ECONOMICS1002 Subject Guide (2016)

Introduction to economics
O. Birchall assisted by D. Verry

EC1002
2016
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a 100 course offered as part of the University of London
International Programmes in Economics, Management, Finance and the Social Sciences.
This is equivalent to Level 4 within the Framework for Higher Education Qualifications in
England, Wales and Northern Ireland (FHEQ).
For more information about the University of London International Programmes
undergraduate study in Economics, Management, Finance and the Social Sciences, see:
www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
O. Birchall, The London School of Economics and Political Science, assisted by D. Verry, The
London School of Economics and Political Science.
This is one of a series of subject guides published by the University. We regret that due
to pressure of work the authors are unable to enter into any correspondence relating to,
or arising from, the guide. If you have any comments on this subject guide, favourable or
unfavourable, please use the form at the back of this guide.
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Contents
Contents
Introduction............................................................................................................. 1
Introduction to the subject area...................................................................................... 1
Aims of the course.......................................................................................................... 1
Learning outcomes......................................................................................................... 2
Overview of learning resources....................................................................................... 2
Route map to the guide.................................................................................................. 4
Study advice................................................................................................................... 6
Use of mathematics........................................................................................................ 7
Examination advice........................................................................................................ 7
Block 1: Economics, the economy and tools of economic analysis......................... 9
Introduction................................................................................................................... 9
Scarcity........................................................................................................................ 12
Rationality.................................................................................................................... 13
The production possibility frontier (PPF)......................................................................... 13
Opportunity cost and absolute and comparative advantage........................................... 15
Markets........................................................................................................................ 16
Microeconomics and macroeconomics.......................................................................... 18
A note on mathematics................................................................................................ 18
Models and theory........................................................................................................ 19
Criticisms of economics ............................................................................................... 22
Overview...................................................................................................................... 22
Reminder of learning outcomes.................................................................................... 23
Sample examination questions...................................................................................... 23
Block 2: Demand, supply and the market.............................................................. 25
Introduction................................................................................................................. 25
Equilibrium................................................................................................................... 26
Demand and supply curves........................................................................................... 27
Shifts in the demand and supply curves......................................................................... 28
Consumer and producer surplus.................................................................................... 29
Overview...................................................................................................................... 32
Block 3: Elasticity ................................................................................................. 35
Introduction................................................................................................................. 35
Price elasticity of demand ............................................................................................ 36
Cross-price elasticity of demand.................................................................................... 39
Income elasticity of demand......................................................................................... 40
Price elasticity of supply................................................................................................ 41
Incidence of a tax ........................................................................................................ 41
Overview...................................................................................................................... 43
EC1002 Introduction to economics
Block 4: Consumer choice...................................................................................... 47

Introduction................................................................................................................. 47
Consumer choice and demand decisions....................................................................... 48
Utility maximisation and choice..................................................................................... 52
Income and price changes............................................................................................ 54
Deriving demand: The individual demand curve........................................................... 56
Deriving demand: The market demand curve............................................................... 58
Complements and substitutes....................................................................................... 58
Cash transfers versus transfers in kind........................................................................... 59
Overview...................................................................................................................... 60
Reminder of your learning outcomes............................................................................. 61
Block 5: The Firm I................................................................................................. 63
Introduction................................................................................................................. 63
Introduction to the firm................................................................................................ 64
The firms supply decision ............................................................................................ 64
Profit = Total revenue Total cost................................................................................. 69
Overview...................................................................................................................... 72
Block 6: The Firm II................................................................................................ 75
Introduction................................................................................................................. 75
Cost, production and output......................................................................................... 75
Overview...................................................................................................................... 81
Block 7: Perfect competition ............................................................................... 87
Introduction................................................................................................................. 87
Assumptions and implications....................................................................................... 88
The firms supply decision............................................................................................. 89
Industry supply curves................................................................................................... 92
Comparative statics ..................................................................................................... 93
Perfect competition and efficiency ................................................................................ 94
Overview...................................................................................................................... 95
Block 8: Pure monopoly......................................................................................... 99
Introduction................................................................................................................. 99
Perfect competition and perfect monopoly................................................................... 100
Monopoly analysis...................................................................................................... 100
Social cost of monopoly.............................................................................................. 105
Price discrimination.................................................................................................... 106
When can monopolies be justified?............................................................................. 107
Overview.................................................................................................................... 108
Reminder of learning outcomes.................................................................................. 108
Sample examination questions.................................................................................... 108
Block 9: Market structure and imperfect competition........................................ 111
Introduction............................................................................................................... 111
A theory of market structure....................................................................................... 112
Monopolistic competition........................................................................................... 113
ii
Contents
Oligopoly................................................................................................................... 114
Game theory.............................................................................................................. 115
Models of oligopoly.................................................................................................... 116
Block 10: The labour market................................................................................ 123
Introduction............................................................................................................... 123
The factors of production............................................................................................ 124
Analysis of the labour market...................................................................................... 125
Labour supply............................................................................................................. 127
Labour market equilibrium ......................................................................................... 128
Disequilibrium in the labour market............................................................................ 130
Wage discrimination................................................................................................... 131
Overview.................................................................................................................... 131
Block 11: Welfare economics............................................................................... 135
Introduction............................................................................................................... 135
Equity and efficiency................................................................................................... 136
Distortion of the market.............................................................................................. 141
Sources of market failure............................................................................................ 141
Overview.................................................................................................................... 145
Block 12: The role of government....................................................................... 147
Introduction............................................................................................................... 147
Government functions................................................................................................ 148
Taxation..................................................................................................................... 148
Public goods............................................................................................................... 150
Merit and demerit goods............................................................................................ 151
Transfer payments and income redistribution............................................................... 151
Principles of taxation.................................................................................................. 153
Local government....................................................................................................... 155
Impact of globalisation............................................................................................... 155
Political economy........................................................................................................ 155
Overview.................................................................................................................... 155
Block 13: Introduction to macroeconomics......................................................... 159
Introduction............................................................................................................... 159
Macroeconomic analysis............................................................................................. 160
The circular flow of income......................................................................................... 160
Measuring GDP.......................................................................................................... 161
Overview.................................................................................................................... 164
Sample examination questions ................................................................................... 165
Block 14: Output and aggregate demand........................................................... 169
Introduction............................................................................................................... 169
Components of aggregate demand: consumption and investment............................... 170
Equilibrium output...................................................................................................... 171
iii
The multiplier............................................................................................................. 173

Foreign trade: exports and imports.............................................................................. 176
Overview.................................................................................................................... 178
Block 15: Money and banking; interest rates and monetary transmission......... 181
Introduction............................................................................................................... 181
Money and banking.................................................................................................... 182
Interest rates and monetary transmission.................................................................... 185
Overview.................................................................................................................... 187
Block 16: Monetary and fiscal policy.................................................................. 191
Introduction............................................................................................................... 191
Monetary policy.......................................................................................................... 192
The IS-LM model........................................................................................................ 192
The policy mix............................................................................................................ 201
Overview.................................................................................................................... 203
Block 17: Aggregate demand and aggregate supply.......................................... 205
Introduction............................................................................................................... 205
Aggregate demand..................................................................................................... 206
Aggregate supply....................................................................................................... 207
Equilibrium inflation................................................................................................... 208
Wage rigidity.............................................................................................................. 209
Short-run aggregate supply......................................................................................... 209
Adjustment to demand shocks.................................................................................... 210
Overview.................................................................................................................... 212
Appendix 17a The AD curve: output and the price level............................................ 215
Appendix 17b Upwardly sloping SAS curves: output and the price level.................... 216
Block 18: Inflation............................................................................................... 217
Introduction............................................................................................................... 217
Money and inflation................................................................................................... 218
The Phillips curve and inflation expectations................................................................ 220
The costs of inflation.................................................................................................. 224
Controlling inflation.................................................................................................... 225
Overview.................................................................................................................... 225
Block 19: Unemployment.................................................................................... 229
Introduction............................................................................................................... 229
Rates of unemployment.............................................................................................. 230
Analysis of unemployment ......................................................................................... 233
Changes in unemployment......................................................................................... 235
Cyclical unemployment............................................................................................... 236
Cost of unemployment............................................................................................... 237
Overview.................................................................................................................... 238
iv
Contents

Block 20: Exchange rates and the balance of payments..................................... 241
Introduction............................................................................................................... 241
The exchange rate...................................................................................................... 242
The balance of payments............................................................................................ 244
Real and PPP exchange rates...................................................................................... 245
The current and financial accounts.............................................................................. 246
Long-run equilibrium.................................................................................................. 248
Overview.................................................................................................................... 248
Block 21: Open economy macroeconomics......................................................... 251
Introduction............................................................................................................... 251
The macroeconomy under fixed exchange rates........................................................... 252
Devalution of a fixed exchange rate............................................................................ 255
The macroeconomy under floating exchange rates....................................................... 256
Overview.................................................................................................................... 259
Block 22: Business cycles..................................................................................... 263
Introduction............................................................................................................... 263
Phases of the business cycle....................................................................................... 264
Theorising the business cycle...................................................................................... 264
Real business cycle theories........................................................................................ 267
Business cycle synchronisation.................................................................................... 268
Schools of macroeconomic thought............................................................................. 268
Overview.................................................................................................................... 270
Block 23: Supply-side economics and economic growth.................................... 273
Introduction............................................................................................................... 273
Supply-side economics................................................................................................ 274
Economic growth....................................................................................................... 275
Inputs to production................................................................................................... 276
Solow growth model.................................................................................................. 276
Romers model of endogenous growth........................................................................ 281
Costs of growth.......................................................................................................... 282
Overview.................................................................................................................... 282
Appendix 1: Syllabus........................................................................................... 285
Appendix 2: Outline of readings......................................................................... 287
Notes
vi
Introduction
Introduction
Introduction to the subject area
Every day people make decisions that belong within the realm of
economics. What to buy? What to make and sell? How many hours to
work? We have all participated in the economy as consumers, many of us
as workers, some of us also as producers. We have paid taxes. We have
saved our earnings in a bank account. All of these activities (and many
more) belong to the realm of economics. Households and firms are the
basic units of an economy and are concerned with the economic problem:
how best to satisfy unlimited wants using the limited resources that are
available? As such, economics is the study of how society uses its scarce
resources. Its aim is to provide insight into the processes governing the
production, distribution and consumption of goods and services in an
exchange economy.
The previous paragraph could be taken to imply that the realm of
economics is limited and clearly defined. However, if economics is
viewed as a way of thinking, or a set of tools that can be used to analyse
human behaviour and the world around us, then you will find that the
principles of economics can be applied to many different areas of life. The
scope is thus very broad, but the principles of analysis are well defined
and these are what you will become familiar with through undertaking
this course. Although the course provides some information that is
descriptive, such as how the banking system works, for example, its main
focus is on introducing models and concepts which are used as tools of
economic analysis. Concepts such as opportunity cost and approaches
such as marginal analysis can be widely applied and prove very useful in
understanding various aspects of society and peoples lives.
Studying economics doesnt just impart knowledge; it also develops
skills such as logical and analytical thinking and problem-solving skills,
which are useful beyond the formal study of economics. For some of you,
economics is not the main area of study, and you may not be intending
to pursue a career as an economist. However, we are sure that an
understanding of basic economic concepts will still prove useful to you in
whatever direction your studies and subsequent career may take.
Aims of the course

The course aims to:
introduce you to an understanding of the domain of economics as a
social theory
introduce you to the main analytical tools which are used in economic
analysis
introduce you to the main conclusions derived from economic analysis
and to develop your understanding of their organisational and policy
implications
enable you to participate in debates on economic matters.
Learning outcomes
At the end of the course and having completed the Essential reading and
activities, you should be able to:
define the main concepts and describe the models and methods used
in economic analysis
formulate real world issues in the language of economic modelling
apply and use economic models to analyse these issues
assess the potential and limitations of the models and methods used in
economic analysis.
Overview of learning resources

Textbooks
This subject guide follows the structure of the primary textbook (below)
and works through the parts of the textbook included in the syllabus
section by section, providing commentary, additional activities and
extending the material in some parts.
Primary textbook
Begg, D., G. Vernasca, S. Fischer and R. Dornbusch Economics. (London: McGraw
Hill, 2014) 11th edition [ISBN 9780077154516]. Referred to as BVFD.
The two supplementary textbooks below can be used to extend your

understanding and also provide an alternative approach which you may
find suits your own style. Although you are encouraged to make use
of these, you should check that you have a good understanding of the
material covered in the primary textbook and the subject guide, as this is
the required material for this course.
Supplementary textbooks
Lipsey, R.G. and K.A. Chrystal Economics. (Oxford: Oxford University Press,
2015) 13th edition [ISBN 9780198746577] international edition;
[ISBN9780199676835] UK edition. Referred to as L&C.
Witztum, A. Economics. (Oxford: Oxford University Press, 2005)
[ISBN 9780199271634]. Referred to as AW.
The material contained in the two supplementary textbooks (where it

goes beyond that contained in BVFD and the subject guide) is not directly
examinable and you are not required to purchase these texts. However,
if you are able to access them, you will find them beneficial and they
will enhance your understanding of the text and this guide. Both have
certain key advantages, for example, L&C contains very clear explanations
and is structured in a very logical way, while AW provides a deeper
understanding of the core concepts both philosophically and in terms of
the analytical approach.
How to use the subject guide

Each of the 23 blocks of the subject guide covers one or two chapters from
the primary textbook. The guide works through the textbook section by
section and you will find additional explanations, activities and questions
to aid and test your understanding. The subject guide has been designed
to accompany the textbook, so you should use them jointly and follow
the reading instructions listed throughout (e.g. Read sections 14.214.3;
answer the following questions to check your understanding etc.).
2
Introduction
One key aim of the guide is to encourage active engagement with the
material, as this is how you will really gain a good understanding. For
example, many of the models which will be covered in this course are
expressed graphically and the subject guide contains empty boxes where
you can practise drawing these graphs. It is very difficult to understand
and remember graphs just by looking at them, so you will need to practise
drawing them for yourself. For more complex graphs in later chapters,
you could even practise using blank paper and then, when you are
confident, draw the graph in the empty box in the subject guide. You are
also encouraged to actively undertake the other activities and questions
in the subject guide. Answers to these are available on the virtual learning
environment (VLE).
The subject guide and the primary textbook must be used together. The
guide will not make much sense without the textbook. Equally, do not be
tempted to neglect the guide and just focus on the textbook. You need to
be aware that the subject guide not only seeks to complement and clarify
the contents of the textbook, but also to extend it in certain places. For the
final examination, you will need to be familiar with the material in both
the textbook and the subject guide. The textbook chapters that are not
covered in the guide, and are not examinable, are: Chapters 11 (except
for section 11.9), 12, 26, 29. We hope that this guide will help you as you
work through the textbook and that you will find it useful in your studies.
Online study resources (VLE, Online Library)

In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your
University of London email account via the Student Portal at:
http://my.londoninternational.ac.uk
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave
on your application form. You have probably already logged in to the
Student Portal in order to register! As soon as you registered, you will
automatically have been granted access to the VLE, Online Library and
your fully functional University of London email account.
If you forget your login details at any point, please email uolia.support@
london.ac.uk quoting your student number.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
Electronic study materials: All of the printed materials which you
receive from the University of London are available to download, to
give you flexibility in how and where you study.
Discussion forums: An open space for you to discuss interests
and seek support from your peers, working collaboratively to solve
problems and discuss subject material. Some forums are moderated by
an LSE academic.
Videos: Recorded academic introductions to many subjects;

interviews and debates with academics who have designed the courses
and teach similar ones at LSE.
Recorded lectures: For a few subjects, where appropriate, various
teaching sessions of the course have been recorded and made available
online via the VLE.
Audiovisual tutorials and solutions: For some of the first year
and larger later courses such as Introduction to Economics, Statistics,
Mathematics and Principles of Banking and Accounting, audio-visual
tutorials are available to help you work through key concepts and to
show the standard expected in exams.
Self-testing activities: Allowing you to test your own
understanding of subject material.
Study skills: Expert advice on getting started with your studies,
preparing for examinations and developing your digital literacy skills.
Note: Students registered for Laws courses also receive access to the
dedicated Laws VLE.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time, and you should check the VLE
regularly for updates.
Answers on the VLE

Answers to the subject guide exercises can be found on the VLE. By far
the most beneficial approach is to attempt the questions and activities
yourself before you look at the answers. If, when you do look at them, you
discover that your own answer is incorrect, try to work out what led you to
that answer (to clear away your misconceptions) and furthermore, try to
understand why the given answer is in fact correct. This will help you to
gain a solid understanding.
Making use of the Online Library

The Online Library (http://onlinelibrary.london.ac.uk) contains a huge
array of journal articles and other resources to help you read widely and
extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login.
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please use the online help pages (http://onlinelibrary.
london.ac.uk/resources/summon) or contact the Online Library team:
onlinelibrary@shl.london.ac.uk
Route map to the guide

The subject guide consists of 23 blocks an introductory block, and then
11 for microeconomics and 11 for macroeconomics. Throughout the guide,
chapter refers to the sections of the textbook, while block refers to the
sections of the subject guide. This is to avoid confusion for example,
when the guide says this concept will be explored further in Chapter 12, it
4
Introduction
should be clear to the reader that this refers to Chapter 12 of the textbook
(BVFD).
Breakdown of readings for each block:
Microeconomics
Block
10
11
12
Chapter
1, 2
6; 7.1, 7.2 and

7appendix
7.3
7.9
8.1
8.4
8.5
8.10
10
13
14;
11.9
Macroeconomics
Block
13
14
15
16
17
18
19
20
21
22
23
Chapter
15
16, 17
18, 19
20
21
22
23
24
25
27
28
Specific topics and concepts to be covered are as follows: This differs from
the syllabus only in the order that topics are listed. The full syllabus can be
found in Appendix 1.
Block 1
Introduction: The economic problem, production possibility frontiers,

opportunity cost, the role of the market, absolute and comparative advantage,
positive and normative economics, micro and macro economics, nominal and
real values, theory and models in economics
Microeconomics
Block 2
Demand, supply and the market: demand, supply, demand functions,

supply functions, equilibrium, consumer and producer surplus.
Block 3
Elasticity: price elasticity of demand, cross-price elasticity of demand, income

elasticity (normal, inferior and luxury goods), elasticity of supply.
Block 4
Consumer choice: rationality, utility, indifference curves, the budget

constraint, utility maximisation, substitution and income effects, substitutes and
complements.
Block 5
The Firm I: the firm, profit maximisation, marginal cost and marginal revenue,
technology and production functions, returns to scale, the law of diminishing
marginal returns, isoquants and isocost lines.
Block 6
The Firm II: cost functions, the distinction between the long and the short-run,
fixed and variable costs, behaviour of the firm in the long and in the short-run,
the firms supply function.
Block 7
Perfect competition: competitive industry, the competitive firm, entry and

exit, short-run and long-run equilibrium, some comparative statics.
Block 8
Pure monopoly: monopoly, price discrimination, natural monopoly,

supernormal profit, monopoly and competitive equilibrium compared.
Block 9
Market structure and imperfect competition: monopolistic competition

(differentiated products, the firms behaviour, the role of entry), oligopoly
(interdependence, game theory, reaction functions).
Block 10
Inputs to production: the labour market: the factors of production,

demand and supply of labour (profit maximisation and the demand for labour,
utility maximisation and the supply of labour), economic rent, monopsony,
factors affecting labour market equilibrium (unions, minimum wages).
Block 11
Welfare economics: general equilibrium, horizontal and vertical equity,

allocative and Pareto efficiency, market failures, externalities, Coase theorem.
Block 12
The role of government: government interventions, public goods, taxation;

the income distribution, the Gini coefficient and Lorenz curves.
Macroeconomics
Block 13
Introduction to macroeconomics: the problem of aggregation, the

circular flow of income, leakages and injections, national income accounting,
depreciation, value added and the NNP = Y identity, real and nominal gross
domestic product (GDP).
Block 14
Aggregate demand: actual and potential output, consumption, investment,

income determination, equilibrium, the multiplier, the paradox of thrift,
consumption and taxation, the government budget, automatic stabilisers (the
financing of government), the multiplier and taxation, the role of fiscal policy,
imports and exports, the multiplier in an open economy.
Block 15
Money and banking: the role of money, real balances, the liquidity
preference approach and the demand for money (liquid assets), commercial
banks and the supply of money (banks and the various multipliers), central
banks and monetary control, equilibrium in the money market.
Block 16
Monetary and fiscal policy: aggregate demand and equilibrium (IS),

equilibrium in the money market (LM), the IS-LM model, monetary and fiscal
policies in a closed economy.
Block 17
Aggregate demand and aggregate supply: Keynesian and classical

assumptions regarding wages and prices, aggregate supply in the long-run and
the short-run, the effects of exogenous demand and supply shocks.
Block 18
Inflation: inflation targeting, the Taylor rule, the quantity theory of money,
the Phillips curve in the long-run and the short-run, stagflation and the role of
expectations, costs of inflation
Block 19
Unemployment: types of unemployment, voluntary and involuntary

unemployment, causes of unemployment, private and social costs, hysteresis
Block 20
Exchange rates and the balance of payments: the foreign currency

market, exchange rate regimes, the balance of payments, capital mobility, the
rate of interest and the price of foreign currency
Block 21
Open economy macroeconomics: the effects of fiscal and monetary policies

under fixed and floating exchange rates with and without capital mobility
Block 22
Business cycles: trend path and business cycles, theories of the business
cycle, real business cycles
Block 23
Supply-side economics and economic growth: growth in potential

output, the steady state, technological progress, capital accumulation,
convergence, endogenous growth, policies to promote growth
Study advice
The British education system, possibly more than others, and economics as
a subject, possibly more than others, both emphasise understanding above
rote learning (learning by heart). It is very difficult (if not impossible)
to do well in economics examinations simply by rote learning. A much
better strategy is to try to gain a good understanding of the concepts and
the models. Although this may involve more work in the short term, the
final outcome will be much better, and the examination much easier. For
example, many of the models we will cover can be summarised in a single
graph or set of equations. You will need to be able to use these graphs to
demonstrate the effects of changes in the economic environment to which
the model relates. This is very difficult to do well through memorisation,
but if you understand why the different lines of the graph are drawn
in that particular way or what a particular equation represents, then
adjusting the graph or modifying the equations will become a relatively
simple and straightforward exercise.
6
Introduction
The textbook, which the subject guide accompanies, assumes that you
havent done any economics before and starts from the basics. It gives a
good explanation of all concepts and uses examples to make these new
concepts intuitive. It also includes material to stretch you, including
Maths boxes. You are required to really master this textbook, including
the Maths boxes and more challenging elements. If there are sections
which are difficult to understand at first, you may find that reading these
through several times is very helpful. In certain places, the subject guide
will also seek to extend the textbook if there are areas where it does not
go far enough. Although you will find the textbook approach of starting
at a fairly basic level very useful, you should expect the examination to
be quite rigorous. For example, examination questions are likely to be
similar to the hard questions in the review questions at the end of each
chapter. In this way, we hope to help you really lay a firm foundation of
understanding in economics, and at the same time demonstrate the high
standard that is expected of you as University of London students.
Use of mathematics
Economic models can be expressed in various ways, in words, in diagrams
and in equations. Although this course mainly uses diagrammatic
representations accompanied by words, simple equations can also be
a concise way of expressing an economic model, and you will need to
become familiar with this approach. At this stage, the maths involved
will be limited to simple algebra and elementary calculus. Some basic
mathematical techniques and ideas will be also introduced in the first
block. It is important to work through the Maths boxes in each chapter,
as these often provide a step-by-step explanation of the mathematical
approach to the models covered. The subject guide will also provide
further explanations where we think this will be helpful. Economics is
becoming an increasingly technical subject and, although the level of
mathematics required for this course is quite basic, we hope that you
will become confident in taking a mathematical approach to analysing
economic issues.
Examination advice
Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Programme
regulations for relevant information about the examination, and the VLE
where you should be advised of any forthcoming changes. You should also
carefully check the rubric/instructions on the paper you actually sit and
follow those instructions.
Examination structure: The structure for the 201617 examination is
as follows:
Part I
worth 50 marks
30 multiple choice questions covering the entire syllabus in
microeconomics and macroeconomics. Candidates should answer
all 30 multiple choice questions.
Part II, Section A

worth 25 marks
three long response questions in microeconomics of which
candidates should answer one question.
Part II, Section B
worth 25 marks
three long response questions in macroeconomics of which
candidates should answer one question.
Further advice for multiple choice questions: Read the question
and each of the possible answers carefully, paying attention to words such
as not and never. Try to manage your time so you are able to check over
your answers again at the end.
Further advice for long-response questions: Marks are not
awarded for irrelevant material. For this reason, when you read a question,
it is best to spend some time thinking about your answer before you start
to write. Quickly writing everything remotely connected to the topic will
not impress the examiner. The best answers demonstrate that candidates
recognise the tools of analysis that are relevant to that question and they
are able to use them effectively to provide a well-reasoned answer.
You can find further guidance on examination technique in the annual
Examiners commentaries for the course which are available on the
University of London International Programmes website, and also in your
academic and study skills handbook, Strategies for success.
Remember, it is important to check the VLE for:
up-to-date information on examination and assessment arrangements
for this course
where available, past examination papers and Examiners commentaries
for the course which give advice on how each question might best be
answered.
Block 1: Economics, the economy and tools of economic analysis
Block 1: Economics, the economy and

tools of economic analysis
Introduction
This block covers the first two chapters of the textbook and is designed to
give you an introduction to economics and some help in starting to use
the tools of economic analysis. The concepts introduced in this block, such
as scarcity, opportunity cost and ceteris paribus (more on these below),
are absolutely essential to your understanding of economics. The more
thoroughly you work through the material in this block, the better your
foundation will be for all the material that follows.
So what is economics? The word economy comes from two Greek words
oikos (meaning house) and nemein (meaning manage) its original
meaning was household management. Households have limited resources
and managing these resources requires many decisions and a certain
organisational system. The meaning of the word economics has developed
over time. Today, economics can be defined as the study of how societies
make choices on what, how and for whom to produce, given the limited
resources available to them. Furthermore, the key economic problem can
be defined as being to reconcile the conflict between peoples virtually
unlimited desires and the scarcity of available resources and means of
production.
These are the definitions provided in the core textbook (BVFD) and indeed
in many other textbooks. They are traditional definitions and have their
origins in an essay by Lionel Robbins (of the London School of Economics
and Political Science) written in 19321 in which he defined economics as
the science which studies human behaviour as a relationship between
ends and scarce means which have alternative uses.
It is important to realise that this definition is not without its critics.
The textbook does not pretend to discuss in any depth the definition
of economics or the legitimate domain of economic investigation.
Those wishing to pursue the philosophical foundations of the nature of
economics could consult the collection of papers edited by Frank Cowell
and Amos Witztum,2 especially papers by Atkinson, Witztum, Backhouse
and Medema.
On a less philosophical note, if we were to follow the definition attributed
to Jacob Viner (an early member of the Chicago School and a teacher of
Nobel laureate Milton Friedman) that economics is what economists do,
the Robbins definition stated above would fall short of describing the way
in which the subject has evolved, in particular in its failure to reflect the
time and effort devoted today to empirical analysis.
Arguably, the definitions provided in the textbook apply more directly to
microeconomics than macroeconomics, the latter being more concerned
with the structure and performance of the aggregate economy and
such issues as growth, cycles, unemployment and inflation. However,
underlying these big issues is the behaviour of individual agents such as
consumers and firms. Recent developments in macroeconomics have been
concerned with establishing microeconomic foundations. So scarcity and
the rational responses to it are not absent from macroeconomics.
1
Lionel Robbins An
essay on the nature and
significance of economic
science. (London:
Macmillan, 1932, 2nd
edition 2014) p.16.
Cowell, Frank and

Amos Witztum (eds)
Lionel Robbinss essay
on the nature and
significance of economic
science: 75th anniversary
conference proceedings.
(London: Suntory and
Toyota International
Centres for Economics
and Related Disciplines,
2009) pp.1500.
Available at http://darp.
lse.ac.uk/papersdb/
LionelRobbinsConference
ProveedingsVolume.pdf
2
Although the definitions above may appear abstract, economics deals with
phenomena you will be very familiar with from your daily activities, and
provides tools and a language to analyse these. While it is not the only
language available, we hope it will prove useful to you.
Economics and the real world

One of the main reasons that BVFD was chosen as the textbook for the
course is that it combines the exposition of economic theory with liberal
use of actual data on many economic issues. Modern economics is a
subject which, at its best, does not theorise in a vacuum but addresses
issues of real world importance and attempts to make its concepts
and theories consistent with the facts. When economists make policy
recommendations these address issues of current importance and
concern. Furthermore, the effectiveness of economic policy is increasingly
subject to empirical evaluation. Sometimes this happens by piloting
a policy on a restricted scale before it is rolled out nationally. Almost
always government departments, private sector analysts and academic
economists attempt to evaluate the consequences of policy in the months
or years after implementation. If you pursue your study of economics to
a more advanced level you will learn how applied economists attempt
to test the relevance and accuracy of their theories and the success or
failure of economic policy using statistical techniques broadly known as
econometrics. However, even at this early stage of your study you should
attempt to familiarise yourself with actual facts about the economy and
think about what these imply for economic theory and the formation and
evaluation of economic policy. The statistics and policy discussions in
BVFD often (but not always) relate to the UK economy; we encourage you
to look for comparable examples wherever you live.
Learning outcomes
By the end of this block and having completed the Essential reading and
recognise economics as the study of how society addresses the conflict
between unlimited desires and scarce resources
describe ways in which society decides what, how and for whom to
produce
identify the opportunity cost of a decision or action
explain the difference between positive and normative economics
define microeconomics and macroeconomics
explain why theories deliberately simplify reality
recognise time-series, cross section and panel data
construct index numbers
explain the difference between real and nominal variables
build a simple theoretical model
plot data and interpret scatter diagrams
use other things equal to ignore, but not forget, some aspects of a
problem in order to focus on core issues.
10
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapters 1 and 2.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 1; UK edition,
Chapter1.
Witztum (AW), Chapter 1.
Synopsis of this block

This block introduces some of the key concepts in economics. First,
scarcity the idea that the means available to society (its labour force, its
capital stock, its natural resources, its technology) are insufficient to meet
all the wants (or the desired goods and services) of the people making up
that society. Related to scarcity is the concept of opportunity cost which
is the value of the best alternative that must be sacrificed. The concept of
scarcity gives rise to the production possibility frontier (PPF), which
shows the maximum amount of one good that can be produced given the
output of another good. The slope of the PPF is the opportunity cost. The
fact that different individuals and countries have different opportunity
costs of producing various goods gives rise to comparative advantage and
creates the possibilities for gains from trade.
In economics, people are assumed to behave rationally only taking a
course of action if its benefits outweigh its costs. Furthermore, people are
assumed to be motivated by self-interest. The idea of the invisible hand
describes how market forces allocate resources efficiently despite the
self-interested motivations of individuals. Markets resolve production and
consumption decisions via the adjustment of prices.
Economics can be divided into different sub groups and approaches.
Positive economics deals with facts about how the economy behaves
and with empirically testable propositions, while normative economics
involves subjective judgements. Microeconomics studies particular markets
and activities in detail, while macroeconomics deals with aggregates and
studies the economy as a whole system.
The interplay of data and theory/models in economics is very important.
Models are deliberate simplifications of reality which help organise how
we think about a problem. A key approach of economic analysis is to
abstract from various factors by holding them constant this is known
as ceteris paribus or other things equal. The second half of this block
examines the relationship between data and theory and also provides
guidance and instruction regarding key practical concepts and skills
such as index numbers, nominal and real variables, measuring change,
diagrams, lines and equations. Chapter 2 concludes by briefly addressing
some popular criticisms of economics and economists.
BVFD: read Chapter 1.
Sections 1.1 and 1.3 introduce the concepts of scarcity, opportunity cost, and efficiency.
These are not separate concepts but are all interrelated and can be demonstrated
using the production possibility frontier introduced in section 1.3. For a more detailed
introduction to these fundamental concepts, you can refer to AW Chapter 1.
Read section 1.1, concept 1.1 and case 1.1.
11
Scarcity
BVFD defines scarcity by saying: a resource is scarce if the demand for
that resource at a zero price would exceed the available supply. Since the
concepts of demand and supply have not yet been introduced to you, we
can also define scarcity by stating that the means available to society (its
labour force, its capital stock, its natural resources, its technology) are
insufficient to meet all the wants (or the desired goods and services) of the
people making up that society. This implies that for any one person to have
more of something, they or someone else must have less of something
else. In turn, this requires choice, both at the level of the individual agent
but also at the societal or collective level. How individuals and societies
cope with scarcity in relation to wants is central to economics. This course
concentrates on the market economy as the basic organisational principle
for coping with scarcity, but modified by governments to rectify market
shortcomings and to achieve distributional ends.
Opportunity cost
Related to scarcity is the concept of opportunity cost one of the key
concepts in economic analysis.
To cement your understanding of opportunity cost, complete the following
activity on this concept.
Activity SG1.1
a. Let us change the details of the problem in concept box 1.1. Suppose that there
were no jobs in the campus shop. The only job available, and this is the alternative
to going to the beach with your friends, is to work at the local fast food restaurant
clearing tables and washing dishes. This job also pays 70, but because of its general
unpleasantness you wouldnt do it unless you were paid at least 55. Should you go
to the beach or work at the fast food restaurant?
b. A high-end ladies fashion boutique purchases winter coats from a manufacturer at
a price of 300 per coat. During the winter the boutique will try to sell the coats at
a price higher than 300 but may not be able to sell all of the coats. Since they are
the latest fashion, no customers would be interested in buying the coats next season.
However, at the end of the winter, the manufacturer will pay the boutique 20% of the
original price for any unsold coats (and re-use the expensive fabrics they are made
from for the next years designs).
i. At the beginning of the year, before the boutique has purchased any coats, what
is the opportunity cost of these coats?
ii. After the boutique has purchased the coats, what is the opportunity cost
associated with selling a coat to a prospective customer? (You can assume the
coat will be unsold at the end of the winter if that customer doesnt buy the coat).
iii. Suppose towards the end of the winter the boutique still has a large inventory of
unsold coats. The boutique has set a retail price of 950 per coat. The marketing
manager argues that the boutique should cut the price to 199 to try to sell
the remaining coats before they become unfashionable at the end of the winter.
However, the general manager disagrees, arguing that would mean a loss of 101
on each coat. Which makes more economic sense the marketing managers
suggestion or the general managers argument?
BVFD: read section 1.2 and case 1.2.
This section raises various economic issues which you may be familiar with
through the news or other sources. It demonstrates what kinds of issues
economics deals with, although in the case of income distribution this is
12
often left to specialised courses. In each case, the authors demonstrate the
impact on the three key questions of what to produce, how to produce it
and for whom.
The global financial crisis of 200709 was a time of great disruption to
economies around the world and indeed to the world economy. As can
be seen in Figure 1.1 of the textbook, the US economy shrank at a faster
rate than had been seen since before the 1980s. The textbook will come
back to this period again and again to provide a fuller account of what
happened, why it happened, and how various countries reacted and to
use this period of recent economic history to illustrate and explain various
points of economic theory.
Rationality
BVFD: read concept box 1.2.
This concept box comes back to the idea of rationality, introduced in
section 1.1 of the textbook. In economics, people are assumed to act
rationally, using all available information to maximise their satisfaction.
In the real world, human behaviour is complex. The field of behavioural
economics examines human behaviour, especially when it appears to
depart from the assumption of rationality. Chapter two (covered in the
second part of this block) concludes with some criticisms of economics,
including the criticisms that people are not as mercenary as economists
think. In fact, depending on the task at hand, behaviour can be modelled
very simply, or in a more complex way to include various other factors,
including altruism. In some cases, even very simple models can go a long
way in explaining human behaviours. When these fail, more complex
elements can be included to make the model more realistic. Behavioural
economics indicates some ways that the simple assumption of rationality
can be extended to provide further insights into human behaviour.
The production possibility frontier (PPF)

BVFD: read section 1.3.
The production possibility frontier is one of the most basic and important
concepts in economics. It shows all the combinations of goods that can be
produced if the means of production are fully employed. It will come up
again in Block 7 when we discuss the perfect competition model of market
structure, Block 11 when we discuss welfare economics and also in Block
23 when we discuss economic growth.
The PPF: scarcity and desirability

The PPF is a boundary. It demonstrates scarcity in that any point beyond
the frontier is unattainable. Society cannot produce combinations that
lie outside the PPF because there are insufficient resources to do so. The
economic problem has been defined as reconciling scarcity with peoples
virtually limitless desires. These desires mean that people wish to have
more of everything as such, points above and to the right of the origin
are seen as better than points closer to the origin. If society produces at a
point on the frontier rather than inside it, society will be better off.
13
The PPF and efficiency

The statements above relate to the idea of efficiency. Points on the PPF
are productive efficient, while points within the curve are inefficient.
An efficient allocation of means of production is one which yields a
combination of outputs where it is not possible to increase the output of
one good without reducing the output of the other.3 Societies must also
choose not just any point on the PPF but a specific point. This relates to
allocative efficiency and will be discussed further in Block 11.
The PPF and opportunity cost

Society has a given amount of resources at its disposal and when the
economy is using these efficiently, using more resources to increase the
production of one good necessarily implies decreasing the production of
the other. This trade-off helps demonstrate the idea of opportunity cost.
The amount by which good B is reduced to increase the production of
good A is the opportunity cost of increasing the production of good A.
Moving along the PPF from one point on the curve to another shows how
much of one good must be given up to increase the production of the other
thus the slope of the PPF is the opportunity cost. The opportunity cost
can also be described as the real price of a good, since it represents the
amount of one good that must be sacrificed in order to attain more of the
other.
The shape of the PPF and marginal analysis

In economics, marginal analysis is very important. Marginal simply means
extra or additional and marginal analysis has to do with decision making
at the margin. Economists often analyse the effects of a one unit change
in something for example: how much better off will a consumer be if
they can purchase one additional unit of a good? How much extra profit
will a company earn by producing one additional unit of a good? How
much more can a company produce if they hire one additional worker?
Asking such questions helps to find the optimal level of (for example)
consumption and production, and you will come across this again and
again throughout the course. For example, Block 4 introduces the idea of
diminishing marginal utility: the first glass of lemonade you drink on a
hot day is very refreshing, the second is less so, and by the time you finish
the third, you may not want to drink any more lemonade for a while. In
this block, the shape of the PPF is linked to diminishing marginal returns:
in the example given in section 1.3, the first worker employed in the film
industry produces 9 units of output, the second produces 8 units, the third
produces 7 units and the fourth produces only 6 units. The fact that the
extra output each additional input can produce diminishes is one reason
why the PPF is concave toward the origin.
14
3
For simplicity, we
assume all goods in the
economy are grouped
into two groups, or
that it is a two-good
economy.
Activity SG1.2
In the box below, draw a production possibility frontier, clearly marking the regions of
inefficient production, efficient production and unattainable production. Illustrate how the
slope of the PPF represents opportunity cost. Why is the frontier concave to the origin?
Opportunity cost and absolute and comparative

advantage
The concept of opportunity cost can also help us to understand why people
(and countries) specialise in the production of certain goods and then
trade.
Let us expand a bit on the treatment of PPFs in the second part of section
1.3, dealing with the two individuals, Jennifer and John, making the two
goods, T-shirts (T) and cakes (C).
We can write, for Jennifer:
Number of T-shirts produced = (T-shirts produced per hour) * hours spent
on T-shirt production (LT).
Or
T=4LT
T
LT =
4
Similarly for Jennifer cake production can be written as:
C=2LC
C
LC =
2
Now, we are also told that Jennifer can work up to 10 hours, in T-shirt
and/or cake production. When she does work 10 hours:
LT +LC = 10
C
T
+
= 10
4
2
Be sure that you understand that for John we have the equation:
2T + C = 10
These equations will show the production possibilities for Jennifer and
John. They will help you in Activity SG1.3 which you should now attempt.
15
Activity SG1.3
a. Putting cakes on the horizontal axis and T-shirts on the vertical axis draw Jennifer and
Johns production possibility frontiers for a 10-hour working day.
b. In what way do these PPFs differ from that drawn in Figure 1.4? Why?
c. Write down the equations of these production possibility frontiers, making T (T-shirts)
a function of C (cakes).
d. What is the interpretation of the slope of these PPFs?
e. In your diagram what represents Jennifers absolute advantage in producing both
goods?
f. In your diagram what represents Johns comparative advantage in making cakes?
To cement your understanding of comparative advantage, complete the

following activity.
Activity SG1.4
Suppose there are two countries (M and W) and two goods (shoes and hats). The table
gives the labour requirements to produce a unit of each output in each country.
Country M
Country W
Shoes
10 labour hrs/unit of output
12
Hats
a. Which country has an absolute advantage in shoes? In hats?

b. Which country has a comparative advantage in shoes? In hats?
c. Assuming each country has 100 labour hours available, what will the total production
of shoes and hats be if each country specialises fully in the production of the good in
which it has a comparative advantage (presumably they would then engage in trade
with each other) compared to what they could produce in a situation with no trade if
they spent half their available labour on each good?
If you are interested in exploring these concepts in more detail you can
read Chapter 29 on Trade (which is optional and will not be covered in
this subject guide).
Markets
BVFD: read section 1.4 and case 1.3 and complete activity 1.1.
As noted above, economics can be defined as the study of how societies
make choices on what, how and for whom to produce. As such, economics
is concerned with the organisation of economic activities in a society and
the institutional arrangements that will provide optimal answers to the
questions above. These institutional arrangements can be thought of as
existing along a continuum from, on the one hand, command economies,
where decisions are made centrally by the government planning office, to,
on the other hand, free market economies where decisions are taken by
individual agents driven by self-interest but organised by market forces as
by an invisible hand.
This section begins to explain how free markets can often bring about
efficient outcomes. In subsequent blocks we will discuss in much greater
detail, and with more rigour, how market forces guide resource allocation.
Although it is true that centrally planned economies (command economies)
16
were riddled with inefficiencies, it would be incorrect to believe that all

non-planned economies are pure market economies. Today we all live in
mixed economies, in which governments play a major role. Subsequent
chapters (13 and 14) will analyse some of the reasons why markets fail
to allocate resources ideally, creating a potential role for the state to step
in. The actual extent of state intervention does, of course, differ quite
significantly across countries and how large the role of the state should be
is a highly contentious issue. Broadly speaking, governments can intervene
in the economy either to promote efficient resource allocation where
markets fail to achieve this end or to achieve more equitable outcomes
than markets generate if left to operate unhindered.
Positive and normative economics

This short section distinguishes in a quite traditional way between positive
and normative economics and you should be clear about the distinction.
There have been some quite eminent economists, such as the Swedish
Nobel Prize winner Gunnar Myrdal who rejected the positive-normative
dichotomy, claiming that normative values are inextricably intertwined
with so called objective or value-free economic analysis. Myrdal argued
that economists would be much better advised to state their values openly
and explicitly rather than pretend that they could be put to one side while
conducting positive analysis. This is not the orthodox view in the profession!
Returning to the treatment in BVFD, complete the following activity.
Activity SG1.5
Classify the following statements as positive or normative:
Inflation is more harmful than unemployment.
_______________________________________________________________
An increase in the minimum wage to 8 per hour would reduce employment by
0.5 percentage points.
_______________________________________________________________
The government should raise the national minimum wage to 8 per hour to help
reduce poverty in society.
_______________________________________________________________
An increase in the price of crude oil on world markets will lead to an increase in
cycling to work.
_______________________________________________________________
A reduction in personal income tax will improve the incentives of unemployed people
to find paid employment.
_______________________________________________________________
Discounts on alcohol have increased the demand for alcohol among teenagers.
_______________________________________________________________
The retirement age should be raised to 70 to combat the effects of our ageing
population.
_______________________________________________________________
17
Microeconomics and macroeconomics

Microeconomics takes a bottom-up approach to studying the economy
focusing on individual consumers, households and firms; while
macroeconomics takes a top-down approach, studying the economy as
a whole system and focusing on aggregates. One analogy that can be used
to describe the difference between macroeconomics and microeconomics
is the study of a rainforest. Macroeconomics studies the ecology of the
rainforest as a whole, while microeconomics studies individual plants and
animals that live there. Most professional economists tend to specialise in
either microeconomics or macroeconomics (indeed, they will specialise on
sub-fields within this broad dichotomy). As you work through the textbook
and the subject guide you may find yourself drawn either to micro or to
macro ahead of the other. That is natural. What you should not do at this
stage of your study of economics is unbalance your commitment of time
to the two halves; that is not a good strategy, either in terms of doing
well in examinations or of building a solid foundation for further study
of the subject. Blocks 11 and 12 cover welfare economics and the role of
the government. Welfare economics employs microeconomic techniques
to analyse welfare at an aggregate (economy-wide) level, and the role of
the government is both micro and macro as governments are involved in
specific markets but also attempt to manage the aggregate level of demand
and encourage economic stability and growth. For simplicity, blocks 11
and 12 are included in the first half of the course on microeconomics.
BVFD: read the Summary and work through the review questions.
A note on mathematics
In discussing the tools of economic analysis, this chapter, perhaps
surprisingly, has little to say in general terms about the role of mathematics
in economics. In its methods and approaches, if not its subject matter,
economics today is almost unrecognisable from the subject taught under
the same name 60 or 70 years ago. Of course, one wouldnt expect the
subject to stand still, but in this case the change has been dramatic. Today,
top universities require a high level of mathematical competence of their
students, even at undergraduate level (and even higher at postgraduate
level) while a cursory scan of the top economics journals might give the
impression that the subject is a branch of mathematics. It isnt. Correctly
used, mathematics in economics is a tool a means to an end not an
end in itself. Nevertheless, some have argued that the pervasiveness of
mathematics in modern economics has had damaging consequences both
on the development of the subject (with concentration on topics that lend
themselves to mathematical analysis and relative neglect of those that dont)
and on the ability of economists to communicate with non-economists,
often including those responsible for formulating economic policy.
Whether or not these criticisms are correct, it is highly unlikely that the
trend towards greater reliance on mathematical tools is likely to be reversed
in the near future. For those of you pursuing the subject beyond the
introductory level you will need to be prepared to use considerably more
18
mathematics. That said, the mathematical requirements of this particular

course are quite low. You need to be able to do basic arithmetic and algebra,
(including solving simultaneous equations) and you need to be able to read
and use graphs. Some of the Maths boxes in BVFD use calculus, including
partial differentiation and you should certainly try to understand this
material. Do not regard the mathematics boxes as optional extras.
Models and theory

BVFD: read the introduction to Chapter 2.
The introduction provides a brief but useful argument explaining why
models and theory are so important in economics. Sometimes students
of introductory economics complain that there is too much theory/too
many models. Why cant the subject just stick to the facts? But which
facts? And what can they tell us without guiding principles? On their own
the facts are silent. Teamed with appropriate models, however, they can
be eloquent. Broadly speaking, two key tools of economic analysis are
models/theory and data and they are best deployed in tandem. Sections
2.1 to 2.4 lay out some important issues relating to economic data, and
then the later sections of the chapter introduce economic models and
discuss how models and data are used together in economics.
BVFD: read sections 2.1 and 2.2 as well as concept 2.1.
Activity SG1.6
Index numbers: work through the following example to help you understand how index
numbers are calculated. Say we want to calculate inflation (a Retail Price Index) for
four specific goods. The index for each good is set at 100 for the first year. Work out the
percentage price change in each good (the first one is filled in for you).
Product
Price year 1
Index year 1 Price year 2
Index year 2
Bread
80p
100
120p
150
Cheese
260p
100
312p
Sausages
300p
100
390p
Toothpaste
100p
100
80p
TOTAL
400/4
Overall index
100
The change in the overall index is the average rate of inflation. What was the rate of
inflation for these four products?
Inflation between year 1 and 2 __________________________?
However, the products in the price index are not equally important and should not be
given an equal weighting in the calculation of the index. That is why Weighted Index
Numbers are often used.
Of the four products above, which do you think represents the lowest proportion of a
familys total spending? Which represents the highest?
If toothpaste represents a small proportion of each familys total spending, then we should
make the price change for toothpaste have a much smaller overall effect on the price index. To
do this we weight each price change to give it more or less importance in the overall index.
19
This has been done in the table below see if you can complete the last column:
Product
Weights Price
year 1
Index
year 1
Weighted Price
index
year 2
year 1
Index
year 2
Weighted
index
year 2
Bread
80p
100
400
120p
150
600
Cheese
260p
100
200
312p
Sausages
300p
100
300
390p
Toothpaste
100p
100
100
80p
TOTAL
10
Overall
index
1,000/10
100
Inflation between year 1 and 2 __________________________?

This figure is considerably higher than the original inflation figure. This is because the
products with the highest weights went up in price the most. The effect of the falling price
of toothpaste on the overall index was reduced because this item had a very small weight.
A weighted index gives a much better estimate of inflation, since it reflects which items
are most important to familys expenditure.
BVFD: read sections 2.3 and 2.4 and concept 2.2.
Activity SG1.7
You got a job in the year 2012 with a salary of 25,000. In 2014, you receive a 3,000
increase in your salary. CPI in 2014 with base year 2012 is 108. Calculate your real
income in 2012 and 2014 as well as the percentage changes in your nominal income and
your real income.
Economic models are a deliberate simplification of reality. Just the same
way that an architectural drawing shows all the important features of a
house without necessarily looking realistic, economic models abstract
from reality to clarify important features. This helps to simplify and clarify
the analysis of the problem at hand.
Economic models often use mathematics as the system of logic which ties
various parts of the model together.
Two terms which you should be familiar with are exogeneity and
endogeneity: Following the definitions provided in L&C (glossary),
an endogenous variable is a variable that is explained within a model or
theory. An exogenous variable influences endogenous variables, but is
itself determined by forces outside the model/theory. In the example of
a model of London Underground revenue, the number of passengers is
an endogenous variable, while factors such as bus fares and passenger
incomes are exogenous.
BVFD: read sections 2.6 and 2.7 and complete activity 2.1.
These sections, and 2.9 below, turn to the use of empirical evidence in
economics. They begin to give an intuitive feel for econometrics, the
application of statistical and mathematical techniques, often with the help
of computers, to economic data, in order to test hypotheses and/or forecast
20
the effects of changes in the economic environment on outcomes of interest

(quantity demanded, hours worked, inflation, unemployment, etc.).
Econometrics is a central and well developed aspect of the subject, which is
generally a required component of an undergraduate degree in economics.
However, it is not usually introduced at elementary level.
Fitting lines through scatter diagrams although the term is not provided
explicitly in this section, the description of how a computer, programmed
to apply defined statistical criteria, quantifies the influences of various
factors in a single model is describing multiple regression analysis.
The subsection Reading diagrams is very basic mathematics, not
econometrics. You need to be competent (and confident) in these basic
techniques to follow subsequent chapters of the textbook and this subject
guide. The following activity enables you to practise basic graphical
techniques.
Note: Figures 2.4 and 2.5 plot quantity on the vertical axis and price on
the horizontal axis. These are simply exercises to teach you techniques
for interpreting diagrams and finding the slope and intercept of a line. In
the following chapter, demand and supply diagrams will be introduced
typical demand and supply diagrams put price on the vertical axis and
quantity on the horizontal axis. Of course, the basic techniques of finding
the slope and intercept of the line will remain the same.
Activity SG1.8
Use the following functions to draw diagrams in the boxes below:
Q = 150 10P
Curve
Q = 50 + 20P
Curve
Slope =
Intercept =
Slope =
Intercept =

In economics, a Latin term is often used to indicate that other factors are
held constant, this term is ceteris paribus, which means other things the
same. This has to do with the conditions under which a theory holds. For
example, the market for one product is often studied under the assumption
that prices of other products are held constant. The purpose of this is not
to say that such factors are unimportant, but rather to focus on one effect
at a time. If many factors are allowed to vary simultaneously, the effects of
these can be difficult to disentangle. This section illustrates a technique of
showing the effect of two variables (fares and income in Figure 2.7) in a
two dimensional diagram. When we study the demand for a good we will
21
do something very similar; allowing changes in income to shift the whole

(downward sloping) relationship between price and quantity.
Regarding the relationship between economic theories and data, one
could ask the old question: what came first the chicken or the egg? In
fact, economic theories and empirical evidence (data) feed back on one
another. Someone may notice a certain relationship expressed in economic
data and develop a theory to explain this relationship. That theory will
then be tested by other data, from different time periods and different
contexts these data will either corroborate the theory, or lead to it being
modified or abandoned in favour of a theory that better fits the evidence.
Criticisms of economics
One criticism levied against economics which is mentioned briefly in this
section is that the actions of human beings cannot be reduced to scientific
laws. However, if we look at human behaviour in general, we can see
stable patterns on average even though the behaviour of individuals is
unpredictable. This has to do with the law of large numbers, a statistical
concept or law which states that as the number of individual cases
increases, random movements tend to offset each other, such that the
difference between the expected value and the actual value tends to zero.
That means the behaviour of a group of people is much more predictable
than the behaviour of certain individuals, because the odd things one
individual does tend to be cancelled out by the odd things that some other
individual does (this is discussed further in previous versions of L&C e.g.
Chapter 2 of the 12th edition).
More recently, economics has been criticised for failing to predict the
financial crisis and associated recession beginning in 200708.4 This led
to some damage to the reputation of the subject and to the status of the
profession. It is too early to say just how damaging this has been (there
doesnt seem to be any major decrease in the demand to study economics
at university or, broadly speaking, in the longer-term employment
prospects of economics graduates in either the private or public sectors).
One consequence of the crisis has been considerable self-examination of
the way in which the subject has been taught in the past and the first signs
of new pedagogical approaches can be detected in the revamping of some
introductory courses.
Overview
Economics analyses what, how and for whom society produces. The key
economic problem is to reconcile the conflict between peoples virtually
unlimited desires and the scarcity of available resources and means
of production. The PPF shows the maximum amount of one good that
can be produced given the output of another. The slope of the PPF is
the opportunity cost (of the good on the horizontal axis in terms of the
other). More generally, opportunity cost is the value of the best alternative
that must be sacrificed. The fact that different individuals and countries
have different opportunity costs of producing various goods gives rise to
comparative advantage and creates the possibilities for gains from trade.
22
4
Some economists
were prescient. Nouriel
Roubini (NYU. Stern
School of Business)
as early as 2006 was
predicting that the
US housing bubble
would burst, leading
to damaging loss of
consumer confidence
and ultimately to
recession. Widely
criticised for being too
pessimistic at the time
Roubinis forecasts were,
if anything, exceeded by
actual events. The link
provides some thoughts
of the Chairman of the
US Federal Reserve,
Ben Bernanke on the
implications of the crisis
for economics:
www.federalreserve.
gov/newsevents/speech/
bernanke20100924a.
htm
In economics, people are assumed to behave rationally only taking an

action if its benefits outweigh its costs. Furthermore, people are assumed
to be motivated by self-interest. The idea of the invisible hand describes
how, under certain conditions, market forces allocate resources efficiently
despite the self-interested motivations of individuals. Markets resolve
production and consumption decisions via the adjustment of prices.
There is a spectrum of government involvement in the economy from a
command economy to a free market economy. Most industrialised nations
have mixed economies.
Economics has many dimensions. Positive economics deals with facts
about how the economy behaves, while normative economics involves
subjective judgements. Microeconomics studies particular markets and
activities in details, while macroeconomics deals with aggregates and
studies the economy as a whole system.
The second half of this block examined the relationship between data
and theory and provided guidance and instruction regarding key practical
concepts and skills such as index numbers, nominal and real variables,
measuring change, diagrams, lines and equations. The interplay of data
and theory/models in economics is very important. Models are deliberate
simplifications of reality which help organise how we think about a
problem. Data can indicate a relationship that will later be theorised
about, and can also be used to quantify relationships and test existing
theories. A key approach of economic analysis is to abstract from various
factors by holding them constant this is known as ceteris paribus or other
things equal. Chapter 2 concludes by briefly addressing some popular
criticisms of economics and economists, such as the extent of disagreement
in the discipline (which in fact often relates more to normative than to
positive economics) and assumptions about human behaviour, which are
sometimes seen as oversimplified.
Reminder of learning outcomes

Now go back to the list of learning outcomes at the start of the block, and
be sure that they have been achieved.
Sample examination questions

Multiple choice questions
For each question, choose the correct response:
1. Every summer, New York City puts on free performances of
Shakespeare in Central Park. Tickets are distributed on a first-comefirst-served basis at 13.00 on the day of the show, but people begin
lining up before dawn. Most of the people in the lines appear to be
young students, but at the performances most of the audience appears
to be made up of older working adults (tickets can be transferred,
so the person picking up the tickets does not have to be the person
watching the performance). Which of the following concepts best
explains this fact?
a. Ceteris paribus.
b. Opportunity cost.
c. Marginal analysis.
d. Absolute advantage.
23
2. The output produced by Samuel and Roberto in 20 labour hours is

given below for wine and cheese. Choose the option with the correct
statement below.
Wine
Cheese
Samuel
Roberto
a. Samuel has an absolute advantage in both products and a

comparative advantage in cheese.
b. Roberto has an absolute advantage in both products and a
comparative advantage in cheese.
c. Roberto has an absolute advantage in cheese and a comparative
advantage in wine, while the opposite is true for Samuel.
d. Samuel has an absolute advantage in both products and a
comparative advantage in wine.
e. Roberto has an absolute advantage in both products and a
comparative advantage in wine.
Long response question

Use the production possibility frontier to illustrate the following concepts:
i. scarcity
ii. opportunity cost
iii. productive efficiency
iv. diminishing marginal returns.
24
Block 2: Demand, supply and the market

Introduction
The previous block introduced economics as the study of how societies
make choices on what, how and for whom to produce, given the limited
resources available to them and described how societies adopt various
institutional arrangements to answer these questions as best they can. In
the societies we all live in, the role of the market is very important as a
means of answering these questions. Markets bring together buyers and
sellers and the mechanism of prices operates to coordinate the quantities
sellers wish to sell with the quantities buyers wish to buy. This chapter
examines demand and supply and the way they interact within markets to
determine quantities and prices.
The focus of this chapter, the demand and supply model, is perhaps the
iconic model of economics. Like all models it has its shortcomings and
knowing when it is appropriate to the analysis of a particular problem,
and when it is not, is something of an art. Some of the strengths and
weaknesses of this basic model will become clearer in subsequent chapters
of the text and blocks in this guide, but first you need to become familiar
with the basic workings of the model. Also postponed until later is the
analysis of the behaviour of individual consumers and individual firms
which lie behind demand and supply curves. It would also be possible to
start with the behaviour of these individual agents and then derive the
market demand and supply curves, however, experience suggests that
the power of supply and demand analysis in showing how prices and
quantities respond to changes in the economic environment can also be
experienced without all the detailed foundations being in place (as long
as they provided subsequently) and that this approach is often more
motivating than the reverse sequencing. The blocks of the subject guide
therefore follow the order of the textbook in firstly presenting the demand
and supply model and then showing later how demand and supply curves
are derived from the behaviour of individual consumers and firms.
Demand is the quantity of a product that buyers wish to purchase at any
given price, while supply is the quantity of a product that suppliers are
willing to sell at any given price. Demand and supply come together in a
market and this determines the price and quantity of goods sold. This will
be described in more detail in this chapter. Since we have all bought (and
maybe also sold) goods before, many of these ideas are quite intuitive.
Nonetheless, it is important to become familiar with the language
economists use to explain these ideas and the way that economics deals
with them. Graphical analysis is very important in economics and you will
need to become very comfortable with drawing demand and supply curves
and using them to demonstrate changes in various influential factors. You
will hopefully find this a very useful tool of analysis.
Learning outcomes
define the concept of a market
draw demand and supply curves (and inverse demand and supply
curves)
25
find equilibrium price and equilibrium quantity

describe how price adjustment reconciles demand and supply in a
market
analyse what shifts demand and supply curves
define reservation prices
describe consumer and producer surplus
analyse excess supply and excess demand
discuss the consequences of imposing price controls
discuss how markets answer what, how and for whom to produce
describe the functions of prices (to ration, to allocate).
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 3.
Further reading
Lipsey and Chrystal (L&C), Chapter 2.
Witztum (AW), sections 2.1 and 4.1.

This chapter introduces demand and supply and how these come together
in a market to determine equilibrium price and quantity. The factors that
underlie demand curves and supply curves are outlined, as is the way that
a change in one of these factors will lead to a shift in the relevant curve.
The concepts of consumer and producer surplus will also be introduced.
These exist because there are consumers who would be happy to pay
more than the market price, and suppliers who would be happy to sell for
less that the market price. The chapter will also show that allowing the
market to determine price (rather than having the government impose a
price) results in the maximum amount of consumer and producer surplus.
Through the readings and the exercises below, these ideas will now be
examined in further detail.
Equilibrium
BVFD: read sections 3.13.3.
Before turning to some activities which will help to consolidate your
understanding of the material in these sections it is worth elaborating
a little on the concept of equilibrium in economics. You will find that
this concept is central in economic theory (whether it is observable in
practice raises further issues which we do not address here) although
it has many interpretations; even in a basic course such as this you will
encounter more than one version. In microeconomics we are about to
look at the concept of equilibrium market price, later when we introduce
game theory we will encounter the concept of a Nash equilibrium and in
macroeconomics we will define equilibrium in terms of aggregate supply
and demand (as opposed to the supply and demand in the market for a
particular good or service), in terms of simultaneous goods and money
market equilibrium (IS-LM equilibrium) and in terms of the so-called
steady state (where capital, investment and output per worker are
constant) in growth theory. What is common in all these examples is that
the system being analysed is in some sense at rest there are no forces at
work generating further changes to the system. In the demand and supply
26
model, an equilibrium price is one where, simultaneously, consumers want

to buy just the amount that firms want to sell. At any other price one or
other of these groups would want to change the amount they buy or sell.
Usually when an economic system is not in equilibrium, there will be
incentives for the actors or agents in the model to change their behaviour
in ways that move the system towards equilibrium.1
Demand and supply curves

Activity SG2.1
Use the data in the following table to draw for yourself a demand curve, a supply curve, and
the whole market where demand and supply interact. Be careful to put price on the vertical
axis and quantity on the horizontal axis. What are the equilibrium price and quantity?
Price of a
Small Table ()
Quantity Demanded
(thousands)
Quantity Supplied
(thousands)
90
10
75
15
20
60
30
30
45
45
40
30
60
50
15
75
60
90
Demand Curve
Supply Curve
1
In more advanced
analysis, questions can
arise as to whether an
equilibrium exists in
the first place and, if it
does, whether it is stable
in the sense that, out
of equilibrium, forces
arise driving the model
being analysed back to
equilibrium. We do not
examine these issues
further on this course.
Demand and Supply
(Note: Although these lines are straight, they are still called demand and supply curves).
BVFD: read Maths box 3.1.
Maths box 3.1 introduces a simple mathematical way of describing the
demand and supply curves and finding equilibrium price and quantity. You
need to be familiar with this algebraic approach where the constants in
the supply and demand curves are given letters (here a, b, c, d) and where
they are expressed as numbers, as in the following activity.
Activity SG2.2
The direct demand function and direct supply function can be used to easily find the
equilibrium quantity and price. Use the following curves to find the equilibrium price and
quantity for noodles:
QD= 30 3/4P
QS= 5 + 1/2P
Equilibrium Price =
Equilibrium Quantity =
27
Although people generally talk about quantity as a function of price, when

it comes to drawing the graph, price is always drawn on the vertical axis,
so it is easier to work with the inverse demand function, where price is
expressed as a function of quantity demanded. For example:
Inverse Demand:
P = 20 QD
Inverse Supply:
P = 6 + QS
These equations are very useful for us to graph the demand and supply
curves, because we can easily read the key characteristics of the curves
straight off the relevant function. To graph the inverse demand function
P = a/b 1/b*QD (using the notation from Maths box 3.1), we can use
the fact that the intercept on the price axis is a/b and the gradient is 1/b.
Similarly, for the inverse supply function P = c/d + 1/dQS, the intercept is
c/d and the gradient is 1/d.
For example, if the inverse demand curve is P = 12 4QD, the demand
curve touches the vertical axis at P = 12 and slopes downward with a
slope of 4.
Activity SG2.3
Find the inverse demand and supply functions using the direct demand and supply
functions in the table below.
Demand/Supply Function
Demand
Q = 30 *P
Supply
QS= 5 + *P
Inverse Demand/Supply Function
and graph these in the following box:

Supply and Demand Curve
Shifts in the demand and supply curves

BVFD: read sections 3.43.7, including cases 3.1 and 3.2.
Activity 3.1 in is important, since it distinguishes between movements along a curve and
shifts in the curve itself. Complete the activity.
Activity SG2.4
For each event in the following table, identify whether this relates to demand or supply, in
what direction the curve would shift, and the effect on price and quantity. If you draw a
graph for each example, you will also see the movement along the other curve, resulting
in the new equilibrium price and quantity. The first line has been completed for you.
28
The market for sushi

Event
Which curve
shifts? Supply
or demand?
Direction? Effect on
price?
Effect on
quantity?
Movement along
the other curve
which direction?
The price of salmon

increases
Supply
Left
Lower
Demand, left
Higher
Sushi becomes more

popular in Europe
The price of similar
alternatives rises
Sushi sellers expect
the price of sushi to
rise in the future
New evidence reveals
sushi is not as healthy
as people had thought
New sushi machines
make production
more efficient
Consumer and producer surplus

BVFD: read section 3.8 and concept 3.1 on consumer and producer
surplus.
Imagine the following scenario:
The current price for a two-litre bottle of orange juice in my local grocery
store is 70p. Thats good news to me, because I was prepared to pay 1.20.
The store manager is happy to see me loading some cartons into my
trolley, because she knows the store would have been happy to sell them
for just 45p.
Im thinking: This is great! Im coming out 50p ahead on each carton!
Shes thinking: Fantastic! Im coming out 25p ahead on each carton!
So we are both enjoying a surplus.
The equilibrium price is set by the marginal consumer and producer who
were only willing to buy/sell for exactly 70p. Consumers who would
have been willing to pay more still just pay the equilibrium price and
enjoy a surplus. Producers who would have been willing to sell it for less
can still ask the equilibrium (market) price and also enjoy a surplus. The
efficient market outcome occurs where consumer and producer surplus are
maximised. We will come back to this later.
29
Activity SG2.5
1. The only four consumers in a market have the following willingness to pay for a good:
Buyer
Willingness to Pay
Sally
15
Simon
25
Susan
35
Shaun
45
If there is only one unit of the good and if the buyers bid against each other for the
right to purchase it, then the consumer surplus will be:
a. 0 or slightly less
b. 10 or slightly less
c. 30 or slightly less
d. 45 or slightly less.
NB: It may help to calculate the price first. Assume it is an open auction where each
bidder calls the price out aloud.
2. Examine the diagram below:
120
Supply Curve
100
80
60
Equilibrium
40
Demand Curve
20
100
Quantity
Figure 2.1: Supply and demand.

At the equilibrium price, the producer surplus is equal to:
a. 2,000
b. 4,000
c. 6,000
d. 10,000.
30
3. Here you see Anthonys demand curve for football matches (you can treat the demand
curve as being approximately linear).
P
8
6
10
Figure 2.2: Anthonys demand for football matches.

When the price per match falls from 8 to 6, his welfare:
a. Rises by 16
b. Falls by 16
c. Rises by 12
d. Falls by 12.
BVFD: read sections 3.9 and 3.10 as well as cases 3.33.5.
These sections will further develop your understanding of demand, supply and
equilibrium. You should read them carefully and try to think each point through. Can
you think of another market where price floors or ceilings have been imposed?
Activity SG2.6
Price floors and ceilings result in a loss of consumer and producer surplus, this is called a
deadweight loss. Can you calculate how much consumer and producer surplus is lost
due to the price ceiling in the diagram below? Has there also been a transfer of surplus
between consumers and producers?
Price
120
100
Supply Curve
80
Free Market Equilibrium
60
40
Excess demand
Demand Curve
20
Price Ceiling
50
100
Quantity
Figure 2.3: Loss of producer and consumer surplus due to a price ceiling.
BVFD: read the summary and work through the review questions.
31
Overview
Buyers and sellers come together in a market and exchange goods and
services. Demand (from buyers) and supply (from sellers) are key concepts
of economic analysis. Demand curves display the quantity that buyers
wish to buy at each price and generally slope downwards demand is
higher when the price is lower. Supply curves display the quantity that
sellers wish to sell at each price and generally slope upwards sellers
are prepared to sell more when the price is higher. The market clears
(and equilibrium is achieved) at the point where the demand and supply
curves intersect. Understanding what demand and supply curves represent
and what makes them shift is the most fundamental lesson from this
block. Price changes are represented by a movement along a curve,
shifts in the curves indicate changes in other factors, such as the price of
complements or substitutes or changes in consumers income (for demand
curves) and changes in technology and input prices (for supply curves).
Shifts in the demand or supply curves change the equilibrium price and
quantity. Inverse demand and supply curves (where price is expressed as
a function of quantity) can be useful for graphing the curves. The block
also introduces consumer and producer surplus and the fact that price
controls lead to a reduction in consumer and producer surplus, whereas
free markets optimise consumer and producer surplus. You need to be able
to calculate consumer and producer surplus and the loss involved due to
price controls.

Now go back to the list of learning outcomes at the start of the block and

1. An increase in consumer incomes would result in:
a. a decrease in demand for bread
b. a decrease in demand for diamonds
c. a decrease in demand for low-quality cars
d. an increase in demand for inter-city bus travel (compared to flying
or taking the train).
2. An increase in the price of chilli would lead to:
a. an increase in demand for Mexican food
b. a decrease in supply of Mexican food
c. an increase in the supply of Mexican food
d. a decrease in demand for other spices.
3. From the diagram below, the loss in consumer surplus due to the price
floor is:
a. 50
b. 100
c. 150
d. 200.
32

Price
50
Supply Curve
Excess supply
40
Price Floor
30
Free Market Equilibrium
20
Demand Curve
10
10
20
30
Quantity
Figure 2.4: Loss of consumer surplus due to a price floor.
4. Given the following inverse demand and supply curves:

P = 8 QD/2
P = 2 + QS
and assuming that price is fixed below the equilibrium price at 5, the
loss in producer surplus due to the price ceiling is:
a. 3.50
b. 4.50
c. 8
d. 9.
5. The demand curve for good A is given by:
Q AD = a bPA + cPB
Where PA is the price of good A, PB is the price of good B, and a, b, c
are positive constants. The supply curve for good A is also linear and is
upward sloping:
a. Goods A and B are complements.
b. Goods A and B are substitutes.
c. Goods A and B are unrelated in consumption.
d. The demand curve for good A is upward sloping.
6. The demand curve for good A is given by:
Q AD = a bPA + cPB
Where PA is the price of good A, PB is the price of good B, and a, b, c
are positive constants. The supply curve for good A is also linear and is
upward sloping. When the price of good B increases:
a. The quantity of A purchased falls and the price of A falls.
b. The quantity of A purchased increases and the price of A increases.
c. The quantity of A purchased increases and the price of A falls.
d. The quantity of A purchased increases and the price of A stays the
same.
7. Suppose that the price of Porto wine was 20 per litre in 2010 and 25
per litre in 2011. Ingrid observes that Margarets consumption of wine
rose from 1 litre per month in 2010 to 1.2 litres per month in 2011.
33
Ingrid concludes that Margarets demand for Porto wine has to be

upward sloping:
a. Ingrid is wrong: given the above information Margarets demand
for Porto wine has to be downward sloping.
b. Ingrid is right: given the above information Margarets demand for
Porto wine has to be upward sloping.
c. Ingrid is wrong: the above information is not enough to conclude
that Margarets demand for Porto is necessarily upward sloping.

Suppose that the inverse demand and supply schedules for rental
apartments in the city of Auckland are as given by the following equations:
Demand: P = 2700 0.12QD
Supply: P = 300 + 0.12QS
a. What is the market equilibrium rental price per month and the market
equilibrium number of apartments demanded and supplied?
b. If the local authority can enforce a rent-control law that sets the
maximum monthly rent at $900, will there be a surplus or a shortage?
Of how many units will this be? And how many units will actually be
rented each month?
c. Suppose that the government decides to implement a policy to keep
out the poor. It declares that the minimum rent that can be charged is
$1,500 per month. If the government can enforce that price floor, will
there be a surplus or a shortage? Of how many units will this be? And
how many units will actually be rented each month?
d. Suppose that the government wishes to decrease the market
equilibrium monthly rent to $900 by increasing the supply of housing.
Assuming that demand remains unchanged, find the new equilibrium
quantity and the new inverse supply curve.
34
Block 3: Elasticity
Block 3: Elasticity
Introduction
The concept of elasticity is very important in microeconomics here we
devote a whole block to it! Elasticity has to do with responsiveness, for
example: how much does the quantity demanded of a good respond to
a change in the price of that good? For some goods, such as life-saving
medicine, peoples demand will not fall much even if the price increases
substantially, while for other goods, such as a particular chocolate bar,
the demand will respond to price much more, since if the price of one
chocolate bar goes up, people will generally be quite happy to purchase
another one (or a different kind of snack) instead. This chapter uses many
examples to make the concepts more intuitive, and also relies on graphs
and simple equations. Make use of the exercises in this block and in the
textbook to really master this concept and its applications.
Learning outcomes
describe how elasticities measure the responsiveness of demand and
supply
define and calculate price elasticity of demand
indicate the determinants of price elasticity
describe the relationship between demand elasticity and revenue
recognise the fallacy of composition
describe how cross-price elasticity relates to complements and
substitutes
define and calculate income elasticity of demand
use income elasticity to identify inferior, normal and luxury goods
define and calculate elasticity of supply
describe how supply and demand elasticities affect tax incidence.
Essential reading
Further reading
Chapter 3.
Witztum (AW), Chapter 2 section 2.4.

This block will explore the reasons why demand for certain goods
responds more or less to a change in price. Furthermore, we will also
explore how demand for a good changes in response to a change in the
price of another good, and also how it responds to a change in consumers
income. As well as the elasticity of demand, we will also examine the
elasticity of supply (i.e. how much producers supply decisions change in
response to a change in price). The implications of elasticity for a firms
total revenue, and for the effects of taxation shall also be examined.
35
Price elasticity of demand

BVFD: read section 4.1 of Chapter 4.
The formula for calculating price elasticity of demand (PED) is important and
also quite intuitive:
Price elasticity of demand = [% change in quantity] /
[% change in price]
As explained in Maths 4.2 this can be expressed using delta notation as:
PED =
Q P
P Q
where Q refers to quantity demanded and P to price. always means change

in, such that Q means change in quantity.
If the quantity demanded changes a lot in response to a change in price, we
say demand is responsive (or sensitive) to the price change, and the
demand is elastic. If the price can change a lot without really affecting the
quantity demanded, we say that demand is unresponsive (or insensitive)
to the change in price and demand for that product is inelastic.
Demand is elastic if the elasticity is more negative than 1.
Demand is inelastic if the price elasticity lies between 1 and 0.
This is represented in the sketch below:
inelastic
elastic
Figure 3.1: Defining elastic and inelastic demand.
When PED=0 demand is said to be perfectly inelastic and when PED=

we say demand is perfectly elastic.
While economists often discuss the absolute value of the elasticity (so if this
is between zero and 1, demand is said to be inelastic, and if it is greater than
1, demand is said to be elastic) we recommend you not to lose track of the
sign of the elasticity. As we shall see below for other elasticities (cross-price
elasticity, income elasticity), the sign has important implications. Nonetheless,
you will often see positive numbers for own-price demand elasticities this is
a shorthand and does not necessarily imply that the law of demand has been
violated.
The Greek letter eta () is often used to denote elasticity. For example, = 0
means that the price elasticity of demand is equal to zero and quantity
demanded will not change at all in response to a change in price.
Activity SG3.1
Consider your own buying habits. Rank the items below in terms of how responsive your
demand for these goods is to a change in their price:
Product
A nice pair of trousers
Rice
Bananas
Medicine
Holidays abroad
36
Rank of responsiveness
Block 3: Elasticity
BVFD: read Maths 4.1 and Maths 4.2.

There are various ways of calculating elasticity. Arc elasticity (Maths 4.1)
is used to find the elasticity between two different points of a demand
curve, in such a way that it is equal whether you analyse the change in
price as an increase or a decrease.
Point elasticity, on the other hand, describes the elasticity at a certain point
on the demand curve. Maths 4.2 on point elasticity uses calculus, however,
it also explains that the derivative of the direct demand function gives
the slope of the direct demand function at a given point. If the function is
Q
linear, the slope is constant for the whole curve, and corresponds to P in
the PED
formula above. The slope of a curve is straightforward and something you
can easily use without any knowledge of calculus.
One thing to be careful of is whether you are using the direct or the
inverse demand function (remember Block 2). For an inverse demand
function, use the inverse of the slope. For a direct demand function, you
can use the slope directly. That should be easy to remember!
That means that for an indirect demand function, the point elasticity is:
PED = 1/s * (P/Q), where s is the slope. For example: P = 20 Q/2 is an
indirect (or inverse) demand function. The slope of this is dP/dQ = 1/2.
In this case, you would use PED = (1/0.5) *(P/Q) = 2*(P/Q).
On the other hand, Q = 40 2P is a direct demand function. The slope of
this is dQ/dP = 2. (To check that the slope of the direct demand function
is equal
Q
P
-10
5
Q
P
to note that if P = 5, Q = 30. If P = 10, Q = 20. Therefore
= 2). In this case you would use PED = 2*(P/Q).
If you want to express the elasticity as a positive number, you will need to
use the absolute value (or just multiply the negative number by the minus
one, which is the same thing).
Activity SG3.2
Part A: Calculating an arc elasticity
Given the following information, calculate the elasticity of demand for the following
goods, expressing the elasticities as positive numbers
Initial Price and Quantity
New Price and Quantity
Good A
Good B
Good C
Good D
P0 = 4
P0 = 4
P0 = 5
P0 = 12
Q0 = 10
Q0 = 10
Q0 = 4
Q0 = 13
P1 = 5
P1 = 5
P1 = 2
P1 = 11
Q1 = 7
Q1 = 9
Q1 = 10
Q1 = 15
PED: value
PED: category
37
Part B: Calculating a point elasticity

Given the following information, calculate the elasticity of demand for the following
goods, expressing the elasticities as positive numbers:
PED = 1/s * (P/Q)
Slope = ____
Price
20
At X, PED =
At Y, PED =
16
At Z, PED =
Y
10
20
30
40
Quantity
Figure 3.2: Calculating point elasticities on a demand curve.
BVFD: read sections 4.24.4 and cases 4.1 and 4.2.

Activity SG3.3
The following table identifies some factors which act as determinants of demand
elasticity. Fill in the fourth column, which has been left blank, with a concrete example.
38
Factor
Example
Effect on demand elasticity
Necessity
People depend on
this
Demand is inelastic
Substitutes
There are many

similar products
available
Demand is elastic
Definition
Good defined very

narrowly
More elastic (because

there are more possible
substitutes)
Time-span
Tastes change/more
drastic adjustments
become feasible
Demand becomes more

elastic
The share of
your budget
Small items
Demand is inelastic
Good/Service
Block 3: Elasticity
Activity SG3.4
Use the boxes below to draw demand curves appropriate to each heading:
Perfectly elastic demand
Perfectly inelastic demand
=
Activity SG3.5
Total spending is the same as the firms revenue. Use the data below to decide, if you
were a manager, whether or not to make the price change in the following cases (you can
ignore costs for the purposes of this activity and just assume that an increase in revenue
is a good thing and a decrease in revenue is bad). For each case, calculate the demand
elasticity (using the arc method), decide whether or not to make the change, and then
check your answer by calculating total revenue before and after the price change.
a. Increasing the price from 6 to 7 will lead to a fall in sales from 10,000 to 8,000.
b. Increasing the price from 8 to 10 will lead to a fall in sales from 15,000 to 12,500.
c. Decreasing the price from 20 to 18 will lead to an increase in sales from 6,000 to
8,000.
This activity emphasises the relationship between elasticity and total
revenue. This is clearly explained in the textbook, but if you are not afraid
of a bit of algebra we can derive a useful formula linking the two:
TR = P * Q
TR QP + PQ
(This approximation depends on P and Q being small so that the
product PP is very small, or what is know as second order small)
Dividing by P
TR
P
but the second term is Q times PED so
TR
P
=Q+P
Q
P
= Q (1 + PED)
Remember that PED is negative and P is positive for a price increase and
negative for a price decrease. So, for example if demand is elastic, say 2,
and price falls, then the sign of TR is positive. If it is inelastic, say 0.3,
and price falls, then the sign of TR is negative.
Cross-price elasticity of demand

In Block 2, we discussed how a change in own-price leads to a movement
along the demand curve, while a change in the price of a related good
leads to a shift in the demand curve. An increase in the price of a
substitute good will shift the demand curve to the right; an increase in the
price of a complement will shift the demand curve to the left. Section 4.5
39
discusses the responsiveness of quantity demanded of a good (lets call this

good i) to a change in the price of a related good (which we can call good
j) this is known as cross-price elasticity of demand. The formulas
for calculating this are the same as for own-price elasticities, except that
you will use the original and new price of good j, and the original and
new quantity of good i. For example, using delta notation the cross-price
elasticity for good i with respect to the price of good j is:
Qi
Pj
Pj
Qi
Unlike the case of a downward sloping demand curve where PED was
always negative, the cross-price elasticity can be positive or negative
depending on how the goods are related in consumption (whether they
are substitutes or complements). The cross-price elasticity of demand is
negative for complements and positive for substitutes. If the price of good i
increases, people will demand less of good j if it is a complement to good i,
and more of good j if it is a substitute for good i. What would be the value
of the cross-price elasticity between two goods if they were completely
unrelated?
Activity SG3.6
Multiple choice question
A Bordurian lawyer explains: Smoking is a Bordurian tradition. If you had coffee, you had
cigarettes; if you had cigarettes, you had coffee. According to this statement, the cross-price
elasticity of the demand for coffee with respect to the price of cigarettes in Borduria is:
a. positive
b. negative
c. zero.
Income elasticity of demand

Activity SG3.7
Classify the following goods, based on their (hypothetical) income elasticity:
Good
Income elasticity
Car
2.98
Food
0.5
Margarine
0.37
Vegetables
0.9
Public transportation
0.36
Books
1.44
Type of good
Would you expect income elasticities for given goods to be broadly similar in different
countries? For example, would you expect the income elasticity of demand for public
transport to be similar in the USA and in Mali? Think about why or why not.
The formula for calculating income elasticity of demand is:
Percentage change in quantity demanded of good X divided by the
percentage change in real consumers income.
Using the delta notation and letting Q represent quantity of the good
40
Block 3: Elasticity
demanded and M represent real consumer income, income elasticity of

demand (IED) is given by the formula:
Q
Price elasticity of supply

BVFD: read sections 4.7 and 4.8 as well as Maths 4.3.
Activity SG3.8
For the following direct supply function, calculate and interpret the PES when Q = 10
and P = 2.5.
Direct Supply Function: QS = 5 + 2P
PES =
Activity SG3.9
Initially, the price of a tennis racket is 20. Demand is 30 and supply is 50. If the price
falls by 5, the quantity demanded rises to 40, the quantity supplied rises to 40, and the
quantity demanded of white cotton t-shirts rises from 70 to 100. Using the arc method,
calculate the own-price demand elasticity and the elasticity of supply for tennis racquets;
and the cross-price demand elasticity for white cotton t-shirts. Are white cotton t-shirts a
complement or substitute to tennis racquets?
Own price elasticity =
Cross-price elasticity =
Elasticity of supply =
Substitute or complement?
BVFD: Examine Table 4.11 this provides a simple but helpful summary
of the chapter up to section 4.8.
Make sure that you also understand section 4.7 which brings together ownprice, cross-price and income elasticities with reference to inflation.
Incidence of a tax
The key point of this section is that the incidence of the tax is not related
to the person who physically pays the money to the government. Rather,
whichever party (consumers or producers) is less price sensitive (either in
demand or supply) will bear the greater share of the burden of the tax.1
Suppose demand were perfectly inelastic, how would the burden of a sales
tax be shared between consumers and producers?
It is important to realise that a sales tax drives a wedge between the price
paid by consumers (sometimes called the demand price) and the price
received by producers (the supply price). In a simple supply and demand
diagram in the absence of taxes these two prices are, of course, the same.
Another point to consider is why goods such as cigarettes and fuel are
taxed so heavily. This isnt only a question of improving health or reducing
pollution consider the PED of these goods and the implications for
government tax revenues of taxing goods such as these.
This is summed up in an
expression which holds
for small taxes, but which
we do not prove here:
PES
D
=
S

PED
In words, the ratio of
the change in the price
the consumer pays (the
demand price) to the
change in the price that
the producer receives
(the supply price) is
equal to the ratio of the
price elasticity of supply
to the price elasticity of
demand.
BVFD: read Maths 4.4.

41
Activity SG3.10
Lets put Maths box 4.4 into practice using a numerical example. If:
QD = 30 4P
QS = 6 + 8P
t = 0.375 where t is a specific tax that has to be paid by suppliers.
Calculate
i. the equilibrium quantities with and without the tax
ii. the increase in the price paid by consumers and the fall in consumer surplus
iii. the fall in the price received by suppliers and the fall in producer surplus
iv. the tax revenue received by the government
v. the deadweight loss of the tax.
Activity SG3.11
Multiple choice question
Here you see the football fans demand curve d for televised football matches together
with the Football Associations (FA) supply curve s for such matches. The market for
televised matches clears where the two curves cross, hence when 10 matches are
televised for 6 each. Suppose now that the Government introduces a tax of 4 per
televised match. The figure shows that the number of televised matches falls from 10 to
6. For these 6 matches fans pay 8 but the FA earns only 4 as the difference goes into
the governments coffers.
P
S
8
6
d
4
2
0
10
Games per year
Figure 3.3: Demand and supply of televised football matches.

As a result of the tax:
a. The welfare of fans increases and the welfare of the FA decreases.
b. The welfare of fans decreases and the welfare of the FA increases.
c. Both fans and the FA lose welfare but the government raises enough tax revenues to
compensate them.
d. Both fans and the FA lose welfare and the government does not raise enough tax
revenues to compensate them.
e. Both fans and the FA gain welfare.
42
Block 3: Elasticity
BVFD: read the summary and work through the Sample examination
questions.
Overview
This block describes the concept of elasticity, explores how to calculate
elasticities and discusses the implications. Conceptually, elasticity has to
do with responsiveness, usually how much demand or supply responds to
a change in price or income. You need to know how to calculate arc and
point elasticities. The type of elasticities you need to be familiar with are
as follows: own-price demand elasticity (elastic if more negative than 1,
unit elastic if 1, inelastic if between 1 and 0; though in practice these
are often expressed as positive numbers using the absolute value), crossprice demand elasticity (generally positive for substitutes and negative for
complements), income elasticity of demand (negative for inferior goods,
larger than 1 for luxury goods) and supply elasticity (positive since the
supply curve slopes upwards). Elasticity has implications for total spending
on a product (which from the companys perspective is simply revenue):
If demand is elastic, a fall in price leads to an increase in revenue. It also
has implications for tax incidence the more price insensitive side of the
market (be it buyers or sellers) will bear a greater burden of the tax.


1. If demand for pork is given by: QD = 200 6P + 2Y, when the price of
pork is 8, a rise in consumers income from 100 to 150 leads to:
a. a fall in demand and an income elasticity of 0.14, pork is an
inferior good
b. a rise in demand and an income elasticity of 0.14, pork is a normal
good and a necessity
c. a rise in demand and an income elasticity of 7.08, pork is a luxury
good
d. a fall in demand and an income elasticity of 7.08, pork is an
inferior good.
2. Suppose that a firm currently charges a price of 100 per unit and
at this price its total revenue is 70,000. Suppose also that at this
price, demand is elastic. Now the firm raises its price by 2 per unit.
Explaining your answer, state which of the following quantities the
firm might sell after the price increase
a. 300
b. 600
c. 900
d. 1,200.
43
3. In Cte dIvoire the own-price elasticity of demand for beef is 1.91. If

the price of beef rises by 10 per cent, the quantity demanded of beef:
a. rises by more than 10 per cent
b. falls by less than 10 per cent
c. falls by more than 10 per cent
d. rises by less than 10 per cent.
4. When price elasticity of demand is greater than unity (in absolute
value), revenue will:
a. increase with an increase in price
b. decrease with a fall in price.
c. decrease with an increase in price.
d. remain unchanged with any change in price.
5. An estimation of demand facing a particular firm produced the
following information with regard to the elasticities of the demand
function for x:
Own price: 2; income: 1.5; cross price, y: 0.8; cross price z: 3.
Where x, y and z are goods and M is income. Therefore:
Select one:
a. If the price of x rose, your sales would fall but your total revenues
would increase.
b. If the price of x fell, your sales would increase and so would your
total revenues.
c. If the price of x fell, your sales would increase but your revenues
would fall.
d. If the price of x rose, your sales would increase and so would your
revenues.
6. With reference to the same information as in question 5:
Select one:
a. Commodities x and z are complements while x and y are gross
substitutes.
b. Commodities x and z are complements and so are x and y.
c. Commodities x and z are gross substitutes and so are x and y.
d. Commodities x and z are gross substitutes but x and y are
complements.
Long-response question:
1. a. Discuss the meaning of elasticity and the various types. What
determines the price elasticity of demand for a certain good? Who
is likely to find this information useful?
b. Assume that the market demand for barley is given by:
Q=1,900 4PB + 0.1M + 2PW
Where Q is the quantity of barley demanded, PB is the price of
barley, M is income (say per capita income of consumers) and
PW is the price of wheat. The prices of wheat and barley are each
200 (say s per tonne) and M is 1,000. The slopes for barley
demand, wheat demand and income are 4, 2 and 0.1 respectively.
44
Block 3: Elasticity
Calculate the own price elasticity of demand, the income elasticity

of demand and the cross-price elasticity of the demand for barley
with respect to the price of wheat.
c. Calculate and illustrate graphically the impact on welfare of a
specific tax of 37.5p per unit to be paid by suppliers when QD = 30
4P and QS = 6 + 8P. How do the welfare implications change if
the tax is paid by consumers instead of suppliers?
2. Interpret the following elasticities for petrol:
Demand elasticity: 0.39
Income elasticity: 1.2
Supply elasticity: 0.7
a. Do there appear to be good substitutes for petrol in the preferences
of buyers?
b. Does petrol appear to be a luxury or a necessity in the preferences
of buyers?
c. Do firms appear to have excess capacity in the petrol industry?
45
Notes
46
Block 4: Consumer choice

Introduction
This block introduces another two fundamental concepts in
microeconomics: indifference curves and the budget constraint. Indifference
curves illustrate a consumers preferences, while the budget constraint
shows what it is possible for them to consume, given a limited budget and
the prices they face. Put together, these concepts are used to determine the
consumers consumption decisions. In this way, we can see how the demand
curves you learned about in Block 2 are derived.
After studying the demand curve in Block 2, it is important to realise that
this curve is the direct result of the assumptions of rationality and individual
decision making as discussed in Block 1. This block, on consumer choice,
draws on the idea of opportunity cost as well as individual preferences to
derive the demand curve.
You will need a good understanding of the intuition behind the models
in this block. It is important that you gain a good grasp of them, because
we use an equivalent set of concepts in analysing how firms make their
production decisions (Block 5), and they are also used to determine
households labour supply (Block 10). As well as this, you will also need
to practise drawing the graphs in this chapter, since they will help to
understand the concepts, and since you may need to be able to reproduce
them for your exam. In particular, practise drawing the income and
substitution effects for normal and inferior goods, since many of the key
concepts are summarised in these graphs.
Learning outcomes
define the relationship between utility and tastes for a consumer
describe the concept of diminishing marginal utility
describe the concept of diminishing marginal rate of substitution and
calculate the marginal rate of substitution (MRS)
represent tastes as indifference curves
derive a budget line
explain how indifference curves and budget constraints explain
consumer choice
describe how changes in consumer income affect quantity demanded
describe how a price change affects quantity demanded
define income and substitution effects
show how the market demand curve relates to the demand curves of
individual consumers.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 5 including the appendix.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 3; UK edition, Chapter 4.
47

The chapter starts by introducing the concept of utility, and the
assumptions that are commonly made by economists about utility. It then
explains indifference curves and the budget constraint and shows how
these are combined to determine the consumers choices. The impact of
changes in the consumers income and changes in price are examined in
detail, including the decomposition of the effects of price changes into
income and substitution effects. The chapter also demonstrates how
these ideas are used to derive the individual demand curve, and then the
market demand curve. The relationship to elasticity, particularly crossprice elasticity, is also discussed. Finally, the chapter explores whether the
consumer benefits more from cash transfers or transfers in kind.
Consumer choice and demand decisions

BVFD: read section 5.1 and concepts 5.1 and 5.2 of Chapter 5.
Utility
The concept of utility was introduced by Jeremy Bentham, in his 1789
book Principles of morals and legislation. He defined it as follows: By utility
is meant that property in any object, whereby it tends to produce benefit,
advantage, pleasure, good, or happiness, (all this in the present case comes
to the same thing) or (what comes again to the same thing) to prevent the
happening of mischief, pain, evil, or unhappiness to the party whose interest
is considered. The philosophy of utilitarianism (the greatest happiness
principle) was invented by Bentham and has been very influential. The
textbook defines utility much more simply as the satisfaction consumers
get from consuming goods (p.84). As you can read in the appendix to
Chapter 5, in the 19th century, economists believed that utility levels could
be measured, and used a unit of measurement called utils. Nowadays,
economists assume that utility is not measurable in this way, however, utility
is still a useful concept that underlies much of microeconomics.
Marginal utility
As discussed in Block 1, consumers and firms make decisions at the
margin. This idea is very important in relation to utility. The marginal
utility of a good or service is the extra utility a person gains from
consuming one more unit of that good or service.
Activity SG4.1
Linking the shape of the indifference curves to the assumptions regarding consumer tastes.
The various assumptions that lie behind indifference curves are reflected in certain
aspects of the shape of the curve. Match the assumption to the characteristic of the curve
and explain why.
Diminishing marginal rate of substitution
Lines never cross
Consumers prefer more to less

(non-satiation)
Any bundle is on some

indifference curve
Completeness
Indifference curves convex to the

origin (ICs look like smiles when
seen from the origin)
Transitivity
Downward sloping
The meaning and representation of preferences and hence the assumptions behind
indifference curves are discussed in detail in AW section 2.2.2.
48
The slope of the indifference curve is the marginal rate of

substitution
The marginal rate of substitution (MRS) between two goods, as you know
from the definition on p.86, measures the quantity of a good the consumer
must sacrifice to increase the quantity of the other good by one unit
without changing total utility. On p.88, in the paragraph discussing how
the slope of a typical indifference curve gets steadily flatter as we move to
the right, there is an important gem of information: The marginal rate of
substitution is simply the slope of the indifference curve. On the graph
below, the tangent T shows the slope of the indifference curve and the
MRS at point b.1
The figure and table below are analogous to L&C international edition:
Figure 3.2 and Table 3.2; UK edition: Figure 4.2 and Table 4.2, where
you can also find a good explanation of these concepts. The MRS is the
absolute value of the ratio of the change in clothing to the change in food.
Since these two changes always have opposite signs, the MRS (slope of an
indifference curve) is obtained by multiplying C/F by 1.
35
a
30
Clothing
1
Some textbooks define
the MRS as the slope of
the indifference curve,
that is as a negative
quantity, others as the
absolute value of the
slope (i.e. as a positive
quantity). This is simply
a matter of convention
and it doesnt matter
which convention is
followed, as long as one
is consistent.
25
20
15
10
5
0
10 15 20 25 30 35
Food
Figure 4.1: The marginal rate of substitution is the slope of the indifference
curve.
Movement Change in clothing Change in food Marginal rate of substitution

From a to b
12
(12/5)*1 = 2.4
From b to c
(5/5)*1 = 1.0
From c to d
(3/5)*1 = 0.6
From d to e
(2/5) * 1 = 0.4
From e to f
(1/5) * 1 = 0.2
Table 4.1
You should remember from Block 3 that (delta) means change.

Examining the movement from a to b and b to c etc. gives us a good
approximation of the slope of various sections of the curve. An even more
accurate way is to examine the change in utility due to a one unit change
in either of the goods: this gives us the marginal utility of each good at
a point on the curve. In fact, the MRS is given by MUC/MUF, (i.e. the
marginal utility of clothing at a certain point on the indifference curve,
divided by the marginal utility of food at that point, multiplied by 1).
We will come back to this again at the end of the block (as it is covered in
more detail in the third part of the appendix and Maths A5.1).
49
Figure 5.5 on p.90 of BVFD also helps to illustrate this idea, showing
indifference curves for people with different tastes. The glutton is more
willing to substitute films for food than the weight-watching film buff and
has a higher MRS. Drawing a tangent to any part of their indifference
curves shows that the slope of the gluttons indifference curve is steeper
reflecting his higher MRS between meals and films.
The slope of a typical indifference curve gets steadily flatter as we move to
the right, reflecting a diminishing marginal rate of substitution.
Clothing
For example:
Food
Figure 4.2: Changes in the slope of an indifference curve reflect a diminishing
marginal rate of substitution.
The slope of the tangent A shows the MRS of food for clothing at point a.
Similarly, the slope of the tangent B shows the MRS at point b. We can see
that the slope flattens as we move from a to b, reflecting a diminishing
MRS. At point a, the person has quite a lot of clothing and is willing to
substitute a fair bit of this for a certain amount of food. At point b, the
person has much less clothing but quite a lot of food and is only willing
to substitute a very small amount of clothing to gain the extra amount of
food. Going back to table 4.1, you can also see the diminishing MRS, as
the amount of clothing the person is willing to substitute for 5 additional
units of food continues to fall.
Activity SG4.2
Draw a map of indifference curves, marking out bundles and comparing them to each
other based on the following story: Mark likes jeans and cowboy boots. He is indifferent
between a bundle with 3 pairs of jeans and 2 pairs of cowboy boots (bundle A) and
a bundle with 2 pairs of jeans and 4 pairs of cowboy boots (bundle B). However, he
would prefer to have a bundle with 4 pairs of jeans and 5 pairs of cowboy boots (bundle
C). He is also indifferent between a bundle with 2 pairs of jeans and 1 pair of cowboy
boots (bundle D) and a bundle of 1 pair of jeans and 3 pairs of cowboy boots (bundle
E), although these last two options are his least preferred options. How do you think he
would feel about a bundle with 3 pairs of jeans and 3 pairs of cowboy boots?
Remember:
An indifference curve shows all the consumption bundles yielding a particular level of
utility.
Any point on a higher indifference curve is preferred to any point on a lower
indifference curve.
50
Indifference map
Budget constraint
Activity SG4.3
The slope depends only on the relative prices of the two goods. Draw budget constraints
for the following three price combinations, assuming a total income of 120.
A:
PX = 12
PY = 20
B:
PX = 10
PY = 20
C:
PX = 12
PY = 15
What is the interpretation of the slope of the budget constraint? It

represents the rate at which the consumer can substitute good x for good
y in the market, or the opportunity cost of x in terms of y. To see this,
suppose the consumer wishes to consume a little more x, x. This will
cost her xPx. Assuming she was spending all her income on x and y (on
her budget line) then she will have to reduce her expenditure on y by the
same amount. So xPx=-yPy, (i.e. the slope y/x=Px/Py).
You should be familiar with the general form of the budget constraint used
in this section, (i.e. where pX is the price of good X, pY the price of good Y, x
the quantity of good X, y the quantity of good Y and M the money income
available to the consumer). Note that the first term on the left-hand side
of this equation is the consumers expenditure on X and the second term
is expenditure on Y. Since we assume that the consumer spends all her
income on these two goods, the amount spent on the two goods sums up
to M which is her income. One important point from this Maths box is that
the slope of the budget constraint is given by pX /pY i.e. the price ratio.
51
The figure in this Maths box shows how you can represent a general case,
where you dont have specific quantities and prices. The intercepts will
then be M/PY and M/PX respectively. This is likely to be how you will draw
a budget constraint most often.
Utility maximisation and choice

Indifference curves and the budget constraint together indicate the
choice a consumer will make to maximise their satisfaction. This can be
represented by the following diagram:
Step 1
Step 2
Preferences
(What the individual wants to do)
Budget Constraint
(What the individual can do)
Step 3
Decision
(Taking constraints into account, the individual attempts
to reach the highest level of satisfaction)
Figure 4.3: Consumer choice and the decision rule.
Decision rule
The point which maximises utility is the point at which the consumer
reaches the highest indifference curve that the budget constraint allows.
For the standard indifference curves we have been looking at, this
decision rule says that the consumer should choose the consumption
bundle where the slope of the budget line and the slope of the indifference
curve coincide. In other words, it is the point at which the indifference
curve is tangent to the budget constraint.
BVFD: read the first part of the appendix for Chapter 5 of, the material in
the appendix applies whether or not utility can actually be measured.
We can describe the consumers optimal decision using equations as
follows: At the chosen bundle, the marginal rate of substitution between
the two goods must equal their relative price, i.e. MRS =MUx/MUy =Px/
Py . Rearranging this gives MUX/PX= MUY/PY .
We can also describe their decision graphically, as follows: The consumer
choses the bundle where the indifference curve is tangent to their budget
constraint. The slope of the indifference curve (MRS = MUx/MUy) and
the slope of the budget constraint (Px/Py )must be equal. The tangency
thus implies MUx/MUy = Px/Py . Rearranging this gives MUX/PX=MUY/PY.
52
Good Y
M/Py
b
u0
M/Px Good X
Figure 4.4: A budget constraint and an indifference curve.
MUX/PX=MUY/PY has the intuitive interpretation that the marginal utility

derived from the last pound spent on X must be equal to the marginal
utility of the last pound spent on Y. Otherwise the consumer would adjust
their consumption pattern and increase their utility.
Imagine that MUX/PX > MUY/PY. This implies that the consumer derives
more utility from the last pound spent on good X than the last pound spent
on good Y. In this case, by consuming one pound more of good X and one
pound less of good Y, they can increase their utility level without spending
any more money. The consumer should continue to adjust their spending
in this way until MUX/PX=MUY/PY.
It is important to understand the intuitive explanation of the consumers
decision, as well as being familiar with the relevant equations and graphs.
Activity SG4.4
Jeremy has M and wants to buy some combination of books and shoes. Books cost PB
each and shoes cost PS per pair. Both of these goods are normal goods to him. Describe
graphically and in equations how he will decide on an optimal combination of the two
goods which will maximise his total utility. What is the intuition behind this?
53
Activity SG4.5
Draw budget constraints and possible indifference curves for the following scenario:
Susan buys cabbages and carrots. Cabbages cost 1 per kilo and carrots cost 0.80 per
kilo. Her income falls from 20 to 16. Carrots are a normal good, but cabbages are an
inferior good.
BVFD: read section 5.3 and cases 5.1 and 5.2.

Activity SG4.6
Page 98 contains a suggestion of two diagrams you should draw to check your
understanding, complete this in the boxes below:
A fall in the price of meals
An increase in the price of films
Income and price changes

Substitution and income effects
Decomposing the effects of a price change into income and substitution
effects is an important piece of economic analysis with many real world
applications. Case 5.1 shows one such application; others relate to the
effects of changes in wages on labour supply and changes in interest rates
on savings decisions. Remember:
The substitution effect is always negative.
The income effect is negative for normal goods and positive for inferior
goods.
For normal goods, the income and substitution effects reinforce each
other.
54
For inferior goods, the income and substitution effects work in

opposite directions.
For inferior goods, if the income effect dominates the substitution
effect, the good is called a Giffen good (in practice, these are very
rare).
Activity SG4.7
For a choice between Good X and Good Y, complete the graphs below, clearly indicating the
income and substitution effects in each case. You will find figures 5.14 and 5.16 helpful for
this activity, and you might want to repeat it a few times on a separate sheet of paper until
you are really comfortable with these concepts. The following order is generally best:
1. Draw the original budget line and indifference curve.
2. Draw the new budget line.
3. Draw the hypothetical budget line parallel to the new budget line and tangent to the
original indifference curve. This gives you the substitution effect.
4. Draw the new indifference curve (where you place this depends on what type of good it
is). This gives you the income effect.
Normal goods, price of X rises
Inferior good, price of X rises
Normal goods, price of X falls
Inferior good, price of X falls
NB: The method used in the textbook and in this activity to break a price change into
income and substitution effects follows an approach suggested by the economist John Hicks
and the effects are known as the Hicksian substitution and income effects. There is also an
alternative approach following the economist Eugen Slutsky. If you are interested to know
more about this, it is explained in AW 2.3.1. However, you are only required to know the
Hicksian approach (as in BVFD) for this course.
55
Deriving demand: The individual demand curve

In Block 2 we introduced demand and supply and learned about the
demand curve. Now we are able to derive the individual demand curve
from the choices of consumers.
Activity SG4.8
Derive the individual demand curve from the information in figure A. Can you now explain
why the demand curve is downward sloping?
Sunglasses
A
(Price per sandwich = p1)
e1
e2
e3
e4
Price-consumption curve
x1 x2 x3 x4
Sandwiches
Price per Sandwich
Sandwiches
Figure 4.5: Deriving the individual demand curve.

BVFD: read the second part of the appendix: deriving demand curves.
This explains why, for normal goods, a fall in price leads to an increase in quantity
demanded, due to both substitution and income effects.
Demand curves and consumer surplus

We have now shown the theoretical underpinnings of a downward sloping
demand curve. In particular we have gone beyond general statements such
as at lower prices existing consumers want to purchase more and new
consumers enter the market and shown that at each point on the demand
MU
curve consumers are maximising their utility by equating their MRS ( MU )
P
with the relative price ( P ) where x is the good on the horizontal axis and
y the good on the vertical axis. This enables us to give further intuition to
the price at any given quantity and to the whole demand curve.
x
56
To do this, we can put some numbers on a given utility maximising point

corresponding to a set of prices for x and y and a given income. For
example, let Px = 4, Py = 2 and income = 40. This is shown on the
diagram below. This diagram shows the consumers utility maximising
combination of x and y (x1, y1) at A in the upper panel and the demand
for x at Px = 4, Py = 2, M = 40 in the lower panel. How much is an
extra unit of x worth to the consumer at A/? At A, due to the tangency,
MRS = 2. This means our consumer would give up 2 units of y in order
to have another unit of x that is the meaning of MRS = 2; one unit of
x has the same value to her as 2 units of y. Since y costs 2 per unit, two
units of y are worth 4, an extra unit of x must also be worth 4 as an
extra unit of x is worth the same as two units of y at A. Another way of
saying this is that at A and A/ the consumers willingness to pay for
another unit of x is 4. So price can be interpreted as the willingness to
pay for an extra unit of the good, given income and prices of other goods.
Similarly, the demand curve can be interpreted as a willingness to pay
curve (its downward slope implying that the more x the consumer has, the
lower her willingness to pay for an extra unit). Although we do not do the
mathematics here, you can see intuitively that because price at a given x
represents the willingness to pay for a marginal unit of x, the area under
the demand curve up to that level of x shows the total willingness to
pay for that amount (the sum of the willingness to pay for each separate
unit). This also makes it easier to see that the consumer surplus (a concept
introduced in Block 2) at any given price and quantity is the difference
between the total willingness to pay for that amount minus what is
actually paid the prevailing price times the quantity.
y
20
y1
At A, MRS = Px/Py = 4/2 = 2
A
Indifference curve
x1
10
Px
A/
Demand curve for x
x1
Figure 4.6: Willingness to pay and consumer surplus.

57
Deriving demand: The market demand curve

The market demand curve is the horizontal addition of the demand curves
of all the individuals in that market. In the following activity we assume
that there are only three consumers, but the method can be applied to
much larger numbers; in such cases kinks in the market demand curve
would tend to be smoothed out.
Activity SG4.9
Consumer 3
12
12
12
12
2 4 6
5 10
Figure 4.7: Deriving the market demand curve.
Complements and substitutes

BVFD: read section 5.5 of and the part of 5.3 which addresses cross-
price elasticities of demand.
The section on complements and substitutes (section 5.5) introduces the
fact that goods are not always substitutes for each other, but may in fact be
complements. This means that if the demand for a good rises, the demand
for other complementary goods will rise as well.
You will remember from Block 3 that cross-price elasticities are negative
when two goods are complements and positive when two goods are
substitutes. The section on cross-price elasticities (in section 5.3) details
three factors which impact on income and substitution effects and can
make the cross-price elasticity for good Y either positive or negative
(responding to a change in the price of good X). These are: whether the
two goods are good substitutes for each other; the income elasticity of
demand of good Y; and good Ys share of the consumers total budget.
This section also shows that not all indifference curves are convex to the
origin as in Figures 5.2 and 5.3 of BVFD. How well the two goods can
be substituted for each other is reflected in the shape of the indifference
curves as follows:
Figure 5.20, LHS perfect substitutes indifference curves are straight
lines full substitution from one to the other if the price of one good
falls below the price of the other good.
Figure 5.18 good substitutes indifference curves are quite flat
large substitution effect of a price change.
Figure 5.17 poor substitutes indifference curves are very curved
small substitution effect of a price change.
58
PRICE
Consumer 2
PRICE
Consumer 1
PRICE
PRICE
Complete the fourth graph, showing the market demand curve. Why might the three
consumers have different demand curves?
Market demand
Figure 5.20, RHS perfect complements indifference curves are

perpendicular lines no substitution effect of a price change, the
consumer will consume more (or less) of both in the same proportion.
Activity SG4.10
Draw the indifference curves for perfect complements together with a budget line. Now
draw a new budget line for a change in the price of one of the goods. Indicate the income
and substitution effects (if any) of the price change.
Perfect complements
Activity SG4.11
Barbara likes peanut butter and jam together on her sandwiches. However, Barbara is very
particular about the proportions of peanut butter and jam. Specifically, Barbara likes 2
scoops of jam with each scoop of peanut butter. The cost of scoops of peanut butter and
jam are 50p and 20p, respectively. Barbara has 9 each week to spend on peanut butter
and jam. (You can assume that Barbaras mother provides the bread for the sandwiches.)
If Barbara is maximising her utility subject to her budget constraint, how many scoops of
peanut butter and jam should she buy?
Activity SG4.12
Suppose that a consumer considers coffee and tea to be perfect substitutes, but he requires two
cups of tea to give up one cup of coffee. This consumers budget constraint can be written as 3C
+ T = 10. What is this consumers optimal consumption bundle?
Cash transfers versus transfers in kind

Figure 4.8 below replicates Figure 5.21 from the textbook, but includes
indifference curves for the case where the consumer starts at e. If the
consumer receives a cash transfer, they may move to point c, where their
utility level is indicated by the curve u1. However, if they receive food
stamps (a transfer in kind), they cannot choose point c, and may move
instead to the feasible point B. At point B, their utility level is indicated by
the curve u0. This is clearly lower than the utility level the consumer could
have reached with a cash transfer. Furthermore, point B is not a tangency
solution: the slope of the indifference curve is not equal to the slope of the
budget constraint. This shows that non-tangency solutions may sometimes
arise from government policy, and also reaffirms the conclusion made
by the textbook: In so far as people can judge their own self-interest
people are better off, or at least no worse off, if they get transfers in cash
rather than transfers in kind (p.108).
59
Films
c
A
u1
u0
Food
Figure 4.8: Transfers in cash and in kind. Figure adapted by author from BVFD.
BVFD: read Appendix part 3 and Maths A5.1.

The section of the appendix entitled ordinal utility and indifference
curves introduces utility functions. As is written, although no one
really knows anyones utility function for any good, expressing utility
numerically through a utility function can be very useful. The maths
box shows how marginal utility can be found using the delta notation
or calculus. If you are familiar with calculus, you may find this makes
marginal analysis much easier. However, it is also possible to use the delta
notation to find marginal utility, or else this will be given to you, as per the
activity below.
Activity SG4.13
Calculate the optimal quantity of each of two goods (x and y) and the consumers total
utility given px = 1, py = 2, M = 80, and U(x,y) = xy, where MUx = y and MUy = x. How
would you represent this graphically?
BVFD: read the summary and work through the review questions in
Chapter 5.
Overview
This block started by introducing utility and indifference curves, as
well as the budget constraint. Indifference curves represent consumer
tastes, while the budget constraint shows the possibilities open to the
consumer, given their limited budget. Putting these together, we learned
the decision rule that determines consumer choice, under the assumption
that consumers maximise utility. In particular, we saw that consumers
will chose the bundle of goods such that MUX/PX = MUY/PY. Expressed
graphically, this means that the highest reachable indifference curve is
tangent to the budget constraint. We then explored how their choices are
affected by changes in income and prices, looking in particular at income
and substitution effects of a price change. This helped us identify normal
and inferior (and Giffen) goods. We also further examined complements
and substitutes. Understanding how consumers make choices lets us see
what lies behind the individual and market demand curves. Finally, the
analysis of budget constraints and indifference curves also made it possible
to evaluate the relative benefits of cash transfers versus transfers in kind.
60
Reminder of your learning outcomes

be sure that they have been achieved

1. The price of car transport is 30 cents per mile. The price of bus
transport is 60 cents per mile. The marginal utility of Marios last mile
of car transportation is 80 utils, and the marginal utility of his last mile
of bus transportation is 150 utils. Hence:
a. Mario is currently maximising his utility.
b. Mario could increase his utility by decreasing his consumption of
car transportation.
c. Mario could increase his utility by increasing his consumption of
car transportation.
2. If an agent has a utility function of the form u(x,y)=xy then:
a. They will be indifferent between (6,4) and (3,8).
b. They will prefer (6,4) over (5,5).
c. They will be indifferent between (6,4) and (5,5).
d. None of the above.
3. The slope of the demand for an inferior good is steeper than that of a
normal good because:
a. Income and substitution effects enhance each other.
b. Substitution effect for a normal good is greater than that of an
inferior good.
c. Income effect of a normal good is smaller in magnitude (absolute
value) than the income effect of an inferior good.
d. Income and substitution effects offset each other.
4. Judith spends all her money buying wine and cheese and wants to
maximise her utility from consuming these two goods. The marginal
utility of the last bottle of wine is 60, and the marginal utility of the
last block of cheese is 30. The price of wine is 3, and the price of
cheese is 2. Judith:
a. is buying wine and cheese in the utility-maximising amounts
b. should buy more wine and less cheese
c. should buy more cheese and less wine
d. is spending too much money on wine and cheese.
61
Long-response questions
1.a. Susan buys bread rolls and cheese. One bread roll costs 1 and
cheese costs 3 per 500g block. Susan has 12 income to spend on
bread and cheese.
i. Draw Susans budget constraint and a possible indifference
curve. Explain the assumptions behind the shape of the
indifference curve you have drawn.
ii. If the price of bread falls to 0.80 per loaf, how will this affect
her purchases? Answer in words and graphically, clearly
indicating income and substitution effects of the price change.
iii. If Susan only enjoys bread and cheese when she has 500g of
cheese for every bread roll that she eats, draw her indifference
curves. How much bread and cheese should she buy to
maximise her utility? Assume Susan has 12, one bread roll
costs 0.80 and cheese costs 3 per 500g block.
b. Now lets assume that Susan grows 100 potatoes each year and
all of her income comes from selling them. She spends all of her
income each year consuming potatoes and other goods. For Susan,
potatoes are a Giffen good, in that if her income is fixed in some
way (i.e. ignoring the fact that she sells potatoes and just fixing her
income at some value) her consumption of potatoes will rise when
their price rises. The price of potatoes falls and she consumes more
potatoes. Taking into account the fact that her income actually
comes from selling potatoes, explain how the last statement can be
consistent with those that precede it.
2. I consume two goods, ice cream and biscuits. I shop once a week,
spending 100, at either Sainsbury or Tesco (two well-known UK
supermarkets). Interestingly, Ive noticed that the bundle I purchase
when I visit Tesco costs more at Sainsbury. Similarly, the bundle I
purchase when I visit Sainsbury costs more at Tesco. And yet, I find
that I get the same utility from shopping at either store (i.e. the
Sainsbury shopping bundle gives me the same utility as the Tesco
shopping bundle). Explain how it is possible for all of these statements
to be true. (Hint: draw a single indifference curve and have me
maximise utility given a 100 budget and different prices in the two
stores).
62
Block 5: The Firm I
Block 5: The Firm I

Introduction
The two most important concepts in microeconomics are demand and
supply. In the previous block, we saw what lies behind the demand curve
and how this is driven by consumer preferences and the constraints
imposed by their budgets. In this and the following blocks, we will explore
what lies behind the supply curve. Basically, supply depends on the
technology available to firms, the cost of inputs, and the market structure
the firm operates in (e.g. the number of other sellers, which affects price
and revenue at each level of output). This block provides an introduction
to the analysis of the firm.
Many of the concepts introduced in this block are quite straightforward,
especially the early material in Chapter 6 of BVFD. Although you will need
to be familiar with this to have a context for the more detailed analysis, you
should concentrate your attention on the material from Chapter 7 (especially
the appendix) and the later parts of Chapter 6. Numerical examples are
provided in the block to help you calculate the firms optimal level of output.
You should also practise representing these concepts graphically.
Learning outcomes
distinguish between economic and accounting definitions of cost
describe the relationship between revenue, cost and profit
describe the production function
identify the point of diminishing marginal returns
demonstrate how the choice of production technique depends on input
prices
use isoquants and isocost curves to derive the firms total cost curve
calculate marginal cost and marginal revenue
find the profit maximising level of output, given the firms demand
curve and total cost curve.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 6; Chapter 7 sections
7.1, 7.2 and appendix.
Further reading
Chapter 5.

This block introduces the firm, including types of firms, the concept
of economic cost and how this differs from accounting cost, and the
arguments in favour of and against the frequently made assumption that
firms intend to maximise their profits. It examines why firms chose a
certain level of output, by firstly introducing the production function, as
well as isoquants and isocost curves (more on these later) and using them
63
to derive the firms total cost curve. It also shows how the demand curve
facing the firm can be used to derive the firms total revenue curve. Profit
is equal to revenue minus cost, thus through understanding the firms
revenue and costs, we can find the profit function. The block concludes by
introducing the concepts of marginal cost and marginal revenue. Providing
that it is profitable for the firm to operate at all, it will choose its level of
production such that marginal cost and marginal revenue are equal.
BVFD: read section 6.16.3, including concepts 6.1 and 6.2 and case 6.1.
Introduction to the firm

Section 6.1 outlines the most common forms of business enterprises: sole
traders, partnerships and limited liability companies. Section 6.2 discusses
a firms accounts. If you have taken any accounting courses, you will be
familiar with these concepts, though here they are approached from an
economic perspective. In particular, the discussion of accounting profit
versus economic profit and the concepts of zero economic profit and
supernormal profit are especially important to understand. Section 6.3
introduces the principal agent problem. These sections provide useful
background knowledge to the economic analysis of the firm.
Activity SG5.1
What is the economic cost of studying for an undergraduate degree?
The firms supply decision

Section 6.4 briefly discusses cost, revenue and profit. Since it is assumed
that firms behave so as to maximise their profits, profit is the key variable
in the analysis of the firm, and profit is equal to revenue minus cost:
Profit = Revenue Cost
Or in the notation frequently used in economics texts (including BVFD):
= TRTC
now total revenue is price per unit (P) multiplied by quantity sold (Q) so
we can write profit () as:
= P*QTC
This section of the textbook looks at these three elements quite briefly, but
using some of the material in Chapter 7 and some additional graphs, we
will explore them in somewhat greater detail. At the end of the paragraph
on cost minimisation is a footnote pointing to the appendix of Chapter 7.
We will work through the appendix in detail, as this will allow us to derive
the firms total cost function. However, first we need an introduction to
the production function this can be found in sections 7.1 and 7.2. After
working through some parts of Chapter 7 relating to cost, we will come
back to Chapter 6 to examine revenue and then use these two concepts
(cost and revenue) to find the firms profit function.
The production function

We begin with production. The hill-shaped structure depicted below is
the production set, the set of technically feasible combinations of output
64
Block 5: The Firm I
Output
Q, measured vertically, and inputs, K and L on the horizontal plane.

It includes all the area on the surface and in the interior of the hill. A
technically efficient production decision will be a point on the hill, while
points in the hill represent technically inefficient production decisions
in the sense that the input combination corresponding to the point is
capable of producing more output. The production function Q= f(K, L)
is only the surface (and not the interior) of the hill, and denotes the set
of technologically efficient points of the production set (i.e. for a given
combination of inputs, K and L, output Q is the maximum feasible output).
The contours of the hill (i.e. the cross-sections of the hill parallel to the
K-L plane) are comparable to the isoquants in the appendix of Chapter 7,
showing combinations of capital and labour that generate a given output.
The slope of the hill viewed from the origin represents returns to scale,
which will be explored in the next block. Note that the production function
as used by economists is a very simplified summary of the relationship
between inputs and output; an engineer setting up a production process
for mobile phones or motor cars (to use two examples from the textbook)
would have a much more detailed blueprint of the production process.
Q=f (K,L)
L
Figure 5.1: The production set.

The total output curve (also known as the total product curve), shown in
Figure 7.2 of the textbook, is a reduced form of the production function
for the short-run, when only one input is allowed to vary and the other is
held fixed. We can find this curve by slicing the hill in Figure SG5.1 above
vertically at the level K0. The reduced production function Q = (L, K0), is
thus a vertical section of the hill.
Activity SG5.2
Describe how the phrase too many cooks spoil the broth can demonstrate the law of
diminishing returns.
65
BVFD: read case 7.1 and Maths 7.1.

Activity SG5.3
Define the following terms and give a formula for (b) and (c):
a. total product
b. average product
c. marginal product.
Activity SG5.4
Complete the following table:
Quantity of
Labour (L)
Total Product
(TP)
Average Product
(AP)
Marginal Product
(MP)
129
480
1,053
1,800
2,625
3,456
4,116
4,608
4,968
10
5,250
11
5,445
12
5,580
The point where marginal product reaches a maximum is called the point of diminishing
marginal returns. At what quantity of labour does diminishing marginal returns set in?
Graph the Total Product curve in the upper section and the marginal and average product
curves in lower section of the boxes below:
66
Block 5: The Firm I
Isoquants and isocost lines

BVFD: read the appendix to Chapter 7.
The appendix to Chapter 7 starts with isoquants. iso (or using Greek
letters) is a Greek word which means equal. Isoquant means equal
quantity, isocost means equal cost. An isoquant is very similar to an
indifference curve while an indifference curve shows different
combinations of goods which generate a certain level of utility, an isoquant
shows different combinations of inputs which generate a certain output.
Read about isoquants on pp.16667.
Activity SG5.5
Based on the production function: Q(L, K) = L0.5 * K0.5 , where Q is output, L is
labour and K is capital, fill in the blanks below and draw isoquants for the three output
levels on a large graph on a separate piece of paper, or using scatter plots in Excel.
(NB: remember x 0.5 = x).
Output = 10
Labour
Capital
Output = 20
Labour
Capital
1
4
5
Labour
20
64
6.25
64
16
16
5
16
64
6.25
64
4
1
Capital
10
20
Output = 24
On the isoquant reflecting an output level of 10 units what is the MRS between labour
and capital when labour changes from 4 to 5 units?
To find the optimal combination of labour and capital, the second tool we
need to use is called the isocost line, the line showing all combinations of
labour and capital (these being our two inputs in the current example)
which generate the same total cost, given the prices of the two inputs
read about the isocost line on pp.16768. It is worth pointing out that
on p.167, the textbook uses the term cost function for the C=wL+rK.
However, this term is usually reserved for the equation showing cost as a
function of output, not input. Given that there are only two inputs, L and K
with prices w and r respectively C=wL+rK is an identity (something that is
always true) this is how we define total cost.
Activity SG5.6
If r = 2/hr and w = 12.50/hr, draw three isocost lines onto the diagram you created in
Activity SG5.4 for when cost is equal to 50; to 100; and to 150. What is the optimal
(i.e. the least-cost or cost-minimising) combination of labour and capital for an output
level of 10? What is the cost?
Equation A7 has an intuitive explanation, namely, that the firm must buy
resources such that the last pound spent on K adds the same amount of
output as the last pound spent on L. This can be easily seen by further
rearranging the equation such that:
r/w = MPK/MPL
r/MPK = w/MPL
(A7)

(A7b)
67
In the case of consumer choice, the budget line was fixed at the consumers
budget, and the consumer maximised their utility by choosing the
combination of goods which put them on the highest possible indifference
curve. For the firm, for a given level of output, the firm minimises cost by
choosing the combination of inputs that puts them on the lowest possible
isocost line. As such, the isoquants together with the isocost curve can be
used to derive the firms total cost function at different levels of output.
Read about this on p.168.
Activity SG5.7
Use the information below to draw isoquants and isocost lines and find four points on the
firms total cost curve.
Rental rate of capital = 2 per hour
Wage = 2 per hour
Cost levels: 12, 16, 20 and 24.
Output combinations:
Qx = 25
Qx = 50
Qx = 75
Qx = 100
Capital
Labour
Capital
Labour
Capital
Labour
Capital
Labour
10
10
10
10
10
11
What is the slope of the isocost lines?

What is the MRS at the points where the isoquants are tangent to the isocost lines?
What does this imply about the firms total cost curve?
Productive efficiency
The fact that the total cost curve shows the least-cost method of producing
each output level implies that the points on the long-run total cost curve
are productive efficient. It is important to note that every point on a firms
average total cost curve is, by definition, productive efficient not just the
minimum point. Productive efficiency occurs when a certain quantity of a
good is produced at the lowest possible input cost. Saying the same thing
in a different way productive efficiency means that the firm is obtaining
the maximum possible output from its inputs.
Activity SG5.8
A firm Sams Lamps has the production function Q(L, K) = L*K. Given labour of 5
and capital of 7, are they producing efficiently by producing 12 units? What level
of production is the productive efficient level? What reasons might there be for not
producing efficiently? Now suppose that Sams Lamps has decided to produce 100 lamps
and the price of labour is 5 per unit and the price of capital is also 5 per unit. The firm
decides to employ 50 units of capital and 10 units of labour. Is this efficient? Hint: with
this production function the marginal product of labour is equal to K and the marginal
product of capital is equal to L.
68
Block 5: The Firm I
Input price changes and input sustainability

The discussion of the effects of changes in the price of inputs (the wage
level or the rental price of capital) on p.169 is equivalent to the discussion
of the change in the price of goods for consumer choice. In that case, we
identified income and substitution effects of a price change here, we
identify output and substitution effects.
The shape of the isoquants reflects how easy or difficult it is to
substitute between inputs such as labour and capital. This is called the
substitutability of inputs. The two figures below display isoquants for
different production functions. Figure (a) reflects a production function
where there are only limited opportunities for input substitution. If labour
is increased significantly (in this example, eight-fold), capital can still
only be reduced by a small amount (5 units) for the level of production
to be maintained. On the other hand, figure (b) reflects a production
function with more abundant opportunities for input substitution if the
firm increases its employment of labour from 25 to 200, it can reduce its
employment of capital substantially, from 80 to 35.
K
80
40
35
25
Q = 50
35
200 L
(a) Production function with limited

input substitution opportunities
Q = 50
200 L
25
(b) Production function with abundant
input substitution opportunities
Figure 5.2: The shape of isoquants and opportunities for substitution.
Activity SG5.9
To produce a subject guide, one author and one computer are perfect complements in
production. One author and two computers would not be more productive. Two authors
is more productive but (probably) only if they each have a computer. Draw the relevant
isoquants for this case. Now imagine that there is a machine that does exactly the same
thing as a human in regards to the production of a certain good. Labour and capital will
be perfect substitutes in production in this case. Draw the relevant isoquants for when the
inputs are labour and this type of machine.
Profit = Total revenue Total cost

Now come back to section 6.4 of BVFD.
Having used isoquants and isocost lines to derive the total cost curve, we
can now come back to section 6.4. Table 6.3 on p.124 contains data for
a certain firm we can use this to graph the firms total cost function, as
follows:
69
Pounds
140
120
100
80
60
40
20
0
TC
10
Output
Figure 5.3: Total cost.
This curve shows how much it costs the firm to produce any output level
for given technology. It represents the total economic cost of production at
various levels of output.
The firm knows its total cost curve. We also assume it knows the demand
curve it faces. Knowing the demand curve, the firm can calculate the
revenue it would receive at various output levels and derive its total
revenue curve.
25
Price
20
15
10
5
0
10
Quantity
Figure 5.4: Demand curve.
140
120
TR
Pounds
100
80
60
40
20
0
0
5 6
Output
10
Figure 5.5: Total revenue.
For example, point X on the demand curve shows the firm will sell 7 units
of output at 15, generating revenue of 105. Point X on the total revenue
curve therefore shows the combination of 7 units of output and revenue of
105.
Putting the total cost and total revenue curves together allows us to find
the profit function (profit as a function of output). For example, when
total cost and total revenue are equal, profit is zero. At 6 units of output,
the gap between the two curves is greatest, and this is the highest point on
the profit curve, showing a profit of 27.
70
Pounds
Block 5: The Firm I
140
120
100
80
60
40
20
0
TC
TR
12
Output
10
Output
10 Profit 12
Profit
Pounds
140
120
100
80
60
40
20
0
20 0
Figure 5.6: Total cost, total revenue and profit.
BVFD: read section 6.5, section 6.6, Maths 6.1 and Maths 6.2.
Marginal analysis
Marginal analysis is one of the key analytical tools in economics. We
have already covered marginal utility in the previous block. This section
introduces marginal cost and marginal revenue. Marginal cost (MC) is the
change in total economic cost due to the production of one more unit of
output. Marginal revenue (MR) is the change in total revenue due to the
sale of one more unit of output. At the profit maximising level of output,
marginal cost and marginal revenue are equal.
Both maths boxes involve calculus, which helps to simplify the analysis.
You should work through these maths boxes to understand the principles
they are expounding.
Activity SG5.10
If the firm faces the demand curve: P = 25 2Q:
a. fill in the blanks in the table below
b. draw the marginal cost and marginal revenue curves
c. find the profit maximising output level for this firm. How much profit is the firm
earning at that point? Assume output must be in integers.
Output
Price
Total
revenue
Total
cost
23
34
42
49
Marginal
Revenue
Marginal
cost
Profit
71
55
65
78
93
110
10
130
Overview
As well as providing an introduction to the basic unit of production the
firm this block has demonstrated what lies behind the firms production
decisions. Using isoquants and isocost curves, the firm can determine the
least-cost combination of inputs to produce a given quantity of output. From
there, the firms total cost curve can be derived. It is assumed that firms
pursue a goal of profit maximisation, and one key point from this block is
that Profit = Revenue Cost. Knowing the demand curve it faces, the firm
can derive its revenue curve, and since it knows both revenue and cost, the
profit-maximising level of output can easily be found. At this level of output,
we have also seen in this block that marginal cost and marginal revenue
are equal. Marginal analysis is a very useful tool in economic analysis, as
we have seen here in the case of the firm. As the textbook also clarifies, the
economic analysis of the firm provides a useful model for understanding
firms behaviour it is not meant to be a practical system for real world
firms to follow, rather, it provides an analytical framework which helps
explain the behaviour of individual firms and the market as a whole.


1. Labour Productivity at Shakespeares Pies:
Number of workers
Output of pies
10
26
36
44
49
52
Note: Pies are sold competitively at 3 each. Labour is the only

variable input and costs 14 per worker. Capital costs are 80. These
are short-run and long-run costs and productivities (i.e. there is no
possibility of using different production techniques or combinations in
the long run).
Using the information above, which describes the number of pies
produced as a function of the number of workers at Shakespeares
Pies, and focusing just on the decision to hire workers (ignoring
the shut-down condition and just trying to pick the best number of
workers), Shakespeares Pies maximises its profit if it hires:
a. 1 worker
b. 3 workers
72
Block 5: The Firm I
c. 5 workers
d. 6 workers.
2. Anita owns a grocery shop. These are her annual revenues and costs:
Revenues 250,000
Supplies 25,000
Electricity and heating
6,000
Employees salaries
75,000
In addition to the above, Anita pays herself a salary of 80,000. If she

closed her shop she could rent out the land and building for 100,000.
Due to her experience at running her own shop the local supermarket
would offer her a job and pay her 95,000.
a. Anitas revenue exceeds her economic costs so she should continue
running her business.
b. Anitas economic costs exceed her accounting costs so she should
shut down her business.
c. Anitas economic costs exceed her revenue so she should shut
down her business.
d. Anitas salary is less than what the supermarket would pay so she
should shut down her business.
3. Choose the statement which is false:
When long-run costs for a firm are at a minimum
a. The ratio MPL/MPK = wage / rental.
b. MPL = MPK.
c. The extra output we get from the last dollar spent on an input
must be the same for all inputs.
d. The firms production is economically efficient.

1. a. What is an isoquant?
b. Why does an isoquant get flatter as you move towards the right?
c. Draw an isoquant and an isocost line which have a point of
tangency and indicate the productive efficient level of output. How
will this change if there is an increase in the wage level? Clearly
indicate output and substitution effects.
d. Use the following information to derive the total cost curve for Ice
Cream Inc. (indicating three points on the curve will be sufficient):
Production function: Q(K, L) = K*L
Rental rate of capital = 15 per hour
Wage = 15 per hour
73
2. a. Fill in the blanks in the table below

Q
TC
10
13
14
16
19
23
28
34
TR
MR
MC
Explain the difference between economists and accountants

definitions of profit. What assumption is required such that the
profit levels you calculated in the table above represent economic
profit?
b. What is the profit maximising level of output? What can you
say about the relationship between marginal cost and marginal
revenue at this point?
c. Draw a graph of a generic marginal cost schedule and a generic
marginal revenue schedule (not based on the figures above) and
indicate the profit maximising level of output.
d. Demonstrate graphically how a fall in the price of the raw
materials will affect the profit maximising level of output.
e. Demonstrate graphically how a fall in demand will affect the profit
maximising level of output.
74
Block 6: The Firm II

Introduction
As in Block 5, we assume that firms attempt to maximise profit and profit
is equal to revenue minus cost. This block extends the analysis of the
firms costs from total cost to fixed and variable costs, average costs as
well as marginal costs, and the relationships between all of these. While
the previous block looked at diminishing marginal returns (a short-run
concept), this block includes a discussion of increasing, constant and
decreasing returns to scale (a long-run concept). The following blocks will
provide more detail on the firms revenues, which are linked to the market
structure in which the firm operates. This current block shows how the
supply curves of individual firms are determined, while the following block
(Block 7) will continue this story by explaining how the market supply
curve is found (this depends on the number of firms in the market, which
is a crucial aspect of market structure the topic of Block 7).
Learning outcomes
identify fixed and variable factors in the short-run
analyse total, average and marginal cost, in the short-run and long-run
draw the relevant cost curves and explain why they have certain
shapes
define returns to scale and their relation to average cost curves
describe how a firm choses output, in the short-run and the long-run
describe the relationship between short-run cost and long-run cost.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 7, sections 3 to 9.
Further reading
Chapter 5.

The textbook chapter discusses production, costs and the output decision
in the short-run (where at least one factor of production is fixed), followed
by production, costs and the output decision in the long-run (where all
inputs are variable). There is also a more detailed discussion of returns to
scale. The chapter concludes by discussing the relationship between shortrun and long-run costs.
Cost, production and output

The first few sentences of this section state that the firms production
function can be translated into a relationship between cost of production
and output. In the jargon of economic theory there is a duality between
75
TP
increasing
marginal
returns
Output
Output
cost and production. We do not explore this duality rigorously; however,

it should be evident that when the costs of inputs are given to the firm,
then how much it costs to produce some level of output will depend on the
amount of inputs needed to produce that output and that the latter will
reflect the firms production function. The following diagram shows how
total and marginal product are related to total and marginal cost:
decreasing
marginal
returns
increasing
marginal
returns
costs
increase
at a
decreasing
rate
TC
costs
increase
at an
increasing
rate
MP
L
Cost
Cost
decreasing
marginal
returns
costs
increase
at a
decreasing
rate
MC
costs
increase
at an
increasing
rate
Figure 6.1: Relationships between total and marginal product and total and
marginal cost.
The top left figure shows the total product curve, which is initially
displaying increasing marginal returns and then displays decreasing
marginal returns after the dotted line. This is a mirror image of the total
cost curve depicted in the figure below it. When marginal returns are
increasing, costs are increasing at a decreasing rate, and vice versa. The
slope of the TP curve gives the marginal product, while the slope of the
TC curve gives marginal cost. The total product curve is also related to
the marginal product curve (top left figure). The marginal product curve
displays increasing marginal returns by increasing up to a maximum point,
and then falling when marginal returns are decreasing. The marginal
cost curve below is the mirror image of the marginal product curve
and demonstrates the rate of change of costs more explicitly it falls
when costs are increasing at a decreasing rate and rises when costs are
increasing at an increasing rate.
76
Activity SG6.1
This section introduces various cost curves practise these in the boxes below as
indicated:
STC, SVC, SFC
SATC, SAVC, SAFC, SMC
Activity SG 6.2
Why does the SMC curve cut the SAVC and SATC curves at their minimum points?
Provide an intuitive answer.
This maths box provides formulas for the various short-run costs based on
a short-run total cost function. You need to remember that:
Total cost = Fixed cost + Variable cost
Marginal cost is the change in total cost as quantity produced changes
Average costs are calculated by dividing the cost by the quantity
produced; this applies to average fixed cost, average variable cost and
average total cost.
Activity SG 6.3
Find the short-run fixed cost, variable cost, marginal cost, average fixed cost, average
variable cost and average total cost for the short-run total cost function STC = M + aQ2,
for which the first derivative is 2aQ.
short-run fixed cost
variable cost
marginal cost
average fixed cost
average variable cost
average total cost.
The output decision

BVFD: read section 7.4 and complete activity 7.1.
This section discusses how the firm chooses its level of output in the short
run. Two points are important: firstly, the firm chooses the output level
where marginal cost is equal to marginal revenue. Secondly, the firm
must check whether the price it receives at this output level enables it to
generate a profit, to cover all of its costs, to cover only its variable costs
and perhaps contribute a little towards the fixed costs, or not even cover
its variable costs. This will show the firm if it should produce at all in the
short run.
77
In this example, price is not necessarily equal to marginal revenue. In fact,

this will depend on the demand curve the firm faces. If the demand curve
is horizontal, marginal revenue will always equal price. If the demand
curve is downward sloping, the marginal revenue curve will also be
downward sloping, as in Figure 7.7, and price will be higher than marginal
revenue. Whether the demand curve is horizontal or downward sloping
depends on whether or not the firm is a price taker, passively accepting the
market price. We will come back to this in detail in the following blocks
where we examine perfect competition and pure monopoly two market
structures where the demand curves facing the firm are quite different.
It is important to note that: The firms short-run supply curve is its
marginal cost curve above the average variable cost curve. The
firm will supply the output at which SMC is equal to MR, provided that
price is not less than the firms SAVC.
Production, costs and output in the long run

We now move on to the long run, and will examine production, costs
and the output decision as we did for the short run. The contents of this
section should be familiar to you already because we covered the appendix
of Chapter 7 in the previous block and this material is a descriptive version
of what is in the appendix. Read through carefully and make sure you are
familiar with these ideas, including the concept of factor intensity.
Activity SG6.4
How does the switch in technique in the final sub-section of section 7.5 relate to the
analysis of a change in factor prices using isocost lines and isoquants (See Figure 7.A4)?
BVFD: read section 7.6
The U-shaped average cost curve is important to understand and is
discussed further in the following section. The relationship between
average and marginal costs is also important and applies both in the short
run and in the long run. To see why average cost must rise if marginal cost
is above the average and fall if marginal is below average, imagine you
calculate the average age of people in a room full of university students
if the next person to walk into the room (the marginal person) is an old
lady, the average age in the room will rise. Similarly, if a baby crawls into
the room, the average age will fall.
Activity SG6.5
Draw the long-run cost curves in the boxes below as marked:
LTC
78
LATC, LMC
BVFD: read section 7.7, cases 7.2 and 7.3 and Maths 7.3.
If five workers and five machines can produce 1,000 soft toys, how many
soft toys could be produced if we employed 10 workers and 10 machines?
This question has to do with returns to scale in production. Does doubling
inputs result in more than double, less than double or exactly double the
original output? This will tell us if there are increasing, decreasing or
constant returns to scale.
Some textbooks, but not BVFD, make a semantic distinction between
returns to scale in production and economies of scale in costs. Thus,
on the production side if there are constant returns to scale then a doubling
of all inputs leads to a doubling of output; and with increasing (decreasing)
returns to scale a doubling of all inputs more (less) than doubles output
(see Maths box 7.3). As long as input prices are held constant then the
relationship between returns to scale in production and economies of scale
in costs is straightforward: if doubling inputs more than doubles output then
cost per unit of output is smaller at higher output. However, if input prices
change as output increases or decreases then the effect of these changes, as
well as underlying scale effects in production, will affect average costs. The
fact that BVFD equates the two concepts implies an underlying assumption
that input prices are not changing as output increases or decreases.
Output
The figure to the right demonstrates varying returns to an increase in

inputs at different levels of input. First let us describe what is meant by
the composite input on the x-axis. This is a combination of labour and
capital where the proportions of each are held constant. Thus, for example,
if we double labour, we also double capital and the capitallabour ratio
remains the same. A change in scale doesnt have to do with changing
the composition of inputs, but rather with changing the amount that is
employed.
Long-run production function
Composite Input
Figure 6.2: Long-run production function.
We can now see how this curve demonstrates initially increasing, then
constant, and finally decreasing returns to scale. The vertical bars rising
up from the x-axis are evenly spaced. However, the quantity of output
generated from these input levels varies greatly. At low levels of input,
increasing the units of input increases the level of output more than
proportionally, representing increasing returns to scale. At high levels of
inputs and outputs, the opposite is the case, since increasing the level of
inputs increases the level of outputs less than proportionally, representing
decreasing returns to scale.
79
Section 7.7 discusses some real-world reasons behind returns to scale and
discusses why firms may face a U-shaped long-run average cost curve. You
should understand the reasons why LRAC may fall initially, be constant for
some time, and then increase.
Activity SG6.6
Increasing returns to scale can be expressed as saying that a certain increase in inputs
leads to a more than proportional increase in output. Equivalently, it can also be
expressed by saying that a certain increase in output requires a less than proportional
increase in inputs. Use this idea and the following isoquant map to derive a production
function (with a composite input on the horizontal axis), assuming that the level of output
represented by each successive isoquant increases by an equal amount each time.
K
X7
X6
X1
X2
X3
X4
X5
X0
L
Figure 6.3: Returns to scale: the relationship between increases in inputs and
increases in output.
The relationship between the level of input and the level of output is
discussed further in AW Section 3.1.2 (which the above activity is based
on).
The only difference to the analysis of the output decision in the short run
is that there are no fixed and variable costs, since all inputs are variable
in the long run. For this reason, the concept of it being worthwhile to
produce as long as variable costs are more than covered has no relevance
and the firm simply choses its output level where MR = LMC, and then
checks if this is profitable using the LRAC curve.
The firms long-run supply curve is its marginal cost curve
above the average cost curve. The firm will supply the output at
which LMC is equal to MR, provided that price is not less than the firms
LRAC.
The short-run cost curve shows the costs for when one input is fixed at a
certain level. If it were fixed at a different level, the short-run cost curves
would also be different. For example, if the level of capital was fixed at a
higher level, short-run costs for producing a given level of output may be
lower, if each worker is more productive with more capital to work with.
There is a different short-run cost curve for each quantity of the fixed
input. This is sometimes described as a family of short-run cost curves. In
the long run the firm chooses the plant size with the lowest average cost
for any given level of output. The LAC includes one point (assuming there
are a large number of feasible plant sizes) from each SAC (not necessarily
80
the minimum point of the short-run curve, as the text explains). The longrun average cost curve can be described as an envelope of these short-run
curves.
Activity SG6.7
Draw six short-run average cost curves, each with a single point of tangency to a long-run
average cost curve showing increasing, constant and then decreasing returns to scale.
Overview
This block introduces the distinction between the short run (when one
factor of production is fixed) and the long run (where all inputs are
variable). The production function, which summarises the technical
possibilities faced by the firm, can be used to derive the firms total cost
curve. Short-run total cost is equal to short-run fixed cost plus shortrun variable cost. Average costs are found by dividing cost by quantity
produced. Average cost is falling if marginal cost is below average cost,
and rising if marginal cost is above average cost. The short-run marginal
cost curve reflects the marginal product of the variable factor (usually
labour). It cuts the SATC and SAVC curves at their minimum points.
In the short run, the firm choses its output level where MC = MR, but
only produces at all if the price received at this level of output at least
covers all variable costs and makes some contribution to fixed costs. The
long-run total cost curve represents the economically efficient (leastcost) production method for each level of output when all inputs can be
varied. The long-run average cost curve is usually U-shaped, representing
increasing, constant and then decreasing returns to scale as output rises.
In the long-run, the firm supplies the output at which MR = LMC as long
as the price is no less than LAC at that level of output. The LAC curve is an
envelope of many SAC curves which all touch the LAC at just one point.
This block showed how the short-run and long-run supply curves of an
individual firm can be found. The following block contains the derivation
of the short-run and long-run industry supply curves for different types
of industries. This block provides a detailed introduction to costs. The
following blocks will also look more in detail at revenue, in relation to the
market structure in which the firm operates.
You need to be able to reproduce the output curves and cost curves
covered in this block. Since there are quite a few, the best way to do this
is to understand what they mean, why they have certain shapes, and
how they are related to each other. Approaching this with understanding
(rather than memorisation) will be an easier and more effective method in
the long run. Furthermore, the examination will test your understanding
81
of these cost concepts (rather than just your capacity for memorisation).
The output and cost curves you need to know for this block are
summarised below. This is a good chance to practise them and make sure
you understand what they represent, where they come from, and how they
are related to each other.
TP
(labour on horizontal axis)
MPL
STC, SVC, SFC
SATC, SAVC, SAFC, SMC
LTC
LATC, LMC
LATC envelope of SATC curves
82


1. Labour Productivity at Shakespeares Pies:
Number of workers
Output of pies
10
26
36
44
49
52
Note: Pies are sold competitively at 3 each. Labour is the only

variable input and costs 14 per worker. Capital costs are 80. These
are short-run and long-run costs and productivities, i.e. there is no
possibility of using different production techniques or combinations in
the long run.
Refer to the information above which describes the number of pies
produced as a function of the number of workers at Shakespeares
Pies and the note, which highlights that capital costs (fixed costs) are
80 in the short and the long run. Assuming wages and prices dont
change, Shakespeares Pies should:
a. shut down immediately
b. stay open in the short run but shut down in the long run
c. stay open in the short run and the long run
d. shut down in the short run but reopen in the long run.
2. If short-run average total cost equals short run marginal cost, then:
a. Short-run average total cost is at a minimum.
b. Short-run marginal cost is at a minimum.
c. Both a. and b. are correct.
d. Neither a. nor b. are correct.
3. Which of the following statements best summarises the law of
diminishing marginal returns?
a. In the short run, as more labour is hired, output diminishes.
b. In the short run, as more labour is hired, output increases at a
diminishing rate.
c. In the short run, the amount of labour a firm will hire diminishes
as output increases.
d. As more labour is hired, the length of time that defines the short
run diminishes.
4. Let the production function be q=ALaKb where q is output, L is labour
and K is capital. The function exhibits increasing returns to scale if:
a. a + b = 1
b. a + b > 1
c. a + b < 1
d. cannot be determined with the information given.
83
5. Suppose the short-run total cost of producing T-shirts can be

represented as STC = 50 + 2q where q is the level of output. The
average and marginal costs of the 5th T-shirt are:
a. 50 and 2
b. 12 and 2
c. 50 and 10
d. 12 and 10.
Long response questions

1. The isocost line is the graph of factor inputs such that their total
combined cost is equal to a given constant. Suppose a firm uses two
factor inputs, labour (L) and capital (K). Per day, the wage rate for
labour is 15 while renting units of capital costs 60.
a. Depict on a graph the isocost line for a firm spending C* = 3,000
on factor inputs. Put on this graph a typical isoquant for output
level, say Q*, to illustrate the optimal input levels N* and K* at
cost C*.
b. The government introduces a minimum wage for labour at 20.
With capital fixed at K* in the short run, show graphically and
describe how much it costs the firm to continue to produce Q*.
c. Taking the minimum wage as given, show graphically and describe
how the optimal factor input mix to produce Q* changes in the
long run. How does the eventual production cost compare to that
in the short run and that before the minimum wage?
2. a.

Bob Smith manages a branch office of a large financial services

firm. He uses computers (capital, K) and people (labour, L) to
produce consulting advice Q, according to the production
function: Q = K L.
Employing people costs the wage rate w = 1 while renting
computers costs the rental rate r. Suppose computers cost twice
what people do (i.e., r = 2w = 2). For now the number of
computers in the branch is fixed at K = K.
i. How much labour does Mr Smith employ if he needs to
produce output Q? Show that total cost is C(Q) = 2K + Q/K
ii. Given that the first derivative of the total cost function above
is 1/K, derive average and marginal cost. How do average and
marginal cost vary with output?
iii. Corporate headquarters has just authorised Mr Smith
to upgrade the branch office by varying the quantity of
computers. What is the optimal (cost-minimising) mix of
capital and labour? Using the production function given above,
the marginal product of labour is equal to K and the marginal
product of capital is equal to L.
84
b. In the diagram below choose levels of output for the three

unlabelled isoquants such that from a to b there are increasing
returns to scale, from b to c constant returns to scale and from c to
d decreasing returns to scale.
K
d
Q4=?
Q3=?
b
2
1
Q2=?
Q1=?
1
85
Notes
86
Block 7: Perfect competition

Introduction
Our study of microeconomics now looks in greater depth at different
types of market structure, which refers to the economic environment
in which buyers and sellers in an industry operate. It is generally
defined according to four characteristics: the size and number of buyers
and sellers, the extent of substitutability of different sellers products,
the extent to which buyers are informed about prices and available
alternatives and the conditions of entry/exit. Although BVFD covers the
two extremes of market structure, perfect competition and pure monopoly,
in one chapter, this subject guide devotes a block to each, enabling some
issues to be covered in a bit more depth.
In perfect competition (Block 7), there is an infinite (or very large)
number of firms and free entry and exit, whereas in monopoly (Block 8),
there is a single firm which supplies the whole market, and very large
barriers to entry into the market. While many real-world firms do not fit
neatly into these two extremes, it is nonetheless worthwhile to study them
first, partly because they do approximate some real-world markets (see
below for examples), but also because they provide a benchmark that is
very useful for comparison with other market structures which are more
commonly encountered in the real world. Perfect competition is a desirable
market structure in terms of maximising the welfare of market participants
and for this reason is often used by economists as a kind of first-best
standard in order to evaluate the welfare losses caused by deviations from
the competitive ideal. The subsequent block (Block 9) will introduce other
market structures (monopolistic competition and oligopoly) which sit on
the continuum in between these two extremes.
As this and the following block utilise material from Blocks 5 and 6, it
is vital that you are familiar with the material contained therein. If you
are not, you should revise them now. In particular, you need to fully
understand why choice of the profit maximising output requires firms to
equate marginal cost and marginal revenue. You should also recall that the
return needed to keep a firm from leaving the industry is already included
in its cost curves, which include all opportunity costs including the next
best alternative return to operating in the current market. In the long
run if a firm is earning a price above average cost it is earning abnormal,
supernormal, or economic profits (these three terms tend to be used
synonymously in economic texts).
Learning outcomes
define perfect competition
describe why a perfectly competitive firm equates marginal cost and
price
demonstrate how profits and losses lead to entry and exit
draw the industry supply curve
carry out comparative static analysis of a competitive industry.
87
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 8, sections 1 to 4
(which builds on Chapter 7 which you should revise if necessary).
Further reading
Chapter 6.

This block introduces the market structure perfect competition. It starts
by outlining the underlying assumptions and the implications of these,
notably that firms in a perfectly competitive market face a horizontal
demand curve and act as price takers, with no ability to influence the
market price. This also means that MR = P for perfectly competitive firms.
The block then describes the firms short-run supply decision and shortrun supply curves. In the short run, firms will stay in business if P > AVC,
even if they are making a loss, however, in the long run, they will exit the
market unless P AC. The firms long-run supply curve is flatter than the
short-run supply curve since it can adjust all inputs in the long run. The
industry supply curve is the horizontal summation of all the individual
firms supply curves. In the long run, firms can exit and enter the market.
This provides a further reason why the long-run industry supply curve is
flatter than the short-run industry supply curve. The chapter also discusses
how firm and industry supply curves are affected by an increase in costs or
a change in the market demand curve.
Assumptions and implications

BVFD: read the introduction to Chapter 8, section 8.1 and concept 8.1.
Perfect competition is a model of market structure. It rests on the
following assumptions:
1. Many firms, each negligible in size relative to the entire industry.
2. All firms produce homogenous goods.
3. Perfect information regarding prices and available alternatives.
4. Free entry and exit.
From these assumptions, the key implication is that the individual firms in
this market face a horizontal demand curve. All act as price-takers, with
no ability to influence the market price.
The textbook mentions the market for corn as a market which closely
resembles a perfectly competitive market. Other examples of markets
which may approximate perfect competition at least along certain
dimensions include forex (foreign exchange) and agricultural
commodities such as cocoa.
Activity SG7.1
For the forex market (e.g. selling US dollars), note down how and to what extent each of
the four assumptions above are met.
In reality, there are not many markets which are truly perfectly
competitive. Nonetheless, for the reasons described in concept 8.1, it is
still a very useful model to study.
88
The firms supply decision

In the previous section, it was established that the negligible size of
individual firms in a competitive market means that each firm faces a
horizontal demand curve. At the beginning of this section, it is shown that
this means, for price taking firms, that price equals marginal revenue. Be
sure you understand this; if you do you will also understand why MR < P
for a firm facing a downward sloping demand curve. We will return to this
point when we discuss monopoly.
For an individual firm, we can write its revenue as TR = P*Q. Dividing by
Q we have
TR
= AR = P
Q
Because the firm is a price taker, P is a constant term in this equation.

Therefore, changes in TR come about via changes in Q.
TR = PQ
or
TR
= MR = P
Q
Marginal revenue, the increase in total revenue when output increases by

one unit, is just the price received for that output.
We can show TR as a function of Q graphically as follows:
TR
TR
Slope=P
Q
Figure 7.1: Total revenue for a competitive firm.
This enables us to provide a diagrammatic treatment of profit

maximisation for a competitive firm.
89

TC
TR
TR, TC
Panel (a)
Q1
Q2
Q3
Q (output)
Q4
Profit,
Profit, , (TRTC)
Panel (b)
Q1
Q2
Q3
Q (output)
Q4
MC
AC
D=AR=MR
Profit,
Panel (c)
Q1
Q2
Q3
Q4
Q (output)
Figure 7.2: Profit maximisation for a competitive firm.
In panel (a), a total cost curve (with fixed costs in the short run and increasing
marginal cost) is superimposed on the TR curve. Profit, which we denote by
, is the vertical distance between total revenue and total cost. It is positive
between Q1 and Q4. For output lower than Q1 or greater than Q4 the firm makes
a loss. Geometrically, profit is maximised when the vertical distance TRTC is
greatest (between Q1 and Q4). This occurs at Q3, where the slope of TR is equal
to the slope of TC. These two slopes are MR and MC respectively, so profit is
maximised when output is chosen such that MR = MC (or P = MC, as MR = P).
Panel (b) simply graphs profit, , against output. Profit maximisation means
getting to the top of the profit hill, again at Q3, of course.
Panel (c) shows the same process in a third equivalent way, using the firms
demand and cost curves (the MC and AC curves corresponding to the TC
curve in panel (a)). Profit maximising output is at Q3 where MC = MR. The
shaded area shows the firms actual profit; it is AR AC, which is profit per
unit at Q3 multiplied by the number of units this is earned on, namely Q3.
Equivalently it is TR (= AR*Q3) minus TC (= AC*Q3).
90
Thinking of the economic intuition rather than the geometry of the MC =

MR (or MC = P) requirement, we can examine the firms position when
MC and MR are not equal, say at Q2 in Figure 7.2. Clearly in panel (b) this
is not at the summit of the profit hill. Panel (c) shows why. At output Q2,
MR>MC. What does this mean? It signifies that at Q2 increasing output by
one unit adds more to revenue than to cost, so increasing output increases
profit. The marginal benefit of increasing output exceeds the marginal cost.
You should be able to see, by the same reasoning, that if output is greater
than Q3, the marginal benefit of contraction exceeds the marginal cost.
You also need to revise, from section 7.4 of BVFD, the so-called shut down
condition (if price falls below short-run variable cost the firm should not
produce any output). It may initially seem counterintuitive for a firm to
produce output in the short run even if it is making a loss. How can this
be? Think about a firms short-run fixed costs, rentals on building and
machines, insurance premiums, contractual management fees, etc. These
are unavoidable even if the firm produces zero output. But losses never
have to be greater than these fixed costs. Any variable costs, costs that
vary with the level of output, can be avoided by not producing. If these
variable costs can be more than covered by producing some output then
the profit on the cost of variable inputs can contribute to paying for the
unavoidable fixed costs, even if the firm is making a loss overall.
Short-run supply decision

The firms short-run decision can be summarised as follows:
The price is determined by the market (by market supply and demand).
For a perfectly competitive firm, P = MR.
A profit maximising firm produces where MR = MC. Because P = MR,
this means that a perfectly competitive firm operates where P = MC.1
The optimal quantity to produce is indicated by the SMC curve, which
is the firms short-run supply curve the firm chooses quantity where
P = MR = SMC.
The firm will only produce if the price lies above its SAVC curve and
only covers all their costs if it is at least equal to its SATC curve.
Activity SG7.2
Draw the short-run cost curves of a perfectly competitive firm and indicate prices at which
they and the quantities they will produce at each of these prices:
i. Make supernormal or economic profits
ii. Will not produce in the short run.
iii. Just cover all their costs.
In actual fact MR = MC
is a necessary but not
sufficient condition for
profit maximisation.
For certain cost curves
and some output level,
MR = MC could maximise
loss not profit. This
problem is not considered
further on this course, but
in the competitive model
we will always be sure
we are maximising profit
at MR = MC as long as
the firm is on the upward
sloping section of its MC
curve.
91
The marginal firm

If the price level is below the lowest point on the firms LAC curve, firms
will exit the market in the long run, as they would otherwise be making
losses. But how do we know which firms will exit? In theory, firms have
access to the same technology and will thus have the same costs curves in
the long run, when enough time has passed for full adjustment of capital
to be made. This assumption is also made in BVFD that all firms in the
market and the potential entrants have identical cost curves. In this case,
which firms exit and which stay would be quite random. However, in the
real world, firms will not all have identical cost curves, since technology is
changing continually and firms have different histories. For example, some
firms will have replaced their capital stock more recently than others.
In a situation where no firms are covering their long-run opportunity
costs, the marginal firm will be the first one whose capital comes up for
replacement. This firm will exit first. (This is discussed in L&C, UK edition:
p.135; international edition: p.111).
Activity SG7.3
Reproduce Figure 8.4 from the textbook, except to show exit, not entry.
Industry supply curves

It is crucial to distinguish carefully between supply curves for an individual
competitive firm and supply curves for the industry (the market as a
whole) the industry supply curves are the horizontal summation of all
the individual firms supply curves. In each case it is also important to
distinguish between the short run and the long run. The previous section
showed that the long-run supply curve for a firm is its LRMC curve above
minimum LRAC. Note that this is average total cost not average variable
cost, because while it may be rational to make a loss in the short run (if
variable costs are more than covered and revenues make a contribution to
covering fixed costs), this is not the case in the long run. In the long run,
if a firm cannot cover its costs it should leave the industry. When firms
leave the industry, industry supply shifts inwards and price increases. This
process continues until revenues just cover costs for remaining firms in the
industry. On the other hand, if firms are making abnormal or economic
profits then new firms will enter the industry and drive down the price.
This process continues until firms are just covering all opportunity costs
(i.e. no abnormal profits are being earned). The long-run industry supply
curve is flatter than its short-run counterpart. It is possible that the longrun industry supply curve is horizontal, and this is the pure theory result
with perfectly elastic supply of inputs. However, due to the likelihood that
input prices will increase as an industry expands, as well as due to the fact
92
that, in practice, firms have different cost curves, it is much more likely that
the long-run industry supply curve will be upward sloping.
Comparative statics
This section is vital for your understanding of competitive markets. If you
fully understand the consequences, both at the level of individual firms
and the industry as a whole, of shifts in the market (industry) supply or
demand curves then you will have mastered an important building block of
microeconomic analysis. The essential point is that entry or exit from the
industry ensure that individual firms have zero profits (remember this can
be compatible with a return to management and entrepreneurship these
are included in the cost function; they are opportunity costs, namely what
managers and entrepreneurs could earn in the next best activity). This
means that in the long run, price must return to the minimum ATC, making
the long-run supply curve horizontal as long as expansion or contraction of
the industry does not change input prices. The two activities are designed
to assist your understanding of this. Note that in this section, at the industry
level, the short-run supply curves hold constant the number of firms in the
industry (at the level of the individual firm the short-run corresponds, as
usual, to one or more of the firms inputs being fixed).
Activity SG7.4
Suppose all firms in a perfectly competitive market are initially in both short-run and
long-run equilibrium. Then a lump-sum tax (i.e. a tax that is unrelated to a firms output)
is introduced.
a. What impact will this have on each firm in the short-run? (Explain your answer).
b. What impact will this have on market price in the long-run? (Explain your answer).
c. What impact will this have on each firms output in the long-run? (Explain your answer).
d. What impact will this have on the number of firms in the industry in the long-run?
(Explain your answer).
Draw a diagram to illustrate the effects of the lump-sum tax on an individual firm and the
whole industry.
The section on shifts in the market demand curve demonstrates that the
short-run industry supply curve is much less elastic than the long-run industry
supply curve. In the short run, firms cannot respond as much to a change in
price and the number of firms is fixed. As such, an increase in demand has a
much greater impact on price in the short run compared to the long run.
Activity SG7.5
Reproduce both graphs in Figure 8.8 but for an increase in demand, rather than an increase
in costs (the textbook also suggests this activity and already provides the industry side).
93
Perfect competition and efficiency

One of the reasons given in concept Box 8.1 for studying competitive
markets is that a perfectly competitive market has some desirable
properties in terms of efficiency of the market outcome. In fact, perfectly
competitive markets lead to an outcome which is both productive efficient
and allocative efficient. Productive efficiency implies that goods and
services are produced at their lowest cost, such that more output of one
good can only be obtained by sacrificing output of other goods. This is
achieved in perfectly competitive markets because firms produce on their
average cost curves, which are based on the cost-minimising combination
of inputs. This, in turn, implies that there are no excess resources being
used in the production of that good which could be released (without
reducing output) to produce another good.
Allocative efficiency means that it is not possible to make someone better
off without making someone else worse off. This is achieved in perfect
competition because P = MR = MC (such that benefit and cost are
equated) and the sum of producer and consumer surplus is maximised
with no deadweight loss. This will be explained in more detail in the
following block, where the allocative efficiency of perfect competition is
contrasted to the allocative inefficiency of pure monopoly. Block 11 on
welfare economics also explores these concepts in greater detail. What
the efficiency of the perfect competition model implies is that society will
be producing at a point on (not inside) the production possibility frontier
(PPF), and that this point is the point that aligns the efficient production
possibilities with the needs and preferences of society.
Using the competitive model: a worked example

Assume that the raspberry growing industry in Scotland is perfectly
competitive, and each producer has a long-run total cost curve given by:
TC = 144 + 20Q + Q2
and its marginal cost by:
MC = 20 + 2Q.
The market demand curve is:
Q = 2,488 2P
(Q is the demand in the market, Q is the output of an individual firm).

a. What is the long-run equilibrium price in this industry?
b. How many active producers are in the raspberry growing industry in a
long-run competitive equilibrium?
c. Illustrate diagrammatically the long-run equilibrium of the firm and
the industry. Your diagram does not have to be drawn to scale but
should contain the relevant information.
94
Solution
a. The first thing we have to realise is that the question is concentrating
on the long-run, so it is the properties of long-run equilibrium that are
going to be relevant in solving this problem. In the competitive model
free entry and exit ensure that firms are earning zero profit (they just
cover all opportunity costs). This is a vital step in solving the problem.
Zero profit means that TR = TC for each firm, i.e.
PQ = 144 + 20Q + Q2
But this is not yet helpful to us because it is one equation with two
unknowns. What can we do? Well our model of the competitive firm
also tells us that it will produce where P = MC. We are given MC so
we can substitute in to the left hand side of the equation above:
(20 + 2Q)Q = 144 + 20Q + Q2
This gives us Q2 = 144, i.e. Q = 12
Now from P = MC we know P = 20 + 2Q, i.e. P = 44.
b. Now turn to the market demand curve and substitute in this price to
estimate market demand:
Q =2488 2 * 44 = 2,400
So now we know that market demand is 2,400 and that each profit
maximising competitive firm produces 12 units.
Therefore the number of firms in the market must be
2,400/12 = 200
c. The diagrams are shown below. Make sure that you label the axes and
any curves or lines in the diagram as well the solution values of prices
and quantities. This should all be obvious but it is surprising how
many examination answers fail to provide these important pieces of
information.
LRMC
P, AC, MC
Market demand
LRAC
Market supply
44
44
12
2400
Figure 7.3: Long-run equilibrium of the firm and the industry.
Overview
A market structure is the economic environment in which buyers and
sellers in an industry operate.
This block covered perfect competition and its underlying assumptions,
including that:
there is a large number of buyers, all small relative to the whole
market and all producing a homogeneous product
buyers and sellers have perfect information regarding prices and
available alternatives
there is free entry and exit.
95
In a competitive industry, buyers and sellers are price-takers and have no

influence over the market price. Price is equal to marginal revenue and the
firm choses output where P = MR = MC. In the short run, the firms supply
curve is its SMC curve above SAVC. In the long run, the firms supply curve is
its LMC curve above its LAC curve. The industry supply curve is obtained by
horizontally adding the supply curves of the individual firms. The long-run
industry supply curve is flatter than the short-run industry supply curve both
because firms can fully adjust their inputs and also because firms can enter or
exit the market. Graphical analysis of short-run and long-run supply curves
was carried out for both the perfectly competitive firm and the perfectly
competitive industry. These are affected by changes in costs and in the market
demand curve, leading to a new equilibrium.

Now go back to the list of learning outcomes at the start of the block and be
sure that they have been achieved.

1. Identify the truthfulness of the following statements for a competitive
profit maximising firm in the short-run:
i. The firm never produces where P<AVC.
ii. The firm never produces where TR<TC.
a. Both i and ii are true.
b. Both i and ii are false.
c. i is true; ii is false.
d. i is false; ii is true.
2. An increase in the cost of capital will have the following effect on a
perfectly competitive market:
a. Short-run average and marginal cost will increase which would lead
to a fall in output and an increase in price. In the long run, firms will
leave and price will rise further.
b. Short-run average and marginal cost will not change but there will
be a fall in output and an increase in price. In the long run, firms will
leave and price will rise further.
c. Short-run average cost will increase but there will be no change in
output or price. In the long run, firms will leave and price will rise.
d. Short-run marginal cost will decrease which would lead to an increase
in output and a decrease in price. In the long-run, firms will enter and
price will become stable.

1. a. i. Define the concept of market structure and list the fundamental
assumptions of the perfect competition model.
ii. Provide a graphical representation of equilibrium in the perfect
competition model in the long run, distinguishing between what
holds for the firm and what holds for the market. Carefully
describe the various components of your graphical representation.
96
iii. Use graphs to illustrate how a decrease in costs changes the longrun equilibrium of a competitive market. Carefully describe the
various components of your graphical representation.
b. In a perfectly competitive industry all firms have the Total Cost
function TC = 4 + q2, where q is output of the individual firm. The
market (industry) demand is given by Q = 120 P where P is price
and Q is industry output. The figure shows the individual firms AC
and MC.
P, AC, MC
MC
AC
i. Suppose that initially the price is 8. How much output does each
firm produce? In the short run, with the number of firms fixed,
how many firms are there in the industry?
ii. Could this be a long-run equilibrium? Explain why or why not.
iii. What is the long-run equilibrium number of firms in this
industry?
97
Notes
98
Block 8: Pure monopoly

Introduction
Having examined perfect competition in the previous block, this block
now covers pure monopoly, which is a market structure where only one
firm supplies the whole market, and thus there is no competition between
firms. Utilities (such as gas or water) supplying a particular region
are often monopolies (this will be explored in the section on natural
monopolies). Furthermore, patents allow companies to hold a monopoly
over an invention (for example a pharmaceutical drug) for a limited
period of time. Although finding other real-world examples of companies
that are pure monopolists can be as difficult as identifying examples of
markets that are perfectly competitive, some companies that come close
include Microsoft, in the market for operating systems, and, a historical
example, de Beers diamonds, which controlled an estimated 80 per cent of
rough diamond supply in the 1980s.1 This block examines the theoretical
aspects of monopoly as a market structure, including how the monopolist
determines its price and output, the social cost of monopoly due to
inefficiency, and price-discrimination by monopolists.
www.economist.com/
node/2921462
1
Learning outcomes
define pure monopoly
find the optimal price and output levels for a monopolist using
MC = MR
relate PED to monopoly power
recognise how output compares under monopoly and perfect
competition
describe how price discrimination affects a monopolists output and
profits.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 8 sections 5 to 10.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 6; UK Edition,
Chapter 7.

This block introduces the case of pure monopoly, with its own underlying
assumptions namely that there is only one firm supplying the whole
market and large barriers to entry. The block describes the profitmaximising output for the monopolist as well as the relationship between
the elasticity of demand and the monopolists degree of market power
(measured by how far above marginal cost, and revenue, it can set the
price it charges). The allocative inefficiency of monopoly is demonstrated
by the loss of social surplus compared to the case of perfect competition.
First, second and third degree price discrimination are explained,
including the impact on the monopolists output, price and profits. Despite
99
the allocative inefficiency of monopoly, one possible advantage could

be that monopoly profits provide an incentive for firms to innovate.
Natural monopolies display a falling long-run average cost curve over the
whole range of production. Government regulation of monopolies is also
discussed.
Perfect competition and perfect monopoly

We turn now to the case of monopoly, which is at the other end of the
spectrum compared to perfect competition. Like the latter, in its pure
form it is likely to be rather rare in practice, but studying the pure form
tells us a lot about how firms behave when they have market power (i.e.
when they face a downward sloping demand curve). The table below
summarises how perfect competition and monopoly differ, according to the
four assumptions made to describe perfect competition in section 8.1.
Number of firms
Nature of product Information
Entry and Exit
Perfect competition Very large, infinite
Homogeneous
Perfect
Free
Monopoly
Homogeneous (One
product )
Perfect
Large barriers to
entry
One
Table 8.1: Characteristics of perfect competition and pure monopoly.
In relation to the final column, BVFD in this chapter essentially rule out
by assumption the entry to the industry of new firms (which would erode
monopoly profits). You should think about why this happens in practice.
Some barriers to entry are natural, for example the unique talents of a
singer or sports star (their monopoly profits are not eroded by the entry of
clones) while others are artificial, such as the monopoly position afforded,
perhaps temporarily, by licences, patents, tariffs and the like. Such
artificial barriers to entry can, in principle and often in reality, be removed
to introduce competition into previously monopolised industries.
BVFD: read section 8.6 and Maths 8.1.
Monopoly analysis
This section shows that profit maximisation for a monopolist, as for
a competitive firm, requires producing where MR = MC. But, unlike
the competitive case, MR is not equal to P it is less than P (see next
paragraph). This means that in profit maximising equilibrium, where
MR = MC, P > MC and this turns out to be the source of monopolys
inefficiency. You need to be sure that you really understand the monopoly
diagram, BVFD Figure 8.11. What follows spells out in a bit more detail
some aspects of the monopoly analysis.
To begin with it is crucial for you to understand why, in the case of
monopoly, MR < P (remember from the previous block that MR = P for
a competitive firm). This is explained in section 8.6, but here it is spelled
out in more detail. The downward sloping demand curve faced by the
monopolist means that if a monopolist wants to sell more output it will
have to lower the price. But the lower price applies to all of its output,
not just the marginal unit. Marginal revenue is the price the monopolist
receives for the marginal unit less the price reduction it must accept on
all the units previously sold at a higher price. This is demonstrated in the
following simple diagrammatic illustration.
100
TR11 = 9.5 11 = 104.5

TR10 = 10 10 = 100
MR = TR11 TR10 = 4.5 = P11 + 10P
(P is negative)
10
9.5
10
11
Figure 8.1: Marginal revenue when the firm faces a downward sloping
demand curve.
When the price is 10, 10 units are sold and total revenue received by the
firm is 100. To sell an extra unit (the 11th unit) the price must fall to
9.5. This, however is not the firms net gain in revenue because it now
sells each of the previously sold 10 units for 9.5 rather than 10. The net
revenue, the marginal revenue, from selling the 11th unit is its price,
9.5, minus the reduced revenue on the first 10 units, i.e. 0.5 * 10 = 5.
Therefore MR = 9.5 5 = 4.5. So MR is less than price.
Activity SG8.1
As part of your studies of microeconomics, it is important for you to be able to draw the
cost and revenue curves for a typical monopolist.
a. Reproduce Figure 8.11, making note of the key points (the point where the MC and
MR curves cross, the price level the monopolist chooses, and the average cost at this
quantity) and highlighting the monopolists profit.
b. Illustrate a rise in costs (as described in the section comparative statics for a
monopolist).
c. Illustrate an increase in demand (as described in the section comparative statics for a
monopolist).
Rise in costs
Increase in demand
As noted above, cutting the price increases demand but reduces the
revenue on existing units. The effect on a firms total revenue depends on
the price elasticity of demand, as you will remember from Blocks 3 and 5.
This is described in more detail in this section, especially the maths box.
101
The formula in equation 7 (or 8) of the maths box is very useful. Although
the derivation in the box uses calculus, the intuition can be seen by using
the delta notation as follows2
TR = P * Q
TR = PQ + QP
Therefore we can write:
MR =
P
TR
=P+Q
Q
Q
But PED (price elasticity of demand), , can be written as =
Q P
.
P Q
Substituting into the above we get, after a bit of manipulation:
=P 1
1
||
MR = P 1 +
which is equivalent to equations 7 and 8 in the maths box. Here you can
see straight away that if demand is inelastic, ||<1, MR is negative. This
shows concisely what is explained in the text, namely that a monopolist
will never operate on the inelastic portion of the demand curve. Also,
because MR = MC for profit maximisation, some further straightforward
manipulation yields:
1
P MC
=
||
P
1
|| , which is the proportionate mark-up of price over marginal cost, is
sometimes used as an index of monopoly power (the Lerner Index). In the
case of perfect competition this index is zero (P = MC, || = ). What is
the maximum value this could take in the case of monopoly?
The equation:
MR = P + Q
P
Q
can also be used to show a useful result for MR where the demand curve is
linear. Suppose the (inverse) demand curve is given by P = a bQ where
P
b is Q
, then substituting into the above equation gives MR = a 2bQ.
(Maths 8.1 shows the same result using calculus). Remember that this
is the case for linear (straight line) demand curves only. The marginal
revenue line has the same intercept on the P axis as the demand curve,
but is twice as steep. Thus, in Figure 8.10, the MR curve crosses the x-axis
at exactly half the quantity at which the demand curve crosses the x-axis
this is due to the fact that when P = a bQ, the DD curve crosses the
x-axis at a/b. The MR curve corresponding to this demand curve is MR =
a 2bQ. This curve crosses the x-axis at a/2b: exactly half the quantity at
which the demand curve crosses.
The following question requires you to use the result we have just
explained about the slope of the MR curve relative to the slope of the
demand curve in order to solve for the monopoly equilibrium:
102
In fact, the expression

in the text is an
approximation. The full
expression for TR is
TR = PQ + QP
+ PQ. For small
changes in P and Q
the final term can be
ignored, giving the
equation in the text.
2
Activity SG8.2
A monopolist faces an (inverse) demand curve given by P = 100 2Q. Marginal cost is
constant and equal to 16. Profit maximisation is achieved when price is equal to:
a. 45
b. 21
c. 58
d. 82
e. 16.
Using the monopoly model: a worked example

The (inverse) demand curve faced by a monopolist is given by:
P = 210 4Q
a. Suppose the monopolist has constant marginal cost equal to 10 (MC
= 10). Use the method shown above to find the monopolists marginal
revenue and, using that, calculate the monopolists profit maximising
output, price and total revenue.
b. Now suppose that the monopolists MC increases to 20. Calculate the
new Q, P, TR.
c. Suppose now that the demand curve given above refers to a perfectly
competitive industry in which each firm has a constant marginal cost
of 10. What is the industry price, output and total revenue?
d. Now in this competitive industry suppose that the MC for each firm
increases to 20. What is the new P, Q and TR for the industry.
e. Compare and comment on the change in TR for the monopoly and the
competitive industry when MC increases from 10 to 20.
103
Solution
a. The MR curve has the same vertical intercept but twice the slope of the
demand curve. i.e.:
MR = 210 8Q
P, MR
210
D (AR)
26.25
52.5
Figure 8.2
The monopolist maximises profit when MR = MC, 210 8Q = 10. So

Q = 25. Put this into the demand curve to calculate P = 110.
TR = P*Q = 2,750.
b. Following a similar procedure, when MC = 20, Q = 23.75, P = 115,
and TR = 2,731.25.
c. When the industry is perfectly competitive, the industry supply curve
is horizontal at P = MC = 10. At this price the demand curve tells us
that Q=50 and therefore TR is 500 (P*Q).
d. By the same method, when MC = 20, industry output is 47.5, P = 20
(from demand curve) and TR = 950.
e. When MC increases from 10 to 20 the monopolists TR falls and the
industry TR increases. Why the difference? The monopolist always
operates on the elastic portion of its demand curve, otherwise
MR would be negative and this is never optimal. So an increase
in price reduces TR a consequence of an elastic demand curve.
At the competitive output, on the other hand, for the industry
as a whole the demand curve is inelastic (you can check this by
calculating the elasticity or by substituting the competitive output into
the MR equation and noting that MR is negative, implying inelastic
demand). Of course, with inelastic demand an increase in MC and
price will increase TR. For each firm in the competitive industry MR is
positive and equal to price.
Activity SG8.3
Consider two monopolists in two industries. One is the sole postal service operating in
a country. The other is the sole producer of a certain type of cheese (no-one else has the
technology to produce this cheese). Which of these do you think faces a more elastic
demand schedule? Draw a rough sketch of the demand, marginal revenue and cost
curves for each industry and examine the gap between the point where MC = MR and
the price chosen by each monopolist. Which firm has greater market power?
104
Social cost of monopoly

This section establishes the important result that, compared with a
perfectly competitive industry, a monopolist produces less output and
charges a higher price (given the same cost conditions). This is the source
of the social cost of monopoly the deadweight loss of monopoly.
The intuition for this is that, with price above MC, consumers place a
higher value on extra output than it costs to produce that extra output
expanding output would be socially productive under such circumstances.
It is this deadweight loss, rather than the existence of monopoly profits,
that economists see as the rationale for competition policy, discussed in
Case 8.1. Competition or antitrust policy works differently in different
countries, but will seek some mix of attempting to generate more
competition in markets which are currently uncompetitive and regulating
the behaviour of firms with market power, for example by setting price
ceilings. Occasionally it will be decided that monopoly is in the public
interest (not an easy concept to pin down!) and therefore its existence
is allowed to continue unchecked by policy. Section 8.9 (Monopoly and
technical change) returns to the potential advantages of monopoly.
The analysis in this section of the textbook uses a horizontal long-run
marginal cost curve. However, remember that Section 8.3 described how,
realistically, industry supply curves are likely to be upward sloping. The
diagram below portrays the social cost of monopoly in the case where the
long-run marginal cost curve slopes upwards. Some consumer surplus
has been lost and has become monopoly profits while some has become
deadweight loss. There is some producer surplus lost compared to the
perfectly competitive model, but this is smaller than the supernormal
profits gained by the monopolist.
Perfectly compeve
market
Pure monopoly
P
D
PM
MC
S
PC
PC
MR
QC
Consumer surplus
Producer surplus
QM
QC
Deadweight loss
Figure 8.3: Monopoly and (in)efficiency.
The previous block described how the perfectly competitive model results
in outcomes which are both productive and allocative efficient. Productive
efficiency occurs because firms choose a quantity on their cost curves.
This applies to monopoly in the same way. Although monopolists are
not under pressure from competition to choose the cost-minimising mix
105
of inputs, they are still likely to do this in order to maximise profits. In

terms of allocative efficiency, the perfect competition model is allocative
efficient because the sum of consumer and producer surplus is maximised.
This means it is not possible to make one party better off without making
the other party worse off. By contrast, the monopolist is not allocative
efficient. As there is a deadweight loss, by lowering the price and
increasing the quantity produced, it would be possible to increase the total
surplus available for distribution between the two parties.
Price discrimination
Although this section is titled A monopoly has no supply curve, which of
course is correct, perhaps the more important material in it is the analysis
of price discrimination. In fact, the basic point is that when firms have
market power (pure monopoly is the extreme case) they can, under certain
circumstances, employ pricing strategies which increase their profits by
raiding the consumer surplus of their customers. Two such strategies are
discussed in Chapter 8 of BVFD; price discrimination and the two-part
tariff (explained in section 8.10).
Up to this point we have taken it as given that there can be only one single
price charged for a unit of a homogeneous good. Imagine this were not the
case. There would be possibilities for mutual gains via arbitrage those
charged a low price could sell the good to those charged a high price; at
intermediate prices both parties gain. Arbitrage would continue until a
single price prevailed. Where such secondary markets are impossible or
can be prevented by simple monitoring strategies, firms with monopoly
power can increase their profits by charging different prices to different
consumers. Can you think of examples where it is difficult or impossible
for secondary markets to erode price differences? In the case of thirddegree price discrimination, by far the most common type in practice,3
BVFD show that the monopolist must equate MR in both sub-markets
(make sure you understand why) and set these equal to the common
value of MC. This leads to higher prices being charged in the sub-market
with the more inelastic demand. We can show this more rigorously using
the formula for MR derived above (and in Maths 8.1). Suppose in market
1 || = 1.5 and in market 2 || =3, then equating MR1 and MR2 gives
P1(11/1.5) = P2(11/3). This means P1/P2 = 2. The profit maximising
monopolist charges twice as much in the more inelastic market 1 than in
the more elastic market 2.
Activity SG8.4
Define first-, second- and third-degree price discrimination. For first-degree price
discrimination, draw graphs illustrating producer and consumer surplus compared to a
competitive industry and to a non-discriminating monopolist.
The two-part tariff is another strategy that, in essence, transfers surplus
from consumers to the monopolist. In BVFD this is explained in the context
of natural monopoly (section 8.10), but this strategy is found more widely
in the real world, not just in the case of natural monopolies. The basic idea
is simple. As in the case of price discrimination, market power enables
firms to transfer some or all consumer surplus from the buyer to the seller.
It does this by charging an entry or subscription fee and, in addition,
charging per unit of the good or service consumed. The per unit price is
106
3
But make sure you
understand the rather
remarkable result
that first-degree price
discrimination eliminates
the deadweight loss
associated with a single
price monopolist.
set to equal marginal cost and the fixed fee is set to equal the consumer
surplus for an individual consumer.
P
CS
P1
MC
Q1
Figure 8.4: Two-part pricing.
Consider a consumer with the demand curve in the above diagram. At

the price P1 per unit of the good, the consumer consumes Q1 and receives
consumer surplus equal to the shaded area CS. If the firm could charge
CS (or fractionally less) as an entry fee or admission charge, the consumer
will still purchase Q1 if the price stays at P1 (which is shown by the
demand curve). The only difference is that what was formerly consumer
surplus now becomes profit to the firm. There are many examples in the
real world of this type of two-part pricing; an annual subscription to a
tennis club and hourly fee for the use of a court, an admission fee to an
amusement park and a separate price per ride once inside, a monthly or
annual phone fee plus a charge per call. In each case the firm is using
its market power to get its hands on some of the consumer surplus of its
customers.
Activity SG8.5
Suppose that all consumers in the market have an inverse demand curve given by
P = 50 0.25Q. Suppose also the firm charges its customers 25 per unit. If it decides
to use a two-part tariff pricing strategy what is the maximum that it could charge each
customer as a fixed entry fee?
When can monopolies be justified?

BVFD: read sections 8.9 and 8.10.
The pharmaceuticals industry provides one example of the controversy
regarding monopoly and competition law. In this industry, production
costs are very small and most of the costs involved are fixed costs on R&D
to discover and test new medicines. Firms can patent their discoveries
for a period of 10 years, allowing some time when they can sell these at
a monopoly price and earn profits which help cover the R&D costs for
that and other drugs. After this time, generic versions of the drugs start
to be sold by rival firms and the price generally falls. On the one hand,
people argue that life-saving drugs should be made available immediately,
especially to developing countries. On the other hand, it is argued that
without the monopoly period provided by the patent, firms would have no
incentive to invest in R&D and new drugs would not be discovered.
The case of natural monopoly discussed in section 8.10 and in concept
8.2 is important, so make sure you understand this and the issues of
regulation that arise. In Figure 8.17, little would have been lost if the LMC
curve were simply a horizontal line. This would correspond to a long-run
107
total cost curve of the form TC = a + bQ where a is the fixed cost and b
the constant marginal cost. Here the falling AC comes about as the fixed
cost a is spread over larger outputs. Take the case of railways where there
are large fixed costs in setting up the track network but the marginal cost
per journey mile (Q) may be quite low in comparison. In this case it would
be very inefficient to have several providers each installing their own
parallel rail networks.
Overview
This block discussed the case of pure monopoly, where there is only
one firm and large barriers to entry, such that the monopolist faces no
competition from incumbent firms or even from potential entrants.
The profit-maximising output for the monopolist is discussed, with
the monopolist choosing the quantity where MC = MR. Price is higher
than MR for the monopolist. Just how much higher it is depends on the
elasticity of demand and indicates the degree of monopoly power for
that industry. Where a monopolist and a perfectly competitive market
can meaningfully be compared, a monopolist charges a higher price
and supplies a lower quantity of output. The allocative inefficiency of
monopoly is demonstrated by the loss of social surplus (called deadweight
loss) compared to the case of perfect competition.
A discriminating monopolist charges different prices to different
consumers. First-, second- and third-degree price discrimination are
explained, including the impact on output, price and profits. Monopolists
can also increase their profits by using a two-part pricing strategy. These
strategies transfer surplus from consumers to producers but reduce the
deadweight loss of the monopolist. Despite the allocative inefficiency of
monopoly, one possible advantage could be that monopoly profits provide
an incentive for firms to innovate. Furthermore, there are some industries
which work best as monopolies, these are called natural monopolies
and have a falling long-run average cost curve over the whole range of
production. These are generally industries with very large fixed costs such
as water, electricity and telecommunications, and are generally either
owned or heavily regulated by government.


For each question, choose the best response
1. A monopolist maximises profits when:
Select one:
a. Average revenue equals average cost.
b. Average revenue equals marginal cost.
c. Marginal revenue equals average cost.
d. Marginal revenue equals marginal cost.
108
2. With full (perfect) price discrimination, equilibrium output of the

monopolist is:
Select one:
a. The same as in a non-discriminating monopolist.
b. Less than in a non-discriminating monopolist.
c. The same as perfect competition.
d. The same as in monopolistic competition.
3. A monopolist faces two consumer groups: old and young. The inverse
demand of old clients for the output of the monopolist is Po = 100
2Qo. This implies that MRo = 100 4Qo. The inverse demand of
young clients for the output of the monopolist is Py = 80 Qy. This
implies that MRy = 80 2Qy. The marginal cost of supplying any type
of client is MC = 10. If the monopolist can price discriminate between
the two groups (i.e., charge a different uniform price to each group),
what price will old and young clients be charged?
a. Po = 45; Py = 55
b. Po = 55; Py = 45
c. Po = 50; Py = 50
d. Po = 40; Py = 60.

1. a. i.

List the fundamental assumptions of the monopoly model and

provide a graphical representation of equilibrium in this
model. Carefully describe the various components of your
graphical representation.
ii. Define and discuss the concept of deadweight loss of

monopoly using your graphical representation of the monopoly
model.
iii. Provide a graphical representation of a monopolist that
engages in third-degree price discrimination, dividing its
customers into a group with a high elasticity of demand and a
group with a low elasticity of demand. Demonstrate how the
monopolist sets its prices to achieve profit maximisation in this
situation.
b. A monopolist faces a demand curve P = 210 4Q. The firm faces a
constant marginal cost MC = 10.
i. Calculate the profit-maximising monopoly quantity and price.
ii. Suppose that all firms in a perfectly competitive equilibrium
had a constant marginal cost MC = 10. Find the long-run
perfectly competitive industry price and quantity.
iii. Compare consumer surplus under monopoly versus perfect
competition. You may find it useful to draw a diagram.
iv. What is the deadweight loss due to monopoly? Is this the same
as the difference between the two consumer surpluses you
calculated in iii.?
109
Notes
110
Block 9: Market structure and imperfect competition
Block 9: Market structure and imperfect

competition
Introduction
Most firms in the real world do not operate within markets described
by the textbook definitions of perfect competition or pure monopoly.
This block introduces a theory of market structure and some models
of imperfect competition. These models help to explain some of the
phenomena we see in real world markets such as advertising, price
wars and product differentiation. Game theory is introduced as a useful
tool for analysing strategic interactions. The maths boxes show how to
find reaction functions of firms competing with each other in a market
structure called duopoly (where there are two firms). You will need to
practise using these to calculate price, output, profits and consumer and
producer welfare and compare these to the outcomes of other market
structures such as monopoly and perfect competition. Although these look
complicated, in fact, they are all based on the simple equations that:
Profit = Total Revenue Total Cost and
Total Revenue = Price * Quantity.
The formulas for marginal revenue and marginal cost can be derived from
these using calculus. MR, in the case of linear demand, can also be derived
using the result from Block 7 (MR has the same intercept on the P axis and
is twice as steep as the demand schedule).
Learning outcomes
recognise imperfect competition, oligopoly and monopolistic
competition
discuss how cost and demand affect market structure
interpret an N-firm concentration ratio
describe how globalisation changes domestic market structure
identify equilibrium in monopolistic competition
recognise the tension between collusion and competition in a cartel
describe game theory and strategic behaviour
define the concepts of commitment and credibility
analyse reaction functions and Nash equilibrium
describe Cournot and Bertrand competition
describe Stackelberg leadership
recognise why there is no market power in a contestable market
define innocent and strategic entry barriers.
Essential reading
111
Further reading
Chapter 8.

This block starts by introducing a theory of market structure, focusing
on how market structure depends on the shape of the industry longrun average cost curve and the position of the market demand curve.
Market structure can be described using an N-firm concentration ratio.
Two specific types of imperfect competition are analysed in this block
monopolistic competition and oligopoly. One key characteristic of
a monopolistically competitive market is product differentiation. The
long-run equilibrium of this market is described graphically. One key
characteristic of oligopoly is strategic interaction. Oligopoly is often
portrayed using a kinked demand curve, although the usefulness of this
concept is a matter of debate. Firms can either compete or collude. If they
compete, this can be analysed using models from game theory, such as the
prisoners dilemma. A specific example of oligopoly is duopoly, where there
are only two firms. They can compete on output (Cournot behaviour)
or price (Bertrand behaviour). If one firm moves first, it is a Stackelberg
leader and will derive different payoffs than the firm which follows. The
outcomes of these interactions are described in this block, and you will
learn how to find these and how to compare them with the outcomes that
arise under monopoly and under perfect competition. The behaviour of
incumbents is affected not only by other firms already in the market, but
also by the threat of entry of new firms. If other firms can enter freely, the
market is called a contestable market, and will exhibit outcomes similar to
perfect competition. Barriers to entry can either be natural (innocent) or
strategic (constructed). Strategic entry deterrence can consist of investing
in spare capacity, in advertising, or in product differentiation, for example.
This can be analysed by use of a decision tree. In all these games, the
concept of Nash equilibrium is important and demonstrates a stable
outcome, from which the players have no incentive to diverge.
A theory of market structure

BVFD: read the introduction and section 9.1 of Chapter 9.
The crucial determinant of market structure is minimum efficient scale
(the lowest point at which a firms LAC curve stops falling) relative to the
size of the total market as shown by the demand curve.
The concentration ratio measures the fraction of total output in an
industry that is produced by some specific number of the industrys largest
firms. The N-firm concentration ratio leaves this number general. Once it
has been specified, we refer to the five-firm concentration ratio, or threefirm concentration ratio, for example.
The degree of competition in a market is also affected by globalisation the closer integration of markets across countries - since this increases the
ability of foreign producers to compete effectively in the domestic market.
As such, the degree of competition does not only depend on the number of
domestic producers alone.
112
Activity SG9.1
1. Calculate the four-firm concentration ratio of an industry with the following
distribution of sales: 40%, 10%, 10%, 10%, 8%, 8%, 6% 4% 2% 1% 1%.
a. 100%
b. 80%
c. 70%
d. 40%.
Monopolistic competition
Monopolistic competition describes a market structure with a large number
of firms, each one selling a product which is an imperfect substitute
for the product of its rivals (this is called product differentiation). Each
firm faces a downward sloping demand curve for its product. Firms in a
monopolistically competitive industry are not price-takers; they have some
market power and can set the price they charge. If they increase price
they will lose some customers, but not all. If they drop their price they
will gain some market share but will not capture the whole market. Since
the number of firms is large, they can ignore any reactions of competitors
when they make their output and pricing decisions. A further important
assumption of this model is that there is free entry and exit. When a new
firm enters the industry, it will take customers from all existing firms,
shifting the demand curve faced by each firm to the left.
The key element that makes monopolistic competition different to perfect
competition is that firms face a downward sloping demand curve rather
than a horizontal demand curve (i.e. demand for their products is not
perfectly elastic as it is in perfect competition). Since this is due to product
differentiation (the assumption that the goods are heterogeneous), firms
have a strong incentive to advertise their products either to inform
customers about what makes their product different, or to create and
enhance customers perceptions of this difference. If advertising is effective,
it can increase the demand for a product and also decrease the elasticity of
that demand, both of which can lead to an increase in revenue for the firm.
Activity SG9.2
Figure 9.2 shows the short-run and long-run equilibria for a firm in a monopolistically
competitive market. Remember that the demand curves DD and DD (and the associated
MR curves) refer to a single firm in the market. The market demand curve, of course,
lies further to the right. Make sure you understand this figure by reproducing it below,
highlighting:
i. the short-run monopoly profits
ii. the tangency of the DD curve and the AC curve in long-run equilibrium.
113
In the long run, the price charged by firms is equal to the average cost and
they are just breaking even. In industries where there are many producers
but of differentiated products, free entry will tend to eliminate profits in
the long run.
Monopolistic competition and efficiency

The long-run equilibrium point is not on the minimum of the LAC curve as
it would be under perfect competition this implies inefficiency, as firms
are operating with extra capacity, on the downward sloping section of their
average cost curves. Any point on the LAC curve is by definition productive
efficient. Producing on the downward sloping part of the AC curve implies
a loss of allocative efficiency, as price will be higher than marginal cost
(since the LMC curve passes through the lowest point of the LAC curve).
Because the price is set higher than the marginal cost, consumer surplus
is lower than it would be if prices were set equal to marginal cost at the
lowest part of the firms AC curve.
However, people are willing to pay to have differentiated products.
For example, people would not be happy if there was only one type of
restaurant to go to, even if this made prices lower. An optimal outcome
would be achieved where the number of differentiated products was
increased until the marginal gain in consumers satisfaction from an
increase in diversity was equal to the loss from having to produce each
existing product at a higher cost (L&C, UK edition p.181; international
edition p.147). Market forces would not necessarily lead to this
outcome, thus it is unclear whether or not the long-run equilibrium of a
monopolistically competitive industry is allocative efficient.
Oligopoly
An oligopoly is a market structure characterised by there being only a few
firms, which interact strategically. Firms are aware that their decisions
affect the actions of other firms and that their own optimal decisions
depend on what the other firms are doing. The basic tension is between
wanting to collaborate to achieve a monopoly outcome, and the incentives
to cheat on any agreement so as to raise ones own market share and
profits. Examples of oligopolies in the UK include the supermarket
industry (dominated by Tesco, Sainsbury, Morrison and ASDA) and retail
banking (dominated by Barclays, Lloyds, the Royal Bank of Scotland
and HSBC). Note the discussion of OPEC in the section on cartels was
written before world oil prices again plummeted in mid-2014. There has
been much debate about the causes of this downturn in oil prices (in
particular, whether it is primarily demand-driven or supply-driven), but
the unwillingness of the Saudis to restrict output, discussed in BVFD, is
certainly one element in the story
Oligopolistic industries tend to be dominated by a few large
firms. One reason for this is that large firms often have a competitive
advantage because their fixed costs (e.g. research and development) can
be spread out over a greater sales volume so the per unit cost is reduced. A
further reason is that large firms can exploit economies of scale and scope,
which creates natural entry barriers. Economies of scale arise because a
large scale facilitates the division of labour, which increases productivity.
Economies of scope apply to firms that produce multiple products and
arise because firms can share resources or functions between different
114
product areas (L&C, UK edition p.184; international edition p.149). In

industries where there are large economies of scale or scope, there is
simply not enough room for a large number of firms, all operating at or
near their minimum efficient scales. Hence, it is more common for a small
number of large firms to dominate the market.
Profits under oligopoly

In some oligopolistic industries, firms manage to approach joint profit
maximisation (in this case, the outcome in terms of market price and
output is similar to pure monopoly). In others, firms compete very
intensely and approach the perfectly competitive output. In the long run,
profits will attract entry, unless there are natural entry barriers such as
large economies of scale.
The kinked demand curve

Figure 9.4 shows the demand curves facing a single firm. Imagine this is
your firm. The assumption is that competitors will match your price-cut
to maintain their market share, but are happy to watch you raise your
price without reacting, since you will lose market share to them if they
keep their price steady when you raise yours. Below Q0, demand is elastic
because if you increase your price by even a little, customers will go away
from you and buy from your competitors, whose prices have remained the
same. Recall from (BVFD, Chapter 4, p.68) that when demand is elastic,
a price rise leads to a fall in total revenue. Above Q0, demand is inelastic
you wont gain many more customers by cutting your price because your
competitors will all drop their prices too. Recall also that when demand
is inelastic, a price cut leads to a fall in total revenue. This helps to
provide an explanation for why prices may be sticky at P0, since there is
no revenue incentive to shift prices in either direction. The discontinuity
in the MR curve shows that prices may well be sticky even when a firms
costs change and shift its MC curve. The ability to predict and explain
price stickiness is one of the merits of this theory. One of its shortcomings
is that it does not explain how the initial price and quantity, the point of
the kink on the demand curve, is determined.
Game theory
Considering the extent to which game theory has revolutionised much of
modern industrial organisation theory, and oligopoly theory in particular,
the treatment here in BVFD is relatively brief (although the treatment in
this section is expanded in section 9.7 of the text). Game theory is a very
useful approach for analysing strategic interaction. In a game, your best
move depends on what your opponent does. This is helpful for analysing
oligopoly, since one of the key features of this market structure is strategic
interaction between firms. One key concept is a dominant strategy
a player has a dominant strategy if one strategy is their best response,
regardless of what the other player does. In Figure 9.5, choosing a high
output is a dominant strategy for each firm. Another key concept is Nash
equilibrium this is a situation where no player has an incentive to
change their strategy, since they are doing as well as they can, given the
strategies chosen by the other players. Note that in Figure 9.5 the Nash
equilibrium is, unsurprisingly, the pair of dominant strategies. However it
is not necessary that both firms have a dominant strategy for there to be a
Nash Equilibrium.
115
Activity SG9.3
The high-output/low-output game is based on a famous game called the Prisoners
dilemma. McGraw Hill has a nice interactive version of this which you can access at
http://highered.mheducation.com/sites/007243404x/student_view0/chapter9/interactive_
activities.html# (though the question appears to be slightly misworded). The prisoners
dilemma is described below. Read through the scenario and decide what you would do if
you were one of the prisoners
You and your partner were just arrested for the burglary you pulled off last
night, and are being interrogated separately in different rooms. The officer
says to you Well, looks like youve got some decisions to make here. You can
confess to the burglary or you can continue to deny any role in it. Your problem
is that the consequence for you depends on what your partner does. If he
confesses and you dont, well throw the book at you and give him immunity.
You get 10 years in jail and he goes free. Of course, the reverse would be true
if you confess and he doesnt. If you both confess, youd both get a lighter
sentence, 5 years. If you both insist on denying the charges, we should have
enough evidence to get you both for 1 year for sure.
Now answer the following questions:
a. What does the payoff matrix for this game look like? (base this on Figure 9.5) (it is
conventional to make the payoff for the player, on the left hand side of the payoff
matrix, the row player, the first entry in each cell and the payoffs for the player at
the top of the matrix, the column player second).
b. Does either player have a dominant strategy?
c. Does this strategy result in the best joint outcome for the prisoners?
d. Does this strategy result in the best outcome for the police?
The game in Figure 9.5, and the traditional prisoners dilemma you have
just worked through are one-off games (sometimes called one shot
games). Many real world economic decisions, such as firms setting prices
or quantities, relate to repeated actions rather than one off moves. This
can quite dramatically change the expected outcomes. The intuition is
that repeated games provide incentives for cooperation that are absent in
one-off games; in a repeated game, honest behaviour can be rewarded and
cheating can be punished (it is necessary that the threat of punishment is
a credible threat). See the McGraw-Hill interactive version for a second
game on repeated interactions.
Models of oligopoly
BVFD: read section 9.5, Maths 9.1 and 9.2 and concept 9.2.
This section covers models of oligopoly (illustrated in the two-firm
case, a duopoly) that preceded game theory by many years (Cournot
and Bertrand were 19th-century French mathematical economists and
Stackelberg, a German economist, first published his analysis in 1934).
While it is often possible to reformulate the models in game theoretic
terms, it is instructive to understand the structure of such models.
Cournot model
The graphical analysis of the Cournot model is useful if you find the
mathematics in Maths box 9.1 difficult. If you dont, the mathematical
treatment is more concise. Note that Maths box 9.1 uses calculus in
deriving the reaction functions. But in the last chapter, we showed that for
116
a linear demand curve the MR curve has the same intercept on the P axis,
but is twice as steep. Let us see how this works out in the example BVFD
use in the maths box.
We are given the market demand curve P = a bQ, which we can write as
P = a bQA bQB. Now we want to write firm As MR curve as a function of
its own output, holding its rivals output constant, so using the result from
the last chapter, MRA= a 2bQA bQB .
Although calculus is the most straightforward means, there is an
alternative method of finding MC. Using delta notation as before,
TCA = cQA. Therefore:
TC MC = c
=
A
QA
aC
aQB
)
2b
2
and similarly for firm B. Solve the two reaction functions simultaneously
to get the Nash equilibrium in quantities. The same method can be used,
with suitable variations (for example in deriving the MR function for firm
A we first substitute Bs reaction function into the demand curve), in the
case of a Stackelberg leader to replace the calculus in Maths box 9.2.
Now setting MRA = MCA gives us As reaction function (QA =
Activity SG9.4
Consider a market for a homogeneous product with demand given by Q = 37.5 P/4.
There are two firms, each with a constant marginal cost equal to 40.
a. Determine output and price under a Cournot equilibrium.
b. Compute the deadweight loss as a percentage of the deadweight loss under a nondiscriminating monopolist.
Activity SG9.5
Which model of strategic duopoly interaction (Cournot or Bertrand) would you think
provides a better approximation to each of the following industries, and why?
i. oil refining
ii. insurance.
Stackelberg model
Activity SG9.6
Suppose there are two firms with the same constant average and marginal cost,
AC = MC = 5, facing the market demand curve Q1 + Q2 = 53 P. Firm 1 is a Stackelberg
leader and makes its output decision before Firm 2 (a Cournot follower).
a. Find the reaction curves that tell each firm how much to produce in terms of the
output of its competitor and use these to calculate how much each firm will produce
and the profits it will make, as well as the market price and the total market profit.
b. If each firm believes that it is the Stackelberg leader, while the other firm is the
Cournot follower, how much will each firm produce, and what will its profit be?
c. In the Stackelberg model, the firm that sets output first has an advantage. Explain
why.
117
Contestable market
A contestable market is a market structure in which there are only a few
companies which nonetheless behave in a competitive manner due to the
threat of new entrants. Globalisation has increased the relevance of this
concept, since foreign firms which are already established in overseas
markets can enter more easily into a domestic market than firms which
need to start production from scratch.
This section also refines the concept of barriers to entry, which we
considered in the previous block on monopoly. There, we differentiated
between natural and artificial barriers to entry, but this was not the only
way to characterise different types of entry barriers. Here BVFD makes a
similar, but not identical, distinction between innocent and non-innocent
barriers to entry. Other texts distinguish between structural barriers, legal
barriers and strategic barriers, the latter referring to deliberate actions
taken by incumbent firms to deter entry by new firms. These types of entry
barriers are discussed in the next section.
Sequential games
The game discussed in this section is represented again below with an
alternative presentation of the payoffs, for clarity. Sequential games such
as this are often represented with the payoffs at the end of the relevant
path. As stated below the diagram, in each case the first payoff in each
set of brackets is the incumbents, the second the potential entrants. This
depiction, and that in Figure 9.9, is known as the extensive form of the
game (sometimes also known as a decision tree).
Without strategic
entry deterrence
With strategic
entry deterrence
Entrant
Entrant
In
In
Out
Incumbent
Accept
(1,1)
Accept
Fight
(-1,-2)
(5,0)
Out
Incumbent
(-2,1)
Fight
(-1,-1)
(2,0)
Payoffs are: (Incumbent, Entrant)

Figure 9.1: Strategic entry deterrence.
Let us start with the case where there has been no strategic entry
deterrence, for example there has been no investment in excess capacity
which can be used to quickly flood the market with extra output. This is
shown as the game on the left above, and in the top row in the matrix in
Figure 9.9. Sequential games can be solved by backwards induction,
which means starting from the final step of the game. In this case, only
118
one leg of the decision tree involves a decision by the incumbent (i.e.
the left leg). The incumbent can either choose between a payoff of 1 (if
it accepts the entry without fighting) or 1 (if it fights). It will choose 1.
The threat to fight entry is not a credible one in this case. Now going back
to the first step of the game, where the entrant has a decision to make.
The entrant can either choose a payoff of 1 (if it enters, since it knows the
best move for the incumbent will be to accept its entry) or 0 (if it does
not enter). It chooses 1. The outcome of the game is thus that the entrant
enters and the incumbent accepts. Both make a profit of 1. Now for the
case where the incumbent has taken steps to deter entry the game on
the right (the second row in Figure 9.9). As described in the textbook, this
could be by investing in spare capacity which is only useful if it chooses to
fight a market entrant. Starting again with the second part of the game,
the incumbent chooses between a payoff of 2 (if it accepts) and 1 (if
it fights). It will choose 1. The entrant thus faces the following choice:
a payoff of 1 (if it enters and the incumbent fights), or a payoff of 0 (if
it doesnt enter). It will choose 0. Thus the outcome of the game is that
the entrant does not enter and the incumbent makes a profit of 2. As
compared to the first case (no spare capacity) the incumbents threat to
fight is credible, it does better by fighting than by accepting. Sequential
games and backward induction are useful tools for analysing this type of
market interaction. However, certain key assumptions are required, for
example that both players have accurate knowledge of the whole decision
tree, including the payoffs of their opponent.
BVFD: read section 9.8 and the summary, and work through the review
questions.
Overview
Market structure is partly determined by firms minimum efficient scale
(the lowest point at which a firms LAC curve stops falling) relative to
the size of the total market as shown by the demand curve. Imperfect
competition exists when firms face a downward sloping demand curve.
The most important forms of imperfect competition are monopolistic
competition, oligopoly and pure monopoly. The key characteristic of a
monopolistically competitive market is product differentiation, which gives
each firm some limited monopoly power in its special brand. There is free
entry and exit. In long-run equilibrium, the demand curve is tangent to
the firms LAC curve, and price is equal to average cost but is greater than
marginal cost and marginal revenue.
The key characteristic of oligopoly is strategic interaction. Oligopoly is
often portrayed using a kinked demand curve. Firms can either compete or
collude, though many forms of collusion are illegal in domestic markets.
Strategic interaction can be analysed using game theory. The outcome
will depend on whether the game is played once or repeatedly, and if it
is possible for firms to make binding commitments. A specific example of
oligopoly is duopoly, where there are only two firms. In a Cournot duopoly,
each firm treats the other firms output as given. In a Bertrand duopoly,
each firm treats the other firms price as given. If one firm moves first, that
firm is a Stackelberg leader and will gain higher payoffs than the firm which
follows.
The outcomes of these forms of interaction can be compared with the
outcomes that arise under monopoly and under perfect competition.
In some oligopolistic industries, firms manage to approach joint profit
maximisation (in this case, the outcome in terms of market price and
119
output is similar to pure monopoly). In others, firms compete very

intensely and approach the perfectly competitive output. In the long run,
profits will attract new firms into the industry unless there are barriers to
entry. The threat of entry of new firms affects the behaviour of incumbents.
If other firms can enter freely, the market is called a contestable market,
and incumbent firms must mimic perfectly competitive behaviour in order
to avoid being flooded by entrants. Barriers to entry can either be natural
(such as scale economies or absolute cost advantages) or strategic (arising
from credible commitments to resist entry if challenged). The analysis
of imperfect competition helps explain real world phenomena such as
advertising, price wars and product differentiation.


For each question, choose the best response.
1. Refer to the box below. Two bus companies offer a daily service
running from London to Nottingham. Each company can decide to
leave early or leave late. Their buses are somewhat different, so the
payoffs are not symmetric. From the payoff matrix, we can see that:
a. neither company has a dominant strategy
b. only bus company A has a dominant strategy
c. only bus company B has a dominant strategy
d. both companies have a dominant strategy.
Box 1
Note: Lower left payoffs are
As. Upper right are Bs
Bus Company
Leave Early
A
Leave Late
Bus Company B
Leave Early
Leave Late
900
1,000
850
950
650
750
800
700
2. Which market structure is characterised by a long-run equilibrium

where price is equal to average cost but is greater than marginal cost
and marginal revenue?
a. perfect competition
b. monopolistic competition
c. oligopoly
d. monopoly.
3. The demand curve faced by a monopolistically competitive firm is
a. elastic
b. unit elastic
c. inelastic
d. perfectly inelastic.
120
4. If an imperfectly competitive firm is producing a level of output where

marginal cost is equal to marginal revenue, marginal revenue is below
average variable cost, and price is equal to average total cost, then the
firm:
a. should shut down
b. should decrease output, but should not shut down
c. should increase output
d. none of the above is correct.
5. An industry having a four-firm concentration ratio of 85 per cent:
a. approximates pure competition
b. is monopolistically competitive
c. is a pure monopoly
d. is an oligopoly.

1. a. Duopoly: There are two firms in a market, both have a linear cost
function C(q) = 2q. The market inverse demand function is given
by P(Q) = 9 Q.
i. What is the Cournot equilibrium output for each firm? What
price will they charge? How much profit will they each earn?
ii. Assume Firm 1 is the Stackelberg leader and Firm 2 follows
afterwards. What is the Stackelberg equilibrium output for
each firm? What price will they charge? How much profit will
they each earn?
iii. Compare the price, total market output and profits for the two
firms under Cournot and Stackelberg duopoly. Which market
structure does Firm 1 prefer? Firm 2?
iv. Which market structure do consumers prefer? Why?
b. Contestable markets:
i. What is a contestable market?
ii. How is globalisation relevant for the analysis of contestable
markets?
iii. For the payoff matrix given below, draw a decision tree and
find and explain the outcome of the game (the payoff to the
incumbent is listed first in each cell).
Potential entrant
Incumbent
In
Out
Accept
15, 10
50, 0
Fight
10, 20
50, 0
2. a. Monopolistic competition:
i. What are the particular characteristics of monopolistic
competition as a market structure?
ii. Draw a short-run equilibrium for monopolistic competition
where the firms are making losses, and show how exit results
in a new, long-run equilibrium.
iii. Is this outcome efficient?
121
b. Concentration ratios:
In the USA, the four-firm concentration ratio for beer increased
from 22 to 95 between 1950 and 2000. Explain what this means
and describe possible reasons for why this occurred.
122
Block 10: The labour market

Introduction
The previous blocks discussed the theory of the firm and various market
structures. Part of the theory of the firm is the way in which firms aim to
combine inputs in the most cost efficient way possible. This gave us the
first taste of the roles of capital and labour in the production process.
In addition to labour and capital, the factors of production also include
land and raw materials, as well as entrepreneurship. These factors will
be briefly explained below. This block then focuses on the labour market.
Some of what you will learn about the labour market is also relevant for
the analysis of the other factors of production; however, there are also
key differences. We will not explore these further in this block. Interested
students can read BVFD Chapter 11 otherwise, you will most likely cover
the analysis of markets for the other factors of production in later years as
you continue your studies in economics.
The study of the labour market is important not least from an individual
point of view, as most of us will allocate a substantial fraction of our
time to the labour market in the future (if you are not already doing
so). Furthermore, many social policy issues concern the labour market
experiences of particular groups of workers. Finally, as we have already
mentioned, labour is a key input in the production process. The overall
productivity of an economy depends to a large extent on the productivity
of its labour force. The approach to this subject matter is similar to the
analysis of markets for consumer goods, and the structure of the textbook
chapter will also be familiar to you (covering demand, supply, equilibrium,
and adjustments). However, in some ways the details are quite different.
For example, labour is human effort, thus the supply of labour depends on
individual preferences.
Learning outcomes
describe the factors of production
analyse a firms demand for inputs in the long run and short run
recognise marginal value product, marginal revenue product and
marginal cost of a factor
define the industry demand for labour
analyse labour supply decisions
define economic rent
define labour market equilibrium and disequilibrium
demonstrate how minimum wages affect unemployment.
Essential reading
Further reading
Lipsey and Chrystal (L&C) international edition, Chapters 8 and 9; UK edition,
Chapters 9 and 10.
123

This block first introduces the factors of production and then provides
an analysis of the firms demand for factors, building on the analysis
from the blocks on the firm (5 and 6) where the firms choice of a costminimising mix of inputs was discussed. Having now analysed various
market structures (Blocks 79), the impact of the shape of the demand
curve the firm faces for their output on their demand for inputs (which is
derived demand) is now clarified, focusing on labour. The more elastic the
firms demand and marginal revenue curves, the more an increase in the
price of labour leads to a fall in the firms demand for labour. In the short
run, at least one factor of production is fixed, but the firm can adjust its
variable input which is labour. Labour is subject to diminishing marginal
returns when other factors are fixed and the marginal physical product
of labour falls as more labour is hired. The firm hires labour until the
marginal cost of labour equals its marginal revenue product. The industrys
demand for labour is less elastic than the horizontal sum of firms shortrun demand curves, because higher industry output in response to a
wage reduction also reduces the output price. In terms of the supply
of labour, this depends on the size of the population, the participation
rate and the number of hours people choose to work. For someone
already in the labour force, a rise in the hourly real wage has both a
substitution effect tending to increase the hours worked and an income
effect tending to reduce the supply of hours worked. Four factors increase
the participation rate: higher real wages, lower fixed costs of working,
lower non-labour income and changes in tastes in favour of working.
The industry supply curve of labour depends on the wage paid relative to
wages in other industries using similar skills. People who would like to
work and are actively seeking work but cannot find a job are unemployed.
Unemployment can be defined as voluntary or involuntary. Possible causes
of involuntary unemployment (representing disequilibrium in the labour
market) are minimum wage agreements, trade unions, scale economies,
insideoutsider distinctions and efficiency wages.
The factors of production

The production of any good or service requires inputs. These are known as
the factors of production. The three main inputs to the production process
are: land, labour and physical capital.
Land comprises all free gifts of nature such as land, forests, minerals
etc. Although its productivity can be improved through fertiliser and
irrigation (for example), its supply is generally considered fixed, even
in the long run.
Labour includes the mental and physical effort of people employed in
return for remuneration. Each individual has different skills, qualities
and qualifications. This is known as their human capital.
Physical capital is the stock of produced goods that are used in the
production of other goods and services by firms (mostly) and also
households. Physical capital is manufactured, which means that the
stock of capital can be increased. It is not completely consumed in the
production process although it does tend to wear down over time
this is known as depreciation.
124
Supplied by
Consumed in production?
Speed of adjustment
Land
Nature
No
Never fixed supply
Labour
Individual people
No
Fast
Capital
Firms (generally)
Not fully
Medium
Table 10.1: Characteristics of key factors of production.
These are the three main inputs to production described in BVFD.

Other textbooks add further inputs, for example: raw materials and
entrepreneurship.
Raw materials are also provided by nature and are included together
with land in many definitions; however one key difference is that
raw materials (such as oil, coal, cotton, etc.) are fully consumed in
the production process. Thus in one sense, there is little difference
between the analysis of markets for raw materials and markets for
final consumption goods.
Entrepreneurship is provided by entrepreneurs or innovators and
includes introducing new ideas and business practices as well as
accepting risk to their own resources and possibly also organising the
other factors of production.
You can read more about the factors of production in BVFD sections
11.1 (capital), 11.8 (land) and concept 11.1 (summary); in AW section
3.1, sub-section Means of production (pp.10507); and L&C Chapter 1,
subsection Resources and scarcity (UK edition p.9; international edition
pp.5-6) as well as Chapter 9 (UK edition) or 8 (international edition).
Analysis of the labour market

One key difference between our analysis of consumption goods in the
previous blocks and our analysis of labour as an input to production in this
block is that the roles of the key market participants have been reversed.
Previously, when we talked about consumption goods, firms were the
suppliers and individuals were the consumers. In the labour market,
individuals are now supplying their labour, which firms demand. A second
key difference is that the demand for labour is derived demand, in that
the demand for labour depends on the demand for the goods produced by
that labour. Firms decisions on how much to produce and how to produce
it imply specific demands for various quantities of inputs.
Labour demand in the long run

When analysing input markets it is important to distinguish between the
short run, when (by definition) the amount of at least one input cannot
be varied by the firm, and the long run, in which the firm is free to vary
all its inputs. This section deals with the labour market in the long run.
Because both labour and capital can be varied, an increase in the price of
labour (the wage rate) will decrease the demand for labour due both to
the substitution effect (capital becomes relatively cheaper so any given
output is produced more capital-intensively) and the output effect (with
higher costs, the profit maximising output level, where MC = MR, falls).
The point made in Figure 10.1 is returned to below in the discussion of
the short-run demand for labour. The final section refers to the appendix
125
where this is demonstrated using budget constraints and indifference

curves. In fact, there is no appendix to this chapter but the analysis is
covered in the appendix to Chapter 7.
Activity SG10.1
Use budget constraints and indifference curves to demonstrate the effect on the demand
for labour of a fall in the wage rate clearly indicate both substitution and output effects
and accompany your graphs with a written explanation.
Activity SG10.2
A fall in the wage rate will:
a. increase the demand for capital but the effect on the demand for labour is uncertain
b. increase the demand for labour but the effect on the demand for capital is uncertain
c. decrease the demand for capital but the effect on the demand for labour is uncertain
d. decrease the demand for labour but the effect on the demand for capital is uncertain.
This section (BVFD Section 10.1) goes beyond the analysis in Chapter 7
to demonstrate how the elasticity of demand impacts on the output effect
of a change in one of the factor prices. The (perfectly elastic) horizontal
demand curve DD is much more elastic than the downward sloping
demand curve DD. If the firm faces the less elastic curve, the output effect
of an increase in costs is smaller as can be seen in Figure 10.1. This
shows the importance of recognising that the demand for factors is derived
demand such that the characteristics of the demand for the output have an
impact on the demand for the factors of production.
Short-run demand for labour

The firm can calculate the optimal amount of capital and labour to use as
inputs in the production process using marginal analysis: the extra value
gained from one more unit of the input must be equal to the unit price of
that input. The extra value gained from one more unit of the input is, in
turn, the marginal physical product of the input multiplied by how much
the firm gets, per unit, from selling that extra output. In the case of a
price taking firm, and section 10.2 only considers competitive firms, the
marginal physical product is just multiplied by the price of output, which
is of course constant for the firm. In the case of a firm facing a downward
sloping demand curve for its product, a monopolist for example, we
cannot just multiply MPL by the original product price to get the monetary
value to the firm of the extra output. Why not? Because to sell more
output the price will have to fall, not just for the marginal unit but for all
units. If you dont remember why this is, revise the monopoly block and
chapter. When the demand curve is downward sloping the optimal rule
for hiring an input is, in the case of labour, to hire labour until the wage is
equal to the marginal revenue product of labour (MRPL)1, i.e. until
W = MRPL = MRQ * MPL
where MRQ is the marginal revenue that the firm gets from selling an extra
unit of output. Recalling from block 7 that:
126
MRQ = P 1 +
Some textbooks using

the term marginal
revenue product for
both competitive and
non-competitive firms,
others, such as BVFD,
reserve the term MVPL
for the competitive case
where MR=P.
1
where is price elasticity of demand for output, the hiring rule becomes to
hire labour up to the point where
1
.MPL
W=P 1+
in the case of perfect competition where =- this just reduces to

W = P * MPL, or W = MVPL in the textbook. Note that because is negative,
the labour demand curve for a non-competitive firm lies below the labour
demand curve for a competitive firm with the same MPL curve and is steeper.
As in Figure 10.1, output, and hence the derived demand for labour, is less
responsive to wage changes the less elastic is the demand for output.2
Activity SG10.3
Imagine you are the manager of a small firm which makes and sells doughnuts and you
need to decide how many workers to employ. Use the information below to make your
decision. A doughnut sells for 1.50. All workers work an eight-hour shift and the wage
rate given is the hourly rate. The market for doughnuts is perfectly competitive. Explain the
reasoning behind your decision.
Workers
Output per hour
20
MPL
MVPL()
2
This is the basis for one
of the Hicks-Marshall
laws of derived demand:
other things equal the
elasticity of labour
demand with respect to
the wage is high when
the price elasticity of
demand for output is
high.
Wage rate ()
7
30
37
42
44
Industry demand curve for labour

As explained in this short section and the accompanying diagram, the
industry demand curve for labour is steeper than the industry MVPL
schedule, the horizontal addition of the original MVPL curves of each firm
in the industry, since a lower wage increases industry output, leading to
a fall in equilibrium price and a shift in the MVPL schedule. The industry
demand curve for labour connects points on multiple MVPL schedules.
The slope of the labour demand curve reflects the elasticity of demand for
the product being produced, since demand for labour is derived demand,
depending on demand for the output.
Labour supply
BVFD: read section 10.4 and Maths 10.2, as well as case 10.1.
This section applies the theory of consumer choice to an individuals
decisions of how to allocate their time between hours of leisure and
hours of paid work3 for individuals who are in the labour force as well as
the decision about whether or not to participate in paid work in the first
place. You should treat Maths 10.2 as an integral part of this section, not
an optional extra. In fact, even the diagrammatic treatment in Maths 10.2
does not go far enough in that, although it indicates whether the income
or substitution effect dominates for a given wage change, it does not show
these effects separately in the first diagram of the Maths box. You are
now asked to remedy this shortcoming by drawing for yourself a choice
diagram which does show the separate income and substitution effects.
In this basic model

these are the only
uses of an individuals
time. The model can
be extended/modified
to incorporate other
important uses of time
such as unpaid work in
the home.
3
127
Activity SG10.4
On a blank piece of paper, draw a large diagram showing a budget constraint and
indifference curve for three different wage levels, such that it can be used to derive a
backwards-bending labour supply curve. For each of the two increases in the wage level,
clearly indicate the income and substitution effects, noting which is larger in each case
(you may need to refer back to Figure 5.14 in Chapter 5 to remember how income and
substitution effects can be distinguished graphically).
This section of the text assumes that leisure is a normal good4, more of it
will be consumed as real income increases. This is likely to be a realistic
assumption, in practice, for most people. However, suppose that leisure is, in
fact, an inferior good. How would this change the analysis of income versus
substitution effects? Could there be a backward bending labour supply curve
in such circumstances?
Participation rates
One important concept from this section is the reservation wage the
lowest wage a worker is willing to accept to work in a given occupation.
For this section, pay attention to the way that the four main factors which
increase participation are represented graphically, as per Figure 10.5.
Activity SG10.5
Match the factor which increases participation to the description of the graphical
representation of this factor in Figure 10.5.
Higher real hourly wage rate
Shorter distance AC
Lower fixed costs of working
Shorter distance BC
Lower non-labour income
Flatter indifference curves
Changes in tastes in favour of

more work and less leisure
Steeper budget constraint line
Supply of labour to an industry

As is mentioned in this section, the supply of certain types of labour to the
economy as a whole is relatively fixed in the short run. In the long run,
population growth and education and training can increase the supply. How
elastic the supply of a certain type of labour is to a particular industry depends
in part on how large that industry is relative to the economy as a whole.
Labour market equilibrium

BVFD: read section 10.5 and case 10.2 as well as concept 10.1.
Labour mobility
The extent of labour mobility into and out of an industry affects the slope of
the industrys labour supply curve and the extent to which this curve shifts
when there is a change in wages in other industries. When there is a high
degree of labour mobility, wage increases in one industry easily flow over
into other industries. Labour mobility is a crucially important determinant
of a countrys economic efficiency, both in static terms, ensuring labour is
128
4
In fact they make
the even stronger
claim that leisure is
probably a luxury good.
Remind yourself of the
distinction between a
normal and a luxury
good (Block 3 BVFD
section 4.6).
allocated to its most productive uses and in dynamic terms, facilitating

the emergence of new activities and industries while allowing for the
orderly decline of some existing activities and industries where output
demand is falling. Geographic mobility, and in particular international
migration, is perhaps the most important dimension of labour mobility, but
occupational mobility, the ability of workers to undertake new tasks
in an ever-changing economy is also important for efficiency and growth.
Labour mobility is a subject which has attracted increasing attention,
both politically and in terms of economic research, in recent years, but is
perhaps too much of a specialised topic for an introductory course and
is more typically reserved for specialised courses in labour economics.
However, a bit of basic supply and demand analysis can help us to see that
some of the more extreme positions taken on international migration are
likely to be misleading. Below we show the market for a particular type of
labour, it could be nurses, builders, etc. Let us take the latter case.
Wage
Domestic supply
W1
Total supply
W2
Demand
N3
N1
N2
Employment
Figure 10.1: International migration and labour supply.
If only domestic builders supply the market, N1 will be employed and

the wage will be W1. Suppose now that there is immigration of builders
shifting the total supply outwards (and possibly, as in the diagram, making
it more elastic). Employment increases to N2 and the wage falls to W2.
We see that immigrant builders do not displace domestic builders on a
1 for 1 basis (as some crude views of immigrant labour would have us
believe). N2N1 immigrant builders are employed, while the employment
of domestic builders falls by the smaller amount N1N3. It is equally wrong
of course to say that building wouldnt get done at all without immigrant
builders. Without the immigrant builders, the higher wages of builders
leads to a fall in the amount of building that gets done, but there is, again,
equilibrium in the market for building and builders.
Monopsony
A single purchaser in any market is called a monopsonist. When an
employer is a monopsonist, workers must either accept the wage offered,
or move to a different market. The analysis of monopsony in the labour
market is, in effect, the mirror image of the monopoly analysis of a firm
in the product market. The labour supply curve is upward sloping, since
more workers will be willing to work when the wage is higher. The
upward sloping labour supply curve represents the average cost curve
of labour for the monopsonist. The marginal cost of labour lies above
129
this curve, because if a non-discriminating monopsonist hirers one more

worker, they must also pay the higher wage to all the workers who are
already employed. The monopsonist is aware that by hiring more workers,
it is increasing the price of labour as such, it will hire fewer workers
than under a competitive market structure. The employment decision of a
firm with monopoly power in its output market has been dealt with above
where the rule to hire labour up to the point where W = P 1 + 1 .MPL was
discussed.
BVFD: read section 10.6 and case 10.3c.

Many of the concepts in this chapter are analogous to concepts from the
general demand and supply analysis of Chapter 3. For example, economic
rent payment to a worker in excess of their reservation wage is
analogous to producer surplus, and is represented graphically by the
area above the labour supply curve and below the equilibrium wage. The
diagram (Figure 10.8) presented in the section refers to the market but,
of course, some individuals with reservation wages well below the market
wage of W0 can earn very substantial economic rents.
Disequilibrium in the labour market

BVFD: read section 10.7 and concept 10.2.
This section introduces five reasons why labour markets may not clear
minimum wage laws, trade unions, scale economies, the insideroutsider
dichotomy, and efficiency wages. If wages are fully flexible, they will be
able to rise and fall to the equilibrium level where demand and supply
are equated and the labour market clears. These five factors provide an
explanation why wage levels may stay above the equilibrium rate, leading
to some of the labour force being unemployed. There is something of a
semantic issue involved in the use of the market clearing concept here.
What is really meant by a non-clearing market in this section is that the
equilibrium wage is above the competitive wage. Nevertheless, it could be
argued that in each of these cases the market does in fact clear, subject to
the institutions in place at the time. Take the case of the minimum wage
in Figure 10.9. The minimum wage essentially rules out that part of the
labour supply curve below W2. Although some workers would be prepared
to work at W < W2, the law of the land does not permit firms to employ
them at these wages, so the supply curve is essentially horizontal at W2
until it hits the supply curve at L = L2. Firms wanting to hire labour in
excess of L2 will have to pay above the minimum wage. So one could say
that the market clears where this modified supply curve intersects the
demand curve (at L = L1). In concept 10.2 this is the argument used in the
sentence just below the diagram.
The case of efficiency wages is another example where it is not really clear
that this is a disequilibrium situation. Firms pay above a market clearing
wage but get higher productivity as a result. Workers may collectively
accept a slightly lower probability of employment as a price worth paying
for the higher wages under such arrangements.
Incidentally, one of the most famous historical cases of efficiency wages
is the case of the Ford Motor Company just over 100 years ago. In 1913
the daily wage at the company was $2.50. Turnover and absenteeism
were high but there was a plentiful supply of workers willing to work at
that wage. Then, at the beginning of 1914 Henry Ford doubled the daily
rate to $5 (for workers who had been with the company for at least six
130
months) as well as shortening the working day. Workers queued outside

Ford factories for employment on the new terms. Quit rates, absentee rates
and firing rates fell dramatically; productivity increased and company
profitability did not suffer in spite of this huge pay rise.5
Wage discrimination
Wage discrimination refers to a situation where equally productive
workers are paid differently based on a characteristic such as age, race
or gender. This section discusses two explanations for this taste-based
discrimination and statistical discrimination. Taste-based discrimination
means the employer (themselves or possibly due to their customers) has
some distaste for hiring a particular type of worker and reduces their
objective MRPL by some factor to a subjective amount MRPL d. This
leads to fewer of this type of worker being employed and those that are
being employed at a lower wage rate.6 Statistical discrimination means
that employers may act on the idea that membership of a particular
group may carry information about a persons productivity. Underlying
uncertainty regarding an applicants true productivity can motivate the
employer to examine statistics about the average performance of the group
to which the applicant belongs and to use this to predict their productivity
and making hiring decisions on this basis. This can benefit members of
high-productivity groups and be a disadvantage for members of lowerproductivity groups.
When observing two groups with different wages we may be interested in
what part of the raw wage differential is due to productivity differences
and what part is due to discrimination. In the BVFD treatment it is
assumed that the two groups are equally productive, but this may not
always be the case. In practice, the raw wage differential may be partly
due to productivity differentials and partly due to discrimination. Take the
case of the lower earnings of older workers. In some industries, especially
where productivity depends on physical strength, older workers may
indeed be less productive, but there may also be age discrimination in
the labour market. Effective anti-discrimination policy needs to target the
discrimination part of the raw differential. Statistical techniques have been
devised to decompose the raw differential into its separate productivity
and discrimination components. While these decomposition techniques
are quite widely used in the empirical labour economics literature they are
subject to a number of well known weaknesses.
Raff, D.M. G. and

Summers, L.H. Did
Henry Ford pay efficiency
wages? Journal of
Labor Economics, (1987)
Pt 2 pp.S57S86.
5
If you initially find

Figure 10.12 difficult
to read, note that in
the left hand panel the
employment of minority
workers increases as we
move leftwards from the
vertical wage axis. This is
the reason why the MCL,
ACL and MRPL curves
have opposite slopes
from the corresponding
curves in the right
hand panel where
employment of majority
workers increases as we
move rightwards.
6
Overview
The three main factors of production are labour, capital and land. Labour
includes all forms of effort supplied by people to those who employ them
for monetary remuneration. Physical capital is the stock of produced
goods that are used in the production of other goods and services. Land
comprises all free gifts of nature such as land, forests, minerals etc.
Firms choose a production technique to minimise the cost of producing
a particular output level. By considering each level of output, they can
construct a total cost curve. Factor demand curves are derived demands.
A shift in the output demand curve for the industry will shift the derived
factor demand curve in the same direction. A firm will hire a variable
131
factor until its marginal cost equals its marginal value product (or
marginal revenue product in the case of a firm which is not a price taker).
A rise in the price of a factor reduces the quantity demanded of that factor
due to both substitution and output effects. A rise in the price of another
factor leads to an increase in demand due to the substitution effect and a
decrease in demand for that factor due to the output effect. It is unclear
which of these effects will dominate.
The supply of labour depends in part on the decisions of individuals to
participate in the labour force and also on the number of hours they
choose to supply. Four things raise the participation rate in the labour
force: higher real wage rates, lower fixed costs of working, lower nonlabour income and changes in tastes in favour of working. Higher wages
impact on the hours of work decision through both a substitution effect,
tending to increase the supply of hours worked, and an income effect,
which at high wage levels tends to reduce the supply of hours worked.
This leads to the labour-supply curve being backward bending. The
industry supply curve of labour depends on the wage paid relative to
wages in other industries using similar skills. Workers in unpleasant jobs
are often paid compensating wage differentials. Workers earning above
their reservation wage are said to be earning economic rent.
The wage is the rental price of labour but certain factors may lead to
wage levels being above the equilibrium level, leading to unemployment
in the labour market. These factors include minimum wage agreements,
trade unions, scale economies, insideroutsider distinctions and efficiency
wages. Discrimination may lead to workers from different groups being
paid different wages.


For each question, choose the correct response.
1. The labour supply curve:
a. is always upward sloping
b. is always downward sloping
c. slopes upwards when the substitution effect dominates
d. slopes upwards when the income effect dominates.
2. Which of the following could explain a decrease in the demand for
labour in a particular job?
a. additional training that increases the productivity of each unit of
labour in this market
b. an increase in the amount of risk associated with this job
c. a decrease in the amount of risk associated with this job
d. a decrease in the productivity of each unit of labour in this market.
132
3. A profit maximising firm will employ labour up to the point where:

a. Marginal revenue = marginal product.
b. Marginal cost = marginal product.
c. Marginal revenue product = average cost of labour.
d. Marginal revenue product = marginal cost of labour.
4. A monopsony occurs if there is a:
a. major employer of labour in a market
b. highly unionised workforce
c. major provider of employees
d. single seller of products in a market.
5. Compared to a monopolist, a perfectly competitive firms demand for
labour is:
a. less responsive to a change in the wage rate
b. more responsive to a change in the wage rate
c. equally responsive to a change in the wage rate
d. the demand for labour does not depend on the wage rate for either
firm.

1.
a. Describe, in words and using graphs, the impact of a change of
hourly wage on a persons labour supply decision, regarding both
hours of work and their participation decision.
b. Alisha earns 20 per hour for up to eight hours of work per day
and is paid 25 for every hour in excess of this. She receives
20 per day from the government in child benefit (regardless of
whether or not she works) and pays 8 per hour for childcare for
each hour she works. If she works, she pays 5 per day for an allday bus ticket. Graph Alishas budget line, for an 18-hour day.
c. Discuss some reasons why labour markets may not clear,
illustrating with diagrams as much as possible.
133
Notes
134
Block 11: Welfare economics

Introduction
This is a good time to think back to the questions from Chapter 1 of
BVFD which asked: what, how and for whom to produce. We have seen
how this question is answered by free markets, concentrating mostly on
markets for a single product or factor. Many economists would agree
that the free market can do quite a good job in allocating resources. But
how can we define what it means to do a good job? Welfare economics
uses the concepts of efficiency and equity to make normative judgements
about the workings of the market. There are reasons why markets fail in
certain circumstances and this can provide a justification for government
intervention in the economy. This block defines and discusses the concept
of externalities, where there is a clear role for government intervention
in the market. The following block will discuss the tools governments
use including taxation, redistributive spending and regulation. This block
on welfare economics is our first step towards looking at the economy
as a whole system. In contrast to the second part of the course on
macroeconomics, this block still uses microeconomic techniques; however,
it examines welfare at the economy-wide level rather than focusing on a
particular market. As such, the concept of general equilibrium is also an
important part of this block.
Learning outcomes
define welfare economics
describe horizontal and vertical equity
discuss the concept of Pareto efficiency
recognise how the invisible hand may achieve efficiency
define the concept of market failure
recognise why partial removal of distortions may be harmful
identify the problem of externalities and possible solutions
discuss how monopoly power causes market failure
analyse distortions from pollution and congestion
discuss why missing markets create distortions
analyse the economics of climate change.
Essential reading
Further reading
Chapter 13.
Witztum (AW), Chapters 6 and 7.

This block examines how well markets work without intervention, as
well as various justifications for government intervention in markets. The
concepts of efficiency and equity are used to evaluate and make normative
135
judgements about various outcomes. Definitions are provided for horizontal

and vertical equity, as well as productive, allocative and Pareto efficiency.
Perfectly competitive markets are both productive and allocative efficient.
The concept of general equilibrium is introduced, which refers to a situation
where multiple (or all) markets are simultaneously in equilibrium. This
block also introduces the first and second welfare theorems and uses the
Edgeworth box to illustrate these. Reasons for market failure include
taxes, imperfect competition, externalities, missing markets and imperfect
information. When only one market is distorted, the first-best solution is
to remove the distortion. However, when this is not possible or there are
reasons why governments prefer not to remove the distortion (for example
for equity reasons), the theory of the second-best says it is better to spread
the distortion thinly over many markets than concentrate it in one market.
Governments can also act against externalities and other distortions by
allocating property rights or imposing regulations.
Equity and efficiency

BVFD: read the introduction to Chapter 13 and section 13.1.
On p.295, in the paragraph beginning Figure 13.2, the fourth sentence should read Any
point inside the frontier is Pareto-inefficient. (not Paretoefficient) (NB: this is only incorrect in the online ebook).
This section introduces the twin notions of equity and efficiency. It is
particularly important to understand clearly the definitions of Pareto
optimality (an allocation of resources is Pareto efficient if any reallocation
would make at least one person worse off) and Pareto gain/improvement
(a reallocation of resources that makes at least one person better off
without making anyone worse off). Many would argue that governments
should favour reallocations that result in Pareto improvements, although
that is itself a value judgement (note the key word should). While the
notions of Pareto efficiency and Pareto improvements are useful principles,
they do have their shortcomings when applied to actual policy decisions,
for at least two reasons. Firstly, there are generally many Pareto optimal
allocations so further value judgements are required to choose the best
allocation from the set of such efficient allocations. Secondly, many policy
decisions have both winners and losers; adopting policies of this kind are
not Pareto improvements because some people are made worse off.1
Equity can be broken down into horizontal and vertical equity. Horizontal
equity is the identical treatment of identical people while vertical equity
has to do with treating people in different situations differently so as to
reduce inequalities between them. Vertical equity is the more contentious
of these two principles; it is hard to see why one would not want to treat
identical people identically, while the optimal amount of vertical equality
is a matter of considerable debate.
Efficiency has to do with making the best use of scare resources to satisfy
peoples needs and desires and can be broken down into productive and
allocative efficiency. To discuss efficiency further, it is useful to come
back to the production possibility frontier PPF introduced in Block 1 and
illustrated below.
136
1
It is sometimes
argued that a policy
rule would be to
accept a reallocation
if the winners could
compensate the losers
(in which case there
is a potential Pareto
improvement). However
if the losers are not
actually compensated
then we again require
value judgements to
decide whether the
reallocation is desirable
on equity grounds.
Output of
good A
B
C
D
E
Output of good B
Figure 11.1: The production possibility frontier.
Productive efficiency is represented by any point on the PPF. Points beyond

the frontier (such as F) are unattainable and points inside (such as A)
are inefficient. Productive efficiency implies that goods and services are
produced at their lowest cost (recall from Block 5 that this has to do with
firms choosing their cost-minimising mix of inputs using the condition that
their isocost curves and isoquants are tangent to each other). More output
of one good can only be obtained by sacrificing output of other goods.
Allocative efficiency has to do with the choice between different
combinations of output only one point on the PPF is allocatively efficient.
This is the point that aligns the efficient production possibilities with the
needs and preferences of society. A point on the PPF is allocatively efficient
when it is not possible to move to a different point on the PPF and make
someone better off without making someone else worse off. Allocative
efficiency is achieved when P = MC, since this means that benefit and cost
are equated. Allocative efficiency occurs when the marginal benefit equals
the marginal cost of producing one extra unit.
An equilibrium may be productively efficient without being allocatively
efficient. In other words, a market where the output generated is being
maximised isnt necessarily maximising social welfare.
As stated above, a Pareto efficient allocation is an allocation there is no
other feasible allocation that makes someone better off without making
anyone else worse off. It relates to both productive and allocative efficiency.
Equity and efficiency are separate concepts. Efficiency doesnt
automatically imply equity.
For example:
An economy contains two people and two goods, oranges and bananas.
Both people like both goods, but value them differently. For person 1,
one orange is exactly equivalent to two bananas, while for person 2,
two oranges are exactly equivalent to one banana. In this case, the three
following allocations are all Pareto efficient:
Person 1 has all the oranges and person 2 has all the bananas.
Person 1 has all the oranges and all the bananas.
Person 2 has all the oranges and all the bananas.2
It is clear that while options 2 and 3 are both Pareto efficient, they are also
highly inequitable!
It is often, but not always, the case that there is a trade-off between equity
and efficiency. An example of a government policy designed to increase
equity that can have a negative effect on efficiency is progressive marginal
taxation, since the high marginal tax rates on those with higher incomes
2
Why are these three
combinations Pareto
efficient? If person1
has no bananas then
any trade that makes
him better off must
involve him getting at
least twice as many
bananas as he gives up
in oranges, which results
in person2 being worse
off. Similarly, if person2
has no oranges then any
trade that makes her
better off must involve
her getting at least
twice as many oranges
as she gives up in
bananas, which results
in person1 being worse
off. On the other hand,
if person1 has some
bananas and person2
has some oranges, then
by transferring one
banana from person1
to person2 and one
orange from person2 to
person1, both of them
are made better off.
137
can reduce work incentives, reducing GDP and/or growth. In addition,

if everyone had the same income, there would be no incentive to work
hard, to change jobs, or even to get an education. Given the widespread
existence of progressive income taxation it would appear that people are
happy to trade off some efficiency for the improvement in equity, which
progressive income taxes deliver. Although equity and efficiency are often
conflicting objectives, it is important to note that this need not always
be the case. An improvement in efficiency should generally improve the
workings of the economy and generate increased growth for all. Increased
efficiency and greater equity are compatible with each other. Another
possible example of a policy that may not imply a trade off is subsidising
the education of children in low income households; this can lead both to
a more equal distribution of earnings and a more productive workforce.
There is no reason why improved efficiency must necessarily lead to
inequality.
Social welfare function

It remains the case, however, that it will be difficult to choose socially
optimal allocations, due to the fact that there are many efficient
allocations and that they have different equity implications. In principle,
the optimal feasible allocation could be selected using what welfare
economics calls a social welfare function; this is something like a set of
social indifference curves which rank combinations of utilities of members
of society. How, if at all, such a social welfare function could be derived in
practice is highly problematic (Chapter 14 will discuss this further). Here
we simply assume the existence of such a function and show how it is used
in deriving the optimal allocation.
Susies
Utility
P
A
C
B
Davids
Utility
Figure 11.2: Utility possibility curve and social welfare function.
In the diagram the PP curve is a utility possibility curve it shows, given

the resources of the economy, the maximum utility that David can achieve
for any given level of Susies utility and vice versa (it is the locus of the
utility levels on the contract curve in the Edgeworth box explained in
concept 13.2 below). All points on the frontier are Pareto efficient, those
beneath the frontier are inefficient. The indifference curves show social
preferences for the David-Susie utility combinations (the indifference
map is the social welfare function). The combination B, although Pareto
inefficient, is preferred to the combination A which is Pareto efficient
but inequitable (Susie has a lot more utility than David). Of course a
movement from B to C would be a Pareto improvement.
Figure 11.1 is a standard PPF where the horizontal and vertical axes show
the output of goods A and B. Only one point of the PPF in Figure 11.1
is allocative efficient. By contrast, the efficient frontier in Figure 13.2 of
138
BVFD and the utility possibility curve Figure 11.2 above have goods/utility
for Susie and David on the horizontal and vertical axes thus they both
focus explicitly on allocation. These curves are constructed in such a way
that all points on the curve are Paretoefficient (implying productive and
allocative efficiency) and the optimal choice requires judgements about
equity, as indicated by the social welfare function.
BVFD: read section 13.2, as well as concepts 13.1 and 13.2.
Efficiency and market structure

We have seen previously (in Block 8) that perfect competition is allocative
efficient because it maximises the sum of producer and consumer surplus
(for further detail on this see AW, section 4.3.1 or refer back to Block 8 for
diagrams showing consumer and producer surplus being maximised under
perfect competition in contrast to the deadweight loss of monopoly).
A further reason is because under perfect competition, marginal cost
will be equal to price in all industries. In order to maximise profits, firms
will produce where MR = MC. Also, MR = P under perfect competition
because the firms face a flat demand curve and therefore have a flat MR
curve which is the same as the demand curve. Thus, P = MC under perfect
competition.
Productive efficiency can occur under a variety of market structures, as
firms will wish to produce at minimum cost in order to maximise profits.
However, allocative efficiency only occurs under perfect competition.
In imperfectly competitive markets, firms are allocatively inefficient as
P > MC.
Perfect competition has consumers trying to maximise their utility and
producers trying to maximise their profits. Market forces ensure that
an equilibrium is reached where gains to all parties are maximised.
Competitive equilibrium ensures that there is no resource transfer between
industries that would make all consumers better off.
General equilibrium
BVFD: read concept 13.1 general equilibrium.
Concept box 13.1 takes a general equilibrium perspective. Up to now, we
have examined equilibrium in markets for a single good or a single factor
of production, this is known as a partial equilibrium approach. General
equilibrium refers to a situation where multiple (or all) markets are
simultaneously in equilibrium. For interested students, there is a detailed
explanation of general equilibrium in AW Chapter 6, section 1.
Concept box 13.2 shows a general equilibrium between two consumers
in an exchange economy, but at the level of the market we can use our
basic supply and demand analysis to analyse general equilibrium. We
need to move from a partial to a general equilibrium approach when
there is significant interdependence between markets; where markets
are completely independent of each other, partial equilibrium analysis
suffices. The following activity is designed to help you to understand how
two markets interact and how equilibrium is attained when the goods
are substitutes. The technique is applicable also in input markets and for
complementary goods or factors.
139
Activity SG11.1
Coffee and tea are substitutes. The demand for each depends on its own price as well as
the price of its substitute. Supply and demand curves are given as follows:
Coffee demand:
Q DC = 60 6PC + 4PT
Coffee supply:
Q SC = 3PC
Tea demand:
Q DT = 20 2PT + PC
Tea supply:
Q ST = 2PT
where PC is the price of coffee, PT the price of tea.

a. Find the equilibrium prices and quantities for coffee and tea. Hint: both markets must
be simultaneously in equilibrium.
b. Suppose that there is a major failure in the coffee crop, leading to a large reduction
in supply. Use supply and demand diagrams to trace out the effect in both markets. In
the new equilibrium what happens to the equilibrium price and quantity of tea?
First and second theorems of welfare economics

Section 13.2 also introduces the first and second theorems of welfare
economics. We dont provide formal proofs of these theorems at this level
of study, although the seven step argument at the beginning of this section
goes some way to proving the first theorem.
First theorem of welfare economics:
When all markets are perfectly competitive, the economy will attain
a Pareto efficient allocation. A perfectly competitive economy induces
selfish individuals independently maximising their private well-being,
to bring the economy to a socially optimal state.
Second theorem of welfare economics:
A planner can achieve any desired Pareto optimal allocation by
appropriately redistributing wealth in a lump-sum fashion and then
letting the market work.
The second welfare theorem provides a theoretical affirmation for the use
of competitive markets in pursuing distributional objectives. Of course, the
lump sum (non-distorting) redistribution of initial endowments (wealth)
required in the second theorem may be quite difficult to achieve in practice.
The Edgeworth box

BVFD: read concept 13.2 the Edgeworth box3
The Edgeworth box, here applied to exchange only (there is also a
production version) is one of the more ingenious diagrams in economics.
It looks complicated and difficult, and it does take a bit of time to master,
but the basic ideas are actually quite straightforward. The key question
behind the movements within an Edgeworth box is, if the two parties trade,
can they achieve a better allocation compared to their initial endowment,
and will this outcome be Pareto optimal? In fact, market forces (working
through the price mechanism) will achieve a Pareto-optimal allocation when
the two parties trade with each other. Furthermore, changes can be made to
the initial endowment so that any particular Pareto-optimal outcome can be
achieved. As such, the Edgeworth box can be used to demonstrate the two
theorems of welfare economics defined above. For interested students, there
is a detailed explanation of the Edgeworth box in AW Chapter 6, section 2.
140
3
Named after Francis
Ysidro Edgeworth
(18451926) a pioneer
of neo-classical
economics, especially
utility theory (including
indifference curves). He
was the founding editor
ofThe Economic Journal,
the most prestigious
British academic journal
of economics.
Activity SG11.2
Household A and B of an exchange economy with two goods x and y have the utility
functions UA(xA, yA) = (xA)(yA), and UB(xB, yB) = (xB)(yB). Household A has the initial
endowment (xA0, yA0) = (10,16) and Household B has (xB0, yB0) = (25,12).
a. Illustrate the initial endowment in an Edgeworth box
b. Assuming that this point is not on the contract curve, draw possible indifference
curves for the two households and indicate the area where trade could result in an
improvement for both households (you can draw standard indifference curves without
reference to the utility functions given above).
y
c. Given the utility functions above, the MRS of Household A is MRSA = xAA and the
y
MRS of household B is MRSB = xBB . Use this information to find the Pareto optimal
point when the price of x is 0.80 and the price of y is 1.00 (i.e. the relative price
is 0.80). Clearly state which household sells which quantity of which good and the
final Pareto-optimal allocation.
d. Calculate the utility of the two households at the initial endowment and at the new
optimal point.
e. Draw your solution onto your graph along with the budget constraint and the new
utility curves at this point. Also draw the contract curve on your diagram.
Distortion of the market

This section reviews the effect of a specific tax on a good and emphasises
that, at least in the absence of other distortions, this will lead to a
distortion in the market for the taxed good the marginal benefit to
consumers is no longer equal to the marginal cost to producers. The fact
that taxes are often distortionary is not an argument against all taxation,
but highlights one important aspect of taxation that must be considered
in designing a tax system. Second best has to do with introducing new
distortions to offset existing distortions and improve efficiency. Taxation is
one specific distortion, and the concept of second-best implies widespread
taxation may be more efficient than taxes in a single market, because
this helps to keeps relative prices intact. Chapter 14 (covered in the next
block) goes into more detail on taxation. Another way of stating the theory
of second best is that when there are several distortions in place (taxes
and subsidies on various goods for example) it is not always desirable to
eliminate some of these distortions; if markets were otherwise competitive,
eliminating all distortions would be efficient, but eliminating some but not
others could actually make the situation worse (increase inefficiency). The
intuition is that some of the distortions may have been offsetting others
and piecemeal removal of distortions may destroy this balance.
Sources of market failure

This section introduces the potential sources of market failure that can
prevent a free market allocation of resources from being efficient, but
doesnt analyse them in depth; subsequent sections do that. The following
is a list of sources of distortions that lead to market failure. Read through
and make sure you understand what each of these means:
141
market power
asymmetric information
taxation
common property
public goods
missing markets
externalities
Common property
All of these are described in BVFD except common property, which refers
to a resource such as fishing grounds or common grazing land, which is
open to everyone, but where one persons activities detract from the total
available to everyone (in this sense common property can be thought of
as a kind of externality). For example, fish in the ocean can be caught
by anyone, but once one is caught, no-one else can catch it. Common
property tends to be over used, leading to a degradation or depletion
of the resource. This is because individuals only take into account their
private costs and benefits and neglect the social cost of their actions.
For this reason, various kinds of sea life are nearing extinction due to
overfishing. This problem applies to any common resource which is
unregulated.
Activity SG11.3
Here is a game-theoretic treatment of the common property problem. Suppose both
England and Norway fish in the North Sea. Both countries know that their fish supplies
are being depleted and that this depletion could be slowed down if they both cut their
fishing fleets in half. The matrix below shows the payoff for both countries (Englands
payoff is first entry in each cell) with unchanged and halved fleets. Will they agree
between them to reduce their fleets? (Hint: what is the Nash equilibrium?). Should they?
Norway
England
10 boats
5 boats
10 boats
300, 300
550, 250
5 boats
250, 550
500, 500
Externalities
This section explores in greater detail one of the sources of distortions
listed above externalities. Externalities can either be positive or negative
and occur when there is a divergence between the private marginal costs
and benefits and the social marginal costs and benefits of production
and consumption. If a restaurant plays loud music, this could be either a
positive or negative externality for the restaurant next door, depending
on whether that restaurants clients like the music and are attracted to
eat there because of it, or if it detracts from their dining experience and
makes them less likely to choose that restaurant. In the case of a negative
externality, the restaurant playing the loud music may be required to
compensate its neighbour for their lost customers. In the case of a positive
externality, they could even ask the neighbouring restaurant to contribute
to the costs of playing the music, since that restaurant is also gaining a
benefit from it. The issue with externalities is that these payments will not
generally occur unless there is regulation, because there is no market for
the externality. The amount of noise produced by the first restaurant will
therefore be inefficient either too much (ignoring the negative impact on
its neighbour) or too little (ignoring the positive impact on its neighbour).
142
Activity SG11.4
Using the equations below, find the level of production which will occur without
regulation and the socially optimal level of production, and calculate the social cost of
the externality. Graph your answers and shade in the area representing the social loss of
inefficient production.
Example 1: Grating, unpleasant music
Demand: DD = 40 0.3*Q
Marginal private cost: MPC = 10
Marginal social cost: MSC = 10 + 0.1*Q.
Example 2: Beautiful, pleasant music
Marginal private benefit: MPB = 20 0.2*Q
Marginal social benefit: MSB = 24 0.2*Q
Marginal cost: MPC = MSC = 4 + 0.2*Q.
As the next section BVFD Chapter 13 will discuss, we live in an age where
the theory of externalities is ever more important; climate change, the
effects of pollution on human health and biological diversity, and many
other examples are increasingly at the centre of policy debates. This
section of BVFD covers the assignment of property rights as a method of
dealing with externalities, postponing the use of taxes and subsidies to
achieve similar ends until the next chapter, although if you want to look at
Figure 14.7 and the accompanying text that would fit in with the current
analysis. It is important to realise that, just as the optimal size of the
neighbours tree is not zero in the example illustrated in Figure 13.7, the
fact that industrial production generates pollution as a side effect does not
mean that the socially optimal level of pollution is zero; what is required
is that the marginal cost of pollution is equal to the marginal benefit (if it
seems strange to you that pollution can have benefits, consider the effect
on the costs of production of requiring firms to reduce pollution levels).
BVFD: read Maths box 13.1.
This maths box provides a mathematical explanation of Coase theorem,
which states that an efficient use of resources can be achieved through
the allocation of property rights, and that this is not affected by whether
the party causing the externality or the party suffering from it is given
the property rights. In the story in this Maths box, the right to pollute
is given to Firm A. Since Firm A can sell this right to Firm B, the cost
and revenue functions of Firm B become relevant to Firm As production
decisions. For this reason, Firm A will decide on a level of polluting where
the marginal private cost is equal to the marginal social cost the efficient
level of pollution in this scenario. As the textbook suggests, try to work
out the case where B is given ownership of the right to pollute. Please
work through the maths box to absorb the basic ideas behind the Coase
theorem (and also understand the reasons why it may be difficult to apply
in practice).
BVFD: read section 13.6 and activity 13.1.
The analysis of greenhouse gas emissions is an application of the principles
discussed in section 13.5 namely a situation where marginal social
costs dramatically exceed marginal private costs. Having determined the
optimal level of emissions in the aggregate, the key economic principle in
terms of achieving this target efficiently is the equalisation of the marginal
143
cost of emissions reduction between businesses/factories. That is the aim

of the market-based programmes such as cap-and-trade, as they use the
trading of credits between firms to allow firms with a lower marginal cost
of reducing emissions to reduce more and firms with a higher marginal
cost of reducing emissions to reduce less. This section also introduces
the important topic of social discounting and its central role formulating
climate change policy. Discount rates have to do with adjusting future
or past values so that values from different time periods can be properly
compared. The choice of the appropriate social discount rate is complex,
and probably involves some value judgements. Complex as these issues are
(and they would be studied in more depth in a specialist course on public
economics, environmental economics or cost-benefit analysis), they are
vital in determining todays policies.
Risk, uncertainty, missing markets and asymmetric information

These two sections again introduce issues that are rigorously analysed in
more advanced courses (risk, uncertainty, missing markets and asymmetric
information tend to be topics dealt with in intermediate microeconomic
courses). However, you should follow the general principles outlined
here. Missing markets are a further reason for market failure. Externalities
occur in cases where there are missing markets, for example for noise or
pollution. Section 13.7 discusses other missing markets, namely time and
risk. That is not to say there are no markets at all which relate to time or
risk, but rather there are many aspects of time and risk that cannot be
traded in markets. The scope of futures contracts is very limited. Also,
although there are many things people can buy insurance for, there are
also many things which cannot be insured against. This is partly due to
moral hazard for example, you cannot insure your house against poor
maintenance or general wear and tear, as insurance companies would not
be able to monitor which parties are taking a reasonable amount of care of
their homes and for this reason, once insurance is taken out, the incentive
to care for the home is reduced.
Section 13.8 discusses other aspects of market failure in relation to
information. Gathering information is costly and incomplete information
may lead to inefficient private choices. Certification provides information
more efficiently, as the benefit is reaped by the whole society but the cost
is borne by a single agency. Certification is generally provided by public or
non-profit organisations rather than businesses because the profit motive
may distort incentives to reveal the truth. This was one of the key causes
behind the recent global financial crisis, when ratings agencies, being paid
by banks and financial institutions, rated junk products as if they were
extremely sound and reliable financial instruments.
The imposition of standards requires value judgements. Costs and benefits
must be calculated and weighed up against each other, but there is often
a subjective element to these calculations (e.g. the value of human life, or
the optimal level of risk-aversion). An economic approach is useful in this
case since it helps make decisions about subjective factors transparent and
as such, can make the calculations as objective as possible.
144
Overview
This block provides an introduction to welfare economics, which involves
normative judgements as to how well the economy is working. Two
key concepts are equity (horizontal and vertical equity) and efficiency
(productive and allocative efficiency, as well as Pareto efficiency). The
textbook shows that perfect competition, under strict assumptions, is
Pareto efficient, since under perfect competition MC = MB = P. Much of
economic policy making concerns a conflict between equity and efficiency.
For example, redistributive taxes improve vertical equity but are not
allocative efficient. Perfectly competitive markets are rare in practice
and, in reality, there are many distortions which lead to market failure.
Distortions occur whenever free market equilibrium does not equate
marginal social cost and marginal social benefit. Key sources of distortions
are taxes, imperfect competition, externalities, and missing markets. The
first best solution to a distortion is to remove it and restore efficiency,
however, if distortions cannot be removed or if policy makers would rather
leave them in place than lose the benefits to equity that arise through these
distortions, the second-best solution is to spread distortions widely over
many markets rather than concentrating the distortion in a single market,
looking for ways in which distortions can be offsetting rather reinforcing.
A major cause of market failure is externalities there are both production
or consumption externalities and these can be either positive or negative.
An externality occurs when there is a divergence of private and social
costs and benefits due to the absence of a market for the externality itself.
Inefficiencies can also occur due to information problems, such as moral
hazard, adverse selection and incomplete information. Regulations provide
information and express societys value judgements about intangibles.


1. Suppose that Bill, Jill and Al constitute the entire market for
consumers of national defence. Each individual has an identical
demand curve for national defence, which can be expressed as P
= 50 Q. Suppose that the marginal cost for national defence can
be expressed as MC = 30. What is the optimal quantity of national
defence?
a. 150 units
b. 60 units
c. 40 units
d. 20 units.
Draw a diagram showing the analysis.
145
2. The equations below describe a negative production externality:

Demand: DD = 80 0.6*Q
Marginal private cost: MPC = 20
Marginal social cost: MSC = 20 + 0.2*Q
The social cost of this externality is equal to
a. 750
b. 3,000
c. 2,250
d. 250.
3. Two goods, x and y, are complements. What will be the effect on the
prices of x and y of a substantial increase in the supply of x?
a. The price of x rises and the price of y rises.
b. The price of x falls and the price of y falls.
c. The price of x rises and the price of y falls.
d. The price of x falls and the price of y rises.

1. This question concerns a two good economy (food and clothing)
where there are two agents (Bill and Ernie) who can trade with each
other.
a. Bill has an initial endowment consisting of 10 units of food and
10 units of clothing. Ernie has an initial endowment of 10 units of
food and 20 units of clothing. Draw an Edgeworth box for these
consumers.
b. Bill regards food and clothing as perfect one-for-one substitutes,
while Ernie regards them as perfect complements but in a ratio of
3 units of clothing for 2 units of food.
i. On your diagram, indicate the area which represents the set of
allocations that are Pareto-preferred or Pareto superior to the
original endowment given above.
ii. Find the Pareto-optimal allocation.
iii. What price ratio would allow this Pareto-optimal trade to take
place?
146
Block 12: The role of government

Introduction
As we saw in the previous block, there are reasons why markets fail in
certain circumstances and this can provide a justification for government
intervention in the economy. This block provides a more concrete
examination of the workings of government from an economic perspective.
Government has an important role to play, for example in maintaining
important institutions such as private property rights, providing public
and merit goods, redistributing income to promote greater equality and
regulating the behaviour of individuals and firms. The main tools the
government uses are taxation, regulation and government spending (on
purchases and transfer payments). The size of government is expressed by
the amount it spends, relative to GDP, and the optimal size is a question
of considerable debate. Key points relating to local government, national
economic sovereignty, and political economy are also briefly introduced
in this block. This block focuses on Chapter 14 of BVFD; however, since
one important function of the government is to redistribute incomes, the
block also provides a short section on the income distribution, drawing on
material from Chapter 11.
Learning outcomes
define different kinds of government spending
discuss why public goods cannot be provided by a market
identify average and marginal tax rates
discuss how taxes can compensate for externalities
describe functional and personal distributions of income
explain what a Gini coefficient measures and compare Ginis across
different countries or time periods
define supply-side economics
describe why tax revenue cannot be raised without limit
recognise how cross-border flows limit national economic sovereignty
describe the political economy within which governments set policy.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 14 and Chapter 11
section 11.9 and concept 11.2.
Further reading
Chapter 14.
Witztum (AW), Chapters 6 and 7.

This block examines the role of government. Government revenues are
mainly from direct and indirect taxes, and government spending consists
largely of purchases and transfer payments. The role of government can
be justified by the presence of externalities, and the fact that free markets
147
will fail to provide the optimal quantities of pubic goods and merit and
demerit goods. Public goods are goods which are non-rival and nonexcludable. As such, the free-rider problem and transaction costs will
mean they are under-provided by free markets. The government also plays
an important role in redistributing incomes to promote greater equality.
This block provides an introduction to taxation, including types of taxes,
their deadweight burden, tax incidence, and the relationship between
tax rates and revenues (as demonstrated by the Laffer curve). Finally,
the block explores further topics related to government including local
government, national economic sovereignty in the face of increasing global
interdependence, and political economy including political equilibrium,
incentives to adopt particular policies and the importance of the median
voter.
Government functions
There are certain basic functions which governments have carried out
throughout history (albeit more or less effectively); these include defence
against invasions from other nations, the protection of private property,
and the enforcement of law and order. As L&C (UK edition p,301;
international edition p.226) summarise: within a secure framework of
law and order, and well-defined and enforced property rights and other
essential institutions, a modern economy can function at least moderately
well without further government assistance. The previous chapter
discussed how in perfectly competitive markets, the price mechanism
and the invisible hand lead to an efficient allocation of resources. It
also discussed reasons why markets fail and the role of government in
improving outcomes in these cases. Another key role of government is to
influence the distribution of incomes within a society so as to promote
greater equality. This is often achieved through transfer spending
providing benefit payments that are funded through taxation. Government
frequently also sponsors education and healthcare, for example with the
aim that at least a basic level is available to all citizens. Social protection,
health and education are the three largest segments of the government
spending pie chart in Figure 14.2.
The size of government is expressed by the amount it spends, relative to
GDP, and the optimal size is a matter of debate. The introduction to this
chapter provides a historical perspective on how the size of government
has changed in recent times.
Taxation
The key source of government revenue is taxation. The introduction
provides definitions of marginal and average tax rates as well as
progressive and regressive taxes. The marginal rate does not apply to the
whole amount of income, but is rather the tax paid on the last pound of
income. The average tax rate, on the other hand, is calculated by dividing
the total tax paid by the total income. The graphs below are based on
Table 14.3 from BVFD and depict marginal and average tax rates for
the two periods in the table. When the marginal tax rate lies above the
average tax rate, the average rate will always be rising.
148
1978/79
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
5,500
7,520 10,500 15,500 25,500 36,900 45,500 75,500

Average Tax Rate
Marginal Tax Rate
2008/09
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
5,500
7,520 10,500 15,500 25,500 36,900 45,500 75,500

Marginal Tax Rate
Average Tax Rate
Figure 12.1: UK marginal and average tax rates based on Table 14.3 of BVFD.
A progressive tax takes a larger percentage of peoples income the larger

their incomes, while a regressive tax is the opposite taking a smaller
percentage of peoples income the larger their incomes. In the UK, income
taxes are progressive, with the marginal rate rising with income. The tax
system as a whole is also progressive, but not to the same extent as the
income tax component, because a substantial amount of tax is collected
via VAT (the sales tax) which is regressive, since poor people tend to
consume a higher proportion of their incomes. Progressive, proportional
and regressive taxes are depicted below how progressive a tax is depends
on the relationship between income and average tax rates.
Average Tax Rates
Progressive
Proportional
Regressive
Personal Income
Figure 12.2: Progressive, proportional and regressive taxes.
BVFD: read section 14.2 as well as case 14.1.
149
This section introduces three areas where government intervention in the

market has a strong justification the provision of public goods, transfer
payments which redistribute income, and the provision of merit goods.
The first and third are discussed briefly below. The second point, on
income redistribution, will then be discussed in greater detail drawing
on material from Chapter 11 of BVFD.
Public goods
Markets tend to deal best with private goods, but there are several other
types of goods which exist. These categories depend on the combinations
of two distinct characteristics: rivalry and excludability, as defined in
BVFD. The table below clarifies all four theoretical types of goods with
examples.
Excludable
Non-excludable
Private goods
Common property
Rival
Examples: ice cream, mobile

phones
Examples: fisheries, common

grazing land
Non-rival
(up to capacity)
Club goods
Public goods
Examples: cinemas, toll roads
Examples: defence, police force
Activity SG12.1
Good
Excludable/
non-excludable?
Rival/
non-rival?
Type of good
Air
Bacon
Coal
House
Private park
Publicly broadcast radio
Satellite
Timber

For public goods, non-excludability results in the free-rider problem.

Because people cannot be excluded from consuming the good once it has
been produced even if they dont pay for it, they have no incentive to pay
voluntarily and the good is unlikely to be produced at all.1 That is why there
is a clear role for government in the production of public goods, especially
important goods such as national defence and policing. It should be noted,
however, that the characteristics that make it difficult to get the good
produced privately may also cause problems for public provision. Read the
subsection Revelation of preferences to understand why this is the case.
It is important to understand, see Figure 14.3 and the accompanying
text, that in analysing the optimal (efficient) amount of the public good
to produce, the demand curves of individual consumers are summed
vertically in order to get the overall demand or the marginal social
benefit at each quantity. Compare this with the method of getting the
market demand curve from the demand curves of individual consumers
for a private good. There, we summed the individual demand curves
horizontally. Each consumer of a private good equates marginal benefit
to price and price is equal to MC in a competitive market. The differences
150
Note, however, that

in Figure 14.3 if the
government doesnt
supply the public good
some is still produced,
although the total
amount is less that the
efficient amount. What
would the MC curve
have looked like for zero
private production?
1
between private and public good equilibria can be characterised, for the
case of N consumers, as follows:
Private good (perfect competition):
q1 + q2 + ... + qN = Q
MB1 = MB2 = ... = MBN = P =MC
Public good:
q1 = q2 = ... = qN = Q
MB1 + MB2 + ... + MBN = MSB =MC
where qi are individual quantities and Q is total quantity. The MBs are
private marginal benefits, MSB is social marginal benefit and MC is
marginal cost.
Merit and demerit goods

Another area of government intervention is in the provision of merit
goods such as healthcare and education. Merit goods are goods that
society thinks everyone should have, regardless of whether an individual
wants them. Looking at education, for example, some children do not
like going to school, and some parents may prefer their children to work
early to support the family, rather than get an education. Nonetheless,
education has many benefits for the individual and also for the society at
large. There is a large externality to having a population where everyone
has a basic level of education. For this reason (among others), education
is compulsory and free in the UK (although private schooling is also
available). Similarly, the provision of free vaccinations can help combat
or even eliminate diseases, preventing their spread in a society. This
represents a benefit to the individual as well as a positive externality to
society. By contrast, the consumption of demerit goods generally has
negative consequences for the individual as well as negative externalities
in society. For example, illicit drug use can lead to physical and mental
health issues for the individual, as well as increased crime rates in society.
Governments try to reduce the consumption of demerit goods, either by
placing a tax on these or by regulating or forbidding their consumption.
Throughout our study of microeconomics we have assumed that
consumers are the best judges of their own utility; for example in judging
Pareto improvements, when we talk about some individuals being better
off without anyone being worse off we implicitly allow individuals to
judge whether they are better or worse off. With merit and demerit goods
this may not be the case; a drug addict may believe that another fix will
improve their welfare. When the state discourages or criminalises drug use
it is acting paternalistically, as it is by requiring children to attend school
up to a certain age.
Transfer payments and income redistribution

A further important role of government is the redistribution of incomes
to increase vertical equity. Figure 14.4 in BVFD shows the distributional
impact of tax and benefit policies in the UK. Taxes take money (mostly)
from the rich, while benefits give it (mostly) to the poor. L&C Figure
14.5 (UK edition; Figure 12.5 international edition) tells a similar story,
showing the income for the population divided into quintiles before
and after redistribution. The final annual incomes (post-redistribution)
are decidedly more equal. In other words governments, but to different
degrees, tend to ameliorate the inequality of market-determined incomes.
151
One aim of redistribution policies is to ensure that all members of the

society are afforded at least a basic, acceptable standard of living. Another
aim is to improve social harmony through reducing huge income gaps.
As a background to income redistribution as a government function
(described above), this section provides a brief introduction to the
distribution of incomes although this is a vast subject and this section
can hardly scratch the surface. Chapters 10 and 11 of BVFD discuss
returns to factors of production (labour, capital and land). The price of
a factor multiplied by the quantity used tells us its income. Knowing the
prices and quantities of all productive factors allows us to understand
how the economys total income is distributed. Section 11.9 explains the
distinction between the functional and personal distribution of incomes.
The functional distribution of income shows the share of national income
which is earned by each of the factors of production. The personal
distribution of income shows how national income is divided between
different individuals regardless of the factor services from which income is
earned.
The differences between the distribution of incomes and the distribution
of earnings, and the distribution of incomes and the distribution of wealth
are also important. Earnings can be defined as the rewards to all types
of labour (e.g. wages and salaries); income includes earnings plus other
types of income such as capital income; and wealth can be defined as the
value of all assets. Earnings generally represent the largest part of income;
however, differences in other income, especially capital income such as
dividends from shares, can contribute significantly to income inequality
due to the concentration of share ownership among the rich. The poorest
10th of the UK population now have just 1.3% of the countrys total
income between them while the richest 10th have 31%. The income of
the richest 10th is more than the income of all those on below-average
incomes (i.e. the bottom half) combined. An infographic on income
inequality in the UK can be accessed here: www.equalitytrust.org.uk/
resources/multimedia/infographic-income-inequality-uk
The distribution of wealth is even more unequal than the distribution of
income Table 11.8 in BVFD shows that the wealthiest 10% own 44% of
wealth in the UK. A recent Oxfam report 2 revealed that the five richest
families in the UK owned more wealth than the poorest 20% of the
population.
Gini coefficient
Income inequality can be measured by the Gini coefficient, which
measures the extent to which the distribution of income (or consumption
expenditure) among individuals or households within an economy
deviates from a perfectly equal distribution, such that a zero coefficient
represents a perfectly equal distribution and an index of 100 implies
maximum inequality. This measure, although it has a number of wellknown shortcomings, is widely used in comparisons of inequality across
countries and over time. Incomes are more unequally distributed in the
UK today than 30 years ago. The Gini coefficient for the UK rose from
0.25 in 1979 to 0.36 in 200708. Worldwide, Gini coefficients range from
approximately 0.23 (Sweden) to 0.70 (Namibia), though there may be
other countries for which reliable data are not available and estimates
differ depending on the data and definitions used.
152
2
www.theguardian.
com/business/2014/
mar/17/oxfam-reportscale-britain-growingfinancial-inequality
Recall Figure 1.5 in BVFD which gives a continuum of government

involvement in the economy from a command economy to a free market
economy. Below, we look at the Gini coefficient for the countries listed
(except Cuba, for which a recent figure measure is hard to find).
45
40
35
30
25
20
15
10
5
0
Cuba
India
Hungary
Sweden
UK
USA
Figure 12.3: Gini coefficients for selected countries.

Data source: World Bank Data Gini Index (http://data.worldbank.org/indicator/
SI.POV.GINI) except for Sweden, for which the source is https://www.cia.gov/
library/publications/the-world-factbook/fields/2172.html. Most recent data
available.
Note: Ginis calculated after taxes and benefits (this tends to lower Gini
coefficients compared to Ginis calculated before transfers)
Focusing especially on Sweden, the UK and the USA, which are all at a
similar stage of development and have a similar per capita GDP, it seems
that greater market freedom is associated with higher levels of income
inequality. Countries which are more concerned about achieving income
equality may therefore display higher levels of government involvement in
the economy, such as higher income taxes or greater spending on health
and education.
Principles of taxation
Although government can earn revenue through various means, such as
publicly owned companies, most revenues are collected through taxation.
Section 14.3 discusses taxation. The first sub-section, on types of taxes, is
very short, and requires some elaboration. You should read through the
other sub-sections carefully and make sure you understand the reasoning
and the graphical representations. An activity on taxation is included in
connection with Maths box 14.1.
Taxes can be classified into two broad types direct and indirect taxes.
Whether a tax is a direct or an indirect tax depends on whether people or
transactions are taxed. The most important direct tax is income tax. Both
individuals and companies pay taxes on their incomes. Personal income
tax depends not only on income but also on the size of the household, for
example. Corporation tax is levied on firms profits and can depend on
the type of company it is. On the other hand, indirect taxes are levied on
a transaction and are paid by an individual due to that individual being
involved in the transaction (L&C, UK edition pp.33740; international
edition pp.25861). The most important indirect tax is sales tax or VAT
(value added tax). VAT is an indirect tax because it depends on the value
of what is made or sold, not on the income or wealth of the person making
or selling it. In the UK, VAT is 20 per cent.
153
Taxes and externalities

This maths box shows how a Pigouvian tax can be used so that a firm
with a negative production externality will take this into account when
determining their efficient level of production, such that their quantity of
production will be the socially optimal quantity.
It is also possible to introduce Pigouvian subsidies to increase activities
with positive externalities.
While this maths box uses calculus, the basic analysis is the same as that
illustrated in Figure 14.7. The tax has to be set at a level equal to the
marginal damage caused by the externality at the socially optimal level
of output it has to raise private costs so that private decision making
generates the socially optimal quantity.
Activity SG12.2
Planting a tree improves the environment: trees improve soil quality and water retention
in the soil, and transform greenhouse gases into oxygen. Assume that the value of this
environmental improvement to society is 10 per tree for the expected lifetime of the
tree. The following equation provides a hypothetical private (excluding the value of the
externality) demand schedule for trees to be planted:
Q = 32 0.8*P where Q refers to the quantity of trees demanded in thousands.

a. Assume that the marginal cost of producing a tree for planting is constant at 20.
Draw a diagram that shows the market equilibrium quantity and price for trees to be
planted.
b. What type of externality is generated by planting a tree? On your diagram, indicate
the optimal number of trees planted. How does this differ from the market outcome?
c. On your diagram, indicate the optimal Pigouvian tax/subsidy (as the case may be).
Explain how this moves the market to the optimal outcome.
The optimal size of government

Government actions can bring many benefits, but also entail costs. There
are direct costs of government actions (such as paying regulators to check
government-imposed safety standards) as well as indirect costs (such as
costs to business involved in complying with tax legislation). Government
can act to counter externalities, but its own actions can also introduce
new externalities. For these, and other, reasons, there is substantial debate
about the optimal size of government. This section examines some of the
implications of a reduction in the size of government (i.e. cuts to spending
and tax rates).
Secondly, this section examines the relationship between tax rates and
tax revenues. If tax rates are high enough, increasing them further may
lead to a fall in revenue, due to negative incentive effects that discourage
people from working and decrease the tax base. This can be represented
by the famous (or notorious!) Laffer curve. This is rarely used in such a
basic form these days; modern research on labour supply tends to focus
on how specific demographic groups (prime aged males, single mothers,
married women, older workers, etc.) respond to specific changes to taxes
or benefits.
154
Local government
Local governments fulfil a different but complementary function to state
and federal governments, addressing local concerns. This section focuses
on the Tiebout model of local government the model is introduced and
its weaknesses are highlighted. The Tiebout model emphasises diversity
and the key mechanism for how preferences are revealed is the invisible
foot, which allocates resources efficiently via competition between local
governments. An alternative model is briefly mentioned at the end of
the section in this model, the size of local governments should be large
enough to include most of the people who use the public services provided
by that jurisdiction, thus internalising any externalities that arise from the
provision of public goods such as transport facilities and parks.
Impact of globalisation
In this time of globalisation, governments are less free to determine
policies independently and must take into consideration what is happening
in the world more broadly. This means that cross-border cooperation
is of increasing importance. Issues such as climate change affect the
whole planet and are best tackled collectively. The Kyoto protocol is a
good example of a widely ratified agreement with binding implications
for individual countries. Even if countries do not enter into binding
agreements, the actions of other countries can have huge effects on the
domestic economy. Unfortunately, such spillovers can also give rise to
free-rider problems, reducing the incentive to sign such protocols; nonsignatories benefit from the reduced pollution of participating nations but
are free themselves to go for growth unrestrained by commitments to
reduce pollution.
Political economy
In the early days of economics as a discipline, it was known as political
economy. Nowadays, the simple term economics is much more widely
used and the meaning of political economy has become much more
specific, referring to the analysis of the interdependence between
economic and political institutions. This section describes the political
economy within which governments set policy, introducing median voter
analysis, itself part of a sub-branch of political economy known as public
choice theory, and giving a taste for the way coalitions of voters (or voters
representatives) by trading votes (log rolling) can produce different
outcomes from independent voting.
Overview
The government plays an important role in basically all economies.
Government revenues mainly come from direct and indirect taxes,
and government spending comprises government purchases of goods
155
and services and transfer payments. The government can also play an
important role in redistributing incomes, especially by using a progressive
tax system. Externalities provide a further justification for government
intervention. These can be dealt with through the allocation of property
rights, the levying of taxes and/or subsidies which cause the private sector
to internalise the externality, or the imposition of standards/regulation.
Public goods are non-rival and non-excludable, and as such will tend
to be underprovided in private markets due to the free-rider problem.
Governments can provide public goods though the socially optimal
level can be difficult to determine in practice. Except for taxes to offset
externalities, taxes are distortionary because they make the sale price
differ from the purchase price, preventing the price system from equating
marginal costs and marginal benefits. Rising taxes initially increase tax
revenues, but at very high tax rates, they eventually lead to such large
falls in the equilibrium quantity of the taxed commodity or activity that
revenue falls. The economic sovereignty of nation states is reduced by
cross-border mobility of goods, capital, workers and consumers. Political
economy examines political equilibrium and incentives to adopt particular
policies. When all those voting have single peaked preferences, majority
voting achieves what the median voter wants.


For each question, choose the best response.
1. The Tiebout model of local government emphasises
a. internalising externalities
b. the user pays principle for public goods
c. competition between jurisdictions
d. log-rolling.
2. Common property is
a. rival and excludable
b. non-rival and excludable
c. rival and non-excludable
d. non-rival and non-excludable.
3. The relationship between tax rates and tax revenue is expressed by
a. the fiscal stance
b. the Laffer curve
c. tax incidence
d. the Lorenz curve.
4. Private negotiations along the lines suggested by the Coase theorem
are best suited to resolve conflicts that affect:
a. a large number of widely dispersed households
b. only a small number of individuals
156
c. only those who create positive externalities

d. only those who create negative externalities.
5. One drawback to the use of taxes to reduce pollution is that:
a. It is not easy to arrive at the exact size of tax to be imposed.
b. Taxing polluters is inherently unfair.
c. The tax is easy to avoid.
d. New technologies will be developed to cut down on pollution.
6. A public good differs from a private good in that it:
a. fails to satisfy individual needs
b. creates benefits that are not exclusive
c. creates benefits that are consumed only by government
d. is more costly because it is produced by government.

1. Pigouvian taxes:
a. An artist produces metal sculptures using a noisy production
process. Lets say the demand curve (showing the marginal social
benefit) can be expressed by the function:
MSB: P = 80 2Q where Q is the number of sculptures
The artists marginal private cost of producing sculptures is given
by:
MPC: P = 2Q
while the marginal social cost is higher, since other people also
experience negative effects due to the noisy production process:
MSC: P = 6Q.
Given these equations, find
i. the free market equilibrium (price and quantity)
ii. the socially optimal price and quantity
iii. the pigouvian tax that should be charged on the artist so that
the social optimal quantity of sculptures is produced
iv. the revenue this tax will raise.
b. Many dairy farmers in California are adopting a new technology
that allows them to produce their own electricity from methane
gas captured from animal wastes. (One cow can produce up to 2
kilowatts a day.) This practice reduces the amount of methane gas
released into the atmosphere. In addition to reducing their own
utility bills, the farmers are allowed to sell any electricity they
produce at favourable rates.
i. Explain how the ability to earn money from capturing and
transforming methane gas behaves like a Pigouvian tax on
methane gas pollution and can lead dairy farmers to emit the
efficient amount of methane gas pollution.
ii. Suppose some dairy farmers have lower costs of transforming
methane into electricity than others. Explain how this system
leads to an efficient allocation of emissions reduction among
farmers.
157
Notes
158
Block 13: Introduction to macroeconomics
Block 13: Introduction to

macroeconomics
Introduction
Macroeconomics is the study of the economy as a system. While
microeconomics is focused on the choices of an individual household or
firm and interactions in a particular market, macroeconomics examines
the whole economy and is therefore concerned with aggregates. The
demands of all the individual consumers and the supply provided by all
individual firms are aggregated together into a whole. The role of the
government and the financial markets in the economy also become much
clearer, as do the effects of international trade and financial transactions.
Macroeconomics makes it possible to examine certain questions which
relate to the whole economy, and which are difficult to answer if we just
focus on any individual market. Issues such as unemployment, inflation
and the business cycle can be studied much more effectively using the
tools of macroeconomic analysis and these and other issues will be covered
in the second part of the guide. This block provides an introduction to
macroeconomics.
Learning outcomes
describe the nature of macroeconomics as the study of the whole
economy
discuss internally consistent national accounts; why measuring GDP by
income, by expenditure or by output produces the same result
explain the circular flow between households and firms
recognise and understand the identity Y C + I + G + NX
explain why leakages always equal injections
identify nominal versus real measures of national income and output
describe the shortcomings of GDP as a measure of economic activity
and wellbeing
analyse more comprehensive measures of national income and output.
Essential reading
Further reading
Chapter 15.
Witztum (AV), Chapter 8.

This block (based on Chapter 15 of the textbook) provides an introduction
to macroeconomic analysis. The major concepts you will need to gain a
detailed understanding of are GDP what it means and how it is measured;
national income accounting, especially the concept of value added; and
the circular flow of income, including injections and leakages into and out
159
of the system. These will be introduced in the textbook chapter and the
exercises and revision questions in this block are designed to help you work
through the key points and gain a better understanding. This will provide a
foundation for more in-depth analysis in the following blocks.
Macroeconomic analysis
BVFD: read the introduction to Chapter 15 and sections 15.1.
The introduction to Chapter 15 explains the difference between
microeconomics and macroeconomics in terms of how economic analysis is
simplified so that it is manageable microeconomics focuses on particular
markets, while macroeconomics stresses broad aggregates. This introduction
is helpful but very brief. For a deeper perspective on why macroeconomic
analysis exists, interested students should read AW Chapter 8.
The eight definitions to the left of section 15.1 are important, basic
concepts that you need to know make sure you are familiar with them
before continuing.
Activity SG13.1
Do you know the long-term trend of growth, unemployment and inflation for your
own country? If you live outside the UK/USA/EU/China it would be useful to attempt
to replicate Table 15.1 for your own country. This will help to provide you with some
empirical context for your study of macroeconomics and also show you how your own
country relates to the places that the textbook has selected. You can use the following
websites to do some research:
stats.oecd.org
data.worldbank.org
www.imf.org/external/datamapper
www.worldeconomics.com
The circular flow of income

BVFD: read section 15.3
The economy can be described using a simple two-sector model containing
just households and firms, as represented in Figure 15.2. Later, other
sectors will be built into this model to make it more realistic. It is
important to gain a good understanding of this simple representation as a
building block for later analysis. Try to reproduce Figure 15.2 for yourself
in the box below; drawing it in such a way that the real flows are clearly
distinguished from the money flows.
160
Measuring GDP
This section also describes the three equivalent ways of measuring the
total economic activity in the economy, namely the:
value of all goods and services produced
total value of earnings arising from the factor services supplied
total value of spending on final goods and services.
Activity SG13.2
Which of these three do you think is easiest to measure? What kind of data would you
use if you were to try to measure economic activity in these three ways?
The table below shows a breakdown of UK GDP in 2012, according to the
methods of measurement. Aside from a small statistical discrepancy, all
three methods lead to the same result.
Expenditure method
Household Consumption
Income method
1070871
Output method*
Employees Earnings
866989
Agriculture, forestry and fishing
11294
Investment
235342
Corporate Profit
313008
Production
245235
Government spending
344102
Other income
219990
Construction
101644
Exports
506470
less imports
533066
Statistical Discrepancy
GDP
10329
1613391
Income based GVA at factor costs

Taxes less subsidies
Statistical discrepancy (income)
GDP
1399988
Services
1255218
210200
3203
1613391
Statistical Discrepancy
GDP
1613391
Table 13.1: Three equivalent methods of measuring GDP.

Data source: ONS, Quarterly National Accounts. NB: Taxes in the Income Method
refer to Taxes on Products and Production. *For the Output Method, these figures
are approximations based on a percentage breakdown from the Blue Book, 2013,
also from the ONS.
You may also find this video on GDP interesting: www.bbc.com/news/

business-33682243
BVFD: read section 15.4 and case 15.1 and complete the following
revision questions.
Activity SG13.3
Fill in the blanks in the table below (based on Table 15.4)
(1) Good
(2) Seller
(3) Buyer
(4) Transaction (5) Value

Value
Added
Wood
Timber
producer
Stamp
manufacturer
100
Wood
Timber
producer
Paper
Manufacturer
800
Stamps
Stamp
manufacturer
Paper
manufacturer
300
Special paper
with stamped
design
Paper
manufacturer
Households
1,200
(6) Spending
on Final Goods
(7) Household
Earnings
Total
Transactions
GDP
161
Activity SG13.4
Short answer questions
1. Which components of GDP would each of the following transactions affect:
a. Your family buys a new TV.
b. All motorways are repaved.
c. You buy a bottle of Italian wine.
d. Porsche opens a new factory in England.
2. Why, in the absence of government and foreign sectors, are saving and investment
always equal? How does this change when the government and foreign sectors are
introduced?
3. The level of wealth can be measured by looking either at the gross national product
or at the GDP. Suppose that the government wants to maximise total income of
British citizens: which of the two concepts should it look at? Would you change
your answer if the aim is that of maximising the total amount of economic activity
occurring in the UK?
4. Leakages and injections complete the following table.
Item
Leakage or Injection?
Savings
Amount (m)
30
80
Taxes
40
Government Spending
20
Imports
25
Exports
What is the formula that summarises this relationship?
The most important formula you will need to know in macroeconomics is
Y C + I + G + NX
It is important to realise that this is an identity. It is true by definition. In
later blocks we move away from pure definition and examine in some detail
economic theories about how each of the components of national income
are determined. To understand why this must always be true, suppose that
not all of the output the economy produced was actually sold in the period
under consideration. Does this mean output is larger than expenditure? No,
the unsold output is inventory accumulation by firms (it is as if firms sold
these goods to themselves) and this is included as part of investment. If in
subsequent years firms run down their inventories, net investment falls. The
final equation in Maths 15.1 (see also Activity SG13.4 question 4 above) is
equivalent to the formula above and is also very important. This is
(S I) + (NT G) NX.
Note that you will sometimes see this written as (S I) + (T G) NX
where the whole equation is in market prices rather than basic prices
and T is direct taxes minus welfare transfers. The general significance
of the equation is the same as the version in the text. To explain the
significance of this equation slightly differently from the text, suppose
that the economy is running an external deficit (NX is negative, imports
are greater than exports). This must have its counterpart either as a
private sector deficit or as a public sector deficit (or both). If, in any sector,
162
spending exceeds receipts there must be borrowing to pay for the excess
spending. Suppose S = I in the private sector then, if the government is
running a deficit (G > T), the government is borrowing from abroad and
there is a deficit with the rest of the world (imports greater than exports).
On the other hand if the government account is in balance (spending =
tax receipts) then a trade deficit (exports insufficient to pay for imports)
requires borrowing in the private sector (I > S).
Y C + I + G + NX represents GDP at market prices, which equals
consumption plus investment plus government spending plus net exports.
We can extend the formula so it represents GDP at basic prices by
subtracting indirect taxes. It would then be: Y C + I + G + NX Te
Maths box 15.1 depicts an extended representation of the circular flow,
including the government sector as well as households and firms. The
overseas sector is implied by arrows pointing outwards for imports and
inwards for exports. Similarly, the banking sector is implied with arrows
pointing outwards for savings and inwards for investment. An alternative
representation that includes all five sectors explicitly is provided below. The
five-sector model is the most complete version of the circular flow of income
model and, as such, you should be familiar with it. It will also help you in
fitting together the material in the remaining macroeconomics blocks.
Activity SG13.5
Access the following website: www.dineshbakshi.com/ap-economics/apmacroeconomics/175-revision-notes/1965-circular-flow-of-income. Re-draw the five
sector model (the second image on the web page) yourself in the box provided, making
sure you understand the meaning behind each of the flows.
Before moving on to consider some welfare aspects of GDP, this might be a

good time to remind yourselves of the relation between the major national
income concepts summarised in Figure 15.3.
Thus:
National Income at basic prices + indirect taxes = Net National
Product (Income) at market prices + depreciation = Gross
Domestic Product at market prices + net property income from
abroad = Gross National Product (Income) at market prices
163
Gross domestic product (GDP)

BVFD: read section 15.5 and case 15.2 and complete activity 15.1.
This section deals with real versus nominal GDP, the GDP deflator, per
capital GDP and the scope of GDP.
Activity SG13.6
Complete the exercises below to check your understanding.
1. Say the price level rises 10% from an index of 1 to an index of 1.1 and nominal GDP
rises from 4 trillion to 4.6 trillion. What is nominal GDP in the second period? What
is real GDP in the second period?
2. The table below shows nominal GDP for two countries A and B. Which economy
experienced higher growth in real GDP per capita between 1960 and 2010?
Country A
Country B
1960
2010
Nominal GDP (current bn)
20
2000
GDP deflator (2010=100)
100
Population (bn)
Nominal GDP (current bn)
60
5000
GDP deflator (2010=100)
100
Population (bn)

Activity SG13.7
From the chapter as a whole, what are the advantages and limitations of GDP as a
measure of wellbeing in an economy?
Overview
This block started by describing the scope of macroeconomics and
macroeconomics as a study of the economy as a whole. The circular
flow was also introduced, and the block extended the discussion in the
textbook to introduce the five sector model, including households, firms,
the government, the financial sector and the overseas sector. Leakages
from the circular flow are always equal to injections, by definition. The
net output of all factors of production is called GDP and this can be
measured in three different but equivalent ways: income, production and
expenditure. For the production method, including only the value added
at each stage is important to avoid double counting. GDP can be measured
at market prices or at basic prices (exclusive of indirect taxation).
Furthermore, there is an important distinction between nominal GDP
(measured at current prices) and real GDP (measured at constant prices).
GDP, and in particular per capita GDP, is a useful indicator of a countrys
economic situation, however, it does have limitations in terms of accuracy
and comprehensiveness.
164


1. Assume that a firm buys all the parts that it puts into a car for
$10,000, pays its workers $10,000 to fabricate the car, and sells it for
$22,000. In this case, the value added by the firm is:
a. $2,000
b. $12,000
c. $20,000
d. $22,000.
2. Assume that total output consists of 4 apples and 6 oranges and that
apples cost 1 each and oranges cost 0.50 each. In this case, the
value of GDP is:
a. 10 pieces of fruit
b. 7
c. 8
d. 10.
3. Which of the following is correct within the context of national
accounting used in this chapter?
a. (S I) = (T G) + (X Z)
b. (S I) + (T G) + (X Z) = 0
c. (S I) + (T G) = (X Z)
d. (S I) + (X Z) = (T G).
4. Assume GDP is 6,000, personal disposable income is 5,100, the
government budget deficit is 200, consumption is 3,800 and the trade
deficit is 100.
a. Saving (S) = 1,300, Investment (I) = 1,300, Government
spending (G) = 1000.
b. Saving (S) = 100, Investment (I) = 100, Government spending
(G) = 200.
c. Saving (S) = 200, Investment (I) = 100, Government spending
(G) = 200.
d. Saving (S) = 1300, Investment (I) = 1,200, Government spending
(G) = 1,100.
5. The leakages and injections approach implies that the government
surplus is equal to:
a. private saving less private investment plus net exports
b. private investment less private saving plus net exports
c. private investment plus private saving plus net exports
d. none of the above.
165
6. Fill in the blanks in the table

Year
Nominal GDP (b)
2010
2011
Real GDP (b)
GDP deflator
90
120
125
125
7. Intermediate goods are excluded from GDP because:

a. They represent goods that have never been purchased so they
cannot be counted.
b. Their inclusion would understate GDP.
c. Their inclusion would involve double counting.
d. The premise of the question is incorrect because intermediate
goods are directly included in calculating GDP.
8. Which of the following is not a final good?
a. a purse sold to a foreign visitor
b. a new computer sold to an LSE student
c. a hot dog sold to a spectator at an American football game
d. a new car sold to Rent-A-Car for use in their fleet of rental cars.
9. If nominal GDP rises we can say that:
a. Production has fallen and prices have risen.
b. Production has risen and prices remain constant.
c. Production has risen or prices have risen or both have risen.
d. Prices have risen and production remains constant.
10. Goods that go into inventory and are not sold during the current
period are:
a. counted as intermediate goods and so are not included in current
period GDP
b. counted in current GDP only if the firm that produced them sells
them to another firm
c. included in current period GDP as inventory investment
d. included in current period GDP as consumption.

1. The graph below shows the per capita annual GDP growth rate for
Pakistan and the USA between 2000 and 2014.
6%
4%
Pakistan
2%
USA
0%
2%
4%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Data from the World Bank. Source: www.google.com/publicdata/

explore?ds=d5bncppjof8f9_
166
a. What are the key features of the trend path for each country?
b. Why is it important to compare per capita growth rates when
countries have different rates of population growth? How might
this apply to the case of Pakistan and the USA?
c. Although Pakistan shows a faster growth rate for many of the
years in the graph above, the level of per capita GDP is much
lower, as can be seen below. Briefly discuss how the magnitude of
each component of GDP is likely to differ for countries at different
stages of development.
2. This graph shows per capital GDP in constant 2005 international $.
USA
50,000
40,000
30,000
20,000
10,000
Pakistan
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Data from the World Bank. Source: www.google.com/publicdata/

explore?ds=d5bncppjof8f9_
a. Why is it important to examine real rather than nominal GDP?
(NB: The graph uses purchasing power parity (PPP) figures to
reflect the cost of living in each country, but you can ignore this for
now since it is not covered until Block 20 just focus your answer
on constant dollars to address the difference between real and
nominal GDP).
b. What are some advantages and limitations of GDP as a measure of
wellbeing?
167
Notes
168
Block 14: Output and aggregate demand

Introduction
The chapter starts by introducing the difference between actual output and
potential output. While potential output tends to increase steadily over
time, actual output tends to fluctuate strongly, sometimes growing faster
than potential output and sometimes growing slower or even decreasing.
Much of macroeconomics is concerned with modelling the gap between
actual and potential output. In Chapter 16, we start to develop a model of
the determination of output, which will be developed further until Chapter
28. Chapters 16 to 20 operate under a basic assumption that the price
level is constant (i.e. there is no inflation). This assumption will be lifted
in Chapter 21 when the supply side is introduced. To start with, the focus
is on demand and actual output is assumed to be demand-determined.
Aggregate demand is defined initially as planned or desired spending and
short-run equilibrium is defined as the point where aggregate demand is
equal to actual output. In the last block we saw that income and output
can be defined as Y = C + I + G + NX. In equilibrium, output and
aggregate demand are equal, hence Y = AD = C + I + G + NX. Chapter
16 goes into more detail on consumption (C) and investment (I), while
Chapter 17 looks at government spending (G) and net exports (NX).
One very important concept in this block is the multiplier, which shows how
much equilibrium output changes due to a change in aggregate demand.
You will need to understand this, be able to calculate it and show how it is
affected by changes in consumption behaviour, taxation and imports.
In macroeconomics, there are two major policy instruments available to
the government: fiscal policy and monetary policy. Fiscal policy has to do
with government spending, taxation and the budget. By the end of this
block, you should have a good understanding of fiscal policy, including its
limitations.
The analysis in these two chapters is best understood by use of graphs, in
particular, the consumption function, the aggregate demand schedule, and
graphs of leakages against injections. You will also need to understand
the meaning of the 45 degree line (along which the values on the x-axis
are equal to the values on the y-axis) and how this can be used to indicate
equilibrium, as well as inflationary and deflationary gaps. You will need
to learn these graphs and practise drawing them. They are the building
blocks you will need in later analysis.
Learning outcomes
contrast actual output and potential output
show how aggregate demand determines short-run equilibrium output
explain inflationary and deflationary gaps
define the marginal propensity to consume c and the marginal
propensity to import z
analyse consumption demand, investment demand, foreign trade and
equilibrium output
calculate the multiplier and the balanced budget multiplier
169
explain the paradox of thrift

analyse how fiscal policy affects aggregate demand
evaluate the limits to discretionary fiscal policy as well as automatic
stabilisers
explain the structural budget and the inflation-adjusted budget.
discuss how budget deficits add to national debt.
Essential reading
Further reading
Lipsey and Chrystal (L&C) international edition, Chapters 14 and 15;
UK edition, Chapters 16 and 17.

This block covers two chapters from the textbook. Chapter 16 explores
aggregate demand, focusing on the components consumption and
investment, and examines equilibrium output, which is assumed to be
demand determined at this stage. Another important concept is the
multiplier, which shows by how much changes in autonomous demand
lead to even greater changes in output. In the simple model presented
in this chapter, the multiplier is equal to 1/(1 MPC), where MPC is the
marginal propensity to consume. Chapter 17 goes on to examine the
other two key components of aggregate demand, namely government
spending and net exports. Government decisions on spending, together
with taxation, make up the governments fiscal policy. This is one of the
two main macroeconomic policy tools (the other is monetary policy). This
block discusses various aspects of fiscal policy, including the balanced
budget multiplier, the fiscal stance, and automatic stabilisers, as well as
the implications of deficits for national debt. This chapter also examines
the impact of imports and exports on national income. Having included
these two sectors, the full multiplier becomes 1/[t + s(1 t) + z], where t
is the proportional net tax rate, s is the marginal propensity to save and z
is the marginal propensity to import.
BVFD: read the introduction to Chapter 16, case 16.1, sections 16.1 and
16.2 and concept 16.1.
Components of aggregate demand: consumption and

investment
This chapter examines two components of aggregate demand:
Consumption which has to do with households and includes
durable goods (e.g. cars), nondurable goods (e.g. clothing) and
services (e.g. getting a haircut)
Investment which mainly has to do with firms and can be defined
as spending on capital (i.e. fixed assets used in future production).
It includes business fixed investment (such as spending on plants
and equipment), residential fixed investment (which is spending
by consumers and landlords on new housing units) and inventory
investment (which is the change in the value of all firms inventories).
170
Activity SG14.1
Draw the consumption function in the box below. What does the intercept mean? What
does the slope indicate?
Consumption function
Interpret the following identities:

Y C + S
interpretation:
MPC + MPS 1
interpretation:
Now draw the aggregate demand schedule for a closed economy with no government
(Figure 16.5). If you were to include a line for investment, how would this look? Why?
Aggregate demand schedule
Equilibrium output
The following fact (from p.372) is important to understand: In short-run
equilibrium, actual output equals the output demanded by households as
consumption and by firms as investment. Thus in short-run equilibrium,
actual output and actual income are equal to aggregate demand (desired
spending). In a graph of desired spending against output and income,
drawing a 45-degree line from the intersection of the x and y-axis shows
all of the points where desired spending and output (and income) are
equal. Where the aggregate demand function crosses this line, we can find
the short-run equilibrium point.
171
Draw the 45-degree diagram and short-run equilibrium output below:
45-degree diagram and short-run

equilibrium output
What is the mechanism by which the economy is brought into short-run

equilibrium? Running down inventories (i.e. unplanned destocking), or
the reverse making unplanned additions to inventory, can move the level
of output to the short-run equilibrium level. Output equals expenditure
because unsold output goes into inventory and is counted as inventory
investment whether or not the inventory build-up was intentional. In
effect, we are assuming that firms purchase their unsold output.
Nonetheless, it is important to remember that nothing guarantees that the
short-run equilibrium is the level of potential output. Potential output is
the economys output when inputs are fully employed.
GDP and bath water: an analogy (based on L&C UK edition, Box 16.3,
p.407) A countrys GDP can be thought of as the amount of water in a bath
when the tap is on and the plughole is unblocked. There are flows into and
out of the bathtub. Whether the level of water is rising or falling depends
on which flow (either in or out) is greater. If both are the same, the level of
water will be constant GDP is in equilibrium. If the bathtub fills up until it
starts to overflow, it is clear that is has reached its capacity (lets call this full
employment equilibrium). Macroeconomics was originally invented to deal
with the problem of the water getting too low, and to find solutions to this
problem.
BVFD: read case 16.2 and case 16.3 how did the financial crash affect
the economy in the country where you live? Also read section 16.4.
Planned investment equals planned savings only in equilibrium. Draw the
savings and investment functions in the left-hand box below and indicate
the equilibrium output level. What is the mechanism that brings the level
of output back to equilibrium, such that planned investment and planned
savings are equal?
172
Activity SG14.2
Using the following savings and investment functions, calculate the equilibrium level of
output Y and the level of planned saving and planned investment. Graph these in the
second box below.
S = 5 + 0.3Y
I = 55
Savings and Investment functions
(general)
Savings and Investment functions

(numerical example)

This maths box shows why planned investment equals planned savings.
Read it through and then, without looking at the textbook, use the
following equations to show that planned investment equals planned
savings:
Y = AD = C + I (in equilibrium)
C = A + cY
S=YC
The multiplier
BVFD: read sections 16.5 and 16.6 and concept 16.2.
These sections introduce the concept of the multiplier. A change in
autonomous spending will result in an even greater change in equilibrium
output. The multiplier shows by how much greater the change in
equilibrium output will be, relative to the initial change in autonomous
spending. At this stage, the multiplier (which equals 1/[1 c] or
equivalently, 1/s) only depends on the marginal propensity to save. In
later chapters when we add in the government and overseas sector, the
multiplier will also depend on taxation and imports, since these are also
leakages from consumption, just like savings.
Coming back again to Maths box 16.1 equilibrium demand is
autonomous demand multiplied by the multiplier. The following question
should now be very straightforward:
173
Activity SG14.3
Given, C = 10 + 0.5Y, calculate the equilibrium output when I = 20.
Now check that Y = AD = C + I in equilibrium.
The paradox of thrift

For a more detailed exposition of this topic, interested students should see
AW chapter 10, self-assessment Q3, which is followed up on with Chapter
12 section 12.4.2 you can return to the discussion in Chapter 12 later
once you have learned the IS-LM framework, to be introduced in later
blocks.
The role of confidence

Business confidence plays a major role in global markets and is largely
determined by news or beliefs about the future. The emotion that drives
business and consumer confidence is sometimes also known as animal
spirits, a term used by John Maynard Keynes in The general theory of
employment, interest and money (1936).
BVFD: read the Summary and attempt the revision questions and read
Chapter 17.
Fiscal policy: government spending and taxation

As you know, Y = C + I + G + NX. Having examined consumption and
investment, we now introduce government spending and net exports.
BVFD: read sections 17.1 and 17.2 as well as Case 17.1.
Activity SG 14.4
Draw the aggregate demand schedule with and without the government sector given the
following parameters:
C = 200 + 0.6YD
I = 300
G = 200
t = 0.3
Aggregate demand (numerical example)
What is the change in equilibrium output?

174
The balanced budget multiplier

Activity SG14.5
1. One of the important underlying tenets of the balanced budget multiplier model is
that:
a. For any increase in taxes, households will finance some of their increased tax
liability out of savings.
b. A change in taxes by the government causes households to change the
composition of stock of wealth and will not affect aggregate demand.
c. A change in fiscal policy changes aggregate demand and this causes a multiple
change in aggregate income and output
d. Any increase in government spending and taxes will have essentially no effect on
aggregate employment and income.
2. A 1 increase in government spending will have a larger impact upon national
income than a 1 cut in taxes since:
a. The government prints the pound it spends.
b. Not all of a tax cut is spent.
c. When taxes are cut, so too is government spending.
d. Taxes are an injection into the system.
The budget
BVFD: read section 17.3 and 17.4 as well as case 1.2.
Activity SG14.6
1. The structural budget shows what the budget would be if is at .
a. actual spending; planned spending
b. actual tax revenue; forecast tax revenue
c. forecast consumers expenditure; actual consumers expenditure
d. output; potential output.
2. The inflation-adjusted budget:
a. uses real interest rates to calculate government spending
b. uses real GDP to calculate the deficit-to-GDP ratio
c. uses the tax rate minus the inflation rate to calculate tax revenues
d. shows what the budget will be if output is at potential output.
175
Activity SG14.7
Which of these are automatic stabilisers and which are discretionary fiscal policies?
a. unemployment benefits
b. a high savings rate
c. increasing the income tax rate
d. decreasing the vat rate
e. decreasing government spending
f. education opportunity grants for low-income families.
BVFD: read concept 17.1.
In a long response question, you may be asked to discuss government
policy responses to a fall in output and their limitations. It is therefore
important to be well acquainted with these points.
Activity SG14.8
Complete the following table
Three ways of reducing debt as a percentage of nominal GDP
Grow Your Way Out
Create Inflation
Default
Explanation:
Explanation:
Explanation:
Historical example:
Historical example:
Historical example:
Recommended approach?
Foreign trade: exports and imports

This introduces the fourth sector in our circular flow model: the rest of the
world. We now have the complete equation: In equilibrium, Y = AD = C
+I+G+XZ
176
Activity SG14.9:
Using the following parameters:
C = 100 + 0.4Y
I = 300
G = 200
t = 0.2
X = 300
z = 0.4
Draw the aggregate demand schedule for the following economies:

a. a closed economy with no government
b. a closed economy with government
c. an open economy with government.
In each case, what is the size of the multiplier? What is the equilibrium level of income?
What is the budget deficit or surplus and the trade balance?
Aggregate demand (numerical example)

The full multiplier, taking into account all leakages savings, taxation
and imports, is lower than in the simple, two-sector model, at
1/[1 c(1 t) + z].
Activity SG14.10
Show that this is equivalent to the version on p.406, given as: 1/[t + s(1 t) + z].
This activity showed that 1/[1 c(1 t) + z] = 1/[t + s(1 t) + z].
These two expressions of the full multiplier (for an open economy with
government) show how including the additional sectors reduce the size
of the multiplier compared to an economy with just households and firms
(where the multiplier is simply 1/[1 c] = 1/s). While a closed economy
with no government sector has only one leakage savings an open
economy with government has three leakages savings, taxation and
imports. In both cases, the multiplier is calculated as the inverse of the
marginal propensity to withdraw. The lower the marginal propensity to
withdraw (lower savings rate, lower marginal tax rate, lower marginal
propensity to import), the greater the final increase in income that will
result from additional spending.
BVFD: read the summary and complete the review questions.
177
Overview
This block examines the components of aggregate demand, as well as how
aggregate demand determines output, based on the multiplier effect.
Aggregate demand is defined in this block as planned or desired spending
and short-run equilibrium is defined as the point where aggregate
demand is equal to actual output. In equilibrium, output and aggregate
demand are equal, hence Y = AD = C + I + G + NX. Chapter 16 of the
textbook examines consumption and investment. Consumption consists of
autonomous consumption (at zero income) plus the proportion of income
that is spent rather than saved. This proportion is represented by the
marginal propensity to consume (MPC). Investment is treated as constant.
When prices and wages are fixed, the goods market is in equilibrium when
planned spending equals actual spending and actual output (not potential
output). In equilibrium, planned saving equals planned investment. When
the goods market is not in equilibrium, companies inventory levels will
change to restore equilibrium either through unplanned disinvestment
(reductions in inventories) or unplanned investments (increases in
inventories). Changes in inventory send a signal to firms to increase or
decrease future output levels. Such changes in planned investment lead to
greater changes in equilibrium output, due to the multiplier effect. In its
simplest form, the multiplier is equal to 1/(1 MPC).
Chapter 17 of the textbook examines the government spending and net
exports components of aggregate demand/output. The government levies
taxes and buys goods and services. Taxes reduce private disposable income
and hence consumption. Government spending raises aggregate demand
and equilibrium output. An equal increase in government spending and
taxation leads to an increase in aggregate demand and output, which is
known as the balanced budget multiplier. Government decisions regarding
spending and taxation are known as fiscal policy. Fiscal policy can either
be expansionary or contractionary, in practice however, fiscal policy
cannot completely stabilise output. The budget deficit is a poor indicator
of the governments fiscal stance, because it is not only influenced by
discretionary policy decisions, but also by economic conditions. Automatic
stabilisers such as unemployment benefits act to reduce fluctuations in
GDP. Budget deficits add to the national debt.
The final element of the equation Y = C + I + G + NX is net exports.
Exports raise aggregate demand and can be viewed as autonomous.
Imports are a leakage and are assumed to rise with domestic income. Both
taxes and imports reduce the effect of the multiplier. In the full model, the
multiplier is equal to 1/[t + s(1 t) + z]. In equilibrium, desired leakages
(S + NT + Z) must equal desired injections (G + I + X).

178

1. Responsible fiscal policy involves:
a. running a balanced budget at all times
b. having a debt less than 60% of GDP
c. running a budget surplus at all times
a. running a deficit some of the time.
2. Suppose the consumption function is C = 100 + 0.95YD. If the tax
rate changes from t = 0 to t = 30%, then the increase in government
spending that leaves equilibrium income unaffected is
a. 570
b. 2,000
c. 2,570
d. 0.
3. Which of the following statements is false?
a. Actual saving is always equal to actual investment.
b. Planned saving is always equal to planned investment.
c. Firms adjust their inventories which ensures that saving and
investment are equal.
d. Consumers must sometimes adjust their savings patterns so that
saving and investment are equal.
4. Potential output is:
a. The maximum an economy could conceivably make.
b. The output when every market in the economy is in long-run
equilibrium.
c. The amount of production a country is striving for through
technological innovation.
d. The output when there are no unemployed workers.

1.
a. How might a fall of five in investment demand cause a fall of 50 in
equilibrium output?
b. Given the following information about an open economy with
government, draw the AD function and find the equilibrium level
of income.
C = 100 + 0.7YD
I = 200
G = 150
t = 0.2
X = 100
z = 0.2
c. Now suppose that there is an upturn in the global economy leading

to an increase in business confidence (so aggregate investment
rises to 250); an increase in overseas incomes (so exports rise
to 200) and an increase in the domestic marginal propensity to
import (such that z increases to 0.3). On the diagram, show the
new AD function and find the new equilibrium income level.
179
Notes
180
Block 15: Money and banking; interest rates and monetary transmission
Block 15: Money and banking; interest

rates and monetary transmission
Introduction
This block introduces an economic approach to the analysis of money.
Money plays a vital role in facilitating the exchange of goods and services.
It differs from standard commodities that are desirable in themselves
the most important aspect of money is its various functions, which will
be discussed further in this block. However, we can still analyse money
in terms of demand and supply and a market equilibrium. The price of
money is the opportunity cost of holding money rather than investing
in other financial products which provide a return, notably bonds. The
interest rate on bonds is thus the price of money; this is an important
application of the concept of opportunity cost. Understanding how interest
rates bring about equilibrium in the market for bonds and the money
market, as well as their impact on the real economy through consumption
and investment is an important aspect of this block. This block is also
heavily informed by what went on in global financial markets leading
up to and during the recent global economic crisis, which originated in
the banking sector. How governments responded to this, especially the
approach of quantitative easing, is also discussed.
Learning outcomes
explain the medium of exchange and other functions of money
explain how banks create money
differentiate between liquidity crisis and solvency crisis
define narrow and broad money
explain the money multiplier and the bank deposit multiplier
identify motives for holding money
discuss how money demand depends on output, prices and interest
rates
describe the central banks role in influencing the money supply and in
financial regulation
describe money market equilibrium
discuss intermediate targets and the transmission mechanism of
monetary policy
describe how a central bank sets interest rates and how interest rates
affect consumption and investment demand.
Essential reading
Further reading
Lipsey and Chrystal (L&C) international edition, Chapters 16 and 17;
UK edition, Chapters 18 and 19.
181
References cited
Tee, O.C. An exchange-rate-centred monetary policy system: Singapores
experience, In Mohanty, M. S., et al. Market volatility and foreign exchange
intervention in EMEs: what has changed?. (Bank for International
Settlements, Monetary and Economic Department, 2013). Available at:
www.bis.org/publ/bppdf/bispap73w.pdf.

Chapter 18 of the textbook starts by introducing money and its functions
as a medium of exchange, a store of value, a unit of account and a
standard of deferred payment. Money can be defined narrowly as the
money base (currency in circulation plus banks cash reserves) or more
broadly a much broader definition (M4) includes deposits at banks and
building societies. The ratio of money supply to the money base is called
the money multiplier, and depends on banks reserve ratios as well as the
publics holdings of cash relative to deposits. The way that banks create
money is described. The demand for money relates to peoples motives
for holding money rather than interest-bearing financial instruments
such as bonds. The quantity of real money demanded falls as the interest
rate rises. Higher real income raises the demand for real money at each
interest rate. Chapter 19 introduces the role of central banks, especially
the Bank of England, and the instruments available to the central bank
in influencing the supply of money. This chapter also examines money
market equilibrium. Finally, the targets and instruments of monetary policy
are introduced, as are the transmission mechanisms for how these impact
on the real economy.
Money and banking

BVFD: read sections 18.118.4 and concept 18.1, and complete
activity 18.1.
The information contained in these four sections is useful background
knowledge. Read the sections through carefully and test your
understanding with the following quick questions:
What are the main functions of money?
How do banks make profits?
How do banks create money?
What factors affect the size of the money multiplier?
BVFD: read maths 18.1 and concept 18.2.
Activity SG15.1
Based on Maths 18.1, use the following information to calculate the money multiplier,
the bank deposit multiplier, and the money supply (broad money).
Deposits = 1,000.
Banks hold cash reserves of 5% of deposits.
The private sector holds cash in circulation of 3% of deposits.
The logic of this maths box is reproduced below in a slightly different
order, following L&C section title: The ratios approach to the creation of
money (UK edition Chapter 18; international edition Chapter 16). It is
equivalent to the approach given in BVFD, however, you may find it a little
more intuitive, as it shows more explicitly that deposits depend on banks
182
reserves and reserve ratios. Using the notation used in BVFD, it works as
follows:
Let R be cash held in bank reserves, C be the cash held by the non-bank
public, H (for high-powered money) be the total cash in the economy, and
D be the size of bank deposits. Thus:
C+R=H
This shows that the all cash in the economy is held by either the banks or
the public. If the desired reserve ratio of the banks is cb , we can write:
R = cbD
If the public holds a fraction, cp, of its bank deposits in cash, then:
C = cpD
Substituting the second and third equations into the first gives:
cbD + cpD = H
And solving for D gives us:
H
D=
cb + cp
which shows that deposits depend on the total cash in the economy,
the banks reserve ratio and the publics ratio of cash to deposits. The
calculation of the money multiplier follows on from this in the same way
as in BVFD, such that:
H = (cb + cp)D
M = C + D = (cp + 1)D
(cp + 1)
M
=
H
(cp + cb)
The bank deposit multiplier is equal to
(cp + 1)
M
=
R
(cb)
Activity SG15.2
Based on the model above, use the following information to calculate the money
multiplier, the bank deposit multiplier, and the money supply (broad money).
Cash held by the public = 600
Banks reserves = 900
Banks hold cash reserves of 5% of deposits
The private sector holds cash in circulation of 3.333% of deposits.
Measures of money
A few points to note:
The terms money-base, narrow money and high-powered money
are interchangeable and generally refer to the sum of currency in
circulation with the public plus cash reserves held by banks.
Money supply generally refers to broad money, which is a more
inclusive measure of money and includes deposits in banks and
building societies.
The exact definitions (i.e. what is included) in various measures of
money differ for different countries, and have also changed over time.
183
Demand for money

This section discusses the demand for money and explains the three main
reasons people hold money rather than storing all their wealth in interestbearing assets such as bonds. These three reasons are the transactions
motive, the precautionary motive and the asset motive. Figure 18.2 shows
the marginal cost and marginal benefit functions for holding money
people hold money up to the point at which the marginal benefit of holding
another pound just equals its marginal cost. Changes in real income shift
the MB schedule while changes in interest rates shift the MC schedule.
Activity SG15.3
Figure 18.2 and Table 18.3 in the textbook provide a good summary of the various factors
behind the demand for money. Draw the MB and MC curves for the demand for money in
an economy, and use these to answer the following question:
What will happen to the demand for money in the following cases, assuming all other
factors remain constant?
Real incomes fall (say, because of a recession).
There is a general rise in prices.
Interest rates fall.
Financial crises
If you are interested in learning more about the causes of the financial
crisis, there is a great deal of information online, including several
documentaries which have been made about it, such as Inside Job
(2010). You may also want to research the changes to regulation that have
been implemented and are still being implemented in many economies
worldwide as a result of the crisis.
BVFD: read the summary and work through the revision questions.
184
Interest rates and monetary transmission

BVFD: read sections 19.119.3, as well as case 19.1.
A countrys central bank has two key responsibilities: monetary control
(section 19.2) and financial stability (section 19.3).
Money market equilibrium

BVFD: read section 19.4 and maths 19.1.
This section discusses the important role of bonds in determining the
interest rate. The interest rate (paid on bonds) is essentially the price of
money, since it is the opportunity cost of holding cash rather than interestbearing bonds. It is important to understand that the interest rate offered
on bonds is the mechanism by which equilibrium can be restored in the
market for money.
A version of Figures 19.1 and 19.2 from the textbook (showing the
demand and supply of money and money market equilibrium) is given
below and labelled slightly differently. This is an important graph which
will be used again in the following block to derive the LM curve (part of
the IS-LM model).
MS
r
B
r2
r2
Md (Y2)
Md (Y1)
Figure 15.1: Money market equilibrium.
The money supply is shown by the vertical line MS, this is set at the level
that is chosen by the central bank. This shifts to the left or right if the
central bank lowers or raises the money supply. (A change in the price
level would also shift this curve, but for now we are assuming a fixed price
level. This assumption will be lifted in Block 17). Money demand is shown
by the downward sloping line Md. This depends on the level of real income
in the economy (GDP). A rise in real income shifts the Md curve upwards.
Money market equilibrium occurs at the intersection of the demand and
supply curves. This is shown by point A (where the interest rate is r1 and
income is Y1) and alternatively at point B (where the interest rate is r2 and
income is Y2).
More competition in banking

This point may require further explanation: The y-axis of Figure 19.1
shows the interest rate paid on bonds, which is different from (and higher
than) the interest rate paid on bank deposits. A change in the rate of
185
interest paid on deposits (for example because of increased competition

between banks) will shift up the demand for money curve, as shown in
Figure 19.2, because it reduces the cost of holding money at each level of
r (the interest rate paid on bonds). This point is further clarified by the
representation of the money market given in Maths 19.1, where rd denotes
the interest rate that can be earned on deposits and r denotes the interest
rate that could be earned by investing wealth elsewhere. The opportunity
cost of holding money is (r rd).
Figures 19.1 and 19.2 in the textbook show the quantity of money
demanded as a function of the price of money (interest rates). As such,
unlike what is written in this maths box, changes in the cost of holding
money (r rd) move us along a given money demand curve while changes
in autonomous money demand or in income and output Y lead to a shift
in money demand. This matches up with what is written in the sub-section
A rise in real income.
Interest rates and money supply

This section describes how central banks now tend to determine the
supply of money indirectly by setting the interest rate at a certain level.
Rather than trying to control cash in circulation or the money multiplier to
determine the money supply directly, central banks now tend to focus on
keeping interest rates at a certain level.
Although many central banks use interest rates as their way of influencing
the money supply, an alternative approach is to focus on the exchange
rate. This is the approach of the Singaporean central bank (the Monetary
Authority of Singapore MAS), and is described more fully below:
Case study: Singapores exchange-rate-centred monetary policy system
Since 1981, monetary policy in Singapore has centred on the management of the exchange
rate. Unlike most other countries, which use interest rates as the instrument of monetary policy,
Singapore has chosen to use the exchange rate. This choice is predicated on the Singapore
economys small size and its high degree of openness to trade and capital flows. In Singapore,
which has no natural resources and is almost completely dependent on imports for necessities
such as food and energy, the import content of domestic consumption is high (with nearly 40
cents out of every $1 spent going to imports).
The economy is thus extremely open to trade, which totalled more than 300% of GDP in 2011.
This openness means that the exchange rate bears a stable and predictable relationship to price
stability as the final target of policy over the medium term. The exchange rate is also relatively
controllable through direct intervention in the foreign exchange markets, which means the
government can use an exchange-rate-based monetary policy to retain greater control over
macroeconomic outcomes such as GDP and consumer price inflation, and over the ultimate
target of price stability. By contrast, interest rates are less easily controlled in Singapore for
various reasons, including the dominance of multinational corporations in the corporate sector.
The effectiveness of the exchange-rate-centred monetary policy as an anti-inflation tool for the
Singapore economy is demonstrated by the relatively low domestic inflation rates over the past
30 years, averaging 2.1% per annum from 1981 to 2012. A further result of the long record of
low inflation is that expectations of price stability have also become more entrenched.
Based on Tee (2013). Available at: www.bis.org/publ/bppdf/bispap73w.pdf
186
Quantative easing (QE)

BVFD: read concept 19.1 and maths 19.2.
Interested students who would like to know more about how QE works
can refer to the following articles:
www.economist.com/node/21558596
www.economist.com/blogs/economist-explains/2015/03/economistexplains-5
www.bbc.com/news/business-15198789
Monetary policy: targets, instruments and the transmission

mechanisms
The table below provides a summary of the transmission mechanisms
described in section 19.7, showing how changes in interest rates and
the money supply impact on aggregate demand and output. However,
it doesnt include some important details on the permanent income
hypothesis and life-cycle hypothesis, and the link between short-term and
long-term interest rates. You will need to learn these parts as well to gain
a thorough understanding.
Transmission mechanisms of monetary policy:
Y = C + I + G + NX
Consumption
Investment
Wealth
Consumer
Credit
Permanent
Income
Fixed Capital
Inventories
Higher real
money supply
increases
wealth directly
The credit
available to
consumers
increases
Lower interest
rates increase
wealth
indirectly
Low interest
rates make
borrowing for
consumption
more
affordable
Consumption
demand
reflects longrun disposable
income. Lower
interest rates
increase
consumption
by increasing
the present
value of
expected
future labour
income
Lower
interest rates
mean more
investment
opportunities
exceed their
opportunity
cost (with a
more powerful
impact on
long-term
investments)
Lower
interest rates
reduce the
opportunity
cost of holding
inventories
Government
Spending
Net Exports
(Fiscal policy
is generally
determined
independently
of monetary
policy)
(The effect of
interest rates
on net exports
is covered in
later parts of
the textbook)
Complete Activity 19.1.

BVFD: read the summary and complete the review questions.
Overview
Chapter 18 of the textbook provides an introduction to the economic
analysis of the money market. The four main functions of money are as
a medium of exchange, a store of value, a unit of account and a standard
of deferred payment. Narrow money, also known as high-powered money
or the money base, consists of currency in circulation plus banks cash
reserves. Broad money (M4), the money supply, includes deposits at banks
187
and building societies. This chapter examines how banks operate, as this
helps generate the money supply. Money supply is greater than the money
base by a factor known as the money multiplier, which depends on banks
reserve ratios and the publics holdings of cash relative to deposits.
Moving on to the demand for money, the textbook discusses how people
have various motives for holding money, including the transactions motive,
the precautionary motive and the asset motive. The cost of holding money
is the interest foregone through not holding assets as bonds. The quantity
of real money demanded rises as the interest rate falls, and is higher at
each interest rate when real income is higher.
Banks play an important role in the economy, but this is not without risk.
Regarding financial crises arising in the banking sector, it is important to
distinguish between liquidity crises and solvency crises. One approach to
dealing with the recent financial crisis (quantitative easing) is explored in
Chapter 19 of the textbook.
Chapter 19 also discusses the Bank of England and the two key
responsibilities of central banks, namely monetary control and financial
stability. It also brings together demand and supply to discuss equilibrium
in money markets. Equilibrium is achieved through changes in the
interest rate, which affects the demand and supply of bonds and thus
indirectly, demand for money. Money supply is controlled by the central
bank, although nowadays, central banks focus on the interest rate rather
than setting a specific money supply target. The central banks decisions
regarding interest rates (or historically, money supply) is known as
monetary policy. Interest rates are a common instrument of monetary
policy, and a common target is price stability (low inflation rates).
Changes in interest rates affect the real economy through their impact
on consumption and investment. Consumption, because higher interest
rates reduce household wealth, make borrowing dearer and reduce the
present value of future labour income, leading to a fall in consumption.
Investment, because higher interest rates mean fewer investment projects
exceed their opportunity cost and the opportunity cost of holding
inventories increases, leading to a fall in investment.


1. All of the following are examples of financial intermediaries except:
a. commercial banks
b. stock exchanges
c. pension funds
d. insurance companies.
2. A credit crunch reduces aggregate demand by:
a. increasing the exchange rate
b. increasing interest rates
188
c. reducing consumption and investment spending

d. reducing the money supply.
3. To the extent that mortgage defaults contributed to the financial crisis
of 200809, blame for these actions lies with:
a. homebuyers who borrowed more than they could afford to repay
b. mortgage brokers who encouraged households to borrow
excessively
c. financial intermediaries who held large positions in mortgagerelated assets
d. all of the above.
4. A bank with assets worth less than liabilities is said to be ,
while a bank without adequate funds immediately available to make
promised payments is said to be .
a. inflated; inverted
b. inverted; inflated
c. insolvent; illiquid
d. illiquid; insolvent.
5. An increase in the demand for money could be caused by an increase in:
a. the general level of prices
b. incomes
c. interest rates
d. synchronisation between payments and receipts.
6. Given a fixed money supply, more competition in banking could lead
to:
a. an increase in the interest rate paid on bonds
b. a decrease in the interest rate paid on bonds
c. no change in the interest rate paid on bonds
d. a decrease in the interest rate paid on bank deposits.

A farmers harvest will be worth 200 if she can borrow 100 worth of
fertiliser. The fertiliser needs to be applied now and harvest will take place
in six months time. There are N savers in the economy, each endowed
with 1. Each agent faces a p% chance that there will be an emergency
such as they will absolutely need their 1 three months from now.
a. Explain why a financial intermediary is needed in this situation.
b. What is the minimum value of N such that a financial intermediary can
solve the problem of getting money from savers to borrowers? (Hint: it
depends on p).
c. On the basis of this example, can you see what economists mean when
they say banks are engaged in maturity transformation?
d. Now for something a bit harder. Instead of p being a fixed number,
suppose that p can turn out to be small (with 90% probability) or large
(with 10% probability). Can you see a bank run developing in this
case?
e. What could the role of a central bank be in this case?
189
Notes
190
Block 16: Monetary and fiscal policy

Introduction
Block 14 discussed the goods market while Block 15 covered the money
market. This block introduces a framework called the IS-LM model which
brings these two markets together in a basic general equilibrium analysis,
that is, it analyses the requirements for the goods and money markets to
be simultaneously in equilibrium and how this simultaneous equilibrium
is affected when certain factors, initially held constant, are allowed to
change. The IS-LM model is a simple and effective model for examining
the two key tools of demand management fiscal and monetary policy.
After completing this block, you should understand how the combination
of these two policies (i.e. the policy mix) affects the level of demand in
the economy. This block completes the demand side of the macro section.
At this stage, we are still making the strong assumption that the price
level is fixed, an assumption that will be relaxed in the following textbook
chapters. Because the price level is fixed there is no distinction between
nominal and real values, so that all the variables in the analysis of this
chapter can be thought of as real.
IS-LM is sometimes not taught, one reason is the above assumption
regarding the price level. Other criticisms of the IS-LM model include the
fact that it is a static model, while interest rates are meaningless unless
time is a factor; and the fact that the central bank no longer uses money
supply targets (most central banks now set inflation targets). Nonetheless,
it is a useful model for clarifying several fundamental concepts and
although it is sometimes seen as being a little old-fashioned, in practice
it is often still used by policy-makers (see, for example, a defence for
teaching it by the Nobel Prize laureate Paul Krugman: http://web.mit.
edu/krugman/www/islm.html). If you work through this block thoroughly
and gain a good understanding of this model and the effects of fiscal and
monetary policy mixes, this will help a great deal in progressing through
the following blocks where the analysis becomes more complex (and more
realistic).
Learning outcomes
describe different forms of monetary policy
derive the IS curve and the LM curve
find equilibrium in both the output and money markets
link shifts in the curves to fiscal and monetary policy respectively
discuss the impact of fiscal policy, with different funding mechanisms
discuss the impact of monetary policy
describe the liquidity trap
use graphs to describe the effect on output and interest rate of the mix
of monetary and fiscal policy
realise how expected future taxes affect current demand.
Essential reading
191
Further reading
Lipsey and Chrystal (L&C) international edition, Chapters 17 and 18; UK
edition, Chapters 19, 20 and 25.

This chapter introduces the IS-LM model and uses this to give insights
into how monetary and fiscal policy work and how the government and
the central bank manage demand in the economy. A derivation of the
IS-LM model is included in this block (although this is not covered in the
textbook). The IS curve shows all the combinations of interest rates and
output at which the goods market (Y = C + I + G) is in equilibrium, and
the LM curve shows all the combinations of interest rates and output at
which the money market is in equilibrium. There are also discussions of the
effects of various policy mixes, the liquidity trap, and Ricardian equivalence.
Monetary policy
In the past, central banks used monetary targeting now they tend to use
inflation targeting. This chapter is based on the assumption that central
banks use monetary targeting, since it makes the concepts in this chapter
easier to understand. However, its important to keep in the back of your
mind that inflation targeting is the most common current practice. The
following chapters will explore inflation targeting more deeply.
The IS-LM model

To derive the IS curve, we focus on the investment component of
aggregate income and start with the investment demand schedule which
you will remember from Chapter 19 of the textbook (p.453). This shows
how a decrease in interest rates leads to an increase in investment. For
example, in the graph below, a fall in interest rates from 10% to 80% leads
to an increase in investment from 150 to 200.
r
10%
8%
I
150 200
= 50
Figure 16.1: Investment schedule.
Since investment is part of autonomous demand, the increase in investment

of 50 leads to an increase in autonomous demand of 50. As such, the
192
increase in demand shifts up the AD curve. If we assume that the multiplier

is equal to 5, this would lead to an increase in output from 1,500 to 1,750.
AD
AD (r = 8%)
B
= 50
AD (r = 10%)
350
300
45
1500 1750
r
A
10%
8%
IS
1500 1750
Figure
Deriving
the
curve.
A: at 16.2:
an interest
rate
ofIS10%
the goods market is in equilibrium at 1500
B: atAanshows
interest
of 8% theingoods
market
is in equilibrium
1750
Point
anrate
equilibrium
the goods
market
where theatinterest
The
IS
curve
gives
you
all
the
combinations
of
interest
rate
and
income
rate is 10% and output is 1,500. Point B shows an equilibrium where the
where rate
the goods
is in equilibrium
interest
is 8% market
and output
is 1,750.
Mapping points A and B onto a graph of interest rates against output gives
us the IS curve. The IS curve shows all the combinations of interest rate
and income where the goods market is in equilibrium.
Activity SG16.1
Given the following information, provide a graphical derivation of the IS curve: The
multiplier is equal to three. When interest rates are equal to 5%, autonomous demand is
200. When the interest rate rises to 8%, investment falls from 100 to 80.
To derive the LM curve, we must start with the money market. This is
depicted below in the left-hand graph.
MS
r
D
15%
10%
15%
D
C
10%
Md (Y2)
LM
M (Y1)
d
Y1
Y2
Figure 16.3: Deriving the LM curve.

193
The money supply is fixed at a certain level by the central bank (remember
in this block we are still assuming the central bank is using a money
supply target). In this depiction of the money market, money demand
depends endogenously on the interest rate r and exogenously on the
level of income Y and is downward sloping. At point C, the market
is in equilibrium. The mechanism that provides the LM curve can be
summarised as follows: if there is an increase in income, this will lead
to an increase in the demand for money at any interest rate (due to the
increase in transactions). This means there will be excess demand for
money at the initial interest rate some people want to sell their bonds
and convert them into cash. These people will need to find a lender, so the
price of bonds would have to fall and the interest rate the return to the
lender would have to increase. In this way, competitive market forces
will restore equilibrium in the money market.
In short: Y Md Pb r, where Y is income, Md is money demand,
Pb is the price of bonds and r is the interest rate.
At point D, interest rates have risen to such a level that equilibrium in the
money market has been restored. Mapping points C and D onto a graph
of interest rate against output gives us the upward sloping LM curve. The
LM curve shows all the combinations of interest rate and output where the
money market is in equilibrium.
Activity SG16.2
Given the following information, provide a graphical derivation of the LM curve. There is
a fixed supply of money. When output is at 600, the money market is in equilibrium when
interest rates are equal to 5%, when output rises to 800, the interest rate rises to 8% to
restore equilibrium in the money market.
Putting the IS curve and the LM curve together gives us the complete
model. This is a general equilibrium model which shows the interactions
between two variables (interest rates and output) which are dependent on
each other but which are determined in different markets.
The IS curve shows combinations of interest rate and output where the
goods market is in equilibrium. These variables are connected in the goods
market because interest rates affect investment (and also consumption),
which are components of aggregate output.
r
LM
X
r*
IS
Y*
Figure 16.4: IS-LM.
The LM curve shows combinations of interest rate and output where the
money market is in equilibrium. These variables are connected in the
money market because the demand for money depends on the income
level and interest rates. In short, the rate of interest is a linking variable
which transmits changes in the money market to the goods market and
194
income is a linking variable which transmits changes in the goods market

to the money market. There is always a pair (Y,r) for which both markets
are in equilibrium. This is shown by point X in the diagram where output
is at Y*and the interest rate is r*.
Activity SG16.3
Answer the five questions in the boxes below:
IS-curve:
LM-curve:
combinations of interest rates and

income that lead to equilibrium in
the goods market
combinations of interest rates and

income that lead to equilibrium in
the money market
Lower interest rates increase consumption The quantity of money demanded rises
demand (Why?)
with the level of output (Why?)
Lower interest rates increase investment

demand (Why?)
Higher interest rates lead to a fall in

money demand (Why?)
(This approach assumes that whatever is

demanded will be supplied. Supply side
economics will be covered in Chapter 28)
Higher output induces a higher interest

rate to keep money demand in line with
money supply. (Who determines this?)
BVFD: read concept 20.1

As discussed above, nowadays, it is much more common for central banks
to set a target interest rate which they maintain through open market
operations than to try to aim for a target money supply. Concept box
20.1 provides an explanation of the LM curve which fits with this modern
approach to central banking. In fact, some treatments dispense with the
notion in concept 20.1 that the monetary authorities raise interest rates
at high output levels and lower them at low output levels and just draw
the LM curve horizontal at the rate chosen by current monetary policy
(see concept 20.2). The curve is sometimes relabelled as MP for monetary
policy, or MR for monetary rule. To maintain the interest rate at the
desired level the monetary authorities will have to supply the amount of
money required to equate supply and demand in the money market at
this interest rate. Therefore changes in the demand for money have no
effect on the interest rate or equilibrium output, the latter determined
by the position of the IS curve at the given interest rate. Of course when
195
the monetary authorities change the interest rate, equilibrium output will
change, other things equal.
Activity SG16.4
Using the IS-LM framework, draw a fiscal expansion and a monetary expansion in the
boxes below. What are the effects on output and interest rates?
Fiscal expansion
Monetary expansion
Crowding out
An increase in government spending, G, leads to an increase in output and
an increase in interest rates. However, this increase in interest rates will
lead to a fall in private spending a fall in investment and consumption.
This means that the overall increase in output is less than it otherwise
would have been. To a certain extent, the increase in government
spending has merely replaced private spending that would otherwise have
taken place. Another way of thinking about this is that an increase in G,
unmatched by an increase in taxation reduces desired national savings.
At unchanged interest rates there will be an excess of desired investment
over desired savings so the interest rate increases to eliminate this excess.
As the text explains, investment does not fall by the same amount that G
has increased unless the LM curve is vertical. Look at the text to determine
under what conditions there would be no crowding out at all.
Not all economists are convinced by the notion that increases in
government spending crowd out private investment. One counter
argument is that when confidence is very low, say in a deep recession,
government spending may actually crowd in private spending by boosting
confidence in the future performance of the economy.
196
Activity SG16.5
The figure below summarises this section, showing how changes in money demand (other
than those caused by changes in interest rates and output) cause the LM curve to shift.
Complete the empty boxes in the second row.
Increase in
banking
competition
Banks pay
higher
interest on
deposits
Banks want
to increase
their profit
margins
Smaller
differential
interest paid
on deposits
and interest
paid on
bonds
Increased
demand for
money
(deposits) at
a given
market
interest rate
r
LM
curve
shifts
left
LM
curve
shifts
right
Figure 16.5
Unpredictable shocks to money demand, and hence the position of the LM
curve, is one reason why money supply targets were eventually abandoned
in favour of interest rate targets.
This maths box provides a neat way of summarising the various factors
at work in these models. Work through the algebra yourself to make sure
you understand it. You would then find it useful to work through the
additional material below.
Derivation of IS-LM
We now provide a mathematical treatment of the derivation of IS-LM. It is
basically an elaboration of Maths 20.1 with the inclusion of government. This
latter extension enables the equations to incorporate the effects of monetary
and fiscal policy.
We begin with the equilibrium condition, discussed in Chapters 16 and 17,
that output equals desired spending in the goods market.
Y=C+I+G
Next, for C we substitute the linear consumption function C = AC + c(Y T).
In this equation AC represents autonomous consumption, c is the marginal
propensity to consume out of disposable income which is gross income Y
minus net taxes T. To keep the mathematics relatively simple we make T
autonomous rather than a linear function of Y as in earlier chapters.
Note that we do not make consumption depend on interest rates in this
section, again simply to avoid the mathematics becoming too turgid. Turning
to investment we allow this to have an autonomous component AI as well
as to depend negatively on the rate of interest, r, as explained in Chapter
19 (see, for example Figure 19.5). Thus, we write investment as I = AI dr
Substituting into the equilibrium condition we have:
197

Y = AC+c(Y T)+AI dr + G
Collecting terms, this gives us the IS curve which we can write in terms of
equation (1a) in Maths 20.1:
Y = A br
Where A =
AC + AI cT + G
1 c
and b =
d
1 c
Turning to the LM curve, we simplify again by assuming that the money

supply is exogenous, M is simply set by the government (we short-circuit the
deposit multiplier analysis) so the equilibrium in the money market is, again
using the notation of Maths 20.1, given by:
M = fY hr
And the LM relation by:
Y = D + er
Where, D = Mf and e = h
f
Solving for simultaneous equilibrium in the goods and money markets (IS=LM)
yields expressions for Y and r in terms of the exogenous variables and the
parameters (constants) c, d, f, and h from the consumption, investment
and money demand functions. The equations (which are the equivalent of
equations (2) in Maths 20.1) are quite complicated but they show how and
why equilibrium income and the interest rate are affected by a change in any
of the exogenous variables in the model. We show the equation for equilibrium
Y only (you are not expected to learn this equation you will not be asked to
reproduce it).
Y=
AC + AI cT + G
(1 c) +
df
h
M
(1 c)
h
d
+f
From these equations we can derive the fiscal and monetary policy multipliers;
the change in Y for a given (relatively small) change in G, T or M.
Y
G
Y
T
Y
M
1
(1 c) + df
h
c
(1 c) + df
h
1
(1 c) h + f
d
Thus, the increase in equilibrium income is large when (1 c) is small (i.e.

when the MPC is large) and the standard multiplier, covered in Chapters 16
and 17, is large and there is less leakage in the re-spending rounds. Other
things equal, the increase in G on Y is larger when d is small. Why? There
is a smaller crowding out effect on investment when the interest rate rises,
as it must given that money supply stays constant while the demand for
money increases due to the increase in income. How much the interest rate
will increase will itself depend on f and h. When f is high the increase in the
demand for money is high when an increase in G raises Y so the interest rate
will have to increase by more to maintain equilibrium in the money market.
This reduces investment by more so the overall increase in equilibrium Y is
smaller. Other things equal, when h is higher in absolute terms (the demand
for money is more sensitive to the interest rate) then a smaller adjustment in
198

r is required to restore equilibrium in the money market when Y increases, so
the negative effect on I is less and the final increase in Y is greater.
It would be useful for you to trace out the economic impacts of c, d, f, and h in
the other two equations.
Activity SG16.6
1. a. Find the interest rate and level of output at which both goods and money markets
are in equilibrium, given the following equations:
Y = 80 4r
(IS curve)
M = 360
(money supply)
M = 10Y 4r
(money demand)
b. How would this change if there is expansionary fiscal policy and autonomous
demand in the IS schedule increases to 102?
2. Find the interest rate and level of output at which both goods and money markets are
in equilibrium, given the following information:
C = 100 + 0.7(Y T)
I = 100 0.2r
G = 150
T = 50
M=310
M = 0.3Y 0.2r.
The liquidity trap

One topic that is not covered in BVFD, but which we think deserves
attention, is the so-called liquidity trap. This relates to what happens in
the money market when interest rates are zero, or very close to zero, and
the implications of this state of affairs for the effectiveness of monetary
policy. Arguably, with the very low interest rates in many economies after
the financial crisis of 200809 (at the time of writing the Bank of England
rate is 0.5% and the Federal Reserve rate in the USA about half of that)
this topic has contemporary relevance. Let us begin by returning to the
demand for money graph as a function of the interest rate and some given
level of income, as shown in Figure 15.1, and ask what happens when the
interest rate is zero (we rule out negative nominal interest rates here). The
interest rate is the opportunity cost of holding money; as it falls people
hold more money. When it is zero there is no opportunity cost, bonds
pay a zero rate of interest as does money so individuals are indifferent
between holding their financial wealth (over and above what they need
for transactions purposes) as money or bonds. We show this by having the
demand for money curve (the bold line in the diagram below) follow the
horizontal axis when the interest rate falls to zero.
199
r
M1s
M2s
Figure 16.6: Supply and demand for money.
When the central bank increases the money supply in the range 0A,
interest rates fall, but beyond A, further increases in the money supply,
beyond MS2 lead to no further reductions in interest rates; individuals will
be prepared to hold the extra money without further reductions in the
interest rate. Now let us ask what happens to the LM curve when money
demand curves are horizontal at zero interest rates.
r
M D (Y3)
M 52
LM(M 52)
M (Y2)
D
M D(Y1)
Y1
Y2
Y3
Figure 16.7: The LM curve and the liquidity trap.
In the above, we derive the LM curve as income increases (Y1<Y2<Y3) and

the money supply is held at MS2. So our LM curves are horizontal when
income falls below Y1. Now lets combine IS and LM to illustrate the
effects of monetary policy under the liquidity trap.
r
IS
LM(M 51)
LM(M 53)
LM(M 52)
A
B
Y
Y
*
Figure 16.8: IS-LM and the liquidity trap.

200
Suppose the economy is initially at A, then by increasing the money

supply, the monetary authorities can lower the interest rate and expand
Y. However, once the money supply is at MS2 the economy is at point B.
Interest rates have fallen to zero and Y* is the maximum income that can
be attained (given the IS curve). Further increases in the money supply,
say to MS3, have no further effect on equilibrium; interest rates cannot
fall below zero and Y remains at Y*. Although the central bank creates
additional liquidity this falls into a trap the extra money is willingly
held as part of wealth portfolios at zero interest and has no effect on
output, which is demand constrained by the IS curve (fiscal policy could
be effective of course). In other words, the interest rate has lost its power
of linking the monetary and goods sectors of the economy; monetary
policy has lost its ability to stimulate investment and other components of
aggregate demand which depend on the rate of interest.
Note that the argument in this section can hold at very low but not quite
zero interest rates. Suppose that at positive but low interest rates people
expect rates to increase to some normal minimum level. This is equivalent
to saying they expect bond prices to fall. If this expected capital loss on
bonds is just equal to the interest yield at the current low rates then the
expected return on bonds is zero and individuals would be indifferent
between holding money and bonds and we would be in the liquidity
trap. Some commentators have argued that Japan in the 1990s and other
advanced countries in post financial crash years have effectively fallen into
this liquidity trap, making monetary policy impotent.
The extent to which the liquidity trap is a serious impediment to
monetary policy is a contentious issue, however. One counter-argument
is that monetary expansion at low interest rates will raise inflationary
expectations making expected real interest rates negative, which
should stimulate investment. Inflationary expectations will be considered
further in subsequent blocks. Another possibility is that the central bank
can lower interest rates on mortgages and corporate debt by purchasing
these loans from commercial banks one aspect of the so-called
quantitative easing policy introduced by central banks when interest rates
fell close to zero.
The policy mix

This section discusses the effects of different policy mixes on the
composition of demand and why different policy mixes may be adopted
in different situations. It is important to realise that there are many
factors affecting an economy at any point in time and there will always
be uncertainty regarding the future; as such there may be disagreement,
even between well-regarded economists, as to the most appropriate
course of action in a given situation. History plays an important role, as
economists will often draw on historical examples, as well as pure theory,
to guide them and to justify their recommendations. While fiscal policy
continues to be heavily influenced by political and ideological concerns,
since being granted more independence from government, the decisionmaking process of central banks regarding monetary policy has become
more influenced by both economic theory and by the experience they have
gained, rather than political concerns.
201
Activity SG16.7
Describe the policy mix you would adopt in the following situations, assuming you are in
a position of power over both fiscal and monetary policy, and provide an explanation of
the reasoning behind your decision:
a. A very deep recession.
b. There is a need to build a solid foundation for long-term growth, but there is currently
a temporary bubble in the economy.
c. The country is heavily engaged in a war which is being fought outside of the country.
This section also briefly makes the point that expansionary fiscal policy
can be financed in different ways. The effects of the policy on interest rates
and output may differ depending on how it is financed. The three main
alternatives for financing an expansionary fiscal policy are below.
a. An expansionary fiscal policy financed via an increase in taxes. This
will not cause an increase in the money supply so fiscal policy and
monetary policy will be independent. It does cause a decrease in
consumption but not by as much as the tax increase since people are
likely to reduce savings as well as consumption. Interest rates will
increase and output will increase, though probably less than it will
in (b).
b. An expansionary fiscal policy financed via borrowing (selling bonds to
the public). This doesnt affect money supply as the money the public
uses to buy bonds is re-injected into the economy. Fiscal and monetary
policy will be independent in this case. Crowding out will occur due
to the increase in interest rates. Output will most likely increase more
than in (a), depending on how much crowding out of investment and
consumption occurs.
c. An expansionary fiscal policy financed via printing money (selling
bonds to the central bank). This will lead to an increase in the money
supply and can be highly inflationary if the government has large debts
more on this later. Output will rise and there will be no crowding
out. The effect on the interest rate is unclear.
Activity SG16.8
Use IS-LM curves to represent these three options graphically (note that at this stage we
still make the assumption that prices are constant).
What are the reasons why Ricardian equivalence is too strong in practice? What evidence
exists to support this?
BVFD: read section 20.7, the summary and work through the review
questions.
202
Overview
This block introduces the IS-LM model and provides a derivation of each
curve. Fiscal policy shifts the IS curve while monetary policy shifts the LM
curve. An expansionary fiscal policy leads to a higher interest rate and
higher output, with government spending a large part of total spending.
An expansionary monetary policy leads to lower interest rates and higher
output, with private consumption spending and investment making up
a large part of total spending. These two policies can be used to support
each other or balance each other out. Often, fiscal policy will be heavily
influenced by political concerns, while in many countries the central bank
makes decisions on monetary policy independent from political influences.
This model provides a simple way of depicting the effects of each policy, as
well as policy mixes.


1. Suppose an economy is in short-run equilibrium at the intersection of
the IS and LM curves. The central bank decreases the money supply.
What will happen to the equilibrium interest rate and equilibrium
output?
a. The interest rate will rise and output will fall.
b. The interest rate will fall and output will rise.
c. The interest rate will fall and output will fall.
d. The interest rate will rise and output will rise.
2. The LM curve will shift down when the:
a. nominal money supply declines
b. price level rises
c. expected inflation declines
d. real money demand declines.
3. An increase in money demand causes the real interest rate to _____
and output to _____ in the short run, before prices adjust to restore
equilibrium.
a. rise; fall
b. fall; fall
c. fall; rise
d. rise; fall.

1. Explain why each of the following is either true or false and discuss
the effectiveness of monetary and fiscal policy to affect income in each
case (in parts a., b., c., monetary policy means controlling the money
supply, in d. it means setting the interest rate).
203
a. If neither consumption or investment is depend on the interest

rate, the IS curve is vertical.
b. If money demand does not depend on the interest rate, the LM
curve is horizontal.
c. If money demand does not depend on income, the LM curve is
horizontal.
d. If the government fixes the interest rate rather than the money
supply, the LM curve is vertical.
2. Assuming constant prices (no inflation) and that the central bank
pursues a money supply target:
a. derive the IS-LM framework graphically and
b. use it to show what will happen if:
i. There is an expansionary fiscal policy financed by borrowing.
ii. There is a contractionary monetary policy.
iii. Both of these policies are in effect at the same time.
204
Block 17: Aggregate demand and aggregate supply
Block 17: Aggregate demand and

aggregate supply
Introduction
Up to this point, the blocks on macroeconomics have assumed that the
price level was fixed. In this block, we introduce a supply side and lift
the assumption of fixed prices. This raises the question of how flexible
prices (and wages) really are. There are different schools of thought on
this issue the classical school assumed that prices and wages were fully
flexible. Later, the Keynesian school argued that they are sticky (especially
downwards) and will not change in the short-run. These two perspectives
give rise to the short-run aggregate supply curve (following the Keynesian
perspective) and the long-run, vertical aggregate supply curve (following
the classical school of thought). This block examines changes in output
and the price level how the economy can deviate from its long-run
equilibrium level of output, and how it can get back there again, either
through market mechanisms or through government intervention.
The AD-AS model can either be represented graphing output against the
price level, or against inflation (i.e. the rate of change in the price level).
BVFD uses the model with inflation. This is the model we will concentrate
on this block and which is examinable for you. However, you may find
it easier to start with the model using the price level. A brief description
of this (based on L&C) has been included in a box (The price level or
its rate of change?) and is laid out in further detail in an appendix to
this block. This is optional material included only to aid your
understanding and is not examinable.
Learning outcomes
describe inflation targets for monetary policy
explain and graph the ii schedule
describe how inflation affects aggregate demand
define aggregate demand and graph the AD schedule
define aggregate supply in the classical model
analyse the equilibrium inflation rate
describe complete crowding out in the classical model
recognise why wage adjustment may be slow
analyse short-run aggregate supply
discuss the effects of short-run and permanent demand and supply
shocks
describe how monetary policy reacts to demand and supply shocks
recognise flexible inflation targets
explain the Taylor rule.
Essential reading
205
Further reading
Lipsey and Chrystal (L&C) international edition, Chapters 19 and 20; UK
edition, Chapters 21 and 22.

In a context of flexible prices and wages, this block firstly defines
aggregate demand and the AD curve, and then aggregate supply and the
AS curve. The AD-AS model can be used to show how output and the
rate of change of the price level are determined. This block examines how
the economy adjusts to different kinds of demand and supply shocks and
how the government (through the central bank) can respond to bring
output back to the potential level of output and keep inflation on target.
The different perspectives of the classical and Keynesian school on the
flexibility of prices is a key element of this chapter. One major reason
why prices are not flexible is that wages are sticky downwards. The
advantages and limitations of government intervention are discussed, as
well as various approaches to monetary policy, including flexible inflation
targeting and the Taylor rule.
Aggregate demand
In the early blocks on macroeconomics, there was an underlying
assumption that the price level is fixed, and aggregate demand was simply
defined as planned or desired spending (see textbook Chapter 16). From
this block (covering Chapter 21) onwards, we leave this assumption
behind, and can now represent aggregate demand at various price levels.
This is summarised by the (dynamic) AD curve, which shows the
relationship between output and inflation.
The price level or its rate of change?
Students looking at other textbooks (e.g. Lipsey and Chrystal (UK edition Chapter 21;
international edition, Chapter 19), Mankiw, Blanchard) may find that the model of
aggregate supply and aggregate demand is first introduced with the price level rather
than inflation on the vertical axis. Our textbook bypasses this model and goes to a
somewhat more advanced model, which can be thought of as a dynamic model of
aggregate supply and demand; dynamic in the sense that the rate of change of prices
rather than their level is what influences aggregate demand and supply in the economy.
While this is more advanced and more modern, in the sense of explicitly incorporating
inflation targeting as currently widely practised by central banks, it does require a
somewhat more complex set of ideas.
Although our textbook relates aggregate supply and demand to inflation it may be worth
understanding the rudiments of the alternative approach using the price level. There are
several different explanations to be found in the literature on why aggregate demand
(AD) is inversely related to the price level (i.e. the AD curve slopes downwards), and
aggregate supply (AS) positively related (AS upward sloping).
On the demand side, a simple version has the demand for real money balances
M
depending positively on income: P = kY , where M is the nominal money supply and k is
a constant. Therefore, with a given nominal money supply, we have an inverse relation
between P and Y. Lipsey and Chrystal also argue that the price level has wealth effects
on consumption and directly affects the competitiveness of exports. This is described in
further detail using the IS-LM model in the appendix to this block.
206
On the supply side, one can think of the AS curve being upward sloping due to increasing
marginal costs of production; for perfectly competitive firms an exogenous increase in
prices raises output and for price-setting firms if higher output increases costs, firms
who price with a mark-up over costs will increase prices. The AD-AS model then jointly
determines output and the price level and enables analysis of the effects of monetary and
fiscal policies as well as supply shocks which exogenously increase or decrease costs to
producers.
Section 21.1 explains why the AD curve is downward sloping in a model
with inflation on the vertical axis. Interest rates and central bank inflation
targeting are the links between inflation and output. When inflation is
high, inflation-targeting central banks raise interest rates and this reduces
those components of aggregate demand, such as investment, which are
sensitive to interest rates. Consumption is also affected by interest rates
(though to a lesser extent than investment) because people often buy
durable goods (such as washing machines) on credit. It is important
to be clear that the implementation of a given monetary policy moves
the economy along a given ii schedule while a general tightening or
loosening of monetary policy shifts the whole ii schedule upwards or
downwards.
The approach adopted in BVFD for explaining the AD schedule is clarified
further in concept 21.1. This shows how input/output, interest rates
and inflation are all interrelated. In Figure 21.1 the ii schedule is drawn
with the real interest rate on the vertical axis, whereas the ii schedule in
concept 21.1 uses the nominal interest rate. Can you see how these two
approaches are reconciled? The answer is that the absolute value of the
slope of the ii schedule in concept 21.1 is greater than 1, implying that
the monetary authorities raise real interest rates when inflation increases;
because i=r , r> means i increases.
Activity SG15.1
Use the framework of concept 21.1 to trace out the effects of a looser monetary policy on
the AD schedule.
Aggregate supply
BVFD: read section 21.2 and case study 21.1.
We now move away from the Keynesian model, with rigid wages and
prices in which output is entirely demand determined, and include a
supply-side in the model of output determination. Aggregate supply
describes the relationship between the output that businesses willingly
produce and the rate of inflation, with other factors held constant. Initially,
the textbook introduces the vertical aggregate supply curve. This is
often known as the long-run aggregate supply curve as it is based on the
assumption that prices and wages are completely flexible. While almost all
economists would agree that prices and wages are flexible in the long-run,
the classical school assumed they were always flexible.
For example, suppose inflation increased; if nominal wage growth did not
change then real wages would fall. But in the classical model, nominal
wage growth would match the new, higher, rate of inflation so that real
wages would be unaffected and there would be no forces acting to change
aggregate output. The vertical aggregate supply curve shows that in the
207
long-run there is no relationship between inflation and the level of output

(similar arguments make the level of output independent of the price
level, but in this chapter, as explained above, we relate output to inflation
rather than to the price level). The level of output is the full employment
equilibrium level and, in the long run, can co-exist with inflation at any
level. Resources are fully employed since price and wage flexibility ensures
that all markets, including the labour market, are in equilibrium, with no
shortages or surpluses.
Optional: For some interesting examples of money illusion and a fuller
discussion, see: Shafir, Diamond and Tversky (1997) Money illusion,
available at: http://qje.oxfordjournals.org/content/112/2/341.short
Equilibrium inflation
Now we can finally put together the pieces of the full model aggregate
demand and aggregate supply to show both the level of output and the
inflation rate. Where the two curves intersect, there is equilibrium in the
goods market, the money market and also the labour market. The position
of the vertical AS curve reflects potential output. The position of the AD
curve reflects the governments monetary policy and the impact of interest
rates on the goods market.
In the long run, aggregate supply is vertical at the level of potential
output determined by the economys available inputs and its technology
(broadly defined). All prices, inputs and outputs increase at the same rate
so nothing real changes. For example both money wages (nominal wages)
and prices change at the same rate so the real wage, which affects both the
supply of and demand for labour, is unchanged.
The SAS curves described in this section display how much firms are
willing to supply at each level of inflation given a certain nominal wage
growth. In Appendix B, there is a description of SAS curves for a model
with the price level on the vertical axis. Once again, this has been included
to aid your understanding and is optional and not examinable.
Figure 21.5 shows why it can be useful to understand the AD curve from
the perspective of interest rates. Then, we can see how the government
can respond actively to a shift in aggregate supply. In this case, the
government responds to an increase in aggregate supply by reducing
interest rates, as this leads to an increase in aggregate demand such that
inflation is maintained at the target rate.
Activity SG17.2
Beginning at point C in Figure 21.5, where would the economy end up if there was an
adverse supply shock shifting the AS curve from AS1 to AS0 and the central bank did not
react?
Activity SG17.3
Select the appropriate response below in regards to the following two statements:
i. Central banks can offset temporary demand shocks but in doing so they will face a
trade-off between stabilising output or inflation.
ii. Central banks can offset temporary supply shocks without facing any trade-off
between stabilising output or inflation.
208
a. i is true and ii is false.

b. ii is true and i is false.
c. i and ii are both true.
d. i and ii are both false.
In the classical model, fiscal expansion cannot increase output. To stop
inflation rising above the target, an increase in government spending
will have to be countered by a rise in real interest rates to restore
aggregate demand to the level of potential output. This means that higher
government spending simply crowds out an equal amount of private
spending, leaving demand and output unchanged. This sub-section on
demand shocks shows why it was so revolutionary for John Maynard
Keynes to suggest, in the Great Depression of the 1930s, that the solution
was to increase government spending. One key contribution of Keynesian
economics was that, at least in the short-run, prices and wages may be
sticky, such that output is not at the full employment equilibrium level. In
such a situation, increasing the level of aggregate demand by increasing
government spending can increase output without bringing the inflation
rate above target.
Monetarism, whose most famous and influential exponent was Milton
Friedman of the University of Chicago, became popular in the 1970s and
1980s and proposes that an increase in the money supply will lead to an
increase in prices (or, in terms of the framework of this chapter, faster
growth of the nominal money supply leads to higher inflation) but would
not affect real variables in the long run. This is based on the quantity
theory of money, which is discussed further in the next chapter in concept
22.1.
Seen very broadly, the perspectives of the classical school and the
Keynesian school can be synthesised by taking a long-run/short-run
approach. In the long run, the AS curve is vertical, as proposed by the
classical school. The following section shows why, as proposed by the
Keynesian school, this does not hold in the short run, where prices and
wages are sticky (i.e. do not move flexibly, especially downwards).
Wage rigidity
This section discusses wage rigidity. It summarises why prices are sticky
(especially downwards), since wages, the largest component of firms
costs, adjust slowly to changes in demand. Prices may also be sticky for
other reasons, such as the fact that it is costly for firms to set, implement
and advertise new prices this may lead to a reluctance to increase prices,
even in situations where a price increase would be expected, for example
due to a major increase in costs or demand.
Short-run aggregate supply

Why do SAS curves slope upwards? An explanation for a model with price
level on the y-axis is included in Appendix B. For the model with inflation
on the y-axis, the discussion below should help you understand the
explanation in the textbook.
209
In the short run, some prices cannot adjust or can only do so partially. To
derive an upward sloping short-run supply curve, this chapter assumes
a very specific type of labour market rigidity, namely that, in the shortrun, firms are stuck with a given rate of growth (note: not level) of
nominal wages inherited from previous wage negotiations. Prices change
more easily than wages. Both suppliers and demanders of labour will
have negotiated the rate of growth of money wages on the basis of their
inflation expectations (i.e. they will have implicitly been negotiating
over real wages). If the rate of change of nominal wages is fixed by wage
agreements but inflation deviates from the rate assumed by the parties
to such agreements then the real wages will differ from those implicitly
agreed by the negotiating parties.
Now suppose that for given expectations about the growth of money
wages and prices, the rate of inflation is higher than expected. Firms get
higher prices for their product and real wages are lower than expected
because prices are rising faster than was expected when nominal wage
growth was negotiated. So production becomes more profitable and firms
increase output. Similarly, if inflation is lower than expected the prices at
which firms sell their output is lower than they were counting on and real
wages are greater than expected. Output falls, unemployment increases.
After a period of time, if inflation deviates from its expectations and thus
the workers and firms are not receiving and paying the real wages they
negotiated, they will go back and renegotiate how fast nominal wages
grow and this in turn will shift the whole short run AS schedule, that
schedule having been drawn for a given rate of change of money wages.
The short-run aggregate supply curves in Figure 21.7 can be written:
Y = Y* + ( e) where is a positive constant and e is expected
inflation. As explained, each supply given is based on inherited agreements
on the growth of money wages.
Shifts in the SAS curve: Each SAS curve reflects a given rate of inherited
nominal wage growth (and more generally, given input prices). When
inherited nominal wage growth is lower, firms will not increase prices
as quickly, and the SAS curve will be lower. Changes in input prices and
changes in productivity also both lead to shifts in the SAS curve.
Adjustment to demand shocks

Section 21.6 shows how, following a demand shock, the gradual
adjustment of wage growth eventually brings output to the full
employment level (potential output) and demonstrates how short-run
aggregate supply curves and the vertical (long-run) aggregate supply curve
fit together. Below is a description of both positive and negative demand
shocks.
Starting at point A, a positive demand shock shifts the AD curve from
AD0 to AD1, leading to a higher output level and a higher rate of inflation
at point B. In time, facing higher inflation than was built into wage
negotiations and thus experiencing a falling real wage, workers will
negotiate higher wage growth and the SAS curve will start shifting
upwards to the left. The higher wage growth will be partly passed on
through higher prices, and output will fall until it is back to the long-run
equilibrium level Y*.
210
The adjustment process for a negative demand shock (described more fully
in section 21.6) is similar 0 just in the opposite direction, with the AD
curve shifting left from AD0 to AD2, moving the economy into recession at
a lower rate of inflation. At point D, there is involuntary unemployment.
This will put downward pressure on future wage negotiations, resulting in
lower wage growth and a shift in the SAS curve, eventually to point E.
AS
SAS1
Inflation
1
0
2
SAS0
SAS2
AD1
AD0
AD2
Y*
Output, income (GDP)
Figure 17.1 Demand shocks.

While section 21.6 describes the adjustment mechanism of how the
economy is brought back to the potential output level via market forces
(notably the change in re-negotiated wage growth), the government can
also act discretionally to influence the level of aggregate demand. Section
21.7 outlines how the central bank can react to shocks using monetary
policy, and the advantages and limitations involved. One important point
to realise is that the downward sloping AD curve used in this chapter
implicitly assumes that the central bank is making a compromise between
stabilising inflation and output in the face of temporary supply shocks. If the
central banks cared only about the inflation target, the ii curve drawn and
explained in section 21.1 would be vertical at the target inflation rate the
bank would immediately offset any change in actual inflation from target
by varying the interest rate. In this case the AD curve would be horizontal
only one inflation rate would be possible, the target rate, and in the face of
temporary supply shocks real interest rates and output would have to vary
by whatever is required to maintain the inflation target. For example, an
adverse supply shock which would normally increase inflation in the short
run would have to be immediately countered by an increase in the interest
rate sufficient to hold inflation constant. Output would fall correspondingly.
Activity SG17.4
Identify the following shocks (demand or supply, permanent or temporary, positive or
negative) and use AD-AS curves to demonstrate their short-run and long-run effects on
output and inflation. Clarify the appropriate monetary policy response and its effects on
output and inflation.
i. A technological breakthrough significantly enhances productivity
ii. A major trading partner suffers a deep recession
iii. A country realises that its stock of minerals is significantly lower than what it had
previously estimated
iv. The price of a key input into production rises for some time.
211
BVFD: read section 21.8, concept 21.2 and maths 21.1.

Activity SG17.5
Search online to find some predictions or analysis relating to the expected (or announced)
actions of a major central bank (e.g. the Bank of England, US Federal Reserve, European
Central Bank). How well do they fit with the theory described in these sections (flexible
inflation targeting and the Taylor rule)?
Overview
This chapter introduces a model of aggregate demand and aggregate
supply, showing the relationships between output and inflation. The ii
schedule is introduced first to help explain the AD curve. The ii schedule
shows, under a policy of inflation targeting, how the central bank sets high
interest rates when inflation is high and low interest rates when inflation
is low. The ii schedule shifts left (right) when monetary policy is loosened
(tightened) this means at each inflation rate, real interest rates are higher
(lower). On the assumption that the central bank is taking this approach,
the AD curve shows how higher inflation reduces aggregate demand by
inducing monetary policy to raise real interest rates.
The classical model of macroeconomics assumes full flexibility of wages
and prices and no money illusion. In the classical model, the economy is
always at full employment equilibrium. This is represented by a vertical
aggregate supply schedule at the level of potential output. Equilibrium
inflation occurs at the intersection of the aggregate demand and aggregate
supply schedules. Monetary policy is set to make the equilibrium inflation
rate coincide with the inflation target. In the classical model, fiscal
expansion cannot raise output, but will simply lead to a crowding out of an
equal amount of private spending.
In the real world, prices and wages do not adjust instantaneously. In
particular, wages are thought to be sticky downwards. This is a feature
of the Keynesian model of macroeconomics. The Keynesian model is a
good guide to short-run behaviour whilst the classical model describes
the long run. The vertical aggregate supply curve is thus called the longrun aggregate supply curve. Short-run aggregate supply curves slope
upwards. They show firms desired output given the inherited growth of
nominal wages. Output is responsive to inflation in the short-run because
nominal wages are already determined and peoples expectations regarding
inflation do not always prove correct. A re-negotiation of the rate of wage
growth causes a shift in the short-run aggregate supply curve.
Permanent supply shocks alter potential output. Regardless of the policy
adopted, their output effects cannot be escaped indefinitely. Temporary
supply shocks merely shift the short-run supply curve for a period.
These force central banks to make a decision on the trade-off between
output stability and inflation stability. Demand shocks however, could be
completely offset by monetary policy, if the effects were instant.
Flexible inflation targeting implies the central bank need not immediately
hit its inflation target, allowing some scope for temporary action to
cushion output fluctuations. A Taylor rule views interest rate decisions
as responding to both deviations of output from target and deviations of
inflation from target. Many central banks appear to follow a Taylor ruletype policy.
212


1. According to the sticky-wage model of economic fluctuations, when
inflation is lower than expected, workers get a (i) _______ real wage
than expected and (ii) _______ workers are hired than expected
(indicate which words go on the blanks labelled (i) and (ii)).
a. (i) lower, (ii) more
b. (i) lower, (ii) fewer
c. (i) higher, (ii) more
d. (i) higher, (ii) fewer.
2. In the classical model, the economy is in long-run equilibrium where
the equilibrium inflation rate is equal to the target inflation rate.
The economy suffers an adverse supply shock (such as a permanent
increase in the price of raw materials). In the new equilibrium:
a. Equilibrium inflation is below the target inflation rate and the
government needs to loosen monetary policy to achieve its target.
b. Equilibrium inflation is above the target inflation rate and the
government needs to tighten monetary policy to achieve its target.
c. Equilibrium inflation is below the target inflation rate and the
government needs to tighten monetary policy to achieve its target.
d. Equilibrium inflation is above the target inflation rate and the
government needs to loosen monetary policy to achieve its target.
3. Beginning in long-run equilibrium with the central banks inflation
target being met, which of the following statements is false?
a. The economy experiences a permanent adverse supply shock (such
as an increase in oil prices). If the central bank wishes to maintain
the pre-shock inflation target monetary policy will have to be
tightened.
b. With a permament positive supply shock it is possible for the
economy to have lower inflation and lower real interest rates
without the central bank changing its monetary policy.
c. If the central bank fails to offset the effects of an adverse
temporary supply shock (a temporary increase in the prices of raw
materials for example) this will initially lead to higher inflation
and real interest rates and lower ouptut and employment. Over
time however, all these effects will be reversed without central
bank intervention.
d. If the central bank loosens monetary policy it can largely offset
the output effects of a temporary adverse supply shock while
continuing to meet its pre-shock inflation target.
213
Long response questions:

1. a.

The classical school of economic thought assumes a vertical short-

run aggregate supply curve whilst the Keynesian school assumes
an upward sloping short-run aggregate supply curve. Explain what
lies behind this difference.
b. Suppose an economy in long-run equilibrium experiences a sharp

rise in oil prices. Use AD-AS curves to demonstrate the shortrun and long-run effects on output and inflation and explain
the mechanisms behind each movement. Clarify the appropriate
monetary policy response and its effects on output and inflation.
c. Suppose that the economy is in long-run equilibrium in the
classical model, with output determined by the availability of
inputs, technology, efficiency, etc. However, the equilibrium
inflation rate exceeds the governments target inflation rate.
Describe the appropriate policy action for the central bank to take
in these circumstances and trace through the effects of the policy
in terms of the aggregate supply and demand curves.
2. Taylor rule The graph below shows the US Federal Funds Rate
(the baseline interest rate) and the Taylor Rule Estimate, from 1995 to
2013.
10
8
6
4
2
0
-2
Shortfall
-4
Taylor Rule Estimate
Source: http://blog.commonwealth.com/independent-marketobserver/2014/01/28/12814-where-are-interest-rates-headed-lets-consultthe-taylor-rule Reproduced with kind permission of P. Essele and B. McMillan.
a. What is the Taylor rule?

b. For the first half of the time period shown, the Taylor rule provides
a good estimate of the actual Fed Funds rate explain why this
might be the case
c. Explain the section of the graph where the green colour (see VLE
version) indicates a substantial shortfall
214
6/1/2013
12/1/2013
6/1/2012
12/1/2012
6/1/2011
12/1/2011
6/1/2010
12/1/2010
6/1/2009
12/1/2009
6/1/2008
12/1/2008
6/1/2007
12/1/2007
6/1/2006
12/1/2006
6/1/2005
12/1/2005
6/1/2004
12/1/2004
6/1/2003
12/1/2003
6/1/2002
12/1/2002
6/1/2001
12/1/2001
6/1/2000
12/1/2000
6/1/1999
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6/1/1998
12/1/1998
6/1/1997
6/1/1996
12/1/1996
6/1/1995
12/1/1995
-8
12/1/1997
Fed Funds
-6
Appendix 17a The AD curve: output and the price level

L&C (UK edition, Chapter 21; international edition, Chapter 19) provide a
derivation of the AD curve with price on the vertical axis using the IS-LM
model. The AD curve below summarises the points of demand-determined
output for each price level. It makes it possible to plot the effects of
changes in the domestic price level on GDP.
The approach taken in L&C outlines how an increase in the price level
shifts both the LM and the IS curves to the left, reducing the equilibrium
level of GDP. This is due to three separate effects: the real money effect
(which shifts the LM curve); the wealth effect (which shifts the IS curve)
and the balance of payments effect (which also shifts the IS curve).
1. The real money effect: An increase in the price level lowers the
real quantity of money (for a given supply of nominal money) and
shifts the LM curve to the left.
2. The wealth effect: An increase in the price level leads to a fall in
private wealth, since assets such as cash and bonds (which have a
fixed nominal money value) decrease in value when the purchasing
power of money falls. A fall in private wealth leads to an increase in
savings (to bring wealth back up to the desired level) and a fall in
consumption spending shifting the IS curve to the left.
3. The balance of payments effect: An increase in the price level
leads to a fall in exports because it makes domestic goods relatively
more expensive for other countries and to an increase in imports
because it makes foreign goods cheaper compared to domestic goods.
This change in net exports shifts the IS curve to the left.
LM2(P2)
LM1(P1)
Interest rate
LM0(P0)
E2
E0
E1
IS0(P0)
IS1(P1)
Y2
IS2(P2)
Y1
Y0
Real GDP
Price level
e2
e1
e0
AD
Y2
Y1
Y0
Real GDP
Figure 17.2
215
The AD curve above shows the relationship between the equilibrium level
of output and the price level. For a given nominal money supply, changing
the price level (from P0 to P1 to P2) causes both the IS and the LM curves
to shift leftward in the upper graph. When the price level is P0, the curves
IS0(P0) and LM0(P0) intersect at E0 with the equilibrium level of output
being Y0. Plotting Y0 against P0 in the lower graph gives the first point on
the AD curve: e0. An increase in the price level to P1 shifts the LM curve to
LM1(P1) and the IS curve to IS1(P1). The intersection of these curves gives
a new equilibrium at E1 where the output level is Y1. Plotting P1 against Y1
gives the point e1 in the lower graph the second point on the AD curve. A
further increase in the price level to P2 shifts the LM curve to LM2(P2) and
the IS curve to IS2(P2). This takes equilibrium to E2 at an output level of Y2.
Plotting P2 against Y2 gives the final point on the AD curve e2. Connecting
points e0, e1 and e2 yields the AD curve, showing the relationship between
output and the price level.
Appendix 17b Upwardly sloping SAS curves: output

and the price level
In an AD-AS model with price on the vertical axis, SAS curves show the
relationship between price and the amount of output firms are willing to
supply in the short-run. Why do SAS curves slope upwards?
L&C (UK edition, Chapter 21; international edition, Chapter 19) describe
how the most common explanation for the positive gradient of SAS curves
is that input prices lag behind output prices firms can change the prices
of the goods and services they sell any time, but wages (a key input price)
are often set using yearly contracts, and thus take longer to change.
First, looking at how the level of output responds to an increase in price:
An increase in the price level represents higher marginal revenue for
firms. Furthermore, an increase in the price level combined with fixed
nominal wages means a fall in real wages. Remembering Figure 6.5 from
the microeconomics section of the textbook, we can see that firms will
increase output until marginal revenue and marginal cost are re-equalised.
Firms will respond to the fall in the price of their inputs relative to their
output prices by hiring more workers and expanding production a higher
price level.
Second, we can also consider how the price level responds in the short
run to increases in output: input prices are assumed constant in the short
run, but unit costs of production will tend to increase as output increases,
partly due to diminishing marginal returns, and also because of factors
such as higher wage costs for overtime pay. The SAS curve is upward
sloping because firms will need to increase their prices if they expand into
the region of higher unit costs of production.
For further alternative explanations of why SAS curves slope upwards see
L&C (UK edition, Chapter 21; international edition, Chapter 19).
216
Block 18: Inflation
Block 18: Inflation

Introduction
In Block 17, we analysed how changes in aggregate demand and aggregate
supply affect output and inflation. Inflation, economic growth (i.e. growth
in output) and unemployment are the three key macroeconomic indicators
you will most likely have heard discussed in the media. In this block, we
focus on inflation, which is defined as a rise in the general level of prices.
This block examines the causes of inflation, its implications, as well as
policies to address it.
Learning outcomes
explain and criticise the quantity theory of money
discuss nominal and real interest rates and inflation
analyse seigniorage, the inflation tax, and why hyperinflations occur
assess when budget deficits cause money growth
explain the Philips curve
analyse inflation expectations
evaluate the costs of inflation
discuss central bank independence and inflation control
analyse how central banks set interest rates.
Essential reading
Further reading
Lipsey and Chrystal (L&C) international edition, Chapters 1921; UK edition,
Chapters 2123.

The chapter starts with some causes of inflation, discussing the
quantity theory of money (which is based on the equation of exchange
(MV = PY) as well as the relationship between inflation and government
indebtedness. A very important topic covered in this block is the Phillips
curve. The short-run Phillips curve demonstrates a trade-off between
inflation and unemployment in response to demand shocks. The longrun Phillips curve is vertical at equilibrium unemployment. Peoples
expectations regarding inflation are central to the analysis of inflation
and the difference between the short and long-run Phillips curves. The
costs of inflation include shoe-leather costs and menu costs, as well as
undesirable redistribution in the case of unexpected inflation. Deflation is
seen as an even greater problem than inflation. Central bank operational
independence has been a key institutional change that has made inflation
targets more credible and facilitated a long period of low inflation in many
advanced economies.
217
Money and inflation

The quantity theory of money can be summarised by the equation: MV
= PY, where M is nominal money, V is the velocity of money the speed
at which the stock of money is passed around the economy as people
transact (p.495) which we could think of as the average number of times
a pound note or a dollar bill changes hands per period or the average
amount of work done by a unit of money, P is the price level and Y is
real income. In some versions of the quantity theory the term T, the total
number of transactions per period, is used instead of Y. This substitution
is likely to be generally correct but there is not a perfect correspondence
between T and Y (think of a transaction involving a second-hand good
this good is not part of output during the period in question).
The equations in section 22.1 and concept 22.1 are equivalent:
MV = PY (this is known as the equation of exchange, which is even
easier to see using the MV = PT version, because PT, the price of a
transaction times the number of transactions, is just the number of dollars
or pounds exchanged per period). Rewriting the basic equation as:
M/P = Y/V
If V reflects the effect of nominal interest rates, r, on money demand, we
have:
M/P = L(Y, r)
If you dont recall the reasons for the demand for real balances depending
on the nominal interest rate have a look at the paragraph under table
22.2 in the next section which summarises these reasons succinctly. The
equations above merely show that real money supply (M/P) and real
money demand (L(Y, r)) are equal. We have already learned that flexible
interest rates bring about equilibrium in the money market. It should
also be clear that both sides of the first form of the equation are equal to
nominal GDP. Nominal GDP is equal to the money supply (M) multiplied
by the number of times this circulated around the economy in a given
period (V). It is also equal to real GDP (Y) multiplied by the price level
(P). The equation of exchange becomes a theoretical model only when
assumptions are made about which variables are fixed exogenously and
which are flexible. If V and Y are assumed to be constant, a change in M
will feed through to the same change in P. The above equations imply that
P = M * V/Y.
Where V/Y is a constant, the price level is directly proportional to the
money supply.
Expressing this equation in terms of percentage changes (%) we can
write:
%P = %M + %(V/Y)
The %P is, of course, inflation. This formulation demonstrates the
reasoning behind the idea that inflation is caused by increases in the
money supply, when V and Y can reasonably be assumed constant. When
real GDP is constant (say, at potential output), changing one nominal
variable (money supply) will mostly affect another nominal variable: the
price level. The formulation (plus considerable empirical analysis) also
lies behind Milton Friedmans famously strong claim that Inflation is
always and everywhere a monetary phenomenon.
218
Block 18: Inflation
Section 22.1 lays out various reasons why this straightforward

interpretation may not tell the full story:
1. The direction of causation between changes in the money supply and
changes in the price level is unclear this depends on how monetary
policy is being operated
2. Demand for real money may not be constant because of different rates
of change in income and in the costs of holding money (e.g. due to
banking competition and inflation)
3. Velocity may not be constant (concept 22.1)
The quantity theory of money has been an important part of
macroeconomic theory for a long time. Although different schools of
thought have different ideas about it, especially its validity in the shortrun, it nonetheless provides a useful framework for analysing and
explaining the relationship between the money supply and the price level.
However, care needs to be taken in interpreting it and in understanding
its long-run implications. In particular, one needs to distinguish between
the long-run situations in which real income is constant or not. Where it
is constant, the long-run demand for money will be constant and there is
a one-to-one relationship between M and P in the long run (but not in the
short run if prices do not adjust quickly). However, where real income is
growing over time, the real demand for money will also be increasing and
changes in M will not be fully reflected in changes in P.
The graph below from the Federal Reserve Bank of St Louis shows the
velocity of M2 money in the US economy. General definition of M2:
money that can be used for spending (M1) plus items that can be quickly
converted to M1. It shows considerable change in the velocity of money,
especially since 1990. The rapid fall in the velocity of money during the
recent financial crisis (final grey bar) is particularly striking.
2.3
2.2
2.1
(Ratio)
2.0
1.9
1.8
1.7
1.6
1.5
1.4
1960
1970
1980
1990
2000
2010
Figure 18.1 Velocity of M2 money stock.

Source: https://research.stlouisfed.org/fred2/series/M2V/ Reproduced with kind
permission.
Read section 22.2.

This section describes the Fisher equation1:

Real interest rate = [nominal interest rate] [inflation rate].
as well as the effect of nominal money growth on nominal interest rates

and the demand for real money. The section also distinguishes between
the Fisher equation, above, and the Fisher hypothesis which states that
real interest rates dont vary all that much as nominal interest rates and
inflation tend to move in tandem.
Note that, strictly

speaking, this
equation is only an
approximation, but
one that is reasonably
accurate as long as
the rates are not too
large. The exact formula
is that (1+i)=(1+r)/
(1+). Suppose the
nominal interest rate
is 8% and inflation is
5%. This makes the real
rate 2.857%. Using the
Fisher equation it is 3%.
1
219
If nominal money growth leads to a fall in demand for real money, P must
rise faster than M so that real money supply (M/P) falls in line with the
fall in demand for real money.
Activity SG18.1
What does this section tell you about the velocity of money during a hyperinflation?
Assume that output is constant and the money supply is rising rapidly (for example
because a government is printing large amounts of money to cover its debts), and use the
equation of exchange to describe the change in the price level.
If governments have been running persistent deficits and the ratio of
accumulated debt to GDP is high they will find it difficult to continue
to finance deficits by borrowing; potential lenders fear they will not be
repaid. Governments need to tighten fiscal policy in such circumstances,
but they might instead be tempted to finance ongoing deficits by printing
money (or increasing the money supply in some equivalent manner). The
real revenue they get from this is called seigniorage.
M .
M
=
P
M
M
P
Seigniorage = real revenue from money creation =
However, the two terms on the right-hand side of this equation are not
independent, because an increase in the growth of the money supply will
increase inflation which, in turn, will decrease the demand for real money
balances. This is the reason for the hump shaped curve in Figure 22.3.
The relation is not a mechanical one. It depends on how quickly increases
in the money supply feed through into increases in inflation and by how
much and how quickly people adjust their real money balances when
inflation changes. This section of the chapter also explains the inflation
tax. Inflation acts as a tax, eroding the real value of money balances. The
inflation rate is analogous to a tax rate and the holding of real money
balances is analogous to the tax rate. So we can write the inflation tax as:
Inflation tax =
M
P
Note that this is not the tax revenue the government gets from increasing
the money supply. That is given in the expression for seigniorage. But
looking at the two equations it is clear that seigniorage and the inflation
M
tax are equivalent when M = i.e. when inflation is equal to nominal
money growth (when nominal money growth and real income are
constant this will be assured).
Activity SG18.2
Use your own words to explain seigniorage and the inflation tax.
The Phillips curve and inflation expectations

Up to this point in the chapter, the emphasis has been on monetary and
fiscal relationships. Section 22.4 relates these more explicitly to the
real economy (via output and unemployment) and begins to analyse
the crucial role of expectations in macroeconomics. The Phillips curve,2
which depicts the relationship between unemployment and inflation, is
220
2
Named after New
Zealand-born economist
A.W. Phillips, who spent
much of his academic
career at the London
School of Economics.
Apart from using
statistical methods
to investigate the
relationship between
unemployment and
inflation, the subject
of this section, Phillips
(who initially trained as
an engineer) was also
famous for building
an analogue hydraulic
computer which could
be used for modelling
the macro economy.
Several copies of this
machine still exist
Block 18: Inflation
introduced. Just as there was for aggregate supply, there is both a long-run
Phillips curve and a short-run Phillips curve. The short-run curve slopes
downwards, depicting a trade-off between unemployment and inflation.
This can be explained in a simple and intuitive way as follows. In the short
run, when inflation increases unemployment decreases. For example,
inflation is usually demand-pull inflation, this occurs when aggregate
demand increases. The quantity supplied by firms needs to increase to
meet the increase in aggregate demand, and to increase quantity supplied,
firms must hire more workers, hence unemployment falls. Higher prices
make firms supply more output and demand more workers. Alternatively,
when unemployment rises, inflation falls. This could be because as
unemployment rises, people can no longer afford to buy as many goods
and services. Thus firms must lower their prices to attract customers and
inflation falls.
In its original form (nave form, some would say) such a relationship could
be written as:
= 0 1u
0 > 0, 1 > 0
This trade-off at first seemed to offer a powerful lever to policy makers
seeking to an acceptable compromise in attaining two of the most
important but seemingly conflicting macroeconomic objectives (low
unemployment and low inflation). However, this trade-off was soon
revealed to be illusory over the longer term; the long-run Phillips curve is
vertical equilibrium unemployment is independent of inflation.
Demand shocks will move the economy along the short-run Phillips curve
permitting the economy to temporarily diverge from equilibrium levels.
Thus an inflation rate that is different from peoples expectations leads to
a movement along the short-run Phillips curve. The height of the short-run
Phillips curve is affected by peoples expectations about future inflation.
A change in expectations leads to a shift in the short-run Phillips curve.
Temporary supply shocks also affect the height of the short-run Phillips
curve (causing it to shift upwards or downwards), while permanent supply
shocks affect the position of the long-run curve.
Inflation depends on inflation expectations and the gap between the actual
and equilibrium unemployment rates. Inflation expectations also depend
on this gap. Therefore, inflation is affected by deviations of unemployment
from the equilibrium rate through two channels directly, and also
through the impact on expectations.
Second, Equation (1) (representing the short-run Phillips curve) shows
that the gap between inflation and inflation expectations is proportionate
to the difference between actual and equilibrium unemployment.
Equation (4) shows that the gap between actual and potential output
is also proportional to the difference between actual and equilibrium
unemployment. Putting these together lets us find the short-run aggregate
supply curve (equation 5) which shows the relationship between the gap
between actual and potential output and the gap between inflation and
inflation expectations.
One of the central points in this section is the correspondence between
the Phillips curve and the aggregate supply curve (see Figure 22.6 and
associated discussion). We can see this mathematically by recalling from
the previous block that aggregate supply can be written:
Y = Y* + ( e)
221
which we can rewrite as:

1
= e + (Y Ye)
Now we want to go from output, Y, to unemployment, U. We can do this
via a version of Okuns Law, named after the American economist Arthur
Melvin Okun who, in the 1960s, investigated the relationship between
changes in the unemployment rate and the growth rate of output in
the USA. If we argue that deviation of output from its potential level is
inversely related to the deviation of unemployment from its equilibrium
rate (following the notation used in Maths 22.1):
Y Y* = h(u u*)
h>0
then substituting into the equation for inflation above we have:

= e b(u u*)
h
b = (u u*) > 0
This version of the Phillips curve is sometimes called the expectationsaugmented Phillips curve, in comparison to the original or nave
Phillips curve shown above. Note that this equation3 is the same as the
first equation in Maths 22.1, to which we return shortly. The argument
in Maths 22.1 begins with the short-run Phillips curve and shows this
to be equivalent to the short-run supply curve. Here we have done the
reverse, starting with the short-run supply curve of the previous chapter
and showing that it is equivalent to the short-run Phillips curve. It is easy
to see from this equation that when, in the long-run, actual and expected
inflation are equal, unemployment is at its natural or equilibrium rate:
= e u = u*
Note that this argument applies to any level of actual and expected
inflation. There is no unique inflation rate corresponding to equilibrium
unemployment; equilibrium unemployment requires that expectations
about inflation are fulfilled, but this can happen at any level of inflation.
When reading news reports on the state of the economy, you may have
come across the term NAIRU, this is an acronym which means the nonaccelerating-inflation rate of unemployment. This is the unemployment
rate consistent with maintaining stable inflation. It is similar to the natural
rate of unemployment discussed in this current chapter.4 Understanding
the accelerationist hypothesis from this concept lets us understand
where the terminology of the NAIRU comes from. When output is at its
potential level, the unemployment rate is not zero, even though this state
is sometimes referred to as the full employment level of output. There will
be a certain level of unemployment that is not caused by a lack of demand,
but rather is caused by the movement of people between jobs (frictional
unemployment) or a mismatch in the skills that workers have and
the skills demanded by employers (structural unemployment). If
unemployment is pushed below its natural rate, or below the NAIRU,
inflation will tend to accelerate. To decrease unemployment permanently
without generating inflation, governments try to decrease the NAIRU by
increasing the efficiency of labour markets and focusing on skills, such as
through retraining programmes.
From our analysis above, and that in concept 22.2 which you have just
read, it is clear that peoples expectations about inflation are crucial. If
we rewrite the above equation with time subscripts, t, t = te b(ut u*)
and assume that people expect this periods inflation to be the same as last
222
3
Note that this equation
can also be written as
= e b(u u*) +
v where v is used to
indicate a short-run
supply shock (longrun supply shocks
change equilibrium
unemployment, u*).
Thus vertical shifts of the
short-run Phillips curve
can result from changes
in inflation expectations
and/or from temporary
supply shocks, the latter
giving rise to cost-push
inflation.
4
The natural rate of
unemployment can
be seen as a more
long-term concept,
whilst the NAIRU can
be interpreted as the
unemployment rate
consistent with steady
inflation in the near
term. In full equilibrium,
they are the same.
Block 18: Inflation
periods we can write: t = t1 b(ut u*) then we can see that if policy
makers keep current inflation above last periods inflation they can hold
e
unemployment below the natural rate. If instead of assuming that t = t1
we instead assume a broader version of adaptive expectations such
that te = t1, broadly similar arguments apply (but not if = 1, in which
case we revert to the nave Phillips curve). However, as concept 22.2 hints
at would people really be fooled by policy makers simply accelerating
inflation; would they not build this into their inflationary expectations?
Where this is the case, with so called rational expectations, the shortrun trade-off between unemployment below its equilibrium rate and
accelerating inflation would not exist.5
This section contains a lot of detail on how the economy functions it may
be good to read it through several times. Two important concepts from
this section are the natural rate of unemployment which is the
long-run equilibrium level of unemployment (this is not zero more on
this later); and stagflation which is the situation where inflation and
unemployment are both high, as many economies experienced during the
1970s due to high oil prices. The experience of stagflation in this period is
what initially led economists to question the validity of the Phillips curve.
The rational
expectations hypothesis
is particularly associated
with the American
economist Thomas
J. Sargent who was
awarded the Nobel Prize
in Economics in 2011
(jointly with Christopher
A. Sims).
5
Activity SG18.3
Based on Figure 22.6, use the LRAS and the long-run Phillips curve, together with the
short-run curves, to depict what will happen to output, unemployment and the price level
when there is:
a. a negative shock to aggregate demand in the context of a credible, constant inflation
target
b. an expectation that the inflation rate will rise and that the central bank will not be
able to contain this
c. the productivity of the labour force increases permanently (for example due to
changes in the countys education and training systems)
d. a temporary adverse supply shock that is not fully accommodated.
223
The costs of inflation

This section discusses the costs of inflation, which are very different to what
many people think. In thinking about the costs of inflation it is important to
ask the following. Is the inflation expected (anticipated) or unexpected? If
expected, has the economy adjusted and adapted to the expected inflation?
Where inflation is fully anticipated and all tax rates, nominal interest rates,
wage rates etc. have all fully adjusted then the remaining costs of inflation
are shoe leather costs and menu costs (make sure you understand
these concepts). Where nominal magnitudes have not adjusted there can be
further costs; if tax brackets have not adjusted to inflation (bracket creep
or fiscal drag) taxpayers will find themselves with a higher real tax burden
(governments gain). Similarly, if capital gains tax (CGT) is levied on the
nominal value of assets people can find themselves paying CGT on assets that
have not increased in real value; again taxpayers lose and governments gain.
When inflation is unexpected or unanticipated there are different types of
costs.
Say inflation is greater than expected. If nominal interests are indexed
to expected inflation then lenders will lose because the real interest rate
they receive (the nominal rate minus the rate of inflation) is less than they
expected. On the other hand borrowers benefit. Similarly if nominal wages
are indexed to expected inflation and actual inflation exceeds expectations
workers receive lower real wages than expected. Firms benefit, on the other
hand, because their real wage costs are lower than expected. Further costs
are incurred if inflation is very volatile or uncertain. Not only does this make
planning and writing contracts more difficult but imposes direct utility costs on
risk averse individuals or firms. To the extent that higher average inflation is
associated with more volatile inflation (there is some evidence for this) this is
another argument in favour of maintaining inflation at reasonably low levels.
This is not to say that zero inflation would be a sensible target either. Low
and stable inflation has benefits as well as costs. One of these, seigniorage,
we have already discussed above. Another benefit of low inflation arises from
noting that zero inflation would provide no margin of error in protecting
against deflation (and the warning of the perils of deflation in Case 22.1
Public enemy number two is timely. At the time of writing this subject
guide in 2015, several Eurozone countries have negative or extremely low
inflation). An inflation rate of 2 or 3 per cent can allow for unexpected price
falls without tipping the economy into deflation. Inflation rates of this order
of magnitude are also helpful if governments want to engineer negative real
interest rates to stimulate investment and consumption. Suppose equilibrium
interest rate in the long-run is 2 per cent (supply equals demand at the
equilibrium or natural level of output in goods markets). If the economy has 3
per cent inflation then nominal rates are 5 per cent. Suppose the government
wants to stimulate the economy in the short-run. It can engineer a reduction
of nominal rates to 0 per cent (but not lower, we assume). This reduces real
interest rates to 3 per cent (nominal interest rate minus rate of inflation)
as long as inflation stays at 3 per cent. On the other hand, if this economy
started with 0% inflation then both real and nominal rates are 2 per cent. In
these circumstances the best the government can do is reduce to the nominal
and real interest rate to zero which obviously provides less of a stimulus
than a rate of 3 per cent.
BVFD: read case 22.1.
224
Block 18: Inflation
Activity SG18.4
You can use the following website to find inflation figures for your country and see how
these changed during the financial crisis. Was there deflation in your country between
2007 and 2009? http://databank.worldbank.org/data
Controlling inflation
BVFD: read sections 22.6 and 22.7 and complete activity 22.1.
While Sections 22.6 and 22.7 are about controlling inflation we have
already dealt with the analytics of this in the previous block and in
Chapter 21 of BVFD (Sections 21.6 through 21.8, including discussion of
the Taylor rule). The final two sections of the current chapter add some
real world institutional context. They describe how credible low inflation
targets are used to get inflation under control, and how this has been
relatively successful in the past 20 years. Central bank independence
has been an important part of this. Nonetheless, deciding where to set
interest rates to achieve an inflation target is no easy task. There are
continual shocks to the economy of various sizes, and it is not always
easy to distinguish permanent and temporary demand and supply shocks,
or to know how best to respond to these. Many central banks publish
reports after their committee meetings, detailing why they have decided
to maintain or to change interest rates.6 Transparency regarding their
decision making process also helps to keep inflationary expectations in
line.
Overview
You can find the Bank

of Englands quarterly
inflation reports here:
www.bankofengland.
co.uk/publications/
Pages/inflationreport/
default.aspx
6
The chapter started by looking at the quantity theory of money, which is

based on the equation of exchange (MV = PY) and argues that increases
in the price level are a direct result of increases in the money supply.
Reasons why this may not hold in the short run include the fact that
income and the velocity of money and may not be constant. Next, the
Fisher hypothesis was introduced, which states that higher inflation leads
to higher nominal interest rates such that real interest rates do not change
greatly. This can be expressed by the Fisher equation: real interest rate =
nominal interest rate inflation. Furthermore, the relationship between
inflation and government indebtedness was discussed. Governments
with excessive debts may be tempted to print money though there is
some scope for revenue generation through seigniorage and the inflation
tax, this approach is very risky and can result in hyperinflations. In most
advanced economies, we do not expect a close relationship between
deficits and money creation. A very important topic covered in this block
is the Phillips curve. The short-run Phillips curve demonstrates a tradeoff between inflation and unemployment in response to demand shocks.
The long-run Phillips curve is vertical at equilibrium unemployment.
Permanent supply shocks shift the long-run Phillips curve left or right,
while temporary supply shocks shift the short-run Phillips curve higher or
lower. Inflationary expectations also shift the short-run Phillips curve, in
part because peoples expectations regarding inflation affect negotiated
wages and nominal wage growth. Stagflation is the situation where
unemployment and inflation are both high. The costs of inflation are
different to what many people think not simply higher prices, but other
costs such as shoe-leather costs and menu costs, as well as undesirable
225
redistribution in the case of unexpected inflation. Although inflation is

seen as a problem (although at low and stable levels it has benefits also),
deflation is potentially an even greater problem. For this reason, central
banks usually have an inflation target slightly above zero, such as the
current 2 per cent CPI target rate for the Bank of England. Central bank
independence from politics has proven effective in making inflation targets
credible and effective in recent years.


1. If the quantity theory of money is true, inflation will be less than the
growth of the money supply if:
a. The growth of output is positive and/or the growth of velocity is
positive.
b. The growth of output is positive and/or the growth of velocity is
negative.
c. The growth of output is negative and/or the growth of velocity is
positive.
d. The growth of output is negative and/or the growth of velocity is
negative.
2. In the case of unanticipated inflation:
a. Creditors are hurt by lending but debtors gain by borrowing.
b. The elderly (mostly savers) are advantaged but the young (mostly
borrowers) are disadvantaged.
c. Workers gain because their real wages are higher than expected.
d. Institutional arrangements such as tax brackets and VAT rates will
be fully adjusted.
3. Which of the following statements is true?
a. Inflation that is higher than expected inflation shifts the short-run
Phillips curve upwards.
b. Higher expected inflation shifts the short-run Phillips curve
upwards.
c. Higher expected inflation shifts the long-run Phillips curve
rightwards.
d. Higher expected inflation shifts the long-run Phillips curve
leftwards.
4. Which of the following statements is false?
a. A positive demand shock leads to a leftward movement along the
short-run Phillips curve.
b. A positive demand shock leads to a rightward movement along the
226
Block 18: Inflation
c. A positive demand shock leads to no change in the position of the

d. A positive demand shock leads to no change in the position of the
long-run Phillips curve.
5. Real revenue from the inflation tax:
a. always rises as the inflation rate rises
b. always falls as the inflation rate rises
c. depends on the size of the governments real deficit
d. depends on the multiple of the inflation rate and the quantity of
real cash.

a. What does the Phillips curve represent? Draw a diagram with a shortrun Phillips curve and a long-run Phillips curve and explain why they
have the shapes they do.
b. Draw diagrams (explaining your answers in words at the same time)
to depict what will happen to output, unemployment and the inflation
rate when there is:
i. a short-term boom in consumption
ii. a fall in the price of oil that is fully accommodated by monetary
policy
iii. a new, very tough and inflation-hating central bank governor
appointed in a period of high inflation
iv. a fall in the natural rate of unemployment.
c. Certain types of inflation can have very serious implications. Discuss
the implications of:
i. negative inflation
ii. hyperinflations.
227
Notes
228
Block 19: Unemployment

Introduction
A microeconomic approach to studying unemployment was introduced in
Block 10. This described disequilibrium in the market for labour, which
occurred due to wages being above the market clearing level for reasons
such as minimum wage laws, trade union power and efficiency wages.
Until the Great Depression of the 1930s, it was generally accepted in
economic theory that unemployment was solely the consequence of wages
being higher than the equilibrium wage rate and that in time, wages
would adjust naturally so that the labour market would clear. The events
of the 1930s, including very high levels of persistent unemployment,
shifted attention to the potential stickiness of wages (i.e. the fact that
wages may not fall despite high levels of unemployment) and the level of
aggregate demand in the economy. This change was primarily thanks to
the revolutionary ideas of British economist John Maynard Keynes, who
published his best-known work The general theory of employment, interest
and money in 1936. A major policy recommendation from this work
was that governments should help reduce unemployment by increasing
government spending to substitute for a lack of demand from private
consumption and investment.
A macroeconomic approach to studying unemployment thus emphasises
the role of aggregate demand, especially any gaps between actual and
potential output. At the same time, market imperfections which cause
wages to be sticky above the market-clearing equilibrium level are also
important factors in determining the rate of unemployment in an economy.
Key themes of this block thus include the different types of unemployment,
as well as their causes and various policies for reducing unemployment.
Although there is a positive role for short-term frictional unemployment in
terms of workers moving between jobs and achieving a better skills-match,
in general, unemployment is associated with large costs on both a personal
and societal level. As such, low unemployment is one of the three major
macroeconomic goals of economic policy, along with steady growth and
low inflation.
Learning outcomes
discuss measured unemployment, both claimant count and
standardised rate
define classical, frictional, structural and demand-deficient
unemployment
distinguish between voluntary and involuntary unemployment
analyse determinants of unemployment
explain how supply-side policies reduce equilibrium unemployment
evaluate private and social costs of unemployment
explain hysteresis.
229
Essential reading
Further reading
Chapter 23.
Witztum (AW), Chapter 9, section 9.3.

The textbook chapter starts by introducing basic concepts such as the
labour force and the unemployment rate and provides some statistics as
to the composition of unemployment in the UK and the flows of people
between being in employment, unemployed and out of the labour force.
The various types of unemployment are introduced, notably frictional,
structural, classical and demand-deficient (or cyclical) unemployment. One
very important concept is the natural rate of unemployment, also known
as equilibrium unemployment or the steady state rate of unemployment.
Unemployment can be caused by a deficiency in aggregate demand,
i.e. when there is a business cycle slump. Such unemployment can be
addressed via demand-management tools, namely fiscal and monetary
policy. Other types of unemployment are related to imperfections in labour
markets and are better addressed by supply-side policies, such as improving
information flows and reducing skills mismatches or disincentives to labour
supply such as high marginal tax rates. The personal and societal costs of
unemployment are also discussed, including a loss of human capital and
lost output resulting from leaving resources idle.
The material in the chapter is very UK-oriented in its applications (although
Case 23.2 gives a more international perspective). Generally, the points made
about the UK have wider application but you are urged below to look at the
position of your country (where that is not the UK) and achieve a broader
understanding of the unemployment experience of different countries.
Rates of unemployment
BVFD: read the introduction to Chapter 23.
The introduction provides a brief historical background on unemployment
rates for the UK.
Do you know how unemployment has risen and fallen in your own country?
For example, the unemployment rate in Malaysia has been surprisingly
steady over the last decade. In contrast to other countries, it only increased
slightly during the global financial crisis, as firms tended to cut down
on overtime rather than lay off workers. Most job losses occurred in the
manufacturing sector and especially among foreign workers. (Khoon and
Mau-Hui, 2010).1
230
Khoon, Goh Soo, and

Lim (Mah-Hui.). The
impact of the global
financial crisis: the case
of Malaysia. (Third
World network (TWN),
2010). Available at:
www.twn.my/title2/ge/
ge26.pdf.
1
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
20
02
20
04
20
06
20
08
20
10
20
12
0.0
Figure 19.1 Malaysia: Unemployment rate.

Source of data: Department of Statistics, Malaysia www.statistics.gov.my/index.
php?r=column/ctimeseries&menu_id=NHJlaGc2Rlg4ZXlGTjh1SU1kaWY5UT09
Reproduced with kind permission.
High unemployment rates in the 1980s were due to a combination of

various factors, including an international recession, the collapse of
commodity prices, weak competitiveness in technology, large outflows
of foreign capital and capital-intensification in the manufacturing sector
(Yi,2003).2
Activity SG 19.1
Find out what the trend has been in the country where you live.
This section contains several important definitions the labour force; the
participation rate and the unemployment rate. The relationships between
these variables can be expressed by the following equations:
Let the number of employed people be E (these are people who work
for at least one hour per week).
Yi, Ilcheong The

national patterns of
unemployment policies
in two Asian countries:
Malaysia and South
Korea. (Working Paper
15: Stein Rokkan Center
for Social Studies,
Bergen University
Research Foundation,
2003) Available at:
www.ub.uib.no/elpub/
rokkan/N/N15-03.pdf.
2
Let the number of unemployed people be U (these are people who are
actively seeking work).
Let the labour force be LF (those who are either employed or looking
for work).
Let people who are not in the labour force be NFL (these are inactive
and include homemakers, students who are not working, people who
are too sick to work, etc.).
Let the working age population be P:
Working-age population: P = LF + NLF
Unemployment rate: u = U/LF
Employment rate: e = E/P
Labour force participation rate: lfp = LF/P.
Activity SG19.2
What is the unemployment rate in a country with a working-age population of 1,000, a
labour force participation rate of 80% and 100 unemployed people?
This section also briefly describes the flows between employment,
unemployment and inactivity, as well as the duration and composition
of unemployment. Long-term unemployment is associated with greater
231
private costs of unemployment such as a deterioration in skills. In order

to supplement the information on long-term unemployment in Table
23.1, and to move beyond the UK orientation of the chapter, look at the
supplementary table below, which looks at the unemployment experience
of selected OECD countries before the financial crisis and associated
recession (2007) and two and half to three years into the recession.
Harmonised unemployment
rates
Long term U (12 months+)

as % of total U
2007
2010
2007
2010
Australia
4.4
5.2
15.4
18.5
France
8.4
9.8
40.2
40.1
Germany
8.7
7.1
56.6
47.4
Spain
8.3
20.1
27.6
45.1
Japan
3.9
5.1
32.0
37.6
Korea
3.2
3.7
0.6
0.3
Sweden
6.1
8.4
13.0
16.6
UK
5.3
7.8
23.7
32.6
USA
4.6
9.6
10.0
29.0
OECD
5.7
8.6
29.0
32.4
Source: OECD Employment Outlook 2011 www.oecd.org/els/emp/EMO%20

2011%20Chap%201%20ENG.pdf
There are several striking features to this table. One is the huge diversity in
the experience of OECD countries (supposedly a relatively homogeneous
group of countries; really poor countries and many emerging economies
are not OECD members). While all countries except Germany experienced
increases in unemployment, for some this increase was relatively modest
(Australia, UK, Korea) while for others it was dramatic; for very different
reasons the unemployment rate more than doubled in the US and in
Spain. The incidence of long-term unemployment (here defined as being
unemployed for a year or more) also increased across the board, with
Germany being the only exception. The USA historically has been a
country with relatively little long-term unemployment, but its incidence
increased threefold during the recession. Given the private and social costs
of long-term unemployment the incidence of long-term unemployment in
some European countries poses very serious problems.
Activity SG19.3
Why do you suppose the incidence of long-term unemployment is so low in Korea?
This section also highlights that youth unemployment is often higher than
unemployment for the labour force as a whole. Young people tend to have
unemployment rates that are higher than the national average, partly
because they generally have less work-experience. In recent years, many
countries have seen extremely high levels of youth unemployment. For a
data visualisation of this problem on a global scale, interested students
should see: www.weforum.org/community/global-agenda-councils/youthunemployment-visualization-2013
232
Analysis of unemployment
Below we take the analysis of equilibrium unemployment a bit further
using the stocks and flows framework but you need also to be familiar
with the graphical analysis in BVFD using the LD, AJ and LF schedules.
Pay special attention to the role of rigid real wages in increasing
unemployment (both equilibrium and Keynesian) within this framework.
Although Figures 23.4 and 23.5 are very similar, they highlight a key
distinction which is very important in the analysis of unemployment.
Figure 23.4 shows how total unemployment at wage w2 (AC) is broken
down into voluntary (BC) and involuntary (AB) unemployment (although,
somewhat confusingly, unemployment AB is subsequently defined as
being voluntary as well (with workers being part of the institutional
arrangements responsible for wage w2 and its stickiness). In this case,
the wage is higher than the equilibrium level due to labour market
imperfections or reasons such trade union power. A rigid real wage above
the equilibrium level is causing there to be both voluntary and involuntary
unemployment. In Figure 23.5, the total unemployment at W* (AF) is also
broken down into voluntary (EF) and involuntary (AE) unemployment,
once again because of a rigid real wage above the equilibrium level. In
this case, the reason is that demand for labour has fallen from LD to LD
(but the equilibrium wage level has not fallen to W** as it is expected to
in the longer term). The distance AE is demand-deficient or Keynesian
unemployment.
The optimal policy approaches to these two situations are quite different.
In the first case, government policy should take a supply-side approach
to addressing wage rigidities. This approach is discussed in section 23.3
(though the supply-side policies discussed in 23.3 also focus on bringing
the AJ and LF curves closer together). On the other hand, unemployment
that is caused by a deficiency in aggregate demand can be addressed
via demand-management tools, namely fiscal and monetary policy. This
is discussed very briefly in section 23.4. In some sense, it has been a
key theme of our analysis for several chapters, as our analysis of the
macroeconomy has focused on reducing or eliminating any gap between
actual and potential output. Whether it is more appropriate to apply
a supply-side approach or a demand management approach depends
on the situation of the economy if output is close to potential output,
trying to increase demand will only lead to inflation. In this case, the
best way to reduce unemployment is to focus on the supply-side. If the
economy is below potential output, there is an important role for demand
management to boost aggregate demand and this would be expected to
bring about a substantial reduction in unemployment.
In the language of the diagrams described above, although involuntary
unemployment could be tackled in both graphs by addressing the rigidity
of the real wage such that wage levels would fall to w* in Figure 23.4 and
w** in Figure 23.5, the demand-management approach is favoured in the
case of demand-deficient or Keynesian unemployment, and this would
be depicted by a rightward shift in the labour demand curve back to the
original position at LD.
233
Activity SG19.4
Match the concept of unemployment with its definition in the schematic below.
Frictional unemployment
The unemployment created when the wage is

deliberately maintained above the level at which the
labour supply and demand schedules intersect
Structural unemployment
This occurs when output is below full capacity
Demand-deficient
unemployment
People spending short spells in unemployment as

they move between jobs
Classical unemployment
Unemployement that arises from the mismatch of

skills and job opportunities as the pattern of demand
and supply changes
Equilibrium unemployment (the

natural rate of unemployment)
Unemployed workers in the labour force who would

accept a job offer at the going wage rate
Voluntary unemployment
The unemployment rate when the labour market is

in equilibrium
Involuntary unemployment
Unemployed worker in the labour force who are not

willing to accept a job offer at the going wage rate
According to the definition in BVFD: voluntary unemployment

includes frictional, structural and classical unemployment, whereas
involuntary unemployment is equivalent to demand-deficient or cyclical
unemployment (which is also known as Keynesian unemployment).
Equilibrium unemployment/the natural rate of unemployment

This rate of unemployment is also called the steady state rate of
unemployment. It is the rate of unemployment such that the rate of inflow
of workers into unemployment equals the rate of hiring of new workers.
This means, of course, that the stock of unemployed workers remains
constant. What follows is a very simple model of flows, which simplifies
the stock-flow diagram of Figure 23.2 by ignoring flows into and out of
the box labelled Out of the labour force (i.e. outflows of workers from
employment become unemployed and outflows from unemployment go to
employment; workers who leave employment dont leave the labour force
and new employment comes from the stock of unemployed workers not
from outside the labour force).
If j is the rate of job loss for those with work, and h is the rate of hiring for
those without jobs, and where E is the total number of employed workers
and U is the total number of unemployed workers, in steady state the
following must hold:
jE=hU
This just says that in a steady state the outflow from employment (inflow
into unemployment) is equal to the inflow into employment (outflow from
unemployment).
Since LF = E + U (where LF is the labour force), and u = U / LF, the
following equation for the steady-state rate of unemployment also holds:
u = j / (j + h)
This equation is useful because it shows several things. Firstly, the natural
rate rises with j and falls with h. A high rate of job loss and a low rate of
hiring both increase the equilibrium unemployment rate. Secondly, 1/h
is an indicator of unemployment duration. For a given level of j, a lower
h means a longer spell of unemployment, as workers wait to fill a given
number of vacancies.3 An increase in the duration of unemployment
increases the natural rate of unemployment. Duration of unemployment is
important because a given unemployment level or rate could arise from a
234
3
Measuring
unemployment
duration in practice
is complicated by the
fact that what we
observe when we
survey the unemployed
are incomplete spells
of unemployment
whereas what we are
primarily interested in
(and certainly what
unemployed workers
are interested in) is how
long a completed spell
of unemployment lasts.
Estimating the latter
from the former raises
some quite complex
statistical issues.
relatively small number of individuals being unemployed for a long time

or a larger number of individuals being unemployed for a short time. The
implications for the individuals concerned are likely to be very different in
the two cases, as are the appropriate policies that may be used to counter
the unemployment.
You should also remember the concept of the NAIRU from the previous
block. This too is very similar to the concept of the natural rate of
unemployment, although the natural rate can be seen as a more long-term
concept, while the NAIRU can be interpreted as the unemployment rate
consistent with steady inflation in the near term. In full equilibrium, they
are the same.
Activity SG19.5
In a country with a working age population equal to 25, aggregate labour demand and
labour supply in an economy are summarised by the following equations:
Labour demand: ND = 24 W
Labour supply: NS = 3 + 2W
a. Determine the equilibrium level of employment and wages as well as the
unemployment and inactivity rates in equilibrium.
b. Determine the unemployment and inactivity rates if the government imposed a
minimum wage of 9.
Changes in unemployment
This section is also UK oriented but in reading the material, do your best
to extract the general principles. For example, the four key reasons cited
for changes in equilibrium unemployment are likely to apply not just to
the UK and you should make sure you understand them clearly and can
explain them using the diagrammatic framework (LD, AJ, LF) used in
BVFD. The specific conclusions drawn depend, of course, on being able
to separate actual from equilibrium unemployment when looking at the
unemployment data for a given economy. The reason that BVFD dont
explain how this is done is because the separation requires understanding
of technical statistical techniques that go beyond what can be covered
in an elementary course. It is perhaps worth saying that estimates of
equilibrium unemployment are likely to be subject to a considerable
margin of error. That does not mean that it is not worth making such
estimates. As explained in the chapter, if observed unemployment coincides
with equilibrium unemployment then governments should not attempt to
reduce it by expanding aggregate demand, but instead need to address the
underlying structural factors, largely on the supply side, that determine
equilibrium unemployment. This is valuable information for policy makers.
An income tax can be seen as a tax on sellers, since workers are supplying
their labour to the firm and income tax reduces the incentives for workers
to supply their labour. This would be represented in Figure 23.9 by an
upward sloping line parallel to and to the left of AJ, passing through point
A. Alternatively, it can be described, as it is in this maths box, as a factor
that shifts demand for labour, since firms care about the gross cost of
hiring workers. This would be represented in Figure 23.9 by a downward
sloping line parallel to and below LD, passing through point B.
235
Activity SG19.6
Use the (LD, AJ, LF) framework to illustrate the effects of the following supply-side factors
on unemployment:
a. a rise in the use of online employment websites for job search decreases skill
mismatch
b. a fall in unemployment benefit, decreasing the replacement rate
c. a fall in trade union power
d. an increase in marginal tax rates.
Activity SG19.7
Based on the equations in Maths 23.1, let a = 10, b = 0.2, c = 0.3, e = 30, f = 1, t = 10
a. Draw a graph of this initial setup with two labour demand curves with and without
the tax.
b. Calculate equilibrium unemployment.
c. How does equilibrium unemployment change when the tax is reduced to 5? Draw this
line onto your diagram as well.
d. Imagine c was in fact equal to 0.8 now calculate equilibrium unemployment when t
is equal to 10 and when t is equal to 5.
Cyclical unemployment
The way that cyclical unemployment is defined in L&C (UK edition p.573;
international edition p.473) helps to connect the analysis here with
what was learned in the previous chapters Cyclical unemployment, or
demand-deficient unemployment, occurs whenever there is a negative
GDP gap (i.e. total demand is insufficient to purchase all of the economys
potential output, causing a recessionary gap in which actual output is
less than potential output). Cyclical unemployment can be measured as
the number of people who would be employed if the economy were at
potential GDP minus the number of persons currently employed.
While section 23.3 focused on supply-side policies to address
unemployment, this section discusses the use of counter-cyclical demand
management policies. Keynes original policy recommendations to
address the extremely high unemployment levels of the 1930s focused on
increasing government spending to offset the lack of private consumption
and investment. He argued it didnt necessarily matter what the money
was spent on (though of course he favoured productive projects) what
was important was to increase aggregate demand. This would lead to
economic growth and a fall in unemployment. Keynesian ideas strongly
influenced the US Presidents Herbert Hoover and Franklin D. Roosevelt,
who embarked on extensive public works programmes including the
building of roads and bridges as well as relief programmes providing
housing support, food, medicines, and other basic necessities to the
unemployed. The massive spending undertaken as countries invested
in armaments for the Second World War has been credited with finally
ending the mass unemployment of the depression years.
Various countries also used expansionary fiscal policy in an attempt to
re-stimulate their economies after the recent credit crunch. For example,
the US Economic Stimulus Act of 2008 (a $152 billion stimulus consisting
236
predominantly of $600 tax rebates to low and middle income Americans),

followed by the American Recovery and Reinvestment Act of 2009
(including direct spending on infrastructure, education, health, energy,
federal tax incentives, and expansion of unemployment benefits and other
social welfare provisions with an estimated cost of $831 billion between
2009 and 2019). The Chinese government also pledged to spend 4 trillion
yuan on infrastructure and social welfare by 2010. The UK also undertook
a large fiscal stimulus programme, including a temporary 2.5 per cent cut
in VAT (sales tax) and a car scrappage scheme similar to ones in France and
Germany, although the scope for fiscal stimulus in the UK has been limited
by the huge debts the government had incurred bailing out the financial
sector. There is evidence that the expansionary fiscal policies employed
in these countries have indeed helped to combat rising unemployment
for example, US states that increased per-capita expenditures the most,
experienced the smallest rises in unemployment rates.
This approach to addressing unemployment is more focused on the short
run, while the supply-side policies discussed in the previous section tend to
focus on reducing longer-term structural unemployment.
BVFD: read case 23.2.
Flexible labour markets: Recall from the section above on the natural rate
of unemployment the definitions of j (the rate of job loss) and h (the rate
of hiring). The figure in this Case displays (approximately) the equivalent
of j plus h over the period of a year, for each of the countries shown.
Cost of unemployment
Despite the safety net that is provided in the UK by Jobseekers Allowance,
most forms of unemployment apart from short-duration frictional
unemployment are associated with large personal costs these include a
loss of income, an erosion of human capital (meaning that skills deteriorate
when they are not being used) and psychic costs such as feeling rejected
or not useful. Furthermore, although it is true that if unemployment is
voluntary then, by definition, the private benefits of unemployment exceed
the private costs, it does not follow that the voluntarily unemployed are
not suffering considerable hardship. This could well be the case where
the potential jobs available to the unemployed are low paid and at the
same time the state pays low unemployment benefits, as measured by the
replacement rate. Look at the case of Greece in case 23.2, for example.
The replacement rate is comparatively low (and falls rapidly after the first
year of eligibility) and the employment opportunities available to Greek
workers during Greeces recent troubled circumstances were very limited
and poorly paid. Unemployed Greek workers have had very low living
standards during this period.
The social costs of unemployment are also extensive, and include a loss of
output and aggregate income, an increase in inequality, a loss of human
capital for the society as a whole resulting in lower productivity.
Hysteresis
Concept 23.2 outlines four reasons why hysteresis (a temporary fall in
demand inducing permanently lower output and employment) may occur
and its policy implications. The existence of hysteresis is one reason why
governments are so eager to prevent unemployment rising in the first
237
place. Hysteresis also undermines the strict classical view of the natural
rate of unemployment whereby fluctuations in demand affect only shortrun output, employment and unemployment, all of which return to their
underlying classically-determined levels in the long run. If hysteresis could
be established empirically as a significant phenomenon, and there is still
controversy on this point, then recessions could raise the natural rate of
unemployment, leaving the economy permanently scarred.
Overview
The total working-age population consists of the labour force and those
who are inactive. The labour force consists of the employed plus the
unemployed. The participation rate is the labour force divided by the
total population. The unemployment rate is the unemployed divided by
the labour force. Unemployment can be classified as frictional, structural,
classical or demand-deficient unemployment. BVFD define voluntary
unemployment, or equilibrium unemployment, to include frictional,
structural and classical unemployment. Involuntary unemployment is
equivalent to demand-deficient unemployment, also known as cyclical or
Keynesian unemployment. The natural rate of unemployment is defined
as the equilibrium rate of voluntary unemployment. Temporary recessions
lead to increased cyclical unemployment. This can be addressed using
the demand-management tools of fiscal and monetary policy. A one
per cent increase in output is likely to lead to a much smaller reduction
in cyclical unemployment due to increases in hours worked by those
currently employed and increased numbers joining the labour force. In
the long run, the only way to reduce unemployment permanently is to
reduce the natural rate of unemployment through supply-side policies
such as reducing mismatch through better information and retraining,
reducing trade union power, cutting the marginal rate of income tax
and reducing unemployment benefits (of course, society may choose
a higher equilibrium rate of unemployment rather than adopt some of
these policies). There is also a link between cyclical unemployment and
the natural rate of unemployment, since short-run changes can move the
economy to a different long-run equilibrium. This is known as hysteresis.
Most forms of unemployment, apart from frictional unemployment, are
associated with large personal costs including lost income, an erosion of
human capital and psychic costs, as well as social costs including a loss of
output and aggregate income, increased inequality, a loss of human capital
for the society as a whole resulting in lower productivity, and the effects
on the public finances of unemployment benefits and lost tax revenue.
Low unemployment is one of the three major macroeconomic goals of
many governments, along with steady growth and low inflation.

238

1. Which of the following is not true?
a. The unemployment rate is counter-cyclical.
b. The average unemployment rate differs substantially across
countries.
c. The sign of a well-functioning economy is that there is no
unemployment.
d. In an advanced economy, the unemployment rate can exceed 20
per cent.
2. The conflict of interest between different groups of workers results in
insiders wanting , while outsiders want .
a. more hirings; high wages
b. high wages; more hirings
c. high wages; fewer hirings
d. fewer hirings; high wages.
3. If the fraction of employed workers who lose their jobs each month
(the rate of job separation) is 0.01 and the fraction of the unemployed
who find a job each month is 0.09 (the rate of job findings), then the
natural rate of unemployment is:
a. 1 per cent (0.01)
b. 9 per cent (0.09)
c. 10 per cent (0.10)
d. about 11 per cent (actually, 1/9).

1. a. Suppose that at the beginning of the month, the number
employed, E, equals 180 million; the number not in the labour
force, N, equals 50 million; and the number unemployed, U, equals
20 million. During the course of the month, the flows indicated
below occurred:
4.0 million moved from employment into unemployment (EU)
1.5 million moved from employment to not being in the
labour force (EN)
2.2 million moved from unemployment into employment (UE)
2.7 million unemployed people dropped out of the labour
force (UN)
0.3 million moved from not being in the labour force directly
into employment (NE)
1.8 million moved from not being in the labour force directly
into unemployment (NU).
i. Assuming that the population has not grown, calculate the
unemployment and labour force participation rates at the
beginning and end of the month.
ii. Excluding movements into and out of the labour force,
calculate the rate of job loss (j), and the rate or hiring (h).
239
b. Use an appropriate graphical framework to illustrate the effects of

the following supply-side factors on unemployment:
i. An increase in marginal tax rates
ii. A fall in unemployment benefit, decreasing the replacement
rate.
2. The graph below shows percentage change in GDP against percentage
change in the unemployment rate for Australia from the 1980s to
2012. (GDI refers to gross domestic income, which is GDP adjusted for
terms of trade: you can ignore this).
a. Describe the movement of GDP growth relative to change in the
unemployment rate, differentiating between periods of time which
seem different to each other.
b. Explain why this might occur. What does this say about
unemployment in Australia in recent decades?
GDP Percent Growth
GDI Percent Growth
Change in Unemployment Rate (% points)
Percent/Percentage Points
8
6
4
2
0
-2
1990
1995
2000
2005
TTY Change in GDP, GDI and the Unemployment Rate

Data sourced from the Australian Bureau of Statistics. Source: http://
markthegraph.blogspot.com/2012/10/gdp-gdi-and-okun.html Reproduced
with permission. Licensed under a Creative Commons Attribution 2.5 Australia
CC-BY.
240
2010
Block 20: Exchange rates and the balance of payments
Block 20: Exchange rates and the balance

of payments
Introduction
This block examines the international sector in some detail. Net exports
has been part of our model of the economy since Block 13 (the very
first macro block), but we have not explored it in any depth. However,
interactions with other countries play an important role in almost all
economies. Globalisation has meant that the world is now very integrated,
such that countries cannot operate independently from each other. As well
as trade flows, there are also massive capital flows in foreign exchange,
shares and bonds, and other financial instruments. This block provides the
tools to analyse the international sector and its impact on the domestic
economy.
Throughout the block, the UK is used as the domestic economy and
pound sterling as the domestic currency. A choice had to made, but US
textbooks would use the dollar as the domestic currency and Malaysian
textbooks the ringgit. In following the analysis, use whatever you are most
comfortable with as the domestic and foreign currencies, but always pay
attention to which way the exchange rate is defined (foreign in terms of
domestic or vice versa).
Learning outcomes
analyse the foreign exchange market
discuss balance of payments accounts
explain determinants of current account flows
define perfect capital mobility
assess speculative behaviour and capital flows
define internal and external balance
analyse the long-run equilibrium exchange rate.
Essential reading
Further reading
Lipsey and Chrystal (L&C) international edition Chapter 22; UK edition
Chapter 24.

This block covers Chapter 24 of the textbook, which introduces exchange
rates and the balance of payments and provides a background to the
following block on open economy macroeconomics. Exchange rates
the number of units of foreign currency that exchange for a unit of the
domestic currency are determined by demand and supply in the foreign
exchange market. The balance of payments consists of the current account
and the capital and financial accounts. These are discussed in more detail
241
in the block. Under floating exchange rates, the balance of payments will
balance automatically, though when exchange rates are fixed, there is a
need for government intervention so that the current account and capital
and financial accounts offset each other. This block also introduces real
and purchasing power parity exchange rates as well as the interest parity
condition. Finally, the block also discusses the importance of external
balance as well as long-run trade balance between countries.
The exchange rate

The exchange rate is the number of units of one currency that exchange
for a unit of another currency. A fall (rise) in the exchange rate is called
depreciation (appreciation). The exchange rate is just a price the price
of one currency in terms of another. This price can rise or fall, like any
other price. As stated above and in the text, it is important to keep track
of which way round the price is expressed the foreign value of the
domestic currency or the domestic value of the foreign currency. Where
we think of the exchange rate as the international or foreign price of the
domestic currency a lower exchange rate makes the domestic economy
more competitive (see the BVFD example of whisky with a UK price of 8
per bottle). Activity SG20.1 gives you some practice at keeping track of the
sometimes confusing concept of the exchange rate.
Activity SG20.1
You are in
Exchange Rate International value of the

What does it mean? (i.e. how
domestic currency, or domestic much of one currency can you
price of foreign exchange?
buy for the other?)
UK
$US1.571/
Germany
1.244/
Malaysia
$US0.286/MR
UK
0.804/
It is common to assume the demand for imports is elastic and draw the
supply curve of currency sloping upwards. When demand for imports is
elastic, a fall in the $/ exchange rate (the pound getting weaker against
the dollar) will lead to a fall in the volume of imports (since US goods
are now more expensive for UK residents), and this fall in volume will
be proportionately larger than the increased price of imports. Therefore,
fewer pounds in total will be spent on imports. Thus there is a positive
relationship between the exchange rate and the supply of pounds, and the
supply curve slopes upwards (when demand for imports is elastic).
Trade is often analysed as taking place between two countries (this
enables use of simple diagrammatic techniques among other things) and
242
in such case the definition of the exchange rate is unproblematic. Concept

24.1 explains a relatively straightforward way to generalise the definition
of the exchange rate to the more realistic case where a country has many
trading partners the effective exchange rate being the weighted average
of individual bilateral exchange rates. The effective exchange rate is
particularly useful for tracking the strength of a currency over time. By
its nature the effective exchange rate is expressed as an index, set at 100
(usually) at some chosen starting date.
Fixed and floating exchange rates

This section discusses fixed and floating exchange rates. This analysis
is essentially the same as standard supply and demand analysis, except
that when the price (the exchange rate) is fixed, this fixed price has to be
maintained by the central bank of the domestic country buying or selling
the foreign currency (although in practice the central banks of both the
domestic and foreign countries may work together to maintain the fixed
exchange rate).
To test your understanding of the basic supply and demand framework
answer the following multiple choice question.
Activity SG20.2
Assume that the UK is the domestic country (and the central bank is the Bank of England)
and that the exchange rate ($/) is fixed. Supply the correct combination to fill the gaps
in the following sentence.
If, at the fixed exchange rate the pound () is the Bank of England must
.. pounds and its dollar ($) reserves will ..
a.
overvalued
buy
rise
b.
overvalued
sell
rise
c.
undervalued
buy
rise
d.
overvalued
buy
fall
Between these two extremes there are other methods of how the
government allows exchange rates to be determined. These include (for
example) a crawling peg system, where a countrys currency is pegged to
the value of another currency, but the government explicitly recognises
that this will be allowed to change from time to time, when needed;
and a managed float, where the currency is allowed to move freely, but
the government participates in the market to damp large fluctuations.
Exchange rate regimes are represented below as a continuum, with the
most government involvement on the left and the most market flexibility
on the right.
Currency Board
Hong Kong, Bulgaria
Currency Union
Eurozone, dollarizaon
Fixed Peg
China, Pakistan
Crawling Peg
Cost Rica
Managed Float
India, Singapore, Russia
Crawling Bands
Denmark
Free Float
UK, USA, Sweden
Figure 20.1: A continuum of exchange rate regimes.

243
For your interest, a description of various exchange rate regimes and a

breakdown of countries adopting them can be found here: www.imf.org/
external/np/mfd/er/2006/eng/0706.htm. Chapter 26 of the textbook also
examines exchange rate regimes in more detail. You can read more about
this topic there if you are interested, but it is not covered in the guide and
is not examinable for this course.
The balance of payments

The balance of payments consists of the current account and the capital
and financial accounts as well as any balancing item required because of
statistical discrepancies. The current account records transactions arising
from trade in goods and services; income (i.e. employee compensation and
investment income paid to and received from people, business or assets in
other countries; and transfers such as the government paying a pension to
someone living abroad or people sending money to relatives abroad). The
capital and financial accounts record transactions related to international
movements of ownership of financial assets, such as shares, bank loans
and government securities. Under floating exchange rates, the balance of
payments is always equal to zero. To see this it is helpful to return to our
national income identity:
Y=C+I+G+XZ
YCGI=XZ
But Y-C-G is national savings, so S I = X Z
S-I is a countrys net capital outflow (the excess of domestic savings over
investment is lent to foreigners), sometimes called net foreign investment.
Therefore if S-I and the trade balance, X-Z, are both positive the domestic
country is, in net terms, lending to foreigners to enable them to purchase
more of the domestic countrys exports (foreign Z) than they can finance
by exporting to the domestic country (domestic Z). The trade surplus is
matched by a deficit (net capital outflows) on the capital and financial
accounts. Conversely, if the domestic country runs a trade deficit, S-I is
negative and the domestic country is borrowing from abroad to enable
it to import more than it exports. Positive net capital inflows lead to a
surplus on the current and financial accounts to offset the trade deficit.
The argument here, of course, abstracts from balancing items (statistical
discrepancies). There is more detail on the components of the current and
financial accounts in sections 24.5 and 24.6.
Under fixed exchange rates the balance of payments is not necessarily
equal to zero and official financing may be required to ensure that overall
demand and supply of currency are equal and the fixed exchange rate is
maintained. Table 24.2 helps to clarify this section.
Activity SG20.3
Complete the following multiple choice questions, providing a reason for your answer.
1. The value of a countrys exports is listed in its balance of payments account as:
a. a credit
b. a debit
c. a payment
d. an investment.
244
2. In the balance of payments, a net inflow of capital shows up as a:

a. surplus in the capital account
b. deficit in the capital account
c. surplus in the current account
d. deficit in the current account.
Real and PPP exchange rates

It is important to make a distinction between the nominal exchange rate
and the real exchange rate. The real exchange rate takes into account the
differences in price levels, or the change in prices, (i.e. inflation) between
countries.
For clarity, note that:
Real exchange rate = Nominal exchange rate (Domestic price level / Foreign price level).
This means that a rise in the domestic price level leads a rise/appreciation
in the real exchange rate (if nominal exchange rates are constant).
The purchasing power parity (PPP) theory holds that in the long run,
the average value of the exchange rate between two currencies depends
on their relative purchasing power (L&C, UK edition pp.599601
international edition pp.49496). It should cost the same to buy a basket
of goods in US dollars in the USA, as to convert the same dollars into
Euros and buy that basket of goods in the EU. Otherwise, there would be
an incentive to buy or sell foreign currency and take advantage of this
discrepancy. The PPP exchange rate is determined by the relative price
levels in the two countries. That is why BVFD define the PPP path as the
path of the nominal exchange rate that maintains a constant real exchange
rate (p.550).
To make the theory of PPP a little more digestible, The Economist came up
with the idea of the Big Mac Index in the mid-1980s. This compares the
price of a McDonalds Big Mac burger in different countries and has since
become a well-known, though rough and ready, indicator of currencies
that are over or undervalued. Since Big Macs are produced to a certain
specification but are sold at local prices, comparing the prices of Big Macs
between countries and comparing this to the market exchange rate gives
an indication of how far above or below a market exchange rate is from
the PPP rate.
This example of how the Big Mac index works looks at the exchange rate
between the US dollar (USD) and the Malaysian ringgit (MYR). At the
time of writing the latest available figures related to January 2015 and
the official (nominal) exchange rate was 1USD = 3.62MYR, or 1MYR =
0.28USD (28 cents). In the USA a Big Mac costs $4.79 and in Malaysia
7.63MYR, or at the nominal exchange rate 7.63/3.62 = $2.11. At these
prices and the nominal exchange rate, the real exchange rate is given by1:
This calculation mirrors

those in Table 24.3 in
BVFD.
1
real exchange rate = RER = price of Malaysian Big Mac in terms of US Big Mac
or
RER =
=
(USD/MYR nominal exchange rate)PM

P US
(0.28 USD/MYR)(7.63MYR/Malaysian Big Mac)

(4.79USD/US Big Mac)
= 0.45
US Big Macs
Malaysian Big Macs
245
(i.e. at current prices and the current nominal exchange rate) one obtains
0.45 of a US Big Mac per Malaysian Big Mac. If the exchange rate reflected
PPP a Big Mac would cost the same in both countries. Clearly, at the
nominal exchange rate a Big Mac is much cheaper in Malaysia than in
the USA. In fact, one can get 2.27 (4.79/2.11) Big Macs in Malaysia for
each US Big Mac. What does this say about the value of the Malaysian
ringgit versus the US dollar? It tells us that the ringgit is undervalued. To
see this, imagine Malaysia could export its Big Macs to the USA and sell
them for $2.11 (transport costs and food decay are ignored here just to
illustrate the basic principle). There would be a big demand for ringgits by
US importers and this would bid up the dollar price of ringgits. Americans
would have to pay more dollars for their ringgits. How much more? This
question is answered by calculating x in 7.63x = 4.79. x is the dollar cost
of a MYR, and the equation calculates what this would have to be in order
for an imported Big Mac to cost the same as a domestically made one. The
answer is $0.63 (63 cents).
When the dollar value of the ringgit increases from 28 to 63 cents it is
no longer advantageous to import Big Macs from Malaysia. Equivalently,
while the nominal exchange rate is 1USD = 3.62MYR, the implied PPP
exchange rate is 1USD = 1.59MYR (1/0.63). At the current nominal
exchange rate the ringgit is undervalued by (3.62 1.59)/3.62 (i.e. 56
per cent). Obviously this is an oversimplified example and it would not
be sensible to defend the precise 56 per cent undervaluation too strongly;
among other shortcomings of our example, transport costs cannot be
ignored, nor can trade barriers and in calculating PPP one needs to use the
price of basket commodities not just the price of a Big Mac. However, the
basic lesson is that calculations of real exchange rates can tell us whether
nominal exchange rates fundamentally undervalue or overvalue a currency
and consequently whether there is pressure for the currency to appreciate
or depreciate.
For more information on this see: www.economist.com/content/big-macindex
Recall from Block 13 that one of the long response questions asked you
to compare the real GDP of two countries using PPP figures. Using the
PPP exchange rate, rather than $US for example, helps provide a better
understanding of the standard of living in each country. Non-traded
goods and services tend to be cheaper in low-income than in highincome countries and any analysis that doesnt take these differences into
account will tend to underestimate the purchasing power of consumers in
emerging market and developing countries and, consequently, their overall
welfare.
The current and financial accounts

BVFD: read sections 24.5 and 24.6 as well as case 24.1.
The balance of payments consists of the current account, the capital account
and the financial account (ignoring the statistical discrepancy). Under
floating exchange rates, the current account is exactly equal and opposite in
sign to the sum of the capital and financial accounts. Section 24.5 discusses
the current account. The capital account is generally very small and is not
discussed here. Section 24.6 discusses the financial account.
To understand section 24.5 on the determinants of the current account,
you should be clear on the relation between the real exchange rate
(RER) and exports (X) and imports (Z). The lower the RER, the cheaper
246
are domestic goods relative to foreign goods; this increases exports and
decreases imports. If you understand this you will see that the following
relationship exists between the RER and net exports (X Z), again taking
the UK as the domestic and the USA as the foreign country (this diagram is
essentially the same as Figure 24.4 in BVFD):
RER
($/)
X-Z
Figure 20.2: Relationship between RER and net exports.
The volume of forex traded internationally is many times as great as global

GDP. While some of this is required for international trade in goods and
services, it has been estimated that at least 80% of the global currency
market consists of exchange rate speculation. Speculation can lead to a
lot of volatility and it is argued that it has been one of the major causes
of several large financial crises such as those in Mexico (1994), South
East Asia (199798), Russia (1998), Brazil (1999), Turkey (2000) and
Argentina (2001).2
Regarding Table 24.5, if you check the calculations, you will notice
that when the exchange rate is exactly 1.8 US$/, $200 actually equals
111.11 and not 110. This difference may be due to rounding, since the
figure of 110 is attained when the exchange rate is 1.81 US$/. Be sure
to examine this table in conjunction with the text as the surrounding text
explains the meaning more clearly than just the table by itself.
www.globalpolicy.org/
global-taxes/currencytransaction-taxes.html
2

This maths box shows that the interest parity condition3 expected
exchange rate changes offset the differences in the returns between
domestic and foreign assets applies for both nominal and real interest
rates and exchange rates. You will not be required to use the equations
from this maths box in the examination, but you do need to understand
the general principle of interest rate parity. The basic idea is that, with
international mobility of capital, the return to investing in two different
countries will be equalised if not there will be the potential for profiting
from any difference in returns by shifting capital between countries
(arbitrage). So if interest rates differ in two countries this must be offset by
expected changes in the exchange rate in order to achieve the no-arbitrage
condition. The return to investing abroad is the interest rate earned abroad
plus the capital gain if the domestic currency depreciates (the overseas
currency now buys more units of the domestic currency when the invested
funds are returned to the home economy). This is captured in the verbal
equation (2) on p.554 (just above the maths box), i.e.
In fact what is covered

in this section is the
uncovered interest rate
parity condition. There is
an analogous condition,
the covered interest
rate parity condition,
which makes investors
indifferent between the
interest rates in two
countries when they can
hedge against exchange
rate risk in the forward
exchange rate market.
3
Return on domestic asset = return on foreign asset

= foreign interest rate + % depreciation of exchange rate while funds abroad
247
This is an equilibrium condition when there is no further scope for

arbitrage. If we are thinking of how investors view returns it is probably
best to think of the last term as the expected depreciation of the exchange
rate. So in the example used in the text we can write:
US interest rate UK interest rate = expected % change in exchange rate.
Long-run equilibrium
BVFD argue that in long-run equilibrium, both internal and external
balance must hold (p.556). The long-run equilibrium exchange rate must
thus be compatible with internal and external balance. The next chapter,
on open economy macroeconomics, takes this assumption as the basis for
much of the reasoning.
However, long-run equilibrium is an analytical construct not often
approached in reality. In practice it can be argued that a current account
deficit is neither intrinsically good nor bad. There are countries such as
Australia (a small open economy) which have sustained current account
deficits for several decades. The IMF writes that whether a country should
run a current account deficit (borrow more) depends on the extent of
its foreign liabilities (its external debt) and on whether the borrowing
will be financing investment that has a higher marginal product than
the interest rate (or rate of return) the country has to pay on its foreign
liabilities.4 This means that running a current account deficit (investing
more than is saved domestically) can be a good idea, even in the longterm, if it is manageable and the incoming capital flows are being invested
productively, generating more wealth for the next generation out of which
the countrys debts can be repaid.
Despite this, external balance is nonetheless important in the sense
that global imbalances can have severe consequences. For example, it is
thought that the current imbalance between the USA and China where
the USA has massive trade deficits and China has massive trade surpluses
(partly a result of the undervalued Chinese yuan) helped establish the
conditions which contributed to the recent financial crisis.
The following block (covering textbook Chapter 25) focuses on internal
and external balance as a way of examining the effects of various fiscal
and monetary policy stances under different types of exchange rate
mechanisms and different assumptions concerning capital mobility.
Overview
This block firstly introduces exchange rates, which express the price of
one countrys currency in terms of another countrys currency. Exchange
rates are determined by the supply and demand for currency, arising
from exports/imports and trade in assets. Floating exchange rates equate
demand and supply, while fixed exchange rates require government
intervention in the forex market (buying or selling domestic or foreign
currency) so that supply and demand are equated. The real exchange rate
takes into consideration the domestic and international price levels.
The balance of payments consists of the current, financial and capital
accounts. Monetary inflows are recorded as credits and outflows as
debits. Under floating exchange rates, the balance of payments is always
248
4
www.imf.org/external/
pubs/ft/fandd/basics/
current.htm
zero. A current account deficit is balanced by a surplus in the capital and

financial account. Under fixed exchange rates, the government may have
to intervene in the forex market to offset a balance of payments surplus or
deficit this is called official financing.
The current account consists primarily of imports and exports and is
determined by the real exchange rate (a rise in the real exchange rate
reduces domestic competitiveness and the demand for exports) as well
as domestic and foreign incomes. In practice, the capital and financial
accounts are dominated by speculative flows of currency seeking the
highest return.
The interest parity condition says that, when capital mobility is perfect,
interest rate differentials across countries should be offset by expected
exchange rate changes so the total expected return is equated across
countries.
As well as achieving internal balance (full employment and stable prices),
governments are also concerned with achieving external balance (a
balanced or at least manageable balance of payments). There is a single
long-run equilibrium real exchange rate that is compatible with internal
and external balance.


1. If the price of a Big Mac is 2 in London and $2 in New York, and the
exchange rate is $2/ then according to purchasing power theory:
a. The should appreciate, i.e. more $ should trade for a .
b. The should depreciate, i.e. less $ should trade for a .
c. The should appreciate, i.e. less $ should trade for a .
d. The should depreciate, i.e. more $ should trade for a .
2. In an economy with a fixed exchange rate policy, when both capital
and current accounts are in surplus:
a. The balance of payments will be balanced through a decrease in
foreign exchange reserves and there will be an increase in the
supply of domestic currency.
b. The balance of payments will be balanced through an increase
in foreign exchange reserves and there will be an increase in the
c. The balance of payments will be balanced through an increase
in foreign exchange reserves and there will be a decrease in the
d. The balance of payments will be balanced through a decrease
in foreign exchange reserves and there will be a decrease in the
249
3. Assuming there is perfect capital mobility, according to the interest

parity condition, an increase in the domestic inflation rate relative to
other countries would lead to:
a. an increase in competitiveness
b. a decrease in the exchange rate
c. a surplus on the current account
d. none of the above.

1.
a. Draw a graph of the supply and demand curves for the foreign
exchange market, expressed in terms of pesos per dollar. Show
the equilibrium price at 5 pesos per dollar. Suppose the demand
for dollars increases so that the new exchange rate is 7 pesos per
dollar. Has the peso appreciated or depreciated? Which currency
has strengthened? Is this good or bad for the USA? For Mexico?
b. True or false (explain): If a Mexican businessperson exports
goods and services to the USA, this will show up in the balance
of payments of both countries; however, the money spent by an
American taking a vacation in Mexico only shows up in the balance
of payments of Mexico.
c. Suppose the following data represent Mexicos international
transactions measured in millions of pesos.
Merchandise exports
15
Merchandise imports
10
Change in foreign assets in Mexico
12
Change in assets abroad
Exports of services
Imports of services
Income receipts on investment
Income payments on investment
10
Unilateral transfers
i. What is Mexicos trade balance?

ii. What is the balance on its current account?
iii. What is the balance on its capital account?
iv. What kind of exchange rate regime is Mexico operating?
250
Block 21: Open economy macroeconomics

Introduction
Having been introduced to fixed and floating exchange rates in the
previous block, this block examines the workings of the economy under
different exchange rate regimes, as well as different assumptions regarding
capital mobility.
By this stage in your studies, the chain of reasoning for why a change in
one variable may impact on another variable has become quite long. As
you read through this chapter of the textbook, it is important to take your
time to think through each step keep asking yourself why is that the
case?. Understanding each step of the argument will help to make the
whole picture clear.
Although there is some discussion of adjustment to other shocks, the focus
of this block is on macroeconomic policy the effectiveness of fiscal and
monetary under different exchange rate regimes and assumptions about
capital mobility. You will see that the exchange rate regime a country
adopts has a profound impact on the way the economy operates and how
it can be managed.
Learning outcomes
describe price and output adjustment under fixed exchange rates
explain the effects of a devaluation
describe what determines floating exchange rates
use the ISLMBP framework to analyse changes in monetary and
fiscal policy under fixed and floating exchange rate regimes.
Essential reading
Further reading

This block examines how the economy operates under different exchange
rate regimes namely, fixed and floating exchange rates, and discusses
the important effects of capital mobility. Furthermore, this block makes
use of IS-LM-BP analysis to illustrate the effects of fiscal and monetary
policy under fixed and floating exchange rates. The block starts by
discussing fixed exchange rates and macroeconomic policy under fixed
exchange rates, then discusses devaluation an occasional adjustment in
an exchange rate that is pegged at a fixed value. Finally, floating exchange
rates are examined, including what determines the level and fluctuations
in these rates as well as the operation of macroeconomic policy when
exchange rates are flexible.
251
The macroeconomy under fixed exchange rates

The textbook describes how the LM curve would be horizontal if there is
perfect capital mobility. An alternative way to represent this is to leave the
LM curve as it is usually (sloping upwards) and to introduce a horizontal
balance of payments or BP curve. The BP curve shows the relationship
between interest rates and output that is required to maintain equilibrium
in the balance of payments (the current and capital accounts offset each
other so that the overall balance of payments is in equilibrium), holding
constant the exchange rate and foreign interest rates (asset returns). While
the intersection of the IS and LM curves establishes internal balance, the
BP curve establishes external balance.
Under perfect capital mobility, the BP curve is horizontal. Why? With
perfect capital mobility and perfect substitutability between domestic and
foreign assets, any small difference between the domestic and foreign
interest rates results in massive (theoretically infinite) capital flows and
the effect on the capital account would completely dominate the position
on the current account. Suppose internal balance (the IS, LM intersection)
resulted in the domestic interest rate being above the world interest
rate. There would be massive inflows of capital more than required to
keep the overall current plus capital account in balance. This position
is unsustainable and domestic interest rates would have to fall to world
levels to achieve general equilibrium (internal and external balance).
When there is some, but not perfect, capital mobility (i.e. when domestic
and foreign assets are not perfect substitutes), the BP curve is upward
sloping. As Y increases, net exports fall due to the increase in imports,
requiring higher interest rates to attract capital inflows to offset the
worsening trade balance. The BP curve will be flatter than the LM curve
when capital is relatively mobile and steeper than the LM curve when
capital is relatively immobile. With completely immobile capital, the BP
curve is vertical (domestic interest rates are independent of world interest
rates). These three cases are demonstrated graphically below. In each case,
the intersection of the three lines indicates the interest rate and level of
output at which there is both internal and external balance.
There may also be periods where an economy is in internal balance but
not external balance, for example. In that case, the IS and LM curves will
cross at a point that is not on the BP curve. The region above the BP curve
indicates that there is a balance of payments surplus, because the domestic
interest rate is inducing greater capital inflows (a credit) than are
necessary at that level of income to maintain the balance of payments in
equilibrium. Conversely, if the internal equilibrium is below the BP curve,
there are insufficient capital inflows at that level of income to maintain a
balance of payments equilibrium and the balance of payments would be in
deficit.
252
Perfect capital mobility

LM
BP
r*
IS
Y*
Full capital controls
Partial capital mobility
BP
LM
LM
BP
r*
r*
IS
Y*
IS
Y*
Figure 21.1: Exchange rates with different levels of capital mobility.
Under fixed ER, the BP curve doesnt shift, regardless of the degree of
capital mobility. If there is a surplus or deficit in the balance of payments,
adjustments occur through changes in the money supply (LM curve), since
the central bank is always ready to buy and sell sufficient quantities of the
domestic currency to keep the exchange rate fixed at an agreed upon level.
(Under flexible exchange rates, the BP curve can shift, but only when
capital is not perfectly mobile. A shift in the BP curve reflects a change in
the level of net exports as net exports rises, the current account improves
(i.e. becomes less negative) and the economy does not need as high a level
of capital inflows at each income level as it did before, therefore, the BP
curve shifts to the right.)
Activity SG21.1
Assuming fixed exchange rates and perfect capital mobility, use the IS-LM-BP framework
to demonstrate the effects of an increase in demand for exports on output and interest
rates.
When there is free capital mobility, countries can fix only one of the
following three: the interest rate, the exchange rate and the money supply.
Countries which peg their exchange rates to another countrys currency
cannot operate an independent monetary policy to address internal
inflation and aggregate demand issues, since domestic interest rates can
only be used to defend the fixed exchange rate. BVFD discuss how the
economy gets back to internal and external balance after a shock despite
not being able to pursue independent monetary policy. Since the domestic
price level is assumed to be constant in the IS-LM model, and since
253
adjustments to restore both internal and external balance require changes

in the price level, BVFD analyse this case using the dynamic AD-AS
framework, which relies on changes in domestic inflation altering the real
exchange rate (even though the nominal exchange rate is fixed) and thus
international competitiveness. This is summarised in Figure 25.2.
BVFD: read case 25.1 Capital controls.
The Tobin tax Although there is still opposition to this idea, support for
a Tobin tax is now quite widespread. It is likely that some (though not
all) member countries of the European Union will introduce a financial
transaction tax (FTT) in the coming years. It has been estimated that in
the year 2000, 80 per cent of foreign-exchange trading took place in just
seven cities and 58 per cent of speculative trading took place in just three:
London, New York and Tokyo. This means that even limited adoption of
such a tax could already have a large impact it is not necessary for there
to be full global agreement for the beneficial effects of this strategy to be
felt. As well as dampening speculation, the tax has enormous revenue
raising potential.
Monetary and fiscal policy under fixed exchange rates

BVFP: read section 25.2.
The following graphs show how IS-LM-BP can be used to show monetary
and fiscal policy under fixed exchange rates and perfect capital mobility.
Fiscal policy, fixed ER, perfect CM
Monetary policy, fixed ER, perfect CM

LM
LM
LM
r1
BP
r*
BP
r*
IS
IS
IS
Y*
Y1 Y2
Figure 21.2: Monetary and fiscal policy under fixed exchange rates and perfect
capital mobility.
In the diagram on the left above, if the government attempts to use

expansionary monetary policy the LM curve would shift right (1),
lowering domestic interest rates and sparking massive capital outflows as
investors switch to higher yielding foreign assets. The central bank buys
the unwanted domestic currency (selling foreign exchange), reducing the
money supply and causing the LM curve to shift leftward again (2). Thus
in an open economy with fixed exchange rates and perfect capital mobility,
monetary policy is not available as an option to combat inflation or to
affect the level of output, as any deviation from world interest rates will
lead to massive capital flows and the effect on money supply will need to
be offset by the central bank to protect the exchange rate, thus restoring
interest rates to their original level.
In the diagram on the right, the government uses an increase in G to
expand the economy. The IS curve shifts outwards (1) (Y increases to
Y1), interest rates are above the foreign level, and capital inflows result.
254
LM
To purchase the foreign exchange, the central bank sells the domestic
currency, increasing the money supply and shifting the LM curve outwards
(2) causing a further increase in output Y1 Y2. Fiscal policy is actually
more effective in this scenario than in a closed economy. This is because
interest rates are held constant to protect the exchange rate, so there is no
crowding out of private investment as there would be in a closed economy
when expansionary fiscal policy is implemented.
This maths box shows that under floating exchange rates, there is a
negative relationship between output and inflation when the government
pursues a monetary policy where they raise interest rates when inflation
is higher. Under a fixed exchange rate, however, there are two ways in
which the price level is related to output through real interest rates,
and through real exchange rates. Since nominal interest rates are fixed,
higher inflation leads to lower real interest rates which boost aggregate
demand. On the other hand, higher inflation leads to an increase in the
real exchange rate and a fall in competitiveness, reducing aggregate
demand. The AD curve will slope down as long as the second effect
dominates the first. Work through the equations in this maths box to make
sure you understand this result.
Devalution of a fixed exchange rate

This section discusses the impact of a devaluation of a pegged exchange
rate in the short, medium and long run. Devaluation may be a useful tool
in response to a shock to the trade balance. It can help to achieve positive
outcomes more quickly than through a slump in the domestic economy.
The J-curve This describes how a devaluation of a fixed exchange
rate may initially lead to a deterioration in the countrys current account
because the money value of imports rises while the domestic price of
exports remains steady. In time, however, once quantities begin to adjust
to the increased competitiveness brought about by the reduction in the
real exchange rate, the trade balance will improve. Examining trade
balance over time thus gives rise to a J-shaped curve (see footnote 4 in
BVFD p.571). This is demonstrated by Figure 21.4. As an example, after
the 1967 devaluation of pound sterling, it took between 18 and 24 months
for the UK current account to move into surplus (L&C 12th edition, Box
23.4).
255
Balance of payments current account
t0
Time
Figure 21.3: J-curve.
It is important to realise, however, that although countries are likely to

see an improvement in the trade balance in the medium term, in the long
run, devaluation has no real effect. As is mentioned in BVFD, empirical
evidence suggests that increases in domestic prices and wages tend to
offset the effects of the devaluation within five years. Looking at Figure
25.3, the graph of the current account (value) initially shows the J-curve
shape as in the figure above, but then drops down again and levels out
in the longer term. In general nominal change will not bring about real
change.
Activity SG21.2
What policy measures should accompany a devaluation of a pegged exchange rate to
ensure optimal results in the medium term? Under what circumstances is a devaluation
likely to have the most positive impact on the economy?
The macroeconomy under floating exchange rates

The following is a key sentence of section 25.4: in the long run, floating
exchange rates adjust to achieve the unique real exchange rate compatible
with internal and external balance. In the short run, exchange rates
can be very volatile. They respond to current interest rate differentials
and inflation differentials between countries, expectations regarding the
future long-run value of the exchange rate and new information which
changes peoples expectations regarding interest rates, inflation or the
long-run equilibrium exchange rate. In working through the explanation
of Figure 25.4 remember that the key assumptions are first that there
are no long-run differences in interest rates between countries and
second that adjustment of the exchange rate to eliminate interest rate
differentials follows interest rate parity, with positive (negative) interest
rate differentials offset by expected and then actual currency depreciation
(appreciation).
256
Activity SG21.3
The following graph shows the exchange rate between GBP and EUR what might
explain the sudden drop just after 09.00 on 28 April?
1,4020
1,4000
1,3980
1,3960
1,3940
18:00
28Apr
06:00
12:00
Source: www.foremostcurrencygroup.co.uk/a-volatile-period-for-sterling/
It is important to realise that when the government fixes the exchange
rate, they lose autonomy over the interest rate. Equally, when the
government fixes the interest rate, they lose autonomy over the exchange
rate. The exchange rate adjusts to prevent massive capital flows in
response to interest rate changes.
Exchange rates as a monetary policy instrument as discussed in Block
15, Singapore uses the exchange rate as its primary tool for conducting
monetary policy. It manages the exchange rate through direct intervention
in the foreign exchange market (operating a managed float regime where
the trade weighted exchange rate for the Singapore dollar is allowed to
fluctuate within a policy band) and lets domestic interest rates move freely
according to market forces. This stands in contrast to standard monetary
policy as implemented in most other countries, where interest rates are
the key tool. This has proven to be a very effective approach for Singapore,
which has a small, very open economy.
Monetary and fiscal policy under floating exchange rates

The following graphs show how IS-LM-BP can be used to show monetary
and fiscal policy under floating exchange rates and perfect capital mobility
(the effectiveness of monetary and fiscal policy under fixed exchange rates
was analysed above, see Figure 21.2). With floating exchange rates, we
need to modify our IS curve to allow for the effect of currency appreciation
or depreciation on international competitiveness; we saw above how net
exports, a component of aggregate demand, are affected by the exchange
rate. (Exports are also affected by income levels abroad, but this factor
is usually taken as fixed in elementary open economy macroeconomics.)
Take first the case of expansionary monetary policy (the left-hand panel
below). LM shifts to the right (1). As the interest rate falls below world
levels there is an outflow of capital (an excess supply of the domestic
currency); the domestic currency depreciates against foreign currency. This
in turn increases net exports and the IS curve shifts outwards (2). This
depreciation continues until interest rates are again at r*. Output is Y2.
Monetary policy is extremely effective.
257
Monetary policy, floating ER, perfect CM

LM
Fiscal policy, floating ER, perfect CM
LM
LM
r1
BP
IS
Y
BP
r*
IS
Y1 Y2
IS
IS
Y*
Y1
Figure 21.5: Monetary and fiscal policy under floating exchange rates and
perfect capital mobility.
On the other hand, fiscal policy is rendered less effective, because it

impacts on interest rates and thus the exchange rate. See the right hand
panel above. A fiscal expansion (1) will cause interest rates to rise,
crowding out private investment, but also leading to large capital inflows
and an appreciation of the exchange rate which dampens demand for net
exports and shifts IS leftwards again (2). The exchange rate will continue
to appreciate until the capital inflow is halted, i.e. until domestic interest
rates are again equal to r* and output is again equal to Y*. Thus the power
of fiscal policy is reduced in an open economy with floating exchange rates
compared to a closed economy.
The table below provides a summary of the effectiveness of fiscal and
monetary policy under different exchange rate regimes. This is based on
the assumption that there is free capital mobility. We have concentrated
on the case of perfectly mobile capital. As an exercise you might think
about what happens when capital is perfectly immobile. Hint: external
balance now requires that the trade balance is zero (exports equal
imports) because there are no additional non-trade capital flows to
offset a trade surplus or deficit. Thus the BP curve must be vertical at
the level of Y which produces internal balance. Under flexible exchange
rates, what happens to the BP curve when shifts in IS or LM change the
internal balance? Answer: the BP curve shifts right or left as the currency
depreciates or appreciates.
Macro Policy Effectiveness
Fiscal Policy
258
Monetary Policy
Fixed
Effective
Exchange (The fiscal stimulus provided by the government
Rates
must be accompanied by an increase in money
supply to hold interest rates constant and protect
the exchange rate, as such there will be no
crowding out of private investment)
Ineffective
Flexible
Ineffective
Exchange (A fiscal expansion leads to a boom, higher
Rates
interest rates, and an appreciation of the nominal
exchange rate, leading to a deterioration of the
current account. This nullifies the initial stimulating
effect. The IS curve returns to its original position)
Effective
(Any monetary expansion must be undone

to defend the fixed exchange rate. The LM
curve returns to its original position due to the
commitment to a fixed rate)
(A monetary expansion leads to a fall in interest

rates and an outflow of domestic currency, leading
to a depreciation of the domestic currency,
increased competitiveness, and higher exports
until the interest rate is restored at a higher level
of income)
BVFD: complete activity 25.1, read the summary and work through the
review questions.
Overview
A countrys exchange rate regime has a profound effect on the way the
economy operates, though this depends on the size and openness of the
economy. Openness is often measured by the size of exports relative to
GDP. However, capital flows also have a big impact. Capital can either
be perfectly mobile, perfectly immobile (due to capital controls) or
partially mobile (such as when foreign and domestic assets are not perfect
substitutes). The impact of various shocks and the effectiveness of fiscal
and monetary policy under fixed or floating exchange rates and different
assumptions about capital mobility can be illustrated using IS-LM-BP
analysis.
Under fixed exchange rates and perfect capital mobility, there is no scope
for monetary policy to influence the domestic economy, since the domestic
interest rate must match foreign rates to prevent massive capital inflows
and outflows. In the long run, internal and external balance may be
restored without policy intervention through changes in prices and output.
Fiscal policy is a powerful tool in the context of fixed exchange rates and
capital mobility, since interest rates must remain stable and there is no
crowding out of private consumption or investment.
The level of fixed exchange rates can sometimes be changed this is
either a revaluation (rise in value) or a devaluation (fall in value) of the
exchange rate. A devaluation improves competitiveness in the short run
but is unlikely to have a large effect in the long run, though it can help
speed up adjustment to shocks.
A floating exchange rate must begin at a level from which the anticipated
convergent path to its long-run equilibrium continuously provides capital
gains or losses to offset expected interest rate differentials. The actual path
of nominal exchange rates reflects changing beliefs about the future course
of domestic and foreign exchange rates and the eventual level of the longrun exchange rate.
Under floating exchange rates, the effectiveness of fiscal policy is limited, but
monetary policy is a powerful tool. Monetary policy impacts on aggregate
demand through consumption and investment (as in a closed economy) and
also through its impact on the exchange rate and competitiveness.

259

1. Suppose we have flexible exchange rates and the current account is
+50. Then the capital account:
a. is 50
b. depends on the level of sterilisation
c. depends on the balance of payments
d. depends on the amount of foreign exchange reserve accumulation.
2. A number of countries in Europe have adopted a single currency, the
Euro. One potential drawback of a single currency for these countries is:
a. Fiscal expansions are no longer effective.
b. They no longer have control over interest rates.
c. Their exchange rates will now be more volatile, therefore reducing
trade.
d. Capital account deficits will increase.
3. If we consider a situation of expansionary monetary policy under
flexible exchange rates, the monetary expansion will lead to _____
of the home currency and thus will be _____ effective in increasing
national income than under fixed exchange rates.
a. an appreciation; more
b. an appreciation; less
c. a depreciation; more
d. a depreciation; less.
4. Under flexible exchange rates:
a. Fiscal policy is most effective in influencing national income when
capital is perfectly immobile internationally and least effective
when the capital is perfectly mobile.
b. Monetary policy is more effective in influencing national income
when capital is perfectly immobile internationally than when
capital is perfectly mobile.
c. Both fiscal and monetary policy are completely ineffective in
influencing national income when capital is perfectly immobile
internationally.
d. Fiscal policy has no effect on national income, regardless of
assumptions regarding the degree of international mobility of
capital.
5. With perfect capital mobility and other things being equal, an
exogenous increase in demand for a countrys exports will lead to
_____ increase in the countrys national income under fixed exchange
rates than under flexible exchange rates.
a. a greater
b. a smaller
c. the same
d. impossible to determine without more information.
6. In the following diagram, with fixed exchange rates, the economy is in
domestic equilibrium at income level _____, and there is _____.
260
LM
BP
IS
Y1
Y2
Y3
a. Y1; a balance of payments surplus

b. Y2; a balance of payments deficit
c. Y2; a balance of payments surplus
d. Y3; equilibrium in the balance of payments.

1. In an open economy with a fixed exchange rate and perfect capital
mobility, a mortgage crisis leads to a fall in consumer spending
a. How does the economy come back to internal and external balance
if the government does not intervene? Explain the process in
words and illustrate graphically.
b. What would be the impact of an expansionary monetary policy?
Explain in words and illustrate graphically.
c. What would be the impact of an expansionary fiscal policy?
Explain in words and illustrate graphically.
d. Now assume the exchange rate is flexible, what would be the most
effective macro policy for the government to employ? Explain in
words and illustrate graphically.
2. Chinas economy has been experiencing an investment and export
boom that has pulled the unemployment rate well below the NAIRU.
The country also has a substantial current account surplus as well as a
significant capital account surplus, a fixed exchange rate, and relative
capital immobility. The Peoples Bank of China (PBOC), Chinas central
bank, always sterilises any foreign exchange market intervention
that it undertakes. The Chinese government is worried about overinvestment in many industries and rising inflation.
a. One alternative (Scenario #1) for dealing with these concerns is
to have the PBOC use monetary policy to stabilise the economy at
potential output. Based only on this information, and making sure
to provide an explanation, use a standard IS-LM-BP model diagram
to accurately and clearly show:
i. Chinas initial economic situation.
ii. What happens to equilibrium income, interest rates, and the
balance of payments if the PBOC uses monetary policy to
stabilise the economy at potential output.
b. Re-draw your initial diagram. A second alternative (Scenario #2)
for dealing with over-investment and rising inflation is for the
261
government to let the exchange rate freely float, assuming that this
would return the economy to potential output. Based only on this
information, use a second standard IS-LM-BP model diagram to
accurately and clearly show:
i. Chinas initial economic situation, and what happens to
equilibrium, interest rates, and the balance of payments if
the Chinese government allows that exchange rate to become
completely flexible.
c. For each of the following variables, identify whether it is higher,
lower, the same, or indeterminate in Scenario #1 (monetary
policy) when compared to Scenario #2 (flexible exchange rate):
i. equilibrium income
ii. interest rates
iii. investment
iv. net exports
v. the exchange rate
vi. the balance of payments.
262
Block 22: Business cycles

Introduction
This block examines fluctuations in aggregate output which occur in a
cyclical manner. This phenomenon occurs in economies all around the
world and recorded data on business cycles goes back to the early 19th
century. Despite this, there is still a lot of uncertainty and controversy
regarding the causes of business cycles. This block describes some of the
leading theories. It discusses fluctuations in actual output, in potential
output (the real business cycle theory), and international business
cycles. It concludes with an overview of the main schools of modern
macroeconomic thought, which is structured according to certain key areas
where there is disagreement within the field. This block is a little shorter
if you become confident working through this material more quickly, it
might be a good chance to go back to some other blocks and revise what
you have covered previously, especially any areas you were unsure about.
Learning outcomes
distinguish between trend growth and economic cycles around this
path
analyse why output gaps may fluctuate
discuss whether potential output also fluctuates
describe the role of dynamic general equilibrium models
contrast real business cycle models and New Keynesian analysis
assess whether national business cycles are now more correlated
summarise key issues dividing the main schools of economic thought.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD) Chapter 27.
Further reading
Chapter 23.

This block starts by introducing the concept of business cycles as well
as the idea of political business cycles. It then discusses several theories
of the business cycle which can explain fluctuations in actual output,
namely the multiplier-accelerator model, the effects of ceiling and floors,
changes in stockbuilding, and reactions to shocks under fixed exchange
rates. These theories are predominantly based on fluctuations in aggregate
demand. The more recent theory of real business cycles is introduced,
which focuses on fluctuations in potential output (i.e. is predominantly
supply orientated). Further supply-side issues are discussed with reference
to hysteresis and the long-term impacts of the recent financial crisis. The
increasing international synchronisation of business cycles is also described
in this block. Finally, some key areas of disagreement among economists as
well as the main schools of modern macroeconomics are described.
263
Phases of the business cycle

This section introduces the concept of the business cycle the fluctuation
of output around a notionally smooth upward trend in potential output.
The phases of the cycle are also spelled out. The output gap shows the
difference between actual output and potential output. Note that this gap
has already been an important part of the analysis of the macroeconomy
for several chapters. The section shows the cycle in real GDP for the UK
(although note that Figure 27.2 graphs the growth rate, not the level, of
real GDP). Semi-regular fluctuations are discernible although from the
mid to late-1990s until 200607 the extent of these fluctuations was much
smaller than in the past (and than what was to come!), which may have
encouraged the UK Chancellor of the Exchequer, and later Prime Minister,
Gordon Brown to boast that we have put an end to the damaging
cycle of boom and bust. Very few political remarks can have earned
more subsequent embarrassment. Cycles, of course, are not unique to the
UK and if you live elsewhere it would be instructive to look at a longish
time series of GDP growth such as that used in Figure 27.2 for your own
country. This section also introduces the notion of the political business
cycle but dismisses political manoeuvring as the primary source of
economic fluctuations, especially in the age of central bank independence.
Activity SG22.1
Draw a quick sketch showing an upward sloping smooth line for trend output and a wavy
line showing actual output mark the phases of the business cycle on the actual output
curve:
Theorising the business cycle

BVFD: read section 27.2 and Maths 27.1, as well as case 27.1.
Figure 27.2 in the previous section showed the strongly pro-cyclical
behaviour of labour productivity. Activity 27.1 discusses the related cyclical
behaviour of wages, describing the real-wage puzzle over the business
cycle. Be sure that you understand why this, initially at least, seems like a
puzzle and why it turns out not to be so when given further consideration
(in relation to the resolution of this puzzle recall the distinction in
microeconomics between movements along a demand curve and shifts
of the curve itself). The cyclical behaviour of wages and productivity are
264
important, but do not in themselves constitute a theory of why business

cycles occur. The textbook now moves on to this question.
One historically famous model that has been proposed to explain business
cycles is the multiplier-accelerator model (first formalised by US
economist Paul Samuelson as long ago as 1939 and later refined by,
among others, the British economist Sir John Hicks). While this model is
less central to the modern analysis of business cycles, it is still instructive
and emphasises the important role in determining economic outcomes
played by time lags and by the magnitude of crucial parameters. The
concept of the multiplier was introduced in Block 12 and refers to the
idea that a change in consumption or investment will have a multiplied
effect on output, since one persons spending is another persons income,
such that the money will flow around the economy multiple times,
increasing the total impact on output. The accelerator theory suggests that
growth of national income (or, in some variants of this model, growth of
consumption) determines the level of investment which in turn influences
future output. The interaction of the multiplier and the accelerator can
give rise to cycles in aggregate output. This section describes two versions
of this model, one in the main text, which focuses on how investment
responds to the lagged change in output, and one in the maths box, where
the model includes consumption.
Regarding the first version of the model, investment can be divided
into autonomous and induced investment. Autonomous investment is
independent of national income. Although the textbook does not name
this explicitly and only describes it for period 1, Table 27.1 works on the
basis that autonomous investment is equal to 10 units in each period. This
has been made more explicit in the table below.
Why does investment remain at 20 in period four even though output
increased by 20 units from period two to period three? Here it is important
to note that changes in investment depend on the rate of output change
not only growth in output, but accelerated growth in output. Since the
growth in output was the same between period 2 and period 3 as between
period 1 and period 2 (20 units in each case), investment increased in
period 3, but didnt increase further in period 4. Therefore output also
remains stable in period 4, since it will only increase if there is a positive
change in investment from the previous to the current period.
Read through this section carefully, working through each step by checking
the figures in the table.
Period Change in
Autonomous
last periods investment
output
IAt
(Yt1 Yt2)
Induced investment Total

Change in
investment
investment
Iit =(Yt1 Yt2)*(1/2)
IAt + Iit = It I = It It1
Output
t=1
10
10
100
t=2
10
10
120
t=3
20
10
10
20
10
140
t=4
20
10
10
20
140
t=5
10
10
-10
120
t=6
20
10
10
-10
100
t=7
20
10
10
100
t=8
10
10
10
120
t=9
20
10
10
20
10
140
Yt = Yt1 + 2*I
265
Activity SG22.2
The table below is based on Maths box 27.1 and includes consumption as a further
element of the system. Use the formulas provided for each column, assuming a = 5/4 and
c = 2/3, to complete the table (do calculations to the nearest whole number). Assume
that Y = 0 prior to period 1 (hint: this makes investment = 38 in period 2). This example
shows how the multiplier-accelerator interaction can produce cycles. In other respects, the
actual numbers are somewhat unrealistic. Think about why this is.
Period (1)
Autonomous
Consumption (2)
Induced
Induced
Consumption (3) Investment (4)
Income /Output
(5) = (2 +3 + 4)
A = 30
cY1,
I = a (Y1 Y2), Y = C + I
30
10
11
12
Figure 22.1 describes how ceilings and floors in aggregate supply and
investment can generate cycles. The various components of the figure can
be explained as follows: The equilibrium path of outcome is EE, around
which actual output fluctuates. FF is the floor line whilst CC is the ceiling.
VW is an expansion phase. The slow-down in growth from VW to WX leads
to a fall in induced investment and results in the downturn at point X.
XY is the recession/contraction phase. Investment is declining.
Once the fall in output slows down, this will lead to another turning point
at Z, followed by another increase in output in the new recovery phase.
Output
E
F
Y
V
Time
Figure 22.1: Ceilings and floors.
266
Business Cycle
Phase (6)
Activity SG22.3
In your own words, briefly summarise the discussion of how fluctuations in stockbuilding
and competitiveness can lead to business cycles.
Another theory of business cycles which is not discussed in this chapter
is Austrian business cycle theory, based largely on the work of
Friedrich Hayek, which proposes that business cycles are driven by
distortions in the availability of credit. For interested students, an article
which briefly explains this theory, and also provides a good overview of
some of the other theories discussed in this chapter, is available here:
www.economist.com/node/1336182 (optional).
Real business cycle theories

Real business cycle theories, although still controversial within the
economics profession because of their reliance on assumptions of fully
flexible prices and consequent market clearing even in the short run,
have provided a major challenge to traditional business cycle theory.
These theories argue that there is no reason why the trend path of
potential output must be smooth and that fluctuations in potential output
are a result of a variety of shocks. This class of theories highlights the
importance of the supply side it is not only about demand, but about the
rational decisions of both firms and households optimising their behaviour
over the long run in response to exogenous changes in the real economic
environment. Thus proponents of these theories argue that there is no role
for short-term demand management policies.
Activity SG22.4
Answer the following multiple choice questions on real business cycles:
1. Real business cycles are cycles in:
a. potential output
b. actual output
c. real output
d. international trade.
2. Real business cycle theorists argue that can explain short- and longterm fluctuations in output:
a. imperfect labour markets
b. rational expectations
c. intertemporal decisions of households, firms and governments
d. variations in mood, caused for example by the weather.
3. Real business cycle theories suggest that there is to correct
departures from the optimal growth path:
a. a role for fiscal policy
b. a role for monetary policy
c. a role for supply-side policies
d. no case for stabilising output over the business cycle.
267
Section 27.4 provides further reasons, in addition to those propounded

by real business cycle theorists, for paying serious attention to supply
side issues when analysing cyclical fluctuations. These include hysteresis
(revise your understanding of the mechanisms by which recessions can
have long lasting scarring effects, in practice affecting equilibrium output
and its growth) and the repercussions of credit constraints on supply.
Business cycle synchronisation

Since the 1990s, countries around the world have experienced an upward
trend in international synchronisation of business cycles, especially in the
euro area, Asia and Latin America. Within Asia, business cycles appear to
be particularly synchronised among the ASEAN-5 economies, including
Indonesia, Malaysia, the Philippines, Singapore and Thailand (Duval et
al., 2014).1 Research suggests that deeper trade and financial integration
can have strong positive effects on the synchronisation of business cycles
between trading partners (e.g. Goggin and Siedschlag, 2009, on Ireland
and its major trading partners in the EU).2 Business cycle synchronisation
appears to be much higher in times of crisis, largely due to effects of trade
this means that trade links can act to propagate crises internationally
(Duval et al., 2014).
Schools of macroeconomic thought

BVFD: read section 27.6. Please refrain from reading Table 27.2 as this
will be used as a model answer for Activity SG22.5 below.
This section briefly but informatively summarises some areas of
disagreement between macroeconomists and the major schools of modern
macroeconomic thought. In some textbooks this section could appear as
a separate chapter, rather than as a sub-section of a chapter on business
cycles, because the differences between schools do not just relate to cycles
but more generally to how the economy operates, its long- and short-run
equilibria and the role for economic policy.
268
1
Duval, M.R.A., M.K.C.
Cheng, K.H. Oh, R. Saraf
and M.D. Seneviratne
Trade integration
and business cycle
synchronization: a
reappraisal with focus
on Asia (No. 14-52),
(International Monetary
Fund, 2014).
2
Goggin, J. and I.
Siedschlag International
transmission of business
cycles between Ireland
and its trading partners.
(No. 279). ESRI (The
Economic and Social
Research Institute,
Dublin, 2009) working
paper.
Activity SG22.5
To help you work through this material, summarise it by filling out the table below. Then check your responses by comparing it to the
summary table the authors have created (Table 27.2).
Schools of Modern Macroeconomic Thought
New Classical
Gradual Monetarist
Moderate Keynesians Extreme Keynesians
Market
clearing
Issues
Unique
long-run
equilibrium?
Expectations
formation
Short run
and long run
Policy
Implications
269
Overview
This block firstly defines business cycles as fluctuations in output around
the long-run trend path of output. Data on output clearly demonstrate the
existence of business cycles, which tend to last around five years. Secondly,
various possible causes of business cycles are discussed, including
political opportunism, the interaction between consumption, investment
and previous output, as described by the multiplier-accelerator model,
fluctuations in stockbuilding, and reactions to shocks under fixed exchange
rates. Some economists argue that potential output also fluctuates; this
is described by real business cycle theory, which argues that fluctuations
in potential output are the result of peoples rational, efficient reactions
to shocks in the real economy, especially productivity shocks. Although
most counter-cyclical policies are demand focused, aggregate demand
and aggregate supply both contribute to the business cycle. If a demand
shock has a long-term impact on output and aggregate supply, such that a
short-run shock impacts the long-run path of the economy, this is known as
hysteresis. The increasing integration of world markets, including financial
markets, has led to movements in output becoming increasingly linked to
output fluctuations worldwide. Synchronisation of business cycles between
countries has increased over the previous few decades, especially between
countries which are trading partners. This block concludes with an
overview of the main schools of modern macroeconomic thought. The key
points on which they differ are the speed with which markets (especially
the labour market) clear, how expectations are formed, the possibility of
hysteresis, and the relative importance of the short run and long run.


1. The accelerator assumes:
a. the marginal propensity to consume is constant
b. the economy is at full employment
c. there is a constant relationship between net investment and the
rate of change of output
d. the rate of growth of output continues in increase over time.
2. Investment depends mainly on:
a. past levels of income
b. future expected profits
c. present national income levels
d. historic data.
3. If an increase in investment leads to a bigger increase in national
income, this is the:
a. accelerator
b. aggregate demand
270
c. real business cycle

d. multiplier.
4. The impossibility of negative gross investment provides a
to fluctuations in
a. ceiling; stockbuilding
b. ceiling; capital prices
c. floor; output
d. floor; the capital-output ratio.

a. The diagram below shows the world GDP growth rate from 1980 to
2015. Label the diagram to show the different phases of a business
cycle (this will be quite approximate what is important is to show the
key phases).
5%
4%
3%
World
2%
1%
0%
-1%
-2%
1980 1982
1984
1986
1988
1990 1992
1994
1996
1998
2000
2002
2004
2006 2008
2010
2012 2014
GDP Growth Rate (World)

Source: www.google.com/publicdata/explore?ds=d5bncppjof8f9_
b. Describe at least two possible reasons for the pattern of actual output
you have depicted.
c. Potential output is often depicted as a smooth, gently rising line.
However, it does not necessarily need to increase smoothly over time.
What might explain fluctuations in potential output?
271
Notes
272
Block 23: Supply-side economics and economic growth
Block 23: Supply-side economics and

economic growth
Introduction
Having built up a model of the macroeconomy over several blocks and
analysed short-term fluctuations in aggregate output, this block now takes
a long-term perspective. Starting with supply-side economics, which has
to do with the economys productive potential, the block moves on to
discuss historical trends of long-term growth in various countries as well
as models which have been proposed to explain these trends. The two key
models presented in this block are the Solow model including population
growth, depreciation and technical progress; and the Romer model of
endogenous growth. The material in this block takes the analysis of these
two models somewhat beyond the coverage in our textbook. Work through
the material carefully the equations, the graphical representations, and
the explanations so you gain a robust understanding of these models.
You are also encouraged to do some research for your own country to find
out what the long-term rate of growth has been, specific factors driving
or hindering growth in different periods, and how this fits into the world
economy as well as the models seeking to explain long-run growth.
Learning outcomes
explain supply-side economics
discuss growth in potential output
describe Malthus forecast of eventual starvation and how technical
progress and capital accumulation made this forecast wrong
describe the Solow model of economic growth
explain the convergence hypothesis
analyse the growth performance of rich and poor countries
discuss endogenous growth and the potential impact of policy on
growth
discuss the implications of growth for environmental sustainability.
Essential reading
Further reading
Lipsey and Chrystal (L&C), international edition, Chapter 23; UK edition,
Chapter 26.

This block discusses supply-side economics and long-run economic growth.
Data on growth rates from a variety of countries over different periods
are presented. Although many factors contribute to countries growth
rates, the basic inputs are land, raw materials, labour, human capital and
physical capital. The way these inputs are combined through technology
273
also has a huge impact, and technological progress is identified as the

key factor facilitating permanent growth in output per worker. This block
introduces models seeking to explain economic growth, notably the Solow
growth model and the Romer model of endogenous growth. Furthermore,
limitations in the measurement of economic growth and the costs of
growth itself are also discussed.
Supply-side economics
While the main focus of this block is on economic growth (i.e. sustained
increases in economic well-being, the chapter begins with a discussion
of factors that can lead to one-off changes in output. Analytically, these
can be characterised as increases in any of the inputs in the economys
aggregate production function (see BVFD section 28.3) or anything that
makes a given level of these inputs more productive.
Economic growth can be represented very simply as an outward shift in a
countrys PPF. The frontier is determined by the quantity and productivity
of a countrys resources (land, labour, capital and raw materials), and an
increase in either will lead to an expansion in the countrys production
possibilities.
Output of
good A
Output of good B
Figure 23.1: PPF before and after economic growth.
Section 28.1 discusses supply-side policies in regards to labour input1 and

labour productivity. More broadly, supply-side policy includes any policy
that improves an economys productive potential, with the aim of shifting
the LRAS curve to the right. Supply side policies include low marginal tax
rates, competition policy, privatisation of state industries, and reducing
unnecessary red tape and bureaucracy. Generally, supply-side policies aim
to increase flexibility in product or labour markets, remove distortions to
incentives, improve the quantity and quality of labour, and increase an
economys competitiveness.
Below is an extract from a speech on the role of supply side policies by
Jean-Claude Trichet, the President of the European Central Bank, in 20042:
The supply side of an economy is responsible for mobilising resources
to supply goods and services, entailing as a crucial part the supply of
labour and capital. The supply side thus contributes to determining
the economys potential growth path and the real income
274
1
The textbook
discussion on increasing
labour input implicitly
holds population
constant, but of course
increases in population
can increase labour
input and total output
as well. The effect of
population growth on
per capita output is, of
course, another matter,
as we discuss below.
2
www.ecb.europa.eu/
press/key/date/2004/
html/sp040622_1.
en.html

of its citizens. Any malfunctioning of the economys supply
side is thus tantamount to leaving opportunities for raising
the welfare of its citizens non-exploited. In this regard, the
best economic measure for raising income opportunities is the
implementation of policies, which help the supply side operate
flexibly and efficiently. These policies include, among many
others, education, research and development. For the euro area,
the focus is increasingly shifting to how lasting impediments to
the functioning of these policies can be removed with the help
of structural reforms. Such well-designed structural reforms
increase the mobility of production factors towards their
most efficient use, thus raising factor productivity, opening up
additional employment opportunities and allowing for lower
prices of goods and services. By exploiting the opportunities of
such a more efficient allocation of production factors, welldesigned structural reforms allow the economy to reach a
higher sustainable long-run growth path, higher employment,
higher real incomes and thus a higher level of welfare.
As noted in BVFD, however, effective supply-side policies are difficult to

implement and often have dramatic consequences for equality and
redistribution. Various policies have been more or less successful in
different contexts, BVFD arguing that such policies are most likely to
succeed in countries where free markets can operate with minimum
regulation at the one extreme or centrally planned economies at the other.
The pressure for structural reforms, often requiring substantial
deregulation, in relatively highly regulated continental EU countries may
offer some tentative support for this broad hypothesis.
Activity SG23.1
Do some research to find out if the current government in your country is pursuing active
supply-side policies and provide some examples of these.
Economic growth
The remainder of this chapter considers economic growth over the longterm. Anything that affects the long-run rate of economic growth by even a
very small amount makes a vast difference to potential output after a few
decades. For example, a difference in annual growth rates of just half a per
cent leads to huge differences in living standards after 25 or 50 years.
annual growth
rate of income
per capita
increase in standard of living
10 years
25 years
50 years
100 years
3.00%
34%
109%
338%
1822%
3.50%
41%
136%
458%
3019%
Source: own calculations based on Mankiw (Macroeconimics, 8th edition, 2012)
This section also discusses the limitations of using GDP or GNP as

measures of economic growth, as they do not include certain important
factors such as leisure, new products or pollution. Another missing
component is production in the informal economy, such as housework.
275
Some alternative measures which have been suggested include the UN

Human Development Index,3 the Index of Sustainable Economic Welfare,
an environmentally-adjusted Green GDP measure used for a time by
China and the Genuine Progress Indicator (GPI). Such measures are
increasingly being referred to by governments seeking to increase their
countries well-being rather than simply average output.
3
For an interesting
discussion of this see the
Harvard Business Review
article The Economics
of Well-Being at https://
hbr.org/2012/01/theeconomics-of-well-being
Inputs to production
BVFD: read sections 28.3 and 28.4 as well as case 28.1.
These two sections describe the inputs to production and provide
information that will be very useful in understanding the models of
economic growth introduced towards the end of the chapter. Section 28.3
can be summarised in a production function as follows:
Y = f(Capital, Labour, Human Capital, Land, Raw Materials)
The amount of output that the available factors of production can
produce depends not only on the amount of each factor, but also on scale
economies and the way that the factors of production are combined, for
example, higher human capital may lead to higher output directly and also
through increasing the productivity of capital.
Adding technical knowledge to this, as per section 28.4, can be expressed in
the following production function, where A represents technical progress.
Y =A*f(Capital, Labour, Human Capital, Land, Raw Materials)
This section emphasises the importance of investment to drive invention
and innovation. Much technical progress is the result of activities by profitseeking firms. To encourage this, governments provide protection for their
ideas in the form of patents. Furthermore, governments also subsidise
research and development for example in universities.
Solow growth model

This section discusses how capital accumulation is important for
sustained economic growth. In particular, the second part of section 28.5
introduces the Solow growth model,4 one of the most used models
in all of macroeconomics, which provides major insights into some of
the mechanisms at work in the growth process. Although the textbook
describes this model (in particular in the two diagrams 28.3 and 28.4 and
Maths 28.1), it is laid out in more detail below. This should help to make
the exposition clearer so you can gain a thorough understanding of this
important model.
The Solow model starts with a simplified production function including
just capital (K) and labour (L). Labour can be defined to include human
capital; for simplicity, no distinction is made between the total population
and the labour force; also for simplicitys sake, land (including raw
materials) is considered as fixed and is not included.
Y =A f(K,L)
As stated above A can be thought of as a representing technology and
changes in A as representing technical progress; higher A makes both
labour and capital more productive (A is sometimes said to represent
total factor productivity).
276
4
This model was initially
developed in the mid1950s by the American
economist Robert Solow,
working at MIT. Solow
received the Nobel Prize
in Economics in 1987
for his contribution to
growth theory.
Two key assumptions of this model are that there are constant returns to
scale (CRS), and diminishing marginal productivity of capital (MPK).
CRS enable us to write the production function in the per worker version:
K
Y
= Af ( ,1)
L
L
(we have multiplied K and L by 1/L. CRS then means Y is also multiplied
by 1/L). Ignoring the constant 1 and writing y and k for output and capital
in per worker terms:
y = AF (k)
This is illustrated in Figure 28.3 of BVFD the green line shows the path
of income against capital per worker, and is concave downward because of
the decreasing MPK. Adding more capital per worker, k, increases output
per worker, y, but with diminishing returns. A slightly fuller version of that
diagram is presented here as Figure 23.1. This enables us to analyse the
Solow model in a bit more detail. The per worker production function is
represented by the curve labelled y. This production function represents
the supply side of the model.
The demand side is represented very simply by the equation Y = C + I
which you should be very familiar from the closed economy macro models
in earlier blocks. Assume a constant marginal (and average) propensity to
save of s. Dividing through by L again we have:
y = (1-s)y + i
or: i = sy = sF(k)
(savings equals investment in a closed economy). This investment
schedule is also shown in Figure 23.2 and by the orange line in BVFD
Figure 28.3. The dotted line from k* up to the green line represents output
at that level of capital per worker. This can be divided into investment
(below point E) and consumption (above point E).
This is the basic model. It is very simple. The production function
determines the economys output and the consumption function
determines how this output is divided between consumption and
investment. There is one additional feature which is important; the Solow
model makes the growth of the economys capital stock endogenous to the
model. Investment increases the capital stock, while depreciation of capital
reduces it. Let per cent of the capital stock wear out each year ( is the
depreciation rate). Thus:
K = I K
Dividing through by L, this can be written in per-worker terms:
K = i K = sy K = sF(k) K
(This is equivalent to equation (1) in Maths 28.1).5
For the capital stock to be constant we require k = 0, i.e. i = K . If L is
not constant, but is growing (due to population growth or immigration) at
a constant rate n, then in order to keep the capital per worker constant not
only does worn out capital have to be replaced but additional investment
is required to provide capital for the new workers resulting from
population growth; so now for k = 0 we require:
Note: k (used above)

denotes the change
in capital between
two periods, such as
two months or two
years, while k (used in
Maths 28.1) denotes
the continuous rate of
change in capital.
5
i = ( + n)k
In Figure 23.2 this is shown by the straight line with slope ( + n). The
( + n)k line is not related to output, it simply depicts the amount of
investment that is required for capital per worker to remain constant when
there is population growth and depreciation; in this sense, one can think
277
of this as break-even investment. To check your understanding, illustrate

the effects of an increase in n in the Solow diagram and explain the result.
Having put the elements of the model in place, we can look at its longterm equilibrium and what happens when the economy is not at the
equilibrium. Suppose the economy is at k1 in Figure 23.2. Investment is
greater than needed to offset depreciation plus population growth, so the
capital stock (per worker) increases. It will go on increasing until I = ( +
n)k (i.e. until new investment exactly offsets depreciation and population
growth). Of course as k increases, so does y (via the production function).
Therefore, knowing the steady state level of capital per worker, k*, also
gives us income and consumption per worker. In Figure 28.3, income per
worker is given by the point where the dotted line rising vertically from
k* meets the green output line and is indicated on the diagram as y*.
Consumption per worker is the gap between income and savings (i.e. the
distance between the green and orange lines at k*).
When I = ( +n)k the capital stock per worker does not change, nor does
output per worker. We call these steady state levels of capital and output
per worker k*, y* respectively. To make sure you understand how the
economy always moves to the steady state trace out what happens when
k > k*.
So, in spite of its name, the long-run equilibrium in the Solow growth
model is characterised by constant output per worker and capital per
worker (with n = 0 the steady state levels of Y and K, not just per worker,
will also be constant). Growth occurs in the transition to the steady state
(or to a new steady state if something previously held constant changes).6
( + n)k
y, , i
y
y*
i = sy
consumption
net investment
depreciation
k1
k*
Figure 23.2: The Solow model.
Shifts in the parameters will shift the relevant lines and lead to a different
steady-state rate of capital per person. The savings rate plays an
important role in the Solow model, but it is important to understand
the exact nature of this role. For a given production function, a higher
propensity to save results in higher k* and y*. As can be seen in BVFD
Figure 28.4, a higher savings rate s shifts the savings/investment line
upwards (but not the y curve). This leads to a higher steady state level
of capital per worker and a higher output per worker. On the other hand,
a higher rate of population growth or depreciation will shift the break278
6
We dont prove it here,
but an important aspect
of transition dynamics
is that the further
below its steady state
output an economy is
the more rapidly it will
grow (towards it). An
analogous result applies
if y > y*
even investment line upwards, leading to a lower steady state capital per
worker and lower output per worker. Thus the Solow model predicts that
countries with high savings rates and low rates of population growth will
tend to have higher per capita income. To some extent, this is empirically
corroborated.
Activity SG23.2
In a model without technical progress, use a graph to demonstrate how an increase in the
rate of population growth can lead to changes in the long-run level of per capita output.
Will this affect the long-run per capita growth rate?
Technical progress
Although it provides some useful insights, the basic model discussed in the
previous section predicts that the rate of per person output growth tends
to zero (i.e. at the steady state, growth in per capita output is zero). Since
that is not what is observed in practice, the Solow model is now extended
to include technical progress specifically, labour augmenting technical
progress. This is key to explaining long-run growth and the improvement
in living standards over generations.
Let us explain more clearly what is meant by labour augmenting technical
progress. Consider the labour input to the production function. We have
written this as L where L is the number of workers. In practice, however,
we are concerned not just with the number of workers but with their
productivity. So we can think of the labour input as being the product
L E (henceforth LE), where E is efficiency per unit of labour. So LE is
units of effective labour (worker-equivalents in BVFD), not just a head
count of workers. Now suppose that due to technical progress E is growing
at a rate t. Hold L constant to keep things simple. Effective labour is
growing at the rate of technical progress, t. If we were to redefine y, and
k as output and capital per unit of effective labour then the steady state
equilibrium would have constant y* (Y*/LE) and k* (K*/LE). For the
capital stock per effective worker to be constant, investment is needed
not just to cover depreciation and population growth but to supply the
extra units of effective labour with capital to work with failure to do this
would result in reductions in capital per unit of effective labour. Note now
that if (Y*/LE) is constant, then with L constant and E growing at a rate
t, Y* and Y*/L must also be growing at a rate t. With technical progress,
the Solow model can produce long-run growth in per capita output. If
we drop the assumption that population and the workforce are constant,
output per worker still grows at t, but total output, Y, in the steady state
grows at t+n.
This extended model is depicted in BVFD Figure 28.5 (for the case where
= 0). The two differences to 28.3 are that the break-even investment
line has the slope (t+n)k, and that all variables are now measured per
unit of effective labour or per worker-equivalent, not per worker. Since
the technological progress was assumed to be labour augmenting, labour
productivity has increased. Investment at the rate (t + n)k now ensures
that steady state capital per worker-equivalent, and hence output per
worker-equivalent, are constant. Since worker-equivalents grow at rate
t+n and workers grow at rate n (which is slower since t is a positive
number), output per worker and capital per worker are increasing at rate
t. With technical progress, there is a steady state level for output and
279
capital per worker-equivalent, but output and capital per worker continue
to grow at a positive rate over time.
Thus the Solow model provides good insights into factors leading to
high levels of output per capita (high saving rate (s), high total factor
productivity (A), low depreciation ()). Growth or decline will occur due
to transition dynamics when something shocks the economy away from
its steady state. The model is less successful at explaining long run growth
in per capita output (income), but exogenous technical progress can
generate such growth. However, as BVFD point out, the fact that there is no
examination of where technical progress comes from it is simply assumed
is unsatisfactory. This shortcoming is what modern endogenous growth
theory attempts to rectify, but before turning to that section 28.7 of the text
provides some more empirical background on economic growth.
OECD and growth

BVFD: read section 28.7 and case 28.2 and complete activity 28.1
Looking at economic growth for different countries over time shows
complex patterns. There is no single, overarching path that every country
takes and can be easily described and predicted. Context matters. That is
why this section and case 28.2, although interesting, may seem somewhat
inconclusive the OECD countries have experienced episodes of faster
and slower growth, depending on an array of factors, and the convergence
hypothesis has both examples which support it and examples which lead
many to question it. Some commentators would also question whether
the post-1973 slowdown in productivity growth really is a cyclical short
run phenomenon as BVFD argue or whether it represents a more seismic
change. There are many unanswered questions in this still developing
field. Nonetheless, the models that have been proposed and the improved
data that have been becoming more available have provided insights
into important factors behind the growth (or stagnation) of countries at
different times. Some of the factors mentioned in this section and the case
box include: historical levels of capital and output; growth in inputs
labour, capital and human capital; productivity growth; technical progress;
the spread of technology; trade openness; absence of internal strife; a
countrys social and political framework; and supply shocks. Some of these
lie outside the sphere of influence of a domestic government, while others
can be influenced by social movements and policy decisions.
Activity 28.1 should be a good guide to whether you have properly
understood the Solow model.
Activity SG23.3
MCQ: Convergence implies that:
a. Rich nations will grow faster than poor nations.
b. The rich will get richer and the poor will get poorer.
c. The rich will get poorer and the poor will get richer.
d. Poor nations will grow faster than rich nations.
280
Romers model of endogenous growth

This section on endogenous growth introduces Romers7 model, which is
sometimes known as the AK model.
Up to now we have used a general form of a production function: Y = A *
f(K,L). The most commonly used production function is the Cobb-Douglas
production function which is given by:
Y = AK L1.
This generally indicates diminishing marginal returns to increases in
the capital stock since is assumed to be less than 1. By contrast, the
endogenous growth model proposed by Paul Romer does not assume
diminishing returns to capital, but rather constant returns to capital. That
means that is set to equal 1, which leads to the simple relationship
Y = AK
A quick glance at
Romers classic paper
(Endogenous technical
change, Journal of
Political Economy 98,
October 1990) will
show that the treatment
here and in BVFD is
drastically simplified,
so much so that it is
something a travesty
to call this the Romer
model, although it does
convey the essence of
Romers innovation.
7
where output is proportional to capital. A represents technology as before

and can be held constant in very basic endogenous growth models. One
could proceed on a per worker basis as before but most expositions of
this model do not do so in the first instance. We do, however, include
depreciation, as in the Solow model. Thus, as in the Solow model:
K = sY K
Dividing by K and using the production function8:
8 K
in the following
K
equation is the same as
g in BVFD.
K = sA
K
But, from the production function (given A)
K
K
Y
Y
, so:
Y = sA
Y
Therefore, in this model, provided that sA = we have continuous
economic growth9 resulting from saving and investment, without having
to resort to exogenous technical change, as in the Solow model. Here the
savings propensity, s, (and A as well) affect the rate of growth of output,
not just its steady state level. Note that s and A are both, in principle,
amenable to manipulation by government policy. By contrast, in the Solow
model, we saw that the steady-state rate of capital growth is (+n),
which is exogenously determined, leaving no scope for government policy
to impact on growth rates in the long run. Only exogenous technical
change leads to increased living standards in the Solow model. In the
Romer model a one-off increase in either s or A leads to a permanent
increase in economic growth.
9
If the rate of growth
of the capital stock
(and hence income)
is sufficient to offset
population growth as
well as depreciation
there will be continuous
growth in per capita
incomes as well.
All this comes about by changing the production function from having
diminishing marginal returns to capital to having constant marginal
returns to capital (MPK = A in the Romer model). What is the intuition
behind this change and is it a reasonable one? If K includes ideas and
knowledge (instructions, recipes, management techniques) as well as
objects (machines, buildings, workers, etc.) then it may well be reasonable
that K doesnt run into diminishing returns. This is partly due to the public
goods nature of ideas they are non-rival (although sometimes excludable
by patents and the like recall the discussion of public goods in Block
12). If one firm uses a given technique to produce an industrial product,
or a formula to produce a medical drug, that technique, that formula,
is not used up it is available for other firms to use also. If one firm
281
introduces just-in-time inventory control that technique is still available

to other firms. One simple characterisation of constant marginal product
of K is that as countries become richer and increase physical capital they
simultaneously increase investment in human capital; the increase in the
ideas component of K offsetting any tendency to diminishing marginal
returns in the objects component of K.
Costs of growth
Growth in output and consumption is often associated with resource
depletion and environmental problems. Below is a link to a BBC
short video on Jose Mujica, the former President of Uruguay, who
has a distinctive perspective on the pursuit of continually increasing
consumption. Known as the worlds poorest president, he instead argues:
poor people are those who always want more and more, who never have
enough of anything: www.bbc.com/news/magazine-20243493
Overview
This block starts by discussing supply-side economics. Supply-side policies
aim to improve an economys productive potential. Higher labour input
and increases in labour productivity are important elements of supply-side
economics as are increased flexibility in product or labour markets and
improved competitiveness. Although policies which boost aggregate supply
are desirable, in practice this may be difficult to achieve.
Secondly, this block examines long-term economic growth. Economic
growth is most commonly measured by real GDP or real GDP per capita,
though this measure has weaknesses and other alternative measures are
being referred to more frequently. Even small annual changes in economic
growth can lead to huge changes in living standards in the long term.
Potential output can be increased either by increasing the inputs of land,
labour, capital and raw materials, or by increasing the output obtained
from given input quantities. Technical advances are an important source
of productivity gains, and can be fostered for example through subsidised
research in universities and the provision of patents for companies that
make new discoveries.
The simplest theory of growth, as characterised in the Solow growth
model, has a steady state in which capital, output and labour all grow at
the same rate. Whatever its initial level of capital, the economy converges
on this steady state path. This theory can explain output growth but not
growth in output per worker (productivity growth). Labour augmenting
technical progress allows permanent growth of labour productivity.
Convergence theory argues that countries will converge, both because
capital deepening is easier when capital per worker is lower and because
of catch-up in technology. There have been several examples of this in
recent decades, where developing countries have grown much faster
than developed countries, though not all countries fit into this pattern.
Institutional frameworks impact on the adoption of new technology, which
strongly influences growth rates.
Theories of endogenous growth are built on the assumption of constant
returns to capital. If this assumption holds, the long-run growth rate of
productivity can be influenced by choices about saving and investment,
282
providing incentives for government to support investments in education,

training, physical capital and innovation.
Although economic growth is associated with improved living standards,
it doesnt necessarily measure happiness. Furthermore, continual increases
in output and consumption today have severe consequences for the
environment and for future generations.


1.
Saving, output and break even investment per worker
Break even investment (n + )k

F
Output y = f(k)
Savings f(k)
E
B
C
k1
k2
k3
Capital per worker
The figure above represents an economy with unchanging technology.

Assume that output only has two uses: consumption and investment.
According to this diagram, in the steady state, consumption per worker
is represented by the length of the segment:
a. D-k2
b. D-E
c. F-k3
d. F-G.
2. According to the Solow model, in an economy with a population
growth rate of n, a depreciation rate of , and where the rate of
technical progress is t, in the steady state of this model, output per
unit of labour will grow at the rate:
a. t
b. n+ t
c. n + t-
d. will grow at the rate n + t +
283
3. Capital widening refers to that part of investment needed to:

a. increase the per capita capital-labour ratio
b. replace capital that has depreciated
c. equip new units of labour at the same capital-labour ratio
d. do all of the above.
4. Real GDP tends to understate income in developing economies by
a. underestimating saving
b. ignoring government deficit spending
c. omitting non-market transactions
d. all of the above.

Starting with two production functions, show the difference between the
key assumptions of the Solow model with technical progress and Romers
model of endogenous growth. What is the long-run growth rate of per
worker output implied by each model and what are the implications of this
for government?
284
Appendix 1: Syllabus
Appendix 1: Syllabus
This is a description of the material to be examined, as published in the
Regulations. On registration, students will receive a detailed subject guide
which provides a framework for covering the topics in the syllabus and
directions to the essential reading
Introduction
The Economic Problem: production possibility frontiers, opportunity
cost, the role of the market, positive and normative economics, theory and
models in economics.
Microeconomics
The Theory of Consumer Behaviour: rationality, utility, indifference
curves, utility maximisation, demand functions, substitution and income
effects, substitutes and complements, demand elasticity, consumer surplus
The Theory of the Firm: technology and production functions, returns
to scale, the law of diminishing marginal return, isoqants and isocost lines,
cost functions, profit maximisation, the distinction between the long and
the short run, fixed and variable costs, behaviour of the firm in the long
and in the short run, the firms supply function.
Markets: demand and supply, equilibrium, competitive industry (the
competitive firm, entry and exit, short-run and long-run equilibrium, some
comparative statistics), monopoly (the firm, monopoly and competitive
equilibrium compared), natural monopoly, monopolistic competition
(differentiated products, the firms behaviour, the role of entry), oligopoly
(interdependence, game theory, reaction functions)
Factors Market: demand and supply of labour (utility maximisation
and the supply of labour, profit maximisation and the demand for
labour), monopsony, factors affecting labour market equilibrium (unions,
immigration), returns to factors of production, economic rent, the income
distribution, the Gini coefficient and Lorenz curves..
Coordination and Welfare: General equilibrium, horizontal
and vertical equity, allocative and Pareto efficiency, market failures,
externalities, Coase theorem, government interventions, public goods,
incidence of a tax
Macroeconomics
Aggregation: the problem of aggregation, value added and the NNP=Y
identity, depreciation, the circular flow of income, real and nominal GDP
The Goods Market: actual and potential output, consumption,
investment, aggregate demand, income determination, equilibrium, the
multiplier, consumption and taxation, the government budget, automatic
stabilisers (the financing of government), aggregate demand and
equilibrium (IS), the multiplier and taxation, the role of fiscal policy, the
paradox of thrift, imports and exports, the multiplier in an open economy.
Money and Banking: the role of money, real balances, the liquidity
preference approach and the demand for money (liquid assets),
commercial banks and the supply of money (banks and the various
285
multipliers), central banks and monetary control, equilibrium in the money

market (LM).
General Equilibrium: the IS-LM model, monetary and fiscal policies in a
closed economy.
Prices, Inflation and the Phillips Curve: Keynesian and classical
assumptions regarding wages and prices, aggregate supply in the long-run
and the short-run, the effects of exogenous demand and supply shocks,
inflation targeting, the Taylor rule, the quantity theory of money, the
Phillips Curve in the long-run and the short-run, stagflation and the role of
expectations, costs of inflation
Unemployment: types of unemployment, voluntary and involuntary
unemployment, causes of unemployment, private and social costs, hysteresis
Exchange Rate Determination and the Money Sector: exchange
rate regimes, the balance of payments, the foreign currency market, capital
mobility, the rate of interest and the price of foreign currency, the effects of
fiscal and monetary policies under fixed and floating exchange rates with and
without capital mobility.
Economic Growth: growth in potential output, the steady state,
technological progress, capital accumulation, convergence, endogenous
growth, policies to promote growth
Business Cycles: trend path and business cycles, theories of the business
cycle, real business cycles
International Trade: absolute and comparative advantage, gains from
trade, tariffs.
286
Appendix 2: Outline of readings
Appendix 2: Outline of readings
Block
Title
Textbook chapter
Introduction
1
Economics, the economy and tools of economic

analysis
1, 2
Microeconomics
2
Demand, supply and the market
Elasticity
Consumer choice
The Firm I
6; 7.1, 7.2 and

7-appendix
The Firm II
7.3 7.9
Perfect competition
8.1 8.4
Pure monopoly
8.5 8.10
Market structure and imperfect competition
10
Inputs to production: the labour market
10
11
Welfare economics
13
12
The role of government
14; 11.9
Macroeconomics
13
Introduction to macroeconomics
15
14
Aggregate demand
16, 17
15
Money and banking
18, 19
16
Monetary and fiscal policy
20
17
Aggregate demand and aggregate supply
21
18
Inflation
22
19
Unemployment
23
20
Exchange rates and the balance of payments
24
21
Open economy macroeconomics
25
22
Business cycles
27
23
Supply side economics and economic growth
28
287

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Introduction to economics

O. Birchall assisted by D. Verry

University of London International Programmes

EC1002 Introduction to economics

Block 4: Consumer choice...................................................................................... 47

EC1002 Introduction to economics

The multiplier............................................................................................................. 173

Reminder of learning outcomes.................................................................................. 238

EC1002 Introduction to economics

Aims of the course

EC1002 Introduction to economics

Overview of learning resources

The two supplementary textbooks below can be used to extend your

The material contained in the two supplementary textbooks (where it

How to use the subject guide

Online study resources (VLE, Online Library)

EC1002 Introduction to economics

Videos: Recorded academic introductions to many subjects;

Answers on the VLE

Making use of the Online Library

Route map to the guide

6; 7.1, 7.2 and

Introduction: The economic problem, production possibility frontiers,

Demand, supply and the market: demand, supply, demand functions,

Elasticity: price elasticity of demand, cross-price elasticity of demand, income

Consumer choice: rationality, utility, indifference curves, the budget

Perfect competition: competitive industry, the competitive firm, entry and

Pure monopoly: monopoly, price discrimination, natural monopoly,

Market structure and imperfect competition: monopolistic competition

Inputs to production: the labour market: the factors of production,

Welfare economics: general equilibrium, horizontal and vertical equity,

The role of government: government interventions, public goods, taxation;

EC1002 Introduction to economics

Introduction to macroeconomics: the problem of aggregation, the

Aggregate demand: actual and potential output, consumption, investment,

Monetary and fiscal policy: aggregate demand and equilibrium (IS),

Aggregate demand and aggregate supply: Keynesian and classical

Unemployment: types of unemployment, voluntary and involuntary

Exchange rates and the balance of payments: the foreign currency

Open economy macroeconomics: the effects of fiscal and monetary policies

Supply-side economics and economic growth: growth in potential

EC1002 Introduction to economics

Part II, Section A

Block 1: Economics, the economy and tools of economic analysis

Block 1: Economics, the economy and

Cowell, Frank and

EC1002 Introduction to economics

Economics and the real world

Block 1: Economics, the economy and tools of economic analysis

Synopsis of this block

EC1002 Introduction to economics

Block 1: Economics, the economy and tools of economic analysis

The production possibility frontier (PPF)

The PPF: scarcity and desirability

EC1002 Introduction to economics

The PPF and efficiency

The PPF and opportunity cost

The shape of the PPF and marginal analysis

Block 1: Economics, the economy and tools of economic analysis

Opportunity cost and absolute and comparative

EC1002 Introduction to economics

To cement your understanding of comparative advantage, complete the

10 labour hrs/unit of output

a. Which country has an absolute advantage in shoes? In hats?