Economics (2007) by Stephen Ison and Stuart Wall PDF

fourth edition ECONOMICS Stephen Ison and Stuart Wall ECONOMICS Visit the Economics, fourth edition Companion Website at www.pearsoned.co.uk/ison to find valuable student learning material including: Answers to mini case studies throughout the chapters of the book Responses to the pau...

fourth edition ECONOMICS Stephen Ison and Stuart Wall ECONOMICS Visit the Economics, fourth edition Companion Website at www.pearsoned.co.uk/ison to find valuable student learning material including: Answers to mini case studies throughout the chapters of the book Responses to the pause for thought boxes throughout the chapters of the book Answers to end of chapter progress and review questions Suggested outlines to essay questions We work with leading authors to develop the strongest educational materials in Economics, bringing cutting-edge thinking and best learning practice to a global market. Under a range of well-known imprints, including Financial Times Prentice Hall, we craft high quality print and electronic publications which help readers to understand and apply their content, whether studying or at work. To find out more about the complete range of our publishing, please visit us on the World Wide Web at: www.pearsoned.co.uk  ECONOMICS Fourth Edition Stephen Ison Loughborough University Stuart Wall Anglia Ruskin University Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world Visit us on the World Wide Web at: www.pearsoned.co.uk Fourth edition published 2007 © Pearson Education Limited 2007 The rights of Stephen Ison and Stuart Wall to be identified as authors of this work have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS. All trademarks used herein are the property of their respective owners. The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affiliation with or endorsement of this book by such owners. ISBN-13: 978-0-273-68107-6 ISBN-10: 0-273-68107-9 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data Ison, Stephen. Economics / Stephen Ison, Stuart Wall. — 4th ed. p. cm. Includes bibliographical references and index. ISBN-13: 978-0-273-68107-6 ISBN-10: 0-273-68107-9 1. Economics—Textbooks. I. Wall, Stuart, 1946– II. Title. HB171.5.I84 2006 330—dc22 2006047252 10 9 8 7 6 5 4 3 2 1 10 09 08 07 06 Typeset in 10/12pt Minion by 35 Printed and bound in Great Britain by Ashford Colour Press, Hampshire The publisher’s policy is to use paper manufactured from sustainable forests.  Contents Preface xvii Acknowledgements xix Publisher Acknowledgements xx Chapter 1 The nature of economics 1 Learning objectives 1 1 Introduction 1 2 Defining economics 2 2.1 The ways in which an economist thinks 2 2.2 The use of tables and diagrams 2 2.3 The economic problem 4 2.4 Opportunity cost 5 2.5 The production possibility frontier (PPF) 5 2.6 The PPF and opportunity cost 7 3 Economic systems 9 4 The market economy 10 4.1 Advantages of the market economy 11 4.2 Disadvantages of the market economy 11 5 The planned economy 13 5.1 Advantages of the planned economy 13 5.2 Disadvantages of the planned economy 13 6 The mixed economy 15 7 Positive and normative economics 15 8 Micro- and macreconomics 16 Key points 16 Further reading 17 Web references 17 Progress and review questions 17 Part One MICROECONOMICS Chapter 2 Demand, supply and market equilibrium 23 Learning objectives 23 1 Introduction 23 2 The market 23 3 Demand 24 3.1 What is demand? 24 3.2 Factors influencing demand 24 3.3 ‘Movements along’ and ‘shifts in’ the demand curve 29 3.4 The derivation of market demand 30 vi CONTENTS 4 Supply 32 4.1 What is supply? 32 4.2 Factors influencing supply 32 4.3 The derivation of market supply 35 4.4 ‘Movements along’ and ‘shifts in’ the supply curve 36 5 Market equilibrium 36 5.1 The equilibrium market price 36 5.2 Changes in the equilibrium market price 37 Key points 39 Further reading 39 Web references 40 Progress and review questions 40 Chapter 3 Elasticity 45 Learning objectives 45 1 Introduction 45 2 Price elasticity of demand (PED) 45 2.1 What is price elasticity of demand? 45 2.2 Price elasticity of demand and total revenue 49 2.3 Factors determining price elasticity of demand 50 3 Income elasticity of demand (YED) 52 3.1 What is income elasticity of demand? 52 3.2 Types of income elasticity of demand 53 4 Cross elasticity of demand (CED) 55 4.1 What is cross elasticity of demand? 55 5 Price elasticity of supply (PES) 57 5.1 What is price elasticity of supply? 57 5.2 Factors determining price elasticity of supply 58 6 The importance of the elasticity concept 60 7 Applications of demand and supply 60 Key points 63 Further reading 64 Web references 64 Progress and review questions 65 Chapter 4 Consumer theory 69 Learning objectives 69 1 Introduction 69 2 Marginal utility theory 69 2.1 What is marginal utility theory? 69 2.2 Total utility 70 2.3 Marginal utility 70 2.4 The law of diminishing marginal utility 70 2.5 The consumer equilibrium 72 2.6 Derivation of the demand curve 74 3 Indifference curve analysis 74 3.1 What is indifference curve analysis? 74 3.2 Indifference curves 75 3.3 The budget line 78  CONTENTS vii 4 The consumer equilibrium under indifference curve analysis 80 4.1 A change in income 81 4.2 A change in price 81 5 The substitution and income effect 82 6 Inferior product or good 84 7 Giffen good 85 8 Derivation of the demand curve 85 Key points 86 Further reading 87 Web references 87 Progress and review questions 88 Chapter 5 Production and costs 94 Learning objectives 94 1 Introduction 94 2 Types of business enterprise 95 2.1 Sole trader 95 2.2 Partnership 95 2.3 Joint stock company 95 2.4 Public sector companies 96 3 The growth of firms 96 3.1 Why do firms wish to grow? 96 3.2 Internal growth 98 3.3 External growth 98 4 The factors of production 100 4.1 What are the factors of production? 100 4.2 Land 100 4.3 Labour 100 4.4 Capital 100 5 Production 100 5.1 Production function 100 5.2 Production in the short run: law of diminishing returns 101 5.3 The average and marginal concept 102 5.4 Production in the long run 103 6 Isoquants 104 7 Isocost 106 8 The least-cost process of production 108 9 The expansion path 108 10 Costs 109 10.1 What are costs? 109 10.2 Short-run and long-run costs 110 10.3 Total, average and marginal cost 111 10.4 Long-run average cost (LRAC) and economies of scale 113 10.5 Sources of economies of scale 114 10.6 Economies of scope 116 10.7 Diseconomies of scale 116 Key points 117 Further reading 118 Web references 118 Progress and review questions 118 viii CONTENTS Chapter 6 Theory of the firm: perfect competition and monopoly 123 Learning objectives 123 1 Introduction 123 2 Revenue, costs and profit 124 2.1 Revenue 124 2.2 Profit maximisation 127 3 Perfect competition 128 3.1 What is perfect competition? 128 3.2 Short-run equilibrium in perfect competition 129 3.3 Long-run equilibrium in perfect competition 131 3.4 Allocative and productive efficiency 132 3.5 Contestable market theory 133 4 Monopoly 134 4.1 What is monopoly? 134 4.2 Barriers to entry 135 4.3 Advantages of a monopoly 136 4.4 Disadvantages of a monopoly 137 5 Price discrimination 138 5.1 Consumer surplus 138 5.2 First degree price discrimination 139 5.3 Second degree price discrimination 140 5.4 Third degree price discrimination 140 Key points 142 Further reading 142 Web references 142 Progress and review questions 143 Chapter 7 Theory of the firm: monopolistic competition and oligopoly 147 Learning objectives 147 1 Introduction 147 2 Monopolistic competition 147 2.1 What is monopolistic competition? 147 2.2 Short-run equilibrium in monopolistic competition 148 2.3 Long-run equilibrium in monopolistic competition 149 3 Oligopoly: non-collusive 150 3.1 What is oligopoly? 150 3.2 The kinked demand curve and price rigidity 150 3.3 Other pricing strategies 152 3.4 Non-price competition 152 4 Oligopoly: collusion 153 4.1 Methods of collusion 154 4.2 Cartels 154 4.3 Price-leadership models 155 5 Game theory 157 5.1 Zero sum games 157 5.2 Non-zero sum games 159  CONTENTS ix 6 Contestable markets 160 Key points 161 Further reading 162 Web references 162 Progress and review questions 162 Chapter 8 Wages, rent and profit 166 Learning objectives 166 1 Introduction 166 2 Marginal productivity theory of wages 166 2.1 Perfectly competitive product and labour market 167 2.2 The firm’s demand curve for labour 168 3 The supply of labour 169 4 The labour market equilibrium 170 4.1 Labour demand and imperfect product markets 172 5 A monopsony market for labour 173 6 Trade unions and the market for labour 175 6.1 Impacts of trade unions 175 6.2 The bargaining strength of trade unions 176 7 Economic rent and transfer earnings 178 7.1 Economic rent 178 7.2 Transfer earnings 178 7.3 Economic rent versus transfer earnings 178 8 Profit 180 8.1 What is profit? 180 8.2 Profit as a cost of production 181 8.3 The function of profit 181 8.4 Determination of profit 181 Key points 182 Further reading 182 Web references 182 Progress and review questions 183 Chapter 9 Regulation, deregulation and competition 187 Learning objectives 187 1 Introduction 187 2 Regulation 187 2.1 Types of regulation 187 2.2 Reasons for deregulation 188 2.3 Deregulation and public interest theory 189 3 Privatisation 190 3.1 The case for privatisation 190 3.2 The case against privatisation 192 3.3 ‘Natural monopoly’ argument 193 4 Regulation of privatised companies 194 4.1 Objectives of regulators 194 5 UK competition policy 194 5.1 The key institutions in UK merger policy 194 x CONTENTS 5.2 Restrictive practices legislation 196 5.3 Cartels in the UK 197 6 EU competition policy 197 7 EU restrictive practices and EU legislation 199 Key points 200 Further reading 201 Web references 201 Progress and review questions 201 Chapter 10 The environment 205 Learning objectives 205 1 Introduction 205 2 The economy and the environment 205 3 A model of pollution 207 4 Policy options 208 4.1 Bargaining and negotiation 208 4.2 Bargaining, game theory and the free-rider problem 209 4.3 Environmental taxes 210 4.4 Tradable permits 211 4.5 Environmental standards 215 5 Transport and the environment 216 5.1 The economic background 217 5.2 Possible policy options 218 Key points 222 Further reading 223 Web references 223 Progress and review questions 223 Part Two MACROECONOMICS Chapter 11 National income and its determination 229 Learning objectives 229 1 Introduction 229 2 The circular flow of income 230 2.1 Circular flow of income: simplified 230 2.2 Circular flow of income: withdrawals and injections 231 3 National income: definitions and measurement 233 3.1 National income definitions 233 3.2 National income measurement 234 3.3 National income accounts 238 4 Using national income statistics 239 4.1 Comparing national living standards over time 239 4.2 Comparing living standards of different nations 241 5 National income determination 242 5.1 Equilibrium in the circular flow: W/J approach 242 5.2 Equilibrium in the circular flow: 45° diagram approach 246 5.3 Equivalence of the two approaches 251 6 Changes in national income 252  CONTENTS xi 6.1 Changes in injections (J) 252 6.2 Changes in withdrawals (W) 253 7 National income and employment multipliers 254 7.1 National income multiplier 254 7.2 Employment multiplier 257 Key points 257 Further reading 258 Web references 258 Economic models and simulation 258 Progress and review questions 259 Chapter 12 Public expenditure, taxation and fiscal policy 267 Learning objectives 267 1 Introduction 267 2 Rationale for a public sector 268 3 Government expenditure 270 3.1 What is government expenditure? 270 3.2 Growth of public expenditure 270 3.3 Total managed expenditure (TME) 271 3.4 Fiscal ‘rules’ 271 3.5 Explanation of the growth in public expenditure 271 4 Planning, monitoring and control 273 4.1 Public Expenditure Survey (PES) 273 4.2 Control total (CT) 274 5 Reasons for the control of public expenditure 274 5.1 More freedom and choice 274 5.2 To control the money supply 275 5.3 Crowding out 275 5.4 Incentives to work, save and take risks 275 6 Taxation 276 6.1 Direct and indirect taxes 277 6.2 Specific and percentage taxes 278 6.3 Progressive and regressive taxes 278 7 Individual taxes 279 7.1 Income tax in the UK 279 7.2 Other direct taxes in the UK 280 7.3 Indirect taxes in the UK 280 7.4 Other taxes in the UK 281 8 Taxes and economic incentives 281 8.1 Taxes and incentives to work 281 8.2 Comparative tax rates 283 9 Direct versus indirect taxes 284 9.1 Macroeconomic management 284 9.2 Economic incentives 285 9.3 Economic welfare 285 9.4 Administrative costs 285 10 Poverty and unemployment ‘traps’ 286 10.1 Poverty trap 286 10.2 Unemployment trap 287 10.3 The black economy 288 xii CONTENTS 11 Fiscal policy 289 11.1 The Budget 289 11.2 Budget terminology 289 12 Fiscal policy and stabilisation 290 12.1 Business cycle 290 12.2 Built-in stabilisation 291 12.3 Discretionary fiscal stabilisation 291 13 Fiscal policy and globalisation 293 Key points 293 Further reading 294 Web references 294 Progress and review questions 296 Chapter 13 Money, financial institutions and monetary policy 300 Learning objectives 300 1 Introduction 300 2 The functions of money 300 2.1 A medium of exchange 301 2.2 A unit of account 301 2.3 A store of value 301 2.4 A standard of deferred payment 301 3 Money supply 302 3.1 What is money? 302 3.2 Near money 302 3.3 Measuring the money supply 303 3.4 Credit creation 304 4 Financial institutions 306 4.1 The role of the financial system 306 4.2 The role of financial intermediaries 307 5 UK financial intermediaries 309 5.1 The UK banking financial intermediaries 310 5.2 UK non-bank financial intermediaries 311 5.3 The Bank of England 313 6 Money supply and the Bank of England 314 6.1 Supply of money 314 7 Money demand and interest rates 316 7.1 What is interest? 316 7.2 Theories of interest rate determination 316 8 Monetary policy 321 8.1 Controlling the money supply 321 8.2 Rate of interest 322 9 Monetary policy and financial globalisation 322 Key points 323 Further reading 324 Web references 324 Progress and review questions 325  CONTENTS xiii Chapter 14 Exchange rates and the balance of payments 329 Learning objectives 329 1 Introduction 329 2 Exchange rate 330 2.1 Determination of exchange rates 331 2.2 Types of exchange rate 332 3 The terms of trade 334 4 The Marshall–Lerner elasticity condition 335 5 The J-curve 337 5.1 Diffusion path for price changes following a currency depreciation 337 5.2 Time lag in adjustment of consumer behaviour to price changes 339 6 Expenditure switching v expenditure reducing policy instruments 339 7 Exchange rate policy and financial globalisation 340 8 Exchange rate systems 341 8.1 Fixed exchange rates (gold standard) 341 8.2 Adjustable peg system (IMF) 342 8.3 The floating exchange rate system 343 9 Single currency (euro) 343 9.1 Advantages of single currency 344 9.2 Disadvantages of single currency 345 9.3 Developments in the eurozone 346 9.4 The ‘Growth and Stability Pact’ 346 10 Balance of payments 347 10.1 Current account 347 10.2 Capital account 348 10.3 Financial account 348 10.4 Balancing item 348 11 Oil prices and the global economy 348 Key points 350 Further reading 351 Web references 351 Progress and review questions 352 Chapter 15 Unemployment and inflation 358 Learning objectives 358 1 Introduction 358 2 Aggregate demand and aggregate supply analysis 358 2.1 Aggregate demand schedule 359 2.2 Aggregate supply schedule 360 2.3 AD/AS and equilibrium national output 362 3 Unemployment and its characteristics 363 3.1 Definition of unemployment 363 3.2 Measuring unemployment 363 3.3 The costs of unemployment 364 3.4 The characteristics of unemployment 364 4 The causes and remedies of unemployment 366 4.1 Frictional unemployment 366 xiv CONTENTS 4.2 Structural unemployment 367 4.3 Demand deficient unemployment 367 4.4 Real wage unemployment 368 4.5 Regional unemployment 370 4.6 Technological unemployment 371 4.7 Natural rate of unemployment (NRU) 372 4.8 Unemployment and supply-side policies 373 5 Inflation 373 5.1 The Retail Price Index (RPI) 374 5.2 RPIX 375 5.3 RPIY 375 5.4 Consumer Price Index (CPI) 376 6 The effects of inflation 376 6.1 Perfectly anticipated inflation 376 6.2 Unanticipated inflation 376 7 Economic theory and inflation 379 7.1 The quantity theory of money 379 7.2 The Phillips curve and inflation 379 7.3 The expectations-augmented Phillips curve 381 8 Aggregate demand, aggregate supply and inflation 382 8.1 Demand-pull inflation 382 8.2 Cost-push inflation 383 9 Counter-inflationary policies 385 9.1 Fiscal policy 385 9.2 Monetary policy 385 9.3 Prices and incomes policy 385 9.4 Supply-side policies 385 Key points 386 Further reading 387 Web references 387 Progress and review questions 388 Chapter 16 International trade, international institutions and globalisation 392 Learning objectives 392 1 Introduction 392 2 The gains from trade 393 2.1 Why trade internationally? 393 2.2 Absolute advantage 393 2.3 Comparative advantage 394 2.4 Comparative advantage and opportunity cost 395 2.5 Limitations of the theory of comparative advantage 396 2.6 National competitive advantage 397 3 The terms of trade 399 4 Free trade and economic welfare 399 5 Protectionism 400 5.1 Tariffs 400 5.2 Quotas 402 5.3 Exchange controls 402  CONTENTS xv 5.4 Subsidies 402 5.5 Administrative barriers 402 5.6 Voluntary export restraints 402 5.7 Arguments for protection 402 5.8 Arguments against protection 403 6 International framework for trade 404 6.1 General Agreement on Tariffs and Trade (GATT) 404 6.2 World Trade Organisation (WTO) 405 7 Regional trading arrangements (RTAs) 407 7.1 Types of regional trading agreements 407 8 Globalisation 408 8.1 Characteristics of globalisation 409 8.2 Indicators of globalisation 411 8.3 Globalisation and the value chain 414 8.4 Relative unit labour costs (RULCs) 414 Key points 416 Further reading 416 Web references 416 Progress and review questions 417 Chapter 17 Economic integration and the European Union 422 Learning objectives 422 1 Introduction 422 2 Customs unions: trade creation and trade diversion 423 3 Origins of the EU 425 3.1 Single European Act (SEA) 426 3.2 Maastricht Treaty 426 4 EU laws and regulations 426 4.1 European Commission (EC) 428 4.2 European Parliament (EP) 428 4.3 European Court of Justice (ECJ) 429 4.4 Council of Ministers 429 4.5 European Council 429 5 Characteristics of the EU 431 5.1 Country-specific data on the original EU 15 431 5.2 EU enlargement 431 6 EU Common Agricultural Policy (CAP) 431 7 Common Fisheries Policy 434 8 EU industrial policy 436 9 EU Social Chapter 438 9.1 Main directives of the Social Chapter 439 9.2 Economic analysis of the Social Chapter 440 9.3 Failures of the competitive labour-market process 443 10 EU competition policy 443 10.1 Cross-border mergers policy 444 10.2 New EU cross-border merger regulations 445 10.3 Restrictive practices and EU legislation 445 10.4 EU competition policy and economic efficiency 447 xvi CONTENTS Key points 448 Further reading 449 Web references 449 Progress and review questions 450 Chapter 18 Growth, sustainable development and the less developed countries 454 Learning objectives 454 1 Introduction 454 2 Theories of economic growth 455 2.1 Classical growth theory 455 2.2 Neo-classical growth theory 456 2.3 Modern growth theories 459 3 Sustainable development 459 3.1 Characteristics of sustainable development 459 3.2 Key conditions for sustainable development 461 3.3 Measuring sustainable development 463 3.4 Technical change and sustainability 465 4 GNP data, developed and developing countries 466 4.1 Human Development Index (HDI) classification 467 5 Major features of LDCs 469 6 International Development Targets 473 7 Urbanisation and developing economies 474 7.1 Impacts of urbanisation 474 7.2 Reasons for urbanisation 476 8 Aid, trade and development 476 8.1 Foreign aid and development 476 8.2 Trade and development 478 9 Debt and development 479 9.1 Reasons for LDC borrowing 479 9.2 Resolving the debt problem 480 10 The role of the IMF and World Bank 480 10.1 IMF ‘stabilisation programmes’ 480 10.2 World Bank ‘structural adjustment lending’ 481 10.3 Stabilisation 481 10.4 Structural adjustment 482 10.5 Criticisms of IMF action 482 Key points 483 Further reading 483 Web references 483 Progress and review questions 484 Answers to selected Mini Case Studies and Progress and Review Questions 488 Index 528  Preface This fourth edition of Economics is somewhat of a departure from the previous editions in that it involves Stuart Wall as a co-author who has vast experience in terms of writing, editing and publishing in the area of economics and business management. His involve- ment in the revision of this book has substantially enhanced the final product. As with the previous editions of this book, a key objective has been to introduce stu- dents to the main concepts, theories and applications of economics in a clear and concise manner. The fourth edition has been thoroughly updated with the addition of many new features. The new features include the following: Learning objectives at the beginning of each chapter, which carefully identify what the reader should learn from the particular chapter. Pause for thought boxes, to be found at strategic points throughout each chapter, to stimulate thinking about issues under discussion. Responses to these can be found on the website to accompany this book. Examples so that the reader can relate the concepts introduced to real world situations. Mini Case Studies and, on occasions, longer Case Studies based on up-to-date informa- tion and events, with questions asked and responses available at the back of the book, or on the student website, as indicated. As with the boxed Examples, the idea is to emphasise the relevance of economics to the real world. Key points at the end of each chapter, which serve as a check to help the reader focus on the main elements of the chapter. Progress and review questions at the end of each chapter, with answers and responses at the end of the book, or on the student website, as indicated, so that the reader can check on progress made. Key terms are to be found in the margins of each chapter, with the various economic terms defined the first time they appear in the text. The eighteen chapters are divided into two parts, microeconomic related chapters (2–10) and macroeconomic related chapters (11–18), though it is readily acknowledged that this distinction is sometimes rather arbitrary. The book is aimed primarily at those students who are new to economics, taking the subject as part of a first year degree or degree equivalent programme or on professional courses. The book may also be useful to the more serious students engaged on A level economics and business studies courses. There are certain topic areas which progress the subject beyond the level expected of the non-specialist or introductory economist. These topics are identified in the few chap- ters in which they occur and can be omitted without interfering with the flow of the book. Whilst these topics are more advanced than is usually required, if you feel that you can cope with them they are worth reading and will enhance your overall understanding of the subject. xviii PREFACE Finally, every effort has been made to make the book as user-friendly as possible for students who are new to economics. This is quite a responsibility but I sincerely hope that you find the book both useful and interesting. Stephen Ison Nottingham April 2006 Supporting resources Visit www.pearsoned.co.uk/ison to find valuable online resources Companion Website for students and instructors Answers to mini case studies throughout the chapters of the book Responses to the pause for thought boxes throughout the chapters of the book Answers to end of chapter progress and review questions Suggested outlines to essay questions For instructors PowerPoint slides that can be downloaded and used for presentations For more information please contact your local Pearson Education sales representative or visit www.pearsoned.co.uk/ison  Acknowledgements Our combined thanks go to Eleanor for many long hours in helping us put the manuscript together. We would also like to thank our respective families for enduring long periods of our working in front of the computer screen. For Stephen, this especially involves Susanna, James, Naomi and Lydia, and for Stuart, Eleanor, Lizzy and Jonathan. Our sincere thanks go to Alan Griffiths for much helpful support and content involv- ing many chapters. Particular thanks also go to Carsten Zimmermann for contributing Chapter 17 on Economic integration and the European Union. We would also like to thank Rachel Byrne and Paula Harris for much helpful advice and encouragement. Other thanks go to students undertaking economics as part of undergraduate courses in Air Transport Management and Transport and Business Management at Loughborough University who have used the book and made useful sug- gestions which have been incorporated in this new edition. Finally, our thanks go to the four anonymous reviewers who made a number of insightful comments in terms of an early draft of the book. We found their contribution to be most useful and it certainly enhanced the final version. Of course, any errors and omissions are entirely our responsibility. Stephen Ison and Stuart Wall  Publisher Acknowledgements We are grateful to the following for permission to reproduce copyright material: Financial Times for Mini Case Study 9.1; HMSO for an extract from The Government’s White Paper on the Future of Air Transport (Cm 6046) published December 2003; Pearson Education for extracts adapted from Economics for Business and Management 2005 by Griffiths and Wall. In some cases we have been unable to trace the owners of copyright material and we would appreciate any information that would enable us to do so. CHAPTER The nature of economics 1 Learning By the end of this chapter you should be able to: objectives Define what is meant by ‘economics’. Outline the ways in which an economist thinks. Understand the importance of graphs, diagrams and charts to the economist. Understand the nature of the economic problem. Outline what is meant by the production possibility frontier and show how useful it is when analysing opportunity cost. Discuss the economic merits and weaknesses of the market economy. Outline the differences between a market economy and a planned economy. Define what is meant by ‘public goods’. Distinguish between positive and normative economics. Distinguish between microeconomics and macroeconomics. 1 INTRODUCTION What determines the demand for a good or service? What happens to the demand for a good if its price rises or falls? Why do firms supply goods? How can firms charge different prices for the same good or service to different groups of customers? What causes unem- ployment? What determines the wage level? What is the role of money in the economy? What causes inflation? Is there a need for government intervention in the economy? These are the types of questions economists are interested in and around which theories have been developed in order to aid our understanding. This chapter seeks to introduce a number of the basic concepts which you will find useful as you progress through the book. The chapter introduces the way in which economists think and the use they make of economic models. In addition, economists make extensive use of graphs, diagrams, charts and tables, which are to be found throughout this book, and are therefore introduced in this chapter. The economic problem of scarcity and choice, which is central to economics, will also be covered in this chapter, together with an explanation of the free market, which is the main mechanism by which resources are allocated throughout the world. The use of a free market is an attempt by nations and the global economy to address this central economic problem of scarcity and choice. 2 ECONOMICS 2 DEFINING ECONOMICS There is no one definition of economics, although a useful starting point is the well estab- lished definition provided by Lord Robbins as long ago as 1932. He defined economics as ‘the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses’. At first reading this may appear a difficult definition to understand; however, if it is studied in more detail it can be seen to offer a useful insight. We can dissect the definition as follows: (a) Economics is a ‘social science’ in that it uses scientific methods to study human behaviour. (b) Human needs are unlimited whereas resources are in limited supply, hence the prob- lem of scarcity. (c) The resources can be put to alternative uses in order to meet certain ends, such as the building of a power station or a new hospital. Since resources are scarce, choices have to be made as to how resources are utilised. 2.1 The ways in which an economist thinks Economics has its own ‘language’ which makes extensive use of selected words and which you will encounter throughout this book, such as production possibility frontier, demand, supply, elasticity, consumer surplus, the multiplier, comparative advantage and so on. Economic models form an important part of the economists’ thinking. They represent a simplification of the real world and often incorporate assumptions, making it easier to understand how the world operates. For example, when international trade is studied the economist may assume that there are only two countries, each of which produces only two products. This is in fact the assumption that is made when studying the benefits from trade in Chapter 16, and using such a ‘two-by-two’ model allows us to focus our thoughts. However, the principles or ideas that apply in the ‘two-by-two’ model can usually be generalised to many countries and many products, though mathematics may be required to capture this more general relationship. Simple economic models will be used all the way through this book and they often utilise diagrams in order to aid in our understanding. 2.2 The use of tables and diagrams Raw data refers to numbers and facts in their original form and which have not, as yet, been treated in any way. One of the simplest ways to give meaning to raw data is to con- struct a table in which some order or shape is given to the raw data. Such tables can often be expressed in visual form as a diagram. Diagrams are used extensively in economics and you will encounter them throughout this book. In order to think like an economist it is important to understand and be able to interpret diagrams. For example, data giving the demand for chocolate bars is presented in Table 1.1 and this can be represented in the form of a diagram as in Figure 1.1. Diagrams have a vertical and horizontal axis each representing a different variable. The price of chocolate bars is measured on the vertical axis and the quantity demanded is measured on the horizontal axis. Remember to express the unit for each variable, pence  CHAPTER 1 · THE NATURE OF ECONOMICS 3 Table 1.1 A demand schedule for chocolate bars Price Quantity demanded (pence per bar) (million bars per week) 0 12 10 10 20 8 30 6 40 4 50 2 60 0 Figure 1.1 The demand for chocolate bars with the price for chocolate bars on the vertical axis and the quantity demanded (million bars demanded per week) on the horizontal axis. for price and million bars for quantity. The quantity demanded also makes use of a time period, here ‘per week’. The dotted lines shown in the diagram are important, indicating specific parts of the diagram you wish to emphasise. For example, point A indicates two pieces of informa- tion, namely that at a price of 30 pence, 6 million chocolate bars will be demanded per week. Point B represents a different price and quantity situation, namely that at a price of 20 pence, 8 million bars will be demanded per week. It is worth noting that the relationship between price and quantity shown in Figure 1.1 is a negative or inverse relationship. This means that the two variables move in the opposite direction, with a reduction in price leading to a rise in the quantity demanded, and vice versa. If the relationship had been positive, then the two variables would have moved in the same direction and the line would have sloped upwards from left to right. 4 ECONOMICS The information presented in Table 1.1 and Figure 1.1 could have been presented mathematically, given by the equation of a straight line. This is beyond the scope of this book but you may like to consider what the equation for the demand curve would be given the above information. ! Pause for thought 1 Can you find the equation for the straight line in Figure 1.1? Why do economists make use of diagrams? By simplifying the situation and dealing with only two variables, economists are making use of the ‘other things equal’ (ceteris paribus in Latin) assumption. In practice, economists are aware that many variables may influence, say, the demand for a particular chocolate bar besides its price – for example the price of rival chocolate bars, the income of the consumer, the amount of advertising, and so on. However, when economists draw the demand curve for a chocolate bar, as in Figure 1.1, they are assuming that all these other variables are unchanged as the price of this chocolate bar rises or falls. Whilst this is an oversimplification of reality, it does allow economists to concentrate on important relationships between two variables. 2.3 The economic problem Economics studies the allocation, distribution and utilisation of resources to meet human Economic problem needs. A central element in the economic problem, then, is the allocation of scarce Relates to the resources among alternative uses. Resources (human, physical and financial) are limited in allocation of scarce supply while human needs and desires are infinite. These needs are usually called ‘wants’. resources among alternative uses. Some of the wants are necessities such as basic food, clothing and housing but there are Choices have to be also desires for other items such as CD players, DVD players or even a night at the opera. made as to how the Probably at the level of the individual and certainly for humankind as a whole, human scarce resources are wants are unlimited. If you think about your own situation, some of the goods and services allocated among the you require you will be able to obtain with the scarce resources, i.e. income, available to different ends, resulting in you. There are likely, however, to be other items you would like to have but are unable to ‘opportunity costs’. obtain because of limited resources. The same economic problem faces all individuals, organisations and societies – unlimited wants, limited resources. The resources an economy has at its disposal are used to satisfy the unlimited wants. Factors of These are often termed by economists inputs or factors of production. They are the means production of producing the goods and services society requires to meet human needs and can norm- The inputs used ally be divided into three main categories: by an economy in the production of a) Land, the natural resource goods and services. b) Labour, the human resource They comprise land, labour, capital and c) Capital, the physical resource. entrepreneurial The factors of production will be dealt with in more detail in Chapter 5: Section 4. ability (in some definitions). Since the resources are limited in supply (i.e. scarce) and there is the existence of unlimited wants, choices have to be made – choices involving the allocation of scarce resources among alternative uses to achieve given ends. Economics is also concerned with the distribution of resources between different groups in society. So, in addition to the problem of what gets produced (allocation), there is the problem of who gets what  CHAPTER 1 · THE NATURE OF ECONOMICS 5 is produced (see Chapter 8). Moreover, there is the problem of resource utilisation, ensuring that all the available resources are used effectively. This is the subject matter of macroeconomics and is dealt with in Part Two. 2.4 Opportunity cost Macroeconomics Resources are limited in supply and have alternative uses. However, if they are used in the An area of production of, say, iPods then they cannot be used in the production of DVD players. So economics that if society chooses to produce more iPods it would have to forgo a certain quantity of DVD concentrates on the economic players which those same resources could have produced. In other words, the opportunity behaviour of the cost of producing more of the former is less of the latter. Opportunity cost can be defined economy as a as the best alternative forgone. This concept is central to the study of economics at a whole, dealing number of levels: with issues such as inflation and (a) At the individual level, if one decides to grow more potatoes in the garden then one unemployment. has to reduce the production of, say, carrots. The limited space in the garden can be viewed as the scarce resource and one cannot produce more of one good, potatoes, and Opportunity cost The best alternative still produce the same amount of another, carrots. forgone. (b) At the level of the firm, limited capital equipment (e.g. machinery) currently used to produce, say, milk chocolate cannot be used to manufacture plain chocolate. (c) At government level, limited tax revenue may mean that a decision to build three new schools may be at the expense of the alternative option of building a new hospital. When considering opportunity cost it is important to note that such choices are only required if all existing resources are being fully used. If this were not the case the idle resources, in our examples garden space, machinery and taxation revenue, could be used instead. Society has to decide what goods and services it is going to produce. This will involve choices because producing more of one good or service will normally mean producing less of another if all existing resources are being fully utilised. Example Opportunity cost: extra spending on NHS The Wanless Commission into the NHS reported in 2002 that UK spending on health at 6.8% of National Income was well below the EU average of 8%. In the five-year plan Production for health spending from 2002–7, the Chancellor of the Exchequer (Gordon Brown) possibility frontier committed the UK to reaching the EU average by 2006, which implied government This represents spending on the NHS rising by more than £100 billion a year. Of course, this extra the boundary government spending on the NHS means less tax revenue is available for spending on between those other public services such as transport and pensions, especially since the growth of combinations of goods and services public spending on education has also been protected up to 2007. which can be produced and those which cannot. 2.5 The production possibility frontier (PPF) The central problem in economics of scarcity, choice, opportunity cost and resource allocation can be analysed by using a production possibility frontier or curve as shown in Figure 1.2. 6 ECONOMICS Figure 1.2 The production possibility frontier AF represents the boundary between the goods and services which can be produced, namely on or within the frontier, and those which cannot. The economy would prefer to be at a point such as C or D on the frontier than at a point such as G inside the frontier. Figure 1.2 represents a hypothetical production possibility frontier AF for an economy producing two products: food and clothing. The PPF shows the alternative combinations of the two products that the country can produce if it fully utilises all of its resources. For example, if all the country’s resources were used in the production of clothing then the total output would be 30 units of clothing and there would be no food production. This is represented by point A. If, however, all the resources were devoted to the production of food, the economy would be at point F with 25 units of food produced but zero clothing. Alternatively, the economy could be at any point on the PPF producing a certain amount of food and clothing. However, if the economy were at point G it would signify that the economy was under-utilising its resources. There would be unemployed resources and by bringing those resources into use the economy could move to a position on the curve such as point D, where more clothing and food could be produced. It is clearly sensible for an economy to be on the PPF rather than inside it since at point G the economy is producing 15 units of clothing and 10 units of food, whereas at point D the economy is producing 21 units of clothing and 15 units of food. Once on the PPF it is not possible to increase the production of one of the two products without reducing the production of the other product. So, for example, if the economy were at point D a move- ment along the frontier to point E would involve a reallocation of resources. Hence an increase in food production of 5 units would require a reduction in clothing production of 6 units. Points outside the frontier such as H, representing other combinations of food  CHAPTER 1 · THE NATURE OF ECONOMICS 7 and clothing output, are unattainable – given the existing resource availability and the state of technology. A shift outwards in the PPF, such as a shift to IJ in Figure 1.3, represents economic growth, which means the ability to produce more goods which in the example used means more food and clothing. This can be brought about either by technological change, i.e. new and better ways of producing the goods and services, or through an increase in the economy’s productive capacity, achieved through an increase in the supply of the factors of production. This means that a point such as H which was previously unattainable is now attainable. Figure 1.3 Technological change or an increase in the economy’s productive capacity allows the production possibility frontier to shift to the right. Example Technological change in microchips That technological change can shift the production possibility frontier outwards is well illustrated by developments in microchip production. The huge new global microchip fabrication plants (‘fabs’) use new technologies to produce microchips, enabling output per unit of input (i.e. productivity) to more than double. For example, more than 225 microchips can now be produced from a ‘wafer’ of silicon using these new technologies, compared to only 100 microchips in smaller, less technologically advanced plants. As a result, the average cost of microchips has fallen by 40% in recent years. 2.6 The PPF and opportunity cost The frontier can be viewed in terms of opportunity cost since to produce more units of one product needs resources to be taken from the production of the other. In Figure 1.2 the frontier is concave to the origin and this means that the opportunity cost will change 8 ECONOMICS as we move along the frontier. If we start at point A and move down the curve we can see how the opportunity cost changes (see Table 1.2). Table 1.2 The opportunity cost of food Movement along Change Change Opportunity cost the curve in food in clothing ∆ in clothing × (−1) ∆ in food From A to B +5 –2 0.4 From B to C +5 –3 0.6 From C to D +5 –4 0.8 From D to E +5 –6 1.2 From E to F +5 –15 3.0 A movement from A to B involving the production of 5 units of food requires a reduc- tion of 2 units in the production of cloth. So the opportunity cost of 5 units of food is 2 units of clothing, with an opportunity cost of 0.4. (One unit of food has been gained at the expense of 0.4 units of clothing.) The opportunity cost is initially small as the resources better suited to the production of food move from the production of clothing. As more food is produced, it is necessary to reallocate resources which are less suited to the production of food. In moving from B to C an extra 5 units of food production will involve a reduction in clothing production of 3 units, with a resulting opportunity cost of 0.6. A movement from C to D will require a loss in clothing production of 4 units (an opportunity cost of 0.8) and from D to E a loss of 6 units of clothing (an opportunity cost of 1.2). Finally, a movement from E to F, again with an extra 5 units of food production, will require forgoing 15 units of clothing with an opportunity cost of 3.0. This is more realistic than a PPF as in Figure 1.4. The figure illustrates a situation of constant opportu- nity cost, 0A/0B, where clothing can be exchanged for food at a constant rate. Planned economy An economic system in which decisions about the allocation of resources is undertaken by the state planning authority. These decisions concern what is produced, how and for whom. Mixed economy An economy where the decisions about what, how and for Figure 1.4 The production possibility frontier AB drawn as a straight line whom to produce are partly made via displays the characteristic of constant opportunity cost. This means that the market and each additional unit of food produced requires that 0A/0B units of clothing partly by the be forgone. Every additional unit of clothing produced requires 0B/0A units government. of food to be forgone.  CHAPTER 1 · THE NATURE OF ECONOMICS 9 ! Pause for thought 2 Explain how the production possibility frontier provides an insight into the issues of scarcity and choice which an economy faces when deciding what goods and services to produce. 3 ECONOMIC SYSTEMS Although all countries throughout the world have to face similar economic problems, the economic system they adopt as a means of dealing with them will differ. Essentially there are three approaches to tackling the economic problem of allocation, distribution and utilisation of resources: Market economy (a) A market economy allocates resources through the price mechanism, with market An economy where prices being determined by the forces of demand and supply. the allocation of resources is (b) A planned economy allocates resources through administrative decisions. Although determined by this type of economic system is no longer in evidence to any great extent worldwide, it the independent may be useful to briefly outline how the planned economic system has operated in parts decisions and actions of individual of the world. consumers and (c) A mixed economy contains features of both the market and planned economic producers in markets guided by price systems, with the government intervening in various ways to influence market prices. signals. In practice most economies are, strictly speaking, mixed economies. Example Mixed economies are the rule The following data shows the extent to which the governments of various countries in 2004 intervened in the economies of those countries. The figures show government spending as a percentage of total economic activity (i.e. gross domestic product: GDP) in those countries. Country Government spending as % of economic activity (GDP) in 2004 Australia 33.1% Price mechanism France 48.5% The way in which Japan 37.8% price acts as a Sweden 50.8% ‘signal’ within a market economy UK 39.6% to influence the USA 30.8% demand for and supply of goods and Clearly governments intervene to a considerable extent in most economies, even though services, thereby helping demand the extent of that intervention does vary. equal supply in a Source: Adapted from Economic Outlook, OECD, 2005 market economy. 10 ECONOMICS 4 THE MARKET ECONOMY In a ‘pure’ free market economy there would be no government intervention and decisions as to the allocation of resources would be taken by individual producers and consumers through a system known as the price mechanism or market mechanism. The market or price mechanism is a central feature of a market economy. An outline of how the market mechanism works can be seen in Figure 1.5. Throughout the economy millions of consumers are making decisions as to how to spend their income. By changing their preferences from good A to good B they are send- ing a signal to the producers of these goods. As the demand for good B increases and that of good A declines the prices of the two products will change and, other things being equal, Figure 1.5 The figure illustrates the market mechanism. Prices change in response to changes in demand and supply resulting in a reallocation of resources.  CHAPTER 1 · THE NATURE OF ECONOMICS 11 the profit obtained from the two products will change. Profit is the key motivator in the market economy and the producers will reallocate their scarce resources to those goods and services which will yield the most profit. One can see why this process is sometimes called the ‘free’ market because the alloca- tion of resources occurs without government intervention – reallocation of resources is ‘automatic’. The consumer has an important role to play in the market economy for it has been change in consumer tastes which have ultimately led to a change in what is pro- duced. The scale of the influence depends on the level of income of the consumer. When consumers spend on a particular product, they are essentially voting for that product. The more income they have, the more ‘money votes’ they can cast and, therefore, the greater their influence on what is produced. 4.1 Advantages of the market economy (a) The market mechanism means that resources are allocated automatically without the need to resort to government intervention. (b) By using ‘money votes’ the consumer dictates to the producers, through the market, what is produced. (c) Producers are motivated by profit thus they have the incentive to respond quickly to changes in consumers’ preferences. 4.2 Disadvantages of the market economy (a) Those with higher income levels have more money votes and, therefore, a greater say in what is produced. The market mechanism is based on the ‘ability to pay’ and not on need, which means that certain members of society are unable to obtain the goods and services they require. (b) The market mechanism generates competition between producers. But monopolies may develop, as larger companies take over or merge with smaller companies, or force them out of business. Monopolies may operate against the public interest, charging higher prices than in a competitive situation in the knowledge that the consumer has no alterna- tive source from which to buy the product. Monopolies will be dealt with in more detail in Chapter 6: Section 4. Externalities (c) In producing goods and services it is possible that externalities will occur. External- Where economic ities are costs (or benefits) which result from production or consumption but which decisions create fall on a third party. In terms of external costs such as pollution, and noise and traffic costs or benefits for people other than congestion, costs will be imposed on society which are not included in the decisions of the decision taker. consumers or suppliers. For example, as part of its productive process a chemical company may dump toxic waste into a river with the result that fish stocks are depleted. This can be viewed as an external cost on fishermen, a cost which is not taken into account by the chemical company. The chemical company is only likely to take account of their private costs, namely the rent, rates, raw material and labour costs incurred, and they are likely to Social cost ignore the costs they impose on others. To obtain the full social cost of production, the cost Private costs plus (or benefit) of externalities should be added to the private cost. The external costs are likely the external costs resulting from to continue unchecked if left to the free market and are one of the reasons for government producing a good or intervention. The whole area of externalities is dealt with in more detail in Chapter 10. providing a service. Mini Case Study 1.1 below looks at externalities involved with air transport. 12 ECONOMICS Public goods (d) Certain goods, namely public goods may be under-provided or not provided at all in Goods or services a market economy. Public goods can be defined as those goods which when consumed by which when one individual can still be consumed by others and from which no one can be excluded. consumed by one individual can still be Examples include defence and flood control, and if they were paid for by one individual consumed by others then others would be able to obtain a ‘free ride’. and from which no one can be Whilst Mini Case Study 1.1 below has relevance here, you might also return to read it excluded. when you have read Chapter 10 relating to the environment. Mini Case Study 1.1 Externalities and air transport The Government recognises the benefits that the expansion in air travel has brought to people’s lives and to the economy of this country. The increased affordability of air travel has opened up the possibilities of foreign travel for many people, and it provides the rapid access that is vital to many modern businesses. But we have to balance those benefits against the environmental impacts of air travel, in particular the growing contribution of aircraft emissions to climate change and the significant impact that airports can have on those living nearby. Air travel has increased five-fold over the past 30 years, and demand is projected to be between two and three times current levels by 2030. Some of our major airports are already close to capacity, so failure to allow for increased capacity could have serious economic consequences, both at national and at regional level. That must be balanced by the need to have regard for the environmental consequences of air travel. The Government believes that simply building more and more capacity to meet demand is not a sustainable way forward. Instead, a balanced approach is required which: recognises the importance of air travel to our national and regional economic prosperity, and that not providing additional capacity where it is needed would significantly damage the economy and national prosperity; reflects people’s desire to travel further and more often by air, and to take advantage of the affordability of air travel and the opportunities this brings; seeks to reduce and minimise the impacts of airports on those who live nearby, and on the natural environment; ensures that, over time, aviation pays the external costs its activities impose on society at large – in other words, that the price of air travel reflects its environmental and social impacts; minimises the need for airport development in new locations by making best use of existing capacity where possible; respects the rights and interests of those affected by airport development; provides greater certainty for all concerned in the planning of future airport capacity, but at the same time is sufficiently flexible to recognise and adapt to the uncertainties inherent in long-term planning. As part of this approach, the Government believes more needs to be done to reduce and mitigate the impacts of air transport and airport development. At the global level, the government will play a major role in pressing for new solutions and stronger action by  CHAPTER 1 · THE NATURE OF ECONOMICS 13 international bodies. And the White Paper sets out proposals to bring aviation within the European Union emissions trading scheme, to help limit greenhouse gas emissions. Source: The government’s White Paper on the Future of Air Transport (Cm 6046). Department for Transport, December 2003 Questions 1 What is meant by ‘externalities’? 2 Outline the advantages and disadvantages of an expansion in air travel. (Note that Chapter 10 covers the whole area of externalities in much more detail.) Answers to questions can be found on the students’ side of the Companion Website. 5 THE PLANNED ECONOMY In a planned economy the government makes all the decisions about what is produced, how resources are allocated and at certain times, through rationing, how the finished products are distributed. A government planning office decides on the allocation of resources, estimating the types of products it considers individuals to want. This kind of economy is rare today with even countries such as North Korea moving towards a market-based system. Prior to the late 1980s the countries of Eastern Europe allocated resources via a planned economy. Whilst this type of economic system no longer exists to any great extent, it is worthwhile briefly outlining its potential advantages and disadvantages. 5.1 Advantages of the planned economy (a) The planning office decides what goods and services are produced, which, in theory at least, means that any wasteful competition is avoided. (b) It has been argued that a planned economy can lead to a more equal distribution of income and wealth since the factors of production are controlled by the state. (c) The planning office administers the prices of products and can, therefore, effectively control inflation. The result is that when shortages occur in the economy they manifest themselves in queues, rationing and the black market rather than in increased prices. 5.2 Disadvantages of the planned economy (a) Since the allocation of resources is undertaken by the planning authority, they may misjudge the preferences of the consumers. This means there may be an overproduction of certain products and an underproduction of others. The shortages will result in long queues and rationing, whereas the overproduction of goods will lead to large stockpiles of unwanted products. (b) As the state owns the assets of the economy it will mean that there is a reduced incentive to work harder. There can be a lack of motivation among management and workers since individuals do not own businesses or benefit directly from the profit those businesses earn. 14 ECONOMICS (c) With business being organised as a state monopoly there is a lack of competition between companies, and a resulting lack of variety and quality of products. In fact, prod- ucts tend to be rather standardised with the absence of product differentiation. (d) In the market economy resources are allocated automatically via the market mechan- ism whereas in the planned economy a large bureaucracy has developed to administer the system. This bureaucracy can be viewed as a misuse of resources. It is because of the failings of the planned economy that in recent years countries throughout Eastern Europe have moved towards a market economy system – in fact becoming more mixed economic systems. Mini Case Study 1.2 Meeting the plan The term ‘communist bloc’ was used in the West until the late 1980s to describe the operation of 25 economies under the Soviet sphere of influence. A characteristic of all these economies was an extensive central planning system, often termed a ‘command economy’. The command economy dominated every aspect of life, telling factories where to buy their inputs, how much to pay their workers, how much to produce and where to sell their output. Individuals were trained in specialist schools and universities and directed to work at specific factories, which provided their wages, houses, health care – even holidays in enterprise-owned hotels and sanatoria. The national bank was told how much to lend to which factories and how much cash to print to pay wages. As a theoretical concept, central planning was very elegant. Using ‘input-output’ analysis (a planning framework which calculated the inputs required for each factory in order for it to deliver its planned outputs to the next stage in the production process), the planning ministry could calculate precisely how much labour, capital and raw materials each enterprise required to achieve its production targets. The various production targets for raw materials and intermediate and final products all fitted together to ensure a perfectly balanced expansion of the economy. Input and output prices were carefully set to ensure that all firms could pay their wage bills and repay loans from the national bank, while at the same time pricing consumer goods to encourage consumption of socially desirable goods (e.g. books, ballet, theatre, public transport, etc.) and discourage consumption of politically unfavoured goods (e.g. international telephone calls, cars, luxury goods). Questions 1 Why do you think the command economy failed to deliver many of the benefits claimed for it in this Mini Case Study? 2 Can you find any clues in the Mini Case Study to explain why the transition from a command economy to a market economy has proved to be so painful for many of these states? 3 What would you consider to be the potential advantages and disadvantages for these states seeking to move from a command to a market economy? Answers to questions can be found at the back of the book (page 488).  CHAPTER 1 · THE NATURE OF ECONOMICS 15 6 THE MIXED ECONOMY As the name suggests, this type of economic system aims to combine the merits of both the market and the planned economies. The main advantage of the market economy is the automatic working of the market mechanism. The mixed economy aims to allow the market to operate, with government intervening in the economy only where the market fails. This means providing those goods and services such as law and order, education and health services, which would have been under-provided if left to the market. The