Economics Unit 4 Notes r4427

Economics Unit 4 Notes Definitions Definition of law of diminishing returns (2 marks) — if increasing quantities of a variable factor are applied to a given quantity of a fixed factor, the marginal product of the variable factor will eventually decrease. In economics, the marginal product of labor(MPL) is the change in output that results from employing an added unit of labor Free Market- an economic system in which prices are determined by unrestricted competition between privately owned businesses. Capitlism- private ownership of resources Income inequality refers to the extent to which income is distributed in an uneven manner among a population. Relative poverty Where individual or household income falls below some national average or median income

Capital Flight' A large-scale exodus of financial assets and capital from a nation due to events such as political or economic instability, currency devaluation or the imposition of capital controls.

Absolute poverty was defined as: a condition characterised by severe deprivation of basic human needs, including food, safe drinking water, sanitation facilities, health, shelter, education and information. It depends not only on income but also on access to services.

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Essay Marking Examination length: 2 hours One essay question with two parts from a choice of three topic areas. Worth 50 marks. One data response question out of a choice of two questions. Worth 50 marks. use and evaluate more complex models involving more variables, for example pricing and output decisions under different market structures (see Unit 3) „ apply models to a wider range of contexts, for example students should consider the causes and consequences of inequality in developed and developing countries (see Unit 4) „ develop the ability to apply and evaluate economic models as represented in written, numerical and graphical form, for example in Unit 3 students will need to be able to draw a cost curve and explain its shape in of diminishing marginal returns and economies of scale „ be able to propose possible solutions to problems, for example in Unit 4, students have to apply concepts and theories which may be appropriate to promote growth and development in a particular economy „ understand the relationships and linkages which underpin macro-economic models, for example in Unit 4, students should understand global factors which influence a country’s exchange rate „ be able to predict the possible impact of policy changes on local, national and international economies, for example in Unit 4 the AD/AS model is applied in analysing and evaluating the use of policies to achieve economic objectives

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„ be able to evaluate the effectiveness of government policies across a range of contexts, for example in Unit 4, students have to examine government policy to increase international competitive Unit 4 students have to identify constraints on growth and development in different economies and reasons for their different growth rates. 30 marks- 4 kaa and 3 eval maybe diagram 10 marks – definition, 2 application, reference and evaluation

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Globalisation Rowstow model J curve Harrod domar model Budget deficit Prebisch singer Infrant industry argument for eval of globaltion Phillps curve

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Globalisation

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Globalisation has involved: Greater free trade. Greater movement of labour. Increased capital flows. Growth of Multi-national companies. Increased integration of global trade cycle. Increased communication and improved transport, effectively reducing barriers between countries.

Benefits of Globalisation

1. 2. 3. 4. 5.

1. Free Trade Free trade is a way for countries to exchange goods and resources. This means countries can specialise in producing goods where they have a comparative advantage (this means they can produce goods at a lower opportunity cost). When countries specialise there will be several gains from trade: Lower prices for consumers Greater choice of goods Bigger export markets for domestic manufacturers Economies of scale through being able to specialise in certain goods Greater competition See: Benefits of Free Trade

2. Free Movement of Labour Increased labour migration gives advantages to both workers and recipient countries. If a country experiences high unemployment, there are increased opportunities to look for work elsewhere. This process of labour migration also helps reduce geographical inequality. This has been quite effective in the EU, with many Eastern European workers migrating west. Also, it helps countries with labour shortages fill important posts. For example, the UK needed to recruit nurses from the far east to fill shortages. However, this issue is also quite controversial. Some are concerned that free movement of labour can cause excess pressure on housing and social services in some countries. Countries like the US have responded to this process by actively trying to prevent migrants from other countries. 3. Increased Economies of Scale.

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Production is increasingly specialised. Globalisation enables goods to be produced in different parts of the world. This greater specialisation enables lower average costs and lower prices for consumers. 4. Greater Competition Domestic monopolies used to be protected by lack of competition. However, globalisation means that firms face greater competition from foreign firms. 5. Increased Investment Globalisation has also enabled increased levels of investment. It has made it easier for countries to attract short term and long term investment. Investment by multinational companies can play a big role in improving the economies of developing countries.

Costs Of Globalisation 1. Free Trade can Harm Developing Economies. Developing countries often struggle to compete with developed countries, therefore it is argued free trade benefits developed countries more. There is an infant industry argument which says industries in developing countries need protection from free trade to be able to develop. However, developing countries are often harmed by tariff protection Western economies have on agriculture. Paradox of Free Trade 2. Environmental Costs One problem of globalisation is that it has increased the use of non renewable resources. It has also contributed to increased pollution and global warming. Firms can also outsource production to where environmental standards are less strict. However, arguably the problem is not so much globalisation as a failure to set satisfactory environmental standards. 3. Labour Drain Globalisation enables workers to move more freely. Therefore, some countries find it difficult to hold onto their best skilled workers, who are attracted by higher wages elsewhere. 4. Less Cultural Diversity Globalisation has led to increased economic and cultural hegemony. With globalisation there is arguably less cultural diversity, however it is also led to more options for some people. 5. Tax Competition and Tax avoidance. Multinational companies like Amazon and Google, can set up offices in countries like Bermuda and Luxembourg with very low rates of corporation tax and then funnel their profits through these subsidiaries. This means they pay very little tax in the countries

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where they do most of their business. This means governments have to increase taxes on VAT and income tax. It is also seen as unfair competition for domestic firms who don’t use same tax avoidance measures. The greater mobility of capital, means that countries have sought to encourage inward investment by offering the lowest corporation tax. (e.g. Ireland offers very low tax rate). This has encouraged lower corporation tax, which leads to higher forms of other tax. (see: Tax competition) Globalization and inequality Accept analysis of different types of inequality e.g. income and wealth. Analysis that inequality between countries has decreased: • Closer integration of countries e.g. through trade liberalisation has resulted in increased living standards in developing countries But: monopsony power of TNCs in developed economies might keep people in developing countries relatively poor • Increased trade has resulted in rapid growth rates in countries such as China and India which have lifted large numbers of people out of poverty But: some countries left behind e.g. those with civil wars such as Mali or wars with neighbours Sudan/South Sudan • Differences in levels of foreign direct investment • Differences in the take up of technology/internet/broadband/mobile phones • Increased demand for commodities has resulted in an increase in prices so leading to an improvement in the of trade and higher living standards of some developing countries. But: problem that supplies of some non-renewable commodities will be exhausted in the future so the decrease in inequality might be temporary; fluctuating commodity prices so reduction in inequality might be emporary Analysis that inequality within countries has increased: (these points may be used as evaluation) • Unskilled workers in developed countries have been priced out of the market by outsourcing of work to low wage countries But: with rising transport and wage costs in developing countries, some companies are moving factories back to developed countries • In developing countries, workers moving to industrialised areas likely to see their wages rise relative to those remaining in rural areas • Evidence that earnings of top 1% of workers has increased relative to those on middle incomes – related to global market for top executives/footballers/entertainers • Relative poverty within countries has increased e.g. because of fall in demand for unskilled labour in developed countries; industrialisation in developing countries But governments can take measures to redistribute incomes. Further evaluative point: • Consideration of the difference between inequality of income and wealth

Current deficits and surplus Number of policies that the government can use to reduce the current deficit. 1. Demand management: Reductions in government spending, higher interest rates and higher taxes could all have the effect of dampening consumer demand reducing the demand for imports. This leads to an increase in spare productive capacity which can then be allocated towards exporting. 2. Natural effects of the economic cycle: One would expect to see a trade deficit fall during a recession – so some of the deficit is partially self-correcting – but this does little to address the problems of a structural balance of payments problem. 3. A lower exchange rate:

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a. The central bank of a country might decide that a lower exchange rate provides a suitable way of improving competitiveness, reducing the overseas price of exports and making imports more expensive b. For those countries operating with a managed exchange rate, the government may decide to authorise intervention in the currency markets to manipulate the value of the currency 4. Supply-side improvements: a. Policies to raise productivity, measures to bring about more innovation and incentives to increase investment in industries with export potential are supply-side measures designed to boost exports performance and compete more effectively with imports. The time-lags for supply-side policies to have an impact are long. b. Policies to encourage business start-ups – successful small businesses with export potential c. Investment in education and health-care to boost human capital and increase competitiveness in fast-growing and high value industries such as bio-technology, engineering, finance, medicine d. Investment in modern critical infrastructure to businesses and industries involved in international markets 5. Protectionist measures such as import quotas and tariffs are rarely used because of our commitments to the World Trade Organisation and our hip of the European Union.

Increasing competitiveness Firms can increase their international competitiveness by: 

Rationalisation output to get rid of high cost plants

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Relocating to places where labour costs are lower

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Process innovation

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Product innovation

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Incorporating the latest technology into investment

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Sourcing from abroad where appropriate

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Seeking out new market opportunities

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Improving relationships with suppliers and customer

Government’s role to improve international competitiveness Governments seek policies which aim to: 

Encourage R&D spending (e.g. through tax breaks)

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Improve the skills base

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Improve the economic infrastructure

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Promote competition between firms

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Operate macro-economic policies favourable to business expansion

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Reduce interest rates to stimulate investment

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Reduce tax rates to stimulate enterprise, effort and investment

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Deregulation to promote competition

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Reduce bureaucracy

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Encourage sharing of ideas and best practice

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Reduce protectionist barriers to stimulate competition

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Encourage investment in human capital

Potential benefits of a budget deficit 1. Government borrowing can benefit growth: A budget deficit can have positive effects if it is used to finance capital spending that leads to an increase in the stock of national assets. For example, spending on transport infrastructure improves the supply-side capacity of the economy. And increased investment in health and education can boost productivity and employment.

2. The budget deficit as a tool of demand management: Keynesian economists the use of changing the level of government borrowing as a legitimate instrument of managing aggregate demand. An increase in borrowing can be a useful stimulus to demand when other sectors of the economy are suffering from weak or falling spending. If crowding out is not a major problem - fiscal policy can play an important counter-cyclical role “leaning against the wind” of the economic cycle. Economic growth is a long-term expansion of a country’s productive potential

Reasons for current deficit.

There are various factors which could cause a current deficit: 1. Fixed Exchange Rate If the currency is overvalued, imports will be cheaper and therefore there will be a higher Q of imports. Exports will become uncompetitive and therefore there will be a fall in the quantity of exports. 2. Economic Growth If there is an increase in national income, people will tend to have more disposable income to consume goods. If domestic producers can not meet the domestic demand, consumers will have to import goods from abroad. In the UK we have a high Marginal propensity to imports mpm because we do not have a comparative advantage in the

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production of manufactured goods. Therefore if there is fast economic growth there tends to be a significant increase in the quantity of imports. 3. Decline in Competitiveness. In the UK there has been a decline in the exporting manufacturing sector, because it has struggled to compete with developing countries in the far east. This has led to a persistent deficit in the balance of trade. 

Higher inflation This makes exports less competitive and imports more competitive. However this factor may be offset by a decline in the value of sterling.

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Recession in other countries. If the UK’s main trading partners experience negative economic growth then they will buy less of our exports, worsening the current . However • Trade in goods balance is just one part of the current and may be balanced by surplus in trade in services or in investment income • Deficit might be financed by inflows into the Financial Significance depends on deficits/surplus as a percentage of GDP Debt forgiveness will mean that the country has to stop paying interest on the loan meaning that outflows from the investment income section of the current decreases leading to a improvement on the current .

Savings gap is the difference between private investment and savings.

A free trade area — is a group of countries that agree to have free trade between themselves.

Customs union — is an agreement between a group of countries to set a common external trade

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Strategies to promote growth and development Microfinance Fair trade schemes Aid Debt CancellationTo reduce absolute poverty: no more interest payments on debt • More resources available for health care leading to increased life expectancy • More resources for education leading to increased school enrolment and higher literacy rates • To provide resources for investment: multiplier effects: link to increased growth and more resources for health, education…. • Effective as an immediate way to fill savings gap • Helps to fill foreign exchange gap enabling LEDCs to buy capital equipment; oil etc • Opportunity cost of debt servicing • More resources for public services Eval Danger of corruption: money saved not spent e.g. to improve health and education • Misuse of money saved e.g. for defence purposes • Creation of a dependency culture • Moral hazard • May be used to generate political influence Developing different sectors of the economy Agriculture Manufacturing industry Tourism Trade Liberalisation Case for trade liberalisation: • LEDCs have access to markets in developed countries: increased exports and higher GDP, the proceeds of which may be used for health, education, improved access to clean water • Increased competition might promote increase efficiency in LEDCs • Incentive for multinationals to establish production plants in the country so contributing to industrialisation • Consumers benefit from lower prices and more choice • More efficient use of resources – based on law of comparative advantage leading to increased growth • Enables LEDCS to become less dependent on aid • Use of tariff diagram to illustrate impact of cut in tariffs e.g. on (30 ) consumer surplus, producer surplus, welfare gains However: • Domestic firms in LEDCs may be unable to compete with TNCs from developed economies • Infant industries may be unable to survive • Monopsony power of TNCs might result in exploitation of resources of LEDcs • Environmental arguments against free trade • Problems of overspecialisation • Dumping by developed countries Other evaluative comments: • It could be argued that without individual freedom, democracy and the rule of law, economic development is not possible • Difficulty of defining economic development precisely

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Factors which cause growth and development to slow down • Primary product dependency But less of an issue if prices of primary products are rising; some countries have developed on the basis of specialisation in primary products • Savings gap But could be offset by FDI or aid; • Foreign exchange gap But could be offset by debt cancellation • Protectionism by developed economies But WTO active in bringing about a reduction in tariffs • Debt But could be offset by debt cancellation • Rapid population growth: creating a high dependency ratio But: larger markets will be created in the future and larger workforces • Poor education and health care • Poor/inadequate infrastructure; land-locked countries • Corruption; poor governance • Political instability; Civil war • Disease e.g. AIDS Other evaluative comments could include: • Prioritisation of factors • Problem of defining economic development precisely • Some problems may be of a short term nature only

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Quantative easing will mean that exhcnage rates decrese

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Policies include: Monetary policy: discussion of transmission mechanism; AD/AS analysis Evaluation: • consideration of whether it is appropriate to target inflation or asset prices; • adverse effects on other variables of changing interest rates e.g. on exchange rate; • time lags; • Negative impact on growth and employment • Inappropriate to raise interest rates when inflation is caused by cost push factors Supply side policies: discussion of those which impact on the price level i.e. measures to increase competition and productivity; transmission mechanism; education and training Evaluation: some policies will have implications for public finances; time lags Fiscal policy: discussion of transmission mechanism; AD/AS analysis (30 ) Evaluation: ineffective if consumers reduce savings following a rise in taxes; very blunt instrument – adverse impact on other variables e.g. unemployment. • In the case of oil, governments might react by cutting the tax on petrol

The interest rate transmission mechanism Interest rates transmit their way to aggregate demand in the following ways: 1. Household demand is affected because changes in interest rates affect savings, which indirectly affect spending. 2. For households or firms with existing debt, such as a mortgage, a change in rates affects repayments, and hence individuals have more (or less) cash after servicing their debts. Changes in rates affect the cash-flow of firms and households. 3. In the case of new debt to fund spending, borrowing is also encouraged (or discouraged) following interest rate changes. 4. Interest rates also affect consumer and business confidence, which in turn affects spending. 5. Asset values are also affected by interest rates. A fall in rates will tend to increase the profitability of firms and they may pay higher dividends to shareholders. This can trigger an increase in household spending. Similarly, a rate fall makes savings less attractive and property more attractive, increasing the value of property and household wealth. 6. Finally, interest rates may affect the exchange rate, which can also influence export demand. For example, a rise in interest rates may raise the exchange rate, pushing up export prices and reducing overseas demand. Changes in the exchange rate also affect the price of imports, which also affect the inflation rate.

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Cancellation of debt Case for debt cancellation: • To reduce absolute poverty: no more interest payments on debt • More resources available for health care leading to increased life expectancy • More resources for education leading to increased school enrolment and higher literacy rates • To provide resources for investment: multiplier effects: link to increased growth and more resources for health, education…. • Effective as an immediate way to fill savings gap • Helps to fill foreign exchange gap enabling LEDCs to buy capital equipment; oil etc • Opportunity cost of debt servicing • More resources for public services eval • Danger of corruption: money saved not spent e.g. to improve health and education • Misuse of money saved e.g. for defence purposes • Creation of a dependency culture • Moral hazard • May be used to generate political influence

The Prebisch-Singer Hypothesis (PSH) is more of an observation rather than a complex theory. It suggests that over the long run the price of primary goods such as coal, coffee cocoa declines in proportion to manufactured goods such as cars, washing machines and computers. The income elasticity for demand of manufactured goods is greater than that for primary products. So as income increase than manufactured goods rise at a faster pace then primary. However it has been criticised If a countries has comparative advantage in producing primary products then it will be more efficient of them to do so. There was a greater price growth of primary goods in 2008 then secondary goods.

Rowstow model

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Duel sector model The model assumes that a developing economy has a surplus of unproductive labour in the agricultural sector. These workers are attracted to the growing manufacturing sector where higher wages are on offer. It is also assumed that the wage on offer in the manufacturing sector is fixed. Entrepreneurs in the manufacturing sector will make a profit because they charge a price above the fixed wage rate. The model then assumes that these profits will be reinvested in the business in the form of more fixed capital. Firms productive capacity is thus increased and entrepreneurs will demand a greater amount of labour. More workers will be employed from the surplus found in the agricultural sector. The process continues until all surplus labour from the agricultural sector has been employed. The manufacturing sector has grown and the economy has moved from a traditional to industrialized one If wages are 30% higher than rural wages (1 mark), workers will move to the modern urban industrial sector where the marginal product of labour is much higher. (1 mark) The industrial sector will then employ these extra workers without pushing up wages. (1 mark) This allows firms to make large profits (1 mark) which are then reinvested. (1 mark) Growth means more jobs for surplus rural labour (1 mark) and the additional workers increase output, and thus also incomes and profits, further. (1 mark) Extra incomes will also increase demand for domestic products (1 mark) while increased profits fund increased investment. (1 mark) Hence rural–urban migration offers selfgenerating growth.

Criticisms of the Model • Model assumes that all profits made by the entrepreneurs will be reinvested, this may not always be the case • Reinvestment may take place in the form of fixed capital but it may be capital that is labour saving and thus demand for labour may in fact fall. • The model also assumes that there is a surplus of labour in the agricultural sector that can easily move to the manufacturing sector. • Wage levels may not always be fixed. There may be upward pressure on wages for example through trade union activity and profits may therefore fall.

Harrod domar model The Harod Domar Model suggests that economic growth rates depend on two things: 1. Level of Savings (higher savings enable higher investment) 2. Capital Output Ratio (efficiency of investment)

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g=s/c where – g is the economic growth rate – s=S/Y is the ratio of saving S to income,Y, – c is marginal capital-output ratio It is argued that in developing countries saving rates are often low, if left to the free market. Therefore, there is a need for governments to increase the savings rate in an economy. Alternatively, developed countries could step in and transfer capital stock to the developing countries, which would increase the productive capacity.

Warranted Growth Rate Roy Harrod introduced a concept known as the warranted growth rate.    

This is the growth rate at which all saving is absorbed into investment. (e.g. £80bn of saving = £80bn of investment. Let us assume, the saving rate is 10%. the Capital output ratio is 4. In other words £10bn of investment, increases output by £2.5bn In this case the economy’s warranted growth rate is 2.5 percent (ten divided by four). This is the growth rate at which the ratio of capital to output would stay constant at four.

The Natural Growth Rate   

The natural growth rate is the rate of economic growth required to maintain full employment. If the labor force grows at 3 percent per year, then to maintain full employment, the economy’s annual growth rate must be 3 percent. This assumes no change in labour productivity which is unrealistic.

Criticisms of Harod Domar Model  

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Developing countries find it difficult to increase saving. Increasing savings ratios may be inappropriate when you are struggling to get enough food to eat. Harod based his model on looking at industrialised countries post depression years. He later came to repudiate his model because he felt it did not provide a model for long term growth rates. The model ignores factors such as labour productivity, technological innovation and levels of corruption. The Harod Domar is at best an oversimplification of complex factors which go into economic growth. There are examples of countries who have experience rapid growth rates despite a lack of savings, such as Thailand.

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It assumes the existences of a reliable finance and transport system. Often the problem for developing countries is a lack of investment in these areas. Increasing capital stock can lead to diminishing returns. Domar was writing during the aftermath of the Great Depression where he could assume there would always be surplus labour willing to use the machines, but, in practice this is not the case. The Model explains boom and bust cycles through the importance of capital, (seeaccelerator theory) However, in practice businesses are influenced by many things other than capital such as expectations. He assumed there was no reason for the actual growth to equal natural growth and that an economy had no tendency to full employment. However, this was based on assumption of wages being fixed.

J curve

Phillps curve

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The curve suggested that changes in the level of unemployment have a direct and predictable effect on the level of price inflation. The accepted explanation during the 1960’s was that a fiscal stimulus, and increase in AD, would trigger the following sequence of responses: 1. An increase in the demand for labour as government spending generates growth. 2. The pool of unemployed will fall. 3. Firms must compete for fewer workers by raising nominal wages. 4. Workers have greater bargaining power to seek out increases in nominal wages. 5. Wage costs will rise. 6. Faced with rising wage costs, firms on these cost increases in higher prices.

Using AD/AS to demonstrate the Phillips Curve effect  This process can also be explained through AD-AS analysis.  Assume the economy is at a stable equilibrium, at Y. An increase in government spending will shift AD from AD to AD1, leading to a rise in income to Y1, and a fall in unemployment, in the short term.

 However, households will successfully predict the higher price level, and build these expectations into their wage bargaining.

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 As a result, wage costs rise and the AS shifts up to AS1 and the economy now moves back to Y, but with a higher price level of P2.  It is argued that the effectiveness of supply side policies has meant that the economy can continue to expand without inflation.

It is argued that the effectiveness of supply side policies has meant that the economy can continue to expand without inflation.

Expansionary (or loose) Fiscal Policy   

This involves increasing AD. Therefore the government will increase spending (G) and / or cut taxes (T). Lower taxes will increase consumers spending because they have more disposable income (C) This will tend worsen the government budget deficit and the government will need to increase borrowing.

Deflationary (or tight) Fiscal Policy   

This involves decreasing AD. Therefore the government will cut government spending (G) and / or increase taxes. Higher taxes will reduce consumer spending (C) Tight fiscal policy will tend to cause an improvement in the government budget deficit.

Marshal learners condition

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Lorenz curve A Lorenz curve shows the % of income earned by a given % of the population. A ‘perfect’ income distribution would be one where each % received the same % of income.

Perfect equality would be, for example, where 60% of the population gain 60% of national income. In the above Lorenz curve, 60% of the population gain only 20% of the income, hence the curve diverges from the line of perfect equality of income. The further the Lorenz curve is from the 45 degree line, the less equal is the distribution of income.

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Changes in the position of the Lorenze curve indicates changes in the distribution of income. The Gini co-efficient or index is a mathematical device used to compare income distributions over time and between economies. The Gini coefficient can be used in conjunction with the Lorenz curve. It is calculated by comparing the area under the Lorenz curve and the area from the 450 line to the right hand and 'x' axis. In of the Gini index, the closer the number is to 100 the greater the degree of inequality.

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