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ContentsChapter Title Introduction to the Study Manual Unit Specification (Syllabus) Coverage of the Syllabus by the Manual 1 The Economic Problem and Production Introduction to Economics Basic Economic Problems and Systems Nature of Production Production Possibilities Some Assumptions Relating to the Market Economy Consumption and Demand Utility The Demand Curve Utility, Price and Consumer Surplus Individual and Market Demand Curves Demand and Revenue Influences on Demand Price Elasticity of Demand Further Demand Elasticities The Classification of Goods and Services Revenue and Revenue Changes Costs of Production Inputs and Outputs: Total, Average and Marginal Product Factor and Input Costs Economic Costs Costs and the Growth of Organisations Small Firms in the Modern Economy Costs, Profit and Supply The Nature of Profit Maximisation of Profit Influences on Supply Price Elasticity of Supply Page v vii xiii 1 2 4 7 12 15 19 20 23 26 27 29 31 35 38 40 42 51 52 57 66 66 70 75 76 79 86 91
Chapter Title 6 Markets and Prices Nature of Markets Functions of Markets Prices in Unregulated Markets Price Regulation Defects in Market Allocation The Case for a Public Sector Methods of Market Intervention: Indirect Taxes, Subsidies and Market Equilibrium Using Indirect Taxes and Subsidies to Correct Market Defects Market Structures: Perfect Competition versus Monopoly Meaning and Importance of Competition Perfect Competition Monopoly Market Structures and Competition: Monopolistic Competition and Oligopoly Monopolistic Competition Oligopoly Profit, Competition, Monopoly, Oligopoly and Alternative Objectives for the Firm Macroeconomic Equilibrium and the Deflationary and Inflationary Gaps The Circular Flows of Production and Income and the Equilibrium Level of National Income The Basic 45 Degree Model of National Income Equilibrium and Full Employment The Deflationary Gap The Inflationary Gap The Aggregate Demand/Aggregate Supply Model of Income Determination Money and the Financial System Money in the Modern Economy The Financial System The Banking System and the Supply of Money The Central Bank Interest Rates Monetary Policy Options for Holding Wealth Liquidity Preference and the Demand for Money Implications of the Interest Sensitivity of the Demand for Money Changes in Liquidity Preference The Quantity Theory of Money and the Importance of Money Supply Methods of Controlling the Supply of Money Monetary Policy and the Control of Inflation
Page 99 101 103 104 108 110 114 115 120 127 128 129 135
157 158 163 164 166 168 177 178 180 184 186 188 193 194 196 198 201 202 204 205
Chapter Title 12 The Economics of International Trade Gains from Trade and Comparative Cost Advantage Trade and Multinational Enterprise Free Trade and Protection Methods of Protection International Agreements International Trade and the Balance of Payments International Trade, National Income and the Balance of Payments Balance of Payments Problems, Surpluses and Deficits Balance of Payments Policy Foreign Exchange Exchange Rates and Exchange Rate Systems Exchange Rate Policy Macroeconomic Policy in Open Economy
Page 209 210 213 216 220 223 229 230 235 238 243 244 250 251
personal development at work. It should also provide you with examples which can be used in your examination answers. And finally We hope you enjoy your studies and find them useful not just for preparing for the examination, but also in understanding the modern world of business and in developing in your own job. We wish you every success in your studies and in the examination for this unit.
Published by: The Association of Business Executives 5th Floor, CI Tower St Georges Square New Malden Surrey KT3 4TE United Kingdom
All our rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without the prior permission of the Association of Business Executives (ABE). The Association of Business Executives (ABE) 2011
Learning Outcome 1The learner will: Understand the nature of economic resources and that their finite supply creates the need for business organisations to make choices. Assessment Criteria The learner can: Indicative Content
1.1 Explain the difference between 1.1.1 Explain what is meant by microeconomics and microeconomics and macroeconomics. macroeconomics. 1.1.2 Provide examples to illustrate the differences between microeconomics and macroeconomics. 1.2 Explain the problems of scarcity and opportunity cost and how these concepts are related, using numerical examples and/or a production possibility frontier. 1.2.1 Define and explain the nature of factors of production. 1.2.2 Explain the basic economic problem of scarcity. 1.2.3 Explain the concept of opportunity cost and use a production possibility frontier to explain scarcity, resource choices and opportunity cost. 1.3.1 Explain what is meant by free market, command and mixed economies. 1.3.2 Explain how different economic systems decide what to produce, how to produce it and who to produce it for.
1.3 Compare, using real world examples, the relative merits of alternative economic arrangements for overcoming the problem of scarcity in society.
Learning Outcome 2The learner will: Understand the concept of market equilibrium and be able to use supply and demand analysis to examine how price is established within a market. Assessment Criteria The learner can: 2.1 Explain, in words and with diagrams, the concept of equilibrium in a supply and demand model, and illustrate the effects of changes in market conditions on equilibrium price and quantity. Indicative Content 2.1.1 Explain with the use of diagrams, the difference between individual and market demand. 2.1.2 Explain the reasons for movements along, or shifts in, supply and demand curves. 2.1.3 Draw supply and demand curves based on data and solve these for the equilibrium price and quantity. 2.1.4 Analyse how equilibrium price and quantity are established and affected by changes in supply and demand.
2.2 Examine, using appropriate supply and demand diagrams, the effects of taxes and subsidies and the effects of price ceilings and price floors on market price and quantity traded. 2.3 Identify examples of positive and negative externalities and, using supply and demand analysis, demonstrate the effects of these externalities on the market equilibrium.
2.2.1 Draw a supply and demand diagram and use this to illustrate and comment upon the effect of a specific tax, a government subsidy and the imposition of maximum/minimum prices. 2.2.2 Identify the burden/benefit of taxation/subsidies on consumers and producers. 2.3.1 Explain the meaning of positive and negative externalities and provide supporting examples to show the distinction between private and social costs and benefits. 2.3.2 Using supply and demand analysis show how positive/negative externalities impact upon resource allocation. 2.3.3 Illustrate, using supply and demand curves, how alternative policies, such as the use of taxation, can be used to correct market failure caused by externalities.
Learning Outcome 3The learner will: Understand the concepts of elasticity of demand and supply and their application within the business decision-making process. Assessment Criteria The learner can: 3.1 Define, measure and interpret: price elasticity of demand; price elasticity of supply; income elasticity of demand, and cross price elasticity of demand. Indicative Content 3.1.1 State the formula for, and explain what is meant by: price elasticity of demand; income elasticity of demand; cross price elasticity of supply, and price elasticity of supply. 3.1.2 Explain the factors which affect the numerical values of each of these elasticities. 3.1.3 Solve simple numerical elasticity problems, using quantitative information. 3.2.1 Explain the relationship between concepts of demand elasticities and the following goods: normal goods; inferior goods; luxury goods; complementary goods, and substitute goods. 3.2.2 Identify real world examples of normal goods; inferior goods; luxury goods; complementary goods and substitute goods. 3.3.1 Identify the implications of price elasticity of demand,; price elasticity of supply, income elasticity of demand and cross price elasticity of demand, for the behaviour of firms. 3.3.2 Evaluate the usefulness of the concepts of elasticity as appropriate decision-making tools for a business.
3.2 Explain, using diagrams and different concepts of demand elasticities, what is meant by each of the following: normal goods; inferior goods; luxury goods; complements, and substitutes. 3.3 Examine the use of the concepts of elasticity by firms to analyse and evaluate market changes.
Learning Outcome 4The learner will: Understand the economic theory of costs, the distinction between short-run and long-run costs, economies and diseconomies of scale, and their application to business. Assessment Criteria The learner can: 4.1 Use formulae, diagrams and examples to explain the differences between fixed cost, variable cost, marginal cost, average cost and total cost. Indicative Content 4.1.1 Explain, using numerical examples and diagrams, the difference between fixed cost, variable cost, marginal cost, average cost and total cost. 4.1.2 Explain, using an appropriate diagram, the relationship between average and marginal cost. 4.1.3 Draw cost curve diagrams based on numerical cost data. 4.1.4 Solve numerical and/or diagrammatic problems using cost data. 4.2.1 Explain the relationship between diminishing marginal returns and the shape of the short-run average cost curve. 4.2.2 Explain the relationship between increasing returns to scale, decreasing returns to scale and the shape of the long-run average cost curve. 4.3.1 Explain what is meant by economies and diseconomies of scale and relate these concepts to the long-run average cost curve. 4.3.2 Identify the potential benefits to the firm associated with economies of scale. 4.3.3 Examine why firms might wish to increase in size. 4.3.4 Explain why small firms might still play an important role in an economy.
4.2 Explain, using examples, the determination of short-run and long-run cost curves and describe the relationship between short and long run average cost curves. 4.3 Distinguish between economies and diseconomies of scale and discuss their relevance to the business decision-making process, including the potential implications for businesses arising from changes in size.
Learning Outcome 5The learner will: Understand the nature and characteristics of different market structures and how these structures affect business conduct and performance. Assessment Criteria The learner can: 5.1 Explain how different market structures determine the marginal conditions for the profit-maximising output decisions of a firm. Indicative Content 5.1.1 Illustrate, using diagrams, and numerical examples, the relationship between total revenue, average revenue, and marginal revenue, and between marginal revenue and the elasticity of demand for a profit maximising firm. 5.1.2 Explain the marginal conditions for the profitmaximising output decision of the firm. 5.1.3 Explain, using words, diagrams and numerical examples, how a firm reaches its profit maximising output with reference to marginal cost and marginal revenue.
5.1.4 Solve diagrammatic and numerical problems of profit maximisation. 5.1.5 Explain, using diagrams, how a firm chooses whether or not to stay in operation or leave the industry in the short run and long run. 5.2 Identify the distinctive features of firms operating in perfect competition, monopolistic competition, oligopoly and monopoly and discuss the implications of these differences regarding pricing and output decisions of firms in the short run and long run. 5.2.1 Illustrate the distinctive features associated with a firm operating in a perfectly competitive market and, using numerical and/or diagrammatic examples, show how the firm establishes its profit maximising equilibrium price and output. 5.2.2 Identify the distinctive features of a monopoly and explain, using diagrams and/or numerical examples, the firms profit maximising equilibrium output and price. 5.2.3 Describe the key characteristics of a firm operating in a monopolistically competitive market and illustrate the profit maximising price and output position in the short run and the long run. 5.2.4 Outline the general characteristics of an oligopoly industry and explain, using diagrams, the profitmaximising price and output position. 5.3.1 Compare the welfare implications of perfect competition and monopoly with reference to equilibrium price and output, deadweight welfare loss, allocative efficiency, productive efficiency and X-inefficiency. 5.3.2 Outline policy alternatives aimed at reducing the social cost of monopoly. 5.3.3 Explain the meaning of collusion and the factors that aid or hamper the ability of firms to collude in the context of oligopoly. 5.3.4 Compare the price, output and welfare implications of oligopoly models relative to the models of monopoly, monopolistic competition and perfect competition, and examine the implications of these findings for policy makers and business decisionmaking.
5.3 Explain how different types of market structure will affect business decision-making and create different policy alternatives within an organisation.
Learning Outcome 6The learner will: Understand the role and importance of the banking and finance sector to the successful operation of a business. Assessment Criteria The learner can: 6.1 Outline the respective roles of the central bank and the commercial banking system and how they relate to the business environment. Indicative Content 6.1.1 Explain the role and functions of money in a modern economy. 6.1.2 Explain the role and functions of a central bank and its importance in relation to business operations. 6.1.3 Examine the key characteristics of the commercial banks and their importance to business.
6.1.4 Explain the relationship between the banking system, the credit creation process and the control of the money supply. 6.2 Explain the concepts of inflation and deflation and their impact on business behaviour. 6.2.1 Define the concepts of inflation and deflation. 6.2.2 Explain the causes of inflation and deflation. 6.2.3 Illustrate and explain inflationary and deflationary gaps, using Keynesian cross diagrams and/or aggregate demand (AD) and aggregate supply (AS) diagrams. 6.2.4 Explain why both inflation and deflation can cause problems for a business. 6.3.1 Explain the meaning and operation of monetary policy and how the different instruments of monetary control, such as the use of interest rate changes, operate. 6.3.2 Identify the factors that determine the effectiveness of monetary policy. 6.3.3 Explain the likely impact of different monetary policies on businesses and the implications of these policies for business decision-making.
6.3 Explain the meaning and operation of monetary policy and how the use of different instruments such as changes in interest rates and changes in the money supply might influence business decision-making.
Learning Outcome 7The learner will: Understand the impact of international free trade and the use of alternative exchange rate regimes upon business performance. Assessment Criteria The learner can: 7.1 Explain how the various measures of the external accounts are constructed and examine the different factors that determine them. Indicative Content 7.1.1 Explain the separate elements of each part of the balance of payments account and distinguish between visible/invisible items; between balance of trade and invisible balance and between current and capital account. 7.1.2 Examine the different factors which determine the state (surplus/deficit) of these accounts. 7.2.1 Explain the difference between absolute and comparative advantage, the gains from specialisation and the benefits of free trade. 7.2.2 Illustrate, using numerical examples, how gains from specialisation arise and identify the gains from trade, using data on opportunity cost for two countries. 7.2.3 Identify the measures that can be employed by governments to restrict or promote trade and their impact on business performance in developed and developing countries. 7.2.4 Examine the costs and benefits associated with the use of measures to restrict free trade.
7.2 Identify the advantages and disadvantages of free trade and explain why governments may decide to impose restrictions on free trade.
7.3 Describe the concepts of exchange rates and terms of trade and compare the effects of alternative exchange rate regimes on business.
7.3.1 Explain the difference between key terms used in the analysis of exchange rates: devaluation; depreciation; revaluation; appreciation. 7.3.2 Describe the ways in which government manipulation of exchange rates may affect business performance.
1.1 Explain the difference between Chap 1 microeconomics and macroeconomics 1.2 Explain the problems of scarcity and Chap 1 opportunity cost and how these concepts are related, using numerical examples and/or a production possibility frontier 1.3 Compare, using real world examples, Chap 1 the relative merits of alternative economic arrangements for overcoming the problem of scarcity in society 2.1 Explain, in words and with diagrams, the concept of equilibrium in a supply and demand model and illustrate the effects on equilibrium price and quantity of changes in market conditions 2.2 Examine, using appropriate supply and demand diagrams, the effects of taxes and subsidies and the effects of price ceilings and price floors on market price and quantity traded 2.3 Identify examples of positive and negative externalities and, using supply and demand analysis, demonstrate the effects of these externalities on the market equilibrium Chaps 1, 3, 5&6
2. Understand the concept of market equilibrium and be able to use supply and demand analysis to examine how price is established within a market
Chap 6
3. Understand the concepts of elasticity of demand and supply and their application within the business decision making process
3.1 Define, measure and interpret: price Chaps 3 & 5 elasticity of demand; price elasticity of supply; income elasticity of demand and cross price elasticity of demand 3.2 Explain, using diagrams and different Chaps 3 & 5 concepts of demand elasticities, what is meant by each of the following: normal goods; inferior goods; luxury goods; complements and substitutes 3.3 Examine the use of the concepts of Chaps 3 & 5 elasticity by firms to analyse and evaluate market changes
4. Understand the economic theory of costs, the distinction between shortrun and long- run costs, economies and diseconomies of scale, and their application to business
4.1 Use formulae, diagrams and examples to explain the differences between fixed cost, variable cost, marginal cost, average cost and total cost 4.2 Explain, using examples, the determination of short-run and long-run cost curves and describe the relationship between short and long run average cost curves 4.3 Distinguish between economies and diseconomies of scale and discuss their relevance to the business decisionmaking process, including the potential implications for businesses arising from changes in size
Chap 4
5. Understand the nature and characteristics of different market structures and how these structures affect business conduct and performance
5.1 Explain how different market structures Chaps 3 & 5 determine the marginal conditions for the profit-maximising output decisions of a firm 5.2 Identify the distinctive features of firms Chaps 7 & 8 operating in Perfect Competition, Monopolistic Competition, Oligopoly and Monopoly and discuss the implications of these differences regarding pricing and output decisions of firms in the short run and long run 5.3 Explain how different types of market Chaps 7 & 8 structure will affect business decision making and create different policy alternatives within an organisation 6.1 Outline the respective roles of the central bank and the commercial banking system and how they relate to the business environment 6.2 Explain the concepts of inflation and deflation and their impact on business behaviour 6.3 Explain the meaning and operation of monetary policy and how the use of different instruments such as changes in interest rates and changes in the money supply might influence business decision making Chaps 9 11
6. Understand the role and importance of the banking and finance sector to the successful operation of a business
Chaps 9 11 Chaps 9 11
7. Understand the impact of 7.1 Explain how the various measures of international free trade and the external accounts are constructed the use of alternative and examine the different factors that exchange rate regimes determine them upon business 7.2 Identify the advantages and performance disadvantages of free trade and explain why governments may decide to impose restrictions on free trade 7.3 Describe the concepts of exchange rates and terms of trade and compare the effects of alternative exchange rate regimes on business
Chaps 12 14
Basic Economic Problems and Systems Some Fundamental Questions Choice and Opportunity Cost Alternative Economic Arrangements
4 4 5 5
Nature of Production Economic Goods and Free Goods Production Factors Enterprise as a Production Factor Fixed and Variable Factors of Production Production Function Total Product
7 7 7 8 9 10 10
Production Possibilities
Some Assumptions Relating to the Market Economy Consistency and Rationality The Forces of Supply and Demand Basic Objectives of Producers and Consumers Consumer Sovereignty
15 15 15 16 16
ObjectivesThe aim of this chapter is to explain the problem of scarcity, the concept of opportunity cost, the difference between macroeconomics and microeconomics and the difference between normative and positive economics. When you have completed this chapter you will be able to: explain the problems of scarcity and opportunity cost explain how scarcity and opportunity cost are related using numerical examples and a production possibility frontier explain what is meant by free market, command and mixed economies discuss, using real world examples, the relative merits of these alternative regimes explain what is meant by microeconomics and macroeconomics and discuss the differences between these areas explain the meaning and implications of the ceteris paribus assumption in microeconomics explain what is meant by normative and positive economics and discuss the differences between these terms.
INTRODUCTION TO ECONOMICSThe study of economics is important because we all live in an economy. Our well-being is closely related to the success, or otherwise, of both the economy in which we live and that of all the other economies in the world. Whether people have jobs or are unemployed, the kind of work people do, the things they produce, how much they are paid, what they purchase, how much they consume, and the influence of the government on economic activity are the subject matter of economics. The study of economics is important for a proper understanding of business. This is because we are all consumers and will be workers for a large part of our lives, so that what we do determines how well business does. The study is important for business because often common sense is not a good guide to how a firm should operate to get the best out of a particular situation. What the study of economics reveals is that in many situations what is obvious is not always correct and what is correct is not always obvious. A sound knowledge and understanding of economics is essential for understanding the business environment and business decision-making. Economics is regarded as a science
because it is based on the formal methods of science. It uses abstract models, mathematical techniques and statistical analysis of markets and economies. The aim is to test and apply theories to advance our understanding of both how economies work and the business environment. If you have not studied economics before there is no need to worry if you do not like mathematics, graphs and equations. This Study Manual provides an introduction to the study of economics, and its application to business, and maths and equations are kept to a minimum. Positive and Normative Economics In the study of economics, because it is a science, an important distinction is made between positive and normative statements. Science is based on theories which are used to make predictions about how some aspect of physical reality works. Successful theories are ones that yield useful predictions and insights into reality. More precisely, successful theories yield predictions that are not refuted when put to the test using real data. Theories that fail to predict correctly are not "good" theories; they are not useful and are unlikely to survive the course of time. Likewise, theories that only predict some things accurately some of the time tend to be replaced or refined. This is how science progresses. Statements and predictions that can be tested, to see if the theories from which they are derived should be accepted or rejected, are called positive statements. Positive economics is concerned with such statements: it seeks to understand how economies function by using theories that can be tested in the real world and rejected if they make false predictions. Positive economics is concerned with "what is" not with "what should be". In contrast statements about how the world, or an economy, should be changed to make it better are based on opinions rather than facts. Such statements cannot be proved or disproved using the methods of science. For example, the statement that an increase in the price of petrol will lead to a reduction in the sale of petrol is an example of positive economics. The statement may be right or wrong: the way to find out is to test the prediction using real world data on petrol sales and the price of petrol. On the other hand, the statement that the government should subsidise the price of petrol to help people on low incomes is a normative statement. Some people may agree with the statement but others may disagree, because it is based on a value judgement. There is no scientific way of "proving" that it is the correct thing for the government to do. That is, even if we all shared the same values and agreed that the government should help people on low incomes, it does not follow that reducing the price of petrol is the best way to help them. Although this is a simplification, positive economics is concerned with facts while normative economics is concerned with opinions. The Methods of Economic Analysis: the Ceteris Paribus Assumption The economic behaviour of individuals is complex. The behaviour of consumers and firms interacting in markets is even more complex. The economic decisions and interactions between all the consumers and firms in the economy, with the added complication of actions by the government, make for mind-bending complexity. Economic theory deals with such complexity by using a useful assumption when developing models of economic behaviour, analysing markets and government economic policy. It makes use of the ceteris paribus assumption. This is a Latin expression which means holding other things constant. An example is the easiest way to illustrate what it means. Suppose the government of a country has increased the amount of tax it charges on each litre of petrol sold. You have data on the price and the quantity of petrol purchased each day before the tax was increased. You collect data on the quantity of petrol purchased each day following the increase in tax. What your data shows is that the quantity of petrol sold each day has now fallen. Can the fall in the sale of petrol be attributed to the increase in the amount of tax on petrol? It may seem obvious that the answer is yes. But this would only be a correct inference if it could be shown that none of the other things affecting the demand for petrol had changed at the same time
as its price increase due to the government's tax. For example, if the price of cars had been increased at the same time or the price of food had just increased people might have had less to spend on petrol. In other words to study the relation between a change in one factor on another it is necessary to be able to rule out other possible influences operating at the same time. This is where the assumption of ceteris paribus comes in useful. Assuming all other things remain constant, economics is able to demonstrate that for normal goods an increase in their price will lead to a fall in demand. Microeconomics and Macroeconomics The functioning of an economy involves the decisions of millions of people as well as the interactions between them. I want to go to town to do some shopping. Should I walk, catch a bus or take my car? If I choose to walk the bus company, the local fuel station and the city centre car park will all be affected: they will have less revenue than if I had decided not to walk to town. Add up all the similar decisions made by thousands or tens of thousands of people a day in just one city, and the revenue implications become significant. If many people decide to switch from using cars to walking or taking a bus because this is better for the environment, then the local fuel station may go out of business and the council and local businesses may suffer a significant fall in revenue. The fuel station closing means unemployment for some people. Reduced council revenue from the car park could mean less support for local amenities. Scale up this example to the entire multitude of decisions taken by all of the people in an economy in a single day, and you can start to appreciate the complexity of the process, and that is just in a day! To make the study of economics more manageable the subject is divided into microeconomics and macroeconomics. Microeconomics ("micro" from Greek, meaning small) considers the economic behaviour of individuals in their roles as consumers and workers, and the behaviour of individual firms. It also involves the study of the behaviour of consumers and firms in individual markets. Microeconomic policy includes the different ways in which governments can use taxation, subsidies and other measures to affect the behaviour of consumers and firms in specific markets rather than the economy as a whole. Macroeconomics ("macro" again from Greek, meaning large) considers the working of the economy as a whole. It deals with questions relating to the reasons why economies grow, undertake international trade and investment, and experience inflation or unemployment. Macroeconomic policy involves the different fiscal and monetary means through which governments can influence the level of economic activity in an economy. Microeconomics is studied in the first eight chapters of this study manual. Macroeconomics and macroeconomic policy is studied in the remaining chapters.
It is usual to identify three basic problems which all human groups have to resolve. These are: what, in terms of goods and/or services, should be produced how resources should be used in order to produce the desired goods and services for whom the goods and services should be produced.
These questions of production and distribution are problems because for most human societies the aspirations or wants of people are unlimited. We often seem to want more of everything whereas the resources available are scarce. This term has a rather special meaning in economics. When we say that resources are scarce we do not mean necessarily that they are in short supply though often, of course, they are but that we cannot make unlimited use of them. In particular when we use (for example) land for one purpose, say as a road, then that land cannot, at the same time, be used for anything else. In this sense, virtually all resources are scarce: for example your time and energy, since you cannot read this chapter and watch a football match or play football at the same time.
In a planned economy, decisions about resource allocation are taken mostly by politicians or officials operating within state institutions. In a market economy, the same decisions are taken mainly by individuals and groups operating in markets where they can choose to buy or not to buy the goods and services offered by suppliers, according to their own assessment of the benefits and opportunity costs of the many choices with which they are faced. A market economy uses the market mechanism to answer the questions of what, how and for whom goods and services should be produced. This mechanism is a decentralised information gathering and processing arrangement based on the role of prices in conveying information about demands and supplies. It operates like a giant computer to co-ordinate and reconcile all the economic decisions made by the millions of different individuals in a society. A small scale example of how the mechanism works is provided by the operation of ebay on the internet. The market is generally accepted as being a highly effective and cost efficient arrangement for determining the pattern of production and consumption. In complete contrast, in a planned economy, the information on which all production and consumption is based depends on the views and decisions of the planners. In practice, this requires the planners to gather, process, interpret and reconcile vast amounts of information. Even with the help of supercomputers, the immense scale of the information gathering and processing required to fully plan all the required decisions, even for very small economy, is almost impossible to achieve effectively. There are two separate but related aspects to the choice of arrangements for determining the pattern of production and consumption which are all too often confused: one involves the ownership of the means of production and the other the arrangements for using the means of production to satisfy human needs. The reason the two are often linked is because ownership of resources is closely linked to the distribution of income and the degree of income or wealth equality in a society. In a fully centrally-planned economy, the state owns all the means of production and also determines what is produced, how it is produced and the allocation of output for consumption. This may be based on the principle of an equal distribution of consumption and equality of living standards. However, the use of the market mechanism to determine which and how goods and services are produced, and for whom, is not restricted to free market economies in which all the means of production are privately owned. The free market mechanism can, and does, operate equally well irrespective of the ownership of resources and, more significantly, with different policies towards the distribution of income and wealth in society. Thus, for example, countries such as Sweden, Norway and Finland are all market based economies, with mainly private ownership of the means of production, but through the use of the tax system have a high degree of equality in the distribution of income. In contrast, other largely market-based economies such as India and Pakistan, suffer from extreme inequalities in the distribution of income and wealth. Until its collapse in the early 1990s, the former Soviet Union was the best known example of a complete centrally-planned economy. Partly in response to the collapse of the Soviet Union and the abandonment of central planning, China, the other major centrally-planned economy in the 20th century, started to move away from reliance on central planning in the late 1980s. Since then, it has actively encouraged and supported the move to a more market-based form of production and consumption. This process of opening-up the economy to market forces continues in China and has delivered impressive results in terms of the resultant increase in its rate of real economic growth and transformation of the economy into the world's leading exporter of manufactured goods. Today, only North Korea remains as an example of a fully centrally-planned economy and it is perhaps no coincidence that it also has one of the lowest living standards of any country in the world. Although the United States of America is usually considered to be the most important example of a free market economy, it does not lie at the extreme end of the opposite range of arrangements to that of a centrally planned economy. While the USA combines individual ownership of economic resources with free market forces in determining the pattern of production and consumption, it does not rely fully on the market in all areas of activity and some services are provided by
the state. By contrast, China has in some respects allowed greater freedom to the operation of market mechanism in determining what and how things are produced than in the USA, although the state continues to retain ownership of most of the means of production. Through much of the twentieth century there has been conflict between the planned economy and the market economy. In the first decade of the 21st century it is market economies that are in the ascendancy, and this course is concerned mainly with the operation of markets and the market economy. At the same time, we need to recognise that market choices have certain limitations and social consequences which cannot be ignored. These include problems involving abuse of market power by firms, especially monopolists, as well as positive and negative externalities in production and consumption, all of which are considered in later chapters. All the major market economies have laws and arrangements for dealing with the limitations of markets, as well as important public sectors within which choices are made through various kinds of non-market institutions and structures.
B. NATURE OF PRODUCTIONEconomic Goods and Free GoodsThe term "goods" is frequently used in a general sense to include services, as long as it does not cause confusion or ambiguity. It is used in this wide sense in this section. Goods are economic if scarce resources have to be used to obtain or modify them so that they are of use, i.e. have utility, for people. They are free if they can be enjoyed or used without any sacrifice of resources. A few minutes' reflection will probably convince you that most goods are economic in the sense just outlined. The air we breathe under normal conditions is free, but not when it has to be purified or kept at a constant and bearable pressure in an airliner. Rainwater, when it falls in the open on growing crops, is free, but not when it has to be carried to the crops along irrigation channels or purified to make it safe for humans to drink. Free goods are indeed very precious and people are becoming increasingly aware of the costs of destroying them by their activities, e.g. by polluting the air in the areas where we live.
Production FactorsSince there are very few free goods most have to be modified in some way before they become capable of satisfying a human want. The process of want satisfaction can also be termed "the creation of utility or usefulness"; it is also what we understand by "production". In its widest economic sense, production includes any human effort directed towards the satisfaction of people's wants. It can be as simple as picking berries, busking to entertain a theatre queue or washing clothes in a stream, or as involved as manufacturing a jet airliner or performing open heart surgery. Production is simple when it involves the use of very few scarce resources, but much more involved and complex when it involves a long chain of interrelated activities and a wide range of resources. We now need to examine the general term "resources", or "economic resources", more closely. The resources employed in the processes of production are usually called the factors of production and, for simplicity, these can be grouped into a few simple classifications. Economists usually identify the following production factors. Land This is used in two senses: (a) the space occupied to carry out any production process, e.g. space for a factory or office
the basic resources within land, sea or air which can be extracted for productive use, e.g. metal ores, coal and oil.
Labour Any mental or physical effort used in a production process. Some economists see labour as the ultimate production factor since nothing happens without the intervention of labour. Even the most advanced computer owes its powers ultimately to some human programmer or group of programmers.
Capital This is also used in several senses, and again we can identify two main categories: (a) Real capital consists of the tools, equipment and human skills employed in production. It can be either physical capital, e.g. factory buildings, machines or equipment, or human capital the accumulated skill, knowledge and experience without which physical capital cannot achieve its full productive potential. Financial capital is the fund of money which, in a modern society, is usually needed to acquire and develop real capital, both physical and human.
Notice how closely related all the production factors are. Most production requires some combination of all the factors. Only labour can function purely on its own, if we ignore the need for space. A singer or storyteller can entertain with voice alone, but will usually give more pleasure with the aid of a musical instrument and is likely to benefit from earlier investment in some kind of training. The hairdresser requires at least a pair of scissors! Much of economic history is the story of people's success in increasing the quantity and quality of production through the accumulation of human capital and the development of technically advanced physical capital. I can dig a small hole in the ground with my bare hands, but creating the Channel Tunnel between Britain and France has required a vast amount of very advanced physical capital together with a great deal of human skill and knowledge. Modern firms depend for their survival and success on both their physical and their human resources. While some may feel that the current trend to replace the business term "personnel management" by "human resource management" is in some degree dehumanising, others welcome it as a sign that firms are recognising the importance of employee skills as human capital.
press. Few would wish to deny that profit has been and often remains the spur that drives them. Nevertheless this identification of enterprise in terms of individual risk-taking raises a great many problems when we attempt to apply it generally to the modern business environment. Much contemporary business activity is controlled by very large international and multinational companies such as Microsoft, Toyota, Sony, Philips and Unilever. Who are the entrepreneurs in such organisations? Are they rewarded by profits? How do these companies recruit and foster enterprise? You, yourself, may work in a large organisation. Can you reconcile the traditional economic concept of enterprise as a factor of production with your observations of the structure of your company? No one doubts the importance of enterprise and profit in modern business. However their traditional explanation in terms of the fourth production factor is at best incomplete and at worst actually dangerous, in that it may be used to justify the very large salaries which company chief executives seem able to award themselves in Britain and the USA. We shall return to the question of profit in Chapter 5.
Production FunctionWe can now summarise the main implications of our recognition of factors of production. We can say that to produce most goods and services we need some combination of land, capital and labour. At present we can leave out enterprise as this is difficult to quantify. In slightly more formal language we say that production is a function of land, capital and labour. Using the symbols Q for production, S for land, K for capital and L for labour, (with for function) this allows us, if we wish, to use the mathematical expression: Q (S, K, L) For further simplicity we can use the assumption of ceteris paribus, which was explained in the introduction to this chapter: we can hold constant the role of two factors of production, land and capital, and concentrate on labour as the only variable input into the production process. That is, as previously noted, we can regard capital and land as fixed and labour as a variable factor.
Total ProductIn this section we examine what happens when a firm increases production in the short run, when the firm's available capital and land is fixed and when the only variable factor into the production process is labour. Once again we can take a simple example of a small firm which has a single factory building (land), and a fixed number of machines (capital), installed in its factory. The only way the firm can increase output in the short run is to increase its use of labour. For simplicity we can use the term worker as a unit of labour, but you may wish to regard a worker as a block of worker-hours which can be varied to meet the needs of the business. Suppose the effect of adding workers to the business is reflected by Table 1.1, where the quantity of production is measured in units and relates to a specific period of time, say, a month. The amount of capital and land employed by the business is fixed. The quantity of production measured here in units produced per month and shown as a graph in Figure 1.1, is, of course, the total product. In this example total product continues to rise until the tenth worker is added to the business; this worker is unable to increase total product. This is no reflection on that particular worker who may, in fact, be working very hard. It is simply that, given the fixed amount of capital, no further increase in productive output is possible. The addition of an eleventh worker would actually cause a fall in production. It is not difficult to see why this could happen. Table 1.1: Number of workers and quantity of production Number of workers 1 2 3 4 5 6 7 8 9 10 11 Quantity of production (units per month) 30 70 120 170 220 260 290 310 320 320 310
Suppose the factory has five different machines, each one of which makes a different component for the finished product. Suppose also that each machine is designed to be operated by two workers. When only one worker is employed he or she will have to waste a lot of time moving between each machine and will not be able to work each machine to its full capacity. Adding a second worker will reduce the time wasted moving between machines and lead to a more than proportional increase in output. As more workers are employed the machines can be progressively operated more efficiently, with two workers to each machine and less and less time wasted by workers moving from one machine to another. As the number of workers employed in the factory increases total product also increases, but at a diminishing rate. Once ten workers are employed then each machine is being operated at its optimum capacity. Adding more workers will not increase production but may actually cause it to fall, as workers start to get in the way of each other and slow the speed of the machines. This is shown in Figure 1.1 by the fall in total product from 320 to 310 when the 11th worker is employed with the fixed number of machines in the factory. Each additional worker's contribution to total product is termed the worker's marginal product. Marginal product is the difference in the total product which arises as each additional worker is employed. Figure 1.1: Total product Units of 350 production (per month)300
10 20 30
Total product
40 50
50 50 40 30
0 0 1 2 3 4 5 6 7 8 9 10 11
Workers Notice how marginal product changes as total product rises: one worker alone can produce 30 units but another enables the business to increase production by 40 units and one more by 50 units. However, these increases cannot continue and the additional third, fourth and fifth workers all add a constant amount to production. Thereafter, further workers, while still increasing production, do so by diminishing amounts until the tenth worker adds nothing to the total. At this level of labour employment production has reached its maximum, and the eleventh worker actually provides a negative return total production falls. Perhaps people get in each other's way or cause distraction and confusion. If the business owner wishes to continue to expand production, thought must be given to increasing capital through more machines and, at some point, increasing the size of the factory building to accommodate additional machines and workers. Short-run expansion at this level of capital has to cease. Only by increasing the fixed factors can further growth be achieved.
This example is purely fictional it is not based on an actual firm; but neither is the pattern of change in marginal product accidental. The figures are chosen deliberately to illustrate some of the most important principles of economics, the so-called laws of varying proportions and diminishing returns. It has been constantly observed in all kinds of business activities that when further increments of one variable production factor are added to a fixed quantity of another factor, the additional production achieved is first likely to increase, then remain roughly constant and eventually diminish. It is this third stage that is usually of the greatest importance, this is the stage of diminishing marginal product, more commonly known as diminishing returns. Most firms are likely to operate under these conditions and it is during this stage that the most difficult managerial decisions, relating to additional production and the expansion of fixed production factors, have to be taken. It must not, of course, be assumed that firms will seek to employ people up to the stage of maximum product when the marginal product of labour equals zero, or on the other hand, that they will not take on any extra employees if diminishing returns are being experienced. The production level at which further employment ceases to be profitable depends on several other considerations, including the value of the marginal product. This depends on the revenue gained from product sales, and the cost of employing labour, made up of wages, labour taxes and compulsory welfare benefits. The higher the cost of employing labour, the less labour will be employed in the short run and the sooner will employers seek to replace labour by capital in the form of labour-saving equipment. You should give some thought to the implications of this production relationship for business costs. We will return to it again in Chapter 4 when we examine costs and the firm's supply curve.
C. PRODUCTION POSSIBILITIESIf individual firms are likely to face a point of maximum production as they reach the limits of their available resources, the same is likely to be true of communities whose total potential product must also be limited by the resources available to the community, and by the level of technology which enables those resources to be put to productive use. This idea is frequently illustrated by economists through what is usually termed the production possibilities frontier (or curve), which is illustrated in Figure 1.2. The frontier represents the limit of what can be produced by a community from its available resources and at its current level of production technology. Because we wish to illustrate this through a simple two-dimensional graph we have to assume there are just two classes of goods. For simplicity, we can call these consumer goods (goods and services for personal and household use) and capital goods (goods and services for use by production organisations for the production of further goods). Because resources are scarce in the sense explained earlier in this chapter, we cannot use the same production factors to produce both sets of goods at the same time. If we want more of one set we must sacrifice some of the other set. However, the extent of the sacrifice (i.e. the opportunity cost) of increasing production of each set is unlikely to be constant through each level of production, since some factors are likely to be more efficient at some kinds of production than others. Consequently the shape of the frontier curve can be assumed to reflect the principle of increasing opportunity costs, shown in Figure 1.2. In this illustration the opportunity cost measured in the lost opportunity to produce (say) arms is much less at the low level of (say) food production of 2 billion units than at the much higher level of 9 billion units. The curve illustrates other features of the production system. For example, the community can produce any combination of consumer and capital goods within and on the frontier but cannot produce a combination outside the frontier say at E. If it produces the mixtures
represented by points A, B or C on the frontier all resources (production factors) are fully employed, i.e. there are no spare or unused resources. The community can produce within the frontier, say at D, but at this point some production factors must be unemployed. Figure 1.2: The production possibilities frontier Production of capital goods (billion units)10 9 8 7 6 5 4
Production of consumer goods (billion units) To raise production of consumer goods from 2 to 3 billion units involves sacrificing the possibility of producing 0.3 billion units of capital goods. However when production of consumer goods is 9 billion units, an additional 1 billion units involves the sacrifice of 1.6 billion units of capital goods. The shape of the curve is based on the principle of increasing opportunity costs. We can, of course, turn the argument round. If we know that some production factors are unemployed, e.g. if people are out of work, farmland is left uncultivated, factories and offices left empty, then we must be producing within and not on the edge of the frontier. The community is losing the opportunity of increasing its production of goods and services and is thus poorer in real terms than it need be. If, at the same time, some goods and services are in evident inadequate supply e.g. if there are long hospital waiting lists, many families without homes, some people short of food or unable to obtain the education or training to fit them for modern life then the production system of the community is clearly not operating efficiently to meet its expressed requirements. Unfortunately it is easier to state these facts than to suggest remedies. There have been very few, if any, examples throughout history of fully efficient production systems where the aspirations of the community have been served by maximum production of the goods and services that the community has desired. Although generally used in relation to the economy as a whole, the production possibilities (sometimes written as "possibility") curve can also be used to illustrate the options open to a particular firm. In this case the shape of the curve need not always follow the pattern of Figure 1.2. It might be that if the firm devoted all its resources to the production of one good (in economics the word "good" is used as the singular of "goods") instead of more than one
then it would be able to use them more efficiently. They would then gain from what will later be described as increasing returns to scale. In this case the curve would be shaped as in Figure 1.3. Figure 1.3: Another production possibilities curve Quantity of Y
The production possibilities curve for a firm gaining increased efficiency by concentrating on one product.
Quantity of X
Yet another possibility is that the firm could switch resources without any gain or loss in efficiency, i.e. it would experience constant returns from scale in using its resources. In this case the curve would be linear (a straight line) as in Figure 1.4. Figure 1.4: A linear production possibilities curve Quantity of Y
The production possibilities curve for a firm which is neither more nor less efficient when it switches resources from one product to another.
Consumer SovereigntyAlthough the separation between supply and demand as two different forces has been stressed, the market economy operates on the assumption that, of these forces, consumer demand is dominant. The market production system is demand led: supply adjusts to meet demand. In this sense the consumer is sovereign. Producers who cannot sell their goods at a profit fail and disappear from the production system. Profit is the driving force of the production system: profit is achieved by the ability to produce goods that people will buy at prices that people will pay, while enabling the producer to earn sufficient profit to stay in business and to wish to stay in business. However strong the demand for goods, if they cannot be produced at a profit they will not, in the long run, be supplied. If you have lived all your life in a market economy none of this will seem strange to you. But to someone who has lived in a command economy (where production decisions and the quantity, quality and distribution of consumer goods have all been determined by the institutions of the state) the full implications of consumer sovereignty, particularly the implications for individual firms operating in a competitive market environment, can be very hard to grasp. In the next five chapters we shall be very largely concerned with different aspects of the forces of demand and supply and how they interact, or sometimes fail to interact, in the market economy.
Review PointsBefore you begin your study of the next chapter you should go back to the start of this one and check that you have achieved the learning objectives. If you do not think that you understand the aim and each of the objectives completely, you should spend more time rereading the relevant sections. You can test your understanding of what you have learnt by attempting to answer the following questions. Check all of your answers with the chapter text. 1. 2. 3. 4. What is the difference between microeconomics and macroeconomics? How does the assumption of ceteris paribus help in trying to understand economic relationships? Is the following statement an example of a positive or a normative statement? "The government should provide free health care for everyone." Is the following statement an example of a positive or a normative statement? "When more and more units of a variable production factor are added to a fixed quantity of another factor, the additional production achieved is likely, first, to increase, then to remain roughly constant and eventually to diminish." 5. "For a given size of its budget, the government of a country can only increase its expenditure on education if it reduces its expenditure on roads or defence". Which of the following economic concepts is illustrated by this statement? (a) (b) (c) (d) 6. normative economics opportunity cost microeconomics marginal product.
Can you name a country that has a planned economy? Is your own country a market economy or a mixed economy?
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The Demand Curve What is a Demand Curve? Use and Importance of Demand Curves General Form of Demand Curves
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ObjectivesThe aim of this chapter is to explain the theory of consumer choice using the concept of utility, individual demand and market demand. When you have completed this chapter you will be able to: explain the concept of utility explain what is meant by marginal utility, utility maximisation and the property of diminishing marginal utility, using diagrams and/or numerical examples explain the relationship between individual utility and individual demand for a good, using examples where required solve numerical problems relating to marginal utility and utility maximisation based on utility or consumption data identify the difference between individual and market demand.
A. UTILITYIn this chapter we introduce the demand curve. The concept of the demand curve is one of the most important concepts used in economics. This is because it provides one of the two keys required to understand how markets work. For this reason it is of great importance for all businessmen and businesswomen. We begin by explaining the concept of utility.
Meaning of UtilityEconomists have always faced problems in explaining clearly why people are prepared to make sacrifices to obtain many of the goods and services which they evidently wish to have. In a market economy this difficulty can be stated as "Why do we buy the things we do buy?" Very often we do not "need" them in the strict sense that they are necessary to our survival. In fact our basic needs are really very small, compared with all the things on which we might spend our money in advanced market economies. We can talk in terms of "wants" and recognise that there seems to be no limit to these wants. We also have to recognise that at any given time we are likely to want some things more than others. What then is the quality that goods must possess that makes us want to acquire them? Clearly this will differ with different goods. Some may be pleasant to eat, some attractive to look at, some warm to wear and so on. The one general term we can apply to all goods and services is that they provide us with utility. This does not necessarily mean that they are useful in the sense that they help us to do something we could not do before we had them. It simply means that we perceive in them some quality that makes us willing to make some degree of sacrifice (usually of money) in order to acquire them. Can we then measure this utility? In an absolute sense, the answer is almost certainly "No". Some economists have proposed adopting a measure called a "util" but no-one, not even the European Commission, has yet proposed that we mark all goods to show how many "utils" they contain. It is more practical to think in terms of money value, since most of us measure the strength of our desire to buy something in terms of the price we are prepared to pay for it. Therefore when an estate agent asks a potential house buyer, "How much are you prepared to offer for this house?" the agent is, in effect, asking the buyer to indicate the value of the utility which the house has for him or her. More often we find ourselves making comparisons of utility. This arises partly because of the basic economic problem of unlimited wants and scarce resources, so that ranking our wants so we can decide what we can afford to buy is, for most people, an almost daily occurrence. But it also arises because, in modern advanced economies, there is likely to be a range of different goods to satisfy any particular want. If I want to travel by public transport from
Birmingham to Glasgow I could do so by motor coach, by train, or by air. My want is to get from Birmingham to Glasgow, and three options offer the utility to satisfy this want. Each involves different sacrifices of money and time and offers different associated utilities of convenience and comfort. My choice will depend on the resources available to me (how much money I can afford to pay and how much time I have) and on my valuation of the utility afforded by each option. Notice, further, that this utility is not an absolute quality but depends on why I want to make the journey. If it is part of a holiday then I might prefer the coach or train. If I am attending a business meeting from which I hope to achieve a financial benefit and need to be fresh and alert, then the air option is likely to offer the greatest utility greater, probably, than the price of the fare. All this may seem very involved, but an appreciation of utility and how it can influence our actions can be a very great help in understanding the true nature of economic demand.
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Quantity Suppose I have no use for more than eight pairs of trousers. This number would provide maximum utility to which we can give a hypothetical numerical value of, say, 100 (representing 100 per cent of the total), but clearly the largest marginal utility would be provided by the first pair. After this purchase the marginal utility of each additional pair diminishes, as indicated by the figures under MU to the right of the vertical axis. The total of 100 is reached with the eighth pair. If I have a ninth, no further utility is added the total remains at 100. Should I receive a tenth pair my total utility actually falls: perhaps they take up space in my wardrobe I would rather have for something else. Does this then mean that I should aim at keeping eight pairs of trousers all the time? Not necessarily, since Figure 2.1 takes no account of other important considerations, which include: the price of trousers, i.e. the sacrifice I must make to buy them my desire for other goods and services, i.e. other marginal utilities (I would not, for example, be too pleased to have eight pairs of trousers if I possessed only one shirt, nor would trousers satisfy my hunger if I did not have enough food to eat) how much money I have, i.e. my marginal utility for money.
Only when all these are taken into account would it be possible to estimate how many pairs of trousers would represent, for me, the best total to try and achieve. Assuming rationality, in the sense explained in Chapter 1, the most satisfactory quantity of trousers for me would be where my marginal utility gained from the last 1 spent on trousers just equalled the marginal utility per 1 spent on all other available goods and services, and
where this also equalled the marginal utility of money. On the assumption that we are valuing utility in monetary terms, the marginal utility of the last 1 of money equals 1. Putting this statement a little more formally as an equation and using the symbols MUA to denote the marginal utility for the good A, MUB for the marginal utility for the good B, PA for the price of A, PB for the price of B and so on, we can say that consumers achieve a position of equilibrium in their expenditure when for them:
Quantity (units of x) per week This example illustrates the general shape of the demand curve and the normal relationship between price and quantity demanded of a product. If all other influences remain constant, we would expect the quantity demanded to rise as price falls and to fall as price rises. Notice that, in our example, we have made the following assumptions: (a) The price of all other goods and services remains constant as the price of good X changes. That is, we are making use of the simplifying ceteris paribus assumption once again. The incomes of consumers also remain constant when the price of good X changes. Another point to remember is that we are considering here a flow of demand related to a set period of time. It is always necessary to do this. We cannot compare a weekly amount at one price directly with a monthly amount at another. When we change one variable here price to analyse its effect on quantity, we have to keep all other elements constant, including the time period to which the stated quantity relates. In our example, this period was a week.
(b) (c)
p1 p D
Figure 2.4: Another demand curve Price ( per unit) D Here, the change in quantity demanded brought about by the change in price is smaller than in Figure 2.3
p1 p
Figure 2.5: Demand curve consumer surplus Price The shaded area represents the consumer surplus at price Op. It is enjoyed by those consumers who could be prepared to a price above Op i.e. those up to Oq.
p Demand
Since the price of 60p per kilo was below my valuation of the marginal utility of a kilo of apples I might decide to buy two or perhaps three kilos. In this case I was valuing the marginal utility of the additional amount bought above my usual quantity at less than the 80p but still now below 60p. If, as seems likely, most consumers react in this way, then we have no difficulty in accepting the general shape of the demand curve outlined in the previous section: that is people are prepared to buy more of a good at a lower than at a higher price. These ideas are illustrated in Figure 2.5, which shows a normal demand curve for a product the price of which is "p" on the graph. The fact that the demand curve extends to prices higher than p indicates that there are consumers who are willing to pay a higher price. However, if the price charged is p, then these consumers achieve a surplus which is represented by the shaded area. The demand curve is downward sloping to indicate that more of the product will be bought as the price falls. This follows the assumption that most people will buy more of a product if they think the price is favourable. Marginal utility diminishes as the quantity already possessed rises. So, to sell more, the supplier is likely to have to reduce price. Remember that, as always, when considering the effect of one change we make the assumption that other things remain unchanged. In practice they will not, and in the next chapter we recognise this. My valuation of the marginal utility of apples will change if I discover that the store has received a large consignment of nectarines and peaches and is selling these at prices around my marginal utility for these fruits.
For example, suppose a firm making bottled fruit juice drinks is faced with an increase in costs due to an increase in the price of fresh oranges. How much will the firm's weekly sales of its bottled orange drink fall if it passes on its increase in costs and puts up the price of its orange drink? To answer this question the firm needs to know what the market demand curve for bottled orange drinks looks like. The market demand curve for a good or service is the horizontal summation of all the separate individual demand curves for the good or service. What this means is that the quantity demanded at different prices by each person is combined with the quantity demanded by all the others in the market, to give the total quantity demanded at each and every price. This is illustrated in Figure 2.6 for a simplified market with only two customers. Figure 2.6: Demand curve illustrating horizontal summation Individual APrice Price
Individual BPrice
Individual A + B
Qa+Qb Quantity
Review PointsBefore you begin your study of the next chapter you should go back to the start of this one and check that you have achieved the learning objectives. If you do not think that you understand the aim and each of the objectives completely, you should spend more time rereading the relevant sections. You can test your understanding of what you have learnt by attempting to answer the following questions. Check all of your answers with the chapter text. 1. 2. 3. 4. Why would a person who likes chocolate, who has just consumed five bars, be unwilling to pay as much for a sixth bar of chocolate as they did for the first bar? What is consumer surplus? What factors are assumed constant when constructing an individual's demand curve for a good? What information would you need to have to construct the market demand curve for a good?
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Further Demand Elasticities Income Elasticity of Demand Influences on Income Elasticity of Demand Cross Elasticity of Demand Influences on Cross Elasticity of Demand The Importance of Elasticity Calculations
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The Classification of Goods and Services Normal Goods Inferior Goods Giffen Goods Luxury Goods Bads
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(Continued over)
Substitutes Complements
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Revenue and Revenue Changes Total Revenue Average Revenue Marginal Revenue Marginal Revenue and Price Elasticity
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ObjectivesThe aim of this chapter is to: explain the concept of elasticity in relation to different types of good and firm behaviour through an understanding of the revenue function; solve numerical problems involving elasticity. When you have completed this chapter you will be able to: explain the reasons for movements along or shifts in demand curves identify the formulae for, and explain what is meant by, own-price, cross-price, and income elasticities of demand and discuss factors which affect each of these elasticities solve numerical demand elasticity problems using demand information explain, in words, diagrams and with reference to demand elasticities, what is meant by each of the following: normal goods, bads, inferior goods, Giffen goods, luxury goods, complements and substitutes identify real world examples of each of these examine, using diagrams and numerical examples, the relationship between total revenue, average revenue and marginal revenue and between marginal revenue and the elasticity of demand for a profit- maximising firm discuss how a profit-maximising firm might respond to information about demand elasticities.
A. INFLUENCES ON DEMANDFlow of DemandThe demand curve which we identified in Chapter 2 illustrates the quantities of a product that a group of consumers are prepared to buy at a range of possible prices. We must remember that these quantities are always related to a time period. Demand is seen in terms of a flow of purchases over a stated time. For example a greengrocer may want to know the weekly quantity of apples he can sell at a price of 80p per kilo, and compare this with the weekly quantity he could sell at 90p per kilo. The time is not always shown in simple demand graphs, but we must not forget its importance. It is not much use being able to sell 100 kilos instead of 50 kilos if it takes three times as long to do so. If we clearly understand this idea of demand flow, remembering the points we made in Chapter 2, we can go on to identify the various influences which affect that flow.
If a new product is introduced to the market, there is likely to be an effect on other goods. For instance the introduction of cheap electronic calculators destroyed the demand for slide rules. On the other hand the development of portable radios and personal stereos also created a demand for the associated (complementary) product the batteries needed for their operation. If a major product is introduced and becomes popular enough to absorb a significant part of personal income, then people will reduce purchases of other products which they may consider less desirable. There may be no obvious association between the desired product and the one neglected. For example, a person who decides to pay for a parttime degree course to enhance career prospects may think it worthwhile to spend less on entertainment or to put off replacing a car or furniture.
Market SizeMany factors can change market size. A firm selling clothes to teenagers will benefit from any increase in the numbers of teenagers in the population. Specialist shops selling babies' and children's wear will suffer from a declining birth rate. Market size can be increased by improvements in communications and technology. The development of the Internet has greatly increased the market area open to many consumer-goods firms. Increased foreign travel by people from a country can extend the demand and market area for foreign wines and foods in that country. Improved techniques of refrigeration extended the market for frozen vegetables.
market sales. Certainly, it is the volume of advertising in relation to competitors' advertising that is likely to be important.
TasteThis is a quality difficult to define. People's desire to buy products is the result of many influences, not all of which are fully understood. Fashions change, and these changes cannot always be caused by advertising. The successful firm is often the one that is able to make an accurate prediction of changes in fashion and taste.
ExpectationsExpectations of future changes in any of the previously mentioned influences can affect present demand. For example, people expecting rising prices will buy now rather than later. On the other hand, if they fear unemployment and falling incomes, they will cut down their present spending. Notice that these reactions may actually help to bring about the feared future changes.
Special InfluencesCertain products may be subject to special influences other than the ones we have already mentioned. The demand for soft drinks or for waterproof clothing, for instance, will be influenced by weather conditions. The demand for private education in an area will be influenced by the reputation of State-owned schools in that area.
Summary of InfluencesAll these influences on demand for a product can be expressed in a form of mathematical shorthand. Thus, we can say that: Q (Po, Pa, Yd, N, A, T). This simply means that the quantity demanded of any product (Q) is a function () of (is dependent upon) its own price (Po), the prices of other goods (Pa), disposable income (Yd), market size (N), marketing effort (A), and customer taste (T).
D1 D O q q1 Quantity
CalculationPrice elasticity of demand can be denoted by the symbol Ed. It is the relationship between a proportional change in quantity demanded and a proportional change in price, such that: Ed proportional change in quantity demanded proportional change in price, or Ed Q P Q P
where: P price of the product Q quantity demanded of the product Q a small change in Q and P a small change in P. As explained earlier, for the great majority of goods a rise in price leads to a reduction in quantity demanded and a fall in price leads to an increase in quantity demanded. Thus the change in quantity is the reverse of the change in price. One of the changes will be negative, indicating a reduction: thus the value of Ed will also be negative. However, to simplify exposition the negative sign is often omitted when talking and writing about demand elasticity, but it must always be remembered that the relationship is usually negative. When the calculation of price elasticity of demand produces a result in which the proportional change in quantity is greater than the proportional change in price, we say that demand is price elastic. When the calculation of price elasticity of demand produces a result in which the proportional change in quantity is less than the proportional change in price, we say that demand is price inelastic. When the calculation of price elasticity of demand produces a figure of 1, i.e. when the proportional change in quantity is equal to the proportional change in price, we say that demand has unitary elasticity.
For example, suppose we have the following demand elasticity estimates: the price elasticity of demand for fish is 0.9, that for washing powder 0.3, and that for eggs 0.02. All three of these demand elasticities are price inelastic (i.e. less than 1), but fish is clearly much more price sensitive than eggs. Note that while the demand for washing powder is price inelastic, for a particular brand of washing powder it might well be price elastic, say around 1.3. Do not forget that each of these elasticity estimates involves an inverse relationship so that the numbers have a negative sign. One important feature of price elasticity of demand is that it changes as price changes. Consider the demand curve shown in Figure 3.2.
Price elasticity of demand is unity, and so demand is neither elastic nor inelastic. Here, revenue remains the same at both prices because the change in price produces exactly the same proportional change in quantity (the size of the ratio Q/Q is the same as the size of the ratio of P/P): Revenue at price 5.5 (i.e. 5.5 x 6.5) revenue at price 6.5 (i.e. 6.5 x 5,5) 35.5 At point B:1 Q 1 P Q P ; therefore, and Ed is greater than 1 ; Q 2 P 10 Q P
Demand is price elastic. The size of the ratio of Q/Q is greater than the size of the ratio of P/P, so a reduction in price at B results in a more than proportional increase in quantity demanded, and there will be an increase in total revenue: A price reduction from 10.5 to 9.5 increases revenue from 15.75 to 23.75. A firm in this position will increase revenue by reducing price, but lose revenue if it increases price. At point C:Q 1 P 1 Q P ; therefore, ; and Ed is less than 1 2 Q 10 P Q P
Here, the position is completely reversed and Ed is less than 1, so demand is price inelastic. The size of the ratio Q/Q is less than the size of the ratio of P/P, so a reduction in price here results in a less than proportional increase in quantity demanded, and there is a fall in total revenue: A price reduction from 2.5 to 1.5 reduces revenue from 23.75 to 15.75. A firm in this position will lose revenue by reducing price, but gain revenue by increasing price. The point of greatest possible revenue on any linear demand curve is where price elasticity is at unity (where Ed 1) i.e. at A. Notice also that the calculations shown in this illustration are made around the midpoint of each change. Calculations made in this way are called "arc elasticity". They are the correct way to measure price elasticity, unless we are able to use the necessary mathematical techniques to calculate "point elasticity" at a particular point on the demand curve. For all but very small changes, point elasticity calculations will show different results depending on whether we assume a price rise or a price fall, and this is confusing and inaccurate. You can test this for yourself if you compare the calculation for a price rise from 9.50 to 10.50 with a price fall from 10.50 to 9.50.
In general, the more highly-priced durable goods (household machines, motor vehicles, etc.) and services are more likely to be income elastic than the staple items of food and clothing. We do not usually buy twice as much of these if we receive double our former income. On the other hand, our spending on holidays may increase by far more than double. Increased spending on motor transport is also associated with rising incomes. Although we have been considering income rises, very similar comments apply to income reductions. Holidays and motor cars are often the first things to be sacrificed in the face of a sudden drop in income.
Price elasticity of demand can also change as a result of other influences. If, for example, there is a long-term trend away from smoking, we can expect demand for cigarettes to become price elastic at lower price levels in the future. If governments wish to influence consumer demand by price changes, they are likely to try to make demand more price elastic by ensuring that suitable substitutes are available for the target product. For instance, to reduce consumption of leaded petrol, the availability and demand for unleaded petrol must be encouraged, and vehicle engines must be capable of easy and cheap conversion to unleaded petrol. They may wish to support any tax changes by changes in the law, perhaps requiring all new vehicles to be adapted to use unleaded fuel.
Normal GoodsThe vast majority of goods and services in the world are normal goods. The demand curve for normal goods slopes downwards from left to right. As explained previously, the defining characteristic of a normal good is that it has a positive income elasticity of demand. A luxury good is a special case of a normal good in that it is a good with a positive and high income elasticity of demand. As incomes increase the demand curves for normal goods shift outwards to the right as shown in Figure 3.1.
Inferior GoodsThe demand curve for an inferior good also slopes downwards from left to right. The defining characteristic of an inferior good is that it has a negative income elasticity of demand. As incomes increase the demand curves for normal goods shifts inwards to the left, indicating that less is demanded at each price. In contrast, a reduction in incomes will shift the demand curve for an inferior good to the right.
Giffen GoodsGiffen goods (named after named after Sir Robert Giffen, who is attributed as first suggesting the existence of such goods) are a special case of inferior goods. A person's demand for inferior goods decreases, ceteris paribus, as their income increases and increases as their income decreases. That is, as we have said, inferior goods have a negative income elasticity of demand. For people on very low incomes their demand for a
good may actually increase as the price of the good increases. This is because the rise in price reduces their real income to such an extent that they cannot afford to buy sufficient of more preferred goods. Real income refers to the quantity of goods and services a person can buy with their money income. If I have 300 a week to spend and the prices of all the things I buy each week double, my real income falls because I can now only buy half the quantity with my 300. The demand curve for Giffen goods slopes upwards from left to right, unlike the demand curve for normal goods, with more demanded at a higher price than at a lower price. The negative real income effect associated with the rise in price outweighs the desire to buy less because of the higher price. In practice Giffen goods are rare. Examples are the types of food items that form an important part of the daily diet of people on very low incomes. Potatoes, bananas or rice, as a source of carbohydrate, are the main daily foods for many of the world's most impoverished people. Depending on their tastes, and their incomes, they may supplement their consumption of one of these sources of carbohydrate with some meat or fish and/or vegetables. But if the price of potatoes rises significantly, some people may be so poor that they can no longer afford to buy potatoes, and fish and vegetables. Faced with a choice between feeling hungry because they can only afford very, very small amounts of potatoes, fish and vegetable on their plate or feeling full because of a large plate of potatoes, they may buy more potatoes despite their higher price. Strictly the term "Giffen" applies only when the "inferior" income effect created by a change in price is more powerful than the normal price substitution effect which leads people to switch their expenditure in favour of goods as they become relatively cheaper. However it is often used more widely whenever demand appears to rise as price rises for whatever reason. There are a number of other possible explanations for this behaviour. For example, people may (rightly or wrongly) associate price with quality, e.g. for tomatoes, and prefer to pay a little more in anticipation of obtaining a more satisfactory fruit. If there were some other trusted mark of quality, the normal price-quantity relationship would hold. Demand may also rise for a work of art which people think is gaining acceptance in the art world. If people think that the price is going to rise even more in the future, they may buy the work of art as an investment and not simply because they get pleasure from looking at it. In this case, we are really dealing with a different product. In yet more cases, the rise in demand is just the result of other influences as described in this chapter, and these are proving more powerful than the influence of price on its own.
Luxury GoodsLuxury goods are usually high-priced goods, often with a well-known brand name. In marked contrast to Giffen goods, the income elasticity for luxury goods is positive, as it is for normal goods. As people's real incomes increase we observe that the pattern of their demand changes: they start to buy goods that they did not purchase when their incomes were low. The demand curve for luxury goods is downward sloping, as for normal goods, but the whole demand curve shifts outwards to the right as consumers' real incomes increase. This rightward shift of the demand curve for luxury goods is very pronounced. This is because in the case of luxury goods the income elasticity of demand is not just positive but it is greater than one. If a person had an income elasticity of demand for a particular good of say 3, this would imply that their demand for the good would increase by 300 per cent if their income doubled. Although the demand curve for some goods that appear to be luxury goods can be upward sloping, like that for a Giffen good, meaning that demand increases as price rises, the economic reason for this is different to that for Giffen goods. In fact, it is better to call these goods "snob" goods, to indicate that they are a special case of luxury goods. The demand for snob goods increases as their price increases for the reason that people attach
importance to their price as a desirable, possibly the most desirable, characteristic of owning and using the good. Does a 10,000 bottle of wine taste that much better than a similar wine costing 100? The answer does not matter for some people: they are buying the 10,000 bottle of wine as a statement or display of their wealth, and the very high price is the thing that shows this! You should be able to think of similar examples involving some makes of luxury car, watches, trainers and ladies' fashion.
Bads"Bads" are simply those things that we would rather not have but which may nevertheless exist, and be consumed in the sense that people have no choice but experience them. Examples include atmospheric pollution, water pollution, noise and crime. By definition there are no demand curves for bads, at least for most people. The concept is still useful, however, because it explains why communities and governments may take action to intervene in markets to reduce or eliminate the production of certain goods and services that are associated with the production of bads, e.g. manufacturing equipment which causes a high level of pollution.
SubstitutesAs explained in an earlier section, when the relationship between the demand for one good and the price of another, as measured by their cross-price elasticity of demand, is positive the two goods are referred to as substitutes. That is, an increase in the price of one of the two goods will lead to an increase in the demand for the other. Conversely, a decrease in the price of one will lead to a decrease in demand for the other. For example, a decrease in the price of digital cameras will lead to a decrease in the demand for traditional film-based cameras.
ComplementsAs explained earlier, when the relationship between the demand for one good and the price of another, as measured by their cross-price elasticity of demand, is negative the two goods are referred to as complements. That is, an increase in the price of one will lead to a decrease in the demand for the other. For example, a large increase in the price of cars will lead to a decrease in the demand for petrol.
Total RevenueIn general revenue refers to the money received from the sales of a product. For this reason, the term "sales revenue" is often used. To have any practical meaning, revenue should also be related either to a time period or to a definite quantity of goods sold. For example, a shopkeeper may refer to her weekly sales revenue (the total amounts of sales achieved in a week) or to her revenue from the sales of n pairs of shoes or k kilos of potatoes. A statement that her revenue is y means nothing, unless we can relate it to some quantity of time. Revenue will not always increase as more goods are sold this will be the case only if a firm can continue to charge the same price, regardless of quantity it sells. If I make leather belts and can sell all the belts I can make at a standard price of 5, then my total revenue is always 5 multiplied by whatever quantity I sell.
This can be shown in the form of a total revenue curve, as in Figure 3.3. Figure 3.3: Total revenue curve120 Revenue 100 80 60 40 20 0 0 5 10 15 20 25
Number of belts sold per week If all belts can be sold at 5 each, total revenue continues to increase at a constant rate However, if I continue to produce more and more belts, there will come a time when customer resistance sets in. I shall have difficulty in finding more people who value belts at this price of 5, i.e. the marginal utility of which is at least 5. When this time comes, I may still find more people who are willing to pay 4. Now, in developed market economies shopping conditions are such that shoppers expect all goods to be priced, so I cannot leave my belts without any price ticket attached and hope to sort out from the people who visit my shop those willing to pay 5 and those willing to pay 4. If I want to sell more belts and am willing to charge 4, then I must charge this price to everyone. If I continue to produce even more, I might then find that to sell the increased quantity I have to charge 3. If I go on doing this, I am likely to find that my total revenue starts to fall. Suppose I find that total revenue rises if I reduce the price from 5 to 4, but falls if I reduce the price to 3. This will happen if the reduction from 4 to 3 does not produce enough additional sales to make good the loss suffered when I charge 3 to those people who would still have bought at prices of 5 or 4. My sales schedule at the three prices might be as in Table 3.1. Table 3.1: Sales schedule for belts Price per belt Number of belts I can sell per month 200 280 340 Total revenue
5 4 3
This effect can be shown in the form of a simple graph but this time the turning point can be seen (Figure 3.4). If I try to reduce the price still further, below 3, I shall lose even more revenue. Figure 3.4: Revenue from sale of belts1200 Revenue 1100 1000 900 800 700 600 140 160 180 200 220 240 260 280 300 320 340 360
Average RevenueWe are going to use the term "average" in its most common sense: the average revenue is the total revenue divided by the quantity of goods sold. If a shop's weekly revenue from selling broccoli is 600 and it sells 300 kilos in the week, the average revenue of the broccoli sold is 2 per kilo. If all goods are sold at the same price in the given time period as, say, with our leather belts then the average revenue is the same as the price. The average revenue curve for the belts is shown in Figure 3.5. Figure 3.5: Average revenue curve for belts5 Price per belt/ Average revenue 4
2 140 160
240 260
340 360
Notice in this case that the average revenue curve is really just the same as the demand curve. This will always be the case where all items sold in the time period are sold at the same price, i.e. where there is no price discrimination between different customers. In most market conditions a firm's average revenue curve is identical with its demand curve and the two terms can be used interchangeably. Figure 3.6: Horizontal average revenue curve Price per kilo 3
The shopkeeper can sell any quantity up to 700 kilos per week at the price of 2 per kilo
Kilos of broccoli sold per week To return to our shopkeeper selling broccoli at 2 per kilo: let us suppose that she is selling every kilo for 2 and that she finds she can sell as much broccoli as she can handle at that price. She does not need to reduce her price to increase quantity sold from 200 kilos per week to 300 or 400 or even 500 kilos. The average revenue curve in this case is still the same as the demand curve, but it reflects this increasing quantity sold at a constant price. This produces the horizontal line graph shown in Figure 3.6.
Marginal RevenueIf a firm is able to maintain a constant price as it increases output, then the additional amount it receives for each extra unit sold is of course that unit's price. In this case the price, which is the same as average revenue, is also the same as the change in total revenue resulting from the sale of the extra unit. The change in total revenue brought about by a small or unit change in the quantity flow of sales is known as the marginal revenue. Marginal revenue is not always the same as the price or average revenue. Remember the example of the leather belts. There, an increase in sales from 280 to 340 belts per month produced a fall in total revenue. For the change in this output range, the marginal revenue must be negative. The reason is the same as for the fall in total revenue in order to increase sales, the price had to be brought down. In this case, the revenue gained on the additional quantity sold was not enough to make good the revenue lost for customers who would have been prepared to buy at the higher price. A simple example will show how marginal revenue can change when price has to be reduced in order to increase the quantity sold. Look at Table 3.2. There are some important features to note about this table. The marginal revenue column has its figures placed midway between the rows. This emphasises that the marginal revenue relates to the change from one output level to the next.
Table 3.2: Change in marginal revenue when price is reduced Number of TV sets sold per week 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Price per set 600 575 550 525 500 475 450 425 400 375 350 325 300 275 Total revenue 600 550 1,150 500 1,650 450 2,100 400 2,500 350 2,850 300 3,150 250 3,400 200 3,600 150 3,750 100 3,850 50 3,900 0 3,900 50 3,850 Marginal revenue
On a graph, the marginal revenue is also plotted midway between the output levels. This is shown in Figure 3.7.
Figure 3.7: Change in marginal revenue when price is reduced Marginal 700 revenue 600 500 400 300 200 100 0 0 -100 2 4 6 8 10 12 14 16
Look carefully at the price and marginal revenue columns in Table 3.2. Notice that, as each additional TV set is sold, the price (average revenue) falls 25. The fall in marginal revenue for each additional set is exactly double this 50. In Figure 3.8, we see the marginal and the average revenue curves together. Figure 3.8: Marginal and the average revenue curves Price, average 700 and marginal revenue 600 500
At each price, marginal revenue is halfway between the price axis and the average revenue
Average Revenue
Marginal Revenue
0 0 -100 2 4 6 8 10 12 14 16
Notice that, at each price level, the marginal revenue is exactly halfway between the price axis and the average revenue. Although Figure 3.8 does not continue the average curve until it meets the quantity axis, we can deduce where it would meet if continued in the same straight line. It would meet the quantity axis at 25 TV sets twice the marginal revenue quantity when marginal revenue equals zero, thus indicating that this supplier would be able to dispose of only 25 sets, even if he did not charge any price at all (i.e. give them away). The average revenue curve cannot of course pass below the quantity axis, as we do not expect suppliers to pay customers to take their goods. However the marginal revenue curve can pass into the negative area of the graph, and so indicate quantities where continued price reductions would result in an actual fall in total revenue. We can see this clearly from Table 3.2. Marginal revenue remains positive until 12 sets are sold. The increase from 12 to 13 sets does not change total revenue at all, so marginal revenue here is zero. If we continue to reduce price and sell 14 sets, then total revenue falls to 3,850 and marginal revenue indicates the loss as 50. The total revenue curve for Table 3.2 is shown in Figure 3.9. Compare this with Figure 3.8 and see how the marginal revenue relates to the total revenue at the various numbers of TV sets sold. Figure 3.9: Total revenue curve4000 Total revenue
Total Revenue
Total revenue is at its maximum (3,900) between 12 and 13 sets per week. If more than 13 sets are sold, total revenue starts to fall i.e. marginal revenue is negative.
0 0 2 4 6 8 10 12 14 16
TV sets sold per week This example has illustrated an important rule. Whenever we have a linear average revenue curve (i.e. where there is a constant relationship between price and quantity changes resulting in a straight-line graph) then the marginal revenue curve is also linear (a straight line) and always bisects (cuts into two equal halves) the horizontal distance between the price/revenue axis and the average revenue curve.
Review PointsBefore you begin your study of the next chapter you should go back to the start of this one and check that you have achieved the learning objectives. If you do not think that you understand the aim and each of the objectives completely, you should spend more time rereading the relevant sections. You can test your understanding of what you have learnt by attempting to answer the following questions. Check all of your answers with the chapter text. 1. 2. What is the difference between a movement along a demand curve and a shift in the demand curve? Other things remaining unchanged, will an increase in income shift the demand curve for a normal good to the: (a) (b) 3. left or right?
If the cross-price elasticity of demand between two goods is positive are the two goods: (a) (b) substitutes or complements?
4. 5. 6.
What is marginal revenue and how does it change as a firm reduces its price? Complete this statement: The other name for a firm's demand curve is its .. A firm is currently selling its product at a price that lies on the inelastic part of its demand curve. In this situation can the firm increase its sales revenue by: (a) (b) increasing its price or decreasing its price? the elastic part of its demand curve or the inelastic part of its demand curve?
To maximise the revenue from placing a sales tax on a good should a government place the tax on a good for which demand is: (a) (b) inelastic or elastic?
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Factor and Input Costs Fixed Costs Variable Costs Total and Average Costs Marginal Costs Long-run Costs
57 58 59 59 61 64
Economic Costs
Costs and the Growth of Organisations Returns to Scale Economies of Scale Diseconomies of Scale External Economies The Law of Diminishing Returns, Returns to Scale and Economies of Scale
66 66 67 68 69 69
Small Firms in the Modern Economy Economies of Scale Services The Role of Small Firms in the Economy
70 70 71 71
Costs of Production
ObjectivesThe aim of this chapter is to: discuss the theory of costs, explaining the differences and relationships between various types of cost and distinguishing between the short and long run; solve numerical problems based on cost information; explain and contrast, in words and diagrams, the concepts of economies of scale and returns to scale. When you have completed this chapter you will be able to: explain with reference to appropriate examples, the difference between fixed and variable factors of production identify the formulae for, and explain what is meant by, fixed cost, variable cost, marginal cost, average cost and total cost solve numerical and/or diagrammatic problems using cost data explain, using an appropriate diagram, the relationship between average and marginal cost explain, using appropriate examples, the difference between fixed cost and sunk cost explain what is meant by economies and diseconomies of scale and relate these concepts to the long-run and short-run average cost curve explain what is meant by increasing, constant and decreasing returns to scale and, using real world examples, how each of the these might arise compare and contrast the concepts of returns to scale and economies of scale.
Total ProductWe begin in this section by repeating part of Chapter 1 and examining what happens when production increases in the short run, when the production factor capital is fixed and when the factor labour is variable. Once again we can take a simple example of a small business which is able to increase its use of labour. For simplicity we can use the term "worker" as a unit of labour, but as remarked before you may wish to regard a worker as a block of workerhours which can be varied to meet the needs of the business. Suppose the effect of adding workers to the business is reflected by Table 4.1, where the quantity of production is measured in units and relates to a specific period of time, say, a month. The amount of capital employed by the business is fixed.
Table 4.1: Number of workers and quantity of production Number of workers 1 2 3 4 5 6 7 8 9 10 11 Quantity of production (units per month) 30 70 120 170 220 260 290 310 320 320 310
The quantity of production (measured here in units produced per month) which is shown as a graph in Figure 4.1 is of course the total product. In this example total product continues to rise until the tenth worker is added to the business. This worker is unable to increase total product. Given the fixed amount of capital, no further increase in productive output is possible. The addition of an eleventh worker would actually cause a fall in production. Figure 4.1: Illustrating total product Units of Production per month350
Total Product
0 0 2 4 6 8 10 12
The marginal product of labour is the change in total product resulting from a change in the amount of labour employed. It is called marginal because it is the change at the edge; the term "marginal" is used in economics to denote a change in the total of one variable which results from a single unit change in another variable. Here the total is quantity of production resulting from changes in the number of workers employed. The marginal product column shows the difference in the total product column at each level of employment. Notice that the marginal value is shown midway between the values for total product and the number of workers. This is because it shows the change that takes place as we move from one level of employment (i.e. adding an additional worker) to the next. In Figure 4.2 the marginal product is represented by the vertical distance between each step in production as each worker is added. The sum of the marginal product values up to each level of worker is equal to the total product at that level.
20 30
40 30
Workers Notice how the value for marginal product changes as total product rises: one worker alone can produce 30 units but another enables the business to increase production by 40 units and one more by 50 units. There are many ways in which this increase might be achieved, e.g. by specialisation and by freeing the manager to improve administration, purchasing and selling. However, these increases cannot continue and the additional third, fourth and fifth workers all add a constant amount to production. Thereafter, further workers, while still increasing production, do so by diminishing amounts until the tenth worker adds nothing to the total. At this level of labour employment production has reached its maximum, and the eleventh worker actually provides a negative return total production falls. Perhaps people get in each other's way or cause distraction and confusion. If the business owner wishes to continue to expand production, thought must be given to increasing capital through more buildings and/or equipment. Short-run expansion at this level of capital has to cease. Only by increasing the fixed factors can further growth be achieved. As remarked in Chapter 1, this particular example is purely fictional it is not based on an actual firm: but neither is the pattern of change in marginal product accidental. The figures are chosen deliberately to illustrate some of the most important principles of economics, the so-called laws of varying proportions and diminishing returns. It has been constantly observed in all kinds of business activities that when further increments of one variable production factor are added to a fixed quantity of another factor, the additional production achieved is likely first to increase, then to remain roughly constant and eventually to diminish. It is this third stage that is usually of the greatest importance, this is the stage of diminishing marginal product, more commonly known as diminishing returns. Most firms are likely to operate under these conditions. It is during this stage that the most difficult managerial decisions, relating to additional production and the expansion of fixed production factors, have to be taken. Of course it must not be assumed that firms will seek to employ people up to the stage of maximum product when the marginal product of labour equals zero, or on the other hand that
they will not take on any extra employees if diminishing returns are being experienced. The production level at which further employment ceases to be profitable depends on several other considerations, including the value of the marginal product. This depends on the revenue gained from product sales, and the cost of employing labour, which is made up of wages, labour taxes and compulsory welfare benefits. The higher the cost of employing labour, the less labour will be employed in the short run and the sooner will employers seek to replace labour by capital in the form of labour-saving equipment.
0 0 -10 2 4 6 8 10 12 Workers
(labour units)
The falling marginal product curve intersects the average product curve at about the 5th worker. Average product then starts to fall because for more workers marginal product is below average product. Notice the relationship between average and marginal product. Average product continues to rise until it is the same as the falling marginal product, then it falls. This must happen as can easily be proved mathematically, and you can see it for yourself if you take any set of figures where marginal product continues to diminish.
Fixed CostsFixed costs are the costs of the fixed factors, i.e. those elements which are not being increased as production or output is being raised. The total fixed costs for a given range of output can be illustrated in the simple graph shown in Figure 4.4. Figure 4.4: Total fixed costs Cost 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
Output (units per week) Examples of fixed costs include rent for land or buildings, rental charge for telephone or telex, business rates, salary of a manager, and fees for a licence to make use of another company's patent. All these costs can change, but the point is they do not change as production level changes. The cost has to be met, whatever the level of output and sales. The graph of average fixed costs, i.e. total fixed costs divided by the number of units of output produced, is shown in Figure 4.5. This is based on the fixed costs of 10,000 assumed in Figure 4.4. Notice the steep fall at the lower levels of output, and the much more gentle slope of the curve at higher levels. Between 140 and 150 units of output per week, the fall in average fixed costs is only from approximately 71 to 67. Figure 4.5: Average fixed costs Cost 1,000 900 800 700 600 500 400 300 200 100 0 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
Variable CostsThe behaviour of variable costs depends on the pattern of production returns. If production is rising faster than the input of variable elements, then costs are increasing less than proportionally to the rise in output. This is because each extra unit of input is adding more to production than it is to cost. This is possible at the lower levels of production represented by the section of graph 0a in Figure 4.6. Later, costs are likely to rise in the same proportion as output this being the stage of constant returns, shown between output levels 0a and 0b. Then, as we reach the level of diminishing returns, costs rise faster (more steeply) than production. This is shown beyond level 0b. Figure 4.6: Total variable costs Cost 24000 22000 20000 18000 16000 14000 12000 10000 8000 6000 4000 2000 0 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
Diminishing returns Cost rise: 7,500 for 45 units Increasing returns Constant returns (100 per unit) Cost rise: 9,500 for 25 units
Fixed Costs
Output (units per week) From the total costs we can obtain average total costs, simply by dividing the total by each successive level of output. Average total costs are often referred to just as average costs. Figure 4.8 shows the graph of average total costs, which has been derived from the total cost curve shown in Figure 4.7. Figure 4.8: Average total costs Cost 1100 1000 900 800 700 600 500 400 300 200 100 0 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
Notice how the shape of the average cost curve at the lower levels of output is very similar to that of the average fixed cost curve in Figure 4.5. This is because, at these levels, fixed costs form a high proportion of total costs. As fixed costs become a smaller proportion of total costs, the curve falls much less steeply. In this illustration, it reaches its lowest point a little below the 110 units per week output level and then begins to rise, as variable costs become steeper in response to diminishing returns to scale. This is the typical shape of the curve in the short run (that is, while "fixed" costs remain the unchanged). Because it falls to a minimum point and then rises, it is often referred to as the "U-shaped" average cost curve, although as you can see, a more accurate description is that of an L with its toe turned upwards. Only if there are particularly severe increasing costs (diminishing returns) to scale, and fixed costs are a very small proportion of total costs, will the second half of the "U" be at all steep; the efficient firm should never allow itself to reach this position. The modern firm is more likely to have a high proportion of fixed to total costs, because of the swing from labour to labour-saving machinery. This movement is described as production becoming more and more capital-intensive. In this case, we can expect the average total cost curve increasingly to resemble the average fixed cost curve.
Marginal CostsYou have already met marginal product, marginal utility and marginal revenue the change in total output, utility or revenue as output changes. You will not then be surprised to know that marginal cost is the change in total cost as output changes. Once again, we relate this change to a single unit of output so that, if we are moving in steps of ten (as in our cost example so far), we shall have to divide any change from one forward step to the next by ten. Table 4.4 is a table of total (fixed plus variable) costs which correspond to our previous graphs. In this table, further columns have been added to show the change in total cost between each output step of ten units per week, and then division by ten to produce the marginal cost. Notice that the figures of the marginal cost column have been placed midway between the figures of the other columns, to emphasise that they relate to a change from one output level to the next.
Table 4.4: Cost table (1) Quantity (2) Total cost (3) (4)
Changes in total cost Marginal cost (column 3 divided by 10) from one quantity level to the next 100
11,000 11,600 12,000 13,000 14,000 15,000 16,000 17,000 18,150 19,500 21,150 23,250 26,000 29,550 34,000
1,000 60 600 40 400 100 1,000 100 1,000 100 1,000 100 1,000 100 1,000 115 1,150 135 1,350 165 1,650 210 2,100 275 2,750 355 3,550 445 4,450
On a graph, the marginal cost is plotted at the midpoints of the various output levels. You will see that this has been done in Figure 4.9, which illustrates the marginal costs shown in Table 4.4.
Marginal Costs300
Output (units per week) In Figure 4.10, the marginal cost graph has been combined with the average cost graph. Notice where these two curves intersect. The rising marginal cost curve cuts the average cost curve at roughly 110 units per week. This is the output level which we have already noted as the lowest level of the average total cost curve. This illustrates a rule that you must remember: the rising marginal cost curve always cuts the average cost curve at its lowest point. If you think a little, you will see that it must do that. If the cost of the last unit to be produced is less than the average up to that point, then the new average will be a little lower. If the cost of the last unit is higher than the average up to that point, then the new average will be a little higher. Experiment with some simple figures and you will see that this must always be true. Remember this relationship, and always show the correct intersection when you draw graphical illustrations.
Long-run CostsIn the long run all factors of production may be increased: no costs are completely fixed. In practice of course the factors which are fixed in the short run will be increased in definite stages, perhaps when a new factory is built or when new technology introduced, etc. The graph of fixed costs in the long run, therefore, appears as in Figure 4.11. Figure 4.11: Fixed costs in the long run Costs
Output The effect of this on the average total cost curve in the long run is shown in Figure 4.12.
The steps result from the increases in fixed costs as output is increased
Output The "flat" part of the average cost curve is prolonged. The question is whether this merely stretches the average cost curve delaying the point of eventual diminishing returns and the rise of the U shape or whether it can be continued indefinitely, in order to prevent the U shape completely and make the long-run average cost curve L-shaped. The relationship between short-run and long-run average cost curves is sometimes shown as in Figure 4.13. This emphasises the fact that one reason for the increase in fixed factors and costs is to overcome the effect of short-run diminishing returns. Figure 4.13: Relationship between short-run and long-run average cost curves Costs As diminishing returns are experienced in the short run, fixed factors are increased and the firm can continue to increase output without serious long-run diseconomies of scale. Short-run Average Cost Curves
C. ECONOMIC COSTSWe are now beginning to see production costs from a variety of angles. Opportunity Costs These were identified in Chapter 1. They may be defined as the cost of using resources in one activity measured in terms of the lost opportunity of using them to produce the best alternative that had to be sacrificed. Absolute Costs These are the full costs of the factors used in the activity under consideration. They may be measured in monetary terms but the real absolute cost is best measured by the actual quantity of factors used, e.g. the amount of land or the numbers of people employed. Private Costs These are the costs actually paid by the producer to the owners or providers of the production factors employed. They are the costs usually taken into account by the accountant and are measured in monetary terms, since the accountant has to account for the use of whatever finance has been entrusted to the production organisation. We have been looking at these costs in this chapter and have also examined the important distinction between fixed and variable costs. External Costs or Social Costs These are the indirect costs imposed on other firms or individuals as a consequence of the process of production by firms. Because these costs are imposed on others in society they are also known as social costs to distinguish them from private costs. Producers have to pay for the direct costs they incur in production (their private costs), but do not take account of the external costs they may also be imposing on society. The main source of such external costs is pollution of the environment. If an electricity supply company burns coal or gas to generate electricity the company pays the market price for the coal or gas it burns as its main input into the production of electricity (its main variable factor of production). Unfortunately for society, and the world environment, the large-scale burning of coal or gas not only generates electricity, it also releases large amounts of pollution into the atmosphere, especially carbon which is a major factor in global warming. Unless governments take action to deal with this problem, by imposing taxes on the use of combustible fuels to generate electricity, the social cost is not taken into account by electricity producers when they decide which fuel and how much of it to use. We will look at these issues in more detail in Chapter 6.
economies of scale. For example this would be the case if a 10 per cent increase in factor inputs produced a 20 per cent increase in production output. If the proportional increase in output is the same as the proportional increase in factor inputs (e.g. when a 15 per cent increase in factors produces a 15 per cent increase in output) then the firm is experiencing constant returns. However if a 15 per cent increase in factor inputs produces less than a 15 per cent increase in output (only 10 per cent, say) then the firm is suffering decreasing returns, or diseconomies of scale.
Economies of ScaleReal scale economies, as defined here, should be distinguished from purely pecuniary or monetary economies. The latter do not represent a more efficient use of factors; rather they are the result of the superior bargaining power of the large firm in the market. For instance, a large customer can often gain discounts greater than can be justified on the grounds of savings in delivery or distribution costs. Or workers in some large firms may be willing to accept a lower wage in return for what is believed to be greater security of employment or the social prestige of working for a famous organisation. Real economies the genuine efficiencies in the use of production factors resulting from growth in the scale of activities can be identified in the following main areas. Labour Economies Labour economies result from greater opportunities for the division of labour which increase with the skills of the workforce, save time and allow greater mechanisation. The automated assembly line in modern motor vehicle assembly is an extreme example of this. Technical Economies Technical economies result chiefly from the use of specialised capital equipment. Large firms are able to make use of equipment that could not be fully employed by smaller operations, and large firms are also able to support reserve machines to avoid disruption following breakdown. A small firm, using three machines, adds one-third to its capital cost if it tries to add a further machine to keep in reserve. A large firm employing 20 machines adds only one-twentieth if it decides to do likewise. Marketing Economies Very great economies are available from large-scale advertising. A television commercial using top stars is very expensive to make, but the cost per potential customer is very low if essentially the same film can be shown in several different countries. Large firms can also afford to keep very skilled marketing specialists fully employed. Financial Economies Large firms are able to obtain finance from markets that are denied to small firms, and multinationals can raise money in many different countries. Nevertheless, although financial economies still exist, we do have to recognise that finance markets have, in recent years, become more responsive to the needs of smaller enterprises. Distribution and Transport Economies Transport movements and the location of depots can be carefully planned by large organisations, so that vehicles and storage space are used efficiently. Managerial Economies Managerial economies arise from the employment of specialised managers and managerial techniques. However many of these techniques have been developed in order to overcome the problems of managing large organisations, and many
economists suggest that managerial economies of scale are often exaggerated and difficult to achieve in practice.
Diseconomies of ScaleDiseconomies of scale are usually associated with the problems arising out of the management and control of large organisations. Formal communication systems are necessary but are expensive to maintain. Whereas the manager of a small organisation can see what is going on around him or her in the course of daily work, the manager of a large firm may have to establish an inspection system to obtain equivalent information which is unlikely to be as reliable. There can also be a loss of control over managers at the lower levels of the managerial pyramid. These managers may then pursue their own private objectives (e.g. building up the power of their own department) at the expense of efficiency and profitability. So diseconomies of scale are mostly managerial. If diseconomies just balance economies, e.g. when a 10 per cent increase in factor inputs produces the same 10 per cent increase in production output, the long-run average cost curve will have the L shape of Figure 4.14. If economies of scale continue roughly to balance diseconomies, this shape may be retained over a long period. However if diseconomies start to rise substantially, then the long-run average cost will again start to rise. Figure 4.14: Long-run average cost curve Costs
Notice here the position of what is called the minimum efficient size (or scale) (MES), also known as the minimum optimum scale (MOS). Up to this output level there are significant gains from internal economies of scale. Firms operating below the MES are at a cost disadvantage when competing against those operating up to or beyond that size. However beyond the MES further cost savings are not significant, and there is no cost advantage in further growth. On the other hand the shape of the curve can change as firms learn how to overcome sources of inefficiency, in particular managerial inefficiency, especially when new managerial skills and communication technology are introduced. It is possible to control very
large firms today in ways that would have been impossible half a century ago. Jet travel and modern telecommunications, not to mention computers and microelectronics, have transformed management techniques.
External EconomiesThe economies of scale listed earlier all apply to the individual firm; they are known as internal economies of scale. There are other economies that are external to the firm. These arise when an industry grows large or when business firms congregate in a particular area. External economies usually arise from the development of specialised services available to many firms. For example, an area containing numbers of small engineering companies may provide opportunities to support one or more specialised toolmakers. Each engineering company can call on the specialist, without having to carry the full cost of having its own specialised department. External economies help small firms to survive in competition with larger organisations. However, if one or two companies become dominant and they internalise these economies by setting up their own specialised departments which they are large enough to keep fully employed, then the external economies may be lost to the smaller firms, which can then no longer survive in the market.
Diseconomy of scale
Economies of ScaleA closer look at economies of scale shows that large firms are not always inevitable. If we assume that the typical successful large company has an L-shaped cost curve, this can still cover a number of different possibilities. Figure 4.15 shows two possible long-run average cost curves. It shows that each reaches a point where further cost reductions as output increases are very small. As noted in the previous section, this point is known as the minimum efficient size: it is reached at 0b for industry B and 0a for industry A. We would therefore expect firms in industry A to be rather larger than in industry B. There is no further significant advantage for firms when they grow beyond these points. Of course this minimum efficient size must be related to the size of the market. If for example industry B served a much larger market than industry A, then we would expect many more firms competing in B than in A. Some world markets have room only for a very few firms. Here, fixed costs are very high and only very large organisations can consider entry. The oil industry is an example of this. Figure 4.15: Long-run average costs for A and B Costs
Industry A Industry B
In contrast, the manufacture of many kinds of plastic household fittings does not require very expensive equipment, and many small firms are able to compete successfully in the market. The general term "economies of scale" also covers both internal and external economies, and it is only internal economies that favour large firms. External economies, such as specialised services, are available to all firms in an area or industry, and these often help small firms to survive. It is when the number of small firms drops below the level necessary for the survival of the specialist as an independent organisation that all the remaining small firms are faced with severe problems, and may have to disappear. Special services to industry such as industrial cleaners, photographers, and designers often serve a restricted market and are likely to remain small. This is especially likely to be true if the service is localised. The service may only be needed occasionally by any one firm, but when it is needed the need is urgent and someone has to be found very quickly. Small local firms are better placed to provide a satisfactory service than a large national organisation. The MES is not the only determinant of the size of firm likely to be found within an industry. The attitudes, abilities and objectives of owners or senior executives play an important part. In the UK Marks and Spencer became a national retail chain in a period when most retail shops were small family firms, as did other high street retailers such as W H Smith, Woolworths and Boots. We can always expect to find some large firms in sectors when small firms form the majority. At the same time we are also likely to find small firms in industries where the MES is large, apparently implying that only very large firms could survive. This may be because they serve a specialist niche which forms a small part of a larger market. Industry definitions can be misleading. For example the term "motor industry" covers activities ranging from motor vehicle assembly to the manufacture of small, specialised components. These activities are not really comparable and the MES for a component manufacturer could be much smaller than for vehicle assembly. Nevertheless it is the giant corporations which dominate the industry. If one of these fails, large numbers of the satellite firms which supply goods and services to it are also likely to fail. If the dominant firms all prosper, the satellites also flourish.
ServicesServices generally tend to be smaller than manufacturing organisations, although there are, of course, some very large service firms developing in activities such as law, accounting and business consultancy. On the other hand, these large firms tend to serve large-scale customers. A leading international accountant is not really suited to do the books of the small corner shop. In any case, the shop would not be able to pay the accountant's fees. There will always therefore be small local firms of accountants, solicitors and so on. If any of these meet problems they cannot handle themselves, then they may be able to call on the specialist services of the giant. As the service sector (including the rising leisure services) of the economy grows, so the scope for small firms continues to increase. As already suggested, new technology based on the microchip and the microcomputer/personal computer is enabling the small firm to achieve a level of administrative efficiency that would have seemed impossible only a short while ago. A business owner who can afford to spend around one to two thousand pounds on a personal computer, software packages and a printer can maintain accounting and secretarial services with just one or two people. In contrast the same standard of service would have required an office of 15 or more people 30 or so years ago or a very expensive mainframe computer complete with specialist programmer.
employment in most economies. Large firms tend to be visible to the public not only because of their physical size but because they usually have well-known brand names which are promoted at home and abroad by extensive marketing. But in most countries the number of very large firms is small in comparison to the very large number of SMEs. Not only do SMEs provide the main source of employment, they also turn out to be the most important source of entrepreneurial development and innovation in both products and processes in the economy. Very large companies may have large research and development (R & D) departments, and very large budgets devoted to R & D, but the evidence is that such activity is also subject to diseconomies of scale and inefficiency. In modern dynamic economies the main source of innovation tends to be the SME sector, and not the very large companies, especially the state-owned or controlled firms. The importance of SMEs for the health and growth of economies, as well as the source of most jobs, has been recognised by governments in many countries and policies have been introduced to support and promote the development of SMEs. Traditionally, the small-firm sector has been seen as the seedbed of enterprise and the nursery in which tomorrow's giants are reared. The microcomputer industry itself is an example. It was not the giant computer monopolists that produced the microcomputer, but brilliant electronics engineers and programmers working on their own initiative. There will always be scope for the entrepreneurial genius as evidenced by such companies as Microsoft, Apple and Google. In recent years the earlier tendencies which resulted in large firms internalising specialised activities have been reversed. Specialist departments which had proved difficult to keep fully employed have been closed, and in many cases the specialists have been helped to form their own businesses, supported with contracts from their former employers. These newly independent firms are once again able to provide their specialist services to large and small organisations. This trend has been developed further by the growth of outsourcing and "offshoring" of business functions to external specialist providers. New communications technology is leading to a revival of a very old form of enterprise what may be seen as a collection of independent firms, all working under the overall guidance of a central, largely marketing, organisation. Computer software production is often produced on this basis, with self-employed programmers producing software to detailed requirements set by the central marketing body. Although the life expectancy of the majority of small firms continues to be short, there are nearly always people willing to fill the gaps left by the casualties. The small firm sector as such continues to exist, and the record of innovation and enterprise from small firms compares favourably with the large corporations. A healthy and dynamic economy requires a diversity of firms of all sizes and activities. Most large organisations have occasion to rely on the services of small firms: often they use them to fulfil contracts which are too small for them to carry out profitably, but which are necessary to retain the goodwill of valued customers. Moreover the continued existence of smaller rivals can often be a healthy reminder to large corporations that they are neither immortal nor indispensable. The growth of own-brand labels developed by the large supermarket chains has provided openings for many smaller manufacturers, who could not otherwise have hoped to compete with the established food corporations. The flexibility and versatility of the modern market economy depends on the existence of many different sorts and sizes of organisation, and this diversity is essential to the maintenance of high living standards and wide employment opportunities.
Review PointsBefore you begin your study of the next chapter you should go back to the start of this one and check that you have achieved the learning objectives. If you do not think that you understand the aim and each of the objectives completely, you should spend more time rereading the relevant sections. You can test your understanding of what you have learnt by attempting to answer the following questions. Check all of your answers with the chapter text. 1. 2. 3. Explain why a firm's short-run average cost curve is U-shaped. Explain why some firms' long-run average cost curve is downward sloping. From the alternatives listed, complete the following: total cost total output (a) (b) (c) 4. (a) (b) (c) (d) 5. (a) (b) (c) (d) 6. fixed cost marginal cost average cost. the total cost of producing an additional unit of output the addition to total cost from producing an additional unit of output total variable cost divided by output the cost saving from economies of scale as a firm increases its output? a reduction in external costs large-scale advertising financial economies transport and distribution economies?
Which of the following will not lead to an economy of scale as a firm expands in size:
A firm expands and doubles its factory size, number of employees and the number of machines and vehicles it uses in production. As a result of this increase in size its average cost of producing each unit of output falls by 20 per cent. Is this an example of: (a) (b) (c) (d) a diseconomy of scale the law of eventual diminishing returns increasing returns to scale a U-shaped short-run average cost curve?
Page76 76 77 77 78
Maximisation of Profit Calculation Profit Maximisation Do Firms Maximise Profits? When to Stop Producing
79 79 83 84 85
Influences on Supply Costs and Supply Supply Curve Other Influences on Supply Effect of Other Influences on Supply Curve Relative Importance of Supply Influences
86 86 88 89 90 91
Price Elasticity of Supply Calculation of Elasticity Elastic and Inelastic Supply Curves Elasticity of Supply in the Long Run
91 91 92 95
ObjectivesThe aim of this chapter is to: explain the concept of profit maximisation and solve problems using diagrams and data; explain the link between a firm's supply curve and its cost functions. When you have completed this chapter you will be able to: explain, using appropriate examples, the difference between fixed cost and sunk cost explain, using words, diagrams and numerical examples, how a firm reaches its profitmaximising choice of output with reference to marginal cost and marginal revenue solve diagrammatic and numerical problems of profit maximisation explain using diagrams how a firm chooses whether or not to stay in operation or leave the industry in the short and long run explain how a firm's supply curve is derived from an analysis of its cost functions explain the reasons for movements along and shifts in supply curves state the formula for the elasticity of supply explain the effect of changes in the elasticity of supply on the diagram of a supply curve solve numerical problems of the elasticity of supply based on data.
Profit as a SurplusIf we see profit not as a factor payment but as a surplus remaining after the production factors have been paid for, the question then arises as to who owns, or should own, this surplus. To Marxist economists the answer is clear. Economic value is created by human labour, without which there can be no economic activity. The berries growing wild on the bush belong to the picker, whose labour of picking has turned them into food. Thus any surplus created by work belongs to those who carry out the work. Therefore profit, to the Marxist who does not recognise a separate entrepreneur, belongs to the workers. However, the Marxist recognises that in the modern capitalist society where production is organised by the owners
of capital and, in the Marxist view, for the benefit of the owners of capital, profit, is in practice, allocated to the owners of capital. If this view is accepted, profit, not interest, becomes the payment to the owners of capital. To the Marxist, the fact that it is paid to the owners of capital rather than to the rightful owners, the contributors of labour, is the result of the domination of capital over labour in the modern capitalist society. In support of this view it is possible to point to company law, which provides that a company's profit belongs to the company's shareholders or, more precisely, to the contributors of the "risk capital" or "equity", the ordinary shareholders in American terminology, the common stockholders. There is no legal requirement that the company should share its profits with the suppliers of labour (employees) or with the suppliers of loan capital, who receive their agreed rate of interest. Still largely accepting this concept of profit as a surplus, other economists, some of whom belong to what has been called the "Austrian school", take a very different view of its economic function. They see it as the driving force of the modern economy and the incentive which has been largely instrumental in bringing about the enormous improvement in general living standards in the market economies over the past two centuries. They see the striving for profit as the force that produces new products, new production technology, new forms of business organisation and new uses for basic resources. The profit that produces this economic energy and invites people of all kinds to take risks with their own resources of money, time and futures, is not "normal profit" but the largest possible profit that can be made in the circumstances within which business operates. There is no need to distinguish between normal and abnormal profit. All profit is necessary to stimulate future economic activity and to provide the investment finance necessary to make the activity possible and raise the level of technology. Unlike Marxists, the economists who take this view do not see profit as being stolen from workers, nor do they see any need for labour to be given only the lowest possible wage. Indeed for business enterprise to succeed, goods and services have to be sold to workers whose incomes are well above subsistence levels, who have disposable incomes and the freedom to choose how to spend these incomes and who expect to have rising incomes. Workers therefore benefit from profitable economic activity by earning rising wages.
The fourth view simply takes the third view further; profit is a positive incentive to "coax out the supply of risk-bearing capital". It is the high return sought by providers of what is often known as "venture capital". The fifth view regards profit as a return to monopoly, whether natural or achieved by artificial means. It is this association of abnormal profit with monopoly that has coloured so much teaching about business profits and objectives. The sixth view recognises the Marxist explanation of profit as surplus value which, for Marx, was properly the reward of the labour that created the value but which, in a capitalist economy, is appropriated by the owners of capital.
Clearly there is no simple or generally agreed explanation of the economic function of profit, though most would agree that both profit and a spirit of enterprise are extremely important elements in modern market economies.
B. MAXIMISATION OF PROFITCalculationWe can arrive at the amount of profit for any given level of output in at least two ways. We can calculate total revenue and total cost and find the difference, or we can calculate the average revenue and the average cost, find the difference and multiply this by the quantity sold. We shall start with the difference between total revenue and total cost. Suppose we return to the example of the last chapter and assume that all units of the product are sold at a given market price of 210 per unit. Costs remain as before. We can now show total revenue and cost columns for each range of output up to 150 units per week as in Table 5.1. Table 5.1: Total cost and total revenue Quantity (units per week) 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Total Cost 10,000 11,000 11,600 12,000 13,000 14,000 15,000 16,000 17,000 18,150 19,500 21,150 23,250 26,000 29,550 34,000 Total Revenue (output level 210) 0 2,100 4,200 6,300 8,400 10,500 12,600 14,700 16,800 18,900 21,000 23,100 25,200 27,300 29,400 31,500
From this table we can see that revenue exceeds total cost at output levels 90 to 130 units per week. At all other output levels, total costs are greater than total revenue, so losses would be suffered. Table 5.2 shows the profit at each output level. Table 5.2: Profit at different output levels Quantity 90 100 110 120 130 Profit 750 1,500 1,950 1,950 1,300
The position is illustrated in Figure 5.1, where the shaded area represents the profit produced when total revenue is greater than total cost. Figure 5.1: Profit in terms of total revenue and total cost Cost/ Revenue/ Profit ()36000
Total Cost The shaded areas show the profit where total revenue exceeds total cost Total Revenue
Units Per Week The same position is shown by the average cost and price/average revenue curves of Figure 5.2. In this case however the shaded area does not represent the total profit, but the profit per unit of output. Total profit would be given by multiplying the profit per unit by the number of units produced.
In this example, the firm is selling all units at a given price, so that the total revenue curve continues to increase though this does not of course mean that it is possible to make a profit at output levels above 130 or so units per week. Figure 5.2: Profit in terms of average revenue and average cost ()600 550 500 450 400 350 300 250
Average Cost
Average Revenue200 150 100 50 0 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
Units Per Week We saw in an earlier chapter that the revenue position could be rather different where the firm had to reduce price in order to increase output. Such a situation is illustrated in Figure 5.3. No specific figures are shown here this is a general model and it shows that the firm can make profits at all output levels between Oa and Ob. These levels, where total revenue just equals total cost, are called the break-even output levels or sometimes break-even points. It is often more convenient to show the average cost and revenue curves (see Figure 5.4). If we assume that the firm is selling all units at any given output level at the same price (i.e. is not discriminating between different customers over price) then the average revenue curve is also the price/output curve (i.e. the demand curve). In this model, we can also see that the firm makes profits between output levels Oa and Ob. This is the quantity range where average revenue is greater than average cost.
Total Cost
b Output
Figure 5.4: Profits, average cost and average revenue () Profits are made between output levels Oa and Ob
Profit MaximisationSo far we have seen the output levels where profits are made, but we have not yet identified the output level where the largest possible (maximum) profit can be made. However, if we refer back to our profit table, we see that there are two points where profits are at their largest at output levels of 110 and 120 units per week. Here, total profit stays at 1,950. If the firm wants to make the largest possible profit, it can choose either of these two levels. It is not unusual for profit to have a rather "flat top" and stretch across two stages in this way. In other cases it can peak at a single stage. Now look back at Table 4.4 in the Chapter 4, which showed marginal costs. Bearing in mind that we assumed the firm to be selling at a constant price of 210, look at the marginal cost column. We have explained that, when the firm can sell at a constant price at all levels of output, the price is also the average revenue and the marginal revenue. Thus, in this case, the firm's marginal revenue is 210. If you look down column 4, you will see that the marginal cost is 210 at the midpoint, representing the change from output level 110 to 120 units per week. This is precisely the output range where profits are at their highest level, i.e. 1,950. This is no accident. It illustrates the general rule that profits are always maximised at the output levels where marginal cost is equal to marginal revenue. The general position is illustrated in Figures 5.5 and 5.6. Figure 5.5 shows the case where average revenue equals marginal revenue (constant price at all output levels) and Figure 5.6 shows the sloping average revenue curve with the marginal revenue curve in the correct position, as we explained before. Figure 5.5: Profit maximisation marginal revenue equals average revenue Revenue/ Cost Profits are maximised at Ob Marginal Revenue Average Revenue Marginal Cost
In both cases, the argument is the same. It does not matter whether the marginal revenue curve slopes or not. If the firm produces at output level Oa, i.e. below the level where marginal cost equals marginal revenue, it would pay it to increase output because the revenue received for each additional unit is greater than the cost of producing that unit. If the firm is producing at output level Oc, above the level where marginal cost equals marginal revenue, then it will pay it to reduce output because revenue lost for each unit of output sacrificed is less than the cost of its production. Only at output level Ob, where marginal cost equals marginal revenue, will it pay the firm to stay at the same level. It cannot then increase profit by any change in quantity produced. This is the level where profits are maximised. This is a most important rule which you should remember carefully, i.e. to maximise profits the firm produces at the output level where marginal cost is equal to marginal revenue.
the short run. In the longer run all costs are variable and the firm will cease production unless the market price increases to a level at which its total revenue exceeds its total costs. Figure 5.7: Loss-making production Costs and Revenue () Marginal Cost Average Total Cost
We can now derive a decision rule for firms regarding whether they should continue or cease production in the short run even when production is unprofitable. A firm should continue to operate at a loss in the short term provided its average revenue exceeds its average variable cost. That is, by choosing to produce anywhere in the range between its average variable cost and its average total cost, the difference between them being average fixed cost, the firm is recovering some of its fixed costs and reducing the magnitude of its unavoidable loss in the short run.
C. INFLUENCES ON SUPPLYCosts and SupplyIf we accept that business firms exist to make profits, then we can recognise that there must be a close link between costs, profits and the willingness of firms to produce the goods and services that consumers wish to buy. After all, profit is the difference between revenue and costs, so that at any given price the amount of profit will depend on production costs. If price remains constant and costs rise, then profit falls and we can expect firms to be less willing to supply goods and services. Similarly, if costs remain unchanged and price rises, then profits will rise and firms will wish to supply more in order to secure the increased profit. We thus have no difficulty in accepting the link between costs and the amount that firms are prepared to supply at a given price or range of prices. If we accept the aim of profit maximisation, then we can be a little more precise than this.
Suppose a firm is seeking to maximise profits and can sell all it can produce at the ruling market price. Suppose too that this market price can change. What will then be the firm's response? Look at Figure 5.8. The profit-maximising firm will seek to produce at that output level where marginal cost is equal to price, i.e. at quantity Oq at price Op, at Oq 1 at price Op1, and Oq2 at price Op2. Figure 5.8: Profit-maximising output levels Price/ Cost The profit-maximising firm will seek to produce at the output level where marginal cost equals price
P2 P1 P Possible Prices
Marginal Cost
Thus we can see that the firm will increase the quantity it is willing to supply as price increases and, conversely, reduce quantity as price falls and that the actual change in quantity will be governed by the marginal cost curve. Therefore under conditions of perfect competition, the individual firm's supply curve is its marginal cost curve. Consequently, the market supply curve is derived from the sum of the marginal cost curves of all the firms operating within the market. This argument continues to hold good when we abandon the assumption of the firm accepting the market price. If a firm faces a downward-sloping demand curve for its product, and hence a downward-sloping marginal revenue curve, we still get the same increase in quantity following the marginal cost curve if we again move the marginal revenue curve outwards, further from the point of origin. This is shown in Figure 5.9. Notice though that Figure 5.9 is drawn on the assumption that the average revenue curve is moving outwards evenly and with its slope unchanged. There is no guarantee that this will ever happen in practice. If the slope of the average revenue curve changes, then so too will the slope of the marginal revenue curve, and there will no longer be the smooth increase in quantity suggested by Figure 5.9. For this reason, we cannot say that, in imperfect markets, the market supply curve will represent the sum of the marginal cost curves of the individual firms. Nevertheless, the general link between supply and marginal costs remains, although it is unlikely to be as direct as in perfect competition.
Figure 5.9: Movement of marginal revenue curve Revenue/ Cost Movement of the marginal revenue curve following increases in demand and price results in an increase in the quantity supplied by a profit-maximising firm
q q1 q2 mr mr1 mr2
Here again, a movement of the marginal revenue curve produces a shift in quantity supplied, in accordance with the marginal cost curve. If you wish you can add the average revenue curves to this graph, and thus show the prices corresponding to the three quantity levels Oq, Oq1 and Oq2. Remember the relationship between average and marginal revenue, and remember that price will be shown by the vertical line from any given quantity level to the average revenue curve.
Supply CurveIf we accept the view that firms will seek to increase the quantity supplied if price increases, and reduce it if price falls, then we can produce a supply curve showing the amounts involved. A supply curve can be for an individual firm in which case, assuming profitmaximising objectives, it will be the marginal cost curve or for all firms supplying a particular product, where it will be made up of the sum of the marginal cost curves of all the firms supplying the product. However the supply curve is formed, we can accept that its general shape will be as in Figure 5.10. This shows the general assumption that more will be supplied as the price rises all other influences remaining the same.
if production is required on a large scale. This can have a marked effect on supply. Thus, small-scale supply may be possible only at much higher prices than large-scale supply, when the different technology becomes worthwhile. The result may be to shift the whole supply curve when production reaches the critical level required for the large-scale technology. Efficiency of the Firm Multinational production of similar products has shown that firms in country A can sometimes produce more from a given combination of labour and capital than similar firms in country B, even though production methods and levels of technology are all much the same. Differences in the productivity of labour and capital (the amount produced per unit of labour and capital) must, in these cases, be caused by differences in managerial efficiency or in the conditions under which people work. In some cases, the movement of managers from one country to the other makes little difference to the gap in factor productivity. The causes of these differing levels of efficiency are not fully understood, but they do help to explain why large multinational firms tend to prefer some countries to others. A change in the level of business efficiency will of course influence supply. Changes in Relative Profitability of Products If a firm can produce either product X or product Y from similar factors, machines and skills, and if it becomes more profitable to produce Y, then the firm is likely to switch its production activities from X to Y. This may happen if the firm normally makes X, but the price of Y rises while the price of X stays the same. There can be other causes of production switches. If there are numbers of firms able to choose between producing X or Y, and the market for Y suddenly disappears, perhaps because of a political decision, then firms previously making Y will have to switch to X if they wish to remain in business. The result will be to increase the supply of X at all prices.
A shift in the supply curve from SS to S1S1 indicates a change in the supply intentions at all prices in the range OP to OP1
Quantity ABE
A shift of this type may follow a change in one or more of the influences as previously described. Moreover, several influences may be operating in different directions. For example, a tax increase may be depressing supply intentions while an improvement in technology is raising them. The final result depends on the relative strength of the influences. It is not easy to analyse these effects through simple graphical models. This is why more advanced studies make rather more use of algebraic models which can be easily handled by computers, and why you should begin to become familiar with functional expressions such as the following. Qs (P, C, T, v, y, o) where: Qs quantity of a product supplied P product's price C factory and input costs T business taxes v level of technology y level of business efficiency o relative profitability of products. This simply states that quantity supplied is a function of, or is dependent on, the various influences symbolised.
Notice that the value of Es is always positive (i.e. greater than zero). This is because the change of quantity is in the same direction as the change in price.
Figure 5.12 shows an example of a simple supply elasticity calculation. Figure 5.12: Supply elasticity calculation Price () 1614 12 10 8 6 4 2 0 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140
Quantity supplied Notice here that figures for both P and Q are obtained from the midpoint of the change in price and quantity, so that the calculation is the same for both a rise and a fall in price. Notice also that the result of this particular calculation is that Es equals unity (1). If you calculate values for Es at any other price level on this curve, you should obtain the same results. The reason for this is explained shortly.
Figure 5.13: Proof of Es = 1 Price can be any angle. As long as the curve passes through O, then ES 1 P1 P 1 P S
Q Q Quantity
But, Es so,P P 1 Q QQ P Q P P Q Q P Q P Q P
and Es 1 A supply curve which passes through the vertical (price) axis is elastic, and one which passes (or, if extended, would pass) through the horizontal (quantity) axis is inelastic. This holds regardless of the slope of the curve, and it applies to the whole curve when this is linear (i.e. forms a straight line). These statements can be proved by the same method as in Figure 5.13. Do not worry if you cannot prove them yourself just remember the position. Examples are given in Figures 5.14 and 5.15.
q q1 Quantity
When the curve is non-linear, the important point is the direction of the tangent to the curve at the price level under consideration. This is shown in Figure 5.16.
Figure 5.16: A non-linear supply curve Price For the non-linear supply curve, tangents show elasticity. At A, supply is elastic, as the tangent cuts the vertical axis. At B, supply is inelastic, as the tangent cuts the horizontal axis. S
Figure 5.17: Change in elasticity over time Price S S1 S2 Supply response over time: at prices above OP, supply becomes more elastic as producers are able to change production in response to changes in price, costs or profitability.
Review PointsBefore you begin your study of the next chapter you should go back to the start of this one and check that you have achieved the learning objectives. If you do not think that you understand the aim and each of the objectives completely, you should spend more time rereading the relevant sections. You can test your understanding of what you have learnt by attempting to answer the following questions. Check all of your answers with the chapter text. 1. Which is the simplest definition of profit? (i) (ii) 2. (i) (ii) (iii) (iv) 3. (i) (ii) The rate of interest paid to savers. The excess of revenue over cost. Average cost is equal to average revenue. Marginal cost is equal to marginal revenue. Total cost is equal to total revenue. Marginal cost is equal to average cost. the elasticity of demand for a good or the elasticity of supply of a good?Qs P PQs proportional change in quantity supplied proportional change in the product' s price Qs P Qs P
To maximise profits which output level should the firm produce at?
Does elasticity of supply measure the responsiveness of a firm's supply to changes in: (i) (ii) the market price of its product or its rate of profit?
Is the main influence on the elasticity of supply the speed with which producers can respond to changes in: (i) (ii) the slope of their supply curve or cost, price and profitability? downward sloping or upward sloping? sales profit elasticity of supply elasticity of demand?
Firms will supply more output if they think it will lead to an increase in their: (i) (ii) (iii) (iv)
A firm should cease production in the short run if its selling price does not enable it to cover all its: (i) (ii) average fixed costs average variable costs?
Nature of Markets The Economic Good Market Area Communications and Transport Conditions of Supply and Demand
Prices in Unregulated Markets Definition of Unregulated Markets Equilibrium Price Changes in Intentions Shifts in the Curves
Defects in Market Allocation External Costs and Benefits Public Goods Inequalities of Income Market Power of some Large Suppliers Deficiencies in the Supply of Public Goods
Methods of Market Intervention: Indirect Taxes, Subsidies and Market Equilibrium What are Indirect Taxes and Subsidies? Effect on Supply Effect of Tax on Price Subsidies Government Use of Indirect Taxes
ObjectivesThe aim of this chapter is to: explain the concept of market equilibrium and examine, using demand and supply analysis, the effects of changes in economic factors upon equilibrium price and quantity; explain the difference between private and social costs, and examine the consequences of externalities for the market equilibrium; examine the effects of various types of government intervention on market outcomes. When you have completed this chapter you will be able to: explain, in words and diagrams, the concept of equilibrium in a supply and demand model, and the process by which equilibrium is reached examine the effects of changes in market conditions (for example a change in the price of a substitute good, a change in consumer income, an increase in advertising expenditure, the introduction of new cost-reducing technology) which lead to shifts in the demand and/or the supply curve upon the equilibrium; explain the importance of elasticity to the impact of such changes draw supply and demand curves based on data and solve for the equilibrium price and quantity explain the meaning of positive and negative externalities, and the distinction between private and social costs and benefits identify real world examples of externalities and discuss how they arise demonstrate the effects of externalities on the market equilibrium using demand and supply analysis and identify the social costs associated with the distortions caused by externalities demonstrate how taxation policy can be used to remedy problems caused by externalities and discuss the merits of a tax approach relative to possible alternative policies examine, using appropriate diagrams, the effects of taxes and subsidies on the market equilibrium, identifying the burden/benefits of taxation/subsidies on consumers and producers examine, using appropriate diagrams, the effects of quotas, price ceilings and price floors on the market price and quantity traded.
A. NATURE OF MARKETSIn economics, a market is an area within which the forces of demand and supply for a particular "economic good" can communicate and interact, so that the "good" can be transferred from suppliers to buyers. This definition contains a number of important elements which have to be considered whenever we analyse a particular market or compare one market with another. Let us look at these elements.
The good can be a physical object, such as a motor car, or it can be a service. It can be a consumer good, an intermediate good, a capital good, or a factor of production. In this course we are concerned chiefly with consumer and production factor markets. We must be careful to give a precise definition of any market we are considering. The total market for motor cars contains a number of subsidiary markets e.g. for sports cars or saloon cars. We must always distinguish the market for the whole class of product from that for a particular brand or other subdivision. Thus, the market for the Mini Metro is distinct from the market for small cars which, in turn, is distinct from that for private cars and from the market for personal transport as a whole. Confusion sometimes arises when we are concerned with the price elasticity of demand for a product. The class or product may be price inelastic, whereas a particular brand may be price elastic. For example, petrol in general may be price inelastic, but the price of K's petrol can be price elastic. The motorist has to have petrol, but she may have the choice of a number of filling stations offering a variety of petrol brands at different prices, and she may also be prepared to go a few miles out of her way to obtain the cheapest brand of petrol.
Market AreaWe need to examine the market area when considering the conditions of a particular market. The area is that within which communication takes place, and not simply where final negotiation is arranged. A sale of antiques or fine paintings may take place in a small room in London. However beforehand catalogues may have been sent to dealers throughout the world, and many foreign buyers may be represented by their agents when the sale or auction actually takes place. In contrast, a small retail shop may be concerned with a market area restricted to a few streets or a single housing estate. The goods it sells may be available in other shops serving different market areas nearby.
The desire to buy must also be realistic. Many of us would like to possess an ocean-going cruiser or a private aeroplane; but few of us have the resources to acquire and operate them.
B. FUNCTIONS OF MARKETSA market has other purposes, apart from providing the means whereby a good is transferred from supplier to buyer.
InformationThe market serves to convey information about the conditions of supply and demand. I may go to a furniture store, not just to buy a piece of furniture but to see what furniture is available and at what price. The better the communication system within the market, the more information I can gain about what can be bought and the more chance I have of achieving full utility from my purchase. This communication function works both ways. The market also informs actual and potential suppliers about the strength and pattern of demand about what people want to acquire and what level of price they are prepared to pay. Suppliers need this information in order to plan production. The problem from the supplier's point of view is often that the information comes too late. The supplier has to make supply decisions before accurate information is available. The supplier wants to know today what market conditions are going to be like tomorrow. The impossibility of achieving accurate forecasts all the time is one of the main sources of business risk.
Establishing PriceArising out of the two-way communication function is a further most important function that of establishing the price at which the buyer is willing to buy and the supplier willing to supply. How this may be achieved is the subject of much of the rest of this chapter. It is such an important function of the market that some large firms ensure that certain markets continue to operate only because they need a reliable mechanism for price-setting. The large manufacturing companies do not really need to buy metal on the London Metal Exchange they can obtain all they need direct from suppliers. But they do need to know the conditions of demand and supply in the main areas where metal is bought and sold. By keeping the metal exchange in operation, they obtain this information, which provides a price-setting mechanism and so helps to reduce some of the uncertainties which they have to face in obtaining essential materials.
Equilibrium PriceThe equilibrium price is the one at which the intentions of suppliers are just matched by the intentions of buyers, i.e. where the amount of the good demanded is just equal to the amount provided. In this state there is no pressure from either supply or demand to move away from this price, so the market forces are in a state of rest in equilibrium. We have examined the concepts of supply and demand schedules and curves. If we put supply and demand schedules and curves together, we can arrive at the equilibrium price, i.e. the market price. Suppose we have the supply and demand schedules for the (fictitious) product Whizzo, as set out in Table 6.1 and illustrated in Figure 6.1. Table 6.1: Supply and demand schedules for Whizzo Price per kilo 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00 Quantity (kilos per week) Producers willing to supply 200 300 400 500 600 700 800 900 Consumers willing to buy 700 675 650 625 600 575 550 525
1 0 200 300 400 500 600 700 800 900 Quantity (kilos per week) We can see from the schedules and the graph that it is only at price 3.50 (600 kilos per week) that the intentions of producers and buyers are the same. At any higher price, producers will be supplying more than buyers are willing to buy. At any lower price, producers will not be supplying enough Whizzo to meet demand. The equilibrium price is 3.50, and 600 kilos per week the equilibrium quantity. As long as neither set of intentions changes, there is no incentive for any movement away from this price and quantity, once it is achieved.
S O q
Here, equilibrium price is Op and equilibrium quantity Oq the price and quantity level where the supply and demand curves intersect. We can develop this approach to analyse the result of movements in the supply and demand curves. (a) Change in Either Demand or Supply Look at Figure 6.3. Here there is a shift in buyers' intentions, caused perhaps by a change in taste, supported by an increase in advertising. The result is a movement of the demand curve from DD to D1D1. In this model, supply intentions remain unchanged. The result is an increase in the equilibrium price and quantity from Op, Oq to Op1, Oq1. We can use the same technique to illustrate the effect of a shift in suppliers' intentions. This is shown in Figure 6.4, where supply falls from SS to S1S1. Demand intentions remain unchanged (DD) and the equilibrium price and quantity move from Op, Oq to Op1, Oq1. Price rises and quantity traded in this market falls. Figure 6.3: Movement of the demand curve D1 D p1 p S D O q q1 Quantity D1 S
Change in Both Demand and Supply So far we have considered only a possible shift in demand or supply. In practice, a movement in one is likely to influence the other through the effect on price and quantity. Suppose there is a major increase in demand, represented by a movement of the demand curve in Figure 6.5, from DD to D1D1. This shift, if supply remains unchanged at SS, results in an increase in equilibrium price from Op to Op1, and in quantity from Oq to Oq1. Now suppose that this increase in quantity makes it worthwhile for one or more producers to develop new production methods, so that the good can be massproduced at a lower unit cost. The result, after a time interval, is to shift the supply curve from SS to St1St1. Here the t 1 indicates a change in time period. The new supply schedule, combined with the increased demand, produces a fresh equilibrium price and quantity at Opt1, Oqt1. We have the apparently unusual result of an increase in demand resulting in a reduction in market price. Note however that this can happen only when given some rather special assumptions about the stage of a product's development and the possibility for change in supply conditions. Figure 6.5: Movement of both the demand and supply curves Price D p1 p pt+1 S St+1 D D1 D1 S
Normally, we expect an increase in demand to raise equilibrium price and quantity. This is the direct effect. The later reduction in price can result only from a shift in the supply curve, indicating a completely new set of supply conditions. A somewhat similar process can be initiated by a change in technology, allowing massproduction at a reduced price. Here, there is first a shift outwards in the supply curve. Demand then rises but not enough to stop the price from falling. Consider the market for mobile phones in this light.
D. PRICE REGULATIONPrice regulation refers to the imposition of a minimum or a maximum market price by government decree or international agreements/organisations, such as OPEC. A maximum price is set by the imposition of a price ceiling. A minimum price is set by the imposition of a price floor. Important applications of such price ceilings and floors include minimum wage legislation, maximum prices for some food items and/or fuel, maximum prices for rented accommodation, and minimum and maximum prices for some commodities in international markets.
ReasonsIf price and quantity will always move to equilibrium provided economic markets are left alone, we must ask why governments and other agencies should ever wish to intervene. In practice, there are several reasons, of which the following are among the most common. (a) Social Unacceptability If the price resulting from an unregulated market were considered to be socially unacceptable, as causing hardship or conflict in the community, attempts might be made to control it. This could happen in a period of food shortage caused by war and/or climatic disaster, and also if there were a shortage of housing in urban areas sufficient to cause hardship and increase risks of disease, crime and other social evils. (b) Incomes of Producers Attempts might be made to maintain high prices if it were desired to raise the income of producers and their employees. This is one of the motives of the European Union's Common Agricultural Policy (CAP). (c) Stability of Supply Some markets are notoriously unstable because of unplanned variations in supply, caused by weather and other circumstances beyond the control of producers. In these cases, attempts may be made to control prices to ensure greater stability in the market.
Looking at the diagram, if price is fixed at p1, quantity supplied (qs1) is more than that demanded (qd1), and there is surplus production. If price is fixed at p2, quantity demanded (qd2) is more than that supplied (qs2), and there is a shortage. Only at price p will quantity supplied equal quantity demanded. We see that any attempt to fix prices at a level other than the market equilibrium price of p will produce either surplus production (fixed price p1 > p) or a shortage (fixed price p2 < p). We are forced to the conclusion that on their own, price controls are ineffective. Governments and other bodies must identify the real problem and seek to solve that. For instance, if the problem is lack of adequate supply (say food or housing shortage), then the government must either increase supply, e.g. by making additional payments (subsidies) to suppliers, or by entering the market as a producer or importer. If these remedies are impossible, the government must ration the available supply among consumers in a way that the community regards as acceptable. Such measures may be effective, at least for a time, though they may be expensive to administer and police. The government or other agency must decide whether the social benefits to be gained from market regulation justify the cost and opportunity costs of the resources used in maintaining the regulations. Care must also be taken to ensure that the regulations themselves do not discourage suppliers to the extent that the basic objects of the policies are defeated. The heavy bureaucracy created by many schemes in the so-called planned or socialist economies often significantly discourages total production. If the problem is excess supply, then the government may seek either to stimulate demand (e.g. by reducing prices through the payment of subsidies), or to reduce supply by encouraging or paying producers to leave the market (as in the case of European Union measures to reduce European milk and wine supplies).
The most difficult problems often involve unplanned fluctuations of supply, when the plans of regulatory bodies can be upset by (say) unusually good or bad crops owing to weather conditions. If there are fairly regular cycles of overproduction or underproduction, and demand is reasonably constant, and if it is possible to store the crops, then the government can apply a mixture of controls over prices and production combined with purchases of overproduction to keep in store for release in periods of underproduction. However, it is found that the guaranteed prices that usually form part of such policies lead inevitably to steady increases in production. The government then finds itself storing quantities of goods that it has little hope of ever releasing for resale, except at very low prices to people in other parts of the world. It may even have to give away some of the surplus produce. Such policies then become a heavy burden on taxpayers and lead to hostility from the community. It is clear that governments which embark on market-intervention policies may, and often do, find that they become involved in increasingly difficult and expensive measures that do very little to solve the problems they were meant to eliminate. There are other reasons why governments may choose to intervene in the market to alter the resultant market equilibrium.
The existence of an external cost associated with the consumption of a good such as alcohol or cigarettes means that the social benefit is less than the private benefit from consumption. Such goods are examples of demerit goods. Because consumers ignore the negative externalities or social costs created by their consumption of such goods, they are overproduced and over-consumed in a free market without government intervention. External Benefits In contrast, it is possible for people to receive benefits from production towards the cost of which they have not contributed. These are external benefits. If a large firm builds modern roads or provides other transport facilities which are then available for use by the general community, then that community gains external benefits. If a business firm provides a good canteen and housing for its workers and, by improving standards of housing and welfare, improves the health of workers and their families, then this, too, is an external benefit. We are well aware of cases where firms cause damage to the environment, but there are also cases were firms improve the environment by renovating property, creating sports grounds, or even parks. The existence of an external benefit associated with the consumption of goods/services such as health care and education means that the social benefit is greater than the private benefit from consumption. Such goods are examples of merit goods. Because consumers ignore the positive externalities or social benefits created by their consumption of such goods, they are underproduced and under-consumed in a free market without government intervention. Economics of Externalities It might be thought that economists would favour external benefits and dislike external costs. In fact, economic theory suggests that all externalities distort the use of resources, and that even external benefits are probably better provided in other ways. The danger of external costs can easily be recognised. For example, if road users, especially heavy goods vehicle users, do not pay the full costs of their road use but pass some of these on to the rest of the community, then the relative costs of transporting goods by road as opposed to by rail or water are distorted in favour of road. Consequently, goods are carried by road transport at a higher cost to the community than it would have paid if they had been carried by other means, say by rail. The community is not making the most efficient possible use of its available resources, and its living standards are lower than they would otherwise be because some production is being lost. Moreover, in situations of this type, the problem tends to be self-worsening. If road transport is artificially cheap, then goods are diverted to road from rail. Road services are overcrowded, and there is pressure to devote more land to roads. Rail services are underused. Agricultural and residential land is lost to roads to carry traffic which could otherwise have been carried by substitute services. This is what we mean when we say that externalities distort the use of scarce economic resources. Externalities and the Government What can be done about externalities? Does the community just have to accept their existence? Clearly neither the producers who are able to pass costs to others, nor the buyers of their goods or services who obtain reduced prices because of the reduction in private costs, are likely to volunteer to pay more unless they are obliged to do so. They could not do so as individuals in competitive markets. Only governments, acting on behalf of the community as a whole and reacting to political pressures, can take effective measures. The options open to government are the following: Legislate to make actions considered undesirable illegal, and enforce the law. In a democracy such laws must be acceptable to the community as a whole; care must be taken to ensure that desirable benefits are not lost and that the cost of law enforcement is not out of proportion to the costs avoided.
Legislate to ensure that producers behave in a socially acceptable way and follow practices designed to avoid the undesirable external costs. Water and sewerage companies may be required to achieve certain minimum standards. The costs of complying with the law thus become private costs and part of the production cost which must be met by users of the goods and services. All producers then become subject to the same requirements so that none can gain a competitive advantage by not complying with the standards. If producers have to compete with foreign imports the government will have to ensure that these imports are subject to the same minimum standards. Impose special taxes designed to make some products very expensive and so discourage their use. There are several objections to this course of action. The government might start to rely on the revenue from the taxes and so take care to keep them at a level where the products are still bought and used; the taxes may well then cease to deter or reduce the external costs. Alternatively the government might impose very high taxes with the result that there is widespread tax evasion; the cost of collecting the tax and punishing evaders then rises to impose additional burdens on the community. Pay subsidies to suppliers to reduce the market price paid by consumers and thereby encourage increased consumption of merit goods. Alternatively, the State may take overproduction and ensure, through legislation, that all the relevant consumers are provided with the socially optimal level of the good or service. For example, compulsory school education is provided by governments in many countries. Clearly it is more desirable to try and ensure that external costs are removed altogether rather than that they should simply become private costs. Even if employers are forced to pay adequate compensation to workers whose lungs are damaged by dusty manufacturing processes, the workers still suffer. However, if manufacturers are required to have efficient dust extraction equipment, private costs are increased but the health of the workers is improved. At the same time care must be taken to ensure that external costs are not simply exported. For example, one way of dealing with dangerous gases might be to ensure that they are expelled through very high chimneys, but unfortunately these may simply redirect the gases to another country for that country to bear the cost.
There is no universal and simple method of dealing with externalities. On the whole it does appear that the market economies have been more successful in controlling and reducing undesirable external costs associated with environmental pollution than have the old command economies. This is probably because in the more open and consumer-orientated societies, producers and government have had to be willing to respond to pressures from the public when that public has been determined to eliminate socially unacceptable practices.
Public GoodsMerit and demerit goods are produced in a free market, without government intervention; the problem is that either too little or too much is produced. Too few merit goods are consumed in a free market because consumers ignore the external benefits associated with such goods. In contrast, there is over-consumption of demerit goods in a free market because consumers ignore the external costs. In the case of "public goods" the market failure is that the goods are not produced at all if left to the free market. Most goods and services, including merit and demerit goods, are private goods and services in the sense that if they are consumed by one person their availability is correspondingly reduced, and one person's consumption cannot be consumed by another person. Public goods are different. Pure public goods are defined as those goods or services which have the characteristic that one person's consumption does not reduce the amount available for consumption by others.
The alternative, and more revealing, way of looking at this characteristic is to note that if such a good or service is provided for just one person the supply is also freely available for consumption by others! What this means is that whoever pays for the production of the good or service is providing the same benefits for all others in society free of charge. The consequence of this is that no one is prepared to provide such a good or service because they are unable to recoup some of the cost by charging others for their consumption of the benefits. Thus public goods are not provided in a free market without government intervention. Although there are very few if any examples of pure public goods, national defence and lighthouses are examples of goods that have many of the features of a public good.
Inequalities of IncomeOne of the virtues claimed for the unregulated market is that it makes the consumer sovereign and that resource allocation responds to demand pressures. However, if we imagine that consumers influence allocation by votes cast when they buy or refrain from buying goods and services, we have to admit that some consumers have more votes than others and large numbers have very few votes. Markets respond quickly to those groups which have the most purchasing power. This does not always ensure that resources are allocated in ways that meet the social expectations of the community. It has always been difficult to ensure that the poorest sections of the community are adequately housed. Normal commercial suppliers of housing are unwilling to meet this demand because the people concerned cannot afford to pay the full "economic costs" of housing, i.e. it is not usually possible to make a profit from providing housing for the poor. It is much more profitable to provide second homes for the wealthy. Not only does this offend against many people's ideas of social justice, but the housing problem rebounds against the community. The community is faced with extra costs because inadequate housing leads to poor health, disease, crime and a wide range of social problems that become a charge on the taxpayers. Only the State can intervene to improve housing for the poor. It cannot do so simply by holding down rents. It has to promote supply either by setting up State suppliers or by subsidising private suppliers so that supply becomes profitable.
In noting the defects of the market economy as a means of allocating resources we have, in effect, made a case for a public sector within which the State, through its political structures, makes good the gaps and deficiencies of the unregulated market. The State can ensure that there is a minimum standard of housing for those with low incomes, build roads and establish communication systems. It can build sewerage systems and a system for piped, clean water, and provide police and fire services. It can provide a health and education service to ensure that all who are sick obtain medical care regardless of income and all children achieve a minimum level of education essential for survival in the modern world. In communities with high living standards the question then arises as to how far State provision should go in the provision of public goods which at some stage tend to become private goods. Let us take a closer look at two particular, high-profile issues.
EducationMost would accept the need for all to receive a basic education, but this does not necessarily mean that all who wish to do so should have the right to free education to doctorate level. Since there is evidence that, on average (but not, of course, for all individuals) there is a correlation between income level and length of time spent in full-time education, then education beyond the minimum represents a personal capital investment; many would argue that such education should be paid for by those who will benefit from it. Counter arguments are that the community benefits from the contribution of its most highly skilled and educated members (e.g. brain surgeons). The community should therefore pay to obtain the maximum potential from its scarce human resources; also those who earn high incomes normally pay the most taxes and thus pay eventually for the education they have received. There is no clear right or wrong answer to this debate, but you can see that the precise boundaries between the public and private sector in the supply of goods such as education are not clearcut and the matter is arguable.
Health CareAnother area of public controversy is the provision of health care. The community clearly needs a health service, if only to defend itself against dangerous diseases which could quickly become plagues if large numbers of people could not afford treatment. Most people's ideas of social justice would accept that a person stricken by accident or sickness should receive treatment regardless of income. However, should this mean that all forms of treatment should be available for all regardless of income? Should the diseases of greed and overindulgence be given the same care as those of poverty and ignorance? If people can afford to pay for additional treatment or for more comfortable treatment, or non-urgent treatment at times that suit them rather than at times that suit a bureaucratic administration, is there any reason why they should not do so? No one passes moral judgment on those who choose to spend their income on exotic holidays rather than a fortnight at Benidorm, yet many pass such judgment on those who prefer to pay for a private room when they are in hospital instead of sharing a public ward. Clearly many of the arguments surrounding health care involve emotionally charged value judgments resulting from past social injustices and history, but there are also serious economic considerations involved. The economist is concerned with the allocation of scarce resources, and we have to recognise that resources devoted to health care are scarce. The march of technology and medical science has made possible cures and treatments unimaginable when the National Health Service commenced in the 1940s. Open heart and transplant surgery require a massive investment in resources but benefit only a relatively few people. The proportion of old people is far greater than in the 1940s and the demands they
make for health care are proportionally much greater also. Not even the most wealthy and advanced nation can provide all the resources that would be required to give immediate treatment to all those wanting it. Difficult allocation decisions have to be made and are made daily. It can be argued that a private health system which permits scarce resources to be allocated on the basis of ability to pay, or by virtue of employment in a company that provides health insurance as part of its remuneration, is diverting resources from areas of greater personal or social need. One person suffers pain so that a consultant can earn a private income treating a less urgent patient in a private hospital. On the other hand it can be argued that the private health service brings in resources that would otherwise not be available. The consultant is willing to work for a relatively low level of pay from the National Health Service because he or she can have the additional income from private patients. Without this, the best surgeons would possibly go to countries where earnings were higher. Private hospitals relieve the public health service of many patients and reduce its need for expensive capital equipment. The debate can again continue with no clear right or wrong. The basic problem is really one of allocation of scarce resources: the public versus private health service is only part of a much larger economic and social issue which concerns to whom, how and on what basis resources should be allocated for health care. How should the community decide what proportion of available scarce resources should be devoted to the technically brilliant feats of surgery which bring acclaim to surgeons and enable them to attend conferences abroad, and how much to the unglamorous, humdrum work of caring for the mentally ill for whom there is no hope of cure and little chance of international laurels for the carer? The unregulated market will not provide an answer, nor will a medical service subject to all the usual human vanities and frailties. The answer must eventually come through the political machinery of the community and the quality of the answer will reflect the health of that machinery. Similar issues can be applied to virtually every other public sector and public utility service, and you should give some thought to the allocation problems inherent in, say, police, fire, water, and housing services.
At this stage it should be clear to you that anything that influences market price will have consequences for both supply and demand, with the result that the final consequences of a tax may not be what the government intended. Sometimes, of course, a tax may be imposed with the deliberate intention of influencing supply or demand. More often it is levied as just another way to raise the revenue that
governments imagine they need, and they seek to have as little effect as possible on the production system. In practice, any tax must have an impact, as we shall see. A subsidy can be seen as a reverse or negative tax. It is a payment to a producer or distributor, so that its effect is to increase supply. So to judge the effects of a subsidy, simply reverse the arguments presented in relation to the tax but remember of course, that in order to pay a subsidy, the government has to have revenue, and its main source of revenue is tax. Generally, then, a subsidy paid to A means that B and C have to be taxed. The harmful effects of the tax may outweigh any beneficial effect of the subsidy.
Effect on SupplyThe effect on supply of an indirect tax being imposed is illustrated in Figure 6.7. This shows a supply curve SS, indicating that production can range from 200 units per week at a price of 4 to 800 units at a price of 10. Figure 6.7: Effect of an indirect tax on supply Price 11 () 10 1 increase in tax 9 8 1 increase in tax 7 6 5 4 0 100 200 300 400 500 600 700 800 900 Units per week S1 S S1 S
Suppose a new tax is imposed at 1 per unit. To supply 500 units per week, producers wanted a price of 7 per unit. After the imposition of the tax, the producers still want to receive 7, but to get this, the price has to rise to 8 to include the 1 per unit that now has to be paid to the government. Similarly, to keep production at 700 units per week, the price has to rise from 9 to 10 per unit. Imposition of the tax thus moves the supply curve to the left (SS to S1S1). The vertical distance between the curves represents the amount of the tax. Of course, a subsidy paid to the producer moves the supply curve to the right because the argument is exactly reversed. In Figure 6.7 the after-tax supply curve S1S1 is parallel to the before-tax curve of SS. This suggests that the tax or tax increase is flat rate, i.e. the same at all price levels. In practice indirect taxes such as VAT depend on value and are sometimes known as ad valorem taxes. Usually we would expect the tax to be expressed as a percentage of value or price, and its
amount will therefore increase as price rises. In such cases the gap between the two supply curves will increase at the higher prices as illustrated in Figure 6.8. Figure 6.8: The effect on supply of an increase in an expenditure tax of 20% Price ()120 110 100 90 80 70 60 50 40 30 20 10 0 0 100 200 300 400 500 600 700 800 900 1000
20 increase in tax
The effect on suppliers intentions of an increase in an expenditure tax of 20% 10 increase in tax
2 increase
Quantity (Units) Although suppliers will seek to recover the full amount of any additional expenditure tax from buyers there is no guarantee they will succeed in raising the price sufficiently to achieve this. The extent to which they can recover the tax or have to absorb it in their total costs through the more efficient use of their production resources depends largely on the strength of any price resistance shown by buyers. If buyers cease to buy the product at the increased price suppliers must reconsider their position. The possible consequences of this interaction between suppliers and buyers are examined later.
Figure 6.9: Effect of tax increase on supply and demand S1 Price De P1 P S Increase in tax
Increase in tax S1 S O q1 q
Now look at Figure 6.10. Here we have the shift in supply curve SS to S1S1 and a demand curve D1D1. Again we have an increase in equilibrium price (Op to Op1) and a reduction in quantity supplied (Oq to Oq1). This time however, the reduction in quantity is less than the increase in price. Figure 6.10: Effect of tax increase on supply and demand, price less elastic Price D1 S1 S Increase in tax P1 P Increase in tax S1 D1 S
q1 q
Why the difference in the two situations? You will have noticed that the curve D1D1 is much steeper than DeDe. This reflects that demand in Figure 6.9 is more price elastic than demand in Figure 6.10. The two illustrations show that the more price elastic the demand for a product is, the smaller will be the market-price increase following an increase in indirect tax, and the greater will be the cutback in supply to the market.
This is after all really common sense. Price elasticity indicates the degree of responsiveness of quantity demanded to any change in price.
SubsidiesThe effect of a subsidy will be the exact reverse of that of a tax. Instead of the movement of the supply curve from SS to S1S1, there is an increase in supply at all prices, i.e. as from S1S1 to SS, and there will be a reduction in market price, as from Op1 to Op. Such a reduction is likely to have been the main government objective in arranging the subsidy, particularly if the good is a "socially worthy" one such as a basic food in a time of shortage, housing, or a merit good such as education or health care. Remember also that the new supply curve need not be exactly parallel to the original before the tax or subsidy change. If the tax or subsidy increases with value, i.e. is an ad valorem tax or subsidy, the gap between the curves will increase as price rises, as shown in Figure 6.8.
account. It is not sufficient simply to increase the price of the good whose use it wishes to discourage. Reverting to our general discussion of the effects of taxes on prices we have not taken into account differing elasticities of supply. This is because supply reactions will take place over a period of time. If suppliers can react by cutting back supply fairly quickly, then there will be further effects on market price. You can examine these for yourself by changing the supply curve to make it more elastic in Figures 6.9 and 6.10.
Marginal Social Benefit Demand (Marginal Private Benefit) Output Conversely, if the good is a demerit good, its marginal social benefit curve will lie to the left of its demand curve because of its negative externality. This is shown in Figure 6.12.
Figure 6.12: The marginal social benefit curve and negative externalities (demerit goods) Benefits and costs s Negative externality
Output A similar situation prevails with the negative externalities that can arise with production. The supply curve for a good or service only takes account of the private costs incurred by the producer of the good. The social costs created by any negative externalities during the process of production, such as water or atmospheric pollution, are ignored by the firm. In this case the firm's supply curve, which measures the marginal private cost of production, lies below the marginal social cost curve that adds the cost of the negative externality to the private costs. This is shown in Figure 6.13. Figure 6.13: The marginal social cost curve and negative externalities Benefits and costs s Marginal Social Cost Supply (Marginal Private Cost)
In some cases the production process for a good or service creates a positive externality and the firm's supply curve fails to reflect the social cost of producing the good. For example, the smelting of aluminium involves large amounts of energy and creates waste heat. In the UAE the waste heat from the aluminium plants is used to distil sea water into fresh water that is then used for irrigation. Unfortunately such examples of positive externalities in production are much less common than the negative externalities due to pollution. Figure 6.14 illustrates the situation in which production creates a positive externality and the marginal social cost curve lies below the supply curve. Figure 6.14: The marginal social cost curve and positive externalities Benefits and costs s Supply (Marginal Private Cost)
Positive externality Demand Output Now we can combine the curves shown here and analyse the action required from government to correct the market failures that result from externalities in production and consumption. Figure 6.15 illustrates how a subsidy can be introduced when the marginal social benefit from a good exceeds the marginal private benefit. In the absence of a government subsidy, the free market equilibrium is where the demand and supply curves, which are also the marginal private benefit and cost curves, intersect at point E. At this point too little is being produced and consumed when account is taken of the marginal social benefits. The private market equilibrium quantity is Q1 which is less than the socially optimum level of output Q2, determined at the point where the marginal private and social costs are equal, point G.
Figure 6.15: Subsidies and the socially optimum production level Benefits and costs s G E H Marginal Social Benefit (MSB) Demand = Marginal Private Benefit Q2 Q1 Output Supply = Marginal Private Cost (MPC)
To achieve the socially optimum level of production and consumption (Q2), where the marginal social benefit equals the marginal private cost of production at G, the government should pay firms a production subsidy of GH per unit produced. The subsidy is equal to the value of the externality which is the difference between the marginal social and marginal private benefits at point G. In the situation where there is a negative externality in production, because the marginal social cost of production exceeds the marginal private cost, firms overproduce the good in relation to the socially optimum level of production and consumption. Output, if left to the free market is Q1, which exceeds the social optimum level of Q2. To correct the market failure the government needs to make firms take account of the negative externality they are responsible for creating. The solution in this case is to impose an indirect tax on each unit of output equal to the difference between marginal social and private costs at the point where the marginal social cost curve intersects the marginal private benefit curve. This requires a tax of EF per unit. This is illustrated in Figure 16.16.
Figure 6.16: Taxes and the socially optimum production level Benefits and costs s Marginal Social Cost (MSC) + unit tax of EF per unit
Supply = MPC E
Review PointsThis is one of the most important chapters in the Study Manual. If you have not mastered its content you are unlikely to be able to achieve a satisfactory level of understanding of economics. Because of the fundamental role of the forces of supply and demand in the determination of prices in markets, and their significance for the behaviour of firms, and government intervention in markets, you need to make absolutely certain that you fully understand the content of this chapter if you want to pass the examination in this subject. It is absolutely vital, before you continue with the next chapter, that you should go back to the start of this one and check that you have achieved the learning objectives and feel confident in undertaking demand and supply curve diagram analysis. If you do not think that you understand fully each of the learning outcomes you should spend more time reading the relevant sections. You can test your understanding of what you have learnt, and your ability to use demand and supply curve analysis, by attempting to answer the following questions. Check all of your answers with the chapter text. 1. In a free market, is the equilibrium market price determined by: (i) (ii) (iii) (iv) 2. demand alone supply alone the interaction of demand and supply government intervention?
If the supply curve is upward sloping, other things remaining unchanged, will a rightward shift in market demand result in: (i) (ii) a decrease in the equilibrium price and quantity supplied, or an increase in the equilibrium price and quantity supplied?
If the demand curve is downward sloping, other things remaining unchanged, will a rightward shift in the supply curve result in: (i) (ii) a decrease in the equilibrium price and an increase in the quantity supplied, or an increase in the equilibrium price and quantity supplied?
The following diagram shows the initial equilibrium position, Q1, in the market for a normal good and a second demand curve D2. Price Supply
Quantity of output
Could the rightward shift in the demand curve be the result of: (i) (ii) (iii) 5. (i) (ii) (iii) 6. (i) (ii) 7. a decrease in the price of a substitute good an increase in the incomes of consumers the introduction of an indirect tax on the good by the government? externality social cost social benefit. a demerit good, or a merit good?
If consumption of a good yields a positive external benefit, is the good referred to as:
In the absence of intervention by the government, if the social marginal cost of a good exceeds its marginal private cost is the good: (i) (ii) overproduced under-consumed?
Explain the meaning of the following: (i) (ii) (iii) price floor price ceiling output quota.
The following diagram shows the free market equilibrium position, Q1, for a merit good. Price Supply = marginal private cost = marginal social cost
To achieve a socially optimal level of production and consumption of the good should the government intervene in the market and: (i) (ii) (iii) (iv) pay producers a subsidy of AB per unit tax producers AB per unit produced impose a price ceiling of P2 impose a price floor of P1?
Perfect Competition Definition Conditions for Perfect Competition Movement towards Equilibrium in Perfectly Competitive Markets Views on Perfect Competition Profit Maximisation as a Result of Perfect Competition
ObjectivesThe aim of this chapter is to: explain the profit-maximising outcomes under monopoly and perfect competition in the short and long run; identify the differences between the two market structures; examine the effects of changes in government policy upon these markets. When you have completed this chapter you will be able to: identify, using diagrams, the characteristics of perfect competition at the firm and industry level and identify, in numerical and/or diagrammatic examples, equilibrium price, firm and/or industry quantity, profit, marginal cost, average cost, marginal revenue and average revenue examine, for perfect competition, the effects of changes in the conditions of the industry upon the market equilibrium in the short and long run and discuss the mechanism by which the industry moves from the short-run to the long-run equilibrium and discuss the welfare implications of perfect competition identify, using diagrams, the characteristics of monopoly and explain the relationship between average and marginal revenue, and identify, in numerical and/or diagrammatic examples, equilibrium price, output, profit, total cost, total revenue, marginal cost, average cost, marginal revenue and deadweight loss examine, for monopoly, the effects of changes in the conditions of the industry upon the market equilibrium in the short and long run and discuss the welfare implications of monopoly with reference to the deadweight loss triangle and X-inefficiency discuss the merits of policy alternatives aimed at reducing the social cost of monopoly solve basic diagrammatic and numerical problems under monopoly and perfect competition identify and discuss real world examples of industries with similar characteristics to the models of perfect competition and monopoly.
Economists have generally been in favour of competition as a force likely to increase the efficient use of scarce resources, and they have developed a concept of perfect competition which we shall examine in this chapter. However more recently they have recognised that traditional views of competition have limitations, and that the pressures on business firms are more complex than have sometimes been believed in the past. There is also a recognition that increased competition can sometimes have consequences that are not beneficial to consumers, or which are not socially very desirable. In particular, competition may be harmful, or at least lead to a socially suboptimal outcome, if firms take no account of the existence of positive and negative externalities in production, and their impact on the environment. So we must be careful in our assessment of the benefits of competition, and be prepared to be critical when examining some of the traditional economic models of competitive markets. These models have been developed in the belief that the degree of competition in a market is likely to influence the behaviour and performance of firms operating in it. In this chapter we look at some of the best known models; these provide an essential starting point for understanding the often complex markets existing in modern economies. However, we must be equally careful in our assessment of competition that we do not impose our values of what is good or bad for society on others who may have different values. It is also important to note the influence of technology on markets and competition. For example, the rapid growth of modern low cost communications and knowledge sharing in the form of mobile phones and the Internet have significantly increased competition, both in markets within countries and between countries. Indeed, the Internet has made the economists' ideal model of perfect competition a much more real description of how many markets now work in the real world.
B. PERFECT COMPETITIONDefinitionOur first theoretical model covers the situation where the economic market operates in its purest or most perfect form. Perfect competition is the state of affairs existing in a market totally free from imperfections in the communication and interaction of the economic forces of supply and demand. Some writers like to make a distinction between perfect or ideal markets and perfect competition, in addition to the distinction between the market as an area and competition as a condition found in that area. They suggest that the conditions for perfect competition are satisfied when the individual firm is a "price-taker", i.e. when it can sell all that it can produce at the market price, which by itself it cannot alter, and when buyers are indifferent as to which seller's product they buy at that price. Such a very limited set of requirements would be satisfied when firms in an industry were subject to a regulated price set by a government or some other regulatory body which had powers to buy goods unsaleable in the market. This would certainly not be a perfect market. For true perfect competition to exist, it seems more realistic to stipulate that sellers must be free to enter and leave the market, so that total supply can change and bring about the equilibrium position. Just to establish a market price through some form of price regulation would not produce the same result, unless the regulating body is very sensitive to demand shifts, and production plans can be adapted quickly. So it seems that full operation of perfect competition can be achieved only in a perfect economic market, and to put too much emphasis on differences between the two does not really help very much in our analysis of the main market forces.
Goods must be Homogeneous This means that in the perception of the buyer, all units of the goods offered by all suppliers are equally acceptable. The buyer is indifferent as to which unit he or she receives, as long as it conforms to any description adopted by, and understood in, the market. Notice that it is the perception of the buyer that is important. Suppose two large retail stores make an arrangement with a manufacturer to be supplied with canned baked beans in plain tins. The manufacturer supplies beans of the same type and quality to each retailer in the plain cans quite impartially. However, each store adds its own label to the cans and sells the beans under completely different brand names and at slightly different prices. The products are physically the same, but they are not homogeneous, because the public perceives them as different and competing products.
Perfect Transport and Communications All consumers in the market must have the same information. Suppliers must have access to the same information about production factors and the technical conditions of production. No producer is in a more favoured situation than any other.
Price Established Only by Market Forces No producer and no buyer is able to influence the price by his or her own actions, nor by actions agreed with other producers or buyers. There is no degree of monopoly power in the market.
Economic Motives Only The actions of suppliers and buyers are influenced only by economic motives. If buyers or sellers are influenced by a desire to support a charity or a political party the market will not be purely economic, however worthy the social motives. Economic rationality in a market economy assumes an underlying self-interest and a desire to maximise benefits that can be gained from available scarce resources. For the consumer this means maximising utility, as defined in Chapter 2, while for producers it is usually interpreted as wishing to maximise profit an objective examined later.
No Barriers Limiting Market Entry and Exit Suppliers and buyers must be free to enter and leave the market as they choose and as they are guided by considerations of profit and utility. This is a very important element in any competitive market and in some modern models of market behaviour, notably that of contestable markets, it is the most important consideration. Barriers to market entry and exit may be "natural", i.e. arising out of the nature of the goods or the production process, or "artificial", i.e. arising out of market regulations. Natural barriers are highest when production requires large amounts of highly specialised capital, e.g. oil exploration and extraction or motor vehicle assembly. Only firms with access to very large amounts of finance can enter these markets. Once this capital has been acquired, the firms are committed to staying in the market, since exit would usually involve very large financial losses. Natural barriers are low when little specialised capital or skill are needed to commence production. When natural barriers are low established producers may seek to protect themselves from new entry by building artificial barriers. These barriers may be membership of a trade or professional association (entry to which may require a long period of apprenticeship), education or high membership fees. It is not unknown for established traders to prevent new entry illegally by the use of force, as in the case of ice cream selling in some areas and, of course, street trading in illegal drugs.
The lower the barriers, both natural and artificial, the more contestable the market; the theory of contestable markets suggests that contestability is a powerful force determining the behaviour of suppliers in a market. If producers know that they can easily be challenged by new competitors, they will behave as if they were subject to competition because they will not wish to provide incentives for new firms to come into the market. Such incentives would include supernormal profit or the existence of buyers who were dissatisfied with existing goods, standards of service or prices. Consequently we would expect a perfectly contestable market to exhibit most if not all the characteristics of perfect competition.
Suppose the price resulting from the interaction of supply and demand in the market as a whole is Op; then there is no level of output at which the firm can produce at a profit. At all levels of output price, average revenue is below the average cost curve. However, the profit-maximising condition of marginal cost equals marginal revenue is also the lossminimising condition, so the best output for the firm to choose is at Oq where marginal cost equals marginal revenue. At this output level, average cost at Oc is higher than average revenue at Op, so the firm suffers a loss equal to the shaded area (cdbp). Given the conditions for perfect competition, if this is the situation faced by one firm, it is the situation of all firms subject to the same market information and technology. Firms cannot continue indefinitely suffering losses. Some will withdraw from the market (remember that
unrestricted entry and exit is another condition of this market) because they are less able to withstand losses or they have other markets they can enter. As supply declines, so the total market supply curve will move to the left, as shown in Figure 7.2. Figure 7.2: Market supply curve moves left D S1 S p1 p S1 S O qm1 qm Output D If firms suffer losses at price Op some withdraw from the market. Market supply falls from Oqm to Oqm1 and equilibrium price rises from Op to Op1 as supply shifts from SS to S1S1.
The market equilibrium price then rises assuming that demand remains unchanged. Supposing the equilibrium price moves up from Op to Op1, this produces the situation for the individual firm illustrated by Figure 7.3. Figure 7.3: Market equilibrium price rises Price/Cost Marginal cost
Now we see that the average revenue at Op1 is higher than average cost at Oc, and the firm is enjoying profits, represented by the shaded area. Notice that once again the most profitable output to aim at is at Oq, where marginal cost is just equal to marginal revenue. Now, given our earlier assumptions, all firms are making profits. If we have defined cost to include a normal return to all production factors (including some return to enterprise in the form of a minimum profit to keep firms in the market and provide necessary capital investment) then this shaded area profit is an additional or abnormal profit, resulting only from the special market opportunities. Owing to perfect communication and free entry, new firms will enter the market to take advantage of these profits. Supply will now increase the supply curve will move to the right and equilibrium price will fall. Suppose it falls to a position between Op and Op1, say to Ope where price/average revenue is just equal to average cost. Now the individual firm is in the position illustrated in Figure 7.4. Here, there is neither abnormal profit nor loss. We assume that the firm's costs include an element of normal profit, which can be defined as a fair return to the firm's enterprise, or sometimes as that amount of profit which is sufficient to keep firms operating in that market. This normal profit is included therefore in the average cost curve. There is no incentive for firms to move into or out of the market: there is no reason why supply should shift and, as long as demand remains unchanged, there is no reason for any movement in this equilibrium balance. Figure 7.4: Perfect competition Price/Cost
Average cost Pe
MR AR Price
Marginal cost
It is on the basis of this kind of argument that textbooks and examiners sometimes make much of the distinction between short-run equilibrium in perfect competition where abnormal profits or losses can be experienced, and long-run equilibrium where only "normal" profits (included in the average total cost curve) are possible. However, we should stress that these are really only partial equilibrium positions relating to supply alone. The model says nothing about influences on demand which is often far from stable. A shift in demand will be quickly reflected in a shift in supply to readjust output to the new market price. Consequently, in markets where demand is inherently unstable as in the stock and commodity exchanges long-run equilibrium may never be reached as suppliers are constantly adapting to the shifting market environment.
Not everyone accepts these arguments, and you should consider the contents of this section in conjunction with the discussion of monopoly, later. One of the arguments against perfect competition is that it prevents producers from making the profit necessary to provide funds for investment and research, to find better ways of producing goods. Another argument is that competition can be wasteful, as resources are doing the same things. If there were fewer competing firms, total costs could be reduced and some resources freed to produce something else. Firms dislike perfect competition because, as indicated earlier, prices are unstable. If communications are good, then supply can adapt very quickly to price changes caused by changes in demand. The result is that prices are constantly adapting to new equilibrium positions as with the Stock Exchange, which is still the common textbook example of a market which is close to perfect competition. In the Stock Exchange, prices change daily, and even hourly. Manufacturers cannot tolerate swiftly-moving prices like this they could survive in such a market only if they could keep changing the prices paid for production factors, including the wages paid to workers. Trade unions have sought to achieve stable jobs and, preferably, rising wages. Producers then want stable and, preferably, rising prices. Those economists who argue for perfect competition in the consumer interest, and then argue for stable wages and secure employment, are being illogical. These two conditions cannot exist together. So perfect competition may or may not be ideal from a purely economic viewpoint. It is certainly far from ideal from a social standpoint.
C. MONOPOLYDefinitionMonopoly is the opposite extreme to perfect competition. It exists when there is only one supplier for a particular product and there are no close substitutes for that product. Again, we have to be careful how we define the product. For example, the Post Office has a monopoly in the delivery of low-price letter mail in Britain. However it does not have a monopoly in personal and business communication, and in recent years the volume of letter mail has declined in the face of competition from the telephone, fax and from private firms of leaflet distributors. It now faces more competition from email and Internet services. Historically almost all monopolies are subject to destruction by the onward march of technology.
Sources of MonopolyMonopoly can arise in three ways: by operation of the law, by possession of a unique feature, or by the achievement of market control. (a) Operation of Law This is a very old source of monopoly power. Kings used to sell monopolies in Europe to raise money: they sold people the right to be sole suppliers of a necessary product, such as salt, in a given area. The monopolist could rely on the support of the King's officers to protect his monopoly, and the profits he could make more than covered the fee he had to pay for his position. Today, some countries may grant a company the right to be sole supplier of a product or service (e.g. telephones) in return for some measure of State inspection and control over profits and prices. In Britain, before 1979, it was usual for such monopolies to be public corporations under public ownership and control. This has been changed by the privatisation programme, which has resulted in a policy of separating regulation from operation. Some important public utilities are now legally companies in the private sector (e.g. British Telecom and British Gas), but are subject to government influence as a shareholder, and regulation by separate bodies (OFTEL and OFGEM respectively). (OFGEM is also the electricity regulator and water industries are regulated by OFWAT.) A more limited monopoly power is granted under patent and copyright laws, which are similar in most countries. The idea of a patent is that the inventor of a new idea shares his or her knowledge with the State for the public benefit, in return for a monopoly control over the use of the idea for a limited number of years. If rival suppliers are unable to develop a competing product without breaking the patent, this form of monopoly can be very valuable for example the monopoly enjoyed for some years by the Polaroid instant film-developing process. (b) Possession of a Unique Feature Individuals have monopoly control over the supply of their own skills, and this may be a source of considerable profit. The top footballers, tennis players and entertainers are monopolists of this type. When the skill lies in producing something written or recorded, then the monopoly position is protected by copyright laws which, however, modern technology has made more difficult to enforce. (c) Market Control It is difficult to achieve total monopoly over supply without the protection of the law, although it is not unknown especially in the production of some intermediate
products. For a number of years, all the valves for pneumatic tyres on British motor vehicles were produced by one manufacturer. Such a monopoly rarely lasts very long. When a large rival decides to challenge the monopolist, there is little that can be done to prevent this.
Average cost P C Pw
Average revenue
Marginal revenue
A monopolist's output is the total market supply, and the demand for its product is the total market demand. The firm will thus face a downward-sloping demand curve. If we assume that it is not practising price discrimination, then this curve will be the price/average revenue curve. The graphical model is shown in Figure 7.5. The profit-maximising monopolist will produce at output Oq, where marginal cost equals marginal revenue, and will charge price Op. Abnormal profit is represented by the shaded area. The average cost is Oc, so Op Oc is the average profit earned on each unit of product sold. If the firm were to set price to equal marginal cost, which is the position desirable from the consumer viewpoint, it would produce output Oqw and charge the lower price Opw. This is why the profit-maximising monopolist is said to restrict output and increase price in comparison with a firm operating in a competitive market. Is it the case that monopoly is worse than competition and operates against the public interest?
Is Monopoly Good?There is much evidence that large firms with considerable market power may not maximise profits but may pursue quite different objectives, such as growth or sales revenue maximisation. The average cost curve was drawn on the basis that abnormal profit was being made. There is nothing in the model itself that says that the average cost curve must be this shape and in this position. We can move it up or down without affecting the other curves, and so alter the profit quite legitimately. In short, the model proves nothing. It simply illustrates the assumptions made. Notice that, if we drop the profit-maximising requirement, we can allow the firm to increase output and reduce price, and so come closer to the consumer-benefiting output level of Oqw. This would also reduce average cost and allow the firm to make more efficient use of its resources. In answer to the charge that monopoly is against the public interest because it restricts output and raises price, the following arguments are often put forward in defence of monopoly: (a) The monopolist's size and ability to produce for the whole market enables it to achieve economies of scale, so that costs are actually lower than they would be under perfect competition. The monopolist employs professional managers who make more efficient use of available resources than small owner/managers, who often lack managerial skill. The monopolist does not maximise profits but is content with just a satisfactory level of profit. Some element of abnormal or monopoly profit (normal profit is considered to be included in the firm's costs as for perfect competition) is desirable, so that the firm can: (i) (ii) spend money on research and gather funds for further capital investment; have the incentive to take risks and innovate, and sometimes suffer losses that would cripple smaller firms.
The position where a monopolist is actually able to charge lower prices than would be possible under perfect competition is illustrated in Figure 7.6. Here, for simplicity, constant average total costs have been assumed and the monopolist's cost curve is below that of small firms by reason of economies of scale and improved technology. Assuming that the monopolist seeks to maximise profits, the appropriate price will be Pm, still higher than the perfectly competitive price of Pc. However, this could be reduced if the monopolist had some other objective such as maximising growth or revenue. The revenue-maximising price (Pr), i.e. the price applicable to producing at the quantity level where marginal revenue is zero, and therefore total revenue is at its maximum, is lower than the perfectly competitive price of Pc. Notice that, unlike the firm under perfect competition, the monopolist can charge a range of prices, depending upon the firm's objectives, and still make a profit.
Figure 7.6: Price and output under perfect competition and monopoly Price, Revenue, Cost
Pm Pc Pr Average cost (Monopoly) Average revenue (Demand) Average cost (Perfect Competition)
Qe Qr Marginal revenue
The argument really boils down to a question of performance. Does the monopolist behave against the community interest or does it achieve levels of efficiency beyond the capacity of small firms operating in highly competitive markets? There is no clear answer. As the extreme cases of monopoly are fairly rare in practice, examination is usually made of markets which approach monopoly conditions. If the demand curve faced by the monopolist shifts, this will alter the marginal revenue curve and consequently the profit-maximising output and price. However, we cannot assume that the demand curve will simply move outwards parallel to the old one. It is possible that its slope may change, becoming steeper or less steep. Consequently, while normally we would expect an increase in demand at all prices to lead to an increase in monopoly price (assuming costs remained unchanged), we cannot be absolutely sure of this. Try experimenting with differently sloped average revenue curves. Remember that the marginal revenue must bisect (cut into two equal halves) the horizontal distance between the average revenue curve and the revenue (vertical) axis. You will find that there are changes that could produce a reduction in the profit-maximising price! X-Inefficiency The problem with the preceding arguments is that they assume that monopolists are efficient. The evidence is that large organisations, not just large firms with considerable market power, are inefficient when compared with smaller organisations and firms in competitive market situations. For example, large government departments and government-owned firms are notoriously inefficient. The UK National Health Service (NHS) is the third largest single organisation in the world (based on its number of staff). While the NHS is wonderful when you are in need of medical attention, many studies show that it is measurably inefficient and cost ineffective in comparison with both public and private health care providers in many other countries.
The concept of X-inefficiency is used to explain the economic inefficiency of large organisations. At its simplest, X-inefficiency is a measure of the excess cost of production of a unit of output of a good or service by an organisation over the cost of producing the same output in the most efficient available organisation. Take an industry with two firms producing the same type and quality of good. Assume the two firms are of different sizes but there are no economies of scale. One firm has a unit cost of production for the good of 3 per unit, while the other firm has a unit cost of production for the same good of 4. The second firm is X-inefficient in comparison with the first firm. Its degree of X-inefficiency is 30 per cent. Xinefficiency in all types of organisations is ultimately the result of managerial failure. The lack of the drive provided by the profit motive, and the threat of bankruptcy and closure for failure to keep costs down, means that bureaucratic organisations tend to be larger than necessary with far too many employees. They are also resistant to change, and tend to defend old, established or traditional ways of operation and prevent innovation, especially when such innovation would mean reducing the number of staff. The main reason for this inefficiency is the lack of an incentive in terms of a reward structure for workers to be efficient in carrying out their jobs. Workers are paid regardless of their individual work effort, usually simply on the basis of their hours at work. The absence of monetary reward or clear promotion prospects for working harder and/or longer than other workers means that most staff will behave in the same way, and follow human nature by taking things easy. Likewise if there is no reward for innovation in the way work is done or changing how departments are organised to reduce cost and increase output, there is likely to be an absence of change. The problem is made worse by another feature of bureaucratic organisational structures in relation to the reward structure for managers. In many bureaucratic organisations, managers' pay and promotion prospects are directly proportional to the number of staff they have working for them. This means that mangers who increase efficiency and can deliver the same or more output with fewer staff damage their own pay and promotion prospects! The incentive structure is perverse, and rewards inefficient managers who can add to their department size and budget by demanding more and more workers to deliver the same or less output. Thus bureaucracies tend to be both cost inefficient for a given state of technology, and prevent or slow down technological innovation. The entire economy of the former Soviet Union was organised as a giant state bureaucracy and, not surprisingly, eventually collapsed because it was unable to match the efficiency and innovation that is a distinguishing feature of more market-orientated economies. It is difficult, if not impossible, to think of any modern consumer good or industry that originated in the former Soviet Union or China. Personal computers, mobile phones, the Internet and most consumer electronic goods all originated from the competitive environment in market economies and not from large bureaucratic organisations. It is no surprise that the economic transformation and success of China in global markets is a consequence of the reform programme introduced in the country in the late 1980s. In this process individuals were encouraged to start their own businesses and many state bureaucratic firms were broken up and privatised and encouraged to compete with each other in return for profit. The concept of X-inefficiency is very important when evaluating the case for and against monopoly. Most arguments in defence of monopoly are based on the economies of scale in production that very large firms may experience, and the capacity of these firms to innovate resulting from their superior ability to fund and undertake research and development. But large firms are subject to the failings of large bureaucratic organisations. That is, the economies of scale that large firms (especially monopoly firms) are supposed to reap assume that they do not suffer from X-inefficiency. If increasing the size of a firm significantly leads to a reduction in unit costs of 25 per cent through technical and marketing economies of scale, but managerial slack resulting from bureaucratic complexity leads to a 30 per cent increase in its costs, the larger firm is less cost efficient not more cost efficient than smaller firms. Studies of efficiency in research and development (R & D) activity, and the sources of innovation in both processes and products, also show that large organisations suffer from X-
inefficiency in undertaking R & D and are not the main source of process innovation in modern economies. The advantages of monopoly are: lower prices than in competitive markets due to economies of scale larger expenditure than competitive firms on R & D more innovation due to large expenditure on R & D high level of investment expenditure because of large profits. higher prices than in competitive markets due to persistence of excess profit cost reducing advantage of scale economies outweighed by cost increases due to Xinefficiency wasteful expenditure on R & D and low productivity of R & D expenditure due to Xinefficiency no incentive to innovate because of high monopoly profit and absence of competition from other firms no incentive to investment in new production process and products because of existing high monopoly profit and absence of competition from other firms lack of customer focus limited choice and poor product quality due to lack of competition.
Review PointsBefore you begin your study of the next chapter you should go back to the start of this one and check that you have achieved the learning objectives. If you do not think that you understand the aim and each of the objectives completely, you should spend more time rereading the relevant sections. You can test your understanding of what you have learnt by attempting to answer the following questions. Check all of your answers with the chapter text. 1. 2. 3. 4. 5. 6. List the key assumptions of the economic model of a perfectly competitive market structure. Why is a perfectly competitive market regarded as the ideal form of market structure? How has the growth of the Internet affected competition in markets? Is eBay an example of perfect competition? Explain the key characteristics of a monopoly industry. Can you identify any real world examples of a monopoly firm? Using an appropriate diagram, outline the model of monopoly. Compare the predictions, including equilibrium price, profit and deadweight loss, of the monopoly model of market structure with those of the model of a perfectly competitive market structure. What is X-inefficiency? Why is it found in bureaucracies as well as large firms? Can you identify examples of X-inefficiency in any organisations with which you are familiar?
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Oligopoly Price Competition Price Stickiness Kinked Demand Curve Limitations of the Kinked Demand Curve Model Price Leadership Collusive Behaviour
Profit, Competition, Monopoly, Oligopoly and Alternative Objectives for the Firm
ObjectivesThe aim of this chapter is to: explain the kinked demand curve model of oligopoly and the model of monopolistic competition; discuss the idea of collusion and identify the factors that affect the stability of a collusive arrangement; compare the predictions of these models with those of monopoly and competition. When you have completed this chapter you will be able to: discuss the general characteristics of an oligopoly industry and identify the characteristic similarities and differences between oligopoly models and the models of perfect competition and monopoly identify, using the appropriate diagram, the characteristics of the kinked demand curve model of oligopoly identify the equilibrium price, output and profit in the kinked demand curve model explain why the kinked demand curve model predicts price stability and discuss the limitations of this model identify, using the appropriate diagram, the characteristics of the model of monopolistic competition identify the equilibrium price, output and profit in the model of monopolistic competition in the short and the long run discuss the meaning of collusion in the context of an oligopoly, examine the factors that aid or hamper the ability of firms to collude and discuss the implications of these findings for policy makers concerned with maximising social welfare discuss the price, output and welfare implications of oligopoly models relative to the models of monopoly and perfect competition.
A. MONOPOLISTIC COMPETITIONMain FeaturesMonopolistic competition still retains many of the features of perfect competition unrestricted entry to and exit from the market, good (but not perfect) communication and transport conditions, motivation by economic considerations only, and the perception by buyers that the products of the various firms are good substitutes for each other. It is in this last point that monopolistic competition differs from perfect competition. Although the products are considered to be good substitutes, they are not homogeneous. Buyers do express preference for one seller's product as opposed to another's. Sellers seek to increase this preference by differentiating their product through branding (giving it distinguishing features) and especially by advertising. The greater the degree of preference they can establish, the stronger the brand loyalty and the greater the freedom gained by the supplier from the need to follow the market price for that class of product. Success brings an increased degree of market power and a reduction in price elasticity of demand.
General ModelHowever in the general model of monopolistic competition, we assume that the individual firm is not able to achieve a high degree of price inelasticity, so that the demand curve for the individual product has only a fairly gentle slope: there is still a high degree of substitutability between competing brands. This prevents the individual firm from making
monopoly profits. It is still closely governed by the market price for the class of product. The result is shown in Figure 8.1. In outline the features of this model are: There is no abnormal or monopoly profit: average cost equals price/average revenue at Op and, as for perfect competition and monopoly, it includes an element of normal profit. At the profit-maximising output of Oq, average cost is still falling to its minimum at Oc, where average cost is equal to marginal cost the output level where the rising marginal cost curve cuts the bottom of the average cost curve. Price (at Op) is above marginal cost (Om) at the profit-maximising output Oq.
Price is thus higher and output lower than would be the case if price were to be equal to marginal cost, as in perfect competition. The lack of monopoly profit is the result of competition and the ability of firms to enter and leave the market. Figure 8.1: Monopolistic competition Price/Cost/ Revenue
p c Average cost
CommentIt can be argued that this market structure is not really in the best interests of either consumers or business firms, for the following reasons: Price is higher and output lower than would be the case with perfect competition. The firm is not making the best use of its resources, since average cost is still falling at output Oq, as we saw. Profits are confined to the normal minimum required to keep firms in the market the amount included in our definition of costs for the purposes of these market models. They cannot achieve the profits needed for investment and research or the high output levels necessary for economies of scale.
That said, it is also argued that consumers are prepared to accept these additional prices and costs in return for the benefits they receive through greater choice of product the ability to choose between competing brands and competing suppliers. This competition may also lead to improvements in product quality and design as well as services to the consumer. We can expect firms operating in such market conditions to seek to increase their monopoly power and make their product-demand curves less elastic. They will do this by brand advertising, by securing favourable treatment from distribution organisations or through technical improvements in their products. They may be able to keep an advantage by securing patent protection or keeping processes secret from their competitors.
B. OLIGOPOLYOligopoly is the market structure where supply is controlled by a few firms which are large in relation to the market size. Very often the firms are also large by any standards, and are likely to be oligopolists in several markets. (For example, Unilever is a very large company which supplies major brands of many grocery products, including Marmite, Flora, Hellman's and PG Tips and washing products including Surf and Persil.) Oligopoly is now commonly found in the advanced industrial countries and a great deal of attention is paid to it. However there is no single model which can be held to apply under all circumstances.
Price CompetitionOne influence that is thought to be important is the extent to which the products are in price competition with each other. If there is little price competition and if consumers are not thought to choose brands on the basis of comparative price (i.e. if cross elasticity of demand is low) then each oligopolist has a high degree of monopoly control over the demand for his own product. This will of course depend chiefly upon whether the products are regarded by consumers as homogeneous or whether they consider each brand to be distinct and different. You might think it is unlikely that consumers will find much to choose between, say, various brands of plain, salted crisps. Cross elasticity of demand between the brands is thus likely to be high when the crisps are on sale in similar distribution outlets. If there are price differences, customers will choose according to price. In these circumstances, suppliers may seek to operate in different sections of the market, e.g. through different supermarket chains or in hotels and pubs rather than retailers. They may also seek to differentiate their products through such devices as flavour or by developing novelty shapes or other related products. You may be familiar with various products which have been developed by the four major firms in this market. A full study of oligopoly is likely to embrace problems of prices and non-price competition, and even the question of how far firms may collude together to limit the extent of competition between established firms and to protect themselves against possible newcomers to the market.
Price StickinessEfforts have been made to produce models based on traditional assumptions of profit maximisation. One such model seeks to explain the observed tendency that the prices of some goods in oligopolistic markets remain steady in spite of fluctuations in the prices of basic commodities. This "stickiness" is apparent in more normal, less inflationary times. For example, the price of bars of chocolate in some markets remains constant in spite of frequent movements in the prices of the basic materials required for chocolate manufacture.
This particular feature of an oligopolistic market for a product still regarded as fairly homogeneous (in spite of brand advertising) has given rise to the model known as the kinked demand curve.
At price 1 the oligopolist has difficulty changing price. At higher prices he loses market share. At lower prices all oligopolists in the market keep the same share but lose revenue.
Now consider possible revenues resulting from this condition, in Table 8.1.
Table 8.1: Possible revenues Price per unit 1.40 1.30 1.20 1.10 1.00 Quantity units per time period 0 10 20 30 40 Total revenue 0.00 130 13.00 110 24.00 90 33.00 70 40.00 60 or 20 0 0.80 0.60 0.40 0.20 0.00 50 60 70 80 90 40.00 40 36.00 80 28.00 120 16.00 160 0.00 Marginal revenue (Change in TR) pence
The kink in the average revenue curve, shown in Figure 8.3, occurs at the price of 1 and the quantity level of 40 units. At prices above 1, demand falls off at the rate of ten units for each 10p rise in price. At prices below 1 however, demand falls by only five units for each 10p rise in price, i.e. the unit price has to fall 20p to enable the oligopolist to gain a quantity increase of ten units. The change in the slope of the average revenue (price) curve results in a similar change in the slope of the marginal revenue curve and you can see that there are two possible marginal revenues at the quantity level of 40 units. The higher (60p) results from the continuation downwards of the upper part of the curve, whilst the lower (20p) results from the upward continuation of the lower part of the curve. This is clearer on the graph but you should be able to work out the same results from the table. Remember the marginal revenue levels in the table belong to the midpoints of the quantity changes. The lower curve is changing at the rate of 40p for each ten units; the upper curve is changing at the rate of 20p for each ten units.
Figure 8.3: Quantity level at which profits are maximised Price/ Revenue140 130 120 110 100 90 80 70 60 50 40 30 20 10 0 -10 0 -20 -30 -40 -50 -60 -70 -80 10 20 30 40 50 60 70 80 90 Q
Price LeadershipAnother tendency observed in some oligopolistic market situations is for the few firms in the market to follow the price movements of one firm, the price leader. Such leaders can be: The least-cost firm, which can oblige competitors with higher costs to follow its prices, even though they cannot maximise their own profits at the levels it sets. A firm which is typical of others in the market and which becomes a barometer of market conditions. If this firm feels that a price change is necessary, then it is probable that others will feel the same. The largest and the dominant firm in the market. The most common model of this situation assumes that this firm, because of its size and the economies of scale it can achieve, is able to achieve lower costs than the others. The lower its costs compared with the other firms' costs the greater will be its market share and, consequently, its dominance in the market. This model is illustrated in Figure 8.4. Figure 8.4: Price leadership model The market is shared between the dominant firm and smaller firms. The lower the costs of the dominant firm the greater its share of the market
Ps Pd Po D O qs qd
Marginal cost of dominant firm Demand for dominant firm Dd qd Marginal revenue of dominant firm
The market is shared between the dominant firm and smaller firms. The lower the costs of the dominant firm the greater its share of the market. The dominant firm model makes the following assumptions: The dominant firm is aware of the total market demand curve and the cost conditions, and hence the supply curve, for the smaller firms in the market. The objective of the dominant firm is to maximise profits.
In Figure 8.4 the demand curve DD is the demand curve for the market and SsSs is the supply curve for the smaller firms. At price Po these firms are unwilling to supply to the market; it is their minimum price. At price Ps the smaller firms are able and willing to supply the full market demand at that price. This knowledge allows the dominant firm to estimate its own demand curve, which is made up of market demand at each price less the amount which the smaller firms are able to supply. Thus the demand for the dominant firm's product is nil at price Ps but it is the same
as market demand at prices Po and below. Between these two prices the dominant firm is able to supply the balance between market demand and supply from the smaller firms. On the assumption of profit maximisation the dominant firm will wish to supply quantity qd, which is the quantity at which its marginal cost is equal to its marginal revenue. At this quantity level the dominant firm's market clearing and profit maximising price is Pd. If it charges this price the other firms will have to follow, and market demand at this price is shared on the basis of qd to the dominant firm and qs to the smaller firms. Notice that if you raise the dominant firm's marginal cost curve then you will reduce q d and increase qs. However, if you lower this curve you will increase the market share going to the dominant firm, which is thus able to maintain its dominance as long as it is able to keep its costs lower than those of the smaller firm. We may assume it is able to achieve this through economies of scale, a higher level of technical knowledge and managerial skill, and by its superior power to secure low prices in the factor markets.
Collusive BehaviourAnother distinguishing feature of oligopolistic market situations is collusion between firms in the industry. Although such behaviour, which includes price fixing (agreements to fix a common price), is illegal in many countries, the nature of oligopolistic market situations lends itself to collusive behaviour and agreements. Competition reduces prices and profits, which is why it is beneficial for consumers and the success of economies, but it makes life hard for the managers of companies and their owners who would prefer higher profits. In perfect competition the very large number of firms in the market makes it difficult for firms to get together and fix the market in their own interest. Oligopoly is different: because of the small number of firms, each one knows the others it is competing against. More importantly, each knows that if it changes its price, or any of the non-price features of its marketing, it will have an effect on the other firms' markets share and they will take action to restore their position. That is, oligopoly market situations involve interdependence between the behaviour of firms. Equally, the small number of firms in the market means that the owners/managers can easily arrange to meet and agree that if they stopped competing, reduced their outputs and set a common price, then they would all make more profit and have a quieter life! Recognising the independent nature of their price and output decisions, and the danger of a price war resulting from each firm trying to increase its market share/profits, leads firms in oligopolistic markets to collude and act as if they were one firm with monopoly power. Such behaviour is more common than you might think: it often involves firms in different countries because many global markets, such as cement, steel and air cargo transport, are oligopolistic in nature. In the EU, where such collusive agreements are illegal, the Competition Commission has been successful in prosecuting firms which have fixed the price of glass, cement, plasterboards and vitamins. The US government has achieved a lot of success in fining firms for entering into collusive agreements. Competition authorities try to prevent or break up collusive agreements between firms, to protect consumer interests against the monopoly exploitation such collusion is intended to achieve. Fortunately for consumers such collusive behaviour also contains the seeds of its own destruction, although it may take several years for the seeds to bear fruit, and consumers still lose out during this period. The instability of collusion in oligopoly and the reasons why collusion agreements break down include: The incentive for each member of a price-fixing and/or market sharing cartel agreement between firms to cheat on the other members. Once the cartel has set an agreed price, each firm will gain more sales and profit if it secretly cuts its own price below the agreed price. This will be done on the assumption that the other firms in the cartel obey the rules and keep their price at the agreed fixed level. Since every firm will reason in this way, each firm in the cartel has an incentive to secretly lower its price and/or try to sell more than its allocated share in another firm's market. The result of
this individually rational behaviour by each firm is that they collectively destroy the price fixing and/or market sharing agreement! Firms in the cartel are reluctant to share full information about their true costs, prices, sales and profit, or they give false information. This can lead to disagreements between members and lack of confidence that other members are sticking to the rules of the cartel. In turn this can lead to members responding to real or imagined rule breaking by other members by breaking the rules themselves. Firms in an oligopolistic market situation recognise that their price and output decisions are interdependent. The significant implication of this is that the normal relationships between price changes, and the consequent changes in sales and sales revenue, depend not just upon the elasticity of the firms demand curve. These relationships also depend upon how other firms respond to a firm in the market changing its price, as shown in the kinked demand curve model. This interdependence creates uncertainty for firms that have to determine their production and pricing decisions on the basis of game theory. The decision making is of the form: "If I increase my price tomorrow by 10 per cent what will be the consequences for the other firms in the industry? How will they react? Will I still gain if they only decide to respond by increasing their prices by 5 per cent? What if my main competitor responds by reducing rather than matching my price increase?" Each firm is in a game situation: think about the card players in a game of poker for a similar example. In such a situation it is highly likely that at some point one firm will make a decision to change its price and output, based on its assumption about the response of the other firms, and get it wrong. In this situation the market is unstable. A price war is a likely consequence, even when firms have a collusive agreement, if at least one firm to the agreement thinks that it can come out the winner in such a situation. Another reason for the instability of collusive agreements exists when such agreements are illegal. There is the incentive for one member to avoid legal prosecution, and a very large fine, by obtaining immunity from prosecution by being the first to spill the beans to the competition authority about the existence and details of the cartel. This is known as "whistle-blowing".
C. PROFIT, COMPETITION, MONOPOLY, OLIGOPOLY AND ALTERNATIVE OBJECTIVES FOR THE FIRMIn the discussions of perfect competition and monopoly, we noted that whereas under perfect competition long-term survival depended on the firm maximising its profits, whether or not this was its conscious objective, under monopoly the firm could survive without actually maximising profits. As long as it made a satisfactory profit it was able to pursue other objectives. We now develop this point more fully. Any firm which possesses a substantial degree of market power as a producer and which is large in relation to the total size of the market in which it operates, will have a product demand curve which is downward sloping. If the firm is successful, it is also likely to be able to make profits above the minimum needed to keep it in the market. Its position may therefore be represented by a model similar to that usually used for monopoly as in Figure 8.5. This model assumes that the firm does not practise price discrimination, so that its product demand curve is also its average revenue curve. Assuming that its market power allows it to make profits above the minimum, there will be a substantial range of output levels and prices between which it can make profits. This, in Figure 8.5, is the range between output level A (price PA) which is the lower break-even point where the falling average cost just equals
average revenue, and output level C (price PC) which is the higher break-even point where the rising average cost just equals average revenue. Figure 8.5: Oligopoly/monopoly model Price Revenue Cost
Average cost Pc Pd
The firm in this situation can pursue objectives other than profit maximisation as long as it operates within this profit range, but, as the model suggests, the range can be very wide. A number of alternative theories of the firm have been developed and each of these is based on different assumptions about firms' behaviour. For convenience we can identify two broad groups of theories those that replace profit maximisation by an assumption that firms seek to maximise something else, and those that abandon any idea of maximisation in the belief that firms seek to pursue several objectives at the same time and cannot therefore hope to optimise any one. Before looking at these alternative theories, which may have much more relevance for monopoly and oligopoly firm behaviour than for firms in competitive markets, it must be clearly understood that no firm has a future unless it can cover its costs. That is, all firms need profit to survive in the longer term. The assumption that all firms seek to maximise their profit is made to enable the development of models of firm behaviour. This assumption is simply the extreme limit of what all firms must do in reality if they want to survive. What the alternative theories do is provide additional rather than alternative insights into how firms might behave in practice provided they are profitable in the long-term.
Alternative Maximising Theories Baumol, an American economist, has suggested that firms seek to maximise revenue, subject to making a minimum profit defined as that level of profit needed to retain the support of the firm's shareholders and the financial markets. In Figure 8.5 the revenuemaximising output level is at D, where marginal revenue is O (at the top of the total revenue curve). However in this model quantity D lies beyond the second break-even point of C, so the firm could not reach D without suffering a loss. If it were to try to maximise revenue subject to achieving minimum profit, it would have to produce at an output level somewhere between B and C and charge a price between PA and PB. A British economist, Marris, has argued that firms seek to maximise their rate of growth (expansion), subject to preserving their share values at a level where the firm can hope to be reasonably safe from the fear of being taken over. If the firm grows too fast, its profit rate tends to fall and this depresses the share value and brings the risk of takeover. Too slow a rate of growth is also likely to bring the firm to the notice of takeover raiders, so the firm has to balance the desire for growth with the need to maintain profits. There are similarities in the Baumol and Marris theories. Both agree that the firm's objectives are really established by its professional managers, who are free to control the firm as long as they keep the shareholders satisfied with their dividends and the financial markets satisfied with their profits. Profit remains important no one doubts that in a market economy but it is not maximised to the exclusion of other aims that meet managerial ambitions. Managers like to operate in large firms because size brings prestige, high salaries and a range of other benefits, so these are pursued, to some extent at the expense of the profits belonging to shareholders. In the Baumol theory, revenue is seen largely as a way of measuring growth. The Marris argument is slightly more complex and stresses growth more directly. Another American economist, Williamson, developed another kind of maximisation, but quite cleverly combined this with the idea that the firm pursued several objectives at the same time. Again agreeing with the idea that managers were the real controllers of the firm, Williamson argued that they sought to maximise managerial utility. This utility was a combination of the pursuit of profit, growth (measured by the number of people employed), and managerial perks (all the various expenses, benefits, etc. that movement up the business managerial ladder tends to bring).
Satisficing Theories The rather ugly word "satisficing" has been coined to express the idea that firms pursue several different objectives at once. Whereas no one objective can be achieved to complete satisfaction, the firm aims to pursue each to a degree of tolerable semisatisfaction, i.e. it "satisfices" without fully satisfying. The idea was first given clear expression by the American economist, Simon, in an influential book, Administrative Behaviour. Simon argued that in practice, firms could not, even if they wished, hope to maximise anything. Rather, they reacted to problems as they arose, and aimed to keep all those involved in the firm reasonably satisfied so that the firm could continue to exist. Following the reasoning of Simon, this idea was developed into a more formal Behavioural Theory of the Firm by two more American economists, Cyert and March (in a book with that title). In this theory the firm is seen as a coalition between shareholders, managers and customers, all of whose support is needed to hold the coalition together. To achieve this support, the firm has to pursue multiple objectives, such as profit, sales growth, market share and products to satisfy customers as well as the needs of production managers, but no one objective can be pursued to the exclusion of the others. The firm has to develop a set of behavioural principles to enable it to hold the coalition together and guide managerial decision-making.
Various other attempts have been made to explain business behaviour, but there is no general agreement as to whether the traditional assumption of profit maximisation should be abandoned and, if so, what should replace it. The alternative theories sometimes seem to describe actual business behaviour more realistically, especially in relation to large oligopolists. Firms do pursue growth, often at the expense of profits, takeover battles are commonplace and the salaries and prestige of top business managers appear to bear little relationship to the profitability of the companies they manage. On the other hand, an economic theory of the firm should be concerned not only with how firms actually do behave but also how they should behave, if the economic goals of technical and allocative efficiency are to be achieved. Unfortunately, the alternative theories appear to suggest that if firms operate as they predict, they are likely to be less efficient in the full economic sense than if they pursue profit maximisation the desire to make the largest achievable profit consistent with market conditions. One thing that has to be remembered always is that profit maximisation does not mean making very large and antisocial profits, but simply the largest profit possible under prevailing market conditions. Profit maximisation under perfect competition suggests lower profits than satisficing behaviour in an oligopolist market. A market economy appears to operate more efficiently when firms seek to maximise profit. Consequently, most economists continue to work with profit-maximising models, whilst fully recognising that firms do frequently depart from profit-maximising behaviour in practice.
Review PointsBefore you begin your study of the next chapter you should go back to the start of this one and check that you have achieved the learning objectives. If you do not think that you understand the aim and each of the objectives completely, you should spend more time rereading the relevant sections. You can test your understanding of what you have learnt by attempting to answer the following questions. Check all of your answers with the chapter text. 1. 2. 3. 4. 5. 6. 7. Outline the main features of the model of monopolistic competition. How does the equilibrium of a firm in a monopolistically competitive market differ from that of the firm in a situation of perfect competition or that of monopoly? Identify some examples of a market structure that resemble that of the economic model of monopolistic competition. Explain the characteristics of an oligopoly industry. Identify some examples of oligopoly market situations. Using appropriate diagrams, explain the kinked demand curve. List some of the forms of collusion undertaken by firms in an oligopoly industry. Explain why collusive arrangements between firms in an oligopoly tend not to be sustainable in the longer run.
The Basic 45 Degree Model of National Income Equilibrium and Full Employment163
The Deflationary Gap Meaning, Causes and Consequences Policy Options for Closing the Deflationary Gap
The Inflationary Gap Meaning, Causes and Consequences Policy Options for Closing the Inflationary Gap
The Aggregate Demand/Aggregate Supply Model of Income Determination Aggregate Demand and Supply The Aggregate Demand Curve Aggregate Supply The Long-Run Aggregate Supply Curve The Short-Run Aggregate Supply Curve The Equilibrium Level of Real Output and the General Price Level Excess and Deficient Aggregate Demand: Inflationary and Deflationary Gaps in the Complete Model of National Income Determination
ObjectivesThe aim of this chapter is to explain the determination of the equilibrium levels of national income using the 45 degree and Aggregate Demand and Aggregate Supply curve macroeconomic models of national income determination and to demonstrate how these can be of use to businesses. When you have completed this chapter you will be able to: explain the concepts of the circular flow of income and the equilibrium level of national income compare and contrast inflationary and deflationary gaps using the 45 degree and AD/AS diagrams discuss the equilibrium level of national income and the causes of deflationary and inflationary gaps in an economy.
A. THE CIRCULAR FLOWS OF PRODUCTION AND INCOME AND THE EQUILIBRIUM LEVEL OF NATIONAL INCOMEFlows of Production, Income and Consumption in the National EconomyIn this chapter we start to examine the national economy as a whole. We see this in terms of one large market, in which total or aggregate demand from the whole of the community is satisfied by total production. We are thus concerned with totals or aggregates in this part of the course. The total or aggregate real output of an economy is termed its national product. When we have gained an understanding of the national system, we can begin to see its interrelationship with the wider international economy. The national income concepts we use assume that: Production and consumption are separate production being organised by business or government organisations, and consumption being decided by individuals, families and households. The family is thus seen as purely a consumption and social unit, and not as a production/consumption/social unit, as it would be in an agrarian (farming) economy. Most of the goods and services produced are exchanged through a market system, with households paying money to buy products, and firms paying money for the use of production factors. A proportion of production is organised by the state and its agencies, and paid for by tax revenue raised by the state from the community.
This system can be illustrated in the form of two circular flow diagrams, as shown in Figure 9.1. One shows the flow of goods and services the productive activities of production factors (Figure 9.1(a)), while the other (Figure 9.1(b)) shows the counter-flow of money which oils the really important flow of production and consumption. Notice that for simplicity, we use the terms "firms" for production organisations, and "households" for the individuals and families who consume what is produced. These diagrams assume that the total volume of production is immediately and totally consumed, i.e. there is nothing to enlarge or diminish this continuous circular flow. Notice that firms are seen as hiring the production factors, which are owned by households, which then supply the labour, capital and land employed in production, and also purchase the goods and services produced.
Figure 9.1(a): Flow of goods and services and Figure 9.1 (b): Flow of money (a) Flow of production and consumption Firms Employ Produce
Product market
Incomes Households
Firms enter the general flow as buyers of goods and services, such as factories, machines and research, in their efforts to increase their capacity to produce. We call this investment or capital accumulation. The government must be seen as a separate force which produces goods and services on behalf of the community as a whole e.g. it builds roads, schools and hospitals, and it provides forces to maintain law and order and defence against external aggression. We can combine all these activities under the heading government expenditure. Firms supply other countries with exports of their products. Trade is a two-way process.
We can regard modifications (a) to (c) as leakages from the main flow of economic activity, because they reduce the purchasing power of total incomes. We can regard (d) to (f) as injections into the flow, because they increase total purchasing power and demand. This concept of leaks from and injections into the main flow is illustrated in Figure 9.2. Figure 9.2: Leaks and injections into the main flow Firms Injections of expenditure Business investment Government expenditure Exports Leaks from income:
National Product, Income and Expenditure and the Equilibrium Level of National incomeThis total flow of economic activity, modified by injections and leaks, can be given the general term national product. This term serves to emphasise that it is the total production of goods and services that is the really important matter. This is the total flow as seen in our first illustration (Figure 9.1(a)). The counter-flow of money in the second diagram (Figure 9.1(b)) can be seen as both the total income of households and as the total expenditure of households. Notice that these three total product, total income and total expenditure are all really describing the same essential flow. They can be regarded as equal provided that the total amount of leakages from income (savings, taxes and imports) is equal to the total amount of injections of expenditure (from investment, government spending and exports). At the moment, we shall assume that this equality does exist and that total production equals total income equals total expenditure. Thus, if we use O to denote total product, Y to denote total income, and E to denote total expenditure, we can say that: OYE
Bearing in mind that total income and total expenditure are different ways of looking at what is, essentially, the same flow, we can use symbols to state a fundamental equation for equilibrium in the circular flow and the determination of the equilibrium level of national income. We have already used E for total expenditure and Y for total income. In addition to these, it is usual to make use of the following: S savings I investment T taxation G government spending C consumer expenditure X exports M imports. Using these symbols, we can now say that: YCSTM and ECIGX Remember that Y E, so that: CSTMCIGX Consumer spending (C) is common to both sides of this equation, so that we can expect the remaining elements of total income and total expenditure to preserve the equality: STMIGX This is a proposition which is of very great importance in our analysis of national product and the equilibrium level of national income in an open economy that is one that trades with the rest of the world. Remember the term "equilibrium" refers to a state of rest where there are no pressures acting to disturb and change the balance of forces. For the economy to be in equilibrium, the planned and actual withdrawals of expenditure from the domestic circular flow through savings, taxation and spending on imports must just be matched by additional injections of planned and actual expenditure in the form of investment by firms, government expenditure and foreign demand for exports. Thus, the following equation defines the condition for equilibrium in the circular flow of income: STMIGX Putting this another way, we could say that total leaks or withdrawals from income equal total injections or additions to aggregate expenditure or, in symbols, W = J where: W total withdrawals = (S, T, M) and J total injections = (I, G, X)
various national income levels are recorded in the curve C J. Remember that J equals injections of investment and government expenditure plus foreign demand for the country's exports which, combined with consumption expenditure, equal the total of all expenditure or demand in the economy. Figure 9.3: The national income in equilibrium National expenditure (E) and intended expenditure
Assuming that the scales of both axes are the same, then the 45 dotted line represents all points where total income just equals total expenditure. Remember too that when expenditure equals income, both are also equal to total output. The graph illustrates that there is only one level of income where total income, output and expenditure are in fact equal i.e. where national income is in equilibrium. This is at the income level OYe, where the intentions curve intersects the dotted 45 line. However what happens if this equilibrium is disturbed? (a) Lower National Income Suppose national income is at the lower level OY1, where intentions are trying to achieve a higher level of spending than that possible from current total output. At level OY1, the combined demand from all households (C) and injections (J) is higher than total output. It cannot be satisfied at the current level of output. Some firms will have stocks of goods produced earlier, and they will be able to sell from these stocks. Others, finding that they have more customers than goods to sell, will ration sales by putting up the price or promising delivery at a future date. Actual consumption and injections will thus be lower than intended, as some would-be buyers are disappointed, but also money spending will be raised by the increased prices of goods. Increased money spending will feed into increased money incomes, and so the money value of national income will move up towards OYe. We can also expect that firms, facing high demand and good profits from rising sales, will seek to increase production. They will hire more labour and pay more wages in order to do this. This will tend to push up production towards OYe. There will be an upward pressure to achieve ABE
at least the money level of OYe, even if this still leaves many spending intentions unsatisfied. (b) Higher National Income We can apply this reasoning in reverse if national income happened to move out of equilibrium to the higher level OY2. Here, more is being produced than people want to buy. Warehouse stocks rise, and customers are not around to buy the goods and services on offer. Traders needing money to meet current expenses will cut prices to achieve sales. Firms, seeing stocks of unsold goods rise, will reduce production, lay off workers and cut overtime working. Incomes will fall through declining wages and falling business profits. There will be a movement downwards towards the equilibrium level OYe. Only at this level will there be no pressures for moving either up or down, because only here does total income equal total output equal total expenditure.
B. THE BASIC 45 DEGREE MODEL OF NATIONAL INCOME EQUILIBRIUM AND FULL EMPLOYMENTThe equilibrium level of national income and the level at which all workers are fully employed are two separate levels which may or may not come together through the operation of the normal economic forces. This concept of the separation of equilibrium and full employment levels of national income is illustrated in Figure 9.4. To start with, we use the model based on the 45 line which, you will remember, represents the curve where all income is expended. The intended levels of expenditure at each level of income are shown by the curve C J (consumer spending plus total injections from investment, government and exports). The equilibrium level, where intentions are fulfilled without changes in prices and stocks, is Oe, where the C J curve intersects the 45 line.
Figure 9.4: The separation of equilibrium and full employment levels Expenditure
Deflationary gap CJ
45 O e f National income
Suppose that possible output of goods and services available for purchase by the community, given full employment of all those seeking work, would push up income to level Of. However, at this level of income there is a gap between the 45 line and the C J curve. This gap indicates that all planned expenditure at income level Of is less than the spending required to achieve equilibrium at full employment.
injections) should be raised to bring the equilibrium level of national income closer to the full potential employment level. This is illustrated in Figure 9.5. Figure 9.5: Raising the aggregate demand curve Expenditure
C J1 Deflationary gap CJ
Since business investment (I) levels are a consequence of firms' experience of past and current consumer demand, and their view of the probable future trend of this demand is also dependent on net export levels, the potential for lifting I when C is depressed is limited. One way to stimulate consumer and investment spending is through the use of monetary policy to lower interest rates. This policy may not work if consumers and firms are very pessimistic regarding their future economic prospects and continue to save rather than responding to lower interest rates by borrowing and spending more. However, there is one other element within total aggregate demand which is not necessarily an inevitable part of the business cycle: government spending (G). Government spending is the result of political decisions that can be taken independently of the national income and consumer demand, if the government abandons the principle of the balanced budget (spending equals taxation revenue). This of course is government spending on such projects as road and communications development. The possible result of increasing government spending is shown by the movement in the C J curve in Figure 9.5. Here, we see that the rise from C J to C J1, brought about by an increase in government spending, is able to close the deflationary gap and remove largescale unemployment.
Inflationary gap
45 O f e National income
Here total demand, from all the forces represented by the C J curve, is forcing an equilibrium level of national income above the level of total production and real spending that is possible given full employment at income level Of. The pressure to buy goods and services that are not being produced forces up prices. In this situation, total spending intentions cannot be fulfilled, so that actual spending is lower than intended. In its simplest terms an inflationary gap arises when aggregate demand is greater than aggregate supply, which is unable to respond sufficiently to reduce the excess demand. This then raises two questions: (a) (b) What causes the excess demand? Why, if it is the function of a market economy for supply to respond to demand, is the production system unable to meet total demand?
Experience has shown that low inflation rates can very rapidly turn into high rates. The inflationary gap produces price rises and waiting lists for goods and services. Unfortunately these do not actually close the gap. If prices rise, people spend the money they had planned to spend, but do not buy all the goods and services they had planned to acquire. The spending pressure remains high and rising prices actually increase demand, since people prefer to buy now at today's price rather than tomorrow at a higher price. If they finance this spending by borrowing they increase the money supply and this adds further inflationary pressures.
In their extreme forms, Keynesians and monetarists have given conflicting answers to these questions. Today, they are closer together, but still place different emphasis on different aspects. These differences are just outlined here. Keynesians blame excess demand on excess income running ahead of potential production. Today, they also accept that excessive money supply and government borrowing may also play a significant part in stimulating demand. Monetarists blame excessive demand on excess money supply (for reasons that are explained later), but they have also linked this with rising wage levels made possible by business borrowing. They have also linked excess money supply to government spending and borrowing. The original Keynesian 45 degree model of the inflationary gap assumed that the production system could respond to rising demand, up to the point where all production factors were fully employed. A significant inflationary gap would only appear when the equilibrium level of national product rose above the full employment level. This basic model offered little scope for a convincing explanation for the stagflation which affected many developed economies in the 1970s and early 1980s, when both inflation and unemployment were rising. Consequently, Keynesians have had to accept deficiencies in the production system at levels below full employment. Monetarists have traditionally been more prepared to see inflation and unemployment as associated, rather than opposing problems of a troubled economy. They do not only regard inflation as a cause of unemployment because of its effect on business productivity and ability to compete in world markets. They also see inflation as being partly caused by defects in the supply side of the economy that encourage people to remain unemployed even though there is excess demand in the economy. Inefficient factor markets permit unused production capacity to remain unused in spite of high levels of demand.
The aggregate demand curve looks to be the same as the microeconomic demand curve used in earlier chapters, but appearances can be deceptive. In aggregate demand and supply diagrams, the vertical axis in the diagram shows the level of prices in the economy as a whole, and not the price of a single good or service. The price level is measured by an index number of prices, an average measure of all the prices in the economy. This is not the same as the rate of inflation or deflation, but a change in the general level of prices in an economy corresponds to the rate of inflation or deflation. For example, the rise in the price level from P2 to P1 shown in Figure 9.7 implies a positive rate of inflation in the economy. The horizontal axis measures the level of real output or real national income in the economy, not the money value of income or output. Real national income is the measure of output that matters for an economy because it is this that determines the standard of living and the level
of employment. If the price of all the goods and services in the economy were to increase by 20 per cent, due to inflation, the value of national output measured in monetary terms would also increase by 20 per cent; but no one would be any better off, because real output would be the same. Actually, if the level of prices rose in an economy due to inflation while all the other economic variables remained the same, the economy would be worse off in the sense that the level of aggregate demand would be lower. This relationship is shown by the downward slope of the aggregate demand (AD) curve from left to right. The downward sloping AD curve results from the fact that as the general level of prices is reduced the real value of the supply of money increases, and the level of the rate of interest decreases. Without explaining this relationship in more detail at this stage, we can deduce that as the general level of prices and the rate of interest decrease, consumers increase their consumption expenditure and firms increase their borrowing and investment expenditure. Thus, all other things remaining constant, as the general level of prices in the economy falls the C and I components of aggregate demand increase: the AD curve slopes downwards from left to right as drawn in Figure 9.7. The entire aggregate demand curve will shift to either the left or the right if, without any change in the level of prices in the economy, there is a change in one of the underlying components of aggregate demand or the supply of money in the economy. For example, all other things remaining constant including government tax revenue, an increase in the level of government expenditure will shift the entire AD curve to the right. Conversely, all other things remaining constant, a decision by consumers to spend less on consumption, which is the same as a decision to save a larger fraction of their incomes, will result in a shift to the left in the AD curve.
Aggregate SupplyAggregate supply (AS) is the economy's total output of goods and services over a given period of time. At the level of the whole economy, we have to recognise that there are two distinct aggregate supply relationships. One is the economy's maximum sustainable level of output. This is termed long-run aggregate supply (LRAS). The other aggregate supply relationship shows how the economy can vary its output in the short term, and recognises that for short periods of time it is possible to produce more real output than is sustainable over longer periods. Think of it this way: it is possible for a person to increase their output by cutting down on time spent sleeping and working longer hours each day. However after a few days with little or no sleep, production would fall to zero because of the need to catch up on lost sleep! This kind of relationship is represented by an economy's short-run aggregate supply (SRAS) curve.
cases. The efficiency or productivity of the labour force is a major determinant of real national output. This explains why education and training are so important in determining living standards, and why they are given so much emphasis in developed, high income, countries. Figure 9.8: LRAS curve Price Level
The LRAS curve is vertical at the level of real output determined by the full utilisation of all the economy's factors of production. This point is also termed the point of full capacity utilisation, the point of full employment, or full employment output. The LRAS curve is shown as vertical, that is, completely price inelastic with respect to the general level of prices. This is because once the economy is operating at its sustainable level of full capacity utilisation merely increasing the level of prices in the economy will not result in any increase in real output. Inflation alone does not have the power to make the economy more productive and increase the availability of goods and services. The position of the LRAS curve is not fixed permanently. Economic growth resulting from increases in the productivity of the economy's factors of production, and/or increases in the available supply of labour and capital through investment, increases the full capacity level of real output. That is, economic growth shifts the LRAS curve to the right. Equivalently, the rightward shift of the LRAS curve through economic growth is equivalent to the rightward expansion of an economy's production possibility frontier. The LRAS curve can also shift inwards to the origin, although fortunately this is much less common, if an economy's productive capacity is destroyed through war or natural disaster (such as an earthquake or flooding).
by employing more workers and increasing the hours worked, is subject to the law of diminishing returns. This means that for a given level of money wages in an economy the cost of each unit of additional output will rise. Thus the SRAS curve will slope upwards from the left to the right and appear to look just the same as the individual firm and industry supply curves considered in earlier chapters. An economy's SRAS curve is shown below in Figure 9.9. That the economy's aggregate supply curve, at least in the short run, slopes upward in the same way as a firm's supply curve should not be surprising, because the aggregate supply curve is simply the sum of all the supply curves of individual firms. Figure 9.9: SRAS curve Price Level SRAS Short Run Aggregate Supply Curve
Real National Output The upward slope of the curve shows that unit costs of production, and hence prices, rise because of diminishing returns as the economy increases its level of real output from a given stock of resources. Each SRAS curve is based upon the assumption of a given level of money wage rates and rates of tax in the economy. Thus, in contrast with the economy's LRAS curve which is fixed at each point in time, there are many possible SRAS curves at any one time depending upon the level of money wages, taxes and import prices. Three such SRAS curves are shown in Figure 9.10.
Figure 9.10: A set of SRAS curves Price Level SRAS2 (Wage/cost level 2)
The curve SRAS1 is based upon a given level of money wages. The point of full employment equilibrium is at E1 where the SRAS curve intersects the economy's LRAS curve. At this point the level of prices in the economy is P1. Now suppose that there is an increase in the level of money wages in the economy, without any corresponding increase in productivity. This will cause the SRAS curve to shift upwards as shown by SRAS2 in Figure 9.10. At the new point of full employment equilibrium on the LRAS curve, E2, the level of prices in the economy has increased in proportion to the increase in money wage rates, P2. This illustrates the fundamental point that simply increasing money wages and other costs in an economy, without any corresponding increase in productivity, will at full employment merely lead to higher prices. The same applies if the increase in costs is due to a rise in the cost of imported energy, such as oil. On the other hand, a reduction in the level of money wage rates in the economy, or a fall in the price of imported raw materials and energy, or a reduction in the level of indirect taxes, will shift the SRAS curve downwards to the right. This is shown in Figure 9.10 by the movement from SRAS1 to SRAS3, and the fall in the general price level from P1 to P3.
The Equilibrium Level of Real Output and the General Price LevelThe equilibrium level of real national output and the general level of prices in the economy is determined by the interaction of aggregate demand and aggregate supply. The intersection of the AD and SRAS curves determines the economy's equilibrium position in the short run. In the short run the economy can suffer from deficient demand, and be in equilibrium with unemployment, or experience excess demand, over full employment and inflation. If the economy achieves full employment without excess aggregate demand the equilibrium point will lie on its LRAS curve and all three curves must intersect at the same point. This is shown at point E in Figure 9.11.
Figure 9.11: Equilibrium level of real output and general price level Price Level SRAS
Excess and Deficient Aggregate Demand: Inflationary and Deflationary Gaps in the Complete Model of National Income DeterminationWe have now brought together all the pieces of the aggregate demand and supply model for the determination of the equilibrium levels of real national output and prices. We can use this model to revisit the concept of inflationary and deflationary gaps examined using the 45 model earlier in this chapter. In Figure 9.12 the aggregate demand curve AD1 intersects the SRAS curve at point E1 to the right of the LRAS curve. This illustrates a situation of excess aggregate demand in the economy and corresponds to the inflationary gap of the earlier analysis. But in the AD/AS model we can see that the point of equilibrium at E1 is unsustainable because the associated level of real national output, Y1, is greater than the economy's long-run output level, Ye. The excess demand will place upwards pressure on wages and hence prices in the economy. The SRAS curve will shift upwards with the rise in the level of money wages until a new point of equilibrium is reached at point E2 on the LRAS curve. The economy will experience inflation as it moves to its sustainable equilibrium at point E 2 with a higher general level of prices in the economy, P2. Inflationary gaps are essentially self correcting unless the economy experiences a further injection of aggregate demand during the movement to the new equilibrium.
Figure 9.12: Excess aggregate demand SRAS2 Price Level LRAS SRAS1
Figure 9.13 illustrates a situation of deficient demand in the economy which corresponds to that termed a deflationary gap in the earlier analysis. The aggregate demand curve AD1 intersects the SRAS curve at E1 and the associated equilibrium level of real national output is Y1. National income level Y1 is less than the full employment capacity output level of Ye as a consequence of the deficient level of aggregate demand. However, using the AD/AS model we can see that the term deflationary gap is misleading, because the economy may remain in its deficient demand equilibrium at point E1 without any change in the general level of prices from P1. Figure 9.13: Deficient aggregate demand Price Level SRAS1 LRAS SRAS2
What is the significant difference between the situation of excess aggregate demand illustrated in Figure 9.12 and the situation of deficient aggregate demand illustrated in Figure 9.13? In the case of excess demand there a few if any forces in the economy to resist the rise in prices that move the economy to its point of long-run equilibrium. In the case of unemployment due to deficient aggregate demand, the economy's automatic adjustment mechanism will only work if money wages and other costs fall to shift the SRAS curve downwards and to the right, until it intersects the unchanged AD curve at point E 2 on the LRAS curve. If workers resist the attempt to cut their money wages, and it may be individually rational for them to do so, this will prevent the economy from achieving full employment. This is an example of how perfectly rational behaviour on the part of each individual nevertheless leads to a collective or aggregate outcome that is socially undesirable. In this situation, the appropriate policy response by the government is to use expansionary fiscal and/or monetary policies to boost aggregate demand, rather than a process of falling wages and prices (deflation), in the economy. The concepts of inflationary and deflationary gaps are useful in illustrating the crucial role of aggregate demand in determining the economy's equilibrium level of real output, and hence employment. They provide a basis for analysing the two most serious macroeconomic problems of inflation and unemployment that can affect an economy. However, as shown when using the aggregate demand and aggregate supply curve model, the concept of a deflationary gap does not necessarily imply falling prices when demand is deficient relative to the level required to achieve full employment. What the analysis also reveals is that even in situations of deficient aggregate demand and unemployed resources in the economy, an increase in aggregate demand will lead to a higher price level and inflation as well as increased real national income. Figure 9.14 illustrates how using expansionary fiscal and/or monetary policies to increase aggregate demand, even when the economy is suffering from a deflationary gap due to deficient aggregate demand, leads to a higher price level as well as an increase in real national output. Figure 9.14: Expansionary monetary and/or fiscal policy to increase demand and eliminate a deflationary gap Price Level
The initial level of aggregate demand is shown by AD1. The initial equilibrium in the economy is at point E1 where AD1 intersects with the short-run aggregate supply curve, SRAS1. At
equilibrium point E1 the economy is operating below its full capacity as represented by the position of the long-run aggregate supply curve, LRAS1, at Ye. The economy is suffering from a deficiency of aggregate demand and its shortfall in real output is equal to the distance Y1-Ye. At the initial equilibrium level of real national output of Y1 the general level of prices in the economy is P1. If the government increases its level of expenditure by running a budget deficit, or uses an expansionary monetary policy to reduce interest rates and increase the level of aggregate demand in the economy, the AD curve will shift to the right. This is shown in Figure 9.14 by the movement to AD2. Provided the government's expansionary policy is calculated correctly, the level of aggregate demand will increase until it intersects SRAS 1 at point E2 on the long-run aggregate supply curve. At point E2 the economy has reached its full capacity point and unemployment will have fallen to its "natural" level. However, in contrast to the earlier 45 analysis of the deflationary gap, which does not include the price level, the elimination of demand deficient unemployment in the economy has resulted in a rise in the general level of prices from P1 to P2, and a rate of inflation calculated as (P2 P1)/P1 per cent. This can be seen by comparing Figures 9.13 and 9.14. In both diagrams the initial point of equilibrium is one involving deficient aggregate demand at Y1. Without government action to boost AD, as illustrated in figure 9.14, full employment can only be restored by a reduction in money wages and prices that shifts the SRAS curve downwards. Comparing Figures 9.13 and 9.14, the point of full employment equilibrium (Ye) is achieved in both cases, but with the significant difference that the level of prices in the economy is higher when aggregate demand is increased through government policy.
Review PointsBefore you begin your study of the next chapter you should go back to the start of this one and check that you have achieved the learning objectives. If you do not think that you understand the aim and each of the objectives completely, you should spend more time rereading the relevant sections. You can test your understanding of what you have learnt by attempting to answer the following questions. Check all of your answers with the chapter text. 1. 2. 3. 4. 5. 6. Explain the concept of the equilibrium level of national income. Illustrate the concept of the full employment level of national income using the 45 degree diagram. Outline the aggregate demand and supply model of income determination. What is the difference between short-run and long-run aggregate supply? Explain what is meant by a deflationary gap using the aggregate demand and supply model of income determination. Explain what is meant by an inflationary gap using the aggregate demand and supply model of income determination.
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The Financial System Structure of the Financial System The Retail Banks Foreign Banks Money Markets Building Societies Unit Trusts and Investment Trusts Hedge Funds and Private Equity Funds
The Banking System and the Supply of Money Money and Bank Credit Credit Creation Illustration The Bank Credit Multiplier
The Central Bank The Functions of the Central Bank Modern Central Banking
Interest Rates Importance of Interest Rates The Determination of Interest Rates The Pattern of Interest Rates
ObjectivesThe aim of this chapter, in conjunction with the following one, is to explain and evaluate the effectiveness of monetary policy in a closed and open economy and discuss the possible impact of monetary policy on business decision-making. When you have completed this chapter and chapter 11 you will be able to: demonstrate an understanding of the relationship between the banking system and the creation of money identify the components of the high-powered money stock and explain why these have a magnified impact on the money supply explain the quantity theory of money and its role in explaining the rate of inflation discuss the components of monetary policy and explain how they work evaluate the factors that determine the effectiveness of monetary policy in a closed economy compare and contrast the relative effectiveness of fiscal and monetary policy.
One of the oldest forms of money, and one that is still in limited use, is gold. When, from time to time, the world economy becomes unstable and other forms of money become less acceptable, the price of gold always rises as people turn (or return) to it as a haven for their threatened savings. Other precious metals have often been used, especially silver, but this lacks some of the qualities of gold. Many metals suffer deterioration over time. To aid recognition, add acceptability and assist in measuring value, many communities over the ages have fashioned coins from previous, semi-precious and base metals. With the exception of a limited supply of gold, these are now used mainly for units of low value. Metal is bulky and expensive to transport in large quantities so, from very early times, traders have used paper as a more convenient substitute. Paper has always been used in two ways as money:
As a receipt or representation of precious metal or some more solid form of money and exchangeable for the preferred form of money under certain conditions. The Bank of England bank note still contains the "promise to pay the bearer on demand the sum of ... ". At one time the holder could exchange such notes for gold. Today handing over a note at the Bank of England will only be met with another note, but the promise serves as a reminder that the paper really just represents money and has no intrinsic value in itself. As an instruction to a clearly identified person or organisation, or a promise from a person or organisation, to make a payment under certain conditions. A letter of credit is an instruction to make money available to the holder while a bill of exchange, still widely used in international trade, is an unconditional promise to make a payment. Such instruments of payment are almost as old as trade itself.
In recent years plastic cards have replaced or supplemented paper as conveyors of instructions to make payments. The development of modern telecommunications has made such cards, with their magnetic strips and chips among the most important means of carrying out everyday trading transactions. As information technology continues to advance we can expect these cards to gain further uses, but we can also expect that transactions will be increasingly made by direct instructions through computers or over the telephone. All of these convenient forms of payment by simple instruction depend on people's willingness to hold their store of money in banks. Early banks actually did store the wealth of their customers in the form of precious metals, but wealth is now stored purely in the form of credit balances recorded in computers. No doubt today's method of storing money has not yet reached its ultimate form, though in simple terms we can ignore all present and future methods of transferring and storing money and simply refer to it as "bank credit". In this form we can choose to store it as a bank deposit or use it to make payments by any of the techniques made available to us by current technology.
Functions of MoneyThe functions of money are generally summarised as follows: (a) Facilitating Exchange The basic purpose of money, as we have already noted, is to make the exchange of goods or services easier. Without money, people have to resort to direct exchange or barter, and this is often wasteful, time-consuming and inefficient. Money allows trade to develop much more freely. (b) Measure of Value Even if people do exchange goods directly, they can be more certain of fair dealing if they can measure the value of their goods in terms of recognised money. If farmers wish to exchange pigs and cows, they are helped if they know the values of both in money terms. (c) Measure of Deferred Payments Exchange and trade can flow more freely if it is possible to carry forward debts of a known amount. Money can help by standing as a measure for any payments that are deferred for future settlement. For example, the farmers exchanging pigs and cattle may agree that A took cattle from B to a higher value than the pigs he passed to B. If the difference in value is expressed in money, then both know the size of the debt and the future payment required. Money measurement may help them later to settle the debt say, with some other animal, perhaps sheep.
Store of Value Finally, money can be kept as a store of value that can be held in reserve for purchases not yet planned. This value can be held over time as long as money value does not fall.
The importance of acceptability has already been stressed. Without it, money cannot be used in exchange. This is why a great deal of international trade is carried out in a relatively few generally acceptable currencies e.g. American dollars, Swiss francs, Japanese yen, British pounds and euros. These currencies are all readily acceptable and transferable in world trade and finance markets. We can see that acceptability and transferability depend on the confidence of traders. If this confidence is lost, then money ceases to have any value, because it cannot fulfil its essential functions. The function that causes the most problems is that of storing value. No form of money in the modern world has escaped the problem of inflation the tendency for money prices to rise as time goes by. If all prices rise, then the value of money itself is falling. The difficulty of storing value undermines confidence, acceptability and transferability, and so makes trade generally more difficult and uncertain.
High-Powered MoneyThe measurement of money supply depends on how we define it. The wider our definition, the more we have to measure. Difficulties in deciding precisely what should be counted as money help to account for the fact that there are several possible definitions. These are can be divided into two groups: Narrow money M0, the narrowest definition, made up of the notes and coin in circulation with the public and banks' till money and the banks' operational balances with the central bank. Broad money M4, made up of notes and coin and all private sector sterling bank and building society deposits.
This distinction is more important than it might appear because of the special role of narrow money in the banking system. The other name for narrow money is "high-powered money". The term "high powered" indicates that it serves as the reserves of the commercial banks in the economy and provides the basis for the creation of bank deposits. Because highpowered money is "created" by the central bank, and hence directly under its control, it enables the central bank to control the deposit creating activities of the commercial banks and the broad money supply.
More recently, a number of banks have entered the field of stockbroking. This has been made possible by the Stock Exchange reforms of October 1986. The retail banks also control a number of specialised subsidiaries, offering hire purchase, leasing and factoring services to customers. Leasing is an alternative to hire purchase, and is used frequently by business firms to obtain vehicles and equipment under a form of instalment credit. Factoring is used chiefly in foreign trade. A factor takes over responsibility for a company's approved trade debts (debts owed to the company) and arranges collection and administration, thus releasing cash to the company. It is an expensive way of speeding up a firm's cash flow (the speed at which money spent on production is recovered from sales) but worthwhile if the cash can be used at greater profit than the cost of the factoring service.
Foreign BanksA feature of recent years has been the globalisation of banking and financial markets and the continued rise in importance of a number of international financial centres including London, New York, Tokyo, Hong Kong and Singapore. Such centres attract foreign banks and this is especially true of London, which is home to several hundred foreign banks as well as the UK's retail banks. On the whole, there has not been any major or sustained competition for the business of British industrial companies. Most foreign banks are concerned chiefly with their own national organisations and with operations in wholesale banking i.e. lending large sums to other banks and financial institutions, usually on a short-term basis. The increase in oil wealth has encouraged the entry to London of a number of Middle Eastern banks. The foreign banks are also active in what is termed the eurocurrency market, which handles transactions in the bank deposits of banks held outside the banks' countries of origin. Thus the dollar deposits of an American bank in London form part of the eurodollar market in Britain. Eurocurrency markets have become a major part of the wholesale banking structure.
Money MarketsThe term "money markets" is given to the markets in short-term money, in which all the main banks, domestic as well as foreign, investment as well as retail, take part. By short-term (when describing money markets) is meant a period of time from 1 to 364 days. Transactions in funds for periods of a year or longer are usually termed capital market transactions, to distinguish them from the very short-term nature of transactions in the money markets, most of which are for days or weeks rather than months. There are a number of different money markets in a developed financial system such as that found in the UK, the EU and the USA. The most important money markets in the UK are the gilt repo market (sale of gilt-edged securities), the interbank market, the certificate of deposit (CD) market, and the commercial paper (CP) market. These markets bring together domestic and foreign business organisations, all banks as well as central and local government, all of which have funds that they have to keep almost liquid but which they cannot afford to have lying idle. In the money market funds are not allowed to lie idle. When London sleeps its money may be working hard in Sydney, Hong Kong, Singapore, Tokyo and many other places. If you have 10 spare you will not earn much interest by lending it overnight, but if you have 10 million it could easily be earning over 1,000 while you sleep and still be back in your account next morning ready to meet any payment due to be made.
Building SocietiesHistorically the main function of these institutions was the provision of funds for house purchase by individual owner-occupiers. They are also a major channel for the savings of individuals. The societies have expanded with the huge growth of private home ownership in
the United Kingdom. At the same time, there have been many mergers so that the number of societies has been falling, but their average size has increased. The Building Societies Act 1986 opened the way for the larger building societies to convert to public companies as well as becoming full banks. Life Assurance Companies and Pension Funds These are the most important financial institutions in terms of their role as the main long-term investing institutions in the economy. The life and pension companies differ from general insurance companies in that they provide long-term investment services, and do not normally sell protection on an annual basis. For instance, a payment made for motor insurance covers the cost of protection for the year of insurance. The premium thus buys a specific and limited service. The typical life assurance or pension contract provides for a return payment to be made at some time in the future, prior to which there is a continuing obligation to pay premiums and a continuing obligation on the part of the company to invest those premiums to the mutual benefit of the company and its policy holders. This gives the life and pension companies substantial funds which they invest in a range of ways including property, shares, and government bonds or in direct lending to business. Today in the UK they are the main investors and holders of company shares, corporate and government bonds, and major participants in the financial markets.
Anyone with a house mortgage or a bank loan knows only too well the effect of changes in interest rates. In order to take our understanding of the issues a little further, we must examine the relationship between the demand for money and its supply. The notion of a relationship between demand and supply may surprise you. In our earlier examination of demand and supply for goods and services, these two market forces were kept separate. However money is rather different. It is not "produced" like other commodities, except in the very limited sense that gold and silver are produced. As we have seen, most of the supply of modern money is not found in physical form at all it is credit held in bank accounts on behalf of the banks' customers. The total amount of credit held by the banks on behalf of customers is not a fixed amount; it can itself be varied by the banks' own actions.
Credit CreationIn fact banks can create credit through lending to their customers, and lending is a most important and profitable part of a bank's activities. When people or firms borrow from the banks, they use the amount borrowed to make payments to other people or firms, who deposit the payments with their own banks. Suppose I borrow 2,000 from my bank to help buy a new car. When I buy the car, I pay the Swifta Motor Company. Suppose this company also has its accounts at the same bank. When I pay my cheque (drawn on the bank) to Swifta, it then pays in my cheque to its own account. In effect, the bank has created 2,000 in one account (my loan account) and thereby increased the volume of its customer deposits (through the extra 2,000 paid in by Swifta). Thus, for the factor capital, we have the peculiar position that demand appears to create its own supply. You may think we have cheated by using one bank only in our example but, as long as there is a fairly closed banking system in a country, the effect will be the same if different banks are involved. In the UK, the great mass (over 80 per cent) of daily payments pass between the four large clearing banks (Barclays, LloydsTSB, NatWest and HSBC), so that this close relationship between demand, borrowing, depositing and supply does exist.
IllustrationIn practice, the banks keep a proportion of all their funds in the form of coin, notes or deposits with the country's central bank (the Bank of England in the UK) which acts as a bank to the retail banks, or in short-term loans to other banking institutions, which can very quickly be recalled. Such funds are the cash reserves of a bank and referred to as highpowered money. If we call these reserves "cash" and assume, for simplicity, that a country has a system of two banks only, each keeping 10 per cent of its assets in cash, then we can give a very simple illustration of how the total supply of bank money can grow following the injection of "new money" from some outside source. Suppose that our two banks are A and B, and the initial injection is 100 currency units, which goes to bank B. Bank A's customers borrow money to pay to customers of B, and vice versa. The banks are of equal size. Bank A Customer deposits 1,000 Held as: Cash Loans 100 900 1,000
Bank B is in the same position. Then there is an injection of 100 to the deposits of A. Bank A initially adds this to its cash but idle cash earns no money. Therefore as soon as possible it lends it to suitable customers, and its accounts then appear as follows.
Bank A Customer deposits 1,100 Held as: Cash Loans 110 990 1,100
This additional lending soon gets paid into customer deposits of bank B, which also lends 90 per cent of this increase, so that its accounts appear as: Bank B Customer deposits 1,090 Held as: Cash Loans 109 981 1,090
Additional loans of 81 units have now been made to customers of bank B, who have made payments to customers of bank A. The process continues, and bank A's accounts become: Bank A Customer deposits 1,181 Held as: Cash Loans 118 1,063 1,181
Notice how the total of deposits (and hence the total money supply) is increasing, but (because 10 per cent is being held back all the time) by a decreasing amount at each lending/deposit round.
1 c
money, then a very similar relationship can be expected for interest rates and the supply of money.
Regulation and supervision of the banking system it is responsible for the stability and integrity of the institutions which make up the banking system. Monetary policy it is responsible for the conduct of monetary policy. In the UK the Bank of England has a duty to control the actual supply of money within the banking
system. The reasons for monetary controls, and the ways in which they may be exercised, are examined in Chapter 11. Management of a country's foreign currency reserves and responsibility for its exchange rate policy.
In the UK the Bank of England keeps the nation's gold reserves and the international accounts for money entering and leaving the country, as well as the nation's reserves in other currencies. The Bank of England works closely with the central banks of other nations. The Bank maintains continuous contacts with the major international banks, especially the International Monetary Fund (the IMF is probably closest to being a genuine world bank). The Bank has a duty to maintain the stability of the national currency in its exchange value with other national currencies, and to cooperate with other countries and international institutions to uphold the stability of the world financial system. It has a special account which it can use to deal in sterling and other currencies in order to stabilise demand, supply and exchange rates.
E. INTEREST RATESImportance of Interest RatesWe have seen how important borrowing and lending are to the workings of a modern economy, but this dealing in money always takes place at a price. The price of money is interest, and the level of interest has become an important issue in modern economics. The reasons why interest rates have gained this importance include the following: (a) Interest rates influence the level of business investment and business costs If interest rates are high, new investment is discouraged. As most loans provide for interest rates to be linked with bank base rates, the costs of existing borrowing rise. The result of a prolonged period of high rates is that business efficiency declines. This reduces the supply of business goods and services, and makes it more difficult for businesses to compete with countries with lower interest rates. (b) Interest rates influence the cost of public borrowing The government, in one form or another, is by far the largest borrower of money. Some government debt is subject to changing rates. A number of loans are linked to rates of price increase, and the government's short debts (treasury bills) have to be constantly renewed at current market rates. Governments have to pay interest out of revenue, and taxation is the largest source of revenue. A large proportion of tax revenue thus has to pay for the costs of past spending, and this proportion is not available for new spending. Any rise in interest rates reduces the amount of public services that can be provided from taxation, and makes the government dependent on further borrowing thus increasing future costs still further. (c) Interest rates influence consumer spending Much consumer spending on major capital goods and the more expensive household durables is with the help of credit. If interest rates are high, consumers may go on spending for a time but: (i) (ii) they purchase less expensive goods, because a higher proportion of the amount spent goes on borrowing costs, and the burden of repayments takes up an increased proportion of income leaving less for other spending.
As everyone with a mortgage loan knows only too well, any increase in the interest charged on the loan reduces the amount of household income left for spending on other goods and services. If for any reason the household cannot meet the mortgage payments the home may be repossessed. Changes in the rate of interest have become of very great importance to large numbers of people. High interest rates also appear to increase savings partly, no doubt, because of the discouragement to spending. An increase in saving and a reduction in consumer spending can have a depressing effect on total business activity. A prolonged period of very high rates can be an important influence leading to general depression and increased unemployment.
Interest rates affect the rate of inflation Because interest rates affect the cost of consumer spending, and because building society and bank mortgage interest rates now affect around 60 per cent of all households in Britain, any change in rates influences movements in the Consumer Prices Index, the official measure of average price increases (inflation). If interest rates go up, then inflation rises and people tend to spend less on new purchases. If spending also falls, then unemployment may rise, even though prices are also rising.
Because of the direct impact of interest changes in all these ways, the ability to make changes has become a major instrument of economic policy in all the main market economies. Since most contemporary governments in the advanced market economies appear to be pursuing mainly monetarist, anti-inflationary policies, they all rely on interest rates to pursue their objectives.
Figure 10.1: The interaction of supply of capital and its marginal efficiency Interest rate Marginal Efficiency of Capital Stock of Capital
Quantity of Capital
In the absence of any other influence, interest rates would be determined by considerations of this nature. However, other influences are almost always present in the shape of government or central bank intervention. Because some governments or central banks intervene to move interest rates to levels thought necessary to achieve their desired economic objectives, other governments also have to intervene to ensure that their economies are not put at a disadvantage. In addition, the central bank may supply large amounts of additional liquidity (increase the supply of high powered money), at times of financial crisis with a view to preventing banks from failing and a loss of public confidence in the soundness of the banking system. If an economy has an inflationary gap, Governments or other regulatory bodies are likely to want to push rates higher than the market equilibrium levels, if they wish to restrict demand and production in order to control inflationary pressures. If an economy has a deflationary gap, they may seek to bring rates below the equilibrium if they are faced with high and rising unemployment and fear a deep recession-depression. By reducing the cost of capital they hope to encourage business investment and consumer demand for goods and services. No major trading country can afford to be too far out of line with interest rates in other countries, otherwise there would be a huge movement of capital towards high-rate countries and away from low-rate countries. This movement would put immense strains on the low-rate countries' balance of payments and on their currency exchange rates. Consequently the freedom of any individual government or central bank is restricted by the actions of governments and banks in other countries. Finance now circulates in a genuinely international market. Governments can influence rates either by controlling the stock of capital, usually by measures over bank lending, or by direct controls over the major banks. Notice that in Figure 10.1 the equilibrium rate will rise if the stock of capital line moves to the left and fall if it moves to the right. This results from the general shape of the MEC curve. The influence of the demand and supply of money, and the control of interest rates through monetary policy, is examined in Chapter 11.
You should examine the deposit accounts offered by several of the main banks and see how far the differences in interest rates offered can be explained by these factors.
Review PointsBefore you begin your study of the next chapter you should go back to the start of this one and check that you have achieved those learning objectives covered in this chapter. If you do not think that you understand these objectives completely, you should spend more time rereading the relevant sections. You can test your understanding of what you have learnt by attempting to answer the following questions. Check all of your answers with the chapter text. 1. 2. 3. 4. What is the difference between narrow and broad money in an economy? What is high-powered money? What is the bank credit multiplier? Explain, using the bank credit multiplier, how an increase in the amount of cash (highpowered money) in the banking system will affect the value of bank deposits and the broad money supply. What is the marginal efficiency of capital? Explain how a reduction in the level of interest rates can affect the volume of bank lending and the level of investment in the economy.
5. 6.
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Implications of the Interest Sensitivity of the Demand for Money Interest Rates and Demand for Goods and Services Monetarist View on the Interest Rate Sensitivity of the Demand for Money and Expenditure The Keynesian View of Interest Rates and Expenditure Implications of the Differences
The Quantity Theory of Money and the Importance of Money Supply The Money Equation Diagrammatic Representation of the Quantity Theory of Money
Methods of Controlling the Supply of Money Interest Rate Control Control over Banking Ratios Direct Controls over Banks Control of Government Borrowing
Monetary Policy
ObjectivesThe aim of this chapter, in conjunction with Chapter 10, is to explain and evaluate the effectiveness of monetary policy in a closed and open economy and discuss the possible impact of monetary policy on business decision-making. When you have completed this chapter and Chapter 10 you will be able to: demonstrate an understanding of the relationship between the banking system and the creation of money identify the components of the high-powered money stock and explain why these have a magnified impact on the money supply explain the quantity theory of money and its role in explaining the rate of inflation discuss the components of monetary policy and explain how they work evaluate the factors that determine the effectiveness of monetary policy
Physical AssetsExamples of physical assets would include houses, land, furniture and private cars. Everyone who has wealth of any kind will have some assets, as these are necessary to everyday life in a modern society, but it is also possible to hold the wealth you wish to store for the future in the form of assets. In this case your choice of which assets to hold will be guided less by what you need or find useful in normal life, but by what you think is most likely to hold or increase its value in the future. Since the future is uncertain you may or may not choose correctly! Holding wealth in the form of physical assets offers the following advantages: They are likely to be useful or enjoyable as well as valuable, and may remain so even if they lose their value; for example, vintage wine may not increase in value as hoped at the time of purchase, but it is very pleasant to drink. In periods of inflation or financial/political uncertainty, they are likely to hold or increase their value when money is losing its purchasing power. They are visible symbols of wealth and status and this can be important for some people. They can excite envy and attract thieves; if as a result they have to be stored in a bank vault, they cannot be enjoyed. They can be destroyed by fire or accident, or damage may reduce their value. Keeping physical assets involves costs such as insurance premiums, maintenance, cleaning and guarding; and these costs can be heavy. Fashions change, and what is in demand and valuable one year may be considered unattractive and without value a few years later. This applies particularly to the socalled "collectibles", such as works of art, coins and postage stamps. Those who
bought houses in the late 1980s know only too well that asset values can fall as well as rise. Therefore under normal circumstances, few people with wealth to store are likely to hold all their wealth in the form of physical assets. This would be an option only when the normal financial system was in danger of collapsing.
Financial SecuritiesFinancial securities are mostly either titles to the ownership of property or rights to share in the benefits of property ownership, or they are promises to make a future payment. It is often an advantage to hold a written title to property, because ownership can be transferred by handing over the written title or it can be used as a security for a loan. Similarly a written promise to make a future payment will also have a value, and the right to receive the payment can be sold to someone else. To be useful as a financial instrument of course, the promise to pay must carry respect. An undertaking by a major High Street bank will be more transferable, and therefore useful, than one signed by an unknown individual. Such promises to pay or to repay a loan or debt on or by a stated date, with interest payable to the holder in the meantime, are often known as bonds or stocks. There are several different kinds of bonds issued by borrowers, but the most common have the important feature that they pay a fixed annual rate of interest, (usually referred to as the "coupon") to the investor holding the bond. The main categories of bonds are government bonds and corporate bonds. In the UK bonds issued by the British government are termed "gilt-edged securities" (gilts) and are an important element in the capital market. Details of these can be obtained from most post offices and their market prices are quoted daily in the financial press. Wealth held in the form of bonds and securities, including the ordinary shares of companies, can also be referred to as loanable funds. Besides ease of transfer, holding wealth in this form has the advantage that it provides the holder with an income from interest or dividends paid by the issuer of the securities. This is in contrast with owning physical assets, which incurs costs of maintenance and insurance. As with any form of wealth there are risks of suffering a loss. For example, if a company which has issued bonds fails and goes into liquidation with insufficient assets to meet its obligations to bondholders, then the bonds are worthless. The bonds of very risky companies are frequently called "junk bonds".
commercial companies, the profits of which might not be expected to fluctuate greatly and the dividends of which are fairly constant. What is high and what is low in relation to interest rates depends on a great many other considerations, including people's experiences of rates in recent years. The 10 per cent used in the previous example would have been regarded as very high in the early 1960s, but very low in the early 1980s. You should take an interest in the movement of interest rates and in changes in the prices of bonds (government stocks) while you are studying economics. This stress on the speculative motive for holding money led Keynes to the belief that the demand for money does have a direct relationship to interest rates. It was thus possible to draw a demand for money curve or "liquidity preference curve" of the type shown in Figure 11.1. Figure 11.1: Liquidity preference curve Keynes view of relationship between liquidity preference and changes in interest rate Interest rate %
i1 i
A rise in rate from Oi to Oi1, reduces the demand for money from Oq to Oq1, because more people are willing to hold bonds as an alternative to money
Notice that, at the lower rates of interest, the curve flattens out, creating a so-called "liquidity trap". This is because no one believes that the rate is likely to fall further, so there are no takers for bonds and people will wish to see a rise to a higher rate before there can be any expectation of a fall and a chance for a speculative gain. The modern view of the influence of money on interest rates gives less emphasis to the speculative demand for money and the idea of a liquidity trap, but rather incorporates the demand for money into the theory of the demand for assets in general. Modern portfolio theory recognises that there is a demand for money as an asset as well as for transactions purposes, and that changes in the level of interest rates affect the demand for money (see Figure 11.2). However, it is also recognised that there is a very close link between the supply of money and inflation, and that inflation also has a significant influence on the demand for money as well as other assets. Figure 11.2: Money supply and the rate of interest
Interest Rate %
Quantity of Money
Figure 11.3: Monetarist view of demand and changes in interest rate Interest rate % If interest rate rises from 0i to 0i1, the demand for goods and services falls from 0q, to 0q1, because people are attracted towards buying bonds and other incomeyielding securities.
Monetarist View on the Interest Rate Sensitivity of the Demand for Money and ExpenditureIn contrast with the Keynesian view, those economists who attached great importance to the influence of money in the economy and its role in inflation, known as Monetarists, believe that the demand (and therefore the supply) of money is not very responsive to changes in interest rates. Putting this in more formal economic language: money demand and supply are interest rate inelastic. On the other hand, the willingness to spend money on goods and services is responsive to changes in interest rates: the expenditure demand for goods and services is interest rate elastic.
Then this change in supply, like any other market shift, will result in a price change. Interest is the "price of money", so a reduction in money supply can be expected to force up interest rates. But the amount of change will depend on the supply and demand elasticities on the responsiveness of supply and demand to interest rates. Given that there will be some effect on interest rates, this in turn will affect total demand for goods and services again, the extent of effect will depend on the relationship between expenditure demand and interest rates. Now we can begin to see the importance of the differences in views between Keynesians and monetarists. These are illustrated in Figure 11.4. Figure 11.4: Keynesian and monetarist views (a) Keynesian view Interest rate % Interest rate % Expenditure i1 i
supply(S) O
Quantity of money
Money supply is reduced (the curve shifts from S to S1). Interest rates rise from Oi to Oi1, but this rise produces a very small cut-back in demand, from Oq to Oq1. (b) Monetarist view Interest rate % i1 i demand supply (S) Interest rate % Expenditure
The process is the same as in the Keynesian view but the movements in interest rates and the reduction in expenditure on goods and services are much greater because of the differing elasticity.
Keynesians believe that there is a close relationship between money demand and interest rates, but this interest rate elasticity ensures that any shift in rates brought about by a forced shift in supply also reduces demand: so in effect, the interest rate change is small. Expenditure is not much influenced by interest rate anyway (it being influenced more by income), and the small rise in interest produces little movement in expenditure. The position according to the monetarist view is very different, although the mechanism is the same. Demand remains largely unaffected by the shift in supply and the change in interest rate, which is thus pushed up higher than in the Keynesian view. This steep rise in rate produces a major reduction in the interest-responsive demand for goods and services. In effect these are very marked contrasts, and you would expect the debate to be settled fairly easily by research into actual interest rate and money supply changes. In practice, economists' research faces a great many practical difficulties. As we shall see, not least the problem of actually defining and measuring money supply and innovations that affect the demand for money in the financial system. However, the Keynesian-monetarist controversy of the 1970s and 1980s is now more of interest to students of the history of economic thought, than for the understanding of monetary policy. The overwhelming weight of empirical evidence and practical experience in the conduct of monetary policy since the 1970s is that money matters, and monetary policy is effective as a means of controlling the level of aggregate demand and hence the rate of inflation.
injections of aggregate demand by means of increases in the supply of money will merely serve to drive up the level of prices. This provides the theoretical foundation for the central banks' use of monetary policy to control demand and the rate of inflation. This accords with the so-called monetarist view of money and inflation represented by the quantity theory of money. This, in very simple form, can be stated as follows. MV PT where: M money supply or stock V velocity of circulation of money (i.e. speed at which it circulates between buyers and sellers) P average price of goods and services T number of transactions i.e. volume of production (T is sometimes written as Q, representing the quantity of production). Now on its own, this equation tells us very little. However, the important issues lie in the relationships between the elements of the equation. Monetarists regard V as fixed or fairly fixed, and they also regard T (or Q) as fixed at a given level of technology. If these assumptions are correct, then effectively the two variables in the equation are M and P. A given change in M (the money supply) can be expected to produce a definite and predictable change in P (average prices). The relationship will not always be as simple as this, because allowance will have to be made for known variations in V and T, owing to forces outside the monetary relationship (e.g. improvements in technology and changes in the financial structure). It will also take time for any change in money supply to work through into general price increases, so that time lags of up to two years are suggested though monetarists are not always in agreement over the precise time lag. There is a further modification that many modern monetarists would make to this argument. This recognises that prices tend to be flexible upwards but not downwards: thus it is argued, if money supply is increased, then average prices will rise as already indicated; however, if money supply is reduced sharply, then prices do not fall. The variable that has to give in this situation is T (or Q), i.e. total output in the economy, as firms cut back production and consequently employ fewer workers. The implication of this is that an attempt to cure inflation by a sudden and sharp reduction in money supply will lead instead to an increase in unemployment rather than a check or reversal in price rises. The reasons for this "ratchet effect" for prices are that large firms are reluctant to reduce their product prices, and trade unions and workers resist strongly any suggestion of a reduction in wages.
Q in the quantity theory equation. The position of the economy's LRAS curve can change over time with economic growth. However in the absence of economic growth, the economy's maximum level of sustainable real output or national income is fixed, and cannot be increased by increasing the level of prices in the economy. This is what is shown by the vertical LRAS curve, and is the same as the assumption made regarding the fixity of T or Q in the quantity theory of money. Figure 11.5: Increase in aggregate demand Price Level
Now assume that the central bank increases the supply of money in the economy from MS1 to MS2. All other things remaining unchanged, the increased supply of money will cause a reduction in the level of interest rates in the economy, as shown in Figure 11.2. The reduction in the level of interest rates will in turn lead to an increase in expenditure in the economy, as shown in Figure 11.3. The increase in expenditure is the same as an increase in the level of aggregate demand, and this is represented in Figure 11.5 by the shift to the right in the aggregate demand (AD) curve from AD1 to AD2. To indicate that the shift in the AD curve is the result of an increase in the supply of money in the economy, the two AD curves have their associated supply of money indicated by MS1 and MS2. At the initial equilibrium price level P1, following the increase in the supply of money the new level of aggregate demand in the economy is E* on AD2. The level of aggregate demand at E* is Y* and this is excessive relative to the economy's capacity output Ye. That is, it lies to the right of the LRAS curve. Although the economy may be able to produce a higher level of output than Ye in the short run by operating on its initial SRAS curves (not shown in Figure 11.5 for clarity of exposition), the excess of aggregate demand in the economy will drive up the level of prices. Indeed, the economy will continue to experience rising prices (inflation in other words), until it reaches a new point of stable equilibrium at E2 on its LRAS curve. The new point of equilibrium at E2 corresponds to the prediction of the quantity theory of money. If the economy is subject to an increase in the nominal supply of money when it is already operating at full capacity, all that will happen once the extra demand created has worked its way through the economy will be a rise in the general level of prices in proportion to the increase in the supply of money. That is, in figure 11.5 the increase in the supply of money from MS1 to MS2 merely moves the economy up the LRAS curve from E1 to E2. The only change is an increase in the level of prices from P1 to P2.
However, even in this case, there may be indirect consequences. If the government enters the finance market to compete for a larger share of private savings, then firms may be forced to borrow from the banks instead of raising money through issues of shares or debentures (long-term securities). This suggests that the government is crowding out private investment and forcing it into the banking system. Also, if the government forces up interest rates because it is competing with building societies and banks and capital markets for private savings, firms will be unwilling to incur long-term debt at high rates of interest. Instead they will prefer to borrow on short-term and on more flexible terms from banks, in the hope that future conditions will be more favourable for longer-term funding.
Modern monetary policy is based on the view that inflation yields no permanent benefit for an economy and can cause much economic harm if unchecked. Once inflation is fully accepted in an economy, monetary policy looses all its power to do good but retains its power to cause yet more inflation. For this reason it is better to avoid high rates of inflation, and the problem of trying to reverse people's expectations of ever increasing inflation, by maintaining a very low rate of inflation and creating the expectation that the rate of inflation will stay low. Monetary policy can be used to achieve monetary stability if the government or the central bank announces a target for the annual rate of inflation, and achieves the target by managing the level of demand in the economy through its control of the rate of interest. Countries that operate monetary policy on the basis of a target for the rate of inflation usually also have an independent central bank. Central bank independence refers to the removal of political control and interference from the conduct of monetary policy by the central bank. A fully independent central bank, such as the European Central Bank (ECB), sets its own target for the rate of inflation as well as operating monetary policy free of government influence in such a way as to achieve its target. It is of the utmost importance for the success of inflation targeting that the central bank is completely free of any control or influence from the government, because such interference would undermine people's confidence in the ability of the central bank to keep inflation under control at the target level. For example in the UK, the government has set the target for the rate of inflation at two per cent, plus or minus one per cent. The government has given the Bank of England the task of achieving the target for the rate of inflation. To make sure that people believe that the Bank of England will achieve the target and keep the UK's rate of inflation close to two per cent, the government gave the Bank of England operational independence in 1997. What this means is that the Bank of England now operates as an independent central bank. The Bank of England is not fully independent, because the UK government still determines the target for the rate of inflation. But given the target set by the government, the Bank has complete autonomy. It is allowed to independently set a monetary policy to enable the economy to achieve the target rate of inflation. This means that the Bank of England sets the level of the rate of interest each month purely on the basis of the level required to control inflation and, more significantly, people's expectations of the rate of inflation. An independent central bank sets interest rates at the level required to achieve the target rate of inflation even when the government, for either valid or politically motivated reasons, would prefer the central bank to set the rate of interest at a different level. If the central bank's independence to determine monetary policy is compromised by political interference, then public confidence in the achievement of a low and stable rate of inflation is likely to be destroyed. Once the belief in an effective anti-inflation policy is lost, the public will start to anticipate accelerating inflation and inflation will return to undermine employment, output and living standards. Monetary policy can be used to increase aggregate demand to eliminate a deflationary gap as well as to reduce aggregate demand to eliminate an inflationary gap. However, in addition to the factors considered in this chapter, the effectiveness of monetary policy in comparison with fiscal policy is also affected by the exchange rate system operated by a country. The influence of the exchange rate system on the effectiveness of monetary policy is considered in chapter 14.
Review PointsBefore you begin your study of the next chapter you should go back to the start of this one and check that you have achieved the learning objectives. If you do not think that you understand the aim and each of the objectives completely, you should spend more time rereading the relevant sections. You can test your understanding of what you have learnt by attempting to answer the following questions. Check all of your answers with the chapter text.
1. 2. 3. 4. 5.
Explain the meaning of the demand for money (liquidity preference). Explain, using a demand for money curve diagram, why the demand for holding money decreases as the rate of interest increases. Outline the quantity theory of money Explain how a central bank controls the level of short-term interest rates in the economy. How is the effectiveness of monetary policy affected by: (i) (ii) the interest sensitivity of the demand for money, and the interest sensitivity of investment expenditure?
6. 7.
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Trade and Multinational Enterprise The Multinational Company Reasons for Growth of Multinational Enterprise Consequences of Multinational Enterprise
Free Trade and Protection Advantages of Free Trade Protection Dangers of Trade Protection
Methods of Protection Tariffs Quotas Embargoes Voluntary Export Restraints Export Subsidies and Bounties Non-tariff Barriers Exchange Control
ObjectivesThe aim of this chapter, in conjunction with Chapter 13, is to explain the fundamental advantages and disadvantages of free trade, including the principles of absolute and comparative advantage. When you have completed this chapter you will be able to: explain, using numerical examples, how gains from specialisation arise interpret data on opportunity cost identify economic reasons why governments may decide to promote free trade or impose restrictions on free trade explain the impact of free trade on business in developed and/or developing economies discuss the means that can be employed by governments to restrict or promote trade and evaluate the advantages and disadvantages of employing policies to restrict free trade.
We must recognise that the threat of competition is often weakened by the development of large multinational companies. Such companies tend to limit world competition by agreements between themselves, and by their own power to absorb competitors. (e) Encouragement of International Cooperation The existence of international trade also leads to a greater degree of interdependence between sovereign states, and this should be a factor making for international peace and friendly cooperation between nations.
Country A apparently has an advantage over country B in the production of both wheat and copper. Both commodities can be produced more cheaply in country A, as with a given outlay more of each will be produced in A than in B. Will there be any scope at all for international trade? The answer will be in the affirmative, provided that A's advantage over B is not proportionately the same for both commodities. A country will thus tend to specialise in the production of those commodities in which it has the greatest comparative advantage, or the least comparative disadvantage. Let us now illustrate this principle with the help of our example. In the absence of international trade, A will produce 300 units of wheat and 150 units of copper, and for the same outlay, B will produce 150 units of wheat and 100 units of copper. This makes a total of 450 units of wheat and 250 units of copper. In A the cost of production of wheat is half that of copper, while in B it is two-thirds that of copper. As A's comparative advantage in the production of wheat is greater than its advantage over B in the production of copper, it will pay A to specialise in the growing of wheat and to leave copper production to B. Suppose B abandons production of wheat and concentrates on copper: then A can make good the lost 150 units of wheat by transferring half the original outlay from copper to wheat. This still leaves A producing 75 units of copper, in addition to the increased 100 units of copper in B. Thus, specialisation in each country has increased copper production without any loss of wheat. Provided both countries trade with each other to share the increased production, both can gain from specialisation and trade and A can gain by reducing its production of copper and importing from B, even though it is more efficient as a copper producer. Table 12.1 illustrates the example just described. Here, the "given outlay in resources" is assumed to be 20 workers available for producing either commodity.
Table 12.1: Advantages of specialisation Country A Product Units Country B Total Units
Wheat Copper
300 150
10 10 20
150 100
450 250
The same total resources (40 workers) now produce an additional 25 units of copper, without any loss of wheat.
For instance in the example just given, if the advantage of country A arises out of superior managerial skill, then the greatest gains might be achieved by exporting managers from A to B and improving the standard of production in B. These are very important qualifications, and they do not always hold good under modern conditions. Production today is often highly specialised, and it is difficult and sometimes impossible to transfer resources (including workers) from one activity to another within a country. Machines are often built for one purpose only, people may take years to retrain, and unions are often hostile to movement. Many people displaced from one activity are just not able to learn the skills required for another (expanding) activity. In these circumstances, it is not unusual to find high unemployment in some sectors of production and a shortage of workers in another.
Rising Costs and Production Difficulties in the Industrial Nations Growing state intervention, the rise of trade union power and rapidly increasing wage, land and other production costs in the USA and Europe encouraged many companies to look to investment opportunities in developing countries. In such countries costs were lower, and there was much less resistance to the introduction of new machines and working methods. Japanese companies have also been influenced by increasing production costs (especially wage costs) within Japan, and have established production divisions in other countries in both Asia and Europe.
Product Life Cycle If a company builds up a large export trade for a product, and if that trade is directed towards countries whose development is a little behind that of the home country, the time is likely to come when the export market in the developing countries is larger than the domestic market in the country of manufacture. By this time in the life of the product, it is probable that competition is developing from firms situated inside or closer to the export market, and the home market may also be starting to decline. It may well be that the production facilities will need replacing. At this stage, the manufacturer is likely to consider setting up new production facilities (factories and machines) in the developing countries, where markets are growing. The remaining market at home can be fed from imports from the new factories. In practice, some or all of these influences may be operating at the same time. The more influences that do bear on an industry, the greater the likelihood that it will become multinational in character.
Trade Barriers Some countries and groups of countries discourage imports by tariffs and other trade barriers. The European Union (EU) has established free trade between members, but it has many barriers to trade with non-members. It has been particularly restrictive against agricultural imports from developing countries.
likely than the British to ensure that managerial and technical posts are filled by their own nationals. Another consequence of divestment for the home country is that visible exports fall and visible imports rise. Invisible earnings rise, as the overseas sections of multinationals pay fees and royalties for patents and services, and remit profits to the home country. Of course profits go to the owners of capital insurance firms and funds and do little to make good the loss of jobs suffered by industrial workers. There is also a good chance that the profits will be reinvested in further foreign production, and not used to develop business at home. (b) Consequences for the Host Country The host country gains jobs and some capital investment. If local capital is raised, then this is denied to the country's own domestic industry and commerce. The country also gains export earnings and saves some import payments, by having producers of products for world markets within its own economy. There is some doubt whether it gains the full value of production though, because the home part of the multinational company will require heavy payments for technical and managerial services, as well as a substantial share of profits. It is notable that the group of what are now called the "newly industrialised countries" (Korea, Greece, Hong Kong, Mexico and others) nevertheless still have a balance of payments deficit with the advanced industrial countries. This is in spite of gaining a substantial share of world production of a growing number of industries (textiles, shoe manufacture, electronic equipment). It is frequently claimed that host countries gain benefits from importing managerial skills and technical know-how. There is certainly some transfer of managerial skill and technology but this can be exaggerated, especially where the majority of skilled functions are kept for nationals of the home country, and where the home country retains full control over all research and development. It will be in the interests of the multinationals to keep factor costs low, and for labour to be non-unionised. This means they will not encourage the development of domestic industries which may prove to be competitors, both in selling products and as employers of production factors. If factors (especially wage costs) do start to rise, then the multinational may be able to transfer production to another country, leaving the original host country worse off than before. (c) Consequences for International Trade There is no doubt that the growth of multinational enterprise has changed the pattern of international trade. Visible trade is no longer a matter of a flow of basic materials to the western industrialised countries and a counter-flow from them of manufactured goods. Manufacturing is now carried out in a very wide range of countries, though much of it is still controlled by and relies on technology supplied by the advanced industrial nations. Even more important perhaps, is that the multinational companies have shown the importance of factor transfer between countries. Consider again the example of specialisation based on comparative advantage given earlier in this chapter. You will see that the whole process is transformed if we allow for the possibility that A's superiority in the production of both products is the result of superior managerial skill, and that this skill could be transferred from country A to country B. We cannot then predict the result of the transfer, because this will depend on which industries are affected, and on which terms the transfer takes place. What we can say is that multinational enterprise on a large scale further undermines the theory of comparative cost advantage as the basis for international trade and exchange. Multinationals will locate in those areas where costs will be lowest for themselves in absolute terms. They are not concerned with the domestic comparative or opportunity costs of local factors they employ. They will seek that combination of
local and "transported" factors (managerial skill and technology) which will give the production levels required at minimum cost. This is likely to mean that some parts of the production process will take place in one country and some in others. We can now see the association between the growth of multinational enterprise and the trade in semi-manufactures, much of which is intra-company trade i.e. transfer between sections of the multinational companies.
The factors of production are immobile. Land, most labour and invested capital cannot move between countries. Only enterprise, uncommitted capital and some labour can move to where the other factors are abundant and production can be organised. Free trade overcomes the immobility of factors: it permits the free movement of the product of immobile factors so that countries worldwide can benefit from an abundant factor endowment in any place. Access to the global market is essential for developing countries if they are to achieve economic growth. Trade with the developed economies would give the developing nations a large market for their goods and the opportunity to import new technology. Firms could gain economies of scale and new techniques; competition would increase efficiency; monopolies are avoided. Production for export helps to diversify the economy: it reduces dependence on what is often a single crop subject to disasters, like sudden frosts which halve the output of coffee.
ProtectionAll trading nations engage in some form of trade protection, as governments have to face political pressures from powerful domestic interest groups. At the same time they are often reluctant to admit that they are imposing barriers, so they may avoid the formal measures that would invite retaliation and invite censure from the World Trade Organisation (WTO). Instead they make use of a variety of devices to delay imports or make them more expensive. These include cumbersome import procedures with complicated documentation or "safety measures" with a dubious safety value. At the same time the more formal measures still survive, and are employed by individual countries and regional groups such as the European Union. The main such measures are:
import tariffs, also known as customs duties, which are taxes imposed on goods when they enter a country or one of a group of countries such as the EU, which contrast with import quotas, which are quantitative restrictions on the import of goods.
We examine these and other forms of protection in the next section of this chapter. The belief that free trade (trade free from imposed restrictions) should be encouraged as much as possible is linked closely to the theory of comparative cost advantage. However, the benefits of comparative advantage have been shown to depend on the existence of competitive markets, absence of monopoly power, full employment, and ready factor transfer within countries and no factor transfer between countries. Instead of this, we have a world economy dominated by the monopoly or oligopolistic power of the large multinational enterprises. Few industries approach anywhere near the conditions of perfect competition, domestic economies are highly specialised, there is large-scale unemployment and little factor transfer within countries but important transfers between countries. In these conditions, we have to ask whether the case for free trade should be questioned and that for import controls looked at more seriously. If a country does decide that, in its own case, the possible benefits of controls outweigh the dangers, the following arguments can be advanced in favour of the use of protectionist measures. (a) Protection of "Infant" Industries "Infant" industries need protection from foreign competition until they become strong enough to stand on their own feet. They are those industries which are being introduced to a country where the industry has not previously been present. The absence of external economies makes the costs of production high for new industries. In other countries, which are in competition with the country imposing the duties, the industries are already in existence and are therefore enjoying external economies of scale. As the infant industry grows, skills and productivity, as well as external economies, will grow also, so increasing the industry's relative competitive advantage. Domestic pressures for protecting home industries are always greatest in periods of economic recession and high unemployment, as in the early years of the 1990s. There are also many people within the EU who would like to try and avoid the challenge of the emerging industrial nations of Asia, by erecting high barriers against the entry of goods from non-EU countries. On the whole, the opponents of increased trade protection have managed to contain the protectionist pressures, while the establishment of the WTO should ensure that these temptations will continue to be resisted and that further progress will be made towards reducing the present barriers. (b) Protection against Dumping It is sometimes suggested that measures are needed to protect a country against the dumping of foreign goods. "Dumping" means the application to international trade of the methods of a discriminating monopoly. Goods are sold abroad at a lower price than at home. This is done partly in order to avoid swamping the home market with a surfeit of goods which would bring down home prices, and partly in order to kill off foreign competition by undercutting it on its own markets. The alternative is "stockpiling", which means the goods may be released in times of need, or sold over a number of years under a controlled agreement. Dumping is generally looked upon as an unfair trading practice, and for that reason industries fearing competition from dumped goods ask for tariff protection. Here again some objections may be raised. The main objection is that many industrialists begin to complain if they have to face competition from foreign goods which are cheaper than their own. However this does not represent dumping if the exported goods are sold at the same prices at which they are available in their home
markets. The home producers may simply be inefficient. Also, when dumping takes place, the imposition of protective duties may be too slow a weapon, since by the time the new duties have been introduced, the dumped goods may already be in the country. (c) Increase in Employment Controls cut imports and therefore there may be an increased demand for homeproduced goods, and a resulting increase in employment. Income is directed away from foreign exports and towards domestic producers. On the other hand, if there is already full employment at home, such measures will tend to be inflationary in their effects. (d) Improvement of the Terms of Trade The imposition of import duties may lead to an improvement in the terms of trade, particularly where the goods taxed are in inelastic supply and elastic demand. (e) National Security Key industries, such as agriculture and those producing goods which are important for the defence of the country, must be maintained for security reasons. A wide diversity of industries is important to a country, as it renders it independent of foreign supplies which may be jeopardised in the event of war. (f) Improvement of the Balance of Payments This point has also been discussed already. However you should remember that the balance of payments is not only concerned with imports but also with exports, and the government will have to consider what effect the imposition of protectionist measures by a country will have on that country's exports. (g) Possibility of Shifting the Burden This is a hope which concerns any tax i.e. that someone else will pay it. We have shown that this is likely to happen only if the foreign country's need to supply us is much greater than our own need to acquire that country's goods. This will be the case where foreign supply is inelastic i.e. does not respond readily to price changes while our demand for imported goods is elastic. If the higher price resulting from the imposition of import duties were to be passed on to the home consumer, purchases would drop substantially and the tendency would be to make up for the higher duty by reducing the import price of the commodity. If the price to the consumer in the importing country rises by less than the full amount of duty, the balance of the duty has in effect been borne by the exporter, in the form of a lower price received for the exported goods. (h) Equalising the Costs of Production It is sometimes suggested that competition from foreign producers who enjoy lower production costs is unfair, and that import duties should be levied at rates which would equalise costs, so that foreign and home producers would then compete on equal terms. This argument is quite nonsensical. International trade takes place just because there are comparative cost differences between different countries. If every country were to impose duties equal to existing cost differences, international trade would practically disappear. There is also a practical argument against the theory just outlined. Cost differences may refer to one of two things: they may refer to basic costs (i.e. differences in wage rates, rents or interest rates) or they may refer to total costs. For instance, the fact that wages in a certain country are lower than in the United Kingdom does not necessarily mean that either wage costs or total costs in that country
are lower than in the UK. It might be that labour is less efficient than UK labour, or it may be wastefully employed. Moreover labour is only one factor of production, and its productivity usually depends on both managerial skill and the availability of modern capital equipment. Countries with low wage costs are often short of capital, so that finance and equipment are frequently scarce and expensive. Countries with high wage costs, but with high levels of labour and managerial skills and ready access to capital, need to adopt different production methods from those applied in low wage cost countries.
value of the national income multiplier. An expanding economy could actually permit more total imports rather than less as a part of increased total consumption.
D. METHODS OF PROTECTIONA country which has nevertheless decided to restrict the freedom of international trade can use many methods. The main methods of protection are: tariffs (customs duties) quotas embargoes voluntary export restraint (VER) export subsidies and bounties non-tariff barriers applied through safety rules and administrative controls exchange control.
TariffsTariffs or customs duties are taxes on imported goods and so of course they raise money for the government. The object is to raise the cost of the imported goods so that importers have to raise prices or accept reduced profits. The imports thus suffer a competitive disadvantage compared with home produced substitutes. The tariff raises the price paid for the imported good by the domestic consumer and reduces the quantity purchased. Thus domestic producers supply more to the market, and foreign suppliers provide less than if there were no tariff. Customs duties may be imposed by a specific duty of so much per item or per tonne or ad valorem (by value). Specific duties work best for goods of low value and high weight, such as iron. Ad valorem duties obviously have more impact as goods increase in value, so they are best applied to items like jewellery and those whose prices change often. The amount received by foreign exporters may be the same or less than before the tariff depending on the elasticity of demand. The more price elastic is the demand for the product, the more the producers have to absorb the effect of the tax to prevent a loss of sales which would cause them a loss. The effects of a tariff are shown in Figure 12.1.
Figure 12.1: The effects of a tariff Price Domestic demand Domestic supply
Q4 Quantity
The gross cost to consumers of the rise in price caused by a tariff is the sum of the areas abcd where: a represents a redistribution of income from consumers to producers b is the production cost arising from the misallocation of domestic resources c is the tariff revenue paid by consumers to the government, and d is the loss of consumption in the country imposing the tariff.
Areas b and d added together give the net costs of tariff protection to the economy. Tax and the additional domestic supply remain in the economy. Not only do consumers pay a higher price and buy less, but there is also some loss of economic welfare because they are forced to buy the domestic product, which restricts their choice.
QuotasQuotas are restrictions on the quantity of a product which can be imported. While the purpose of protective customs duties is to restrict the import of goods by making them more expensive to the home consumer in order to persuade consumers not to buy them, the purpose of import quotas is to lay down the exact quantity of a commodity which may be imported in a given period of time. Import quotas may, but need not, be accompanied by customs duties. If they are, it means that the limited amount of goods which may be imported is subject to the duty as well. Quotas first came into prominence during the 1920s and 1930s, but they have also been widely used since the Second World War.
The reasons why some countries prefer to substitute quotas for customs duties or to strengthen protective duties by quotas are as follows: (a) Protective duties are sometimes considered to be insufficiently protective. This is particularly the case where the duty is a specific one rather than one related to the value of the imported goods. A specific duty is one which is imposed at so many pence (or pounds) per unit of commodity. At a time of quickly rising prices the specific duty becomes a declining proportion of the price of the commodity, and so loses much of its protective value. Frequent changes in the rate of duty may be difficult to administer, and would also lead to strong protests from the countries importing the goods. Thus a quota appears to provide the simplest solution to the problem. Quotas may generally be altered by administrative means e.g. by an order by the Department of Trade and Industry. On the other hand customs duties are taxes, and as such they are subject to parliamentary control. If it is desired to strengthen or to relax protection, a change in customs duties might be hotly contested in Parliament, while a change in quotas could be brought into effect without much ado. Many pre-war international trade agreements expressly prohibited the participating countries from changing their existing customs duties, and the imposition of quotas was one way of getting round this restriction. Quotas also lend themselves admirably to a policy of discrimination. With customs duties, the same rate of duty will normally be payable on goods of a certain kind, irrespective of the country from which they come. A country wishing to reduce the volume of its imports may wish to cut down imports from a particular source e.g. because the country concerned has a so-called hard currency, i.e. a currency which is in short supply. This end may be achieved by a quota scheme under which different countries are allocated different quotas, the quotas for goods from countries with soft currencies being rather more generous than those for countries with hard currencies. An occasionally heard (if mistaken) argument in favour of quotas is that quotas, unlike customs duties, will not lead to higher prices. This argument is wrong because, if a quota is effective in the sense that it lowers the supply of certain imported goods, these goods will then be in scarce supply in relation to the demand. This situation will inevitably lead to higher prices.
EmbargoesAn embargo is a total ban on imports or exports, usually applied for political reasons. A recent example is the United Nations embargo on exports of armaments to Iraq and on oil exports from Iraq.
Non-tariff BarriersThis is a term used to cover a multitude of measures applied to restrict imports, especially where countries cannot use tariffs and quotas because they belong to WTO or a free trade area. They include oppressive safety measures, like the USA requirement for destructive car tests, which would require the whole annual output of a small specialist manufacturer to be crashed. France attempted to keep out Far Eastern video recorders by insisting they went through one small, remote customs post where there were bound to be very long delays in clearing them. In the 1970s Britain required importers to pay an advance deposit on all goods: this imposed an extra borrowing cost and pushed up the price of imports. Around the same time the UK had two rates of VAT: the higher rate applied to goods like motorbikes which were mostly imported. The term is also applied, when discussing trade liberalisation, to all restrictive measures except tariffs. This is because tariffs are the only measure to be visible and measurable with accuracy. Agreements to reduce tariffs are pointless if duties are replaced by other measures which are difficult to police.
Exchange ControlControl is enforced in many countries by requiring all buying and selling of foreign exchange to be done through the central bank; the currency is not convertible into other currencies of the holder's choice. The government can then allocate foreign exchange to whichever activities it considers should have priority. This is effectively the same as a quota and is subject to the same dangers. Governments can avoid some of the problems by auctioning off foreign exchange, as was done in Nigeria. The amount released to auction is determined by the state of the balance of payments. Governments have also set multiple exchange rates for example the South African rand had a commercial and a financial rate until 1995 and they can alter the value of the currency to make exports cheaper and imports dearer. In recent years many governments have recognised economic damage done by exchange and capital controls, as well as their ineffectiveness in achieving what they were intended to achieve, and abolished them either completely or in large part. This is especially true of the world's developed countries and newly developed countries. The important exceptions amongst the world's rapidly developing countries in 2008 are China and India. However, both China and India have relaxed their controls, and indicated their intention to move to even greater freedom of currency and capital mobility.
E. INTERNATIONAL AGREEMENTSTrading BlocsCountries can join together in several different ways to obtain the benefits of free trade among themselves while keeping others out. What is included in the agreement depends on the political will of the members; they may be unwilling to expose agriculture to competition, or to accept the full degree of international specialisation which goes with completely free trade. Giving up some control of their national economies makes it difficult for countries to enter into these agreements. There are effects on the direction of trade some countries benefit and others lose. These blocs all have tariff walls which discriminate against imports from non-members. Trade may be diverted by the tariff from a low-cost producer country which is a non-member to a highcost member state. The effects of trading blocs have to be carefully evaluated to see if they really do benefit the citizens of the member countries, and not just protect inefficient producers.
Types of Bloc The types of international integration are as follows. In preference areas countries agree to levy reduced or preferential tariffs on imports from qualifying countries. The EU operates a system of preferences through its Association Convention, covering the former colonies of member countries. Free trade areas are where the members abolish tariffs on trade between themselves, but each country keeps its own tariff on imports from outside the area. This makes it necessary to have rules of origin to prevent imports being brought in through the lowest external tariff country. The North American Free Trade Area and the Association of South East Asian Nations are examples. Customs unions have free trade within the area with a common external tariff. Common markets are customs unions with additional measures to encourage the mobility of the factors of production and capital. The EU opened its common internal market on 1 January 1993. Citizens of the member countries can live and work anywhere in the EU, capital can move freely and there is a continuing programme of harmonisation of standards and regulations to permit the free flow of goods and services. The 1991 Maastricht Treaty agreed to a programme to move to economic and monetary union and to take the first steps towards political union by agreeing common foreign policies. Since 2003 the single European currency, the euro, has replaced the previous national currencies of the 15 member countries of the eurozone.
Effects of a Bloc Creating a trade bloc has two major effects: Trade creation when a country which previously placed tariffs on imports from another member and produced the goods itself switches to buying such goods from another member country, this creates trade (although it may cause structural unemployment). Trade diversion, when the removal of barriers inside the bloc results in trade being switched from a more efficient producer outside the union to a less efficient one inside.
In addition to the benefits of trade creation, there are other benefits from setting up a free trade area: Economies of scale develop because the member countries now have a much larger "home" market. Specialisation in products having a comparative advantage creates greater opportunities of economies of scale. Greater efficiency is enforced because the members' industries are exposed to more competition. Consumer welfare is increased as people have more, better quality and cheaper goods, with more variety, to choose from. There is more political cooperation as the member countries develop common policies and become more dependent on each other.
Against this must be set loss of political and economic independence, because the countries must take into account the policies and rules of the bloc when deciding their own policies.
The larger the trading bloc the greater the potential benefits, because of the better chance of including the lowest cost producer and the bigger opportunities for economies of scale. There will be more opportunities for trade creation, whereas there will have been a lot of duplication, and large cost differences, between the production of the members before the union. There will be more to be gained from specialisation. This is especially the case when there were high tariffs before the union; there would then have been a lot of domestic production for relatively small markets. The lower the external tariffs imposed by the union the better, as this reduces the possibilities of trade diversion. (c) Monetary Union: the Single European Currency As early as 1970 the (then) EEC had a plan and a programme aimed at achieving economic and monetary union by 1980. By 1974 the attempt had failed, although the development of the European Monetary System (EMS) in 1979 gave a new impetus to monetary union and, until its breakdown after 1992, the monetary discipline it imposed appeared to bring the economies of the Member States closer to convergence. The Maastricht Treaty laid down rules and a timetable for monetary union through a series of stages, culminating in the establishment of a common currency and associated financial institutions and policies. The key stage was reached in 1998 with confirmation of the countries meeting the convergence criteria, and EMU started on 1 January 1999. The convergence criteria were that: planned or actual government budget deficits should not exceed three per cent of GDP at market prices the ratio of total government debt should not exceed 60 per cent of GDP at market prices one-year inflation rates must be within 1.5 per cent of the three best performing economies one-year long-term interest rates must be within two per cent of the three best performing economies currency of Member States must have remained within the narrow ERM band for the two previous years without devaluation.
Some softening of the requirements in the treaty, allowing for the debt ratio to be reducing and for the annual deficit to be ignored if it is temporary, enables more countries to meet the criteria. (Ironically, Britain which has reserved the right to opt out and hold a referendum on future membership is one of the few nations able to meet all the criteria.) The European Central Bank, located in Germany, took over from the European Monetary Institute and became responsible for monetary policy as part of the European System of Central Banks (ESCB), the other members being the national central banks. The European Central Bank has to ensure that the ESCB carries out the tasks imposed on it by Maastricht, namely: to define and implement the monetary policy of the EU to conduct foreign exchange operations to hold and manage the foreign exchange reserves of the Member States of the EU to promote the smooth operation of the payments system for cross-border monetary transfers to contribute to the smooth conduct of policies concerning prudential supervision of credit institutions
The jury is still out on the success of European Monetary Union and the euro. The role and status of the euro on the world's money markets since its introduction as a full currency in 2003 has gradually improved, so that it now rivals the US dollar as a major international currency. It did not fare well in value against the US dollar over the early years of its existence, although its loss of value against other currencies made euroland highly competitive against other countries. However since 2005, it has risen in value against the US dollar and other major currencies. There have been undoubted benefits to industry and commerce for the euro-using countries of the EU, with the problems and costs of doing business in two currencies disappearing. This has had the expected incentive and led to increased inter-regional trade between the euro-using countries. The main unresolved policy debate has been over the implication of a single currency for fiscal policy, and the need to maintain fiscal discipline and integrate fiscal policies. This implies that countries have to give up much of their control of their individual economic policies. France, Italy and Germany have all broken the requirement for fiscal discipline and exceeded the maximum permitted figure for the ratio of government budget deficit to GDP. In addition several countries, especially France, have tried to compromise the independence of the European Central Bank by bringing pressure on it to relax its policy stance against inflation.
However the International Trade Organisation was too much for the 23 countries to accept they would not give up sovereign power over their trade. The result was the General Agreement on Tariffs and Trade (GATT), which has no controlling powers but has attempted to get countries to agree to liberalise trade through a series of conferences. Trade liberalisation has been carried forward in a series of GATT Rounds (talks) which started in 1947 and reached the eighth (the Uruguay Round) in 1986. By that time, the average level of tariffs had been reduced from 40 per cent to 7 per cent. GATT had also had considerable success in ending trade discrimination, but several problems remained where major countries and groups had entrenched positions. There are now over 100 members who agree to abide by the "most favoured nation" rule, which means that one member that grants trade concessions to another agrees to extend them to all members of GATT. Since it started in 1986, the Uruguay Round continued in a series of meetings, but by 1993 it had failed to make progress on certain vital areas. These included agricultural subsidies and
protection for textiles, which are of interest to developing countries, and intellectual property (patents, etc.) and trade in services where the developed countries wanted protection. However there was a last minute agreement in December 1993 which went far beyond anything which could have been expected in 1986. The new deal came into force in 1995, eliminating tariffs on 40 per cent of manufactured goods and reducing others substantially. Non-tariff barriers were also reduced and a new transparency in international protection established, as easy-to-hide non-tariff barriers were replaced by published tariffs. A new framework of rules on subsidies, trade restrictions and public purchases was agreed, agriculture was brought fully into GATT for the first time, and trade in intellectual property was also covered for the first time, giving protection to patents, copyright and trademarks. The French managed to exclude audio-visual services from the deal and the USA was unwilling to permit the inclusion of maritime services. Financial services were only partly liberated, with a reciprocity rule applying between countries, so that any liberalisation by one partner has to be matched by the other. Despite these limitations, the agreement represents the largest ever liberalisation of trade and is expected to make the world $6 trillion wealthier developed countries benefit from the removal of barriers to services, and developing countries benefit from freeing trade in agriculture and textiles. For the longer term, the most significant development may have been the transformation of GATT into the new World Trade Organisation in 1993, with real powers to police protective practices. The WTO was immediately faced with a trade dispute between America and Japan over trading practices, and another between America and China over intellectual property, and has been dogged by disputes about the influence of developed countries and multinational companies, and under-representation of the interests of developing countries. This has meant that further trade liberalisation has been limited, although a major agreement on telecommunications was concluded in 1997. However, the most significant development since 1997 has been the granting of full membership of WTO to China, and the dramatic rise of China to become one of the world's leading exporters of manufactured goods.
Review PointsBefore you begin your study of the next chapter you should go back to the start of this one and check that you have achieved the learning objectives. If you do not think that you understand each of the objectives completely, you should spend more time rereading the relevant sections. You can test your understanding of what you have learnt by attempting to answer the following questions. Check all of your answers with the chapter text. 1. 2. 3. 4. 5. 6. Explain the meaning of comparative advantage. Explain the meaning of absolute advantage. Outline the benefits of free trade. What are the arguments that may be used to justify restrictions on trade between countries? What is the difference between a tariff and a quota when used to restrict international trade? A country that currently use tariffs and quotas to restrict international trade announces that it is going to abolish all barriers to international trade and allow completely free trade. Explain the possible economic benefits of the new policy if foreign firms decide to invest in the country by building new factories.
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Balance of Payments Problems, Surpluses and Deficits Current Balance Surplus Current Balance Deficit Causes of a Persistent Current Balance Deficit
Balance of Payments Policy Devaluation or Depreciation Deflation Import Controls Need for a Healthy Business System
ObjectivesThe aim of this chapter, in conjunction with chapter 12, is to explain how international trade affects the level of economic activity in an economy and how a country's balance of payments accounts records its international transactions. When you have completed this chapter you will be able to: explain how the various measures of the external account (for example, current account, capital account, balance on visible trade) are constructed describe the different factors which determine the state (surplus/deficit) of these accounts.
therefore a leak from the circular flow of economic activity, while exports can be regarded as an injection. Using the symbol M for imports (because I has already been used for investment) and X for exports (because E has already been used for expenditure), we can now incorporate trading transactions into the model. We can do this either by adding to both sides of the equilibrium equation, i.e. STMIGX or we can emphasise the rather separate nature of these transactions by keeping M and X together. We can then ignore them on the income side and include them on the expenditure side, to produce: C S T C I G(X M) where X M represents the net expenditure flow resulting from the balance of trading transactions. If import payments exceed export receipts, then the net result is of course negative. Notice that C has been reintroduced here, because we can regard much spending on imports as being a part of household consumption. Total import spending from total income will of course be made up of spending on consumer goods, investment goods, and goods required by the government. If total imports equal total exports in value, then there is no direct effect on the size of the national income flow. Leaks are just balanced by injections. If import payments are greater than export receipts, then there is a contraction in the circular flow. If export payments are greater than import payments, then there is an increase. Remember always that it is payments that concern us, not volume. A net excess of import payments brings down the equilibrium level of national income, while a net excess of export earnings increases it. This is what normal common sense leads us to expect. People gain jobs and earn incomes by providing and selling goods and services for export. On the other hand, if people spend their incomes on foreign-made goods, then this leads to the creation of jobs and incomes in foreign countries. Imports reduce the value of the national income, in the sense that: (a) (b) increased consumption of imports withdraws expenditure from the circular flow of income; any increase in the import element in business investment spending reduces the net rise in I and, hence the injection brought about by I; if a firm buys machines made in another country, it is not creating jobs in home factories; any government spending on imports reduces the value of G to the domestic income in exactly the same way.
There is nothing strange in any of these propositions. They are exactly what we would expect. However, we should remember that they all assume that the home and foreign economies are entirely distinct i.e. that the home economy is not affected in any way by changes in foreign economies. A little further thought causes us to doubt this. Modern economies are closely interrelated. It is true that there is no direct relationship between the size of the national income of country A and the level of exports to country B. However, if the two countries are trading partners, the national income of country B and its ability to buy goods from A will depend to some extent on its ability to sell its own products to A. There is a connection, and we should beware of making over-simple deductions from the apparently obvious propositions just given. To understand better how international trade and other cross-border transactions affect an economy it is necessary to consider the nature and implications of all such transactions in detail. The detailed information is recorded in a county's balance of payments accounts.
Table 13.1: The Balance of Payments Accounts billion Current account Goods Exports Imports Balance of visible trade Services Exports Imports Interest, profits and dividends IPD receipts IPD payments Transfers Transfer receipts Transfer payments Balance of invisible trade Balance of payments on current account Transactions in external assets and liabilities (the Capital account) Direct and portfolio investment Investment overseas Investment into the country Net investment Bank transactions Lending abroad Borrowing abroad Net lending and borrowing General Government Transactions Overseas assets Overseas liabilities Net increase or decrease Domestic Non-banks transactions Lending overseas Borrowing overseas Net lending and borrowing Net transactions in assets and liabilities (balance of payments on capital account) Balancing item +2.7 (Note: The figures may not add because of rounding) 0.6 0.1 0.7 10.1 +12.7 +2.6 +8.3 102.9 +49.5 53.4 +12.7 +23.7 +36.4 +121.4 134.6 13.2 +36.6 31.6 +74.0 71.0 +5.4 10.5 +2.9 10.3
Visible Trade When we think of trade, we usually think first of trade in actual physical goods, such as cars, oil, and food. This is normally called the trade in "visible goods", and the balance between the value of imports and exports is often called the "visibles balance". The correct term for this balance is the trade balance or balance of trade. Visible trade is usually classified into a number of broad groups, and it is a useful exercise to look at the composition of UK trade on the basis of these groups. (You should try to obtain similar figures for your own country, if this is not the UK.) The main classes are the following: food, beverage and tobacco basic materials mineral fuels and lubricants semi-manufactured goods finished manufactured goods.
Direction of Visible Trade Flows You should also be aware of the main trading partners in this general process of international exchange. For example, Britain's main trading partner has, for some years, been the rest of the European Union (EU).
Invisible Trade Invisible trade is so called to distinguish it from trade in goods, which are tangible items. It consists of: Services including sea and air transport, tourism, consultancy and financial services. Interest, profits and dividend (IPD) comprises the annual flow of interest payments, profits from business and dividend payments on shares coming into a country from its lending and physical and financial investments overseas, less the payments of interest, profit and dividends due to foreign banks, companies and investors flowing out of the country. Transfers of funds to or receipts from other countries for non-trading and noncommercial transactions. The main source of transfers usually involves governments. For example, in the UK the government is responsible for most transfers in the form of grants to developing countries, subscriptions to international organisations like the United Nations and net payments to the EU. Private transfers include payments to dependants abroad by UK residents, and gifts.
The amount of IPD earnings depends on the amount invested in the past. Direct investment refers to the purchase of foreign assets. It includes buying control of firms in other countries, establishing subsidiaries and acquiring land and property. Portfolio investment is in stocks and shares. IPD receipts are influenced by the level of interest rates and the conditions in the economy which affect interest and dividend payments. Profits and dividends in the balance of payments can cause confusion about how they appear in the accounts. If a British company has a wholly owned subsidiary overseas which earns a profit, the invisible earnings are the profit remitted to the UK. But the part of the profit which is retained in the overseas subsidiary is treated as a capital outflow, and appears under direct investments in the capital account. If the British company does not control the overseas subsidiary but receives a share of the profit, it only appears in the invisible account.
The Capital Account The correct name for this account is "transactions in external assets and liabilities". This account records only changes in assets and liabilities. For example, in the UK when the pound rises in value against other currencies, it becomes relatively cheap for British companies to invest abroad. Whereas if the dollar is strong compared to sterling, American investors will buy assets in the UK. Portfolio investment is undertaken by insurance companies, pension funds, unit trusts and investment trusts to diversify their portfolios and to seek gains from rising share prices in rapidly growing countries.
The Balancing Item The balancing item is a statistical adjustment to account for the failure to record some of the thousands of items in the current and capital accounts. It is the difference between the recorded entries in the balance of payments accounts and the change in official foreign exchange reserves.
Although people, the media and politicians talk about a country having a balance of payments deficit or surplus this is technically incorrect. When you hear or read about a country's balance of payments problem, usually it is a deficit or surplus on a country's current account that is being referred to. Because the balance of payments accounts are based on double-entry bookkeeping, the balance of payments of a country will "always balance". However in effect this balance may have to be achieved by borrowing, from payments from past reserves and with the help of a balancing item which is often quite substantial! For example, if a country's balance of payments accounts show that it has imported far more goods and services in a year than it has exported to the rest of the world, it must also have already financed this deficit in some way unless the rest of the world has become very generous and supplied the goods and services for free! The really important balance though, is the current one. This shows whether the country is trading profitably and successfully or not. It is the current balance which is the best indication of a country's economic health. No country can overspend its current income and draw on past savings or borrow from other countries for ever.
The ability to allow or to encourage money to be used abroad will also help the country's political power and influence. It is little wonder that governments seek to achieve a balance of payments surplus on current account.
The unit value index represents the average movement in price of a unit of imports or exports. The "unit" itself is a kind of average of all types of visible imports and exports. The terms of trade thus gives a general indication of how average import and export prices are moving. At one time, a rise in the index was regarded as being favourable because a given quantity of higher-priced exports could earn enough to buy more imports. In the modern world, the results of trading-price movements are a little more complex.
Import Prices Rise Faster than Export Prices The effect will depend upon the elasticity of demand for imports. We can assume that in an advanced country, the demand for imported raw materials and foods and oil is fairly price inelastic. However the demand for most manufactured (especially consumer) goods is likely to be price elastic provided that the home country is able to manufacture acceptable substitutes for foreign-made products. In this case, the demand for the price inelastic goods will fall in a smaller proportion than the rise in price, so that the total cost of payments for these imports will rise. In the case of imports the demand for which is price elastic, the fall in demand will be greater in proportion to the rise in price, and the total cost of these imports will fall. For a country such as Britain, where over half of the imports consist of manufactured goods, the effect of a change in import prices will depend on which imports are most affected. A price increase on foods, basic materials or imported oil would create a balance of payments deficit or make an existing deficit worse. If it is the prices of the manufactured goods that rise, we would expect there to be a fall in the total cost of imports. That is of course if demand is price elastic. If in fact there are not sufficient home-produced alternatives to make good the higherpriced imported products, then the demand may turn out to be inelastic and upset the predictions relating to total revenue. For a developing country, most imports are likely to be demand inelastic if they are needed to promote development, so that a rise in import prices would make for a deficit or aggravate an existing deficit.
Rise in Export Prices Again, the effect depends on the price elasticity of demand for exports. In this connection, a developing country exporting basic materials with price inelastic demand would gain, and would receive an increase in total export earnings. In a developing country, it might be difficult to absorb a large balance of payments surplus, and much of it might have to be invested abroad until the home economy could be developed. This was the case of some oil exporting countries when they gained from oil price rises. One problem for a developing country that relies on the export of a few basic commodities is that its living standards are very much at the mercy of world prices of these commodities. When prices are high, the country might develop a standard of living highly dependent on imports, and this might be very difficult to maintain if world prices of the exported goods fall. It would be no use trying to stimulate demand by reducing prices, because this would only cut export earnings still further. For a country such as Britain, chiefly exporting services and manufactured goods, export demand is likely to be price elastic and a price rise caused, perhaps, by home inflation is likely to lead to a fall in total export earnings, and hence to a deficit or the worsening of an existing deficit.
Economic Weakness Many economists think that relative price movements are little more than a symptom of economic conditions, rather than a basic cause of those conditions. For a developing country, a balance of payments deficit may simply reflect the world market situation that ensures that total export earnings for the volume of goods exported are not sufficient to provide enough money to pay for the goods and services needed for development. The position will be made worse if: world demand is declining for the country's basic exports, or
there is a failure in production, resulting from natural disaster or other causes e.g. a crop failure or internal conflict, or there is a high demand for imported consumer goods from a section of the population that has developed a fashion or taste for imported clothes, cars or food.
For an advanced country, the problem may be caused by a weak economic or business structure, an economy that is less successful than that of competing nations. If production is cut by poor working methods, under-investment in modern machinery or labour disputes, then export earnings are likely to fall and imports and the cost of imports rise, almost regardless of price advances, in favour of the home country. For example Germany and Japan have been consistently more successful in exporting than Britain and the USA. (c) Activities of Multinational Companies About a third of international trade is made up of payments between the different parts of multinational empires. These companies, operating on a world scale, may prefer to move production away from high-cost, highly-taxed and closely-regulated countries to other areas where they have lower costs and more control over production methods. It is notable that countries with a high proportion of multinationals the USA and Britain tend to have persistent problems with their balance of payments. On the other hand Germany and Japan, which until recently have not produced worldwide enterprises, have had very successful export records and few balance of payments difficulties. It will be interesting to see which effect the development of German and Japanese multinationals has on those countries' payments balances.
Devaluation or DepreciationBy devaluation or depreciation we mean the reduction in the exchange value of a nation's currency in terms of foreign currencies. For example, before devaluation a British pound might be equal to US$2, but after devaluation it may be equal to only US$1.5. If a country allows its currency to float on the foreign exchange market, then the value of its currency will fall if demand for the currency falls. For example if the demand for pounds falls and that for US dollars rises, the price of the pound is likely to fall relative to that of the US dollar. This is called depreciation, and is a normal part of the operation of foreign exchange markets. Devaluation happens when a country operates a fixed exchange rate policy (see Chapter 14), and the government decides to reduce the fixed value. The government can then simply change the value by declaration. In whichever way it is brought about, a depreciation/devaluation raises the price of imports and reduces the price of exports, at least in the short term. It is important to understand the distinction between devaluation (action by governments when exchange rates are fixed) and depreciation (fall in value of a currency as a result of market movements). But you must also recognise that governments do intervene in currency markets to try to influence market movements, and a change in interest rates is sometimes brought about by a government in a deliberate attempt to change the currency value.
The J Curve It is sometimes pointed out that in the very short term firms cannot change their plans. It takes a little time for traders to react to international price changes resulting from exchange rate movements. Consequently, a swift devaluation or depreciation will increase the prices of imports and decrease those of exports without changing quantities traded to any great extent. The immediate effect of the price changes will be to deepen the balance of payments deficit. However fairly soon plans and trading patterns are modified, and we would expect demand for imports to fall and foreign demand for exports to rise. The result would be to reduce the deficit and, if the reactions were strong enough, to turn it into a surplus. This is illustrated by what is usually known as the J curve, as illustrated in Figure 13.3. Figure 13.3: The J curve Millions
O Time
The rise in import prices and the fall in export prices will make a balance of payments deficit worse until trading patterns react to the changed prices and export revenues rise and import costs fall.
Importance of Demand Elasticities For the changed trading pattern to replace a balance of payments deficit by a surplus, the rise in demand for exports at the reduced world price must increase export revenues by a greater amount than any increase in import costs resulting from the import price rise. It will of course help if the import costs actually fall. The desired gain in net revenues can only come about if the combined price elasticities of demand for exports and imports add up to a value that is more negative than 1. Effect in Industrial and Developing Countries In the case of a developed country such as the UK, where manufactured goods dominate exports and form a high proportion of imports, we would expect a devaluation to have a favourable effect on the balance of payments in the short term. In the long term, this beneficial effect of increasing net earnings is likely to be weakened. Any rise in the prices of imported fuels, raw materials and foods must soon increase the costs of manufacturing. It will also lead to an increase in the living costs of the workers. If the workers are able to secure wage increases in an attempt to restore living standards, then
manufacturing costs will again rise. Inflation of both prices and wages thus erodes the competitive price advantages gained for exports against imports by the devaluation. If inflation continues at a high rate, the export price advantage may be lost very quickly. For a developing country, both exports and imports are likely to be price inelastic. Thus the result of a devaluation in this case is to worsen an existing balance of payments deficit. The devaluation will reduce total export earnings and increase total import costs. Therefore devaluation will not help a developing country with balance of payments problems. It may help an advanced industrial country, but probably only in the short term. In itself, devaluation does nothing to cure the basic economic weakness which gave rise to the trading imbalance in the first place.
DeflationSpending on imports is a form of consumption that is usually regarded as being dependent on the level of income of a community. The higher the income, the more is likely to be spent on imports. So one way to correct a balance of payments deficit is to reduce import levels or, at least to stop them rising too fast. A government faced with a balance of payments problem may seek to reduce disposable income in the hands of consumers, and so reduce all consumption expenditure. This will cut the demand for imports and also reduce the strength of demand for home-produced goods, so releasing them for export markets if firms can be persuaded to make a bigger export effort. The government will achieve deflation by: reducing its own spending and the demand for workers in the public sector increasing taxes, and so reducing consumers' disposable (after-tax) incomes increasing interest rates by restricting the money supply, so making it difficult for firms and households to maintain investment and consumption expenditure.
For a developing country deflation is unlikely to be a satisfactory solution, because the imports are needed for economic development. Also, if living standards are already very low, any reduction could lead to violent social and political unrest.
Import ControlsCountries can also attempt to remedy a persistent current account deficit by introducing control over imports through measures such as quotas and tariffs. Supporters of controls suggest that the danger of retaliation is not as great as is often assumed, and they say that only with the protection of controls can the economy be fully revised. They usually also suggest that massive government aid would be needed for industrial modernisation and investment, and that the government would have to have greater controls over industry if it were to provide this aid. Taxes would also be likely to stay high if this policy were adopted. Other people remember that it was the attempt of individual countries to impose controls over imports, and at the same time keep on exporting, that led to the trade wars of the earlier part of the twentieth century. These in turn helped to bring about the very severe depression and unemployment in the 1930s. They feel that the risk of such a tragedy being repeated is too great to allow import controls to be tried. However, the demand for controls is very strong in the face of what are often termed "unfair trading practices" of some countries. Another danger is that industries do not in fact reorganise behind the protective barrier, and simply become less competitive and rely on satisfactory home demand. This is why advocates of import controls also tend to advocate increased public control to force modernisation. The demand for import controls always increases during an economic recession, when there tends to be strong political pressure from industries with high unemployment rates or suffering from economic change to be given protection from foreign competition. There was a
tendency in the late 1980s and early 1990s for informal methods of protection the use of various administrative devices to make importing more difficult and expensive to increase. The then GATT (General Agreement on Tariffs and Trade) negotiations for reducing tariff and other barriers in order to encourage world trade (originally due to be completed in 1992) encountered many difficulties, as governments sought to defend their own politically powerful groups including of course the farmers. The negotiations were eventually concluded by the end of 1994, and some progress was made towards further trade liberalisation. However progress was extremely modest in relation to the three major trading blocs of the EU, North America and Japan. At the beginning of 1995, GATT was replaced by a more structured body, the World Trade Organisation (WTO), which was given limited powers to enforce agreements and discourage openly protectionist measures. These were quickly tested by a trading dispute between the USA and Japan, though this was resolved without breaching WTO rules.
Review PointsBefore you begin your study of the next chapter you should go back to the start of this one and check that you have achieved the learning objectives. If you do not think that you understand the aim and each of the objectives completely, you should spend more time rereading the relevant sections. You can test your understanding of what you have learnt by attempting to answer the following questions. Check all of your answers with the chapter text. 1. 2. 3. 4. Explain the terms of trade. Explain the difference between the current and capital accounts of the balance of payments. If the balance of payments account must always balance explain the different ways in which a country can finance a deficit on its current account. List the benefits to a country of allowing foreign direct investment into the country.
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Foreign Exchange
ObjectivesThe aim of this chapter is to explain how exchange rates are determined and to evaluate the relative merits of fixed and floating exchange rate regimes. When you have completed this chapter you will be able to: explain the differences between the key terms used in the analysis of exchange rates: devaluation, depreciation, revaluation and appreciation explain the terms of trade examine the concept of purchasing power parity theory and its implications identify the relationship between fiscal/monetary policy and fixed/floating exchange rates explain the ways in which government manipulation of exchange rates can generate a competitive advantage explain how a country's exchange rate system affects the effectiveness of monetary policy.
On the other hand imports become dearer, and this will affect the pound price of goods imported from other countries. Suppose the vehicle manufacturer buys steel from abroad and pays for it in US dollars. Each $1,000 worth of steel, which used to cost 769.23 (1,000 1.3), now costs 909.09 (1,000 1.1). Most manufactured goods contain materials imported from other countries, so that manufacturing costs inevitably rise following a fall in the exchange rate. There will also be other effects. A high proportion of British food and many consumer goods come from overseas and so they rise in price. Living costs are pushed up and workers seek wage increases in order to try to maintain their living standards. If they succeed, then labour costs rise, and also manufacturing costs and prices are also likely to rise. Under circumstances such as these, it is highly unlikely that manufacturers will reduce their foreign prices by as much as the full fall in currency value. In our example, the motor manufacturer will want more than 5,000. We can see that the effects of currency changes are farreaching, and not always too certain.
against a particular foreign currency can be expected to be equal to the excess of the home rate of price inflation over the other country's rate of price inflation. In other words, it is held that changes in currency values reflect changes in the purchasing power of the various national currencies. If country A has a higher rate of inflation than country B, then its currency buys fewer goods, and consequently it will fall in exchange value in terms of the currency of country B. This will continue until B's currency returns to the position where it will purchase roughly the same quantity of goods in A, when converted to A's currency, as it did before the price inflation. The theory is attractive but it is not entirely supported by the available evidence. It fails to take into account elements other than price which affect the demand for exports and imports. The theory also assumes perfect markets in currencies, but in practice governments tend to intervene to defend exchange rates. Governments can influence the rate of interest offered to investors or depositors of money. Traders may be persuaded to leave funds in London in pounds, in order to earn high interest rates likely to more than compensate for any change in exchange value. In the long term, currency movements are most probably influenced by relative rates of inflation; in the short term this consideration can be outweighed by other influences such as interest rates, trade flows and political stability. You should also remember that as in other markets, buyers and sellers are as much concerned with the future as with the present and the past. If the market thinks that a currency is likely to fall in the future, it will anticipate that belief by selling now so that expectations can be self-fulfilling. This does not mean that the market is always right. Anticipations about future movements are based on past experience, so that the market may not recognise that a fundamental shift has taken place until this becomes completely clear and then it may overreact. For example, between 1962 and 1992 Britain had a generally poor record in controlling inflation. By 1995 currency markets remained sceptical about future inflation rates in Britain, in spite of the declared intentions of the British government and its relative successes between 1992 and 1995. Over a similar period Japan's economic record had been one of spectacular success, so that the market continued to believe that its economic problems of the first half of the 1990s were likely to be temporary. It is quite feasible that the judgement of the currency markets was wrong in the mid-1990s for both countries. The currency traders risked losing a great deal of money if their beliefs were wrong and only future events will show whether or not they were correct.
developments, until the currency values get so out of touch with reality that a structural upheaval becomes inevitable. Nevertheless there have been a number of important attempts to create exchange rate structures to provide the stability that business firms desire. The longest, most comprehensive and for many years the most successful attempt was the Bretton Woods system (see Study Unit 15). This linked the main currencies to the United States dollar throughout the 1950s and 1960s a period of generally rising world living standards and of considerable prosperity for the Western world. The European Community's Exchange Rate Mechanism (ERM) sought to reproduce the Bretton Woods conditions. It had a roughly similar system of limited currency movements within defined bands, and operated during the 1980s and 1990s in the lead up to the establishment of the single European currency. Supporters of such systems usually claim that they: provide the stability and reduction in currency risks that traders need if they are to expand trade and production oblige governments to pursue financially responsible economic policies designed to control inflation and curb the tendencies of communities to live beyond the means provided by their production and trading systems.
Opponents of fixed rate structures point out that periods of apparent exchange rate stability tend to be punctuated with intense speculative crises and periods of serious and damaging instability. This happens when finance markets realise that a major currency (usually sterling!) has become overvalued and they suspect that the government does not have the power to prevent a devaluation. A series of crises led to the abandonment of the Bretton Woods system in the early 1970s and a similar crisis led to the withdrawal of sterling from the ERM in 1992. Opponents also point out that the only measures that governments can take to uphold the exchange value of a currency in the short term are extremely damaging to their domestic economies and further undermine long-term confidence in the currency. A monetarist government will rely on high interest rates to keep capital in the country, but these high rates can have a devastating effect on consumer demand and business investment, as shown in Britain in the period 19891992. A Keynesian government would raise taxation and curb wages and other incomes, and this would have a similar deflationary effect to high interest rates. Clearly a government seeking to maintain an overvalued currency will damage its own domestic economy, create high unemployment and destroy business firms. Living standards fall in the interests of an artificial currency stability, which cannot be sustained for more than a short period. Currency exchange rates represent the market price of a nation's currency. They are the international traders' valuation of the nation's production system. Stable exchange rates can only be achieved when economies are themselves stable, prosperous and competitive in world markets. A falling exchange rate is the symptom of an unhealthy economy. To prop it up artificially is like propping up a weak patient and pretending that the patient is fit and well. It is as dangerous to the economy as it is to a sick person, and eventually all such pretences have to be abandoned. (b) Floating Exchange Rates When the price of the currency in terms of every other currency is set by demand and supply in the market, the country is said to have a freely floating exchange rate. If the demand increases and the supply remains the same, the exchange rate rises (appreciates); should the supply increase faster than demand, the rate falls (depreciates). There are no exchange controls and the government does not intervene in the market. Figures 14.1 and 14.2 show how changes in demand and supply affect the exchange rate of a currency.
Figure 14.1: The effect of increased UK exports or more investment in Britain Rate of exchange ($ per ) S
Figure 14.2: The effect of increased UK imports or more UK investment abroad Rate of exchange ($ per )
If Britain's exports increase there will be more demand from importers to exchange their currencies into sterling. The pound will also be in demand if people want to invest more in the UK, either in deposits and shares or in physical assets. More sterling will be supplied if importers in Britain are buying more from overseas and require more foreign currency. UK investment abroad increases the supply of pounds. Just as in any other market, an increase in demand for pounds, with supply unchanged, will cause the price of sterling to rise or appreciate more dollars have to be paid for each pound. Conversely an increase in supply, with demand remaining the same, would cause the currency to depreciate and each dollar would buy more pounds i.e. the price of a pound has fallen. Governments have often attempted to manage floating exchange rates: this is called "dirty floating". A government may intervene in the market to buy or sell its currency
because it wants to hold down a rise in the rate, which would affect international competitiveness, or support a rate, to keep foreign investments. There have been attempts by the major industrial countries to influence the exchange rate of the US dollar. Many commodities and raw materials, especially oil, are priced worldwide in dollars; a rise in the value of the dollar for speculative reasons unconnected to trade could cause inflation. When, in 1991, the dollar rose by a quarter against the Deutschmark, the G7 (the seven most industrialised nations) took concerted action to stem the rise by central bank intervention to sell dollars. In 1995 the dollar was falling against other currencies because of fears about the effect of the very large US government deficit and the political situation. This led to a flight into the Deutschmark, a rise in its rate and a depreciation of other currencies. The effect is to make the exports of appreciating countries less competitive and those of depreciating ones more so this is destabilising and has nothing to do with the trading position of the countries. Central banks intervened to buy dollars in an attempt to prevent further falls in the rate. Even when all the major central banks act together, they cannot have a significant effect on the foreign exchange market. The sheer size of the market's daily dealings makes the reserves of the industrialised countries look small. The banks can try to influence the feeling in the market so that dealers change their attitude to the future of the currency. The advantages of floating exchange rates are: There is an inbuilt adjustment mechanism. If imports exceed exports, the currency will depreciate and exports become relatively cheaper in foreign countries, thus helping to increase exports. There is no need for government intervention. There is continuous adjustment of the rate, in contrast to the infrequent, large and disruptive revaluations in fixed systems. Domestic economic policy can be managed independently of external constraints imposed by the need to maintain the exchange rate. There is no possibility of imported inflation, as the exchange rate adjusts relative prices. There is no need for large official reserves (unless there is managed floating). Adjustments to the exchange rate are made by the market: they are not delayed by political considerations. They create uncertainty and raise the costs of international activities because of the need to cover risk. There are no restraints on inflationary domestic economic policies. Changes in the rate may be due to speculation or flight from weakening currencies and have nothing to do with the trading position of the country. This may make exports relatively dearer and imports cheaper and cause a payments deficit.
The impact of a change in a floating exchange rate depends on the price elasticities of demand for exports and imports. If both are elastic, a fall in the rate will reduce imports, which become dearer in the home market, and increase exports, which become cheaper in foreign markets. The opposite happens if the rate appreciates. If the demand for exports abroad is inelastic, the effect of depreciation will be that the volume of exports does not increase but the lower price earns less foreign exchange. If imports
are price inelastic, the rise in their price does not reduce demand significantly and more foreign exchange is bought to pay for them: this worsens the balance of payments. Higher import prices for materials, components and finished goods may cause inflation.
The unit value index represents the average movement in price of a "unit" of imports or exports. The unit itself is a kind of average of all types of visible imports and exports. The terms of trade thus gives a general indication of how average import and export prices are moving. A high terms of trade is beneficial for a country, provided it goes hand in hand with a high demand for its exports. But a high terms of trade also results from overvaluation of a country's currency, and if this leads to falling exports and rising imports the country will suffer. A country can manipulate its exchange rate to alter its terms of trade. A country may adopt a fixed value for its currency that is deliberately undervalued, so that its export industries have a big competitive advantage in international markets. This policy will worsen its terms of trade and make imports expensive, but it can lead to export led growth
and a very large surplus on its balance of trade. The low terms of trade means that the country suffers a lower standard of living than it could achieve if it increased its exchange rate, or allowed its currency to appreciate. This is because it is selling its exports "cheaply" in international markets relative to what it has to pay for its imports. But on the plus side, if its exchange rate is sufficiently undervalued as to give its firms a really big cost advantage in exporting, and it can resist the pressure from those countries experiencing huge trade deficits as the counterpart of its huge trade surplus to revalue its currency, then its industry, employment and growth will prosper. The best example in recent times of a country deliberately maintaining an undervalued fixed exchange rate to boost its economic growth is provided by the rise to dominance of China as one of the world's leading export nations. Such a policy does not come without its economic consequences. As explained next, maintaining a fixed exchange rate leaves a country open to importing inflation. Artificially depressing the terms of trade to gain an advantage in exporting adds further to domestic inflationary pressure by increasing the price of imports. This is the problem experienced by China towards the end of the first decade of the twenty-first century. China is not the first or only country to seek to grow its domestic economy through export-led growth based on maintaining an undervalued currency. The best example is provided by Japan. Japanese economic policy towards its exchange rate under the IMF Bretton Woods system of fixed exchange rates was to keep its currency seriously undervalued, and resist all pressure, especially from its main export market in the USA, to revalue its currency. Japanese success as one of the world's leading exporters owes much to its exchange rate policy. Since Japan adopted a floating exchange rate in the 1970s, the Japanese government and the Bank of Japan have managed the exchange rate through intervention in the foreign exchange market, to limit its appreciation and maintain Japanese companies export competitiveness. The extent of the intervention is seen most clearly whenever the yen appreciates against the US dollar and looks like increasing to such an extent that the US dollar falls below 100 yen to the dollar. When this happens the yen soon loses value again and depreciates in value against the US dollar, much to the relief of Japanese based exporters.
two variables will be determined by market forces. Thus, if a government decides to fix the value of its currency against that of another country by adopting a fixed exchange rate regime, the government will have to accept that it cannot also determine the level of interest rates in the economy and control the rate of inflation. Rather, the government will have to vary the rate of interest to defend its fixed value of its exchange rate, and how it changes the level of its rate of interest will be dictated by rate changes overseas. Likewise, the rate of inflation in the country will be determined partly by the level of interest rates and the rate of inflation in the global economy. If a government decides that its most important macroeconomic policy objective is to control the rate of inflation, then it must sacrifice its ability to simultaneously determine its exchange rate and the level of interest rates. This particular dilemma explains why most of the world's advanced economies have abandoned fixed exchange rates in favour of floating exchange rates, and given their central banks independence to use interest rates to achieve a fixed target for the rate of inflation. Given the choice between a fixed exchange rate and achieving a target rate of inflation, many governments have decided that a floating exchange rate is a small price to pay for achieving control over the rate of inflation. Conversely, those countries that have opted to operate a fixed exchange rate regime for trade advantage reasons, especially China, have discovered the hard way that eventually this policy choice leads to the problem of increasing domestic inflation. Thus, an open economy enables a country to enjoy the gains from international trade, but it also constrains the choice of macroeconomic policy objectives. There is a further consequence: the choice of exchange rate regime also affects the effectiveness of monetary and fiscal policies in controlling demand in the economy. Governments need to recognise that: Fiscal policy is most effective and monetary policy least effective if a country operates a fixed exchange rate regime. Monetary policy is most effective and fiscal policy least effective if a country operates a freely floating exchange rate.
The explanation for this involves the rate of interest. Remember that as the level of national income increases, so does the demand for money. If the supply of money remains constant, this will cause the rate of interest to increase. Remember also that increased borrowing by a government, to finance its budget deficit, will drive up the level of the rate of interest. If economies are open to international trade and financial flows, then differences in interest rates between countries will cause investing institutions to move funds between countries in search of the highest return. The flow of funds into and out of a country will result in pressure on its exchange rate to change. The implication of these relationships depends upon a country's exchange rate regime. (a) A country operating a fixed exchange rate regime The country's central bank will have to use the rate of interest and intervention in the foreign exchange market to maintain the exchange rate at the fixed level chosen by the government. If the government undertakes an expansionary fiscal policy, the resultant upward pressure on the rate of interest will attract an inflow of money from the rest of the world. If this is unchecked, it will cause the exchange rate to appreciate above its fixed rate value. This will force the central bank to intervene in the foreign exchange market, by buying foreign currency at the fixed rate and increasing the supply of the domestic currency. The increased supply of the domestic currency will put downward pressure on the rate of interest. The net result is that the expansionary fiscal policy is unchecked by any induced off-setting rise in interest rates. Fiscal policy is thus highly effective in this case. In contrast, monetary policy is largely ineffective under a regime of fixed interest rates.
For example, an expansionary monetary policy will lower the domestic rate of interest and cause an outflow of funds from the economy. The outflow of the domestic currency increases its supply relative to demand on the foreign exchange market, and causes downward pressure on the exchange rate. To maintain the fixed value for the exchange rate, the central bank has to intervene in the foreign exchange market by selling foreign currencies from the country's reserves, and in return take domestic currency out of the market. The consequence of this buy back of domestic currency by the central bank is to push the domestic rate of interest back up to its value before the expansionary monetary policy was undertaken. The net result of the attempted expansionary monetary policy is that the domestic money supply and the rate of interest return to their initial values, but the country has a small stock of foreign currency reserves. (b) A country operating a freely floating exchange rate regime If a country operates with a freely floating exchange rate regime the previous conclusions regarding the effectiveness of fiscal and monetary policy are reversed completely. The value of the exchange rate is now determined by the forces of demand and supply in the foreign exchange market, without any intervention by the central bank. An expansionary monetary policy reduces the rate of interest and causes funds to flow overseas in search of a higher return. Without any intervention by the central bank, the increased supply of domestic money on the foreign exchange market will cause the currency to depreciate, i.e. the value of the exchange rate will be reduced. This depreciation of the exchange rate has two consequences which enhance the effectiveness of monetary policy in boosting demand. The depreciation of the currency will make exports more competitive, and thus boost the demand for the country's exports. The depreciation in the exchange rate also makes imports more expensive, and will cause domestic demand to switch from imports towards domestic suppliers. Both of these effects, the strength of which depends upon elasticity of demand and supply, increase injections and reduce withdrawals from the circular flow of income. This reinforces the initial boost to demand from the reduction in interest rates. Monetary policy is highly effective in this case. The same process works in reverse to strengthen the demand reducing effect of a contractionary monetary policy. With a freely floating exchange rate fiscal policy is largely ineffective, because of the way in which it induces off-setting changes in the exchange rate. For example, an expansionary fiscal policy which initially boosts demand and causes the rate of interest to rise. The rise in the domestic interest rate relative to the level overseas will cause foreign demand for its currency to rise on the foreign exchange market and its value to appreciate. As the currency appreciates the country's export competitiveness will decline, and it will experience a decline in its exports. At the same time, the appreciation of the currency will make imports and overseas travel more attractive. Thus as the government's fiscal expansion increases injections into the circular flow of income, either in the form of more G, or C and I, the induced affect on the rate of interest and the exchange rate produces an off-setting decline in X and increase in M. Fiscal policy is thus rendered ineffective due to interest rate and exchange rate "crowding out". This explanation is simplified, and in practice monetary and fiscal policy are never completely ineffective whichever exchange rate regime a country operates. This is because freely floating exchange rates are rarely left completely free by central banks, and funds are not completely free of all restrictions to move between all countries. However, the basic point remains valid. It helps to explain why, following the adoption of floating exchange rates by many governments from the 1970s onwards, much more importance is given to monetary policy to control the level of demand and hence the rate of inflation in an economy. Fiscal policy is still used to influence aggregate demand, but much less so than in the 1950s and 1960s, when most countries adopted a fixed exchange rate regime. Today fiscal policy is
used more to achieve supply-side objectives rather than regulate aggregate demand in the economy.
Review PointsYou should go back to the start of this chapter and check that you have achieved the learning objectives. If you do not think that you understand the aim and each of the objectives completely, you should spend more time rereading the relevant sections. You can test your understanding of what you have learnt by attempting to answer the following questions. Check all of your answers with the chapter text. 1. 2. 3. Explain the difference between devaluation/revaluation and depreciation/appreciation of currencies on the foreign exchange market. What is purchasing power parity? If a country has a higher rate of inflation than other countries then its nominal exchange rate will eventually depreciate to maintain purchasing power parity. True or false? 4. 5. 6. 7. Explain, using a demand and supply diagram, how an increase in a country's imports will affect its exchange rate on the foreign exchange market. Explain the meaning of "export led growth". What are the advantages of a country choosing a freely floating rather than a fixed exchange rate? How does a country's exchange rate system affect the effectiveness of its monetary policy?