Microeconomics Notes PDF

Giorgio Dal Pont MICROECONOMICS ( Chapter 1 —> 6 ) 1  Giorgio Dal Pont Chapter 1: the foundations of economics - Microeconomics —>examines the behaviour of individual deci...

Giorgio Dal Pont MICROECONOMICS ( Chapter 1 —> 6 ) 1  Giorgio Dal Pont Chapter 1: the foundations of economics - Microeconomics —>examines the behaviour of individual decision-making units in the economy —> uses consumers and firms - Macroeconomics —> examines the economy as a whole to obtain a broad overall picture —> uses aggregates (collections of many individual units) The four factors of production: - Land —> all natural resource - Labour —> the physical and mental effort that people contribute to the production of goods - Capital —> physical capital —> a man-made factor of production used to produced goods - Entrepreneurship —> organises the other three factors of production and takes on the risks Other meanings of capital: - Physical capital - Human capital —> skills, abilities and knowledge acquired by people - Natural capital —> refers to an expanded meaning of the factor of production “land” - Financial capital —> investments in financial instruments Opportunity cost and scarcity: - Opportunity cost —> the value of the next best alternative that must be sacrificed for a good - Scarcity —> resources are finite whereas wants are infinite - Economics —> the study of choices leading to the best use of scarse resource to best satisfy the unlimited human needs and wants - Sustainability —> the environment and the economy can produce needs and wants in the future - Free good —> a good that is not scarce and so has zero opportunity cost - Economic good —> any good that is scarse and has an opportunity cost bigger than zero The basic economic questions: 1) What / how much to produce 2) How to produce 3) For whom to produce - Resource allocation —> assigning resources to specific uses, chosen among many alternatives - Government intervention changes the allocation of resources Production Possibilities curve: - Represents all combinations of the max. amounts of two goods that can be produced by an economy (production possibilities —> points on curve) - All resources must be fully employed to be on the line - All resources must be used efficiently 2  Giorgio Dal Pont - Because of scarcity the economy cannot produce outside the PPC - The economy must make a choice on what combination of goods will be produced - Choices involve opportunity costs - Economic growth —> increase in the quantity of output produced in an economy over a time - Actual growth —> caused by a reduction in unemployment and increases in the efficiency of production ——————————————————————————————————————— 3  Giorgio Dal Pont Chapter 2: competitive markets (demand and supply) 2.1 Introduction to competitive markets Markets: - market —> where buyers and sellers of goods, services and resources carry out an exchange —> can be local, national and international —> goods and services are sold in product markets while resources in factor markets - Competition —> a process in which rivals compete in order to achieve some objective - The greater the market power of a firm, the greater is the control over price - Competitive market —> composed of large numbers of sellers and buyers acting independently —> no one individual seller has the ability to control the price of the product —> price determined by interactions of many sellers and buyers 2.2 Demand The law of demand and the demand curve: - Individual demand —> indicates the various quantities of a good the consumer is willing and able to buy at different possible prices, ceteris paribus - Law of demand —> negative causal relationship between the price of a good and its quantity demanded (inversely proportional), ceteris paribus - Market demand —> sum of all individual demands for a good Non-price determinants of demand (shift) + price: - Non-price determinants of demand —> the variables other than price that can influence demand and bring to a shift of the demand curve to the right or to the left - Non-price determinants of demand —> income in the case of normal goods —> income in the case of inferior goods —> Preferences and tastes —> Prices of substitute goods —> Prices of complementary goods —> Number of consumers - Price —> whenever the price of a good changes, ceteris paribus, it leads to a movement along the demand curve 4  Giorgio Dal Pont 2.3 Supply The law of supply and the supply curve: - Individual supply —> the various quantities of a good a firm is willing and able to produce and supply to the market for sale at different possible prices, ceteris paribus - Law of supply —> positive causal relationship between the price of a good and its quantity supplied (proportional), ceteris paribus - Market demand —> sum of all individual supplies for a good - The vertical supply curve (fixed quantity) —> no time to produce more of it —> no possibility of ever producing more of it Non-price determinants of supply (shift) + price: - Non-price determinants of supply —> the variables other than price that can influence supply and bring to a shift of the supply curve to the right or to the left - Non-price determinants of supply —> Costs of factors of production —> Technology —> Prices of related goods: competitive supply —> Prices of related goods: joint supply —> Producer (price) expectation —> Taxes or subsidies —> Number of firms —> Shocks or sudden unpredictable events - Price —> whenever the price of a good changes, ceteris paribus, it leads to a movement along the supply curve 2.4 Competitive Market Equilibrium Market equilibrium: - Market equilibrium —> quantity demanded is equal to quantity supplied - Equilibrium price —> the price at market equilibrium - Equilibrium quantity —> the quantity at market equilibrium - Market disequilibrium —> excess in supply or demand which cause the price to change until the market reaches equilibrium - Excess in demand —> shortages - Excess in supply —> surplus - Changes in market equilibrium are due to shifts of the demand and the supply curve 5  Giorgio Dal Pont 2.5 The role of the price mechanism and market efficiency Functions of the price mechanism: - Signals —> prices communicate information to decision-makers - Incentives —> prices motivate decision-makers to respond to the information - Market demand and market supply determine equilibrium prices and quantities for goods - What to produce —> firms produce only those goods consumers are willing and able to buy - How to produce —> factors of p. that the firm is willing and able to pay - Price rationing —> wether or not a consumer will get a good is determined by the price of it - Non-price rationing —> planned economies or non-price rationing systems Allocative efficiency in competitive markets: - Allocative efficiency —> producing the quantity of goods mostly wanted by society - Marginal benefit —> the extra benefit that you get from each additional unit of something bought - Demand curve = Marginal benefit curve - Marginal cost —> the extra cost of one more unit of output —> typically increases as units of output produced increase - MB = MC —> allocative efficiency - MB > MC —> greater value on the last unit of the good produced than it costs to produce it - MB < MC —> costing society more to produce the last unit of the good than the value it has Consumer and Producer surplus: - Consumer surplus —> the highest price consumers are willing to pay for a good minus the price actually paid (the area) —> ((P intercept of D curve - P of consumers) * Q purchased) / 2 - Producer surplus —> the price received by firms for selling their good minus the lowest price that they are willing to accept to produce the good (the area) —> ((P of producers - P intercept of S curve) * Q sold) / 2 - Social/community surplus —> sum of consumer and producer surplus - Welfare —> the amount of consumer and producer surplus (when MB = MC) - Governments should intervene because: —> efficiency can only arise under a number of very strict and highly unrealistic conditions —> competitive market is unable to answer the for whom question —> to counteract the failing of markets —> helps realise their potential advantages ——————————————————————————————————————————— 6  Giorgio Dal Pont Chapter 3: Elasticities The use of percentages for elasticities: - Independent of units (cars, oranges, …) - Independent of currencies (different currencies across countries) - Allows to express elasticities in common terms - Allows to put responsiveness into perspective 3.1 Price elasticity of demand Price elasticity of demand: - A measure of the responsiveness of the quantity of a good demanded to changes in its price - The minus sign is always dropped - Steeper the demand curve, the less elastic the demand. Flatter the demand curve the more elastic - Price elastic —> quantity demanded is highly responsive to a change in price - Price inelastic —> quantity demanded is not very responsive to a change in price - The formula for PED —> (% change in Quantity)/(% change in Price) —> (change in quantity / initial quantity) / (change in price / initial price) Ranges of value of PED: - PED < 1 —> Price inelastic - PED = 0 - PED > 1 —> Price elastic - PED = infinity - PED = 1 —> Unitary elastic 7  Giorgio Dal Pont Determinants of PED: - Number and closeness of substitutes —> the more substitutes, the more elastic is the demand —> the closer the substitute, the greater the elasticity - Necessities versus luxuries —> the more necessary a good, the less elastic the demand —> the greater the degree of addiction, the more inelastic the demand - Length of time —> the longer the period, the more elastic the demand PED and total revenue: - Total revenue —> the amount of money receive by firms when they sell a good (Price * Quantity) - When PED > 1 —> total revenue increases if there is a price decrease - When PED < 1 —> total revenue decreases if there is a price decrease - When PED = 1 —> total revenue remains constant to changes in price PED and firm pricing decisions and taxes: - Business must take PED into account when considering changes in the price of their product - If governments are interested in increasing their tax revenues, they must consider the PED because the lower the PED for the taxed good, the greater the tax revenue. 3.2 (YED) income elasticity of demand Income elasticity of demand: - A measure of the responsiveness of demand to changes in income, involves demand curve shifts - Formula for YED —> (change in quantity / initial quantity) / (change in income / initial income) - YED —> can be both positive or negative Ranges of value of YED: - YED > 0 —> normal good - YED < 0 —> inferior good - YED < 1 —> Necessities good - YED > 1 —> Luxuries and services Engel curve: - If the lines’ projection touches the vertical axis (luxury or service) - If the lines’ projections doesn’t touch the vertical axis (necessity) - At very low incomes a good may be luxury, as income increases it becomes necessity, and at high income level it becomes inferior 3.3 Price elasticity of supply (PES) Price elasticity of supply: - PES —> is a measure of the responsiveness of the quantity of a good supplied to changes in price - Steeper the demand curve, the less elastic the demand. Flatter the demand curve the more elastic 8  Giorgio Dal Pont - Price elastic —> quantity supplied is highly responsive to a change in price - Price inelastic —> quantity supplied is not very responsive to a change in price - The formula for PES —> (% change in Quantity)/(% change in Price) —> (change in quantity / initial quantity) / (change in price / initial price) Ranges of value of PES: - PES < 1 —> Price inelastic - PES = 0 - PES > 1 —> Price elastic - PES = infinity - PES = 1 —> Unitary elastic Determinants of PES: - Length of time —> over a very short time, the firm may be unable to increase or decrease any of its inputs to change the quantity it produces - Mobility of factors of production —> the more easily and quickly resources can be shifted out of one line of production and into another, the greater the PES - Space capacity of firms —> the greater the spare capacity, the higher the PES - Rate at which costs increase —> if the costs of producing extra output increase rapidly, the supply will be inelastic and viceversa ———————————————————————————————————————— 9  Giorgio Dal Pont Chapter 4: Government intervention in microeconomics 4.1 Government intervention in markets Why governments intervene in markets: - Earn revenue for the government —> indirect taxes - Provide support to firms —> with subsidies, trade protection measures (tariffs, quotas,…) - Provide support to households on low incomes —> subsidies, price ceilings, direct provision - Influence the levels of production of firms - Influence levels of consumption of consumers - Correct market failure (failures to achieve allocative efficiency in markets) - Promote equity How governments intervene in markets: - Price controls —> price ceilings and price floors - Indirect taxes - Subsidies - Direct provision of services - Command and control regulation and legislation - Consumer nudges 4.2 Price controls Fixed prices —> prices are fixed at a particular level (ticket prices, …) Price controls —> the setting of minimum or maximum prices by the government Price ceilings: - Legal maximum price set below the equilibrium price, in order to make goods more affordable to people on low incomes - Used to make certain goods more affordable to people on low incomes Consequences for markets: - Shortages - Non-price rationing of goods and services - Underground (or parallel) markets - Underallocation of resources and allocative inefficiency - Negative welfare impacts 10  Giorgio Dal Pont Consequences for stakeholders: - Consumers —> partly gain and partly lose (some buy at lower price, some can’t buy, not enough) - Producers —> sell a smaller quantity at a lower price - Workers —> some workers are likely to be fired - Governments —> may gain political popularity Price floors: - A minimum price set below the equilibrium price, in order to provide income support to farmers or to increase the wages of low-skilled workers Consequences for markets: - Surpluses —> the government will buy the excess supply generates by price floors - Government measures to dispose of surpluses —> store it or export the surplus - Firm inefficiency —> firms with price floors do not face incentives to cut costs - Overallocation of resources to the production and allocative inefficiency - Negative welfare impacts Consequences for stakeholders: - Consumers —> must now pay a higher price for the good - Producers —> gain as they receive a higher price and produce a larger quantity - Workers —> gain as employment increases - Government —> less government funds to spend on other desirable activities in the economy - Stakeholders in other countries —> waste of resources Minimum wages: - the minimum price of labour that an employer must pay - Labour surplus and unemployment - Illegal workers at wages below the minimum wage - Misallocation of labour resources (they cost more) - Misallocation in product markets (increase in costs of production) - Workers —> some gain because higher wage, some lose because they lose their job - Consumers —> leads to a decrease in supply of products 4.3 indirect taxes - are imposed on spending to buy goods and services and are paid partly by consumers, but are paid to the government by producers - Excise taxes —> imposed on particular goods and services (specific taxes —> fixed amount of tax per unit, or ad valorem taxes —> fixed percentage of the price) 11  Giorgio Dal Pont Why governments impose indirect taxes: - Are a source of government revenue - Are a method to discourage consumption of goods that are harmful for the individual - Can be used to redistribute income —> can focus on luxury goods - A method to improve allocation of resources by correcting negative externalities Consequences of indirect taxes for various stakeholders - Consumers —> are receiving less of the good and paying more for it - Producers —> fall in price they receive and fall in the quantity of output they sell - Government —> positive for the government budget as more revenue - Workers —> a lower amount of output means that fewer workers will be needed - Society —> underallocation of resources to the production of the good 4.4 Subsidies - Refers to assistance by the government to individuals or groups of individuals - Specific subsidies —> consist in payments by the government to firms Uses of subsidies: - Can be used to increase revenues of producers - Can be used to make certain goods affordable to low-income consumers - Can be used to encourage production and consumption of goods that are desirable for consumers - Can be used to support the growth of particular industries in an economy - Can be used to encourage exports of particular goods - A method to improve the allocation or resource by correcting positive externalities Consequences of subsidies for various stakeholders: - Consumers —> fall in price and increase in quantity - Producers —> they receive a higher price and produce a larger quantity - Government —> government’s budget is negative as it pays the subsidies - Workers —> firms are likely to hire more worker to produce the extra output - Society —> overallocation of resource to the production of a good - Foreign producers —> negative for producers of other countries as may be unable to compete ———————————————————————————————————————— 12  Giorgio Dal Pont Chapter 5: Common pool resources and negative externalities 5.1 The meaning of common pool resources Common pool resources: - Resources not owned by anyone, do not have a price and are available for anyone to use without payment or any other restriction. They are rivalrous and non-excludable - Rivalrous —> its consumption by one person reduces its availability for someone else - Excludable —> it is possible to exclude people by using the good or charging a price - Unsustainable production —> using resources unsustainably, depleting or degrading them - Non-renewable resources —> resources that do not last indefinitely as they have a finite supply - Renewable resource —> resources that can last indefinitely if they are managed properly 5.2 Diverging private and social benefits and costs Externalities: - Occurs when the actions of consumers or producers give rise to negative or positive side-effects on third parties, and whose interest are not considered - Positive externality —> benefits to third parties - Negative externality —> negative side-effects to third parties - Consumption externality when results from consumption activities, and production externalities when results from production activities - Marginal private cost (MPC) —> the costs to producers of producing one more unit of a good - Marginal social cost (MSC) —> the costs to society of producing one more unit of a good - Marginal private benefits (MPB) —> benefits to consumers from consuming one more unit - Marginal social benefits (MSB) —> benefits to society from consuming one more unit of a good 5.3 Negative production externalities - the external costs created by producers - It causes a welfare loss, involving a reduction in social benefits due to misallocation of resources - Qm > Qopt and MSC > MSB 13  Giorgio Dal Pont Market-based policies 1 - Indirect (Pigouvian) taxes: - Work by changing the incentives firms face - The optimal tax policy is to impose a tax that is exactly equal to the external cost - In this way the MPC curve shifts upward until it overlaps with the MSC curve Market-based policies 2 - Carbon taxes -Is a tax per unit of carbon emissions of fossil fuels -The more carbon emitted, the higher the tax -As a result firms switch to alternative, less polluting resources Market-based policies 3 - Tradable permits: - A policy involving permits to pollute issued to firms by a government or an international body - They can be bought and sold among interested firms - Provide incentives to producers to switch to less polluting resources for which is not necessary to buy permits Advantages of market-based policies: - Both taxes and tradable permits have the effect of internalising the externality - Taxes on pollutants emitted provide incentives to firms to economise on the use of polluting resources and use production methods that pollute less - Taxation leads to lower pollution levels at a lower overall cost to society Disadvantages of market-based policies: - Taxes —> Designing a tax equal in value to the amount of the pollution is very difficult —> Usually set to low to make a significant impact —> What production methods produce pollutants? —> Which pollutants are harmful? —> What is the value of the harm? —> What is the appropriate amount of tax? —> How will consumers be affected? - Tradable permits —> Face the technical limitations as for taxes —> governments has to set a maximum acceptable level of pollutants “cap” —> Political favouritism may come into play and unlikely to achieve 14  Giorgio Dal Pont Government legislation and regulation: - Legislations and regulations intended to reduce the effects of production externalities and limit environmental damage typically involve emissions standards, quotas, license, …, restrictions - Maximum level of pollutants permitted - Install smokestack scrubbers to reduce emissions - Banning the use of harmful substances Advantages: - Simple to put into effect and oversee - Easier to implement compared to market-based polices and with no technical difficulties - Quite effective Disadvantages: - Do not offer incentives to reduce emission by using alternative fuels - Pollution is reduced at a higher overall cost - Lack of sufficient technical information on types and amount of pollutants emitted - Possible violations, and possible problems with enforcement - Can only attempt to partially correct the problem Collective self-governance: - An approach to manage resources undertaken by communities of resource users by themselves, as they realise that it is in their own best interests to work collectively for the preservation of res. - Concept by Elinor Ostrom - Advantages —> people do not always act in the self-interest —> solutions can be achieved in the absence of private ownership of resources - Disadvantages —> people must be able to communicate with each other to create rules —> difficult to apply to vast resources such as the oceans Education and awareness creation: - Education of the public and provision of information —> firms are forced to take consumers’ opinions into consideration and change their production methods to reduce the externality - Advantages —> firms are very much influenced by the opinions of their costumers - Disadvantages —> only make a small difference as only on one industry (needed a broader scale) International agreements: - Co-operation among governments and international agreements are crucial to control and prevent negative consequences on certain resources - Important as for development and diffusion of new technologies to deal with global environmental issues 15  Giorgio Dal Pont 5.4 Negative consumption externalities - The external costs created by consumers - There is welfare loss because of the reduction in benefits for society due to the overallocation of resources to the production of the good - MSC > MSB and Qm > Qopt - Demerit goods —> goods considered to be undesirable for consumers, but are overprovided by the market (alcohol,…) Market-based policies: - Indirect taxes can be imposed on the good whose consumption creates external costs - When such a tax is imposed, there is a decrease in supply - The tax therefore permits allocative efficiency to be achieved - Advantage —> the good that is taxed becomes relatively more expensive so consumption is less - Disadvantages —> difficulties in measuring the value of the external costs —> difficulties involved in trying to asses who and what is affected —> some goods have an inelastic demand, so tax won’t change consumption Government legislation and regulation: -Regulations can be used to prevent or limit consumer activities that impose costs on third parties -Advantages —> regulation can be very effective —> restricting smoking in public places -Disadvantages —> difficult to regulate consumption of certain good such as fuel Education and awareness-creation: - Educating the public and creating awareness by the government can be used to try to persuade consumers to buy fewer good with negative externalities - Advantages —> simpler than other methods - Disadvantages —> government campaigns founded with tax funds, so less funds available for use elsewhere in the economy ———————————————————————————————————————— 16  Giorgio Dal Pont Chapter 6: Positive externalities and public goods 6.1 Positive production externalities - Refer to external benefits created by producers - Qm < Qopt and MSC < MSB - Welfare loss —> the underallocation of resources to the production of a good with a positive production externality leads to welfare loss Correcting positive production externalities: - Shifting the MPC curve downward toward the MSC curve - Quantity produced and consumed must increase to Qopt as price falls to Popt - Direct government provision —> government provides goods and service by itself - Subsidies —> price of good falls from MPC to MSC - Direct government provision and subsidies have the same outcome 6.2 Positive consumption externalities -External benefits are created by consumers -The free market underallocates resources to the production of the good so too little of it is produced relative to the social optimum -MPB < MSB and Qm < Qopt -Loss of welfare due to the underproduction of the good Merit goods: - goods that are held to be desirable for consumers, but which are under provided by the market - Many reasons for which underprovision could happen: - The good may have positive externalities —> too little is provided - Low levels of income and poverty —> people cannot afford to buy them - Consumer ignorance —> people ignorant of the benefits 17  Giorgio Dal Pont Correcting positive consumption externalities: - Government legislation and regulation —> legislation can be used to promote greater consumption of goods with positive externalities (ex. Education) - Education and awareness creation —> persuade consumers to buy more goods with positive ext. - Direct government provision —> Government provides certain goods and services (ex. Health) - Subsidies —> has the same effects as direct government provision - Problems —> use of government funds (opportunity costs), which goods should be supported and how much, high political nature 6.3 Market failure and public goods - A public good is non-excludable and non-rivalrous - Free rider problem —> when people can enjoy the use of a good without paying for it - A type of market failure because private firms do not produce these goods so the market fails to allocate resources to their production Government intervention: - Direct government provision - Contracting out to the private sector: —> when a gov. makes an agreement with a private firm to carry out an activity —> financed out of tax revenues —> accompanied by detailed specifications on the activity, so better quality control —> provides access to a border range of skills and technology —> private firm may be more flexible and innovative than the government —> better quality and less costly —> gov. becomes less accountable for the public goods it provides —> gov. loses control over the services it has contracted out —> risk of making a poor contract so higher costs and lower quality —> contracting out needs to be monitored by the gov. so adds costs ———————————————————————————————————————— 18  Giorgio Dal Pont MACROECONOMICS (Chapter 8 —> 13) 19  Giorgio Dal Pont Chapter 8: The level of overall economic activity 8.1 Economic activity The circular flow of income model: Adding leakages and injections: - If leakages are greater than injections, the size of the circular flow becomes smaller —> this results in fewer services purchased, firms cutting back on their output and unemployment - If injections are larger than leakages, the opposite happens 8.2 / 8.3 Measures of economic activity and calculations - national income accounting —> an economy’s national income or the value of output - National output —> the output of an economy (aggregate output) - Knowing this two values allows to —> assess an economy’s performance over time —> compare income and output performance with others —> have a basis for making policies to meet econ. objectives - GDP —> the market value of all final goods and services produced in a country over a period Measuring the value of national output Expenditure approach: - Measures the total amount of spending to buy final goods and services in a country - Includes only purchases of final goods + serv. and allows to see contribution of each component - C + I + G + (X - M) = GDP (Gross domestic product) - C —> consumption spending —> all purchases by households on final goods and serv. in a year - I —> investment spending —> spending by firms on capital goods + spending on constructions - G —> Government spending —> spending by governments within a country - X - M —> the value of all exports minus the value of all imports of a country 20  Giorgio Dal Pont Income approach: - Adds up all income earned by the factors of production within a country over a time period - National income —> when all factor incomes are added up - This approach allows economists to see the relative income shares of the different factors of p. and how these might change over time and across countries Output approach: - Measures the value of each good and service produced in the economy over a particular time period and then sums them up to obtain the total value of output produced - It includes only the value of all final goods and serv. to avoid double counting - It calculates the value of output by economic sector (agriculture, …) and then adds all up - This approach provides economists the opportunity to study the performance of each sector GDP and GNI: - GNI —> the total income received by the residents of a country, equal to the value of all final goods and services produced by the factors of p. supplied by the country’s residents regardless where the factors are located - GNI —> Gross National Income —> GDP + net income from abroad Nominal and real: - Nominal if the measure is in terms of current prices, so not accounting the changes in prices - Real if the measure of economic activity has eliminated the influence of changes in prices - It is important to use real values when comparing a variable over time - Nominal GDP measures the value of current output valued at current prices - Real GDP measures the value of current output valued at constant (base year) prices Total and per capita values: - Per capita —> per person —> useful as a measure of standard of living in a country - Needed because of —> differing population sizes across countries —> population growth Purchasing Power Parity (PPP): - Buying power equivalence - The amount of a country’s currency that is needed to buy the same quantity of local goods and services that can be bought with US $1 in the United States - It makes comparisons across countries far more accurate GDP deflator: - Price index —> a measure of average prices in a period relative to average prices in a base year - Real GDP = (Nominal GDP / price deflator) * 100 21  Giorgio Dal Pont 8.4 The business cycle The business cycle: - Short-term fluctuations in the growth of real output, which are alternating periods of expansion and of contraction - Expansion —> when there is a positive growth in real GDP - Peak —> the cycle’s maximum real GDP - Contraction —> when the economy begins to experience falling real GDP - Trough —> the cycle’s minimum level of GDP - Potential output / GDP —> the output represented by the long-term growth trend - Natural rate of unemployment —> only when in a point on the long-term growth trend line Macroeconomic objectives: - Reducing the intensity of expansions and contractions to make output gaps as small as possible - Increasing the steepness of the line representing potential output to achieve a more rapid economic growth over long periods of time 8.5 National income statistics and alternative measures Accuracy of national income statistics: (GDP and GNI) - Do not include non-marketed output (which is likely to be far greater in developing countries compared to developed ones) - Do not include output sold in underground (parallel) markets - Do not take into account quality improvements in goods and services. Technological advances often permit improved products to be sold at a lower price giving benefits to consumers - Do not account for the value of negative externalities such as pollution and toxic wastes - Do not take into account the depletion of natural resources used to produce the output - May not take into account differing domestic price levels (PPP) Measure of economic well-being measuring issue: (GDP and GNI) - Make no distinctions about the composition of output (not taking into account the degree to which they contribute to standards of living (military, …) ) - Cannot reflect achievements in levels of education, health and life expectancy - Provide no information on the distribution of income and output only of the average - Do not take into account increased leisure —> average number of hours worked per week - Do not account for quality of life factors —> non-economic factors (crime rate, stress levels, well-functioning institutions, …) 22  Giorgio Dal Pont Alternative measures of well-being OECD Better Life Index: - It is based on a number of factors that the member countries themselves selected as factors that make better life - Purpose —> provide a more accurate representation of well-being and form the basis of policies intended to improve the quality of life and well-being more generally Happiness Index: - Tries to address the interdependent economic, social and env. challenges faced by the world - Based on —> Real GDP per capita, social support, healthy life expectancy, freedom to make life choices, generosity and perceptions of corruption - Happiness is difficult to quantify and measure making this ranking less reliable for comparisons Happy Planet Index: - A measure of sustainable well-being - HPI = (Life expectancy * well-being * inequality of outcomes) / ecological footprint ———————————————————————————————————————— 23  Giorgio Dal Pont Chapter 9: Aggregate demand and supply 9.1 AD and the AD curve - Aggregate demand —> the total quantity of aggregate output, or real GDP, that all buyers in an economy want to buy at different possible price levels, ceteris paribus - It consists of all components of GDP Causes of changes in consumption spending: - Changes in consumer confidence —> the more optimistic consumers are about their future the more they will spend - Changes in interest rates —> because some consumer spending is financed by borrowing, and the lower the interest rate, the more consumers will spend - Changes in wealth —> wealth is the value of assets that people own. The more people feel wealthier, the more consumer spending - Changes in income taxes —> the lower the income taxes, the higher the disposable income - Changes in the level of household indebtedness —> the lower the level of dept, the higher the spending by consumers - Expectations of future price levels —> if lower prices expected in future, spending is postponed Causes of changes in investment spending: - Changes in business confidence —> the more optimistic firms are about their future sales and economic activity, the higher the investment - Changes in interest rates —> decreasing in interest rates lowers costs of borrowing, making firms able to invest more money - Changes (improvements) in technology —> they stimulate investment spending - Changes in business taxes —> firms profits after taxes fall, therefore decreasing investment - Level of corporate indebtedness —> high levels of dept will make the firm less willing to invest - Legal / institutional changes —> increasing access to credit and securing property rights would result in increases in investment spending Causes of changes in government spending: - Changes in political priorities - Changes in economic priorities —> gov. can use its own spending to influence AD Causes of changes in X / M spending: - Changes in national income abroad - Changes in exchange rates - Changes in trade policies, or the level of trade protection 24  Giorgio Dal Pont 9.2 Short-run AS and equilibrium in AD-AS - Aggregate supply —> the total quantity of goods and services produced in an economy over a particular time period at different price levels - Short-run AS (SRAS) —> shows the relationship between the price level and the quantity of real output produced by firms when resource prices (especially wages) do not change Causes of shift of SRAS curve: - Changes in wages - Changes in non-labour resource prices - Changes in indirect taxes - Changes in subsidies offered to businesses - Supply shocks such as wars and violent conflicts - In the AD-AS model, the equilibrium level of output occurs where AD intersects with AS 9.3 Long-run AS and equilibrium The monetarist / new classical model: - Importance of the price mechanism in co-ordinating economic activities - Concept of competitive market equilibrium - The economy as a harmonious system that automatically tends towards full employment - The LRAS curve is vertical at the full employment level of output - Long-run equilibrium occurs when the SRAS and AD curves intersect on the LRAS curve - LRAS curve is vertical because with constant real costs, firms’ profits are also constant, and firms no longer have any incentive to increase or decrease their output levels - Governments should try to make markets work as freely as possible, to let it adjust alone Short-run equilibrium: - Deflationary gap —> unemployment is greater than the natural rate of unemployment —> not enough total demand in the economy to make it worthwhile for firms to produce potential GDP, so requiring less labour - Inflationary gap —> real GDP is > than potential GDP and unemp. is less than the natural rate —> to much total demand in the economy and firm produce a greater quantity - Full employment of output —> real GDP = potential GDP —> unemp. is = to the natural rate and no deflation or inflation gap - The economy has a built-in tendency towards full employment equilibrium 25  Giorgio Dal Pont 9.4 AS and equilibrium in the Keynesian model - Inflexible wages and prices in the downward direction mean that the economy cannot move into the long run when experiencing a deflationary gap (can be seen in the Keynesian AS curve) - If wages and prices do not fall easily, this means the economy may get stuck in the short run - The gov. must intervene in the economy with policies to help it come out of deflationary gap Keynesian AS curve: - Section I —> real GDP is low —> a lot of unemployment of resources and scarce capacities - Section II —> real GDP increases with the price levels and output increases, so increasing also employment of resources - Section III —> real GDP reaches a level beyond which it cannot increase anymore —> firms are using the max. amount of labour and all other resources in the economy 26  Giorgio Dal Pont The three equilibrium states: - The economy in the Keynesian model can remain indefinitely stuck in a deflationary gap - Increases in AD does not necessarily result in increases in the price level 9.5 Shifting AS curve over the long term Influences on AS over the long term: - Increases in quantities of the factors of production - Improvements in the quality of factors of production - Improvements in technology - Increases in efficiency - Institutional changes —> how efficiently resources are used - Reductions in the natural rate of unemployment ———————————————————————————————————————— 27  Giorgio Dal Pont Chapter 10: Macroeconomic objectives I 10.1 Low unemployment Unemployment: - Unemployment —> people of working age actively looking for a job but who are unemployed - Labour force —> the number of people employed + the number of people of working age who are unemployed - Measured in two ways —> numerical —> total number of unemployed people in the economy —> unemp. rate —> (number of unemployed / labour force) x 100 Difficulties in measuring unemployment: - Official statistics underestimate true employment because of hidden unemployment —> discouraged workers who gave up looking for a job are not excluded —> do not make a distinction between full-time and part-time employment —> do not make a distinction on the type of work done —> do not consider people on retraining programmes and early retired people - Official statistics may overestimate true unemployment because of: —> do not include people working in the underground economy - A disadvantage of this calculation is that it is an average over the entire population —> for this reason the calculation is done on different population groups in a society (region, gender, age …) Costs of unemployment: Economic costs: - A loss of real output (real GDP) - A loss of income for unemployed workers - A loss of tax revenue for the government —> larger budget deficit or smaller budget surplus - Costs to the government of unemployment benefits - Costs to the government od dealing with social problems resulting from unemployment - More unequal distribution of income - Unemployed people may have difficulties finding work in the future (lose the skills) Personal and social costs: - Personal problems —> indebtedness and loss of self-esteem - Greater social problems —> increased crime and violence, drug use and homelessness - Arising levels of poverty Types and causes of unemployment: - Natural rate of unemployment —> the sum of Structural, Frictional and seasonal unemployment 28  Giorgio Dal Pont Structural unemployment: - Caused by changes in demand for particular labour skills - Caused by changes in the geographical location of jobs —> firms may move … - Caused by labour market rigidities —> factors preventing the forces of supply and demand from operating in the labour market —> minimum wage legislation —> labour union activities and wage bargaining —> employment protection laws —> generous unemployment benefits Frictional unemployment: - Occurs when workers are between jobs —> have been fired, are in search of a better job or - Tends to be short term —> does not involve a lack of skills that are in demand Seasonal unemployment: - Occurs when the demand for labour in certain industries changes on a seasonal basis because of variations in needs Cyclical unemployment: - Occurs during the downturns of the business cycle in a deflationary gap - The downturn arises from low aggregate demand (demand-deficit unemployment) 10.2 Low and stable rate of inflation - Inflation —> a sustained increase in the general price level - Inflation indicates that prices of goods and services are increasing on average - Deflation —> a sustained decrease in the general price level - Disinflation —> a decrease in the rate of inflation - Consumer price index —> a measure of cost of living for the typical household —> compares the value of a basket of goods and services in one year with the value of a base year —> ( ( Final value of A- initial value of A ) / initial value of A ) x 100 - Real income —> ( nominal income / CPI ) x 100 29  Giorgio Dal Pont Problems with CPI: - Different rates of inflation for different income earners - Different rates of inflation depending on regional and cultural factors - Changes in consumption patterns due to consumer substitutions when relative prices change - Changes in consumption patterns due to increasing use of discount stores and sales —> prices are lower than those indicated in the CPI calculations - International comparisons —> types of goods included, weights used and methods of calculation - Changes in consumption patters due to introduction of new products - Changes in product quality - Comparability over time —> revising CPI baskets and changing the base year Causes of inflation: - Demand-pull inflation —> increases in aggregate demand shift right of AD) - Cost-pull inflation —> increases in costs of production or shocks (AS to left) Impact of inflation: Negative impacted by inflation: - People who receive fixed income or wages - People who receive income that increase less rapidly than the rate of inflation - Holders of cash - Savers —> interest rates must be greater than inflation - Lenders —> (lend money to people) —> money will lose a bit of its value over time Positive impacted by inflation: - Borrowers - Payers of fixed incomes or wages - Payers of incomes or wages that increase less rapidly than the rate of inflation - Uncertainty —> cannot predict future changes in purchasing power —> fewer investments - Savers —> lowered incentive to save money - Export —> become more expensive to foreign buyers and imports become cheaper —> ability to compete with foreign centuries is reduced - Economic growth —> lowered economic growth for the country - Resource allocation —> prices rise rapidly so the signalling and incentive functions not effective - Social and personal costs are unequally distributed —> poor people more affected by inflation Hyperinflation: - When there are very high rates of inflation - Results from very significant increases in the supply of money - Inflationary spiral —> inflation sets in motion a series of events that worsen inflation - A low and stable rate of inflation between 2-3% if preferred overall 30  Giorgio Dal Pont Causes of deflation: - Deflation occurs very rarely because: —> wages of workers do not ordinarily fall —> large oligopolistic firms may fear price wars - It is caused by decreases in AD and increases in AS Costs of deflation: - Falling price levels —> individuals on fixed incomes, holders of cash, savers and lenders gain —> borrowers and payers of individuals with fixed incomes lose - Increases in real value of debt - Uncertainty —> firms unable to forecast their costs and revenues due to declining price levels - Deferred consumption —> consumers postpone spending —> deflationary spiral - Risk of bankruptcies and a financial crisis - Inefficient resource allocation —> signalling and incentive functions are not effective - Policy ineffectiveness —> people won’t be willing to spend - Exports may increase as prices will be lower —> not enough to sustain all other negative effects 10.3 The relationship between unemployment and inflation - An increase of one percentage point in unemployment lowers well-being nearly six times more than a one percentage point increase in inflation - Misery index —> the sum of the unemployment rate and the inflation rate of a country —> the higher the index, the greater the misery of a population —> does not distinguish between the separate effects of unemployment and inflation on the well-being of the population ———————————————————————————————————————— 31  Giorgio Dal Pont Chapter 11: Macroeconomic objectives II 11.1 Economic growth Economic growth: - Refers to an increase in real GDP, or the real quantity of goods and services produced over a period of time - Percentage change in real GDP or in real GDP per capita - % change in real GDP = ((final value of real GDP - initial value of real GDP)/initial value) x 100 - % change in real GDP per capita = % change in real GDP - % change in population Short term growth vs long term growth: - Economic growth occurs as a result of: —> increases in aggregate demand (short-term growth) —> increases in short-run aggregate supply (short-term growth) —> increases in long-run aggregate supply (long-term growth) - In the Keynesian model, short-term growth does not involve an increase in potential output - Short-term growth is affected far more by increases in aggregate demand rather than in short-run aggregate supply - Short-term growth is shown in the expansion phase of the business cycle - Usually long term growth needs an extended period of time to take effect Why economic growth occurs: - Increase in the quantity and improvements in the quality of physical capita, due to investments - Increased quantities of labour are unlikely to be a source of economic growth over long periods, but improvements in the quality of labour effects greatly economic growth - Marketable commodities (minerals, metals, ecological resources, …) can contribute to growth but are not essential - Common pool resources are crucially important to long-term growth —> as ability of countries to maintain them 32  Giorgio Dal Pont Impact of economic growth on living standards: - Greater potential for people to increase their consumption of goods and services, and improve their standards of living —> require policies to make effective use of the resources available - Distribution of income —> greater income going to poorer household means greater living stand. - Household spending —> greater income spent on food, education, health is greater living stand. - Share of income controlled by women —> the greater, the stronger the impact - Government spending on merit goods —> budget allocated to areas such as education or health - Contributions by non-gov. organisations —> poverty oriented that reach more poor people Impact of economic growth on the environment: 1) Some environmental damage is irreversible 2) Growth justifies government inaction on the environment 3) Growth is not bad for the environment but how it is pursued 4) Growth based on unsustainable resources use may threaten future growth To pursue growth ecofriendily: —> governments implement market-based policies that internalise the externality —> Governments pursue more env. regulations that encourage pollution-free tech. change —> Increased emphasis on human capital in production (which is pollution-free) —> increased emphasis on green investments —> changes in the structure of the economy towards more pollution-free services Inappropriate gov. policies: —> introduction of capital-using technologies (labour-saving) —> low levels of government investment in human capital —> services and infrastructure to urban areas ignoring rural sector with most people —> concentrating investments in rich people and ignoring the urban slums 11.3 Potential conflict between macroeconomic objectives Demand-pull inflation and economic growth: - In the Keynesian model —> as long as AD increases along horizontal part of AS curve —> economic growth with no inflation —> no conflict between low inflation and growth - New classical model —> when in a deflationary gap, increases in AD result in both growth and increase in price level —> possible conflict Cost-push inflation and economic growth: - Caused by decreases in SRAS due to factors such as high prices of factors of production - Stagflation —> negative economic growth (not possible to have positive growth in cost-push) ———————————————————————————————————————— 33  Giorgio Dal Pont Chapter 12: Economics of inequality and poverty 12.1 Inequality Economic inequality: - Refers to the degree that people in a pop. differ in their ability to satisfy their economic needs - It results mainly from differences in income and wealth - Income inequality —> differences in how evenly income is distributed in a population —> income includes interest from saving, bonds and share in stock markets - Wealth inequality —> arises from differences in the amount of wealth people own Measurements of economic inequality: - Income is distributed in a quintiles of the population (20% of the whole) Lorenz curve: - Is used to show the degree of income inequality in an economy - The closer a Lorenz curve is to the diagonal representing perfect income equality, the greater is the equality in income distribution Gini coefficient: - Is a summary measure of the information contained in the Lorenz curve of an economy - (Area between diagonal and Lorenz curve / Entire area under diagonal) - Has a value between 0 and 1 - The closer the value to 1 the greater the income inequality Wealth inequality: - The Lorenz curve and the Gini coefficient can be used in the same way to show wealth inequality - Reasons behind greater wealth inequality: —> Limited growth in wages makes it difficult for low-income people to accumulate wealth —> High-income people consume a smaller fraction of their income —> can save more —> Income and wealth inequalities feed on each other 12.2 Poverty - Refers to an inability to satisfy minimum consumption needs - Absolute poverty —> a situation where a person does not have enough income to meet basic human needs - Poverty line —> minimum income level before absolute poverty - World bank poverty lines —> living on less than 1.90 $ a day is extreme poverty —> living on less than 3.20 $ a day for lower-middle income countries —> living on less than 5.50 $ a day for upper-middle income countries 34  Giorgio Dal Pont - Relative poverty —> compares the income of individuals in a society with median incomes - Poverty rates differ widely among social groups in a society - Measures for absolute and relative poverty are useful to governments as guides to policies providing income support as well as measures intended to combat poverty Minimum income standards (MIS): - Method to measure poverty - Consists of ongoing research on what people in a population believe are the essentials for a minimum acceptable standard of living that allows people to participate in society - It calculates the minimum income that is required for different family types to be able to buy the essentials in the basket - This measure reveals info on —> number of people living under minimum income —> the relative contribution of each item in the basket —> how these factors change over time Composite indicators: - Measures of complex phenomena that cannot easily be described by a single indicator - Multidimensional poverty index (MPI) —> measures poverty in three dimensions —> health, education and living standards —> each dimension is intended to reflect deprivations - MPI of the world bank —> as noted by the bank, the standard monetary measure of poverty does not capture important aspects of well-being, such as access to health care or a secure community Difficulties in measuring poverty: - Poverty has different meaning and different approaches to measurement - Measurement problems —> do not take wealth or savings into consideration —> in some cases poverty is measured based on household surveys —> is subjective —> do not include homeless people —> freelance work or income from investments not included - Overestimation or underestimation of the national poverty line 12.3 Causes of economic inequality and poverty Causes of inequality: - Circumstances that affect life opportunities and are beyond one’s control include: —> parents’ level of education, occupation and income —> place of birth —> gender —> race and ethnicity 35  Giorgio Dal Pont - Different levels of human capital —> differences in skills, education and good health possessed - Different levels of resource owned —> some people inherit, or accumulate through savings from high incomes, financial capital or other forms of property which gives both income and wealth - Discrimination —> some social groups often face discrimination in the job market, with the result that they may receive lower wages or may find greater difficulty finding work - Unequal status and power —> people in positions of power may sometimes use this to influence government policies favouring their own interests, rather than policies favouring redistribution - Government tax and benefits policies —> people on low income must often rely heavily on transfer payments and social services and merit goods provided by the government —> tax policies that favour the rich and do not favour redistribution of income - Technological change —> it has eliminated some jobs by replacing human labour with machines - Globalisation —> economic integration on a global scale —> foreign direct investment involves greater demand for skilled rather than unskilled workers + economies may offshore certain jobs - Market-based supply-side policies —> such as discouraging trade unions and reducing bargaining power of labour, or reducing the minimum wage - Increases in pay of certain occupations —> certain occupations increased much more than others - Unemployment —> if long-term then an individual is more likely to become poor - Geography —> people may live in remote regions with limited possibilities for employment - Age —> older people may receive pensions that are barely enough to cover minimum needs - Poverty —> low incomes leads to low human capital, and so further low income 12.4 Impacts of income and wealth inequality Economic growth: - Greater inequality lowers growth by reducing the ability of lower income people to invest - Children of low-income families are likely to also have low incomes in future - Savings of wealthy people often leave the country (reduces resources available domestically) - Income and wealth in a few hands results in significant political control —> influence policies - Significant political control by the rich may result in less government provision of merit goods - Improved income distribution increases the demand for locally produced goods and services —> encourages local production and promotes local employment and investment - High income inequality means that the poor are unable to obtain credit so can’t make investments - High income inequality leads to social dissatisfaction, unrest and political instability Low living standards: - Lack of access to health care and education - Higher infant, child and maternal mortality - Higher levels of preventable diseases - Social problems (crime rates, drug use, …) - Inability to realise one’s full potential —> waste of human capital 36  Giorgio Dal Pont Social and political instability: - High income and wealth inequalities create societies that are polarised and divided —> different interests created so interactions between groups are difficult - The groups at the top begin to have a stronger political influence - Rise in sense of dissatisfaction 12.5 Policies to reduce income and wealth inequalities and poverty Taxation: - It can lower inequalities by taking more taxes from the rich than from the poor - Are the most important source of government revenues - Divided in two types —> direct taxes and indirect taxes Direct taxes: - Taxes paid directly to the government tax authorities by the taxpayer - Personal income taxes —> taxes paid by individuals on all forms of income - Corporate income taxes —> taxes on the profits of corporations - Wealth taxes —> taxes on ownership of assets (property taxes or inheritance taxes) Indirect taxes: - Taxes on spending on goods and services - General expenditure taxes —> VAT for Europe and sales taxes for USA - Excise taxes —> taxes paid on specific goods and services such as cigarettes and petrol - Customs duties (tariffs) —> tax applied on imports of foreign goods into a country —> it keeps imports out of the country and it raises tax revenue - Indirect taxes are inconsistent with the objective of a more equal distribution of income Taxation types: - Proportional —> as income increases, the tax rate remains constant - Progressive —> as income increases, the tax rate increases - Regressive —> as income increases, the tax rate decreases Evaluating taxes as a policy for redistribution: Transfer payments: - Payments made by the government to individuals specifically for the purpose of redistributing income away from certain groups and towards other groups (vulnerable groups) - Conditional cash transfers if they are granted with conditions to meet certain requirements - They use a big part of the government budget and create incentives for people not to work 37  Giorgio Dal Pont Targeted gov. spending: - Governments spend to provide merit goods that are under provided by the market - Uses tax revenue to provide the good in larger quantities and at very low or zero prices Universal basic income: - A method intended to provide residents in a country with a sum of money that they would receive regardless of any other income they may have Polivies to reduce discrimination: - Countries around the world usually have legislation that forbids discrimination in the workplace - It is essential to ensure that discrimination does not occur Government intervention in markets: - Minimum wage legislation —> sets a legal minimum wage - Price controls such as food price ceilings or price floors for farmers - 25% of redistribution occurs through the tax system while 75% occurs through benefits ———————————————————————————————————————— 38  Giorgio Dal Pont Chapter 13: Demand-side and supply-side policies 13.1 Macroeconomic policies Demand-side policies: - Also called demand management —> focus on changing AD to achieve macroeconomic goals - Try to counteract the effects of short-term fluctuations in real GDP and bring full employment level of real GDP, or potential GDP - Two types of stabilisation policies —> either monetary policies or fiscal policies —> try to minimise the short-run fluctuations of the business cycle Supply-side policies: - Focus on the production and supply side of the economy (specifically the LRAS curve) - Aim to increase potential output and achieve long-term economic growth - Focus on increasing the quantity and quality of factors of production (LRAS curve factors) - Two major categories of supply-side policies: —> market-based (rely on the working of the market) —> interventionist (rely on government intervention) ———————————————————————————————————————— 13.2 Demand management and monetary policy The role of central banks: - Monetary policy is carried out by the central bank of each country - Commercial banks are financial institutions whose main functions are to hold deposits for their costumers, loans, transfer funds and to buy government funds —> cannot be central banks - Are responsible for: —> Banker to the government (as commercial banks for costumers) —> Banker to commercial banks —> holds deposits for them and for loans —> Regulator of commercial banks —> regulates and supervises them —> Monetary policy —> controls the supply of money and interest rates - It has a degree of independence from government interference in the pursuit of monetary policy The goals of monetary policy: - Low and stable inflation - Low unemployment (specifically cyclical unemployment) - Reduce business cycle fluctuations - Promote a stable economic environment for long-term growth —> needed to be able to plan and carry out economic activities - External balance —> country’s revenues from exports are balanced by spending on imports over an extended period of time 39  Giorgio Dal Pont Inflation targeting: - The public announcement of medium-term numerical targets for inflation with an institutional commitment by the monetary authority to achieve these targets - Between 1.5% and 2.5% usually - Advantages —> achievement of a low and stable rate of inflation —> improved ability of economic decision-maker to anticipate future inflation —> greater co-ordination between monetary and fiscal policy - Disadvantages —> reduced ability of the central bank to pursue macroeconomic objectives —> conflict between a low rate of inflation and low unemployment —> reduced ability of CB to respond to supply-side policies —> leads to cost- push inflation and stagflation —> a too low inflation target may lead to higher unemployment —> a too high inflation target may lead to problems resulting from high inflation Real vs Nominal interest rates: - Real interest rate = nominal interest rate - rate of inflation The role of monetary policy: - The point of changing the money supply and changing interest rates is ultimately to influence AD - Changes in interest rates affect —> Investments and consumption in the GDP - Higher interest rates —> lower spending so AD to the left - Lower interest rates —> higher spending so AD to the right - Expansionary monetary policy —> An increase in the money supply by the central bank —> aim to expand AD and the level of economic activity —> easy money policy - Contractionary monetary policy —> A decrease in the money supply by the central bank —> aim to contract AD and the economy —> tight money policy - Ratchet effect —> the price level moves up when there is an increase in AD and then remains at the same level until there is a further increase in AD Evaluating monetary policies: Strengths: - Interest rate changes can be incremental - Central bank independence - Interest rates changes are reversible - Limited political constraints (no changes in - Monetary policy is flexible government budget) - Relatively short time lags (time delays) - No crowding out 40  Giorgio Dal Pont Constraints: - Possible ineffectiveness in recession —> rates cannot fall when approaching zero —> low consumer and producer confidence —> banks may be fearful of lending - Conflict between government objectives - May be inflationary - Problematic when dealing with stagflation or cost-push inflation as they are supply-side issues ———————————————————————————————————————— 13.3 Demand management and fiscal policy The government budget: - Type of plan of a country’s revenues and expenditures over a period of time (usually one year) that the government makes to plan its activities - Sources of gov. revenue —> taxes of all types —> from the sale of goods and services —> from the sale of government-owned assets or properties - Types of gov. Expenditures: —> Current expenditures —> spending on day-to-day items that are recurring (wages, …) —> Capital expenditures —> include public investments or spending to produce physical capital (roads, airports, …) —> Transfer payments —> payments to vulnerable groups (for income redistribution) Goals of fiscal policy: - Refer to manipulations by the gov. of its own expenditures and taxes to influence AD - Can affect G, C and I components of the GDP - Equitable distribution of income - Low and stable rate of inflation - Low unemployment - Reduce business cycle fluctuations - Promote a stable economic environment for long-term growth - External balance (Imports - Exports) Expansionary fiscal policy: Contractionary fiscal policy: - Increasing government spending - Decreasing government spending - Decreasing personal income taxes - Increasing personal income taxes - Decreasing business taxes (taxes on profits) - Increasing business taxes - Combination of the above - Combination of the above 41  Giorgio Dal Pont Evaluating fiscal policy: Strengths: - Pulling an economy out of a deep recession - Ability to target sectors of the economy - Direct impact of government spending on AD - Dealing with rapid and escalating inflation - Ability to affect potential output Constraints: - Problems of time lags —> problem must be recognised, appropriate policy must be decided, policy takes effect in the economy - Political constraints —> as numerous political pressures - Sustainable dept - In a recession, tax cuts may not be effective in increasing AD - Inability to “fine tune” the economy —> cannot be used to reach a precise target as general - May be inflationary —> if it lasts to long - Unable to deal with cost push inflation or stagflation as it is a demand-side policy ———————————————————————————————————————— 13.6 Supply-side policies Goals of supply-side policies: - Promote long-term growth by increasing the productive capacity of the economy - Improve competition and efficiency - Reduce costs of labour and reduce unemployment through greater labour market flexibility - Increase incentives of firms to invest in innovation by lowering costs of production - Reduce inflation to improve international competitiveness Market-based supply-side policies: Encouraging competition: - Privatisation —> increases efficiency due to improved management and operation of private - Deregulation —> elimination or reduction of government regulation of private sector activities - Contracting out to the private sector - Anti-monopoly regulation —> assures fair competition - Trade liberalisation Labour market reforms: - Abolishing minimum wage legislation - Reducing unemployment benefits - Weakening the power of labour unions - Reducing job security (against being fired) 42  Giorgio Dal Pont Incentive-related policies: - Lowering personal income taxes - Lowering taxes on capital gains and interest income - Lowering business taxes Strengths: - Improved resource allocation - May not burden the government budget - Ability to create employment - Ability to reduce inflationary pressure (LRAS to right) Constraints: - Time lags as effects over the long term - Possible unfavourable impact on unemployment (competition may increase unemployment) - Possible negative effects on equity - Negative impact on the government budget (policies in the form of tax cuts) - Possible interference of vested interests (strong personal interests) —> oppose and may prevent the policies from being implemented - Possible negative effects on the environment Interventionist supply-side policies: - Presuppose that the free market economy alone cannot achieve the desired results in terms of increasing potential output —> so gov. intervention is required - Investment in human capital —> training and education —> improved health care services and access to these - Investment in new technology —> research and development —> results in new or improved capital goods —> gov. usually provides incentives to firms for this - Investment in infrastructure —> can lead to more efficient transport of goods … - Industrial policies —> gov. policies designed to support the growth of the industrial sector —> Support for small and medium-sized enterprises of firms (SMEs) —> tax exemptions, grants, low-interest loans and business guidance —> support for infant industries (as SMEs but also protection against exports) 43  Giorgio Dal Pont Strengths: - Direct support of sectors important for growth - Ability to create employment —> enabling workers to acquire the skills… —> providing assistance to workers to relocate —> providing info that reduces unemployment when workers are between jobs/season - Potential ability to reduce inflationary pressure —> by increasing potential output - Possible positive effects on equity —> skilled workers are more likely to be employed and be an active and productive part of the society Constraints: - Time lags —> time needed is long - Negative impact on the government budget as heavily based on gov. spending Overlaps between demand-side and supply-side policies: - Interventionist supply-side policies involve an increase in government spending —> more AD - Market-based supply-side policies encourage firms to invest more in R&D —> it is an investment so leads to an increase in AD - Demand-side policies can contribute to long-term growth of potential GDP by providing a stable macroeconomic environment - Fiscal policies —> gov. spending for provision of physical capital improves also quality of goods —> gov. spending for instruction also improves the quality of the labour force —> lower business taxes also promote technological innovations - Monetary policies —> a fall in interest rates encourages more spending by firms on capital goods, so increasing their quantity —> this affects potential output ———————————————————————————————————————— 44  Giorgio Dal Pont THE GLOBAL ECONOMY (Chapter 14 —> 20) 45  Giorgio Dal Pont Chapter 14: International trade Part I 14.1 The benefits of international trade - Free trade —> the absence of gov. intervention of any kind in international trade (no barriers, …) Benefits: - Increased competition - Greater efficiency in production - Lower prices for consumers - Greater choice for consumers - Acquiring needed resources —> need for their domestic production a variety of natural resources or capital goods that are not available domestically - Source of foreign exchange —> acquiring foreign exchange from exports —> < ability to import - Access to larger markets —> world market - Economies of scale in production —> access to larger markets allows firms to grow beyond the limits of national boundaries —> produce more output and take advantage of economies of scale - Increases in domestic production and consumption as a result of specialisation —> countries concentrate production on one or a few goods and services - More efficient allocation of resources —> due to specialisation - Trade makes possible the flow of new ideas and technology - Trade makes countries interdependent —> reduced possibility of hostilities and violences - Trade as an “engine for growth” —> contribute to increases in domestic output, so growth Export or import: - Autarky (self-sufficiency) —> self-sufficient country in all the goods it produces and consumes - Export —> if the domestic price of the good without trade is lower than the world price - Import —> if the domestic prices of the good without trade is higher than the world price ———————————————————————————————————————— 14.3 Types of trade protection - Trade protection —> involves gov. intervention in international trade through the imposition of trade restrictions (barriers), to prevent the free entry of imports into a country - To protect the domestic economy (domestic firms and their workers) from foreign competition 46  Giorgio Dal Pont Tariffs: - “Custom duties” —> most common form of trade restriction —> are taxes on imported goods - Protective tariff —> protect a domestic industry from foreign competition - Revenue tariff —> raise revenue for the government - Effects on the economy are the same Winners: - Domestic producers —> producers surplus increases - Domestic employment in the protected industry increases - The government gains tariff revenues Losers: - Domestic consumers —> consumer surplus drops - Domestic income distribution worsens —> is a type of regressive tax as people on lower incomes proportionately pay more than people on higher incomes - Increased inefficiency in production - Foreign producers are worse off - Global misallocation of resource results Import quotas: - Legal limit to quantity of a good that can be imported over a particular time period —> effects of quotas are similar to effects of tariffs, except that they do not create revenue for the gov. Winners: - Domestic producers —> greater producer surplus - Domestic employment increases Neutral impact: - The gov. neither gains nor loses —> import licenses to foreign govs. Losers: - Domestic consumers —> loss of consumer surplus - Domestic income distribution —> result in a higher price - Increased inefficiency in production - The exporting countries may be worse off or better off —> as they gain the quota revenues - Global misallocation of resources 47  Giorgio Dal Pont Production subsidies: - Payments per unit of output granted by the gov. to domestic firms that compete with imports - Are granted on goods that are produced for the domestic market —> entire quantity produced is sold domestically Winners: - Domestic producers —> loss of producer surplus as gov. has to pay - Domestic employment increases Neutral: - Consumers are not affected Losers: - The government budget - Taxpayers are worse off - Increased inefficiency in production - Exporting countries - Global misallocation of resources Export subsidies: - Similar to production subsidies, but is a subsidy paid for each unit of the good that is exported Winners: - Producers —> loss of producer surplus as gov. has to pay - Domestic employment increases Losers: - Consumers —> loss of consumer surplus - Negative effect on the government budget - Taxpayers are worse off - Domestic income distribution worsens (increased price for them) - Exporting countries are worse off - Increase in global misallocation of resources Administrative barriers: - Whenever a good is imported form another country, it must go through a number of customs procedures (inspections, valuation, …) —> are time-consuming, costly and difficult - Importing countries can impose requirements that imported goods must follow —> quantity of imports is reduced ———————————————————————————————————————— 48  Giorgio Dal Pont Chapter 15: International trade Part II 15.1 Arguments for and against trade protection Arguments for trade protection: Infant industry argument: - Infant industry —> is a new domestic industry that has not had time to establish itself and achieve efficiencies in production —> is unable to compete with more mature competitor firms - They will need protection from imports until they grow —> to high cost of p. at the beginning - Introduced in 1791 by Alexander Hamilton —> first UA secretary of the treasury - A country may have a comparative advantage in the production of a particular industrial good, but can’t specialise in it unless it first receives some protection - The gov. must know which industries have the potential to become low cost producers, they could lead to inefficiency as no more a strong competition, and may be a to long protection National security: - Certain industries are essential for national defence (weapons, chemicals and minerals) —> should be protected so that country is self-sufficient - In times of war the country should not have to depend on imports for its defence - Excuse could be used by industries that have an indirect use in defence (steel) to have protection - Decisions should be made on political and military —> not economic Health, safety and environmental standards: - Countries maintain health, … standards that all imported products must meet before they are allowed to enter —> may be used as a form of hidden protection to keep certain goods out Efforts of a developing country to diversify: - Diversification —> change involving greater variety - Economically least developed countries (ELDCs) —> highly specialised in producing and exporting only few primary commodities —> can be dangerous - Trade protection policies to keep out imports of goods they would like to produce domestically - Gov. may not know which products are more appropriate to protect and positive diversification Arguments which are questionable: Anti-dumping: - Dumping —> selling a good in international markets at a price below the cost of producing it - Is illegal according to international agreements - If a country suspects that a trading partner is practising dumping it has the right to impose tariffs or quotas —> to limit imports of subsidised or duped goods —> anti-dumping - Govs. may use it as an excuse to offer protection to their domestic producers even if unjustified 49  Giorgio Dal Pont Unfair competition: - Practices that countries may use in order to gain a competitive advantage over other countries in order to unfairly increase their exports at the expense of other countries - Countries use those reasons to impose protectionist measure even if not justifiable - Dumping - Subsidies to reduce costs of production - Administrative barriers or hidden protection - Undervaluing currencies —> exports are more competitive in foreign markets - Violation of intellectual property —> ideas, trade secrets, inventions, … Correcting a balance of payments deficit: - When the outflow of money from a country is greater than the inflow - Trade protection is a solution as a short-term emergency measure if there is a serious deficit - Other solutions on the long-term even though Tariffs as a source of government revenue: - Frequent in developing countries —> even half or more of all gov. revenues - Easy to tax imports —> goods that must pass though borders where they can be monitored - Govs. may rely on tariff revenues as an excuse to delay tax system reforms - Should be temporary and gradually phased out as countries grow and develop Protection of domestic jobs: - Restrictions on imports are needed to protect domestic employment - If an industry uses imported inputs with restrictions, they will pay a higher price —> higher costs of production and so higher unemployment in the domestic country - Unemployments increases in the countries that are forced to export less ———————————————————————————————————————— 50  Giorgio Dal Pont 15.2 Economic integration: trading blocs - Economic integration —> economic co-operation between countries and co-ordination fo their economic policies —> increased economic links between them - Countries expect to derive benefits from this - Begins from agreements between countries to reduce or eliminate trade and other barriers between them + extend co-operation (on labour policies, the environment, monetary, …) Trade agreements: Preferential trade agreements (PTA): - Agreement between two or more countries to lower trade barriers on particular products in trade - Trade barriers remain on the rest of the products, and on imports from non-member countries - Sometime involve co-operation between members on other issues (labour standards, env., …) - Several forms —> free trade areas, customs unions or common markets —> bilateral or regional (several countries) Bilateral, regional and multilateral trade agreements: - Bilateral TA —> agreement between two countries - Multilateral TA —> agreement between many countries —> World Trade Organisation - Regional TA —> agreement between a group of countries that are within a geographical region - All promote trade liberalisation - WTO —> aim to reduce trade barriers —> fundamental principle is non-discrimination —> a country cannot impose higher barriers on imports from one country and lower ones from another Trading blocs: - A group of countries that have agree to reduce tariff and other barriers to trade to encourage free trade and co-operation between them Free trade area agreement: - Countries agree to gradually eliminate trade barriers between themselves - The most common type of integration area - Problem —> a product may be improved into the FTA by a country that has the lowest external trade barriers and then sold to countries within the FTA that have higher external trade barriers - NAFTA (north American), ASEAN (Association of southeast asian nations), … Customs union: - Countries that fulfil the requirements of FTA + adopt a common policy towards all non-members - Involves a higher degree of economic integration than an FTA 51  Giorgio Dal Pont - Have the advantage that they avoid having to create complicated rules of origin for imports - Problem —> coordination on policies toward non-members must be met - CEFTA —> central European free trad agreement Common market: - Countries that have formed a customs union proceed further to eliminate any remaining tariffs in trade between them —> they agree to eliminate all restrictions on movements of any factors of p. - Enjoy free trade and all its advantages - Workers are free to move and work in any member country without restrictions - Capital can flow from country to country without restrictions - Result in better use of capital resources and improved allocation of resources - Problem —> requires even greater policy coordination among members —> requires the willingness of member govs. to give up some of their policy authority —> it is lengthy to do all of this Evaluating trading blocs: - Increased competition - Expansion into larger markets - Economies of scale - Lower prices for consumers and greater consumer choice - Increased investments