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100% found this document useful (2 votes)

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CB2 Flashcard

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nikuloha

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Download as PDF, TXT or read online on Scribd

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Business Economics

Flashcards
for exams in 2019

The Actuarial Education Company

on behalf of the Institute and Faculty of Actuaries
Introduction

These flashcards cover the key points of the CB2 course that most students
like to commit to memory. They also contain the main diagrams. However,
please appreciate that individuals may have their own preferences.
Therefore, you may prefer not to learn all of the information covered and
instead be happy to deduce some things from first principles. Alternatively,
you may prefer to learn even more material than we have covered.

Each flashcard has questions on one side and the answers on the reverse
and hence we recommend that you use the cards actively and test yourself as
you go. Have a note book handy to practise drawing the diagrams. However,
you can use the reverse side of most cards as a stand-alone revision tool if
you prefer from time to time.
Flashcards may be used to complement your other study and revision
materials. They are not a short cut to success but they should help you learn
the essential material required for the Subject CB2 exam.

However, being able to use and apply the knowledge you acquire is equally
important and so it’s vital that you still practise lots and lots of questions (from
past papers, assignments and the Q&A Bank) as part of your revision.

Module 1
CB2 Module 1: Economic concepts and systems
1

Explain what each of the following terms mean:

 scarcity

 consumption

 production.

© IFE: 2019 

Scarcity

Scarcity is the excess of human wants over what can be produced to fulfil
those wants.

Consumption

Consumption is the act of using goods and services to satisfy wants. This will
normally involve purchasing the goods and services.

Production

Production is the transformation of inputs into outputs by firms in order to earn

profit (or meet some other objective).

Outline the three categories of inputs or factors of production.

© IFE: 2019 

Categories of inputs or factors of production

1. labour – all forms of human input (both mental and physical) into current
production

2. land and raw materials – inputs that are provided by nature,

eg unimproved land, oil and mineral deposits

3. capital - all inputs that have themselves been produced, eg factories,

computers, tools

Distinguish between ‘macroeconomics’ and ‘microeconomics’.

© IFE: 2019 

Macroeconomics and microeconomics

Macroeconomics is concerned with the economy as a whole and studies

economic aggregates, such as national income, unemployment and the
general level of prices.

It considers aggregate demand and aggregate supply.

Microeconomics is concerned with individual parts of the economy

(eg households, firms and industries) and the way they interact to determine
the pattern of production and distribution of goods and services.

Distinguish between ‘aggregate demand’ and ‘aggregate supply’.

© IFE: 2019 

Aggregate demand and aggregate supply

Aggregate demand is the total level of spending in the economy, by

consumers, firms and the government.

Aggregate supply is the total amount of output (ie goods and services) in the
economy.

Define the following macroeconomic terms:

1. recession
2. unemployment
3. inflation
4. the rate of inflation
5. the balance of trade.

© IFE: 2019 

Macroeconomic terms

A recession is a period where national output falls, ie economic growth is

negative. The official definition is where output declines for two or more
consecutive quarters.

Unemployment refers to people of working age who are currently without a

job, but are actively looking for work.

Inflation refers to a general rise in the level of prices throughout the economy.

The rate of inflation refers to a percentage increase in the level of prices over
a 12-month period.

The balance of trade = exports of goods and services

– imports of goods and services

NB If exports exceed (are less than) imports, there is a balance of trade

surplus (deficit).
© IFE: 2019
CB2 Module 1: Economic concepts and systems
6

Distinguish between demand-side policy and supply-side policy.

Give one example of each type of policy.

© IFE: 2019 

Demand-side policy

Demand-side policy seeks to influence the level of spending and hence

aggregate demand, eg by cutting taxes, increasing government spending
and/or reducing interest rates.

It will also indirectly affect output, employment and prices.

Supply-side policy

Supply-side policy seeks to influence the level of production directly and

hence aggregate supply, eg by introducing tax incentives for firms to invest in
new capital.

State the three main microeconomic choices that have to be made by an

economy because resources are scarce

© IFE: 2019 

Main microeconomic choices

1. What goods and services will be produced and in what quantities?

2. How are the goods and services going to be produced, ie what

resources and production methods are going to be used?

3. For whom are goods and services going to be produced, ie how is the
total national income going to be distributed?

Define the following microeconomic terms:

 opportunity cost
 marginal cost
 marginal benefit
 rational choice
 rational decision making.

© IFE: 2019 

Microeconomic terms

 The opportunity cost of an activity is the cost of the activity measured in

terms of the best alternative foregone.

 For a firm, the marginal cost is the additional cost of producing one
more unit of output. For an individual, it is the additional cost of a little
bit more of a particular activity.

 For a firm, the marginal benefit is the additional benefit of producing one
more unit of output. For an individual, it is the additional benefit of a
little bit more of a particular activity.

 A rational choice is one that involves weighing up the benefit of an

activity against its opportunity cost, so the decision maker successfully
maximises their objective, ie happiness or profits.

 Rational decision making involves doing more (less) of an activity its

marginal benefit exceeds (is less than) its marginal cost.
© IFE: 2019
CB2 Module 1: Economic concepts and systems
9

Define ‘production possibility curve’.

Draw a production possibility curve and explain why it is a curve rather than a
straight line.

© IFE: 2019 

Production possibility curve

Good Y
A
15
B
13
C
10

6 F D

E
0 1 2 3 4 Good X

It shows the possible combinations of two goods that a country can produce
within a specified time period with all its resources fully and efficiently
employed. It is a curve due to the increasing opportunity costs of production,
ie the fact that the additional production of one good involves ever-increasing
sacrifices of another.
© IFE: 2019
CB2 Module 1: Economic concepts and systems
10

Use the production possibility curve on the previous card to demonstrate:

 choice and opportunity cost
 rising opportunity cost as output of one product increases
 output at less than the economy’s full potential.

How would growth in the economy’s potential output affect the production
possibility curve for a country?

© IFE: 2019 

Choice and opportunity cost

Starting at point A, in order to produce a first unit of X, the country would have
to reduce output of Y by 2 units. So, the opportunity cost of 1X is 2Y.

Rising opportunity cost as output of one product increases

At point B, the opportunity cost of an additional unit of X has risen to 3Y and at

point C, to 4Y.

Output at less than the economy’s full potential

This occurs at point F, as the output of both goods could be increased.

Growth in the economy’s potential output

This would shift the production possibility curve outwards.

Define the following terms:

 centrally planned or command economy

 free market economy

 mixed economy.

© IFE: 2019 

Centrally planned or command economy

An economy where all economic decisions are taken by the central authority.

Free market economy

An economy where all economic decisions are taken by individual households

and firms, with no government intervention.

Mixed economy

An economy where economic decisions are partly taken by the government

and partly through the market.

NB In practice all economies are mixed.

Outline how resources are allocated and output distributed in a command

economy with reference to the three levels of planning.

© IFE: 2019 

How resources are allocated and output distributed in a command
economy

The state plans the allocation of resources at three levels:

1. It plans the allocation of resources between current consumption and

investment for the future. Sacrificing consumption and investing more
now may increase the economy’s growth rate.

2. At a microeconomic level, it plans the output of each industry and firm,

using input-output analysis.

3. It plans the distribution of output between consumers. This will reflect

the government’s aims.

Describe how resources are allocated and output distributed in a free market
economy.

© IFE: 2019 

How resources are allocated and output distributed in a free market
economy

Consumers are free to decide what to buy with their incomes. Firms are free
to choose what to sell and how to make it.

Their demand and supply decisions are transmitted to each other through the
price mechanism, by which prices respond to changes in demand and supply.

If demand exceeds supply the resulting shortage leads to a rise in price to

restore equilibrium, at which supply again equals demand. If supply exceeds
demand, the resulting surplus leads to a fall in price to restore equilibrium.

More generally, an increase in demand and/or decrease in supply will result in

a rise in price and vice versa.

Define the following terms:

 price mechanism

 equilibrium

 equilibrium price.

© IFE: 2019 

Definitions

The price mechanism is the system in a market economy whereby changes in

price in response to changes in demand and supply have the effect of making
demand equal to supply.

Equilibrium refers to a position of balance from which there is no inherent

tendency to move away, eg from current prices and quantities

The equilibrium price is the price at which the quantity demanded equals the
quantity supplied, so there is no shortage or surplus.

Describe how resources are allocated and output distributed in a mixed

economy.

© IFE: 2019 

How resources are allocated and output distributed in a mixed economy

In a mixed economy, many allocation and output decisions are determined by

prices in a free market. However, the government may control:
 the relative prices of goods and services, eg by taxes, subsidies or price
controls
 relative incomes, eg using incomes taxes, benefits, wage and rent
controls
 the pattern of production and consumption, eg by legislation or taxes
and subsidies
 macroeconomic problems such as inflation, unemployment and lack of
growth, eg using government spending and taxes, interest rates,
exchange controls etc.

List five problems of a command economy.

© IFE: 2019 

Problems of a command economy

1. Complicated plans are likely to be costly to administer and involve

cumbersome bureaucracy.
2. Without prices, or with arbitrarily set prices, resources are likely to be
used inefficiently.
3. It is difficult to devise appropriate incentives to encourage workers and
managers to be more productive without a reduction in quality.
4. Complete state control over resource allocation would lead to a loss of
individual liberty.
5. If production is planned, but consumers are free to spend money
incomes as they wish, shortages and surpluses will occur if consumers’
wishes change.

List nine problems of a free market economy.

© IFE: 2019 

Problems of a free market economy

1. Power and property may be unequally distributed.

2. Competition between firms is often limited.
3. Consumers and firms may not have full information and so may make
wrong decisions.
4. Firms may persuade consumers by advertising, rather than responding
to demands.
5. Lack of competition and high profits may remove the incentive for firms
to be efficient.
6. Some firms’ practices may be socially undesirable, eg pollution.
7. Some socially desirable goods will not be produced.
8. It may lead to economic instability.
9. It may encourage selfishness, greed, materialism etc.

Summary Card

Scarcity, consumption & production Cards 1 & 2

Macroeconomics: definitions & policies Cards 3 to 6

Microeconomics: definitions & choices Cards 3, 7 & 8

Production possibility curve Cards 9 & 10

Command economy Cards 11, 12 & 16

Free market economy Cards 11,13, 14 & 17

Mixed economy Cards 11 & 15

© IFE: 2019 

CB2

Module 2
CB2 Module 2: Main strands of economic thinking
1

Define the following terms:

 surplus value

 labour power.

© IFE: 2019 

Surplus value

Surplus value is the value of the output workers have produced in excess of
their own labour cost. It is enjoyed by the owners of capital.

Labour power

Labour power is the commodity (ie the combination of mental and physical
capabilities) that workers provide to the owners of capital in exchange for a
wage.

The value of labour power (the long-run wage rate) is the amount sufficient to
sustain the workers.

Describe Marx’s labour theory of value.

© IFE: 2019 

Marx’s labour theory of value

According to the theory of value, the value of a product is determined by the

number of hours of labour used to produce the product.

Marx argued that the theory can explain the value of all commodities including
the commodity that workers provide, which he called labour power.

This is the number of hours of work that is sufficient to sustain the workers
and is the long-run wage rate. For example, if it takes 6 hours of labour per
day for a worker to earn enough to afford his living expenses, and if one hour
of work is equivalent to £1, then the wage rate would be £6 per day.

However, Marx argued, the owners of capital make the workers work in
excess of what is necessary to sustain them; workers could work 10 hours but
are paid £6. The surplus value, which is the difference between the total
revenue and cost, is enjoyed by the owners of capital.

Explain why Marx predicted the collapse of capitalism.

© IFE: 2019 

Why Marx predicted the collapse of capitalism

Marx predicted that competition amongst the capitalists would drive most
capitalists out of the market and into the labour market and create
monopolies.

Eventually the workers would gain enough power to dismantle the whole
system. A socialist system was an inevitable outcome.

The message was adopted by political movements and socialist regimes were
formed, notably the Soviet Union in 1922.

Outline the views of heterodox economists.

© IFE: 2019 

Heterodox economists

 Heterodox economists reject the assumptions of neoclassical

economics, in particular the assumption of rational optimising
behaviour.

 They believe that people are unable to form rational expectations and
that it is very difficult to make predictions.

 Decisions are therefore hampered by uncertainty.

 They also highlight the importance of understanding the various

influences on institutional and human behaviour.

Explain why the Austrian school believes central planning would be

impossible.

© IFE: 2019 

Why the Austrian school believes central planning would be impossible

Followers of the Austrian school believe that information about the

preferences of consumers and about costs of different ways of producing
goods and services is subjective and dispersed.

Different people have different preferences that cannot be known by

government, making successful central planning of the economy impossible.

These preferences may be complex and not necessarily rational in the

conventional sense.

Give an example of irrational behaviour.

Explain how, according to the Austrian school, the market can cope with
irrational behaviour.

© IFE: 2019 

Example of irrational behaviour

A customer might have a preference to buy a product from a mutually-owned

insurance company even if the product is more expensive and in other
respects identical.

How, according to the Austrian school, the market can cope with
irrational behaviour

They believe that the market process reveals consumer preferences and, as
such, competition and entrepreneurship within the context of a market is
necessary to promote the welfare of society as a whole.

Although it cannot be known in advance whether different ways of producing

goods and services will be cheaper or satisfy consumers better, the process of
competition will ensure that efficient firms that innovate and produce goods
that are valued by customers will prosper.

Explain why the Austrian school:

 places little weight on modelling equilibrium outcomes

 focuses on ‘risk’ and ‘uncertainty’.

© IFE: 2019 

Why the Austrian school places little weight on modelling equilibrium
outcomes and focuses on risk and uncertainty

Preferences and the costs of different methods of production are continually

changing, so the Austrian school’s focus is on competition to reveal
preferences and efficient business practices, rather than placing the emphasis
on modelling equilibrium outcomes.

They believe that businesses will pursue many ideas and ventures because of the
uncertain environments in which they operate. It is only in retrospect that
success or failure can be identified.

As a result, the Austrian school of thought focuses on the importance of

‘uncertainty’, which cannot be quantified, as well as ‘risk’ which can be
quantified.

Explain the Austrian school’s view of government intervention in the form of

providing a legal framework.

© IFE: 2019 

Austrian school’s view of providing a legal framework

They generally believe that the government should provide a framework of

law, for example, to enforce contracts and to prevent fraud.

Explain, with reference to the financial sector, the Austrian school’s view of
government intervention in the form of regulation.

© IFE: 2019 

Austrian school’s view of regulation

The Austrian school does not support government regulation that directs
economic activity in particular ways – including in the financial sector. In
general, they would not approve of the regulation of products or risk
management in financial institutions.

They argue that successful regulations cannot be known in advance. They

offer as an example the financial crisis of 2008 to demonstrate that many
forms of government regulation could have the opposite of their intended
effect.

They also believe that systems of regulation evolve within the market itself
and so emphasise the role of the market rather than the government in
regulation.

Discuss the Austrian school’s view of monetary policy.

© IFE: 2019 

Austrian school’s view of monetary policy

Followers of the Austrian school believe that central banks’ pursuit of a

monetary policy that is too loose, would lead to the distortion of the economy
and inflation.

They argue that low interest rates, for example, cause an unsustainable
investment boom which will correct itself (possibly with damaging
consequences) when the boom comes to an end.

Other schools of thought do not place the same emphasis on these

processes.

Summary Card

Marxist socialism Cards 1 to 3

Heterodox economists Card 4

Austrian school Cards 5 to 10

© IFE: 2019 

CB2

Module 3
CB2 Module 3: Supply and demand (1)
1

Explain what is meant by the following terms, which relate to the concept of
demand:

 the law of demand

 the income effect

 the substitution effect

 quantity demanded.

© IFE: 2019 

Demand-related terms

The law of demand states that the quantity of a good demanded per period of
time will fall as the price rises and rise as the price falls, other things being
equal. This is due to the income and substitution effects.

The income effect is the effect of a change in price on quantity demanded

arising from the consumer becoming better or worse off as a result of the price
change.

The substitution effect is the effect of a change in price on quantity demanded

arising from the consumer switching to or from alternative (substitute)
products.

Quantity demanded is the amount of a good that a consumer is willing and

able to buy at a given price over a given time period.

Draw a diagram showing the demand curve for a typical good.

Describe what it shows.

© IFE: 2019 

The demand curve

P2
D

Q1 Q2 Q

The demand curve shows the quantity of a good (Q) that would be demanded
at each price (P) over a given time period, assuming all other factors that
determine demand are held constant.

Explain the difference between a change in demand and a change in the

quantity demanded.

© IFE: 2019 

Change in demand

A change in demand refers to a shift in the demand curve, which occurs when
a determinant other than price changes.

Change in the quantity demanded

A change in the quantity demanded refers to a movement along a demand

curve, which occurs when there is a change in price.

State six factors that could cause the demand curve to shift.

© IFE: 2019 

Shifts in the demand curve

The demand curve will shift if any of the following change:

1. consumer tastes
2. the number and prices of substitute goods
3. the number and prices of complementary goods
4. consumer incomes
5. the distribution of income
6. expectations of future price changes.

Each of these factors could cause the demand curve to shift to the left
(decrease in demand) or to the right (increase in demand).

Distinguish, with the aid of examples, between the following different

categories of goods:

 substitute goods

 complementary goods

 normal goods

 inferior goods.

© IFE: 2019 

Different categories of goods

 Substitute goods are goods that consumers consider to be alternatives

to each other, eg two different brands of bottled water. As the price of
one increases, the demand for the other rises.

 Complementary goods are pairs of goods that are consumed together,

eg cars and car insurance. As the price of one goes up, the demand for
both goods will fall.

 Normal goods are goods for which demand rises as people’s incomes
rise. Most goods are normal goods.

 Inferior goods are goods for which demand falls as people’s incomes
rise, eg own-brand products.

Draw a diagram showing the supply curve for a typical good.

Describe what it shows.

© IFE: 2019 

The supply curve

S
P

Q1 Q2 Q

A supply curve shows the quantity of a good (Q) that would be supplied at
each price (P) over a given time period, assuming all other factors that
determine supply are held constant.
© IFE: 2019
CB2 Module 3: Supply and demand (1)
7

Give three reasons why quantity supplied will typically rise when the price of a
good rises.

© IFE: 2019 

Why quantity supplied rises when the price of a good rises

1. As firms supply more, beyond a certain output level, costs are likely to
rise more and more rapidly. So, it will only be worthwhile producing
more and incurring those higher costs if prices rise.

2. The higher the price of a good, the more profitable it becomes to

produce. So firms will be encouraged to produce more of it by
switching production from less profitable goods.

3. In the long run, if the price of a good remains high, new firms will set up
production – so total market supply increases.

Explain the differences between:

 substitutes in supply and goods in joint supply

 a change in supply and a change in the quantity supplied.

© IFE: 2019 

Substitutes in supply and goods in joint supply

Substitutes in supply are two goods for which an increase in production of one
involves diverting resources away from producing the other, eg beef and lamb.

Goods in joint supply are goods for which the production of more of one leads
to the production of more of the other, eg bacon and sausages.

Change in supply and change in the quantity supplied

A change in supply refers to a shift in the supply curve, which occurs when a
determinant other than price changes.

A change in the quantity supplied refers to a movement along a supply curve,

which occurs when there is a change in price.

State seven factors that could cause the supply curve to shift.

© IFE: 2019 

Shifts in the supply curve

The supply curve will shift if any of the following change:

1. the costs of production
2. the profitability of alternative products (substitutes in supply)
3. the profitability of goods in joint supply
4. nature, random shocks and other unpredictable events, eg extreme
weather, earthquakes
5. the aims of producers, eg maximising sales rather than profits
6. expectations of future price changes
7. the number of suppliers.

Each of these factors could cause the supply curve to shift to the left
(decrease in supply) or to the right (increase in supply).

Give four main reasons for changes in the costs of production.

© IFE: 2019 

Reasons for changes in the costs of production

1. changes in input prices, eg wages, rent, raw material prices

2. changes in technology, eg faster PCs

3. organisational changes within the firm, eg to achieve greater

specialisation

4. changes in government policy, eg with regard to taxes and subsidies on

goods

Define the following terms:

 price taker

 market clearing.

© IFE: 2019 

Price taker

This is a firm (or person) that is unable to influence the market price. Instead
it must accept the market price as given.

Market clearing

A market clears when supply matches demand leaving no shortage or surplus.

Draw a demand and supply diagram showing the equilibrium price and
quantity for a typical good.

Describe the condition for a market to be in equilibrium and explain how

equilibrium is restored if the market is initially in disequilibrium.

© IFE: 2019 

Market equilibrium
P S
excess supply

P*
D
excess demand

Q* Q

 Market equilibrium occurs when demand equals supply.

 Excess supply (a surplus) leads to price falls.
 Excess demand (a shortage) leads to price rises.

Draw diagrams to show the effect on the equilibrium price and quantity of:

 an increase in demand

 a decrease in demand.

© IFE: 2019 

Diagrams to show the effect of:

(a) increase in demand (b) decrease in demand

price S price S

P2 P1
P1 D2 P2 D1
D1 D2

Q1 Q2 quantity Q2 Q1 quantity

Here P and Q both rise. Here P and Q both fall.

Draw diagrams to show the effect on the equilibrium price and quantity of:

 an increase in supply

 a decrease in supply.

© IFE: 2019 

Diagrams to show the effect of:

(a) increase in supply (b) decrease in supply

S2
price S1 price S1

P2
S2
P1 P1
P2 D D

Q1 Q2 quantity Q2 Q1 quantity

Here P falls and Q rises. Here P rises and Q falls.

Give examples of:

 financial incentives (2)

 non-financial incentives (3)

 perverse incentives (2).

© IFE: 2019 

Financial incentives
1. Consumers buy less of a good when its price (and hence opportunity
cost) rises.
2. Firms produce more of a good when its price rises, as it is more
profitable to do so.

Non-financial incentives
1. charitable giving
2. supporting a sports team
3. buying presents for family members

Perverse incentives
1. Making cars safer encourages people to drive faster.
2. Increasing income tax rates may make people work less, so that tax
revenues fall.

Explain the problem of identifying the demand and supply curves from limited
data, ie the identification problem.

© IFE: 2019 

Identification problem

This refers to the fact that it is difficult to derive the demand curve, say, for a
good from the evidence of price and quantity alone.

For example, if we have two observations, (high price, low quantity) and (low
price, high quantity), we might assume that the supply curve has shifted and
that we have two points on the demand curve. However, we cannot know
whether or not the demand curve has also shifted (due to changes in the
non-price determinants of demand) and if so by how much.

Equally, it is difficult to identify a supply curve when the demand curve shifts,
as we cannot be sure whether the change in price and quantity is due entirely
to the shift in the demand curve or whether the supply curve has shifted too.

Summary Card

Demand, demand curves & quantity demanded Cards 1 to 4

Categories of goods Cards 5 & 8

Supply, supply curves & quantity supplied Cards 6 to 10

Equilibrium, equilibrium prices & market clearing Cards 11 to 14

Incentives Card 15

Identification problem Card 16

© IFE: 2019 

CB2

Module 4
CB2 Module 4: Supply and demand (2)
1

Define the following types of elasticity:

 arc elasticity

 point elasticity.

Give a formula for point elasticity.

© IFE: 2019 

Arc elasticity and point elasticity

Arc elasticity is the measurement of elasticity between two points on a curve.

Point elasticity is the measurement of elasticity at a point on a curve.

The formula for point elasticity is:

dQ P

dP Q

dQ
where is the inverse of the slope of the tangent to the demand curve at
dP
the point in question.

Define price elasticity of demand ( P D ).

State the general formula (in terms of percentage changes) for P D and the
formula for arc elasticity using both the original and average (or ‘midpoint’)
methods.

© IFE: 2019 

Price elasticity of demand ( P D )

Price elasticity of demand ( P D ) measures the responsiveness of quantity

demanded to a change in price.

The general formula (in terms of percentage changes) is:

% QD
P D 
% P

This can be expressed using:

QD / original QD
 the original method as P D 
P / original P

QD / average QD
 the average method as P D  .
P / average P
© IFE: 2019
CB2 Module 4: Supply and demand (2)
3

The price of Good X increases from $6 to $9 and the quantity demanded

decreases from 100 to 90. Calculate and interpret the price elasticity of
demand using the original method.

© IFE: 2019 

Price elasticity of demand using the original method

QD / original QD
P D 
P / original P

 10
 100  10%  0.2
3 50%
6

Negative sign - indicates downward-sloping demand curve.

Absolute value < 1 - indicates demand is relatively inelastic, ie increase in

price has led to a less than proportionate decrease in quantity demanded.

Describe three determinants of the price elasticity of demand ( P D ).

© IFE: 2019 

Determinants of the P D

P D is determined by:

1. the number and closeness of substitute goods, which in turn may

depend on the broadness of the product definition. More substitutes
generally means a more elastic demand.

2. the proportion of income spent on the good. A larger proportion

generally means a more elastic demand.

3. the time period, as it takes time to find alternative goods. The longer
the time period, the more elastic is the demand.

Define total revenue and describe the effect on total revenue of an increase in
price if:

 demand is perfectly inelastic ( P D  0 )

 demand is (relatively) inelastic ( P D  1)

 demand is of unit elasticity ( P D  1)

 demand is (relatively) elastic ( P D  1)

 demand is perfectly elastic ( P D  ) .

© IFE: 2019 

Elasticity and total revenue

Total revenue (TR) is the total amount received by firms from the sale of a
product, before the deduction of taxes or any other costs. It is the price of the
good multiplied by the quantity sold, ie:

TR = P ¥ Q

When price increases, if demand is:

 perfectly inelastic - total revenue increases (in proportion to increase
in price)
 (relatively) inelastic - total revenue increases
 of unit elasticity - total revenue remains constant
 (relatively) elastic - total revenue decreases
 perfectly elastic - total revenue decreases to zero.

Draw the following curves:

(i) a demand curve with unit elasticity of demand

(ii) a demand curve with zero elasticity

(iii) a demand curve with infinite elasticity.

© IFE: 2019 

Various demand curves

(i) P  D  1 (ii) P D  0

P P D

b
D
a b

Q Q

(iii) P  D  
P

Explain with the aid of a diagram the intended effect of advertising on the
demand curve.

© IFE: 2019 

The intended effects of advertising on the demand curve

price

P2
Demand curve with advertising
P1
Demand curve without advertising

quantity
Q1 Q2 Q*

1. to shift the product’s demand curve to the right (by bringing the product
more to consumers’ attention and increasing the attractiveness and
marginal utility of the product)

2. to make the product’s demand less price-elastic (by creating brand

loyalty and so reducing the number of perceived substitute goods).
© IFE: 2019
CB2 Module 4: Supply and demand (2)
8

Explain how price elasticity of demand ( P D ) varies along a straight-line

demand curve of the form P  a  bQ .

© IFE: 2019 

How P D varies along a straight-line demand curve

For a straight-line demand curve:

P  a  bQ , where a and b are constants.

dP
Hence  b .
dQ

dQ P 1 P
Point elasticity is given by P D     .
dP Q b Q

Since b is a constant, the elasticity along the demand curve varies directly
with the ratio of P to Q.

Define price elasticity of supply ( P S ).

State the general formula (in terms of percentage changes) for P S and the
formula for arc elasticity using both the original and average (or ‘midpoint’)
methods.

© IFE: 2019 

Price elasticity of supply ( P S )

Price elasticity of supply ( P S ) measures the responsiveness of quantity

supplied to a change in price.

The general formula (in terms of percentage changes) is:

% QS
P S 
% P

This can be expressed using:

QS / original QS
 the original method as P S 
P / original P

QS / average QS
 the average method as P S  .
P / average P
© IFE: 2019
CB2 Module 4: Supply and demand (2)
10

The quantity supplied of a good is given by:

QS  2P  10

Calculate and interpret the point price elasticity of supply when the price is
£15.

© IFE: 2019 

Price elasticity of supply using the point method

dQS P
P S  
dP QS

P P
 2  2
QS 2P  10

15 30
 2   1.5
2  15  10 20

Positive sign - indicates an upward-sloping supply curve.

Value > 1 - indicates that supply is relatively elastic, ie an increase in price

leads to a more than proportionate increase in quantity supplied.

State the two main factors that influence the value of price elasticity of supply.

© IFE: 2019 

Factors influencing price elasticity of supply

1. The amount that the firms’ costs rise as output rises, ie the firms’
marginal costs – if it costs very little to produce each extra unit of
output, supply will be very elastic; if it is very expensive to supply
another unit, supply will be very inelastic.

2. Time period – it takes time to increase factor inputs and hence output
and so supply will be more elastic in the long run than the short run.

Define income elasticity of demand ( Y  D ).

State the general formula (in terms of percentage changes) for Y  D and the
formula for arc elasticity using both the original and average (or ‘midpoint’)
methods.

© IFE: 2019 

Income elasticity of demand ( Y  D )

Income elasticity of demand ( Y  D ) measures the responsiveness of demand

to a change in consumer incomes (Y).

The general formula (in terms of percentage changes) is:

% QD
YD 
% Y

This can be expressed using:

QD / original QD
 the original method as Y  D 
Y / original Y

QD / average QD
 the average method as Y  D  .
Y / average Y
© IFE: 2019
CB2 Module 4: Supply and demand (2)
13

Define the following types of goods:

 normal goods

 inferior goods.

State how the income elasticity of demand for luxury goods compares to that
of more basic goods.

© IFE: 2019 

Normal and inferior goods

Normal goods are goods whose demand increases as consumer incomes

increase. They have a positive income elasticity of demand. Luxury goods
will have a higher income elasticity of demand than more basic goods.

Inferior goods are goods whose demand decreases as consumer incomes

increase. Such goods have a negative income elasticity of demand.

Income increases from $18,000 to $22,000 and the quantity of goods

demanded increases from 40 to 60. Calculate and interpret the income
elasticity of demand using the average method.

© IFE: 2019 

Income elasticity of demand using the average method

QD / average QD
YD 
Y / average Y

 20 40%
 50   2
 4,000 20%
20,000

Positive sign - indicates a normal good.

Describe the main factor that influences the value of income elasticity of
demand.

© IFE: 2019 

Main factor influencing income elasticity of demand

The main factor influencing the value of income elasticity of demand is the
degree of necessity of the good.

In developed countries, the demand for luxury goods expands rapidly as

consumer incomes rise, so demand will be very income elastic. In contrast,
the demand for basic goods rises only a little (if at all) as consumer incomes
rise, so demand will be very income inelastic.

Define cross-price elasticity of demand ( C  D ).

State the general formula (in terms of percentage changes) for C  D and the
formula for arc elasticity using both the original and average (or ‘midpoint’)
methods.

© IFE: 2019 

Cross-price elasticity of demand ( C  D )

Cross-price elasticity of demand ( C  D ) measures the responsiveness of

AB
demand for one good (Good A) to a change in the price of another (Good B).

The general formula (in terms of percentage changes) is:

% QDA
C  DAB 
% PB

This can be expressed using:

QDA / original QDA
 the original method as C  D 
AB PB / original PB

QDA / average QDA

 the average method as C  D  .
AB PB / average PB
© IFE: 2019
CB2 Module 4: Supply and demand (2)
17

Using the concept of cross-price elasticity of demand, define (and give an

example of):

 substitute goods

 complementary goods.

© IFE: 2019 

Substitute and complementary goods

Substitute goods
 alternative goods, eg two different brands of coffee
 cross-price elasticity of demand is positive - an increase in price of one
good leads to (a decrease in demand for that good and) an increase in
demand for the other

Complementary goods
 goods that are consumed together, eg cars and petrol
 cross-price elasticity of demand is negative - an increase in price of
one good leads to (a decrease in demand for that good and) a decrease
in demand for the other

The price of Good X is $2.50 and the price of Good Y is $5. The quantity
demanded of Good X is 120 units. The cross-price elasticity of demand for
Good X with respect to changes in the price of Good Y using the original
method is +3. What will be the effect on the demand for Good X if the price of
Good Y increases to $5.50?

© IFE: 2019 

Cross-price elasticity of demand

QDX / original QDX

C  DXY 
PY / original PY
QDX
C  DXY  120  3
 0.5
5

QDX  3  0.5  120  36

Therefore demand will increase from 120 to 156 units.

Note that as the cross-price elasticity of demand is positive, Goods X and Y

are likely to be substitute goods.

Describe the main factor that influences the value of cross-price elasticity of
demand.

© IFE: 2019 

Main factor influencing cross-price elasticity of demand

The main factor influencing the value of cross-price elasticity of demand is the
closeness of the substitute or complement.

The closer the goods are as substitutes or complements, the bigger will be the
effect on the first good of a change in the price of the substitute or
complement and hence the greater the cross-price elasticity.

Draw a diagram to show how an increase in demand may lead to:

 a short-run rise in price

 a subsequent fall in price in the long run.

© IFE: 2019 

Short-run and long-run adjustment following an increase in demand

P SSR

P2 SLR
P3
P1

D2
D1

Q1 Q2Q3 Q

Starting from the initial equilibrium (P1, Q1), an increase in demand from D1 to
D2 results in a price increase to P2 in the short run, followed by a fall to P3 in
the long run.

Draw a diagram to show how an increase in supply may lead to:

 a short-run fall in price

 a subsequent rise in price in the long run.

© IFE: 2019 

Short-run and long-run adjustment following an increase in supply

S1
P

P1 S2

P2
DLR

DSR

Q1 Q2 Q3 Q

Starting from the initial equilibrium (P1, Q1), an increase in supply from S1 to S2
results in a price decrease to P2 in the short run, followed by a rise to P3 in the
long run.
© IFE: 2019
CB2 Module 4: Supply and demand (2)
22

Define speculation and self-fulfilling speculation.

Distinguish between stabilising and destabilising speculation.

© IFE: 2019 

Speculation

Speculation is where people make buying or selling decisions based on their

anticipations of future prices.

Self-fulfilling speculation is where the actions of speculators tend to cause the

very effect that they had anticipated.

Stabilising speculation arises where the actions of speculators tend to reduce

price fluctuations. It occurs when suppliers and/or buyers believe that a
change in price is only temporary.

Destabilising speculation arises where the actions of speculators tend to make

price movements larger. It occurs when suppliers and/or buyers believe that
an initial change in price means further price changes are to come.

Draw a diagram to illustrate the effect of stabilising speculation in response to

an initial fall in demand, which leads to an initial fall in price.

© IFE: 2019 

Stabilising speculation
D1

P D3 S2
S1
D2
P1
P3

Q2 Q3 Q1 Q

Starting from the initial equilibrium (P1, Q1), demand falls to D2. In the
absence of speculation, the new equilibrium would be (P2, Q2). If suppliers
speculate that the fall is temporary, then they will cut supply to S2 (to sell
later), and if demanders speculate that the fall is temporary, then they will
increase demand back to D3, to buy the good while it is cheap.

Draw a diagram to illustrate the effect of destabilising speculation in response

to an initial fall in demand, which leads to an initial fall in price.

© IFE: 2019 

Destabilising speculation

P S1

S2
P1

D1
P3
D2

Q3 Q2 Q1 Q

Starting from the initial equilibrium (P1, Q1), demand falls to D2. In the
absence of speculation, the new equilibrium would be (P2, Q2). However, if
suppliers speculate that there will be a further fall in price, then they will
increase supply to S2 (to gain sales now), and if demanders speculate that
there will be a further fall, then they will decrease demand again to D3 (to wait
for an even lower price).
© IFE: 2019
CB2 Module 4: Supply and demand (2)
25

Distinguish between risk and uncertainty.

Outline four ways in which a firm can deal with uncertainty when supplying
goods.

© IFE: 2019 

Risk and uncertainty

Risk refers a situation in which a (desirable) outcome of an action may or may

not occur, but the probability of it occurring is known. The lower the
probability, the greater the risk involved in taking the action.

Uncertainty refers to a situation in which an outcome may or may not occur

and its probability of occurring is unknown.

A firm can deal with uncertainty when supplying goods by:

1. holding stocks of goods and services – which can be supplied to the
market when prices are favourable
2. purchasing information, eg market research and trade publications
3. using futures and forwards
4. using insurance.

Define short selling (or shorting) and outline the advantages and
disadvantages of short selling.

© IFE: 2019 

Short selling (shorting)

Short selling (or shorting) is where investors borrow an asset, such as shares,
oil contracts or foreign currency; sell the asset, hoping the price will soon fall;
then buy it back later and return it to the lender. Assuming the price has
fallen, the short seller will make a profit equal to the difference (minus any
fees). There is always the danger, however, that the price may have risen, in
which case the short seller will make a loss.

Short selling:
+ enables an investor to make a profit from a fall in the price of an asset
– can lead to losses for the investor
– can make markets and the price of individual assets more unstable,
eg by driving down share prices that are anticipated to fall.

Define futures or forward market and explain how futures and forwards can be
used by:

 firms and individuals to reduce uncertainty

 speculators to try to make profits.

Explain the difference between the spot price and the future price of an asset.

© IFE: 2019 

Futures and forwards, spot price and future price

A futures or forward market is a market in which contracts are made to buy or

sell at some future date at a price agreed today.

Futures and forwards:

 enable firms and individuals to fix prices for transactions taking place in
the future and thereby remove uncertainty
 enable speculators to gamble on prices changing; if the speculators are
correct in their predictions, then they can make a profit.

The spot price is the current market price ie the price agreed now to exchange
an asset now, whereas the future price is the price agreed now to exchange
an asset at an agreed date in the future.

Define the term minimum price (or ‘floor’) and a draw a diagram to illustrate
the effect on quantity demanded and supplied of a minimum price set above
the equilibrium price.

© IFE: 2019 

Minimum price

A minimum price is a price floor set by the government or some other agency.
The price is not allowed to fall below this level (although it is allowed to rise
above it).

price S
A price floor of Pmin
leads to a quantity
Pmin
demanded of Q1 , a
quantity supplied of P
Q2 , and hence a
surplus of Q2 - Q1 .

Q1 Q Q2 quantity

Define the term maximum price (or ‘ceiling’) and a draw a diagram to illustrate
the effect on quantity demanded and supplied of a maximum price set below
the equilibrium price.

© IFE: 2019 

Maximum price

A maximum price is a price ceiling set by the government or some other

agency. The price is not allowed to rise above this level (although it is allowed
to fall below it).
price
S
A price ceiling of Pmax
leads to a quantity
demanded of Q2 , a
P
quantity supplied of Q1 ,
and hence a shortage of Pmax
Q2 - Q1 .

Q1 Q Q2 quantity

Explain and illustrate how price elasticity of supply and demand will affect the
size of a surplus arising from a minimum price.

© IFE: 2019 

The effect of price elasticity of supply/demand on the size of a surplus
Si
Suppose there is a price
price Se
floor at Pmin.

If supply and demand are

Pmin
relatively inelastic (i), then
the quantity demanded is Pe
QDi and the quantity
supplied is QSi , leaving a
surplus of QSi  QDi .
De
Di
If supply and demand are
relatively elastic (e), then QDe Qe QSe quantity
the quantity demanded is QDi QSi
QDe and the quantity
supplied is QSe , leaving a (larger) surplus of QSe  QDe .

Explain and illustrate how price elasticity of supply and demand will affect the
size of a shortage arising from a maximum price.

© IFE: 2019 

The effect of elasticity of supply/demand on the size of a shortage
Si
Suppose there is a price
price Se
ceiling at Pmax.

If supply and demand are

relatively inelastic (i), then
the quantity demanded is Pe
QDi and the quantity Pmax
supplied is QSi , leaving a
shortage of QDi  QSi .
De
Di
If supply and demand are
relatively elastic (e), then QSe Qe QDe quantity
the quantity demanded is QSi QDi
QDe and the quantity
supplied is QSe , leaving a (larger) surplus of QDe  QSe .

Outline the possible reasons for imposing a minimum price.

© IFE: 2019 

Possible reasons for imposing a minimum price

The government might impose a minimum price in order to:

 protect producers’ incomes – this might be appropriate where the

industry is subject to supply, and hence price, fluctuations

 create a surplus – this might be appropriate when it is desirable to store

output in preparation for potential future shortages

 deter the consumption of particular goods – this may be appropriate

when, for example, consumers do not fully appreciate the future costs
of consuming the good on their health

 prevent workers’ wage rates from falling below a certain level – this may
be part of a government’s policy on poverty and inequality.

Discuss the effects of imposing a minimum price that is above the equilibrium
market price and the ways that government may address these effects.

© IFE: 2019 

Effects of imposing a minimum price and how these may be addressed

The main effect is the creation of a surplus. The government might address
this by:
 buying the surplus itself and storing it / destroying it / selling it abroad in
other markets
 (artificially) lowering supply by restricting producers to particular quotas
 raising demand through advertising / by finding alternative uses for the
good / by reducing consumption of substitute goods.

Other effects of imposing a minimum price are:

 firms may try to evade the price control and cut their prices
 that artificially high prices may support inefficiency …
… or may discourage firms from producing alternative goods that they
could produce more efficiently or which are in higher demand.

Outline the possible reasons for imposing a maximum price.

© IFE: 2019 

Possible reasons for imposing a maximum price

The government might impose a maximum price in order to prevent prices

from rising above a certain level. The rationale for this is usually fairness, eg:

 to ensure that people on lower incomes can afford to buy basic goods

 to ensure that accommodation is affordable

 to ration scarce goods in times of conflict or famine.

Discuss the effects of imposing a maximum price that is below the equilibrium
market price and the ways that government may address these effects.

© IFE: 2019 

Effects of imposing a maximum price and how these may be addressed

The main effect is the creation of a shortage and therefore firms having to
allocate the good amongst potential customers using methods such as ‘first-
come, first-served’, favoured customers, a measure of merit or a rule or
regulation. The government might address this by adopting a system of
rationing.

Other effects of imposing a maximum price are that:

 illegal markets (also known as underground or shadow markets) might
emerge
 it reduces the quantity produced of an already scarce commodity.

In general, the government might address shortages by:

 encouraging supply, eg through direct production, subsidies
 reducing demand, eg by producing alternative goods or reducing
people’s incomes.
© IFE: 2019
CB2 Module 4: Supply and demand (2)
36

Define the following terms, which are all types of tax:

 indirect tax

 specific tax

 ad valorem tax.

© IFE: 2019 

Types of tax

An indirect tax is a tax on the expenditure on goods. Indirect taxes include

value added tax (VAT) and duties on tobacco, alcoholic drinks and petrol.
These taxes are not paid directly by the consumer, but indirectly via the sellers
of the good. Indirect taxes contrast with direct taxes (such as income tax)
which are paid directly out of people’s incomes.

A specific tax is an indirect tax of a fixed sum per unit sold.

An ad valorem tax is an indirect tax of a certain percentage of the price of the

good.

Explain, with the aid of a diagram, the impact of a specific tax on the
equilibrium quantity and price.

On your diagram, mark the price paid by consumers, the price received by the
producer, and the area that represents the total tax revenue raised by the tax,
indicating how this is shared between the consumer and the producer.

© IFE: 2019 

Effect of a specific tax

The price paid by the S + tax

consumer increases S
price
to P2 .
specific tax
The price received by
the producer falls to
P2  tax . P2
C tax revenue
The shaded area P1
P
represents the tax
revenue; C is paid by P2 - t D
the consumer and P
by the producer.
Q2 Q1 quantity

Explain, with the aid of a diagram, the impact of an ad valorem tax on the
equilibrium quantity and price.

© IFE: 2019 

Effect of an ad valorem tax

The price paid by the S + tax

consumer increases
price
to P2 .

The price received by S

the producer falls to
P2  tax . P2
C tax revenue
The shaded area
P1
represents the tax P
revenue; C is paid by P2 - t D
the consumer and P
by the producer.
Q2 Q1 quantity

Define incidence of tax.

Explain how price elasticities of demand and supply affect tax incidence and
tax revenue.

© IFE: 2019 

Effect of elasticities on tax incidence and revenue

The incidence of tax is the distribution of the burden of tax between sellers
and buyers.

Price will rise by more (and the consumers’ share of the tax will be larger):
 the less elastic the demand
 the more elastic the supply.

Price will rise by less (and the producers’ share of the tax will be larger):
 the more elastic the demand
 the less elastic the supply.

Quantity will fall by less (and hence the tax revenue will be larger):
 the less elastic the demand
 the less elastic the supply.
© IFE: 2019
CB2 Module 4: Supply and demand (2)

Summary Card

Price elasticity of demand Cards 1 to 8

Price elasticity of supply Cards 9 to 11

Income elasticity of demand Cards 12 to 15

Cross-price elasticity of demand Cards 16 to 19

Time dimension of market adjustment Cards 20 to 27

The control of prices Cards 28 to 35

Indirect taxes & subsidies Cards 36 to 39

© IFE: 2019 

CB2

Module 5
CB2 Module 5: Background to demand
1

Explain what is meant by the following terms:

 rational consumer

 total utility

 marginal utility

 the principle of diminishing marginal utility.

© IFE: 2019 

Rational consumer
A person who weighs up the costs and benefits to themselves of each
additional unit purchased.

Total utility
The total satisfaction derived from the consumption of all the units of a good
consumed within a given time period.

Marginal utility
The additional satisfaction derived from the consumption of one extra unit of a
good within a given time period, assuming that the consumption of other
goods is held constant.

Diminishing marginal utility

This states that the additional utility gained from consuming successive units
of a good will decrease.

Explain and illustrate the relationship between the total utility and marginal
utility curves, for a risk-averse individual.

© IFE: 2019 

Total utility and marginal utility

total marginal
utility utility
TU

income income

Marginal utility is equal to the gradient of the total utility curve and so is
positive and decreasing.

Give three reasons why a person’s marginal utility schedule (for a particular
good) might change.

© IFE: 2019 

Why a person’s marginal utility schedule might change

Due to changes in their:

1. consumption of other goods, especially complements and substitutes

2. tastes, eg if they decide to lose weight and/or eat more healthily

3. other circumstances, eg the amount of leisure time available.

Describe and clarify the water-diamond paradox.

© IFE: 2019 

Water-diamond paradox

The total utility derived from water is very high but, for most of us, the marginal
utility of water is very low. This is because water is plentiful, ie there is high
supply, and so we can consume nearly as much water as we want.

In contrast, there is a very low supply of diamonds. So even if the demand for
diamonds is lower than the demand for water, the price of diamonds could still
be higher.

The total utility derived from diamonds is much lower than that derived from
water because we consume so few of them. However, the marginal utility of
diamonds is much higher than the marginal utility of water.

It is marginal utility, not total utility, that determines the price. The higher
marginal utility of diamonds is then associated with the higher price of
diamonds.

Distinguish between ‘marginal consumer surplus’ and ‘total consumer surplus’.

Draw a diagram to illustrate total consumer surplus.

© IFE: 2019 

Consumer surplus

Marginal consumer surplus (MCS) is

the excess utility gained over and MU, P
(in $)
above the price paid for an additional
unit of a good, ie MCS = MU - P . Total consumer
Surplus

Total consumer surplus (TCS) is the

total excess of what the person P*
would have paid over what they Total
actually paid for the goods expenditure MU
consumed. It represents the total
Q* Q
utility gained less the total
expenditure, ie TCS = TU - TE .

Explain how consumer surplus is related to rational consumer behaviour.

Hence, explain the derivation of the (downward-sloping) demand curve

according to the one-commodity model.

© IFE: 2019 

Consumer surplus, rational consumer behaviour and the demand curve

 Rational consumer behaviour attempts to maximise total consumer

surplus.
 If the marginal utility (MU) of a good when expressed in terms of price is
greater than the price (P) paid for that good, then the consumer should
buy more.
 Consumer surplus is maximised where the marginal utility of a good is
equal to the price paid for that good, ie people should consume a good
up to the point where MU = P .
 Hence an individual’s demand curve is the same as their MU curve.
 Consequently, diminishing MU implies that each individual’s demand
curve slopes downwards.
 Horizontally summing all the individuals’ demand curves thus gives the
downward-sloping market demand curve.

State the three weaknesses of the one-commodity model.

© IFE: 2019 

Weaknesses of the one-commodity model

1. It ignores the effect on the marginal utility of one good of changes in the
consumption of other goods, specifically complements and substitutes.

2. It ignores the dependence of consumption on income.

3. The derivation of the demand curve from the marginal utility curve
assumes that money itself has a constant marginal utility.

State and derive the ‘equi-marginal principle’ (in consumption), ie explain why
the optimum combination of goods consumed occurs where the marginal
utility per £ spent is equal for all goods.

© IFE: 2019 

Equi-marginal principle (in consumption)

Consumers maximise the total utility from their incomes by consuming the
combination of Goods A and B where:

MU A PA
=
MUB PB

Suppose MU A MUB > PA PB . You could gain utility by consuming more A

and less B. By doing so, the principle of diminishing MU means that MU A
would fall, while MUB would increase.

To maximise total utility, you would continue this substitution until the ratio of
the MUs ( MU A MUB ) equals the ratio of the two prices ( PA PB ), at which
point no further gains could be made by switching between goods. So, this
must be the optimum combination of A and B to consume.
© IFE: 2019
CB2 Module 5: Background to demand
9

Explain the derivation of the demand curve according to the multi-commodity

model.

© IFE: 2019 

Derivation of the demand curve according to the multi-commodity model

Suppose the equi-marginal principle equation relates the MU and P of Good A

to the MU and P of any other good, B, C, D, etc.

So, for any given income and set of prices for all Goods A, B, C, D etc, the
quantity of A demanded satisfies the equation MU A MUB = PA PB (and
similarly for Goods B, C, D, etc). This gives one point on the demand curve
for A.

If PA now falls, so that MU A MUB > PA PB (and similarly for Goods B, C, D,

etc), the person would buy more A, and less of the all the other goods, until
the equation again holds. This gives a second point on A’s demand curve.

Likewise, further changes in PA would then enable the individual’s demand

curve for A to be derived.

Explain how a rational consumer can make optimal choices when the costs
and benefits of consumption occur over a period of time.

© IFE: 2019 

Optimal choices when the costs and benefits of consumption occur over
a period of time

 Optimal choices are made by comparing the costs and benefits from
consumption today with the discounted costs and benefits received
from future consumption.

 Future costs and benefits are weighted using exponential discounting,

in order to determine the present value (in consumption), ie the value a
person places today on a good that will not be consumed until some
point in the future.

 The discount rate used for this will reflect how much less, from the
consumer’s perspective, future utility and costs (from decision made
today) are than gaining utility and/or incurring the costs today.

Define ‘indifference curve’.

Describe the main benefit of indifference analysis over marginal utility theory.

© IFE: 2019 

Indifference curve analysis

An indifference curve shows all those combinations of two goods between

which a consumer is indifferent because they yield the same level of utility.

The main benefit of indifference analysis over marginal utility theory is that it
gets around the problem of being unable to measure utility by instead ranking
various combinations of goods in order of preference.

Define, and state a formula for, the ‘marginal rate of substitution’ (MRS) of
Good Y for Good X.

Define ‘diminishing ‘marginal rate of substitution’ and state what it implies for
the shapes of indifference curves.

© IFE: 2019 

Marginal rate of substitution

This is the amount of Good Y that a consumer is prepared to give up in order

to obtain one more unit of Good X, ie DY DX .

MU X
MRS = = slope of indifference curve (ignoring the ‘–‘ sign)
MUY

Diminishing marginal rate of substitution

The more of Good X a person consumes and the less of Good Y, the less
additional Y that person will be prepared to give up for an extra unit of
Good X, ie DY DX diminishes.

It implies that indifference curves are convex to the origin.

Define ‘budget line’.

Express the slope of the budget line in terms of the prices of Goods X and Y.

Draw a budget line for a consumer who has $20 to spend on Good X and
Good Y. Assume Good X costs $1 per unit, Good Y costs $2 per unit.

© IFE: 2019 

Budget line

 This is a line showing the possible combinations of two goods that can
be purchased at given prices and for a given budget (assuming all the
budget income is spent).

PX
 Slope of budget line = - .
PY

Good Y
10

20 Good X

A consumer has $20 to spend on Good X and Good Y. Good X costs $1 per
unit, Good Y costs $2 per unit. The consumer’s budget line is given below:

Good Y
10

20 Good X

Describe how the budget line would change if (taken separately):

(i) income = $40
(ii) price of Good X = $2 and the price of Good Y = $1.

© IFE: 2019 

Changes to budget line

Good Y
20

BL(ii)
10

BL BL(i)

10 20 40 Good X

(i) A change in real income (due either to a change in money income or in

the general level of prices) causes a parallel shift in the budget line. In
this case, the increase in real income causes a shift to right.

(ii) A change in relative prices causes a change in the slope of the budget
line. Here, Good X has become relatively dearer and so the budget line
becomes steeper.
© IFE: 2019
CB2 Module 5: Background to demand
15

Explain and illustrate how a consumer chooses a consumption bundle that

maximises utility from a given income.

© IFE: 2019 

Equilibrium consumption bundle

Good Y

A
Y*
I3
I2
I1
BL

X* Good X

 The indifference map (represented by I1 , I2 , I3 ) shows the consumer’s

preferences - the further to the right, the higher the utility.
 The budget line (BL) shows that the consumer can afford any bundle
along the line or to its left.
 Bundle A (X* of Good X plus Y* of Good Y) is chosen because it gives
the maximum utility out of affordable bundles.
© IFE: 2019
CB2 Module 5: Background to demand
16

What condition holds at the utility-maximising consumption bundle?

© IFE: 2019 

Utility-maximising condition

The budget line is tangential to the indifference curve.

This can be expressed in any of these ways:

 slope of budget line = slope of indifference curve

 ratio of prices = marginal rate of substitution

 ratio of prices = ratio of marginal utilities

PX MU X
ie = = MRS
PY MUY

Assume that Good X is a normal good and Good Y is an inferior good.

Illustrate the effect of an increase in real income on the demand for Good X
and Good Y.

© IFE: 2019 

Effect of increase in real income

Good Y

Y1 A
Y2 B
I2
I1
BL1 BL2
X1 X2 Good X
 The increase in real income shifts the budget line to the right ( BL1 to
BL2 ) and the consumer’s new bundle is B.
 Consumer has increased her consumption of the normal good, Good X,
(from X1 to X 2 ) and decreased her consumption of the inferior good,
Good Y, (from Y1 to Y2 ).
© IFE: 2019
CB2 Module 5: Background to demand
18

Assuming that income and total utility are constant, illustrate the effect of an
increase in the price of Good X and a decrease in the price of Good Y on the
demand for Good X and Good Y.

© IFE: 2019 

Effect of a change in relative prices
Good Y

Y2 B

A
Y1 I1

X2 BL2 X1 BL1
Good X

 The Increase in the price of Good X and the decrease in the price of
Good Y cause the budget line to become steeper ( BL1 to BL2 ) and the
consumer’s new bundle is B.
 The consumer has decreased her consumption of the relatively dearer
good, Good X (from X1 to X 2 ), and increased her consumption of the
relatively cheaper good, Good Y (from Y1 to Y2 ).

Illustrate the effect of a fall in the price of Good X on the demand for Good X,
assuming that Good X is not a Giffen good.

© IFE: 2019 

Effect of a fall in price for a non-Giffen good

Good Y

A B

I2
I1
BL1 BL2

X1 X2 Good X
 A fall in the price of Good X causes the budget line to pivot and become
flatter ( BL1 to BL2 ). Consumer’s equilibrium consumption bundle is
now B.
 Consumer has increased her consumption of Good X from X1 to X 2 .
 Good X has a downward-sloping demand curve: as price falls, quantity
demanded increases.
© IFE: 2019
CB2 Module 5: Background to demand
20

The overall effect of a change in price on quantity demanded can be split into
two effects: the substitution effect and the income effect.

Define the ‘substitution effect’ and discuss its sign (ie the direction of the
relationship between price and quantity demanded).

© IFE: 2019 

Substitution effect of a price change

 The substitution effect represents that portion of a change in quantity

demanded that results from the change in the relative price of a good.

 For example, if price of Good X falls, it becomes cheaper relative to

Good Y and this causes consumer to substitute it for Good Y.

 Theory predicts that consumers always substitute relatively cheaper

good for relatively dearer good and therefore …

… the substitution effect is always negative (as price and quantity move
in opposite directions).

Define the ‘income effect’ of a price change and discuss its sign (ie the
direction of the relationship between price and quantity demanded).

© IFE: 2019 

Income effect of a price change

 The income effect represents that portion of a change in quantity

demanded that results from the change in real income, ie income
measured in terms of how much it can buy.

 For example, if price of Good X falls, consumer’s real income increases

and …

… this causes increase in demand for normal good and decrease in

demand for inferior good.

 Income effect is therefore …

… negative for a normal good and positive for an inferior good,

Remember, the relationship is between price and quantity demanded.

Explain how a hypothetical budget line can be used to split up the overall
effect on quantity demanded of a reduction in price into the substitution effect
and the income effect.

© IFE: 2019 

The hypothetical budget line
Good Y

I1
BL1 BL2
H
Good X

 The hypothetical budget line (H) is parallel to BL2 (and therefore

reflects new relative prices), but tangential to the old indifference curve
(and therefore reflects the old real income).
 Substitution effect: from the original bundle to the hypothetical bundle
(same real income; difference purely due to the change in relative
prices)
 Income effect: from hypothetical bundle to new bundle (same relative
prices; difference purely due to the change in real income).

Draw a diagram to illustrate the substitution and income effects resulting from
a fall in the price of a normal good.

© IFE: 2019 

Substitution and income effects - normal good

Good Y

A
B
C
I2
I1

BL1 H BL2
X1 X3 X2 Good X

The fall in the price of Good X causes demand for Good X to increase from
X1 to X 2 . This is result of the:
 negative substitution effect ( X1 to X 3 )
 negative income effect ( X 3 to X 2 ).
© IFE: 2019
CB2 Module 5: Background to demand
24

Draw a diagram to illustrate the substitution and income effects resulting from
a fall in the price of an inferior (but not Giffen) good.

© IFE: 2019 

Substitution and income effects - inferior, non-Giffen good
Good Y

B
A
I2

C
I1

BL1 H BL2
X1 X2 X3 Good X

The fall in the price of Good X causes the demand for Good X to increase
from X1 to X 2 . This is result of the:
 negative substitution effect ( X1 to X 3 )
 positive income effect ( X 3 to X 2 ).

Draw a diagram to illustrate the substitution and income effects resulting from
a fall in the price of a Giffen good.

© IFE: 2019 

Substitution and income effects - Giffen good
Good Y

B
I2
A
C
I1
X2 X1 X3 Good X

The fall in the price of Good X causes the demand for Good X to decrease
from X1 to X 2 . This is made up of the:
 negative substitution effect ( X1 to X 3 )
 positive income effect ( X 3 to X 2 ), which outweighs the substitution
effect.
© IFE: 2019
CB2 Module 5: Background to demand
26

Explain the way in which an individual’s demand curve for Good X may be
derived using indifference analysis.

© IFE: 2019 

How to derive the individual’s demand curve using indifference analysis

 An indifference curve diagram is drawn on which the vertical axis

represents total expenditure on all other goods.

 Budget lines are then drawn for different prices of Good X to trace out
the price-consumption curve. This shows how the person’s optimum
consumption of X and all other goods changes as the price of X
changes (assuming that income and the prices of all other goods
remain constant).

 The price and quantity combinations of Good X so derived can then be

drawn in PX  QX space to trace out the demand curve for Good X.

List four limitations of indifference curve analysis.

© IFE: 2019 

Limitations of indifference curve analysis

1. In practice, it is virtually impossible to derive indifference curves.

2. Consumers may not behave rationally, ie they may not give careful
consideration to the satisfaction they will gain from consuming goods.

3. Consumers lack ‘perfect knowledge’ about the utility they will gain from
the consumption of a good and so the ‘optimal bundle’ may not actually
maximise their actual utility.

4. Indifference curves assume that marginal increases in one good can be

traded for marginal decreases in another, which may not be possible,
eg for consumer durables, which are bought only occasionally.

Explain how the problem of imperfect information affects the purchase of

consumer durable goods and assets.

© IFE: 2019 

How imperfect information affects the purchase of consumer durable
goods and assets

The cost of buying a good or an asset is known at the time of purchase.

However, when purchasing a consumer durable, ie a consumer good that

lasts a period of time, the consumer cannot be certain how much utility they
will gain from subsequently using it. For example, this may be because they
cannot predict the subsequent performance of the good or how their needs or
tastes may change.

Likewise, when buying an asset, such as a property, there is uncertainty over

its future price and hence how much capital gain or loss it will yield.

Explain the different attitudes of:

 risk-neutral

 risk-loving

 risk-averse

individuals towards accepting or rejecting a fair gamble.

© IFE: 2019 

Risk-neutral, risk-loving and risk-averse individuals

 A risk-neutral person is indifferent to risk and hence between accepting

or rejecting a fair gamble, which offers no expected gain. She will
therefore always choose the option with the highest expected value.

 A risk-loving person likes risk and will always accept a fair gamble.

 A risk-averse person dislikes risk and will always reject a fair gamble.

Define the following terms:

 expected value

 certainty equivalent

 risk premium.

© IFE: 2019 

Expected value

The average value of an outcome of an activity when the same activity is

repeated many times.

Certainty equivalent

The guaranteed amount of money that an individual would view as equally

desirable as the expected value of a gamble. For a risk-averse person, it is
less than the expected value.

Risk premium

The expected value of a gamble minus a person’s certainty equivalent.

For a risk-averse person, this is positive and equals the amount they would be
willing to forego to avoid the risk associated with the gamble.

Define ‘diminishing marginal utility of income’.

Explain why diminishing marginal utility of income accords with risk-averse

behaviour

© IFE: 2019 

Diminishing marginal utility of income and risk aversion

Diminishing marginal utility of income is where each additional unit of income

yields less additional utility than the previous pound.

It means that the additional utility from winning a fair gamble is less than the
loss of utility from losing a fair gamble.

Consequently, the certain utility from rejecting the fair gamble exceeds the
average (or expected) utility from accepting it and so the fair gamble will be
rejected.

This accords with the behaviour of a risk-averse person.

Explain why insurance companies are able to make profits.

© IFE: 2019 

Why insurance companies are able to make profits

This is because most people are risk-averse and so may be prepared to pay a
premium for insurance that is greater than the expected value of their loss,
ie they will be left with less than the expected value of not buying insurance
and instead taking the gamble of a loss.

The total premiums paid to insurance companies will therefore exceed the
amount they pay out in claims and consequently they will have enough to pay
other costs and make profits.

Explain why insurance companies are typically less risk-averse than their
customers.

© IFE: 2019 

Why insurance companies are typically less risk-averse than their
customers

They are able to spread the risks they face. The more policies they issue and
the more independent the risks are from these policies, the more predictable
will be the number of claims.

In practice, this can be done by:

 issuing large numbers of similar policies on independent risks, ie risky

events that are unconnected and so the occurrence of one will not
affect the likelihood of occurrence of the other, eg buildings insurance
on properties scattered all over the country

 diversifying away risk by expanding into different types of insurance,

eg health, home, car etc.

Define ‘adverse selection’ in the context of insurance.

State the main implication of adverse selection for insurance companies and
suggest what the insurance company may do to deal with this.

© IFE: 2019 

Adverse selection

Adverse selection is where those who are bad risks are more inclined to take
out insurance at a price based on the average risk of all the potential
customers than those who are good risks.

Consequently, the insurer will make a loss if it bases the premium on the
average risk.

To mitigate this risk, insurance companies find out relevant information about
the risk characteristics of prospective policyholders, split them into small,
homogeneous pools and charge appropriate rates.

Define ‘moral hazard’ in the context of insurance.

State the main implication of moral hazard for insurance companies and
suggest what the insurance company may do to deal with this.

© IFE: 2019 

Moral hazard

Moral hazard arises when people who have insurance may behave in a way
that makes the insured event more likely.

Consequently, the insurer will make a loss if they don’t allow for this change in
behaviour.

To mitigate this risk, insurance companies might:

 impose conditions on claims, eg exclusions

 base future premiums on the past claims history, eg no-claims discount

 charge an excess.

Explain how behavioural economics differs from traditional economics.

© IFE: 2019 

How behavioural economics differs from traditional economics

Traditional economic theory assumes that individuals always make rational

decisions in order to maximise their own self-interest.

However, there is evidence to suggest that this is not always the case, eg:
 experimental evidence
 real-world evidence of people making repeated mistakes during the
financial crisis
 charitable giving.

Behavioural economics therefore attempts to build on traditional theory to

explain these apparently irrational actions and hence to better explain
real-world behaviour.

Define, and give examples of, the following terms:

 bounded rationality

 heuristics.

© IFE: 2019 

Bounded rationality

When the ability to make rational decisions is limited by:

 a lack of information, eg when buying consumer durables
 the time and possibly the expense of obtaining such information, or
 a lack of understanding of complex situations, eg when faced with many
choices.

Heuristics

These are mental short-cuts or rules of thumb that people use when trying to
solve complex problems or when faced with limited information, eg trial and
error, buying trusted brands or buying brands their friends have bought.

They reduce the computational or research effort required but sometimes lead
to systematic errors.

Define, and give examples of, the following terms:

 framing

 nudge theory.

© IFE: 2019 

Framing

Refers to the way in which a choice is presented or understood. A person

may make different choices depending on whether a choice is presented
optimistically or pessimistically.

For example, a person may buy more of a good when it is highlighted as a

special offer than they would otherwise have bought at the same price.

Nudge theory

The theory that positive reinforcement or making the decision easy can
persuade people to make a particular choice. They can be ‘nudged’ into doing
so.

For example, people may be required to opt out of organ donation or

charitable giving rather than to opt in.

Define the following terms:

 reference-dependent loss aversion

 endowment effect (or divestiture aversion).

© IFE: 2019 

Reference-dependent loss aversion

Where people value (or ‘code’) outcomes as either gains or losses in relation
to a reference point.

This can mean that losses are disliked more than would be predicted by
standard diminishing marginal utility.

Endowment effect (or divestiture aversion)

The hypothesis that people ascribe more value to things when they own them
than when they are merely considering purchasing them or acquiring them,
ie the reference point is one of ownership rather than non-ownership.

Define, and give examples of, the following terms:

 time consistency

 present bias.

© IFE: 2019 

Time consistency

Where a person’s preferences remain the same over time.

For example, it is time-consistent if you plan to buy a new car when your
end-of-year bonus arrives and then actually do so when it does.

Present bias

Time-inconsistent behaviour whereby people give greater weight to present

payoffs relative to future ones than would be predicted by standard
discounting techniques.

For example, people may put excess weight on the costs of things they
believe are good for them but don’t like (eg dieting) and may put excess
weight on the benefits of things they like doing but believe are bad for them
(eg eating chocolate).

Define, and give an example of, ‘reciprocity’.

© IFE: 2019 

Reciprocity

Where people’s behaviour is influenced by the effects it will have on others.

For example, people’s utility may increase by being kind (unkind) to people
they believe have been kind (unkind) to them.

Describe the role of behavioural economics in designing economic policy.

© IFE: 2019 

Role of behavioural economics in designing economic policy

Economic policy is often designed to change behaviour to meet economic

objectives, eg using taxes to discourage smoking or pollution. Traditional
economic theory predicts that people respond in a particular way to a change in
a particular variable.

Behavioural economics adds to our understanding of how people behave and

why they behave in a particular way. This understanding might then lead to the
development of alternative strategies for achieving the desired result.

For example, ‘nudge theory’, which suggests that people often need a ‘nudge’ to
persuade them to re-think many of the decisions that they currently make ‘out of
habit’ or according to simple rules, has been used to successfully alter
behaviour, eg increasing private pension contributions in the UK.

Summary Card
Marginal utility theory Cards 1 to 9

Timing of costs & benefits Card 10

Indifference curve analysis Cards 11 to 27

Demand under uncertainty & risk Cards 28 to 31

Insurance, adverse selection & moral hazard Cards 32 to 35

Behavioural economics Cards 36 to 42

© IFE: 2019 

CB2

Module 6
CB2 Module 6: Background to supply
1

Distinguish between the following time periods:

 the very short run

 the short run

 the long run

 the very long run.

© IFE: 2019 

Time periods

The very short run is the period in which all factor inputs and hence output is
fixed, giving a vertical supply curve.

In the short run at least one factor is fixed and production is eventually subject
to diminishing returns to the variable factor.

In the long run, all factors are variable, but of fixed quality. Production may
face increasing, decreasing or constant returns to scale.

In the very long run, all factors are variable and their quality and hence
productivity (MPP, APP and TPP) may change.

Distinguish between:

 fixed factors of production

 variable factors of production.

© IFE: 2019 

Fixed and variable factors of production

A fixed factor of production is an input that cannot be increased in supply in a

given time period (ie the short run), eg capital.

A variable factor of production is one that can be increased in a given time

period (ie the short run), eg labour, raw materials.

State the law of diminishing (marginal) returns.

Over which time period does it apply?

© IFE: 2019 

Law of diminishing (marginal) returns

The law of diminishing (marginal) returns states that when one or more factors
are held fixed, there will come a point beyond which the extra output from
additional units of the variable factor will diminish.

It applies in the short run, as the fixed factors become overloaded.

Define the following terms, which relate to production in the short run:

 total physical product (TPP)

 average physical product (APP)

 marginal physical product (MPP).

What is the relationship between each of APP and MPP to TPP?

© IFE: 2019 

Production in the short run

Total physical product (TPP) is the total output of a product per period of time
that is obtained from a given amount of inputs.

Average physical product (APP) is equal to total output (TPP) per unit of the
variable factor in question. So, if Qv is the quantity of the variable factor:

TPP
APP =
Qv

Marginal physical product (MPP) is the extra output gained by the employment
of one more unit of the variable factor (when the input of other factors is held
constant), ie:

DTPP
MPP =
DQv
© IFE: 2019
CB2 Module 6: Background to supply
5

State the three universal rules about the relationship between averages and
marginals.

© IFE: 2019 

The relationship between averages and marginals

1. If the marginal equals the average, the average will not change.

2. If the marginal is above the average, the average will rise.

3. If the marginal is below the average, the average will fall.

Draw two diagrams, one on top of the other, with units of labour (the variable
factor) along the horizontal axis.

On the top diagram draw the total physical product of labour curve (TPP), and
on the bottom diagram draw the average and marginal product of labour
curves (APP and MPP).

Assume increasing returns to labour at first, followed by diminishing returns to

labour.

© IFE: 2019 

Productivity of labour (graphs)

TPP

diminishing marginal
returns to labour begins

units of labour
APP,
MPP

MPP

APP

units of labour

Define technical efficiency.

© IFE: 2019 

Technical efficiency

Technical efficiency is achieved if the firm is producing as much output as is

technologically possible given the quantity of factor inputs it is using.

Define the following types of costs:

 explicit costs

 implicit costs

 sunk costs

 historic costs.

© IFE: 2019 

Types of costs

Explicit costs are the payments made to outside suppliers of inputs (ie factors
that are not owned by the firm).

Implicit costs are costs that do not involve a direct payment of money to a third
party, but which nevertheless involve a sacrifice of some alternative.

Sunk costs are costs that cannot be recouped, (eg by transferring assets to
other uses). Examples include specialised machinery or the costs of an
advertising campaign.

Historic costs refer to the original amount the firm paid for the factors it now
owns.

Explain how to measure the opportunity cost of any production decision for a
firm.

© IFE: 2019 

Measuring the opportunity cost of any production decision

The opportunity cost of any production decision is equal to the explicit and
implicit costs that are incurred if the firm choses any one particular course of
action.

Explicit costs are simply measured as the price that the firm has to pay.

Implicit costs do not involve an actual outlay of cash. They can be measured
as the amount that the factors could earn for the firm in some alternative use,
either within the firm or hired out to some other firm.

State the bygones principle.

© IFE: 2019 

The bygones principle

The bygones principle states that sunk costs should be ignored when deciding
whether to produce or sell more or less of a product. Only those costs that
can be avoided should be taken into account

Define the following types of costs:

 fixed costs (FC )

 variable costs (VC )

 total cost (TC )

and draw a diagram showing how they are typically related.

© IFE: 2019 

Definitions of total costs

Fixed costs are costs that do not vary with the level of output produced.

Variable costs are costs that do vary with the level of output produced.

Total cost is the sum of total fixed costs (TFC) and total variable costs (TVC),
ie: TC = TFC + TVC .
cost
TC

TVC

TFC

output
© IFE: 2019
CB2 Module 6: Background to supply
12

Define the following types of costs:

 average fixed cost ( AFC )

 average variable cost ( AVC )

 average total cost ( AC )

 marginal cost (MC ) .

© IFE: 2019 

Definitions of average and marginal costs

Assume that Q is the number of units of output produced.

TFC
Average fixed cost (AFC) is total fixed cost per unit of output: AFC = .
Q
Average variable cost (AVC) is total variable cost per unit of output:
TVC
AVC = .
Q
Average total cost (AC) is total cost (fixed plus variable) per unit of output:
AC = AFC + AVC .

Marginal cost (MC) is the extra cost of producing one more unit of output:
TC
MC  .
Q

Draw a diagram showing the following short-run cost curves:

 short-run average fixed cost (SRAFC)

 short-run average variable cost (SRAVC)

 short-run average total cost (SRATC)

 short-run marginal cost (SRMC).

Give brief explanations of their shapes.

© IFE: 2019 

Short-run cost curves

cost SRMC
SRATC

SRAVC

SRAFC

output
 short run: some costs fixed (eg capital); other costs variable (eg labour)
 AFC falls as overheads are spread over more units of output
 other curves U-shaped because of increasing and then diminishing
returns to labour
 SRMC goes through minimum of SRATC and SRAVC
(If MC < AC, AC falls; if MC > AC, AC rises)

Give three decisions that the firm will need to make in the long run.

© IFE: 2019 

Decisions the firm will need to make in the long run

Firms will need to make decisions about the:

1. scale of production

2. location of production

3. production techniques to use.

Distinguish between:

 increasing returns to scale

 constant returns to scale

 decreasing returns to scale.

© IFE: 2019 

Returns to scale

Increasing returns to scale arise when changing all inputs by the same
percentage leads to a greater percentage change in output.

Constant returns to scale arise when changing all inputs by the same
percentage leads to the same percentage change in output.

Decreasing returns to scale arise when changing all inputs by the same
percentage leads to a smaller percentage change in output.

Define the following terms:

 economies of scale

 plant economies of scale

 diseconomies of scale.

State the relationship(s) between returns to scale and (dis)economies of

scale.

© IFE: 2019 

Economies of scale

Economies of scale occur when increasing the scale of production leads to a

lower cost per unit of output.

If all factor costs are constant, then increasing returns to scale will result in
economies of scale.

Plant economies of scale

These are economies of scale that arise because of the large size of a factory.

Diseconomies of scale

Diseconomies of scale occur where costs per unit of output increase as the
scale of production increases.

If all factor costs are constant, then decreasing returns to scale will result in
diseconomies of scale.
© IFE: 2019
CB2 Module 6: Background to supply
17

Describe six factors that lead to plant economies of scale.

© IFE: 2019 

Plant economies of scale
1. specialisation and the division of labour – where work is broken down
into smaller and smaller tasks in which workers specialise, thereby
becoming more efficient and productive
2. indivisibilities – the impossibility of dividing some factors (eg large
machinery) into smaller units
3. the ‘container’ principle, whereby the average cost of a unit of output
produced by capital equipment that contains things (eg oil tankers) falls
with the size of the capital equipment
4. the greater efficiency of large machines, eg only one worker may be
required to operate a machine whether it is large or small
5. the production of by-products, in sufficient amounts that they can be
sold profitably
6. multistage production, which saves the time and cost involved in
moving unfinished goods between locations
© IFE: 2019
CB2 Module 6: Background to supply
18

Describe four other possible economies of scale.

© IFE: 2019 

Other economies of scale

1. organisational – perhaps due to rationalisation, which involves

reorganising production to reduce waste and duplication
2. spreading overhead costs, ie the general costs associated with running
a business that are only loosely related to output level, eg marketing,
human resources
3. financial economies, eg lower interest costs, discounts for bulk
purchases
4. economies of scope, when increasing the range of goods produced
reduces the cost of producing each good, eg shared marketing

Note that these arise from the large size of the firm, rather than the large size
of the factory or office.

Describe four factors that may lead to diseconomies of scale.

© IFE: 2019 

Possible causes of diseconomies of scale

1. managerial problems of co-ordination and communication may increase

as the firm becomes larger and more complex, and as lines of
communication get longer

2. alienation and poor motivation of the workforce – this may be due to

jobs being boring, or if workers feel that they are an insignificantly small
part of a large organisation

3. poor industrial relations as a result of the more complex

interrelationships between different categories of worker, which may
lead to even greater levels of ‘people management’

4. problems in one area holding up all production – this is due to the

complex interdependencies of mass production

Define the following terms:

 external economies of scale

 external diseconomies of scale

 industry’s infrastructure.

© IFE: 2019 

External economies of scale

This refers to a situation where a firm’s costs per unit of output (ie average
costs) decrease as the size of the whole industry grows. (This may reflect
improvements in the industry’s infrastructure.)

External diseconomies of scale

This refers to a situation where a firm’s costs per unit of output (ie average
costs) increase as the size of the whole industry increases, (eg due to a
shortage of suitable factor inputs).

Industry’s infrastructure

This is the network of supply agents, communications, skills, training facilities,

distribution channels, specialised financial services, etc, that supports a
particular industry.

State two factors that will influence the firm’s choice of location.

© IFE: 2019 

Factors that will influence the firm’s choice of location

1. the availability, suitability and cost of factor inputs

2. transport costs – reflecting the distance to the market and the distance
from the raw materials

Define productive efficiency and state the condition for the cost-minimising
combination of factors in:

 the two-factor case

 the multi-factor case.

© IFE: 2019 

Productive efficiency

Productive efficiency is the least-cost combination of factors for a given

output.

Cost-minimising combination of factors

MPPL MPPK
Two-factor case: 
PL PK

MPPa MPPb MPPc MPPn

Multifactor case:    ... 
Pa Pb Pc Pn

Note that MPPi is the marginal physical product of Factor i and Pi is the price
of Factor i.

Draw a diagram showing the relationship between the following long-run cost
curves:

 long-run average cost (LRAC)

 long-run marginal cost (LRMC).

Give brief explanations of the shapes of these curves.

© IFE: 2019 

Long-run cost curves

cost LRMC
LRAC

output

 all factors variable, ie scale of production can change

 curves U-shaped because of economies and diseconomies of scale

Define the minimum efficient scale and the long-run average cost curve.

Draw a diagram showing a saucer-shaped long-run average cost curve. On

your diagram indicate:
 the minimum efficient scale
 the ranges of output over which:
– economies of scale apply
– diseconomies of scale apply
– long-run average cost is constant.

© IFE: 2019 

Minimum efficient scale and long-run average cost (LRAC) curve

The minimum efficient scale is the level of output beyond which no significant
additional economies of scale can be achieved (Q1 on the diagram below).

The long-run average cost curve shows how average cost varies with output
in the long run, ie when all factors can be varied.

long-run
average
costs Economies Constant Diseconomies
of Scale LRAC of Scale

Q1 output
© IFE: 2019
CB2 Module 6: Background to supply
25

State three key assumptions underlying the long-run average cost (LRAC)
curve.

Draw a diagram showing the typical relationship between the long-run

average cost curve and the corresponding short-run average cost (SRAC)
curves.

© IFE: 2019 

Long-run average cost (LRAC) curve

Assumptions Relationship with SRAC curves

Factor prices are given, cost

although they may vary
with output. SRAC3 LRAC
SRAC1 SRAC2
Technology and factor
quality are given.
Firms choose the least-
cost combination of
factors for each output
level.
output

Note that the long-run average cost curve in the diagram is known as an
envelope curve – drawn as the tangency points of a series of short-run
average cost curves.
© IFE: 2019
CB2 Module 6: Background to supply
26

Define the following types of revenue:

 total revenue (TR)

 average revenue (AR)

 marginal revenue (MR).

How is each type of revenue calculated?

© IFE: 2019 

Revenue

Total revenue (TR) refers to the total earnings of a firm from a specified level
of sales within a specified period. In general:
TR = P ¥ Q

Average revenue ( AR ) is the total revenue per unit of output. When all output
is sold at the same price, average revenue will be the same as price:
TR
AR  P
Q

Marginal revenue (MR) is the extra revenue gained by selling one more unit
per period of time. It can be estimated as:
DTR
MR =
DQ
© IFE: 2019
CB2 Module 6: Background to supply

Describe and explain the relationship between a downward-sloping average

revenue (AR) curve and the corresponding marginal revenue (MR) curve.

When the AR curve is a downward-sloping straight line, what is the

relationship between AR and MR?

© IFE: 2019 

The AR / MR relationship

MR is less than AR and falls more steeply than AR because:

 price has to fall to sell more
 to sell more, price of all previous units must usually fall too.

When AR is a downward-sloping straight line, MR is twice as steep as AR.

Consider AR  P  a  bQ .

Then TR  P  Q  aQ  bQ 2

d (TR )
So MR   a  2bQ
d (Q)

ie MR is twice as steep as AR and has same intercept.

Distinguish between a price taker and a price maker.

© IFE: 2019 

Price taker

A price taker is a firm that is too small to be able to influence the market price.

Note that it is forced to accept the market price determined by the interaction
of supply and demand.

Price maker

A price maker is a firm that has the ability to influence the price charged for its
good or service.

Draw diagrams showing the market equilibrium and the average and marginal
revenue curves for a price taker.

© IFE: 2019 

Revenue curves for a price taker

industry firm
P P
S

P* D = AR = MR
P*
D

Q* Q Q

Draw two diagrams, one above the other.

In the top diagram draw a downward-sloping, straight-line average revenue

(demand) curve and the corresponding marginal revenue curve.

In the bottom diagram, draw the corresponding total revenue curve.

Indicate where demand is elastic, inelastic and of unit elasticity and explain
the implications of this for total revenue.

© IFE: 2019 

Revenue curves for a price maker
AR
MR If demand is elastic, then reducing the
elastic demand
price will increase total revenue. This
is because a fall in price will lead to a
unit elasticity
more than proportionate increase in
quantity demanded.
inelastic demand

D (AR)
At a point of unit elasticity, total
Q
revenue is maximised.
MR

If demand is inelastic, then increasing

TR the price will increase total revenue.
This is because a rise in price will lead
to a smaller than proportionate fall in
quantity demanded.
TR

Define the following types of profit:

 normal profit

 supernormal profit.

Explain in detail what is meant by normal profit.

© IFE: 2019 

Normal and supernormal profit

Normal profit is the opportunity cost of being in a certain business: the profit
that could have been earned in the next best alternative business. It is
counted as a cost of production. It:
 arises because by investing their time and money in a business, the
owners of the business forego the opportunity to invest their time and
money to make profits elsewhere
 can be expressed as the rate of return foregone by investing capital in
the business, which consists of the rate of interest on a risk-free loan
plus a suitable risk premium, reflecting the riskiness of the business
 is the minimum return required by the owners in order to stay in the
business. If they earn less than normal profit, then they will leave the
business in the long run.

Supernormal profit (also known as pure profit, economic profit or profit) is the
excess of total profit above normal profit.
© IFE: 2019
CB2 Module 6: Background to supply

State:

 how profit is calculated

 the profit-maximisation rule.

© IFE: 2019 

Profit and profit maximisation

Profit (T P ) is equal to total revenue less total cost, ie:

T P = TR - TC

Profit maximisation

Profit is maximised where marginal revenue is equal to marginal cost, ie:

MR  MC

Draw two diagrams:

 on one diagram, show how profit, total revenue and total cost typically
vary with output

 on one diagram, show how marginal revenue and marginal cost

typically vary with output.

On your diagrams indicate the profit-maximising output level, Q * .

© IFE: 2019 

Profit maximisation diagrams

TC
£ £
MC

a
TR
Note that
a=b
b MR
Q* Q Q* Q
T

Draw a diagram to illustrate profit maximisation for a firm making supernormal

profits. Assume that the firm is a price maker. On your diagram show and
label the following:
 marginal revenue curve (MR ) and average revenue curve ( AR )
 marginal cost curve (MC ) and average total cost curve ( AC )
 the profit-maximising price (P *) and output (Q *)
 average cost ( AC *) and average revenue ( AR *) at the
profit-maximising output
 the (supernormal) profit.

© IFE: 2019 

Profit maximisation for a firm making supernormal profits

£
profit MC
AC

P*=AR*

AC*

MR AR
Q* Q

Note that profit is maximised at the output level where MR  MC .

Draw a diagram to show the loss-minimising output for a firm that is making a
loss. Assume that the firm is a price maker. On your diagram show and label
the following:
 marginal revenue curve (MR ) and average revenue curve ( AR )
 marginal cost curve (MC ) and average total cost curve ( AC )
 the loss-minimising price (P *) and output (Q *)
 average cost ( AC *) and average revenue ( AR *) at the
profit-maximising output
 the loss.

© IFE: 2019 

Loss-minimising output

£ loss AC
MC

AC*
P*=AR*

MR AR
Q* Q

Explain how a firm decides whether or not to produce in the short run and the
long run.

© IFE: 2019 

Shut-down points

The short-run shut-down point is where the AR curve is tangential to the AVC
curve. The firm can only just cover its variable costs. Any fall in revenue
below this level will cause a profit-maximising firm to shut down immediately.

The long-run shut-down point is where the AR curve is tangential to the LRAC
curve. The firm can just make normal profits. Any fall in revenue below this
level will cause a profit-maximising firm to shut down once all costs have
become variable.

Draw a diagram to illustrate the short-run shut-down point. Assume that the
firm is a price maker. On your diagram show and label the following:
 average revenue curve ( AR )
 marginal cost curve (MC )
 average variable cost curve ( AVC )
 the shut-down price (P *) and output (Q *)
 average variable cost ( AVC *) at the shut-down output.

© IFE: 2019 

Diagram to show the short-run shut-down point

AC
£
AVC

P*=AVC*

AR = D
Q* Q

Summary Card

Time periods Card 1

Production (short run) Cards 2 to 6

Efficiency Card 7

Costs (short run) Cards 8 to 13

Production (long run) Cards 14 to 22

Costs (long run) Cards 23 to 25

Revenue Cards 26 to 30

Profit maximisation Cards 31 to 37

© IFE: 2019 

CB2

Module 7
CB2 Module 7: Perfect competition and monopoly
1

Describe briefly the four different types of market structure.

What is the meaning of the term imperfect competition?

© IFE: 2019 

Four different types of market structure

1. Perfect competition is a market structure where there are many firms,

none of which is large; where there is freedom of entry to the industry;
where all firms produce an identical product; and where all firms are price
takers.
2. Monopolistic competition is a market structure where there are many
firms and freedom of entry into the industry, but where each firm
produces a differentiated product and thus has some control over its
price.
3. Oligopoly is a market structure where there are few enough firms to
enable barriers to be erected against the entry of new firms.
4. Monopoly is a market structure where there is only one firm in the
industry.

Imperfect competition is the collective name for monopolistic competition and

oligopoly.
© IFE: 2019
CB2 Module 7: Perfect competition and monopoly
2

Outline the factors that influence a firm’s degree of control over price, ie its
market power.

Give one additional measure that can be is used to assess the extent of
market competition.

© IFE: 2019 

Factors that determine the degree of market power of firms

 number of firms in the industry – the fewer firms, the greater the market
power
 freedom of entry into the industry – the more restrictions on entry, the
greater the market power
 nature of the product – the more differentiated, the greater the market
power

These factors will have implications for a firm’s demand curve, and therefore
the price(s) it can charge. The greater the degree of market power, the less
elastic the demand curve will be.

The extent of market competition can be assessed by the x-firm concentration

ratio. This measures the market share of the x largest firms in the industry.

State the four assumptions under perfect competition.

© IFE: 2019 

Assumptions under perfect competition

1. Firms are price takers.

2. There is complete freedom of entry into the industry for new firms.

3. All firms produce an identical product.

4. Producers and consumers have perfect knowledge of the market, ie:

– producers are fully aware of prices, costs and market

opportunities

– consumers are fully aware of the price, quality and availability of

the product.

Draw the firm and industry demand curves for a perfectly competitive industry.

Give brief explanations of the shapes of these curves.

© IFE: 2019 

Firm and industry demand curves for a perfectly competitive industry

industry firm
P P
S

Demand = AR = MR
P* P*
D

Q* Q Q

 Market price determined by demand and supply in the market.

 Firm has no influence on market price; it takes the price as given.
 If it increased its price, it would lose all its customers.
 Since price (AR) is constant, MR = AR.
© IFE: 2019
CB2 Module 7: Perfect competition and monopoly
5

Distinguish between the short run under perfect competition and the long run
under perfect competition.

© IFE: 2019 

Short run and long run under perfect competition

The short run under perfect competition is the period of time during which
there is insufficient time for new firms to enter the industry.

The long run under perfect competition is the period of time that is long
enough for new firms to enter the industry.

Draw the short-run equilibrium position for a firm in perfect competition that is
making supernormal profit.

Give a brief explanation of how perfectly competitive firms determine the

equilibrium price and output in the short run.

© IFE: 2019 

Perfectly competitive firm making supernormal profit in the short run
£
supernormal profit Notes:
AC  U-shaped AC curve
MC with MC through
minimum AC
AR = MR
P1 (common to all
market structures)
AC1  Horizontal AR = MR
 To show supernormal
profit, P (ie AR) > AC

Q1 Q
 Price (P1) is determined by market supply and demand.
 Output is determined by where profit is maximised, ie where MR = MC;
at output Q1.
 Average cost of making Q1 = AC1.
 Average cost includes opportunity cost, ie it includes normal profit.
 P1 > AC1 so firm makes supernormal profit.
© IFE: 2019
CB2 Module 7: Perfect competition and monopoly
7

Draw the short-run equilibrium position for a firm in perfect competition that is
making losses that are insufficient to cause it to shut down.

Give a brief explanation of the key features of the diagram.

© IFE: 2019 

Perfectly competitive firm making losses in the short run
£ MC AC Notes:
losses
 To show losses,
P (ie AR) < AC
AVC  To show the firm does
not shut down
AC1 P (ie AR) > AVC
AR = MR  So: AVC < P < AC
P1

Q1 Q

 Price (P1) is determined by market supply and demand.

 Output is determined by where profit is maximised, ie where MR = MC,
ie at Q1
 Average cost of making Q1 = AC1.
 P1 < AC1 so firm makes losses, ie less than normal profit.
 Since P1 > AVC at Q1, firm will produce Q1, ie it will not shut down.
© IFE: 2019
CB2 Module 7: Perfect competition and monopoly
8

Draw the long-run equilibrium diagram.

Explain what happens in the long run if perfectly competitive firms make
supernormal profit or losses in the short run.

© IFE: 2019 

Long-run equilibrium under PC
MC
£ AC

PL AR = MR

QL Q
 If supernormal profits are earned in short run, new firms enter the
industry, causing the industry supply curve to shift to right and price to
fall. The AR curve facing the firm will shift downwards.
 If losses are made in short run, firms leave the industry, causing the
industry supply curve to shift to left and price to rise. The AR curve
facing the firm will shift upwards.
 The above processes continue until only normal profit is earned.
© IFE: 2019
CB2 Module 7: Perfect competition and monopoly
9

Explain the derivation of the short-run supply curve of:

 the firm

 the industry

under perfect competition.

© IFE: 2019 

Short-run supply curves under perfect competition

Short-run supply curves show output that will be produced at each price per
time period in the short run.

The firm
 Supply curve is marginal cost (MC) curve above the point of the
minimum average variable cost (AVC).
 Firm produces where MC = MR. Since MR = price in perfect
competition, MC curve shows what will be produced at each price.
 Firm produces no output if price < AVC.

The industry
Supply curve is horizontal summation of all the individual firms’ supply curves
(ie MC curves are above the point of minimum AVC).

Explain the shapes of the three possible long-run supply curves for an industry
under perfect competition.

© IFE: 2019 

Long-run industry supply curves under perfect competition

The long-run industry supply curve can be derived by analysing the impact of
an increase in demand for factor inputs on the market (initially in equilibrium):
 If the extra demand for inputs generated by new entrants puts upward
pressure on their price, the long-run industry supply curve is upward
sloping. (This is known as an increasing-cost industry.)
 If the extra demand for inputs generated by new entrants does not
affect their price, then the long-run industry supply curve is horizontal.
(This is known as a constant-cost industry.)
 If the extra demand for inputs generated by new entrants causes their
price to decrease, then the long-run industry supply curve is downward
sloping. (This is known as a decreasing-cost industry.)

Note that the long-run industry supply curve cannot be determined as the
summation of the individual firms’ supply curves (as it is in the short run)
because in the long run, the number of firms is not fixed.
© IFE: 2019
CB2 Module 7: Perfect competition and monopoly
11

Explain the effect on a perfectly competitive (PC) firm’s output, price and profit
in the short run of a fall in its fixed costs, eg lower interest on its loan.

Assume the firm is initially making normal profit.

© IFE: 2019 

Effect of a fall in fixed costs in the short run under PC

 AC curve falls; MC curve unaffected

 Price remains same (since MR and AR unaffected)
 Output remains same (since MC and MR unaffected)
 Profit increases (AR constant but AC falls)

Illustrate the effect of an increase in demand on the firm and the industry in
both the short run and the long run under perfect competition.

Assume all firms face the same cost conditions and factor prices are constant.

© IFE: 2019 

Effect of an increase in demand under PC
industry firm MC
£ £
S1
AC
S2
P2 AR2 = MR2
P2

P1
P1 AR1 = MR1
D2
D1
Q1 Q2 Q3 Q X1 X2 Q

 Increase in demand (D1 to D2) causes price to rise (P1 to P2) and output
to increase in short run (X1 to X2 for firm and Q1 to Q2 for industry).
 In long run, new firms enter so supply increases (S1 to S2) and price
falls (P2 to P1). Firms reduce output (X2 to X1) but industry has more
firms and so produces more output (Q2 to Q3).
© IFE: 2019
CB2 Module 7: Perfect competition and monopoly
13

Describe why perfect competition is incompatible with substantial economies

of scale.

© IFE: 2019 

Incompatibility of perfect competition and economies of scale

For perfect competition to occur, there must be many firms and each one must
be a price taker. In practice, this means that firms must be relatively small so
that they do not have economies of scale.

Once a firm expands sufficiently to achieve economies of scale, it will usually

gain market power and use this to cut prices and drive out (smaller)
competitors. The conditions for perfect competition will no longer be met.

Therefore perfect competition can only exist in an industry where there are no
(or virtually no) economies of scale.

Explain why producing goods where the price of the goods equals marginal
cost is regarded as an optimal (or allocatively efficient) position.

© IFE: 2019 

Why price = marginal cost is an optimal position

If price is greater than marginal cost, then consumers are putting a higher
value on the production of extra units than they cost to produce, therefore
more ought to be produced.

If price is less than marginal cost, then consumers are putting a lower value
on the production of extra units than they cost to produce, therefore less ought
to be produced.

Hence, if they are equal, then production levels are ‘just right’ and this is an
optimal (or allocatively efficient) position.

Discuss the extent to which perfectly competitive firms are productively

efficient.

© IFE: 2019 

Extent to which perfectly competitive firms are productively efficient

In order for firms to survive, they are forced to be as efficient as possible, and
they produce at the minimum point of their average cost curves.

However, firms are small, so do not:

 benefit from economies of scale
 make supernormal profits that enable them to carry out R&D to improve
the efficiency of production in the future.

Outline the benefits of perfect competition for society.

© IFE: 2019 

Benefits of perfect competition for society

+ Price equals marginal cost.

+ Long-run equilibrium cost is at the bottom of the firm’s long-run AC

curve.

+ Firms are encouraged to be as efficient as possible (as only the most

efficient survive).

+ The combination of (long-run) production being at minimum average

cost and each firm making only normal profits keeps prices at a
minimum.

+ If consumer tastes change, the resulting price change will lead firms to
respond (quickly).

Outline the possible disadvantages of perfect competition for society.

© IFE: 2019 

Possible disadvantages of perfect competition for society

– The free market will not necessarily distribute goods to consumers in

the fairest proportions.

– The free market will not necessarily lead to the optimum combination of
goods being produced when society’s views on equity are taken into
account.

– The production of goods may lead to undesirable side effects, such as

pollution.

– The long-run profits may not be sufficient to fund R&D.

– Even if it can be afforded, firms will not conduct R&D as other firms will
simply copy them.

– There is a lack of variety (as firms produce undifferentiated products).

Describe the main features of a monopoly.

© IFE: 2019 

Main features of a monopoly

A monopoly exists when there is only one firm in the industry.

Under monopoly:
 barriers restrict new firms from entering the industry
 the firm tends to produce a unique product
 the firm has considerable control over price: the demand curve is
downward sloping and tends to be more inelastic than under other
market structures
 the firm is often able to make supernormal profits in the long run
 the firm may be subject to heavy regulation
 the firm may be able to price discriminate.

Explain briefly, with the aid of an example, what is meant by the term natural
monopoly.

© IFE: 2019 

Natural monopoly

A natural monopoly arises where long-run average costs would be lower if an

industry were under a monopoly than if it were shared between two or more
competitors, eg the national grid for electricity.

Define the term ‘barriers to entry’.

© IFE: 2019 

Barriers to entry

Barriers to entry are anything that prevents or impedes the entry of firms into
an industry and thereby limits the amount of competition faced by existing
firms.

Distinguish between structural and strategic barriers to entry.

© IFE: 2019 

Structural vs strategic barriers to entry

Structural barriers to entry exist because of the characteristics of the industry.

The firm is not deliberately seeking to construct such barriers. Rather, they
are a side effect of attempts by the monopoly to run its business more
efficiently.

Strategic barriers to entry are the result of actions by the firm for the sole
purpose of deterring potential entrants.

List nine examples of barriers to entry.

© IFE: 2019 

Barriers to entry

1. economies of scale
2. absolute cost advantages
3. switching costs for consumers
4. product differentiation and brand loyalty
5. more favourable or complete control over access to customers
6. legal protection
7. threat of mergers and takeovers
8. aggressive tactics
9. intimidation

List:

 four examples of factors that might give a monopolist an absolute cost

advantage

 five examples of switching costs.

© IFE: 2019 

Cost advantages and switching costs

Factors that might give a monopolist an absolute cost advantage include:

1. more favourable access or control over key inputs
2. superior technology
3. more efficient production methods
4. economies of scope.

Examples of switching costs include:

1. searching costs
2. contractual costs
3. learning costs
4. product uncertainty costs
5. compatibility costs.

Draw the equilibrium position for a monopolist that is making supernormal

profits.

Give a brief explanation of how monopolists determine the equilibrium price

and output.

© IFE: 2019 

Monopolist making supernormal profit
£
supernormal Notes:
profit MC
 U-shaped AC curve
AC with MC through
P1 minimum AC
(common to all
diagrams)
AC1
 AR > MR
 To show supernormal
AR = D profit, P > AC
Q1 MR Q

 Profit is maximised where MR = MC, ie at output Q1.

 Price (AR) = P1.
 Average cost of making Q1 = AC1.
 P1 > AC1, so firm makes supernormal profit.

The demand curve facing the monopolist is the market demand curve.
© IFE: 2019
CB2 Module 7: Perfect competition and monopoly
25

State the different possible levels of profit made by a monopolist in the short
run.

© IFE: 2019 

Profits in equilibrium for monopolists

In the short run, monopolists might make:

 supernormal profits
 normal profit
 losses.

Define:

 productive efficiency

 allocative efficiency

 social optimum.

© IFE: 2019 

Productive and allocative efficiency, and social optimum

Productive efficiency is achieved if firms are producing the maximum output

for a given amount of inputs, or producing a given output at the least cost.

Allocative efficiency is achieved if the current combination of goods produced

and sold gives the maximum satisfaction for each consumer at their current
levels of income.

The social optimum is the level of output at which resources are allocated in
such a way as to maximise welfare, ie allocative efficiency is achieved.

In the absence of externalities, it occurs when P = MC (assuming there are no

externalities).

Discuss whether or not monopolists might be productively efficient (ie produce

at minimum cost) and allocatively efficient (ie produce output at the socially
optimal output level).

© IFE: 2019 

Productive and allocative efficiency of monopolists

Monopolists are unlikely to be productively efficient because they are not

compelled to produce at the minimum point of their average cost curves. In
addition, a lack of competition might result in cost curves being higher than
necessary. However, monopolists might have to be efficient to avoid the
threat of takeover, and monopolists might be more productively efficient than
firms under perfect competition because:
 they should be able to achieve substantial economies of scale
 they may be able to lower their cost curves through R&D and increased
investment.

Profit-maximising monopolists typically overcharge and underproduce

compared with the socially optimal output level, therefore they do not typically
achieve allocative efficiency. However, regulation might force monopolists to
produce (close to) the social optimum and state-run monopolists may choose
to produce the social optimum.
© IFE: 2019
CB2 Module 7: Perfect competition and monopoly
28

Draw a diagram to compare price and output under perfect competition and
monopoly.

Assume both operate with the same costs.

© IFE: 2019 

Perfect competition and monopoly – a comparison

S (MC) Notes:
£
 Must compare at the
PM industry level
 Draw demand and
PP supply (for PC)
 Add MR (for
monopoly)
D = AR  Can omit AC from
diagram
MR

QM QP Q

 Perfectly competitive industry produces where P = MC, ie QP and PP.

 Monopolist produces where MR = MC, ie QM and PM.
 Monopolist produces less and charges more.
 But monopolist’s costs may be lower.

Outline the advantages of monopoly for the public.

© IFE: 2019 

Advantages of monopoly for the public

+ Monopolists may be able to achieve substantial economies of scale,

resulting in lower prices.

+ Monopolists may have lower cost curves and hence prices due to more
R&D and investment.

+ Competition for corporate control might force monopolists to be efficient

(in order to avoid being taken over) and hence allow them to charge
relatively low prices.

+ Monopoly might lead to the more innovation and new products for the
public (if these are expected to increase profits).

Outline the disadvantages of monopoly for the public.

© IFE: 2019 

Disadvantages of monopoly for the public

– Monopoly is likely to lead to higher prices and lower output than under
perfect competition in both the short run and the long run.

– Monopolists may have higher cost curves due to lack of competition.

– The high profits earned by monopolists may be considered unfair.

– Monopolists might lack the incentive to produce new product varieties.

– Monopolies may lobby politicians in order to obtain favourable

treatment, to the detriment of the public.

Define:

 a perfectly contestable market

 hit and run.

Discuss the importance of costless exit.

© IFE: 2019 

Contestable markets and costless exit

A perfectly contestable market is a market where there is free and costless

entry and exit and the monopolist cannot immediately respond to entry.

Hit and run is a strategy whereby a firm is willing to enter a market and make
short-run profits and then leave again when the existing firm(s) cut prices.

Whether a new firm can quickly leave a market depends on the cost of exit,
ie the extent of sunk costs.

Costless exit makes hit-and-run behaviour more likely.

Distinguish between actual competition and perfect competition.

© IFE: 2019 

Actual and potential competition

Actual competition exists if there are actually other firms in the market. There
is no actual competition within a monopoly market industry.

Potential competition exists if there is a threat of competition, ie if another firm

could potentially take away all of its customers with little difficulty. The threat
of competition has a similar effect to actual competition.

Describe how the following are affected in a perfectly contestable market:

 price and profit

 efficiency.

© IFE: 2019 

Price, profit and efficiency in a perfectly contestable market

According to the theory, in perfectly contestable markets:

 firms will keep prices down
 only normal profits will be made
 firms will produce as efficiently as possible, taking advantage of any
economies of scale and any new technology.

Discuss the strengths and limitations of the theory of contestable markets.

© IFE: 2019 

Strengths and limitations of the theory of contestable markets

+ It is an improvement on simple monopoly theory as it allows for potential

competition.

+ It can be argued to provide a more useful ‘ideal type’ of market structure

than perfect competition because it provides a better means of
predicting firms’ price and output behaviour.

– It can be argued that it does not take sufficient account of the possible
reactions of the established firm.

+ It helps to focus on the importance of sunk costs (rather than the

barriers to entry).

Discuss whether contestable markets are good for the public interest both in
theory and in practice.

© IFE: 2019 

Contestable markets and the public interest

Perfectly contestable markets might:

 enable the firm to achieve low costs through economies of scale
 keep profits and hence prices down due to potential competition.

However:
 few markets are perfectly contestable, so the existence of some entry
and exit costs will still enable a monopoly to make supernormal profits
in the long run
 there are other possible failings of the market beside monopoly power
(eg inequality, externalities).

Summary Card

Market structures & market power Cards 1 & 2

Perfect competition Cards 3 to 17

Monopoly Cards 18 to 19, 24 to 30

Barriers to entry Card 20 to 23

Contestable markets Card 31 to 35

© IFE: 2019 

CB2

Module 8
CB2 Module 8: Monopolistic competition and oligopoly
1

State the three assumptions underlying monopolistic competition.

© IFE: 2019 

Assumptions underlying monopolistic competition

1. There are quite a large number of firms in the market and each firm has
a small enough market share to make firms independent of each other.

2. There is freedom of entry into the industry.

3. Each firm sells a differentiated product.

Explain what is meant by:

 independence (of firms in a market)

 product differentiation.

© IFE: 2019 

Independence (of firms in a market)

Independence (of firms in a market) occurs where the decisions of one firm in
a market will not have any significant effect on the demand curves of its rivals.

Product differentiation

Product differentiation is where one firm’s product is sufficiently different from

its rivals’ to allow it to raise the price of the product without customers all
switching to the rivals’ products.

Each firm therefore faces a downward-sloping demand curve.

Draw a diagram for a firm in monopolistic competition making supernormal

profits.

Give a brief explanation of how firms operating under monopolistic competition

determine the equilibrium price and output in the short run.

© IFE: 2019 

Firm in monopolistic competition making supernormal profits

£ supernormal MC
profit
AC
P1
AC1

MR D = AR
Q1 Q
 Profit is maximised where MR = MC, ie at output Q1.
 Price (AR) = P1.
 Average cost of making Q1 = AC1.
 P1 > AC1, so firm makes supernormal profit.

Explain what happens in the long run if firms are making losses in the short
run and draw the long-run equilibrium diagram for a firm in monopolistic
competition.

© IFE: 2019 

Long-run equilibrium in monopolistic competition

 Loss-making firms begin to leave the industry.

 Demand curves facing remaining firms shift to right.
 Process continues until all remaining firms make a normal profit.

£ Notes:
MC
AC Tricky to draw since
MR=MC & AR=AC
must happen at Q1.
P1 = AC1
 Draw AC & MC
 Draw AR as
tangent to AC
 Find P1 & Q1.
 Draw MR to
MR AR
equal MC at Q1.
Q1 Q

 Profit maximised where MR = MC, ie at output Q1.

 Price (AR) = P1 = Average cost of making Q1 = AC1.
 Only normal profit is earned.
© IFE: 2019
CB2 Module 8: Monopolistic competition and oligopoly
5

Outline the limitations of the model of monopolistic competition.

© IFE: 2019 

Limitations of model of monopolistic competition

In practice, a monopolistically competitive firm could make supernormal profits

in the long run if:
 information is not perfect, so other firms do not enter the market
 firms differ in their size and cost structures as well as their product
 there is not complete freedom of entry.

Furthermore:
 it may not be possible to derive a demand curve for the industry as a
whole, so the analysis has to be confined to the level of the firm
 the simple model concentrates on price and output and ignores non-
price competition.

Discuss the two major elements of non-price competition.

© IFE: 2019 

Major elements of non-price competition

The two major elements are:

1. Product development – to produce a product that will sell well and that
is distinct from rivals’ products (ie has relatively inelastic demand
because of a lack of close substitutes).

2. Advertising – to inform potential consumers of the product’s existence

and availability and to try to persuade them to purchase the good.

Both elements aim to both increase demand and to make the firm’s demand
curve less elastic.

The effect of non-price competition is difficult to forecast and may be different

at different prices

Draw a diagram to compare price and output under perfect competition and
monopolistic competition.

Assume both operate with the same costs.

How does price compare under monopoly and monopolistic competition?

© IFE: 2019 

Perfect competition and monopolistic competition – a comparison
£ LRAC

PMC DPC = ARPC

PPC

DMC = ARMC

QMC QPC Q

 Perfectly competitive firms produce QPC at price PPC.

 Monopolistically competitive firms produce output QMC (< QPC) at price
PMC (> PPC).

A lack of competition may lead a monopolist to charge higher prices than firms
operating under monopolistic competition. However, the benefits of
economies of scale and R&D may lead a monopolist to charge less than
monopolistically competitive firms.
© IFE: 2019
CB2 Module 8: Monopolistic competition and oligopoly
8

Compare monopolistic competition with both perfect competition and

monopoly in terms of productive efficiency.

© IFE: 2019 

Productive efficiency under monopolistic competition

In the long run, monopolistically competitive firms produce at a point to the left
of the minimum point on their average cost curve. In this sense, they are
likely to be:
 less productively efficient than perfectly competitive firms (although if
their demand curves are highly elastic, this effect may be small)
 more productively efficient than monopolies (which are likely to produce
even further to the left as a result of demand being more inelastic).

However, monopolistically competitive firms may be argued to be:

 more productively efficient than perfectly competitive firms if they
benefit from some economies of scale
 less productively efficient than monopolies which might benefit from
significant economies of scale, investment and R&D.

Compare monopolistic competition with both perfect competition and

monopoly in terms of allocative efficiency.

Compare monopolistic competition with perfect competition in terms of product

choice.

© IFE: 2019 

Allocative efficiency under monopolistic competition

Allocative efficiency (ie producing at – or near – the social optimum) is likely to

be greatest for perfect competition, followed by monopolistic competition, and
then monopoly.

Product choice under monopolistic competition

Under monopolistic competition, consumers will benefit from having a greater

variety of products to choose from than under perfect competition.

State the two key features of oligopoly.

© IFE: 2019 

Key features of oligopoly

1. barriers to entry

2. interdependence of firms (each firm will be affected by its rivals’

decisions and likewise, its decisions will affect those of its rivals)

Distinguish between the following types of oligopoly:

 duopoly

 collusive oligopoly

 non-collusive oligopoly.

Distinguish between competition and collusion.

© IFE: 2019 

Types of oligopoly

 A duopoly is an oligopoly where there are just two firms in the market.

 A collusive oligopoly exists where oligopolists agree (formally or

informally) to limit competition between themselves, eg setting quotas,
fixing prices, limiting product promotion or development, or agreeing not
to ‘poach’ each other’s markets.

 A non-collusive oligopoly exists where oligopolists have no agreement

between themselves, either formal, informal or tacit.

Competition and collusion

Some firms might believe that by competing, they can increase their profits,
however, others might conclude that competition will be destructive and will
lead to lower profits. In the latter case, firms might favour collusion.

Describe and illustrate the industry equilibrium for a cartel.

© IFE: 2019 

Cartel

 A cartel is a formal agreement to collude.

 A cartel will maximise profits if it acts like a monopoly, ie profits will be
maximised when output is such that MR = MC for the industry.

 Having agreed to sell at price P1, the firms have to divide the market
(Q1) between them, eg by non-price competition or quotas.

£
MCind

Dind = ARind

Q1 MRind Q
© IFE: 2019
CB2 Module 8: Monopolistic competition and oligopoly
13

Define tacit collusion and outline five different forms of tacit collusion.

© IFE: 2019 

Tacit collusion

Tacit collusion occurs where oligopolists take care not to engage in price
cutting, excessive advertising or other forms of competition. There may be
unwritten ‘rules’ of collusive behaviour, eg price leadership. Forms include:
1. dominant firm price leadership – where firms (the followers) choose the
same price as that set by a dominant firm in the industry (the leader)
2. barometric firm price leadership – where the price leader is the one
whose prices are believed to reflect market conditions in the most
satisfactory way; the barometer firm itself may (frequently) change
3. average cost pricing – where a firm sets its price by adding a certain
percentage for (average) profit on top of average cost
4. price benchmarks – this is a price that is typically used (eg £9.99);
firms, when raising prices, will usually raise them from one benchmark
to another
5. advertising / product design rules of thumb.
© IFE: 2019
CB2 Module 8: Monopolistic competition and oligopoly
14

Draw the equilibrium diagram for a price leadership model that assumes that
the dominant leader takes the part of the market not taken by the other firms.

© IFE: 2019 

Dominant firm price leadership

The price leader sets its price at the output level (Qleader) where its MR = MC.
The rest of the industry adopts the same price (Pleader) and the followers
supply Qf. The overall market quantity (Qind) is determined by the market
demand curve (Dmarket).
£

MCleader
Sall other firms

Pleader

Dmarket = ARmarket
Dleader = ARleader

Qleader Qf Qind Q

MRleader
© IFE: 2019
CB2 Module 8: Monopolistic competition and oligopoly
15

Draw the equilibrium diagram for a price leadership model that assumes that
the dominant or barometric leader takes a constant market share.

© IFE: 2019 

Price leadership with the leader taking a constant market share

The price leader sets its price at the output level (Qleader) where its MR = MC.

The rest of the market adopts the same price (Pleader). The market quantity
(Qmarket) is determined by the market demand curve (Dmarket).

£
MC

Pleader Dmarket = ARmarket

Dleader = ARleader

Qleader Qmarket Q

MRleader
© IFE: 2019
CB2 Module 8: Monopolistic competition and oligopoly
16

State the conditions under which collusion is more likely.

© IFE: 2019 

Conditions under which collusion is more likely

 There are only very few firms, all well known to each other.
 They are not very secretive with each other about costs and production
methods.
 They have similar production methods and average costs, and are thus
likely to want to change prices at the same time and by the same
percentage.
 They produce similar products and can thus more easily reach
agreements on price.
 There is a dominant firm.
 There are significant barriers to entry and therefore little fear of
disruption by new firms.
 The market is stable.
 There are no government measures to curb collusion.
© IFE: 2019
CB2 Module 8: Monopolistic competition and oligopoly
17

State the main reason why collusion may break down.

© IFE: 2019 

Main reason for collusion breaking down

There will always be the temptation for individual oligopolists to ‘cheat’ by

cutting prices or by selling more than their allotted quota.

Describe the Cournot model.

State the assumptions underlying the Cournot model.

© IFE: 2019 

Cournot model of duopoly and assumptions underlying it

The Cournot model is a model of duopoly where each firm makes its price and
output decisions on the assumption that its rival will produce a particular
quantity.

The assumptions are:

 Each firm has to choose an output level for a given period without
knowing its rivals’ production plans (although they will know how much
their rivals have produced in the past).
 Production has long lead times and is relatively inflexible.
 Whereas output has long lead times, the market price adjusts instantly
so that each firm is able to sell all the output it produces.
 The good is homogeneous and each firm has the same costs (so that
all firms sell their output for the same price).

Sketch the cost and revenue curves for the Cournot model of duopoly and
explain equilibrium.

© IFE: 2019 

Cournot model of duopoly

Firm A determines its demand curve (DA) according to the industry demand
curve (Dind) and the assumed quantity that Firm B produces (QB). It then sets
its price (PA) at the profit-maximising output level (QA).

The Cournot equilibrium is where each of two firm’s actual output is the same
as what the other firm predicted it would produce.
£

MCA

Dind = ARind
DA = ARA
QA Q
QB
MRA

State the assumptions underlying the Bertrand model.

© IFE: 2019 

Assumptions underlying the Bertrand model of oligopoly

 Each firm has to choose its price without knowing the price set by the
other firm. It assumes its rival will charge the same price in the current
period as it did in the previous period.

 Firms have to set prices in advance and decisions cannot be easily

changed, ie prices are inflexible.

 The good is homogeneous – the only thing that customers care about
when they purchase the product is its price.

 Each firm can adjust its output instantly and has no capacity
constraints. Therefore, if a firm charges a lower price than its rival, it
can immediately supply the entire market.

Discuss the likely industry profits under the Cournot and Bertrand models.

© IFE: 2019 

Industry profits under the Cournot and Bertrand models

Under the Cournot model, industry profits are:

 less than under a monopoly or cartel because price will be lower than
the monopoly price
 higher than under perfect competition since price is still above marginal
cost. (Note that as the number of firms in the industry increases, the
price moves closer to the level in a competitive market and industry
profits fall.)

Under the Bertrand model, each firm will keep reducing its price until all
supernormal profits are competed away.

State the assumptions underlying the kinked demand curve model and
illustrate on a diagram the equilibrium position.

© IFE: 2019 

Kinked demand curve model of oligopoly

The model assumes that if the oligopolist:

 raises its price, its rivals will not follow suit – this leads to a relatively
elastic demand curve at prices higher than the current price
 cuts its price, its rivals will follow suit – this leads to a less elastic
demand curve at prices lower than the current price.

£
MC

MR D = AR
Q1 Q

Using the kinked demand model, draw a short-run equilibrium position for an
oligopolist making supernormal profit, and explain how it would differ in the
long run.

© IFE: 2019 

Oligopolist making supernormal profit

Hints:
£  Draw AR and MR
MC AC as on Card 22
 Draw MC through
P1 the discontinuous
part of MR
AC1
 Draw AC to show
supernormal profit
(P > AC)

AR
MR
Q1 Q

 Profit is maximised where MC = MR, ie at output Q1 and price P1.

 P1 > AC1, so firm makes supernormal profit.
 No change in long run because of barriers to entry.

No change in equilibrium if MC changes within discontinuous section of MR.

Discuss the link between the kinked demand model and price stability and
state the two major limitations of the theory.

© IFE: 2019 

Kinked demand model – price stability and limitations

Price stability results from:

 the reluctance to raise / lower prices (due to the kinked demand curve)
 the unchanged profit-maximising price and output level if costs change
slightly (ie MC moves within the discontinuous section of the MR curve).

Major limitations:
 price stability may be due to other factors, eg firms not wanting to
change prices too frequently
 the model does not explain how prices are set in the first place.

Outline the possible disadvantages of oligopoly for society.

© IFE: 2019 

Possible disadvantages of oligopoly for society

Oligopoly may not be in the best interests of society if the oligopolists:

 collude to jointly maximise industry profits (so that prices are high)
 are individually too small to benefit fully from economies of scale
 engage in excessive advertising.

These problems will be reduced if:

 oligopolists to not collude
 there is some degree of price competition
 barriers to entry are weak
 oligopolists are forced to sell their product to other powerful firms
 the market in which they operate is contestable.

Outline the benefits of oligopoly for society.

© IFE: 2019 

Benefits of oligopoly for society

Oligopoly may actually benefit society if:

 oligopolists can use part of their supernormal profit for R&D –
oligopolists have a greater incentive to do this than monopolies to do so
in order to gain market share – this might lead to greater efficiency and
innovation
 consumer choice is increased due to product differentiation (resulting
from competition).

In terms of game theory, define:

 a simultaneous single-move game

 a sequential-move game

 dominant-strategy game.

© IFE: 2019 

Types of games

A simultaneous single-move game is a game where each player has just one
move, where each player plays at the same time and acts without knowledge
of the actions chosen by other players.

A sequential-move game involves one firm (the first mover) making and
implementing a decision. Rival firms (second movers) can observe the
actions taken by the first mover before making their own decisions.

A dominant-strategy game is one where the firm’s optimal strategy remains

the same, irrespective of what it assumes its rivals are going to do.

Define a Nash equilibrium position.

Give an example of a game without a dominant strategy, but with a Nash

equilibrium (or Nash equilibria).

© IFE: 2019 

Nash equilibrium

A Nash equilibrium is the position resulting from everyone making their

optimal decision based on their assumptions about rivals’ decisions. Without
collusion, there is no incentive for any firm to move from this position.

Firm B
High price Low price
High price (10, 10) ( - 20, 100)
Firm A
Low price (100, - 20) ( - 40, - 40)

 Neither firm has dominant strategy.

 Bottom left is Nash equilibrium - given that B is High, A is better off
staying Low; and given that A is Low, B is better off staying High.
 Top right is also Nash equilibrium.
 Top left and bottom right are not Nash equilibria - in both cases, both
firms would change strategy, given the strategy of the other.
© IFE: 2019
CB2 Module 8: Monopolistic competition and oligopoly
29

Define:

 maximin

 maximax.

© IFE: 2019 

Maximin and maximax

A maximin strategy is the strategy of choosing the policy whose worst possible
outcome is the least bad. Maximin is usually a low-risk strategy.

A maximax strategy is the strategy of choosing the policy that has the best
possible outcome. Maximax is usually a high-risk strategy.

In the context of game theory, define each of the following terms:

 prisoners’ dilemma

 credible threat (or promise)

 first-mover advantage

 decision tree (or game tree).

© IFE: 2019 

Game theory definitions

The prisoners’ dilemma is a scenario under which two or more firms (or
people) who, by attempting independently to choose the best strategy based
on what the other(s) is likely to do, end up in a worse position than if they had
co-operated in the first place.

A credible threat (or promise) is one that is believable to rivals because it is in

the threatener’s interests to carry it out.

A first-mover advantage is when a firm gains from being the first one to take
action.

A decision tree (or game tree) is a diagram showing the sequence of possible
decisions by competitor firms and the outcome of each combination of
decisions.

Give an example to illustrate the prisoners’ dilemma.

© IFE: 2019 

Example of prisoners’ dilemma

Firm B
High price Low price
High price (60, 60) (20, 100)
Firm A
Low price (100, 20) (30, 30)

The table shows profit (A, B) from each joint strategy.

 If Firm B charges High, Firm A chooses Low.

 If Firm B charges Low, Firm A chooses Low, so …
 … A’s dominant strategy is Low.
 By symmetry, B’s dominant strategy is also Low, so …
 Low, Low is dominant equilibrium, but …
 … High, High would give better result for each player.

Sketch a decision tree for a sequential-move game involving two moves. Call
the two ‘players’ Firm A and Firm B, and assume their strategies are to go
‘high’ or ‘low’.

© IFE: 2019 

Decision tree for a sequential-move game

(Payout to A(1), Payout to B(1))

gh
Firm B's

Hi
decision

B1
gh

Lo w
Firm A's
Hi

(Payout to A(2), Payout to B(2))

decision
(Payout to A(3), Payout to B(3))
gh
A Hi
Firm B's
Lo w decision

Lo w
(Payout to A(4), Payout to B(4))

Discuss the benefits and limitations of game theory.

© IFE: 2019 

Benefits and limitations of game theory

+ It provides a useful framework within which to think about competitive

environments where there is strategic independence.
+ It highlights the importance of each firm trying to think through situations
from their rival’s viewpoint in order to work out their own profit-
maximising decision.
– In practice, there may be many firms and many possible decisions,
making the theory impractical to use.
– It may be impossible to obtain precise information on payoffs to all rivals
from all options and the impact of all possible actions of all rivals on a
firm’s own payoffs.
– Furthermore:
 when making decisions under uncertainty, decision makers may
make systematic errors
 behaviour patterns may change over time
 different firms may have different objectives.
© IFE: 2019
CB2 Module 8: Monopolistic competition and oligopoly

Summary Card

Monopolistic competition Cards 1 to 9

Oligopoly (in general) Cards 10 to 11 & 25 to 26

Collusive oligopoly Cards 12 to 17

Non-collusive oligopoly Cards 18 to 24

Game theory Cards 27 to 33

© IFE: 2019 

CB2

Module 9
CB2 Module 9: Pricing strategies
1

Explain what is meant by:

 average cost or mark-up pricing

 limit pricing.

© IFE: 2019 

Average cost or mark-up pricing and limit pricing

Average cost or mark-up pricing is where firms set the price by adding a
percentage mark-up to average cost,

ie price = average fixed cost + average variable cost + mark-up

Limit pricing is where a monopolist or an oligopolist charges a price below the

short-run profit-maximising level in order to deter new entrants.

Although profits may be reduced in the short run, deterring new entrants may
lead to greater long-run profits.

It relies on the existing firm having lower average costs than potential new
entrants.

Outline the factors affecting the mark-up.

© IFE: 2019 

Factors affecting the mark-up

 The firm’s aims – it might be aiming for high / maximum profits or some
other target.
 Likely actions of rivals – it might try to predict its competitors’ responses
to changes in this firm’s price and how these responses will affect
demand.
 State of the market – in expanding markets, the size of the mark-up
may be higher.
 Degree of market power of the firm – the more market power, the
greater the likely mark-up.
 Whether the firm sells multiple products – in this case, the firm might try
to optimise profits across all products, leading to different mark-ups for
each product.
 The elasticity of demand for the product – products with inelastic
demand are likely to have greater mark-ups.
© IFE: 2019
CB2 Module 9: Pricing strategies
3

Draw a diagram to illustrate limit pricing.

Explain the diagram.

© IFE: 2019 

Limit pricing diagram

£
ACA
MCM
ACB
P1
ACM
PL

AR=D
MR
Q1Q3 Q2 Q

Assume that the profit-maximising position for the existing firm (Firm M) is
selling Q1 units at price P1 . A potential firm (Firm A) could not make profits at
this price, so would not enter the industry, however another potential firm
(Firm B) could. Therefore, Firm M could set the price at PL , so as to prevent
Firm B from earning a supernormal profit and thus deter it from entering the
market. At this price, Firm M would sell Q2 units.
© IFE: 2019
CB2 Module 9: Pricing strategies
4

Define:

 first-degree price discrimination (FDPD)

 second-degree price discrimination (SDPD)

 third-degree price discrimination (TDPD).

© IFE: 2019 

Types of price discrimination

FDPD is where the seller of the product charges each consumer the maximum
price they are prepared to pay for each unit.

SDPD is where a firm offers consumers a range of different pricing options for
the same or similar product. Consumers are then free to choose whichever
option they wish, but the price is often dependent on some factor such as the
quantity purchased.

TDPD is where a firm divides consumers into different groups based on some
characteristic that is relatively easy to observe and informative about how
much consumers are willing to pay. The firm then charges a different price to
consumers in different groups, but the same price to all the consumers within
a group.

Discuss the extent to which first-degree price discrimination (FDPD) can be

used in practice.

Under second-degree price discrimination (SDPD), the pricing options offered

to consumers are conditional on one or more factors. List four examples of
these factors.

© IFE: 2019 

How FDPD is applied in practice

FDPD – Sellers are rarely able to obtain reliable information on the maximum
amount each consumer is willing to pay. However, there are some real-world
examples of how sellers attempt to do this, for example, haggling in markets.

Factors that affect pricing options under SDPD

SDPD – The pricing options may be conditional on factors such as:

 the quantity of the product purchased
 the use of coupons / vouchers
 when the product is purchased, eg peak / off-peak
 the version of the product purchased, eg discounts for damaged goods.

Outline the key requirements of the characteristics used to divide customers

under third-degree price discrimination (TDPD).

Give examples of characteristics that may be used to divide customers under

TDPD.

© IFE: 2019 

How TDPD is applied in practice

TDPD – The characteristic used to divide consumers must be:

 relatively easy to observe
 informative about consumers’ willingness to pay
 legal
 acceptable to the consumer.

Examples include charging different prices based on:

 age, eg rail prices, cinema tickets
 gender, eg ladies nights
 nationality, eg foreign visitors pay more than locals to visit tourist sites
 occupation, eg providing discounts to employees
 geographical location, eg different prices for drugs in different countries
 business/individual, eg lower prices to individuals for academic journals
 past buying behaviour, eg lower prices to new customers.
© IFE: 2019
CB2 Module 9: Pricing strategies
7

Outline three conditions necessary for price discrimination to occur.

© IFE: 2019 

Conditions necessary for price discrimination to occur

1. The firm must be able to set its price, ie it must have a degree of market
power (and face a downward-sloping demand curve).

2. The markets must be separable, ie consumers in the low-priced market

must not be able to resell the product in the high-priced market.

3. Demand elasticity must differ in each market (and the firm will charge
the higher price in the market where demand is less elastic).

State the main advantages to the firm of using price discrimination.

© IFE: 2019 

Main advantages to the firm of using price discrimination

+ It allows the firm to earn a higher revenue from any given level of sales.

+ The firm may be able to use it to drive competitors out of business,

eg by using high profits from one market (where the provider has a
monopoly) to subsidise another market (where competition exists).

Illustrate and explain how the firm:

(a) increases total revenue

(b) determines the profit-maximising prices and total output

under first-degree price discrimination (FDPD).

© IFE: 2019 

Diagram illustrating first-degree price discrimination (FDPD)
Additional
(a) price revenue (b) price
MC

D D = MR

Q1 quantity Q1 Q2 quantity

The total revenue earned if a single Since an increase in sales does not
price is charged is represented by involve lowering the price for any
the area P1  Q1 . Under FDPD, total unit except the extra one sold, the
revenue also includes the triangle MR curve becomes the same as the
above this. D curve and profit is maximised by
producing where MR = MC..

Illustrate and explain how the firm increases total revenue under third-degree
price discrimination (TDPD).

© IFE: 2019 

Diagram illustrating how the firm increases total revenue under TDPD

price
Additional revenue

Q2 Q1 quantity

If a single price is charged, then in order to sell Q1 units, the firm must charge
a price P1 . Total revenue will be P1  Q1 . However, if the firm practises TDPD
and charges a price P2 for the first Q2 units, then it will earn additional
revenue of (P2  P1)  Q2 .

Illustrate and explain how the firm determines the profit-maximising prices and
total output under third-degree price discrimination (TDPD).

© IFE: 2019 

Diagram illustrating third-degree price discrimination (TDPD)
£ £ £

PX
P*
PY DM

MC
DY
DX MRM
MRX MRY

QX Q QY Q Q* Q
Market X Market Y Total (Market X + Market Y)

The firm determines the total quantity to produce by maximising profits overall,
ie producing where MRM  MC . It then equates this level of MC to the
marginal revenues in the individual markets ( MRX and MRY ) to determine
the quantities and hence the prices to sell at in Markets X and Y.
© IFE: 2019
CB2 Module 9: Pricing strategies
12

Define the following pricing strategies:

 peak-load pricing

 predatory pricing.

© IFE: 2019 

Different pricing strategies

Peak-load pricing is a form of price discrimination (second or third degree)

where a higher price is charged in peak periods and a lower price in off-peak
periods.

Predatory pricing is where a firm sets its prices below average cost in order to
drive competitors out of business.

Illustrate and explain:

(a) the total revenue earned by the firm

(b) how the firm determines the profit-maximising prices and total output

under peak-load pricing.

© IFE: 2019 

Diagram illustrating peak-load pricing

price
MC

Ppeak

Poff-peak

ARoff-peak ARpeak
MRoff-peak MRpeak
Qoff-peak Qpeak quantity

The total revenue There are peak and off-peak demand (AR) curves
earned is the sum of with corresponding MR curves. Profit is maximised
Poff -peak  Qoff -peak in each case where MR  MC , ie at quantities
and Ppeak  Qpeak . Qpeak & Qoff -peak , and prices Ppeak & Poff -peak .

Discuss whether or not price discrimination is in the public interest with regard
to:

 distributional effects on those customers who previously purchased the

good at a uniform price

 the impact of any extra sales.

© IFE: 2019 

Price discrimination and the public interest

Distributional effects – Consumers who are able to purchase a good that they
would otherwise not be able to buy, or who pay a lower price than would
otherwise be the case, gain consumer surplus, while consumers who have to
pay more than would otherwise be the case lose consumer surplus. However,
consideration should be given to who is winning / losing as well as on the
effect on total welfare.

Sales – FDPD and SDPD will both increase output compared to if a single
price is charged. TDPD may or may not increase output. Extra sales have a
positive impact on the welfare of society: they increase both consumer surplus
and profit.

Discuss whether or not price discrimination is in the public interest with regard
to:

 misallocation effects

 competition

 profits.

© IFE: 2019 

Price discrimination and the public interest

Misallocation effects – TDPD could lead to a misallocation of resources. If

total sales remain constant and the product is reallocated from those who
were prepared to pay a higher price to those with a lower willingness to pay,
then assuming that price reflects utility, total welfare would fall.

Competition – A firm may use price discrimination to drive competitors out of

business (predatory pricing), which reduces competition, however, if a firm
uses the higher profits generated to break into another market and withstand a
price war, competition will be increased.

Profits – Higher profits may be seen as an undesirable redistribution of income

in society (especially if the average price is raised), however, higher profits
might be reinvested, which could lead to innovation and/or lower costs in
future.

Define the following pricing-related terms:

 loss leader

 full-range pricing

 by-product.

Give examples of situations in which a firm considers the pricing of its

products as a whole rather than as individual products.

© IFE: 2019 

Pricing-related definitions

A loss leader is a product whose price is cut by the business in order to attract
custom.

Full-range pricing is a pricing strategy in which a business, seeking to improve

its profit performance, assesses the pricing of its goods as a whole rather than
individually.

A by-product is a good or service that is produced as a consequence of

producing another good or service.

Examples of where products are priced as a whole include:

 supermarkets offering loss leaders (eg ‘bargain buys’) to attract
customers to the store
 businesses selling complementary products (eg Apple iPods and music
from the iTunes store) and substitute products (eg a range of cereals)
 pricing cheese and whey (a by-product of cheese) together.
© IFE: 2019
CB2 Module 9: Pricing strategies
17

Describe the four stages of the product life cycle.

© IFE: 2019 

Four stages of the product life cycle

1. launch – this might occur under the conditions of monopoly; demand is

likely to be rapidly expanding and price-inelastic so that it may be
possible for the firm to make large profits

2. a period of rapid sales growth – unless entry barriers are high, large
profits and rapid growth will attract new firms, however, if the market is
growing fast enough, all firms may still be able to increase their sales

3. maturity (a levelling off in sales) – there may be many firms and growth
in sales has slowed so there will be competition for market share;
collusion may begin to break down; firms may try to invest in product
innovation

4. a period of decline – as the market becomes saturated with alternatives

or the product becomes obsolete, sales will start to fall

Explain and illustrate how pricing varies with each stage in the life cycle of a
product.

© IFE: 2019 

The life cycle of a typical product
sales
per
period

product does not become obsolete

product becomes obsolete

launch growth maturity decline time

 launch – the firm might be able to charge very high prices, however it
might choose to keep prices low to deter new entrants
 growth – some price competition may emerge but it is unlikely to be
intense; new entrants may compete in terms of product differences
 maturity – pricing may be aggressive and price wars might break out
 decline – price offers may exist initially, but eventually, the market might
become a stable oligopoly with a high degree of tacit price collusion
© IFE: 2019
CB2 Module 9: Pricing strategies

Summary Card

Average cost & limit pricing Cards 1 to 3

Price discrimination Cards 4 to 15

Other pricing strategies Card 16

Product life cycle Cards 17 & 18

© IFE: 2019 

CB2

Module 10
CB2 Module 10: Market failure and government intervention
1

Define:

 rational economic behaviour

 private efficiency.

Explain why private efficiency occurs where marginal benefit (MB (or marginal
utility (MU)) equals marginal cost (MC).

© IFE: 2019 

Rational economic behaviour and private efficiency

Rational economic behaviour describes decisions that involve doing more of

those activities whose marginal benefit exceeds their marginal cost and doing
less of those activities whose marginal cost exceeds their marginal benefit.

Private efficiency occurs where a person’s marginal benefit from a given

activity equals the marginal cost.

If the marginal benefit (or marginal utility) from an activity is greater than its
marginal cost, then a rational person would do more of that activity. Similarly,
if the marginal benefit from the activity is lower than its marginal cost, then a
rational person would do less of that activity. Consequently, the optimum
position occurs where MB  MC .

Define:

 Pareto improvement

 Pareto optimality

 social efficiency.

Explain why social efficiency occurs where marginal social benefit equals
marginal social cost ( MSB  MSC ).

© IFE: 2019 

Pareto optimality and social efficiency

Pareto improvement refers to a situation in which changes in production or

consumption can make at least one person better off without making anyone
worse off.

Pareto optimality refers to a situation in which all possible Pareto

improvements have been made: where, therefore, it is impossible to make
anyone better off without making some else worse off.

Social efficiency refers to a situation of Pareto optimality.

If the MSB from an activity is greater than its MSC, then there would be a
Pareto optimality if there were an increase in the activity. Similarly, if the MSB
from the activity is lower than its MSC, then society would gain from a
decrease in that activity being undertaken. Consequently, the social efficiency
occurs where MSB  MSC .

Define externalities.

© IFE: 2019 

Externalities

Externalities are costs or benefits of production or consumption experienced

by people other than the producers and consumers directly involved in the
transaction. They are sometimes referred to as ‘spillover’ or ‘third-party’ costs
or benefits.

State the two conditions for private efficiency to result in social efficiency.

© IFE: 2019 

Conditions for private efficiency to result in social efficiency

1. There must be perfect competition throughout the economy.

2. There must be no externalities.

Define the following terms in the context of social efficiency:

 total producer surplus

 total (private) surplus

 total social surplus.

© IFE: 2019 

Social efficiency definitions

Total producer surplus is equal to total revenue minus total variable costs
( TR  TVC ), or, in other words, total profit plus total fixed costs ( T   TFC ).

Total (private) surplus is total consumer surplus (the excess of a person’s total
utility from the consumption of a good over the amount that person spends on
it ( TU  TE )) plus total producer surplus.

Total social surplus is total benefits to society from consuming a good minus
total costs to society from producing it. In the absence of externalities, total
social surplus is the same as total (private) surplus.

Explain how perfect competition achieves social efficiency in the absence of

externalities.

© IFE: 2019 

How perfect competition achieves social efficiency

An explanation of how perfect competition achieves social efficiency should

include the following reasoning:

Social efficiency occurs where MSB  MSC . This can be derived as follows:

MSB  MB (or MU ): in the absence of consumption externalities

 P (ie MC to consumers): rational consumers will maximise consumer surplus

 MR : under perfect competition

 MC : profit-maximisation

 MSC : in the absence of production externalities

Explain how, following an increase in demand for a good, the market economy
(operating like an invisible hand) reallocates resources to restore social
efficiency to this market.

© IFE: 2019 

How the market economy reallocates resources to restore social
efficiency

An increase in the marginal utility (ie the MSB) of consuming a good leads to
an increase in demand …

… which will increase consumption …

… which will drive up the market price …

… which will lead to firms increasing their production …

… which will increase marginal costs (a movement along the MC curve) …

… which will increase the MSC.

List the three main types of market failure and explain how each type causes
an unsatisfactory (suboptimal or inequitable) allocation of resources.

© IFE: 2019 

Main types of market failure

1. Externalities – The existence of external costs and benefits means that

the free market will under/over produce/consume the good/service.

2. Public goods – The positive externalities are so great that the free
market may not produce them at all.

3. Market power – Firms with a degree of market power will tend to

produce where MR  MC in order to maximise profits, rather than
MSB  MSC . This leads to a deadweight welfare loss to society.

Externalities, public goods and market power are three types of market failure.
List three additional types of market failure and explain how each type causes
an unsatisfactory (suboptimal or inequitable) allocation of resources.

© IFE: 2019 

Three additional types of market failure

1. Imperfect information – Consumers may lack up-to-date information on

products and be unaware of product quality. They may also be swayed
by misleading advertising. Firms may be ignorant of market
opportunities, prices, costs, the productivity of factors, the activity of
rivals etc. Furthermore, there may be asymmetries of information.
Such a lack of information might lead to suboptimal decisions being
made.

2. Immobility of factors and time lags in response – Factors (especially

labour) may be slow to respond to changes in demand or supply, during
which time demand and supply may have changed again. As a result,
the economy is in a constant state of disequilibrium.

3. Protecting people’s interests – Individuals might make poor decisions

on their own behalf or for others (eg dependants). Examples of this
include merit goods, which are under-consumed by individuals.

Define the following terms, which are related to externalities:

 external costs

 external benefits

 social cost

 social benefit

 deadweight welfare loss from externalities.

© IFE: 2019 

Definitions related to market failure

External costs are costs of production (or consumption) that are borne by
people other than the producer (or consumer) directly involved in the
transaction.

External benefits are benefits from production (or consumption) that are
experienced by people other than the producer (or consumer) directly involved
in the transaction.

Social cost is made up of the private cost (to the producer) plus externalities in
production.

Social benefit is made up of the private benefit (to consumers) plus

externalities in consumption.

The deadweight welfare loss is the loss of social surplus (total social benefits
minus total social costs) at the competitive market equilibrium compared with
the social optimum where MSB  MSC .
© IFE: 2019
CB2 Module 10: Market failure and government intervention
11

Give examples of:

 external costs of production

 external benefits of production

 external costs of consumption

 external benefits of consumption.

© IFE: 2019 

Examples of external costs and benefits

External costs of production – pollution in the air / water as a result of

chemical firms dumping waste.

External benefits of production – companies in the forestry industry planting

new woodlands.

External costs of consumption – extra policing / public health costs resulting

from alcohol consumption.

External benefits of consumption – reduced traffic congestion and pollution

resulting from consumers using public transport.

Draw a diagram to illustrate:

 negative externalities in production

 positive externalities in production.

© IFE: 2019 

Externalities in production

MSC MPC (= SPC )

costs and = MPC + MECP costs and
benefits deadweight benefits deadweight
welfare loss welfare loss
MSC
=MPC – MEBP
MPC (= SPC )
MSCPC
P* PPC
PPC P*
D= MPB = MSB
MSCPC
D = MPB
= MSB

MECP

MEBP

Q* QPC quantity QPC Q* quantity

overproduction underproduction

Negative externalities Positive externalities

Draw a diagram to illustrate:

 negative externalities in consumption

 positive externalities in consumption.

© IFE: 2019 

Externalities in consumption

costs and costs and

benefits benefits
SPC
deadweight deadweight
welfare loss = MPC = MSC welfare loss SPC
= MPC = MSC

PPC MSBPC

P* P*
MSBPC D = MPB PPC MSB
= MPB + MEBC
MECC
D = MPB
MSB = MPB – MECC MEBC

Q* QPC quantity QPC Q* quantity

overconsumption underconsumption

Negative externalities Positive externalities

Define public good and describe the two key features of a public good.

© IFE: 2019 

Public good

A public good is a good or service that has the features of non-rivalry and
non-excludability and as a result would not be provided by the free market.

Non-rivalry exists where consumption of the good or service by one person

will not prevent others from enjoying it.

Non-excludability exists where it is not possible to provide a good or service to

one person without it thereby being available free for others to enjoy.

Define the following types of goods, which are related to public goods:

 pure public good

 impure public good

 club good

 common good or resource.

Give an example of each.

© IFE: 2019 

Definitions related to public goods

A pure public good is a good or service that has the characteristics of being
perfectly non-rival and completely non-excludable and, as a result, would not
be provided by the free market. National defence is an example of a service
that comes close to being a pure public good.

An impure public good is a good that is partially non-rivalrous and

non-excludable. Examples are street lighting and policing.

A club good is a good which has a low degree of rivalry but is easily
excludable. Examples are password-protected wireless internet connections
in public places and subscription TV services.

A common good or resource is a good or resource that has a high degree of

rivalry but the exclusion of non-payers is difficult. Examples are fishing in the
open ocean and the felling of trees in rainforests.

Draw a diagram to illustrate the efficient output of a pure public good.

Give a brief explanation of the key features of the diagram.

© IFE: 2019 

Efficient output of a pure public good

 Assume there are just two

costs and
benefits MSB = DM = DA + DB consumers (A and B) who
have individual demand
MPC = MSC = S curves DA and DB, and that
there are no externalities.
DB  The demand curve for the
market (M) is derived by
DA
considering how much
consumers are willing to pay
in total for each possible
level of output, ie it is the
Q* quantity
vertical aggregation of the
individual demand curves.
 Production of a public good is similar to production of a private good, so
the supply curve is upward-sloping.
 The socially efficient quantity is found where MSB = MSC (ie at Q*).
© IFE: 2019
CB2 Module 10: Market failure and government intervention
17

Describe the following problems, which are related to public goods:

 the tragedy of the commons

 the free-rider problem.

© IFE: 2019 

Problems related to public goods

The tragedy of the commons describes when resources are commonly

available at no charge, people are likely to overexploit them.

The free rider problem occurs when it is not possible to exclude other people
from consuming a good that someone has bought. The result of this is that
the free market might not produce them at all, because nobody would have an
incentive to pay for them. Anybody that did pay for them would feel aggrieved
that non-payers were able to enjoy the benefits from consuming the good
without paying anything towards the cost of providing it (ie get a ‘free ride’).

Define and illustrate the deadweight welfare loss of monopoly.

On your diagram, indicate which area would represent each of the following
under both perfect competition and monopoly:

 consumer surplus

 producer surplus

 total private surplus.

Assume there are no externalities and that costs are the same under both
market structures.

© IFE: 2019 

Welfare loss under monopoly

Under perfect competition:

£
 consumer surplus =
MC ( = MSC) = SPC
a+b+c
a
 producer surplus = d + e PM
b
 total (private) surplus = c
a+b+c +d +e PPC
d e
D = AR
( = MB = MSB)
Under monopoly:
MR
 consumer surplus = a
QM QPC Q
 producer surplus = b + d

 total (private) surplus = a + b + d , hence the deadweight welfare loss is

c e.
© IFE: 2019
CB2 Module 10: Market failure and government intervention
19

Define merit good.

Give two examples of a merit good and give two examples of goods with
opposite characteristics to a merit good.

© IFE: 2019 

Merit goods

Merit goods are goods that the government feels people will underconsume
and which therefore ought to be subsidised or provided free.

Examples of merit goods include education, healthcare, pensions and training.

Examples of goods that the government feels people will overconsume (and
which therefore ought to be discouraged) include cigarettes, alcohol, drugs
and gambling.

Such goods are often referred to as demerit goods.

List the main types of government intervention.

© IFE: 2019 

Government intervention to correct market failure

 taxes and subsidies

 changes in property rights

 laws prohibiting or regulating undesirable structures or behaviour

 regulatory bodies

 price controls

 provision of information

 direct provision of goods and services

Define the following terms, which are related to taxes and subsidies:

 government surplus (from a tax on a good)

 excess burden (of a tax on a good)

 Pigouvian tax (or subsidy).

© IFE: 2019 

Definitions related to taxes and subsidies

Government surplus (from a tax on a good) – This is the total tax revenue
earned by the government from sales of a good.

Excess burden (of a tax on a good) – This is the amount by which the loss in
consumer surplus plus producer surplus exceeds the government surplus.

In other words, this is the deadweight welfare loss from the tax.

Pigouvian tax (or subsidy) – This is a tax (or subsidy) designed to ‘internalise’
an externality. The marginal rate of a Pigouvian tax (or subsidy) should be
equal to the marginal external cost (or benefit).

Draw a diagram to illustrate a Pigouvian tax to correct an external cost of

production under perfect competition.

Give a brief explanation of the diagram.

© IFE: 2019 

A Pigouvian tax to correct an external cost of production under perfect
competition

MSC
In the absence of a tax, the costs and
optimum tax
( = MPC + tax)
= MECP = MSC – MPC
market would produce where benefits
MPC = S
MPB = MPC, ie at Q1 . Social
optimum is where MSB = MSC, P
D ( = MSB = MPB)
ie at Q2 . MC

The tax on the good is set equal

to the external cost of production MECP
at the social optimum, Q2 .
Q2 Q1 quantity
The tax increases private costs
(thereby internalising the externality) so that the new MPC including the tax
equals the MPB at the social optimum, Q2 .

Draw a diagram to illustrate a Pigouvian tax where market power exists.

Give a brief explanation.

© IFE: 2019 

A Pigouvian tax where market power exists
MSC MPC + tax
In the absence of a tax, the costs and
market would produce where benefits
MR = MPC, ie at Q1 . Social MPC
optimum is where MSB = P3
MSC, ie at Q2 . P2
P1
Note that the extent of
overproduction is lower than Ppc
it would be in a perfectly optimum
competitive market. tax MR D = MSB
Q3 Q2 Q1 Qpc quantity
The tax on the good is set so
that MR = MPC + tax, ie so that output is at the social optimum, Q2 .

This tax is less than the full amount of the externality because of the monopoly
power.

Draw a diagram to show the deadweight welfare loss from a tax on a good
assuming there is no market failure.

© IFE: 2019 

Deadweight welfare loss arising from a tax on a good

Prior to the tax:

 consumer surplus = S + tax

a+b+c +d £
S
 producer surplus =
e+f +g +h a
Pc = P2
b
After the tax: P1 e
cd
g
 consumer surplus = a f
Pp = P2 – tax
 producer surplus = h h D

 tax receipts amount to Q2 Q1 Q

b+c +e+f .

So, deadweight welfare loss = d + g .

Discuss the relative merits of taxes and subsidies as a means of correcting

market failure.

© IFE: 2019 

Relative merits of taxes and subsidies

+ The market is still allowed to operate.

+ Firms are forced to take on board the full social costs and benefits of
their actions.
+ Taxes and subsidies can be adjusted according to the magnitude of the
problem.
+ Taxes encourage firms to find more desirable production methods /
practices.
+ For some externalities there is a measurable cost / benefit, in which
case taxes / subsidies are very appropriate.
– It is infeasible to use different tax and subsidy rates for different firms
and different externalities.
– The government often lacks the knowledge to measure the cost /
benefit and apportion the blame accordingly.

State the Coase theorem.

Give two examples of situations in which extending property rights might be

useful.

Give three examples of the problems associated with extending property

rights.

© IFE: 2019 

Coase theorem and extending property rights

The Coase theorem suggests that when there are well-defined property rights
and zero bargaining costs, then negotiations between the party creating the
externality and the party affected by the externality can bring about the
socially efficient market quantity.

Extending property rights might be a useful solution where:

1. there are a few, easily identifiable culprits and sufferers
2. there are clearly defined costs.

The problems with extending property rights include:

1. the practical difficulties of negotiation where many people suffer
2. the time and expense of negotiation and litigation
3. the inequality in the distribution of legal services and property.
© IFE: 2019
CB2 Module 10: Market failure and government intervention
27

State the three types of law that are used to correct market imperfections.

© IFE: 2019 

Laws used to correct market imperfections

1. those that prohibit or regulate behaviour that imposes external costs

2. those that prevent or regulate monopolies and oligopolies

3. those that prevent firms from exploiting people’s ignorance

State:

 three advantages and one disadvantage of laws that ban or restrict

certain activities

 one advantage and one disadvantage of regulatory systems that

investigate on a case-by-case basis.

© IFE: 2019 

Laws that ban or restrict certain activities

+ simple, clear and easy to administer

+ safer than alternative policies when the danger is great
+ quickly implemented in the case of an emergency
– do not encourage further improvements in good behaviour

Regulatory systems that investigate on a case-by-case basis

+ adopt the most appropriate remedies in each case

 can be slow, expensive and weak

Give two forms of price controls and state the problems with each.

© IFE: 2019 

Price controls

Can take the form of:

1. maximum prices (ceilings)  to protect consumers
2. minimum prices (floors)  to protect producers.

Problems with these include:

1. Ceilings below the equilibrium price will cause shortages. Non-price
rationing needs to be introduced and underground (black) markets
might develop.
2. Floors above the equilibrium price will lead to surpluses. In the case of
goods, governments either have to set quotas for firms or they need to
buy the surplus supplies, store them, and then either destroy them or sell
them cheaply on the world market.

Give examples of the sorts of information the government might provide to the
public to help correct a type of market failure.

© IFE: 2019 

Types of information provided

Information on:

 the jobs provided by job centres to those looking for work – this should
speed up the ‘matching process’ between the unemployed and
employers

 the effects of smoking or eating vegetables – this should help

consumers to make better choices

 prices, costs, employment, sales trends etc – this should enable firms to
plan with greater certainty.

List the four reasons why the government provides health and education
(which are not public goods) for free or well below cost.

Give brief explanations.

© IFE: 2019 

Main reasons for government provision of merit goods

1. social justice – society may feel that these things should be provided
according to need rather than ability to pay

2. large positive externalities – people other than the consumer may

benefit substantially

3. dependants – people’s right to these should not be based on the

decisions of others, eg parents

4. imperfect information  people may not appreciate the benefits

Describe the problems caused by government intervention in a free market.

© IFE: 2019 

Problems caused by government intervention in a free market

 Shortages and surpluses may arise if the government uses price

controls.
 Poor information may lead to the government being unaware of
people’s wishes or misinterpreting their behaviour.
 Bureaucracy and inefficiency will result from the additional
administrative costs of the intervention.
 Lack of market incentives may be a result of the government
intervention removing / reducing the effect of market forces.
 Shifts in government policy may increase costs and reduce efficiency
for firms if government policy is changed too frequently.
 Lack of freedom for individuals, ie a loss of freedom in making choices,
which may itself be seen to be socially undesirable.

Describe the advantages of the free market.

© IFE: 2019 

Advantages of the free market

A free market:
 automatically adjusts to supply and demand changes (whereas
government intervention requires administration)
 has dynamic advantages, ie the chances of making high profits will
encourage monopolies / oligopolies to invest in new products and new
techniques (whereas government intervention could lead to a loss in
innovation and growth)
 experiences a high degree of competition even under monopoly /
oligopoly due to the threat of competition, competition from closely
related industries or foreign firms, counterveiling powers and/or
competition for corporate control.

Give three reasons why no firm conclusions can be drawn in the debate over
the best level of government intervention.

© IFE: 2019 

Reasons why it is hard to draw firm conclusions regarding government
intervention

1. The debate involves issues that cannot be settled by economic

analysis, eg issues that involve ethics as well as economic gains and
losses.

2. Costs and benefits of intervention are hard (if not impossible) to identify
and measure, especially then the costs are borne by different people
and when externalities are involved.

3. There are too many uncertainties to predict the effect of more or less
intervention.

Give three ways in which market power can be used against the public
interest.

Give three reasons why the existence of market power is not always bad.

© IFE: 2019 

Ways in which market power can be used against the public interest

1. The firm can make supernormal profits.

2. Consumers are charged high prices compared to the cost of production.

3. The firm has little incentive to improve efficiency.

Reasons why the existence of market power is not always bad

1. Firms may choose not to exploit fully their market power.

2. Economies of scale may lead to lower prices.

3. Profits may be spent on research and development, and capital

investment, which may lead to improved products or lower prices.

Describe the three targets of competition policy.

© IFE: 2019 

Targets of competition policy

1. monopoly policy – which is concerned with the abuse of market power

and anti-competitive practices of a firm acting alone

2. merger policy – which aims to regulate mergers that result in a

concentration that would significantly impede effective competition, in
particular by the creation or strengthening of a dominant position

3. restrictive practices policy – which control anti-competitive practices

amongst a group of firms (ie oligopolists)

Define:

 exclusionary abuses

 restrictive practices.

© IFE: 2019 

Exclusionary abuses

Exclusionary abuses are business practices that limit or prevent effective

competition from either actual or potential rivals.

Restrictive practices

Restrictive practices are where two or more firms agree to adopt common
practise to restrict competition.

Outline six examples of exclusionary abuses that are commonly cited in

competition cases.

© IFE: 2019 

Exclusionary abuses

1. predatory pricing – where the dominant firm sets its prices below its
average variable cost in order to drive competitors out of business
2. exclusivity rebates / discounts – where customers are offered special
deals if the agree to make most / all of their purchases from the
dominant firm
3. tying – where a firm is only prepared to sell a first product (the tying
good) on the condition that its consumers buy a second product from it
(the tied good)
4. refusal to supply and margin squeeze – where a vertically integrated
firm with a dominant position in an upstream market deliberately refuses
to supply inputs or charges high prices for an input required by firms in
a downstream market to drive them out of business
5. price discrimination – where lower prices may be used to drive
competitors out of business
6. vertical restraints – conditions imposed by one firm on another which is
either its supplier or its customer
© IFE: 2019
CB2 Module 10: Market failure and government intervention
39

Outline five examples of restrictive practices that are commonly cited in

competition cases.

© IFE: 2019 

Restrictive practices

1. horizontal price fixing – agreements between rival firms to fix prices

above competitive levels

2. market sharing – agreements on how to distribute markets or customers

between the firms

3. limit production – where firms agree quotas on how much each should
produce

4. bid rigging – where two or more firms secretly agree on the prices they
will tender for a contract; these prices will be above those that would
have been submitted under a genuinely competitive tendering process

5. information sharing – where firms share sensitive information with one

another, eg future plans on pricing, product design and output

List the actions that may be taken in the UK if a firm breaches one or more
elements of UK competition policy.

© IFE: 2019 

Actions that may be taken

 The firm may be ordered to cease the activities.

 The firm may be fined.

 Individuals may be prosecuted and receive a prison sentence and/or a

fine.

 Individuals may be barred from serving as a director of a UK company.

List the main stages in the process of investigating a merger and state three
possible decisions that may be reached following merger investigations in the
UK.

© IFE: 2019 

Stages in the process of investigating a merger and decisions that may
be reached

 notification of relevant mergers to an appropriate body

 a preliminary investigation to check whether competition is likely to be

threatened

 a more detailed investigation, if required

 a decision, which may be:

1. unconditional clearance of the merger
2. conditional clearance subject to the firms taking certain actions
that are legally binding
3. prohibition of the merger

Discuss the effectiveness of each of the three aspects of competition policy.

© IFE: 2019 

The effectiveness of competition policy

It is generally accepted that it is correct for monopoly policy to concentrate on

anti-competitive practices and their effects rather than simply on the existence
of market dominance:
 economic power is only a problem when it is abused
 monopolies might result in economies of scale and increased
investment and R&D, which can benefit consumers.

Strict restrictive practices policies are generally favoured, however the main
difficulty is identifying the existence of collusion.

Merger policy is more controversial. Specific areas of contention are whether

firms should be forced to notify the authorities of proposed mergers and be
prevented from undertaking any integration activities until the merger is
cleared, and whether mergers should be judged more on their impact on
public interests rather than competition levels.
© IFE: 2019
CB2 Module 10: Market failure and government intervention
43

Define technology policy and describe the three stages of technological

change.

© IFE: 2019 

Technology policy

Technology policy involves government initiatives to influence the process of

technological change and its rate of adoption.

Stages of technological change

1. Invention – Research (either general research or research that is

directed towards a particular goal) leads to new ideas and new
products.

2. Innovation – The new ideas are put into practice. A firm will introduce
the new technology (hopefully leading to a commercial advantage).

3. Diffusion – The new products and processes are copied, and possibly
adapted, by competitor firms. The effects of the new technology spread
throughout the economy, affecting general productivity levels and
competitiveness.
© IFE: 2019
CB2 Module 10: Market failure and government intervention
44

Outline four reasons why market forces might fail to encourage sufficient R&D.

© IFE: 2019 

Reasons market forces fail to encourage sufficient R&D

1. The existence of R&D free riders, whereby firms benefit from the results
of research findings without contributing to the costs or taking any risk.

2. The existence of monopolies and oligopolies, which have less pressure

to innovate than competitive firms – although, the higher profits of
monopolies may help fund R&D.

3. Several firms within an industry may duplicate the same area of

research.

4. The risk that a particular line of research will be unsuccessful leads

firms to focus on research with short-term benefits and to avoid more
risky, but potentially more beneficial, long-term projects.

Describe five specific forms of government intervention in the stages of

technological change.

© IFE: 2019 

Government intervention in the stages of technological change

1. awarding patents (a form of temporary legal monopoly) to an inventor

who registers an invention – this will encourage businesses to conduct
R&D as they may be able to reap greater rewards from its results
2. public provision of R&D, either through its own research institutions or
via funding to universities / other research organisations
3. R&D subsidies – these would reduce the cost and hence the risk for
businesses conducting R&D and could also ensure that the outcome
from the R&D activity is more rapidly diffused throughout the economy
4. encouragement of co-operative R&D by being actively involved in the
R&D process or acting as a facilitator – this will reduce the potential for
duplication and will encourage the pooling of scarce R&D resources
5. diffusion policies to spread new information and technology – this might
involve the provision of information concerning new technology or the
use of subsidies to encourage businesses to adopt new technology

List four other policies that may indirectly influence the level of R&D
undertaken.

© IFE: 2019 

Other policies that may indirectly influence the level of R&D

1. education and training policy

2. competition policy

3. national defence policy and initiatives

4. policy on standards and compatibility

Summary Card

Efficiency under perfect competition Cards 1 to 7

The case for government intervention Cards 8 to 19

Forms of government intervention Cards 20 to 31

Government failure & the case for the market Cards 32 to 34

Competition policy Cards 35 to 42

Technology & R&D policy Cards 43 to 46

© IFE: 2019 

CB2

Module 11
CB2 Module 11: The macroeconomic environment
1

Describe why the financial system is important to economies.

© IFE: 2019 

Why the financial system is important to economies

Financial markets, financial institutions and financial instruments (ie tradable

financial assets such as shares and bonds) have become increasingly
important in determining the financial well-being of:
 nations
 organisations
 governments
 people.

The increasing importance of the financial system to economies is known as

financialisation.

Explain, with reference to the three accounts that are completed, how the
financial well-being of the country can be analysed.

© IFE: 2019 

How the financial well-being of the country can be analysed

Three accounts are compiled for the household, corporate and government
sectors and for the economy as a whole:
1. The income account records the various flows of income (eg wages)
alongside the amounts either spent (eg on rent) or saved.
2. The financial account records (1) the balance sheet, ie a record of the
stocks of financial assets (eg bank deposits, bonds and shares) and
financial liabilities (eg mortgages, business loans) and (2) financial
flows, comprising new saving, borrowing and repayments.
3. The capital account records the stock of non-financial wealth, which
includes physical assets (eg property) and the capital flows, which
occur when acquiring or disposing of physical assets.

The balance of a sector’s or a country’s financial and non-financial assets over

its financial liabilities is known as its net worth.
© IFE: 2019
CB2 Module 11: The macroeconomic environment
3

List the five major macroeconomic objectives.

© IFE: 2019 

Major macroeconomic objectives

1. high and stable economic growth

2. low unemployment
3. low inflation
4. the avoidance of balance of payments deficits and excessive exchange
rate fluctuations
5. a stable financial system and the avoidance of excessively financially
distressed sectors of the economy, including government

State the two main branches of macroeconomic policy used to achieve the
objectives on the previous card.

© IFE: 2019 

Main branches of macroeconomic policy

1. demand-side policy – used to influence aggregate demand in the

economy

2. supply-side policy – used to increase aggregate supply directly,

independently of aggregate demand.

Give three examples of the main instruments of government macroeconomic

policy.

© IFE: 2019 

Macroeconomic policy instruments

1. fiscal policy – the use of government spending and/or taxation to

influence aggregate demand (total spending)

2. monetary policy – the use of the money supply and/or interest rates to
influence aggregate demand

3. other policy instruments, eg exchange rate policy, competition policy

import controls

Define the three types of withdrawals of spending from the circular flow of
income.

© IFE: 2019 

Withdrawals from the circular flow of income

1. Net savings, S = savings  borrowing  drawing on past savings

where savings is that part of income that is not spent.

2. Net taxes, T = taxes  transfer payments

where transfer payments are payments where money is transferred

from one group to another without any production taking place,
ie benefits and subsidies.

3. Imports (M ) is expenditure on goods and services produced outside of

the domestic economy.

Define the three types of injections of spending into the circular flow of
income.

© IFE: 2019 

Injections into the circular flow of income

1. Investment (I ) is expenditure on capital goods such as plant and

equipment, plus the building up of stocks.

2. Government expenditure (G) is expenditure on goods and services

such as tarmac for the roads and books for schools. (This does not
include spending on transfer payments.)

3. Exports (X) is expenditure by foreign residents and companies on

goods and services produced domestically.

Draw a diagram showing the circular flow of income, including all injections
and withdrawals into and out of the circular flow.

© IFE: 2019 

Circular flow of income

INJECTIONS
FIRMS
The productive
sector Investment, I Government
spending, G
Exports, X
Factor Consumption
payments, of domestically
Y produced goods, Banks Government Abroad
Cd

Imports, M
Net taxes, T
HOUSEHOLDS Net savings, S
Owners of factors of
production
WITHDRAWALS

Explain why planned withdrawals need not equal planned injections.

State the condition for an equilibrium level of national income.

© IFE: 2019 

Why planned withdrawals need not equal planned injections

Exports (E) are bought by firms and people abroad, whereas imports (M) are
bought by firms and people in the domestic economy – consequently, they are
likely to differ.

Firms may wish to invest (I) more or less than people wish to save (S)

The governments may choose to spend (G) more or less than it receives in
taxes (T).

The condition for an equilibrium level of national income

planned injections (J) = planned withdrawals (W)

ie I +G + X = S +T + M

Explain how equilibrium is restored if there is a change in withdrawals or

injections.

© IFE: 2019 

How equilibrium is restored if there is a change in withdrawals or
injection

Suppose J > W, eg as a rise in business confidence had lead to an increase in

investment (I).

The excess of J over W will lead to a rise in national income.

This in turn will lead to households not only spending more on domestic goods
( Cd ), but also saving more (S), paying more taxes (T) and buying more
imports (M).

So, withdrawals will rise and will continue to do so until J = W once more, at
which point national income will stop rising and hence so will withdrawals.

Define gross domestic product (GDP) at market prices.

Give the three methods by which it can be calculated.

© IFE: 2019 

Gross domestic product (GDP) at market prices

GDP at market prices is the value of output produced within a country over a
12-month period in terms of the prices actually paid. It can be calculated by
the:

1. product method: adds up the ‘value added’ of each industry (avoiding

‘double counting’ of intermediate products) to get gross value added
(GVA), then adds taxes less subsidies on products

2. income method: adds up the incomes earned before taxes, ie wages,

interest, rent and profit (excludes transfer payments) to get GDP (=
GVA) at basic prices, then adds taxes on products less subsidies on
products

3. expenditure method: sums consumption + investment + government

spending (excluding transfer payments) + exports – imports.

Define:

 the value added of a firm

 gross value added (GVA) at basic prices.

© IFE: 2019 

Value added

The value added of a firm is its total revenue less its purchases from other
firms. It is equal to the incomes earned by the factors used in its production
process, ie wages, interest, rent and profit.

Gross value added (GVA) at basic prices

GVA at basic prices is the sum of all the values added by all the industries in
the economy over a year.

Define gross national income (GNY).

State how:

 GNY is related to GDP at market prices.

 net national income (NNY) is related to GNY.

© IFE: 2019 

Gross national income (GNY)

 GNY is the value of income earned by the nation’s resources.

 GNY at market prices = GDP at market prices

+ net income from abroad

 NNY at market prices = GNY at market prices

– depreciation

where depreciation refers to the decline in the value of capital

equipment due to obsolescence or wear and tear.

Define households’ disposable income and state how it is calculated.

© IFE: 2019 

Households’ disposable income

Households’ disposable income is the income that is available for households

to spend, ie personal incomes after deducting taxes on income and adding
benefits. It is calculated as follows:

GNY at market prices

– taxes paid by firms
+ subsidies received by firms
– depreciation
– undistributed profit (ie profit retained by the firms)
– personal taxes
+ benefits

Outline, with the aid of a simple numerical example, how national income
figures can be adjusted to take account of inflation.

© IFE: 2019 

How national income figures can be adjusted to take account of inflation

Nominal (or money) GDP measures GDP in terms of current prices.

Real GDP is GDP adjusted to allow for inflation, ie GDP measured in terms of
constant prices.

For example, if nominal GDP increased by 5% over the last year, whilst
average prices rose by 3%, then real GDP increased by about 2%.

Discuss, with the aid of a simple numerical example, how national income
figures can be adjusted to take account of the population.

© IFE: 2019 

How national income figures can be adjusted to take account of
population

GDP per head (or per capita) is total GDP divided by the population of the
country.

It enables:
 comparisons of living standards in countries with different populations
 assessments of changes in living standards within the same country
over time, allowing for population changes.

For example, if the real GDP in a country increased by 3% over the last year,
while the population rose by 1%, then real GDP per head increased by about
2%.

Define:
 the purchasing power parity (PPP) exchange rate
 the purchasing power standard (PPS) GDP.

Outline, with the aid of a simple numerical example, how national income
figures can be adjusted to take account of different currencies.

© IFE: 2019 

Purchasing power parity (PPP) exchange rate

This is an exchange rate corrected to allow for the purchasing power of a

currency. $1 would buy the same in each country after conversion into its
currency at the PPP rate.

For example, if a basket of goods costs an average of $1.20 in the US and £1

in the UK, then the PPP exchange rate is $1.20/£1.

Purchasing power standard (PPS) GDP

This is GDP measured at a country’s PPP exchange rate.

To compare US and UK living standards, we divide US GDP per head in $s

using the PPP exchange rate of $1.20/£1 (not the actual exchange rate) and
compare this with UK GDP per head in £s.

Explain why the aggregate demand (AD) curve slopes downwards

© IFE: 2019 

Why the aggregate demand (AD) curve slopes downwards

The AD curve slopes downwards because as prices increase, there will be

three substitution effects:
1. exports become less competitive and imports more competitive so net
exports ( X - M ) fall (international substitution effect)
2. interest rates increase and so C and I fall (inter-temporal substitution
effect)
3. the real value of savings falls and so savings increase to compensate
and C falls (real balance effect).

There will also be an income effect if incomes do not increase in line with
prices, causing real incomes and hence C to fall. Firms’ profits will rise if real
wages fall, but, since C is falling, firms are unlikely to increase I , so C + I
falls.

Explain why the short-run aggregate supply (AS) curve slopes upwards and
may get steeper.

© IFE: 2019 

Why the short-run aggregate supply (SRAS) curve slopes upwards and
may get steeper

The SRAS curve slopes upwards because of the assumption that factor
prices, eg wages, are constant, or at least ‘sticky’ and inflexible, and so do not
rise as rapidly as prices.

Consequently, a rise in prices leads to an increase in profitability and so firms

are willing to supply more.

In addition:
 diminishing returns to variable factors such as labour
 growing shortages of certain variable factors, eg skilled labour,

mean that the SRAS may also become steeper as national output increases.

Draw a diagram to show equilibrium in the aggregate demand-aggregate

supply model.

© IFE: 2019 

Equilibrium in the aggregate demand-aggregate supply (AD-AS) model

price
level SRAS

Ye real national income (GDP)

The equilibrium price level and real national income level are determined by
the intersection of AD and SRAS.

Draw diagrams to illustrate the effect of:

 an increase in aggregate demand
 a decrease in aggregate supply.

on the price level (p) and real GDP (Y).

© IFE: 2019 

Increase in AD Decrease in AS

price SRAS SRAS2

price
level level SRAS1
P2
P2
P1 AD2 P1
AD
AD1

Y1 Y2 GDP Y2 Y1 YF GDP

This leads to increases in both the This leads to an increase in the

price level and real GDP. price level and a decrease in real
GDP.

Summary Card

Financial systems & financial well-being Cards 1 & 2

Macroeconomic objectives & policies Cards 3 to 5

Circular flow of income Cards 6 to 8

Equilibrium national income Cards 9 & 10

Measurement of national income Cards 11 to 17

Aggregate demand-aggregate supply model Cards 18 to 21

© IFE: 2019 

CB2

Module 12
CB2 Module 12: Macroeconomic objectives
1

Define the following terms in the context of economic growth:

 actual growth

 potential growth

 potential output

 output gap

 full-capacity output.

© IFE: 2019 

Economic growth definitions

 Actual growth is the percentage increase in national output actually

produced.

 Potential growth is the percentage increase in the capacity of the

economy to produce, ie its potential output.

 Potential output is the sustainable level of output that could be

produced, ie one that involves a ‘normal’ level of capacity utilisation and
does not result in rising inflation.

 The output gap is actual output less potential output.

 Full-capacity output is the absolute maximum level output that could be

produced with all firms working flat out.

Describe the likely impact on spare capacity, unemployment and the output
gap if the actual growth rate is less than the potential growth rate.

© IFE: 2019 

The likely impact on spare capacity, unemployment and the output gap
of the actual growth rate is less than the potential growth rate

It will lead to:

 an increase in spare capacity
 an increase in unemployment
 the output gap becoming less positive, or perhaps negative, depending
on the economy’s starting point.

Give two factors that will contribute to growth in potential output.

© IFE: 2019 

Factors that contribute to growth in potential output

1. increases in the quantity of resources, ie capital, labour, land and raw

materials

2. increases in the productivity of resources, eg due to technological

advances or improved labour skills

Outline the influences on actual economic growth in the short run and the long
run.

© IFE: 2019 

Influences on actual economic growth

Short run

The key influence is aggregate demand (AD). An increase in AD will help to

bring the economy out of recession and move it closer to full employment.

Long run

The key influence is the rate of growth in potential output, ie the supply-side of
the economy. This will reflect:
 growth of the quantity of factors available, eg the size of the workforce
 productivity growth, eg due to better skills and education.

Draw a diagram to show the four phases of the business cycle.

© IFE: 2019 

Phases of the business cycle
full-capacity output
GDP

4
actual output 3

3
2
trend / potential output
4

2
1

time

1. the upturn 3. the peaking out

2. the expansion 4. the slowdown, recession or slump

Describe two ways in which business cycles may be irregular.

© IFE: 2019 

Ways in which business cycles may be irregular

1. the length of the phases – some booms (recessions) are short-lived and
last only a few months, whilst others may last for several years.

2. the magnitude of the phases – which will reflect the rate of economic
growth in booms, or decline in recessions.

Outline the components of aggregate demand (AD) and the relationship

between AD and the business cycle.

© IFE: 2019 

The components of aggregate demand (AD) and the relationship
between AD and the business cycle

AD = C + I + G + X - M

where:
 C = consumption  X = exports
 I = investment  M = imports
 G = government spending

Increases (decreases) in AD will lead to increases (falls) in national income.

Outline the influences of the following on the business cycle:

 consumer spending

 investment

 the financial sector

 aggregate supply.

© IFE: 2019 

Influences on the business cycle

Consumer spending (C) is the largest component of AD and so changes in C

have a major effect on AD and hence GDP.

Investment (I) is very sensitive to changes in GDP (ie growth) and the
resulting changes in I often magnify the fluctuations in GDP.

Changes in the financial sector can amplify economic shocks and growth,
eg banks boost lending when growth is strong and reducing it when growth is
weak.

Supply-side shocks, eg sudden sharp changes in oil prices, can cause

fluctuations in output. Equally, ‘technological shocks’ can influence potential
output and, in turn, actual output.

Define the following terms:

 the unemployed

 the labour force

 the unemployment rate.

© IFE: 2019 

Unemployment: definitions

The unemployed are those people of working age without jobs who are
available for work at current wage rates.

The labour force is made up of the unemployed plus the employed (those with
jobs).

The unemployment rate is:

number unemployed
labour force

Describe the two official measures of unemployment and the differences

between them.

© IFE: 2019 

Measures of the unemployment rate

1. The standardised unemployment rate is the main measure of

unemployment. The unemployed are defined as persons of working
age who are without work, are available to start work within two weeks
and have either actively looked for work in the last two weeks, or are
waiting to take up an appointment.

This measure is used by the International Labour Organisation (ILO)

and the Organisation for Economic Co-operation and Development
(OECD) and so can be used for international comparisons.

2. Claimant unemployment is a measure of all those in receipt of

unemployment-related benefits. It tends to underestimate the true level
of unemployment and is sensitive to changes in eligibility conditions for
unemployment-related benefits.

List eight costs of unemployment.

© IFE: 2019 

Costs of unemployment

1. the financial cost to the unemployed

2. the personal cost to the unemployed, eg loss of self-esteem
3. the personal cost to the family and friends of the unemployed
4. the worsening of the government’s budgetary (or fiscal) position
5. the lost services or investment the government could have provided
(instead of paying unemployment benefit)
6. the under-utilisation of the nation’s resources, resulting in actual output
being below potential output (and lower profits and incomes for firms
and other workers)
7. the long-term effect of unemployed resources on the productive
capacity of the nation (ie potential output could fall)
8. increased crime and vandalism

Describe the three factors that affect the average duration of unemployment.

© IFE: 2019 

Factors that affect the average duration of unemployment

1. The number unemployed (the size of the ‘stock’ of unemployment. The

higher the stock, the longer will tend to be the duration of
unemployment.

2. The size of the inflow and outflow from the stock of unemployment. The
larger the flows relative to the total number unemployed, the less will be
the average duration of unemployment.

3. The phase of the business cycle. People will on average have been
unemployed for longer after a few years of recession, and this long-term
unemployment is likely to persist even when the economy pulls out of
the recession.

Outline who makes up the inflows to and outflows from the pool of
unemployment.

© IFE: 2019 

Inflows to the pool of unemployment

 those leaving jobs due to redundancy, resignation, being sacked, or

temporarily laid off
 those entering the labour force, ie school/college leavers, newly arrived
immigrants and people returning to the labour force eg after having
children

Outflows from the pool of unemployment

 those taking new jobs or returning to old jobs after being temporarily
laid off
 those leaving the labour force, eg as they give up looking for a job,
reach retirement, temporarily withdraw from the labour force (eg to raise
a family), emigrate or die

State a formula for the average duration of unemployment using figures for the
stock of unemployment and outflow from unemployment.

© IFE: 2019 

The average duration of unemployment

U
DU 
F

where:
 DU = average duration of unemployment
 U = stock of unemployment
 F = outflow from unemployment.

Describe the three causes of disequilibrium unemployment.

© IFE: 2019 

Disequilibrium unemployment

Causes of disequilibrium unemployment:

1. demand-deficient (or cyclical) unemployment – caused by a fall in

aggregate demand (with no corresponding fall in the real wage rate)

2. real-wage unemployment – caused by inflexible wages held above the

equilibrium level, eg due to trade union power, minimum wage
legislation or fixed wage contracts

3. growth in the labour supply with no corresponding increase in the

demand for labour or fall in the real wage rate

Outline five different categories of equilibrium unemployment.

© IFE: 2019 

Categories of equilibrium unemployment

1. frictional (or search) unemployment – results from imperfect information

about the labour market, so that employers and employees take time to
search for the “right” employee and the “right” job

2. structural unemployment caused by changes in the pattern of demand

and/or supply in the economy

3. structural unemployment resulting from the introduction of labour-saving

technology, ie technological unemployment

4. structural unemployment that is concentrated in a particular region of

the country, ie regional unemployment

5. seasonal unemployment – caused by a decrease in the demand for

labour at particular times of the year in particular industries or regions

State a formula for the real wage rate in terms of the nominal wage rate and a
price index.

© IFE: 2019 

Real wage rate

Wn
Wr 
P

 Wr = real wage rate

 Wn = nominal wage rate
 P = price index.

Outline two potential remedies for frictional (search) unemployment.

© IFE: 2019 

Potential remedies for frictional (search) unemployment

1. Provision of better job information, eg through government job centres,

private employment agencies, the internet, apps or the media.

2. Reducing the level of unemployment benefit to increase the incentive to

work.

Outline two causes of structural unemployment.

© IFE: 2019 

Causes of structural unemployment

1. Change in the patterns of demand, eg declining demand for domestic

products may be due to changing tastes or competition from suppliers
abroad.

2. Changes in production methods, eg new technologies allow the same

output to be produced using fewer workers, resulting in technological
unemployment.

Outline three factors that determine the level of structural unemployment.

© IFE: 2019 

Factors that determine the level of structural unemployment

1. The degree of regional concentration of industry – a greater

concentration leads to greater structural unemployment when particular
industries decline.

2. The speed of change of demand and supply in the economy – more

rapid change will lead to more redundancies.

3. The immobility of labour – the less willing and/or able workers are to
move to a new job, the higher will be the level of structural
unemployment.

Outline, with examples, the two main approaches to reducing structural

unemployment.

© IFE: 2019 

Main approaches to reducing structural unemployment

1. A market-orientated approach involves encouraging people to:

• look more actively for jobs, if necessary in other parts of the
country
• adopt a more willing attitude to retraining
• accept a reduction in wages, if necessary.

2. An interventionist approach involves direct government action to match

jobs to the unemployed, eg by:
• giving grants to firms to set up in areas of high unemployment
• providing government-funded training schemes.

Define the

 aggregate demand for labour curve ( ADL )

 aggregate supply of labour curve ( ASL )

and explain their slopes.

© IFE: 2019 

Aggregate demand for labour curve

This shows the total demand for labour in the economy at different average
real wage rates.

It slopes downwards because diminishing marginal returns to labour means

that firms will take on more labour only if there is a fall in the real wage rate to
compensate them for the lower output produced by the additional workers.

Aggregate supply of labour curve

This shows the number of people willing and able to accept jobs immediately
at different average real wage rates.

It slopes upwards as a higher wage rate will encourage more people to enter
the labour market and also because the unemployed will be more willing to
accept job offers than continuing to search for a better-paid job.

Define:

 the equilibrium (or natural) level of unemployment

 disequilibrium unemployment.

© IFE: 2019 

Equilibrium (or natural) level of unemployment

This is the unemployment level that exists when the labour market is in
equilibrium (ie when ADL = ASL ). It is the difference between those who
would like employment at the current average wage rate and those willing to
immediately accept a job at the equilibrium average real wage rate.

Disequilibrium unemployment

This is unemployment resulting from real wages being held above their
equilibrium level.

Draw a diagram of the labour market. On your diagram show:

 the aggregate demand for labour curve ( ADL )

 the aggregate supply of labour curve ( ASL )

 the registered labour force curve ( RLF )

 the equilibrium level of unemployment

 disequilibrium unemployment.

© IFE: 2019 

Labour market diagram

average
ASL
real wage RLF
rate D E
w1 C
A B
we

ADL

Qe number of workers

 AB is the equilibrium level of unemployment.

 CD is the disequilibrium unemployment at real wage w1 ( > w e ) .

State the two conditions that must hold for disequilibrium unemployment to
occur.

© IFE: 2019 

Conditions for disequilibrium unemployment:

1. aggregate supply of labour > aggregate demand for labour

2. real wages are ‘sticky’, ie inflexible downwards, so they don’t

immediately fall to the market-clearing wage..

Explain the slopes of the ‘wage offer’ ( Wo ) and ‘wage acceptability’ ( Wa )

curves.

© IFE: 2019 

Slopes of the wage offer and wage acceptability curves

The wage offer curve slopes upwards, as the longer people search for a job,
the better wage offers they are likely to be made.

The wage acceptability curve slopes downwards, as the longer people search
for a job, the more anxious they will be to get a job and the lower is the wage
rate they will accept.

Draw a diagram to show the ‘wage offer’ ( Wo ) and ‘wage acceptability’ ( Wa )

curves for an unemployed individual.

Indicate on your diagram the average duration of unemployment, Te .

© IFE: 2019 

How wage offers and wage expectations for an unemployed individual
vary with the length of time unemployed

wage
rate

Te length of time unemployed

State the differences between the consumer prices index (CPI), the retail
prices index (RPI) and the GDP deflator.

© IFE: 2019 

Differences between the consumer prices index (CPI), the retail prices
index (RPI) and the GDP deflator

 The RPI and CPI both measure the average price of a basket of
consumer goods and services, whereas the GDP deflator is a price
index of all domestically-produced goods and services, ie everything
that contributes to GDP.

 The RPI is calculated as an arithmetic mean; the CPI is based on a

geometric mean.

 The RPI includes housing costs; the CPI doesn’t.

 RPI inflation is typically higher than the CPI inflation.

 The CPI is used throughout the EU.

State a formula for the annual rate of inflation in terms of price index values.

© IFE: 2019 

Formula for the annual rate of inflation

Pt  Pt 1
t   100
Pt 1

where:
  t = inflation rate at time t
 Pt = price index at time t.

Define demand-pull inflation

Illustrate demand-pull inflation on an AD-AS diagram.

© IFE: 2019 

Demand-pull inflation

Demand-pull inflation is caused by persistent increases in the level of

aggregate demand, eg increases in C, I, G and/or X–M.

Firms respond to the increases in price AS

aggregate demand by increasing level
prices and increasing output.
P2
Demand-pull inflation is associated
with a boom in the economy. P1 AD2

AD1

Y1 Y2 GDP

Define cost-push inflation.

Illustrate cost-push inflation on an AD-AS diagram.

© IFE: 2019 

Cost-push inflation

Cost-push inflation is caused by persistent increases in production costs

independent of the level of aggregate demand (eg rises in raw material prices
or wage increases in excess of productivity gains).

Firms respond to the increases in

price AS2
costs by increasing prices. This level
causes a reduction in aggregate AS1
demand so firms reduce output.
P2
Cost-push inflation is often P1
associated with a slump. AD

Y2 Y1 GDP

Define and draw the (original) Phillips curve.

© IFE: 2019 

Phillips curve

The (original) Phillips curve showed an inverse relationship between

unemployment and inflation. It suggested that governments could choose
lower unemployment at the cost of higher inflation and vice versa.

wage
inflation
(%)

unemployment (%)

Define ‘money illusion’.

© IFE: 2019 

Money illusion

This is when people believe that a money wage or price increase represents a
real increase. In other words, they ignore or underestimate inflation.

Distinguish between demand / supply ‘shocks’ and persistent changes in

demand / supply.

© IFE: 2019 

Demand / supply ‘shocks’ and persistent changes in demand / supply

Demand and / supply ‘shocks’ are one-off events, as opposed to the continual
increases in consumption, investment etc that cause aggregate demand to
increase or the continual increases in wage that reduce aggregate supply.

They lead to a ‘single’ rise (or fall) in prices.

Examples include:
 a change in tax and benefit rates
 a rapid increase in oil prices
 a good or bad harvest
 political events.

Describe seven costs of inflation.

© IFE: 2019 

Costs of inflation

1. Menu costs, ie the costs of changing menus, vending machines etc

2. Mental arithmetic, ie the difficulties of comparing prices over time and
the problem of confusing nominal figures with real figures
3. The redistribution of income from savers to borrowers and from those in
weak bargaining positions to those in stronger bargaining positions
4. Uncertainty, causing greater business caution, which may reduce
investment and economic growth
5. The worsening of the balance of payments as exports become less
competitive
6. The greater need for resources to help businesses cope with higher
and/or more uncertain inflation
7. The possibility of hyperinflation, which could lead to the complete
collapse of an economy and its currency
© IFE: 2019
CB2 Module 12: Macroeconomic objectives
36

Give two examples of how demand-pull and cost-push inflation may interact.

© IFE: 2019 

How demand-pull and cost-push inflation may interact.

1. An initial cost-push inflation, eg due to a rise in commodity prices, may

encourage the government to expand aggregate demand to offset rises in
unemployment, leading to demand-pull inflation.

2. An initial demand-pull inflation, eg due to increased consumption, may

increase firms’ and workers’ expectations of higher inflation, leading to
higher wage increases and subsequent cost-push inflation.

Summary Card

Economic growth Cards 1 to 4

Business cycles Cards 5 to 8

Unemployment Cards 9 to 27

Inflation Cards 28 to 31, 34 to 36

Phillips curve & money illusion Cards 32 & 33

© IFE: 2019 

CB2

Module 13
CB2 Module 13: International trade and payments
1

Define ‘globalisation’.

Give four main factors that drive globalisation.

© IFE: 2019 

Globalisation

Globalisation refers to the process of developing increasing political, cultural

and economic ties between people all around the world.

Drivers of globalisation

1. market drivers – reflecting the increasing similarities between

consumers and hence markets in different countries
2. cost drivers – reflecting the potential for reducing production costs
(eg via outsourcing, economies of scale and technological innovation)
and advances in transportation
3. government drivers – such as privatisation, the removal of tariffs and
quotas and shifts to more open, free market economies
4. competitive drivers – such as global competition leading firms to adopt
global business strategies, eg via networks and alliances
© IFE: 2019
CB2 Module 13: International trade and payments
2

Give six possible benefits of globalisation.

© IFE: 2019 

Benefits of globalisation

1. increased opportunities for specialisation and the exploitation of

economies of scale, leading to increased production of goods and
services, lower prices and higher profits

2. the faster spread of technology

3. greater competition, lower prices and a wider range of goods for

consumers

4. increased investment in developing countries, leading to growth and

improvements in living standards

5. closer political ties and hence greater political stability

6. greater cultural exchange to the benefit of people in different countries

Give four possible arguments against globalisation.

© IFE: 2019 

Arguments against globalisation

Globalisation:

1. contributes to growing inequalities between countries

2. makes poor countries even poorer as multinationals exploit their

dominant position in foreign markets

3. contributes to environmental problems because rapid growth and

increased transportation cause pollution and the depletion of natural
resources

4. leads to political, economic and cultural domination by large,

multinational brands.

Outline the principal patterns and trends in the volume and value of goods and
services traded internationally over recent decades.

© IFE: 2019 

Principal patterns and trends in international trade over recent decades

The volume and value of both goods and services traded internationally have
increased significantly over recent decades.

The share of developed countries’ exports has declined over time, as that of
the developing nations, especially the BRICS countries (Brazil, Russia, India,
China and South Africa) has increased.

Describe the benefits of specialisation.

© IFE: 2019 

Benefits of specialisation

It allows countries to exploit:

 economies of scale
 their entrepreneurial and management skills
 the skills of their labour force.

It allows them to benefit from:

 their particular location
 the ownership of any particular capital equipment and other assets they
might possess.

By producing more than they need of certain products and exporting the
excess, they can used the revenues earned from exports to import products
not produced in sufficient amounts at home.

Define ‘absolute advantage’.

© IFE: 2019 

Absolute advantage

Country X has an absolute advantage over Country Y in producing a good

when Country X can produce one unit of that good using fewer scarce
resources than Country Y.

Define ‘comparative advantage’.

State the law of comparative advantage.

© IFE: 2019 

Comparative advantage

Country X has comparative advantage over Country Y in producing a good

when Country X has a lower opportunity cost of producing that good than
Country Y, ie if it has to forego fewer other goods in order to produce it.

Law of comparative advantage

This states that whenever the opportunity cost of producing a good differs
between two countries, each country can gain from trade if it produces and
exports those goods for which it faces a lower opportunity cost and imports
those goods for which it faces a higher opportunity cost.

The table below shows the number of labour-hours needed to produce

100 bottles of rum and whisky in Scotland and Jamaica.

Quantity of labour needed to produce one bottle of ...

Rum Whisky
Scotland 4 hours 2 hours
Jamaica 5 hours 5 hours

Which country has an absolute advantage in which drink?

Which country has a comparative advantage in which drink?

© IFE: 2019 

Absolute and comparative advantage example

Scotland takes fewer labour-hours to produce both rum and whisky. It

therefore has an absolute advantage in the production of both drinks.

The opportunity cost of a bottle of rum is 2 bottles of whisky for Scotland and
1 bottle of whisky for Jamaica.

The opportunity cost of a bottle of whisky is half a bottle of rum for Scotland
and 1 bottle of rum for Jamaica.

So:
 Scotland has the comparative advantage in producing whisky
 Jamaica has the comparative advantage in producing rum.

Explain why a country that specialises experiences increasing opportunity

costs and state three other limits to trade.

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Why a country that specialises experiences increasing opportunity costs

As a country increasingly specialises in one good, it will have to use resources

that are less and less suited to its production and which are more suited for
other goods. So, ever-increasing amounts of other goods have to be
sacrificed.

Other limits to trade

1. Transport costs may outweigh any comparative advantage.

2. It may be the factors of production, rather than the goods themselves,
that move from country to country.
3. Governments may restrict trade.

State:

 the formula for the terms of trade index

 three factors that could cause an improvement (ie increase) in the terms
of trade index.
.

© IFE: 2019 

Terms of trade index

index of export prices

Terms of trade index = × 100
index of import prices

The terms of trade index improves if:

1. export prices increase
2. import prices fall
3. the value of domestic currency rises (as import prices fall when
measured in the domestic currency).

Use the terms of trade and opportunity cost ratio to describe when a country
would gain by increasing specialisation and trade.

© IFE: 2019 

The terms of trade, the opportunity cost ratio and the gains by
increasing specialisation and trade

With two goods x and m, trade can be advantageous to a country so long as

the terms of trade, Px Pm , differs from the opportunity cost ratio of the two
goods, MC x MC m .

For example, if Px Pm  MC x MC m , then the country would benefit from

producing more x for export in return for imports of m, since the relative value
of producing x ( Px Pm ) exceeds the relative cost ( MC x MC m ).

NB If increasing specialisation leads to increasing opportunity costs, ie MC x

rises and MC m falls, then the gains from specialisation and trade will increase
up to the point where Px Pm  MC x MC m , at which point there are no further
gains from trade.
© IFE: 2019
CB2 Module 13: International trade and payments
12

Explain the influence of elasticities on the size of a country’s gains from trade.

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Influence of elasticities on the size of a country’s gains from trade

In general, a country’s gains from trade will be greater:

 the less elastic its own domestic demand and supply of tradable goods
 the more elastic the demand and supply of other countries.

The less elastic the domestic demand and supply of tradable goods, the
bigger will be the effect of trade on prices faced by that country.

The more the trade price differs from the pre-trade price, the bigger the gain.

List eight advantages of international trade.

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Advantages of international trade

1. It enables countries to specialise and exploit comparative advantage.

2. It enables countries to exploit economies of scale, reducing costs.
3. Countries can export goods for which the domestic supply exceeds the
domestic demand, which may be more efficient than switching
production to goods that it is less well suited to making.
4. Trade may be a driver for economic growth, especially if exports have a
high income elasticity of demand.
5. There may be political, social and cultural advantages to trade.
6. Increased competition may lead to the greater efficiency of domestic
firms.
7. Increased competition results in lower prices for consumers.
8. Increased competition leads to a greater variety and choice for
consumers.
© IFE: 2019
CB2 Module 13: International trade and payments
14

State how the abundance of resources affects a country’s comparative

advantage (CA).

List four other key reasons why countries are competitive in the production of
some products but not others.

© IFE: 2019 

How the abundance of resources affects a country’s comparative
advantage (CA)

If a country has an abundance of a particular resource, eg land, then it is likely

to enjoy a CA in products that make use of this abundant resource.
Consequently, it should specialise in the producing such products.

Other key reasons why countries are competitive in the production of

some products but not others

1. The availability and quality of resources

2. Demand conditions in the home market
3. The strategy, structure and rivalry of firms, ie competition between firms
4. The existence of related and supporting industries, ie an efficient value
chain

Outline what is meant by the ‘competitive advantage of nations’.

© IFE: 2019 

The competitive advantage of nations

This is the ability of countries to compete in the market for exports and with
potential importers to their country.

It depends on:
 the four factors listed on Card 14
 government policy.

There is also an element of chance.

Explain why China has a comparative advantage (CA) in the production of

labour-intensive manufactured goods and how this CA may change in the
future.

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China’s comparative advantage (CA)

China has enjoyed a CA due to its abundance of cheap labour, which meant
that labour costs were much lower than in Western economies.

However, in recent years higher wages, shorter hours and greater benefits
have lead to rapid increases in its labour costs.

So, in future it may need to follow the pattern of Western economies and
move up the value chain to find products it can specialise in that are not easily
transferable to lower-wage countries.

List eight methods by which governments may restrict trade.

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Methods by which governments may restrict trade

1. customs duties / tariffs (ie ad valorem / percentage taxes) on imports

2. quotas on import volumes
3. exchange controls, eg limits on how much foreign exchange is available
to importers
4. import licensing, ie requiring importers to obtain licences
5. embargoes, ie total bans on certain imports
6. administrative regulations designed to exclude imports
7. procurement policies, ie favouring domestic suppliers for government
purchases
8. dumping – where exports are sold at prices below marginal cost, often
as a result of government subsidies

 strategic trade theory

 infant industry

 optimum tariff.

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Strategic trade theory

This is the theory that protecting / supporting certain industries can enable
them to compete more effectively with large monopolistic rivals abroad.

The effect of protection is to increase long-run competition and may enable

the protected firms to exploit a comparative advantage that they could not
have done otherwise.

Infant industry

An infant industry is a new industry that has a potential comparative

advantage, but is currently not sufficiently developed to realise this potential.

Optimum tariff

A tariff that reduces imports to the point where marginal social cost equals
marginal social benefit.
© IFE: 2019
CB2 Module 13: International trade and payments
19

List four strategic trade theory arguments in favour of restricting trade.

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Strategic trade theory arguments in favour of restricting trade

1. to protect infant industries

2. to reduce the reliance on goods with little dynamic potential

3. to prevent dumping and other unfair trade practices

4. to prevent the establishment of a foreign-based monopoly

List six other economic arguments in favour of restricting trade.

© IFE: 2019 

Economic arguments in favour of restricting trade

1. to spread the risks of exposure to fluctuating markets

2. to reduce the influence of trade on consumer tastes
3. to prevent the importation of harmful goods
4. to take account of externalities
5. to take advantage of market power in world trade
6. to protect declining industries

List four non-economic arguments in favour of restricting trade.

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Non-economic arguments in favour of restricting trade

1. maintaining self-sufficiency in case trade is denied in the future

2. imposing trade sanctions on countries with which the country disagrees

politically

3. maintaining traditional ways of life, eg in rural communities

4. maintaining a diverse society based on a range of industries, rather

than one based too narrowly on certain industries

List eight problems with protection.

© IFE: 2019 

Problems with protection

1. It increases the price of goods and may restrict the choice of goods
available.
2. Imposing a tariff will lead to a welfare loss (see Cards 25 and 26).
3. It may be only the second-best course of action for a government,
eg retraining might be a better solution for declining industries.
4. It may lead to world multiplier effects due to reduced exports worldwide.
5. It may lead to retaliation from other countries, leading to reduced trade,
higher costs and less choice for consumers in both countries.
6. Protecting infant or declining industries may allow them to remain
inefficient, if they are not exposed to international competition.
7. There can be large costs involved in administering protection policies.
8. It may lead to corruption.

Draw a diagram to show how a country that has a monopoly on the supply of
a good can set the level of an export tax to maximise profits.

© IFE: 2019 

Export tax to maximise profits

£ MC = total supply
by country

P2
optimum
export P1
tax
P3

World demand

Q2 Q1 Q
MR

Draw a diagram to show how a country that has monopsony power in the
demand for an import can set the level of import tariff to maximise its gain
from trade.

© IFE: 2019 

Import tariff to maximise gains from trade

£ MC to
the country
world supply to
the country

P3
optimum
P1
tariff
P2

demand by
the country

Q2 Q1 Q

Draw a diagram to illustrate the effects of a tariff on:

 price

 the quantity of imports.

Assume that the product is produced in a perfectly competitive home market

and that imported supplies are perfectly elastic at the world price.

© IFE: 2019 

Effects of a tariff
P S dom = MC

b S world + tariff
P w+t

c d e f
S world
Pw
g
D dom

Q1 Q3 Q4 Q2 Q
imports with tariff
imports without tariff

Using the labelling in the previous diagram, identify:

1. consumer surplus before protection
2. producer surplus before protection
3. total surplus before protection
4. consumer surplus after protection
5. producer surplus after protection
6. government surplus with protection
7. total surplus after protection
8. welfare loss of protection.

© IFE: 2019 

Welfare effects of a tariff

1. consumer surplus before protection = a + b + c + d + e + f

2. producer surplus before protection = g

3. total surplus before protection = a + b + c + d + e + f + g

4. consumer surplus after protection = a + b

5. producer surplus after protection = c + g

6. government surplus with protection = e

7. total surplus after protection = a + b + c + e + g

8. welfare loss of protection = d + f

Outline the five rules that World Trade Organisation (WTO) members have to
follow.

© IFE: 2019 

World Trade Organisation (WTO) rules

1. non-discrimination (‘most-favoured nations clause’) – if a trade

concession is made to one WTO member it must be given to all
members (but concessions made within free-trade areas are excluded)

2. reciprocity – if a nation benefits from a tariff reduction it should reduce

its own tariffs

3. the prohibition of quotas

4. fair competition – a country can ask for permission to retaliate against

any trade barriers erected against it

5. binding tariffs – a country cannot raise existing tariffs without

negotiation with their trading partners

Define the balance of payments account.

List the three constituent accounts within the balance of payments.

State the fourth item that might be necessary to ensure the account balances.

© IFE: 2019 

Balance of payments account

This is the record of all economic transactions between the residents of a

country and the rest of the world for a specific time period. It records all
inflows of money as credits (+) and outflows of money as debits (–) under
various headings.

The constituent accounts within the balance of payments account are:

1. the current account

2. the capital account

3. the financial account.

The net errors and omissions item is included to make the accounts balance.

Define the current account of the balance of payments and outline its four
component parts.

© IFE: 2019 

Current account of the balance of payments

The current account records a country’s imports and exports of goods and
services, plus incomes and transfers of money to and from abroad. It has four
component parts:

1. the trade in goods account – records exports (+), less imports (–), of
physical goods (previously known as ‘visibles’), eg oil, food

2. the trade in services account – records income from (+), less

expenditure on (–), services, eg insurance, shipping

3. net income flows – rent, dividends, interest and wages earned abroad
by a country’s residents (+) and earned within the country by foreign
residents (–)

4. net current transfers of money – international transfers of money by

individuals and firms, and government contributions to (+) and receipts
(–) from international organisations
© IFE: 2019
CB2 Module 13: International trade and payments
30

Explain what is recorded in the capital account of the balance of payments.

© IFE: 2019 

Capital account of the balance of payments

This records the transfers of capital to (–) and from (+) abroad. It is divided
into two sections:

1. Capital transfers such as:

● the transfer of ownership of long-term assets
● money brought into the country by migrants
● official debt forgiveness by governments.

2. The acquisition or disposal of non-produced, non-financial assets such

as patents, copyrights, trademarks and franchises.

Define the financial account of the balance of payments and outline its four
component parts.

© IFE: 2019 

Financial account of the balance of payments

The financial account records the flows of money into (+) or out of (–) the
country for the purposes of investment or as deposits in banks and other
financial institutions.

It has four component parts:

1. direct investment in physical assets, eg in overseas subsidiaries,

factories, property

2. portfolio investment in financial securities, eg shares and bonds

3. other financial flows, eg into short-term bank deposits and loans

4. flows to and from the country’s reserves of gold and foreign currency.

Define:

 exchange rate

 exchange rate index (or effective exchange rate).

Draw a diagram to illustrate the determination of the exchange rate in a free

foreign exchange market.

© IFE: 2019 

Exchange rate

An exchange rate is the rate at which one currency trades for another on the
foreign exchange market. This is also known as the nominal exchange rate.
In a free market it is determined by the supply and demand for the currency.

$/£
An exchange rate index is a
Supply of £
weighted average of the exchange
rate of a particular currency against Excess supply of pounds
all other currencies expressed as 1.30
an index, where the weights are Shortage of pounds
based on the proportion of
transactions between each Demand for £

currency.

Q* Quantity of £ exchanged for $

Define the following terms:

 arbitrage

 floating exchange rate.

© IFE: 2019 

Arbitrage

This is buying an asset in a market where it las a lower price and selling it
again in another market where it has a higher price and thereby making a
profit.

Floating exchange rate.

A floating exchange rate occurs when the government and central bank do not
intervene in the foreign exchange markets, so the exchange rate is
determined solely by supply and demand in the currency markets.

Explain the difference between a depreciation of a currency and an

appreciation.

Draw a diagram to show a depreciation of sterling against the US dollar in

response to a change in demand and supply.

© IFE: 2019 

Depreciation and appreciation of a currency

A fall in the free market exchange rate of the domestic currency with a foreign
currency is called a depreciation.

A rise in the free market exchange rate of the domestic currency with a foreign
currency is called an appreciation.

$/£ S1
In the diagram a rightwards shift
in the supply curve and a S2
leftwards shift in the demand
1.60
curve, leads the exchange rate to
fall from $1.60/£1 to $1.40/£1.
1.40

D1
D2

Quantity of £ exchanged for $

List six possible causes of a depreciation of a currency.

© IFE: 2019 

Possible causes of a depreciation

1. a fall in domestic interest rates relative to those abroad – so ‘hot money’

would go abroad

2. higher inflation in the domestic economy than abroad – so domestic

goods are less competitive

3. a rise in domestic incomes relative to income abroad – so the demand

for imports increases (relative to exports)

4. relative investment prospects improving abroad – so investment moves

abroad

5. speculation that the exchange rate will fall – so traders sell the currency

6. longer-term changes in international trading patterns – eg due to

changes in consumer tastes or production costs
© IFE: 2019
CB2 Module 13: International trade and payments
36

Explain, by means of an example involving a rise in UK interest rates, how the

balance of payments will automatically balance without intervention in the
foreign exchange markets.

© IFE: 2019 

How the balance of payments will automatically balance without
intervention in the foreign exchange markets

Suppose that initially each part of the balance of payments balances and that
interest rates then rise.

This will lead to short-term financial inflows, as people abroad deposit money
in the UK to enjoy the higher returns, and a rise in the demand for pounds. In
addition, UK residents will keep more of their money in the UK and so financial
outflows from the UK will decrease, leading to a fall in the supply of pounds.
Consequently, the financial account will go into surplus and the pound will
appreciate.

However, this will cause imports to become cheaper and exports to become
more expensive, so the current account will move into deficit. Consequently,
there will be a movement up along the new demand and supply curves until a
new equilibrium is reached at which any financial account surplus is matched
by an equal current deficit.
© IFE: 2019
CB2 Module 13: International trade and payments

Summary Card

Globalisation Cards 1 to 4

Absolute & comparative advantage Cards 6 to 9, 16

Terms of trade Cards 10 to 12

Specialisation & the benefits of trade Cards 5, 13 to 15

Restrictions on trade & the WTO Cards 17 to 27

Balance of payments Cards 28 to 31

Exchange rates Cards 32 to 36

© IFE: 2019 

CB2

Module 14
CB2 Module 14: The financial system and the money supply
1

State the four constituent parts of a financial system.

© IFE: 2019 

Constituent parts of a financial system

1. money
2. the financial markets
3. banks
4. financial institutions and instruments

List five factors that enhance the effectiveness of a financial system.

© IFE: 2019 

Factors that enhance the effectiveness of a financial system

1. greater investor participation

2. competition among institutions
3. lower costs
4. correct security pricing
5. fair play in trading

Outline the role of each of the following in a financial system:

 financial markets
 financial instruments
 financial institutions
 regulatory authorities.

© IFE: 2019 

Financial markets
Financial markets where instruments are traded determine the prices of
securities and enable the allocation of capital.

Financial instruments
Financial instruments, such as shares and bonds transfer resources from
savers to investors.

Financial institutions
Financial institutions offer a wide range of financial products and services and
act as financial intermediaries.

Regulatory authorities
Regulatory and supervisory authorities enforce rules to protect investors,
eg they promote participation in financial markets by ensuring that it is
perceived by investors to be fair.
© IFE: 2019
CB2 Module 14: The financial system and the money supply
4

Outline the evolution of financial systems in Western economies.

© IFE: 2019 

The evolution of financial systems in Western economies

Changes have included:

 financial integration
 globalisation
 deregulation
 financial innovation.

These changes have altered the operation and impact of the financial system
on the rest of the economy.

Financial integration and globalisation have yielded great benefits such as

greater productivity, higher liquidity, capital mobility and economic growth, but
have also increased international financial interdependence and systemic risk.

Outline the evolution of the UK financial services industry since the 1980s.

© IFE: 2019 

The evolution of the UK financial services industry since the 1980s

In the 1980s substantial reforms, such as deregulation of the banking sector

and the Big Bang, led to a more competitive environment and enabled both
existing and new banks to compete effectively with foreign banks.

A more competitive environment and a higher degree of financial innovation in

financial instruments and markets made London one of the world’s most
important financial centres.

However, banks’ excessive risk-taking, insufficient regulatory constraint and

introduction of complex financial products contributed to the financial crisis of
2008.

Major restructuring of regulatory framework and new regulation after the

financial crisis was aimed at protecting investors, restoring investor confidence
and enhancing the future stability of the financial system and the economy.

Outline the evolution of financial systems in China.

© IFE: 2019 

The evolution of financial systems in China

In its move towards a market-oriented economy, China has undertaken

reforms of its banking sector where the main commercial banks are listed on
stock exchanges and play a key role in China’s economic growth.

These reforms have resulted in China’s banking sector becoming one of the
world’s largest.

Development of an efficient banking sector together with developing its

financial markets and financial instruments will enable it to move towards
achieving its economic objectives.

Outline the evolution of Islamic finance.

© IFE: 2019 

The evolution of Islamic finance

A new development in finance since the 1970s has been the growth of Islamic
finance, practised in the Islamic world.

Islamic banking complies with Islamic law (called Sharia), which prohibits
Riba, generally interpreted as ‘interest on money’.

In the 1970s, a number of Islamic banks were formed that carried out
Sharia-compliant transactions. The number of banks and Islamic institutions
has grown since, and Islamic banking is expected to continue its growth into
the future.

Give the five main services provided by financial intermediaries.

© IFE: 2019 

The main services provided by financial intermediaries

1. expert advice to customers

2. expertise in channelling funds
3. maturity transformation, ie the transformation of funds from short-term
savers to long-term borrowers
4. risk transformation, ie the spreading of risk.
5. transmission of payments by the use of cheques, debit cards, direct
debits, internet banking etc.

Outline the roles of retail banks, wholesale banks and building societies.

© IFE: 2019 

Retail banks

Provide banking services for individuals and businesses at published rates of

interest and charges, via branch networks, postal, telephone and internet
banking.

Wholesale banks

Deal in large scale deposits and loans, mainly with companies and other
banks and financial institutions. Interest rates ands charges may be
negotiable.

Building societies

Specialise in providing mortgages for house purchase, as well as current

account, savings accounts and other retail banking services for their
members.

Give the five main liabilities of retail banks.

© IFE: 2019 

Liabilities of retail banks

1. sight deposits – which can be withdrawn on demand without penalty,

eg current accounts

2. time deposits – which require notice of withdrawal or where a penalty is

charged for instant withdrawal, eg savings accounts

3. certificates of deposit (CDs) – tradable certificates issued by banks for

fixed-term, interest-bearing deposits made by customers (usually firms
and other banks)

4. sale and repurchase agreements (repos) – an agreement between two

financial institutions whereby one borrows from the other by selling its
assets, agreeing to buy them back at a fixed price on a fixed date

5. capital and other funds – the amount contributed by the shareholders

Give the five main assets of retail banks.

© IFE: 2019 

Assets of retail banks

1. cash – to meet customers’ demands

2. deposits at the central bank – in the form of reserve balances (for

clearing purposes) and cash ratio deposits (required in the UK by the
Bank of England, which earn no interest and cannot be withdrawn on
demand)

3. short-term loans such as market loans, bills of exchange (bank bills and
Treasury bills) and reverse repos

4. longer-term loans - advances to customers (personal and business) in

the form of fixed-term loans, overdrafts, outstanding balances on credit
cards and mortgages

5. investments - often in government bonds or “gilts” (fixed-interest loans

to government) with less than 5 years to redemption
© IFE: 2019
CB2 Module 14: The financial system and the money supply
12

Define:
 liquidity
 the liquidity ratio
 the maturity gap.

Comment on the relationship between:

 the maturity gap and profitability
 the maturity gap and liquidity.

© IFE: 2019 

Liquidity and the liquidity ratio

The liquidity of an asset is the ease with which it can be converted into cash
without loss.

The liquidity ratio is the proportion of a bank’s assets held in liquid form.

Maturity gap and its relationship to profitability and liquidity risk

The maturity gap is the difference in the average maturity of loans and
deposits.

The larger the maturity gap, the greater the profitability.

The larger the maturity gap, the lower the liquidity.

Explain the conflict between liquidity and profitability for banks.

© IFE: 2019 

Conflict between liquidity and profitability for banks

 Banks would like to lend out as much as possible on a long-term basis

because long-term loans are typically more profitable.

 However, they need to maintain sufficient liquidity to be able to meet

their customers’ demands for cash.

 They therefore have to balance their desire for profitability (requiring a

low liquidity ratio) with the need to avoid a financial panic (requiring a
high liquidity ratio).

Define:

 secondary marketing

 securitisation

 special purpose vehicle (SPV)

 collateralised debt obligations (CDOs).

© IFE: 2019 

Definitions related to securitisation

The secondary marketing of assets is the sale of assets before maturity. The
main example is securitisation.

Securitisation is the process of pooling assets, such as loans or mortgages,

and selling marketable securities, such as bonds, backed by these assets.

A special purpose vehicle (SPV) is a legal entity created by a financial

institution for conducting a specific financial function, such as securitisation.

Collateralised debt obligations (CDOs) are fixed-income bonds backed by a

range of assets, eg corporate bonds, mortgage debt and credit-card debt,
issued as part of a securitisation.

Explain, using the example of certificates of deposits (CDs), how secondary

marketing can reconcile the conflicting objectives of liquidity and profitability.

© IFE: 2019 

How secondary marketing can reconcile the conflicting objectives of
liquidity and profitability

The secondary marketing of assets can enable banks to maintain/reduce the

maturity gap for liquidity purposes, but to increase/maintain the gap for
profitability purposes.

For example, if a bank raises funds by issuing CDs (rather than attracting
further sight deposits), it has an illiquid liability since it won’t have to pay the
bearers of the CDs until the end of the period, eg a year. It can therefore
increase the proportion of illiquid assets without increasing the maturity gap.

However, because CDs are liquid to the holder, (ie they can be sold at any
time), the bank can pay a low rate of interest, and therefore increase
profitability.

Draw a diagram to show the financial institutions and the financial instruments
involved in the securitisation process.

© IFE: 2019 

The securitisation process

Sells assets, Sells

eg mortgages CDOs

Bank A
SPV Investors
(originator)

Buys Buy
assets with CDOs
cash with cash

Define:
 sub-prime debt
 capital adequacy and the capital adequacy ratio.

Explain the importance of capital adequacy, especially when banks hold

holding increasing amounts of sub-prime debt.

© IFE: 2019 

Sub-prime debt and capital adequacy

Sub-prime debt is debt with a high risk of default by the borrowers,

eg mortgages granted to low-income earners.

Capital adequacy is a measure of a bank’s capital (ie share capital and

shareholder reserves) relative to its assets, where the assets are weighted
according to the degree of risk.

bank ’s capital (reserves and shares )

capital adequacy ratio =
risk-weighted assets

The riskier the assets, the greater the capital required. So, if banks hold
increasing amounts of sub-prime debt, they require more capital to allow them
to meet all demands from depositors and to cover losses if sub-prime
borrowers default on payment.

Explain why securitisation can lead to the problem of moral hazard.

© IFE: 2019 

Why securitisation can lead to the problem of moral hazard

By pooling the underlying loans or mortgages, securitisation reduces the cash

flow risk facing investors.

In addition, securitisation enables the originator banks to pass the risk of

default on the underlying mortgages onto the buyers of the CDOs.

It may therefore encourage banks to lower their credit criteria by offering

higher income multiples (advances relative to household incomes) and/or
higher loan to values (advances relative to the price of housing), thereby
increasing the overall risk of default..

Discuss the potential adverse effects of securitisation on the banking system.

© IFE: 2019 

Potential adverse effects of securitisation on the banking system

1. A lower liquidity ratio throughout the banking system might lead to an

excessive expansion of credit, resulting in asset price bubbles.

2. A moral hazard problem occurs, in that banks might be tempted to take

greater risks in their lending.

3. There is increased systemic risk of banking collapse because:

– of the lower liquidity ratio throughout the banking system
– the fortunes of the banks are even more intertwined.

Explain the role of securitisation in the financial crisis of 2008.

© IFE: 2019 

The role of securitisation in the financial crisis of 2008

Securitisation enabled a massive increase in bank lending in the 2000s,

including to sub-prime household borrowers.

In 2006, higher interest rates lead to many of these borrowers defaulting on

their loans.

This lead to losses for the holders of the securitised bonds (CDOs), who
included financial institutions in many different countries.

This is turn lead to a deterioration of banks’ balance sheets globally, the

collapse in the demand for securitised assets ands a drying up of liquidity in
world-wide money markets.

List the six functions of the central bank.

© IFE: 2019 

Functions of the central bank

1. issuer of notes

2. banker to the government, to the banks and to overseas central banks

3. operator of the government’s monetary policy, eg by using open market

operations to influence short-term interest rates

4. provider of liquidity, as necessary, to the banks via the money market,

ie it acts as a ‘liquidity backstop’ should banks have insufficient liquidity

5. oversees activities of banks and other financial institutions. It requires

all banks to maintain adequate liquidity (prudential control) and is
responsible for macro-prudential regulation (which focuses on the
overall stability of the financial system and its resilience to shocks).

6. operator of the country’s exchange rate policy, via the exchange

equalisation account (the gold and foreign currency reserves account)
© IFE: 2019
CB2 Module 14: The financial system and the money supply
22

Distinguish between the capital markets and the money markets.

© IFE: 2019 

Capital market

This is the market where longer-term debt instruments, like government bonds
(gilts), can be bought and sold.

Money market

This is the market for short-term loans between banks, the government and
industry. It is divided into:
– the discount and repo markets, ie the discount market (for trading
Treasury bills and corporate bills) and the repo market for sale and
repurchase agreements
– the parallel money markets, eg for certificates of deposit (CDs), foreign
currency and inter-bank lending

Explain the role of the Bank of England as ‘lender of last resort’.

© IFE: 2019 

Lender of last resort

This is the role of the Bank of England as the guarantor of sufficient liquidity in
the monetary system.

If banks are short of cash:

1. they can sell gilts to the Bank of England (in exchange for cash) with an
agreement to buy them back at a fixed price at a fixed date, ie repo
arrangements

2. the Bank of England will buy back Treasury bills from them before
maturity (and at a price below the face value), ie rediscounting.

Explain what is meant by an asset bubble and give an example of one.

© IFE: 2019 

Asset bubble

This is a period during which asset prices increase rapidly over a short period
of time, normally due to speculation.

Such bubbles typically ‘burst’ leading to a subsequent dramatic fall in asset

prices.

Examples include:
 ‘tulipmania’ in 17tth century Holland
 the Wall Street crash of the 1920s
 the dot com bubble in 2000.

Explain what is meant by a banking crisis and how such crises can arise.

© IFE: 2019 

Banking crises

A banking crisis occurs when a large number of banks fail or come very close
to failure.

Such crises are caused by an asset bubble where banks lend to those
investing in an asset with a rapidly rising price, expecting the price rise to
continue.

When the price of the asset reaches an unrealistic level and buyers are no
longer prepared to purchase the asset, the bubble bursts. Falling asset prices
lead to losses for the investors and undermine confidence in the banks that
lent to them.

A run on one bank will cause the depositors and lenders to lose confidence in
the safety of their money with other banks and result in widespread bank
failure.

Define financial market contagion.

© IFE: 2019 

Financial market contagion

Financial market contagion refers to the spread of financial difficulties between

banks and hence throughout the financial system.
.
The problem arises because as banks try to sell assets quickly to repay the
depositors/investors, the forced sales reduce the price of these assets.

Since other banks and financial institutions hold similar assets, the falling
prices also force these banks to sell assets at reduced prices causing even
more banks to run into serious difficulty and leading to severe disruption of the
financial system.

Outline, with the aid of an example, the factors affecting a country’s ability to
respond to a banking crisis.

© IFE: 2019 

The factors affecting a country’s ability to respond to a banking crisis

Countries can respond well to crises if they are better prepared in terms of
sound economic conditions and healthy government finances. These will
allow traditional economic policy tools to offset the effect of external shocks.

For example, a policy to expand the economy would lead to problems with the
balance of payments, placing downward pressure on the exchange rate,
potentially depleting foreign currency reserves.

So, a government’s ability to adopt a policy to stimulate the economy is limited

if the foreign reserves are low. This may be problematic if the government is
pursuing an exchange rate target.

Outline the failings of classic economic theory.

© IFE: 2019 

The failings of classic economic theory

Economics is the study of human behaviour and assumes humans make

decisions rationally and not based on emotions.

Since the crisis of 2008, psycho-analysts have begun to take more note of the
behaviour of the participants in the stock market and have discovered human
emotions have a critical impact on financial markets.

The classic economic theory focuses on explaining the way that economic
agents behave but it does not concern itself with whether the result is good or
bad, moral or ethical.

The crisis has generated discussion by focusing attention on ethical issues.

For example, the rescue of the major banks by governments has caused the
debate about moral hazard and private gain/public loss.

Describe the four main functions of money.

© IFE: 2019 

The main functions of money

1. a medium of exchange – ie as something that is generally acceptable

as a means of payment

2. a means of storing wealth – as money can be saved

3. a means of evaluation – as it allows values to be compared and allows

values to be added together. It is a ‘unit of account’.

4. a means of establishing the value of future claims and payments – such

as pension liabilities

Define the following terms relating to the money supply:

 monetary base

 broad money

 the bank deposits multiplier

 the money multiplier.

© IFE: 2019 

Money supply definitions

 The monetary base (or narrow money) consists of notes in circulation

outside the central bank.

 Broad money consists of cash in circulation plus retail and wholesale

bank and building society deposits.

 The bank deposits multiplier is number of times greater the expansion

of bank deposits is than the additional liquidity in the banks that causes
1
it ie , where L is the liquidity ratio.
L

 The money multiplier is the number of times greater the expansion of

the money supply is than the expansion of the monetary base that
caused it.

State the formula for the money multiplier.

Give two reasons why the money multiplier is typically smaller than the bank
multiplier.

© IFE: 2019 

Money multiplier formula

1 c
m
r c

where:
 r = fraction of any increase in banks’ deposits held as reserves
 c = fraction of any rise in publics’ deposits held as cash.

Why money multiplier is typically less than the bank multiplier

1. Firms and households may choose not to borrow as much as banks are
willing to lend.

2. Some of the extra cash created by lending may be retained by firms

and households and held outside of the banking system, so an initial
deposit will have less impact on total deposits.

Give three complications affecting the credit creation process, which mean
that in practice it is difficult to predict accurately the effect of an increase in the
monetary base on the broad money supply.

© IFE: 2019 

Monetary base and the broad money supply

In practice, it is difficult to predict accurately the effect of an increase in the

monetary base on the broad money supply because:

1. Banks’ liquidity ratios might vary, eg seasonally, with general credit

conditions or according to the mix of liquid assets that they hold.

2. Firms’ and households’ willingness to borrow may vary unpredictably.

3. The proportion of any extra cash that is retained by firms and

households outside of the banking system may vary unpredictably.

List the five main causes of changes in the money supply.

© IFE: 2019 

Main causes of changes in the money supply

1. a change in the monetary policy pursued by the central bank

2. changes in banks’ liquidity ratios

3. a change in firms’ and households’ holdings of cash

4. an inflow (or outflow) of funds from (or to) abroad

5. a public sector deficit

Summary Card

Financial systems Cards 1 to 8, 22

Banks & banking Cards 9 to 11

Liquidity, capital adequacy & regulation Cards 12, 13, 17

Securitisation & secondary marketing Cards 14 to 16, 18 to 20

The central bank Cards 21, 23

Banking crises Cards 24 to 28

Money: functions, definitions & credit creation Cards 29 to 33

© IFE: 2019 

CB2

Module 15
CB2 Module 15: The money market and monetary policy
1

Explain, with the aid of a diagram, what is meant by an exogenous money

supply.

© IFE: 2019 

Exogenous money supply

An exogenous money supply is a rate of interest Ms

money supply that does not
depend on interest rates.

It is assumed to be determined
solely by the authorities (the
government or the central bank),
so the money supply curve is
vertical.

quantity
of money

Explain, with the aid of a diagram, what is meant by an endogenous money

supply.

© IFE: 2019 

Endogenous money supply

An endogenous money supply is a rate of interest Ms

money supply that depends (in
part) on interest rates.

An increase in interest rates will

encourage banks to lend more, as
it may be more profitable to do so.
So, the money supply curve slopes
upwards.

quantity
of money

State the three motives for holding money.

© IFE: 2019 

Motives for holding money

1. the transactions motive, ie for buying everyday goods and services

2. the precautionary motive, ie in case of unexpected expenditures, such as

a car breakdown

3. the speculative (or asset) motive, ie as a form of storing wealth. Money

will be compared with alternative assets, such as bonds and shares, in
terms of risk and return.

List the five factors affecting the transactions and precautionary demands for
money.

© IFE: 2019 

Factors affecting the transactions and precautionary demands for
money

1. money national income

2. the frequency with which people are paid

3. seasonality and other factors that affect consumption

4. the rate of interest, which may encourage people to save more

5. financial innovations, eg the increasing use of credit cards, debit cards

etc

Outline the three factors affecting the speculative (or asset) demand for
money.

© IFE: 2019 

Factors affecting the speculative (or asset) demand for money

1. The rate of interest (or return) on alternative assets

The higher the rate of return on shares and bonds, the higher the
opportunity cost of holding money and the smaller is the speculative
demand for money.

2. Expectations of changes in the prices of securities and other assets

For example, if share prices are expected to rise, people will buy shares
and hold smaller speculative money balances.

3. Expectations of changes in the value of the currency

For example, if investors believe the pound is likely to appreciate, they

may want to hold pounds to take advantage of that appreciation.

Outline two additional effects of expectations on the total demand for money.

© IFE: 2019 

Additional effects of expectations on the total demand for money

1. Expectations about prices

If people expect prices to rise, they may reduce their money balances
and buy goods and assets now, before their prices rise.

2. Expectations of interest levels over the longer term

If current interest rates are seen as low compared to their ‘normal’ long-
term level, then they may hold speculative balances in anticipation of a
rise in interest rates.

Draw the:
 demand for active money curve
 demand for idle money curve
 demand for money or ‘liquidity preference’ curve.

© IFE: 2019 

Demand for money curves

rate of interest

L = L1 + L2

L2
L1
quantity of money

L1 = active balances (transactions and precautionary motives)

L2 = idle balances (speculative purposes)
L = total money demand
© IFE: 2019
CB2 Module 15: The money market and monetary policy
8

Draw diagrams of the money market to show the effects of:

 an increase in the money supply on the interest rate

 an increase in the demand for money on the interest rate.

Assume that the money supply is endogenous.

© IFE: 2019 

Money market diagrams

rate of interest M s1 M s2 rate of interest

r1 r1 L2
r2
L L1

Q1 Q2 quantity Q1 Q2 quantity
of money of money

An increase in the money supply An increase in the demand for money

Give three reasons why an increase in the money supply causes a reduction
in the domestic exchange rate.

© IFE: 2019 

Effect of an increase in the money supply

The domestic exchange rate will fall because:

1. part of the excess money balances will be spent on foreign assets,

thereby increasing the supply of the domestic currency on the foreign
exchange market

2. the rate of return on domestic assets will fall relative to those on foreign
assets, causing a reduction in the demand for domestic assets and
hence a reduction in the demand for the domestic currency

3. speculators expect the domestic currency to depreciate, so they sell it

and buy foreign currencies.

Outline the three possible approaches to the role of the central bank in
monetary policy and give an example of each.

© IFE: 2019 

Possible approaches to the role of the central bank

1. The government sets both the policy target and decides the measures
necessary to achieve it, eg the interest rate. This approach was used in
the UK until 1997

2. The government sets the policy targets, but the central bank is given
independence in deciding the interest rates need to achieve it. This is
the current approach in the UK.

3. The central bank is given independence to set the policy target and also
in deciding the measures needed to achieve it. This is the approach
used in the Eurozone.

State the two key influences on monetary growth over the medium and long
term and explain how they could be controlled to reduce monetary growth.

© IFE: 2019 

Key influences on monetary growth over the medium and long term

Key influences on monetary growth are banks’ liquidity ratios and public sector
deficits.

1. The central bank could control the liquidity of banks by imposing a

statutory minimum reserve ratio (a liquidity ratio of cash and other liquid
assets to deposits) on the banks, above the level that the banks would
freely choose. This would prevent banks from reducing their liquidity
ratios and expanding credit.

2. The government could control public sector deficits and reduce the
need for government borrowing. Some forms of government borrowing
increase the money supply (eg selling Treasury bills to the banks).
Although a pure fiscal expansion (ie one that does not increase the
money supply) is possible, it would cause higher interest rates and
financial crowding out, so may not be desirable.

Outline, with reference to the neutrality of money, the link between long-term
monetary control and inflation.

© IFE: 2019 

Link between long-term monetary control and inflation

It is argued that in the long run, a change in the money supply will ultimately
be reflected by a change in the general level of prices. However, it will not
lead to permanent changes in real variables such as output and employment,
which depend on real factors such as technology.

This principle is referred to as the long-run neutrality of money.

It underlies much economic thinking and suggests that in order to keep

inflation under control it is important to control the money supply.

Moreover, short-term monetary expansion must not be allowed if long-term

monetary control is to be achieved.

Give three categories of monetary measures that may be used to tighten

monetary policy in the short term.

© IFE: 2019 

Monetary measures to tighten monetary policy

1. reducing the money supply, rate of interest M s2 M s1

which will increase interest
rates (see diagram)

2. increasing interest rates (and

then reducing the money
supply) r2
r1
L
3. rationing the credit offered by
financial institutions, so that
the money supply falls without Q2 Q1 quantity
increasing interest rates. of money

State the two broad approaches to controlling the money supply.

© IFE: 2019 

Broad approaches to controlling the money supply

1. altering the level of liquidity in the banking system, on which credit is

created

2. altering the size of the bank deposits multiplier, by altering the ratio of
reserves to deposits

Outline four techniques that the central bank can use to reduce banks’ liquidity
and hence the money supply.

© IFE: 2019 

Techniques to reduce banks’ liquidity and the money supply

1. open market operations, whereby the central bank sells government

securities in the open market to reduce banks’ liquidity

2. reducing the amount it is willing to lend to banks, to reduce the banks’

cash / liquid assets, and/or raising the interest rate at which it lends to
banks, so reducing their willingness to borrow from it

3. funding, whereby it increases the balance of long-term government

bonds (illiquid) to short-term Treasury bills (liquid) for a given level of
government borrowing

4. raising the minimum reserve ratio (the ratio of cash and other liquid
assets to deposits) that a bank is required to maintain, so reducing the
amount of bank lending possible for a given quantity of liquid assets

Explain why it may be difficult for the central bank to control the monetary
base.

© IFE: 2019 

Why it may be difficult to control the monetary base

Banks could choose to deliberately hold excess cash, so that they could
respond to any restriction of cash by reducing their cash ratio, rather than
reducing lending.

If the minimum cash ratio doesn’t apply to all financial institutions, then some
lending many shift to uncontrolled institutions, including those overseas,
ie disintermediation may occur, and domestic banks may lend to domestic
customers using foreign money markets, thus shifting business abroad.

If banks subject to the cash ratios are short of cash, they could attract cash
away from the uncontrolled financial institutions, or by offering higher interest
rates to individual depositors, so as to expand their cash reserves.

The central bank is always prepared to provide cash to banks via repos and/or
rediscounting if it is demanded.

Explain why it may be difficult for the central bank to control the broad money
supply and the problems with doing so.

© IFE: 2019 

Difficulties and problems with controlling the broad money supply

The value of the money multiplier varies unpredictability, eg if banks vary their
liquidity ratios, so changes in the monetary base due to open market
operations (OMO) can have unpredictable effects on the broad money supply.

Potential purchasers of bonds under OMO may hold off buying them if they
believe interest rates will rise in the future, so a large immediate rise in bond
interest rates may be required.

In times of recession, when the central bank wants to expand the broad
money supply, people might not want to borrow and spend and banks may be
reluctant to lend.

Changing the money supply can lead to large fluctuations in interest rates,
especially if money demand is inelastic and or variable, leading to uncertainty
and reduced investment and growth.

Explain how the central bank can control interest rates, assuming it decides to
raise them, and discuss how this will affect interest rates more generally.

© IFE: 2019 

How the central bank can control interest rates

In order to increase interest rates, the central bank will announce the increase
in interest rates and then create a shortage of banking liquidity (eg by open
market operations).

It will then, in its role as lender of last resort, raise the interest rate (bank rate)
at which it lends to the banks (through the repo rate and the Treasury bill
rediscount rate).

This will lead to higher interest rates generally throughout the banking system,
However, changes in the bank rate will not necessarily have an identical effect
on other interest rates, which will also reflect the supply of short-term lending
and borrowing in the wider money market and the wider macroeconomic
environment.

Give two reasons why interest rates may be ineffective at controlling credit.

© IFE: 2019 

Why interest rates may be ineffective at controlling credit

1. The demand for money is insensitive to interest rates. If this is the

case, a large rise in interest rates will be required to reduce the demand
for money, which may have adverse effects elsewhere in the economy.

2. The demand for money may vary greatly and unpredictably due to
speculation, with regard to:
 interest rates
 the exchange rate
 inflation
 economy growth.

List five problems with high interest rates.

© IFE: 2019 

Problems with high interest rates

High interest rates may:

1. reduce long-term investment and hence long-term economic growth

2. add to production costs and hence inflation in the short run

3. be politically unpopular

4. require the issue of high-interest rate bonds, which the government

must service in future years

5. attract inflows of money from abroad, increasing the exchange rate and
making imports more attractive and exports less competitive.

Discuss the effectiveness of monetary policy in influencing the level of

aggregate demand (AD).
.

© IFE: 2019 

The effectiveness of monetary policy in influencing aggregate demand

It is particularly weak when it’s pulling against the expectations of firms and
households and when it is implemented too late.

However, a tight monetary policy will eventually reduce lending and aggregate
demand.

An expansionary policy is less reliable, though, as in a recession, firms and

households cannot be forced to borrow, no matter how low interest rates go.

A particular difficulty arises with cutting interest rates, when very low rates fail
to stimulate the economy, as they cannot be negative.

However, interest rates can be changed quickly, unlike fiscal and can be used
to signal a commitment to reduce inflation and so influence expectations..

State the two main policy responses of the Bank of England and the European
Central Bank (ECB) to the financial crisis of 2008.

© IFE: 2019 

The responses of the Bank of England and the ECB to the financial crisis

1. The bank of England and the ECB both cut their lending rates to record
low levels.

2. They both also undertook quantitative easing (see Card 23) in order to
increase the money supply.

Define quantitative easing.

© IFE: 2019 

Quantitative easing

Quantitative easing involves a deliberate attempt by the central bank to increase

the money supply by buying large quantities of securities (eg securitised
mortgage and other private sector debt or government bonds), through open
market operations.

It aims to:
 drive up bond and other asset prices, so reducing borrowing costs
throughout the economy and increasing C and I
 increase the money supply by increasing banks’ liquidity and hence their
lending to firms and households.

NB The increased asset prices (and resulting higher wealth) may also lead to
higher AD and increased demand for loans.

Summary Card

The supply of money Cards 1 to 2

The demand for money Cards 3 to 7

Money market diagram Card 8

Monetary policy Cards 9 to 21

Monetary policy responses to the financial crisis Cards 22 & 23

© IFE: 2019 

CB2

Module 16
CB2 Module 16: Classical and Keynesian theory
1

Explain why, according to classical theory, savings equals investment.

© IFE: 2019 

Why, according to classical theory, savings equals investment

This would be brought about by flexible interest rates in the market for
loanable funds, ie the market for loans and deposits into the banking system.

The investment demand from firms to finance new plant and equipment
represents a demand for loanable funds, whilst savings represents a supply of
loanable funds.

Real interest rates (ie nominal interest rates adjusted for inflation) will adjust
until the demand for and supply of loanable funds are the same, ie the market
for loanable funds is in equilibrium, with S = I.

Define the ‘gold standard’.

© IFE: 2019 

Gold standard

The system whereby:

 countries’ exchange rates were fixed in terms of a certain amount of
gold
 balance of payments deficits were paid in gold.

Explain why, according to classical theory, imports equals exports.

© IFE: 2019 

Why, according to classical theory, imports equals exports

Suppose a country had a trade deficit, ie M > X.

Under the gold standard, the deficit had to be paid for in gold from its
reserves. The country was then supposed to respond to this outflow of gold
by reducing the amount of money in the economy and hence reducing total
expenditure.

This would create surpluses in the goods and labour markets, leading to falls
in prices and wages.

The resulting fall in the prices of domestic goods would increase exports and
reduce imports until the deficit was eliminated, ie until M = X.

Explain why, according to classical theory, there will be no deficiency of

demand (and therefore no unemployment).

© IFE: 2019 

Why, according to classical theory, there will be no deficiency of
demand and no unemployment

Classical economists argued that flexible interest rates and prices, as well as
the gold standard, would ensure that S = I and that M = X.

Thus, if the government were to balance its budget and make T = G, total
withdrawals would equal total injections, ie W = J.

Consequently, there would be no deficiency of demand and full employment.

State and justify ‘Say’s law’.

© IFE: 2019 

Say’s law

Supply creates its own demand, ie the production of goods will generate
sufficient demand to ensure that they are sold.

Consequently, there will be no deficiency of demand and full employment.

This is because when firms produce goods, they pay out money to other firms
and income to households (as factor payments). This income is partly paid
back to firms as consumption expenditure ( Cd ) – the inner circular flow of
income.

But any withdrawals are also fully paid back to firms as injections, since S = I,
M = X and T = G. So, all incomes generated by firms’ supply will be
transformed into demand for their products and so there will be no deficiency
of demand and no unemployment.

State the ‘equation of exchange’ (or quantity equation).

Describe the assumptions and the main prediction of the ‘quantity theory of
money’.

© IFE: 2019 

The equation of exchange and the quantity theory of money

The equation of exchange is:

MV = PY

where:
 M is the money supply
 V is the velocity of circulation (the average number of times per year
that the money is spent on goods and services that make up GDP)
 P is the price level, expressed as an index
 Y is real national income (or real GDP).

The quantity theory of money assumes that V and Y are stable, and that any
increase in the money supply leads to a proportionate increase in prices.

Define the ‘neutrality of money’.

Explain why, according to classical theory, an increase in the money supply

causes inflation.

© IFE: 2019 

Neutrality of money

The principle that changes in the money supply affect only nominal variables
(ie prices) and have no affect on real variables (eg real GDP).

Why, according to classical theory, an increase in the money supply

causes inflation

Classical economists argued that as V and Y were determined independently

of the money supply, they could be assumed to be constants in the equation
of exchange. Consequently, increases in the money supply simply led to
inflation and would not affect real variables, such as output.

State three main causes of the Great Depression in the UK in the 1930s.

© IFE: 2019 

Main causes of the Great Depression in the UK in the 1930s

1. The return to the gold standard at the pre-war rate of £1=$4.86, coupled
with the loss of export markets during the war and a rise in imports to
rebuild the economy, led to a severe trade deficit.

2. Deflationary policies introduced to drive down wages and increase the

competitiveness of exports led to a severe recession.

3. The Wall Street crash of 1929 led to a US slump. The resultant world
slump reduced international trade, including UK exports, leading to a
deeper depression.

Outline the classical (Treasury) view of the following policies to combat the
depression:
 encouraging wage cuts
 encouraging saving
 public works projects.

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Classical (Treasury) view of encouraging wage cuts

This would reduce prices and restore export demand, so correcting the
balance of payments.

Classical (Treasury) view of encouraging saving

This would lead to lower interest rates and more investment and hence a
growth in output and the demand for labour.

Classical (Treasury) view of public works projects

Public works (eg building roads and houses) would not reduce unemployment,
but could have costly side effects, such as crowding out private sector
expenditure and higher inflation.

Define ‘crowding out’, with reference to:

 resource crowding out
 financial crowding out.

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Crowding out

This is where increased public expenditure diverts money or resources away

from the private sector.

Resource crowding out

This is when the government uses resources, eg labour, that would otherwise
be used by the private sector. It’s less of a problem when there is slack in the
economy, and hence unemployed resources.

Financial crowding out

This occurs when extra government spending diverts funds from private sector
firms, depriving them of the finance necessary for investment. The demand
for extra borrowing by the government is likely to drive up interest rates
generally.

Use the AD-AS model to explain why classical economists believed that the
long-run AS curve is vertical.

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Why classical economists believed that the long-run AS curve is vertical

In the short run, an increase in the price LRAS

AD leads to a rise in output level, p SRAS2
and prices.
SRAS1

However, nominal wages will

eventually increase, leading to a p3
fall in SRAS. p2
p1 AD2
AD1
So, ultimately, output falls back to
its potential (or natural) level of YP Y2 GDP (Y)
real output, Yp .

Explain how Keynes criticised the classical policy of cutting wages.

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Keynes’ criticisms of the classical policy of cutting wages

 Wages are ‘sticky’ downwards, as workers would resist wage cuts.

 Consequently, they would not fall far or fast enough to clear the labour
market and eradicate demand-deficient unemployment.

 In addition, reducing wages would reduce consumption and hence

aggregate demand.

Explain how Keynes criticised the classical loanable funds theory.

© IFE: 2019 

Keynes’ criticisms of the classical loanable funds theory

 Although encouraging saving might decrease interest rates and hence

encourage some investment, it would also reduce consumption and
hence aggregate demand.

 This, in turn, would reduce business confidence and hence investment.

 In addition, savings and investment might be very insensitive to

changes in interest rates.

Explain how Keynes criticised the classical quantity theory of money.

© IFE: 2019 

Keynes’ criticisms of the classical quantity theory of money

 Keynes argues that if there is slack in the economy, then increasing the
money supply might lead to increased spending and substantial
increases in real income (Y), with little effect on prices (P).

 Conversely, the major effect of cutting the money supply to reduce

prices might be to reduce output and employment instead.

Explain how Keynes criticised Say’s law and also outline his main conclusion
and policy recommendation.

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Keynes’ criticisms of Say’s law

 Keynes argued that it was demand that created supply.

 If AD rose, firms would respond by producing more and employing more

people. Conversely, a fall in AD would lead to less output and higher
unemployment.

Main conclusion and policy recommendation

 His main conclusion was that an unregulated market economy could not
ensure sufficient demand.

 Governments should therefore abandon laissez-faire and intervene to

control AD.

Explain why Keynesian economists believe that the labour market is not
always at equilibrium and that demand-deficient unemployment can occur.

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Why Keynesian economists believe that the labour market is not always
at equilibrium and that demand-deficient unemployment can occur.

 They argue that wage are inflexible, as they are often set annually.

 This is a concern when AD is falling, as it means that it can lead to

significant falls in the quantities of output and employment.

 They argue that firms respond to falls in consumption by laying off

workers and/or cutting hours, rather than by cutting wages.

 Consequently, wages are often insensitive to a fall in demand and so

will fail to fall so as to clear the labour market, resulting in demand-
deficient (disequilibrium) unemployment.

Explain why Keynesian economists believe that the short-run AS curve may
be horizontal and that the long-run AS curve is not vertical.

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Why Keynesian economists believe that the short-run AS curve may be
horizontal and that the long-run AS curve is not vertical

 Sticky wages mean that in the short run output may change rather than
prices. Consequently, the SRAS curve may be horizontal.

 Many Keynesians argue that prices and especially wages exhibit some
inflexibility over quite a long period of time and so the LRAS curve may
not be vertical. As a result, the economy could be stuck at an output
below its potential level.

Define the following terms:

 multiplier effect

 demand-management policies

 stop-go policies.

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Multiplier effect

This is where an initial increase in aggregate demand leads to a greater

absolute increase in national income.

Demand-management policies

These are demand-side policies (fiscal and/or monetary) designed to smooth

out the fluctuations in the business cycle.

Stop-go policies

These are alternate contractionary and expansionary policies to tackle the

currently most pressing of the four problems (growth, inflation, unemployment,
balance of payments) that fluctuate with the business cycle.

Give an example of a fiscal policy and a monetary policy that could be used:

 if aggregate demand is too low

 if aggregate demand is too high.

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Fiscal policy if aggregate demand is too low (high)

Government spending (G) could be increased (decreased) to increase

(decrease) aggregate demand.

Or taxes (T) could be decreased (increased) to increase (decrease)

consumption and investment and hence aggregate demand.

Monetary policy if aggregate demand is too low (high)

Interest rates could be lowered (raised) and/or the money supply increased
(decreased).

List five criticisms of Keynesian policies that emerged in the 1960s.

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Criticisms of Keynesian policies that emerged in the 1960s

1. Economic fluctuations still existed

2. The neglect of underlying structural problems
3. Balance of payments problems with fixed exchange rate meant
deflationary policies were pursued to boost net exports
4. The breakdown of the simple Phillips curve, as both inflation and
unemployment increased
5. The focus on aggregate demand meant that the supply side was largely
ignored

Define the following terms:

 marginal propensity to consume

 disposable income

 consumption smoothing.

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Marginal propensity to consume

The proportion of a rise in national income that goes on consumption, ie:

C
mpc 
Y

Disposable income

Household income after the deduction of taxes and the addition of benefits.

Consumption smoothing

The act by households of smoothing their levels of consumption over time

despite facing volatile incomes.

Draw a consumption function of the form C  a  bY and explain the

relationship between consumption and income.

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Consumption function

Consumption increases with

C (£bn) Y
income, but the proportion of
income consumed decreases as C  a  bY
income rises.

b = slope of
consumption
function
a

Y (£bn)
Note that:
 a = exogenous (or autonomous) consumption
 b = gradient of consumption function, ie the mpc.

List the nine factors (other than income) that affect consumption.

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Factors (other than income) that affect consumption

1. Taxation
2. Expected future incomes
3. The financial system and attitudes of lenders
4. Wealth and household sector balance sheets
5. Consumer sentiment
6. Expectations of future prices
7. The distribution of income
8. Tastes and attitudes
9. The age of durables

Distinguish between factors that cause:

 a movement along the consumption function

 a change in the slope of the consumption function

 a shift in the consumption function.

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Factors that change the consumption function

 A change in national income causes a movement along the

consumption function.

 A change in the mpc causes a change in the slope of the consumption

function. This will be affected by changes in the marginal propensities
to save and be taxed.

 A change in autonomous consumption causes a shift in the

consumption function.

Explain why the consumption function might be steeper in the long run than in
the short run.

© IFE: 2019 

Why the consumption function might be steeper in the long run than in
the short run

This is because in the short run, people might be slow to respond to a rise in
income, perhaps because they are cautious about whether their higher
income will last or are slow to change their consumption habits.

In the long run, however, people have time to adjust their consumption
patterns.

Draw and explain the ‘withdrawals function’.

© IFE: 2019 

Withdrawals function

Withdrawals, W  S  T  M .
£ bn
W

0
Y

As S, T and M are all assumed to increase with Y, the withdrawals function is

normally drawn as an upward-sloping straight line. It is negative at low levels
of Y, as people will dis-save (ie borrow) to fund consumption.

List the factors that affect:

 net savings
 net taxes
 imports (four factors).

© IFE: 2019 

Net savings

These largely depend on the same factors as consumption (see Card 23), as
more spending usually means less saving.

Net taxes

These reflect tax rates (which are often progressive) and benefit rates.

Imports

These depend on:

 the relative prices of domestic goods and imports
 consumer tastes
 the relative quality of domestic and foreign products
 the determinants of consumption, since imports are part of total
consumption

Draw and explain the ‘injections function’.

© IFE: 2019 

Injections function

Injections, J  I  G  X .

£ bn

0
Y

As I, G and X are all assumed to be independent of Y, the injections function

is normally drawn as a horizontal straight line.

Give the five determinants of investment.

Determinants of investment

1. Increased consumer demand, as extra capital equipment may be

needed to meet the extra demand

2. Firms’ expectations about future market conditions

3. The cost and efficiency of capital equipment

4. The rate of interest, which determines the cost of financing investment

5. The availability of finance, eg from retained earnings, bank loans or new

issues of bonds or shares.

Define the ‘injections multiplier’ and state the formulae typically used to
calculate its numerical value.

Injections multiplier (k)

The number of times by which a change in income exceeds the change in

injections that caused it, ie:

Y
k
J

It is typically calculated as:

1 1
k or k
mpw 1  mpcd

where:
 mpw = marginal propensity to withdraw
 mpcd = marginal propensity to consume domestic products.
© IFE: 2019
CB2 Module 16: Classical and Keynesian theory
31

State the two conditions for equilibrium national income.

Conditions for equilibrium national income

1. withdrawals = injections

ie I G  X  S T  M

2. national income = aggregate expenditure

ie Y E

 Y  Cd  I  G  X

Note that this can also be written as:

Y  C I G  X M

Draw the Keynesian 45 diagram showing equilibrium national income where
Y E.

Keynesian 45 diagram

Y = Cd + W
E, Cd, J, W
E = Cd + J

o
45
Ye GDP (Y)

Draw a diagram to show equilibrium national income where W  J .

Equilibrium national income where W = J

W,J
W

Ye Y

Draw a Keynesian 45 diagram to show the effect of an increase in injections.

Effect of an increase in injections

Y = Cd + W
E, Cd, J, W
E2 = Cd + J2
E1 = Cd + J1

o
45
Ye1 Ye2 GDP (Y)

An increase in injections from J1 to J2 leads to a larger increase in

equilibrium national income from Ye1 to Ye 2 .

Define the ‘full-employment level of national income’.

Full-employment level of national income

This is the level of national income at which there is no deficiency of demand

(and hence no demand-deficient unemployment).

Define ‘recessionary (or deflationary) gap’ and draw a diagram to show it.

Recessionary (or deflationary) gap

The recessionary (or deflationary) gap is the shortfall of aggregate

expenditure ( E ) below national income at the full-employment level of income
(YF ) .
Y
E recessionary gap
a E
b

o
45
Ye YF GDP

Note that if E increased by (a - b ) , equilibrium income would increase by

Define ’inflationary gap’ and draw a diagram to show it.

Inflationary gap

The inflationary gap is the excess of aggregate expenditure aggregate

demand ( E ) above national income at the full-employment level of income.

E Y
inflationary
gap E
c
d

o
45
YF Ye GDP

Note that if E decreased by (c - d ) , equilibrium income would decrease by

Give five reasons why an inflationary gap might close automatically.

Reasons why an inflationary gap might close automatically

1. Higher domestic prices will lead to a fall in X – M.

2. Higher prices increase the demand for money, leading to a rise in

interest rates, a reduction in I and an increase in S.

3. Higher prices reduce the real value of people’s savings and so they
more save more to compensate for this.

4. As money incomes go up, people will end up paying more tax.

5. If the rich are better able to protect themselves from inflation than the
poor, there will be a redistribution of income/wealth from the poor to the
rich, which will lead to a rise in S and a fall in C.

Draw the aggregate supply (AS) curve implied by the simple Keynesian model
and explain its shape.

AS curve (Inflation and unemployment) in the simple Keynesian model

price
level AS

YF GDP

The simple Keynesian model suggests that unemployment and inflation

cannot occur at the same time. This is because unemployment (and a low
output level) is caused by too little demand and inflation is caused by too
much demand (at maximum output).

Draw the aggregate supply (AS) curve that is likely in practice and explain its
shape.

AS curve in practice

The AS curve is likely to be upward p SRAS

sloping.

This is because shortage of resources in

some industries and diminishing returns
mean that prices are likely to rise before
the economy reaches full-employment
output.
YF Y

Give two reasons why unemployment and inflation can exist at the same time.

Reasons unemployment and inflation can exist at the same time

1. There are types of inflation and unemployment not caused by an

excess or deficiency of AD, eg cost-push and expectations-generated
inflation and frictional and structural unemployment.

This means that demand-management policies will be unable to

eliminate all inflation and unemployment.

2. Not all firms operate with the same degree of slack. Thus, a rise in AD
can lead to both a reduction in unemployment and a rise in prices, as
some firms respond by increasing output and some by increasing
prices.

 accelerator theory

 marginal capital/output ratio.

Accelerator theory

This says that the level of investment depends on the rate of change of
national income and, as a result, tends to be subject to substantial
fluctuations.

Marginal capital/output ratio

The amount of extra capital (in money terms), K, needed to produce a £1

increase in national income, Y.

DK
ie k =
DY

Explain the Keynesian view of the causes of the business cycle in terms of
fluctuations in aggregate demand, particularly private sector spending,
compounded by market imperfections.

Keynesian view of the causes of the business cycle

 Keynesians argue that the instability of AD is central to explaining the

business cycle.

 In the upturn, AD starts to rise. It rises rapidly in the expansionary

phase. It then slows down and may start to fall in the peaking-out
phase. It then falls or remains stagnant in the recession phase.

 In addition, market imperfections can magnify the impact of the

instability in AD.

 For example, menu costs mean firms may change output levels, rather
than prices, in response to fluctuations in demand.

Explain how the level of investment varies over the four phases of the
business cycle according to the accelerator theory of investment.

Investment and the business cycle (accelerator theory)

1. Upturn – very rapid increase in (induced) investment to cope with the

increase in demand; as the rate of change in income increases, new
investment increases (which further increases AD)

2. Expansion – levelling out of investment; if the rate of growth of income

is constant, the level of new investment will be constant

3. Peaking out – decrease in new investment as the rate of growth of

income slows down (which reduces AD)

4. Recession – no need for any new investment, except to replace

investment that wears out.

Give five reasons why the size of the accelerator is difficult to predict.

Reasons why the size of the accelerator is difficult to predict

1. Some firms have spare capacity and/or stocks and so can meet extra
demand without new investment.

2. The willingness of firms to invest depends on their confidence in future

demand.

3. Firms often make their investment plans a long time in advance and
may be unable to change them quickly.

4. Even if firms decide to invest more, the producer goods industries may
be unable to supply the additional demand for machinery.

5. Machines generally don’t wear out suddenly. So, firms can delay
replacing machines and keep old ones running if they’re uncertain
about future demand.

Explain how the multiplier and accelerator interact to increase the swings in
output over the course of the business cycle

The multiplier/accelerator interaction

Suppose G rises, leading to a multiplied increase in national income. Firms

will respond to the rise in Y and C by investing more (accelerator).

This rise in I produces a further rise in J and a second multiplied rise in Y. If

this rise in Y is larger than the first, there will be a second rise in I
(accelerator), which will cause a third rise in Y and so on.

However, Y cannot go on rising indefinitely as:

 It will eventually reach the ceiling of full employment output.
 For I to go on rising, Y must keep rising at a faster rate. Once the
growth in Y slows down, I will fall and the whole process will be
reversed, ie a fall in I will lead to a fall in Y, which will lead to a massive
fall in I.

Outline how the level of stocks will vary over the course of the four phases of
the business cycle.

Stock levels and the business cycle

1. Upturn – stock levels fall as firms are cautious about increasing output
and employment.

2. Expansion – to build up stock levels, output grows faster than demand

(and causes a multiplier effect on income) but once stocks have
recovered, the rate of growth of output slows.

3. Peaking out – stocks may increase as firms continue to produce more

than is required (thus delaying the recession).

4. Recession – to reduce stock levels, output falls faster than the falling
demand (and causes a downward multiplier effect on income).

Outline how borrowing and debt will vary over the course of the four phases of
the business cycle.

How borrowing and debt will vary over the business cycle

During an upswing, confidence is high and so:

 businesses and consumers are more willing to borrow to spend
 banks are more willing to lend, being confident in people’s ability to
repay.

This fuels expansion, and borrowing and debt rise as a percentage of GDP.

During a recession:
 banks are less willing to lend
 firms and consumers are less willing to borrow. They may instead seek
to reduce their debts by overpayments.

The reduction in borrowing and spending will push the economy deeper into
recession.

Outline the three aggregate demand-related reasons why booms and slumps
may persist.

Why booms and slumps persist

1. Time lags

It takes time for consumers, firms and governments to respond to signals in

the economy. Once they do respond, it takes time for changes in aggregate
demand to have an effect (via the multiplier) on output and employment.

2. Bandwagon effects

Waves of optimism and pessimism can take hold in booms and recessions.
The multiplier and the accelerator interact to accentuate booms and slumps
and the changes in borrowing an lending amplify these effects.

3. Group behaviour

Households and businesses copy the behaviour of others and therefore

reinforce bandwagon effects.

Give six factors that lead to turning points in the business cycle.

Turning points in the business cycle

1. ceilings and floors  eg the natural ceiling of full-capacity output, the

floor to consumption of food and basic necessities
2. echo effects  the necessity of replacing consumer durables and
capital equipment when they wear out
3. the accelerator  once the rate of growth of consumer demand slows
down, investment falls
4. changes of sentiment and in expectations can lead to a change in
spending that will be amplified by bandwagon effects and group
behaviour
5. random shocks, such as a terrorist attack, can have a dramatic effect
on confidence and thus affect aggregate demand
6. government policy  eg demand-management policies used to smooth
out cyclical fluctuations

Summary Card

Classical theory Cards 1 to 11

Keynesian revolution Cards 12 to 20

Consumption & the consumption function Cards 21 to 25

Withdrawals & injections Cards 26 to 29

Determination of national income & the multiplier Cards 30 to 34

Keynesian analysis of unemployment & inflation Cards 35 to 41

Keynesian analysis of the business cycle Cards 42 to 50

CB2

Module 17
CB2 Module 17: Monetarist and new classical schools and Keynesian responses
1

Define the following terms:

 stagflation

 natural rate of unemployment.

Stagflation

Refers to a combination of stagnation (low growth and high unemployment)

and high inflation.

Natural rate of unemployment

The rate of unemployment consistent with:

 market clearing in the labour market.
 the long-run Phillips curve.

Explain how, according to monetarists, an increase in the money supply

causes inflation in the long run.

How an increase in the money supply causes inflation in the long run

 Monetarists argued that if, over the long tem, the money supply rises
faster than potential output, then inflation will be the inevitable result.

 In terms of the quantity of money, they argued that the velocity of

circulation (V) and national income (Y) are determined independently of
the money supply (M).

 Consequently, increases in the money supply will lead to increases in

the price level (P), and hence inflation.

Explain how, according to monetarists, an increase in the money supply might

result in lower unemployment in the short run but not in the long run.

State the implication of this for the slope of the long-run Phillips curve.

How an increase in the money supply might result in lower
unemployment in the short run but not in the long run

 If the money supply rises, the resulting rise in AD will lead to higher
output and employment in the short run.

 However, firms and workers will soon come to expect higher wages and
prices and their actions then ensure that wages and prices increase.

 So, after a short period, the extra demand is taken up by inflation and
so output and employment fall back again.

 The implication of this is that the long-run Phillips curve is vertical.

Discuss how, according to monetarists, a decrease in the rate of money

supply growth will reduce inflation without increasing unemployment in the
long run.

How a decrease in money supply growth will reduce inflation without
increasing unemployment in the long run

 Reducing the rate of growth of the money supply will lead to temporary
increases in unemployment, as the demand for goods and labour fall.

 However, as price and wage inflation adjust down to the new lower level
of demand, unemployment will fall.

 This process will be hindered and high unemployment will persist if

workers continue demanding excessive wage increases or if firms and
workers continue to expect high inflation rates.

Explain why monetarists suggest that the government should set targets for
the rate of growth of the money supply.

Why monetarists suggest that the government should set targets for the
rate of growth of the money supply

Setting modest and well-publicised targets should help reduce the:

 expected rate of inflation
 uncertainty associated with inflation, which reduces investment and a
country’s competitiveness in international trade.

Explain why, if the government wishes to reduce the natural level of

unemployment, it should use supply-side policies to do so.

Why supply-side policies should be used to reduce the natural level of
unemployment

 Monetarists believe that In the long run an increase in AD is fully

absorbed by higher inflation. Consequently, it will have no long-run
effect on output and unemployment.

 So, if unemployment is to be reduced in the long run, the vertical long-

run Phillips curve must be shifted to the left.

 This is achieved by a reduction in the natural rate of unemployment, not

by an increase in AD.

 To reduce the natural rate, supply-side policies should be reduced,

which focus on increasing potential output by increasing the quantity
and/or productivity of factors of production.

Define the ‘new classical school’ of economists.

New classical school

 A body of economists who believe that markets are highly competitive

and clear very rapidly.

 So, any expansion in demand will instantly feed through to higher

prices, resulting in a vertical Phillips curve in the short run (as well as
the long run).

Define the following assumptions associated with the new classical school:
 continuous market clearing
 rational expectations.

State the implication of combining these assumptions.

Continuous market clearing

The assumption that all markets in the economy clear continuously so that the
economy is in permanent equilibrium.

Rational expectations

Expectations based on the current situation, ie the information that people

have to hand. While this information may be imperfect and so people will
make errors, these errors will be random.

Implication

The implication of combining these assumptions is that a change in AD will

simply cause a change in prices and not in output and employment, even in
the short run.

Define the following terms associated with the new classical school:

 policy ineffectiveness proposition

 real business cycle theories.

Policy ineffectiveness proposition

The new classical conclusion that when economic agents anticipate economic
changes in economic policy, output and employment remain at their
equilibrium (or natural) level.

Real business cycle theories

The new classical theory that explains fluctuations in real GDP in terms of
economic shocks, especially technology shocks, which have persistent effects
on potential output.

Explain, with the aid of an example, what is meant by ‘monetary surprises’.

State why they will not occur in the new classical model.

Monetary surprises

 Monetary surprise models show how unexpected changes in monetary

policy can result in both firms and workers changing their supply
decisions so that the economy temporarily deviates from equilibrium.

 For example, if an unexpected monetary expansion leads to

unexpected increase in inflation, leading to rises and price and wages,
then workers and firms may (mistakenly) believe that the real price of
the labour and output has increased and so they will supply more.

 This will not occur in the new classical model due to the assumptions of
continuous market clearing and rational expectations.

Explain the ‘real business cycle theory’, giving examples of supply-side

shocks or ‘impulses’.

Real business cycle theory

The real business cycle theory explains cyclical business cycles in terms of
shifts in potential output, rather than fluctuations around potential output, ie AS
and not AD.

These shifts come from supply-side shocks or ‘impulses’, often due to

technology shocks, ie anything that affects production processes and
productivity levels.

Examples include changes in:

 technology, eg improvements in IT
 the availability of raw materials, eg the depletion of oil reserves.

The theory removes the distinction between business cycles and long-term
economic growth.

Define the ‘expectations-augmented Phillips curve’ and draw a diagram

showing expectations-augmented Phillips curves.

State the corresponding formula relating actual inflation to expected inflation.

Expectations-augmented Phillips curve

This is a short-run Phillips curve whose position depends no the expected rate
of inflation.

inflation rate, p

pe= 6%
pe= 3%
pe= 0%
unemployment rate

The actual inflation rate ( p ) is inversely related to unemployment ( U ) and

positively related to the expected inflation rate (p e ) , ie p = f (1 U ) + p e + k .
© IFE: 2019
CB2 Module 17: Monetarist and new classical schools and Keynesian responses
13

Define the following terms:

 adaptive expectations

 natural rate hypothesis.

Adaptive expectations

Where people adjust their expectations of inflation in the light of what has
happened in the past.

NB This assumption underlies the expectations-augmented Phillips curve.

Natural rate hypothesis

The theory that, following fluctuations in AD, unemployment will return to a

natural rate.

This rate is determined by supply-side factors, such as labour mobility.

Outline, with the aid of a diagram, the implications of the accelerationist theory
of inflation.

Accelerationist theory of inflation

In the long run there is no trade-off between unemployment and inflation, so

the long-run Phillips curve (LRPC) is vertical at U* – the natural or
non-accelerating-inflation rate of unemployment.

Unemployment can be held below U* only at the expense of accelerating

inflation.
inflation LRPC
rate, p
9%

6%
pe= 6%
3%
pe= 3%
U
U1 U* e
p = 0%

Define the ‘political business cycle’ and draw a diagram showing clockwise
Phillips loops to illustrate it.

Political business cycle

The theory that after being elected, governments, will engineer an economic
contraction to reduce inflation (E to G). Then later on, they will engineer a
pre-election boom to get re-elected (G to A).

LRPC
inflation rate, 

9% E
D F

6% C  e  9%
G
3%  e  6%
B H
 e  3%
A
U
Un
 e  0%

Give three possible causes of stagflation.

Possible causes of stagflation

1. an increase in structural or frictional unemployment at the same time as

an increase in cost-push inflationary pressures

2. an increase in structural or frictional unemployment at the same time as

an increase in AD, since an increase in AD will not reduce these forms
of unemployment and will add to inflationary pressures

3. government policy to reduce unemployment by increasing AD is

reversed because it has caused inflation. So, unemployment will rise
but inflation might continue to rise as expectations of inflation have
been fuelled.

Outline the implications of the monetarist model for:

 demand-side policy

 supply-side policy

 the use of rules and targets.

Policy implications of the monetarist model

 Demand-side policy (ie monetary and fiscal policy) have no long-run

effect on unemployment and output. They can only be used to
influence inflation or to achieve temporary reductions in unemployment.
However, such policies can also be destabilising.

 Supply-side policy should be used to reduce unemployment and

increase output permanently.

 Rules and targets should be set for inflation and the growth of the
money supply in order to reduce both expected and actual inflation.

Define the term ‘new Keynesians’.

New Keynesians

Economists who seeks to explain how market imperfections and frictions can
lead to fluctuations in real GDP and the persistence of unemployment.

Explain the implications of price rigidity for the new classical view that real
output is not affected by changes in aggregate demand.

Implications of price rigidity for the new classical view that real output is
not affected by changes in aggregate demand

 Price rigidities mean that changes in AD can have significant effects on

actual output.

 So, in the presence of such frictions to market adjustment, governments

may need to intervene to affect the level of AD.

List six sources of market imperfections.

Sources of market imperfections

1. Price inelasticity of demand

2. Anticipating other firms’ pricing strategy
3. Sticky nominal wages
4. Real wage rigidity
5. Sources of finance
6. Attitudes towards debt

Explain the ‘efficiency wage hypothesis’, with reference to real wage rigidity.

Efficiency wage hypothesis

 This is the hypothesis that the productivity of workers is affected by the

wage rate they receive.

 It suggests that firms may pay wage rates above market levels in order
to incentivise workers.

 Consequently, firms may be reluctant to cut wages in a downturn for

fear of lowering morale and reducing productivity.

In the context of real wage rigidity, define ‘insiders’ and ‘outsiders’ and outline
what is suggested by insider-outsider theories.

‘Insiders’, ‘outsiders’ and insider-outsider theories

 Insiders are those in employment who can use their privileged position
(either union members or because of specific skills) to secure pay rises
or resist wage cuts, despite an excess supply of labour
(unemployment).

 Outsiders are those out of work or employed on a casual, part-time or

short-term basis, who have little or no power to influence wages or
employment.

 Insider-outsider theories suggest that existing employees may be able

to resist real wage cuts, as they can prevent the unemployed from
competing wages down.

Draw a diagram to show the effect of menu costs on a monopolistically

competitive firm faced with a decrease in demand.

Effect of menu costs on a monopolistically competitive firm faced with a
decrease in demand

30
25

MC = AC
10 D2
MR2 D1
MR1
50 70 100 output

NB Although demand decreases from D1 to D2, menu costs may make it

more profitable to keep the price at 30 and sell 50, rather than dropping the
price to 25 and selling 70.

Define:
 hysteresis
 the non-accelerating inflation rate of unemployment (NAIRU).

Explain the impact of the former on the latter.

Hysteresis

The persistence of unemployment even when the demand deficiency that

caused it no longer exists.

Non-accelerating inflation rate of unemployment (NAIRU)

The unemployment rate consistent with steady inflation in the near term, say,
over the next 12 months.

Impact of hysteresis on the NAIRU

Long-term unemployment may cause the unemployed to become deskilled

and demoralised and so firms will become more cautious about taking on
workers, even when demand increases. Hence, employment and output may
fail to recover following a recession, ie hysteresis occurs, resulting in a
decrease in potential output and an increase in the NAIRU.

Describe the Keynesian view of demand-management policies.

Keynesian view of demand-management policies

 Targeted government intervention may be needed to help smooth the

path of AD and a substantial increase in AD may be needed if there is
as danger of deep recession.

 One approach is to undertake infrastructure projects that can directly

impact potential output and have a relatively low import content and so
don’t lead to balance of payments problems.

 Longer-term, the government should use appropriate

demand-management policies to maintain a high and stable AD, so as
to keep unemployment low and create an environment for long-term
investment and growth.

Summary Card

The monetarist school Cards 1 to 6, 17

The new classical school Cards 7 to 11

Expectations-augmented Phillips curve Cards 12 & 13

The accelerationist theory Card 14

The political business cycle & stagflation Cards 15 & 16

The Keynesian response Cards 18 to 25

CB2

Module 18
CB2 Module 18: Relationship between the goods and money markets
1

Explain the difference between the realised (ex post) real rate of interest and
the perceived (ex ante) real rate of interest.

Realised (ex post) real rate of interest

This is the nominal (actual) interest received adjusted for the actual rate of
inflation.

It is the real rate of interest actually achieved over the course of a financial
contract.

Perceived (ex ante) real rate of interest

This is the nominal rate of interest adjusted for the expected rate of inflation.
It is the expected real rate of interest when entering into a financial contract.

Describe the ‘interest rate transmission mechanism’ with reference to its three
stages.

Interest rate transmission mechanism

This is the process by which a change in the money supply affects national
income via a change in interest rates and AD. It has three stages:

1. An increase in the nominal money supply leads to a fall in the real rate
of interest.

2. This leads to a rise in investment and consumption and a reduction in

saving.

3. The resultant increase in AD leads to a rise in real national income and

/ or an increase in price level.

Describe the circumstances in which an increase in the money supply will

have a relatively large effect on national income.

Circumstances in which an increase in the money supply will have a
relatively large effect on national income

The effect will be bigger:

 the less elastic the liquidity preference curve. This will cause a bigger
change in the interest rate.

 the more interest-elastic the investment curve. This will cause a bigger
change in investment.

 the lower the marginal propensity to withdraw (mpw) and hence the
flatter the withdrawals function. This will cause a bigger multiplied
change in national income.

Define ‘liquidity trap’ and state its implication for the slope of the liquidity
preference curve.

Liquidity trap

The absorption of any additional money supply into idle balances at very low
rates of interest leaving aggregate demand unchanged.

It means that any further increases in the money supply are not spent but held
in asset balances as people wait for the economy to recover and/or interest
rates to rise, leaving AD unchanged.

It results in the liquidity preference curve being horizontal.

Give four problems with the interest rate transmission mechanism and state at
which stage of the mechanism they apply.

Problems with the interest rate transmission mechanism

At the money supply-interest rate stage

1. An interest-elastic demand for money, which leads to only a small fall in

interest rates
2. An unstable demand for money, which makes it difficult to predict the
effects of a change in the money supply on interest rates

At the interest rate-investment stage

3. An interest-inelastic investment demand, which means interest changes

have only a small effect on investment
4. An unstable investment demand, makes it difficult to predict the effects
of a change in interest rates on investment

Describe the ‘exchange rate transmission mechanism’ with reference to its

four stages.

Exchange rate transmission mechanism

This is the process by which a change in the money supply affects national
income and AD via a change in exchange rates. It has four stages:

1. Money market and interest rates. A rise in the money supply causes a
fall in domestic interest rates.

2. Interest rates and foreign exchange market. The fall in interest rate
leads to net financial outflows and a depreciation of the exchange rate.

3. Exchange rates and net exports. The depreciation leads to an increase

in net exports.

4. Net exports and national income. The rise in net exports causes an
increase in AD and a (multiplied) increase in real national income and
/or the price level.

Analyse the strength of the exchange rate transmission mechanism at:

 the money supply-interest rate link

 the interest rate-exchange rate link

 the exchange rate-net exports link

 the net exports-national income link.

Strength of the exchange rate transmission mechanism

 The money supply-interest rate link will tend to be more powerful in an

open economy (as the liquidity preference curve will tend to be less
elastic and so interest rates will fall further) and will depend on how
much people think the exchange rate will fall.
 The interest rate-exchange rate link is likely to be very strong, as
international financial flows can be enormous in response to interest
rate changes.
 The exchange rate-net exports link may be limited in the short run, but
larger in the long run, as trade becomes more responsive to the change
in the exchange rate.
 The net exports-national income link is likely to be less than the full
multiplier effect, as the increase in national income will lead to higher
money demand and interest rates.

Define ‘portfolio balance’.

Explain the way in which an increase in the money supply affects portfolio
balance and hence has an impact on aggregate demand (AD).

Portfolio balance

This is the balance of assets, according to liquidity, that people choose to hold
in their portfolios.

How an increase in the money supply affects portfolio balance and

hence AD

If the money supply expands, people may find themselves holding more
money than they require, ie their portfolios are unnecessarily liquid.

Some of this money will therefore be spent on financial assets and some on
goods and services.

This additional consumption will lead to an increase in AD.

Discuss the stability of the velocity of circulation (V) in the short run and in the
long run.

Stability of the velocity of circulation (V)

Most economists agree that there is some variability in V in the short run in
response to a change in the money supply.

For example, if an increase in the money supply leads to a fall in interest

rates, people are likely to hold more idle balances and therefore V will fall.

Also, V can be unpredictable in the short run due to unpredictable changes in

the demand for money, eg due to changing expectations of prices, interest
rates and exchange rates.

Monetarists claim that V is likely to be stable in the long run, once the full
effects of any monetary changes have worked through the economy. Any
changes that do occur are the predictable outcomes of institutional changes,
eg the increased use of credit cards.

Explain the difference between the effect of an increase in an injection on

national income if:

 the money supply is fixed

 the central bank allows the money supply to increases in response to

the increase in the demand for money.

Use investment as the example of an injection.

Effect of an increase in injections on national income

Suppose investment increases due to a rise in business confidence. This

would lead to a rise in real national income.

This would in turn lead to a rise in the transactions demand for money.

If the money supply is fixed, then interest rates would rise, leading to a
reduction in investment and consumption, which would dampen down the
overall increase in real national income.

If, however, the central bank increases the money supply in response to the
increased demand so that interest rates are unchanged, then there will be no
dampening effect.

Describe the specific effect on national income of an increase in government

spending necessitating an increase in government borrowing, if the
government borrows:

 from the non-bank private sector

 from the central bank or by selling Treasury bills to the commercial

banks.

Effect on national income of an increase in government spending
necessitating an increase in government borrowing

The increase in government spending will lead to an increase in AD and

hence in real national income and also the transactions demand for money.

If the government borrows from the non-bank private sector, there will be no
increase in the money supply. Consequently, interest rates will rise, reducing
investment and consumption, ie financial crowding out will occur.

Suppose, however, the government borrows from the central bank or by

selling Treasury bills to the commercial banks. Then the money supply will
increase, meaning that interest rates won’t change and hence there will no
financial crowding out.

Explain the following determinants of the extent of crowding out:

 the interest-elasticity of the demand for money

 the interest-elasticity of the demand for investment

 the interest-elasticity of the supply of money (the extent to which the

supply of money is endogenous)

The extent of crowding out

 The greater the interest-elasticity of the demand for money, the smaller
will be the rise in interest rates due to the rise in money demand and
the less the extent of crowding out.

 The lower the interest-elasticity of the demand for investment, the

smaller will be the reduction in investment following an interest rate rise
and the less the extent of crowding out.

 The higher the interest-elasticity of the supply of money (ie the greater
the extent to which the supply of money is endogenous), the smaller will
be the rise in interest rates due to the rise in money demand and the
less the extent of crowding out.

Describe the views on crowding out of:

 the Keynesian school

 the monetarist and new classical schools.

Views on crowding out

Keynesians believe that the rise in money demand arising from an

expansionary fiscal policy will have:
 only a small effect on interest rates
 an even smaller effect on investment.

Consequently, little or no crowding out will occur.

Monetarist and new classical economists argue that:

 interest rates will rise significantly
 there will be a severe effect on investment.

So, crowding out will be substantial and will be total in the long run.

State what the IS curve shows.

Explain why the IS curve slopes downwards.

IS curve

This shows the combinations of real national income (Y) and real interest
rates (r) at which the goods market is in equilibrium, ie at which:
 planned expenditure (AD) equals national income (Y)
 injections (J) equal withdrawals (W).

Suppose that investment (I) is the only injection, savings (S) the only
withdrawal and that initially the economy is in equilibrium with I = S.

Suppose that r falls: I will increase and S will fall, so that I > S (ie J > W). This
will lead to an increase in Y, which will continue until savings have increased
so that I = S (and J = W) again and the economy is once more in equilibrium.

In other words, a decrease in r results in an increase in AD and in Y and so

the IS curve slopes downwards.

Distinguish between a movement along, and a shift in, the IS curve.

Movements along and shifts in the IS curve

Movements along the IS curve are caused by changes in interest rates.

Shifts in the IS curve are caused by changes in any other determinants of

injections ands withdrawals, eg:
 increases in C and I due to improved confidence would shift the curve
to the right
 reductions in G and/or increases in T would shift it to the left.

Explain the two determinants of the elasticity of the IS curve.

Elasticity of the IS curve

This depends on:

 the responsiveness of I and S to interest rates (r). The more interest-

elastic they are, the bigger will be the effect on Y of a change in r and
hence the more elastic (flatter) will be the IS curve.

 the size of the multiplier. The higher the value of the multiplier, the
bigger will be the effect on Y of any rise in I and fall in S, and the more
elastic (flatter) will be the IS curve.

Distinguish between Keynesian and monetarist views of the elasticity of the

IS curve.

Keynesian views of the elasticity of the IS curve

 They argue that the IS curve is likely to be fairly inelastic (steep).

 This is because S and I are not very responsive to changes in r.
 So, a change in r will lead to a small change in Y.

Monetarist views of the elasticity of the IS curve

 They argue that I and S are relatively responsive to changes in r and so

the IS curve is relatively elastic (flat).

State what the LM curve shows.

Explain why the LM curve slopes upwards.

LM curve

This shows the combinations of real national income (Y) and real interest
rates (r) at which the money market is in equilibrium, ie at which the demand
for money (liquidity preference, L) equals the supply of money, M.

Suppose the economy is in equilibrium and that Y then rises.

This will lead to an increase in money demand (ie the transactions and
precautionary demands). The excess demand for money therefore leads to
an increase in r in order to regain equilibrium in the money market.

In other words, a higher Y is associated with a higher r, and so the LM curve

slopes upwards.

Distinguish between a movement along, and a shift in, the LM curve.

Movements along and shifts in the LM curve

Movements along the LM curve are caused by changes in national income.

Shifts in the LM curve are caused by changes in any other determinants of the
demand and supply of money, eg:
 increases in the demand for money due to people being paid less
frequently, or speculation that security prices will fall or the exchange
rate will rise, would shift the curve upwards. (This would cause an
increase in r for a given Y.)
 an increase in the supply of money would shift downwards. (This would
cause a decrease in r for a given Y.)

Explain the two determinants of the slope of the LM curve.

Note that in the case of the LM curve, it’s easier to talk in terms of the slope
than the elasticity since ‘more elastic’ is not the same as ‘flatter’.

This is because here r is the dependent variable and Y the independent

variable. Consequently, elasticity is extent to which r changes in response to
a change in Y. This means that a steep curve is an elastic curve.

Slope of the LM curve

This depends on:

 the responsiveness of the demand for money to changes in Y. The

greater the marginal propensity to consume, the more the transactions
demand for money will increase with Y, and thus the more the liquidity
preference curve will shift to the right. Hence, the more the equilibrium
r will rise and the steeper (more elastic) will be the LM curve.

 responsiveness of the demand for money to changes in r. The more

the demand for money responds to a change in r, the flatter will be the
liquidity preference curve and the less the equilibrium r will change for
any given shift in the liquidity preference curve. Hence, the less the
equilibrium r will change and the flatter (less elastic) will be the LM
curve.

Distinguish between Keynesian and monetarist views of the slope of the LM

curve.

Keynesian views of the slope of the LM curve

 They argue that the liquidity preference curve is relatively flat.

 Consequently, the LM curve is relatively flat (inelastic).

Monetarist views of the slope of the LM curve

 They argue that LM curve is relatively steep (elastic).

 This is because the demand for money is insensitive to changes in r
and the supply of money is exogenous.

Draw an IS-LM diagram to show equilibrium in the goods and money markets.

Equilibrium in the goods and money markets

real rate
of interest

Y* real national income

Draw an IS-LM diagram to show the effect of an increase in an injection.

Effect of an increase in an injection

LM
real rate
of interest

r1 IS2
IS1

Y1 Y2 real national income

Draw an IS-LM diagram to show the effect of an increase in the money supply.

Effect of an increase in the money supply

LM1
LM2

real rate
of interest

Y1 Y2 real national income

State what the MP (monetary policy) curve shows.

Explain why the MP curve slopes upwards.

MP (monetary policy) curve

This shows the combinations of real national income (Y) and real interest
rates (r) consistent with meeting the central bank’s inflation target.

Assume that initially the inflation rate is at the target level and Y is at the
potential output level.

Suppose C increases due to a rise in consumer confidence. This will lead to a

rise in Y and an increase in inflation above its target level. Consequently, the
central bank will need to raise r in order to deflate the economy and reduce
inflation back down to its target level.

In other words, a higher Y is associated with a higher r, and so the MP curve

slopes upwards.

Explain why the slope of the MP curve gets steeper as the economy
approaches full capacity.

Why the slope of the MP curve gets steeper as the economy approaches
full capacity

If the economy is operating at well below potential output, a rise in Y will have
little effect on inflation and hence on the desired real interest rate (r)

If, however, firms are operating close to full capacity, a rise in Y will be
reflected in a larger rise in inflation, causing the central bank to make a
relatively large change to r.

Give four examples of factors that would cause changes in the MP curve,

Factors that would cause changes in the MP curve

1. a change in the target rate of inflation – eg if the target is raised, the

MP curve will shift downwards
2. an inflationary shock – eg an oil price increase would shift the MP curve
upwards, as a higher inflation rate would be associated with a given
level of Y and so the central bank would choose a higher level of r
3. a change in central bank policy – eg placing a greater emphasis on
targeting Y would make the MP curve steeper, as changes in Y would
cause the central bank to make larger changes in r than if it only
targeted inflation. Alternatively, loosening monetary policy by setting a
lower r for any given level of Y and inflation would shift the MP curve
vertically downwards.
4. a change in potential national income – eg a rise would shift the
MP curve to the right, as a given inflation rate would be associated with
a higher level of Y.
© IFE: 2019
CB2 Module 18: Relationship between the goods and money markets
28

Draw an IS-MP diagram to show equilibrium in the goods and money markets.

Equilibrium in the goods and money markets

real rate
of interest

Y* real national income

Draw an IS-MP diagram to show the effect of an increase in injections.

Effect of an increase in injections

MP
real rate
of interest

r1 IS2
IS1

Y1 Y2 real national income

Draw an IS-MP diagram to show the effect of a loosening of monetary policy

or a rise in potential national income.

Effect of a loosening of monetary policy or a rise in potential national
income

MP1
MP2

real rate
of interest

Y1 Y2 real national income

Summary Card

Effects of monetary changes on national income Cards 1 to 9

Crowding out Cards 10 to 13

IS curve Cards 14 to 17

LM curve Cards 18 to 21

IS-LM diagrams Cards 22 to 24

MP curve Cards 25 to 27

IS-MP diagrams Cards 28 to 30

CB2

Module 19
CB2 Module 19: Supply-side policy
1

Define the term supply-side policies.

Definition of supply-side policies

Supply-side policies are policies that attempt to influence aggregate supply

directly, rather than through aggregate demand

They do so by increasing the quantity of factors of production and/or improve

their productivity.

Describe the aims of supply-side policies.

Aims of supply-side policies

Supply-side policies aim to increase aggregate supply directly, increasing the

quantity and/or productivity of factors of production. They can be used to:
 increase a country’s potential output and its rate of potential economic
growth, possibly through encouraging R&D, education, training,
infrastructure, industrial organisation work practices and incentives
 reduce equilibrium unemployment by helping workers to be more
responsive to changes in job opportunities, making employers more
adaptable and willing to operate within existing labour constraints, and
reducing the power of unions to drive real wages up
 reduce cost-push inflation by reducing the power of unions and/or firms
and thereby encouraging more competition, preventing people from
exercising that power and by encouraging increases in productivity
through retraining, investment grants to firms, tax incentives etc.

They might additionally be used to improve the balance of payments and/or

Distinguish between the two main approaches to supply-side policy and the
intermediate ‘Third Way’ approach.

Different approaches to supply-side policy

New classical economists advocate policies to ‘free up’ the market: policies
that encourage private enterprise, or provide incentives and reward initiative.
(These are known as market-orientated supply-side policies.) The Neo-
Austrian / libertarian school is a school of thought that advocates maximum
liberty for economic agents to pursue their own interests and to own property.

Modern Keynesians advocate supply-side policies that are more

interventionist in nature, eg training schemes, policies that encourage firms to
set up in areas of high unemployment.

‘Third Way’ supply-side policies advocate incentives, low taxes and free
movement of capital, but also means whereby governments can provide
support for individuals in need while improving economic performance by
investing in the country’s infrastructure (eg transport and telecommunication
systems) and its social capital (eg schools, libraries and hospitals).

Give examples to illustrate the links between demand-side and supply-side

policies.

Links between demand-side and supply-side policies

A supply-side policy that involves increasing government expenditure on

retraining schemes / R&D / industrial relocation will also cause a rise in
aggregate demand (unless accompanied by a rise in taxes).

A demand-management policy that involves cutting interest rates to increase

investment and hence national income will also create increased productive
capacity (which is a supply-side effect).

Define market-orientated supply-side policies and outline how they aim to

increase potential output.

Market-orientated supply-side policies

Market-orientated policies are policies to increase aggregate supply by freeing

up the market.

They aim to increase the potential output of the economy by increasing the
role of markets (and decreasing the role of government) and by removing
impediments to the market such as government intervention.

They do this by encouraging private enterprise and competition.

Outline eight examples of market-orientated supply-side policies.

Examples of market-orientated supply-side policies

1. reducing government expenditure so as to encourage private sector

investment without an increase in aggregate demand (and hence
inflationary pressures
2. reducing income taxes to encourage individuals to work
3. reducing taxes on profits and/or increasing tax reliefs to increase
investment
4. reducing the monopoly power of trade unions so as to encourage
greater flexibility in both wages and working practices and to allow
labour markets to clear
5. reducing the automatic entitlement to certain welfare benefits so as to
encourage greater self-reliance
6. reducing red tape and other impediments to investment and risk-taking
7. encouraging competition through deregulation and privatisation
8. abolishing exchange controls and other impediments to the free
movement of capital
© IFE: 2019
CB2 Module 19: Supply-side policy
7

Discuss the aims and effectiveness of reducing government spending.

Aims and effectiveness of reducing government spending

Government spending should be reduced because the public sector is often

seen to be more bureaucratic and less efficient than the private sector.

The aims are to:

 make more efficient use of resources within the public sector
 reduce the size of the public sector.

In practice, governments have found it very difficult to cut spending (as a

proportion of GDP) because it involves very difficult choices concerning the
level of services and the provision of infrastructure.

Describe five ways in which cutting the marginal rate of income tax might have
a beneficial effect on output and discuss its effectiveness in practice.

Reducing tax to influence the labour market

1. people work longer hours – there is a substitution effect (inducing

people to work more) and an income effect (causing people to work
less); evidence suggests that these two effects roughly cancel each
other out; note that in the short run, people may not be able to change
their hours
2. more people wish to work – a rise in after-tax wages might encourage
people (eg parents currently raising children) to go and look for jobs; the
cut in tax must be large enough to make a significant difference to the
individual; note that if the unemployment rate is currently high, the
government might not want to increase the size of the labour force
3. people work more enthusiastically – people may work harder if they
keep more of their pay, although there is little evidence to support this
4. employment rises – this is illustrated on Card 9
5. unemployment falls – there will be a greater difference between after-
tax wage rates and unemployment benefit, providing greater motivation
to work; see also Card 9
© IFE: 2019
CB2 Module 19: Supply-side policy
9

Illustrate on a labour market diagram the impact of reducing the marginal rate
of income tax.

Give a brief explanation of the key features of the diagram.

The impact of reducing the marginal rate of income tax
ASL N
At an initial income tax per

after-tax wage rates (W)

a
worker of a  b , workers lc 1

labour costs (lc) and

lc2 c
will receive an after-tax
wage of W1 and will supply W2 f
W1 d
b e
Q1 labour. (Firms will pay
ADL
the pre-tax wage lc1 and
demand Q1 labour.)
Q1 Q2 number of workers

If the income tax per worker falls to c  d , firms will employ more workers
because their labour costs have fallen to lc 2 and more workers will take up
jobs because their after-tax wages have risen to W2 .

Note that equilibrium unemployment has fallen from e  b to f  d .

Describe two market-orientated policies that might be used to encourage

investment and discuss their effectiveness.

Market-orientated policies to encourage investment

1. A cut in taxes on business profits – This will increase after-tax profits,

leaving more money to spend on investment. The higher after-tax
return on investment will also encourage investment.

The potential problem with cutting corporation taxes in an attempt to

make the country internationally competitive, is that all countries take
the same action, the net result being that global taxes are lower and
governments receive less in tax revenue.

2. Tax relief or other incentives for investment – If firms are able to offset
the cost of investment against their pre-tax profit, they will be able to
reduce their tax liability. This should incentivise firms to carry out R&D.

Illustrate on a labour market diagram the impact of reducing the power of

labour.

Give a brief explanation of the key features of the diagram.

The impact of reducing the power of labour
wage
Suppose that initially trade rate ASL N
union power was holding
w1
wage rates at w 1 . There
we
would be disequilibrium
unemployment of Q2  Q1 .
ADL
If trade union power was
reduced (or removed), then
Q1 Qe Q2 number of workers
wage rates would fall to w e
and disequilibrium unemployment would disappear. (Note that equilibrium
unemployment would rise.)

Lower labour costs leads to increased profits for firms. As a result of this,
firms will have a reduced incentive to increase labour productivity. (This is a
potential danger with driving down wages through increased competition.)
© IFE: 2019
CB2 Module 19: Supply-side policy
12

Describe how reducing welfare can reduce equilibrium unemployment.

Illustrate your description with a labour market diagram.

How reducing welfare can reduce unemployment

If the difference between the welfare benefits of the unemployed and the take-
home pay of the employed is small, then individuals will have little incentive to
work. A possible solution to this is to cut unemployment benefits.

This would shift the labour real wage ASL1

ASL2
rate N
supply curve to the right.
Equilibrium unemployment W e1 b e
a
would fall from a  b to We c
d
c  d if real wages are
flexible downwards, or
from a  b to a  e if they ADL
are not.

This may be seen to be a number of workers

Outline five examples of market-orientated policies designed to encourage

competition.

Market-orientated policies designed to encourage competition

1. Privatisation – a number of private firms (or private firms competing with

the public sector) can lead to increased efficiency, more consumer
choice and lower prices.
2. Deregulation – the removal of monopoly rights to a firm can lead to
increased competition.
3. Introducing market relationships into the public sector – different
departments can be encouraged to ‘trade’ with each other to encourage
competition and efficiency.
4. Public-private partnerships (PPPs) – this involves funding public
expenditure with private capital: the government would contract a
private company to carry out a project.
5. Free trade and capital movements – this increases the level of
international competition.

Greater competition should increase national output and reduce inflation.

Define the following terms:

 interventionist supply-side policies

 industrial policies

 regional multiplier effects.

Definitions related to Interventionist supply-side policies

Interventionist supply-side policies are policies to increase aggregate supply

by government intervention to counteract the deficiencies of the market.

Industrial policies are policies to encourage industrial investment and greater

industrial efficiency.

Regional multiplier effects occur when a change in injections into or

withdrawals from a particular region causes a multiplied change in income in
that region.

Explain why interventionist policies are thought necessary, ie why there are
low levels of investment, R&D, education and training.

Reasons for interventionist supply-side policies

The free market might fail to provide sufficient R&D, training and investment
because:
 firms ‘free ride’ on the investment of other firms
 there are substantial external benefits, so that the social rate of return
on such investments exceeds the private rate of return
 firms consider such investments too risky
 finance might be difficult to obtain as a result of banks’ reluctance to
lend and shareholders’ interest in short-term, rather than long-term,
profitability.

Give six examples of interventionist supply-side policies.

Examples of interventionist supply-side policies

1. nationalisation

2. direct provision of capital (eg infrastructure, factories)

3. funding and support for R&D, eg tax relief, patent law

4. provision of and/or support for training and education

5. advisory services to help firms increase efficiency and innovation

6. provision of information, eg to bring firms together and create a climate

of greater certainty

Discuss the causes of regional imbalances and the policies that could be used
to reduce / correct them.

Causes of regional imbalances and policies to correct them

Regional imbalances normally result from structural problems, for example,

the decline of certain industries that are concentrated in certain areas.
Regional multiplier effects will then depress areas further. In addition, labour
may be geographically immobile, leading to greater levels of unemployment in
certain areas.

Policies to reduce or correct regional imbalances include:

 subsidies and tax concessions in the depressed regions
 the provision of facilities in the depressed regions
 the siting of government offices in the depressed regions.

Summary Card

Definitions and uses of supply-side policy Cards 1 to 4

Market-orientated supply-side policies Cards 5 to 13

Interventionist supply-side policies Cards 14 to 17

CB2

Module 20
CB2 Module 20: Demand-side macroeconomic policy
1

Define fiscal policy.

State what is meant by:

 an expansionary fiscal policy

 a contractionary fiscal policy.

Fiscal policy

 Fiscal policy is policy to affect the level of aggregate demand in the

economy, ie total spending on domestically produced goods and
services, by altering the balance between government spending and/or
taxation.

 An expansionary fiscal policy aims to increase aggregate demand by

increasing government spending and/or decreasing taxation.

 A contractionary fiscal policy aims to decrease aggregate demand by

decreasing government spending and/or increasing taxation.

Define the following terms in the context of government spending:

 current expenditure

 capital expenditure

 final expenditure

 transfers.

Government spending definitions

 Current expenditure is recurrent spending on goods and factor

payments, eg medicines, salaries and welfare payments.

 Capital expenditure is investment expenditure on assets, eg schools,

hospitals, roads.

 Final expenditure is expenditure on goods and services, which is part of

GDP and aggregate demand (AD).

 Transfers are payments from taxpayers to recipients of benefits and

subsidies. They are equivalent to a negative tax.

Define the following terms in the context of government deficits and surpluses:

 budget deficit

 budget surplus

 fiscal stance.
.

Definitions relating to government deficits and surpluses

 A budget deficit arises if, in any given year, government spending

exceeds tax receipts.

 A budget surplus arises if, in any given year, tax receipts exceed
government spending.

 The fiscal stance refers to the extent to which fiscal policy across the
entire public sector (ie central government, local government and public
corporations), is expansionary or contractionary.

Define the following terms in the context of government deficits and surpluses:

 public sector net borrowing (PSNB)

 public sector net cash requirement (PSNCR)

 the national debt

 structural deficit (or surplus)

 public sector current budget deficit.

Definitions relating to government deficits and surpluses

 Public sector net borrowing (PSNB) is the difference between the

expenditures of the public sector and its receipts from taxation and the
revenues from public corporations.
 The public sector net cash requirement (PSNCR) is the annual deficit of
the public sector and thus the amount the public sector must borrow in
any year.
 The national debt is the accumulated deficits of central government. It
represents the total amount owed by central government, both
domestically and internationally.
 The structural deficit (or surplus) is the public sector deficit (or surplus)
that would occur if the economy were operating at the potential level of
national income, ie with a zero output gap.
 The public sector current budget deficit is the amount by which public
sector current expenditures exceed public sector receipts.

Describe the main roles of fiscal policy with respect to aggregate demand and
aggregate supply.

Main roles of fiscal policy

With respect to aggregate demand (AD)

To prevent the occurrence of fundamental disequilibria in the economy, ie by

removing any severe inflationary or deflationary gaps, eg during the global
recession in 2008-09.

Stabilisation policies, ie as a fine-tuning policy, to smooth out cyclical

fluctuations in the economy.

With respect to aggregate supply (AS)

To influence aggregate supply, eg by increasing government expenditure on

education, training and infrastructure and/or giving tax incentives for
investment and R&D.

Outline the four key fiscal indicators that can be used to assess the financial
position of the public sector.

Key fiscal indicators

1. Public sector net borrowing (PSNB) – see Card 4

2. Public sector net debt – gross public sector debt minus liquid financial
assets

3. Public sector current budget deficit – see Card 4

4. Primary surplus (or deficit) – the situation when the sum of public sector
expenditure excluding interest payments on public sector debt is less
(or greater) than public sector receipts

Explain the influence of the business cycle on the public finances.

The influence of the business cycle on the public finances

If the economy is booming, with high profits and incomes, tax revenues will be
high. Also, unemployment and unemployment benefit payments will be low.

So, the combined the combined effect of increased taxes and lower benefits is
to reduce public sector net borrowing and there may even be a surplus.

Conversely, if the economy is depressed, then tax revenues will be low,

benefit payments will be high and the public sector deficit will be high.

Describe the relationship between the size of the deficit or surplus (and
changes in it) and the government’s fiscal stance.

The relationship between the size of the deficit or surplus (and changes
in it) and the government’s fiscal stance

The existence of a public sector deficit (or surplus) does not mean that the
fiscal stance is expansionary (or contractionary).

This is because whether the economy expands or contracts depends on the

balance of total injections and total withdrawals.

Instead we need to focus on changes in the size of the deficit or surplus.

If the deficit is lower this year than last, then (all else being equal) aggregate
demand will be lower this year than last because either G (an injection) has
fallen and/or T (a withdrawal) has increased.

So, the size of a deficit or surplus is a poor guide to the stance of fiscal policy,
as a large deficit may be due to a deliberate policy of increasing AD or simply
to the fact that the economy is depressed.
© IFE: 2019
CB2 Module 20: Demand-side macroeconomic policy
9

Define:
 automatic fiscal stabilisers
 discretionary fiscal policy
 pure fiscal policy.

Automatic fiscal stabilisers

These are the forms of government spending and taxes that adjust
automatically to the state of the economy (without the government taking any
action) and reduce the size of fluctuations in national income.

Discretionary fiscal policy

This refers to deliberate changes in tax rates and/or government spending in

order to influence the level of aggregate demand.

Pure fiscal policy

This is fiscal policy that does not involve a change in the money supply.

Outline the pros and cons of automatic fiscal stabilisers.

The pros and cons of automatic fiscal stabilisers

+ They act instantly as soon as AD fluctuates, whereas it takes time to

institute discretionary policy and for it to work.

– Their effect is to reduce the size of fluctuations rather than eliminate

them entirely.

– Although higher tax rates provide more stability, they may discourage
effort and initiative.

– Although high unemployment benefits provide more stability, they may

increase equilibrium unemployment

– High income-related benefits may create a poverty trap, ie lower-paid

people may be better off not working.

State the three things that can be altered using discretionary changes in
government spending and/or taxes.

Things that can be altered using discretionary changes in government
spending and/or taxes

1. the overall level of aggregate demand, by increasing the overall levels

of G and/or T

2. aggregate supply, eg using tax incentives to encourage work or R&D

3. the distribution of income, by using taxes and benefits to redistribute

incomes form the rich to the poor

Discuss the relative merits of changing government spending (G) and taxes,
with reference to the tax multiplier.

The relative merits of changing government spending (G) and taxes (T)

Increasing G will have a full multiplied rise in national income, as all the
money gets spent and so it all goes to boosting AD.

Cutting taxes, eg on income, by the same amount will have a smaller effect on
national income, as only part of the additional disposable income will be spent.

Part will instead be withdrawn, eg as extra savings and imports, and so won’t
be passed on round the circular flow of income.

NB It can be shown the tax multiplier is always one less than the government
spending multiplier.

Describe the problems of magnitude and problems of timing associated with

the use of discretionary fiscal policy.

Problems of magnitude

This refers to the fact that it is impossible to predict the sizes of the effects of
changes in G and/or T on national income.

Problems of timing

This refers to the fact that it will take a long time for the full effect of changes
in G and T on national income to occur, during which economic conditions will
have changed in unpredictable ways.

Consequently, by the time the policies take full effect, they may turn out to be
inappropriate and possibly even destabilising.

List seven reasons why the size of the effect of fiscal policy on national
income is difficult to predict.

Why the size of the effect of fiscal policy is difficult to predict

1. a rise in government spending may simply replace private sector

expenditure
2. a pure fiscal expansion (which does not increase the money supply)
may cause crowding out as higher interest rates reduce private sector
borrowing and spending
3. the effect of tax cuts depends on the level of confidence in the
economy, who gets the tax cuts and the state of financial well-being
4. the multiplier effect depends on the size of the marginal propensity to
consume, which varies with attitudes to saving and spending on imports
5. the accelerator and the pump-priming effects depend on business, bank
and consumer confidence
6. multiplier/accelerator interactions are virtually impossible to estimate
7. the economy is subject to unpredictable random shocks
© IFE: 2019
CB2 Module 20: Demand-side macroeconomic policy
15

Outline the five possible time lags associated with fiscal policy, which mean it
takes time to work.

Possible time lags associated with fiscal policy

1. the time lag to recognition of the problem, eg inflation

2. the time lag between recognition and action, ie deciding what to do and
implementing the policy

3. the time lag between action and the changes taking effect, eg as some
taxes are paid in arrears between action and the changes taking effect

4. the time lag between the changes in G and T and the resulting change
in national income, prices and employment, as the multiplier and
accelerator effects take time

5. consumption may respond slowly to changes in taxation – the short-run

consumption function tends to be flatter than the long-run one

 the UK’s golden rule

 the UK’s sustainable investment rule

 the EU’s Stability and Growth pact (SGP)

 the EU’s Fiscal Compact.

UK Golden rule
This required that total receipts equalled total current expenditure over the
business cycle.

UK Sustainable investment rule

This required that public sector net debt averaged no more than 40% of GDP
over the business cycle.

EU Stability and Growth pact (SGP)

This required governments adopting the euro to seek to balance their budgets
over the business cycle and also that deficits should not exceed 3% of GDP in
any year.

EU Fiscal Compact
This requires that governments not only abide by the deficit requirements of
the SGP, but they also keep structural deficits no higher than 0.5 of GDP.

Explain the two main arguments against discretionary (fiscal and monetary)
policy.

Main arguments against discretionary policy

1. Political behaviour, ie politicians may attempt to manipulate the

economy for their own political purposes, such as the desire to be re-
elected.

For example, they may overstimulate the economy prior to an election,

so that growth is strong at election time, without regard to the inflation
that may later result.

2. The time lags associated with discretionary policy (both fiscal and
monetary), which can make the policies at best ineffective and at worst
destabilising.

Explain the four arguments in favour of (fiscal and monetary) targets and
rules.

Arguments in favour of targets and rules

1. If firms are not protected from adverse market conditions by

discretionary demand management they will improve their efficiency.

2. Setting and sticking to rules, eg with regard to inflation, will influence

people’s expectations that inflation will be lower, making an inflation
target easier to attain.

3. Having a stable monetary and fiscal framework makes it easier for firms
to make long-term planning decisions leading to more investment and
growth.

4. Rules work well if different countries follow mutually consistent rules,

eg similar inflation targets.

Explain the three arguments in favour of discretionary policy.

Arguments in favour of discretionary policy

1. Active intervention enables the government to respond appropriately to

the unpredictable shocks that continually affect the economy,
eg changes in expectations, domestic political events and world
economic factors.

2. Without discretionary stabilisation policies, the uncertainty associated

with such shocks would be damaging to investment and long-term
growth.

3. In addition, sticking to an inflation target could require excessive

fluctuations in interest rates, which could again discourage investment
and growth.

Explain the problems with targets and rules.

Problems with targets and rules

It can be difficult to decide:

1. whether to stick with the rule(s) come what may
2. what degree of flexibility to design into any rules
3. whether policy makers should have some discretion to change the
rules, eg if circumstances change so the target becomes inappropriate.

Inflation targets can become consistent with both a buoyant and a depressed
economy, ie the Phillips curve may become horizontal, so they may not tackle
the problem of creating stable long-term growth.

Also, targeting one variable (eg inflation) can have adverse effects elsewhere
in the economy (eg on growth).

Discuss the use of a Taylor rule and the effect of different Taylor rules on the
dynamic aggregate demand (DAD) curve.

Use of a Taylor rule

A Taylor rule takes two objectives into account, eg inflation and real national
income or unemployment, and seeks to get the optimum degree of stability of
the two.

The degree of importance attached to each of the two objectives is decided by

the government or central bank.

The central bank adjusts interest rates when either inflation diverges from its
target or the level of real national income (or unemployment) diverges from its
potential (or natural) level.

The more weight is given to stable inflation, the flatter will be the DAD curve.

List the five factors that will influence the choice between discretion and rules.

Factors that will influence the choice between discretion and rules

1. the degree of confidence people have in the effectiveness of either

discretion or rules – greater confidence increases the likelihood that
the policy in question will be effective

2. the degree of inherent stability of the economy

3. the size and frequency of exogenous shocks to demand, eg financial

crashes

4. the ability and determination of the government to stick to rules and

the confidence people have that they will be effective

5. the ability of the government to adopt and speedily execute

discretionary policies that have the desired effect (because it has
expert analysts and forecasters).

Summary Card

Fiscal policy: definitions & roles Cards 1 & 5

Public finances: deficits & surpluses Cards 2 to 4, 6 to 8

Automatic fiscal stabilisers Cards 9 & 10

Discretionary fiscal policy Cards 11 to 15, 17, 19, 22

Fiscal targets & rules Cards 16, 18, 20 to 22

CB2

Module 21
CB2 Module 21: Exchange rate policy
1

Discuss the potential conflicts between attaining internal and external balance.

Potential conflicts between attaining internal and external balance

Suppose the economy is in recession and GDP is below its potential level
(ie internal imbalance), but the current account of the balance of payments is
in balance (ie external balance).

The government therefore expands aggregate demand by increasing G to

close the output gap and restore internal balance.

The increase in GDP will lead to an increase in imports (due to higher

income).

Consequently, internal balance will be restored at the expense of introducing

an external imbalance.

Conversely, reducing GDP to increase net exports and restore external

balance is likely to lead to a recession and an internal imbalance.

Discuss the relationship between the balance of trade and the public finances.

Relationship between the balance of trade and the public finances

Actual injections must always equal actual withdrawals:

ie I +G + X = S +T + M

This can be rearranged to give:

(T - G ) = ( X - M ) + (I - S )

So, if the public sector runs a budget surplus (T - G > 0 ) , it’s possible that
the trade balance is in surplus too.

In fact, if I = S , then a budget surplus or deficit would be exactly matched by

a trade surplus or deficit.

Define the real exchange rate and state a formula for the real exchange rate
index (RERI) in terms of the nominal exchange rate index (NERI).

Real exchange rate

This is the nominal exchange rate (at which currencies are exchanged)
adjusted for changes in the domestic currency prices of exports relative to the
foreign currency prices of imports.

Real exchange rate index

RERI = NERI ¥ PX PM

where:
 PX is the domestic currency price index of exports
 PM is the foreign currency weighted price index of imports.

Define the following exchange rate regimes:

 totally fixed exchange rate

 freely floating exchange rate

 intermediate exchange rate regime.

Totally fixed exchange rate

This is where the government (or central bank) takes whatever measures are
necessary to maintain the exchange rate at a fixed level (eg against another
currency or basket of currencies).

Freely floating exchange rate

The exchange rate is determined by demand and supply in the foreign

exchange market without any government intervention.

Intermediate exchange rate regime

This is where the government intervenes to influence movements in the

exchange rate.

Explain the need for central bank intervention in the currency markets under a
fixed exchange rate regime.

The need for central bank intervention in the currency markets under a
fixed exchange rate regime

Unless the demand for and supply of currency are equal at the fixed rate, the
central bank will have to intervene in the currency markets and buy or sell to
make up the difference.

For example, if there is an excess of supply over demand, the central bank will
need to buy up the excess supply by selling its foreign currency reserves (or
borrowing foreign currency from foreign banks to sell) so as to stop the
currency depreciating.

Conversely, if there an excess of demand over supply, the central bank will
need to sell extra domestic currency in exchange for foreign currency reserves
so as to stop the currency appreciating.

Describe the effect on the money supply (and hence the domestic economy)
of central bank intervention in the currency markets under a fixed exchange
rate regime.

Effect on the money supply and the domestic economy of central bank
intervention under a fixed exchange rate regime

If the fixed rate is too high, ie there is a balance of payments deficit and
therefore an excess supply of domestic currency on the currency market, the
central bank will buy up the excess domestic currency.

This domestic currency is withdraw from circulation and so the domestic

money supply is reduced and interest rates rise.

This attracts financial inflows from abroad and improves the financial account
of the balance of payments. It will also dampen aggregate demand, reducing
imports and improving the current account.

However, it will also reduce GDP and possibly lead to a recession.

The opposite effects will occur is the fixed rate is too low.

Define sterilisation and discuss its use when there is an excess supply of
domestic currency on the currency markets.

Sterilisation

This is where the central bank uses open market operations (or other
monetary measures) to neutralise the effects of balance of payments
surpluses or deficits on the domestic money supply.

For example, if there is an excess supply of domestic currency on the

currency markets, buying the excess domestic currency would reduce the
money supply, which could be countered by buying government bonds to
inject money back into the economy. This would avoid a rise in interest rates
and a possible recession.

However, not allowing the money supply to change means that the excess
supply of domestic currency persists (ie the balance of payments deficit
persists, and the central bank is continuing to sell reserves to support the
currency), which cannot continue indefinitely as foreign currency reserves are
finite.

Discuss how to correct a persistent balance of payments deficit under a fixed

exchange rate.

Correcting a persistent balance of payments deficit under a fixed
exchange rate

 The government could reduce the balance of payments deficit and

hence the supply of the domestic currency on the currency markets
using contractionary fiscal and/or monetary policy.

 Contractionary policy to reduce GDP would reduce expenditure,

including that on imports. However, this would also lead to a fall in
growth and a rise in unemployment.

 If contractionary policy reduces inflation, then exports would become

relatively cheaper and imports relatively more expensive, leading to an
increase in net exports. This would also counteract the adverse effect
on growth and employment.

 Alternatively, restrictions on imports (eg tariffs and quotas) or subsiding

Discuss the correction of a balance of payments deficit under a free-floating

exchange rate regime.

Correcting a balance of payments deficit under a free-floating exchange
rate regime

 A freely floating exchange rate should automatically adjust to correct a

balance of payments surplus or deficit.

 A deficit results in an excess supply of domestic currency, so the

currency depreciates. This makes exports cheaper in foreign currency
terms and imports dearer in domestic currency terms. Hence, net
exports should increase, so correcting the deficit.

 However, the rise in net exports will increase GDP and hence the
demand for imports, reducing the effectiveness of the depreciation.

 This increase in GDP will also reduce unemployment and may lead to
higher inflation, which would make the depreciation less effective.

Discuss the effectiveness of monetary policy under fixed exchange rates.

Effectiveness of monetary policy under fixed exchange rates

 If inflation is high, the central bank will cut monetary growth, which will
increase interest rates and reduce GDP and demand-pull inflation.
 Lower GDP and inflation will reduce imports and increase exports,
leading to a current account surplus.
 Also, higher interest rates will lead to financial inflows and a financial
account surplus.
 This balance of payments surplus (leading to an excess demand for the
currency satisfied by an increased supply of it by the central bank) will
thus increase the money supply and reduce interest rates back towards
their original level and GDP will rise back to its original level.
 So, monetary policy is not very effective under fixed exchange rates.

Discuss the effectiveness of fiscal policy under fixed exchange rates

Effectiveness of fiscal policy under fixed exchange rates

 In a recession, the government may increase aggregate demand by

increasing G and/or cutting T.
 This increases GDP and inflation, leading to higher imports, lower
exports and a current account deficit.
 The GDP increase will also increase money demand and hence interest
rates, leading to financial inflows and a financial account surplus.
 To stop this swamping the current account deficit, the central bank must
increase the money supply to stop interest rates rising too much.
 This monetary expansion reinforces the expansionary fiscal policy and
prevents crowding out.
 So, fiscal policy is much more effective under fixed exchange rates.

Describe the four causes of long-term balance of payment problems under

fixed exchange rates.

Causes of long-term balance of payment problems under fixed exchange
rates

1. Different inflation rates between countries – which change the

competitiveness of imports and exports.
2. Different growth rates between countries – imports tend to grow faster
than exports for countries with higher growth rates.
3. The Income elasticity of demand for imports is higher than for exports –
for countries where this the case, imports will grow more quickly than
exports as world GDP grows.
4. Long-term structural changes, eg:
– emergence of trading blocs
– countries exercising monopoly power, eg OPEC
– development of import substitutes
– changes in countries’ products.
© IFE: 2019
CB2 Module 21: Exchange rate policy
13

Outline the four advantages of fixed exchange rates.

Four advantages of fixed exchange rates

1. Certainty – international trade and investment are less risky as profits

are not affected by exchange rate fluctuations
2. Little or no speculation – provided the exchange is completely fixed and
people believe it will remain so
3. Automatic correction of monetary errors. If the money supply grows too
fast, lower interest rates will lead to a balance of payments deficit. So,
the central bank must then either buy the domestic currency, causing
the money supply to fall again, or it must raise interest rates, either of
which will correct the initial error.
4. Preventing governments from pursuing ‘irresponsible’ macroeconomic
policies – eg if it expands spending excessively to gain popularity, the
resulting balance of payments deficit will force it to constrain demand
again.

Explain the two new classical criticisms of fixed exchange rates.

New classical criticisms of fixed exchange rates

1. They make monetary policy ineffective

The money supply must be varied so that interest rates ensure the overall
balance of payments balances, rather than to achieve domestic objectives
such as reducing inflation. (See Card 10)

2. They contradict the objective of having free markets

New classical economists argue that the foreign exchange market should be
treated like any other market and left to supply and demand.

Outline the four problems with fixed exchange rates identified by Keynesian
economists.

Problems with fixed exchange rates identified by Keynesian economists

1. Balance of payments deficits can lead to a recession – eg if they result

in persistently higher interest rates that reduce growth and employment

2. Competitive deflations leading to a world recession

3. Problems of international liquidity – as the supply of each currency is

likely to be determined by domestic economic factors, rather than the
needs of the international economy

4. Speculation – which can lead to a devaluation (revaluation) if a currency

is thought to be overvalued (undervalued)

International liquidity is the supply of currencies in the world acceptable for

financing international trade and investment.

Explain the purchasing power parity (PPP) theory with the aid of a numerical
example.

Purchasing power parity (PPP) theory

PPP says that nominal exchange rates will adjust so as to offset differences in
countries’ inflation rates and ensure that relative prices remain unchanged, ie
the real exchange rate stays the same.

For example, suppose a product costs £1 in the UK and $1.40 in the US, and
that the exchange rate is £1 = $1.40. So, the purchasing power of £1 in the
UK and the US (converted at £1= $1.40) is the same, ie one unit of the good.

PPP says that if the UK price of the good were to rise to £1.40, with no
change in the US price, then the exchange rate would change to £1 = $1, so
that the purchasing power of £1.40 in the UK and the US (converted at
£1 = $1) is still the same, ie one unit of the good.

Note that PPP assumes that real interest rates are the same in the countries
involved.

Explain why high real interest rates may lead to the breakdown of the
purchasing power parity (PPP) theory.

Why high real interest rates may lead to the breakdown of the
purchasing power parity (PPP) theory

Suppose a rise in aggregate demand (AD) leads to higher real interest rates
(eg due to higher money demand) and higher inflation.

The higher AD and inflation will lead to a current account deficit, putting
downward pressure on the exchange rate.

However, higher real interest rates will lead to financial inflows and upward
pressure on the currency.

The overall result will depend on which effect is larger, but either way, the
financial account effect means the exchange rate will be above the rate
according to PPP.

Explain why the carry trade may lead to the breakdown of the purchasing
power parity (PPP) theory.

Why the carry trade may lead to the breakdown of the purchasing power
parity (PPP) theory

Often countries with current account deficits have high interest rates (to attract
cash inflows to offset the deficits), while current account surplus countries
have low interest rates.

So, it is profitable to borrow at a low interest rate in a surplus country and

deposit the cash to earn a high interest rate in a deficit country, ie to
undertake a carry trade.

This carry trade has the effect of making the currencies of deficit countries
appreciate, rather than depreciate as suggested by PPP, making their goods
less competitive and worsening the deficit.

Describe how floating exchange rates may protect the domestic economy
from world economic fluctuations, using the example of a world recession.

How floating exchange rates may protect the domestic economy from
world economic fluctuations

Suppose the rest of the world goes into recession, with no change in
international interest rates.

Then exports will fall, reducing domestic demand and GDP.

However, the exchange rate will depreciate, making exports more competitive
and imports less competitive.

Consequently, net exports will increase, boosting aggregate demand and

GDP, so reducing the effect of the world recession.

Describe, with the aid of a diagram, the exchange rate path to long-run
equilibrium after a shock (in the absence of speculation).

Exchange rate path to long-run equilibrium after a shock (in the absence
of speculation)

Suppose a rise in AD results in rises The size of the appreciation will

in interest rates and imports, and a such that that the subsequent
current account deficit. Higher depreciation will exactly offset the
interest rates then lead to financial higher initial level of interest rates.
inflows and an rise in the exchange
rate (to er1 ). nominal
exchange
rate
er1
Subsequently, the exchange rate will
fall back to its long-run rate ( erL ) as
higher interest rates curb AD and so erL
interest rates can come back down.

t1 t2 time

Explain the possible effects of stabilising and destabilising speculation on the

exchange rate.

Effects of stabilising and destabilising speculation on the exchange rate

 Stabilising speculation occurs when speculators believe that any

exchange rate movement will soon be reversed.

For example, suppose the exchange rate has fallen, but speculators
think it will soon rise again (eg if they expect the central bank to raise
interest rates), then they will buy the currency in anticipation of this,
causing the exchange rate to rise as anticipated.

 Destabilising speculation occurs when speculators believe that

exchange rate movements will continue in the same direction.

For example, suppose the exchange rate has fallen due to high
inflation. If they expect inflation to remain high and the exchange rate
to fall further, then they will sell the currency, which will itself cause the
currency to fall further, resulting in exchange rate overshooting.

Explain the four advantages of free-floating exchange rates.

Advantages of free-floating exchange rates

1. Automatic correction of balance of payments surpluses and deficits by

movements in the exchange rate, without the need for specific
government policies.

2. No problem of international liquidity and reserves. No central bank

intervention means no reserves are required

3. Insulation from external economic events. Countries are not tied to the
inflation rates of others and are protected from external shocks to some
extent by exchange rate movements.

4. Governments are free to choose their domestic policy. Government

policy is not constrained by the need to maintain a fixed exchange rate,
so the government is free to target whatever level of demand is best for
the economy.

Explain the three disadvantages of free-floating exchange rates.

Disadvantages of free-floating exchange rates

1. Speculation can lead to high levels of exchange rate volatility.

2. Uncertainty for international traders and investors, which may reduce

international trade (and the associated benefits) and international
investment (and hence world growth).

3. Lack of discipline on the domestic economy, which may allow the

government to pursue ‘irresponsible’ policies and unions and firms to
push up wages and prices.

NB Uncertainty may be reduced via the forward exchange market, where

contracts are made today for the price at which currency can be exchanged at
some specified future date.

Discuss the effectiveness of monetary policy under free-floating exchange

rates.

Effectiveness of monetary policy under free-floating exchange rates

 Suppose the economy is in recession and so interest rates are cut to

increase aggregate demand (AD).

 Lower interest rates will cause the currency to fall in value, making
exports more competitive and imports dearer, leading to increased net
exports and reinforcing the increase in domestic AD.

 In addition, speculation may lead temporarily to exchange rate

overshooting, causing the exchange rate to go even lower, causing a
further rise in AD.

 So, under a floating exchange rate monetary policy is strong.

Discuss the effectiveness of fiscal policy under free-floating exchange rates.

Effectiveness of fiscal policy under free-floating exchange rates

 Suppose the economy is in recession, so the government cuts T and/or

increases G to increase AD.

 The rise in AD will increase imports and (if inflation rises) reduce
exports, and the resulting current account deficit will put downward
pressure on the exchange rate.

 However, increased money demand will raise interest rates, leading to

financial inflows and upward pressure on the exchange rate.

 If, as is likely, the overall effect is an appreciation of the exchange rate,

this will reduce net exports, reducing AD and the effectiveness of the
fiscal policy.

 So, under a floating exchange rate fiscal policy is weak.

Describe the operation of the Bretton Woods system.

Bretton Woods system

 This was an adjustable peg system whereby currencies were pegged to

the US dollar, which in turn was convertible into gold at price of $35 per
ounce, implying that $1 = 1/35 of an ounce of gold.

 To prevent short-term temporary fluctuations in the exchange rate

(beyond 1%), central banks intervened in the foreign exchange market
using their foreign currency reserves.

 If the disequilibrium became more serious, governments were

supposed to pursue deflationary or reflationary policies. They could
also borrow funds from the IMF to help maintain their exchange rate.

 If the deficit became severe, countries could devalue their currency, in

consultation with the IMF.

Describe three ways by which the Bretton Woods system contributed to world
growth.

Contribution of the Bretton Woods system to world growth

1. Fixing exchange rates for a long period of time reduced uncertainty,

which encouraged world trade.

2. Pegged rates, plus the oversight of the IMF, prevented governments

pursuing irresponsible policies, helped to bring about an international
harmonisation of economic policy and kept world inflation in check.

3. The ability to devalue when faced with a severe deficit prevented

governments being forced into deflationary or protectionist policies.
The IMF ensured an orderly process of devaluation.

Describe the three problems of adjustment to balance of payments

disequilibria and international liquidity that led to the collapse of the Bretton
Woods system.

Problems of adjustment to balance of payments disequilibria and
international liquidity that led to the collapse of the Bretton Woods
system

1. It was difficult to identify whether a deficit was fundamental.

Governments were frequently over-optimistic about the future balance
of payments position.

2. A devaluation could be very disruptive, as it altered the costs and

revenues of importers and exporters substantially. If a devaluation was
felt to be imminent, it led to uncertainty making international traders
reluctant to take on new commitments.

3. A devaluation could initially make a current account deficit worse before

it eventually improved – the J-curve effect.

Explain, with the aid of a diagram, the J-curve effect.

J-curve effect

This is where a devaluation causes the balance of payments to first

deteriorate and then to improve.

It arises because the price X-M

devaluation at t1
elasticities of demand for imports
and exports may be low in the short
run, as many trade deals are agreed
several weeks or months in advance. surplus
deficit
So, to start off with, fewer additional
exports will be sold, but more
domestic currency will have to be
paid for imports.
t1 time

Describe the operation of the managed floating system since the early 1970s.

Operation of the managed floating system since the early 1970s

The managed floating exchange rate system has allowed the adjustments
required to the inevitable shifts in demand and supply to be gentler, avoiding
wild swings in exchange rates, exacerbated by speculation.

Some minor currencies are pegged to the US dollar, whilst others are pegged
to each other, but float jointly against the rest of the world, eg the exchange
rate mechanism (ERM), which operated prior to the euro.

Although some countries allow their currencies to float freely, most have from
time to time attempted to stabilise their exchange rate, an approach known as
managed flexibility. Two main methods are used to prevent a depreciation:
1. using reserves or foreign currency loans to purchase domestic currency
2. raising interest rates to attract short-term deposits.

Describe the three problems with managed floating since 1972.

Problems with managed floating since 1972

1. Predicting what the long-term equilibrium exchange rate should be – as

this will reflect not just purchasing power parity, but other factors such
as oil crises, the dismantling and/or erection of trade barriers and
changes in technology and tastes.

2. The growth in speculative financial flows – which has made it difficult for
countries to control exchange rates by currency sales and purchases
alone. So, more emphasis has been placed on using interest rates.

3. However, using interest rates for this purpose may conflict with internal
policy objectives, such as meeting an inflation target.

List nine reasons for the increased volatility of exchange rates.

Reasons for the increased volatility of exchange rates

1. inflation or money supply targets, requiring changes to interest rates.

2. the huge growth in international financial markets
3. the widespread abolition of exchange controls
4. the growth in IT, which has facilitated international financial flows
5. the preference for liquidity
6. growing speculation by trading companies to take advantage of
currency movements
7. the growth of speculation by banks and other financial institutions
8. the growth of a ‘speculative mentality’ leading to destabilising
speculation
9. the growing belief that governments are powerless to prevent currency
movements

Describe the BP (balance of payments) curve.

Explain why it slopes upwards and also the factors affecting its gradient.

BP (balance of payments) curve

This shows the combinations of interest rates (r) and national income (Y) that
correspond to a position of balance of payments equilibrium.

It slopes upwards because (assuming prices are fixed) an increase in r causes

a financial account surplus, whereas an increase in Y leads to a current
account deficit (as imports rise). So a rise in r must be accompanied by a rise
in Y to keep the balance of payments in equilibrium.

Its gradient depends on:

 the marginal propensity to import (mpm) – a higher mpm means a
steeper BP curve, as a given rise in Y leads to a larger current account
deficit, requiring a higher rise in r to restore external balance
 the elasticity of supply of international finance – a higher elasticity
means a flatter BP curve, as a smaller rise in r is needed to restore
external balance.
© IFE: 2019
CB2 Module 21: Exchange rate policy
34

Draw a diagram to show the effect on output of an expansionary fiscal policy

under fixed exchange rates using the extended IS-LM model.

Assume that the BP curve is flatter than the LM curve.

Effect of expansionary fiscal policy under fixed exchange rates

r LM1
LM2

r2 BP1

r3
r1

IS2

IS1

Y1 Y2 Y3 GDP

Draw a diagram to show the effect on output of an expansionary monetary

policy under fixed exchange rates using the extended IS-LM model.

Assume that the BP curve is flatter than the LM curve.

Effect of expansionary monetary policy under fixed exchange rates

r LM1
LM2
BP1

IS1

Y1 Y2 GDP
NB The economy shifts to ( r2, Y2) and then back again.

Draw a diagram to show the effect on output of an expansionary fiscal policy

under floating exchange rates using the extended IS-LM model.

Assume that the BP curve is flatter than the LM curve.

Effect of expansionary fiscal policy under floating exchange rates

r LM1

BP2
r2 BP1
r3

IS2
IS3
IS1

Y1 Y3 Y2 GDP

Draw a diagram to show the effect on output of an expansionary monetary

policy under floating exchange rates using the extended IS-LM model.

Assume that the BP curve is flatter than the LM curve.

Effect of expansionary monetary policy under floating exchange rates

r LM1
LM2
BP1
BP2
r1
r3
r2

IS2

IS1

Y1 Y2 Y3 GDP

Summary Card

Internal & external balance Cards 1 & 2

Real exchange rates Card 3

Fixed exchange rates Cards 4 to 8,10 to 15

Floating exchange rates Cards 4, 9, 19 to 25

Purchasing power parity (PPP) Cards 3, 16 to 18

Exchange rate systems in practice Cards 26 to 32

Extended IS-LM model Cards 33 to 37

CB2

Module 22
CB2 Module 22: Global harmonisation and monetary union
1

Define the following terms:

 international trade multiplier

 international harmonisation of economic policies

 convergence of economies.

International trade multiplier

The effect on national income in Country Y of a change in exports (or imports)

in Country X.

International harmonisation of economic policies

Where countries attempt to co-ordinate their macroeconomic policies so as to

achieve common goals.

Convergence of economies

When countries achieve similar levels of economic growth, inflation and

budget deficits as a % of GDP and similar balance of payments positions etc.

Discuss, with the aid of an example, what is meant by the interdependence of

economies through international trade.

Interdependence of economies through international trade

Trade between nations means that the economic policies of one nation will
affect other nations. For example, if inflation is too high in the US, it may
adopt deflationary measures aimed at reducing domestic demand. However,
these will also reduce its imports and hence have a deflationary effect in other
economies via the international trade multiplier.

The more open to trade is an economy, the more it is exposed to changes in

economic activity in the rest of the world.

The increasing volumes of trade as a proportion of world GDP over recent

decades have led to increased interdependence through trade.

Discuss the causes of the financial interdependence of economies.

Causes of the financial interdependence of economies

The financial interdependence of economies has grown due to the increase in:
 international flows of money seeking higher interest rates

 financial institutions and individuals holding assets in other countries,

eg bank deposits and government securities

 financial deregulation and innovation, eg securitisation.

Discuss, using the example of a rise in US interest rates, the implications of

the financial interdependence of economies.

Implications of the financial interdependence of economies

Changes in financial conditions in one economy can affect aggregate demand

and hence GDP in other countries.

For example, a rise in US interest rates will:

 reduce US GDP and hence exports from, and GDP in, other countries

 lead to interest rates rises in other countries and consequent falls in

their GDPs

 lead to an inflow of funds into the US economy, resulting in a rise in the

US dollar and a fall in other currencies, which will make the exports of
other countries more attractive, thereby increasing their GDP.

Note how the first two factors lead to falls in GDP, while the final factor leads
to rises in GDP.

Outline the meaning of international business cycles.

Outline the meaning of international business cycles

The trade and financial interdependence of economies means that the world
economy tends to experience fluctuations in economic activity, ie international
business cycles.

As a result, individual economies tend to move together and experience

similar economic conditions and problems at the same time.

Explain, with the aid of an example, the need for international policy
co-ordination.

List four international organisations that provide a forum for international policy
co-ordination

Need for international policy co-ordination

International business cycles mean it is better to try and seek common

international solutions to the problems faced, rather than each country doing
what is in its own self-interest. In other words, they point to the need for
international policy co-ordination.

For example, faced with a world recession, if one country depreciates its
currency, this will increase its exports and GDP, but only at the expense of
other countries. A better policy would instead be for all countries to adopt
similar expansionary policies.

Four international organisations

The G7, G20, World Trade Organisation (WTO) and the International
Monetary Fund (IMF) all provide a forum for discussing global economic
problems and considering co-ordinated policy responses.

Explain the need for the international harmonisation of economic policies and
the difficulties in achieving it

Need for the international harmonisation of economic policies

This is needed to generate world economic growth without major currency

fluctuations.

The difficulties in achieving it

These arise because different countries may face significant domestic

differences, eg with regard to:
 budget deficits and national debt
 inflation and interest rates
 structural relationships (eg between inflation and unemployment)
 productivity, investment etc

and they may be unwilling to change their domestic policies to fall in line with
other countries.

Define the following terms:

 economic and monetary union (EMU)

 exchange rate mechanism (ERM)

 currency union.

Economic and monetary union (EMU)

The adoption by a group of countries of a single currency, with a single central

bank and monetary policy.

In the EU, it refers to the countries that have adopted the euro.

Exchange rate mechanism (ERM)

A semi-fixed system in which participating EU countries allowed fluctuations

against each other’s currencies within agreed bands. Collectively, the
currencies floated freely against other currencies.

Currency union

A group of countries using a common currency.

Describe the operation of the exchange rate mechanism (ERM) in principle.

Operation of the exchange rate mechanism (ERM) in principle

 The ERM was an adjustable peg system, ie members’ exchange rates

were pegged against each other but floating against the rest of the
world.

 Member currencies were allowed to fluctuate against each other,

typically by up to 0.25% around a central rate.

 The central rates were adjusted occasionally by agreement.

 If a member currency approached the upper or lower limit against

another member currency, central banks would intervene, typically
buying the weak currency and selling the strong one. Interest rates
might also be raised / lowered by the weaker / stronger currency
countries.

Describe the operation of the exchange rate mechanism (ERM) in practice,

with particular reference to the UK.
.

Operation of the exchange rate mechanism (ERM) in practice

 The ERM started in 1979 with most EU countries joining, though some
countries joined later, eg the UK in 1990.

 Sterling entered at £1 = 2.95 German Marks 6%. However, high

German interest rates following reunification pushed the mark up and
other currencies down to the bottom of their permitted bands, including
the pound.

 In September 1992, despite raising interest rates, the UK was forced to

suspend its membership of the ERM – the pound was floated and fell
substantially.

 Thereafter, the pound remained outside of the ERM.

 In 1999, the ERM was replaced by the single currency.

Describe the steps taken prior to the birth of the euro.

Steps taken prior to the birth of the euro

 In 1992, the Maastricht Treaty finalised the path towards European

Economic and Monetary Union (EMU) and set a deadline of 1999 for
the adoption of the single currency.

 Member states were required to meet five convergence criteria before

they could adopt the single currency.

 Before launching the single currency, the EU’s Council of Minsters

decided who met the criteria.

 A European System of Central Banks (ESCB) was set up, consisting of

a European Central Bank (ECB) and the central banks of the member
states. The ECB would operate an independent monetary policy on
behalf of the countries that adopted the single currency.

List the five convergence criteria for adopting the euro.

Five convergence criteria for adopting the euro

1. Inflation should be no more than 1.5% above the average inflation rate
of the three EU countries with the lowest inflation.

2. The interest rate on long-term government bonds should be no more

than 2% above average of the three EU countries with the lowest
inflation.

3. The budget deficit should be no more than 3% of GDP at market prices.

4. The national debt should be no more than 60% of GDP at market

prices.

5. The exchange rate should have been within the normal ERM bands for
at least two years with no realignments or excessive intervention.

Describe the birth of the euro.

Birth of the euro

 In 1998, the European Commission decided that 11 member states

were eligible to adopt the euro.
 All 11 met the interest rate and inflation rate criteria, but there was
some doubt as to whether they all genuinely met the other three criteria.
 The euro came into being on 1 January 1999. Subsequently, national
currencies existed alongside the euro at fixed rates.
 Euro banknotes and coins were introduced on 1 January 2002. The
banknotes and coins of national currencies were withdrawn shortly
afterwards.
.
Note that eight further countries have since joined the euro. Before doing so,
they each had to both meet the convergence criteria and enter a new version
of the ERM based on a 15% band around a central rate against the euro.

Outline five advantages of the single currency.

Advantages of the single currency

1. elimination of the costs of converting currencies – when moving money

/ trading between member countries

2. increased competition and efficiency – due to greater transparency of

prices and downward pressure on prices

3. elimination of exchange rate uncertainty between the member countries

– which encourages trade between them

4. increased inward investment from the rest of the world into a trading
area with no risk of internal currency movements

5. lower inflation and interest rates – due to a single monetary policy and
an independent ECB targeting low inflation

Outline three arguments against EMU in principle.

Arguments against EMU in principle

1. The lack of national currencies removes the ability of countries

(eg those with high inflation) to remain competitive by depreciating their
currency.

2. The loss of separate monetary policies means member countries must

all have similar interest rates, which may be inappropriate when
countries face very different economic conditions.

3. It is more difficult to adjust to asymmetric shocks, such as a world

recession or a financial crisis, that affect each country to a different
degree.

Define the following terms:

 optimal currency area

 asymmetric shocks.

Optimal currency area

One that maximises the benefits from having a single currency relative to the
costs. If it were increased or decreased in size then the costs would rise
relative to the benefits.

Asymmetric shocks

Shocks that have different-sized effects on different industries, regions or

countries, eg a sudden oil price rise.

Outline two main arguments against the current design of EMU.

Arguments against the current design of EMU

1. Monetary policy

It’s argued that the ECB’s remit makes it very averse to inflation and less
responsive to downturns in economic activity, especially when they’re
accompanied by high inflation.

2. Fiscal policy

The Stability and Growth Pact, which required that budget deficits and national
debt be kept below 3% and 60% of GDP respectively, was not rigidly
enforced. Consequently, deficits and debts both rose dramatically following
the financial crisis.

This led to the introduction of the Fiscal Compact in 2013, which also required
that structural deficits be kept to less than 0.5% of GDP.

Discuss the future of the euro with reference to the Greek crisis.

Future of the euro with reference to the Greek crisis

 Prior to 2015, the perilous state of Greece’s public finances led to two
bailouts. These:
– involved the Troika (European Commission, ECB and IMF)
– imposed austerity measures that further weakened the Greek
economy.

 Following a default on an IMF loan in 2015, a third bailout and further

austerity measures were agreed. However, Greek’s national debt
continued to rise.

 Although Greece’s departure from the euro (Grexit) has so far been
avoided, its experience has raised questions about the conditions under
which other EU members might join the euro or existing members might
find it beneficial to leave.

Discuss the future of the euro with reference to the single currency and the
gains from trade.

Future of the euro with reference to the single currency and the gains
from trade

 About two thirds of trade in the EU is between member states, though

the percentage varies greatly between states.
 The gains from trade will depend upon factors such as:
– the % of trade within the Eurozone
– the degree of convergence between economies (similar
economies will face similar / symmetric shocks)
– the flexibility of labour markets (wage flexibility and labour
mobility provide mechanisms for countries within the euro to
remain competitive).
 However, economic convergence remains limited and labour
productivity, and hence unit labour costs, differ, which puts countries
such as Greece, Spain and Italy at a competitive disadvantage.

Discuss the future of the euro with reference to the fiscal framework.

Future of the euro with reference to the fiscal framework

 Fiscal transfers of income between countries can provide a buffer

against asymmetric shocks.
 However, so far, the eurozone has resisted the centralisation of national
budgets. Consequently, fiscal transfers are possible only between
regions within a country.
 Such transfers are constrained by the sustainability of national budgets,
eg in countries such as Greece, Italy and Portugal with high debt-to-
GDP ratios.
 The sustainability of the current decentralised approach to fiscal policy
may be crucial to the future for the euro and the countries using the
euro.

Summary Card

Interdependence between economies Cards 1 to 5

International policy co-ordination Cards 6 & 7

European economic & monetary union (EMU) Cards 8 to 10

The euro Cards 11 to 17

Future of the euro Cards 18 to 20

CB2

Module 23
CB2 Module 23: Summary of debates on theory and policy
1

Give a broad outline of the development of macroeconomic theory during

the classical period (1920s and 1930s).

The development of macro theory during the classical period

 Macroeconomic had its birth as a separate branch of economics with

the mass unemployment during the 1920s and 1930s.
 The old ‘classical theories’ of the time, which said that free markets
would provide a healthy economy with full employment, could not
provide solutions to the problem.
 John Maynard Keynes put forward a new analysis that did offer
solutions in The General Theory of Employment, Interest and Money in
1936.
 Keynes advocated active intervention by governments, in particular,
through changes in G and T to affect AD.
 By carefully managing AD, governments could avoid both mass
unemployment and an ‘overheated’ economy with high inflation.

Give a broad outline of the development of macroeconomic theory during

the Keynesian period (1940s to 1960s).

The development of macroeconomic theory during the Keynesian period

 After the Second World War, many governments adopted Keynesian

demand-management polices, which seemed to be successful.

 The 1950s and 1960s saw low inflation, low unemployment and
relatively high growth.

 Macroeconomists were largely concerned with refining Keynesian

economics.

Give a broad outline of the development of macroeconomic theory during

the controversial monetarist period (1970s and 1980s).

The development of macroeconomic theory during the monetarist period

 In the 1970s, the macroeconomic consensus broke down in the face of

both high inflation and unemployment and low growth.

 Different schools of thought had their own explanations of what was

going on and their own solutions to the problems.