of total utilit . This is also her marginal utilit . When she bu s a second T shirt, her total utilit
increases from 15 utils to 27 utils, but her marginal utilit , or e tra satisfaction from bu ing the
second T shirt has fallen to 12 utils. The marginal utilit of the second unit is simpl the total utilit
of the second unit minus the total utilit of the first unit, hich is 27 utils 15 utils = 12 utils. And so
on ith each e tra T shirt she bu s. Her total utilit increases, but her marginal utilit falls. Marginal
utilit keeps decreasing and at some point it ma even become negative, meaning that total utilit
starts to fall. This pattern illustrates the la of diminishing marginal utilit , hich is based on the idea
that the satisfaction consumers get from consuming more and more units of a good decreases.
The la of diminishing marginal utilit e plains the la of demand. As e kno , according to the
la of demand, as the price of a good decreases, quantit demanded increases ceteris paribus. The
la of diminishing marginal utilit sho s that if the consumer derives less and less utilit from each
e tra unit of a good consumed, then she or he ill bu additional units onl if the price of the good
falls.
According to the , as consumption of a good increases,

marginal utilit , or the e tra utilit the consumer receives, decreases ith each additional unit
consumed. This underlies the la of demand, as it sho s that a consumer ill be illing to bu an
additional unit of a good onl if its price falls.
N T T (U ) M (U )
0 0
1 15 15
2 27 12
3 36 9
4 42 6
5 45 3
6 45 0
7 42 3
T 2.2: Total and marginal utilit
The concept of marginal utilit is the basic building block of the theor of consumer behaviour,
according to hich consumers arrange their purchases of man different goods in a a that ill
allo them to ma imise the total utilit the derive.
T
The income and substitution effects are an alternative e planation of the la of demand.
As e have seen, the la of demand sho s the relationship bet een the price of a good and quantit
of the good demanded, ceteris paribus. An price change causes a change in quantit demanded,
sho n as a movement along the demand curve. We ill no see that the total effect of a price change
on quantit demanded can be broken do n into t o separate effects: the substitution effect and the
income effect, ith the total effect of a price change being the sum of these t o effects.
The : If the price of a good falls, the consumer substitutes (bu s more) of the
no less e pensive good. Therefore quantit demanded increases. There is al a s a negative
relationship bet een price and quantit demanded as a result of the substitution effect: as price
falls, the quantit of the good demanded increases; as price increases, quantit demanded falls.
The : Consider again a fall in price. This means that the consumer s real income
(or purchasing po er) has increased. (To understand hat this means consider the follo ing
e ample. Sa ou have $12 and ou ant to bu some pencils. When the price is $4 per pencil,
ou can bu three pencils. Suppose then that the price of pencils falls to $3 per pencil. You can
no bu four pencils. The sum of mone at our disposal ($12) has not changed, and et the
purchasing po er of $12, or hat our mone can bu , has increased as a result of the fall in
the price of pencils. Real income is the same as purchasing po er ; it increases as prices fall,
and it decreases as prices rise.) Therefore as price falls and real income increases, quantit
demanded of the good increases. Once again there is a negative relationship bet een price and
quantit demanded.
The substitution effect and the income effect reinforce each other: a fall in price leads to an
increase in quantit demanded, both because of the substitution effect and because of the income
effect.
In the case of most goods, hose price is a small fraction of income, the substitution effect is the
most important part of the e planation of the la of demand, because being a small fraction of
income, the effect that a price change has on real income ill be tin . The income effect becomes
important onl in the case of purchases of goods hose price take up a large fraction of income.
Note that the above anal sis refers to normal goods, here income and demand change in the same
direction; as real income increases, consumers ant to bu more of the good. If ou are interested in
seeing hat happens in the case of inferior goods ou can read about it in the 'Digital coursebook:
E tra material' section as Supplementar material.

1 Using an e ample, e plain the la of diminishing marginal utilit .
Ho is this la related to the do n ard sloping demand curve?
2 E plain ho the income and substitution effects can e plain the do n ard sloping demand
curve.
2.3 Suppl
LEARNING OBJECTIVES
After st d ing this section o ill be able to:

define all the terms appearing in orange bold in the te t (AO1)
e plain the la of s ppl (AO2)
dra a s ppl c r e (AO4)
e plain the relationship bet een indi id al s ppl and market s ppl (AO2)
anal se the non-price determinants of s ppl as ca ses of s ppl c r e shifts (AO2)
sing diagrams, disting ish bet een mo ements along the s ppl c r e and shifts of the s ppl
c r e (AO4)
e plain the ass mptions that nderlie the la of s ppl (HL onl ) (AO2)
la of diminishing marginal ret rns
increasing marginal cost
Understanding the law of suppl and the suppl curve

S ppl is concerned ith the beha io r of sellers, hich incl de firms in the prod ct markets and
ho seholds in reso rce markets. As e are foc sing on prod ct markets, e ill consider the beha io r
of firms as sellers (tho gh the same general principles also appl to sellers of factors of prod ction in
reso rce markets).
Individual suppl
Firms prod ce goods and ser ices, and the s ppl them to prod ct markets for sale. As sellers,
therefore, the are s ppliers of goods and ser ices.
The suppl of an indi id al firm indicates the ario s q antities of a good (or ser ice) a firm is
illi g a d able to prod ce and s ppl to the market for sale at different possible prices, d ring a
partic lar time period, ce e i a ib .
A firm s s ppl of a good can be presented as a s ppl sched le, or a table sho ing the ario s
q antities of a good the firm is illing and able to prod ce and s ppl at ario s prices. Table 2.3 sho s
a firm s s ppl sched le for chocolate bars. The same information appears as a graph in Fig re 2.5,
here price is plotted on the ertical a is and q antit on the hori ontal a is. The line appearing in the
diagram is the suppl curve of the firm. If the price is $4, the firm s pplies 500 chocolate bars in the
co rse of a eek; if price ere $3, then the firm o ld s ppl 400 chocolate bars, and so on.
As in the case of demand, here price is onl one thing that determines ho m ch is demanded, so in
the case of s ppl , price is onl one thing that infl ences ho m ch the firm s pplies to the market;
hence the ce e i a ib ass mption. For the moment, e ill ignore other possible infl ences on
s ppl and foc s onl on the relationship bet een price and q antit .
Price of chocolate bars ($) Quantit of chocolate bars supplied (per week)
5 600
Price of chocolate bars ($) Quantit of chocolate bars supplied (per week)
4 500
3 400
2 300
1 200
Table 2.3: S ppl sched le for a firm
Figure 2.5: S ppl c r e for a firm
The s ppl sched le and the s ppl c r e do not tell s an thing abo t ho man chocolate bars the
firm ill act all s ppl to the market nor hat price the firm ill recei e. The s ppl information tells
s onl ho man chocolate bars the firm o ld be prepared to prod ce and sell if the price ere $5, or
$4, and so on.
The law of suppl

The s ppl c r e in Fig re 2.5 ill strates an important relationship: as price increases, q antit s pplied
also increases. When t o ariables change in the same direction (as one increases, the other also
increases), the are said to ha e a positi e (or direct ) relationship. This relationship is a ca sal one,
beca se changes in price ca e changes in q antit s pplied. The positi e ca sal relationship bet een
the t o ariables, price and q antit s pplied, is s mmarised in the la of s ppl .
According to the law of suppl , there is a positi e relationship bet een the q antit of a good
s pplied o er a partic lar time period and its price, ce e i a ib : as the price of the good increases,
the q antit of the good s pplied also increases; as the price falls, the q antit s pplied also falls,
ce e i a ib .
From individual suppl to market suppl

Market s ppl indicates the total q antities of a good that firms are illing and able to s ppl in the
market at different possible prices and is gi en b the s m of all indi id al s pplies of that good. Fig re
2.6 pro ides an e ample here at each price, the q antit s pplied b firm A is added to the q antit
s pplied b firm B, and so on, ntil all the q antities s pplied b all firms prod cing chocolate bars are
added p. For e ample, at the price of $3, firm A s pplies 400 bars per eek and firm B s pplies 300
bars. If e add these q antities together ith all the q antities s pplied b other firms, e obtain 8000
bars per eek, hich is a point on the market s ppl c r e, Sm, corresponding to the price of $3. When
the firms s pplies are added p this a for each possible price, e deri e the market s ppl c r e, Sm.
Figure 2.6: Market s ppl as the s m of indi id al s pplies
Market suppl is the s m of all indi id al firms s pplies for a good. The market s ppl c r e
ill strates the la of s ppl , sho n b a positi e relationship bet een price and q antit s pplied.
The vertical suppl curve

Under certain special circ mstances, the s ppl c r e is ertical at some partic lar fi ed q antit , as in
Fig re 2.7. A ertical s ppl c r e tells s that e en as price increases, the q antit s pplied cannot
increase; it remains constant. The q antit s pplied is independent of price. There are t o reasons h
this ma occ r:
There is a fi ed q antit of the good s pplied beca se there is no time to prod ce more of it. For
e ample, there is a fi ed q antit of tickets in a theatre, beca se there is a fi ed n mber of seats. No
matter ho high the price, it is not possible to increase the n mber of seats in a short period of time.
There is a fi ed q antit of the good beca se there is no possibilit of e er prod cing more of it.
This is the case ith original antiq es (for e ample, Stradi ari s iolins) and original paintings and
sc lpt res of famo s artists. It ma be possible to make reprod ctions, b t it is not possible to make
more originals.
Figure 2.7: The ertical s ppl c r e
Non-price determinants of suppl and shifts of the suppl curve
The non-price determinants

We no t rn to the non-price determinants of suppl , or the factors other than price that can infl ence
s ppl . Changes in the determinants of s ppl ca se shifts in the s ppl c r e. A right ard shift means
that for a gi en price, s ppl increases and more is s pplied; a left ard shift means that for an price,
s ppl decreases and less is s pplied. As Fig re 2.8(b) sho s, hen s ppl is S1, q antit Q1 ill be
s pplied at price P1. If there is an increase in s ppl to S2, at the same price P1, then Q2 q antit is
s pplied. If s ppl falls to S3, then Q3 q antit is s pplied at the same price P1.
A right ard shift of the s ppl c r e indicates that more is s pplied for a gi en price; a left ard shift
of the s ppl c r e indicates that less is s pplied for a gi en price. A right ard shift of the c r e is
called an i c ea e i l ; a left ard shift is called a dec ea e i l .
The non-price determinants of market s ppl incl de the follo ing:

Costs of factors of production (factor or resource prices). The firm b s ario s factors of
prod ction (land, labo r, capital, entreprene rship) that it ses to prod ce its prod ct. Prices of
factors of prod ction (s ch as ages, hich are the price of labo r) determine the firm s costs of
prod ction. If a factor price rises, prod ction costs increase, prod ction becomes less profitable and
the firm prod ces less; the s ppl c r e shifts to the left. If a factor price falls, costs of prod ction
fall, prod ction becomes more profitable and the firm prod ces more; the s ppl c r e shifts to the
right.
Technolog . A ne impro ed technolog lo ers costs of prod ction, th s making prod ction more
profitable. S ppl increases and the s ppl c r e shifts to the right. In the (less likel ) e ent that a
firm ses a less prod cti e technolog , costs of prod ction increase and the s ppl c r e shifts
left ard.
Prices of related goods: competitive suppl . Competitive suppl of t o or more prod cts refers
to prod ction of one or the other b a firm; the goods compete for the se of the same reso rces,
and prod cing more of one means prod cing less of the other. For e ample, a farmer, ho can gro
heat or corn, chooses to gro heat. If the price of corn increases, the farmer ma s itch to corn
prod ction as this is no more profitable, res lting in a fall in heat s ppl and a left ard shift of
the s ppl c r e. A fall in the price of corn res lts in an increase in heat s ppl and a right ard
shift of the s ppl c r e.
Prices of related goods: joint suppl . Joint suppl of t o or more prod cts refers to prod ction of
goods that are deri ed from a single prod ct, so that it is not possible to prod ce more of one
itho t prod cing more of the other. For e ample, b tter and skimmed milk are both prod ced
from hole milk; petrol (gasoline), diesel oil and heating oil are all prod ced from cr de oil. This
means that an increase in the price of one leads to an increase in its q antit s pplied and also to an
increase in s ppl of the other joint prod ct(s).
Figure 2.8: Mo ements along and shifts of the s ppl c r e
Producer (firm) price expectations. If firms e pect the price of their prod ct to rise, the ma
ithhold some of their c rrent s ppl from the market (not offer it for sale), e pecting that the ill
be able to sell it at the higher price in the f t re; in this case, there is a fall in s ppl in the present
and a left ard shift in the s ppl c r e. If the e pectation is that the price of their prod ct ill fall,
s ppl increases in the present to take ad antage of the c rrent higher price, hence a right ard shift
in the s ppl c r e.
Taxes (indirect taxes or taxes on profits). Firms treat ta es as if the ere costs of prod ction.
Therefore, the imposition of a ne ta or the increase of an e isting ta represents an increase in
prod ction costs, so s ppl ill decrease and the s ppl c r e shifts to the left. The elimination of a
ta or a decrease in an e isting ta represents a fall in prod ction costs; s ppl increases and the
s ppl c r e shifts to the right. (See Chapter 4.)
Subsidies. A subsid is a pa ment made to the firm b the go ernment, and so has the opposite
effect of a ta . (S bsidies ma be gi en in order to increase the incomes of prod cers or to
enco rage an increase in the prod ction of the good prod ced.) The introd ction of a s bsid or an
increase in an e isting s bsid is eq i alent to a fall in prod ction costs, res lting in a right ard
shift in the s ppl c r e, hile the elimination of a s bsid or a decrease in a s bsid leads to a
left ard shift. (See Chapter 4).
The number of firms. An increase in the n mber of firms prod cing the good increases s ppl ,
res lting in a right ard shift in the s ppl c r e; a decrease in the n mber of firms decreases
s ppl and prod ces a left ard shift. This follo s from the fact that market s ppl is the s m of all
indi id al s pplies.
Shocks , or sudden unpredictable events. S dden, npredictable e ents called shocks , can
affect s ppl , s ch as eather conditions in the case of agric lt ral prod cts, ar, or nat ral/man-
made catastrophes. For e ample, the Lo isiana oil spill in 2010 res lted in a decrease in the s ppl
of locall prod ced seafood.
Movement along a suppl curve and shift of the suppl curve

J st as in the case of the demand c r e, so in the case of the s ppl c r e e disting ish bet een
mo ements along and shifts of the entire c r e. Mo ements along a s ppl c r e can be ca sed onl b
changes in price. In Fig re 2.8(a), as price increases from P1 to P2, q antit s pplied increases from Q1
to Q2. There has been a mo ement along the s ppl c r e from A to B. This is called a cha ge i
a i lied. If there is a change in a non-price determinant of s ppl , s ppl ill increase or
decrease, and the entire c r e ill shift to the right or to the left, as in Fig re 2.8(b). This is called a
cha ge i l .
An change in price prod ces a cha ge i a i lied, sho n as a mo ement on the s ppl
c r e. An change in a determinant of s ppl (other than price) prod ces a cha ge i l ,
represented b a shift of the hole s ppl c r e.

1 a Define s ppl .
b State the la of s ppl .
c E plain the relationship bet een price and the q antit s pplied.
d Sho the la of s ppl in a diagram.
e Describe the relationship bet een indi id al s ppl and market s ppl .
f Disting ish bet een a change in s ppl and a change in q antit s pplied and e plain the
ca se or ca ses of each.
g Dra t o diagrams to sho the difference bet een a mo ement along the s ppl c r e and a
shift of the s ppl c r e.
h Identif the non-price determinants of s ppl .
2 Gi e some e amples of goods ith a ertical s ppl c r e.
3 Using diagrams, sho the impact of each of the follo ing on the s ppl c r e of prod ct A.
a The n mber of firms in the ind str prod cing prod ct A decreases.
b The price of oil, a ke inp t in the prod ction of prod ct A, increases.
c Firms e pect that the price of prod ct A ill fall in the f t re.
d The go ernment grants a s bsid on each nit of A prod ced.
e The price of prod ct B falls, and B is in competiti e s ppl ith A.
f The price of prod ct B increases, and B is in joint s ppl ith A.
g A ne technolog is adopted b firms in the ind str prod cing A.
Assumptions underl ing the law of suppl (HL onl )
The la of s ppl is based on the relationship bet een prod ction and the costs of prod ction. We
begin this section b introd cing some ne concepts that are essential to nderstanding the
relationship bet een prod ction and costs.
Law of diminishing marginal returns

The short run and the long run in microeconomics
All firms se i (or reso rces, or factors of prod ction) to prod ce o tp t. The q antities of
inp ts needed to prod ce o tp t is determined b a technical relationship bet een inp ts and o tp t.
This technical relationship depends on a distinction bet een the h and the l g :
The short run is a time period d ring hich at least one inp t is fi ed and cannot be changed b
the firm. When e sa fi ed, e mean it is nchanging in q antit and q alit . For e ample, if a
firm ants to increase o tp t, it can hire more labo r and increase materials, tools and
eq ipment, b t it cannot easil change the si e of its b ildings, factories and hea machiner .
The b ildings, factories and hea machiner that are nchanging are fi ed, hereas the labo r
and materials are a iable. As long as the firm has at least one fi ed inp t, it is operating in the
short r n.
The long run is a time period hen all inp ts can be changed. Using the e ample abo e, in this
time period the firm can b ild ne b ildings and factories and b more hea machiner ; it can
change all of its inp ts. In the long r n the firm has no fi ed inp ts; e sa all inp ts are
a iable.
Note that the short r n and the long r n do not correspond to an partic lar length of time. Some
ind stries ma change their fi ed inp ts o er eeks or months hile others ma do so o er man
ears.
We ill make e tensi e se of the distinction bet een the short r n and the long r n in Chapter 7.
For no o sho ld note that the ideas de eloped in this section are concerned l i h he h
.
The meaning of marginal product

We ill no e amine the relationship bet een inp ts and o tp t in the short r n. Since e are
st d ing the short r n, e kno the firm has both fi ed and ariable inp ts. For simplicit , let s
consider a farm that prod ces potatoes, here the si e of the farm and the agric lt ral machiner and
tools are fi ed. The ariable inp ts are labo r and other agric lt ral inp ts (seeds, fertiliser and so
on). The onl a the farmer can increase the q antit of o tp t in the short r n is b increasing the
q antit of the ariable inp ts it ses. We can no disting ish bet een:
total product, hich is the total q antit of o tp t (potatoes) prod ced b the firm
marginal product, hich is the e tra or additional o tp t (potatoes) prod ced b one additional
nit of a ariable inp t, hich e ill ass me to be labo r; it tells s b ho m ch o tp t
increases as labo r increases b one orker.
Table 2.4 sho s ho the total prod ct and marginal prod ct of each orker change as the n mber of
orkers increases. We can see that the total prod ct increases contin o sl . The marginal or e tra
prod ct added b each orker is simpl the addition to total prod ct b each orker. So the first
orker adds 20 kilos of potatoes to total prod ct, the second orker adds 30 kilos (= 50 20), the
third orker 40 kilos (= 90 50) and so on.
Number of workers (the Total product (kilos of Marginal product (kilos of

variable input) potatoes) potatoes)
0 0 -
Number of workers (the Total product (kilos of Marginal product (kilos of
variable input) potatoes) potatoes)
1 20 20
2 50 30
3 90 40
4 120 30
5 140 20
6 150 0
Table 2.4: Total prod ct and marginal prod ct
Diminishing marginal returns

What is interesting to note in Table 2.4 is that the marginal prod ct of o r ariable inp t of labo r at
first increases, it reaches a ma im m ith the third orker, and then begins to fall. This pattern of
increasing and then falling marginal prod ct is so ni ersall alid it has the stat s of a la : it is
kno n as the la f dimi i hi g ma gi al e or for short, the la f dimi i hi g e .
Let s e amine the reasoning behind this pattern. When there are ero orkers on the land, there is no
o tp t at all; it is eq al to ero. When one orker is hired, there ill be some o tp t and so total
prod ct is 20 kilos of potatoes. Marginal prod ct is also eq al to 20 kilos. B t one orker alone on
the farm m st do all the plo ghing, planting, har esting, and so on, and so o tp t is q ite lo . When
a second orker is hired, the t o orkers share the ork, and total prod ct increases to fift kilos,
indicating that the o tp t prod ced b the t o together is more than do ble the o tp t of the first
orking alone. The additional (or marginal) prod ct d e to the second orker (30 kilos) is greater
than that of the first (20 kilos). This process is repeated ith the addition of the third, and marginal
prod ct increases.
With three orkers, marginal prod ct is the greatest it can be; hen the fo rth orker is added,
marginal prod ct begins to fall, and falls contin o sl thereafter. This is the point at hich
diminishing ret rns begin. Wh does this happen? It happens beca se of o ercro ding: each
additional orker has less and less land to ork ith, and so prod ces less and less o tp t.
E ent all , the conditions on the farm become so cro ded that the si th orker adds ero e tra
o tp t.
More generall , marginal prod ct ill begin to fall at some point not j st on a farm ith a fi ed piece
of land, b t hene er more and more nits of a ariable inp t are added to a fi ed inp t (pro ided the
technolog of prod ction is nchanging). For e ample, in the case of a factor here more and more
orkers are hired, each e tra orker ill ha e fe er and fe er machines and eq ipment to ork
ith, and so ill add less and less o tp t.
Imagine hat o ld happen if diminishing ret rns did not e ist. Using o r farm e ample, it o ld be
possible for food prod ction to increase indefinitel j st b contin o sl adding ariable inp ts to a
fi ed piece of land a clear impossibilit !
According to the law of diminishing marginal returns as more and more nits of a ariable inp t
(s ch as labo r) are added to one or more fi ed inp ts (s ch as land), the marginal prod ct of the
ariable inp t at first increases, b t there comes a point hen it begins to decrease. This
relationship pres pposes that the fi ed inp t(s) remain fi ed, and that the technolog of prod ction
is also fi ed.
Increasing marginal costs and the firm s suppl curve

We ill no disco er the relationship bet een diminishing marginal ret rns, costs of prod ction, and
the firm s s ppl c r e.
The meaning of marginal costs
In economics e make freq ent se of the concept of total cost, hich refers er simpl to all costs
of prod ction inc rred b a firm. We can no consider the meaning of a ne concept, ma gi al c .
REAL WORLD FOCUS 2.1

David Ricardo and the end of agricultural output growth
Da id Ricardo, a famo s English economist of the 19th cent r , belie ed that agric lt ral o tp t
o ld e ent all stop gro ing, beca se as more and more labo r and capital inp ts ere added to
land that as fi ed in q antit , the additional o tp t of labo r and capital o ld become smaller
and smaller ntil it o ld no longer be possible for total o tp t to increase f rther.
Figure 2.9: Chit an, Nepal. People orking in rice field at s nrise
Appl ing our skills

1 E plain the concept that describes the process Ricardo as referring to.
2 To hat e tent do o think Ricardo s fears ere j stified?
3 S ggest reasons for the gro th of agric lt ral o tp t in the real orld in spite of a fi ed
q antit of land.
Marginal cost i he e a addi i al c f d ci g e m e i f . It tells s b

ho m ch total costs increase if there is an increase in o tp t b one nit.
To nderstand hat this means, e can e amine Table 2.5. We can see that as the n mber of nits of
total prod ct increases, total cost increases, hich is hat e o ld e pect since more o tp t al a s
in ol es more cost. Marginal cost sho s the addition to total cost arising from the prod ction of one
more nit of o tp t. So prod ction of the first nit adds $12 to total cost, the second nit adds $8 to
total cost, the third nit $6, and so on.
Total product (number of units) Total cost ($) Marginal cost ($)
1 12 12
2 20 8
3 26 6
4 34 8
5 46 12
6 62 16
Table 2.5: Total cost and marginal cost
How marginal costs are related to diminishing marginal returns

Yo ma ha e noted that marginal cost at first decreases and then increases. In fact this is the
opposite of hat happens ith diminishing marginal ret rns. This is not a coincidence, in fact the
pattern follo ed b marginal cost is determined entirel b diminishing marginal ret rns. This can be
seen in Fig re 2.10.
When marginal prod ct increases, marginal cost decreases; hen marginal prod ct is ma im m,
marginal cost is minim m; and hen marginal prod ct falls, marginal cost increases.
Let s e amine this relationship more caref ll . Remember that at lo le els of o tp t, the marginal
prod ct of labo r, or the o tp t of each e tra orker increases. So each orker prod ces more and
more o tp t. Since orkers add to costs, and each orker prod ces more and more o tp t, the cost of
prod cing each additional nit of o tp t falls.
On the other hand, hen marginal prod ct or the additional o tp t of each orker becomes less and
less, the cost of each e tra nit prod ced (marginal cost) m st be increasing.
Similarl , hen the additional o tp t prod ced b an e tra orker is the most it can be, then the e tra
labo r cost of prod cing an additional nit of o tp t is the least it can be.
Figure 2.10: Marginal prod ct, marginal cost and the firm s s ppl c r e
Marginal cost and the firm s suppl curve

As e disc ssed earlier, the firm s s ppl c r e sho s the q antities of a good the firm is illing and
able to prod ce and sell at ario s prices, ce e i a ib . We no kno , ho e er, that the firm has
costs of prod ction. These costs m st be co ered thro gh the firm s earnings from selling its o tp t.
The firm s earnings per nit of o tp t sold are determined b the price of each nit of the good.
It follo s then that the firm ill be illing and able to s ppl some q antit as long as the price is
eno gh to co er its costs. Therefore e can think of the s ppl c r e as sho ing the price that the
firm is illing to accept to prod ce one more nit of the good. In fact, hen marginal cost is
increasing, the firm can onl prod ce more o tp t if the price of the good increases to co er the e tra
cost of each e tra nit prod ced. As a res lt, a portion of the p ard sloping part of the marginal cost
c r e in Fig re 2.10 is the firm s s ppl c r e. This is represented in the bold face portion of the
marginal cost c r e. The s ppl c r e begins at the point on the marginal cost c r e here the firm is
making eno gh re en e so that it is better off prod cing than sh tting do n.1
The firm s s ppl c r e is a portion of its marginal cost c r e that sho s the priceq antit
combinations here the e tra cost of prod cing one more nit of o tp t (the marginal cost) is
eq al to the price of that nit.

1 E plain the la of diminishing marginal ret rns and o tline h this la holds onl in the
short r n.
2 E plain h marginal cost falls as marginal prod ct increases, and h it increases as
marginal prod ct falls.
3 Anal se the relationship bet een a firm s marginal costs and its s ppl c r e.
1 This occ rs hen the firm is co ering all of its ariable costs. An e planation of this topic is be ond the scope
of the IB s llab s.
2.4 C :
LEARNING OBJECTIVES

draw a diagram to illustrate how demand and supply interact to determine market equilibrium
(AO4)
analyse demand curve and supply curve shifts that give rise to a new market equilibrium, using
the concepts of excess demand (shortage) and excess supply (surplus) (AO2)
draw diagrams to illustrate how shifts in demand and supply give rise to a new equilibrium
(AO4)
The market demand and market supply for chocolate bars that we considered separately earlier in this
chapter show the quantities consumers and firms are illi g a d able to buy and sell at each price. We
will now put market demand and market supply together to find out how these interact to determine what
happens in the market for chocolate bars.
E ( ) ( )
Figure 2.11 presents the same market demand and supply curves that appeared in Figures 2.2(c) and
2.6(c). The same information appears as a demand schedule and a supply schedule in Table 2.6.
In both Table 2.6 and Figure 2.11 we see that when the price of chocolate bars is $3, quantity demanded
is exactly equal to quantity supplied, at 8000 chocolate bars. Note that there is only one price where this
can occur. At a higher price, say $4, quantity supplied (10 000 bars) is greater than quantity demanded
(6000 bars). There is , or a of 4000 bars (10 000 6000). At the even higher price
of $5, there is a larger excess supply (surplus) of 8000 bars.
Suppose the price in this market is initially $5. At this price, chocolate producers would be willing and
able to produce 12 000 bars, but consumers would only be willing and able to buy 4000 bars. What will
happen? With unsold output of 8000 bars, producers will lower their price to encourage consumers to
buy more chocolate. As the price falls, quantity supplied becomes smaller and quantity demanded
becomes bigger. As long as there is a surplus, there will be a downward pressure on the price. The price
will keep falling until it reaches the point where quantity demanded is equal to quantity supplied, and the
surplus is eliminated.
At a lower price than $3, say $2, quantity demanded (10 000 bars) is larger than quantity supplied (6000
bars). There is now or a of 4000 bars (10 000 6000). If price were even
lower, at $1, the shortage would be larger, at 8000 bars. At a price of $1, producers would be willing and
able to supply only 4000 bars, whereas consumers would be willing and able to buy 12 000 bars.
Producers will notice that the chocolate bars are quickly sold out, and so begin to raise the price. As they
do so, quantity demanded begins to fall and quantity supplied begins to rise. The shortage in the
chocolate market exerts an upward pressure on price. The price will keep increasing until the shortage is
eliminated; this will happen when quantity supplied is exactly equal to quantity demanded.
P ($) Q Q
( ) ( )
P ($) Q Q
( ) ( )
5 4000 12 000
4 6000 10 000
3 8000 8000
2 10 000 6000
1 12 000 4000
T 2.6: Market demand and supply schedules for chocolate bars
F 2.11: Market equilibrium
The existence of e ce de a d (a shortage) or e ce l (a l ) in a free market will cause

the price to change so that the quantity demanded will be made equal to quantity supplied. In the
event of excess demand, price will rise; in the event of excess supply, price will fall.
M
E is defined as a state of balance between different forces, such that there is no tendency to
change. This is an important concept in economics that we will encounter repeatedly. When quantity
demanded is equal to quantity supplied, there is ; the forces of supply and demand
are in balance, and there is no tendency for the price to change. Market equilibrium is determined at the
point where the demand curve intersects the supply curve. The price in market equilibrium is the
, and the quantity is the . At the equilibrium price, the quantity
consumers are willing and able to buy is exactly equal to the quantity firms are willing and able to sell.
This price is known as the a ke ice. In the market for chocolate bars in Figure 2.11, the equilibrium
price is $3 per chocolate bar, and the equilibrium quantity is 8000 bars. At any price other than the
equilibrium price, there is a ke di e ilib i . In a free competitive market, a market disequilibrium
cannot last, as demand and supply force the price to change until it reaches its equilibrium level.
, quantity demanded equals quantity supplied, and there is no

tendency for the price to change. In a market disequilibrium, there is excess demand (shortage) or
excess supply (surplus), and the forces of demand and supply cause the price to change until the
market reaches equilibrium.
C
Once a price reaches its equilibrium level, consumers and firms are satisfied and will not engage in any
action to make it change. However, if there is a change in any of the non-price determinants of demand
or supply, a shift in the curves results, and the market will adjust to a new equilibrium.
C ( )
In Figure 2.12(a), D1 intersects S at point a, resulting in equilibrium price and quantity P1 and Q1.
Consider a change in a determinant of demand that causes the demand curve to shift to the right from D1
to D2 (for example, an increase in consumer income in the case of a normal good). Given D2, at the
initial price, P1, there is a movement to point b, which results in excess demand equal to the hori ontal
distance between points a and b. Point b represents a disequilibrium, where quantity demanded is larger
than quantity supplied, thus exerting an upward pressure on price. The price therefore begins to increase,
causing a movement up D2 to point c, where excess demand is eliminated and a new equilibrium is
reached. At c, there is a higher equilibrium price, P2, and greater equilibrium quantity, Q2, given by the
intersection of D2 with S.
F 2.12: Changes in demand and the new equilibrium price and quantity
A decrease in demand, shown in Figure 2.12(b), leads to a leftward shift in the demand curve from D1 to
D3 (for example, due to a decrease in the number of consumers). Given D3, at price P1, there is a move
from the initial equilibrium (point a) to point b, where quantity demanded is less than quantity supplied,
and therefore a disequilibrium where there is excess supply equal to the hori ontal difference between a
and b. This exerts a downward pressure on price, which falls, causing a movement down D3to point c,
where excess supply is eliminated, and a new equilibrium is reached. At c, there is a lower equilibrium
price, P3, and a lower equilibrium quantity, Q3, given by the intersection of D3 with S.
C ( )
We now consider supply curve shifts that can arise from changes in the determinants of supply. In Figure
2.13(a), the initial equilibrium is at point a where D intersects S1, and where equilibrium price and
quantity are P1 and Q1. An increase in supply (say, due to an improvement in technology) shifts the
supply curve to S2. With S2 and initial price P1, there is a move from point a to b, where there is
disequilibrium due to excess supply (by the amount equal to the hori ontal distance between a and b).
Therefore, price begins to fall, and there results a movement down S2 to point c where a new equilibrium
is reached. At c, excess supply has been eliminated, and there is a lower equilibrium price, P2, but a
higher equilibrium quantity, Q2.
A decrease in supply is shown in Figure 2.13(b) (say, due to a fall in the number of firms). With the new
supply curve S3, at the initial price P1, there has been a move from initial equilibrium a to disequilibrium
point b, where there is excess demand (equal to the distance between a and b). This causes an upward
pressure on price, which begins to increase, causing a move up S3 until a final equilibrium is reached at
point c, where the excess demand has been eliminated, and there is a higher equilibrium price P3 and
lower quantity Q3.
F 2.13: Changes in supply and the new equilibrium price and quantity
F
You may remember from Chapter 1, Section 1.1, that free goods are goods that are not subject to the
condition of scarcity and have a ero opportunity cost, while economic goods are subject to scarcity and
have an opportunity cost greater than ero. We are now in a better position to understand the difference
between the two by use of demand and supply analysis. Figures 2.14(a) and (b) show a free and
economic good respectively. A f ee g d is a good for which the quantity supplied is greater than the
quantity demanded when the price is ero. Supply is so large relative to demand that there is excess
quantity supplied even at a ero price. An ec ic g d is a good for which quantity supplied is
smaller than quantity demanded when the price is ero. A free good can change into an economic good
as a result of a leftward shift in the supply curve (reduced supply) or a rightward shift in the demand
curve (increased demand). When demand and supply intersect at a price greater than ero, the good has
become an economic good.
F 2.14: Free and economic goods
REAL ORLD FOCUS 2.2

P I: A
For thousands of years the avocado was held to be a sacred fruit in Central America.Yet this was not
so in much of the rest of the world. In 1982, it was reported that an oversupply of avocados in the
United States led to a drop in price so large that producers considered selling it as food for dogs
(though avocados cause an upset stomach in dogs). An important reason why consumers avoided
avocados was their high fat content.
In more recent years, consumers regard for the avocado has changed dramatically, thanks to the
distinction that science has made between the good and bad fat content of foods. Avocados are
plentiful in good or healthy (monounsaturated) fats, and in addition contain a host of healthful
minerals and vitamins. Consumers around the world are now eating far more avocados than ever
before, and their price is rising.
F 2.15: Green Hass avocado fruit
S : RiverheadLOCAL
P II: P ( )
The summer of 2018 was the hottest in the UK since 1976. As a result there was a significant drop in
quantities produced of many crops. By the fall UK farmers noted that potato crops were reduced by
one-third. This gave rise to an increase in the price of potato chips (crisps).
S : I de e de
A
Using diagrams in each case, analyse and explain
1 the effect on avocado prices of consumers perceptions that avocados are unhealthy due to their
high fat content
2 the effect on avocado prices of the information that avocados are very healthy
3 the effect on the price of potato chips (crisps) of extreme weather conditions in the UK.

1 In Figure 2.11. state whether there is excess supply (a surplus) or excess demand (a shortage),
and how large this is if price per chocolate bar is:
$5,
$4,
$3,
$2, and
$1.
2 Use a demand and supply diagram to:
show equilibrium price and quantity,
show possible disequilibrium prices and quantities,
relate disequilibrium prices to excess demand (shortages) and excess supply (surpluses),
explain the meaning of market equilibrium , and
explain the roles of demand and supply in achieving market equilibrium.
3 Use supply and demand diagrams to illustrate the following events.
Free ing weather destroys the orange crop and the price of oranges rises.
The mass media report on the fat content of cheese and the price of cheese falls.
A new technology of production for computers is developed and the price of computers
falls.
Milk, an input for ice cream production, becomes more expensive and the price of ice cream
increases.
The mass media report on the health benefits of olive oil and the price of olive oil increases.
4 Assuming a competitive market, use demand and supply diagrams to show in each of the
following cases how the change in demand or supply for product A creates a disequilibrium
consisting of excess demand or excess supply, and how the change in price eliminates the
disequilibrium.
Consumer income increases (A is a normal good).
Consumer income falls (A is an inferior good).
There is an increase in labour costs.
The price of substitute good B falls.
The number of firms in the industry producing product A increases.
A successful advertising campaign emphasises the health benefits of product A.
2.5 T
LEARNING OBJECTI ES

anal se the price mechanism ith respect to its functions including (AO2)
resource allocation (signalling and incentive functions)
rationing
e plain the meaning of consumer and producer surplus, as ell as social or communit surplus
(AO2)
dra a diagram sho ing ma imum social surplus at competitive market equilibrium (AO4)
e plain the conditions for achievement of allocative efficienc at competitive market equilibrium
(AO2)
social surplus is ma imum
marginal benefits are equal to marginal costs
calculate consumer and producer surplus from a diagram (AO4)
Prices determined b the forces of suppl and demand in competitive markets are kno n as the
. The price mechanism serves some important functions that e ill no e plore.
P
In Chapter 1 e sa that the condition of scarcit forces societies to make choices. As the production
possibilities model illustrated (Figure 1.1), assuming the econom is producing on its production
possibilities curve (PPC), it must decide on hat particular point on the PPC it ishes to produce. This
involves a choice about ha /ho m ch o od ce, hich is a decision on one aspect of resource
allocation. It also involves a choice about hich of its available resources and in hat quantities, it ill
allocate to produce the combination of goods and services it has chosen. This is a choice on the ho o
od ce question of resource allocation.
This brings us to an important question. Ho does a societ make a choice about here to be on its
PPC? Who decides, and ho is this decision carried out? In a market econom , it is simpl prices in free
markets, resulting from the interactions of demanders and suppliers, hich make the decisions and carr
them out. We have learned that hen markets operate under competitive conditions, market demand and
market suppl , composed of numerous individual demanders and suppliers, determine equilibrium prices
and quantities for goods (and services and resources). At these equilibrium positions, the bu ing and
selling choices of all bu ers and sellers are satisfied and are in balance. This market mechanism,
orking through prices, is kno n as the in i ible hand of he ma ke , a phrase first used b Adam Smith,
hose contributions to economics ere e plained in Chapter 1. The invisible hand succeeds in co-
ordinating the bu ing and selling decisions of thousands or millions of decision-makers in an econom
ithout an central authorit . The ha /ho m ch o od ce question of resource allocation is
ans ered because firms produce onl those goods consumers are illing and able to bu , hile
consumers bu onl those goods producers are illing and able to suppl ; and the ho o od ce
question of resource allocation is ans ered because firms use those resources and technologies in their
production process that the are illing and able to pa for.
Ho do prices and markets achieve the task of resource allocation?
The ke to the market s abilit to allocate resources can be found in the and
functions of prices in resource allocation. As signals, prices communicate information to decision-
makers. As incentives, prices motivate decision-makers to respond to the information.
We ill e amine the signalling and incentive functions of prices b use of the follo ing t o e amples.
A
Suppose consumers decide the ould like to eat more stra berries because of their health benefits (a
change in tastes); demand increases and the demand curve shifts to the right from D1 to D2 in Figure
2.16(a). At the initial price, P1, this results in a shortage equal to the difference bet een Q2 and Q1: the
quantit demanded Q2, due to the increase in demand to D2, is larger than quantit supplied, Q1. The
price of stra berries therefore begins to rise and ill continue to rise until the shortage has disappeared.
This happens at price P2 and quantit Q3, given b the point of intersection of the suppl curve ith the
ne demand curve, D2.
F 2.16: Price as a signal and incentive
What has happened? The ne , higher price signalled or conve ed information to producers that a
shortage in the stra berr market had emerged. The increase in price is also an incentive for producers
to increase the quantit of stra berries supplied; at the higher price, stra berr production is more
profitable, so producers move along the suppl curve from point A to point C, increasing quantit
supplied from Q1 to Q3. But the ne , higher price is a signal and incentive for consumers: it signals that
stra berries are no more e pensive, and is an incentive for them to bu fe er stra berries. The
therefore move along the ne demand curve from B to C, bu ing fe er stra berries than at the original
price P1 (Q3 is smaller than Q2). The increase in the price of stra berries resulted in a ealloca ion of
e o ce . More resources are no allocated to stra berr production. (This affects the ans er to the
ha o od ce question of resource allocation.)
A
The second e ample is from the labour market (a resource market). The vertical a is in Figure 2.16(b)
measures the price of labour (the age) and the hori ontal a is the quantit of labour. Firms are
interested in bu ing labour services, and their demand for labour is given b D. O ners of labour
services ( orkers) suppl their labour in the labour market, and the initial suppl of labour is sho n b
S1.2
Assume that because of immigration (foreign orkers enter the countr ), the suppl of labour increases,
so the labour suppl curve shifts to S2. At the old age, W1, there is a surplus of labour sho n b the
difference bet een Q2 and Q1 of labour. The surplus causes the age to start falling, and this falls until
the surplus has disappeared. The ne equilibrium age is W2, and the equilibrium quantit of labour Q3,
given b the intersection of D ith S2.
The falling age has acted as a signal and an incentive. It signalled to firms that there as a surplus in
the labour market, and it provided them ith an incentive to hire more labour; therefore, the move
along the labour demand curve from point A to point C (Q3 is larger than Q1). The lo er age is also a
signal to orkers, providing them ith the incentive to move along the ne suppl curve, S2, from B to
C, here the offer less of their services at the lo er age (Q3 is less than Q2). With firms and orkers
responding to price signals and incentives, there occurred a reallocation of labour resources ith firms
no producing output ith a larger quantit of labour. (This affects the ans er to the ho o od ce
question of resource allocation.)
P
Ra ioning is a method of apportioning or parceling out goods and services among consumers or
households. The market mechanism uses ice a ioning for this purpose, hich involves the use of
prices freel determined in markets. This simpl means that hether or not a consumer ill get a good is
determined b the price of that good. All those ho are illing and able to pa the price of a good or
service ill get it, and all those ho are not illing or able to pa the price ill not get it. Price, and
price alone is the factor that decides. This happens because at the market-determined equilibrium price
and quantit , the bu ing and selling choices of all bu ers and sellers in the market for a good are
satisfied and are in balance.
Price rationing is simpl the market mechanism at ork, kno n as Adam Smith s in i ible hand of he
ma ke (see Chapter 1), hich coordinates the countless bu ing and selling decisions of decision-making
units in an econom ithout an central authorit .
When the price mechanism is not orking properl , such as in planned economies (see Chapter 1) or if
there are price controls (see Chapter 4), then non- ice a ioning s stems come into pla in order to
apportion goods and services among their various users.
The most common non-price rationing method is the aiting line or queue, here consumers get a good
on a first come, first served basis. Non-price rationing ill be discussed in Chapter 4.
TEST O R NDERSTANDING 2.7

1 E plain the role of prices in resource allocation.
Describe ho this relates to Adam Smith s in i ible hand.
2 Consider the market for coffee, and suppose that the demand for coffee falls (because of a fall in
the price of tea, a substitute good), leading to a ne equilibrium price and quantit of coffee.
Using diagrams, e plain the role of price as a signal and as an incentive for consumers and for
firms in reallocating resources.
3 Consider the labour market, and suppose the suppl of labour falls (due to large-scale departure
of orkers to another countr ), resulting in a ne equilibrium price and quantit of labour. Using
diagrams, e plain the role of price as a signal and as an incentive for orkers (the suppliers of
labour) and firms (the demanders of labour) in reallocating resources.
4 Distinguish bet een price rationing and non-price rationing.
A
Efficienc , as e sa in Chapter 1, is one of the ke concepts running through this course, and ver
broadl means making the best possible use of resources. We ill no stud ho competitive markets
achieve a special t pe of efficienc called allocative efficienc .
A refers to producing the quantit of goods mostl anted b societ . Allocative
efficienc is achieved hen the econom allocates its resources so that the societ gets the most benefits
from consumption. Since allocative efficienc refers to producing hat consumers mostl ant, it
ans ers the ha /ho m ch o od ce question in the best possible a .3
R :
Before e consider allocative efficienc at competitive market equilibrium, e ill pause a moment to
e plore a different interpretation of demand and suppl .
T
Consumers bu goods and services because these provide them ith some benefit, or satisfaction. The
greater the quantit of a good consumed, the greater the satisfaction. Ho ever, the e tra benefit provided
b each additional unit increases b smaller and smaller amounts. Imagine ou bu a soft drink, hich
provides ou a certain amount of benefit. You are still thirst , so ou bu a second soft drink. Whereas
ou ill enjo this ou ill most likel enjo it less than the first; the second soft drink provides ou
ith less benefit than the first. If ou bu a third, ou ill get even less benefit than from the second,
and so on ith each additional soft drink. The e tra benefit that ou get from each additional unit of
something ou bu is called the (marginal means e tra or additional).
No remember that the demand curve, as ou learned earlier in this chapter, sho s the various quantities
of a good that a consumer is illing and able to bu at different possible prices, ce e i a ib . But it
can also be thought of as sho ing the amount of mone that the consumer is illing to pa to get one
more unit of the good. Since the e tra or marginal benefit that the consumer gets from bu ing one more
unit of the good becomes smaller and smaller as the quantit increases, this means that the price the
consumer is illing to pa also gets smaller and smaller as the number of units bought increases.
Since marginal benefit decreases as the quantit of a good consumed increases, consumers ill be
illing to bu an e tra unit of the good onl if its price falls. The demand curve can therefore also be
called a ma ginal benefi (MB) c e
(Students stud ing this course at HL ill notice that the concept of marginal benefits is ver similar to
the concept of marginal utilit e amined earlier. The difference bet een the t o is actuall ver subtle.
Marginal utilit as e have seen is something that cannot be measured. Marginal benefit, on the other
hand, is interpreted to indicate the consumer s illingne o a for the last or marginal unit bought,
hich is simpl price, and is therefore measurable. The differences bet een the t o concepts are be ond
the scope of the IB s llabus.)
T
In order to be able to produce goods and services, firms have co , hich involve pa ments that must be
made in order to acquire factors of production. For e ample, a farmer must bu seeds and fertilisers, pa
orkers to ork on the land, and so on. The e tra cost of producing one more unit of output is called the
ma ginal co . Marginal cost t picall increases as the units of output produced increase. (The reasons
for this ere studied at HL earlier in this chapter in Section 2.3.) This means that the farmer can onl
produce more output if the price of the good increases to cover the e tra cost of each e tra unit
produced.
The firm s suppl curve as ou ma remember, sho s the various quantities of a good that a firm is
illing and able to produce and suppl at various possible prices, ce e i a ib . But in vie of the
firm s costs of production, the suppl curve also sho s the price that the firm is illing to accept in
order to produce one more unit of the good.
Since marginal cost increases as the quantit of a good produced increases, producers ill be illing
to produce and sell an e tra unit of the good onl of its price increases. The suppl curve can
therefore also be called a ma ginal co (MC) c e.
A : B= C
As e kno , market equilibrium occurs at the point of intersection of the demand and suppl curves, but
depending on ho e interpret the demand and suppl curves, market equilibrium can be thought of
differentl . If e interpret the demand curve as a marginal benefit (MB) curve, and the suppl curve as a
marginal cost (MC) curve, then market equilibrium occurs here MB = MC. The equalit of MB ith
MC tells us that the e tra benefit to societ of getting one more unit of the good is equal to the e tra cost
to societ of producing one more unit of the good. When this happens, societ s resources are being used
to produce the right quantit of the good; in other ords, societ has allocated the right amount of
resources to the production of the good, and is producing the quantit of the good that is mostl anted
b societ . Thi i none o he han alloca i e efficienc and is sho n in Figure 2.17.
To understand this, consider that if MB > MC, then societ ould be placing a greater value on the last
unit of the good produced than it costs to produce it, and so more of it should be produced. If MC > MB,
then it ould be costing societ more to produce the last unit of the good produced than the value
societ puts on it, and so less should be produced. If MC = MB, then just the right quantit of the good
is being produced.
Putting the above points together, e can conclude that at the point of competitive market equilibrium,
here MB = MC, the econom achieves allocative efficienc . For allocative efficienc to be achieved for
an entire econom , the condition MB = MC, must hold in all markets.
I
There is another a e can understand ho allocative efficienc is achieved b the competitive market
econom ; this involves the concepts of consumer surplus and producer surplus.
C
C is defined as the highest price consumers are illing to pa for a good minus the
price actuall paid. The highest price the are illing to pa is given b the demand curve. The price
actuall paid is determined at the market equilibrium b suppl and demand. Consumer surplus is sho n
in Figure 2.17 as the shaded area bet een the demand curve, and the equilibrium price Pe, up to quantit
Qe.
Consumer surplus is the area under the demand curve and belo the price paid b the consumer, up to
the quantit purchased.
Consumer surplus indicates that hereas man consumers ere illing to pa a higher price to get the
good, the actuall received it for less. For e ample, man consumers ere illing to pa price P2 to get
quantit Qa, et the got Qa b pa ing onl the lo er price Pe. The difference bet een P2 and Peis
consumer surplus for quantit Qa. Similarl , man consumers ere illing to pa price P3 in order to
get quantit Qb, et the got it b pa ing onl Pe. Again, the difference P3 Pe is consumer surplus for
quantit Qb. The same principle applies to all possible prices bet een the highest price P1 and the
equilibrium price Pe. Therefore, all the consumers ho ere illing to pa a higher price than Pe to get
the good received some benefit over and above hat the actuall paid for the good. This e tra benefit is
called consumer surplus.
F 2.17: Consumer and producer surplus in a competitive market
P
P is defined as the price received b firms for selling their good minus the lo est price
that the are illing to accept to produce the good. The price received is given b the market equilibrium
price. The lo est price the are illing to accept is sho n b the suppl curve. Producer surplus appears
in Figure 2.17 as the shaded area bet een the suppl curve, and the equilibrium price Pe, up to quantit
Qe.
Producer surplus is sho n as the area above the firms suppl curve and belo the price received b
the firm, up to the quantit produced.
As e can see in Figure 2.17, firms that ere illing to produce quantit Qa for price P5 actuall
received price Pe. The difference Pe P5 is producer surplus for quantit Qa. Similarl , the producer
surplus for quantit Qb is given b the price Pe actuall received minus P4 that the firms ere illing to
accept for producing Qb. The same principle applies to all possible prices bet een the lo est price P6
and the equilibrium price Pe. Therefore, total producer surplus is sho n b the shaded area bet een the
equilibrium price Pe and the suppl curve, up to the quantit produced and sold.
C :
At the point of competitive market equilibrium, the sum of consumer and producer surplus is ma imum,
or the greatest it can be. To see h , consider hat ould happen if an quantit less than Qe ere
produced in Figure 2.17. If, sa , Qb is produced, the sum of consumer plus producer surplus ould be
smaller, as this sum ould be equal to the shaded area bet een the demand and suppl curves onl o
o Qb. It follo s, then, that the sum of consumer plus producer surplus is ma imised at the point of
market equilibrium. The sum of consumer and producer surplus is kno n as (or
). 4
At the point of competitive market equilibrium, social surplus, defined as the sum of consumer plus
producer surplus, is ma imum.
Let s no e amine the importance of ma imum social surplus at the point of competitive market
equilibrium. You ill note that competitive market equilibrium is none other than the point here
marginal benefit equals marginal cost, or MB = MC. Based on our discussion above, e kno that hen
MB = MC there is allocative efficienc . Therefore ma imum social surplus is just another a of sa ing
that there is allocative efficienc .
At the point of competitive market equilibrium sho n in Figure 2.17, production of a good occurs
here MB = MC, hich is also he e ocial l , o he m of con me l od ce l i
ma im m. This means that markets are achieving allocative efficienc , producing the quantit of
goods mostl anted b societ . Societ is making the best possible use of its scarce resources.
When the competitive market realises allocative efficienc , e sa that social elfare is ma imised.
What does this mean? The term in economics refers to the amount of consumer and producer
surplus. Welfare is clearl ma imum hen social surplus is ma imum, or hen MB = MC. We can
therefore sa that:
In competitive markets, hen MB = MC, or hen social surplus is ma imum, social elfare is
ma imum.
C
Figure 2.18(a) is similar to Figure 2.17 onl in that it includes figures that allo us to calculate consumer
and producer surplus. To see ho this is done, note the follo ing t o terms.
P in e ce = the point on the P a is that is met b a curve. In Figure 2.18(a), the demand curve has a P
intercept = 6.5 and the suppl curve has a P intercept = 1.
Q in e ce = the point on the Q a is that is met b a curve. In Figure 2.18(a), e are not sho n an Q
intercept. Ho ever, in Figure 2.18(b) e see that the suppl curve has a Q intercept = 2.
Let s begin ith a calculation of consumer and producer surplus in Figure 2.18(a). Consumer surplus, as
e kno , is the area under the demand curve and belo the price paid b consumers, up to the quantit
purchased. It is simple to calculate consumer surplus if e think of it as half the area of the rectangle
hose one side equals the P intercept of the demand curve minus the price paid b consumers, and
hose other side equals the number of units purchased.
C =
(P intercept of D curve minus P of consumers) Q purchased 2
Therefore consumer surplus= (6.5 3) 4.52 2 = 3.5 4.5 2 =$7.88

Producer surplus is the area above the suppl curve and belo the price received b producers, up to the
quantit produced. In Figure 2.18(a), it is half the area of the rectangle hose one side equals the price
received b producers minus the P intercept of the suppl curve, and hose other side equals the number
of units sold.
P =
(P of producers minus P intercept of S curve) Q sold 2
Therefore:
producer surplus= (3 1) 4.5 2 = (2 4.5) 2 =$4.50
Notice that both consumer surplus and producer surplus are given in terms of $, this is because the
e press a mone a al e that has been gained b consumers and producers.
It follo s then that social surplus, being the sum of consumer and producer surplus = $7.88 + $4.50 =
$12.38.
Ho ever, it should be noted that the suppl curve does not al a s have a P intercept. This can be seen in
Figure 2.18(b), here the suppl curve begins on the Q a is, having a Q intercept = 2. In cases like this,
the formula given above for producer surplus is not appropriate. Instead, to find the area above the
suppl curve and under the price up to the quantit produced e need to use the formula for a a e i m.
A trape ium is a geometrical shape here one pair of opposite sides is parallel but the other pair is not
parallel. In Figure 2.18(b), let s call the lengths of the t o parallel sides a and b, hile the distance
bet een these t o sides is called c. The area of a trape ium then is:
area of trape ium= (a+b) c 2
Therefore considering Figure 2.18(b) e can calculate that:

producer surplus= (4+2) 3 2 = 6 3 2 =$9.00
Consumer surplus in Figure 2.18(b), using the formula given earlier is:
consumer surplus = (6.5 3) 4 2 = 3.5 4 2 =$7.00
Social surplus, being the sum of consumer and producer surplus = $7.00 + $9.00 = $16.00.
As e ill discover in later chapters, consumer surplus is al a s given b the area of a triangle.
Producer surplus and social surplus are usuall given b the area of a triangle but sometimes the
ma be the area of a trape ium. Therefore, before ou use a formula for a calculation, ou must first
identif hether ou are calculating the area of a triangle or the area of a trape ium.
F 2.18: Calculating consumer and producer surplus and social surplus
A S
Adam Smith did not think of consumer and producer surplus, or marginal benefits and marginal costs,
but he did come up ith the idea that individuals acting in the best self-interest ould through the
orkings of markets, produce an outcome for societ that ould be in societ s best interests. We are
no in a far better position to understand the in i ible hand that as introduced in Chapter 1. It means
that the market is able to coordinate the decisions of countless actions of individual economic decision-
makers ithout an central authorit , simpl through the orkings of demand and suppl , hile at the
same time promoting efficienc hich encourages the best allocation of scarce resources. This is perhaps
the most important contribution of Adam Smith to economic thought.
A
We have seen that the competitive market succeeds in achieving allocative efficienc , thus ensuring the
best possible use of scarce resources. This idea suggests that there should not be government
intervention in markets, as these ork ver ell on their o n. Ho ever, there are t o important issues
that arise, calling into question the idea that governments should not intervene.
The first is that efficienc can onl arise under a number of ver strict and highl unrealistic conditions
that are practicall never met in the real orld. In the real orld the market fails to achieve allocative
efficienc . Market failures are an important justification for government intervention. When markets fail
to achieve allocative efficienc , this means that social surplus is reduced, resulting in hat is kno n as
(also called dead eigh lo ). In other ords, social elfare is no longer ma imum on
account of a portion of it being lost. Welfare loss ill be discussed in later chapters.
The second is that the competitive market is unable to provide a satisfactor ans er to the fo hom o
od ce question, or output and income distribution, thus also inviting some government intervention.
The topic of distribution and hat can be done to improve outcomes ill also be e amined in Chapters
12 and 19, as ell as in Chapter 6 at HL. It is also discussed in the Theor of kno ledge feature 2.1.
These observations do not lessen the significance of the market s potential advantages; the onl point
out that in the real orld, there is a need for government policies to counteract the failings of markets,
thus allo ing them to realise their potential advantages. There are important reasons h economists
stud the competitive market e tensivel . One is that government policies can be assessed ith respect
to their efficienc consequences (Chapter 4). Another is that it can form the basis for government
policies that tr to create conditions in the real orld that allo actual economies to come closer to
achieving economic efficienc (Chapters 5 7). A third is that it provides standards for economic
efficienc against hich actual outcomes, hich are less than perfectl efficient, can be assessed
(Chapters 4 and 7).

1 E plain the meaning of allocative efficienc .
2 E plain the meaning of
consumer surplus,
producer surplus,
social (or communit ) surplus, and
ma imum social elfare .
3 Use a demand and suppl diagram to illustrate consumer and producer surplus.
Identif the level of output here their sum is ma imum.
E plain the condition MB = MC, and use our diagram of part (a) to sho at hich level of
output this condition is satisfied.
Outline hat the conditions of ma imum consumer plus producer surplus, and MB = MC
tell us about allocative efficienc , and hat the tell us about social elfare.
4 Describe some limitations of the concept of ma imum social elfare.
5 Using the diagram calculate consumer and producer surplus at the initial equilibrium given
b S1 and D.
Suppose the suppl curve shifts to S2. Calculate the ne consumer and producer surplus
that arise at the ne equilibrium.
Calculate the increase or decrease in consumer and producer surplus due to the shift in the
suppl curve.
E plain hat accounts for the changes in consumer and producer surplus in terms of the
changes in P and Q.

T
We must be ver careful hen interpreting the meaning of ma im m ocial elfa e. The achievement
of MB = MC, or ma imum social surplus, deals ith the ha /ho m ch o od ce and ho o
od ce questions, and therefore ith ho a societ can realise allocative efficienc .
Even if it is assumed that allocative efficienc is achieved, in hich case e have ma imum social
elfare , this tells us nothing about ho output and income are, or should be, distributed. The
achievement of allocative efficienc is, in fact, consistent ith an possible distribution of output or
income. This means that e can have an e tremel unequal distribution of output and income, here
one person in societ gets all the output, or a highl equal distribution here ever one gets an equal
share, and both of these situations can lead to allocative efficienc . This idea highlights the point that
hen e efe o ma im m ocial elfa e, e a e onl alking abo making he be o ible e of
ca ce e o ce , hile a ing no hing abo ho ge he benefi of ha he e o ce od ce. For
an distribution of income and output, ranging from the most unequal to the most equal, it is possible
to have a situation of ma imum social surplus and therefore allocative efficienc .
The pursuit of efficienc , dealing ith the ha /ho m ch o od ce and ho o od ce questions,
is based on social scientific investigation, and tries to discover the most effective a s to increase
efficienc in resource allocation. Man economists ould argue that this is a matter of positive
economics (see Chapter 1 on the distinction bet een positive and normative economics). On the other
hand, the fo hom o od ce question is a matter of normative economics. Positive economic
thinking, based on the scientific method described in Chapter 1, is not intended to make judgements
about hat is fair or unfair, or equitable or inequitable. It is intended to deal ith issues of things that
are or ill be under different conditions. Therefore, hile it can tell us about hat methods are
most likel to lead to increases in efficienc , it is not intended to tell us about ho income and output
should be distributed. The issue of equit (introduced in Chapter 1) is a normative issue, because hat
is considered fair is a matter of beliefs and value judgements about things that ought to be . What
share of total income, or hat particular goods and services o gh individuals to have? Is there a
minimum income that people o gh to have? If so, based on hat kinds of equit principles o gh
distribution and redistribution to take place?
There are no right or rong ans ers to these questions. The ans ers that are chosen are based on
beliefs and value judgements about hat is good for societ and the people ithin it. According to the
standard vie , economists should be concerned ith positive aspects of economics. Their positive
thinking could tell us about the likel consequences of policies to change the distribution of income,
but should not make recommendations about ho the distribution of income ought to change.
We ill continue ith the topic in Theor of kno ledge 6.1 in Chapter 6.
T
What is the significance of language in conve ing meaning; does the e pression ma imum
social elfare accuratel reflect its actual meaning?
If economists, as social scientists, cannot make recommendations about normative issues like the
distribution of income, ho are these decisions made? (Think about the political process, social
values, tradition and histor .)
Based on our reading about economics in the press and listening to the ne s, do ou think that
economists in the real orld make a clear distinction bet een positive and normative ideas?
Do ou agree ith the principle that economists (and social scientists generall ) should onl be
concerned ith positive thinking (social scientific investigation) and should leave normative
issues (about things that ought to be) to societal decision-making?
2 The demand curve has the usual do n ard-sloping shape, because as the age falls, firms are prompted to hire
more labour and so the quantit of labour demanded increases. The suppl curve has the usual up ard-sloping
shape because the higher the age, the more illing orkers ill be to suppl their labour in the market.
3 At the same time it also ans ers the ho o od ce question in the best possible a . An e planation of this is
be ond the scope of the IB s llabus.
4 Note that the term surplus is used in t o senses in this chapter. In one sense it refers to e cess suppl
(Section 2.4) and in the other it refers to benefits received b consumers and producers. You can avoid
confusing the t o concepts b noting that henever the term is used on its o n, it refers to e cess suppl .
2.6 Critique of the ma imising behaviour of
consumers and producers (HL onl )
LEARNING OBJECTIVES
Af e d ing hi ec ion o ill be able o:

define all he e m appea ing in orange bold in he e (AO1)
e al a e he a mp ion of con me a ionali , ili ma imi a ion and pe fec info ma ion
(AO3)
efe ing o he follo ing poin , di c he limi a ion of anda d con me beha io made
b beha io al economi (AO3)
bia e incl ding le of h mb, ancho ing, f aming, a ailabili
bo nded a ionali
bo nded elf-con ol
bo nded elfi hne
impe fec info ma ion
di c policie in pi ed b beha io al economic (AO3)
choice a chi ec e i h e pec o defa l , e ic ed and manda ed choice
n dge heo
di ing i h be een a io objec i e of b ine e (AO3)
p ofi ma imi a ion
al e na i e objec i e incl ding co po a e ocial e pon ibili , ma ke ha e, a i ficing,
go h
Rational economic decision-making

S anda d economic heo ie and model a e ba ed on an impo an a mp ion, ha of a ional elf-
in e e , o a a ec c dec - a . Thi mean ha indi id al a e a med o ac in
hei be elf-in e e , ing o a e (make a la ge a po ible) he a i fac ion he e pec o
ecei e f om hei economic deci ion . I i a med ha con me pend hei mone on p cha e
o ma imi e he a i fac ion he ge f om b ing diffe en good and e ice . Simila l , i i
a med ha fi m (o p od ce ) o ma imi e he p ofi he make f om hei b ine e ;
o ke o ec e he highe po ible age hen he ge a job; in e o in he ock ma ke
o ge he highe po ible e n on hei in e men , and o on.
A e ill ee in he di c ion belo , he a mp ion of a ional economic deci ion-making and he
p inciple of elf-in e e ed ma imi a ion nde l ing economic heo ha come o be e io l
q e ioned.
Rational consumer choice

The anda d heo of con me beha io i ba ed on ome a mp ion of rational consumer
choice hich e di c belo .
Assumptions of rational consumer choice
Consumer rationalit
Acco ding o a a c e c ce con me make p cha ing deci ion acco ding o hei
a e and p efe ence hich a i f h ee a mp ion .
1 The con me i able o ank good acco ding o he p efe ence . Thi mean ha if conf on ed
i h o good , o o g o p of good , A and B, he con me can a i h ce ain ha he
p efe A o B, o he p efe B o A, o he i indiffe en be een A and B. (Thi i called he
c e e e a mp ion.)
2 P efe ence among al e na i e choice a e con i en . Thi mean ha if he con me p efe A
o B, and B o C, hen he m p efe A o C. (Thi i called he a a mp ion.)
3 The con me al a p efe mo e of a good o le . If he e a e o g o p of good he e one
g o p con ain mo e of one good han he o he g o p, he con me ill al a p efe he
g o p ha ha mo e of he one good. (Thi i called he -a a a mp ion.)
Perfect information
I i f he a med ha con me ha e a hei di po al pe fec info ma ion abo all hei
al e na i e , o ha he e i no nce ain . In o he o d , hen a con me choo e good A o e
good B, he po e e all po ible info ma ion abo good A and good B, o ha he e a e no do b ,
q e ion o nce ain ie abo he good being cho en. The con me ha kno ledge of all po ible
p od c , p od c q ali ie and p ice .
Utilit ma imisation
U , a e a ea lie in hi chap e , efe o he a i fac ion ha con me de i e f om
con ming ome hing. Acco ding o he heo of con me beha io , con me a e e
, meaning he make i a la ge a po ible, b b ing he combina ion of good and e ice
ha e l in he g ea e amo n of ili fo a gi en amo n of mone pen ( he con me
b dge o income). Thi beha io i ba ed on he a mp ion of a ionali and pe fec info ma ion
ha e e p e en ed abo e.
The concep of ma ginal ili , and he la of dimini hing ma ginal ili , a e f ndamen al b ilding
block of he heo of con me beha io ha allo economi o ho ho con me make hei
choice among al e na i e in o de o ma imi e ili . 5
Behavioural economics: limitations of the assumptions of

rational behaviour
Beha io al economic a in od ced in Chap e 1, Sec ion 1.5. I i a ne b anch of economic
ongl infl enced mainl b p cholog , b al o b ociolog and ne o cience, ba ed on he idea
ha h man beha io i fa mo e comple han con me a ionali a me . While he a mp ion
of a ionali ha al a been q e ioned on he g o nd ha people e of en do no beha e a
a ionall a i p e med, i i onl ince abo he beginning of he 21 cen ha beha io al
economic began o flo i h in o a di inc b anch of economic .
Beha io al economic c i ici e con me a ionali and he idea of ili ma imi a ion on he
follo ing g o nd .
Biases
A bias (al o kno n a c e b a ) i a e m f om p cholog ha efe o ema ic e o in
hinking o e al a ing. Bia e a e depa e f om no mal anda d of ho gh o j dgmen . Bia e
ha affec con me choice incl de he follo ing:
Rules of thumb. Rules of thumb a e imple g ideline ba ed on e pe ience and common en e,
implif ing complica ed deci ion ha o ld ha e o be ba ed on he comple con ide a ion of
e e po ible choice. E ample of le of h mb a e: one po ion of alad i eq al o o
handf l ; a c p of fil e coffee ha 80 mg of caffeine; one e ing of f i i he i e of a fi .
The e e ample ho ha a he han make complica ed mea emen and calc la ion people
of en el on imple le o implif deci ion .
Anchoring. Anchoring in ol e he e of i ele an info ma ion o make deci ion , hich
of en occ d e o i being he fi piece of info ma ion ha he con me happen o come
ac o . Fo e ample, o find a pai of jean o an ha co $150, and hen o find a
imila one fo $100 ha o b hinking i a ba gain, b hen o di co e o co ld ha e
go en he ame hing fo $50 ome he e el e.
Framing. Framing deal i h ho choice a e p e en ed o deci ion-make (f amed). Fo
e ample, con me p efe beef de c ibed a 80% lean a he han 20% fa . Ye he a ional
con me o ld be indiffe en be een he o a he info ma ion i e ac l he ame, i i onl
p e en ed (f amed) diffe en l . In ano he e ample, con me co ld be illing o pa a highe
p ice fo a faded pai of jean in a bo iq e han fo he iden ical pai of jean in a di co n o e.
In he fi e ample he p cha e i f amed b lang age; in he econd i i f amed b he elle
en i onmen .
Availabilit . Availabilit efe o info ma ion ha i mo ecen l a ailable, hich people
end o el on mo e hea il , ho gh he e i no ea on o e pec ha hi info ma ion i an
mo e eliable han o he info ma ion ha a a ailable a an ea lie ime. Thi ma be d e a
lea pa l o he fac ha people emembe ecen e en o info ma ion mo e eadil han olde
e en o info ma ion. Fo e ample, if a con me ha ecen l ecei ed a lo of ad e i ing
info ma ion abo he pe io i of one b and o e o he b and , he ma be mo e likel o
elec ha b and, ha ing been infl enced b he ecen ad e i ing.
The p e ence of bia e ha infl ence con me choice ha led o al e na i e concep and idea p
fo a d ha ma be mo e acc a e de c ip ion of con me beha io :
Bounded rationalit
Bounded rationalit i an idea de eloped b He be Simon, ho ecei ed he Nobel P i e in
economic on 1971 fo hi o k on economic deci ion-making. Simon a g ed ha people do no ha e
an nlimi ed capaci o p oce info ma ion and ha ea ching fo info ma ion needed o ma imi e
ili i i elf a co l p oce . He he efo e gge ed he concep of bo nded a ionali o de c ibe
con me beha io . Bo nded a ionali i he idea ha con me a e a ional onl i hin limi , a
con me a ionali i limi ed b con me in fficien info ma ion, he co line of ob aining
info ma ion, and he limi a ion of he h man mind o p oce la ge amo n of info ma ion.
Acco ding o Simon, a he han ma imi e, con me a f ce, meaning he eek a a i fac o
o come a he han an op imal (o be ) one.
Bounded self-control
Bounded self-control i ela ed o bo nded a ionali ( ee abo e). I efe o he idea ha people in
eali e e ci e elf-con ol onl i hin limi . Thi mean he of en do no ha e he elf-con ol ha
o ld be eq i ed of hem o make a ional deci ion . People ma a ime ea oo m ch, pend oo
m ch, a e oo li le o o k oo li le; all hi i incon i en i h he a mp ion of a ional
beha io .
Bounded selfishness
Ano he ela ed concep i ha of bounded selfishness, hich i he idea ha people a e elfi h onl
i hin limi , and ha he a mp ion of elf-in e e ed beha io nde l ing he ma imi a ion
p inciple canno e plain he n me o acco n of elfle beha io and illingne o con ib e o
he p blic good e en a he co of ed ced pe onal elfa e ( he e poin a e f he di c ed in
Theo of kno ledge 2.2 belo ).
Imperfect information
The heo of con me beha io a e ha e een i ba ed on he a mp ion ha con me ha e
acce o all he info ma ion needed o make f ll info med deci ion , ega ding p ice , p od c ,
p od c q ali . If he did no ha e acce o ch comple e info ma ion, hei deci ion and choice
o ld no be op imal, o be . Ho e e , i i ab ndan l clea ha con me do no and canno
po ibl ha e ch f ll acce o info ma ion. Thi mean he a e nable o ma imi e ili a he
make choice ba ed on fa l and incomple e info ma ion.
Theor of knowledge 2.2

Altruism, perceptions of fairness and self-interested behaviour of rational economic decision-
makers
Economi ha e long been a a e of he p e ence of al i m and ac ba ed on pe cep ion of
fai ne in he beha io of economic deci ion-make . Fo e ample, hen con me make
anon mo dona ion o cha i o ol n ee hei e ice h o gh man ho of o k fo he
p blic good, he a e no mo i a ed b e pec a ion of mone a gain. Fi m , oo, of en ac in he
p blic in e e b no fi ing o ke in ime of ece ion o a no o inc ea e nemplo men and
ca e pe onal ha d hip, e en ho gh hi c in o hei p ofi .
Economi ome ime a g e ha he e i no eal conflic be een ch al i ic beha io and
beha io ba ed on elf-in e e , beca e people engaging in al i ic and cha i able ac gain
a i fac ion f om hei con ib ion o ocie , and hi o k o inc ea e hei ili . Selfle ne
and ca ing fo o he a e h in e p e ed o be con i en i h a ional elf-in e e and i h ili
ma imi a ion. The efo e in hi ie con me a e beha ing a ionall e en hen he beha e
al i icall .
A e io p oblem i h hi a g men i ha if he a mp ion of ili ma imi a ion i
in e p e ed o b oadl ha e e h man ac i con i en i h i , i lo e i ef lne a a heo
of con me beha io . To p i impl , if i e plain e e hing, b being con i en i h all
h man ac ion , i e plain no hing. In he o d of He be Simon, Economic heo ha ea ed
economic gain a he p ima h man mo i e.
An empi icall g o nded heo o ld a ign compa able eigh o o he mo i e , incl ding
al i m and he o gani a ional iden ifica ion a ocia ed i h i . 6 In o he o d , al i m ho ld
be ea ed epa a el , and no be made con i en i h he a mp ion of a ional elf-in e e
h o gh an all-incl i e in e p e a ion of ili .
Simon hinking b ing o mind he idea of Adam Smi h, di c ed in Chap e 1, Sec ion 1.5. In
all likelihood, Smi h o ld be e emel p i ed and di appoin ed o di co e ha hi
con ib ion o economic ega ding he in i ible hand of ma ke ha e been aken o of con e
o mean ha he be e l fo ocie a i e beca e people beha e e ba f e f-
e e . A no ed in Chap e 1, in hi ea l book, T e T e f M a Se e , Smi h a g ed
ha people elfi hne i e ained b mo al en imen , hich a e he need fo elf- e pec
and he e pec of o he , a i ing f om empa h ( hich he efe o a mpa h ) and he de i e
fo hono and j ice. O he economi of he cla ical pe iod, among hom a Da id Rica do,
ag eed i h Smi h ha people mo i a ion a e comple , in ol ing a combina ion of elf-in e e
and o he mo i e like empa h and conce n fo o he people. I a onl m ch la e , in he la e
19 h and ea l 20 h cen ie , ha economi implified and ed ced h man mo i a ion olel o
he idea of ili ma imi a ion in he name of a ional elf-in e e . Thi ga e i e o he e m
ec c (f om he La in o d meaning man, and he G eek o d ec c
meaning economic) o ha an la e in o ec c a , a m hical being ho goe abo life
a ionall ma imi ing hi elf-in e e . A Ga Becke , a no ed Nobel P i e inne (1992) a ed
decade la e , elf-in e e i a med o domina e all o he mo i e .
Since Simon ime, economi and o he cien i ha e ca ied o ho and of e pe imen ha
p o ide ample e idence of he p e ence of al i m in h man being . I i belie ed ha al i m
ma de i e f om c l e, o f om p chological de elopmen and ociali a ion, o f om inna e
biological ai . (See al o Theo of kno ledge 5.1 in Chap e 5 on ainabili and a ional
elf-in e e .)
Thinking points
H ec c , an a med being ho i fo e e a ionall ma imi ing ili a a con me
(o fo e e a ionall ma imi ing p ofi a a p od ce ), i a f ndamen al b ilding block of
mic oeconomic heo . Thi m hical being came in o e i ence a a ime hen economi ee
ing o imi a e he me hod of he cience , e peciall ph ic . J a ph ic a me he
e i ence of in pa icle (like a om ) ha beha e in a ce ain p edic able a , o con me and
fi m became he pa icle of economic ha beha e in ce ain p edic able a . Al ho gh a om
a e no i ible i h he naked e e, ph ici ha e de eloped ool o de ec hei e i ence and
de c ibe hei beha io .
Wha ool do economi e o make a mp ion abo he e i ence and beha io of
homo economic ?
In ha a a e ph ici ool he ame o diffe en f om economi ool ? Do o hink
ph ici and economi ool a e eliable o he ame e en ?
Behavioural economics in action

Beha io al economic die ho indi id al and g o p of indi id al make deci ion . In ead of
el ing on a mp ion abo h man beha io , a in he heo of con me beha io , beha io al
economic elie e en i el on e pe imen ha o ob e e and nde and ho people beha e
and eac in a a ie of i a ion .
Nudge theor
The o d d e mean poking omeone gen l o ge a en ion. A an economic e m, a nudge ha
come o mean a me hod de igned o infl ence con me choice in a p edic able a , i ho
offe ing financial incen i e o impo ing anc ion , and i ho limi ing choice. A an economic
e m he o d d e a coined b o Ame ican economi , Richa d Thale and Ca S n ein in
hei no cla ic book of 2008, N d e: I Dec ab Hea , Wea a d Ha e .
N dge o infl ence people o beha e in ociall de i able a , b i ho impo ing an
con ain on hei beha io , and b main aining f eedom of choice. Richa d Thale ecei ed he
Nobel P i e in Economic in 2017 in pa fo hi o k on beha io al economic .
While beha io al economic a ini ia ed in he Uni ed S a e , i ha aken a ong hold o e polic
in man co n ie in he o ld, i h ome co n ie e abli hing n dge ni o p e and ppo
hi app oach o a a ie of p blic polic a ea . I i no onl go e nmen b al o he p i a e ec o
ha ha e nde aken n dge ini ia i e .
E ample of n dge and hei e l incl de he follo ing:
In he Uni ed Kingdom, a pa men of la e a pa e inc ea ed b 15% hen he e e old
b he UK e en e e ice ha mo people in hei a ea had al ead paid hei a e . Thi
o ked beca e he la e a pa e e e made o feel he e e he e cep ion o ha a he
no m in hei comm ni .
In a Dani h m nicipali , he ee ligh n ed hen ola panel a e no longe fficien o
po e he ligh , making e iden mo e a a e of hei elec ici con mp ion.
P ing heal h food in mo e i ible and acce ible po i ion in o e ha been ho n o
inc ea e ale of ch food . In addi ion, colo f l foo ep leading con me o he loca ion
of heal h food ha al o been effec i e.
When non-pa e of ehicle a e ecei ed pe onali ed me age a he han a ning le e ,
he n mbe of pa e do bled; hen he me age incl ded a pho o of he ca in q e ion, he
n mbe of pa e ipled.
When a pa e ecei ed no ifica ion f om a a ho i ie in hi e en elope in ead of b o n
i h hei name hand i en a he han ped, he e a a 16% inc ea e in people pa ing hei
a .
The e e ample indica e ha people e pond fa o abl hen d ed o pe fo m ac ion ha he
migh no o he i e be inclined o do.
Beha io al pa e n ch a he e a e aken a e idence ha bo o ing f om p cholog , ociolog
and ne o cience in an a emp o nde and h h man being beha e he a he do can ha e
impo an e l in changing beha io o enco age achie emen of ociall de i able e l .
Beha io al economic ha been mo e cce f l in he a ea of finance, he e i ha al ead ongl
infl enced economic hinking. O he a ea he e i i making ome head a a e de elopmen ,
heal h, la and economic , p blic economic , o gani a ional economic and age de e mina ion.
Choice architecture
Choice architecture i he de ign of pa ic la a o en i onmen in hich people make choice ;
i i ba ed on he idea ha con me make deci ion in a pa ic la con e and ha choice of
deci ion-make a e infl enced b a e e e ed e . Choice a chi ec a e
indi id al o o gani a ion ha a ange he con e in hich choice a e made. The e m c ce
a c ec e a al o coined b Richa d Thale and Ca S n ein in hei book on n dge no ed
abo e. F a , hich a e plained ea lie , i a e impo an pa of choice a chi ec e, a i
define he con e in hich choice a e p e en ed o deci ion-make , h ing o infl ence hei
deci ion .
Choice a chi ec e offe diffe en kind of choice ha a e de c ibed belo .
Default choice i a choice ha i made b defa l , hich mean doing he op ion ha e l
hen one doe no do an hing. People of en make choice b defa l d e o habi o lack of
in e e in aking a delibe a e ac ion, e en if doing no hing ma no he be choice fo hem.
Some ime he feel mo e comfo able no ha ing o make a choice. The efo e one a of
ind cing people o follo a pa ic la co e of ac ion i o p o ide i a a defa l choice. See
Real o ld foc 2.3 belo fo an e ample of he ole of defa l choice in o gan dona ion.
Restricted choice i a choice ha i limi ed b he go e nmen o o he a ho i . People
e e he e a e bjec o co n le e ic ion of all kind , anging f om peed limi , o ing
age, and ec cling eg la ion o moking p ohibi ion and ocial no m like haking hand . I i
a g ed ha e ic ion ch a he e a e nece a beca e people ha e oo man choice
a ailable o hem, and in he ab ence of mo e and be e info ma ion, o d e o poo j dgemen ,
he of en make poo choice . The efo e choice a chi ec e can ake ad an age of e ic ion o
enco age people o make choice i h ociall de i able o come .
Mandated choice i a choice be een al e na i e ha i made manda o (comp l o ) b he
go e nmen o o he a ho i . I can be ho gh of a eq i ed choice. I i a f ee choice, b i i
comp l o o make ha f ee choice. See Real o ld foc 2.3 fo an e ample of he ole of
defa l choice in o gan dona ion.
No e ha defa l choice, e ic ed choice and manda ed choice a e diffe en pe of d e

i hin c ce a c ec e ha a e in ended o o k o a d infl encing people choice in a
di ec ion held o be ociall de i able.

Choice architecture, nudging and organ donation
In he a ea of o gan dona ion, i i a challenge o inc ea e he n mbe of o gan dono in man
co n ie a o nd he o ld. Man co n ie ha e a defa c ce fo people o be ei he (a)
dono , in hich ca e he a oma icall become a dono if he do no hing, and o ld ha e o
make a delibe a e effo o egi e a a non-dono ; o (b) non-dono , in hich ca e he
a oma icall become a non-dono and o ld ha e o egi e o become a dono . In co n ie
he e he defa l op ion i o be a dono , fo e ample A ia, Belgi m, F ance, H nga , Poland,
Po gal, and he Uni ed Kingdom, he pa icipa ion a e in o gan dona ion i e high, ome ime
a m ch a 90% of he pop la ion o mo e. B con a , in co n ie he e he defa l op ion i o
be a non-dono , fo e ample Denma k, Ge man , and he Uni ed S a e , he pa icipa ion a e i
m ch lo e .
Figure 2.19: O gan dono ca d
O gan dona ion can al o be ed o ill a e a da ed c ce. In he a e of Illinoi in he Uni ed

S a e , in o de o ge a d i e licence ene ed i i manda o (comp l o ) o an e a q e ion
on he he one i he o be an o gan dono . The e l ha gi en i e o a 60% a e of igning p
o be a dono , compa ed o onl 38% fo he US na ional a e age he e manda ed choice doe no
e i .
The defa l choice ha make people dono b defa l he efo e appea o be effec i e. Ho e e ,
n dge ma in ome ca e backfi e, gi ing i e o oppo i e e l han he de i ed one . In he
Ne he land , a 2016 la made being a dono he defa l choice, in he hope ha he n mbe of
dono o ld inc ea e. Ye in a d i e ha ook place ho l af e he bill a pa ed, he
p i ing e l a ha he e e e e a a -d a d . A likel e plana ion
fo ch an ne pec ed e l ma be ha he D ch pop la ion ebelled again he n dge
in en ion . The e had been a lo of p e co e age of he go e nmen deci ion o change he
defa l choice, and i appea he D ch people did no an he go e nmen o make choice fo
hem.
Sources: Dee G , H a d e e e, UCLA A de Re e , Sc f
Ma a e e , 12 Se e be 2018
Appl ing our skills
1 Acco ding o he e pe ience of man co n ie , he defa l choice fo o gan dona ion appea
o be cceeding in inc ea ing he n mbe of dono . Can o hink of o he a ea he e hi
pe of defa l choice co ld be applied?
2 Wha i he le on abo n dging ha can be lea ned f om he D ch e pe ience?
3 Some ob e e a g e ha n dging, in pi e of i po en ial benefi , al o ca ie a i k of
manip la ion of he p blic opinion in b le a ha ma no al a be de ec able. Wha
doe he D ch e pe ience a abo hi po ible i k? (See al o Q e ion 4 nde I
a d ef ec a he end of hi chap e .)
The response of mainstream economists to the critique of utilit

theor
In e pon e o he c i ici m of ili heo and a ional beha io , man main eam economi
o ld a g e ha in pi e of i impe fec ion , he heo of con me beha io ba ed on he
a mp ion of a ionali doe a ea onabl good job in e plaining and p edic ing ho con me
beha e nde man ci c m ance . The e i e idence ha con me do e pond a ionall o
mone a fac o . Fo e ample, an inc ea e in he ga oline o pe ol a ill mo likel lead o a
lo e q an i of pe ol demanded, a p edic ed b he do n a d loping demand c e ba ed on
con me a ionali . E ample abo nd of e ha ha e empi icall ho n (no ef ed) he
e i ence of do n a d loping demand c e , hich a e ba ed on he heo of ili
ma imi a ion. So e en if con me do no beha e a ionall all he ime acco ding o he le of
a ionali , on a e age, o e all, hei beha io i con i en i h he p edic ion of ili heo .
Mo eo e , ome economi o ld a g e ha choice a chi ec e and he e of n dge i
manip la i e, a i a emp o e e ci e con ol and infl ence o e con me choice . The idea of f ee
choice i he efo e eakened and become an ill ion of f ee choice a he han ac al f ee choice.
Wha ma be o e i ha i of en affec con me on a b-con cio le el, making hem do
hing ha he migh no choo e o do if he e e f ll a a e of he f ll implica ion of hei
choice .
In effec , choice a chi ec e ake ad an age of he incomple e info ma ion a ailable o he
con me , and elec i el p o ide info ma ion ( ch a h o gh f aming and choice a chi ec e) o
enco age con me o ac in a pa ic la a .
Fo he e ea on i i a g ed ha he e ho ld be an pa enc and open di c ion of n dge ed
fo economic polic .
Evaluating behavioural economics and economic polic

Potential advantages
Beha io al economic ma be a ela i el imple and lo -co a o infl ence people
beha io o ac in ociall de i able a .
I ha been ed cce f ll in a n mbe of a ea , gge ing ha he me hod of choice
a chi ec e and n dging ma ha e n me o po ible applica ion in a ea ha a e a e
ne plo ed.
I offe con me and ci i en , gene all , f eedom of choice i ho fo cing hem o do
an hing o p e en ing hem f om doing an hing, hence i ho e ic ing hei choice .
I ma be able o o e come he eakne e of he heo of con me beha io , hich i no
al a able o e plain he incon i encie and eeming i a ionali of ac al con me
beha io .
Policie a e ba ed on p inciple of p cholog , ch a f aming, man of hich ha e been
p e io l e ed o e man ea .
The de elopmen of policie i ba ed on ial , indica ing he e of a fle ible ial-and-e o
me hod of di co e ing polic mea e ha can o k in achie ing de i ed e l .
Potential disadvantages
The bod of kno ledge being de eloped i no ba ed on an nde anding of h man beha io ,
and i he efo e nable o lead o a ema ic and nif ing heo of ho con me beha e
i h gene al applicabili .
The e l ing n ema ic app oach (diffe en policie fo diffe en i a ion ) ma no be alid
o e ime o ac o diffe en income g o p , ocial g o p o c l e ; hi ed ce he
applicabili of he policie being de eloped o e ime and ac o ocial, economic and c l al
go p.
The e ma be i k of ing p chological p inciple o manip la e con me , in m ch he
ame a ha ad e i ing and ma ke ing ha e been ing imila p inciple o e man ea in
o de o manip la e con me a e and p efe ence fo he p po e of con incing con me o
ac in a ha a e no nece a il in hei be in e e ( ch a ad e i ing fo ga and fa
food p od c ha a e nheal h ).
The e ma be i k ha beha io al policie ma be ed a b i e fo nece a b
poli icall co l economic policie , ch a he impo i ion of a e on ociall ha mf l good
kno n a de e d o good leading o e a e e e a e ( ee Chap e 5).
T adi ional economic policie (fo e ample indi ec a e , b idie , o be di c ed in Chap e
4 and 5) ma be mo e effec i e.
I ma be a ne fo m of go e nmen eg la ion, onl camo flaged nde he g i e of f eedom of
choice, and he efo e mo e dange o a people ma no be a a e of i e i ence and i effec
on hei choice .
Choice a chi ec e and n dging ma cce f ll affec people choice , b he e choice ma
no be a eflec ion of hei e p efe ence .

1 a Di c ha i mean o be a a ional con me in economic .
b To ha e en a e o pe onall a a ional con me ?
2 Fo each of he bia e di c ed in he e , e plain h he co ld no occ acco ding o he
heo of con me beha io .
3 In he e ample of n dge gi en in he e , iden if he f aming elemen in he n dge.
4 Di ing i h be een defa l , e ic ed and manda ed choice. E plain ho he e can be ed
a n dge .
5 Di ing i h be een bo nded a ionali , bo nded elf-con ol and bo nded elfi hne .
P o ide an e ample fo each of he e. E plain h he a e all incon i en i h a ional
con me beha io .
6 Di c he po en ial ad an age and di ad an age of beha io al economic .
Firm business objectives
Rational producer behaviour: profit ma imisation

S anda d economic heo of he fi m a me rational producer behaviour acco ding o hich
fi m a e g ided b he goal o ma imi e p ofi . P ofi ma imi a ion in ol e de e mining he le el of
o p ha he fi m ho ld p od ce o make p ofi a la ge a po ible.
On a e gene al le el, p ofi i eq al o he o al e en e ea ned b a fi m min he o al co
inc ed b he fi m in he p oce of p od cing i o p .
S ppo e o ha e a pi a e a an and o ell 400 pi a a da a $7 each. Yo ha e e en e of 7
400 = $2800 pe da . On he o he hand he co of b ing he pi a ing edien , pa ing o
o ke and mee ing all o he e pen e of nning o e a an amo n o $2650 pe da . Yo
p ofi pe da i
P ofi = e en e co = 2800 2650 = $150 pe da .
The objec i e of p ofi ma imi a ion i o make he diffe ence be een e en e and co a la ge a
po ible o a o make p ofi a la ge a po ible. We ill come back o he opic of p ofi
ma imi a ion in Chap e 7 (a HL).
Alternative business objectives

O e he ea , economi ha e de eloped man heo ie abo fi m beha io . The follo ing i a
b ief e of ome of he mo e impo an one . The common heme of all of he e i ha p ofi
ma imi a ion ma no be he o e iding objec i e of fi m , a in fac he ma ha e o he goal ha
ma be mo e impo an .
Corporate social responsibilit : ethical and environmental

concerns
The elf-in e e ed beha io of fi m of en lead o nega i e con eq ence fo ocie . I i of en he
ca e ha he ell-being of fi m i no con i en i h he ell-being of ocie . A p ime e ample i
he elf-in e e ed fi m ha poll e he en i onmen . (S ch ac ion of fi m ill be e amined in
Chap e 5 nde he opic of nega i e e e nali ie and common pool e o ce .) In addi ion, fi m
can engage in ac ion ha mo con me o ld con ide o be e hicall naccep able, ch a he
p ac ice in man de eloping co n ie of emplo ing poo l paid child en fo ced o o k long ho ,
o emplo ing labo ha i fo ced o o k nde nheal h o dange o condi ion . The e i a ion
ma a i e in co n ie he e he e i ide p ead po e , and go e nmen legi la ion p o ec ing he
igh of child en and o ke i ei he non-e i en o poo l enfo ced.
Ho e e , man fi m inc ea ingl ecogni e ha he p i of elf-in e e need no nece a il
conflic i h e hical and en i onmen all e pon ible beha io . A nega i e image of he fi m held b
o ke and b e of he p od c can c deepl in o he fi m e en e and p ofi b lo e ing
o ke p od c i i and he fi m ale . F he , ociall i e pon ible fi m beha io ma lead o
go e nmen eg la ion of he fi m in ended o minimi e he nega i e con eq ence of he fi m
ac ion fo ocie , he ea ociall e pon ible beha io co ld in ead e l in le go e nmen
eg la ion. The efo e, fi m face incen i e o di pla corporate social responsibilit b engaging in
ociall beneficial ac i i ie . The e can ake man fo m , incl ding:
a oidance of poll ing ac i i ie
engaging in en i onmen all o nd p ac ice
ppo fo h man igh , ch a a oiding e ploi a ion of child labo and labo in gene al in
le de eloped co n ie , o a oiding in e men in co n ie i h poli icall opp e i e
egime
a and a hle ic pon o hip
dona ion o cha i ie .
Man of he e p ac ice a e he e l of inc ea ed con me a a ene of ocial and en i onmen al
i e , g o ing con me conce n o e e hical and en i onmen al a pec of b ine p ac ice , and
e en con me ac i i m ha e l in bo co of offending fi m . One indica ion of he infl ence
and conce n of con me i he apidl g o ing in e e in in e men in companie ( h o gh ock
ma ke ) ha mee ce ain ocial, e hical and ecological c i e ia.
Economi ed o hink ha e hical and en i onmen all e pon ible beha io of fi m o ld
ed ce hei p ofi . Thi a ba ed on con ide ing onl he co a pec of p ofi ; fo e ample, fi m
ing cheap child labo face lo e co , and hence ill make highe p ofi han fi m a oiding
ch p ac ice . Ye p ofi depend no onl on co , b al o on e en e ha ill fall if con me
a oid b ing he p od c of offending fi m .
A n mbe of die ha e a emp ed o mea e he effec of ociall e pon ible beha io on he
p ofi of fi m . Doe e hical and en i onmen all e pon ible beha io lo e o inc ea e fi m
p ofi ? The e l of he e die ha e been inconcl i e. The beha io of fi m hem el e ,
ho e e , gge ha he of en do no an o i k con me di plea e.
Market share
Market share efe o he pe cen age of o al ale in a ma ke ha i ea ned b a ingle fi m. Fo
e ample, if a p od c ha o al ale i hin a co n of $50 million, and a fi m ell $10 million
o h of ha p od c , hen ha fi m ha a 20% ma ke ha e. A high ma ke ha e mean ha he fi m
i enjo ing la ge ale of i p od c o p od c , and i an indica ion of he p od c pop la i
among b e .
A la ge ma ke ha e mean ha i i likel ha he fi m i achie ing ec e f ca e (falling co
pe ni of o p a he fi m g o , o be died a HL in Chap e 7). Economie of cale allo a
fi m o inc ea e i p ofi abili .
In gene al, ma ke ha e i o impo an ha la ge companie ch a m l ina ional co po a ion
(la ge fi m ha ha e p od c i e facili ie in mo e han one co n ) of en mea e hei pe fo mance
in e m of hei ma ke ha e in pecific co n ie . Ma ke ha e i an impo an indica o of
pe fo mance beca e i allo he fi m o moni o ho ell i i doing in ela ion o i compe i o .
A fi m ha cceed in main aining i ma ke ha e o e ime mean ha i i likel ea ning e en e
ha a e g o ing a he ame a e a he o e all ma ke . A g o ing ma ke ha e i a ign ha he fi m
i doing ell in ela ion o i compe i o . I i likel ha i e en e a e g o ing fa e han he
e en e of compe i o fi m . A falling ma ke ha e on he o he hand mean ha he fi m i no
doing a ell a i compe i o in e m of ale of i p od c .
In o de o inc ea e i ma ke ha e, he fi m ma o lo e i p ice , o in od ce ne o
inno a i e p od c in o he ma ke , o e ad e i ing. Each of he e a egie ma ha e he effec
of lo e ing p ofi . Lo e p ice ma ed ce e en e ( ho gh no nece a il , hi ill be e plo ed
in Chap e 3). The in od c ion of ne p od c in ol e inc ea ed co on e ea ch and
de elopmen , hile ad e i ing al o in ol e inc ea ed fi m pending o pa fo he ad e i ing.
Po ible lo e p ice i h highe co ill c in o p ofi . Ho e e , a long a he fi m emain
p ofi able, and i con in e o ea n a a i fac o le el of p ofi , he benefi of main aining o
inc ea ing ma ke ha e a e likel o make he lo e p ofi o h hile.
Growth ma imisation
Ano he po ible objec i e i ma imi a ion of g o h a he han p ofi .7 Growth ma imisation can
be a ac i e fo he follo ing ea on :
A g o ing fi m can achie e economie of cale ( ee Chap e 7) and lo e i a e age co , h
inc ea ing i p ofi abili .
A a fi m g o i can di e if in o p od c ion of diffe en p od c and ma ke and ed ce i
dependence on a ingle p od c o ma ke .
A la ge fi m ha g ea e ma ke po e and inc ea ed abili o infl ence p ice , h again
po en iall inc ea ing i p ofi abili .
A la ge fi m ed ce i i k beca e i ma be le affec ed in an economic do n n (a
ece ion) and i le likel o be aken o e (bo gh ) b ano he fi m.
The objec i e of g o h ma imi a ion econcile he in e e of bo h o ne and manage ,
beca e bo h g o p ha e m ch o gain f om a g o ing fi m. O he ma imi a ion objec i e
ma pi fi m o ne again fi m manage ; fo e ample, p ofi ma imi a ion i fa o ed b
o ne hile e en e ma imi a ion i fa o ed b manage .
Revenue ma imisation
In one heo of fi m beha io , i i a g ed ha he epa a ion of fi m managemen f om fi m
o ne hip, hich inc ea ingl domina e b ine o gani a ion, ha mean ha fi m objec i e ha e
changed. Whe ea p ofi ma imi a ion ma be he dominan mo i e of he adi ional o ne -managed
fi m, fi m manage ho a e hi ed b he o ne o pe fo m managemen a k ma be mo e
in e e ed in inc ea ing ale and ma imi ing he e en e ha a i e f om la ge q an i ie old. Thi
goal of fi m i efe ed o a e e e a a .8 Inc ea ing ale and ma imi ing e en e ma
be mo e ef l o a fi m han p ofi ma imi a ion fo he follo ing ea on :
Sale can be iden ified and mea ed mo e ea il o e he ho e m han p ofi , and inc ea ed
ale a ge can be ed o mo i a e emplo ee .
Re a d fo manage and emplo ee a e of en linked o inc ea ed ale a he han inc ea ed
p ofi .
I i of en a med ha e en e f om mo e ale ill inc ea e mo e apidl han co ; if hi i
he ca e, p ofi (= o al e en e o al co ) ill al o inc ea e.
Inc ea ed ale gi e i e o a feeling of cce , he ea declining ale c ea e a feeling of
fail e.
(N e a e e e a a , e a , e ab .)
Satisficing
Man of he abo e objec i e a me ha he fi m ie o ma imi e ome a iable, he he i i
p ofi , ma ke ha e, g o h o e en e. He be Simon, a Nobel P i e- inning economi (al o
men ioned ea lie in connec ion i h he idea of bo nded a ionali a a c i iq e of con me
a ionali ), ha a g ed ha he la ge mode n en e p i e canno be looked pon a a ingle en i ih
a ingle ma imi ing objec i e; in ead i i compo ed of man epa a e g o p i hin he fi m, each
i h i o n objec i e hich ma o e lap o ma conflic . Thi m l iplici of objec i e doe no
allo he fi m o p e an kind of ma imi ing beha io . Fi m he efo e o e abli h p oce e
h o gh hich he can make comp omi e and econcile conflic o a i e a ag eemen , he e l
of hich i he p i of man objec i e ha a e placed in a hie a ch . Thi beha io a e med
satisficing b Simon. (Simon ed hi e m o de c ibe he beha io of con me a ell.) I efe
o he idea ha fi m o achie e a a i fac o le el of p ofi oge he i h a i fac o e l fo
man mo e objec i e , a he han op imal o be e l fo an one objec i e.

Imagine o a e he o ne of a b ine . Di c and j if an b ine goal o ma ha e ha
a e no di ec l conce ned i h p ofi ma imi a ion.
THEORY OF KNOWLEDGE 2.3

How important are the criticisms of profit ma imisation as the firm s main goal?
S anda d economic heo a me ha p ofi ma imi a ion i he mo impo an goal of fi m . A
e ill ee in Chap e 7, he d of fi m beha io i ba ed e hea il on he a mp ion of p ofi
ma imi a ion. Ye hi a mp ion i c i ici ed fo e e al ea on :
The e of ma ginal concep (fo e ample a a c ) in he heo i n eali ic; fi m
canno ea il iden if ma ginal co , and do no e en o do o; he efo e, hi heo doe no
acc a el de c ibe me hod ac all ed b fi m o de e mine p ice and o p .
The model i ba ed on he a mp ion ha fi m ha e pe fec info ma ion a hei di po al,
he ea in fac he info ma ion on hich he ba e hei deci ion i highl f agmen a and
nce ain; fi m do no kno ha demand c e he face fo hei p od c and he do no
kno ho compe i o fi m ill beha e in e pon e o hei ac ion .
Sho - n p ofi ma imi a ion ma be n eali ic; fi m ma p efe lo e p ofi in he ho n
in e change fo la ge p ofi o e he long n.
The fac o de e mining demand and ppl fo p od c and e o ce a e con in o l
changing, i h demand and ppl c e con in o l hif ing, o ha an p ofi -ma imi ing
deci ion ega ding p ice and o p made oda nde c en condi ion ma be i ele an b
he ime he o p i p od ced and ead fo ale in he ma ke .
The e i eal- o ld e idence gge ing ha fi m beha io ma be mo i a ed b a a ie of
objec i e o he han p ofi ma imi a ion, hich e e di c ed abo e.
Mil on F iedman, an Ame ican Nobel P i e- inning economi , a g ed in a famo book9 ha i doe
no ma e if he a mp ion of a heo a e n eali ic, a long a he heo ha p edic i e po e .
In fac , good heo ie a e of en ba ed on n eali ic a mp ion ha do no acc a el de c ibe he
eal o ld, beca e he ole of a mp ion i o po a onl he impo an a pec of a p oce ha i
modelled o heo i ed abo , igno ing he i ele an de ail .
Pa l Sam el on, ano he Ame ican Nobel P i e- inning economi , f ndamen all di ag eed.
Sam el on a g ed ha he p edic ion of a heo can onl be a empi icall alid a he heo i elf,
and a he a mp ion on hich he heo e . If he a mp ion a e n eali ic o in alid, hen
he heo and i p edic ion ill imila l be in alid; i i no po ible o ha e a heo ih
p edic i e po e if i a mp ion a e n eali ic. If he p edic ion of a heo a e empi icall alid,
o i he heo and i a mp ion . Logicall , hen, i i no po ible o epa a e he p edic ion of a
heo f om he a mp ion of he heo ; he all and o fall oge he .
Thinking points
Remembe ha a heo ie o e plain eal- o ld e en . Doe i ma e if a heo i ba ed on
n eali ic a mp ion ?
A o ead h o gh Chap e 7, o ma an o keep he e i e in mind, a e ill enco n e
f he n eali ic a mp ion in ome ma ke model di c ed in ha chap e ( ee al o Theo
of kno ledge 7.1 abo pe fec compe i ion).

The follo ing q e ion ill help o eflec on o lea ning and enhance o nde anding of ke
opic in hi chap e . The a e gge ion fo inq i ie ha o can nde ake on o o n o in
g o p in o de o e i e he lea ning objec i e of hi chap e .
1 Ad e i ing make g ea e of bia e ha infl ence con me a of hinking. A o a ch
TV, hen a comme cial come on, o ee if he me age being con e ed o he con me
make e of bia e in o de o con ince con me o b he p od c .
2 An a ea ha ha been e amined e en i el in ol e p o iding heal h l nche a chool and
ing n dge o enco age pa en and den o p efe he e. In e iga e ha kind of n dge
ha e been gge ed, hen and he e he ha e been implemen ed, and ha e e he e l .
T o de ign a p og amme he e o co ld ecommend n dge ha o hink ma be effec i e
in inc ea ing demand fo heal h chool meal .
3 Wa o deci ion o d IB economic a a ional choice? Iden if he condi ion ha o ld
ha e o be a i fied fo hi choice o ha e been a a ional one. If i a no a ional, iden if
ome bia e ha ma ha e affec ed o choice.
4 Richa d Thale and Ca S n ein, ho became famo fo hei con ib ion o n dge . coined
he ph a e be a a a e a o de c ibe n dge a a fo m of go e nmen in e en ion. The
o d be a a (f om he La in o d be a hich mean f eedom) efe o a philo oph
he e libe o f eedom and a onom a e he main p inciple , meaning ha people ho ld ha e
f eedom of choice and ho ld be f ee of a ho i . The o d a e a (f om he G eek o d
a e hich mean fa he ) efe o ac ion ha limi people f eedom o a onom ; ch ac ion
a e of en j ified on he g o nd ha he a e in he people be in e e . Con ide he ph a e
be a a a e a , and de e mine he he he e o concep ma be con adic o o
he he he can be made con i en i h each o he a Thale and S n ein ha e ied o do
h o gh he polic of n dge .

5 I i be ond he cope of hi book o e plain ho he la of dimini hing ma ginal ili i ed o e plain
a ional con me in o de o ma imi e ili .
6 He be Simon, Al i m and Economic , Ea e Ec cJ a Vol. 18, No. 1 (Win e , 1992), pp. 73 83
7 Thi i ba ed on he o k of R. Ma i and o he .
8 The e en e-ma imi a ion goal of fi m a de c ibed b W. J. Ba mol in 1959.
9 Mil on F iedman (1953) The Me hodolog of Po i i e Economic in E a in Po i i e Economic ,

Uni e i of Chicago P e .
C a e 3
Ea c e
BEFORE YOU START
When the price of a good or service that ou ant rises, ho likel is it that ou ill purchase it
an a ? You might sa it depends. What factors might influence our decision?
If producers of a good or service ant to increase their revenue, sometimes the increase their
price. Does this strateg al a s ork? Wh or h not?
If someone is poor and over time becomes richer, hat kinds of changes might ou e pect to see
in her or his purchasing habits? What if she or he is rich and over time becomes poorer?
The topics above relate to the concept of elasticit . E a c is a measure of the responsiveness of a
variable to changes in price or an of the variable s determinants. In this chapter e ill e amine three
kinds of elasticities:
price elasticit of demand, hich e amines the responsiveness of quantit demanded to changes in
price
income elasticit of demand, hich e amines the responsiveness of demand to changes in income
price elasticit of suppl , hich e amines the responsiveness of quantit supplied to changes in
price.
Each of these has a number of applications to important economic problems.
3.1 Price elasticit of demand (PED)
LEARNING OBJECTIVES
Af e d ing hi ec i n ill be able :

define all he e m a ea ing in orange bold in he e (AO1)
e he f m la f ice ela ici f demand (PED) calc la e PED, change in ice, change
in an i and al e en e (AO4)
iden if he a i deg ee and ange f al e f PED (AO2)
d a diag am h ing he ange f al e f PED, incl ding (AO4)
ela i el ela ic and inela ic demand
c n an al e f e fec l ela ic demand, e fec l inela ic demand and ni a PED
e lain and ill a e in a diag am changing PED al ng a aigh -line d n a d l ing demand
c e (HL nl ) (AO2, AO4)
anal e he de e minan f PED (AO2)
e lain he ela i n hi be een PED and al e en e (AO2)
d a a diag am h h al e en e change in e ne a ice change de ending n
ela ic inela ic demand (AO4)
a l PED :
di c i im ance f fi m and g e nmen deci i n-making (AO3)
anal e he ea n h ima c mm di ie gene all ha e a l e PED han
man fac ed d c (HL nl ) (AO2)
Price elasticit of demand
Understanding price elasticit of demand (PED)

Acc ding he la f demand, he e i a nega i e ela i n hi be een ice and an i demanded:
he highe he ice, he l e he an i demanded, and ice e a, ce e i a ib . We n an
kn b h ch an i e nd change in ice.
Price elasticit of demand (PED) i a mea e f he e n i ene f he an i fag d

demanded change in i ice. PED i calc la ed al ng a gi en demand c e. In gene al, if
an i demanded i highl e n i e a change in ice, demand i efe ed a being ice
e a ic; if an i demanded i n e e n i e, demand i ice i e a ic.
The formula for PED

S e e a e c n ide ing PED f g d X. The f m la ed mea e i PED i :
ice ela ici f demand (PED)

= e cen age change in an i demanded e cen age change in ice
If e abb e ia e change in b he G eek le e , hi f m la can be e i en a :
PED= % Q % P
Sim lif ing, he ab e f m la can be e i en a :
PED= Q Q 100 P P 100 = Q Q P P = he e
Q = Qfinal al e Qini ial al e
Q = Qini ial al e
P = Pfinal al e Pini ial al e
P = Pini ial al e
The sign of PED

Since ice and an i demanded a e nega i el ela ed, PED i a nega i e n mbe . An e cen age
inc ea e in ice (a i i e den mina ) gi e i e a e cen age dec ea e in an i demanded (a
nega i e n me a ), leading a nega i e PED. Simila l , a e cen age ice dec ea e e l in a
e cen age an i inc ea e. H e e , he c ac ice i d he i ig a d c ide PED
a a ii e be . (In ma hema ic hi i called aking he ab l e al e.) Thi i d ne a id
c nf i n hen making c m a i n be een diffe en al e f PED. U ing i i e n mbe , e can
a , f e am le, ha a PED f 3 i la ge han a PED f 2. (Had e been ing he min ign, 2
ld be la ge han 3.)
The use of percentages

Ela ici i mea ed in e m f e cen age change f P and Q f ea n :
We need a mea e f e n i ene ha i inde enden f ni . I make li le en e c m a e
ni f ange i h ni fc m e ca . Al , e an be able c m a e ela ici ie
ac c n ie ha ha e diffe en c encie ; an ela ici mea ed in e m f e ill n be
c m a able i h an ela ici mea ed in en nd . The e f e cen age all
e e ela ici ie in c mm n e m .
I i meaningle hink f change in ice an i ie in ab l e e m (f e am le, a $15
inc ea e in ice a 20 ni dec ea e in an i ). A $15 ice inc ea e mean me hing e
diffe en f a g d h e iginal ice i $100 han f a g d h e iginal ice i $5000. In
he fi ca e he e i a 15% inc ea e, and in he ec nd he e i a 0.3% inc ea e. U ing e cen age
all e n i ene in e ec i e.
The ame a g men a l all he ela ici ie e ill c n ide .
Calculating PED, change in price and change in quantit

We can n e he f m la ab e calc la e PED. S e c n me b 6000 TV hen he ice
i $255 e ni , and he b 5000 TV hen he ice i $300.
PED= 6000 5000 5000 255 300 300 = 1000 5000 45 300 = 0.20 0.15 = 1.33
1.33 ince e d he min ign. The ef e PED f TV i 1.3.1
N e ha ela ici i mea ed a a n mbe , n a a e cen age, and he e a e n ni .
If e kn PED and he e cen age change in P, e can calc la e he e cen age change in Q. S e
PED = 1.25 and ice f g d X i c ea e b 12%. Calc la e he e cen age change in Q demanded:
PED=1.25= % Q 0.12 ⇒% Q= 0.12 1.25= 0.15 15%.Q an i dec ea ed b 15%.
Simila l , if e kn PED and he e cen age change in Q demanded, e can calc la e he e cen age
change in P. S e PED = 0.80 and an i f g d Y demanded fa b 16%. Calc la e he
e cen age change in P:
PED=0.80= 0.16 % P =⇒0.80 % P= 0.16 ⇒% P=0.20 20%. P ice inc ea ed b 20%.
Y ma n e ha he e e ha e ed nega i e ign in he calc la i n h dec ea e , h e e hi
i n nece a ince he final ela ici al e i aken a a i i e n mbe (ab l e al e).
T al e en e calc la i n ( efe ed in he lea ning bjec i e ) ill be e en ed bel .

1 a Think f me f m im an need and an , and hen e lain he he he e a e
a i fied b g d b e ice .
b Iden if he f fac f d c i n.
2 Sae h e ea PED a if i ee i i e, e en h gh i i all nega i e.
3 I i b e ed ha hen he ice f i a i $16 e i a, 100 i a a e ld; hen he ice
fall $12 e i a, 120 i a a e ld. Calc la e ice ela ici f demand.
4 A 10% inc ea e in he ice f a a ic la g d gi e i e an 8% dec ea e in an i b gh .
Calc la e he ice ela ici f demand.
5 The PED f g d X i 0.8. If he ice f g d X inc ea ed b 15%, calc la e he e cen age
dec ea e in an i demanded.
6 The PED f g d Y i 1.5. If an i fg d Y inc ea e b 30%, calc la e he e cen age
dec ea e in he ice f g d Y.
The range of values for PED

The al e f PED in l e a c m a i n f n mbe : he e cen age change in an i demanded
( he n me a in he PED f m la) and he e cen age change in ice ( he den mina ). Thi
c m a i n ield e e al ible al e and ange f al e f PED. The e a e ill a ed in Fig e
3.1 and mma i ed in Table 3.1.
Demand is price inelastic when PED < 1 (but greater than ero). The e cen age change in
an i demanded i malle han he e cen age change in ice, he al e f PED i le han
ne; an i demanded i ela i el ne ni e change in ice, and demand i price
inelastic. Fig e 3.1(a) ill a e ice inela ic demand: he e cen age change in an i
demanded (a 5% dec ea e) i malle han he e cen age change in ice (a 10% inc ea e),
he ef e PED i le han ne.
Demand is price elastic when PED > 1 (but less than infinit ). The e cen age change in
an i demanded i la ge han he e cen age change in ice, he al e f PED i g ea e han
ne; an i demanded i ela i el e n i e ice change , and demand i price elastic. In
Fig e 3.1(b) he e cen age change in an i demanded ( 10%) i la ge han he e cen age
change in ice (5%), he ef e PED i g ea e han ne.
In addi i n, he e a e h ee ecial ca e he e PED i c n an ( nchanging) al ng he f ll leng h f he
demand c e:
Demand is unit elastic when PED = 1. The e cen age change in an i demanded i e al
he e cen age change in ice, PED i e al ne; demand i hen i e a ic; he e i unitar
PED. Fig e 3.1(c) h a ni ela ic demand c e, he e he e cen age change in an i
demanded ( 5%) i e al he e cen age change in ice (5%).
Demand is perfectl inelastic when PED = 0. The e cen age change in an i demanded i
e ; he e i n change in an i demanded, hich emain c n an a Q1 n ma e ha
ha en ice; PED i hen e al e and demand i perfectl inelastic. F e am le, a
he in addic an i f he in demanded i n e n i e change in he ice f he in.
Fig e 3.1(d) h ha a e fec l inela ic demand c e i e ical.
Demand is perfectl elastic when PED = infinit . When a change in ice e l in an infini el
la ge e n e in an i demanded, demand i perfectl elastic. A h n in Fig e 3.1(e) he
e fec l ela ic demand c e i h i n al. A ice P1, c n me ill b an an i ha i
a ailable. If ice fall , b e ill b all he can (an infini el la ge e n e); if he e i an
inc ea e in ice, an i demanded d e . Thi a a en l ange kind f demand ill be
c n ide ed in Cha e 7 (a HL).
The n me ical al e f PED can he ef e a f m e infini . In gene al, he la ge he al e f
PED, he g ea e he e n i ene f an i demanded. While he ca e f ni ela ic, e fec l
inela ic and e fec l ela ic demand a e a el enc n e ed in ac ice, he ha e im an
a lica i n in ec n mic he .
Value of PED Classification Interpretation
Frequentl encountered cases
0 < PED < 1 (g ea e han e ice inela ic demand an i demanded i

and le han ne) ela i el n e n i e
ice
1 < PED < (g ea e han 1 and ice ela ic demand an i demanded i

le han infini ) ela i el e n i e ice
Special cases: constant PED

along the length of the demand
curve
PED = 1 ni ela ic demand e cen age change in

an i demanded e al
e cen age change in ice
PED = 0 e fec l inela ic demand an i demanded i

c m le el n e n i e
ice
PED = e fec l ela ic demand an i demanded i

infini el e n i e ice
Table 3.1: Cha ac e i ic f ice ela ici f demand

Figure 3.1: Demand c e and PED
PED and the steepness of the demand curve

The a ie f demand c e and hei PED in Fig e 3.1 gge ha he fla e he demand c e, he
m e ela ic he demand ( he highe he PED); he ee e he demand c e, he le ela ic he demand
( he l e he PED).
H e e , i i n al a acc a e c ncl de ha demand i m e ela ic le ela ic in diffe en
demand c e im l b c m a ing hei ee ne . The ea n i ha demand c e d a n n
diffe en cale a e n c m a able. Fig e 3.2 h iden ical demand c e i h diffe en cale
n he h i n al a i . I ld be inc ec c ncl de ha he ee e demand c e ha a le ela ic
demand.
Figure 3.2: T iden ical demand c e
S hen i i c ec c m a e PED f demand c e b efe ing hei ee ne ? Thi ca be

d e he he demand c e in e ec a me in , ch a demand c e D1 and D2 in Fig e 3.3.
In hi fig e, f an ice, D1 i fla e and m e ela ic han D2. F e am le, if ice fall f m P1
P2, he e l ing e cen age change in an i ill be la ge f D1 (inc ea e f m Q1 Q3) han f D2
(inc ea e f m Q1 Q2). In gene al, hen demand c e in e ec , hen f an gi en ice, he fla e
he demand c e, he m e ela ic i he demand. Thi gene ali a i n h ld f c m a i n be een
demand c e a a a ic la ice.
We f en e he ela i e ee ne f demand c e be an indica i n f PED, ha c m a ing

demand c e , he ne ha i fla e i aid be m e ela ic hile he ne ha i ee e i aid
be m e inela ic. (Thi i d ne n he a m i n ha if he e e d a n n he ame diag am
he ld in e ec a me in .)
Figure 3.3: Demand c e and PED

1 S ecif he al e f each f he f ll ing PED and h , ing diag am , he ha e f he
demand c e ha c e nd each ne:
a e fec l ela ic demand,
b ni a PED ( ni ela ic demand) and
c e fec l inela ic demand.
2 P ide e am le fg d likel ha e demand ha i
a ela ic, and
b inela ic.
3 Iden if hich ice ela ici f demand al e ange f al e e ee m f e en l in he
eal ld.
4 A ming demand c e in e ec , e lain hich f he ill be ela i el m e ela ic
f a gi en ice.
Changing PED and the straight-line demand curve (HL onl )
Wh PED varies
Al ng an d a d- i g, aigh - i e de a d c e, he PED a ie (change ) a e m e
al ng he c e. Thi a lie all demand c e f he e h n in Fig e 3.1(a) and (b). I
e cl de ni ela ic, e fec l inela ic and e fec l ela ic demand c e ( he e PED i c n an ).
We can ee in Fig e 3.4 ha hen ice i l and an i i high, demand i inela ic; a e m e
he demand c e a d highe ice and l e an i ie , demand bec me m e and m e
ela ic. The fig e h he PED al e al ng diffe en a f he demand c e.
The ea n behind he changing PED al ng a aigh -line demand c e ha d i h h PED i
calc la ed. A high ice and l an i ie , he e cen age change in Q i ela i el la ge ( ince he
den mina f Q/Q i mall), hile he e cen age change in P i ela i el mall (beca e he
den mina f P/P i la ge). The ef e, he al e f PED, gi en b a la ge e cen age change in Q
di ided b a mall e cen age change in P e l in a la ge PED (ela ic demand). A l ice and
high an i ie , he i e h ld . The al e f PED i gi en b a l e cen age change in Q
di ided b a high e cen age change in P, e l ing in a l PED (inela ic demand).
Figure 3.4: Va iabili f PED al ng a aigh -line demand c e
On an d n a d- l ing, aigh -line demand c e, demand i ice-ela ic a high ice and

l an i ie , and ice-inela ic a l ice and la ge an i ie . A he mid in f he demand
c e, he e i ni ela ic demand.
The ef e, he e m ela ic and inela ic h ld n be ed efe an en i e demand c e
( i h he e ce i n f he h ee ecial ca e he e PED i c n an ), b nl a i n f he
demand c e c e nding a a ic la ice ice ange.
Wh PED varies along a straight-line demand curve from a

different perspective
A fa im le e lana i n f he a ing PED al ng a aigh -line demand c e i he f ll ing.
N e ha he l e f demand c e2 = P Q, hile
PED= Q Q P P = Q P PQ=1 l e PQ
N e kn ha he l e al ng a aigh line i al a c n an , he ef e he in e e f he l e =
1/ l e i al c n an .
The ef e PED i e al a c n an n mbe m l i lied b P/Q. A e m e d n he demand c e,
e kn ha P ge malle and malle , hile Q ge bigge and bigge , he ef e P/Q bec me
c n in l malle . Thi mean ha a e m e d n he demand c e, PED, hich i e al a
c n an n mbe ime an e e dec ea ing n mbe , m be ge ing malle and malle . We h ha e a
im le e lana i n f h PED c n in l dec ea e a e m e d n he demand c e.

1 U ing he inf ma i n in Fig e 3.4, calc la e PED be een:
a in a and b, he e ice inc ea e f m $10 $15;
b in c and d, he e ice inc ea e f m $25 $30; and
c in e and f, he e ice inc ea e f m $40 $45.
d S a e he gene al inci le ab al e f he PED al ng he aigh -line demand c e
ha calc la i n h .
Determinants of price elasticit of demand

We ill n c n ide he fac ha de e mine he he he demand f ag d i ela ic inela ic.
Number and closeness of substitutes

The m e b i e a g d ( e ice) ha , he m e ela ic i i demand. If he ice f a g d i h
man b i e inc ea e , c n me can i ch he b i e d c , he ef e e l ing in a
ela i el la ge d (la ge e n i ene ) in an i demanded. F e am le, he e a e man b and f
h a e, hich a e cl e b i e f each he . An inc ea e in he ice f ne, i h he ice f
he c n an ill lead c n me i ch he he ; hence demand f a ecific h a e b and
i ice ela ic. If a g d e ice ha fe n b i e , hen an inc ea e in ice ill b ing f h a
ela i el mall d in an i demanded. An inc ea e in he ice f e l (ga line) i likel lead
a ela i el mall dec ea e in an i demanded, beca e he e a e n cl e b i e ; he ef e,
demand f e l i ice inela ic.
Al im an i he cl ene f b i e .F e am le, C ca-C la and Pe i a e m ch cl e
b i e han C ca-C la and ange j ice; e a ha C ca-C la and Pe i ha e g ea e
b i abi i . The cl e b i e ae each he , he g ea e he e n i ene f an i
demanded a change in he ice f he b i e, hence he g ea e he PED, beca e i i ea ie f
he c n me i ch f m ne d c he he .
A fac ha affec he n mbe f b i e i he he he g d i defined b adl na l .F
e am le, f i i a b ad defini i n in c m a i n ecific f i like ange , a le and ea , hich
a e na l defined. If e had c n ide ed f i in ela i n f d, f d i b ad and f i i na . The
in he e i ha he na e he defini i n f a g d, he g ea e he n mbe f cl e b i e and
he m e ela ic he demand. The demand f a le i m e ela ic han he demand f f i ; demand
f f i i m e ela ic han he demand f f d. Simila l , a H nda ha a highe PED han all ca
c n ide ed ge he .
Necessities versus lu uries

Necessities a e g d e ice e c n ide be e en ial nece a in li e ; e cann d
ih hem. Lu uries a e n nece a e en ial. The demand f nece i ie i le ela ic han he
demand f l ie . F e am le, he demand f medica i n end be e inela ic beca e
e le heal h life de end n hem; he ef e, an i demanded i n e e n i e change in
ice. The demand f f d i al inela ic, beca e e le cann li e i h i . On he he hand, he
demand f diam nd ing i ela ic a m e le ie hem a l ie . In gene al, he m e
nece a a g d, he le ela ic he demand.
A ecial ca e f nece i i a c n me addic i n a g d. The g ea e he deg ee f addic i n a
b ance (alc h l, ciga e e , and n), he m e inela ic i he demand. A ice inc ea e ill n
b ing f h a ignifican ed c i n in an i demanded if ne i e e el addic ed.
Length of time
The l nge he ime e i d in hich a c n me make a cha ing deci i n, he m e ela ic he
demand. A ime g e b , c n me ha e he ni c n ide he he he eall an he
g d, and ge inf ma i n n he a ailabili f al e na i e he g d in e i n. F e am le, if
he e i an inc ea e in he ice f hea ing il, c n me can d li le i ch he f m f hea ing
in a h e i d f ime, and he ef e demand f hea ing il end be inela ic e h ei d.
B a ime g e b , he can i ch he hea ing em , ch a ga , he can in all be e
in la i n, and demand f hea ing il bec me m e ela ic.
Proportion of income spent on a good

The la ge he i n f ne inc me needed b a g d, he m e ela ic he demand. An i em
ch a a en ake a e mall i n f ne inc me, he ea a ca ake a m ch la ge
i n. F he ame e cen age inc ea e in he ice f en and in he ice f ca , he e n e in
an i demanded i likel be g ea e in he ca e f he ca han in he ca e f en .

1 Iden if and e lain he de e minan f ice ela ici f demand.
2 S a e in hich ca e demand i likel be m e ela ic in each f he f ll ing ai fg d,
and h :
a ch c la e Cadb ch c la e
b ange j ice ae
c ciga e e ee
d a n e ad ac m e
e hea ing il in ne eek in ne ea
f b ead mea .
Applications of price elasticit of demand

P ice ela ici f demand i a e im an c nce in ec n mic , i h n me a lica i n . S me
f he e ill be c n ide ed bel ; he ill be died in la e cha e .
PED and total revenue

PED and the effects of price changes on total revenue
Total revenue (TR) i he am n f m ne ecei ed b fi m hen he ell a g d ( e ice), and i
e al he ice (P) f he g d ime he an i (Q) f he g d ld. The ef e, TR = P Q.

What happens when demand is highl price inelastic?
A gi l ell lem nade a a and f 50 cen (= $0.50) a c . On a e h da , he lem nade
bec me e en m e la , and he gi l eali e he can ai e he ice a li le and ill ell all he
lem nade. One af e n n, a diabe ic b c me al ng a king f lem nade i h e a ga beca e
hi bl d ga ha fallen dange l l le el . The gi l ee an ni and inc ea e he
ice b 500%. The b d e n ha e en gh m ne , b he ell him he ill gi e him he lem nade
igh a a ided he mi e n h me af e a d, ge he m ne and e n a he he f ll
ice. Ha ing n ch ice, he b ag ee .
Figure 3.5: Li le gi l elling lem nade
Appl ing our skills
1 a De c ibe he b ice ela ici f demand f ee lem nade a ha a ic la m men .

b Iden if ha de e minan f PED acc n f hi .
2 Wha ld ha e ha ened he an i f lem nade demanded if he he child en e e
faced i h a 500% inc ea e in i ice? E lain in e m f hei ice ela ici f demand f
lem nade.
Sources: Ada ed f Te Se a i, F ee a e d a a d he igh hi g
ega di g hea h ca e i The De e e Ne , 15 N e be 2009.
We a e in e e ed in e amining ha ill ha en he fi m al e en e (TR) hen he e i a change

in he ice f he g d i d ce and ell . We kn ha an inc ea e in P lead a dec ea e in Q
demanded and ice e a. Wha can e a ab he e l ing change in al e en e? Will i inc ea e,
dec ea e a he ame? The change ill de end n ice ela ici f demand f he g d. We ha e
he f ll ing h ee ibili ie :
Demand is elastic (PED > 1)

When demand i ela ic, an inc ea e in ice ca e a fall in al e en e, hile a dec ea e in ice
ca e a i e in al e en e. T ee h , c n ide ha if demand i ela ic, PED>1, an inc ea e in
ice e l in a i na el la ge dec ea e in an i demanded. F e am le, if ice i e b
10% an i demanded ill fall b m e han 10%. The dec ea e in an i ha a bigge im ac n
al e en e han he inc ea e in ice; he ef e, al e en e fall . If he e i a ice dec ea e, a 10%
ice fall e l in a la ge han 10% inc ea e in an i demanded, and al e en e inc ea e .
When demand i ela ic, an inc ea e in ice ca e a fall in al e en e, hile a dec ea e in ice
ca e a i e in al e en e.
Demand is inelastic (PED < 1)
When demand i inela ic, an inc ea e in ice ca e an inc ea e in al e en e, hile a dec ea e in
ice ca e a fall in al e en e. Since PED < 1, an inc ea e in ice ca e a i na el malle
dec ea e in an i demanded. F e am le, a 10% ice inc ea e d ce a malle han 10%
dec ea e in an i demanded, and al e en e i e . If ice fall , a e cen age ice dec ea e gi e
i e a malle e cen age inc ea e in an i demanded and al e en e fall . In b h ca e , he
effec n al e en e f he change in ice i la ge han he effec f he change in an i .
When demand i inela ic, an inc ea e in ice ca e an inc ea e in al e en e, hile a dec ea e in

ice ca e a fall in al e en e.
Demand is unit elastic (unitar PED; PED = 1)

When demand i ni ela ic, he e cen age change in an i i e al he e cen age change in
ice, and al e en e emain c n an .
When demand i ni ela ic, a change in ice d e n ca e an change in al e en e.
Using diagrams to illustrate PED and the effects of price changes

on total revenue
Fig e 3.6 h h ee demand c e . The fi h a ice ange he e PED>1, he ec nd a ice
ange he e PED<1 and he hi d ni a PED h gh i ange. In all h ee diag am al e en e
TR i h n b he ec angle e e en ed b P Q.
Elastic demand: as P increases TR falls: P and TR change in opposite directions

In Fig e 3.6(a), he e demand i ela ic, a he ini ial ice and an i , P1 and Q1, al e en e i
gi en b he m f he ec angle A and B. When ice inc ea e P2 and an i d Q2, al
e en e i gi en b he m f he ec angle A and C. D e he ice inc ea e ec angle B a l and
he ec angle C a gained. Since he l (B) i la ge han he gain (C), al e en e fell.
We can e he ame diag am e l e a ice dec ea e hen PED > 1, im l b a ming ha he
ini ial ice and an i a e P2 and Q2; ice hen fall P1 hile an i inc ea e Q1. The gain in
TR i gi en b ec angle B, hich i g ea e han he l h n b ec angle C, h al e en e
inc ea e .
Inelastic demand: as P increases TR increases: P and TR change in same direction

The e e l can be een in Fig e 3.6(b). Wi h a ice inc ea e, al e en e gained ( ec angle C) i
la ge han al e en e l ( ec angle B); he ef e, al e en e inc ea e . If ice fall f m P2 P1,
he gain in al e en e ( ec angle B) i malle han he l ( ec angle C) and al e en e fall .
Unitar PED: an change in P leaves TR unchanged

In Fig e 3.6(c), a ice and an i change, he gain in al e en e i e ac l ma ched b he l ,
and al e en e emain nchanged.
Figure 3.6: PED and al e en e
Calculating total revenue at different points on the demand curve

We can e he inf ma i n in Fig e 3.6 calc la e al e en e a ice change . In Fig e 3.6(a)
he e demand i ela ic, ini iall TR = P1 Q1= 4 11 = $44. Af e he ice inc ea e TR = P2 Q2 = 5
8 = $40. The ef e he inc ea e in ice ca ed a fall in al e en e, c nfi ming he in ha hen
demand i ela ic P and TR change in i e di ec i n .
In Fig e 3.6(b) demand i inela ic. Ini iall TR = P1 Q1 = 5 14 = $70. Af e he ice inc ea e TR =
P2 Q2 = 7 12 = $84. The ice inc ea e he e led an inc ea e in al e en e c nfi ming he in
ha hen demand i inela ic ice and al e en e change in he ame di ec i n.
PED and firm pricing decisions

The ab e di c i n h ha b ine e m ake PED in acc n hen c n ide ing change in
he ice f hei d c . If a b ine an inc ea e al e en e, i m d i ice if demand i
ela ic, inc ea e i ice if demand i inela ic. If demand i ni ela ic, he fi m i nable change
i al e en e b changing i ice.
A fi m al e en e h ld n be c nf ed i h fi . P fi i al e en e min al c .
Figure 3.7: PED, indi ec a e and g e nmen a e en e
PED and indirect ta es

G e nmen f en im e a e n ecific g d . S ch a e a e a e f i di ec a ( be di c ed
in Cha e 4). If g e nmen a e in e e ed in inc ea ing hei a e en e , he m c n ide he PED
f he g d be a ed f he f ll ing ea n.
The l e he ice ela ici f demand f he a ed g d, he g ea e he g e nmen a e en e .
Thi can be een in Fig e 3.7, h ing he ca e f inela ic demand in a (a) and ela ic demand in
a (b).3 When a a i im ed n a g d, i ha he effec f hif ing he l c e a d. The
ea n i ha f e e le el f he fi m i illing and able l he ma ke , i m
ecei e a ice ha i highe han he iginal ice b he am n f he a . (Thi i e i alen a
lef a d hif f he l c e; f an e lana i n ee Q an i a i e echni e cha e in he 'Digi al
c eb k: E a ma e ial' ec i n.) The c e hif f m S1 S2 ha he e ical di ance be een
S1 and S2 i e al he am n f he a e ni f . The ne , af e - a e ilib i m cc a
ice P and an i Q , de e mined b he in e ec i n f he demand c e, D, and he ne l
c e, S2. The haded a ea e e en he g e nmen a e en e, b ained b m l i l ing he am n
f a e ni ime he n mbe f ni , an i Q . A c m a i n f he fig e indica e ha
a e en e i la ge hen demand i inela ic. Thi e l f ll f m he inci le ha hen demand
i inela ic (0 <PED < 1), an inc ea e in ice (he e d e he inc ea e in he a ) lead a
i na el malle dec ea e in an i demanded, and hence an inc ea e in al e en e (i.e. a
e en e). Indi ec a e a e he ef e all im ed n g d like ciga e e and e l (ga line),
hich ha e a l PED.

1 E lain and h , ing diag am , h al e en e ill change if
a ice inc ea e and demand i ela ic,
b ice dec ea e and demand i inela ic,
c ice inc ea e and demand i e fec l inela ic,
d ice inc ea e and demand i inela ic,
e ice dec ea e and demand ha ni ela ici , and
f ice dec ea e and demand i ela ic.
2 U ing diag am , di c h a fi m kn ledge f ice ela ici f demand f i d c can
hel i in i icing deci i n .
3 Refe Fig e 3.2 in hi cha e .
a Calc la e he change in al e en e hen ice inc ea e f m $4 $5.
b Calc la e he change in al e en e hen ice inc ea e f m $1 $2.
c Gi en e l in (a) and (b), c mmen n he i e f he PED f a ice change f m
$4 $5, and he i e f he PED f a ice change f m $1 $2.
d Calc la e PED f he ice change c nfi m an e .
4 (HL nl ) Refe ing Fig e 3.4 calc la e he change in al e en e ha e l hen:
a ice inc ea e f m $10 $15, and
b ice inc ea e f m $40 $45.
c N ing hen al e en e inc ea ed and hen i dec ea ed, e lain ha calc la i n
h ab PED al ng a aigh -line demand c e.
5 The g e nmen ld like le indi ec a e n ce ain g d ai e a e en e. U ing
diag am , e lain h ice ela ici f demand can hel i decide hich d c i h ld a .
PED in relation to primar commodities and manufactured
products (HL onl )
Wh man primar commodities have a lower PED compared

with the PED of manufactured products
Primar commodities a e g d a i ing di ec l f m he e f na al e ce , he fac f
d c i n land ( ee Cha e 1). P ima c mm di ie he ef e incl de ag ic l al, fi hing and
f e d c , a ell a d c f e ac i e ind ie ( il, c al, mine al , and n).
Ag ic l al d c incl de f d, a ell a he , n n-edible c mm di ie ( ch a c n and
bbe ).
Man ima c mm di ie ha e a l PED, hich i all l e han he PED f man fac ed
d c (a ell a e ice ). Manufactured products a e g d d ced b lab all
king ge he i h ca i al a ell a a ma e ial , ch a f e am le ca , c m e and
ele i i n . F d ha a highl ice inela ic demand, beca e i i a nece i and i ha n
b i e . The ame a lie a a ie f he ima d c ( ch a il and mine al ). In he
ca e f f d, in de el ed c n ie he PED i e ima ed be be een 0.20 and 0.25. B c n a ,
he demand f man fac ed d c end be m e ice ela ic, beca e he e d c , h gh
he ma be nece i ie (in me ca e ), all d ha e b i e . The ef e, gi en a ice change,
an i demanded i gene all m e e n i e in he ca e f man fac ed d c c m a ed i h
ima c mm di ie . (N e, h e e , ha he e a e e ce i n . F e am le, medica i n a e
man fac ed d c , e hei demand end be inela ic beca e he a e nece i ie and ha e
n b i e .)
Man ima c mm di ie ha e a ela i el l PED ( ice inela ic demand) beca e he a e

nece i ie and ha e n b i e (f e am le, f d and il). The PED f man fac ed
d c i ela i el high ( ice ela ic demand) beca e he all ha e b i e .
Consequences of a low PED for primar commodities

(Supplementar material)
L ice ela ici f demand, ge he i h fl c a i n in l e h e i d f ime,
c ea e e i blem f ima c mm di d ce , beca e he e l in la ge fl c a i n
in ima c mm di ice , and he e al affec d ce inc me .
C n ide he diag am in Fig e 3.8. Pa (a) h ela i el inela ic demand ( ch a f ima
c mm di ie ) and a (b) h ela i el ela ic demand ( ch a f man fac ed d c ).
Figure 3.8: P ice fl c a i n a e la ge f ima c mm di ie beca e f l PED
B h diag am h he effec n ice and an i hen he e i a dec ea e in l (f m S1

S2) and hen he e i an inc ea e in l (f m S1 S3). A c m a i n f he diag am e eal
ha hif in he l c e e l in la ge ice fl c a i n hen demand i inela ic, and m ch
milde ne hen demand i ela ic. La ge ice fl c a i n e h e i d f ime a e efe ed
a ice a i i . (V la ili mean in abili high a iabili .)
Fig e 3.8 e lain h , in he eal ld, ice f ima c mm di ie can be highl la ile,
he ea he end be m ch le in he man fac ing and e ice ec .
T e l f ll f m hi :
A ima c mm di ice fl c a e idel , d d ce inc me , hich de end n he
e en e ( ice an i ) d ce ecei e f m elling hei .
In ie f he ela i n hi be een PED and al e en e ( ee ab e), a fall in he l fa
ima c mm di i h inela ic demand (f m S1 S2 in Fig e 3.8(a)) lead an inc ea e in
al e en e f d ce beca e he e cen age inc ea e in ice i la ge han he e cen age
dec ea e in an i . An inc ea e in l lead l e e en e ( he e cen age dec ea e in
ice i la ge han he e cen age inc ea e in an i ).
The e in lead me ne ec ed c ncl i n . The h ha a c in ag ic l e, a d e
ea he c ndi i n , hich e l in a fall in l (S2 in Fig e 3.8(a)), lead highe
ice and highe al e en e f fa me . A g d c e l ing in a l inc ea e, S3, lead
l e ice and l e fa me e en e . We c me, he ef e, he i nic c ncl i n ha a
c ma be g d f fa me hile a g d c ma be bad f hem.
If l f ag ic l al d c e e ela i el able, he blem ld be le e i a
ag ic l al d c ice ld al be m e able. H e e , ag ic l al d c i n de end n
man fac be nd he fa me c n l, ch a d gh , e , fl d , f and he ch na al
di a e , a ell a e ce i nall g d ea he c ndi i n , hich cc e h e i d f ime.
The e ca e f e en and la ge l change ( l c e hif ).
The blem f n able fa me e en e i an im an ea n behind g e nmen in e en i n
fa me inc me , hich e ill d in Cha e 4. The im lica i n f n able ima
d c ice f fa me e en e and he ec n m ill be e l ed in Cha e 19 .

1 S e fl ding de a b an ial i n f hi ea n c . U ing diag am , e lain
ha i likel ha en fa me e en e , a ming he demand f he d c he
d ce i inela ic.
2 a U ing e am le , e lain h man ima c mm di ie ha e a ela i el l PED
hile man man fac ed d c ha e a ela i el high PED.
b U e he c nce f PED and diag am e lain h ag ic l al d c ice end
fl c a e m e (a e m e la ile) c m a ed i h man fac ed d c ice e he
h e m. (O i nal)
1 Y ma n e ha he al e f hi ela ici f demand de end n he ch ice f he ini ial ice an i

c mbina i n. In he calc la i n ab e, hi a aken be 300, 5000. If e had aken 255, 6000 a he ini ial
ice an i c mbina i n, e ld ge a PED al e f 0.94. (Y c ld calc la e hi a an e e ci e.) Thi
diffic l can be e c me b e f he mid in f m la . N e ha ae n e i ed kn he
mid in f m la:
PED = Q X a e age Q X P X a e age P X
In he e i e am le,
PED= 1000 5500 45 277.5 =1.12, he e 5500= (5000+6000) 2 and 277.5= (255+300) 2
i.e. e e he a e age f he Q al e and he a e age f he P al e in ead f he ini ial Q and

ini ial P . N e ha a en e i ed kn he mid in f m la.
2 I ma be n ed ha ic l eaking he l e f he demand c e i Q/ P. The ea n i ha

ma hema icall he l e i defined a he change in he de enden a iable di ided b he change in he
inde enden a iable. In he ca e f demand, Q i he de enden a iable and P i he inde enden a iable.
H e e beca e f he ac ice f e e ing he P and Q a e , and ing P n he e ical a i , e ma ake
he l e a being P/ Q. In an ca e hi d e n make an diffe ence he in f he a g men in he e
beca e b h Q/ P and P/ Q a e c n an al ng a aigh line.
N e e a e a ming ha he demand c e a e d a n n he ame cale, and ha if he e e d a n in
3
he ame diag am he ld in e ec , he ef e he PED a e c m a able.
3.2 I (YED)
LEARNING OBJECTI ES
Af er d ing hi ec ion o ill be able o:

define all he erm appearing in in he e (AO1)
e he form la for income ela ici of demand (YED) o calc la e YED, change in income and
q an i demanded (AO4)
dra an Engel c r e diagram o ho income ela ic, income inela ic and inferior good (AO4)
depending on he ign of YED, di ing i h be een normal and inferior good (AO2)
depending on he al e of YED (le han one or grea er han one), di ing i h be een
nece i ie , er ice and l r good (AO2)
appl YED o (HL onl ) (AO3)
di c i rele ance o firm
di c change in he ec oral r c re of an econom
Con mer income i an impor an fac or infl encing demand for a good and he po i ion of he demand
c r e. We ha e alread enco n ered he role of income in Chap er 2, here e a ha income i a
fac or ha ca e demand c r e hif ( ee Chap er 2).
I (YED) i a mea re of he re pon i ene of demand o change in

income, and in ol e demand c r e hif . I pro ide informa ion on he direc ion of change of
demand gi en a change in income (increa e or decrea e) and he i e of he change ( i e of demand
c r e hif ).
C YED,
The form la for YED ha he ame ba ic form a he o her ela ici form lae, and ho he rela ion hip
be een he percen age change in q an i demanded of a good, X, and he percen age change in income,
hich e abbre ia e a Y:
income ela ici of demand (YED)

= percen age change in q an i demanded of good percen age change in income
YED= % Q % P
Which can be re ri en a :
Q Q 100 Y Y 100 = Q Q Y Y here

Q = Qini ial al e
Y = Yfinal al e Yini ial al e
P = Yini ial al e
S ppo e o r income increa e from $800 per mon h o $1000 per mon h, and o r p rcha e of clo he
increa e from $100 o $140 per mon h. Wha i o r income ela ici of demand for clo he ?
YED= 40 100 200 800 = 0.40 0.25 =+1.6
Yo r income ela ici demand for clo he i +1.6.
If e kno YED and he percen age change in q an i demanded, i i imple o calc la e he
percen age change in income. S ppo e YED = 0.75 and q an i demanded of a normal good ha
increa ed b 15%. The percen age change in income i fo nd b aking
YED=0.75= 0.15 % Y ⇒0.75 % Y=0.15⇒% Y =0.20 or 20%.
Income increa ed b 20%.
Similarl if e kno YED and he percen age change in income, e can calc la e he percen age change
in q an i demanded. S ppo e YED = 1.25 and income increa e b 20%. The percen age change in Q
i fo nd b :
YED=1.25= % Q 0.20 ⇒% Q=1.25 0.20=0.25 or 25%
Q an i demanded increa ed b 25%.
I
Income ela ici of demand pro ide o kind of informa ion:
he ign of YED: po i i e or nega i e
he n merical al e of YED: he her i i grea er or maller han one (a ming i i po i i e).
T :
The ign of YED ell he her a good i normal or inferior:
YED > 0. A po i i e income ela ici of demand indica e ha he good in q e ion i normal;
demand for he good and income change in he ame direc ion (bo h increa e or bo h decrea e).
Mo good are normal good ( ee Chap er 2).
YED < 0. A nega i e income ela ici of demand indica e ha he good i inferior: demand for
he good and income mo e in oppo i e direc ion (a one increa e he o her decrea e ).
E ample incl de b ride , ed clo he and ed car ; in he e ca e , a income increa e , he
demand for he e good fall a con mer i ch o con mp ion of normal good (ne car ,
ne clo he and o on; ee Chap er 2).
The difference be een normal and inferior good can be een in Fig re 3.9, ho ing a demand c r e,
D1, and hif of he c r e ha occ r in re pon e o increa e in income. A income increa e , he
demand c r e hif righ ard from D1 o D3 or D4 hen good are normal (YED > 0), b hif
lef ard o D2 hen good are inferior good (YED < 0).
T : ,
Here e are making a di inc ion be een good ha ha e a YED ha i po i i e and le han or grea er
han one:
YED < 1: Necessities. If a good ha a YED ha i po i i e b le han one, i ha

: a percen age increa e in income prod ce a maller percen age increa e in
q an i demanded. Nece i ie are income inela ic good .
YED > 1: Lu uries and ser ices. If a good ha a YED ha i grea er han one, i ha
: a percen age increa e in income prod ce a larger percen age increa e in
q an i demanded. L rie and er ice are income ela ic.
Nece i ie , ch a food, clo hing and ho ing, end o ha e a YED ha i po i i e b le han one;
he are normal good ha are income inela ic. In he ca e of food, a income increa e , people b
more food b he amo n of income pen on food increa e more lo l han income. In de eloped
co n rie , YED for food i abo 0.15 o 0.2. Thi mean ha a 1% increa e in income prod ce a 0.15%
o 0.2% increa e in pending on food; or a 10% increa e in income re l in a 1.5% o 2% increa e in
pending on food. B con ra , l rie , ch a je eller and e pen i e car , a ell a man er ice ,
ch a ra el o o her co n rie , pri a e ed ca ion and ea ing in re a ran are income ela ic: a income
increa e , he amo n of income pen on ch good increa e fa er han income ( he denomina or in
he YED form la i maller han he n mera or).
Wha i a nece i and ha i a l r depend on income le el . For people i h e remel lo
income , e en food and cer ainl clo hing can be l rie . A income increa e , cer ain i em ha ed
o be l rie become nece i ie . For e ample, i em like Coca-Cola and coffee for man poor people
in le de eloped co n rie are l rie , herea for con mer in de eloped co n rie he ha e
become nece i ie . Income ela ici of demand for par ic lar i em herefore arie idel depending
on income le el . While YED for food i abo 0.15 0.20 in more de eloped co n rie , i i abo 0.8 in
poor co n rie . For an increa e in income of 10%, pending on food increa e b onl 1.5% 2% in rich
co n rie and b 8% in poor co n rie .
In Fig re 3.9, e ee ha in he ca e of nece i ie , an increa e in income ill prod ce a rela i el mall
righ ard hif in he demand c r e; in he ca e of l rie and er ice , he righ ard hif ill be
larger.
F 3.9: Demand c r e hif in re pon e o increa e in income for differen YED

E plain he meaning of income ela ici of demand. Wh do e a i in ol e a hif ing
1 demand c r e?
2 E plain he difference be een normal and inferior good and pro ide e ample of each.
3 Yo r income increa e from 1000 a mon h o 1200 a mon h. A a re l , o increa e o r
p rcha e of pi a from 8 o 12 per mon h, and o decrea e o r p rcha e of chee e
and iche from 15 o 10 per mon h.
Calc la e o r income ela ici of demand for pi a and for chee e and iche .
Wha kind of good are pi a and chee e and iche for o ?
Sho ing diagram he effec of o r increa e in income on o r demand for pi a and
chee e and iche .
4 A 15% increa e in income lead o a 10% increa e in demand for good A and 20% increa e in
demand for good B.
Iden if hich of he o good i income ela ic and hich i income inela ic.
Iden if hich of he o good i likel o be a nece i good and hich a l r good.
T E
The Engel c r e i a far more acc ra e a o ill ra e YED han demand c r e hif . I i named af er
Ern Engel, a German a i ician and economi ho li ed in he 19 h cen r , and ho a he fir o
d he rela ion hip be een con mer income and demand for a prod c . An Engel c r e i ho n in
Fig re 3.10, here he er ical a i mea re he income of a con mer per eek, he hori on al a i
mea re he q an i of ho dog he or he b each eek, hile he olid line ho he c r e i elf.
We can ee raigh a a ha ho dog are a normal good from poin A o poin C, ince a income
increa e from $100 o $250, he q an i increa e from 4 ho dog o 9 ho dog . A income increa e
f r her o $350 he q an i remain con an a 9 ho dog , b a income increa e e en more he
q an i fall from 9 o 8 ho dog . We can ee herefore ha hen income goe abo e $350, ho dog
become an inferior good for hi con mer.
Wi h income on he er ical a i and q an i on he hori on al a i of an E diagram, e

can ee he follo ing:
YED>0 in he p ard loping par of he c r e ho ing q an i and income bo h increa ing,
hich indica e he good i normal
YED<0 in he do n ard loping par ho ing q an i decrea ing a income increa e , hich
indica e he good i inferior.
The Engel c r e can al o ho he her a good i income inela ic or income ela ic. In Fig re 3.10, for
er lo income le han $150, ho dog are a l r a YED>1. A he higher income le el be een
$250 and $350, ho dog ha e become a nece i a YED < 1.
There i a imple r le ha allo o di ing i h be een a l r and a nece i on he p ard
loping par of he Engel c r e.
Imagine each egmen of he Engel c r e e ending back ard o o ch ei her he er ical a i or he

hori on al a i , a ho n b he do ed line :
YED>1 if he line o che he er ical a i , a i h he line AB, o ha i i a l r or er ice
YED<1 if he line o che he hori on al a i , a i h line BC, o ha i i a nece i .
F 3.10: The Engel c r e ho ing differen YED
(The ma hema icall inclined den can ea il ee h hi i o. A e kno

YED= Q Q Q Y = Q Y YQ=YQ Y Q
Imagine no a line joining he origin i h poin B on he Engel c r e. The lope of hi line i Y/Q.
No e al o ha he lope of he Engel c r e i Y/ Q. Therefore YED ha been ri en a he ra io of he
o lope : lope of OB/ lope of Engel c r e. No no e ha OB i eeper han AB, herefore he lope
of OB> he lope of he Engel c r e from A o B, and o YED>1 p o poin B. On he o her hand, OB i
fla er han BC, herefore he lope of OB< he lope of he Engel c r e from B o C, and o YED < 1
from B o C.)
The Engel c r e ho a con in m: a er lo income a good ma be a l r ; a income

increa e i become a nece i and finall a high income le el i become inferior.
The informa ion in Fig re 3.10 can be ed o calc la e YED in order o confirm he abo e poin . Thi
ill be gi en o o a an e erci e.

1 Dra an Engel c r e for a pical good and e plain ho i change from income ela ic o
income inela ic o inferior a income increa e .
2 De cribe h income ela ici of demand for food ha been e ima ed o be abo 0.15 o 0.2 in
more de eloped co n rie and abo 0.8 in le de eloped co n rie .
3 U ing he informa ion in Fig re 3.10, calc la e YED for an increa e in income
from $100 o $150,
$150 o $250,
$250 o $350, and
$350 o $450.
E plain ha o r re l for he e YED ell o abo he na re of he good for he
ario income le el .
A (HL )
YED :
O er ime, a co n rie e perience economic gro h, ocie income increa e . Increa ing income
mean a gro ing demand for good and er ice . S ppo e ha o al income in an econom gro a
an a erage ra e of abo 3% per ear. If good and er ice ha e income ela ic demand (YED > 1),
hi mean ha demand for he e good and er ice gro a a higher ra e han 3%. E ample
all incl de re a ran , mo ie , heal h care and foreign ra el. O her good and er ice ha e
income inela ic demand (YED < 1), meaning ha he demand for he e gro a a ra e of le han
3%. E ample incl de food, clo hing and f rni re. The fir gro p ( i h he ela ic demand) incl de
good and er ice prod ced b ind rie ha gro and e pand fa er han o al income in he
econom , hile he econd gro p incl de good or er ice prod ced b ind rie gro ing more
lo l han o al income.
The higher he YED for a good or er ice, he grea er he e pan ion of i marke i likel o be in he
f re; he lo er he YED, he maller he e pan ion. Prod cer in ere ed in prod cing in an
e panding marke ma herefore an o kno YED of ario good and er ice .
In con ra o period of economic gro h, if an econom i e periencing a rece ion (falling o p
and income , ee Chap er 8), good and er ice i h high YED (YED>1) are he harde hi ,
e periencing he large decline in ale . Prod c i h lo YED (YED<1) can a oid large fall in
ale , hile inferior good (YED<0) can e en e perience increa e in ale .
YED
The implica ion of differing YED for he econom follo from ha happen o par ic lar
ind rie in he econom a income gro , di c ed abo e.
E er econom ha hree ec or (or par ): he primar ec or incl ding primar prod c
(agric l re, fore r , fi hing and e rac i e ind rie ), he man fac ring ec or and he er ice
ec or (incl ding en er ainmen , ra el, banking, in rance, heal h care, ed ca ion, and o on). Wi h
economic gro h, he rela i e i e of he hree ec or all change o er ime, and he e change
can be e plained in erm of income ela ici of demand.
Agric l re, he main par of he primar ec or, prod ce food, hich a no ed abo e ha a YED ha
i po i i e b le han one (i i income inela ic). A ocie income gro o er ime, he demand
for agric l ral o p gro more lo l han he gro h in income. O her primar prod c al o
ha e a lo income ela ici of demand. For e ample, co on and r bber ha e n he ic b i e , o
a income increa e a rela i el larger propor ion of i i pen on he n he ic ma erial , hile a
rela i el lo er frac ion goe o ard co on and r bber. B con ra , man fac red prod c (car ,
ele i ion , comp er , and o on) ha e a YED ha i all grea er han one (income ela ic), o
ha a ocie income gro , he demand for he e prod c gro fa er han income. Man
er ice ha e e en higher YED , o he percen age increa e in he demand for he e i m ch larger.
Therefore, o er ime, he hare of agric l ral o p in o al o p in he econom hrink , hile he
hare of man fac red o p gro . Wi h con in ed gro h, he er ice ec or e pand a he
e pen e of bo h agric l re and man fac ring.
REAL ORLD FOC S 3.2

I
According o he World Bank (an in erna ional organi a ion ha lend o de eloping co n rie , ee
Chap er 20), he global ra e of gro h in demand for agric l ral commodi ie like rice and hea
ill fall from an a erage of 2.8% per ear in he period 2010 2016 o an a erage of 1.8% in he
period 2017 2018. The rea on for hi e pec ed rend i ha a con mer income increa e,
con mer i ch from commodi ie like rice and hea o o her food ha ha e a high pro ein
and fa con en .
F 3.11: A Nepali oman inno ing rice, hich i he major crop in Nepal
A
1 E plain he meaning of income ela ic demand and income inela ic demand.
2 Ba ed on he informa ion in he e , o line o r concl ion abo he YED of commodi ie
like rice and hea , in compari on i h he YED of food i h a high pro ein and fa con en .
In o her ord , hich of he o i likel o be grea er?
3 E plain h good and er ice i h highl income ela ic demand and o gain he mo
from ri ing con mer income .
S : Mana Chakra ar World Bank a long erm gro h in commodi con mp ion
o eaken , 13 J ne 2018, Li emin
F 3.12: Changing rela i e hare (a percen age of o al o p ) of primar , man fac ring and
er ice ec or for a h po he ical econom a i gro
In Fig re 3.12, hi i ho n for a h po he ical gro ing econom in he change of rela i e ec or

i e from par (a) o (b) o (c).
Economicall le de eloped co n rie all ha e a large primar ec or d e o he impor ance of
agric l re and e rac i e ac i i ie , hile man fac ring and er ice are far le impor an . The
de eloped co n rie of oda ere in a imilar po i ion man decade ago. The hi orical e perience
of bo h more and le de eloped co n rie ho ha i h economic gro h, he primar ec or
become le and le impor an , and i par l replaced b man fac ring and er ice . A he
econom gro f r her, he rela i e impor ance of he primar ec or con in e o hrink, and
man fac ring become increa ingl replaced b er ice . Th , hile le de eloped co n rie are
all domina ed b he primar ec or, more de eloped co n rie are domina ed b er ice . In he
de eloped orld oda , among he ind rie e periencing he fa e gro h are er ice , incl ding
ed ca ion, heal h care, ra el and financial er ice .
No e ha if o al o p i increa ing o er ime, a falling hare for a par ic lar ec or ( ch a he
primar ec or) doe no nece aril mean ha primar ec or o p i falling. Mo likel i mean
ha hi ec or o p i gro ing, b more lo l han o al o p . An increa ing hare for a ec or
mean ha i o p i gro ing more rapidl han o al o p .
1 Di c h firm o ld be in ere ed in kno ing he YED of ario good and er ice .

2 E plain a likel rea on behind he ob er ed rapid gro h in cer ain er ice ind rie ,
incl ding heal h care, ed ca ion and financial er ice , compared i h o her ind rie ch
a food (in he primar ec or) and f rni re (in he econdar ec or).
3 Di c he role of YED in he ob er ed pa ern of change in he rela i e hare of he
primar , econdar and er iar ec or in he econom a a co n r gro and de elop .
3.3 Price elasticit of suppl (PES)
LEARNING OBJECTIVES

e he fo m la fo p ice ela ici of ppl (PES) o calc la e PES, change in p ice and
change in q an i (AO4)
iden if he a io deg ee and ange of al e fo PES (AO2)
d a diag am ho ing he ange of al e fo PES, incl ding ela i el ela ic and inela ic
ppl ; and con an al e fo pe fec l ela ic ppl , pe fec l inela ic ppl and ni a
PES (AO4)
anal e he de e minan of PES (AO2)
appl PES o anal e he ea on h p ima commodi ie gene all ha e a lo e PES han
man fac ed p od c (HL onl ) (AO2)
Price elasticit of suppl
Understanding price elasticit of suppl

Un il no , e ha e died o demand ela ici ie , bo h of hich in ol e con me e pon e . We no
n o e amine p ice ela ici of ppl , hich conce n fi m (b ine ) e pon e o change in p ice.
Acco ding o he la of ppl , he e i a po i i e ela ion hip be een p ice and q an i pplied:
hen p ice inc ea e , q an i pplied inc ea e and ice e a, ce e a b . B b ho m ch doe
q an i pplied change?
Price elasticit of suppl (PES) i a mea e of he e pon i ene of he q an i of a good pplied

o change in i p ice. PES i calc la ed along a gi en ppl c e. In gene al, if he e i a ela i el
la ge e pon i ene of q an i pplied, ppl i efe ed o a being ela ic; if he e i a ela i el
mall e pon i ene , ppl i e a c.
Calculating PES
The fo m la fo p ice ela ici of ppl (PES) follo he ame gene al fo m of ela ici fo m lae,
onl no e con ide he ela ion hip be een he pe cen age change in he p ice of a good, X, and he
pe cen age change in q an i of X pplied:
p ice ela ici of ppl (PES)

= pe cen age change in q an i of good X pplied pe cen age change in p ice of good X
PED= % Q % P
hich can be e i en a
Q Q 100 P P 100 = Q Q P P he e
Q = Qini ial al e
P = Pfinal al e Pini ial al e
P = Pini ial al e
Calculating PES, change in price and change in quantit

S ppo e he p ice of a be ie inc ea e f om 3 pe kg o 3.50 pe kg, and he q an i of
a be ie pplied inc ea e f om 1000 o 1100 onne pe ea on. Calc la e PES fo a be ie .
PES= 100 1000 0.50 3.00 = 0.10 0.17 =+0.59
P ice ela ici of ppl fo a be ie i +0.59.
If o a e gi en PES and he pe cen age change in q an i pplied, o can find he pe cen age change
in p ice b ol ing fo hi ba ed on he fo m la abo e, in e ac l he ame a a in he ca e of PED.
Simila l , o can ol e fo he pe cen age change in q an i pplied if o a e gi en PES and
pe cen age change in p ice.
Interpreting price elasticit of suppl
The range of values for PES

P ice ela ici of ppl ange in al e f om e o o infini . Beca e of he po i i e ela ion hip
be een p ice and q an i pplied, PES i po i i e.
The al e of PES in ol e a compa i on of he pe cen age change in q an i pplied ( he n me a o in
he fo m la fo PES) i h he pe cen age change in p ice ( he denomina o ). Thi compa i on ield he
follo ing po ible al e and ange of al e of PES, hich a e ill a ed in Fig e 3.13 and
mma i ed in Table 3.2:
Suppl is price inelastic when PES < 1. The pe cen age change in q an i pplied i malle
han he pe cen age change in p ice, o he al e of PES i le han one; q an i pplied i
ela i el n e pon i e o change in p ice, and ppl i ce e a c o e a c. Fig e 3.13(a)
ho an inela ic ppl c e (PES < 1), he e a 10% p ice inc ea e lead o a 5% inc ea e in
q an i pplied. When PES < 1, he ppl c e e end p a d and o he igh f om he
ho i on al a i ; i end-poin c he ho i on al a i .4
Suppl is price elastic when PES > 1. The pe cen age change in q an i pplied i la ge han
he pe cen age change in p ice, o he al e of he PES i g ea e han one; q an i pplied i
ela i el e pon i e o p ice change , and ppl i ce e a c o e a c. Fig e 3.13(b) ho
an ela ic ppl c e (PES > 1) he e he pe cen age inc ea e in p ice (10%) i malle han he
pe cen age inc ea e in q an i (15%). When PES > 1, he ppl c e e end p a d and o he
igh f om he e ical a i ; i end-poin c he e ical a i .5
Figure 3.13: S ppl c e and PES
In addi ion, he e a e h ee pecial ca e of con an PES along he leng h of he ppl c e:

Suppl is unit elastic when PES = 1. The pe cen age change in q an i pplied i eq al o he
pe cen age change in p ice, o PES i eq al o one; ppl i e a c; he e i unitar PES. In
Fig e 3.13(c), all h ee ppl c e ho n a e ni ela ic ppl c e , i.e. fo all h ee, PES =
1. An ppl c e ha pa e h o gh he o igin ha a PES eq al o ni . The ea on fo hi i
ha along an aigh line ha pa e h o gh he o igin, be een an o poin on he line he
pe cen age change in he e ical a i ( he p ice) i eq al o he pe cen age change in he ho i on al
a i ( he q an i ). The efo e, fo line ha pa h o gh he o igin, i i impo an no o conf e
he eepne of he c e i h he ela ici of he c e.
Suppl is perfectl inelastic when PES = 0. The pe cen age change in q an i pplied i e o;
he e i no change in q an i pplied no ma e ha happen o p ice; PES i eq al o e o and
ppl i aid o be perfectl inelastic. In Fig e 3.13(d), he ppl c e i e ical a he poin of
fi ed q an i pplied, Q1. Thi i he ame a he ppl c e ho n in Fig e 2.7 in Chap e 2.
E ample of a e ical ppl c e incl de he ppl of fi h a he momen hen fi hing boa
e n f om ea; he ea on en i e ha e of f e h p od ce b o gh o ma ke ; he ppl of
Pica o pain ing .
Suppl is perfectl elastic when PES = . The pe cen age change in q an i pplied i infini e;
an change in p ice lead o an infini el la ge e pon e in q an i pplied; ppl in hi ca e i
called perfectl elastic, and i ho n in Fig e 3.13(e) a a ho i on al line. (We ill enco n e ch
a ppl c e in Chap e 14.)
P ice ela ici ie of ppl mo commonl enco n e ed in he eal o ld a e ho e ep e en ing ela ic o
inela ic ppl , i h pe fec l ela ic, pe fec l inela ic and ni ela ic ppl being pecial ca e .
No e ha onl hen o ppl c e in e ec ( hen he ha e a p ice and q an i combina ion) i i
po ible o make compa i on of p ice ela ici ie of ppl b efe ence o he eepne of he c e .
(We ha e he ame condi ion fo making compa i on of PED in he ca e of demand c e a
e plained ea lie ). In he ca e of in e ec ing ppl c e , he fla e he ppl c e, he mo e ela ic
i i a an gi en p ice. Fo e ample, in Fig e 3.14, a an one pa ic la p ice le el, S3 i mo e ela ic
han S2, hich i mo e ela ic han S1.
Figure 3.14: The leng h of ime and PES
Value of PES Classification Interpretation
Frequentl encountered cases
0 < PES < 1 inela ic ppl q an i pplied i

(g ea e han e o and le han ela i el n e pon i e o
one) p ice
1 < PES < ela ic ppl q an i pplied i

(g ea e han one and le han ela i el e pon i e o p ice
infini )
Special cases
PES = 1 ni ela ic ppl pe cen age change in

q an i pplied eq al
pe cen age change in p ice
PES = 0 pe fec l inela ic ppl q an i pplied i

comple el n e pon i e o
p ice
PES = pe fec l ela ic ppl q an i pplied i infini el

e pon i e o p ice
Table 3.2: Cha ac e i ic of p ice ela ici of ppl
Determinants of price elasticit of suppl

We ill no con ide he fac o ha de e mine he he he ppl fo a good i ela ic o inela ic.
Length of time
An impo an fac o de e mining PES i he amo n of ime fi m ha e o adj hei inp ( e o ce )
and he q an i pplied in e pon e o change in p ice. O e a e ho ime, he fi m ma be nable
o inc ea e o dec ea e an of i inp o change he q an i i p od ce . In hi ca e, ppl i highl
inela ic, and ma e en be pe fec l inela ic (PES = 0). In Fig e 3.14, hi i ep e en ed b S1. Fo
e ample, a fi hing boa pon i e n f om a fi hing ip ha onl o man fi h o ppl in he ma ke .
E en if he p ice of fi h i e , he e can be no e pon e in q an i pplied. A he leng h of ime ha
fi m ha e inc ea e , he e pon i ene of q an i pplied o p ice change begin o i e, and PES
inc ea e .
In Fig e 3.14, he ppl c e S2 co e pond o a ime pe iod hen he fi hing boa can be aken o
o ea mo e of en, and mo e labo can be hi ed o fi h, o a p ice inc ea e o P2, q an i pplied
inc ea e o Q2 ( he 10% p ice inc ea e f om P1 o P2 lead o a 3% inc ea e in q an i pplied,
indica ing inela ic ppl , a PES < 1). If an e en longe ime pe iod goe b , he abili of fi m o
e pond o p ice change become m ch g ea e . The o ne of he fi hing boa can no no onl hi e
mo e labo b can al o b mo e fi hing boa , h g ea l inc ea ing he amo n of fi h ha can be
pplied. Thi i ho n b he ppl c e S3, fo hich he p ice P2 gi e i e o he m ch la ge
q an i Q3 ( he 10% p ice inc ea e f om P1 o P2 lead o a 15% inc ea e in q an i pplied,
indica ing ela ic ppl , a PES > 1). The efo e, he la ge amo n of ime fi m ha e o adj hei
inp inc ea e , he la ge he PES.
Mobilit of factors of production

The mo e ea il and q ickl e o ce can be hif ed o of one line of p od c ion and in o ano he
( he e p ice i inc ea ing), he g ea e he e pon i ene of q an i pplied o change in p ice, and
hence he g ea e he PES. Fo e ample, a fa m o ke can mo e mo e ea il f om a be
c l i a ion o co n c l i a ion han he ame fa m o ke can mo e o ca p od c ion.
Spare (unused) capacit of firms

Some ime fi m ma ha e capaci o p od ce ha i no being ed (fo e ample, fac o ie o
eq ipmen ma be idle fo ome ho each da ). If hi occ , i i ela i el ea fo a fi m o e pond
i h inc ea ed o p o a p ice i e. B if he fi m capaci i f ll ed, i ill be mo e diffic l o
e pond o a p ice i e. The g ea e he pa e ( n ed) capaci , he highe he PES ( he mo e ela ic he
ppl ).
Abilit to store stocks

Some fi m o e ock of o p he p od ce b do no ell igh a a . Fi m ha ha e an abili o
o e ock a e likel o ha e a highe PES fo hei p od c han fi m ha canno o e ock .
Rate at which costs increase

If he co of p od cing e a o p inc ea e apidl , hen ppl ill be inela ic, a fi m ill ha e
diffic l e panding hei o p ince he a e nlikel o an o inc la ge co . On he o he hand, if
he co of p od cing mo e o p i e lo l , i ill be ea ie fo fi m o e pand hei o p o ppl
ill be ela ic. Fo e ample, if he p ice of fe ili e i i ing apidl , h ai ing he fa m co of
p od c ion, he fa me ill find i mo e diffic l o e pand o p q ickl , he efo e PES i likel o be
lo e han if he p ice of fe ili e e e able.

1 a E plain he meaning of p ice ela ici of ppl .
b Wh do e a i mea e e pon i ene of q an i a gag e c e?
2 Iden if he al e o ange of al e fo each of he follo ing PES , and ho , ing diag am ,
he hape of he ppl c e ha co e pond o each one:
a pe fec l ela ic ppl
b ni ela ic ppl
c pe fec l inela ic ppl .
3 a Iden if he p ice ela ici of ppl al e o ange of al e ha e ee mo f eq en l
in he eal o ld.
b Compa e he e b d a ing ppl c e in a ingle diag am.
4 U ing e ample , e plain he de e minan of PES.
5 S ppo e ha in e pon e o an inc ea e in he p ice of good X f om $10 o $15 pe ni , he
q an i of good X p od ced
a doe no e pond a all d ing he fi eek,
b inc ea e f om 10 000 ni o 12 000 ni o e fi e mon h , and
c inc ea e f om 10 000 o 18 000 ni o e o ea . Calc la e PES fo each of he e h ee
ime pe iod and iden if hen i i p ice ela ic, p ice inela ic o pe fec l inela ic.
6 a E plain ha fac o can acco n fo he diffe ence in he i e of he h ee ela ici ie of
q e ion 5.
b D a a ppl c e ha i likel o co e pond o each of he h ee ela ici ie in a ingle
diag am.
Applications of price elasticit of suppl (HL onl )
PES in relation to primar commodities and manufactured

products
Wh man primar commodities have a lower PES compared with the PES of
manufactured products
In gene al, p ima commodi ie all ha e a lo e PES han man fac ed p od c . The main
ea on i he ime needed fo q an i pplied o e pond o p ice change . In he ca e of ag ic l e,
i ake a long ime fo e o ce o be hif ed in and o of ag ic l e. Fa me need a lea a
plan ing ea on o be able o e pond o highe p ice . In mo a ea he e i a limi ed amo n of ne
land ha can be b o gh in o c l i a ion. In ome egion of he o ld land app op ia e fo ag ic l e
i h inking d e o en i onmen al de c ion (ca ed b o e -fa ming ha deple e he oil of
mine al needed b c op ). Unde ch condi ion , ha i needed i an inc ea e in o p pe ni of
land c l i a ed (c op ield ), b hi eq i e echnological change in ag ic l e, in ol ing ne
eed o o he inp ha a e mo e p od c i e, and ake a g ea deal of ime. Al o needed a e mo e
and be e i iga ion em , al ho gh man co n ie face a g o ing a e ho age. All he e
fac o e plain h a long ime i needed fo he q an i of an ag ic l al commodi o e pond o
inc ea e in p ice.
In he ca e of o he p ima p od c , ch a oil, na al ga and mine al , ime i needed o make
he nece a in e men and o begin p od c ion. Beca e of he co in ol ed, fi m do no
e pond q ickl o p ice inc ea e , and ai fo a e io ho age (e ce demand) in he commodi
o a i e befo e he ake ac ion o inc ea e p od c ion.
Consequences of a low PES for primar commodities (Supplementar material)
Ea lie , in o di c ion of p ice ela ici of demand (PED), e a ha p ice inela ic demand fo
p ima p od c i an impo an fac o con ib ing o ho - e m p ice and e en e in abili fo
p od ce ch a fa me . Inela ic ppl of ag ic l al and o he p ima p od c al o con ib e
o p ice and income in abili fo p ima p od c p od ce .
Fig e 3.15 ho a fl c a ing demand c e: in pa (a) i in e ac i h inela ic ppl , hich i
pical in he ca e of p ima p od c , and in pa (b) i h ela ic ppl , mo e pical of
man fac ed p od c . Clea l , p ice fl c a ion a e la ge in he ca e of inela ic ppl . La ge
p ice fl c a ion mean la ge e en e fl c a ion , o n able e en e fo p od ce of p ima
commodi ie . We ill come back o he implica ion of n able p ice and e en e fo p od ce
and fo he econom in Chap e 4 and 19.
Figure 3.15: P ice fl c a ion a e la ge fo p ima commodi ie beca e of lo PES

Short-term and long-term price elasticities of suppl
I a no ed abo e ha ag ic l al p od c (and o he p ima commodi ie ) all ha e lo e
p ice ela ici ie of ppl han man fac ed p od c beca e he need mo e ime o e pond o
p ice change . Thi gge ha o e longe pe iod of ime he PES of ag ic l al p od c i
la ge .
Table 3.3 ho ha hi i in fac he ca e. The longe he ime p od ce ha e o make he nece a
adj men , he g ea e he e pon i ene of q an i pplied o p ice change ( ee Fig e 3.14).
Commodit Short-term PES Long-term PES
Cabbage 0.36 1.20
Ca o 0.14 1.00
C c mbe 0.29 2.20
Onion 0.34 1.00
G een pea 0.31 4.40
Toma oe 0.16 0.90
Ca liflo e 0.14 1.10
Cele 0.14 0.95
Table 3.3: Sho - n and long- n PES fo elec ed ag ic l al commodi ie

1 a E plain h he PES fo man p ima commodi ie i ela i el lo and fo man
man fac ed p od c i ela i el highe .
b U e he concep of PES o e plain h ag ic l al p od c p ice a e ola ile o e he ho
e m. (Op ional)
Summar of PED, ED and PES

Table 3.4 p o ide a mma of ke cha ac e i ic of all he ela ici ie con ide ed in hi chap e .
Elasticit Possible values Description Examples
P ice ela ici of PED = 0 pe fec l inela ic concep ed in

demand economic heo
PES= % Q % P
0<PED<1 p ice inela ic ga oline, ciga e e ,
food
PED = 1 ni ela ic concep ed in

economic heo
PED>1 p ice ela ic ach , e pen i e

holida
PED = pe fec l ela ic concep ed in

economic heo
Income ela ici of YED > 0 no mal good ne ca , ne clo he
demand
YED= % Q % Y YED < 0 infe io good ed ca , ed clo he
YED >1 income ela ic, l e pen i e ca and

clo he , man e ice
YED < 1 income inela ic, food, medicine

nece i
P ice ela ici of PES = 0 pe fec l inela ic concep ed in

ppl economic heo
PES= % Q % P
PES <1 p ice inela ic oil and ga oline, ome
ag ic l al p od c
PES = 1 ni ela ic concep ed in

economic heo
PES >1 p ice ela ic an good ha can be

p od ced q ickl
PES = pe fec l ela ic concep ed in

economic heo
Table 3.4: Ela ici concep : a mma

1 Re ea ch and find p od c ha a e bjec o indi ec a e in he co n o li e in. Do o
hink he a e likel o be p ice ela ic o p ice inela ic? I he go e nmen likel o ha e high o
lo e en e a i ing f om he indi ec a e ?
2 Think of ome good ha a e likel o ha e changing YED on acco n of hei being l ie ,
nece i ie and infe io good depending on he income le el.
3 Con ide a good i h a PES ha ange f om e o, po i i e b le han one, and g ea e han
one depending on he ime pe iod and e plain h PES a ie . T o con ide a man
de e minan of ppl o e plain o an e .
4 The ea oning he e i e ac l he ame a in he ca e of he Engel c e he e YED<1 if he e en ion of he

Engel c e o che he ho i on al a i .
5 He e, oo, he logic i he ame a in he Engel c e he e YED>1 if he Engel c e o che he e ical a i .

C a 4
G
c c c
BEFORE YOU START
Sometimes governments ta goods and services. What might be some reasons for doing so?
Sometimes governments give mone to (subsidise) certain producers. Wh do ou think
government would do this?
Besides ta ing and subsidising, can ou think of other wa s that governments intervene in
markets?
This chapter will e amine the following t pes of government intervention in markets:
price controls:
price ceilings
price floors
indirect ta es
subsidies.
We will see what effects these policies have on markets and we will evaluate their effects on
stakeholders.
4.1 G e e e e a e
LEARNING OBJECTIVES
A :
a ge b d (AO1)
(AO2)
Wh g e e e e e a e
I C 1,
.T
.
I C 13.
Ea e e ef he g e e
G i di ec a e , .N
, C 12. I C 3
,
.T ,
0<PED<1, , / .
P de f
G .S
.S
,
- ( ,
). I , b idie ice f ,
.F ,
, a iff
a, C 14.
P de h eh d c e
H
( , , ). T
, b idie , ice cei i g di ec ii f e ice ,
, .A , a fe
a e , , ,
; C 12 20.
I f e ce he e e f d c ff
( ,
),
.O , i di ec a e ;
.
I f e ce e e fc fh eh d /c e
I ,
( ei g d)
(de e i g d ). E
; .M
C 5 6. T , b idie
di ec ii f e ice ( ), dge ( C 2), c a d
a dc eh d , ,
.T , i di ec a e
, , dge , c a da dc eh d
.
N c a da dc .I
- C 1.
C ec a e fa e
Ma ke fai e (
C 2 C 5 7). ,
.I ,
. ,
, .P
i di ec a e , b idie , dge , di ec
ii f e ice c a da dc eh d .A C 5 7.
P ee (e a )
T ( ) .A
C 1, .M
,
, ,
.G
.S
ice cei i g a d b idie . O C 12 20.
Wha f d e g e e e e a e a e a he
c ec c e e?
T .
, each f he e k i f e ce
de a d f ag d e ice, h affec i g a ke c e .T
:
:
( C 2 HL).
T , .
4.2 P
LEA NING OBJEC I E

define all he e m a ea ing in in he e (AO1)
e lain he con e ence of ice ceiling and ice floo on ma ke and akeholde (AO2)
d a diag am o ill a e he effec of ice ceiling and ice floo on ma ke and
akeholde (AO4)
e al a e he effec of ice ceiling and ice floo on ma ke and akeholde (AO3)
calc la e he effec of ice ceiling and ice floo on ma ke and akeholde (HL onl )
(AO4)
I
The fi e of in e en ion e ill con ide in ol e ice con ol .
P efe o he e ing of minim m o ma im m ice b he go e nmen (o i a e

o gani a ion ) o ha ice a e nable o adj o hei e ilib i m le el de e mined b demand and
l . P ice con ol e l in ma ke di e ilib i m, and he efo e in ho age (e ce demand) o
l e (e ce l ).
P ice con ol diffe in a f ndamen al a f om o he e of go e nmen in e en ion ha e ill

d belo (indi ec a e and b idie ). When a a i im o ed o a b id g an ed, he ma ke
e e a a e e b , he e he e i a balance of demand i h he ne l . P ice con ol
diffe beca e, once he a e im o ed, he do no allo a ne e ilib i m o be e abli hed, and in ead
fo ce a i a ion he e he e i e g a e d e b .
Ma ke di e ilib i m mean ha he ma ke i e en ed f om eaching a ma ke -clea ing ice, and
he e eme ge ho age (e ce demand) o l e (e ce l ) ( ee Cha e 2).
In he di c ion ha follo , i i im o an o bea in mind ha he e m ha o diffe en
meaning . In one en e i efe o e ce l e l ing hen an i lied i g ea e han
an i demanded, a e di c ed in Cha e 2. In he econd en e i efe o he benefi ha
con me o od ce ecei e f om b ing o elling ( ee Cha e 2). Thi i no a conf ing a i
ma o nd, beca e in he econd en e i efe ed o a con me l ,o od ce
l o ocial l (o comm ni l ).
P :
?
A go e nmen ma in ome i a ion e a legal a ce fo a a ic la good; hi i called a
ce ce g. I mean ha he ice ha can be legall cha ged b elle of he good m no be highe
han he legal ma im m ice. P ice ceiling a e all e in o de o make ce ain good mo e
affo dable o eo le on lo income .
Fig e 4.1 ho ho hi o k . The e ilib i m ice i Pe, de e mined b he fo ce of demand and
l . The ice ceiling, Pc, i e b he go e nmen a a le el belo he e ilib i m ice, leading o a
ho age (e ce demand), ince an i demanded, Qd, i g ea e han an i lied, Q . If he
ma ke e e f ee, he fo ce of demand and l o ld fo ce ice o Pe. Ho e e , no hi canno
ha en, beca e he ice hi he legall e ice ceiling.
No e ha o ha e an effec , he ice ceiling m be be he e ilib i m ice. If i e e highe han
he e ilib i m ice, he ma ke o ld achie e e ilib i m, and he ice ceiling o ld ha e no effec .
F 4.1: P ice ceiling (ma im m ice) and ma ke o come
A i a e belo he e ilib i m ice, in o de o make good mo e

affo dable o eo le on lo income .
C
B im o ing a ice ha i belo he e ilib i m ice, a ice ceiling e l in a lo e an i
lied and old han a he e ilib i m ice. Thi i ho n in Fig e 4.1, he e he ice ceiling, Pc,
gi e i e o an i , Q , ha fi m l , hich i le han he e ilib i m an i , Qe, ha lie
o ld l a ice Pe.
In addi ion, he ice ceiling, Pc, gi e i e o a la ge an i demanded han a he e ilib i m ice:
he an i con me an o b a ice Pc i gi en b Qd, hich i g ea e han an i , Qe, ha
he o ld b a ice Pe.
A ice ceiling doe no allo he ma ke o clea ; i c ea e a i a ion of di e ilib i m he e he e i a
ho age (e ce demand).
A ice ceiling, Pc, e belo he e ilib i m ice of a good c ea e a ho age. A Pc, no all in e e ed
b e ho a e illing and able o b he good a e able o do o beca e he e i no eno gh of he
good being lied. In Fig e 4.1, he ho age i e al o Qd Q .
N -
The e m a g efe o a me hod of di iding ome hing among o ible e ( ee Cha e 2). In
a f ee ma ke , hi i achie ed b he ice em: ho e ho a e illing and able o a fo a good ill
do o, and he good i a ioned among e acco ding o ho b i ; hi i called ce a g.
Ho e e , once a ho age a i e d e o a ice ceiling, he ice mechani m no longe achie e i
a ioning f nc ion. Some demande illing and able o b he good a Pc in Fig e 4.1 ill go
n a i fied. Ho ill he an i Q be di ib ed among all in e e ed b e ? Thi can onl be done
h o gh - ce a g me hod , hich incl de:
ai ing in line and he fi -come-fi - e ed inci le: ho e ho come fi ill b he good
he di ib ion of co on o all in e e ed b e , o ha he can cha e a fi ed amo n of he
good in a gi en ime e iod
fa o i i m: he elle can ell he good o hei efe ed c ome .
( )
U de g d (o a a e ) a e in ol e b ing/ elling an ac ion ha a e n eco ded, and a e
all illegal. In he ca e of ice ceiling , he a e a ecial kind of ice a ioning. The in ol e
b ing a good a he ma im m legal ice, and hen illegall e elling i a a ice abo e he legal
ma im m. Unde g o nd ma ke can a i e hen he e a e di a i fied eo le ho ha e no cceeded in
b ing he good beca e he e a no eno gh of i , and a e illing o a mo e han he ceiling ice o
ge i . If he e e e no ho age, he ice of he good o ld be a i e ilib i m ice, and no one
o ld be in e e ed in a ing a highe han e ilib i m ice fo i . Unde g o nd ma ke a e
ine i able, and f a e he objec i e o gh b he ice ceiling, hich i o e a ma im m ice.
The ice ceiling, being lo e han he e ilib i m ice, e l in a malle an i lied; in Fig e
4.1 Q < Qe, no eno gh e o ce a e alloca ed o he od c ion of he good, e l ing in
nde od c ion ela i e o he ocial o im m (o be ). Socie i o e off d e o nde alloca ion of
e o ce and alloca i e inefficienc .
N
Alloca i e efficienc , and he condi ion of ma im m ocial l and MC = MB e e e lained in
Cha e 2. In a com e i i e f ee ma ke e ilib i m, ho n in Fig e 4.2(a), con me l a ea
a he haded a ea abo e ice Pe and nde he demand c e o an i Qe; od ce l i he
haded a ea abo e he l c e and nde ice Pe o Qe. A he com e i i e f ee ma ke
e ilib i m, he m of con me and od ce l , o ocial l , i ma im m, and MB = MC,
indica ing ha alloca i e efficienc i achie ed.
F 4.2: Effec of a ice ceiling (ma im m ice) on con me and od ce l
In Fig e 4.2(b), if he e e e no ice con ol, he ma ke o ld de e mine ice Pe and an i Qe a

e ilib i m. Con me l o ld be e al o a ea a + b. P od ce l , o ld be e al o a ea
c + d + e. Con me l od ce l o ld be ma im m, and e al o a + b + c + d + e. Al o, MB
= MC, and he e o ld be alloca i e efficienc .
If a ice ceiling, Pc, i im o ed, onl he an i Q i od ced and con med. Con me l i
no he a ea nde he demand c e and abo e Pc, b onl o Q , ince ha i all ha i con med.
The efo e, con me l become a + c. P od ce l i he a ea abo e he l c e and
belo Pc, al o onl o Q ince ha i all ha i od ced. P od ce l he efo e fall o a ea e.
To al ocial l af e he ice ceiling i a + c + e. Com a ing i h o al ocial l befo e he
ice ceiling, e ee ha he haded a ea b and d ha e been lo and e e en e fa e . Welfa e lo
e e en benefi ha a e lo o ocie beca e of e o ce mi alloca ion.
(al o kno n a dead e gh ) e e en ocial l o elfa e benefi ha a e

lo o ocie beca e e o ce a e no alloca ed efficien l .
We can ee he e i alloca i e inefficienc al o beca e MB > MC a he oin of od c ion, Q : he

benefi con me ecei e f om he la ni of he good he b i g ea e han he ma ginal co of
od cing i . The efo e, ocie i no ge ing eno gh of he good, a he e i an nde alloca ion of
e o ce o i od c ion.
A ce ce g c ea e a elfa e lo , indica ing ha he ice ceiling in od ce alloca i e

inefficienc d e o an nde alloca ion of e o ce o he od c ion of he good. Thi i ho n b Q
< Qe. Al o, MB > MC, indica ing ha ocie i no ge ing eno gh of he good.
C
S a eh de a e indi id al o g o of indi id al ho ha e an in e e in ome hing and a e affec ed
b i.
C
Con me a l gain and a l lo e. The gain a ea c f om od ce b he lo e a ea b ( ee Fig e
4.2(b)). Thi i beca e ho e con me ho a e able o b he good a he lo e ice a e be e off.
Ho e e , ome con me emain n a i fied ince he don ge o b he good a all, beca e a he
ceiling ice he e i no eno gh of he good o a i f all demande .
P
P od ce a e o e off, beca e i h he ice ceiling he ell a malle an i of he good a a lo e
ice; he efo e, hei e en e d o f om Pe Qe o Pc Q . Thi i clea al o f om hei lo of ome
od ce l , a ea c ( hich i an fe ed o con me ), a ell a a ea d ( elfa e lo ) in Fig e
4.2(b).
The fall in o (f om Qe o Q ) mean ha ome o ke a e likel o be fi ed, e l ing in

nem lo men ; clea l he e o ke ill be o e off.
G
The e ill be no gain o lo e fo he go e nmen b dge , e he go e nmen ma gain in oli ical
o la i among he con me ho a e be e off d e o he ice ceiling.
P ice ceiling a e fo he mo a e in o de o make ce ain good con ide ed o be nece i ie mo e

affo dable o lo -income ea ne .
Ren con ol con i of a ma im m legal en on ho ing, hich i belo he ma ke -de e mined le el
of en ( he ice of en al ho ing). I i nde aken b go e nmen in ome ci ie a o nd he o ld o
make ho ing mo e affo dable o lo -income ea ne . Con e ence of en con ol incl de:
ho ing become mo e affo dable o lo -income ea ne
a ho age of ho ing, a he an i of ho ing demanded a he legall ma im m en i g ea e
han he an i a ailable
long ai ing li of in e e ed enan ai ing fo hei n o ec e an a a men /fla
a ma ke fo en ed ni he e enan ble hei a a men a en abo e he legal ma im m
(an nde g o nd ma ke )
n-do n and oo l main ained en al ho ing beca e i i n ofi able fo landlo d o main ain
o eno a e hei en al ni ince lo en e l in lo e en e .
F
Some go e nmen e food ice con ol a a me hod o make food mo e affo dable o lo -income
ea ne , e eciall d ing ime hen food ice a e i ing a idl . The e l of food ice con ol
follo he ame a e n a di c ed abo e: lo e food ice and g ea e affo dabili ; food ho age
a an i demanded i g ea e han an i lied; non- ice a ioning me hod ( ch a e e) o
deal i h he ho age ; de elo men of nde g o nd ma ke ; falling fa me income d e o lo e
e en e ; mo e nem lo men in he ag ic l al ec o ; mi alloca ion of e o ce ; o ible g ea e
o la i fo he go e nmen among con me ho benefi .
EAL O LD FOC 4.1

P
Some ea ago, d e o high a e of infla ion (a i ing gene al ice le el), he Vie name e
go e nmen con ide ed he im o i ion of ice con ol . The e con i ed of ice ceiling on
n me o od c , incl ding chemical fe ili e , al , milk o de , ice, ga , animal feed , coal,
cemen , a e , e book and man mo e. If i in od ced he e mea e , he icing le o ld
a l no j o dome ic go e nmen o ned b ine e b al o i a e fi m and fo eign-o ned
b ine e . I a fea ed ha Vie nam migh be mo ing a a f om i f ee ma ke o ien a ion of
ecen ea and back o a d he a of a command econom . Fo eign di loma a ned he
go e nmen ha ice con ol o ld damage b ine confidence in he co n .
F 4.3: Vie nam. T an o on he Saigon Ri e
A
1 O line ha i mean o mo e o a d he a of a command econom .
2 Di c he con e ence fo he econom and akeholde ha migh ha e a i en if he
go e nmen im o ed he ice con ol .
3 Wh do o hink ha ice con ol co ld damage b ine confidence?
: Ada ed f The Ec I e ge ce U , V e a ec : ef -bac ?
V e W e Ne A a , 21 Se e be 2010.
4.1
1 Define a ice ceiling and, o iding e am le , o line ome ea on h go e nmen im o e
hem.
2 U ing a diag am, e lain h ice con ol lead o di e ilib i m ma ke o come .
3 D a a diag am ill a ing a ice ceiling, and anal e i effec on ma ke o come ( ice,
an i demanded, an i lied, ma ke di e ilib i m) and con e ence fo he econom
( ho age , non- ice a ioning, alloca i e inefficienc , elfa e lo ).
4 E lain he diffe ence be een ice a ioning and non- ice a ioning.
De c ibe he ci c m ance nde hich non- ice a ioning a i e .
Iden if ome fo m of non- ice a ioning.
O line h nde g o nd ma ke a e a fo m of ice a ioning.
5 D a a diag am ho ing od ce and con me l in a f ee ma ke com e i i e
e ilib i m.
A ming a ice ceiling i im o ed in hi ma ke , d a a ne diag am ho ing he ne
con me l , od ce l and elfa e lo .
Com a ing o diag am fo a (a) and (b), ha can o concl de abo con me
l , od ce l and elfa e lo ?
De c ibe he ela ion hi be een ma ginal benefi and ma ginal co a he ne
e ilib i m. O line ha hi e eal abo alloca i e efficienc (o inefficienc ).
6 E amine he con e ence of ice ceiling fo diffe en akeholde in he ca e of:
en con ol , and
food ice con ol .
C
(HL )
Fig e 4.4 o ide i h a n me ical e am le of a ice ceiling. A e ilib i m, ice i e al o
8 and an i demanded and lied i 20 000 ni of he good e eek. When a ice ceiling i
im o ed a Pc= 5.00 e ni , an i demanded become Qd= 30 000 ni , and an i lied
Q = 10 000 ni .
( )
The ho age, o e ce demand, i e al o Qd Q , hich in hi ca e i 30 000 10 000 = 20 000
ni e eek.
F 4.4: Calc la ing effec of a ice ceiling
C
Con me e endi e i gi en b he ice e ni of he good ime he n mbe of ni cha ed.
A e ilib i m, io o he ice ceiling, con me end Pe Qe = 8 20 000 ni = 160 000.
Af e he ice ceiling i im o ed, con me end Pc Q = 5.00 10 000 ni = 50 000. The
change i he efo e 160 000 50 000 = 110 000, meaning ha con me no end 110 000
le han a e ilib i m.
C ( )
Fi m e en e i he ame a con me e endi e bo h befo e and af e he im o i ion of he ice
ceiling. Thi i beca e e en e i e al o ice e ni ime an i of ni old, and bo h he
ice (Pc) and he an i (Q ) a e he ame fo bo h con me and od ce . The efo e, befo e he
ice ceiling i im o ed, fi m e en e i 160 000, and af e he ice ceiling, fi m e en e i ed ced
o 50 000. The efo e, fi m e en e fall b he amo n 110 000.
No e ha he change in con me e endi e and he change in fi m e en e a e he ame, beca e
ice and an i e e he ame fo con me and fi m bo h befo e and af e he ice ceiling a
im o ed.
C
In Cha e 2, e a ho con me and od ce l a e calc la ed. Yo ma emembe ha a
ma ke e ilib i m con me l i half he a ea of he ec angle ho e one ide e al he P
in e ce of he demand c e min he ice aid b con me , and ho e o he ide e al he
n mbe of ni cha ed:
Con me l = (P in e ce of D c e min P of con me ) Q cha ed 2
The efo e, ing he info ma ion in Fig e 4.4, con me l befo e he ice ceiling i :
Ini ial con me l = (14 8) 20 000 2 = 6 20 000 2 = 60000
No no ice ha af e he ice ceiling i im o ed, con me l no longe ha he a ea of a
iangle. I con i of a a e i m com o ed of a ea a + c. The fo m la fo a a e i m a al o
e en ed in Cha e 2. I he f he a a e de e he d a ce be ee he d ded
b 2. The efo e:
Final con me l = [(14 5) + (11 5) ] 10 000 2 = (9+6) 10 000 2 = 150 000 2 = 75 000
The efo e con me l ha inc ea ed b 75 000 60 000 = 15 000.
P od ce l a ma ke e ilib i m i half he a ea of he ec angle ho e one ide e al he
ice ecei ed b od ce min he P in e ce of he a l c e, S1 and ho e o he ide
e al he n mbe of ni old:
P od ce l = (P of od ce min P in e ce of S c e) Q old 2
The efo e od ce l befo e he ice ceiling i :
Ini ial od ce l = (8 2) 20 000 2 = 6 20 000 2 = 60 000
No ice ha af e he ice ceiling i im o ed od ce l i he a ea of iangle e he efo e e
can a l he iangle fo m la:
Final od ce l = (5 2) 10 000 2 = 3 10 000 2 = 15 000
P od ce l ha dec ea ed b 60 000 15 000 = 45 000.
The elfa e lo i gi en b he a ea of iangle a l b:
Welfa e lo = (11 5) (20 000 10 000) 2 = 6 10 000 2 = 30 000
E O NDE ANDING 4.2

1 In he e am le of he ma ke ill a ed in Fig e 4.4, commen on he effec of a ice ceiling
e a 10.
2 The diag am belo ho a ice ceiling of 30 ha ha been e fo good X. Calc la e:
he ho age (e ce demand),
he change in con me e endi e,
he change in od ce e en e,
he change in con me l ,
he change in od ce l , and
elfa e lo .
P :
?
A legall e ce i called a ce f . The ice ha can be legall cha ged b elle of he
good m no be lo e han he ice floo , o minim m ice. In Fig e 4.5, a ice floo , Pf, i e
abo e he e ilib i m ice, Pe. A Pe, con me a e illing and able o b Qd of he good, b fi m
a e illing and able o l Q of he good. The efo e, a l , o e ce l , e al o he
diffe ence be een Q and Qd, a i e . If he ma ke e e f ee, he fo ce of demand and l o ld
fo ce he ice do n o Pe. Ho e e , no hi canno ha en.
F 4.5: P ice floo (minim m ice) and ma ke o come
No e ha o ha e an effec , he ice floo m be ab e he e ilib i m ice. If i e e belo he

e ilib i m ice, he ma ke o ld achie e e ilib i m and he ice floo o ld ha e no effec .
P ice floo a e commonl ed fo o ea on : (a) o o ide income o fo fa me b offe ing

hem ice fo hei od c ha a e abo e ma ke -de e mined ice ; and (b) o o ec lo - killed,
lo - age o ke b offe ing hem a age ( he minim m age) ha i abo e he le el de e mined in
he ma ke . No e ha he fi of he e in ol e ice con ol in od c ma ke , hile he econd
conce n ice con ol in a e o ce ma ke . While ma ke o come a e imila , each e of ice
con ol ha diffe en con e ence fo he econom and akeholde . We ill he efo e con ide each
one e a a el .
A i a e belo he e ilib i m ice, in o de o o ide income

o o fa me o o inc ea e he age of lo - killed o ke .
To a oid ge ing conf ed abo hich i hich, no e ha he o i ion of a ice floo and a ice
ceiling in ela ion o he e ilib i m ice i al a he o o i e of he floo and ceiling of a oom.
The ce f ab e a d he ce ce g be .
C
Fa me income in man co n ie , e l ing f om he ale of hei od c in f ee ma ke , a e of en
n able o oo lo . Some im o an ea on fo bo h in abili and lo income e e con ide ed in
Cha e 3. Un able income a i e f om n able ag ic l al od c ice , hich a e d e o lo ice
ela ici ie of demand and lo ice ela ici ie of l fo ag ic l al od c . Lo fa me income
ma a i e f om lo income ela ici ie of demand.
One me hod go e nmen e o o fa me income i o e ice floo fo ce ain ag ic l al
od c , he objec i e being o ai e he ice abo e hei e ilib i m ma ke ice. The con e ence
a e e lained belo .
Fig e 4.6 ill a e he ma ke fo an ag ic l al od c i h a ice floo , Pf, e abo e he

e ilib i m ice, Pe. The ice floo e l in a la ge an i lied, Q , han he an i lied
a ma ke e ilib i m, Qe. In addi ion, he ice floo , Pf, lead o a malle an i demanded and
cha ed han a he e ilib i m ice: he an i con me an o b a Pf i Qd, hich i malle
han he an i Qe ha he bo gh a ice Pe.
F 4.6: An ag ic l al od c ma ke ih ice floo and go e nmen cha e of he l
A ice floo e l in di e ilib i m he e he e i a l (e ce l ). A common ac ice i fo

he go e nmen o b he e ce l , and hi ca e he demand c e fo he od c o hif o he
igh o he ne demand c e D l go e nmen cha e . B b ing he e ce l , he
go e nmen i able o main ain he ice floo a Pf.
I ho ld be no ed ha if he go e nmen did no b he l , he ice o ld fall back o i
e ilib i m le el. The ea on i ha fa me o ld ha e e ce o i h no b e , and o o ld
ha e o lo e he ice in o de o be able o ell all he l .
G
The go e nmen m make a deci ion abo ha o do i h he l (e ce l )i cha e .
One o ion i o o e i , gi ing i e o addi ional co fo o age abo e he co of he cha e.
Ano he me hod i o e o he l ( ell i ab oad); hi of en e i e g an ing a b id ( hi i
mone gi en o od ce , o be di c ed la e in hi cha e ) o lo e he ice of he good ince
fo eign co n ie o ld no an o b i a he high ice. Clea l , b idie in ol e addi ional co
fo he go e nmen . In gene al, an co e cho en b he go e nmen o ge id of he l e i
oblema ic.
F
Highe han e ilib i m od c ice can lead o inefficien od c ion; inefficien fi m i h high
co of od c ion do no face incen i e o c co b ing mo e efficien od c ion me hod
beca e he high ice offe hem o ec ion again lo e -co com e i o . Thi lead o inefficienc .
Too man e o ce a e alloca ed o he od c ion of he good, e l ing in a la ge han o im m (o

be ) an i od ced. Whe ea he o im m an i i Qe, ac all Q i od ced.
N
In Fig e 4.7(a), ice Pe and an i Qe e e en ma ke e ilib i m i h no ice floo , and he e
ocial l i ma im m. In a (b), hen he e i no ice floo , con me l i gi en b a + b +
c and od ce l b d + e. Al o, MB = MC.
Af e a ice floo , Pf, i im o ed, con me l become he a ea nde he demand c e and
abo e Pf, o he an i con me b , Qd, and o fall o a. P od ce l become he a ea
abo e he l c e and belo Pf, o he an i od ced, Q , and o become d + e + b + c + f.
Thi mean ha he m of con me l od ce l c ea e b he a ea f af e he ice floo i
im o ed. Thi ha en beca e od ce gain he a ea b and c lo b con me , and in addi ion gain f.
On he o he hand, go e nmen ending o b he e ce l i e al o he ice aid e ni , Pf,
ime he l an i i cha e : Pf (Q Qd), co e onding o he ec angle o lined in bold.
Since go e nmen ending i financed o of a e i h al e na i e e (o o ni co ),
go e nmen ending o main ain he ice floo in ol e lo e fo ocie .
The efo e, he e i a gain in l of f and a lo e al o he ec angle ho n in bold. S b ac ing he
lo f om he gain e a e lef i h he bl e haded a ea, hich i elfa e lo , e e en ing lo of
benefi d e o alloca i e inefficienc ca ed b o e alloca ion of e o ce o he od c ion of he
good. Thi i al o ho n b MB < MC a he oin of od c ion, Q , indica ing ha ocie o ld be
be e off if le of he good e e od ced.
F 4.7: Welfa e im ac of a ice floo (minim m ice) fo ag ic l al od c and go e nmen
cha e of he l
Ano he a o ee ha he bl e haded a ea i he elfa e lo i o no e im l ha he ice floo

e l in a gain of f and a lo of c + e + f + g, o he bold ec angle of go e nmen ending. And o he
ne lo i im l ha a of go e nmen ending ha i no gained. In o he o d he ne change i f
(c + e + f + g) = (c + e + g).
A ice floo c ea e elfa e lo , indica ing ha he ice floo in od ce alloca i e inefficienc d e
o an o e alloca ion of e o ce o he od c ion of he good, ho n b Q > Qe. Al o MB < MC,
indica ing ha ocie i ge ing oo m ch of he good.
C
C
Con me a e o e off, a he m no a a highe ice fo he good (Pf > Pe), hile he b a
malle an i of i (Qd < Qe). Thi i clea al o f om hei lo of ome con me l .
P
P od ce gain a he ecei e a highe ice and od ce a la ge an i , and ince he go e nmen
b he l , he inc ea e hei e en e f om Pe Qe o Pf Q . Remembe , hi i he main
a ionale of ag ic l al ice floo . Al o, od ce become o ec ed again lo -co com e i ion and
do no face a ong incen i e o become efficien od ce ; he a e he efo e le likel o go o of
b ine if he a e od cing inefficien l ( i h highe co ).
Wo ke a e likel o gain a em lo men inc ea e on acco n of g ea e od c ion of he good.
G
When he go e nmen b he e ce l , hi i a b den on i b dge , e l ing in le go e nmen
f nd o end on o he de i able ac i i ie in he econom . The co o he go e nmen a e aid fo o
of a e (and he efo e b a a e ). In addi ion, he e a e f he co of o ing he l o
b idi ing i fo e o ( ale o o he co n ie ).
The E o ean Union, he Uni ed S a e and man o he mo e de elo ed co n ie el on ice floo fo

ag ic l al od c o o hei fa me . The l e a e ome ime e o ed ( old o o he
co n ie ), leading o lo e o ld ice d e o he e a l made a ailable in o ld ma ke .
Co n ie ha do no ha e ice o a e fo ced o ell hei ag ic l al od c a lo o ld
ice . The lo ice in he e co n ie ignal o local fa me ha he ho ld c back on hei
od c ion, e l ing in an nde alloca ion of e o ce o he e od c . The e e en of en o k
again he in e e of le de elo ed co n ie ( hi o ic ill be di c ed in Cha e 19).
O e all, a global mi alloca ion of e o ce can e l in a a e of e o ce , a ice floo ca e high-
co od ce o od ce mo e and lo -co od ce o od ce le han he ocial o im m.
E O NDE ANDING 4.3
1 Define a ice floo , and o iding e am le , e lain ome ea on h go e nmen im o e

hem.
2 D a a diag am ill a ing a ice floo ha i im o ed in a od c ma ke , and anal e i
effec on ma ke o come ( ice, an i demanded, an i lied, ma ke di e ilib i m,
e ce l , fi m inefficienc , alloca i e inefficienc , elfa e lo ).
3 Iden if ome mea e go e nmen can ake o di o e of l e ha e l f om he
im o i ion of a ice floo in an ag ic l al od c ma ke . Commen on he oblem
a ocia ed i h he e mea e .
4 A ming a ice floo i im o ed in a ma ke fo an ag ic l al od c , and ha he
go e nmen cha e he en i e e ce l ha e l in o de o main ain he ice:
d a a diag am ill a ing elfa e lo , and
commen on he ela ion hi be een ma ginal benefi and ma ginal co in he ne
e ilib i m and ha i e eal abo alloca i e efficienc (o inefficienc ).
5 E amine he con e ence fo diffe en akeholde of a ice floo fo an ag ic l al od c
ho e e ce l i cha ed b he go e nmen .
C
(HL )
Fig e 4.8 o ide a n me ical e am le of a ice floo on an ag ic l al od c . A e ilib i m,
ice i e al o 20 and an i i e al o 60 000 kg e eek. When a ice floo i im o ed a Pf
= 25, an i demanded i Qd = 40 000 kg e eek and an i lied i Q = 80 000 kg e
eek.
( )
The l , o e ce l i e al o Q Qd, hich in hi ca e i 80 000 40 000 = 40 000 kg
e eek.
C
Con me e endi e i gi en b he ice e kg of he good ime he n mbe of kg cha ed e
eek. A e ilib i m, befo e he ice floo , con me end Pe Qe = 20 60 000 kg = 1.2
million e eek. Af e he ice floo i im o ed, con me end Pf Qd = 25 40 000 kg = 1
million e eek. The efo e, con me end 200 000 le on he good e eek.
C
Befo e he ice floo , od ce e en e i he ame a con me e endi e, ince e en e i e al
o ice e kg ime an i old, and bo h he ice (Pe) and he an i (Qe) a e he ame fo
con me and od ce . The efo e od ce e en e befo e he ice floo i 1.2 million e eek.
Once he ice floo i im o ed and he go e nmen cha e he l (e ce l ), fi m
ecei e e en e of Pf Q , and o od ce e en e inc ea e o 25 80 000 kg = 2 million e
eek. The efo e, he change i 800 000, o addi ional od ce e en e of hi amo n e eek.
F 4.8: Calc la ing effec of a ice floo on an ag ic l al od c i h go e nmen
cha e of he l
G
In o de o cha e he e ce l of he ag ic l al od c , he go e nmen end an amo n
e al o he ice of he good a he ice floo ime he n mbe of kg cha ed, o Pf (Q Qd) =
25 40 000 = 1 million.
No e ha go e nmen e endi e ( 1 million) i e al o o al od ce e en e ( 2 million) min
o al con me e endi e ( 1 million) e eek.
C
No ice ha all a ea of con me and od ce l , bo h befo e and af e he ice floo , a e he
a ea of iangle .
In hi ca e, a e kno , he fo m la fo calc la ing con me l i:
Con me l = (P in e ce of D c e min P of con me ) Q cha ed 2
The efo e, ing he info ma ion in Fig e 4.8, con me l befo e he ice floo i :
Ini ial con me l (35 20) 60 000 2 = 450 000
Af e he ice floo i im o ed con me l i:
Final con me l = (35 25) 40 000 2 = 10 40 000 2
The efo e, con me l dec ea ed b 450 000 200 000 = 250 000.
P od ce l i gi en b :
P od ce l = (P of od ce min P in e ce of S c e) Q old 2
Befo e he ice floo od ce l i:
Ini ial od ce l = (20 5) 60 000 2 = 15 60 000 2 = 450 000
Af e he ice floo i im o ed od ce l i:
Final od ce l = (25 5) 80 000 2 = 20 80 000 2 = 800 000
The efo e, od ce l c ea ed b 800 000 450 000 = 350 000.
The elfa e lo i gi en b he haded a ea in Fig e 4.7, hich acco ding o Fig e 4.8 i he
ec angle of go e nmen ending min a ea f.
We ha e fo nd abo e ha go e nmen ending on he b id i 1 million.
A ea f = (25 20) (80 000 40 000) 2 = (5 40 000) 2 = 100 000
The efo e, elfa e lo = 1 million 100 000 = 900 000.
E O NDE ANDING 4.4

1 In he e am le of he ma ke ill a ed in Fig e 4.8, ha o ld be he effec of a ice floo
e a 15?
2 The diag am belo ho a ice floo of $50 ha ha been e fo good Y. Calc la e:
he l (e ce l ),
he change in con me e endi e,
he change in od ce e en e,
he change in con me l ,
he change in od ce l , and
elfa e lo .
M
I
Man co n ie a o nd he o ld ha e la ha de e mine he minim m ice of
labo ( he age a e) ha an em lo e (a fi m) m a . The objec i e i o g a an ee an ade a e
income o lo -income o ke , ho end o be mo l n killed. (The ma ke -de e mined age of
killed o ke a e all highe han he minim m age.) Fig e 4.9 ho he ma ke fo labo . The
demand fo labo c e ho he
an i of labo ha fi m a e illing and able o hi e a each
age, and he l of labo c e ho he an i of labo ha o ke l a each age.
S l and demand de e mine he e ilib i m ice of labo , hich i he age, We, he e he
an i of labo demanded i e al o he an i of labo lied, Qe.
F 4.9: Labo ma ke i h minim m age ( ice floo )
The minim m age, Wm, lie abo e he e ilib i m age, We. The efo e, a Wm, he an i of labo
lied, Q , i la ge han he an i of labo lied hen he labo ma ke i in e ilib i m (Qe).
The an i of labo demanded, Qd, i le han he an i demanded a e ilib i m, Qe. The e
e l a l of labo in he ma ke e al o he diffe ence be een Q and Qd. The labo ma ke
doe no clea hen he e i a minim m age.
C
Lab (e ce )a d e e
The im o i ion of a minim m age in he labo ma ke c ea e a l of labo e al o Q Qd in
Fig e 4.9, hich i nem lo men , a i co e ond o eo le ho o ld like o o k b a e no
em lo ed. The nem lo men i d e a l o he dec ea e in an i of labo demanded b fi m ( he
diffe ence be een Qe and Qd) and a l o an inc ea e in he an i of labo lied ( he diffe ence
be een Q and Qe). Thi occ beca e he highe age make o k mo e a ac i e, ca ing a
mo emen he labo l c e. Thi nem lo men i likel o in ol e n killed o ke .
I ega e a age be e age
Illegal em lo men of ome o ke a age belo he legal minim m ma e l ; hi of en in ol e
illegal immig an ho ma be illing o l hei labo a e lo age .
M a ca f ab e ce
The minim m age affec he alloca ion of ab e ce , a i e en he ma ke f om
e abli hing a ma ke -clea ing ice of labo . In Cha e 2, e a ho he age ac a a ignal and
incen i e o o ke ( he lie of labo ) and fi m ( he demande of labo ) o de e mine he
o imal alloca ion of labo e o ce . The im o i ion of a minim m age change he e ignal and
incen i e fo n killed labo , ho e age i affec ed b he ice floo . The efo e, ind ie ha el
hea il on n killed o ke a e mo e likel o be affec ed, and ill hi e le n killed labo .
M a ca d c a e
Fi m el ing hea il on n killed o ke e e ience an inc ea e in hei co of od c ion, leading o
a lef a d hif in hei d c l c e ( ee Cha e 2), e l ing in malle an i ie of o
od ced. The efo e, he mi alloca ion of labo e o ce lead al o o mi alloca ion in od c
ma ke .
C
F (e e f ab )
Fi m a e o e off a he face highe co of od c ion d e o he highe labo co .
W e ( e f ab )
The im ac on o ke a e mi ed. Some gain beca e he ecei e a highe age han e io l (Wm
> We), b ome lo e beca e he lo e hei job. No e ha he o ke ho lo e hei job a e ho e
e e en ed b Qe Qd. Thi i no he f ll amo n of nem lo men c ea ed b he minim m age,
beca e he minim m age lead o add a nem lo men of Q Qe, ince mo e o ke l
hei labo in he ma ke hen he age inc ea e .
C e
Con me a e nega i el affec ed, beca e he inc ea e in labo co lead o a dec ea e in l of
od c (a lef a d hif in fi m l c e ) ca ing highe od c ice and lo e an i ie .
P
Economi ag ee ha ice floo fo ag ic l al od c lead o l e (e ce lie ) and a e
highl inefficien fo he ea on di c ed abo e. Ye he con in e o be ed in man co n ie
beca e of ong oli ical e e e e ed b fa me ho claim o need he e fo income o .
The effec of minim m age , on he o he hand, a e con o e ial, a i i e ionable he he he
lead o nem lo men o he e en ha economic heo edic . The e i ag eemen ha if a minim m
age i e a a high le el ela i e o he f ee ma ke e ilib i m age, i i likel o c ea e ome
nem lo men . Ye a la ge and g o ing n mbe of die ho ha a minim m age ma ha e no
effec o e en a o i i e effec on a em lo men . Some fi m e ond o he minim m age b
main aining he ame n mbe of o ke b c ing non- age benefi ( ch a aid holida o ick
lea e). Al o, i i o ible ha labo od c i i (defined a he amo n of o od ced e
o ke ) ma inc ea e d e o he minim m age, a o ke feel mo i a ed o o k ha de , i h he
e l ha ome fi m hi e mo e n killed labo in e on e o minim m age .
While he effec of minim m age emain con o e ial, he e i gene all ong oli ical o fo
hei con in ed e on he g o nd of g ea e e i in income di ib ion. In fac , he deba e i no
abo he he o no he e ho ld be minim m age , b a he ha hei le el ho ld be.
Some ime ice ma be fi ed a a a ic la le el, ch a i h icke ice fo hea e , mo ie and

o e en , he e ice a e all fi ed ahead of ime b he o gani ing bod ( hich ma be i a e
o blic), and o canno inc ea e o dec ea e acco ding o l and demand.
Fig e 4.10 ho he ma ke fo icke fo a o e en . The l c e i e ical beca e he e i
a fi ed l of icke (d e o a fi ed n mbe of ea ; ee Cha e 2). The icke ice i fi ed a Pf
b he o gani ing bod . Fig e 4.10(a) ill a e an e en fo hich he e i la ge demand, gi en b D1.
If he ice co ld e ond o ma ke fo ce , i o ld i e o Pe, b ince i i fi ed a Pf a ho age of
icke a i e e al o he ho i on al diffe ence be een oin a and b. Fig e 4.10(b) ill a e an e en
fo hich he e i lo demand, gi en b D2. He e, he e ilib i m ice o ld ha e been Pe, ho e e
ice i fi ed a he highe le el Pf , e l ing in a l of icke e al o he ho i on al diffe ence
be een oin c and d.
F 4.10: P ice fi ing and l e and ho age
E O NDE ANDING 4.5

1 Define a minim m age. S gge ea on h man go e nmen a o nd he o ld im o e
hem.
2 D a a diag am ill a ing he im o i ion of a minim m age, and anal e i effec on ma ke
o come ( he age, an i of labo demanded and lied, ma ke di e ilib i m) and
con e ence fo he labo ma ke ( nem lo men of labo , illegal o k, e o ce
mi alloca ion, elfa e lo ).
3 S gge h , in ac ice, minim m age ma no lead o inc ea ed nem lo men if he a e
no e oo high.
4 U ing diag am ho ho e ce demand o e ce l of icke e l hen icke ice
a e e a a le el ha i
lo e han e ilib i m, and
highe han e ilib i m.
4.3 I
LEARNING OBJECTIVES

e plain he con eq ence of indirec a e on marke and akeholder (AO2)
dra diagram o ill ra e he effec of indirec a e on marke and akeholder (AO4)
e al a e he effec of indirec a e on marke and akeholder (AO3)
calc la e he effec of indirec a e on marke and akeholder (HL onl ) (AO4)
T
I are impo ed on pending o b good and er ice . The are paid par l b con mer ,
b are paid o he go ernmen b prod cer (firm ), and for hi rea on are called indirec . There are
o pe of indirec a e :
e cise ta es, impo ed on par ic lar good and er ice , ch a pe rol (ga oline), cigare e and
alcohol
ta es on spending on all (or most) goods and services, ch a general sales ta es ( ed in he
Uni ed S a e ) and value added ta es ( ed in he E ropean Union, Canada and man o her
co n rie ).
Indirec a e differ from , in ol ing pa men of he a b he a pa er direc l o he
go ernmen ( ee Chap er 12).
In hi chap er, e ill d e ci e a e .
I
Ta e ha e he effec of changing he alloca ion of re o rce . In Chap er 2 e learned ha price ac a
ignal and incen i e , hich de ermine he pa ern of re o rce alloca ion. Since indirec (e ci e) a e
are impo ed on par ic lar good , he increa e he price paid b con mer , ca ing con mer o red ce
heir pending on a ed good . E ci e a e al o lo er he price recei ed b prod cer , ca ing hem o
prod ce le . Therefore, b changing price ignal and incen i e , e ci e a e affec he alloca ion of
re o rce .
The in ere ing q e ion i he her indirec a e ork o red ce or o increa e alloca i e efficienc . The
an er depend on he degree of alloca i e efficienc in he econom before he a i impo ed. If an
econom begin i h an efficien alloca ion of re o rce , he a crea e alloca i e inefficienc and a
elfare lo . We ill ee ho hi happen belo . In an econom i h an inefficien re o rce alloca ion,
indirec a e po en iall ha e he effec of impro ing re o rce alloca ion if he are de igned o remo e
he o rce of alloca i e inefficienc . Thi ill be died in Chap er 5.
Go ernmen impo e e ci e a e for e eral rea on :

I . Go ernmen collec re en e from indirec
a e . A e kno from Chap er 3, he lo er he price ela ici of demand, he grea er he
go ernmen re en e genera ed.
I
. The con mp ion of cer ain good i con idered harmf l for he indi id al (for
e ample, cigare e moking, e ce alcohol con mp ion or gambling). Ta ing he e good i likel
o red ce heir con mp ion. Ho e er, he e en o hich he e a e are cce f l in red cing
con mp ion depend on he price ela ici of demand; if i i lo , an indirec a ill likel re l
in onl a rela i el mall decrea e in q an i demanded ( ee Chap er 5).
I . Some e ci e a e foc on
(e pen i e car , boa , f r , je eller , and o on). The objec i e i o a good ha can onl be
afforded b high-income earner . Pa men of a a on he p rcha e of he e good red ce af er- a
income, h narro ing difference i h he income of lo er-income earner .
I (
) . If here are marke imperfec ion (in he form
of nega i e e ernali ie ), pre en ing he achie emen of alloca i e efficienc , indirec a e can be
ed o r o impro e he alloca ion of re o rce . Thi opic ill be di c ed in Chap er 5.
In hi chap er, e a me ha he econom begin i h alloca i e efficienc in order o ee ho he
in rod c ion of indirec a e lead o alloca i e inefficienc .
I :
D ad alo em
Indirec , e ci e a e can be:
specific ta es, a fi ed amo n of a per ni of he good or er ice old; for e ample, 5 per packe
of cigare e
ad valorem ta es, a fi ed percen age of he price of he good or er ice; in hi ca e, he amo n of
a increa e a he price of he good or er ice increa e .
In o r d of indirec a e , e ill con ider onl pecific a e , in o her ord a pecific amo n of
a for each ni of he good old.
When a a i impo ed on a good or er ice, i i paid o he go ernmen b he firm. Thi mean ha for
e er le el of o p he firm i illing and able o ppl o he marke , i m recei e a price ha i
higher han he original price b he amo n of he a . Thi in ol e a hif of he ppl c r e p ard
b he amo n of he a , and i ho n in Fig re 4.11(a). The a ca e a parallel p ard hif , beca e
he a i a fi ed amo n for each ni of o p . Therefore, in Fig re 4.11(a) S2 i parallel o S1 (No e
ha hi i eq i alen o a lef ard hif of he ppl c r e, meaning ha for each price, he firm i
illing o ppl le o p ; hi eq i alence i e plained in Q an i a i e echniq e chap er in he
'Digi al co r ebook: E ra ma erial' ec ion).
The impac of pecific a e on marke o come are ho n in Fig re 4.11(b). The ppl c r e are
he ame a in Fig re 4.11(a); a demand c r e ha al o been added. The pre- a eq ilibri m i
de ermined b he in er ec ion of he demand c r e D and he ppl c r e S1, o he price paid b
con mer and recei ed b prod cer i P* and q an i demanded and pplied i Q*. If he
go ernmen impo e a pecific a on he good, he ppl c r e hif p ard o S2 = S1 + a . The
demand c r e remain con an a D ince demand i no affec ed. The ne marke eq ilibri m i
de ermined b he demand c r e D and he ne ppl c r e S2, o he price paid b con mer
increa e o Pc, and he q an i p rcha ed fall o Q . The amo n of a per ni of o p i ho n on
he er ical a i b Pc Pp, or he er ical difference be een he o ppl c r e . Wherea prod cer
recei e from con mer Pc per ni , he m pa he go ernmen Pc Pp per ni ( a per ni ).
Therefore, Pp i he final price recei ed b prod cer af er pa men of he a .
F 4.11: S ppl c r e hif d e o an indirec a
The a i aid o dri e a edge be een he price Pc paid b con mer and he price Pp recei ed b
prod cer .
The marke o come d e o he a are he follo ing:
eq ilibri m q an i prod ced and con med fall from Q* o Q
eq ilibri m price increa e from P* o Pc, hich i he price paid b con mer
con mer e pendi re on he good i gi en b he price of he good per ni ime he q an i of

ni bo gh ; i herefore change from P* Q* o Pc Q
price recei ed b he firm fall from P* o Pp, hich i Pp = Pc a per ni
he firm re en e fall from P* Q* o Pp Q
he go ernmen recei e a re en e, gi en b (Pc Pp) Q , or he amo n of a per ni ime he

n mber of ni old; hi i he haded area in Fig re 4.12
here i an nderalloca ion of re o rce o he prod c ion of he good: Q i le han he free marke
q an i , Q*.
C
C
Con mer are affec ed in o a : b he increa e in he price of he good (from P* o Pc, ho n in
Fig re 4.11(b)) and b he decrea e in he q an i he b (from Q* o Q ). Bo h he e change make
hem or e off, a he are no recei ing le of he good and pa ing more for i .
P ( )
Prod cer are affec ed in o a : b he fall in he price he recei e (from P* o Pp), and b he fall
in he q an i of o p he ell (from Q* o Q ). The e effec ran la e in o a fall in heir re en e ,
from P* Q* before he a o Pp Q . Firm are herefore or e off a a re l of he a .
T
The go ernmen i he onl akeholder ha gain , a i no ha re en e eq al o (Pc Pp) Q in
Fig re 4.11(b). Thi i po i i e for he go ernmen b dge .
A lo er amo n of o p , from Q* o Q , mean ha fe er orker are needed o prod ce i ; herefore,

he a ma lead o ome nemplo men . Worker are or e off if he become nemplo ed.
S :
Socie i or e off a a re l of he a , beca e here i an nderalloca ion of re o rce o he
prod c ion of he good (Q < Q*). Wha happen o ocial rpl af er he impo i ion of he a ? We can
ee hi in Fig re 4.12. Par (a) ho he ma im m con mer pl prod cer rpl in a compe i i e
free marke ha e are familiar i h. The effec of he indirec a can be een in par (b), here
con mer rpl become he haded area nder he demand c r e and abo e Pc p o Q . Prod cer
rpl become he haded area abo e he ppl c r e S1 and belo Pp p o Q . A por ion of
con mer rpl became go ernmen a re en e, and ano her por ion a lo a riangle a. A por ion
of prod cer rpl al o became go ernmen a re en e, and ano her por ion a lo a riangle b.
To al go ernmen re en e can be een in Fig re 4.12(b).
No e ha hen iden if ing prod cer rpl af er he impo i ion of an indirec a , e al a refer o
he initial suppl curve, hich i S1 in Fig re 4.12b.
The con mer and prod cer rpl ha i ran formed in o go ernmen a re en e come back o
ocie in he form of go ernmen pending from he a re en e . Therefore, he af er- a ocial rpl
in Fig re 4.12(b) i eq al o af er- a con mer and prod cer rpl pl go ernmen re en e.
Ho e er, af er- a ocial rpl i le han pre- a ocial rpl b he amo n of riangle a + b. The
area a + b repre en ocial rpl ha i comple el lo , and i elfare lo .
In hi ca e, elfare lo appear beca e he a ca e a maller han op im m q an i o be prod ced:
Q < Q*. The a ha ca ed nderprod c ion of he good rela i e o ha i ociall de irable, and an
nderalloca ion of re o rce , or alloca i e inefficienc .
No e ha a he ne poin of prod c ion, Q , MB > MC, meaning ha he benefi con mer recei e
from he la ni of he good he b are grea er han he marginal co of prod cing i . Con mer
o ld be be er off if more of he good ere prod ced (for an e plana ion ee Chap er 2).
The impo i ion of an indirec a re l in red ced con mer and prod cer rpl , par of hich i
ran formed in o go ernmen re en e, and par of hich i a elfare lo . The elfare lo in hi
ca e i he re l of nderalloca ion of re o rce o he prod c ion of he good ( nderprod c ion).
Thi i al o indica ed b MB > MC: oo li le of he good i prod ced and con med rela i e o he
ocial op im m.
F 4.12: Effec of indirec a e on con mer and prod cer rpl

1 De cribe ha indirec mean in reference o indirec a e .
2 S a e ome rea on h go ernmen impo e indirec a e .
3 O line ho indirec a e affec he alloca ion of re o rce .
4 E plain h in con ra o price con rol , an indirec a doe no re l in di eq ilibri m.
5 The go ernmen i con idering impo ing a 0.50 a per li re of pe rol (ga oline).
a Dra a diagram for he ga oline marke before he impo i ion of he a , ho ing he
price paid b con mer , he price recei ed b prod cer and he q an i of pe rol
(ga oline) ha i bo gh / old.
Dra a diagram for he pe rol (ga oline) marke af er he impo i ion of he a , ho ing he
price paid b con mer , he price recei ed b prod cer and he q an i of pe rol
(ga oline) bo gh / old.
6 For q e ion (5):
anal e he impac on he marke of he a on pe rol (ga oline), and
di c he con eq ence for akeholder .
7 U ing a diagram, ho he effec of an indirec a on con mer and prod cer rpl , a ell
a elfare lo . E plain h elfare lo ari e a a re l of a mi alloca ion of re o rce .
C
(HL )
S ppo e he go ernmen impo e an indirec (e ci e) a on romple of 6 per ni . Thi mean ha
he ppl c r e ill hif p ard b 6 for each le el of o p Q.
H , S2
In Fig re 4.13, he ne ppl c r e, S2 = S1 + a , lie 6 abo e he ini ial ppl c r e, S1. We can
co n 6 p ard along he er ical a i from he P in ercep of S1, and hen dra a line parallel o S1
from hi ne P in ercep . Thi i gi e he ne ppl c r e, S2. For an Q, he er ical difference
be een he o ppl c r e i 6, hich i he a per ni of o p .
F 4.13: Demand and ppl i h indirec a e
H ,
,
Af er he a i impo ed, he demand c r e D and he ne ppl c r e, S2, de ermine a ne
eq ilibri m price, hich i Pc or he price paid b con mer , a ne eq ilibri m q an i , Q , and Pp
or he price recei ed b prod cer (Pp = Pc a per ni ) ( ee al o Fig re 4.11(b)).
Therefore, a he ne af er- a eq ilibri m, he price paid b con mer i Pc = 19, he eq ilibri m
q an i of romple demanded and pplied i 22 ni per da , i.e. Q = 22, and he price recei ed
b prod cer i Pp = Pc a per ni = 19 6 = 13. The e re l are ho n in Fig re 4.13.
We ha e fo nd ha he price paid b con mer ha increa ed from 16 o 19, he price recei ed b
prod cer ha fallen from 16 o 13, and he q an i prod ced and con med ha fallen from 28
ni o 22 ni .
We no an o e hi price and q an i informa ion, oge her i h he graph in Fig re 4.13, o
calc la e he follo ing: con mer e pendi re, prod cer re en e, go ernmen re en e, con mer
rpl and prod cer rpl .
C
Con mer e pendi re i gi en b he price paid per ni of romple ime he n mber of romple
p rcha ed. Therefore, before he a , con mer pen P* Q* = 16 28 ni = 448 per da ; af er
he a a impo ed, con mer pen Pc Q = 19 22 ni = 418 per da . Therefore con mer
e pendi re fell b 30 per da (= 448 418).
P
Prod cer re en e i gi en b he price recei ed per ni of romple ime he n mber of romple
old. Therefore, before he a , prod cer re en e a P* Q* = 16 28 ni = 448 per da , hich
i he ame a ha con mer pen ; firm re en e a e ac l eq al o con mer e pendi re. Af er
he a a impo ed, firm re en e fell o Pp Q = 13 22 ni = 286 per da . Prod cer re en e
fell b 162 per da (= 448 286). Firm re en e i no le han con mer e pendi re.
G
Go ernmen re en e can be calc la ed in o a :
I i eq al o a per ni (Pc Pp) ime he n mber of ni old, Q , and i herefore 6 22
romple = 132.
I i al o eq al o he difference be een con mer e pendi re and prod cer re en e af er he
a : 418 286 = 132.
C ,
A e ha e een abo e, con mer and prod cer rpl bo h before and af er he indirec a are he
area of riangle , herefore e e he familiar riangle form la o calc la e hem.
Fig re 4.14 i he ame a Fig re 4.12, b al o ho P and Q al e , hich are he ame al e a
in Fig re 4.13. In par (a), con mer rpl i he haded area nder he demand c r e and abo e P*
= 16, p o Q* = 28. In par (b), i i he haded area nder he demand c r e and abo e Pc = 19, p o
Q = 22.
A o ma recall, con mer rpl i:
Con mer rpl = (P in ercep of D c r e min P of con mer ) Q p rcha ed 2
Therefore, con mer rpl before he a i :
(30 P*) Q* 2 = (30 16) 28 2 = 14 28 2 = 392 2 = 196
Con mer rpl af er he a i :
(30 P c ) Q 2 = (30 19) 22 2 = 11 22 2 = 242 2 = 121
In he ca e of prod cer rpl , o ma recall ha i i :
Prod cer rpl = (P of prod cer min P in ercep of S 1 c r e) Q old 2
In Fig re 4.14(a), prod cer rpl i he area abo e he ppl c r e S and belo P* = 16, p o Q*
= 28. In Fig re 4.14(b), i i he area abo e he ppl c r e S1 and belo Pp = 13, p o Q = 22.
F 4.14: Calc la ing con mer and prod cer rpl before and af er an indirec a
To calc la e prod cer rpl , e can hink of i a half he area of he rec angle ho e one ide
eq al he price recei ed b prod cer min he P in ercep of he ini ial ppl c r e, S1, and ho e
o her ide eq al he n mber of ni old:
Prod cer rpl = (P of prod cer min P in ercep of S 1 c r e) Q old 2
Therefore, prod cer rpl before he a i :
(P* 2)*Q* 2 = (16 2) 28 2 = 14 28 2 = 382 2 = 196
Prod cer rpl af er he a i :
( P P 2) Q 2 = (13 2) 22 2 = 11 22 2 = 242 2 = 121
No e ha o calc la e prod cer rpl af er he a ha been impo ed, e e he ini ial suppl
curve, S1.
(Yo ma ha e no iced ha con mer and prod cer rpl are eq al o each o her, bo h before and
af er he a ; this is coincidental, as the need not be equal to each other.)
The elfare lo can be fo nd b aking he pre- a m of con mer and prod cer rpl ( o al
ocial rpl ), and b rac ing from ha he po - a m of benefi (po - a con mer rpl ,
prod cer rpl and a re en e): 196 + 196 (121 + 121 + 132) = 18.
Thi i al o eq al o he area of he riangle:
(Pc P p )(Q* Q ) 2 = (19 13)(28 22) 2 = 6 6 2 = 18
1 U ing he concep of alloca i e efficienc e plain h an indirec a crea e elfare lo .
2 In he marke for good e a, he P in ercep of he demand c r e i a he poin here Q = 0
and P = 7, and he P in ercep of he ppl c r e i a he poin here Q = 0 and P = 1. The
poin of in er ec ion of he demand c r e and he ppl c r e a free marke eq ilibri m i a
he poin here Q = 6 and P = 4.
Dra he demand and ppl c r e , and iden if he eq ilibri m price and q an i .
S ppo e ha price i mea red in $, and q an i of e a in onne per da , and ha a a
of $2 per onne i impo ed; dra he ne ppl c r e and iden if he price paid b
con mer , he price recei ed b prod cer and he ne eq ilibri m q an i .
E plain h he increa e in price paid b con mer i maller han he amo n of a
per ni .
U ing o r re l , calc la e he change in con mer e pendi re, he change in firm
re en e, go ernmen re en e, he change in con mer rpl , he change in prod cer
rpl and elfare lo .
Iden if , in o r diagram, he area ha corre pond o go ernmen re en e, elfare lo
and af er- a con mer and prod cer rpl .
O line ho he rela ion hip be een marginal benefi and marginal co a he ne
(af er- a ) eq ilibri m rela e o alloca i e efficienc (or inefficienc ).
T
(S )
When a good i a ed, par of he a i paid b con mer and par b prod cer ; herefore he a
b rden i hared be een he o. If o are in ere ed in eeing ho he a i hared o can read
abo i in he 'Digi al co r ebook: E ra ma erial' ec ion a S pplemen ar ma erial.
4.4 Subsidies
LEARNING OBJECTIVES
Af e d i g hi ec i i be ab e :
defi e a he e a ea i g i orange bold i he e (AO1)
e ai he c e e ce f b idie a ke a d akeh de (AO2)
d a diag a i a e he effec f b idie a ke a d akeh de (AO4)
e a a e he effec f b idie a ke a d akeh de (AO3)
ca c a e he effec f b idie a ke a d akeh de (HL ) (AO4)
Introduction to subsidies
The meaning of subsidies

A subsid , i a ge e a e e, efe a i a ce b he g e e i di id a g f
i di id a , ch a fi ,c e , i d ie ec f a ec . S b idie a ake he f
f di ec ca h a e he f f a i a ce ch a -i e e i e e -f ee a (f
e a e, de , -i c e c e f he cha e f g d a d e ice ch a h i g,
fi eedi g a i a ce), he ii f g d a d e ice b he g e e a be - a ke
ice ; a e ief (i.e. a i g e a e ); a d he .
I hi ec i , e i c ide b idie c i i g f a e b he g e e fi . S ch
a e ae a a fi ed a e i f , a d a e he ef e c c b .
Subsidies and the allocation of resources

S b idie , ike a e , ha e he effec f cha gi g he a ca i f e ce beca e he affec e a i e
ice , h cha gi g he ig a a d i ce i e ice c e . A b id g a ed a fi ( g f
fi ) ha he effec f i c ea i g he ice ecei ed b d ce , ca i g he d ce e, a d
e i g he ice aid b c e , ca i g he b e. The ef e, he a ca i f e ce
cha ge a d e i g ea e d ci a dc i ha i he f ee a ke .
A i h i di ec a e , e a e i e e ed i eei g he he he g a i g f a b id i e e
he a ca i f e ce . He e, , he a e de e d he deg ee f a ca i e efficie c i he
a ke bef e he b id . I a ec he e e ce a e a ca ed efficie , a b id i d ce
a ca i e i efficie c a d e fa e e . Thi i be he ic f hi ec i . B if he ec
begi i h a ca i e i efficie c (d e a ke i e fec i ), he a b id ca k i e
he a ca i f e ce if i i de ig ed c ec he ce f he i efficie c . Thi i be
e a i ed i Cha e 6.
Wh governments grant subsidies

The e a e e e a ea h g e e ga b idie fi :
Subsidies can be used to increase revenues (and hence incomes) of producers. S b idie ha e
he effec f i c ea i g he e e e f d ce . The ef e, g e e fe ga b idie
a ic a d ce h e e e e (a d he ef e i c e ) he d ike .
Subsidies can be used to make certain goods (necessities) affordable to low-income consumers.
S b idie ha e he effec f e i g he ice f he g d ha i aid b c e , h aki g
he g d e aff dab e. F e a e, a g e e a ih ake a f d a e ( ch a
b ead ice) e aff dab e -i c e ea e . I ca d b g a i ga b id
d ce f he g d.
Subsidies can be used to encourage production and consumption of particular goods and
services that are believed to be desirable for consumers. A b id ha he effec f i c ea i g
he a i fag d d ced a d c ed. If a g e e i he e c age c i
f a g d beca e i i c ide ed be de i ab e (f e a e, ed ca i , acci a i ), i ca e
a b id achie e hi .
Subsidies can be used to support the growth of particular industries in an econom . Si ce
b idie ha e he effec f i c ea i g he a i f d ced, if g a ed fi i a
a ic a i d , he he g h f ha i d .F e a e, b idie he a
i d a e i e ded e he g h f a e . O he e a e i c de che ica ,
e i e , ee , f i f e a d a e.
Subsidies can be used to encourage e ports of particular goods. Si ce b idie e he ice
aid b c e , he a e e i e g a ed g d ha a e e ed ( d he c ie ),
i ce e e ice i c ea e he a i fe ( ee Cha e 14).
Subsidies are a method to improve the allocation of resources (reduce allocative inefficiencies)
b correcting positive e ternalities. I a ed ab e ha a ke i e fec i e e he
achie e e f a ca i e efficie c ; i e ca e ( ch a he he e a e i i e e e a i ie ), i
a be ib e e b idie i e a ca i e efficie c ( ee Cha e 6).
S b idie a e a c e ia ic i ec ic beca e he a e e e e i e a d a e f e de ig ed
achie e ce ai bjec i e ha a be c i e i h he i a bjec i e . F e a e,
a c ie g a b idie f i f e , hich c a bjec i e f ai ab e
de e e a d hich a c adic he bjec i e f he b idie i e ded he g h
f a e a i e e e g . F i -f e b idie a e k a e e e b idie . S b idie f ag ic e
a de a e a high c e ia ( ee Cha e 14).
Subsidies: impacts on market outcomes and consequences for

stakeholders
Illustrating and anal sing impacts of subsidies on market

outcomes
I Fig e 4.15, he i i ia , e- b id e i ib i i de e i ed b he i e ec i f he de a d c e
D a d he c e S1, gi i g i e e i ib i ice P* aid b c e a d ecei ed b
d ce , a d e i ib i a i Q*. N he g e e g a a b id c i i g f a a e
he fi f a fi ed a f each i f d. Thi ea ha f each i f he
fi i i i g a d ab e d ce, i ecei e a e ice ha he igi a b he a f he
b id ; hi d ce a d a d, a a e hif f he c e b he a f he b id , he
e c e S2 = S1 b id . (The ea e b ac he b id i ha i k c a
c c , h ca i g a d a d hif f he S c e. I i he e ac i e f he i di ec
a hich i added he S c e ca e a a d hif . (See Q a i a i e ech i e cha e i he
'Digi a c eb k: E a a e ia '). The de a d c e e ai c a a D i ce de a d i
affec ed. The de a d c e a d e c e S2 de e i e a e e i ib i , he e ice i Pc
( he ice aid b c e ) a d he a i d ced a d d i c ea e Q b. Si ce he e ica
diffe e ce be ee he c e e ee he b id e i f , he fi ecei e
ice P , hich i e a he ice aid b he c e , Pc, he b id e i f .
Figure 4.15: I ac f b idie a ke c e
The a ke c e d e he b id a e he f i g:
e i ib i a i d ced a d c ed i c ea e f Q* Qb
he e i ib i ice fa f P* Pc; hi i he ice aid b c e
he ice ecei ed b d ce i c ea e f P* P
he a f he b id i gi e b (P Pc) Q b, he a f b id e i i ied
b he be f i d; hi i he e i e haded a ea, a d e e e g e e e di g
ide he b id
he e i a e a ca i f e ce he d ci f he g d: Q b i g ea e ha he f ee
a ke a i , Q*.
Consequences of subsidies for various stakeholders

Consumers
C e a e affec ed b he fa i ice f he g d f P* Pc (Fig e 4.15) a d he i c ea e i
a i cha ed (f Q* Q b). B h he e cha ge ake he be e ff.
Producers
P d ce a e a be e ff, beca e he ecei e a highe ice (P > P*) a d d ce a a ge a i
(Q b > Q*), ee i Fig e 4.15. The ice a d a i effec a aei a i c ea e i e e e .
Bef e he g a i g f he b id , fi had e e e f P* Q*. F i g he b id , fi e e e
i c ea e P Q b.
The government
The g e e a he b id , hich i a b de i b dge . T b ai he e e e f he
b id , he g e e a ha e ed ce e e di e e e he e i he ec , i a ha e
ai e a e , i a ha e a b dge defici (g e e e e di e g ea e ha a e e e ).
Wha e e he ca e, he i ac he g e e b dge i ega i e.
Workers
A e a d f Q* Q b, fi a e ike hi e e ke d ce he e a ,
he ef e ke h fi d e j b a e be e ff.
Societ as a whole: consumer and producer surplus, and welfare loss

S cie a a h e i e ff beca e he e i a e a ca i f e ce he d ci f he
g d; Q b > Q*. I addi i , cie i e ff beca e he highe ice ecei ed b d ce ec
e a i e i efficie e ,a i g he c i e d ce.
Fig e 4.16 h c e a d d ce bef e a d af e he b id . I a (a), a he f ee
a ke e i ib i bef e he b id , cia (c e d ce ) i a i a d MB =
MC, i dica i g he achie e e f a ca i e efficie c .
Af e he g a i g f he b id , b h c e a d d ce i c ea e. I Fig e
4.16(b), c e i he a ea de he de a d c e a d ab e ice Pc, Q b.
The a i c e i h b he haded a ea abe ed gai i c e . P d ce
bec e he a ea ab e he c e S1a d be he ice P , Q b. The a i
d ce i h b he haded a ea abe ed gai i d ce .
Figure 4.16: Effec f b idie c e a d d ce
N e ha he ide if i g d ce af e he g a i g f a b id , e a a efe he
a c , hich i S1 i Fig e 4.16.
A he a e i e ha d ce a d c e gai , he g e e e beca e f he ega i e

effec i b dge . The b id i aid f b a e ha ha e a i c (a e a i e e ha
a e ac ificed). A e k ,g e e e e di e ide he b id i (P Pc) Q b. T
ac a a c a c a a. The ef e, he cia
e d e g e e e di g a e g ea e ha he gai i c e a d d ce b he
a a. The a ea a i e fa e e ee i g be efi f cie , ca ed b a a ge ha
i a i d ced: Q b > Q*. The b id ha ca ed e d ci eai e ha i
cia de i ab e, a d a e a ca i f e ce , a ca i e i efficie c .
We ca a ee i Fig e 4.16(b) ha a Q b, MB < MC, ea i g ha he be efi c e ecei e
f he a i f he g d he b i e ha he a gi a c f d ci g i . The ef e, cie
d be be e ff if e f he g d e e d ced.
The g a i g f a b id e i g ea e c e a d d ce ; h e e , cie e
d e g e e e di g he b id . Si ce he f g e e e di g i g ea e ha
he gai i c e a d d ce , e fa e e , ef ec i g a ca i e i efficie c ,
hich i hi ca e i d e e a ca i f e ce he d ci f he g d
( e d c i ). Thi i a i a ed b MB < MC: ch f he g d i bei g d ced a d
c ed e a i e he cia i .
Foreign producers
If he b id i g a ed e (g d d he c ie ), i e ice a d i c ea e he
a i fe . Whi e hi i i i e f d e ic d ce , i i ega i e f he d ce f he
c ie h a be ab e c e e i h he e ice f he b idi ed g d . (Thi ic i
be di c ed i Cha e 14 a d 18.)
1 Defi e b idie a d idi g e a e, i e e ea h g e e ga he .

2 The g e e i c ide i g g a i g a 0.50 b id e ki g a f chee e.
a D a a diag a f he chee e a ke bef e he g a i g f he b id , h i g he ice
aid b c e , he ice ecei ed b d ce a d he a i f chee e ha i
b gh / d.
b U i g he a e diag a , h ha ha e i he chee e a ke af e he g a i g f he
b id , i dica i g he ice aid b c e , he ice ecei ed b d ce , he
a i f chee e b gh / d a d g e e e di g he b id .
3 C ide i g e i 2 ab e:
a a a e he i ac he a ke f he b id , a d
b di c he c e e ce f akeh de .
4 U i g a diag a , h he i c ea e i c e a d d ce ha e f he
g a i g f a b id . E ai h e fa e aie e e h gh b h c e a d d ce
i c ea e. Sh he e fa e i diag a .

Farm subsidies in the United States
Fa e i he U i ed S a e ha e bee ecei i g b idie f ce ai ag ic a d c (c ,
hea , bea , c , ice a d he ) i ce he G ea De e i f he 1930 . I 1996, a a a
a ed e d b idie a d c ea e a f ee a ke i ag ic e. H e e , he f ee a ke i
ag ic e e e a e ia i ed. S fa e c a a e e $20 bi i a ea . Thi
i j ified b he c be ief ha he g e e i he i g a fa e i e. Ye
acc di g he US De a e f Ag ic e ( he ag ic e i i ), he a ge a d ea hie
fa e ecei e he b k f fa b idie . The ea i ha b idie a e aid acc di g he
a fc d ced. S a e fa e ecei e e a a , hi e fa e h c i ae
f i a d ege ab e ecei e b idie a a . I fac , a bi i ai e ( h a e he e f e
a ge ag ic a c a ie ) ecei e fa b idie . Acc di g he E i e a W ki g
G , 50 e e i he F be i f 400 ea hie A e ica ecei ed b idie i he e i d 1995
2014. Si ce 2008, he e eci ie f b idie each ecei ed a a e age f $18.2 i i .
Sources: A a Fa b ca a
a a c L H a -L a , 11 J 2010. C E a , R
a a c , Ta a b b 82, Ca , 12 A 2018 Ma
US a b $1 c b, A a A , F b , 14 A 2018
Figure 4.17: Wa hi g , D.C., USA. The Na i a Fa e U i ge C ge a a fa

bi
Appl ing our skills

1 Di c he c e e ce f fa b idie f ag ic a a ke a d akeh de .
2 S gge ea h he g e e c i e ga ag ic a b idie e e h gh he
a ec a d fai .
Calculating the effects of subsidies on market outcomes and

social welfare (HL onl )
If he g e e ga a b id fe f $4 e kg, he c e hif d a d b $4
f each kg f Q.
How to graph the new suppl curve, S2
I Fig e 4.18, he e c e, S2 = S1 b id , ie $4 be he i i ia c e, S1. We
ca c $4 d a d a g he e ica a i f he P i e ce f S1, a d he d a a i e
aa e S1 f hi e P i e ce . Thi gi e he e c e, S2. F a Q, he
e ica diffe e ce be ee he c e i $4, hich i he b id e i f .
The ef e, a he e e i ib i , he ice aid b c e i Pc = $18, he e i ib i a i
i Q b = 24 kg, a d he ice ecei ed b d ce i P = Pc + b id e i = $18 + $4 = $22.
The e e ae h i Fig e 4.18.
We ha e f d ha he ice aid b c e ha fa e f $20 $18 e kg, he ice ecei ed
b d ce ha i c ea ed f $20 $22 e kg, a d he a i d ced a d c ed ha
i c ea ed f 20 kg 24 kg.
We i e hi ice a d a i i f ai ge he i h he g a h i Fig e 4.18
ca c a e c e e e di e, d ce e e e, g e e e e di e, c e ,
d ce a d e fa e .
Consumer e penditure
C e e e di e e a he ice aid e kg f f e i e he be f kg cha ed.
The ef e, bef e he b id , c e e P* Q* = $20 20 kg = $400 e da ; af e he
b id , c e e Pc Q b= $18 24 kg = $432 e da . The ef e c e e e di e
i c ea ed b $32 e da (= $432 $400).
Producer revenue
P d ce e e e i gi e b he ice ecei ed e kg f f e i e he be f kg d.
The ef e, bef e he b id a g a ed, d ce e e e a P* Q* = $20 20 kg = $400 e
da , hich i e ac he a e a ha c e e ; fi e e e a e ac e a c e
e e di e. Af e he b id a g a ed, d ce e e e i c ea ed P Q b= $22 24 kg =
$528 e da . P d ce e e e i c ea ed b $128 e da (= $528 $400). N e ha fi e e ei
e ha c e e e di e.
Figure 4.18: De a d a d ih b idie
Government e penditure
G e e e e di e he b id ca be ca c a ed i a :
a I i e a he b id e kg (P Pc) i e he be f kg d (Q b), a d i he ef e $4
24 kg = $96 e da .
b I i a e a he diffe e ce be ee d ce e e e a d c e e e di e af e he
b id : $528 $432 = $96 e da .
Calculating the effects of subsidies on consumer and producer surplus and

welfare loss
C e a d d ce b h bef e a d af e he b id a e he a ea f ia g e , he ef e
e e he fa i ia ia g e f a ca c a e he .
E a i i g Fig e 4.18, e ca ee ha c e a he f ee a ke e i ib i (bef e he
b id ) i e e e ed b he a ea de he de a d c e a d ab e ice P* = 20 a i
Q* = 20. Af e he b id , i i he a ea de he de a d c e a d ab e ice Pc = 18
a i Q b= 24.
C e = (P i e ce fDc e i P fc e ) Q cha ed 2
The ef e, c e bef e he b id i :
(30 P*) Q*2=(30 20) 202=10 202=200 2=$100
C e af e he b id i :
(30 Pc) Q b2= (30 18) 24 2=12 242=2882=$144
The ef e, c e i c ea ed b $44 (= $144 $100).
P d ce bef e he b id i Fig e 4.18, i he a ea ab e he c e S1 a d be
P* = 20 Q* = 20. Af e he b id , i i he a ea ab e he c e S1 a d be P = 22
Q b= 24.
P d ce i a ca c a ed i g he a e eh da i h i di ec a e :
P d ce = (P f d ce i P i e ce f S1 c e) Q d2
The ef e, d ce bef e he b id i :
(P* 10) Q* 2 = (20 10) 20 2 = 10 20 2 = 200 2 =$100
P d ce af e he b id i :
(P 10) Q b 2 = (22 10) 24 2 = 12 24 2 = 288 2 =$144
The ef e d ce i c ea ed b $44 (= $144 $100).
N e ha ca c a e d ce af e he b id ha bee g a ed, e e he a
c , S1 (a e d a i he ca e f i di ec a e ).
(The e a i f d ce a d c e a d d ce , bef e a d af e he b id , i
c i cide a .)
S cia i c ea ed b he a f he i c ea e i c e he a f he
i c ea e i d ce = $44 + $44 = $88.
We fa e ca be f db :
(P P c )( Q b Q*) 2 = (22 18)(24 20) 2 = 4 4 2 =$8
1 U i g he c ce fa ca i e efficie c , e ai h a b id c ea e e fa e .
2 I he a ke f g d a ha he P i e ce f he de a d c e i a he i he e Q = 0
a d P = 7 a d he P i e ce f he c e i a he i he e Q = 0 a d P = 1. The
i f i e ec i f he de a d c e a d he c e a f ee a ke e i ib i i a
he i he e Q = 6 a d P = 4.
a Da he de a d a d c e , a d ide if he e i ib i ice a d a i .
b S e ha ice i ea ed i , a d a i i e e da , a d ha a b id f
2 e e i g a ed. D a he e c e, a d fi d ( h gh g a h) he
ice aid b c e , he ice ecei ed b d ce a d he e e i ib i
a i .
c Ui g e , ca c a e he cha ge i c e e e di e, he cha ge i fi
e e e, g e e e e di e, he cha ge i c e , he cha ge i
d ce a d e fa e .
d Ide if , i diag a , he a ea ha c e d g e e e e di e, e fa e
, he i c ea e i c e a d he i c ea e i d ce .
e O i eh he e a i hi be ee a gi a be efi a d a gi a c a he e
(af e - b id ) e i ib i eae a ca i e efficie c ( i efficie c ).

Allocative efficienc : is it reall value-free?
Th gh hi cha e , e ha e ed he c e i i e a ke de , e ai ed i Cha e 2, a he
ba i f aki g a e e ab g e e i e e i i he ec . Acc di g hi
de , he he e i c e i i i he e e f a b e a d e e h ac acc di g hei
be e f-i e e , a d he a ke f ce a e f ee de e i e e i ib i ice , a i a i i
eached he e he e i a ca i e efficie c a d a i cia e fa e. Sca ce e ce a e
a ca ed i he be ib e a , d ci g he f ha e e a ,a di i
ib e ake a e be e ff i h aki g e e e ff, a c di i ca ed Pa
a .
The c ce f Pa e i a i e e ged i he a e 19 h ce af e a e i d he ec i
ee i g ake ec ic e cie ific i i a ach. Scie ific ea ec ic h d
ge id f a a e j dge e ab hi g ha gh be a d ba e i e f e i e ii e
hi ki g ( ee Cha e 1). The fa c a ica ec i f ea ie i e (Ada S i h, Th a
R be Ma h , Da id Rica d , J h S a Mi , Ka Ma a d a he ) e di c ed hei
idea ab ha gh ha e i cie ( a i e idea ) ge he i h hei i i e idea f
hi g ha a e i be . Ye b he a e 19 h ce , i a be ie ed ha a e cie ce i a e-
f ee, a d ec i e i i a e he e h d f he a a cie ce , e ecia h ic .
The c ce f Pa e i a i , de e ed b Vi f ed Pa e (a I a ia e gi ee , ci gi ,
ec i a d hi he ), a e c ed a bei g f ee f a i e a ec . I i a ed
ha de ce ai a i , e f ee ac i g c e a d d ce beha i g acc di g
hei i di id a efe e ce , gi e i e a c e f a i efficie c a d a i cia
e fa e (defi ed a MB = MC a i cia ).
O he face, hi d ike a a e-f ee, i i e a e e . Ye i a e ea (a d he
e e ), a ec i c i ici ed i he g d ha i i ac a hea i ba ed ai e
idea , a d i he ef e a e-f ee. The diffic i de ec i g he e a e i ha he e a e i ici ;
he a e e ici , a a e.
Ec i h e i he a e-f ee a e f Pa e i ai i ha he c ce f
e fa e i defi ed i e a i i di id a efe e ce fc e a d d ce (deci i ade
he ba i f a i a e f-i e e ) ha de e i e c e a d d ce . I di id a
efe e ce bec e he a da d, ea i g ick, b hich ec i e a a e ea - d
i ai a dg e e i e e i i a ke . A e a i hi cha e , a f ee c eii e
a ke i be ; g e e i e e i i hi a ke ed ce e fa e.
B e he e a e he defi i i f e fa e, ch a e a i f i , f eed f h ge
a d di ea e, h a igh , fai e a d a e. A he e a e a i e c ce , b he , b he
a e ke , e fa e defi ed a a i cia i a a a i e c ce , he ba i f
hich a j dge e i ade ab h e h he ec k.
S e ec i ake he e idea f he , a d a g e ha Pa e i a i b he b d f
ic ec ic hich i e i a a e-f ee. The idea ha cie ie h d e
a ca i e efficie c f f c c a ca c c a
a b ca c c . Ye , e e be f Cha e 1, a cie ie
a e h ee ba ic ec ic e i : a / c , a d c . The
defi i i f ec ic c e he fi f he e a d ig e he hi d. The ea f
eg ec i g he c e i i ha ec i c ide he fi e i be
a f i i e hi ki g a d he hi d a a f a i e hi ki g ( ee The fk edge 2.1 i
Cha e 2). H e e , if efficie c ( a a d c ) ead a i e fa e, he e he
defi i i f e fa e i ba ed a a e j dg e , ec i ha e c e f ci c e a d ha e ba ed
hei -ca ed ii ea a i a a e j dge e .
I ie f he ab e, e ec i a g e ha he f c fg e e icie efficie c ,
defi ed a Pa e i a i , di e a e i a a f he be f i c e di ib i , a d
j ifie g e e i ac i i hi a ea. Wha i he i f ea i i g ( c i g c e ea i i g)
Pa e i a i i he ea d, if a a ge i f he a i i a i g beca e he ha e
i c e?
Acc di g G a M da , a S edi h ec i h he N be P i e i 1974, he cia
cie ce a e i e i ab ba ed a e , b he e a e h d be ade e ici :
The a e ca i ef bjec i i i he e ica a a i i e e he a a i i
f igh , aki g he c ci , ecific a d e ici , a d e i he de e i e he
he e ica e ea ch [ ] he e i hi g g, , i h a e- aded c ce if he a e
c ea defi ed i e f e ici a ed a e e ie. 1
Thinking points
I ie , i Pa e i ai a e-f ee, i i i ici ba ed a a e j dge e ?

D e a g age i he e e i a i cia e fa e c e a e ?I i ib e ha e
a e-f ee a g age?
D e he i e i ab e e f a g age i he i f ec ic k edge c ica e he j b f
ec i a cia c i i f a e-f ee k edge?
D hi k he a a cie ce a e a e-f ee?
D ag ee i h M da c ai ha i a be ib e each bjec i i i he e ica
cia cie ce b aki g a e e ici ?
D hi k ec ic i , e e ca be, c ee a e-f ee?

The f i g e i i he ef ec ea i g a d e ha ce de a di g f ke
ic i hi cha e . The a e gge i f i i ie ha ca de ake i
g i de e i e he ea i g bjec i e f hi cha e .
1 Fi d if he ci a ea i ei e e c . If i d e , ea ch i e a d fi d a
ci a ea he e e c a ei ace. Re ea ch he effec f he e c a de a ae
hei ef e . C ide b idie h i g, hich i a e a i e ic ha c d ha e bee
ed ake h i g aff dab e e e i c e .C a ea dc a he
icie a d de e i e he ad a age a d di ad a age f each. U i g k edge
f ec ic , de e i e hich f he icie h d be efe ed. J if c c i .
2 Fi d if b idie a e g a ed i c . If , fi d a ea - de a e f e e
b idie , e ea ch he akeh de i ed a d he ea h he b idie a e gi e .
E a a e he e i f he b idie b c ide i g he effec f he b idie a ke a d
akeh de .
Y ca fi d e i i he e f IB e a i he 'Digi a c eb k: E a a e ia ' ec i .
1 G. M da (1970) Ob c S ca R a c , Ge a d D ck h.
Chap er 5
Marke fail re and ociall

nde irable o come I:
Common pool re o rce and nega i e e ernali ie
BEFORE YOU START

Ca hi k f eg d e ice ha he c ed d ced ca e ha he
e e h gh he did c e d ce he ?
Wha d hi k h d be he e fg e e ed ce he ha ca ed b ch ha f
ac i ?
I hi cha e e i di c e h he a ke ec fai achie e a fi i e .I

a ic a e i ee h e ac i f i di id a g f i di id a a ha e ega i e
i ac he a d he e i e . We i a d h g e e i e e i ca he
a ke e c e hei h c i g .
5.1 T a
LEARNING OBJECTIVES

• define all the terms appearing in a b in the text (AO1)
• explain the meaning of common pool resources in terms of (AO2)
• the concepts of rivalry and non-excludability
• the tragedy of the commons
• explain the meaning of unsustainable production (AO2)
Environmental problems can be studied by examining a special category of resources known as common
pool resources.1 C are resources that are not owned by anyone, do not have a
price and are available for anyone to use without payment or any other restriction. Examples include
clean air, lakes, rivers, fish in the open seas, wildlife, hunting grounds, forests, biodiversity, the fertility
of the soil that occurs in nature, open grazing land, the ozone layer, the stable global climate, and many
more.
U a
C : a b - ab
Common pool resources differ from any other kind of resource or good, because they possess a special
combination of characteristics: they are rivalrous and non-excludable. To understand what these terms
mean, it is useful to consider the definition of private goods. A private good has two characteristics:
• It is a : its consumption by one person reduces its availability for someone else; for
example, your computer, textbook, pencils and clothes are rivalrous, because when you buy them,
another person cannot buy the same ones; most goods are rivalrous.
• It is ab : it is possible to exclude people from using the good; exclusion is usually achieved
by charging a price for the good; if someone is unwilling or unable to pay the price, he or she will
not have the benefit of using it; most goods are excludable.
As noted above, most goods are rivalrous. Common pool resources are also rivalrous. If we use up clean
air, there is less left over for use by others; when we catch fish in the open sea, there are fewer fish left
over for others to catch; if we destroy the stability of the global climate, it will not be available for use
by future generations.
Also, it was noted that most goods are excludable. However, open pool resources differ because they
have no price or any other means of excluding users; anyone can use them without payment or other
restriction; therefore they are - ab . Non-excludable means it is not possible to exclude
someone from using a good or resource.
Common pool resources are rivalrous but nonexcludable. This combination poses serious threats to
the environment. Rivalry means that the use of resources reduces their availability for others. Non-
excludability means that the resources can be used abundantly without restrictions and therefore may
be overused, degraded and depleted.
There is no end to examples of overuse, depletion and degradation of common pool resources. When
factories, homes or cars use fossil fuels that emit pollutants into the atmosphere or into oceans, rivers
and lakes, they ‘overuse’ a portion of these natural resources without paying for them. Some of these
activities give rise to global warming, with likely devastating effects on agriculture, health and
ecosystems; this involves ‘overusing’ the benefits provided by a stable global climate. When fish are
overfished, the fishing industry uses up an excessive amount of the global stock of fish and disrupts the
marine ecosystem. Similarly, when forests are cleared to create land for use in agriculture or for the sale
of timber by the lumber industry, there are huge consequences in terms of loss of biodiversity and threats
to wildlife, the ozone layer and the global climate. Land is being overgrazed because of excessive
grazing; arable land is lost because of soil erosion and salinisation; wildlife is endangered because of the
destruction of natural habitats due to the encroachment of settlers and agriculture. In all these cases,
common pool resources are used and overused, leading to serious environmental degradation and
depletion.
C :T a
The a is a story about cattle that feed on a fertile pasture that is owned in
common by a group of herders (cattle owners). In the beginning each herder had a small number of cattle
and all the animals had plenty of space and grass on which to feed. As this was a profitable business,
each herder began to increase the number of cattle grazing on the pasture. But as the cattle increased,
after some time the pasture became overfilled with grazing cattle that had to increasingly compete with
each other for food that was becoming more and more scarce. In the end the grass was all gone, the soil
was eroded and the pasture could no longer be used for grazing.
This story allows us to better understand the concepts of rivalry and non-excludability. The fertile
pasture is rivalrous because whatever grass is eaten by one animal is not available for another. It is also
non-excludable since one herder cannot exclude others from using it. This story is used by
environmentalists to illustrate the overuse of a resource when there are no restrictions on its use.
The tragedy of the commons has been challenged by the ideas of Elinor Ostrom, that we will study
below under the topic Collective self-governance as well as in Theory of knowledge 5.1.
S a ab a
As we know from Chapter 1, sustainability in connection with the environment refers to the use of
resources in ways that do not result in fewer or lower-quality resources for future generations.
Sustainable production is production that uses resources in a sustainable way, in other words by not
degrading or depleting them. By contrast, a ab refers to production that uses
resources unsustainably, depleting or degrading them.
S a ab : a a ab
(S a a a)
A simple example shown in Figure 5.1(a) illustrates the meaning of sustainable and unsustainable
production and resource use. Fish in the open seas are a common pool resource that anyone has access to
without payment. The horizontal axis measures the number of fishing boats, and the vertical axis
measures the quantity of fish caught in tonnes. The first, second and third boats each catch 4 tonnes;
therefore, in this range of ‘constant average yield’ (yield refers to the amount of output), the three boats
together catch 12 tonnes, or 4 tonnes each on average.
F 5.1: Illustrating sustainable and unsustainable resource use
When a fourth boat goes out to sea, it brings back only 3 tonnes of fish; this translates into a smaller
quantity of fish caught by each boat on average. The four boats together have caught 15 tonnes, or an
average of 3.75 tonnes (= 15 4 ) instead of 4 tonnes.
When the fifth boat is added, the five boats catch 17 tonnes, and the average catch falls further to 3.4
tonnes (= 17 5 ) . With the sixth boat, the total is only 19 tonnes or 3.2 tonnes for each boat on average.
This is the range of ‘decreasing average yield’, meaning that each boat that goes out brings back a
smaller amount of fish than the previous one.
What happens if a seventh boat goes out? The total amount of fish caught by the seven boats together
(17 tonnes) is less than what was caught by 6 boats (18 tonnes). As the graph indicates, in this range of
‘absolutely decreasing yield’, as more and more boats go fishing, the total amount of fish they bring
back becomes less and less.
This example illustrates that the fish were plentiful for the first three boats, but with the addition of the
fourth, fishing became more difficult because it began to put pressure on the supply of fish in the ocean.
As the supply of fish was more and more depleted, it became increasingly difficult to catch fish, so the
average quantity of fish brought back fell with the addition of each boat. Finally, with the addition of the
seventh boat, the fish supply was overused; the fish population was no longer able to reproduce itself,
and therefore the quantity of fish in the ocean began to drop
Figure 5.1(b) shows that the point of maximum yield of a common pool resource is the resource’s
maximum sustainable yield. This is the maximum use that can be made of the resource that is also
sustainable, in that the resource can reproduce itself. All points to the left of the maximum sustainable
yield indicate sustainable levels of use; points to the right indicate unsustainable use, meaning that the
resource is being depleted or degraded. The further to the right, the greater the resource depletion or
degradation. In the real world, many common pool resources are used unsustainably, i.e. to the right of
their maximum sustainable yield.
Note that while it is an easy matter to discuss the maximum sustainable yield of a resource in theoretical
terms as we have done here, it is very difficult in practice to determine what this actually is for any
resource.
Sustainable resource use means that resources are used at a rate that allows them to reproduce
themselves, so that they do not become degraded or depleted.
A ab a - ab ,a
a ab
Non-renewable resources are those resources that do not last indefinitely, because they have a finite
supply (they need tens of thousands or millions of years to reproduce themselves). Examples include
metals, minerals and fossil fuels, such as oil, natural gas and coal. Many of these resources, with the
exception of fossil fuels, do not get destroyed through their use, and so through effective recycling could
be made to last indefinitely. By contrast, fossil fuels are destroyed when used, and moreover have
devastating effects on the earth’s atmosphere, the global climate and the ozone layer.
Renewable resources are those resources that can last indefinitely if they are managed properly (not
overused), because they are reproduced over relatively short periods of time by natural processes.
Examples include forests, wildlife, fish, biomass, water resources, geothermal power, soil fertility and
biodiversity. The idea of sustainable resource use applies mainly to renewable resources, because given
appropriate management, these resources can be made to last forever. On the other hand, through
mismanagement or overuse, these resources become depleted and degraded, indicating unsustainability.
The idea of sustainable resource use does not apply to non-renewable resources, such as fossil fuels. If
resources are non-renewable, they could be used sustainably only if they were not used at all. On the
other hand, as we will see in the pages that follow the idea of sustainability is relevant to fossil fuels
when referring to the negative externalities that are created by their use.

1 Provide examples of common pool resources, making reference to their overuse.
2 a Define common pool resources using the concepts of rivalry and nonexcludability.
b Explain how these characteristics pose a threat to the environment.
Outline how these characteristics can be illustrated by the tragedy of the commons.
3 Outline the meaning of sustainable production.
4 a In discussions of common pool resources, there is an emphasis on their overuse rather than
their use. Explain why.
b Explain why cutting down a small amount of forest over an extended period of time may be
consistent with the concept of environmental sustainability.
1 It may be noted that in the previous syllabus these were known as common access resources . The term was
changed as common pool resources is more commonly used.
5.2 Ma e a ea de e a e :d e
a e a d c a be e a dc
LEARNING OBJECTIVES
A :
a eb d (AO1)
(AO2)
;
MSC=MSB ( ) (AO2)
(AO4)
(AO2)
I d c a e a e: e a e e a e ac e e
a ca e e c e c
O ,
.I C 2 ,
,
.T
, (MB = MC),
.
H ,
.T , ,
.T :
.
M
- ; , ,
.A
- .O
,
.
Ma e a e .M
a ca e e ce c ,
.O
( );
( ).

1 U , ,
, .
2 E , , .
T e ea e e a e :d e a ea d ca
be e a dc
U de a d e e a e
W , .W
, .S
, .W
, .
A e e a
- ,
.
T .I -
, ee e a , (
) ; , - , e a e
e e a , ( ) .
E ( )
( ).
Ma a a e be e a dc ,a d a a c a be e
a dc
T , C 2.
A ,
( F 2.17, C 2). S
,
, i ae , MPB F 5.2.
F e 5.2: D ,
T , ( F
2.17). M .T
i ae , MPC F 5.2.
N , , -
, (D) (S)
cia i , .I
F 5.2, P Q .A
.Q ca .
I, , , ,
.T a gi a cia
be efi (MSB) ; a gi a cia c (MSC)
.
W ,
(MPB) (MPC) , a ca i e i efficie c
.
I , , MSB,
, ,
MSC, .W MSB MSC
, .
F 5.2 ( ).
T D = MPB = MSB, S = MPC = MSC.
a a a ec (MPC) .
a a ca c (MSC) .
a a a e be e (MPB)
.
a a c a be e (MSB) .
W MSC = MSB, cia i .W

, MPC = MSC = MPB =
MSB, F 5.2, .A
MPC MSC MPB MSB. W ,
MPB = MPC, MSB MSC, .
E .
Y MSC = MSB MC = MB .
I C 4 MC = MB
.
W :
.
T , ,
.T , ,
C 6.
T c e ce ,
, .
1 a O .
b U .
2 E :
a ,
b .
3 S , ,
.
5.3 Negative production externalities
LEARNING OBJECTIVES

e lain nega i e e e nali ie f d c i n and he e l ing elfa e l (AO2)
d a a diag am ill a ing nega i e e e nali ie f d c i n and elfa e l (AO4)
calc la e elfa e l ha a i e f m nega i e e e nali ie f d c i n (HL nl ) (AO4)
e lain ha nega i e d c i n e e nali ie can be ed ill ae e e f c mm n l
e ce (AO2)
e lain g e nmen in e en i n c ec nega i e e e nali ie f d c i n and e en
e e f c mm n l e ce incl ding: (AO2)
indi ec (Pig ian) a e
ca b n a e
adable e mi
legi la i n and eg la i n
c llec i e elf-g e nance
ed ca i n-a a ene c ea i n
in e na i nal ag eemen
d a diag am ill a e he ab eg e nmen e n e (AO4)
di c eng h and limi a i n f he ab e g e nmen licie i h e ec : (AO3)
diffic l ie in mea emen f e e nali ie
deg ee f effec i ene
c n e ence f akeh lde
Explaining and illustrating negative production externalities

Negative production externalities efe e e nal c c ea ed b d ce . The blem f
en i nmen al ll i n, c ea ed a a ide-effec f d c i n ac i i ie , i e c mm nl anal ed a a
nega i e d c i n e e nali .
C n ide a cemen fac ha emi m ke in he ai and di e i a e b d m ing i in he
cean. The e i a d c i n e e nali , beca e e and ab e he fi m i aec f d c i n,
he e a e addi i nal c ha ill e n cie d e he ll ed ai and cean, i h nega i e
c n e ence f he l cal inhabi an , imme , ea life, he fi hing ind and he ma ine
ec em. Thi i h n in Fig e 5.3, he e he l c e, S = MPC, eflec he fi m i ae
c f d c i n, and he ma ginal cial c c e gi en b MSC e e en he f ll c cie
f d cing cemen . F each le el f , Q, he cial c f d cing cemen gi en b MSC a e
g ea e han he fi m i aec . The e ical diffe ence be een MSC and MPC e e en he
e e nal c . Since he e e nali in l e nl d c i n ( he l c e), he demand c e
e e en b h ma ginal i a e benefi and ma ginal cial benefi .
Figure 5.3: Nega i e d c i n e e nali
Fig e 5.3 ill a e a gene al in ha h ld kee in mind hene e e amine ( d a ) an

e e nali diag am: he f ee ma ke c me i de e mined b he in e ec i n f MPB and MPC,
e l ing in an i Qm and ice Pm. The ciall im m ( be ) c me i gi en b he
in e ec i n f MSB i h MSC, hich de e mine an i Q and ice P .
We can d a an im an c ncl i n f m he nega i e e e nali in Fig e 5.3:
When he e i a nega i e d c i n e e nali , he f ee ma ke e all ca e e ce he

d c i n f he g d and m ch f i i d ced ela i e he cial im m. Thi i h n
b Qm > Q and MSC > MSB a he in f d c i n, Qm, in Fig e 5.3.
The welfare loss of negative production externalities

Welfare loss
Whene e he e i an e e nali , he e i a elfa e l , in l ing a ed c i n in cial benefi , d e
he mi all ca i n f e ce .
In Fig e 5.4(a), he haded a ea e e en he elfa e l a i ing f m he nega i e d ci n
e e nali . F all ni f g ea e han Q , MSC > MSB, meaning ha cie ld be be e
ff if le ee d ced. The elfa e l i e al he diffe ence be een MSC and MSB f he
am n f ha i e d ced (Qm Q ). I i a l f cial benefi d e e d ci n
f he g d ca ed b he e e nali . If he e e nali e e c ec ed, ha he ec n m eache he
cial im m, he l f benefi ld di a ea . I ma be ef l n e ha he in f he
elfa e l iangle al a lie a he Q an i f .
Calculating welfare loss (HL onl )

Fig e 5.4(b) i imila 5.4(a) e ce ha i incl de fig e ha all calc la e elfa e l .
T find he a ea f he haded iangle, e ake he heigh ime he id h f he iangle and di ide i
b 2. N e ha he heigh f he iangle i e al he e e nal c e ni , MSC MPC, and he
id h i e al he am n f e d c i n b he ma ke Qm Q :
Welfa e l = (6 4) (100 70) 2 = 2 30 2 =$30

Figure 5.4: Welfa e l in a nega i e d c i n e e nali
Welfare loss in relation to consumer and producer surplus (Supplementar
material)
We can e he c nce f c n me and d ce l nde and he elfa e l d e he
e e nali . In Fig e 5.4(c), in ma ke e ilib i m, c n me l i e al a ea a + b + c + d,
hile d ce l i e al a ea f + g + h. The al e f he e e nal c i he diffe ence
be een he MSC and MPC c e Qm ( he an i d ced b he ma ke ), and i he ef e
e al c + d + e + g + h. The al cial benefi in ma ke e ilib i m a e e al c n me l
l d ce l min he e e nal c :
(a + b + c + d) + (f + g + h) (c + d + e + g + h) = a + b + f e
A he cial im m, a Q and P , c n me l i e al a ea a, and d ce l i
e al a ea b + f. The e e nal c i n e al e . The ef e, he al cial benefi a e e al
c n me l l d ce l :
a+b+f
C m a ing al cial benefi a he ma ke e ilib i m and a he cial im m, e find ha he
a e malle a he ma ke e ilib i m b he a ea e. Thi i he elfa e l .
Negative production externalities and overuse of common pool

resources
The c nce f nega i e e e nali ie ha e died ab e can be ed ill a e he blem f
e e f c mm n l e ce and i effec n ainabili . F e am le, in he nega i e
d c i n e e nali diag am f Fig e 5.3 he diffe ence be een he MPC and MSC c e can be
in e e ed a he e e nal c a i ing f m he cemen fac e e f clean ai , a e and ea life
n acc n f i de endence n f il f el ; i can al be in e e ed a he c cie f ca ing
gl bal a ming (de ing he abili f he gl bal clima e, hich i al a c mm n l e ce).
The b ning f f il f el c ea e e e nal c in e m f e e f c mm n l e ce .
If i e e ible make he cemen fac a f he e e f he e e ce , he d ce ld
n nece a il i ll ing ac i i ie en i el , and ld n c mm n l e ce .
H e e,i ld e hem, h leading a ainable e f c mm n l e ce .
Fig e 5.3 can be ed ill a e he e e f man c mm n l e ce a a nega i e d ci n
e e nali . F e am le, if he S = MPC c e e e en he i a e c f a fi hing fi m ha fi he in
he en ea , he e e nal c ld be de le i n f he ck f fi h, and en i nmen al damage d e
di i n f he ma ine ec em, he c mm n l e ce ha he fi hing fi m ha e ed
b n aid f . The c cie f he fi m fi hing ac i i ie a e gi en b MSC, hich a e he
i aec l he e e nal c .

1 a U ing a diag am, h h ma ginal i aec and ma ginal cial c diffe hen he e
i a nega i e d c i n e e nali .
b E lain he diffe ence be een he e ilib i m an i de e mined b he ma ke and he
an i ha i imal f m he in f ie f cie efe ence .
c De c ibe he blem i h he all ca i n f e ce achie ed b he ma ke hen he e i a
nega i e d c i n e e nali .
d Sh he elfa e l c ea ed b he nega i e d c i n e e nali in diag am, and
e lain ha hi mean .
2 a P ide e am le f nega i e d c i n e e nali ie .
b U ing diag am and e am le , e lain h nega i e d c i n e e nali ie can be ed
anal e he e e f c mm n l e ce .
Policies to correct negative production externalities and prevent

overuse of common pool resources and their evaluation
We ill e amine and e al a e a a ie f licie deal i h nega i e d c i n e e nali ie and
e e f c mm n l e ce .
Market-based policies I: indirect (Pigouvian) taxes

An im an g f licie ha can be ed b g e nmen el n he ma ke c ec
nega i e d c i n e e nali ie and m e ainable e f c mm n l e ce . Ma ke -ba ed
licie k b changing he incen i e faced b fi m .
In ne ch a ach he g e nmen c ld im e an indi ec a n he fi m e ni f
d ced. Thi i kn n a a Pigouvian tax ( Pigovian tax), af e he Engli h ec n mi A h Cecil
Pig h a he fi e he idea f im ing a a in de c ec a nega i e e e nali . In
Fig e 5.5(a), he a e l in an a d hif f he l c e, f m S = MPC MSC (=MPC +
a ). The imal ( be ) a lic i im e a a ha i e ac l e al he e e nal c , he
MPC c e hif a d n il i e la i h MSC. The ne , af e - a e ilib i m i gi en b he
in e ec i n f MSC and he demand c e, D =MPB =MSB, e e e, a a f
he g d d ced, Q , and highe , imal ice, P .N e ha he ea he indi ec a e di c ed
in Cha e 4 d ced a ca e eff c e c , indi ec a e in he e en c n e a e in ended ead
a ca e eff c e c .
Bea ing in mind di c i n f indi ec a e in Cha e 4, ma n e ha P i he ice aid b
c n me , Pc, hile he ice ecei ed b d ce i P , hich i e al Pc min a e ni .
Market-based policies II: carbon taxes

Ca b n a e a e a kind f a de igned deal i h ha i e ha he ingle m e ing and
c m le h ea he gl bal ec em: gl bal a ming, ca ed b emi i n f g eenh e ga e , he
m im an f hich i ca b n di ide. When e eak f he c n ib i n f g eenh e ga e
gl bal a ming, e efe h e ga e emi ed b man-made ce e , and ecificall b he b ning
f f il f el ( il, c al and na al ga ).
The e a e ke mea e nde di c i n in he gl bal c mm ni deal i h he blem f
ca b n di ide emi i n : ca b n a e and adable e mi ( ee bel ).
The carbon tax i a a e ni f ca b n emi i n f f il f el . F il f el d n all emi he ame
am n f ca b n hen b ned, he ef e he ca b n a i calc la ed n he ba i f h m ch ca b n
he f el emi : e e ca b e ed, e e e a . Thi can be ill a ed b he ame diag am
ed h he effec f a a e ni f , in Fig e 5.5(a). F ll ing he im i i n f he a ,
fi m m a he highe ice b he f il f el. Thi a ea in Fig e 5.5(a) a he familia
a d hif in S = MPC a d MSC beca e f he fi m highe c f d c i n, b hi ha
f he c n e ence . Since he e a e he b i e ene g ce i h l e ca b n emi i n ( h
a ed a a l e a e), ha d n emi ca b n (if he a e n f il f el , h n a ed a all), he
inc ea e in he ice f he high-ca b n f el c ea e incen i e f fi m i ch he , le ll ing
n n- ll ing ene g ce .
Figure 5.5: Ma ke -ba ed licie c ec nega i e d c i n e e nali ie and m e ainable
e f c mm n l e ce
The e l i ha if he fi m i che al e na i e, le ll ing e ce , Q F e 5.3

c ea e, beca e e e e a c f d c e bec e a e . Thi can be een in
Fig e 5.5(b), he e he MSC c e hif f m MSC1 MSC2, indica ing ha he e e nal c ae
l e d e he e f he le ll ing e ce . Wi h he fall in e e nal c , he im m an i
f inc ea e f m Q 1 Q 2 . (N e ha hi al in l e a l e a n ll an , h n
b he malle di ance be een he demand c e and MSC2 .)
Ca b n a e a e ed in man c n ie a a me h d ed ce ll i n, f e am le, Denma k,
Finland, F ance, I eland, Ja an, Me ic , P land, S eden, a ell a me a e in Canada and he
Uni ed S a e and m e.
A a n ca b n ( n emi i n gene all ) ha he effec f c ea ing incen i e f d ce

ed ce he am n f ll i n he c ea e b cha ing le ll ing e ce ( ch a f il
f el ), and i ch le ll ing echn l gie (al e na i e ene g e ce ). Thi ed ce he
i e f he nega i e e e nali and inc ea e he im m an i f . A a n he f
he ll e d e n ha e hi effec ; i c ec he e all ca i n f e ce he g d, ed cing
he an i f d ced.
Market-based policies III: tradable permits

Tradable permits, al kn n a ca a d ade c e e , a e a lic in l ing e e
i ed fi m b a g e nmen an in e na i nal b d . The e e mi ll e can be aded (b gh
and ld) in a ma ke . C n ide a n mbe f fi m h e d c i n ll e he en i nmen . The
g e nmen g an each fi m a a ic la n mbe f e mi ( igh ) d ce a a ic la le el f
ll an e a gi en ime e i d. The e mi ll e can be b gh and ld am ng in e e ed
fi m , i h he ice f e mi being de e mined b l and demand. If a fi m can d ce i
d c b emi ing a l e le el f ll an han he le el e b i e mi , i can ell i e a
e mi in he ma ke . If a fi m need emi m e ll an han he le el e b i e mi , i can b
m e e mi in he ma ke .
Fig e 5.5(c) h a ma ke f adable ll i n e mi . The l f e mi i e fec l inela ic
(i.e. he l c e i e ical), a i i fi ed a a a ic la le el b he g e nmen ( an in e na i nal
a h i if e e al c n ie a e a ici a ing). F hi lic effec i el ed ce he le el f
ll i n, he al ll i n ha i e mi ed ba ed n he ll i n e mi m be e a e
a f c ea ed e . The fi ed l f e mi i di ib ed fi m . The
i i n f he demand-f - e mi c e de e mine he e ilib i m ice. A an ec n m g and
he fi m inc ea e hei le el , he demand f e mi i likel inc ea e, a h n b he
igh a d hif f he demand c e f m D1 D2. Wi h l fi ed, he ice f e mi inc ea e
f m P1 P2.
T adable e mi a e like a e n emi i n in ha he ide incen i e d ce i ch le
ll ing e ce f hich i i n nece a b e mi . If a fi m find a a ed ce i
emi i n , i can ell i e mi h adding fi . Pe mi a e he ef e in ended ed ce he
an i f ll an emi ed, h ed cing he i e f he nega i e e e nali , and inc ea ing he
im m an i f d ced, b hif ing he MSC c e ad a d MPC, a h n in
Fig e 5.5(b).
T adable e mi cheme ma be e i hin a c n , ch a Ka akh an (2013), S i e land
(2008), Ne Zealand (2008); i hin a g f c n ie ch a he E ean Uni n Emi i n
T ading S em (EU ETS) (2005); in e na i nall ch a he Pa i Ag eemen (2016; ee bel
I e a a a ee e ). T adable e mi a e h l deba ed ge he i h ca b n a e ; ee Real
W ld F c 5.1.
Y ma n e in eading ab adable e mi ha he a e efe ed a an Emi i n T ading
S em (ETS).
Advantages of market-based policies

Ec n mi all efe he ma ke -ba ed l i n g e nmen eg la i n deal i h nega i e
d c i n e e nali ie and e e f c mm n l e ce , a l ng a he a ic la e e nali
e mi he e f ch licie . B h a e and adable e mi ha e he effec f e a e
e e a , meaning ha he c ha e e e i l e e nal a e made in e nal, beca e he a e n
aid f b d ce and c n me h a e a ie he an ac i n.
In he ca e f a e , a e e c a e ca b a ae e a e . Ta e n
nl ide incen i e d ce ed ce he an i f d ced i h a gi en
echn l g and gi en ll ing e ce , b n ed ce he am n f ll i n he c ea e
i ch le ll ing e ce .
Ta e n ll an emi ed ide incen i e fi m ec n mi e n he e f ll ing e ce
( ch a f il f el ) and e d c i n me h d ha ll e le . Fi m d n all face he ame c f
ed cing ll i n; f me, he c f ed cing ll i n a e l e han f he , and he e ill be
he ne m likel c hei ll i n emi i n a id a ing he a . Fi m ha face he highe
c f ed cing ll i n ill be he ne lea likel c hei ll an , and ill a he a .
The e l i ha a a ead e e e a a e ea c c e ince he fi m
ha ill i ch clean f m f ene g a e he ne ha can d i m e chea l .
Simila l , in he ca e f adable e mi , he em c ea e incen i e f fi m c back n hei
ll i n if he can d a ela i el l c . If i i a ela i el l -c ced e f a fi m
ed ce i ll an emi i n , i ill be in i in e e d and ell e ce e mi . Fi m ha can
nl ed ce ll i n a high c ill be f ced b addi i nal e mi . The ef e, b h a e and
adable e mi a e me h d ed ce ll i n m e efficien l (a a l e c ).
Disadvantages of market-based policies

Whe ea a e and adable e mi a e im le in he , in ac ice he a e faced i h n me
echnical diffic l ie . While i i kn n i h a ea nable deg ee f ce ain ha man-made g eenh e
ga e ca e gl bal a ming, he e i emend nce ain in calc la ing he eci e c n ib i n f
each f he e inc ea e in gl bal em e a e . Thi gi e i e diffic l ie in de igning effec i e
ca b n a e and adable e mi cheme .
Taxes
Ta e face e i ac ical diffic l ie ha in l e de igning a a e al in al e he am n f he
ll i n. An effec i e a lic e i e an e he f ll ing e i n :
What production methods produce pollutants? Diffe en d c i n me h d c ea e diffe en
ll an . I i nece a iden if ha me h d d ce hich ll an , hich i echnicall
e diffic l .
Which pollutants are harmful? I i nece a iden if he ha mf l ll an , hich i al
echnicall diffic l , and he e i m ch c n e am ng cien i e he e en f ha m d ne
b each e f ll an .
What is the value of the harm? I i hen nece a a ach a m ne a al e he ha m: h
m ch i he ha m d ne b each ll an h? Thi ai e e i n ha ha e n ea an e :
h ha i ha med; h i he al e f ha m be mea ed?
What is the appropriate amount of tax? I i nece a de e mine he i e f he a make i
e al he al e f he ha m.
How will consumers be affected? Indi ec a e a e e e e (a ill lea n in in Cha e 12)
meaning ha l e inc me e le ha e a a highe i n f hei inc me in a han
highe inc me e le, hich i c n ide ed ine i able ( nfai ).
A ei blem i h ca b n a e i ha he a e all e l make a ignifican im ac .
Acc ding he OECD Sec e a Gene al:
T e f be ee da ca b ce a d e ac a c f e a e
acce ab e. P c ca b c ec a c c e e a d c -effec e a c a e c a e.
We a e a a ee ec e a a -ca b a a d
ec e e e da a a e .2
The ea n i ha i i li icall diffic l im e ca b n a e ha a e high en gh make he
nece a diffe ence.
A ide f m he echnical diffic l ie , he e i al a i k ha e en if a e a e im ed me ll ing
fi m ma n l e hei ll i n le el , c n in ing ll e e en h gh he a a a .
Tradable permits
T adable e mi face he echnical limi a i n ega ding d c i n me h d and ll an n ed ab e
f a e . In addi i n, adable e mi e i e he g e nmen ( in e na i nal b d ) e a ma im m
acce able le el f each e f ll an , called a ca . Thi a k demand ha ing echnical
inf ma i n n an i ie f each ll an ha a e acce able f m an en i nmen al in f ie ,
hich i f en n a ailable. If he ma im m le el i e high, i ill n ha e he de i ed effec n
c ing ll i n le el . If i i e l , he e mi bec me e c l , ca ing ha d hi f fi m
ha need b hem. T da e, adable e mi ha e been de el ed f j a fe ll an (CO2,
SO2).
In addi i n, a me h d m be f nd di ib e e mi ll ing fi m in a fai a . I e f
li ical fa i i m ma c me in la , a g e nmen gi e efe en ial ea men hei f iend
and e .
In ac ice, he m ha can be h ed f i a hif f he MPC c e a d he MSC c e, a ell
me ed c i n in he i e f he e e nali , b i i nlikel ha he e licie can achie e he imal
e l .

Carbon taxes versus tradable permits: how to best limit carbon dioxide emissions
The e i a g ing m men m a nd he ld im lemen ca b n icing in me f m. A f
2019 e 60 c n ie , a e ci ie had im lemen ed me f m f ca b n icing, ei he h gh
ca b n a e h gh adable e mi . A e f e le in fi e c n ie (A alia, India, S h
Af ica, he Uni ed Kingd m and he Uni ed S a e ) f nd ha be een 60% (in he Uni ed S a e ) and
80% (in India) ed ca b n a e ided he e e e n a gl bal cale and he e en e e e
e ned he e le en n clima e jec .
Figure 5.6: Kli en, Ge man . Ligni e-fi ed e ai n
H e e , ca b n icing emain n la am ng b h c n me and b ine e . B ine e a e

f en ed beca e i ai e he c f d c i n. O he a ha i i nfai in he e en ha
he ade i h c n ie ha d n ha e ca b n icing. In A alia, a ca b n a a e ealed in
2014 n he g nd ha i a de ing j b . I i f en ed b c n me beca e i ha he
effec f ai ing ice . I ha a nge effec n he beca e i ai e h eh ld ene g ice .4
A ma ke -ba ed me h d ed ce emi i n , b h ca b n a e and adable e mi ide
incen i e fi m i ch le ll ing f m f ene g . H e e , a e ha e een he diffe
in h he a em d hi . Ca b n a e fi he ice f he ll an in he f m f a a n
ca b n and all he an i f ca b n emi ed a , de ending n h fi m e nd he a ;
ca and ade cheme fi he an i f he e mi ible ll an , and all i ice a ,
de ending n l and demand.
Carbon taxes versus tradable permits: an evaluation
Carbon taxes make energ prices more predictable. F il f el ice in gl bal ma ke
fl c a e acc ding demand and l . Unde adable e mi , he ice f f il f el migh
fl c a e e en m e d e fl c a i n in he ice f ca b n e mi . P ice edic abili i
im an f b ine e ha need lan hei c ahead f ime.
Carbon taxes are easier to design and implement. T adable e mi a e diffic l de ign and
im lemen a he in l e c m lica ed deci i n ch a e ing he ca a he igh le el and
di ib ing he e mi am ng all in e e ed e .
Carbon taxes can be applied to all users of fossil fuels. T adable e mi cheme f en a ge
ne a ic la ind , mall g f ind ie . Ca b n a e can be a lied all e f
f il f el , incl ding all d ce and c n me .
Carbon taxes do not offer opportunities for manipulation b governments and interest
groups. P li ician f en efe adable e mi cheme ca b n a e , and i i belie ed ha
hi ma be beca e i i ea mani la e he di ib i n f e mi f he benefi f
efe ed g and e , ih affec ing he im ac n he en i nmen (beca e f
he ca ).
Carbon taxes do not require as much monitoring for enforcement. T adable e mi cheme
e i e m ni ing f emi i n , he i e fi m ma chea b emi ing m e ll an
han he a e e mi ed. Ca b n a e a e ea ie m ni a he nl in l e a men fa a
de ending n he e and an i f f il f el cha ed.
Tradable permit schemes face political pressures to set the cap too high. If he ca n
ll an i e high, i ld ha e a e limi ed n im ac n ed cing ca b n
emi i n .
The e a e al me a g men again ca b n a e and in fa f adable e mi cheme :
Carbon taxes face political pressures to be set too low. G e nmen ma be n illing e
ca b n a e high en gh f he e ide he nece a incen i e f e i ch le
ll ing ene g ce .
Carbon taxes cannot target a particular level of carbon reduction. Since ca b n a e cann
fi ( ca ) he e mi ible le el f ca b n emi i n , he lead nce ain ca b n- ed cing
c me .
Carbon taxes are regressive. A eg e i e a i ne he e he a a a f ac i n f inc me i
highe f l -inc me ea ne han i i f highe -inc me ea ne , and g again he inci le
f e i ( ee Cha e 12). A ca b n a n a fi m i an indi ec a ha i aid a l b
d ce and a l b c n me . The ef e, c n me ld al be affec ed, and l e -
inc me c n me ld be affec ed i na el m e.
Appl ing our skills
1 C m a e and c n a me ke i e nding he deba e n ca b n a e e ca and
ade cheme .
2 The W ld Bank eg la l da e he f ll ing i e i h inf ma i n n ca b n icing (ca b n
a e adable e mi ) ha c n ie a nd he ld a e ei he im lemen ing lanning
im lemen . Selec ne m e c n ie f ch ice and in e iga e he ca b n icing ha
ha been elec ed. Re ea ch he e e ience f c n c n ie i h e ec (a)
li ical acce abili , (b) effec i ene i h e ec ed cing ca b n emi i n , (c) an f e
lan f ackling he ca b n emi i n blem.
Sources: Ca b P c Da b a d
Government legislation and regulation

G e nmen legi la i n and eg la i n el n he c mmand a ach, he e he g e nmen e i
a h i enac legi la i n and eg la i n in he blic in e e ( ee Cha e 1 f a di c i n f
c mmand deci i n-making).
Legi la i n and eg la i n in ended ed ce he effec f d c i n e e nali ie and limi
en i nmen al damage icall in l e emi i n anda d , a , licence , e mi igh
e ic i n . E am le incl de:
e ic i n n emi i n f ll an f m fac ie and ind ial d ci n b e ing a
ma im m le el f ll an e mi ed
e i emen f eel mill and elec ici gene a ing lan in all m ke ack c bbe
ed ce emi i n
banning he e f ha mf l b ance (e.g. a be ,ag f mine al ha a e e ic ha i
banned in man c n ie )
i ing licence e mi f a ic la ac i i ie ( ch a h n ing)
hibi ing c n c i n ( ch a h ing) ind ag ic l e in ec ed a ea
e ic i n n he an i f l gging
e ic i n in he f m f a f fi hing (ma im m e mi ible an i f fi h ha can be
ca gh ) in he f m f he i e f hi ing flee , al ban f ecific a ea ecific ime
f he ea
e abli hmen f ec ed a ea f he ec i n f bi di e i and endange ed ec em .
The im ac i l e he an i f he g d d ced and b ing i cl e Q in Fig e 5.7 b
hif ing he MPC c e ad a d he MSC c e. P ll an and e ic i n achie e hi b
f cing he fi m d ce le . Re i emen in all echn l gie ed cing emi i n achie e hi b
im ing highe c f d ci nd e he cha e f he n n- ll ing echn l gie . Ideall , he
highe c f d ci n ld be e al he al e f he nega i e e e nali . The g e nmen
lic bjec i e i make he MPC c e hif a d n il i c incide i h he MSC c e, in hich
ca e Q i d ced, ice inc ea e f m Pm P , and he blem f e all ca i n f e ce
he d c i n f he g d i c ec ed. If ll ing fi m d n c m l i h he eg la i n , he ld
ha e a fine .
Figure 5.7: G e nmen eg la i n c ec nega i e d c i n e e nali ie and m e

ainable e f c mm n l e ce
Advantages
Legi la i n and eg la i n , incl ding e ic i n ch a in he e am le ab e, ha e he ad an age ha
he a e im le in effec and e ee. The a e ea ie im lemen c m a ed ma ke -ba ed
lice and a id he echnical diffic l ie ha a i e in he e f ma ke -ba ed l i n . The can al
be i e effec i e. F e am le, banning ha mf l b ance , hibi ing h n ing in ce ain a ea ,
e ic ing he an i f l gging (ch ing d n ee ) ma be he m effec i e a deal i h
ce ain blem . M e e , eg la i n f ce fi m c m l and ed ce hei ha mf l ac i i ie ( hich
ma ke -ba ed licie ma n al a d ). F he e ea n , eg la i n a e fa m e c mm nl ed a
a me h d limi nega i e e e nali ie f ll i n in c n ie a nd he ld.
Disadvantages
H e e , he al face limi a i n . In he ca e f emi i n f ll an , he d n ffe incen i e
ed ce emi i n b ing le ll ing e ce , inc ea e ene g efficienc and i ch
al e na i e f el . The cann di ing i h be een fi m ha ha e l e highe c f ed cing
ll i n, hich ld limi he e all c f ed cing ll i n (e lained ab e). The e l i ha
ll i n i ed ced a a highe e all c .
In addi i n, al h gh he can be im lemen ed m e ea il , he ffe f m imila limi a i n a he
ma ke -ba ed licie (lack f fficien echnical inf ma i n n e and am n f ll an
emi ed), and can in m ca e be nl a iall effec i e in ed cing he ll i n c ea ed. Finall ,
he e a e c f m ni ing and e i i n de ec ible i la i n , leading ni c ,
and he e ma be blem i h enf cemen . The ef e, ch mea e can nl a em a iall
c ec he blem.
O e all, he effec i ene f legi la i n m be a e ed in ela i n he a ic la ef hich i i
in ended, a i can be m e effec i e in me i a i n han in he .
C ec i n f nega i e d c i n e e nali ie b ma ke -ba ed a ache g e nmen legi la i n

and eg la i n all in l e hif ing he MPC c e ad a d he MSC c e h gh a
a ie f licie . F all ca i e efficienc be achie ed, he an i f he g d d ced and
c n med m fall Q a ice inc ea e P . 5
Collective self-governance: the contribution of Elinor Ostrom

The c nce f collective self-governance efe a l i n he e f c mm n l e ce
he e he e ake c n l f he e ce and e hem in a ainable a . Thi c nce n
c ne he idea f he a ed f e c , di c ed ab e, he e each e make e f he
e ce a he e en e f he i h he e l l ima el deg ade and de le e i .
C llec i e elf-g e nance, a he e m gge , i n a lic ha i im ed b he g e nmen . I i
a he an a ach manage e ce nde aken b c mm ni ie f e ce e b hem el e ,
beca e he eali e ha i i in hei n be in e e k c llec i el f he e e a i n f
e ce ha a e i al hei li elih d.
C llec i e elf-g e nance a an a ach c mm n l e ce a made fam b Elin
O m, an Ame ican li ical cien i h became he fi man ecei e he N bel P i e in
Ec n mic (2009) f he k n he managemen f c mm n l e ce . O m en decade
d ing h c mm ni ie gani e hem el e manage c mm n e ce ch a fi h ck ,
d , lake , a e and g nd a e ba in . She di c e ed ha c mm ni ie f en de el c m le
mechani m n h make deci i n and h enf ce le , e l ing in c me ha diffe idel
f m h e edic ed b anda d ec n mic he . In an in e ie in 2010, he aid:
If ae af e a ea a ea d fa - e be ef a
d de ,a d f ca a e e e e e a e ce, e a e
f e e a f a ca e a d a e e f ce e . B f e c d e
a ea d a fc ca eac e ec f e f- a a ae ,
e a e, a d e e be fa e . 6
O m and he c lleag e e f med h nd ed f e e imen , hich h ha hen e le a e e

f a c mm n l e ce, he a e f en able find l i n n h manage i ainabl ,
ih e ing and de ing i , ded e a e d e d fc ca be ee e .7
The make le ab h each e h ld beha e and c n ib e he managemen f he e ce,
and le f enf cemen and anc i n again h e h i la e he le . Man die b O m and
he ch la f eal-life i a i n , in l ing he managemen f c mm n l e ce , c nfi m he
e l f he e e e imen .
H e e , ne e i emen f ainable e ce managemen i ha he e m be b nda ie f an
a ea ( ch a a a e, a d a lake, and n) c e nding he a ea ha he e ce e a e
managing. Thi ai e he e i n he he O m a ach i i able f dealing i h gl bal
blem ch a he cean and clima e change. She he elf n e he f ll ing:
I ea de a e e cea . . . I e a ec a a d c a ef
ca a d e e .W e b b a ca d a.I ec d e ad
a be ,b e ea e a e a e f d a.
Advantages
Elin O m k ha h n ha e le d n al a ac in he elf-in e e ed, na manne
e ed b he aged f he c mm n . In ead, b king c e a i el , e le can find
l i n he blem f e e f c mm n l e ce i h -d n l i n im ed b
g e nmen . The e c e a i e l i n can be achie ed in he ab ence f i a e ne hi f
e ce (em ha i ed b e f f ee ma ke ec n mie he e hi i an e en ial cha ac e i ic)
a ell a in he ab ence f g e nmen - ned e (em ha i ed b e f c mmand
lanned ec n mie ; ee Cha e 1 f he e di inc i n ). H e e , i i im an ha e a legal em
f a d in lace ( ee Cha e 19 and 20).
Disadvantages
F e le be able manage c mm n l e ce n hei n he e a e im an c ndi i n
ha m be a i fied, he m be able c mm nica e i h each he in de c ea e le f he
e f he c mm n l e ce , and he e m be a b nda f he e ce. A O m he elf
admi hi i diffic l f e ce ch a he cean .
Education and awareness creation

Ed ca i n f he blic and i i n f inf ma i n ega ding he ll ing ac i i ie f fi m ( he
ac i i ie i h nega i e e e nal effec ) f en make c n me n a a f m he d c , ih
nega i e effec n he fi m ale . A a e l he fi m a e f ced ake c n me ini n in
c n ide a i n and change hei d c i n me h d in de ed ce he e e nali ie .
Advantages
The ad an age he e i ha fi m a e e m ch infl enced b he ini n f hei c me and an
kee hem ha , he i e he ill ffe d in ale .
Disadvantages
The diffic l i h hi a ach i ha i can nl make a mall diffe ence in e m f l ing he
blem f d c i n e e nali ie and ainabili . F e am le, if he e i inf ma i n ab a fi m
c ea ing ignifican en i nmen al damage in a l cali ed a ea ( ch a ca ing an il ill ha affec he
li elih d and heal h f he l cal inhabi an ), c n me ma bec me c nce ned and b c he fi m
f a hile. H e e blem f a m e gene al and b ade na e, ch a he e f f il f el ha
ca e clima e change l a h f he en i nmen al blem , e i e l i n n a fa b ade
cale. In fac ca b n a e and adable e mi (di c ed ab e) a e fa m e effec i e in ackling
blem f hi kind.
International agreements
P licie a e made mainl b na i nal g e nmen . H e e , nega i e d c i n e e nali ie and he
e e f c mm n l e ce e f en ha e in e na i nal e e c i n , in hich ca e c -
e a i n am ng g e nmen and in e na i nal ag eemen a e c ciall im an c n l and
e en nega i e c n e ence n ce ain e ce , ch a he gl bal clima e and he ne la e . In
addi i n, c - e a i n am ng g e nmen i e im an f he de el men and diff i n f ne
echn l gie in ended deal i h gl bal en i nmen al i e . C - e a i n be een g e nmen ma
be gl bal egi nal.
F e am le, he ne la e ha ffe ed ne de le i n, leading ed ced ec i n again he
n l a i le adia i n. Thi e l ed f m h man ac i i ie in l ing he d c i n f ni gen
ide and chl fl ca b n (CFC ). The ne la e i a c mm n l e ce. N ne n i ,
and n ne can claim damage f i de c i n. The e n ibili f i de c i n lie i h
ll ing ac i i ie i hin i all e e c n , and he c n e ence f i de c i n a e fel
gl ball . The ame c n ide a i n a l he gl bal clima e.
One f m cce f l e am le f in e na i nal c llab a i n f he en i nmen i he M n eal
P c l, igned in 1987 and c ming in effec in 1989, in ended ha e b ance ha ha e
ca ed de le i n f he ne la e . B 2009, all membe a e f he Uni ed Na i n had a ified he
ag eemen , and ignifican g e ha been made in he a ea f ha ing ne-de le ing
b ance .
An he cce f l e am le f a egi nal c llab a i e a angemen i he E ean Uni n adable
e mi cheme f ca b n, kn n a he E ean Uni n Emi i n T ading S em (EU ETS), hich
a ini ia ed in Jan a 2005. The cheme c e he ec f e and hea gene a i n, il efine ie ,
me al , l and a e , and ene g in en i e ind . In hi em, ne e mi , EU All ance
(EUA) e mi he h lde elea e ne nne f ca b n di ide. Each emi e f ca b n i all ca ed
EUA , hich a e aded in a a idl g ing ca b n ma ke . The EU ETS i he c ne ne f he
E ean Uni n lic n clima e change. Acc ding a maj d , hile hi ha hel ed in
ed cing ca b n emi i n i ha n had nega i e im ac n he ec n mic e f mance f fi m in
e m f e en e , fi and em l men .8
An he maj , b le cce f l in e na i nal ag eemen f he en i nmen a he K P c l
f 2005 2012. I bjec i e a make igna c n ie c mmi hem el e ed ce emi i n f
ca b n di ide and he g eenh e ga e l d n clima e change. I al c n ained ii n f
he de el men f a ma ke f adable emi i n e mi . The c n ie ha igned e e di ided in
de el ed and de el ing. Onl he de el ed c n ie had emi i n e ic i n . The de el ing
c n ie a ici a ed b in e ing in jec ha e e ed l e hei emi i n . The Uni ed
S a e , hich a he c n i h he highe g eenh e ga emi i n , did n ign he K
c l n he g nd ha i a facing nfai c m e i i n ince de el ing c n ie did n face
e ic i n . China, he ec nd highe g eenh e emi e , did n a ici a e a i a n in he g
f de el ed c n ie . Man en i nmen al eciali a g ed ha he ag eed ed c i n in emi i n
ee mall ha e fficien im ac n he blem f gl bal a ming.
In 2016, he Pa i Ag eemen came in effec , ini iall igned b 55 a ie , hich eached 197 b 2019.
The e f he ag eemen i eng hen in e na i nal c - e a i n n clima e change, ba ed n he
g al f limi ing he gl bal em e a e inc ea e 1.5%. In addi i n i aim inc ea e he abili f
c n ie ada nega i e effec f clima e change. I e abli he binding ag eemen n all a ie
e mea e d me icall ha ill ed ce g eenh e emi i n . C n ie a e f ee e
mea e f hei ch ice b a ge f emi i n ed c i n m be m e ambi i han ea lie ne .
The membe ha e ag eed ack hei g e and e hi each he , c - e a e and
ide f clima e ac i n de el ing c n ie . In J ne 2017, he Uni ed S a e ann nced i
in en i n i hd a f m he Pa i ag eemen i h N embe 2020 he effec i e da e f i hd a al.

1 F each f he e am le ided in e i n 2(a) in Te nde anding 5.4, a e and
e lain me me h d( ) ha c ld be ed c ec he e e nali .
2 O line he h ee e f ma ke -ba ed licie ha can be ed c ec a nega i e d ci n
e e nali .
3 U ing a diag am, h h a nega i e d c i n e e nali c ea ed b he e ff il f el
can be c ec ed b e f
a a e n ,
b a e n emi i n ,
c adable e mi , and
d legi la i n and eg la i n.
e Di c me ad an age and di ad an age f each f he e e f lic mea e.
4 a O line he meaning f and iden if licie ha in e nali e an e e nali .
b C m a e and c n a ma ke -ba ed me h d and c mmand me h d ( ch a legi la i n
and eg la i n ) deal i h nega i e d c i n e e nali ie .
c Iden if me diffic l ie ha g e nmen face in de igning ma ke ba ed me h d .
5 a Define c llec i e elf-g e nance and di c hi a a me h d deal i h e e f
c mm n l e ce .
b O line me ible limi a i n ha hi a ach face .
E lain h a e n emi i n ch a ca b n a e and adable e mi a e imila ih
6 a e ec hei bjec i e . (H : hink ab incen i e .)
b De c ibe h he diffe f m a e n f he fi m c ea ing nega i e e e nali ie .
c Iden if he lic ha i efe able f m he in f ie f ed cing he e e nal c f
a nega i e d c i n e e nali : a a n a a n emi i n .
7 U ing e am le , e lain nde ha ci c m ance in e na i nal c - e a i n am ng
g e nmen i e en ial f he e e a i n f he en i nmen .

Effects of pesticides on bees
A e icide kn n a lf afl i idel ed kill in ec in ag ic l e. In 2013 i a a ed
b he En i nmen al P ec i n Agenc (EPA) be ed in he Uni ed S a e . H e e , a
lf afl a kn n be ic bee , he EPA ec mmended ha i h ld n be ed hen
c a e fl e ing, hich i hen he a ac bee .
S n af e , a n mbe f beekee ing g ed he EPA a g ing ha he e f lf afl ld
en he blem f he declining bee la i n. A a e l , a US fede al (na i nal) c
cancelled he EPA a al f lf afl n he g nd ha he e a in fficien e idence ha i
a n ha mf l bee . In 2015 he EPA ed all ing he ale f lf afl in he Uni ed
Sae .
H e e , in 2016, he EPA ea ed he e f lf afl , b e cl ded c ha a e a ac i e
bee and ha fl e a a i ime h gh he ea . In addi i n, he EPA all ed he m e
gene al e f lf afl n an eme genc ba i . The EPA ha he a h i g an ch
e em i n e en f e icide ha a e n fficiall a ed, in he e en f a dden a ea ance f
in ec ha damage c .
In he e i d 2017 2018, he EPA a ed m e han 100 eme genc e em i n f lf afl .
In 2018, i a ed n e 16 milli n ac e f fa mland f c n and gh m al ne.
Ye i i ell kn n ha he e f lf afl i ha mf l bee , i h e i c n e ence f hei
e d c i e abili ie . Acc ding a eni cien i a he Cen e f Bi l gical Di e i , S a ing
16 milli n ac e f bee-a ac i e c i h a bee-killing e icide in a ime f gl bal in ec decline i
*
be nd he ale . . . The EPA i inel mi ing he eme genc ce ge lf afl
a ed beca e i ic make i h gh n mal e icide e ie .
Acc ding a d bli hed in he j nal B ca C e a , he e i a dange decline
a nd he ld in m e han 40% f in ec ecie and ne hi d a e endange ed. The a e f
e inc i n f in ec i eigh ime fa e han ha f mammal , bi d and e ile . The ca e i
in en i e ag ic l e and e eciall he hea e f e icide .
Figure 5.8: Dead bee ha died b e icide
* Thi h a e mean nacce able, in le able, age

Sources: Ec Wa c ; A e ca C e ca S c e ; T e G a d a
Appl ing our skills
1 The e inc i n f in ec e e en a l f biodi ersit , hich i a c mm n l e ce.

Di c h he c nce f i al and n n-e cl dabili can be ed e lain de le i n f hi
e ce d e he hea e f e icide .
2 a U ing a diag am e lain ha kind f e e nali i in l ed in he ca e f he ha m being
ca ed bee .
b Iden if and e al a e licie ha c ld be ed deal i h hi e e nali .
c U ing a diag am, h h hi lic c ld k c ec he e e nali .

Economic thinking on sustainabilit and Elinor Ostrom, winner of the 2009 Nobel Pri e in
Economics
In d f ainabili , e ha e een ha in ec n mi a f hinking, en i nmen al
de c i n i anal ed in e m f nega i e e e nali ie . In he ca e f c mm n l e ce , hei
e e i im l he e e a c f e le dina an ac i n ha d n ake acc n f
c n e ence n he en i nmen . In he d , he de ci n f he en i nmen i me hing
ha i h gh f a being de e a e e fe e .
An im an ea n f hinking hi a ab he en i nmen i ha mic ec n mic he i
ba ed n he ideali ed and fic i nal ld f e fec ma ke i h n fail e , d i en b ec n mic
deci i n-make h make ch ice acc ding hei be elf-in e e , e nding ice a
ignal and incen i e , all f hich lead ma im m cial elfa e.
Ec n mi nde anding f e e nali ie a he di e gence be een i a e and cial c and
i a e and cial benefi i ba ed n j hi a m i n f na elf-in e e : c n me and
fi m c n me and d ce aking nl hei n i a e in e e in acc n , ign ing ible
e e nal c ha hei ac i n gi e i e . E e nal c a i e beca e c e a d d ce a e
a ed be a e a a e e ee f c e a a e.
The main ca eg ie f mea e deal i h en i nmen al e e nali ie e di c ed,
g e nmen eg la i n and ma ke -ba ed licie , a e b h ba ed n hi a m i n ab elf-
in e e ed beha i . Reg la i n e he c mmand a ach f ce d ce and c n me
ed ce he e e nal c f hei elf-in e e ed ac i n , and ma ke -ba ed licie c ea e ice
incen i e ha b ing he elf-in e e ed beha i f ec n mic deci i n-make in line i h
cie be in e e .
Ye all hi ai e me in e e ing e i n . D e i make en e ie en i nmen al de c i n
el a he b - d c f e le indiffe ence a d he en i nmen beca e he a e elf-
in e e ed being ? A e he e i a i n hen e le d n di la he na elf-in e e ed
beha i a med b anda d ec n mic he ? If , ha a e he im lica i n , and ha ld be
he a ia e lic e n e ?
The e a e he kind f e i n ed b Elin O m, h n he N bel P i e in Ec n mic
(2009) f he k n he c llec i e elf-g e nance f c mm n l e ce (di c ed ab e).
In ne f he maj k ,O m i e ha he cen al e i n
a f c a ae a e de e de a ca a ea d e
e e e ba c be ef e a face e a f ee- de, ,
e e ac ca . 9
A di c ed in he e , O m h nd ed f e e imen h ha e le can find l i n
managing e ce ainabl b making le ega ding hei beha i and managemen f he
c mm n l e ce ha m be f ll ed b e e ne. He finding d n n en i el c n e
he c ncl i n f anda d ec n mic he , ince lack f g d me h d f c mm nica i n
be een e le d e l in he fail e e died in hi cha e . H e e , he finding de a f m
anda d ec n mic he in a e im an e ec : he ha f nd ha e e fa e a e
e ab e, beca e a i nal ec n mic beha i d e n al a mean ac ing in ne n be elf-
in e e ; i f en mean ac ing in ha i in he be e e . Thi kind f ac i n a i e a a
e l f in i i n ha e mi c mm nica i n be een he e ce e , leading binding
ag eemen , i h m ni ing and enf cemen le ha en e ainable e ce e.
O m c ncl i n f c n he in ha e le f en beha e c - e a e a e a
c e e , and hi ha e im an lic im lica i n . S me ime , he be me h d f
e e ing c mm n l e ce i b all ing he e ce e hem el e manage hem,
a he han h gh cen ali ed g e nmen in e fe ence. When he c ndi i n f c - e a i e
l i n a e e en , he g e nmen le h ld be m e in i i n ha enable he e
manage he e ce, ch a a c em f e l ing di e and in i i n ha ide
cien ific kn ledge f e ce managemen . Of en, hi in l e ec gni ing ha l cal c -
e a i e in i i n ma be ei in i i n ha a e im ed n e le f m ab e f m
ide.
If decide ead f he ab O m k, ill find ha he e he e m c mm n l
e ce ; he ch la e c mm n e e ce . B h he e e m mean c mm n l
e ce ha a e g e ned b a e f le .
Thinking points
H eali ic d hink i he a m i n ha ec n mic deci i n-make a e m i a ed b
a i nal elf-in e e in making ec n mic deci i n ?
Man ec n mi a g e ha e en if a i nal elf-in e e i n a eali ic a m i n, i d e n
ma e a l ng a he edic i n f a he fi i h ha ha en in he eal ld ( ee al
The f kn ledge 7.1). Wha d e O m k ell ab hi e ec i e?
If e le me ime beha e c - e a i el a he han c m e i i el , ha a e he im lica i n
f he idea ha en i nmen al de c i n i ca ed b e e nali ie ?
O m gge ha man e le ld change hei beha i if he nde d ha ce ain
ch ice ld be in hei n be in e e a ell a in cie be in e e (f e am le,
biking a he han ing a ca ). B man e le ma n kn ab ch j in e nal and
cial benefi . Wha can be d ne ab hi ?
2 OECD, Fe c n ie a e icing ca b n high en gh mee clima e a ge
3 Ec n mi find a gl bal a n ca b n ma be fea ible
4 Wh P icing Ca b n I S ill M e The Than Reali
5 See Q an i a i e echni e cha e in he 'Digi al c eb k: E a ma e ial' ec i n f an e lana i n f

he e i alence f a d and lef a d hif f he l c e.
6 In e ie i h Elin O m, b F an K en, , 27 Feb a 2010.
7 The e e imen a e ca ied a he W k h in P li ical The and P lic Anal i a Indiana Uni e i
he e O m a a fe .
8 O gani a i n f Ec n mic C - e a i n and De el men
9 Elin O m (1990) G e eC :T eE fI f C ec e Ac , Camb idge

Uni e i P e .
5.4 Negative consumption externalities
LEARNING OBJECTIVES
Af e d ing hi ec ion, o ill be able o:

e plain nega i e e e nali ie of con mp ion and he e l ing elfa e lo (AO2)
d a a diag am ill a ing nega i e e e nali ie of con mp ion and elfa e lo (AO4)
e plain he meaning of deme i good (AO2)
calc la e elfa e lo ha a i e f om nega i e e e nali ie of con mp ion (HL onl ) (AO4)
e plain go e nmen in e en ion o co ec nega i e e e nali ie of con mp ion: (AO2)
indi ec (Pigo ian) a e
legi la ion and eg la ion
ed ca ion and a a ene c ea ion
n dge (HL onl )
d a diag am o ill a e he abo e go e nmen e pon e (AO4)
di c eng h and limi a ion of he abo e go e nmen policie i h e pec o: (AO3)
diffic l ie in mea emen of e e nali ie
deg ee of effec i ene
con eq ence fo akeholde
Explaining and illustrating negative consumption externalities

Negative consumption externalities efe o e e nal co c ea ed b con me . Fo e ample, hen
con me moke in p blic place , he e a e e e nal co ha pill o e on o ocie in he fo m of
co o non- moke d e o pa i e moking. In addi ion, moking- ela ed di ea e e l in highe han
nece a heal h ca e co ha a e an addi ional b den pon ocie . When he e i a con mp ion
e e nali , he ma ginal p i a e benefi (demand) c e doe no eflec ocial benefi . In Fig e 5.9,
he b e of ciga e e ha e a demand c e, MPB, b , hen moking, c ea e e e nal co fo non-
moke . The e co can be ho gh of a nega i e benefi , hich he efo e ca e he MSB c e o
lie belo he MPB c e. The e ical diffe ence be een MPB and MSB ep e en he e e nal co .
No e ha ince he e e nali in ol e con mp ion (i.e. he demand c e), he ppl c e ep e en
bo h ma ginal p i a e co and ma ginal ocial co . The ma ke de e mine an eq ilib i m q an i , Q
m, and p ice Pm, gi en b he in e ec ion of he MPB and MPC c e , b he ocial op im m i Q op
and Pop , de e mined b he in e ec ion of he MSB and MSC c e .
O he e ample of nega i e con mp ion e e nali ie incl de hea ing home and d i ing ca b e of
fo il f el ha poll e he a mo phe e.
When he e i a nega i e con mp ion e e nali , he f ee ma ke o e alloca e e o ce o he

p od c ion of he good, and oo m ch of i i p od ced ela i e o ha i ociall op im m. Thi i
ho n b Qm > Qop and MSC > MSB a Qm in Fig e 5.9.
In gene al, nega i e e e nali ie , he he he e a i e f om p od c ion o con mp ion ac i i ie , lead
o alloca i e inefficienc a i ing f om an o e alloca ion of e o ce o he good and o i
o e p o i ion.
Figure 5.9: Nega i e con mp ion e e nali
The welfare loss of negative consumption externalities

Welfare loss
The elfa e lo e l ing f om nega i e con mp ion e e nali ie i he haded a ea in Fig e 5.10(a)
and ep e en he ed c ion in benefi fo ocie d e o he o e alloca ion of e o ce o he
p od c ion of he good. Fo all ni of o p g ea e han Q op , MSC > MSB, indica ing ha oo m ch
of he good i p od ced. The elfa e lo i eq al o he diffe ence be een he MSC and MSB c e
fo he amo n of o p ha i o e p od ced ela i e o he ocial op im m (Q m Q op ). I ep e en
he lo of ocial benefi f om o e p od c ion d e o he e e nali . If hi e e nali e e co ec ed,
ocie o ld gain he benefi ep e en ed b he haded a ea. No e ha , once again, he poin of he
elfa e lo iangle lie a he Q op q an i of o p (a in he ca e of nega i e p od c ion
e e nali ie ).
Calculating welfare loss (HL only)

Fig e 5.10(b) i he ame a pa (a) onl i h fig e o e can calc la e elfa e lo . The a ea of
he haded iangle i he heigh ime he id h of he iangle di ided b 2. No e ha he heigh of
he iangle i eq al o he e e nal co pe ni , o MPB MSB, and he id h i eq al o he amo n
of o e p od c ion b he ma ke o Q m Q op :
Welfa e lo = (6 4) (100 70) 2 = 2 30 2 =$30
Welfare loss in relation to consumer and producer surplus (Supplementary

material)
Fig e 5.10(c) ho ho he elfa e lo of a nega i e con mp ion e e nali i ela ed o con me
and p od ce pl and he e e nal co . In ma ke eq ilib i m, con me pl i eq al o he a ea
a + b, hile p od ce pl i eq al o he a ea c + d + f. The co of he e e nali i ep e en ed b
a + d + e (i i he diffe ence be een he MPB and MSB c e p o Q m). The o al ocial benefi a e
he efo e con me pl pl p od ce pl min he e e nal co :
(a + b) + (c + d + f) (a + d + e) = b + c + f e
A he ocial op im m, con me pl i eq al o b + c, and p od ce pl i eq al o f, hile
e e nal co a e e o. The efo e, he o al ocial pl i eq al o p od ce pl con me pl :
b+c+f
Compa ing he o al ocial benefi a ma ke eq ilib i m and a he ocial op im m, e ee he a e
malle a ma ke eq ilib i m b he a ea e, hich i he elfa e lo .
Figure 5.10: Welfa e lo in a nega i e con mp ion e e nali
The case of demerit goods
Demerit goods a e good ha a e con ide ed o be nde i able fo con me , b hich a e
o e p o ided b he ma ke . E ample of deme i good incl de ciga e e , alcohol and gambling. One
impo an ea on fo o e p o i ion i ha he good ma ha e nega i e con mp ion e e nali ie , in
hich ca e he ma ke o e alloca e e o ce o i p od c ion. Thi co ld occ beca e of con me
igno ance abo i nega i e effec o indiffe ence: con me ma no be a a e of he ha mf l effec
pon o he of hei ac ion , o he ma no ca e.
Negative consumption externalities and overuse of common pool

resources
O e e of common pool e o ce i een a e l ing mo e f om p od c ion ac i i ie han
con mp ion ac i i ie , he efo e ela ing mo e o nega i e p od c ion a he han con mp ion
e e nali ie . Ho e e , o e e of common pool e o ce al o e l f om nega i e con mp ion
e e nali ie , ho n in Fig e 5.9. Take he demand fo hea ing oil, ep e en ed b he demand c e
MPB. The o e e of clean ai ( he common pool e o ce) i he e e nal co ha ca e he ma ginal
ocial benefi c e (MSB) o lie belo he MPB c e. The ame applie o he e of ca ha n on
ga oline (pe ol). Mo e impo an l , ai a el i a con mp ion ac i i ha e l in ignifican and
apidl inc ea ing g eenho e ga e ha ca e global a ming. The e ac i i ie on he pa of con me
e l in o e e of he common pool e o ce of clean ai , e io l h ea ening he abili of he
global clima e.

1 a U ing a diag am, ho ho ma ginal p i a e benefi and ma ginal ocial benefi diffe
hen he e i nega i e con mp ion e e nali .
b E plain he diffe ence be een he eq ilib i m q an i de e mined b he ma ke and he
q an i ha i op imal f om he poin of ie of ocie p efe ence .
c De c ibe he p oblem i h he alloca ion of e o ce achie ed b he ma ke hen he e i
a nega i e con mp ion e e nali .
d Sho he elfa e lo c ea ed b he nega i e con mp ion e e nali in o diag am, and
e plain ha hi mean .
2 P o ide ome e ample of nega i e con mp ion e e nali ie .
Policies to correct negative consumption externalities and prevent

overuse of common pool resources
Market-based policies
A ke ma ke -ba ed polic o co ec nega i e con mp ion e e nali ie (incl ding deme i good )
in ol e he impo i ion of indi ec Pigo ian a e , a in he ca e of nega i e p od c ion e e nali ie .
Indi ec a e can be impo ed on he good ho e con mp ion c ea e e e nal co (fo e ample,
ciga e e and pe ol/ga oline).
The effec of an indi ec a a e ho n in Fig e 5.11(a). When ch a a i impo ed on he good
ho e con mp ion c ea e he e e nal co , he e l i a dec ea e in ppl and an p a d hif of he
ppl c e f om MPC o MPC + a . If he a eq al he e e nal co , he MPC + a c e in e ec
MPB a he Q op le el of o p , and q an i p od ced and con med d op o Q op . (The demand
c e doe no hif b emain a D = MPB.) Qop i he ociall op im m q an i , and p ice inc ea e
f om Pm o Pc . The a he efo e pe mi alloca i e efficienc o be achie ed.10
Advantages and disadvantages
A i h nega i e p od c ion e e nali ie , economi p efe ma ke -ba ed ol ion o he p oblem of
nega i e con mp ion e e nali ie , a long a he i a ion pe mi he e of ma ke -ba ed polic .
The efo e, indi ec a e a e he p efe ed mea e, a he in e nali e he e e nali (a in he ca e of
nega i e p od c ion e e nali ie ). B changing ela i e p ice , indi ec a e c ea e incen i e fo
con me o change hei con mp ion pa e n ; he good ha i a ed become ela i el mo e
e pen i e and con mp ion i ed ced.
Ho e e , he e a e a n mbe of diffic l ie in hi app oach. The fi in ol e diffic l ie in mea ing
he al e of he e e nal co . Take, fo e ample, he ca e of pa i e moking, an e e nal co c ea ed
b moke , o he ca e of pe ol (ga oline) con mp ion, hich c ea e e e nal co in he fo m of
en i onmen al poll ion. The e a e man echnical diffic l ie in ol ed in ing o a e ho and ha
i affec ed, a ell a o de e mine he al e of he e e nal co , on he ba i of hich a a can be
de igned.
Figure 5.11: Co ec ing nega i e con mp ion e e nali ie
A f he diffic l i ha ome of he good ho e con mp ion lead o nega i e con mp ion

e e nali ie (fo e ample, pe ol/ga oline and ciga e e ) ha e an inela ic demand. A o ma
emembe f om Chap e 3, hen demand i inela ic, he pe cen age dec ea e in q an i demanded i
malle han he pe cen age inc ea e in p ice (d e o he a ). The efo e, i i po ible ha impo ing a e
on ch good a pe ol (ga oline) and ciga e e (bo h of hich ha e an inela ic demand) o k o
inc ea e go e nmen a e en e hile no ignifican l dec ea ing he q an i demanded of he e
good . Thi co ld mean ha in o de o achie e Q op , a e high indi ec a o ld ha e o be impo ed,
hich o ld e likel be poli icall naccep able. On he o he hand, he la ge a e en e can be
ed o finance ed ca ion p og amme o di co age con mp ion of pa ic la good .
A tax on producers or consumers? (Supplementary material)

Yo ma be onde ing h he a o co ec nega i e con mp ion e e nali ie ho ld affec
p od ce , hif ing he ppl c e p a d in Fig e 5.11(a), and no con me b hif ing he demand
c e do n a d, ho af e all a e he one c ea ing he e e nali h o gh con mp ion. Yo ill find
he an e o hi q e ion in he 'Digi al co ebook: E a ma e ial' ec ion a S pplemen a ma e ial.
Government legislation and regulation

If nega i e con mp ion e e nali ie e e co ec ed, Q op q an i of he good o ld be p od ced,
eflec ing alloca i e efficienc . Reg la ion can be ed o p e en o limi con me ac i i ie ha
impo e co on hi d pa ie , ch a legal e ic ion on ac i i ie like moking in p blic place o age
e ic ion fo cing elle o do b ine onl i h ad l . Thi ha he effec of hif ing he D1 = MPB
c e o a d he MSB c e in Fig e 5.11(b), n il D2 o e lap i h MSB. Thi o ld elimina e he
e e nali , i h p od c ion and con mp ion occ ing a Qop and p ice falling o Pop .

Some eg la ion can be e effec i e in ed cing he e e nal co of ce ain con mp ion ac i i ie .
E ample incl de p ohibi ing moking in p blic place and placing e ic ion on ca en e ing ci
cen e . Ho e e , he canno be ed o deal i h o he kind of nega i e con mp ion e e nali ie .
Fo e ample, i o ld be e diffic l o eg la e pe ol (ga oline) con mp ion; on he o he hand,
impo ing indi ec a e on ch good ma be mo e effec i e ( ho gh bjec o he limi a ion no ed
abo e on inela ic demand).
Education and awareness-creation

Ed ca ing he p blic and c ea ing a a ene b he go e nmen can be ed o o pe ade
con me o b fe e good i h nega i e e e nali ie , ch a an i- moking campaign , campaign
o a oid con mp ion of nheal h food , o campaign o ed ce he con mp ion of good and e ice
ba ed on fo il f el e. E ample incl de ing p blic an po a ion o economi e on pe ol (ga oline)
e o imp o ing home in la ion o ed ce oil con mp ion (fo hea ing) o p o iding info ma ion o
con me on he amo n of ca bon p od ced b ai a el.
The objec i e i o o dec ea e demand fo good gi ing i e o nega i e con mp ion e e nali ie ,
and he effec a e he ame a i h go e nmen eg la ion , ho n in Fig e 5.11(b). The MPB c e
hif o D2 af e he campaign, he e i coincide i h MSB, he e Q op i p od ced and con med,
and he p ice fall f om Pm o Pop .

Ed ca ion and c ea ion a a ene ha e he ad an age ha he a e imple han o he me hod , b he
oo ha e hei di ad an age . One of he e in ol e he co o he go e nmen of campaign , hich a e
f nded o of a f nd , meaning he e a e le f nd a ailable fo e el e he e in he econom ( he e
a e oppo ni co ). The e i al o he po ibili ha ch me hod ma no be effec i e eno gh in
ed cing he nega i e e e nali .
Nudges (HL only)

N dge e e in od ced in Chap e 2 he e e a ha he fo m a pa of beha io al economic ,
in ol ing he de ign of me hod o infl ence con me beha io . The can be ed in a imila
o ed ca ion and con me a a ene o enco age con me o el le on good i h nega i e
e e nali ie , ch a nheal h food and ciga e e . Fo e ample, nheal h food can be placed in
le acce ible place in hop , o g aphic pic e of he con eq ence of moking ma be placed on
ciga e e pack . In ch ca e demand fo he p od c fall o ha he MPB c e hif o a d MSB
a in Fig e 5.11(b). In addi ion, n dge can be ed o enco age de i able beha io , ch a
c ea ing bic cle lane o mo i a e ca d i e o e bic cle in ead.

The e ma be diffic l ie in de igning effec i e n dge a he e a e ill a ne me hod in ended o
infl ence con me beha io , and no eno gh i kno n e abo ho con me e pond o
pa ic la n dge and choice a chi ec e. The e i , oo, he i e ha pa ic la n dge ma no ha e
he ame effec ac o income g o p o c l al g o p .
Co ec ion of nega i e con mp ion e e nali ie in ol e ei he dec ea ing ppl and hif ing he
MPC c e p a d b impo ing an indi ec (Pigo ian) a ; o b dec ea ing demand and hif ing
he MPB c e o a d he MSB c e h o gh eg la ion , ed ca ion and a a ene c ea ion o
n dge . Bo h ppl dec ea e and demand dec ea e a e in ended o lead o p od c ion and
con mp ion a Qop and he achie emen of alloca i e efficienc
In gene al, gi en he limi a ion abo e fo all he a io policie i i onl po ible o mo e he

econom in a di ec ion o a d co ec ion of he e e nali , a he han achie ing a p eci e alloca ion of
e o ce he e Q op i p od ced and con med. Ve of en, he e of e e al policie oge he ma be
he be a o add e he e e nali . Fo e ample, a e en e f om he impo i ion of a Pigo ian a
ma be ed o finance ed ca ion and a a ene c ea ion p og amme a ell a n dge . Go e nmen
m he efo e be elec i e in he me hod he e o ed ce con mp ion e e nali ie , depending on
he pa ic la good ha c ea e he e e nal co .

1 Fo each of he e ample o p o ided in q e ion 2 of Te o nde anding 5.6, e plain
ome me hod ha co ld be ed o co ec he e e nali .
2 U ing diag am , ho ho a nega i e con mp ion e e nali can be co ec ed b e of
a legi la ion and eg la ion ha limi he e e nal co ,
b ed ca ion and a a ene c ea ion,
c (HL onl ) n dge , and
d indi ec a e .
e Iden if ome ad an age and di ad an age of each of he e polic mea e.
3 E plain he meaning of a deme i good and p o ide e ample .
4 E plain ho a nega i e con mp ion e e nali diffe f om a nega i e p od c ion e e nali .
5 a E plain ha kind of mea e economi p efe o co ec nega i e con mp ion
e e nali ie .
b Iden if i a ion he e he e migh no be e effec i e.

Policies to reduce sugar consumption
Follo ing a 2015 epo b he Wo ld Heal h O gani a ion (of he Uni ed Na ion ) de ailing he
nega i e heal h effec of ga , mo e and mo e co n ie a o nd he o ld a e impo ing a a on he
ga con en of food and d ink in an effo o ed ce obe i and o he heal h p oblem like
diabe e a i ing f om ga o e con mp ion. The e a e ha e gene all me i h li le oppo i ion
f om he p blic. The a e a e impo ed on food and/o d ink i h ga , hich a e a ed in
acco dance i h he q an i of ga he con ain.
In e pon e o he implemen a ion of he e policie , man majo food p od ce a o nd he o ld
ha e e ponded b c ea ing ne p od c i h no added ga , o ed ced ga , hile a he ame
ime ing o main ain he o iginal a e. In ome ed ced ga i em , he ga con en i lo e ed
eno gh o ha he a can be a oided al oge he . In addi ion, ome go e nmen a e o king i h
food p od ce o e abli h ol n a ag eemen i h p od ce o lo e he ga con en of hei
food p od c .
Ano he app oach in ol e banning he ad e i emen of nheal h food d ing he ime hen
child en a ch ele i ion. A ill diffe en app oach in ol e he e of elec onic o de ing em
ha offe con me heal h good a he defa l op ion .
Figure 5.12: Cla ic coke food label decode ho ing high ga le el
Applying your skills
1 U ing a diag am, e plain ha kind of e e nali he a icle i efe ing o.

2 U ing a diag am, e plain ho a a on he ga con en of food and d ink can help ed ce he
e e nali .
3 O line a likel ea on ha he a e ha e gene all me i h li le p blic oppo i ion.
4 a Iden if and e plain he o he pe of policie (o he han indi ec a e ) ha he a icle efe
o, ha co ld help o ed ce he e e nali .
b U ing diag am , ho ho he e policie a e e pec ed o o k.
Source: Kerry

The ethical dimensions of sustainability and preserving the global climate
In Chap e 1 e a ha ol ion o he p oblem of ainabili face majo echnical diffic l ie
d e o nce ain ie and incomple e kno ledge of ocial and na al cien i ega ding he comple
ela ion hip be een en i onmen al, economic, ocial and in i ional a iable . The e kind of
echnical diffic l ie a e al o e pon ible fo he nce ain ie o nding bo h eg la o and
ma ke -ba ed economic policie o add e en i onmen al e e nali ie di c ed in he p e en
chap e .
O e and abo e he echnical diffic l ie , he p oblem of ainabili face majo e hical i e of
fai ne and j ice, ela ing o in e gene a ional eq i ( nning f om gene a ion o gene a ion), a
ell a eq i ac o na ion and ocial g o p i hin na ion of he p e en gene a ion.
In he a ea of clima e change alone, impo an i e incl de (a) ho ill he b den of ha ing o
make ac ifice in he p e en be di ib ed among co n ie ; (b) ho ill he impac of clima e
change be e al a ed; and (c) ho ill in e gene a ional eq i be acco n ed fo ?11
To de e mine he di ib ion of ac ifice , a po ible e hical p inciple ha can be ed i he poll e
pa p inciple, acco ding o hich he ac ifice i di ib ed acco ding o ho m ch each co n
con ib e o clima e change. In one a ian of hi p inciple, i o ld be nece a o ake in o
acco n c m la i e (hi o ical) con ib ion o g eenho e ga emi ion . Thi o ld place an e a
b den on he de eloped co n ie of oda , hich o e ime, ha e con ib ed fa mo e o emi ion
han de eloping co n ie . A a co n e a g men , opponen efe o e c able igno ance , meaning
i ho ld no be nece a o pa fo pa emi ion if he e e e made i ho kno ledge of hei
effec on he global clima e. Acco ding o a diffe en e hical p inciple, he pa o ld be igno ed and
f e emi ion igh o ld be di ib ed o all co n ie on a per capita ba i .
On he econd i e, conce ning e al a ion of impac of clima e change, one app oach in ol e
elfa e anal i . Thi ha gi en i e o di ag eemen abo ho o calc la e elfa e and add i p
ac o indi id al in he p e en a ell a in he f e. Ano he app oach foc e on h man igh a
he ba i fo e al a ing impac , ch a he igh o food, a e and hel e , hich ma be
h ea ened b clima e change.
In e gene a ional eq i , he hi d i e, i clo el ela ed o he e al a ion of impac of clima e
change, a he e m acco n fo impac no onl on he p e en gene a ion b f e gene a ion a
ell.
The e kind of q e ion clea l belong o he no ma i e ealm of ho gh . Gi en he echnical
diffic l ie a ell, i i no onde ha he e a e b oad di ag eemen o e ainabili , and no ea
ol ion appea on he ho i on.
Thinking points
Wha do o hink ho ld be he ole of cience and ocial cience in p o iding an e o he e
kind of q e ion ?
To ha e en do o hink ma ke fo ce can be elied pon, if a all, o deal i h p oblem of
en i onmen al ainabili ?
Ma ke economie a e ba ed pon h man beha io mo i a ed b a ional elf-in e e ( ee
Chap e 2). To ha e en do o hink hi elf-in e e i he oo ca e of he en i onmen al
p oblem ha be e he h man ace oda ? (See al o Theo of kno ledge 5.1.)
Gi en ha , hi o icall , economicall mo e de eloped co n ie ha e been mainl e pon ible
fo oda en i onmen al p oblem , do o ag ee i h he ie ha economicall le
de eloped co n ie ho ld impl igno e call fo hem o limi hei g o h a e o p e en
f he global a ming?

1 Iden if a good o e ice in o co n o a co n o a e in e e ed in ha gi e i e o a
pa ic la nega i e p od c ion e e nali . E amine he e en of he e e nal co and ho he
affec a io akeholde . In e iga e he ol ion ha a e being ed o ed ce i p od c ion
and con mp ion. Di c he eng h and limi a ion of he e ol ion , and o iden if he
effec on a io akeholde .
2 See q e ion 1 abo e and appl i o a nega i e con mp ion e e nali .
3 Iden if a cheme of adable pe mi ha ha been implemen ed. Re ea ch and di c i
eng h and limi a ion .
4 Iden if a common pool e o ce ha i of in e e o o and in e iga e ha , if an , mea e
a e being aken in o co n of e idence o a co n o a e in e e ed in o deal i h i
po ible o e e.
5 A indica ed in Real o ld foc 5.3, a n mbe of co n ie a o nd he o ld ha e impo ed o
a e planning o impo e indi ec (Pigo ian) a e on a io food i em ( ga and/o fa ) ha
a e con ide ed o be ha mf l o h man heal h. E amine he he ch a a i ed o i nde
con ide a ion in o co n o a co n o a e in e e ed in, and e amine he e e nal co
of con mp ion of ch food , a ell a he effec of he a on a io akeholde .
In e iga e he he an die ha e been done o e al a e he impac of he a , and he e en
o hich i ha been cce f l i h e pec o a aining i objec i e of ed cing con mp ion of
ch food . Con ide al o addi ional, complemen a policie ha a e in e fo hi p po e in
o co n of choice.
6 Ai a el i he fa e -g o ing con ib o o ca bon emi ion . Re pon ible fo abo 5% of
global a ming in 2018, b 2050 emi ion ma g o b mo e han 700%, aking p one-
q a e of he global ca bon b dge fo limi ing he empe a e i e o 1.5%. Ye he global
ai line ind ejec policie ch a ca bon p icing and eg la ion of a ia ion emi ion b
go e nmen o in e na ional bodie . In ead i ha op ed fo a cheme called Ca bon Off e ing
and Red c ion Scheme fo In e na ional A ia ion (CORSIA) hich ha been c i ici ed a being
ineffec i e. (a) Re ea ch CORSIA and iden if ome ad an age and di ad an age a a me hod
o ackle he p oblem of ai line emi ion . (b) Re ea ch and o line ep ha a elle can ake
in o de o ed ce hei ca bon foo p in hen he a el b ai .
10 No e ha he ne eq ilib i m p ice, Pc, i he p ice paid b con me ; he p ice ecei ed b p od ce i Pp =

Pc min a pe ni ( ee Chap e 4, Sec ion 4.2).
11 The Wo ld Bank (2009) World Development Report 2010: Development and Climate Change.
Chap er 6
Marke fail re and sociall

ndesirable o comes II:
Positive e ternalities, public goods, as mmetric
information and inabilit to achieve equit
BEFORE YOU START

Can ou think of some goods or services that hen consumed or produced bring benefits to
others even though the didn t consume or produce them?
You ma have noticed that some goods and services are provided free of charge, such as roads,
parks, street lighting, public schools, and man more. Who pa s for these and hat might be the
reasons people can enjo them ithout having to pa for them?
In this chapter e continue the discussion begun in Chapter 5 on the inabilit of the market to fulfill
some of its promises. We ill begin b e amining positive e ternalities of production and consumption.
We ill then discover public goods, hich are not produced at all b the market even though the are
sociall desirable. We ill then e amine the consequences of information as mmetries bet een bu ers
and sellers, and ill conclude ith a discussion of the market s inabilit to achieve equit in the
distribution of income and ealth.
6.1 P a
LEARNING OBJECTIVES

define all the terms appearing in a b in the te t (AO1)
e plain positive e ternalities of production and the resulting elfare loss (AO2)
dra a diagram illustrating positive e ternalities of production and elfare loss (AO4)
calculate elfare loss that arises from positive e ternalities of production (HL onl ) (AO4)
e plain government intervention to correct positive e ternalities of production: (AO2)
government provision
subsidies
dra diagrams to illustrate the above government responses (AO4)
discuss strengths and limitations of the above government policies ith respect to: (AO3)
difficulties in measurement of e ternalities
degree of effectiveness
consequences for stakeholders
E a a a a
E ternalities as a form of market failure ere introduced in Chapter 5, here e discussed negative
e ternalities of production and consumption. We no turn our attention to positive e ternalities.
P a refer to e ternal benefits created b producers. If, for e ample, a firm
engages in research and development, and succeeds in developing a ne technolog that spreads
throughout the econom , there are e ternal benefits because not onl the firm but also societ benefits
from idespread adoption of the ne technolog . Therefore, the social costs of research and
development are lo er than the private costs. In Figure 6.1, the MSC curve lies belo the MPC curve,
and the difference bet een the t o curves is the value of the e ternal benefits (these can be thought of as
negative costs ). The demand curve represents both MPB and MSB since the e ternalit involves onl
production. The market gives rise to equilibrium quantit Qm and price Pm, determined b the
intersection of the MPB and MPC curves, hile the social optimum is given b Qopt and Popt,
determined b the intersection of the MSB ith MSC curves. Since Qm < Qopt, the market underallocates
resources to research and development activities that lead to ne technologies, and not enough of them
are undertaken.
F 6.1: Positive production e ternalit
When there is a positive production e ternalit , the free market underallocates resources to the
production of the good: too fe resources are allocated to its production, and too little of it is
produced. This is sho n b Qm < Qopt and MSB > MSC at Qm in Figure 6.1.
More e amples of positive production e ternalities include:

firms train orkers ho later s itch jobs and ork else here; e ternal benefits are created as the
ne emplo ers and societ benefit from the trained orkers
a firm provides first aid classes to emplo ees to improve ork safet ; e ternal benefits are created
as this kno ledge is applied also to people outside the orkplace.
T a a
W a
The underallocation of resources to the production of a good ith a positive production e ternalit leads
to a elfare loss, sho n in Figure 6.2(a) as the shaded area. This loss is equal to the difference bet een
the MSB and MSC curves for the amount of output that is underproduced relative to the social optimum
(Qopt Qm). It involves e ternal benefits for societ that are lost because not enough of the good is
produced. If the e ternalit ere corrected, societ ould gain the benefits represented b the shaded
area. Note that the point of the elfare loss triangle lies at the Qopt quantit of output.
Ca a a (HL )
Figure 6.2(b) is similar to part (a) ith figures so e can calculate elfare loss. The area of the
elfare loss triangle is the height times the idth of the triangle divided b 2. The height of the
triangle is equal to the e ternal benefit per unit, or MPC − MSC, and the idth is equal to the amount
of underproduction b the market or Qopt Qm:
Welfare loss = (6 4) (90 60) 30 = 2 30 2 =$30
W a a a (S a
a a)
Figure 6.2(c) sho s the elfare loss in relation to consumer and producer surplus and the e ternalit . At
market equilibrium, consumer surplus is area a, producer surplus is area b + e, and the e ternal benefits
are c + f (the difference bet een the MPC and MSC curves up to the point of production b the market,
Qm). The total benefits are therefore consumer surplus plus producer surplus plus e ternal benefits:
a + (b + e) + (c + f) = a + b + e + c + f
At the social optimum, consumer surplus is a + b + c + d, producer surplus is e + f + g, and e ternal
benefits are ero, making a total of:
(a + b + c + d) + (e + f + g) = a + b + c + d + e + f + g
Comparing total benefits at market equilibrium and at the social optimum, e find that at the social
optimum there are additional benefits of the amount d + g, corresponding to the shaded area in the
figure. This is the amount of elfare that is lost at market equilibrium due to underallocation of
resources arising from the positive production e ternalit .
F 6.2: Welfare loss in a positive production e ternalit
C a
D
A solution often pursued b governments involves direct government provision of the good or service
creating the positive production e ternalit . For e ample, governments often engage in research and
development (R&D) for ne technolog , for medicine and pharmaceuticals, and man other areas. The
government can also directl provide training for orkers. Governments pa for such activities ith
government funds, raised through ta es. Figure 6.3(a) sho s that hen the government intervenes b
providing goods and services itself, this has the effect of shifting the suppl curve (= MPC curve)
do n ard (or to the right), to ard the MSC curve so that the optimum quantit of the good, Qopt, ill
be produced, ith price falling from Pm to Popt .
S b
We studied subsidies and their effects in Chapter 4, here e sa ho their introduction into a perfect
market ( ith no market failures) creates allocative inefficienc . No , e ill see ho subsidies can
correct allocative inefficienc b correcting a market failure.
If the government provides a subsid to a firm per unit of the good produced that is equal to the e ternal
benefit, then the marginal private cost (MPC = suppl ) curve shifts do n ard (or right ard1) until it
coincides ith the MSC curve, as sho n in Figure 6.3(b). The result is to increase quantit produced to
Qopt and to lo er the price from Pm to Popt . The problem of underallocation of resources and
underprovision of the good is corrected, and allocative efficienc is achieved.
F 6.3: Correcting positive production e ternalities
You ma note that direct government provision and subsidies have the same market outcomes.
Correction of positive production e ternalities involves shifting the MPC curve do n ard to ard the
MSC curve through direct government provision or b subsidies. For allocative efficienc to be
achieved, the quantit produced and consumed must increase to Qopt as price falls to Popt.
E a a a
This topic ill be discussed together ith policies to correct positive consumption e ternalities belo
(Section 6.2) because of similarities of the policies involved.

1 a Using a diagram, sho ho marginal private costs and marginal social costs differ hen
there is a positive production e ternalit .
b E plain the difference bet een the equilibrium quantit determined b the market and the
quantit that is optimal from the point of vie of societ s preferences.
Describe hat this tells ou about the allocation of resources achieved b the market hen
there is a positive production e ternalit .
Sho the elfare loss created b the positive production e ternalit in our diagram, and
e plain hat this means.
2 Provide some e amples of positive production e ternalities.
3 For each of the e amples ou provided in question 2, e plain some methods that can be used to
correct the e ternalit .
1 See Quantitative techniques in the 'Digital coursebook: E tra material' section for an e planation of the
equivalence of do n ard and right ard shifts of the suppl curve.
6.2 P
LEARNING OBJECTIVES

e plain positive e ternalities of consumption and the resulting elfare loss (AO2)
dra a diagram illustrating positive e ternalities of consumption and elfare loss (AO4)
e plain the meaning of merit goods (AO2)
calculate elfare loss that arises from positive e ternalities of consumption (HL onl ) (AO4)
e plain government intervention to correct positive e ternalities of consumption: (AO2)
legislation and regulation
education and a areness creation
nudges (HL onl )
government provision
subsidies
dra diagrams to illustrate the above government responses (AO4)
discuss strengths and limitations of the above government policies ith respect to: (AO3)
difficulties in measurement of e ternalities
degree of effectiveness
consequences for stakeholders
E
When there is a , e ternal benefits are created b consumers. For
e ample, the consumption of education benefits the person ho receives the education, but in addition
gives rise to e ternal benefits, involving social benefits from a more productive orkforce, lo er
unemplo ment, higher rate of gro th, more economic development, lo er crime rate, and so on.
Similarl , the consumption of health care services benefits not onl the person receiving the services but
also societ and the econom , because a healthier population is more productive, enjo s a higher
standard of living, does not pass on contagious diseases as much and ma have a higher rate of economic
gro th. In Figure 6.4, e see that the marginal social benefit (MSB) curve lies above the marginal
private benefit (MPB) curve, and the difference bet een the t o consists of the e ternal benefits to
societ . The sociall optimum quantit , Qopt, is given b the point here MSB = MSC, and the quantit
produced b the market is given b the point here MPB = MPC. Since Q opt > Q m, the market
underallocates resources to the good or service, and too little of it is produced.
When there is a positive consumption e ternalit , the free market underallocates resources to the
production of the good, and too little of it is produced relative to the social optimum. This is sho n
b Qm < Qopt and MSB > MSC at Qm in Figure 6.4.
In general, positive e ternalities (e ternal benefits), hether these arise from production or
consumption activities, lead to an underallocation of resources to the good in question, and therefore
to its underprovision.
F 6.4: Positive consumption e ternalit
The elfare loss arising from a positive consumption e ternalit is the shaded area in Figure 6.5(a), and
is the difference bet een the MSB and MSC curves for the amount of output that is underproduced
relative to the social optimum (Qopt Qm). It represents the loss of social benefits due to
underproduction of the good. If this e ternalit ere corrected, societ ould gain the benefits
represented b the shaded area. Once again, e see that the point of the elfare loss triangle lies at the
Qopt quantit of output.
F 6.5: Welfare loss in a positive consumption e ternalit
You ma have noticed that in the case of negative e ternalities of production and consumption, here
Qopt < Qm, the elfare loss triangle al a s points left ard to ard Qopt. B contrast, in the case of
positive e ternalities of production and consumption, here Qopt > Qm, the elfare loss triangle al a s
points right ard, again to ard Qopt.
C (HL )
Figure 6.5(b) is similar to part (a) ith figures so e can calculate elfare loss. The area of the
elfare loss triangle the height times the idth of the triangle divided b 2. The height of the triangle
is equal to the e ternal benefits per unit, or MSB MPB, and the idth is equal to the amount of
underproduction b the market or Qopt Qm:
Welfare loss = (6 4) (90 60) 30 = 2 30 2 =$30
(S
)
In Figure 6.5(c) e see ho the elfare loss arises in relation to consumer and producer surplus and the
e ternal benefits. In market equilibrium, consumer surplus is equal to areas b + d, producer surplus is
area g, and the e ternal benefits are a + e (or the difference bet een MSB and MPB up to production at
Qm b the market). The total social benefits in market equilibrium are equal to consumer surplus plus
producer surplus plus the e ternal benefits:
(b + d) + g + (a + e) = b + d + g + a + e =a+b+d+e+g
At the social optimum, consumer surplus is given b a + b + c, producer surplus is d + e + f + g, and the
e ternal benefits are ero. Therefore the total social benefits are:
(a + b + c) + (d + e + f + g) = a + b + c + d + e + f + g
Comparing the total social benefits at market equilibrium ith those at the social optimum, e find that
at the social optimum the are greater b the amount c + f. This is the elfare loss that arises hen
production occurs at market equilibrium as a result of an underallocation of resources due to the positive
consumption e ternalit .
T
M are goods that are held to be desirable for consumers, but hich are underprovided b the
market. (Note that the term good in the e pression merit good applies to both goods and services.)
Reasons for underprovision include:
T . In this case too little is provided b the market.
E amples of merit goods include education (for the reasons noted above in the discussion of
e ternalities); immunisation programmes ( hich benefit not onl those ho have received them but
also the broader population b iping out a disease).
L . Some consumers ma ant certain goods or services but
cannot afford to bu them. Remember demand sho s the quantities of a good or service that
consumers are illing and able to bu at different prices. If the have lo incomes, the ma be
illing but not able to bu something, in hich case their desire does not sho up in the market,
and market demand (the sum of all individual demands) is too lo . E amples include health care
services, medicines, education and recreational facilities, hich people on lo incomes often
cannot afford to bu in the market.
C . Consumers ma be better off if the consume certain goods and services but
the ma be ignorant of the benefits, and so do not demand them. For e ample, preventive health
care (such as immunisation, annual health check-ups) can prevent serious diseases, but lack of
kno ledge about the benefits ma lead consumers to demand too little of these services.
Note that more than one factor ma be at ork simultaneousl ; for e ample, the underprovision of health
care services can result from all three reasons listed above.
C
G
Legislation can be used to promote greater consumption of goods ith positive e ternalities. For
e ample, most countries have legislation that makes education compulsor up to a certain age (note that
education is a merit good). In this case, demand for education increases, and the demand curve D1 =
MPB shifts to the right (or up ard), as in Figure 6.6(a). Ideall , it ill shift until it reaches the MSB
curve, here D2 = MSB, and Qopt is produced and consumed.
E
Governments can use education of the public, a areness creation, to tr to persuade consumers to bu
more goods ith positive e ternalities. For e ample, the can tr to encourage the use of sports facilities
for improved health. The objective is to increase demand for such services, and the effect is the same as
ith legislation, sho n in Figure 6.6(a): D1 shifts to D2= MSB and Qopt is produced and consumed,
hile price increases to Popt.
F 6.6: Correcting positive consumption e ternalities
N (HL )
Nudges have similar effects as education and a areness creation programmes. Governments can use
nudges like the creation of bic cle lanes to encourage the use of bike riding for more ph sical
e ercise. (Note that this nudge also has the effect of reducing the negative e ternalit of gasoline
(petrol) consumption from the use of cars, noted earlier.) Here, too, the objective is to increase
demand shifting D1 to ard D2.
D
Governments are frequentl involved in the direct provision of goods and services ith positive
consumption e ternalities. The most important e amples include government (public) provision of
education and health care in virtuall all countries in the orld. Education and health care are merit
goods ith e ternal benefits so large and important that it is idel believed that the must not be left to
private sector provision alone. In most countries here there is government provision of health care and
education, there is also private sector provision of these services (though to var ing degrees).
Direct government provision is sho n in Figure 6.6(b), and has the effect of increasing suppl and
therefore shifting the suppl curve S right ard (or do n ard) to S + government provision. To achieve
the social optimum Qopt, the ne suppl curve must intersect MPB at the level of output Qopt, as seen in
the figure. At the ne equilibrium, price falls to Pc, Qopt is produced and allocative efficienc is
achieved.
S
A subsid to the producer of the good ith the positive e ternalit has the same effects as direct
government provision. It results in increasing suppl and shifting the suppl curve right ard (or
do n ard), as sho n in Figure 6.6(c) ( hich is similar to Figure 6.6(b)). If the subsid is equal to the
e ternal benefit, the ne suppl curve is MPC subsid ,2 and it intersects MPB at the Qopt level of
output. Again, price falls from Pm to Pc, Qopt is produced and allocative efficienc is achieved.
Correction of positive consumption e ternalities involves either increasing demand and shifting the
MPB curve to ards the MSB curve through legislation or education and a areness creation; or
increasing suppl and shifting the MPC curve do n ard b direct government provision or b
granting a subsid . Both demand increases and suppl increases can lead to production and
consumption at Qopt and the achievement of allocative efficienc . The price paid b consumers
increases hen demand increases, and falls hen suppl increases.
Note that the problem of underprovision of merit goods b the market (defined above) can be addressed
b all the methods noted above: legislation, education and a areness creation, direct government
provision and granting of subsidies. All are intended to increase the amount of the good produced and
consumed, as increased consumption of such goods is held to be desirable for societ .
Both direct government provision and subsidies are idel used as methods to deal ith positive
consumption e ternalities, and to a lesser e tent also ith positive production e ternalities. Both
methods are ver effective in increasing the quantit of the good produced and consumed, and both have
the added advantage of lo ering the price of the good to consumers.
There are, ho ever, difficulties involved in achieving the optimum results ( here MSC = MSB). First,
both direct government provision and granting of subsidies involve the use of government funds that rel
on ta revenues. Governments generall have ver man possible alternative uses for these funds, each
of hich has an opportunit cost. As it is not possible for the government to directl provide or subsidise
all goods and services ith positive e ternalities, choices must be made on (a) hich goods should be
supported, and (b) b ho much the should be supported.
Ideall , choices should be made on the basis of economic criteria, hich ould specif the amount of
social benefits e pected in relation to the cost of providing them, the objective being to ma imise the
benefits for each good and service to be provided or subsidised for a given cost. Ho ever, in practice it
is ver difficult to measure the si e of the e ternal benefits, and therefore to calculate precisel hich
goods and services should be supported and the level of support the should receive. In addition, both
direct provision and subsidies are often highl political in nature, as different groups compete ith each
other over ho ill receive the most benefits. Governments are often susceptible to political pressures
and sometimes make choices based on political rather than economic criteria.
(HL onl ) Nudges are subject to the same limitations that ere noted in connection ith negative
consumption e ternalities (Chapter 5), involving difficulties in designing effective nudges in vie of
insufficient kno ledge about ho people respond to nudges and choice architecture, as ell as the
possible different responses these ma have across income and cultural groups.
Therefore, in the real orld it is ver unlikel that governments are able to shift the MPC or MPB curves
b the amount necessar to correct the positive e ternalities. The most that can be hoped for is that the
policies in question ill be a step in the right direction.
Legislation, education and a areness creation are subject to similar limitations concerning calculating
the si e of e ternal benefits. Onl sometimes can the be effective, and then can onl help shift the MPB
curve in the right direction, rather than achieve a demand increase that ill bring the econom to the
Qopt level of output. For e ample, the can have ver positive effects in certain cases (such as legislation
requiring schooling up to a minimum age or education on the importance of good nutrition), but in other
cases are ineffective (for e ample, the cannot on their o n increase consumption of health care services
and education to the optimum level). Moreover, the have the further effect of raising the price of the
good to consumers, hich ma make the good unaffordable for some consumer groups. Therefore,
legislation and a areness creation sometimes can be used more effectivel if the are implemented
together ith direct provision and subsidies. A good e ample is education, here compulsor schooling
up to a certain age (legislation) goes together ith direct government provision.

1 Using a diagram, sho ho marginal private benefits and marginal social benefits differ
hen there is a positive consumption e ternalit .
E plain the difference bet een the equilibrium quantit determined b the market and the
quantit that is optimal from the point of vie of societ s preferences.
Describe the problem ith the allocation of resources achieved b the market hen there is
a positive consumption e ternalit .
Sho the elfare loss created b the positive consumption e ternalit in our diagram, and
e plain hat this means.
2 Provide some e amples of positive consumption e ternalities.
3 For each of the e amples ou provided in question 2, e plain some methods that could be used to
correct the e ternalit .
4 Outline ho a positive consumption e ternalit differs from a positive production e ternalit .
5 E plain the meaning of a merit good, and provide e amples.
6 Discuss advantages and disadvantages of the polic measures that governments can use to
correct positive e ternalities of production and consumption.
REAL ORLD FOCUS 6.1

P
A highl successful polic used in Bra il to reduce povert and income inequalities is the Bolsa
Familia programme implemented b the Bra ilian government. Through this programme poor
families receive cash transfers c di i that the send their children to school and get them
vaccinated. These programmes are therefore called c di i a ca h a fe (CCTs). The
programme is so successful in reducing povert over the short term through the cash transfers and
over the long term b increasing human capital that it has attracted great attention around the orld.
F 6.7: Feijao, Acre Province, Bra il. School children in a rural school classroom
A stud on crime in Bra il has found that the Bolsa Familia programme has had a significant impact
on crime reduction in S o Paolo. It concludes that in the areas here CCTs are implemented there is a
negative impact on crime. This is not related to the increased time spent in school but rather is due to
reduced povert and inequalit , resulting in a reduction primaril of robberies, hence economicall
motivated crimes.
S :S i e f c di i a ca h a fe ga e IZA, DP N . 6371
A
You ma note that this is a t pe of positive e ternalit that cannot be anal sed b means of the usual
e ternalit diagram as there is no market that can be easil identified here. Ho ever the idea of a
positive e ternalit resulting from government spending on CCTs is clear. E plain hat kind of
e ternalit this represents, identif the e ternal benefits and describe the implications for the
government s CCT polic .
S
Table 6.1 summarises important information on each t pe of e ternalit .
T E P
T E P
N Producers impose e ternal costs Indirect (Pigouvian)

on societ ta es
Production b use of fossil fuels; Carbon ta es
e ternal costs include global Tradable permits
arming, negative effects on
health, environmental pollution Legislation, regulation
Collective self-
governance
Education, a areness
creation
International
agreements
N Consumers impose e ternal costs Indirect (Pigouvian)
on societ ta es
Use of cars and heating using Legislation, regulation
fossil fuels; e ternal costs include Education, a areness
global arming, negative effects creation
on health, environmental pollution
Nudges (HL onl )
P Producers create e ternal benefits Government provision

for societ
Subsidies
Research b private firms leads to
development of ne technologies
that benefit the hole of societ
P Consumers create e ternal Legislation, regulation

benefits for societ
Education, a areness
Education and health care lead to creation
benefits for the hole of societ , Nudges (HLonl )
including lo er unemplo ment,
lo er crime rates, higher Government provision
economic gro th Subsidies
T 6.1: Summar of e ternalities

The information in this section applies to a e e a i ie , including the negative ones presented in
Chapter 5 and the positive ones of this chapter.
H
Students often have difficult learning ho to dra the e ternalit diagrams and labelling the curves
correctl . The follo ing rules ill help ou dra an e ternalit diagram ithout memorising.
T
1 In a production e ternalit , the suppl curve splits into t o; in a consumption e ternalit , the
demand curve splits into t o.
2 Suppl reflects costs; demand reflects benefits.
3 The market equilibrium quantit Qm corresponds to private costs and benefits, MPC and MPB; the
social optimum reflects social costs or benefits.
4 In a negative e ternalit Qm > Qopt, meaning that he a e ide ch f a bad hi g; in a
positive e ternalit Qm < Qopt, meaning that he a e ide i e f a g d hi g.
H
1 Dra a demand and suppl diagram and label the a es P and Q.
2 For a production e ternalit dra t o parallel up ard sloping curves; for a consumption e ternalit
dra t o parallel do n ard sloping curves. Find the t o equilibrium quantities on the Q a is (but
do not label them et).
3 In a negative e ternalit , since Qm > Qopt, label the larger quantit Qm and the smaller quantit
Qopt; in a positive e ternalit , since Qm < Qopt, label the larger quantit Qopt and the smaller
quantit Qm.
4 Using rule 3 above, Qm gives MPC and MPB, hile Qopt gives MSC and MSB. You can no label
all the curves. (Note that the demand curve, D and suppl curve, S represent i a e benefits and
costs; therefore D = MPB and S = MPC.)
5 Find the triangle that points to Qopt, and that lies in bet een the t o curves that have split. This is
elfare loss.
S
Here are some points to bear in mind:
All negative e ternalities (of production and consumption) c ea e e e a c . Whe he e a e
e e a c , MSC > MSB a he i f d c i b he a e .
All positive e ternalities (of production and consumption) c ea e e e a be efi . Whe he e a e
e e a be efi MSB > MSC a he i f d c i b he a e .
All production e ternalities (positive and negative) create a di e ge ce be ee i aea d cia
c (MPC a d MSC).
All consumption e ternalities (positive and negative) create a di e ge ce be ee i ae a d
cia be efi (MPB a d MSB).
2 You ma note that the reason for the minus sign in MPC subsid is that the amount of the subsid is
b ac ed from MPC in order to arrive at the ne suppl curve.
6.3 M
LEARNING OBJECTIVES

• explain public goods as being (AO2)
• non-rivalrous, non-excludable
• subject to the free-rider problem
• evaluate government intervention to provide public goods (AO3)
• direct provision
• contracting out to the private sector
P - -
We learned the meaning of rivalry and excludability in Chapter 5. A good is rivalrous when its
consumption by one person reduces its availability for someone else. It is excludable if it is possible to
exclude people from using it. Private goods as we have seen are rivalrous and excludable. Common pool
resources are rivalrous and non-excludable. Public goods, by contrast, are non-rivalrous and non-
excludable.
A has the following two characteristics:

• It is - ; its consumption by one person does not reduce consumption by someone
else.
• It is - ; it is not possible to exclude someone from using the good.
For example, a lighthouse is non-rivalrous, because its use by one person does not make it less available
for use by others. Also, it is non-excludable, because there is no way to exclude anyone from using it.
Other examples of public goods include the police force, national defence, flood control, non-toll roads,
fire protection, basic research, anti-poverty programmes and many others.
P
How do public goods relate to market failure? In the case of excludable goods, it is possible to prevent
people from buying and using a good simply by charging a price for it, since those who are unable or
unwilling to pay the price do not get to use it. Therefore, private firms have an incentive to provide
excludable goods because they can charge a price for them, and therefore can cover their costs. Non-
excludable goods differ: if a non-excludable good were produced by a private firm, people could not be
prevented from using it even though they would not pay for it. Yet no profit-maximising firm would be
willing to produce a good it cannot sell at some price. As a result, the market fails to produce goods that
are non-excludable, giving rise to resource misallocation, as no resources are allocated to the production
of public goods.
Public goods illustrate the , occurring when people can enjoy the use of a good
without paying for it. The free rider problem arises from non-excludability: people cannot be
excluded from using the good. Public goods are a type of market failure because, due to the free rider
problem, private firms do not produce these goods: the market fails to allocate resources to their
production.
Table 6.2 summarises different types of goods according to their rivalry and excludability characteristics.
R N -
E Private goods Quasi-public goods

Goods with or without positive or Goods that do not fall neatly
negative externalities (both into the other three
production and consumption) sold categories; often (but not
for a price. Merit goods (as long always) have large positive
as they are produced by the externalities so may be
market) and demerit goods provided by the government
Examples: computers, books, Examples: uncrowded toll
clothes, education, petrol roads, museums, public
(gasoline) swimming pools that charge
entrance fees, cable TV
See the section below for an
explanation of quasi-public
goods.
N - Common pool resources Public goods
Natural resources that are not See the section below for an
owned by anyone, not sold in explanation of quasi-public
markets and not having a price; goods.
their lack of a price makes them Socially desirable goods not
subject to overuse (unsustainable produced by private firms
use), depletion and degradation because it is not possible to
Examples: forests, rivers, lakes, charge a price; they are
soil quality, fish in the oceans subject to the f ee ide
p oblem: people use them
without having to pay; since
they are socially desirable
they are produced by the
government and provided
free of charge
Examples: national defence,
street lighting
T 6.2: Summary of different kinds of goods based on rivalry and excludability
Q - (S )
Some goods do not fit neatly into the category of private goods or public goods. They can be considered
to be ‘impure public goods, also known as ‘quasi-public goods . These goods are:
• non-rivalrous (like public goods), and
• excludable (like private goods).
Examples include public museums that charge an entrance fee and toll roads. All these are excludable
because consumers must pay to use them. They are also non-rivalrous since use by one does not reduce
availability for others. Since the price system can be made to work here to exclude potential users, they
could be provided by private firms. However, they all have very large positive externalities, thus
justifying direct government provision.
D
We have seen that the market fails to allocate resources to the production of public goods. This means
the government must step in to ensure that public goods are produced at socially desirable levels. Thus
public goods are directly provided by the government, are financed out of tax revenues and are made
available to the public free of charge (or nearly free of charge).
Government provision of public goods raises some issues of choice about (a) which public goods should
be provided, and (b) in what quantities they should be provided. These issues are similar to what was
noted earlier in connection with direct government provision and subsidies for goods with positive
externalities. Limited government funds force choices on what public goods to produce, and each choice
has an opportunity cost in terms of other goods and services that are foregone (sacrificed).
Here, too, the government must use economic criteria to decide which public goods will provide the
greatest social benefits for a given amount of money. However, in the case of public goods, governments
face a major additional difficulty in calculating expected benefits. With private goods that are provided
or subsidised by the government, it is possible to make estimates of expected benefits by using the
market price of the good. (Remember the market price reflects the benefits consumers receive and so
reveals its value to consumers.) Therefore, the government can use the market price of private goods
with positive externalities to estimate their value to consumers, but with public goods there is no such
possibility as they are not produced by private firms and have no price.
This means the government must try to estimate the demand (or ‘price ) of public goods through such
means as votes or surveys of people who are asked how much a good would be worth to them. This
information is used in co benefi anal i , which compares the estimated benefits to society of a
particular good with its costs. If the total benefits expected from a public good are greater than the total
costs of providing it, then the good should be provided. If benefits are less than costs, then it should not
be provided. Assuming that cost–benefit analysis indicates a public good should be provided, the
decision on how much of it to provide is made by comparing marginal benefits with marginal costs: the
public good should be provided up to the point where MB = MC.
Whereas the costs of providing a public good are relatively easy to estimate, there are clear difficulties in
estimating benefits. A major difficulty arising with surveys is that people who really want something are
likely to exaggerate its value. Therefore, cost–benefit analysis is a very rough and approximate method
used to make choices about public goods.
In addition, it should be noted that just like in the case of positive externalities which invite direct
government provision and subsidies for their correction, the provision of public goods is also political in
nature, with different groups competing against each other, and with government sometimes susceptible
to political pressures that influence their decisions.
C
When the government provides a public good, it may either provide it itself directly, or it may contract it
out to a private firm. C by the public sector to the private sector occurs when a
government makes an agreement (or contract) with a private firm to carry out an activity that the
government was previously doing itself. This is a practice that many governments around the world have
been increasingly undertaking. Suppose the government would like to build a new highway system.
Rather than build it itself by directly hiring engineers, workers, and supplying the materials, it may
contract its construction out to a private construction firm.
Note that whether goods are provided directly by the government or contracted out, they are in both
cases financed out of tax revenues.
The potential advantages of contracting out include the following:
• It is often done by competitive tendering (a competition between firms that would like to provide
the government with the service) resulting in the selection of a provider that can offer the lowest
cost.
• It is usually accompanied by detailed specifications regarding the activity that will be provided with
criteria for measurement of the provider s performance, which may allow for better quality control.
• It provides access to a broader range of skills and technology of the private firm than the
government is likely to have available itself.
• The private firm may be more flexible and innovative than the government.
• Due to all of the above it may be possible for the public goods provided to be better quality and less
costly.
On the other hand, contracting out also has potential disadvantages:
• The government becomes less accountable for the public goods it provides.
• The government loses control over the services it has contracted out.
• The costs of contracting out may be greater than if the government had provided the public good
itself, as the contracting private firms often charge high prices for their services.
• There is a risk that quality may be reduced because competition between firms on the basis of cost
may lower the quality of the services provided.
• There is a risk of making a poor contract with a private sector firm, resulting in higher costs and
lower quality, along with reduced accountability and control noted above.
• Contracting out needs to be monitored by the government, which adds to costs.
As a result of all of the above it is difficult to generalise about the effectiveness of contracting out as a
method to provide public goods.
Moreover, it should be noted that contracting out only addresses issues of the quality, costs, skills, and so
on discussed above; it does not address the difficulties faced by the government in making decisions
about what public goods to produce and in what quantities, which as we have seen above depend on the
very difficult problem of trying to determine expected benefits and costs of alternative public goods.

1 Explain how the concepts of rivalry and excludability relate to the distinction between public
goods and private goods.
2 Provide some examples of public goods, and outline how they relate to the concepts of non-
rivalry and non-excludability.
3 Use the concepts of resource allocation and the free rider problem to explain how public goods
are a type of market failure.
4 Discuss the difficulties of direct government provision of public goods.
5 Evaluate the government s policy option to contract out to the private sector the provision of
public goods.
6.4 A c a (HL )
LEARNING OBJECTIVES

• distinguish between adverse selection and moral hazard (AO2)
• evaluate government responses to the problem of asymmetric information, including
legislation and regulation, and provision of information (AO3)
• evaluate private responses to the problem of asymmetric information, including signalling and
screening (AO3)
The competitive market mechanism presupposes that all firms and all consumers have complete
information regarding products, prices, resources and methods of production. However, as we know
from Chapter 2 this condition is hardly ever met in the real world where firms, consumers and
resource owners find themselves in situations where information is missing. A c
a refers to something more than just missing information; it refers to situations where
buyers and sellers do not have eq al acce to information. In some cases buyers may have more
information than sellers; in other cases the opposite holds where sellers have more information than
buyers. As we will see, this usually results in an nde alloca ion of e o ce to the production of
goods or services, and therefore to allocative inefficiency.
We will study two different types of problems of asymmetric information: adverse selection and
moral hazard.
A c
A c refers to situations where one party in a transaction has more information about
the quality of the product being sold than the other party.
A c a a a ab b
b
Sellers often have information about the quality of a good or service that they do not make available
to consumers. Sellers of used cars have information about the car’s quality that they are unlikely to
reveal to potential buyers if the car has a defect. In a free and unregulated market, sellers of food
could sell products that are unsafe for human consumption, possibly leading to illness and even death.
Sellers of medicines could sell unsafe medications that could be ineffective or dangerous. Individuals
claiming to be doctors, some of whom have little or no training, could practise medicine and even
surgery, resulting in huge costs in terms of human health and safety.
In a free unregulated market, the result is usually to underallocate resources to the production of the
good or service. Consumers are likely to be aware of possible dangers to themselves, and will be
cautious about buying the good or service, resulting in lower demand, less production and lower
sales. However, if consumers are unaware of possible hidden dangers, such as with unsafe food or
toys, there could result an overallocation of resources to the production of these goods and services.
P b a c
a b
G
R a
According to one method, governments can pass laws and regulations that ensure quality standards
and safety features that must be maintained by producers and sellers of goods and services, such as
food, medications, private schools, toys, buildings and all types of construction.
These methods are not without their difficulties. Legislation and regulation are time-consuming,
bureaucratic procedures, which sometimes work to slow down economic activities. It takes a long
time, for example, to test new medications and certify their safety, and is a costly process. Also,
regulatory and quality control activities have very large opportunity costs. Just in the case of food
safety control, which involves not only food and beverage products but also hygiene in restaurants,
there is a huge number of products and service providers involved, who require regulation and
monitoring from the level of the farm (regarding the kinds and amounts of chemical inputs) to the
moment the food reaches the table.
P a
Governments may also respond by directly supplying information to consumers, or by forcing
producers to provide information, thus protecting consumers in their purchasing decisions. This may
include information about the quality of medical care by different providers, about communicable
diseases, crime rates by neighbourhoods, health hazards related to different activities, products or
substances, nutritional labelling on foods, and so on. In some countries, particularly in Europe,
governments provide fee schedules for services (such as legal, medical, architectural) to ensure that
consumers receive a particular quality of services for a particular range of prices.
When the government is the provider of information, there are difficulties involving the collection
and dissemination of all the necessary information to consumers, the accuracy of the information, as
well as opportunity costs in providing the information. When a private seller/producer is the provider
of the information, there are serious questions about whether information regarding all hazards in
products or substances and materials used in products, or all information regarding the quality of
services (whether legal, medical, financial, and so on) is accurate and complete.
Another problem is that it is sometimes not possible to eliminate an information asymmetry between
sellers and buyers, because no matter what regulations and information are provided, there is still
some room for the seller to hide some information from the buyer. In the areas of health care and law,
doctors and lawyers have specialised, technical information about their clients that the clients
themselves do not possess. Doctors and lawyers often use this information for their own private gain
by selectively revealing information to their clients that causes them to demand more services than
are necessary. This practice leads to what is known as ‘supplier-induced demand’, or demand that is
induced (created) by the supplier, which would not have appeared if the client had equal access to
information.
Lc
In the case of doctors, most countries around the world have laws requiring doctors to be licensed,
and a licence can only be obtained upon proof of adequate medical competence. Licensing is
similarly required for many other professions in many countries, from teachers and lawyers to
plumbers and electricians.
Some economists criticise licensing, because it may work to limit the supply of people in a
profession, raising the price of their services and increasing their incomes at the expense of
consumers who must pay higher prices (this refers to ma ke po e discussed in Chapter 7 at HL).
P a
Sc
Sc is a method used by the party with the limited information, in this case the buyer. The
buyers may try to get more information about what they are buying, in other words they screen the
product or the producer or seller of the product. Consumers may find information provided on the
internet about reliable used car dealers, or they may informally ask friends for information about the
quality of health care service providers, or legal service providers.
While screening may help in providing consumers with some missing information, it can by no
means on its own solve the problem as it cannot provide systematic and complete information to
match the information available on the seller’s side.
S a
S a is a method used by the party that has more information, or in this case the seller. The
purpose of signalling is to convince the buyers that the product being sold is of good quality.
Common methods include the use of warranties, establishment of brand names that convey a feeling
of reliability, and, in the case of used cars, making service records available or exhibiting cars in
fancy show rooms.
The problem with signalling is that it is unlikely to provide full information to buyers, and it may
even provide inaccurate or misleading information by sellers eager to promote and sell their products.
A c a a a ab b b
Adverse selection where the buyer has information not available to the seller often arises in the area
of insurance services, where the buyer of insurance has more information than the seller. This
situation arises most often in the area of health insurance. Buyers of health insurance know more
about the state of their health than sellers of insurance, and those with health problems are unlikely to
tell the full truth to the insurance company. In a free unregulated market, adverse selection results in
an underallocation of resources to health insurance services, as the insurance company reduces the
supply of insurance to protect itself against having to provide insurance coverage to very high risks,
or people who are more likely to become ill. Adverse selection also leads to high insurance costs for
insurance buyers.
P b a c b
P a
Private insurance companies usually protect themselves by offering a range of policies where the
lower the cost of the insurance, the higher the deductible (out-of-pocket payments). This offers people
choice, so that those who believe they have a low risk of getting sick can buy a low-cost policy with a
higher deductible, while higher-cost policies with lower deductibles can be selected by people who
believe they have high levels of health risk. This is actually a method of c eening undertaken by the
party with the limited information, or seller of insurance. The choice of high or low deductible given
to the buyers of insurance is intended to screen them by indirectly providing information about their
state of health to the seller of insurance.
However in practice, it does not work out this way. An important reason is that lower-income earners
choose low-cost policies with high out-of-pocket payments because these are more affordable,
ega dle of he a e of hei heal h. From the perspective of equity or fairness, this is undesirable
because it discriminates against those on low incomes. Another reason is that in trying to protect
themselves against high risks, insurance companies usually refuse to insure people above a certain
age, as elderly people generally have a higher chance of becoming ill. The result is that those who
mostly need health insurance coverage, who are poor people who cannot afford to buy health care in
the private market and elderly people who are more likely to become ill, are left with little or no
insurance coverage.
G
To deal with this problem, government responses may take the form of direct provision of health care
services at low or zero prices to an entire population, financed by tax revenues, thus ensuring that the
entire population has health insurance coverage, such as in countries with a National Health Service
(as in many European countries). Alternatively, they make take the form of social health insurance,
which may cover a country’s entire population (as in several European countries), or which
selectively covers only certain vulnerable groups of the population (as in the United States). The
benefit of these approaches, particularly in countries that offer insurance coverage to their entire
population, is that no one in need of health care goes without it.
A potential problem with government-funded or social health care systems involves difficulties in
controlling costs of providing health care and growing burdens on the government budget or social
health insurance budget.
M a a a
E a a a a
M a a a refers to situations where one party takes risks, but does not face the full costs of these
risks because the full costs of the risks are borne by the other party. It usually arises when the buyer
of insurance changes his or her behaviour af e obtaining insurance, so that the outcome works
against the interests of the seller of insurance. For example, buyers of car theft insurance may be less
careful about protecting their car against theft, because they know they will be reimbursed if someone
steals their car. Some buyers of medical malpractice insurance (doctors) may be less careful about
avoiding malpractice, because of the knowledge that malpractice costs will be covered by the insurer.
Unemployment insurance may lead some people to be less hesitant about becoming unemployed, in
the knowledge that their insurance will provide them with some income.
In all these cases, the buyers of insurance have information about their future intentions that is not
available to the sellers of insurance. In a free, unregulated market, the result of moral hazard is to
underallocate resources to the production of insurance services, as sellers of insurance try to protect
themselves against higher costs due to the risky behaviour of the buyers of insurance.
Many economists have noted that the financial crisis that began in 2008 was partly a case of moral
hazard. It is argued that many financial institutions made risky loans and engaged in other highly
risky financial transactions because they believed that the government would support them in the
event of difficulties (which, in fact, it did). (Note that this is not a matter of taking out an insurance
policy in the strict sense of the term, but it is a sort of ‘insurance’ nonetheless, in that the government
provides a kind of assurance of protection in the event that financial institutions face difficulties due
to poor loan repayments.)
You may note that the term ‘moral hazard’ does not refer to unethical or immoral behaviour. It is
simply a historical remnant of a very old insurance term that originally meant ‘subjective’.
R a a a
Problems of moral hazard in insurance are usually dealt with by the provider of insurance. This is
often done by making the buyer of insurance pay for part of the cost of damages through deductibles
(out-of-pocket payments). This is intended to make the insurance buyer face the consequences of
risky behaviour, thus leading to less risky behaviour. It will be recalled from the discussion above that
deductibles are a form of c eening.
A problem with deductibles is that it has different effects depending on the income level of insurance
buyers. As noted earlier in connection with adverse selection, private insurance companies usually
offer a range of policies from which buyers can choose, where the lower the cost of the insurance, the
higher the deductibles. Higher-income earners usually choose higher-cost policies with low
deductibles, while lower-income earners choose low-cost policies with high deductibles because these
are more affordable. This suggests that higher-income earners are more likely to engage in risky
behaviour because they are offered more insurance protection, while lower-income earners are less
likely to engage in risky behaviour.
In the financial area, moral hazard is dealt with through government regulation of financial
institutions, intended to oversee and prevent highly risky behaviour. This raises a whole set of issues
regarding the types and degrees of government regulations that are required if these are to be
effective. In general, following the onset of the global financial crisis in 2008 governments in Europe
and the United States have taken steps to increase regulation of the financial sector, though there are
concerns that this has not been enough, especially in the United States.

1 a Using examples, identify two main types of information problems that give rise to
market failure.
b Using the concept of allocative efficiency, explain why information asymmetries
represent market failure.
2 a Provide examples of information asymmetries where information is available to sellers
but not to buyers.
b Explain how governments can intervene to correct these information asymmetries.
c Explain possible private responses to information asymmetries.
Discuss some advantages and disadvantages of both government intervention and
private responses.
3 a Provide examples of information asymmetries where information is available to buyers
but not to sellers.
b Explain how governments can intervene to correct these information asymmetries.
c Discuss advantages and disadvantages of these types of government intervention.
6.5 E
(HL )
LEARNING OBJECTIVES

explain why the free market results in an unequal distribution of income and wealth (AO2)
draw a circular flow of income diagram to show why free markets give rise to income
inequalities (AO4)
W
In Chapter 1, we saw that equity refers to the idea of being fair and just, while equality is the state of
being equal with respect to something. Therefore income equality would mean that everyone in a
society receives the same amount of income. We also learned that while equity and equality have
different meanings, in most countries the pursuit of equity is understood to refer to efforts to reduce
significant inequalities in income and wealth. The reason for this is that people around the world
generally share the belief or value judgement that the free market economy results in inequalities that
are considered to be unfair. We will now see why this is so.
Our study of the circular flow model in Chapter 1 shows that in a market economy the amount of
goods and services that households receive depends on their income, as this determines how much
they can buy. Figure 1.4, showing the simple circular flow model (with no leakages and injections),
appears below as Figure 6.8. We can see here that the income of households depends on payments
they receive by selling the factors of production they own. Therefore, output and income distribution
in a market economy depend on how many resources consumers (households) own and are able to
sell in resource markets, as well as on the prices of the factors of production they sell.
F 6.8: Circular flow of income model
The problem of income distribution arises because ownership of factors of production is highly
unequal, and because the prices of factors of production determined in the market vary enormously.
Most people have labour resources that they provide in labour markets, for which they receive wages.
Yet some people are able to receive very high wages because of special skills and education or natural
talents, while others who are less skilled, educated or talented may receive wages so low that they
may be unable to cover the most basic needs for themselves and their families (food, shelter, clothing,
etc.).
Further, there may be people who would like to work but cannot do so because they lack the kinds of
skills firms want to hire, or because they are sick, or old, or have special needs that prevent them from
working, or because there simply are not enough jobs in the economy to provide work for everyone.
Then there are some individuals who possess some of the additional factors of production of land,
capital and entrepreneurial abilities, for which they receive rental, interest and profit income. These
additional factors of production are generally highly unequally distributed. As a result, the market-
determined distribution of income in an economy is likely to be very unequal, with some people
receiving far larger shares than others.
It follows that markets cannot ensure that everyone in a population will secure enough income to
satisfy their basic needs. Most societies consider this to be a disadvantage of the free market
economy, because of the belief held by most people that everyone in a population should be able to
satisfy a minimum of basic human needs. Governments around the world therefore use a variety of
methods to change the market-determined distribution of income and output, and arrive at a more
socially desirable outcome. This is referred to as redistribution. We will come back to the topic of
income distribution in Chapters 12 and 20.
I
As we have seen in connection with the circular flow model, income refers to the flow of money that
is received by the owners of the factors of production. W , on the other hand, refers to the money
or things of value that people own, such as savings deposits (money saved in a bank); stocks in the
stock market; bonds; land, houses and other property; valuable paintings or jewellery, and so on;
minus debt to banks or other financial institutions.
Income gives rise to the possibility of saving, which can then be used to create wealth, and so wealth
and income are related to each other as would be expected. Yet they are distinct and are not always
closely linked together. For example, some people may have high incomes but low savings because
they spend a lot, in which case they will have relatively low wealth. On the other hand, there may be
people who have inherited wealth, or pensioners who have saved over a lifetime of work, who have
high levels of wealth but relatively low incomes.
In general, however, we can say that the higher the income, the greater the possibilities for saving and
for accumulating wealth. Therefore, just as the free market economy results in income inequalities, so
too it results in wealth inequalities.
We will come back to the topic of inequalities in income and wealth in Chapter 12, where we will
discover that inequalities in wealth are in fact far greater than inequalities in income.
I
It should be noted that the inability of the market to ensure that everyone in a population will secure
enough income to satisfy their basic needs is not strictly speaking market failure. This follows from
the way that market failure is defined. As we know, market failure is the inability of the market to
achieve allocative efficiency, where MSB = MSC, or where social surplus is maximum. This bears no
connection with income or wealth distribution. It is in fact possible to have allocative efficiency and
maximum social surplus either with complete income equality or with extreme inequality, where for
example a large portion of the population is starving. This peculiarity will be discussed in the Theory
of knowledge 6.1.

1 Explain, using examples, the difference between equity and equality in income wealth
distribution.
2 Using the circular flow of income diagram, explain why the market system cannot ensure that
everyone in a society will be able to secure an adequate income to satisfy basic needs.
THEOR OF KNOWLEDGE 6.1

I :
It was noted above that inequalities in income and wealth are not a type of market failure, because it is
possible to have any degree of inequality where there is at the same time allocative efficiency with
maximum social surplus.
Yet you may wonder, how can there be maximum social surplus with extreme inequality? The answer
to this lies partly in the positive-normative distinction we discussed in Chapter 2. If you revisit Theory
of knowledge 2.1 in Chapter 2 (at the end of Section 2.5), you will be reminded that maximum social
surplus (or welfare) refers to the what/how much to produce and how to produce questions of
economics, and the idea of making the best possible use of resources, which are in the sphere of
positive economics. Equality and inequality on the other hand refer to the for whom to produce
question, which belongs to the sphere of normative economics.
Yet this by itself is not a satisfactory explanation, especially if we remember that allocative efficiency
can be defined as producing the combination of goods mostly wanted by society. In Chapter 2, Section
2.5, we saw that allocative efficiency is achieved when the economy allocates its resources so that the
benefits from consumption are maximised for the whole of society.
This clearly gives rise to a pu le. How can benefits from consumption be maximised for the whole of
society if there is extreme inequality with a large part of the population starving?
We can find the answer to this pu le in the definition of demand, which we studied in Chapter 2
(Section 2.1). As you may recall, demand shows the various quantities of a good that a consumer is
willing and able to buy at different possible prices, ceteris paribus. The answer to our pu le lies in
the able to buy part of this definition. If consumers have little or no income, they are not able to buy
the good, and therefore they do not have any demand for it. In other words, no demand will show up
in the market for the good from consumers with little or no income, however much they may want to
buy it.
We now have the answer to the pu le. As we know, the condition MSB = MSC is equivalent to
maximum social surplus (or welfare). Alternatively, we can say that MB = MC is equivalent to
maximum social surplus when there are no externalities. But MB is simply the demand curve! And
MSB is also simply a demand curve for the whole of society that accounts for any possible external
costs or benefits! This means that when we say that there is allocative efficiency and maximum social
surplus when the benefits from consumption are maximised for the whole of society, we are simply
talking about that part of society that has a demand because consumers are not only willing but also
able to buy the good! Consumers from the rest of society with little or no income and hence no
demand are bypassed, ignored and forgotten.
In other words, allocative efficiency is defined on the basis of demand from those consumers who
have enough income to make their preferences felt in the market.
T
The work of the classical economists, such as Adam Smith who we met in Chapter 1, was not based
on the positive-normative distinction. Economists at the time, as you may remember were moral
philosophers, and Adam Smith was deeply concerned with issues of ethics. It was only in the early
20th century that economists became influenced by the methods of the natural sciences and the idea
that facts should be kept distinct from values. Yet in more recent years, some economists, such as
Amartya Sen, an Indian Nobel Pri e winning economist for his work on Economic Development,
argue that it does not make sense for economists to maintain this strict separation between facts and
values. Sen s work reintroduces ethics and values into economic analysis and mixes them to create a
unified whole. We will encounter Amartya Sen in Chapter 18.
In your study of economics, you are encouraged to consider the positive-normative distinction.
Do you agree with the idea that facts (positive) should be kept distinct from values (normative)
in the study of economics? Is it even possible to always make this distinction, or do values creep
into the work of economists? We will come back to this point in Theory of knowledge features
9.1, 10.1, 15.1 and 18.1.
Consider what redistribution of income leading to reduced inequalities in an economy implies for
the concept of allocative efficiency. In particular, consider that people who previously had no
demand for a good or service may now have such a demand based on their higher income. What
is likely to happen to the efficient level of output of particular goods and services?
INQUIR AND REFLECTION

The following questions will help you reflect on your learning and enhance your understanding of key
topics in this chapter. They are suggestions for inquiries that you can undertake on your own or in
groups in order to revise the learning objectives of this chapter.
1 Identify a good or service in your country or a country you are interested in that gives rise to a
particular positive consumption externality. Examine the external benefits and their effects on
stakeholders, investigate solutions in use, evaluate the solutions and identify effects on
stakeholders.
2 Identify a public good that has been contracted out to the private sector in a country you are
interested in and investigate the advantages and disadvantages that have emerged.
3 Investigate a situation where asymmetric information involves adverse selection or moral ha ard
and identify public and private solutions that have been used to address it.
E AM ST LE QUESTIONS
You can find questions in the style of IB exams in the 'Digital coursebook: Extra material' section.
Cha e 7
Ma ke fail e and ciall

nde i abl c me III:
Ma ke e (HL nl )
BEFORE YOU START

In what ways do firms compete with each other in order to increase their sales?
When firms compete with each other to increase sales, some firms might have advantages
over others. Can you think of what some of these advantages may be?
From the consumer s point of view can you think of some advantages and disadvantages of
firms that grow to a very large size?
This chapter is concerned with the relationship between the behaviour of firms and market failure. We
will begin by introducing the fundamental concepts of revenues, costs and profits needed to study
firm behaviour. We will then see how firm behaviour within particular markets gives rise to market
power, which is linked to an important kind of market failure.
7.1 I c , a
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LEARNING OBJECTIVES
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7.2 P
LEARNING OBJEC I E

e lain co , e en e and ofi conce (AO2)
o al e en e, a e age e en e, ma ginal e en e
o al co , a e age co , ma ginal co
abno mal ofi , no mal ofi , lo
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TR= P Q
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ni of o (Q):
AR=TRQ
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R
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R :
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of he good in i a ion he e a fi m canno con ol ice. Col mn 3, 4 and 5 a e calc la ed f om
he da a in col mn 1 and 2, ing he defini ion gi en abo e. No e ha he p ice a hich he good
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7.2.
1 2 3 4 5A
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MR= TR Q
( )
0
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
6 10 60 10 10
7 10 70 10 10
7.2: Calc la ing o al, ma ginal and a e age e en e hen ice i con an : he fi m ha no
con ol ice; he ca e of e fec com e i ion
F 7.1: To al, ma ginal and a e age e en e c e hen ice i con an : he fi m ha no

con ol o e ice; he ca e of e fec com e i ion
R : ,
,
Table 7.3 ho o al, ma ginal and a e age e en e f om ice and an i info ma ion in he ca e
he e he fi m ha ome infl ence o e ice. The me hod of calc la ion i e ac l he ame a in he
com e i i e ca e abo e, he e col mn 3 5 a e calc la ed ing he info ma ion of he fi o
col mn . The diffe ence i in he ice da a, a ea ing in col mn 2, ho ing ha he p ice a hich
he good i old change a he an i of o p change . The lo e he ice he g ea e he
an i of o , ill a ing he la of demand. Thi occ nde all ma ke model ha e ill
d o he han e fec com e i ion. Fig e 7.2 lo he da a of Table 7.3.
1 2 3 4 5
P M A
(Q) (P) ( = P Q)
( ) ( ) MR= TR Q AR=TRQ
( ) ( )
0
1 12 12 12 12
2 11 22 10 11
3 10 30 8 10
4 9 36 6 9
5 8 40 4 8
6 7 42 2 7
7 6 42 0 6
8 5 40 2 5
9 4 36 4 4
10 3 30 6 3
7.3: Calc la ing o al, ma ginal and a e age e en e hen ice a ie : he fi m ha ome
con ol o e ice; he ca e of mono ol , mono oli ic com e i ion, oligo ol
F 7.2: To al, ma ginal and a e age e en e c e hen ice a ie : he fi m ha ome con ol
o e ice; he ca e of mono ol , mono oli ic com e i ion, oligo ol
C
To calc la e e en e , i i onl nece a o emembe and nde and he ela ion hi be een he
a io e en e conce , beginning i h he idea ha TR = P Q. If o a e gi en da a on P and Q,
o can find TR, and f om he e o can calc la e AR=TRQ and MR= TR Q . Yo can al o o k
back a d o find TR and MR if o kno AR and Q, o o find TR and AR if o kno MR and Q.
Remembe al o ha AR = P in all ca e , o ha if o kno AR, o al o kno he ice of he
od c .
To calc la e e en e f om a diag am, e im l ead off he info ma ion a ea ing in he g a h, and
a l e ac l he ame inci le a abo e o calc la e he e en e a iable o a iable e a e
in e e ed in.
When fi m e in o e o ce o od ce, he inc , hich incl de mone

a men o b e o ce l an hing el e gi en b a fi m fo he e of e o ce . The
e o ce incl de land, labo , ca i al and en e ene hi ( ee Cha e 1).
When he fi m e e o ce i doe no o n, i b hem f om o ide and make a men of
mone o he e o ce lie . Fo e am le, a fi m hi e labo and a a age; i cha e
ma e ial and a he ice o he elle . S ch a men made b a fi m o o ide o ac i e
e o ce fo e in od c ion a e kno n a e plici co .
On he o he hand, hen he fi m e e o ce i o n , he e i ill a co , hich con i of he
income ha i ac ificed hen he fi m e ch a elf-o ned e o ce. Fo e am le, in he ca e of
an office b ilding o ned and ed b he fi m, he co i he en al income ha co ld ha e been
ea ned if he b ilding e e en ed o . Yo can hink of hi a an o o ni co . The ho of o k
a fi m o ne in o hi o he o n b ine ha e an o o ni co e al o ha he fi m o ne
co ld ha e ea ned if /he had o ked el e he e. The en e ene ial abili ie he fi m o ne in o
he b ine ( i k- aking, inno a i e, o gani a ional and manage ial abili ie ) in ol e a f he
o o ni co e al o ha he e abili ie co ld ha e ea ned el e he e. The ac ificed income
a i ing f om he e of elf-o ned e o ce b a fi m i an implici co .

1 Define
o al e en e,
ma ginal e en e, and
a e age e en e.
2 Gi en he follo ing ice and an i da a fo a od c , calc la e o al e en e, ma ginal
e en e and a e age e en e.
P ($) 5 5 5 5 5
Q ( ) 0 1 2 3 4
3 Gi en he follo ing ice and an i da a fo a od c , calc la e o al e en e, ma ginal

e en e and a e age e en e.
P ($) 8 7 6 5 4 3 2
Q ( ) 2 3 4 5 6 7 8
4 O line ha can be concl ded abo ho ice change (o doe no change) fo each
ni of o old in e ion 2 and 3.
E lain he ela ion hi be een ice and a e age e en e.
5 Gi en he follo ing da a, calc la e o al e en e and ma ginal e en e fo each le el of
o . Iden if he ice a each le el of o .
Q ( ) 1 2 3 4 5 6
A ( ) 20 18 16 14 12 10
6 Gi en he follo ing da a, calc la e o al e en e and a e age e en e fo each le el of

o . Iden if he ice a each le el of o .
Q ( ) 1 2 3 4 5 6
M ( ) 14 12 10 8 6 4
The m of e lici and im lici co inc ed b a fi m fo i e of e o ce , he he

cha ed o elf-o ned, a e kno n a economic co . When economi efe o co he
mean economic co .
C
In Cha e 2 (Sec ion A mp ion nde l ing he la of ppl ), o e e in od ced o co of
od c ion. (I i gge ed ha o e ead hi ec ion befo e con in ing f he .) Ve b iefl , he
ele an a f om ha ec ion incl de he follo ing conce :
ho n = he e iod of ime hen a lea one fac o of od c ion i fi ed
long n = he e iod of ime hen all fac o of od c ion a e a iable
o al co = all co of od c ion inc ed b a fi m
ma ginal co (MC) = he e a o addi ional co of od cing one mo e ni of o .
To calc la e MC, e e he fo m la
MC= TC Q
We no need o in od ce one mo e co conce : (AC), hich i co e ni of o
od ced, o o al co (TC) di ided b ni of o (Q):
AC=TCQ
Table 7.4 belo i he ame a Table 2.5 in Cha e 2 ( he e o lea ned ho o calc la e ma ginal
co ) and in addi ion incl de a ne col mn ho ing a e age co .
( ( C) M A (AC) ($)
, Q) ($) (MC) ($)
1 12 12 12
2 20 8 10
3 26 6 8.67
4 34 8 8.5
5 46 12 9.2
6 62 16 10.33
7.4: To al co , ma ginal co and a e age co
Fig e 7.3 lo ma ginal co and a e age co ba ed on he da a ha a ea in Table 7.4. A

e lained in Cha e 2 he MC c e i ba ed on he la of dimini hing ma ginal e n (Sec ion
A mp ion nde l ing he la of ppl ). The ame a lie o he AC c e. Yo ma ecall ha
dimini hing e n hold onl in he ho n hen a lea one fac o of od c ion i fi ed.
The efo e o anal i of co in hi ec ion clea l applie o he ho n.
F 7.3: Ma ginal co and a e age co in he ho n
I i im o an o no e he ela ion hi be een he a e age co and ma ginal co c e : hen he

ma ginal co c e lie belo he a e age co c e, (MC<AC), a e age co i falling; and hen
he ma ginal co c e lie abo e he a e age co c e (MC>AC), a e age co i inc ea ing. Thi
mean ha he ma ginal co c e al a in e ec he a e age co c e hen hi i a i
minim m. The ea on lie in he ma hema ical ela ion hi be een he a e age and ma ginal al e
of an a iable.
Con ide a im le e am le in ol ing e co e . Sa o ha e an a e age of 80 in o e . If o
ne e co e ( he ma ginal co e) i g ea e han o a e age of 80, o a e age ill inc ea e. If
o ne e co e i lo e han o a e age of 80, o a e age ill fall. The ela ion hi be een
a e age and ma ginal e co e i e ac l he ame a he ela ion hi be een a e age and ma ginal
co .
C -
Yo can calc la e co ea il if o emembe and nde and he ela ion hi be een he co
conce e ha e j di c ed. If o ha e info ma ion on ni of o (Q) and o al co (TC),
o can find AC = TC Q and MC= TC Q . Yo can al o o k back a d o find TC and MC if o
kno AC and Q, o o find TC and AC if o kno MC and Q.
To calc la e co f om a diag am, o can j ead off he info ma ion a ea ing in he g a h, and
a l e ac l he ame inci le a abo e o calc la e he co a iable o a iable o a e
in e e ed in.

1 Define
o al co ,
ma ginal co , and
a e age co .
2 Gi en he follo ing an i and o al co da a fo a od c , calc la e a e age co and
ma ginal co .
Q 2 5 9 14 18 21 23 24
( )
( ) 300 400 500 600 700 800 900 1000
3 Gi en he follo ing da a, calc la e o al co and ma ginal co fo each le el of o .
Q ( ) 1 2 3 4 5
A ( ) 180 140 133 135 140
4 Gi en he follo ing da a, calc la e o al co and a e age co fo each le el of o
Q ( ) 1 2 3 4 5
Q ( ) 11 12 10 12 14
C
Yo ma emembe ha he long n i he e iod of ime hen he fi m a ie (change ) all i
fac o of od c ion. We a e in e e ed in e amining ho he fi m a e age co , o i co e
ni of o , change hen i g o la ge b inc ea ing all of i fac o of p od c ion.
A an momen in ime, hen he fi m i in he ho n, i ha a a ic la ho - n AC c e; e
can call hi i SRAC. When i g o o e ime, e can hink of i a going in o he long n,
inc ea ing all i fac o of od c ion, and hen going in o a ne ho n i h a ne SRAC.
Imagine hi oce e ea ing i elf again and again: he fi m goe f om one ho - n o i ion o
ano he and hen o ano he , and he e ho n o i ion a e connec ed o each o he h o gh
momen hen he fi m en e he long n in o de o inc ea e all of i fac o of od c ion. Thi
oce i ho n in Fig e 7.4(a), he e e ee ha a he fi m g o bigge , i ha a e ie of SRAC
c e , SRAC1, SRAC2, and o on. Imagine no an infini e n mbe of SRAC ; he ill ace o he
long n a e age co c e, o LRAC, hich i he c e ha j o che (i angen o) each of he
ho - n c e .
We can ee ha he SRAC c e kee hif ing o he igh , hich i ha e o ld e ec ince
he e i mo e and mo e o (Q) being od ced. B no e ha he SRAC c e no onl mo e o
he igh , b al o a fi mo e do n a d, and af e a oin he mo e a d. I i hi U- ha e of
he LRAC c e ha e an o e amine.
F 7.4: The long- n a e age co c e
The ea on fo he U- ha e of he LRAC ha e no hing o do i h dimini hing ma ginal e n ,

hich a e a fea e of ho - n od c ion and co . The U- ha e of he LRAC c e can be fo nd
in economic and di economie of cale.
E a e dec ea e in a e age co of od c ion o e he long n a a fi m inc ea e
all i fac o of od c ion. The e lain he do n a d- lo ing o ion of he LRAC c e.
Some ea on h hi occ incl de:
. A he cale of od c ion inc ea e , mo e o ke m be em lo ed,
allo ing fo g ea e labo peciali a ion. Each o ke eciali e in e fo ming a k ha make
e of kill , in e e and alen , h inc ea ing efficienc and allo ing o o be od ced
a a lo e a e age co .
. La ge cale of od c ion allo fo mo e manage o be
em lo ed, each of hom can be eciali ed in a a ic la a ea ( ch a od c ion, ale ,
finance, and o on), again e l ing in g ea e efficienc and lo e a e age co .
B ( ). A an i ie of in cha ed inc ea e, he
ice e ni d o .
F . La ge fi m ma ha e lo e in e e ae , h con ib ing o lo e
co e ni of o .
, , . Co of
ce ain ac i i ie ch a ma ke ing and ad e i ing, de ign, e ea ch and de elo men , e l in
lo e a e age co if he can be ead o e la ge ol me of o .
Di economie of cale, on he o he hand, a e inc ea e in he a e age co of od c ion in he long
n a a fi m inc ea e i o b inc ea ing all i in . The a e e on ible fo he a d-
lo ing a of he LRAC c e: a a fi m inc ea e i cale of od c ion, a e age co inc ea e.
Rea on fo di economie of cale incl de:
C - . A a fi m g o la ge , i managemen ma n
in o diffic l ie of co-o dina ion, o gani a ion, co-o e a ion and moni o ing. The e l in ol e
g o ing inefficiencie ca ing a e age co o inc ea e a he fi m e and .
C . A la ge fi m i e ma lead o diffic l ie in comm nica ion
be een a io com onen a of he fi m, e l ing in inefficiencie and highe a e age
co .
P . If o ke begin o lo e hei mo i a ion, o feel bo ed and o ca e
li le abo hei o k, he become le efficien , e l ing in highe a e age co .
S anda d economic heo a me ha fi m di la a ional beha io b ing o ma imi e hei

ofi , meaning ha he o make hei ofi a la ge a o ible (Cha e 2). In gene al,
ofi = e en e co of od c ion
In economic , ofi i defined a :
ofi = o al e en e economic co
= o al e en e he m of e lici co + im lici co
ince economic co a e he m of e lici l im lici co .
P
S anda d economic heo of he fi m a me ha fi m beha io i g ided b he fi m goal o
ma imi e ofi . P in ol e de e mining he le el of o ha he fi m ho ld
od ce o make ofi a la ge a o ible.
Ye fi m do no al a make a ofi ; in ome ca e , hei o al e en e i no fficien o co e all
co , in hich ca e he make a , hich can be ho gh of a nega i e ofi . If a fi m i making
a lo , i ma e en all go o of b ine , b n il i decide o h do n, i ill be in e e ed in
od cing he an i of o ha ill make i lo a mall a o ible. The efo e, he heo of
he fi m i al o conce ned i h ho m ch o a lo -making fi m ho ld od ce in o de o
minimi e i lo .
The e a e o a oache o anal ing ofi ma imi a ion (o lo minimi a ion): one in ol e e
of o al e en e and o al co and he o he in ol e e of ma ginal e en e and ma ginal co .
Bo h he e a oache ield he ame e l fo he ofi -ma imi ing (o lo -minimi ing) le el of
o .
P
Thi a oach i ba ed on he im le inci le ha
ofi = o al e en e (TR) o al co (TC)
he e TC i he fi m economic co (e lici l im lici ).
The fi m ofi -ma imi a ion le i o od ce he le el of o he e TR TC i a la ge a
o ible.
The amo n of ofi made b he fi m i e al o he n me ical diffe ence be een TR and TC.
Po i i e ofi : TR > TC; he fi m ea n .

Ze o ofi : TR = TC; he fi m ea n .
Nega i e ofi : TR < TC; he fi m make a
We ill e n o he e m abno mal p ofi and no mal p ofi .
P
P ofi ma imi a ion ing hi a oach i ba ed on a com a i on of ma ginal e en e (MR) i h
ma ginal co (MC) o de e mine he ofi -ma imi ing le el of o . The fi m ofi -
ma imi a ion le
(and lo -minimi a ion) i o choo e o od ce he le el of o he e MC = MR.
In Fig e 7.5, bo h a (a) and (b) ho he anda d MC c e ha e died abo e (a ell a in
Cha e 2 in connec ion i h he fi m l c e). A e kno , he e a e o kind of ma ginal
e en e c e , de ending on he he o no he fi m ha con ol o e he ice of i o . Pa (a)
ho he MR c e of he fi m i h no con ol o e ice. Pa (b) ho he MR c e of he fi m
i h ome con ol o e ice. Bo h a (a) and (b) ill a e he iden ical inci le abo ofi
ma imi a ion.
Acco ding o he ofi -ma imi ing le, MC = MR, he oin of in e ec ion be een he MC and MR
c e de e mine he ofi -ma imi ing le el of o ; hi i Q ma in Fig e 7.5(a) and (b). Wh
i hi o? Con ide a fi m od cing o Q1 in bo h a (a) and (b), he e MR > MC. If hi fi m
inc ea e i o b one ni , he addi ional e en e i o ld ecei e (MR) ill be g ea e han i
addi ional co (MC). I i he efo e in he fi m in e e o inc ea e i le el of o n il i eache
Q ma he e MR = MC. If i con in e o inc ea e o be ond Q ma , a o Q2, he e MR < MC,
he addi ional e en e i o ld ecei e fo an e a ni of o i le han he addi ional co , and
o i ho ld c back on i Q. The e i onl one oin he e he fi m can do no hing o im o e i
o i ion, and ha i Q ma , he e MR = MC, and ofi i he g ea e i can be.
F 7.5: P ofi ma imi a ion ing he ma ginal e en e and ma ginal co a oach
Fi m ma imi e ofi o minimi e lo e hen he od ce a an i of o he e MC =

MR. Thi hold fo all ma ke c e.
When e a e gi en da a fo MC and MR (and no info ma ion on o al co and o al e en e ), all e

can do i find he ofi -ma imi ing le el of o he e MC = MR, b e canno find he amo n
of ofi (o lo ) nle e ha e mo e info ma ion. We ill ee ho hi i done belo hen e
d he ma ke c e.

1 Iden if he oa oache o ofi ma imi a ion b fi m .
De c ibe he f nc ion of he e o a ioning mechani m .
2 Sa a fi m i od cing a le el of o Q he e MC > MR. S a e ha i ho ld do o
inc ea e i ofi (o ed ce i lo ).
S a e ha i ho ld do if i i od cing Q he e MC < MR.
3 A me ha a fi m ha ha no con ol o e i ice ell i o a $5 e ni .
Gi en he follo ing da a, e he o al e en e and o al co a oach o de e mine he
le el of o a hich he fi m ill ma imi e ofi .
Calc la e ho m ch ofi i ill make.*
Calc la e he amo n of ofi (o lo ) hen Q = 3, Q = 6, Q = 10.
1 2 3 4 5 6 7 8 9 10
(Q)
($) 15 18 20 21 23 26 30 35 41 48
4 Gi en he da a in e ion 3
de e mine he le el of o a hich he fi m ill ma imi e ofi ing he ma ginal
e en e (MR) and ma ginal co (MC) a oach. (Hin : o m e he info ma ion in
he e ion o find MR and MC.)
Did o find he ame ofi -ma imi ing le el of o a in e ion 3(a)?
5 S o e ha a fi m i h ome con ol o e ice face he co and ice e ni of o
ho n in he able belo .
U e he o al e en e and o al co a oach o de e mine he le el of o a hich
he fi m ill ma imi e ofi .
Calc la e ho m ch ofi ill i make.*
Calc la e he amo n of ofi (o lo ) hen Q = 2, Q = 3, Q = 8.
1 2 3 4 5 6 7 8
(Q)
($) 15 18 20 21 23 26 30 35
P ($) 10 9 8 7 6 5 4 3
6 Gi en he da a in e ion 5,
de e mine he le el of o a hich he fi m ill ma imi e ofi ing he ma ginal
e en e (MR) and ma ginal co (MC) a oach. (Hin : o m e he info ma ion in
he e ion o find MR and MC.)
Did o find he ame ofi -ma imi ing le el of o a in e ion 5?
* When ing he TR and TC a oach o e l gi e o ofi -ma imi ing le el of o ,
he ea he MR and MC a oach gi e onl one. Thi i beca e he MR and MC a oach i
ac all mo e eci e han he TR and TC a oach. I i a good idea o e he la ge of he o
al e of o ha o ge b ing he TR and TC a oach.
When ofi i e al o e o, and o al e en e i e al o o al economic co , he fi m i aid o be

making no mal ofi .
No mal p ofi can be defined a he minim m amo n of e en e ha he fi m m ecei e o ha

i ill kee he b ine nning (a o o ed o h ing do n). I can al o be defined a he
amo n of e en e ha co e all e lici and im lici co . The efo e, a fi m ea n no mal ofi
hen o al e en e = economic co and ofi = e o.
The e a a en l diffe en defini ion a e in fac con i en : he minim m amo n of e en e he fi m

m ecei e o make i o h hile o a in b ine i e al o he e en e ha co e all of he
fi m co , im lici l e lici .
No e ha no mal ofi al o incl de he pa men fo en ep ene hip. En e ene hi , o ill
emembe , incl de he alen o o gani e and manage a b ine and ake i k . En e ene hi
ecei e a a men j a all o he fac o of od c ion do, and hi a men i incl ded in no mal
ofi . Thi mean ha if o a e he o ne of a i a e a an hich i ea ning no mal ofi
(meaning e o ofi ) o a e ill ge ing aid fo all o o k a en e ene in o b ine .
The efo e o ha e no ea on o clo e do n o e a an .
Thi mean ha a fi m ill con in e o od ce e en if i i ea ning e o ofi , meaning i i ea ning
no mal ofi .

1 Define ofi and no mal ofi , and e lain he diffe ence be een hem.
2 E lain h ofi can be o i i e, e o o nega i e.
3 A fi m ea n eo ofi , and e i doe no h do n. E lain h .
7.3 P
LEARNING OBJEC I ES

e plain firm in perfec compe i ion a price aker ha ing no marke po er (AO2)
e plain profi ma imi a ion in he hor r n and in he long r n (AO2)
e plain he meaning of alloca i e efficienc in erm of i nece ar condi ion , P = MC or
MB = MC or ma im m ocial rpl (AO2)
dra diagram ho ing (AO4)
he perfec l compe i i e firm a a price aker here P = D = AR = MR
he perfec l compe i i e firm making abnormal profi , normal profi , lo
perfec l compe i i e marke eq ilibri m ho ing alloca i e efficienc
di c he ad an age and di ad an age of perfec compe i ion (AO3)
Le remind o r el e of he charac eri ic of perfec compe i ion:

There i a er large n mber of firm in he ind r .
All he firm in he ind r ell a homogeneo or iden ical ( ndifferen ia ed) prod c .
There are no barrier o en r in o he ind r .
( )
S ppo e o ha e a farm ha prod ce ra berrie . Yo are one of man mall ra berr
prod cer , o r ra berrie are er imilar o ho e prod ced b o her ra berr farmer , and
an one ho o ld like o prod ce ra berrie can do o ( here are no barrier o en r ).
Table 7.5 mmari e he co , prod c , re en e and profi concep e ha e died.
R D F
To al re en e The o al earning of a firm from he TR = P Q

ale of i o p .
Marginal re en e The addi ional re en e of a firm MR= TR Q

ari ing from he ale of an addi ional
ni of o p .
A erage re en e Re en e per ni of o p . AR= ER Q =P
E plici co The mone ar pa men made b a

firm o an o ider o acq ire an inp .
Implici co The income acrificed b a firm ha
e a re o rce i o n .
To al co (TC) The m of e plici and implici co
A erage o al co (AC) To al co per ni of o p . AC= TC Q
Marginal co (MC) The change in co ari ing from one MC= TC Q

addi ional ni of o p .
Long-r n a erage co A U- haped c r e ho ing a erage

(LRAC) c r e co in he long r n hen all of he
firm inp are ariable.
Profi To al re en e min o al co ( he TR TC
m of e plici pl implici co ).
Normal profi Occ r hen o al re en e eq al o al TR=TC

co . I i he minim m amo n of
re en e req ired b a firm o keep
r nning.
Abnormal profi Profi ha re l hen o al re en e TR>TC

i grea er han o al co . I i re en e
ha i o er and abo e normal profi .
Lo Nega i e profi ; occ r hen o al TR<TC

re en e i le han o al co
7.5: S mmar of co , prod c , re en e and profi concep
Fig re 7.6(a) ho andard marke demand and ppl c r e for ra berrie , hich de ermine he
eq ilibri m price, Pe. Fig re 7.6(b) ho he demand c r e for ra berrie a i a ea , he
a be d ce . I i perfec l ela ic, appearing a a hori on al line a Pe de ermined in he
marke . A perfec l ela ic demand c r e ha a price ela ici of demand (PED) eq al o infini
hro gho i range ( ee Chap er 3, Sec ion 3.1). Wha doe hi mean for o ?
F 7.6: Marke (ind r ) demand and ppl de ermine demand faced b he perfec l
compe i i e firm
A a ra berr prod cer, being mall, o can do no hing o infl ence hi price; o m accep Pe
and ell he amo n of ra berr o p ha ill ma imi e o r profi . Yo r farm (or o r firm) i
herefore a - . If o rai e o r price abo e Pe, o ill no ell an ra berrie beca e
b er ill b ra berrie el e here a he lo er price Pe. On he o her hand, ince o can ell all
o an a price Pe, o o ld ha e no hing o gain and ome hing o lo e ( ome re en e) if o
dropped o r price belo Pe. Therefore, o ell all o r ra berr o p a Pe.
The demand c r e for a good facing he perfec l compe i i e firm i perfec l ela ic (hori on al)
a he price de ermined in he marke for ha good. Thi mean he firm i a price- aker, a i
accep he price de ermined in he marke . The firm ha no abili o infl ence price herefore i
ha no marke po er.
The firm e are con idering i he one died in Sec ion 7.2 abo e, hen e died re en e da a
and c r e for he firm ha i nable infl ence ice. Con ider once again he e ample ed in
Table 7.2 and Fig re 7.1. A me ha a perfec l compe i i e firm ell a good a 10 per ni . In
Table 7.2, col mn 3 ho o al re en e, calc la ed b m l ipl ing ni of o p in col mn 1 b
price ho n in col mn 2. Col mn 4 calc la e marginal re en e, b aking he change in o al
re en e and di iding i b he change in o p . Col mn 5 ho a erage re en e, ob ained b
di iding o al re en e b q an i of o p . The da a in he able re eal an in ere ing pa ern:
No ma er ho m ch o p he perfec l compe i i e firm ell , P = MR = AR and he e are

con an a he le el of he hori on al demand c r e. Thi follo from he fac ha price i
con an regardle of he le el of o p old.
Thi re l hold onl for firm opera ing nder perfec compe i ion, beca e he e are he onl firm
ha are nable o infl ence price and are forced o ell all heir o p a he ingle price de ermined
in he marke .
The da a of Table 7.2 are plo ed in Fig re 7.7 belo hich i he ame a Fig re 7.1(b), here e
ee ha ince price i con an a 10, P = MR= AR, and he all coincide i h he hori on al demand
c r e.
F 7.7: Demand, marginal re en e and a erage re en e in perfec compe i ion

1 O line he charac eri ic of perfec compe i ion.
2 E plain h he perfec l compe i i e firm i a price- aker.
O line ha o ld happen if hi firm ried o rai e i price abo e he marke price or if
i lo ered i price belo he marke price.
3 O line ho he demand c r e facing he perfec l compe i i e firm rela e o he
ind r /marke eq ilibri m.
4 U ing a diagram, e plain he rela ion hip be een he firm a erage re en e (AR) and
marginal re en e (MR) in perfec compe i ion. O line ho are he rela ed o
prod c price,
he demand c r e facing he firm, and
he principle ha each firm i a price aker.
P
Remember, he hor r n i he period hen he firm ha a lea one fi ed inp . Thi mean he
n mber of firm in he ind r i al o fi ed. To en er or lea e an ind r , a firm m be able o ar
all i in . Since hi canno be done in he hor r n, firm canno en er or lea e he ind r ( n il
he mo e in o he long r n).
In erm of o r ra berr farm, hi mean ha o ha e ome fi ed inp ch a he land o
c l i a e, and perhap o r farm machiner . A long a all o her ra berr prod cer al o ha e a
fi ed amo n of agric l ral land and farm machiner , no one can en er or lea e ra berr
prod c ion.
When a firm an o ma imi e profi in he hor r n, ha m i do? Since i i a price- aker, i
canno infl ence i elling price. I can onl make a choice on ho m ch q an i of o p i ho ld
prod ce. We ill ee ho he firm doe hi ing he marginal re en e and marginal co r le,
in rod ced abo e.
S -
The anal i con i of hree ep .

F -
( - ) . A e kno , a firm in ere ed in ma imi ing
profi (or minimi ing lo ) prod ce o p here MR= MC. Fig re 7.5(a) ho Q ma o be
he profi -ma imi ing le el of o p .
C ( )
( ) . A compari on of a erage re en e ( hich i eq al o price) i h
a erage co ho he amo n of profi (or lo ) per ni of o p . We kno profi = T R TC.
If e di ide hi hro gho b o p , Q, e ge an e pre ion for profi per ni of o p , in
o her ord , in erm of a erage :
profi Q = TR Q TC Q
Al erna i el ,
profi Q =AR AC.
Moreo er, ince P = AR, i follo ha
profi Q =P AC
Thi i he ke o calc la ing ho m ch profi or lo per ni of o p he firm i making.
F ( ). To do hi , e m l ipl :
profi Q b Q (or lo Q b Q)
A he profi -ma imi ing le el of o p Q:

If AR > AC (or P > AC), he firm make abnormal profi (po i i e profi ).
If AR = AC (or P = AC), he firm make normal profi ( ero profi )
If AR < AC (or P < AC), he firm make a lo (nega i e profi ).
F 7.8: Shor -r n profi ma imi a ion in perfec compe i ion
U ing he abo e hree ep approach, e ill e amine he beha io r of he perfec l compe i i e firm
in he hor r n, making e of he diagram in Fig re 7.8. Each of he e diagram con ain iden ical
AC and MC co c r e ; no e ha MC al a in er ec AC a i minim m poin . Wha differ
be een he diagram i he po i ion of he perfec l ela ic demand c r e, ho ing differen po ible
price ha he firm, being a price- aker, m accep .
P
In Fig re 7.8(a), price P1= AR1= MR1 repre en he demand c r e facing he firm. U ing he r le MR
= MC, e arri e a he profi ma imi ing le el of o p Q1 ( impl dra a er ical line from he
poin of in er ec ion o he hori on al a i ). We hen compare P1 i h AC, along hi ame er ical
line, and ince P1> AC, e concl de he firm i making abnormal profi per ni eq al o P1 AC1,
gi en b he er ical di ance be een poin a and b. To find o al profi e m l ipl profi per ni
ime he o al n mber of ni prod ced, gi en b
profi = profi Q Q and i repre en ed b he haded area in he diagram.
When P>AC (or AR>AC) a he le el of o p here MC = MR, he firm earn abnormal profi
(po i i e profi ).
P
S ppo e he marke -de ermined price fall o P2, corre ponding o demand c r e D2 a in Fig re
7.8(b). Appl ing again he MR = MC r le, e find he profi -ma imi ing le el of o p Q2.
Comparing P2 i h AC a o p Q2, e ee he are eq al o each o her; herefore, profi per ni i
P2 AC2 = 0. Therefore, profi i ero and he firm i earning normal profi . When profi i ero,
price eq al minim m AC. The firm o al re en e are eq al o i o al co .
When P = minim m AC (or AR = minim m AC) a he le el of o p here MC = MR, he firm

earn normal profi ( ero profi ).
L
If he marke price fall belo minim m AC, ch a P3 in Fig re 7.8(c), corre ponding o demand
c r e D3 a in Fig re 7.8(b), he firm doe no earn eno gh re en e o co er all i co . U ing he
MC= MR r le, e ee ha he profi -ma imi ing or lo -minimi ing le el of o p i Q3, a hich P3
< AC, indica ing he firm i making a nega i e profi , or lo . Therefore, Q3 i he firm lo -
minimi ing o p . AC3 P3, or he difference be een poin c and d, repre en he firm lo per
ni of o p , or lo Q .
If e m l ipl hi er ical di ance b Q3, e ge he firm o al lo , gi en b he haded area.
When P < minim m AC (or AR < minim m AC) a he le el of o p here MC = MR, he firm
make a lo (nega i e profi ).
P
In he long r n, all he firm fac or of prod c ion are ariable; herefore, he n mber of firm in he
ind r i no longer nchanging. Ne firm can en er he ind r , e i ing firm can change heir
i e (increa e or decrea e all heir inp ), or firm can lea e he ind r al oge her. There i
herefore free en r of firm in an ind r .
F 7.9: The firm and ind r long-r n eq ilibri m po i ion in perfec compe i ion
N
In he long-r n eq ilibri m of perfec compe i ion, all firm earn ero profi , in o her ord , he earn
normal profi . The long-r n eq ilibri m po i ion of each firm and he ind r nder perfec
compe i ion i ho n in Fig re 7.9. The marke e le a he price Pe, hich i j eq al o he firm
minim m AC, here each firm i earning normal profi , ince P = AC (or AR = AC). Yo ma no e
ha a hi poin AC m be minim m ince profi ma imi a ion occ r here MR= MC, and MC
in er ec AC a i minim m poin . Each firm in he ind r prod ce o p Qf, and he ind r a
a hole prod ce o p Qi (eq al o he m of all he firm o p ).
Wh doe hi happen? Ho i i ha he firm ha ere in he hor r n earning abnormal profi , or
ere making lo e , end p making normal profi in he long r n?
S ppo e he ra berr ind r i profi able, meaning ha ra berr farm (or firm ) are making
abnormal profi , o ha P> AC (or AR> AC). In he long r n, hen firm can ar all heir inp ,
ne farmer are a rac ed in o he ra berr ind r ince he o ld al o like o earn abnormal
profi . A more and more farm begin o prod ce ra berrie , he ppl of ra berrie increa e ,
and hi ha he effec of red cing he price of ra berrie . B a he price of ra berrie fall , he
abnormal profi of ra berr prod cer fall. The price of ra berrie con in e o fall n il i i j
eq al o minim m AC. A ha poin he ra berr prod cer , ho a ice- ake m accep he
price ha i de ermined in he marke , end p earning normal profi here P = AC (or AR = AC).
S ppo e no ha he ra berr ind r ere lo -making, in hich ca e P< AC (or AR< AC). In
he long r n ome ra berr farm o ld clo e do n, or el e he migh op prod cing ra berrie
and begin prod cing ano her more profi able crop. A ra berr farmer lea e he ind r or i ch
o of ra berrie , he ppl of ra berrie decrea e , ca ing he price of ra berrie o ri e.
Thi proce con in e n il price i j eq al o AC. Here oo, he remaining ra berr prod cer in
he ind r ill end p earning normal profi here P = AC (or AR = AC).
The in ere ed den ma ee ho hi proce occ r ing diagram (pre en ed a S pplemen ar
ma erial in he 'Digi al co r ebook: E ra ma erial' ec ion).
In perfec l compe i i e long-r n eq ilibri m, firm profi and lo e are elimina ed, and
re en e are j eno gh o co er all co o ha e er firm earn normal profi .
Thi proce ill ra e an impor an principle, hich i ha compe i ion lead o a proce of firm
opening (or clo ing) ch ha price i dri en do n (or p) o he lo e le el ha i accep able o he
firm in order for i o con in e opera ing. Thi i he price ha i eq al o minim m a erage co , and
ha allo he firm o earn normal profi o ha i i j co ering all i co . A e ill ee in he
page belo , an hing ha e ic c m e i i n e l in highe ice , abn mal fi f fi m
and elfa e l f cie .

1 U ing diagram , ho hen a firm
earn profi ( ho profi per ni and o al profi ),
earn normal profi , and
earn nega i e profi (a lo ) ( ho lo per ni and o al lo ).
2 For each of he follo ing, calc la e abnormal profi or lo per ni of o p , and hen
calc la e o al abnormal profi or lo :
Q = 200 ni ; AC = $8, P = $9
Q = 250 ni ; AC = $15, P = $13
Q = 150 ni ; AC = $17, P = $17
3 Gi en he informa ion in he able,
if price = 6, calc la e ho m ch he profi -ma imi ing (lo -minimi ing) firm ill
prod ce, and ho m ch profi or lo i ill make;
if price = 4, calc la e ho m ch he profi -ma imi ing (lo -minimi ing) firm ill
prod ce, and ho m ch profi or lo i ill make.
( A ( ) M ( )
)
1 14.00 4
2 8.50 3
3 6.33 2
4 5.00 1
5 4.40 2
6 4.17 3
7 4.14 4
8 4.25 5
9 4.44 6
10 4.70 7
4 U ing a diagram ho and e plain a perfec l compe i i e firm long r n eq ilibri m

po i ion.
O line he proce b hich he firm reache hi po i ion.
E plain ha kind of profi he firm make in long r n eq ilibri m.
A
In Chap er 2, e a ha compe i i e marke achie e alloca i e efficienc , beca e eq ilibri m i
de ermined b MB = MC, here con mer pl prod cer ( ocial) rpl i ma im m. Thi
di c ion foc ed on efficienc a he le el of he ma ke , or ind r . We no an o ee ho
efficienc can be anal ed al o a he le el of he indi id al firm.
R
All ca i e efficienc i achie ed hen MB = MC; b ince MB = P, i follo here i alloca i e
efficienc hen P = MC. No e ha hi condi ion hold onl hen here are no e ernali ie , in hich
ca e i i al o r e ha MSB= MSC ( hi a o r condi ion for alloca i e efficienc hen e died
e ernali ie in Chap er 5 and 6).
All ca i e efficienc occ r hen firm prod ce he par ic lar combina ion of good and er ice
ha con mer mo l prefer. The condi ion i he follo ing:
Alloca i e efficienc i achie ed hen P = MC ( al e na i el MB =MC)
The price, P, paid b con mer o acq ire a good reflec he marginal benefi he deri e from
con mp ion of one more ni of he good and ho he amo n of mone he are illing o pa o
b one more ni . Marginal co , MC, mea re he al e of he re o rce ed o prod ce one e ra
ni of he good. When price i eq al o marginal co , here i eq ali be een ha con mer are
prepared o pa for one more ni and ha i co o prod ce i .
Wha o ld happen if P and MC ere no eq al o each o her? If P > MC, an addi ional ni of he
good i or h more o con mer han he co o prod ce i . There i an nderalloca ion of re o rce
o i prod c ion, and con mer o ld be be er off if more of i ere prod ced. If P < MC, an
addi ional ni of he good co more o prod ce han i i or h o con mer ; here i an
o eralloca ion of re o rce o he good, and con mer o ld be be er off if o p ere red ced. In
bo h he e ca e , alloca i e inefficienc re l . Therefore, re o rce are alloca ed efficien l onl
hen he price of a good i eq al o he marginal co of prod cing i .
A
Fig re 7.10 ho he long-r n eq ilibri m po i ion of a firm and ind r in perfec compe i ion.
Par (a) ho he firm o be earning normal profi , and indica e ha in long-r n eq ilibri m, he
perfec l compe i i e firm achie e alloca i e efficienc ince a he profi -ma imi ing le el of
o p , Qe, P = MC. Par (b) ho he ind r o be achie ing alloca i e efficienc (MB = MC and
ocial rpl i ma im m). I ill ra e ho he efficienc a he le el of he firm corre pond o
efficienc a he le el of he ind r .
In long-r n eq ilibri m nder perfec compe i ion, he firm achie e alloca i e efficienc here P
= MC ( he e MB = MC). A he le el of he ind r , ocial rpl (con mer pl prod cer
rpl ) i ma im m, and MB = MC.
The achie emen of alloca i e efficienc in long-r n eq ilibri m i an impor an re l , beca e
perfec compe i ion i he onl marke r c re here hi occ r .
E
Perfec compe i ion, ho gh no a reali ic marke r c re, offer a n mber of in igh in o he
orking of compe i i e marke .
I
A . Perfec compe i ion lead o he be or op imal alloca ion of re o rce ,
achie ed hro gh P = MC (or MB = MC) in long-r n eq ilibri m.
L . Con mer benefi from lo price , d e o he ab ence of abnormal
profi , hich o ld ha e led o a higher price. Yo can check hi b comparing Fig re 7.8(a)
and (b), ho ing ha he price hen he firm earn abnormal profi i higher han he price hen
he firm earn onl normal profi .
C . Inefficien firm are ho e
ha prod ce a higher han nece ar co . Inefficienc co ld be d e o fac or like le
prod c i e labo r, or he e of o da ed echnologie , or poor en reprene r hip. The re en e of
inefficien firm are in fficien o co er all co , leading o lo e ha force he e firm o
lea e he ind r in he long r n.
. Change in con mer a e are reflec ed in change
in marke demand and herefore marke price. B crea ing hor -r n abnormal profi or lo e ,
price change re l in long-r n adj men ha make he q an i of o p prod ced b he
ind r re pond o con mer a e .
L
. The model re on ric and nreali ic a mp ion ha are rarel
me in he real orld.
C . Economie of cale lead o lo er a erage co
a a firm gro larger and larger. In perfec compe i ion firm are oo mall o gro o a i e
large eno gh o ha e economie of cale.
L . All firm i hin an ind r prod ce iden ical or ndifferen ia ed
(homogeneo ) prod c , ho e er con mer prefer prod c arie .
L . The lack of abnormal profi in he
long r n doe no offer firm he nece ar f nd o p r e re earch and de elopmen . In an
ca e, ince prod c are ndifferen ia ed, firm do no ha e he incen i e o p r e prod c
de elopmen or impro emen .
F 7.10: Alloca i e efficienc in perfec compe i ion in he long r n

1 O line h e d he perfec l compe i i e marke model e en i el hen hi model i
ba ed on o man nreali ic a mp ion .
2 E plain he meaning of and a e he condi ion for alloca i e efficienc .
U ing diagram , ho ho he perfec l compe i i e fi m and ind achie e alloca i e
efficienc in long-r n eq ilibri m.
E al a e he perfec l compe i i e marke model b referring o he in igh i offer and i
3 limi a ion .
7.4 Monopol
LEARNING OBJECTIVES

e plain he monopoli ma ke po e ing a diag am he e AR>MC (AO2, AO4)
e plain p ofi ma imi a ion b he monopoli i h diag am ho ing abno mal p ofi ,
no mal p ofi , lo (AO2, AO4)
e plain he monopoli alloca i e inefficienc ill a ing ma ke fail e (AO2)
e plain elfa e lo compa ed o pe fec compe i ion i h a diag am ho ing lo e o p
and highe p ice and elfa e lo (AO2, AO4)
e plain na al monopol and d a a diag am fo na al monopol (AO2, AO4)
di c ad an age and di ad an age of monopol (AO3)
The e m monopol i de i ed f om he G eek o d (monopolio) meaning ingle

elle . We begin b eminding o el e of he cha ac e i ic of monopol :
he e i a ingle fi m in he ind
he fi m p od ce and ell a ni e good o e ice, i h no clo e b i e
he e a e high ba ie o en in he ind .
Monopol lie a he oppo i e e eme of ma ke c e o pe fec compe i ion. A a ingle elle ,
he monopoli face no compe i ion f om o he fi m and i ha b an ial ma ke po e ( he abili
o con ol p ice).
Barriers to entr
The e a e e e al kind of ba ie o en , de c ibed belo .
Economies of scale
Economie of cale e l in he do n a d- loping po ion of a fi m long- n a e age co c e
(LRAC), e l ing in lo e a e age co a he fi m inc ea e i i e (Fig e 7.11). La ge economie
of cale c ea e a ba ie o en . In Fig e 7.11 he a e age co of a la ge fi m on SRAC1 a e
b an iall lo e han he a e age co faced b a malle fi m on SRAC2. The la ge fi m can
cha ge a lo e p ice han he malle fi m, and can fo ce he malle fi m in o a i a ion he e i ill
no be able o co e i co . The efo e, if ne fi m o en e he ind on a mall cale he
ill be nable o compe e i h he la ge one.
On he o he hand, a ne fi m a emp ing o en e he ma ke on a e la ge cale o ld enco n e
h ge a - p co , and o ld be nlikel o ake he i k. Economie of cale fo m a ignifican
ba ie o en al o in oligopolie .
Figure 7.11: Economie of cale a a ba ie o en
Natural monopolies
Na al m lie a e fi m ha ha e economie of cale o la ge ha he can p od ce fo an
en i e ma ke and ill no e ha hei economie of cale. The ill be e amined in mo e de ail
belo .
Branding
B anding in ol e he c ea ion b a fi m of a ni e image and name of a p od c . I o k h o gh
ad e i ing campaign ha o infl ence con me a e in fa o of he p od c , a emp ing o
e abli h con me lo al . If b anding i cce f l, man con me ill be con inced of he
p od c pe io i , and ill be n illing o i ch o b i e p od c , e en ho gh he e ma be
ali a i el e imila . B anding ma o k a a ba ie o en b making i diffic l fo ne
fi m o en e a ma ke ha i domina ed b a cce f l b and. No e ha b anding need no lead o a
monopol (i i a me hod ed al o b fi m in monopoli ic compe i ion and oligopol ), b i doe
ha e he effec of limi ing he n mbe of ne compe i o fi m ha en e a ma ke . E ample of
b anding incl de b and-name i em ( ch a NIKE , Adida , Coca-Cola , e c.).
Legal barriers
E ample of legal ba ie incl de he follo ing:
Patents a e igh gi en b he go e nmen o a fi m ha ha de eloped a ne p od c o
in en ion o be i ole p od ce fo a pecified pe iod of ime. Fo ha pe iod, he fi m
p od cing he pa en ed p od c ha a monopol on p od c ion and ale of he p od c . E ample
incl de pa en on ne pha mace ical p od c , and In el and mic op oce o chip ed b
IBM comp e .
Licences a e g an ed b go e nmen fo pa ic la p ofe ion o pa ic la ind ie . Licence
ma be e i ed, fo e ample, o ope a e adio o ele i ion a ion , o o en e a pa ic la
p ofe ion ( ch a medicine, den i , a chi ec e, la and o he ). S ch licence do no
all e l in a monopol , b he do ha e he impac of limi ing compe i ion.
Cop rights g a an ee ha an a ho (o an a ho appoin ed pe on) ha he ole igh o
p in , p bli h and ell cop igh ed o k .
Tariffs, quotas and other trade restrictions limi he an i ie of a good ha can be impo ed
in o a co n , h ed cing compe i ion.
No all of he e legal ba ie lead o monopol , b he all ha e he effec of limi ing compe i ion,
h con ib ing o he c ea ion of ome deg ee of ma ke po e .
Control of essential resources

Monopolie can a i e f om o ne hip o con ol of an e en ial e o ce. A cla ic e ample of an
in e na ional monopol i DeBee , he So h Af ican diamond fi m, ho e con ol of he diamond
ind peaked a 90% in he 1980 , allo ing i o ha e a ignifican con ol o e he p ice of
diamond . (Mo e ecen l DeBee no longe ha con ol and diamond p ice a e d i en b he
ma ke .) On a na ional le el, an e ample i Alcoa ( he Al min m Compan of Ame ica), hich,
follo ing he e pi a ion of pa en in 1909, a able o main ain i monopol po i ion on he
p od c ion of al mini m i hin he Uni ed S a e n il he Second Wo ld Wa , beca e of i con ol
of almo all he ba i e e o ce i hin he co n . On a local le el, p ofe ional po leag e
c ea e a local monopol b igning long- e m con ac i h he be pla e and ec ing e cl i e
e of po adi m . A local monopol i a ingle p od ce / pplie i hin a pa ic la
geog aphical a ea. Local monopolie appea mo e commonl han na ional o in e na ional one . Fo
e ample, a local g oce o e in a e iden ial a ea loca ed ome di ance f om an o he o e ma
be a local monopol .
Aggressi e tactics
If a monopoli i conf on ed i h he po ibili of a ne en an in o he ind , i can c ea e en
ba ie b c ing i p ice, ad e i ing agg e i el , h ea ening a akeo e of he po en ial en an ,
o an o he beha io ha can di ade a ne fi m f om en e ing he ma ke .
Demand and re enue cur es under monopol
The demand cur e (AR cur e) facing the monopolist

Since he p e monopoli i he en i e ind , he demand o AR c e i face i he ind o
ma ke demand c e, hich i do n a d- loping. The o demand c e ho n in Fig e 7.12
indica e ha he pe fec l compe i i e fi m i a p ice- ake i h e o ma ke po e , hile he
monopoli i a price-maker i h a ignifican deg ee of ma ke po e .
Figure 7.12: Demand c e
All fi m nde ma ke c e o he han pe fec compe i ion a e o a ing deg ee p ice-make ,

a he all face do n a d- loping demand c e . Of he e, he monopoli ha he g ea e deg ee of
ma ke po e , o he abili o con ol p ice, beca e i i he ole o dominan fi m in he ind .
Ma ke po e a i e hene e a fi m face a do n a d- loping demand c e. Fi m in all
ma ke c e e cep pe fec compe i ion face a do n a d- loping demand c e, and
he efo e ha e a ing deg ee of ma ke po e , o he abili o con ol he p ice a hich he
ell hei o p ; he a e he efo e ice-make .
Ho e e , he ea he monopoli ha a la ge con ol o e p ice, hi con ol i limi ed b he po i ion

of he ma ke demand c e. In Fig e 7.12(b), hen he monopoli choo e ho m ch o p o
p od ce, a Q1, i im l aneo l de e mine he p ice a hich he good can be old, o P1. I co ld
no ell o p Q1 a a p ice ch a P2, ince he p ice an i combina ion P2 and Q1 i a poin a,
l ing off he demand c e.
The monopolist s re enue cur es

When a fi m face a do n a d- loping demand c e, p ice i no longe con an fo all o p : mo e
o p can onl be old a a lo e p ice. Con ide he e ample ed in Table 7.3 and Fig e 7.2
ho ing e en e da a and c e fo he fi m ha ha ome abili o con ol p ice. Table 7.6
p o ide he ame da a fo a monopoli o al, ma ginal and a e age e en e , and Fig e 7.13 plo
he e da a.
1 2 3 4 5
Units of output Product price (P) Total re enue Marginal A erage re enue
(Q) ( ) TR = P Q ( ) re enue MR= AR= TR Q ( )
TR Q ( )
0
1 12 12 12 12
2 11 22 10 11
3 10 30 8 10
4 9 36 6 9
5 8 40 4 8
6 7 42 2 7
7 6 42 0 6
8 5 40 2 5
9 4 36 4 4
10 3 30 6 3
Table 7.6: To al, ma ginal and a e age e en e hen p ice a ie iho p
Looking a Table 7.6 and Fig e 7.13, e ma no e he follo ing:

A p ice (P) fall , o p (Q) inc ea e gi ing i e o he do n a d- loping demand c e.
Ma ginal e en e, ho ing he change in o al e en e e l ing f om a change in o p , fall
con in o l ; MR i e al o e o hen o al e en e i a i ma im m (a e en ni of
o p ), and become nega i e hen o al e en e fall . I ma be no ed ha he MR c e
ho he lope (g adien ) of he TR c e. The efo e hen TR i ma im m, MR= 0. When TR
i falling, MR i nega i e.
A e age e en e (col mn 5 of Table 7.6) i e al o p ice ( ee col mn 2).
Figure 7.13: Re en e c e in monopol
Since TR = P Q, and AR= TR Q, i follo ha P i e al AR.

The AR a d P c e e ee he dema d c e faci g he fi m.
The MR c e lie bel he dema d c e. The ea on i ha , nlike in pe fec compe i ion,
he e MR = P, he e he fi m m lo e i p ice in o de o ell mo e o p . The lo e p ice i
cha ged no onl fo he la ni of o p b all he p e io ni of o p old. Ma ginal
e en e, o he e a e en e f om elling an addi ional ni of o p , i he efo e e al o he
amo n of he p ice of he la ni old min ha i lo b elling all he o he ni of o p
a he no lo e p ice. 1

1 O line he a mp ion defining he ma ke model of monopol .
2 U ing a diag am, e plain ho economie of cale can e l in a monopol ma ke c e
b po ing ba ie o en .
3 U ing e ample , e plain ho b anding and legal fac o p o ide ba ie o en in o an
ind .
4 a Compa e and con a he demand c e facing he pe fec l compe i i e fi m and ha
facing he monopoli .
b E plain h one fi m i a p ice- ake and he o he a p ice-make .
5 a E plain he ela ion hip be een he monopoli a e age e en e (AR) and ma ginal
e en e (MR).
O line ho he a e ela ed o
b p od c p ice, and
c he demand c e facing he fi m.
Profit ma imisation b the monopolist
Profit ma imisation based on the marginal re enue and cost

approach
The monopoli in e e ed in ma imi ing p ofi (o minimi ing lo ) follo he ame h ee- ep
app oach ed b he pe fec l compe i i e fi m:
i The monopoli de e mine he p ofi -ma imi ing (o lo -minimi ing) le el o p ing he
MC = MR le.
ii Fo ha le el of o p , i de e mine p ofi pe ni o lo pe ni b ing
p ofi Q =P AC
If AR > AC ( P > AC), he monopoli i making abno mal p ofi ;
if AR = AC (o P = AC) i i ea ning no mal p ofi ( e o p ofi );
if AR < AC (o P < AC) i i making a lo .
iii The fi m m l iplie p ofi Q b Q o de e mine o al p ofi , o lo Q b Q o de e mine o al
lo .
Fig e 7.14 (a), (b) and (c) ho he anda d AC and MC c e ; he e a e he ame a ho e ed fo
p ofi ma imi a ion in pe fec compe i ion. On he e co c e , he monopoli demand and
ma ginal e en e c e a e added. Con ide fi pa (a).
We fi find he e MR = MC, hich de e mine he p ofi -ma imi ing le el of o p , Qe.
A Qe, e d a a e ical line p a d o he AR (o demand) c e and f om he e e end a
ho i on al line lef a d o he e ical a i ; hi ill de e mine he p ice, Pe, a hich he
monopoli ell o p Qe.
Fo o p Qe, e find p ofi pe ni ( p ofi Q), gi en b P AC; hi i he e ical di ance
be een he a e age e en e (demand) and AC c e .
To find o al p ofi , e m l ipl p ofi pe ni ime he o al n mbe of ni p od ced, hich i
p ofi = p ofi Q Q
and i ep e en ed b he haded a ea.
The monopoli need no al a make p ofi ; i ma make lo e if p ice canno co e AC. Thi i
ho n in Fig e 7.14(c), he e he monopoli i minimi ing lo . A he le el of o p Qe,
de e mined b MR = MC, he monopoli lo i minimi ed. The p ice ha ill be cha ged i gi en
b Pe, fo nd b e ending a line p a d o he demand c e a o p le el Qe. Lo pe ni of
o p ( lo Q ) i gi en b AC P, and o al lo i gi en b he haded a ea, fo nd b m l ipl ing
lo pe ni of o p b he o al n mbe of ni p od ced.
I i al o po ible ha he monopoli ea n no mal p ofi . Thi i ho n in Fig e 7.14(b), he e Qe
occ he e P = AC.
No e ha he di inc ion be een he ho n and he long n i no impo an in monopol a i i
in pe fec compe i ion. In pe fec compe i ion, hi di inc ion i c cial beca e a fi m en e and
e i an ind in he long n, abno mal p ofi and lo e di appea , and fi m a e lef i h no mal
p ofi in long- n e ilib i m. Thi i no po ible in monopol , d e o he p e ence of ba ie o
en .
Figure 7.14: P ofi ma imi a ion and lo minimi a ion in monopol : ma ginal e en e and co
app oach
Unde monopol , high ba ie o en p e en po en ial compe i o fi m f om en e ing a p ofi -

making ind , and he monopoli can he efo e con in e making abno mal p ofi indefini el
in he long n.
Natural monopol
A natural monopol i a fi m ha ha economie of cale o la ge ha i i po ible fo he ingle
fi m alone o ppl he en i e ma ke a a lo e a e age co han o o mo e fi m .
A na al monopol i ill a ed in Fig e 7.15. The na al monopoli demand c e in e ec i
LRAC c e a a poin he e a e age co a e ill falling. A he le el of o p Q*, he e a e ill
economie of cale. The fig e ho ha hi fi m canno p od ce an o p g ea e han Q* and
no make a lo . If i did, hen P hich i gi en b he demand c e o ld be lo e han LRAC. B
a e kno , P< AC mean he fi m i making a lo . So if he fi m i o ea n no mal p ofi o
abno mal p ofi , i m p od ce a an i le han o e al o Q* and cha ge a p ice g ea e han o
e al o AC*.
Figure 7.15: Na al monopol
S ppo e no ha hi fi m i pli in o o fi m of e al i e. Each o ld p od ce o p Q1 and

i h a e age co a AC1. Clea l , a e age co o ld be highe , and he p ice ha o ld allo he
fi m o ea n no mal p ofi , he e P= AC, o ld al o be highe .
If he ma ke demand fo a p od c c LRAC hen hi i falling, hi mean ha a ingle la ge

fi m can p od ce fo he en i e ma ke a a lo e a e age o al co han o o mo e malle fi m .
When hi occ , he fi m i called a natural monopol .
Na al monopol ac a a ong ba ie o en beca e po en ial en an eali e ha i o ld be

e emel diffic l o a ain he lo co of he al ead e i ing fi m. High a e age co o ld mean
ha ing o cha ge a high p ice fo he p od c , o ha he ne fi m o ld be nable o compe e i h
he e i ing fi m.
E ample of na al monopolie incl de a e , ga and elec ici di ib ion, cable ele i ion, fi e
p o ec ion and po al e ice . The falling a e age co o e a e la ge ange of o p of en occ
beca e of e la ge capi al co ( ch a la ing pipe fo a e di ib ion, o la ing cable fo
elec ici di ib ion, o p ing a a elli e in o o bi ).
A na al monopol ma op being na al if changing echnologie c ea e condi ion ha allo
ne compe i o fi m o en e he ind and begin p od c ion a a ela i el lo co . Thi ha
happened in ecen ea i h echnological change in elecomm nica ion , fo cing elephone
companie ha p e io l e e na al companie o compe e i h ne en an in o he ma ke .

1 U ing diag am , ho he ca e he e a monopoli
a ea n abno mal p ofi ( ho p ofi pe ni and o al p ofi ),
b ea n no mal p ofi , and
c inc lo e ( ho lo pe ni and o al lo ).
2 a O line he diffe ence, if an , be een he ho - n and long- n e ilib i m of a
monopoli .
b O line h a monopoli can con in e o ea n p ofi in he long n.
3 The da a in he able belo ho he demand c e and co (AC andMC) facing a
monopoli .
a Calc la e he monopoli o al e en e and ma ginal e en e fo each le el of o p .
b Iden if hi monopoli p ofi -ma imi ing le el of o p .
c Iden if he p ice a hich hi le el of o p be old.
d Calc la e he monopoli p ofi pe ni and o al p ofi .
Units of output Price ($) A erage cost ($) Marginal cost ($)
1 10 14.0 4.0
2 9 8.5 3.0
3 8 6.3 2.0
4 7 5.0 1.0
5 6 4.4 2.0
6 5 4.2 3.0
7 4 4.1 4.0
8 3 4.3 5.0
4 a E plain he ele ance of economie of cale o na al monopol .

b U ing a diag am and e ample , e plain ha a na al monopol i .
c O line h a na al monopol can be a ong ba ie o en in o an ind .
d S gge h go e nmen of en do no b eak p na al monopolie in o de o inc ea e
compe i ion.
Monopol market outcomes and efficienc
Higher price and lo er output b the monopolist compared to

the industr in perfect competition
A compa i on of monopol i h pe fec compe i ion a he le el of he ind e eal ha p ice i
highe and an i of o p p od ced lo e in monopol . Fig e 7.16 ho he long- n
e ilib i m po i ion of a pe fec l compe i i e ind , compo ed of man mall fi m , and of a
monopol , hich i he en i e ind . Pa (a) fo he pe fec l compe i i e ind ho
e ilib i m p ice and an i o be Ppc and Qpc, Poin a, he e he ind demand and ppl
c e in e ec , appea al o in pa (b), ho ing ha o ld happen o p ice and an i if he
pe fec l compe i i e ind e e o gani ed a a monopol . The MC c e of pa (a), o he
compe i i e ind ppl c e become he monopoli ma ginal co c e.2 The demand
c e emain nchanged, b he monopoli ma ginal e en e (MRm) c e lie belo D. When
he p ofi -ma imi ing monopoli applie he MR = MC, he e l i o p Qm and p ice Pm.
Figure 7.16: Highe p ice, lo e o p b he fi m in monopol
Since Qm < Qpc, he ind nde monopol p od ce a malle an i of o p han he ind

nde pe fec compe i ion. And ince Pm > Ppc, he monopoli ell o p a a highe p ice han he
pe fec l compe i i e ind . Highe p ice and lo e o p go again con me in e e .
Allocati e inefficienc and market failure

Loss of consumer and producer surplus
The highe p ice and lo e o p of he monopoli ha e impo an implica ion fo con me and
p od ce pl . Whe ea he pe fec l compe i i e ind achie e alloca i e efficienc ho n b
MB= MC and ma im m ocial pl , monopol doe no . Thi can be een in Fig e 7.17, hich i
he ame a Fig e 7.16, onl con me and p od ce pl ha e been added. In pa (a), a ea A
ep e en con me pl , hile a ea B i p od ce pl , i h A + B ho ing ma im m ocial
pl . Pa (b) ho he inefficiencie ha e l in monopol .
A ea C, con me pl in monopol , i malle han a ea A in pe fec compe i ion. Pa of A
a con e ed in o p od ce pl beca e of he highe monopol p ice (Pm a he han Ppc),
and ano he pa of A a lo a iangle E beca e of he lo e monopol an i (Qm a he
han Qpc). A ea E ep e en a elfa e lo .
A ea D, p od ce pl in monopol , ho ha p od ce pl ha inc ea ed b aking
a a a po ion of con me pl (d e o he monopoli highe p ice), and i ha al o
dec ea ed b lo ing a ea F (d e o he monopoli lo e an i ). A ea F i al o a elfa e
lo .
E + F = elfa e lo ep e en lo of ocial benefi (con me and p od ce pl ) d e o
monopol highe p ice and lo e an i .
Figure 7.17: Con me and p od ce pl and elfa e lo in monopol compa ed i h pe fec
compe i ion
No e ha he p e ence of elfa e lo mean ha MC and MB a e no longe e al. A he poin of

monopol p od c ion, Qm, MB > MC, meaning ha he e i an nde alloca ion of e o ce o he
good, and con me a e no ge ing a m ch of i a he o ld ha e liked.
The p e ence of elfa e lo in monopol indica e ma ke fail e: he e i alloca i e inefficienc ,

ho n al o b MB > MC a Qm, meaning he e i nde alloca ion of e o ce : oo li le of he
good i p od ced. Al o, he monopoli gain a he e pen e of con me a a po ion of
con me pl i con e ed in o p od ce pl .
Allocati e inefficienc :P > MC

Fig e 7.18 ho he long- n e ilib i m po i ion of he fi m in pe fec compe i ion and monopol .
The condi ion fo alloca i e efficienc i gi en b P= MC a he p ofi -ma imi ing le el of o p . A
e kno , hi condi ion hold fo he fi m in pe fec compe i ion. In Fig e 7.18(b) e can ee ha a
he p ofi -ma imi ing le el of o p Qm, he monopoli p ice, Pe, i g ea e han ma ginal co .
Thi i ha dl p i ing, ince P > MC i he ame a MB > MC ( ince P= MB), hich e a in
Fig e 7.17(b).
The efo e, e concl de once again ha he monopoli doe no achie e alloca i e efficienc .
Figure 7.18: Alloca i e efficienc in pe fec compe i ion and alloca i e inefficienc in monopol
In monopol he nde alloca ion of e o ce o he good i indica ed al o b P > MC a he p ofi -
ma imi ing le el of o p .
Market failure and market po er

The abo e di c ion ho clea l ha monopol i a pe of ma ke fail e, ince i e l in an
nde alloca ion of e o ce o he p od c ion of he good i h elfa e lo .
We can no al o ee ho ma ke e i connec ed o ma ke fail e. Ea lie in hi chap e ma ke
po e a defined a he abili of a fi m o con ol he p ice a hich i ell i o p . Wh doe
hi lead o ma ke fail e?
The an e lie in Fig e 7.16, hich compa e pe fec compe i ion i h monopol . In pa (a) e
ee he pe fec l compe i i e fi m i h i ho i on al demand c e accep ing a P ha i e al o MC,
he efo e he e i alloca i e efficienc . In pa (b) e ee he monopoli i h i do n a d loping
demand c e cha ging a P ha i g ea e han MC, he efo e he e i alloca i e inefficienc . In fac
hi alloca i e inefficienc i he e l of he do n a d loping demand c e i h he e l ing
ma ke e ha i p o ide o he fi m. We can he efo e edefine ma ke po e .
Ma ke po e efe o he abili of a fi m o cha ge a p ice g ea e han ma ginal co , o P>MC.

Thi can onl occ hen a fi m face a do n a d loping demand c e.
In ie of hei e en i e ma ke po e , monopolie a e held o be nde i able f om a ocial poin of

ie . Fo hi ea on, p i a e, n eg la ed monopolie a e illegal in mo co n ie in he o ld.

1 U ing a diag am, compa e and con a he p ice and o p o come of a pe fec l
compe i i e ind and an ind o gani ed a a monopol .
2 U ing diag am , compa e and con a elfa e o come of a pe fec l compe i i e ind
and a monopoli ic ind . E plain he meaning of MB > MC a he monopoli
e ilib i m le el of o p .
3 U ing diag am , ho he he o no he monopoli achie e alloca i e efficienc , and
compa e i h he fi m in pe fec compe i ion.
4 U ing diag am , e plain he ela ion hip be een ma ke po e and ma ke fail e.
E aluating monopol and comparing ith perfect competition
Criticisms of monopol
Welfare loss, allocati e inefficienc and market failure
In con a o pe fec compe i ion, he monopoli fail o achie e alloca i e efficienc . Fig e 7.17
ho he lo of ocial pl and he appea ance of elfa e lo hile Fig e 7.18 ho ha P>
MC. Bo h diag am al o ho ha MB> MC, hich a e indica ion ha he monopoli
nde alloca e e o ce o he p od c ion of a good. Monopol he efo e ep e en a fo m of ma ke
fail e.
Higher price and lo er output in monopol

The elfa e lo no ed abo e in fac a i e beca e he monopoli p od ce a malle an i of
o p and ell i a a highe p ice han a pe fec l compe i i e ind a ho n in Fig e 7.16,
once again ho ing ha monopol i no in he in e e of con me .
Loss of consumer surplus to the monopolist

B cha ging a highe p ice han he pe fec l compe i i e fi m, ch ha P> MC mean ha a po ion
of con me pl i aken a a f om con me and gained b he monopoli . Fig e 7.17, ho
ha he monopoli gain a he e pen e of con me .
Negati e impacts on the distribution of income

Since monopolie cha ge highe p ice han pe fec l compe i i e fi m , he e i a edi ib ion of
income a a f om con me ho m pa he highe p ice and o a d he o ne of he
monopol in he fo m of highe p ofi .
Lack of competition ma gi e rise to higher costs

Whe ea fi m in pe fec compe i ion a e nde con an p e e o p od ce i h he lo e po ible
co o i e, nde monopol he ab ence of compe i o fi m ma e l in highe a e age co
fo man po ible ea on ch a a poo l mo i a ed o kfo ce, lack of inno a ion, poo
managemen o a oidance of i k. The po ibili of main aining abno mal p ofi o e he long n
d e o high ba ie o en can make he monopoli le conce ned abo keeping co lo . Thi i
kno n a X-i efficie c .
Possibl less inno ati e

While monopolie ha e good ea on o p e R&D fo p od c de elopmen and inno a ion, he
oppo i e ma al o occ . High ba ie o en , hielding monopolie f om compe i ion, co ld make
hem le likel o inno a e han fi m in monopoli ic compe i ion o oligopol ( ee belo ) hich
a e con an l nde p e e o inno a e o main ain o inc ea e hei ha e of ale . (See Real o ld
foc 7.2.)
Potential benefits of monopol

Ec e f ca e
Economie of cale a e a majo a g men in fa o of la ge fi m ha can achie e lo e co a he
g o la ge .Monopolie , beca e of hei i e, a e e ell placed o ake ad an age of economie of
cale. Lo e a e age co p o ide he monopoli i h he po ibili of lo e ing p ice , hich
co ld po ibl app oach ho e achie ed in pe fec compe i ion. Con me can he efo e gain beca e
lo e a e age co ma po en iall an la e in o lo e p ice , a ell a inc ea ed an i of
o p . Socie al o gain f om economie of cale beca e he lo e a e age co of p od c ion
mean he e i le a e in he e of e o ce . A pe fec l compe i i e fi m, d e o i e mall
i e, canno cap e economie of cale.
Natural monopol
In he e en of a na al monopol , he e a e added benefi d e o he achie emen of e lo
a e age co b he ingle fi m. See he di c ion abo e on na al monopolie .
Research and de elopment (R&D) for product de elopment and technological

inno ation
Fi m in pe fec compe i ion a e nlikel o engage in R&D. The ha e no abno mal p ofi in he
long- n i h hich he can finance R&D. The ell iden ical p od c and he efo e a e no
in e e ed in p od c de elopmen ha o ld diffe en ia e hei p od c . The a e nable o c ea e
ba ie o en a he a e oo mall and o ha e no incen i e o engage in R&D.
B con a , a n mbe of fac o gge ha monopolie ha e good ea on o p e inno a ion:
Thei abno mal p ofi p o ide hem i h he abili o finance la ge R&D p ojec .
P o ec ion f om compe i ion d e o high ba ie o en ma fa o inno a ion and p od c
de elopmen , b offe ing fi m he oppo ni o enjo he p ofi a i ing f om hei inno a i e
ac i i ie (ne in en ion , ne p od c , ne echnologie , e c.). Thi , af e all, i he a ionale
of a a ding fi m pa en p o ec ion fo a pe iod of ime.
Fi m ma e p od c de elopmen and echnological inno a ion a a mean of main aining
hei abno mal p ofi o e he long e m, b c ea ing ba ie o en fo ne po en ial i al . If
a fi m can de elop a ne p od c ha po en ial i al a e nable o p od ce, he i al ma be
le likel o o en e he ind and compe e i h he inno a ing monopoli .

1 U ing diag am , compa e and con a he ma ke c e of pe fec compe i ion and
monopol , empha i ing he ad an age and di ad an age of each.
2 Di c
a he fac o ha ma make monopol a de i able ma ke c e; and
b h monopol a a ma ke c e, and ma ke po e gene all , come nde hea
c i ici m and a e held o be again ocie be in e e .
1 To nde and hi , con ide he follo ing n me ical e ample. Sa o p inc ea e f om 3 o 4 ni . Ma ginal
e en e ill be he e l of a gain and a lo . The gain i 9, ob ained f om elling he fo h ni of o p a
he p ice of 9. The lo i e al o 1 fo each of he ini ial 3 ni of o p ha p e io l e e elling fo
10 and m no ell fo 9, e al o 3. Ma ginal e en e i e al o he gain min he lo , o 9 3 = 6.
2 Ho e e , no e ha he monopoli MC c e i no i ppl c e. In fac , he monopoli doe no ha e a

ppl c e, beca e he e i no ingle ela ion hip be een p ice and an i pplied in monopol . The
ea on i ha he MC = MR le fo he monopoli ma e l in diffe en p ice fo he ame an i ,
depending on demand condi ion fo he monopoli p od c .
7.5 M
LEARNING OBJECTI ES

explain that monopolistic competition has less market power due to many substitutes
compared to monopoly and illustrate with a diagram showing a more elastic demand curve
compared with monopoly (AO2, AO4)
explain profit maximisation in the short run and long run, with diagrams showing abnormal
profit, normal profit, loss (AO2, AO4)
explain allocative inefficiency and market failure in monopolistic competition (AO2)
explain that monopolistic competition has more product variety in exchange for less efficiency
(AO2)
discuss the advantages and disadvantages of monopolistic competition (AO3)
The model of mono oli ic com e i ion is based on the following assumptions:
There is a large number of firms; this is similar to perfect competition.
There are no barriers to entry, as in perfect competition.
There is product differentiation; unlike in perfect competition where products are identical.
Product differentiation can be achieved by:
physical differences products may differ in si e, shape, materials, texture, taste, packaging, etc.
(think, for example, of the variety of clothes, shoes, books, processed foods, furniture)
quality differences products can differ in quality
location some firms attempt to differentiate their product by locating themselves in areas that
allow easy access for customers, such as hotels near airports and convenience stores in
residential areas
services some firms offer specific services to make their products more attractive, such as
home delivery, product demonstrations, free support, warranties and purchase terms
product image some firms attempt to create a favourable image by use of celebrity advertising
or endorsements, by brand names, or attractive packaging.
Examples of monopolistically competitive industries include book publishing, clothing, shoes,
processed foods of all kinds, jewellery, furniture, textiles, dry cleaners, petrol (gas) stations,
restaurants.
M
As the term monopolistic competition suggests, this market structure combines elements of both
competition and monopoly. It resembles perfect competition because there are many firms in the
industry and there is freedom of entry. It is like monopoly because of product differentiation. Each
firm in an industry is a mini-monopoly in the specific version of the good that it produces. For
example, Adidas is a monopoly in Adidas shoes, NIKE is a monopoly in NIKE shoes, and Puma is
a monopoly in Puma shoes. This means that each of these producers faces a downward-sloping
demand curve for its product. However, because each of these products is at the same time a
substitute for the other, this demand curve is relatively elastic, i.e. it is more elastic than in monopoly,
but less elastic than in perfect competition, as shown in Figure 7.19.
F 7.19: Demand curves facing the firm under three market structures
In perfect competition, if a firm raises its price, it loses all its sales to its competitors (Figure 7.19(a)).
In monopoly, if a firm raises its price, it loses some but not all sales, as it is the sole producer of the
good and consumers have no alternative product they can buy (Figure 7.19(b)).
In monopolistic competition (Figure 7.19 (c)), if a firm raises its price, it will lose more sales than the
monopolist, because consumers now do have substitutes they can switch to; but it will lose fewer
sales than the perfectly competitive firm because of product differentiation the available substitutes
are not perfect substitutes, as they are in perfect competition.
This has important implications: it means that if consumers can be convinced that the product they
are purchasing (for example, Puma shoes) is superior to the available substitutes (Adidas and
NIKE shoes), then Puma has succeeded in establishing a mini-monopoly for its product. Therefore
if the price of Puma shoes increases, only some, and not all, buyers of Puma shoes will switch to
other brands. Those who believe that Puma shoes are superior will continue to buy them, in spite of
the higher price.
Firms in monopolistic competition face a demand curve that is less elastic than in perfect
competition but more elastic than in monopoly.
T -
P occurs when a firm lowers its price to attract customers away from rival firms,
thus increasing sales at the expense of other firms. N - occurs when firms use
methods other than price reductions to attract customers from rivals. The most common forms of non-
price competition are product differentiation (including all the features noted above, such as physical
and quality differences, packaging, services provision, location, etc.), advertising and branding
(creating brand names for products).
Monopolistically competitive firms compete with each other on the basis of both price and non-price
competition. They engage heavily in product differentiation through R&D in product development, as
well as in advertising and branding. Firms that can attract customers by use of these methods increase
their market power and their ability to charge a higher price without risking loss of buyers to rival
firms.
In general, the more differentiated the product is from its substitutes and the more successful the
advertising and branding as methods of convincing consumers about the superiority of a product, the
less elastic will be the demand curve facing the firm,3 the greater the market power (the ability to
control price), and the larger the firm s potential to increase short-run profits. By contrast, firms that
are less able to achieve consumer loyalty for their product, and whose product is less differentiated
from substitutes, may have to rely more on price competition to increase their sales.
1 Outline the assumptions defining the market model of monopolistic competition.
2 List some examples of monopolistically competitive firms in your neighbourhood. Analyse
what makes them so.
3 Describe how a monopolistically competitive firm is like a firm in perfect competition; how it
is like a monopoly.
4 Explain
what firms in monopolistic competition try to achieve through product differentiation,
advertising and branding, and
how these activities affect the demand and revenue curves facing the firm.
5 Explain why we never see price competition and non-price competition in
perfectly competitive firms, and
monopolies.
Explain their importance in monopolistic competition.
A
The short-run equilibrium position of the individual firm in monopolistic competition is identical to
that of the monopolist, the only difference being that the demand curve is more elastic and flatter in
monopolistic competition than in monopoly. In the short run, the firm can make either abnormal
profit (i.e. positive profit), normal profit or losses (negative economic profit). Each of these
possibilities is shown in Figure 7.20. The firm applies the MR = MC rule to find the profit-
maximising or loss-minimising level of output (Qe), and then for that level of output compares price
(given by the demand curve) with AC to determine profit per unit or loss per unit.
In part (a) of Figure 7.20 the firm earns abnormal profits, since P> AC at Qe; in part (b) the firm s
profit is exactly ero since P = AC at Qe, and therefore the firm is earning normal profit; and in part
(c), the firm is making losses because P< AC at Qe. Total profit or total loss is found by multiplying
profit:
profit Q by Q or loss Q by Q
F 7.20: Short-run equilibrium positions of the firm in monopolistic competition

N
The assumption of free entry of firms in the industry is very important in determining the long-run
equilibrium of the firm (like in perfect competition).
In monopolistic competition, in the long run, profit-making industries attract new entrants; in loss-
making industries, some firms shut down and exit the industry. The process of entry and exit of
firms in the long run ensures that economic profit or loss is ero and all firms earn normal profit.
Figure 7.21 shows the long-run equilibrium of the monopolistically competitive firm. At the level of
output where MR = MC, P= AC; therefore, profit is ero and each firm is earning normal profit. This
figure is the same as Figure 7.20 where it happens that the firm is earning normal profit in the short
run.
The process of adjustment to normal profit in the long run is different to that of perfect competition.
In monopolistic competition suppose firms are making abnormal profits in the short run. New firms
will enter and they will attract customers away from the existing firms. The result will be to decrease
the demand facing existing firms, so that it shifts to the left until it is just tangent to (it just touches)
the AC curve. When this happens, the firms earn normal profit since P= AC. This is shown in Figure
7.21
F 7.21: Long-run equilibrium of the firm in monopolistic competition
On the other hand if firms are making losses in the short run, some of them will leave the industry in
the long run. As they do so, their customers switch their purchases to the remaining firms, which
experience an increase in demand for their product. This appears as a rightward shift of the demand
curve facing them, and this process continues until losses disappear and firms are earning normal
profit where P= MC.
M ,
Allocative efficiency is given by the condition P = MC. Figure 7.21, showing the long-run
equilibrium of the firm in monopolistic competition, indicates that allocative efficiency is not
achieved.
Comparing price with marginal cost along the vertical line at the equilibrium level of output, Qe, we
can see that price is higher than MC, indicating that there is an underallocation of resources to the
production of the good: society would have liked to have more units of the good produced.
In monopolistic competition P>MC or alternatively MB>MC, indicating there is market failure.

The market underallocates resources to the production of the good and too little of it is produced.
I
Economists argue that some inefficiency in monopolistic competition is justified by the presence of
product differentiation, which leads to greater product variety. In other words consumers gain product
variety while giving up some efficiency. Perfect competition, by contrast achieves efficiency but at
the cost of ero product variety. Because consumers enjoy product variety, it is often argued that with
monopolistic competition some inefficiency may be the price consumers pay for having greater
product variety.
On the other hand there is much debate among economists about how much product variety is
socially desirable. Some economists argue that there is too much product variety, such as for example
too many brands of breakfast cereals, detergents, cars or virtually any other product. This leads to
confusion among consumers, as well as high costs of advertising and new product development
which result in higher prices. It is sometimes argued that consumers would be better off with less
product variety and lower prices.
Below is a summary of the important differences between the market models.
M
S
Large number of firms.
Free entry of firms into an industry (no barriers to entry).
Normal profit in the long run, abnormal profit or loss in the short run (due to no barriers).
D
M . Firms in perfect competition have no market power;
they are price-takers facing a perfectly elastic (hori ontal) demand curve they face. Firms in
monopolistic competition do have some market power (ability to influence price), reflected in
their downward-sloping demand curve.
A . Whereas the perfectly competitive firm achieves allocative efficiency in
long-run equilibrium, the monopolistically competitive firm does not. Fewer than optimal
resources are allocated to the production of the good. Since P> MC, consumers pay a higher
price for the good than in perfect competition. Monopolistic competition is therefore a type of
market failure.
P . Whereas all firms in perfect competition produce the identical product, under
monopolistic competition firms go to great lengths to differentiate their products. From the
consumer s perspective, product variety is usually an advantage; perfect competition cannot
offer this advantage. Some inefficiency in monopolistic competition may be the price
consumers pay for greater product variety.
E . Firms in perfect competition cannot achieve economies of scale because
they are very small. Firms in monopolistic competition may have some small room for achieving
economies of scale but only to a relatively small degree as these firms also tend to be relatively
small.
M
S
N . Both these market structures face
downward-sloping demand curves, and therefore both have MR curves that lie below the demand
curve. This means that at the profit-maximising level of output (found by MR = MC), P> MC for
both (i.e. no allocative efficiency).
D
N . While in monopolistic competition there is a large number of firms, in
monopoly there is a single firm, or else the industry is dominated by one large firm.
S . In monopolistic competition firms are usually small, whereas in monopoly the
fact that there is a single or dominant firm suggests a very large si e.
B . Monopolistic competition is characterised by free entry whereas in monopoly
there are high barriers to entry.
N . Whereas the firm under monopolistic competition earns normal
profit in the long run, the monopoly can earn abnormal profits due to high barriers to entry.
C . Free entry and exit under monopolistic competition drive abnormal
profits down to ero in the long run, and allow prices to be lower for the consumer than is
possible under monopoly, where barriers to entry allow the firm to maintain abnormal profits
over the long run. Therefore prices under monopolistic competition are likely to be lower and
quantity larger than in monopoly and more in the interests of consumers.
M . While both monopolies and firms in monopolistic competition have market
power, a monopoly is likely to have more market power because there are no substitutes for the
good it produces. The availability of substitutes means that consumers can switch to substitute
goods, thus reducing the firm s market power. This is another reason why prices tend to be lower
in monopolistic competition than in monopoly thus favouring consumers.
C . Competition between firms in monopolistic competition puts a
downward pressure on costs as firms compete with each other. These competitive pressures may
force less efficient firms to leave the industry. The absence of competition in monopoly does not
exert such a downward pressure on costs.
R . The abnormal profits that monopolies can earn over the long run
puts them in a better position than monopolistically competitive firms with respect to financing
R&D. However, the pressures of competition faced by monopolistically competitive firms may
induce them to pursue R&D for product development in order to maintain or increase their sales.
E .Some small economies of scale
may be achieved by firms under monopolistic competition, but the potential for this is much
greater under monopoly, which can benefit consumers through lower prices.
P .Whereas many monopolies sell more than one product, there is likely to be far
greater product variety in monopolistic competition which is characterised by many
firms producing products that are substitutes for each other.

1 Use diagrams to explain how a firm in monopolistic competition can
earn abnormal profit (show profit per unit and total profit),
earn normal profit, and
2 Outline the role of free entry of firms in monopolistic competition in the adjustment from
short-run to long-run equilibrium.
3 Using a diagram, show the firm s long-run equilibrium position in monopolistic
competition.
Comment on whether the firm achieves abnormal profit or normal profit in long-run
equilibrium.
4 Explain why the firm in monopolistic competition represents a type of market failure.
5 Explain what is meant by the idea that some inefficiency is the price of product variety.
6 Evaluate monopolistic competition in comparison with
perfect competition, and
monopoly.
3 Advertising and branding work by making the demand curve shift to the right and making it rotate so it
becomes steeper. These two changes mean that demand increases and it becomes less elastic.
7.6 O
LEARNING OBJECTI ES
Af er s d ing his sec ion o ill be able o:

define all he erms appearing in in he e (AO1)
dis ing ish be een coll si e and noncoll si e oligopol and dra a diagram sho ing
coll si e oligopol (AO2, AO4)
e plain fea res of oligopol incl ding in erdependence, risk of price ar, and incen i e o
coll de ers s incen i e o chea (AO2)
e plain he rele ance of price and non-price compe i ion for firms in oligopol (AO2)
e plain he presence of alloca i e inefficienc and marke fail re (AO2)
e plain he simple game heor pa off ma ri (AO2)
e plain he meaning of marke concen ra ion and concen ra ion ra ios (AO2)
disc ss ad an ages and disad an ages of oligopol (AO3)
Oligopolies ha e he follo ing charac eris ics:

T . The erm oligopol deri es from he Greek ord
(oligopolio) meaning fe sellers . Oligopolis ic ind s ries are domina ed b a small
n mber of large firms, ho gh in an one ind s r he firms are likel o ar in si e.
T . All he barriers o en r disc ssed nder monopol are
rele an o oligopol . The incl de economies of scale (for e ample, he aircraf and car
ind s ries); legal barriers s ch as pa en s ( he pharmace ical ind s r ); con rol of na ral
reso rces (s ch as oil, copper, sil er); aggressi e ac ics s ch as ad er ising or hrea s of
akeo ers of po en ial ne firms. An addi ional barrier o en r in oligopol in ol es high s ar -
p cos s ( he cos s of s ar ing a ne firm) associa ed i h de eloping a ne or differen ia ed
prod c . Man es ablished oligopolies spend enormo s s ms on prod c differen ia ion and
ad er ising, making i diffic l for ne firms o ma ch s ch e pendi res.
T . Firms in perfec and monopolis ic compe i ion, d e o heir large
n mbers in an ind s r , beha e independen l of each o her, so hen he make decisions s ch
as ho m ch o prod ce he do no ake he possible ac ions of o her firms in o considera ion.
B con ras , he small n mber of firms in oligopolis ic ind s ries makes he firms m all
in erdependen ; decisions aken b one firm affec o her firms in he ind s r . If an one firm
changes i s beha io r, his can ha e a major impac on he demand c r e facing he o her firms.
Therefore, firms are keenl a are of he ac ions of heir ri als.
Mos prod c s of oligopolis ic firms are differen ia ed s ch as pharmace icals, cars, aircraf ,
breakfas cereals, cigare es, refrigera ors and free ers, cameras, res, bic cles, mo orc cles, soaps,
de ergen s. Homogeneo s or ndifferen ia ed prod c s incl de oil, s eel, al mini m, copper, cemen .
I , -
I
The in erdependence of oligopolis ic firms has impor an implica ions for heir beha io r:
S .S ra egic beha io r is based on plans of ac ion ha ake in o acco n ri als
possible co rses of ac ion. I is similar o pla ing a card game, or chess, here indi id al
pla ers ac ions are based on he e pec ed ac ions and reac ions of heir ri al(s). S ra egic
beha io r of oligopolis ic firms is he res l of heir in erdependence. For e ample, a firm plans
a co rse of ac ion X ass ming i s ri als ill follo one polic , and i plans co rse of ac ion Y
ass ming i s ri als follo a differen polic . Under oligopol , firms planning heir s ra egies
make grea effor s o g ess he ac ions and reac ions of heir ri als in order o form la e heir
o n s ra eg .
C f ic i g i ce i e . Firms in oligopol face incen i es ha conflic , or clash i h each o her:
Incen i e o coll de he erm coll ion refers o an agreemen be een firms o limi
compe i ion be een hem, s all b fi ing price and herefore lo ering q an i
prod ced. B coll ding o limi compe i ion, he red ce ncer ain ies res l ing from no
kno ing ho ri als ill beha e, and ma imise profi s for he ind s r as a hole.
Incen i e o compe e, o o chea in a coll i e ag eemen a he same ime, each firm
faces an incen i e o compe e i h i s ri als in he hope ha i ill cap re a por ion of i s
ri als marke shares and profi s, hereb increasing profi s a he e pense of o her firms. If
firms ha e formed a coll si e agreemen , he face an incen i e o chea on heir par ners
in he agreemen in order o increase heir profi s a heir e pense.
E :
/
The charac eris ics of in erdependence, s ra egic beha io r, and conflic ing incen i es are ill s ra ed
er effec i el b , a ma hema ical echniq e anal sing he beha io r of decision-
makers ho are dependen on each o her, and ho displa s ra egic beha io r. Game heor has
become an impor an ool in microeconomics, and is based hea il on he ork of American
ma hema ician and economis John F. Nash ( he s bjec of he 2001 film, A Bea if l Mind), ho
oge her i h John Harsan i and Reinhard Sel en, recei ed he 1994 Nobel Pri e in Economics.
The game e ill se here ill s ra es he p i one dilemma, sho ing ho o ra ional decision-
makers, ho se s ra egic beha io r o ma imise profi s b r ing o g ess he ri al s beha io r, ma
end p being collec i el orse off. The final posi ion ha res l s from he game is called a Na h
eq ilib i m.
S ppose here are o oligopolis ic firms in he space ra el ind s r : In ergalac ic Space Tra el
(IST) and Uni ersal Space Line (USL). Each firm m s decide on a pricing s ra eg , i.e. ha price o
charge cons mers for i s space ra el ser ices, and can choose ei her a high-price or a lo -price
s ra eg . Each firm is in eres ed in making i s o n profi as large as possible, b i s profi ill depend
on he par ic lar combina ion of pricing s ra egies ha he o firms choose.
Fig re 7.22 sho s fo r possible combina ions of pricing s ra egies and heir corresponding profi
o comes (called pa offs ) for he o firms. This fig re represen s a . For e ample, if
bo h IST and USL choose he high-price s ra eg , in bo 4, each ill ha e profi of 40 million
Zelninks (abbre ia ed as Zs). Bo 3 sho s he profi o comes of differing price s ra egies; USL i h
a lo -price s ra eg makes 70 million Zs, and IST i h a high-price s ra eg makes 10 million Zs.
The reason h he lo -price firm makes m ch higher profi s is ha b charging a lo price i
cap res a large por ion of sales from i s ri al.
F 7.22: Game heor : he prisoner s dilemma
S ppose he o firms begin in bo 1, here he are compe ing i h each o her on he basis of price
(price compe i ion) and herefore ha e a lo price, leading o a lo profi of 20 million Zs each.
Realising ha he ill bo h be be er off if he en er in o a coll si e agreemen and charge a high
price, he collabora e and agree o adop a high-price s ra eg , h s en ering bo 4 here each one
earns profi s of 40 million Zs.
No each firm faces a dilemma. Le s look a he dilemma from IST s poin of ie ( ho gh USL is
hinking along he same lines). IST realises ha b s icking o he agreemen , i ill con in e o earn
40 million Zs, along i h USL. On he o her hand, IST also realises ha b chea ing, in o her ords
secre l breaking he agreemen , and charging a lo er price, i can earn he m ch higher profi of 70
million Zs, hile USL earns onl 10 million Zs. In addi ion, IST realises ha USL migh break he
agreemen , in hich case IST ill find i self making onl 10 million Zs ( orse han e en hen i as
in compe i ion i h USL, making 20 million Zs).
Wha sho ld IST do? As i ries o o g ess USL, i is likel o c i s price o bea USL o he
higher profi s, b since USL is hinking along e ac l he same lines, he are bo h likel o adop
he lo -price s ra eg , in hich case he ill end p in bo 1 here he bo h ha e lo prices and
lo profi s. This is he Nash eq ilibri m, in hich bo h firms become orse off.
The Nash eq ilibri m sho s ha here is some imes a conflic be een he p rs i of indi id al
self-in eres and he collec i e firm in eres . This conflic is he prisoner s dilemma. Al ho gh he
firms co ld be be er off b coopera ing, each firm, r ing o make i self be er off, ends p making
bo h i self and i s ri al orse off.
This game ill s ra es man real- orld aspec s of oligopolis ic firms, hich:
are in erdependen ha happens o he profi s of one firm depends on he s ra egies adop ed
b o her firms; he herefore r o predic he ac ions of heir ri als in order o plan o heir
o n s ra eg
displa s ra egic beha io r he plan heir ac ions based on g esses abo ha heir
compe i ors are likel o do
face conflic ing incen i es he face he incen i e o coll de (agree o fi prices and mo e o
bo 4 here he bo h earn high profi s); and he face incen i es o compe e, or in his case o
chea on he agreemen , b lo ering heir price
become orse off as a res l of price compe i ion ( r ing o cap re sales from heir ri als b
c ing prices) since he ri als are likel o ma ch he price c s, all firms end p i h lo er
prices and lo er profi s (bo 1); his is called a
ha e a s rong in eres in a oiding price ars, beca se he realise ha e er one ill become
orse off hro gh price c ing his crea es a s rong incen i e for hem o compe e on he basis
of fac ors o her han price (non-price compe i ion).
T -
Unlike firms in monopolis ic compe i ion ha compe e on he basis of bo h price and non-price
compe i ion, oligopolis ic firms go o grea leng hs o a oid p ice compe i ion. The are er caref l
no o rigger a price ar, here one firm s price c is ma ched b a re alia or price c b ano her
firm. As o r disc ssion of game heor sho ed, a price ar makes all he firms of an ind s r
collec i el orse off d e o lo er prices and lo er profi s. A price ar ma e en lead o prices
lo er han a erage cos s, and herefore losses.
Ho e er, oligopolis ic firms s all do engage in in ense non-p ice compe i ion, in ol ing effor s b
firms o increase marke share b me hods o her han price, hich picall incl de he follo ing:
prod c de elopmen
ad er ising
branding
n mero s ser ices s ch as q ali c s omer ser ice, arran ies, pro ision of credi , disco n s on
pgrades and o hers.
Non-price compe i ion is er impor an in oligopol for he follo ing reasons:
Oligopolis ic firms of en ha e considerable financial reso rces (d e o large profi s) ha he
can de o e o bo h R&D and ad er ising and branding. Whereas monopolis icall compe i i e
firms also engage in non-price compe i ion, heir reso rces for hese p rposes are generall no
as large.
The de elopmen of ne prod c s pro ides firms i h a compe i i e edge; he increase heir
marke po er, demand for he firm s prod c becomes less elas ic, and s ccessf l prod c s gi e
rise o oppor ni ies for s bs an iall increased sales and profi s.
Prod c differen ia ion can increase a firm s profi posi ion i ho crea ing risks for immedia e
re alia ion b ri als. I akes ime and reso rces for ri al firms o de elop ne compe i i e
prod c s.

1 Iden if he main charac eris ics of an oligopol .
2 Iden if he conflic ing incen i es faced b oligopolis ic firms.
E plain ho he rela e o heir in erdependence.
3 Referring o he conflic ing incen i es faced b oligopolis ic firms, e plain h he
pa off ma ri sho n belo ill s ra es he prisoner s dilemma confron ing he pla ers
of his game.
E plain he possible profi o comes of he o firms.
Describe ho hese o comes are rela ed o he firms in erdependence.
4 Pro ide e amples of non-price compe i ion, and e plain h i is impor an o firms in
oligopol .
5 O line h oligopolis ic firms a oid price compe i ion.
Define a price ar, and o line h oligopolis ic firms a oid i .
C -
There are o predominan pes of oligopolies: coll si e and non-coll si e.
C
C refers o si a ions here firms agree o coll de, hich means he form an
agreemen be een hemsel es o limi compe i ion, increase marke po er and increase profi s. The
mos common form of in ol es agreemen s o fi prices s ch as b holding prices cons an
a some le el, raising prices b some fi ed amo n , fi ing price differences be een differen
prod c s, and o hers.
Coll sion is illegal in mos co n ries, beca se i orks o limi compe i ion.
C
A common pe of coll sion in ol es he forma ion of a ca el, hich is a formal agreemen be een
firms in an ind s r o ake ac ions o limi compe i ion in order o increase profi s. The agreemen
ma in ol e limi ing and fi ing he q an i o be prod ced b each firm, hich res l s in an increase
in price; fi ing he price a hich o p can be sold; di iding he marke according o geographical
or o her fac ors; or agreeing o se p barriers o en r . Wha e er he case, he objec i e is o limi
compe i ion, increase he marke po er of he firms, and increase profi s.
S ppose he firms of an ind s r decide o form a car el b fi ing price. Fig re 7.23 ill s ra es ho
he car el ma imises profi . No e ha his fig re is iden ical o Fig re 7.14(a), hich ill s ra es profi
ma imisa ion for a monopolis .
The ke objec i e of a car el is o limi compe i ion be een he member firms and a emp o
ma imise join profi s. Car el members collec i el beha e like a monopol .
F 7.23: Profi ma imisa ion b a price-fi ing car el
In Fig re 7.23 he demand c r e and marginal re en e c r e sho n are for he ind s r as a hole.
The MC c r e is he s m of all he MC c r es of all he firms in he car el. The car el eq a es MR
i h MC o find he car el s profi -ma imising le el of o p , Q ma , and hen de ermines price Pe
(gi en b he demand c r e). I is hen a q es ion of di iding p ind s r o p Q ma be een all
he firms, or deciding ho m ch of he o al q an i ill be prod ced b each firm. One a his can
be done is o agree on ha share of he marke each firm ill ha e based on his orical marke shares.
Ano her a is ha firms ma agree o compe e i h each o her for marke shares sing non-price
compe i ion (prod c differen ia ion and ad er ising).
The bes -kno n e ample of a car el is OPEC (Organi a ion of he Pe role m E por ing Co n ries),
composed of a gro p of 13 oil-prod cing co n ries. OPEC periodicall ries o raise he orld price
of oil b c ing back on i s o al o p . Each member co n r is assigned an o p le el (q o a) ha
i is permi ed o prod ce. The res ric ed q an i of oil res l s in a higher price.
Firms par icipa ing in a car el ha e m ch o gain:
increased marke po er and hence he abili o con rol price of he prod c
increased profi s d e o higher prices
elimina ion of compe i ion be een he firms, and herefore no more ncer ain or need o
o g ess heir ri als.
Ho e er, coll si e oligopol is illegal in mos co n ries, for he same reasons ha pri a e
nreg la ed monopolies are also illegal: he res ric compe i ion, raise prices, red ce q an i ies of
o p and are held o be agains cons mers and socie s bes in eres s. Ho e er, in prac ice i is
diffic l for a hori ies o disco er and pro e he e is ence of a car el. I is s spec ed ha here ma
be far more cases of coll si e oligopol han ha are disco ered.
While car els bring impor an benefi s o heir members, he are no eas o crea e and main ain for
se eral reasons.
T . E er firm in a car el faces an incen i e o chea on he agreemen , b
offering o secre l lo er he price for some b ers. B if man firms chea , or if chea ing is
disco ered b o her firms in he car el, hen he car el ma collapse.
C . Since he price agreed pon b he car el is common o all he
firms, firms i h higher a erage cos s ha e lo er profi s, hile lo er-cos firms enjo higher
profi s. Cos differences be een firms lead o diffic l ies in agreeing on a common price.
N . The larger he n mber of firms, he more diffic l i is o arri e a an
agreemen regarding price and he alloca ion of o p , as he grea er n mber of differing ie s
make agreemen and compromise more diffic l o achie e.
T . A possible o come of one or more firms chea ing on he car el
agreemen is a price ar, here one firm s price c is ma ched b re alia or price c s b o her
firms. The res l of a price ar is o make all he firms of an ind s r collec i el orse off d e
o lo er prices and lo er profi s (in he e ample of game heor ).
O
The diffic l ies in ol ed in es ablishing and main aining car els as ell as heir illegali some imes
make firms rn o ards informal pes of coll sion. Info mal coll ion refers o co-opera ion ha is
implici or nders ood be een he co-opera ing firms, i ho a formal agreemen . The objec i es of
informal coll sion are also o co-ordina e prices, a oid compe i i e price-c ing, limi compe i ion,
red ce ncer ain ies and increase profi s.
One pe of informal coll sion is p ice leade hip, here a dominan firm in he ind s r ( hich ma
be he larges , or he one i h lo es cos s) se s a price and also ini ia es an price changes. The
remaining firms in he ind s r become price- akers, accep ing he price ha has been es ablished b
he leader. The implici agreemen (as here is no formal agreemen ) binds he firms as far as price
goes, b he are free o engage in non-price compe i ion. A charac eris ic of price leadership
arrangemen s is ha price changes end o be infreq en , and are nder aken b he leader onl hen
major demand or cos changes occ r. E amples incl de he airline ind s r , s permarke s and fas
food res a ran s.
N -
N - refers o oligopolis ic firms ha do no coll de in an a in order o fi or
coordina e prices and limi compe i ion. Each firm beha es independen l ; ho e er, he are s ill
a are of each o her in heir pricing decisions and displa s ra egic beha io r in ha he ake he
possible ac ions of heir ri als in o considera ion.
I can be obser ed ha in he real orld, prices of oligopolis ic ind s ries end o be rigid or
infle ible; once a par ic lar price is reached, i ends o be rela i el s able o er long periods of ime.
Moreo er, in si a ions hen prices do change, he end o change oge her for all he firms in an
ind s r . S ch price rigidi ies can be easil e plained b coll si e oligopol , since firms beha e like
a monopol in s ch cases and so end o ha e similar prices, b ho can he be e plained in
si a ions here firms do no coll de?
We can nders and he obser ed price s abili of oligopolis ic firms ha do no coll de sing he idea
of s ra egic beha io r. S ppose here are hree oligopolis ic firms, A, B and C prod cing a similar
prod c . A, B and C do no coll de or comm nica e i h each o her in an a , ins ead heir pricing
beha io r is s ra egic, and is s rongl infl enced b heir e pec a ions of ho ri al firms ill reac if
he nder ake a price change.
S ppose firm A considers a price change, b before changing (increasing or decreasing) i s price, i
ries o predic ho firms B and C ill reac , and ha ill be he conseq ences of heir reac ion.
Firm A s reasoning is as follo s:
If I raise m price, ha ill B and C do? The are nlikel o increase heir price, beca se if
he con in e o sell a heir lo er price he ill ake a a a por ion of m sales, he ill be
be er off and I ill be orse off. Therefore I sho ld no inc ea e m p ice.
If I drop m price, ha ill B and C do? The are likel o drop heir price as ell, and so as a
res l , I am nlikel o be m ch be er off han I am no , and I ma be orse off i h a lo er
price, so I sho ld no d op m p ice.
This line of reasoning is he same for all hree firms, A, B and C, and ends o res l in price s abili .
This simple idea ill s ra es hree impor an poin s:
F
. O her ise he risk lo ering heir re en es and profi s, hich in
rn co ld lead o price ins abili .
E , . Firms are rel c an o
change heir price beca se of he likel ac ions of heir ri als, hich co ld res l in lo er profi s
for he firm ini ia ing price changes.
F . The do no r o increase heir
sales b a rac ing c s omers hro gh lo er prices. A lo er price no onl in i es price c s b
ri als, i h res l ing lo er profi s for all he firms, b also risks se ing off a p ice a .
T
As oligopolies in ol e a small n mber of large firms ha domina e an ind s r , i is impor an o
kno ho concen ra ed he ind s r s o p is among he ind s r s larges firms, as his
informa ion ma pro ide cl es on he her oligopolies ha e oo m ch marke po er. A
pro ides an indica ion of he percen age of o p prod ced b he larges firms
in an ind s r ; i meas res . There is no fi ed n mber of firms for hich a
concen ra ion is calc la ed. For e ample, e co ld sa ha he 3-firm concen ra ion ra io of ind s r
X is 78%, hich means ha he hree larges firms of ind s r X prod ce 78% of he ind s r s o al
o p ; or he 4-firm concen ra ion ra io of ind s r Y is 45%, hich means ha he fo r larges firms
in ind s r Y prod ce 45% of he ind s r s o al o p . Table 7.7 pro ides some e amples of
concen ra ion ra ios in he Uni ed S a es. We can see here are ide aria ions from ind s r o
ind s r , i h he mos concen ra ed ind s r of hose appearing in he able being ranspor a ion
eq ipmen and he leas concen ra ed being f rni re.
I 4-firm 8-firm
F 35.0% 46.7%
C 44.8% 58.7%
T 64.3% 77.7%
F 18.8% 26.5%
T 32.0% 44.9%
S : Concen a ion Ra io
T 7.7: Selec ed concen ra ion ra ios in domes ic US man fac ring
Concen ra ion ra ios pro ide an indica ion of he degree of compe i ion in an ind s r . The s gges
ha he higher he concen ra ion ra io, he lo er he degree of compe i ion, hile a lo concen ra ion
ra io o ld indica e a grea er degree of compe i ion.
In general, an ind s r is considered o be oligopolis ic if he fo r larges firms con rol 40% of o p .
(This is an arbi rar c -off poin , as here is no hing special abo a concen ra ion ra io of 40%.)
Concen ra ion ra ios ha e se eral eaknesses ha limi heir sef lness as a meas re of he degree of
compe i ion:
Whereas concen ra ion ra ios reflec concen ra ion in a na ional marke , he do no reflec
compe i ion from abroad, arising from impor s.
Concen ra ion ra ios pro ide no indica ion of he impor ance of firms in he global marke ; here
ma be some compe i ion in a domes ic marke , b he firms ma ha e a er s rong, or
dominan posi ion in he global marke .
Concen ra ion ra ios do no acco n for compe i ion from o her ind s ries, hich ma be
impor an in he case of s bs i e goods, s ch as in he case of differen me als. Whereas here
ma be a high concen ra ion ra io in he al mini m ind s r , for e ample, his o ld be lo er if
considered oge her i h copper, i h hich al mini m compe es.
Concen ra ion ra ios do no dis ing ish be een differen possible si es of he larges firms. For
e ample, a hree-firm concen ra ion ra io of 90% co ld consis of hree firms i h 30% of he
marke each, or of hree firms, one of hich has 60% of he marke and he o her o ha e 15%
each.
REAL ORLD FOCUS 7.1

P
For -fo r s a es in he Uni ed S a es filed a la s i in 2019 agains 20 pharmace ical firms for
fi ing prices of o er 100 common generic (non-pa en ed) medicines, incl ding rea men s for
diabe es and cancer. Follo ing a fi e- ear in es iga ion, he firms ha e been acc sed of illegal
conspiracies o ei her s op prices from falling or o raise prices, in some cases b more han
1000%. The A orne General of he S a e of Connec ic s a es ha :
We ha e ha d e idence ha he gene ic d g ind pe pe a ed a m l i-billion-dolla f a d on
he Ame ican people. We ha e email , e me age , elephone eco d and fo me compan
in ide ha e belie e ill p o e a m l i- ea con pi ac o fi p ice and di ide ma ke ha e fo
h ge n mbe of gene ic d g .
The legal ac ion seeks damages, ci il penal ies and co r ac ions o res ore compe i ion o he
generic dr g marke . Generic dr gs are lo er-priced al erna i es o brand-name dr gs and as a
res l sa e dr g b ers and a pa ers billions of dollars a ear. Ye according o he la s i :
Prices for h ndreds of generic dr gs has risen hile some ha e sk rocke ed, i ho
e plana ion, sparking o rage from poli icians, pa ers and cons mers across he co n r .
S : CNBC; BMJ
F 7.24: Caps les con aining b siness and economics form las
A
1 Iden if his pharmace ical oligopol as coll si e or non-coll si e, offering reasons h .
2 Dra a diagram and se i o e plain ho his oligopol fails o achie e alloca i e efficienc .
3 Normall , i is er diffic l o de ermine he presence of coll sion. O line h his ma no
be he case here.
O ,
As firms in coll si e oligopol beha e like a monopol , i is clear ha here is elfare loss, alloca i e
inefficienc and marke fail re, as Fig re 7.22 demons ra es.
Ye he same is also r e of oligopolis ic firms ha do no coll de. The also face a do n ard sloping
demand c r e, and he marke prod ces a le el of o p ha is belo he le el here social s rpl s
is ma im m. Therefore, here is elfare loss here oo as in he case of coll si e oligopol .
C
To he e en ha oligopolis ic firms s cceed in a oiding price compe i ion, he achie e a
considerable degree of marke po er, and herefore face similar cri icisms as monopol :
Welfare loss, alloca i e inefficienc and marke fail re.
Higher prices and lo er q an i ies of o p han nder compe i i e condi ions.
Loss of cons mer s rpl s o he oligopolis s d e o higher prices res l ing in P> MC.
Nega i e impac s on he dis rib ion of income.
There ma be higher prod c ion cos s d e o lack of price compe i ion.
Possibl less inno a i e.
In addi ion, here is a f r her arg men agains oligopol :
Whereas man co n ries ha e an i-monopol legisla ion ha pro ec s agains he ab se of
marke po er, he diffic l ies of de ec ing and pro ing coll sion among oligopolis ic firms
means ha s ch firms ma ac all beha e like monopolies b coll ding and e ma ge a a
ihi.
B
The benefi s of oligopol are also similar o he benefi s of monopol :
Economies of scale can be achie ed d e o he large si e of oligopolis ic firms, leading o lo er
prod c ion cos s o he benefi of socie and he cons mer ( hro gh lo er prices).
Prod c de elopmen and echnological inno a ions can be p rs ed d e o he high abnormal
profi s from hich research f nds can be dra n. This benefi of oligopol is more impor an
han in he case of monopol , since non-price compe i ion forces firms o be inno a i e in order
o increase heir marke share and profi s.
Technological inno a ions ha impro e efficienc and lo er cos s of prod c ion ma be passed
o cons mers in he form of lo er prices.
O er and abo e he benefi s of oligopol ha are similar o monopol , oligopol also offers he
follo ing ad an age:
Prod c de elopmen leads o increased prod c arie , h s pro iding cons mers i h grea er
choice (monopol does no offer m ch prod c differen ia ion and arie ).

1 O line he meaning of coll sion.
Iden if ha firms in an oligopol r o achie e hro gh coll sion.
2 Define a car el.
Using a diagram, sho ho a car el resembles a monopol .
E plain h car els are illegal in mos co n ries.
3 O line h he car el members face he incen i e o chea .
Iden if some obs acles o forming and main aining car els.
4 E plain ho non-coll si e oligopol differs from coll si e oligopol .
5 E plain he meaning of concen ra ion ra io and pro ide e amples ( he ma be
h po he ical).
S a e he p rpose of calc la ing concen ra ion ra ios.
Iden if some shor comings of concen ra ion ra ios.
6 Oligopol is a pe of marke fail re. J s if his s a emen .
7 Disc ss po en ial ad an ages and disad an ages of oligopolis ic firms.

P
The model of perfec compe i ion is he basis of an idealised free-marke econom , here price is
he ra ioning s s em ha s pplies ans ers o he ha and ho o p od ce q es ions.4 The marke
and he price mechanism are he means b hich alloca i e efficienc is achie ed, h s a oiding
as e of reso rces.
Man economis s ha e s rongl cri icised preocc pa ion i h he perfec l compe i i e model.
The no e ha he real orld is domina ed b large oligopolis ic firms and monopolis icall
compe i i e firms, and he model of perfec compe i ion bears no rela ionship o ei her of hese.
Tr ing o es he perfec l compe i i e model o ld be meaningless gi en he real- orld con e
of firm beha io r. The er concep of compe i ion has as l differen meanings, i h
compe i ion in perfec compe i ion being anon mo s and eq i alen o comple e absence of
marke po er (no abili o infl ence price), and compe i ion in he o her o marke models
in ol ing effor s o cap re marke shares from ri al firms, ei her hro gh price c s or hro gh
prod c differen ia ion and ad er ising (non-price compe i ion). These real- orld pes of
compe i ion are comple el irrele an for he perfec l compe i i e firm ha can nei her gain
an hing b lo ering i s price nor can i differen ia e and ad er ise i s prod c .
In addi ion, man economis s q es ion he no ion of eq ilibri m (an idea borro ed from ph sics),
and poin o ha eq ilibri m for he firm makes sense onl nder condi ions of comple e cer ain
and perfec kno ledge. As here is no s ch hing in he real orld, here can be no eq ilibri m.
On he o her hand, defenders of he perfec l compe i i e marke model arg e ha his can be sed
as a parable ha can appro ima e (or describe er ro ghl ) he o comes of real- orld firm
beha io r, regardless he her hese firms are oligopolis ic or monopolis icall compe i i e. The
also arg e ha in spi e of i s lack of realism, his model ser es as a ool for assessing real- orld
si a ions ha depar from he ideal of alloca i e efficienc , h s helping go ernmen s prescribe
polic meas res o deal i h iss es in he ind s rial sec or.
T
Ho sef l do o hink is he model of perfec compe i ion?
Do o hink i ma ers ha i is based on highl nrealis ic ass mp ions (see also Theor of
kno ledge 2.3 in Chap er 2)?
Do o hink economis s sho ld foc s more on de eloping and sing more realis ic marke
models, based on monopolis ic compe i ion and oligopol ?
4 I also ans ers hefo hom o p od ce q es ion on income dis rib ion. Ho e er, he ans er pro ided is
generall highl nsa isfac or , and for his reason becomes a norma i e iss e abo ho go ernmen s sho ld
in er ene in marke s o change marke -de ermined income dis rib ion (see Chap er 12).
7.7 G
LEARNING OBJECTIVES

di c ad an age f la ge fi m i h ignifican ma ke e , incl ding ec n mie f cale
and in e men in R&D financed b abn mal fi , inn a i n (AO3)
di c ik i h e ec , ice, c n me ch ice in ma ke d mina ed b la ge
fi m (AO3)
di c ad an age and di ad an age f g e nmen in e en i n deal i h ab e f
ma ke e incl ding legi la i n and eg la i n, g e nmen ne hi , fine (AO3)
In he di c i n ab e n m n l and lig l e a ha la ge fi m i h ignifican ma ke

e ffe a n mbe f en ial ad an age , incl ding:
ad an age a i ing f m la ge ec n mie f cale and na al m n l
he abili f ch fi m ca R&D n ne d c and echn l g de el men .
We ha e al een ha he e a e a n mbe f di ad an age and i k in e m f:
all ca i e inefficienc and elfa e l
highe ice and l e
l f c n me l he la ge fi m fi m
nega i e im ac n he di ib i n f inc me
highe han nece a a e age c d e lack f ice c m e i i n
ibl le inn a i e.
G :
T ab se
We ha e een ha all ma ke c e he han e fec c m e i i n e e en ma ke fail e,
e l ing in a ice ab e ma ginal c (P> MC), and elfa e l a le e g ea e deg ee.
H e e , al kn n a a i-c e i i e ac ice , efe i ai n
he e fi m engage in ac i i ie ha e l in ed ced c m e i i n. Acc ding he E ean
C mmi i n ( f he EU):
A c a ca e ic c e i i if i i i a ii f e gh a gi e a e. A
d i a ii i i i e f a i-c e i i e, b if he c a e i hi ii
ei i aec e i i , i i c ide ed ha e ab sed it.
E am le incl de:
cha ging n ea nabl high ice
de i ing malle c m e i f c me b elling a a ificiall l ice he can
c m ee ih
b c ing c m e i in he ma ke ( in an he ela ed ma ke ) b f cing c n me b
a d c hich i a ificiall ela ed a m e la , in-demand d c
ef ing deal i h ce ain c me ffe ing ecial di c n c me h b all
m f hei lie f m he d minan c m an
making he ale f ne d c c ndi i nal n he ale f an he d c .5
In gene al e can a he f ll ing:
M ie n he h le ha e he highe deg ee f ma ke e hich i ab i e d e he
lack f c m e i i n; hi i h i a e, n eg la ed m n lie a e illegal m e e he e.
Fi i ig ie ma ma n ab e hei ma ke e . The ma ke e f a c ll i e
lig l i imila ha f a m n l , and e e en a f m f ab e; he ef e c ll i n i
illegal m e e he e. N n-c ll i e lig lie ma ma n ab e hei ma ke e,
de ending n he i a i n.
Fi i i ic c e i i ha e le ma ke e hich f he m a he d n
ab e beca e he e i ignifican c m e i i n am ng fi m ha d ce b i eg d .

R
In 2019 he In e na i nal M ne a F nd (IMF, ee Cha e 20) bli hed a d iding
e idence in f he e la n i n ha c m e i i n i eakening a ma ke a e
bec ming m e and m e c ncen a ed. The d e amined ma k e ma ginal c ( he
am n added c b ain he ice) f 900 000 fi m in 27 c n ie . Ma k e ma ginal
c a e an indica f ma ke e . I f nd ha ma k inc ea ed b 8% n a e age in he
e i d 2000 2015, inc ea ing m in he Uni ed S a e and a le e e en in E e.
B he d al f nd ha he i ing ma k a ed e nl a mall ha e f he fi m . The
10% f fi m i h he highe ma k inc ea ed he e b m e han 30% c m a ed hei
c m e i fi m . M e e , me ge and ac i i i n , hich clea l e l in inc ea ed
c ncen a i n, a e f ll ed b ignifican l highe ma k .
In addi i n i f nd ha highe ma k a e linked i h le in e men in h ical ca i al, hich
i e ima ed ha e e l ed in l e GDP g h b ne e cen age in in ad anced
ec n mie . F he , he fi m
i h he highe ma k a ke a malle ha e f he al e he c ea e, c n ib ing
inc me ine ali . Finall , he d a n ha ma ke e ma e l in le inn a i n a
fi m bec me c mf able in hei i i n d e dec ea ing c m e i i e e e.
The e nega i e end ma en if ma ke e i n checked.
S ce: The Ec i
F 7.25: Da id G lia h b ine c m e i i n, ill a ing g ea diffic l ie f mall
b ine e again la ge c ai n
A
1 O line he meaning f inc ea ing ma ke c ncen a i n
2 De c ibe he e idence ed b he IMF c ncl de ha he e i inc ea ing ma ke
c ncen a i n.
3 E lain he i k c n me and he ec n m f inc ea ing c ncen a i n f ma ke .
The ef e g e nmen in e en i n in e ne ab e f ma ke e cc mainl in he ca e

f m n l and lig l .
L
M c n ie ha e la ha m ec m eii nb e en ing c i be een
lig li ic fi m , a ell a e en ing an i-c m e i i e beha i b a ingle fi m ha d mina e a
ma ke ( ee Real ld f c 7.1). Thi i kn na c eii ic . Fi m ha a e f nd g il f
an ic m e i i e beha i ae all a ked a fine ( ee Real ld f c 7.5), ma be b ken
in malle fi m .
Diffic l ie ha ma a i e in c nnec i n i h c m e i i n licie incl de:
P ible diffic l ie in in e e ing he legi la i n in c nnec i n i h he beha i f he
ffending fi m . Diffe en e le ma ha e diffe en ie n ha ac i n in l e an i-
c m e i i e beha i . The la hem el e ma be ag e, all ing m ch m f diffe en
in e e a i n . Acc ding he OECD, De e mining hen a fi m beha i i an ab e f
ma ke e,a ed a c m e i i e ac i n, i ne f he m c m le and c n e ial
a ea in c m e i i n lic . 6
La in a a ic la c n ma be enf ced a ing deg ee , i h me g e nmen
enf cing hem m e ic l han he , de ending n hei i i ie hei li ical and
ide l gical ie . S me g e nmen ma acce he inci le ha g e nmen in e en i n in
he ma ke in he f m f ic enf cemen f c m e i i n licie i nece a ec
c n me again m n li ic ac ice and achie e all ca i e efficienc . O he
g e nmen ma acce he inci le ha g e nmen in e en i n in he ma ke i n
nece a achie e c n me ec i n and all ca i e efficienc , beca e e l ng e i d f
ime, he ma ke and c m e i i e f ce n hei n acc m li h he e f nc i n . The e i n
igh ng an e hi i e, a i de end n n ma i e idea ab he ec n m .
If fi m c ll de, i i diffic l di c e e idence f he c ll i n and e i , a c ll i n
cc ec e l , ince i i illegal.
L
A me ge i an ag eemen be een m e fi m j in ge he and bec me a ingle fi m.
Me ge ma cc f a n mbe f ea n , ch a an in e e in ca ing ec n mie f cale (a
ingle la ge fi m ma be able d ce a l e a e age c ), an in e e in fi m g h ( he
fi m ld like bec me la ge ), in e e in ac i ing ma ke e , hich i made ible b
he la ge i e f he ne , la ge fi m.
Me ge a e an i e in c m e i i n lic beca e f he ibili ha he ingle fi m c ea ed f m
he me ge ha e m ch ma ke e . Legi la i n all in l e limi n he i e f he
c mbined fi m . (See Real ld f c 7.4.)
Diffic l ie i h me ge licie incl de e i n and nce ain ie ab ha fi m h ld be
all ed me ge and ha fi m h ld n , ela ed i e f in e e ing he legi la i n a ell a
ide l gical diffe ence am ng diffe en g e nmen n he de i abili n f a high deg ee f
ma ke e.
T
Fine a e f en im ed if a g e nmen agenc e n ible f in e iga ing an i-c m e i i e
beha i di c e me ngd ing ( ee Real ld f c 7.5 bel f e am le ).
A blem i h fine i ha fi m ill f en ge hei la e calc la e he he b eaking he la
c m l ing i h he la i m e c l ( m e fi able). Of en, he fi f fi m ha ab e
ma ke e a e g ea en gh ha he a e be e ff illegall ab ing hei e and a ing fine ,
han n ab ing hei e and n a ing fine . M e e , f en he a e n ca gh f an i-
c m e i i e beha i , ibl beca e f he li ical clima e, beca e he a e ca ef l c e
hei ac i n .
Big fi m f en neglec he e hic f ngf l beha i if he belie e ha ge ing ca gh i n a
c l a c m liance.

C
In 2018 he E ean C mmi i n ( f he EU) im ed a fine f $5 billi n n G gle f i la ing
he EU c m e i i n le b e i ing h ne man fac e ein all G gle Sea ch and i
b e a , Ch me, in de acce G gle Pla , G gle a e. Acc ding he EU,
The e ac ice ha e denied i al he chance inn a e and c m e e n he me i . The ha e
denied E ean c n me he benefi f effec i e c m e i i n in he im an m bile he e. 7
S n af e P e iden D nald T m ee ed The E ean Uni n j la ed a Fi e Billi n
D lla fine n ne f g ea c m anie , G gle. The l ha e aken ad an age f he U.S.,
b n f l ng! S me ea ea lie P e iden Ba ack Obama had a ed:
S e i e he E ea e e he e i ec e cia d i e ha a hi g e e. We ha e
ed he i e e , c a ie ha e c ea ed i , e a ded i , e fec ed i i a ha he
[E ea fi ] ca c e e. A d f e i e ha i a ed a high- i ded ii
i e e i e i j de ig ed ca e e f hei c e cia i e e . 8
La e US Sena Eli abe h Wa en a g ed:

T da big ech c a ie ha e ch e ch e e ec ,
cie , a d de c ac . The e b d ed c e i i , ed i aei f ai f
fi , a d i ed he a i g fie d agai e e e e e. A d i he ce , he ha e h a
b i e e a d if ed i ai . 9
T deal i h hi , he e b eaking he big ech c m anie .

T le C en, a US ec n mic fe di ag ee , a g ing ha la ge ech c m anie a e maj
inn a , and b eaking hem c ld eaken hem and he ef e h inn a i n.
S : EUROPA; The Ne Y e ; Medi
F 7.26: E ean C mmi i ne Ma g e he Ve age , 18 J l 2018, hen he EU ga e

G gle 90 da end illegal ac ice face f he fine (af e being fined $5billi n)
A
1 De c ibe h he E ean C mmi i n h gh G gle a ab ing i ma ke e.
2 T ha e en d hink he E ean C mmi i n c nce n a e legi ima e?
3 C m a e and c n a he licie f an im i i n f a fine e legi la i n b eak
G gle.

C UK
In 2019, B i ain C m e i i n and Ma ke A h i (CMA) bl cked a me ge be een A da, he
Uni ed Kingd m ec nd la ge e ma ke , i h Sain b , he hi d la ge . The
e ma ke c mbined ld ha e had a ma ke ha e f 30.7%, and ld ha e bec me he
la ge e ma ke in he c n . In hei ed me ge , A da and Sain b a g ed ha he
me ge ld ha e all ed hem c c i h e l ing ice dec ea e f a m ch a 10%.
H e e , he CMA claimed e ha e f nd hi deal ld lead inc ea ed ice , ed ced
ali and ch ice f d c , a e h ing e e ience f all f hei UK h e .
The e i g ing c nce n in he Uni ed Kingd m ha he e i inc ea ing c ncen a i n f fi m in
he d me ic ec n m , he e he e ha e been $2 illi n h f me ge and ac i i i n in he
a decade. The e a e imila c nce n in he Uni ed S a e ha he ec n m ha bec me
c ncen a ed, limi ing c m e i i n and ed cing elfa e ( ee al Real ld f c 7.2). The ef e
he CMA deci i n n he e ma ke me ge c ld e e be an im an m men in he
ef m f B i ain e -c ncen a ed ec n m .
S : The Ec i
F 7.27: Flin , UK. A da and Sain b
A l ing kill
1 U e a diag am e lain h he me ge f he e ma ke migh ha e e l ed in
l e a e age c .
2 E lain he he e ical a g men behind he CMA ea ning ha he me ge ld likel
e l in highe ice and ed ced ali and ch ice f d c .
T
While m c n ie a nd he ld d n enc age m n l , an e ce i n i made if he e i a
na al m n l , beca e i i n in cie in e e b eak i in malle fi m , a hi
ld e l in highe a e age c and a a e f e ce .
G
One ible l i n na al m n l i na i nali e i , hich in l e an fe f ne hi
f m he i a e ec he blic ec ( he g e nmen ). G e nmen ne hi all he
g e nmen eg la e na al m n lie , f cing hem l e ice and inc ea e an i ie
d ced in he in e e f c n me , he eb ed cing all ca i e inefficienc and elfa e l .
H e e g e nmen ne hi me ime lead inefficiencie and highe han nece a c f
d c i n, a g e nmen a e n d i en b he g al ma imi e fi . In gene al ince he 1990
he e ha been a end a nd ld i a i e ( he i e f na i nali e) g e nmen
en e i e .
G
G e nmen all eg la e na al m n lie , en e m e ciall de i able ice and
an i c me , and hi can be d ne e en hen he m n l emain nde i a e ne hi .
The e a e a hi can be d ne.

F E U
In 2019 a g f bank (Ba cla , J.P. M gan, MUFG and R al Bank f Sc land) e e fined
$1.2 billi n f igging he m l i- illi n-d lla f eign e change ma ke f 11 c encie . The
S i bank UBS a e em ed f m he fine beca e i ale ed he e i ence f ca el he
E ean Uni n.
A he ame ime an he g f bank (Ba cla , BNB Pa iba , Ci ig , J.P. M gan, R al
Bank f Sc land and UBS) e e fined $2.8 billi n b U.S. eg la al f igging e change
ae .
S : Ba cla , Ci ig and JP M gan am ng bank fined $1.2 billi n f f e igging
F 7.28: M n ain Vie , Calif nia, USA. One f he G gle b ilding
In 2019, G gle a fined 1.5 f e ic ing c m e i i n b im ing an ic m e i i e

c n ac al e ic i n n hi d- a eb i e f e en ea .
In 2018, G gle a fined 5 billi n f e i ing h ne man fac e ein all G gle
Sea ch and i b e a , Ch me, in de acce G gle Pla , G gle a e.
In 2018, Q alc mm a fined $1.2 billi n f making ignifican a men A le f
ing Q alc mm chi a he han c m e ing chi .
In 2017, G gle a fined 2.7 billi n f gi ing i G gle Sh ing Se ice an illegal
ad an age in he ea ch e l .
In 2009, In el a fined $1.45 billi n f ffe ing c me ice ed c i n if he ed
In el mic ce in ead f i i al AMD.
S : The G a dian;
B ine In ide ;
Re e ;
A
O line h each f he e i la i n ma che he E ean C mmi i n defini i n and e am le
f ab e f ma ke e ( ee Sec i n The ea i g f ab e f a e e ab e).
M
The g e nmen can f ce he m n l cha ge a ice e al ma ginal c , ince i h P = MC
he m n li ill achie e all ca i e efficienc , i h P falling and Q inc ea ing he ciall
de i able le el. Thi i called a gi a c ici g.
H e e , ma ginal c icing lead l e f he na al m n li . The ea n i ha P = MC
e l in a ice ha i l f he fi m be able c e i a e age c . A a e l , he fi m
ill ei he g f b ine , he i e he g e nmen ld ha e b idi e i in de c e
i l e . (Thi need n cc in a m n l ha i n a na al m n l .) F he e ea n
ma ginal c icing i n a la a eg la e na al m n lie .
(The in e e ed eade ma efe he 'Digi al c eb k: E a ma e ial' ec i n, ill a ing a
na al m n l i h ma ginal c icing, a S lemen a ma e ial.)
A
T a id c ea ing l e f he na al m n li , g e nmen can f ce he fi m cha ge a ice
e al i a e age c , he e P = AC, meaning ha he fi m ea n n mal fi . Thi i called
a e age c ici g. Thi e l in a highe ice and l e an i han ma ginal c icing.
H e e , i lead a ice and an i c mbina i n ha i ei ha f he n eg la ed
m n li , meaning ha ice i l e and an i g ea e .
Al h gh all ca i e efficienc i n achie ed h gh a e age c icing, hi lic ffe
e im an ad an age : (a) he m n li make n mal fi and i n in dange f ha ing
h d n; and (b) i i m e efficien han he ma ke l i n.
Ye , a e age c icing al ha di ad an age . A m n li in a f ee, n eg la ed ma ke face
incen i e kee i a e age c l , in de ma imi e fi . If, h gh eg la i n, i i
g a an eed a ice e al i a e age c , i l e hi incen i e. If a e age c inc ea e d e
inefficienc , i ill ill ecei e a ice c e ing i c .
An he ible di ad an age i ha he eg la ed m n l ma c n in e i ea am n l ,
e en h gh i ma being a na al m n l (if echn l gical im emen change c
c ndi i n , ch a in elec mm nica i n ). C n in ed eg la i n ide ec i n he fi m
f m ne c m e i ha ld ha e been able d ce m e efficien l .

1 Di c
en ial ad an age f la ge fi m i h ignifican ma ke e , and
en ial i k in ma ke d mina ed b la ge fi m .
2 O line he meaning f ab e f ma ke e.
3 Di c ad an age and di ad an age f ible g e nmen in e en i n deal i h
ab e f ma ke e.
4 U ing a diag am, e lain he meaning f na al m n l .
Di c lic i n f g e nmen deal i h na al m n l .

The f ll ing e i n ill hel eflec n lea ning and enhance nde anding f
ke ic in hi cha e . The a e gge i n f in i ie ha can nde ake n n
in g in de e i e he lea ning bjec i e f hi cha e .
1 Re ea ch and find an e am le f c ll i e lig l in c n f e idence in an
he c n f ch ice. T di c e h he fi m c ll ded, h hei c ll i n a
di c e ed, ha if an e e he fine im ed, and ha e e he c n e ence .
2 Re ea ch a ca e f c m e i i n lic in a c n and ind f ch ice he e fi m
ha e been acc ed f an i-c m e i i e beha i . E lain h he beha i n again he
in e e f c n me and cie , and h he ac i n aken b he c m e i i n a h i
ld c ec he blem.
3 The e i a maj ng ing deba e ab ma ke e c ncen a i n in he la ge ech fi m like
Ama n, G gle and Faceb k. Acc ding man b e e hi i e ce i el high and
g ing. Re ea ch and e lain he a g men ha fa eg la i n and legi la i n limi
he ma ke e f ch fi m . E lain he ible i k c n me and cie f he
i ing ma ke e f he e fi m . De c ibe he a i licie ha a e being ed
eg la e hi ind .
Y can find e i n in he le f IB e am in he 'Digi al c eb k: E a ma e ial' ec i n.
5 Ab e f a d minan ii n
6 Ab e f d minance and m n li a i n
7 An i : C mmi i n fine G gle 4.34 billi n f illegal ac ice ega ding And id m bile de ice
eng hen d minance f G gle' ea ch engine
8 Wh Did he E ean C mmi i n Fine G gle Fi e Billi n D lla ?
9 He e h e can b eak Big Tech

3
M
Mac ec ic die he ec a a h e. We f c he a ge ic e f he
ec ,c ed f c ec i f a c e , fi , e ce e a d a e .
I ead f i di id a d c ice , e d he ge e a ice e e f he ec ;i ead
f de a d f i di id a d c , e e a i e a de a d f g d a d e ice ; a d
i ead f i di id a fi a d i d , e e a i e he a d ced i he
ec . F he , e d a e e , a i e e , a e a di a d
e ch a h e , hich i ac ec ic a e ca ed aggrega e .
I d f ac ec ic e i de e ha i a a a e a a ie
f icie g e e ca ei de achie e a be f i a
ac ec ic b ec i e , ch a i fai a d e e , ec ic g ha da
e e i ab e di ib i f i c e.
Rea d i e 1: Wha acc f a ia i i

ec ic ac i i e i e, a d h i hi
i a ?
CONCEP AL NDER ANDING
1 The c di i f he de a d ide a d he ide f he ec ae b ec
c i cha ge, hich ca e a ia i i ec ic ac i i e i e.
2 F c ai i ec ic ac i i ha e a effec he ec c e -be g f
cie ie a d he i di id a i hi he .
3 Diffe e ch f h gh ffe diffe e e a a i f ac ec ic be
a d gge diffe e i f dea i g i h he e.
The e ic a e add e ed i he e fi e cha e . Cha e 8 i c ce ed i h he ca e

f cha ge i ec ic ac i i a d he be f h ec i ea e ec ic e -
bei g. Cha e 9 i d ce f da e a ac ec ic c ce ha e i e a a e
he ac ec , i a ic a agg ega e de a d a d he ec e ia agg ega e
. Cha e 10 a d 11 i di c he i a ac i e f i f a i ,
e e , ec ic g h a d deb . Fi a , Cha e 12 dea i h he cha e ge
ed b i c ea i g i e a i ie a d h he e a be effec i e add e ed.
Mad id, S ai . J b ee e ide a e e age c

_______________________________________________
C a e 8
T e e e e a ec c ac
BEFORE YOU START
In the news you have probably heard reports describing the state of the economy . What do you
think the economy is?
News reports often comment on how the economy has improved or worsened. What do you think
characterises an economy that has improved or worsened?
In this chapter we will discover how economists measure an economy s total output and income. We will
study the business cycle, that shows how economic activity fluctuates over time. Finally, we will
examine the limitations of standard measurements of output and income, and will consider alternative
methods that may be more appropriate for measuring economic well-being.
8.1 Ec c ac
LEARNING OBJECTIVES
Af e d g ec be ab e :
def e a e e a ea g a ge b d e e (AO1)
e e e c c a f f c e de d ced C a e 1 a d da a d ag a f
de (AO2, AO4)
The c c a f f c e de
T ec c a f f c e de a d ced C a e 1, Sec 1.3. We b ef e e ee
a f e ba f de a d g e ac ec .
The de ac ed ec h g e e
F g e 8.1 e a e a F g e 1.4 (C a e 1), c d ced e e a a d e de e de ce
be ee e d (c e )a df (b e e ), ed ge e g d c a e a d
e ce a e .
F g e 8.1: C c a f f c e de ea age a d ec
H e d ,a e f fac f d c ( a d, ab , ca a a d e e e e ) e ee
f ,a d e a b e d c a f d ce. F b e fac f d c ,a d e e
g d a d e ce e d ce c e .T e e e ef e a f ec c ed ec f
fac f d c f e d f , a d f g d a d e ce f f e d.
T ec ec c e d ec f f mone . H e d ece e c e e e e e
fac f d c f ef f en (f a d), age (f ab ), in e e (f ca a ) a d
p ofi (f e e e e ). C e e a e ho ehold e pendi e c e e e e d
b g d a d e ce . F e e a d a e co of p od c ion e e b e fac f
d c , a d e ece e e en e e e e e g d a d e ce .
We ee a e income flo f f e d e a e e pendi e flo f
e d f : e e d c e f e a e f fac f d c e a e d
e e d e g d a d e ce . T e ci c la flo of income.
T ee f a ea e a e a e fg d a d e ce , e al e of o p flo . T
e a e f e d c f eac g d a d e ce ed b e ec e ce, g g e
a e f a . T e ef e:
T ec c a f f c e a a g e e e d ( a a ea ), e al e of o p
d ced a ec e a e o al income ge e a ed d c g a , c e a
e e pendi e ade c ae a .
Add g ea age a d ec
F g e 8.2 e a e a F g e 1.6, g ec c a f f c e de injec ion ( e
f g ) a d leakage ( e f g ,a a i hd a al ) e e f fFg e
8.1.
F g e 8.2: C c a f f c e de ea age a d ec
Lea age a d ec a e a ed ge e a a ea f ef ca c e bac a a

ec :
ea age ec
a g e e
a e g e e e d g
e d g e e d g
Sa ga d e e
Sa g a a f c e c e a e , e ef e a ea age. I e e e d g
a b f f e d c f ca a g d ( e f ef fac f d c , ca
ca a ). T ca a g d a e a a e e g d .H e d ace e a g
f a c a a e (ba acc , c a e f c a d b d , e c.) a d f ba f d f
f a ca a e ( g b g, g c a d b d , e c.) f a ce e e , e
d c f ca a g d . T e e f d e ef e f bac ee e d ef a ec .
Sa g ea f ef fc e e e d e, a e g f a ca a e ,a d e
ec ed bac ee e d ef a e e .
Ta e a d g e e e d g
Ta e a d g e e e d g a e c ec ed g eg e e . Ta e a e a ea age ce
e d a a e eg e e ead f b g g d a d e ce , a d g e e e d g
a ac e (ed ca , ea , defe ce, e c.) c e bac ef a a ec .
I a de
A ec a a de g e a a ade a open econom . I a de
ae ed ge e g e c e .I e e e a ea age beca e e a e e d
e d g a ea e e c e a d ce e g d a d e ce . E e ee a
ec beca e e a e e d g b f e g e b d e ca d ced g d a d e ce .
The e f he c c a f ea he e f ea age a d
ec
T e e a e e f ea age a d ec a a c e e ce f e e f e c c a f . If
ea age a e g ea e a ec , e e f ec c a f bec e a e.S e a g a ge
a e e , a e e d c e a ea a a g f a ca a e d e a c e
bac ef a e e .T e e a fe e g d a d e ce ae c a ed, f c bac
e , e b fe e fac f d c , e e c ea e ( ce f b a a e
a f ab ) a d e d c e ed ced.
If ec a e a ge a ea age , e e f ec c a f bec e a ge . S e e d g
e g ea e a e d g .T ea a f e g e de a d a g ea e a fg d
a d e ce ,f beg d ce eb c a g e fac f d c , e e fa
(a f b a a ge a f ab ), a d e d c e c ea e .
T a e:
Lea age f ec c a f f c e ( a g, a e a d ) a e a c ed b ec
ec c a f f c e( e e ,g e e e d ga de ), g e e eed be
e a eac e . If ec a e a e a ea age , e c ef bec e a e; f
ec a e a ge a ea age e c e f bec e a ge .

I gge ed a e Te de a d g 1.10 C a e 1 e e e a f
ec c a f f c e de .
8.2 M
LEARNING OBJECTIVES

e plain he e pendi re, income and o p approaches o meas ring GDP in na ional income
acco n ing, and sho heir eq i alence sing he circ lar flo of income model (AO2, AO4)
e plain he follo ing meas res (AO2)
nominal Gross domes ic prod c (GDP)
nominal Gross na ional income (GNI)
real GDP and real GNI
real GDP and real GNI per person (per capi a)
real GDP and real GNI per person (per capi a) a p rchasing po er pari (PPP)
I
Meas remen of economic ac i i in ol es meas ring an econom s na ional income or he al e of
o p , and is referred o as . The o p of an econom is referred o as
, also kno n as aggregate output, hich means o al o p . Kno ing na ional income
and he al e of aggrega e o p is er sef l beca se his allo s s o:
assess an econom s performance o er ime (are income and o p increasing o er ime; are he
decreasing?)
make comparisons of income and o p performance i h o her economies
es ablish a basis for making policies ha ill mee economic objec i es.
Yo ma ha e no iced ha e of en refer o he al e of o p . Wh speak in erms of al es, and no
in erms of q an i ies, as e did in microeconomics? The ans er is ha in macroeconomics e m s
find a a o add p q an i ies of o p of h ndreds of ho sands of differen goods and ser ices. Ye
ho can e add p q an i ies of comp ers, apples, cars and hea re icke s? Wha ni of meas remen
can e se? To ge aro nd his diffic l , e meas re o p in mone erms, or he al e of goods and
ser ices. The al e of a good is simpl i s q an i m l iplied b i s price. Some imes al e ma no
be e plici l men ioned. For e ample, one ma speak of he le el of aggrega e o p or simpl
aggrega e o p . Wha e er is he case, in macroeconomics o p is al a s in al e erms.
H
The circ lar flo of income model sho ed ha he al e of aggrega e o p prod ced is eq al o he
o al income genera ed in prod cing ha o p , hich is eq al o he e pendi res made o p rchase ha
o p . For his reason, he erm , or he o al income of an econom , is some imes sed
in erchangeabl i h he al e of aggregate output. We ill no se his principle o see ho na ional
income or he al e of aggrega e o p is meas red.
There are hree a s o meas re he al e of na ional o p (or aggrega e o p ), s gges ed b he

circ lar flo of income model, all gi ing rise o he same res l :
he adds p all spending o b final goods and ser ices prod ced i hin
a co n r o er a ime period
he adds p all income earned b he fac ors of prod c ion ha prod ce all
goods and ser ices i hin a co n r o er a ime period
he calc la es he al e of all final goods and ser ices prod ced in a co n r
o er a ime period.
T
The e pendi re approach meas res he o al amo n of spending o b final goods and ser ices in a
co n r ( s all i hin a ear). The erm final refers o goods and ser ices read for final se, and can
be con ras ed i h in ermedia e goods and ser ices, or hose p rchased as inp s for he prod c ion of
final goods. When e meas re he al e of aggrega e o p , e incl de onl p rchases of final goods
and ser ices. For e ample, food i ems like mea and ege ables are in ermedia e goods for a res a ran
ha ses hem o prepare a meal, and he meal is he final good. If in meas ring e pendi res e
incl ded spending on he food i ems pl s spending on he meal, his o ld in ol e do ble co n ing and
he al e of aggrega e o p o ld be e aggera ed. On he o her hand, mea and ege ables bo gh b a
ho sehold for cons mp ion co n as final goods, since he are no sed as inp s for he prod c ion of
ano her good or ser ice.
To al spending is broken do n in o fo r componen s:
C , C, incl des all p rchases b ho seholds on final goods
and ser ices in a ear (e cep ho sing, hich is classified nder in es men ).1 Cons mp ion
spending is of en referred o as for shor .
I , I, incl des:
spending b firms on capi al goods (i.e. b ildings, machiner , eq ipmen , e c.)
spending on ne cons r c ion (ho sing and o her b ildings).2

In es men spending is of en referred o as for shor .
G , G, refers o spending b go ernmen s i hin a co n r
(na ional, regional, local). I incl des p rchases b he go ernmen of fac ors of prod c ion,
incl ding labo r ser ices. I incl des go ernmen in es men , referred o as p blic in es men ,
hich s all in ol es roads, airpor s, po er genera ors, b ildings.
N ( ), X M, refers o he al e of all e por s
(abbre ia ed as X) min s he al e of all impor s (abbre ia ed as M). E por s are goods and ser ices
prod ced i hin he co n r and so m s be incl ded in he meas remen of aggrega e o p .
Impor s, ho e er, in ol e domes ic spending on goods and ser ices ha ha e been prod ced in
o her co n ries, and so m s be s b rac ed from e pendi res meas ring domes ic o p .
If e add oge her he fo r componen s of spending, e ob ain a meas re of aggrega e o p kno n as
gross domestic product (GDP):
C + I + G + (X M) = GDP
This approach allo s economis s o see he rela i e con rib ion of each componen of GDP, ho hese
migh change o er ime, and o make comparisons o er ime or across co n ries. For e ample, if one is
in eres ed in in es men , i is possible o race o ho he share of in es men in GDP changes o er
ime and o see ho he share of in es men in one co n r compares i h i s share in o her co n ries.
G (GDP) is defined as he marke al e of all final goods and ser ices

prod ced in a co n r o er a ime period ( s all a ear). I incl des spending b he fo r
componen s, C + I + G + (X M). I is one of he mos commonl sed meas res of he al e of
aggrega e o p .
S
In es men refers o spending b firms or he go ernmen on capi al goods and on cons r c ion. There is
a common misconcep ion ha in es men is nder aken onl b firms. This is incorrec , beca se as e
ha e seen in he disc ssion abo e, in es men is also nder aken b go ernmen s (p blic in es men s).
One reason for his misconcep ion is ha firms are major decision-makers hose con rib ion o GDP is
in he form of in es men .
Ano her iss e is ha in meas res of aggrega e o p , in es men in capi al incl des onl spending on
ph sical capi al. I does no incl de spending on h man capi al and of en i does no incl de spending on
na ral capi al (see Chap er 1, Sec ion 1.1 for hese dis inc ions). This can be conf sing, beca se
economis s of en refer o in es men s in h man capi al and in es men s in na ral capi al , and e
hese in es men s do no appear as in es men s in meas res of aggrega e o p . Man economis s
arg e ha na ional income acco n ing me hods sho ld be changed o incl de hese pes of in es men s
as ell.
No e ha meas res of aggrega e o p also do no incl de financial capi al or social capi al (see Chap er
1, Sec ion 1.1), b his is j s ifiable as hese pes of capi al do no represen al e of goods and
ser ices prod ced.
T
The income approach adds p all income earned b he fac ors of prod c ion i hin a co n r o er a
ime period ( s all a ear): ages earned b labo r, ren earned b land, in eres earned b capi al and
profi s earned b en reprene rship. When all fac or incomes are added p, he res l is national income.
Whereas na ional income is of en sed as a meas re of he le el of economic ac i i , i is no he same
as GDP. To calc la e GDP sing he income approach, i is necessar o make some adj s men s o
na ional income.3
This approach allo s economis s o see he rela i e income shares of he differen fac ors of prod c ion,
ho hese migh change o er ime, and o make comparisons o er ime or across co n ries. For e ample,
if e are in eres ed in ages of orkers, e can see ho he share of ages in na ional income changes
o er ime and ho his share in one co n r compares i h i s share in o her co n ries.
T
The o p approach meas res he al e of each good and ser ice prod ced in he econom o er a
par ic lar ime period ( s all a ear) and hen s ms hem p o ob ain he o al al e of o p
prod ced. I incl des he al e of all final goods and ser ices, in order o a oid he do ble co n ing ha
o ld arise from incl ding he al es of in ermedia e goods and ser ices.4
The o p approach calc la es he al e of o p b economic sec or, s ch as agric l re,
man fac ring, ranspor , banking, e c. The al e of o p of each sec or is hen added p o ob ain he
o al al e of o p for he en ire econom .
This approach pro ides economis s i h he oppor ni o s d he performance of each indi id al
sec or b looking a i s rela i e share in o al o p , ho his changes o er ime and o make
comparisons of performance across sec ors across co n ries.
The hree approaches gi e rise o he same res l , af er allo ance is made for s a is ical differences ha
arise in he co rse of meas ring he differen ariables in ol ed.
1 E plain h he erms na ional income and aggrega e o p are of en sed in erchangeabl .

2 Iden if some reasons h i is sef l o kno he al e of aggrega e o p .
3 E plain h
e meas re aggrega e o p in al e erms, and
e co n onl he al e of final goods and ser ices hen meas ring he al e of o p .
4 Iden if he fo r e pendi re componen s of GDP and e plain each of hese.
5 E plain hree a s ha GDP can be meas red.
O line he pe of informa ion each approach offers abo he econom .
6 Using he circ lar flo model, e plain h he hree a s o meas re GDP gi e rise o he same
res l .
D GDP GNI
Under he e pendi re approach o meas ring aggrega e o p , e learned he meaning of gross
domes ic prod c (GDP), hich is he marke al e of all final goods and ser ices prod ced in a co n r
o er a ime period ( s all a ear), and incl des he fo r componen s of spending: C + I + G + (X M).
In addi ion, sing he circ lar flo of income model, e learned ha he al e of o p prod ced in an
econom is eq al o he o al income genera ed in prod cing ha o p . Ho e er, in he real orld, his
eq ali does no al a s hold. Some imes he o p of an econom is prod ced b fac ors of prod c ion
ha belong o foreigners. Consider he case here a US m l ina ional firm in India remi s (sends back)
i s profi s o he Uni ed S a es. The o p of he m l ina ional is prod ced in India, b he profi income
is recei ed b residen s in he Uni ed S a es. Does he profi income co n as Indian or US income and
o p ? Consider also a R ssian orker ho li es and orks in Spain, and sends a large par of her
income o her famil in R ssia. Her o p is prod ced in Spain, b he income she sends home is
R ssian income; sho ld his income co n as R ssia s or Spain s income and o p ?
The concep s domes ic and na ional are sed o dis ing ish be een meas res of aggrega e o p
and income ha deal i h his iss e. The erm domes ic in gross domes ic prod c means ha o p
has been prod ced b fac ors of prod c ion domes icall , or i hin he co n r , regardless of ho o ns
hem (residen s or foreigners). The erm na ional is sed in ano her meas re of aggrega e o p kno n
as (GNI). The erm na ional in GNI means ha he income i meas res is he
income of he co n r s residen s, regardless here his income comes from.
In he firs e ample abo e, he profi income remi ed o he Uni ed S a es is incl ded in Indian GDP
beca se i is crea ed b prod c ion in India, b i is par of US GNI beca se i is income recei ed b US
residen s. The R ssian orker s o p in Spain is incl ded in Spain s GDP, b her income sen o
R ssia is par of R ssia s GNI.
GDP is he o al al e of all final goods and ser ices prod ced i hin a co n r o er a ime period
( s all a ear), regardless who owns the factors of production. GNI is he o al income recei ed b
he residen s of a co n r , eq al o he al e of all final goods and ser ices prod ced b he fac ors of
prod c ion s pplied b he co n r s residen s regardless where the factors are located.
We ill disc ss GDP and GNI f r her in Chap er 18. I ma in eres o o rn o Table 18.2 o see
some in erna ional comparisons.
D
Earlier e no ed ha in macroeconomics e meas re o p in al e erms, and e defined al e o be
he q an i of a good m l iplied b i s price. N is mone al e, or al e meas red in
erms of prices ha pre ail a he ime of meas remen . For e ample, if a pair of shoes cos s 100, his is
i s nominal al e. If o b his pair of shoes, 100 is o r nominal e pendi re on hese shoes. If o r
mon hl income is 2000, his is o r nominal income. Therefore, hen e calc la e he al e of
aggrega e o p , or e pendi re, or income, in mone erms, e speak of nominal GDP, nominal GNI,
nominal e penditure, e c.
Ye prices change o er ime, and his poses a meas remen problem. Le s sa ha nominal GDP
increases in a ear. This increase ma be d e o changes in he q an i ies of o p prod ced, or changes
in he prices of goods and ser ices, or a combina ion of bo h. We do no kno ha par of he increase
is d e o changes in o p and ha par o changes in prices. Ye e are in eres ed in kno ing ho
m ch he quantit of goods and ser ices has increased. We m s herefore find a meas re of GDP ha is
no infl enced b price changes.
To elimina e he infl ence of changing prices on he al e of o p , e m s calc la e real al es. R
is a meas re of al e ha akes in o acco n changes in prices o er ime. Meaningf l comparisons
o er ime in he al e of o p , or e pendi res, or income, or an ariable ha is meas red in mone
erms, req ire he se of real al es. For e ample, hen e make comparisons of GDP in a co n r o er
ime, e m s be s re o se real GDP al es, as hese ha e elimina ed he infl ence of price changes,
and gi e s an indica ion of ho ac al o p prod ced has changed.
N GDP and GNI are meas red in erms of c rren prices (prices a he ime of
meas remen ), hich does no acco n for changes in prices. R GDP and GNI are meas res
of economic ac i i ha ha e elimina ed he infl ence of changes in prices. When a ariable is being
compared o er ime, i is impor an o se real al es.
D per capi a
Per capita is a Latin e pression that means per person. A per capita meas re akes he o al al e (of
o p , income, e pendi re, e c.) and di ides his b he o al pop la ion of a co n r . Therefore GDP
per capi a of a co n r is o al GDP of ha co n r di ided b i s pop la ion.
The dis inc ion be een o al and per capita meas res is er impor an for o reasons:
D . Le s sa here are o co n ries ha ha e iden ical
o al GDPs of 10 billion. Co n r A has a pop la ion of 1 million people and co n r B has a
pop la ion of 2 million people. If e di ide o al GDP b pop la ion e ge GDP per capita of 10
000 for co n r A and 5000 for co n r B. Whereas bo h co n ries ha e iden ical GDPs, co n r
B s per capita GDP is onl half ha of co n r A, beca se of differing pop la ion si es.
P . Changes in he si e of GDP (or GNI) per capita o er ime depend er m ch
on he rela ionship be een gro h in o al GDP (or GNI) and gro h in pop la ion. In general, if
o al GDP increases fas er han he pop la ion, hen GDP per capita increases. B if he co n r s
pop la ion increases fas er han o al GDP, hen GDP per capita falls.
To al meas res of he al e of o p and income (s ch as GDP and GNI), pro ide a s mmar
s a emen of he o erall si e of an econom . Per capi a fig res are sef l as a summar measure of
he s andard of li ing in a co n r , beca se he pro ide an indica ion of ho m ch of o al o p or
o al income in he econom corresponds o each person in he pop la ion on a erage.
T GDP/GNI per capi a

(PPP)
In order o be able o make acc ra e comparisons of real GDP/real GNI or real GDP per capita/real GNI
per capita across countries, e need o make ano her dis inc ion. The reason is ha differen co n ries
ha e differen price levels. This means ha he same amo n of mone in a lo -price co n r has grea er
p rchasing po er (can b more hings) han in a high-price co n r .
S ppose a cand bar cos s 3 in a high-price co n r and he same cand bar cos s 1.50 in a lo -price
co n r . This means ha he 3 o ha e in o r pocke can b one cand bar in he high-price co n r
and o cand bars in he lo -price co n r . Yo r 3 has grea er purchasing power in he lo -price
co n r . P rchasing po er refers o he q an i of goods and ser ices ha can be bo gh i h mone .
Clearl if e do no ake price le el differences in o acco n , e ill no ge an acc ra e pic re of
differences across co n ries in he al e of o p he prod ce.
We herefore need a me hod of c rrenc con ersions (changing he c rrenc of one co n r in o he
c rrenc of ano her co n r ) ha acco n s for differen price le els, and herefore differen p rchasing
po ers across co n ries. S ch a me hod is pro ided b special e change ra es called
(PPP ). (Yo ill learn abo e change ra es in Chap er 16.) P rchasing po er pari li erall
means b ing po er eq i alence . I is defined as he amo n of a co n r s c rrenc ha is needed o
b he same q an i of local goods and ser ices ha can be bo gh i h US$1 in he Uni ed S a es.
The se of PPPs o make comparisons of an meas re, he her GDP or GNI or an hing else, elimina es
he infl ence of price le el differences and makes comparisons across co n ries far more acc ra e. (Use
of he US$ as he basis for he con ersions is onl a ma er of con en ion, as o her c rrencies o ld also
ha e been s i able for his p rpose.)
P rchasing po er pari ies ill be disc ssed f r her in Chap er 18. Yo ma be in eres ed o see Table
18.3, hich sho s per capi a GDP calc la ed bo h b se of s andard e change ra es (col mn 1) and b
se of p rchasing po er pari ies (col mn 2).
Comparisons of GDP per capita (or GNI per capita) across co n ries req ire meas res of per capita
o p or income based on con ersions of na ional c rrencies in o US$ b se of p rchasing po er
pari ies (PPPs), o elimina e he infl ence of price differences on he al e of o p or income.
P rchasing po er pari e change ra es are comp ed and p blished on a reg lar basis b se eral
in erna ional bodies, incl ding he Organisa ion for Economic Co-opera ion and De elopmen (OECD),
E ropean Union, he World Bank and Uni ed Na ions agencies
T gross (S
)
If o are in eres ed in learning abo he meaning of gross in gross domestic product o ill find he
e plana ion in he digi ial co rsebook.

1 Define GDP and GNI, and o line ho he differ.
Research and pro ide some e amples of co n ries here (i) GNI is likel o be larger han
GDP, and (ii) GDP is likel o be larger han GNI.
2 E plain he difference be een nominal GDP and real GDP (or nominal and real GNI).
3 O line h i is impor an o se real al es hen making comparisons o er ime.
4 Yo read in he ne spaper ha go ernmen spending on ed ca ion in o r co n r increased b
7% las ear. Iden if and describe f r her informa ion ha co ld help o make sense of his
fig re.
5 O line he difference be een o al GDP (or GNI) and per capita GDP (or GNI).
E plain h is i some imes impor an o make a dis inc ion be een o al meas res and per
capita meas res of income and o p .
6 E plain h price changes o er ime pose a problem hen e an o make comparisons of
GDP (or an meas re of o p or income) o er ime.
O line h he se of p rchasing po er pari ies (PPPs) is necessar o ens re ha
comparisons of GDP or GNI fig res across co n ries are meaningf l.
1
Spending b cons mers is classified as spending on (i) cons mer d rable goods ( i h an e pec ed life of more
han hree ears, s ch as cars, refrigera ors, ashing machines, ele isions, e c.), (ii) cons mer non-d rable
goods ( i h an e pec ed life of less han hree ears, s ch as food, clo hing and medicines), and (iii) ser ices
(en er ainmen , banking, heal h care, ed ca ion, e c.).
2 In es men spending incl des one more i em: changes in in en ories. In en ories refer o o p prod ced b
firms ha remains nsold. B sinesses as a r le keep in en ories o help hem mee ne pec ed increases in he
demand for heir prod c . Since in en ories are o p , i means ha he m s be co n ed as par of he
aggrega e o p ha is being meas red. Ho e er, since he are o p ha has no been sold, he canno be
co n ed nder cons mp ion e pendi re; he are herefore co n ed nder in es men . In es men spending is
of en referred o as for shor .
3 A de ailed considera ion of hese adj s men s is be ond he scope of his book. For he in eres ed s den , he
ill be men ioned briefl here. If e add deprecia ion and indirec a es o na ional income, e ob ain a
meas re of aggrega e o p called gross na ional income (GNI). The difference be een GNI and GDP ill be
considered la er in his chap er. Deprecia ion refers o he earing o of capi al goods, and ill also be
considered la er. The reason e add deprecia ion and indirec a es o na ional income in order o ob ain GNI
(and GDP) is ha he al e of o p meas red b he e pendi re approach incl des bo h hese i ems. B
con ras , na ional income, meas ring onl he incomes of he fac ors of prod c ion, does no incl de ei her of
he o.
4 The me hod sed o ob ain he al e of onl final goods and ser ices is o co n onl he al e added in each
s ep of he prod c ion process. For e ample, sa he prod c ion of a good goes hro gh he follo ing s eps.
Firm A sells ra ma erials for $700 o firm B. Firm B ses he ra ma erials and prod ces an in ermedia e
good ha i sells o firm C for $1100. Firm C ses his in ermedia e good o prod ce a final good ha i sells for
$1700. Ho m ch al e has been added in his process? Firm A added $700 of al e. Firm B added $400 of
al e (= $1100 $700), and firm C added $600 of al e (= $1700 $1100). When e add hese p e ob ain:
$700 + $400 + $600 = $1700. No e ha he s m of he al es ha ere added in each s ep of he prod c ion
process is e ac l eq al o he al e of he final prod c . If e had added p he al es of he o in ermedia e
prod c s and he final prod c , e o ld ha e: $700 + $1100 + $1700 = $3500, hich grea l e aggera es he
al e of he prod c d e o do ble co n ing. B co n ing onl al es added in each s ep of he prod c ion
process, he problem of do ble co n ing is a oided.
8.3 C
LEARNING OBJECTI ES

define all the terms appearing in in the te t
calculate the follo ing measures (AO4)
nominal Gross domestic product (GDP) using the e penditure approach
nominal Gross national income (GNI)
real GDP and real GNI
real GDP and real GNI per capita
C GDP
We ha e seen that the measurement of GDP using the e penditure approach in ol es adding up the four
spending components: consumption (C), firm in estment (I), go ernment spending (G) and e ports
minus imports (X M). Therefore, GDP = C + I + G + (X M). (It is also possible to calculate GDP
using the income and output approaches but this is be ond the scope of IB requirements.)
Suppose e are gi en the national income statistics for a countr called Mountainland in Table 8.1 (Mnl
is Mountainland s national currenc ).
Consumer spending 11.3
In estment spending 3.2
Go ernment spending 3.5
E ports of goods and ser ices 2.5
Imports of goods and ser ices 2.1
T 8.1: National income statistics for Mountainland, 2019 (billion Mnl)
Using this information, e find that nominal GDP = 11.3 + 3.2 + 3.5 + 2.5 2.1 = 18.4 billion Mnl in
2019. Note that all these figures are in nominal terms; therefore, this alue of GDP is a nominal alue.
C GNI
The difference bet een GDP and GNI as e plained earlier. Gi en data on GDP, e can find GNI in the
follo ing a : e add to GDP the income of domestic residents earned abroad, and subtract from GDP
the income paid abroad to foreigners. Therefore:
GNI = GDP + income from abroad income sent abroad
Income from abroad income sent abroad can be simpl ritten as net income from abroad . We
therefore ha e:
GNI = GDP + net income from abroad
Note that in the United Kingdom and in some other countries, net income from abroad ma be referred
to as net propert income from abroad . In the United States, it is sometimes referred to as net foreign
factor income or net factor income .
For e ample, suppose in 2020, Ri erland s GDP as $46 billion: income earned abroad and sent home
to Ri erland as $2.7 billion; income earned in Ri erland and sent abroad as $4.7 billion. What as
Ri erland s 2020 GNI?
Ri erland s net income from abroad as $2.7 billion minus $4.7 billion = $2 billion. Therefore,
2020 GNI = $46 billion $2 billion = $44 billion
Note that this alue of GNI is a nominal alue.
C GDP GNI
GDP
The distinction bet een nominal and real alues as discussed abo e. We ill no use a numerical
e ample to sho ho real GDP can be calculated from nominal GDP. This is normall done b
statistical ser ices in each countr and our e ample here is for illustration purposes onl ( ou ill not
ha e to perform such calculations).
Table 8.2 assumes a simple econom producing three items (burgers, haircuts and tractors). Part (a)
sho s their quantities and prices for three ears and the corresponding nominal GDP. In 2001, 37
burgers selling at 3 each made the total alue of burgers 111; 15 haircuts at 18 each had a alue of
270; and 10 tractors at 50 each made the total alue of tractors 500. Adding up the three total alues,
e find nominal GDP of 881 in 2001. The nominal GDP figures for 2002 and 2003 are calculated in
the same a .
Part (b) of Table 8.2 sho s that to find real GDP, it is onl necessar to find the alue of quantities
produced in 2001, 2002 and 2003 using the same prices of a single ear, called a base ear. An ear
can be used as the base ear. In the table the base ear is 2001. To calculate real GDP, e simpl
multipl the quantities of output produced each ear b 2001 prices. Notice that columns 3, 6 and 9 are
identical.
For e ample, in 2002, the 40 burgers are alued at the 2001 burger price of 3; the 17 haircuts are alued
at the 2001 price of 18, and the 11 tractors are alued at the 2001 price of 50. Adding up the resulting
alues of the three items in column 7, e get a measure of real GDP of 976 in 2001 prices. Similarl ,
for 2003, the three quantities are also alued at the 2001 prices. Therefore, real GDP is a meas re of
o tp t al ed at constant ( nchanging) prices.
Nominal GDP measures the alue of current output alued at current prices, hile real GDP measures
the alue of current output alued at constant (base ear) prices.
Calculating nominal GDP
1 2 3 4 5 6 7 8 9 10
G 2001 2001 2001 2002 2002 2002 2003 2003 2003
Q P Q P Q P
(Q P) (Q P) (Q P)
B 37 3 111 40 4 160 39 5 195
H 15 18 270 17 20 340 18 21 378
T 10 50 500 11 60 660 10 65 650

1 2 3 4 5 6 7 8 9 10
G 2001 2001 2001 2002 2002 2002 2003 2003 2003
Q P Q P Q P
(Q P) (Q P) (Q P)
N 881 1160 1223
GDP
Calculating real GDP
1 2 3 4 5 6 7 8 9 10
G 2001 2001 2001 2002 2001 2002 2003 2001 2003
Q P Q P Q P
2001 2001 2001
P P P
(Q P) (Q P) (Q P)
B 37 3 111 40 3 120 39 3 117
H 15 18 270 17 18 306 18 18 324
T 10 50 500 11 50 550 10 50 500
R 881 976 941

GDP
T 8.2: Nominal and real GDP in a h pothetical econom
E amining the changes in real GDP that occurred bet een 2001 and 2003, e find that real GDP
increased from 2001 to 2002 (from 881 to 976), but decreased bet een 2002 and 2003, falling from
976 to 941. Note that real GDP fell in 2002 2003 e en as nominal GDP increased o er the same
period; price increases caused nominal GDP to rise, hile falling quantities meant that real GDP as
falling.
Note also that in the base ear, 2001, nominal GDP is equal to real GDP; this is al a s so for the base
ear since real GDP is alued at base ear prices.
When e refer to real GDP figures, e must also refer to the specific base ear used for the
computation. In the e ample abo e, e sa in 2003 real GDP at 2001 prices as 941 . The figure of
941 is other ise meaningless, because if e had used a different base ear, e ould ha e arri ed at a
completel different figure for 2003 real GDP. It is also meaningless to compare real GDP figures
calculated on the basis of different base ears.
GDP
In the real orld, the abo e method of con erting nominal alues into real alues is e tremel length
and complicated, as there are hundreds of thousands of products hose alues must be measured.
Ho e er, this is not a problem because economists use short-cut methods that take the form of price
indices (indices is the plural of inde ). A price inde is a measure of a erage prices in one period relati e
to a erage prices in a base ear. A price inde commonl used to con ert nominal GDP to real GDP is a
kno n as the GDP deflator:
GDP deflator= nominal GDP real GDP 100
Statistical ser ices deri e the GDP deflator b using the alues of nominal and real GDP the ha e
alread calculated (b the method in Table 8.2):
GDP deflator in 2001= 881 881 100=100.0
GDP deflator in 2002= 1160 976 100=118.8
GDP deflator in 2003= 1223 941 100=130.8
These results are summarised in Table 8.3. Note that the GDP deflator is 100.0 for 2001. The inde
n mber for the base ear is al a s eq al to 100, for all indices. This follo s from the equalit of
nominal and real GDP in 2001, as e had selected 2001 to be the base ear.
N GDP R GDP GDP
2001 881 881 100.0
2002 1160 976 118.8
2003 1223 941 130.0
T 8.3: Nominal and real GDP
GDP GDP
Statistical ser ices in each countr regularl publish GDP deflators (and other price indices). Using this
information, it is a simple matter for economists to calculate real GDP from nominal GDP:
real GDP = nominal GDP price deflator 100
For e ample, suppose e are gi en the follo ing alues of nominal GDP for a h pothetical Countr X:
$7850 billion in 2001; $9237 billion in 2002; and $10 732 billion in 2003. We are also gi en the GDP
deflator in Table 8.3, and are asked to calculate real GDP:
real GDP in 2001= 7850 100.0 100=$7850 billion
Note that an increasing GDP deflator indicates rising prices on a erage, hile a decreasing GDP deflator
indicates falling prices on a erage. Suppose e ha e the follo ing price inde representing the GDP
deflator:
2004 2005 2006 2007 2008

95.7 97.7 100.0 105.9 102.4
We can see that hereas prices on a erage increased in the period 2004 2007, in 2008 the fell. We can
also see that the base ear is 2006. Note that it is possible for some ears to ha e a price inde that is less
than 100.0, hich means simpl that in those ears, the a erage price le el as lo er than in the base
ear.
C per capita
Suppose that the population of Countr X abo e as 310 million in 2001. We ould like to calculate its
real GDP per capita in that ear:
real GDP per capita = $7850 billion 310 billion =$25 323
Note that real GNI per capita, or an other measure per capita is calculated in e actl the same a .

1 Calculate nominal GDP, gi en the follo ing information from the national accounts of Flatland
for the ear 2019 (all figures are in billion Ftl, the national currenc ). Consumer spending = 125;
go ernment spending = 46; in estment spending = 35; e ports of goods and ser ices = 12;
imports of goods and ser ices = 17.
2 No suppose that profits of foreign multinational corporations in Flatland and incomes of
foreign orkers in Flatland that ere sent home in 2019 ere Ftl 3.7 billion. The profits of
Flatland s multinational corporations abroad and income of Flatland orkers abroad that ere
sent back to Flatland ere Ftl 4.5 billion. What as Flatland s GNI in 2019?
3 You read in one source of information that real GDP in a h pothetical countr in 2001 as $243
billion; in another source of information ou read that real GDP in 2002 as $277 billion. State
hat information ou need to be sure that the t o figures can be compared ith each other.
4 You are gi en the information in the table on an imaginar countr called Lakeland.
2015 2016 2017 2018 2019
N GDP 19.9 20.7 21.9 22.6 22.3

( L )
P 98.5 100.0 102.3 107.6 103.7

(GDP )
P 1.20 1.21 1.22 1.23 1.27
Identif the base ear.

Calculate real GDP for each of the fi e ears in the table.
State hich ear real GDP is the same as nominal GDP. Outline h .
In 2017 2018, nominal GDP increased, but real GDP fell (check that this is hat our
calculations sho ). E plain ho this could ha e happened.
In 2018 2019, nominal GDP fell, but real GDP increased (check that this is hat our
Calculate real GDP per capita for each of the ears.
In 2018 2019, real GDP increased but real GDP per capita fell (check that this is hat our
8.4 T
LEARNING OBJECTIVES

• explain the business cycle (AO2, AO4)
• distinguish between short-term fluctuations and the long-term growth trend (potential output) and
draw a diagram illustrating these (AO2, AO4)
T
Whereas real output in most countries around the world grows over long periods of time, output growth
virtually everywhere is uneven and irregular. In some years (or months) real output may grow rapidly, in
other years (or months) more slowly, and in still others it may even fall, indicating negative growth.
A business cycle is shown in Figure 8.3, which plots real GDP on the vertical axis, against time on the
horizontal axis. GDP is measured in real terms, so that the vertical axis measures changes in the volume
of output produced after the influence of price-level changes has been eliminated. The cyclical line
shows actual output, or real GDP that is actually achieved over time.
B consist of - in the growth of real output, which are alternating

periods of expansion (increasing real output) and contraction (decreasing real output).
Each cycle consists of the following phases:

• E . An expansion occurs when there is positive growth in real GDP, shown by those parts
of the curve in Figure 8.4 that slope upward. During expansions, employment of resources
increases, and the general price level of the economy (which is an average over all prices) usually
begins to rise more rapidly (this is known as inflation, to be discussed in Chapter 10).
• P . A peak represents the cycle s maximum real GDP, and marks the end of the expansion. When
the economy reaches a peak, unemployment of resources has fallen substantially, and the general
price level may be rising quite rapidly; the economy is likely to be experiencing inflation.
• C . Following the peak, the economy begins to experience falling real GDP (negative
growth), shown by the downward-sloping parts of the curve. If the contraction lasts six months (two
quarters) or more, it is termed a , characterised by falling real GDP and growing
unemployment of resources. Increases in the price level may slow down a lot, and it is even
possible that prices in some sectors may begin to fall.
• T . A trough represents the cycle s minimum level of GDP, or the end of the contraction.
There may now be widespread unemployment. A trough is followed by a new period of expansion
(also known as a recovery), marking the beginning of a new cycle.
The term ‘business cycle suggests a phenomenon that is regular and predictable, whereas business
cycles are in fact both irregular, as they do not occur at regular time intervals, and unpredictable. For
these reasons, many economists prefer to call them ‘short-term economic fluctuations .
While each cycle typically lasts several years, it is not possible to generalise, as there is wide variation in
how long the cycle lasts, as well as in intensity (how strong the expansion is and how deep the
contraction or recession is). Expansions usually last longer than contractions. These are the reasons why
the curve in Figure 8.3 has an irregular shape.
S - -
T -
Figure 8.3 shows a line going through the cyclical line; this represents average growth over long periods
of time (many years) and is known as the - . The long-term growth trend shows
how output grows over time when cyclical fluctuations are ironed out. As you can see in the figure, real
GDP actually achieved fluctuates around potential GDP (it fluctuates around the long-term growth
trend).
F 8.3: The business cycle
The output represented by the long-term growth trend is known as or potential GDP.
To understand the meaning of potential output, we must examine the relationship between real GDP and
unemployment.
H
When real GDP fluctuates, it does so together with other macroeconomic variables. One of the most
important of these is unemployment of labour, or how many people in the workforce are out of work.
When real GDP grows in the expansion phase, unemployment falls; in the contraction phase when real
GDP falls, unemployment increases. You can easily see why: in an expansion, real GDP increases
because firms produce more output; to do this, they hire more labour (and other resources) and
unemployment falls. In a contraction, real GDP falls because firms cut back on production; as they lay
off workers, unemployment increases.
For every economy, there is a level of real GDP at which the economy experiences ‘full employment .
This is known as the full employment level of output, or full employment level of real GDP. The term
does not mean that all resources, including all labour resources, are employed to the
greatest extent possible. Whenever the economy produces its ‘full employment level of output , there is
still some unemployment, known as the ‘natural rate of unemployment .
This is because at any time, there are some people who are in between jobs, some who are moving from
one geographical area to another, some people who are training or retraining to be able to get a new or
better job, and some people who are temporarily out of work. Therefore, there are always some people
who are unemployed.
Coming back to potential output (shown by the long-term growth trend), we can now say that this is the
level of output produced when there is ‘full employment , meaning that unemployment is equal to the
natural rate of unemployment. But when actual GDP is greater than potential GDP, unemployment is
lower than the natural rate; when actual GDP is less than potential GDP, unemployment is greater than
the natural rate.
C ,
Figure 8.4 introduces another concept related to the business cycle. When actual GDP lies above
potential GDP (as at point d), or below potential GDP (as at point e), there results a GDP gap, also
known as an output gap. The output gap is simply actual GDP minus potential GDP, and may be positive
or negative. When actual GDP is equal to potential GDP (as at points a, b, c) the output gap is equal to
zero.
The usefulness of these concepts will become apparent in later chapters when we make use of them to
analyse short-term economic fluctuations and long-term growth.
Figure 8.4 shows that actual GDP fluctuates around full employment GDP, also known as potential
GDP. When the economy s actual GDP is at points such as a, b and c, actual GDP is equal to potential
GDP, and the economy is achieving full employment, where unemployment is equal
. When the economy s actual GDP is greater than potential GDP, such as at
point d, there is an output gap, and unemployment falls to less than the natural rate. When actual GDP
is less than potential GDP, such as at point e, there is an output gap where unemployment is greater
than the natural rate.
F 8.4: Illustrating actual output, potential output and unemployment in the business cycle
W
In an ideal world, every economy would experience economic growth over long periods of time, with
continuous low levels of unemployment and a stable or gently rising price level (low inflation). Rapid
economic growth, full employment, and price stability are among the key macroeconomic objectives of
economies. Figure 8.5 illustrates these objectives in terms of the business cycle.
Using the business cycle, we can understand macroeconomic objectives to include:
Reducing the intensity of expansions and contractions: this is aimed at making output gaps as
small as possible (the dotted line in Figure 8.5(a)), by flattening the cyclical curve. This would
lessen the problems of rising price levels or inflation in expansions and unemployment in
contractions.
Increasing the steepness of the line representing potential output (the dotted line in Figure
8.5(b)), by achieving more rapid economic growth over long periods of time.
F 8.5: Illustrating three macroeconomic objectives
In the next chapter we will develop analytical tools to help us understand the causes of the business
cycle, and in Chapter 13 we will study government policies intended to achieve full employment, price
stability and economic growth.

1 Using the business cycle diagram, distinguish between short-term fluctuations and the longterm
growth trend.
2 Using a diagram:
identify the phases of the business cycle,
describe how they relate to unemployment, and
distinguish between actual and potential output.
3 Describe how the ‘natural rate of unemployment relates to the ‘full employment level of output
and to ‘potential output .
4 Suggest what an economy s business cycle is experiencing when there is
a horizontal potential GDP line, and
a downward-sloping potential GDP line.
5 Use a business cycle diagram to describe three important macroeconomic objectives.
THEOR OF KNOWLEDGE 8.1

T , :
We have seen in our discussion of the business cycle (see Figure 8.4) that economists are concerned
with two representations of output growth: growth of actual output and growth of potential output.
Growth of actual output is straightforward to measure and show graphically; it consists of real GDP
(or GNI) calculated for each year, and plotted on the vertical axis against time measured on the
horizontal axis. When such data are plotted for any country over long periods of time, a cyclical
pattern is likely to emerge (though an irregular one, for reasons explained in the text), known as the
business cycle, or short-term fluctuations. Therefore, the empirical evidence supports the existence of
a business cycle.
The case of potential output is different. Potential output is defined as full employment output, where
unemployment is equal to the natural rate of unemployment, and its growth is shown by the long-term
growth trend. However, for any particular economy, for any particular year, no one really knows what
potential output is; nor does anyone know what the natural rate of unemployment is. Economists do
not have any variable called ‘potential output or ‘natural rate of unemployment that they can
observe in the real world and measure. Of course, economists make efforts to estimate the value of
potential output (and the natural rate of unemployment), and to estimate how potential output changes
over time. This then raises the question, does potential output actually e ist, in the way that actual
output can be said to exist, or is it a mythical idea that economists have created to help with their
analysis of the macro economy?
It is not possible to provide a definite answer to this question; since potential output cannot be
observed or measured, we cannot know if it exists. However, when theorising, there is nothing wrong
with assuming the existence of something that cannot be directly observed; in other words, something
whose existence is not supported by direct evidence. (Note that this is very different from making
unrealistic assumptions, which conflict with the real world.) Physicists do this sometimes, with
success. For example, to explain an event at the sub-atomic level (within atoms) it was necessary to
presume the existence of a particle, though there was no direct evidence that such a particle actually
existed. This fictional particle was named a neutrino, and 20 years later the neutrino was
experimentally detected.
Sometimes, the unobserved variable may be supported by indirect evidence. For example, say we
cannot observe X, but if X exists, then it is likely that Y exists; if we can observe and measure Y, then
we can infer some characteristics about X. In the case of the neutrino, its existence was inferred from
indirect evidence. (Note, however, that inference is not a full-proof method to arrive at conclusions
about something, and may lead to wrong conclusions. For example, it may be true that if X exists,
then Y also exists; but this does not necessarily mean that if Y exists, then X exists. To understand
why, suppose that X = it is raining and Y = it is cloudy. If X is true (it is raining), then Y is true (it is
cloudy). But if Y is true (it is cloudy), X (it is raining) is not necessarily true.)
Some economists argue that the existence of potential output is supported by indirect evidence, which
may be helpful in making estimates about its size. Estimates of potential output can be useful to
economists concerned with economic policy.
T
• Can you think of other variables used by economists that are not directly observable or
measurable?
• Do you think the inability to observe some variables makes the social scientific method less
‘scientific ?
• What kinds of difficulties might be created for policy-makers who use the concept of ‘potential
output to determine appropriate policies for the economy?
8.5 National income statistics and alternative
measures
LEARNING OBJECTIVES

define all he e m appea ing in orange bold in he e
e al a e he app op ia ene of GDP o GNI a i ic fo he p po e of (AO3)
mea ing economic ell-being o e ime
compa ing economic ell-being ac o co n ie
e plain al e na i e mea e of ell-being incl ding (AO2)
he OECD Be e Life Inde
he Happine Inde
he Happ Plane Inde
Evaluating national income statistics

When eal e ca i a GDP o eal e ca i a GNI of a co n inc ea e o e ime, e migh e pec ha
he pop la ion of hi co n imp o e economic ell-being. Al e na i el , if GDP e ca i a o GNI
e ca i a in one co n i highe han in ano he co n , e migh e pec ha he fi co n enjo
a highe economic ell-being. B o ld he e concl ion be alid?
The an e i ha e canno be e. The e a e o ea on h hi i o. One i ha national income
statistics (o a i ical da a ed o mea e na ional income and o p and o he mea e of economic
pe fo mance) do no acc a el mea e he e al e of o p p od ced in an econom . The o he i
ha economic ell-being i clo el ela ed o a a ie of fac o ha GDP and GNI a e nable o
acco n fo . A a e l , e ca i a fig e of bo h GDP and GNI ma be mi leading hen ed o make
compa i on o e ime o compa i on be een co n ie , and hen ed a he ba i fo economic ell-
being concl ion .
Why national income statistics (GDP/GNI) do not accurately

measure the ‘true value of output
GDP and GNI do not include non-marketed output. GDP mea e he al e of good and
e ice ha a e aded in he ma ke place and ha gene a e income fo he fac o of p od c ion.
Ye ome o p of good and e ice i no old in he ma ke and doe no gene a e an income;
hi i called non-ma ke ed o p . An e ample i one o n o k on epai ing and imp o ing
one home; if he home epai e e ca ied o b hi ed o ke , GDP o ld be g ea e b he
amo n of hei age . In de eloping co n ie ho ehold a e of en q i e elf- fficien , i h a
b an ial po ion of p od c ion, ch a ag ic l al p od c ion, aking place fo a ho ehold
o n e and con mp ion, and ne e eaching he ma ke place. Non-ma ke ed o p he efo e i
likel o be fa g ea e in de eloping co n ie compa ed o mo e de eloped one . Man co n ie
a emp o a i e a an e ima e of non-ma ke ed o p , and b adding hi o fig e on ma ke ed
o p a i e a a clo e app o ima ion of e GDP/GNI.
GDP and GNI do not include output sold in underground (parallel) markets. He e e ha e he
ca e he e good a e aded in ma ke and do gene a e income , b he go n eco ded and
he efo e a e no incl ded in GDP/GNI. An nde g o nd ma ke (al o kno n a a pa allel o an
info mal ma ke ) e i hene e a b ing/ elling an ac ion i n eco ded. I ma in ol e he
ale of legal good and e ice , ch a e elling a good a a highe p ice if he e i a p ice ceiling
( ee Chap e 4); o hen a pl mbe doe epai in o home and doe no epo he income
ecei ed o a oid pa ing a e . Al e na i el , i ma incl de an ac ion in ol ing illegal good
and e ice ( ch a d g ). In he e ca e a ell, e ima e of he i e of nde g o nd ma ke
can be made, and hen added o he official (o eco ded) econom , can a i e a a clo e
app o ima ion of e GDP and GNI.
GDP and GNI do not take into account quality improvements in goods and services. The
q ali of man p od c imp o e o e ime, e hi i no aken in o acco n in calc la ing he
al e of o al o p . Technological ad ance of en pe mi imp o ed p od c o be old a lo e
p ice (fo e ample, mobile phone and comp e ). Thi p oce offe ignifican benefi o
con me , hich do no ho p in GDP and GNI fig e .
GDP and GNI do not account for the value of negative externalities, such as pollution, toxic
wastes and other undesirable by-products of production. Vi all all co n ie con ib e o
en i onmen al deg ada ion, ed cing ocie ell-being, ho gh hi i no eflec ed in GDP/GNI
fig e .
GDP and GNI do not take into account the depletion of natural resources. The deple ion of
na al e o ce ( ainfo e , ildlife, ag ic l al oil , e c.) al o ed ce ocie ell-being, e
i no aken in o con ide a ion.
GDP and GNI and differing domestic price levels. Good and e ice of en ell fo e
diffe en p ice in diffe en co n ie . If in e na ional compa i on of GDP do no acco n fo
diffe ing p ice le el ac o co n ie , he e l i a highl mi leading pic e of anda d of li ing
in diffe en co n ie . Thi p oblem can be effec i el deal i h if e con e al e of GDP and
GNI of diffe en co n ie in o a ingle common c enc b e of cha i g e a i ie ha
ake in o con ide a ion he diffe ing p ice le el . P cha ing po e pa i ie e e di c ed abo e.
Why measures of the value of output (GDP/GNI) cannot

accurately measure economic well-being
GDP and GNI make no distinctions about the composition of output. Whe he a co n
p od ce mili a good ( eapon , g n , ank , e c.) o me i good (ed ca ion, heal h ca e, clean
ae pplie , and o he e ice ) o an o he pe of good , GDP and GNI incl de he al e of
all i ho an di inc ion abo he deg ee o hich he con ib e o anda d of li ing. One
co n ma ha e a lo e e ca i a GDP han ano he , b highe le el of ocial e ice and
me i good p o i ion han he o he . Which ha highe anda d of li ing? The GDP and GNI
mea e a e nable o p o ide an indica ion.
GDP and GNI cannot reflect achievements in levels of education, health and life expectancy. A
ocie le el of heal h and ed ca ion con ib e ignifican l o anda d of li ing. Co n ie
ma achie e highe o lo e le el of heal h and ed ca ion i h a gi en amo n of GDP/GNI e
ca i a, b he e emain nacco n ed fo in mea e of GDP and GNI. Inc ea ed life e pec anc
( he n mbe of ea one can e pec o li e, on a e age) i ano he benefi of echnological
imp o emen , imp o ed heal h and highe income le el ha ha con ib ed eno mo l o a
highe anda d of li ing, b i no acco n ed fo in GDP and GNI fig e .
GDP and GNI provide no information on the distribution of income and output. Ho eq all
o neq all income and o p a e di ib ed i ano he fac o nde l ing ocie ell-being.
A e he eal h and income of a na ion highl concen a ed in ela i el fe hand hile la ge
po ion of he pop la ion a e nable o a i f hei ba ic need , o a e he e ela i el mo e
eq all di ib ed? A e he benefi of a g o ing GDP concen a ed among a mall g o p of
beneficia ie , o a e he idel di ib ed? A e ineq ali ie inc ea ing o dec ea ing? Mea e of
GDP o GNI e ca i a canno add e an of he e q e ion , a he onl p o ide an indica ion of
a e age o a e age i c me pe pe on.
GDP and GNI do not take into account increased leisure. In man co n ie a o nd he o ld
he a e age n mbe of ho o ked pe eek ha declined ignifican l , i h he n mbe of ho
of lei e co e pondingl inc ea ing. Thi con ib e o ocie anda d of li ing, e i no
acco n ed fo in GDP o GNI.
GDP and GNI do not account for quality of life factors. A ocie ell-being depend pon a
n mbe of non-economic fac o , ch a he c ime a e, a en e of ec i and peace a i ing f om
ela ion i h o he co n ie , ell-f nc ioning in i ion , e le el f om o king condi ion ,
in ec i ie a i ing f om nce ain ie ela ing o one job, he deg ee of poli ical f eedom, and
man o he . GDP and GNI canno acco n fo an of he e.
National income measures and comparisons of economic well-

being over time and between countries
Comparisons over time
Ea lie in he chap e e a ha o make compa i on o e ime, e m e eal al e of income
and o p mea e , hich ake in o acco n change in he p ice le el o e ime. Ye e en hen ing
eal al e of income and o p , i i clea f om he di c ion abo e ha compa i on of eal
GDP/GNI o e ime ma be mi leading. An inc ea e in eal GDP of ome pe cen age fo a pa ic la
co n ma o e e ima e o nde e ima e he e change in he pop la ion economic ell-being
beca e of ch fac o a imp o ed p od c q ali , imp o emen in heal h and ed ca ion, inc ea ed
lei e, imp o emen (o de e io a ion) in q ali of life fac o , po ible change in he al e of non-
ma ke ed o p , o in he i e of nde g o nd ma ke , and o on.
Comparisons between countries

Bo h he inabili of GDP/GNI o mea e he e al e of o p , and he e cl ion of man fac o
ha con ib e o economic ell-being, imila l con ib e o limi ing he alidi of in e na ional
compa i on b e of he e mea e . Fo e ample, one co n ma ha e a high le el of GDP e
ca i a, hich i concen a ed among a mall pe cen age of he pop la ion, hile ano he ma ha e a
lo e le el of GDP e ca i a, hich i mo e eq all di ib ed. A compa i on of GDP/GNI fig e
ill no e eal an info ma ion on hi poin , a ell a on he o he poin li ed abo e.

1 E plain ome ea on h na ional income a i ic do no mea e he e al e of income
and o p .
2 E plain ome ea on h GDP e ca i a o GNI e ca i a ma be inapp op ia e a he ba i
fo making compa i on of a pop la ion economic ell-being o e ime, o compa i on
be een co n ie .
Alternative measures of well-being

In e pon e o g o ing conce n ha na ional income acco n ing mea e ch a GDP and GNI do no
acc a el eflec economic ell-being, e e al al e na i e mea e ha e been de eloped ha o
cap e mo e fac o ha affec ell-being and q ali of life.
OECD Better Life Index

The O gani a ion of Economic Co-ope a ion and De elopmen (OECD) i an in e go e nmen al
o gani a ion e abli hed in 1961, con i ing of 36 membe co n ie a of 2020. Mo of he membe
a e economicall mo e de eloped co n ie . I main p po e i o p o ide a fo m fo membe co n ie
o di c common p oblem and policie and o p omo e policie ha ill enco age economic ell-
being.
The OECD ha de eloped he OECD Better Life Index ha i ba ed on a n mbe of fac o ha he
membe co n ie hem el e elec ed a fac o ha make a be e life. The p po e of hi mea e i
o p o ide a mo e acc a e ep e en a ion of ell-being and o fo m he ba i of policie in ended o
imp o e he q ali of life and ell-being mo e gene all . A he OECD no e
S cie al g e i ab im eme i he ell-bei g f e le a d h eh ld . A e i g ch
g e e i e l ki g l a he f c i i g f he ec mic em b al a he di e e
e e ie ce a d li i g c di i f e le. 5
Fig e 8.6 ho ha acco ding o he OECD he e a e o g o p of fac o ha de e mine ell-being

in he p e en : q ali of life hich i mea ed in eigh dimen ion o indica o , and ma e ial
condi ion hich a e mea ed in h ee. Bo h q ali of life fac o and ma e ial condi ion depend on
fo pe of capi al in he f e. Na al capi al efe o en i onmen al e o ce ; h man capi al efe
o le el of ed ca ion, kill and heal h; economic capi al efe o mone and eal h; and ocial capi al
efe o ne o k of people i h ha ed al e and nde anding ha facili a e co-ope a ion. The e
fo pe of capi al en e ha he e ill be fficien e o ce in he f e in o de fo a ocie o be
able o main ain he ell-being of i pop la ion.
Figure 8.6: OECD f ame o k fo mea ing ell-being and p og e
U ing he ele en indica o ho n in Fig e 8.6, he OECD con c an inde ha ank he co n ie

acco ding o hei pe fo mance. Each ea ince 2011 i p bli he he anking of he co n ie and in
addi ion ho ho each co n fa e i h e pec o each of he ele en dimen ion .
The OECD Be e Life Inde i ill nde de elopmen a diffe en dimen ion a e ome ime added o
aken o . Fo e ample i ha been c i ici ed fo no aking eq i fac o in o con ide a ion. A he ime
of i ing he OECD i o king on ho o inco po a e eq i in o i Inde . In addi ion i i likel ha
he Inde ffe f om diffic l ie in mea emen of e e al of i dimen ion , hich ma make he
alidi of compa i on ac o co n ie ome ha q e ionable.
Happiness Index
The Happiness Index began o be compiled in 2012 b he Uni ed Na ion S ainable De elopmen
Ne o k. Thi i an o gani a ion foc ed on ga he ing cien ific and echnological kno ledge o
enco age policie fo ainable de elopmen , incl ding implemen a ion of he S ainable
De elopmen Goal ( ee Chap e 18) and he Pa i Clima e Ag eemen ( ee Chap e 5). The goal i o
add e he in e dependen economic, ocial and en i onmen al challenge faced b he o ld. In 2019
he Happine Inde incl ded 156 co n ie .
The Happine Inde i ba ed on he follo ing dimen ion :
eal GDP e ca i a
ocial ppo
heal h life e pec anc
f eedom o make life choice
gene o i
pe cep ion of co p ion.
Da a f om all he pa icipa ing co n ie a e compiled f om he Gall p Wo ld Poll hich collec
a i ic ba ed on elephone e in co n ie a o nd he o ld on n me o opic like ell-being,
emplo men , acce o food and man mo e. The W ld Ha i e Re ank co n ie acco ding o
he happine of hei pop la ion . In 2019, 156 co n ie e e incl ded. In addi ion, in 2018, co n ie
e e anked b he happine of hei immig an . The Repo gi e each co n a ank f om one o en
fo each of he dimen ion abo e, i h en being he be and one he o . The co n ie a e al o gi en
an o e all ank mma i ing hei pe fo mance in all he dimen ion .
The e l a e p bli hed each ea in The W ld Ha i e Re . In addi ion o p e en ing he co n
anking , he epo each ea foc e on a heme opic and i ela ion o happine . In 2019, fo
e ample, i a happine and comm ni , in 2018 i a mig a ion and happine , and in 2017 i a
he ocial fo nda ion of happine .
The Happine Inde ha been c i ici ed fo limi a ion of ome of he da a and a iable i e , and in
addi ion fo being ba ed on he concep of happine . Happine i e diffic l o q an if and o
mea e. Happine clea l mean diffe en hing o diffe en people, and i meaning a ie ac o
c l e , po ibl making i anking le eliable fo compa i on ac o co n ie .
Happy Planet Index

The Happy Planet Index (HPI) a de eloped b he Ne Economic Fo nda ion (NEF), a B i i h
non-go e nmen al o gani a ion (NGO, ee Chap e 20) de o ed o e plo ing ne economic model
ba ed on eq ali , di e i and economic abili .
In 2006, he NEF la nched he Happ Plane Inde (HPI) o challenge he idea ha g o h of GDP
ho ld be he mo impo an goal of economic polic . I i a g ed ha
Pe le e f li ical a ie ha he e cei e be m ca able f deli e i g a g
ec m , a d lic make i i i e licie ha i c ea e i GDP a a e l . D i g ha led
h - e mi m, de e i a i g cial c di i , a d a al i i he face f clima e cha ge.
I fac , GDP g h i d e mea a be e life f e e e, a ic la l i c ie
ha a e al ead eal h . I d e eflec i e ali ie i ma e ial c di i be ee e le i a
c .I d e e l al e he hi g ha eall ma e e le like cial ela i , heal h,
h he e d hei f ee ime. A d c ciall , e e -m e ec mic g h i i c m a ible i h he
la e a limi e a e agai . (em ha i i igi al). 6
The Happ Plane Inde i in ended o be a mea e of ainable ell-being. I ake in o con ide a ion
life e pec anc , ho people feel abo hei o n pe onal ell-being, hich a e adj ed fo ineq ali ie
and ecological foo p in . I i calc la ed in he follo ing a :
Happ Plane Inde (HPI)=life e pec anc ell-being ineq ali of o come ecological foo p in
Life e ec a c i he a e age n mbe of ea a pe on e pec o li e, ba ed on Uni ed Na ion
da a.
Well-bei g i aken o be a pop la ion a i fac ion mea ed b da a collec ed b he Gall p Wo ld
Poll
I e ali f c me efe o ineq ali ie be een people i h ega d o life e pec anc and
ell-being. A e age ell-being and life e pec anc a e adj ed do n a d o ake in o acco n
ineq ali ie in he e dimen ion .
Ec l gical f i i he impac on he en i onmen of each indi id al in a ocie on a e age. I
i mea ed a he amo n of land needed o p o ide fo all hei eq i emen and he amo n of
land needed o ab o b hei CO2 emi ion . The highe he ecological foo p in , he lo e he HPI.
The HPI i calc la ed fo 140 150 co n ie , depending on da a a ailabili . Each co n ecei e a
co e f om 0 o 100, he highe being he be .
No e ha he Ha Pla e I de and he Ha i e I de efe o e diffe en idea . The Happine
Inde i conce ned i h pe onal happine hile he Happ Plane Inde i conce ned i h happine
of he plane . The Happ Plane Inde i he efo e m ch mo e of a mea e of ainabili and ho
ell e o ce can ppo a pop la ion ell-being.
The Happ Plane Inde ha been c i ici ed fo i mea e of ell-being, and i i al o a g ed ha he
ecological foo p in on hich i i ba ed i a con o e ial concep .

1 E plain h ee al e na i e me hod o mea e ell-being ha ha e been p fo a db a io
o gani a ion .
2 In each of he e ca e , iden if he fac o ha make hem pe io o anda d na ional income
a i ic a a po ible ba i fo compa i on o e ime o compa i on be een co n ie .

The GDP concept
GDP a a concep a de eloped in he Uni ed S a e in 1934 (d ing he G ea Dep e ion) b US
Nobel P i e inning economi Simon K ne .
Af e he Second Wo ld Wa , i became he main me ic fo mea ing he i e of a co n
econom , i p po e being o mea e he econom abili o p od ce. Ho e e , ince hen, i ha
become a g ide o policie o deal i h n me o a pec of he econom , incl ding infla ion,
nemplo men , a e , in e na ional ade and m ch mo e. In addi ion, i i ed a an indica o of
de elopmen , ell-being and geopoli ical eng h. The US Comme ce Depa men efe o i a one
of he g ea e in en ion of he en ie h cen .
Ye K ne had a ned abo he limi a ion of he GDP concep :7
The al able ca aci f he h ma mi d im lif a c m le i a i i a c m ac
cha ac e i a i bec me da ge he c lled i e m f defi i el a ed c i e ia . . .
Ec mic elfa e ca be ade a el mea ed le he e al di ib i f i c me i
k ...
The elfa e f a a i ca , he ef e, ca cel be i fe ed f m a mea eme f a i al
i c me a defi ed ab e.
Man ea la e he o e:8
Di i c i m be ke i mi d be ee a i a d ali f g h, be ee c a d
e , a d be ee he h a d l g . G al f m eg h h ld ecif m e g h f
ha a d f ha .
M ch mo e ecen l Jo eph S igli , ano he US Nobel P i e inning economi o e he follo ing:9
GDP i a g d mea e f ell-bei g. Wha e mea e affec ha e d : if e mea e
he g hi g, e ill d he g hi g. If e f c l ma e ial ell-bei g , a , he
d ci f g d , a he ha heal h, ed ca i , a d he e i me e bec me di ed
i he ame a ha he e mea e a e di ed; e bec me m e ma e iali ic.
In fac GDP i a ma e iali ic concep , acco ding o hich he o e iding goal of an econom i
g ea e p od c ion, i ho an ega d a o he he i make people be e off. Ye in pi e of i
limi a ion , i i an a ac i e me ic, beca e i i no poli ical, and a a e l , i allo go e nmen
and poli ician o p e i i ho ha ing o e o o diffic l q e ion abo ha gh o be
ocie goal . E e one an mo e o p a he han le o p , he efo e p i of mo e o p
doe no ai e poli ical o ideological objec ion . On he o he hand, p i of g ea e income
eq ali , en i onmen al ainabili and mo e p o i ion of me i good incl ding ed ca ion and
heal h ca e a e poli icall highl con o e ial i e .
If ocie an o p e g ea e eq ali in income di ib ion, i m ha e a mea e of ell-
being ha incl de mea e of ineq ali . If ocie an o p e en i onmen al ainabili , i
m ha e a mea e of ell-being ha inco po a e achie emen in hi dimen ion. And o on i h
he n me o po ible goal ha a ocie migh elec .
B hen, ho i ag eemen , o poli ical con en o be eached i hin a ocie ega ding hich a e
he mo e impo an ocie al goal , ince diffe en g o p ma a ach g ea e impo ance o ome goal
and le impo ance o o he ? Who i o decide on ha pa ic la dimen ion ho ld be incl ded in a
mea e of ell-being ha ill be ed a he ba i fo polic ?
Sources: Wo ld Economic Fo m ;
The Economi
Thinking points
E plain ha S igli mean hen he i e , Wha e mea e affec ha e do: if e
mea e he ong hing, e ill do he ong hing.
A e kno , economi end o a oid no ma i e i e in hei hinking. To ha e en do o
hink hi i beca e al e j dgemen ho ld be kep epa a e f om economic anal i ? Do
al e j dgemen omeho con amina e he impa ial handling of economic fac and da a?

1 Re ea ch GNI and GDP fo a io co n ie n il o find a co n i h a la ge diffe ence
be een he o al e . In e iga e o find ha acco n fo he diffe ence.
2 Selec fi e o mo e OECD co n ie o a e in e e ed in, e ea ch and find hei eal GDP o
GNI pe capi a in $PPP, and ank hem f om highe o lo e . Find he co e ponding co n ie
in he OECD Be e Life Inde and ank he e oo f om highe o lo e . Compa e o o
anking in o de o ee he e en o hich he diffe . E amine each of he dimen ion in o de
o gge po ible fac o ha migh acco n fo he diffe ence be een o GDP/GNI ank
and he OECD Be e Life Inde ank .
3 Selec fi e o mo e co n ie ha appea in he Happine Inde and Happ Plane Inde . Find
hei eal GNI o GDP pe capi a in $PPP and ank hem f om highe o lo e . Find he
co e ponding co n ie in he Happine Inde and Happ Plane Inde and ank he e oo f om
highe o lo e . Yo ho ld no ha e h ee e of ank fo o g o p of co n ie . Compa e
he e h ee e i h each o he in o de o ee he e en o hich he diffe . S gge po ible
ea on h he anking migh diffe f om each o he .

5 Mea ing Well-being and P og e : Well-being Re ea ch
6 Wh do e need he Happ Plane Inde ?

7 Simon K ne , U e and Ab e of Na ional Income Mea emen , Repo o he US Cong e , 1934
8 Simon K ne , Ho To J dge Q ali . The Ne Rep blic, 20 Oc obe 20 1962
9 GDP i no a good mea e of ellbeing i ' oo ma e iali ic

C a e 9
A e a e de a d a d a e ae
BEFORE YOU START

In the previous chapter you learned what growth is and that there are short-term fluctuations and a
long-term trend in growth.
1 What kinds of economic activities do you think cause short-term fluctuations in growth?
2 What kinds of economic activities do you think cause changes to the long-term growth trend?
In this chapter we will develop the aggregate demand aggregate supply (AD-AS) model of the
macroeconomy, an important analytical tool for studying output fluctuations, changes in the price level
and unemployment, and economic growth.
9.1 A a a (AD) a a a
a
LEARNING OBJECTIVES

define all the terms appearing in a b in the text (AO1)
explain the aggregate demand curve in terms of its components: consumption (C), investment (I),
government spending (G), net exports (X M) (AO2)
explain the determinants of the components of aggregate demand: (AO2)
consumption (C): consumer confidence, interest rates, wealth, income taxes, level of
household indebtedness, expectations of future price level
investment (I): interest rates, business confidence, technology, business taxes, level of
corporate indebtedness
government (G): political and economic priorities
net exports (X M): income of trading partners, exchange rates, trade policies
explain shifts in the aggregate demand curve by reference to changes in the determinants of the
components (AO2)
draw the aggregate demand curve and shifts of the aggregate demand curve (AO4)
E a a a a a a a a
T a a a a a a a a
Agg ega e de a d is the total quantity of aggregate (total) output, or real GDP, that all buyers in an
economy want to buy at different possible price levels, ce e a b . The agg ega e de a d (AD)
c e shows the relationship between the aggregate output buyers want to buy, or real GDP demanded,
and the economy s price level, ce e a b . Figure 9.1(a) presents an aggregate demand curve. The
hori ontal axis measures aggregate output, or real GDP, and the vertical axis measures the general price
level in the economy, which is an average over the prices of all goods and services.
Aggregate demand is not just the demand of all consumers, as one might think from the study of
microeconomics. It consists of all the components of aggregate expenditure that we studied in Chapter 8,
Section 8.2:
the demand of consumers (C)
the demand of businesses (firms) (I)
the demand of government (G)
the demand of foreigners for exports (X) minus the demand for imports (M) (X M or net exports).
F 9.1: The aggregate demand (AD) curve
A a a is the total amount of real output (real GDP) that consumers, firms, the
government and foreigners want to buy at each possible price level, over a particular time period. T
a a a (AD) shows the relationship between the total amount of real output
demanded by the four components and the economy s price level over a particular time period. It is
downwardsloping, indicating a negative relationship between the price level and aggregate output
demanded.1
T a ( a ) a a a
(S a a a)
The reasons behind the downward slope of the aggregate demand are very different from demand in a
single market in microeconomics. If you are interested in discovering the reasons behind the shape of the
aggregate demand curve you may read about it in the 'Digital coursebook: Extra material' section.
T a a a a ( AD )
T a a a a
It is important to distinguish between movements along the aggregate demand curve, caused by changes
in the price level, discussed above, and shifts of the aggregate demand curve, caused by the
a a a a , to which we turn next. (This is analogous to shifts of and
movements along the demand curve in microeconomics.) Aggregate demand curve shifts are shown in
Figure 9.1(b).
A rightward shift from AD1 to AD2 means that aggregate demand increases: for any price level, a
larger amount of real GDP is demanded. A leftward shift from AD1 to AD3 means that aggregate
demand decreases: for any price level, a smaller amount of real GDP is demanded.
Since aggregate demand is composed of consumer spending (C), investment spending (I), government
spending (G), and net export spending (X M), changes in aggregate demand and shifts in the aggregate
demand curve can be caused by any factor that produces a change in one of these four components.
Ca a
C a . Consumer confidence is a measure of how optimistic
consumers are about their future income and the future of the economy. If consumers are optimistic
about the future, they are likely to spend more on buying goods and services, and the AD curve
shifts to the right. Low consumer confidence indicates expectations of falling incomes and
worsening economic conditions, due to fears of cuts in wages or unemployment, causing decreases
in spending, appearing as a leftward shift of the AD curve. Governments around the world regularly
measure consumer confidence (through surveys based on questionnaires of consumers) to try to
predict the level of consumer spending.
C a a . Some consumer spending is financed by borrowing, and so is influenced
by interest rate changes. An increase in interest rates makes borrowing more expensive, resulting in
lower consumer spending, and therefore a leftward shift in the AD curve. A fall in interest rates
makes borrowing less expensive, and results in more consumer spending and a rightward shift in
the AD curve. Interest rates can change as a result of a type of policy called monetary policy (see
Chapter 13).
C a a .Wa is the value of assets that people own, such as savings in their bank
accounts, houses, stocks and bonds, jewellery, works of art, and so on; minus debt to banks or other
financial institutions. An increase in consumer wealth (for example, an increase in the value of
homes) makes people feel wealthier; therefore, they spend more and the AD curve shifts to the
right. A decrease in wealth lowers aggregate demand; the AD curve shifts to the left.
C a a . If the government increases c e a e (taxes paid by households on
their incomes), then consumer d ab e c e, which is the income left over after personal
income taxes have been paid, falls; therefore, spending drops, and the AD curve shifts to the left. If
personal income taxes are lowered, the result is higher disposable income and a rightward shift in
the AD curve. Changes in taxes are the result of a type of government policy called fiscal policy
(see Chapter 13).
C a b . Indebtedness refers to how much money
people owe from borrowing in the past. If consumers have a high level of debt (such as credit card
use or taking out loans), then they are under pressure to make high monthly payments to pay back
their loans plus interest, and so are likely to cut back on their present expenditures. Therefore, a
high level of indebtedness lowers consumption spending and shifts the AD curve to the left. A low
level of indebtedness increases consumption spending and shifts the AD curve to the right.
E a . Consumer spending may be influenced by what they expect
prices to be in the future. If they expect prices of goods and services to fall, they may postpone
spending as they wait for prices to fall, causing AD to decrease, shifting AD to the left. On the other
hand if they expect future prices to increase, they may buy more now in order to avoid the higher
prices later, thus causing AD to increase shifting to the right.
Ca a
C a b . Business confidence refers to how optimistic firms are about
their future sales and economic activity. If businesses are optimistic, they spend more on
investment, and the AD curve shifts to the right. Business pessimism, on the other hand, results in a
leftward shift in the AD curve.
C a a . Increases in interest rates raise the cost of borrowing, and force
businesses to reduce investment spending financed by borrowing, and therefore the AD curve shifts
to the left. Decreases in interest rates mean businesses can now finance their investment spending
by borrowing at a lower cost, and the AD curve shifts to the right. As noted above, interest rates
change as a result of monetary policy (see Chapter 13).
C a ( ) . Improvements in technology stimulate investment
spending, thus causing increases in aggregate demand and a rightward shift in the AD curve.
C a b a . Business taxes in this context refer to taxes on profits (also known as
corporate income taxes). If the government increases taxes on profits of businesses (as part of its
fiscal policy; see Chapter 13), firms after-tax profits fall; therefore, investment spending decreases
and the AD curve shifts to the left. Decreases in taxes on profits result in increased aggregate
demand and a rightward AD curve shift.
T a b . As in the case of household indebtedness, if businesses have
high levels of debt due to past borrowing, they will be less willing to make investments and the AD
curve shifts to the left. A low level of corporate indebtedness, on the other hand, leads to more
investment and a rightward shift in the AD curve.
L a/ a a . Sometimes, the legal and institutional environment in which
businesses operate has an impact on investment spending. This is often the case in many developing
economies where laws and institutions do not favour small businesses. For example, small
businesses often do not have access to credit, meaning they cannot borrow easily to finance
investments. Many developing economies do not have the necessary laws that secure property
rights (legal rights to ownership). In such situations, increasing access to credit (the ability to
borrow) and securing property rights would result in increases in investment spending, shifting the
AD curve to the right.
Ca a
C a a . Governments have many expenditures, arising from provision of
merit goods and public goods, spending on subsidies and pensions, payments of wages and salaries
to its employees, purchases of goods for its own use, and so on. It may decide to increase or
decrease its expenditures in response to changes in its priorities. Increased government spending
shifts the AD curve to the right, and decreased government spending shifts it to the left.
C a : b a a a a . The
government can use its own spending as part of a deliberate attempt to influence aggregate demand.
The effects of such changes in government spending on aggregate demand are exactly the same as
above. This is another aspect of fiscal policy (to be discussed in Chapter 13).
Ca a
C a a a ab a . Consider aggregate demand in country A, which has trade
links with country B. If country B s national income increases, it will import more goods and
services from country A, so that country A s exports will increase. Therefore the AD curve in
country A shifts to the right. If, on the other hand, country B s national income falls, it will buy less
from country A, and country A s AD curve shifts to the left.
C a a a . An exchange rate is the price of one country s currency in terms of
another country s currency (see Chapter 16). Consider again country A, and assume that the price of
its currency increases, becoming more expensive relative to the currency of country B. Country B
now finds country A s output more expensive, and so it imports less from country A; therefore,
country A s exports fall, and its AD curve shifts to the left. At the same time, country A now finds
country B s output cheaper, and so it increases its imports from country B. Therefore, the increase
in price of country A s currency has two effects: a fall in its exports and an increase in imports so
that net exports, X M, fall, and the AD curve shifts to the left. In the opposite situation, where the
price of country A s currency decreases, an increase in exports and a decrease in imports will result,
so that X M increases, and country A s AD curve shifts to the right.
C a a , a . Trade protection refers to
restrictions to free international trade often imposed by governments (see Chapter 14). Suppose
country A trades freely with country B (with no trade restrictions). However, country B s
government decides to impose restrictions on imports from country A. Country A s exports will fall,
and its AD curve will shift to the left. On the other hand, in country B, lower imports mean that the
value of X M increases, and its AD curve shifts to the right.
Table 9.1 summarises the factors that can cause shifts of the aggregate demand curve.
S a a a a a b :
Changes in consumer spending, arising from:
changes in consumer confidence
changes in interest rates (monetary policy)
changes in wealth
changes in personal income taxes (fiscal policy)
changes in the level of household indebtedness
expectations of future price levels
Changes in investment spending, arising from:
changes in business confidence
changes in interest rates (monetary policy)
changes (improvement) in technology
changes in business taxes (fiscal policy)
changes in the level of corporate indebtedness
legal/institutional changes
Changes in government spending, arising from:
changes in political priorities
changes in economic priorities: deliberate efforts to influence aggregate demand (fiscal policy)
Changes in foreigners spending, arising from:
changes in national income abroad
changes in exchange rates
changes in the level of trade protection
Tab 9.1: Factors causing shifts of the aggregate demand curve

1 a Define aggregate demand and explain each of its four components.
b Show aggregate demand diagrammatically and define the relationship it represents.
2 Using diagrams, distinguish between a movement along the AD curve and a shift of the AD curve,
and provide examples of the causes of each. Identify the four components of spending that cause
shifts of the aggregate demand curve.
3 Using diagrams, show the impact of each of the following on the aggregate demand curve;
explain what happens to aggregate demand in each case; and identify the component(s) of
aggregate expenditure involved.
a Consumer confidence improves as consumers become optimistic about future economic
conditions.
b The government decides to increase taxes on firms profits.
Firms become fearful that a recession is about to begin.
The government decides to increase its spending on health care services.
There is a decline in the real estate market (average house prices fall).
The central bank (a government organisation) decides to increase interest rates.
There is an increase in the level of indebtedness of consumers and firms.
Real incomes in countries that purchase a large share of country A s exports fall; examine the
impact on aggregate demand in country A.
The government lowers personal income taxes (taxes on income of households).
New legislation makes property rights more secure.
There is an appreciation (an increase) in the value of the euro relative to the US dollar;
examine the impact on aggregate demand in euro one countries (countries that use the euro).
There is an appreciation (an increase) in the value of the euro relative to the US dollar;
examine the impact on aggregate demand in the United States.
A non-governmental organisation (NGO) introduces a programme providing credit to small
farmers, making it easier for small farmers to borrow to finance the building of irrigation
projects.
S AD a a a
Note that income is not included among the factors that can shift the AD curve. The reason is that
c a ge a a c e ca a e a AD c e f . This follows from the point noted earlier
that real GDP, measured on the hori ontal axis, also represents national income. It is not possible for any
variable measured on either of the two axes to cause a shift of a curve (for an explanation, see the
Quantitative techniques chapter in the 'Digital coursebook: Extra material' section).2 (This point will
become clearer when we discuss the Keynesian multiplier at HL; see Chapter 13).
1 You may have noticed something odd about the definition of aggregate demand. In Chapter 8, Section 8.2 we
defined GDP to be equal to spending by the four components: C + I + G + (X M). Now we are saying that
aggregate demand is also equal to C + I + G + (X M). Yet aggregate demand is not the same as GDP. The
explanation for this apparent oddity can be found in the 'Digital coursebook: Extra material' section
Understanding aggregate demand and the multiplier in terms of the Keynesian cross model , included as
Supplementary material.
2 Note that this does not contradict the ability of changes in disposable (or after-tax) income due to changes in
taxes to affect aggregate demand. This is because changes in taxes and disposable income do not affect national
income, as they simply involve a transfer of income from households to the government. National income
remains unchanged.
9.2 S - a a a -
b AD-AS
N :T IB
.S , - ,
A (AS) .
LEARNING OBJECTIVES
A :
a b (AO1)
(SRAS) (AO2)
SRAS : (AO2)
SRAS (AO2)
SRAS SRAS (AO4)
(AO2)
- - (AO4)
,
.M
. .
S - a a
T a a
T
.T h n in mac ec n mic
, ;
.T , .T l ng n in
mac ec n mic ,
( ), change al ng i h change in he ice le el.
, ,
, .
.T ( )
( ), :
,
, .
T
, .
D a a a - a a
- .
A a ( GDP)
.
T - a a (SRAS)
( GDP) ( )
.
F 9.2( ) - , ( )
GDP :
GDP, GDP.
F 9.2: T - (SRAS)
W SRAS a -
T ( GDP) :
, ;
( ), .A
, ,
GDP .
S , ; ,
, .
C a - a a ( SRAS )
A ( ) SRAS , F
9.2( ). T C 2
.
A SRAS1 SRAS2 - :
, GDP. A SRAS1
SRAS3 : ,
GDP.
I SRAS :
C a a .I , , ,
SRAS , SRAS1 SRAS3 F 9.2( ). I
, , ,
SRAS , SRAS1 SRAS2.
C a - ab .C - ,
, , , , SRAS
.A SRAS ;
.
C a a .I C 4 5. T
.T ,
SRAS .L
SRAS .3
C a b b .S ,
.I , SRAS
; , SRAS .
S . S -
( C 2, S 2.3). F ,
,
SRAS .
, SRAS . B
SRAS .
O , SRAS
( ,
), .

1 a D .
b E - - .
2 a D .
b (
)?
3 a S - (SRAS) ,
.
b I SRAS .
I SRAS .
4 , SRAS ;
SRAS .
a T ( ) .
b B - .
T .
T .
T .
S - b AD-AS
I a - b
- ,
- .
I AD-AS , b
.S - b AD SRAS
, , GDP .
T F 9.3 Pl Y
GDP.
A GDP Pl Y, .A
Pl1, GDP , ,
Pl . A Pl , Pl2,
GDP , ,
Pl . A Pl , GDP , -
.
F 9.3: S -
I a a - b
T -
- .S ,
( ,
). I F 9.4( ), AD AD1 AD2,
Pl1 Pl2, GDP, Y1 Y2. T
.
I ( , ,
), AD AD1 AD3; GDP Pl1 Pl3
Y1 Y3, .
F 9.4( ) SRAS .A SRAS1 SRAS2 ( ,
), , Pl2,
GDP, Y2, .O , SRAS1
SRAS3 ( , )
Pl3, Y3 .
F 9.4: I -

1 , - ,
, .
a T ( ) .
b F .
B - .
T .
T .
T .
A .
C .
3 C 4 5
.A ,
.T agg ega e .S Q
'D :E ' .
9.3 L - -
/
LEARNING OBJECTI ES

explain the monetarist/new classical perspective on the long-run aggregate supply (LRAS) curve
(AO2)
explain that in the monetarist/new classical model macroeconomic equilibrium in the long run is
determined at full employment (or potential) output (AO2)
explain that when the economy is at long-run equilibrium (full employment equilibrium)
unemployment is equal to the natural rate of unemployment (AO2)
draw the LRAS curve and macroeconomic equilibrium in the long run (AO4)
explain inflationary and deflationary (recessionary) gaps (AO2)
explain how in the monetarist/new classical perspective the economy automatically adjusts to full
employment output (AO2)
T /
T - -
This section examines the theoretical perspective of / economists, which builds
on the work of the classical economists of the 19th century. Both the monetarist/new classical and
classical perspectives are based on the following key principles: the importance of the price mechanism
in co-ordinating economic activities; the concept of competitive market equilibrium; and thinking about
the economy as a harmonious system that automatically tends towards full employment. While
economists generally accept these principles in the study of microeconomics, there is major
disagreement over their relevance to the study of economics at the macro level. (See Chapter 1, Section
1.5 for a brief review.)
The monetarist/new classical approach to aggregate supply rests crucially on the distinction made earlier
between the macroeconomic short run and long run. It examines what happens to aggregate supply when
the economy moves into the long run, when all resource prices including wages change to match changes
in the price level. The long-run supply relationship between the price level and aggregate output is
referred to as - (LRA ), shown graphically as the LRA . The LRAS
curve is vertical at potential GDP, also known as the full employment level of real GDP, Yp, as shown in
Figure 9.5. A vertical LRAS curve means that in the long run any change in AD results only in changes in
the price level while the quantity of real GDP produced remains the same. The economy is in -
when the AD curve and the SRAS curve intersect at any point on the LRAS curve, seen in
Figure 9.5.
F 9.5: The LRAS curve and long-run equilibrium in the monetarist/new classical model
According to the monetarist/new classical perspective, the long-run aggregate supply (LRAS) curve is
vertical at the full employment level of output, indicating that in the long run the economy produces
potential GDP, which is independent of the price level. Long-run equilibrium occurs when the SRAS
and AD curves intersect on the LRAS curve at the level of full employment or potential output.
L -
You may recall from Chapter 8 (Section 8.4), that when the economy produces at potential output, we
say that the economy is experiencing full employment . This is why the terms full emplo ment output
and potential output both refer to the output that is produced when the economy is at long-run
equilibrium. Note that this is the level of output determined at the point where the LRAS curve is situated
as you can see in Figure 9.5.
As we saw in Chapter 8, while we call this full employment output the economy still has unemployed
labour and other resources. The unemployment that exists when the economy is producing its full
employment output is known as the natural rate of unemployment. This will become clearer to you in
Chapter 10.
LRA
There is a very simple explanation for the vertical shape of the LRAS curve. Since wages (and other
resource prices) are now changing to match output price changes, firms costs of production remain
constant even as the price level changes. Therefore, as the price level increases or decreases, ith
constant real costs, firms profits are also constant, and firms no longer ha e an incenti e to increase
or decrease their output le els.
For example, say the price level increases. In the short run, with wages (and other input prices) constant,
firms profits increase, and firms therefore increase the quantity of output produced by moving upward
along an upward-sloping SRAS curve. However, in the long run, wages (and other resource prices) also
increase by the same amount. In effect, nothing has changed from the firms point of view, and so they
have no reason to increase the quantity of output they produce. Similarly, any price level decrease is
fully matched by the same decrease in wages (and other resource prices), so that firms have no incentive
to decrease the quantity of output produced.
S - -
: ( )
As we have seen in Figure 9.5 when AD and SRAS intersect on the LRAS curve, there is long-run
equilibrium. But what happens if AD and SRAS intersect at some other point that is not on the LRAS
curve?
There are two such possibilities, shown in Figure 9.6(a) and (b). In all three diagrams Yp represents
potential output, or full employment output, which is given by the position of the LRAS curve on the
hori ontal axis. At Yp, unemployment is equal to the natural rate of unemployment.
F 9.6( ): ( ) . In part (a), equilibrium real GDP, Ye, lies to the
left of potential GDP, Yp. When real GDP is less than potential GDP, the economy is experiencing a
deflationar gap (also known as a recessionar gap), and unemployment is greater than the natural
rate of unemployment. Why does this happen? The deflationary gap has been created because at the
price level Ple, the amount of real GDP that the four components of aggregate demand want to buy
is less than the economy s potential GDP. There is not enough total demand in the econom to make
it worthwhile for firms to produce potential GDP. This also means that firms require less labour for
their production; therefore, unemployment is greater than the natural rate of unemployment.
F 9.6( ): . In part (b), equilibrium real GDP, Ye, lies to the right of potential
GDP, Yp. When real GDP is larger than potential GDP, the economy is experiencing an inflationar
gap, and unemployment is less than the natural rate of unemployment. An inflationary gap arises
because with aggregate demand AD, the quantity of real GDP that the four components want to buy
at the price level (Ple) is greater than the economy s potential output. There is too much total
demand in the econom , and firms respond by producing a greater quantity of real GDP than
potential GDP. To produce more output, firms labour needs to increase, and unemployment falls to
become less than the natural rate of unemployment.
F 9.6( ): F GDP, or . Part (c) is the same as
Figure 9.5, showing long-run equilibrium, where equilibrium real GDP is equal to full employment
or potential GDP. When the economy is producing its potential GDP, unemployment is equal to the
natural rate of unemployment and there is no deflationary or inflationary gap.
F 9.6: Deflationary (recessionary) and inflationary gaps in relation to potential output
You can now see that the three states of the economy in Figure 9.6 correspond to the phases of the
business cycle that we studied in Chapter 8: Ye of Figure 9.6(a) corresponds to a point like e in Figure
8.4, where the economy is experiencing recession, unemployment is greater than the natural rate and
actual GDP is less than potential GDP. Ye of Figure 9.6(b) corresponds to a point like d in Figure 8.4,
where unemployment is lower than the natural rate and actual GDP is greater than potential GDP.
Finally, Yp of Figure 9.6(c) corresponds to points like a, b, and c in Figure 8.4, where the economy is
producing actual GDP equal to potential GDP, with unemployment at its natural rate. Therefore,
recessionary and inflationary gaps are two types of output gaps.
Recessionary (deflationary) and inflationary gaps represent short-run equilibrium positions of the
economy. A ( ) is a situation where real GDP is less than potential
GDP (and unemployment is greater than the natural rate of unemployment) due to insufficient
aggregate demand. An is a situation where real GDP is greater than potential GDP
(and unemployment is smaller than the natural rate of unemployment) due to excess aggregate
demand. When the economy is at its full employment equilibrium level of GDP, the AD curve
intersects the SRAS curve at the level of potential GDP, and there is no deflationary or inflationary
gap. This is the economy s , also known as .
S AD RA
It is now a simple matter to consider the possible causes of the business cycle studied in Chapter 8. In
Figure 9.7(a) and (b), the economy is initially at full employment equilibrium, producing potential
output Yp. In part (a), a fall in aggregate demand, shifting the AD curve leftward from AD1 to AD2
causes a recessionary gap. If the economy experiences an increase in aggregate demand, appearing as a
rightward shift in the AD curve from AD1 to AD3, this causes an inflationary gap.
Shifts in the SRAS curve can also contribute to economic fluctuations.4 In Figure 9.7(b), starting again
from full employment equilibrium, a fall in SRAS, shifting SRAS1 to SRAS2, leads to an economic
contraction, with real GDP falling to Y2 and unemployment increasing. Note, however, that this
contraction differs from the recessionary gap resulting from the fall in aggregate demand: the fall in
aggregate supply leads to an increase in the price le el, along ith a decrease in real GDP. This special
set of circumstances is especially undesirable for an economy, as it involves the appearance of two
problems: recession (with unemployment) and a rising price level. This is known as stagflation
(combining stagnation with inflation ), a term coined in the 1970s. We will come back to this topic in
Chapter 10.
An increase in SRAS, shifting SRAS1 to SRAS3 leads to an economic expansion as real GDP increases to
Y3 and unemployment falls. This expansion results in a falling price level, in contrast to the rising price
level following an increase in aggregate demand.
Most economists believe that changes in aggregate demand are more frequent than changes in
aggregate suppl as causes of the business cycle.
F 9.7: Possible causes of the business cycle
A
GDP (
)
In our discussion above, we saw that inflationary and deflationary gaps are two possible short-run
equilibrium positions of the economy where the equilibrium level of real GDP differs from potential
GDP. If the LRAS curve is vertical at potential GDP, it follows that inflationary and deflationary gaps are
only short-run phenomena that cannot persist in the long run. As soon as the economy moves into the
long run, the gaps disappear, and the economy achieves full employment equilibrium.
To see how this occurs, consider Figure 9.8(a), where an economy is initially in long-run equilibrium at
point a producing potential output, Yp. A fall in aggregate demand from AD1 to AD2 causes the economy
to move in the short run from point a to point b, where there arises a deflationary gap; at b, real GDP has
fallen to Ydef and the price level has fallen from Pl1 to Pl2. However, the economy cannot remain there
in the long run. In the long run, the fall in the price level is matched by a fall in wages (and falls in other
resource prices), so the SRAS curve shifts to the right from SRAS1 to SRAS2 until the economy is back on
the LRAS curve, at point c. The assumption of age and price fle ibilit in the long run has allo ed the
econom to automaticall come back to its long-run equilibrium le el of output. The deflationary gap is
eliminated, and the only thing that changes due to the fall in aggregate demand is the fall in the price
level (from Pl1 to Pl3).5
In Figure 9.8(b) we see what happens if there is an increase in aggregate demand. Beginning from long-
run equilibrium at point a, aggregate demand shifts from AD1to AD2; in the short run the economy
moves to point b, real GDP increases to Yinfl where there is an inflationary gap, and the price level
increases from Pl1 to Pl2. However, the economy cannot remain at point b in the long run, because once
wages (and other resource prices) increase to match the increase in the price level, SRAS shifts from
SRAS1to SRAS2, and the economy arrives at point c, which is once again on the LRAS curve. In the long
run, the inflationary gap is eliminated and the only thing that changes after the increase in aggregate
demand is the increase in the price level (to Pl3).6
In the monetarist/new classical perspective, recessionary (deflationary) and inflationary gaps are
eliminated in the long run. This ensures that in the long run the LRAS curve is vertical at the level of
potential GDP. The economy has a built-in tendency towards full employment equilibrium.
The move from point a to c in the long run in the case of a fall in AD that causes a deflationary gap
(Figure 9.8(a)), and an increase in AD that causes an inflationary gap (Figure 9.8(b)), indicates the
following important principle.
F 9.8: Automatic adjustment to long-run full employment equilibrium in the monetarist/new
classical model
In the monetarist/new classical perspective, changes in aggregate demand can have an influence on
real GDP only in the short run; in the long run, the only impact of a change in aggregate demand is to
change the price level, having no impact on real GDP, as this remains constant at the level of potential
or full employment output (see also Figure 9.14(a)). Increases in aggregate demand in the long run
are therefore inflationary (cause inflation).

1 Define the long run in macroeconomics and use a diagram to show the long-run aggregate
supply (LRAS) curve.
Outline what the vertical shape of the LRAS curve tells us about the relationship between the
price level and real GDP in the long run.
2 Define and use a diagram to show long-run equilibrium in the AD-AS model (show the
relationship between the LRAS, SRAS and AD curves).
Outline what the long-run equilibrium says about the level of unemployment.
3 Draw two diagrams, illustrating recessionary and inflationary gaps in relation to the LRAS curve.
4 Using the three possible states of the economy shown in Figure 9.6, explain the phases of the
business cycle (refer to expansions, contractions, and potential output).
5 Using diagrams explain why inflationary or deflationary gaps (short-term fluctuations) cannot
persist in the long run according to the monetarist/new classical perspective.
6 Assuming the economy begins from a position of full employment equilibrium, explain how each
of the events listed in the question in Test your understanding 9.3 can contribute to short-term
economic fluctuations.
4 It may be noted that changes in aggregate supply can cause contractions and expansions; however, these are not
called deflationary (recessionary) or inflationary gaps. The reason is that deflationary and inflationary gaps are
defined in terms of the level of actual aggregate demand relative to the aggregate demand that is required to
bring about full employment equilibrium. A deflationary gap is therefore caused by insufficient aggregate
demand, and an inflationary gap by too much aggregate demand.
5 You may be wondering why wages will fall in the long run, thereby causing the shift in the SRAS curve that
makes the economy move back to full employment equilibrium. The reason involves adjustments that take
place in the labour market. As we know from our earlier discussion, if there is a recessionary gap, aggregate
demand is weak and there is unemployment of labour that is greater than the natural rate of unemployment.
This means that there is a surplus of labour in the labour market; in other words, the quantity of labour supplied
is greater than the quantity of labour demanded. This creates pressures on wages to fall, so as to bring about a
balance between the quantity of labour demanded by firms and the quantity supplied by workers. Therefore,
wages fall in the long run, in order to eliminate the labour surplus, and when there is no longer any surplus
labour, the economy reverts to long-run equilibrium through the shift in the SRAS curve.
6 When there is an inflationary gap, unemployment falls below the natural rate, and there is a shortage of labour
in the labour market. Firms have a strong demand for labour (as well as other resources) and workers would
like to negotiate higher wages because the price level has increased. In the long run, the wage is free to change
in response to the forces of supply and demand, and moves upward to the point where quantity of labour
demanded is brought into balance with quantity of labour supplied. When this occurs, the economy returns to
long-run equilibrium through the shift in the SRAS curve.
9.4 A a a b
K a
LEARNING OBJECTIVES

explain the Keynesian perspective of the aggregate supply (AS) curve (AO2)
explain equilibrium in the Keynesian model (AO2)
draw a diagram showing equilibrium in the Keynesian model (AO4)
explain that in the Keynesian model deflationary/recessionary gaps may persist so that the
equilibrium level of output may differ from the full employment level of output (AO2)
This section presents the theoretical model of Keynesian economists. Keynesian economists base their
ideas on the work of John Maynard Keynes, one of the most famous economists of the 20th century,
whose work in the first half of the century came to form the basis of modern macroeconomics. (See
Chapter 1, Section 1.5 for an overview.) Keynes questioned the classical economists view of the
economic system as a harmonious system that automatically tends towards full employment, and showed
that it is possible for economies to remain in a position of short-run equilibrium for long periods of time.
Wa a a b
The LRAS curve in the monetarist/new classical model depends on the idea that all resource prices and
product prices are fully flexible and respond to the forces of supply and demand. However, what if
resource prices cannot fall, even over long periods of time? Keynesian economists argue that there is an
asymmetry between wage changes in the upward and downward directions. Under conditions of an
economic expansion and strong aggregate demand (rightward shifts in the AD curve causing an
inflationary gap), with unemployment lower than the natural rate and a rising price level, wages quickly
begin to move upward. Yet in a recessionary gap, where aggregate demand is weak and the economy is
in recession with unemployment greater than the natural rate, wages do not fall easily, even over long
periods of time, because of a variety of factors (such as labour contracts, minimum wage legislation;
worker and union resistance to wage cuts; employer resistance due to morale).
Keynesian economists also argue that not only wages but also product prices do not fall easily, even if an
economy is in a recessionary gap. In a recession, if wages will not go down, firms will avoid lowering
their prices because that would reduce their profits. Furthermore, large oligopolistic firms may fear price
wars; if one firm lowers its price, then others may lower theirs more aggressively in an effort to capture
market shares, and then all the firms will be worse off. Such factors, it is argued, make prices unlikely to
fall even in a recession.
T ab
If wages and prices do not fall easily, this means the economy may get stuck in the short run. Consider
Figure 9.9(a), which is similar to Figure 9.8(a). Beginning at point a where an economy is producing
potential output Yp, aggregate demand falls so the AD curve shifts from AD1 to AD2. The monetarist/new
classical model predicts that the economy will move to point b in the short run, where there is a
recessionary gap and the price level falls from P 1 to P 2; in the long run it will move to point c with Pl3
and the economy is once again producing potential output Yp.
However, if the price level cannot fall from P 1, the economy will move to point d on the new, lower,
aggregate demand curve, AD2. Even if the price level succeeds in falling to P 2, so the economy moves
to point b, the economy may get stuck there if wages do not fall (remember that wages must fall for the
SRAS curve to shift to SRAS2 on the LRAS curve). It follows that if the price level cannot fall, or if wages
cannot fall, the economy gets stuck in the short run, and is unable to move into the long run where it
eliminates the recessionary gap.
This argument suggests that the SRAS curve has the shape shown in Figure 9.9(b). The hori ontal part of
the curve is based on the Keynesian idea that wages and prices do not move downward. Point d in Figure
9.9(a) corresponds roughly to point d in Figure 9.9(b). The economy is in a deflationary gap and may
stay there indefinitely unless the government intervenes with specific policies.
In the Keynesian model, inflexible wages and prices in the downward direction mean that the
economy cannot move into the long run when experiencing a deflationary gap. Inflexible wages and
prices are shown graphically by a hori ontal section of the Keynesian aggregate supply (AS) curve.
F 9.9: Keynesian analysis
Keynesians would not suggest that wages and prices can never fall. They would agree that if a recession
or depression (which is a very severe recession) continues for a long enough time (perhaps years), wages
and prices would eventually begin to fall. In the meantime a long-lasting recession would be very costly
in terms of unemployment, low incomes and lost output. Therefore, it would be necessary for the
government to intervene with active policies to help the economy come out of the recession.
T a K a a a
Figure 9.10 shows that the K a a a has three sections. In section I, real GDP
is low, and the price level remains constant as real GDP increases. In this range of real GDP, there is a lot
of unemployment of resources and a e ca ac . Spare capacity refers to the availability of resources
including physical capital (machines, equipment, etc.) are labour that are not used. Firms can easily
increase their output by employing the unemployed capital and other unemployed resources, without
having to bid up wages and other resource prices. In section II, real GDP increases are accompanied by
increases in the price level. The reason is that as output increases, so does employment of resources, and
eventually bottlenecks in resource supplies begin to appear as there is no longer spare capacity in the
economy. Wages and other resource prices begin to rise, which means that costs of production increase.
The only way that firms will be induced to increase their output is if they can sell it at higher prices.
Therefore, growing output leads to an increasing price level.
At output level Yp, the economy has reached its full employment level of real GDP. This is also its
potential output level, and unemployment has fallen to the point where it is now equal to the natural rate
of unemployment. However, as we know, the natural rate of unemployment is not maximum
employment, as unemployment can fall further, which is what happens when real GDP continues to
increase beyond Yp. Real GDP can continue to increase until it reaches section III.
F 9.10: The Keynesian aggregate supply curve
In section III, the AS curve becomes vertical at Ymax, indicating that real GDP reaches a level beyond
which it cannot increase anymore; at this point, the price level rises very rapidly. Real GDP can no
longer increase because firms are using the maximum amount of labour and all other resources in the
economy. Any efforts on the part of firms to increase their output only result in greater increases in the
price level.
T b a K a
Macroeconomic equilibrium in the Keynesian model is determined by the point where the AD curve
intersects the Keynesian AS curve. This can occur at any level of real GDP. There are three equilibrium
states of the economy, shown in Figure 9.11.
Figure 9.11(a) shows the AD curve intersecting the AS curve in its hori ontal section, determining Ye,
which is less than Yp (potential GDP), indicating a deflationary (recessionary) gap with unemployment
greater than the natural rate. Aggregate demand is too weak to induce firms to produce at Yp. In part (b),
the economy is producing at Ye, which is greater than Yp, and is experiencing an inflationary gap. There
is strong aggregate demand, unemployment has fallen below its natural rate, and as the economy
approaches its maximum capacity, the price level has increased. Part (c) shows the case where the
economy has achieved full employment equilibrium, or potential output, at Yp.
These three equilibrium states of the economy can be related to the business cycle (see Chapter 8): Ye in
Figure 9.11(a) corresponds to a point like e in Figure 8.4, where there is a deflationary gap; Ye of Figure
9.11(b) corresponds to a point like d in Figure 8.4, where there is an inflationary gap; and Yp of Figure
9.11(c) corresponds to points like a, b and c in Figure 8.4, where the economy s actual output is equal to
its potential output.
It should be noted that potential output and natural unemployment , which we have used to illustrate
the three kinds of equilibrium, are actually ea concepts. On the other hand, inflationary and
deflationary (recessionary) gaps are Ke e a concepts. As our analysis shows, the two models can
usefully borrow concepts from each other in order to show how different real-world situations can be
understood and interpreted differently depending on the theoretical approach used.
The Keynesian model arrives at some conclusions that differ significantly from the conclusions of the
monetarist/new classical model. Very briefly, these are that:
the economy in the Keynesian model can remain indefinitely stuck in a deflationary gap, unlike in
the monetarist/new classical model where the economy automatically returns to full employment
equilibrium
increases in aggregate demand in the Keynesian model need not necessarily result in increases in
the price level, unlike in the monetarist/new classical model where increases in aggregate demand
always result in a higher price level.
As a result of these differences, the two models have very different policy recommendations about how
to deal with some very important problems of the macroeconomy.
F 9.11: Three equilibrium states of the economy in the Keynesian model

1 Define aggregate supply. Explain whether the meaning of this concept changes in the context of
the SRAS, LRAS or Keynesian AS curves.
2 a Explain what it means for the shape of the aggregate supply curve if wages and prices are
inflexible in the downward direction.
b Can the economy move into the long run?
Outline what the hori ontal section of the AS curve tells us about spare capacity in the
economy.
3 a Use a diagram to show the Keynesian AS curve.
b Outline what the flat section of this curve indicates about the relationship between the price
level and real GDP.
Outline what the upward-sloping section indicates about this relationship.
Outline what the vertical section indicates.
4 Using the Keynesian model and diagrams, show the three short-run equilibrium states of the
economy, describing recessionary (deflationary) and inflationary gaps and their relationship to the
full employment equilibrium position of the economy (potential output).
5 Using diagrams illustrating the Keynesian model, show and explain what happens to the
equilibrium level of real GDP and the price level if aggregate demand shifts within
a the hori ontal section of the Keynesian AS curve,
b the upward-sloping section of the Keynesian AS curve, and
the vertical section of the Keynesian AS curve.

T Ia a a
In early 2019 business confidence in Italy fell to the lowest level in four years, suggesting that
Italy s economic contraction which began the previous year may continue. Consumer confidence also
fell. Falling real GDP for the last two quarters of the previous year meant that Italy was in recession.
The economic downturn was the result of falling output in agriculture, forestry, fishing and industry.
Net exports on the other hand increased, but not by enough to make up for the declines.
S :B be g; BBC
F 9.12: Naples, Italy. Narrow street in the old part of the city
A
1 Using AD-AS diagrams, explain the effect on Italy s real GDP of
a the drop in business and consumer confidence, and
b the increase in net exports.
2 Outline which components of aggregate demand were affected by the drop in business and
consumer confidence.
3 Explain the likely position of the Italian economy in early 2019
a using a business cycle diagram,
b using an AD-AS diagram with an LRAS curve, and
using an AD-AS diagram with a Keynesian AS curve.
4 Outline which method of national income accounting allowed economists to determine
a the increase in Italy s net exports, and
b the decrease in output of the agriculture, forestry, fishing and industry sectors.
9.5 S
LEARNING OBJECTIVES
A :
(AO1)
AS ( / LRA )
(K ) (AO2)
/
K A LRA (AO4)
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9.6 I K
/
LEARNING OBJEC I ES

discuss the differing assumptions of the Ke nesian and monetarist/new classical models and their
implications for the econom and for polic (AO3)
A -
Our stud of Figure 9.8 showed that in the monetarist/new classical model inflationar and deflationar
gaps are automaticall corrected as long as resource prices, especiall wages, are free to change as the
price level changes. B contrast, one of the most important ideas arising from the Ke nesian
interpretation of the AD AS model is that deflationar /recessionar gaps can persist over long periods of
time. According to Ke nes, this happens partl because of the inabilit of wages and prices to fall. In
addition, the problem is caused b insufficient aggregate demand. Whenever aggregate demand
intersects the hori ontal section of the Ke nesian AS curve, the econom is in a deflationar gap because
aggregate demand is too low, and its four components are unable to bu enough output to make it
worthwhile for firms to produce potential GDP. Therefore, equilibrium GDP is lower than potential
GDP. In Figure 9.11(a), the equilibrium level of real GDP settles at Ye, and can remain there indefinitel .
Ke nesian anal sis is therefore essentiall a short-term anal sis. This does not mean that Ke nesian
economists do not consider what happens over long periods of time; it means onl that the do not
accept the idea that the econom can move into what monetarist/new classical economists define as the
long run (where there is full resource and product price fle ibilit ).
In contrast to the monetarist/new classical model, which automaticall corrects

deflationar /recessionar gaps b returning to full emplo ment equilibrium, the Ke nesian model
shows that an econom can remain for long periods of time in an equilibrium where there is less than
full emplo ment (i.e. a deflationar /recessionar gap), caused b insufficient aggregate demand.
The two different models have important implications for economic polic . According to the
monetarist/new classical model, governments should tr to make markets work as freel as possible, so
that wages and product prices can respond to the forces of demand and suppl , without government
interference in markets. B contrast, according to the Ke nesian model, the government must intervene
in the econom with specific measures to help it come out of the deflationar gap.
Another important difference between the two models has to do with the effects of increases in aggregate
demand on the price level. In the monetarist/new classical model, increases in aggregate demand alwa s
result in price-level increases. In the short run, as AD shifts to the right causing a movement along an
upward-sloping SRAS curve, an increase in real GDP and an increase in the price level result, as can be
seen in Figure 9.4(a). In the long run, increases in aggregate demand give rise onl to increases in the
price level, leaving real GDP unaffected, as in Figure 9.15(a). In the Ke nesian model, when the
econom is in the hori ontal part of the AS curve, increases in aggregate demand lead to increases in real
GDP without affecting the price level. This can be seen in Figure 9.15(b). It is onl when the Ke nesian
AS curve begins to slope upward, when it is close to the full emplo ment level of output, that further
increases in aggregate demand begin to result in changes in the price level as well. When the AS curve
becomes vertical, increases in aggregate demand result in rapid price level increases while leaving real
GDP unchanged.
F 9.15: Effects of increases in aggregate demand on real GDP and the price level
In the Ke nesian view increases in aggregate demand need not result in a higher price level. This is in
contrast to the monetarist new/ classical model where increases in aggregate demand alwa s result in
a higher price level.
Here too, there are differing implications for economic polic . As we will see in Chapter 10, rapid
increases in the price level (or inflation) are undesirable. In the monetarist/new classical view, since
increases in aggregate demand will alwa s lead to increases in the price level, economic polic should
focus on policies to achieve g- g h, which are based on efforts to shift the LRAS curve to the
right.
B contrast, in the Ke nesian view, since increases in aggregate demand do not lead to price level
increases when the econom is in a deflationar gap, policies focusing on increasing aggregate demand
are not onl harmless, but in fact are essential in order to both prevent and reduce the si e of both
deflationar and inflationar gaps.

1 Compare and contrast the Ke nesian and monetarist/new classical models regarding the abilit of
an econom to achieve full emplo ment equilibrium on its own without an government
intervention.
2 Using the Ke nesian model, e plain when increases in aggregate demand can be e pected to
lead to increases in the price level (inflation) and when the are unlikel to do so.
E plain how the Ke nesian model differs from the monetarist/new classical model in its
prediction of rising price levels following an increase in aggregate demand.
3 E plain wh use of the LRAS curve to account for economic growth leads to the polic
implication that governments should focus on policies that tr to influence the suppl side of the
econom .
4 E plain wh use of the Ke nesian threesection aggregate suppl curve leads to the polic
implication that governments should focus on the policies that tr to influence the demand side of
the econom .
HEOR OF KNO LEDGE 9.1

C
The two perspectives we have studied in this chapter, the monetarist/new classical and Ke nesian, are
based on ver different wa s of viewing the economic world. The differences between the two are not
just of theoretical interest; the have important implications for the real world, because each
perspective provides ver different polic recommendations to deal with macroeconomic problems.
/
In the monetarist/new classical perspective, the econom is seen as a stable s stem that automaticall
tends towards long-run equilibrium where there is full emplo ment at the natural rate of
unemplo ment. This argument has important implications for the short-term fluctuations of the
business c cle and long-term economic growth. Since short-term fluctuations
(deflationar /recessionar and inflationar gaps) correct themselves automaticall , there is no need
for the government to do an thing to correct them. Instead, the government must ensure that markets
work as competitivel as possible, so that all resource and product prices are able to rise or fall as
required to allow the econom to settle at its point of long-run equilibrium, at the level of potential
GDP.
In fact, continues the argument, if governments do intervene with policies intended to correct short-
term fluctuations, the ma achieve the opposite of the intended results. Rather than reduce the si e of
fluctuations, the ma make them bigger. Man monetarist/new classical economists believe that the
departures of actual GDP from potential GDP that occur in real-world business c cles are as large as
the are because of government intervention in the econom .
When it comes to promoting economic growth, aggregate demand cannot affect real GDP over the
long run. If aggregate demand increases, it will onl result in increasing price levels and inflation.
Governments should therefore concentrate on policies that affect the suppl side of the econom ,
which attempt to shift the LRAS curve to the right, with the objective of increasing real GDP without
causing inflation.
K
In the Ke nesian perspective, the econom is an unstable s stem because of repeating short-term
fluctuations that cannot automaticall correct themselves. Such fluctuations arise mainl due to
changes in aggregate demand caused b spontaneous actions of firms and consumers. Ke nes himself
considered business c cle fluctuations to be caused mainl b changes in investment spending caused
b changes in firms e pectations about the future. Optimism about the future increases investment
spending, causing a rightward shift in the AD curve; pessimism decreases investment spending,
leading to a leftward shift. Ke nes referred to alternating waves of optimism and pessimism as
animal spirits .
In the Ke nesian view, when there is a deflationar gap, there are man factors preventing the
operation of market forces, and so wages and product prices do not fall easil even over long periods
of time. This means the econom can remain in a less than full emplo ment equilibrium (deflationar
gap) for long periods. Therefore, there is an important role for government polic to pla to restore
full emplo ment and raise real GDP to the level of potential GDP. Governments should focus on
policies that increase aggregate demand when there is a deflationar gap, and decrease aggregate
demand when there is an inflationar gap. Policies to influence aggregate demand are particularl
important when aggregate demand is low.
?
Most economists toda are unlikel to be purel monetarist / new classical or purel Ke nesian .
After decades of debate, man would argue that elements of both perspectives have some merit, and
that policies attempting to influence both aggregate suppl and aggregate demand are important in
achieving the goals of reducing short-term fluctuations while promoting economic growth. Even so,
most economists are still likel to side more with one perspective or the other. Wh has the
disagreement not been resolved after all these ears? According to Mark Blaug, a prominent UK
economist, there has been:
. . . a e di g e ie f eff d ce a deci i e e i ica e f he Ke e ia a d
e a i ie f he ca e f ec ic f c a i . A de ached b e e igh be f gi e f
hi i g ha hi di c i ha ed hi g b ha e i ica e ide ce i a a e
i ca ab e f a i g a ec i cha ge hi i d . . . B a c e a he i e a e e ea
. . . a g i g a ecia i f he i i a i f a he c e a i ica e f he e a i e
effec i e e f [g e e ] icie . . . A he a e i e, i be ad i ed ha he
e i e ce f hi c e , de i e a he e a dc e e i b h ca , ca be
e ai ed i e f ce ai dee - ea ed ha d c e di ag ee e ab he e f-adj i g
ca aci f he i a e ec i i ed ec ie a d, he ce, he e e hich [g e e ]
ic i i fac abi i i g de abi i i g . . . O ce agai , he deba e be ee Ke e ia a d
ea i h ha ec i (i ea he cie i ) i cha ac e i ica defe d he c e
f hei be ief f he h ea f b e ed a a ie . . . 7
Blaug is suggesting that the controvers persists because economists have different beliefs. What kind
of beliefs could these be? On a general level, the must be beliefs about the superiorit of one
perspective over the other. However, this begs the question, where did these beliefs come from, and
how can the be justified? Certainl not b the scientific method, based on empirical testing, since as
Blaug clearl tells us, it has not been possible for an empirical test to falsif one or the other
perspective based on the effectiveness of their polic recommendations. Therefore, ver likel , these
are beliefs that come from outside the realm of social scientific thinking, which ma be political and
ideological beliefs stemming from personal values.
Most economists do not den the role of values and ideolog in economics. Nobel Pri e-winning
economist, Robert Solow, writes the following:
S cia cie i , i e e e e e e, ha e c a i e e , ide gica c i e ,a d a e f
a i d. B a cia cie ce e ea ch, i e e ea ch he e g h f a e ia he
c e f he hae g bi ec e, ie e c e he c e f h e ide gie , i e e ,
a d a e . Whe he he cia cie i i i i , e ha e e if he figh i , hi ch ice
f e ea ch be , he e i he a , he e i he d e a , hi a a ica f a e ,
he e d he e, ae a i e be, i e ea e, a ef ec i f hi i e e ,
ide gie a d a e .8
Do ou agree with Solow that it is ver likel that personal value judgements influence
economists choices between alternative theories (the choice of anal tical framework ) and
more generall their work as social scientists?
Is the effective use of the scientific method influenced b economists personal beliefs and
ideologies?
Do the social sciences, and economics in particular, differ from the natural sciences b having
political beliefs and ideologies influence thinking?
What kind of political beliefs and ideologies do ou think are likel to be linked with (a) the
monetarist/new classical perspective, and (b) the Ke nesian perspective?
INQ IR AND REFLEC ION

The following questions will help ou reflect on our learning and enhance our understanding of ke
topics in this chapter. The are suggestions for inquiries that ou can undertake on our own or in
1 Research an econom that has recentl been (or is currentl ) in a recession.
2 Identif the causes of the recession and tr to link them with what ou have learned about the
factors that cause aggregate demand and/or short-run aggregate suppl to shift.
E AM S LE Q ES IONS
You can find questions in the st le of IB e ams in the 'Digital coursebook: E tra material' section.
7 Mark Blaug (1980) The Me h d g f Ec ic , Cambridge Universit Press, pp. 217 and 221.
8 Robert M. Solow (1996) Science and ideolog in economics in D. M. Hausman, The Phi h f
Ec ic , Cambridge Universit Press.
C a e 10
Mac ec c b ec e I: L
e e , a d ab e a e f
fa
Bef e a
Unemplo men occ r hen people ho are looking for a job canno find one. Wh do o
hink people become nemplo ed?
Wha problem are a ocia ed i h nemplo men on a per onal and ocial le el? Can o hink
of ome ac ion go ernmen can ake o help nemplo ed people become emplo ed?
Price of good and er ice end o ri e o er ime. Thi i kno n a infla ion . Wh do o
hink infla ion occ r o er ime?
Thi chap er i concerned i h o impor an macroeconomic objec i e : lo nemplo men and lo

and able ra e of infla ion. Bo h of he e are clo el rela ed o achie ing po en ial o p , ho n in he
b ine c cle diagram in Chap er 8; ee Fig re 8.4.
10.1 Low unemployment
LEARNING OBJECTIVES

define all he erms appearing in orange bold in he e (AO1)
e plain ho nemplo men and he nemplo men ra e are calc la ed (AO2)
calc la e he nemplo men ra e (AO4)
e plain he diffic l ies of meas ring nemplo men (AO2)
e plain and disc ss he economic, personal and social cos s of nemplo men (AO3)1
e plain he ca ses of nemplo men : c clical, s r c ral, seasonal and fric ional (AO2)
dra diagrams sho ing (AO4)
a fall in labo r demand for a par ic lar marke or geographical area
nemplo men res l ing from a minim m age
defla ionar gap sho ing c clical nemplo men
e plain ha he na ral ra e of nemplo men is he s m of s r c ral, seasonal and fric ional
nemplo men (AO2)
Unemployment and its measurement

Unemplo men , in a general sense, refers o idle, or no f ll sed reso rces. When economis s se he
erms nemplo men (or emplo men ) on heir o n, he s all refer o nemplo men or
emplo men of labo r. If he an o refer o ano her fac or of prod c ion, he refer o i e plici l ,
s ch as nemplo men of capi al reso rces , or more generall , nemplo men of reso rces .
O r disc ssion in his chap er ill foc s on he econom s labo r reso rces. Unemplo men is defined
as follo s:
Unemployment refers o people of orking age ho are ac i el looking for a job b ho are no
emplo ed.
A closel rela ed erm is , referring o people of orking age i h par - ime jobs hen
he o ld ra her ork f ll ime, or i h jobs ha do no make f ll se of heir skills and ed ca ion.
E amples incl de people ho ork fe er ho rs per eek han he o ld like, or rained indi id als,
s ch as engineers, economis s, or comp er anal s s, ho ork as a i dri ers, or ai ers or ai resses,
or an hing else nrela ed o heir profession, hen he o ld ra her ha e a job in heir profession.
Bo h nemplo men and nderemplo men mean ha an econom is as ing scarce reso rces b no
sing hem f ll . In he case of nemplo men his is ob io s. Wi h nderemplo men , orking a a job
o her han in one s profession also in ol es reso rce as e , beca se some reso rces ha ere sed for
raining and ed ca ion are as ed hen people are forced o ork a a job ha does no make se of heir
skills.
Calculating unemployment: the unemployment rate

The ab is defined as he n mber of people ho are emplo ed ( orking) pl s he n mber of
people of orking age ho are nemplo ed (no orking b seeking ork). The labo r force is ac all
a frac ion of he o al pop la ion of a co n r , beca se i e cl des children, re ired persons, ad l
s den s, all people ho canno ork beca se of illness or disabili , as ell as all people ho do no
an o ork.
Unemplo men can be meas red as a n mber or percen age:
As a n mber, nemplo men is he o al n mber of nemplo ed persons in he econom , i.e. all
persons of orking age ho are ac i el seeking ork b are no emplo ed.
As a percen age, nemplo men is called he a , defined as
unemployment rate = n mber of nemplo ed labo r force 100
For e ample, if he nemplo men ra e in an econom is 6%, his means ha si o of e er 100 people
in he labo r force are nemplo ed.
S ppose here is a pop la ion of 35.5 million people, of hom 17.3 million are in he labo r force, 1.5
million ork par ime ho gh he o ld ra her ork f ll ime, and 1.4 million are looking for ork b
canno find an . Wha is he nemplo men ra e?
The nemplo men ra e is 1.4 17.3 100=8.1%, hich is he n mber looking for ork nable o find an
di ided b he si e of he labo r force, imes 100. No e ha e ignore he si e of he o al pop la ion (i
is irrele an ), as ell as he n mber of people ho are orking par - ime ( he are considered o be
emplo ed).
Underemplo men can similarl be meas red as a n mber or as a percen age. If he nderemplo men
ra e is 15%, his means ha 15 o of e er 100 people in he labo r force are nderemplo ed.
Difficulties in measuring unemployment

The nemplo men ra e is one of he mos idel repor ed meas res of economic ac i i , sed
e ensi el as an indica or of economic performance. Ye i is ac all diffic l o ob ain an acc ra e
meas remen of nemplo men .
Official s a is ics of en nderes ima e r e nemplo men beca se of , arising from
he follo ing:
Unemplo men fig res incl de nemplo ed persons ho are ac i el looking for ork. This
e cl des disco raged orkers , ho are nemplo ed orkers ho ga e p looking for a job
beca se, af er r ing ns ccessf ll o find ork for some ime, he became disco raged and
s opped searching. These people in effec drop o of he labo r force.
Unemplo men fig res do no make a dis inc ion be een f ll- ime and par - ime emplo men , and
co n people i h par - ime jobs as ha ing f ll- ime jobs ho gh in fac he are nderemplo ed.
Unemplo men fig res make no dis inc ion on he pe of ork done. If a highl rained person
orks as a ai er, his co n s as f ll emplo ed.
Unemplo men fig res do no incl de people on re raining programmes ho pre io sl los heir
jobs, as ell as people ho re ire earl al ho gh he o ld ra her be orking.
In addi ion, official s a is ics ma o eres ima e r e nemplo men , beca se:
nemplo men fig res do no incl de people orking in he ndergro nd econom (or informal
econom ). This is he por ion of he econom ha is nregis ered, legall nreg la ed and no
repor ed o a a hori ies. Some people ma be officiall regis ered as nemplo ed, e he ma
be orking in an nrepor ed ( ndergro nd) ac i i .
A f r her disad an age of he na ional nemplo men ra e (calc la ed for an en ire na ion) is ha i is an
a erage o er he en ire pop la ion, and herefore does no acco n for differences in nemplo men ha
of en arise among differen a in a socie . Wi hin a na ional pop la ion, nemplo men
ma differ b :
region regions i h declining ind s ries ma ha e higher nemplo men ra es han o her regions
gender omen some imes face higher nemplo men ra es han men
e hnic gro ps some e hnic gro ps ma be disad an aged d e o discrimina ion, or d e o lo er
le els of ed ca ion and raining
age o h nemplo men ( s all referring o persons nder he age of 25) of en face higher
nemplo men ra es han older pop la ion gro ps, of en d e o lo er skill le els; people ho are
ageing also some imes face higher nemplo men ra es as emplo ers ma be less illing o
emplo hem
occ pa ion and ed ca ional a ainmen people ho are rela i el less skilled ma ha e higher
nemplo men ra es han more skilled orkers ( ho gh in some co n ries higher nemplo men
ra es ma be fo nd among highl ed ca ed gro ps).
Costs of unemployment
Unemplo men of labo r is one of he mos impor an economic concerns o co n ries aro nd he orld.
Red c ion of nemplo men is a ke objec i e of go ernmen s e er here, as i s presence has major
economic and social conseq ences.
Economic costs
Unemplo men has he follo ing economic conseq ences:
A loss of real output (real GDP). Since fe er people ork han are a ailable o ork, he amo n
of o p prod ced is less han he le el he econom is capable of prod cing. This is h
nemplo men means ha an econom finds i self some here inside i s prod c ion possibili
c r e (PPC; see Chap er 1, Sec ion 1.3), prod cing a lo er le el of o p han i is capable of
prod cing.
A loss of income for unemployed workers. People ho are nemplo ed do no ha e an income
from ork. E en if he recei e nemplo men benefi s, he are likel o be orse off financiall
han if he had been orking.
A loss of tax revenue for the government. Since nemplo ed people do no ha e income from
ork, he do no pa income a es; his res l s in less a re en e for he go ernmen .
Costs to the government of unemployment benefits. If he go ernmen pa s nemplo men
benefi s o nemplo ed orkers, he grea er he nemplo men , he larger he nemplo men
benefi s ha m s be paid, and he less a re en e lef o er o pa for impor an go ernmen -
pro ided goods and ser ices s ch as p blic goods and meri goods.
Costs to the government of dealing with social problems resulting from unemployment. The
social problems ha arise from nemplo men (no ed belo ) of en req ire go ernmen f nds o be
appropria el deal i h.
Larger budget deficit or smaller budget surplus. A go ernmen b dge defici occ rs hen a
re en es are less han go ernmen e pendi res, hile a b dge s rpl s is he opposi e, in ol ing
grea er a re en es han e pendi res. Unemplo men leads o a loss of a re en e for he
go ernmen as e ha e seen, b a he same ime grea er e pendi res for nemplo men benefi s
as ell as social problems d e o nemplo men . As e pendi res rise hile a re en es fall, a
b dge s rpl s ill become smaller hile a b dge defici ill become larger, in rn leading o
more go ernmen deb .
More unequal distribution of income. Some people ( he nemplo ed) become poorer hile o hers
( he emplo ed) are able o main ain heir income le els. Since cer ain pop la ion gro ps (e hnic
gro ps, regional gro ps, e c., disc ssed earlier) ma be affec ed more b nemplo men han
o hers, he effec s of increasing income ineq ali ies and res l ing po er are of en concen ra ed
among pop la ion gro ps ho are more disad an aged o begin i h. If nemplo men is high or
ends o persis o er long periods of ime, his ma lead o increased social ensions and social
nres .
Unemployed people may have difficulties finding work in the future. When people remain o
of ork for long periods, he ma no find ork easil a a la er ime in he f re. This can
happen beca se he nemplo ed orkers ma par l lose heir skills d e o no orking for a long
ime, or beca se in he mean ime ne skills ma be req ired ha orkers ha e no been able o
keep p i h, or beca se firms ha e fo nd a s o manage i h fe er orkers. This process is
kno n as (from he Greek ord meaning dela or lagging behind
some hing , in his case he lagging behind of emplo men ). H s eresis s gges s ha high
nemplo men ra es in he presen ma mean con in ed high nemplo men ra es in he f re,
e en hen economic condi ions become more fa o rable.
Personal and social costs

Unemplo men has he follo ing personal and social conseq ences:
Personal problems. Being nemplo ed and nable o sec re a job in ol es a loss of income,
increased indeb edness as people m s borro o s r i e, as ell as loss of self-es eem. All hese
fac ors ca se grea ps chological s ress, some imes res l ing in lo er le els of heal h, famil
ensions, famil breakdo n and e en s icide.
Greater social problems. High ra es of nemplo men , par ic larl hen he are neq all
dis rib ed for he reasons no ed earlier, can lead o serio s social problems, incl ding increased
crime and iolence, dr g se and homelessness, arising from gro ing po er .

1 Define nemplo men and e plain ho i differs from nderemplo men .
2 O line ho e meas re he nemplo men ra e.
3 E plain h nemplo men fig res are no s all acc ra e.
4 Iden if some of he economic and social conseq ences of nemplo men .
5 Calc la e he nemplo men ra e in an econom i h a pop la ion of 57.7 million people, of
hich he labo r force is 62%, and he n mber of emplo ed are 32.9 million.
Types and causes of unemployment

We ill e amine fo r pes of nemplo men : s r c ral, fric ional, seasonal and c clical.
Structural unemployment
Structural unemployment occ rs as a res l of changes in demand for par ic lar pes of labo r skills,
changes in he geographical loca ion of ind s ries and herefore jobs, and labo r marke rigidi ies.
Changes in demand for particular labour skills

The demand for par ic lar pes of labo r skills changes o er ime. This ma be he res l of
echnological change, hich of en leads o a need for ne pes of skills, hile he demand for o her
skills falls. For e ample, comp er echnolog , he in rod c ion of a oma ed eller machines (ATMs),
and elec rical rela s and digi al s i ching echnolog grea l red ced he need for pis s, bank ellers
and elephone opera ors, hile increasing he need for orkers i h comp er li erac and comp er
programming and o her skills. There are gro ing concerns ha a oma ion ( he in rod c ion of
a oma ic machines in man fac ring) ma increasingl lead o job losses and herefore o more of his
pe of nemplo men . According o a s d b O ford Economics, he in rod c ion of robo s aro nd
he orld ma replace 20 million man fac ring jobs b 2030. Those ho lose heir jobs ill likel find
jobs in o her sec ors incl ding ranspor , cons r c ion, main enance and office ork. The s d no es ha
areas here orkers end o ha e lo er skills ill be s rongl affec ed.2
In addi ion, changes in demand for labo r skills ma occ r beca se of changes in he s r c re of he
econom , leading o some gro ing ind s ries and some declining ind s ries. Workers ho lose heir jobs
in declining ind s ries ma no ha e he necessar skills o ork in gro ing ind s ries, and become
s r c rall nemplo ed. For e ample, as he agric l ral sec or declines in rela i e impor ance and he
man fac ring and ser ices sec ors gro , agric l ral orkers ma lose heir jobs. Workers lacking he
necessar skills o ork in ind s r or ser ices ma become s r c rall nemplo ed. (This pe of
s r c ral change as e plained in erms of income elas ici of demand (YED); see Chap er 3.)
These kinds of changes lead o a be een labo r skills demanded b emplo ers and labo r
skills s pplied b orkers. S ch misma ches ca se s r c ral nemplo men .
Changes in the geographical location of jobs

When a large firm or e en an ind s r mo es i s ph sical loca ion from one region o ano her, here is a
fall in demand for labo r in one region and an increase in he region here i reloca es. (The same
problem co ld arise if a large firm or ind s r closes do n.) If people canno mo e o economicall
e panding regions, he ma become s r c rall nemplo ed. Some imes firms reloca e o foreign
co n ries, increasing he o erall s r c ral nemplo men i hin a co n r . Once again, he res l ill be
a a be een labo r demanded and labo r s pplied i hin a geographical region (or co n r ).
Using a diagram to show structural unemployment arising from mismatches

between labour demand and labour supply
S r c ral nemplo men arising from misma ches be een labo r demand and s ppl can be sho n in
Fig re 10.1(a), sho ing he labo r marke for a par ic lar ind s r (or marke ) or for a par ic lar
geographical area. The er ical a is meas res he age ( he price of labo r) hile he hori on al a is
meas res he q an i of labo r. The demand c r e sho s he q an i of labo r firms are illing and
able o hire a each age, and he s ppl c r e sho s he q an i of labo r orkers s ppl a each
age. The ini ial eq ilibri m is de ermined b S and D1 a W1 and Q1.
S ppose no ha d e o echnological change ha red ces demand for some labo r skills, or d e o a
change in he s r c re of he econom , or d e o he mo e of an ind s r o ano her geographical area,
here is a fall in he demand for labo r, sho n b he shif from D1 o D2. If marke forces orked
perfec l , he problem of s r c ral nemplo men o ld be sol ed. A he lo er age W2, onl Q2
orkers o ld an o ork, so a ha lo er age here o ld no be an e cess s ppl of labo r.
Ho e er in prac ice, ages do no fall easil o er shor periods of ime, and if he ere o fall he
o ld need a long ime o do so. This means ha if he age remains a W1, a leas for he foreseeable
f re, his gi es rise o an e cess s ppl of labo r ha corresponds o s r c ral nemplo men crea ed
b he fall in he demand for labo r. E en if he age falls a li le, here o ld s ill be an e cess s ppl
of labo r as long as i does no drop o he le el of W2.3
Figure 10.1: S r c ral nemplo men
Labour market rigidities

Lab a are fac ors pre en ing he forces of s ppl and demand from opera ing in he
labo r marke . The incl de:
minimum wage legislation, hich leads o higher han eq ilibri m ages
labour union activities and wage bargaining with employers, res l ing in higher han
eq ilibri m ages
employment protection laws, hich make i cos l for firms o fire orkers (beca se he m s
pa compensa ion), h s making firms more ca io s abo hiring
generous unemployment benefits, hich increase he a rac i eness of remaining nemplo ed and
red ce he incen i es o ork.
Al ho gh economis s do no al a s agree on he effec s of hese fac ors on nemplo men , man arg e
ha he are responsible for higher nemplo men ra es in co n ries i h s rong labo r pro ec ion
s s ems (s ch as in E rope) compared o co n ries i h eaker labo r pro ec ion s s ems (s ch as he
Uni ed S a es).
Using diagrams to show structural unemployment arising from labour market

rigidities
Unemplo men arising from minim m ages and labo r nion ac i i ies leading o higher han
eq ilibri m ages, can be sho n in a labo r marke diagram, as in Fig re 10.1(b). The higher han
eq ilibri m age, Wm, res l s in nemplo men of labo r eq al o Qs Qd. Yo ma no e ha his
diagram is he same as Fig re 4.9 (Chap er 4) sho ing a price floor applied in he labo r marke .
Unemplo men arising from minim m age legisla ion, labo r nion ac i i ies and emplo men
pro ec ion la s can also be sho n indirec l , hro gh a prod c s ppl and demand diagram, as in Fig re
10.1(c). Higher han eq ilibri m ages and emplo men pro ec ion lead o higher cos s of prod c ion for
firms, ca sing he firm s ppl c r e o shif o he lef from S1 o S2, leading o a smaller q an i of
o p prod ced, Q2 ins ead of Q1. Firms herefore hire a smaller q an i of labo r, and his con rib es
o s r c ral nemplo men of hese pes.
S r c ral nemplo men (of all pes) is a serio s pe of nemplo men beca se i ends o be long
erm. A cer ain amo n of s r c ral nemplo men is na oidable in an d namic, gro ing econom ,
and is herefore considered o be par of na ral nemplo men . Ho e er, his does no mean i canno
be lo ered. There are man policies go ernmen s can p rs e o red ce i , incl ding meas res
enco raging orkers o re rain and ob ain ne skills, and o reloca e (mo e) o areas i h grea er
emplo men oppor ni ies; pro iding incen i es o firms o hire s r c rall nemplo ed orkers; and
meas res o red ce labo r marke rigidi ies. These policies ill be disc ssed in Chap er 13.
Frictional unemployment
Frictional unemployment occ rs hen orkers are be een jobs. Workers ma lea e heir job beca se
he ha e been fired, or beca se he are in search of a be er job, or he ma be ai ing o s ar a ne
job. Fric ional nemplo men ends o be shor erm, and does no in ol e a lack of skills ha are in
demand. I is herefore less serio s han s r c ral nemplo men .
A cer ain amo n of fric ional nemplo men is ine i able in an gro ing, changing econom , here
some ind s ries e pand hile o hers con rac , some firms gro fas er han o hers, and orkers seek o
ad ance heir income and professional posi ions. An impor an ca se of fric ional nemplo men is
incomple e informa ion be een emplo ers and orkers regarding job acancies and req ired
q alifica ions. Imagine 100 job acancies and 100 job applican s ho ha e e ac l he righ job
q alifica ions. Beca se of incomple e informa ion, i akes ime for he righ applican s o ge ma ched p
i h he righ jobs. Therefore, fric ional nemplo men is also par of na ral nemplo men .

The textile industry in Naoussa
Nao ssa is a ci in nor hern Greece i h a cen riesold e iles ind s r , based on highl labo r-
in ensi e prod c ion me hods. When he marke s of neighbo ring ransi ion economies opened p in
he 1990s, Greek firms fo nd i profi able o reloca e o co n ries incl ding Albania, B lgaria, Nor h
Macedonia and Romania, on acco n of heir far lo er labo r cos s. The Greek go ernmen
in rod ced legisla ion in ended o lo er labo r cos s (easier firing r les, e ension of o er- ime ork),
e Greek firms sed some of hese pro isions o red ce heir local orkforce and mo e abroad.
In 2005, he remo al of rade barriers on impor s of Chinese e iles (according o WTO r les; see
Chap er 15) led o a h ge increase in Chinese e iles in he Greek marke , forcing man Greek e ile
firms o close do n as he ere nable o compe e i h he lo er-cos Chinese impor s.
Nao ssa as one of he areas mos s rongl affec ed. The combina ion of firm reloca ions and firm
clos res led o he loss of ens of ho sands of jobs. In 2005, nemplo men in Nao ssa as es ima ed
o ha e reached a record 35 40%.
Source: A a Ma L b , C a ab Ka , 23
S b 2005; E a a a b a - ,
M a a a ,2O b 2006.
Figure 10.2: Greek e ile design i h oli e branches

1 Iden if he kind of nemplo men as Nao ssa e periencing b 2005.
2 Use a demand and s ppl diagram o e plain ho his pe of nemplo men came abo .
3 a Use a demand and s ppl diagram o sho he effec s of legisla ion in ending o lo er labo r
cos s in he e ile ind s r .
b Wh do o hink his legisla ion as ineffec i e in keeping Greek firms from reloca ing?
Meas res o deal i h fric ional nemplo men aim a red cing he ime ha a orker spends in be een
jobs and impro ing informa ion flo s be een orkers and emplo ers (see Chap er 13).
Seasonal unemployment
Seasonal unemployment occ rs hen he demand for labo r in cer ain ind s ries changes on a seasonal
basis beca se of aria ions in needs. Farm orkers e perience seasonal nemplo men beca se he are
hired d ring peak har es ing seasons and laid off for he res of he ear. The same applies o lifeg ards
and gardeners, ho are mos l in demand d ring s mmer mon hs, people orking in he o ris ind s r ,
hich aries from season o season, shop assis an s, ho are in grea er demand d ring peak selling
mon hs, and man o hers.
Some seasonal nemplo men is na oidable in an econom , as here ill al a s be some ind s ries
i h seasonal aria ions in labo r demand. Therefore, seasonal nemplo men is also par of na ral
nemplo men .
Structural, frictional and seasonal unemployment: the natural

rate of unemployment
As o kno from Chap ers 8 and 9, hen he econom prod ces a f ll emplo men o p , or
po en ial o p , i has nemplo men eq al o he na ral ra e of nemplo men . We are no in a
posi ion o define his more acc ra el . The na ral ra e of nemplo men is eq al o he s m of
s r c ral, fric ional pl s seasonal nemplo men . Ano her a of sa ing his is ha hen an econom
has f ll emplo men , i ac all has nemplo men eq al o he s m of s r c ral, fric ional and
seasonal nemplo men . Theor of kno ledge 10.1 belo e amines his pec liar erminolog .
Cyclical (demand-deficient) unemployment

We ha e seen ha pes of nemplo men e is hen an econom is prod cing a i s po en ial or f ll
emplo men le el of o p . Wha abo nemplo men arising hen he econom prod ces less han i s
po en ial o p ? Unemplo men no consis s of addi ional nemplo men , o er and abo e he na ral
ra e, hich is kno n as a .
Cyclical unemployment, as he erm s gges s, occ rs d ring he do n rns of he b siness c cle, hen
he econom is in a defla ionar /recessionar gap. The do n rn is seen as arising from declining or lo
aggrega e demand (AD), and so is also kno n as demand-deficient unemployment. As real GDP falls
d e o a fall in AD, nemplo men increases beca se firms la off orkers. In he p rn of he b siness
c cle, as real GDP increases, he defla ionar /recessionar gap becomes smaller and c clical
nemplo men falls. When he econom prod ces real GDP a he le el of po en ial o p , here is no
longer an c clical nemplo men , i is eq al o ero.
Al ho gh c clical nemplo men is a Ke nesian concep , i can be ill s ra ed b se of bo h he
mone aris /ne classical and Ke nesian ersions of he AD-AS model, sho n in Fig re 10.3. In bo h
par s, he econom is ini iall prod cing po en ial o p Yp, i h ero c clical nemplo men . A fall in
aggrega e demand, ca sing AD1 o shif o AD2, crea es a defla ionar /recessionar gap as real o p
falls o Yrec. A Yrec, he ne nemplo men crea ed is c clical nemplo men .
Figure 10.3: C clical nemplo men
Since c clical nemplo men arises from a deficienc of aggrega e demand, meas res o red ce his
nemplo men in ol e he se of go ernmen policies o increase aggrega e demand, and elimina e he
recessionar gap (see Chap er 13).
The four types of unemployment in relation to the AD-AS model

The fo r pes of nemplo men are sho n in rela ion o he AD-AS model in Fig re 10.4. (For
simplici , he mone aris /ne classical model is sho n.) A o p Yp, real GDP is eq al o po en ial or
f ll emplo men GDP, here here is nemplo men eq al o he na ral ra e, or he s m of s r c ral,
fric ional and seasonal nemplo men , and c clical nemplo men is eq al o ero.
If GDP falls o an le el less han Yp, here is a defla ionar /recessionar gap, and nemplo men
increases so ha in addi ion o s r c ral pl s fric ional pl s seasonal nemplo men here is also
c clical (demand-deficien ) nemplo men . If GDP increases o an le el grea er han Yp, here is an
infla ionar gap, and nemplo men falls belo he na ral ra e of nemplo men . This means ha some
orkers ho ere s r c rall , fric ionall or seasonall nemplo ed no find jobs. Ho e er, hese jobs
end o be of a shor d ra ion, beca se he econom does no s all remain in an infla ionar gap
indefini el . The go ernmen is likel o s ep in i h policies ( ha e ill s d in Chap er 13) o bring
he econom back o o p le el Yp, here nemplo men ill once again reach he na ral ra e.
Whereas i is a simple ma er o dis ing ish be een he fo r pes of nemplo men on a heore ical
le el, in he real orld i can be er diffic l o iden if and dis ing ish be een he differen pes of
nemplo men . The labo r marke is in a con in o s s a e of change, i h some orkers q i ing heir
jobs, o hers being fired, i h some nemplo ed orkers ai ing for an appropria e job and o hers
re raining for a ne job, i h some firms e panding, o hers con rac ing, and i h some people ne l
en ering he labo r force and o hers lea ing. The ncer ain ies s rro nding he ca ses of nemplo men
mean ha i is no al a s an eas ma er for go ernmen s o de ise appropria e policies o lo er i .
Figure 10.4: The fo r pes of nemplo men in rela ion o he AD-AS model
1 E plain he her or no f ll emplo men mean he absence of nemplo men .

2 Describe, sing e amples, he meaning and ca ses of s r c ral, fric ional and seasonal
nemplo men .
3 Use diagrams o sho s r c ral nemplo men arising from
a a change in demand for labo r skills,
b a change in he geographical loca ion of ind s ries, and
c higher han eq ilibri m ages.
4 O line ho he s m of s r c ral, fric ional and seasonal nemplo men rela es o he concep s
of f ll emplo men and po en ial o p in he con e of he AD-AS model.
5 Using a diagram, e plain c clical (demanddeficien ) nemplo men and he circ ms ances nder
hich i arises.
6 Iden if and o line he differen kinds of nemplo men an econom is likel o be e periencing
hen i is in
a a defla ionar /recessionar gap,
b an infla ionar gap, and
c hen i is prod cing real GDP eq al o po en ial GDP.

What is ‘natural about the natural rate of unemployment?
We ha e defined he na ral ra e of nemplo men o be he s m of s r c ral, fric ional and seasonal
nemplo men , or more simpl all nemplo men o her han ha ca sed b he b siness c cle. To
call his nemplo men na ral appears s range; i s gges s here is some hing normal, s al or
s andard abo hese pes of nemplo men . Ye , ha can be na ral abo par ic lar pes of
nemplo men ?
I is also s range ha na ral nemplo men corresponds o f ll emplo men . E en ho gh, as e
kno , i is ne er possible o ha e f ll emplo men in he sense of ero nemplo men , h sho ld
he presence of s r c ral, fric ional and seasonal nemplo men be kno n as f ll emplo men ?
We can nders and he reasons behind he se of hese erms if e p he na ral ra e concep in
his orical perspec i e. This concep as de eloped in he la e 1960s b Mil on Friedman, he fo nder
of mone arism , for hich he recei ed he Nobel Pri e. (Edm nd Phelps, ano her Nobel Pri e
inner, also independen l de eloped his concep .)
The na ral ra e concep is a reflec ion of he mone aris model, hich ie s he econom as a s able
s s em ha a oma icall ends o ard long-r n eq ilibri m here here are no recessionar or
infla ionar gaps (see Chap er 9, Sec ion 9.3). In his ie , he forces of s ppl and demand ork o
alloca e reso rces efficien l , and he mos efficien alloca ion ha is possible is reached hen he
econom is a long-r n eq ilibri m. If he labo r marke orked comple el perfec l according o
s ppl and demand, nemplo men o ld in fac drop o ero. Ho e er, in he real orld his does
no occ r, beca se of ins i ions ha lead o labo r marke imperfec ions: here ill al a s be some
people ho canno ins an l find jobs d e o lack of informa ion, b in addi ion, and mos
impor an l , people canno find jobs beca se of he presence of labo r marke rigidi ies, incl ding
minim m ages, labo r nion ac i i ies and lack of incen i es o ork.
In fac , Friedman belie ed (and mone aris economis s con in e o belie e) ha he na ral ra e of
nemplo men is ca sed onl b labo r marke rigidi ies. In he long r n, labo r marke rigidi ies can
e plain a , incl ding fric ional, seasonal and all of s r c ral nemplo men
disc ssed abo e (c clical nemplo men , o ma remember, is ero hen he econom is a long-
r n eq ilibri m). If people become nemplo ed beca se ind s ries change or mo e, in he long r n in
a free compe i i e marke he o ld all respond o marke incen i es and he o ld all find jobs.
Therefore, in his ie , in he long r n, all nemplo men arises a a from an imperfec l
orking labo r marke . Since he labo r marke ins i ions ha lead o his na ral nemplo men
are considered as gi en (fi ed) in an econom , i is reasonable o consider ha he econom has
hen all orkers are emplo ed a ab
a .
I is or h q o ing Nobel Pri e- inning economis Rober Solo once again:
W a , a , a
b , a , a , a a a a ,
,a a b , a ,a , a
a . 4( a a a a , )
Friedman as an en h sias ic belie er in he po ers of he free marke o sol e he major economic
problems, and he s rongl opposed go ernmen in er en ion. His poli ical con ic ions and al es
ndo b edl infl enced his heore ical orien a ions, as ell as his choice of ords. His ideas had an
impor an impac on polic -making, especiall d ring he 1970s and 1980s, and his infl ence can s ill
be fel o he presen da . He as highl infl en ial in he de elopmen of s ppl -side policies (see
Chap er 13).
Some economis s cri icise his na ral ra e concep (as ell as all his o her ideas), especiall since he
1990s. James K. Galbrai h, a Ke nesian economis (and son of he famo s economis John Kenne h
Galbrai h), ro e he follo ing:
Aa , a a a a a a b .W , a
.I b , ! . . . [E ] b a a - a
a a a a , . Sa , a
b ab a ... 5
In addi ion o being diffic l o es ima e, he na ral ra e of nemplo men is also imprecise as o i s
meaning. In his e , e follo he prac ice of mos e books in sing he erm na ral ra e of
nemplo men o refer o he s m of s r c ral, fric ional and seasonal nemplo men . This is a
con enien a o make a dis inc ion be een c clical and all o her pes of nemplo men . This
does no pres ppose ha i is eas or e en possible o ac all meas re an pe of nemplo men
indi id all . As no ed in he e , in he real orld i is er diffic l o dis ing ish be een he
differen kinds of nemplo men .
We end i h a q es ion. Wh do economis s bo her o meas re he na ral ra e of nemplo men
and h is his so impor an ? We ill re rn o his q es ion in he Theor of kno ledge 10.2 a he
end of his chap er (a HL).
Thinking points
Do he erms na ral ra e of nemplo men and f ll emplo men ha e a norma i e aspec ?
Wha do he s gges in erms of go ernmen polic ac ion (or inac ion) o red ce he ra e of
nemplo men ?
Can he se of lang age o reflec an nderl ing poli ical ideolog in erfere i h he se of he
scien ific me hod?
Do o agree i h Friedman (and o her economis s) ha all non-c clical nemplo men can be
e plained in erms of labo r marke ins i ions ha crea e rigidi ies in he labo r marke ?
1 This poin appears as AO2 in he s llab s, ho e er i becomes AO3 in he poin en i led Rela i e cos s of
nemplo men ers s infla ion considered la er in his chap er.
2 Source: Robo s ' o replace p o 20 million fac or jobs' b 2030
3 Some economis s make se of a differen pe of labo r marke diagram, hich sho s o labo r s ppl
c r es: one for he labo r force, and ano her represen ing he illingness of orkers o ake on jobs a differen
age le els; he hori on al difference be een he o s ppl c r es a he marke clearing age represen s
na ral nemplo men (of hich s r c ral is he mos impor an ). This diagram presen s na ral (hence
s r c ral) nemplo men as being holl ol n ar ; jobs e is , b orkers choose no o ake hem beca se
he do no an hem. This is a highl inacc ra e represen a ion of s r c ral nemplo men , hich is ha
people an o ork b canno find jobs.
4 Rober M. Solo (1996) Science and ideolog in economics, in D. M. Ha sman, T P

E , Cambridge Uni ersi Press.
5 James K. Galbrai h (1996) The s rrender of economic polic , in T A a P , March April.

10.2 Low and stable rate of inflation
LEARNING OBJECTIVES

di ing i h be een infla i n, di infla i n and defla i n (AO2)
e lain h he infla i n a e i mea ed ing a c n me ice inde (AO2)
calc la e a eigh ed ice inde ing an i ie cha ed a eigh (HL nl ) (AO4)
calc la e he a e f infla i n (AO4)
e lain he limi a i n f he CPI in mea ing infla i n (AO2)
e lain he ca e f infla i n: demand- ll and c - h (AO2)
d a diag am ill a ing demand- ll and c - h infla i n (AO4)
e lain and di c he c f infla i n incl ding edi ib i e effec , nce ain , a ing,
e c m e i i ene , ec n mic g h, inefficienc in e ce all ca i n (AO3)6
e lain he ca e f defla i n: dec ea e in AD and inc ea e in SRAS (AO2)
d a diag am ill a ing defla i n (AO4)
e lain he c f defla i n incl ding edi ib i e effec , nce ain , defe ed c n m i n,
high le el f c clical nem l men , bank cie , eal al e f deb , inefficienc in e ce
all ca i n, ineffec i ene f lic (AO2)
Inflation, disinflation and deflation

Inflation i defined a a ained inc ea e in he gene al ice le el. When e eak f he gene al
ice le el e efe an a e age f ice f g d and e ice in he en i e ec n m , n he ice
f an ne a ic la g d e ice. S ained mean ha he gene al ice le el m inc ea e a
ne le el and n fall back again i e i l e le el. F he , an inc ea e in he gene al ice
le el d e n nece a il mean ha ice f all g d and e ice a e inc ea ing; ice f me g d
and e ice ma be c n an e en falling, hile he a e inc ea ing. The e ence f infla i n
indica e ha ice f g d and e ice a e inc ea ing on a erage.
Deflation i defined a a ained dec ea e in he gene al ice le el. A in he ca e f infla i n,
defla i n efe an a e age f ice ; i i likel be ne en, i h me ice c n an e en
inc ea ing.
Infla i n i fa m e c mm n han defla i n; in fac , ince he 1930 ( he e i d f he G ea
De e i n), m ec n mie a nd he ld ha e been e e iencing a i ing ice le el, infla i n.
S den me ime c nf e he diffe ence be een change in he ice le el and change in he a e f
infla i n. In di c i n f he AD-AS m del, e ha e f e en l een inc ea e in he ice le el;
he e indica e infla i n. A change in he a e f infla i n, b c n a , efe a change in h fa he
ice le el i i ing. If he ice le el inc ea e b 5% in ne ea and hen inc ea e b 7% he ne
ea , hi e e en an increase in the rate of inflation. If he ice le el inc ea e b 10% in ne ea
and b 7% he ne ea , hi e e en a decrease in the rate of inflation, and i called disinflation.
Di infla i n he ef e cc hen infla i n cc a a l e a e.
Y m al be ca ef l n c nf e a fall in he a e f infla i n, di infla i n, i h a fall in he
ice le el, defla i n. A fall in he a e f infla i n, ch a f m 10% 7%, mean ha he ice le el
i inc ea ing a a l e a e, hence i di infla i n. A fall in he ice le el indica e ha defla i n i
cc ing. Defla i n can be h gh f a nega i e infla i n. F e am le, defla i n f 2% mean ha
he ice le el i falling a he a e f 2%.
Measuring inflation and deflation
The consumer price inde

Mea e f infla i n (and defla i n) a e b ained b e f ice indice (indices i he l al f inde ).
A ice inde i a mea e f a e age ice in ne e i d ela i e a e age ice in a efe ence e i d
called a ba e e i d. One f he m c mm nl ed ice indice mea e infla i n i he c n me
ice inde (CPI).
The c n me ice inde (CPI) i a mea e f he c f li ing, he c f g d and e ice
cha ed b he ical h eh ld in an ec n m . I i c n c ed b a a i ical e ice in each
c n , hich c ea e a h he ical ba ke c n aining h and f g d and e ice ha a e
c n med b he ical h eh ld in he c e f a ea . The al e f hi ba ke i calc la ed f a
a ic la ea (called a ba e ea ); hi i d ne b m l i l ing ice ime an i f each g d and
e ice in he ba ke , and adding b ain he al al e f he ba ke . The al e f the same basket
f g d and e ice i hen calc la ed f b e en ea . The e l i a e ie f n mbe ha h
he al e f he same basket f g d and e ice f diffe en ea . The CPI i hen c n c ed
h h he al e f he ba ke change f m ea ea b c m a ing i al e i h he ba e ea .
Once he c n me ice inde i c n c ed, infla i n and defla i n can be e e ed a a e cen age
change f he inde f m ne ea he he , hich i im l a mea e f the percentage change in
the alue of the basket from one ear to another. Since he al e f he ba ke change f m ne e i d
an he beca e f change in he ice f he g d in he ba ke , he e e cen age change eflec
change in he a e age ice le el. A i ing ice inde indica e infla i n; a falling ice inde indica e
defla i n. CPI and a e f change in he ice le el a e al calc la ed n a m n hl ba i and a
a e l ba i .
The consumer price inde (CPI) i a mea e f he c f li ing f he ical h eh ld, and
c m a e he al e f a ba ke f g d and e ice in ne ea i h he al e f he ame ba ke in
a ba e ea . Infla i n (and defla i n) a e mea ed a a e cen age change in he al e f he ba ke
f m ne ea an he . A i i e e cen age change indica e infla i n. A nega i e e cen age
change indica e defla i n.
Constructing a weighted price inde (HL onl )

We ill c n c a c n me ice inde (CPI) f a im le ec n m he e c n me icall
c n me h ee g d and e ice : b ge , m ie icke and hai c , h n in c l mn 1 f Table
10.1. C l mn 2 gi e he an i ie f each ha he ical h eh ld b in a ea ; he e a e he
eights. N e ha a weighted price inde i a ice inde ha eigh he a i g d and
e ice acc ding hei ela i e im 7
ance in c n me ending. T c n c a CPI, e f ll
he e e :
1 Decide hich f he ea ill be he ba e ea ; e ch e 2017.
2 U e he ice f each g d and e ice in he ba e ea (2017), calc la e i ba e ea al e
(m l i l an i in c l mn 2 b 2017 ice in c l mn 3); he e al e a ea in c l mn 4.
3 Add all al e in c l mn 4 ge he al al e f he ba ke in he ba e ea ; hi i $756,
a ea ing a he b m f c l mn 4.
4 U e he ice f each g d and e ice in 2018 calc la e i 2018 al e (m l i l he n mbe
f ni in he ba ke (c l mn 2) b 2018 ice (c l mn 5)); hen d he ame ing 2019 ice
(c l mn 7); he e l ing al e a ea in c l mn 6 f 2018 and c l mn 8 f 2019.
Add he al e in c l mn 6 b ain he al al e f he ba ke in 2018; hi i $798
5 a ea ing a he b m f c l mn 6; d he ame find he al e f he ba ke in 2019, hich
i $900, a ea ing a he b m f c l mn 8.
We n ha e all he inf ma i n e need c n c ice inde f 2017, 2018 and 2019. N e
ha :
price inde for a specific ear

= al e f ba ke in a ecific ea al e f ame ba ke in ba e ea 100
The ef e, he ice inde n mbe f 2017, 2018 and 2019 a e:
ice inde f 2017= 756 756 100=1.00 100 = 100.0
ice inde f 2018= 798 756 100=1.055 100 = 105.0
ice inde f 2019= 900 756 100=1.190 100 = 119.0
N e ha he ice inde f he ba e ea i al a e al 100.
1 2 3 4 5 6 7 8
Good Quantit Prices of Value of Prices of Value of Prices of Value of
and (number basket basket basket basket basket basket
services of units) goods goods goods goods goods goods
in basket and and and and and and
(weights) services services services services services services
in base in base in 2018 in 2018 in 2019 in 2019
ear ear
(2017) (2017)
Burgers 37 $3 $111 $4 $148 $5 $185
Movie 25 $15 $375 $14 $350 $16 $400

tickets
Haircuts 15 $18 $270 $20 $300 $21 $315
Total $756 $798 $900

value of
basket
Table 10.1: C n c ing a h he ical ice inde
T c n c a eigh ed ice inde , (i) find he al e f he ba ke in c en ice f each ea ;

(ii) di ide he al e f he ba ke f each ea b he al e f he ba ke in he ba e ea and
m l i l b 100. Thi ill gi e he ice inde n mbe f each ea .
In he eal ld, calc la i n f ice indice a e c m lica ed a he in l e c llec ing ice da a n

h and f g d and e ice and ca ing all nece a c m a i n . Thi i d ne b
eciali ed a i ical e ice in e e c n .
Using a weighted price inde (the CPI) to calculate the rate of

inflation
A ice inde can be ed calc la e he a e f infla i n. S e e a e gi en he f ll ing ice
inde (i i ac all he ne calc la ed ab e f HL). The hi d al h he al e f he ba ke
f each f he ea .
Year 2017 2018 2019
C n me ice inde 100.0 105.5 119.0
Val e f ba ke $756 $798 $900
The a e f infla i n i he e cen age change in he ice inde . I i al gi en b he e cen age change
in he al e f he ba ke . (Thi f ll f m he fac ha he ice inde i calc la ed f m he al e f
he ba ke .) The e cen age change in a a iable A i calc la ed b he f ll ing:
% change in A= final al e f A ini ial al e f A ini ial al e f A 100
(See Q an i a i e echni e cha e in he 'Digi al c eb k: E a ma e ial' ec i n f m e
inf ma i n.)
T calc la e he e cen age change in he ice le el f m 2017 2018, e ha e he e cen age change
in ice inde f m 2017 2018:
= 105.5 100.0 100.0 100=5.5%
In fac , e did n need d hi calc la i n: e can im l ead he infla i n a e f m he ice inde ,
ince 105.5 100.0 = 5.5%.
When he ice le el i e en ed a a ice inde , he a e f infla i n i e al he inde n mbe f

an ea min he inde n mbe f he ba e ea ( hich i al a 100).
The ef e, i f ll ha he a e f infla i n in he e i d 2017 2019 i 119.0 100.0 = 19.0%.

H e e , i i nl ible ead ff he a e f infla i n f m a ice inde in hi im le a in h e
ca e in l ing a e cen age change in he ice le el relati e to the base ear, h e ice inde
n mbe i e al 100.8 In he ca e , e m e he f m la ab e calc la e he a e f infla i n.
F e am le, find he a e f infla i n in 2018 2019:
% change in ice inde in 2018 2019
= 119.0 105.0 105.0 100=12.8%
We c ld ha e f nd he ame a e f infla i n b calc la ing he e cen age change in he al e f he
ba ke :
% change in al e f he ba ke in 2017 2018
= 798 756 756 100=5.5%
% change in al e f he ba ke in 2018 2019
= 900 798 798 100=12.8% . We can ee ha he e e cen age a e he ame a h e calc la ed b
e f he c n me ice inde .
N e ha a ice inde i h inc ea ing al e e ime ( ch a he e am le ab e) indica e infla i n.
Dec ea ing al e e ime indica e defla i n. Al , n e ha he fi ea in a ice inde need n be
he ba e ea . F e am le, e e ha e he f ll ing ice inde :
2000 2001 2002 2003 2004

97.5 100.0 107.3 109.7 107.8
The ba e ea i 2001, f hich he ice inde i 100. Thi ice inde indica e ha infla i n ha
cc ed in 2000 2001, 2001 2002, and 2002 2003, b deflation ha cc ed in 2003 2004.
Calculating real income (Supplementar material)

In Cha e 8, e lea ned h calc la e eal GDP f m n minal GDP ing he GDP defla . We can
n e he CPI calc la e eal inc me ( f c n me , en i ne , he cial g ):
eal inc me = n minal inc me CPI 100
Clea l , if n minal inc me inc ea e b he ame e cen age a he ice le el (mea ed b he CPI),
eal inc me emain nchanged. The CPI i , in fac , e ef l f calc la ing adj men ha m be
made n minal inc me ( f age-ea ne , en i ne , e c.) in de f he e g main ain a
c n an inc ea ing eal inc me.
A word of caution
Since he CPI c m a e ice le el ba ed n g d and e ice in a ecific ba ke , i nl make
en e calc la e infla i n a e f m a ice inde c n c ed b e f he ame ba ke . F he , i i
n ible make c m a i n f ice le el (i.e. calc la e a e f infla i n) ac ea b e f
ice indice ha ha e a diffe en ba e ea , e en if he ba ke f g d and e ice i he ame.
The ef e, f c m a i n f inde n mbe be meaningf l, he inde n mbe m be calc la ed
ing he ame ba e ea , and f he ame ba ke f g d and e ice .
Comparing the CPI with the GDP deflator (Supplementar

material)
If ld like lea n ab he diffe ence be een he CPI and he GDP defla , an he ice
inde e di c ed in Cha e 8, ma ead ab hi in he 'Digi al c eb k: E a ma e ial'
ec i n.

1 De c ibe he meaning f he c n me ice inde (CPI) and e lain he ef hich i i
c n c ed.
2 a Di ing i h be een infla i n, defla i n and di infla i n, and ide n me ical e am le
ill a ing each f he e.
b E lain, ing e am le , he diffe ence be een an inc ea e in he ice le el and an
inc ea e in he a e f infla i n.
3 C n ide he f ll ing ice inde ihc e nding al e f he ba ke f he e i d 2014-
2018:
Year 2014 2015 2016 2017 2018

CPI 97 95 100 105 107
a Iden if he ba e ea .
b Calc la e he a e f infla i n in he e i d 2016 2017, and 2016 2018 i h ing he
e cen age change f m la.
c Calc la e he a e f infla i n/defla i n in 2014 2015, 2015 2016, and 2017 2018 ing he
CPI.
d Iden if he e i d f ime hen defla i n cc ed.
e O line he he di infla i n cc ed a an ime.
4 O line h i i im an e eigh f he g d and e ice c n med b he ical
h eh ld.
5 (HL nl ) U ing he da a f m he able,
a c n c a c n me ice inde ing 2016 a he ba e ea .
b Iden if he eigh ae ing.
c Calc la e he a e f infla i n/defla i n f he ea 2015 2016, 2016 2017, 2017 2018.
d Iden if he ea hen infla i n/defla i n/di infla i n cc ed, and e lain
c ncl i n .
e C n c a ne ice inde ing 2017 a he ba e ea .
f Calc la e he a e f infla i n/defla i n f he ame h ee- ea e i d a in e i n (c).
g C m a e he a e f infla i n/defla i n f nd ing he ice indice ( he h ld
be he ame!).
h E lain he he n i ld i make en e c m a e an inde n mbe f m he fi
ice inde i h an inde n mbe f m he ec nd ice inde .
Good/ Quantit in Price per Price per Price per Price per
service basket unit in 2015 unit in 2016 unit in 2017 unit in 2018
( ) ( ) ( ) ( )
Pi a 25 7 6 7 6
M ie icke 9 15 17 18 18
B ide 47 2 4 4 3
Problems with the consumer price inde (CPI)

Different rates of inflation for different income earners. The a e f infla i n calc la ed b e
f he CPI eflec he change in a e age ice f g d and e ice incl ded in he ba ke .
H e e , diffe en c n me ha e diffe en c n m i n a e n de ending n hei inc me
le el , and he e ma diffe f m ha i incl ded in he ba ke . Thi mean he face diffe en a e
f infla i n han ha i calc la ed n he ba i f he CPI ba ke .
Different rates of inflation depending on regional or cultural factors. E ac l he ame idea a
ab e a lie c n me g h e cha e diffe f m he ical h eh ld
c n m i n a e n , beca e f a ia i n in a e d e c l al and egi nal fac .
Changes in consumption patterns due to consumer substitutions when relative prices change.
Each g d and e ice incl ded in he ba ke i eigh ed (m l i lied b he n mbe f ni f he
g d e ice cha ed b he ical h eh ld e a ea ). H e e , a me g d and
e ice bec me chea e m e e en i e e ime, c n me make b i i n , b ing m e
ni f he chea e g d and le f he m e e en i e ne . Thi e l in changing eigh ,
b beca e he eigh in he ba ke a e fi ed, he change in c n m i n a e n cann be
acc n ed f in he CPI. The ef e, he CPI gi e a mi leading im e i n f he deg ee f
infla i n, all e a ing i .
Changes in consumption patterns due to increasing use of discount stores and sales. In man
c n ie , c n me inc ea ingl make e f di c n e and ale , h b ing me g d
and e ice a l e ice han h e ed in CPI calc la i n . Thi i an he ea n h he CPI
end e a e infla i n.
Changes in consumption patterns due to introduction of new products. In hi ca e, , a fi ed
ba ke f g d and e ice cann acc n f ne d c in d ced in he ma ke , a ell a
lde d c ha bec me le la a e i hd a n (c n ide f e am le he e lacemen f
DVD b n-demand e ice ch a Ne fli ).
Changes in product qualit . The CPI cann acc n f ali change e ime.
International comparisons. The CPI f diffe en c n ie diffe f m each he i h e ec
he e f g d and e ice incl ded in he ba ke , he eigh ed and me h d f calc la i n.
Thi limi he c m a abili f CPI and infla i n a e f m c n c n . T add e hi
blem, he E ean Uni n (EU) ha de i ed a Ha m ni ed Inde f C n me P ice (HICP).
The HICP de e mine c n i en and c m a ible le ha m be f ll ed b EU c n ie in
de calc la e CPI ha a e c n i en i h each he . 9
Comparabilit over time. Vi all all c n ie a nd he ld e i dicall e i e hei CPI

ba ke and change he ba e ea ( all ab e e en ea ) deal i h man f he
blem n ed ab e. In man c n ie he eigh f g d and e ice a e changed a f en a
e e ea . Thi mean ha he ea ice inde n mbe a e c m a able e h e i d f ime,
e l nge e i d c m a abili i le ened beca e f c m la i e change in he ba ke f g d
and e ice .
The core rate of inflation (Supplementar material)

The e a e ce ain g d , n abl f d and ene g d c ( ch a il) ha ha e highl la ile ice
(meaning he fl c a e idel e h e i d f ime). Rea n f ice la ili incl de ide
ing in l demand, ca ing la ge and ab ice change . When ch g d a e incl ded in
he CPI, he ma gi e i e mi leading im e i n ega ding he a e f infla i n. T deal i h hi
blem, ec n mi mea e a core rate of inflation, hich all i d ne b c n c ing a CPI ha
d e n incl de f d and ene g d c i h highl la ile ice .

1 E lain h he CPI ma n be an acc a e mea e f he a e f infla i n.
2 (O i nal) De c ibe he meaning f a c e a e f infla i n and h hi i calc la ed.
Causes of inflation
We ill e amine ca e f infla i n: demand- ll infla i n and c - h infla i n.
Demand-pull inflation
Demand- ll infla i n i ca ed b inc ea e in agg ega e demand, in n b gh ab b change in
an f he de e minan f agg ega e demand ( ee Cha e 9, Sec i n 9.1). A me he ec n m i
ini iall a f ll em l men e ilib i m, d cing en ial GDP, h n a Y in Fig e 10.5(a) and (b).
The ec n m e e ience an inc ea e in agg ega e demand a ea ing a a igh a d hif f he AD
c e f m AD1 AD2 in b h diag am . The im ac n he ec n m i inc ea e he ice le el f m
Pl1 Pl2, and inc ea e he e ilib i m le el f eal GDP f m Y Yinfl. The inc ea e in he ice
le el f m Pl1 Pl2 d e he inc ea e in agg ega e demand i kn n a demand- ll infla i n.
Figure 10.5: Demand- ll infla i n
N e ha demand- ll infla i n i a cia ed i h an infla i na ga : eal GDP i g ea e han f ll

em l men GDP, and nem l men fall a le el bel he na al a e f nem l men . The
demand f lab i la ge ha me ke h ae c all , f ic i nall ea nall
nem l ed em a il find j b .
Demand-pull inflation in l e an e ce f agg ega e demand e aggregate suppl a he f ll
em l men le el f , and i ca ed b an inc ea e in agg ega e demand. I i h n in he AD-
AS m del a a igh a d hif in he AD c e.
Cost-push inflation
C - h infla i n i ca ed b inc ea e in c f d ci n l - ide h ck . A me he
ec n m i ini iall a he f ll em l men le el f , Y in Fig e 10.6, and e he e i an
inc ea e in c f d c i n. The SRAS c e hif f m SRAS1 SRAS2, leading an inc ea e in
he ice le el f m Pl1 Pl2, and a fall in he e ilib i m le el f eal GDP f m Y Y ec. The
inc ea e in he ice le el d e he fall in SRAS i kn n a c - h infla i n.
C - h infla i n i anal ed nl b mean f he m ne a i /ne cla ical AD-AS m del. The
Ke ne ian m del i n e i ed deal i h h - e m fl c a i n f agg ega e l . Ke ne a
c nce ned i h h ing he im ance f aggregate demand in ca ing h - e m fl c a i n . The
le el Y ec, h gh indica ing a ece i n, i n called a ece i na /defla i na ga , beca e
ga ( he he ece i na infla i na ) can nl be ca ed b li le m ch agg ega e
demand ( ee Cha e 9, f n e 4).
Figure 10.6: C - h infla i n
In Cha e 9, e a ha a dec ea e in SRAS e a ecial e f blem beca e i lead b h

infla i n and a fall in eal GDP ( i h m e nem l men ; ee Sec i n 9.3). The e ence f b h
infla i n and nem l men i called stagflation, a c mbina i n f he d agna i n and
infla i n . Thi h ld be c n a ed i h an inc ea e in agg ega e demand leading demand- ll
infla i n, hich e l in a highe ice le el b an increase in eal GDP ( i h le nem l men ).
C - h infla i n, agfla i n, i m e diffic l deal i h effec i el , a e ill di c e in
Cha e 13.
Cost-push inflation i ca ed b a fall in agg ega e l , in n e l ing f m inc ea e in age
ice f he in , h n in he AD-AS m del a lef a d hif f he AS c e.

1 U ing a ia e diag am , e lain he diffe ence be een demand- ll and c - h infla i n.
2 O line h c - h infla i n i en iall m e e i han demand- ll infla i n,
3 U ing diag am , h he effec n he ice le el f he f ll ing e en , and e lain he he
i i c - h demand- ll infla i n.
a Real GDP in f eign c n ie ha ade i h c n inc ea e , leading inc ea ed
demand f c n e .
b B ine e a e imi ic ha a ece i n i ab end, and inc ea e in e men
ending.
c An inc ea e in h ing ice make c n me inc ea e hei c n m i n e endi e.
d A dden inc ea e in he ice f il, a ke in in d c i n, cc .

Rising inflation in Pakistan
The c n me ice inde in Paki an ha nea l i led in he c e f ne ea , i ing f m 3.2% in
Ma ch 2018 9.4% a ea la e , eaching he highe infla i n a e in e en ea . Thi ha been he
e l f a mi f demand- ll and c - h fac . The c e a e f infla i n, hich e cl de f d
and ene g ice , i nl ligh l l e a 8.5%. Inc ea e in ene g ice and i ing c f
d c i n, ha e been e n ible f c - h infla i n. Demand ll infla i n ha been he e l f
inc ea ing demand, i elf he e l f an inc ea e in he l f m ne . I i e ec ed ha infla i n
ill n i e f he d ble digi .
Source: Business Recorder
Figure 10.7: Ka achi, Paki an. Em e Ma ke B ilding, nded b n me ma ke and
h
Appl ing our skills

1 E lain he meaning and e f he
a c n me ice inde (CPI),
b c e infla i n a e.
2 U ing diag am , e lain ha fac ha e e l ed in c - h and demand- ll infla i n in
Paki an.
Costs of a high rate of inflation

Infla i n, and e eciall a high a e f infla i n, e blem f an ec n m , beca e i affec
a ic la la i n g e eciall ngl , a ell a he ec n m a a h le.
The relationship between inflation, purchasing power and
nominal and real income
T nde and h blem can a i e, le c n ide he ela i n hi be een infla i n and cha ing
e , and n minal and eal inc me. P cha ing e efe he an i f g d and e ice ha
can be b gh i h m ne . Imagine ha e 60 end n hi . Y can hink f hi a
n minal inc me . When he ice i 20 e hi , can b h ee hi . If he ice inc ea e 30
e hi , can nl b hi . Y m ne , n minal inc me f 60 ha n changed, e
he cha ing e f he 60, ha hi m ne can b , ha fallen d e he inc ea e in ice.
Real inc me i he ame a cha ing e ;i efe ha m ne can b : i dec ea e a
ice i e, and inc ea e a ice fall.
Change in eal inc me, m ne inc me and he gene al ice le el a e ela ed each he in he
f ll ing a :
% change in eal inc me ( cha ing e ) = % change in n minal inc me % change in he
ice le el ( he a e f infla i n)
The e ela i n hi ill a e me im an in . Infla i n lead a fall in eal inc me,
cha ing e , nl if n minal inc me i c n an , if n minal inc me inc ea e m e l l han
he ice le el. Sa he e i a 5% inc ea e in he ice le el, hich i a 5% a e f infla i n. H ill
eal inc me be affec ed? If n minal inc me al inc ea e b 5%, eal inc me,
cha ing e , emain nchanged. The ef e, f , infla i n i n a blem. If, h e e ,
n minal inc me emain c n an inc ea e b le han 5%, eal inc me fall , and ill be
e ff ince he cha ing e f inc me i ed ced.
Costs of inflation
Redistribution effects
Infla i n edi ib e inc me a a f m ce ain g in he ec n m and a d he g .
Redi ib i n a i e in i a i n he e ce ain g l e me cha ing e and bec me e
ff, hile he g gain cha ing e and bec me be e ff. G h l e f m infla i n
incl de:
People who receive fi ed incomes or wages. When indi id al ecei e an inc me age ha i
fi ed c n an , a he gene al ice le el inc ea e he bec me e ff. Thi cc hen:
ke ha e age c n ac fi ing hei age e a e i d f ime
en i ne ecei e fi ed en i n
landl d ecei e fi ed en al inc me
indi id al ecei e fi ed elfa e a men .
People who receive incomes or wages that increase less rapidl than the rate of inflation.
When indi id al inc me d n kee i h a i ing ice le el (d n inc ea e a fa a he
ice le el), a fall in hei eal inc me e l and he he ef e bec me e ff. The e g
ma incl de all h e n ed ab e l an he kind f inc me ecei e h e inc me i n
inc ea ing a a idl a he ice le el.
Holders of cash. A he ice le el inc ea e , he eal al e cha ing e f an ca h held
fall .
Savers. Pe le h a e m ne ma bec me e ff a a e l f infla i n. In de main ain
he eal al e f hei a ing , a e m ecei e a a e f in e e ha i a lea e al he a e
f infla i n. S e de i $1000 in a bank acc n ha a n in e e . If he e i
infla i n, he eal al e f a ing ill fall. H e e , ma be able ec he
cha ing e f a ing . Sa he a e f infla i n i 5% e ea . If ecei e in e e n
de i a he a e f 5% e ea , ha ill l e h gh infla i n ill be e ac l ma ched
b ha gain h gh in e e inc me. In hi ca e, he eal al e ( cha ing e) f
a ing emain naffec ed. In gene al, a e h ecei e a a e f in e e n hei a ing l e
han he a e f infla i n ffe a fall in he eal al e ( cha ing e ) f hei a ing .
Lenders (creditors). Pe le ( financial in i i n ch a bank ) h lend m ne ma be e
ff d e infla i n. A me lend f iend 100 f ne ea (and d n cha ge
in e e ). If in he c e f he ea he e i an inc ea e in he ice le el (infla i n), he eal al e
f he 100 ill ge back f m f iend a he end f he ea ill ha e fallen. If cha ged
f iend a a e f in e e e al he a e f infla i n, hen he eal al e f l an
f iend ill be e ac l main ained. In gene al, lending a a l e in e e a e han he a e f
infla i n make he lende (c edi ) e ff a he end f he l an e i d.
G h gain f m infla i n incl de:
Borrowers (debtors). In he e am le ab e, f iend h b ed 100 f m benefi
ince he 100 aid back af e ne ea i h le han ne ea ag . If had cha ged in e e ,
f iend ( he b e) ld benefi a l ng a he a e f in e e i l e han he a e f
infla i n. In gene al, b ing a a l e in e e a e han he a e f infla i n make he b e
(deb ) be e ff a he end f he l an e i d.
Pa ers of fi ed incomes or wages. A l ng a n minal age , en i n , en , elfa e a men ,
e c., a e fi ed hile he e i infla i n, he a e ( he he he a e fi m , he g e nmen , a e f
en , e c.) benefi a he eal al e f hei a men fall d e infla i n.
Pa ers of incomes or wages that increase less rapidl than the rate of inflation. A l ng a
inc me f an kind inc ea e le a idl han he a e f infla i n, he a e f he e inc me
benefi d e he falling eal al e f hei a men .
Uncertaint
Inabili acc a el edic ha infla i n ill be in he f e mean ha e le cann edic f e
change in cha ing e ( f inc me, eal h, l an and an hing el e ha i mea ed in e m f
m ne ). Thi ca e nce ain am ng ec n mic deci i n-make . Fi m , in a ic la , bec me m e
ca i ab making f e lan nde nce ain ab f e ice le el , beca e he a e nable
make acc a e f eca fc and e en e . Thei nce ain lead hem make fe e
in e men , hich ma lead l e ec n mic g h.
Effects on saving
We a ab e ha hen he e i infla i n, a e l e if he ecei e n in e e n hei a ing if he
a e f in e e n hei a ing i l e han he a e f infla i n. The ef e, infla i n l e he
incen i e a e. F he , if he a e f infla i n i high, e le ma end m e n in de a id
highe ice in he f e, in hich ca e he effec ma be f he l e a ing.
International (e port) competitiveness

When he ice le el in a c n inc ea e m e a idl han he ice le el in he c n ie i h
hich i ade , i e bec me m e e en i e f eign b e , hile im bec me chea e
d me ic b e . The c n in e na i nal c m e i i ene , i abili c m e e i h f eign
c n ie , i ed ced. The e l i ha he an i fe fall , and he an i f im
inc ea e . Thi in n ma c ea e diffic l ie f he c n balance f a men ( ee Cha e 16).
Effects on economic growth

High infla i n d e n fa ec n mic g h. A e ha e een ab e, am ng he c n e ence f
infla i n a e nce ain am ng fi m , hich ca e in e men fall; in addi i n l e a ing mean
ha he e a e le f nd a ailable f in e men . The e fac lead d in in e men , hich i
a c m nen f agg ega e demand, he ef e a fall in agg ega e demand. M e e , e ha e al een
ha infla i n lead l e e and highe im , b h c n ib ing a fall in ne e , hich
al ca e a fall in agg ega e demand. Falling agg ega e demand lead l e eal GDP.
Effects on resource allocation
A e di c ed in Cha e 2, he ice mechani m la an im an le in e ce all ca i n. If
ice a e i ing a idl , he ignalling and incen i e f nc i n d n k effec i el . The ea n i ha
ice d n inc ea e in he ame i n f all d c , he i e m e f me d c han f
he , meaning ha he ignal and incen i e he ide f c n me and d ce bec me
di ed and he ef e inacc a e. The e l i ha all ca i e inefficienc i inc ea ed.
Social and personal costs that are unequall distributed

In ie f he edi ib i n effec f infla i n, e ha e een ha e le n fi ed inc me ffe l e
a hei inc me l e i cha ing e . Thi f en incl de en i ne , nem l ed e le ecei ing
nem l men benefi , and al ke h e age a e ei he fi ed d n i e a fa a he a e
f infla i n. In addi i n, e le n l inc me a e n in ii n lace hei a ing in a e ha d
n l e hei al e i h infla i n, ch a eal e a e, ck in he ck ma ke , g ld e en je elle .
F he , i ing ice f nece i ie ch a f d and ene g needed f hea ing can c dee l in he
inc me f l e inc me e le. The ef e i i likel ha e le n l inc me a e m e e i l
affec ed b high a e f infla i n han e le n highe inc me .
Consequences of h perinflation
H e infla i n c n i f e high a e f infla i n. I i defined a cc ing hen he ice le el
inc ea e b m e han 50% e m n h, h gh i can each h and e en milli n f e cen age
in e ea . One f he m d ama ic h e infla i n in hi cc ed in Ge man af e he Fi
W ld Wa , hen he ice le el in 1924 a m e han 100 illi n ime highe han in 1914. In m e
ecen ea , man h e infla i n ha e been c ncen a ed in La in Ame ica f m he mid-1980 he
ea l 1990 , and in ea e n E ean and f me S ie Uni n c n ie in he ea l 1990 f ll ing he
c lla e f he S ie Uni n. Peak ann al a e f infla i n came ab 7500% in Pe in 1990;
3080% in A gen ina in 1989; 2950% in B a il in 1990; 1735% in R ia in 1992; 4735% in Uk aine in
1995; and 1060% in B lga ia in 1997. One f he m ei ca e f h e infla i n cc ed in
Zimbab e, he e he a e f infla i n en f m e 1000% in 2006, 12 000% in 2007, and e
11 milli n % ( n an ann al ba i ) in he mme f 2008. In Vene ela in 2018 infla i n a an
e ima ed 80 000%.
H e infla i n e l f m e ignifican inc ea e in he l f m ne , hich im ac di ec l n
he ice le el. H e infla i n cc hen g e nmen e in ing m ne , he eb inc ea ing i
l .
H e infla i n ha e i nega i e c n e ence , e and ab e h e di c ed ab e, beca e
m ne l e i al e e a idl . C n me inc ea e hei ending benefi f m he c en ice
bef e he inc ea e in he f e, he eb feeding agg ega e demand, hich ca e demand- ll
infla i n. W ke demand highe n minal age main ain he eal al e f hei c en and f e
inc me , he eb feeding c - h infla i n. The ef e, an inflationar spiral i c ea ed (a ce
he e infla i n e in m i n a e ie f e en ha en he infla i n).
Se i h e infla i n e l in a ma i e di i n f ec n mic ac i i : b ine e in e ing in
d c i e ac i i ie and in e in ead in a e ha a e belie ed main ain hei al e a ice i e
(g ld, eal e a e je el ); fi m al i hh ld g d f m ale in he ma ke ha he can ell hem
la e a highe ice ; lende (c edi ) ffe ma i e l e a he eal al e f deb fall
d ama icall . A he e eme, m ne l e i al e al ge he and e le e ba e ( he di ec
e change f g d e ice , elimina ing he need f m ne ), hich in i elf make d c i n and
e change e emel diffic l . Se i h e infla i n can al lead li ical and cial n e .
What is an appropriate rate of inflation?

M g e nmen efe a lo and stable rate of inflation, n a e a e f infla i n. The ea n h a
e a e f infla i n, meaning a c n an ice le el, i n efe ed i ha hi c me dange l cl e
defla i n, hich a e ill ee bel can ca e e i blem f an ec n m .
The e i n ne a ic la a e f infla i n ha i ideal, b man g e nmen ld like ee hi in
he ange f ab 2 3% e ea . Le han 2% migh be c n ide ed a c ming cl e defla i n; m e
han 4% i een a being high.

1 U ing a n me ical e am le, e lain he ela i n hi be een infla i n and cha ing e.
2 E lain ha ha en eal inc me ( cha ing e ) in each f he f ll ing
i ai n :
a n minal inc me inc ea e b 5% and he a e f infla i n i 8%,
b n minal inc me fall b 10%, and he a e f infla i n i 3%, and
c n minal inc me inc ea e b 7% and he a e f infla i n i 7%.
3 a Infla i n e l in edi ib i n f cha ing e . E lain h i likel gain and
h i likel l e f m he edi ib i n effec f infla i n.
b Iden if and e lain me he nega i e c n e ence f infla i n ( he han
edi ib i n).
Causes of deflation
Wh deflation occurs rarel in the real world

Defla i n, a falling ice le el n a e age, i n a c mm n hen men n. Whe ea i i f en he ca e
ha he ice f a a ic la g d e ice ma fall e ime, i i a e ee he gene al ice le el f
an ec n m falling. The e a e e e al fac ha acc n f hi :
Wages of workers do not ordinaril fall. Thi mean i i diffic l f fi m l e he ice f
hei d c , a hi ld c in hei fi , e eciall ince age e e en a la ge
i n f fi m c f d c i n. The e a e e e al ea n h age d n fall ea il
(lab c n ac , minim m age legi la i n, ke and ni n e i ance age c , idea f
fai ne , fea f nega i e im ac n ke m ale, e c.)
Large oligopolistic firms ma fear price wars. If ne fi m l e i ice, hen he ma l e
hei m e agg e i el in an eff ca e ma ke ha e, and hen all he fi m ill be e
ff. The ef e, fi m a id c ing hei ice .
Whe ea defla i n cc a el , i ha a ea ed e i dicall , f e am le in B i ain and he Uni ed
S a e in he la e 19 h cen , in he Uni ed S a e d ing he G ea De e i n f he 1930 (1933
1937), and in Ja an f m 1999 2006. In 2003 and again in 2008, he e e e e i c nce n in
E e and he Uni ed S a e ha defla i n migh cc . Defla i n i gene all fea ed m e han infla i n
f ea n e ill di c e bel .
Causes of deflation
We can make a di inc i n be een ca e f defla i n: dec ea e in agg ega e demand and
inc ea e in agg ega e l . The e can be een in Fig e 10.8.
In Fig e 10.8(a) a dec ea e in agg ega e demand (f e am le, d e b ine e imi m) ca e he
AD c e hif f m AD1 AD2. Whe ea he AD-AS m del edic a d in he ice le el,
defla i n, hi i nlikel cc e a h e i d f ime f he ea n di c ed ab e, acc n ing
f he highl inf e en cc ence f defla i n.10 H e e , if l agg ega e demand e i e a
l ng e i d, he ice le el fall Pl2. Thi i me ime efe ed a bad defla i n beca e i i
a cia ed i h ece i n, falling inc me and ince eal GDP fall f m Y1 Y2, and c clical
nem l men . The e a e he ci c m ance ha cha ac e i ed he defla i n f he G ea De e i n
d ing he 1930 and, m e ecen l , in Ja an.
Fig e 10.8(b) h a igh a d hif f he SRAS c e, i h he AD c e c n an , hich gi e i e
a ne in f e ilib i m ha cc a a l e ice le el. Thi i me ime efe ed a g d
defla i n beca e i i a cia ed i h ec n mic e an i n ince eal GDP inc ea e f m Y1 Y2,
i ing inc me and , inc ea ing em l men and ec n mic g h. S me ec n mi a g e ha i
a nde ch ci c m ance ha he defla i n f B i ain and he Uni ed S a e in he la e 19 h cen
cc ed.
H e e , i m be e ed ha hile i ma be ible make a he e ical di inc i n be een
g d and bad defla i n, no deflation is e er good. We ill di c e he ea n f hi in he
f ll ing age , he e e ill ee ha defla i n di c age ending, ca ing agg ega e demand
fall ega dle f he ca e f defla i n. Defla i n i he ef e c n ide ed b ec n mi be a g ea e
h ea han infla i n.
Figure 10.8: Ca e f defla i n
Costs of deflation
Redistribution effects
The edi ib i n effec f defla i n a e he i e f h e f infla i n: i h a falling ice le el,
indi id al n fi ed inc me , h lde f ca h, a e and lende (c edi ) all gain a he eal al e f
hei inc me h lding inc ea e . B c n a , b e (deb ) and a e f indi id al i h fi ed
inc me l e i h a falling ice le el, a he m a m ha ha e an inc ea ing eal al e.
Increase in the real value of debt
In ie f he ab e, he eal al e f deb inc ea e . If h ld $1000 and he ice le el fall , hi
mean ha he cha ing e f m ne inc ea e beca e can b m e hing i h ha
am n . In j he ame a if e hi $1000, i eal al e in e m f i cha ing e
inc ea e hen he ice le el fall .
Uncertaint
Defla i n, like infla i n, c ea e nce ain f fi m , hich a e nable f eca hei c and
e en e d e declining ice le el .
Deferred consumption, high and increasing c clical unemplo ment: risk of a

deflationar spiral
Deferred consumption mean ha c n me ne ending. C n me ne making
cha e hen he ee falling ice a he e ec ha ice ill c n in e fall. The ef e,
defla i n di c age ending. Defla i n al di c age b ing b b h c n me and fi m ,
beca e he eal al e f deb inc ea e a he ice le el fall . The e l i ha c n me and b ine
ending fall , ca ing agg ega e demand fall. Falling AD e l in l e eal GDP i h c clical
nem l men , and al ca e he ice le el fall f he . Thi in n gi e i e f he
nemen f ending, AD fall f he , nem l men inc ea e f he , inc me and ice fall
f he , defla i na e e inc ea e f he , and n in a d n a d i al. Thi i kn n a a
defla i na i al, h n in Fig e 10.9.
Risk of bankruptcies and a financial crisis

A e a ab e, defla i n e l in an inc ea e in he eal al e f deb . If he ec n m i in ece i n,
and inc me a e falling hile he eal al e f deb i inc ea ing, he e l ill m likel be
bank cie f fi m and c n me h a e nable a back hei deb . If ch bank cie
bec me ide ead, bank and financial in i i n ill be affec ed, and a la ge i k f a maj financial
cii aie.
Figure 10.9: Defla i na i al

Inefficient resource allocation
A e a ea lie , high a e f infla i n lead inefficien e ce all ca i n beca e he ignalling and
incen i e f nc i n f ice a e nable k effec i el . In defla i n, ice f all g d and e ice
d n fall nif ml , i h he e l ha he ice ignal and incen i e ge di ed, leading
e ce mi all ca i n.
Polic ineffectiveness
Once a defla i n e in, i ma be diffic l f lic make deal i h i . One ea n i ha hen
e le e ec a i n f a falling ice le el bec me ell e abli hed, and he ge ed ending le
in e ec a i n f falling ice , i ma be diffic l f hem change hei mind e . An he e
im an ea n i ha e an i na m ne a lic ( be di c ed in Cha e 13) ma bec me
ineffec i e. Thi m ne a lic in l e dec ea e in he a e f in e e in de enc age m e
b ing and ending b c n me and fi m , h e e nce in e e a e a ach e he cann
c n in e fall. The ef e, m ne a lic cann be elied n l e he blem.
Summing up deflation
High c clical nem l men , ge he i h he i k f a defla i na i al and a financial c i i , e eal
he ecial and en iall e i dange f defla i n. The e a e ened b he diffic l ie f finding
l i n he blem f defla i n.
Y can n ee h g e nmen efe a lo and stable rate of inflation, i h a a ge a e f a nd
2% e ea , hich i fficien l ab e e a n be cl e defla i n.
In addi i n, can ee h he di inc i n be een g d and bad defla i n i ac all meaningle ,
beca e nce defla i n e in i d e n ma e h i igina ed ince a defla i na i al ma e l
e en f m g d defla i n.
A positive effect of deflation

In i e f all he nega i e f defla i n, he e i ne i i e effec h men i ning. While infla i n
h in e na i nal c m e i i ene , defla i n b ing benefi . A l e ice le el mean ha e
ma inc ea e a f eigne n efe b ing f m he c n i h l e ice hile im ma fall
a d me ic c n me efe he l e - ice d me icall d ced g d . The ef e ne e (X
M) inc ea e, ing an ad e e n agg ega e demand and eal GDP. H e e , hi ii e
effec i n en gh c n e ac all he i k and dange f defla i n.

1 O line h defla i n cc a el in he eal ld.
2 E lain ha ha en eal inc me ( cha ing e ) in each f he f ll ing
i ai n :
a n minal inc me inc ea e b 5% and he a e f defla i n i 3%,
b n minal inc me fall b 10%, and he a e f defla i n i 2%, and
c n minal inc me fall b 3% and he a e f defla i n i 4%. (Y h ld hink f
defla i n a nega i e infla i n.)
3 U ing diag am , e lain ible ca e f defla i n.
4 a E lain me nega i e c n e ence f defla i n.
b E lain h defla i n ma be e eciall ei f an ec n m .
6 O line h a l ,b ab e e , a e f infla i n i de i able.
6 Thi in a ea a AO2 in he llab , h e e i bec me AO3 in he in en i led Rela i e c f
nem l men e infla i n c n ide ed la e in hi cha e .
7 In he eal ld, he eigh ed c n c he CPI a e ba ed n he i n f c n me ending n

each g d e ice n a e age, a he han n he an i f each g d e ice c n med.
8 N e ha e can nl e hi le f ea after he ba e ea and n bef e. F e am le, if he CPI i 92 in

2007 and 100 in 2008, e cann a he e i an 8% inc ea e in he ice le el in he e i d 2007 2008. T
c n ince elf, d he calc la i n. Y ill find ha he a e f infla i n i 8.7%.
9 The HICP d e n de e mine a nif m ba ke f all c n ie ( hi i d ne in ec gni i n f he in n ed

ab e ha diffe en egi n /c n ie ha e diffe en c n m i n a e n d e di e e a e , c l al fac
and inc me le el ). The HICP cceed a la ge e en in e l ing he c m a abili blem, and he ea i
i n in ended e lace na i nal CPI , i i ed in all ca e he e c m a i n ac c n ie need be
made. The HICP i calc la ed b all E ean Uni n c n ie l Iceland and N a . The fi ba e ea
be ed a 1996, and he inde began being calc la ed f m Jan a 1997.
10 The inf e en cc ence f defla i n ill be e lained b he a che effec , be di c ed in Cha e 13.
10.3 E
LEARNING OBJEC I ES

disc ss he rela i e cos s of nemplo men ers s infla ion (AO3)
disc ss he po en ial conflic be een lo nemplo men and lo infla ion (AO2)11
disc ss he rade-off be een nemplo men and infla ion: he shor -r n and long-r n Phillips
c r es (HL onl ) (AO3)
dra diagrams sing he AD-AS model and sho ing he shor -r n and long-r n Phillips c r es
(HL onl ) (AO4)
In Sec ions 10.1 and 10.2 abo e, e disco ered ha bo h nemplo men and infla ion ha e a n mber of
cos s. Yo sho ld be able o iden if ha hese are and disc ss hem.
D ring he 1970s, a ell-kno n U.S. economis , Ar h r Ok n, crea ed a miser inde hich consis s
of he s m of he nemplo men ra e and he infla ion ra e of a co n r . The higher he inde , he grea er
he miser of a pop la ion. Ho e er, he miser inde does no dis ing ish be een he separa e effec s
of nemplo men and infla ion on he ell-being, or lack of ell-being, of a pop la ion. Can e sa
an hing abo hich of he o con rib es more o miser , or has grea er cos s? From a p rel
economic perspec i e, i is diffic l o generalise abo hich of he o is less desirable, as his is likel
o depend on he par ic lar circ ms ances of he econom being considered, as ell as on ho high is
he nemplo men ers s ho high is he infla ion.
In addi ion o he economic cos s, e ha e seen ha bo h nemplo men and infla ion ha e personal and
social cos s, o er and abo e he economic ones. A n mber of s dies ha ha e e amined he effec s of
nemplo men ers s infla ion on ell-being concl de ha , be een he o, nemplo men has a
s ronger nega i e impac .
According o one s ch s d ha meas red he loss of ell-being, i as fo nd ha bo h nemplo men
and infla ion increase nhappiness.12 The s d as based on a er large E ropean da ase for he
period 1975 2013, hich incl ded periods of high infla ion as ell as periods of high nemplo men . I
as fo nd ha nemplo men increases nhappiness far more han infla ion. Specificall a i c ea e f
e e ce age i i em l me l e ell-bei g ea l i ime m e ha a e e ce age
i i c ea e i i fla i . Unemplo men lo ers he happiness of no onl he nemplo ed b also he
people aro nd hem, i h omen and he elderl being rela i el more affec ed.
This is perhaps hardl s rprising as he loss of a job leading o nemplo men and herefore loss of
income has po en iall er serio s financial, personal and social effec s on he nemplo ed indi id als
and heir families.
There are a n mber of po en ial conflic s be een macroeconomic objec i es, hich e ill s d in
Chap er 11. One of hese conflic s is be een he objec i es of lo nemplo men and lo infla ion.
This can be nders ood b se of he Ke nesian AD-AS model, sho n again in Fig re 10.10. When here
is a defla ionar gap and he econom is in recession s ch as a o p le el Y1 or Y2, he ra e of infla ion
is lo ( he price le el is cons an ) b here is high c clical nemplo men . As aggrega e demand
increases and he econom approaches po en ial o p , Yp, he price le el begins o rise hile c clical
nemplo men falls. As aggrega e demand con in es o increase, he price le el increases e en fas er,
hile nemplo men con in es o fall. If aggrega e demand increases f r her res l ing in an infla ionar
gap s ch as a Y4, nemplo men falls o a le el ha is e en lo er han he na ral ra e, since some of
he s r c rall , seasonall and fric ionall nemplo ed ill no find emplo men (see Fig re 10.4 for
an e plana ion).
The reason behind he increasing infla ionar press res is ha as aggrega e demand increases, reso rces
are sed more f ll , gi ing rise o bo lenecks ha res l in higher ages and o her reso rce prices. This
process gi es rise o higher prod c prices and hence a rising price le el.
F 10.10: Ke nesian model sho ing increasing price le el i h decreasing nemplo men
I can herefore be concl ded ha i ma be diffic l o achie e bo h a lo ra e of infla ion and a lo

nemplo men ra e a he same ime.
- (HL )
- P
The P is concerned i h he rela ionship be een nemplo men and infla ion. In he
la e 1950s, a Ne Zealand economis A.W. Phillips p blished a s d sho ing ha here appeared o
be a long- erm nega i e rela ionship be een he nemplo men ra e and he ra e of change in
nominal (mone ) ages; his rela ionship as la er e ended b economis s o appl o he
rela ionship be een nemplo men and infla ion. The rela ionship sho ed ha he lo er he ra e of
infla ion, he higher he nemplo men ra e; and he higher he ra e of infla ion, he lo er he
nemplo men ra e. This rela ionship is sho n in Fig re 10.11(a), here he nemplo men ra e is
meas red along he hori on al a is, and he ra e of infla ion along he er ical a is. (No e ha he
er ical a is does no meas re he price le el, as in he AD-AS model.)
The Phillips c r e s gges s ha if here is a cons an nega i e rela ionship be een he o ariables,
hen e er econom faces a rade-off be een infla ion and nemplo men : i can choose be een a
rela i el lo ra e of infla ion and a higher nemplo men ra e, s ch as poin a on he c r e, or a
higher ra e of infla ion and a lo er nemplo men ra e, s ch as poin d. Whereas, ideall , i o ld be
preferable for an econom o ha e lo infla ion and lo nemplo men , s ch as poin e, his is no
possible according o he heor of he Phillips c r e, as he onl achie able poin s are hose on (or
close o) he c r e.
The reasoning behind he shape of he c r e can be ill s ra ed b se of he AD-AS model, sho n in
Fig re 10.11(b). Ass me a fi ed, p ard-sloping SRAS c r e, and imagine a s ccession of aggrega e
demand increases ( hich co ld be ca sed b an of he fac ors e are familiar i h from Chap er 9
(Table 9.1)). As aggrega e demand shif s from AD1 o AD2, he price le el rises from Pl1 o Pl2, he
le el of real GDP increases from Y1 o Y2, and he le el of nemplo men correspondingl falls. The
same process is repea ed as aggrega e demand increases from AD2 o AD3, and hen o AD4, and so
on. Wi h e er increase in aggrega e demand, e ha e an increase in he price le el and a fall in
nemplo men . I follo s, hen, ha e can simpl hink of each poin on he Phillips c r e (s ch as
a, b, c or d) as corresponding o he poin of in ersec ion of SRAS i h a differen AD c r e (a, b, c or
d). The choice of here o be on he Phillips c r e in par (a) h s corresponds o a choice of AD
c r e in par (b) of he fig re.13
F 10.11: The shor -r n Phillips c r e
:
D ring he 1960s, man economis s came o belie e ha he Phillips c r e did offer he possibili of
choice be een infla ion and nemplo men . A ha ime aggrega e s ppl as rela i el s able, and
major changes in economic ac i i ere ca sed b s ings in aggrega e demand. Mos economis s a
he ime ere er s rongl infl enced b Ke nesian hinking, belie ing ha demand-side policies
(see Chap er 13) ere er impor an in infl encing he le el of economic ac i i and real GDP. The
Phillips c r e appeared o offer go ernmen s he possibili of sing demand-side policies o choose
be een ario s al erna i es. High aggrega e demand o ld lead o lo nemplo men and higher
infla ion, hile lo aggrega e demand o ld lead o higher nemplo men and lo er infla ion.
E en s of he 1970s and 1980s pse his line of hinking, and he s able rela ionship be een
infla ion and nemplo men ha as s gges ed b he Phillips c r e appeared o break do n.
Whereas i had been s pposed ha aggrega e s ppl co ld remain s able o er long periods of ime, a
n mber of aggrega e s ppl shocks led o a period of agfla i , a erm coined a he ime o refer o
he ne phenomenon of s agna ion (or recession) i h nemplo men and infla ion sim l aneo sl .
The mos impor an of he s ppl shocks in ol ed he oil price increases bro gh on b he ac ions of
OPEC (Organi a ion of he Pe role m E por ing Co n ries), hich res ric ed he global s ppl of oil.
Ano her s ppl shock in ol ed food price increases res l ing from orld ide crop fail res,
res ric ing he global s ppl of food.
The impac s of hese e en s on he Phillips c r e and on he SRAS c r e are sho n in Fig res
10.12(a) and (b). In par (b), e see ha as he s ppl shocks ca se he SRAS c r e o shif lef ard
from SRAS1 o SRAS2 and hen o SRAS3, he res l is higher price le els (from Pl1 o Pl2 and Pl3)
and lo er le els of GDP (from Y1 o Y2 and Y3), signif ing increases in nemplo men . In o her
ords, decreases in SRAS ( i h AD cons an ) res l in higher price le els and higher nemplo men .
This phenomenon is inconsis en i h he logic of he Phillips c r e, and as in erpre ed o in ol e
a d hif i he Philli c e, hich n il hen as ho gh o be s able and cons an . The
o ard Phillips c r e shif s appear in par (a), indica ing ha higher ra es of infla ion are associa ed
i h higher ra es of nemplo men ; he mo e from poin a o b and c in par (a) correspond o poin s
a, b and c in par (b).
F 10.12: S agfla ion: o ard shif s of he shor -r n Phillips c r e d e o decreasing SRAS
- P
In he la e 1970s, he Nobel Pri e- inning, mone aris economis Mil on Friedman a acked he idea
of a s able nega i e rela ionship be een infla ion and nemplo men , and arg ed ha here is onl a
emporar rade-off be een infla ion and nemplo men , no a permanen one. Friedman made a
dis inc ion be een a shor -r n Phillips c r e and a long-r n Phillips c r e.
The shor -r n Phillips c r e is ha e ha e considered in Fig re 10.11(a), hich e can see once
again in Fig re 10.13(a), represen ed b SRPC1 and SRPC2. According o Mil on Friedman, in he
long r n, his nega i e rela ionship no longer holds. Ins ead, he long-r n Phillips c r e is er ical a
he le el of f ll emplo men , or here nemplo men eq als he a al a e f em l me . (In
fac , he na ral ra e of nemplo men is a concep firs in rod ced b Mil on Friedman.) The long-
r n Phillips c r e is LRPC in Fig re 10.13(a).
Wh is he long-r n Phillips c r e er ical a he econom s na ral ra e of nemplo men ? The
ans er is q i e simple: i is so for he same reasons ha he LRAS c r e is er ical a he le el of real
GDP corresponding o he na ral ra e of nemplo men ( his as e plained in Chap er 9, Sec ion
9.3). Consider Fig re 10.13, and s ppose he econom is ini iall a poin a in bo h par s. (No e ha
Fig re 10.13(b) is he same as Fig re 9.8(b) in Chap er 9.) In par (b), poin a indica es ha he
econom is a a poin of long-r n eq ilibri m on AD1, SRAS1 and he LRAS c r e, i h real GDP
eq al o po en ial GDP sho n b Yp. A Yp, nemplo men is eq al o he na ral ra e of
nemplo men , hich e ass me o be 5%. In par (a), poin a indica es ha he econom is on a
shor -r n Phillips c r e, SRPC1, here i is e periencing a ra e of infla ion of 5% and an
nemplo men ra e of 5%, or he na ral ra e of nemplo men .
F 10.13: The shor -r n and long-r n Phillips c r es
S ppose here occ rs an increase in aggrega e demand, so ha he AD c r e in par (b) shif s from
AD1 o AD2. In he shor r n he econom mo es o poin b on he SRAS1 c r e, corresponding o a
higher price le el, Pl2, increased real GDP, Yinfl, and lo er nemplo men ( nemplo men falls
belo he na ral ra e). This corresponds o poin b on he SRPC1 in par (a), here here is a higher
infla ion ra e of 7% and lo er nemplo men ra e a 3%.
The econom mo ed o poin b in he shor r n, beca se in he shor r n ages are cons an ; i h he
price le el increasing, firm profi abili increases, o p increases and nemplo men falls. B in
he long r n, poin b canno be a poin of eq ilibri m, beca se, as e kno from Chap er 9, ages
ill rise o mee he increases in he price le el, ca sing he SRAS c r e o shif lef ard from SRAS1
o SRAS2, here i in ersec s AD2 a a poin on he LRAS c r e, or poin c. Poin c in par (b) is
associa ed i h a higher price le el Pl3, b real GDP has fallen back o Yp, and he ra e of
nemplo men has re rned o he na ral ra e. In par (a), hese changes mean he econom has
mo ed o poin c, here he shor -r n Phillips c r e has shif ed o he righ o SRPC2 (remember,
hen he SRAS c r e shif s lef ard i h a cons an AD c r e, he SRPC c r e shif s righ ard, as
e sa in Fig re 10.12). A poin c, here is a higher ra e of infla ion, no s anding a 9%, and
nemplo men has climbed back p o 5%, or he na ral ra e. The er ical line connec ing a and c is
he long-r n Phillips c r e (LRPC), si a ed a he na ral ra e of nemplo men .14
Since he na ral ra e of nemplo men occ rs a long-r n eq ilibri m, i is also kno n as
e ilib i m em l me .
The shor -r n Phillips c r e is a ool preferred b Ke nesian economis s, ho see in his he
possibili of sing policies ha foc s on infl encing aggrega e demand o make choices abo he
ra e of infla ion and he ra e of nemplo men (and herefore he le el of real GDP). B con ras , he
long-r n Phillips c r e is an anal ical ool preferred b mone aris /ne classical economis s, ho
are highl skep ical abo he effec i eness of demand-side policies, and ho se i o sho ha
e pansionar demand-side policies are more likel o res l in infla ion han o infl ence
nemplo men and real GDP. These economis s prefer policies ha foc s on infl encing aggrega e
s ppl . We ill come back o hese iss es in Chap er 13.
According o he - P in Fig re 10.11(a), here is a nega i e rela ionship
be een he ra e of infla ion and he nemplo men ra e, s gges ing ha in he shor r n polic -
makers can choose be een he compe ing al erna i es of lo infla ion or lo nemplo men b
sing policies ha affec aggrega e demand. The - P is er ical a he na ral
ra e of nemplo men , indica ing ha nemplo men is independen of he ra e of infla ion, and
ha polic -makers do no ha e a choice be een he o compe ing al erna i es. In he long r n,
he onl impac of an increase in aggrega e demand is o increase he ra e of infla ion, hile he
le el of real o p and nemplo men remain nchanged a he na ral ra e of nemplo men .
- P
In he ears follo ing he global financial crisis, he shor -r n rela ionship be een infla ion and
nemplo men sho n in Fig re 10.11(a) came o be q es ioned again. Man economis s aro nd he
orld began o arg e ha his rela ionship has broken do n. The reason is ha hile nemplo men
has fallen o er lo le els, infla ion has no been increasing as he Phillips c r e o ld predic . A
n mber of arg men s ha e been p for ard r ing o e plain his. According o one, rising global
compe i ion makes i diffic l for firms o raise prices e en as nemplo men falls. According o
ano her, ages ha e no been rising in man economicall more de eloped co n ries, herefore here
has no been a s rong p ard press re on prices. Reasons h ages ha e no been rising incl de
di erse fac ors like he decline of labo r nions, echnolog , and globalisa ion. S ill o her economis s
arg e ha o er he pas se en decades hen he Phillips c r e began o be sed as a basis for polic ,
here ha e been se eral occasions hen he rela ionship be een infla ion and nemplo men became
ns able, as ho gh i ere aking a break from he normal pa ern; his co ld again be a emporar
break before he normal pa ern res mes again. A deba e has emerged, i h some economis s arg ing
ha here is no longer an Phillips c r e, hile o hers are s gges ing ha i is onl a ma er of ime
before he infla ion and nemplo men rela ionship raced o in Fig re 10.11(a) emerges once again.

1 E plain h here ma be a conflic be een he goals of lo nemplo men and lo
infla ion. (HL onl )
2 Using he concep of he shor -r n Phillips c r e and he AD-AS model, e plain h
man economis s d ring he 1960s considered ha polic -makers had a choice be een
lo infla ion and high nemplo men , or high infla ion and lo nemplo men .
Iden if he e en s of he 1970s and 1980s ha made economis s belie e ha he shor -
r n rela ionship be een infla ion and nemplo men as ns able (no fi ed and
permanen ).
E plain, sing diagrams and he concep of s agfla ion, he rela ionship be een shif s in
he SRAS c r e and he posi ion of he shor -r n Phillips c r e.
3 Using one or more diagrams, sho ho he long-r n Phillips c r e differs from he
shor -r n Phillips c r e.
O line ha he long-r n Phillips c r e ells s abo he rela ionship be een he ra e
of infla ion and he ra e of nemplo men in he long r n.
4 O line he rela ionship be een
he long-r n Phillips c r e and he na ral ra e of nemplo men , and
he long-r n Phillips c r e and he f ll emplo men le el of o p .
5 According o he heor of he Phillips c r e, e plain ha ill happen o he ra e of infla ion,
he ra e of nemplo men and real GDP if polic -makers a emp o increase aggrega e
demand in order o increase he le el of real GDP
in he shor r n, and
in he long r n.
6 Using an AD-AS diagram, e plain h he long-r n Phillips c r e is er ical.

C :
We re rn o he q es ion posed a he end of he Theor of kno ledge 10.1 earlier in his chap er:
ha is so impor an abo meas ring he na ral ra e of nemplo men ? In addi ion, ho ma he
choice of polic goals be affec ed b he general poli ical mood and ideolog of socie ies and heir
go ernmen s?
Based on he Phillips c r e anal sis, e can easil ans er he firs q es ion. If he ac al ra e of
nemplo men is abo e he na ral ra e, polic -makers can se demand-side policies o increase
aggrega e demand, i ho fearing infla ion. If, ho e er, ac al nemplo men is a or belo he
na ral ra e, an increase in aggrega e demand onl emporaril lo ers nemplo men , as his ill go
back o he na ral ra e once ages ha e adj s ed, onl a a higher price le el (see Fig re 10.13). In
he long r n, he increase in aggrega e demand onl crea es infla ion. Therefore, kno ing he na ral
ra e is impor an as a g ide o polic -makers.
Ho e er, if he na ral ra e changes of en, and canno e en be acc ra el es ima ed, here ma be
serio s do b s abo ho reliable i is as he basis for g iding polic . Ye , since he 1970s, Friedman s
hinking has been highl infl en ial in crea ing a polic approach in man co n ries ha foc ses on
keeping infla ion lo , e en if nemplo men is high. The arg men is ha i ce dema d- ide licie
cha ge agg ega e dema d ca l e em l me a a , lic h ld f c kee i g
i fla i l .
Man economis s disagree i h his perspec i e. According o Nobel Pri e- inning economis Joseph
S igli :
P licie ha f c e cl i el i fla i a e mi g ided . . . A a ac ical ma e , . . . he
ela i hi be ee em l me a d i fla i i highl able. I i i all im ible
di ce he ela i hi f m he da a e ce i a fe i la ed e i d .
[P lic -make ] face c ide able ce ai ab he le el f he [ a al a e f
em l me ]. Th , he ill face a ade- ff be ee hi g em l me l , a d
e i g ff a e i de f i fla i , a d hi g ha d e gh e l i g i a ece a a e
f e ce .
H e ie he e i k de e d he c f d i g mi ake . . . The eigh f he
e ide ce i dica e ha he c f d i g he mi ake f hi g em l me d fa i
i elf e l . . . I hi ie , [ lic -make ] h ld agg e i el el em l me ,
il i i h ha i fla i i i i g.
B c a , i fla i ha k 15 a g e ha i fla i m be a acked [ e e i el ] . . . [T]hi
a ce i a ma e f eligi , ec mic cie ce. The e i im l li le em i ical e ide ce
ha i fla i , a he l m de a e a e ha ha e e ailed i ece decade , ha a
ig ifica ha mf l eal effec , em l me , g h he di ib i f i c me. N
i he e e ide ce ha i fla i , h ld i i c ea e ligh l , ca be e e ed a a ela i el mi
c ...
The ie [ ha hi g ca be d e ab em l me ] bel g a ch l f m de
mac ec mic ha a me . . . e fec l c m e i i e ma ke . . . Beca e ma ke [i hi
ie ] a e al a efficie , he e i eed f g e me i e e i . M e [da ge l ],
ma e f hi ie , he c f ed i h he eali f em l me , a g e ha i
aie l beca e f g e me -im ed igidi ie a d ade i . I hei ideal ld
ih ei he , he e ld, he claim, be em l me . 16
The idea ha con rol of infla ion is more impor an han keeping nemplo men lo is poli icall
conser a i e, and is of en embraced b people ho belie e in he s periori of free marke s o er
go ernmen in er en ion o sol e economic problems. Less conser a i e economis s and orkers ho
ha e onl heir job o rel on as a so rce of income, end o prefer lo nemplo men o er lo
infla ion (pro ided of co rse ha infla ion is modera e and does no ge o of hand). The also end
o fa o r some in er en ion in marke s aiming o keep nemplo men lo .
The na ral ra e concep , fa o ring lo infla ion o er lo nemplo men , became a rac i e o
polic -makers for o reasons. One as ha beca se of s agfla ion, i forced economis s o q es ion
he Ke nesian se of demand-side policies o deal i h economic fl c a ions. The second, and er
impor an reason, as ha since he la e 1970s, here occ rred a shif in he general poli ical mood
a a f m g e me i e e i a d a d he ma ke (par ic larl in he Uni ed S a es and
Uni ed Kingdom); he na ral ra e concep i h i s s rong free-marke orien a ion, offered i self as an
appealing heore ical approach o polic -making. I s free-marke recommenda ions, incl ding
abolishing or red cing minim m ages and red cing labo r nion po er, ere a rac i e o polic -
makers ho opposed in er en ion in marke s. Therefore, he na ral ra e concep as con enien l
adop ed as a g ide o polic , placing a grea er emphasis on con rolling infla ion ra her han red cing
nemplo men .
Wha does S igli mean hen he sa s he perspec i e of infla ion ha ks is a ma er of religion,

no economic science ?
On he basis of ha kno ledge cri eria ha e socie ies made a consis en choice o er man ears
o make a priori of lo infla ion o er lo nemplo men ?
Wh do man economis s consider he polic choice be een lo infla ion and lo
nemplo men o be a ba le be een conser a i e and non-conser a i e economis s?

The follo ing q es ions ill help o reflec on o r learning and enhance o r nders anding of ke
opics in his chap er. The are s gges ions for inq iries ha o can nder ake on o r o n or in
gro ps in order o re ise he learning objec i es of his chap er.
1 Research and find da a on nemplo men o er a period of abo en ears in selec ed co n ries
o are in eres ed in, and r o find a co n r ha has e perienced significan fl c a ions in i s
nemplo men ra e. Tr o find informa ion on he ca ses of he fl c a ions, specificall ha
are he fac ors ha ha e led o increases or decreases o er he ears? Is i possible o come o an
concl sions abo he her c clical fl c a ions ( he b siness c cle) ha e pla ed a role in
nemplo men in hese fl c a ions? Tr o find an e ample of s r c ral nemplo men , sing
he ca ses of s r c ral nemplo men o ha e learned abo in his chap er.
2 Research and find da a on infla ion o er a period of abo en ears in he co n r o li e in or
a co n r o are in eres ed in. Yo are likel o find al erna ing rising or falling infla ion ra es.
Tr o disco er he ca ses of rising infla ion or disinfla ion. See if o can de ermine he her
hese are demand-p ll or cos -p sh fac ors.
3 (HL onl ) In he e abo e i as no ed ha he shor -r n Phillips c r e has come o be
q es ioned b man economis s, ho gh man o hers arg e ha i is onl a ma er of ime before
he familiar in erse rela ionship be een infla ion and nemplo men res mes. Research he
mos recen ri ings on he Phillips c r e, in order o disco er if and ho he deba e has been
resol ed. De ermine he her nemplo men and infla ion are displa ing he rela ionship sho n
b he shor -r n Phillips c r e, and if he are no e amine he reasons p for ard o e plain
his.
E S Q
Yo can find q es ions in he s le of IB e ams in he 'Digi al co rsebook: E ra ma erial' sec ion.

11 No e ha his b lle poin as ell as he ne o come from he s llab s sec ion Po en ial conflic be een
macroeconomic objec i e'.
12 The Happiness Trade-Off be een Unemplo men and Infla ion
13 The correspondence be een Fig re 10.11(a) and (b) is no en irel acc ra e. The er ical a is of par (a)
meas res he ra e of infla ion, or he percen age increase in he price le el. The er ical a is of par (b)
meas res he price le el, hich is er differen from he ra e of infla ion. There can be increases in he price
le el i h no increase in he ra e of infla ion and e en i h a decrease in he ra e of infla ion (or disinfla ion;
for e ample, he ra e of infla ion increases b 5% in 2000 and b 3% in 2001). The s ccession of AD c r es in
par (b), leading o increasingl larger rises in he price le el, has been dra n i h his poin in mind, e en
ho gh i is s ill no acc ra e.
14 This same arg men is of en made in erms of ac al and e pec ed ra es of infla ion. Le s ass me ha hen he
econom is ini iall a poin a, nominal ages are se on he e pec a ion ha he ra e of infla ion ill be 5%,
and herefore nominal ages ha e been agreed i h emplo ers o increase b 5% so as o main ain a cons an
real age. Le s sa ha he increase in aggrega e demand, ho e er, in ac al fac gi es rise o an infla ion ra e
of 7%. Real ages decline as a res l , firm profi abili increases, real GDP increases as he econom mo es
p ard along SRAS1, and nemplo men falls belo he na ral ra e o 3%. Th s e ha e he mo emen from
poin a o poin b on SRAS1 and on SRPC1. In he long r n, he econom mo es o poin c beca se nominal
ages adj s o ac al ra es of infla ion, i h he res l ha real ages increase o heir pre io s le el, firm
profi abili falls o i s original le el, real GDP falls o Yp, and nemplo men climbs back o he na ral ra e of
5%. The onl difference from he ini ial eq ilibri m is ha here is no a higher ra e of infla ion, of 9%. In he
long r n, hen he ac al ra e of infla ion is eq al o he e pec ed ra e of infla ion, nominal ages increase in
line i h he ac al ra e of infla ion, real ages remain cons an , and he rade-off be een infla ion and
nemplo men disappears.
15 Infla ion ha ks are polic -makers ho belie e ha infla ion has highl nega i e effec s and sho ld be
con rolled.
16 Joseph S igli (2006) The Phelps Fac or, Projec S ndica e.

C a e 11
Mac ec c b ec e II:
Ec cg , a ab e e e f deb
Bef e a
1 We have seen that countries tend to achieve economic growth over a period of time. What do ou
think might be some positive and negative consequences of economic growth?
2 Governments sometimes accumulate debt in order to achieve their economic objectives. What
might be some problems faced b countries with high levels of debt?
In this chapter we will stud two more important macroeconomic objectives: economic growth and
sustainable level of debt.
11.1 E
LEARNING OBJEC I E

define all he e m appea ing in in he e (AO1)
e plain ho - e m g o h in e m of (AO2)
ac al g o h in he PPC model
he ole of agg ega e demand in he AD-AS model
e plain long- e m g o h in e m of (AO2)
hif in he PPC ill a ing g o h in p od c ion po ibili ie
he ole of LRAS in he AD-AS model
d a diag am of he PPC model ho ing ac al g o h and g o h in p od c ion po ibili ie
(AO4)
d a diag am of he AD-AS model ill a ing (AO4)
inc ea e in AD o ho inc ea e in eal o p
inc ea e in LRAS o ho inc ea e in f ll emplo men o p
e plain ho economic g o h i mea ed (AO2)
calc la e he a e of g o h f om da a (AO4)
di c he con e ence of g o h incl ding i impac on (AO3)
li ing anda d
he en i onmen
income di ib ion
Yo e e in od ced o ec ic g h in Chap e 1 in connec ion i h he p od c ion po ibili ie

model. I a al o b iefl di c ed in Chap e 9 in connec ion i h he AD- AS model.
Economic g o h efe o an inc ea e in eal GDP, o he eal an i of good and e ice p od ced
o e a pe iod of ime ( picall a ea ), and i all e p e ed a :
a pe cen age change in eal GDP o e a pe iod of ime, o
a pe cen age change in eal GDP e ca i a o e a pe iod of ime.
The di inc ion be een g o h in eal GDP and eal GDP e ca i a i impo an beca e he o
mea e a e e likel o be diffe en . Whe ea eal GDP mea e he o al o p p od ced in an
econom , eal GDP e ca i a mea e o al o p pe pe on. Real GDP e ca i a i a be e
indica o of he anda d of li ing of a pop la ion, ince i mea e he amo n of eal GDP
co e ponding o each
pe on on a e age.
No e ha economic g o h i mea ed a he pe cen age change in ea a oppo ed o i a GDP.
The eal fig e elimina e he impac of p ice change , h pe mi ing meaningf l compa i on of le el
of o p o e ime.
C
C
The fo m la fo calc la ing pe cen age change in eal GDP i he follo ing:
% change in eal GDP =
final al e of eal GDP ini ial al e of eal GDP ini ial al e of eal GDP 100
Fo mo e info ma ion on pe cen age change , ee Q an a i i e echni e chap e in he 'Digi al
co ebook: E a ma e ial' ec ion.
If an econom had eal GDP of $75.3 billion in 2017 and $81.7 in 2018, b ho m ch did eal GDP
g o in 2017 2018? U ing he fo m la abo e e find
% change in eal GDP=81.7-75.375.3 100=6.475.3 100=8.5%
The iden ical fo m la i of co e ed o calc la e he pe cen age change in eal GDP e ca i a.
S ppo e an econom ha eal GDP e ca i a of $1402 in 2017, $1457 in 2018 and $1410 in 2019. B
ho m ch did eal GDP e ca i a g o in 2017 2018 and in 2018 2019?
2017 2018 change in eal GDP e ca i a
= 1457 1402 1402 100
= 55 1402 100=3.9%
2018 2019 change in eal GDP e ca i a
= 1410 1457 1457 100
= 47 1457 100= 3.2%
No e ha in he econd pe iod, economic g o h a nega i e.
R GDP GDP
S ppo e eal GDP i g o ing in a h po he ical econom , o i ha a po i i e g o h a e. Doe hi mean
i al o ha po i i e e ca i a GDP g o h? The an e depend on ho fa he pop la ion i g o ing.
If eal GDP i g o ing fa e han he pop la ion, hen he amo n of eal GDP ha co e pond o each
pe on on a e age inc ea e , e l ing in po i i e g o h in eal GDP e ca i a. If, on he o he hand,
he pop la ion i g o ing fa e han eal GDP, hen he amo n of GDP pe pe on on a e age
dec ea e , and he g o h a e of eal GDP e ca i a i nega i e.
If e kno he pe cen age change in eal GDP and he pe cen age change in he pop la ion, e can find
he pe cen age change in eal GDP e ca i a in a e imple a :
% change in eal GDP e ca i a = % change in eal GDP % change in pop la ion
Fo e ample, if eal GDP g e b 2% in a ea , and he pop la ion g e b 1.5%, hen eal GDP e
ca i a g o h a 0.5%. If, ho e e , he pop la ion g e b 2.5%, hen he % change in eal GDP e
ca i a a 0.5%, indica ing ha o p pe pe on fell.
Economic g o h a e achie ed b co n ie a o nd he o ld a idel . While ome co n ie

e pe ience apid g o h, o he g o m ch mo e lo l , hile o he con ac fo a pe iod of ime. Thi
can be een in Table 11.1, ho ing a e age ann al g o h a e of eal GDP fo e e al co n ie fo he
pe iod 2013 2018.
A GDP (%)
2013 2018
E 9.40
B 6.72
I 5.51
2.71
J 1.25
A 0.15
E 4.81
: Li fc ie b ea GDP g h ae
11.1: Real GDP pe cen age g o h
Diffe ing g o h a e ha e eno mo implica ion fo a co n economic pe fo mance o e long

pe iod of ime. Le con ide ha o ld happen o eal GDP of h ee h po he ical economie ha
g o a diffe en a e o e a pe iod of fi e ea (a in he able). Imagine ha each econom a o
in he ea 2015 i h a eal GDP of $1000. The fi one g o fo fi e ea a he high ann al a e of
9.40%; he econd co n g o a he lo a e age ann al a e of 0.15 %; and he hi d co n
con ac a he ann al a e of 4.81% (nega i e g o h). The e l a e p e en ed in Table 11.2.
The co n ha g o a 9.40% pe ea fo fi e ea end p i h a eal GDP ha i do ble ha of
he co n i h he nega i e g o h a e of 4.81%. The co n ha g o a he lo a e age a e of
0.15% pe ea onl add $8 o i GDP.
2015 GDP A 2020 GDP

$1000 9.40% $1567
$1000 0.15% $1008
$1000 4.81% $782
11.2: G o h of eal GDP in h po he ical economie
The la ge c m la i e impac ha a e of g o h ha e on le el of eal GDP e plain h go e nmen

a o nd he o ld foc ongl on policie in ended o inc ea e hei g o h.

1 De c ibe he meaning of economic g o h and e plain i ignificance o e a pe iod of ea .
2 When e calc la e economic g o h, o line he he e ho ld e nominal o eal al e of
GDP.
3 E plain he ad an age of calc la ing g o h of eal GDP in e ca i a e m a he han g o h
of eal GDP.
4 S ppo e an econom had eal GDP e ca i a of 1579 in 2017, 1611 in 2018 and 1597 in
2019. Find he a e of economic g o h
in 2017 2018, and
in 2018 2019.
S a e hen he econom e pe ienced nega i e g o h.
5 O line ho i i po ible ha a co n can ha e po i i e eal GDP g o h and e ha e
nega i e eal GDP e ca i a g o h.
S ppo e ha an econom eal GDP g e b 2.2% in 2007, and i pop la ion g e b 1.5%
6 d ing he ame ea . Calc la e b ho m ch i eal GDP e ca i a g e .
- -
We ill no make a di inc ion be een - , hich ake place o e ela i el ho
pe iod of ime, and - , hich need a long ime o ake effec .
Man of he idea ha ill be di c ed in hi ec ion ha e been died in p e io chap e , and o
m ch of ha o ill ead abo in hi ec ion ill be a e ie fo o .
AD-AS
In he AD-AS model, economic g o h, o inc ea e in eal GDP, occ a a e l of:
inc ea e in agg ega e demand, hich i efe ed o a ho - e m g o h
inc ea e in ho - n agg ega e ppl ( ho gh hi i fa le common), al o a pe of ho - e m
go h
inc ea e in long- n agg ega e ppl , efe ed o a long- e m g o h.
- : (AD)
Fig e 11.1 ho ho - e m g o h in he mone a i /ne cla ical model. I can be ca ed b
inc ea e in agg ega e demand, ill a ed in pa (a) b he igh a d hif of he AD c e f om AD1 o
AD2, e l ing in a eal GDP inc ea e f om Y1 o Y2. No e ha h - e ec ic g hd e
i e a i c ea e i e ia , and he efo e he e i no igh a d hif of he LRAS c e.
In he Ke ne ian model, ho - e m economic g o h can be een in Fig e 11.1(b), he e cce i e
inc ea e in agg ega e demand f om AD1 o AD2 o AD3 and AD4 e l in g o h of eal GDP f om Y1
o Y2 o Y3 and Y4. No e ha he e, oo, h - e ec ic g hd e i e a i c ea e i
e ia , and hence no igh a d hif of he AS c e.
Thi pe of ho - e m g o h can be ca ed b an of he fac o ha can ca e inc ea e in agg ega e
demand (AD) ha o died in Chap e 9, Sec ion De e i a f agg ega e de a d. AD can
inc ea e a a e l of an inc ea e in an one o mo e of he componen of AD, hich a e con mp ion
(C), in e men (I), go e nmen pending (G) and ne e po (X M).
- : - ( RA )
Sho - e m g o h can al o be ca ed b inc ea e in ho - n agg ega e ppl , o a igh a d hif of
he SRAS c e f om SRAS1 o SRAS2 in Fig e 11.1(c), ca ing eal GDP o inc ea e f om Y1 o Y2. The
ca e of hi pe of g o h incl de he fac o ha can inc ea e ho n agg ega e ppl (SRAS) ha
o died in Chap e 9, Sec ion Cha ge i h agg ega e : fall in p ice of fac o of
p od c ion (labo and non-labo e o ce ), inc ea e in b idie , o po i i e ppl hock .
I h d be ed, h e e , ha h - e ec ic g h i affec ed fa e b i c ea e i
agg ega e de a d a he ha i h - agg ega e .
L - : - (LRAS) K
AS
In Chap e 9, Sec ion Shif i g agg ega e c e e he g e , o lea ned abo a n mbe
of fac o ha affec he po i ion of he LRAS and Ke ne ian AS c e , ca ing he e c e o hif o
he igh . Since he e all need an e ended pe iod of ime o ake effec , hei effec on he econom
a e efe ed o a g- e g h. Bo h of he e a e ho n in Fig e 11.2, hich i he ame a Fig e
9.13.
F 11.1: Sho - e m g o h
A o ma ecall, he e fac o incl de inc ea e in he an i and imp o emen in he ali of

fac o of p od c ion, echnological change, imp o emen in efficienc and in i ional change .
F 11.2: Inc ea ing po en ial o p , hif in agg ega e ppl c e and long- e m economic
go h
AD-AS ,
In Chap e 9 e a ha infla iona and defla iona gap co e pond o he p a d and do n a d
pha e of he b ine c cle in od ced in Chap e 8, Fig e 8.4 and 8.5. We al o a ha hen he e i
no infla iona o defla iona gap, he econom p od ce a i f ll emplo men le el of o p , o
po en ial GDP. I i no imple o ee he connec ion be een economic g o h and he b ine c cle.
Sho - e m g o h i ho n in he e pan ion pha e of he b ine c cle, hen eal GDP i inc ea ing
o e ime, ho gh hi i follo ed b a con ac ion, o a pe iod of dec ea ing eal GDP. The con ac ion
ill a e i a ion he e he e i nega i e g o h. The p a d pha e of he b ine c cle a e ca ed
mainl b inc ea e in agg ega e demand, and o a le e e en b inc ea e in ho - n agg ega e
ppl . Simila l he do n a d pha e , ill a ing nega i e g o h, a e ca ed b dec ea ing agg ega e
demand and o a le e e en dec ea ing ho - n agg ega e ppl .
On he o he hand, o e long pe iod of ime, mo economie e pe ience po i i e economic g o h. The
b ine c cle diag am, ho ing an p a d- loping, long- e m g o h end, indica e ha he
econom eal GDP i g o ing o e ime. The long- e m g o h end, o ma emembe , a
efe ed o a e ia ; hi i none o he han he eal GDP le el a hich he LRAS c e i
i a ed, and he po en ial o p e ee in he Ke ne ian model.
Sho - e m g o h ca ed mainl b inc ea e in agg ega e demand (and o a le e e en inc ea e

in ho - n agg ega e ppl ) co e pond o e pan ion of eal GDP in he b ine c cle diag am.
Long- e m g o h ca ed b igh a d hif ing LRAS o Ke ne ian AS c e ha ho inc ea e in
po en ial o p co e pond o he long- e m g o h end in he b ine c cle diag am.
Fig e 11.3 ill a e ho mac oeconomic e ilib i m change o e he long e m hen po en ial
o p i inc ea ing. Y1 and Y2, hich a e he long- n e ilib i m poin of pa (a) and he Ke ne ian
e ilib i m poin of pa (b) co e pond o poin in he b ine c cle diag am he e ac al o p i
e al o po en ial o p . The e a e he poin of in e ec ion of he c e ho ing ac al GDP and
po en ial GDP. The long- e m g o h end of he b ine c cle diag am impl ace o he inc ea e
in po en ial o p ho n in he AD- AS model .
F 11.3: Long- e m economic g o h: achie ing po en ial (f ll emplo men ) o p in a g o ing

econom
In he eal o ld, i i e diffic l o e amine economic ac i i and a i e a acc a e concl ion

abo ha pa of g o h i d e o ho - e m fl c a ion of he b ine c cle and ha pa og o h
in po en ial o p . Ho e e , economi con in o l make effo o mea e po en ial o p and i
g o h, beca e ha ing e ima e of he e can help go e nmen fo m la e app op ia e policie o g ide
he mac oeconom in he de i ed di ec ion .
Thi model a in od ced in Chap e 1 (Sec ion I d ci g he d ci ibi i ie de ). I i
gge ed ha o e ead hi ec ion a i i highl ele an o he di c ion of g o h belo .
- :
Yo ma emembe ha he p od c ion po ibili ie c e (PPC) ho combina ion of ma im m
o p ha can be p od ced b an econom i h fi ed e o ce and echnolog , ided he e i f
a i e e f e ce a d efficie c i d c i . Ma im m emplo men in hi model
doe no mean f ll emplo men a in AD- AS model ; i mean ha all e o ce a e emplo ed o he
f lle e en and he e i e o nemplo men .
In Chap e 1, e lea ned ha i i highl nlikel fo an econom o be p od cing on i PPC, a hi
p e ppo e f ll o ma im m emplo men of all e o ce and efficienc , hich canno be achie ed in
he eal o ld. An co n i he efo e mo likel o be p od cing a a poin in ide i PPC. I can
mo e clo e o i PPC and i c ea e he ac a a i f i d ce b ed ci g e e
b i i g he efficie c f e ce e. In Fig e 11.4(a), hich i he ame a Fig e 1.3(a) in
Chap e 1, he mo emen f om poin A o poin B ho g o h of ac al o p . We efe o hi a
ac a g h, hich i a kind of h - e g h, beca e i can occ o e ho pe iod of ime.
L - :
I i clea f om Fig e 11.4(a) ha ed c ion of nemplo men and inefficiencie can onl e l in a
limi ed amo n of economic g o h. The p e ence of he PPC e an ppe bo nd o ho m ch mo e
o p can be p od ced. The onl a o p od ce mo e o p be ond he limi c ea ed b he PPC i if
he PPC hif o a d a in Fig e 11.4(b), allo ing mo e of bo h g o p of good ( i i a g d and
c e g d ), o be p od ced. The hif f om PPC1 o PPC2 o PPC3, called g hi d ci
ibi i ie , a e efe ed o a g- e g h, beca e i i likel o occ o e long pe iod of ime.
In Fig e 11.4(b), oge he i h he g o h in p od c ion po ibili ie he e i al o ac al g o h ho n
b he o a d mo emen of he econom ac al o p , f om A o B o C.
A o lea ned in Chap e 1, he fac o ha lead o o a d hif of he PPC, o inc ea e in
p od c ion po ibili ie a e:
inc ea e in he an i of e o ce (fac o of p od c ion) in he econom
imp o emen in he ali of e o ce (fo e ample, h o gh mo e ed ca ed labo , o imp o ed
ph ical capi al h o gh echnological change).
A p od c ion po ibili ie g o , effo m be made o keep nemplo men a lo le el and ed ce
inefficiencie o en e ha ac al o p g o along i h p od c ion po ibili ie , a in Fig e 11.4(b).
Fo e ample, if he i e of he labo fo ce inc ea e , hi ill no lead o ac al g o h if m ch of hi
labo emain nemplo ed, in hi ca e he econom co ld emain ck a poin A e en a PPC1 hif
o PPC2. Simila l , he di co e of majo oil e e e ma no lead o ac al g o h if he e e e e
emain ne ploi ed, o if hei e ploi a ion i nde aken inefficien l .
A o ma emembe f om Chap e 1, he PPC can al o hif in a d, indica ing a dec ea e in
p od c ion po ibili ie . Thi mean ha le of he o good i being p od ced, a ho n in Fig e
11.4(c). Thi e l f om a dec ea e in he an i of e o ce o o ening of e o ce ali . I
ep e en he ca e of nega i e g o h.
F 11.4: U ing he p od c ion po ibili ie model o ill a e economic g o h
Ac al g o h i ho e -g h, beca e i can occ o e ho pe iod of ime and i d e o

ed c ion in nemplo men o inefficienc in p od c ion. G o h in p od c ion po ibili ie i g-
e g h, beca e i all e i e long pe iod of ime and i d e o inc ea e in an i o
imp o emen in ali of fac o of p od c ion.
Table 11.3 p o ide a mma of he fac o ha ca e ho - e m and long- e m g o h in he o

model . We can ee ha he a e in ome e pec imila ega ding he ca e of g o h. In he PPC
model, ed c ion of nemplo men i a ke ca e of ac al g o h o e he ho e m. In he AD- AS
model, inc ea e in AD o SRAS bo h in ol e ed c ion in nemplo men , ince i i no po ible o
p od ce a la ge amo n of eal GDP i ho mo e labo being hi ed, hich lead o a fall in
nemplo men . The efo e, in bo h model fall in nemplo men a e a majo fac o behind g o h.
Rega ding long- e m g o h, e can ee ha he fi h ee ca e of g o h ha a e li ed a e common
o bo h model . The imila i ie be een he o model a e ha dl p i ing ince bo h ill a e
economic g o h. On he o he hand i i al o no p i ing ha he e a e ome diffe ence be een he
o model . The o AS c e a e in ended o ho he ela ion hip be een he p ice le el and eal
GDP. The p od c ion po ibili ie model doe no deal i h he p ice le el, i i be e i ed o ill a e
he p inciple of e o ce ca ci and oppo ni co of economic choice .
AD-AS PPC
-
inc ea e in AD ed c ion in
inc ea e in SRAS nemplo men
(le impo an ) imp o emen in
efficienc
L - inc ea ed e o ce an i
imp o ed e o ce ali
echnological change
imp o emen in
efficienc
in i ional change
11.3: Fac o ha ca e economic g o h

1 U ing diag am( ), e plain he diffe ence be een an inc ea e in ac al o p and an inc ea e in
p od c ion po ibili ie . U ing e ample iden if he ca e of each.
2 U ing diag am , e plain he diffe ence be een long- e m economic g o h and ho - e m
economic g o h d e o economic fl c a ion .
U ing e ample , iden if he ca e of each.
O line ho po en ial o p change / doe no change in each ca e.
3 U e he p od c ion po ibili ie model and diag am o ho ho he follo ing can e l in
economic g o h (po i i e o nega i e), di ing i hing be een PPC hif and mo emen of a
poin clo e o o f he f om a gi en PPC:
a di co e of ne oil e e e ,
a fall in na al nemplo men ,
an inc ea e in c clical nemplo men ,
an imp o emen in le el of heal h of he pop la ion,
an imp o emen in efficienc in p od c ion,
he ide p ead e of a ne echnolog ,
a iolen conflic de o a po ion of a co n fac o ie , machine and oad em,
la ge c in go e nmen pending on ed ca ion and heal h ca e lo e le el of ed ca ion
and heal h in a pop la ion,
an inc ea e in he an i of capi al good ,
an imp o emen in he le el of ed ca ion and kill of o ke , and
ind ial poll ion de o he en i onmen .
( )
To nde and h inc ea e in e o ce an i ie and imp o emen in e o ce ali incl ding

echnological change ca e long- e m g o h in bo h model , e ill e he e panded meaning of
ca i a , in od ced in Chap e 1, Sec ion Re ce a fac f d c i . Capi al gene all efe o
e o ce ha can p od ce a f e eam of benefi . Thi f e eam of benefi a i e f om
in e men , o pending nde aken o c ea e ha eam of benefi .
Th ee of he fo fac o of p od c ion: land, o na al e o ce ; labo , o h man e o ce ; and
ph ical capi al, can be in e p e ed a a pe of capi al :
Ph ica ca i a ,al o efe ed o a capi al good i he anda d pe of capi al; a e kno f om
Chap e 8 i e l f om in e men , o pending o p od ce machine , e ipmen , oad , e c.
H a ca i a efe o he kill , abili ie , kno ledge and le el of heal h of o ke . H man
capi al e l f om in e men , o pending on ed ca ion, aining, p o i ion of heal h ca e
e ice , clean a e pplie , good n i ion, and gene all an hing ha affec le el of
ed ca ion and heal h.
Na a ca i a incl de e e hing ha adi ionall fall i hin land , o na al e o ce . I
incl de e e hing nde he land (mine al depo i , me al , oil, na al ga , e c.) pl e e hing
on he land ( i e , lake , ocean , fo e , oil , e c.), pl a co n o e all na al en i onmen
and eco em (ai , ildlife, biodi e i , clima e, o one la e , and o on). Whe ea land and
na al capi al incl de he ame hing , he e i an impo an diffe ence in ho he o e m a e
in e p e ed. Land i a med o be gi en b na e and doe no change. Na al capi al doe
change, beca e i can be de o ed (b c ing do n fo e , poll ing he ai and a e , deple ing
fi h). I can al o be imp o ed (b plan ing mo e fo e , imp o ing oil ali ). Main aining
na al capi al and imp o ing i ali depend on in e men ha aim o p e e e and imp o e
na al e o ce an i and ali .
B e panding he meaning of capi al , e ha e e ended he meaning of in e men o appl o all
h ee fac o of p od c ion li ed abo e:
ph ical capi al i ela ed o in e men in ph ical capi al
labo = h man e o ce i ela ed o in e men

in h man capi al
land = na al e o ce i ela ed o in e men in na al capi al

In e men can be nde aken b he p i a e ec o (fi m o p i a e indi id al ) o b he p blic ec o
( he go e nmen ).1 I e e i c cia b i di g ca i a f a e.
We ill no ee ho in e men in he h ee pe of capi al lead o economic g o h.
P ,
An inc ea e in he a i f h ica ca i a in ol e an inc ea e in he n mbe of machine , ool ,
e ipmen , oad em , po , e c. a ailable in an econom .
An imp o emen in he a i f h ica ca i a depend on echnological ad ance , hich lead o ne
and be e machine , ool and e ipmen . Technological ad ance a e all inco po a ed in o ne
capi al good ; fo e ample, a ne comp e ha i fa e and mo e po e f l inco po a e i hin i he
ne echnolog ha make i fa e and mo e po e f l. When a echnological ad ance i inco po a ed
in o a capi al good, i i efe ed o a being e b died in he ne capi al.
The efo e, imp o ed capi al good a e capi al good ha embod a ne echnolog . U e of capi al
good embod ing ne echnologie lead o a la ge an i of o p p od ced; fo e ample, he e of
a mo e po e f l comp e allo a o ke o p od ce mo e o p .
Inc ea e in he an i and imp o emen in he ali of ph ical capi al, a i ing f om

in e men in ph ical capi al and ne echnolog , a e among he mo impo an o ce of
economic g o h o e long pe iod of ime.
H ,
The an i of labo can ome ime be an impo an o ce of economic g o h; fo e ample, he
infl of fo eign o ke in o Ge man in he 1960 and 1970 pla ed an impo an ole in p omo ing i
g o h. Ho e e , man co n ie (e peciall le de eloped one ) ome ime face high le el of
nemplo men and nde emplo men . The efo e, inc ea e in he an i of labo ma no al a be
a o ce of g o h.
Fa mo e impo an han inc ea e in he an i of labo i imp o emen in he ali of labo ,
de e mined b kill , abili ie , kno ledge and le el of heal h of he o kfo ce. Imp o ed labo ali
i he e l of in e men in h man capi al, incl ding pending on ed ca ion, b ilding chool ,
p o iding meal fo choolchild en and p o iding oca ional aining; a ell a pending o p o ide
medical e ice , imm ni a ion, and en ing acce b he o e all pop la ion o heal h ca e e ice ,
oge he i h he p o i ion of ani a ion and clean a e pplie , and keeping he en i onmen
npoll ed.
Highe le el of kill , kno ledge and heal h, e l ing f om in e men in h man capi al, a e a e
impo an o ce of economic g o h beca e a highl killed, ell-ed ca ed and heal h labo fo ce i
mo e p od c i e han an n killed, ned ca ed and nheal h one: a killed and heal h o ke can
p od ce mo e o p han a o ke ho i n killed o nheal h .
Inc ea ed an i ie of labo a e nlikel o be a o ce of economic g o h o e long pe iod , b

imp o emen in he ali of labo , a i ing f om in e men in h man capi al, a e among he mo
impo an o ce of g o h.
N ,
When hinking abo he con ib ion of na al e o ce (na al capi al) o economic g o h, i i
ef l o make a di inc ion be een o kind of na al capi al: a ke ab e c di ie (commodi ie
ha a e bo gh and old) ch a imbe , mine al , me al , na al ga , coal and oil; and ecological
e o ce ch a oil ali , i e , clean ai , biodi e i , he o one la e (and, mo e gene all ,
common pool e o ce ).
Ma ke ab e c di ie ca c ib e g hb a e e e ia . Fo e ample, he Uni ed S a e
benefi ed eno mo l f om i la ge ac of good ali ag ic l al land, oil e e e and mine al
depo i . Ye he e idence gge ha co n ie do no need o be ich in ma ke able commodi - pe
na al e o ce o achie e high a e of g o h. The e a e man economie , ch a I ael, Japan,
Hong Kong, Singapo e, So h Ko ea, S i e land, Tai an and o he , ha ha e achie ed high a e of
g o h o e long pe iod and ha e a ained high le el of GDP e ca i a, in pi e of p od cing fe , if
an , ma ke able commodi ie .
C e ce a e c cia i a g- e g h. Long- e m economic g o h

depend c i icall on he abili of co n ie o main ain, and if po ible imp o e, en i onmen al ali ,
and he efo e na al capi al ha incl de common pool e o ce ( ee Chap e 5). En i onmen al
de c ion can ha e di ec effec on he amo n of o p p od ced; fo e ample, a fa me o king
i h poo e ali oil p od ce le o p ; fi he ie in fi h-deple ed ea ha e a malle ca ch.
De pi e hi , i can al o ha e impo an indi ec effec ; fo e ample, o ke ho e heal h i affec ed b
en i onmen al poll ion become le p od c i e, and hi in ol e deple ion of h man capi al oge he
i h deple ion of na al capi al.
Anal ed in e m of he p od c ion po ibili ie model, he e effec in ol e an in a d hif of he PPC
d e o fe e and lo e ali en i onmen al and h man e o ce (na al and h man capi al) and
he efo e lo e (o e en nega i e) economic g o h in he f e, een in Fig e 11.4(c). The efo e,
con in ed economic g o h in he f e e i e in e men in he p e en in na al capi al fo
en i onmen al p e e a ion.
The con ib ion of e o ce an i ie and ali o economic g o h can be mma i ed in he

concep of d c i i , efe ing o he an i of o p p od ced fo each ho of o k of he
o king pop la ion. Fo an econom a a hole, p od c i i can be mea ed a eal GDP di ided b
he o al n mbe of ho o ked.
An imp o emen in p od c i i mean ha o ke become mo e p od c i e: he an i of o p
p od ced in an ho of o k inc ea e . Imp o emen in p od c i i lead o economic g o h, beca e
each ho of o k no p od ce mo e o p .
Wha a e he fac o ha ca e imp o emen in p od c i i ? The a e e ac l he fac o making he
mo impo an con ib ion o long- e m economic g o h di c ed abo e. The incl de:
inc ea e in an i and imp o emen in ali of ph ical capi al ( h o gh in e men in
ph ical capi al and echnological change)
imp o emen in he ali of labo ( h o gh in e men in h man capi al)
imp o emen in (o a lea main enance of) he an i and ali of ecological e o ce
( h o gh in e men in na al capi al).
P od c i i imp o emen e l in igh a d hif of he LRAS o Ke ne ian AS c e , and o ad
hif of he PPC.

1 E plain he ela ion hip be een in e men and ph ical, h man and na al capi al.
2 Refe ing o land, labo and ph ical capi al, and he concep of capi al a applied o each of
he e e o ce , e plain ho each one can con ib e o economic g o h.
3 Define p od c i i .
E plain h imp o ed p od c i i i impo an fo economic g o h.
Wha a e he mo impo an fac o ha e l in p od c i i imp o emen ?
Sho p od c i i go h ing PPC and LRAS diag am .
C
Economic g o h impac pon man a pec of he econom , and ome of i po ible con e ence a e
po i i e hile o he ma be nega i e. I i impo an o no e ha man of he e con e ence , he he
po i i e o nega i e, a e no ine i able, b a he f f he a ha g hi ed.
I
Li i g a da d (o a da d f i i g) efe o le el of income, eal h and con mp ion of good and
e ice , incl ding heal h ca e and ed ca ion. If eal GDP of a co n inc ea e fa e han i
pop la ion, hen an inc ea e in GDP e ca i a e l . Thi indica e ha he e i a g ea e e ia f
e e i c ea e hei c i f g d a d e ice , a d i e hei a da d f i i g.
Acco ding o n me o die ca ied o o e man ea , economic g o h i a ocia ed i h
imp o emen in anda d of li ing indica o . Thi i ha e o ld e pec , ince g o h p o ide
addi ional e o ce allo ing fo imp o emen in li ing anda d . Ho e e , GDP e ca i a o income
e ca i a i onl an a e age mea e, and doe no ell ho he inc ea e in income i di ib ed o
he he he e i a b oadl di ib ed imp o emen in li ing anda d . The efo e imp o emen a a
lo f om co n o co n and f om ime pe iod o ime pe iod, o ha fo a gi en a e of g o h he
a e in ome ca e mall and in o he m ch la ge . Wha acco n fo ch diffe ence ?
Impo an fac o ha allo economic g o h o ha e po i i e effec on anda d of li ing incl de he
follo ing:
. The g ea e he ha e of income going o poo e ho ehold , he
g ea e he po en ial fo con ib ing o imp o emen in li ing anda d a he poo e ho ehold
a e ho e i h he g ea e dep i a ion . If inc ea e in income made po ible b economic g o h
b pa he poo e ho ehold , g o h ha limi ed effec on b oadl ha ed imp o emen in li ing
anda d .
H . The g ea e he ha e of ho ehold income pen on good and e ice ch
a food, ed ca ion and heal h ca e, he g ea e he imp o emen in li ing anda d .
. The g ea e hi i , he onge he impac ( ee al o
Chap e 19 on he ole of omen).
G . Thi ela e o he ha e of he go e nmen b dge
alloca ed o p io i a ea like ed ca ion, heal h ca e and inf a c e incl ding clean a e
pplie and ani a ion; he la ge hi i , he g ea e he po i i e effec of g o h.
C - (NGO ). Beca e of hei po e o ien a ion
and hei gene al effec i ene in eaching poo people, NGO con ib e o inc ea ing he impac
of g o h on highe anda d of li ing.
A majo d of da a be een 1970 and 2005 fo 111 co n ie b he Uni ed Na ion De elopmen
P og amme (UNDP)2 ho ha he g ea e imp o emen in li e ac and life e pec anc ( o
componen of he H man De elopmen Inde (HDI); ee Chap e 18) a e cc i g i he fa e
g i g ec ie f he d ( he onl o e cep ion being China and Ko ea). Fac o con ib ing
o HDI imp o emen a e go e nmen e pan ion of ed ca ion and heal h ca e, oge he i h he
in e na ional comm ni con ib ion of accine and an ibio ic .
The efo e, hi e ec ic g h ffe he e ia achie e i e e i a da d f i i g,
he e i e e d cc a a ica a a e f ec ic g hb e i e app op ia e
policie o make effec i e e of he e o ce g o h make a ailable.
I
E pe ience ho ha g o h, e peciall apid g o h, of en lead o n ainable e o ce e
(pa ic la l in he ca e of common pool e o ce ). Fo e ample, e high g o h a e in Ea A ian
co n ie ha e been a ocia ed i h e io en i onmen al lo e aking he fo m of e high le el of
ban ai poll ion, oil deg ada ion d e o oil e o ion, a e logging and o e g a ing, h ea o
biodi e i and e io defo e a ion. Ind iali a ion ba ed on fo il f el i a majo o ce of
poll ion (nega i e p od c ion e e nali ie ). Inc ea ing income lead o con mp ion pa e n al o ba ed
on g ea e fo il f el con mp ion ( e of ca , ai condi ione , ai a el, e c., c ea ing nega i e
con mp ion e e nali ie ). O he ac i i ie , ch a comme cial logging and ag ic l al p ac ice ba ed
on a lack of p icing mechani m fo common pool e o ce , e l in hei n ainable e.
E pe ience like he e ha e led o he ide p ead belief ha economic g o h and en i onmen al
ainabili a e conflic ing objec i e : mo e of one mean le of he o he . Man go e nmen a o nd
he o ld ha e ba ed hei policie on hi belief b follo ing he g o no , clean p la e a of
hinking, hich a g e ha ince ing e o ce o p e e e he en i onmen ed ce g o h, i i
p efe able o p e g o h i h i nega i e effec on he en i onmen , and po pone he clean- p job
of en i onmen al p e e a ion fo la e hen income ill be highe . Fo e ample, he in alla ion of
poll ion-con ol e ipmen in ol e g ea e co fo fi m , hich ma mean lo e p ofi , lo e
in e men and lo e economic g o h. S i ching o en i onmen all o nd ag ic l al p ac ice
imila l in ol e co ha ma c in o f e economic g o h p o pec . Se ing limi o
defo e a ion fo imbe place e ic ion on he g o h of he imbe ind . The efo e, alloca ing
e o ce fo en i onmen al p o ec ion a g abl an la e in o malle inc ea e in o p and hence
lo e economic g o h.
Ye , hi a of hinking i n o nd fo e e al ea on . One i ha ee i e a da age i
i e e ib e; i ill no be po ible o co ec he damage in he f e, and ome e o ce ill be lo
fo e e . Fo e ample, lo biodi e i can ne e be eco e ed; lo li e d e o poll ion-ind ced
illne e can imila l ne e be eco e ed. A econd i ha i j ifie g e e i ac i he
e i e . Go e nmen and polic -make of en ongl a me ha en i onmen al i e ill
a oma icall be egained in he f e a income inc ea e i h g o h. Thi i n eali ic, beca e
p e e a ion of he en i onmen e i e policie aiming o limi nega i e en i onmen al e e nali ie .
A hi d, ela ed ea on i ha i i g h i e f ha i bad f he e i e , b a he he a
ha g hi ed. If g o h e ep ed diffe en l , i need no conflic i h en i onmen al
ainabili . A fo h ea on i ha g h ba ed ai ab e e ce e a ead
de ci f a a e ce ch a ide ca e ha he ibi i f c i ed f eg h a
be h ea e ed.
Mode n g o h heo ho ha economic g o h and en i onmen al ainabili a e in fac
con i en i h each o he , and ca be cce f ed ge he de ce ai c di i , ch a
he follo ing:
Go e nmen implemen ma ke -ba ed policie ha in e nali e he e e nali ie , h no onl
co ec ing hem (a lea in pa ) b al o p o iding incen i e fo ainable e o ce e and
p omo ion of g een (o clean ) echnologie ( ee Chap e 5).
Go e nmen p e mo e en i onmen al eg la ion ha enco age poll ion-f ee echnological
change (g een echnologie ).
The e i an inc ea ed empha i on h man capi al in p od c ion ( hich i poll ion-f ee) a oppo ed
o ph ical capi al.
The e i an inc ea ed empha i on g een in e men , hich p omo e g o h hile no h ing he
en i onmen : b ilding p blic an po a ion em ; in e ing in in la ion in home and
b ilding ; in e ing in clean echnolog e ea ch and de elopmen (R&D) and clean echnologie .
The e a e change in he c e of he econom o a d mo e e ice ( hich end o be
poll ion-f ee), oge he i h mo e in e men in he p o ec ion of na al e o ce .
A income inc ea e i h economic g o h, mo e e o ce a e made a ailable i h hich go e nmen
can p e he abo e kind of policie , enco aging economic g o h a he ame ime ha he
enco age ainabili . The efo e, ec ic g ha d ai abi i ca be ed ge he
ided g e e ake a ia e ea e e e ai ab e e ce e. Thi i he e
meaning behind he concep of ainable de elopmen ( ee Chap e 5).
Ho e e , e en nde he be po ible ci c m ance he e all of he abo e condi ion a e f lfilled,
mode n g o h heo ie ho ha he e i a a i ae fg h ha i c i e ih
e i e a ai abi i , and ha if an econom e ceed hi a e, e o ce e ill become
n ainable. The ea on i ha p i of ainabili e p ome e o ce (fo e ample an i-
poll ion con ol , co of eg la ion, e c.), and he e e o ce ep e en an oppo ni co in e m of
lo economic g o h. No e, ho e e , ha hi onl applie o a lo of a po ion of e high a e of
g o h.3
The appa en conflic be een g o h and ainabili a i e beca e of he a ec ic g hi

defi ed. The idea of conflic follo f om he con en ional mea e of economic g o h, aken o be
inc ea e in eal GDP e ca i a. Thi in n depend on he defini ion of GDP, hich i he al e of
all good and e ice p od ced in a co n in he co e of a ea .
A o ma emembe f om Chap e 8, Sec ion E a a i g a i a i c e a i ic , one of he
e io limi a ion of he mea e of eal GDP pe capi a i ha i doe no acco n fo nega i e
e e nali ie and en i onmen al lo e a i ing f om en i onmen al deg ada ion. Thi limi a ion co ld
be co ec ed if co n ie adop ed o he acco n ing me hod ha incl ded en i onmen al deg ada ion
in ome fo m ( ch a he OECD Be e Life Inde o he Happ Plane Inde ). If economic g o h
a calc la ed in a a ha ook acco n of en i onmen al de c ion a ell a po ible nega i e
heal h con e ence of poll ion e o ld find ha in mo co n ie a o nd he o ld economic
g o h a e o ld be fa lo e han ho e ba ed on con en ional GDP mea e , and in man ca e
o ld be nega i e. Man co n ie o ld find ha hei lo e d e o en i onmen al deg ada ion a e
g ea e han hei gain d e o inc ea ed p od c ion of good and e ice .
If economic g o h e e edefined o a o ake in o acco n ch lo e , he onl a hen o
achie e high a e of g o h o ld be b inc ea ing he p od c ion of good and e ice i ho
ca ing en i onmen al de c ion (o ca ing onl mall amo n of en i onmen al de c ion);
al e na i el , inc ea e in he p od c ion of good and e ice o ld incl de imp o emen in he
ali of en i onmen al e o ce e l ing f om in e men in na al capi al.
The p oblem of he conflic be een g o h (con en ionall defined) and ainabili i ela ed o
economi ema ic neglec of he fac o of p od c ion land . G o h model in main eam
economic ho ho o p inc ea e in ela ion o labo and capi al (in he en e of ph ical
capi al), ome ime al o con ide ing h man capi al, hile comple el igno ing land, hich a aken
o be an nimpo an fac o ha a pe manen l fi ed in an i and ali . I i onl in ecen
ea ha land ha been edefined b en i onmen al economi o con i of na al capi al , hich
can be de o ed o imp o ed h o gh in e men a di c ed abo e in Sec ion Wh ec ic
g h cc (S pplemen a ma e ial).
Ho doe he a e hink of (o define) g o h affec i ela ion hip o he en i onmen ?

Do e ha e a mo al obliga ion o na e and he en i onmen ?
I o choice of ho o mea eg o h ba ed on economic o mo al c i e ia (o bo h)?
If go e nmen began ing al e na i e acco n ing me hod , o ld p od c ion and con mp ion
pa e n nece a il change o a o become mo e con i en i h ainabili ?
Some migh a g e ha con in o g o h i impo ible beca e i i n ainable o achie e
indefini e g o h. I hi a g men alid?
I
A la ge n mbe of die ha e been ca ied o in e iga ing he ela ion hip be een g o h in GDP
e ca i a and income di ib ion in de eloping and de eloped co n ie . The e l ha e been
inconcl i e: hile in ome co n ie income di ib ion o ened in he ea l pe iod of g o h and
hen imp o ed, in ome o he he oppo i e happened, hile in man o he , income di ib ion did no
ho an clea pa e n of change. The e e l lead o he concl ion ha he e i c ea e a i hi
be ee g h i GDP e ca i a a d i c e di ib i ; in ead, ha happen o income
di ib ion a a co n g o i a eflec ion of pa ic la condi ion in each co n and he kind of
g o h policie ha a e p ed.
Fo e ample, man co n ie in La in Ame ica had highl ne al income di ib ion o begin i h;
income di ib ion in he e co n ie ha ended o emain highl ne al. A n mbe of co n ie in
Ea A ia (fo e ample So h Ko ea) had fa mo e e al income di ib ion hen he began hei
apid g o h, and hi emained o e en i h apid g o h d ing he 1970 and 1980 . In addi ion,
co n ie of Ea A ia placed a ong empha i on he de elopmen of h man capi al, a polic ha
pla ed a ke ole in en ing b oad-ba ed pa icipa ion in he benefi of g o h, i h po i i e effec on
he e ali of income di ib ion.
Ye , income ine ali ie in man co n ie a o nd he o ld ha e been idening o e he pa h ee o
o decade . The ha e been g o ing in China, India, Indone ia, Thailand and o he Ea A ian and
So h-ea A ian co n ie ha had achie ed g ea e income e ali and ed c ion in po e in hei
ea l ea of g o h. R ia and mo o he cen al and ea e n E opean co n ie ha e imila l been
e pe iencing ha p i e in income ine ali ie . A n mbe of co n ie in La in Ame ica ha e een
g o ing ine ali ie a ell. Almo all OECD4 co n ie al o ho o ening income di ib ion .
Some of he e co n ie ha e al o e pe ienced inc ea e in he n mbe of ho ehold belo he po e
line.
In bo h de eloped and de eloping co n ie , a majo fac o behind inc ea ing income ine ali ie ha
been he g o ing e of ma ke -ba ed ppl - ide policie ( ee Chap e 13). Economie in cen al and
ea e n E ope and he fo me So ie Union ha an i ioned o ma ke -ba ed em ha e addi ionall
been infl enced b he i ch o ma ke economie and he lo of go e nmen p o ec ion of lne able
g o p . In de eloping co n ie , income ine ali ie inc ea ed d e o economic and ade libe ali a ion,
hich a e ill ee gi e i e o bo h inne and lo e (Chap e 20). While ho e ho can ake
ad an age of ne oppo ni ie gain, man become o e off, if he a e le ed ca ed o killed, canno
ge c edi , a e geog aphicall i ola ed, ha e no hing o p od ce fo e po , lo e hei job d e o
p i a i a ion o ed c ion in he i e of he go e nmen ec o , and o on.
In addi ion, income di ib ion in de eloping co n ie can o en a a e l of economic g o h d e
o inapp op ia e go e nmen policie , ch a :
he in od c ion of capi al- ing (labo - a ing) echnologie in ind and ag ic l e, hich
end o e ela i el mo e capi al inp in pi e of ela i el ab ndan pplie of labo , c ea ing
al and ban nemplo men ( ee Chap e 19)
lo le el of go e nmen in e men in h man capi al, hich nega i el affec people on lo e
income and he poo di p opo iona el mo e han eal hie people
alloca ing mo e ice and inf a c e in e men o ban a ea and igno ing he al ec o
he e mo of he poo li e
i hin he ban ec o , concen a ing inf a c e and e ice in e men i hin he fo mal
(mode n and highl paid) ec o and igno ing he ban l m .
I can he efo e be concl ded ha ec ic g h i ei he g d bad f i c e di ib i ;
hi i ead de e d e ch he ki d f icie c ie ad i de achie eg h.
I
( )
If o a e in e e ed in hi opic o ma ead abo i in he 'Digi al co ebook: E a ma e ial' ec ion
a S pplemen a ma e ial.
A
We ha e e amined he effec of economic g o h on e e al fac o . No e ha he e fac o can al o
impac on economic g o h:
L . Economic g o h can be e pec ed o impac on li ing anda d , b imp o ed
li ing anda d mea ed a imp o emen in h man capi al o ed ced income ine ali ie a e
majo fac o con ib ing o economic g o h ( ee hi chap e on ca e of g o h and Chap e
19).
E . Economic g o h ha igno e he effec on he en i onmen lead o en i onmen al
n ainabili , b n ainabili al o lead o lo e economic g o h d e o de c ion of
common pool e o ce . On he o he hand, economic g o h ba ed on he p inciple of ainable
de elopmen lead o en i onmen al p e e a ion, hich in n can be e pec ed o lead o highe
economic g o h in he f e.
D . Economic g o h can make he di ib ion of income mo e o le e al
(e i able), b a mo e e al di ib ion of income ha a po i i e effec on g o h ( ee Chap e
19).
The likelihood of a o- a ca ali , he e economic g o h impac pon fac o ch a he abo e,
and he e he e fac o in n impac pon economic g o h, ome ime make i diffic l in he eal
o ld o de e mine ha ca e ha .

Di c he po ible nega i e and po i i e con e ence of economic g o h on
li ing anda d ,
he en i onmen , and
income di ib ion. To ha e en can go e nmen make he con e ence lean mo e o a d
he po i i e?
1 No e ha in he AD-AS model, p i a e in e men i ca ied o b fi m (I) and go e nmen in e men i

incl ded in he G componen .
2 Uni ed Na ion De elopmen P og amme, H man De elopmen Repo 2010.
3 Yo ma be onde ing ha he e a e of g o h a e. I i no po ible o a ach n me ical al e o he e

gi en he p e en a e of economi and cien i kno ledge, beca e no eno gh i kno n abo he co
and benefi of g o h and en i onmen al ainabili .
4 The OECD i he O gani a ion fo Economic Co-ope a ion and De elopmen , con i ing mo l of de eloped
co n ie .
11.2 S (HL
)
LEARNING OBJECTI ES

e plain he ela ion hip be een a b dge defici and go e nmen (na ional) deb (AO2)
e plain ha go e nmen (na ional) deb i mea ed a a pe cen age of GDP (AO2)
e plain he co of a high go e nmen (na ional) deb on he follo ing (AO2)
deb e icing co
c edi a ing
f e a a ion and go e nmen pending
T
G , al o kno n a ,o blic deb , efe o he amo n of mone ha a
go e nmen o e o lende o ide of he go e nmen i elf.
H
Ag e e b dge i a pe of plan of a co n e en e and e pendi e o e a pe iod of ime
( all a ea ). Mo of he go e nmen e en e come f om a e . I e pendi e con i of
pending on n me o i em ch a age of go e nmen emplo ee , p o i ion of me i good ,
in e men in inf a c e like oad , and an fe pa men o lne able g o p like
nemplo men benefi and child b idie . (We ill e amine go e nmen e en e and e pendi e
in mo e de ail in Chap e 13.)
If a e en e a e eq al o go e nmen e pendi e o e ha pe iod, he go e nmen i aid o ha e
a bala ced b dge . Ho e e , in p ac ice, he go e nmen b dge i a el if e e balanced. If
e pendi e a e la ge han a e en e , he e i a ; if e pendi e a e malle han
a e en e , he e i a . When he e i a b dge defici , he go e nmen finance
(pa fo ) he e a e pendi e o e e en e b bo o ing. Thi i imila o pe onal finance: if
o pend mo e han o ea n, i i likel ha o bo o o pa fo o e a pending o e o
income.
Go e nmen e of en ha e defici . The ha e man commi men in e m of hei pending, a
he m p o ide heal h ca e, ed ca ion, inf a c e, defen e, and he pa ala ie o hei
emplo ee and make an fe pa men . Of en hei commi men a e g ea e han hei e en e , and
bo o ing allo hem o con in e o pend i ho ha ing o inc ea e a e . The e i a g ea e need
fo bo o ing d ing a ece ion beca e a nemplo men inc ea e , a e en e fall hile
go e nmen pending on nemplo men benefi i e ( ee Chap e 10).
O e ime, he go e nmen acc m la ion of defici min pl e i efe ed o a g e e
deb , o a i al deb o blic deb . In an pa ic la ea , if he go e nmen n a b dge defici ,
i deb ill become la ge ; if i n a b dge pl , i deb ill become malle . S
efe o a le el of deb he e he bo o ing go e nmen ha eno gh e en e o mee i deb
obliga ion (pa men of in e e and epa men of he bo o ed amo n ) i ho acc m la ing
a ea (o e d e deb pa men ) hile al o allo ing economic g o h o con in e a an accep able
le el.
H
Go e nmen e commonl bo o b i ing bond , hich a e a fo m of deb . When he
go e nmen bo o o finance a defici , i i e a ce ifica e called a bond ha p omi e o pa
in e e a a io in e al n il a ce ain da e hen he mone i epaid o he bond holde . The
holde of he bond i he efo e he lende , and he i e of he bond i he bo o e . Financial
in e o , ho ma indi id al , fi m , bank , o an pe of o gani a ion, ha e he incen i e o b
bond beca e of he in e e income he ecei e. Some ime co n ie ma al o bo o di ec l
f om financial in i ion ( o be di c ed in Chap e 20). The bo o ing ma be f om in e nal
o ce , i hin he co n , o f om e e nal o ce , f om o he co n ie .
M GDP
One of he mo common a o mea e he i e of a co n go e nmen deb i a a ha e of
GDP of he bo o ing co n . Thi i efe ed o a he deb - -GDP a i .
Table 11.4 ho he le el of deb a a ha e of GDP of elec ed co n ie . The co n i h he
la ge go e nmen deb a a ha e of GDP i Japan, follo ed b G eece and I al .
Go e nmen deb ha been inc ea ing apidl ince he global financial c i i ha began in 2008, i h
he la ge inc ea e gene all occ ing in de eloped co n ie .
C
High le el of deb ha e a n mbe of di ad an age fo he economie of deb o co n ie .
D
D efe o he pa men ha m be made in o de o epa he p incipal ( he amo n
of he loan) pl in e e pa men . La ge deb e ice pa men ha e majo oppo ni co
beca e he go e nmen ha fe e e o ce o pend on ocial e ice (heal h, ed ca ion, e c.) and
inf a c e.
In addi ion, he po ion of he deb ha i f om e e nal (fo eign) lende m be epaid in fo eign
e change (fo eign c encie ). Thi mean ha he go e nmen i fo ced o e e po ea ning fo
deb e icing, e l ing in le fo eign e change o pa fo impo of needed capi al eq ipmen ,
o he p od c ion inp and good and e ice gene all . The fo egone impo a e an addi ional
oppo ni co i h nega i e con eq ence fo economic g o h. (Thi ill become clea e o o
ha e died Chap e 16.)
P
A c edi a ing i an a e men of he abili of a bo o e o pa back loan , all ca ied o b
agencie ha a e q alified o do hi . (E ample of ch agencie incl de S anda d & Poo , Fi ch
Ra ing , and Mood .) A high c edi a ing ecei ed b a go e nmen mean ha i i e pec ed o be
able o pa back i loan in f ll and on ime i ho diffic l ie . A lo c edi a ing mean ha i i
e pec ed ha he go e nmen ma ha e diffic l ie e icing i deb . Thi make i mo e diffic l fo
he bo o ing go e nmen o find financial in e o illing o lend (b b ing he go e nmen
bond ) a ell a mo e diffic l o bo o f om financial in i ion . If a go e nmen ha a high le el
of deb , ho n b a high deb - o-GDP a io, i i likel o ecei e a lo e c edi a ing, c ea ing
diffic l ie fo he go e nmen abili o bo o in he f e. Thi of en fo ce he bo o ing
go e nmen o offe highe in e e a e o financial in e o in o de o ind ce hem o b he
bond (in o he o d o lend), hich inc ea e he deb e icing co o he go e nmen .
C D - -GDP C D - -GDP
% 2018 % 2018
Japan 234.2 Zimbab e 72.6

G eece 181.8 Angola 71.6
I al 127.5 Zambia 68.0
Uni ed S a e 109.5 India 67.3
Gambia 105.2 Sie a Leone 64.0
F ance 96.2 China 54.4
B a il 90.2 Came oon 34.1
Canada 83.8 Chile 24.6
Uni ed Kingdom 85.9 B lga ia 22.8
S : Deb GDP Ra i b C 2020

T 11.4: Deb - o-GDP a io in elec ed co n ie
I
If a go e nmen an o dec ea e he i e of i deb , i m ha e b dge pl e a he han
b dge defici . A b dge pl a e ha e een abo e mean ha go e nmen e en e a e g ea e
han go e nmen pending. Thi e a amo n of e en e o e and abo e pending can be ed o pa
back a po ion of he deb , hich ill o k o ed ce i o e all i e.
Ho e e , hi ma c ea e e io diffic l ie fo he go e nmen . In o de o achie e b dge
pl e , i m ei he inc ea e a e , o i m dec ea e pending. Bo h of he e a e poli icall
npop la . B mo e e io han he poli ical con eq ence a e he economic con eq ence of
inc ea ed a e o lo e go e nmen pending. A o ma emembe f om Chap e 9, inc ea ed
a e on con me income ed ce con mp ion pending (C) hile inc ea ed a e on b ine
p ofi ed ce in e men pending (I). Red c ion in bo h C and I ca e agg ega e demand o fall,
e l ing in lo e eal GDP. A he ame ime, dec ea e in go e nmen pending al o ca e
agg ega e demand o fall, e e ing a f he do n a d p h on eal GDP. The e l i ha a he
go e nmen ie o achie e a b dge pl , i ca e eal GDP o fall, c ea ing a ece ion o a
defla iona gap (nega i e g o h).
Wha happen hen o he deb - o-GDP a io? I ac all inc ea e ! The go e nmen can hen end p
being o e off in e m of he i e of i deb ela i e o GDP.
B he o doe no end he e. Once he ece ion begin , c clical nemplo men inc ea e , and
income fall, hich mean ha he go e nmen a e en e fall. A he ame ime, he go e nmen
pending on nemplo men benefi inc ea e. The fall in a e en e and inc ea e in go e nmen
e pendi e happen a he ame ime ha he go e nmen i ing o inc ea e i a e en e and
ed ce i e pendi e . A a e l he go e nmen i conf on ed b a i a ion he e o achie e a
b dge pl i m inc ea e a e e en mo e and c pending e en mo e, c ea ing a icio ci cle
of f he dec ea e in agg ega e demand and falling eal GDP.
Thi i ha happened in he ca e of G eece, hich a Table 11.4 ho ha he econd highe deb -
o-GDP a io in he o ld ( ee Real o ld foc 11.1 and 17.1, Chap e 17).
In fac , a co n deb - o-GDP a io can be ed ced in ano he , fa mo e logical a . Ve impl ,
hi can be done h o gh economic g o h hich a e kno in ol e highe eal GDP. A GDP
inc ea e , he deb - o-GDP a io fall . Fo e ample, he Uni ed S a e af e he Second Wo ld Wa had
he e high deb - o-GDP a io of 122%. Wi hin en ea hi had been c in half d e o economic
g o h, i ho he go e nmen ha ing paid back i deb .
I
Go e nmen deb i likel o inc ea e ineq ali in income di ib ion. B e of go e nmen bond ,
ho a e he lende o he go e nmen , end o be highe income people. When he go e nmen pa
hem in e e , i doe o h o gh a e en e . The efo e he e i a an fe of income a a f om
lo e income a pa e and o a d highe income bond holde .
L
Fea ha a go e nmen ma be nable o e ice i deb c ea e nce ain ega ding economic
condi ion and ca e a a p i a e in e o , bo h dome ic and fo eign. E en if in e men doe ake
place, i i mo e likel o in ol e ho - e m in e men p ojec i h q ick e n , a he han
longe - e m one i h g ea e po en ial o ppo economic g o h.
P
A le el of deb i e, he e come a poin he e he le el of deb canno be ained: ne deb
eq i e highe deb e ice pa men , hich eq i e mo e fo eign bo o ing, hich lead o mo e
deb e icing pa men , and o on, in a elf- einfo cing pi al in hich he co n i apped. Thi
ha been e med he deb ap , in ol ing a i a ion he e a co n m keep on aking o ne
loan in o de o pa back he old one . Man co n ie , pa ic la l in La in Ame ica and b-
Saha an Af ica, e e ca gh in a deb ap d ing he 1980 and G eece ha been ca gh in one in
mo e ecen ea .
L
The abo e fac o ma o k o lo e economic g o h in co n ie i h high le el of deb , d e o
lo e go e nmen pending, inc ea ed a e , ed ced in e men and fe e impo of capi al good .

1 E plain he meaning of go e nmen deb in ela ion o b dge pl e and defici .
2 Di c ome of he co of a high le el of go e nmen deb .
REAL ORLD FOCUS 11.1

A
The polic of inc ea ing a e and ed cing go e nmen pending o deal i h b dge defici and
go e nmen deb i kno n a a e i . A e ill di co e in Chap e 13 i i ell kno n ha
a e i i likel o lead o ece ion. Ho e e , in pi e of ha he e i a majo deba e among
economi abo he he hi i he app op ia e polic o deal i h defici and deb .
When he financial c i i of 2008 occ ed, man e o one co n ie fea ed a deb c i i , in hich
hei pending o pa back deb o ld be oo high, in o he o d he fea ed hei deb o ld
become n ainable. G eece in fac did face a e io deb c i i ( ee Real o ld foc 17.1,
Chap e 17). The he efo e began a polic of a e i .
Ye acco ding o n me o die , incl ding o b The In i e of In e na ional Finance and
O fo d Economic , he a e i polic led o lo e GDP g o h in he ea follo ing he c i i .
Thi in ol ed ed c ion of bo h ac al GDP a ell a po en ial GDP. In e m of he b ine
c cle diag am in Fig e 8.4 (Chap e 8) hi ha mean malle e pan ion of ac al o p and a
fla e long- e m g o h end ho ing po en ial GDP. I a like le ing ai o of a bo ncing
ball. I abili o bo nce back go o e he mo e i a defla ed. 5 I i e ima ed ha in he en
ea ince 2008, E ope lo an econom he i e of Spain, i h a GDP of $1.3 illion and 19
million emplo ed people.
Mo eo e , he deb i e a no ol ed. In ead, h o gh lo e eal GDP g o h, he deb b den
a inc ea ed a he han ed ced. Acco ding o he Ha a d B ine Re ie
E eg e e e eciall h e i ggli g S he E ea c ie (S ai ,
G eece, P gal) i ched d a a icall a d a e i i he ea 2010-2014. M
e e ag ee ha he e licie had ch da agi g a d e i e ega i e effec
g h ha he e e elf-defea i g. G e e e e ed ci g e di g i de bi g
hei deb le el de c l. B GDP fell ch ha he ac al effec a h he
a i f deb GDP. A a e l , deb beca e e e le ai able ha bef e he a e i
ea e e e i le e ed.
F 11.5: Mad id, Spain. P o e o in he Ma ch fo digni in 2014, p o e ing again he

go e nmen ' a e i p og amme and he ocial and economic c i i
S : B i e I ide
Ha a d B i e Re ie
A
1 U e a b ine c cle diag am o ho ho a ei affec ed
ho - e m fl c a ion , and
he long- e m g o h end of e o one economie .
2 Al ho gh a goal of a e i i o ed ce he deb - o-GDP a io, e plain ho hi polic had
he oppo i e effec in he e o one.
5 E ope ha made a poli ical deci ion o go in o ece ion

11.3 P a c c b ac c c
b c
LEARNING OBJECTIVES

• discuss the trade-off between inflation and unemployment based on: (HL only)
• the short-run and long-run Phillips curves (AO3)
• AD-AS diagrams (AO4)
• Phillips curve diagrams (AO4)
• discuss the potential conflict between (AO3)
• low unemployment and low inflation
• high economic growth and low inflation
• high economic growth and environmental sustainability
• high economic growth and equity in income distribution
L a a
The trade-off based on the Phillips curve (HL only) and the potential conflict between low
unemployment and low inflation were discussed in Chapter 10, Section The c f c be ee
e e a d fa . The discussion came at the end of the discussion of low unemployment
and low inflation which were the two macroeconomic objectives discussed in Chapter 10.
H c c a a
This topic was introduced above under C e e ce f ec cg h. We can now discuss this
further by referring to the distinction between demand-pull and cost-push inflation.
D a - a a c c
Demand-pull inflation is caused by increases in aggregate demand. This can be shown both by use of the
monetarist-new classical model and the Keynesian model as a rightward shift in the AD curve, shown in
Figure 10.5 (Chapter 10).
In the Keynesian model, as long as AD increases along the horizontal portion of the AS curve, there is
economic growth with no inflation. Therefore as long as the economy is operating in a deflationary gap,
below potential output, there is no conflict between low inflation and economic growth as growth can
occur with no inflationary pressures. The same is not true in the monetarist/new classical model, as here
when the economy is in a deflationary gap, an increase in aggregate demand will result in both economic
growth and an increase in the price level, suggesting a possible conflict.
However, as the economy approaches potential output, inflationary pressures appear also in the
Keynesian model due to resource bottlenecks, suggesting the emergence of a conflict between economic
growth and low inflation in this model as well.
The only way that further increases in aggregate demand will not be inflationary, in the context of both
models, is if at the same time that aggregate demand is increasing there is an increase in long-run
aggregate supply (LRAS) or Keynesian AS, shown by rightward shifts in these two curves as in Figure
11.3. We can see in this figure that as AD increases by the same amount as the AS curves, increases in
real GDP are not accompanied by a higher price level. The reason is that as the economy s total demand
for real GDP increases, there is a corresponding increase in the economy s ability to supply that real
GDP. But if AD increases faster than LRAS or Keynesian AS, then increases in real GDP or economic
growth will result in inflation.
C - a
This is caused by decreases in short-run aggregate supply due to such factors as higher prices of factors
of production. As Figure 10.6 (Chapter 10) shows, the leftward shift in the SRAS curve leads to a higher
price level and a fall in real GDP, or negative economic growth, also known as s agf a . Therefore,
with cost-push inflation it is not possible to have positive economic growth at the same time as the price
level is rising.
H c c a a a ab
This topic was explored above under C e e ce f ec cg h, where it was concluded that
economic growth and environmental sustainability can be pursued together provided governments take
appropriate measures to ensure sustainable resource use. This is the meaning behind the concept of
a ab e de e e .
H c c a c b
This topic was also explored under C e e ce f ec cg h. It was concluded that economic
growth is neither good nor bad for income distribution; this instead depends very much on the kinds
of policies countries adopt in order to achieve and handle growth.

Using your knowledge of economics and the information provided in this chapter and Chapter 10,
discuss the extent to which there may be a conflict between:
a low unemployment and low inflation
b high economic growth and low inflation
c high economic growth and environmental sustainability
high economic growth and equity in income distribution.

The following questions will help you reflect on your learning and enhance your understanding of key
topics in this chapter. They are suggestions for inquiries that you can undertake on your own or in
1 Select a country you are interested in. Examine possible conflicts between its growth and
environmental sustainability. Investigate whether any measures are being taken to deal with the
environment.
2 There are some developed countries with high debt-to-GDP ratios. Research such a country of
your choice. Does a large ratio always mean the country is struggling? Why can some developed
countries (such as the United States) maintain high debt-to-GDP ratios while others suffer
immensely?

You can find questions in the style of IB exams in the 'Digital coursebook: Extra material' section.
Chapter 12
Economics of inequalit and povert

BEFORE YOU START
In most societies, we see that there are some people who have high incomes and accumulate a lot
of wealth while others have ver little. What do ou think might be some reasons for such
extreme differences in income and wealth?
What, if an thing, do ou think governments should do to reduce extreme inequalities in income
and wealth?
Povert and inequalities in income and wealth are major issues in countries around the world. While
povert is more prominent in developing countries, it is present in rich countries as well. This chapter
will discuss causes and consequences of povert and inequalit , their measurement and policies to tackle
them.
12.1 I
LEARNING OBJECTI ES

e plain the relationship bet een equit and equalit (AO2)
e plain economic inequalit as (AO2)
unequal distribution of income
unequal distribution of ealth
use the Loren cur e and Gini coefficient (inde ) to measure economic inequalit (AO2)
dra Loren cur es to sho the distribution of income and changes in the distribution of income
(redistribution) (AO4)
construct a Loren cur e based on income quintile data (HL onl ) (AO4)
T
We encountered the concepts of equit and equalit in Chapter 1 (see Section 1.4). As eq i in ol es
fairness, something is eq i able if it is fair. This is a normati e concept because different people ha e
different ideas and beliefs about hat is fair. On the other hand eq ali or the idea of being the same is a
positi e concept because something ma be equal or unequal on the basis of some measure.
The concepts of equit and equalit are used in economics mainl to describe the distribution of income
and/or ealth. As e kno from our stud of the circular flo model (Chapters 1 and 8), income is the
mone recei ed b o ners of factors of production. Weal h, on the other hand, refers to the mone ,
assets or things of alue that people o n, such as sa ings deposits (mone sa ed in a bank); stocks in the
stock market; bonds; land, houses and other propert ; aluable paintings or je ellr , and so on.
While equit differs from equalit , it is usuall interpreted to mean equalit . Therefore the e pressions a
more equitable or more equal distribution of income or ealth usuall mean the same thing. Both
e pressions are correct, pro ided it is understood that in these cases, eq i i in e p e ed a g ea e
eq ali (o le ineq ali ). The reason that equit is most often interpreted in this a is that there is a
idel shared belief around the orld that highl unequal distributions of income are unfair. Therefore
go ernments around the orld usuall ha e in place policies that tr to reduce income inequalities.
T
E refers to the degree that people in a population differ in their abilit to satisf their
economic needs; it means inequalit in li ing conditions that arise due to monetar factors. There are
man sources of economic inequalit , including income and ealth, education, health, nutrition, gender
and more, but economists focus on inequalities that result mainl from diffe ence in income and eal h.
Income ineq ali arises from diffe ence in ho e enl income is distributed in a population. Income
includes the mone that people recei e from their emplo ment as ell as other sources including interest
from sa ings accounts and holdings of bonds, di idends from shares (stocks) in the stock market, rents
from propert that is o ned and rented out, pensions or go ernment benefits.
Weal h ineq ali arises from differences in the amount of ealth people o n, hich as noted abo e
refers to the mone or things of monetar alue including sa ings, stocks, land, houses, and more.
Both income and ealth are generall distributed unequall , so that some groups ha e much more
income and/or ealth than other groups. This applies both to populations ithin countries, as ell as
across countries.
H
Table 12.1 presents data on income distribution of selected countries around the orld. The data sho
ho income is distributed b q in ile of the population. A is a 20% portion of a countr s
population; e can di ide a population into fi e quintiles, ranging from the lo est (the poorest 20% of
the population) to the highest (the richest 20%). If income ere completel equall distributed, e er one
ould recei e e actl the same income, so e er quintile ould recei e 20% of income. Ho e er, in the
real orld this is a irtual impossibilit . In all countries in the orld, the presence of inequalities in
income distribution means that the poorest quintile of the population recei es less than 20% of income,
and the richest quintile more than 20%.
This can be seen in Table 12.1. For e ample, in Bra il the lo est quintile recei es 3.2% of income and
the highest quintile 57.8%. In Belarus, the lo est quintile recei es 9.9% and the highest quintile 35.5%.
The higher the percentage share of income recei ed b the poorest quintile, and the lo er the percentage
share recei ed b the highest quintile, the more equal the distribution of income. Therefore, income
distribution in Belarus is more equal than in Bra il.
Income shares can also be sho n b decile , hich are 10% portions of the population (there are ten
deciles) as ell as q a ile , or 25% portions of the population (there are four quartiles). Sometimes
income shares are broken do n into 1% particularl for the top, or e en the top 0.1%.
T L
AL is used to sho the degree of income inequalit in an econom . Named after an
American economist Ma Otto Loren , ho de ised this measure of income inequalit in 1905, it is a
isual representation of the kind of income distribution data in Table 12.1. To construct a Loren cur e,
e dra a square bo , as in Figure 12.1 here the ertical a is measures the total amount of income in
an econom in cumulati e percentages (therefore it runs from 0 to 100%), and the hori ontal a is plots
the total population in the econom , also in cumulati e percentages (from 0 to 100%). ( Cumulati e
means that 20 represents the poorest 20% of the population, 40 represents the poorest 40%, and so on.)
The diagonal line in the diagram represents perfect equalit , as it sho s that if income ere perfectl
equall distributed, 20% of the population ould recei e 20% of income, 40% ould recei e 40% of
income, and so on. The Loren cur e plots the ac al ela ion hip bet een percentages of the population
and the shares of income the recei e.
C P S T F R G
20% 20% 20% 20% 20%
Australia 6.8 12.0 16.1 22.1 43.0 0.36

2014
Belarus 9.9 14.2 17.9 22.5 35.5 0.25

2017
Boli ia 4.1 9.5 15.0 22.8 48.5 0.44

2017
Bra il 3.2 7.4 12.2 19.5 57.8 0.53

2017
China 6.4 10.6 15.3 22.3 45.4 0.39
2015
Denmark 9.4 13.9 17.2 21.8 37.7 0.28

2015
S. Africa 2.4 4.8 8.2 16.5 68.2 0.63

2014
United 7.5 12.2 16.8 23.0 40.6 0.33

Kingdom
2015
United 5.0 10.2 15.3 22.6 46.9 0.42

States
2016
S : Da aBank .camb idge.o g/link /ecib d8050

T 12.1: Distribution of income b quintiles and gini coefficients in selected countries
In general, the closer a Loren cur e is to the diagonal representing perfect income equalit , the
greater is the equalit in income distribution. As e can see in Figure 12.1, Belarus clearl has
greater income equalit than Bra il.
F 12.1: Loren cur es: Belarus achie es greater income equalit than Bra il
H L
(HL )
Figure 12.1 plots t o Loren cur es, one for Bra il, and one for Belarus (based on the data in Table
12.1). In the case of Bra il, the poorest 20% of the population recei e 3.2% of income; this is sho n
b point a. Point b on Bra il s cur e is obtained b adding the 3.2% of income of the poorest quintile
to the 7.4% of income recei ed b the second quintile, gi ing 10.6%, or the cumulati e income of the
bottom 40% of the population. Similarl , point c is obtained b adding the percentages of income
recei ed b the bottom three quintiles, gi ing 22.8% of income, and finall to find point d e add the
incomes of the bottom four quintiles, getting 42.3% of income for 80% of the population. When these
points are joined together starting from 0 and going up to 100% of the population, e obtain Bra il s
Loren cur e. Points e, f, g and h on Belarus cur e are calculated and plotted in e actl the same
a . As e pected Bra il s Loren cur e is further a a from the line of perfect equalit indicating
greater income inequalit .
Note that to plot a Loren cur e, e could use income distribution figures that di ide the population
into ten deciles (or tenths), or an other con enient subdi ision.
T G
The G (or G ), named after Corrado Gini, an Italian statistician, is a summar
measure of the information contained in the Loren cur e of an econom . It is defined as
Gini coefficient =
area bet een diagonal and Loren cur e entire area under diagonal = A A+B
Where A and B represent the areas sho n in Figure 12.2.
The Gini coefficient has a alue bet een 0 and 1. If there ere perfect income equalit , the coefficient
ould be ero, since the numerator of the ratio ould be ero. The larger the Gini coefficient, and the
closer it is to 1, the greater is the income inequalit , since the further a a is the Loren cur e from the
diagonal. (A perfectl unequal income distribution ould be here a single household recei es all the
income of the econom , and the numerator ould be equal to the entire area under the diagonal, making
the Gini coefficient equal to 1.)
Note that some publications e press Gini coefficients as a percentage rather than a decimal. For
e ample, a coefficient of 0.27 ould appear as 27.0. This does not in an a change in the meaning of
the Gini coefficient, hich in this method of e pression has a alue ranging bet een 0 and 100.
F 12.2: Deri ing the Gini coefficient from a Loren cur e
The last column in Table 12.1 sho s Gini coefficients that correspond to each of the income
distributions. Belarus Gini coefficient of 0.25 and Bra il s of 0.53 clearl indicate that Belarus has a
relati el more equal income distribution.
The Gini coefficien is a summar measure of income inequalit . In a Lo en diag am it is the ratio of
the area bet een the diagonal and the Loren cur e, to the total area under the diagonal. It has a alue
bet een 0 and 1; the closer the alue is to 0, the greater the income equalit ; the closer the alue is to
1, the greater the income inequalit .
E er thing that has been said abo e about measurement of income inequalit applies also to ealth
inequalit . The three methods discussed abo e, namel (i) quintiles (or deciles or quartiles), (ii) Loren
cur es, and (iii) Gini coefficients can be used in e actl the same a to sho the e tent of ealth
inequalit .
The distribution of ealth is generall far more unequal than the distribution of income in most countries
in the orld. On a erage, Gini coefficients in the case of ealth distribution are roughl double the si e
of the Gini coefficients of income distribution. This is sho n in Figure 12.3. We can see here that
de eloped countries on the hole ha e slightl lo er ealth and income inequalit than emerging
market economies, but in both groups ealth inequalit is far greater than income inequalit .
Reasons behind greater ealth inequalit include the follo ing:
Limited gro th in ages makes it difficult for lo -income and middle-income people to sa e and
accumulate ealth.
High-income people tend to consume a smaller fraction of their income than lo er-income people
therefore ha e greater possibilities of sa ing and accumulating ealth.
Income and ealth inequalities feed on each other. The greater the income, the more possibilities
for accumulating ealth, but man t pes of ealth (stocks, bonds, real estate) lead to e en more
income and hence e en more possibilities for accumulating more ealth. For e ample, in the
United States, in 2015 the share of income that came from ealth for the richest 1% of the
population as nearl 60%, hile the share of income coming from ealth for the bo om half (or
50%) of the population as about 5%.1
F 12.3: Income and ealth inequalit in ad anced economies* and emerging market economies**
* Ad anced economies include de eloped countries
** Emerging market economies include Argentina, Bra il, China, India, Indonesia, Me ico, Pakistan,
Thailand and Turke
S : In e na ional Mone a F nd
Later in this chapter, e ill consider methods go ernments can use to redistribute income and ealth,
to make their distribution more equal. Graphicall , this appears as a shift of a countr s Loren cur e
closer to the diagonal line, and is reflected in a lo er Gini coefficient. Figure 12.4 sho s ho a Loren
cur e shifts to ards the diagonal after the go ernment pursues policies to redistribute income or ealth
to reduce the degree of economic inequalit in the econom .
F 12.4: Loren cur es and income redistribution

1 Outline the meaning of equit and equalit and ho the relate to each other.
2 Using e amples, e plain the meaning of economic inequalit .
3 Outline the meaning of quintiles, and ho e use them to measure income distribution.
4 List the countries in Table 12.1 in order of increasing income inequalit and e plain our
reasoning.
5 Define the Gini coefficient.
Using a diagram, describe ho e deri e it from a Loren cur e diagram.
State its possible range of alues.
Outline ho e interpret its possible alues ith regard to income equalit /inequalit .
6 Choose an t o countries from Table 12.1 and dra their Loren cur es in a single diagram
(HL students should plot the Loren cur es).
Outline ho ou use our Loren cur e to determine hich countr has a more equal
distribution of income.
Describe ho ou can use the corresponding Gini coefficients to compare the income
distributions of the t o countries.
7 Outline ho redistribution of income changes the position of a countr s Loren cur e.
Describe ho redistribution ould be reflected in a Gini coefficient. (Make sure ou
distinguish bet een redistribution that increases or decreases income equalit .)
8 Describe the methods that can be used to measure ealth inequalit .
REAL ORLD FOC S 12.1

T
Trends in ealth concentration In the United States, ealth concentration had peaked in 1929 hen
the top 0.1% of the population o ned nearl 25% of ealth. It then began to fall steadil , reaching a
lo in 1978 hen the top 0.1% o ned 7% of ealth. Since then it has been steadil climbing again.
In the period before 2020 the richest 0.1% o ned o er 20%, hile the richest 1% o ned 40% of
ealth.2 Moreo er, the three richest Americans held more ealth than the bottom 50% of the
population of the United States.3
In England ( hich is part of the United Kingdom) less than 1% of the population o ns half of
England s land. This includes about 25 000 lando ners, consisting mainl of the aristocrac and
corporations. B contrast, all of England s homeo ners (in a population of about 55 million people)
o n 5% of the land.4
High ealth concentration e ists on a global le el as ell, here ealth inequalit is also gro ing. It
is estimated that the richest 1% of the global population o ns half of the orld s ealth.5 The top
10% of the combined populations of China, Europe and the US o n more than 70% of ealth, hile
the bottom 50% o ns less than 2% of ealth. If countries in Latin America, Africa and the rest of
Asia ere included, ealth concentration ould be e en greater as in most countries the share of
ealth o ned b the bottom 50% is close to ero.6
If trends in ealth accumulation that began in 2008 ith the Global Financial Crisis continue, the
orld s richest 1% ill control t o-thirds of the orld s ealth b 2030. Since 2008, the ealth of
the richest 1% has been gro ing at about 6% per ear, compared to 3% per ear for the remaining
99%.7
F 12.5: Bel Air Los Angeles, USA. Neighborhood ith mansions and golf course
A
1 Dra Loren cur es to illustrate the changes obser ed in ealth distribution in the United States
from the earl 20th centur up to the present.
2 Dra Loren cur es to illustrate the change in global ealth distribution since 2008.
1 Wealth inequalit is e en orse than income inequalit
2 Global Wealth Inequalit
3 The 3 Richest Americans Hold More Wealth Than Bottom 50% Of The Countr , Stud Finds
4 Half of England is o ned b less than 1% of the population
5 Causes and Consequences of Income Inequalit : A Global Perspecti e
6 Global Wealth Inequalit
7 Richest 1% on target to o n t o-thirds of all ealth b 2030

12.2 P
LEA NING OBJEC I E

e plain he diffe ence be een ab ol e and ela i e po e (AO2)
e plain ho po e i mea ed ing (AO2)
ingle indica o incl ding
in e na ional po e line
minim m income anda d
compo i e indica o incl ding
he M l idimen ional Po e Inde (MPI)
e plain diffic l ie in mea ing po e (AO2)
P efe o an inabili o a i f minim m con mp ion need . Be ond hi gene al defini ion,
he e a e o diffe en pe pec i e on ho be o define po e : in an ab ol e en e and in a ela i e
en e.
A
A efe o a i a ion he e a pe on o famil doe no ha e eno gh income o mee
ba ic h man need . Mea e of begin b defining a minim m income le el called a
. Acco ding o he OECD, a po e line i : An income le el ha i con ide ed minimall
fficien o ain a famil in e m of food, ho ing, clo hing, medical need and o on. 8 Mo
co n ie ha e a na ional po e line, de e mined b go e nmen a ho i ie a an app op ia e amo n
of income eq i ed o a i f minim m need . In addi ion, he Wo ld Bank (an in e na ional o gani a ion
ha lend o de eloping co n ie fo de elopmen p po e ; ee Chap e 20) ha de e mined an
in e na ional po e line o be:
li ing on le han $1.90 a da , hich i defined a ; hi fig e i pe iodicall
adj ed o ake infla ion in o acco n
Once a po e line ha been de e mined, he amo n of po e i fo nd b aking he pe cen age of a
pop la ion (o he n mbe of indi id al ) ho e income fall belo he po e line.
Da a on e eme po e in elec ed co n ie a o nd he o ld, compiled b he Wo ld Bank, appea in
Table 12.2. No e ha he able incl de de eloped co n ie a ell a de eloping one .
In a majo d on global po e in 2018, he Wo ld Bank concl ded ha he e ha been ignifican
p og e in ed cing e eme po e , hich fell f om 36% of he global pop la ion in 1990 o 10% in
2015. Acco ding o he Bank, he g ea e p og e a made in Ea A ia and So h A ia, hile b-
Saha an Af ica ho ed a m ch lo e pace of po e ed c ion.
C P % C P %
Iceland 0 India 13.4
Po gal 0.1 Banglade h 15.2
No a 0.2 So h Af ica 18.9
I eland 0.2 E hiopia 27.0
Uni ed Kingdom 0.2 Chad 34.1
A alia 0.5 Tan ania 40.7
China 0.7 R anda 51.5
B a il 3.4 Mo ambiq e 62.2
Philippine 8.3 Cen al Af ican Rep blic 77.7
:P T :T P P
12.2: E eme po e (li ing on le han $1.90 pe da ) in elec ed co n ie , 2015
A no ed abo e, in addi ion o he Wo ld Bank line, bo h de eloped and de eloping

co n ie al o ha e na ional po e line . The e a e all e a a highe income le el han ha of he
Wo ld Bank, o ha a la ge pe cen age of people a e con ide ed poo b na ional anda d .
The Wo ld Bank ha been c i ici ed on he g o nd ha i in e na ional po e line of $1.90 pe da i
oo lo o be meaningf l in e m of po e ed c ion.9 Fo e ample, in So h Af ica he Bank
in e na ional po e line p 18.9% of he pop la ion belo he po e line, hile acco ding o he
So h Af ican go e nmen po e line 55% of he pop la ion a e poo .10
In ackno ledgemen of hi poin he Wo ld Bank p e en o mo e po e line :
li ing on le han $3.20 a da i a po e line fo lo e -middle-income co n ie
li ing on le han $5.50 a da i a po e line fo ppe -middle-income co n ie .11
Nea l half of he o ld pop la ion li e belo he po e line of $5.50 pe da .12
In addi ion, in ecogni ion of he limi a ion of in e na ional po e line , he Wo ld Bank ha p opo ed
a mea e of po e ha ake in o acco n dimen ion of po e in addi ion o
income, o be di c ed belo .
i a concep ha compa e he income of indi id al o ho ehold in a ocie ih

median13 income . I i clo el ela ed o ho eq all o neq all ocie income i di ib ed
among i o al pop la ion. If income e e eq all di ib ed, he e o ld be no ela i e po e , ince
no one o ld be poo ela i e o omeone el e. In gene al, he mo e neq al he di ib ion of income,
he g ea e i he deg ee of ela i e po e .
The idea behind ela i e po e i ha po e i m ch mo e han being nable o affo d a minim m of
ba ic good and e ice . E en ho gh people ma be able o b ba ic nece i ie , he a e ill poo if
he canno affo d good and e ice and a life le ha a e pical in a ocie . The mea emen of
ha i pical i ba ed on a anda d de e mined b he median income le el. If people income fall
fa belo hi median le el, he a e con ide ed poo . Mea emen of ela i e po e in ol e
pecif ing a pa ic la pe cen age of median income belo hich he e i po e . Of en hi i aken o
be 50%. Fo e ample, a he median ann al famil income in an econom i $20 000. Taking 50% of
hi , e ha e $10 000. An famil ho e ann al income fall belo $10 000 i con ide ed poo (in
ela i e e m ). Table 12.3 p e en da a on ela i e po e in ome de eloped co n ie .
C % C % of pop la ion
50% li ing belo 50% of
median income
(2017 (2017 o la e
) a ailable)
Iceland 5.4 Ge man 10.4
Denma k 5.5 Uni ed Kingdom 11.1
Ne he land 8.3 A alia 12.1
No a 8.4 Canada 12.4
Belgi m 9.7 G eece 14.4
I eland 9.8 La ia 16.9
H nga 10.1 Uni ed S a e 17.8
:P
12.3: Rela i e po e in economicall mo e de eloped co n ie , 2017
Whe ea he di c ion abo e ha been in e m of po e a e , i i impo an o no e ha

po e a e diffe idel among ocial g o p in a ocie . In gene al, olde people, child en, ingle-
pa en ho ehold , omen, and acial and e hnic g o p ha ffe di c imina ion, face highe po e
a e han na ional a e age . Thi applie o mo co n ie in he o ld, bo h mo e and le de eloped.
Table 12.4 ho ho po e a e a in he Uni ed S a e b ace and b age fo each ace.
18 % 18 64 % 65
%
Black 28.8 18.3 19.3
Hi panic 24.7 15.0 17.0
A ian 11.1 9.5 10.8
Whi e 10.5 8.6 7.0
12.4: Uni ed S a e po e ae b ace and age, 201714
While he di c ion he e i abo ineq ali b ocial g o p in po e , i migh be no ed ha he e i

ineq ali b ocial g o p in eal h a ell. The e i a la ge acial gap in eal h in he Uni ed S a e ,
hich i o ening a Black eal h i dec ea ing hile Whi e eal h i inc ea ing. Acco ding o
p ojec ion , in 2020, Whi e ho ehold ill o n 86 ime mo e eal h han Black ho ehold . If p e en
end con in e, in 2053 Black median eal h ill ha e hi e o, hile Whi e median eal h ill
inc ea e o $137 000.15 The e de elopmen indica e ha Black ho ehold on a e age a e a i k of
becoming impo e i hed.
Bo h ab ol e and ela i e po e mea e , on a na ional le el and fo pa ic la ocial g o p , a e e
ef l o go e nmen a g ide o policie p o iding income ppo ( ch a an fe pa men ; ee
Sec ion 12.5) a ell a mea e in ended o comba po e .
M
M (MIS) efe o a me hod o mea e po e de eloped b he Jo eph
Ro n ee Fo nda ion in he UK. The me hod con i of ongoing e ea ch on ha people in a
pop la ion belie e a e he e en ial fo a minim m accep able anda d of li ing ha allo people o
pa icipa e in ocie . The MIS hen p od ce b dge fo a ba ke of good incl ding n me o e en ial
i em like food, clo hing, ho ing, childca e, f el co and ocial and c l al pa icipa ion, eq i ed b
ho ehold in o de o achie e he minim m anda d of li ing. Ba ed on hi info ma ion i calc la e
he minim m income ha i eq i ed fo diffe en famil pe (acco ding o n mbe of people, age ,
geog aphical a ea , e c.) o be able o b he e en ial in he ba ke .
The MIS e eal impo an info ma ion abo :
he n mbe of people li ing belo he minim m income eq i ed o b he e en ial
he ela i e con ib ion of each i em in he ba ke o ho ehold abili ie o achie e MIS
ho he e change o e ime.
Thi info ma ion can be helpf l o go e nmen a a g ide o making policie o deal i h po e .
Calc la ion of he MIS began in he UK in 2008. Se e al co n ie ha e been cond c ing pilo
(e pe imen al) die i h he MIS incl ding F ance, I eland, Japan, Me ico, Po gal, Singapo e,
So h Af ica and Thailand.
C
Compo i e indica o a e mea e of comple phenomena ha canno ea il be de c ibed b a ingle
indica o . The he efo e o cap e mo e han one dimen ion of he i e in q e ion. We ill d
compo i e indica o in g ea e de ail in Chap e 18.
M P I (MPI)
The M P I (MPI) a de eloped in 2010 b he Uni ed Na ion
De elopmen P og amme and he O fo d Po e and H man De elopmen Ini ia i e. I mea e
po e in h ee dimen ion : heal h, ed ca ion and li ing anda d . Each of he e dimen ion i in ended
o eflec (e en ial hing ha people do no ha e) mea ed b he follo ing en
indica o :
Heal h i mea ed b Li ing anda d a e mea ed b

child mo ali cooking f el
n i ion ani a ion
Ed ca ion i mea ed b d inking a e
ea of chooling elec ici
chool a endance ho ing
a e
HEO OF KNO LEDGE 12.1

A
The concep of ab ol e and ela i e po e ha e diffe en implica ion fo he meaning of po e .
The concep of ab ol e po e , ba ed on an ab ol e po e line ha doe no change o e ime
(e cep fo adj men fo infla ion), gge ha i h economic g o h e e one ill e en all
i e abo e he po e line. The efo e, man co n ie ha e pe ience long- e m g o h ha e been
eeing falling ab ol e po e a e . The ela i e po e line, b con a , change con an l o e
ime a income g o , and he poo a e ho e ho canno keep p i h i ing a e age/median
income . Rela i e po e ha ac all been in man co n ie o e ecen decade , d e o
income ineq ali ie .
The follo ing famo pa age, i en b Adam Smi h ( he Fa he of Economic ) in he 18 h
cen in hi cla ic book, T N , offe an e plana ion of he diffe ence be een he
o meaning of po e , b efe ing o he meaning he a ache o nece a ie :
B I ,
, ,
, . A , , , ,
.T G R ,I , ,
. B , E , -
,
, , ,
. . . Unde nece a ie he efo e, I comp ehend, no onl ho e hing
hich na e, b ho e hing hich e abli hed le of decenc ha e ende ed nece a o he
lo e ank of people. 16
Acco ding o Adam Smi h, a pe on ho ha he ba ic nece i ie of life eq i ed fo ph ical
i al b doe no ha e a linen hi i ela i el poo , b no ab ol el poo . One ho doe no
e en ha e he ba ic nece i ie of life i ab ol el poo (and, of co e, al o ela i el poo ).
A no ed in he e , mea e of po e a e impo an beca e he fo m he ba i fo an i-po e
p og amme ch a an fe pa men . Diffe en co n ie e diffe en mea e fo hi p po e.
Fo e ample, in he Uni ed S a e he official po e mea e ed o de e mine eligibili fo
go e nmen a i ance i an ab ol e one; in he E opean Union, he official po e mea e i a
ela i e one ( ho gh bo h calc la e ab ol e and ela i e po e a e ).
Doe ocie ha e a mo al obliga ion o help he poo ?

Adam Smi h iden ifie nece a ie o be ho e hing hich e abli hed le of decenc
ha e ende ed nece a . Wo ld he define po e in he ab ol e o in he ela i e en e?
Wha kind of c i e ia a e impo an fo making a choice be een ab ol e and ela i e
po e a he ba i fo an i-po e p og amme ( ocial cien ific, e hical o o he )?
A ocie choice be een an ab ol e o ela i e po e mea e a he ba i fo polic
e on ome p inciple of eq i . Wha do o hink migh be an eq i p inciple fo he US
e of ab ol e po e and fo he EU e of ela i e po e ? Ho do he eq i p inciple
diffe f om each o he ?
A hi li of indica o ho , he MPI goe be ond con ide ing po e olel in e m of ,

con ide ing in ead a a ie of a ea in hich poo people e pe ience . The empha i on
dep i a ion a in od ced b he Nobel P i e inning Indian economi Ama a Sen ( ee Chap e
18).
The MPI i ed a a mea e of po e in de eloping co n ie ( he e ill be died in Chap e 18
20). I incl de 105 co n ie (a of 2019) co e ing 5.7 billion people o 77% of he o ld pop la ion.
Each co n ecei e an MPI al e f om 0 o 1, he e he highe he MPI al e he g ea e he po e .
In o de o be co n ed a , people m be dep i ed in a lea one- hi d of he indica o li ed
abo e. Info ma ion i p o ided on he n mbe of people and he pe cen age of he o al pop la ion ho
a e poo in each co n . An impo an ad an age of he MPI i ha i can be b oken do n b indica o
o ha fo each co n i i po ible o de e mine hich indica o make he mo impo an
con ib ion o po e .
Fo e ample, Tajiki an and Pe ha e imila MPI , hich a e 0.049 fo Tajiki an and 0.052 fo Pe .
B in Pe 18% of po e i d e o dep i a ion in ea of chooling hile in Tajiki an onl 1% of
po e i d e o hi indica o . B con a , in Tajiki an 35% of po e come f om maln i ion hile
in Pe i i abo 18%.17
Table 12.5 ho ha nea l one-q a e of he pop la ion of he 105 co n ie li e in m l idimen ional
po e . Mo of he o ld MPI poo , o 89%, li e in So h A ia o b-Saha an Af ica.
D MPI N %
( ) *
Ea e n E ope and 0.009 3.5 2.4%

Cen al A ia
Ea A ia and he 0.025 117.7 5.9%

Pacific
La in Ame ica and 0.033 30.7 7.7%

he Ca ibbean
A ab S a e 0.098 65.7 19.2%
So h A ia 0.143 545.9 31.3%
S b-Saha an Af ica 0.317 559.4 57.7%
Global MPI 0.115 1.33 billion 23.2%

De eloping egion
* Poo people a e defined o ho e ho a e dep i ed in one- hi d o mo e of he indica o

:G M P I 2018
12.5: M l idimen ional po e b egion 2018
While he MPI con ide po e in de eloping co n ie , a e ha e een he e i po e in de eloped

co n ie a ell. Acco ding o he Uni ed Na ion De elopmen P og amme:
D .
A 11 O E C -
D (OECD18) 2014. A 2012
633 000 S 284 000 G ...A 15
15 29
. H . T
53.8 OECD
, ,
. 19
M P I MPI) B
The Wo ld Bank ( ee Chap e 20) i in he p oce of de eloping ano he MPI. A no ed b he Bank, he
anda d mone a mea e of po e doe no cap e impo an a pec of ell-being, ch a acce
o heal h ca e o a ec e comm ni . I he efo e p opo e a ne MPI o complemen ha of he UNDP
and O fo d b incl ding a mone a indica o (income ) a ell a ome addi ional indica o .
The Wo ld Bank p opo ed indica o a e ho n in Table 12.6.
Income pe capi a Elec ici
Child chool en olmen Co e age of ke heal h e ice
Ad l chool a ainmen Malno i hmen (child and ad l )
Limi ed- anda d d inking a e Incidence of c ime
Limi ed- anda d ani a ion Incidence of na al di a e
:O K R
12.6: Wo ld bank p opo ed indica o fo M l idimen ional Po e Inde
D
The mea emen of po e i a challenging a k fo e e al ea on .
P
A e ha e een he e a e diffe en mea e of po e , depending on ho hi i in e p e ed. The e i
he di inc ion be een ab ol e po e and ela i e po e , hich gi e i e o e diffe en e ima e
on he e en of po e . In addi ion, he e i po e mea ed on he ba i of income, a ell a po e
mea ed on he ba i of dep i a ion in a n mbe of diffe en non-mone a a ea , kno n a
m l idimen ional po e . All he e a e no con i en i h each o he .
M
Of en, a e ha e een, po e i mea ed on he ba i of income of a ho ehold. Ho e e ,
people al o ha e ome eal h o le e o g ea e deg ee , o he ma ha e ome a ing , on hich
he can fall back in ha d ime . Income mea e of po e do no ake eal h o a ing in o
con ide a ion.
In ome ca e po e i mea ed b e of ho ehold e . Thi ai e e e al i e:
he info ma ion p o ided b he ho ehold ha a e e ed i bjec i e, o ha diffe en
people ma ha e diffe en opinion abo hei economic i a ion
ch e do no incl de homele people and people in in i ion ho a e m ch mo e
affec ed b po e , e l ing in nde e ima e of he e en of po e
income fig e ma be nde a ed in ca e he e he e i f eelance o k o income f om
in e men , e l ing in o e e ima e of po e .
U ban a ea all ha e a highe co of li ing han al a ea , o na ional po e line of en
e cl de man poo in ban a ea ho canno affo d nece i ie like food, ho ing.
Po e line ell ho man people (o he pe cen age of people) fall belo he po e line, b
do no p o ide an info ma ion on ho m ch he fall belo he po e line. In one ca e he
majo i of poo ma be belo b clo e o he po e line, he ea in ano he he ma be fa
belo . Clea l he e i g ea e po e in he econd ca e han in he fi .
O
Depending on pa ic la goal of go e nmen , he na ional po e line (fo ab ol e po e ) ma be
o e e ima ed o nde e ima ed.
O e e ima ion e l in a la ge p opo ion of a pop la ion ho e income fall belo hi line. Thi can
be ed b go e nmen o a g e in fa o of ecei ing mo e fo eign aid o m l ila e al a i ance ( ee
Chap e 20).
Unde e ima ion e l in a malle p opo ion of a pop la ion i h an income belo hi minim m.
Thi can be ed b go e nmen fo m la ing na ional a egie fo po e ed c ion, in he e en ha
he o ld like o pend le on po e ed c ion han on o he ac i i ie demanding go e nmen
f nding.
E O NDE ANDING 12.2
1 E plain he diffe ence be een ab ol e and ela i e po e .

O line he he i make en e o compa e po e a e mea ing ab ol e po e ih
a e mea ing ela i e po e .
2 Di ing i h be een po e line and minim m income anda d a mea e of po e .
3 The Wo ld Bank lend o de eloping co n ie fo de elopmen p po e . O line he he o
hink i make en e o e he Wo ld Bank defini ion of ab ol e po e o mea e po e
in de eloped co n ie .
4 U ing e ample , e plain po ible ad an age of compo i e indica o o e ingle indica o a
mea e of po e .
5 Di c diffic l ie o nding effo o mea e po e .
8 OECD, Glo a of S a i ical Te m , Po e Line.
9 Wh he Wo ld Bank i aking a ide-angle ie of po e
10 Wh he Wo ld Bank op imi m abo global po e mi e he poin
11 Lo e -middle-income co n ie ha e a pe capi a GNI of $996 $3895 hile ppe -middle-income co n ie

ha e a pe capi a GNI of $3896 $12 055 Ne co n cla ifica ion b income le el: 2018-2019
12 Nea l Half he Wo ld Li e on Le han $5.50 a Da
13 The median i he n mbe ha i in he middle of a e ie of n mbe . The efo e, he median income i ha

income ha lie in he middle of all income le el , o ha half of income le el a e g ea e and half a e lo e .
No e ha he median i diffe en f om he a e age o mean.
14 Hi o ical Po e Table : People and Familie - 1959 o 2018
15 Repo : The Road o Ze o Weal h
16 Adam Smi h (1937) An Enq i in o he Na e and Ca e of he Weal h of Na ion , Ne Yo k, Mode n

Lib a , pp. 821 2 (Book V, Chap e II, Pa II, A icle 4 h).
17 Global M l idimen ional Po e Inde 2018
18 The OECD incl de 36 co n ie mo of hich a e de eloped.
19 H man De elopmen Repo 2016

12.3 C
LEARNING OBJECTIVES

e plain causes of economic inequalit and povert including (AO2)
inequalit of opportunit
different levels of resource o nership
different levels of human capital
discrimination (race, gender and others)
unequal status and po er
government ta and benefits policies
globalisation
technological change
market-based suppl -side policies
Economic inequalit and povert have similar and overlapping causes. The societies that have the most
equal distributions of income also tend to have lo er levels of povert (mainl in Nordic countries). The
reason is that policies that favour greater income equalit overlap ith those that reduce povert . We ill
e amine such policies later in this chapter.
I
O can be defined as a set of circumstances that makes it possible for someone to do
something. To understand ine ali f ni , it is useful to compare and contrast it ith ec n mic
ine ali .
Economic inequalit is concerned ith inequalities in standards of living that arise from monetar
factors like income and ealth. As such it is concerned ith inequalities in c me in anda d f
li ing arising from income and ealth differences.
Inequalit of opportunit is concerned ith inequalities in en ial c me in anda d f li ing that
arise from circumstances that are be nd ne c n l. The World Bank terms it the lotter of birth .20
Important circumstances that affect life opportunities and are be ond one s control include such factors
as:
parents level of education and occupation
parents level of income
place of birth
gender
race and ethnicit .
There ould be equalit of opportunit if ever one began life from a situation here all factors like the
above ere equal. In such a h pothetical situation, inequalities in c me ould be due to
circumstances over hich people have control, such as effort in school, effort on the job and hard ork.
Yet in the real orld, it is apparent that large and gro ing economic inequalities cannot be e plained b
differences in circumstances over hich people have control, such as effort and hard ork. For this
reason, economists have recentl taken a strong interest in stud ing the factors that give rise to
inequalit of opportunit , and the e tent to hich inequalit of opportunit contributes to economic
inequalit .
An earl stud of si Latin American countries found that circumstances over hich people have no
control (father s occupation, parents education, and region of birth) contributed to economic inequalit
from at least 25% in Columbia to at least 51% in Guatemala.21 A larger stud of 41 countries found that
circumstances contributed 4% in Nor a and 40% in Mali.22
A more detailed stud of the United Kingdom and the United States found that such circumstances as
parent s education, time spent ith parents, race and childhood behavioural problems are responsible for
31% of inequalit in the United Kingdom and 45% in the United States.23
D
Human capital refers to the skills, education and good health that people possess (see Chapter 11). Lo
levels of education and skills translate into lo incomes because there is generall a positive (direct)
relationship bet een skill/educational attainment and income levels. Poor levels of health also lead to
lo incomes because an unhealth person is likel to be less productive and therefore more poorl paid.
Unskilled people ma rel on the minimum age, hich ma be insufficient to support a famil .
D
Some people inherit, or accumulate through savings from ver high incomes, financial capital (cash,
stocks and bonds) or other forms of propert (such as agricultural land or a home), hich gives them
both an income advantage as ell as increased ealth. Yet man others have no resources to rel on
other than their labour, hich for numerous reasons (such as lo levels of human capital, discrimination
and others) ma not provide them ith an adequate income. People on lo incomes often do not o n a
home and therefore have to pa rent, hich ma take up a substantial portion of their income ithout
building up their ealth (unlike home-o ners graduall pa ing off a mortgage). Lo incomes ma mean
poor housing, affecting health and further lo ering one s income potential, and ma even lead to
homelessness.

I
On average, children from rich and middle-income families are more likel to do better at school, go
to universit and have higher incomes as adults. The advantages of children from higher-income
families begin from a ver oung age, as a result of better nutrition and famil spending on activities
that involve books and a variet of non-school educational activities.
According to a stud about the United States, spending per child on education in the poorest fifth of
the population increased b about 55% bet een the mid-1970s and the mid-2000s, hile it rose b
155% for the richest fifth over the same period. This, together ith additional advantages enjo ed b
children of richer families (spending on non-school activities), is increasing the gap in educational
attainment bet een rich and poor.
School s stems can often reinforce these trends. For e ample, schools ith children from
disadvantaged families often find it difficult to attract qualified teachers, ith the result that
disadvantaged children receive lo er qualit education.
In all OECD countries, children of parents ho did not attend universit are themselves less likel to
go to universit . On average, the proportion of universit students of parents ho did not themselves
attend is about half of hat it ould have been if all social groups ere proportionall represented.
Since people ith lo er levels of educational attainment have lo er levels of income compared to
those ho are more educated, it follo s that inequalit of opportunit in education contributes to
income inequalit . Moreover, the problem is intergenerational, since inequalities are transferred from
generation to generation.
F 12.6: Ethiopia. Children in school ith alls made of cla and stra , ith no light or
electricit
A stud at the London School of Economics has found that the advantages offered b high-income
families can persist for more than half a millennium. UK students ith names of prominent families
could be traced back to the Normans ho invaded England in the 11th centur , and attended the
e clusive universities of O ford and Cambridge. B contrast, students ith lo er status surnames
attended these universities ith far less consistenc .
Some researchers also argue that such intergenerational advantages last longer in more unequal
societies.
S : Keele , B. (2015), Income Inequalit : The Gap bet een Rich and Poor, OECD Insights, OECD
Publishing, Paris
A
Based on our e perience ou ma be able to identif individuals or groups of individuals ho face
unequal opportunities. Identif ho their opportunities differ based on differing circumstances that
are be ond their control. Describe some advantages or disadvantages the face due to differing
opportunities.
D
Discrimination is a serious problem both for the individuals involved as ell as for the job market. Some
social groups (racial and ethnic groups, omen) often face discrimination in the job market, ith the
result that the ma receive lo er ages than others for the same ork, or ma find greater difficult
finding ork than the orker ho does not face discrimination. The often live in poor qualit
environments and have less access to social services. For e ample, omen are at higher risk of povert
because the are less likel than men to be in paid emplo ment, often do unpaid caring ork, the often
receive lo er pa for the same job, and have lo er pensions.
U
S a refers to one s social or professional position in a societ . It ma be due to level of education, or
level of income and ealth, or some form of social arrangement (as in an aristocrac ). Status is often
closel related to po er, as individuals or groups ith a high status are also often able to control and
influence other people or events. Large inequalities in status can affect economic inequalit because
people in positions of po er ma sometimes use this to influence government policies favouring their
o n interests and hence protecting their incomes and ealth, rather than policies that favour
redistribution (to be discussed belo . See Real orld focus 12.4.).
G
People on lo incomes must often rel heavil on transfer pa ments (see belo ) and social services and
merit goods (health care, education, housing) provided or subsidised b the government, as their
incomes are insufficient to purchase these in the market. If these are limited or are reduced b the
government, people on lo incomes ma be forced into povert b having to purchase these in the
market.
In addition, government ta policies pla a cruciall important role in determining income and ealth
distribution. (We ill stud these later in this chapter.) Ta policies that favour the rich and do not favour
redistribution contribute to increasing income and ealth inequalities and povert . In man countries,
particularl developed ones, changing ta policies have contributed to idening income inequalities (see
the discussion later in this chapter).
T
While the development of ne technologies contributes greatl to improving labour productivit (output
per orker; see Chapter 11) and therefore to promoting economic gro th, in recent ears it has
contributed to greater inequalit . The reason is that it has eliminated some jobs b replacing human
labour b machines (automation). For e ample, jobs in packaging or manufacturing that require a lot of
repetitive ork have been replaced b machines that can complete the ork faster and more effectivel .
The result is that ages of lo -skill labour hose jobs are being eliminated do not rise much. At the
same time, ne technologies have created demand for ne higher-level skills, meaning that ages of
such orkers rise faster than those of lo -skill orkers. As a result, income differences bet een higher-
skill and lo er-skill labour are increasing.
Another related factor is that technological change that leads to the replacement of labour b capital
(ne machines) means that there is an increase in incomes of o ners of capital. This results in gro ing
income inequalit bet een orkers hose income comes from their labour and the o ners of capital
ho invest in ne machines.
G
G contributes to the above process. It refers to economic integration on a global scale,
involving increasing interconnectedness throughout the orld in man areas (trade, finance, investment,
people, technolog , ideas, kno ledge, communications and culture). Increased foreign direct investment
(FDI, involving investments b multinational corporations; see Chapter 20) from developed economies
increase income inequalities in both developed and developing economies because FDI tends to involve
greater demand for skilled rather than unskilled orkers, increasing the income differences bet een the
t o. In addition, developed economies sometimes offshore certain jobs (relocating them to other
countries ith lo er labour costs), resulting in a lo er domestic demand for certain skills.
M - -
These policies ill be studied at length in Chapters 13 and 20, here e ill see that in some cases the
lead to greater unemplo ment, or lo er incomes for lo er-skilled orkers, and hence to increased
income inequalities and povert . The have been increasingl used in man countries around the orld
since the 1980s. Policies such as discouraging trade unions and reduction of the bargaining po er of
labour, reduction of the minimum age, and reductions in emplo ment protection have been found to
contribute significantl to increasing inequalities.24
H
(HL )
Some large firms ith market po er have been able to earn ver high and increasing abnormal profits
hich transfer income and ealth a a from consumers ho have to pa higher prices and to ard
the o ners of the firms (see Chapter 7, Section E al a ing m n l and c m a ing i h e fec
c m e i i n).
I
Certain occupations, in particular e ecutives and professionals in the financial sector and non-financial
e ecutives have been enjo ing huge increases in pa . In the United States, the ratio of pa of CEOs to
pa of the average orker increased from 20 to 1 in 1965 to 300 to 1 in 2013.25
U
An unemplo ed individual receives no income but ma receive some unemplo ment benefits; ho ever;
these are generall lo relative to income received for ork, and in most countries are onl provided for
limited periods. If unemplo ment is long term (such as ith structural unemplo ment), then an
individual or famil is more likel to become poor. The risk of falling into povert is far greater in
single-parent households here the parent is unemplo ed, or if both heads of a household are
unemplo ed over long periods.
G
Some people ma live in remote, isolated geographical regions, ith limited possibilities for
emplo ment, and ith limited possibilities to relocate (move) to other more economicall active regions
(due to povert , age, or lack of communication and lack of marketable skills); this problem ma be
especiall significant in some rural areas in developing countries.
A
Older people ma receive pensions that are barel enough to cover minimum needs, and in man
countries (particularl developing ones) ma receive no pension at all if the have been living and
orking in the informal econom (outside the legall registered econom ; see Chapter 19).
P
Povert itself ma become a cause of further povert . If people do not have access to essential services
such as health care, education and housing, a self-perpetuating c cle ma be set into motion here lo
incomes lead to lo human capital, and further to lo incomes. This is part of the povert c cle , to be
studied in Chapter 19.

1 E plain the meaning of inequalit of opportunit and using e amples discuss ho it contributes
to economic inequalit and povert .
Identif some further causes of economic inequalit and povert , e plaining in each case ho
2 inequalit or povert are created or orsened.
20 The Data Minute: What is Inequalit of Opportunit ?
21 The Measurement of Inequalit of Opportunit : Theor and an Application to Latin America
22 Inequalit of Opportunit , Income Inequalit and Economic Mobilit
23 Inequalit of Opportunit : Ne Measurements Reveal the Consequences of Unequal Life Chances
24 Causes and Consequences of Income Inequalit : A Global Perspective
25 Inequalit and Economic Gro th

12.4 The i ac fi c e a d eal h i e ali
LEARNING OBJECTIVES

evaluate the impact of income and wealth inequality on (AO3)
economic growth
standards of living
social stability
Ec ic g h
In Chapter 11 we examined the impact of economic growth on income distribution. Now we look at the
impact of income (and wealth) distribution on growth.
There is increasing evidence that high levels of inequality are not good for economic growth. A number
of studies confirm this point. For example, a study by the International Monetary Fund (IMF) concludes
that lower inequality is linked with faster and more sustained growth, while policies that redistribute
income do not generally have negative effects on growth.26 Another study by the IMF found that periods
of growth were more likely to come to an end in countries that have more unequal income
distributions.27
Yet another study by the IMF based on data from 159 developed and developing countries finds that
increases in the share of income of the poor and middle class works to increase growth, whereas an
increasing share of the top 20% results in lower growth.28 According to the study if the income share of
the top 20% (the rich) increases, then GDP growth actually declines over the medium term while an
increase in the income share of the bottom 20% (the poor) is associated with higher GDP growth .
Reasons why inequality leads to lower growth include the following:
Greater inequality lowers growth by reducing the ability of lower income households to invest in
human and physical capital. For example it leads to lower spending on education, with poor
children going to lower-quality schools, which in turn makes it more difficult for them to continue
to university. This results in lower labour productivity (output per worker) hence lower growth.
Countries with higher levels of income inequality have higher levels of inequality of opportunity in
education, which is transferred from generation to generation so that children of low-income
families are likely to also have low incomes (see also Real world focus 12.2).
High income inequality may lead to lower growth because the wealthy spend a lower fraction of
their incomes than middle income and lower income groups.29 But the higher savings of higher
income groups often leave the country as financial investments abroad, thus reducing resources
available for domestic investments.
The concentration of income and wealth in a few hands results in significant political control and
the ability of powerful groups to influence government policies for their own benefit, even though
these policies may go against the interests of the whole population. For example, it is considered
that the period of higher inequality in developed countries gave rise to activities that led to the
global financial crisis of 2008 (such as financial institutions extending too much credit, and reduced
government regulation) which greatly reduced rates of growth.30
Significant political control by the rich may also result in less government provision of essential
merit goods (education, health care, infrastructure, etc.) which works against the interests of lower
income groups and also works against growth. For example, spending on education increases the
income-earning potential of the poor, but also leads to greater economic growth by increasing
human capital.
An improved income distribution increases the demand for locally produced goods and services,
thus encouraging local production and promoting local employment and investment. With high
income inequalities, these potential benefits are lost. This is especially relevant to developing
countries.
Highly unequal income distributions mean that the poor are unable to obtain credit, because they
have no collateral as they have no wealth, meaning fewer investments for people on lower incomes,
leading to lower growth and development. Also, opportunities to pay for education and health care
through borrowing are reduced, leading to lower human capital and lower growth and development.
A more equal distribution of income leads to greater political stability; highly unequal distributions
can lead to social dissatisfaction, unrest and political instability, resulting in lower growth.
L li i g a da d
This is an obvious consequence arising from low incomes. Low living standards are associated with
greater levels of psychological stress, substance abuse, poor nutrition and poor levels of health, all
leading to poorer job and income-earning prospects. Low living standards are also a consequence of the
factors below:
Lac f acce hea h ca e a d ed ca i . Reduced ability to access health care and education leads
to lower human capital formation, lower productivity and lower incomes, possibly resulting in the self-
perpetuating poverty cycle noted above (see Chapter 19).
Highe i fa , chi d a d a e a a i . The inability to access needed health care services, as well
as poor nutrition for mothers and children lead to large numbers of unnecessary deaths among infants,
children and women due to pregnancy-related causes.
Highe e e f e e ab e di ea e . Poor hygiene and nutrition make both children and adults more
prone to illnesses.
S cia be . These include higher crime rates, drug use, family breakdowns and homelessness.
I abi i ea i e e f e ia . Due to all of the above people in very low income groups are
unable to realise their full potential, leading to a waste of human talent, and in addition to the personal
costs, may result in lower economic growth (by adversely affecting the economy s PPC or L A curve).
S cial a d li ical abili

High income and wealth inequalities create societies that are polarised and divided, consisting of social
groups with different interests that make interactions between them difficult. This leads to a reduced
sense of social solidarity and trust in the system, while at the same time the groups at the top begin to
feel entitled (that they have rights over others).
The groups at the top begin to have a stronger political influence. The result is that economic inequality
leads to political inequality. But those groups at the top with political power influence economic policies
(such as tax and social benefits and merit goods policies) in their favour, so that economic inequality
becomes even greater. They also influence the political rules of system in order to increase their political
power. This results in a vicious circle of greater economic inequality and political inequality.31
Growing inequalities increasingly give rise to the feeling that people at or close to the bottom are
socially inferior, giving rise to a pronounced sense of dissatisfaction which may eventually pave the way
for social instability with possible social conflicts. Governments may further polarise society by serving
the interests of their supporters such as lobbyists or big money donors at the expense of the interests of
the whole of society. As divisions between social groups widen, it becomes more and more difficult to
reach consensus on important challenges.

1 Discuss some of the reasons why high economic inequality is not good for growth.
2 Evaluate the impact of income and wealth inequality on
a living standards, and
b social stability.
26 Redistribution, inequality and growth
27 Warning! Inequality may be hazardous to your growth
28 Causes and Consequences of Income Inequality : A Global Perspective
29 Causes and Consequences of Income Inequality: A Global Perspective
30 Causes and Consequences of Income Inequality: A Global Perspective
31 Income Inequality
12.5 Policies to reduce income and ealth
inequalities and povert
LEARNING OBJECTIVES

di ing i h be een g e i e, i nal and eg e i e a e (AO2)
di ing i h be een (AO2)
di ec a e
e nal inc me
c a e inc me
eal h
indi ec a e
calc la e he am n f indi ec a aid f m an am n f e endi e, gi en he indi ec a ae
(HL nl ) (AO4)
calc la e al and a e age a a e f m da a ided (HL nl ) (AO4)
e lain a e age and ma ginal a a e (HL nl ) (AO2)
e al a e he le f diffe en e f a e in ed cing inc me and eal h ine ali ie and e
(AO3)
e lain and e al a e f he licie ed ce inc me and eal h ine ali ie and e incl ding
(AO3)
licie ed ce ine ali ie f ni ch a in e men in h man ca i al
an fe a men
a ge ed ending n g d and e ice
ni e al ba ic inc me
licie ed ce di c imina i n
minim m age
Ta ation policies to reduce income and ealth inequalities and

povert
Inc me and eal h ine ali ie and e a e ha e een a e maj gl bal c nce n . T make ma e
e inc me and eal h ine ali ie a e inc ea ing in man c n ie a nd he ld. In hi ec i n e
ill c n ide a n mbe f lic l g e nmen can e m e e i ( a g ea e deg ee f inc me
eal h e ali ) and alle ia i n f e .
The role of ta ation in promoting (or orsening) equit (income

redistribution)
One f he m im an in men f inc me and eal h edi ib i n i a a i n, beca e i can l e
ine ali ie b aking m e a e f m he ich han f m he .
Ta e a e he m im an ce f g e nmen e en e , and ide he f nd f man e , ch
a blic g d , an fe a men and me i g d , c ec ing e e nali ie , iding b idie , changing he
all ca i n f e ce , changing he di ib i n f inc me, and man m e.
The e a e e b ad ca eg ie f a e , di ec a e and indi ec a e .
Direct ta es
Direct ta es a e a e aid di ec l he g e nmen a a h i ie b he a a e . The m im an
kind f di ec a e incl de he f ll ing:
Personal income ta es. Thi i he m im an ce f g e nmen a e en e in man c n ie
(e eciall de el ed c n ie ), and in l e a e aid b h eh ld indi id al in h eh ld .
The a e aid n all f m f inc me, incl ding age , en al inc me, in e e inc me and di idend
( hich a e inc me f m ne hi f ha e in a c m an , and a e he ef e inc me f m fi ).
Corporate income ta es. C a i n a e b ine e (fi m ) ha ha e f med a legal b d called a
c a i n ha i legall e a a e f m i ne . C a e inc me a e a e a e n he fi f
c ai n .
Wealth ta es. The e a e a e n he ne hi f a e . T c mm n eal h a e a e propert ta es,
ba ed n he al e f e ned, and inheritance ta es, ba ed n he al e f e inhe i ed.
The e en e c llec ed f m all f he ab e f m f a a i n i aid in he g e nmen b dge and i ed
finance a b ad a ie f g e nmen e endi e . In c n a he e, he e i an addi i nal f m f
di ec a a i n:
Social insurance (social securit ) contributions or pa roll ta es. The e a e a e aid b ke and
hei em l e ( h a n behalf f hei em l ee ). The e en e f m he e a e a e n aid in
he g e nmen b dge , b a he in ecific f nd , and a e ed finance ecific e endi e ,
ch a en i n , cial in ance and heal h ca e (in me c n ie ).
Indirect ta es
Indirect ta es a e a e n ending n g d and e ice , di c ed in Cha e 4 and 5. The a e called
indi ec beca e, hile c n me a e he l ima e a e f a a f he e a e , he a indi ec l h gh
he lie f he g d e ice cha ed ( he lie ma be he d ce , he e aile , gene all
he elle ). The m im an kind f indi ec a e incl de he f ll ing:
General e penditure ta es, also kno n as sales ta es. The e a e a e n ending ale f g d
and e ice . In he Uni ed S a e ( he e he a e kn n a ale a e ), he a e a fi ed e cen age f
he e ail ice f g d and e ice . The c e nding a ed in he E ean Uni n and man he
c n ie a nd he ld i he al e added a (VAT). VAT diffe f m a ale a in ha i i a a
aid n he al e added b each d ce in he d ci n ce .32 In ac ice, man c n ie ha
e he VAT a ell a a e in he Uni ed S a e e em e cl de ce ain g d and e ice f m
a men f a e n he g nd f e i (f e am le, g d and e ice like f d, ha mace ical ,
en n h ing, and he ); in me ca e he e ma be diffe en a e f diffe en e f g d and
e ice n he g nd f e i .
E cise ta es. In c n a e endi e/ ale a e , e ci e a e a e a e aid n ecific g d and
e ice , ch a ciga e e and e l (ga line). (See Cha e 4 and 5.)
Customs duties, also kno n as tariffs. C m d ie a iff a e a e f a a lied n im f
f eign g d in a c n . The e a e main ea n h g e nmen le a iff . One i kee
im f he c n b making hem m e e en i e c n me , and he he i ai e a
e en e . We ill d a iff in Cha e 14.
Proportional ta ation Progressive ta ation Regressive

ta ation
Income Ta rate Amount Ta rate Amount Ta rate Amount Ta Amount
(proportional) of ta (mildl of ta (strongl of ta rate of ta
progressive) progressive)
10 000 15% 1500 15% 1500 15% 1500 15% 1500

20 000 15% 3000 20% 4000 25% 5000 10% 2000
30 000 15% 4500 25% 7500 40% 12 000 5% 1500
Table 12.7: P g e i e, i nal and eg e i e a a i n
Ta em a en m l f m c n c n a nd he ld, and he e a e n c n ie ha
ha e he ame a em. While m c n ie ha e a mi f di ec and indi ec a e , he a i h ega d
he deg ee f eliance n each f he e, a ell a n he a ic la mi f e f a e i hin each g .
In addi i n, he can a en m l i h e ec a a e and man he echnical de ail .
Understanding the principles of proportional, progressive and

regressive ta ation
Ta e can be defined a being i nal, ge i e eg e i e acc ding he ela i n hi be een
inc me and he f ac i n f inc me aid a a . The f ac i n f inc me aid a a , in e cen age e m , i
efe ed a a ta rate.
Proportional ta ation: a inc me inc ea e , he f ac i n f inc me aid a a e emain c n an ; he e
i a c n an a a e.
Progressive ta ation: a inc me inc ea e , he f ac i n f inc me aid a a e inc ea e ; he e i an
inc ea ing a a e.
Regressive ta ation: a inc me inc ea e , he f ac i n f inc me aid a a e dec ea e ; he e i a
dec ea ing a a e.
The e ela i n hi a e ill a ed in he n me ical e am le a ea ing in Table 12.7. The able h h ee
ible inc me le el , and f h he ical a a i n em i h diffe ing a a e . In each ca e, he
am n f a i calc la ed b m l i l ing he am n f inc me ime he c e nding a a e. In he ca e
f i nal a a i n, he a a e emain c n an (a 15%) f all inc me le el ; he ef e, he am n f
a aid inc ea e in he ame i n a inc me. In he ca e f g e i e a a i n, e am le a e
e en ed. In b h, he a a e inc ea e a inc me inc ea e ; a a e l , he am n f a aid inc ea e
m e han in i n inc me. The fi e am le i mildl g e i e , meaning ha he a a e
inc ea e l l a inc me inc ea e . In he ngl g e i e e am le, he a a e inc ea e m ch m e
a idl .
Ign ing eg e i e a a i n f he m men , le c m a e he am n f a aid in he ca e f i nal,
mildl g e i e and ngl g e i e a a i n. In all h ee ca e , a inc me inc ea e , he am n f a
aid bec me la ge . Which f he h ee i he m fai ? (All h ee a i f he inci le f e ical e i ,
acc ding hich h e i h g ea e inc me h ld a a la ge a han h e i h le inc me; ee The
f kn ledge fea e 12.2.) Thi i im ible an e ing ec n mic ea ning, beca e fai ne i a
n ma i e e i n ha de end n al e j dgmen .
The nl hing ha can be aid i h ce ain i ha he m e g e i ea a em, he m e e al ( le
ne al) he af e - a di ib i n f inc me bec me . We can ee h b e amining he fig e in he able.
In all h ee a a i n em , he a a e face he ame a a e and he ame am n f a f inc me f
10 000. H e e , a inc me inc ea e 20 000 and hen 30 000, he am n f a aid inc ea e
m e a idl in he mildl ge i e em and e en m e a idl in he ngl ge i e em. B
h inking he diffe ence be een he high and l inc me le el , g e i e a a i n achie e a m e e al
inc me di ib i n han i nal a a i n; and he m e g e i e he a em, he g ea e he
inc me e ali achie ed.
In eg e i e a a i n, he a a e dec ea e a inc me inc ea e ; he i n f inc me aid in a fall a
inc me i e . Reg e i e a a i n he ef e make inc me di ib i n le e al.
Wh indirect ta es are regressive

Al h gh g e i e, i nal and eg e i e a a i n a e defined ela i e inc me, he d n a l
j inc me a e , b all e f a e , he he di ec indi ec . Thi i beca e a e a e aid f
inc me, and can he ef e be c m a ed i h inc me. T ee he he a a i g e i e, i nal
eg e i e, i can be calc la ed a a f ac i n f he inc me f hich i i aid. F e am le, c ae
inc me a e a e all i nal. S cial in ance c n ib i n a e al all i nal (f b h
ke and hei em l e ). Indi ec a e ( f all e ) a e eg e i e.
T ee h indi ec a e a e eg e i e, c n ide indi id al , XX and XY. Each ne b a ca f $10
000 ( i h a ), n hich he e i an indi ec a (VAT, ale a , a iff) f 10%, am n ing $1000.
Indi id al XY ha an ann al inc me f $10 000 and indi id al XX ha an ann al inc me f $20 000. The
$1000 f a i 10% f indi id al XY inc me, and i i 5% f indi id al XX inc me. In he d ,a
inc me inc ea e f m $10 000 $20 000, he f ac i n f inc me aid n he indi ec a dec ea e f m
10% 5%. Thi i he defini i n f eg e i e a a i n. Since all indi ec a e k n he ame inci le,
e can c ncl de ha indi ec a e a e eg e i e. It follo s that indirect ta es are inconsistent ith the
objective of a more equal distribution of income.
In he eal ld, me g d and e ice c n ide ed be nece i ie , ch a f d and medicine , ma be
e em ed f m gene al e endi e ale a e . Thi make indi ec a e me ha le eg e i e, h gh
he emain eg e i e e all.
The a em f i all all c n ie c n i f man diffe en e f a e . Whe he he e all a
em f a c n i m e ge i e eg e i e de end n he mi f a e and a a e , and hei
ela i e im ance a ce f g e nmen e en e. F e am le, a c n ha elie ela i el m e n
g e i e inc me a e i likel ha e a a em ha i ela i el m e g e i e c m a ed a
c n ha elie ela i el m e n indi ec a e .
The m e g e i ea a em, he m e e al i he af e - a di ib i n f inc me c m a ed he

e- a di ib i n f inc me. Reg e i e a em end make he di ib i n f inc me le e al.

1 Di ing i h be een di ec and indi ec a e , iding e am le f each.
2 Define and e lain, ing e am le , he diffe ence be een i nal, g e i e and eg e i e
a a i n.
3 E lain h inc me a e can be ed l e inc me ine ali ie .
4 a E lain h indi ec a e a e eg e i e.
b O line he ea n f e cl ding me g d and e ice c n ide ed be nece i ie f m
a men f indi ec a e ( ch a VAT and ale a e ).
c De c ibe he im ac hi ha nh eg e i e he indi ec a e a e.
5 O line h he i e f ing a e edi ib e inc me i a l a n ma i e i e.

Principles of equit for ta ation
E i efe he idea f being fai j . The de ign f a a em e i e me inci le f e i
if i i be c n ide ed fai j . The e a e main inci le f e i in a a i n, e lained bel .
The benefits-received principle
Acc ding hi inci le, c n me and fi m h ld a a e n g d and e ice ided b he
g e nmen in acc dance i h he e he make f hem. The idea he e i ha ch g d and e ice
h ld be aid f b hei e in he ame a ha g d and e ice ided b he ma ke a e aid
f : he a e e a imila f nc i n a ice in he ma ke , and a e en e a e ed a (a lea a l )
f i i n f he g d and e ice b he g e nmen . E am le f g d aid f ( a ed) hi a
incl de a k ha ha e admi i n fee , ad and b idge ha cha ge ll , ad and high a financed b
e l (ga line) a e , and blicl financed ch l aid f b e a e.
In each ca e, he benefi inci le i ed, e en h gh i i n al a he ca e ha he a e f he a i
he ne h immedia el benefi f m he e f he g d e ice. F e am le, e a e ed
a f blicl -financed ch l a e ba ed n he a m i n ha e le h li e in a a ic la a ea ill
end hei child en he l cal ch l; he e l (ga line) a ed a f high a c n c i n and
main enance e e ha h e h b e l (ga line) a e al h e h ill benefi f m he e
f he high a .
The benefi inci le i c n ide ed fai in he en e ha e le a f benefi he ecei e, and d n
a f benefi ha a e enj ed b he . H e e , i cann be ed a a gene al inci le f a a i n
f main ea n . One i ha i i e diffic l , if a all ible, iden if h ecei e he benefi
f n me blic g d like na i nal defence, lice ec i n and he c em. The he i ha i
d e n all f an edi ib i n, ch a ha ided b an fe a men .
The abilit -to-pa principle
Acc ding hi inci le, a e h ld be le ied n indi id al h eh ld acc ding hei abili
a a a , in acc dance i h hei inc me eal h. The abili - - a inci le i de i ed f m he
idea n di ib i e j ice (fai ne ) f he fam G eek hil he A i le, h di ing i hed
be een h i n al and e ical e i . Acc ding he idea f h i n al e i , e le h a e e al
i h e ec ce ain cha ac e i ic h ld be ea ed e all . When a lied a a em, hi mean
ha e le i h imila inc me eal h ( a imila abili a ) h ld be a ed b he ame am n .
Acc ding he idea f e ical e i , e le h a e ne al i h e ec ce ain cha ac e i ic
h ld be ea ed ne all , and in i n hei ine ali ie . In a a em, ince man e le a e
ne al i h e ec inc me and eal h (abili a ), h e i h g ea e inc me and eal h h ld
a a la ge a han h e i h le inc me and eal h. If a a em i de igned i h he e idea in
mind, he di ib i n f inc me ill bec me m e e al ( le ne al).
The abili - - a inci le i c n ide ed fai beca e e le i h highe inc me a m e a han
e le i h l e inc me . I al hel l e he blem f edi ib i n h gh ch me h d a
an fe a men . Whe ea i i idel acce ed, and i ed in m c n ie a he ba i f de igning
inc me a em , in ac ice i i e diffic l each ag eemen ab h he c nce f e ical
and h i n al e i h ld be in e e ed. E en if i i ag eed ha he ich h ld a m e han he ,
he e i n i , h m ch m e? Thi i a highl c n e ial e i n, and he an e de end e
m ch n li ical belief and al e em (n ma i e i e ).
Thinking points
D hink i i im an f a a em be ba ed n a inci le f e i ha i gene all
acce ed b he membe f a cie ?
E amine he benefi - ecei ed and he abili - - a inci le f m he e ec i e f e i . Which
d hink i m e fai ? H ld j if a g men ?
D he e le f a cie ha e a m al bliga i n a a e ? Wha if he d n ag ee i h he
e i inci le f he a em?
Achieving progressivit through proportional ta ation

(Supplementar material)
If a e in e e ed can ead ab hi in he 'Digi al c eb k: E a ma e ial' ec i n a
S lemen a ma e ial.
Calculations of direct and indirect ta es (HL onl )
Ho to calculate total income ta es and average ta rates

T ee h inc me a e a e calc la ed in he eal ld, e ill make a di inc i n be een ma ginal and
a e age a a e . A marginal ta rate i defined a he a a e aid n addi i nal inc me, n he la
am n f a aid, e e ed a a e cen age. An average ta rate i a aid di ided b al inc me,
al e e ed a a e cen age. All he a a e a ea ing in Table 12.7 a e a e age a a e .
In he eal ld, inc me a e in a ge i e a em a e calc la ed ing cce i e la e f
inc me and a l ing a diffe en a a e each la e . The la e f inc me a e called a b acke , and he
c e nding a a e a e he ma ginal a a e . A n me ical e am le ill hel nde and hi .
C l mn 1 f Table 12.8 h a b acke ( he la e f inc me) in a h he ical ec n m , and c l mn
2 gi e he ma ginal a a e ha a lie each b acke .
S e e an calc la e he am n f inc me a aid n an ann al inc me f $59 000. The al a
aid ill be 0 f he fi $10 000 f hi inc me; 9% n inc me be een $10 001 and $25 000; 22% n
inc me be een $25 001 and $55 000; and finall 40% n inc me be een $55 001 and $59 000. We
calc la e he al a aid a f ll .
(0 $10 000) +(0.09 $15 000) + (0.22 $30 000) + (0.40 $4000) = 0 + $1350 + $6600 + $1600 =
$9550
Wha i he a e age a aef he inc me f $59 000? I i al a aid di ided b inc me e e ed a
a e cen age,
$9550 $59 000 =0.162, 16.2%
U ing he inf ma i n in Table 12.8, le n calc la e he inc me a aid n inc me f $175 000.
(0 $10 000) + (0.09 $15 000) + (0.22 $30 000 +
(0.40 $60 000) + (0.55 $60 000) = 0 + $1350 + $6600 + $24 000 + $33 000 = $64 950 = inc me a
aid
The a e age a a e n inc me f $175 000 i 37.1%
i.e. $64 950 $175 000 =0.371, 37.1%
C m a ing he a e age a a e f inc me f $59 000 (16.2%) i h he a e age a a e f inc me f
$175 000 (37.1%), e ee ha he highe inc me ha a highe a e age a a e, j a e ec ed ince hi
i a ge i e a em.
1 2
Annual income ($) Marginal ta rate (%)
0 10 000 0
10 001 25 000 9
25 001 55 000 22
55 001 115 000 40
115 001 m e 55
Table 12.8: Inc me a e i h inc ea ing ma ginal a ae
Calculations involving indirect ta es

S e a famil i h an ann al inc me f 60 000 a inc me a e f 15 000. I disposable income
i 45 000 (di able inc me i af e a inc me i i 60 000 15 000). I average rate of income ta
i
15 000 60 000 = 25.0%
S e he famil end all f i di able inc me. Thi ending incl de an indi ec a ha i
im ed n cha e f all g d and e ice f 12.5%. The ef e he ac al am n en n he
cha e ill be le han 45 000. The e i n e an an e i ho much indirect ta hi famil
a .
Y migh be em ed a ha he am n aid i 12.5% f 45 000 hich i 5625 (= 0.125 45 000).
H e e hi ld be inc ec .33
T find he indi ec a aid, le Z = he am n f ending n g d and e ice hem el e n
incl ding he indi ec a .
I f ll hen ha :
Z + 0.125 Z = 45 000 m e im l 1.125 Z = 45 000. S l ing f Z e ha e
Z= 45 000 1.125 =40 000.
The e a e a e can n find he am n f a . One a i b ac ending bef e he a
f m ending af e he a , ha :
45 000 40 000 = 5000 = am n f ending n he indi ec a .
An al e na i e a i ake 12.5% f 40 000
0.125 40 000 = 5000.
M e gene all e can a ha ince he am n f ending n he indi ec a = 0.125 Z, and ince
Z= 45 000 1.125 i f ll ha
am n f ending n he indi ec a =
0.125 45 000 1.125 = 5000
Gene ali ing, e can a ha if S = he am n a ailable f cha e and r = he a e f indi ec a ,

he am n f ending n he
indi ec a = 100 S 1+ 100
T c n ince elf, can e he e am le ab e b le ing S = 45000 and = 12.5%. Y ill
find e ac l he ame e l a ab e.
I i n ible calc la e he average rate of indirect ta f hi famil .

a e age a e f indi ec a = 5000 60 000 =0.0833 8.33%
S e en an find he al a e age a e f a f hi famil , ha incl de b h he di ec and
he indi ec a . T d hi e add he am n f di ec a he am n f indi ec a and di ide b al
inc me
al a e age a a e = 15 000+5000 60 000 = 20000 60000 =0.3333 33.33%
N e ha e can al find hi b adding ge he he a e age a a e ha ef nd ab e: a e age
a e f inc me a + a e age a e f indi ec a = 25.0% + 8.33 = 33.33%

The f ll ing e i n a e ba ed n he da a in Table 12.8.
1 Calc la e he am n f inc me a aid b familie i h ann al inc me le el f
a $6500,
b $15 700,
c $31 000,
d $48 000, and
e $120 000.
2 F each f he i em in e i n 1,
a calc la e each famil a e age inc me a a e,
b line ha ha en he a e age a a e a inc me inc ea e and e lain h , and
c a e each famil ma ginal a a e.
3 S e ha he famil i h inc me f $48 000 end 85% f i di able (af e a ) inc me (i
a e 15% f i ). S e, , ha he famil a a 17% al e added a (VAT) n i ending
n all g d and e ice .
a Calc la e he am n f indi ec a aid.
b Calc la e he am n f indi ec a aid a a e cen age f inc me ( he a e age indi ec a
a e).
c U ing an e e i n 2, calc la e he al a e age a a e incl ding b h di ec and
indi ec a .
Thi mean ha hi famil i a ing ne- hi d f i al inc me, 33.33% a a e , incl ding b h
di ec and indi ec .
Evaluating ta es as a polic for redistribution

In ad anced ec n mie , an e ima ed 25% f edi ib i n cc h gh he a em ( he emaining 75%
cc ing h gh benefi like an fe a men ; ee bel ).
A l ng- anding deba e am ng ec n mi ha c nce ned he ible c nflic be een ec n mic g h and
e i , in e e ed mean g ea e ec n mic e ali . In Sec i n 12.4 e a ha he e i ng e idence
ha a high le el f ec n mic ine ali i n g d f g h. The ef e i ld eem f ll ha a
em ha a e de igned ed ce inc me ine ali ie ld be g d f g h. S ch a em ld
fa di ec a e f all e ha a e g e i e ( e nal inc me a e , c a i n a e and eal h
a e ), ince he m e g e i ea a em, he g ea e he f ac i n f inc me, fi eal h ha i
a ed a a , and he ef e he g ea e he e l ing e ali in di ib i n. Thi line f ea ning ld al
gge he e h ld be le eliance n indi ec a e , a he e a e eg e i e.
Ye man ec n mi ld di ag ee n he g nd ha g e i e a e ha e di incen i e effec . I i
a g ed ha income ta es ed ce af e - a inc me, ac ing a a di incen i e k, a ell a a e,
a ic la l am ng high inc me ea ne h ld be a ed m e hea il . The ha e he effec f ed cing
he an i f lab ffe ed in he ma ke and al ed ce a ing . L e a ing ha a nega i e effec n
in e men , and he ef e n d c i n f ne ca i al g d . In addi i n, corporation ta es, hich a e a e
n he fi f c a i n , ha e he effec f ed cing he incen i e in e , al e l ing in l e
d c i n f ne ca i al g d . L e an i ie f lab and ca i al in n an la e in l e a e f
g h f he ec n m . S me ec n mi f he a g e ha ealth ta es al ha e nega i e effec n
efficienc and inn a i n b ed cing incen i e in e in d c i e ca i al, h al leading l e
g h.
Thi hinking i e m ch in line i h ma ke -ba ed l - ide licie ha e ill d in Cha e 13,
hich ha bec me inc ea ingl la in man c n ie ince he 1980 . Thi ma e lain he end in
ed c i n f ce ain kind f di ec a e in man c n ie in he la decade . Since he 1980 he le f
a e ha eakened a a me h d f edi ib i n. Thi ha been d e declining a a e in man c n ie ,
hich ha e c n ib ed inc ea ing ec n mic ine ali .
F e am le, f he 36 c n ie f he OECD, el e c n ie had eal h a e in 1990, and b 2017 he e
had been ed ced nl f c n ie .34 In he ca e f inhe i ance a e , he i n f g e nmen
e en e ai ed b hi e f a ha e fallen b h ee fif h ince he 1960 in OECD c n ie . C ai n
a e ha e al been falling in man c n ie . In 1990 he a e age c a i n a in he G20 c n ie 35 a
40%. B 2015 i had fallen 28.7%. In addi i n, m l ina i nal c a i n make inc ea ing e f a
ha en (c n ie he e c a i n d n ha e a a e ) a ell a he me h d a id a ing
a e . The IMF e ima e ha a e en e f m m l ina i nal c ai n h a m ch a 1% f GDP f
OECD c n ie a e l each ea .36
Ye he e i n e idence ha l e a e ha e he effec ha hei nen claim. L e inc me a e
need n lead m e k, he ma im l lead m e lei e ime ( ime a a f m k). L e
c a i n a e need n lead g ea e in e men , in fac a c in he c a i n a ha k lace in he
Uni ed S a e in 2017 led less in e men b c a i n ( ee Real ld f c 12.4 and e eciall 13.2 in
Cha e 13). M e e , c n a he ab e claim , ce ain eal h a e , incl ding a e n eal e a e and
land a e b h e i able and efficien .37
In ead, he ab e end ha e led inc ea ing ec n mic ine ali .38
In ie f he ab e, he e a e man minen ec n mi h a g e ha he be a e e e he end
a d inc ea ed eal h ine ali i b a ing c a i n and eal h, incl ding im ing inhe i ance a e .
F e am le, a maj 39
d b he OECD a g e ha he e i a ng ca e f add e ing eal h ine ali
h gh he a em. I ec mmend b ad-ba ed ca i al inc me a e (inc me f m financial
in e men ) hich h ld be c m lemen ed b a f m f eal h a e , efe abl inhe i ance a e .
M e e , he In e na i nal M ne a F nd40 (IMF, ee Cha e 20) a g e ha a n mbe f diffe en eal h
a e h ld be c n ide ed add e he blem f inc ea ing ine ali . F he , acc ding he IMF
declining g e i i in inc me a e f man c n ie in ecen decade h ld be e e ed, i h fea
ha hi ill ed ce g h, beca e he e i n e idence ha highe inc me a e ill ha e nega i e effec
ng h.
Other policies to reduce income and ealth inequalities and povert
In addi i n a e he e a e a n mbe ff he edi ib i n licie ha g e nmen can e add e
ec n mic ine ali and e .
Policies to reduce inequalit of opportunit : investment in human

capital
Ine ali f ni i a maj fac leading inc me and eal h ine ali . A ke lic ackle hi
in l e in e men in h man ca i al incl ding acce high ali ed ca i n and heal h ca e.
In ed ca i n, di ad an aged g ha e m ch l e ed ca i nal a ainmen . F e am le, in b-Saha an
Af ica, he e he diffe ence be een high and l inc me e le a e he m n nced, alm 60% f
he e in ile (20%) f he h la i n aged 10 24 ha e le han f ea f ch ling,
c m a ed 15% f he iche in ile. 41
Rega ding acce heal h ca e, he e a e ignifican diffe ence be een he iche and e in ile
e e he e in he ld, h gh he a e m e n nced in de el ing c n ie . F e am le, infan
m ali a e in de el ing c n ie n a e age a e ab 67 e 1000 li e bi h f he l e in ile
c m a ed 48 f he highe in ile. In eme ging ma ke ec n mie he c e nding fig e a e 34% and
18%.42
Pe le i h de i a i n in a ea ch a ed ca i n and heal h a e nable ffe hei child en ni ie
a ailable highe inc me familie . The ef e in e men b he g e nmen in h man ca i al en e
ni e al acce ed ca i n and heal h ca e i im e a i e. T each e le n e l inc me he e
e ice h ld be ided f ee f cha ge a he han el n - f- cke ( i a e) a men i ae
i i n, a ch e ice a e be nd he each f he .
Transfer pa ments
Transfer pa ments (cash transfers) a e a men made b he g e nmen indi id al ecificall f he
e f edi ib ing inc me a a f m ce ain g and a d he g ; he an fe inc me
f m h e h k and a a e a d h e h need a i ance. The g f e le h ecei e he
an fe a men ma incl de lde e le, ick e le, e e le, child en f familie ,
nem l ed e le and he ; in hei en i e he a e efe ed a vulnerable groups. T an fe a men
incl de ld age en i n , di abili en i n , nem l men benefi , a e e an benefi , ma e ni
benefi , child all ance , h ing benefi f he , den g an , and man m e. T an fe a men
a e made ible b a e c llec ed b he g e nmen . A i n f a e aid he g e nmen b he
king la i n i ed make an fe a men lne able g , he eb achie ing me inc me
edi ib i n.
T an fe a men a e ed in man c n ie a nd he ld, b h de el ed and de el ing. A man a
60 m e de el ing c n ie e conditional cash transfers, meaning ha he e a e g an ed
h eh ld n c ndi i n ha he mee ce ain e i emen , all linked i h child en ed ca i n and
heal h ca e. The ha e bec me a maj an i- e l and ha e al been in d ced in he Uni ed S a e .
The a e e eciall im an a he f c n he e emel im an bjec i e f b ilding h man ca i al
T an fe a men la a maj le in im ing inc me di ib i n. In de el ed c n ie he c n ib e
an e ima ed 75% im ed di ib i n ( he 25% being d e he a em). A di ad an age f an fe
a men in l e he b den n he g e nmen b dge and he ni c ( ac ificed al e na i e
g e nmen ending). Al , me a g e ha an fe a men c ea e incen i e f e le n k,
h e e he e a e e i e i n ab he e en hich hi a g men i alid ( ee Real ld f c
12.3).
Targeted government spending on goods and services

G e nmen end ide merit goods, hich a e g d ha a e beneficial f c n me , f en i h
i i e c n m i n e e nali ie , ha a e nde ided b he ma ke and nde c n med ( ee Cha e 6).
In he ab ence f g e nmen in e en i n, f he m im an me i g d ha ld be
nde c n med d e l inc me and e ld be ed ca i n and heal h ca e. Ed ca i n and heal h
ca e a e im an ha he a e f en ie ed a f ndamen al h man igh .
Thi mean ha i i n en gh f g e nmen j ide ed ca i n and heal h ca e ( lemen he
in fficien an i ie ided b he ma ke ). G e nmen m al en e ha he e a e aff dable f
e l inc me g . Thi can be acc m li hed hen g e nmen ffe ed ca i n and heal h ca e
e ice ha a e f ee ( nea l f ee) f cha ge c n me . G e nmen ma al ide b idie
i ae ide inc ea e l ( ee Cha e 6). In addi i n, ed ca i n and heal h ca e can be made m e
aff dable h gh an fe a men .
O he me i g d ha a e e eciall im an in de el ing c n ie he e he e a e la ge g f e le
n e l inc me incl de infrastructure, hich c n i f n me kind f h ical ca i al, ch a
clean a e lie , ani a i n and e e age. Offe ing he e a e l ice make hem aff dable
e le h ld he i e be nable a f hem. (Inf a c e ill be di c ed in m e de ail
in Cha e 19.)
Wha e e he me i g d, he g e nmen e a e en e ide he g d in la ge an i ie han he
ma ke ld ha e ided, and addi i nall make i a ailable a e l ( e ) ice , h ffe ing
b an ial am n f edi ib i n. In addi i n, a e kn f m Cha e 6, i i n f me i g d
in l e c ec i n f i i e c n m i n e e nali ie , hich a e a e f ma ke fail e, and a em
c ec he ma ke nde all ca i n f e ce .
On he nega i e ide, me i g d i i n i a b den n he g e nmen b dge and en ail ni c
in e m f f eg ne al e na i e .
Universal basic income

Universal basic income i a me h d in ended ide e iden in a c n i h a m f m ne ha he
ld ecei e ega dle f an he inc me he ma ha e. I ei ed ce inc me ine ali ie and
e . I i ba ed n he inci le ha e e ne in a cie i en i led a ba ic inc me, ega dle he he
n he kf i nde ha ci c m ance he ha e been b n in . The idea ha bec me m e
la in ie f ec gni i n f g ing inc me ine ali ie , a ell a fea ha ne echn l gie ill
inc ea ingl gi e i e j b l e leading g ea e e .
Financing ld c me a l f m a a and ibl f m a ing f m c ing he cial e ice
g amme .
S e f hi idea claim ha i ill be effec i e in ed cing e , and i ld be admini a i el
e im le ca .I ld di e e g like den in ni e i , ng c le l king
a familie , n aid ca e ke , and b dding en e ene ihn he ce f inc me. I ld
ide a be e balance be een ke and em l e b gi ing ke m e f eed m lea e j b he
a e nha i h. I ld al abili e he ec n m d ing a ece i n b iding inc me he
nem l ed (like an a ma ic abili e ; ee Cha e 13).
O nen claim ha i ld be e en i e, ince all h eh ld incl ding middle-inc me and high-
inc me ne ha d n need i ld al ecei e i . I ha been a g ed ha i c ld be financed nl if he e
ee ei c in he cial e ice , ch a an fe a men lne able g ( ee ab e). Ye i
ma be n ea nable c m ne g ing e le h need i in de ide an inc me e e ne
incl ding h e h d n need i . In ie f hi , an al e na i e ha ha been ed ld be ffe a
ba ic inc me nl e le h e inc me fall bel a ce ain am n .
In addi i n he e a e ie ha me e le ma l e he incen i e k, h gh ial ca ied in
Finland, N h Ca lina (Uni ed S a e ) and Sea le d n ide e idence ha hi cc . The e a e al
ni c f g e nmen ending d e di e i n f f nd f m he i i a ea like heal h ca e
and ed ca i n.
An in e e ing ca e hich a ea be cce f l i he Ala ka Pe manen F nd he e e e ci i en f he
a e ecei e m ne e e ea ( h gh i i n called a ni e al ba ic inc me). While man e e imen
ha e been d ne he e i n c n a e a he ime f i ing he e a ni e al ba ic inc me ha been
ad ed n a na i nal le el.
Policies to reduce discrimination

C n ie a nd he ld all ha e legi la i n ha f bid di c imina i n in he k lace. Thi i
e en ial en e ha di c imina i n d e n cc . G e nmen m f he en e ha em l e a e
inf med ab la n di c imina i n. In addi i n la , eff m be made ed ca e em l e and
ke n he benefi f m l ic l ali m. Addi i nal mea e incl de managemen aining n an i-
di c imina i n ac ice , and c mm nica i n f an i-di c imina i n lic em l ee .
H e e , em l e ma n al a c m l i h he la . In me ca e he ma n be fficien l
c nce ned ab di c imina i n nde ake he a ie f mea e ab e e en i .
Government intervention in markets: minimum ages and price

controls
P ice c n l affec he di ib i n f inc me. One e f ice c n l in l e:
minimum age legislation, hich b e ing a legal minim m age, ai e he l e e mi ible age
ab e he e ilib i m ma ke le el, he eb ai ing he age f l -inc me (and all n killed)
ke . Whe ea anda d ec n mic he edic hi ill c ea e nem l men , ac al ac ice
indica e ha hi i m f en n he ca e, and he ef e k im e inc me di ib i n hile
al all inc ea ing em l men ( ee Cha e 4).
In addi i n, g e nmen ma e ice c n l incl ding:
f d ice ceiling ha e ma im m ice f ce ain f d d c ( ice bel he ma ke -
de e mined e ilib i m ice), making f d m e aff dable f l -inc me g , en c n l ha
e ma im m en l inc me e le
ice fl f fa me ha e legal minim m ice f ce ain ag ic l al d c ( f en in l ing
g e nmen cha e f he e l ing l e ), ai ing hei ice ab e he e ilib i m ma ke ice
in de fa me inc me .
B h he e e f ice c n l lead all ca i e inefficienc and a l f cial l ( ee Cha e 4).

1 Di c he im ance f in e men in h man ca i al a a me h d e c me ine ali ie f
ni .
2 U ing e am le , e lain h an fe a men and a ge ed ending n g d and e ice can hel
edi ib e inc me.
3 E lain h ni e al ba ic inc me i in ended k.
4 E lain ha i likel ha en ac n L en c e and Gini c efficien if i g e nmen :
a inc ea e inc me a a e a lied highe inc me
b lace a g ea e em ha i n indi ec a e ela i e di ec a e a ce f a e en e
c ed ce an fe a men
d in d ce a em f f ee ed ca i n and heal h ca e
e enac legi la i n ed ce di c imina i n.
Di c he ad an age and di ad an age f
a a e,
b an fe a men ,
c a ge ed ending n g d and e ice ,
d ni e al ba ic inc me,
e di c imina i n licie , and
f g e nmen in e en i n in he f m f ice c n l incl ding minim m age .

The role of ta es and benefits in UK income redistribution
In he Uni ed Kingd m, he 20% ( in ile) f he la i n ha an inc me ha i el e ime he
inc me f he b m in ile bef e a e and cial benefi . Af e a e and benefi hi n mbe fall
fi e ime .
While ge i e a e la a le, benefi a e e n ible f he la ge a in he d in ine ali .
The b m 20% ( in ile) f he la i n ecei e i een ime m e in benefi a a ha e f inc me
han he in ile d e .
B he in ile a nl 2.7 ime a m ch di ec a a a ha e f inc me a he b m in ile.
N e ha hi d e n acc n f he effec f indi ec a e , hich a e eg e i e.
Figure 12.7: Ja ick, England. The m de i ed a ea in England
In 2017, he g e nmen im ed a limi n benefi , hich e ic ed he e he fi child en nl .

Wi hin he fi ea f he c , an e ima ed 600 000 child en e e affec ed. I i e ec ed ha an
addi i nal 300 000 child en ill be hed in e b 2024. The lic ha been j ified n he
g nd ha he c ill ide an incen i e f e le n benefi k. Acc ding fficial fig e
h e e m f he e le affec ed a e al ead king.43
In 2019, he e e e al f a a c ha ld benefi highe inc me ea ne , a ell a al

ed ce he c a i n a e en h gh hi i al ead ne f he l e am ng de el ed c n ie .
Source: The Guardian
Appl ing our skills
1 Da L en c e h ing he Uni ed Kingd m inc me di ib i n bef e and af e a e
and benefi .
2 E lain h benefi make a g ea e c n ib i n inc me edi ib i n han a e in he Uni ed
Kingd m.
3 Di c he likel effec n he Uni ed Kingd m inc me and eal h di ib i n f he c in child
benefi and ed a change .

Increasing market concentration, inequalit and lo gro th (HL onl )
J e h S igli , a N bel P i e inning ec n mi , in ha ine ali in he Uni ed S a e i a i
highe ince 1928, GDP g h ha been e l in c m a i n i h he decade af e he Sec nd W ld
Wa , and ma ke c ncen a i n i g ing ( ee Cha e 7, Real ld f c 7.2). S igli ee he e h ee
end a being in e c nnec ed.
Ma ke e ha inc ea ed beca e b ine leade make g ea eff c ea e ba ie c m e i i n;
a ne i c m e i i n i f l e . C m e i i n la ha e n been da ed and a e n being ic l
enf ced. Wi h g ing ma ke e la ge fi m e l i hei c me h gh highe ice and
ee e hei em l ee , h e n ba gaining e and legal ec i n a e being eakened .
(S igli i efe ing he e ma ke -ba ed l - ide licie ; ee he ec i n ab e nde Causes of
economic inequalit and povert .) C ae fi a e he ef e inc ea ing. A he ame ime ha
ke a i agnan , CEO and eni e ec i e a e inc ea ing hei n a , ih ing highe
fi inc ea e in e men .
Recen a c f 2017 in he Uni ed S a e , hich incl ded c in he c a i n a , a e e ec ed
fa he ich hile h ing he 44
. T make ma e e, S igli n e ha c a e e ec i e
ed m f he benefi f he a c en ich hem el e a he han in e m e.
S igli a g e ha inc ea ing ma ke e f la ge fi m inc ea e hei abili infl ence Ame ica
licie . And a he em ha bec me m e igged in b ine fa , i ha bec me m ch ha de f
dina ci i en eek ed e f mi ea men ab e.
S igli i c nce ned ab he effec f i ing ine ali hich lead falling agg ega e demand a he
ich c n me a malle f ac i n f inc me. A he ame ime, ma ke e ed ce he incen i e in e
and inn a e. P li ical in e men in ge ing l e a e ield fa highe e n han eal in e men in
lan and e i men . The able bel h inc me g h f diffe en inc me g e a 35- ea
e i d.
Share of population Percentage increase
T 0.1% 236%
T 1% 142%
T 20% 95%
F h 20% 28%
Thi d 20% 28%
Sec nd 20% 28%
B m 20% 26%
Table 12.9: US inc me g h in eal e m , 1979 201445

Source: Columbia Business School
Figure 12.8: S cial ine ali be een ich and dina e le
Appl ing our skills

1 Iden if ible ba ie en died in Cha e 7 and e lain h he ma be linked i ing
inc me and eal h ine ali ie .
2 E lain ha S igli mean b he em ha bec me m e igged , and h i ela e i ing
inc me and eal h ine ali ie .
3 U e an AD-AS diag am hel e lain he effec f i ing ine ali d e he diffe ence in
ending a e n f ich e l - and middle-inc me h eh ld .

The f ll ing e i n ill hel eflec n lea ning and enhance nde anding f ke
ic in hi cha e . The a e gge i n f in i ie ha can nde ake n n in g in
de e i e he lea ning bjec i e f hi cha e
1 Re ea ch he defini i n f e in he c n li e in a c n f ch ice. Wha
inc me i e i ed be ab e e line? Di c ih cla ma e ha ela i e e l k
like he e li e. Wha kind f g d and e ice a e c n ide ed be hing ha m f he
la i n enj ?
2 In e iga e licie ed ce e and ine ali ie in a c n f ch ice. C n ide he e en
hich he e ha e been cce f l, and ible a ha he migh be im ed.
3 Re ea ch h ee c n ie he e ni e al ba ic inc me e e imen ha e been ca ied . E al a e
he effec i ene f each gi en hei e ec i e e l .
4 Iden if a c n f ch ice and e ea ch h i inc me and eal h di ib i n ha e changed
e he la c le f decade . Wha a e he fac ha ha e c n ib ed he change b e e?

32 Val e added efe he al e f a fi m min he al e f i in . If he e i m e han ne age in he

d ci n ce , he fi m a VAT f each age in hich al e i added. Th he al VAT aid b he fi m i
he m f he al e added a e aid a each age in he d ci n ce . When he g d e ice eache he
ma ke lace, i ice incl de he VAT ha ha been aid b all he fi m in l ed in i d c i n. Each c n in
he E ean Uni n ha i n a ic la VAT a e .
33 T ee h hi i n e ha if 5625 i aid a indi ec a , hi mean ha 39 375 (= 45 000 5625) i he

am n f ending b g d and e ice . Since he e i a 12.5% a n ending b all g d and e ice ,
hi mean ha he famil m a 0.125 39 375 = 4921.87 n a , making al ending = 39 375 + 4921.87
= 44 296.87 hich i n ible ince al ending incl ding a i 45 000.
34 IMF Fi cal M ni : Tackling Ine ali , Oc be 2017
35 An in e na i nal f m c n i ing f nine een c n ie and he E ean Uni n in ended m e in e na i nal

c e a i n.
36 An Ec n m f he 99%: I ime b ild a h man ec n m ha benefi e e ne, n j he i ileged fe
39 The R le and De ign f Ne Weal h Ta e in he OECD
41 Ca e and C n e ence f Inc me Ine ali : A Gl bal Pe ec i e
42 Ca e and C n e ence f Inc me Ine ali : A Gl bal Pe ec i e
43 T -child benefi limi he familie f he in e d
44 H he Re blican a la h he and hel he ich, in ne cha
45 The Di ib i n f H eh ld Inc me, 2014 Ine ali and Ec n mic G h

Cha e 13
Dema d- ide a d l - ide licie

Bef e a
I ha a d g e e ge e a e e e e?
Wha d g e e e d e a d h d he i i i e ce ai ch ice e he ?
Ca hi f a he g e e i e e e e he be f e e a d
i fai ?
I hi cha e e i e he AD-AS de a he ba i f a a i g a d e a a i g ic a e a i e
ha ca be ed b g e e achie e a a ie f ac ec ic bjec i e .
13.1 In od c ion o mac oeconomic policie
LEARNING OBJECTIVES
Af e d i g hi ec i i be ab e :
defi e a he e a ea i g i o ange bold i he e (AO1)
i e he ba ic i ci e f de a d- ide a d - ide icie (AO1)
Demand- ide policie

Demand- ide policie , a a demand managemen , f c cha gi g agg ega e de a d,
hif i g he agg ega e de a d c e i he AD-AS de , achie e e e a ac ec ic g a . The
a e ba ed he idea ha h - e f c a i i ea GDP f he b i e c c e a e d e ac i f
fi a dc e affec i g agg ega e de a d, ca i g i f a i a def a i a / ece i a ga .
De a d- ide icie c e ac he effec f he e ac i a d b i g agg ega e de a d he f
e e e e f ea GDP, e ia GDP.
The e a e e f de a d- ide icie :
ea ic
fi ca ic .
M e a a d fi ca icie a e ed ce he h - f c ai f he b i e c c e. The a e
ca ed s abilisa ion policies, beca e he abi i e he ec ,ei i ai g h -
i abi i ie ca ed b i c ea e a d dec ea e f agg ega e de a d. If abi i a i icie ed a
i e ded, he b i e c c e d be f a e ed , a d he ec ac a d be e c e
i e ia ( ee Cha e 8, Fig e 8.4). I ac ice, he ha abi i a i ca h e
achie e i e e he e e i ie f he b i e c c e.
S ppl - ide policie

S ppl - ide policie f c he d ci a d ide f he ec , ecifica fac
ai ed a hif i g he g- agg ega e (LRAS) Ke e ia AS c e he igh , i c ea e
e ia a d achie e g- e ec ic g h ( ee Cha e 11, Fig e 11.2). The d
a e abi i e he ec b ed ci g he f c a i f he b i e c c e. I ead, he f c
i c ea i g he a i a d a i f fac f d ci ,a e a i i i a cha ge
i e ded i e he ec d c i e ca aci .
The e a e a ca eg ie f - ide icie :
a e -ba ed, hich e he i g f he a e
i e e i i , hich e g e e i e e i .
13.2 D
LEARNING OBJECTI ES

e plain he goal of mone a polic (AO2)
lo and able a e of infla ion incl ding infla ion a ge ing
lo nemplo men
ed c ion of b ine c cle fl c a ion
p omo ion of a able economic en i onmen fo long e m g o h
e e nal balance
e plain ho eq ilib i m in e e a e a e de e mined (AO2) (HL onl )
d a a diag am o ho de e mina ion of eq ilib i m in e e a e (AO4) (HL onl )
e plain ho comme cial bank c ea e mone (AO2) (HL onl )
e plain he ool of mone a polic (AO2) (HL onl )
open ma ke ope a ion
minim m e e e eq i emen
change in cen al bank minim m lending a e
q an i a i e ea ing
di ing i h be een eal and nominal in e e a e and calc la e eal in e e a e f om da a
(AO2) (AO4)
e plain and e al a e e pan iona and con ac iona mone a policie o clo e infla iona and
defla iona / ece iona gap (AO3)
d a AD-AS diag am o ho e pan iona and con ac iona mone a polic (AO4)
di c con ain on mone a polic incl ding he limi ed cope of ed cing in e e a e
hen he e a e app oaching e o, and con eq ence of lo con me and b ine confidence
(AO3)
di c eng h of mone a polic incl ding ha i i inc emen al, fle ible, ea il e e ible
and ha ho ime lag (AO3)
e al a e mone a polic i h e pec o p omo ing lo nemplo men , lo and able a e of
infla ion and g o h (AO3); ee Sec ion 13.7
T
M i ca ied o b he cen al bank of each co n . The cen al bank m be
di ing i hed f om comme cial bank . C a e financial in i ion ( hich ma be
p i a e o p blic) ho e main f nc ion a e o hold depo i fo hei c ome (con me and fi m ),
o make loan o hei c ome , o an fe f nd b cheq e (check) elec onicall f om one bank o
ano he , and o b go e nmen bond . (Go e nmen bond e e e plained in Chap e 11 in he ec ion
on Go e nmen deb .)
The i all a go e nmen financial in i ion i h e e al impo an e pon ibili ie :
B . The cen al bank ac a a banke o he go e nmen in he a ha
comme cial bank ac a banke o hei c ome . I hold he go e nmen ca h (a depo i ),
ecei e pa men fo he go e nmen and make pa men fo he go e nmen , and manage he
go e nmen bo o ing b elling bond o comme cial bank and he p blic.
B . The cen al bank al o ac a a banke o comme cial bank b
holding depo i fo hem and can al o make loan o hem in ime of need. (I i no a banke o
con me and fi m .)
R . The cen al bank eg la e and pe i e comme cial bank ,
making e he ope a e i h app op ia e le el of ca h, acco ding o le ha en e he afe of
he financial em.
C . The cen al bank i e pon ible fo mone a polic , ba ed on i
control of the suppl of mone and interest rates.
E e co n ha a cen al bank. In he co n ie of he E opean Union ha ha e fo med he E opean
Mone a Union ( ha ha e adop ed he e o, al o kno n a e o one co n ie ), he na ional cen al
bank main ain man of hei f nc ion , no ed abo e, b he e pon ibili fo mone a polic ha been
an fe ed o a ingle o gani a ion, he E opean Cen al Bank.
C
Al ho gh he cen al bank i all a go e nmen in i ion, in man co n ie i ha a deg ee of
independence f om go e nmen in e fe ence in he p i of mone a polic . Independence en e ha
mone a polic can be cond c ed in he be longe - e m in e e of he econom , i ho in e fe ence
f om poli ical p e e ( ch a enco aging economic ac i i j befo e an elec ion). The e i a
gene al end a o nd he o ld fo go e nmen o make cen al bank inc ea ingl independen .
T
Mone a polic a emp o achie e he follo ing goal :
L . In Chap e 10 e lea ned ha high a e of infla ion ha e e e al
nde i able effec on he econom and he pop la ion. Mone a polic a emp o achie e a lo
and able a e infla ion, hich a ie f om co n o co n b i of en abo 2%; lo b no o
lo ha i i dange o l clo e o defla ion ( ee Chap e 10). Man cen al bank p ac ice he
polic of inflation targeting, di c ed belo .
L . We ha e een in Chap e 10 ha nemplo men al o ha e e al economic a
ell a pe onal and ocial co . One of he goal of mone a polic ma be o o main ain
nemplo men a ela i el lo le el . The pe of nemplo men in ol ed he e i c clical
nemplo men , a i ing in a defla iona gap d e o in fficien agg ega e demand.
R . We died he b ine c cle in Chap e 8. Fig e 8.3
ho ed ha eal GDP g o h i ne en and i eg la . Fl c a ion a o nd po en ial o p a e
di p i e o he no mal f nc ioning of he econom , ca ing infla ion hen o p i abo e
po en ial o p , and c clical nemplo men hen i i belo he po en ial. One of he objec i e of
mone a polic i o o make he fl c a ion of he b ine c cle a mall a po ible.
P - . Con me and fi m need a
able economic en i onmen o be able o plan and ca o hei economic ac i i ie . Fi m , in
pa ic la , m make plan ch a ha capi al good o in e in, ho m ch o in e , and
he he , ho and in ha a ea o p e e ea ch and de elopmen (R&D) and echnological
inno a ion . To be able o plan, fi m need economic abili , con i ing of a oidance of ha p
economic p n (infla ion and infla iona gap ) and do n n ( ece ion and nemplo men in
defla iona gap ). Mone a polic help c ea e he mac oeconomic en i onmen ha enco age
ac i i ie impac ing on long- e m economic g o h.
E . E e nal balance efe o a i a ion he e a co n e en e f om e po
a e balanced b pending on impo o e an e ended pe iod of ime. Thi i pa l he e l of he
al e of he co n c enc , o i e change a e (Chap e 16). The cen al bank can infl ence
e change a e beca e of he clo e ela ion hip be een in e e a e and e change a e .
I
While f ll emplo men and a lo and able a e of infla ion a e among he goal of mone a polic , in
ecen ea mo e and mo e cen al bank a o nd he o ld a e ing a kind of mone a polic ha aim
a main aining a pa ic la a ge ed a e of infla ion (fo e ample, A alia, B a il, Canada, Chile,
Finland, I ael, Me ico, Ne Zealand, No a , S eden, S i e land, he Uni ed Kingdom, he
E opean Union and man o he ).
The In e na ional Mone a F nd (IMF) define a:
. . . the public announcement of medium-term numerical targets for inflation ith an institutional
commitment b the monetar authorit to achieve these targets. 1
Man co n ie p ing infla ion a ge ing ha e a ge be een 1.5% and 2.5%, i h one pe cen age
poin abo e and belo a a ole ance ma gin. The infla ion a ge i e in e m of he con me p ice
inde (CPI), hich al o ake in o acco n p ice of impo ed good (incl ded in he CPI ba ke ).
Ho e e , infla ion a ge ing i all ba ed on fo eca o p edic ion of future infla ion ba ed on he
CPI ( ee Chap e 10 fo a di c ion of he CPI).
Infla ion a ge ing offe a n mbe of ad an age incl ding:
achie emen of a lo and able a e of infla ion
imp o ed abili of economic deci ion-make (fi m , con me ) o an icipa e he f e a e of
infla ion and he efo e plan hei economic ac i i ie
g ea e co-o dina ion be een mone a and fi cal polic ince kno ledge abo infla ion a ge
allo he go e nmen o plan i fi cal polic o complemen he cen al bank mone a polic .
Ye he e a e al o di ad an age :
ed ced abili of he cen al bank o p e o he mac oeconomic objec i e , pa ic la l he goal
of f ll emplo men ; hi i e peciall impo an in ie of he po en ial conflic be een a lo a e
of infla ion and lo nemplo men ( ee Chap e 10)
ed ced abili of he cen al bank o e pond o ppl - ide hock ; in he e en of a ppl - ide
hock, ch a a dden inc ea e in oil p ice leading o co -p h infla ion and agfla ion, he
cen al bank ma need fle ibili o p e an e pan iona polic o b ing he econom o of
ece ion; hi ma mean a highe a e of infla ion han he a ge
an infla ion a ge ha i oo lo ma lead o highe nemplo men ; if i i oo high, i co ld lead o
he p oblem e l ing f om high infla ion.
D (HL )
T
Mone a polic impac indi ec l on agg ega e demand h o gh he (o
). To nde and mone a polic , e m con ide ho he a e of in e e i de e mined.
When e bo o mone , e m make a pa men fo he loan in addi ion o epa ing he p incipal
( he amo n of he loan); hi pa men fo a loan i . In e e i all e p e ed a a
pe cen age of he p incipal o be paid pe ea , called he rate of interest. If o bo o $1000 fo one
ea a he a e of in e e of 10% pe ea ; a he end of he ea o m pa back he p incipal of
$1000, pl $100 of in e e (10% of $1000).
In he eal o ld he e a e man diffe en a e of in e e , depending on e e al fac o , ch a he
le el of i k of a loan ( he g ea e he i k, he highe he in e e a e); he amo n of ime o e hich
he loan m be paid, kno n a ma i ( he longe he ime pe iod, he highe he in e e a e);
he i e of he loan ( he la ge he loan, he lo e he in e e a e); he deg ee of ma ke po e of he
lende ( he g ea e he ma ke po e , he highe he in e e a e), and o he . Ho e e , hen
economi anal e he a e of in e e in economic model (a e a e doing he e), he implif he
anal i b adop ing he common p ac ice of efe ing o he a e of in e e a if he e e e onl
one.
We can nde and ho he a e of in e e i de e mined a an applica ion of ppl and demand in a
pecial ma ke , he mone ma ke , ho n in Fig e 13.1(a). M i defined a an hing ha i
accep able a pa men fo good and e ice ; i incl de c enc (coin and pape mone ) and
cheq e (checking) acco n . In he mone ma ke he demand fo mone and he ppl of mone
de e mine he eq ilib i m a e of in e e . The ho i on al a i mea e he q an i of mone in he
econom , and he e ical a i mea e he a e of in e e .
The a e of in e e can be ho gh of a he p ice of mone e ice . The i fi ed
a a le el decided pon b he cen al bank. (We ill ee la e in hi chap e ho hi i done.) I
appea in Fig e 13.1(a) a a e ical line, Sm, beca e i doe no depend on he a e of in e e .
The demand for mone , Dm, ha he familia do n a d- loping hape of a demand c e. A he a e
of in e e fall , he q an i of mone demanded b he p blic (con me , fi m , he go e nmen )
inc ea e . To ee h , emembe ha mone i defined o be c enc and cheq e (checking)
acco n ; he impo an hing o no e he e i ha mone does not earn interest. S ppo e o ha e
ome a ing ; le al o a o ha e a choice be een p ing o a ing in a fo m ha ea n
in e e , ch a a a ing depo i in a bank, o el e o can hold o a ing in he fo m of c enc
o a checking acco n in a bank ha doe no ea n in e e . Clea l , he highe he in e e a e, he
le a ac i e i i fo o o hold mone , and he lo e he q an i of mone o a e likel o
demand. Thi i he e plana ion behind he do n a d loping demand fo mone c e.
The poin of in e ec ion be een Dm and Sm de e mine he eq ilib i m a e of in e e , i, ill a ed
in Fig e 13.1(a).
If he cen al bank change he mone ppl , he Sm c e hif , de e mining a ne a e of in e e .
Thi i ho n in Fig e 13.1(b). S ppo e ini iall he mone ppl i a Sm1; i h demand fo
mone Dm, he eq ilib i m a e of in e e i i1. If he cen al bank inc ea e he mone ppl , Sm1
hif o Sm2, and he eq ilib i m a e of in e e fall o i2. If he cen al bank dec ea e he mone
ppl , Sm1 hif o Sm3, and he eq ilib i m a e of in e e i e o i3.
An inc ea e in he ppl of mone lead o a fall in he a e of in e e ; a dec ea e in he ppl of

mone lead o an inc ea e in he a e of in e e .
F 13.1: The mone ma ke and de e mina ion of he a e of in e e
S
The cen al bank decide pon a a ge in e e a e i an o achie e, and hen ake ep o adj
he mone ppl o ha he ac al eq ilib i m in e e a e ill become eq al o he a ge in e e
a e.
To ee ho hi o k , ppo e he Bank of Ri e land (Ri e land cen al bank) decide o inc ea e
he in e e a e f om i1 o i3 in Fig e 13.1(b). To do o, i ake mea e o ed ce he ppl of
mone n il he in e e a e inc ea e o i3. If he ac al ma ke in e e a e de ia e f om he a ge
a e, i ill con in e o adj he mone ppl in o de o achie e he a ge a e. Yo can ee, hen,
ha cen al bank do no ac all e o fi in e e a e , b a he allo he e o be de e mined b
he ma ke .
The efo e, if o hea in he ne ha he Bank of Ri e land inc ea ed he in e e a e f om 3.25%
o 3.50%, o o ld nde and ha 3.50% i he ne a ge in e e a e ha he Bank of Ri e land
i ing o achie e b ed cing he mone ppl .
In he eal o ld he e a e man in e e a e (a e plained abo e), o ha in e e a e do cen al
bank a ge ? Thi a ie f om co n o co n , depending on he na e of he mone a em. In
he Uni ed Kingdom, he cen al bank a ge he ba e a e , hich i he in e e a e a hich he
Bank of England ( he cen al bank) lend o comme cial bank . In he Uni ed S a e , he Fede al
Re e e ( he cen al bank) a ge he fede al f nd a e , hich i he a e ed b comme cial bank
o bo o and lend f om and o each o he o e a 24-ho pe iod. The E opean Cen al Bank (of he
e o one co n ie ) a ge he minim m efinancing a e , hich i he in e e a e paid b
comme cial bank hen he bo o f om hei e pec i e na ional cen al bank o efinance hei
acco n .

1 Di ing i h be een a co n cen al bank and comme cial bank .
2 O line he goal of mone a polic .
3 (HL )
U ing a diag am, e plain ho eq ilib i m in e e a e a e de e mined.
O line ha a cen al bank o ld do if i an ed o lo e in e e a e , and o
inc ea e in e e a e .
H (HL )
To nde and he p oce of b comme cial bank , e m fi ee ho mone i
c ea ed. A e ill no di co e , mone i c ea ed b comme cial bank , ho gh ho much mone
he can c ea e i de e mined b he cen al bank.
H
S ppo e o ha e ea ned 1000 in o mme job, and o o ld like o depo i hi in o local
comme cial bank. Yo go o o bank and open a depo i , in o hich o place o 1000. Wha
happen o o 1000? Yo bank i nlikel o keep hi mone in i a l fo o o collec i
hen o i h. In ead, i i likel o lend o a good po ion of i o o he people ho an o
bo o f om he bank.
In gene al hen comme cial bank ecei e depo i f om hei c ome , he do no keep all hi
ca h i hin hei a l . The f nd he m legall keep a e called required reserves, hich a e a
legall de e mined f ac ion of o al depo i , called he o required
reserve ratio. The e a e called e cess reserves and can be len o .
S ppo e he minim m e e e eq i emen in o bank i 20%. The bank m keep 200 of
eq i ed e e e in i a l , and can lend o he emaining 800 of e ce e e e . S ppo e
indi id al A bo o he 800 and b a comp e f om indi id al B, ho hen depo i hi
amo n in he bank. Thi bank m keep 20% of 800 o 160 (= 0.20 800), and can lend o he
emaining amo n , hich i 640 (= 800 160). Thi p oce con in e an infini e n mbe of
ime , and in he end he amo n of ne loan ha ha e been c ea ed ill be 4000.
Thi amo n i he e l of a p oce he e he amo n of ini ial e ce e e e of 800 a e
m l iplied b a mone a m l iplie , eq al o 1 eq i ed e e e a io, hich in hi ca e i :
1 0.20 =5.
The efo e he amo n of ne loan ha ha e been c ea ed = 5 800 = 4000. B these ne loans
are none other than ne mone created, ince all he bo o e f om he bank e e able o e hei
loan o ca o hei an ac ion b e of mone .
No e ha if he minim m e e e eq i emen had been lo e , a 15%, he bank ha ecei ed o
ini ial depo i of 1000 o ld ha e e ce e e e of 850 a he han 800, i o ld he efo e be
able o lend o hi 850, he mone a m l iplie o ld ha e been 1 0.15 =6.67, o he amo n of
ne loan , o ac all ne mone , ha co ld ha e been c ea ed o ld be = 6.67 850 = 5670.
No e al o ha hi amo n of ne mone i a ma imum amount ha can be c ea ed b a comme cial
bank gi en he ini ial depo i . I doe no mean ha he bank ill ac all make all ho e loan . In
ac al fac i i po ible ha he bank ill c ea e le han he ma im m allo able amo n .
When bank make loan , he a e ac all creating ne mone . The lo e he minim m e e e

eq i emen , he g ea e he e ce e e e , he mo e loan can be made b comme cial bank ,
and he mo e ne mone can be c ea ed. The minim m e e e eq i emen de e mine he
ma im m amo n of ne mone ha can be c ea ed.
Thi p oce of mone c ea ion i ba ed on he idea ha onl a f ac ion of depo i need o be kep in
he bank a l , i i he efo e called a fractional reserve s stem.
T
We ill no ee ho he cen al bank con ol he amo n of ne mone c ea ion b e amining he
mone a polic ool of cen al bank .
O
The mo impo an ool ed b cen al bank o infl ence he ppl of mone i
. Open ma ke ope a ion o k b e of bonds ( ee Chap e 11 in connec ion i h ho
go e nmen bo o ). Bond a e impl deb . The bo o e i e a ce ifica e called a bond ha
p omi e o pa in e e a a io in e al n il a ce ain da e hen he mone i epaid o he bond
holde . The holde of he bond i he efo e he lende , and he i e of he bond i he bo o e . Open
ma ke ope a ion o k h o gh he b ing and elling of pre-e isting go e nmen bond in he bond
ma ke . The bond ma ke i impl a ma ke he e holde of bond can b and ell pre-e isting
bond .
S ppo e a cen al bank i he o lo e he in e e a e, and m he efo e inc ea e he mone
ppl . I ill bu go e nmen bond f om comme cial bank . When he cen al bank b he bond
i pa he comme cial bank fo he e. Thi p oce inc ea e he comme cial bank e ce e e e ,
hich he can e o make mo e loan , and he efo e he mone ppl inc ea e gi ing i e o lo e
in e e a e , a Fig e 13.1 ho .
On he o he hand if he cen al bank an o ai e he in e e a e, i sells bond o comme cial
bank ; a he bank m pa he cen al bank fo he e, hei e ce e e e and he efo e hei
lending abili a e ed ced, and he mone ppl i lo e ed. In Fig e 13.1 he mone ppl c e
hif o he lef , e l ing in a highe in e e a e.
Cen al bank ma b and ell bond no onl f om comme cial bank b al o f om he p blic in
gene al. The end e l i he ame, onl i occ indi ec l .
M
Thi ool in ol e change of he minim m e e e eq i emen b he cen al bank. A e a
ea lie , if he e e e eq i emen dec ea e, hi mean ha he comme cial bank e ce e e e
inc ea e, he efo e hei lending abili inc ea e , o oo hei abili o c ea e mone . Hence he
mone ppl inc ea e . On he o he hand if he e e e eq i emen inc ea e, he e l i he
oppo i e. E ce e e e d op, he bank lending abili dec ea e , o oo hei abili o c ea e
mone , hence he mone ppl dec ea e .
C
One of he f nc ion of a cen al bank i ha i ome ime lend o comme cial bank . When i doe
hi i cha ge hem an in e e a e, kno n a a (acco ding o UK
e minolog ). Thi in e e a e ha diffe en name in diffe en co n ie , fo e ample in he
E opean Union i i kno n a he refinancing rate, in he Uni ed S a e a he discount rate, in he
Uni ed Kingdom a he base rate.
If comme cial bank an e e e o inc ea e hei lending he can bo o f om he cen al bank.
The efo e, he minim m lending a e eflec he co o comme cial bank of acq i ing mo e
e e e . If he cen al bank dec ea e hi in e e a e, i become le co l fo comme cial bank
o bo o f om he cen al bank, and o he can inc ea e hei bo o ing, inc ea e hei e e e ,
he efo e inc ea ing he mone ppl . If he cen al bank inc ea e hi a e, bo o ing become
mo e co l fo he comme cial bank , he efo e hei lending abili i ed ced and he mone ppl
dec ea e .
Q
Q i imila o b ing bond in open ma ke ope a ion , b on a m ch la ge cale,
in ol ing mo e pe of financial a e and la ge q an i ie of he e. I i an ncon en ional pe of
mone a polic ha a fi ed b Japan in 2001, and la e b o he cen al bank d e o he
global financial c i i . The Uni ed S a e began ing he polic in 2008 and he E opean Cen al
Bank in 2015. Con en ional mone a polic had ed ced in e e a e o e lo le el ,
app oaching e o. The objec i e a o enco age bo o ing b fi m and con me in o de o
inc ea e agg ega e demand. B hen in e e a e fall o lo con en ional mone a polic
become ineffec i e ( e ill ee h la e in hi chap e ). Wi h q an i a i e ea ing, he cen al bank
b h ge q an i ie of a e ha comme cial bank ha e o o n. In o de o pa fo he a e he
cen al bank c ea e e e e elec onicall fo he comme cial bank . A a e l he comme cial
bank ha ell he a e end p i h man mo e e e e hich he can hen e o make loan , he
objec i e being o inc ea e agg ega e demand.
Table 13.1 mma i e he ool of mone a polic .
T T
O B bond inc ea ing Sell bond dec ea ing

comme cial bank e e e comme cial bank e e e h
h inc ea ing he mone dec ea ing he mone ppl
ppl
M Lo e e e e eq i emen Inc ea e e e e eq i emen

inc ea ing comme cial bank dec ea ing comme cial bank
e e e h inc ea ing he e e e h dec ea ing he
mone ppl mone ppl
C Lo e minim m lending Inc ea e minim m lending a e

a e inc ea ing comme cial dec ea ing comme cial bank
bank e e e h e e e h dec ea ing he
inc ea ing he mone mone ppl
ppl
Q C ea e ne e e e
elec onicall ed b he
cen al bank o b a h ge
a ie and q an i of
a e h di ec l
inc ea ing he mone
ppl
T 13.1: Tool of mone a polic
TEST O R NDERSTANDING 13.2 (HL ONL )

1 U ing he concep of minim m e e e eq i emen , e plain he p oce b hich
comme cial bank c ea e mone .
2 E plain ho a cen al bank co ld e he ool of
open ma ke ope a ion ,
minim m e e e eq i emen ,
changing he minim m lending a e o inc ea e he ppl of mone , o dec ea e he
ppl of mone .
3 E plain ha i mean b he polic of q an i a i e ea ing.
R
The i impl he ma ke a e ha p e ail a an momen in ime. If o bank
ell o ha o ill ecei e 5% in e e on o a ing , ha i he nominal in e e a e. The
i he in e e a e ha ha been co ec ed fo infla ion. When e kno he a e of infla ion
and he nominal in e e a e, e can calc la e he eal in e e a e
eal in e e a e = nominal in e e ae a e of infla ion
If he ann al a e of infla ion i 3% and he nominal in e e a e i 5% pe ea , he eal a e of in e e i

5% 3% = 2% pe ea . So if o ha e $1000 in a bank acco n ha ea n 5% pe ea , af e one ea
hi ill be a nominal amo n of $1050 (= 1000 1.05) b in eal e m , o in e m of he p cha ing
po e of o o iginal $1000 o ill ha e $1020 (= 1000 1.02).
When e died he co of infla ion, e lea ned ha a e can p o ec hem el e again lo e in
he eal al e of hei a ing if he can ecei e an in e e a e ha i a lea a high a he a e of
infla ion. If he ann al a e of infla ion i 3% b he nominal in e e a e i onl 2% pe ea , he eal
a e of in e e ill be 2% 3% = 1%. Yo $1000 in eal e m ill be o h $990 (= 1000 0.99)
af e one ea . In o de o p o ec o elf again infla ion o m ecei e a nominal a e of in e e
ha i a lea 3%, eq al o he a e of infla ion.
T : /
C
The poin of changing he mone ppl o a o change in e e a e i l ima el o infl ence
agg ega e demand. Change in in e e a e affec o of he fo componen of agg ega e demand:
in e men , I, and con mp ion, C ( ee Chap e 9, Table 9.1). Since ome con me and fi m pending i
paid fo b bo o ing, a change in in e e a e i in ended o affec he amo n of con me pending
(C) and in e men pending (I).
An inc ea e in in e e a e i in ended o lo e con me and b ine bo o ing and hence pending
(lo e C and I), and he efo e hif AD o he lef . A dec ea e in in e e a e i in ended o inc ea e
con me and b ine bo o ing and hence pending (highe C and I), and he efo e hif AD o he
igh .
E ( )
S ppo e he econom i e pe iencing a defla iona ( ece iona ) gap d e o in fficien agg ega e
demand, a in Fig e 13.2(a) and (b). The cen al bank decide o inc ea e he mone ppl , ca ing a
igh a d hif in he ppl of mone c e f om Sm1 o Sm2 in Fig e 13.1(b). Wi h he demand fo
mone con an , he in e e a e fall f om i1 o i2.
The d op in he in e e a e mean a lo e co of bo o ing; he efo e, con me and fi m a e likel
o bo o mo e and pend mo e, o ha con mp ion pending (C) and in e men pending (I) inc ea e.
The effec i o inc ea e agg ega e demand and ca e a igh a d hif of he AD c e. Thi i ho n in
Fig e 13.2(a) and (b), he e he ece iona gap ha been clo ed h o gh he hif f om AD1 o AD2.
F 13.2: Effec of e pan iona polic : elimina ing a ece iona /defla iona gap
Bo h he mone a i /ne cla ical and he Ke ne ian model p edic ha an inc ea e in AD inc ea e eal
GDP. Ho e e , he i e of he inc ea e in eal GDP ill no be he ame. I ill be malle in he
mone a i /ne cla ical model han in he Ke ne ian one, beca e of he p a d- loping SRAS c e.
The effec diffe al o in he ca e of he p ice le el. In he mone a i /ne cla ical model, he inc ea e in
AD al a e l in a i e in he p ice le el beca e of he p a d- loping SRAS c e. In he
Ke ne ian model, he inc ea e in AD ma e l in no inc ea e in he p ice le el a all if he AD hif
occ en i el i hin he ho i on al ec ion of he AS c e. If he AD hif eache in o he p a d-
loping pa of he Ke ne ian AS c e, a in Fig e 13.2(b), he e ill be onl a malle inc ea e in he
p ice le el.
An inc ea e in he mone ppl b he cen al bank i efe ed o a an
ince he objec i e i o e pand agg ega e demand and he le el of economic ac i i . I i al o an eas
mone polic , ince i e l f om an inc ea e in he ppl of mone compa ed o he mone a i /ne
cla ical model.
C ( )
S ppo e no ha he econom i e pe iencing an infla iona gap ca ed b e ce agg ega e demand,
a in Fig e 13.3(a), (b) and (c) he e he agg ega e demand c e AD1 in e ec he SRAS c e and
he Ke ne ian AS c e a a le el of eal GDP, Yinfl, ha i g ea e han he f ll emplo men o po en ial
o p le el Yp. The cen al bank ed ce he mone ppl ; hi appea in Fig e 13.1(b) a a lef a d
hif of he Sm c e, f om Sm1 o Sm3. Wi h he demand fo mone con an , he e l i a highe a e of
in e e , i3, o a highe co of bo o ing, and he efo e ed ced bo o ing b con me and fi m . The
effec of lo e in e men pending (I) and lo e con me pending (C) i o dec ea e agg ega e
demand. Thi i ho n in all pa of Fig e 13.3, he e he infla iona gap ha been clo ed h o gh he
hif f om AD1 o AD2.
A dec ea e in he mone ppl b he cen al bank i efe ed o a a ,
a he objec i e i o con ac agg ega e demand and he efo e he econom . I i al o kno n a a tight
mone polic , in ie of he dec ea e in he ppl of mone .
F 13.3: Effec of con ac iona polic : elimina ing an infla iona gap
No e ha he effec of a fall in agg ega e demand ma be diffe en depending on he model con ide ed.
If AD fall i hin he p a d- loping pa of he AS c e in he Ke ne ian model (a in pa (b)) he
effec on he p ice le el and eal GDP a e imila in he o model (pa (a) and (b)) beca e he lope
of he c e i imila . B if AD e e o dec ea e in o he ho i on al pa of he AS c e, he e o ld
be a la ge fall in eal GDP and a malle fall in he p ice le el in he Ke ne ian model, o none a all,
compa ed i h he mone a i /ne cla ical model. (The a g men i analogo o ha no ed abo e in
connec ion i h e pan iona polic .)
T K
We kno ha a fea e of he Ke ne ian model i ha he p ice le el can ea il inc ea e i h ong
agg ega e demand, b doe no ea il fall a agg ega e demand dec ea e . The efo e, he dec ea e in he
p ice le el ho n in Fig e 13.3(b) doe no make en e. To ake hi in o acco n , man economi
efe o he a che effec , ho n in Fig e 13.3(c).2 Acco ding o he a che effec , he p ice le el
mo e p hen he e i an inc ea e in AD, and hen emain a he ame le el n il he e i a f he
inc ea e in AD. In Fig e 13.3(c), he change f om AD1 o AD2 ca e eal GDP o fall o Yp, b he
p ice le el emain con an a pl1. Thi i a mo e eali ic ep e en a ion of ha all happen in he
eal o ld. (Yo ma no e ha he dec ea e in AD eq i ed o b ing eal GDP o Yp f om Yinfl i malle
i h he a che effec han i ho .)
Mone a polic i ca ied o b he cen al bank, hich aim a changing in e e a e o infl ence
he I and C componen of agg ega e demand. In a defla iona ece iona gap, he cen al bank
ma p e an e pan iona (ea mone ) polic h o gh lo e in e e a e o enco age I and C
pending, he objec i e being o hif he AD c e o he igh leading o eq ilib i m a he f ll
emplo men le el of eal GDP (po en ial GDP). In an infla iona gap, he cen al bank can p ea
con ac iona ( igh mone ) polic h o gh highe in e e a e aimed a di co aging I and C
pending, ca ing he AD c e o hif o he lef leading o eq ilib i m a he f ll emplo men le el
of eal GDP (po en ial GDP).
1 Di ing i h be een nominal and eal in e e ae .
Calc la e he eal in e e a e if he nominal a e i 5% and he a e of infla ion i 3%.
Calc la e he eal in e e a e if he nominal a e i 4% and he a e of infla ion i 7%.
O line he meaning of a nega i e eal in e e a e.
2 Di ing i h be een e pan iona and con ac iona mone a polic .
S a e he componen of agg ega e demand ha mone a polic can infl ence.
E plain he ole of he a e of in e e in mone a polic .
3 U ing diag am , ho ho he go e nmen can e mone a polic hen he e i
a ece iona /defla iona gap, and
an infla iona gap.
4 U ing he mone a i /ne cla ical model, e plain he impac on eal GDP, he p ice le el and
nemplo men , of he follo ing policie of a co n cen al bank:
a fall in he a e of in e e
an inc ea e in he a e of in e e .
5 An e pa (a) and (b) in q e ion 3 abo e ing he Ke ne ian AD-AS model.
E plain ho he p edic ion of he o model diffe .
De c ibe hen he a che effec come in o pla .
E
Whe ea mone a polic i in ended o achie e pa ic la objec i e , i doe no al a o ka
e pec ed.
C
P . Whe ea mone a polic can o k effec i el hen i ai e
in e e a e o figh infla ion, i i le ce ain o be a effec i e in a deep ece ion, beca e:
I e e a e ca fall he a achi g e . A in e e a e app oach e o, he canno
fall f he o enco age pending b fi m and con me .
L c e a d d ce c fide ce. If fi m and con me a e pe imi ic abo f e
economic condi ion , he ma a oid aking o ne loan , and ma e en ed ce hei
in e men and con me pending, o ha agg ega e demand ill no inc ea e (i ma e en
dec ea e).
Ba k a be fea f l f le di g. In a e e e ece ion, bank ma be n illing o inc ea e
hei lending, beca e he ma fea ha bo o e migh be nable o epa he loan .
S ch polic ineffec i ene i no ome hing ha happen of en; ho e e , i appea o ha e occ ed
d ing he G ea Dep e ion of he 1930 , in Japan in he la e 1990 and ea l 2000 , and in he global
ece ion ha began in he a mn of 2008.
C . Manip la ion of in e e a e affec no onl a iable
in he dome ic econom (con mp ion and in e men pending, infla ion, nemplo men ) b al o
a iable in he fo eign ec o of he econom , ch a e change a e . The p i of dome ic
objec i e ma conflic i h he p i of he goal of e e nal balance in he fo eign ec o ( ee
Chap e 16, 17).
M . If i la oo long i ma be infla iona , if agg ega e demand inc ea e
be ond ha i nece a o elimina e a defla iona / ece iona gap.
P - . Mone a polic i a demand-
side polic , and i he efo e nable o deal effec i el i h ppl - ide ca e of in abili .
S
I . In e e a e can be adj ed in e mall ep ,
making mone a polic ell i ed o fine ning of he econom .
I . In e e a e change can al o be ea il e e ed if
nece a . An e pan iona polic can ea il be e e ed in o a con ac iona polic and ice
e a.
M . In e e a e can be changed of en acco ding o need .
R ( ). While mone a polic can be implemen ed ela i el
q ickl , i i bjec o ime lag a i ake ime fo in e e a e change o affec he econom ,
ho gh he e a e no a long a in he ca e of fi cal polic .
C . Independence f om he go e nmen di c ed abo e mean he
cen al bank can ake deci ion ha a e in he be longe - e m in e e of he econom , and can
he efo e p e policie ha ma be poli icall npop la ( ch a highe in e e a e making
bo o ing mo e co l ).
L . Mone a polic doe no face poli ical p e e a fi cal polic
doe , ince i doe no in ol e making change in he go e nmen b dge , he he in e m of
go e nmen pending ha o ld affec me i and p blic good p o i ion o go e nmen a e ( ee
he di c ion on fi cal polic belo ).
N . I doe no lead o b dge defici o inc ea ed le el of deb a fi cal
polic doe in he ca e of e pan iona polic .
N . Mone a polic doe no lead o c o ding o , hich ma be a eakne of
e pan iona fi cal polic ( hi ill be di c ed belo a HL).

1 E plain h mone a polic i no e ell i ed o dealing i h in abili ie ca ed b
dec ea e in SRAS.
2 E amine he eng h and eakne e of mone a polic and di c hich of he e o hink
a e mo e impo an .
1 The IMF i an in e na ional financial in i ion ha e ill d in Chap e 20. IMF, De Fac o Cla ifica ion
of E change Ra e Regime and Mone a Polic F ame o k , 31 Ap il 2008.
2 A a che i a imple machine ha allo fo ome hing o mo e onl in one di ec ion.

13.3 Demand management and fiscal policy
LEARNING OBJECTIVES

define all the terms appearing in orange bold in the te t (AO1)
fiscal polic distinguish bet een (AO2)
sources of re enue direct and indirect ta ation, sales of goods and ser ices b state-o ned
enterprises, sale of go ernment assets
e penditures current e penditures, capital e penditures, transfer pa ments
e plain the goals of fiscal polic (AO2)
lo and stable rate of inflation
lo unemplo ment
reduction of business c cle fluctuations
promotion of a stable economic en ironment for long term gro th
equitable distribution of income
e ternal balance
e plain and e aluate e pansionar and contractionar fiscal policies to close inflationar and
deflationar /recessionar gaps (AO3)
dra AD-AS diagrams to sho e pansionar and contractionar monetar policies (AO4)
discuss constraints on fiscal polic including political pressures, time lags, sustainable debt
(AO3)
discuss the constraint of cro ding out and dra a diagram illustrating it (HL onl ) (AO3) (AO4)
discuss strengths of fiscal polic including the abilit to target specific sectors, effecti eness of
go ernment spending in deep recession (AO3)
discuss automatic stabilisers (unemplo ment benefits, progressi e ta es) (HL onl ) (AO3)
e aluate fiscal polic ith respect to promoting lo unemplo ment, lo and stable rate of
inflation and gro th (AO3); see Section 13.7
The government budget

The go ernment budget is a t pe of plan of a countr s re enues and e penditures o er a period of time
(usuall a ear) that the go ernment makes to plan its acti ities.
Sources of government revenue

Go ernment re enue consists of all the funds that flo to ard the go ernment from outsiders. The main
sources of re enue are:
Taxes of all types, both direct and indirect. Ta es are the most important source of go ernment
re enues.
From the sale of goods and services. Go ernments pro ide man goods and ser ices free of
charge to their users (such as public goods). Ho e er there are man ser ices for hich the users
must make a pa ment, including transportation, electricit , ater and man more. The re enues
from these sales usuall go to ard co ering the go ernment s costs of pro iding them.
From the sale of government-owned (state-owned) assets, or property. Such sales are kno n as
pri atisation, hich in ol es the transfer of o nership from the go ernment to pri ate o ners.
Types of government expenditure

Go ernments ha e three t pes of e penditures:
Current expenditures include the go ernment s spending on da -to-da items that are recurring
(repeat themsel es) and items that are used up or consumed as a good or ser ice is pro ided. The
include ages and salaries (for all go ernment emplo ees); spending for supplies and equipment
for the da -to-da operation of go ernment acti ities, including for e ample, school supplies and
medical supplies for public schools and public health care ser ices; pro ision of subsidies; and
interest pa ments on go ernment loans.
Capital expenditures include public in estments, or spending to produce ph sical capital, such as
building roads, airports, harbours, school buildings, hospitals, etc.
Transfer payments include pa ments b the go ernment to ulnerable groups for the purposes of
income redistribution (for e ample, unemplo ment benefits, child allo ances, etc.).
Both current and capital e penditures are included in the measurement of GDP; the are included under
G, for go ernment spending , in the e penditure approach to measuring GDP (see Chapter 8). Ho e er
transfer pa ments are not, because the represent income that is redistributed a a from ta pa ers and
to ard the recei ers of the transfer pa ments; the do not represent alue of ne output produced.
As e kno from Chapter 11 if ta re enues are equal to go ernment e penditures o er a period of time
the go ernment is said to ha e a balanced b dget. If e penditures are larger than ta re enues, there is a
b dget deficit; if e penditures are smaller than ta re enues, there is a b dget s rpl s. When there is a
budget deficit, the go ernment finances (pa s for) the e cess of e penditures o er re enues b
borro ing. O er time, the go ernment s accumulation of deficits minus surpluses is referred to as or
go ernment debt or national debt or p blic debt.
The goals of fiscal policy

Fiscal policy refers to manipulations b the go ernment of its o n e penditures and ta es to influence
the le el of aggregate demand. The goals of fiscal polic are the same as the goals of monetar polic ,
e cept that fiscal polic also has the goal of achie ing an equitable distribution of income.
Low and stable rate of inflation Fiscal polic tries to maintain a slo and stable rate of inflation
b manipulating ta es and go ernment spending to influence aggregate demand. Unlike monetar
polic , fiscal polic does not ha e an inflation target, but ma be used to complement monetar
polic if monetar polic is not as effecti e as e pected.
Low unemployment Fiscal polic similarl ma tr to influence aggregate demand and therefore
unemplo ment. Here too the t pe of unemplo ment in ol ed is c clical, hen the econom is in a
deflationar gap due to insufficient aggregate demand.
Reduce business cycle fluctuations Fiscal polic tries to reduce the si e of the fluctuations of the
business c cle to make inflationar and deflationar gaps as small as possible.
Promote a stable economic environment for long-term growth As ith monetar polic , firms in
particular need a stable economic en ironment ithout sharp inflationar or deflationar gaps in
order to promote business confidence so that firms can carr out the acti ities needed for long-term
economic gro th.
External balance Fiscal polic can help achie e e ternal balance ( here a countr s re enues from
e ports are roughl equal to its spending on imports) b influencing the le el of imports through its
effects on aggregate demand. This topic ill be presented in Chapter 17 (at HL).
Equitable distribution of income This goal is not shared ith monetar polic . Fiscal polic has
major effects on the distribution of income b determining ta policies and go ernment spending to
produce and pro ide particular goods and ser ices, such as merit goods. This topic as discussed in
Chapter 12.

1 E plain
a the sources of go ernment re enues, and
b the t pes of go ernment e penditures.
2 Outline
a the goals of fiscal polic , and
b the difference bet een go ernment budget deficit and go ernment debt .
The role of fiscal policy in demand management

We ha e seen that fiscal polic in ol es manipulations b the go ernment of its o n spending and ta es
to influence aggregate demand. The components of aggregate demand are consumption (C), in estment
(I), go ernment spending (G), and net e ports (X M). Fiscal polic can affect three of these
components:
The le el of the go ernment s o n spending, G.
The le el of consumption spending, C, can be influenced if the go ernment changes ta es on
consumers (personal income ta es), changing their le el of disposable income (consumer income
after income ta es ha e been paid).
The le el of in estment spending, I, can also be influenced if the go ernment changes ta es on
business profits.
Expansionary fiscal policy

The diagrams needed to understand fiscal polic are the same as those for monetar polic . Suppose the
econom is e periencing a recessionar /deflationar gap caused b insufficient aggregate demand. In
Figure 13.2(a) and (b) AD1 intersects both the SRAS cur e and the Ke nesian AS cur e at a le el of real
GDP, Yrec, that is belo the full emplo ment (potential output) le el, Yp. The effects of fiscal polic can
be illustrated equall ell b both the monetarist/ne classical model in part (a) and the Ke nesian
model in part (b). The go ernment s objecti e is to shift AD1 to AD2, here the econom ill achie e
full emplo ment or potential output, Yp, thereb closing the recessionar gap. This is expansionary
fiscal policy, because it orks to e pand aggregate demand and the le el of economic acti it .
E pansionar fiscal polic ma consist of:
increasing go ernment spending
decreasing personal income ta es
decreasing business ta es (ta es on profits), or
a combination of the abo e.
An increase in go ernment spending impacts directl on aggregate demand, hich increases. If the
go ernment decreases ta es, aggregate demand is affected in a t o-step process. If personal income
ta es are cut, there is a rise in disposable income, hich is then likel to lead to an increase in
consumption spending, causing the AD cur e to shift to the right. If business ta es are cut, after-ta
business profits increase, hich in turn is likel to lead to higher in estment spending and therefore
higher AD. In all three cases, AD is intended to shift to the right from AD1 to AD2, allo ing the econom
to achie e full emplo ment or potential output Yp.
Finall , the go ernment ma decide to pursue a polic of increasing go ernment spending and lo ering
ta es simultaneousl . Ho can it increase its o n spending hile keeping ta es constant or decreasing
them? It can do so b borro ing. If initiall it has a balanced budget, an increase in G hile ta es
remain constant or fall creates a budget deficit. If it alread has a budget deficit at the outset, the deficit
ill become larger. If it has a budget surplus at the outset, then the surplus either ill become smaller, or
it ill turn into a deficit.
Note that the effects of the AD increase are different depending on the shape of the AS cur es. In the
monetarist/ne classical model, there is a smaller increase in real GDP and a larger increase in the price
le el compared to the Ke nesian model. This is analogous to the AD increase in the case of monetar
polic .
Contractionary fiscal policy

Suppose the econom is e periencing an inflationar gap caused b e cessi e aggregate demand, sho n
in Figure 13.3(a) and (b). The go ernment s objecti e no is to attempt to shift AD1 to AD2, so that AD2
intersects aggregate suppl at the full emplo ment le el of output, Yp, thereb closing the inflationar
gap. This is called contractionary fiscal policy, because it orks to contract aggregate demand and the
le el of economic acti it . Contractionar fiscal polic consists of:
decreasing go ernment spending
increasing personal income ta es
increasing business ta es (ta es on profits), or
a combination of the abo e.
A decrease in go ernment spending has a direct influence on the aggregate demand cur e, causing it to
shift to the left. An increase in personal income ta es or business ta es is intended to affect aggregate
demand in a t o-step process. As personal income ta es increase, after-ta income falls, causing
consumption spending and aggregate demand to fall. As ta es on profits increase, after-ta profits fall,
leading businesses to spend less on in estment and causing aggregate demand to fall. In all three cases,
the aggregate demand cur e is meant to shift to the left.
The go ernment can also pursue a combination of decreases in go ernment spending ith increases in
personal income and business ta es. Depending on the initial conditions in the go ernment s budget,
such a combination of policies ould lead to the creation of a budget surplus, or the shrinkage of a
budget deficit, or turning a budget deficit into a surplus.
As in the case of monetar polic , if AD falls ithin the up ard-sloping part of the AS cur e in the
Ke nesian model, the effects on the price le el and real GDP are similar to those in the monetarist/ne
classical model, sho n in parts (a) and (b). But if AD ere to decrease into the hori ontal part of the AS
cur e, there ould be a larger fall in real GDP and a smaller fall in the price le el in the Ke nesian
model. Note also the ratchet effect, sho n in Figure 13.3(c), hich takes into account the unlikelihood
of the price le el falling in the Ke nesian model as AD decreases.
Fiscal polic in ol es manipulations b the go ernment of its o n e penditures and ta es to

influence the G, C or I components of aggregate demand. E pansionar fiscal polic can be used
hen there is a recessionar gap, and aims to shift the AD cur e to the right leading to equilibrium at
the full emplo ment le el of real GDP (potential GDP). Contractionar fiscal polic can be used
hen there is an inflationar gap, and aims to shift the AD cur e to the left leading to equilibrium at
the full emplo ment le el of real GDP (potential GDP).
The effects of both t pes of polic ha e been illustrated b use of the same diagrams (Figures 13.2 and
13.3). Yet this simple diagrammatical anal sis hides important differences bet een the t o t pes of
polic , related to the different channels that affect spending of the arious AD components. These
differences are summarised in Table 13.2.
E pansionar polic in recessionar /deflationar gaps (recession)
Type of policy Measures Effects
Monetar polic increase suppl of mone lo er interest rate
(i) increase consumption spending increase AD
(ii) increase in estment spending increase AD
Fiscal polic increase go ernment spending increase AD
lo er personal income ta es increase increase AD

consumption spending
lo er business ta es (on profits) increase increase AD

in estment spending
Contractionar polic in inflationar gaps (inflation)
Type of policy Measures Effects
Monetar polic decrease suppl of mone raise interest rate
(i) decrease consumption spending decrease AD
(ii) decrease in estment spending decrease AD
Fiscal polic decrease go ernment spending decrease AD
raise personal income ta es decrease decrease AD

consumption spending
raise business ta es (on profits) decrease decrease AD

in estment spending
Table 13.2: Demand-side policies to correct deflationar / recessionar and inflationar gaps

1 a Distinguish bet een e pansionar and contractionar fiscal polic .
b Identif hat components of aggregate demand are affected b fiscal polic ; outline ho the
are affected.
2 Using diagrams, sho ho the go ernment can use fiscal polic hen there is
a a recessionar gap, and
b an inflationar gap.
3 Using the monetarist/ne classical model, e plain ho the follo ing policies can impact on real
GDP, the price le el and unemplo ment:
a The go ernment lo ers income ta es.
b The go ernment decreases its spending on defence.
c The go ernment increases ta es on business profits.
d The go ernment increases its spending on the countr s road and high a s stem.
4 a Ans er parts (a) (d) in question 4 abo e using the Ke nesian AD-AS model.
b E plain ho the predictions of the t o models differ.
c State hen the ratchet effect comes into pla .
Evaluating fiscal policy

Fiscal policies also do not al a s achie e the desired and e pected impacts, though mostl for different
reasons than monetar polic .
Constraints on fiscal policy

Problems of time lags. There are a number of time dela s until:
the problem (recessionar or inflationar gap) is recognised b the go ernment authorities and
economists
the appropriate polic to deal ith the problem is decided upon
the polic takes effect in the econom .
Some months ma pass in the case of each of these. B the time the polic action has taken effect
the problem ma ha e become less or more se ere, so that the polic action is no longer the most
appropriate one.
Political constraints Go ernment spending and ta ation face numerous political pressures.
Spending for social ser ices (merit goods) and public goods cannot easil be cut if a contractionar
polic is required. On the other hand, ta increases are politicall unpopular and ma be a oided b
the go ernment e en though the might be necessar . Ta decreases could also be inappropriatel
enacted because the are politicall popular. Therefore political factors ma sometimes lead to
unsuitable fiscal policies.
Sustainable debt As e plained abo e, deficits arise hen go ernment spending is more than
go ernment re enues, financed b borro ing, hich contributes to the building up of debt.
Sustainable debt refers to a le el of debt here a borro ing go ernment can meet its present and
future debt obligations (interest pa ments plus repa ment of capital) ithout accumulating o erdue
debt pa ments. Particularl if the econom is in recession, hen ta re enues fall (as
unemplo ment rises) and go ernment spending increases (on unemplo ment benefits) deficits are
likel to increase. O er an e tended period these ma create a problem of unsustainable debt
possibl leading to default (inabilit to pa back debts).
In a recession, tax cuts may not be very effective in increasing aggregate demand Ta cuts are
less effecti e in a recession than increases in go ernment spending because part of the increase in
after-ta income is sa ed. If the proportion of income sa ed rises due to pessimism about the future,
the impacts of ta cuts on aggregate demand are e en eaker. Increases in go ernment spending are
more po erful because the ork in their entiret to increase aggregate demand.
Inability to ‘fine tune’ the economy Whereas fiscal polic can lead the econom in a general
direction of larger or smaller aggregate demand, it cannot fine tune the econom ; it cannot be used
to reach a precise target ith respect to the le el of output, emplo ment and the price le el.
May be inflationary If it lasts too long it ma be inflationar , this ma occur if aggregate demand
increases be ond hat is necessar to eliminate a deflationar /recessionar gap. This eakness is
similar to monetar polic .
Inability to deal with cost push inflation, or stagflation Fiscal polic , like monetar polic is a
demand-side polic , and is therefore unable to deal effecti el ith suppl -side causes of
instabilit .
Crowding out (HL only) If the go ernment pursues an e pansionar fiscal polic in ol ing
spending increases ithout an increase in re enues, it is forced to borro . Go ernment
borro ing in ol es an increase in the demand for mone , hich leads to an increase in the rate
of interest. A higher interest rate in turn can lead to lo er in estment spending b pri ate firms,
or a cro ding out of pri ate in estment. This means that the go ernment s e pansionar fiscal
polic is eakened, since a greater G (go ernment spending) is counteracted b a lo er I
(in estment spending). Cro ding out is illustrated in Figure 13.4. In part (a) there is a right ard
shift from AD1 to AD2 due to the increase in G, and a left ard shift from AD2 to AD3 due to the
fall in I. This sho s partial cro ding out, here the fall in in estment spending is smaller than
the increase in go ernment spending. Part (b) sho s complete cro ding out, here the fall in I
is equal to the increase in G. Cro ding out is contro ersial. Some economists, mainl in the
Ke nesian tradition, belie e that in a recession, the stimulus pro ided to the econom b the
go ernment s increased spending ma raise output and emplo ment, impro e business
e pectations about their future sales, and increase in estment spending in spite of the increase in
the interest rate. In this case, the go ernment s deficit spending is less likel to cro d out pri ate
in estment. Other economists, mainl in the monetarist/ne classical tradition, belie e that
in estment spending ill be cro ded out in the e ent of deficit financing e en in a recession.
Figure 13.4: Cro ding out of pri ate in estment
Strengths of fiscal policy

Pulling an economy out of a deep recession Until the Great Depression of the 1930s, classical
economists belie ed that short-term economic fluctuations ere self-correcting: in a recession,
age and price fle ibilit ould make the econom return to full emplo ment. (This is like the
thinking of monetarist/ne classical economists; see Chapter 9.) Yet the e perience of the Great
Depression, ith lo le els of output and incomes and high unemplo ment o er a long period of
time, sho ed that market forces alone ere unable to pull the econom out of the deep recession. In
the no classic ork, The General Theor of Emplo ment, Interest and Mone (1936), John
Ma nard Ke nes (the originator of Ke nesian economics ) argued that ages and prices ere
infle ible in the do n ard direction e en in the face of steep recession, and that lo aggregate
demand could keep the econom stuck in a recessionar gap indefinitel . This can occur hen the
AD cur e intersects the Ke nesian aggregate suppl (AS) cur e at a point on its hori ontal section,
here real GDP is less than full emplo ment GDP. The strength of fiscal polic is to pull an
econom out of a deep recession. In the global recession that began in autumn 2008, fears of a
major global recession made go ernments around the orld turn to e pansionar fiscal polic to
stimulate lo aggregate demand.
Ability to target sectors of the economy Fiscal polic can target spending in specific sectors
according to go ernment priorities. For e ample, it ma focus on changing the amount of spending
on education and particular le els ithin education; health care, focusing on particular social
groups; infrastructure and particular t pes of infrastructure (airports, roads, hospitals) or the
locations of infrastructure, focusing if necessar on economicall depressed regions; a ariet of
public goods (police force, public parks, etc.); and so on.
Direct impact of government spending on aggregate demand Changes in go ernment spending
impact directl on aggregate demand, and this can be helpful to polic -makers ho ant to be
reasonabl certain that changes in spending are likel to change aggregate demand in the desired
direction. Changes in ta es are less direct, as the ork b changing consumer disposable income
and firm after-ta profits and this poses some uncertainties about their effects on aggregate demand.
Dealing with rapid and escalating inflation. Inflationar pressures arising hen there is an
inflationar gap can sometimes get out of hand, resulting in rapid increases in the price le el.
Contractionar fiscal polic ma then be used effecti el to help bring the problem under control.
Ability to affect potential output Fiscal polic can affect potential output and long-term economic
gro th indirectl (b creating a stable macroeconomic en ironment) and directl through
in estments in human capital and ph sical capital (infrastructure) and through offering incenti es to
firms to in est
Automatic stabilisers (HL only) Automatic stabilisers are factors that automaticall , ithout
an action b go ernment authorities, ork to ard stabilising the econom b reducing short-
term fluctuations of the business c cle. There are t o important stabilisers: progressi e income
ta es and unemplo ment benefits.
Progre i e income a e . Income ta es are progressi e hen the fraction of income that is
ta ed increases as income increases (see Chapter 12). In the ups ing of the business c cle,
as real GDP and incomes rise, income ta es rise proportionatel more than the rise in
income, causing after-ta (disposable) income to be lo er than it ould other ise be. This
means aggregate demand increases less, and this counteracts the economic e pansion,
making it smaller than it ould other ise be.
In a recession, the opposite occurs. With real GDP and incomes falling, income ta es fall
proportionatel more in a progressi e ta s stem causing after-ta (disposable) income to
be higher than it ould other ise be. Therefore aggregate demand falls less, making the
recession less se ere.
The more progressi e an income ta s stem, the greater the stabilising effect on economic
acti it .
Unemplo men benefi . In a recession, as real GDP falls and unemplo ment increases,
unemplo ment benefits rise. If there ere no unemplo ment benefits, unemplo ed
orkers spending ould fall significantl , putting a strong do n ard pressure on
consumption spending and aggregate demand. The presence of unemplo ment benefits
means that as orkers become unemplo ed, their consumption ill be maintained to some
e tent as their benefits partiall replace their lost income, thus lessening the do n ard
pressure on aggregate demand. In an e pansion, unemplo ment benefits are reduced as
unemplo ment falls; therefore, consumption increases less than it ould in the absence of
unemplo ment benefits.
You should note that a progressi e ta s stem and unemplo ment benefits cannot b
themsel es stabilise the econom and eliminate inflationar and recessionar gaps on their
o n. The can onl help make economic fluctuations milder.
A note on monetary versus fiscal policy for demand management

Most economists belie e that due to the ad antages of monetar polic discussed earlier, this should pla
a more important role in demand management. The fact that it is incremental, fle ible, and easil
re ersible, relati el free of political constraints, and ith shorter time lags, makes it more appropriate
as a tool to influence aggregate demand. B contrast, fiscal polic has an important role to pla in deep
recessions here e en highl e pansionar monetar polic ma become ineffecti e (see for e ample
Real orld focus 13.1).

1 E amine the strengths and eaknesses of fiscal polic and discuss hich of these ou think are
more important.
2 (HL onl )
a Outline the meaning of automatic stabilisers.
b E plain ho
i unemplo ment benefits, and
ii a progressi e ta s stem ork to stabilise increases and decreases of aggregate
demand.
3 a Use a diagram to e plain cro ding out.
b Outline the disagreement o er its importance hen the econom is in recession.
4 Outline h decisions on hether or not to use fiscal polic measures depend on more than just
economic considerations.
5 E plain h monetar polic is used more often than fiscal polic as a demand management
tool.

US fiscal policy and recession: two views
In Februar 2009, the Obama administration in the United States appro ed a fiscal stimulus package
of $787 billion to support the US econom that as in recession. This had the effect of increasing the
budget deficit. In spite of the fiscal measure, unemplo ment gre to o er 10%. In the meantime, due
to e pansionar monetar polic , interest rates had fallen to nearl ero, suggesting that lo interest
rates ere not orking to increase aggregate demand.
Figure 13.5: Lake ood, Colorado, USA. Workers install solar panels funded b a federal (national)
fiscal stimulus programme in 2010 to support the US econom
A Keynesian view on appropriate fiscal policy

The recession as deeper than originall estimated; therefore, a ne fiscal stimulus package is
required to supplement the first one. Recession in ol es lo aggregate demand, and the go ernment
must step in b increasing its o n spending. Through the multiplier (see Section 13.4), this orks to
increase spending in the econom b a multiplied amount, thus directl increasing AD and real GDP.
Without the initial e pansionar fiscal polic , the recession ould ha e been deeper and longer, and
unemplo ment much higher. The go ernment s budget deficit increased, but this is una oidable in
recession, because of automatic stabilisers that ork to lo er ta es and increase go ernment spending
on unemplo ment benefits.
A monetarist/new classical view on appropriate fiscal policy
The go ernment should not ha e implemented the first fiscal stimulus package at all. It could ha e
focused on reducing the budget deficit; this ould impro e business confidence, hich ould
increase in estment, and therefore economic gro th. Other ise, it could ha e implemented ta cuts,
hich are preferable to increased go ernment spending, because deficit spending leads to higher
interest rates that cro d out pri ate in estment spending. This reduces the e pansionar effect of
go ernment spending. The increase of unemplo ment to o er 10% suggests that the stimulus package
did not ork as e pected.
A Keynesian response
The idea of reducing the budget deficit in a recession does not make sense. A household that spends
more than its income can cut back on its spending, but if a go ernment does that, the effect ill be to
reduce output and incomes, and increase unemplo ment, possibl making it e en more difficult for
the go ernment to pa back its debts in the future. It is er unlikel that higher interest rates ill
cro d out in estment in a recession hen interest rates are alread er lo . Also, ta cuts ha e a
smaller effect on increasing AD, because part of the ta cut is lost as increased sa ing; and if
consumer confidence is er lo , consumers ma not spend their higher after-ta incomes and sa e
most of it.
A monetarist/new classical response
Increased go ernment spending adds to a large go ernment that likel increases go ernment
inter ention, hich is inefficient, and acts as a drag on the econom . The focus should be on
stimulating the econom ithout increasing the si e of the go ernment. Ta cuts offer this
e pansionar stimulus and at the same time create incenti es for people to ork more, thus possibl
leading to lo er unemplo ment ithout adding to go ernment spending.
1 E plain the meaning of
a automatic stabilisers,
b deficit spending, and
c cro ding out.
2 What assumptions about the macroeconom are made b
a Ke nesian economists, and
b monetarist/ne classical economists, hich lead them to differing conclusions about
appropriate fiscal polic ?
13.4 K (HL )
LEARNING OBJEC I E

e plain he Ke ne ian m l iplier ing he marginal propen i o con me, marginal
propen i o a e, marginal propen i o a , marginal propen i o impor (AO2)
calc la e he m l iplier ing (AO4)
1 1 MPC or 1 MPS+MPT+MPM
U ing he Ke ne ian m l iplier calc la e he effec on GDP of a change in an injec ion
(in e men , go ernmen pending, e por ) (AO4)
I
S ppo e here i an increa e in one of he componen of aggrega e demand, d e o a change in C, or
I, or G, or X M e pendi re .3 Thi ill prod ce an increa e in aggrega e demand, and an increa e
in real GDP. Ye he final increa e in real GDP ill mo likel be grea er han he ini ial increa e in
e pendi re . The rea on for hi can be fo nd in he K , defined a he change in
real GDP di ided b he ini ial change in e pendi re:
m l iplier = change in real GDP ini ial change in e pendi re
o ha
ini ial change in e pendi re m l iplier = change in real GDP
A a r le, he m l iplier >1; herefore, he change in real GDP i likel o be grea er han he ini ial
change in e pendi re.
The m l iplier i a rib ed o John Ma nard Ke ne , and i of en referred o a he Ke ne ian
m l iplier . I i impor an beca e i ho ha hene er here i a change in a componen of AD,
here i likel o be a m l iplied effec on real GDP. I i ef l for polic -maker ho of en r o
infl ence he le el of aggrega e demand in order o affec he le el of real GDP and nemplo men .
Wh doe a change in e pendi re prod ce a larger change in o al aggrega e demand and real GDP?
The e plana ion i ha he ini ial change in e pendi re prod ce a chain reac ion of f r her
e pendi re , i h he effec of increa ing AD and real GDP o a al e grea er han he ini ial
e pendi re.
A me an ini ial increa e in in e men pending of $8 million (d e o b ine op imi m or an
o her fac or affec ing in e men pending). Thi pending of $8 million re l in an increa e in real
GDP of $8 million. Ho e er, he or doe no end here, beca e he $8 million increa e in real
GDP prod ce a f r her chain of pending, called ind ced pending (i i ind ced, or ca ed b he
change in real GDP). The $8 million increa e in in e men pending i ed b b ine e o pa for
ma erial , eq ipmen , labo r, e c., and all hi pending ran la e in o income for o ner of he
fac or of prod c ion, ho e i o increa e heir con mp ion pending. A con mp ion pending
increa e , i re l in a f r her increa e in real GDP and income , hich prod ce more con mp ion
pending. Thi proce con in e , increa ing real GDP be ond he amo n of he ini ial in e men of
$8 million.
To calc la e he al e of he m l iplier, e m look a con mer pending more caref ll . We kno
from he circ lar flo model ha a por ion of income flo o of he e pendi re flo a leakage :
con mer a e par of heir income, he pa a e o he go ernmen , and he b impor ed good
and er ice . The remaining par of income i pen on b ing dome ic good and er ice , called
con mp ion e pendi re . Thi in rod ce o a ne concep , he
, abbre ia ed a MPC, defined a he frac ion of addi ional income ha ho ehold pend on
con mp ion of dome icall prod ced good and er ice . For e ample, if he MPC i 3 4, hi
mean ha gi en an increa e in na ional income of $10 million, 3 4 of hi , or $7.5 million i
con mp ion e pendi re, and he remaining 1 4 of income, or $2.5 million, leak o in he form of
a ing, a e and pending on impor .
Corre ponding o he marginal propen i o con me (MPC) i he
(MPS, or frac ion of addi ional income a ed), he (MPT, or frac ion of
addi ional income a ed), and he (MPM, or frac ion of addi ional
income pen on impor ed good and er ice ). No e ha he MPC + MPS + MPT + MPM = 1. To ee
h , imagine ha na ional income increa e b $1. I follo ha he frac ion of he $1 ha ill be
con med, a ed, pen on a e and pen on impor ill add p o $1.
A ming, a in Table 13.3 ha he MPC = 3 4, e can de ermine he al e of he m l iplier. The
ini ial increa e in in e men pending of $8 million re l in an eq i alen increa e in income (or
real GDP) of $8 million. Since he MPC = 3 4, hi re l in $6 million of con mp ion e pendi re (
3 4 $8 million = $6 million). In he econd ro nd of income change , he ind ced con mp ion
e pendi re of $6 million lead o an eq i alen increa e in income of $6 million, hich hen
m l iplied b he MPC prod ce ne ind ced con mp ion pending of $4.5 million. Thi proce
con in e , i h ind ced con mp ion pending and change in income ge ing maller and maller
n il finall he drop o ero. Adding p all change in income e arri e a a o al increa e of $32
million. Thi i he amo n b hich real GDP ha increa ed. Thi increa e i eq al o he ini ial
change in in e men pending of $8 million pl he o al increa e in ind ced con mp ion pending
of $24 million.
I C I
$8 : ( GDP) ($ ) ($ )
1 8 3 4 8=6
2 6 3 4 6=4.5
3 4.5 3 4 4.5=3.38
4 3.38 3 4 3.38=2.5
(proce con in e an infini e n mber of ime )
32 3 4 32=24
13.3: De ermining he al e of he m l iplier i h he MPC = 3 4
I h follo ha in hi e ample, he al e of he m l iplier i :

m l iplier= change in real GDP ini ial change in e pendi re = $32 billion $8 billion =4
Al erna i el , e can a ha :
4 $8 million = $32 million
I i clear from he able ha he al e of he m l iplier of 4 depend on he ind ced change in
con mp ion, hich depend on he al e of he MPC, a med here o be 3 4. The rela ion hip
be een he m l iplier and he MPC i :
m l iplier= 1 1 MPC
If he MPC= 3 4 :
m l iplier = 1 1 3 4 =4
Therefore, if e kno he al e of he MPC, e can calc la e he al e of he m l iplier.
No e kno from he abo e ha
MPC + MPS + MPT + MPM = 1
Rearranging hi e pre ion, e can ri e:
1 MPC = MPS + MPT + MPM
We can herefore re ri e he m l iplier a :
m l iplier = 1 1 MPC = 1 MPS+MPT+MPN
The al e of he m l iplier i gi en b 1 1 MPC, hich i eq i alen o:

1 MPS+MPT+MPM
Therefore, if e kno he al e of he MPC, e can calc la e he al e of he m l iplier.
Al erna i el , if e kno he al e of he MPS, MPT and MPM, e can calc la e he al e of he
m l iplier.
Ba ed on he e e pre ion , e can arri e a he follo ing concl ion : he la ge he MPC, he

malle he al e of he denomina o of he fi f ac ion, and o he g ea e i he m l iplie .
Therefore, he grea er he propor ion of income pen on con mp ion, he grea er he m l iplier.
Al erna i el , e can ee from he econd frac ion ha he malle he leakage f om he pending
eam, he g ea e he m l iplie . Therefore he maller he a ing, or he le el of a e , or he
ol me of impor , he larger ill be he i e of he m l iplier.
Wherea e calc la ed he m l iplier ba ed on an increa e in in e men pending, he ame re l
o ld be ob ained gi en an ini ial increa e in an injec ion in o he income flo , he her i i I, G, or
X M (a ell a change in C ha ha e no been ca ed b change in income).
E er hing ha ha been aid abo he m l iplier in rela ion o increa e in e pendi re applie
eq all o decrea e in e pendi re . Therefore, in he e ample abo e, if e had looked a a decrea e
in in e men e pendi re of $8 million, and an MPC of 3 4, here o ld re l a decrea e in GDP of
$32 million (= $8 million 4).
For e ample, Greece e perienced an e remel deep rece ion in he period 2009 2018. Thi
rece ion a m ch more erio han had been e pec ed beca e he In erna ional Mone ar F nd
(IMF, ee Chap er 20) ndere ima ed he i e of Greece m l iplier. Therefore in ie of he ac al
i e of he m l iplier, pending c led o far grea er decrea e in real GDP han ere an icipa ed
( ee Real World Foc 17.1).
C GDP
S ppo e a co n r i h a real GDP of 135 billion and an MPC of 4 5 e perience an increa e in
e por of 2 billion. Wha i he change in real GDP, and he final al e of real GDP?
To an er hi q e ion, e m fir find he m l iplier
1 1 MPC = 1 1 4 5 = 1 1 5 =5
Therefore, here ill be an increa e in real GDP of 2 billion m l iplier = 2 billion 5 = 10
billion.
Therefore, he final al e of real GDP ill be 135 billion + 10 billion = 145 billion.
If here had been a dec ea e in e por of 2 billion, here o ld re l a 10 billion dec ea e in real
GDP, h making he final al e of real GDP = 135 billion 10 billion = 125 billion.
, GDP
H
U ing he e ample of an $8 million increa e in in e men pending, e can ee i effec on
aggrega e demand in Fig re 13.6. The o al aggrega e demand hif i di ided in o o par . The fir
par i he $8 million increa e in in e men pending, called a onomo pending, meaning i ha
no been ca ed b a change in income. The econd par i he effec on aggrega e demand of he
m l iplier, hich i $24 million of ind ced pending, meaning pending ca ed b change in
income. The o al effec on aggrega e demand i he m of a onomo pl ind ced pending, or
$32 million. Thi i eq i alen o aking he ini ial change in a onomo in e men pending and
m l ipl ing i b he m l iplier: $8 million 4 = $32 million.
F 13.6: Aggrega e demand, real GDP and he m l iplier in he Ke ne ian model
All he fac or li ed in Table 9.1 (Chap er 9) nder Shif in he aggrega e demand c r e can ca e
a change in pending re l ing in a m l iplier effec . All he e fac or in ol e change in a onomo
pending, beca e all are nrela ed o income. (Remember ha he fac or li ed in Table 9.1 are non-
income fac or .) Thi mean ha he m l iplie effec can onl be ini ia ed b a change in pending
ha i no ca ed b a change in income.
We are no in a po i ion o nder and h hi i o. Con ider he AD-AS model in Fig re 9.11.
Each diagram ho an econom ha i in eq ilib i m. Thi eq ilibri m de ermine a par ic lar le el
of na ional income or real GDP. Since he econom i in eq ilibri m, i i impo ible fo na ional
income (o eal GDP) o change nle ome hing ac pon i f om o ide he em. Thi
ome hing m be nrela ed o income, and can be an of he fac or li ed in Table 9.1, hich are
a onomo .
In o r e ample, he o ide change a a onomo in e men pending of $8 million. Thi o ide
fac or ca ed a change in income, and onl hen a i po ible for he change in income o ca e
change in con mp ion and aggrega e demand; he e are he ind ced change ho n in Fig re 13.6
a he hif from AD2 o AD3.
In order for he m l iplier o ha e he grea e po ible effec on real GDP, i i nece ar ha he

price le el i con an . We can ee h in Fig re 13.7, hich ho he Ke ne ian AD-AS model
i h hree eq al AD c r e hif : from AD1 o AD2, hen o AD3, and finall o AD4. The hori on al
di ance be een each AD c r e i iden ical. Ho e er, each hif occ r in a differen ec ion of he
AS c r e. The hif from AD1 o AD2 i in he hori on al par here he price le el i con an , and
he inc ea e in eal GDP f om Y1 o Y2 i e ac l eq al o he inc ea e in agg ega e demand. Here e
ha e he f ll m l iplier effec . The hif from AD2 o AD3 occ r in he p ard- loping par of he AS
c r e, here he increa e in real GDP, from Y2 o Y3, i maller, beca e of he increa e in he price
le el. The hif from AD3 o AD4 occ r in he er ical par of he AS c r e, and re l in no change
a all in real GDP. The increa ing price le el ha ab orbed he en ire m l iplier effec , hich here i
ero.
F 13.7: Ho he effec of he m l iplier change depending on he price le el
In he mone ari /ne cla ical model, increa e in aggrega e demand al a (bo h in he hor r n
and in he long r n) lead o increa e in he price le el, herefore in hi model i i ne er po ible for
real GDP o increa e b he f ll amo n of he increa e in AD.
The m l iplier i ba ed on Ke ne ian hinking, hich empha i e he poin ha in a rece ionar gap
(in he hori on al ec ion of he AS c r e), nemplo ed re o rce and pare capaci allo aggrega e
demand o increa e i ho p ing an p ard pre re on he price le el. Hence an a onomo
increa e in pending lead o a b an iall larger increa e in real GDP.
Therefore, hen e e he m l iplier o calc la e he effec on real GDP of a change in a onomo
pending, e a e p e ppo ing a con an p ice le el.
E O R NDER ANDING 13.8 (HL ONL )

1 Define he m l iplier.
O line h change in real GDP are likel o be larger han he ini ial change in
pending b a componen of aggrega e demand.
U ing a h po he ical n merical e ample e plain h he m l iplier i impor an .
2 Define he marginal propen i o con me (MPC).
O line h he MPC i impor an in de ermining he i e of he m l iplier.
O line he role of leakage in de ermining he i e of he m l iplier.
3 Calc la e he m l iplier hen he MPC i
45
34
23
12
4 Ba ed on o r an er o q e ion 3, o line ha e can concl de abo he rela ion hip
be een he i e of he MPC and he i e of he m l iplier.
5 Calc la e he al e of he m l iplier hen
he MPS = MPT = MPM = 0.1, and
he MPS = 0.13, MPT = 0.12, and he MPM = 0.15.
6 Ba ed on o r an er o q e ion 5, o line ha e can concl de abo he rela ion hip
be een he i e of MPS + MPT + MPM and he i e of he m l iplier. E plain he rea oning
behind hi rela ion hip.
7 In a co n r i h a real GDP of $50 billion and an MPC = 2 3 , find he change in real GDP
and he final al e of real GDP (a ming a con an price le el) for each of he follo ing:
an increa e in ne e por (e por min impor ) of $2 billion,
a fall in in e men pending of $3 billion,
an increa e in go ernmen pending of $7 billion, and
a decrea e in con mp ion pending of $1.5 billion.
8 An er all he par of q e ion 7 a ming ha he MPS + MPT + MPM = 1 4
9 O U ing a diagram ho ing he Ke ne ian AD-AS model, ho he effec of he
m l iplier hen
he price le el i con an , and
he price le el i increa ing.
3 The change m be a onomo , meaning i ha no been crea ed b a change in income.

13.5 F e c e e a d
Ke e a ec c e (S e e a
a e a ec e ded HL )
If o are interested in e ploring these iss es f rther, o ill find a disc ssion in the 'Digital
co rsebook: E tra material' section. The first part e amines the relationship bet een the m ltiplier
and fiscal polic more closel . The second part presents the Ke nesian cross model hich allo s a
better nderstanding of aggregate demand and its relationship to aggregate o tp t (real GDP), and is
also sef l backgro nd to a deeper nderstanding of the m ltiplier.
13.6 Supply-side policies
LEARNING OBJECTIVES

define all he erms appearing in orange bold in he e (AO1)
e plain he goals of s ppl -side policies (AO2)
long- erm gro h hro gh increases of prod c i e capaci of he econom
impro e compe i ion and efficienc
labo r marke fle ibili o red ce labo r cos s and nemplo men
red ce infla ion o impro e in erna ional compe i i eness
impro e firm incen i es o in es in inno a ion b decreasing cos s
e plain marke -based policies incl ding (AO2)
policies o promo e compe i ion dereg la ion, pri a isa ion, rade liberalisa ion, an i-
monopol reg la ion
labo r marke policies red ce po er of labo r nions, lo er nemplo men benefi s,
elimina e minim m ages
incen i e rela ed policies c s in personal income a es, b siness a es, capi al gains
a es)
dra a labo r marke diagram o sho he minim m age (AO4)
e plain in er en ionis policies incl ding (AO2)
ed ca ion, raining
access o more and be er heal h care
research and de elopmen
pro ision of infras r c re
ind s rial policies
dra an AD-AS diagram i h LRAS o sho effec s of s ppl -side policies (AO4)
e plain he demand-side effec s of s ppl -side policies (AO2)
e plain he s ppl -side effec s of demand-side policies (AO2)
disc ss cons rains on s ppl -side policies (AO3)
marke -based effec s on eq i , ime lags, es ed in eres s, impac on he en ironmen
in er en ionis cos s, ime lags
disc ss s reng hs of s ppl -side policies (AO3)
marke -based impro ed reso rce alloca ion, no b rden on he go ernmen b dge
in er en ionis direc s ppor of sec ors arge ed o s ppor gro h
e al a e s ppl -side policies i h respec o promo ing lo nemplo men , lo and s able ra e
of infla ion and gro h (AO3); see Sec ion 13.7
Goals of supply-side policies
The goals of s ppl -side policies incl de he follo ing:
Promote long-term growth by increasing the productive capacity of the economy. The main
objec i e is o increase po en ial o p , sho n b a s eeper long- erm gro h rend in he b siness
c cle diagram, or righ ard shif s of he LRAS c r e (or Ke nesian AS c r e).
Improve competition and efficiency. The objec i e is o make he econom more responsi e o he
marke forces of demand and s ppl so as o increase efficienc in prod c ion.
Reduce costs of labour and reduce unemployment through greater labour market flexibility.
Grea er labo r marke fle ibili means making he labo r marke more responsi e o he marke
forces of demand and s ppl so as o red ce nemplo men as ell as labo r cos s.
Increase incentives of firms to invest in innovation by lowering costs of production. Higher
af er- a profi s hro gh lo er cos s of prod c ion as ell as lo er a es pro ide firms i h
incen i es o engage in research and de elopmen ha increases he prod c i e capaci of he
econom res l ing in grea er increases in prod c i e capaci and gro h in po en ial o p .
Reduce inflation to improve international competitiveness. Increases in po en ial o p red ce
infla ionar press res in he econom , h s making e por s more compe i i e in global marke s.
There are o pes of s ppl -side policies: marke -based and in er en ionis . Marke -based policies
emphasise he impor ance of ell-f nc ioning compe i i e marke s, and are s all fa o red b
mone aris /ne classical economis s. In er en ionis policies rel on go ernmen in er en ion o achie e
gro h in po en ial o p , and are s all fa o red b economis s infl enced b Ke nesian hinking.
Market-based supply-side policies

In he earl 1980s, some highl infl en ial mone aris /ne classical economis s in he Uni ed Kingdom
and he Uni ed S a es began o emphasise he ie ha gro h in real GDP depends on he s ppl side
of he econom . This ie as adop ed b he go ernmen headed b Margare Tha cher in he Uni ed
Kingdom, and b he go ernmen nder Ronald Reagan in he Uni ed S a es. Since hen, man
go ernmen s hro gho he orld ha e p rs ed policies infl enced b marke -based s ppl -side
hinking. In his ie , he econom s real GDP ends a oma icall o ards long-r n f ll emplo men
eq ilibri m and po en ial GDP (see Chap er 9). The foc s of go ernmen policies sho ld herefore be o
crea e condi ions ha allo marke forces o ork ell.
This perspec i e s gges s ha an econom p rs ing s ppl -side policies ill be able o achie e rapid
gro h, price s abili and f ll emplo men all a he same ime. As he econom ends o ards f ll
emplo men eq ilibri m, i a oma icall elimina es recessionar and infla ionar gaps. If increases in
aggrega e s ppl ma ch increases in aggrega e demand so ha he LRAS and SRAS c r es4 shif b he
same amo n as he AD c r e, here need no be an price le el increases. See Fig re 11.3(a) in Chap er
11.
Market-based supply-side policies can be gro ped nder hree headings:
1 Enco raging compe i ion
2 Labo r marke reforms
3 Incen i e-rela ed policies.
Encouraging competition
Grea er compe i ion among firms forces hem o red ce cos s, con rib ing o grea er efficienc in
prod c ion and impro ing reso rce alloca ion, i h he possible added benefi of impro ing he q ali
of goods and ser ices. These benefi s ill allo po en ial o p o increase and he LRAS c r e o shif
o he righ .
Privatisation. Privatisation, in ol ing a ransfer of o nership of a firm from he p blic o he
pri a e sec or, can increase efficienc d e o impro ed managemen and opera ion of he pri a ised
firm. This is based on he arg men ha go ernmen en erprises are of en inefficien d e o
b rea cra ic proced res, high adminis ra i e cos s and nprod c i e orkers, beca se he do no
face incen i es o lo er cos s and ma imise profi s.
Deregulation. Deregulation in ol es elimina ion or red c ion of go ernmen reg la ion of pri a e
sec or ac i i ies, based on he arg men ha go ernmen reg la ion s ifles compe i ion and increases
inefficienc . There are o main pes of reg la ion (and dereg la ion): economic and social.
Economic reg la ion in ol es go ernmen con rol of prices, o p , and o her ac i i ies of firms,
offering hem pro ec ion again com e i ion. In he las o o hree decades, man co n ries ha e
mo ed o ard remo al of go ernmen reg la ions, and hence economic dereg la ion. A main form
of dereg la ion has been o allo ne , pri a e firms o en er in o monopolis ic or oligopolis ic
ind s ries, h s forcing e is ing firms o face compe i ion. The objec i e has been o increase
efficienc , lo er cos s and impro e q ali . Ind s ries affec ed incl de ranspor , airlines, ele ision
broadcas ing, elecomm nica ions, na ral gas, elec rici , financial ser ices and o hers. Social
reg la ion in ol es pro ec ing cons mers agains ndesirable effec s of pri a e sec or ac i i ies
(man of hese in ol e nega i e e ernali ies) in n mero s areas, incl ding food, pharmace ical
and o her prod c safe , orker pro ec ion agains inj ries, and poll ion con rol. In con ras o
economic reg la ion, social reg la ion is being s reng hened in man co n ries in he in eres s of
p blic safe . Some economis s, ho e er, arg e ha social reg la ion is e cessi e, gi ing rise o
cos l and inefficien b rea cra ic proced res, paper ork and nnecessar go ernmen
in erference, and sho ld herefore be red ced.
Contracting out to the private sector. This is a polic op ion hereb go ernmen s make a
con rac al agreemen i h pri a e firms o pro ide goods and ser ices for he go ernmen (see
Chap er 6). E amples incl de p blic goods, informa ion echnolog , h man reso rces managemen
and acco n ing ser ices. These res l in increased compe i ion as pri a e firms compe e i h each
o her o ge con rac s i h he go ernmen .
Anti-monopoly regulation. Increased compe i ion can res l from res ric ing marke po er of
firms b enforcing an i-monopol legisla ion, b breaking p large firms ha ha e been fo nd o
engage in monopolis ic prac ices in o smaller ni s ha ill beha e more compe i i el , and b
pre en ing mergers be een firms ha migh res l in oo m ch marke po er. Grea er scope for
he forces of s ppl and demand ma res l in increased efficienc , lo er cos s and impro ed
q ali .
Trade liberalisation. In erna ional rade be een co n ries has become freer (libe ali ed) in recen
decades d e o red c ions in rade barriers. Free or freer rade increases compe i ion be een firms
bo h domes icall and globall , hich can res l in grea er efficienc in prod c ion and an
impro ed alloca ion of reso rces ( e ill s d his in Chap er 14).
Labour market reforms

Labo r marke reforms are some imes referred o as increasing labo ma ke fle ibili , or red cing
labo ma ke igidi ie disc ssed in Chap er 10 as one ca se of s r c ral nemplo men . Labo r
marke reforms are in ended o ge rid of rigidi ies b making labo r marke s more compe i i e, making
ages respond o he forces of s ppl and demand, lo ering labo r cos s and increasing emplo men b
lo ering he na ral ra e of nemplo men . Lo er cos s of prod c ion can lead o increased profi s,
hich in rn ma res l in grea er in es men b firms, increased R&D, increased capi al goods
prod c ion, and herefore increases in po en ial o p (economic gro h).
Labo r marke reforms incl de:
Abolishing minimum wage legislation. Elimina ion or red c ion of he legal minim m age i is
arg ed, red ces nemplo men b allo ing he eq ilibri m age o fall. The benefi s o ld
incl de lo er nemplo men ; grea er firm profi s, as age cos s o ld be lo ered; more
in es men and economic gro h. This can be seen in Fig re 10.1(b) (Chap er 10).
Weakening the power of labour (trade) unions. A labour union, or rade nion, is an associa ion
of orkers in a par ic lar profession, hose objec i e is o impro e orking condi ions and defend
righ s of orkers, represen ing i s members in nego ia ions i h emplo ers. Unionised labo r
freq en l s cceeds in sec ring high age increases; if labo r nions are eakened, ages ill be
more responsi e o he forces of s ppl and demand, and ill herefore be more likel o fall in if
here is nemplo men . This o ld also lead o he same benefi s as abolishing minim m age
legisla ion.
Reducing unemployment benefits. I is arg ed ha nemplo men benefi s ha e he nin ended
effec of red cing he incen i e o search for a ne job, ca sing some nemplo ed orkers o
remain nemplo ed for longer periods han necessar . Therefore, red cing nemplo men benefi s
is e pec ed o lo er nemplo men , as i o ld enco rage he nemplo ed o look for ork. This
co ld ork o red ce he na ral ra e of nemplo men .
Reducing job security. Man co n ries ha e la s pro ec ing orkers agains being fired, making i
cos l for firms o fire orkers beca se of high le els of compensa ion ha m s be paid o he
orker being laid off. I is arg ed ha red cing orkers job sec ri b making i easier and less
cos l for firms o le go of orkers has he effec of increasing emplo men , beca se firms are
more likel o hire ne orkers if he kno he can fire hem easil and i ho cos if he are
no longer needed. In addi ion, red cing job sec ri o ld decrease firms labo r cos s beca se of
he lo er cos s of firing, and o ld herefore increase profi s, in es men and economic gro h.
Incentive-related policies
Incentive-related policies in ol e c ing ario s pes of a es, hich are e pec ed o change he
incen i es faced b a pa ers, he her firms or cons mers.
Lowering personal income taxes. As e kno , c s in personal income a es can increase
aggrega e demand. S ppl -side economis s arg e ha changes in personal income a es ha e an
e en grea er impac on aggrega e s ppl beca se he lead o highe af e - a income , c ea ing an
incen i e fo eo le o o ide mo e o k: his can happen hro gh an increase in he n mber of
ho rs orked per eek; an increase in he n mber of people in eres ed in finding ork ( ho ere
formerl no in eres ed in orking); an increase in he n mber of ears orked, as people ma
decide o re ire la er; a decrease in nemplo men as nemplo ed orkers choose o shor en he
d ra ion of heir nemplo men . All hese fac ors ma ork o shif he LRAS c r e o he righ ,
increasing po en ial o p .
Lowering taxes on capital gains and interest income. Ta es on capital gains are a es on profi s
from financial in es men s (s ch as s ocks and bonds) or from b ing and selling real es a e. If he
a es on capi al gains and on income from in eres on sa ings deposi s are red ced, people ma be
more mo i a ed o sa e, h s increasing he amo n of sa ings a ailable for in es men . More
in es men means a grea er prod c ion of capi al goods and an increase in po en ial o p .
Lowering business taxes. Lo er a es on b siness profi s (corpora ion a es) can ork o increase
aggrega e demand b increasing in es men spending. S ppl -side economis s arg e ha c ing
a es on firms profi s is a s ppl -side meas re beca se increases in he le el of af er- a profi s
mean ha firms ha e grea er financial reso rces for in es men and for p rs ing echnological
inno a ions hro gh more R&D, res l ing in grea er po en ial o p .
Interventionist supply-side policies

Interventionist supply-side policies pres ppose ha he free marke econom alone canno achie e he
desired res l s in erms of increasing po en ial o p , and herefore go ernmen in er en ion is req ired.
Investment in human capital: education and health services

In es men in h man capi al can ake he follo ing impor an forms:
Training and education. More and be er raining and ed ca ion lead o an impro emen in he
q ali of labo r reso rces, increasing he prod c i i of labo r, hich is one of he ke ca ses of
economic gro h (see Chap er 11). Ed ca ion also has n mero s posi i e e ernali ies, j s if ing
go ernmen in er en ion. P blic raining and ed ca ion programmes can assis orkers o become
more emplo able, h s red cing he na ral ra e of nemplo men . Specific meas res incl de
se ing p re raining programmes for s r c rall nemplo ed orkers o ob ain skills in grea er
demand; assis ing o ng people o p rs e raining and ed ca ion hro gh gran s or lo in eres
loans; direc go ernmen hiring and pro ision of on- he-job raining; pro iding gran s o firms ha
offer on- he-job raining; offering s bsidies o firms ha hire s r c rall nemplo ed orkers;
assis ing orkers o reloca e o geographical areas here here is a grea er demand for labo r
hro gh gran s and s bsidies (s ch as pro ision of lo -cos ho sing); pro iding informa ion on job
a ailabili in ario s geographical areas; es ablishing go ernmen projec s in he depressed areas
ha res l in ne emplo men crea ion.
Improved health care services and access to these. When orkers (and he general pop la ion)
ha e access o good q ali heal h care ser ices, he become heal hier and more prod c i e. More
and impro ed heal h care ser ices and access o hese b he orking pop la ion is ano her fac or
leading o impro emen s in he q ali of labo r reso rces, increasing he econom s po en ial
o p . Heal h care also has man posi i e e ernali ies, j s if ing go ernmen in er en ion.
In es men s in h man capi al res l in an increase in aggrega e demand o er he shor erm, and o er he
longer- erm lead o increases in po en ial o p , b shif ing he LRAS or Ke nesian AS c r es o he
righ .
Investment in new technology: research and development

Research and de elopmen (R&D) is he f ndamen al ac i i behind he de elopmen of ne
echnologies, res l ing in ne or impro ed capi al goods (ph sical capi al), hich is ano her impor an
ca se of increases in po en ial o p and economic gro h (see Chap er 11). R&D also has posi i e
prod c ion e ernali ies, hereb j s if ing go ernmen in er en ion.
Go ernmen s in man co n ries aro nd he orld are herefore hea il in ol ed in R&D. In addi ion,
go ernmen s of en pro ide incen i es o pri a e sec or firms o engage in R&D ac i i ies; hese s all
ake he form of a incen i es, as ell as he gran ing of pa en s for he pro ec ion of in en ions.
Go ernmen spending in s ppor of ne echnolog de elopmen leads o increases in aggrega e demand
o er he shor erm and increases in po en ial o p o er he longer erm shif ing he LRAS or Ke nesian
AS c r es o he righ .
Investment in infrastructure
Infrastructure is a pe of ph sical capi al, and herefore res l s from in es men ; i incl des po er,
elecomm nica ions, roads, dams, rban ranspor , por s airpor s, irriga ion s s ems, e c. Man pes of
infras r c re q alif as meri goods or p blic goods, hereb j s if ing go ernmen in er en ion. More
and be er infras r c re increases efficiencies in prod c ion as i lo ers cos s. Good roads, rail a and
o her ranspor s s ems, for e ample, sa e ime and effor spen in ranspor ing goods and ser ices,
allo ing more o p o be ranspor ed and cos s o be lo ered. The a ailabili of effec i e
elecomm nica ions permi s fas er and easier comm nica ions, enabling economic ac i i ies o be carried
o more efficien l . More and be er infras r c re impro es labo r prod c i i . In es men s in
infras r c re herefore ork o increase aggrega e demand o er he shor erm, b he also con rib e
o increases in po en ial o p and AS increases o er he longer erm.
Industrial policies
Industrial policies are go ernmen policies designed o s ppor he gro h of he ind s rial sec or of an
econom . The incl de:
Support for small and medium-sized enterprises or firms (SMEs). This ma ake he form of
a e emp ions, gran s, lo -in eres loans and b siness g idance. These meas res pro ide s ppor
for he pri a e sec or, promo ing efficienc , more capi al forma ion, more emplo men possibili ies
and herefore increases in aggrega e demand as ell as po en ial o p .
Support for ‘infant industries . Infan ind s ries are ne l emerging ind s ries in de eloping
co n ries, hich some imes recei e go ernmen s ppor in he form of gran s, s bsidies, a
e emp ions, and ariffs or o her forms of pro ec ion agains e por s (see Chap er 14). This also
pro ides s ppor for gro h of he pri a e sec or and increases in aggrega e demand and gro h in
po en ial o p .
1 a E plain he goals of s ppl -side policies.
b O line he o ca egories of s ppl side policies no ing ho he differ in heir general
foc s.
2 Using an appropria e diagram based on he AD-AS model, ill s ra e and e plain he e pec ed
impac s of s ppl -side policies on real GDP, he price le el and nemplo men . (Yo ma se
he Ke nesian or mone aris /ne classical model o ill s ra e.)
3 a Pro ide some e amples of in er en ionis s ppl -side policies.
b Using a diagram, e plain ho hese policies affec aggrega e demand o er he shor erm
and also increase LRAS.
c Sho hese effec s sing he Ke nesian AD-AS model.
4 E plain h s ppor ers of marke -based s ppl -side policies arg e ha b foc sing on he
s ppl side of he econom , i is possible o address he polic goals of economic gro h, price
s abili and nemplo men all a he same ime.
5 O line ha ad an ages s ppl -side policies migh ha e o er demand-side policies in he e en
ha an econom is e periencing s agfla ion (sim l aneo s infla ion and nemplo men i h
recession).
6 Pro ide some e amples of s ppl -side policies ha aim o achie e each of he follo ing
objec i es:
a increase compe i ion,
b impro e incen i es, and
c make he labo r marke more responsi e o s ppl and demand.
Overlaps between demand-side and supply-side policies

Demand-side policies are foc sed on infl encing he shor - erm fl c a ions of aggrega e demand hile
s ppl -side policies are in ended o affec long r n aggrega e s ppl . Ye here are some impor an
o erlaps be een he o.
Demand-side effects of supply-side policies

Interventionist supply-side policies
When he go ernmen in es s in ed ca ion or raining, heal h care ser ices, research de elopmen ,
pro ision of infras r c re i increases he q an i or impro es he q ali of ph sical capi al and h man
capi al h s ha ing an impac on LRAS (or Ke nesian AS). Ho e er, hese ac i i ies in ol e an increase
in go ernmen spending, hich has he effec of shif ing aggrega e demand o he righ . These are
in er en ionis s ppl -side policies i h effec s on he demand side of he econom .
Market-based supply-side policies

Incen i e-rela ed policies, incl ding lo er a es on b siness profi s, are in ended o enco rage firms o
in es more in R&D, ne echnologies and ne capi al goods i h he in en ion o increase LRAS. B
an increase in in es men leads o an increase in aggrega e demand. Similarl , c s in personal income
a es crea e incen i es for orkers o ork more, h s increasing LRAS. Ye c s in income a es also
increase disposable income hich increase cons mp ion, h s increasing aggrega e demand.
Supply-side effects of demand-side policies
Fiscal polic foc ses mainl on shor - erm demand managemen . Ho e er, i can also con rib e o
long- erm gro h of po en ial GDP. I can do so indirec l , b pro iding a s able macroeconomic
en ironmen (disc ssed nder fiscal polic ), and direc l , b leading o aggrega e e pendi res ha res l
in gro h of po en ial GDP.
Direct supply-side effects of demand-side policies on potential output and long-

term economic growth
Fiscal policy
Go ernmen spending for pro ision of ph sical capi al goods, s ch as infras r c re (roads and
ranspor s s ems, elecomm nica ions, harbo rs, airpor s, e c.), as ell as on R&D, hich
impro es echnolog and herefore he q ali of capi al goods, and increases he prod c i i of
labo r.
Go ernmen spending for he de elopmen of h man capi al, s ch as raining and ed ca ion
programmes as ell as heal h care ha impro e he q ali of he labo r force and increase he
prod c i i of labo r.
Pro ision of incen i es o enco rage in es men b firms hro gh lo er b siness a es hereb
con rib ing o ne capi al forma ion and R&D ha promo es echnological inno a ions.
Monetary policy
While fiscal polic has he s ronger abili o affec po en ial o p , mone ar polic can also affec i .
A fall in in eres ra es enco rages more spending b firms on capi al goods, hich increases heir
q an i . An increase in he q an i of an fac or of prod c ion affec s po en ial o p , herefore a fall
in in eres ra es has an impac on long erm gro h.
All hese fac ors ork o increase aggrega e demand as ell as po en ial o p , h s s ppor ing long-
erm economic gro h. These effec s can be seen in Fig re 11.3 (Chap er 11). S ppose an econom is
ini iall in eq ilibri m prod cing real o p Y1, and he go ernmen p rs es a arie of demand-side
fiscal policies, incl ding increases in go ernmen e pendi res on infras r c re, R&D and raining and
ed ca ion, hereb increasing he q an i of capi al goods, and impro ing he le el of echnolog and
he q ali of labo r force. These policies prod ce increases in aggrega e demand o er he shor erm, so
ha AD shif s from AD1 o AD2. Ho e er, hese policies also impac on aggrega e s ppl , beca se of he
increase in he q an i of capi al goods, he impro emen s in he q ali of labo r, e c., so ha he LRAS
and SRAS c r es (par (a)) and he Ke nesian AS c r e (par (b)) also shif o he righ increasing
po en ial o p o er he long erm.
Some demand-side policies ha e no onl demand-side b also s ppl -side effec s, and can affec
long- erm economic gro h b increasing po en ial o p . Their con rib ion o economic gro h
incl des crea ing a s able economic en ironmen , as ell pri a e in es men spending and
go ernmen spending, in rn leading o increases in po en ial o p hro gh ne capi al forma ion,
increased R&D and echnological impro emen s, and impro emen s in he q ali of he labo r force.
Evaluating supply-side policies

We rn o an e al a ion of he effec i eness of s ppl -side policies.
Constraints on market-based supply-side policies

Time lags
The policies ork af er significan ime lags, making heir effec s on he l ide of he econom
(aggrega e s ppl ) o er he longer erm. This is beca se he ac i i ies se in o mo ion (increased
compe i ion, labo r marke reforms, changing incen i es) need ime o ma erialise and affec po en ial
o p .
Possible unfavourable impact on unemployment
Marke -based policies ha foc s on enco raging compe i ion ma ell inc ea e nemplo men , a leas
o er he shor - erm. In he case of pri a isa ion, as pri a ised firms r o make heir opera ions more
efficien , he of en r o c cos s b firing orkers. Con rac ing o o he pri a e sec or leads o
go ernmen job losses, and job losses for he co n r as a hole if projec s are con rac ed o o firms in
o her lo er cos co n ries. In addi ion, economic dereg la ion has freq en l led o increased
nemplo men , d e o increased compe i i e press res ha ca se firms o fire orkers in order o lo er
heir cos s. I is possible ha increased nemplo men on acco n of hese policies ma be shor - erm,
and ma be re ersed o er he longer erm as he econom begins o benefi from he broader effec s of
s ppl -side policies.
Possible negative effects on equity
Marke -based policies of en ha e nega i e effec s on eq i . Grea er compe i ion ma ha e a nega i e
effec if i res l s in some nemplo men , in ol ing a loss of income. Labo r marke reforms incl de
changes in legisla ion and ins i ions ha pro ide pro ec ion for orkers i h er lo incomes and
i h income ncer ain ies (minim m age legisla ion, pro ec ion agains being fired, nemplo men
benefi s). Red ced pro ec ion res l s in lo er incomes for some orkers and increased job insec ri ,
and con rib es o rising income ineq ali ies. Minim m age legisla ion, for e ample, is in ended o
pro ec nskilled orkers on er lo incomes. Unemplo men benefi s and job sec ri are especiall
impor an o people on er lo incomes ho ha e no hing o fall back on if he are lef nemplo ed.
In he case of incen i e-rela ed policies, a c s in ended o crea e incen i es o ork, sa e and in es
ma also orsen income dis rib ion. The arg men ha high a es crea e disincen i es o ork and sa e
applies mainl o higher income gro ps ho face higher a erage a ra es; herefore, o re erse his
problem, a c s m s be designed o affec he af er- a incomes of higher income gro ps. Ye his
o ld make he a s s em less progressi e, red cing he redis rib i e effec s of personal income a es
and making income dis rib ion less eq al. In addi ion, since i is he eal h ho enjo capi al gains
and earn mos of he in eres income and b siness profi s, a c s in hese areas ill affec eal h
people b increasing heir af er- a incomes more han he ill affec lo er income gro ps of he
pop la ion.
Ano her poin concerns he prices of prod c s sold b pri a ised firms. If pri a e firms ha e a degree of
marke po er, he are likel o raise heir prices o er ha he go ernmen sed o charge (as ell as
res ric he q an i of o p prod ced). As a res l heir prod c s become less affordable, i h
damaging conseq ences for lo er income gro ps, par ic larl if he pri a ised firms pro ide necessi ies
or meri goods, s ch as ili ies, incl ding po er, a er s pplies, se age s s ems, e c. (This is a problem
in some de eloping co n ries, here pri a isa ion of ser ices has made hese naffordable for er poor
people.)
Negative impact on the government budget
Marke -based policies do no need go ernmen f nds o be implemen ed as he are based on pri a e
ini ia i e. Ho e er, incen i e-rela ed policies in he form of a c s nega i el affec he b dge as he
red ce a re en es. The can herefore lead o a b dge defici or increase an e is ing one. (See Real
orld foc s 13.2.)
Possible interference of vested interests
Ve ed in e e are s rong personal in eres s in some hing. Marke -based policies of en affec par ic lar
s akeholders in a s hich are no in heir bes in eres s, and hese gro ps herefore oppose and ma
pre en he policies from being implemen ed. For e ample, s rong labo r nions oppose an polic ha
o ld eaken heir po er, or o ld red ce or abolish he minim m age. Workers in p blic
(go ernmen -o ned) en erprises ma be opposed o pri a isa ion as he fear for heir jobs hich ma
be c hen he pri a ised firm ries o red ce cos s. Firms i h s rong marke po er in ind s ries here
here is li le compe i ion are likel o be s rongl opposed o policies ha promo e compe i ion b
breaking p large firms i h oo m ch marke po er, or pre en ing mergers be een firms ha o ld
like o ha e more marke po er.
Possible negative effects on the environment
Marke -based policies foc sed on increasing compe i ion (pri a isa ion, dereg la ion) ma ha e nega i e
effec s on he en ironmen beca se of he increased scope for ac i i ies leading o nega i e e ernali ies
affec ing he en ironmen .
Constraints on interventionist supply-side policies

Time lags
Here oo he policies ork af er significan ime lags beca se of he ime needed for in es men s, ne
h man and ph sical capi al, R&D, and so on o be realised and o ake effec .
Negative impact on the government budget
In er en ionis policies ha e nega i e effec s on he go ernmen b dge beca se he are hea il based
on go ernmen spending. The can herefore crea e a b dge defici (or can increase he si e of he
defici if here as one o begin i h).
Strengths of market-based supply-side policies

Improved resource allocation
Marke -based s ppl -side policies foc s on impro ing he orkings of he marke s s em based on he
opera ion of demand and s ppl , and hese are e pec ed o res l in impro ed efficienc in reso rce
alloca ion.
May not burden the government budget
Mos marke -based policies do no need go ernmen f nds o be implemen ed as he are based on
pri a e ini ia i e. (Ta c s are an e cep ion; see abo e.)
Ability to create employment
Marke -based policies in ol ing labo r marke reforms ma also con rib e o red cing he na ral ra e
of nemplo men b foc sing on making he labo r marke more responsi e o s ppl and demand
(lo er ages and prod c ion cos s, easier hiring and firing, e c.).
Ability to reduce inflationary pressure
B increasing po en ial o p s ppl -side policies are likel o red ce infla ionar press res o er he
longer erm. As po en ial o p increases i h LRAS shif ing o he righ so as o ma ch increases in
aggrega e demand, here ill be li le or no p ard press re on he price le el. This can be seen in
Fig re 11.3 (Chap er 11).
The abili of marke -based policies o red ce infla ionar press res can also be nders ood in erms of
he foc s on keeping firms cos s of prod c ion do n hro gh increases in efficienc (d e o increased
compe i ion) and lo er age cos s (d e o increased labo r marke fle ibili ).
Strengths of interventionist supply-side policies

Direct support of sectors important for growth
The go ernmen selec s par ic lar sec ors or ac i i ies o promo e, hich ma be impor an for gro h.
For e ample if a co n r needs infras r c re s ch as road s s ems, por s or airpor s, go ernmen s ppor
for hese can be cr ciall impor an for he effec i e f nc ioning and gro h of he econom .
Ability to create employment
In er en ionis policies in ol ing in es men s in ed ca ion and raining can make a direc impac on a
red c ion of nemplo men b :
enabling orkers o acq ire he skills, raining and re raining necessar o mee he needs of
emplo ers (s r c ral nemplo men )
pro iding assis ance o orkers o reloca e (s r c ral nemplo men )
pro iding informa ion ha red ces nemplo men hen orkers are be een jobs (fric ional
nemplo men ) or be een seasons (seasonal nemplo men ).
Potential ability to reduce inflationary pressure
In er en ionis policies ma also red ce infla ionar press res b increasing po en ial o p , as Fig re
11.3 sho s.
Possible positive effects on equity
In er en ionis policies ha foc s on in es men s in h man capi al ha are broadl dis rib ed
hro gho he pop la ion are likel o ha e posi i e effec s on eq i o er he longer erm. The reason is
ha ed ca ed, skilled and heal h orkers are more likel o be emplo ed and be an ac i e and
prod c i e par of socie , i h he res l ha income is likel o be rela i el more eq all dis rib ed.

The US reduces corporate taxes
In 2017, he Uni ed S a es enac ed he larges e er red c ion in corpora e a ra es in US his or , from
35% o 21%, bringing hem o heir lo es le el in 50 ears. This as j s ified on he gro nds ha
increased in es men d e o he a c o ld res l in more gro h ha o ld in rn lead o higher
real incomes. According o he US Presiden s economic ad isor, Wi h s ppl -side a c s . . . e
are prod cing er significan gro h i h ir all no infla ion. 5
Figure 13.8: B sinessman abo oc a a paper
Ye according o a major s r e of corpora ions, he a c package appeared o ha e no major

impac on b sinesses capi al in es men or hiring plans .6 The In erna ional Mone ar F nd (IMF)
similarl concl des ha he a c s ha e no bro gh for h he e pec ed le els of in es men .
In he mean ime, corpora e a re en es fell b do ble he e pec ed amo n in 2018. Economis s are
deba ing he possible ca ses of his b ha e e o iden if hem. The significan drops in a
re en es are enlarging he b dge defici .
The benefi s of he a c en o corpora e shareholders in he form of higher profi s (di idends on
heir shares of s ocks) ha are no being rein es ed. Ye 35% of corpora e o nership is foreign. This
means ha 35% of he benefi s of he a c is ransferred abroad o in es ors o side he Uni ed
S a es. Pa l Kr gman, US Nobel pri e inning economis , no es ha his amo n s o more han $40
billion each ear ha is gi en a a o eal h foreign in es ors. He also no es ha his amo n is
m ch higher han ha he Uni ed S a es spends on foreign aid.
Sources: BBC ;
Lo Angele Time ;
CNBC;
The Ne Yo k Time
1 Using a diagram, e plain ha he US Presiden s economic ad isor mean in he s a emen
q o ed in he firs paragraph.
2 Referring o he opic of income ineq ali of Chap er 12, e plain he possible connec ion
be een he c s in corpora e income a es i h increasing eal h ineq ali
3 The corpora e a c has been ho l deba ed in he Uni ed S a es. Research his opic and presen
bo h sides of he deba e.
Some ongoing debates

Mos economis s o ld agree ha i is nlikel ha an polic can ield posi i e res l s i ho some
nega i e conseq ences. Mos belie e ha in er en ionis and marke -based policies sho ld complemen
each o her, and he par ic lar mi of policies ha sho ld be sed ill likel be differen according o
each co n r s par ic lar economic and social condi ions (see for e ample Real orld foc s 13.3).
Ho e er, major disagreemen s persis o er he s i abili and par ic lar mi of policies for achie ing
long erm economic gro h. Here is a small sample of he deba es.
The debate over increases in potential output

Economis s generall agree ha s ppl -side policies pla an impor an role in increasing po en ial
o p . Ho e er, he disagree on he her in er en ionis or marke -based polices are more effec i e.
S ppor ers of in er en ionis policies arg e in erms of he major ad an ages of arge ed go ernmen
s ppor in areas s ch as in es men , R&D, raining and ed ca ion, pro ision of credi on fa o rable
erms (lo in eres ra es, long repa men periods), and so on; he arg e ha he marke is nlikel o
pro ide hem as needed. Moreo er, ind s rial policies allo he go ernmen o s ppor par ic lar
ind s ries ha are held o offer he grea es possibili ies for gro h in he f re. The poin o he
e periences of a gro p of Asian co n ries ( he Asian Tigers ; see Chap er 20) hich achie ed er high
ra es of gro h b se of highl in er en ionis policies foc sing on in es men s in h man capi al and
ind s rial policies. The also poin o he q es ionable gro h performance of man de eloping
co n ries ha adop ed marke -based s ppl -side policies in he 1990s and be ond (see Chap er 20).
S ppor ers of marke -based policies arg e ha go ernmen in erference in he marke ma lead o
inefficiencies and reso rce misalloca ion, hereas reliance on he marke can achie e long- erm gro h
hile a oiding hese disad an ages. A major arg men agains go ernmen in er en ion and ind s rial
policies in ol es he idea ha go ernmen in erference ma res l in less efficien o comes beca se of
he infl ence of poli ical press res, lack of necessar informa ion and nin ended and n an ed
conseq ences of go ernmen ac ions. Go ernmen s ma lack he abili o choose he righ ind s ries o
s ppor , and incorrec choices ill lead o a poor alloca ion of reso rces.
S ppor ers of marke -based policies also no e ha in er en ionis policies rel hea il on go ernmen
spending, sing reso rces ha migh ha e be er al erna i e ses else here (oppor ni cos s).
Go ernmen s req ire s bs an ial amo n s of a re en es o be able o pro ide he s ppor ser ices,
hich means high a es and a large go ernmen sec or. High a es ac as disincen i es o ork, and a
large go ernmen sec or promo es inefficiencies.
The debate over incentive-related policies

Ta c s (incen i e-rela ed policies) are among he more con ro ersial marke -based policies, beca se of
heir q es ionable effec s on ork, sa ing and gro h of po en ial o p . Ta c s ha e bo h demand-
side and s ppl -side effec s. Some economis s q es ion he s reng h of he s ppl -side effec s, belie ing
hese o be small compared o he impac on aggrega e demand. Increases in disposable income d e o
c s in personal income a es ma res l in he decision o ork less if people prefer o se heir e ra
(af er- a ) income o increase heir ime for leis re. Also, orkers ma decide o se heir higher af er-
a income o cons me more ra her han sa e, in hich case he a c s ma no significan l affec
sa ing and in es men . In he Uni ed S a es, for e ample, hereas here ha e been a series of a c s,
sa ings are a heir lo es poin in he pas cen r . In co n ries here a c s ere implemen ed as
s ppl -side policies (s ch as in he Uni ed Kingdom and he Uni ed S a es), economis s disagree on
he her or no hese ha e orked o increase po en ial o p . The reason is ha ha e er gro h has
occ rred has been he res l of bo h demand-side and s ppl -side effec s of demand-side and s ppl -side
policies, and i is er diffic l o de ec hich par ic lar polic has been responsible for each par ic lar
effec .
The debate over minimum wages

Based on he anal sis of Fig re 10.1(b) (Chap er 10), ha sho s nemplo men res l ing from a
minim m age, s ppor ers of marke -based policies arg e in fa o r of red cing he minim m age o
red ce nemplo men . Ho e er, here is some q es ion o er he her red cing minim m ages ill
prod ce his res l . Man economis s arg e ha pa ing orkers a higher han eq ilibri m age
enco rages hem o ork harder, increasing heir prod c i i ( he o p prod ced per orker).
Increased labo r prod c i i ca ses firms o increase heir demand for labo r, hich has he impac of
increasing emplo men and j s if ing he higher ages. If his arg men is correc , here o ld be li le
benefi for firms if go ernmen s c he minim m age. There are man s dies ha empiricall s ppor
his arg men .7 According o some ie s i ma be he case ha he minim m age ma begin o ha e
an impac on nemplo men onl hen i approaches er high le els.

1 Using e amples, e plain
a some s ppl -side effec s of demand-side policies, and
b demand-side effec s of s ppl -side policies.
2 Disc ss ad an ages and disad an ages of in er en ionis s ppl -side policies, incl ding
a in es men in h man capi al,
b in es men in ne echnolog ,
c in es men in infras r c re, and
d ind s rial policies.
3 Disc ss ad an ages and disad an ages of marke -based s ppl -side policies, incl ding
a policies o enco rage compe i ion,
b labo r marke reforms, and
c incen i e-rela ed policies.
4 E plain h minim m ages ma no lead o nemplo men , as ill s ra ed in a labo r marke
diagram.

‘Flexicurity in Denmark
The people of Denmark appear o ha e achie ed a combina ion of hings ha man economis s o ld
consider impossible. The Danish econom has been one of he bes performing in he orld; i s GNI
e ca i a in ($PPP) ranks second in he EU; he po er ra e is among he lo es in he orld; i has
one of he mos eq al dis rib ions of income in he orld; and according o he World Map of
Happiness , he Danes are he second happies people in he orld; all his hile also pa ing among
he highes a es in he orld, i h one of he lo es a e asion ra es in he orld.
Figure 13.9: Copenhagen, Denmark. N ha n Ne Harbo r canal
Go ernmen officials from E rope and he Uni ed S a es ha e been ra elling o Denmark o disco er
he secre of i s s ccess, hich lies par l in he niq e prac ice of fle ic ri , deri ed from
fle ibili and sec ri .
The fle ibili par of fle ic ri is based on Denmark s highl fle ible labo r marke . Workers can
be easil fired i h li le prior no ice, meaning he can also be easil hired (beca se here is li le or
no cos in ol ed in firing). There is a er large rno er in he labo r marke , i h 30% of he labo r
force s i ching jobs each ear. Mos of hese s i ches are no d e o la -offs, b mo ing on o be er
jobs. Tho gh his gi es rise o some nemplo men , Denmark has achie ed one of he lo es
nemplo men ra es in he E ropean Union.
The sec ri par of fle ic ri is based on Denmark s e ensi e social pro ec ion s s em. Once a
orker is fired, he are is en i led o er genero s nemplo men benefi s, amo n ing o 90% of he
age for a ma im m of hree ears o er a life ime of ork. This pro ides orkers i h he incen i e
o find a ne job soon af er he ha e been laid off.
One condi ion of recei ing nemplo men benefi s is ha orkers m s be a ailable o ake on a job
ha is offered o hem hro gh go ernmen job cen res af er 12 mon hs of nemplo men . In addi ion,
he go ernmen pro ides free ed ca ion and raining o nemplo ed orkers o help hem easil find
ne jobs. Mos orkers belong o labo r nions ha ork er closel i h b sinesses o disco er
ha skills and ed ca ion emplo ers req ire. This helps red ce he le el of s r c ral nemplo men
in he econom . Denmark has a highl skilled and ed ca ed labo r force.
The sec ri par of fle ic ri is also based on p blic pro ision of free ed ca ion from kindergar en
hro gh ni ersi , free heal h care and hospi als, genero s re iremen pensions, ho sing s bsidies for
lo -income earners and n mero s o her social benefi s.
An addi ional possible e plana ion for Denmark s economic s ccess is i s marke -orien ed econom ,
based on free rade, compe i ion, and limi ed go ernmen o nership or in er en ion in b siness. I is
also considered o be he co n r i h he leas amo n of b rea crac and he shor es amo n of
s ar - p ime for ne firms in he E ropean Union.
Denmark also has among he highes income a ra es in he orld, i h incomes a ed a nearl 56%
on a erage. Personal income a es are s rongl progressi e, and his con rib es o he high degree of
income eq ali . Also, i has a er high al e added a (VAT, an indirec a ) a 25%. High a es are
necessar o pa for he er genero s nemplo men benefi s, free ed ca ion and heal h care, and
o her meri goods pro ided b he go ernmen . On he o her hand, b siness a es are comparable i h
mos o her E ropean co n ries.
Source: Economic Ne and Anal i
1 Iden if ha policies in Denmark are sef l for main aining lo ra es of
a fric ional nemplo men , and
b s r c ral nemplo men .
2 Describe ho a highl progressi e a s s em con rib es o grea er eq ali in income
dis rib ion (see Chap er 12).
3 I is of en arg ed ha highl fle ible labo r marke s lead o grea er income ineq ali . Iden if
he policies ha Denmark ses o ens re his does no occ r.
4 Denmark has combined high economic gro h ra es oge her i h a es ha are among he
highes in he orld. Describe ha his s gges s abo possible disincen i e effec s of er high
a es.
5 Denmark s nemplo men benefi s are among he mos genero s in he orld, e i has er lo
nemplo men ra es. Describe ha policies are sed o a oid possible disincen i e effec s of
nemplo men benefi s o ard ork.
6 Iden if he kind of nemplo men in ol ed b orkers mo ing on o be er jobs .
7 Denmark has a niq e mi re of in er en ionis and marke -orien ed s ppl -side policies ha
appear o con rib e o i s s ccess. E plain ha hese are.
4 See Chap er 9 Sec ion The ela ion hi be een he SRAS and LRAS c e in he mone a i /ne cla ical
model for an e plana ion of h SRAS also shif s.
5 $1.5 rillion US a c has no major impac on b siness spending plans: S r e
6 $1.5 rillion US a c has no major impac on b siness spending plans: S r e
7 See for e ample Labor Marke Is Doing Fine Wi h Higher Minim m Wages Research Sho s Minim m Wage
Increases Do No Ca se Job Loss
13.7 E - -
,
LEARNING OBJECTIVES

evaluate monetar polic , fiscal polic and suppl -side policies with respect to promoting low
unemplo ment, low and stable rate of inflation and growth (AO3)
P
Different t pes of unemplo ment (see Chapter 10) require different kinds of policies for their solution.
The main distinction is between c clical (demand-deficient) unemplo ment and natural unemplo ment.
C
Since c clical unemplo ment is caused b low or falling aggregate demand, measures to correct it
involve expansionar demand-side policies, or monetar and fiscal policies. The intended effects of such
policies are shown in Figure 13.2(a) and (b), where the econom is initiall in a recessionar gap
producing output Yrec. Efforts b the government or central bank to shift AD from AD1 to AD2 are
intended to increase real GDP Yp representing potential output. As AD shifts to the right, the
recessionar gap shrinks, and c clical unemplo ment falls until it is eliminated at Yp.
M ea lic has the advantages that it can be used incrementall , and it can easil be reversed or
changed in the event that aggregate demand increases too little or too much in response to lower interest
rates. In addition, it is not subject to political constraints and does not have as long time lags as fiscal
polic . It also does not lead to crowding out, and does not lead to increased government spending with
larger budget deficits and government debt.
However, if the recession is deep, with low business and consumer confidence and fears of bankruptcies
in the banking sector, lower interest rates ma not lead to the needed increase in aggregate demand.
Moreover, once interest rates reach ero the cannot be reduced further.
Fi cal lic has the abilit to pull an econom out of deep recession with a high rate of c clical
unemplo ment. In a deep recession expansionar fiscal polic can complement monetar polic .
Increased government spending, in particular, has a direct impact on aggregate demand. Government
spending has the further advantage that it can be targeted to particular economic activities, such as
spending on infrastructure, that have suppl -side effects through their impact on potential output.
Moreover, automatic stabilisers in the form of progressive income taxes and/or unemplo ment benefits
make the recession less severe, and therefore make c clical unemplo ment not as high as it would have
been if these stabilisers were not present.
On the other hand, fiscal polic faces a number of disadvantages. It cannot fine tune the econom and is
subject to major time lags, so that b the time the polic takes effect it ma no longer be appropriate. In
addition, since in a recession tax revenues fall due to rising unemplo ment and government spending
increases on unemplo ment benefits, the government is likel to have a budget deficit resulting in
increased government debt. Increased government borrowing ma lead to higher interest rates possibl
crowding out private investment.
S l - ide licie mainl affect potential output, whereas c clical unemplo ment is due to insufficient
aggregate demand. Market-based suppl -side policies will not help reduce c clical unemplo ment.
However interventionist suppl -side policies could be effective since the have demand-side effects as
discussed earlier.
N
Structural unemplo ment is the most serious part of natural unemplo ment, and most economic policies
intended to lower the natural rate of unemplo ment focus on this.
Dema d- ide licie are generall not appropriate. To see wh , suppose that an econom is producing
at the level of potential output, with unemplo ment equal to the natural rate. If aggregate demand is
increased through fiscal or monetar polic , the natural rate of unemplo ment will fall temporaril ;
however, this will cause inflation ( ou can see this b using either the monetarist/new classical or
Ke nesian models). Polic -makers would therefore reduce aggregate demand to lower the rate of
inflation and unemplo ment will fall once again to its natural rate. Alternativel , in the event that there is
downward price and wage flexibilit , the monetarist/new classical model shows that in the long run the
econom will revert to long-run equilibrium with unemplo ment once more equal to the natural rate.
Fi cal lic however ma have effects on natural unemplo ment because of its - de e ec .
These kinds of fiscal polic measures are included within interventionist suppl -side policies.
I e e i i l - ide mea e to reduce structural unemplo ment include setting up retraining
programmes; support for re-training through grants and low interest loans; direct government hiring and
provision of on-the-job training; grants to firms offering on-the-job training; subsidies to firms hiring
structurall unemplo ed workers; grants and subsidies to assist relocation; information on job
availabilit in various geographical areas; government projects in the depressed areas for emplo ment
creation.
Measures to reduce frictional unemplo ment aim at improving information flows between emplo ers
and job seekers, reducing the time a worker spends searching for a job. Improved information can result
from the establishment of job centres, emplo ment agencies and other methods of facilitating
information exchanges, such as job websites.
Measures to reduce seasonal unemplo ment include provision of information to workers on jobs
available during off-peak seasons in other industries.
The advantages of such policies are that the have a direct positive impact on reducing unemplo ment,
without contributing to increased income inequalities and loss of job securit . Disadvantages include the
negative impacts on the government budget and opportunit costs of government spending.
Ma ke -ba ed l - ide mea e include labour market reforms that increase labour market
flexibilit . As we know, reducing the minimum wage could potentiall reduce unemplo ment b
lowering wages of unskilled workers; weaker labour unions reduce the upward pressure on wages
making it easier for firms to hire because of lower costs; reducing job securit makes it easier for firms
to hire because the can more easil fire; and reduction of unemplo ment benefits increase workers
incentives to find work.
These measures are aimed at structural, frictional and seasonal unemplo ment. The advantages of these
policies are that the can reduce the natural rate of unemplo ment without negative effects on the
government budget. The major disadvantages are that the contribute to income inequalit and loss of
protection for low-income workers.
P
It is important to bear in mind the distinction between demand-pull and cost-push inflation (see Chapter
10) as this determines the policies appropriate to deal with each one.
D -
Since demand-pull inflation is caused b increases in aggregate demand, appropriate policies are
contractionar demand-side policies, or monetar and fiscal policies that attempt to bring about a
decrease in aggregate demand, so that AD2 shifts toward AD1 in Figure 13.3(a) and (b) bringing the
econom back to potential output Yp.
M ea lic in the first instance is more appropriate as it can be used incrementall , and can easil
be reversed or changed in the event that aggregate demand decreases too little or too much in response to
higher interest rates. In addition it has the important advantage of shorter time lags compared with fiscal
polic . The further advantage of no political constraints is more important here than in the case of
dealing with unemplo ment, because the tax increases or government spending cuts called for b
contractionar fiscal polic are politicall highl unpopular, making it difficult for governments to
undertake these policies.
On the negative side there ma be conflict among government objectives. Inflation requires higher
interest rates, but this ma increase the exchange rate (appreciation), which will make imports cheaper
and exports more expensive to foreigners. If the countr has a trade deficit (more imports than exports),
a currenc appreciation ma work to increase the si e of the trade deficit, which is not desirable (see
Chapter 16).
Fi cal lic ma be useful to deal with rapid and escalating inflation as a complementar polic to
monetar polic . Cuts in government spending could also have a direct impact on reducing aggregate
demand. Finall , automatic stabilisers are expected to pla a positive role as progressive income taxes
and unemplo ment benefits work to make the inflation less severe.
However, cuts in government spending are highl unpopular, as are also increases in taxes. Fiscal polic
is a cumbersome tool not well suited to fine tuning the econom . In addition time lags could make the
polic inappropriate b the time it takes effect.
S l - ide licie cannot be used to deal with demand-pull inflation over short periods of time,
because demand-pull inflation has causes l ing on the demand-side, and suppl -side policies work with
a long time lag. However, over long periods, suppl -side policies, whether interventionist or market-
based do have the tendenc to reduce inflationar pressures that might have demand-side causes,
because the shift the LRAS or Ke nesian AS curves to the right (see Figure 11.3) As long as the
productive capacit of the econom is growing at least as fast as aggregate demand, inflationar
pressures are kept under control.
C -
Cost-push inflation is caused b an increase in costs of production or suppl -side shocks, causing a
leftward shift in the SRAS curve, resulting not onl in a higher price level but also a fall in real output
and a rise in unemplo ment.
Dema d- ide licie are problematic, because, whereas the problem of inflation requires a decrease in
aggregate demand, the problem of unemplo ment requires an increase in aggregate demand. In spite of
this conflict central banks committed to a low rate of inflation use contractionar monetar polic
(raising interest rates) to lower aggregate demand. This comes at the cost of more recession and therefore
increased unemplo ment. Fiscal polic is not appropriate and is not generall used.
S l - ide licie ma be used though there are no general solutions to the problem of cost-push
inflation. Policies that can be pursued depend ver much on the specific cause of the increase in costs.
For example, if cost-push inflation is due to increases in wages, the appropriate solution ma lie in
suppl -side policies that attempt to stop or reverse the wage increases. These could involve labour
market measures such as lowering the minimum wage, or reducing the power of labour unions so that
these are unable to negotiate high wage increases with emplo ers.
If the increase in costs is due to an increase in the price of an imported input, then the solution is less
obvious. An imported cause of cost-push inflation around the world over the past 40 ears has involved
increases in the price of oil, an input that is heavil used as energ in most lines of production in both
industr and agriculture. There are no eas solutions to this t pe of cost-push inflation. Since the earl
1970s, when the price of oil began to increase, man countries have attempted to address the problem
through efforts to develop alternative forms of energ , as well as b encouraging users to economise on
the use of products that depend on oil as an input. Such policies focus on reducing the de a d , so
as to lower its price. If the price of oil falls, there results a rightward shift of the SRAS curve due to lower
costs of production. However, this is a polic that takes a long time to take effect.
Another t pe of cost-push inflation ma arise if firms with substantial market power (such as
oligopolies) increase their profits b increasing the prices the charge to consumers. In this case, policies
pursued ma be to break up the market power of firms, and encourage competition (market-based
suppl -side policies).
Another t pe of cost-push inflation ma occur if a countr s currenc falls in value, resulting in an
increase in the prices it has to pa for imported goods (this will be explained in Chapter 16). Firms that
are heav users of imported inputs and raw materials experience an increase in their costs of production
and cost-push inflation will result. One possible solution is to implement policies that aim to reduce
dependence on imports ( expenditure switching policies). However these policies come with their own
problems, which we will discover in Chapter 17 (at HL).
P
We must here make a distinction between short-term growth and long-term growth (see Chapter 11).
Short-term growth is caused mainl b increases in aggregate demand. Long-term growth is caused b
increases in long run aggregate suppl (LRAS) or Ke nesian AS, hence resulting in increases in potential
output. Therefore the policies leading to short-term growth include expansionar fiscal and monetar
policies, while the policies for long-term growth include suppl -side policies, both interventionist and
market-based.
However, it is important to consider the overlaps between demand-side and suppl -side policies because
in practice it is ver difficult to distinguish what polic has what effect. Our theoretical distinctions
between short-term and long-term growth become blurred in the real world. In fact, polic -makers do not
usuall make a distinction between the short term and long term or between expected effects on the
demand side (AD) or the suppl side (LRAS) of the econom , as the often focus just on the idea of
growth in real GDP.
Therefore, when evaluating policies to achieve growth, we must remember that there is a wide variet of
policies that include both expansionar demand-side policies as well as all suppl -side policies, all of
which can be expected to contribute to growth. All these policies have their advantages and
disadvantages, and should be carefull selected b polic -makers in accordance with the particular
circumstances of the countr in question.
For example, if a countr is in a deflationar gap and facing a recession with c clical unemplo ment,
appropriate policies are likel to be those discussed earlier in connection with c clical unemplo ment.
The include demand-side policies possibl along with suppl -side policies, particularl of the
interventionist t pe which actuall overlap with expansionar fiscal policies. As the econom
approaches potential output, or comes close to facing an inflationar gap, it becomes all the more
important that suppl -side policies are pursued, because demand-side policies on their own run the risk
of creating inflationar pressures that can onl be reduced b increases in the productive capacit of the
econom , hence increases in LRAS or Ke nesian AS (as Figure 11.3 in Chapter 11 shows).
Be ond the above, each t pe of polic must be evaluated on the basis of its own strengths and
weaknesses.

1 Answer the questions below for
c clical unemplo ment,
structural unemplo ment,
frictional and seasonal unemplo ment,
demand-pull inflation,
cost-push inflation.
Identif policies ou would recommend.
Identif what policies, if an , ou would not recommend.
Explain the advantages and disadvantages of our polic recommendations.
2 Discuss wh it is important to examine where in the business c cle an econom finds itself
before recommending particular policies to achieve growth.

P
Thomas Kuhn was a ph sicist who became ver well known for his work in the philosoph of science
through his famous book, T e S c e Sc e c Re . Kuhn argued that science (and b
extension, social science), does not grow and progress in a continuous wa through a gradual build-up
of knowledge, but rather progresses through abrupt scientific revolutions , known as paradigm shifts.
The word a ad comes from the Greek word ( a ade a), which means pattern, or
example, or representation. Kuhn used it to refer to a thought pattern that defines a scientific
discipline at a particular time. According to Kuhn, a paradigm is not just a theor , but a whole world
view that goes along with a theor or set of theories, which is shared b the members of the scientific
communit . A paradigm shift occurs when there is change in the paradigm of a discipline. A paradigm
shift does not occur easil , as there is resistance to the shift b adherents to the paradigm being
challenged.
Some economists argue that there occurred two major paradigm shifts in macroeconomics in the 20th
centur , and that there ma be a third one occurring as a result of the global financial crisis that began
in 2008.
F K
In the earl 20th centur , economists were guided in their macroeconomic policies b the principles of
classical economics , which were based strongl on the microeconomic theor of suppl and
demand. Classical economists believed in the abilit of the market and the price mechanism to solve
all the major economic problems and allocate resources in the most efficient wa . These principles,
which are still accepted for the microeconom , were then believed to appl to the macroeconom as
well. Major disruptions to the macroeconom , affecting output and emplo ment, were thought to be
caused b factors external to the market s stem (such as wars, droughts or taxes), and were believed
to be short-run phenomena that would be solved b the market, without interference b the
government.
However, the Great Depression of the 1930s, which caused ver large declines in output and large
increases in unemplo ment, and which persisted for ears, forced economists to question the abilit of
the market s stem to automaticall generate the aggregate demand that was needed to get the
econom out of the depression.
In 1936, John Ma nard Ke nes published his famous book, T e Ge e a T e E e ,
I e e a d M e , in which he explained that the rigidit of wages and prices would not allow the
market s stem to correct a recession (or depression) and bring the econom back to full emplo ment.
Soon after, with the outbreak of the Second World War in 1939, massive increases in government
militar expenditures showed economists the powerful effects of aggregate demand increases on
emplo ment and output.
The lessons of this experience brought forth a revolution in economic thinking, or a paradigm shift,
involving abandonment of the classical paradigm and a shift to the Ke nesian one. In contrast to the
classical world view, in which well-functioning markets meant there was not much for governments
to do, in the Ke nesian world view, markets were not self-correcting, and required active demand
management (fiscal and monetar policies) to deal with economic fluctuations; government
intervention in markets was indispensable for the proper functioning of the macroeconom . B the
end of the 1960s, man economists believed the had discovered in government intervention and
demand management the secret to sustained economic growth, with low inflation and low
unemplo ment.
F K /
In the earl 1970s, this state of affairs was disrupted b the appearance of stagflation, or the
simultaneous increase in inflation and unemplo ment, caused b falling aggregate suppl (due to oil
price and food price shocks). Economists realised that demand-side policies were not as effective as
the were previousl thought to be, since what was needed was expansionar polic for high
unemplo ment and contractionar polic for inflation.
The 1970s saw high inflation and low output growth. This brought forth a new revolution in
economic thinking, or paradigm shift, involving the ideas of Milton Friedman, the founder of
monetarism, which appeared to address the problem of stagflation, and also fitted in well with a
political and ideological turn toward a market orientation that was occurring at the time as a reaction
to the idea of big government (see Theor of knowledge 10.2 in Chapter 10). The world view of
monetarist economists was similar to that of the classical economists, based on a belief in the abilit
of markets to lead to efficient outcomes and address the problems of the macroeconom , again
impl ing that the role of government should be small. Though demand management continued to be
used, the new world view paved the wa for the suppl -side policies that dominated the 1980s and
1990s, which focused on tr ing to make the market s stem work more effectivel .
T ?
The global financial crisis that began in 2008 revealed the weaknesses of excessive deregulation of
the financial sector, and the failure of markets to work as well as had been supposed. In addition to the
enormous sums of mone spent b governments to save banks and other financial institutions from
failing, there have also been numerous calls for increased regulation and oversight of financial
activities on both national and global fronts. This raises the question whether another paradigm shift,
involving greater government intervention and less reliance on the market ma be imminent. Nobel
Pri e-winning economist, Joseph Stiglit , writes:
T e ba e a e c e e e e be ece ce e G ea
De e ...B e ec c e bea e a a e[e b ]. I ded
e de a a ec e a a a e c d be e - e a ed, a e e e
e c e a d e -c ec . . . T da , ec a a be b e
ec c a ad a ed a ed e ea be e e c ...
F ae , e c e a ea c ed e e a ed de , e e ea c e
e e e a ed de e a e a e a ac e . Ec c e ad a ead a
a e ce a c c e a da d de e e [ e ab e] . . .
C a a ad ea . T a a e e ed c e de . L e e
P e aca e e e e ea -ce c e e e e, e e be e c e
add c e e a d e e e e a da d a ad . T e e de be a
e e a d c e ba ed e a d be e , b e ae e a .N e
a a a ad d .
B a e a ad , I be e e, a : e e ec a b d b c ae e e... 8
Joseph Stiglit and another Nobel Pri e-winning economist, George Akerlof, note:
T e ec ca d a ca c a bee a e e e ec c e ,
a a - a d dea e e . I c e ce de ed b ab eca e
e, e a e c e ec c e ee e c c d be a ca e
ea c ce . . .
J a ec a e a ed ab e eed e a , a e e
e ee a a e a e a d a d de be e
c e ec c e c ...
F ae , e e ec ee e dea e -e a , e ce
a e a a a e a a e e , e ec a d ca ce a e bee
e a a e d ee a ac e . . .
M c e e c ec c de a e e d e b da ec c
c de b c , ca c e ,a d c . We a e c ea , ,
ec c .9
T
Can ou detect a pattern in the balance between markets and government intervention that has
been occurring in the shift from one paradigm to another?
Can ou think of an paradigm shifts that ma have occurred in another social science or science
ou are stud ing?
Based on the paradigm shifts described above, what has happened in the econom in each case to
bring forth a paradigm shift?
What kind of events do ou think are likel to lead to paradigm shifts in other social sciences and
in the natural sciences? Do the differ from those in economics?
Wh do ou think paradigm shifts do not happen easil ? Wh do the occur infrequentl ?

1 Select a countr of our choice that is or has recentl been in recession and examine what
policies the government or central bank have pursued in order to deal with this. Consider the
extent to which the policies have been successful as well as the difficulties that the policies ma
have encountered in attempting to achieve their goals.
2 Find four recent news sources with examples of the following four kinds of macroeconomic
policies:
a fiscal polic ,
b monetar polic ,
c interventionist suppl -side polic , and
d market-based suppl -side polic .
For each one of these, describe the polic . For example, in the case of fiscal polic is it contractionar
or expansionar ; does it involve changes in taxes or government spending; what is the objective of the
polic . In addition, ou should note if an of the policies fall into more than one categor . For
example, some fiscal policies overlap with interventionist or market-based suppl -side policies and
vice versa.
You can find questions in the st le of IB exams in the 'Digital coursebook: Extra material' section.
8 Joseph Stiglit , Needed: a new economic paradigm in the F a c a T e , 19 August 2010.
9 George Akerlof and Joseph E. Stiglit , Let a hundred theories bloom in P ec S d ca e, 26 October 2009.
Unit 4
The Global Economy

I d f ec c fa , e ha e bee e a g c ed ec e , ec e
ha a e c ed ec c ea h he c e . I he ea d, c e ha e
a ec c h he c e, gf f g d , e ce a d e ce ,
a e a a e a d e ac c e f a e . The e e a a
ec c , h ch a e c e ea d e e de e de , a e a
economic integration. Cha e 14 17 a e c ce ed h he e e a a ec c
.
La e h e e a e he ec a be f de e gc e . I Cha e
18 20 e e he c e de e ed ha de a d he c c a ce
f de e gc e he g ba ec a d ha ca be d e ha e he
de e e a d e a da d f g a d e -be g e e he e.
Rea d e 1: Wh a d h e f he
eg a f he ec e f d?
1 G g ec c in e dependence be ee c e b g h be ef a e
a c .
2 G g ec c eg a a ead g ea e efficienc , e fa e ga a d
e e economic ell-being, b he be ef a be ineq i abl
d b ed.
I Cha e 14 a d 15 e d e a a ade heor , e a g h c e

ade h each he , a d ha a e he be ef f ade. We a e a e e a a
ade polic , he e e d c e he ea h c e e ce ea e ha
affec e a a ade, e e e c g , a e a he c e e ce f he e
ce .
Cha e 16 17 be c ce ed hf f a e f ec a he . We
ee h c e ea e f f e he ece e f he c e a d ha
he e d he c e . We a d he be ha ca a e he e e f
ba a ce be ee he e f ,a e a ce c ec ch ba a ce . We ea
ha he e a e g e c ec be ee e e he d e c ec a d he
e a a ec , h ch ea ha f e ec c ce c ec a d e c
ec c b e ha e ac ec c ea h he c e.
I d f e a a ec c, e d c e ha he be ef f ec c
eg a ae e e d b ed: ec e g h c e ga h e
he a be e ff. We e a e h ga , h e a d h .
Rec c f a c a ca e a G ee h , a e c , F a ce, 19 h ce
_______________________________________________________________
C 14
I :P I
BEFORE OU START
Ca hi k f me ea h c ie ade i h each he ?
Y ha e babl hea d e e f ade a . Ca hi k f me ea h
c ie migh a e ic ade ?
I e a i al ade, he b i g a d elli g f g d a d e ice ac i e a i al b da ie , ha

ake lace i ce a cie ime , b Eg ia , G eek , R ma a d Ph e icia , a d la e b all maj
e h gh hi he e e . B i ha e e bee im a he ec mie f
i all all c ie i he ld a i i da . G d a d e ice d ced d me icall ld
b e ab ad a e exports; g d a d e ice b gh f m he c ie f d me ic e a e imports.
I ece decade , he al e f e a d im a a ha e f GDP ha bee i c ea i g i m
c ie a d he ld.
Y ma ecall f m d f mac ec mic ha e e (= e mi im , X
M), i e f he c m e f agg ega e dema d. I i a c m e i h maj c e e ce f
d me ic ec mie a ell a he gl bal ec m , me i i e a d me ega i e. O he h le he
i i e c e e ce a e f e g ea e ha he ega i e e , a d e he e a e ma ea h
c ie me ime e ic he fl f ade. The e e ic i f e gi e i e m ch
di ag eeme a d e e c flic i hi a d be ee c ie .
I hi cha e e ill d he be efi f i e a i al ade, a ell a diffe e ki d f mea e
ed b c ie e ic he am f ade, k a trade protection.
14.1 T
LEARNING OBJECTIVES

e plain the various benefits that countries can e pect from trade (AO2)
dra diagrams illustrating free trade resulting in e ports or in imports (AO4)
calculate, from free trade diagrams, quantit of e ports, e port revenue; quantit of imports,
import e penditure (HL onl ) (AO4)
W ?
International trade results in a number of important benefits or . The benefits are far
greater if trade is free. F refers to the absence of government intervention of an kind in
international trade, so that trade takes place ithout an restrictions (barriers) bet een individuals, firms
or governments of different countries.
I
When countries trade ith each other, the import products from other countries so that domestic firms
become e posed to competition from products produced b firms in foreign countries. In addition, the
e port products to other countries so their o n products are forced to compete ith other products
produced in those countries. Greater competition results in several benefits discussed belo .
G
As a result of greater competition firms are forced to become more efficient, in other ords the must tr
to produce at the lo est possible cost. If the do not become more efficient, the ill have to sell their
output at higher prices to cover their higher costs; domestic consumers ill prefer the lo er-priced
imported products, hile foreign consumers ill prefer lo er-priced goods produced in other countries.
As a result, higher-cost firms ill have lo er sales and ma go out of business. Therefore, increased
competition leads to greater efficienc .
L
Increased competition among firms and greater efficienc lead to lo er prices for consumers. In
addition, as imports consist of goods that are produced more efficientl in other countries, this also leads
to lo er prices for consumers.
G
B trading ith each other, countries can import a larger variet of goods and services, possibl of
higher qualit , than the ones the can produce themselves. This increases choice for consumers.
A
Countries are likel to need for their domestic production a variet of natural resources or capital goods
that are not available domesticall . For e ample, oil is a resource that virtuall all countries depend on,
et most are forced to rel on imported oil because the do not produce it themselves. The same ma
appl to a variet of other resources such as timber, minerals and semi-finished products used as inputs,
as ell as capital goods (machiner and equipment) used in production. Trade allo s countries to import
inputs the need for domestic production.
S
When countries e port, the acquire foreign e change (or foreign currencies), hich allo s them to
make pa ments to other countries for the goods and services the import, or make other pa ments
abroad (see Chapter 16). Acquiring foreign e change from e ports increases their abilit to import.
A
In the absence of trade, the amount of output an firm can produce is limited b the si e of the domestic
market. If the domestic market is small (if the countr is small), the firm is unable to gro as it does not
have a market for increasing its sales. With trade and e ports to other countries there ma be an
e pansion in the si e of the market and therefore the possibilit of e panding sales of the firm.
E
Economies of scale involve the abilit of firms to decrease average costs of production (cost per unit of
output) b becoming larger and increasing the quantit of output produced. (This topic as studied in
Chapter 7 at HL.) When a firm lo ers its average costs, it becomes more efficient, and can sell its output
at a lo er price. Access to larger markets allo s firms to gro be ond the limits of national boundaries,
produce more output and take advantage of economies of scale. With lo er average costs, the can
lo er their prices and enjo greater e port competitiveness, or the abilit to compete better and sell more
in foreign markets.
I
Man of the benefits of trade arise from . Specialisation occurs hen an individual, firm
or countr concentrates production on one or a fe goods and services. Here, e are referring to
specialisation b a countr in the production of goods or services it can produce efficientl (at a lo
cost). A countr that does not trade must itself produce all the goods and services consumed, and
therefore cannot specialise. But if it uses its resources to specialise in the production of those goods and
services it can produce more efficientl ( ith lo er costs of production, or ith fe er resources), it can
produce more of these, and trade some of them for other goods produced more efficientl in other
countries. This a it is able to produce a greater quantit of output because it does not aste its scarce
resources on producing goods and services at a relativel high cost. It can also increase its consumption
of goods and services, because b e porting part of its larger domestic output in e change for other
output produced more cheapl else here, it can acquire a larger overall quantit of goods and services.
This, in a simple form, is the theor of comparative advantage that e ill stud belo .
M
If trade is free, meaning there are no restrictions on trade, it can lead to a more efficient allocation of
resources both ithin countries as ell as globall . This follo s from specialisation discussed above. If
each countr specialises in producing the goods it can produce relativel more efficientl ith lo er
costs of production or fe er resources compared ith its trading partners, there ill be less aste of
scarce resources and therefore more efficient resource allocation.
T
As goods and services flo from one countr to another, the enable ne ideas and ne technologies
and skills to be transferred from one countr to another.
T ,
Strong international trade links bet een countries can form the basis for economic relationships that
reduce the possibilit of ar or other hostilities. One of the reasons behind the establishment of the
European Economic Communit in 1957 (the EEC, the precursor of the European Union) as to
eliminate the possibilit of future ars bet een France and German . The strong economic
interdependence created b trade (and other) links bet een these countries makes the possibilit of ar
bet een them inconceivable toda .
T
Increased competition, greater efficiencies in production, e panding markets, acquisition of needed
resources, economies of scale, greater specialisation, improved resource allocation and sharing of
technological advances, all made possible b international trade, contribute to increases in domestic
output, and therefore to greater economic gro th. For these reasons international trade has been termed
an engine for gro th .

1 Identif hat products or groups of products our countr specialises in.
2 Discuss ho each of the follo ing can benefit from trade:
consumers
producers
the domestic econom and societ
the global econom and societ
3 Outline h international trade been termed an engine for gro th .
U
We have seen that f ee ade refers to the absence of government intervention of an kind in international
trade, resulting in trade ithout an restrictions. Under free trade the prices of goods that are traded
internationall (imported and e ported) are determined entirel b the forces of demand and suppl .
S ?
Suppose that bindles are a good produced b man countries around the orld, hich have free trade for
bindles. This means that there is a free orld market for bindles, involving man individuals or firms in
countries around the orld ho bu and sell bindles. The orld bindle price is determined b orld
demand and orld suppl , here orld demand is the sum of all countr demands and orld suppl is
the sum of all countr supplies. All the countries that are part of this orld market bu and sell bindles at
the orld price. The orld price, P , is sho n in Figure 14.1(a).
F 14.1: Using diagrams to illustrate free trade
Imagine no a countr called Tradenia that also produces bindles but is closed to international trade; this
is called a a k , the Greek ord for elf- fficie c , since the countr is self-sufficient in all the goods
it produces and consumes. Tradenia is not part of the orld market so its domestic price of bindles is
determined entirel b the familiar domestic demand and domestic suppl studied in Chapter 2.
Tradenia then decides to open its econom to international trade, so that it ill no begin to e port and
import various goods. In the case of bindles, the question arises, should these be e ported or imported?
The a e de e d he d me ic ice f bi dle bef e ade, c m a ed i h he ice f bi dle i
he ld bi dle ma ke .
It is assumed (for simplicit ) that the Tradenian bindle market is relativel small compared to the overall
si e of the orld bindle market, so that if Tradenia bu s (imports) or sells (e ports) bindles in the orld
market it ill not influence the orld bindle price. This means that once Tradenia enters the orld bindle
market it ill accept the orld price of bindles so that its previous domestic price before trade no longer
e ists. In other ords, Tradenia no faces a perfectl elastic bindle suppl curve, appearing as a
hori ontal line at the level of the orld price (see Chapter 3 on elasticities). A e fec l ela ic l
c e a he ld ice im l mea ha all bi dle i T ade ia a e b gh a d ld a he ld ice
a d he ice. 1
W
Whether Tradenia should e port or import bindles is e plained in Figure 14.1. Figure 14.1(b) sho s the
case here Tradenia becomes a bindle e porter. The orld price, P , determined in the orld bindle
market, is higher than Tradenia s domestic price, Pd. Once Tradenia opens its econom to international
trade and joins the orld market, it accepts the orld price P , and the domestic price, Pd is no longer
relevant. At the higher price P , the quantit of bindles supplied, Qs, is larger than the quantit of
bindles demanded, Qd. This e cess quantit supplied, hich is Qs Qd, is available to be sold to bu ers
abroad, or e ported. It follo s then that de f ee ade, he he ld ice i highe ha he
d me ic ice, he g d i e i i e ed.
W
Figure 14.1(c) sho s that the orld price of bindles determined in the orld market, P , is lo er than
Tradenia s domestic price, Pd. At the orld price P , the quantit of bindles demanded, Qd, is larger
than quantit of bindles supplied, Qs. Tradenia no has an e cess quantit demanded, Qd Qs, hich is
the quantit of bindles to be purchased from abroad, or imported. U de f ee ade, he he ld ice
i l e ha he d me ic ice, he g d i e i i im ed.
A countr ill e port a good if its domestic price ithout trade is lo er than the orld price and it
ill import a good if its domestic price ithout trade is higher than the orld price.

Using international trade diagrams, e plain hen a countr should e port a good and hen it should
import a good.
C ,
(HL )
We ill use the principles e plained above to calculate the effects of international trade on several
variables, based on the information presented in Figure 14.2.
F 14.2: E porting or importing under free trade
T
Figure 14.2(a) sho s that hen Tradenia as a closed econom , it as producing 60 million bindles
and selling them at a price of $5 per bindle. When it opened up its econom to international trade, it
began accepting the global price of $7 per bindle.
G ,
At this higher price, domestic quantit produced increased from 60 million to 100 million bindles,
hile domestic quantit demanded fell from 60 million to 20 million bindles. This means that there is
no e cess quantit supplied of 100 million 20 million = 80 million bindles. Thi e ce a i
lied ill be e ed he ef e e = 80 milli bi dle .
E
As a result, domestic producers ill no be earning e port revenues hich are equal to the quantit
of e ports times the orld price the receive per unit. E e e e a e he ef e 80 milli $7 =
$560 milli .
W
Producers benefit on t o counts: the higher price as ell as the greater quantit the produce hich
means that the have higher revenues. Consumers on the other hand are orse off on t o counts: the
can onl bu a smaller quantit and must pa a higher price.
T
Figure 14.2(b) sho s that the orld price that Tradenia is no facing is $3 per bindle, hich is lo er
than the domestic price of $5 ithout trade.
S ,
At this lo er orld price, the domestic quantit produced fell from 60 million to 20 million bindles.
At the same time, domestic quantit demanded increased from 60 million to 100 million bindles.
There is therefore e cess quantit demanded of 100 million 20 million = 80 million bindles. Thi
e ce a i dema ded ill be a i fied b im he ef e im = 80 milli bi dle .
I
These imports ill give rise to an amount of import e penditure (the amount of spending to bu
imports) that is equal to the quantit of imports times the orld price per unit. The ef e im
e e di e i 80 milli $3 = $240 milli .
W
Producers are no orse off because the produce a smaller quantit hich the sell at a lo er price.
Consumers on the other hand are better off since the can bu a larger quantit for a lo er price.

1 Tradenia s domestic prices before trade are $50 per unit of good X and $200 per unit of good
Y. When it begins to trade it faces a orld price of $35 for good X and $225 for good Y.
Identif hich good Tradenia ill e port and hich it ill import. E plain h .
Identif ho ill gain or lose from importing a good and ho ill gain or lose from
e porting a good.
C ,
(S )
If ou are interested in pursuing this topic further ou ma do so b referring to the 'Digital
coursebook: E tra material' section. You ill discover that elfare anal sis reveals the interesting
result that free trade al a s increases social surplus regardless hether the countr is an importer or
e porter, though the effects are unevenl shared bet een consumers and producers.

1 Using the diagram belo , sho ing Tradenia before trade and after trade, calculate
the quantit of e ports,
e port revenues,
(optional*) the change in producer revenue,
(optional*) change in consumer e penditure.
2 using the diagram belo , sho ing tradenia before and after trade, calculate
the quantit of imports,
import e penditures,
(optional*) the change in producer revenue, and
(optional*) the change in consumer e penditure.
*This is not required b the s llabus but it is good practice for later problems
1 Students taking this course at HL ma note that this is similar to firms in perfect competition that are
price-takers, accepting the price determined in the market and selling all the can at that price. See
Chapter 7.
14.2 F :
(HL )
LEARNING OBJECTI ES

e plain the theor of absolute advantage using the concept of gains from trade (AO2)
e plain the sources of comparative advantage (AO2)
evaluate the theor of comparative advantage (AO3)
dra a linear PPC diagram illustrating different opportunit costs, and gains from
specialisation and trade arising from comparative advantage (AO4)
calculate opportunit costs from data and identif comparative advantage. (AO4)
The theories of absolute and comparative advantage provide po erful e planations for the principle
that countries can gain significant benefits through specialisation and trade.
T
The theor of absolute advantage dates back to the ork of the famous 18th centur economist Adam
Smith, considered to be the Father of Economics (see Chapter 1). Adam Smith as a strong believer
in the principle that specialisation and free trade can make all countries better off. To e plain this, he
formulated the theor of absolute advantage. A refers to the abilit of one countr
to produce a good using fe er resources than another countr . Putting it differentl , a c ha a
ab e ad a age i a g d if i h he a e a i f e ce i ca d ce e f he g d
ha a he c .
Consider a simple orld econom of t o countries, Coffenia and Robotia, that produce coffee and
robots. In Table 14.1, columns 1 and 2 sho the quantities of coffee and robots that one orker in one
da can produce in Coffenia and in Robotia, if the produce onl coffee or onl robots. Coffenia can
produce either 8 units of coffee (and 0 robots), or it can produce 4 robots (and 0 units of coffee).
Similarl Robotia can produce either 3 units of coffee (and 0 robots) or 6 robots (and 0 units of
coffee).
Coffenia therefore has an absolute advantage in coffee, because ith one orker it can produce 8
units of coffee compared to onl 3 in Robotia. Robotia has an absolute advantage in robots, since it
can produce 6 robots, compared to onl 4 in Coffenia.
1 Coffee 2 Robots
Coffenia 8 or 4
Robotia 3 or 6
T 14.1: Absolute advantage
Using this information, e can construct production possibilities curves (PPCs) for Coffenia and
Robotia, sho n in Figure 14.3. For simplicit , e use straight-line PPCs (see Chapter 1). When
Coffenia produces 8 units of coffee, it is at point A, producing 0 robots; and hen it produces 4
robots, it is at point B producing 0 units of coffee. In the same a e plot points C and D for
Robotia. Joining points A and B, e get Coffenia s PPC; joining points C and D gives Robotia s
PPC.
Comparing the t o PPC s, e immediatel see Robotia s absolute advantage is in robots, because its
PPC e tends further to the right on the robot a is; and Coffenia s absolute advantage is in coffee,
since its PPC e tends further up on the coffee a is.
Suppose that both countries agree to specialise in and e port the good in hich the have absolute
advantage. Coffenia specialises entirel in coffee production, and e ports part of its coffee in
e change for robot imports. Robotia specialises entirel in robot production, and it e ports a portion
of its robots in e change for coffee imports. The result ill be that hereas both countries ill be
producing some here on their PPC, d e ecia i a i a d ade he ca c ea a i
ide hei PPC! This is sho n in Figure 14.3. Both countries become better off because
specialisation according to absolute advantage leads to a global reallocation of resources here
production takes place b the most efficient (lo -cost) producers.
F 14.3: Coffenia has absolute advantage in coffee; Robotia has absolute advantage in robots
According to the , if countries specialise in and e port the good in

hich the have an absolute advantage (can produce ith fe er resources) the result is increased
production and consumption in each countr .
T
The theor of absolute advantage e plains onl a small part of gains from specialisation and trade. A
much more po erful argument as provided b a ell-kno n economist of the 19th centur , David
Ricardo, in his famous theor of comparative advantage. Ricardo sho ed that countries can gain from
specialisation and trade even if one countr has an absolute advantage in b h g d . In order for this
surprising result to hold, it is onl necessar that countries have diffe e i c for their
goods, so that the production of one good is relativel cheaper to produce in one countr than in
another, even if it is not absolutel cheaper. C refers to the situation here
one countr has a lo er opportunit cost (relative cost) in the production of a good than another
countr .
Consider a simple orld econom of t o countries, Cottonia and Microchippia, producing cotton and
microchips. Table 14.2 sho s the quantities of each good that one orker can produce in one da if
onl one or the other good is produced. Cottonia can produce either 20 units of cotton (and ero units
of microchips) or it can produce 10 units of microchips (and ero cotton). Microchippia can produce
either 25 units of cotton (and ero units of microchips) or 50 units of microchips (and ero units of
cotton). We can see that Microchippia has an absolute advantage in the production of b h c a d
ic chi , because ith the same resources (one orker in one da ) it can produce more of both
goods than Cottonia.
P O O
1 2 3 4
Cotton Microchips
C 20 or 10 10 units of microchips 20 units of cotton 10
20 units of cotton = 1 units of microchips =
2 2
M 25 or 50 50 units of microchips 25 units of cotton 50
25 units of cotton = 2 units of microchips =
12
T 14.2: Comparative advantage
Figure 14.4 plots the PPCs of each of the t o countries based on the data of Table 14.2 (assuming
straight-line PPCs). Microchippia s absolute advantage in the production of both goods is apparent
from the fact that i PPC ie e i e ab e he PPC f C ia. When comparing the PPCs of t o
countries, e can see immediatel hether one countr has the absolute advantage in one or both of
the goods. If the PPCs intersect, as in Figure 14.3, this means that each countr has an absolute
advantage in one of the t o goods. If the PPCs do not intersect, as in Figure 14.4 this means that the
countr ith the PPC l ing full above the second PPC has an absolute advantage in the production
of both goods (in our e ample, Microchippia).
F 14.4: Comparative advantage
If the t o PPCs do not intersect, as in Figure 14.4, ho can e determine comparative advantages?
Ver simpl , he c ha ha he f a e PPC ha a c a a i e ad a age i he g d ea ed
he h i a a i . It follo s that the countr ith the steeper PPC has a comparative advantage
in the good measured along the vertical a is. In Figure 14.4, Microchippia s PPC is flatter than
Cottonia s PPC, therefore Microchippia has a comparative advantage in microchips, hich are
measured along the hori ontal a is. Cottonia, ith the steeper PPC, has the comparative advantage in
cotton.
Note that hen a countr does not have a comparative advantage in the production of a good, e can
sa it has a c a a i e di ad a age. Therefore in our e ample above, Cottonia has a comparative
disadvantage in the production of microchips..
C
We ill no calculate opportunit costs to identif comparative advantage. Opportunit cost is the
ne t best alternative that must be sacrificed in order to obtain something (see Chapter 1).
Columns 3 and 4 in Table 14.2 calculate the opportunit costs of the t o goods in each countr .
(Since e are using straight-line PPCs, this means that opportunit costs are constant throughout the
PPC). In general ou can use the follo ing rule to calculate opportunit cost:
Opportunit cost = sacrifice of one good gain of the other good
Therefore for Cottonia, the opportunit cost of cotton is the quantit of microchips that must be
sacrificed (10 units) divided b the gain in cotton (20 units). The opportunit cost of microchips is the
amount of cotton that must be sacrificed (20 units) divided b the gain in microchips (10 units). We
perform similar calculations to find the opportunit costs for Microchippia.
The results sho that Microchippia has a lo er opportunit cost in producing microchips, hile
Cottonia has a lo er opportunit cost in producing cotton. Though Cottonia has a highe ab e
c in producing cotton, it has a e e a i e c , meaning that if Cottonia ants to produce more
cotton, it needs to sacrifice a smaller quantit of microchips than does Microchippia. The ef e
C ia ha a c a a i e ad a age i c d c i , hi e Mic chi ia ha c a ai e
ad a age i ic chi .
This ties in ith our conclusions above based on the PPCs of Cottonia and Microchippia. In fact, it is
possible to calculate opportunit costs directl from Figure 14.2.
A countr has a comparative advantage in the production of the good that has a lo er opportunit
cost (lo er relative cost).
T
The theor of comparative advantage is so important that it is often referred to as the a f
c a a i e ad a age. This states that if countries specialise and trade according to their
comparative advantage, global production and consumption ill increase because of an improvement
in the global allocation of resources, making all countries involved better off.
Because of this improvement in resource allocation, even though both countries produce at a point on
their PPCs, h gh ecia i a i a d ade he c ea a i ide hei PPC! Cottonia can
consume at a point like B hile Microchippia can consume at a point like A in Figure 14.4.
A countr has a comparative advantage in the production of a good hen this can be produced at a
lo er opportunit cost. According to the ( ) , as long as
opportunit costs in t o (or more) countries differ, it is possible for all countries to gain from
specialisation and trade according to their comparative advantage. The global allocation of
resources improves, resulting in greater global output and greater global consumption, allo ing
countries to consume outside their PPC.
T PPC
What if the PPCs of t o countries are parallel to each other, as in Figure 14.5? Here, countr A has
an absolute advantage in the production of both good Y and good X. The fact that the t o PPCs are
parallel means that the t o countries face identical opportunit costs for the t o goods.3 If
opportunit costs are identical, there is no countr in hich one good is relativel cheaper; therefore
there is no countr that has a comparative advantage in the production of one or the other good.
Under these circumstances ( hich do not occur ver often in the real orld), there are no possibilities
for countries to gain from specialisation and trade, and there ould be no point in trading.
F 14.5: Identical opportunit costs: no gains from trade
A
As e have seen, according to the theor of comparative advantage, countries gain from
specialisation and trade as long as the have different relative costs of production. This means that the
theor of absolute advantage is simpl a special case of the theor of comparative advantage.
Considering the case of Coffenia and Robotia, the fact that Coffenia has an absolute advantage in
coffee and Robotia in robots does not affect the conclusions of the theor of comparative advantage.
R S ?
o that e have studied the theor of comparative advantage, e can better understand the diagrams
presented in Figure 14.1, hich in fact are illustrations of the principle of comparative advantage. In
Figure 14.1(b), the lo er domestic price compared to the orld price indicates that Tradenia has a
c a a i e ad a age in the production of bindles, it can produce these more efficientl (at a lo er
cost) than other countries, and can therefore sell them at a lo er price. When it opens the econom to
international trade, it accepts the higher orld price, increases its domestic production of bindles and
e ports some of these to other, less efficient countries. In Figure 14.1(c), Tradenia s higher domestic
price indicates that it has a c a a i e di ad a age: it is less efficient than other countries. When it
opens itself to trade, it accepts the lo er orld price, and the e cess demand is satisfied b imports
produced in other countries more efficientl .
T
The possibilit of increased production and consumption through specialisation is made possible
because countries can make use of differences in quantities and qualit of factors of production, as
ell as levels of technolog , hich altogether are called factor endo ments . For e ample, a countr
ith a temperate climate ill find it more costl to produce crops such as coffee or cocoa, hich are
better suited to tropical climates. Mountainous countries are less ell suited to agriculture than
countries ith fertile plains.
Depending on their factor endo ments, different countries are more efficient in the production of
certain goods and services than others. Greece is a mountainous countr ith a large coastline,
countless beaches and rich historical sites. It is therefore better suited to producing shipping services
as ell as tourism services. S it erland, being a landlocked countr , is not ell suited to shipping,
but has developed technologies that have made it ell suited to the production of high-qualit
atches and clocks.
The theor of comparative advantage forms the basis of trade policies in man countries. Its ke
conclusion, that free trade increases global production and consumption, leading to an improved
global allocation of resources, forms the justification of the major polic trend since the earl 1990s
around the orld to ard , involving the freeing up of trade through the gradual
removal of trade restrictions. Ho ever, in spite of its potentials, the theor of comparative advantage
is subject to several limitations:
The he f c m a a i e ad an age de end n man n eali ic a m i n:
F fi ed, in other ords the do not move from one
countr to another and do not change. Yet in the real orld, factors of production, particularl
labour and capital, can and often do move from countr to countr ; moreover, there are likel to
be changes in qualit , such as hen labour acquires more skills and education. This means that
factor endo ments change over time, and so comparative advantage also changes.
T fi ed; this is highl unrealistic since ne technologies are
continuousl being introduced. This too causes comparative advantage to change.
T , meaning that factors of
production can be instantl and costlessl moved from one line of production to another. This
does not occur in practice, as there are costs hen production s itches from one product to
another that ma be so high as to change comparative advantage.
T (countries produce hei PPC ); this is hardl
ever met, especiall in developing countries, here there is often ver high unemplo ment and
underemplo ment of labour. When this occurs, comparative advantage is different from hat it
ould have been ith full emplo ment.
T , meaning that trade flo s (imports and e ports) are determined entirel b
market forces; in realit , there is strong government intervention in markets that influences
quantities of imports and e ports.
T ; the product is identical in ever respect, for e ample all
computers are e actl the same. This is rarel if ever the case in the real orld.
T . In the real orld, there are costs of transportation for
imports and e ports that change relative prices and ma limit the benefits of specialisation.
S eciali a i n acc ding c m a a i e ad an age ma n all nece a c al change
cc in an ec n m As an econom gro s and develops, major changes in its structure usuall
occur, ith the agricultural sector becoming less important, and manufacturing and services
becoming more important (see Figure 3.12, Chapter 3). These changes are especiall important for
developing countries, indicating that comparative advantage changes over time. For e ample, an
agricultural econom ma have a comparative advantage in agricultural products, but as it becomes
more industrialised, its comparative advantage ma change in favour of manufactured products. If
countries specialise according to their comparative advantage, the ould have to go on producing
and e porting according to that same advantage, and this ould not permit the necessar structural
changes to take place in the econom . This is an important issue for developing countries that e ill
come back to later in this chapter and in Chapter 19.
T ade n he ba i f c m a a i e ad an age ma lead e ce i e eciali a i n If a countr has a
comparative advantage in onl one or a fe products, specialisation according to comparative
advantage ma lead to too much specialisation, hich ma make countries vulnerable if the become
too dependent on e ports of these products. For e ample, if there is a fall in e ports due to a global
recession, or a fall in e port prices due to declining demand, there ill result falling revenues from
e ports, falling incomes and economic decline. Further, primar products (including agricultural
products) are subject to strong price fluctuations, hich lead to unstable e port revenues, also ith
negative impacts on the econom (see Chapter 19).

1 E plain the difference bet een absolute advantage and comparative advantage .
Outline hich of the t o concepts is a more po erful e planation of the benefits from trade.
2 Dra a diagram sho ing Oceanland s absolute advantage in shipping services and Flatland s
absolute advantage in agricultural products.
Using PPC diagrams, e plain ho Oceanland and Flatland can gain from specialisation and
trade.
3 Lakeland has an absolute advantage over Mountainland in the production of both fish and
computers, but Lakeland has a comparative advantage in fish production.
Dra a diagram sho ing the absolute and comparative advantages of the t o countries.
E plain ho Lakeland and Mountainland can gain from specialisation and trade.
4 Using the data in Table 14.1, calculate the opportunit cost of coffee and robots in Coffenia
and Robotia.
Use our results of differing opportunit costs to e plain h the theor of absolute
advantage is a special case of the theor of comparative advantage.
Ans er these questions based on the follo ing diagrams:
5
In diagram (i), identif hich of the t o countries has the absolute advantage in the
production of hich goods.
In diagram (ii), can either countr benefit from specialisation and trade? Wh or h not?
In diagram (iii), does an countr have an absolute advantage in the production of either
good?
In diagram (iii), can either countr benefit from specialisation and trade? Wh or h not? If
the can benefit, hat good should each one specialise in?
6 According to the theor of comparative advantage, outline under hat circumstances it is not
orth hile for countries to specialise and trade.
7 For each case belo ,
calculate opportunit costs for Countr A and Countr B, and determine the good in hich
each countr has a comparative advantage (if an ),
dra PPC diagrams indicating comparative advantage.
indicate hich good each countr should specialise, e port and import.
P C A C B
C A C B
8 2
2 4
8 2
6 4
1 4
2 2
6 3
3 1
1 2
2 4
8 Outline some of the unrealistic assumptions on hich the theor of comparative advantage
rests.
E plain some of the problems that countries ma run into if the specialise and trade
according to their comparative advantage.
3 This follo s from the point that t o parallel lines have identical slopes, and since the slope is the opportunit
cost of the good measured on the hori ontal a is, it follo s that opportunit costs are identical.
14.3 :
LEARNING OBJEC I E

f each f he f ll ing e f ade ec i n (i) a iff , (ii) a , (iii) b idie , (i ) e
b idie :
e lain he effec n ma ke and akeh lde (AO2)
d a diag am ill a ing effec n ice, d c i n, c n m i n, e endi e,
e en e , elfa e (AO4)
calc la e, f m diag am , effec n akeh lde (HL nl ) (AO4)
e lain admini a i e ba ie (AO2)
di c ad an age and di ad an age f (AO3)
a iff
a
b idie
e b idie
admini a i e ba ie
F
The benefi f ade and a ic la l f ee ade e e di c ed a he beginning f hi cha e . In
c n a f ee ade, in l e g e nmen in e en i n in in e na i nal ade h gh
he im i i n f ade e ic i n (ba ie ) e en he f ee en f im in a c n . Thi i
d ne ec he d me ic ec n m , a ic la l d me ic fi m and hei ke , f m f eign
c m e i i n.
A Fig e 14.1(c) h , nde f ee ade a g d i im ed hen i d me ic ice i highe han he
ld ice, indica ing ha a c n ha a c m a a i e di ad an age (i.e. i ela i el inefficien ) in
d cing he g d. We a ha hen he c n begin ade, d ce bec me e ff beca e
he a e f ced ecei e he l e ld ice and d ce a malle an i , e l ing in ed ced
d ce e en e . Thi i he ea n h d ce and hei ke f en fa ade ec i n
mea e ha ill limi he an i f im and make hem be e ff.
The ic f f ee ade e ade ec i n i highl c n e ial and ha cc ied ec n mi f
e 300 ea . In ecen decade i ha bec me ne f he m im an in e na i nal lic i e.
, al kn n a c m d ie , a e a e n im ed g d , and a e he m c mm n f m f
ade e ic i n. Ta iff ma e e e . One i ec a d me ic ind f m f eign
c m e i i n (a ec i e a iff), and he he i ai e e en e f he g e nmen (a e en e a iff).
Wha e e he a iff e, he effec n he ec n m a e he ame.
The effec f a a iff a e ill a ed in Fig e 14.6. Pa (a) h ha nde f ee ade, he c n
acce he ld ice P hich i l e han he d me ic ice Pd (HL den ma n e hi mean
he c n ha a c m a a i e di ad an age). A P i d ce an i Q1, demand an i Q4, and
im Q4 Q1. S e a a iff i im ed n he im ed g d. A a e l , the price of the imported
good rises, to P + t, ca ing he d me ic ice f he g d i e ab e he ld ice b he am n
f he a iff, P + t.
E :
A he ne ice P + t, d me ic an i lied inc ea e f m Q1 Q2, d me ic an i
demanded fall Q3, and he an i f im fall Q3 Q2. We ill n e amine h gain and
h l e f m he e change .
F 14.6: Effec f a a iff
D . D me ic d ce h ecei e he ec i n gain f m he
a iff, beca e he ecei e a highe ice, P + t, and he ell a la ge an i , Q2 ( a he han
Q1).
D . Since d me ic d ce ell a la ge
an i , hi ha he effec f inc ea ing em l men in he ec ed ind .
. The am n f e en e he g e nmen ecei e f m he
a iff i h n b he haded a ea in Fig e 14.6(a), de e mined b m l i l ing he am n f a iff
( e ni f he g d) ime he an i f im . Since he a iff i aid b c n me ( h a
he ice P + t), he g e nmen a iff e en e e e en inc me ha i an fe ed f m
c n me he g e nmen .
L
D . C n me l e f m he a iff, beca e he m a a
highe ice, P + t; and he can nl b a malle an i , Q3 ( a he han Q4).
D . The e i a nega i e im ac n inc me di ib i n,
beca e he a iff i a e f eg e i e a ( ee Cha e 12), hich b den e le n l e
inc me i na el m e han e le n highe inc me ; a inc me inc ea e , he i n
f inc me aid a a fall .
I . The inc ea e in d me ic e e en an inc ea e in
d c i n b ela i el inefficien d me ic d ce , e l ing in a a e f ca ce e ce
(inefficienc ). Remembe , he ea n h he d me ic ice bef e ade i highe han he ld
ice i ha d me ic d ce a e n a efficien a f eigne h d ce and e he ame
g d.
F . The d ce f he e ing c n ie a e e ff, beca e
he ea he ecei e he ld ice, P , f hei e , he e a malle an i , ince he
an i f im in he im ing c n i ed ced. The e ing c n ie he ef e l e
e e en e d e he fall in he an i fe .
A . The dec ea e in c n m i n, and he hif f
d c i n a a f m m e efficien f eign d ce and a d m e inefficien d me ic
d ce , indica e ha he e i an inc ea e in he mi all ca i n f e ce b h d me icall and
gl ball .
:
Fig e 14.6(b) h he effec f he a iff n c n me and d ce l . Pa (b) i iden ical
a (a), e ce ha i label he a ea in he iangle and ec angle . C n me l i he a ea nde
he demand c e and ab e he ice aid b c n me ( ee Cha e 2). Bef e he im i i n f he
a iff i incl de he a ea a + b + c + d + e + f, e e en ing he a ea nde he demand c e and ab e
he ld ice P . P d ce l bef e he a iff i he a ea g bel he ice d ce ecei e and
ab e he l c e. The ef e cial (c n me l d ce ) l i a + b + c + d + e + f + g.
Af e he a iff i im ed, c n me l d a + b, indica ing ha c n me a e e ff and
d ce l bec me c + g, ha ing inc ea ed b he am n f c, indica ing ha d ce a e
be e ff. Al , he g e nmen gain he e en e e al e. The ef e cial l af e he a iff i a
+ b + c + e + g.
T find he effec f he a iff n cial l , e can b ac l af e he a iff f m l
bef e he a iff find he diffe ence:
(a + b + c + d + e + f + g) (a + b + c + e + g) = d + f = elfare (dead eight) loss appearing as the
shaded areas in the diagram.
In effec c n me l a ea c hich a gained b d ce , e hich a gained b he g e nmen ,
a ell a d d e inefficienc in d c i n and f d e l e an i ie . The ef e, he ne l i d+
f. I e l f m a mi all ca i n f e ce ca ed b inc ea ed d c i n b inefficien d ce
(a ea d) and dec ea ed c n m i n f c n me (a ea f).

1 d a a diag am h ing he effec f a a iff n
he d me ic ice f he ec ed g d,
an i d ced d me icall ,
an i c n med b d me ic c n me ,
an i f im , and
g e nmen e en e f m he a iff.
2 U ing diag am f m e i n 1, di c he effec f a a iff n
d me ic c n me ,
d me ic d ce ,
d me ic em l men ,
f eign d ce ,
he g e nmen ,
efficienc in d c i n, and
he gl bal all ca i n f e ce .
3 In he Uni ed S a e , E ean mea , F ench ch c la e and ham enj a 100% a iff hile
helled ean enj a 131.8% a iff.4 E al a e he effec f he e a iff , aking in acc n
ai akeh lde , he d me ic ec n m , he ec n mie f e e , and he gl bal
ec n m . Make e c n ide he elfa e effec (effec n c n me l , d ce
l , and elfa e l ).
C (HL )
The a iff diag am in Fig e 14.7 i imila Fig e 14.6, nl e a e gi en n me ical da a f
ice and an i ie f a g d mea ed in milli n f ni . We ld like calc la e he
f ll ing inf ma i n:
The a iff e ni i he ld ice + a iff min he ld ice, $9 $7 = $2 e ni .
Q
Im bef e he a iff a e 2.8 milli n 1 milli n = 1.8 milli n ni . Im af e he a iff a e 2.2
milli n 1.5 milli n = 0.7 milli n ni . The ef e im fall b 1.8 milli n 0.7 milli n = 1.1
milli n ni .
Im e endi e bef e he a iff e e P ime he an i f im = $7 1.8 = $12.6
milli n b af e he a iff he fell P ime he ne an i f im = $7 0.7 = $4.9 milli n.
(N e he e ha im e endi e af e he a iff a e calc la ed ing P , n P + t, beca e he t
a f P + t i he a iff e ni hich i c llec ed b he g e nmen .)
The e a he ef e a fall in im e endi e f $12.6 $4.9 = $7.7 milli n. (M e im l he
fall in im e endi e can be calc la ed a P ime he fall in im = $7 1.1 = $7.7
milli n.)
D
The ice aid b c n me inc ea e f m $7 $9, b $2 e ni . The an i cha ed b
c n me fall f m 2.8 milli n ni 2.2 milli n ni , b 0.6 milli n ni . C n me
e endi e bef e he a iff i $7 2.8 milli n = $19.6 milli n, and af e he a iff i i $9 2.2
milli n = $19.8 milli n. The ef e c n me e endi e inc ea e . N e h e e , ha this need not
happen. I i ible f c n me e endi e fall, if he an i effec n e endi e i la ge
han he ice effec . Consumers are orse off regardless, because the must pa a higher price for a
smaller quantit .
D
The ice ecei ed b d ce inc ea e f m $7 $9, b $2 e ni . The an i d ced
al inc ea e f m 1 milli n 1.5 milli n ni , b 0.5 milli n ni . The ef e, d ce e en e
inc ea e f m $7 1 milli n ni = $7 milli n bef e he a iff $9 1.5 milli n ni = $13.5
milli n af e he a iff, b $6.5 milli n (= $13.5 milli n $7 milli n). P d ce a e be e ff.
G
G e nmen e en e f m he a iff inc ea e f m e an am n e al he a iff e ni ($2)
ime he an i f im after he a iff ha been im ed (0.7 milli n ni ). I i he ef e $2
0.7 milli n = $1.4 milli n. The g e nmen b dge he ef e gain .
C
C n me l bef e he a iff i (16.5 7) 2.8 2 = $13.3 milli n. Af e he a iff i fall (16.5
9) 2.2 2 = $8.25 milli n. The ef e c n me l fall b 13.3 8.25 = $5.05 milli n.
P d ce l bef e he a iff i (7 3) 1 2 = $2 milli n, hile af e he a iff i inc ea e (9
3) 1.5 5 = $4.5 milli n. The ef e d ce l inc ea e b $4.5 $2 = $2.5 milli n.
Welfa e l can be calc la ed a he a ea f he haded iangle : [ (9 7) (1.5 1) 2 ] + [ (9

7) (2.8 2.2) 2 ] = 0.5 + 0.6 = $1.1 milli n.
F
E f f eign d ce he c n ha im e he a iff fall b an am n e al he fall
in he c n im , calc la ed ab e be 1.1 milli n ni . E e en e f he f eign
d ce fall b an am n e al he fall in he an i fe (1.1 milli n ni ) ime he
ld ice ($7), hich i $7.7 milli n (= $7 1.1 milli n). N e ha hi i he ame a he fall in
im e endi e calc la ed ab e. The ef e f eign d ce a e e ff.
F 14.7: Calc la ing he effec f a a iff

1 Wi h n ade, he ice f c m e in Lakeland a $400 e c m e . Unde f ee ade,
he ice f c m e in Lakeland a $300 e ni ; d me ic c m e d c i n a 100
000 ni e ea and im d a 250 000 ni e ea . F ll ing he im i i n b
he g e nmen f a $50 e ni a iff n c m e , d me ic d c i n inc ea ed 200
000 ni and im fell 70 000 ni . U ing he c nce f c m a a i e ad an age and
he ice f c m e in Lakeland nde n ade and nde f ee ade, e lain h
Lakeland i an im e f c m e . Calc la e
ing he ne ice aid b c n me ,
calc la e he ne ice ecei ed b d me ic d ce ,
al d me ic c m e ale bef e he a iff, and
al d me ic c m e ale af e he a iff.
2 U ing e l in e i n 1, calc la e he f ll ing effec f he im i i n f he $50
e ni a iff n c m e :
change in c n me e endi e,
change in im e endi e,
change in d me ic d ce e en e,
change in he g e nmen e en e,
change in f eign d ce an i fc m e e Lakeland,
change in f eign d ce e e en e f m c m e e Lakeland,
change in c n me l ,
change in d ce l , and
elfa e l . (Y ma find i ef l e a a iff diag am d calc la i n . The
diag am d e n ha e be d a n cale.)
I
An ( m e im l , ) i a legal limi he an i f a g d ha can be im ed
e a a ic la ime e i d ( icall a ea ). The effec f a a e imila he effec f a iff ,
e ce ha he all d n c ea e e en e f he g e nmen .
Fig e 14.8(a) h he effec f an im a. S e ini iall he ec n m i im ing nde
f ee ade; an i Q1 i lied b d me ic d ce , an i Q4 i demanded, and he e ce f
an i demanded e an i lied, Q4 Q1, e e en im . (HL den ma n e ha a in
he ca e f a iff , he c n ha a c m a a i e di ad an age ince P lie bel he d me ic ice
ih ade.) The g e nmen hen decide im e a a n im , limi ing he an i ha can
be legall im ed Q3 Q2. Thi mean ha a ne l c e i c ea ed b he addi i n f he
am n f he a d me ic l . In he d , f each ice, he an i ha i a ailable be
cha ed b d me ic c n me i e al he an i d ced b d me ic d ce ( h n b
he d me ic l c e Sd) l he an i f im e mi ed b he a. In Fig e 14.8(a), he
ne , af e - a l c e i h n b Sd . Sd begin a ice P , indica ing ha i i n ible
im he g d a a ice l e han P (a n f eign d ce ld ell a a ice l e han P ).
The ne e ilib i m d me ic ice i de e mined b he in e ec i n f he d me ic demand c e i h
Sd , and i P .
When he g e nmen e a a, i i e a limi ed n mbe f im licence de e mining he legal
limi n he an i f im . The h lde f he e licence a e he nl indi id al i h he legal
igh im . The e licence h lde gain a e en e (al kn n a a en ) beca e
he ea he b he g d a he ld ice P , he ell i c n me a he highe d me ic ice
P . U all , he g e nmen gi e he licence g e nmen f e ing c n ie , hich hen
di ib e hem hei n d ce e e , h b a he ice P and ell a P . A a e l ,
he e e ( d ce ) f e ing c n ie ecei e he a e en e .5 Beca e f hi , f eign
g e nmen / d ce efe ha ing a a he han a iff im ed n hei e .
E :
Wi h he e ce i n f h ge he a e en e, and elfa e l , he effec f an im a a e he
ame a in he ca e f a a iff.
A he ne l c e, Sd , d me ic d c i n inc ea e Q2, d me ic an i demanded fall
Q3, and he an i f im fall Q3 Q2.
D . A in he ca e f a a iff, d me ic d ce h ecei e he
ec i n gain f m he a, a he ecei e a highe ice, P , and he ell a la ge an i , Q2
( a he han Q1).
D . A in he ca e f a a iff, d me ic em l men in he ec ed
ind inc ea e ince d ce inc ea e he an i f he d ce.
N
. Since he g e nmen all gi e he im licence
f eign g e nmen , he g e nmen b dge i n affec ed.
L
D . A in he ca e f a a iff, c n me l e f m he a,
beca e he m a a highe ice, P , and he can nl b a malle an i , Q3 ( a he han
Q4).
D . Q a d n in l e a a in he ame a ha a iff
d ; h e e , he d e l in a highe ice, and he diffe ence P P , he inc ea e in ice,
ha he ame effec a he a iff in ha i i eg e i e. In he d , he am n P P
e e en a highe f ac i n f inc me hen inc me i l . The ef e a ha e he effec f
ening he di ib i n f inc me.
I . A in he ca e f a iff , he e e l an inc ea e in
d ci nb ela i el inefficien d me ic d ce .
. A in he ca e f a a iff, he d ce
f he e ing c n ie e a malle an i , e l ing in a l fe e en e . H e e ,
ince he e ing c n ie ecei e he im licence , he gain he a e en e . The ef e,
he he he ill be e ff be e ff de end n hich i la ge : he l fe e en e
he gain f a e en e .
A . The dec ea e in c n m i n, and he hif f
d c i n a a f m m e efficien f eign d ce and a d m e inefficien d me ic
d ce indica e ha he e i an inc ea e in he mi all ca i n f e ce gl ball , affec ing
b h c n me and d ce .
:
The effec f a n c n me and d ce l a e h n in Fig e 14.8(b), hich i he ame
a a (a) a a f m he labelling f he a ea . The elfa e effec f a diffe f m h e f a iff
beca e f a en hich a e l he d me ic ec n m ( he ea a iff e en e c me back
cie d e g e nmen ending n me i g d ). Bef e he a, c n me l i he a ea a +
b + c + d + e + f, and d ce l b a ea g. Af e he a, c n me ha e l e al a ea a
+ b, and d ce ha e l e al g + c. A ea d and f ha e been l a elfa e l , d e
inefficiencie in d c i n (a ea d) and ed ced c n m i n (a ea f). A ea e e e en a e en e
ha i an fe ed ab ad e ing c n ie . The ef e, he al l l d e he ai d+e
+ f. The ef e, a e l in g ea e elfa e l e f he d me ic ec n m han a iff .
F 14.8: Effec fa a
A
While i i ela i el aigh f ad nde and a iff and hei diag am , a can me ime be a
li le c nf ing. H e e , he al bec me e aigh f a d and im le nde and if ne ake
he f ll ing idea in c n ide a i n.
Ta iff and a ae diffe en a f achie ing he ame e l , hich i a lo er quantit of
imports and a higher domestic price. Ta iff k b inc ea ing he ice f im , and hen all ing
demand and l a i e a he ne , l e , an i f im .Q a k b e ic ing he
an i f im , and hen all ing demand and l a i e a he ne , highe , ice f im .
Thi i h he effec f a iff and a a e he ame ( i h he e ce i n f a en and hence
elfa e l ).
Thi i al h he diag am a e e imila . The follo ing simple instructions ill sho ou ho
to convert a tariff diagram into a quota diagram. D a a a iff diag am a in Fig e 14.6(a), hich i
e d ced b he g een line in Fig e 14.9.
1 Dele e he i n f he P + t c e ha lie he igh f he Dd c e ( he i n ha i
c ed i h ed line ).
2 A he in he e Dd in e ec P + t, d a a line a allel he Sd c e P and label i
Sd ; hi a ea a a bl e line in Fig e 14.9.
F 14.9: C n e ing a a iff diag am in a a diag am
Y n ha e all he line f he a diag am ha a e needed. I i nl nece a n d me e-

labelling.
3 C P + t and e-label he ice P .
4 W i e in a be een he l c e a in Fig e 14.8.
You no have a quota diagram that is identical to the quota diagram in Figure 14.8.

1 D a a diag am h ing he effec fa a n
he d me ic ice f he ec ed g d,
an i c n med b d me ic c n me ,
an i f im , and
a e en e.
2 U ing diag am f m e i n 1, and a ming he g e nmen gi e a licence
f eign fi m , anal e he effec f a a n
d me ic c n me ,
d me ic d ce ,
d me ic em l men ,
f eign d ce (Hint: ake in acc n l fe e en e and gain f a
e en e),
he g e nmen ,
3 Wha i he main diffe ence be een he effec f a a iff and a a?
E lain h f eign d ce a e likel efe a a iff .
E lain h a iff a e efe able f m he in f ie f he c n ha im e ade
ec i n mea e .
4 The E ean Uni n im e a n beef, acc ding hich i di ib e licence ce ain
e ing c n ie f 6
ecific beef an i ie . E al a e he effec f ch a aking in
acc n a i akeh lde , he d me ic ec n m , he ec n mie f e e , and he gl bal
ec n m . Make e c n ide he elfa e effec (effec n c n me l , d ce
l , and elfa e l ).
C (HL )
The a diag am in Fig e 14.10 i imila Fig e 14.8, nl e a e gi en n me ical da a f
ice and an i ie f a g d mea ed in milli n f ni . We ld like calc la e he
I
The im a can be ead ff a 16 milli n 11 milli n = 5 milli n ni , i.e. hi i he
e mi ible n mbe f ni ha can en e he c n e ime e i d ( ch a a ea ).
The ice aid b c n me and ecei ed b domestic d ce inc ea e f m 10 14.
Q
Im fall f m = 15 milli n ni (= 20 5) bef e he a 5 milli n ni (= 16 11) af e he
a ( hi i he n mbe f ni e mi ed b he a). The ef e, im fall b 10 milli n ni .
Im e endi e bef e he a e e P ime he an i f im = 10 15 = $150 milli n
and af e he a he e e P ime he ne l e an i f im = 10 5 = $50 milli n.
The ef e im e endi e fell b $100 milli n (= 150 50). M e im l he fall in im
e endi e can be calc la ed a P ime he fall in im = 10 10 = $100 milli n.)
D
The ice aid b c n me inc ea e f m 10 14, b 4 e ni . The an i cha ed
b c n me fall f m 20 milli n ni 16 milli n ni , b 4 milli n ni . C n me
e endi e bef e he a i 10 20 milli n = 200 milli n, and af e he a i i 14 16
milli n = 224 milli n. The ef e, c n me e endi e inc ea e . N e h e e , ha a in he ca e
f a iff , this need not happen. C n me a e e ff beca e he m a a highe ice f a
malle an i .
D
The ice ecei ed b d ce al inc ea e f m 10 14, b 4 e ni . The an i
d ced inc ea e f m 5 milli n 11 milli n ni , b 6 milli n ni . The ef e, d ce
e en e inc ea e f m 10 5 milli n ni = 50 milli n bef e he a 14 11 milli n ni
= 154 milli n af e he a, b 104 milli n (= 154 milli n 50 milli n). P d ce a e
be e ff.
The g e nmen b dge i n affec ed.
C
C n me l bef e he a a (30 10) 20 2 = $200 milli n, hile af e he ai
d ed (30 14) 16 2 = $128 milli n. The ef e c n me l fell b $200 $128 = $72
milli n.
P d ce l bef e he a a (10 7) 5 2 = $7.5 milli n. Af e he a i inc ea ed
(14 7) 11 2 = $38.5 milli n. The ef e d ce gained l f $38.5 $7.5 = $31 milli n.
Welfa e l in he ca e f a diffe f m he ca e f a iff beca e f he a en ha a e

an fe ed ab ad he e ing c n ie . The ef e elfa e l i e al he a ea d + e + f in
Fig e 14.8(b). A ea d = (14 10) (11 5) 2 = $12 milli n + a ea e = (14 10) (16 11) = $20
milli n + a ea f = (14 10) (20 16) 2 = $8 milli n making a al elfa e l f $40 milli n.
A ea d + e + f f m a a e i m hich can be m e ea il calc la ed b m l i l ing he a e age f
he a allel ide b he heigh . Thi gi e (5 + 15) 2 4 = $40 milli n.
(Calc la i n f he a ea f a a e i m a e lained in Cha e 2.)
F
E f f eign d ce he c n im ing he a fall b an am n e al he fall in
he c n im , calc la ed ab e be 10 milli n ni . E e en e f he f eign
d ce fall b an am n e al he fall in he an i fe (10 milli n ni ) ime he
ld ice ( 10), hich i 100 milli n (= 10 10 milli n). H e e , ince he f eign d ce
ecei e he a e en e (b ecei ing he a licence ), he gain 20 milli n (e al he
inc ea e in ice e ni d e he a, 4, ime he n mbe f ni all ed b he a, 5
milli n). The ef e hei l e a e 80 milli n (= 100 milli n 20 milli n). (I i ible f he
gain f m a e en e be g ea e han he l fe e en e , ha f eign d ce
c ld be be e ff i h he a han i h i .)
F 14.10: Calc la ing he effec f an im a

1 Unde f ee ade, he ice f m bile h ne in Lineland i 100 e ni ; d me ic ale a e
700 000 ni e ea , f hich 500 000 ni a e im ed. F ll ing he im i i n f an
im a f 200 000 ni e ea , d me ic ale fall 500 000 ni e ea , and he
ice inc ea e 120 e ni . Find he an i f m bile h ne d ced d me icall
bef e he a, and
af e he a.
Wha i he an i f im af e he a?
Da a a diag am l ing he e fig e .
2 U ing e l in e i n 5, calc la e he
change in d ce e en e,
a e en e,
change in f eign d ce an i f m bile h ne e Lineland,
change in f eign d ce e e en e f m m bile h ne e Lineland,
elfa e l . (Y ma find i ef l ea a diag am d calc la i n .)
3 A ming ha a e en e a e gained b f eign d ce , e lain
he effec n he g e nmen b dge , and
he al gain /l e f f eign d ce , aking in acc n b h e e en e and
a e en e .
REAL ORLD FOC 14.1

Q
I
A e ill ee la e in hi cha e , hen ade i e ic ed he e ma be f he nega i e effec ha
e end be nd he ec ed ind in he en i e ec n m . One f he e i inc ea ed c f
d c i n ha a i e hen a ec ed g d i ed a an in in d c i n, he e highe ice d e
a iff lead c - h infla i n, a cia ed j b l e and l fe c m e i i ene . In
addi i n, ec i n b ne c n ma lead e alia i n b he c n ie .
F 14.11: Jeane e e, L i iana, USA. S ga cane d c i n fac
The ga ind in he Uni ed S a e ha been ecei ing ec i n ince 1789. One f he fea e
f ec i n i im a , hich e ic he an i f im . The im c me f m 40
c n ie , each f hich i i ed a a licence ecif ing h m ch ga he can e he
Uni ed S a e .
The e l f he an i e ic i n i ai e he d me ic ice f ga ab d ble he ld
ice. Thi k inc ea e d me ic ga d c i n, hile m e efficien ga fa me in
de el ing c n ie a e de i ed f e ma ke and e e en e . Of al US ga
c n m i n, 80% i d ced d me icall and 20% i im ed.
The im a ae ed b US ga fa me , h gh he n again he in e e f US
c n me h m a he highe ice, a ell a c nfec i ne and da make h e ga a
an in .
The g amme ha nega i e e all em l men effec . While j b a e c ea ed in he ga -
d cing ind , man m e a e l in he ind ie ha el n ga . Acc ding he Ame ican
En e i e In i e, ab 10 000 20 000 j b a e l each ea . A n mbe f cand fac ie ha e
el ca ed Me ic e he ea a he f nd he e e n fi able in he Uni ed S a e .
The e a e al en i nmen al c in l ed. O e half f ga c me f m ga bee , g n n
e fe ile i iga ed land ha c ld ha e been ed f he c . The e f he ga c me f m
ga cane ha e la ge am n f ni gen and he fe ili e , i h e i effec n he a e
ali and na al ec l g f he egi n he e he a e g n.
: Jenn Grimberg, The Cost of Protecting the United States Sugar Industr ; Vincent H.
Smith, The U.S. Spends $4 billion a ear subsidi ing Stalinist-st le domestic sugar
production , Market Watch, 26 June, 2018,
A
1 U ing a a diag am, e lain h US ga d ce he im a.
2 U ing an AD-AS diag am, e lain h he a ha e nega i e e all effec n em l men .
3 E lain ha kind f nem l men ha been c ea ed b he el ca i n f me c nfec i ne
fac ie Me ic .
4 U e an a ia e e e nali diag am e lain he en i nmen al c f ga d c i n.
5 U ing a diag am, e al a e he effec f he ga im a n ai akeh lde , he US
ec n m and ga -e ing c n ie .
6 E al a e he e f ga im a in he Uni ed S a e .
P
Subsidies e e in d ced in Cha e 4, he e e a ha a b id i a a men b he g e nmen
a fi m f each ni f d ced. In he c n e f ade ec i n he e a e kind f
b idie . One i in ended ec d me ic fi m ha c m e e i h im , called a d ci n
b id , ha e c n ide in hi ec i n; he he i a b id in ended ec d me ic fi m ha
e , called an e b id . hich e ill c n ide in he ne ec i n.
In he c n e f ade ec i n, production subsidies a e a men e ni f g an ed b he
g e nmen d me ic fi m ha c m e e i h im . In Fig e 14.12 (a), nde f ee ade, he
c n ld d ce an i Q1 f he g d, an i demanded ld be Q2, and e ce demand f
Q2 Q1 ld be a i fied b im .N e he g e nmen g an a b id d me ic fi m
e ni f d ced. We kn f m Cha e 4 ha he b id ca e he d me ic l c e
hif d n a d b he am n f he e ni b id , Sd . The g d c n in e ell d me icall
a he ld ice, P , h gh he ice ecei ed b d ce i n P + s.
E :
The d me ic fi m l he la ge an i Q3, de e mined b he in e ec i n f he af e - b id
l c e Sd i h he ld ice line. A a e l an i f im fall f m Q2 Q1 Q2 Q3.
D . A a e l f he b id , d me ic d ce in he ec ed
ind ecei e he ice P + (= P l he b id e ni ), and d me ic d c i n e and
f m Q1 Q3; he ef e d ce benefi .
D . The inc ea e in d me ic d c i n f m Q1 Q3 ca e
d me ic em l men in he ec ed ind inc ea e.
N
C . C n m i n f he g d b h bef e and af e he b id i a Q2
ni f , and he ice a he ame, a P . (F ll ing he im i i n f he b id ,
c n me b m e f he d me ic g d h e d c i n ha inc ea ed, and le f he im ed
g d.)
L
. The g e nmen b dge i nega i el affec ed a he g e nmen m
end a e en e n he b id . The am n en n he b id i P + s P ( he b id
e ni ) ime Q3, he an i d ced d me icall .
. Ta a e l e a a i n f a e en e i en n d ci n
b idie ha ha e he effec f inc ea ing d c i n f inefficien d ce . The am n l i
ha i en n he b id f he g e nmen b dge ( ee ab e). The e f nd c ld ha e
been en el e he e i h benefi f a a e ( ch a ending n me i g d ).
I . A in he ca e f a iff and a, d c i n f d me ic
inefficien d ce inc ea e , hile he d c i n f m e efficien f eign d ce fall .
. F eign d ce e ing he g d a e e ff
beca e he can e le f he g d, and e e en e f he e c n ie fall.
A . The hif f d c i n f m efficien inefficien
d ce in l e an inc ea e in he gl bal mi all ca i n f e ce , nega i el affec ing
ec n mie .
I h ld be n ed ha he b idie di c ed he e a e g an ed n g d ha a e d ced f he
d me ic ma ke , a he en i e an i d ced i ld d me icall . The bjec i e f ch b idie , a
e ha e een, i ai e he d me ic ice d ce and inc ea e hei an i lied, h
dec ea ing he an i f im , he ef e iding ec i n d ce (and hei ke ).
I i ible, h e e , if he b id i e la ge, f d ce inc ea e hei d ci nb m ch
ha an i lied bec me g ea e han all f d me ic an i demanded. In hi ca e, he e ce
f an i lied e an i demanded ld be e ed. A highe c c n bec me an
e e , i h an e en g ea e d me ic and gl bal mi all ca i n f e ce .
Fig e 14.12(a) al h he effec f d c i n b idie n c n me and d ce l .

C n me l i n affec ed, ince b h ice aid and an i b gh b c n me ha e n
changed. P d ce , n he he hand, gain l gi en b he a ea a d e he highe ice he
ecei e and he la ge an i he ell. H e e , he g e nmen l e he a ea (P + s P ) Q3 = a
+ b, d e g e nmen ending ide he b id . The ef e b b ac ing ha i l d e
g e nmen ending f m ha i gained b d ce , e find a ne l cie f he haded a ea
b.
F m an efficienc in f ie he effec f d c i n b idie ma n be a ha mf l a h e f
a iff and a , beca e hile he enc age inefficien d c i n (like a iff and a ) he d
n ha e nega i e effec n c n m i n hich emain he ame bef e and af e he b id . Thi can
be een f m he l f nl d ce l in Fig e 14.12(a).
F 14.12: Effec fa d ci n b id

1 D a a diag am h ing he effec fa d ci n b id n
he d me ic ice f he b idi ed g d,
an i c n med b d me ic c n me , and
an i f im .
2 U ing diag am f m e i n 1, e lain he effec fa d ci n b id n
d me ic c n me ,
d me ic d ce ,
d me ic em l men ,
f eign d ce ,
he g e nmen ,
3 The US g e nmen end m e han $20 billi n a ea n b idie f ag ic l al d c ,
man f hich a e e ed in addi i n being ld in he d me ic ma ke . E al a e he effec
f ch d c i n b idie , aking in acc n a i akeh lde , he d me ic ec n m ,
he ec n mie f e e and he gl bal ec n m .
4 Ec n mi gene all efe d ci n b idie a iff and a . U ing a b id diag am
e lain hei ea ning.
C
(HL )
The b id diag am in Fig e 14.12(b) i imila Fig e 14.12(a), nl e a e gi en n me ical
da a f ice and an i ie f a g d mea ed in milli n f ni . We an calc la e he
The b id e ni i he e ical diffe ence be een he l c e, 9 5= 4 e

ni .
Q
Im bef e he b id a e 425 h and ni (= 500 75). Im af e he b id a e 325
h and ni (= 500 175). The ef e im fall b 100 h and ni (= 425 325). Im
e endi e fall b he dec ea e in im (100 h and ni ) ime he ld ice ( 5) = 500
h and.
D
C n me a e n affec ed. The a he ame ice, 5, and he b he ame an i , 500
h and ni bef e and af e he b id .
D
The ice ecei ed b d ce inc ea e f m 5 9, b 4 e ni , hich i he b id e
ni . The an i d ced al inc ea e f m 75 175 h and ni , b 100 h and ni .
The ef e d ce e en e inc ea e f m 5 75 = 375 h and bef e he b id 9 175 =
1575 h and af e he b id , b 1200 milli n (= 1575 375). P d ce a e be e ff.
G
G e nmen e endi e n he b id inc ea e f m e an am n e al he b id e
ni ( 4) ime he an i d ced d me icall after he b id ha been g an ed (175 h and
ni ). I i he ef e 4 175 = 700 h and. The g e nmen b dge he ef e l e . Ta a e
ae e ff b he e i alen am n , a hei a f nd a e en n b iding inefficien d ce
i h n benefi hem el e .
C
C n me b he ame an i a he ame ice bef e and af e he d c i n, c n me l
emain nchanged a (19 5) 500 2 = 3500 h and.
P d ce l ini iall bef e he d c i n b id a (5 2) 75 2 = 112.5 h and. Af e
he b id i i (9 2) 175 2 = 612.5 h and. The ef e d ce l inc ea e b 612.5
112.5 = 500 h and.
Welfa e l i he iangle gi en b (9 5) (175 75) 2 = 200 h and.
F
E f f eign d ce he c n g an ing he b id fall b an am n e al he fall in
he c n im ( hich i al e al he inc ea e in d me ic d c i n), calc la ed ab e
be 100 h and ni . E e en e f he f eign d ce fall b an am n e al he fall in
he an i f im (100 h and ni ) ime he ld ice ( 5), hich i 500 h and.
(N e ha hi i e al he fall in im e endi e n ed ab e.) The ef e f eign d ce
ae e ff.

1 Wi h n ade, he ice f ele i i n in Radi land a 300 e ele i i n. Unde f ee ade,
he ice f ele i i n in Radi land a 200 e ni ; d me ic ele i i n d ci n a
300 000 ni and d me ic ele i i n ale e e 900 000 ni . F ll ing he im i i n f a
50 e ni b id n ele i i n , d me ic d c i n inc ea ed 550 000 ni .
U ing he c nce f c m a a i e ad an age and he ice f ele i i n nde n ade
and nde f ee ade, e lain h Radi land i an im e f ele i i n .
S a e/calc la e he
- b id ice aid b c n me ,
- b id ice ecei ed b d me ic d ce ,
e- b id an i f im ,
- b id an i f im , and
- b id ele i i n ale .
2 U ing e l in e i n 1, a e/calc la e he
change in he g e nmen b dge ,
change in f eign d ce an i f ele i i n e Radi land,
change in f eign d ce e e en e f m ele i i n e Radi land,
elfa e l . (Y ma find i ef l ea b id diag am d calc la i n .
Thi d e n ha e be d a n cale.)
E
E a e imila d c i n b idie in ha he in l e a a men b he g e nmen
e ni f he b idi ed g d, e ce ha n the subsid is paid for each unit of the good that is
e ported. E b idie a e ill a ed in Fig e 14.13, h ing an e ing c n ha cceed in
inc ea ing i l me f e b g an ing an e b id .
F 14.13: Effec f an e b id
We ee ha bef e ade he ld ice P i highe han he d me ic ice (gi en b he in e ec i n

f d me ic demand Dd and d me ic l Sd), e kn ha nce he c n en i elf
ade, i bec me an e e f he g d. A he ld ice P d me ic an i demanded i Q1,
d me ic an i lied i Q2, and Q2 Q1 e e en he an i fe .
The g e nmen n decide g an an e b id e ni f he g d e ed in de
inc ea e he an i fe . The l c e hif d n a d b he am n f he b id e ni
S . A he in e ec i n f S i h he ld ice line P , e d a a e ical line a d find he
ne highe d me ic ice, P + , hich i e al he ld ice P l he b id e ni . A he
highe ice P + , d ce inc ea e he an i he l Q4, hile c n me dec ea e he
an i he demand Q3. The an i Q4 Q3 n e e en e . The ice aid b f eigne
emain a he ld ice, P . In he d , the higher domestic price P + applies onl to domestic
producers and consumers.
(Y ma n ice ha i h an e b id , c n me a he highe ice f P + , in c n a
d c i n b idie he e he ice aid b c n me emain nchanged a P . Thi i beca e he
e b id ha he effec f ed cing he an i f he g d a ailable in he d me ic ma ke f m
Q1 Q3, h e l ing in an inc ea e in ice (an a d m emen al ng he demand c e). B
c n a , iha d c i n b id g an ed in a c n ha i im ing he g d, he inc ea e in he
an i f im a i fie he f ll am n f d me ic an i demanded a he ld ice P ,
he ef e he e i n hing h he ice .)
E :
We n e amine h gain and h l e f m he e b id .
P . P d ce ecei e a highe ice, P + , and ell a la ge an i , Q4

a he han Q2, ince he l me f e inc ea e f m Q2 Q1 Q4 Q3.
D . The inc ea e in d me ic d c i n ca e d me ic
em l men inc ea e.
L
C . C n me m a a highe ice f he g d, P + , and he
c n me a malle an i , Q3 a he han Q1.
N . The g e nmen m a f he b id an am n
hich i e al he b id e ni ime he an i fe .
. Ta a e m a indi ec l f he b id , a he b id i financed
f a e en e ; m e e he l e b n ha ing he b id f nd a ailable f al e na i e
e ( ch a me i g d ).
D . The ea n f he ening f inc me di ib i n i he
ame a in he ca e f a . While he e i n eg e i e a (a in he ca e f a iff ), c n me
d ha e a a highe ice d e he e b id , and he inc ea e in ice, e e en ed b P
+ P , i eg e i e beca e i i a highe f ac i n f l e inc me han f highe inc me .
I . A in he ca e f all ade ec i n c n ide ed ( a iff ,
a, d ci n b idie ) inefficien d me ic d ce a e ec ed b he highe ice.
. F eign d ce a e e ff a he l e a ha e f
hei gl bal ma ke h gh he inc ea e in b idi ed e , and hei e e en e fall.
. C n me and d ce a nd
he ld a e nega i el affec ed ince he inefficienc f e ce all ca i n a nd he ld
inc ea e . In fac , he nega i e effec f e b idie can be e e i . Real ld f c 14.2
ide m e de ail ab he e effec .
:
Fig e 14.13(a) h he elfa e effec f he e b id . C n me l e a ea a + b d e he
highe ice he m a and he l e an i he b . P d ce gain a ea a + b + c a he a e
n ecei ing a highe ice and d cing a la ge an i . The g e nmen l e a ea b + c + d,
hich i he am n he m a f he b id , e al he b id e ni ime he an i f
e , Q4 Q3. The ef e he ne l cie i e al he gain f d ce min he l e f
c n me l he g e nmen = (a + b + c) (a + b) (b + c + d) = (b + d). Welfa e l cie
c ni f he haded iangle , b and d.
N e ha he elfa e l f me b idie a e g ea e han h e f d ci n b idie , beca e
ihe b idie n nl d ce b al c n me a e e ff.

1 D a a diag am h ing he effec f an e b id n
he d me ic ice f he b idi ed g d,
an i c n med b d me ic c n me , and
an i fe .
2 U ing diag am f m e i n 1, di c he effec f an e b id n
d me ic c n me ,
d me ic d ce ,
d me ic em l men ,
f eign d ce ,
he g e nmen ,
3 India ide e b idie f a n mbe f d c incl ding ha mace ical , chemical ,
inf ma i n echn l g d c , e ile and a a el. Acc ding he WTO nl c n ie
i h GNI e ca i a le han $1000 can e e b idie , and India d e n alif .7
E al a e he effec f ch e b idie , aking in acc n a i akeh lde , he
d me ic ec n m , he ec n mie f e e and he gl bal ec n m .
C (HL
)
The b id diag am in Fig e 14.13(b) i imila Fig e 14.13(a), nl e a e gi en n me ical
da a f ice and an i ie f a g d mea ed in milli n f ni . We an calc la e he
The b id e ni i he e ical diffe ence be een he l c e, 16 12 = 4 e

ni .
Q
E bef e he b id a e 125 h and ni (= 325 200). E af e he b id a e 350
h and ni (= 450 100). The ef e, e inc ea e b 225 h and ni (= 350 125).
E e en e inc ea e b he inc ea e in e (225 h and ni ) ime he ld ice ( 12)
= 2700 h and.
D
C n me a a highe ice, 16 a he han 12 and he b a malle an i , 100 h and
a he han 200 h and ni . C n me e endi e bef e he b id a 12 200 = 2400
h and he ea af e he b id i i 16 100 = 1600. (A n ed ab e he he c n me
e endi e inc ea e dec ea e de end n he he he ice he an i dec ea e i la ge .)
D
The ice ecei ed b d ce inc ea e f m 12 16, b 4 e ni , hich i he b id e
ni . The an i d ced al inc ea e f m 325 450 h and ni , b 125 h and ni .
The ef e d ce e en e inc ea e f m 12 325 = 3900 h and bef e he b id 16
450 = 7200 h and af e he b id , b 3300 h and (= 7200 3900). P d ce a e
be e ff.
G
G e nmen e endi e n he b id inc ea e f m e an am n e al he b id e
ni ( 4) ime he an i fe (350 h and ni ). I i he ef e 4 350 = 1400 h and.
The g e nmen b dge he ef e l e . Ta a e a e e ff b he e i alen am n , a hei
a f nd a e en n b iding inefficien d ce ihn benefi hem el e .
C
Consumer surplus falls from (20 12) 200 2 = 800 (20 16) 100 2 = 200 h and d e
he e b id .
P d ce l ini iall bef e he e b id a (12 2) 325 2 = 1625 h and. Af e he
e b id i i (16 2) 450 2 = 3150 h and. The ef e, d ce l inc ea e b 3150
1625 = 1525 h and.
Welfa e l i gi en b he haded iangle gi en b [ (16 12) (200 100) 2 ] + [ (16 12)

(450 325) 2 ] = 200 + 250 = 450 h and.
1 Wi h n ade, he ice f fi h in Oceanland a $2 e kil g am (kg). Unde f ee ade, he

ice f fi h a $3 e kg, Oceanland fi h d c i n a 700 000 kg and fi h
c n m i n a 400 000 kg. Af e he g e nmen g an ed an e b id f $1 e kg,
Oceanland fi h d c i n inc ea ed 900 000 kg hile fi h c n m i n fell 250 000
kg.
U ing he c nce f c m a a i e ad an age and he ice f fi h nde n ade and
nde f ee ade, e lain h Oceanland i an e e f fi h.
Calc la e
he - b id ice aid b d me ic c n me ,
- b id ice ecei ed b d me ic d ce ,
e- b id an i fe , and
- b id an i fe .
2 U ing he inf ma i n and e l in e i n 1, a e/calc la e he
change in e e en e,
change in he g e nmen b dge ,
elfa e l . (Y ma find i ef l ea b id diag am d calc la i n .
Thi d e n ha e be d a n cale.)
REAL ORLD FOC 14.2

E :A O
Note: The World Trade Organi ation (WTO) is an international organisation responsible for
overseeing the international trade s stem. We ill e amine the WTO in Chapter 15.
E b idie im ed b de el ed c n ie n hei ag ic l al d c ha e been la
b h in de el ed b al in de el ing c n ie . F de el ed c n ie , he ea n i b i :
fa me clea l benefi a he ecei e a highe ice f he d c , and d c i n inc ea e a he
an i fe g e . T nde and he ea ning f m he in f ie f de el ing
c n ie , e m g a li le be nd m del f e b idie f Fig e 14.13.
F 14.14: Gene a, S i e land. W ld T ade O gani a i n (WTO) head a e
In anal i f ade ec i n, e ha e made he im lif ing a m i n ha he im ing

e ing c n i mall ha i cann make an im ac n he ld ice. H e e , in he eal
ld e f en deal i h c n ie ch a he Uni ed S a e , g f c n ie ch a he
E ean Uni n, hich a e e la ge. Thei ha e f ade i me ime la ge ha he d ha e an
im ac n he ld ice. In he ca e f US and EU e , he an i ie e ed a e me ime
la ge ha he f en ha e he effec f l e ing he ld ice. The ef e, e b idie im ed
b la ge c n ie , b inc ea ing e , ha e he effec ff he l e ing he ld ice, and
hence he ice f im in de el ing c n ie .
The e l e im ice ha e e diffe en effec n c n me and d ce in de el ing
c n ie . C n me a e be e ff, beca e he can b f d m e chea l . B d ce a e h
beca e he a e f ced c m e e i h l e iced im . Thi l e hei incen i e d ce,
d c i n fall , i l e hei e en e , i l e hei anda d f li ing, and in man ca e
f ce hem g f b ine . T make ma e e, hi lead he c n g ing eliance
n f d im , hich i ha dl de i able in c n ie ha me ime ffe f m ch nic f d
h age .
In ie f hi , h did de el ing c n g e nmen like de el ed c n e b idie ? I
i beca e he an ed chea im ed f d kee c n me ha . F d i an im an li ical
i e in man c n ie and high f d ice can ca e cial and li ical n e .
The e i an i n in ha ich c n lic -make ca ed m e ab fa me h a e a in f ac i n
f he la i n, acc n ing f ab 2 4% f em l men in he Uni ed S a e and E ean
Uni n, hile de el ing c n lic -make ca ed le ab fa me h c m i e a m ch a
40 60% ( m e) f al em l men .
We can ee clea l ha e b idie ha e highl damaging effec beca e he :
ed ce c m e i i ene f de el ed c n fa me h gh a ificiall l ice
all inefficien ich c n fa me gain ma ke ha e in he ag ic l al ec f
c n ie
ed ce anda d f li ing f c n fa me
ed ce f d d c i n and f d ec i in c n ie hile inc ea ing eliance n im .
A a WHO c nfe ence held in Nai bi in Decembe 2015, an ag eemen a eached elimina e
e b idie . Thi a hailed a a g ea cce and a l ng e d e c me f WHO
neg ia i n . Whe ea he GATT, he ec f he WTO, had hibi ed e b idie (a ell
a im a ) n man fac ed d c , i had e mi ed hem f ag ic l al d c d e
e e f m de el ed c n ie e nding he ecial in e e f hei fa me .
A he ame ime ha de el ed c n ie ha e ha ed hei e b idie , he e ha e beg n
be a lied b a n mbe f de el ing c n ie , f e am le China f c n, India f ga , and
Vie nam and Thailand f ice. S me de el ing c n ie bjec he WTO hibi i n f e
b idie , a g ing ha de el ing c n ie h ld be e cl ded f m he hibi i n.
: Hein Strubenhoff, The WTO s decision to end agricultural e port subsidies is good ne s for farmers
and consumers , Brookings, Kimberl Ann Elliot, The WTO, Agriculture and Development: A Lost Cause?
International Centre for Trade and Sustainable Development, Bridges Africa, Volume 7, Number 1,
A
1 U ing demand and l anal i , e lain he effec ha inc ea e fe b la ge c n ie
can ha e n he ld ice f a g d.
2 ing he inf ma i n in he e , e lain h e b idie a e en iall m e ha mf l han
d c i n b idie .
3 U ing an e b id diag am di c he im ac f an e b id n maj akeh lde .
4 Wh d hink ich c n lic -make ca e m ch ab hei fa me e en h gh he
a e ch a mall f ac i n f he king la i n?
5 E al a e he ible c n e ence f he WTO ag eemen end e b idie .
6 S me de el ing c n ie a g e ha he hibi i n f e b idie h ld n a l
hem n he g nd ha a he a e making eff g and de el , he h ld be en i led
benefi ha ha e been enj ed b de el ed c n ie f decade . Di c hi in f
ie .
A
Whene e a g d i im ed f m an he c n , i m g h gh a n mbe f c m ced e
in l ing in ec i n , al a i n (de e mining he al e f he g d), and he . In an eff im e
b acle im and ed ce hei an i , c n ie ma inc ea e he am n f ed- a e check and
ced e , making hem e ime-c n ming and diffic l . In addi i n, im ing c n ie can im e
e i emen ha im ed g d m be ackaged in a ic la a . Since e e d n al a
f lfil he e i emen , he an i f im i ed ced.
In addi i n, man c n ie im e e i emen ha im ed g d m f lfil a ic la echnical
anda d , hich in l e heal h, afe and en i nmen al c ndi i n . In man ca e , he e anda d
a ma icall elimina e a ange f im . In he ca e , ce ain d c m nde g e ing and
in ec i n ced e ha a e c l and ime-c n ming ha nce again he effec i ed ce he
an i f im .
All he ab e ced e and e i emen a e kn na .
In me ca e , he im i i n f ch anda d i j ified b g e nmen c nce n f he heal h and
afe f he d me ic la i n, a ell a ible nega i e en i nmen al effec f im ed g d .
H e e , i i gene all belie ed ha he e ce i e e f he e kind f mea e b g e nmen i a
di g i ed a em limi im , and he ef e i a kind f hidden ade ec i n. See Real ld
f c 15.1 (Cha e 15) f an e am le.
Admini a i e ba ie , like he f m f ade ec i n, ha e he effec f inc ea ing he d me ic
ice f he im ed g d, ec ing inefficien d ce and inc ea ing all ca i e inefficienc .

Re ea ch and find eal ld e am le f admini a i e im ced e and heal h, afe and
en i nmen al anda d a lied im ed g d ha a e likel be a f m f hidden ade
ec i n. U ing finding , e lain hei likel effec n akeh lde in he d me ic and gl bal
ec n mie .

ic in hi cha e . The a e gge i n f in i ie ha can nde ake n n in
g in de e i e he lea ning bjec i e f hi cha e .
1 Wha a e me f he m im an e and im , a a ha e f al e and
im , in he c n li e in? Can e he he f c m a a i e ad an age e lain
me f he a e n f ade (e and im ) ha b e e?
2 Wha c n ie a e he m im an ading a ne f he c n li e in? Can
iden if me benefi ha a i e f m ade i h he e c n ie ?
3 Re ea ch eal- ld e am le f c n ie ha ake ad an age f hei fac end men .
Iden if he end men and e lain h he a e ela ed e .
4 Selec me f he m e im an im in c n , and in e iga e ha , if an , e f
ade ec i n mea e he e a e bjec . Iden if a lea ne d c ha i bjec a
a iff, a a and a b id . E amine he likel ea n ha hi ec i n ha been ffe ed. T
e lain he effec he e mea e a e likel ha e n he a i akeh lde and he
ec n m a e d ing.
E AM LE Q E ION

4 Uni ed S a e In e na i nal T ade C mmi i n, efe ed in F ench jam, ch c la e, and ham 100% a iff
5 I i al ible f he g e nmen ell he licence d me ic im e , in hich ca e i gain he a

e en e; al e na i el , he g e nmen c ld di ib e he licence d me ic im e ih cha ging a
ice, he im e gain he a e en e , beca e he b he im a ice P and ell hem a P .
H e e , nei he f he e i n a e c mm nl ac i ed.
6 EU Beef a age
7 US challenge India e b id g am a WTO E b idie h ld g

C 15
I :P II
BEFORE OU START
Ho valid do ou think are arguments in favour of trade protection (trade restrictions)?
When countries engage in reducing or increasing trade barriers, hat stakeholders do ou think
are affected and ho might the become better off or orse off?
What do ou think is the meaning of economic integration?
This chapter continues the discussion of Chapter 14. We ill revie the arguments in favour for and
against trade protection. We ill then consider various forms of economic integration, that involve the
removal of trade barriers and the promotion of free trade, either among small countr groupings or the
global econom through agreements involving man countries around the orld. We ill also consider
monetar union, here countries give up their national currenc b adopting a single currenc ith a
unified monetar polic .
15.1 A
LEARNING OBJECTI ES

e plain and pro ide e ample of arg men in fa o r of rade pro ec ion (AO2)
e plain and pro ide e ample of arg men again rade pro ec ion (AO2)
e al a e free rade er rade pro ec ion, referring o he follo ing: (AO3)
he arg men in fa o r of and again rade pro ec ion di c ed in hi ec ion
he benefi of rade di c ed in Chap er 14, Sec ion 14.1
he ad an age and di ad an age of he ario rade pro ec ion mea re di c ed in
Chap er 14, Sec ion 14.3
A
In Chap er 14 e e amined a arie of mea re ha go ernmen e o crea e barrier o in erna ional
rade. The e barrier crea e ome inner and ome lo er , b in all ca e re l in inefficienc in
prod c ion and global re o rce mi alloca ion. Wh , hen, do go ernmen aro nd he orld con in e o
e rade pro ec ioni policie ?
A
The e are arg men ha ma ha e alidi nder cer ain condi ion . Their alidi ma depend on non-
economic con idera ion , or on he e pec a ion ha longer- erm economic benefi of rade pro ec ion
are grea er han hor - erm economic co .
I
An i a ne dome ic ind r ha ha no had ime o e abli h i elf and achie e
efficiencie in prod c ion, and ma herefore be nable o compe e i h more ma re compe i or firm
from abroad. Ma re foreign firm , opera ing i h lo er co of prod c ion, are able o ell a lo er
price ; dome ic firm , being nable o compe e, are nable o gro and ma be forced o h do n.
Thi arg men re on he principle of economie of cale, according o hich a firm achie e lo er
a erage co a i gro in i e and prod ce more o p . Therefore, a ne firm i h high co of
prod c ion ha ha no e gro n in i e ma need pro ec ion from impor n il i gro o a i e here
pro ec ion i no longer needed.
Thi arg men a fir ed in 1791 b Ale ander Hamil on, he fir US Secre ar of he Trea r , o
in rod ce ariff o pro ec US ind r and promo e economic gro h. Toda i i ed mainl for
de eloping co n rie r ing o e pand heir prod c ion in o ne area and ind rie . Economi
con ider i o be one of he ronge arg men in fa o r of rade pro ec ion i h a heore ical
j ifica ion. I i j ified on he gro nd ha a co n r ma ha e a compara i e ad an age in he
prod c ion of a par ic lar i d ia good, b canno peciali e in i nle i fir recei e ome
pro ec ion. Ho e er, he pro ec ion offered o infan ind rie m be emporar . O er a longer period,
once he ind r ma re , he pro ec ion m be elimina ed and he ind r m compe e in global
marke nder condi ion of free rade.
In pi e of i rong heore ical j ifica ion, here are ome danger in he infan ind r arg men . One
i ha i ma be diffic l for go ernmen o kno hich par ic lar ind rie ha e he po en ial o
become lo co prod cer . Ano her i ha once he elec ion of an ind r i made, ind rie
pro ec ed from compe i ion ma no ha e a rong incen i e o become efficien . A hird i ha
go ernmen ma con in e o pro ec an ind r e en long af er i ha ma red and i no longer an
infan .
N
According o hi arg men , cer ain ind rie are e en ial for na ional defence ( ch a aircraf ,
eapon , chemical , cer ain mineral ), and ho ld be pro ec ed o ha a co n r can prod ce hem i elf.
In ime of ar or a na ional emergenc , a co n r ho ld no ha e o depend on impor for i defence.
Moreo er, here ma be danger in ha ing nfriendl na ion peciali e in eapon prod c ion.
While here i ome meri o hi arg men , a problem i ha i can be ed b ind rie ha ha e an
indirec e in defence ( ch a he eel ind r ) o r o acq ire pro ec ion again foreign
compe i ion. In 2018, he Uni ed S a e impo ed highl con ro er ial ariff on eel and al mini m
impor from a n mber of co n rie , hich ended p pro oking a rade ar ( ee Real orld foc 15.2).
The e ariff ere j ified b reference o na ional ec ri , ho gh i i likel ha o her fac or ere a
pla . In he pa , good like candle , glo e , mbrella , pla ic , and o her ha e recei ed pro ec ion on
he gro nd ha he ere needed for na ional defence.
The na ional defence arg men i a non-economic one, and o deci ion ho ld be made on poli ical and
mili ar , no economic, gro nd . Ye i i ome ime diffic l o dra he line be een ha i e en ial
for na ional defence and ha i no .
H ,
Man co n rie main ain heal h, afe and en ironmen al andard ha all impor ed prod c m
mee before he are allo ed o en er. Each co n r e i o n andard , and go ernmen are
j ifiabl concerned ha impor ed good ma fall hor of he e. Ho e er, here i a concern ha he e
andard ma ome ime be ed a a form of hidden pro ec ion o keep cer ain good o if he are
compe ing i h dome icall prod ced good , ch a admini ra i e barrier ( ee Chap er 14).
E
D mean change in ol ing grea er arie ; economic di er ifica ion refer o increa ing he
arie of good and er ice prod ced; i i he oppo i e of ecia i a i . (HL den ma no e ha
di er ifica ion ma no be con i en i h he heor of compara i e ad an age.) A n mber of
de eloping co n rie , e peciall (ELDC ) hich are among he
poore co n rie in he orld, are er highl peciali ed in prod cing and e por ing onl a fe
primar commodi ie (for e ample ee Table 19.1, Chap er 19). S ch e ce i e peciali a ion carrie
i h i danger , and co n rie ma be be er off di er if ing heir prod c ion and e por ( o be
di c ed in Chap er 19 and 20). To be able o di er if , co n rie ma ha e o e rade pro ec ion
policie o keep o impor of good he o ld like o prod ce hem el e . For e ample, if a co n r
o ld like o di er if in o prod c ion of comp er , i ill ha e o impo e barrier on impor of
comp er ; al erna i el he go ernmen co ld pro ide b idie o dome ic comp er prod cer .
Thi arg men applie onl o de eloping co n rie . Ho e er, here ma be a ri k ha go ernmen ma
no kno hich prod c or ind rie are he mo appropria e o elec for pro ec ion ha ill allo for
cce f l di er ifica ion.
A
Q e ionable arg men ha e limi ed alidi , ho gh he ma ha e ome al e nder pecial
circ m ance in offering hor - erm, emporar ol ion o problem .
A -
D i g refer o he prac ice of elling a good in in erna ional marke a a price ha i belo he co
of prod cing i ( all b pro iding e por b idie , ee Chap er 14). D mping i con idered o be an
nfair rade prac ice, and i illegal according o in erna ional agreemen . None hele , i i a prac ice
ha con in e o be ed. According o he an i-d mping arg men in fa o r of rade pro ec ion, if a
co n r pec ha a rading par ner i prac i ing d mping, i ho ld ha e he righ o impo e ariff or
q o a in order o limi impor of he b idi ed, or d mped good; hi i he - arg men in
fa o r of rade pro ec ion.
The main problem i h hi arg men i ha beca e of diffic l ie in ol ed in pro ing ha d mping i
being prac i ed, man go ernmen of en e i a an e c e o offer pro ec ion o heir dome ic
prod cer hen hi pro ec ion i no nece ar or j ifiable.
refer o prac ice ha co n rie ma e in order o gain a compe i i e ad an age

o er o her co n rie in order o nfairl increa e heir e por a he e pen e of o her co n rie .
E ample incl de:
d mping, di c ed abo e
he more general e of prod c ion and e por b idie hereb e por ing firm ar ificiall
achie e lo er co of prod c ion h increa ing heir e por ( ee Chap er 14)
admini ra i e barrier or hidden pro ec ion hereb co n rie limi heir impor ing
q e ionable mean ( ee Chap er 14)
nder al ed c rrencie hereb co n rie eek a lo er al e for heir c rrenc in order o make
heir e por more compe i i e in foreign marke ( ee Chap er 16)
iola ion of in ellec al proper hereb firm or indi id al i hin co n rie illegall ob ain
idea , rade ecre , in en ion or an hing el e hich i a crea ion of he h man mind (in ellec al
ork ) and hen e he e o heir o n ad an age.
The problem here i imilar o he ca e of d mping, hich i diffic l and ime con ming o pro e. A a
re l , rading par ner ma ake ad an age of ch arg men o impo e pro ec ioni mea re , ing
hem a an e c e o pro ec heir o n ind rie hen pro ec ion i no j ifiable.
C
A balance of pa men defici occ r hen he o flo of mone from a co n r i grea er han he
inflo , and all happen hen here are more impor han e por ( ee Chap er 16). I o ld eem
ha a a o correc hi problem o ld be o impo e barrier o he en r of impor in o he co n r ,
limi ing impor and herefore he need o make pa men abroad. Ho e er, decrea ed impor o ld
come a he e pen e of falling e por in e por ing co n rie , and here i a ri k of re alia ion. Trade
pro ec ion co ld be ed a a hor - erm emergenc mea re if here i a erio balance of pa men
defici ; o er he longer erm here are o her, more effec i e a o deal i h hi problem ( ee Chap er
16 and 17).
T
Tariff a a o rce of go ernmen re en e ere common in he earl age of de elopmen of c rren l
more de eloped co n rie . In he Uni ed S a e , for e ample, ariff re en e acco n ed for 56% of
federal (cen ral) go ernmen re en e in 1880; b 1900 he e ere 41%, and b 2000 he had fallen o
le han 1%. Toda , he e of ariff for re en e p rpo e i more freq en in de eloping co n rie ,
here ariff re en e can ome ime acco n for a m ch a half or more of all go ernmen re en e .
The rea on for rong reliance on ariff for re en e i rela ed o he ea e i h hich impor can be
a ed, ince he are good ha m pa hro gh border here he can be moni ored.1
Ho e er, ariff ha e di ad an age , a he are a regre i e pe of a , and o ha e nega i e impac
on income di rib ion; in addi ion, he ha e nega i e effec on alloca i e efficienc . The con enience
of rel ing on ariff re en e ma al o ork a an e c e for go ernmen o dela a em reform.
Therefore reliance on ariff a a o rce of go ernmen re en e ho ld be a emporar mea re o be
grad all pha ed o a co n rie gro and de elop.
P
According o hi arg men , re ric ion on impor are needed o pro ec dome ic emplo men . Impor
re ric ion increa e dome ic prod c ion, h increa ing emplo men .
One problem i h hi arg men i ha if impor re ric ion appl o good ha are ed a inp in he
prod c ion of o her good , i i likel ha here ill be higher co of prod c ion d e o he higher
price of he impor ed inp , lo er prod c ion in he e ind rie , and herefore increa ed
nemplo men . I i e en po ible for he nega i e emplo men effec in he broader econom o be
grea er han he po i i e emplo men effec in he pro ec ed ind r . See Real orld foc 14.1,
Chap er 14, for an e ample.
Ano her problem i h hi arg men i ha if nemplo men in he dome ic econom fall d e o
impor re ric ion , hi mean ha nemplo men increa e in he co n rie ha are forced o e por
le . The foreign co n rie ha are h r ma re alia e b impo ing impor re ric ion of heir o n. If he
go ernmen objec i e i o increa e emplo men in he econom , fi cal, mone ar or ppl - ide
policie ma be more appropria e. If, on he o her hand, he go ernmen an o increa e emplo men
in a par ic lar ind r , a b id i likel o be more appropria e han impor re ric ion ( ariff and
q o a ), beca e b idie ha e fe er nega i e effec ( ee Chap er 14).

A
There i a concern in A ralia ha he e of hidden barrier in a n mber of i rading par ner i
gro ing. Thi incl de e en ome co n rie i h hich A ralia ha free rade agreemen .
According o he A ralian Trade Mini er, Tariff and q o a are here for he hole orld o ee,
b a e con in e o hif o ard a more open global econom , e re eeing a rend o ard he e
of hidden or in i ible rade barrier .
According o an anal i cond c ed b Mea a d Li e ck A a ia and he A a ia Mea
I d C ci , non- ariff barrier in 41 co n rie are co ing $3.4 billion a ear.
F 15.1: Pro erpine, Q een land, A ralia. Loading garcane
The A ralian Trade Mini er aid, We ab ol el recogni e he righ of co n rie o pro ec

con mer and he en ironmen , hro gh packaging req iremen , hipmen in pec ion , heal h and
afe con rol . . . Whil man of he e req iremen are legi ima e, e re eeing a hif o ard
ho reg la ion and red ape are being manip la ed and ed a a delibera e ool o di or rade flo
and pro ec dome ic ind rie .
The A ralian go ernmen plan o e diploma ic pre re on he co n rie pec ed of ing
hidden rade pro ec ion mea re .
S : B ad Th .ca b idge. g/ i k /ecib d8116 , Financial Re ie , 7 December 2018.
A
1 U ing o r kno ledge of rading bloc , (af er o ha e read Sec ion 15.2 belo ) e plain h
co n rie i h hich A ralia ha free rade agreemen migh face e en grea er incen i e o
e hidden rade barrier .
2 O line h hidden rade pro ec ion i a pe of nfair compe i ion.
3 Wha did A ralia Trade Mini er mean i h hi a emen ha hidden pro ec ion mea re
di or rade flo and pro ec dome ic ind rie ?
A
Economi are mo of en cri ical of rade pro ec ion beca e i or en he alloca ion of re o rce and
impo e a arie of co on he dome ic and he global economie . In Chap er 14 e a in ome
de ail ho gain and ho lo e from he impo i ion of a arie of pro ec ioni mea re in in erna ional
rade. Table 15.1 pro ide a mmar of he effec .
I T Q P E A
P gain gain gain gain gain

gain gain gain gain gain
G gain ne ral lo e lo e ne ral
T ne ral ne ral lo e lo e ne ral
C lo e lo e ne ral lo e lo e
D lo e lo e lo e lo e lo e
P
D lo e lo e ne ral lo e lo e
I
D lo e lo e lo e lo e lo e
R
F lo e lo e lo e lo e lo e
G lo e lo e lo e lo e lo e
R
T 15.1: S mmar : ho in and ho lo e from rade barrier
Ba ed on he informa ion in Table 15.1, e ma no e he follo ing:

P ( )
. Thi i hardl rpri ing, ince
pro ec ioni policie are all nder aken i h a ie o pro ec ing dome ic prod c ion and
dome ic emplo men .
H ,
. The e re l from all pe of rade pro ec ion. In fac , long- erm reliance on pro ec ion
again foreign compe i ion elimina e incen i e for firm o lo er co and opera e efficien l .
C . Thi i d e o higher price of pro ec ed good and lo er q an i ie
of good a ailable in he marke ( he onl e cep ion i prod c ion b idie , here he q an i
con med and price paid b con mer remain naffec ed). Con mer al o face red ced con mer
choice hro gh lo er impor . The lo e e perienced b con mer a a r le are grea er han he
benefi o prod cer , confirmed b man die ha mea re he effec of rade re ric ion .
I . The onl e cep ion i prod c ion b idie , here he
price paid b con mer doe no change.
F . Thi i apparen from he red c ion in impor of he
co n r impo ing pro ec ioni mea re .
D . Dome icall ,
he appearance of elfare lo mean re o rce mi alloca ion. In addi ion, here i re o rce
mi alloca ion on a global cale a pro ec ion mean ha prod c ion mo e a a from lo er co
prod cer in o her co n rie o higher co prod cer ho are enjo ing he pro ec i e mea re .
There are ome addi ional poin or h men ioning:
L , ,
, GDP . Some dome icall prod ced
good ha are pro ec ed ma be ed a inp in he prod c ion of o her good . For e ample, if a
e ile ind r recei e pro ec ion from e ile impor , he dome ic price of e ile ill
increa e; clo he man fac rer ha need e ile o prod ce clo he face higher co of prod c ion.
U ing he AD-AS model e can ee ha hor r n aggrega e ppl decrea e , he SRAS c r e hif
o he lef , ca ing co -p h infla ion. Wha ha happened i ha real GDP fall and nemplo men
increa e , hile he price le el al o increa e . The re l i ha final clo hing prod c ell a a
higher price.
T . Some
dome icall prod ced good ha are pro ec ed ma be ed a inp in he prod c ion of o her
good ha are e por ed. In he abo e e ample, if he prod c of he clo he man fac rer are
e por ed, here ill be lo er compe i i ene in e por marke d e o he higher price of clo he .
Similarl , if a fer ili er ind r i pro ec ed from fer ili er impor , he dome ic price of fer ili er
ill be higher han he orld price; farmer b ing he fer ili er face higher co of prod c ion,
ca ing he final agric l ral prod c o ell a a higher price. Thi re l in lo er compe i i ene
in e por marke .
T . A one co n r impo e
barrier on impor , o her co n rie ma re alia e b impo ing heir o n barrier . Thi can prod ce
chain reac ion i h co n rie becoming more and more pro ec ioni , i h erio nega i e effec
on global o p and re o rce alloca ion.
T . For e ample, re ric ion on impor ma
pa e he a for bribe and m ggling good illegall in o a co n r , or ma re l in ariff and
o her re en e going in o he pocke of b rea cra ra her han he go ernmen b dge .

1 Iden if ome arg men in fa o r of rade pro ec ion.
E plain po ible pecial circ m ance nder hich he are con idered o be alid.
Wha problem can he gi e ri e o?
2 U ing e ample of barrier o rade, di c ome arg men again rade pro ec ion.
3 E plain he infan ind r arg men .
Wha i i heore ical j ifica ion?
E plain ome po en ial problem i ma gi e ri e o.

T S
Beginning in Jan ar 2018, he Uni ed S a e began impo ing a erie of ariff on ario good
impor ed from e eral co n rie . Follo ing he impo i ion of US ariff , he affec ed co n rie began
o re alia e.
A f ndamen al rea on behind he ariff a he US rade defici (an e ce of impor o er e por ;
ee Chap er 16) hich i he large in he orld. According o hi arg men he impo i ion of ariff
o ld red ce impor , h helping o correc he defici . In addi ion, i a belie ed ha ariff o ld
help pro ec job in he man fac ring ec or.
F 15.2: The US impo e ariff on impor
P 1: T
In March 2018, he Uni ed S a e impo ed ariff of 25% on eel impor and 15% on al min m
impor . The ra ionale a ha he e ariff ere needed on he gro nd of na ional ec ri . In fac i
a a ed ha he eel and al min m impor hrea en o impair he na ional ec ri of he Uni ed
S a e . Ye mo US impor of eel and al min m are prod ced b US allie ch a Canada and he
E ropean Union.
P 2: S : S
In hi pre iden ial campaign, Pre iden Tr mp promi ed o pro ec American job . Therefore he
impo i ion of he ariff a e pec ed o lead o increa e in US emplo men .
Ye b Sep ember 2018, he US Ta Fo nda ion had e ima ed ha he ariff ha had alread come
in o effec pl planned ariff oge her o ld lead o a lo of 459 816 job .
Thi co ld ell be an ndere ima e. According o an anal i b Trade Par ner hip World ide, here
o ld be an increa e of 26 280 job in he eel and al min m ind rie o er he fir one o hree
ear , b emplo men hro gho he re of he econom o ld fall b 432 747, gi ing a ne lo of
400 445 job . I a fo nd ha 16 job o ld be lo for e er eel/al min m job gained .
F r her, he US Cen er for A omo i e Re earch claimed ha if he Uni ed S a e impo e ariff on
car , he lo of job o ld amo n o 715 000. A d b he Federal Re er e ( he Uni ed S a e
cen ral bank) in December 2019 no e We find ha he 2018 ariff are a ocia ed i h rela i e
red c ion in man fac ring emplo men and rela i e increa e in prod cer price . . . For
man fac ring emplo men , a mall boo from he impor pro ec ion effec of ariff i more han
off e b larger drag from he effec of ri ing inp co and re alia or ariff . 8
Rea on behind he job lo e incl de higher co of impor ed inp , ch a par made of eel and
al min m, hich make prod c ion le profi able. In ome ca e i i e en po ible for US firm o
reloca e o o her co n rie in order o a oid he price increa e d e o he ariff ( ee Par 3 belo ).
Moreo er, ariff on US impor impo ed b o her co n rie in re alia ion ha e he effec of red cing
US e por , f r her h r ing US firm .
P 3: S C :
One of he co n rie mo rongl affec ed b he US ariff i China, hich acco n for he large
hare of he US rade defici .
China re ponded o he US ariff b q ickl re alia ing i h a erie of i o n ariff on billion of
dollar or h of US good . One ca egor of he e good a car . In he mmer of 2018, i increa ed
i ariff on US car from 25% o 40%. B in an effor o boo dome ic con mp ion i red ced i
ariff on car impor from all o her co n rie o 15%. In addi ion, i lo ered ariff on 1400 prod c
incl ding ho ehold good , apparel and appliance .
O erall impor from So h Korea, Japan and he E ropean Union increa ed b 31%, 24% and 20%
re pec i el in he mmer of 2018 hile impor from he Uni ed S a e increa ed b a mere 11%. A
he ame ime, d e o rong con mer demand, Chine e e por o he Uni ed S a e increa ed b
11%, in pi e of he US ariff on Chine e good .
American a o maker are er concerned abo he impac of he Chine e ariff. Vol o, hich had
recen l opened a ne plan in So h Carolina i h a promi e of 4000 ne job , ha a ed ha i ma
ha e o go back on i promi e in ie of he US eel ariff and hrea of re alia or ariff from
o her co n rie .
BMW, he large US car e por er, i alread e panding i prod c ion in China, mo ing prod c ion
a a from So h Carolina in he Uni ed S a e . Thi a i ill be able o a oid he high ariff on US-
made car . Ironicall , job in he Uni ed S a e are no increa ing, b he migh ac all be mo ing
o China.
S : Nikkei A ia Re ie
The Ne Y k Ti e
F be
A
1 Wha do o hink of he claim ha eel and al min m ariff are j ified on na ional ec ri
gro nd hen mo impor come from US allie ? Wha kind of rade pro ec ion do o hink
hi i ?
2 U e a ariff diagram o e plain h ariff ere e pec ed o gi e ri e o ne job in he Uni ed
Sae .
3 U ing an AD-AS diagram, e plain h he US ariff are likel o lead o job lo e in he o erall
econom .
4 U ing he ame diagram a in q e ion 3, and aking in o acco n po ible effec on he price
le el, e plain he effec of he ariff on US con mer . Wha kind of infla ion i in ol ed here?
5 U e a demand and ppl diagram, o ill ra e and e plain he effec ha re alia or ariff b
o her co n rie ill likel ha e on he demand for US good .
6 U ing an AD-AS diagram, e plain he likel effec on economic gro h of co n rie engaged in
rade ar .
7 Re earch c rren ne repor on he impac of he ariff on
nemplo men ,
he price le el, and
ario prod c marke ch a car , o lining he mo recen effec of he ariff .
1 B con ra , income a e , hich c rren l make p he large hare of go ernmen re en e in de eloped

co n rie , are more diffic l o le and collec in le de eloped co n rie , par l beca e large hare of he
pop la ion r i e on er lo income , par l beca e a er large propor ion of he pop la ion are elf-
emplo ed and orking in he informal ec or here a e are no collec ed, and par l beca e of poor
enforcemen of a collec ion and high a e a ion ra e .
8 Fed d : Tr mp ariff ca ed job lo e , higher price

15.2 E :
LEARNING OBJECTIVES

dis ing ish be een preferen ial rade agreemen s: bila eral, regional and m l ila eral WTO
(AO1)
e plain and pro ide e amples of differen pes of rading blocs (AO2)
free rade area / agreemen
c s oms nion
common marke
disc ss he ad an ages and disad an ages of economic in egra ion arising from he differen pes
of rading blocs (AO3)
E refers o economic co-opera ion be een co n ries and co-ordina ion of heir
economic policies, leading o increased economic links be een hem. I occ rs beca se he co-opera ing
co n ries e pec o deri e benefi s from polic co-ordina ion. I of en begins b agreemen be een
co n ries o red ce or elimina e rade and o her barriers be een hem, and can e end o co-opera ion on
o her ma ers, s ch as labo r policies or en ironmen al policies and e en mone ar polic . There are
ario s degrees of in egra ion, depending on he pe of agreemen and he degree o hich barriers
be een co n ries are remo ed.
P
A (PTA) is an agreemen be een o or more co n ries o lo er rade
barriers on par ic lar prod c s in rade be een each o her. Trade barriers ma remain on he res of he
prod c s, and on impor s from non-member co n ries. The res l is ha a member of he agreemen has
easier access o he marke s of o her members for he selec ed prod c s, han co n ries ha are no
members.
PTAs some imes in ol e co-opera ion be een members on o her iss es, s ch as labo r s andards,
en ironmen al iss es or in ellec al proper la s.
PTAs can ake se eral forms, incl ding free rade areas, c s oms nions or common marke s, and he
ma be bila eral (in ol ing o co n ries) or regional (in ol ing se eral co n ries).2
B , ( TO)
A is an agreemen be een o co n ries, hereas a
in ol es an agreemen be een man co n ries. Ano her dis inc ion in ol es
, hich as he erm s gges s in ol es rade agreemen s be een a gro p of co n ries ha are
i hin a geographical region. The main objec i e of bila eral, regional and m l ila eral rade agreemen s
is o promo e , hich is free (or freer) rade b red cing or elimina ing rade barriers
be een members.
The rade agreemen s reached nder he World Trade Organi a ion (WTO) are multilateral, beca se he
incl de man member co n ries aro nd he orld (164 in 2019) and beca se he req ire all member
co n ries o red ce rade barriers a he same ime. One of he f ndamen al principles of he WTO is
non-discrimination, meaning ha a co n r canno discrimina e be een an WTO members. In o her
ords, i canno impose higher barriers on impor s from one co n r and lo er ones on impor s from
ano her co n r . This is a fundamental principle for the development of free trade globall . Ho e er, he
WTO makes an e cep ion for bila eral and regional rade agreemen s, e en ho gh all preferen ial rade
agreemen s in ol e discrimina ion agains non-member co n ries.
T
A is a gro p of co n ries ha ha e agreed o red ce ariff and o her barriers o rade for he
p rpose of enco raging free or freer rade and co-opera ion be een hem. Beginning i h he lo es
degree of economic in egra ion, e can dis ing ish be een he follo ing rading blocs.
F ( )
A ( ) consis s of a gro p of co n ries ha agree o grad all elimina e rade
barriers be een hemsel es, and is he mos common pe of in egra ion area. Each member co n r
re ains he righ o p rs e i s o n rade polic o ards o her non-member co n ries ( o impose i s o n
rade barriers). In rade rela ions be een members, here ma be free rade in some prod c s, and some
pro ec ion in o her prod c s.
E amples of free rade areas (FTAs) are NAFTA (Nor h American Free Trade Agreemen ), incl ding
Canada, Me ico and he Uni ed S a es; and ASEAN (Associa ion of So heas Asian Na ions), and
SAARC (So h Asian Associa ion for Regional Coopera ion).
One problem ha arises in free rade areas is ha a prod c ma be impor ed in o he FTA b he co n r
ha has he lo es e ernal rade barriers, and hen sold o co n ries i hin he FTA ha ha e higher
e ernal rade barriers. This problem arises beca se each co n r has i s o n indi id al barriers o ard
non-members. I crea es diffic l ies for hose co n ries i h higher barriers beca se he ma end p
impor ing more of he good han he o ld like. To deal i h his problem, free rade areas make
complica ed r les of origin for impor s, designed o pre en goods from en ering co n ries i h lo er
e ernal barriers.
C
A consis s of a gro p of co n ries ha f lfils he req iremen s of a free rade area
(elimina ion of rade barriers be een members) and in addi ion adop s a common polic o ards all
non-member co n ries. Each co n r in a c s oms nion is no longer free o de ermine i s o n rade
polic o ards non-member co n ries. Also, he member co n ries of he c s oms nion ac as a gro p
in all rade nego ia ions and agreemen s i h non-members. A c s oms nion herefore in ol es a higher
degree of economic in egra ion han a free rade area.
E amples of c s oms nions incl de CEFTA (Cen ral E ropean Free Trade Agreemen ), SACU (So h
African C s oms Union), PARTA (Pacific Regional Trade Agreemen ), and o hers.
C s oms nions ha e he ad an age o er FTAs ha he a oid ha ing o crea e complica ed r les of
origin for impor s, since he all ha e he same common e ernal barriers. Ho e er, c s oms nions
face he problem ha he m s co-ordina e heir policies o ard non-members. This gi es rise o he
possibili of disagreemen s, as he ma no all agree on ha are appropria e le els of ariff and o her
barriers on non-members.
C
A is an e en higher degree of economic in egra ion, in hich co n ries ha ha e
formed a c s oms nion proceed f r her o elimina e an remaining ariffs in rade be een hem; he
con in e o ha e a common e ernal polic (as in a c s oms nion), and in addi ion, he agree o
elimina e all res ric ions on mo emen s of an fac ors of prod c ion i hin hem. The fac ors of
prod c ion of impor ance are labo r and capi al, hich in a common marke are free o cross all borders
and mo e, ra el and find emplo men freel i hin all member co n ries.
The bes -kno n common marke is he E ropean Economic Comm ni (EEC, he prec rsor of he
presen E ropean Union), formed in 1957. Ano her e ample is he Caribbean Comm ni (CARICOM)
Single Marke and Econom (CSME).
A common marke offers major ad an ages o i s members compared o FTAs and c s oms nions. The
enjo free rade and all i s ad an ages (lo er prices, grea er cons mer choice, e c., see Chap er 14).
Workers are free o mo e and ork in an member co n r i ho res ric ions, and capi al (ph sical
and financial) can also flo from co n r o co n r i ho res ric ions. This res l s in a be er se of
fac ors of prod c ion. For e ample, here ma be high nemplo men in one co n r , and a high demand
for labo r in ano her co n r . This ill enco rage nemplo ed orkers o seek ork in he co n r
facing labo r shor ages. Similarl , if he profi abili of in es ing is grea er in one co n r han in
ano her, capi al ill gra i a e o he more profi able co n r , making be er se of capi al reso rces.
Fac or mobili across co n ries impro es he alloca ion of reso rces.
Ho e er, he de elopmen of a common marke req ires e en grea er polic co-ordina ion among
members han in a c s oms nion, and req ires he illingness of member go ernmen s o gi e p some
of heir polic -making a hori o an organisa ion i h po ers o er all he member go ernmen s. Bo h
hese req iremen s can be diffic l o accomplish, and need a long ime for all co n ries o make he
necessar polic changes o achie e co-ordina ion. For his reason here are far fe er common marke s
in he orld han free rade areas and c s oms nions.
P
Economic in egra ion o er he long erm can be e pec ed o bring for h man of he benefi s of free
rade. Benefi s ha member co n ries can e pec o deri e incl de he follo ing:
T ade c ea i (HL )
When a rading bloc is es ablished, pa erns of rade be een co n ries change, since rade be een
he members is enco raged hro gh he lo ering of rade barriers, hile rade i h non-members is
disco raged hro gh he main enance of rade barriers. T refers o he si a ion here
higher cos prod c s (impor ed or domes icall prod ced) are replaced b lo er cos impor s.
Consider an e ample. S ppose Co onia and Microchippia bo h prod ce co on. Co onia has a
compara i e ad an age in co on, i has a lo er co on price, and herefore Microchippia impor s
co on from Co onia. Ini iall , Microchippia imposes ariffs on i s co on impor s, his a pro ec ing
i s o n co on prod cers. Then Co onia and Microchippia form a bila eral rade agreemen , and
ariffs on co on are abolished. Microchippia s co on impor s increase (corresponding o an increase
in Co onia s co on e por s), and i s domes ic prod c ion of co on decreases. This is a case of trade
creation, beca se higher cos domes ic co on prod c ion in Microchippia is par l replaced b lo er
cos impor s of co on.
The benefi s of rade crea ion incl de ge ing rid of disad an ages of ariffs. The decrease in
Microchippia s domes ic prod c ion of co on leads o grea er efficienc in prod c ion, and oge her
i h he increase in cons mp ion made possible b more impor s, here is grea er alloca i e
efficienc .
In general, rade crea ion has he effec of increasing social elfare.
I c ea ed c eii
The remo al of rade barriers i hin rading blocs res l s in increased compe i ion among prod cers in
member co n ries. Wi h lo or no barriers, impor s increase, forcing domes ic prod cers o compe e
i h lo er cos prod cers from o her co n ries. Trade barriers, on he o her hand, pro ec inefficien
domes ic prod cers. Increased compe i ion offers major ad an ages in erms of prod c ion b more
efficien prod cers, lo er prices for cons mers and impro ed alloca ion of reso rces.
E a i i la ge a ke
This is an ob io s benefi arising from he abili of firms o sell be ond heir na ional bo ndaries, and
increasing heir e por s.
Ec ie f cale
This follo s from he abo e poin . In a small marke a firm canno ake ad an age of economies of scale
(lo er a erage cos s) since a firm canno gro large eno gh so ha i s a erage cos s begin o fall
s bs an iall . When an econom opens i self p o free rade i h o her co n ries, i s e por s are likel o
increase and as he si e of he marke e pands, he firm can achie e lo er a erage cos s.
L e ice f c e a d g ea e c e ch ice
The elimina ion of rade barriers (along i h increased compe i ion and economies of scale) res l s in
lo er prices for cons mers. In addi ion, increased impor s mean a grea er of arie of goods from
hich cons mers can choose.
I c ea ed i e e
Enlarged marke s of en gi e rise o increased in es men b firms ha an o ake ad an age of he
larger marke si e. This in es men ma be in ernal, ha is, b firms origina ing from a co n r i hin
he rading bloc, or e ernal, origina ing from a co n r ha is o side he rading bloc (b m l ina ional
corpora ions). A major incen i e faced b o sider firms o se p prod c ion ni s i hin he bloc is ha
he escape he ariff or o her pro ec ion ha he rading bloc imposes on impor s from o side. One of
he incen i es faced b co n ries o form rading blocs is o a rac in es men s b m l ina ional
corpora ions ( o be s died in Chap er 20).
Be e e f fac f d ci : i ed e ce all ca i a d g ea e e l e
i ie
If a rading bloc de elops in o a common marke , hich in ol es free mo emen of fac ors of
prod c ion, specificall capi al and labo r, here ill also be a be er se of hese i hin he bloc. As
disc ssed abo e, nemplo ed orkers in one co n r ma seek a job else here here here are more
emplo men oppor ni ies. Capi al can also mo e freel in search of grea er profi s. A be er alloca ion
of reso rces res l s.
I ed efficie c i d ci a d g ea e ec ic g h
As e kno from Chap er 14, he elimina ion of rade barriers and free rade lead o impro ed efficienc
in prod c ion, as inefficien prod cers lose heir pro ec ion, leading o be er prospec s for achie ing
more rapid economic gro h.
S ge ba gai i g e
When co n ries bargain indi id all in m l ila eral nego ia ions, s ch as i h he World Trade
Organi a ion, he do no ha e m ch bargaining po er especiall if he are rela i el small. If he
bargain as a rading bloc he ha e m ch grea er po er, increasing heir chances of being heard and
achie ing heir objec i es.
P li ical ad a age
Grea er economic in egra ion is likel o res l in a red ced likelihood of hos ili ies arising be een
co n ries hose economies are becoming more in erdependen hro gh increased rade, in es men ,
labo r and financial flo s. F r her, economic in egra ion ma lead o poli ical s abili as ell as co-
opera ion, res l ing in f r her benefi s for member co n ries.
P
T ade di e i (HL l )
T refers o he si a ion here lo er cos impor s are replaced b higher cos impor s
from a member af er he forma ion of he bloc. I is he opposi e of rade crea ion,
S ppose Co onia, Robo ia and Microchippia all prod ce co on. Co onia is he lo es cos prod cer
of he hree, follo ed b Robo ia, and hen b Microchippia, hich is he highes cos prod cer.
Ini iall , Microchippia imposes a ariff on all impor s of co on, regardless of co n r of origin. Since
Co onia is he lo es cos prod cer, Microchippia impor s from Co onia and no from Robo ia
(Co onia s co on price pl s he ariff is lo er han Robo ia s price pl s he ariff). Microchippia hen
decides o form a rading bloc i h Robo ia. I herefore elimina es he ariff on co on from Robo ia,
and main ains he ariff on co on from Co onia. The res l is ha i no becomes cheaper for
Microchippia o impor co on from Robo ia ra her han Co onia. Microchippia s impor s ha e
shif ed from a lo er cos prod cer, Co onia, o a higher cos prod cer, Robo ia; his is herefore a
case of rade di ersion.3
The possibili of rade di ersion res l ing from a rading bloc is an arg men against rading blocs,
and in favour of m l ila eral (WTO) rade liberalisa ion. The reason is ha rade di ersion canno
occ r i h m l ila eral red c ion or elimina ion of rade barriers. Trade di ersion occ rs hen an
impor ing co n r is forced o impor from a higher cos prod cer i hin a rading bloc, hereas
before i joined he rading bloc i as impor ing from a lo er-cos prod cer else here. If all
co n ries red ce heir barriers a he same ime, i is no possible for lo er-cos impor s o be replaced
b higher-cos impor s; he impor ing co n r ill simpl impor from lo er cos prod cers ho sell
a lo er prices.
While rade crea ion, disc ssed abo e, has he effec of increasing social elfare, rade di ersion
red ces i . Therefore, hereas a rading bloc crea es free rade for he members, i ma or ma no
impro e he alloca ion of reso rces. Reso rce alloca ion ill impro e onl if rade crea ion effec s
are larger han rade di ersion effec s.
No e, ho e er, ha e en if a rading bloc leads o rade di ersion o er he shor erm, i is possible
ha he longer- erm posi i e effec s disc ssed abo e ill more han compensa e co n ries for possible
shor - erm losses. According o some s dies, he long- erm effec s ma be fi e or si imes more
impor an han he shor - erm ones.
T adi g bl c a be a challe ge l ila e al (WTO) adi g eg ia i ( ade

libe ali a i )
Man economis s belie e ha hile he es ablishmen of rading blocs i h free rade be een members
ma be an impro emen o er rade pro ec ion, rading blocs are inferior o he WTO s m l ila eral
approach of red cing rade barriers o ards all co n ries. The belie e ha he break- p of he orld
rading s s em in o man blocs can crea e rade conflic s be een differen blocs ha ma slo do n
he process of global rade liberalisa ion. Some large rading blocs ma enjo free rade and all i s
benefi s i hin he bloc, b ma impose high rade barriers on non-members, and he res l ma be o
limi rade ra her han o increase i on a global scale. This co ld lead o a orse global alloca ion of
reso rces.
U e al di ib i f gai a d ible l e
Co n ries forming a rading bloc are nlikel o gain eq all from he opera ion of he rading bloc, and
his crea es he po en ial for conflic s be een he members and makes i diffic l o reach agreemen s. I
is also possible for some co n ries o gain hile o hers become orse off in some respec s. The same
applies o gains and losses i hin he member co n ries, as some s akeholders are likel o gain hile
o hers lose. This is an impor an iss e ha e ill come back o hen e e al a e preferen ial rade
agreemen s as a rade s ra eg o achie e economic gro h and de elopmen in Chap er 20.
Ec ic i eg a i i l e al f e eig
Sovereignt refers o a hori o er decision-making i hin he na ional econom . The forma ion of
rading blocs in ol es gi ing p some domes ic decision-making po er o a s prana ional a hori . The
loss of so ereign is he leas in a free rade agreemen , becoming progressi el grea er in he case of a
c s oms nion and common marke . The loss of so ereign is e en grea er in he case of mone ar
nion (see belo ).
1 Define and dis ing ish be een a free rade area, c s oms nion and common marke .
Ho do hese ill s ra e an increasing degree of economic in egra ion?
2 Research and find real- orld e amples of free rade areas, c s oms nions and common marke s.
Choose one or more of hese and disc ss some of he ad an ages and disad an ages.
3 Wha do o hink is one reason h co n ries ha an o form a rading bloc s all s ar o
b forming a free rade area, and hen grad all mo e o ards a c s oms nion, and e en la er
o ards a common marke ?

A A CFTA
In March 2018, af er fi e ears of planning, he African Con inen al Free Trade Area (AfCFTA) as
la nched a he Kigali S mmi (in R anda). Wi h 55 co n ries, a pop la ion of 1.27 billion and GDP
of $2.5 rillion, i ill be he larges free rade area in he orld.
I s objec i es are o crea e a single marke for goods and ser ices in he en ire African con inen ,
oge her i h free mo emen of labo r and capi al, h s e en all becoming a common marke . I is
e pec ed o lead o major cos ad an ages for firms ha ill ha e oppor ni ies o benefi from
economies of scale and increased compe i i eness. According o forecas s, rade i hin Africa ill
increase b 52% b 2022 rela i e o 2010. This is significan beca se rade i hin Africa (in ra-Africa
e por s) in 2017 ere onl 16.6% of o al e por s, compared i h 68% in E rope and 59% in Asia.
F 15.3: Kigali, R anda. The African heads of s a e es ablishing he African Con inen al Free
Trade Area (AfCFTA)
In addi ion, AfCFTA aims o achie e s s ainable and incl si e de elopmen , o promo e gender
eq ali , and o promo e ind s rial de elopmen hro gh di ersifica ion. According o he Direc or of
he African E por Impor Bank (Afre imbank), Cons rained access o marke s limi s he gro h of
firms. Therefore, for domes ic firms, ge ing rid of local marke cons rain s ma impro e gro h
prospec s and access o finance and echnolog in he global econom . There are, ho e er, no able
challenges. If large firms gain a dominan posi ion in he African marke , he ma cro d o small
and medi m-si ed firms.
Small- and medi m-si ed firms, hich absorb more han 80% of Africa s emplo men , are e pec ed
o benefi from ne marke s, red c ions in inp cos s, increased efficienc and increased sales.
Ho e er, here are also challenges. Some small- and medi m-si ed firms ma be nable o i hs and
he compe i ion from larger b sinesses. Trade liberalisa ion ma h r he poor. Workers from poor
co n ries ma ork long ho rs and li e in condi ions of po er in order o send mone home o heir
families. S ronger compe i ion ma lead o grea er en ironmen al degrada ion as small- and medi m-
si ed firms r o c cos s b d mping as es.
Moreo er, African co n ries ar enormo sl b le el of economic de elopmen and b si e. Three
co n ries alone, Eg p , Nigeria and So h Africa con rib e o er 50% of Africa s GDP hile si
island na ions oge her con rib e j s 1%. The eaker co n ries ma req ire preferen ial rea men in
order o ens re ha he risks arising from increased compe i ion are red ced for hem. For e ample,
he co ld be permi ed o main ain ariffs or o her forms of pro ec ion for infan ind s ries or for he
p rposes of di ersif ing heir economies.
According o he Nigerian Labo r Congress (an organisa ion of rade nions), he rade agreemen is
an e remel dangero s and radioac i e neo-liberal polic ini ia i e .
On he o her hand, i is also arg ed ha i h all of Africa ni ed as a h ge bargaining ni , i can be
far more infl en ial in in erna ional rade nego ia ions i h o her co n ries or gro ps of co n ries
aro nd he orld. According o Professor Ngaire Woods a O ford Uni ersi , Africa co ld s ride
on o he rade nego ia ion s age as one enormo s marke . This co ld lead o a ne engine of gro h
across he con inen . 1
S : Global Agenda ;
The Sun
Africa's new free trade area is promising, et full of hurdles
A
1 Describe ho AfCFTA represen s economic in egra ion. Iden if ha fea re ill allo i o
e ol e in o a common marke .
2 E plain ha AfCFTA member co n ries hope o gain from in egra ion.
3 Iden if he s akeholders ho are likel o gain as ell as hose likel o lose from he forma ion
of AfCFTA.
4 Wh are some of he member co n ries fearf l of in egra ion? Iden if and e plain heir
concerns.
5 (HL onl ) S ppose one AfCFTA member co n r has an absol e ad an age o er ano her
AfCFTA member co n r in he prod c ion of all goods.
Using a diagram, e plain nder ha condi ions i ma s ill be possible for bo h co n ries o
gain from rade.
Under ha circ ms ances migh specialisa ion according o compara i e ad an age no be
desirable? Disc ss.
6 Using he informa ion in he e , e al a e he likel effec s of AfCFTA on he economies of he
member co n ries.

B :T UK E U
H : E U
The E ropean Union has i s origins in he E ropean Coal and S eel Comm ni (ECSC), a free rade
area formed in 1952 b a small gro p of si E ropean co n ries.4 The ECSC abolished rade barriers
in impor an mili ar and economic reso rces incl ding coal, s eel, scrap and iron ore. A he same
ime, i es ablished ins i ions for adminis ra ion, legisla ion and polic as ell as a Co r of J s ice
o resol e disp es. The crea ion of his free rade area as he firs s ep in a series of effor s o ard
closer in egra ion of E ropean co n ries. One of he ke mo i a ing fac ors as o reb ild E rope
af er he Second World War as ell as o pre en f re hos ili ies and promo e las ing peace be een
France and German .
F 15.4: London, Uni ed Kingdom. Pro-Bre i s ppor ers ga her in Parliamen Sq are
In 1957, he same gro p of co n ries formed he E ropean Economic Comm ni (EEC), hich
incl ded lo ering of rade barriers for a far broader range of prod c s. The Uni ed Kingdom joined
he EEC in 1973. The EEC es ablished a common marke hich in addi ion o free rade and common
rade polic o ard non-members also incl ded free mo emen of labo r and capi al, a Common
Agric l ral Polic (CAP), a social polic o promo e labo r mobili and orker pro ec ion, as ell
as policies o promo e marke compe i ion, incl ding reg la ions pre en ing an i-compe i i e
beha io r b firms. I s membership gre grad all o er he ears, and b 2013 here ere 28
members.
The abo e policies, in ol ing increasing economic in egra ion be een he member co n ries, ere
implemen ed b s prana ional bodies i h a hori o er na ional go ernmen s. There are se eral
s ch bodies, he mos impor an of hich are he E ropean Commission, hich proposes ne policies
and legisla ion; he Co ncil of he E ropean Union and he E ropean Parliamen , responsible for
legisla ion (la s) ha all member co n ries m s abide b ; and he E ropean Co r of J s ice, ha
resol es disp es.
In 1993, he EEC changed i s name o he E ropean Union, kno n as he EU. O er ime, addi ional
f nc ions and objec i es ere de eloped, among hich ere co-ordina ion of foreign polic ,
de elopmen assis ance polic for less de eloped co n ries, a common research and de elopmen
polic (R&D), a social polic pro ec ing orkers righ s and a regional de elopmen polic ha
s ppor s raining o red ce nemplo men .
E en all 19 of he 28 EU co n ries ga e p heir na ional c rrencies, adop ed he e ro as heir
c rrenc , and ga e p heir o n independen mone ar polic hro gh he es ablishmen of he
E ropean Mone ar Union (see belo ). The United Kingdom was not among the countries that
adopted the euro, preferring o be in he EU i h i s o n c rrenc , he Bri ish po nd, and i s o n
independen mone ar polic .
Grad all , o er he decades, he E ropean Union has achie ed an npreceden ed degree of economic
in egra ion, far grea er han an o her in erna ional organisa ion.
B : UK E U
In J ne 2016, af er 43 ears of membership, he Uni ed Kingdom held a referend m in hich i s
ci i ens ere asked if he ished he Uni ed Kingdom o lea e or remain i hin he E ropean
Union. England and Wales o ed o lea e, hile Nor hern Ireland and Sco land o ed o remain. The
res l o erall came o in fa o r of lea ing i h 52% Lea ers as opposed o 48% Remainers . This
e en came o be kno n as Bre it, made p of he ords Bri ain and e i .5 I as recei ed i h grea
s rprise aro nd he orld as he e pec a ion e er here as ha he Uni ed Kingdom o ld choose
o remain in he EU.
T EU :
L f e eig Man Lea e o ers belie e ha decisions ha in ol e he Uni ed Kingdom
sho ld be aken in he UK b he UK go ernmen , no b b rea cra s in Br ssels here he EU s
adminis ra ion is loca ed. I is arg ed ha he EU ins i ions are no acco n able o o ers.
O ii i ig a i The free movement of labour principle of he EU res l s in ne
in ard migra ion in o he Uni ed Kingdom from o her EU co n ries. Man Lea ers belie e ha
he Uni ed Kingdom sho ld ake back con rol of i s borders so as o regain he abili o res ric
immigra ion, and con rol he range of skills of orkers ho en er he co n r in accordance i h
needs.
O ii he c i As a member of he EU c s oms nion, he Uni ed Kingdom is
nable o nego ia e rade agreemen s i h hird co n ries independen l , as i m s conform o
he common e ernal polic o ard hird co n ries of he EU. Lea ing he EU o ld mean ha
he Uni ed Kingdom can nego ia e an rade deal i ishes i h an o her co n r or gro p of
co n ries.
O ii c ib i he EU b dge The EU collec s mone from each of he member
co n ries, hich is spen on he Common Agric l ral Polic , s ppor for depressed regions, and
o her ac i i ies. EU membership has a ne cos o he UK of 7.1 billion po nds ann all , hich
amo n s o abo 0.03% of GDP according o he Office of Na ional S a is ics. Opponen s o he
EU, or Lea ers, arg e ha he UK sho ld ake back con rol o er ho his mone is spen .
O ii he e The Uni ed Kingdom has no adop ed he e ro as no ed abo e. Ho e er,
n mero s economis s arg e ha he s r i al of he e ro depends on he e ro one co n ries
becoming e en more economicall in egra ed s ch as hro gh a fiscal nion. As Lea ers are
opposed o more in egra ion and loss of so ereign , he see he e ro as a hrea .
O ii he C Ag ic l al P lic (CAP) The CAP, hich s ppor s EU farmers
ho gh a range of in er en ionis meas res s ch as price con rols and s bsidies, absorbs a large
propor ion of EU f nds. Ye i promo es inefficienc . Lea ers arg e ha he Uni ed Kingdom
does no need s ppor of he EU s CAP nor do he an o con rib e o i s f nding.
O ii legi la i ec i g ke I has been arg ed ha EU legisla ion ha pro ec s
orkers righ s is cos l , ha er significan sa ings co ld be made b ge ing rid of social and
emplo men pro ec ion.
A ag e f he li ical igh : he EU i e a eg la i Some people arg e
ha he EU has oo man r les and reg la ions as ell as social pro ec ion (see abo e) ha s ifle
economic ac i i and pri a e ini ia i e, hile promo ing lef ing principles.
A ag e f he li ical lef : he EU big c ai People on he opposi e
end of he poli ical spec r m arg e ha he EU gi es oo m ch po er o large corpora ions,
s ppor ing he in eres s of po erf l eli es.
T EU :
T ade i h he EU Ro ghl 50% of he UK s e por s are o ard he EU, i h marke s of o er
half a billion people, o hich he Uni ed Kingdom has free access i h no rade res ric ions. If
he Uni ed Kingdom lea es he EU, i ill be er diffic l if a all possible o nego ia e rade
deals i h o her co n ries ha co ld replace he rade los i h he EU. The res l o ld be a
significan decline in UK e por s.
I e e M ch of UK in es men is linked i h he g aran eed marke s of he EU ha he
Uni ed Kingdom e por s o. Lea ing he EU and he po en ial loss of he EU marke s poses a risk
ha UK in es men ill s ffer.
F eig di ec i e e (FDI) The Uni ed Kingdom a rac s a lo of foreign direc in es men
beca se i offers free access o he marke s of he EU co n ries. Lea ing he EU crea es he risk
ha FDI ill lea e he Uni ed Kingdom, going o EU co n ries ha main ain ha access.
J b a de l e The abo e risks ha arise from rade and in es men crea e risks for he
labo r marke ha o ld s ffer from a red c ion in a ailable jobs.
Ca i g b i e i EU c ie Common r les for carr ing o b siness mean ha here
is no red ape and na ional reg la ions ha UK firms m s confron in heir dealings i h o her
b sinesses in he EU co n ries.
EU ke legi la i The EU has la s abo eq al pa for men and omen; fo r eeks paid
ann al lea e for all orkers; bans on discrimina ion d e o age, race or se al orien a ion; pl s
n mero s o her benefi s for orkers.
The i e f i ig a i Some s ppor ers of EU membership arg e ha immigra ion is a rich
so rce of c l re ha sho ld be elcomed. I is moreo er an impor an so rce of labo r skills of
hich here are no eno gh in he Uni ed Kingdom. Wi ho immigran s here o ld be
shor ages of labo r in he hospi al and care ser ices, as ell as b ilding and ser ice ind s ries.
Moreo er, nearl 750 000 UK ci i ens li e or ork in o her EU co n ries. UK ci i ens o ld
lose he righ o mo e o an EU co n r o li e and ork here.
The C Ag ic l al P lic (CAP) The CAP is in he process of being reformed, i h a
ie o red cing i s inefficiencies. If he Uni ed Kingdom remains in he EU i co ld par icipa e
in i s reform hich co ld ork o he Uni ed Kingdom s long- erm in eres .
The fall f he d A Lea e o e in he referend m as e pec ed o res l in a sharp drop in
he po nd d e o he ncer ain ies ha Bre i o ld crea e in he b siness orld. In fac he
po nd did s ffer a precipi o s decline, hich crea ed infla ionar press res. Since he
referend m, he UK has e perienced infla ion, and i h nominal incomes s agnan , real incomes
ha e been falling.
Gl bal li ical i fl e ce I is likel ha he Uni ed Kingdom can ha e a grea er infl ence in
global poli ics and nego ia ions as a member of a large a po erf l bloc like he EU, ra her han
ac ing on i s o n.
The referend m of J ne 2016 did no mean ha he Uni ed Kingdom o ld immedia el lea e he
EU. In March 2017, he Bri ish Prime Minis er formall informed he EU ha he Uni ed Kingdom
as lea ing ( hro gh he so-called Ar icle 50). Follo ing his, he Uni ed Kingdom had a period of
o ears o nego ia e i h he EU he na re of i s rela ionship i h he EU af er i s formal depar re,
sched led o ake place in March 2019. D e o inabili o comple e he nego ia ions, his da e as
la er e ended o 31 Oc ober 2019. Follo ing ano her dela Bre i ook place on 31 Jan ar 2020.
I became apparen d ring he nego ia ions ha he Uni ed Kingdom an ed o main ain free rade
i h he EU, from hich i has remendo s benefi s, b i h res ric ions on immigra ion. The EU on
he o her hand ref sed o spli he free mo emen of goods, ser ices, people and capi al.
A
1 Dis ing ish be een membership in he E ropean Union and membership in he E ropean
Mone ar Union.
2 Using an appropria e diagram e plain h he drop in he po nd crea ed infla ionar press res in
he Uni ed Kingdom.
3 E plain he difference be een nominal and real incomes. Using he informa ion in he e
e plain h real incomes in he Uni ed Kingdom ha e been falling.
Up o he ime of Bre i , n mero s s dies had ried o predic he economic effec s ha his
4 o ld ha e. Mos of hese ere pessimis ic b highl ariable, predic ing mildl nega i e o
er s rongl nega i e effec s. In es iga e he effec s ha Bre i has had on he UK econom b
e amining
he al e of he po nd in rela ion o he e ro,
e por s,
he c rren acco n ,
nemplo men ,
infla ion,
economic gro h, and
foreign direc in es men .
2 Preferen ial rade agreemen is some imes sed in ano her sense o refer o he eakes form of economic
in egra ion, coming he forma ion of bila eral or regional rading blocs. This pe of PTA is no of
in eres o s beca se i is no allo ed b WTO r les.
3 A f ll anal sis of rade di ersion is ac all a li le more complica ed, beca se rade di ersion comes i h some
benefi s, ho e er his disc ssion is be ond he scope of his book.
4 The si co n ries ere Belgi m, France, I al , L embo rg, Ne herlands and Wes German .
5 Bri ain is composed of England, Sco land, Wales. The Uni ed Kingdom on he o her hand is composed of he
hree co n ries of Bri ain pl s Nor hern Ireland. The f ll name is Uni ed Kingdom of Grea Bri ain and
Nor hern Ireland.
15.3 Ec ic i eg a i : ea i
LEARNING OBJECTIVES

• define all the terms appearing in a ge b d in the text (AO1)
• explain monetary union (AO2)
• discuss advantages and disadvantages of monetary union (HL only) (AO3) (This will be
discussed in Chapter 17, Section 17.3 after you have studied exchange rates.)
M ea i
T : Re ec af e a e d ed e c a ge a e C a e 16 a d 17 a e be
ab e be e de a d e a e a ec .Y be e ded C a e 17 e
ec .
M ea i involves a far greater degree of integration than a common market, and occurs when
the member countries of a common market adopt a common currency and a common central bank
responsible for monetary policy. A monetary union has been formed by a number of the countries of the
European Union, known as the ‘euro zone countries’. There are many other trading blocs around the
world that have plans to form a monetary union in the future.
Following years of preparation for monetary union, 11 countries of the European Union adopted a single
currency, the euro, in 1999. These countries were Austria, Belgium, Finland, France, Germany, Ireland,
Italy, Luxembourg, the Netherlands, Portugal and Spain. They were joined by Greece in 2001, Slovenia
in 2007, and Cyprus and Malta in 2008. The countries that have adopted the euro are members of the
European Monetary Union. On 1 January 1999 the new currency, the euro, came into being and the
currencies of the participating countries were locked together through fixed and absolutely unchangeable
exchange rates. Euro notes and coins were introduced on 1 January 2002 and for the period of one year
they coexisted side by side with national currencies. On 1 January 2003 the national currencies of the
participating countries were abandoned and the euro became the sole currency of the euro zone
countries.
The creation of the European Monetary Union was one of the most significant economic events in the
post-Second World War period, as it was the first time ever that such a large group of countries gave up
their national currencies to adopt a single common currency. As part of their preparation for
membership, the countries had to agree to a number of conditions known as ‘convergence requirements’,
including limiting their rate of inflation, limiting their budget deficit to 3% of GDP, limiting their
government debt to 60% of GDP, and others. Moreover, in adopting the common currency, they gave up
a significant part of their economic sovereignty to a supranational body, the European Central Bank,
which assumed the responsibility for monetary policy for all the member countries. Following the
adoption of the euro, the member countries gave up control of their money supply and their ability to
carry out their own monetary policy, transferring these powers from each of their national central banks
to a single institution, the European Central Bank.
Monetary union, or the formation of a single currency, can be partly thought of as a system of ‘fixed’
exchange rates among the participating currencies, but one in which there is no possibility ever of
changing the value of one currency in relation to another (no possibility of ever revaluing or devaluing,
see Chapter 16).

1 Explain the meaning of monetary union.
2 Outline why it is a higher form of integration than a common market.
15.4 T O
LEARNING OBJECTI ES

e plain he objec i e , f nc ion and fac or affec ing he infl ence of he World Trade
Organi a ion (WTO) incl ding diffic l ie in reaching agreemen and member neq al
bargaining po er (AO2)
TO
The T O ( TO) de cribe i elf a an organi a ion for liberali ing (freeing p)
rade, i h he follo ing objec i e and f nc ion :6
I admi i e WTO ade ag eeme . The WTO help in he implemen a ion and admini ra ion
of in erna ional rade agreemen .
I ide a f m f ade eg ia i . The WTO pro ide a for m for member o di c
heir rade problem and nego ia e rade agreemen on ho o liberali e rade. Thi i one of he
mo impor an WTO f nc ion .
I ha dle ade di e . When WTO member di agree on rade i e , he WTO make deci ion
o re ol e he difference on he ba i of he legal fo nda ion of he rade agreemen .
I m i a i al ade licie . The WTO carrie o periodic re ie of i member na ional
rade policie . Member are req ired o no if he WTO of an change in rade polic . The WTO
al o e amine ne rading bloc arrangemen .
I ide ech ical a i a ce a d ai i g f de el i g c ie . The WTO pro ide
a i ance in he form of raining of go ernmen official a ell a jo rnali , academia and
pri a e ec or repre en a i e in de eloping co n rie on rade-rela ed i e ari ing from WTO
rade agreemen .
I facili a e c - e a i i h he i e a i al ga i a i . The WTO co-opera e i h o her
in erna ional organi a ion ( ch a he World Bank and In erna ional Mone ar F nd di c ed in
Chap er 20), in order o facili a e co-ordina ion of global police .
T TO :
The WTO claim o offer benefi o he global rading em ari ing from i con rib ion o he
de elopmen of free rade, he e abli hmen of an effec i e em of rading r le and a mechani m o
re ol e rade di p e be een co n rie . Ye he WTO i a highl con ro er ial organi a ion in he
orld oda , ro ing pa iona e feeling among bo h ppor er and cri ic .
T TO
The mo comprehen i e and far-reaching rade liberali a ion agreemen in hi or , he Ur g a Ro nd,

a achie ed in 1994 nder he GATT, he WTO predece or. I re l ed in ariff red c ion of 33% on
a erage, i h he hare of good i h no ariff increa ing from 20 22% o 40 45%. Ye he agreemen
did no cceed in pro iding co n rie i h eq al oppor ni ie o hare in he benefi of increa ed rade
The 1997 H man De elopmen Repor of he Uni ed Na ion De elopmen Programme (UNDP)
mmari e he impac of he Ur g a Ro nd.
P c e e e beca e e e e a e a e b a ed a a e , a c a
e ea e a a ade. T e U a R d ade ed e e ce. A de e
c e a e ee- a e e d e e, e e a a e a d e
c e a e e a ed a d a a e e e e A a a d La
A e ca. 7

H T O
D ring he Grea Depre ion of he 1930 , hen co n rie aro nd he orld ere ffering major
decline in o p and high ra e of nemplo men , he re or ed o ariff and o her re ric ion o
limi impor and pro ec dome ic prod c ion and emplo men . A each co n r rai ed i ariff , i
pro oked re alia or ariff increa e from i rading par ner , re l ing in ariff ar ha grea l
red ced he ol me of in erna ional rade i ho po i i e effec on o p and emplo men .
In 1947, 23 co n rie formed an agreemen kno n a he General Agreemen on Tariff and Trade
(GATT), in ended o grad all liberali e (free p) in erna ional rade and pre en f r her o break of
ariff ar . Up o ha ime, all co n rie had been free o impo e an pe of rade pro ec ion
mea re on impor from o her co n rie .
F 15.5: Q e on Ci , Philippine . Pro e or oppo ed o WTO member hip belie ed o ha e

led o ma i e flooding of impor ed food and agric l ral prod c
The GATT a ba ed on he follo ing principle :

-d c a : eq al, non-di crimina or rea men for all member co n rie ; hi mean
ha a co n r rade polic canno di crimina e be een i rading par ner (for e ample, i
canno impo e a higher ariff on impor from one co n r and a lo er one on impor from
ano her co n r ); e cep ion a made for bila eral and regional rading bloc
e a -a ade ba e : grad al elimina ion of non- ariff barrier (q o a ,
b idie , admini ra i e barrier ); e cep ion ere made for agric l ral prod c and co n rie
i h balance of pa men diffic l ie
c a e e ade d e : GATT pro ided a for m for di c ion o re ol e
di agreemen be een co n rie .
The member of GATT o ld periodicall cond c ro nd of nego ia ion in hich he ried o
achie e he abo e objec i e . The cond c ed eigh ro nd in o al, he la one being he Ur g a
Ro nd (beca e i a la nched in P n e del E e in Ur g a ), hich la ed from 1986 o 1994. In
1994, b hich ime he member co n rie had increa ed o 124, an agreemen a reached o replace
he GATT b a ne in erna ional rade bod . Thi bod a e abli hed on 1 Jan ar 1995, and a
called he World Trade Organi a ion (WTO).
Toda , he WTO pro ide he in i ional and legal frame ork for he rading em ha e i
be een member na ion orld ide. A of 2019, i had 164 member , acco n ing for o er 98% of he
al e of global rade. In addi ion, i had 23 Ob er er co n rie , hich m appl for f ll
member hip i hin fi e ear of ha ing Ob er er a .
A
1 E plain he main p rpo e behind he crea ion of he GATT, hich a he prec r or of he
WTO.
2 In ie of increa ing pro ec ioni rend in he global econom , and he danger po ed b rade
ar , di c he po en iall impor an role of he World Trade Organi a ion in he global
econom .
Rea on for he nfa o rable rea men of de eloping co n rie incl ded he follo ing:
De eloped co n rie recei ed grea er ariff red c ion han de eloping one .
The prac ice of making increa ed e of non- ariff and hidden barrier again de eloping co n r
e por a no fficien l addre ed.
Wherea he Ur g a Ro nd pro ided for red c ion in agric l ral b idie , he e ere no
implemen ed beca e of re i ance in de eloped co n rie .
Pro ec ion of in ellec al proper increa ed he co of acq iring ne echnolog b de eloping
co n rie .
M l ina ional corpora ion (MNC , ee Chap er 20) no longer had o b heir pplie locall ; hi
mean he co ld no longer increa e demand for locall prod ced good and er ice , hich o ld
increa e local emplo men .
T TO
In 2001, he WTO began nego ia ion kno n a he Doha De elopmen Ro nd (la nched in Doha,
Qa ar). Ho e er, i oon became apparen ha de eloped co n r in ere ere domina ing he
nego ia ion . B he end of J l 2008 he nego ia ion collap ed, mainl beca e of e ab eac
a ee e ec de e ed c a e . De eloped co n rie ha e long been pro ec ing
heir farmer hro gh prod c ion and e por b idie , i h n mero nega i e effec on he farmer
and economie of de eloping co n rie (See Real orld foc 14.2, Chap er 14 and Chap er 19).
While farmer pro ec ion con in e in man de eloped co n rie , par ic larl he Uni ed S a e , he
E ropean Union and Japan, one ke cce of he WTO ho ld be no ed here, hich i an agreemen in
2015 o pha e o e por b idie (Real orld foc 14.2, Chap er 14).
T TO
The WTO rea all co n rie a if he are a he ame le el of de elopmen , i h he ole e cep ion of
Lea De e ed C e (lo income co n rie iden ified b he Uni ed Na ion hich face e ere
con rain in achie ing ainable de elopmen ( o be di c ed in Chap er 18)). Thi mean ha
agreemen req iring co n rie o lo er heir rade pro ec ion for he mo par appl o de eloped and
de eloping co n rie alike. Ho e er, here are man de eloping co n rie ha ma need rade
pro ec ion on he gro nd of de eloping heir infan ind rie or di er if ing heir prod c ion and
economie o red ce reliance on (primar commodi ie ).
T TO
I i arg ed ha he WTO doe no pa eno gh a en ion o i e rela ing o he en ironmen . For
e ample, i ha enco raged remo al of rade barrier on impor from co n rie ha ha e lo
en ironmen al pro ec ion andard . I ha al o no ried o red ce b idie on ac i i ie ha harm he
en ironmen ch a agric l re, coal and ran por . S ppor er of he WTO arg e ha hi i he fa l of
he member co n rie hich are no fficien l in ere ed in addre ing en ironmen al i e .
De eloped co n rie oppo e he elimina ion of b idie , hile de eloping co n rie claim ha WTO
r le rela ing o he en ironmen ma be a form of hidden pro ec ion.
Regarding labo r andard , he WTO i acc ed of ignoring i e like child labo r or o her iola ion
of in erna ionall accep ed labo r andard . The WTO ha no linked he remo al of rade barrier o
impro ed labo r prac ice . De eloping co n rie oppo e he incl ion of labo r andard in rade
agreemen , in par beca e he are afraid ha hi can al o be ed a a pe of hidden pro ec ion.
TO
From a formal poin of ie , deci ion-making in he WTO i democra ic beca e of he WTO r le ha
each member co n r ha one o e.8 Ye deci ion are all made b con en , meaning ha once
here i a propo ed deci ion, a con en emerge if no member pre en a he mee ing objec o he
deci ion.
Cri ic arg e ha he WTO i ac all ndemocra ic, and deci ion are ba ed on he po er of member
in pi e of he one o e per member r le. Economicall po erf l co n rie domina e agenda- e ing and
e pre opinion ha carr grea er eigh . Le po erf l co n rie of en remain ilen and gi e in o he
demand of he more po erf l in fear of po ible re alia ion.
In addi ion, he diffic l of reaching a con en in ie of he large n mber of co n rie in ol ed
lead o he forma ion of co n r coali ion hich increa e he po er of he eal hier co n rie .
Ano her i e in ol e he proce of nego ia ion , hich incl de mee ing ha of en re ric
par icipa ion o he more infl en ial and dominan co n rie . Thi , combined i h he ome ime eak
nego ia ing abili ie of eaker member , re l in o come ha fa o r he more po erf l.
The ilence of de eloping co n rie a an impor an fac or in he o come of he Ur g a Ro nd of
1994 ( ee abo e), hich benefi ed he de eloped co n rie . In ie of he abo e i e , here ha e been
man call for reforming he WTO deci ion-making proce i h a ie o making i gen inel
democra ic and hence more effec i e.
A TO:
In addi ion o agreeing on he pha ing o of e por b idie ( ee abo e), he WTO al o cceeded in
making an agreemen be een ome of he WTO member in ol ing c ing ariff on informa ion
echnolog . Al o, he WTO i credi ed i h ha ing pre en ed a re rn o f ll cale rade pro ec ion
d ring he global financial cri i beginning in 2008.
In pi e of he e cce e , here are concern ha he WTO ha come o a alema e crea ed b
de eloped co n r demand ha de eloping co n rie open p heir marke o ind rial prod c and
er ice , hile he hem el e con in e o offer pro ec ion o heir farmer .
Moreo er, here are fear ha he global rading em ma be facing a e back beca e of gro ing
rade pro ec ion endencie aro nd he orld, rongl reinforced b he po i ion of he Uni ed S a e
ince 2018 ( ee Real orld foc 15.2). In addi ion, gro ing impa ience i h he WTO a he main
mechani m for rade liberali a ion i a fac or ha ha re l ed in a ignifican increa e in free rade
agreemen aro nd he orld. The n mber of rade agreemen repor ed o he WTO gre from 20 in
1990 o 159 in 2007 and o 270 in 2017.
Ano her re pon e on he par of co n rie impa ien i h he WTO ha come in he form of ae a
a ee e , gge ed b he US and Canada, hich in ol e agreemen b WTO member on a
a ba . Pl rali ic agreemen ha e been rongl cri ici ed on he gro nd ha he ill
erio l ndermine he m l ila eral approach of he WTO hich in ol e par icipa ion in agreemen
b a e be c e.
A TO:
One of he mo impor an role of he WTO i i abili o re ol e rade di p e be een co n rie ha

di agree on rade prac ice . The WTO ha been carr ing o hi f nc ion hro gh i Appella e Bod ,
a commi ee of e en j dge ho hear complain of WTO member again o her WTO member i h
hom here are di agreemen . The deci ion req ire ha he di agreeing par ie m compl i h
in erna ional rading r le , h re ol ing di p e . In December 2019 he Uni ed S a e blocked he
appoin men of ne j dge of he Appella e Bod . If hi i e i no re ol ed i i feared ha a a re l
he WTO ill be nable o con in e o carr o hi impor an f nc ion.

US C M
In 2008, Canada and Me ico acc ed he Uni ed S a e of illegall req iring impor ed pork and beef
o ha e co n r -of-origin labelling (COOL). According o official , Co n r of origin labelling
harm Canadian and Me ican li e ock prod cer , a ell a U.S. proce or and prod cer .
S ppor er of hi labelling in he Uni ed S a e arg ed ha i a impor an for con mer o kno
here he mea came from. Opponen arg ed ha in ie of food afe in pec ion alread in place,
he labelling did no con rib e an hing o food afe . In ead, he claimed ha hi a a form of
hidden pro ec ion ha crea ed comple b rea cra ic proced re re l ing in higher price of impor ed
mea , making i le compe i i e in he US econom .
F 15.6: Whea on, Mar land, USA. Mea labelling in he Uni ed S a e ha iola ed WTO r le
Canada and Me ico ook he ca e o he World Trade Organi a ion, hich fo nd ha COOL a in
iola ion of in erna ional rade r le . In December 2015, he WTO anno nced ha Canada a lo ing
US$740 million ann all and Me ico abo US$228 million ann all , a a re l of COOL. In
December 2015, he WTO herefore ga e permi ion o bo h Canada and Me ico o re alia e b
impo ing ariff on a range of impor ed prod c from he Uni ed S a e .
Reac ion in he Uni ed S a e a if . Faced i h he pro pec of re alia or ariff b Canada and
Me ico, a US official aid, If Canada and Me ico ake ep o rai e impor d ie on U.S. e por , i
ill onl harm he economie of all hree rading par ner .
In December 2015, he Uni ed S a e repealed he COOL cheme.
S : CBC ;
T e G be a d Ma ;
Sea c Re Web e I e a a Ce e T ade & S a ab e De e e ;
CBS Ne 2015; Pa e a 2015; I e a a Ce e T ade a d S a ab e De e e 2016
A
1 Iden if he pe of rade pro ec ion ha COOL repre en ed.
2 U ing an AD-AS diagram, e plain he a emen ha COOL harmed US proce or and
prod cer . U ing he ame diagram, e plain he effec ha COOL had on con mer .
3 U ing an in erna ional rade diagram, e plain he US claim ha if Canada and Me ico ere o
impo e ariff (impor d ie ), a e ec e a ee ad a e .

1 Wha are he objec i e of he World Trade Organi a ion (WTO)?
2 Wha are ome po i i e con rib ion of he WTO o he global rading em?
3 Wha are ome cri ici m of he WTO?
4 E plain ome challenge faced b he WTO.

I ?
Perhap he ronge economic arg men in fa o r of free rade i ha i lead o grea er efficiencie
in prod c ion and an impro ed alloca ion of re o rce . If he differen pe of rade pro ec ion
di c ed in hi chap er ere remo ed, here o ld be efficienc impro emen . Ye e er one
recogni e ha he e efficienc gain in ol e bo h inner and lo er : ho e ho gain from rade
pro ec ion lo e from he remo al of rade pro ec ion; and he lo er from rade pro ec ion become he
gainer af er i remo al.
In ie of he fac ha here are bo h gainer and lo er , i i po ible o arg e in fa o r of free rade
on a p rel ocial cien ific ba i , i ho moral j dgemen ? Welfare anal i ho ha he gain o
ocie are grea er han he lo e from a remo al of rade barrier , b e en o, here i ill a moral
j dgemen in ol ed in he a emen I oka o acrifice he ell-being of ome people for he ake
of gain in he ell-being of a larger n mber of people. Economi (and o her ) recogni e hi poin .
Ho hen o ge aro nd hi problem, o a o be able o recommend free rade on a cien ific ba i ?
Economi fo nd he ol ion in ha i kno n a he Hick /Kaldor cri erion9 according o hich if
he inner can afford o compen a e he lo er and ill be be er off, hen he remo al of rade
barrier and he i ch o free rade i ce ca j ified.
In prac ice, hi co ld mean ha he go ernmen a e he gainer and hen omeho pa he lo er
for heir lo e . Ho e er, in he real orld hi prac icall ne er happen . When i ne er happen ,
economi , for heir par , can arg e ha he ha e done heir job a economi , and from here on i
i he go ernmen re pon ibili o p r e he righ policie .
Ho e er, if economi recommend, and go ernmen adop free rade policie , ed e a
ee be a c e a e e , i he recommenda ion ill free of moral
j dgemen ? Or i i ba ed on he ame moral j dgemen a ha no ed abo e, ha I oka o
acrifice he ell-being of ome people for he ake of gain in he ell-being of a larger n mber of
people.
We ill re rn o he opic of free rade in Theor of kno ledge 20.1 in Chap er 20.
T
Do o agree ha here i a moral j dgemen in he economic arg men in fa o r of free rade?
If here i a moral j dgemen , doe i ma er ha i i generall co ered p and ignored in
di c ion of free rade?
Do economi ha e a moral re pon ibili o ard ocie ie hen making polic
recommenda ion , or can he make recommenda ion in he belief ha he are f nc ioning
p rel a ocial cien i ?

The follo ing q e ion ill help o reflec on o r learning and enhance o r nder anding of ke
opic in hi chap er. The are gge ion for inq irie ha o can nder ake on o r o n or in
gro p in order o re i e he learning objec i e of hi chap er.
1 E amine he her he co n r o li e in i a member of one or more rading bloc . E amine,
oo, he her i i c rren l in he proce of nego ia ing he forma ion of or en r in o a ne
rading bloc. In each ca e, ha form of in egra ion i in ol ed: free rade agreemen , c om
nion or common marke ? Are he agreemen bila eral or regional? Choo e one or more of he e
rading bloc and r o de ermine hich akeholder are likel o be be er off or or e off a a
re l of he agreemen . Tr o iden if he po ible ad an age and di ad an age for
akeholder and for he econom .
2 Since he ime of ri ing of hi book, he rade ar ha began in earl 2018 be een he Uni ed
S a e and e eral o her co n rie i likel o ha e e ol ed. E amine he c rren i a ion: a
he rade ar re ol ed i h ariff grad all being pha ed o ; did i e cala e i h more ariff
being impo ed; ha i pread o more co n rie hich ha e been affec ed b rade barrier ? Wha ,
if an , ha been he role of he World Trade Organi a ion in re ol ing he di p e ? Wa or i
o r co n r in ol ed in he rade ar? If o ha ha e been ome of he con eq ence ?
3 E amine he mo recen de elopmen regarding he WTO role in re ol ing di p e . Ha e
here been an ne appoin men o he Appella e Bod ? Wha are he pro pec for hi role of
he WTO? Wha po ible fac or migh be leading o he de elopmen ?
E S Q
Yo can find q e ion in he le of IB e am in he 'Digi al co r ebook: E ra ma erial' ec ion.
6 Wha i he World Trade Organi a ion?
7 Uni ed Na ion De elopmen Programme, H man De elopmen Repor 1997 , p. 85.
8 Thi i in con ra o he o ing po er a he In erna ional Mone ar F nd (IMF) and World Bank ( ee Chap er
20) here o ing po er i in accordance i h he i e of con rib ion o he b dge , gi ing ob io po er o
he larger and eal hier co n rie .
9 Thi ork i ba ed on he ork of Bri i h economi John Hick and H ngarian-born economi Nichola
Kaldor. Hick and Kaldor ere among he more infl en ial economi of he 20 h cen r .
Chapter 16
Exchange rates and the balance of

payments
BEFORE YOU START
• Perhaps you have travelled to a foreign country or know others who have. When travelling, you
pay for goods and services using that country s currency so you need to exchange your currency
for the foreign currency. What do you think determines the price you pay to exchange
currencies?
This chapter examines the monetary or financial side of international links between countries. We will
discover how exchange rates are determined and we will examine the positive or negative consequences
of exchange rate changes. We will then study the balance of payments accounts, in order to see how
countries record and oversee international money flows.
16.1 F
LEARNING OBJECTIVES

e plain ho e change a e a e de e mined b demand and ppl of a c enc in he fo eign
e change ma ke (AO2)
d a diag am ill a ing e change a e de e mina ion and e change a e change ho ing
app ecia ion and dep ecia ion (AO4)
calc la e p ice of good in diffe en c encie (AO4)
e plain he a io fac o ha ma ca e change in demand and/o ppl of a c enc (AO2)
calc la e change in he al e of c encie , a i ing f om change in c enc demand o ppl
(AO4)
D
A an momen in ime, he e i a con in o flo of mone in and o of e e co n in he o ld.
Thi happen beca e he e iden of each co n , he he indi id al , o g o p of indi id al , o
fi m , o he go e nmen , ha e ran ac ion (o dealing of an kind in ol ing mone ) i h he e iden
of o he co n ie . In e na ional an ac ion in ol e he e of diffe en na ional c encie , kno n a
. The e na ional c encie a e aded fo each o he in he fo eign e change ma ke ,
he e indi id al , fi m , bank , o he financial in i ion and go e nmen b and ell c encie .
The fo eign e change ma ke i no a cen ali ed mee ing place, b in ol e an loca ion he e one
c enc can be e changed fo ano he , and an indi id al o o gani a ion ha engage in he e change
of one c enc fo ano he .
S ppo e o a e a e iden of R ia a elling o Denma k. Yo ill an o e change ome of o
o ble fo Dani h k one . To do hi , o ell o o ble and b Dani h k one in he fo eign
e change ma ke . The ea on o m do o i ha he e iden of Denma k all p efe o be paid in
Dani h k one . Like i e, e iden of E opean Mone a Union co n ie ( he co n ie of he
E opean Union ha ha e adop ed he e o, al o kno n a e o one co n ie ) an o be paid in
e o ; and e iden of Chile an o be paid in Chilean pe o .
The fo eign e change ma ke , like an ma ke , i made p of demand and ppl of c encie . A a
a elle f om R ia, hen o change o o ble in o Dani h k one , o demand Dani h k one ,
and o ppl o ble in he fo eign e change ma ke .
Simila l , ppo e e iden in he Uni ed Kingdom and Japan an o ade i h each o he . When
Japane e e iden impo f om he Uni ed Kingdom, he b B i i h po nd i h hich o pa UK
e po e ; he he efo e demand B i i h po nd in he fo eign e change ma ke . To ecei e he po nd ,
he ell o ppl en in he fo eign e change ma ke . When UK e iden impo f om Japan, he
demand en, and ppl po nd in he fo eign e change ma ke o ecei e he en.
Thi imple o-co n e ample ill a e he eq i alence be een he demand fo a fo eign c enc
and he ppl of a dome ic c enc . The demand fo po nd i eq i alen o a ppl of en, and he
demand fo en i eq i alen o a ppl of po nd . The e i a imila eq i alence in he eal o ld,
he e he e a e man diffe en c encie : he demand fo en i eq i alen o he pplie of all o he
c encie offe ed (o old) in he fo eign e change ma ke o b en. Simila l , he demand fo po nd
i eq i alen o he ppl of all o he c encie offe ed o b po nd .
The demand fo fo eign c encie gene a e a ppl of dome ic c enc ; and demand fo he
dome ic c enc gene a e a ppl of fo eign c encie . In a imple o-c enc e ample ing
po nd and en, i follo ha :
demand fo po nd ⇔ ppl of en
demand fo en ⇔ ppl of po nd
E
If na ional c encie can be e changed fo each o he , he e m be ome mechani m of e abli hing
he al e of each c enc . Thi i done h o gh he , hich i he al e of one c enc
e p e ed in e m of ano he . Con ide a h po he ical e change a e be een he US dolla and he e o:
n mbe of dolla pe e o: 1.5 dolla = 1 e o
n mbe of e o pe dolla : 0.67 e o = 1 dolla
The fi e p e ion gi e he al e o p ice of 1 e o in e m of dolla , ho ing ho man dolla
m be gi en p o b 1 e o, a ell a ho man dolla can be go en if one e o i gi en p. The
econd gi e he al e o p ice of 1 dolla in e m of e o , ho ing ho man e o m be gi en
p o b 1 dolla , a ell a ho man e o can be go en in e change fo one dolla . The o
e p e ion a e eq i alen . The ha e o be, ince he al e of each c enc i e p e ed in e m of he
o he .
To nde and ho e change a e a e de e mined, e ill con ide o p e e change a e em :
he floa ing e change ra e em, and he fi ed e change ra e em. We ill al o d he ac al
em ed b mo co n ie oda , kno n a a managed floa , o managed e change ra e em,
hich lie in be een he o p e em , ho gh i i clo e o floa ing e change a e .
D
In a (al o kno n a fle ible e change a e em), e change a e a e
de e mined b ma ke fo ce , o he fo ce of demand and ppl , i h no go e nmen o cen al bank
in e en ion in he fo eign e change ma ke .
Con ide a implified o ld i h o c encie , he US dolla and he e o. In a floa ing em, he
p ice of he dolla and he p ice of he e o a e each de e mined in he ame a ha p ice a e
de e mined in an f ee ma ke . Ho e e , a e kno f om o di c ion abo e, he p ice of one
c enc i al a e p e ed in e m of ano he c enc , a he e i no independen ni e can e o
e p e he al e of c encie .
Fig e 16.1(a) ho he ma ke fo dolla . The ho i on al a i mea e he q an i of dolla , and he
e ical a i mea e he p ice of dolla in e m of e o . The demand c e ep e en he demand
fo dolla , and he ppl c e ep e en he ppl of dolla .
F 16.1: E change a e de e mina ion in a floa ing e change a e em
The demand fo dolla , ho n b a familia do n a d- loping c e, come f om e o one e iden

ho need dolla o ca o an ac ion in he Uni ed S a e : e o one impo e b ing good f om
he US, e o one in e o ho an o in e in he US, con me going on holida o he US, e c.
The do n a d lope of he c e indica e ha a he p ice of dolla in e m of e o inc ea e , e o
one e iden b fe e dolla . Fo e ample, if 0.80 e o a e needed o b 1 dolla , e o one
e iden b fe e dolla han if 0.5 e o a e needed o b 1 dolla .
The ppl of dolla , ho n b a familia p a d- loping c e, come f om US e iden ho o ld
like o ell dolla o b e o : US e iden ho o ld like o impo good f om e o one
co n ie , o ho an o ake a holida in a e o one co n , o ho plan o in e in a e o one
co n , e c. To ee h he ppl -of-dolla c e i p a d loping, con ide ha if he p ice of
dolla i 0.5 e o pe dolla , US e iden need o ppl 1 dolla o b 0.5 e o o h of e o one
good ; if he p ice of dolla inc ea e o 0.8 e o pe dolla , hen b elling 1 dolla US e iden can
b 0.8 e o o h of e o one good . A he p ice of dolla goe p, e o one good become
cheape , and o mo e dolla a e pplied. The efo e, a he p ice of dolla in e m of e o inc ea e ,
he q an i of dolla pplied inc ea e .
The in e ec ion of he demand and ppl c e de e mine he eq ilib i m p ice of he dolla in
e m of he e o; hi i he eq ilib i m e change a e, hich i 0.67 e o pe dolla . If he e change
a e e e highe han he eq ilib i m, a a 0.8 e o pe dolla , he e o ld be an e ce ppl of
dolla . A an e change a e lo e han he eq ilib i m, ch a 0.5 e o pe dolla , he e o ld be an
e ce demand fo dolla .
In a floa ing e change a e em, he eq ilib i m e change a e i de e mined b he fo ce of

demand and ppl a he poin he e he q an i of a c enc demanded eq al q an i pplied,
i ho an go e nmen o cen al bank in e en ion.
Fig e 16.1(b) ho he ma ke fo e o . Since he demand fo dolla i eq i alen o he ppl of

e o , and he ppl of dolla i eq i alen o he demand fo e o , i follo ha hen e de e mine
he p ice of dolla , e al o de e mine he p ice of e o . The demand c e, ho ing demand fo
e o b US e iden ho an o b e o o impo , a el, in e , e c. in e o one co n ie , i a
eflec ion of he ppl -of-dolla c e in pa (a). The ppl c e, ho ing he ppl of e o f om
e o one e iden ho an o b dolla o impo , a el, in e , e c. in he Uni ed S a e , i a
eflec ion of he demand-fo -dolla c e in pa (a). The in e ec ion of he demand-fo -e o and
ppl -of-e o c e de e mine he eq ilib i m e change a e, o he p ice of he e o in e m of
he dolla , hich i 1 e o = 1.5 dolla .
The o eq ilib i m e change a e in Fig e 16.1 a e eq i alen o each o he . A an o he e change
a e, he ma ke a e in di eq ilib i m. When he p ice of dolla in e m of e o i 0.80, he e i an
e ce ppl of dolla ha co e pond o an e ce demand fo e o . When he p ice of dolla in
e m of e o i 0.50, he e ce demand fo dolla eflec an e ce ppl of e o .
E :
Once an e change a e e le a i eq ilib i m al e, i ill emain he e n il he e i a change in
demand o ppl of he c enc , e p e ed a a hif in he c enc demand o ppl c e.
Fig e 16.2 ho ho a c enc change in al e in e pon e o change in demand o ppl of he
c enc . An inc ea e in he al e of a c enc ( ch a he dolla ) in a floa ing e change a e em i
called an . Thi i ho n in Fig e 16.2(a) o e l f om an inc ea e in he demand fo
dolla , ca ing he demand-fo -dolla c e o hif o he igh , e l ing in a highe e change a e e2.
In addi ion, i ma e l f om a dec ea e in he ppl of dolla , ho n in pa (b), ca ing he ppl -
of-dolla c e o hif o he lef .
F 16.2: E change a e change in a floa ing e change a e em
A fall in he al e of a c enc ( he dolla ) in a floa ing e change a e em i called a .

The al e of he dolla dec ea e in Fig e 16.2(c) d e o a fall in he demand fo dolla , ca ing a
lef a d hif in he demand-fo -dolla c e, hence a fall in he al e of he dolla o e2; o in pa (d)
d e o an inc ea e in he ppl of dolla , ca ing a igh a d hif in he ppl -of-dolla c e.
The ame gene al p inciple appl o he in e na ional em con i ing of man na ional c encie .
When one c enc app ecia e i doe o again all o he in a floa ing e change a e em, meaning
ha all o he dep ecia e ela i e o i . When a c enc dep ecia e , all o he c encie app ecia e
ela i e o i .
In a floa ing e change a e em, app ecia ion (inc ea e in al e) and dep ecia ion (dec ea e in
al e) of a c enc occ a a e l of change in demand o ppl fo a c enc in he ab ence of
an go e nmen o cen al bank in e en ion.

1 S a e h e change a e a e mea ed in e m of he q an i of ano he c enc .
2 E plain ho e change a e a e de e mined in a floa ing e change a e em.
3 E plain ho each of he follo ing affec he demand o ppl of he US dolla :
An in e o f om he Uni ed S a e in e in he ock ma ke of B a il.
A Pe ian impo e b good f om he Uni ed S a e .
A US e iden a el o China a a o i .
The Uni ed S a e con ib e o fo eign aid in Af ica.
4 Define app ecia ion and dep ecia ion of a c enc .
5 S ppo e he Uni ed S a e o ld like o inc ea e i impo f om e o one co n ie . U ing
diag am , ho he effec on
he al e of he US dolla , and
he e o.
S a e hich c enc ill app ecia e and hich ill dep ecia e.
C
In he eal o ld, he e a e n me o ongoing change in demand and ppl of c encie , ca ing
e change a e of mo c encie a o nd he o ld o fl c a e on a dail o e en ho l ba i .
C
C enc demand in ol e fac o ha lead o inflo of f nd in o a co n .
E
Foreign demand for e por of good . Change in fo eign demand fo a co n e po affec i
e change a e. If he e i an inc ea e in fo eigne demand fo S i a che , he demand fo S i
f anc inc ea e , he demand-fo -f anc c e hif o he igh , and he f anc app ecia e . If fo eigne
demand fo S i a che fall , he demand fo f anc dec ea e and he f anc dep ecia e .
Foreign demand for e por of er ice , ch a o ri m er ice . An inc ea e in o i m f om ab oad
ep e en an inc ea e in e po of e ice ( o i m e ice ). To i coming f om ab oad demand
mo e of he co n c enc and he c enc app ecia e . If o i m f om ab oad fall , demand fo
he c enc fall and he c enc dep ecia e .
The ra e of infla ion rela i e o o her co n rie . If S eden e pe ience a lo e a e of infla ion han
o he co n ie , demand fo i e po inc ea e a o he co n ie no find hem ela i el le
e pen i e. The inc ea e in S edi h e po ca e demand fo S edi h k ono ( he S edi h c enc )
o hif o he igh ca ing he S edi h k ono o app ecia e. If S eden a e of infla ion i highe han
ha of o he co n ie , fo eign demand fo i e po fall , and demand fo he S edi h k ono fall , and
he k ono dep ecia e .
Rela i e gro h ra e . If Ken a ading pa ne e pe ience high economic g o h, hi mean ha
hei income a e i ing and o he demand mo e e po f om Ken a, he demand fo he Ken an
hilling inc ea e , he demand-fo - hilling c e hif o he igh , and he hilling app ecia e . B
con a , lo e economic g o h o ece ion in Ken a ading pa ne ill lead o a dep ecia ion of
he hilling.
I
In ard foreign direc in e men (FDI) and por folio in e men . The e a e o pe of in e men b
fo eigne : (in e men b m l ina ional co po a ion in p od c i e facili ie ;
ee Chap e 20) and (financial in e men , ch a p cha e of ock and bond ).
Bo h pe of in e men ha e he ame impac on e change a e . If he in e men i in ard (coming
in o he co n ), fo eigne a e b inging in f nd f om ab oad b demanding he dome ic c enc . If
fo eigne an o inc ea e hei in e men in China, he m b Chine e an, and he demand-fo -
an c e hif o he igh , app ecia ing he an. If fo eigne dec ea e hei in e men in China, he
demand fo an fall and he an dep ecia e . Thi applie o bo h FDI and po folio in e men .
Rela i e in ere ra e . Financial capi al (defined in Chap e 1, Sec ion 1.1) efe o f nd ha a e ed
o make financial in e men , o in e men ha ecei e a e n ba ed pa l on he a e of in e e .
(Financial in e men a e a pe of por folio in e men , defined abo e.) Fo e ample, a ing depo i
in bank and p cha e of bond depend on he a e of in e e ha can be ecei ed. The highe he a e
of in e e in a co n , he mo e a ac i e a e he a ing depo i and bond . If in e e a e in he
Uni ed Kingdom inc ea e ela i e o in e e a e in o he co n ie , financial in e men become mo e
a ac i e, mo e financial capi al ill flo in, demand fo B i i h po nd inc ea e , he demand-fo -
po nd c e hif o he igh , and he po nd app ecia e . Simila l , if in e e a e in he Uni ed
Kingdom fall ela i e o in e e a e in o he co n ie , le financial capi al ill flo in and he po nd
ill dep ecia e. Ve of en e pec a ion of financial in e o ha in e e a e ill i e o fall in a
co n a e eno gh o ca e c enc app ecia ion o dep ecia ion.
O
In ard flo of remi ance . R in ol e a an fe of mone f om one co n o ano he , in
mo ca e b fo eign o ke ho end mone f om hei ea ning in he co n of e idence o hei
famil in hei home co n . In 2018, India and China e e b fa he la ge ecei e of emi ance of
hei o ke ab oad ho en mone home. An inc ea e in emi ance in o a co n en f om ab oad,
fo e ample in o India, lead o an inc ea e in he demand fo he Indian pee and a pee app ecia ion.
A fall in emi ance in o India lead o a fall in demand fo he Indian pee hence a pee dep ecia ion.
Spec la ion ha a c rrenc ill apprecia e. C enc in ol e b ing and elling
c encie o make a p ofi f om change in e change a e . B ing and elling i ba ed on e pec a ion
of f e e change a e change . If c enc pec la o e pec a co n c enc o app ecia e, he
b i in he hope of elling i la e af e i app ecia ion, he eb making a p ofi . Ho e e , a he b
he c enc he ma ca e i o app ecia e; he e i he efo e a elf-f lfilling p ophec a o k.
Spec la o can he efo e ca e e change a e change h o gh hei ac ion .
Cen ral bank in er en ion o increa e he al e of a c rrenc . E e cen al bank hold e e e of
fo eign c encie ha i ome ime b o ell o infl ence he al e of he dome ic c enc ( ee
belo ). If he cen al bank an o inc ea e he al e of he dome ic c enc , i demand (b ) he
dome ic c enc (b elling fo eign c encie ), he demand c e hif o he igh , and he c enc
app ecia e .
C
C enc ppl in ol e fac o ha lead o o flo of f nd f om a co n .
I
Dome ic demand for impor of good . Change in a co n demand fo impo affec i e change
a e. If con me in he Uni ed S a e impo mo e fo eign-made ca , US impo e m b mo e
fo eign c encie , and o he ppl ( ell) mo e US dolla in he fo eign e change ma ke . A he
ppl of dolla inc ea e , he ppl -of-dolla c e hif o he igh , and he dolla dep ecia e . If he
US demand fo fo eign ca fall , he e i a lef a d hif in he ppl -of-dolla c e and he dolla
app ecia e .
Dome ic demand for impor of er ice , ch a o ri m. Impo of o i m e ice efe o o i
a elling ab oad o fo eign co n ie . To do o he ell dome ic c enc o b fo eign e change ha
he can e ab oad. Inc ea ing n mbe of F ench o i a elling ab oad o ide of he e o one
mean he ppl of e o ill inc ea e, and o he e o ill dep ecia e. On he o he hand if he n mbe
of F ench o i a elling ab oad o ide of he e o one fall , hi mean he ppl of he e o ill
dec ea e o he e o ill app ecia e.
The ra e of infla ion rela i e o o her co n rie . If S eden a e of infla ion i lo e han ha of o he
co n ie , demand fo impo dec ea e a he e a e ela i el mo e e pen i e compa ed o
dome icall p od ced good , and ppl fo he S edi h k ono dec ea e , ca ing i o app ecia e
(no e hi einfo ce he effec of g ea e demand fo e po di c ed abo e). If S eden e pe ience a
highe a e of infla ion compa ed o o he co n ie , impo f om o he co n ie i h lo e infla ion
a e ill inc ea e a S ede find hem cheape . The e i a igh a d hif in ppl of k one , ca ing
he S edi h k ono o dep ecia e. (Thi einfo ce he effec of lo e demand fo e po no ed ea lie .)
Rela i e gro h ra e . If Ken a e pe ience highe economic g o h i h g o h in income i demand
fo impo ill i e, he efo e he ppl of Ken an hilling inc ea e and he hilling dep ecia e . On
he o he hand lo e g o h a e in Ken a mean lo e income g o h, he demand fo impo ill
dec ea e, he efo e he ppl of Ken an hilling dec ea e and he hilling app ecia e .
I
O ard foreign direc in e men (FDI) and por folio in e men . In e men b m l ina ional
co po a ion in p od c i e facili ie in co n ie o ide of he home co n , a ell a po folio
in e men ( ch a p cha e of ock and bond ) o ide he home co n , in ol e f nd flo ing
o h gi ing i e o ppl of he dome ic c enc . If Thai in e o inc ea e hei in e men
o ide of Thailand he e ill be an inc ea e in he ppl of Thai bah and he bah ill dep ecia e. If
Thai in e o dec ea e hei in e men ab oad, he ppl of bah ill dec ea e and he bah ill
app ecia e.
Rela i e in ere ra e . We ha e een ha in e e a e infl ence he flo of f nd in ea ch of highe
a e of e n f om co n o co n . A a e l , in e e a e and e change a e end o mo e
oge he , ce eri parib . If in e e a e in he Uni ed Kingdom fall ela i e o in e e a e in o he
co n ie , mo e financial capi al ill flo o of he co n , and he ppl of po nd ill inc ea e,
ca ing dep ecia ion. B if in e e a e in he Uni ed Kingdom inc ea e ela i e o in e e a e in
o he co n ie , le financial capi al ill flo o of he Uni ed Kingdom, beca e dome ic in e o
ill an o ake ad an age of he highe dome ic in e e a e , he ppl of B i i h po nd dec ea e ,
and he po nd app ecia e . (No e ha he e effec einfo ce ho e e l ing f om change in demand fo
a c enc .)
O
O ard flo of remi ance . The e a e o a d flo of mone b fo eign o ke in a co n ho
end mone home. In 2018, he Uni ed S a e a b fa he leading co n in he o ld of emi ance
o flo . The mo impo an co n ie ha ecei ed emi ance f om he Uni ed S a e e e Me ico,
China, India and he Philippine . An inc ea e in emi ance en home b o ke li ing in he Uni ed
S a e e l in an inc ea e in he ppl of US $, o he $ dep ecia e . A dec ea e in emi ance en
home b o ke in he Uni ed S a e lead o a fall in he ppl of US $ and $ app ecia ion.
Spec la ion ha a c rrenc ill deprecia e. If c enc pec la o e pec a co n c enc o
dep ecia e, he ell i in he hope of b ing i la e af e i dep ecia ion, he eb making a p ofi .
Ho e e , a he ell he c enc he ma ca e he ppl c e o hif o he igh making he
c enc dep ecia e; he e i he efo e a elf-f lfilling p ophec a o k.
Cen ral bank in er en ion o decrea e he al e of a c rrenc . If he cen al bank an o lo e he
al e of he dome ic c enc , i pplie ( ell ) mo e of he dome ic c enc (b b ing fo eign
c encie ), he ppl of he c enc inc ea e and he c enc dep ecia e .
W
We ha e een ha ome e en ca e bo h demand and ppl of he ame c rrenc o change a he
ame ime:
Ra e of infla ion rela i e o o her co n rie . If S eden ha a lo e a e of infla ion ela i e o o he
co n ie , demand fo i e po inc ea e and demand fo impo dec ea e ; bo h he e fac o lead o
c enc app ecia ion.
In ere ra e rela i e o o her co n rie . An inc ea e in in e e a e in he Uni ed Kingdom a ac
financial capi al, ca ing he demand fo he B i i h po nd o inc ea e and ppl of he B i i h po nd o
dec ea e; bo h he e fac o lead o po nd app ecia ion.
F I F O
I D D I
F F F F
16.2( ) D 16.2( ) D 16.2( ) S 16.2( ) S
Inc ea e in fo eign Dec ea e in fo eign Dec ea e in dome ic Inc ea e in dome ic

demand fo e po of demand fo e po of demand fo impo of demand fo impo of
good and e ice good and e ice good and e ice good and e ice
Lo e infla ion leading Highe infla ion leading Lo e infla ion leading Highe infla ion leading
o inc ea e in fo eign o dec ea e in fo eign o dec ea e in dome ic o inc ea e in dome ic
demand fo e po demand fo e po demand fo impo demand fo impo
High g o h a e of Lo g o h a e of Lo dome ic g o h High dome ic g o h
ading pa ne leading ading pa ne leading a e leading o dec ea e a e leading o inc ea e
o inc ea e in fo eign o dec ea e in fo eign in dome ic demand fo in dome ic demand fo
demand fo e po demand fo e po impo impo
Inc ea e in in a d Dec ea e in in a d Dec ea e in o ad Inc ea e in o ad
in e men in e men in e men in e men
Highe in e e a e Lo e in e e a e Highe in e e a e Lo e in e e a e
leading o mo e in a d leading o le in a d leading o le financial leading o mo e
financial in e men financial in e men in e men b dome ic financial in e men b
e iden in fo eign dome ic e iden in
co n ie fo eign co n ie
Inc ea e in inflo of Dec ea e in inflo of Dec ea e in o flo of Inc ea e in o flo of
emi ance emi ance emi ance emi ance
Spec la o e pec - - Spec la o e pec
c enc X ill i e o c enc X ill fall o
he b c enc X he ell c enc X
Cen al bank b he - - Cen al bank ell he
dome ic c enc dome ic c enc
T 16.1: S mma of ca e of e change a e change

1 Fo each of he follo ing e en , d a e change a e diag am and ho ho a hif ing c enc
demand o ppl c e ca e an app ecia ion o dep ecia ion of he c enc :
An inc ea e in in e e a e in he Uni ed S a e ela i e o he e of he o ld; ho he
impac on he US dolla and on he B i i h po nd.
An inc ea e in in e e a e in he Uni ed S a e ela i e o he e of he o ld; ho he
impac on he US dolla and on he B i i h po nd.
An inc ea e in he a e of infla ion in Thailand ela i e o i ading pa ne ; ho he
impac on he bah (Thailand c enc ) and on he inggi (Mala ia c enc ; Mala ia
i a ading pa ne of Thailand).
C enc pec la o belie e ha he B a ilian eal ill app ecia e; ho he impac on he
B a ilian eal.
Japan i in ece ion, and income a e falling; ho he impac on he Japane e en.
China e pe ience an inc ea e in o i m; ho he impac on he Chine e an.
Fa hion fa o Indian e ile ; ho he impac on he Indian pee.
Fo eign di ec in e men f om Ma i i in o India inc ea e ; ho he effec on he
Ma i ian pee and he Indian pee.
The cen al bank of Bo ana doe no an o allo he p la o dep ecia e; ho he
impac on he p la.
2 Some of he i em appea ing in Table 16.1 gi e i e o change in bo h demand and ppl of he
ame c rrenc . Iden if ha he e a e and e plain h bo h c enc demand and ppl a e
affec ed.
C
E ample 1
A h po he ical e change a e of 1.5 dolla = 1 e o gi e he p ice of 1 e o in e m of dolla . If e
an o find he p ice of 1 dolla in e m of e o , e di ide he ni c enc (e o) b he o he
c enc (dolla ). The efo e,
1 dolla = 1 1.5 e o = 0.67 e o
The e p e ion 1.5 dolla = 1 e o, and 0.67 e o = 1 dolla a e eq i alen .
E ample 2
The h po he ical e change a e 0.37 R ian o ble (RUB) = 1 Japane e en (JPY) gi e he p ice of 1
en in e m of o ble . Find he p ice of 1 o ble in e m of en.
1 o ble = 1 0.37 en = 2.70 en
The e p e ion 0.37 o ble = 1 en, and 2.70 en = 1 o ble a e eq i alen .

In he eal o ld, e change a e a e all e p e ed o man decimal place . Fo e ample, e ma
find ha 1 ble = 2.70135 en. E en a e mall change in an e change a e can amo n o la ge
diffe ence in he o al al e being aded if la ge q an i ie of mone a e in ol ed.
C
S ppo e an impo e in he Uni ed Kingdom impo ine f om F ance ( hich i a e o one co n ).
The h po he ical e change a e be een B i i h po nd ( ) and e o ( ) i 1.22 = 1. The impo e
an o impo 1000 bo le a he p ice of 5 pe bo le. Since he impo e ill ppl o make he
pa men in , he i in e e ed in finding he co in .
In e m of e o , he co i 1000 5 = 5000. To find hi amo n in po nd , e impl m l ipl i b
1.22 ( ince 1 = 1.22), and e find 1.22 5000 = 6100.
C
I
S ppo e o a e gi en a e of da a on he follo ing e change a e change o e ime. He e e con ide
an imagina co n called Bopland ho e na ional c enc i he bople.
The da a in Table 16.2 ho he al e of 1 bople in e m of US $. Ha he bople app ecia ed o
dep ecia ed in he pe iod f om Jan a o Decembe 2020? In Jan a , 1 bople a o h $1.22, hile in
Decembe i a o h $1.69. The al e of he bople inc ea ed, in o he o d he bople app ecia ed
ela i e o he $. Ho e e , i did no app ecia e e e mon h. In J ne, J l and A g i dep ecia ed (o
lo ome al e) compa ed o he p e io mon h.
J 2020 1.22 J 2020 1.40
F 2020 1.25 A 2020 1.37
M 2020 1.33 S 2020 1.45
A 2020 1.39 O 2020 1.58
M 2020 1.47 N 2020 1.63
J 2020 1.43 D 2020 1.69
T 16.2: US$ pe 1 bople; a e age mon hl e change a e
C
Wha a he pe cen age change in he al e of he bople be een Jan a and Decembe 2020? (Fo a
e ie of pe cen age change , ee Q an i a i e echniq e chap e in he 'Digi al co ebook: E a
ma e ial' ec ion.)
% change in he bople (Jan a Decembe ) = 1.69 1.22 1.22 100 = 0.47 1.22 100 = 38.52%
The efo e he bople app ecia ed b 38.52% ela i e o he $ d ing 2020.

The bople app ecia ion ela i e o he $ co e pond o a $ dep ecia ion ela i e o he bople. To find he
pe cen age change in he al e of he $ fo hi pe iod, e m fi find he p ice of he $ in e m of
bople . In Jan a , $1.22 = 1 bople, he efo e:
$1 = 1 1.22 bople = 0.82 bople
In Decembe , $1.69 = 1 bople, he efo e:
$1 = 1 1.69 bople = 0.59 bople
We can no e hi info ma ion o find he pe cen age change in he $:
% change in he $ (Jan a decembe ) = 0.59 0.82 0.82 100 = -0.23 0.82 100 = -28.05%
The nega i e pe cen age change indica e a fall in he al e of he $; he efo e he $ dep ecia ed b
28.05% ela i e o he bople in 2020.
Thi e e ci e indica e ha al ho gh an app ecia ion of c enc X ela i e o c enc Y i eq i alen
o a dep ecia ion of c enc Y ela i e o c enc X, he pe cen age change are no he ame ( i h
one being po i i e and he o he nega i e).1
1 1 Canadian dolla = 0.99 US dolla . Calc la e he al e of 1 US dolla in e m of Canadian
dolla .
1 Indian pee = 1.84 Japane e en. Calc la e he p ice of 1 Japane e en in e m of
Indian pee .
1 Japane e en = 1.34 S i Lanka pee. Calc la e he al e of 1 S i Lanka pee in e m of
Japane e en.
1 B i i h po nd= 1.62 Canadian dolla . Calc la e he al e of 1 Canadian dolla in e m of
B i i h po nd .
2 The p ice of i em X in India i 50 Indian pee . U ing he e change a e in q e ion 1, find i
p ice in
Japane e en, and
S i Lanka pee .
Impo e in Japan and S i Lanka an o impo 1000 ni of i em X. Calc la e hei p ice
in en and pee , e pec i el .
3 The p ice of i em Y in Canada i 75 Canadian dolla . U ing he e change a e in q e ion 1,
find i p ice in
US dolla , and
B i i h po nd .
Wha i he co of 5000 ni of i em Y in dolla and po nd ?
4 On 1 J ne 2010, 1 B i i h po nd a o h US $1.46; on 1 No embe 1 B i i h po nd a
o h US $1.60.
Iden if hich c enc app ecia ed and hich dep ecia ed.
Calc la e he pe cen age app ecia ion of he app ecia ing c enc .
Calc la e he pe cen age dep ecia ion of he dep ecia ing c enc .
5 U ing he able belo , de e mine hich c enc app ecia ed, and hich dep ecia ed f om
he 1 o he 30 h of Sep embe .
Calc la e he pe cen age app ecia ion of he app ecia ing c enc .
Calc la e he pe cen age dep ecia ion of he dep ecia ing c enc .
E 1 US$ ( 1 US )
1 Sep . 2010 1.2800

8 Sep . 2010 1.2697
16 Sep . 2010 1.2989
23 Sep . 2010 1.3364
30 Sep . 2010 1.3611
1 The ea on fo hi i ha pe cen age change a e calc la ed ela i e o an ini ial al e. Since he ini ial al e
a e diffe en fo he o c encie , hei pe cen age change a e al o diffe en .
16.2 C c c a c a a :
a a a
LEARNING OBJECTIVES

define all the terms appearing in a b d in the text (AO1)
evaluate the consequences of changes in exchange rates on economic variables such as inflation,
unemplo ment, economic growth, the current account balance, standards of living (AO3)
draw AD-AS diagrams to show consequences of exchange rate changes on important
macroeconomic variables (AO4)
When a currenc appreciates, a unit of it can bu more of other currencies, therefore it can bu more
foreign goods; foreign goods, or imports, become cheaper. As a result we expect imports to increase. At
the same time, foreigners need to give up more of their currencies to bu the domestic currenc , so that
foreigners can bu fewer of the domestic goods; therefore domestic goods, or exports, become more
expensive to foreigners and we expect that exports will fall. This means that net exports or (X M) will
decrease.
When a currenc depreciates, the opposite happens. It loses its value relative to other currencies, so
imports become more expensive while exports become cheaper to foreigners. The depreciated currenc
can therefore bu fewer foreign goods, or imports, while foreigners can bu more domestic goods, or
exports. This means that net exports, or (X M) will increase. (HL students will learn that this depends
on the Marshall-Lerner condition; see Chapter 17.)
Currenc appreciation can be expected to result in a decrease in net exports (X M) while currenc
depreciation can be expected to lead to an increase in net exports (X M).
Man of the consequences of exchange rate changes follow from the above results.
E c a a
Exchange rate changes can affect inflation in two wa s.
D a d- a
Exchange rate changes affect aggregate demand b influencing net exports (X M). A currenc
depreciation, b making exports cheaper and imports more expensive, works to increase the quantit of
exports and lower the quantit of imports, thus increasing net exports (X M). An increase in net
exports results in a rightward shift of the aggregate demand curve. Using the Ke nesian AD-AS model,
we can see that whether or not this will cause demand-pull inflation depends on where the econom is in
the business c cle. If it is in recession, an increase in AD will not cause demand-pull inflation, however
if the econom is producing at or close to potential output, inflationar pressures will result due to
excess aggregate demand (see Section 10.2, Chapter 10).
A currenc appreciation will work to reduce demand-pull inflationar pressures in an econom due to a
decrease in net exports (X M), causing AD to fall.
C - a
A currenc depreciation, as we have seen, makes imports more expensive. If domestic producers are
heavil dependent on imported factors of production, their costs of production increase, resulting in a
leftward shift of the SRAS curve resulting in cost-push inflation (see Section 10.2, Chapter 10).
A currenc appreciation, b making imports less expensive, results in a rightward shift of the SRAS
curve, lowering inflationar pressures in the econom (lower cost-push inflation).
E c c c
The effects of exchange rate changes on economic growth work directl through net exports and
aggregate demand, discussed above, but the ma also have effects on aggregate suppl .
A currenc depreciation increases net exports, increasing aggregate demand, thus causing an increase in
real GDP produced. This is short-term growth (see Chapter 11). Also, if the growth of export industries
leads to increased investment spending in the domestic econom (production of capital goods), there
ma be effects on aggregate suppl , causing increases in potential output (rightward shifts in the LRAS or
Ke nesian AS curves). This is long-term growth.
However, on the negative side, to the extent that there is cost-push inflation (see above) there ma a
downward pressure on real GDP which ma fall due to the decrease in short-run aggregate suppl
(leftward shift in the SRAS curve).
What will happen to real GDP depends on which of the two effects is stronger: the upward effect due to
the increase in aggregate demand or the downward effect due to the decrease in short run aggregate
suppl . On the other hand, a currenc appreciation, b reducing net exports is likel to reduce growth of
real GDP.
E c
We have seen that a currenc depreciation increases net exports and therefore aggregate demand. This
causes a fall in c clical unemplo ment if the econom is in a recessionar gap. If the econom is at or
close to potential GDP, the increase in aggregate demand ma cause a e a decrease in natural
unemplo ment, however this will come with strong demand-pull inflationar pressures.
Emplo ment in export industries is likel to increase since exports are likel to rise. In addition
emplo ment in industries producing goods that compete with imports is also likel to increase since
imports are expected to fall with depreciation.
On the other hand, as we have seen above, depreciation ma lead to cost-push inflation. This involves
lower real GDP due to the decrease in short run aggregate suppl (leftward shift of the SRAS curve),
hence an increase in unemplo ment. The overall effect on unemplo ment depends on which of the two
effects is stronger: the upward effect due to the increase in aggregate demand or the downward effect due
to the decrease in short-run aggregate suppl .
A currenc appreciation, b reducing net exports and aggregate demand, will create a recessionar gap
and therefore lead to c clical unemplo ment if the econom begins at or close to potential output, or will
lead to an increase in c clical unemplo ment if it is alread in a recessionar gap.
Emplo ment in export industries as well as in industries producing goods that compete with imports is
likel to decrease since exports are expected to fall while imports are expected to increase.
E c c acc ba a c
The c e acc ba a ce will be studied in Section 16.4. For now we can sa that it consists mainl
of the balance of exports and imports of goods and services, specificall the value of exports minus the
value of imports, or more simpl X M. For reasons we will discover later in this chapter, major
differences between the value of exports and the value of imports are considered undesirable, especiall
if the persist over long periods.
As we know, depreciation is likel to cause imports to decrease and exports to increase. If a countr has
an excess of imports over exports (a trade deficit ), its deficit is likel to become smaller after a period
of time. If it has excess of exports over imports to begin with (a trade surplus ), its trade surplus is likel
to become larger. An appreciation, b contrast, will cause imports to increase and exports to fall, thus
having the opposite effects on the current account balance. These points will become clearer to ou after
ou have studied Section 16.4 below. (HL students will stud this topic further under the Marshall-
Lerner condition in Chapter 17.)
E c d b
A depreciation, b lowering the value of the domestic currenc , causes the value of foreign debt to
increase. Suppose Mountainland owes foreigners $1000, and initiall has an exchange rate of Mnl 1.5 =
$1 (Mnl is Mountainland s national currenc ); its foreign debt is therefore Mnl 1500. If the Mnl
depreciates, so that now Mnl 2 = $1, Mountainland s foreign debt of $1000 becomes Mnl 2000. This is a
problem faced b man developing countries, which find themselves having a larger debt burden if their
currenc depreciates (see Chapter 20). On the other hand, a currenc appreciation causes the value of
foreign debt to fall.
E c a da d
When a currenc depreciates, it causes imported goods to become more expensive in the domestic
econom , therefore residents become worse off as all imported goods become more expensive. If the
countr depends on imports of oil, residents will be affected b increased prices of gasoline as well as
heating oil. In addition, if there are important imported inputs in production, such as oil or capital goods,
there will be cost-push inflation, that will increase the general price level, making the cost of living
higher and therefore reducing the real incomes of residents. The upward effects on aggregate demand
(see above) ma add to the inflationar pressures through demand-pull inflation. Further, travellers
abroad such as tourists to other countries will find their holida s have been made more expensive b the
depreciation. The effects on unemplo ment are likel to be mixed, as explained above in the section on
unemplo ment.
If, on the other hand, a currenc appreciates, the effects on living standards of the residents are likel to
be positive. Prices of imported goods fall, imported inputs become less expensive, leading to a
downward pressure on the rate of inflation, which is reinforced b the likel decrease in demand-pull
inflation. Therefore, real incomes will increase. Travellers abroad will also benefit as the cost of
travelling outside of the countr will decrease. As regards unemplo ment, the effects here too are likel
to be mixed.

1 Using AD-AS diagrams, explain the likel effects on
a inflation in Canada if the Canadian $ appreciates,
b living standards in Belarus if the Belarusian ruble appreciates,
c unemplo ment in the United Kingdom if the British pound depreciates,
d inflation in Chile if the Chilean peso depreciates,
living standards in Singapore if the Singapore $ depreciates,
economic growth in Iceland if the Icelandic kr na depreciates,
unemplo ment in Sri Lanka if the Sri Lankan rupee appreciates, and
economic growth in Morocco if the Moroccan dirham appreciates.
2 Explain the likel effects of
a currenc appreciation, and
b currenc depreciation on
current account balance, and
foreign debt.
T a I da
The ear 2018 was a difficult one for the Indian rupee, which fell significantl relative to the US
dollar. Among the factors responsible for rupee weakness is the tightened monetar polic of the US
Federal Reserve (the central bank of the United States), which raised interest rates four times in the
course of the ear. Higher oil prices contributed to a widening current account deficit in India, which
depends heavil on imported oil. India imports as much as 70% of the crude oil it consumes. It is
expected that in 2018 the current account deficit will widen to 2.8% of GDP compared to 1.9% the
previous ear.
F 16.3: Mumbai, India. Reserve Bank of India, the central bank
The rupee depreciation has contributed to inflationar pressures in India. The prices of consumer
goods, such as soaps, detergents and shampoos, whose production depends on crude oil, will be
affected. In addition petrol and diesel prices will rise.
Other goods that India imports in large quantities, such as fertilisers, medicines, iron ore and some
food products, are also becoming more expensive due to the weak rupee.
Emplo ment in industries that depend heavil on imports will also be negativel affected. For
example, electronic consumer goods such as computers, television and mobile phones have imported
components. Tourism will be influenced on account of higher airfares arising from the higher cost of
fuel, as well as the cost of spending abroad which will increase in terms of rupees. The automobile
sector will suffer due to the use of imported components, as well as loans that have to be repaid in
foreign currencies.
S c :A a Se g a, A R ee S Rec d L f 71, He e W I Fa g L e Ne e
Bef e , Ne 18, 31 A g 2018
C a a K a , F e fac a affec ed I d a c e c 2018 ,
B e T da , 23 Dece be 2018
A
1 Using an exchange rate diagram and evidence from the text, explain the effects on the Indian
rupee of higher interest rates in the United States.
2 Using AD-AS diagrams, explain the effects of rupee depreciation on
a demand-pull inflation, and
b cost-push inflation.
3 Discuss the likel effects of rupee depreciation on growth, unemplo ment, the current account
balance, foreign debt and standards of living.
4 Investigate how the value of the rupee has changed since 2018. Determine whether the rupee has
depreciated further, or if it has appreciated, and examine the factors behind the changes.
16.3 G
LEARNING OBJECTIVES

e plain e change rate determination in a fi ed e change rate s stem, including currenc
devaluation and revaluation (AO2)
dra a diagram to sho ho fi ed e change rates are maintained (AO4)
e plain e change rate determination in a managed e change rate s stem (AO2)
e plain overvalued and undervalued currencies (AO2)
dra a diagram to sho ho equilibrium e change rates are determined and change in a
managed e change rate s stem (AO4)
evaluate fi ed versus floating e change rate s stems (HL onl ) (AO3) (to be considered in
Chapter 17)
U
In a , e change rates are fi ed b the central bank of each countr at a
particular level (or narro range), and are not permitted to change freel in response to changes in
currenc suppl and demand. The e change rate is still determined b currenc demand and suppl , but
these are manipulated b the central bank or government in order to arrive at the particular equilibrium
that ill give rise to the desired e change rate. Therefore maintaining the value of a currenc at its fi ed
rate requires constant intervention b the central bank or government. This intervention takes the form of
bu ing and selling reserve currencies b the central bank, as ell as making other adjustments in the
domestic econom , all intended to shift the currenc demand or suppl curves in order to arrive at the
predetermined equilibrium.
To see ho this orks, again consider Bopland and its national currenc , the bople. The market for
boples is sho n in Figure 16.4(a). The central bank of Bopland has fi ed the bople US dollar e change
rate at 2 US dollars = 1 bople. Initiall there is equilibrium in the bople market, at point A. Suppose
there occurs a left ard shift in the demand for boples (because, for e ample, of a fall in demand for
Bopland s e ports), so the demand-for-boples curve shifts from D1 to D2. At the fi ed e change rate of 2
dollars = 1 bople, there is an e cess suppl of boples (the distance A B). Under a floating e change
rates, the e change rate ould fall to 1.50 dollars per bople (point C), eliminating the e cess suppl ; but
if the fi ed e change rate of 2 dollars per bople is to be maintained, the central bank or government must
intervene.
F 16.4: Fi ed e change rates: maintaining the value of the bople at 1 bople = $2.00
I
U
In the e ample above, there is an e cess suppl of boples, so the central bank of Bopland can intervene
b bu ing the e cess boples b selling some of its foreign currenc reserves. This shifts the demand for
boples curve back to D1, and the fi ed e change rate of 2.00 dollars = 1 bople is maintained.
If there had been an e cess demand for boples, the central bank ould sell some boples b bu ing
dollars.
Ho ever, if Bopland faces an e cess suppl of boples and a do n ard pressure on the bople s value
over a long time, its central bank ill eventuall run out of foreign currenc reserves, and ill be unable
to go on bu ing e cess boples. At that point, the central bank or government must use additional
methods to maintain the fi ed e change rate. Ho ever, each of these measures comes ith some
disadvantages.
The need for additional measures to maintain a fi ed e change rate arises primaril hen there is an
e cess suppl of the domestic currenc over a long time. In the opposite situation, here there is an
up ard pressure on the currenc due to e cess demand, the central bank can keep on selling the
domestic currenc and bu ing foreign e change, thus maintaining the e change rate.
I
The central bank can increase interest rates, hich attract financial investments from other countries (see
Section 16.1). This leads to a higher demand for the domestic currenc , shifting the demand for boples
back to D1 in Figure 16.4(a). Ho ever, increases in interest rates involve contractionar monetar polic
and ma lead to a recession in the domestic econom .
B
If the countr borro s from abroad, its loans ill come in the form of foreign e change, hich hen
converted into boples ill cause an increase in the demand for boples and hence a right ard shift in the
demand curve to ard D1. Ho ever, e tensive borro ing from abroad comes ith a number of costs (see
Chapters 19 and 20).
E
The government could use policies to limit imports, because this reduces the suppl of the domestic
currenc (since it reduces demand for foreign e change needed to bu imports), causing a left ard shift
in the currenc suppl curve. In Figure 16.4(b), this appears as a shift from S1 to S2, ith the e change
rate remaining fi ed at 2.00 dollars = 1 bople (point B, given b the intersection of D2 ith S2). To limit
imports, governments can use (a) contractionar fiscal and monetar policies, hich lo er aggregate
demand, lo er incomes, and therefore result in fe er imports; (b) trade protection trade policies, hich
ork to directl lo er the quantit of imports that can enter the countr . Ho ever, contractionar
policies ma lead to recession, hile trade protection comes ith numerous disadvantages, including the
possibilit of retaliation b trading partners, hich ould result in lo er e ports (see Chapter 14).
E change rates are al a s determined b demand and suppl of a currenc in both floating and fi ed
e change rate s stems. Whereas in a floating e change rate s stem the price of a currenc adjusts
freel to changes in suppl and demand, in a fi ed e change rate s stem the currenc suppl and
demand are forced to adjust to the predetermined price , or fi ed e change rate, through central bank
and government intervention that manipulates them.
C :
If a countr e periences serious difficulties in maintaining the fi ed e change rate, a different fi ed rate
can be set. If the currenc value is higher than hat can be maintained through intervention, the
government ma change it to a ne , lo er value; this is called of the currenc . If, on the
other hand, the currenc has a lo er value than can be maintained b intervention, the government ma
set a ne higher value; this is called .
As an e ample of devaluation suppose 2 US dollars e change for 1 British pound; the dollar devalues
and, at the ne fi ed rate, 3 dollars e change for 1 pound. Before the devaluation, 2 dollars ere needed
to bu 1 pound; no 3 dollars are needed, because the dollar has lost some of its value. This is
equivalent to a revaluation of the pound relative to the dollar (the pound increases in value).
Like depreciation, devaluation results in cheaper e ports to foreigners and more e pensive imports for
domestic residents, giving rise to more e ports and fe er imports. Like appreciation, revaluation leads to
more e pensive e ports to foreigners and cheaper imports for domestic residents, and therefore fe er
e ports and more imports.
Historicall , a s stem of fi ed e change rates as in place until 1973. In the period 1879 1934, the fi ed
rate s stem as kno n as the gold standard , as countries fi ed their e change rates relative to the
value of gold. In the period 1944 1973, the fi ed rate s stem came to be kno n as the Bretton Woods
s stem, hich no longer tied currencies to gold, and permitted periodic devaluations or revaluations.
Under this s stem, hen an countr revalued/devalued its currenc , it did so not against just one other
currenc but against all other currencies simultaneousl , since all currencies ere fi ed against each
other. This is analogous to the appreciation and depreciation that takes place under fle ible e change
rates.
Toda , the closest to fi ed e change rates are pegged e change rates, involving a currenc that is fi ed
against one other currenc . While this is similar to a fi ed e change rate, it is considered b the
International Monetar fund (IMF) to be a t pe of managed s stem, so ill be considered belo .2

1 Describe a fi ed e change rate s stem.
2 Using a diagram, e plain some methods that central banks and governments can use to
maintain a fi ed e change rate.
Wh do each of these lead to problems?
3 Distinguish bet een devaluation and revaluation.
When is each of these undertaken b a government?
4 Distinguish bet een
depreciation and devaluation, and
appreciation and revaluation.
5 Outline h it is easier to maintain a fi ed e change rate hen there are up ard pressures on the
value of a currenc than hen there are do n ard pressures.
U
In bet een the t o e tremes of floating e change rates and fi ed e change rates is the s stem of
, also kno n as the a aged fl a . Combining elements of both, though closer
to floating e change rates, this is the current s stem, in use since 1973. E change rates are for the most
part free to float to their market levels over long periods of time; ho ever, central banks periodicall
intervene to stabilise them over the short term.
The objective of central bank intervention is to prevent large and abrupt fluctuations in e change rates
that could arise if currencies ere left entirel to market forces. Large and abrupt e change rate changes
disrupt the orderl flo of international trade and create uncertainties that undermine investment and
economic activit . Under managed e change rates, the currenc is supposed to move to ards its long-
term equilibrium position determined b the market. Central banks intervene so that this adjustment can
occur in a smooth and orderl a , ithout major and abrupt fluctuations that ma destabilise the
econom .
Intervention mainl takes the form of bu ing and selling of currencies b the central bank, influencing
currenc demand and suppl . In addition, central banks ma change interest rates, hich also impact
upon e change rates. Ver infrequentl (mainl in the event of a severe disequilibrium here there is a
strong do n ard pressure on the value of a currenc ) governments ma have to resort to contractionar
macroeconomic policies or protectionist measures (as in the case of fi ed e change rates).
P
A number of countries peg (i.e. fi ) their currencies to the US dollar, and float together ith it, hile a
fe other economies peg their currencies to the euro. The pegged currenc is allo ed to fluctuate onl
ithin a narro range above and belo a target e change rate relative to the dollar or the euro, so that if
the actual e change rate hits the upper or lo er limit of the range, the central bank intervenes to keep it
ithin the limits.
To see ho this orks, suppose Bopland decides to peg the bople to the US dollar, as sho n in Figure
16.5. The target e change rate chosen is 2 dollars = 1 bople; the bople is allo ed to fluctuate up to a
ma imum of 2.10 dollars = 1 bople, and a minimum of 1.90 dollars = 1 bople. Suppose that market
forces cause the e change rate to drop to 1.90 dollars = 1 bople, due to a fall in the demand for boples
from D1 to ard D2. At that point the Bank of Bopland (the central bank) ill intervene b bu ing boples
(and selling dollars), so that the demand-for-boples curve ill stop shifting left ard and the bople stops
falling. If the bople increases in value and hits the ma imum of 2.10 dollars = 1 bople because of an
increase in the demand for boples from D1 to ard D3, the central bank ill intervene b selling boples
(and bu ing dollars) to prevent a further rise in the value of the bople.
F 16.5: Illustrating a pegged currenc
A pegged currenc combines fi ed and floating e change rates, because the pegged currencies are fi ed
ithin the specified range of the US dollar (or the euro), and the float in relation to all other currencies,
together ith the dollar (or the euro). Pegging a currenc stabilises its e change rate in relation to the
currenc to hich it is pegged, preventing abrupt or strong fluctuations. Countries that peg their
currencies to the US dollar e perience e change rate stabilit relative to the dollar as ell as relative to
each other, and this facilitates trade flo s ith the United States as ell as bet een the countries ith
pegged currencies. In addition, some economies that are strong financial centers (such as Hong Kong;
see Real orld focus 16.2) peg their currenc to the US dollar.
Under the managed float, e change rates are determined mainl through market forces, but ith
periodic intervention b central banks aiming to smooth out abrupt fluctuations. Intervention takes
mainl the form of the bu ing and selling of official reserves. Some economies peg their currencies to
the dollar or euro; pegged currencies are fi ed in relation to the dollar or euro, and float in relation to
all other currencies.
C
An has a value that is too high relative to its equilibrium free market value. Its
e change rate has been set at a higher level than the equilibrium market e change rate. An
has a value too lo relative to its equilibrium free market value; its e change rate is lo
relative to the one the market ould have determined.
Overvalued and undervalued currencies cannot come about in a freel floating e change rate s stem,
here e change rates are determined purel b free market forces. Ho ever, the can and do often occur
in fi ed and managed e change rate s stems.
We can use Figure 16.1(a) to illustrate both overvalued and undervalued currencies. The market
determines a price of US dollars at 0.67 euro = 1 dollar. If the US central bank (kno n as the Federal
Reserve) anted to overvalue the US dollar, it could tr to maintain a price in terms of the euro above
the equilibrium, such as at 0.80 euro = 1 dollar. In the case of an undervaluation, the central bank ould
select a price of the dollar in terms of the euro belo the equilibrium price, such as at 0.50 euro = 1
dollar. The overvaluation or undervaluation of the currenc can be achieved b central bank and
government interventions that maintain the e change rate at the selected level (or range of levels, as
hen a currenc is pegged).
There are a number of advantages that ma arise from overvaluation and undervaluation of currencies,
though these generall come ith costs.
O
Most developing countries have at one time or other had overvalued e change rates. If an e change rate
is overvalued, imports become cheaper. The main reason for overvaluing their e change rates is that
man developing countries have anted cheap imports of capital goods, ra materials and other inputs
for use in manufacturing industries, to speed up industrialisation.

H K US
Hong Kong has been pegging its currenc to the US dollar since 1983. The Hong Kong dollar is
pegged at HK$7.80 to US$1and is allo ed to fluctuate ithin a band of ten cents relative to the US
dollar (HK$7.75 to HK$7.85). The Hong Kong Monetar Authorit (HKMA, or central bank)
changes interest rates mainl in order to support the peg ithin this narro band. For e ample,
interest rates rise hen the Hong Kong dollar falls to the lo er range of the band, and fall hen the
Hong Kong dollar rise to the higher edge of the band. Apart from this, interest rates in Hong Kong
can change onl as long as the Hong Kong dollar remains ithin the predefined narro band relative
to the US dollar. In effect the HKMA is unable to carr out an independent monetar polic .
F 16.6: 100 Hong Kong dollar ith 100 US dollar
The HKMA also has another eapon to defend the Hong Kong dollar in case this begins to eaken
belo the lo er edge of the band. It holds US$440 billion in reserve assets (foreign e change
reserves), hich amounts to 1.4 times its GDP. This is the largest amount of e ca i a foreign
e change reserves in the orld.
S : Willia Pe ek, Ti e c a H g K g c e c eg , Nikkei A ia Re ie , 28 Ma 2018,
S efa Ge lach, H g K g ha bee ell e ed b egged e cha ge a e f 35 ea ,
S h Chi a M i g P , 8 Ma 2018
A
1 Use an e change rate diagram to e plain ho the HKMA is able to keep the Hong Kong dollar
pegged to the US dollar ithin the narro band of ten cents b use of
interest rates, and
foreign e change reserves.
2 Using our kno ledge about fi ed e change rates, discuss some advantages and disadvantages
of the HKMA pegged e change rates.
Ho ever, overvalued e change rates come ith man disadvantages. One of the most important of these
is that e ports become more e pensive, thus hurting domestic e porters. Increased imports and reduced
e ports lead to a orsening current account balance (referred to above, and e plained belo , Section
16.4), resulting in pa ments difficulties. In addition, b increasing imports, overvalued e change rates
can hurt domestic producers ho have to compete ith artificiall lo -price imports, ith negative
consequences for domestic emplo ment and resource allocation. Overvaluation has often resulted in the
need for countries to devalue or depreciate their currencies to correct the overvaluation.
U
When a currenc is undervalued, e ports become less e pensive to foreign bu ers, hile imports
become more e pensive domesticall . Some developing countries have used undervaluation as a method
to e pand their e port industries, e pand their economies and therefore also increase their emplo ment
levels. Achieving these objectives b means of an undervalued currenc is considered to involve the
creation of an unfair competitive advantage compared to other countries that do not undervalue their
currencies, and hich suffer the consequences of increased imports and lo er e ports. Currenc
undervaluation is therefore considered to be a kind of cheating . In the conte t of a managed float,
undervalued currencies are sometimes referred to as a dirt float . A disadvantage of an overvalued
currenc is that it can lead to cost-push inflation due to the higher price of imports. Correction of the
undervalued currenc ould involve revaluation or appreciation of the currenc .
1 In hat a s is the managed float an e change rate s stem that lies bet een fi ed and
floating e change rate s stems?
Outline h is it closer to floating e change rates.
2 Describe the reasons for government intervention in a managed float.
3 Outline the meaning of pegging a currenc in the conte t of the managed float s stem.
4 Distinguish bet een overvalued and undervalued e change rates.
State the reasons for overvaluing or undervaluing a currenc .
Outline the disadvantages of each.
5 E plain h overvalued and undervalued e change rates do not arise in a freel floating
e change rates s stem.
Outline h undervalued currencies are sometimes referred to as a dirt float .
6 Research and find one or more countries that peg their currenc to another currenc . Based on
our findings, determine the reasons for the peg. Describe the advantages and disadvantages of
the pegged currenc in our e ample.
C
(HL )
This topic ill be discussed in Chapter 17, Section 17.2, after ou have learned about the balance of
pa ments.
2 The IMF, discussed in Chapter 20, overseas the global financial s stem.
16.4 The balance of payments
LEARNING OBJECTIVES

define all the terms appearing in orange bold in the text (AO1)
explain the balance of pa ments in terms of the current account, the capital account and the
financial account, and the items that compose each of the three accounts (AO2)
explain the interdependence between the three accounts in terms of a ero balance, the balance
between credits and debits, and the balance between deficits and surpluses (AO2)
calculate items of the balance of pa ments given a set of data (AO4)
The role of the balance of payments

Innumerable transactions between residents of different countries involve activities like importing and
exporting, travel, investments in stocks and bonds, investments b multinational corporations, bu ing
propert , sending or receiving gifts, and in general, an thing that gives rise to a flow of mone across
international boundaries. All these transactions are recorded in the balance of pa ments:
The balance of payments of a countr is a record (usuall for a ear) of all transactions between the
residents of the countr and the residents of all other countries. Its role is to show all pa ments
received from other countries, called credits, and all pa ments made to other countries, called debits.
In the course of a ear, all inflows of pa ments (credits) must exactl equal the outflows of pa ments
(debits); the sum of all credits is equal to the sum of all debits.
Wh do countries record all their foreign transactions; wh do the keep records of all possible inflows
and outflows of mone ? The reason is that when mone flows into or out of a countr , it involves the
exchange of different national currencies. These currenc exchanges are an important part of
understanding the balance of pa ments.
Relating the demand and supply of a currency to the balance of

payments
We will consider the balance of pa ments accounts of Bopland, whose national currenc is the bople. All
the inflows of mone from abroad into Bopland, or all credits, can onl be made if foreigners bu
boples; therefore credits represent a foreign demand for boples, corresponding to a foreign suppl of all
other currencies given up to bu boples. Outflows of mone from Bopland to other countries, or debits,
represent a Boplander suppl of boples, corresponding to Boplander demand for foreign currencies.
In the balance of pa ments accounts of a countr , all credits (inflows of mone into the countr )
create a foreign demand for the countr s currenc ; and all debits (outflows of mone from the
countr ) create a suppl of the domestic currenc .
The structure of the balance of payments

Table 16.3 shows Bopland s balance of pa ments for the ear 2019. The balance of pa ments consists of
three accounts: the current account, the capital account and the financial account. Each of the items in
the three accounts is accompanied b a plus or minus sign: the plus sign denotes credits (mone inflows)
and the minus sign denotes debits (mone outflows).
Current account
1 Exports of goods + 40
2 Imports of goods 65
Balance of trade in goods (items 1 + 2) 25

3 Exports of services + 25
4 Imports of services 15
Balance of trade in services (items 3 + 4) + 10

Balance of trade in goods and services (items 1 + 2 + 3 + 4) 15
5 Income (inflows minus outflows) 6
6 Current transfers (secondar income) (inflows minus outflows) +1
Balance on current account (items 1 + 2 + 3 + 4 + 5 + 6) 20

Capital account
7 Capital transfers (inflows minus outflows) + 0.7
8 Transactions in-produced, non-financial assets (inflows minus outflows) + 0.3
Balance on capital account (items 7 + 8) +1

Financial account
9 Foreign direct investment (FDI; inflows minus outflows) + 23
10 Portfolio investment (inflows minus outflows) 4
11 Reserve assets (official reserves) +1
12 Official borrowing 1
Balance on financial account (items 9 + 10 + 11 + 12) + 19

Balance (sum of all items from 1 to 12) 0
Table 16.3: Balance of pa ments of Bopland, 2019 (in billions of boples)
For each of these three accounts, when the credits and debits are added up, the sum is a positive or
negative number, depending on whether the credits are greater than the debits (a positive sum) or the
debits are greater than the credits (a negative sum).
A surplus in an account occurs whenever a balance has a positive value, meaning that credits are
larger than debits (there is an excess of credits).
A deficit in an account occurs whenever a balance has a negative value, meaning that debits are
larger than credits (there is an excess of debits).
The current account

Balance of trade in goods
Items 1 and 2 show the value of exports and the value of imports of goods respectivel . Exports are the
sale of goods to other countries, for which pa ment is received in boples; therefore exports are a credit
and have a plus sign. Imports are the purchase of goods from other countries, for which pa ment is made
in foreign currencies (generating a suppl of boples); imports are therefore a debit and have a minus
sign. The balance of trade in goods is calculated b subtracting imports from exports, or what is the
same thing, adding items 1 and 2 (note that we must take into account the minus sign), so the balance of
trade is 40 65 = 25 billion boples, indicating a negative balance of trade in goods, or a deficit in this
balance.
Balance of trade in services

Items 3 and 4 are analogous to items 1 and 2, onl the involve the value of exports and value of imports
of services. Services include a variet of activities, such as insurance, tourism, transportation and
consulting. When foreigners visit Bopland as tourists, Bopland is exporting tourism services; similarl ,
when foreigners bu insurance from Boplander companies, this represents exports of insurance services.
When Boplanders visit other countries as tourists, or bu insurance from other countries, the are
importing tourism and insurance services. Table 16.3 shows that Bopland s exports of services are larger
than its imports of services, and so the balance of trade in services (items 3 + 4) is +10 billion boples.
Bopland therefore has a surplus in its balance of trade in services.
Balance of trade in goods and services

The next line states Balance of trade in goods and services , which is the sum of all the items 1-4. This
is often referred to as the trade balance or balance of trade for short, and includes the value of all
exports minus the value of all imports. You ma note that this corresponds to what we call the net
exports component of GDP, abbreviated as X M. Bopland has a negative trade balance ( 15 billion
boples).
Income
Item 5, or income refers to all inflows into Bopland of rents, interest and profits from abroad, minus all
outflows of rents, interest and profits. Boplanders ma earn income abroad, if the own rental propert
abroad that earns rental income, or have bank accounts abroad that earn interest, or if the own stocks in
another countr that earn dividend income, or if the own a subsidiar of a multinational corporation
that earns profits. Whatever income flows into Bopland from abroad is a credit, while whatever income
flows out of Bopland is a debit. In Bopland, income outflows are greater than income inflows, leading to
a value of 6 billion boples for income.
Current transfers
Item 6, or current transfers refers to inflows into Bopland due to transfers from abroad like gifts,
remittances (mone sent home to relatives b Boplanders living abroad), foreign aid, and pensions,
minus outflows of such transfers to other countries. This item is positive (+1 billion boples), indicating
that credits are greater than debits, as Bopland receives more transfers from abroad than it makes to other
countries.
Balance on current account

When we add up all the items in the current account (items 1 6), we get the balance on current account
known also as the current account balance. Bopland has a current account deficit of -20 billion
boples; the debits (outflows) are larger than the credits (inflows) b this amount. (If the credits were
larger than the debits Bopland would have had a current account surplus.)
From the point of view of demand and suppl of boples, the deficit on this account means there is an
excess suppl of the currenc in the foreign exchange market: the quantit of boples supplied (debits
created b Boplanders) is larger than the quantit of boples demanded (credits created b foreigners).
(The quantit of boples demanded to make the credits possible is equal to the sum of all the credits, or +
40 + 25 + 1 = + 66 billion boples; whereas the quantit of boples supplied to make the debits possible is
equal to the sum of all the debits, or 65 15 6 = 86. Adding the credits to the debits we have + 66
86 = 20 billion boples, which is excess suppl of boples, or the deficit on the current account.)
In general, the trade balance (meaning the balance of trade in goods and services) is the most important
part of the current account in most countries. Therefore a deficit on the current account is usuall due to
an excess of imports of goods over exports, whereas a surplus on the current account is usuall due to an
excess of exports of goods over imports.
The current account of the balance of pa ments is the sum of: (i) the balance of trade in goods; (ii)
the balance of trade in services; (iii) income inflows minus outflows; and (iv) current transfer inflows
minus outflows. The most important part of the current account in most countries is the balance of
trade in goods and services (i + ii).
The capital account

The capital account consists of two items. In item 7, capital transfers, include inflows minus outflows
for such things as debt forgiveness (when debt is cancelled), non-life insurance claims, and investment
grants (mone given as a gift b governments to finance ph sical capital).
Item 8, transactions in non-produced, non-financial assets, consist mainl of the purchase or use of
natural resources that have not been produced (land, mineral rights, forestr rights, water, fishing rights,
airspace and electromagnetic spectrum). It includes all inflows of funds into Bopland (credits) minus
outflows of funds from Bopland (debits) due to such transactions.
The sum of items 7 and 8 give the balance on capital account, in which Bopland has a surplus of +1
billion boples, meaning that the credits (pa ment inflows) are more than the debits (pa ment outflows).
The quantit of boples demanded is larger than the quantit of boples supplied. Therefore a surplus on
an account indicates there is an excess demand of the currenc in the foreign exchange market.
In general, the capital account is relativel unimportant in terms of si e compared to the other two
accounts
The capital account of the balance of pa ments of a countr is composed of inflows minus outflows
of funds for capital transfers and transactions in non-produced, non-financial assets. The capital
account is relativel small compared to the current account and financial account.
The financial account

The financial account consists of four items.
Foreign direct investment (FDI)

Item 9 deals with foreign direct investment (to be studied in Chapter 20). This includes investments in
productive facilities, consisting of ph sical capital, such as buildings and factories, undertaken b
multinational corporations. The figure for this item includes inflows due to direct investment b
foreigners in Bopland (credits) minus outflows due to Boplander investment abroad (debits). Bopland
accepted more direct investments b foreigners than it made in other countries, b the amount of 23
billion boples.
Portfolio investment
Item 10, portfolio investment, shows investments in financial capital (such as stocks and bonds). In
Bopland, inflows (credits) for the purchase of stocks and bonds were less than outflows (debits) for the
same purpose ( 4 billion boples).
(You ma note the distinction between inflows or outflows of funds due to the purchase of assets, and
inflows or outflows of funds due to income generated b the purchase of assets. If a multinational
corporation decides to invest in Bopland b purchasing ph sical capital, there results an inflow of funds
into Bopland appearing as a credit in Bopland s financial account. If the owners of the multinational
corporation decide to take their profits out of Bopland and back to the home countr , there is an outflow
of funds from Bopland appearing as a debit in Bopland s current account.)
Reserve assets
Item 11, reserve assets (or official reserves), refers to foreign currenc reserves that the central bank can
bu or sell to influence the value of the countr s currenc . Suppose the Central Bank of Bopland holds
reserves of US dollars. If it sells dollars, it does so b bu ing boples. This is an inflow of boples,
appearing as a credit in the financial account. Table 16.3 shows the Central Bank to have bought 1
billion boples, appearing with a plus sign (a credit). (If the central bank had sold boples b bu ing
dollars, this would be an outflow of boples and would appear as a debit in the financial account.)
Official borrowing
Official borrowing refers to government borrowing from abroad. Inflows of funds into Bopland due to
borrowing b the Boplander government from foreign lenders (foreign government debt, to be discussed
in Chapter 19; also Chapter 11 at HL) appear as credits. Similarl , Boplander loans to foreign
governments lead to an outflow of funds from Bopland appearing as debits. The figure of 1 billion
boples indicates that Bopland is a net lender (outflows are greater than inflows).
Balance on financial account

The balance on financial account, given b the sum of items 9, 10, 11 and 12 shows a surplus of 19
billion boples (the credits are more than the debits). Therefore there is an excess demand of 19 billion
boples in the foreign exchange market for this account.
The financial account of the balance of pa ments consists of inflows minus outflows of funds for (i)
foreign direct investment; (ii) portfolio investment; (iii) reserve assets and (iv) official borrowing.
Two clarifications
Errors and omissions
In the real world, it is extremel difficult (if at all possible) to record ever single transaction between a
countr and all other countries, and some of these go unrecorded. However, since the sum of all credits
must equal the sum of all debits, it is necessar for actual accounts to include an item creating this
equalit . Therefore, the real-world balance of pa ment accounts include an item called errors and
omissions to create an equalit between the sum of credits and the sum of debits. It is simpl a
statistical trick that does not affect our anal sis of the balance of pa ments, and so for simplicit is not
included here.
The capital account and the financial account

Economists often use the term capital account to refer to both the capital and financial accounts that
appear in Table 16.3. However, since 1997, countries around the world are increasingl using the
classification s stem shown in Table 16.3 in their balance of pa ments. Therefore if ou come across the
expression capital account in our general reading, ou should be aware that reference is being made to
what is actuall the financial account , together with the relativel unimportant capital account .

1 Define the balance of pa ments. Describe its role.
2 a Define debits and credits, relating these to the demand for or suppl of a currenc in the
foreign exchange market.
b Provide some examples of mone flows into and out of the countr where ou live, and
explain whether these are credits, or debits.
3 Explain, providing examples,
a the four components of the current account,
b the two components of the capital account, and
c the four components of the financial account.
4 a Outline the meaning of a deficit and a surplus on an account. Explain in terms of debits
and credits.
b Explain the meaning of a deficit or surplus in the current account. Identif what items in the
balance of pa ments are most likel responsible for a deficit or surplus.
Calculating elements of the balance of payments

Given the components of the balance of pa ments and their relationships, we can calculate various
elements in the balance of pa ments. You are given some exercises in Test our understanding 16.8.

Answer the questions below based on the table showing the balance of pa ments accounts of
Lakeland (2019, billion Lkl).
Current account
Exports of goods + 310
Imports of goods 525
Balance of trade in goods
Exports of services + 52
Imports of services 71
Balance of trade in services
Income + 25
Current transfers + 73
Balance on current account
Capital account
Capital transfers 3
Transactions in non-produced, non-financial assets +7
Balance on capital account
Financial account
Direct investment + 107
Portfolio investment + 29
Reserve assets 7
Official-borrowing
Balance on financial account
Balance
1 Fill in the blanks in the table. Check our results b using the relation: current account = capital
account + financial account.
2 Identif which of the three accounts are in surplus and which in deficit. Explain our answer
using the concepts of debits and credits.
3 Is Lakeland experiencing a balance of pa ments deficit or a balance of pa ments surplus?
4 Outline whether or not it is possible that the value of the Lkl is determined in a freel floating
exchange rate s stem? Explain.
The interdependence between the accounts
The meaning of zero balance in the balance of payments

In the balance of pa ments, the sum of all the items is alwa s ero. This is another wa of sa ing that the
sum of all credits alwa s balances with the sum of all debits. In addition it is another wa of sa ing that
deficits are matched b surpluses.
As ou can see in Bopland s case, the deficit in the current account of 20 billion boples is exactl
matched b the surplus in the combined capital and financial accounts: 20 billion boples ⇔ + 1 + 19
billion boples. In other words, the excess suppl of boples in the current account, which is in deficit, is
exactl matched b an excess demand for boples in the remaining two accounts, which altogether are in
surplus.
We turn now to an explanation of this point.
Why is there a zero balance in the balance of payments?

The question arises, wh does the balance of pa ments have a ero balance?
There is a ver simple answer to this question. You ma recall from our discussion above that all credits
in the balance of pa ments create demand for a currenc , and all debits create suppl of the currenc .
You ma also recall that exchange rates are alwa s determined b currenc demand and suppl , in both
floating and fixed exchange rate s stems. The same is true for managed exchange rates since these are
floating exchange rates with some intervention to influence currenc demand or suppl . It follows then
that at the point where an equilibrium exchange rate is determined, in other words at the point where
currenc demand equals currenc suppl , it is also the case that the sum of credits is equal to the sum of
debits. Therefore deficits must match surpluses.
How does this work in practice? We turn to this question next.
Why the current account and financial account are

interdependent
When a countr trades with other countries, its imports of goods and services are unlikel to be equal to
its exports. If imports are greater than exports, it has a deficit in its trade balance, and since this is the
most important component of the current account, it also likel has a current account deficit. Using the
production possibilities model, we can see this in Figure 16.7(a). The countr s PPC defines the
maximum it can produce, but the countr is consuming at a point outside its PPC, such as point C,
because it is importing more than it is exporting.
Figure 16.7: Using a PPC to illustrate a trade deficit and a trade surplus
(HL students note that achieving a point outside the PPC b means of a trade deficit is ver different
from achieving such a point b specialisation and trade according to comparative (or absolute) advantage
(Chapter 14). The theor of comparative advantage presupposes that imports and exports balance each
other, so there is no trade deficit or trade surplus: a point outside the PPC is achieved because of an
increase in allocative efficienc .)
If there is a current account deficit, there must be a financial account surplus (the capital account being
ver small), which provides it with the foreign exchange it needs to pa for the excess of imports over
exports. The surplus on the financial account ma arise from investments in ph sical or financial capital
b foreigners including loans from foreigners. It follows, then, that a deficit in the current account is
matched b a surplus in the financial account (along with the unimportant capital account).
If the econom s exports of goods and services are greater than its imports, it has a surplus in its current
account, meaning it is bu ing from foreigners less than what it sells to them. While it is producing
somewhere on the PPC, it is consuming less, so the output available for domestic consumption is at a
point inside its PPC, such as D in Figure 16.7(b). The difference between what it consumes and what it
produces is the excess of exports over imports.
When there is a surplus on the current account, the countr is accumulating foreign exchange (as it earns
more foreign exchange from exports than it pa s out to bu imports), which it can use to bu assets
abroad (direct or portfolio investments, including loans to other countries). It follows, then, that a surplus
in the current account is matched b a deficit in the financial account.
In fact, most economists believe that the surplus or deficit of a financial account of a countr ver often
is the result of what is happening in the current account. If there is a deficit in the current account, the
financial account is a reflection of the need to finance that deficit; if there is a surplus in the current
account, the financial account reflects investments in foreign countries undertaken to dispose of the extra
foreign exchange.
A current account deficit means a countr consumes more than it produces; and it pa s for extra
output consumed through a financial account surplus. A current account surplus means a countr
consumes less than it produces, and part of the income generated from the sale of extra output
produced corresponds to a financial account deficit.
The meaning of imbalance in the balance of payments

Since the balance of pa ments must alwa s balance, wh do we often hear the expressions balance of
pa ments deficit or balance of pa ments surplus ? A balance of pa ments deficit means there is a
deficit in the combined current, capital and financial accounts (plus errors and omissions), excluding
central bank intervention. A balance of pa ments surplus means there is a surplus in the combined three
accounts (plus errors and omissions), excluding central bank intervention. Bopland, for example, has a
balance of pa ments deficit:
current account deficit ( 20 billion) + capital account surplus (+ 1 billion) + financial account
surplus excluding the central bank purchase of 1 billion (+ 18 billion) = 1 billion = balance of
pa ments deficit
The reason for central bank intervention can be found in just this deficit. B bu ing up excess boples of
1 billion, the central bank creates a balance in the balance of pa ments.
Such imbalances (deficits or surpluses) occur in virtuall all countries all the time, but a balance is
alwa s created in the sense that debits are made to equal credits. There are man wa s to do this, which
involve either reliance on market forces or on government intervention. HL students will see how this is
accomplished in Chapter 17.

1 Explain wh
a a trade surplus means that a countr is consuming less than it is producing
b a trade deficit means that a countr is consuming more than it is producing.
2 Explain the relationship between the current account, capital account and financial account.
3 Using the balance of pa ments accounts for Lakeland appearing in Test our understanding 16.8,
draw a PPC diagram to show how much Lakeland is consuming in relation to how much it is
producing.
4 Explain wh current account deficits are likel to be roughl matched b financial account
surpluses, and current account surpluses to be roughl matched b financial account deficits.

1 Select a countr ou are interested in and examine how the exchange rate of its currenc has
developed over the course of the last several ears, noting when it has been appreciating and
when it has been depreciating. Tr to identif the most important factors that have led to
exchange rate changes. Have these factors led to changes in currenc demand, or currenc
suppl or both?
2 Select a countr ou are interested in that has a managed exchange rate. Tr to identif the
objectives of the government or central bank intervention in the foreign exchange market to
manage the exchange rate; is intervention intended to lead to currenc appreciation or
depreciation relative to the free market value? Wh does the government or central bank want
the currenc to appreciate or depreciate? What methods does the government or central bank use
to achieve the objectives regarding the exchange rate? Can ou identif an important
consequences of exchange rate management in the domestic econom ?
3 Choose one or more countries that are major trading partners of the countr ou live in. Does
our countr of residence have a current account surplus or deficit with this countr or
countries? To what extent is the current account surplus or deficit due to a trade surplus or
deficit? Are there are other components of the current account, such as income (possibl profit
income or remittances), that pla an important role in determining the current account balance?
You can find questions in the st le of IB exams in the 'Digital coursebook: Extra material' section.
Chap e 17
F he opic on e change a e and

he balance of pa men (HL onl )
BEFORE YOU START
As ou ha e learned, a current account deficit/surplus is dri en b a countr s balance of
trade. What do ou think could be the ad antages or disad antages of running a current
account deficit or surplus? What if the deficit or surplus is persistent o er man ears?
A monetar union means participating countries use a common currenc hile sharing a
common central bank. What might be some ad antages and disad antages of this le el of
economic integration?
This chapter ill e plore more closel some of the topics on international monetar flo s that ere
introduced in Chapter 16. We ill e amine ho surpluses and deficits in the current and financial
accounts are likel to impact upon e change rates. We ill e aluate fi ed and floating e change rate
s stems, as ell as monetar union, hich in some a s is like a s stem of permanentl fi ed
e change rates. Finall , e ill stud the consequences of imbalances in the balance of pa ments, as
ell as ho countries deal ith the potentiall serious issue of persistent current account deficits.
17.1 H ec e acc a d ef a ca
acc a e e a ed e c a e ae
LEARNING OBJECTIVES
A :
a eb d (AO1)
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LEARNING OBJECTIVES
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a ;a a a a .
A a a a a .A a , a ,
a a a a a a .T a
a a a a a .
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a a a , a ,a
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a .T a a a a a a
a a a a a a a a a a
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a a , a a .H ,
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.
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a a a a a a a a
a a a a , a a a a .
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a a a a a a a a a
a a a a , a a
a a ( C a 19)
a a a a a a a a a
a a , a
a a a a a a a a .
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a a a a a .F a , a
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a a ). T a a a a a a ,a
a a a a a .
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a a a a a . (A
a a a a a , a
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C a a a a a a .I a
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T a a a, a , a a a a
a a 1973. S a a a a a
a a a a
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a a ). A , a a a a a
a a a a a ,
a a a a a a a
a a a a a a a a .
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a a a a .T a a a
a a a aa a a a
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a a a aa ,a U Sa a .F
a a a a a a
a a a ( a ; C a 16).
F a a a a ; ,
a a a a a a a
a a a a .

1 D a a a a a a a a a a a .
2 (O a)D a a a a a a a a a .
17.3 E a a a
LEARNING OBJECTIVES
In Chap er 15, Sec ion 15.3, he las learning objec i e as o disc ss ad an ages and
disad an ages of mone ar nion. No ha e ha e s died e change ra es e can e al a e
mone ar nion (AO3). (Yo are reminded o re ie his sec ion in Chap er 15.)
In Chap er 15, e sa ha monetary union occ rs hen he member co n ries of a common marke
adop a common c rrenc and a common cen ral bank responsible for mone ar polic , s ch as he
E ropean Mone ar Union hose member co n ries ha e adop ed he e ro. I as briefl no ed ha
in some a s mone ar nion is like a s s em of fi ed e change ra es for he co n ries ha
par icipa e in he nion, b i ho an possibili of re al ing or de al ing heir c rrencies. In
o her ords, b adop ing a single c rrenc i is as ho gh he permanen l fi he al es of heir
c rrencies agains each o her. From his perspec i e, some ( ho gh cer ainl no all) of he ad an ages
and disad an ages of mone ar nion are similar o he ad an ages and disad an ages of fi ed ers s
fle ible e change ra es. B , addi ionall , mone ar nion has a f r her er significan charac eris ic:
he crea ion of a single c rrenc , o erseen and con rolled b a single cen ral bank. This charac eris ic
offers f r her po en ial benefi s, as ell as possible cos s.
A a a a
A single currenc eliminates exchange rate risk and uncertaint . E change ra e fl c a ions crea e
risks and ncer ain ies for raders and in es ors, ho do no kno ha he f re e change ra es ill
be. A single c rrenc elimina es he risks and ncer ain ies, i h benefi s for impor ers and e por ers,
cons mers and in es ors, hereb enco raging rade and in es men s across bo ndaries. This
con rib es o achie ing a more efficien alloca ion of reso rces.
A single currenc encourages price transparenc . Price ransparenc refers o he abili of
cons mers and firms o compare prices in all he co n ries ha ha e adop ed a common c rrenc
i ho ha ing o make e change ra e calc la ions and con ersions. This makes i easier for all
economic decision-makers o see price differences q ickl and acc ra el across co n ries and make
price comparisons, and has he effec of promo ing compe i ion and efficienc .
A single currenc eliminates transaction costs. Whene er here is a con ersion of one c rrenc in o
ano her, he banks (or ha e er ins i ion performs he con ersion) charge a fee for he con ersion;
his is a pe of ransac ion cos . A single c rrenc elimina es he ransac ion cos s of he con ersion,
res l ing in significan sa ings ha ha e he effec of enco raging rade, in es men s and
in erna ional financial flo s of all kinds. I has been es ima ed ha he sa ings from he elimina ion
of ransac ion cos s of c rrenc con ersions i hin he e ro one co n ries amo n s o abo 1% of
he combined GDPs of he co n ries in ol ed.
A single currenc promotes a higher level of inward investment. In ard in es men refers o
in es men s from o siders o ards he member co n ries i h a common c rrenc , and hese can be
e pec ed o rise beca se of he absence of c rrenc risk i hin an e panded marke , res l ing in
grea er economic gro h.
Low rates of inflation give rise to low interest rates, more investment, increased output. If a
member co n r has a high ra e of infla ion, i s e por s become less compe i i e, possibl a c rren
acco n defici . B here is no possibili of c rrenc deprecia ion o regain compe i i eness since
here is no domes ic c rrenc . Therefore member co n ries become commi ed o main aining a lo
ra e of infla ion. Lo ra es of infla ion con rib e o crea ing impor an benefi s: lo ra es of in eres ,
higher le els of in es men and higher le els of o p . A n mber of e ro one co n ries, incl ding
so hern E ropean co n ries as ell as economies ha ransi ioned from cen ral planning o marke
economies, had high ra es of infla ion prior o mone ar nion. All ha e bro gh do n heir infla ion
ra es o lo le els i h adop ion of he e ro.
D a a a a
A single currenc involves loss of domestic monetar polic as an instrument of economic polic .
For all e ro one co n ries, mone ar polic is he responsibili of he E ropean Cen ral Bank, he
objec i e being price s abili for he region as a hole. Each indi id al co n r , ha e er i s
par ic lar circ ms ances (higher or lo er infla ion, nemplo men , e c., han he a erage of he e ro
one co n ries), is nable o carr o i s o n mone ar polic o infl ence he ra e of in eres and
hence he le el of economic ac i i i hin i s bo ndaries.
Monetar polic pursued b the single central bank will impact differentl on each member
countr , depending on its own particular circumstances. Since co n ries are likel o differ from
each o her i h respec o degrees of infla ion, nemplo men , e c., he single mone ar polic
p rs ed b he single cen ral bank is likel o ha e differen impac s on each of he member
co n ries.
A single currenc involves loss of exchange rates as a mechanism for adjustment. If a member
co n r has a rade defici i h ano her member co n r , i no longer has i s o n na ional c rrenc
ha co ld deprecia e (in a fle ible e change ra e s s em) or de al e (in a pegged s s em) in order o
correc he imbalance. Similarl , if a member co n r has a higher ra e of infla ion and i s goods
become less compe i i e abroad, he problem canno be sol ed b c rrenc deprecia ion or
de al a ion. Ins ead i has o se con rac ionar fiscal polic o correc he imbalance hich leads o
recession.
Fiscal polic is constrained b the convergence requirements. Whereas each member co n r
re ains he abili o carr o i s o n fiscal polic , here are cer ain res ric ions imposed b
convergence requirements. In he case of E ropean Mone ar Union, o al p blic deb canno be
grea er han 60% of GDP and he b dge defici of an gi en ear canno be grea er han 3% of GDP.
Whereas his is seen b man o be an ad an age (beca se i promo es fiscal discipline), o hers ie
i as a res ric ion of he a hori of he go ernmen of a co n r , and consider i o be a disad an age
of mone ar in egra ion. (Man EMU co n ries ha e a ario s imes iola ed he con ergence
req iremen s.)
A single currenc overseen b the single central bank involves loss of national governments
authorit in economic polic -making. I is no longer na ional go ernmen s and na ional cen ral
banks ha are responsible for economic polic , b ra her he cen ral bank ha o ersees he mone ar
s s em of all he member co n ries of he mone ar nion. Moreo er, a hori is ransferred a a
from democra icall elec ed na ional go ernmen s o ards an independen bod ha ma be
nelec ed (as in he case of he E ropean Cen ral Bank).
Man economis s arg e ha he EMU ma no s r i e o er he long erm if i does no reform. One
change he consider o be essen ial is fiscal union. Fiscal nion is an e en higher form of economic
in egra ion ha o ld in ol e he es ablishmen of a cen ral fiscal bod i h a hori o er all
member co n ries. This bod o ld ha e he po ers o a he member co n ries hro gh cen ral
a a ion policies and o ld also spend a re en es in accordance i h cen rall de ermined policies.
S ch a fiscal nion has ne er been a emp ed o da e among an gro p of co n ries. The co n ries of
he e ro one each make decisions abo a ing and spending on a na ional le el.
Economis s consider fiscal nion o be essen ial o he long- erm s ccess of mone ar nion in order
o deal i h he obs acles posed b he elimina ion of independen mone ar and e change ra e
policies. (See Real orld foc s 17.1.) E amples no ed are he Uni ed S a es, German and
S i erland, all comprised of s a es i h heir o n s a e go ernmen s headed b an o erarching
federal (na ional) go ernmen i h po ers o er all he s a es o a and spend. This means ha a
depressed s a e, for e ample, hich has no mone ar polic of i s o n or c rrenc ha i can
deprecia e o increase e por s, o ld recei e financial assis ance o emerge from i s recession.
Ho e er, here remain serio s poli ical cons rain s o he de elopmen of fiscal nion among he e ro
one co n ries. The reason for his lies mainl i h he loss of so ereign ha man co n ries fear
res l s from increasing economic in egra ion.

Disc ss ad an ages and disad an ages of mone ar nion.
T G a a EMU
T a EMU
D ring he firs decade since he es ablishmen of he E ropean Mone ar Union (EMU), here
ere no major problems. B i h he onse of he global financial crisis in 2008, here as
concern ha as EMU co n ries en in o recession, he one-si e-fi s-all mone ar polic and he
inabili o p rs e a na ional e change ra e polic co ld pose serio s problems for co n ries i h
go ernmen defici s and deb . When a co n r goes in o recession, he go ernmen defici (and
deb ) increase beca se of falling a re en es and increasing go ernmen e pendi res. B 2009,
man of he 16 e ro one co n ries had defici s and deb e ceeding he 3% and 60% of GDP
req iremen s of he EMU. The bombshell e ploded hen i as anno nced ha he Greek p blic
defici and deb ere so large ha Greece as ha ing diffic l ies borro ing o finance (pa for) i s
defici and deb .
F 17.2: A hens, Greece. Pensioners rall agains a s eri policies and pension c s
Wi h Greece being a small co n r hose GDP amo n s o onl 2.6% of e ro one GDP, h
sho ld an one orr abo Greek deb ? The ans er had o do i h he e ro i self. Beca se se eral
e ro one co n ries had large and rapidl gro ing b dge defici s and deb s, financial in es ors
(in es ors in go ernmen bonds, or go ernmen deb ) became orried ha he borro ing co n ries
migh defa l , in hich case heir in es men s in bonds o ld be or hless. When his happens, i
becomes more and more diffic l for go ernmen s o borro . The reason is ha financial in es ors
req ire m ch higher in eres ra es on bonds, in order o compensa e hem for he increased risk
( his is called a risk premi m ). If in eres ra es on bonds rise o er high le els, go ernmen s can
no longer afford o borro from financial marke s. If he can no longer borro , a serio s risk of
defa l arises, and one co n r co ld begin defa l ing af er ano her. No e here is a self-f lfilling
prophes a ork here.
So he ans er o he problem o ld appear o be ha e ro one co n ries m s lo er heir defici s
and deb s. Ho co ld he do his? This is here some of he diffic l ies of he e ro presen ed
hemsel es.
T a
The easies a o come o of a si a ion of er high deb is o gro o of i . As Nobel Pri e-
inning economis Pa l Kr gman e plains, in 1946, af er he Second World War, he Uni ed S a es
had a er large federal go ernmen deb of 122% of GDP. Ye in es ors ere no concerned. Ten
ears la er, deb as a share of GDP had been c in half. In fac , he US go ernmen did no e en
pa back i s deb d ring ha period; ha happened is ha GDP gre , ro ghl do bling o er he
same period.2
Therefore, ha is needed in co n ries i h large defici s and deb s is economic gro h. To
achie e gro h, co n ries need o rel on e pansionar policies. Co n ries i h high deb s like
Japan, he Uni ed Kingdom and he Uni ed S a es ha e heir o n c rrencies, hich he can
deprecia e, gi ing a compe i i e ad an age o heir e por s. The can also cond c an independen ,
e pansionar mone ar polic , hich o ld f r her enco rage gro h. For e ample, he cen ral
banks of some co n ries (like Japan and he Uni ed S a es), in heir effor s o figh recession,
lo ered heir in eres ra e o nearl ero in he earl ears of he global financial crisis. The hope
as ha as heir economies came o of recession and began o gro , he co ld grad all emerge
from heir si a ion of high deb .
Ye s ch independen e change ra e or mone ar polic ac ion is no an op ion for co n ries i hin
he e ro one. Greece, as ell as o her so hern E ropean co n ries in he EMU, needed er lo
in eres ra es o enco rage economic ac i i . Ho e er, he E ropean Cen ral Bank, infl enced b
German s concern abo infla ion, did no allo he in eres ra e o fall for fear his o ld crea e
infla ionar press res. Therefore, for co n ries in he EMU ha needed o red ce heir defici s and
deb s, he onl a ailable domes ic polic ools ha co ld s ppor gro h ere s ppl -side
meas res in ended o increase in erna ional compe i i eness.
These, ho e er, need a long ime o ake effec . Ano her problem is ha s ppl -side meas res b
hemsel es are no eno gh o sol e he deb problem. Highl indeb ed go ernmen s m s also r
o deal direc l i h defici s and deb b c ing go ernmen e pendi res and increasing a es.
This is he er opposi e of ha is req ired for gro h, since hese policies are ac all
con rac ionar : they work to lower GDP rather than increase it.
W G a EMU?
An ob io s co rse of ac ion o ld ha e been for Greece o lea e he EMU, re rn o i s na ional
c rrenc ( he drachma), and regain i s abili o cond c independen mone ar and e change ra e
policies. Ho e er, his op ion o ld no be serio sl considered b Greece or an o her e ro one
co n r , e cep as a las resor . If one co n r ere o lea e he e ro one d e o deb problems,
his co ld lead o a chain of e en s i h po en iall disas ro s conseq ences: i co ld sha er he
confidence of in es ors in he abili of e ro one co n ries o pa back heir deb s, leading o
sales of e ro asse s, a dras ic fall in he al e of he e ro, inabili of go ernmen s o borro , a
series of defa l s in co n ries i hin he EMU, possibl e ending o o her indeb ed co n ries
o side he e ro one (s ch as he Uni ed Kingdom), and a massi e global financial crisis i h a
er deep global recession.
T a - a
In a si a ion like his, an EMU- ide polic of m al assis ance and co-opera ion o ld ha e
been er sef l. The E ropean Cen ral Bank co ld ha e considered lo er in eres ra es o help
he co n ries in grea need of some s im l s. The E ropean In es men Bank co ld ha e
considered in es men s ha o ld co n erac he effec s of b dge c s and a increases. A
solidari f nd co ld ha e been es ablished o offer lo -in eres loans for in es men s in
co n ries needing o enco rage heir gro h. In fac , had here been an EMU- ide fiscal a hori
he problem migh ha e been a oided al oge her, or a leas migh ha e been far less se ere.
Prominen economis s, incl ding Joseph S igli , Pa l Kr gman (bo h Nobel Pri e inners) and
Mar in Felds ein, ha e compared he e ro one o he Uni ed S a es, e plaining ha he reason h
he Uni ed S a es orks ell as a c rrenc area is ha here is a cen ralised fiscal polic . As Pa l
Kr gman ri es:
Consider the often-made comparison between Greece and the state of California. Both are in
deep fiscal trouble, both have a history of fiscal irresponsibility. . . .
But California s fiscal woes just don t matter as much, even to its own residents, as those of
Greece. Why? Because much of the money spent in California comes from Washington, not
Sacramento. State funding may be slashed, but Medicare reimbursements, Social Security
checks, and payments to defence contractors will keep on coming.
What this means, among other things, is that California s budget woes won t keep the state
from sharing in a broader US economic recovery. Greece s budget cuts, on the other hand, will
have a strong depressing effect on an already depressed economy. 3
In earl 2010, he e ro one co n ries, nder he leadership of German , failed o presen a ni ed
fron in he face of a member co n r s deb problems. According o G s a A. Horn, Direc or of
German s Macroeconomic Polic Ins i e, he EU sho ld ha e e plained credibl and clearl
ha i o ld ake a shared common responsibili of an eq al member of he common in ernal
marke .4 Ins ead, as he EU hesi a ed and dela ed aking ac ion, financial marke s reac ed b
demanding e er-increasing and prohibi i el high in eres ra es in order o lend o Greece, making
i impossible for Greece o borro from pri a e in es ors. As a res l , Greece as forced o
borro from he EU and he In erna ional Mone ar F nd (IMF, o be disc ssed in Chap er 20). In
Horn s ords,
As a result of the active assistance of the German government, what has happened is exactly
the thing that was supposed to be avoided, and what could have been avoided namely that
Greece has indeed been forced to ask for financial help from other European countries. 5
The EU/IMF loans ere made on condi ion ha Greece p rs es highl con rac ionar policies,
in ol ing er harsh c s in go ernmen spending and h ge a increases. Beca se of i s large
deb , Greece o ld in an case ha e had o p rs e con rac ionar policies, as e plained abo e.
Ho e er, i h he lack of an independen mone ar and e change ra e polic , he b dge c s and
a increases had o be far grea er. Since he Greek econom as alread in recession, his had he
effec of making he recession m ch deeper, a a high h man cos in erms of nemplo men ,
red ced social benefi s and increasing po er .
According o Joseph S igli :
. . . one hoped the Greek tragedy would convince policymakers that the euro cannot succeed
without greater cooperation (including fiscal assistance). But Germany (and its Constitutional
Court), partly following popular opinion, opposed giving Greece the help that it needs.
To many, both in and outside of Greece, this stance was peculiar: billions had been spent
saving big banks, but evidently saving a country of 11 million people was taboo.6
T E a
B he spring of 2011, i as becoming increasingl apparen ha he bailo for Greece b he
EU and IMF as based on a serio s shor coming: nega i e gro h ra es e perienced b he Greek
econom d e o he se ere recession made i m ch more diffic l for Greece o make i s deb
repa men s. Higher a es and lo er go ernmen spending led o lo er incomes and lo er a
re en es, and herefore an increased need o con in e o borro o make deb repa men s. Greece
as ge ing ca gh in an ns s ainable deb si a ion, or deb rap , here a co n r m s keep
aking o more and more ne loans o pa he old ones, h s increasing ra her han red cing he
le el of i s deb .
In he mean ime, he E ropean deb crisis as spreading o o her co n ries. In No ember 2010,
Ireland req es ed financial assis ance from he EU and IMF d e o he acc m la ion of
go ernmen deb arising from effor s o resc e i s failing banks. This as follo ed b a similar
req es in Ma 2011 b Por gal, ha as also facing mo n ing deb problems d e o an e cess of
go ernmen spending o er a re en es. B he s mmer of 2011, here ere major fears ha Spain
and I al migh also be req iring bailo s.
T G a
In fac , he con rac ion of he Greek econom as far grea er han ha had been e pec ed. In
2013 he In erna ional Mone ar F nd (IMF) made he as o nding re ela ion ha i had
nderes ima ed he si e of Greece s m l iplier (see Sec ion 13.4, Chap er 13). This mean ha he
red c ions in spending ha ere forced on he Greek econom b i s lenders had a grea er han
e pec ed effec on real GDP, ca sing a far deeper recession.*
T a a a EMU
The common c rrenc of he e ro one co n ries means ha e change ra e changes canno correc
c rren acco n defici s or s rpl ses. Some e ro one co n ries (especiall German ) ha e
increased heir e por compe i i eness, acc m la ing large rade s rpl ses, hile o hers, incl ding
Greece, ha e los compe i i eness, and herefore ha e rade defici s. German s er large rade
s rpl ses (abo o- hirds of German s e por re en es come from e ro one co n ries) o e
heir e is ence par l o an nder al ed c rrenc . If he e ro did no e is , i s na ional c rrenc
o ld apprecia e, i o ld lose par of i s s rong compe i i e ad an age, and i s gro h
performance o ld be eakened. A he same ime, eaker e ro one co n ries c rrencies o ld
deprecia e, gi ing hem he compe i i e ad an age he s rongl need o s ppor heir economies.
As he German Finance Minis er has admi ed, German became so prospero s beca se i has
more ad an ages from E ropean in egra ion han an o her co n r .7
Since e change ra e adj s men s are no possible i hin he e ro one, here is an rgen need for
ano her adj s men mechanism for EMU o ork. Man economis s arg e ha he presen EMU
ins i ions m s be s pplemen ed b an EMU- ide fiscal a hori , i h po ers o a , spend and
in es , ransfer f nds and moni or member co n ries. This o ld allo depressed areas o recei e
he necessar f nds and in es men s o boos heir gro h. Ye here is remendo s opposi ion o
his i hin he EMU co n ries hemsel es. Some of he co n ries ha are b far he s ronges
opponen s o close co-opera ion and fiscal polic co-ordina ion are he same ones ha ha e gained
he mos from E ropean in egra ion.
T a a
In A g s 2018, eigh ears af er he firs bailo b he IMF and EU, and af er o addi ional
bailo s in s bseq en ears, Greece re rned o borro ing from financial marke s. This as
considered o be a grea momen .
Ho e er, he cos s for he Greek econom and people ha e been remendo s. Greece is j s
s ar ing o come o of he grea es depression of an ad anced co n r in recorded his or . As a
res l of he p nishing condi ions imposed in e change for he bailo s, real GDP is 25% smaller,
hile nemplo men remains he highes in he e ro one co n ries. In 2013, o h nemplo men
peaked a nearl 60% and o erall nemplo men a nearl 28%. Pensions ha e dropped
significan l and disposable incomes ha e dropped b one- hird. One person in hree li es a or
belo he po er line. Thro gho his period, highl op imis ic projec ions for gro h ere
consis en l dispro en and gro h ra es s ill remain far belo hose of o her co n ries in E rope.
O er 400 000 Greeks, ro ghl 4% of he pop la ion, mos of hem in heir en ies and hir ies,
lef he co n r in search of ork, i h li le likelihood of heir e er re rning in ie of
emplo men prospec s in Greece. Mos of hem ere highl skilled and ed ca ed. This is a
massi e drain of h man capi al.
T a a
A ke iss e is ha Greece has been forced b i s credi ors o r n a primar b dge s rpl s, hich
is an e cess of go ernmen re en es o er spending, no incl ding in eres pa men s. The reason
for his is ha a b dge s rpl s is he onl a ha a borro ing co n r can repa i s deb s, and
credi or co n ries like German an ed o be s re he ge heir mone back.
Ho e er, r nning a b dge s rpl s is b i s na re contractionary fiscal polic , since i akes a a
from he econom s spending s ream in he form of a es more han i re rns in he form of
go ernmen spending. Therefore he onl a his co ld ork i ho sending he econom in o a
deep recession is if here is economic gro h.
Ins ead, i h nega i e gro h ra es o er se eral ears, a s eri and he necessi o acc m la e
b dge s rpl ses, he Greek e perience has sho n he disas ro s conseq ences of s ch a polic
mi , hich orks o deepen he recession, making deb repa men come a a er high h man
cos . Nobel pri e- inning economis Joseph S igli no es he follo ing:
Germany of all countries should understand this. At the end of World War I, Germany was
made to pay reparations by the Treaty of Versailles. To finance the reparations, it would have
to run a surplus. Keynes8 correctly predicted that German reparations and the resulting
German surplus would cause a German recession or worse. The depression in Germany that
followed had disastrous political consequences not just for Germany for the entire world . . .
Given the history, it is shocking that Germany and [Greece s creditors] have demanded that
Greece and other crisis countries maintain large primary budget surpluses. 9
The fear is ha if recession hi s Greece again, here ill be no more room for fiscal igh ening, as
go ernmen spending has no room for falling f r her hile p ni i e a es canno rise f r her. Since
2015 here has been a difference of opinion be een he IMF and E ropean credi ors. The IMF has
been ad oca ing lenien deb res r c ring on he gro nds ha rapid deb red c ion decreases
economic ac i i , as a res l making deb repa men far more diffic l . The EU on he o her hand
has been rejec ing his approach rel ing on harsher meas res.
O er he longer erm, i appears nlikel ha he EMU can ork i ho fiscal mechanisms of
coordina ion, m al s ppor and s r eillance, hich o ld also allo i s members o share bo h
he benefi s and cos s of EMU membership more eq all .
S : Krugman 2010a; Krugman 2010b; Stiglitz 2010a; Stiglitz 2010b; Feldstein, 2010; Acropolis
now , The Economist, 2010;
TIME ;
The Economist
A
1 a E plain ho economic gro h helps co n ries lo er heir deb - o-GDP ra io.

Using an AD-AS diagram, e plain h con rac ionar policies make i more diffic l o
lo er he deb - o-GDP ra io.
2 E plain h a common c rrenc can be in erpre ed as being nder al ed for co n ries i h
rade s rpl ses and o er al ed for co n ries i h rade defici s.
3 Use a PPC diagram o sho he effec s of emigra ion of o ng people on Greece s f re
gro h prospec s.
4 Use a circ lar flo diagram and he concep s of leakages injec ions o sho h r nning a
b dge s rpl s b he go ernmen leads o con rac ion of he econom .
5 E plain ho Greece s e perience ill s ra es he disad an ages of mone ar nion.
2 Pa l Kr gman, Learning from Greece in he New York Times, 8 April 2010.
3 Pa l Kr gman, A mone oo far in he International Herald Tribune, 6 Ma 2010.
* So rce: I.M.F. Concedes Major Miss eps in Bailo of Greece
4 G s a A. Horn, Ho German made he Greek deb crisis orse , Speigelonline In erna ional, 27 April 2010.
5 ibid
6 Joseph S igli , Reform he e ro or bin i in he Guardian, 5 Ma 2010.
7 Q o ed in Forge Greece: E rope s real problem is German in he Washington Post, 21 Ma 2010.
8 This is a reference o John Ma nard Ke nes ho as in rod ced in Chap er 1.
9 Joseph E. S igli , (2017) The Euro and its threat to the future of Europe, Peng in Books.
17.4 Understanding current account deficits
and surpluses
LEARNING OBJECTIVES

define all he erm appearing in orange bold in he e (AO1)
e al a e he implica ion of a per i en c rren acco n defici i h regard o e change ra e ,
in ere ra e , ale of dome ic a e o foreigner , deb , credi ra ing , demand managemen ,
and economic gro h (AO3)
e plain and e al a e me hod o correc a per i en c rren acco n defici : (AO2, AO3)
e pendi re i ching
e pendi re red cing
ppl - ide policie
e plain and appl he Mar hall-Lerner condi ion and J-c r e effec (AO2)
dra a diagram ill ra ing he J-c r e referring o he Mar hall-Lerner condi ion (AO4)
e al a e he implica ion of a per i en c rren acco n rpl i h regard o e change ra e ,
dome ic con mp ion and in e men , infla ion, emplo men , and e por compe i i ene
(AO3)
Consequences of persistent current account deficits

Mo balance of pa men problem all ari e in connec ion i h c rren acco n defici , mainl
d e o an e ce of impor o er e por o er long period of ime. Thi allo co n rie o enjo
increa ed le el of con mp ion o er ha he prod ce, a e a in he PPC diagram in Fig re
16.7(a), ho e er hi canno go on indefini el . While c rren acco n defici for hor period of
ime, or c rren acco n defici ha al erna e i h c rren acco n rpl e , do no generall po e
problem , o er he long erm here are likel o be e eral nega i e con eq ence .
C rren acco n defici , a e kno , are paid for b financial acco n rpl e . A he cen ral bank
doe no ha e endle amo n of foreign c rrenc re er e o pa for a c rren acco n defici , i
m do o ei her hro gh loan (borro ing from abroad) or b elling ome of i ph ical or
financial a e ; all he e me hod re l in inflo of foreign e change. Ye bo h borro ing and ale
of a e ma po e problem if p r ed for a long ime.
Depreciating exchange rate. A c rren acco n defici p a do n ard pre re on he
e change ra e. Large deprecia ion can lead o impor ed infla ion. If here i a ri k of defa l he
do n ard pre re on he c rrenc i m ch ronger beca e people don an o hold
c rrencie ho e al e i e pec ed o fall f r her, and he c rrenc become lnerable o
pec la ion.
Possible need for higher interest rates to attract foreign financial investments, leading to
recession. If a co n r ha diffic l ge ing loan , i ma ha e o increa e i in ere ra e o
a rac financial in e men . Ho e er, higher in ere ra e di co rage dome ic in e men and
con mp ion pending, po ibl crea ing a rece ion in he econom .
Foreign ownership of domestic assets. The need for inflo of f nd , or credi , in he
financial acco n ma lead co n rie o ell dome ic a e o foreigner , ch a ock in he
ock marke , real e a e or fac orie , all of hich e en all ma lead o lo of con rol o er i
a e .
Increasing levels of debt. If a co n r borro o er long period of ime, i r n he ri k of
acc m la ing o m ch deb ha i ma be nable o pa i back; hi i called a ri k of defa l .
Ri k of defa l , along i h ac al defa l , come i h man problem , ch a ignifican
c rrenc deprecia ion, diffic l ie of ge ing more loan and painf l demand- ide policie ( ee
belo ).
Cost of paying interest on loans. The in ere pa men ha m be made on loan e p
na ional income of he co n r ha co ld ha e been pen el e here in he dome ic econom ,
ch a for in e men or pro i ion of meri and p blic good .
Fewer imports of needed capital goods. In ere pa men on loan al o e p carce foreign
e change earning (from e por ) ha co ld ha e been ed on impor of capi al good or o her
inp for prod c ion; he co n r ma herefore no be in a po i ion o ec re all needed impor
for prod c ion.
Poor international credit ratings. In erna ional agencie rank co n rie according o ho
credi - or h he are, meaning ho likel he are o repa heir loan in f ll and on ime.
Thi i called a credit rating. Co n rie i h large and per i en c rren acco n defici ha e
lo credi ra ing , making i more diffic l o ge more loan in he f re (no one an o lend
o a co n r ha ma be nable o pa back i loan ). Under ch circ m ance , a co n r ma
ha e o rai e i in ere ra e er high o a rac foreign financial capi al, and hi can crea e a
erio rece ion or make an e i ing rece ion deeper. In addi ion, he abili of a co n r o go
on indefini el financing i c rren acco n defici b elling off i a e depend er m ch
on he confidence ha foreign in e or ha e in he dome ic econom and c rrenc . If here i a
belief ha he c rrenc ma deprecia e b an iall , or ha he econom ill no perform ell
in he f re, he ma be n illing o con in e o in e in he co n r , or he ma e en r o
ell heir a e in he co n r , in hich ca e he co n r ill be nable o finance i c rren
acco n defici . Thi i likel o re l in a ignifican and rapid deprecia ion of he dome ic
c rrenc .
Painful demand management policies. Co n rie i h erio c rren acco n defici m
of en p r e con rac ionar policie . Con rac ionar mone ar and fi cal policie ha e he effec
of lo ering income , hich in rn lead o lo er impor ha ma help o red ce he c rren
acco n defici . We ill con ider he e policie belo
Possibility of lower economic growth. If loan acc m la e o er long period of ime, he
c m la i e impac of he abo e ma mean lo er economic gro h, a re o rce are ed p on
in ere pa men and loan repa men .
Lower standard of living in the future. In order o be able o pa back he loan in he f re,
he local pop la ion ill a ome poin ha e o con me le han he prod ce, gi ing ri e o a
decline in heir andard of li ing. The rea on i ha pa ing back heir deb req ire a financial
acco n defici , corre ponding o a c rren acco n rpl . (Thi i imilar o one per onal
finance : if o pend more han o earn b borro ing, in he f re hen o pa back o r
deb o ill ha e o pend le han o earn. (See al o Fig re 16.7(b) in Chap er 16).
Co n rie ha ell off heir a e do no ha e o pa back loan ; ho e er, he are elling off a
por ion of heir dome ic proper . In hi ca e, he ill ha e o con me le han he amo n
he prod ce in he f re if he an o regain po e ion of heir dome ic a e .
Ho e er, he e problem eed ece a a e. Borro ing can lead o economic gro h, and if
e ca a o p and income increa e, i become po ible o ha e increa ed con mp ion of good
and er ice e en a loan are being paid back. Impor an req iremen for hi o happen are:
he c rren acco n defici remain rela i el mall and doe no ge o of hand b e ce i e
borro ing
borro ed f nd are ed o finance impor of capi al good and o her inp needed in
prod c ion (in ead of con mer good impor )
ome prod c ion i geared o ard e por ind rie o ha e por increa e, making increa ed
e por earning po ible ( o help pa back loan and in ere , and finance more capi al good
impor ).
Policies to correct persistent current account deficits and their
evaluation
Expenditure reducing policies (reductions in aggregate demand)
Con rac ionar fi cal and mone ar policie red ce aggrega e demand and herefore o p and
income , leading o lo er demand for impor . In addi ion, red ced aggrega e demand i likel o
gi e ri e o a lo er ra e of infla ion, making dome ic good more compe i i e, h increa ing
e por . The combina ion of fe er impor and more e por ma ork o red ce he c rren acco n
defici . The e policie are kno n a expenditure reducing policies, beca e he r o infl ence he
le el of impor and e por b red cing dome ic e pendi re hro gh lo er aggrega e demand.
Thi approach come i h di ad an age , a i ma crea e a rece ion in he dome ic econom .
Moreo er, here i al o a ri k ha higher in ere ra e (con rac ionar mone ar polic ) lead o
c rrenc apprecia ion, hich ma di co rage e por and enco rage impor , par l cancelling o
he beneficial effec of e pendi re red cing policie on impor and e por .
Expenditure switching policies

Expenditure switching policies a emp o i ch con mp ion a a from impor ed good and
o ard dome icall prod ced good .
Trade protection
Co n rie i h a long- erm c rren acco n defici co ld re or o increa ed rade pro ec ion, crea ing
or increa ing barrier o rade. The e policie can red ce he c rren acco n defici b direc l
re ric ing impor ; ho e er, he ha e a n mber of nega i e effec , ch a higher dome ic price
of pro ec ed good , lo er dome ic con mp ion, inefficienc and a dome ic and global re o rce
mi alloca ion of re o rce . There al o ari e a danger ha co n rie again hich he pro ec i e
barrier are impo ed ma re alia e i h heir o n barrier , crea ing a piral of pro ec ioni policie
i h erio con eq ence on global rade and global gro h.
Depreciation
The c rrenc of a co n r i h a per i en c rren acco n defici i likel o face a rong do n ard
pre re on i al e. The go ernmen or cen ral bank ma allo he c rrenc o deprecia e, in hich
ca e i enco rage e por ( hich become cheaper o foreigner ) and di co rage impor ( hich
become more e pen i e o dome ic b er ). Thi i ano her pe of e pendi re- i ching polic ,
beca e i , oo, i che con mp ion a a from impor and o ard dome icall prod ced good .
Ho e er, hi polic oo ma ha e nega i e effec on he dome ic econom . Higher impor price
d e o he lo er al e of he c rrenc of en re l in higher dome ic infla ion. If he impor ed good
incl de capi al good and o her prod c ion inp , firm e perience higher co of prod c ion, hich
ma be pa ed on o con mer in he form of higher price . Thi i a pe of co -p h infla ion, and
b hif ing he SRAS c r e o he lef , ma ha e rece ionar effec .
Supply-side policies to increase competitiveness

Marke -orien ed ppl - ide policie are in ended o lo er co of prod c ion for firm , and b
hif ing he SRAS and LRAS c r e o he righ can re l in lo er ra e of infla ion ( ee Chap er 13,
Sec ion 13.6). Se eral policie , ch a increa ing compe i ion, red cing he po er of labo r nion ,
red cing or elimina ing he minim m age, c ing b ine a e , dereg la ion, and o her , co ld
ha e he effec of making firm more compe i i e in global marke . O er a long period of ime,
lo er ra e of infla ion ma increa e e por , hereb addre ing he c rren acco n defici .
Co n rie can al o e in er en ioni ppl - ide policie , ch a ppor for raining, ed ca ion,
re earch and de elopmen and ind rial policie , o promo e ind rie ha prod ce for e por .
A di ad an age of ppl - ide policie i ha he generall ake a long ime o make heir effec
fel . For f r her e al a ion of he e policie ee Chap er 13.
Marshall Lerner condition and J-curve
Marshall Lerner condition

When a co n r c rrenc de al e or deprecia e , i impor become more e pen i e dome icall
and e por become le e pen i e o foreigner . Thi gge ha he q an i of impor decrea e
and he q an i of e por increa e . The q e ion of in ere i he her a de al a ion or deprecia ion
red ce he i e of a rade defici (and herefore a c rren acco n defici ). The Mar hall Lerner
condi ion i a condi ion ha , if a i fied, allo de al a ion or deprecia ion o lead o an
impro emen in a co n r balance of rade (and herefore in i c rren acco n ).
The Mar hall Lerner condi ion in ol e he de al ing/deprecia ing co n r price ela ici of
demand for impor (PEDm) and foreigner price ela ici of demand for he co n r e por
(PED ). Ela ici ie are impor an beca e ha ma er i no change in he a e of impor
and e por , b ra her change in he a e of impor and e por .
If PED for impor i le han one, a percen age increa e in he price of impor (d e o he
de al a ion/deprecia ion) lead o a maller percen age decrea e in q an i of impor demanded, o
ha he al e of impor increa e , prod cing a nega i e effec on he rade balance; if here i a rade
defici , hi ill end o become larger. On he o her hand, if he PED for impor i grea er han one,
he al e of impor ill fall, prod cing a po i i e effec on he rade balance. In general, he larger
he PED for impor , he grea er he cope for impro emen in a rade defici .
The PED for e por i al o impor an . The larger he PED for e por , he larger he increa e in
q an i of e por ha re l follo ing a de al a ion/deprecia ion, and he larger he po i i e effec
on he rade balance.
Ye i i no nece ar for bo h PED and PEDm o be larger han one for a de al a ion or
deprecia ion o re l in a maller rade defici . According o he Mar hall-Lerner condi ion, i i onl
nece ar ha heir m be grea er han one.10
The Mar hall-Lerner condi ion a e he condi ion nder hich a de al a ion/deprecia ion ill
re l in a maller rade defici :
The Marshall Lerner condition a e he follo ing:

If he m of he PED for impor and e por i grea er han 1, i.e. PEDm + PED >1,
de al a ion/deprecia ion ill impro e he rade balance ( ill make a rade defici maller).
If he m of he o PED i le han 1, de al a ion/deprecia ion ill or en he rade
balance ( ill make a rade defici bigger).
If he m of he o PED i eq al o 1, de al a ion/deprecia ion ill lea e he rade balance
nchanged.
The grea er he price ela ici ie of demand for impor and for e por , he grea er he cope for
impro emen in he rade balance. Wi h lo PED , i o ld be nece ar o ha e large
de al a ion /deprecia ion o ob ain ignifican rade balance impro emen . The higher he PED ,
he maller he de al a ion or deprecia ion needed o ob ain rade balance impro emen .
Understanding the Marshall-Lerner condition in more detail

(Supplementary material)
If o o ld like o nder and he Mar hall-Lerner condi ion in more de ail o ma do o in he
'Digi al co r ebook: E ra ma erial' ec ion.
J-curve effect
A de al ing/deprecia ing co n r ma ee a or ening rade balance in he period immedia el
follo ing he de al a ion or deprecia ion of i c rrenc ; la er, he rade defici ill begin o hrink,
and he rade balance ill begin o impro e, pro ided he Mar hall Lerner condi ion hold . Thi i
kno n a he J-curve effect, ho n in a graph ha plo he balance of rade ( he al e of e por
min impor ) on he er ical a i and ime on he hori on al a i , ho n in Fig re 17.3. All al e
grea er han ero on he er ical a i ill ra e a rade rpl , and all al e le han ero ill ra e a
rade defici . When he rade balance i eq al o ero (a he origin), e por are eq al o impor . I
follo ha a he al e increa e along he er ical a i , a rade defici become maller n il i
reache (X M) = 0, and abo e ha become a rade rpl .
Figure 17.3: J-c r e effec
In par (a), he co n r ini iall ha a al e of e por eq al o he al e of impor (no rade defici or

rpl ); follo ing he de al a ion/deprecia ion a rade defici emerge hich la er become a rade
rpl . In par (b), he co n r ini iall ha a rade defici , hich become larger immedia el
follo ing he de al a ion/deprecia ion, and hich hen impro e , e en all becoming a rpl .
Thi i called a J c r e beca e of i hape.
The e plana ion behind he hape of he J-c r e can be raced direc l o he Mar hall-Lerner
condi ion. In he period immedia el follo ing a c rrenc de al a ion/deprecia ion, price ela ici ie
of demand for impor and e por are er lo , and he Mar hall-Lerner condi ion i no a i fied:
PEDm + PED < 1. Therefore he rade balance de eriora e . A ime pa e , PED for impor and
e por increa e, and if here come a poin hen PEDm + PED > 1, he rade balance begin o
impro e.
The rea on for ini ial lo PED for impor and e por lie in ime lag ( ime dela ) be een
de al a ion/deprecia ion and i effec on q an i ie of e por and impor demanded.
De al a ion/deprecia ion in ol e change in rela i e price of impor and e por . Ho e er,
con mer and prod cer need ime o adj o he price change . Al ho gh impor ha e become
more e pen i e dome icall , he are ill p rcha ed for a arie of rea on , ch a he ime needed
for b er o become a are of he price change , or prior commi men , or he ime needed o place
ne order , or par ic lar preference of b er ha need ime o change. In he mean ime, he price of
e por ha fallen for foreigner ; ho e er, he oo ha e prior commi men , par ic lar preference
and o on, herefore he q an i demanded increa e onl lo l . Wi h PEDm + PED < 1 ini iall ,
he rade balance de eriora e , re l ing in he do n ard- loping por ion of he J-c r e.
A ime pa e , con mer and prod cer adj o he change in price , PED of bo h impor and
e por increa e, q an i of impor demanded fall and q an i of e por demanded increa e and
he balance of rade begin o impro e ( he p ard- loping por ion of he J-c r e).
Empirical e idence ppor he e i ence of a J-c r e. According o die e ima ing PED for
impor and e por in de eloped co n rie , o er hor period of ime (le han i mon h ) mo
man fac red good ha e PED ha are oo lo o a i f he Mar hall Lerner condi ion; he m of
PED for impor and e por i le han 1, indica ing he do n ard- loping par of he J-c r e (a
or ening rade balance). In a period of more han i mon h and le han a ear, he PED for mo
prod c ha e increa ed o he poin ha he Mar hall Lerner condi ion i a i fied, o ha he m of
he o PED i grea er han 1, leading o an impro ing rade balance.
Consequences of persistent current account surpluses

Co n rie i h a c rren acco n rpl mo likel ha e a rade rpl , i h e por grea er han
impor . The are herefore ne p rcha er of a e abroad or ne lender o o her co n rie ( h
ha ing financial acco n defici ). Per i en c rren acco n rpl e ma lead o he follo ing
problem :
Low domestic consumption. Large and per i en c rren acco n rpl e mean lo er
con mp ion le el and lo er andard of li ing for he pop la ion ince o erall prod c ion i
grea er han con mp ion. Thi i clear from Fig re 16.7(b) ho ing ha co n ie i h a rade
rpl con me in ide heir PPC.
Insufficient domestic investment. The financial acco n defici (corre ponding o he c rren
acco n rpl ) mean ha f nd are lea ing he co n r , re l ing in a ri k of in fficien
dome ic in e men , limi ing economic gro h pro pec .
Appreciation of the domestic currency. A c rren acco n rpl p an p ard pre re on
he al e of a c rrenc , hich can lead o lo er e por and higher impor (red ced ne
e por ). Thi co ld lo er he ra e of gro h of he dome ic econom a a re l of lo er
aggrega e demand.
Inflation. Lo er aggrega e demand d e o red ced ne e por p a do n ard pre re on
demand-p ll infla ion. F r her lo er impor price p a do n ard pre re on co -p h
infla ion
Employment. The effec ma be mi ed. Lo er aggrega e demand ma lead o higher
nemplo men a orker begin o lo e heir job . Ho e er nemplo men ma decrea e in
firm ha enjo lo er impor co d e o he apprecia ion.
Reduced export competitiveness. A he dome ic c rrenc apprecia e , e por become more
e pen i e o foreigner , and hi make i more diffic l for dome ic firm o compe e i h
firm abroad
Possibility of retaliation by trading partners through trade barriers. C rren acco n
rpl e in ome co n rie corre pond o c rren acco n defici in o her co n rie . C rren
acco n rpl e per i ing o er long period ma promp he defici co n rie o impo e rade
re ric ion o red ce heir impor from he rpl co n rie . (See Real orld foc 15.2.)

Pakistan s current account deficit
In he period 2014 2017, he S a e Bank of Paki an (SBP, Paki an cen ral bank) managed he
Paki ani r pee, pre en ing a deprecia ion ha o ld mo likel ha e occ rred if he r pee had
been lef o free marke force . The deprecia ion i likel o ha e occ rred beca e of a large rade
and c rren acco n defici in Paki an.
The SBP ed foreign e change re er e o manage he r pee. I in er en ion in he foreign
e change marke re l ed in a rela i el able r pee o US dollar e change ra e. B a he r pee
co ld no fall o i free marke le el i became o er al ed. A a re l , i cceeded in bringing
do n he ra e of infla ion from 8.6% in 2014 o 2.9% in 2016, ho gh hi ro e o 4.2% in 2017.
Ho e er, he generall lo er ra e of infla ion in rela ion o 2014 came a he co of a larger rade
and c rren acco n defici . The rade defici increa ed b more han 50% in he period 2014 2017
a he o er al ed r pee re l ed in more impor and fe er e por .
Figure 17.4: Lahore, Paki an. Freigh rain i h cargo con ainer
An al erna i e o ing foreign e change re er e o pre en r pee deprecia ion o ld ha e been

for he SBP o increa e in ere ra e . Ho e er, in ere ra e ere main ained a lo le el d ring
hi period.
In addi ion o foreign e change re er e , he r pee a ppor ed b Paki ani borro ing from
abroad. From he end of 2014 o he end of 2017 Paki an e ernal deb increa ed b nearl 30%.
A he end of 2017 he deci ion a made o allo he r pee o floa ( o be de ermined b marke
force ). The re l a an immedia e and er ignifican r pee deprecia ion. Ye e en a he r pee
fell, he rade and c rren acco n defici con in ed o iden.
The ra e of infla ion in he mean ime ar ed o ri e again. The SBP ha increa ed in ere ra e .
There are concern ha a ing ill be direc ed o ard por folio in e men and a ing depo i
ra her han o firm in ere ed in in e ing in prod c i e capaci . Confidence in he econom i
falling. The e fac or are rai ing concern abo he f re of he Paki ani econom . I i e pec ed
ha economic gro h in 2018 2019 ill be he lo e in nine ear .
Sources: H a H Za d , I e e d e ab e c ee a e ,T eE e T b e,
28 Dece be 2018;
N H Z be , PKR de a a , c ae a e de a g ac ec , 4 Dece be 2018;
B e Rec de ; Pa a ec cg e c e ea , 18 Dece be 2018;
D a Ne
1 U e an e change ra e diagram o e plain ho he SBP cceeded in main aining a able
al e of he r pee in rela ion o he US dollar.
2 E plain ho o er al a ion of he r pee con rib ed o
a lo ering he ra e of infla ion, and
b a idening rade defici .
3 The e a e ha an al erna i e o ing foreign e change re er e o main ain he al e of
he r pee o ld ha e been for he SBP o increa e in ere ra e .
a U ing an AD-AS diagram, iden if ha kind of mone ar polic hi i and ho he
likel effec of ri ing in ere ra e on he Paki ani econom .
b U ing an e change ra e diagram e plain he likel impac of hi polic on he al e of
he r pee.
4 Referring o he concep of debi and credi in he balance of pa men , e plain ho o
fac or con rib ed o crea ing a ero balance in Paki an balance of pa men .
5 U ing a PPC diagram dra o poin ill ra ing
a here Paki an co ld po ibl be prod cing, and
b here Paki an co ld po ibl be con ming.
6 U ing an appropria e diagram e plain one po ible rea on ha acco n for he idening
rade defici in Paki an af er he deprecia ion of he r pee.
7 U ing an appropria e diagram e plain h he al e of he r pee o ld ha e fallen if he
SBP had no in er ened.
8 Di c he implica ion of Paki an c rren acco n defici for he Paki ani econom .
9 E al a e al erna i e me hod ha he SBP of go ernmen of Paki an can p r e o correc
he c rren acco n defici .
Fiscal and monetary policy and conflicting objectives in an

open economy (Supplementary material)
When an econom i open o in erna ional rade and financial flo , in addi ion o he goal of price
abili , f ll emplo men and economic gro h, i ha he f r her goal of achie ing a rea onable
balance of rade and a oiding harp fl c a ion in i e change ra e. Ho e er, economie ma be
nable o achie e all he e objec i e a he ame ime. Go ernmen of en find ha b p r ing a
polic o correc one problem, he ma crea e a problem el e here. If o are in ere ed in reading
abo he e conflic ing objec i e , o ma do o in he 'Digi al co r ebook: E ra ma erial' ec ion.
1 Di c ome problem faced b co n rie ha ha e
a a c rren acco n defici and a financial acco n rpl , and
b a c rren acco n rpl and a financial acco n defici .
2 Di c ad an age and di ad an age of
a e pendi re red cing,
b e pendi re i ching policie , and
c ppl - ide policie a me hod o correc a per i en c rren acco n defici .
3 E plain h he price ela ici ie of demand (PED ) for impor and e por are impor an in
de ermining ha ill happen o a co n r rade balance follo ing a de al a ion or
deprecia ion of he dome ic c rrenc .
4 S ppo e a co n r ha a defici in i balance of rade, and deprecia e or de al e i
c rrenc . E plain ha ill happen o i rade balance if
a i PED for impor i 0.2 and i PED for e por i 0.5,
b i PED for impor i 0.7 and i PED for e por i 0.3, and
c i PED for impor i 0.8 and i PED for e por i 0.6.
5 S a e he Mar hall Lerner condi ion.
6 S ppo e ha a co n r PED for impor i 0.6 and for i e por i 0.2.
a E plain h a deprecia ion of i c rrenc ma ini iall lead o a larger rade defici , and
b dra a diagram o ho he effec .

The follo ing q e ion ill help o reflec on o r learning and enhance o r nder anding of
ke opic in hi chap er. The are gge ion for inq irie ha o can nder ake on o r o n
or in gro p in order o re i e he learning objec i e of hi chap er.
1 iden if and re earch a co n r ha ha a erio and per i en c rren acco n defici . ho
did hi defici come abo ? r o iden if ome of he con eq ence of hi defici in he
dome ic econom . i he go ernmen or cen ral bank aking mea re o red ce hi defici ; if
o ha are he e mea re ? can o commen on he po ible po i i e and nega i e
con eq ence of he e mea re ?
2 Iden if and re earch a co n r i h a per i en c rren acco n defici ha e or ha ed
e pendi re i ching or e pendi re red cing policie . Di c he con eq ence of he e
policie .
3 Iden if one or more co n rie ha manage heir e change ra e and re earch he ca e and
con eq ence of e change ra e managemen .

The PED for e por ork differen l han he PED for impor . Follo ing a deprecia ion, he price of e por
10
fall in erm of foreign c rrencie , b i remain he ame in erm of he dome ic c rrenc . Thi mean ha
follo ing a de al a ion/deprecia ion, he al e of e por ill al a increa e regardle of he PED of
e por , beca e he al e of e por i de ermined b m l ipl ing a con an price (in erm of he dome ic
c rrenc ) b a larger q an i . If o are in ere ed in finding o more abo hi ee Under anding he
Mar hall-Lerner condi ion in more de ail pre en ed a S pplemen ar ma erial in he 'Digi al co r ebook:
E ra ma erial' ec ion.
C a 18
U a c c
BEFORE YOU START
What do you think makes for a decent standard of living for a country s citizens?
What kind of indicators would you consider to measure standards of living and well-being?
This chapter examines the goals of sustainable development as well as the relationship between
economic growth and economic development. In addition, it focuses on the methods that can be used to
measure economic development, which is a process with many dimensions. We will discover that there
are numerous ways to approach its measurement, each with advantages and drawbacks.
18.1 S a ab e de e e
LEARNING OBJECTIVES

• define all the terms appearing in a ge b d in the text (AO1)
• explain the meaning of sustainable development (AO2)
• explain the sustainable development goals (AO2)
• explain the relationship between sustainability and poverty (HL only) (AO2)
The ea g f a ab e de e e
The concept of sustainability, introduced in Chapter 1, concerns the joint preservation of the
environment and the economy: how to achieve environmental preservation along with preservation of
humankind s ability to provide goods and services to satisfy needs and wants into the future.
The problem of sustainability arises because of conflicts between environmental and economic goals.
Economic goals involve efforts to increase the quantities of output produced and consumed; but
focusing on economic goals while disregarding the environment may result in its irreversible
destruction. Environmental goals involve the preservation of the environment; but focusing on
environmental goals while disregarding the economy may result in humankind s inability to satisfy
needs and wants.
The important question, then, is how to strike a balance between environmental and economic goals,
so that both can be satisfied into the future. The answer to this question is provided by the concept of
a ab e de e e (introduced in Chapter 1), defined as ‘de e e ha ee he eed f
he e e ih c i i g he abi i f f e ge e a i ee hei eed .1 This
concept was coined by the Brundtland Commission on Environment and Development, set up by the
United Nations in the 1980s and named after the Norwegian Gro Harlem Brundtland who headed the
Commission. It means that societies should pursue economic growth ha d e de e e deg ade
a a e ce , so that future generations will not have fewer or lower-quality natural resources to
satisfy their own needs.
S a ab e de e e g a
The S a ab e De e e G a (SDG ) are a set of seventeen goals that were developed at the
United Nations Conference on Sustainable Development in Rio de Janeiro in 2012. In the words of
the United Nations, ‘The objective was to produce a set of universal goals that meet the urgent
environmental, political and economic challenges facing our world. 2
The SDGs continue and expand upon the work that had begun years earlier by the Millennium
Development Goals (MDGs), which ran until 2015. Like the MDGs, the SDGs are accompanied by
numerous targets that are intended to be met within the 15-year period 2015 to 2030. The targets have
one to three indicators used to monitor and measure countries progress toward achieving the goals
and targets. Indicators will be discussed below.
The SDGs with their corresponding targets and indicators are very important tools used by
international organisations and national governments in their fight against poverty and efforts to
achieve sustainable economic development. They are used systematically to monitor and measure
progress (or setbacks) achieved in each country with respect to each of the goals.
The Sustainable Development Goals are listed in Table 18.1. If you are interested in more information
such as the targets and indicators that are included for each goal you may visit their website by
searching for ‘UN sustainable development goals .
The e a h be ee a ab a d e (HL )
We often think of environmental degradation as the by-product of high-income production and
consumption activities resulting from increasing quantities of output produced and consumed
(economic growth). This type of environmental damage has been termed ‘pollution of affluence and
arises mainly from industrial production based on use of fossil fuels (such as oil) and using up
common pool resources like clean air, rivers, lakes, and so on, leading to climate change.
However, there is another type of very important environmental damage, occuring mainly in
developing countries, and arising from production and consumption activities that are due to poverty.
This second type of environmental damage has been termed ‘pollution of poverty , and is due to
economic activities pursued by very poor people in an effort to survive.
According to the Brundtland Commission, which coined the term ‘sustainable development , poverty
is a cause of environmental destruction due to the overexploitation by poor people of their scarce
environmental resources. Poor people lack modern agricultural inputs, and being too poor to buy
inputs that preserve the soil s fertility, they deplete the soil s natural minerals, making soils less
productive. Poor people usually have higher birth rates and higher population growth, creating
pressures for them to open up new lands for agriculture. With suitable agricultural land becoming
increasingly scarce, they cut down forests (deforestation) in search of new farmland, they move to
fragile lands in mountains and hills, causing soil erosion, and they overgraze animals on pasture
lands, depleting the nutrients there as well. Lacking modern energy sources, they also cut down
forests to obtain firewood. Poor people have limited abilities to borrow to finance the purchase of
inputs, and this works against their ability to make improvements in sanitation, irrigation, improved
agricultural inputs and land improvements, which would reverse or reduce these types of
environmental degradation.
The production and consumption activities of very poor people that endanger the environment and
sustainability can also be interpreted as negative externalities involving overuse of common pool
resources. In Figure 5.3 (Chapter 5), the MPC curve may be a farmer s private costs of farming, with
the difference between the MPC and MSC curves representing overuse of forests that have been
cleared for agriculture, or the overuse of soil leading to depletion of nutrients.
Whereas the pollution of poverty occurs mainly in developing countries, this is not to say that
developing countries are not guilty of creating some ‘pollution of affluence . Increasingly, the
pollution of affluence arises also in developing countries that grow by engaging in industrial
production and consumption activities without regard for the environment.

1 Explain
a the meaning of sustainable development, and
b the objectives of the Sustainable Development Goals.
2 (HL only) Explain the relationship between sustainability and poverty.
1 Brundtland Commission (World Commission on Environment and Development) (1987) O C F e,

Oxford University Press.
2 Background on the goals

18.2 Meas ring de elopment
LEARNING OBJECTIVES

e lain he m l idimen i nal na e f ec n mic de el men (AO2)
e lain he e f ingle indica , incl ding: (AO2)
GDP/GNI per capita a US$PPP
heal h and ed ca i n indica
ec n mic/ cial ine ali indica
ene g indica
en i nmen al indica
e lain he e fc m i e indica incl ding: (AO2)
H man De el men Inde (HDI)
Ine ali -adj ed H man De el men Inde (IHDI)
Gende Ine ali Inde (GII)
Ha Plane Inde
di c eng h and limi a i n f he ai a ache mea emen f ec n mic
de el men (AO3)
di c he ela i n hi be een ec n mic g h and ec n mic de el men (AO3)
Goal E cerpts from the United Nations SDG site3

1 End e in all i P e i m e han he lack f inc me and e ce en e a
f m e e he e ainable li elih d. I manife a i n incl de h nge and
maln i i n, limi ed acce ed ca i n and he ba ic e ice ,
cial di c imina i n and e cl i n a ell a he lack f a ici a i n
in deci i n-making
2 End h nge , achie e Righ n , il , f e h a e , cean , f e and bi di e i a e
f d ec i and being a idl deg aded. Clima e change i ing e en m e e e
im ed n i i n and n he e ce e de end n, inc ea ing i k a cia ed i h
m e ainable di a e , ch a d gh and fl d
ag ic l e
A f nd change f he gl bal f d and ag ic l e em i
needed if e a e n i h he 815 milli n e le h a e h ng
da and he addi i nal 2 billi n e le e ec ed be
nde n i hed b 2050
3 En e heal h li e and Man m e eff a e needed f ll e adica e a ide ange f
m e ell-being f di ea e and add e man diffe en e i en and eme ging heal h
all a all age i e . B f c ing n iding m e efficien f nding f heal h
em , im ed ani a i n and h giene, inc ea ed acce
h ician and m e i n a ed ce ambien ll i n,
ignifican ge can be made in hel ing a e he li e f
milli n
4 En e incl i e and The ea n f lack f ali ed ca i n a e d e lack f ade a el
e i able ali ained eache , c ndi i n f ch l and e i i e ela ed
ed ca i n and m e ni ie ided al child en. F ali ed ca i n be
lifel ng lea ning ided he child en f im e i hed familie , in e men i
ni ie f all needed in ed ca i nal ch la hi , eache aining k h , ch l
b ilding and im emen f a e and elec ici acce ch l
5 Achie e gende e ali Gende e ali i n nl a f ndamen al h man igh , b a
and em e all men nece a f nda i n f a eacef l, e and ainable ld.
and gi l
P iding men and gi l i h e al acce ed ca i n, heal h ca e,
decen k, and e e en a i n in li ical and ec n mic deci i n-
making ce e ill f el ainable ec n mie and benefi cie ie
and h mani a la ge
6 En e a ailabili and Clean, acce ible a e f all i an e en ial a f he ld e
ainable managemen an li e in and he e i fficien f e h a e n he lane
f a e and ani a i n achie e hi .
f all
Wa e ca ci , ae ali and inade a e ani a i n nega i el
im ac f d ec i , li elih d ch ice and ed ca i nal ni ie
f familie ac he ld
7 En e acce F c ing n ni e al acce ene g , inc ea ed ene g efficienc
aff dable, eliable, and he inc ea ed e f ene able ene g h gh ne ec n mic and
ainable and m de n j b ni ie i c cial c ea ing m e ainable and incl i e
ene g f all c mm ni ie and e ilience en i nmen al i e like clima e
change
8 P m e ained, S ainable ec n mic g h ill e i e cie ie c ea e he
incl i e and c ndi i n ha all e le ha e ali j b ha im la e he
ainable ec n mic ec n m hile n ha ming he en i nmen . J b ni ie and
g h, f ll and decen king c ndi i n a e al e i ed f he h le king age
d c i e em l men la i n
and decen k f all
9 B ild e ilien In e men in inf a c e an , i iga i n, ene g and

inf a c e, m e inf ma i n and c mm nica i n echn l g a e c cial achie ing
incl i e and ainable de el men and em e ing c mm ni ie in man
ainable c n ie
ind iali a i n and
f e inn a i n Techn l gical g e i he f nda i n f eff achie e
en i nmen al bjec i e , ch a inc ea ed e ce and ene g -
efficienc
10 Red ce ine ali The e i g ing c n en ha ec n mic g hi n f cien
i hin and am ng ed ce e if i i n incl i e and if i d e n in l e he h ee
c n ie dimen i n f ainable de el men ec n mic, cial and
en i nmen al
T ed ce ine ali , licie h ld be ni e al in inci le, a ing

a en i n he need f di ad an aged and ma ginali ed la i n
11 Make ci ie and h man Man challenge e i main aining ci ie in a a ha c n in e
e lemen incl i e, c ea e j b and ei ih aining land and e ce .
afe, e ilien and C mm n ban challenge incl de c nge i n, lack f f nd ide
ainable ba ic e ice , a h age f ade a e h ing, declining inf a c e
and i ing ai ll i n i hin ci ie
12 En e ainable S ainable c n m i n and d c i n i ab m ing e ce
c n m i n and and ene g efficienc , ainable inf a c e, and iding acce
d ci n a en ba ic e ice , g een and decen j b and a be e ali f life f
all
Since ainable c n m i n and d c i n aim a d ing m e

and be e i h le , ne elfa e gain f m ec n mic ac i i ie can
inc ea e b ed cing e ce e, deg ada i n and ll i n al ng he
h le life c cle, hile inc ea ing ali f life
13 Take gen ac i n Clima e change i n affec ing e e c n ne e c n inen
c mba clima e change
and i im ac Aff dable, calable l i n a e n a ailable enable c n ie
lea f g cleane , m e e ilien ec n mie
Clima e change, h e e , i a gl bal challenge ha d e n e ec

na i nal b de . I i an i e ha e i e l i n ha need be
c dina ed a he in e na i nal le el hel de el ing c n ie
m e a d a l -ca b n ec n m
14 C n e e and O ain a e , d inking a e , ea he , clima e, c a line , m ch f
ainabl e he f d, and e en he gen in he ai e b ea he, a e all l ima el
cean , ea and ma ine ided and eg la ed b he ea
e ce f ainable
de el men Ca ef l managemen f hi e en ial gl bal e ce i a ke fea e
fa ainable f e
15 P ec , e e and F e c e 30.7 e cen f he Ea h face and, in addi i n
m e ainable e iding f d ec i and hel e , he a e ke c mba ing clima e
f e e ial change, ec ing bi di e i and he h me f he indigen
ec em , ainabl la i n. B ec ing f e , e ill al be able eng hen
manage f e , c mba na al e ce managemen and inc ea e land d ci i
de e ifica i n, and hal
and e e e land
deg ada i n and hal
bi di e i l
16 P m e eacef l and The h ea f in e na i nal h micide, i lence again child en,

incl i e cie ie f h man afficking and e al i lence a e im an add e
ainable m e eacef l and incl i e cie ie f ainable de el men
de el men , ide
acce j ice f all T ackle he e challenge and b ild m e eacef l, incl i e cie ie ,
and b ild effec i e, he e need be m e efficien and an a en eg la i n in lace
acc n able and and c m ehen i e, eali ic g e nmen b dge
incl i e in i i n a
all le el
17 S eng hen he mean f A cce f l ainable de el men agenda e i e a ne hi

im lemen a i n and be een g e nmen , he i a e ec and ci il cie . The e
e i ali e he gl bal incl i e a ne hi b il n inci le and al e , a ha ed i i n,
a ne hi f and ha ed g al ha lace e le and he lane a he cen e, a e
ainable de el men needed a he gl bal, egi nal, na i nal and l cal le el
So rce: Sustainable Development Goals

Table 18.1: S ainable De el men G al
The m ltidimensional nat re of economic de elopment

Economic gro th ers s economic de elopment
Economic growth efe inc ea e in ( eal GDP) and inc me e ime, f en mea ed n a
per capita ba i . Economic development efe a ce ha lead im ed anda d f li ing f
a la i n a a h le. Inc ea ing le el f and inc me e l ing f m ec n mic g h mean
ha cie ie can be e a i f he need and an f hei la i n and ec e im emen in
hei anda d f li ing. H e e , ec n mic g h d e n b i elf g a an ee ha hi ill cc .
Pe i ing e and he fail e f man c n ie ec e l ng-la ing im emen in ell-being,
e en i h e ec able a e f g h e e ended e i d f ime, ha e h n ha ec n mic
de el men i a highl c m le and me ime el i e ce .
Wh economic de elopment is m ltidimensional

The e ol ing meaning of economic de elopment
The meaning f ec n mic de el men ha changed e he ea . In he 1950 and 1960 , ec n mi
h gh ha ec n mic g h and ec n mic de el men e e ac icall ne and he ame. A fam
de el men ec n mi , Cha le P. Kindlebe ge , e in 1965, G h and de el men a e f en
ed n n m l in ec n mic di c i n, and hi i en i el a ia e. 4 I a belie ed ha
ec n mic g h e l ng e i d ld a ma icall ide ec n mic and cial benefi f he
en i e la i n. La ge an i ie f g d and e ice , incl ding heal h ca e and ed ca i n, and
em l men ni ie and cial change ld e en all be ead e m e le in an
ec n m . Thi a e med he ickle-d n he : benefi f g h ld e en all ickle d n
e e ne.
B he la e 1960 and ea l 1970 , i a bec ming clea ha man de el ing c n ie e e n
e f ming acc ding e ec a i n . The GNI per capita ga be een ich and c n ie had
5
m e han d bled n a e age in he e i d 1950 1975. While me le de el ed c n ie e e
g ing a idl (e eciall me il- ich c n ie ), he e e e e iencing e l e en nega i e
g h a e (e eciall in Af ica). The n mbe f e le li ing in e eme e (defined hen a
li ing n le han US$1 e da ) a inc ea ing a he han dec ea ing. I a a a en ha he benefi
f ec n mic g h e en ickling d n he e membe f cie .
Ec n mi began nde and ha ha a needed a an a ach ha ld di ec l deal i h he
blem f de el ing c n ie , and ecificall he blem f e i ing e . A ne e ec i e
eme ged em ha i ing edi ib i n f inc me and eal h, and im ed acce f he ba ic
g d and e ice .
The man dimensions of economic de elopment

Since he 1970 , ec n mic de el men ha been nde d be a ce i h man dimen i n .
Economic de elopment i defined a a ce he e inc ea e in eal e ca i a and inc me

a e acc m anied b im emen in anda d f li ing f he la i n and ed c i n in e ,
inc ea ed acce g d and e ice ha a i f ba ic need (incl ding f d, hel e , heal h ca e,
ed ca i n, ani a i n and he ), im ed gende e ali , inc ea ing em l men ni ie and
ed c i n f nem l men , and ed c i n f e i ine ali ie in inc me and eal h.
H man de elopment
Thinking ab de el men ha g e ed f he , b ilding n an e en b ade in e e a i n f
de el men ided b Deni G le a ea l a 1971. G le defined h ee c e al e f
de el men : 6
Life s stenance efe acce ba ic e ice (me i g d ) ch a ed ca i n and heal h ca e

e ice , a ell a a i fac i n f ba ic need like f d, cl hing and hel e .
Self-esteem in l e he feeling f elf- e ec ; de el men ide indi id al i h digni ,
h n and inde endence. Self-e eem i ela ed he ab ence f e l i a i n and d minance
a cia ed i h e and de endence.
Freedom in l e f eed m f m an , ign ance and al ; i i f eed m make ch ice ha
a e n a ailable e le h a e bjec ed c ndi i n f e .
The ec n mi Ama a Sen, h n he N bel P i e in Ec n mic in 1998 f hi k n e
and ec n mic de el men , e and n G le idea , and ee im emen in h man ell-being a
a i ing f m a ce f e anding f eed m :
‘Development can be seen . . . as a process of expanding the real freedoms that people enjoy.
Focusing on human freedom contrasts with narrower views of development, such as identifying
development with the growth of gross national product, or with the rise in personal incomes, or with
industrialisation, or with technological advance, or with social modernisation. Growth of GNI or of
individual incomes can, of course, be very important as mean to expanding the freedoms enjoyed by
the members of the society. But freedoms depend also on other determinants, such as social and
economic arrangements (for example, facilities for education and health care), as well as political
and civil rights (for example, the liberty to participate in public discussion and scrutiny) . . . 7
Sen a ach ha been c alli ed in he c nce f human development, in d ced in he fi
H man De el men Re f he Uni ed Na i n De el men P g amme (UNDP) in 1990.8
Human development i a ce f e anding h man f eed m : he f eed m a i f h nge ; be

ade a el fed; be f ee f e en able illne e ; ha e ade a e cl hing and hel e ; ha e
acce clean a e and ani a i n; be able ead, i e and ecei e an a ia e ed ca i n;
be kn ledgeable; be able find k; enj legal ec i n; a ici a e in cial and
li ical life; and, in gene al, ha e he f eed m de el ne en ial and lead a f ll and
d c i e life.
U ing he c nce f h man de el men , he UNDP make a di inc i n be een income poverty and
human poverty. Inc me e cc hen inc me fall bel a na i nall in e na i nall
de e mined e line. H man e in l e de i a i n and he lack f ni ie ha all
indi id al lead a l ng, heal h , c ea i e life and enj a decen anda d f li ing, f eed m,
digni , elf-e eem and he e ec f he .9
T nde and he di inc i n be een he , c n ide a illage h e inc me inc ea e , ha n
he he i able cha e m e g d and e ice . If he e a e n ch l heal h ca e e ice in
he a ea, if he illage i infe ed i h mala ia, he highe inc me ill be f li le e in ec ing a
highe anda d f li ing. Inc me e i ed ced, b h man e cann be l e ed i h
mea e ide a b ad ange f cial e ice he en i e la i n. On he he hand, if
e le n l inc me ha e acce ed ca i n, heal h e ice , im ed ani a i n, im ed a e
lie , and n, h man e can be ed ced e en hile inc me e emain .

The al es of economic de elopment
Whe ea he d f ec n mic de el men i a f he cial cience f ec n mic , i cann be
e a a ed f m n ma i e al e ab ha i belie ed be g d f de el men . A n ed ab e,
in 1971 Deni G le ided h ee c e al e f de el men , hich ha e d he e f ime
and f med he c ne ne f he meaning f ec n mic and h man de el men : life enance,
elfe eem and f eed m. On he e h ee ba ic al e , n me he ha e been e im ed:
e alle ia i n, im ed inc me di ib i n, ni e al ed ca i n, im ed acce heal h
ca e, im ed em l men ni ie , men em e men , in i i nal m de ni a i n, and
man m e. All he e e e en mean a d he end f achie ing he g al f life enance, elf-
e eem and f eed m, and a he ame ime he a e al end in hem el e (g al ) beca e f he
c mm nl held belief ha he a e g d hing f all cie ie in he ld achie e.
The meaning f de el men cann be e a a ed f m he e n ma i e al e . The S ainable
De el men G al (SDG ), all f hich e n n ma i e al e ab ha i g d f cie ie ,
a e g al f de el men , and a he ame ime he a e al he a e mea e h de el men
ad ance , b e f he indica ha mea e h m ch g e ha been made a d achie ing
each g al.
H d e ec n mic a a cial cience ec ncile i elf i h he e ence f n me al e f
de el men ? The an e i ha he cien ific a f ec n mic can be ed h ha kind f
licie a e m effec i e, n effec i e in achie ing a a ic la g al; ha licie a e
c n i en i h each he c nflic in he i f ne m e g al ; ha i he lea c l
a achie e me g al; hich membe f a cie a e m likel benefi f m ad ancing
a d a g al; and n.
Thinking points
I de el men an a ia e c nce eflec he idea and al e di c ed ab e, migh
an he c nce , like ge , an f ma i n , me hing el e be m e a ia e?
The e a e e man diffe en c l e a nd he ld, each f hich ha i n e f cial
c m and al e . E amine each f he g al li ed in he S ainable De el men G al and
de e mine he he he e migh be me al e ha ld n be acce ed b me
c l e.
D hink he e a e an ni e al al e f de el men , al e ha a e ha ed b all
cie ie in he ld?
Meas ring economic de elopment
Introd ction to the se of indicators

Ec n mic de el men , being c m le and m l idimen i nal, i n acc a el eflec ed in an ingle
mea e. Ec n mi he ef e c n ide man diffe en indi id al a ib e cha ac e i ic ha
di ing i h c n ie acc ding hei le el f ec n mic h man de el men .
Indi id al a ib e and cha ac e i ic a e mea ed b e f indicators. An indica i a mea able
a iable ha indica e he a e le el f me hing being mea ed. F e am le, GDP per capita i
an indica f he le el f e e n. The n mbe f ea f life e ec anc i an indica fa
la i n a e f heal h. The i n fa la i n ha can ead and i e (li e ac ) i an
indica f he le el f ed ca i n. All he e a e a ib e f ec n mic h man de el men .
The da a c m i ing ec n mic h man de el men indica a e c m iled b a i ical e ice in
e e c n and a e made a ailable in e na i nal gani a i n ch a he W ld Bank and Uni ed
Na i n agencie . Indica a e e emel ef l f :
m ni ing h ac n change (de el ) e ime i h e ec he a ib e mea ed b
he indica
making c m a i n be een c n ie i h e ec he a ib e
a e ing h ell a c n i e f ming i h e ec a ic la g al a ge f
de el men (f e am le, an inc ea e in he li e ac a e indica e an im emen in ed ca i nal
le el)
de i ing a ia e lic mea e deal i h ecific blem .
In addi i n indi id al a ib e and hei indica , ec n mi al e composite indicators, hich
a e a mma mea e f e e al dimen i n g al f de el men . We ill c n ide b h indi id al
and c m i e indica .
Single indicators
The e a e man h nd ed f indica ed a mea e f diffe en cha ac e i ic f an ec n m and
f dimen i n f de el men . We ill c n ide me im an e am le .
GDP per capita and GNI per capita

In Cha e 8, e lea ned ha GDP i an indica f he al e f d ced i hin a c n , and
GNI i an indica f he inc me ( al e f ) ecei ed b he e iden f a c n , all
i hin a ea . Per capita mean ha he e al e a e calc la ed n a e e n ba i .
F m c n ie he diffe ence in he i e f GDP per capita and GNI per capita i n e la ge.
Thi ha en hen infl f inc me in a c n a e ghl balanced b inc me fl .
O he i e, he diffe ence can be ignifican . The fac f d c i n ha mainl acc n f
diffe ence a e lab and ca i al.
When a c n ha man ke f m he c n ie (lab ) h end a f hei age back
h me ( ke emi ance ), f eign c a i n (ca i al) ha end hei fi back h me ( fi
e a ia i n), hi dec ea e GNI ela i e GDP ha d me ic inc me ecei ed n a e age (GNI per
capita) a e l e han he al e f d ced in he c n (GDP e ca i a).
B c n a infl f m ne in a c n f m ke ab ad f m c a i n l ca ed ab ad
inc ea e he i e f GNI ela i e GDP, making d me ic inc me n a e age (GNI per capita) highe
han he al e f d ced in he c n (GDP per capita). I f ll he ef e ha :
GNI per capita i a be e indica f he anda d f li ing f a c n , beca e i e e en

inc me e e n ecei ed b he e iden . GDP e ca i a i a be e indica f he le el f
e e n d ced in a c n .
Table 18.2 ide me e am le f GNI per capita and GDP per capita. The la c l mn, h ing
GNI a a e cen age f GDP, i a c n enien a c m a e he . If he al e f he e cen age i
la ge han 100, GNI > GDP; if i i malle , GNI < GDP.
GNI per capita (US$) GDP per capita (US$) GNI as % of GDP*
High income co ntries
Uni ed Kingd m 40 600 39 954 101.6
Ja an 38 520 38 430 100.2
S i e land 81 130 80 343 101.0
Uni ed S a e 59 160 59 928 98.7
A alia 51 360 53 793 95.5
Canada 42 790 44 871 95.4
I eland 53 370 68 885 77.5
Middle and lo -income co ntries
Phili ine 3660 2989 122.5
Le h 1210 1154 104.9
Paki an 1580 1548 102.1
China 8690 8827 98.4
Banglade h 1470 1516 97.0
Chad 640 662 96.7
C l mbia 5980 6409 93.3
Ind ne ia 3540 3846 92.0
India 1790 1979 90.4
Ka akh an 7970 9030 88.3
R ia 9220 10 749 85.8
* GNI a % f GDP i iden ical GNI per capita a % f GDP per capita
So rce: World Bank, World Development Indicators
Table 18.2: GNI per capita and GDP e ca i a in elec ed c n ie , 2017
T c n ie in he able ha and a e I eland and he Phili ine . I eland GNI i 77.5% f i

GDP per capita beca e i ha man m l ina i nal c a i n , a ell a f eign ke , h end
fi and age inc me back hei h me c n ie . In he ca e f he Phili ine , i GNI e ca i a
i 122.5% f i GDP e ca i a, d e he im an le la ed b ke emi ance .
GDP per capita and GNI per capita in terms of PPPs

In Table 18.2, e c m a ed GDP per capita i h GNI e capita fig e f indi id al c n ie .
H e e , if e an ed c m a e GDP per capita ( GNI per capita) across countries, he
inf ma i n in hi able ld lead mi leading c ncl i n beca e diffe en c n ie ha e diffe en
price levels. Thi ic a di c ed in Cha e 8 he e e a ha ha he ame am n f m ne in
a l - ice c n ha g ea e cha ing e (can b m e hing ) han in a high- ice c n .
Thi blem i e l ed b e f cha ing e a i (PPP) e change a e . PPP elimina e he
effec f ice le el diffe ence , making GDP GNI fig e di ec l c m a able ac c n ie .
Table 18.3, h ing GDP per capita calc la ed b h b e f anda d e change a e (c l mn 1) and
b e f cha ing e a i ie (c l mn 2), e eal an in e e ing a e n: f he e c n ie
a ing a he f he able, GDP fig e ba ed n PPP a e highe han h e ba ed n e change
a e ; f he eal hie c n ie a he b m f he able, GDP fig e ba ed n PPP a e l e han
h e ba ed n e change a e .
1 2
GDP per capita (con erted into US$ GDP per capita (con erted into US$
b se of e change rates) b se of US$ PPP)
B ndi 292 735
Paki an 1548 5539
Phili ine 2989 8360
China 8827 16 842
A gen ina 14 398 20 829
C ech Re blic 20 380 38 020
Ja an 42 583 42 067
Uni ed S a e 59 928 59 928
N a 75 704 62 183
S i e land 80 343 66 307
W ld 10 749 17 100
Table 18.3: GDP per capita ing e change a e and cha ing e a i ie
The ea n i ha ice f g d and e ice n a e age end be l e in c n ie i h l per
capita GDP , and highe in c n ie i h high per capita GDP . C n ide c n ie ha d ce an
iden ical an i f , b ha ha e diffe en ice f hi . When he al e f i
calc la ed in e m f US$ ing e change a e , i a ea l e in he l e ice c n han in he
highe ice c n , e en h gh he an i f i he ame.
Thi i e ac l ha ha en in he eal ld. C l mn 2, ing PPP c n e GDP per capita,
elimina e he im ac n GDP f diffe ing ice le el , and a a e l , he diffe ence in per capita GDP
be een c n ie h ink en m l . C m a ing S i e land i h B ndi, e ee ha S i e land
GDP per capita ba ed n e change a e i 275 ime g ea e han B ndi ; ba ed n cha ing e
a i ie , i i 90 ime g ea e . The ec nd c m a i n i a m ch be e indica f he diffe ence in
d ced in B ndi and S i e land.
In he ca e f he Uni ed S a e , he fig e a e iden ical, ince i i he cha ing e f he US$
i hin he Uni ed S a e ha i ed a he ba i f he PPP c n e i n .
E e hing ha ha been aid he e ab c m a i n f GDP per capita ac c n ie a lie
e all GNI per capita ( an he inc me mea e).
C m a i n f GDP per capita ( GNI per capita) ac c n ie e i e mea e f per capita

inc me ba ed n c n e i n f na i nal c encie in US$ b e f cha ing e
a i ie (PPP ), elimina e he infl ence f ice diffe ence n he al e f inc me.
P cha ing e a i e change a e a e c m ed and bli hed n a eg la ba i b e e al

in e na i nal b die , incl ding he O gani a i n f Ec n mic C - e a i n and De el men (OECD),
he E ean Uni n, he W ld Bank and Uni ed Na i n agencie .
Health indicators
Th ee c mm n heal h indica a e life e ec anc a bi h, infan m ali and ma e nal m ali .
Da a f all h ee, ge he i h GNI e ca i a (US$ PPP), f elec ed c n ie a e ided in Table
18.4. (We a e ing GNI per capita a hi i a be e indica f li ing anda d , and e a e ing
al e in US$ PPP elimina e he infl ence f ice-le el diffe ence ac c n ie .)
Co ntr GNI per capita Life e pectanc Infant mortalit Maternal

US$ PPP 2017 at birth ( ears) rate (per 1000 mortalit ratio
2017 li e births) 2017 (per 100 000 li e
births) 2017
N a 64 760 83 2 5
Uni ed S a e 61 120 79 6 14
Finland 46 880 81 2 3
Uni ed Kingd m 44 090 81 4 9
Ja an 43 540 84 2 5
G eece 28 640 81 4 3
T ke 27 640 76 10 16
R ia 25 120 72 7 25
Chile 23 780 80 6 22
China 16 800 76 8 27
S i Lanka 12 520 75 8 30
A menia 10 060 75 11 25
India 6950 69 32 174
Ang la 6450 62 54 477
M ld a 6100 72 13 23
Zambia 3900 62 42 224
Chad 1920 53 73 856
Uganda 1820 62 35 343
Sie a Le ne 1510 52 82 1360
B ndi 730 58 43 712
W ld 17 043 72 29 216
Table 18.4: Heal h indica in elec ed c n ie in ela i n GNI per capita in US$ PPP
Life expectancy at birth i he a e age n mbe f ea f life in a la i n. I i ne f he m

c mm nl ed indica f de el men . Infant mortality efe he n mbe f infan dea h f m
he ime f bi h n il he age f ne, e 1000 li e bi h . Maternal mortality efe he n mbe f
men h die e ea a a e l f egnanc - ela ed ca e , e 100 000 li e bi h .
Table 18.4 h ha highe le el f GNI per capita (US$ PPP) end be linked i h highe life
e ec ancie , and l e infan and ma e nal m ali ie . Thi i ha e ld e ec , ince highe
inc me c n ie ha e m e e ce ide he nece a e ice and a ia e li ing
c ndi i n f hei la i n . H e e , he e a e e ide de a e f m hi b ad a e n,
gge ing ha income per capita is not the only factor that determines health outcomes in a country.
Am ng m e de el ed c n ie , he Uni ed S a e and f i l e life e ec anc and highe
infan and ma e nal m ali ie c m a ed he m e de el ed c n ie .
Am ng le de el ed c n ie , e find me e i ing heal h c me . B ndi i h a GNI e
ca i a le han half ha f Sie a Le ne ha infan m ali and ma e nal m ali a e ha a e alm
half ha f he la e . M ld a i h GNI e ca i a l e han h e f Ang la and India ha an infan
m ali a e, b e eciall ma e nal m ali a e, fa l e han he he c n ie . The able
ha m e ch e am le .
H i i ible ha me c n ie ha e managed achie e fa be e heal h c me han he
i h imila e en l e inc me per capita? The an e i ha f an gi en le el f inc me per
capita, life e ec anc i higher, and infan m ali and ma e nal m ali a e lower, hen he e a e:
ade a e blic heal h e ice ( ch a imm ni a i n, i i n f heal h inf ma i n and
ed ca i n), and e en i n f c mm nicable di ea e ( ch a mala ia, be c l i , HIV/AIDS)
ade a e heal h ca e e ice i h b ad acce b he en i e la i n
a heal h en i nmen , incl ding afe d inking a e , e e age and ani a i n, and l le el f
ll i n
an ade a e die and a idance f maln ii n
a high le el f ed ca i n f he en i e la i n
ab ence f e i inc me ine ali ie and e .
The ef e, heal h c me de end a l nh ell c n ie achie e he e bjec i e . F e am le:
Heal h c me in he Uni ed S a e ma be d e ine ali ie in inc me and ed ca i n e l ing
in cke f e , c nnec ed h ing and li ing c ndi i n , n i i n and heal h,
and in fficien acce medical ca e (d e lack f medical c e age). S ch fac e l in
e heal h c me am ng l -inc me g , hich l e he a e age e he en i e
Ame ican la i n.
Heal h c me in c n ie like B ndi and M ld a (and man he ) a e d e g e nmen
licie lacing a high i i n blic heal h and he i i n f heal h ca e e ice f l -
inc me g ,a ell a n ed ca i n.
Heal h c me in b-Saha an Af ican c n ie a e d e a e la ge e en he di a
im ac f HIV/AIDS, a ell a blem i h ani a i n, afe d inking a e , lack f ed ca i n
and inf ma i n, blic heal h and heal h ca e e ice , and ema e dea h d e di ea e
ha a e b h e en able and ea able.
The di c i n f heal h indica ill a e ha :

GNI per capita ( an he inc me mea e) i an in fficien indica f heal h
c me .
Limi ed e ce , d e l GNI e ca i a, a e n al a he m im an ca e f
heal h c me . M (if n all) c n ie , b h m e and le de el ed, can d m e i h
hei a ailable e ce mee ec n mic de el men g al . The can eall ca e e ce
ad i i n f m e cial e ice and me i g d , im ing he in i i n h gh
hich he e e ice a e deli e ed, a ell a ed cing e .
S me de el men i e a l n nl de el ing, b de el ed c n ie a ell,
beca e f he e ence f e in eal h cie ie ha make e le n l inc me bjec
imila de i a i n a e le in de el ing ec n mie .
Ed cation indicators
Ed ca i n indica mea e le el f ed ca i nal a ainmen . The e a e man ch indica f hich
h ee a e h n in Table 18.5.
Co ntr GNI per capita Total ad lt Primar school Lo er secondar

US$ PPP 2017 literac rate (% enrolment (% of school enrolment
of people aged 15 children of (% of children of
and abo e) 2015 official school official school
2016 age) 2010 2016 age) 2010 2016
China 16 800 96.4 97
C l mbia 14 120 94.7 94 77
Pe 12 900 94.2 92 86
S i Lanka 12 520 91.9
Ec ad 11 350 94.4 97
A menia 10 060 99.7 100 98
M cc 8050 68.5 89
B li ia 7350 92.5 97
India 6950 71.2 83
Ang la 6450 71.1 76 31
M ld a 6100 99.4
Zambia 3900 63.4 87 49
Chad 1920 22.3 50 13
Uganda 1820 78.4 87 17
Sie a Le ne 1510 48.1 76 36
B ndi 730 85.6 85 11
So rce: GNI per capita US$ PPP World Bank, World Development Indicators
Literacy rates CIA The World Factbook
Primary school enrolment Unicef, Data and Analytics Section, Division of Data Research and Policy
Table 18.5: Ed ca i n indica in ela i n GNI per capita
The ad l li e ac a e mea e he e cen age f e le aged 15 m e in he la i n h can

ead and i e. P ima ch l en lmen mea e he e cen age f ch l-age child en h a e
en lled in ima ch l (elemen a ch l). L e ec nda ch l en lmen mea e he
e cen age f child en en lled in he l e ea f ec nda ch l (high ch l).
Table 18.5 h ha a inc me per capita inc ea e , all h ee indica end inc ea e. H e e , a
in he ca e f heal h indica , he e a e man e ce i n , in l ing c n ie i h ela i el l
inc me ha ha e high le el f ed ca i nal a ainmen , e eciall in ad l li e ac and ima ch l
en lmen .
The e a e main ea n f he e e ce i n . One i ha c n ie f he f me S ie Uni n and
he f me c mm ni c n ie ha e e g d ed ca i n c me beca e hi icall , c mm ni
g e nmen laced a high i i n ed ca i n. Thi e lain he high achie emen f A menia and
M ld a ela i e hei GNI e ca i a. The ec nd ea n i ha me g e nmen ha e made a
ecial eff ide ed ca i n e ice hei la i n . We he ef e ee c n ie like B li ia
and Uganda i h e g d ed ca i n c me c m a ed c n ie i h c m a able highe
inc me per capita. Pe ha m iking a e he ima en lmen a e f Zambia, Uganda and
B ndi, am ng he e c n ie in he ld, a ell a B ndi li e ac a e , achie ed in i e
f e l GNI e ca i a.
The ca e f ec nda en lmen i diffe en . C n ie ha a e ec n micall le de el ed m e
hei ca ce e ce ide ima ed ca i n achie e ni e al li e ac , hich i an im an
ec ndi i n f ec n mic g h and de el men . Sec nda ed ca i n i le fa i i f l -
inc me c n ie . The ef e, i i n i ing ha c n ie i h e g d achie emen in ima
en lmen lag behind in ec nda en lmen .
C n ie can achie e ni e al li e ac and ni e al ima ed ca i n e en if he ha e ela i el

l per capita inc me , ided hei g e nmen all ca e en gh e ce ed ca i n e ice ,
and en e ha all child en ha e acce he e.
Economic ineq alit indicators

Ec n mic ine ali indica e e e en ed in Cha e 12. The incl de L en c e , Gini
c efficien , e line , minim m inc me anda d , and he M l idimen i nal P e Inde .

Rich co ntr lifest le diseases threaten progress in Africa
Life e ec anc in Af ica i l nge han e e bef e. In b-Saha an Af ica i i 66 ea f men
and 62 ea f men, 64 ea n a e age. In he ea 2000, life e ec anc a 53 ea . Thi ha
been acc m anied b a h ge dec ea e in m ali f child en nge han fi e, he e he n mbe f
dea h fell f m 45% in 1950 10% in 2017.
I i e ima ed ha ab ne- hi d f he im emen ha e c me f m inc ea ing e ca i a
inc me , ne- hi d f m im emen in ed ca i n, and ne- hi d f m change ha incl de
echn l gical im emen ch a accine and im ed di ea e c n l me h d . Addi i nal
ea n ma incl de im ed j b ni ie , be e king c ndi i n and afe h ing.
Fig re 18.1: An Af ican bab gi l being eighed n a cale
S ill, Af ica ha fa g each he le el f heal h f m e de el ed c n ie he e life

e ec anc n a e age i 82 f men and 76 f men. The ga be een Af ica and de el ed
c n ie a i e mainl f m he e alence f di ea e ha a e c able e en able b h, ha ing
hei in e ( ee Cha e 19).
A ide f m he e fac , a maj d n he leading ca e f dea h in b-Saha an Af ica f nd
ha inc ea ingl , dea h a e ca ed b life le fac ha a e im ed f m ich c n ie . In ich
c n ie , n n-c mm nicable di ea e incl ding hea a ack and ke a e am ng he maj ca e
f dea h. The e illne e a e ngl linked life le fac ch a alc h l c n m i n,
nheal h die and lack f e e ci e, ha e l in high bl d e e, diabe e and be i .
F e le f age 50 69, he maj ca e f dea h in b-Saha an Af ica c en l a e ke and
hea a ack , hich a e a cia ed i h high bl d e e, diabe e and be i . Thi gge ha
life le fac ma a e de he gain made in life e ec anc e he la decade .
So rce: People are living longer in Africa but the rise of lifestyle diseases threatens progress
Appl ing o r skills
C n ide and di c he ible licie ha g e nmen and in e na i nal aid gani a i n can
ad in de add e he blem ca ed b life le fac affec ing life e ec anc in Af ica.
Social ineq alit indicators

The e a e e man indica f cial ine ali . The li bel e en j a fe e am le f he e:
Ad le cen fe ili ae
P e alence f nde n i hmen
Ine ali in life e ec anc
Ine ali in ed ca i n
Gende ine ali ie
P la i n lne able e
Child maln ii n
Infan lacking imm ni a i n
Child lab
Old-age en i n eci ien
H mele e le d e na al di a e
Bi h egi a i n

Child labo r
G al 8 f he S ainable De el men G al Decen W k and Ec n mic G h and i
a cia ed Ta ge 8.7 a k he in e na i nal c mm ni
‘Take immediate and effective measures to eradicate forced labour, end modern slavery and
human trafficking and secure the prohibition and elimination of the worst forms of child labour,
including recruitment and use of child soldiers, and by 2025 end child labour in all its forms.
A Lake V l a in Ghana, ne in i child en be een he age f 6 and 14 d ha a d k 17 h
a da , facing a a i n and bea ing a ni hmen . Thi e l f m e , ih k ffe ing
m ne he famil and he mi e f lea ning a ade, b e e ae e b de i ing
child en f an ed ca i n and ca ing ch l gical damage.
Fig re 18.2: I ah a, El Sal ad . A en- ea - ld b k a a b ick fac
The In e na i nal Lab O gani a i n f he Uni ed Na i n began m ni ing child lab in 2000.
Since ha ime maj ge a made in ed cing child lab , e l ing in a ed c i n f child
lab b 94 milli n child en in he e i d 2000 2016. H e e he g e ha alled in he la
fe ea . I i e ima ed ha 152 milli n child en, incl ding 64 milli n gi l and 88 milli n b ae
engaged in child lab , i h nea l half f hem, 73 milli n, in l ed in k ha endange hei
heal h, afe m al de el men .
N e ha child lab d e n incl de legal f m f child em l men , hich in l e an addi i nal
66 milli n child en.
Child en aged 5 11 a e he la ge ha e f child lab and al he la ge ha e f dange
k. Man f he e child en a e c m le el de i ed f ed ca i n. H e e , e en hen he child en
d a end ch l, e ea ch indica e ha hei ac i i ie a lab e in e fe e i h hei die and
he e f m l a ch l.
48% 5 11 ea ld 58% b 70.9% ag ic l e 43.0% l inc me c n ie

28% 12 14 ea ld 42% gi l 11.9% ind 38.4% l e middle inc me
24% 15 17 ea ld 17.2% e ice c n ie
17.3% e middle inc me
c n ie
1.3 % high inc me c n ie
Table 18.6: 152 milli n child en in child lab
P licie in he figh again child lab incl de he f ll ing:

P i i n f f ee and c m l ed ca i n a minim m age.
P i i n f cial ec i n em deal i h e (f e am le ca h an fe ,
nem l men ec i n, ld-age en i n , ( ee Cha e 20) in de ed ce de endence n
child en lemen famil inc me.
Lab ma ke licie ackle h nem l men , incl ding ca i nal and echnical
aining, i h an em ha i n ke igh and ec i n f m ha a d k c ndi i n .
So rce: Children in employment ;
BORGEN Magazine
Appl ing o r skills
U ea e c cle diag am e lain h child lab a child en in a life ime f e .
Energ indicators
Ene g indica a e imila l e n me . E am le incl de he f ll ing:
ene able ene g c n m i n
acce elec ici
elec ic e c n m i n.
A j in blica i n f fi e gani a i n , Indicators for Sustainable Development: Guidelines and
Methodologies,10 ha iden ified 30 indica , ed ced f m an iginal e f m e han 130, be ed
facili a e na i nal lic -making and mea emen f e f mance. The e indica a e cla ified
acc ding h ee dimen i n : cial, ec n mic and en i nmen al. F e am le:
Social dimension
Sha e f h eh ld ( la i n) i h elec ici c mme cial ene g , hea il de enden
n n n-c mme cial ene g .
Sha e f h eh ld inc me en n f el and elec ici .
Economic dimension
Ene g e e ca i a.
Rene able ene g ha e in ene g and elec ici .
En ironmental dimension
Ai ll an emi i n f m ene g em .
Ra e f def e a i n a ib ed ene g e.
En ironmental indicators
En i nmen al indica hel ide a de c i i n f de el men affec ing he en i nmen ha can
be ed m ni change and ge a d mee ing en i nmen al bjec i e . S ch indica ae
al e n me , ha ing bec me inc ea ingl la ince he 1990 . S me e am le incl de he
f ll ing:
CO2 emi i n e ni f GDP per capita
Emi i n f he ha a d b ance
Bi d ecie h ea ened
Fi h ecie h ea ened
Mea e f ne la e de le i n
Mea e f a e gene a i n
Mea e f a e ae ea men
Mea e f in en i f ae e

1 a Di ing i h be een ec n mic g h and ec n mic de el men .
b O line he dimen i n f ec n mic de el men .
2 a E lain he diffe ence be een GDP per capita and GNI per capita.
b O line he fac ha acc n f diffe ence be een he mea e.
c E lain h I eland e high GDP per capita gi e a mi leading im e i n f a e age
anda d f li ing in I eland.
d E amine he fig e f R ia in Table 18.2 and de e mine ha migh acc n f he
diffe ence be een i GDP per capita and GNI per capita.
3 O line he meaning f cha ing e a i ie (PPP ) n ing h he a e im an f
making alid c m a i n f GDP GNI ac c n ie .
4 a U ing Table 18.4, e lain me diffe ence in heal h c me be een m e and le
de el ed c n ie .
b P ide e am le f c n ie ha ha e achie ed g d heal h c me ela i e hei le el
f inc me.
c P ide e am le f c n ie ha c ld likel achie e be e c me , e en i h hei
gi en le el f inc me.
d U e a PPC diag am ill ae an e .
5 An e all he a f e i n4 ing Table 18.5, efe ing ed ca i n c me .
6 Iden if e am le f
a ec n mic ine ali indica ,
b cial ine ali indica ,
c ene g indica , and
d en i nmen al indica .
Composite indicators
Being m l i-dimen i nal, ec n mic de el men cann be ade a el mea ed b an ingle
indica . Thi blem led fam ec n mi Mahb b l Ha , a highl infl en ial Paki ani
de el men ec n mi , and Ama a Sen, an Indian ec n mi h n he N bel P i e f hi k
in ec n mic de el men de el composite indicators, hich a e mma mea e f m e
han ne dimen i n f de el men . B incl ding m e han ne dimen i n, c m i e indica ae
m e acc a e mea e f de el men . Thei k a ca ied a he Uni ed Na i n De el men
P g amme (UNDP), hich ince 1990 d ce a H man De el men Re e e ea i h
anal e f a i de el men i e a ell a a i ical inf ma i n, incl ding inf ma i n n he
S ainable De el men G al , indica a ge and c m i e indica . We ill d h ee f he
c m i e indica e a ed b he UNDP: he H man De el men Inde (HDI), he Ine ali -
adj ed H man De el men Inde (IHDI), and he Gende Ine ali Inde (GII).
In addi i n e ill e amine he Ha Plane Inde , in d ced in Cha e 8, hich i e a ed b Ne
Ec n mic F nda i n.
C m i e indica ae all e e ed a an inde a e f n mbe h ing he ela i e
i i n f a a iable in a li . Thi ill bec me clea e in he di c i n bel .
The H man De elopment Inde

The H man De elopment Inde (HDI), he be -kn n and m idel ed inde f he UNDP, i
ba ed n he c nce f human development di c ed ea lie in hi cha e . The HDI mea e a e age
achie emen in h ee dimen i n : a l ng and heal h life, acce kn ledge and a decen anda d f
li ing. A f 2010, he e h ee dimen i n a e mea ed b he f ll ing indica :
a l ng and heal h life i mea ed b life e ec anc a bi h
acce kn ledge i mea ed b mean ea f ch ling and e ec ed ea f ch ling
a decen anda d f li ing i mea ed b GNI per capita (US$ PPP).
Each dimen i n i e e ed a a al e be een 0 and 1, i h 0 being he l e ible al e f he
dimen i n, and 1 being he highe .
The c m i e inde i he a e age e he h ee dimen i n . Each c n ecei e an HDI al e f m
0 1, and he c n ie a e anked acc ding hei HDI al e .
HDI ank and HDI al e f elec ed c n ie , ge he i h hei c e nding GNI per capita (in
US$ PPP), a ea in Table 18.7, he e elec ed c n ie a e li ed in de f declining HDI .
C n ie ha e been elec ed h h i i ible achie e imila le el f h man de el men
i h e diffe en le el f GNI per capita.
Co ntr HDI rank H man Life E pected Mean ears GNI per
2017 De elopment e pectanc ears of of schooling capita US$
Inde 2017 at birth schooling PPP
S ain 25 0.891 83.3 17.9 9.8 34 258
L emb g 26 0.914 82.0 14.0 12.1 65 016
Tajiki an 127 0.650 71.2 11.2 10.4 3317
Namibia 128 0.647 64.9 12.3 6.8 9387
India 129 0.640 68.8 12.3 6.4 6353
M anma 147 0.578 66.7 10.0 4.9 5567
Ne al 148 0.574 70.6 12.2 4.9 2471
So rce: Uni ed Na i n De el men P g amme, H man De el men Re 2018
Table 18.7: H man De el men Inde (GDI) and GNI e ca i a (US$ PPP) f elec ed c n ie
F e am le, M anma and Ne al ha e imila HDI , indica ing ha he ha e a ained a ima el

he ame le el f h man de el men , e Ne al ha acc m li hed hi i h a GNI e ca i al ha i
le han half f M anma GNI e ca i a. The ame can be aid f Tajiki an, Namibia and India.
C m a i n be een HDI and GNI per capita c nfi m he in made ea lie :

GNI ( GDP) per capita ed al ne can be a mea e f he diffe en dimen i n f
de el men .
man c n ie , e en i h hei gi en le el f gni per capita, a e ca able f making ignifican
im emen in he ell-being f hei la i n b making diffe en ch ice ega ding he
e ce all ca ed heal h, ed ca i n and he e ice me i g d .
Ec n mic and h man de el men i e a l n nl de el ing c n ie , b
de el ed c n ie a ell.
The HDI i e ef l a a l f g e nmen i hing de i e licie f c ing n ec n mic and

h man de el men , and it is far superior to single indicators as a measure of development. H e e ,
he HDI, , ha i h c ming . Thi i beca e ec n mic and h man de el men a e m ch b ade
c nce i h m e dimen i n han a e eflec ed in he HDI. The HDI d e n ide ih
inf ma i n ab inc me di ib i n, maln i i n, dem g a hic end , nem l men , gende and
he ine ali ie , li ical a ici a i n, e c.
Ineq alit -adj sted H man De elopment Inde

The Ineq alit -adj sted H man De elopment Inde (IHDI) mea e h man de el men in he
ame h ee dimen i n a he HDI, b each dimen i n i adj ed f inequality in he c e nding
dimen i n. The IHDI a em mea e l e in h man de el men ha a i e f m ine ali . If
he e e e e fec e ali in inc me, heal h and ed ca i n, he IHDI ld be e ac l e al he HDI.
Whe e he e a e ine ali ie , he IHDI i l e han he HDI, and he g ea e he ine ali ie , he l e
he IHDI ela i n he HDI.
In e e ingl , he IHDI i l e han he HDI in he ca e f all c n ie e amined b he Uni ed Na i n
De el men P g amme (UNDP). Table 18.8 h he fi e c n ie h e HDI ha dec ea ed he
lea a ell a he fi e c n ie h e HDI dec ea ed he m n acc n f ine ali ie . The c l mn
h ing O e all l h he e cen age f he HDI ha a l d e he e ence f ine ali ie .
The la c l mn h he Gini c efficien f each f he c n ie . The da a gge a e n . One
i ha he c n ie ha l he lea f hei HDI al e a e c n ie i h a high h man de el men
hile h e ha l he m ha e a ela i el l h man de el men . The he i ha c n ie ha
l he lea ha e a ela i el m e e al di ib i n f inc me a indica ed b hei Gini c efficien .
Thi i ha e ld e ec ince inc me ine ali i ne f he dimen i n f he IHDI. Acc ding
he UNDP, A he gl bal le el, ine ali in inc me c n ib e he m e all ine ali ,
f ll ed b ed ca i n and life e ec anc . 11
Co ntr HDI IHDI O erall loss (%) Gini coefficient

Ja an 0.909 0.876 3.6 32.1
C ech Re blic 0.888 0.840 5.3 25.9
Finland 0.920 0.868 5.6 27.1
Sl enia 0.896 0.846 5.6 25.4
Iceland 0.935 0.878 6.0 25.6
Gambia 0.460 0.289 37.2 35.9
Chad 0.404 0.249 38.3 43.3
Hai i 0.498 0.304 39.0 41.1
Cen al Af ican Re blic 0.367 0.212 42.1 56.2
C m 0.503 0.275 45.3 45.3
W ld 0.728 0.582 20.0 -
So rce: Uni ed Na i n De el men P g amme, H man De el men Re 2018
Table 18.8: Ine ali -adj ed H man De el men Inde (IHDI) in ela i n he H man De el men
Inde (HDI) and Gini c efficien
I ma be n ed ha he IHDI i an im emen e he HDI in ha i incl de he dimen i n f

ine ali . H e e i , , i an inc m le e mea e f he le el f ec n mic de el men f he ame
ea n a he HDI n ed ea lie .
Gender Ineq alit Inde

The Gender Ineq alit Inde (GII) mea e ine ali ie be een he gende in h ee dimen i n
mea ed b he f ll ing indica :
e d c i e heal h i mea ed b
he ma e nal m ali a i (dea h e 100 000 li e bi h ; ee Table 18.4)
he ad le cen bi h a e (bi h e 1000 men age 15 19)
em e men i mea ed b
he ha e f a liamen a ea held b men
he i n f men in he al la i n i h a lea me ec nda ed ca i n
lab ma ke a ici a i n i mea ed b he i n f men in he lab f ce.
The GII mea e he l in h man de el men f men d e ine ali ie in he e a ea . The
highe he GII, he g ea e he gende ine ali . Table 18.9 h al e f he GII acc ding g
f c n ie .
Co ntr gro p Gender Ineq alit Inde

S b-Saha an Af ica 0.569
A ab S a e 0.531
S h A ia 0.515
La in Ame ica and he Ca ibbean 0.386
Ea A ia and he Pacific 0.312
E e and Cen al A ia 0.270
OECD c n ie 0.186
W ld 0.441
So rce: United Nations Development Programme, Human Development Report 2018
Table 18.9: The Gende Ine ali Inde acc ding g f c n ie
Happ Planet Inde

The Happ Planet Inde (HPI) a di c ed in Cha e 8. I i gge ed ha e ead hi ec i n.
A ma ecall, he a chi ec f he HPI a g e ha GDP ( imila l GNI) i n a g d indica f
ell-being. B c n a , he HPI i ed a a mea e f ainable ell-being, ha ake in
c n ide a i n life e ec anc , e le feeling ab hei n e nal ell-being, i h adj men
f ine ali ie and ec l gical f in . The HPI ank c n ie n he ba i f hei e f mance ba ed
n he e indica . Table 18.10 h he HPI ank f elec ed c n ie , and c m a e hem i h GNI
e ca i a a ell a HDI ank .
Co ntr Happ Planet Happ Planet H man GNI per capita

Inde Rank Inde De elopment US$ PPP
Inde Rank
C a Rica 1 44.7 63 14 636
Ind ne ia 16 35.7 115 10 846
Ge man 49 29.8 4 46 136
India 50 29.2 129 6 353
Canada 85 23.0 12 43 433
Mala i 98 22.1 170 1064
Tan ania
A alia 105 21.2 3 43 560
L emb g 139 13.2 26 65 016
So rce: Happy Planet Index
Human Development index and GNI per capita United Nations Development Programme, Human
Development Report 2018
Table 18.10: Ha Plane Inde in ela i n GNI e ca i a and HDI ank f elec ed c n ie
A he able h , c n ie i h high ank n he ba i f he GNI e ca i a HDI ank d n

ank highl n he HPI, in fac he e i li le c e ndence be een he h ee indica h n in he
able. F he m a hi i d e he ec l gical f in f high-inc me c n ie ch a
Ge man , Canada, A alia and L emb g, hich k b an iall l e hei ank in he HPI.
Y ma n e ha Ge man i h a GNI e ca i a ha i m e han e en ime g ea e ha f India,
ha alm he ame HPI ank a India. Thi i al d e Ge man ng ec l gical f in
c m a ed India e g d e f mance in hi e ec .
The Ha Plane Inde ide inf ma i n ha i f a e diffe en na e he UNDP indice , a i
i he nl ne ha adj f n ainable e ce e h gh i incl i n f he ec l gical
f in . Ye i i inc m le e a i d e n acc n f he im an dimen i n f de el men ,
hile he c nce f ell-being and ec l gical f in emain c n e ial.

1 Di ing i h be een ingle and c m i e indica .P ide me e am le f each.
2 a O line he h ee dimen i n f de el men mea ed b he H man De el men Inde
(HDI).
b E lain he ad an age f ing he H man De el men Inde e GDP GNI per capita
a a mea e f ec n mic and h man de el men .
3 a Iden if he meaning f a high HDI ank and HDI al e in e m f he le el f h man
de el men .
b E lain ha i mean if a c n GNI per capita ank i (i) highe han i HDI ank, and
(ii) l e han i HDI ank.
4 a E lain he diffe ence be een he HDI and he IHDI.
b E lain h he IHDI i l e han he HDI f all c n ie .
c E lain he ela i n hi be een he i e f he Gini c efficien a ea ing in Table 18.8 and
he e en f he l f he HDI f he c n ie a ea ing in he able.
5 a O line he dimen i n f he Gende Ine ali Inde (GII) and he indica ed
mea e he e.
b Iden if he meaning f a high GII al e in e m f he e en f gende ine ali .
6 a De c ibe he dimen i n f he Ha Plane Inde .
b E lain he main fac ha acc n f he ela i el l ank f ec n micall m e
de el ed c n ie and ela i el high ank f me ec n micall le de el ed c n ie .
7 U e e am le f indi id al c m i e indica ( ma e he able in he e )
ill a e he f ll ing in :
a GNI per capita i me ime a indica f le el f ec n mic and h man de el men .
b Man c n ie a nd he ld can d m e m e he ell-being f hei la i n
h gh a eall ca i n f e ce , e en in he ab ence f ec n mic g h.
c S me ec n mic de el men i e a l m e de el ed c n ie a ell a le
de el ed c n ie .
d C n ie ma be m e de el ed i h e ec me indica and le de el ed i h
e ec he indica .
Strengths and limitations of meas res of economic de elopment

Indi id al and c m i e indica , ed al ne in c mbina i n i h per capita GNI ( GDP)
a i ic , a e en m l ef l a mea e f diffe en a ec f de el men .
H e e , a ec n mic de el men i a c m le and m l idimen i nal ce , i cann be acc a el
e e en ed b an ne mea e. Each ingle indica , g f indica in a c m i e inde , can
nl ca e ha a a f de el men ha i mea e . The ef e, e cann el n an ne
mea e b ain a c m le e ic e f he le el f de el men f a c n . Ve f en i i nece a
c mbine he e f man indica b ain an e all ic e.
M e e , ince diffe en ingle c m i e indica mea e diffe en a ec f de el men , he
me ime e en c nflic ing e ec i e . F e am le, he H man De el men Inde (HDI)
c nflic in a i h he Ine ali -adj ed H man De el men Inde (IHDI), and b h f he e
c nflic i h he Ha Plane Inde (HPI). The c nflic ing e ec i e e l in diffe en al e and
anking f he c n ie , de ending n hei e f mance in he a ic la dimen i n f de el men
ha he c m i e indica i mea ing.
In addi i n, b h ingle and c m i e indica a e bjec limi a i n a i ing f m he fac ha he
a e ba ed n a i ical inf ma i n, hich e a di inc e f blem :
S me c n ie ha e a limi ed ca aci f c llec i n f a i ical da a.
Da a a e n f ll a ailable in man c n ie .
In me i a i n ( h gh n al a ) he e da a a e mi ing in e na i nal agencie c me
i h e ima e b he e ma n be acc a e.
Ve f en in e na i nal agencie d n ha e acce all he m ecen l a ailable da a i h he
e l ha da a f diffe en ea ma be c m a ed again each he .
Defini i n f a iable and me h d ed b a i ical e ice a f m c n c n ,
de i e eff b in e na i nal gani a i n ( ch a he W ld Bank and Uni ed Na i n agencie )
achie e anda di a i n. Thi mean ha he da a ma n al a be di ec l c m a able f m
c n c n .
The e a i ical blem mean ha he indica cann al a be eci e and h ld be ed a gh
g ide f end e ime diffe ence be een c n ie , a he han a e eci e mea e .
Relationship bet een economic gro th and economic

de elopment
Ec n mic g h can cc ih ec n mic de el men . I a hi e e ience f man c n ie in
he 1950 and 1960 ha e l ed in e hinking and edefining ec n mic de el men . Can ec n mic
de el men cc ih ec n mic g h?
S me ec n mic de el men i ible in he ab ence f a id g h, if a ia e licie a e
f ll ed ide acce ba ic cial e ice f he . The d ci n ibili ie m del e
died in Cha e 1 h h hi can cc . In Fig e 18.3, an ec n m d ce me c mbina i n
f ind ial g d (mea ed n he e ical a i ) and me i g d (mea ed n he h i n al a i ).
The me i g d incl de ed ca i n, heal h ca e e ice , ani a i n, and clean a e lie , made
a ailable e le n l inc me , h ld n he i e ha e acce hem. (F im lici i i
a med ha ac al i a me in n he PPC). An ec n m ha d e n e e ience g h
can ill achie e me ec n mic de el men , b eall ca ing i e ce , c ing back n ind ial
d c i n and inc ea ing me i g d d c i n; hi ld en ail a m emen al ng PPC1 f m in
A a in like B.
Fig re 18.3: Ec n mic g h and ec n mic de el men

O e l ng e i d f ime, he ibili ie f im ing he la i n ell-being b m ing al ng
he ame PPC ill be e ha ed, and f he im emen ill de end n a d PPC hif , ch a
f m PPC1 PPC2 in Fig e 18.3. S ch a d hif , e e en ing ec n mic g h a an inc ea e in
d ci n ibili ie , a e he ef e nece a f ec n mic de el men be main ained. G ing
per capita an la e in highe inc me and an im ed abili ide he g d and
e ice needed b he la i n. H e e , ec n mic g h does not guarantee that economic
development will occur. If an ec n m m e f m in A in C, f e am le, he e i li le if an
inc ea e in me i g d i i n.
In hi cha e e ha e een e e al e am le f c n ie ha ha e g ea e achie emen in ed ca i n
and heal h han he c n ie i h highe le el f eal GNI e ca i a. We ha e al een e am le f
c n ie ha cceeded in eaching a H man De el men (HDI) al e and ank imila h e f
he c n ie i h b an iall highe GNI e ca i a. The e e am le ill a e ha i i ible
achie e me ec n mic de el men b all ca ing e ce ac i i ie ha im e li ing anda d
f he b ade la i n.

1 a E lain h i i ea ie mea e ec n mic g h han ec n mic de el men .
b Iden if me diffic l ie in l ed in mea ing ec n mic de el men .
2 U e he PPC m del
a h h ac n can e e ience g h ih ec n mic de el men ,
b h h i can achie e me ec n mic de el men ih ec n mic g h, and
c e lain h ec n mic de el men e l ng e i d f ime e i e ec n mic g h.

ic in hi cha e . The a e gge i n f in i ie ha can nde ake n n in
g in de e i e he lea ning bjec i e hi cha e .
1 Ch e a S ainable De el men G al ha a e in e e ed in and e ea ch i a ge and
indica . E lain h he a ge a e ela ed he g al, and h he indica can be ed in
de mea e a c n e f mance i h e ec achie ing he a ge and he g al.
2 Selec c n ie f ch ice i h a c m a able le el f GNI e ca i a (US$ PPP). F
each f he e c nd c an in e iga i n f i
a H man De el men Inde (HDI),
b Ine ali -adj ed H man De el men Inde (IGDI),
c Gende Ine ali Inde (GII), and
d Ha Plane Inde .
E amine h he c n ie c m a e i h e ec hei ank in each f he indice . Then
in e iga e he dimen i n f each f he indice f c n ie and c m a e
e l .Y h ld be able a i e a im an c ncl i n ega ding ha dimen i n f each
inde a e e n ible f an diffe ence b e e in he inde ank f c n ie .
F ce f inf ma i n ma e he ce a ea ing in he able f hi cha e , an
m e ecen e i n f he e blica i n .

3 Ab he S ainable De el men G al
4 Cha le P. Kindlebe ge (1965) Economic Development, McG a -Hill.
5 Da id M a e (1977) Twenty-Five Years of Economic Development: 1950–1975, W ld Bank.
6 D. G le (1971) The Cruel Choice: A New Concept on the Theory of Development, A hene m.
7 Ama a Sen (2001) Development as Freedom, O f d Uni e i P e . Em ha i in he iginal.
8 The Uni ed Na i n De el men P g amme (UNDP) i an agenc f he Uni ed Na i n de igned m e

de el men in ec n micall le de el ed c n ie and ed ce e . The UNDP H man De el men
Re a e c m iled ann all and ide a i ical and he inf ma i n n n me i e ela ing
h man de el men in le de el ed c n ie a nd he ld.
9 Uni ed Na i n De el men P g amme, Human Development Report 1997.
10 In e na i nal A mic Agenc , Uni ed Na i n De a men f Ec n mic and S cial Affai , In e na i nal
Ene g Agenc , E a,E ean En i nmen Agenc
11 Uni ed Na i n De el men P g amme, H man De el men Re 2018, 4

C a 19
Ba c c a
c c
BEFORE YOU START
Wha fac d hi e e ce ai g f e ef c i bi g f e ?
Wha fac d hi ee c ie e a i e ?
De e i g c ie face e ba ie ec ic g h a d ec ic de e e .S e f
he e a e d e d e ic fac hi e he a e ed i e a i i h he c ie a d he
i e a i a ec . Wha e e he ca e, i i i a ide if ha he e a e i de be
ide if icie e c e he .
19.1 P ( a )
LEARNING OBJECTIVES

• explain the meaning of poverty cycles, also known as poverty traps (AO2)
• draw a diagram showing a poverty trap where poverty is perpetuated (AO4)
We learned about poverty in Chapter 12. While all countries in the world have poverty, most of extreme
poverty (defined as living on less than $1.90 per day) is concentrated in developing countries. Poverty is
caused by many factors, but one of the causes of poverty in some situations can be poverty itself. When
conditions of poverty feed on themselves and create more poverty, they give rise to the poverty cycle, or
trap.
U a
People who are very poor spend their entire incomes just on essentials (food and other essential items),
and often even this is not enough for survival. The physical capital they have is very low, whether this is
farm tools, roads, water supplies or sanitation systems. Their human capital is very low: they have little
if any education, low levels of skills and poor levels of health. Their natural capital often becomes
depleted as they destroy their natural environment in an effort to survive (depletion of minerals in the
soils, cutting of forests, overfishing of lakes, rivers and oceans, etc.). To come out of their state of
poverty, they need more capital: physical, human and natural. The new capital can only be created by
saving, which would enable them to make the necessary investments to increase their capital, but since
all their income is spent on necessities, there is nothing left over to save; therefore, they cannot make
investments in the capital they need. As a result, they are trapped in a situation where their poverty leads
to more poverty, in a cycle. The poverty cycle is illustrated in Figure 19.1.
F 19.1: The poverty cycle (poverty trap)
A ( a ) arises when low incomes result in low (or zero) savings, permitting
only low (or zero) investments in physical, human and natural capital, and therefore low productivity
of labour and of land. This gives rise to low, if any, growth in income (sometimes growth may be
negative), and hence low incomes once again. A poverty cycle may occur in a family, a community, a
part of an economy, or in an economy as a whole. An important feature of the poverty cycle is that
poverty is transmitted from generation to generation.
H a a a
There are a number of ways that poverty is transmitted across generations:
• People often cannot afford to send their children to school, either because the children work to
supplement the family income, or because the parents cannot afford transport costs to school or the
school fees.
• They cannot afford the necessary medical care for themselves or for their children, and sometimes
cannot provide enough food for the family, leading to malnourished and physically disadvantaged
children.
• They often have large families, whether because they see children as a source of additional income
(if the children work), or as a source of security in old age, or because they do not have access to
family planning services. Large families increase the level of poverty, as the income of the parents
must be stretched to cover the needs of more people.
In all these cases, the children are penalised for life, as they grow into adulthood lacking skills, often
unable to realise their full health potential, and condemned to low productivity and low incomes.

T a a : a a
Evidence indicates that having many children increases poverty. Yet it is also the case that poor
people tend to have more children. The reasons are many and varied: children may be viewed as a
source of unpaid labour (on the farm), income (if the child is sent out to work), old-age security of the
parents (the children, males in particular, are expected to take care of the parents in their old age); in
addition, the children may be viewed as a source of prestige for the parents; or they may result from
lack of access to contraception and family planning services.
F 19.2: Amazon rainforest, Brazil. Amazon riverine family - ibei inho - living near the rivers
with fishing as the main source of living, also cultivating small clearings for their own consumption
There is, therefore, a close and mutually reinforcing relationship between poverty and population
growth: poor people have more children, and more children keep poor families trapped in poverty;
this is known as the demog aphic ap. It is closely related to the poverty cycle or trap.
Experiences of many countries around the world show that there is a clear relationship between birth
rates and economic growth and development: as countries grow and develop, birth rates fall. This
relationship has given rise to the simplistic expression: ‘Development is the best contraception.’ It is
simplistic because it begs the question: what aspects of growth and development lead to lower birth
rates? Is it rising incomes, more education, increased contraception, increased employment
opportunities, or another?
While there are many factors contributing to lower birth rates, the most important ones involve
education and job opportunities for women. These are even more important than higher income per
capita in order to break out of the demographic trap. When girls receive an education that prepares
them for the job market, and when they join the labour force, they are far more likely to have fewer
children. Reasons include later marriage, greater reproductive choice, increased awareness of the
economic benefits of having fewer children (i.e. the ability to provide more per child if there are
fewer children), and reduced need to view children as sources of income and old-age security. Nobel
Prize-winning development economist Amartya Sen notes that in some of the richest districts of India,
where women do not work and tend to receive less education, birth rates are much higher than in
some far poorer districts where women have much higher literacy rates and greater labour force
participation.1
A
1 Outline why the demographic trap is a barrier to growth and development.
2 Explain the role of education and job opportunities for women in breaking out of the
demographic trap.
3 Explain how the demographic trap is related to the poverty cycle (after reading about the poverty
cycle).
Moreover, poor people who are unable to buy or invest in modern agricultural inputs (fertilisers,
irrigation facilities, improved seeds) because their incomes are too low are forced to overuse their land,
thus depleting the soil of essential nutrients, with the result that their children will be forced to work on
soils of poorer quality that have lower yields (lower output per unit of land).
Since poor people cannot make investments because they do not have enough savings, it would help if
they could borrow. However, banks do not usually lend to poor people, who lack the necessary collateral
(see Section 19.3 below). Therefore, the poor remain without access to the credit that could help raise
them out of their poverty, and poverty is carried into the next generation.
B a
Poor people and poor communities trapped in a poverty cycle cannot emerge from this on their own.
They require the intervention of the government, which must undertake investments in human capital
(health services, education, nutrition), physical capital in the form of infrastructure (sanitation, water
supplies, roads, power supplies and irrigation), and natural capital (conservation and regulation of the
environment to preserve environmental quality). Further, the government must take the necessary steps
to ensure that poor people can participate in private sector activities, such as ensuring access to credit so
that the poor can borrow to finance private investments. However, the public investments needed to
break out of the poverty trap depend on the availability of government revenues. What if the country is
so poor and overall savings so low that the government does not have the revenues required to undertake
the necessary investments? Then an entire country is trapped in a poverty cycle. There are several
countries in sub-Saharan Africa that are trapped this way.
When an entire nation is trapped in a poverty cycle, escape is possible if resources are provided through
foreign aid, to be discussed in Chapter 20.

1 a Using a diagram explain the poverty cycle.
b Outline how the poverty cycle is transmitted from generation to generation.
Explain why external intervention is necessary to break out of this cycle.
1 Amartya Sen, (1999) De elopmen a F eedom, Oxford University Press.

19.2 Economic barriers
LEARNING OBJECTIVES
Af e d i g hi ec i ill be able :
defi e all he e a ea i g i orange bold i he e (AO1)
e lai h each f he f ll i g k a a ba ie ec ic g h a d de el e :
(AO2)
i i g ec ic i e ali
li i ed acce i fa c ea da ia e ech l g
l le el fh a ca i al: li i ed acce ed ca i a d heal h ca e
de e de ce i a d ci
li i ed acce i e a i al a ke
i f al ec
ca i al fligh
i deb ed e
ge g a h a d la dl cked c ie
ical cli a e a d e de ic di ea e
e al a e he ig ifica ce f each f he ab e fac a a ba ie ec ic g h a d
de el e (AO3)
Economic inequality
The importance of income inequality

Ec i ha e bee deba i g he ela i hi be ee ec ic g h a d i c e di ib i e
a decade . The ed belie e ha i he ea l ea f g h, high i c e i e ali i
ece a . O e ea gi e a ha g e e e di g alle ia e e a di ei c e
di ib i ( ch a h gh e di g ei g d) ld ake ca ce e ce a a f
i e e i i d ial d c i , h ed ci g g h. A he a g e a ba ed he belief
ha he ich a e e ha he , e li gi ei e e , e h ical ca i al a d he ce
eg h. The ef e, i h a e e al i c e di ib i , a i g ld d , i e e ld
be l e , a d g h ld be ed ced.
T da , ec i a g e ha he i e i he ca e: highl e al di ib i f i c e a e ac all
a ba a dd .N c a c a ,b a
a c d b a ad a d a d d . The ea f
hi e e di c ed a le g h i Cha e 12. I i gge ed ha e ie hi ec i a i i highl
ele a c e ic.
F e a le, he A ia ec ie ha ha e g e a idl , k a he A ia Tige (Mala ia,
Si ga e, S h K ea, Tai a , a d he ) ha e e e al i c e di ib i ha c ie i
La i A e ica a d Af ica, hich ha e bee g i g fa le a idl . The A ia Tige laced a e
g e ha i he de el e f h a ca i al, i h i i e effec he e ali fi c e
di ib i a d e cce f l g h a d de el e c e.
Rising economic inequality
The e f a ce f de el i g c ie i h e ec i c e di ib i a ie idel , a i e
c ie i c e di ib i ha i ed, he ea i he i ha e ed. Acc di g he W ld
Ba k, i c e i e ali i c ea ed i 2008 2013 i 34 f 83 c ie i ed. Thi a d e e
a id i c e g ha g highe i c e g hile i 23 c ie he e 40% e e ie ced a
decli e i i c e.2 I li e i h gl bal e d i e ali ie i eal h a e e i gi de el i g
c ie . See Cha e 12 f a e ie f hi ic.
Limited access to infrastructure
The importance of infrastructure

Infrastructure i a e f h ical ca i al, a d he ef e e l f i e e .I i i a f
he effec i e f c i i g f a ec a d i cl de e g d a d e ice ch a e,
elec ica i , i e e acce , i ed a e lie , a i a i a d e e age, ad , da a d ca al
k f i iga i a d d ai age, ba a , a d ai .
I f a c e la a aj le i ec ie , e e e i g ab 20% f al i e e i
de el i g c ie . The a ailabili fi f a c e, a d b ad acce he e ice i ffe ake
aj c ib i ec ic g h, ec ic de el e a d e alle ia i .
I fa c e ii ac icall e e he e i he ld i l ag e e e ibili .
G e e le i he e l f a l g hi ical ce j ified b i f a c e g ea li ical,
ec ic a d a egic i a ce, c ce ab a ke e if i e e i i a e ha d , a d i e e
i idi g e e ial e ice he e all la i fac . N e ha a e f
i f a c e alif a blic g d a e i g d , i.e. g d i h i i e e e ali ie i
c i .
Barriers to infrastructure development

M de el i g c ie e f l i i f a c e de el e a d i i . F e a le, i
2015, 1 i 4 heal h ca e facili ie did ha e acce ba ic a e e ice . 3 i 10 e le lacked
acce afel a aged d i ki g a e hile 6 i 10 lacked acce afel a aged a i a i
facili ie . 2.4 billi e le did ha e acce ba ic a i a i e ice like ile a d la i e . 13%
f he ld la i had acce elec ici . 3

Global warming has increased global economic inequality
A d bli hed i he P ceedi g f he Na i al Acade f Scie ce f he U i ed S a e ha
f d ha gl bal a i g ha e likel e ace ba ed gl bal ec ic i e ali . I i a g ed ha
he e i a g ea e ha 90% likelih d ha ca a GDP i c ie i l e ha i
ld ha e bee i he ab e ce f gl bal a i g.
T , a, add a a d c b
, a c a b ca a db a a a
c c ...
T d c a c d d a a a a c db a
c a c a , b ca ac c c a c b ca
d d a add a a d b d a b
d c a d a ...
Figure 19.3: Balaka Di ic , Mala i. Gi l ca i g b cke f ae hei a back f a
b eh le. Gl bal a i g i e ec ed c ib e a e ca ci ha a di lace 700
illi e le ld ide b 2030
A he a e i e, i i ible ha e de el ed c ie a e be efi i g f gl bal a i g,

a d he e effec a e e ec ed bec e e ced i he f e.
. . . ca d c c b d c c a c a a,
a a c c c db add a a ,
c a ...
T a b a a d c c a a - a
a c a c c a dd c a a c .F a ,
c c c a N a, a c - a a c
ca , c a c c b . I c a , a c
c a I d a, a c - a a ,
c a .
The d al e ha :
. . . a a c a b b a a ca
a , a c a d c a ac a ca d
c a c a a c ca a a c .
Source: PNAS
1 E lai h c ie i a e cli a e e d face hea ie c e e ce f gl bal
a i g.
2 T ha e e h ld de el ed c ie ake e ibili f ea e c ec he
ble f gl bal a i g?
3 Ide if a c ha ha al ead beg be affec ed b gl bal a i g. Re ea ch he
e ial c e e ce .
The ea f ef a ce ca be a i ed de he f ll i g headi g :
Problems of financing. G e e cha ge e f hei c i f i f a c e e ice
(f e a le, cha ge f c ec i i ed a e a d e e age, a e e, ele h e cha ge ,
e c.). H e e , i de el i g c ie , a a f g e e cial lic i e ded ake
e ice aff dable, he ice cha ged f i f a c e e ice ha e bee ke bel c ,
e l i g i i fficie e e e f he a e e e i e idi g i f a c e.
Inadequate maintenance and poor quality. Lack f e e e ea ha i f a c e facili ie
ae fe l ai ai ed, e l i g i l ali a d eliable e ice .
Limited access by the poor. Lack f e e e al ea c ai i a i fi fa c e
facili ie ha ca be c c ed, ha i a c ie i ha bee ible ide
e ice f he e i e la i . I i ge e all he h e d ffe di i a el f
lack f acce , b h i al a ea a d i ba l .
Misallocation of resources. The i f a c e ided i ei e i a ia e gi e he eed
f he la i a d he c le el f ec ic de el e ; i e e a be ade i
i f a c e facili ie ha e ai de ed beca e he e i e gh de a d f hei e ice
( ch a e , elec ica i , ), hile he e ice ( ch a e ad , be e
ai e a ce a d i e e i e ice ali ) a e eglec ed.
Neglect of the environment. I f a c e ca ha e e ega i e e i e al effec ,
i cl di g he fail e ade a el c l ece a e i i , a ef l c i f ae i
l de ig ed l ai ai ed i iga i facili ie , b ildi g ad a d da i ec l gicall
l e able a ea , a d he .

UN resolution recognises water as a right
O 28 J l 2010, he U i ed Na i Ge e al A e bl a ed a e l i ec g i i g acce
clea a e a d a i a i a a f da e al h a igh . The e l i a e ha he igh afe
a d clea d i ki g a e a d a i a i [i ] a h a igh ha i e e ial f he f ll e j e f
life a d all h a igh . I ge g e e a d i e a i al ga i a i eff
ide afe, clea , acce ible a d aff dable d i ki g a e a d a i a i all.
Figure 19.4: Bi hkek, K g a . Ga he i g d i ki g a e l e able c a i ai f ah

a d bac e ia ca i g he a i i a d he a e -b e ill e e
Lack f acce clea a e a d a i a i i e f he i a ba ie ec ic

de el e a d he achie e e f dece li i g a da d . Acc di g he S ai able
De el e G al , e e da ea l 1000 child e die d e a e a d a i a i - ela ed dia heal
di ea e ha a e e e able. M e ha 40% f he ld la i i affec ed b a e ca ci
a d hi i e ec ed i e. A e e 27% f he la i i de el i g c ie ha acce ba ic
ha d a hi g facili ie (2015 da a).4
Wa e i bei g i c ea i gl c e ed i ac di , hich i iced a d ld. Thi eake he
idea f acce a e a a h a igh . The UN e l i a he ef e elc ed a a hi ic e
i hi ce b e f a e igh .
The S ai able De el e G al (SDG ) a e c i ed achie i g i e al a d e i able
acce afe a d aff dable d i ki g a e b 2030. 5
Source: U d Na
1 E lai diffe e ible a ha acce clea a e ca c ib e ec ic
de el e .
2 D ag ee ha acce ae h ld be c ide ed a a f da e al a d i e al h a
igh ? Wh ?
Limited access to appropriate technology

Ne ech l g c ib e i i g he a f h ical ca i al. While e ech l g
c ib e ec ic g h ( ee Cha e 11), i de el i g c ie i i e eciall i a
c ide he a a f e ech l gie l cal c di i . The e a e a ech l gie
de el ed a d ed i ec icall ad a ced c ie ha a e ell- i ed he c di i f le
de el ed e . T be effec i e, ech l gie be ell- i ed a ic la ec ic, ge g a hical,
ec l gical a d cli a e c di i . Appropriate technology i a ech l g ha a i fie he e
c di i .
Different factor supplies (labour and physical capital)

De el i g c ie a e cha ac e i ed b ela i el la ge a i ie f lab ( ch f hich i
e l ed de e l ed), hile h ical ca i al i ela i el ca ce a d c l ac i e.
M e e , he ca aci f de el i g c ie d ce, e a e a d ai ai ech l gicall
ad a ced e i e i li i ed. I de el ed c ie , lab i ela i el ca ce i ela i e
ab da h ical ca i al, a d he e i a la ge ca aci f d ci g a d ai ai i g ech l gicall
ad a ced achi e a d e i e . The ef e, de el i g a d de el ed c ie ha e diffe e eed
i h e ec he ki d f ca i al g d / ech l gie ha a e be i ed hei c di i .
De el i g c ie eed ca i al g d a d ech l gie ha ake e f hei ab da lab
lie a d ha a e ela i el i le d ce, ai ai a d e a e.
C ide a fa i a le de el ed c he e he e i ide ead al e l e a d
6
e . T adi i all , fa i g ha bee ca ied b e f a i i i e ech l g i l i g he
ade, h e, ha d ickle a d ick l gh. The fa ha he i i d ce a e
ech l g . The e a e ch ice : hea ag ic l al achi e , i cl di g he ac , he e f
l gh lled b a i al . B h he e e ech l gie ld i c ea e he d ci i f lab .
Which e h ld be ad ed?
The ac ech l g i ee e i e, a d e fa le lab c a ed he e i
l gh ech l g . Thi ea a f he ke he fa ill l e hei j b a d hei i c e,
i h al e i c ea i g. Al , i ca be d ced d e icall a d ill ha e be i ed;
hi i l e he e f ca ce f eig e cha ge i h ega i e effec he bala ce f a e .
F he , killed lab ill be eeded e ai i a d a a ha e be i ed.
The l gh ech l g i le e e i e. I e i e a g ea e a i f lab f i e,
e l e he fa ill i c ea e, leadi g le al e l e a d de e l e ,
c ea i g e i c e a d ed ci g al e . I ca be d ced l call , e l i g i i c ea ed
e l e ide he fa a l cal ke begi a fac e he e i e . L call a ailable
kill ill be ed, a d e ke ca be ai ed he j b d ce he e e i e . The e ill
be eed f i a d ca ce f eig e cha ge ill be a ed, i h ega i e effec he bala ce
f a e .
Clea l , he fa h ld ad he l gh ech l g . We ca he ef e ake a di i c i be ee he
f ll i g ki d f ech l g :
Lab - ( ab - ) ech l gie e e lab i ela i ca i al. The e l

i i c ea e i l cal e l e a d he e f l cal kill a d a e ial , i c ea e i i c e
a d e alle ia i , a d a e he e f ca ce f eig e cha ge.
Ca a - (ca a - ) ech l gie e e ca i al i ela i lab . I
de el i g c ie i h la ge lie f lab he di lace ke a d i c ea e
e l e , ed ce i c e a d h e le i e , a d e i e kill le el ha a
be c l a d diffic l ac i e, a ell a he e f f eig e cha ge f i .
M ech l gical ad a ce e d be f he ca i al- i g e, beca e e ea ch a d

ech l gical de el e cc i de el ed c ie ha f c hei i i ie a d eed .
Thi e ei ble f de el i g c ie ha l e i e lab - i g ech l gie a d
ha e li i ed e ce f de el i g ech l gie ell i ed hei ec ic a d h ical
e i e .
Ma de el i g c ie ha e a i e ied c i i a e he d ci ech i e f he
de el ed ld, e l i g i he e f a a c , ch a ac ech l gie i
ag ic l e, a d ca i al-i e i e ech l gie i i d .A g he fail e f g ha d
de el e licie , a aj e a he h f i d iali a i i g de , ca i al- i g
ech l gie i b h i d a d ag ic l e. Thi c ib ed g ea l e l e a d
de e l e a dg h f he i f al ec i a c ie a d he ld ( ee Cha e
20).
Different climate and ecological conditions

Ma f he ech l gie de el ed i ich c ie a e al i a ia e he cli a e , ge g a h
a d ec l gical c di i f a de el i g c ie . Thi i a ic la l ele a he eed f
ag ic l e, cha ac e i ed b diffe e cli a ic c di i , il , di ea e age a d he ag ic
fac .
Difficulties in the development of appropriate technologies

Al h gh e de el i g c ie ha e ig ifica l i c ea ed i e e i e ea ch a d
de el e (R&D) (f e a le, Chi a, I dia, B a il), ech l gical i ai cc i
de el ed c ie . Ma de el i g c ie ha e e fe e ce de e R&D a d e
ech l g de el e . Ma de el ed c ie e d e ha 2% f GDP R&D, f e a le
S ede 3.3%, Ja a 3.2%, De a k a d Ge a 2.9%, Fi la d 2.8%, U i ed S a e 2.7%). B
c a a l e i c ec ie icall e d le ha 0.5%.7 Taki g i acc hei fa
l e ca a GDP , c ie e d e hi g i ab l e e c a ed he
de el ed ld.
A f he ble i ha he i a e ec i de el i g c ie face fe i ce i e e gage i
R&D. I de el ed c ie he i a e ec i e ible f e 50 60% f R&D e e di e ;
h e e , i l -i c e c ie he i a e ec c ib i i e l (f 2% ghl 20%).
Ma de el ed c fi d ce a d i a e f la ge a ke , a d he e ec a i f la ge
fi c ea e e f l i ce i e i aei de c e e, ca e a ke ha e a d ake
ad a age f e i ie . Fi i de el i g c ie , e eciall i he l e i c e e ,
ha e ei he he e ce he a ke R&D ac i i ie .
Low levels of human capital

H a ca i al efe kill , abili ie a d k ledge ac i ed b e le a ell a g d le el f
heal h, all f hich ake he e d c i e. H a ca i al i i a i a cie b i
de el i g c ie i ac i e a ecial ig ifica ce beca e he e a e la ge i f la i i
a c ie ha ha e ela i el l le el f ed ca i al a ai e , a d al l le el f heal h. I
Cha e 18, e a ha de el i g c ie lag behi d i b h ed ca i a d heal h. The e i he ef e
a h ge c e f i c ea i g h a ca i al, hich ca ake a ig ifica diffe e ce d ci i ,
e l e i ie , g h a d de el e ec .
Ed ca i a d heal h, a he c e a f h a ca i al, a e al a g he ke g al f
ec ic a d h a de el e . The a e i cl ded i he S ai able De el e G al a d a e
al f he h ee di e i f he H a De el e I de ( ee Cha e 18).

The value of education
T d c
Ai le, a cie G eek hil he
A d a b a
Ca aig l ga f he U i ed Neg C llege F d i 1972
A d a b
Be ja i F a kli , e f he F di g Fa he f he U i ed S a e
H a c d ,c a
Vic H g , F e ch hil he
Ed ca a c ca c a d
Nel Ma dela, S h Af ica a i-a a heid ac i i
Ed ca b d c d c .C d c b d .H b d ac
C f ci , Chi e e hil he
Ed ca i i a e f l ea agai c le ill . O a e al le el i i he ea h gh
hich a i di id al ca eali e he hi f ll e ial a a h a bei g. O a cie al le el i i he
ea h gh hich a i di id al ca c ib e he g ea e cial g d.
Thinking points
1 C ide each f he ab e a e e . E a i e ha each a e e ea ega di g he
c ib i ed ca i ake
a h a de el e (Cha e 18, Sec i 18.2), a d
b ec ic g h a d ec ic de el e .
2 S e e le i b h ich a d c ie a f ll a ecia e he al e f ed ca i .
H d hi k hi i e h ld be deal i h i a cie ? D e e le ( ch a he
g e e ) ha e he igh i e ed ca i he e le h a a he el e
hei child e be be e ed ca ed?
Barriers to education
SDG 4 a e E e i cl i e a d e i able ali ed ca i a d e lifel g lea i g
i ie f all . The e a e e e al ba ie i cl i e a d e i able ali ed ca i i
de el i g c ie .
Insufficient funding for education. Ma de el i g c ie , e eciall he e e ,d
ha e fficie g e e e e e f d ed ca i . A he e f he SDG he e a a $39
billi ga ide ali ed ca i all child e b 2030.8 Ma de el i g c ie h ld
i c ea e he i fg e e b dge f d e ed ca i . A Table 18.5 h ed,
a c ie ca d fa be e i h ed ca i gi e hei le el f GNI ca a. I addi i ,
e aid f d h ld be di ec ed ed ca i .
Insufficient teachers or untrained teachers. The eae e gh eache a he i a a d
ec da le el , a d h e ha a e a ailable d ha e he ece a ai i g. The e l i ha
a child e d ecei e he ba ic ai i g he eed lea he ba ic kill f eadi g, i i g
a d a i h e ic. F e a le, i al I dia ea l - hi d f hi d g ade child e ca l ea
2-digi b ac i ble , a d half f fif h g ade ill ca d i. 9
Insufficient classrooms and basic facilities. Ma c ie i b-Saha a Af ica d ha e

e gh cla ,a d a f h e ha a e a ailable d ha e i g ae ile . F
e a le i Chad l e i e e ch l ha able a e a d e i f ha ile , hile l
e- hi d f a ailable ile a e f gi l l .10
Lack of teaching materials. Te b k a e f e ld a d , a d h e ha a e a ailable a e
ha ed b e e al child e . I Ca e f e a le, he e a e 11 i a ch l de f
e e eadi g b k, a d 13 ec d g ade de f e e a i h e ic b k. Si ila l all he
eachi g a e ial a e i e h l . 11
Children with disabilities are excluded. I he e c ie i i e i a ed ha 95% f

child e i h di abili ie d a e d ch l hile al faci g di c i i a i .
Gender discrimination. I i e i a ed ha e 130 illi gi l d g ch l acc f
bei g a gi l ( ee al Table 19.4 bel ).
Conflict or risk of conflict. I i e i a ed ha 250 illi child e li e i c ie he e he e
a e c flic , hile 61 illi d g ch l beca e f c flic .
Distance of school from home. I i c f a child ha e alk h ee h a da
ge ch l.
Hunger and malnutrition. Ma illi f child e ae al i hed. Bei g al i hed
e i l affec a child abili lea .
Inability to pay for education. Whe ea i i ci le i a ed ca i i f ee i all
e e he e, e e e f ha i g b b k , e , e a fee he i f al fee ea ha
a fa ilie l cked i e ca aff d e d hei child e ch l.
Barriers to achieving good health

SDG 3 a e E e heal h li e a d e ell-bei g f all a all age . Ba ie i cl de:
Insufficient funding for health care. I i e i a ed ha he e i a fi a ci g ga f $370 billi i
de he each he SDG a ge f g al 3 ed ab e. The fi a ci g ga i e eciall e i i
b-Saha a Af ica hich ake 16% f he ld la i , b ca ie 23% f he ld
di ea e b de , hile acc i g f 1% f gl bal heal h ca e e di g.12
Insufficient access to health care services. A d b he W ld Ba k a d W ld Heal h
O ga i a i ha f d ha a lea half f he ld la i d ha e acce all he
e e ial heal h ca e e ice he eed.
Private payments for health care. The W ld Ba k a d W ld Heal h O ga i a i e i a e ha
800 illi e le e d a lea 10% f hei b dge heal h ca e e ice , hile 100 illi a e
hed i e e e e (li i g le ha $1.90) a da beca e f hi .13 F b-Saha a
Af ica i i e i a ed ha 37% f all e di g heal h ca e i ade - f- cke . Thi ha
di a effec a 11% f he Af ica la i i hed i e a a e l f ha i g
ake he e a e hile a he 37% d e ecei e edical ea e d e he high c .14
Geographical access. Heal h ca e facili ie a e f e i a ed e fa f he e e le li e. L g
di a ce , lack f ad a d a ai ea ha a e le d ha e acce heal h ca e
facili ie . Re ea ch ha f d ha a da d f heal h ca e i e he di a ce i ed ced. F
e a le, i Gha a i a f d ha he he di a ce a heal h ca e facili a hal ed he
ili a i f he e ice d bled.15
I fficie mbe f ai ed medical ac i i e . Thi i a e e el e i ble
beca e e e he e edical ac i i e a e a ailable he a e f e i effec i e. The W ld Heal h
O ga i a i e i a ed f e e Af ica c ie ha edical ac i i e ake c ec
diag e e- hi d h ee-f h f he i e. 16
Insufficient medical facilities and medical supplies. The e a e aj ble f fi a ci g i

de e , aff a d e i edical facili ie e e acce al la i .
Acceptability of modern medical practices. I e e cie ie de edical ac ice
ae acce ed a e le efe adi i al edici e.
Insufficient access to clean water and sanitation. Ade a e acce ali heal h ca e e ice
i e gh e e g d heal h. I i al ece a e e acce clea a e lie a d
a i a i . F e a le, he e a e e ha 340 000 child e e ea h die d e dia h eal
di ea e f afe d i ki g a e a d a i a i ; hi i e i el e e able.17

1 U e PPC diag a a d AD-AS diag a e lai he likel effec f
a g ea e ec ic e ali ,
b he de el e f e i fa c e,
c he e fa ia e ech l g ,a d
d i e e i h a ca i al.
Dependence of production and exports on the primary sector

The primary sector f a ec i he ec ha d ce a c d , hich a e g d
a i i gf he fac f d ci a d ( ee Cha e 1). The i cl de ag ic l al, fi hi g a d f e
d c , a ell a d c f e ac i e i d ie ( il, c al, i e al , e c.). De el i g c ie ,
e eciall he l e i c e e , e d eciali e i he d ci f l a fe g d , hich all
ae i a c di ie . The e fa c a e de e i ed a la ge e e b he g d i
d ce . The ef e, if i eciali e i i a d c ,i e a e likel be d i a ed b
i a d c .

Education and health as fundamental human rights
The e i a ge e al belief a d he ld ha ed ca i a d heal h a e f da e al h a igh .
Acc di g hi ie , e e e h ld be e i led ecei e a ed ca i a d ha e acce
e ice all i g he achie e hei e ial f g d heal h. Thi i ci le i eflec ed i he
U i ed Na i U i e al Decla a i f H a Righ (1948), affi i g he i di id al igh a
a da d f li i g ade a e f he heal h a d ell-bei g f hi elf a d hi fa il , i cl di g f d,
cl hi g, h i g a d edical ca e a ell a a igh ed ca i ha i c l a d f ee, a
lea i he ele e a a d f da e al age . The igh ed ca i a d heal h ha e bee f he
a e ed b he I e a i al C e a Ec ic a d S cial Righ (1966), a d a e g a a eed b
he a i al c i i f a c ie .
Figure 19.5: De al heal h check
A f da e al h a igh , ed ca i a d heal h ca e a e c ciall i a i g edie i he

ce f e a di g h a f eed , he defi i g cha ac e i ic f h a de el e ( ee
Cha e 18, Sec i 18.2). A i di id al h i li e a e a d k ledgeable, ade a el fed, f ee f
e e able di ea e , a d h ha acce clea a e , a i a i a d heal h ca e e ice , ha
ig ifica l i ed i ie fi d e l e , ha e a dece i c e, e ca e e e e
e , a d lead a l g a d heal h , c ea i e life a d e j a dece a da d f li i g, f eed ,
18
dig i , elf-e ee a d he e ec f he . E ide ce acc la ed h gh he ld
e hel i gl h ha ed ca i lead i ed e l e i ie a d highe le el
f i c e. I ed heal h ed ce ill e a d h ical di abili , i c ea e life e ec a c ,
i e ali f life a d ed ce e .
Ba ed al he di c i i Cha e 20, Sec i 20.4, e a i e ec ic a d -ec ic
ea ha j if g e e i e e i i he ii f ed ca i a d heal h ca e. E lai
hich f he e c ide be he i a .
Country Commodities as a % Leading commodity export as a % share of

share of total exports total commodity exports
Commodity Share in commodity
exports %
B li ia 95 a al ga 48
B a a 94 ea l , eci a d 85
e i- eci e
Ce al Af ica 90 f e d c 41
Re blic
Chad 98 il 92
Chile 86 c e 32
C 77 ice 91
C ed I ie 86 c c a 45
Gab 95 il 79
Mala i 84 bacc 60
Mali 92 g ld 71
M g lia 98 c e 49
Nige ia 97 il 78
Se chelle 90 fi he d c 84
S alia 95 li e a i al 70
Ve e ela 92 il 81
Za bia 86 c e 79
Zi bab e 83 bacc 40
Source: UNCTAD S a C d D d c 2016
Table 19.1: E de e de ce i a c di ie
Ma f he c ie i b-Saha a Af ica a d La i A e ica ecei e a lea half hei e ea i g

f i a c di ie . Table 19.1 e e a li f elec ed de el i g c ie ha a e
c a d: he a e highl de e de c di e , a ell a a i gle d c ha
e e e a high e ce age f he al al e f c di e .C ie ch a he e face a
be f i k a d b acle ha k agai g h a d de el e bjec i e , di c ed bel .
Price volatility of primary products

Thi ic a e lai ed i Cha e 3, he e e a ha he ice f i a d c ae e
a (fl c ae e) ha he ice f a fac ed d c beca e he ha e l ice
ela ici ie f de a d a d l ice ela ici ie f l (b h a e all le ha e). We al
e a i ed h i a d c ha e l PED a d PES .
V la ili f i a d c ice ha e i ega i e c e e ce f d ce a d f he
ec a a h le. A d c ice fl c a e, d fa e i c e , al g i h ag ic l al
i e e ,e l e a d age f ag ic l al ke . P d ce a e able la , a he a e
able de e i e he f e fi abili fi e e .
Whe he d c i e ed, fl c a i g ice al a la e i fl c a i g a d able e
ea i g , affec i g he c bala ce f a e a d abili i . I addi i he ice
fl c ai affec he g e e e e e i h ega i e c e e ce i eff la f
g h a d de el e a d de ake ece a i e e i e i g d (heal h ca e, ed ca i
i fa c e).
F he e ea , la ili f i a d c ice ha bee a aj ba ie g ha d
de el e i a de el i g c ie ha a e highl de e de a fe i a d c f hei
e ea i g .
Limited access to international markets

The i abili acce i e a i al a ke efe diffic l ie e c e ed b de el i g c ie i
hei e de el ed c ie .
Tariff barriers
P d c fi e e de el i g c ie face ela i el high a iff ba ie
The e a e i a diffe e ce ega di g a iff le el be ee d c a d d c ca eg ie . I
a ic la , a iff e ai high f d c fi e e de el i g c ie , hich i cl de ag ic l al
d c , e ile a d a a el.19 Ag ic l al d c i a ic la face ch highe a iff ha h ei
a fac i g a d a al e ce .
U e f a iff ba ie di c age he de el me f ma fac i g a d di e ifica i
Whe c ie eciali e i i a d c he a a e ial ed f a fac i g, he
d e ic a ailabili f he a a e ial k i la e a fac i g i d c ba ed he e
a a e ial . I i ch ea ie f a ec d ce ch c la e he i d ce he c c a bea
ha a e he ba ic i f ch c la e. Thi i called ca d ca ,a di l e i gi
a fac i g ha ake e f d e icall d ced i .A be f de el i g c ie
ided a aj b hei g h a d de el e h gh hi e f di e ifica i (f
e a le, Mala ia, Thaila d, I d e ia, Chi a, Chile a d Ma i i ).
H e e , b h de el i g a d de el ed c ie i el a iff a a e ial ( ce ed
i a d c ), a d ch highe a iff ce ed d c . Thi i e ed a ca a . Ta iff
e cala i ake i diffic l f de el i g c ie e a di a fac i g, i ce he g ea e he
deg ee f a fac i g, he e diffic l i i f he d c be e ed de el ed c ie .
Clea l , a iff e cala i k di c age de el i g c ie f di e if i g hei d ci
i a fac i g. Ta iff e cala i cc fe i d c ha a e i a de el i g
c ie , ch a a a el, a i al d c , a i g a d a fac i g. 20
Agricultural trade and rich country subsidies

Ag ic l al b ich c ie i e f he ble a ic i e i i e a i al ade.
Ag ic l e i e f he ec ed ec f de el ed c ie , j ified he g d ha
fa e ea l i c e a d he ef e be a i ed. Ye he e ide ce i dica e ha f he
be efi f ec i a e ac all e j ed b e la ge fa e . Thi 21 ec i ha aj ega i e
c e e ce f a de el i gc i a d c e a df e alle ia i .
M de el ed c ie ha e ef f e f hei fa e , f hich he be
k a e he E ea U i C Ag ic l al P lic (CAP) a d he U i ed S a e fa lic .
B h fa ec i e i l ea i f ice fl a d b idie ( ee Cha e 4).
Negative consequences of developed country farm support in

developing countries
O e a d ab e he ega i e c e e ce f ec i i he d e ic ec (high c e
ice , ec i f i efficie d ce , c a a e f ec i , e c. ee Cha e 4), he e a e
a be f ega i e c e e ce f he gl bal ec a d de el i g c ie :
Global misallocation of resources. Highe ice ecei ed b de el ed c fa e d e
ice , a ell a d ci b idie , e l i a e all ca i f e ce he
d ci f ec ed g d i he de el ed c ie , a d he ef e e ce d ci a d
l e . Whe he e g d a e e ed he a ificiall l e he i e a i al ice f he
g d , aki g i e diffic l f fa e i de el i g c ie c e e. Ve l ice
f ce e fa e i de el i g c ie aba d ed ce c l i a i f he d c.
The ef e ch f he ec ed g d i d ced i he de el ed c ie ( e all ca i f
e ce ) a d li le i de el i g c ie ( de all ca i f e ce ).
Global inefficiency. De el i g c ie ca f e d ce ce ai ag ic l al d c a a fa
l e c ha de el ed c ie , e beca e f ec i , he e i efficie de el ed
c d ce c i e d ce, ca i g gl bal a ke ha e f he e efficie
de el i g c d ce . F e a le, he U i ed S a e i he ld la ge e e f
c , hich ecei e ice a d b idie h billi f d lla a all , e i al ha
a g he highe c fc d c i i he ld.
Lower export earnings for developing countries. De el i g c ie ha e d c
ecei i g ec i i de el ed c ie ffe d e l e e , a ell a l e ice (d e
he ich-c b idie ), a d he ef e ha e l e e ea i g ; hi ca c ib e
bala ce f a e diffic l ie a d i c ea ed deb b de .
Increased poverty among affected farmers. L e a dl ice ecei ed b de el i g
c fa e a d he i abili c e e i h he fa e f de el ed c ie ea l e
i c e, l e i e e ibili ie f fa e , l e e l e i ie f fa
ke a d i c ea ed e . S e di laced fa e a e f ced ig a e he ci ie , he e
he fi d k i he i f al ec hile c ib i g he g h f ba l .
Other non-tariff barriers: the ‘new trade protection

The e i e c ce ha ce ai - a iff ba ie ha e beg i c ea e i ece ea , he
i a f hich i l e ech ical eg la i , a da d a d e i e e , e i g a d ce ifica i ,
labelli g a d ackagi g e i e e ; c a d ad i i a i e ced e ; a d a i a ea e
i cl di g f d afe a d ali a da d . The e a e efe ed a ad a ba i Cha e
14. (See Real ld f c 15.1 i Cha e 15.) Beca e he e ki d f ba ie ha e bee i i g a idl
i ece ea , he a e efe ed a he e ade ec i . N - a iff ba ie c e he e i e
a ge f d c e ed b de el i g c ie . Whe ea he eed f i i afe a d ali
a da d i i e i , he e a e c ce ha e f he e c l a e bei g ed a a hidde
a li i a i ie f i .

1 E lai h ch eciali a i i a c di d ci a de a ha e
ega i e effec de el i g c ie eff g a d de el .
2 E a i e he ible ega i e effec f h -e la ili fc di ice .
3 Ide if e fac ha ake i diffic l f de el i g c ie acce f eig a ke f
hei e .
The informal economy

A a c efe he a f a ec ha i egi e ed a d legall eg la ed; a informal
economy b defi i i lie ide he f al ec , a d efe ec ic ac i i ie ha a e
egi e ed a d legall eg la ed.
I f al ec ie e i e e he e i he ld, b a e ch ei a i de el i g
c ie . I de el ed c ie , he i f al ec i cl de egi e ed k e li gi a
e a i , a ell a c i c i e hich a e illegal. I de el i g c ie , he i f al ec
ffe k ha ca ake all he diffe e ce be ee h ical i al a d a a i f i di id al a d
hei fa il . A he I e a i al Lab O ga i a i (ILO) 22 e e, k i he i f al ec i
de el i g c ie i de ake a id a e f a e b a lab he legi la i a
i de el ed c ie . ILO c i e f c ie all e he ld ag eed ha e le e e
he i f al ec b ch ice, b a a c e e ce f a lack f i ie i he f al
ec a d i he ab e ce f he ea f li elih d. 23
E a le f ac i i ie i he i f al ec i ba a ea i cl de e e hi g f ba be , c bble ,
ca e e , ic cle a d edicab d i e , ga bage c llec a d all h e , ki g i
e a a , h el a d ea h ( a fac i g e e i e he e ke a e aid e l age
a d kl gh de heal h c di i ), i c c i , i d e ic h eh ld k i
ffice a e a hel . I al a ea he e he i f al ec i e e ei a , a
ac i i ie ela e ag ic l e.
Region Share of informal employment in total

employment, % 2016
Af ica 85.8
A ab S a e 68.6
A ia a d Pacific 68.2
A e ica 40.0
E e a d Ce al A ia 25.1
T al 61.2
Source: ILO, W e a d Me i he I f al Ec : A a i ical ic e, 2018
Table 19.2: Si e f he i f al ec gl ball
A aj d b he ILO e i a e ha billi e le aged 15 a d ab e, c e di g 61.2%

f gl bal e l e , k i he i f al ec 24
. Of he e billi e le, 93% a e i iddle-
i c e a d l -i c e de el i g c ie . Table 19.2 h he b eakd b ge g a hical egi .
The le el f i f al e l e i cl el li ked i h a c le el f h a de el e a
ea ed b he H a De el e I de (HDI). C ie i h a high le el f i f al e l e
ha e a l e HDI al e. Thi i beca e he le el f i f al e l e i g ea e i l e i c e
c ie , a d i i al affec ed b le el f ed ca i . I f al e l e dec ea e a he le el f
ed ca i i c ea e . Pe le h ha e c le ed ec da e ia ( i e i ) ed ca i a e le
likel be i he i f al ec c a ed i h ke i h ed ca i i a le el
ed ca i .
I addi i , e le i al a ea a e ea l ice a likel ha e i f al e l e c a ed
e le i ba a ea .
The i f al ec e a ble . Clea l if ke a e egi e ed he g e e l e
a e e e . B i addi i a d e i a l , he e a e e i ble f he ke
he el e a he e i ke ec i . W ke a e l e able e l i a i ;e i e al
da ge a d heal h ha a d i l ih ba ic e ice like a e a i a i a d e e age; acce
c edi f ke ; li i ed ibili ie f ed ca i a d ai i g; cial ec i i cl di g
e i ,a d a e.
G al 8 f he S ai able De el e G al , hich i P e ai ed, i cl i e a d ai able
ec ic g h, f ll a d d ci ee l e a d dece k f all i cl de a a ge a d
i dica i e ded ackle he ble f he i f al ec . Acc di g e f he a h f he
ILO d ed ab e
T a d ac a . F d d , a
a a ac ca c , a a dd c c d ,a d
a d c a d ac acc a c .
The Di ec f ILO De a e f S a i ic add
T cd c a a a ad cc ,
a d c a d , a c a,a a c a a a d c
a a d a ab a d c d . Ha a a d a a
d , c d d SDG d ca a , ca b a a c
a d ac , a c a a a a ab c a ab da a c . 25
Capital flight
Capital flight efe he la ge- cale a fe f i a el - ed fi a cial ca i al (f d ) a he
c . I h ld be di i g i hed f al fi a cial ca i al fl ha cc beca e f he
de i e f e ide di e if hei h ldi g f f eig a e . I ead, i e l f high ce ai
a d i k a cia ed i h h ldi g d e ic a e , a d cc he he e ide b i e e fa
c a e fea f l ha hei eal h i c e li elih d ( e e hei h ical afe i e e e
ca e ) a e bei g h ea e ed i he c f e ide ce. The a be fea f l ab he ec f l f
e h gh c fi ca i , dde i c ea e i a a i , li ical i abili ha a lead
cial a d ec ic il i h ega i e effec ec ic e f a ce, ab a hi g ha a
lead he l f al e f he d e ic c e c , ch a high a e f i fla i , e i bala ce f
a e ble , e i f eig deb ble , a d he ibili f de al a i de ecia i f
he d e ic c e c . I all he e ca e fi a cial ca i al lea e he c i ea ch f afe i e e
i a e i a afe fi a cial, ec ic a d li ical e i e , a d he d e ic c e c i
e cha ged f able c e cie ha a e e ec ed l e hei al e.
Ca i al fligh ca be a aj ble , beca e i i l e a l f fi a cial ca i al ha c ld ha e bee
i e ed d e icall . F he , a i c i f he ale f he d e ic c e c (i de cha e
f eig e cha ge ha lea e he c ), i e e a d ad e e he al e f he c e c ,
f e f ci g g e e de al e all he c e c de ecia e. Whe ca i al fligh i
ed b fea f c e c de al a i , i ha he effec f bec i g a elf-f lfilli g he : fea
f de al a i lead ale f he d e ic c e c , hich ca e he c e c be de al ed
de ecia ed. S e i e , d e he i ac f ca i al fligh , a la ed de al a i i ca ied ea lie
i la ge ha ha he g e e had igi all e i i ed.
Ca i al fligh ha la ed a aj le i e i g he e e al deb ble f a de el i g
c ie , a ic la l d i g he 1980 ( ee he di c i deb bel ). I i l e he e f ca ce
f eig e cha ge, a d i i he ca ci f f eig e cha ge ha had led a c ie b
i c ea i gl . Ca i al fligh he ef e i c ea e he eed f e e al b i g. I ha bee e i a ed ha
i he e i d 1973 1987, he a f ca i al fligh i e e al La i A e ica c ie acc ed f
e ha half he i c ea e i f eig deb e he a e e i d. I A ge i a 61% a d i Me ic 64%
f f eig deb acc la i a d e ca i al fligh . I Ve e ela, ca i al fl e e e e g ea e
ha f eig deb acc la i ; i he d he f d fl i g d e ca i al fligh e e g ea e
ha he f d fl i g i a d d e e l a !26 Ve e ela i e e ie ci g i ila ble i e
ece ea .
Ca i al fligh ha al la ed a aj le i fi a cial c i e . I Me ic , li ical i abili ( li ical
a a i ai a d g e illa ebelli ) a d lack f c fide ce i he ec led a i e ale f
e ( he Me ica c e c ), a h ge d i f eig e cha ge e e e , a i e ca i al fligh , e
de al a i , a d a fall i eal f 7% i 1994 1995. I R ia, i he la e 1990 , l f c fide ce
i he ble ( he R ia c e c ) a d i he g e e abili e a i deb led fea f a ble
de al a i a d a i e fligh f ble i f eig c e cie . I e e a e aid b he
g e e i ble l a cli bed 150%, a d i i e f IMF a d W ld Ba k l a i e ded
he ble, i a de al ed i 1998, a d l ea l half i al e i he c e f a fe h .I
e e al Ea A ia c ie , i he la e 1990 , ca i al fligh la ed a aj le i eci i a i g a c i i
ha h ea e ed gl bal fi a cial abili .
Indebtedness
The begi i g f he deb ble da e back he il h ck f 1973 1974, he he O ga i ai f
he Pe le E i gC ie (OPEC) dde l i c ea ed he ice f il. Al e igh , il-
i i g de el i g c ie e e faced i h la ge i e e di e d e highe il ice a d
bega b c e hei defici . B he ea l 1980 a de el i g c ie had a a ed e
high le el f deb a d e e he e ge f ba k c .
Historical background (Supplementary material)

If ld like ead e ab h he deb ble e e ged a d de el ed, a d i
he 'Digi al c eb k: E a a e ial' ec i .
More recent developments

The diffic l ie ca ed b high le el f deb led e e c edi ca cel deb f highl
i deb ed c ie . The e i i ia i e ill be f he di c ed i Cha e 20.
I 1996, he W ld Ba k a d IMF bega he Hea il I deb ed P C ie (HIPC) I i ia i e,
i e ded ide debt relief e highl i deb ed c ie b ca celli g a i f hei
deb . Si ce he , 30 Af ica c ie ecei ed e $100 billi i deb elief, hich all ed he
ed ce hei deb e ice c (e lai ed i Cha e 11) a d i c ea e e di g cial e ice i h
ig ifica i i e effec : ed c i f e a d h ge , a d i c ea ed e di g i i a
ed ca i a d heal h, i h highl fa able effec heal h i dica ( ed c i f i fa a d child
ali a e , i cide ce f be c l i a d HIV/AIDS).
H e e , he deb i a i f a c ie ha agai de e i a ed. B 2018, e ha e- hi d
f he c ie ha had ecei ed deb elief e e back ea l back a hei e-HIPC deb le el ,
hile l 4 f he 30 c ie e e a l i k.
The e a e e e al fac behi d he e de el e .27
The gl bal fi a cial c i i (GFC) ha bega i 2008 hi a ec ie a d he ld,
e l i g i ec ic d a d ece i . Bef e hi i e, f he c ie i e i
had a b dge l ,b i h he e f he GFC he l ed i defici .
I 2014, he e a a aj d i gl bal c di ice . A all he c ie i e i ae
c di e e , he ffe ed a g ea l fe e e e e l i g i e e la ge defici .
Y a e e be ha b dge defici a e c e ed b b i g, he ef e he i c ea i g defici
led he eed f eb i g.
I e e a e i ec icall de el ed c ie d ed e l le el a ce al ba k
f ll ed e ea ea licie i de add e he ece i ca ed b he GFC. Thi
ade i ea ie f e Af ica c ie b f i e a i al le de .
L le el f a i g a d la ge fi a ci g eed f i f a c e i Af ica c ie led he
b ei de i e i i fa c e jec . Chi a ha bec e a aj le de b-
Saha a Af ica c ie , a ic la l f i f a c e jec ( ad , ail) ha i g e $125
billi l a i he e i d 2000 2017.
P g e a ce ( be di c ed bel ) led a i c ea e i deb .
E cha ge a e de ecia i f ll i g he c di ice dec ea e ca ed he eal al e f deb
i c ea e ( ee Cha e 16).
I a be f c ie i c ea ed b i g led e g e e e di g a he ha
i e e
The e a a i c ea e i b i gf i ae ce (c e cial ba k ) hich le d a a ke
a e ( ha a e highe ha W ld Ba k a d IMF a e f e c ie ), e l i g i highe
deb - e ici g c .
Ri i g deb le el a e c ea i g c ce ha i ec ie deb a be i c ea i g ai able
le el , i h e i ega i e c e e ce f hei g h a d de el e ec . The c f
high le el f deb e e di c ed i Cha e 11 (a HL). The ill be b iefl li ed he e.
Deb e ici g c ea ha he g e e ha fe e e ce f cial e ice ,
i fa c e, e c.
P c edi a i g ea i i i c ea i gl diffic l f g e e b .
I a be ece a i c ea e a e a d c g e e e di g i de ed ce he le el f
deb , hich i c ac i a f he ec .
The e a be i c ea ed i c e i e ali if he g e e i e b d ha a e held b highe
i c e e le.
The e i l e i aei e e d e ce ai .
The e i a ibili f a deb a he e he g e e kee b i g e a back i ld
deb .
The e i l e ec ic g hd e all f he ab e.
Geography and landlocked countries

Ada S i h i he 18 h ce ( ee Cha e 1) b e ed ha ge g a h la a le i he de el e
f a ke , i g ha a a i b ea i le e e i e ha b la d, e hi g ha e ai e
da i i e f h ge ad a ce i ea f la d a .
La dl cked de el i g c ie (LLDC ) a e a ic la l di ad a aged i ce i de acce
f hei e a di ac i i ie he de e d hei eighb i g c ie , i h hich he a
e i e ha e ela i , hich a ha e ad i f a c e, hich a face c flic
a d li ical i abili . E e i he be f ci c a ce he face ad i i a i e ced e a d high
a c , hich a i e a be highe ha he al e f he he i h ell. The e fac
e e hei i eg a i i he gl bal g adi g e . I addi i , a f he e c ie a e e l
de e de a all a ge f i a c di ie ( ee ab e), i c ea i g he a ge f challe ge he
face.
Table 19.3 ide a li f la dl cked de el i g c ie . Ma f he e ha e a l ha e f ld
e , e l GNI ca a a d l H a De el e I de a k a d al e .
I ec g i i f he ecial ble f LLDC , he i e a i al c i ha ad ed he Vie a
P ga e f Ac i f he e i d 2014 202428 i h he g al a i he e c ie i hei eff
achie e he S ai able De el e G al (SDG ).
Africa Asia Europe Latin America

B a a Nige Afgha i a A e ia B li ia
B ki a Fa R a da Bh a A e baija Pa ag a
B di S h S da Ka akh a M ld a
Ce al Af ica Re blic Uga da K g a N h Maced ia
Chad Za bia La
E ai i Zi bab e M g lia
E hi ia Ne al
Le h Tajiki a
Mala i T k e i a
Mali U beki a
Table 19.3: La dl cked de el i g c ie
Tropical climates and endemic diseases

C ie diffe i hei cli a e, hich i a i a fac de e i i g he a e f hei ec ic
ac i i ie . Cli a e diffe e ce a e ke i de e i i g e a d e h d f ag ic l al d ci ,
a i al h ba d a d e e lab d c i i . F e a le, hea a d h idi a ed ce lab
d c i i , hile ical a d b ical cli a e a e k ed ce il ali a d ega i el
affec he heal h f b h h a a d a i al .
While he e a e b i l cli a e diffe e ce f c c , he h le de el ed
c ie ha e e e a e cli a e , hile al all de el i g c ie ha e ical a d b ical
cli a e . Thi i c ide ed be a fac ha ha c ib ed he diffe e de el e a e f
de el ed a d de el i g c ie .
I addi i , ical a d b ical cli a e a e c d ci e ce ai di ea e ch a ala ia a d
a a i ic di ea e (i fec i di ea e ca ed b a a i e ). E d c d a a e h e ha a e e
c l f d i a a ea. F e a le, i Af ica, e c di ea e i cl de e ia, ala ia,
dia h ea a d be c l i all f hich a e f he a c able e e able. I addi i , a aj
heal h i e i Af ica i HIV/AIDS hich i al e e able.
I h ld be e ha i ed ha di ea e i de el i g c ie a e ed i he c e e ce f
e , i cl di g i i , i ade a e acci a i c e age, lack f clea a e lie , li i ed
acce a iai ,i d ai ll i d e i a ia e c ki g f el , li i ed acce
heal h ca e facili ie a d edica i , a d heal h ed ca i .M f he di ea e i l i c e
c ie a e ei he e e able ea able.
1 E lai h each f he f ll i g i a ba ie de el i g c ie eff g a d
de el :
a he i f al ec
b ca i al fligh
c i deb ed e
d he ge g a h f la dl cked c ie
e ical cli a e a d e de ic di ea e .
2 H a De el e Re 2016
3 Ab he S ai able De el e G al
4 E e a ailabili a d ai able a age e f ae a d a iai f all
5 E e a ailabili a d ai able a age e f ae a d a iai f all
6 See B. F. J h a d P. Kilb (1975) A c a a d S c a Ta a : Ec c S a

La -D C , O f d U i e i P e , he e he e idea a e e l ed e f ll .
7 The W ld Ba k, W ld De el e I dica
8 10 Ba ie Ed ca i Tha Child e Li i g i P e Face
9 The Ed ca i C i i : Bei g i Sch lI N he Sa e a Lea i g
12 Cl i g Af ica heal h fi a ci g ga
13 W ld Ba k a d WHO: Half he ld lack acce e e ial heal h e ice , 100 illi ill hed i
e e e e beca e f heal h e e e
14 Cl i g Af ica heal h fi a ci g ga
15 Heal hca e i he Re e De el i g W ld: Wh heal hca e i i acce ible a d a egie ad i i g

c e heal hca e del
16 L ali heal hca e i i c ea i g he b de f ill e a d heal h c gl ball
17 Wa e Fac _ a e _ a i a i _h gie e_Se 2018. df
18 U i ed Na i De el e P ga e, H a D R 1997
19 Ke S a i ic a d T e d i T ade P lic 2018
20 Ke S a i ic a d T e d i T ade P lic 2018
21 I i i i g ha he la ge fa e ge f he be efi f ec i , i ce b idie a e aid

he ba i f he i e f he fa , a ell a he ba i f hi ical d ci , a i d ced e a
e i d f ea .
22 The I e a i al Lab O ga i a i i a age c f he U i ed Na i c ce ed i h gl bal lab i e.
23 .49 W e a d e i he i f al ec : A a i ical ic e
24 W e a d e i he i f al ec : A a i ical ic e
25 M e ha 60 e ce f he ld e l ed la i a ei he i f al ec
26 Ec ic P lic I i e, (1987) Ca a F a d La A ca D b C , Wa hi g , D.C.
27 B ki g I b-Saha a Af ica faci g a he e ic e eig deb c i i ?
28 Vie a P g a e f Ac i f La dl cked De el i g C ie f he Decade 2014 2024

19.3 Political and social barriers
LEARNING OBJECTIVES

define all he erm appearing in orange bold in he e (AO1)
e plain ho each of he follo ing ork a a barrier o economic gro h and de elopmen
(AO2)
eak in i ional frame ork
legal em
ineffec i e a a ion em
banking em
proper righ
gender ineq ali
lack of good go ernance and corr p ion
neq al poli ical po er and a
e al a e he ignificance of each of he abo e fac or a a barrier o economic gro h and
de elopmen (AO3)
Weak institutional framework

The World Bank define in i ion a he r le , organi a ion and ocial norm ha facili a e co-
ordina ion of h man ac ion .29 There are man economic, legal and ocial in i ion ha infl ence
economic gro h. In man economicall le de eloped co n rie , here i a need o de elop in i ion
rela ing o proper righ (la and reg la ion ha define righ o o ner hip, e and ran fer of
proper ); a ell-f nc ioning legal em ha pro ide effec i e enforcemen of la , con rac and
mechani m for e ling conflic ; an efficien , fair and ran paren a em; banking and credi
in i ion ha pro ide effec i e link be een a er and in e or , and broad acce b he pop la ion
(incl ding he poor) o credi ; in i ion ha pro ec again corr p ion; and more. Man de eloping
co n rie are making grea effor o b ild in i ion ince a marke em canno f nc ion ell
i ho ell-de eloped in i ion ch a he e.
Legal framework and access to justice

A ell-f nc ioning legal em i er impor an o gro h and de elopmen . Thi incl de eq al
acce o j ice for all, incl ding lnerable gro p . According o he Uni ed Na ion Declara ion of he
High-le el Mee ing on he R le of La , member a e ha e commi ed hem el e o ake all nece ar
ep o pro ide fair, ran paren , effec i e, non-di crimina or and acco n able er ice ha promo e
acce o j ice for all .30 Acce o j ice i nece ar o elimina e po er , a po er i of en he
re l of di empo ermen , e cl ion and di crimina ion.
In order o ha e eq al acce o j ice for all, i i nece ar o ha e he appropria e in i ion in place
ha pro ide a legal frame ork for he proper f nc ioning of he econom , incl ding effec i e a
collec ion em and pro ec ion of proper righ ( ee belo ) a ell effec i e abili o re ol e
di p e .
Ineffective taxation structures

Go ernmen need re en e o be able o make in e men in h man capi al, pro ide infra r c re, and
nder ake ac i i ie req ired for gro h and de elopmen (and o her) p rpo e . Go ernmen re en e
generall ari e from a a ion. Ye de eloping co n rie of en ha e inadeq a e a a ion in i ion and
a r c re , re l ing in lo le el of re en e , of en i h nega i e impac on eq i and re o rce
alloca ion.
De eloping co n r a em picall di pla he follo ing fea re :
high dependence on indirec a a ion ( ee Sec ion 12.5, Chap er 12)
inefficien and highl b rea cra ic a em
eak a collec ion em , of en marked b a ignifican le el of corr p ion
concen ra ion of poli ical and economic po er in eal h gro p , enabling hem o infl ence
go ernmen a polic o a o minimi e heir
a b rden.
We ill no e amine he impac of he e charac eri ic on:
le el of re en e
eq i
re o rce alloca ion.
Low levels of revenues

In erna ional compara i e die ho ha he lo er he GDP a a of a co n r , he lo er he a
re en e a a hare of GDP; he higher he le el of GDP a a, he higher he a re en e a a
hare of GDP. While i i r e ha poor co n rie do no ha e he capaci o genera e a m ch a
re en e a a hare of GDP a rich co n rie (d e o lo le el of income for b an ial por ion of he
pop la ion, hich mean ha mo of income m go o a i f con mp ion need ), here are al o
indica ion ha a a a a a :
corr p ion in a collec ion, in ol ing pa ing a collec or bribe o lo er he amo n of a paid
inefficiencie in a collec ion, in ol ing complica ed b rea cra ic proced re and comple a
legi la ion, ha re l in a e of re o rce and al o crea e ignifican oppor ni ie for a e a ion
(a oidance of a pa men )
a e emp ion and pri ilege of eal h people and large firm , made po ible b heir economic
and poli ical po er and infl ence on go ernmen polic , or b go ernmen effor o promo e
par ic lar pri a e ec or ac i i ie ,31 hich are of en e ploi ed o he e reme i h he re l ha
here are ignifican lo e of a re en e
lo proper a ra e ; proper a e co ld be a ignifican o rce of a re en e in man
co n rie , ho e er proper a ra e end o be m ch lo er in de eloping co n rie compared o
de eloped one . Proper a e q i e ob io l a he rela i el eal hier gro p , ho are he
o ner of proper . The problem i par ic larl ac e in co n rie here he di rib ion of land
o ner hip i highl neq al (for e ample in La in America), here beca e of he poli ical and
economic po er of eal h lando ner , go ernmen he i a e o increa e a ra e or o enforce
pa men of a e
he poli ical and economic po er of eli e infl ence go ernmen a policie generall (no onl in
connec ion i h proper a e ), in order o minimi e heir a b rden; eal h , eli e gro p can
afford o p rcha e pri a el man meri good (heal h er ice , ed ca ion, e c.) and all alread
ha e acce o he limi ed le el of infra r c re made a ailable b he go ernmen , a he e
gro p are he fir o benefi from he pro i ion of p blicl pro ided er ice (clean a er pplie ,
e erage em , comm nica ion , e c). Therefore he end o be far le concerned abo
pa men of a e for he p rpo e of enabling he go ernmen o nder ake in e men in er ice
ha ill benefi he poor. Since higher income gro p ha e a far grea er abili o pa a e han
lo er income gro p , a lo a b rden on he rich ran la e in o er ignifican lo e of a
re en e .
Lo er le el of a re en e mean ha he go ernmen ha fe er re en e i h hich i can nder ake
nece ar in e men in e en ial er ice (ed ca ion, heal h care, a er pplie , ani a ion, irriga ion,
road em , e c.).
Inequities in tax s stems

Ta a ion em in le de eloped co n rie are of en ineq i able; rea on incl de he follo ing:
The are no par ic larl progre i e, and ma e en be regre i e (lo er income people pa a
higher propor ion of income in a e han higher income people); rea on for he lack of
progre i i are ha
de eloping co n r a em picall rel far more on indirec ra her han direc a e ,
incl ding ariff a compared i h more de eloped co n rie , beca e he e kind of a e are
m ch ea ier o collec
o he e en ha a em rel on direc a e , he e are no al a er progre i e.
The fac or no ed earlier, incl ding a e a ion, a conce ion and pri ilege for higher income
gro p , and lo proper a e , mean ha er high income gro p end p pa ing far le o erall
a e in rela ion o heir income han medi m and lo er income gro p , hereb making he a
em e en more regre i e.
Ineq i ie in he a em accen a e income ineq ali ie : here i limi ed redi rib ion from higher
income o lo er income gro p .
Negative impacts on resource allocation

All a em ha e impac on re o rce alloca ion b changing rela i e price and incen i e r c re .
A ell-de igned a em rie o be a ne ral a po ible i h re pec o i impac on re o rce
alloca ion. I , a a a a a a a a
a,a , a a . Some e ample of
poorl de igned a policie i h di or ing effec incl de he follo ing:
man firm or ec or benefi from a arie of a ad an age , ch a lo er a ra e , hich deri e
from go ernmen in ere in promo ing par ic lar ec or , or beca e poli ician fa or allie and
ppor er ; a e en erpri e of en pa li le or no a a all
medi m- i ed firm end o be penali ed b ha ing o ho lder a higher a b rden; hi occ r
beca e large firm can more ea il e ade a e hro gh loophole and a ad an age
a ad an age enjo ed b older firm ha are ell connec ed i h poli ician ac a a di incen i e
for ne firm r ing o en er a marke and ar p a ne b ine
impor of capi al good are of en e emp ed from impor ariff ; hi prod ce an ar ificiall lo er
price for capi al good and promo e he e of capi al-in en i e echnologie .
The e fac or con rib e o crea ing pa ern of re o rce alloca ion ha are no in ocie be in ere .
When re o rce are mi alloca ed (or poorl alloca ed), he ha /ho m ch o prod ce and he ho o
prod ce q e ion of economic are no being an ered in he be po ible a ; ocie ie are or e off
beca e he rong combina ion of good and er ice end p being prod ced, and he rong
combina ion of re o rce are ed for prod c ion ( ch a e of capi al in en i e echnologie ).
Banking
Banking er ice and acce o credi are er impor an o economic gro h and de elopmen . The
pro ide he link be een a er and in e or , making f nd a ed b a er a ailable o borro er ho
i h o make in e men . If f nd of a er co ld no be borro ed b in e or , people o ld ha e o
rel on indi id al a ing for in e men , and he e o ld hardl be eno gh o finance he needed le el
of ne capi al forma ion.
Importance of banking for growth and development
Banking and credi in i ion con rib e o gro h and de elopmen in he follo ing a :
The pro ide an incen i e for people o a e, beca e he offer a re rn (in he form of in ere ) on
a ing . The grea er he a ing in an econom , he grea er are he f nd a ailable o be in e ed.
The pro ide b ine e and farmer i h credi o open, r n and e pand heir b ine e and
farm . Increa ed borro ing permi grea er in e men , re l ing in increa ed o p and herefore
gro h.
The pro ide con mer i h credi ha can be ed for in e men in h man capi al (ed ca ion
for heir children a ell a e en ial medical care), increa ing he prod c i i of labo r and
con rib ing o gro h and de elopmen .
Acce o credi i er impor an for po er alle ia ion beca e poor people are lea able o a e
an par of heir income, ince he are forced o pend mo of i on e en ial ( ch a in he
po er c cle). Making credi a ailable o er lo -income earner can herefore allo hem o
make nece ar in e men in ph ical, h man and na ral capi al. I can al o con rib e o
impro ing he di rib ion of income a he in e men ha credi make po ible increa e he
income of he poor and allo hem o par icipa e in economic gro h.
Ye he commercial banking em in de eloping co n rie i no ell de eloped. The o al amo n of
f nd in bank depo i on a erage i abo 15% of na ional income, compared o 30% or more in
de eloped co n rie . The n mber of bank and heir branche in rela ion o he pop la ion in de eloping
co n rie i far maller han in de eloped one , o ha b ine e and con mer ma no ha e ea
acce o banking er ice .
Al o, here i a high degree of p blic ec or o ner hip of commercial bank (in con ra o mo l
pri a e ec or o ner hip in more de eloped co n rie ). High p blic ec or o ner hip ha hi oricall
been j ified on he gro nd ha hi allo go ernmen o g ide bank lending and re o rce alloca ion
o highl prod c i e in e men . Ho e er, he e idence gge ha p blic o ner hip of bank lead
o lo er le el of efficienc , le borro ing and a ing, highl b rea cra ic proced re ha di co rage
pri a e in e men hro gh borro ing, le compe i ion and lo er prod c i i .
Exclusion of the poor from access to credit

Commercial bank in de eloping co n rie of en ca er o larger, eal hier borro er , b pa ing he
medi m- i ed and e peciall maller borro er . Man commercial bank are o er ea branche of large
m l ina ional bank ha are more in ere ed in pro iding loan o m l ina ional corpora ion or large
dome ic firm . E en dome ic bank , of en nder go ernmen direc ion, prefer borro er in
man fac ring ho are con idered o be more credi or h and ho are belie ed o be he dri ing force
of ind riali a ion. Some ime , bank lending i infl enced b poli ical in ere and he po er of local
eli e i h large con rol o er he b ine and financial ec or . F r hermore, commercial bank are
in ere ed in large loan ha are afe, ec red i h colla eral or ome form of eal h. Poor and mall-
cale prod cer , farmer and rader need er mall loan , and er of en lack colla eral o ec re heir
loan . Therefore, lack of eal h picall mean lack of acce o credi .
The re l i ha he o er helming majori of people in de eloping co n rie are forced o rel on
informal (illegal) o rce of credi con i ing of mone lender , al o kno n a loan hark , ho charge
er high in ere ra e ; pa nbroker ho lend amo n far maller han he al e of he ar icle ha ha
been pa ned; and friend and famil , from hom he ppl of loanable f nd i irreg lar or
in fficien . I i e ima ed ha almo hree billion poor people do no ha e acce o ba ic financial
er ice ha are e en ial o managing heir li e .32
Lack of acce o credi b he poor and b mall- and medi m- i ed farm and en erpri e i herefore a
major de erren o gro h and broad-ba ed de elopmen .
Propert rights and land rights33

Propert rights
Propert rights refer o he la and reg la ion ha define righ o o ner hip, e and ran fer of
proper . A marke econom need ec re proper righ o elimina e ncer ain and ri k a ocia ed
i h nder aking in e men rela ing o he proper . I i ri k o b ild a fac or , or make
impro emen on a farm, if he e are loca ed on a piece of land ho e o ner hip ha no been legall
ec red. I ha been ob er ed in die co ering a broad range of co n rie ha he more ec re he
proper righ , he fa er he economic gro h. Sec re proper righ in ol e , hereb he
o ner of a proper recei ed a , hich i legal e idence of o ner hip.
Investment and access to credit

An impor an impac of ec re proper righ i on in e men , hich i ri kier and herefore le likel
o be nder aken hen proper righ are no ec re. For e ample, in a n mber of ea ern E ropean
ran i ion economie (i.e. making a ran i ion from cen ral planning nder comm ni m o a marke
orien a ion), en reprene r ho had ec red heir proper righ rein e ed 14 40% more of heir profi
in heir b ine e han ho e ho had no .34
When proper righ ha e been legall ec red, here i impro ed acce o credi beca e he borro er
can pro e o ner hip of a proper ha can be ed a colla eral (or eal h). In he ab ence of a legal i le
o he proper , he lender ( ch a a commercial bank) con ider he loan ri kier, beca e of he
ncer ain o ner hip of proper ed a colla eral, and ill be le likel o offer he loan. The le
ec re he proper righ , he lo er he acce o credi , he or e he erm (i.e. he higher he ra e of
in ere ), and o he fe er he in e men financed b credi .
Land rights
Land rights refer o he righ and r le o po e , occ p and e land. Land righ are no nece aril
he ame a proper righ ba ed on i ling. In de eloping co n rie , land righ are of en reg la ed b
or b a , hich do no in ol e i le . The erm a here refer o na ral
re o rce incl ding he land i elf, ree , mineral , pa re, a er. Land i an e remel impor an
re o rce and probabl he mo impor an a e (or form of eal h) for he poor. I i al o he ba i of
m ch of economic ac i i a i pla a role in agric l ral prod c ion, pro ide ork for mo of he
r ral pop la ion, enable people o ge credi , and i a o rce of li elihood for he billion of he r ral
pop la ion of de eloping co n rie .
Ye onl 30% of he orld pop la ion ha legall regi ered righ o heir land and home.35 A he
ame ime, more han 2.5 billion people depend on comm ni land for heir r i al. The e land ,
co ering more han 50% of he orld rface, are held, ed or managed collec i el . In Africa, 90%
of r ral land ha e no doc men a ion. 36
In he 1990 , Hernando de So o, a Per ian economi , arg ed ha eak or non-e i en proper righ
ere re pon ible for he fail re of de eloping co n rie o gro . He herefore recommended he
e abli hmen of proper righ incl ding land regi ra ion and i ling a a ke ra eg for economic
de elopmen . Rea on h ec re proper righ o ld lead o gro h incl ded ec ri for
in e men , be er acce o credi , de elopmen of efficien marke for b ing and elling proper ,
increa e in a re en e and increa ed foreign in e men .
Thi hinking a in line i h he marke -ba ed ppl - ide policie ha ere being ad oca ed a he
ime, foc ing on he de elopmen of marke ( ee Chap er 13). The World Bank oge her i h aid
organi a ion embarked on he proce of land i ling in man co n rie , of en aimed a pri a i ing land
o ner hip and de eloping marke for land. Ye b eq en e perience ho ed ha herea he e idea
ma appl o rban and o her proper ie , here are erio do b o er heir applicabili o land,
par ic larl agric l ral land in de eloping co n rie .
Propert rights as a western concept with limited applicabilit to

land in developing countries
In 2005, a pecial commi ion par l chaired b Hernando de So o in e iga ed he re l of i ling. I
concl ion , p bli hed in 2008, no ed ha he benefi of i ling cheme had been e aggera ed and ha
i ma be inappropria e o impl ran plan he e ern concep of proper righ in o he legal em
of de eloping co n rie .37
Some rea on h land i ling did no ork a e pec ed are he follo ing:
Ti le ere of en cap red b eli e ho co ld pa higher price .
Once i le are e abli hed a e ma be impo ed; if he poor canno pa hem he are forced o ell
heir proper or land.
If he poor borro ing he land a colla eral and are nable o pa he loan for e ample d e o a
poor har e he ill lo e he land o he lender.
An emporar economic hard hip ch a a poor har e or a drop in commodi price ma force
he poor he ell he land.
Ti ling increa e he marke al e of land making i le affordable o he poor.
In all he e ca e he poor find hem el e landle . Ti ling cheme herefore of en led o increa ed
ineq ali ie . In ead of increa ed ec ri for he r ral poor he of en led o le ec ri and
impo eri hmen .
The commi ion recogni ed ha he a majori of he orld poor li e in he informal econom , h
no benefi ing from a legal order. Moreo er, i ling programme neglec ed form of en re ba ed on
c om and collec i e righ hich co ld be highl legi ima e and effec i e in g aran eeing ec ri of
38
en re . Therefore
T a , a b a a a b
.T a ,a a a ,a a a a
a a a , , , a
a . . . 39
The e righ go far be ond he imple proper righ of i ling and ill be con idered in Chap er 20.
The problem of land grabs

For ear inadeq a e or in ec re land righ led o he problem of a ab in man de eloping
co n rie , e peciall in b-Saharan Africa, in ol ing he b ing or lea ing of large piece of land b
indi id al , large companie or m l ina ional corpora ion . Thi proce in en ified in 2008 2009 hen
high food price ola ili enco raged he de elopmen of large- cale agric l re and land acq i i ion for
hi p rpo e, and con in e o hi da . The land ha i aken o er from a legal poin of ie i ei her
p blic or a e land or land ha i ed b c om or comm nall .
The re l of ch prac ice i he ri k of e ic ion and di placemen of million of poor farmer . In
addi ion, i con rib e o decrea ed food ec ri a large farm of en prod ce commodi ie for e por ,
ra her han food prod c prod ced b mall farmer .
The World Bank ( ee Chap er 20) ha con rib ed o hi proce b enco raging he pri a i a ion and
akeo er of land b large agrib ine firm ha con in e o di po e mall farmer and ndermine
food ec ri .40

1 Iden if he ke in i ional eakne e of man de eloping co n rie ha ere di c ed in
hi ec ion and e amine heir implica ion for he abili of he e co n rie o gro and de elop.
2 Selec a de eloping co n r of o r choice. E amine he e en o hich hi co n r i affec ed
o iden ified in q e ion 1.
Gender inequalit
The problem of gender inequalities

Man de elopmen co n rie face erio gender ineq ali ie , or ineq ali ie be een omen and men,
and girl and bo . The e rela e o con rol of re o rce and acce o oppor ni ie , and are he re l of
di crimina ion again girl and omen, i h profo nd con eq ence for gro h and de elopmen .
Gender ineq ali ie re l in erio depri a ion and limi ed acce of omen and girl o ocial,
economic and poli ical oppor ni ie compared i h men and bo . Elimina ing he depri a ion and
crea ing condi ion of eq ali of oppor ni ie i called . The empo ermen of omen i
er impor an in economic de elopmen , beca e no onl doe i impro e he ell-being of girl and
omen affec ed, b i al o gi e ri e o major e ernal benefi ha pill o er in o o her area
infl encing gro h and de elopmen .
Gender inequalities in health and education

In ed ca ion, girl do no al a ha e he ame oppor ni ie a bo , par ic larl in lo -income
familie here re o rce are in fficien o ed ca e all children eq all . Moreo er, c l ral fac or
f r her dic a e ha a girl ed ca ion i no a impor an a a bo , ince girl are of en no in ended o
eek ork in he labo r marke on reaching ad l hood. In ome ocie ie , ed ca ed girl are le
marriageable.
Table 19.4 pro ide da a on hree indica or ho ing gender ineq ali ie in ed ca ion: ad l li erac ,
mean ear of chooling (for people aged 25 ear and older), and e pec ed ear of chooling (for a
child of chool-en rance age). The co n rie are li ed in order of decrea ing GNI a a (US$ PPP)
( ho n in he la col mn). Wi h he e cep ion of Colombia, in all he co n rie ho n, ad l female
li erac i lo er han ad l male li erac . The da a on mean ear of chooling indica e ha in mo
co n rie girl recei e fe er ear of chooling han bo . Colombia i an e cep ion here oo, a ell a
Armenia here he mean ear are he ame for girl and bo .
In ere ingl , he da a on e pec ed ear of chooling pre en a differen pic re for he co n rie in he
pper half of he able, here e pec ed ear of chooling i grea er for girl han for bo . Thi gge
ha o er ime, he gender di pari ie in li erac in he e co n rie ill dimini h: he girl ho are in
chool oda ill become par of he li era e pop la ion in he f re. Ho e er, hi applie o co n rie
i h a rela i el higher GNI per capi a, gge ing ha in co n rie i h lo er income gender eq ali in
ed ca ion ill no be reali ed in he fore eeable f re.
Gender inequalities in the labour market

Lo er le el of ed ca ion and kill place omen a a grea di ad an age rela i e o men, a he do no
ha e q alifica ion o ake on job req iring kill . E en if a oman ha he ame le el of kill a a
man, di crimina ion pre en her from ec ring a high-le el job. Women in lo income co n rie are
more likel o ork in he informal econom , hich mean ha apar from recei ing lo er income ,
he canno recei e he benefi offered o orker in he formal ec or (job ec ri , legal pro ec ion of
orker righ , pen ion , e c.) and are bjec o he e ploi a ion ha of en accompanie ork in an
nreg la ed labo r marke . F r her, omen are far more likel han men o ha e npaid re pon ibili ie
(child-rearing, ho ehold chore , and b i ence farming, i.e. c l i a ing food for he famil , no for
ale in he marke , hich i all performed b omen).
Countr Female Male Mean Mean Expected Expected GNI e

adult adult ears of ears of ears of ears of ca i a
literac literac schooling schooling schooling schooling US$ PPP
rate (% of rate (% Female Male 2017 Female Male 2017
females of males 2017 2017 2017
aged 15 aged 15
and above) and
2015 2016 above)
2015
2016
China 94.5 98.2 7.6 8.3 14.0 13.6 16 800
Colombia 94.9 94.4 8.5 8.1 14.9 14.3 14 120
Per 91.2 97.2 8.7 9.7 13.9 13.6 12 900
Sri Lanka 91.0 93.0 10.3 11.4 14.1 13.6 12 520
Ec ador 93.3 95.4 8.6 8.8 15.4 13.9 11 350
Armenia 99.6 99.7 11.7 11.7 13.4 12.6 10 060
Morocco 58.8 78.6 4.5 6.5 12.0 12.8 8050
Boli ia 88.6 96.5 8.2 9.7 14.0 14.0 7350
India 60.6 81.3 4.8 8.2 12.9 11.9 6950
Angola 60.7 82.0 - - 11.0 12.7 6450
Moldo a 99.1 99.7 11.5 11.7 11.9 11.4 6100
Zambia 56.0 70.9 6.5 7.4 12.0 13.0 3900
Chad 14.0 31.3 1.2 3.4 6.4 9.5 1920
Uganda 71.5 85.3 4.7 7.2 11.0 12.2 1820
Sierra 37.7 58.7 2.7 4.3 9.3 10.2 1510
Leone
B r ndi 83.1 88.2 2.7 3.7 9.3 10.2 730
Source: GNI a a US$ PPP W Ba , W D I a
L a a CIA T W Fa b
M a a a a U Na D P a ,
H a D R 2018
Table 19.4: Gender ineq ali ie in ed ca ion
Gender inequalities in inheritance rights and propert rights

In man de eloping co n rie inheri ance righ and proper righ are pa ed mainl o men. Wherea
man co n rie ha e pa ed la en ring eq ali be een he e e in inheri ance righ , he e la
are of en no enforced. The ame co n rie all al o re ric he righ of omen o o n proper .
Land i o er helmingl o ned b men, e en in ocie ie here agric l ral ork i mainl he
re pon ibili of omen.

The problem of missing women
Wherea he ra io of omen o men in France, he Uni ed Kingdom and he Uni ed S a e i grea er
han 1.05, in ome le de eloped co n rie i i m ch lo er: 0.95 in Eg p , 0.94 in Banglade h,
China and We A ia, 0.93 in India and 0.90 in Paki an. A ra io of omen o men of 1.05 mean ha
here are 105 omen for e er 100 men. The main rea on for hi i biological: omen ha e higher
r i al ra e han men. A ra io of 0.90 mean ha here are 90 omen for e er 100 men. Ba ed on
he e fig re , i i ea o calc la e ho man more omen he e co n rie ho ld ha e had if he
had had he ame ra io of omen o men a in de eloped co n rie . The hor fall in he n mber of
omen i kno n a he problem of mi ing omen , i.e. he are mi ing d e o nnece ar
dea h . More han o decade ago i a e ima ed ha here are more han 50 million omen
mi ing in China alone, and man more han 100 million mi ing in A ia and Nor h Africa.41 More
recen da a e ima e 65 million mi ing omen for India alone, here he ra io be een omen and
men ha been or ening in e eral a e in recen ear .42
Figure 19.6: India. Mara hi omen perform a folkdance pro e ing again female infan icide
dedica ed o he godde D rga and he empo ermen of omen and girl
According o recen foreca of mi ing omen, he e are e pec ed o reach 150 million b 2035. I
i e pec ed ha ne l mi ing omen ill be o er hree million a ear e er ear n il 2050.43
The mo impor an rea on for mi ing omen ha been higher female infan and child mor ali
(dea h ) d e o le heal h care and poorer n ri ion of girl compared o bo in familie here here
i no eno gh income o co er he need of all he children. Ano her rea on hich i increa ingl
gro ing in impor ance ari e from prena al (prior o bir h) e elec ion hich occ r hen female
foe e are abor ed.
The a hor of he d of India mi ing omen44 ake heir arg men f r her, no ing ha d e o
he mi ing omen problem, India o ing pop la ion i ignifican l red ced, re l ing in a gender
bia in policie ha fa o r men.
S a a , a a a
a a a a
a b a ...
T a a a b
a a . T a a I a a a b
a a a a a a a .
Appl ing our skills
Selec a co n r o are in ere ed in and re earch he problem of mi ing omen. Ho man omen
are e ima ed o be mi ing? Are he n mber increa ing or decrea ing o er ime? Doe he
go ernmen ha e an policie in place o pre en hi from con in ing? Wha policie o ld o
recommend?
Gender inequalities in access to credit

Women face erio re ric ion in ob aining credi . O er and abo e he problem of di crimina ion, lack
of proper righ mean ha omen ha e li le if an hing he can e a colla eral. Moreo er, heir
lo earning po er make hem far le a rac i e candida e o recei e credi from he poin of ie of
credi in i ion (bank ).
Gender inequalities in income, wealth and povert
A n mber of fac or combine o en re ha omen income are on a erage b an iall lo er han
men : lo er le el of ed ca ion and kill , di crimina ion again omen in he labo r marke o ha
omen are paid le for he ame ork, and omen ork in he informal ec or. Moreo er, lack of
inheri ance and proper righ of omen en re ha mo eal h ( ch a land and o her a e ) i
concen ra ed in he hand of men.
The e fac or con rib e o making omen among he poore par of he pop la ion in man
de eloping co n rie . Po er among omen i par ic larl prono nced hen omen are head of
ho ehold (i.e. here i no man in he ho ehold earning an income); beca e of heir er lo earning
po en ial, female-headed ho ehold are loca ed in he poore region , i h limi ed or no acce o
ani a ion, clean a er, heal h er ice , e c.

1 Iden if ome of he ke area of gender ineq ali ie .
2 a E plain ome e ernal benefi of omen empo ermen .
b U e an e ernali diagram o ho ho po i i e con mp ion e ernali ie of ed ca ion and
heal h care for omen are a pe of marke fail re.
c Iden if go ernmen policie ha can help correc hi marke fail re.
3 E plain h Amar a Sen el e here refer o omen a ac i e agen of change .
Inappropriate governance
According o a World Bank repor , governance i he proce hro gh hich a e and non a e ac or
in erac o de ign and implemen policie i hin a gi en e of formal and informal r le ha hape and
are haped b po er. Thi repor define a he abili of gro p and indi id al o make o her
ac in he in ere of ho e gro p and indi id al o bring abo pecific o come . 45
Go ernance i no abo a i done for economic gro h and de elopmen , b ra her i i done. I
i abo he effec i ene of go ernmen , b al o i in ol e he rela ion be een go ernmen and
ocie , and ho he in erac o make deci ion . According o re earcher on hi opic,
go ernance con i of i principle :46
Participation he e en o hich he akeholder affec ed b policie are in ol ed in making
deci ion and in he implemen a ion of deci ion .
Fairness he e en o hich r le appl o e er one in ocie eq all .
Decenc he e en o hich he forma ion and implemen a ion of r le doe no harm or
h milia e an one.
Accountabilit he e en o hich poli ical fig re and deci ion-maker are re pon ible o
ocie for he ac ion and heir a emen .
Transparenc he e en o hich deci ion made b go ernmen are clear and open.
Efficienc he e en o hich carce re o rce are ed i ho a e, dela or corr p ion.
Good go ernance i impor an beca e according o die making cro -co n r compari on , be er
go ernance i rela ed o more in e men and grea er economic gro h. The effec i ene of
go ernmen , he efficienc of b rea crac and r le of la are po i i el rela ed o economic
performance and ad l li erac , and nega i el rela ed o infan mor ali .47
In ie of he abo e, he lack of effec i e go ernance in man de eloping co n rie i a major barrier o
gro h and de elopmen .
Corruption
The World Bank define corr p ion a he ab e of p blic office for pri a e gain . Corr p ion can ake
man form , incl ding briber , pa ronage, con r c ion kickback , proc remen fra d, e or ion, fal e
cer ifica ion, cron i m, nepo i m and embe lemen . I occ r e er here in he orld, b i e peciall
prono nced in co n rie here he legal em, ma media and he em of p blic admini ra ion are
eak and nderde eloped, condi ion hich end o be more prominen in le de eloped co n rie .
The cope of corr p ion i a . In 2018, he Uni ed Na ion e ima ed ha he global co of corr p ion
i a lea US$2.6 rillion per ear, corre ponding o 5% of global gro dome ic prod c .48 More han
US$1 rillion i pen on bribe alone; hi fig re incl de in erna ional flo of bribe , mainl in ol ing
m l ina ional corpora ion .
Corr p ion aro nd he orld i moni ored b Tran parenc In erna ional (TI), hich i an organi a ion
ha mea re le el of corr p ion and ran parenc . U ing p blic opinion r e ha ga ge
re ponden ie on he degree of corr p ion in heir co n r , TI compile an inde ann all , he
Corr p ion Percep ion Inde , hich rank more han 150 co n rie on he ba i of percei ed le el of
corr p ion.49
Corr p ion i increa ingl recogni ed a a major barrier o gro h and de elopmen ; i i ell
doc men ed ha higher le el of corr p ion are fo nd in co n rie i h lo a a income and lo
ra e of gro h. A in he ca e of poli ical in abili , he ca ali r n in bo h direc ion : high le el of
corr p ion are a ocia ed i h lo er in e men and gro h, hich in rn perpe a e he condi ion ha
nderlie corr p ion.
Wh i corr p ion a ocia ed i h lo er gro h and poorer de elopmen performance? We can
di ing i h he follo ing fac or :
corr p ion, in he form of a pa men made o ob ain ome hing, i like a a , hich in effec make
pri a e in e men more co l , hereb red cing he o erall le el of in e men , and lo ering he
ra e of gro h
bribe of en ha e o be paid in order o ob ain ba ic er ice ( ch a bribe o eacher and heal h
orker ); hen hi happen he ork like a a , beca e lo er income people m
pa propor iona el more han higher income people in order o ob ain he er ice (i.e. he bribe i a
higher frac ion of heir o al income); he re l i o depri e he poor of ba ic ocial er ice ,
hereb going clearl again de elopmen objec i e
nlike a f nd , ha are paid o he go ernmen and ha become a ailable for e in ociall
de irable ac i i ie , bribe go in o he pocke of p blic er an and poli ician , and are no
a ailable o he go ernmen for he pro i ion of ocial er ice ; moreo er, corr p ion ha ake he
form of bribe for a e a ion f r her depri e he go ernmen ec or of re o rce ha o ld ha e
been a ailable for in e men in ed ca ion, heal h and infra r c re
corr p ion can re l in mi alloca ion of re o rce a go ernmen official ma accep bribe o
p r e neconomic projec ( ch a dam and po er plan ), hile neglec ing in e men in ba ic
ocial er ice (heal h care facili ie , ed ca ion, ani a ion, clean a er, e c.)
corr p ion pre en he opera ion of compe i i e marke , beca e i re ric he en r of ne firm
ha m pa bribe o begin opera ion ; hi i ano her fac or hindering pri a e in e men
corr p ion red ce hope for en ironmen al ainabili a go ernmen official accep bribe in
order o b pa en ironmen al reg la ion , a hori e he ab e and de r c ion of na ral re o rce ,
or finance en ironmen all n o nd projec
corr p ion damage he people r in he a e, i in i ion and leader hip, and enco rage
con emp for he r le of la .
Unequal political power and status
Political power
Co n rie differ in he pe of poli ical em he ha e. A poli ical em i a e of legal in i ion
ha define ho a go ernmen i r c red and f nc ion . There i a er broad arie in pe of
poli ical em , incl ding monarchie , democracie , rep blic , oligarchie , and o her , i h ar ing
form of legal, con i ional and organi a ional arrangemen .
Wha e er he pe of poli ical em, ha i impor an i a co n r poli ical r c re, in ol ing he
rela ion hip be een ario gro p i hin a ocie and he degree of poli ical po er he con rol.
Eli e gro p i hin a ocie , he her he e are lando ner , ind riali or banker , ma infl ence he
kind of gro h and de elopmen policie ha can be p r ed, and he e differ broadl among
de eloping co n rie . An gro p ha ha di propor iona el grea poli ical po er al o ha he
corre ponding abili o infl ence he go ernmen o ard making deci ion ha fa o r i o n in ere
ra her han he in ere of he econom or he in ere of di empo ered, lnerable e cl ded gro p
ho e in ere are nderrepre en ed.
In general, i i diffic l o carr o a de elopmen programme i ho he ppor of poli ical eli e .
Thi po e diffic l ie for go ernmen nder aking policie ha migh hrea en he in ere of he eli e .
Social class and status

All ocie ie ha e ome pe of a a a , hich con i of an arrangemen of he pop la ion
in la er (or ra a) on he ba i of an neq al di rib ion of income, eal h, po er and pre ige. The
op la er ha he mo income, eal h, po er and pre ige, hile he bo om la er ha he lea . Cla
and ca e em are o er impor an a ha ocial ra ifica ion i achie ed. An impor an
difference be een cla and ca e i he degree of ocial mobili , or he po ibili of mo ing from one
ocial la er o ano her.
In a a , an indi id al ocial po i ion i de ermined b bir h, and canno be changed. The
mo ell-kno n ca e em i ha in India, here di crimina ion ba ed on ca e ill per i ho gh i
i illegal. Ca e em ma be ba ed on religion ( ch a Hind i m in he ca e of India ca e em)
or on race ( ch a kin colo r in ca em impo ed in Africa b E ropean coloni er , here hi e
kin a he perior ca e), or on e hnic fac or .
In a a , b con ra , an indi id al ocial po i ion i de ermined b fac or o er hich here i
ome con rol (ed ca ion, income, pe of ork). A ca e em i clearl more harmf l o gro h and
de elopmen , a i prede ermine an indi id al lo in life, ho e er rigid cla em can ha e imilar
impac . Bo h are a ocia ed i h he e erci e of prej dice and di crimina ion, i h he pper cla e or
ca e di crimina ing again he lo er one . Moreo er, in ca e or rigid and highl hierarchical cla
em , he op ca e or cla of en e i po er o pre en he lo er ca e or cla e from a aining
ocial mobili and mo ing o of heir di ad an aged ocial and economic po i ion .
Racial and ethnic issues

Racial and e hnic ie form er rong bond be een he people ho are member of par ic lar racial
or e hnic ocial gro p . Ra refer o people ho ha e been gro ped oge her on he ba i of cer ain
ph ical charac eri ic ( ch a kin colo r). E refer o people ho hare common c l ral
charac eri ic ( ch a lang age, dre , food, al e , place of origin), and ho hare a common c l ral
iden i . Some ime race and e hnici coincide (for e ample, African-American and Japane e-
American ). Race and e hnici ome ime lead o he e erci e of prej dice and di crimina ion a ell a
in olerance, and a ime re l in ocial en ion and iolen conflic .
Political stabilit
Poli ical abili refer o able go ernmen and i abili o i h and forcible remo al from po er.
Co n rie differ enormo l i h re pec o heir degree of poli ical abili . The pre ence of poli ical
abili i a ocia ed i h higher ra e of gro h and impro ed de elopmen o come for he follo ing
rea on .50
A able go ernmen i nece ar for effec i e go ernmen deci ion-making and for implemen ing
economic and o her policie ha ha e con in i o er ome ear , crea ing a able economic
en ironmen .
Poli ical in abili crea e an en ironmen of ncer ain rela ed o economic polic , proper
righ , po ibili of e propria ion, and a a ion r le , all of hich make bo h dome ic and foreign
in e men far ri kier, hereb red cing in e men .
Poli ical in abili of en lead o an o flo of financial capi al a people eek afe for heir
financial a e (capi al fligh ), depri ing he co n r of i carce financial re o rce and
con rib ing o balance of pa men defici .
Poli ical in abili increa e lnerabili o h nger and famine, a i depri e go ernmen of he
capaci o pro ide relief, hile re o rce are di er ed o mili ar or police ac i i ie . The 1984
1985 famine in E hiopia re l ing in o er one million dea h ( i h ano her e en million people
e erel affec ed) a ca ed a m ch b poli ical in abili , in ernal ar and iolence a b
dro gh . According o he World Bank, he mo impor an ca e of famine in de eloping co n rie
i no po er or lo agric l ral o p , b mili ar conflic .
There i a clo e rela ion hip be een poli ical in abili and le el of income: in general, lo le el of
income a a are a ocia ed i h higher le el of poli ical in abili . The ca ali (ca e and
effec ) r n in bo h direc ion : poli ical in abili i a ca e of lo income beca e i gi e ri e o lo
economic gro h; and lo income are a ca e of poli ical in abili beca e he lead o ide pread
di a i fac ion and fr ra ion i h economic condi ion for hich he go ernmen i held re pon ible.

1 E plain h each of he follo ing i a barrier o de eloping co n rie effor o gro and
de elop:
a gender ineq ali ie
b inappropria e go ernance
c corr p ion
d poli ical po er and a
e (op ional) poli ical in abili .

The follo ing q e ion ill help o reflec on o r learning and enhance o r nder anding of ke
opic in hi chap er. The are gge ion for inq irie ha o can nder ake on o r o n or in
gro p in order o re i e he learning objec i e of hi chap er.
1 Some con ider he One Lap op per Child non-profi ini ia i e an e ample of appropria e
echnolog ho gh he projec ha i cri ic . Re earch he OLPC. Do o belie e i i an
e ample of appropria e echnolog ? Wh or h no ?
2 Re earch and find a de eloping co n r ha ha e perienced an impro emen in i di rib ion
of income and ano her co n r here hi ha or ened. Iden if he fac or re pon ible for he
increa ed and decrea ed eq ali in di rib ion.
3 Sec ion L a a a li man barrier o ed ca ion and good heal h. Re earch a
co n r of o r choice and iden if barrier ha co n r face . Find fac and a i ic o ppor
he e i ence of he barrier o iden if . Share o r finding i h a cla ma e and li en o heir
re earch oo.
4 Re earch a de eloping co n r of o r choice ha face gender ineq ali ie i h regard o a
arie of fac or ( chooling, heal h, proper o ner hip, e c.). For ha par ic lar co n r ,
gge rea on h he e ineq ali ie e i and a e he c rren rend and po ibili ie in he
f re for omen o clo e he ineq ali gap.
29 The World Bank (2003) W D R , 2003: S a ab D a D a W :

Ta I ,G a Q a L , O ford Uni er i Pre .
30 Acce oJ ice
31 Go ernmen in le de eloped co n rie of en e a conce ion a a mean of im la ing ac i i b

crea ing incen i e for b ine e ; he beneficiarie of he e a conce ion are of en m l ina ional
corpora ion , a ell a large dome ic firm in ec or ha he go ernmen an o promo e a par of i
gro h ra eg .
32 Con l a i e Gro p o A i he Poor (CGAP)
33 Land righ are a llab erm in Chap er 20.
34 W D R 2005
35 Wh S reng hening Land Righ S reng hen De elopmen
36 Wh indigeno and comm ni land righ ma er for e er one
37 The Role of Proper Righ in he Deba e on Large-Scale Land Acq i i ion
38 The Role of Proper Righ in he Deba e on Large-Scale Land Acq i i ion
39 CLEP (High-Le el Commi ion on he Legal Empo ermen of he Poor) (2008) F a , Ne York:
Uni ed Na ion .
40 The Highe Bidder ake i all

The highe bidder ake i all: World Bank ne cheme o pri a i e land in he Global So h
41 Amar a Sen (1999) D a F , O ford Uni er i Pre .
42 Wha India 65 million mi ing omen mean for he a e of i democrac
43 John Bongaar and Chri ophe G ilmo o, Ho man more mi ing omen? E ce female mor ali and
prena al e elec ion: 1970-2050 P a a D R , 2015, ol 41, i e 2
44 Kapoor, M., and Ra i, S. (2013) W I a a :A . A ailable a SSRN

2231026
45 World Bank World De elopmen Repor 2017
46 Goran H den, J li Co r and Mea e, Kenne h. (2004) Making en e of go ernance: empirical e idence from
16 de eloping co n rie , O er ea De elopmen In i e.
47 J li Co r (2006) Go ernance, de elopmen and aid effec i ene : a q ick g ide o comple rela ion hip ,
O er ea De elopmen In i e.
48 Global Co of Corr p ion a Lea 5 Per Cen of World Gro Dome ic Prod c , Secre ar -General Tell
Sec ri Co ncil, Ci ing World Economic For m Da a
49 The in ere ed den can acce he Corr p ion Percep ion Inde b going o Tran parenc In erna ional
home page
50 al ho gh poli ical abili i no ea il q an ifiable, i i ro inel moni ored for co n rie aro nd he orld b
in erna ional organi a ion ( ch a he orld bank) b e of e eral indica or ha mea re people
percep ion of he likelihood ha he go ernmen in po er co ld be o er hro n or de abili ed b iolen or
ncon i ional mean . e ample of ome of he e indica or incl de ci il ar, re ol ion , a a ina ion ,
in ernal conflic , e hnic en ion , demon ra ion , rio , rike , freq enc of elec ion , go ernmen cri e ,
major con i ional change , cabine change , religio en ion , and o her . he lo er he likelihood ha he
go ernmen co ld be bro gh do n, he grea er he percei ed poli ical abili .
C a 20
S a c c
a c c
BEFORE YOU START
Recalling hat ou ha e learned in microeconomics, macroeconomics and international
economics, can ou think of measures and policies go ernments can use to encourage economic
gro th and economic de elopment in their countr ?
Would some measures and policies be more appropriate for de eloping countries, and others
more appropriate for de eloped countries?
This chapter criticall e amines a broad ariet of policies and strategies that de eloping countries ma
pursue in order to promote their gro th and de elopment. Where er rele ant, reference is made to
particular Sustainable De elopment Goals (SDGs) that relate to the polic in question.
20.1 I
LEARNING OBJECTIVES

e plain and evaluate trade strategies including: (AO3)
import substitution
e port promotion
economic integration
trade liberalisation
I
I , also known as impor b i ing ind riali a ion, is a growth and trade strateg
where a countr begins to manufacture simple consumer goods for the domestic market to promote its
domestic industr (for e ample, shoes, te tiles, beverages, electrical appliances, etc.). Import
substitution depends on protective measures (tariffs, quotas, etc.) preventing the entr of imports that
compete with domestic producers.
Man Latin American countries adopted these policies from the 1930s onward. B the 1950s and 1960s,
most developing countries around the world were pursuing industrialisation based on import
substitution. It was attractive because most currentl developed countries had used import-substituting
policies in the initial phases of their industrialisation. The theoretical justification was provided b the
infant industr argument recommending the use of trade barriers to protect infant domestic firms
against competition from imports (see Chapter 15).
I -
Import substitution policies had the following common characteristics and consequences:
H , . Protection
took mainl the form of tariffs, quotas and import licences. The resulting lack of competition led to
high costs and inefficienc in private and public sector industries, resource misallocation and high
prices for consumer goods.
O . Man countries overvalued their e change rates (set them at a higher
level than the free market level) reducing the price of imports and increasing the price of e ports
(see Chapter 16). The objective was to allow firms to import capital inputs more cheapl ; however,
it had two negative effects:
Cheap capital imports led to capital-intensive production methods (inappropriate
technologies), unemplo ment and growth of the informal econom in urban areas.
It made agricultural e ports more e pensive, worsening rural povert .
T . Most import-substituting countries relied
heavil on industrial policies (interventionist suppl -side policies; see Chapter 13), with strong
intervention in the form of protective trade barriers, overvalued e change rates, subsidised credit,
ta allowances, production subsidies, wage subsidies, price controls, etc., as well as e tensive
public ownership of firms and industries (fertilisers, steel, petrochemicals, cement, banking and
financial services, infrastructure, and man others). This led to serious resource misallocation and
inefficiencies in production.
N . Agriculture was neglected, and due to the failure to make agricultural
investments, there was an increased need for food imports.
D . The balance of pa ments deteriorated because of:
increasing imports of capital equipment as inputs in production
increased need for food imports
outward flow of financial capital due to profit repatriation of foreign multinational
corporations (profits taken to the home countr ).
E - . It was believed that this would result
in more rapid growth. There was no effort to provide support for small entrepreneurs more likel to
use labour-intensive techniques.
N . Capital-intensive technologies and
the neglect of small producers increased unemplo ment and contributed to the development and
growth of the informal econom , along with worsening income distribution and increasing povert .
L . In spite of some growth in the earl
periods, there came a point when it was no longer possible to grow through import substitution.
This was due to serious inefficiencies (high costs of production). Man firms enjo ing protection
never grew up to become efficient, low-cost producers, firms that should have closed down were
kept going, while others that should have been set up or e panded were not.
B the 1970s and 1980s, there was general agreement among economists that import substitution had not
lived up to e pectations. It therefore began to be abandoned in favour of e por promo ion.
Toda import substitution is not practised as a general strateg for growth and industrialisation, however
there ma be elec i e impor b i ion, that ma include industrial policies for particular infant
industries.
E
E is a growth and trade strateg where a countr attempts to achieve economic growth
b e panding e ports. Like import substitution, e port promotion was based on strong government
intervention, justified b the idea that this is necessar to help countries develop a strong manufacturing
sector oriented towards e ports.
T
E port promotion strategies evolved graduall as an e tension of import substitution. In man cases, the
industries that became the strongest e porters were the ones that had received strong import-substituting
protection.
The economies that first turned to e port promotion included China, Indonesia, Japan, Mala sia,
Singapore, South Korea, Thailand and others; the are known as the A ian Tiger . While each econom
was unique in the blend of policies, some t pical policies included the following:
F , including:
Targeting of e port industries that used increasingl higher skill and technological levels.
Industrial policies to support e port industries, including investment grants, production
subsidies, e emptions from tariffs of imported inputs, ta e emptions, e port subsidies, and
special benefits for e port oriented multinational corporations.
Provision of incentives to the private sector for R&D in high technolog products to
encourage the development of domestic skills and technologies appropriate to local conditions.
S , including:
State ownership and control of financial institutions (banking and insurance) to provide
subsidised credit to the industries being promoted, such as lower interest rates and other
favourable borrowing terms.
Large public investments in ke areas including education and skills, R&D, and e pansion
and modernisation of transport and communications infrastructure.
R , intended to ma imise the benefits of
foreign direct investments, such as the promotion of R&D, transfer of desired and targeted
technologies into the domestic econom , training of domestic workers, and the use of local inputs
where possible.
E , involving nder al ed c rrencie that encourage e ports while
making imports more e pensive.
These policies resulted in immensel successful e port performance and achievement of ver high
growth rates, due to increases in aggregate demand. Since the 1950s, the Asian Tigers have been the
fastest growing economies in the developing world. In addition, the succeeded in making significant
improvements in their levels of economic and human development.
Wh were the Asian Tigers so successful?

E , taking advantage of economies of scale.
E . Beginning with support for simple, labour-intensive goods (for
e ample, te tiles and clothing), industrial policies later supported diversification based on
increasing skill and technolog levels (see below)
M , including education, training and skills.
A . Governments supported R&D for the development of appropriate
technologies, as well as transfer from abroad of technologies appropriate to local conditions.
I , resulting from the use of labour-intensive technologies.
N , due to significant increases in e ports and e port earnings.
P
E porting countries ma become overl dependent on e ports so that in the event of recession in
the major trading partners, e ports will fall leading to a drop in aggregate demand with consequent
recession.
There ma be efforts to maintain low wages to keep labour costs low thus making e ports more
competitive; hence workers ma not benefit from growth that e ports make possible.
Strong e ports over a long period of time lead to a trade surplus corresponding to trade deficits in
trading partners, possibl leading to trade protection b the trading partners who feel threatened b
e cessive imports.
E
SDG 17.10 (goal 17, target 10) states, Promote a universal, rules-based, open, non-discriminator and
equitable multilateral trading s stem under the World Trade Organi ation . . . .
T
This topic was introduced in Chapter 15. In the last few decades, there has been a ver large increase in
the number of bilateral and regional trade agreements around the world. The number of trade agreements
reported to the World Trade Organi ation (WTO) grew from 20 in 1990 to 159 in 2007, and 270 b
2019. One reason is that man countries are becoming frustrated with what the believe is the slow
progress made b the WTO (see Chapter 15). Another is that developing countries see in trading blocs
the possibilities of enjo ing the benefits of free trade, b passing obstacles created b rich countr trade
protection, while maintaining some of the benefits of trade protection (toward non-members).
Chapter 15 offered an evaluation of trading blocs in terms of their advantages and disadvantages as a
method to achieve free trade. (You should refer to this discussion as it is closel related to our present
topic). We will now evaluate trading blocs as a strateg to achieve growth and development. To do so,
we must make the distinction between regional and bilateral trade agreements.
R (FTA ):
Economists generall agree that free trade agreements have the greatest potential to help developing
countries achieve growth and development when the involve:
regional agreements
geographical closeness
similar level of development and technological capabilities
similar market si es
shared commitment to co-operation.
These conditions allow countries to achieve the benefits of integration we studied in Chapter 15.
Regional groupings allow countries to e pand their markets (achieving economies of scale) and to
diversif production and e ports. Larger markets increase domestic and foreign direct investment. When
countries are at a similar level of development with similar technological capabilities as well as similar
market si es, the new competition created b increased imports is more fair and easier to deal with (it
does not involve unfair competitive advantages of foreign firms caused b lower costs due to use of
more advanced technologies, greater managerial know-how, larger si e due to larger home markets).
If there is a shared commitment to co-operation, there are several policies that can be pursued jointl b
members so the can further benefit from their integration. The can invest in transport infrastructure
needed for trade, as well as in energ and water supplies needed for growth and development. The can
collaborate on R&D projects and new technolog development that would be mutuall beneficial. The
can work together on environmental issues of common interest.
These factors greatl increase the likelihood that integration will lead to increased growth and more
development. While it is difficult for all these conditions to be met in practice, it is not surprising that we
usuall find neighbouring countries forming regional blocs such as in Latin America (MERCOSUR),
southeast Asia (ASEAN), eastern and southern Africa (COMESA), central Africa (CEMAC), Central
America (CAIS), etc.
B (FTA ):
Most of the trade agreements in e istence are bilateral, and most bilateral agreements are between
developing and developed countries that are no usuall in the same geographical region (though there
are e ceptions). The developed countries mainl involved are the United States, which has agreements
with a number of developing countries, the European Union (which acts as a unit) that also has
agreements with developing countries and transition economies, and Japan, with agreements mainl in
the Asia-Pacific region.
A bilateral agreement has the potential to provide a developing countr with access to the developed
countr market, and the prospect of gaining such access is wh developing countries enter into such
agreements. However, this potential comes with risks:
The developing countr must make equal and matching cuts in tariff and other barriers, often much
greater than those required b WTO agreements. This puts even efficient developing countr firms
at a competitive disadvantage because the are forced to compete with a lower cost developed
countr . The result ma be to destro even efficient local firms.
When man developing countries form FTAs with the same developed countr to gain market
access, the advantage each hopes to gain individuall is lost, as the must now all compete with
each other for the developed countr market. Thus, increases in e ports ma be limited.
Increased imports and onl slightl increasing e ports ma result in trade deficits, balance of
pa ments problems and increasing foreign debt. The ma also result in greater unemplo ment,
worsening income distribution and increased povert .
Bilateral negotiations put developing countries at a disadvantage due to weaker bargaining power
compared to the multilateral negotiations of the WTO where the can join together and present their
interests as one.
The developing countr must agree to other requirements that ma not be in its best interests (such
as freer rules on foreign direct investment, stricter rules on cop right and patent laws).
Bilateral agreements divide developing countries b creating different interests. The also weaken
regional trade agreements when a member countr makes a bilateral agreement with a third countr .
According to the United Nations Conference on Trade and Development (UNCTAD),1 developing
countries are better off pursuing regional trade agreements. The trend toward bilateral trade agreements:
hrea en he iabili of e i ing regional coopera ion arrangemen among de eloping co n rie ,
and, mo impor an l , he op ion a ailable o he e co n rie for p r ing heir na ional
de elopmen ra egie .
FTA can re l in ome e por gain , and po ibl increa ed FDI (foreign direc in e men ) flo ,
b he i e and d rabili of he e benefi i highl ncer ain, a are he ne gain for rade and
o p gro h. Thi i beca e he FTA ill mo likel lead o an increa e in impor , i h
implica ion for he rade balance and, in ome ca e , he e ernal deb po i ion. Moreo er, if f re .
. . FTA are modelled on ho e ha ha e been nego ia ed o far, i i likel ha he ill con iderabl
red ce or f ll remo e polic op ion and in r men a ailable o a de eloping co n r o p r e i
de elopmen objec i e . 2
T
A fourth important trade strateg is trade liberalisation. This will be presented below in connection with
market-based policies.

1 Define import substitution and e plain wh it has an inward orientation.
What were some factors that led most developing countries to adopt import substitution as an
industrialisation strateg in the 1950s?
E plain some of the ke policies that were associated with importsubstituting strategies.
Evaluate the effectiveness of these strategies with respect to their impacts on economic
performance and economic growth and development.
2 Define e port promotion and e plain wh it has an outward orientation.
What were some of the countries that adopted an e port orientation during the 1960s, and
what prompted them to do so?
E plain some of the ke policies that were associated with e port promotion.
Evaluate the effectiveness of these policies with respect to economic performance, e port
growth and economic growth and development.
3 Discuss the potential advantages and disadvantages of
regional trade agreements, and
bilateral trade agreements as a strateg to promote growth and development.
1 UNCTAD is a United Nations organisation concerned with international trade issues in developing countries.
2 UNCTAD, Trade and De elopmen Repor , 2007

20.2 D e ca a d ca e e e
LEARNING OBJECTIVES

• define all the terms appearing in a e b d in the text (AO1)
• explain and evaluate the strategies of (AO3)
• diversification
• social enterprise
D e ca ec c ac
D e ca involves a reallocation of resources into new activities that broaden the range of goods
or services produced. As a country grows and develops, the relative share of the primary sector in GDP
usually shrinks, becoming progressively replaced by manufacturing (industry) and later by services. The
decline in the relative share of the primary sector s contribution to GDP is made possible by the
diversification of production into manufacturing as well as services (see Chapter 3 for an explanation in
terms of the income elasticity of demand.) As the country diversifies into manufacturing and services, its
exports are likely to become more varied accordingly. Such diversification of production and exports has
been taking place particularly in higher income developing countries.
T e a ce e a d e a e-added d c
The concept of value added refers to the value of a good that is added in each step of a production
process.3 For example, suppose a country produces cocoa beans. The beans are cleaned, roasted, and
shelled, then ground into a paste, called cocoa liquor. A portion of the liquor goes into hydraulic presses
that remove the cocoa butter, leaving behind a paste that is ground into a fine powder for use in the
baking industry. The cocoa butter is mixed with the other portion of the liquor together with sugar,
vanilla and milk, all of which are kneaded well and placed into machines called conches that stir and
shake the mixture under heat for some days. When the mixture cools, it is converted into chocolate bars
or is used in baking and confectionary industries.
Each step in this process adds value to the cocoa beans. If a country that produces cocoa beans goes on
to produce chocolate, it adds value to its primary commodity and diversifies into chocolate
manufacturing.
Adding value in diversification is important because it means:
• engaging in more varied production activities
• creating employment opportunities
• establishing new firms involved with manufactured goods
• expanding into activities requiring higher skill and technology levels.
If a countr produces primar commodities and e ports these in their raw form, it misses the benefits
listed above. It becomes trapped in methods and kinds of production that keep it in a state of stagnation,
with limited prospects for change. Developing countries must therefore seek out new opportunities for
processing of raw materials and manufacturing.
The issue of too much specialisation and the importance of diversification is related to a key criticism of
the theory of comparative advantage (HL only; see Chapter 14). If a country has a comparative
advantage in the production of primary products, specialisation and trade according to comparative
advantage would seriously limit its growth and development prospects.
O e ec a a e d e ca
In Chapter 19 (Section 19.2), we saw that overspecialisation in a narrow range of primary commodities
is a major barrier to growth and development. As Table 19.1 illustrates, a number of the countries that
are overspecialised are rich in natural resources. Ironically this resource wealth often works against
them. It has been observed that since the 1960s resource-poor developing countries have been growing
faster than resource-rich countries. This surprising trend has been termed the curse of natural resources
because it suggests that resource-rich countries might have been better off without these natural
resources. Examples of countries that have experienced low and sometimes negative rates of growth in
spite of their abundant resource supplies include Russia (rich in oil, natural gas, metals and timber),
Nigeria, Mexico and Venezuela (rich in oil), Congo and Sierra Leone (rich in mineral deposits), South
Africa (rich in oil and mineral deposits), and others.
The reasons behind the better performance of resource-poor countries can be found in their earlier
diversification into manufacturing. The inability to rely on production and export of primary
commodities made them turn early on toward labour-intensive manufacturing, together with investments
in human capital and appropriate technologies. Resource-rich countries, on the other hand, became
heavily dependent on primary commodities, with short-term volatility of export revenues, the need to
resort to external borrowing and accumulation of large debts, and balance of payments difficulties.
T e be e d e ca
It is hardly possible to overemphasise the importance of diversification as a strategy for growth and
development. It permits countries to achieve the following important objectives:
• S a ed c ea e e . Increase in exports must be maintained over long periods. This can
only be achieved through diversification into markets with a sustained increase in global demand,
which commodity exports do not satisfy.
• De e e ec ca ca ab e a d . Diversification provides incentives to
acquire new technologies and higher training, education and skill levels, which are very important
for growth and development. This was one factor behind the spectacular success of the Asian
Tigers.
• Red ced e ab -e ce a . Diversification protects countries against
losses from fluctuating export prices.
• Ue d e c a c d e . Countries that already produce primary products are in a
special position to use these as the basis for their diversification into manufacturing, as the domestic
availability of the necessary raw materials can work to stimulate industry. Countries that got a
major boost to their growth and development through this type of diversification include Malaysia,
Thailand, Indonesia, China, Chile and Mauritius.
S ca e e e
A ca e e e is a type of commercial organisation that aims to achieve particular social goals to
improve people s well-being and promote social change. Social enterprises may be either for-profit or
not-for-profit organisations. If they are for profit their primary objective is to achieve their social goals,
not to maximise profit. They try to be commercially viable (cover all their costs) rather than rely on
grants or donations, by selling the services or products they provide. If they make profits these are put
back into the enterprise rather than received as profit income by the owners.
Social enterprises exist everywhere in the world but are becoming increasingly popular in developing
countries where they focus on anti-poverty programmes and other efforts to meet important social,
economic or environmental goals.
Social enterprises operate in a broad variety of areas, including education, health, social care, agriculture,
fisheries, forestry, energy, clean technology and transport. Most of the workers are relatively young and
there is a high female participation rate.
Provision of microfinance (see below) is considered to be a type of social enterprise. Muhammad Yunus,
the founder of microfinance, used the expression social enterprise in connection with his work.
1 Outline the benefits that a country can expect from expanding into higher valueadded production.
2 Explain how diversification can help a country grow and develop.
3 Explain how social enterprise can contribute to economic development.

S ca e e e: Ba b e
Bambike produces hand-made bicycles made of bamboo in the Philippines. Their website states
Bambike is a socio-ecological enterprise based in the Philippines that hand makes bamboo
bic cles with fair trade labor and sustainable building practices. Our bamboo bike builders aka
Bambuilders come from Gawad Kalinga, a Philippine based communit development organisation
for the poor, working to bring an end to povert . We have programmes that include scholarships,
sponsoring a pre-school teacher and a weekl feeding programme for children, as well as a
bamboo nurser for reforestation. Bambike is a compan that is interested in helping out people
and the planet, dedicated to social and environmental stewardship. Our goal is to do better
business and to make the greenest bikes on the planet.
F e 20.1: Manilla, Philippines. A bambike
In addition, Bambike produces sunglasses, tumblers and cups all made of bamboo. They also offer
guided tours of historic neighborhoods and other destinations on bamboo bicycles.
S ce: Bambike
A
1 While Bambike is a for-profit organisation it has important social goals. Use the information
above and on its website to outline Bambike s social goals.
2 Research and identify one or more other social enterprises in a country of your choice. Discuss
how the activities of the social enterprises help achieve the country s development goals.
3 For a numerical example, see footnote 4, Chapter 8

20.3 Ma - a
LEARNING OBJECTIVES

define all he erm appearing in a in he e (AO3)
e plain and e al a e marke -ba ed policie incl ding (AO3)
rade liberali a ion
pri a i a ion
dereg la ion
Ta a a , a a , a a
The pec ac lar cce e of he A ian Tiger made a harp con ra o he performance of mo
de eloping co n rie . In he earl 1980 , man ere ho ing poor e por and gro h performance, and
ere highl indeb ed. Thi a he ime hen mone ari /ne cla ical economi ere in rod cing
marke -ba ed ppl - ide idea , empha i ing he impor ance of limi ed go ernmen in er en ion and he
compe i i e free marke .
A a rade and gro h ra eg , limi ed go ernmen in er en ion mean a a a (elimina ion
of rade barrier o achie e free rade) and a free marke approach in he dome ic econom . Thi free
marke approach o gro h and de elopmen came o be kno n a he Wa C , beca e i
a hared b he World Bank, he In erna ional Mone ar F nd, he Uni ed S a e Congre , and a
n mber of US agencie (all ba ed in Wa hing on, DC). The main policie recommended b he
Wa hing on Con en incl ded:
a a a in ol ing mo ing o free rade b lo ering and elimina ing ariff and o her
barrier o rade
a a a , ch a ran por , oil, ga
a of labo r and prod c marke ; hi mean adop ing marke -ba ed ppl - ide policie
for labo r (red cing labo r nion po er and nemplo men benefi , red cing or elimina ing
minim m age ; ee Chap er 13); i al o mean remo ing barrier o en er prod c marke .
Addi ional policie incl ded:
enco raging floa ing e change ra e ; no e change ra e managemen
red ced re ric ion o foreign direc in e men b m l ina ional corpora ion
limi ing borro ing b he go ernmen ; keeping b dge defici nder con rol
re ric ing he e of ind rial policie .
The e mea re in ol ed freeing p marke and c ing back on he role of go ernmen . Co n rie
ho ld no longer follo he highl cce f l e por promo ion policie ba ed on rong go ernmen
in er en ion. The ere ba ed on he idea ha reliance on marke force and free rade impro e
efficienc and he dome ic and global alloca ion of re o rce , and increa e economic gro h.
Since he 1980 , man de eloping co n rie increa ingl adop ed liberali ing policie b follo ing he e
polic pre crip ion . E ample incl de Argen ina, Bra il, China, Chile, India, Ken a, Sri Lanka,
Tan ania, T rke , he co n rie of Ea A ia, and man more. The e co n rie did no comple el
abandon heir in er en ioni policie , b in ead began a grad al red c ion of go ernmen in er en ion,
i h ome co n rie liberali ing more, or more rapidl , han o her .
T a a a a
B he 1990 here a e idence ha liberali a ion of rade and he econom a no bringing abo he
e pec ed benefi :
L a a
Man co n rie fo nd hem el e lo ing e por hare in orld marke ( he propor ion of e por in
rela ion o global e por ). The lo e ere grea e in Africa. The UNDP no e ha if, b he earl
2000 , Africa ill had i 1980 hare of orld e por , i e por o ld be grea er b US$119 billion (in
con an $ in erm of he ear 2000); hi i eq i alen o abo fi e ime he amo n of aid pro ided b
donor in 2002.4
On he hole liberali a ion policie did no help de eloping co n rie di er if prod c ion in o increa ed
man fac ring. In 2000, j fi e de eloping co n rie ere re pon ible for o- hird of de eloping
co n r lo echnolog man fac red e por , hile onl i ere re pon ible for more han fo r-fif h
of de eloping co n r medi m and high echnolog man fac red e por .5 In mo La in American and
African co n rie , gro h of man fac ring e por a lo o modera e, i h no ignifican change
indica ing di er ifica ion in o man fac ring. In ome La in American co n rie here a a in
he rela i e hare of man fac ring. The co n rie ha fared be ere ho e ha had alread de eloped
ignifican e por ec or ( he Ea A ian co n rie ).6
Par l , he e nega i e effec of liberali a ion ere d e o he rade pro ec ion policie of de eloped
co n rie on de eloping co n r e por , incl ding pro ec ion of agric l re and ariff e cala ion ( ee
Chap er 19). The ere al o d e o gro ing reliance on free marke policie . Remember, he grea
cce e of he Ea A ian co n rie ere ba ed on ind rial policie in ol ing rong go ernmen
in er en ion. Wi h le go ernmen ppor , man de eloping co n rie ere no able o perform ell.
L
According o ell-kno n de elopmen economi , There i li le e idence ha open rade policie in
he form of lo er ariff and non- ariff barrier o rading are ignifican l a ocia ed i h economic
gro h. 7 F r hermore, Perhap he mo comprehen i e a e men of he link be een economic
gro h and rade liberali a ion nder aken o da e concl ded ha here i no clear link be een hem.
Thi mean ha he projec ed benefi are merel h po he ical. 8
According o he Uni ed Na ion De elopmen Programme:
O a a a a a a a aa a
a ...H , a a a ,a
a a a a a .F a a a
a a a a .9
I a a a
There i clear e idence ha economic and rade liberali a ion re l ed in grea er income ineq ali ie and
po er . A World Bank d no ed ha rade liberali a ion lead o lo er income gro h among he
poore 40% of he pop la ion, b higher income gro h for he higher income gro p . In o her ord ,
i help he rich ge richer and he poor ge poorer.10
The rea on i ha economic and rade liberali a ion crea e bo h inner and lo er . When ne
e por marke are opened p, ho e ho find emplo men in he prod c ion of e por good ill be
be er off; people ho find job in a gro ing formal ec or ill al o gain; people i h ome ed ca ion
and kill ma al o gain a he are be er able o e ploi ne oppor ni ie in he more compe i i e
en ironmen . Ho e er, here ill al o be ho e ho ill become or e off. The incl de:
le ed ca ed or illi era e people, ho are nable o compe e in he ne en ironmen
poor people ho lack colla eral ( eal h), and ho canno ge credi o open or e pand a b ine o
ake ad an age of ne oppor ni ie
people in remo e geographical area i h no ran por link o marke
people ho ha e no hing o e por , and no po ibili ie of prod cing for e por
people in agric l re ho i ch o prod cing commodi ie for e por , making hem el e more
lnerable o ide fl c a ion ( ola ili ) in commodi price
people ho lo e heir job a p blic emplo ee d e o c back in he p blic ec or (in Zimbab e,
he are referred o a he ne poor )
people ho lo e heir job in he pri a e ec or a firm clo e hen he are nable o compe e i h
impor of prod c prod ced b large firm in richer co n rie
people ho become nemplo ed d e o pri a i a ion of p blic en erpri e , hich fire orker o
lo er co
people affec ed b c in go ernmen pending on meri good , forced b a grea er reliance on
marke force
people affec ed b lo er le el of ocial pro ec ion ca ed b ppl - ide policie ( ch a lo er
minim m age , lo er pro ec ion again being fired, e c.; ee Chap er 13)
people forced in o he informal econom , here age are lo er and ocial pro ec ion i non-
e i en , d e o remo al of rade pro ec ion leading o clo re of formal ec or firm ha can no
longer compe e (in Zambia, for e ample, formal emplo men fell b 15% in he decade of he
1990 11).
In erna ional rade heor recogni e ha free rade i likel o gi e ri e o bo h inner and lo er .
Ho e er, i arg e ha ince he o erall gain ill be grea er han he o erall lo e , he gainer can
compen a e he lo er , i h he re l ha no one need be or e off. Ye , in he real orld, ch
compen a ion rarel (if e er) ake place.
The free marke approach of he Wa hing on Con en a q e ioned e en b ome indi id al i hin
he World Bank. Jo eph S igli , a Chief Economi of he World Bank, ri e he follo ing:
T a 12 a a a , a
a a , a a a , a a
a a a , a a ,a . Ma a a
a a , a a .S
a a a ,a
a a a a ... a a a a a
a .S a a a , a
a a .O a a a ...
a a a a a a . 13
A : a a a a a
Since he la e 1990 , ppor er and cri ic of marke liberali a ion ha e been mo ing o ard a ne
con en according o hich here ho ld be a mi of marke i h go ernmen in er en ion o ppor
gro h and de elopmen . The follo ing are ome of he idea in hi ie :14
Go ernmen m ppor ed ca ion, heal h er ice and infra r c re de elopmen , a ell a
re earch and de elopmen (R&D) and ran fer of echnolog for bo h ind r and agric l re.
Large b dge defici ho ld be a oided, b if con rac ionar fi cal polic i needed, i ho ld no
affec pending on ed ca ion, heal h and infra r c re.
Go ernmen m pa a en ion o he effec of policie on income di rib ion, and m p r e
policie ha promo e income eq ali and alle ia ion of po er .
Go ernmen m pro ide a proper reg la or frame ork for marke o ork effec i el ; for
e ample, here ho ld be effec i e reg la ion for compe i ion (o her i e pri a i a ion ma lead o
he de elopmen of pri a e monopolie ).
Effor m be made o promo e in i ion ch a proper and land righ , an effec i e a
em, and effec i e banking and credi em ( ee belo ).
De eloped co n rie m a i economic de elopmen b increa ing foreign aid and pro iding
increa ed acce o heir marke for de eloping co n r e por .
De eloping co n rie ho ld recei e pecial rea men b in erna ional rade agreemen nder he
World Trade Organi a ion regarding remo al of rich co n r rade pro ec ion mea re (for
e ample, in agric l re).
According o he ne con en , go ernmen in er en ion i impor an o help crea e he condi ion
for marke and rade o ork o he ad an age of de eloping co n rie .

M a a a a
In he Theor of kno ledge 15.1 (Chap er 15), e con idered he moral j dgemen ha i implied in
he recommenda ion ha co n rie adop free rade. Here, o r opic i broader and perhap more
erio , and in ol e he moral implica ion of he rade (and economic) liberali a ion policie
recommended for de eloping co n rie (and ome ime forced pon hem; ee belo ) b de eloped
one .
The i e are n mero , b can be di ided in o o broad ca egorie : rade pro ec ion policie of
more de eloped co n rie ha pre en de eloping co n r acce o heir marke (agric l ral
pro ec ion of farmer , high ariff barrier , ariff e cala ion) and he rade liberali a ion policie of he
Wa hing on Con en , he WTO and bila eral rade agreemen .
Nobel Pri e- inning economi Jo eph S igli , referring o he free marke approach o in erna ional
rade ha ince he 1990 ha domina ed de elopmen policie , ri e he follo ing abo moral and
e hical i e in rela ion be een de eloped and de eloping co n rie :
E a a - a
a , a .B a a a a
a .N - / a aa a
a , , a [ ]
a ...
E a a a a
a a , a a a a a
, a a a a a a a
a . [T a ] a a ,
a a , a a : a a a a
a a a a , a a a a a
a a a a
a a a a a a 15
; a a a a
a a a a a a
. 16
T
Do de eloped co n r ocie ie ha e a moral obliga ion o help de eloping one (e peciall he
poorer one )?
Con ider he follo ing q e ion po ed b Jo eph S igli . A one le el, i i na ral for a co n r
o p r e i o n in ere . B . . . a ha poin doe hi p r i of a co n r o n in ere (or,
a i more freq en l he ca e, pecial in ere i hin one co n r ) a he e pen e of he poor,
become a moral i e? 17
Are de eloped co n rie morall j ified in promo ing bila eral free rade agreemen ih
de eloping co n rie hen he ref e o gi e p pro ec ion of heir farmer ?
Ho fair are he rade r le of he WTO?
Do he organi a ion of he Wa hing on Con en ( he World Bank, IMF and US go ernmen )
bear an moral re pon ibili o ard de eloping co n rie for mi aken policie ha in ome
ca e ere damaging o he poor of ho e co n rie ( ch a co n rie in b-Saharan Africa)?
1 a Define rade liberali a ion, referring o i objec i e .

O line he main idea behind he marke -ba ed policie recommended for de eloping
co n rie .
E plain he connec ion be een he marke -ba ed ppl - ide policie di c ed in Chap er
12 and he Wa hing on Con en .
2 Di c he effec of liberali ing policie on e por gro h, di er ifica ion, economic gro h and
income di rib ion.
4 Uni ed Na ion De elopmen Programme, H a D R 2002.
6 S. M. Shafaeddin (2005) Trade liberali a ion and economic reform in de eloping co n rie : r c ral change
or de-ind riali a ion? , Di c ion Paper, UN Conference on Trade and De elopmen (UNCTAD).
7 F. Rodrig e and D. Rodrik (1999) Trade polic and economic gro h: a kep ic g ide o he cro -na ional
e idence , Di c ion Paper, Na ional B rea of Economic Re earch.
8 L. Alan Win er (2000) Trade liberali a ion and po er , Paper, Cen re for Economic Polic Re earch,
London, and Cen re for Economic Performance, London School of Economic .
10 M. L ndberg and L. Sq ire (1999) I a a G :L P , The World Bank.
11 Win er (2000) Trade liberali a ion and po er .
12 B he erm neoliberal model , S igli i referring o he free marke approach of he Wa hing on Con en .
13 Jo eph E. S igli (1998) Kno ledge for de elopmen : economic cience, economic polic , and economic
ad ice , Ann al World Bank Conference on De elopmen Economic , Wa hing on, DC, April 1998.
14 Jo eph E. S igli (1998) More in r men and broader goal : mo ing o ard he Po -Wa hing on
Con en , Ann al Lec re, World In i e for De elopmen Economic Re earch, Hel inki, 1998; and
To ard a ne paradigm for de elopmen ra egie and proce e , Prebi ch Lec re, UNCTAD, Gene a,
1998.
15 Thi i a reference o b-Saharan Africa.
16 Jo eph S igl i , (2005) E hic , economic ad ice and economic polic , Ini ia i e for Polic Dialog e, 24
Oc ober.
17 Jo eph S igli (2005) E hic , economic ad ice and economic polic .

20.4 I e e c e : ed b a d
f e d
LEARNING OBJECTIVES

define all the terms appearing in a e b d in the te t (AO1)
e plain and evaluate interventionist policies including (AO3)
redistribution policies including
ta policies
transfer pa ments
minimum ages
e plain and evaluate provision of merit goods including
education programmes
health programmes
infrastructure (energ , transport, telecommunications, clean ater and sanitation)
Red b ce
SDG 10 states Reduce inequalit ithin and among countries . This is the objective of redistribution
policies.
Ta ce
SDG 17.1 (goal 17, target 1) states strengthen domestic resource mobilisation . . . to improve domestic
capacit for ta and other revenue collection .
In Chapter 19 e sa that developing countries often face a number of difficulties regarding ta ation,
leading to lo levels of revenues, inequities, and negative effects on resource allocation. In vie of these
difficulties it is important that developing countries undertake reforms that ill improve their ta ation
s stems.
The International Monetar Fund recommends that developing countr governments should:18
increase the progressivit of the ta s stem, hich is generall lo er in comparison ith developed
countries
graduall e pand the coverage of personal income ta es
e pand the use of indirect ta es on lu ur goods and goods that create negative e ternalities, such
as cigarettes, alcohol and energ based on fossil fuels
increase ta ation from capital income (profits), hich is essential to ensure progressivit
impose or increase ta es on real estate and land
take measures to reduce ta evasion.
T a fe a e
Transfer pa ments ere discussed in Chapter 12 here e sa that the are an important method used
to improve income distribution and reduce povert .
SDG 1.3 (goal 1, target 3) states Implement nationall appropriate social protection s stems and
measures for all, including floors, and b 2030 achieve substantial coverage of the poor and the
vulnerable.
Building on this, the World Bank and International Labour Organi ation (ILO)19 called on countries
around the orld to design and implement b 2030 universal social protection. Universal social
protection means access b an entire population to social protection hich includes child benefits,
pensions for older persons, and benefits for maternit , disabilit ork injur or unemplo ment.
In 2019, four billion people or more than half of the orld s population had no access to even one social
protection benefit. 45% of the global population had access to one benefit, one-third of children had a
famil and child benefit, and onl 28% of people ith disabilities had a benefit. Old age pensions ere
the most prevalent, ith 68% of older persons receiving pensions.20
The benefits take mainl the form of transfer pa ments hich are cash transfers or benefits in kind. The
are ver important because the :
reduce povert and encourage social inclusion
empo er individuals and encourage them to make decisions that reflect their preferences rather
than the preference of the government or aid or development organisations
increase incomes that are used to increase demand for locall produced goods, thus also helping
local producers
promote economic gro th b raising incomes, consumption and investment that increases
aggregate demand
help provide safet against sudden hardships or emergencies
improve access to health care and education
encourage empo erment of omen, and dela ed marriage
reduce malnutrition and child mortalit
help bring the poor into the formal econom
result in reductions of child labour
build political stabilit and reduce social tensions
according to numerous studies, do not reduce the incentive of adults to ork.21
A special polic that has become increasingl popular involves conditional cash transfers (CCTs),
involving mone paid on condition that the households receiving the mone undertake activities related
to education and health care, often for children. (See Real orld focus 6.1 in Chapter 6 on the Bolsa
Familia programme in Bra il.) Non-conditional cash transfers do not impose restrictions, providing
fle ibilit to households to manage their e penditures freel in accordance ith their needs. At the time
of riting there did not appear to be a consensus on hich of the t o is more successful as an
antipovert polic as there is a large variet of programmes of both t pes around the orld hose results
have not et been full evaluated.
Universal social protection s stems are costl and ma be be ond the means of man developing
countries suggesting that the cannot be full implemented over the short term. Moreover, their full
effectiveness depends on government policies to address the cruciall important issues of providing
schools, hospitals, and infrastructure including roads, clean ater and sanitation, trained doctors and
nurses as ell as good training for doctors and nurses, all of hich are needed for development. Further
issues involve difficulties in the design and implementation so that the mone ill reach the population
groups that are most in need.
M a e
Minimum ages ere introduced in Chapter 4. According to standard theor , hereas the are designed
to support incomes of unskilled orkers, the give rise to unemplo ment. In line ith this thinking, in
the 1980s and 1990s market-based suppl -side policies emphasised reducing or eliminating minimum
ages to increase emplo ment (Chapter 13). Ho ever since then, a gro ing number of studies have
indicated that in practice such job losses do not occur unless minimum ages are set at ver high levels.
As a result, since the late 1990s, man countries around the orld introduced or increased their
minimum ages.
In vie of this change in thinking about minimum ages, countries anting to reduce income
inequalities see minimum ages as polic that can help. In man countries the question is not hether or
not to have minimum ages but ho to best design a minimum age s stem. Addressing this issue of
polic design the International Polic Centre for Inclusive Gro th (IPC-IG)22 notes the follo ing:
Minimum ages should be set b governments after consulting ith representatives of orkers and
emplo ers in order to take all relevant points of vie into account.
In deciding on the level of the minimum age it is important to consider the needs of orkers and
their families; to monitor and evaluate the effects; and to have a mechanism allo ing possible
changes ever ear or t o in order to make necessar adjustments.
It is important to establish measures to ensure compliance and enforcement, to avoid ork at ages
belo the legal minimum.
P f e d
Education and health services have been discussed at length in Chapters 6, 12, 18 and 19. The are merit
goods hose importance for gro th and development cannot be overemphasised. Education and health
appear in the follo ing SDGs:
SDG 1.A.2 (goal 1, target A, indicator 2) states Proportion of total government spending on
essential services (education, health, social protection) . This is a measure of resource mobilisation
to end povert .
SDG 4 states Ensure inclusive and equitable qualit education and promote lifelong learning
opportunities for all .
SDG 3 states Ensure health lives and promote ell-being for all at all ages .
Ed ca a d ea e ce a e d
P ee e a e f ed ca f a d de e e
Education provides man benefits for societ , making the social benefits of education far greater than
individual benefits; e ternal benefits arise from positive consumption e ternalities:
Economic gro th is partl a benefit of education, as the benefits of education e tend to societ in
the form of increased labour productivit and greater output.
Education contributes to improvements in the qualit of ph sical capital (i.e. technological
advances), because kno ledge can be applied to research and development, and especiall to the
development of technologies appropriate to local economic, ecological and climate conditions.
Education results in lo er unemplo ment, lo er absenteeism from ork and increased
international competitiveness; and it attracts foreign direct investment.
Education leads to increased political stabilit , an important condition for economic gro th and
development.
Education provides further social benefits, such as a lo er crime rate and a better qualit of life.
The education of omen in particular promotes their increased participation in the labour force,
lo er birth rates (fe er children), leading to lo er rates of population gro th and reduction of
povert .
Some benefits of education spill over into health:
The education of omen leads to improvements in maternal health and reductions in maternal
mortalit (deaths).
The education of mothers results in healthier children through improved health care and better
nutrition and lo er child mortalit (deaths)
Schools teach children basic principles of h giene and sanitation, hich improve the levels of
children s and famil health.
T e a ce f e e e a ed ca a d e a e ac
Man studies have sho n that East Asian countries (including China, Indonesia, South Korea, Thailand,
and others) have invested more heavil in education than other countries ith comparable income levels.
It is idel believed that this has been a ke factor behind their superior gro th and development
performance.
One of the most important investments in education involves achieving universal literac rates. The
highl successful East Asian countries began their initial drive for gro th and development b pursuing
high literac rates, and later graduall increasing investments in secondar and tertiar (universit )
education in line ith developments in their technological capabilities.
According to estimates made b the World Bank, in the case of countries at a relativel lo level of
development, the greatest contribution to economic gro th can be made b primar (elementar ) school
education. Yet developing countries often invest too heavil in higher (secondar and universit )
education, hile ignoring the basic elementar level. This misallocation of resources results in:
an international brain drain, hereb universit graduates from developing countries migrate to
developed ones, resulting in loss of human capital. In effect, poor countr resources build human
capital in rich countries.
an internal brain drain, hereb
highl educated individuals ho cannot find emplo ment in their field ork in unrelated areas
requiring lo er skill levels (for e ample, a doctor or engineer orking as a ta i driver)
doctors and medical personnel educated in government-funded institutions do not ork in
public medical institutions intended to provide free services to lo er income groups, but
instead ork in the private sector hich serves ealth patients
highl educated individuals appl their skills and abilities to research and technolog
development in areas that are more relevant to the needs of developed countries because these
are more prestigious, hile ignoring local technological needs (such as building lo -cost
schools, hospitals and housing, etc.).
Both give rise to a significant misallocation and aste of scarce public resources.
P ee e a e f ea ca e f a d de e e
An improved level of health also provides benefits be ond the individual ones:
Health leads to greater orker productivit and therefore greater output and economic gro th.
Health people do not transmit diseases, thus lo ering the risk of spreading diseases to the
communit .
Immunisation benefits not onl the immunised person but also the communit b lo ering the risk
of contracting a disease.
Healthier people provide more benefits to the communit through more active and productive
participation.
Some benefits of higher levels of health spill over into education, ith:
increased levels of health and good nutrition improve school attendance and performance in
school, leading to longer time spent in school
healthier individuals make better use of the kno ledge and skills the possess
better health means a longer lifespan, and so a longer time during hich the benefits of
education can affect the econom and societ .
Appropriate intervention in education and health care in developing countries involves mainl direct
government provision of services that are free of charge. An estimated 100 million people are forced into
e treme povert b having to pa for health care, hile man die unnecessaril because the cannot
afford to pa for it.23 In addition to health services, also important are investments in sanitation, clean
ater and se erage, as ell as legislation making education compulsor up to a certain age. Advertising
and persuasion as ell as nudges (HL concept) ma also help convince parents of the benefits of
education and preventive health services (such as immunisation). Note that legislation, advertising and
persuasion ould be entirel useless in a situation here there are no schools or health clinics; this is
h governments must step in and provide these services directl in areas here the do not e ist.
According to Gro Harlem Brundtland (former Director General of the World Health Organi ation):
In man countries, while those with mone are able to access good healthcare and education,
hundreds of millions of ordinar people are denied life-saving health services or are plunged into
povert because the are forced to pa unaffordable fees for their care. The burden is particularl
felt b women and children, who have high needs for services but the least access to financial
resources. In some countries, poor women and their babies are even imprisoned in hospitals because
the can t pa their medical bills after giving birth.
The solution to this problem is simple: universal public services provided free at the point of deliver .
Unfortunatel , powerful political interests often oppose this proven wa to reduce inequalities.
Overcoming this opposition and launching equitable public services requires a large investment of
public financing and political capital b governments and political leaders. As well as improving
social indicators, accelerating economic growth and reducing inequalities, this is also a smart
political choice that can strengthen social cohesion and provide an enduring legac .
According to O fam, public services of education and health care must be:
universal, meaning that ever one should have access to them
free at the point of use, meaning that users of the services should not have to pa for them
public, not private, meaning the should be provided b the government
able to prioritise services important to omen, and promote omen as orkers (see belo on
omen s empo erment)
accountable to those the serve.24
I f a c e
Infrastructure is addressed in SDG 6: Ensure availabilit and sustainable management of ater and
sanitation for all and SDG 9: Build resilient infrastructure, promote inclusive and sustainable
industrialisation and foster innovation .
I f a c e a d ec c a d de e e
Infrastructure increases productivit (output per orker) and lo ers costs of production. Good road and
rail a s stems save time and effort in transporting goods and services, allo ing more output to be
transported and production costs to be lo ered. The availabilit of effective telecommunications permits
faster and easier communications, enabling economic activities to be carried out more efficientl .
Irrigation contributes to higher ields (output per unit of land) and e pansion of agricultural output.
The availabilit of infrastructure also facilitates modernisation and diversification of the econom . The
gro th of electronic communication and data e change has contributed to more efficient practices and
e pansion of manufacturing, financial services and government economic activities. The availabilit of
po er (electricit ) allo s for increases in orker productivit through the introduction of simple
electricall po ered machines and equipment. Safe ater sources, sanitation and se erage permit
countries to diversif into the production of processed foods. The quantit and qualit of infrastructure
are important for a countr s international competitiveness, because the determine shipping costs. The
availabilit of good qualit infrastructure also attracts foreign direct investment.
Infrastructure provides services that are essential for maintaining a basic standard of living. Safe ater
supplies, sanitation and se erage s stems have major effects on levels of health of a population,
contributing to the reduction of avoidable illnesses and premature deaths.
Transport services also affect health and education b bringing people in remote rural areas closer to
educational and health facilities. Transport increases emplo ment opportunities b allo ing the
movement of people across longer distances, thus increasing incomes and contributing to the alleviation
of povert . It also facilitates access to markets, reducing the time and costs of transporting goods. The
availabilit of transport can be cruciall important to integrating people in remote and isolated rural
areas into the market econom .
Availabilit of ater supplies, along ith infrastructure suppl ing energ (electricit and gas), have
major impacts on gender equit . When these services are not available, omen and girls are forced to
spend a large proportion of their time carr ing ater and fuel- ood; in some African countries these
activities take as much as t o-thirds of omen s household time. The availabilit of piped ater
supplies, and electricit and gas, b freeing time, increases school enrolment among girls. In the case of
omen, the availabilit of these services leads to increased emplo ment outside the home, and reduced
fertilit (fe er children in the famil ) and hence reduced povert .
In addition, the availabilit of safe energ sources (electricit and gas) results in less indoor air pollution
(arising from the burning of polluting fuels for cooking and light), ith strong positive effects on the
health of omen and children, ho spend more time indoors. The introduction of irrigation over large
areas, b increasing ields (output per unit of land) similarl increases incomes and contributes to raising
people out of povert . Construction and maintenance of infrastructure contributes to creating
emplo ment opportunities for the people ho ork to construct and maintain the facilities, thus also
increasing incomes. The emplo ment-creating effects are especiall strong in the case of labour-
intensive methods used to build roads.

1 Discuss ho
a ta policies,
b transfer pa ments, and
c minimum ages can be used to redistribute income.
2 E amine ho the contributions of
a education programmes,
b health programmes, and
c provision of infrastructure can contribute to economic gro th and development.
18 IMF Fiscal Monitor: Tackling Inequalit , October 2017
19 The ILO is an agenc of the United Nations.
20 Countries urged to act on universal social protection
21 From one to man : Cash transfer debates in ending e treme povert

Conditional & Unconditional Cash Transfers
Universal Social Protection 2030
22 The IPC-IG is a partnership bet een the United Nations and the Government of Bra il to promote social
policies for developing countries. Minimum age: global challenges and perspectives
World Bank and WHO: Half the orld lacks access to essential health services, 100 million still pushed into
23 e treme povert because of health e penses
24 Public Good or Private Wealth?

20.5 F
(MNC )
LEARNING OBJECTI ES
After st d ing this section o ill be able to:

e plain and e al ate foreign direct in estment (AO3)
F (FDI) is in estment b firms based in one co ntr (the home co ntr ) in

prod cti e acti ities in another co ntr (the host co ntr ) ith control of at least 10 per cent of the firm
in the host co ntr . A firm that ndertakes foreign direct in estment is referred to as a
(MNC), beca se it operates in more than one co ntr . A corporation is a t pe of firm
composed of a legal entit that is separate from the indi id als ho o n it.
T
M ltinational corporations r n b siness operations in both the home co ntr and in other (host)
co ntries. Historicall , MNCs ha e been acti e since abo t the middle of the 19th cent r . Their
importance gre in the 1950s hen US m ltinationals stepped p their in estments in E rope as part of
E ropean post- ar reconstr ction. In the last se eral decades their gro th has been e plosi e. In the
earl 1990s, there ere an estimated 37 000 m ltinational corporations globall ; b 2009, the had
increased to 82 000 and emplo ed 80 million people in their foreign affiliates alone.25
For most of the 20th cent r , FDI originated in de eloped co ntries and as also directed mainl
to ards de eloped co ntries. Since the 1980s, de eloping co ntries ha e been recei ing an increasing
share of inflo s, approaching half of the total ann al FDI inflo s as Table 20.1 indicates.
H % %
World 100.0
De eloped co ntries 49.9
De eloping co ntries 46.9 100.0
Africa 3.0 6.4
Asia 33.3 70.9
Latin America and the Caribbean 10.6 22.6
Transition economies* 3.3
* Incl de So th East E rope, the Common ealth of Independent States, Georgia
S : UNCTAD, W I R 2018
T 20.1: Geographical distrib tion of foreign direct in estment inflo s, 2017
The larger of the m ltinational corporations are enormo s in si e. In 2017, the top ten non-financial
m ltinational corporations (ranked b si e of re en es) had re en es of more than US$2.7 trillion.26
M ltinational corporations are estimated to prod ce 33% of global o tp t, nearl t o-thirds of hich is
in the home co ntr and the remaining third in their foreign affiliates. The acco nt for more than half of
orld e ports and nearl half of imports.27
Yet FDI remains a small share of total pri ate in estment in de eloping co ntries; total in estment b
local firms tends to be far greater than total in estment b m ltinational corporations. This raises an
interesting q estion. If FDI forms onl a small share of total pri ate in estment in de eloping co ntries,
h is it the s bject of heated disc ssions and contro ers ? The ans er is that FDI is q alitati el er
different from local in estment, beca se of the er large si e of MNCs, their significant economic and
political po er, and their s perior technical and managerial e pertise, kno -ho and technologies.
Foreign direct in estment is the most important so rce of foreign finance flo s to de eloping co ntries
as a hole. Ho e er, for man lo -income de eloping co ntries that are almost completel b passed b
MNCs, foreign aid is the main so rce of foreign finance.
MNC
M ltinational corporations e pand into de eloping co ntries (as else here) in the hope of sec ring
higher profits. De eloping co ntries offer possibilities for MNCs to:
I . Some de eloping co ntries ha e large or rapidl gro ing markets
(for e ample, China, India and co ntries in Latin America), hich offer the potential for large
increases in sales and re en es.
B . Prod cing in co ntries ith trade barriers allo s MNCs to b pass these
and sec re access to local markets.
L . Labo r costs take p a large proportion of total prod ction costs, and
de eloping co ntries generall ha e lo er labo r costs than in de eloped co ntries. This is a ke
reason for e ample, h the United States has m ltinational corporations operating in Me ico.
U . If an MNC needs ra materials in the form of nat ral
reso rces for its prod ction, it is far less costl to obtain them locall than to import them, on
acco nt of transportation costs.
F . Some MNCs specialise in the e traction
of nat ral reso rces (oil, al mini m, ba ite, etc.). Man de eloping co ntries are er rich in
nat ral reso rces (for e ample in Africa), and therefore it is nat ral for MNCs to ant to locate in
s ch reso rce-rich co ntries.
M ltinational corporations are highl selecti e in their choice of hosts. The prefer to in est in co ntries
pro iding them the freedom to p rs e their economic interests ith the least amo nt of go ernment
interference, in a safe economic and political en ironment that minimises ncertainties and potential
risks of losses on their in estments. The look for:
political stabilit and a stable political en ironment
a stable macroeconomic en ironment: lo inflation, stable c rrenc , acceptable le els of foreign
debt, absence of major balance of pa ments problems
fa o rable ta r les (to ens re lo ta pa ments)
eak labo r protection la s (to lo er the cost of labo r)
a liberalised (free market) econom and trade polic ith an emphasis on e ports
large markets
rapid economic gro th and e pectations of contin ed rapid gro th
ell-f nctioning infrastr ct re, incl ding transportation and comm nications, to facilitate imports
and e ports
a ell-ed cated labo r force.
It is eas to see that the rapid gro th of FDI aro nd the orld in the past se eral decades has been dri en
b the liberalisation of the global econom and domestic economies of man co ntries. Since the 1980s,
as de eloping co ntries t rned more and more to ard the market MNCs ha e fo nd it profitable to
establish affiliates in hospitable foreign co ntries that accommodate their goals.
A FDI
M ltinational corporations are profit-seeking entities; the are not organisations concerned ith the
gro th and de elopment problems of de eloping co ntries. Wh then do de eloping co ntries ie
them as a mechanism that can help accelerate gro th and de elopment?
P MNC
MNC . In estment f nds flo ing into a
co ntr from abroad appear as credits in the financial acco nt, and can help offset a c rrent acco nt
deficit. As the acti ities of m ltinational corporations are s all e port oriented, increased e port
earnings positi el affect the c rrent acco nt.
MNC ,
. When m ltinational corporations set p affiliates, the bring ith them technical and
managerial e pertise, as ell as ne prod ction technologies, hich can be learned and adopted b
the local labo r force ( orkers and managers) and local b sinesses.
MNC
. The inflo s of FDI f nds into a co ntr can add to ins fficient domestic sa ings,
increasing the amo nt of in estment.
MNC . If m ltinational corporations are
ta ed b the go ernment of the host co ntr , there ill be increased ta re en es.
MNC . When MNCs b locall prod ced inp ts, the promote
the de elopment of local ind stries. This ma lead to the gro th of e isting local firms, or the
establishment of ne local firms.
MNC .
MNCs can increase emplo ment b hiring local orkers.
MNC . Increased le els of in estment,
impro ed technolog and increases in h man capital as ell as the promotion of local ind str and
greater ta re en es, can lead to higher economic gro th in the host co ntr ith increased
possibilities for p rs ing de elopment objecti es.
P MNC
MNC . While MNCs

s all bring foreign e change into the host co ntr , the also engage in acti ities res lting in
foreign e change o tflo s. These incl de repatriation of profits (profits sent back to the host
co ntr ); or MNC imports of ra materials and other inp ts; or beca se the finance their acti ities
b borro ing from the parent corporation in the home co ntr , so the m st repa the loan pl s pa
interest. Therefore the net inflo s of foreign e change (inflo s min s o tflo s) ma be small.
MNC , . The
reason is that the links bet een MNC acti ities and the local econom are often limited, in hich
case local orkers do not ha e the opport nit to learn from the MNC. Also, MNCs often hire
personnel from the home co ntr .
MNC . MNCs enjo man ta
pri ileges and benefits, often lo ering the amo nt of ta paid. Ta benefits are offered as an
incenti e to attract MNCs into the host co ntr . Another reason in ol es the practice of a
, hich orks in the follo ing a . Man MNCs b inp ts from their ario s affiliates in
other co ntries. B claiming that the prices the paid to b inp ts is higher than the act al price
paid, their profits appear lo er. Since the ta paid is a percentage of profit, lo er-stated profits
mean lo er ta es (sometimes significantl lo er). It is estimated that lost ta re en es d e to
transfer pricing are in the billions of dollars each ear.
MNC . The operation of MNCs sometimes forces local
competing firms to go o t of b siness, or alternati el does not permit ne local firms to establish
themsel es in ind stries that are directl competiti e ith the MNC.
MNC . If, as noted abo e, MNCs
pre ent the de elopment of local ind str , then their job-creating impact ill be limited. In
addition, some MNCs ma sometimes import into the host co ntr capital-intensi e technologies
that are inappropriate to local conditions, th s contrib ting to nemplo ment and the gro th of the
informal econom . (Ho e er, some MNCs engage in labo r-intensi e acti ities that make
e tensi e se of cheap local labo r).
F MNC
MNC . MNCs often p rs e acti ities that ca se serio s
en ironmental degradation. Preferring to in est in co ntries ith fe en ironmental restrictions,
the are kno n to engage in acti ities that ha e ca sed tremendo s en ironmental damage. One of
the greatest disasters ca sed b MNCs in ol ed an e plosion in a Union Carbide plant in India in
1984 that killed more than 20 000 people and left more than 100 000 ith serio s and permanent
health problems. While destr ction on s ch a scale is n s al, there are n mero s ell-doc mented
cases of MNCs ndertaking en ironmentall ns stainable acti ities. Moreo er, MNCs are
responsible for the prod ction of the b lk of ind strial poll tants (s ch as chlorofl orocarbons, a
main ca se of o one depletion, as ell as pesticides, plastics, petrole m, ind strial chemicals, and
man others). It has been estimated that since 1988, 100 MNCs ha e been responsible for more
than 71% of greenho se gas emissions.28
MNC . Critics charge
that MNCs, thro gh ad ertising, create ne cons mption needs and promote inappropriate
cons mption patterns. This charge applies to the role of MNCs in de eloped co ntries as ell, b t
hat makes it more po erf l in the case of de eloping co ntries is that pop lations plag ed b
h nger, maln trition, disease and lack of basic ser ices can less afford to spend their small incomes
on nnecessar goods hile their basic needs remain nsatisfied. E amples incl de cons mption of
soft drinks, s eets, fast foods, hite bread, e pensi e brand name goods, and man others.
MNC MNC
. MNCs sometimes req ire infrastr ct re (road s stems, ports,
telecomm nications, etc.) hich the de eloping co ntr m st make a ailable if it is to become
attracti e as a host co ntr . To b ild these t pes of infrastr ct re, it ma ha e to shift some of its
scarce reso rces a a from needed merit goods (clean ater, sanitation, schools and health care
ser ices) and to ard infrastr ct re for MNCs.
MNC
. The er large si e of man MNCs gi es them e ceptional
economic and political po er that the can se to infl ence host go ernments to p rs e policies
that are in their o n interests b t against economic de elopment. For e ample, MNCs are interested
in in esting in co ntries that ha e eak labo r protection la s, since this res lts in lo er costs of
prod ction; and the are interested in in esting in co ntries ith eak en ironmental reg lations,
as this allo s them to a oid costs associated ith en ironmental protection. When the interests of
MNCs and those of de eloping co ntries conflict, de eloping co ntr go ernments find themsel es
in a eak bargaining position beca se if the do not gi e in to MNC demands, the ill lose the
in estment to another de eloping co ntr that is more illing to compromise. For e ample, in Per ,
a mining compan press red the go ernment not to ndertake health tests for children li ing close
to the mining operations.
C MNC . Man
de eloping co ntries compete ith each other o er hich ill create better conditions to attract
MNCs. Yet MNC demands ma conflict ith hat is in a co ntr s best interests. This has been
termed the race to the bottom , beca se the desire to host MNCs ma in ol e sacrifices in terms of
needed policies for gro th and de elopment.

1 Describe foreign direct in estment (FDI) and m ltinational corporations (MNCs).
E plain h MNCs ha e an interest in e panding into de eloping co ntries.
In ie of their relati el small share in total pri ate in estment in de eloping co ntries,
e plain h MNCs are a highl contro ersial topic.
2 O tline characteristics of de eloping co ntries that MNCs look for hen deciding here to
in est.
S ggest h lo -income co ntries recei e negligible amo nts of foreign direct in estment.
O tline hat factors acco nt for the massi e gro th in foreign direct in estment in
de eloping co ntries in recent ears.
3 Disc ss ad antages and disad antages of MNCs in de eloping co ntries.
4 O tline h some obser ers refer to the competition bet een de eloping co ntries to attract
MNCs as the race to the bottom .
25 According to the OECD more recent data are not a ailable M ltinational enterprises in the global econom
26 Finance Online The top ten non-financial firms ere Walmart, State Grid Corporation of China, Sinopec
Gro p, China National Petrole m Corporation, To ota Motor, Volks agen, Ro al D tch Shell, Berkshire
Hath a , Apple Inc, E onMobil.
27 OECD M ltinational Enterprises in the Global econom , Ma 2018
28 https://fort ne.com/2017/07/10/climate-change-green-ho se-gases

20.6 F
LEARNING OBJEC I ES

distinguish bet een humanitarian aid and de elopment aid (AO2)
e plain and e aluate foreign aid in the form of (AO3)
Official De elopment Assistance (ODA)
non-go ernmental organisations (NGOs)
debt relief
SDG 17.2 (goal 17, target 2) states: De eloped countries to implement full their official de elopment
assistance commitments, including the commitment b man de eloped countries to achie e the target
of 0.7 per cent of ODA/GNI to de eloping countries .
F is defined as the transfer of funds or goods and ser ices to de eloping countries ith the
main objecti e to bring about impro ements in their economic, social or political conditions. Figure 20.2
pro iding an o er ie of foreign aid, sho s that for such transfers to be considered as foreign aid, the
must be:
c ce a , hich means that the transfers in ol e more fa ourable conditions than could be
achie ed in the market. If the aid in ol es loans, interest rates are lo er and repa ment periods are
longer than borro ers ould get in commercial banks. Also, the aid ma in ol e a , hich are
gifts of either mone or goods and ser ices that do not need to be repaid.
The must be -c e c a , meaning that the must not in ol e bu ing and selling (commerce)
or other acti ities concerned ith making a profit.
F 20.2: O er ie of foreign aid
Figure 20.2 also sho s hat does account as foreign aid, for e ample militar aid, peacekeeping,
refugee assistance, and others. These acti ities are not included under foreign aid because the are not
directl concerned ith bringing about impro ements in the economic, social or political conditions of
de eloping countries.
Under Who offers foreign aid in Figure 20.2, e see there are t o sources of aid. The first is O c a
De e e A a ce (ODA), pro ided b de eloped countr go ernments, and the second is aid
pro ided b - e e a a a (NGO ). All pro iders of aid are referred to as donors of
aid; the de eloping countries that recei e the aid are recipients .
Under T pes of foreign aid in the figure, e see that there are t o main categories of aid: humanitarian
and de elopment.
H
H in ol es aid e tended in regions here there are emergencies caused b iolent
conflicts or natural disasters such as floods, earthquakes and tsunamis. The are intended to sa e li es,
to ensure access to basic necessities such as food, ater, shelter and health care, and to pro ide
assistance ith reconstruction ork in order to help displaced people cope.
Humanitarian aid is e tended b donors through grants (sending mone as a gift) or through goods-in-
kind (food, medical supplies, blankets, etc.).
D
D is intended to help de eloping countries achie e their economic gro th and
de elopment objecti es. It ma in ol e financial support for specific projects, such as building schools,
clinics, hospitals, irrigation s stems or other agricultural infrastructure; financial support to sectors, such
as education, health care, agriculture, energ , the en ironment, or others; ec ca a a ce in the form
of technical ad ice b specialists such as doctors, teachers, agronomists, or others; as ell as debt relief
(to be discussed belo ).
As Figure 20.2 indicates, de elopment aid is e tended b donors through grants or through concessional
long-term loans as ell as debt forgi eness.
Humanitarian aid and de elopment aid are offered b both ODA and NGOs. Whene er it in ol es
financial inflo s, these enter as credits in the balance of pa ments, thus bringing in foreign e change
and helping countries offset possible deficits in their trade balance.
O D A (ODA)
O D A (ODA), all of hich is public in the sense that it comes from
go ernment funds, forms the largest part of foreign aid. Most ODA funds (nearl three-quarters) take the
form of grants.
ODA funds reach de eloping countries in three a s:
through b a e a a d, hich is the most important a funds go directl from the donor
go ernment to the de eloping countr recipient; e amples of bilateral aid agencies are USAID (US
Agenc for Internal De elopment) in the United States and DFID (Department for International
De elopment) in the United Kingdom
through a e a a d, going indirectl from donor go ernments to international organisations,
hich transfer the funds to de eloping countr go ernments
through NGOs donor go ernments transfer ODA funds to NGOs hich spend them in de eloping
countries.
The donor countries include most of the members of the Organi ation for Economic Co-operation and
De elopment (OECD), some members of the Organi ation of the Petroleum E porting Countries
(OPEC), and more recentl also some eastern European countries.
International organisations pro iding ODA include United Nations agencies; single-issue funds like the
Global Fund to Fight Aids, Tuberculosis and Malaria; the International De elopment Association (IDA,
hich is an organisation of the World Bank29), regional de elopment banks (such as the European Bank
for Reconstruction and De elopment (EBRD), the Inter-American De elopment Bank (IDB); the
International Monetar Fund (IMF) assistance for debt relief under debt relief initiati es.
D ODA
Donor countries are moti ated to pro ide aid through ODA for a ariet of reasons:
P . For e ample, during the Cold War, the United States pro ided aid
to restrict the spread of communism. The So iet Union pro ided aid to communist states as ell as
some non-communist states ith communist leanings. European po ers pro ided aid to their
former colonies. Often aid has been used to support regimes in de eloping countries that are
considered to be friendl to the interests of the donor go ernments.
E . De eloped countries often regard it to be in their interest to assist countries
ith hich the ha e strong economic ties. For e ample, much of Japan s aid is directed to ards
neighbouring countries ith hich it has strong trade and in estment links. The practice of ed a d
(to be discussed belo ), is an important e ample of economic moti es of donors.
H . Some aid is pro ided on humanitarian grounds for short-term
emergenc assistance, such as in the case of famines, ars or natural disasters. Concern about the
e tent of po ert in de eloping countries is a moti e for allocating aid funds for long-term
de elopment purposes.
As a result of these priorities of donors, aid funds do not go to the countries that need them the most. In
fact, dd e c e de e c e ece e e e a c ad e e e e e e a
e c ec e. 30
P ( ) : -
(NGO )
N - (NGO ) are the second t pe of aid flo ing into de eloping countries.
Like ODA, the in ol e concessional flo s, but the are all grants (there are no loans that must be
repaid).
The World Bank defines NGOs as pri ate organisations that pursue acti ities to relie e suffering,
promote the interests of the poor, protect the en ironment, pro ide basic social ser ices, or undertake
communit de elopment .31 NGOs are pri ate in the sense that the are not part of an go ernmental
structure; the are not pri ate in the sense of being part of the market s stem. NGOs are an e pression of
ci il societ , and as such are often referred to as comprising a third sector (the first and second being the
go ernment and market sectors).
NGOs include a ide ariet of organisations, such as charitable organisations, non-profit organisations,
nationall based groups ith a national or international reach, locall based communit groups, or
grassroots organisations, and the ma operate in de eloped or de eloping countries (or both). Among
the better-kno n international NGOs (INGOs) are Amnest International, Greenpeace, O fam, Sa e the
Children and World Wide Fund for Nature, also kno n as the World Wildlife Fund (both abbre iated as
WWF).
NGOs in de eloping countries ha e gro n massi el in numbers and in in ol ement since the 1980s. It
is estimated that de eloping countries no ha e se eral tens of thousands of a a NGOs, and se eral
hundreds of thousands of c -ba ed NGOs. A gro ing number of these no ha e consultati e
status ith United Nations agencies; from 41 in 1948, the number of NGOs ith consultati e status
toda is in the thousands. Most of these are small local groups pursuing de elopment objecti es ithin a
relati el small communit .
NGOs obtain their funds from pri ate oluntar contributions including pri ate sector corporations and,
increasingl , from bilateral and multilateral ODA funds. In other ords, more and more of ODA funds
are channelled through NGOs, particularl in the case of humanitarian assistance. The reason for this is
that NGOs can perform functions that are not performed as effecti el b national go ernments.
NGOs are in ol ed in a ast range of acti ities, including pro ision of humanitarian aid in times of
crisis, promotion of sustainable de elopment, promotion of communit de elopment, ser ice deli er ,
po ert alle iation, protection of child health, promotion of omen s rights, promotion of small-scale
entrepreneurs, support of the poor in the informal sector, pro ision of technical assistance to small
farmers, pro ision of credit to poor people (microfinance), research acti ities, political ad ocac , support
for people s mo ements, and more.
A O D A (ODA)
A
To emerge from a po ert c cle (Chapter 19), poor people and poor communities need the go ernment
to inter ene b undertaking the necessar in estments in ph sical, human and natural capital. If the
go ernment does not ha e enough ta re enues, the onl a the countr , or communit ithin a
countr , can escape the po ert c cle is through foreign aid that makes up for the lack of sa ings. Ver
poor de eloping countries do not ha e enough funds to make the necessar in estments in health care,
education and basic infrastructure to help people escape the po ert c cle. Therefore, countries can
escape the po ert c cle if foreign aid pro ides the missing funds for these in estments.
A
E en if a countr is not caught in a po ert c cle, aid can make resources a ailable for in estments in
health, education and infrastructure, hich can help poor people impro e their emplo ment
opportunities and impro e their incomes. In a number of sub-Saharan African countries, foreign aid is an
important component of social budgets. Man of these programmes contribute to significantl limiting
the incidence of pre entable diseases and reducing infant and child deaths.
A
B focusing on the most disad antaged groups in societ , aid can help impro e the relati e income
positions of the beneficiaries and contribute to impro ed income distribution.
A
There is strong e idence that aid leads to economic gro th, because it makes possible increased
in estment and consumption le els, leading to increased olumes of output.
A S D G (SDG )
The pro ision of aid is cruciall important to the achie ement of the Sustainable De elopment Goals
(SDGs). Much of aid is closel linked to the achie ement of these goals. According to the United
Nations De elopment Programme, it ill not be possible for de eloping countries to achie e the SDGs
ithout enough aid.
A ,
Countries that are hea il indebted (ha e high le els of debt) face serious negati e consequences for
their gro th and de elopment, especiall hen caught in a debt trap , here the must go on borro ing
more and more in order to ser ice old debts (see belo ). Aid for debt relief helps countries reduce their
debt burden and releases resources that can be used for po ert reduction and economic gro th and
de elopment.
F O D
A (ODA)
A number of factors limit the effecti eness of aid as a mechanism for achie ing economic and human
de elopment and po ert alle iation. The most important of these include the follo ing.
One of the most important limitations of the effecti eness of ODA funds is the practice of ed a d,
hereb donors make the recipients of aid spend all or a portion of borro ed funds to bu goods and
ser ices from the donor countr . It occurs onl in the conte t of bilateral (not multilateral) aid, and gi es
rise to se eral serious disad antages:
Recipient countries cannot seek lo er price alternati es for the goods and ser ices the are forced
to bu from the donor countr , so recipients of tied aid face higher than necessar import costs.
Ha ing to bu specific goods and ser ices from the donor countr often results in bu ing
inappropriate, capital-intensi e technologies.
Those ho benefit from tied aid are usuall large firms in de eloped countries hose goods and
ser ices the recipient countries are forced to bu . This is a kind of support for industr of de eloped
countries, occurring at the e pense of poor countr de elopment objecti es.
See Real orld focus 20.2.
The OECD defines tied aid as loans or grants offered on the condition that it be used to procure
goods or ser ices from the pro ider of the aid . It has been unsuccessfull ad ocating for the unt ing
of aid since 2001. It claims that the cost of a de elopment project can increase b 15% 30% due to
the t ing of aid, pre enting recipient countries from recei ing good alue for mone for ser ices,
goods, or orks .
The OECD notes that untied aid increased from 41% in 1999 2001 to 79% in 2018. Ho e er these
figures are disputed b the European Net ork on Debt and De elopment, hich claims that if the
informal t ing of aid is included almost half of total aid is tied. The orst offenders are the United
States ith 95% tied aid, Australia ith 93% and the United Kingdom ith 90%. According to a
senior officer,
T e c e e d a d e ce acc a a ead e b e e
a d e d acc d e ae .S a e adb d e , a
$55 b 2015. Ma eed e a ac ed e a ed a d e a
ac e e a ac e a a e a d e a e .H e e, e
a e e a ac ce a e eac . 33
In response to OECD recommendations that member countries untie aid, Japan responded b arguing
that tied aid is more likel to recei e public support in donor countries . . . hich in turn helps us
increase the support of public funds to ards de elopment. 34
F 20.3: Port Sudan. A docker unloads a bag of sorghum (cereal) from a ship carr ing
humanitarian aid supplies pro ided b the US aid agenc USAID; the shipment ill be distributed
to o er a million Sudanese in need of assistance
A
Research a de eloping countr of our choice that is highl dependent on foreign aid. In estigate
hether an of this is tied aid, e plore the consequences.
S : INQUIRER;
E dad ;
De e
C ( )
Most donors of ODA impose numerous conditions that must be met b the recipients of aid. Donors see
these conditions as a mechanism for forcing de eloping countries to make important polic changes, as
ell as for ensuring that aid funds are used effecti el . The kinds of conditions ar from requiring the
recipient to pursue policies to achie e a greater market orientation (such as pri atisation, elimination of
trade barriers, etc.), to forcing the recipient to accept particular projects that the donors decide on.
Conditional lending creates disad antages for de eloping countries. Donors do not pa sufficient
attention to the preferences of the go ernment or of the population groups the project is intended to
benefit. Polic prescriptions b donors ma be incorrect; the ma not fit in ith the go ernment s
de elopment strateg and priorities; and the ma eaken the recipient go ernment s authorit and
accountabilit to its citi ens.
A
The flo of aid funds (particularl bilateral flo s) into de eloping countries is olatile (unstable) and
unpredictable. This is partl due to changing olumes of aid in donor budgets, and changing donor
priorities on ho to allocate aid funds. This makes it difficult for recipient go ernments to implement
policies that depend on aid funds, as the cannot be sure if and hen funds ill be a ailable to undertake
necessar in estments and acti ities. In er poor countries that depend hea il on aid for pro ision of
basic ser ices (such as education or health care ser ices), disruptions in aid flo s can ha e er serious
effects on the elfare of the population groups affected b the aid cuts.
In an recipient countr there are usuall large numbers of donors (bilateral and multilateral) ho
finance uncoordinated acti ities, gi ing rise to numerous inefficiencies in the use of aid resources.
Sometimes the numbers of aid-funded projects are in the hundreds. Lack of co-ordination of such
projects results in o erlapping and duplication of some projects, inconsistencies bet een other projects,
and the lack of coherence in the entire aid effort.
A
Aid resources are intended to supplement insufficient domestic resources. A possible danger is that
go ernments in recipient countries ma use aid funds to substitute for domestic resources, and not make
enough effort to increase domestic re enues through ta ation. The e idence on this issue is mi ed;
hereas some countries ha e been unable to increase ta re enues in spite of gro th, others ha e
succeeded in increasing ta re enues e en as aid increases rapidl .
A
Aid resources are not allocated on the basis of the greatest need for po ert alle iation. Donors do not
allocate aid resources according to countr needs, focusing instead on promoting their o n interests. As
noted b the US Congressional Research Ser ice, aid can act as both carrot and stick and is a means of
influencing e ents, sol ing specific problems and projecting US alues .32 In addition, recipient countr
go ernments ma not be genuinel committed to po ert alle iation; the ma lack the necessar
e pertise to design and implement po ert alle iation policies; tied aid ma fa our projects that are not
appropriate for po ert alle iation; donors ma select projects that are not the most effecti e from the
point of ie of po ert alle iation.
A
Corruption in ol es misuse of aid funds b recipient countries, and is a ke problem associated ith the
pro ision of aid. Corruption is a reflection of the degree of transparenc and accountabilit in public
affairs, and tends to be more prominent the lo er the e ca a income of a countr .
SDG 17.1 (goal 17, target 2) states De eloped countries to implement full their official de elopment
assistance commitments, including the commitment b man de eloped countries to achie e the target
of 0.7 per cent of ODA/GNI to de eloping countries . . .
Donors ha e repeatedl promised to allocate 0.7% of their GNI for ODA, ho e er onl a fe meet this
target. Since those that do not are among the larger and ealthier donors, it means that o erall ODA
funds are far less than the target amount. If rich countries fail to follo through on their commitments,
de eloping countries ill be unable to make the in estments in health, education and infrastructure
needed to impro e elfare and support the econom on the scale required to achie e the SDGs.
A NGO: NGO
More and more bilateral and multilateral donors of ODA are channelling their funds through NGOs
because of their abilit to perform some functions better than de eloping countr go ernments. The
reasons for better performance include:
S -
NGO acti ities are for the most part concerned ith reaching poor people and helping them emerge from
their po ert . Go ernments often ha e difficulties in reaching the er poor; NGOs ha e an ad antage
b orking er closel ith communities of poor people and responding to their particular needs as
these arise in their o n particular economic, social and en ironmental conditions.
One of the strongest ad antages of NGOs is that the ork closel ith their beneficiaries, in ol ing
local people in the design and implementation of de elopment projects. In ol ement b local people
allo s them to participate in deciding hat problems should be addressed and ho the should be
sol ed, and gi es them a sense of o nership and commitment to the project, contributing greatl to
success.
C ,
Such participator practices contribute to a process of democratisation, hich can be important in

countries that do not ha e democratic institutions. Poor people usuall lack political oice and
representation, and their concerns are not heard at higher go ernment le els. NGOs pla an important
leadership role in acting as ad ocates on public polic issues, and ensuring that poor people s concerns
are heard.
O
International NGOs accumulate e perience from a ariet of countries and local settings, man of hich
ma be rele ant and transferable to similar settings in other countries. The recruit e perts in a ariet of
areas in accordance ith need, and the e perts are highl moti ated out of a strong commitment to the
objecti es of the NGO ith hich the are affiliated.
A
Unlike go ernments, hich often take a uniform approach to problems, NGOs, b orking closel ith
their beneficiaries, can be more creati e and inno ati e in de ising solutions to er specific problems
that arise in local settings.
NGOs ha e a greater freedom than go ernments to use their e pertise and technical kno ledge to assess
problems independentl and arri e at suggestions for solutions. NGOs also enjo more freedom because
their acti ities are not subject to the conditions often imposed b donors of aid (conditionalit ); and the
are not subject to the restrictions associated ith tied aid.
E
Poor people are often highl suspicious and mistrusting of go ernment officials and administrators,
feeling at best neglected and at orst e ploited. NGOs sometimes enjo greater trust than go ernments,
because of their close relationship ith project beneficiaries, and their commitment to sol ing problems
at grassroots le el.
C NGO
S NGO
NGOs ma be too small and eak to be able to pla an important role as agents of change and
de elopment. The often ha e limited resources, and ma face difficulties in attracting skilled personnel,
so that the effecti eness of their projects ma be limited.
One of the potential strengths of NGOs is their abilit to act independentl , free of constraints imposed
b go ernments, aid agencies, and bilateral and multilateral donors. Ho e er, as the become more and
more dependent on these outside sources for their funding, the ma lose their independence if the are
forced to conform to the demands of funders.
NGO
The gro ing role of NGOs in de elopment creates a demand for technical e perts and personnel that
ma depri e go ernments of scarce highl qualified personnel, as NGOs are often in a position to offer
higher salaries and benefits than the go ernment.
C
Whereas go ernments generall elcome NGOs that complement their acti ities in po ert alle iation,
the often dislike the ad ocac role taken on b man NGOs, hich ma conflict ith go ernment
polic or question its authorit .
The consensus ie on NGOs o erall is fa ourable. Ho e er, NGOs must act in partnership ith
go ernments, and must not be considered to be a replacement of go ernment. Go ernments ha e crucial
roles to pla in the de elopment process, hich NGOs, e en under the most fa ourable circumstances,
cannot possibl undertake. Go ernments are essential for establishing an o erall polic frame ork for
the econom , including a frame ork for sustainable de elopment; for pro iding a legal, institutional and
regulator frame ork for the econom ; for pursuing policies to ensure economic stabilit ; and for
correcting market failures.
An e ample of an NGO, the Grameen Bank, hich pro ides credit to poor people in Bangladesh, is
discussed in Real orld focus 20.3.
D
SDG 17.4 (goal 17, target 4) states Assist de eloping countries in attaining long-term debt sustainabilit
through coordinated policies aimed at fostering debt financing, debt relief and debt restructuring .
In Chapter 19 e sa h indebtedness is a major barrier to gro th and de elopment. In 1982,
follo ing the buildup of large amounts of debt, the international communit stepped in ith a series of
measures to pre ent de eloping countr defaults. These measures included debt restructuring, in ol ing
ne loans b commercial banks on better terms, such as granting ne loans that ere stretched out o er
longer periods at lo er interest rates. The loans ere used to pa off some of the old loans, and therefore
ease the pain of ha ing to ser ice the debts. The IMF ga e loans that ould help co er large and
gro ing current account deficits. The loans ere c d a in that the ere made onl if the
borro ing countr go ernment agreed to pursue policies prescribed b the IMF including tight fiscal and
monetar policies, liberalisation policies and market-based suppl -side policies (see abo e). The World
Bank also made conditional loans, hich also forced the borro ing countr go ernment to pursue
economic and trade liberalisation policies to qualif for recei ing a loan.
In 1996, the World Bank and IMF began the Hea il Indebted Poor Countries (HIPC) Initiati e,
intended to pro ide debt relief to some highl indebted poor countries b cancelling a portion of their
e ternal (foreign) debts. The objecti e as to ensure that no poor countr faces a debt burden it cannot
manage .35 In 2005, this as supplemented b the Multilateral Debt Relief Initiati e (MDRI) hich
pro ides 100% debt relief for debts b the World Bank, IMF and other multilateral institutions).
To qualif for debt cancellation, countries must:
ha e a e ca a GNI belo a particular le el
ha e a debt le el that cannot be sustained (i.e. the must be in a debt trap)
sho e idence that the are follo ing certain elements of IMF and World Bank policies (such as
cutting go ernment e penditures and liberalising their markets)
commit themsel es to pursuing a po ert reduction strateg .
As of 2019, there ere 39 countries eligible to recei e HIPC assistance, of hich 36 ere full debt
relief.
Debt relief under the HIPC frees up resources that can be spent for de elopment purposes, since the
countr s sa ings from debt reduction must be spent on projects that attack po ert . These include
de elopment of rural infrastructure, pro iding health ser ices and education, creating ne jobs, and
pro iding famil planning ser ices. In addition, debt reduction is made part of a broader de elopment
effort hich ensures that more mone is directed to the needs of the poor than just the sa ings from debt
reduction. The result is that spending on health, education and other social ser ices is on a erage about
fi e times the debt-ser ice pa ments that are sa ed.
The HICP Initiati e is considered to be a elcome step in the direction of sol ing the debt problem, but
has been criticised for se eral reasons:
Some of the bilateral creditors ha e not pro ided an relief and the rate of deli er of funds remains
lo . Their participation is oluntar so the cannot be forced to pro ide funds.
The programme takes effect too slo l , risking that the benefits of debt relief ma follo too
slo l to be of much use to the countries.
Some measures that are imposed as conditions for a countr to qualif are too se ere, including for
e ample, charging fees for schools and hospitals, pri atising ke public enterprises such as
electricit and telephone, reductions in go ernment e penditures that reduce the pro ision of social
ser ices and infrastructure.
There are man other countries that are highl indebted but hich ha e not been included in the
HIPC Initiati e; these countries, hose debt situation is considered to be more manageable, are not
poor enough or indebted enough to qualif for assistance, et still suffer the consequences of high
le els of debt, but unable to benefit from debt relief.

1 Define foreign aid, using the concept of concessional flo s.
2 Distinguish bet een
ODA and NGOs, and
humanitarian aid and de elopment aid, e plaining in each case hat these consist of.
3 E plain some reasons h foreign aid ma be important to the gro th and de elopment of poor
countries.
4 E plain the meaning of tied aid and the reasons it limits the effecti eness of aid.
Describe some other factors that limit aid s effecti eness.
5 Outline the kinds of acti ities NGOs support in de eloping countries.
Suggest reasons h more and more ODA is channelled through NGOs.
Discuss strengths and eaknesses of NGOs.
6 Discuss arguments
in fa our of foreign aid, and
against foreign aid.
7 E plain
the meaning of debt relief, and
some ad antages of debt cancellation for hea il indebted countries. (You should refer to
Chapter 19.)
8 Discuss some criticisms of the HICP Initiati e.
The International De elopment Association (IDA) is part of the World Bank but it offers the poorest of
29 de eloping countries concessional loans, i.e. soft loans unlike World Bank loans, hich are e tended on
commercial terms.
30 Financing the end of e treme po ert
31 The World Bank, Operational Directi e 14.70, 28 August 1989.
32 As a s stem, foreign aid is a fraud and does nothing for inequalit
33 Eurodad
34 OECD pushes fi on untied aid, Japan pushes back
35 Debt Relief Under the Hea il Indebted Poor Countries (HIPC) Initiati e
20.7 M a a a a
LEARNING OBJECTIVES

explain and evaluate the roles of (AO3)
the World Bank.
International Monetary Fund (IMF)
M a a a a involves lending to developing countries on non-conce ional

terms, in other words with rates of interest and repayment periods determined in the market.
There are a number of major multilateral lenders to developing countries such as:
multilateral development banks, which lend in order to support economic growth and development,
including the:
World Bank
African Development Bank
Asian Development Bank
Inter-American Development Bank
European Bank for Reconstruction and Development
the International Monetary Fund (IMF), which lends in order to alleviate external payments
difficulties.
Lending by both multilateral development banks and by the International Monetary Fund differ from
commercial bank lending because they are involved with lending for economic development or
international financial stability, rather than for commercial or profit reasons.
T W Ba
The W Ba is a development assistance organisation that extends long-term loans to developing
country governments for the purpose of promoting economic development and structural change. It was
established in 1944, at the end of the Second World War, as part of an effort to help reconstruct Europe.
Its activities were extended to developing countries from the late 1950s when European reconstruction
was completed. It is composed of 189 member states that are its joint owners. It consists of two
organisations:
the International Bank for Reconstruction and Development (IBRD), which lends on non-
concessional (i.e. commercial) terms to middle income developing countries, therefore its activities
and lending do not form part of foreign aid; by far the greatest part of World Bank lending for
development purposes (about 75%) is offered by the IBRD, and for this reason the World Bank, for
the most part, is not considered to be an aid agency.
the International Development Association (IDA), established in 1960, which has similar activities
to the IBRD but extends loans to lo income co n ie on highly concessional terms.
The IBRD and IDA are complemented by three additional organisations, that focus mainly on private
investments in developing countries.36
The importance of the World Bank as a development assistance organisation lies mainly in its role as a
lender of funds to governments, and therefore focuses on the roles of the IBRD and IDA.
B W Ba a
In the early years of its involvement with developing countries, the World Bank focused on lending for
the development of infrastructure, such as energy, transport, telecommunications and irrigation.
By the early 1970s, the World Bank had turned its attention towards poverty alleviation. It grew
enormously through an expansion of its funding and technical personnel, and greatly stepped up its
lending to developing countries. It redirected a portion of its lending towards poverty alleviation,
promising to help the poorest 40% of developing country populations through projects focusing on water
supplies, sanitation, education, health, employment, and more.
At the end of the 1970s and in the early 1980s, the Bank s focus changed once more to a new type of
lending: c al adj men loan (SAL ) intended to change the course of policy-making in
developing countries by reducing government intervention and promoting competition and the role of
markets. It was believed that a strong market orientation of the economy would help developing
countries expand their exports and increase their rates of growth.
Loans were intended to provide assistance in areas like the removal of price controls; interest rate
liberalisation (freeing up of interest rates); trade liberalisation (lowering and eliminating tariff and other
barriers to trade); eliminating restrictions to new foreign direct investments (by multinational
corporations); privatisation (aimed at reducing the si e of the public sector); deregulation (aimed at
increasing the scope of market forces); cuts in government spending (to reduce budget deficits); and
others. Acceptance of the measures included in the loans was a condition that had to be met in order for a
country to qualify for a loan.
By the 1990s, SALs had come under very strong and widespread criticism because of their negative
consequences on developing country economies. (See the section above The effec of economic and
ade libe ali a ion.)
C W Ba a
Since the mid-1990s, the World Bank has again shifted towards a poverty orientation, and has committed
itself to helping countries achieve first the Millennium Development Goals and more recently the
Sustainable Development Goals. Its poverty-oriented projects are meant to be environmentally
sustainable; they must not give rise to environmental destruction, and whenever possible they must also
improve upon the quality of the environment.
In addition, the World Bank has changed its views on the appropriate role of government in economic
growth and development. According to the new perspective, poverty alleviation requires intervention by
governments in many areas: education, health care, public health, infrastructure (water, sanitation,
transport, irrigation, and many others); access to credit by the poor; land reforms for a more equitable
distribution of agricultural land; policies to reverse environmental degradation; policies to help the poor
escape the poverty cycle; policies to promote gender equity. (These issues had been ignored by SALs,
with negative consequences for income distribution, poverty and the environment.)
The World Bank is also paying increasing attention to the need for institutional development, based on
the idea that markets need institutions that provide education and health services; ensure availability of
and access to necessary infrastructure (water, sanitation, transport, etc.); provide an effective and
equitable taxation system; ensure access to credit by all who need it; secure property and land rights;
minimise the possibilities for the exercise of corruption; empower women and other disadvantaged
groups; promote appropriate technology development and innovation; give a political voice to the
economically weak; ensure and promote competition; and more.
E a a W Ba
Some of the more important issues include the following:
S a a a . In the early years it was criticised for implementing socially
unsound projects (such as building hydroelectric dams that displace indigenous people), as well as
environmentally unsustainable projects (such as building infrastructure that destroys the natural
environment and local ecosystem). In recent years, the World Bank has become far more aware of
the social and environmental implications of the projects it funds, and currently makes greater
efforts to ensure that project objectives are consistent with the SDGs.
W Ba a a b . The World Bank is owned by its 189
member states; however, voting power in its governance is determined by the si e of financial
contributions made by each country to the organisation, which are in proportion to the si e of each
economy, giving far greater power to rich countries. Critics argue that decisions are made without
due regard for the needs and wishes of developing countries.
E a a . Critics argue that the World Bank interferes
excessively in the domestic policy affairs of developing countries.
C a a a ( ). Conditional assistance (or conditional lending) refers to the
imposition of conditions that must be met by borrowing countries to qualify for a loan. (It is also
one of the problems of foreign aid; see above.) The imposition of conditions is a mechanism for
inducing policy changes. It is problematic because it deprives countries of control over their
domestic economic activities.
I a a a a a . Although the World Bank has in recent years turned
its attention to poverty issues, critics argue that it is not doing enough to meet the challenges of
extreme poverty in developing countries by not allocating enough funds for loans intended to meet
the needed investments in education, health services, and infrastructure (clean water supplies,
sanitation, etc.). In addition, it has been criticised for not doing enough in the area of debt relief
through the Heavily Indebted Poor Countries (HIPC) Initiative (see above).
E a -ba - . The World Bank s Wo ld De elo men
Re o , 2019 has been criticised by the International Labour Organi ation for focusing excessively
on increasing flexibility in labour markets, which in the ILO s opinion is not necessary, while
ignoring the negative effects on workers37 (see Chapter 13). Further it has been criticised for
encouraging land grabs through privatisations and land takeovers that displace poor farmers (see
Chapter 19).
T I a a M a F
The I a a M a F is a multilateral financial institution that was established jointly
with the World Bank in 1944 with the original purpose of lending to countries experiencing balance of
payments deficits under the system of fixed exchange rates that existed at the time. Its objectives have
changed over the years in accordance with the evolution of the international financial system. At the
present time, the IMF is composed of 189 member countries. Its purpose is to oversee the global
financial system, follow the macroeconomic policies of its member countries, stabilise exchange rates
and help countries that experience difficulties making their international payments by extending them
short-term loans on commercial (i.e. non-concessional) terms.
A I a a M a F
In the first two decades of IMF s existence, more than half of its lending was to developed countries. Its
role in developing countries grew with the debt crisis beginning in the 1970s and 1980s. This was the
time when many poor oil-importing countries developed serious balance of payments difficulties as a
result of dramatic increases in oil import expenditures. During the 1990s, the IMF expanded its lending
to transition economies in central and eastern Europe and the former Soviet Union. Since 2008 its
lending has increased significantly to countries around the world as a result of international payments
difficulties brought on by the global financial crisis, including some developed countries (Greece,
Iceland, Ireland, Portugal).
The loans provided by the IMF usually come with a package of policies that the country must adopt as a
condition for receiving the loan (another example of conditionality). These policies, known as
abili a ion olicie , vary from country to country, but typically include the following:
contractionary monetary policy, through increases in interest rates, intended to lower aggregate
demand, reduce the level of economic activity and reduce demand for imports while encouraging
inflows of financial capital, thereby helping the balance of payments position
contractionary fiscal policy, also intended to lower aggregate demand and reduce the level of
economic activity, through cuts in government spending (including cuts in provision of merit goods,
such as health services, education, infrastructure, etc.) and cuts in food and other subsidies, as well
as increases in taxation, and the imposition of fees for schooling and health care services38
currency devaluation or depreciation, intended to discourage imports and encourage exports and
help the balance of payments position
cuts in real wages (i.e. wages after taking into account the impact of price changes) to lower costs
of production as a market-based supply side policy
liberalisation policies, such as eliminating or reducing controls on prices, interest rates, imports and
foreign exchange, to promote a free market and free trade environment.
E a a I a a M a F
The IMF is far more controversial than the World Bank, and is subject to more intense criticism due to
the negative impact on countries resulting from its stabilisation policies. While it shares some of the
criticisms against the World Bank, the main criticism focuses on the harshness of the measures imposed
on borrowing countries.
IMF a a b . As with the World Bank voting power in its
governance is in proportion to the si e of each economy, giving rich countries far greater power in
decision-making.
E a a . Even more than in the case of the World
Bank, critics argue that IMF interference in domestic economies is too great.
C a ( a ). Countries have been forced to accept harsh conditions
running counter to their growth and development objectives.
Da a . Stabilisation policies have the impact of lowering
economic growth, often creating a recession with increasing unemployment and increasing levels of
poverty. Cuts in real wages where wages are low to begin with, cuts in government spending on
merit goods and food subsidies on which many poor people depend for their physical survival, the
imposition of fees for schooling and health care services among people who cannot afford them,
along with the increases in poverty that arise from liberalisation policies, are wholly inconsistent
with economic growth and development objectives, with huge human costs.
IMF ab a ba a a . Some economists argue that in addition to
the human cost, there may be something fundamentally wrong with the IMF s approach. Experience
shows that many countries that have tried the IMF programme suffer not only increasing poverty
but also low or negative rates of growth, and therefore are unable to grow out of their balance of
payments difficulties or external debt problems. (See Real world focus 17.1.)
It should be noted however that in recent years there are indications that the IMF has moderated the
harshness of its policies. An article entitled Neoliberalism: Oversold? 39 states
In ead of deli e ing g o h, ome neolibe al olicie ha e inc ea ed ine ali , in n
jeo a di ing d able e an ion
Referring to three disquieting conclusions the article states that
The benefits in terms of increased growth seem fairly difficult to establish when looking at a broad
group of countries.
The costs in terms of increased inequality are prominent . . . .
Increased inequality in turn hurts the level and sustainability of growth. Even if growth is the sole
or main purpose of the neoliberal agenda, advocates of that agenda still need to pay attention to the
distributional effects.
The last point is confirmed by a series of studies by the IMF noted in Chapter 12 (Section 12.4). It
therefore appears that the IMF may be rethinking its policies.

1 The lending activities of multilateral organisations such as the World Bank and IMF are
sometimes referred to as foreign aid . Outline why this is mostly an incorrect use of the term
foreign aid .
2 a Explain the role of the World Bank in developing countries.
b Outline why many of its lending programmes have come under criticism.
Evaluate the role of the World Bank as a development assistance organisation.
3 a Describe the role of the International Monetary Fund.
b Explain why it is unpopular in countries to which it lends.
Evaluate the role of the International Monetary Fund in its aim to assist countries with balance
of payments difficulties.
36 These are the International Finance Corporation (IFC), International Centre for Settlement of Investment
Disputes (ICSID), and Multilateral Investment Guarantee Agency (MIGA).
37 International Labour Office expresses concern about World Bank report on future of work
38 Countries with serious balance of payments problems also typically face large government budget deficits (an
excess of government spending over government revenues), and so an additional objective of these policies is
to reduce government spending and increase revenues in order to reduce the si e of the budget deficit.
39 Neoliberalism: Oversold?
20.8 I
LEARNING OBJECTI ES

e plain and e aluate strategies to (AO3)
impro e access to banking including
microfinance
mobile banking
increase omen s empo erment
reduce corruption
establish propert rights and land rights
SDG 16 states Promote peaceful and inclusi e societies for sustainable de elopment, pro ide access to
justice for all and build effecti e, accountable and inclusi e institutions at all le els .
M
SDG 1.4 makes reference to ic fi a ce as one of items that all men and omen, particularl the poor
and ulnerable, should ha e equal access to.
M , commonl kno n as ic c edi , refers to credit (loans) in small amounts to people ho
do not ordinaril ha e access to credit. Micro is the Greek ord for small ( ), and refers to the
small amounts of the loans, the er small si e of businesses or acti ities that are financed b the loans
( micro-enterprises ) and the short repa ment periods in ol ed.
Microcredit is deli ered to poor people through ic fi a ce i i i (MFI ), hich include a ide
ariet of organisations such as credit unions, financial non-go ernmental organisations (NGOs),
informal sa ings and loan groups, and e en some commercial banks ith special programmes for the
poor.
Microcredit schemes first appeared in the 1970s as isolated, e perimental programmes pro iding tin
loans to groups of poor omen lacking collateral, ho in ested the borro ed funds in micro-enterprises.
As there as no collateral for the loans, loan repa ment as ensured and enforced b a guarantee
pro ided for each member b e er other member in the group. These kinds of programmes ere
e panded during the 1980s and 1990s, and re ealed that the poor (particularl omen) ere capable of
e cellent repa ment rates, and ere able to pa interest rates high enough to allo the MFIs to co er all
their costs. Microcredit schemes ha e e ol ed and no pro ide a great ariet of programmes
depending on the t pe of MFI and t pe of borro er.
MFIs lend to a ide ariet of borro ers: micro-enterprises (street endors, carpenters, seamstresses,
and man others, most of hom are in the informal econom ), as ell as landless rural orkers, small
farmers, female heads of households, pensioners and displaced persons. The tend to target omen
because omen ha e pro ed to be more likel than men to repa loans, and also because the are more
likel to use the earnings from their in estments to impro e the famil s ell-being.
The e idence on microcredit schemes indicates that these ha e a positi e impact on po ert reduction.
The result in higher incomes, more stable incomes, as ell as impro ements in health, nutrition and
primar school attendance. The also result in an impro ed social and economic status of omen.
Microcredit schemes reach onl a er small proportion of poor people as there are not enough
microcredit schemes and MFIs.
C
Although most de elopment economists belie e that microcredit fills an important gap in access to credit
b poor people, man also point out that microcredit schemes carr certain dangers that must be
addressed:
M -
. There ma be a danger that microcredit ma be ie ed as a substitute for other,
complementar go ernment policies needed to combat po ert that are the responsibilit of the
public sector. For e ample, go ernment has a role to pla in the pro ision of merit goods, including
education, health care ser ices and infrastructure. Poor people should not ha e to borro to be able
to pa for health care and education, and no amount of borro ing b poor people ill produce the
needed in estments in infrastructure (sanitation, clean ater supplies, transport, etc.). Similarl ,
go ernment must pro ide protection for people ho are disabled, ph sicall or mentall ill,
displaced (due to ar or other conflict) or in other ulnerable groups, as these people are not
appropriate clients for micro-credit.
M . The micro-enterprises
that are created through micro credit operate for the most part in the informal econom , hich is
unregulated, here orkers ha e no social protection, and here e ploitati e conditions often
pre ail. Microcredit encourages the gro th of this contro ersial sector.
S . The poorest
of the poor usuall lack skills of all kinds, including skills necessar to begin a micro-enterprise
such as basic literac and numerac skills. In such cases, microcredit ma end up burdening some
e tremel poor people ith pa ments on loans that cannot produce a stable source of income. In
ie of this risk, some microcredit schemes tr to integrate credit ith the pro ision of education
so that borro ers ill acquire the skills required to use their loans effecti el .
I . Interest rates in microcredit schemes tend to
be higher than market rates of interest (although the are much lo er than in informal credit
markets, such as mone lenders). The costs of pro iding er man , er small loans are higher than
the costs of pro iding fe er large loans. High interest rates are necessar if MFIs are to be able to
co er the costs of pro iding micro credit. Some economists argue that the high interest rates should
be subsidised to make repa ment easier for er poor people. Yet donor funds are neither sufficient,
nor reliable enough, to be able to co er interest rate subsidies and at the same time allo micro
credit schemes to keep on gro ing. A compromise ould in ol e creating programmes that offer
subsidised interest rates onl for the poorest borro ers.

M , G B , 2006 N P P
In 1976, Professor Muhammad Yunus of the Uni ersit of Chittagong in Bangladesh initiated a
project e amining hether it ould be possible to pro ide banking ser ices for the rural poor. Kno n
as the Grameen Bank project ( grameen means illage or rural in the Bangla language), it began
making loans to er poor people ho had no collateral. At that time, man people belie ed that the
poor could not find pa ing occupations, and ould be unable to pa back loans. The highl successful
Grameen project contradicted these beliefs and demonstrated the tremendous potential that e tension
of credit to poor people has as a strateg for alle iating po ert .
O er the course of a fe ears, the original Grameen project spread to se eral districts of Bangladesh,
and in 1983 it as made an independent bank de oted to pro iding loans to rural poor ho lacked
collateral. From the most modest beginnings, consisting of $27 lent b Muhammad Yunus to a group
of er poor people, Grameen Bank no consists of a fe thousand branches ith millions of
borro ers. In 2006, the Nobel Peace Pri e as a arded in t o equal parts to Muhammad Yunus and
Grameen Bank, in recognition of their efforts to promote economic and social de elopment through
the e tension of microcredit to the er poor. As the Nobel Committee pointed out, Grameen Bank
has been a highl inno ati e programme, and a source of ideas and models borro ed b man
institutions around the orld in ol ed ith microcredit, and has moreo er sho n that microcredit is a
major eapon in the fight against po ert .
F 20.4: Ne York, USA. Muhammad Yunus speaks onstage during the Whitaker Peace and
De elopment Initiati e on 27 September 2019
As Muhammad Yunus tells us, these are some of the principles on hich Grameen Bank s lending is
based:
Credit is ie ed as a human right.
Its mission is to help poor families help themsel es to o ercome po ert .
It is targeted to ards the poor, particularl omen.
Lending is not based on collateral, or legall enforceable contracts, but rather on trust.
A main objecti e is to create self-emplo ment in income-generating acti ities such as rice
husking, machine repairing, purchase of milk co s and goats, simple manufacturing such as
potter , ea ing, garment se ing, simple storage, marketing and transport s stems, as ell as
housing.
High priorit is gi en to the formation of human capital and en ironmental protection,
communit organisation and de elopment, as ell as the de elopment of leadership and financial
management skills.
It is estimated that those ho ha e benefited most from Grameen borro ing are the landless poor,
follo ed b er small lando ners. O er time, incomes ha e risen more for Grameen borro ers than
nonborro ers. There is also a shift a a from age labour ( here orkers are emplo ed b someone
else ho pa s them a age) and to ards self-emplo ment in micro-enterprises. Man omen ha e
impro ed their status, ha e become less dependent on their husbands, and ha e become successful
micro-entrepreneurs.
S : Ada ed f he G a ee F da i eb i e
A
1 Identif a countr here groups of poor people ha e benefited from microfinance. Identif
possible ad antages and disad antages of microcredit.
Muhammad Yunus has gi en numerous inter ie s o er the ears about his ork in microcredit.
2 Summarise some of his ke ie s based on one or more of these.
M
M in ol es the use of mobile telephones to recei e or send mone and to pa bills. It has
been made possible b ad ances in mobile technolog that allo ed mone ser ices to gro rapidl .
Globall , 53% of adults do not ha e access to formal financial ser ices. These ar from a high of 80%
in sub-Saharan Africa, 65% in Latin America, 68% in the Middle East, 59% in east and southeast Asia,
to 58% in south Asia. This should be contrasted ith 8% in high income OECD countries.40
In most de eloping countries there are more people ho ha e mobile phones than ha e bank accounts.
The ad antages offered b mobile banking include:
ease of making pa ments to famil and businesses ith instant access and no dela s in making or
recei ing pa ments
a oidance of ha ing to tra el long distances holding cash hich ma be stolen
reduced costs of transferring mone
stronger links bet een relati es or businesses in rural and urban areas
easier to pa orkers deli ering aid to geographicall remote areas
easier to get loans, insurance and other ser ices that facilitate opening a business
easier to stretch out pa ments for purchases of equipment needed for a business
helps omen e pand their range of acti ities such as lea ing subsistence farming and beginning
small businesses
ease of bu ing inputs for businesses ithout ha ing to tra el long distances to pa for them
due to all of the abo e, mobile banking makes a major contribution to ard po ert reduction.
Challenges of mobile banking include:
net ork problems, causing dela s
cost of the ser ices, hich is high in relation to er lo incomes especiall in rural areas, though
generall lo er than banking ser ices
inabilit of some older people to read, hich makes them more susceptible to fraud.
SDG 5 states Achie e gender equalit and empo er all omen and girls . While omen account for
half the orld s population, the represent 70% of the orld s poor and the earn 10% of the orld s
income.41 See Chapters 18 and 19 for further information on the problem of gender inequalities.
P ( )
For man ears, economic de elopment and po ert alle iation efforts made no distinction bet een the
se es ith regard to their implications for gro th and de elopment. Since the 1980s and 1990s,
de elopment economists ha e realised that omen s empo erment has enormous effects on gro th and
de elopment, e tending be ond the omen themsel es. These e ternal benefits can be thought of as
consumption e ternalities of omen s health and education, anal sed as standard health and education
e ternalities:
I . Increased education of
omen has major positi e effects on the health of children, because of impro ed kno ledge about
health, health ser ices, basic h giene and nutrition. Increased education of men leads to a smaller
impro ement in children s health. Also, increases in omen s income le els ha e a greater positi e
effect on their children s health than increases in men s incomes.42
I . Mothers ha e a major influence o er the
education of their children, and studies sho that the more educated the mother, the more educated
the children. As in the case of health, increases in men s education ha e a smaller impact on their
children s education. Further, increases in omen s incomes also ha e a greater impact on their
children s education than increases in the incomes of men.
Q . The impacts of increased education and incomes of omen on le els
of health and education of their children ha e enormous cumulati e effects on the qualit of human
resources in a countr that e tend o er man ears, ith the potential to affect profoundl the
course of economic gro th and de elopment, as ell as human de elopment. De elopment policies
that focus on impro ing the education of omen also ha e a major potential to help poor families
and communities break out of the po ert c cle.
L ( ). Increased education of omen, more and better ork outside
the home, and higher incomes lead to ha ing fe er children, because of later marriage and greater
reproducti e choice, and therefore lo er population gro th, ith all its related benefits (see Real
orld focus 19.1, Chapter 19).
The Nobel Pri e- inning Indian economist Amart a Sen ie s omen as acti e agents of change . Sen
rites that the role of omen is one of the more neglected areas of de elopment studies, and one that is
most urgentl in need of correction . Nothing toda in the political econom of de elopment is as
important as an adequate recognition of political, economic and social participation and leadership of
omen .43 Reflecting this idea, the UNDP has de eloped a composite indicator, the Gender Inequalit
Inde (GII), measuring gender differences in arious dimensions (see Chapter18).
In the 1990s, the United Nations Population Fund (UNFPA) identified the follo ing policies to eliminate
inequalities bet een omen and men that are still highl rele ant toda . 44
Establishing mechanisms for equal participation and representation b omen in the political
process.
Promoting education, skill de elopment and emplo ment hile gi ing top priorit to elimination of
po ert , illiterac and poor health.
Impro ing omen s abilit to earn income be ond traditional occupations, hile ensuring equal
rights in the labour market.
Eliminating iolence against omen.
Eliminating all discrimination against omen, including discriminator practices b emplo ers.
Making it possible for omen to combine childbearing and child rearing ith participation in the
labour force.
SDG fi e, Achie e gender equalit and empo er all omen and girls , repeats man of the abo e
points, noting that
P idi g e a d gi l i h e al acce ed ca i , heal h ca e, dece k, a d
e e e ai i li ical a d ec ic deci i - aki g ce e ill f el ai able ec ie
a d be efi cie ie a d h a i a la ge. I le e i g e legal f a e k ega di g fe ale
e ali i he k lace a d he e adica i f ha f l ac ice a ge ed a e i c cial
e di g he ge de -ba ed di c i i a i e ale i a c ie a d he ld. 45
R
SDG 16.5 (goal 16, target 5) states Substantiall reduce corruption and briber in all their forms .
The problem of corruption as a barrier to gro th and de elopment as e plained in Chapter 19. The
International Monetar Fund (IMF, discussed abo e) notes that the fight against corruption requires
political ill to create strong fiscal institutions that promote integrit and accountabilit throughout the
public sector .46 The follo ing policies are recommended:
De elop high le els of transparenc and independent e ternal scrutin hich allo s audit agencies
and the public to pro ide super ision. For e ample Columbia, Costa Rica and Paragua use an
online platform here citi ens can monitor ph sical and financial progress of public in estment
projects.
Reform institutions of ta administration.
Build a professional ci il ser ice, based on transparent, merit-based hiring and pa .
Focus on areas here there is a higher risk of corruption, such as procurement, re enue
administration and natural resource management.
Cooperate ith other countries to make it more difficult for corruption to take place across borders.
For e ample more than 40 countries made it a crime for companies to pa bribes to secure business
abroad.
The World Bank tries to help countries fight corruption b :47
Establishing institutions and incenti es to pre ent corruption from occurring.
Creating mechanisms that discourage corruption b pro iding penalties and sanctions.
Influencing the de elopment of perceptions of the t pe of go ernance needed for long term efforts
to fight corruption.
P
SDG 1.4.2 (goal 1, target 4, indicator 2) states Proportion of total adult population ith secure tenure
rights to land, ith legall recogni ed documentation and ho percei e their rights to land as secure, b
se and b t pe of tenure . This is a measure of equal rights to economic resources, particularl b the
poor and ulnerable (target 4).
Propert rights and land rights ere discussed in Chapter 19. The establishment of propert rights that
takes the form of titling to propert is important for gro th as it encourages in estment and facilitates
credit that allo s in estment to increase. Ho e er, hereas titling can be successful in urban areas it
ma be problematic in de eloping countries particularl in connection ith land. As e ha e seen the
establishment of propert rights based on titles ill not pro ide the necessar legal protection for land
based on custom or communal use. Yet the abilit of communities to secure land rights is cruciall
important to sustainable de elopment.48 Secure land rights:
contribute to food securit as the impro e sustainable land use, impro e access to credit, and
increase producti it of small farmers
lead to lo er rates of deforestation
preser e di erse food cultures and biodi ersit
support indigenous peoples and impro e their economic and social status
contribute to gender equalit hen granted to omen
contribute to po ert reduction.
In response to the urgenc of this issue, as ell as to the problem of land grabs (see Chapter 19), in 2012
the Food and Agricultural Organi ation (FAO) of the United Nations, in collaboration ith ci il societ ,
the pri ate sector and research institutions, established V l a G ideli e he Re ible
G e a ce f Te e f La d, Fi he ie a d F e i he C e f Na i al F d Sec i .49
According to the Director General of the FAO,
Gi i g a d l e able e le ec e a d e i able igh acce la d a d he a al
e ce i a ke c di i i he figh agai h ge a d e . I i a hi ic b eak h gh ha
c ie ha e ag eed he e fi -e e gl bal la d e e g ideli e . We ha e a ha ed i i .
I a a i g i ha ill hel i e he f e di e i a i f he h g a d . 50
In order to secure land use rights, it is necessar to record indi idual and collecti e tenure rights of the
state and public sector, the pri ate sector, indigenous peoples and other communities. This means there
must be a s stem of recording, maintaining and publicising tenure rights and responsibilities, including
ho holds the rights to land, fisheries or forests. The Guidelines set out the best practices countries
should follo for the registration and transfer of land use rights, including rights of indigenous
communities and mechanisms for resol ing disputes.
In addition, there should be anti-e iction legislation, along ith access to legal ad isors so that formall
recognised rights of poor farmers are supported. In cases here e treme po ert is linked ith
landlessness, go ernments should consider agrarian reforms aiming to redistribute land to ensure more
equitable access.51
1 Define microfinance schemes, and discuss their objecti es.

What are some ad antages and disad antages of micro credit?
2 Use an AD-AS diagram to sho the effects of an increase in credit leading to an increase in
consumption and in estment spending.
3 E plain ho microfinance can help people escape the po ert c cle.
4 Discuss policies that can contribute to economic gro th and de elopment in the areas of
increased omen s empo erment,
reducing corruption, and
propert rights and land rights.
40 TOP 9 Mobile Mone Ad antages!
41 De eloping Nations need Women s Empo erment
42 One e planation is that omen, ho tend to be more concerned about their children s ell-being, ha e limited,
if an , control o er ho the husband s income is spent; men, on the other hand, are more likel to spend
increases in their income on acti ities outside the home, including purchases reflecting social status.
43 Amart a Sen (1999) De el e a F eed , O ford Uni ersit Press, p. 203. We encountered Amart a Sen
in Chapter 18, Section 18.2 in connection ith the concept of h a de el e .
44 Issue 7: Women Empo erment
45 Goal 5: Achie e gender equalit and empo er all omen and girls
46 Tackling Corruption in Go ernment
47 Combating Corruption
48 7 reasons for land and propert rights to be at the top of the global agenda
Wh indigenous and communit land rights matter for e er one
49 Responsible Go ernance of Tenure
50 Countries adopt global guidelines on tenure of land, forests, fisheries
51 The Role of Propert Rights in the Debate on Large-Scale Land Acquisitions

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Ec mic

The e a emen in od ce he ke concep of he ni .

A b lle ed li a he beginning of each ec ion clea l ho he lea ning objec i e of he ec ion.

TEST YOUR UNDERSTANDING

REAL WORLD FOCUS

Ke poin , ch a impo an la , concep , defini ion and concl ion , a e highligh ed in an

EXAM STYLE QUESTIONS

BEFORE YOU START

INQUIRY AND REFLECTION

Ke e m a e highligh ed in a ge b d fon a hei fi appea ance in he book o o can

Checkli : Mea e f ec ic ac i i , ell-bei g, ec ic i e ali a d

Checkli : P licie f Pa e 3 (HL l )

1 Economics for the IB Diploma - Tragakes © Cambridge University Press 2020

1 Economic i a ocial cience in hich here i in e dependence be een people ho

Man rgen i e in o r orld oda , ch a po er , poll ion, he en ironmen , economic

After stud ing this section ou ill be able to:

TEST OUR UNDERSTANDING 1.1

TEST OUR UNDERSTANDING 1.2

TEST OUR UNDERSTANDING 1.3

TEST OUR UNDERSTANDING 1.4

TEST OUR UNDERSTANDING 1.5

Dirt air: ho India became the most polluted countr on earth

After stud ing this section ou will be able to:

E O R NDER ANDING 1.6

E O R NDER ANDING 1.7

E O R NDER ANDING 1.8

R private sector public sector public and private sectors

E - private sector public sector public and private sectors

R price rationing non-price price rationing and non-price

1.1: Free market, planned and mixed economies

After studying this section you will be able to:

1.2: Combinations of microwave ovens and computers

The ( ) represents all combinations of the maximum amounts

F 1.1: Production possibilities curve

E refers to increases in the quantity of output produced in an economy over a period of

F 1.3: Using the production possibilities model to illustrate economic growth

ES O R NDERS ANDING 1.9

F 1.4: Circular flow of income model in a closed economy with no government

F 1.5: Leakages and injections

F 1.6: Circular flow of income model with leakages and injections

ES O R NDERS ANDING 1.10

After studying this section you will be able to:

Incomes have fallen by 7%. Incomes should be increased.

Income inequality is increasing. Income inequality has increased too much.

T 1.3: More examples of positive and normative economics

TEST OUR UNDERSTANDING 1.11

TEST OUR UNDERSTANDING 1.12

THEOR OF KNO LEDGE 1.1

P is the study of economics based on the scientific method, used to arrive at

TEST OUR UNDERSTANDING 1.13

THEOR OF KNO LEDGE 1.2

After stud ing this section ou ill be able to:

A S (1723 1790) as a Scottish philosopher ho is often referred to as the Fa he f

K M (1818 1883) as a German philosopher ho had a profound influence on the course of

Karl Mar developed a theor according to hich ca i ali m ld be e e all e laced b

We ill stud the problem of sustainable resource use in Chapter 5.

ES O R NDERS ANDING 1.14

5 The full title of the book as A I i i he Na e a d Ca e f he Weal h f Na i .

6 The other- orldl philosophers

7 London Waste and Rec cling Board (LWARB)

Rea d i e 1: H a e ch ice ade b

The e ic a e add e ed i Cha e 2 a d 3. I Cha e 2 e i di c e he ba ic

Competitive markets: Demand and