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Economics
Theme 1: Markets and Market Failure
Key terms:
Ceteris paribus - All things being equal; the assumption that whilst the effects of a change in one
variable are being investigated, all other variables remain unchanged
Normative statement - A statement that carries value judgement, so cannot be supported or
rejected
Positive statement - An objective statement that can be supported or rejected by referring to
available evidence
Base period - the period (e
...
a year) with which all other values in a series are compared
Index number - An indication showing the relative value of one number to the base, which has a
numerical value of 100
Nominal value - Values unadjusted to the effects of inflation
Real value - Values adjusted to the effects of inflation
The basic economic problem is that wants our infinite but resources are scarce, so resources
need to be allocated between competing uses
...

Types of economic resources:
- Capital: a factor of production; stock of manufactured goods used in the production of other
goods and services
...
The reward is rent
- Labour: a factor of production; the human input into the production process
...
g
...
This is known
as the division of labour when an individual specialises
...

In the long run, firms can achieve economies of scale as their output increases despite using the
same level of resources
...

Workers can do jobs that are best suited to their skills set, and due to the lower amount of training
required, costs for the firm may be reduced
...

The size of a market determines whether specialisation is possible
...
The economy will not be self-sufficient if they only specialise in a select few
industries, creating a lack of flexibility
...
g
...
They can be used to
illustrate opportunity costs through marginal analysis
...
By producing more of one good, there is a trade off for the other good
...


Inward shifts in the PPF curve show a decline in the economy, whereas an outward shift shows
economic growth, because the number of available resources increase and thus so does
productive potential
...
An inward shift may be caused by a
natural disaster, causing a shrink in the size of the economy
...
Points beyond the
curve are unobtainable
...

Types of economies:
Within an economic system there is a complex network of individuals (workers and consumers),
organisations and institutions, as well as government all of which interrelate to allocate resources
...
The interactions
between supply and demand determine where resources are allocated and at what price
...
There is also increased risk to civilians (e
...
they are more at risk of having fewer
provisions like health care)
- Planned economy: Resources are owned and allocated by the government
...
However, income and wealth tends to be more evenly
distributed
- Mixed economy: More resources are allocated through government planning, but resources are
owned and allocated by the market mechanism as well
...
They will make decisions to maximise their net
benefits
...


Consumers will maximise economic welfare and utility
...
g
...
)
- Firms aim to maximise profits
- Governments should aim to achieve macroeconomic objectives and improve the welfare of
citizens, however corrupt governments may act in their own interests
...

They may not act rationally because of;
- Habitual behaviour
- The influence of other people (i
...
they may not act as an individual due to social norms)
- Consumer weakness at computation (calculating which good has the greater marginal utility, etc)
Demand is the quantity buyers are willing and able to buy at an agreed price in a given period of
time
...

There is a negative relationship between quantity demanded and price
...


As price increases there is a contraction in demand, as price decreases there is an extension in
demand
...

Demand can shift outwards, so that more is demanded at each and every price level
...
Shifts in the demand curve are caused by;
- Change in population
- Change in advertising
- Change in the price of substitutes
- Change in incomes
- Change in fashion and trends
- Change in interest rates
- Change in the price of complements
- Change in legislation (e
...
seat belts)

Price elasticity of demand measures the responsiveness of demand to a change in price
...
Perfect elasticity occurs when PED equals infinity
...
Perfect inelasticity occurs when PED equals 0
...

Determinants of price elasticity of demand;
- Availability of close substitutes
- Time period under consideration
- Width of market definitions
- Whether the good is luxury or necessity
- Where the good is a habit forming good
- Percentage of income spent on a good
Total revenue equals quantity sold times average price per unit
...

If firms increase the price of a good with price inelastic demand, total revenue should increase
...

Income elasticity of demand measures the responsiveness of quantity demanded to a change in
income
...


Inferior goods - goods where demand falls as income rises - have a negative income elasticity of
demand
...

Luxury goods - have an income elasticity of demand that is a lot greater than 1
...

Substitutes - a good which can be easily replaced by another to satisfy wants - have a positive
cross elasticity of demand with each other
...

Unrelated goods - have a cross elasticity of demand of 0
...

There is a positive relationship between price and quantity supplied, so higher prices lead to
increased producer surplus
...

Firms are incentivised to supply more when prices are higher
...

Also, due to rising marginal costs prices need to increase in order to cover the costs of producing
more output
...

The relative elasticity of PES is the same as that for PED
...

The market clearing price is the price at which their is neither excess demand or supply, so the
market is cleared of goods
...
A market may
not always tend towards equilibrium price, and the price set may not be that which reflects greatest
economic efficiency
...
g
...
Higher prices encourage more supply, but discourage demand
...
There are two types;

- Ad valorem tax which is a percentage of the price of a good
- Specific tax which is a set tax per unit
An increase in taxation causes an inward shift in supply, where less of the good is supplied at each
and every price level
...
Consumers may pay higher
prices, but the government should receive greater tax revenues
...
The incidence of the tax on the producer however
depends on the elasticity of demand and supply
...
If demand is price inelastic or supply is price
elastic, the consumer will bear the greater burden
...
It causes an outward shift in supply
...
This can hugely help
infant industries develop and protect UK markets from more competitive foreign markets
...

If demand is inelastic or supply is elastic there will be a larger fall in price, which will primarily
benefit the consumers
...



Normal market failure is when resources are inefficiently allocated due to imperfections of the
working market mechanism
...


Partial market failure is when a market for a good exists, but there is either under- or
overproduction of the good
...
There is a difference between the social costs and private costs or social benefits

compared to private benefits
...
The social optimum of output occurs when social costs equal social benefits
...


A private cost is the cost of an activity to an individual (e
...
a firm or consumer), where as the
social cost is the cost to society as a whole
...


The marginal cost and benefits of consuming and production are the changes to total costs/
benefits of producing/consuming one extra unit of a good
...


Positive externalities of production occur when the social cost of producing a good is less than
the private cost
...


Negative externalities can be illustrated using welfare loss triangles; the area between the social
optimum and the difference between social and private costs at the current output
...
This is the area between the social
optimum and the difference between the marginal social benefits and private benefits

- Under-provision of public goods

Pure public goods possess the following characteristics; thy are non-rival, non-excludable and
non-rejectable
...
It also means that once provided, an individual cannot be
excluded from benefitting and cannot opt out of receiving the benefits
...


However, public goods give rise to the free rider problem
...
This is why
the good would be under provided if left to market forces, leading to market failure, because the
firms would be unable to regulate charging individuals for consumption of the good
...



- Information gaps/Asymmetric information

In a perfect market, buyers and sellers have potential
access to the same information; symmetric information
...

The buyer or seller with more information is able to exploit
the information gap to their benefit
...


Information gaps can be illustrated on a diagram
...


The principal-agent problem occurs when the principals of an economic decision, and therefore
those who gain or lose, have different goals/objectives to the agents
...

Government intervention can be used to correct market failure if the costs of intervening are less
than the welfare gained from intervention
...

Governments can intervene through;


- The use of indirect taxes

Imposing a tax can cause an inward shift in production or consumption, depending on who the
tax is burdened upon
...
The tax reduces over-production and over-consumption of a
good with negative externalities
...
It is difficult to calculate the size of the tax needed
and whether a tax will have an effect
...
It should cover the difference between marginal private
benefit and marginal social benefit, so that output is at the social optimum
...
An
opportunity cost is also presented to the government, which may result in conflicting objectives
...



- Maximum prices

A maximum price is set below market equilibrium to ensure that everyone can afford basic
goods and services
...

There are problems associated such as; decreases in quality, excess demand and the increased
risk of black markets forming
...
However, it is likely to cause excess supply, which again can result in
black markets
...
g
...


It is difficult for the government to introduce an efficient level of enforcement, as the reduction in
externalities produced must equal the economic cost of imposing the regulation (e
...
extending
property rights)
...
It may be more expensive for one firm to reduce externalities than another, making the
total economic cost greater than it needed to be
...
The government allocates permits to firms, which is a cap of how much
pollution they can produce
...
The higher
the price of the permit, the greater the incentive for firms to decrease emissions
...
Merit
goods are goods whose consumption are considered to result in benefits to society (where as
demerit goods are considered to be harmful for society)
...
The drawbacks, however,
include the fact that; it may lead to inefficient production and there may be misallocation of
resources (e
...
too many soldiers, not enough hospital beds), leading to wasted resources that
would have given greater satisfaction and utility if used elsewhere
...
This can help reduce the over-consumption of goods that produce negative
externalities
...
g
...

Government failure occurs when government intervention results in a net welfare loss compared
to the free market solution
...
The types of government failure include;
- Distortion of price signals - from setting maximum and minimum prices
- The law of unintended consequences - e
...
CAP increased the price of agriculture for
consumers and caused dumping of crops
- Excessive administration costs outweigh the welfare benefit
- Information gaps - e
...
underestimated construction costs as it is difficult to carry out cost-benefit
analysis accurately
- Conflicting objects and opportunity costs
- Political self interest - e
...
political lobbying, rent-seeking (resulting in increased private benefit,
but no change in social benefits) and policy ‘myopia’
- Regulatory capture - regulatory boards act in their own interests
- Red tape - the cost of enforcement hurts enterprise and incentives, which could result in tax
avoidance/evasion, etc
...
GDP
is a measure of the value of goods and services produced within an economy in a given time
period
...
They are all equal to each other
...
GNP is GDP plus the value of goods and services produced using domestic resources
overseas
...




The circular flow of income shows
how money flows through an
economy
...




Net national income is national
income minus depreciation of the
nation’s capital stock
...
The value is equal to volume multiplied by current price level
...
Income may come from wages,
dividends from stocks and shares
...
e
...
g
...








Standard of living is a mix of variables such as income, health, political freedom and the
environment that determine how well off one is
...


When comparing living standards, it is better to compare GDP per capita
...
Purchasing power parities are also used when comparing the living standards
and national income of different countries
...


Furthermore, comparisons with national income in the past in relation to the standard of living
are difficult to make because of differences in the accuracy of statistics, changes in price levels,
changes in demographics, changes in the quality of goods and services, changes in defence
spending (e
...
due to the war), changes in investment to consumption levels, changes in
externalities and differences in income distribution
...



Economic growth can be divided into actual growth - recorded changes in real GDP over time as well as potential growth - measured changed in the productive potential of an economy over
time
...
These fluctuations
are around the trend growth of an economy’s productive potential
...
Recession is technically defined at two successive quarters of negative growth
...
Demand-side shocks may
be changes in the housing market, the stock market crashing or a sharp rise in central bank
interest rates
...




Long run economic growth is primarily lead an increase in long run aggregate supply and the
level of factor inputs
...
Labour may improve by increasing participation rates,
changes in demography and migration and improvements in human capital
...




Hysteresis is the process whereby a variable does not return to it former value when changed
...




There are many benefits of economic growth
...
As a result,
households have more disposable income to improve their economic welfare and quality of life
...
More firms
may be set up
...


However, economic growth may be unsustainable and the impacts may not distributed equally
...
Also, as stated before the Easterlin
paradox states that an increase in economic growth may not lead to increased happiness
...
This can include
full-time, part-time and self-employed work
...
The employment rate is
the number of those in work divided by the size of the active population as a percentage
...
The inactive population includes those who are not willing and able to work, such
as those who are not working age (between the statutory school leaving age and retirement age)
or those with disabilities
...

Underemployment occurs when a worker seeks more hours or is in a job below their skill level
...
The hidden unemployed includes the percentage of the population that are not actively
seeking work, but would be willing to work in certain jobs
...




There are several types of unemployment
...
Seasonal unemployment occurs when workers are unemployed at

certain times of the year
...

Structural unemployment occurs due to a decline in industry, which may be due to regional
issues or sectoral issues
...
Technological unemployment
occurs when workers are replaced by capital
...
Because wage rates are sticky downwards, it is unlikely
that firms can reduce wages to take on more workers, therefore more workers are laid off
...
Net migration into a country
increases the pool of workers available and the supply of labour, thus bringing down wage rates
...




There are many costs of unemployment
...
They may find themselves in a poverty trap
...
Government will receive less tax
revenues and there may be regional costs, such as increased violence and crime
...



- Inflation aiming for 2% plus/minus 1%

Inflation is the sustained rise in the general prices levels in an economy over time
...
CPI is calculated
using a basket of goods that average households buy
...
A base year is
used to calculate the difference in index number
...




Deflation is a sustained decrease in the general price level, whereas disinflation is when inflation
rises at a declining rate
...


There are two types of inflation; cost-push inflation and demand-pull inflation
...




The benefits of low inflation, around 2% plus/minus 1%, are that it improves flexibility within the
economy and lower the real cost of borrowing over time, which should provide incentive for
consumers and firms to borrow more, thus stimulating aggregate demand
...


Deflation also has negative effects such as a lack of consumer and business confidence and an
increase in savings, thus more money being leaked out of the circular flow of income
...
The current account measures the trade in goods and services, as
well as primary (from UK factors of production) and secondary incomes (from government
transfers)
...
A trade
surplus occurs when exports exceed imports and a trade deficit occurs when imports exceed
exports
...

The aggregate demand curve shows the relationship between price level and equilibrium output in
an economy
...


Aggregate demand is made up of the following components;


- Consumption (C)

This is the spending on consumer goods and services over a period of time
...
The wealth effect occurs when a
rise in real wealth results in an increase in consumer spending
...


The relationship between consumption and these factors is called the consumption function
...
Average propensity to consume is total consumption in an economy over
total income
...
Savings are the proportion of a households disposable income that are not spent over
time
...
Average propensity to save is the ratio of total
savings to total income
...



- Investment (I)

Investment is the spending of firms on investment goods
...
It is also affected by interest rates, as firms tend to take out loans to invest
...
Investment may shift due to
changes in business confidence, the rate of economic growth, costs, the world economy, access
to credit, retained profit and government regulations/influences
...


Gross investment is the addition to capital stock, both to replace depreciated capital (worn out/
used up capital) and the creation of additional capital
...


The accelerator theory shows the relationship between investment levels and changes in
national income
...
e
...



- Government spending (G)

This includes all the spending done by the government to provide goods and services for their
citizens (e
...
on infrastructure and roads), but does not include transfer payments
...


Government spending may be used to adjust aggregate demand over the trade cycle and as
part of fiscal policy
...



- Exports minus Imports (X-M)

International competitiveness (on price and non-price factors), exchange rates, real incomes, the
degree or protectionism and the state of the world economy are major influences on the levels of
import and exports
...

The aggregate supply curve shows the level of output in the whole economy at any given general
price level
...
The long run aggregate supply curve
also shows the full capacity of an economy; the maximum output an economy can produce if all
resources are used
...


The long run aggregate supply curve can be plotted against the short run growth path of GDP to
show the difference between output and long run aggregate supply, known as the output gap
...
A negative output gap occurs when there is spare capacity, whereas a positive
output gap occurs when output is above the productive potential, causing inflationary pressures
...

They Keynesian long run aggregate supply curve suggests that when an economy operates at full
capacity, it will start to overheat, thus massively increasing general price levels
...

Equilibrium is shown where the aggregate supply curve meets the aggregate demand curve
...

Causes of shifts in the short run aggregate supply curve:
A change in wage rates
A change in the price of raw materials (which can lead to a supply side shock)
Change in taxation
A change in exchange rates (if imports become more expensive, general price levels will rise)
A change in productivity and the productive potential of the economy

-

Causes of shifts in the long run aggregate supply curve:
Technological advances
Changes in relative productivity to competing economies
Changes in education and skills
Changes in government regulation
Demographic changes
Changes in migration
Changes in competition policies (as competition encourages efficiency)
Changes in enterprise
Changes in factor mobility
Providing economic incentives to increase productivity

-

The multiplier effect states that an increase in injections into an economy leads to a greater
increase in incomes, which is a multiple of the original injection
...
It is the
ratio of the final change in income to the initial change in injections
...
These types of policies can be divided into two types; fiscal
policy (using taxation and government spending/borrowing) and monetary policy (manipulating

monetary variables)
...

The Bank of England base rate is the rate of interest charged by the Bank of England to banks to
borrow money, thus influencing high street rates
...
By using expansionary monetary policy aggregate demand should shift
outwards
...


Quantitative easing is a monetary policy instrument where the central bank buys financial assets
and bonds in exchange for money in order to increase the supply of money and therefore levels of
borrowing and lending within the economy
...




The budget is a statement of the spending and income (taxation) plans of the government
...
If this value is
positive the government are running a budget deficit
...
A fiscal surplus
is run when taxation is greater than government spending
...

Expansionary fiscal policy uses changes in taxation and government spending to stimulate
aggregate demand
...
The increase in
injections into the economy may have a positive multiplier effect
...
This
may be used when the economy is overheating and general price levels are too high
...

Although demand-side policies should stimulate demand and increase economic growth and
output, they may have some drawbacks including;
- Increased inflation
- Potentially increased national debt
- Time lags
- Reducing interest rates may have little impact because they are already so low
- Uncertainty of the magnitude of effect
Supply-side policies are government policies that are used to increase the productive potential of
the economy, causing an outward shift in the long run aggregate supply curve
...


Market-based policies reduce barriers to trade in order to achieve economic growth, where as
interventionist policies focus on correcting market failures
...
This can be done by improving transport links and providing more training for workers
to improve their human capital
...
They are focused on reducing
unemployment as more workers should be required to produce more output
...

However, the economy may not benefit equally from supply-side policies,
leading to increased income inequalities
...


Furthermore, there is a time lag for supply side policies to take effect and
there is an opportunity cost presented
...

The short run Phillips curve shows the trade-off between unemployment
and inflation
...


Theme 3: Business Growth
Large firms exist because of economies of scale, allowing them to produce at the minimum
efficient scale of production
...
High barriers of entry may also exist to
protect large firms
...

Large firms may experience a divorce of ownership from control, where the managers and
directors of a business are a different group of people to the owners of the business
...

Public sector organisations - Organisations that are owned and controlled by the state
...
They may make profits, but this is
not their main aim
Private sector organisations - Organisations that are owned by individuals or companies rather
than the state
...
This includes charities, who receive tax advantages, and smaller not-forprofit operations
Businesses choose to grow to benefit from economies of scale, have greater market control,
reduce competition, reduce risk by spreading risk and where there is a divorce of ownership of
control, a larger company is more able to justify higher salaries
...


This is an easy, but slower paced way that many firms increase their size through
...



- External growth

This can be achieved through merger, amalgamation or takeover
...


Horizontal integration - A merger between two firms in the same industry at the same stage of
production
...

However, like with most mergers they are not usually successful and expensive, with firms
paying too much
...
This can either be forward (merging with a buyer) or backward (merging with a
supplier)
...
However, firms may merger
into parts of industries they have little knowledge in possibly leading to inefficiencies
...


Conglomerate integration - A merger between firms with no common interests
...
On the other hand, firms are moving into
markets they have no knowledge about potentially reducing market performance and asset
stripping is a short hand profit generator
...

Constraints on business growth include;
The size of the market may be limited, reducing opportunities for expansion
Smaller firms may be less able to access finance
The owners objective may not coincide with greater growth
Regulation may make it more difficult for firms to merge and expand

-

A demerger occurs when a firm splits itself into two or more separate firms
...
This could be due to the
poor performance of one firm reducing the share price of the other firm
- There is an increased trend for firms to be highly focussed and specialise in one market
Firms and consumers will benefit from demergers if the increased specialisation leads to greater
efficiencies
...
If the demerger leads to inefficiencies, workers may lose their jobs in the long run
...
It is
equal to total quantity sold multiplied by average price
...
When price is falling, total revenue increases then peaks when the marginal revenue is
equal to zero
...
It is calculated by dividing total revenue by
quantity sold
...
It is downward sloping when price is
falling
...
It is the difference between
total revenue at different levels of outputs (i
...
the change in total revenue over the change in
output)
...
It is downward sloping and is always half
the average revenue curve when price is falling
...

When demand is price inelastic, an increase in price leaded to an increase in total revenue and the
opposite is demand is price elastic
...

The average revenue curve also shows the demand curve
...
When this decline occurs
the returns per input decrease
...

Total product - The quantity of output measured in physical units produced by a given number of
inputs over a period of time

Average product - The quantity of output per unit of factor input; total product divided by quantity of
inputs
Marginal product - The addition to output produced by an extra unit of input; change in total output
divided by change in level of inputs
Increasing returns to scale - An increase in inputs leads to a more than proportional increase in
output
Constant returns to scale - An increase in inputs leads to a proportional increase in output
Decreasing returns to scale - An increase in inputs leads to a less than proportional increase in
output
Economic cost of production for a firm is the opportunity cost of production
...

Imputed costs are resources which have an opportunity cost but for which no payment is made;
- Labour
- Financial capital
- Depreciation of physical capital
- Goodwill of brands
Fixed cost - A cost which does not vary directly with output
Variable cost - A cost which varies directly with output
Semi-variable cost - A cost which contains a fixed cost element and a variable cost element
Total cost - The cost of producing any given level of output and is equal to total variable cost plus
total fixed cost
Total variable cost - The overall cost of factors of production that vary directly with the amount
produced
Total fixed cost - The overall cost of factors of production which do not vary directly with output
Average cost - The average cost of production per unit and is equal to the total cost divided by the
quantity produced or the sum of the average fixed and variable costs
Average variable cost - Total variable cost over quantity produced
Average fixed cost - Total fixed cost over quantity produced
Marginal cost - The cost of producing an extra unit of output, which is equal to change in total costs
over change in quantity produced
Types of short run cost curves:
- Total cost curves
- Average cost curves
- Marginal cost curves
Key relationships between curves:
The AC and MC curves are u-shaped because of the laws of diminishing marginal returns
The AC and MC curves are opposite to the AP and MP curves
The AC curve is above the MC curve when average costs are falling
The AC curve is below the MC curve when average cost is rising
Average cost and marginal cost are equal when average cost is constant

-

The long run average cost curve has a broad u-shape, and is said to be an ‘envelope’ for the short
run average cost curves, each of which are tangential to the curve at their lowest point
...
After the optimal level of output (the range of output over
which long run average cost is lowest) firm is experiencing diseconomies of scale
...

Causes of shifts in long run average costs:

- Taxation
- Changes in technology
- Economies and diseconomies of scale (falls/rises in long run average costs)

Types of internal economies of scale (a fall in LRAC due to growth of a firm/increased
production):
- Risk bearing
- Financial
- Technological/Technical
- Managerial
- Purchasing
- Marketing
External economies of scale arise when there is a growth in the size of the industry in which the
firm operates
...

Diseconomies of scale may occur due to problems with coordination and cooperation
...
It is maximised when this difference is greater
Break-even point - Where total revenue is equal to total cost
Normal profit - the profit that the firm could use to make by using its resources in their next best
use; it is an economic/opportunity cost of capital and is sufficient to prevent the firm from exiting
the market
Supernormal profit - The profit over and above normal profit
Profit is maximised when MC equals MR (marginal cost must be rising)
...

An increase in production costs will cause an inward shift in marginal costs, thus decreasing the
profit maximising output
...

Shut down points is the point of production which results in losses than revenue that are so great
the firm has to cease production
...
It
will not produce if revenue is less than this because its losses would be greater than if they didn’t
produce at all
...

In the long run the shut down point is the output and price tangential to the average total costs
curve
...
These include;
- The number of firms within a market and their relative size
- The number of firms entering a market and barriers to entry
- The extent to which goods are homogenous or differentiated
- The extent to which there is perfect knowledge
- Whether firms are dependent or independent
Market concentration - The degree to which the output of an industry is dominated by its largest
producers
Concentration ratio - The market share of the large firms in the industry
...
g
...
The types of barriers to entry are;
- Capital costs
- Sunk costs (i
...
the costs that are not recoverable when a firm leaves the industry)

- Scale economies (e
...
a natural monopoly can deter new entrants by producing at the optimal
-

level of production and thus reducing costs
...
g
...
g
...

Types of competition:
Price
Quality
After-sales service
Delivery date
Image

-

Types of market structure:
1) Perfect competition

Perfect competition describes a market where there is a high degree of competition; there are
many buyers and sellers, who are market price takers (i
...
have no control over price)
...
All goods produced are
homogenous and there are no externalities from production and consumption
...
The demand curve for firms in a perfectively competitive market is
horizontal and perfectly elastic
...


In the short run the supply curve of a firm will be its marginal revenue cost curve
...
If firms receive abnormal profits in the short run, new firms will be incentivised to enter
the market, shifting out supply and lowering market price
...
In the long run AC=AR=MR=MC
...
The only change may
be market price and output supplied
...


2) Monopolistic competition

In a monopolistically competitive market there is a large number of relatively small buyers and
sellers, no barriers to entry or exit and firms selling non-homogenous goods
...
In the short run firms are profit maximisers
...
But because other firms offer close
substitutes, the market power of firms is relatively weak
...
In the long run the demand curve is
tangential to the base of the average costs curve
...
Therefore, MC=MR and AC=AR
...
Market supply is concentrated in the hands of a few relatively large firms
...


Oligopolies can partake in competitive or collusive behaviour because of their
interdependence
...
Formal collusions is when firms make agreements to limit
competition, such as a price agreement to fix prices
...
An
agreement amongst many firms is known as a cartel, who limit supply in order to raise prices
...


Tacit collusion exists when there is still collusion, even without a formal agreement
...


Game theory is the theory which can be used to understand a firms benefits from colluding
...

The payoff matrix shows how the strategy of one firm in a duopoly affects each firms profits
...
Nash equilibrium is a situation where the chosen strategy of each player
maximises payoffs given the other player’s choice, so that there is no incentive to alter
behaviour
...


Non-price competition is determined by the marketing mix; product, price, promotion, place and
branding
...
By colluding, oligopolies may maintain stability within the market,
however, there may be static inefficiencies, which be resolved through having a competitive
oligopoly structure
...
This means that
there is no incentive for firms to change prices, as if they increase price they will lose market
share, but a decrease in price will lead to a less than proportional increase in market share
...
The market
demand curve us the same as the monopolists demand curve, and is download sloping
...
Marginal revenue falls twice as steeply as the average
revenue curve
...
The short run
cost and profit curves are the same as the long run curves
...
The sources of monopoly power include high barriers to
entry and product differentiation leading to fewer close substitutes
...
They determine what output they
produce and what they charge for it
...
Although monopolies may experience

allocative inefficiency and exploit consumers, they may benefit from large economies of scale,
supernormal profits to be spent on innovation and increased international competitiveness
...
Price discrimination is charging a
different price for the same good in different markets
...
In order for price discrimination to be effective the
market must be able to be split into distinguishable groups which can be easily kept separate
and each have their own demand curve for the product/service
...
First degree discrimination is where each
individual consumer is charged a different price, and second degree price discrimination when
a monopolist charges according to how much you buy
...
Even though it may cost more for firms to
regulate price discrimination, they are likely to gain more revenue so are able to supply the
good to everyone
...
As
they are a monopoly this would result in decreased choice for the consumer
...
It is likely to be more productively efficient than if two firms
were competing in that market
...
A
multi-plant monopolist is where there is one sole producer in an industry, but where production
takes place at a number of different plants, each of which could be sold off to provide
competition in the industry
...
They can result in lower prices
being paid to suppliers and changes to the volume demanded and supplied by exploiting their
monopsony power
...
A bilateral monopsony occurs where one
monopsonist faces ones monopolist, which is likely to increase the allocative efficiency in the
market
...
However, as the supply increase, the supply of inputs which a firm has
monopsony power over falls
...
Customers may benefit from a monopsonist passing on lower prices so long as the
supply of goods which the monopsonist buys in is price inelastic and thus unaffected by
decreases in price
...

In a contestable market the barriers to entry and exit are low and there is perfect knowledge
...
Abnormal profits can be earned in the short run, but only normal profits
can be earned in the long run
...
Incumbent firms may maintain low prices to deter new entrants from entering
the market, as well as invest heavily in non-price competitiveness to increase the barriers to entry
...

Creative destruction is the process by which a change in product or production process causes the
previous method to be replaced
...

The stakeholders in a business who have the ability to influence a firms decisions include;
- The owners
- Shareholders
- Directors and managers
- The workers and trade unions
- The government and state

- Consumers (e
...
through consumer sovereignty; the power of consumers to allocate resources
according to their own preferences through spending decisions)
- Pressure groups
Types of business objectives:

- Short run profit maximisation, where MC=MR and firms may adjust prices
...
g
...

Productive and allocative efficiency are static concepts of efficiency
...
It can only occur when
there is technical efficiency; a given output is made using the minimum number of inputs
...

X-inefficiency is a type of productive inefficiency when a firm is not producing at the lowest possible
cost for a given output (i
...
it is producing within the boundary of the cost curve)
...

Allocative efficiency is present when resources are allocated to those goods and services
demanded by consumers and price equals marginal cost
...
This is because they can afford to earn abnormal profits in the long run, thus meaning they
are not producing at the lowest possible cost, and price does not equal marginal cost
...

For example, the rate of investment and the sustainability of growth are types of dynamic
efficiency
...
Dynamic efficiency can be illustrated by a PPF curve that is shifting
outwards
...
Profit maximising
monopolies are neither productively or allocatively efficient, but there may be some dynamic
efficiencies as there is incentive to innovate
...

Governments can intervene to prevent market failure where monopolists are exploiting
consumers
...
The government may choose to intervene by;
- Price controls and regulation, however it is hard for the government to know where a
monopolists cost curves lie
- Profit controls and regulation, however monopolists may use asymmetric information to predict
higher future costs than there will be, and a monopolist is able to produce less efficiently and
burden the consumer with higher costs in order to decrease their profits
- Quality standards
- Performance targets
- Breaking up the monopolist
- Lowering entry barriers (e
...
legal barriers)
- Windfall taxes on abnormal profits, although they tend to be arbitrary and not a good long term
solution

- Privatisation of state owned monopolies (i
...
selling the firm to private sector owners), as private
-

sector firms will look to increase efficiency
Nationalisation of private monopolists, to provide the goods at a lower price and greater output
in order to improve consumer welfare
Deregulation (the process of removing government controls)
Subsidising the monopolist to lower the cost of production and the price passed onto consumers
Self-regulation
Merger policies to prevent the creation of new monopolies with too larger a market share

The government can also promote competition by;
- Encouraging the growth of small businesses
- Regulating anti-competitive prices
- Deregulation
- Lowering barriers to entry
- Competitive tendering, where the government introduces competition among private sector firms
by contracting out (getting private firms to produce goods and services for the state) part of the
public sector and getting firms to put in bids for work
...
g
...

Government intervention may be ineffective due to the potential of firms to influence them through
lobbying, regulatory capture (when firms are able to influence a regulatory body) and asymmetric
information which favours the firms
...
In the long run
...
In the short run, the law of diminishing returns sets in
...
Marginal revenue product is the value of the
physical addition to output of an extra unit of a variable factor of production
...
The
marginal revenue product curve for a firm is also the firm’s demand for labour
...

The wage elasticity of demand for labour is a measure of the responsiveness of the quantity
demanded for labour to a change in price of labour and is calculated in the percentage change in
quantity demanded for labour over the percentage change in wage rate
...
Unit about costs are the cost of employing
labour per unit of output
...
e
...
Work is an
inferior good, so with higher incomes workers will choose to substitute work hours for leisure time
...

The elasticity of supply of labour is a measure of the
responsiveness of the quantity supplied to a change in the
price of labour
...
It is affected by the availability of suitable
labour, the time period under consideration and the extent of
underemployment and unemployment
...
These all affect the
participation rates of the population in the labour force
...

Geographical immobility is when workers cannot move between areas for work
...
Occupational immobility
is when the skills of a worker cannot be transferred from one occupation to another
...
The equilibrium wage rate is where marginal revenue product meets supply
...

In reality, because labour is not homogenous, wage rates differ
...

In a perfectively competitive labour marker there is a large number of small firms hiring a large
number of individual workers
...
The firm will hire up to the point where marginal revenue product is equal to the
marginal cost of labour
...
g
...
A monopsonist will hire up to the point where MRP+MC, and is then likely to lower
wage rates through exploiting their monopsonist power
...

A monopoly seller of labour, such as a trade union, have collective bargaining power to influence
wage rates
...
This
should result in higher wages than in a perfectively competitive market, but may also lead to
decreased employment
...

Government may intervene in the labour market to resolve labour market issues
...
Especially during times of financial crisis, youth unemployment is likely to
rise significantly
...
The
minimum wage is a pay floor below which employers cannot legally go
...
This is dependent on the
difference in wage rates from before and the relative elasticities of demand and supply of labour
...
This may be done to control
inflation and reduce public sector spending in public sector operations
...
It is
easier for the government to set public sector wage rates (e
...
pay freezes), but in the long run this
may lead to a shortage in labour as workers move to the private sector
...
These include improving
education and training, subsidising workers, providing compensation for workers who have to
move, increasing the knowledge of job opportunities and application processes, reducing
discrimination, improving transport links and reforming the tax and benefits system
...

Other ways in which the government may try to improve issues within the labour market
include;
- Using changes in fiscal policy to incentivise work (e
...
lowering benefits to prevent a poverty trap
or making income tax more progressive)
- Trade union reforms
- Invest in regional policies to reduce regional inequalities (e
...
subsidising firms to relocate to
areas of higher unemployment)


Theme 4: Globalisation
Globalisation is the ever-increasing integration of the world’s local, regional and national
economies into a single international market
...

It is characterised by;
- The free trade of goods and service across national boundaries
- The free movement of labour
- The free movement of capital
- The free interchange of technology and intellectual capital
The trading possibilities curve shows the consumption possibilities under conditions of free trade
...
There are many
reasons for international trade including;
- Differences in factor endowment
- Differences in the cost of production
- Product differentiation and non-price factors giving a wider choice of goods for consumers
- Political reasons (e
...
trade agreements and embargoes)
The pattern of trade between countries describes the way in which countries are trading, for
example which goods countries are trading and where to
...
Factors affecting the patterns of trade include;
- Comparative and absolute advantage

Comparative advantage exists when a country is able to produce a good at a lower opportunity
cost than another country
...
However, comparative advantage
theory assumes that there are no transport costs/tariffs, costs are constant (i
...
there are no
economies of scale), only two countries produce homogenised goods and factors are perfectly
mobile
...


A country is said to have an absolute advantage when they are able to produce a good using
fewer factor inputs than another country
...

- Changes in emerging economies as well as the decline of certain economies
- Trading blocs and bilateral agreements
- Changes in relative exchange rates
The benefits of increased international trade include;
Increased specialisation
Economies of scale
Increased consumer choice
Increased investment in research and design as well as innovation

-

The costs of increased international trade include;
Over dependency on international trade and interdependency between economies
Risk of structural unemployment if changes in demand occur
Fluctuations in import and export prices may negatively impact the balance of trade
Widened inequalities
Environmental costs
Loss of national sovereignty
Loss of culture

-

The terms of trade is the ratio between
average export prices and average import
prices
...

The terms of trade improves when it value increases, so export prices rise relative to import prices
...

The effect of these changes on the balance of payments depends on the price elasticity of demand
for imports and exports
...
Likewise, if the price elasticity of
demand for imports is elastic and the terms of trade increases, then the level of imports should
increase
...
This is turn has a domino effect on the domestic economy
...
g
...
It is also known as a
regional trading agreement
...

Types of trading blocs and stages of economic integration;

- Preferential trading areas

-

-

-

A preferential trading area is a group of countries that have signed a preferential trade
agreement to lower or abolish some protectionist barriers between members
Free trade areas

A free trade area is a group of countries between which there is free trade and members may
set their own external tariffs to non-members
Custom unions

A custom unions is a group of countries between which there is free trade and a common
external tariff
...
This includes the free movement of factors of production
...
There
is likely to be a monetary union and common currency, reducing uncertainty due to fluctuating
exchange rates
Economic unions

Where the economies of member countries are as fully integrated economically as the different
regions within a country
...

Member countries may also share a single currency
...


Trade diversion occurs when a country switches from purchasing products from a low-cost
producer to a higher-cost producer
...
Likewise, when trade
diversion outweighs trade creation, there are welfare losses
...

Potential dynamic gains from custom unions:

- Economies of scale


The customer market for firms is larger in a customs union, making it easier for firms to achieve
economies of scale through internal growth or mergers with foreign firms
...

- Competition

A common market reduces barriers to trade immensely, therefore domestic markets face more
competition from foreign firms
...
However, competition is likely to be
reduced in the long run, because some firms will be able to maintain monopoly power
...
This can lead to
worsened inequalities
...

A monetary union occurs when at least two countries share the same currency, such as members
of the EU
...
It also manages interest rates and the foreign currency reserves (i
...

foreign exchange rates)
...
The main two rules are
to; not exceed a fiscal deficit more than 3% of GDP and have a national debt of no more than 60%
of GDP
...
In order for a monetary union to be successful and achieve the benefits
of an optimum currency area the following conditions must be met;
- Free movement of labour
- Capital mobility
- Automatic fiscal transfers to poorly performing individuals
- Countries should share the same trade cycles
Advantages of a monetary union:

- Fixed prices from reduced exchange rate fluctuations between member countries
- Reduced exchange rate costs during transactions, which may increase trade and economies of
scale for firms
- Greater price transparency
- The potential for increased inward investment
- Price stability
Disadvantages of a monetary union:
Transition costs associated with switching currency
Loss of policy independence
Inability to change the value of a currency
Wealth and income inequalities due to structural problems
Potential for collapse

-

The World Trade Organisation (WTO) was set up in 1995 to replace the General Agreement on
Tariffs and Trade (GATT)
...
This

includes dealing with trade disputes and complaints made between countries
...

Some of the agreements made during the Uruguay round include;

- Replacing quotas with tariffs in agriculture
- Dismantling protectionist barriers and textiles
- Industries such as finance and telecommunications were opened up


Some of the agreements made during the Doha round include;
- Cutting protectionist measures in agriculture
- Reducing tariffs in manufacturing
- Allowing foreign companies to bid for government contracts
- Tightening intellectual property rights
- Increasing the WTO’s power to settle trade disputes

Criticisms of the WTO:
Allowing rich countries to exploit developing countries workers
Encouraging environmentally unsustainable practices
Unequal gains from lower trade barriers; more developed countries tend to benefit more
Loss of culture and standardisation of goods
Unfair ownership of governance between countries

-

Free trade is when international trade is able to be conducted without barriers to trade, whereas
protectionism is the use of economic policies to regulate trade between countries
...

- Quotas

Quotas are a physical limit on the quantity of an import or a
voluntary export restraint of goods to another country
...
Governments
may also subsidise domestic firms to improve their
competitiveness compared to imports
...

- Exchange rate manipulation

Lowering exchange rates to artificially depress the value of currency makes imports appear
more expensive and exports appear cheaper, helping improve the balance of trade
...
g
...
They also create
less competition for domestic firms, which could lead to inefficiencies
...


In the short run it does help protect jobs by preventing the decline of certain domestic industries,
but in the long run the market would reallocate resources so that workers had greater job security,
so it shouldn’t have that great an impact
...
This can have
negative impacts on the living standards of citizens
...
There is also a decreased risk that countries will retaliate in response to protectionist
measures through using their own
...
The financial account records financial capital flows in and out of the UK economy and is
split into three parts; foreign direct investment (when one firm purchases a controlling interest
in a foreign firm, which is 10% or more of the shares), portfolio investments (foreign flows to
purchases shares less than 10%) and other investments such as trade credit, land and bank
deposits
...

Increasing capital flows are driven by speculators (both consumers and firms believing they can
increase profit), increased international trade, banks lending in multiple countries, remittances and
government encouraging foreigners to purchase their bonds in order to improve credit supply
...
However, it greatly increases interdependency within countries and
decreases sovereignty of national assets
...

Some countries have a continuous current account surplus or deficit because;
They have an abundance of natural resources, such as oil in Norway
They have underlying competitiveness and comparative/absolute advantages, encouraging FDI
Artificially kept exchange rates in order to boost exports or reduce the cost of imports
Rates of inflation which affect international competitiveness
The level of foreign investment
...
This will only be successful if the PED for imports and exports is price elastic and
cost-push inflation is low, or else there will be a conflict of objectives
- Expenditure reducing policies; government policies to reduce aggregate demand, reducing
imports
...
It will only be successful if the MPM is high and there is a
competitive inflation rate
- Supply side policies
- Protectionist measures

- Currency purchasing controls to reduce the purchase of foreign currency and goods by domestic
citizens and firms
...
Financial
crises can be prevented by having central banks and governments bail out banks and local
government bodies, or by using the IMF to borrow money from
...
They will not be able to borrow money
in the medium term, there may be a reduction in supply from oversea firms (e
...
for medication)
and there may be refusal by international creditors to lend money to cover imports
...

The most effective solution involves a debt restructuring agreement
...
The bilateral
exchange rate is the exchange rate of a single currency for another single currency, whereas the
trade weighted exchange rate is used to compare multiple currencies to a single currency
...


A spot exchange rate is the exchange rate at a current point in time
...


Currency is bought and sold on the foreign exchange market; this takes place in the form of
international trade, capital movements and speculation
...
Speculative activity
such as this, however, only has a significant impact in the short run
...
It is calculated using the purchasing
power parities
...


The equilibrium exchange rate may be free-floating or fixed
...
A fixed exchange rate is when one currency has a fixed value
against another currency over a period of time
...

A managed exchange rate system is an exchange rate system where free markers determine the
value of a currency, but the central bank can intervene to manage the value of currency
...
This may be done by buying and
selling gold and foreign currency reserves or changing interest rates to affect the demand for
imports and exports
...


Revaluation is an official rise in the value of a currency, where as devaluation is where the value of
a currency falls
...


When evaluating the effectiveness of an exchange rate system the following points must be
considered;
- Robustness

Free floating exchange rates are the most robust, as they are least likely to collapse
...
g
...
A free floating
exchange rate system automatically adjusts to disequilibrium
- Financial discipline

Free floating exchange rates may reward poor financial discipline (e
...
over spending) in the
short term as they have expansionary effects, but in the long term they are unsustainable
Depreciation of a currency leads to a rise in the total sterling value or exports, a fall in the total
sterling value of imports and an improvement on the current account on the balance of payments
...


The problems associated with a depreciated currency may include;
Cost-push inflation or an inflationary spiral if the PED of imports is price inelastic
Competitive devaluation may lead to retaliation
Poor economic growth if more money is leaked out to purchase price inelastic imports
Unequal changes in unemployment
Although short run depreciation may attract FDI, chronic depreciation will detract FDI as it is a
sign of economic instability

-

The J curve effect states that in the short run a devaluation of the currency is likely to have a
negative impact on the current account balance, before it starts to improve
...


International competitiveness may be measured using relative unit labour costs (total wages
divided by real output) and relative export prices of trading countries (i
...
price competitiveness)
...

International competitiveness may also be affected by;
- Exchange rates
- Productivity
- Wage and non-wage costs
- Levels of regulation
- Quality
- Research and development and therefore levels of innovation
- Levels of taxation
The government may use supply-side policies, exchange rate policies and maintain stable inflation
in order to improve international competitiveness
...
They are also likely to attract FDI and are
able to purchase overseas assets
...
The greater demand for workers may
improve wage rates, and therefore employees standard of living
...

However, it is difficult to maintain international competitiveness
...
This
reduces a country price competitiveness
...

Less competitive countries may also introduce trade barriers to reduce other countries
competitiveness
...

Within a market or mixed economy there is unequal personal distribution of income (the
distribution of total income of all individuals)
...
g
...
g
...
The Lorenz
curve is a graphical representation of the degree of income or wealth inequality and shows the
relationship between cumulative income and percent of the population
...
The greater the
number, the higher the level of inequality
...
25 a day to live off
...
Their
income and living standards are lower than the average in the economy
...
g
...
The productive potential of the economy is greatly reduced
...
Horizontal equity is the identical
treatment of identical individuals and groups in society in identical situations
...

Within a society there may be absolute and relative poverty as well as a lack of horizontal equity
...

The government may;
- Increase expenditure, such as on public goods like education to provide equal opportunities for
all citizens as well as welfare payments
- Using a progressive tax system and reducing the use of regressive taxes
...
Proportional taxes takes the same proportion of everyones income
...
This
could lead to a capital flight out of the economy or tax evasion
...
g
...
g
...

Countries may be classified based on their stage of development
...

Emerging economies are economies that have experienced rapid economic growth with some
industrialisation and characteristics of developed markets (e
...
tiger economies in South-East Asia
and BRIC countries)
...

It may be measured using the Human Development Index
...
Each of these indicators is giving a weighting and a geometric mean is taking to
give a score between 0 and 1, where a higher score indicates a greater level of development
...
It also ignores housing, employment and the environment
...
The greater the
inequalities, the greater the negative impact on the IHDI score
...

- Ensure environmental stability
- Develop a global partnership for development
The Multidimensional Poverty Index (MPI) is a measure of the percentage of the population that
is multidimensionally poor
...
It also takes into accounts the assets that
households own
...


The Genuine Progress Indicator is a comprehensive measure of economic development that is
calculated from 26 variables divided into the categories economic, environmental and social
...
g
...
g
...
Fluctuating
commodity prices may increase
leakages out of the economy or
decrease the value of exports
...
g
capital flight)
- Remittances (immigrants sending
income abroad)
- Gender inequalities
- Pressures to improve environmental
sustainability, which increases costs of
production
- Savings ratios in relation to
technological progress
...


The savings gap (the difference between actual savings and the level of savings needed to
finance investment for economic growth) and foreign exchange gap (the difference between
actual exports and the level needed to create growth) may be plugged by foreign aid



Different types of developmental strategies


-

- Trade liberalisation and trade protectionism

Although protectionism can lead to import substitution, protecting domestic markets in the short
run and thus increasing employment levels, in the long run it prevents economies from
benefitting from the gains associated with specialisation
...


Export-led growth can occur when trade barriers are lowered, allowing resources to be
reallocated to where economies have a comparative advantage, allowing them to specialise and
gain international competitiveness
...



- Promotion of FDI and joint ventures

Promoting FDI can help improve capital inflows into an economy, and the increased injections
due to more investment may have a positive multiplier effect
...
The government may choose to embark
on a joint venture, where both the government and firm own the new business
...



- Removal of government subsidies

Subsidising essential items such as food and fuel can be used to minimise absolute poverty, as
low income households spend a smaller proportion of their discretionary income
...
Economic theory suggests it would be more
effective to give low income households cash payments instead
...



- Free floating exchange rates and managed exchange rates

The government may intervene to fix exchange rates to maintain exchange rate stability as well
as affect the competitiveness of imports and exports
...



- Privatisation

Privatisation should lead to increased economic efficiency, as output is left to free market forces
...
However, in the case of a privatised monopoly, there may be reduced
pressures to improve efficiency, leading to higher prices and reduced economic welfare
...
g
...
This is why some firms
should be owned and run by the government
...
This can increase employment,
boosting consumer expenditure and causing a positive multiplier effect on the economy
...



- Infrastructure development

If the development of infrastructure would be profitable and efficient, it is likely that the free
market would be more effective at funding infrastructure development
...
However, if the development of infrastructure would not be profitable
or efficient, then there would be under provision (e
...
of education and healthcare) if left to free
market forces, leading to an economic welfare loss
...



- Buffer stock schemes

A buffer stock scheme may be used in markets with volatile supply, where prices would fluctuate
greatly if left to market forces
...
g
...
If supply suddenly increases, some of the yield is held in the stocks
to limit supply and prevent a decrease in price below the minimum price
...

They are good for maintaining price stability and the incomes of suppliers
...
Many buffer

stock schemes run out of money and collapse
...
Production must be sustainable and not lead to environmental degradation
...
Supermarkets may exploit the
use of a fair-trade logo to improve sales, decreasing demand for non fair-trade produce and
therefore leaving those suppliers worse off
...
They can
help plug the savings and foreign exchange gap in developing countries, as well as help target
countries most in need
...
A grant is sum
of money that is donated, a loan is transfer of money that is paid back with either a commercial
rate of interest or a lower rate of interest (a soft loan)
...


Bilateral aid is the transfer of aid between two countries, where as multilateral aid is a situation
where donor countries give money to international agencies, who disperse the aid to many
countries
...
e
...


Debt that is limiting growth or is mainly made up of interest repayments may be written off, which
is known as debt forgiveness or debt relief
...
This has negative impacts in
the long run
...

The five stages of economic growth for developing economies, as according to Rostow are:
1) The traditional society, where most production is in agriculture and investment is low
2) The preconditions period, where agricultural productivity increases so assets can be
transferred to increase diversification
3) The take-off, where the economy passes through 20-30 year period of accelerated economic
growth with rising investment levels relative to GDP
...
g
...
This industrialisation could improve the marginal productivity of the economy
...

There is a chance however, that increased rural depopulation will lead to urban poverty, rather than
increased affluence
...

Tourism is a tertiary sector export that can have a significant positive multiplier effect on a country
as it increases injections into an economy, as well as provides more jobs
...

The International Monetary Fund was set up after the Second World War to ‘promote
international monetary co-operation, exchange rate stability, and orderly exchange rate

arrangements; to foster economic growth and high levels of employment; and to provide temporary
financial assistance to countries to help ease balance of payment adjustment’
...

The cost of these reforms is usually expensive and reduces the available resources available by
reducing imports
...
It is made up of the International Bank for Reconstruction and Development (IBRD)
and the International Development Association (IDA)
...

Private sector banks may lend money internationally, helping to facilitate foreign direct investment
and portfolio investment in a country
...

Non-governmental organisations (NGOs) are organisations that are privately owned and run but
are non-commercial
...
They will never be as effective as the
government can be
...

Financial markets are important for facilitating;
- Saving of financial assets
- Lending
- The exchange of goods and services by creating payment systems
- The provision of forward markets (i
...
where an agreed price is payed in the future)
- The provision of equity markets; an equity is part ownership of a company, which can be sold,
improving the liquidity of the market
- The provision of insurance services
Liquidity is the extent to which an asset can be converted in the short term and without the holder
incurring a cost
...

The different types of financial institutions:
- Retail banks

Retail banks provide services to individuals, such as savings accounts, loans, mortgages and
credit cards
...
They charge for their services
...
They may borrow to businesses, allowing
them to secure their funds in one place, or they may lend out loans
...



- Investment banks

Investment banks trade in foreign exchange, commodities, bonds, shares and derivatives
...
Examples,
include; pension funds, assurance firms, investment trust companies and private equity and

hedge funds
...



- Insurance companies

Insurance companies provide insurance against risks by charging consumers a premium
...
e
...
Bonds are long-term loans issued by firms and government, whereas shares are part
ownerships in a company
Foreign exchange markets; foreign exchange markets are where the exchange of different
currencies takes place
...
g
...
A
derivatives markets is where these financial instruments valued on other financial instruments
are traded
Insurance markets; Insurance markets are where individuals, forms and governments can
purchase insurance
...
g
...
g
...
It is caused by herding behaviour; investors purchase more
as they notice the price rising, then all sell at once (e
...
housing market bubble caused by overlending)
- Market rigging; where a group of individuals collude to fix prices or exchange information that
will improve their own gains (e
...
insider trading; where an individual has knowledge about what
a firm is about to do in the market)
- Externalities; (e
...
the tax payer helped bail out and nationalise many UK banks and building
societies in 2008)
A central bank is the financial institution within a country or group of countries that is typically
responsible for;
- Issuing of notes and coins
- Implementing monetary policy
- Managing exchange rates/gold and foreign currency reserves
- Acting as banker to the government, such as handling accounts of government departments,
managing national debt or making short term advances to the government
- Acting as banker to banks (i
...
the lender of last resort), as banks deposit in the central bank the
central bank can help improve the liquidity of the bank
- Regulating financial systems, which involves assessing the systemic risk of a financial system
and regulating it to prevent it from collapsing
...
Shadow banking are parts of the financial market that are much less
regulated than normal

- Liaising with other central banks/international financial organisations
A bank becomes insolvent when it more liabilities than assets (i
...
it owes more money than it
owns)
...

When determining interest rates a bank must take into account the demand for money, which is
affected by;
- Transactions demand for money
- Precautionary demand for money
- The speculative demand for money
The market for lovable funds is the notion that households will be influenced by the rate of interest
in making savings decisions, which will determine the quantity of loanable funds available for firms
to invest
...

Public expenditure is government spending on behalf of citizens
...
It is used;
- To improve efficiency and correct market failure

The government improve the productive efficiency of healthcare by benefitting from being a
monopsonist
...
Finally they
improve dynamic efficiency by providing incentives for farms to improve research and
development
- To improve equity and equality
- To achieve macroeconomic objectives
Capital government expenditure is spending on investment goods (e
...
infrastructure), where as
current expenditure is general government final consumption plus transfer payments plus debt
interest
...
e
...
Transfer payments are welfare
payments with no corresponding output
...

The effects of government expenditure:
- Living standards and equality should improve as market failures are corrected
...
g
...
Some argue that taxing some to benefit others decreases economic
welfare
...
However, economies with high levels of
government spending can only sustain this if they have high levels of taxation
- Increased public sector spending can lead to crowding out, where there is decreased private
sector spending as a consequence
...
Which effect that will take place
depends on the amount on government spending on transfer payments (as transfer payments
have no corresponding output), the levels of unemployment (low employment leads to crowding
out typically) and whether the increased government spending causes a shift in the PPF curve
- Productivity and growth may improve if resources are allocated effectively or there are positive
externalities
The government collect taxes for many reasons, namely to pay for government expenditure,
correct market failure by reducing the consumption of goods with negative externalities, to achieve
macroeconomic objectives (e
...
target inflation rates) and to redistribute income
...

The Laffer Curve shows the relationship between the rate of tax and the tax revenue collected
...
It may also
increase the rate of tax avoidance/evasion
...

The type of tax used also has an effect on income distribution
...

An increase in regressive taxes, such as VAT, may cause greater
inequalities in incomes
...

Direct taxes such as income tax will affect aggregate demand, as they change levels of consumers
discretionary income
...
An
increase in income tax could cause workers to demand higher wages to cover their loss in real
income, thus leading to a wage price spiral in the long run
...
If taxes increase, firms may cut back production to cover the increased cost,
causing an inward shift in aggregate supply, thus leading to less output and lower employment
rates
...
Decreased consumption leads to a negative multiplier effect,
also leading to decreased capital imports by firms
...

Some countries have lowered their rates of corporation tax to attract inflows of FDI
...
However, the ‘race to the bottom’ with tax competition means that tax
rates actually have a lower impact on firms decisions on where to invest
...
Many MNC’s have
exploited low tax rates to avoid taxation, thus leading to fiscal costs as tax revenues are still low
...

A cyclical deficit occurs due to fluctuations in government spending due to the trade cycle (e
...

during a boom, welfare benefits are likely to be lower and vice versa)
...

The actual deficit is the cyclical deficit added to the structural deficit
...

A current budget deficit occurs when government revenues are less than current expenditure
...
The size of this rise is dependent on the magnitude of government
borrowing, whether the government borrow internationally, whether quantitative easing is being
implemented and the ratio of government borrowing to private sector borrowing (they tend to
balance during a recession)
...

- Economists argue that increase the size of the National Debt and fiscal deficit has negative
implications for future generations, thus decreasing inter-generational equity
...

- A large National Debt and fiscal deficit may mean that firms have to either borrow more from the
private sector, which leads to no change in aggregate demand, or they can print money (i
...
use
quantitative easing to increase their money supply)
...
However, the rise in
inflation may not be significant if the economy is not near full capacity
...
A decreased credit rating leads to higher interest
rates, which may be reflected in domestic markets
...

Fiscal policy
Fiscal policy is a demand-side policy that uses changes in government spending, borrowing and
taxation to achieve macroeconomic objectives
...

Contractionary fiscal policy is the opposite
...
g
...
g
...

A fiscal deficit that is greater than 3% of GDP is likely to lead to an increase in the size of the
National Debt, which presents a problem as the National Debt may become so great that the cost
of servicing it creates a huge opportunity cost for the government
...
The government could wait for automatic
stabilisers to take effect, however this may not be as effective if the economy is in crisis
...
A decrease in terse
rates should decrease the economy’s marginal propensity to save
...
With more money injected into the
circular flow of income, there should be an outward shift in aggregate demand
...

Exchange rate policies

Exchange rate policies involves manipulating the exchange rate in order to achieve some
macroeconomic objectives
...
An increase in the exchange rate makes an economy less internationally
competitive, which has a negative impact on the balance of payments
...
This may be achieved through;
- Improving education and training to improve human capital
- Improving health care to improve productivity of the workforce
- Encouraging entrepreneurship
- Reducing discrimination
- Increasing benefits
- Decreasing direct taxes
- Capital investment
- Subsidies
- Reducing monopoly power in certain markets
Direct controls are government measures imposed on the price or quantity of a single product of
factor of production
...
These can be used tot target individuals in
an economy, thus improving economic welfare
...

Problems facing policy makers:

- External shocks, such as financial crisis and commodity price shocks
- Inaccurate information
- Risks and uncertainties



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