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FACULTY OF MANAGEMENT AND LAW

SCHOOL OF MANAGEMENT

D I S T A N C E

L E A R N I N G

2015/16

MAN4100M

Business
Economics
MODULE STUDY BOOK

M B A

Study Book: Business Economics

Copyright University of Bradford 1999, 2002, 2003, 2004, 2005, 2006,


2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2015
First published 1999
Second edition 2002
Third edition 2003
Fourth edition 2004
Combined edition 2005
Combined edition 2006
Seventh UK edition 2007
Eighth UK edition 2008

Ninth UK edition 2009


Tenth revised UK edition 2010
Eleventh UK edition 2011
Twelfth UK edition 2012
Thirteenth UK edition 2013
Fourteenth UK edition 2014
Fifteenth UK edition 2015

MBABEUKSB152015 MAN4100M

Bradford University School of Management


Director of Studies
Jonathan Muir
Global Campus Postgraduate Programme Administrator
Matt Hayes m.j.hayes2@bradford.ac.uk
Anne Carter a.e.carter@bradford.ac.uk (Dubai only)
Clare Haynes c.l.haynes@bradford.ac.uk (Bradford Executive MBA)
Distance Learning Programmes Administrator
Gavin Turner G.B.Turner@bradford.ac.uk
Module Leader
Dr Simon Rudkin
Module Development Team
Bryan Lowes, Damian Ward, Chris Pass, Christine Swales, Simon Rudkin
Bradford University School of Management
Emm Lane
Bradford BD9 4JL
Tel: 01274 234936
Website: www.bradford.ac.uk/management
This Study Book may not be sold, hired out or reproduced in part or in
whole in any form or by any means whatsoever without the publishers
prior consent in writing.

Bradford MBA

Contents
Introduction to Business Economics

Your Module Leader


Overview of Module and Module Descriptor
Assessment criteria
Support for your learning
Developing good academic practice

7
7
9
12
15

Module feedback from previous students

16

PART I: MICROECONOMICS

17

Unit 1: Introduction to Economics

19

Introduction
Objectives
Diminishing marginal returns
Scarcity and choice
Opportunity cost
Production possibility frontier
Summary
Unit 2: Issues Relating to Demand
Introduction
Objectives
The demand curve
Price elasticity of demand
Consumer surplus
Summary
Unit 3: Production and Output Decisions

19
20
20
21
22
22
26
27
27
28
28
32
40
42
47

Introduction
Objectives

47
48

Production and output in the short run


Law of diminishing marginal returns
Definitions of costs

48
49
51

Shutdown point
Deriving the firms supply curve
The supply curve

57
58
58

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Study Book: Business Economics

Elasticity of supply
Costs of production in the long run
Returns to scale
Economies of scale
Economies of scale at work
Motives for growth
Summary
References
Unit 4: Markets in Action

61
63
63
63
65
66
67
69
71

Introduction
Objectives

71
71

Equilibrium
Disequilibrium
Labour markets
Market failure
Summary
References

72
75
77
78
81
82

Unit 5: Market Structures


Introduction
Objectives
Profit maximisation
Perfect competition
Consumer sovereignty
Efficiency
Monopoly
Comparison of perfect competition and monopoly
Monopoly and the public interest
Oligopoly
Price rigidity
Summary
References

83
83
83
84
84
91
91
92
95
95
97
99
102
104

PART II: MACROECONOMICS

105

Unit 6: Introduction to Macroeconomics

107

Introduction

107

Objectives
Economic targets
Main macroeconomic policy tools

108
108
108

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Contents

Inflation
What causes inflation?
Tackling inflation
Unemployment
What causes unemployment?
Healthy balance of payments
Exchange rates
Healthy economic growth
What causes economic growth?
Circular flow of income
Summary

109
109
110
111
112
115
115
116
117
118
122

References

124

Unit 7: Evaluating Government Economic Policy

125

Introduction
Objectives
Keynesian theory of national income
Keynesian solution to unemployment revisited
The multiplier
Problems with Keynesian theory
Keynesian view of inflation revisited
Economic policy tools

125
126
126
129
130
130
132
133

Monetary policy
Money, banks and money supply
Demand for money
Money market equilibrium
Updating the Keynesian model
Supply side policies
Summary
References

134
134
136
136
142
144
148
150

Unit 8: Economics of the Global Economy

151

Introduction
Objectives

151
151

Benefits of international trade


Theory of comparative advantage
Balance of payments

152
152
154

Terms of trade
Exchange rates revisited
Floating or fixed exchange rate?

155
155
160

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Study Book: Business Economics

Economic and monetary union (EMU)


Need for fiscal harmonisation
Europe the future
Trends in world trade
Multinational corporations
Summary
References

161
163
164
165
165
167
168

Unit 9: Revision and Assessment

169

Appendix A: Module descriptor

171

Appendix B: Model Answers to Activities

175

Unit 1
Unit 2
Unit 3
Unit 4
Unit 5
Unit 6
Unit 7
Unit 8

175
178
183
188
191
194
196
200

Bradford MBA

Introduction to
Business Economics
Your Module Leader
Dr Simon Rudkin
An active researcher in the fields of supermarket impact, oligopolistic
competition and regional linkages, Dr Rudkin graduated from the
University of Manchester with his PhD in 2008. With work experience at
the University of Manchester and at Xian Jiaotong-Liverpool University in
Suzhou, China prior to coming to the University of Bradford he has a wide
range of international academic teaching experience.
Recent publications include a novel model of local shopping as an
alternative to a monopolist supermarket in Economics Letters, and a
review of the distributional impacts of a new supermarket on fruit and
vegetable consumption in a poor neighbourhood of Leeds, West Yorkshire
in Environment and Planning A. These are being extended to consider
other industries, such as Chinese online shopping, and full dietary
diversity.
Keen to consider how applied economics can help answer questions in
various fields, Dr Rudkin has also this year completed working papers on
fiscal competition, the role of China in South-East Asia and the ethics of
large corporations dealing with the crises self-regulation may create.
A fellow of the Higher Education Academy with an active interest in new
teaching technologies, he has undertaken research into breaking down
silence culture with tablet computers, considered how collaborative wikis
can aid learning and sought new ways to bring live elements into
established teaching materials.

Overview of Module and


Module Descriptor
The aim of the Business Economics module is to provide you with an
understanding of the market environment within which organisations
operate and to acquaint you with the broader macroeconomic forces which
influence organisations.

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Study Book: Business Economics

We emphasise the application of economics to business, and its role as a


foundation subject for other business disciplines: strategy, marketing,
finance, etc. This module has two parts.

Part I: Microeconomics
This part develops the central theme of economics. We examine the
functioning of markets by analysing how firms and consumers make
decisions to buy and supply goods. We then place the organisation within
its market environment to understand the determinants of its performance,
and in turn explore the application of economics to decision making and
strategy.

Part II: Macroeconomics


This part aims to give you an appreciation and understanding of the
macroeconomy, both in a domestic and in an international setting. The
units aim to develop a more detailed review of the major areas of
macroeconomic interest and controversy including macroeconomic policy,
aspects of open economy macroeconomics and world trade, and the
challenges currently facing the unified Europe. The module will develop
frameworks that enable you to evaluate these topics and more generally
give you a basis for assessing the choices that are made by governments
on a daily basis; choices which affect us both as individuals and
organisations.

Module aims and objectives


This module is designed to:

provide an awareness of economic theory

enable you to think economically

enable you to apply economic ideas to issues in the news and


applications in business

enable you to develop problem-solving skills

enable you to interpret diagrams and become familiar in their use

enable you to construct and develop lines of argument

enable you to analyse and critically assess both theory and the
application of theory.

Please see Appendix A for the module descriptor.

Bradford MBA

Introduction to Business Economics

Assessment criteria
A written assignment of 2,000 words, based on both microeconomics and
macroeconomics. Assignments must be submitted by 12 January 2016.
To view the assignment questions, go to the Business Economics
Blackboard site and click on Assessment in the left hand menu. You
should see a folder named Distance Learning Assessment. Click on this
and you will see the assignments.

Assignment
The assignment contributes 100 per cent of the assessment for this
module. For guidance on completing assignments see the Effective
Learning Service (www.bradford.ac.uk/management/els/)

Assignment aim
The aim of the assignment is for you to show your understanding of the
economic concepts covered in the module and your ability to apply the
economic concepts in a meaningful, insightful and balanced way. The
assignment emphasises the durability and the wider application of the
range of economic techniques you have studied and shows how
economics can be used to aid decision-making and problem-solving in a
business context.
The best practice for the assignment is doing the activities and review
activities that have been set in this Study Book. Wherever possible, it
would be helpful to think how you could develop your answers to the
questions and seek out supporting arguments.

Answering economic questions


Here are some pointers for report writing and answering economics
questions.
The starting point lies in careful preparation: reading widely, drawing on
knowledge from the textbook and the Study Book, becoming familiar with
the major debates or viewpoints, gathering evidence, and organising these
building blocks in the form of a report plan. Finding the best way to fit
together all the elements of your answer is intellectually demanding but a
good outline plan makes the actual writing much easier. How should you
go about this task?
The introduction is one of the most important parts of your reports and
should be written carefully. Use this opportunity at the beginning of your
report to address the question. This is the place where you can set out
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Study Book: Business Economics

what you are going to look at in the reports, you can identify and define
any terms and significant issues, and say how you propose to examine
them. This has two effects: it compels you to discipline yourself and
address the question in a relevant fashion; it also shows the reader that
you are in control of the subject, and that your report is not just going to
meander aimlessly until it has filled a respectable number of pages. The
report should not be a magical mystery tour.
In the main body of the report, you should unfold the main arguments in a
coherent sequence, bringing relevant evidence to bear on the points you
are making. In economics, this section of the report normally requires you
to show your understanding of the relevant theory relating to the topic
under discussion and the ability to apply the economic concepts in a
meaningful, insightful and balanced way. Rarely will this section produce
any clear-cut outcome. Rather this section will highlight your
understanding of the economic toolkit and, more importantly, your ability to
use it to analyse a wide range of complex and strategic issues, and devise
appropriate strategies to deal with the situation in the question. Your ability
to use economic theory to think around a problem, reveal the different
options/choices that can be made and evaluate the relative effectiveness
and appropriateness of these strategies under different circumstances is a
strength of economics and a skill you need to show.
You should also consider what you yourself may be able to add to the set
of issues under discussion. Often this is not easy but it may be possible to
point to problems in the theory, the discussion or debate, for example,
ambiguity in the use of economic concepts or the limitations of the existing
evidence.
Finally, there is the conclusion. Here you draw together the main
elements of the reports in a summary fashion, stating the conclusion (if
any) you have reached. These points may help:

do not include any new information or ideas at this stage

summarise briefly the main content of the report

give your own opinion.

While there is no single blueprint for the ideal report, the following
guidelines should be helpful.

The report should answer the question set, in your own words (that is,
without plagiarising anybody else), and employ accurate grammar,
spelling and syntax.

The answer should be well structured, informed and reveal a clear


understanding of the topic.

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Introduction to Business Economics

The literature on which the report is based should be acknowledged,


references cited, and a bibliography provided, which is adequate in
range and accurate in detail.

The report should make good use of a range of economic concepts and
apply them broadly in a logical and balanced manner.

Do not make unsubstantiated statements; back them up with theoretical


or practical evidence.

Credit will be given for answers that adopt a critical or original approach
to the questions and that are written with clarity and fluency.

Submitting the assignment


Hand-in date for the assignment is 12 January 2016.
All assignments will be submitted electronically via Turnitin on the module
Blackboard site: go to Blackboard > Module Site > Assessment > Distance
Learning Assessment > Turnitin.
Click on View/Complete.
You will then be taken to a submission page.
The First and Last name boxes are automatically filled in. Check that your
details are correct.
In the submission title box, you should label your work using your
UB number and the module code e.g. 0123456789 MAN1234M (you can
find the MAN code on the title verso of this Study Book). It is imperative
that you upload your assignment in the above format failure to do so
may result in examiners being unable to mark your work.
Click the Browse button to upload your file. Navigate to your file and click
Open.
Click Upload. Wait while your file is uploaded to the server.
The next page gives you the opportunity to review your submission. At
this point you have not yet submitted, and can return to the submission
page to start again if you so wish. If you are happy that this is the correct
paper and you want to continue to submit, scroll to the bottom of the page
and click Submit.
You will then be emailed a receipt to your university email address,
which will include your assignment identification reference.

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Study Book: Business Economics

For further information on how to submit your assignments using Turnitin,


go to the How To section of Blackboard (Under My Organisations) and
see How to Submit an Assignment Electronically.

Support for your learning


General guidance on the support available for students can be found in
the Student Handbook, available online at:
http://www.bradford.ac.uk/information-services/.

Approach to studying business economics


As a distance learning student, you will be studying this module at a time
and place that fits around your work, social and family commitments. To be
successful in your studies, you will need to juggle these commitments and
make every effort to maintain a steady flow of activity as you work your
way through the module materials. You will need to find windows of time
for your studies on a regular, weekly basis. It is strongly advised that
you progress through the module studying one unit per week. If you
do this, you will find that the issues addressed in the discussion forums
and the live online tutorials will correspond closely to your own studies.
With this in mind you should aim to start your studies from the first
week of the term on 12 October 2015. This is when the Blackboard
materials for this module will be made available. If you follow the study
pattern suggested (completing a unit per week) you will finish the final unit
of this module at the end of the term around 13 December 2015.

Textbook
Throughout the module, you will need to refer to the module textbook:
Begg, D. and Ward, D. (2013) Economics for Business 4th edition.
Maidenhead: McGraw Hill.
The textbook forms an essential part of your study. It is vital that you read
the chapters specified at the beginning of each unit to familiarise yourself
with the concepts and issues to be covered. A word of warning at this
stage: dont spend too long studying the material in the textbook; a quick
reading should be sufficient.

Module Study Book


This Study Book will provide pointers to what is most essential and allow
you to focus on the most important ideas in more depth. When working

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Introduction to Business Economics

through each unit, you will be directed to read specific pages or analyse
particular cases, tables and diagrams.
Activities and review exercises have been provided to help you test your
understanding, and guidance has been provided in Appendix B at the end
of the module so that you can assess your responses. Completion of the
exercises is absolutely essential if you are to develop a good
understanding of economics. Reading the textbook and the Study Book
will not be sufficient to establish a clear grasp of the concepts and issues
covered. You should try wherever possible to consider your own personal
experience and provide examples from your own business environment to
amplify your answers. You will need to interact with the material and
become involved. This requires a commitment to active study.
A word of warning: the units in the Study Book are of unequal length.
Some units such as those on scarcity and choice are quite brief. You are
advised to break up the study of longer units and allow a little time for
concepts to sink in before moving on to the next stage.
Model answers to the activities, where applicable, are provided in
Appendix B.

Lecture audio recordings and slides


In each unit, you will be advised to listen to audio recordings and consult
the corresponding slides highlighting key theories and ideas.

The discussion board


The discussion board in Blackboard enables you to engage in discussion
with other students and the tutor. You will be able to participate in two
discussion forums for the following purposes.

General module issues This is a forum for general questions about


the module and its content and direction as well as questions about all
the material you will work through on the module.

Assessment issues You are urged to put any general queries about
the assessment here, since the reply provided by the tutor may also
answer queries from other students.

Live tutorials on Blackboard Collaborate virtual


classroom platform
During the module, you will be required to attend four live, online tutorials
conducted by a module tutor. These online tutorials will provide you with
an opportunity to engage in detailed, real-time discussions on key issues
and concepts with other students and academics. The subject and
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Study Book: Business Economics

materials for each live online tutorial are outlined in the Study Book. You
will be given details of the times and dates of these tutorial sessions once
the module has commenced.
If you have never used the Blackboard Collaborate virtual classroom
platform before, it is essential that you familiarise yourself with the platform
and test your computer setup before you attend the first tutorial. To test
your sound settings, please go to the Blackboard Collaborate Support site
at http://bit.ly/1etRu2Y. For further support materials and information about
Blackboard Collaborate, please see the Blackboard Collaborate Support
site at http://bit.ly/1jBpgUc.

Formative assessment
You will be provided with an opportunity to submit two pieces of work that
your module tutor will assess and give you detailed feedback on. The two
opportunities for formative feedback relate to issues discussed in Units 2
and 7 (see relevant units in the Study Book for further details).
Please note: none of your answers to these formative tasks will count
toward the final grade they are optional exercises that allow you to test
(and receive feedback on) your understanding of key concepts/theories
and ideas.

Multiple-choice questions
After completing each unit in the Study Book you can test your basic
knowledge and understanding of the main economic ideas by tackling the
15 multiple-choice questions. These are available online in Blackboard.

Internet resources
The World Wide Web provides a very useful resource. You will find it
particularly useful when you want to analyse business organisations or
when you wish to read informed opinion regarding macroeconomic issues.
Sites well worth checking out include:
http://econlinks.com/
www.economist.com
www.ft.com
www.euromoney.com
The Bradford University School of Management library and your local
library hold publications and databases relating to industries, organisations

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Introduction to Business Economics

and economic trends. The internet also gives you the possibility to access
libraries elsewhere.

Additional textbooks
Sloman, J., Hinde, K. and Garratt, D. (2010) Economics for Business
5th edition. Harlow: FT/Prentice Hall.
Sloman, J. and Jones, E. (2011) Economics and the Business
Environment 3rd edition. Harlow: FT/Prentice Hall.
Griffiths, A. and Wall, S. (2011) Economics for Business and Management
3rd edition. Harlow: FT/Prentice Hall.

Developing good academic practice


Harvard referencing style
Students will be required to provide references to the sources used to
produce work. This shows what students have read, supports the
arguments and acknowledges the work of others.
The referencing system used in this programme is called Harvard.
The reference consists of two parts:
1. A citation in the text. This appears next to the information you have
used. It consists of the family name of the author followed by the year of
publication. Each citation is matched to a reference.
2. The reference goes in a reference list at the end of your work. The list is
in alphabetical order. It contains the full details of all of the sources
referred to in the text.
For details on how to create your reference list, go to:
http://www.bradford.ac.uk/library/help/referencing/.

A note about referencing in the Study Book


This Study Book provides you with a model for citing literature and
presenting reference lists. Citations in the body of the units and in the
references section at the end of each unit follow the University of Bradford
version of the Harvard referencing system. However, please note that the
references provided in the grey boxes at the start of each unit and at
intervals throughout use a different convention, with hyperlinks embedded
behind the title of the item (rather than given separately at the end of the

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Study Book: Business Economics

reference) and no access date included. This is simply to increase the flow
of text in the grey boxes.

Module feedback from previous students


At the end of the module you will receive an email (and required link)
inviting you to comment on the module. Please ensure that you provide
feedback regarding your learning experience for the module.
Previous student feedback on the module include:
The module was presented in simple language that made it easy to be
understood
The strengths of the Business Economics module were the areas
covered during the course and the fact that it provided non-experts with
a basis in order to improve further their understanding of economics
Course handbook used in conjunction with the textbook made a difficult
area of study fairly understandable
Subject was stimulating and relevant to life
I liked the simplicity of the study materials. Easy to understand

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Bradford MBA

PART I:
MICROECONOMICS

Unit 1:
Introduction to Economics
Key reading:
1. Begg, D. and Ward, J. (2013), Chapter 1
Key audio/video:
1. An Introduction to MBA Business Economics (Blackboard > Module Site
> Module Materials > Unit 1) Activity 1.1
Other:
1. Unit 1 lecture slides and audio (Blackboard > Module Site > Module
Materials > Unit 1 > Lecture slides and audio)
2. Unit 1 multiple-choice questions (Blackboard > Module Site > Formative
Exercises > Multiple-Choice Questions > Unit 1) Activity 1.6

Introduction
Think of something you like; a good example is chocolate. Imagine now
you are in a shop and they will allow you eat as much as you like and
there will be no charge. How much would you take? What considerations
would you give in deciding? As a business trying to meet these needs,
how does your company decide how much to provide to the market? What
other goods are sold? How do you decide how many resources to allocate
to each product?
In economics we recognise that there is a lot more to the market than
simply price and the availability of goods. Consumers want a range of
products, and in greater quantities than the market can provide. The basic
economic problem is thus that consumers have essentially infinite wants
but resources are limited; someone, or something, must decide how to
allocate resources. No matter how much money you have, or how
developed a nation is, these issues persist. Our discussion is phrased in
terms of happiness rather than money, because it is the utility we get as
individuals that matters. A great example of this is the child who plays with
the box rather than the present on their birthday; they value the box more
than the toy despite what the market says the prices should be.
This unit develops a theoretical framework that will enable you to
understand the problem of scarcity over choice, and answer the questions
posed above.
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Study Book: Business Economics

Objectives
By the end of this unit, you should be able to:

understand the concept of diminishing marginal returns and its role in


economics

understand the importance of utility as a measure of benefit rather than


the pure financial value assigned to a good

define the economic problem

define the concept of opportunity cost and understand its importance in a


variety of economic situations but with particular reference to business

recognise production possibility frontiers and how they may be applied

distinguish between different economic systems and identify key


features of each

develop an initial appreciation of how economists use diagrams as a


means of explaining information.

Activity 1.1 watch and reflect


Watch: An Introduction to MBA Business Economics (Blackboard >
Module Site > Module Materials > Unit 1)

Diminishing marginal returns


One of the most important concepts in economics is the law of diminishing
marginal returns, the idea that benefits get smaller as quantity rises. This
can apply to the amount of a good consumed, the benefits a firm gets from
an employee, the output from a machine, even the benefits of having
leisure time. This law is quite intuitive but does not make financial sense,
as the price (or cost) stays unchanged.
Consider the case of free chocolate. You are offered as much as you
would like, and the price will always be zero. This is a great offer and of
course you will be really happy about it; the first piece will be really good.
Indeed as you eat the 2nd, 3rd, 4th, 5th, 6th piece you will still be really
enjoying the great taste. However, after a while you will start feeling like
you have eaten too much, maybe feeling guilty for the calories, or sick
from the sweetness. As this happens that next piece will not bring you the
happiness that the previous one did. Slowly, but surely, there will come a
point at which you have had enough and the next piece does not give you
any extra happiness at all. Figure 1.1 shows how the extra happiness
might look when plotted over the quantity of chocolate consumed.

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Unit 1: Introduction to Business Economics

Figure 1.1: Diminishing marginal returns

In the figure the second unit brings almost as much happiness to the eater
as the first, u2 u1 u1. As the quantity goes up this is no longer true, the
22nd piece only increases the utility by u4 u3.
What about the workers? They arrive fresh and ready to work and can
produce the first unit quickly, soon getting into a rhythm and producing
more. However, over time they will inevitably tire, or become bored, and be
able to produce less and less. In the extreme they will need sleep and be
unable to produce any more. From your own work you will know there are
times when you are more productive than others, but you receive the
same wage for each unit of time so there is no financial reason not to
assume the same output per unit wage.
Economics begins from the idea that returns, whether happiness from
consumption, the output of labour or otherwise, diminish.

Scarcity and choice


The second essential thought on economics comes from the fact that it is
not possible to satisfy everyone all of the time with the limited resources of
the planet. We can get more money and buy more inputs, we can use
existing resources more productively by improving technology, but we
cannot create infinite resources. The factors of production, land, labour,
capital and enterprise, simply cannot deliver the goods and services we all
desire. Somehow a decision must be made as to how resources are used
and who will get their wants. At the national level many of these decisions
are solved by governments, the state providing the services the market
may not otherwise offer to everyone. In extreme cases all allocation may
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Study Book: Business Economics

be done by the market, or by central government planners. Neither a


complete free market economy, nor a totally planned economy exists in
modern times. Economies today are mixed economies, both the private
(business) and public (government) sectors exist side by side.
Figure 1.2: The basic economic problem

Opportunity cost
Read: Begg and Ward (2013), pp.528
Resources can only be allocated once, and some wants will not get the
inputs they need. The alternative uses for the resources are termed the
opportunity costs as the economy loses the chance to enjoy the gains that
those uses of the resources would have brought. A government spending
on education cannot then use that same money to spend more on
transport. The opportunity cost in this case might be a new high-speed
railway. When you choose to spend time watching television then the
alternatives, such as reading a book, are the opportunity cost.
Recognising that resources have alternative uses and decisions impact on
what we can, and cannot, do is a key part of economics. It is essential to
addressing the basic economic problem.

Production possibility frontier


The production possibility frontier (PPF) allows the economist to
demonstrate the consequences of some decisions on how resources
should be allocated. It gives an indication as to how much production can
take place if all the economys resources are used efficiently. In addition, it
allows for a comparison of production over time and an assessment of
how efficiently society is using the resources at its disposal.
Consider Figure 1.3, in which the output of the economy is either capital or
consumer goods. These indices could include anything; guns and butter
have often been used as examples in the past. We have used capital and
consumer goods since they represent massive categories of production as
well as representing the different general consumption choices of
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Unit 1: Introduction to Business Economics

households and businesses. The curve represents the PPF and the PPF
demonstrates the various combinations of capital and consumer goods
that could be produced. Any point along the PPF represents a full
utilisation of resources and a very efficient economy.
Figure 1.3: Production possibility frontier
Consumer
goods
b
c

x
d

a
Capital
goods

Points a, b, c, d and e all represent a full utilisation of scarce resources


within an economy. With existing productive capacity the economy is
unable to reach point x. The only way point x can be reached in future is
through developing productive capacity, that is, through economic growth.
Now consider point y. Production is below the PPF and as such
represents an underutilisation of resources. A society in such a situation
faces a major challenge if it is to allocate its resources more effectively.

Activity 1.2 stop and think


Question 1: In theory all points along the PPF signify a well-functioning
economy. Can you identify, however, future problems that may occur
with the extreme combinations of goods produced at points a and b in
Figure 1.3?
Question 2: Which represents the best combination: c or e?

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Activity 1.2 stop and think answers:

The PPF can be used to examine the concept of opportunity cost. Take an
individual firm that has diversified its production and produces good A and
good B.
Figure 1.4: Production of good A and good B
Good A

a1

a2

b1

b2

Good B

Currently the firm is producing at point x which represents a1 production of


good A and b1 production of good B. The firm, after extensive market
research, decides that product B represents the more profitable long-term
future and decides to reallocate resources from the production of good A
to good B. This decision would involve a reduction in the output of good A
from a1 to a2 (the opportunity cost) in order to increase the production of B
from b1 to b2, point y.

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Unit 1: Introduction to Business Economics

Figure 1.5: Production possibility frontier graph

Activity 1.3 read and reflect


Consider Figure 1.5, a PPF for an agricultural economy.
Question 1: Why does the frontier curve?
Question 2: What will happen if technology allows the countrys resources
produce twice as much meat?
Activity 1.3 read and reflect answers:

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Summary
Read: Begg and Ward (2013), Summary, p.25
In this unit we have introduced three of the most important concepts in
economics; diminishing marginal returns, the basic economic problem and
opportunity cost. Each of these will appear prominently in all of the study
units that follow. As economists we recognise that decisions must be
driven by happiness; there will necessarily be winners and losers.
Production possibility frontiers help us to visualise all of these problems in
a clear and simple way. Frontiers also show the importance of getting
allocation decisions right.

Review activity 1.4


The United Kingdom government is keen to build a high-speed rail link
from Leeds/Manchester to London at a cost of 50bn. It is assumed that
there will be huge growth benefits as capacity for trade along traditional
routes is freed up by fast trains going onto the new line.
Question 1: What are the opportunity costs for the UK government when
deciding to invest taxpayers money in this scheme?
Question 2: What effect will the high speed rail link have on the UK
production possibility frontier?
Question 3: Why might the government choose a 300km/h line when it is
possible to build even faster lines that can operate safely?
Question 4: When your business faces investment decisions like this what
are the opportunity costs? How are your production possibilities affected?

Activity 1.5 lecture slides and audio


Listen to: the audio for this unit and view the accompanying slides at the
same time. (Blackboard > Module Site > Module Materials > Unit 1 ).

Activity 1.6 multiple-choice questions


The multiple-choice questions for this unit will enable you to test your
knowledge and understanding of the key concepts covered. (Blackboard >
Module Site > Formative Exercises > Multiple-Choice Questions > Unit 1)

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Unit 2:
Issues Relating to Demand
Key reading:
1. Begg, D. and Ward, J. (2013), Chapter 2
Other:
1. Unit 2 lecture slides and audio (Blackboard > Module Site > Module
Materials > Unit 2 > Lecture slides and audio)
2. Unit 2 multiple-choice questions (Blackboard > Module Site > Formative
Exercises > Multiple-Choice Questions > Unit 2) Activity 2.7
3. Unit 2 live online tutorial (Blackboard > Module Site > Collaborate)
Activity 2.8
4. Unit 2 marked formative assessment (Blackboard > Module Site >
Formative Exercises > Marked Formative Assessment > Unit 2)
Activity 2.9

Introduction
In most economies, markets are the principal ways in which scarce
resources are allocated to the production of goods and services. A market
is anywhere there is a buyer and seller. In essence, markets operate
through the price mechanism which co-ordinates the buyers and sellers.
For example, as prices rise relative to costs of production, firms offer more
for sale. In this way, the price acts as a signal to firms that scarce
resources should be reallocated from markets where profits are low to
markets where profits are high. The price mechanism is often referred to
as the invisible hand since it is the result of free market forces.
Have you ever considered why baked beans only cost 25p when they
enjoy so much popularity? Why do firms not cash in on this demand by
charging 99p? Why does a pint of beer cost 2.95 in your local pub
compared to 5.00 in a nightclub? Why does the government tax
cigarettes and beer but not apples? Why does the accountant working at
your firm earn more than the cleaner? The answers to all these questions
can be found by analysing how demand and supply interact in the market
place.

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In this unit you will begin to develop your understanding of how markets
behave. First, you will concentrate on the demand side of the market.
What affects the level of demand, how do consumers react to price
changes, how can firms set prices that will maximise their revenues; and
why do firms set different prices for different market segments? Once you
feel comfortable with this knowledge, Unit 3 will then introduce concepts
related to the supply side of the market. Unit 4 will then combine the ideas
from Units 2 and 3 into an integrated understanding of markets. Hopefully,
you can see that economics is a subject which builds upon itself and it is,
therefore, important to gain confidence in the ideas and issues of each unit
before moving onto the next.

Objectives
By the end of this unit, you should be able to:

explain the theory of demand

understand the determinants of demand

explain the concept of consumer and producer surplus

explain the concept of elasticity and appreciate its importance when


managers are developing pricing strategies

explain the relationship between elasticity and revenue.

The demand curve


Read: Begg and Ward (2013), Chapter 2, pp.3240
The demand curve demonstrates the relationship between the quantity
demanded and price. Demand is considered as effective demand, which
means demand backed up by the ability to pay. Much of the demand curve
is hypothetical in that it states what consumers would demand at relative
prices. The demand curve is sometimes drawn as a straight line or as a
curve. It doesnt really matter since both are examples of how the
economist attempts to develop theory through making assumptions to
simplify the process.

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Unit 2: Issues Relating to Demand

Figure 2.1: The demand curve


Price

D
q

Quantity

If we examine the demand curve in Figure 2.1, consider how demand is


higher at low prices and how this demand changes as prices increase.
Look at how the demand changes as price drops from p1 to p2. There is an
extension of demand from q1 to q2. What would cause a contraction of
demand? The only factor that causes either an extension or contraction of
demand is a change in the price of the product itself. Anything other than a
change in price causes a shift in the demand curve itself. These other
factors are referred to as the determinants of demand and include:

price of substitute and complementary goods

changes in consumer incomes

consumers tastes and preferences and how these may be affected by


advertising, fashion, etc

expectations of future price changes

time period.

A change in any of these determinants of demand causes a shift in the


demand curve. In Figure 2.2, a shift from D1 to D2 means more of the
product is demanded at every price. A shift from D1 to D3 is a reduction in
demand at every price.

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Figure 2.2: Demand curves


Price

D2
D1

D3
q

Quantity

If the original price is p0, a successful advertising campaign may increase


the demand from D1 to D2. We have shifted from point a to point b on
Figure 2.3 below. The quantity demanded at this price has increased from
q1 to q2.
Figure 2.3: Change in the demand curve
Price

p0

D2
D1
q1

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Unit 2: Issues Relating to Demand

Activity 2.1 stop and think


For each of the following scenarios, draw a diagram to show the effect on
your firms demand.
Scenario 1: An increase in the price of a complementary good.
Scenario 2: A decrease in the price of a substitute good.
Scenario 3: An increase in consumer incomes.
Scenario 4: A brilliant advertising campaign by your main competitor.
Scenario 5: A decrease in the price of your product.
Activity 2.1 stop and think answers:

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Of course, at this stage we are only focusing upon demand. You should go
back to our definition of a market. We now need to examine the role of the
sellers who supply the products if we are to establish how the market
determines price and output.

Price elasticity of demand


Read: Begg and Ward (2013), Chapter 2, pp.4049
Price elasticity of demand is a crucial concept for businesses to grasp if
they are to be successful in the marketplace. It is worthwhile reflecting on
the material at each stage that follows and taking stock of the ideas
covered before tackling the activities to be covered later in the unit.
The price elasticity of demand measures the responsiveness of the
change in demand for a change in price. If a firm has control over its own
pricing policies, the concept allows the firm to establish the effects of a
change in price on its revenue and, hence, its profits. It allows firms to
answer the questions such as what will happen to revenue if we increase
our prices by 2% or reduce price by 75p.
Elasticity of demand can be calculated using the formula:
Ed =

% change in quantity demanded


% change in price

Different demand elasticities

If the Ed is > 0 but less than 1 the demand is price inelastic.

If the Ed is >1 the demand is price elastic

Exceptional cases are:

If the Ed is = 1 the demand has unit elasticity.

If the Ed is infinity the demand is perfectly elastic.

If the Ed is = 0 the demand is perfectly inelastic.

Elastic and inelastic demand


Elastic demand means that a relatively small change in price leads
to a relatively large change in the quantity demanded. This is shown in
Figure 2.4.

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Unit 2: Issues Relating to Demand

Figure 2.4: Elastic demand


Price

p
2
p
1

Quantity

Inelastic demand means that a relatively large change in price leads


to a relatively small change in the quantity demanded. This is shown in
Figure 2.5.
Figure 2.5: Inelastic demand
Price

p
p

Quantity

If we examine Figures 2.4 and 2.5, we can show the relationships between
the relative changes in price and quantity demanded. Strictly speaking this
approach should be used to simplify the idea only, since the validity of the
diagrams is dependent upon the scale of the axes.

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Special cases
The perfectly elastic demand curve suggests even a tiny increase in price
will lead to none of the product being sold (see Figure 2.6).
The perfectly inelastic demand curve suggests no matter what happens to
price the quantity demanded will not change (see Figure 2.7).
The unit elasticity suggests a 5% change in price will lead to a 5% change
in quantity demanded (see Figure 2.8).
Figure 2.6: Perfectly elastic demand curve
Price

q1

q2

Quantity

Figure 2.7: Perfectly inelastic demand curve


Price

p2

p1

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Unit 2: Issues Relating to Demand

Figure 2.8: Unit elasticity


Price

This is a rectangular hyperbola

Quantity

Determinants of elasticity

The number and closeness of substitute goods.

The proportion of income spent on the good.

The time factor (short run or long run).

Relationship between elasticity and revenue


If demand is elastic and if there are many close substitutes available then:

an increase in price will lead to a large reduction in the quantity sold


and revenue will fall

a decrease in price will lead to a large increase in the quantity sold and
revenue will increase.

If demand is inelastic and if there are no close substitutes available then:

an increase in price will only lead to a small reduction in demand and


revenue will increase

a decrease in price will only lead to a small increase in demand and


revenue will decrease.

Now at this point you might ask: well, if demand is inelastic and consumers
will continue to purchase the product even if the price increases, why dont
firms just keep on raising prices indefinitely? This is a good question and it
is worthwhile spending some time analysing the response to this question.
At this point, we could take the soft option and state it would be easier to
answer this question at the end of Unit 3. In
Unit 3, we identify how firms choose the level of output which will
maximise profits. Having selected this output, the market demand will
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determine the price that the firm charges. You need to remember that
profit is equal to revenue minus costs. Raising prices might increase
revenue but the traditional theory of a firm assumes the firm will aim to
maximise profits and not revenue. This will be clearer at the end of Unit 3.
So how can we answer the question without taking the easy option? This
requires a more complex response. The elasticity of demand varies along
the course of the demand curve. If we examine Figure 2.9, we note that
the demand is inelastic, at lower prices and elastic at higher prices. This
would suggest a firm could increase its prices when the price is low and,
since demand is inelastic, there will be a smaller proportionate reduction in
demand: hence, there is an increase in revenue. But as price is increased
and demand becomes more elastic there will come a point where an
increase in price will lead to a larger proportionate reduction in demand.
Think of consumers who stick with a product when prices are low and
remain loyal as prices increase, but when prices get much higher a larger
number of consumers start to look at alternative products.
Figure 2.9: The demand curve and the elasticity of demand
Price

Elastic

Inelastic

Quantity

In summary, we can assume the firm will set price at the point where
demand is just about to become elastic: that is, the firm has kept on
increasing price until the point where it cant raise it any more without
reducing revenue. Note: here we are referring to revenue and not profit.

Activity 2.2 stop and think


Consider Figure 2.10 and explain what is happening.

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Unit 2: Issues Relating to Demand

Figure 2.10: Elasticity, the demand curve and total revenue


Total
revenue

Elastic

Inelastic

Total revenue
Quantity

Price
Elastic

Unit elasticity

Inelastic

D
Quantity

Activity 2.2 stop and think answers:

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How the time period affects the elasticity of demand


If we consider Figure 2.11, the original demand curve D1 exists within a
market that gives an equilibrium price of p1 with a quantity exchanged of
q1. If the market price increased to p2, then in the initial period consumers
have very little time to seek alternatives and quantity bought might only fall
a little to q2. After a little more time has passed, consumers have the ability
to adapt their purchasing habits and will have made initial checks on
alternatives that exist for the original product. The new demand curve
becomes D2 and this gives a reduction in demand to q3 for the market
price p2. In the longer period, we can see that the demand curve becomes
D3 as this process continues, and we can clearly see that the elasticity of
demand has varied over the different time periods given.
Figure 2.11: Time and elasticity of demand

Price

D2

D1

D3

p2
E

p1

D3
D2
D1

q4

q3 q2 q1

Quantity

Other kinds of elasticity of demand


Other elasticities of demand exist in addition to the price elasticity of
demand we have covered so far.

Income elasticity
Income elasticity measures the responsiveness of a change in demand for
a change in income. Income elasticity of demand can be calculated using
the formula:
YE d

Proportion ate change in demand


Proportion ate change in income

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Unit 2: Issues Relating to Demand

Cross elasticity
Cross elasticity measures the responsiveness of a change in demand for
good A for a change in the price of good B. How will a change in the price
of a competitors product affect the demand for our product?
Cross elasticity can be calculated using the following formula:
Ed A

Proportion ate change in demand for good A


Proportion ate change in price for good B

Importance of income elasticity


As incomes increase, consumers adapt and change their spending
patterns and this will have an obvious influence on business. This
influence will vary depending upon the income elasticity of demand. Take
two firms products in separate markets, one with an YEd of 1.5 and one
with a value of 0.02. The first business can be optimistic since the market
for its product is likely to grow and it will face an expanding market as
consumer incomes increase. Its target will be maximising the potential that
this opportunity provides and grasping as much of this market growth as is
profitable. The firm in the second situation with an income elasticity of 0.02
has a much bleaker outlook. The product is very income inelastic in
demand and the market shows little opportunity for growth. Indeed, it is
more likely that this firm will consider itself within a static market and its
aim will be to devise marketing strategies to take market share from its
competitors in this market.

Activity 2.3 stop and think


Question 1: Can you identify how income elasticity of demand affects your
business? Is your product(s) income elastic or income inelastic in
demand? Who is your product aimed at? How would rising prosperity of
the well off or less well off affect the demand for your product? Can you
identify products with a high income elasticity of demand (elastic) and give
examples of products with a low income elasticity of demand (inelastic).
Question 2: Can you remember which of these numerical elasticity values
corresponds with elastic, inelastic and unitary?

Ed > 0 and < 1

Ed = 1

Ed > 1

Question 3: Can you find examples of firms that have products with high
cross elasticity of demand for your firms product?

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Activity 2.3 stop and think answers:

Consumer surplus
Read: Begg and Ward (2013), Chapter 2, pp.4954
Consumer surplus is measured for each consumer and is calculated as
the difference between the price of the product and the maximum price the
consumer would be willing to pay. So if a latte coffee costs 2.00 and I am
willing to pay up to 2.50 for a latte coffee, then my consumer surplus is
0.50. If a caffeine junky is willing to pay up to 4.00 for a latte coffee, then
his or her consumer surplus would be 2.00.
The consumer surplus for all consumers demanding a given product is
illustrated in Figure 2.12.
Figure 2.12: Consumer surplus
Price

Consumer
surplus

pe

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Unit 2: Issues Relating to Demand

Consumer surplus is important because it represents enhanced consumer


welfare, but also lost profits for firms. Governments like to see markets
that grow the overall size of the consumer surplus. Firms develop sales
tactics that seek to convert consumer surplus into profits. These tactics are
generally referred to as price discrimination.

First degree price discrimination charges each consumer the


maximum price that they are willing to pay.

Second degree price discrimination charges consumers according to


usage. Higher users are charged differently from low rate users.

Third degree price discrimination seeks to charge a different price to


each consumer group.

An auction is an example of first degree price discrimination. Various


mobile telephone tariffs for low and high users are examples of second
degree price discrimination. Business and economy class airline tickets
are examples of third degree price discrimination.

Activity 2.4 stop and think


Question 1: Can you think of additional examples of price discrimination?
Question 2: Will first, second, or third degree price discrimination extract
the most consumer surplus?
Question 3: Why do we not observe more first degree price
discrimination?
Activity 2.4 stop and think answers:

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Summary
Read: Begg and Ward (2013), Summary, p.54
You should now be able to understand the theory of demand and explain
the difference between a movement along and a shift in the demand
curves. You should also have a grasp of the important factors behind
pricing decisions and how the market reacts to changing conditions. You
have examined the ideas of consumer surplus and considered ways in
which businesses might maximise revenue in their pricing policies.
Importantly, you should have a good knowledge of the concept of
elasticity, and its importance to decision making and market strategy.

Review activity 2.5 demand for flights


Objectives
1. To reinforce the economic theory of demand and the related concept of
elasticity by the use of a real life example.
2. To explore the links between elasticity and the total revenue.
3. To understand the concept and importance of consumer surplus.
4. To explore the strategic insights of demand theory.
Emirates Airlines, hubbed in Dubai, this summer announced it was
increasing services to London, Birmingham, Copenhagen, Manchester
and Madrid by using bigger Airbus A380 double-decker planes. On these
planes it has three classes of accommodation: first, business and
economy. In advertising it plays on the spa facilities for first class
customers on the A380, the bar for business class passengers and the
sheer size of the economy cabin. For all classes it points to vast inflight
entertainment options and on board wifi. In each case Emirates seeks to
differentiate its product from its competitors, and indeed its older smaller
planes.
Undoubtedly the airline sector is highly competitive with global hubs
offering connectivity to anywhere on the planet for business and tourist
travellers alike. Business customers want space to work and to ensure
they arrive at their destination relaxed and prepared; they will look for the
airline that offers this best. By contrast tourists are looking for new
experiences and a comparatively comfortable way to get to their
destination. Price sensitivity will be stronger in the tourism sector.
As part of the market research into upgrading its third daily flight to
Manchester the airline gathers the following information about customers
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Unit 2: Issues Relating to Demand

willingness to pay for flights to Dubai. It surveys 400 potential business


passengers and 1200 potential economy class fliers.
Table 2.1: Willingness to pay for return flights to Dubai split by traveller
type and class of travel
Maximum willingness to pay (/return trip)
Percentage
of Sample
0
5
10
15
20
25
30
35
40
45
50
55
60
65
70
75
80
85
90
95

Business Travellers
Business
2500
2413
2324
2228
2144
2047
1957
1874
1784
1693
1598
1510
1422
1334
1240
1150
1057
974
881
791

Economy
1000
976
951
927
898
875
849
826
799
776
748
726
702
677
649
627
601
575
550
523

Tourists
Business
700
680
669
650
646
619
611
591
581
570
556
529
521
502
493
469
462
445
433
418

Economy
450
440
429
422
408
401
392
382
368
361
348
339
327
317
312
297
289
278
270
259

Task 1: Sketch the following demand curves on separate axes:


a) Business passengers demand for business class.
b) Business passengers demand for economy class.
c) Tourists demand for business class.
d) Tourists demand for economy class.
Task 2: Look at your answers to Task 1 and comment on the elasticities of
the demand functions. Is there any reason why the curves might have the
elasticities that they do?
Task 3: Emirates can only choose one price for its business class ticket to
allow it to be advertised. What price ticket will maximise the revenue from
business class seats on the plane? (Note: The airline has no way to know
whether the passenger buying the ticket is a business passenger or a
tourist.)
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Task 4: If business class tickets sell for 1000 and economy class tickets
sell for 350, illustrate the consumer surplus gained by passengers when
customers only fly in the class that is best suited to their needs: that is,
business passengers fly business class and tourists buy economy class
tickets.
Task 5: Table 2.2 provides details of Emirates prices for a return ticket
between Manchester and Dubai. Why might we see pricing like this? What
type(s) of price discrimination are being applied here?
Table 2.2: Return flight prices using Emirates Airlines from Manchester to
Dubai
Leaving

Returning

Business

Economy

Saturday 10 October

Saturday 17 October

2,411

448

Sunday 11 October

Sunday 18 October

2,391

395

Monday 12 October

Monday 19 October

2,391

363

Tuesday 13 October

Tuesday 20 October

2,391

363

Data sourced from www.emirates.com, 10 August 2015.


Task 6: Emirates big rival Etihad has also launched its own A380 with
individual suite first class tickets between Abu Dhabi and London
Heathrow. With reference to the study on this unit, what is likely to happen
to demand for Emirates tickets:
(a) in first class on the Manchester to Dubai route
(b) in first class on the London Heathrow to Dubai route
(c) in economy class on the Manchester to Dubai route.

Activity 2.6 lecture slides and audio


Listen to: the audio for this unit and view the accompanying slides at the
same time. (Blackboard > Module Site > Module Materials > Unit 2 >
Lecture slides and audio)

Activity 2.7 multiple-choice questions


The multiple-choice questions for this unit will enable you to test your
knowledge and understanding of the key concepts covered. (Blackboard >
Module Site > Formative Exercises > Multiple-Choice Questions > Unit 2)

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Unit 2: Issues Relating to Demand

Activity 2.8 live online tutorial


Live online tutorial: To access the tutorial, please go to Blackboard >
Module Site > Collaborate. To test your sound settings for the Blackboard
Collaborate virtual classroom, please go to the Blackboard Collaborate
Support site at http://bit.ly/1etRu2Y. For further support materials and
information about Blackboard Collaborate, please see the Blackboard
Collaborate Support site at http://bit.ly/1jBpgUc.
Before the tutorial a short article will be posted onto the module
Blackboard site which raises issues from the first two units (Blackboard >
Module Site > Module Materials > Collaborate, to gain access to the
article). A set of questions will accompany the article. Please read the
article and prepare answers to the questions posed.
Question 1: What are the main determinants of demand in the industry
being studied?
Question 2: What issues are raised for future demand in the companies
mentioned in the article?
Question 3: How do these issues relate to the demand for the product of
your business?
Question 4: How should your business deal with a similar competition
threat as that discussed in the article?

Activity 2.9 marked formative assessment


Explain why reducing price might not generate extra revenue for your
company.
Use no more than 500 words and be sure to both demonstrate your
knowledge and understanding of economics and your ability to apply
economics to real business issues.
Email your answer to your tutor, who will advise you via Blackboard on the
deadline for submissions in order to receive feedback on your work.

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Unit 3:
Production and Output
Decisions
Key reading:
1. Begg, D. and Ward, J. (2013), Chapters 3 and 4
Other:
1. Unit 3 lecture slides and audio (Blackboard > Module Site > Module
Materials > Unit 3 > Lecture slides and audio)
2. Unit 3 multiple-choice questions (Blackboard > Module Site > Formative
Exercises > Multiple-Choice Questions > Unit 3) Activity 3.11

Introduction
As already identified in the introduction to Unit 1, the factors of production
are subject to a law of diminishing marginal returns. This unit provides
some of the important background understanding required for our
examination of markets in Unit 4 and competition in Unit 5. While
consumers can simply turn up at a market and demand goods, firms are
not as fortunate. In supplying goods, firms face a number of issues
concerning the actual production of goods and services. Having decided
what and where to produce, they must make important decisions
regarding how much labour and capital should be used. Should it buy
components from suppliers, and if so which firms, or should it produce the
whole of the product in house? How much will it cost to make different
quantities of output? When might the firm expand or when should it shut
down?
An important distinction made by economists is that costs behave
differently depending on the time scale. The short run is the period of time
in which the firm is unable to vary all its factors of production. In other
words, at least one factor of production is fixed. This could be particularly
skilled workers in very short supply or it could be a machine that takes a
long time to arrive often an order is made. The long run is defined as the
period of time in which it is possible to vary all the factors of production.
Production may be defined as anything which satisfies a want or a need
and, as such, covers the output of services as much as the output of
goods.

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Objectives
By the end of this unit, you should be able to:

explain the law of diminishing marginal returns

provide a categorisation for costs and understand the relationship


between them

discover when the firm has reached its shut-down point

recognise the importance of decisions taken on the margin

understand the reasons why a firm may expand and how economies of
scale affect the firms costs.

Production and output in the short run


Read: Begg and Ward (2013), Chapter 3, pp.5866
We look first at how output varies in the short run. We will hold all factors
of production fixed apart from the number of workers, which can vary. We
can represent how production changes in Table 3.1.
Table 3.1: Changes in product with labour changes
Labour

Total product

Average product Marginal product

43

43

43

160

80

117

351

117

191

600

150

249

875

175

275

1,152

192

277

1,372

196

220

1,536

192

164

1,656

184

120

10

1,750

175

94

11

1,815

165

65

12

1,860

155

45

Total product = Total amount produced


Average product =

Total product
Number of workers

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Unit 3: Production and Output Decisions

Marginal product = (Total product produced by n)


(total product produced by n 1)
We can express marginal product another way: the additional output
achieved by employing one more unit of labour.
The total product can be shown by means of a graph (Figure 3.1).
Figure 3.1: Total product
Total
product

Total
product

Labour units

Note how the total product increases at first, and how it begins to tail off as
more units of labour are employed. For the purpose of this theory we need
to assume that each worker is just as good and hard working as the next
and that the production methods do not change, so that we can isolate the
relationship between the number of workers employed and output.

Law of diminishing marginal returns


This law states that as we add successive units of a variable factor to a
number of fixed factors of production, after a certain point, total output will
continue to grow but at a diminishing rate. This can be shown by means of
a different kind of diagram which explores the relationship between
average product and marginal product (Figure 3.2).
Note that the marginal product intersects the average product at the
highest point on the average product curve. Diminishing marginal returns
set in when the marginal product begins to fall. The last worker employed
allows production to increase but at a slower rate. This can be identified in
Table 3.1. The sixth worker to be employed caused the total production to
increase from 875 units to 1,152 units, a difference of 277 units. However,
the seventh worker causes output to increase by only 220 units. The law of
diminishing returns has set in after the employment of the seventh worker.

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This theory would suggest that in the short run a firm faces strong
limitations on its output; less flexibility gives the firm much less room for
manoeuvre than is the case in the long run which we will examine later.
Figure 3.2: Average product and marginal product
Product

Average
product
Marginal
product

Labour units

Activity 3.1 stop and think


Question 1: Complete the following table.
Labour

Total product

10

24

42

56

70

72

Average
product

Marginal
product

Using graph paper can you plot the total product curve, the average
product curve and the marginal product curve?
Question 2: At what point does diminishing marginal returns set in?
Question 3: Why do you think that diminishing returns set in?

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Activity 3.1 stop and think answers:

Definitions of costs
Fixed costs = Costs which do not vary with output
Variable costs = Costs which vary with output
Total costs = Fixed + variable costs
Average total cost =

Average variable cost =

Total variable cost


Output

Marginal cost = Total cost of producing n units minus total cost of


producing (n 1) units; or, in other words, the total cost of producing one
extra unit of production
Average fixed cost =

Total cost
Output

Fixed cost
Output

Lets take a look at Table 3.2, note how the fixed cost remains the same
regardless of the number of workers are employed. If we plotted this
information in a graph, we would have the situation shown in Figure 3.3.
Table 3.2: Changes in costs with changes in labour
Labour

Fixed cost

Variable cost

Total cost

100

20

120

100

40

140

100

60

160

100

80

180

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Figure 3.3: Labour and costs


Cost

Total
cost

Variable
cost
Fixed cost

Labour units

Activity 3.2 stop and think


Complete the following table calculating the missing figures.
Output

Fixed cost

200

Variable cost
0

200

300

Total cost
200

800

1,200

2,200

Average costs
Average total costs =

Total cost
Output

Another way of calculating average total cost is:

Average total cost (ATC)


= Average variable cost (AVC) + average fixed cost (AFC)

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Consider Table 3.3. We can deduce that the total fixed cost must be 200.
Can you see how this has been done? In Figure 3.4 we can show how the
AFC is shaped as total fixed cost is spread over a greater quantity of
output.
Table 3.3: Output and costs
Output

AVC

AFC

ATC

200

200

400

150

100

250

200

67

267

300

50

350

400

40

440

Figure 3.4: Average fixed cost

Marginal cost of production


Table 3.4: Output and marginal costs
Output

Total cost

Marginal cost

400

500

100

800

300

1,400

600

2,200

800

The first marginal cost value is a dash since we are not given the fixed
cost when output is zero. If we plot the average cost and marginal cost
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curves on the same diagram, we have Figure 3.5. Notice how the marginal
cost curve intersects the average cost curve at its lowest point. This is not
just coincidence! This is an important part of the relationship and it is
essential for you to remember this when we examine the theoretical
framework behind a firms output decisions in Unit 4.
Figure 3.5: Average cost and marginal cost
Cost
Average cost
Marginal cost

Units of output

Activity 3.3 stop and think


Question 1: Complete the following table.
Total
output

Fixed cost

Variable
cost

Total cost

Marginal
cost

Average
cost

10

10

10

12

12

12

20

26

30

32

39

54

71

10

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Using graph paper can you now plot the average cost and marginal cost
curves on the same diagram? Remember, plot costs on the vertical axis
and output along the horizontal axis.
Question 2: Complete the following table.
Output

TFC

40

TVC

06

11

15

TC

60

66

AFC

AVC

ATC

MC

On graph paper can you plot TFC, TVC and TC against output; and AFC,
AVC, ATC and MC against output?
Question 3: Complete the following table which includes both revenue
and cost information and calculate the missing figures.
Output

Price

TR

10

10

10

10

10

10

MR

FC

VC

TC

MC

Profit

2
7

+1
8
+4
36
5

Activity 3.4 read and reflect


Read the following scenario and then answers the questions that follow.

Hitachi to open 82m train plant in Durham this year


Adapted from the Financial Times (www.ft.com)
The Newton Aycliffe site, the Japanese companys first European train
factory, was given the go-ahead after the government awarded Hitachi Rail
Europe the contract to supply the intercity express programme, the next
generation of trains for the East Coast and Great Western main lines.
Under this 5.7bn contract, which includes maintenance and runs for
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27.5 years, Hitachi will build 122 trains comprising 866 carriages. Twelve
trains are being manufactured at its Kasado works in Japan and the rest at
Newton Aycliffe. Hitachi has also been named by Abellio, an arm of the
Dutch state rail operator, as preferred bidder for 70 trains for ScotRail.
We arent going to rely on the Japanese supplier base for components.
We are going to Europeanise as much of this plant as we can, Mr Foster
[Jamie Foster, Procurement Director for Hitachi] said. The company said it
was working with 56 suppliers in Europe, 32 of them based in the UK.
In contrast to Nissans high-volume, just-in-time Sunderland operation,
which requires some suppliers to be located next to, or even in, the plant,
Hitachi, with its longer manufacturing timescales, does not need them on
the doorstep.
(Source: Tighe and Powley 2015)
Answer the following questions.
Question 1: What fixed costs are incurred by switching production from
Kosado to Durham?
Question 2: What are the likely effects on variable costs from using this
new plant?
Question 3: How do the variable costs of Nissan and Hitachi differ
according to this article?
Question 4: Train orders are known for being cyclical. Explain why it might
be better to have a larger variable cost base in an industry like this.
Activity 3.4 read and reflect answers:

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Unit 3: Production and Output Decisions

Shutdown point
Read: Begg and Ward (2013), Chapter 3, pp.6680
In the short run, the firm has already committed to the fixed costs. They
have been paid and can be left out of the short-term decision-making
about output. In the short run, the firm will continue to produce provided
that the revenue generated exceeds the variable cost. At each output
level, the surplus of revenue over variable cost makes a contribution
towards paying for the fixed costs. If the revenue is less than the variable
cost, it will be more sensible for the firm to cease production. Stopping
production will reduce the size of the loss and limit it to the value of the
fixed costs already paid. Therefore, the short-run shutdown point occurs
when the revenue cannot cover the variable costs.
Of course, in the long run the firm is operating under different decisionmaking criteria and can vary all its factors of production. In such cases, the
firm is more concerned about covering total costs rather than just variable
costs. In the long run, the firm will shut down if it cannot cover the total
costs.
Figure 3.6: Costs and revenues and output

If we consider Figure 3.6, we can see this clearly. Imagine that the vertical
axis includes both costs and revenue. If the average revenue AR1 is below
point y, then the AVC exceeds the AR. The firm is not covering its variable
costs and should cease production. At point y, the average revenue AR2 is
equal to the AVC and the firm is therefore just covering its variable costs.
This firm will continue to produce in the short run. At point z, the firms
average revenue AR3 is equal to the ATC and as such the firm's revenue
is covering all its costs and the firm will continue to produce in the long
run. Clearly the short- and long-run shutdown points differ. In the short run,
the firm will shut down to the left of point y, where it cannot cover its
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variable costs. In the long run, it will shut down to the left of point z, since
the revenue does not cover total costs.

Deriving the firms supply curve


Figure 3.6 can also be used in order to derive the firms supply curve for
the product. At points to the left of y, the firm would not be willing to supply
the product since AVC exceeds revenue. At point y, the firm is happy to
supply in the short run since it is covering AVC. At point z, the firm is
happy to produce in the long run since it is covering ATC. At all points to
the right of point z, the firm is willing to supply since the revenue exceeds
the ATC and the firm will be earning profit. Therefore taking all this
information together, the firm is willing to produce in the short run at all
points on the MC curve provided it is at or above point y. The MC curve
above point y becomes the firms supply curve.
Another way of explaining this idea, which will be useful when we compare
the pricing and output decisions of monopolies with those of firms in
competitive markets in Unit 4, is as follows:

a firms supply schedule shows the quantities that the firm is willing to
offer at each market price

since a firm is assumed to operate for profits, then it will only offer
output when the market price is greater than the cost of producing the
last unit offered

therefore, the firms supply schedule is also the firms marginal cost
curve (where MC exceeds AVC in the short run or ATC in the long run).

The industry or market supply schedule is simply a summation of all firms


supply schedules.
Analysing firms in the short run shows how constrained they are by having
some factors of production fixed. They have far less flexibility in their
decision-making and little room for manoeuvre.

The supply curve


Read: Begg and Ward (2013), Chapter 4, pp.8498
The supply curve demonstrates the relationship between the quantity a
firm would wish to supply at every price. In Figure 3.7, the firm wishes to
supply q1 at price p1. If the price of the product was higher, the firm would
wish to supply more goods (an extension of supply). If the price was lower,
there would be a contraction of supply. A change in the price of the good or
service is the only factor that causes a movement along the supply curve.

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Figure 3.7: The supply curve


Price

p1

q1

Quantity

Any other factors other than a change in price will cause a shift in the
supply curve itself. These factors are referred to as the determinants of
supply and include:

changes in the costs of production

changes in the profitability of substitute goods or goods in joint supply

nature, unexpected random shocks, for example, weather in agriculture,


the credit crunch and the loss of banking companies

changes in the aims of the firm

expectations of future price changes

state of technology.

Figure 3.8: Supply curves


Price
S3

S2

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A change in any of the determinants of supply will cause a shift in the


supply curve. In Figure 3.8, the initial quantity q1 is supplied at the price p1.
A shift from S1 to S2 represents an increase in supply at every price. A shift
from S1 to S3 represents a reduction in supply at every price.

Activity 3.5 stop and think


For each of the following situations, construct a diagram to demonstrate
the effect on supply.
Situation 1: An increase in the cost of raw materials.
Situation 2: An increase in the price of your product.
Situation 3: An increase in productivity on the shop floor.
Situation 4: An increase in wages at all levels in the firm not matched by
increased productivity.
Activity 3.5 stop and think answers:

Although it may seem somewhat mechanical undertaking these activities,


it is to develop a good grasp of demand and supply. This is fundamental to
an understanding of the market. To understand how market price is
established, we need to understand the behaviour of firms that supply
goods and services and the private individuals who demand these
products. Economists make an assumption that firms attempt to maximise
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profit and consumers aim to maximise utility (satisfaction). You need to


remember that in reality the market can be very complex and not always
easy to predict. The economist needs to use the idea of ceteris paribus
(everything else remains the same) to continue building an understanding
of how the market works.

Elasticity of supply
Elasticity of supply measures the responsiveness of quantity supplied for a
given change in price.
Factors affecting elasticity of supply include

time period

level of spare capacity.

The time period effect on the elasticity of supply works in much the same
way as for the elasticity of demand.
Figure 3.9: Time and elasticity of supply
S

Price

p2
p1

q q q
1

Quantity

Activity 3.6 stop and think


Using the explanation of the time period effect for elasticity of demand as a
guide, can you explain Figure 3.9?

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Activity 3.6 stop and think answers:

Spare capacity
Spare capacity describes the ability of a firm to expand its output given its
existing factors of production. A firm may have the flexibility to respond
rapidly to increased demand if it carries a large stock of finished products
or has the ability to quickly expand output. It might have a large amount of
work in progress or workers without a full workload, or the capacity for
overtime, or machines that are currently underutilised. When a firm has no
spare capacity, it has little room for manoeuvre and the supply curve is
relatively inelastic. The concept of spare capacity will be looked at again
when we examine how government policy affects the supply of products in
the macroeconomics part of the course.

Activity 3.7 stop and think


Using your firm as an example, consider how you would be able to
respond to an increased demand for your product or service. How flexible
is your firm when faced with the opposite scenario: that is, when demand
is falling?
Activity 3.7 stop and think answers:

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Unit 3: Production and Output Decisions

Costs of production in the long run


Lets start by reminding ourselves of the definition of long run: this is the
period of time in which all the factors of production become variable. When
all factors of production are variable an economist can analyse how firms
perform as they change their scale of production. The word scale implies
that the same combination of factors of production are used and in the
same ratios: that is, the firm may expand but retains the same proportions
of factors of production. Of course, in reality the firm has the flexibility to
change the proportions by replacing labour with capital etc, but for the
purpose of theory this assumption allows economists to establish how
scale influences a firms costs of production.

Returns to scale
Returns to scale looks at the relationship between changes in the scale of
operation and the amount of output generated.
Increasing returns to scale mean that bigger firms are able to generate
greater returns than smaller ones. A large number of these will come from
the firms market power, discussed in Units 4 and 5.
Constant returns to scale occur when size does not matter.
Decreasing returns to scale occur when firms become too large. A classic
example being the costs that bureaucracy can impose on large firms
decision-making.

Economies of scale
Economies of scale explores the relationship between changes in the
scale of operation and the average costs of production. We can define it
as those aspects of increasing a firms size that lead to falling average
costs. These economies of scale can be either internal or external. Internal
economies of scale are those that arise from the growth of the firm itself.
External economies of scale are those that arise from factors outside the
individual firm, such as developments in the local infrastructure and
improved road communication links, etc.
Firms do not always find that growth leads to falling average costs.
Sometimes they can become too big and the diseconomies of scale
outweigh the economies of scale. It is important to remember that when
looking at how scale affects costs, we are looking at the overall effect of
changing scale. When a firm begins to grow it starts to experience
economies of scale but also suffers some of the disadvantages of growth.
It is why we refer to the outweighing nature of the concept.

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Activity 3.8 stop and think


Considering the diseconomies of scale arising from the growth of the firm,
can you identify how these factors work within your business organisation?
If you work for a small firm, identify what problems might emerge from the
growth of your firm.
Can you summarise what is happening in Figure 3.10?
Figure 3.10: Economies of scale
LRATC

Cost

Economies of scale

Constant

Output
Diseconomies

Activity 3.8 stop and think answers:

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Economies of scale at work


If we take Figure 3.11 as our starting point, we can establish the basis for
understanding the envelope curve in the textbook.
Figure 3.11: Economies and diseconomies of scale
Cost
SRAC
c

SRAC
c

q Output
2

We start on the short-run average cost curve 1 (SRAC1). The current level
of production in the short run is q1. The firm in the short run is able to
produce this level of output for an average cost of c1. If there is an
increase in demand for the product so that the firm considers the level of
production should be q2, the firm can only meet this output target in the
short run if there is an increase in the average cost to c2. (The firm may
need to pay overtime to meet the target.) However, in the long run, the firm
can increase the scale of production and moves to short-run average cost
curve 2 (SRAC2). The new target output of q2 can now be produced for the
reduced average cost c3. The firm is experiencing economies of scale,
which outweigh the diseconomies of scale.
If the firm continues to grow, it would move to another short-run average
cost curve. At some point it will theoretically reach the optimum scale of
production where the product is produced as cheaply as possible. After
this level of output the diseconomies of scale outweigh the economies of
scale. In Figure 3.12 we draw a long-run average cost curve (LRACC)
which envelops the SRACCs. This represents the theoretical view of how
average costs vary with the scale of the firm.
In practice, however, many large firms do not experience the envelope
curve as described in Figure 3.12. The firm experiences the first part of the
curve, where increasing size leads to falling average costs. However,
when the optimum scale is reached the firm finds that continued growth
leads to constant returns to scale. That is, the economies and

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diseconomies of further growth tend to cancel each other out. This is


demonstrated in Figure 3.13 and is referred to as an L-shaped average
cost curve.
Figure 3.12: Long-run average cost curve
Cost

SRACC

SRACC

LRACC

Output

Figure 3.13: L-shaped average cost curve


Cost

LRACC

Output

Motives for growth


This is an extension of ideas. If you are interested, read Chapter 7 for
more details. Why would firms wish to grow? There are several reasons:

to benefit from economies of scale

to secure a greater market share

to enjoy greater market security.

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Summary
This unit has demonstrated some of the constraints placed upon the firm
in the short run. The firm is significantly hampered by having at least one
factor of production fixed. The theory of diminishing returns shows how the
marginal product falls as the units of the variable factor are increased
beyond a certain level. In the long run, the firm has far more flexibility and
can respond to changing market conditions by expanding the scale of
operations. Appreciating the interrelationship between the various costs
and revenue will allow us to focus in Unit 4 on how firms arrive at their
pricing and output decisions in different market structures.

Review activity 3.9


Question 1: Do you consider that your firm is at its optimum scale of
production? How would the diseconomies of scale apply to your
organisation if it were to expand? If your firm were to expand how should it
best go about this?
Question 2: A knitwear manufacturer produces sweaters in a production
facility which incurs unavoidable (fixed) costs of 50 per day. The going
rate of pay for workers is 25 per day and each sweater uses materials
costing 2. The following table gives output data and some cost
information for the knitwear manufacturer.
Labour
(No of
workers)

Output:
Sweaters
(per day)

TFC
(/day)

Total
labour
cost
(/day)

Total
material
cost
(/day)

TVC
(/day)

TC
(/day)

50

50

50

25

33

83

10

13

15

16

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Complete the following table.


Labour
(/sweater)

Output
(/sweater)

10

13

15

16

AFC
(/sweater)

AVC
(/sweater)

ATC

MC

Question 3: Using the clues below, complete the following table.


Output

TC

MC

ATC

AFC

AVC

TVC

2
3
4
5
6
Clues
1. AFC for 6 units of output is 9.
2. AVC for 2 units of output is 30.
3. Total cost is increased by 28 when the third unit of output is added.
4. ATC of 4 units of output is the same as the ATC of 3 units of output.
5. Total cost for 5 units of output is 258.
6. Total variable cost is increased by 100 when the sixth unit of output is
added.
7. Total cost increases by 8 when the second unit of output is added.

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Unit 3: Production and Output Decisions

Activity 3.10 lecture slides and audio


Listen to: the audio for this unit and view the accompanying slides at the
same time. (Blackboard > Module Site > Module Materials > Unit 3 >
Lecture slide and audio)

Activity 3.11 multiple-choice questions


The multiple-choice questions for this unit will enable you to test your
knowledge and understanding of the key concepts covered. (Blackboard >
Module Site > Formative Exercises > Multiple-Choice Questions > Unit 3)

References
Tighe, C. and Powley, T. (2015) Hitachi to open 82m train plant in
Durham this year. Financial Times, 11 January.
http://www.ft.com/cms/s/0/972f7360-89fa-11e4-9b5f00144feabdc0.html#ixzz3iERW8fGQ. Accessed 8 August 2015.

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Unit 4:
Markets in Action
Key reading:
1. Begg, D. and Ward, J. (2013), Chapter 4 and part of Chapter 8
2. DAveni, R. (2015) The 3-D Printing Revolution. Harvard Business
Review, May (Blackboard > Module Site > Module Materials > Unit 4)
Other:
1. Unit 4 lecture slides and audio (Blackboard > Module Site > Module
Materials > Unit 4 > Lecture slides and audio)
2. Unit 4 multiple-choice questions (Blackboard > Module Site > Formative
Exercises > Multiple-Choice Questions > Unit 4) Activity 4.6

Introduction
In this unit we will combine the demand and supply analysis developed in
Units 2 and 3. The purpose of which is to understand the forces that
determine the price and quantity of a product traded in a market.
Our analysis will use demand and supply curves within a single diagram
and will highlight the concept of market equilibrium. We also consider
market disequilibrium and address the forces that push a market back
towards equilibrium
While markets are often viewed by economists as an optimal resource
allocation mechanism, there are instances where markets can fail. We
consider all these factors with a specific focus on the applications to
business.

Objectives
By the end of this unit you will be able to:

understand the concept of market equilibrium

understand how changes in demand and supply lead to changes in the


market equilibrium

understand how market failure relates to sub-optimal outcomes.

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understand some of the solutions to market failure.

Equilibrium
Read: Begg and Ward (2013), Chapter 4, pp.8491
Consider Figure 4.1 showing the interaction of demand and supply in the
market. The point where demand and supply intersect is called the
equilibrium. This is the point at which the buyers and sellers are in
agreement about both the price and the quantity to be exchanged at this
price.
Figure 4.1: Market equilibrium
Price

S
p

Quantity

Characteristics of equilibrium

The equilibrium condition (p1, q1) is unique.

All other combinations of price and quantity represent points of


disequilibrium.

The equilibrium is efficient (demonstrated in Unit 5 when we examine


perfect competition).

Free market forces will push the market towards equilibrium.

Effects of changes in demand


In Figure 4.2, there is an increase in demand due to an increase in the
fashionability of our product. The demand shifts from D1 to D2, which leads
to an extension of supply. The new equilibrium gives a market price of p2
and a quantity exchanged of q2.

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Unit 4: Markets in Action

Figure 4.2: Increase in demand


Price

p
p

S1
2

D2
D1

q1

q2 Quantity

In Figure 4.3, there is a decrease in demand and this leads to a shift in the
demand curve to the left (if you are struggling to see how this shift is to the
left think of how the demand curve has moved for every level of price). The
new demand D2 gives a new price of p2 and causes a contraction of
supply. The quantity of the product exchanged is q2.
Figure 4.3: Decrease in demand
Price

S1
p1
p2
D1
D2

q2

q1 Quantity

Effects of changes in supply


In Figure 4.4, there is an increase in supply at every price. The new supply
curve S2 moves to the right causing a decrease in market price to p2 and
this causes an extension of demand to q2 of the product exchanged.

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Figure 4.4: Increase in supply


Price
S1
S2

p1
p2

D1

q2

q1

Quantity

In Figure 4.5, there is a reduction of supply. The new supply curve S2


gives a new price of p2, which causes a contraction of demand and a new
output exchanged of q2.
Figure 4.5: Decrease in supply
Price
S2
p

S1

D1

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Disequilibrium
Read: Begg and Ward (2013), Chapter 4, pp.9198
In Figure 4.6, the market has supplied a level of output q2, which at the
market price p2 charged for the product exceeds the quantity demanded q1
at this price. This is described as an example of excess supply. If free
market forces operate, what is likely to happen next?
Although firms have produced q2 units of output they only receive revenue
from the sale of q1. They are left with q2 q1 units unsold. In order to clear
this excess supply, the price will need to fall. As price falls firms will
produce less and there will be an extension of demand until the
equilibrium situation is reached. The key point here is that this will happen
automatically if the market is left to its own free market devices.
Figure 4.6: Market disequilibrium
Price

S
p

D
q

Quantity

In Figure 4.7 the price p3 lies below the equilibrium. This time the quantity
demanded is q2 and the quantity supplied is q1. This leads to a shortage.
The market price will be bid up by consumers until and equilibrium position
is found.

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Figure 4.7: Market disequilibrium shortage

Activity 4.1 stop and think


How do companies launching new products use market disequilibrium to
promote their products?
Activity 4.1 stop and think answers:

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Labour markets
Wages in the labour market are established through the interaction of
demand and supply for labour. The demand for labour is partly derived
from the demand for the good or service. The firm also has other factors
affecting its elasticity of demand for labour, for example, proportion of total
costs accounted for by labour, the ease with which labour can be replaced
by machinery or other workers, etc. The elasticity of supply of labour is
affected mainly by the length of training required to perform a particular
task.
Compare the position of the managing director and the cleaner in your
company. Compare, for example, their wages. The managing director
requires skill and expertise that makes him or her far more inelastic in
supply than the cleaner. The cleaner performs a necessary role for the firm
but does not require much training and can be more easily replaced with
other cleaners. This gives the cleaner a weak position when wage
bargaining.
Figure 4.8: Comparing wages of different personnel
Wage
S
W2
D

S
W1
D
L2

L1 Number
of workers

Activity 4.2 stop and think


Using Figure 4.8 to help you, explain why doctors get paid more than
nurses. Imagine a scenario in which there is an increase in demand for
both doctors and nurses due to extra government investment. Draw a new
demand curve on your diagram for the doctors and nurses and comment
on what you see.

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Activity 4.2 stop and think answers:

Market failure
Read: Begg and Ward (2013), Chapter 8, pp.200215
In some cases, the market does not (or would not) give society the optimal
output allocation and, in these cases, the government may intervene to
influence the market. Examples might include the provision of public and
merit goods, policies to influence the inequitable distribution of income,
minimum wage legislation, policies to tackle the uses and abuses of
monopoly power, including privatisation.

Public goods
Public goods are goods for which a supply might not be forthcoming if the
government did not intervene. It is hard to establish who would pay for
these goods at the point of use. Clearly there is a demand for street
lighting, but would a firm be willing to supply this service when it is difficult
to work out which consumers are using the service and how often? Would
the free market be able to provide a police force if left to its own devices?

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Merit goods
Merit goods are goods that can be provided by the private sector but
which are considered so important that the government intervenes to
enable a greater benefit to society. Examples include the provision of
education and health services.

Inequitable distribution of income


The market mechanism cannot differentiate between the spending of a
rich or a poor person. The market responds to demand, and scarce
resources of society may be allocated to luxuries for the rich rather than
necessities for the poor. The demand for products in a free market has
been likened to votes in an economic ballot box. However, some people
clearly have more votes than others. The government may intervene to
enable the system to make more provision for consumers on lower
incomes. The taxation system and government welfare spending
programmes are used to tackle the problem of inequality.

Monopoly power
Inevitably, in a competitive situation there will be some winners and some
losers. In business, the winners may get increasingly powerful and may
grow in size by expanding or through company takeovers. As these firms
get bigger and more powerful, they can influence the market significantly.
As we shall see in Unit 5 monopolies are able to make more profits and
charge higher prices than firms in markets in which substantial competition
exists. The UK government has set up agencies such as the Competition
and Markets Authority and Financial Conduct Authority, and various
watchdogs to regulate monopoly power.

Government intervention in the labour market


Some governments have established a national minimum wage to protect
workers in low-paid jobs. A great deal of debate surrounded the
introduction of this policy. There were fears of widespread job losses as
firms cut back on their growing wage bills by reducing the size of the
workforce. Having accepted the principle of minimum wage the
government now faces the dilemma of deciding on the going rate.

Taxing demerit goods


The government taxes some goods both in order to generate revenue but
also to reduce demand for goods it considers to be harmful. Think of
cigarettes and petrol.

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For example, if the government increases the tax on production of a good


by 10p, this will cause a shift in the supply curve to the left. A firm
producing the goods will be receiving 10p less than before, so it will supply
less at every price. In Figure 4.9, the new supply curve S2 is 10p higher
than S1 if you look at the vertical difference between any two points on the
S1 and S2. The market price has increased from 1 to 1.06. This means
the consumer is paying an extra 6p. The firm must be paying 4p of the 10p
tax. The more inelastic the demand, the more of a tax increase is paid by
the consumer.
Figure 4.9: Market price increase and tax
S2

Price
10p

S1

1.06
1

Quantity

Activity 4.3 stop and think


Around the world governments provide subsidies (negative taxes) for
households to make their homes more energy efficient. This helps
companies supplying solar panels, installing double glazing or insulating
walls.
Question 1: How does the subsidy influence the market for solar panels?
Question 2: How will the market for double glazing be affected by the
elasticity of demand?
Question 3: If consumer demand for wall insulation reduced by 3 per cent
and price increased by 5 per cent what would be the elasticity of demand?
Question 4: Which of the three products would you expect to have the
most elastic demand?

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Activity 4.3 stop and think answers:

Summary
This chapter has focused on key economic ideas associated with markets.
Demand and supply, developed in previous units, have now been
integrated into one framework. The importance is now in understanding
the equilibrium price and quantity, as well as the factors that cause
demand and supply to change, thus altering the equilibrium. Development
of these important concepts include the analysis of disequilibrium, which
covers output shortages or surpluses, changes in the elasticity of demand
and supply, and a consideration of informational asymmetries. The market
framework will now be mixed with cost and revenue concepts to enable a
consideration of competition in Unit 5.

Review activity 4.4


Read: DAveni, R. (2015) The 3-D Printing Revolution. Harvard Business
Review, May (Blackboard > Module Site > Module Materials > Unit 4)
Question 1: Using supply and demand analysis explain the impact on the
United States hearing aid market from firms switching to 100% 3D printing
production of hearing aids.
Hint: In your answer think about what happens to marginal costs, fixed
costs and variable costs. Consider how this affects supply.

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Question 2: 3D printing is heralded for its ability to create a product that


can be easily customised to individual needs. Using supply and demand
analysis explain what this will do to the market equilibrium.
Question 3: How are your answers to question 1 and question 2 changed
by the elasticity of supply?
Question 4: How might technology impact on the equilibrium in the market
your business serves?

Activity 4.5 lecture slides and audio


Listen to the audio for this unit and view the accompanying slides at the
same time. (Blackboard > Module Site > Module Materials > Unit 4 >
Lecture slides and audio)

Activity 4.6 multiple-choice questions


The multiple-choice questions for this unit will enable you to test your
knowledge and understanding of the key concepts covered. (Blackboard >
Module Site > Formative Exercises > Multiple-Choice Questions > Unit 4)

References
DAveni, R. (2015) The 3-D Printing Revolution. Harvard Business Review,
May.
http://search.ebscohost.com.ezproxy.brad.ac.uk/login.aspx?direct=true&db
=bth&AN=102262142&site=ehost-live. Accessed 28 August 2015.

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Unit 5:
Market Structures
Key reading:
1. Begg, D. and Ward, J. (2013), Chapter 5
Other:
1. Unit 5 lecture slides and audio (Blackboard > Module Site > Module
Materials > Unit 5 > Lecture slides and audio)
2. Unit 5 multiple-choice questions (Blackboard > Module Site > Formative
Exercises > Multiple-Choice Questions > Unit 5) Activity 5.10
3. Unit 5 live online tutorial (Blackboard > Module Site > Collaborate)
Activity 5.11

Introduction
In this unit we examine the firm and how it responds to competition in the
marketplace. We will analyse the pricing and output decisions of firms
within three different market structures. The analysis will also allow us to
make an assessment regarding profitability and efficiency in the allocation
of resources. We shall build models for the three market structures:

perfect competition, where there are many competitors

monopoly, where a firm faces little or no competition

oligopoly, where large firms face strong competition from a small


number of other firms.

We focus first on how perfect competition and then monopoly works; then
we compare the two market structures focusing upon price, output, profit
and efficiency. Finally, we examine oligopoly and examine the ways in
which this market structure forces firms to compete.

Objectives
By the end of this unit, you should be able to:

understand profit maximisation

understand the theory of perfect competition

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evaluate the price and output decisions of firms within perfect


competition and how these decisions affect profitability in the long run

identify the market structure faced by a monopolist and compare this


with perfect competition

understand oligopolists and the competitive environment within which


they operate.

Profit maximisation
Read: Begg and Ward (2013), Chapter 5, pp.104112
Economists assume that firms are in business to make profits for their
owners (shareholders). A stronger assumption is that firms seek to
maximise profits. In this unit and throughout this module we will also
assume profit maximisation. But if you are interested in alternative
assumptions for a firms behaviour then take some time to read
pages 189199 of Begg and Ward (2013).
If firms are profit maximisers, then they will produce an output where
marginal revenue equals marginal cost. The textbook provides a long but
accessible explanation for why marginal cost must equal marginal
revenue. However, a concise approach is to acknowledge that the firm
must maximise profits when the profit from the last unit is zero, i.e. all
profits have been extracted and equally where marginal cost equals
marginal revenue.

Market structure
Figure 5.1: Continuum of market structure

Perfect
competition

Monopolistic Oligopoly
competition

Monopoly

Figure 5.1 shows a continuum of market structure. Note that the perfect
competition (PC) is at the opposite end of the continuum to monopoly. In
between lies monopolistic competition and oligopoly, both market
structures where the firm faces imperfect competition. In this unit, we will
not analyse monopolistic competition.

Perfect competition
Read: Begg and Ward (2013), Chapter 5, pp.112119

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Perfect competition is a theoretical market idea which is extremely useful


as a yardstick. It acts as a means of comparison with other market
structures. A firm within perfect competition operates in a market in which it
has virtually no market power. The firm is powerless to exert any influence
on market price. The firm can produce an unlimited amount of its product
and sell it all, since it represents such a small part of overall supply.

Assumptions of perfect competition


With perfect competition:

firms are price takers

products are homogeneous

there is perfect knowledge and information

there are no barriers to entry or exit

there is freedom of movement of buyers and sellers in the market.

In essence, the individual firm is so small that it cannot influence market


supply and it takes the price established by the market. The firm cannot
charge a higher price since consumers have perfect knowledge and know
they can get an identical product cheaper elsewhere. There is no incentive
to produce and supply at a lower price since firms can sell all that they
wish at the market price. This is shown in Figure 5.2.
Figure 5.2: Perfect competition
Price

Price

MR=AR=D

D
Output
Market

Output
Firm

Figure 5.2 shows the interaction of market demand and supply that gives a
market price of p. The individual firm will charge this price for its product
since it is a price taker. The firm faces a perfectly elastic demand curve.
You should remember what this means from Unit 2. If the price is 50p for
example, then the firm will receive 50p for each product sold. This means
the firm will have an average revenue (AR) equal to 50p. Selling one more
unit will provide the firm with an extra 50p so the marginal revenue (MR)
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will be 50p also. The firm faces a perfectly elastic demand curve and, at
this market price, price is equal to average revenue and marginal revenue.
The obvious question to ask at this stage is why doesnt the firm just keep
on producing more and more of the product if it can sell an infinite amount
at the market price? The answer to this question allows the economist to
draw together some of the work covered in Units 2 and 3. So far the
perfectly elastic demand curve is just focusing on the demand and
revenue situation faced by the firm. Profit is the difference between
revenue and costs and so we need to introduce the cost curves we
identified in Unit 3. We do this, as in Figure 5.3, by introducing the average
cost (AC) and marginal cost (MC) curves.
Figure 5.3: Output, price and cost
Price
MC AC

MR=AR=P

q1

q2

q3

q4 Output

Figure 5.3 throws up some important information and a couple of


conceptual points that we need to explain. Note carefully that there are
four levels of output that have been marked on the diagram: q1, q2, q3 and
q4. Each of these refers to a point of interest.
Before examining them, however, we must firstly define profit. Normal
profit is that which is just about sufficient to keep the firm in that particular
industry. It occurs when AR = AC. We include normal profit within AC to
denote the opportunity cost of remaining in the industry. Therefore, when
AR = AC we are left with normal profit. Any profit in excess of normal profit
is referred to as abnormal profit (AR > AC).
If we refer to Figure 5.3 again then points q1 and q4 both show output
levels where AR = AC. The firm is making normal profits in each case. At
q2 the firm is making maximum profit per unit since the greatest difference
exists between AR and AC. However, the profit maximising level of output
occurs at q3. Since the theory of the firm assumes that firms aim to
maximise the level of profit, q3 is the level of output that the firm chooses
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to produce. The shaded area in Figure 5.4 shows the level of abnormal
profit earned by the firm in the short run.
Figure 5.4: Output and profit
Price

MC

AC

MR=AR=D

q3 Quantity

The abnormal profit is q3 units of output multiplied by the difference


between AR and AC at this point. So why is the profit maximising level of
output at q3 rather than q2? Well, its true that the firm does maximise profit
per unit at q2 but if the firm produced at the bottom of the AC curve, see
how much of the shaded profit it would lose out on. The extra profit the
firm earns for each level of output beyond q2 (since AR > AC) exceeds the
tiny amount of extra AC the firm needs to pay.
The firm maximises profit and produces where MR = MC. It produces right
up to the point where MR = MC (q3) in order to squeeze every last bit of
profit possible. Producing beyond q3 would not be sensible since the MC
would be greater than the MR for the last unit produced and so the level of
abnormal profit would fall.
If you still need convincing that q3 is better for the firm than q2, then
consider the following argument. Imagine q2 represents output of
10 million units. The p = AR = MR is 4 per unit. The AC is 2 per unit.
Abnormal profit in this example is: 4 2 = 2 per unit. The firm is
producing 10 million units, so this gives abnormal profit of 20 million.
Now consider q3. The firm is producing 12 million units at this point but AC
has increased to 2.20. Abnormal profit is 4 2.20 = 1.80 per unit. The
firm is producing 12 million units, so abnormal profit is 21.6 million. The
average cost has increased, there is less profit per unit, but total profit has
increased.

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The key point to remember is that the firm maximises profit by producing
at the level of output where MR = MC.
Of course, not all firms will be able to make a profit. Some firms will find
that nobody wants to purchase their goods, they may be unfashionable. In
these cases, a firm will minimise its losses in the short run by producing
where MR = MC.
If we now go back to the theoretical model of perfect competition we are
developing, in the short run the firm is making abnormal profit. Other firms
will see this abnormal profit since they have perfect information and so
resources are reallocated in the market to increase the output levels of this
profitable good. The individual firm is powerless to prevent this happing
since there are no effective barriers to entry. Other firms enter the industry
and this causes the market supply curve to move to the right. This will
force down the market price and will continue to do so until normal profits
are earned again by the now expanded number of suppliers. Note that this
is the free market at work. The price acts as a signal to firms and the
resources are reallocated accordingly.
Consider Figure 5.5. Note that the supply curve moves to the right. This
new supply S2 gives a new equilibrium price of p2 and in diagram b this
gives a new perfectly elastic demand curve at this price. In diagram c,
MR = MC at the same point as AR = AC and so the firm is earning normal
profit. The firm will continue to produce at this point until the next change
takes place within the market.

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Figure 5.5: Maximising profit


Price
Price

S1
S1

S2
S2

P1
P1
P2
P2
D
D

(a)

Quantity

(a)
Price

Quantity

Price
D1

MR=AR

D
D21

MR=AR
MR=AR

D2

MR=AR

(b)

Quantity

(b)

Quantity

Price

MC

AC

Price

MC

AC

AR=MR

AR=MR

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Activity 5.1 stop and think


Using Figure 5.6 to help, can you explain what is happening to the firm
that is making short-term losses and how the change in market supply
restores normal profit?
Activity 5.1 stop and think answers:

Figure 5.6: Making a loss

MC

AC

Price

D=MR=AR

q Quantity

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Consumer sovereignty
The perfectly competitive market structure, operating in the way we have
described suggests that the market responds to the wishes of the
consumer. The consumer dictates how a societys scarce resources
should be allocated and the market responds positively and efficiently to
the consumers wishes. Consumer sovereignty has been likened to
casting votes in the economic ballot box. The more that a product is
demanded, the more votes it receives.

Efficiency
An economist might refer to efficiency as productive efficiency or
allocative efficiency. A firm is efficient when it is producing at the bottom
of its AC curve. This is known as productive efficiency. By referring to our
perfect competition diagrams, we can see that perfect competition is
productively efficient in the long run. Allocative efficiency refers to the
resources being allocated efficiently, and occurs when the firm is charging
a price equal to its marginal costs. This concept also requires the firm to
be earning normal profits. If a firm is earning abnormal profits, then by
deduction, more of the product needs to be supplied to the market to force
down prices to the level where normal profits are earned. Therefore, we
can state that the firm in perfect competition is allocatively efficient in the
long run.
It is important to remember that we must not confuse efficiency and
profit. They are related and in general everyday life we know that
efficiency can lead to profit. But, a firm that isnt efficient can also be
profitable and so the distinction is important.

Activity 5.2 stop and think


Question 1: How realistic is perfect competition?
Question 2: Examine the assumptions and consider their validity. Why do
we bother to study a market structure that is unrealistic?

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Activity 5.2 stop and think answers:

Monopoly
Read: Begg and Ward (2013), Chapter 5, pp.119126
Definitions of a monopoly can vary from a market where the consumer has
no discernible choice of supplier to the UK governments definition that a
monopoly is a firm with over 25 per cent of the market. For the purpose of
our analysis, we shall take a monopoly to be a firm that faces no direct
competition. We shall assume that there is one seller and many buyers, no
close substitutes exist and the monopolist has highly effective barriers to
entry.
A monopolist can control either the price of the product or the amount sold.
It cannot do both since it cannot control the market demand. The demand
curve facing the firm is the market demand curve. If the monopoly firm
wishes to sell an extra unit of the product it can do so, provided it lowers
the price. If price is lowered, the marginal revenue falls more steeply for
the firm since all the products sold to date need to be sold for less. In
numerical terms, if the firm lowers price by 1p it sells one more unit per
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month but the marginal revenue falls by more than 1p since the eight
products sold by the firm originally have reduced revenue by 8 times 1p.
This is shown in Figure 5.7.
Figure 5.7: Monopolies and the demand curve
Price

AR=D
MR
Quantity

The profit-maximising monopolist


The profit-maximising monopolist produces at the point where MR = MC
(Figure 5.8).
Figure 5.8: Profit and the monopolist
Price
MC

AC

p1
c1

AR=D

MR
q1

Quantity

In Figure 5.8, the monopolist produces at the point where MR = MC. We


draw this point down to the horizontal axis to denote the level of output.
The market demand suggests that p1 is the price consumers are happy to
pay for this level of output. The AC of producing this level of output is c1.

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The shaded area denotes the abnormal profit. In the short run, the
monopolist can earn abnormal profit. If this is perfect competition, then
other firms would enter the market. This cant happen in monopoly since
the firm has effective barriers to entry. Therefore, the monopolist can earn
abnormal profit in both the short run and the long run.

Activity 5.3 stop and think


Outline the monopolists barriers to entry.
Question 1: Is the monopolist productively efficient?
Question 2: Is the monopolist allocatively efficient?
Question 3: Who provides the monopolist with the abnormal profit?
Activity 5.3 stop and think answers:

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Comparison of perfect competition


and monopoly
In Unit 4, we identified that an individual firms supply curve was that part
of the MC which was above the AVC curve. The market supply was the
sum of these MC curves added together. This allows us to show the
supply curve and MC curve as the same (Figure 5.9).
Figure 5.9: Perfect competition and a monopoly

The price in perfect competition is p1 and this is below the price in


monopoly of p2. The output in perfect competition is q1 and this is greater
than the output in monopoly of q2. The monopolist is restricting output to
increase price to create abnormal profit in both the short and long run.

Monopoly and the public interest


Is a monopoly always against the public interest? In exceptional cases, it
may be possible that a monopolist benefiting from substantial economies
of scale could provide the product at a lower price than a market where
competition exists. It might mean an inefficient market allocation according
to the definitions of efficiency that we have given, but the consumer would
not complain if the price of the product is lower.
If a firm faces little domestic competition and, therefore, appears to be a
strong monopolist, then it would be important to examine its competition
from abroad. It might be competing against a strong and all-powerful
monopolist in Germany or France. A large domestic monopoly would have
a better chance of survival when faced with international competition and
this would make jobs safer, etc.

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In some markets, the amount of investment required to keep up with


innovations both to the production process and the finished product may
require the security offered by a firm with massive assets when seeking
financial input. Small firms may be unable or unwilling to take on the
massive amounts of investment required.

Activity 5.4 read and reflect


Read the following scenario and then answer the questions that follow.
Eurostar, operator of high speed rail services between the UK and
continental Europe began life as a co-operation between the British,
French and Belgian governments. For years a competition restriction
prevented any other rail operator from using the Channel Tunnel. Recently
that limit has been lifted and rivals will begin services into London soon.
For example Deutsche Bahn, the German state operator, is looking at
introducing services between Frankfurt and London.
Using the discussion of this unit briefly explain the benefits of allowing
Eurostar to operate as a monopoly for its formative years.
Activity 5.4 read and reflect answers:

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Oligopoly
Many markets in the real world cannot be characterised as either perfectly
competitive or monopolistic. Instead, many markets are characterised by a
small number of large suppliers. For example, food retailing is usually
dominated by a small number of supermarket chains, and retail financial
services is controlled predominantly by a small number of banks. Since
many of these markets are very important to us as consumers, and also as
potential sources of employment, it is clearly important that we have an
understanding of these markets. The theory of oligopoly helps us here.
The theories of perfect competition and monopoly assume away the
existence of competitive rivalry between firms (why?). In contrast, the
theory of oligopoly focuses in on competitive rivalry between firms and,
as a consequence, is a major source of economic ideas on strategic
decision-making.
Consider a market with only four major suppliers. If one firm decides to
change the product that it offers, the price it asks for its product, or the
amount it is willing to supply, then this will have a major impact on its
competitors businesses. As a consequence, economic theory aims to
model the behaviour of a firm as a reaction to the expected behaviour of
its rival. If you play chess you will know precisely what is being referred to!
Read: Begg and Ward (2013), Chapter 6, pages 136156

Features of an oligopoly market


The key features of an oligopoly market are:

there are few suppliers

firms select their prices

there is non-price competition

products are differentiated

barriers to entry exist.

An oligopolist at work
Oligopoly means competition between the few. Although price competition
can occur, a feature of the oligopoly market is non-price competition. The
oligopolist always needs to take the likely reaction of competitors into
account when making decisions. In many ways, the oligopolists might be
considered as incredibly powerful: they are often household names; they
advertise frequently; they have impressive business premises and
locations; they tend to attract graduates with good salaries and pension
plans; they have executive boxes at important sporting occasions, etc.
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But, and it is a big but, they face incredible competition and live in a
ruthless business environment.
The oligopolist has a strange looking demand curve. It is referred to as a
kinked demand curve. It is really made up of two demand curves. A
relatively elastic demand curve to represent the demand faced when
prices are increased and a relatively inelastic demand curve to
demonstrate the demand faced when price falls (Figure 5.10). The
demand curve dd denotes the effect of a price increase by the firm. Note it
is relatively elastic. The demand curve DD, represents the demand faced
by the firm if it were to decrease price. Note the relatively inelastic nature
of this demand curve. Where the two demand curves intersect is the
starting price for the firm. This point z can be represented on a slightly
different diagram to highlight the workings of an oligopoly market
(Figure 5.11).
Figure 5.10: Oligopolists demand curves

Figure 5.11: Oligopoly market

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If the firm in oligopoly starts off at point z, the price charged is p1 and the
output is q1. If the firm increases its price then a relatively large reduction
in demand will occur. The competitors of the firm will leave their prices
unchanged and so only the customers with strong brand loyalty will
remain. If the firm lowers its price then its competitors would follow suit
and so a relatively large reduction in price would lead to a relatively small
increase in demand. Quite clearly, faced with this scenario, the firm would
not wish to engage in price competition.

Activity 5.5 stop and think


List the many ways in which firms compete in non-price ways. Consider
petrol, breweries, banks, supermarkets and hi-fi companies. Consider all
the ways in which your firm competes and establish how well this fits with
the theory.
Activity 5.5 stop and think answers:

Price rigidity
Another means of explaining why oligopolists tend not to compete on price
can be found by adapting our earlier diagrams. When we covered
monopoly earlier in the unit we identified that the marginal revenue curve
slopes more steeply than the demand curve. In Figure 5.12, there is a
marginal revenue curve which corresponds to the relatively elastic
demand curve and one which complies with the relatively inelastic demand
curve. There is also a vertical discontinuity which exists on this marginal
revenue curve, denoted by points a and b. We could mathematically
explain this but we will invoke the principle of opportunity cost and the
notion of what we could more usefully do with our time!

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Figure 5.12: Oligopoly and price

When we consider the price rigidity diagram, Figure 5.12, MC1, MC2 and
MC3 denote one firm with three different levels of efficiency. To begin with,
the firm with MC1, charges a price p1. When the firm increases efficiency,
the MC falls to MC2and then MC3, but the firm will still charge the same
price since the MC crosses the MR in the vertical discontinuity area. The
firm becomes more profitable by increasing efficiency. In the oligopolists
marketplace, characterised by cut-throat competition, increasing efficiency
becomes one of the most reliable forms of competing. Research and
development becomes integral to the success of the firm.
The more the firms in oligopoly can co-operate, the more the firms should
have a chance of being profitable. With less the co-operation, then there is
more chance that all firms will suffer. In a risky market situation, is it
surprising that firms diversify to spread the risk? Consider the amount of
diversification in the electrical and white goods markets. Consider the
incredible number of new products being launched. Is the consumer still
sovereign amidst this vast amount of product choice?

Activity 5.6 read and reflect


Read the following article and answer the questions that follow.

Africas supermarket shopping revolution


Adapted from the Financial Times, 24 July 2015
Malls are replacing traditional outdoor markets and street vendors. The
new consumerism is all about status, choice and Swiss chocolate.
At the entrance to the Shoprite supermarket in downtown Lusaka, women
are wrestling with shopping trolleys. It is the end of the month and salaries
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have been paid: the women have bought nappies, rice, sugar and sacks of
maize meal half the weight of a bag of cement. In front of the main doors,
young men stand in the hot sun selling tomatoes and onions; five kwacha
a kilo (approximately 40 pence). On the street outside, makeshift stalls
tout plastic-weave shopping bags, cellophane-wrapped Bibles, pens and
herbals potions. In the car park, women sit on the tarmac selling avocados
and dried kapenta fish, a type of sardine. It is, in miniature, a scene typical
of the street-side bustle that has long been the African shopping
experience.
The supermarket, however, is a newer phenomenon both to Lusaka,
the capital of Zambia, and to Africa. Serene, air-conditioned and well
stocked, it is an experience urban Africans are becoming increasingly
accustomed to as South African retailers advance north across the
Limpopo river. The trend is being felt from Lagos to Luanda, Maputo to
Kampala, and it is radically altering the shopping habits of the burgeoning
middle class. Where the supermarkets have led, other international brands
have followed: from Barclays to KFC and Nandos. According to forecasts
by McKinsey, Africas consumer-facing industries will grow by more than
$400bn by 2020. All want the same thing to tap into the aspirations of a
new generation.
Before supermarkets arrived in Lusaka, Anga Kasanda, a 37-year-old
account assistant, used to do her shopping at the sprawling open-air
Soweto market. Packed with people and ripe vegetables, the place is full
of sweat, noise and dust. Now she rarely goes. In the Shoprite on Cairo
Road, one of Lusakas main highways, Kasanda browses shelves of Italian
(rather than Egyptian) pasta. Every location you go, theres malls ... I can
say thats development, she tells me. Its changed the perspective of
people. For her, its the basics that have made a difference: being able to
get hold of electrical appliances such as a steam iron, and being able to
do an entire shop under one roof. For millions of Africans, following a
decade of strong economic growth, it is these seemingly mundane things
that have helped to raise living standards. Its revolutionised the way
people are shopping, she adds. We dont want to go backwards.
(Source: England 2015)
Question 1: Why might oligopoly supermarkets be welcomed by
consumers when theory tells us that perfect competition amongst small
stall holders is better?
Question 2: What are the likely effects of allowing the growth of
supermarkets in Africa?

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Activity 5.6 read and reflect answers:

Summary
There are such a large number of different firms operating in the
marketplace that we place them into a market structure. Economists
examine the price, output, efficiency and profitability of firms in each of the
different market structures. Understanding the context of a firms strategic
decision-making allows us to make much more sense of an ever-changing
market situation that all firms face. Firms do not always behave in the way
our theoretical models would suggest; take, for instance, the assumption
concerning profit maximisation.
As a general rule of thumb, it would appear that the more competition in
the marketplace the better. This is hardly a surprising revelation. Most
people in the street would be able to make this same assertion! We do,
however, now have as economists a theoretical underpinning to this
general rule of thumb.

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Now is the time to broaden the picture by examining the macroeconomy


within which the firm operates.

Review activity 5.7


Question 1: If marginal revenue is 10 and marginal cost is 8 will the firm
increase or decrease its level of output?
Question 2: Why do you not observe managers trying to measure
marginal revenue and marginal cost?

Review activity 5.8


Examine your own industry. Pick one model of competition which best
describes your industry. Explain the model and justify why you think the
model best describes your industry.

Activity 5.9 lecture slides and audio


Listen to: the audio for this unit and view the accompanying slides at the
same time. (Blackboard > Module Site > Module Materials > Unit 5 >
Lecture slides and audio)

Activity 5.10 multiple-choice questions


The multiple-choice questions for this unit will enable you to test your
knowledge and understanding of the key concepts covered. (Blackboard >
Module Site > Formative Exercises > Multiple-Choice Questions > Unit 5).

Activity 5.11 live online tutorial


Live online tutorial: To access the tutorial, please go to Blackboard >
Module Site > Collaborate. To test your sound settings for the Blackboard
Collaborate virtual classroom, please go to the Blackboard Collaborate
Support site at http://bit.ly/1etRu2Y. For further support materials and
information about Blackboard Collaborate, please see the Blackboard
Collaborate Support site at http://bit.ly/1jBpgUc.
Before the tutorial a short article will be posted onto the module
Blackboard site which raises issues from Units 3, 4 and 5 (Blackboard >
Module Site > Module Materials > Collaborate, to gain access to the
article). A set of questions will accompany the article. Please read the
article and prepare answers to the questions posed.

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Question 1: How is the merger likely to affect competition within the


industry?
Question 2: Is it always the case that fewer firms in an industry is bad for
competition?
Question 3: If there is a similar merger involving two large players in your
industry how would your firm react?
(Hint: You should think about the type of competition you face and how
that affects your demand.)
Question 4: Apart from lowering price what else might you consider to
help with competition?

References
England, A (2015) Africas supermarket shopping revolution. Financial
Times, 24 July. http://www.ft.com/cms/s/0/6c0f2576-30b3-11e5-8873775ba7c2ea3d.html#slide0. Accessed 26 August 2015.

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PART II:
MACROECONOMICS

Unit 6:
Introduction to
Macroeconomics
Key reading:
1. Begg, D. and Ward, J. (2013), Chapters 9 and 10
Other:
1. Unit 6 lecture slides and audio (Blackboard > Module Site > Module
Materials > Unit 6 > Lecture slides and audio)
2. Unit 6 multiple-choice questions (Blackboard > Module Site > Formative
Exercises > Multiple-Choice Questions > Unit 6) Activity 6.7

Introduction
The macroeconomic environment is ever changing. New policies or
agreements are continually being made (for example, the current
negotiations over the Trans-Pacific Trade Partnership), adjustments to key
economic variables (for example, interest rates) are announced, and
almost daily some evidence is reported about the present state of the
economy. But what does all this indicate? For firms, it is the recognition
that not only must they respond to internal change and to changes in
trading relationships, but also to the changing macroeconomic
environment in which they operate. For example, what are the implications
of high or unstable exchange rates? What are the implications of
increasing world trade flows and international competition? How does
monetary/interest rate policy affect the well-being of firms? Similarly, as
individuals, we must recognise the importance of the macroeconomic
environment to our everyday well-being. Our ability to gain employment or
our potential for a sustained increase in our standard of living are both
factors influenced to some extent by macroeconomics.
In this unit, we introduce some of the key macroeconomic concepts and
introduce a conceptual framework which we will develop in Unit 7.

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Objectives
By the end of this unit, you should be able to:

highlight the importance of macroeconomics to businesses and


individuals

identify the key economic issues and problems in macroeconomics

develop a framework in which to understand the workings of the


macroeconomy

be familiar with concepts such as GDP, economic growth, balance of


payments, inflation, unemployment, fiscal and monetary policy, the
circular flow of income, aggregate demand and supply.

Economic targets
Read: Begg and Ward (2013), Chapter 10, pp.247271
Every government, regardless of its political persuasion, aims to achieve:

low inflation

low unemployment

healthy balance of payments

healthy economic growth.

Each government may differ in the priority attached to the objectives and
indeed in the methods and policies used to achieve them. The main
difficulty for the government is that it is hard to achieve all these objectives
at the same time. Reducing inflation may very well lead to increased
unemployment and slower economic growth. Reducing unemployment
may be at the expense of rising inflation and increased difficulties with the
balance of payments.

Main macroeconomic policy tools


The government can use either fiscal or monetary policy.

Fiscal policy involves the use of taxation and government expenditure.

Monetary policy uses the manipulation of interest rates and policies to


influence the money supply.

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Inflation
Inflation means the general rise in prices. It is expressed as an annual
percentage increased and is calculated using the consumer price index or
the retail price index (RPI). The products that are priced every month are
weighted in order to represent the importance in terms of spending. Quite
clearly, an increase in the mortgage rates or cost of electricity is far more
important to a households outlay each month than a doubling in the price
of a box of matches. Inflation means that the pound in your pocket is worth
less than it was a year ago in terms of what that pound will buy.

Why is inflation important?


We all feel aggrieved that we pay much more for a product than we did
when we were younger; however, there are a number of other important
problems associated with inflation. Inflation brings uncertainty to the
business environment and business does not like uncertainty. Uncertainty
will, ceteris paribus, reduce the amount of investment in the economy and,
as such, affect the level of economic growth.
Inflation may bring unemployment. If the UK domestic inflation rate is
higher than that of its international competitors, then its goods will face a
general reduction in demand. This will cut firms profit margins and they
will cut back production. This will inevitably lead to a reduction in
employment. This reduction in the demand for products will result from UK
exports being relatively more expensive and imports into the UK being
relatively cheap.
Inflation affects our standard of living. We all feel worse off and so the
wage bargaining process is affected. People on fixed incomes such as
pensioners and welfare recipients find themselves becoming worse off.
Savings become worth less, although the size of borrowers debts
becomes worth less in real terms. Generally, these factors add up to a
more turbulent and riskier economic environment.

What causes inflation?


Inflation can be caused by three main factors.

Cost-push: this type of inflation may result from an increase in the price
of a raw material or component. Or it might arise from an increase in the
price of a factor of production such as higher labour costs or an
increased cost of machinery or higher council tax. An increase a the
firms costs that is not matched by increased productivity leads to
increased costs of production. Firms respond by pushing up prices to
maintain profit margins.

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Keynesian demand-pull: this kind of inflation is caused by the


aggregate demand in the economy being too great and, subsequently,
pulling up prices. Aggregate demand consists of all the spending in the
economy: government, consumer, investment and export expenditure;
we examine this in more depth later. If the aggregate demand exceeds
the ability to supply output, then the demand pulls up prices.

Monetarist demand-pull: this inflation originates in the excess growth


of the money supply. If the amount of money in the economy exceeds
the supply of products, prices are pulled up. For example, assume the
economy only produces red socks, the amount of money in the
economy is 200 and there is an output of 100 pairs of socks. Each pair
costs 2. If the money supply is doubled and the production of red
socks remains unchanged, then 400 will be chasing the red socks.
The likely outcome will be an increase in the price of red socks to 4
per pair. The money supply is doubled and the price level is doubled.

The difference between the Keynesian demand-pull and the monetarist


demand-pull lies in the starting point. Roughly speaking, monetarists
believe that inflation stems from an increased money supply; Keynesians
believe that the money supply changes to accommodate the level of
demand and spending in the economy. We examine both these issues in
more depth later.
In reality, inflation is probably a feature of all three causes. They may differ
in emphasis and detail, and they may change according to different
economic times and circumstances, but essentially they may all be factors
causing inflation.

Tackling inflation
Inflation can be tackled in a number of ways depending on the economists
view about what caused the inflation in the first place.

Tackling cost-push inflation


The aim is to keep firms costs down. If wages are too high, then wage
restraint is urged. The message is that wages should only increase as fast
as productivity allows. The success of this policy depends upon the
willingness of firms and unions to accept it, and the government would not
wish to resort to an incomes policy. If raw materials are increasing in
price and this is fuelling the inflation, then the government could increase
interest rates. As we see later, increasing interest rates has the effect of
making the pound stronger on the foreign exchange market. Since firms in
Britain import a lot of raw materials, the higher exchange rate will reduce
import prices and subsequently dampen cost-push inflation.

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Tackling Keynesian demand-pull inflation


Keynesians believe inflation is caused by too much demand. So the
solution is to reduce demand. This can be done using contractionary fiscal
and monetary policies. We explore these ideas further in Unit 7. Basically,
contractionary fiscal policy means increasing taxation or reducing the
growth of government spending. If tax is increased, consumers have less
disposable income and so there will be a general reduction in demand
which will slow down the rate of price increases. Additionally, higher
interest rates will make credit spending more expensive and so cut
expenditure on credit-related goods. Another feature of higher interest
rates is that consumers may save more as the opportunity cost of
spending becomes higher and, after paying the higher mortgage rate, etc,
we have less money to spend.

Tackling monetarist demand-pull


Monetarists believe inflation is caused by the excess growth of the money
supply, so the solution is to cut the growth of the money supply. This can
be done by restricting the banking sectors ability to increase credit in the
economy.

Which solution is the best?


The best solution is one that uses elements of all three approaches. If
inflation can be caused by different factors that vary in importance
according to time and circumstance, then the best solution is one that
recognises this fact and incorporates the best elements of each method to
make an integrated anti-inflation strategy.

Unemployment
Unemployment may be defined as the difference between the number of
people willing and able to work at the prevailing market wage and the
number that have jobs. To classify as unemployed for the purpose of
government statistics, an individual must be entitled to benefits.

Why is unemployment important?


The cost to the unemployed individual may be harmful. Unemployment
can lead to a greater strain on social services due to the social problems
that may arise from depression, etc. If there is a greater amount of crime
and vandalism in times of high unemployment, then a greater strain is
placed upon the police and the legal system. Although as economists we
might feel sympathy for the problems that unemployment brings, we are
more concerned with financial cost to the government and the opportunity

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cost of the money allocated to tackling the social problems that arise from
greater unemployment. Not only does the government have to allocate
vast resources to the problems that unemployment brings, it also loses out
on the extra tax revenues it would have received had the unemployed
been working instead.
In addition to these financial implications, society has lost out on a vast
amount of goods and services that would have been produced if everyone
had been working. These extra goods and services would have enhanced
the standard of living and contributed to government popularity. Think
about the production possibility frontiers at this point.
Unemployment affects everyone, not just the unemployed. Think of the
opportunity cost and the effects on income tax if there was less
unemployment. Or, consider how tax revenues could be switched to
reducing the length of hospital waiting lists and teacher-pupil ratios.

What causes unemployment?


The classical view and monetarist view
Classical economists, whom we can refer to as the pre-Keynesians for the
purpose of this unit, believed unemployment was caused by excess wages
in the labour market. If we consider Figure 6.1, the equilibrium market
wage would be w1 and the number of people employed would be n1.
However, if the wage level was w2 then the firms would cut back their
demand for labour to point n2. The higher wage would attract a labour
supply of n3. According to the theory of how a free market operates, wages
would fall to the equilibrium at w1 and this would sort out the surplus
labour. The falling wage will allow firms to increase the number of workers
until an equilibrium is reached.
Figure 6.1: Workers and wages

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If wages dont fall, the pre-Keynesians would say that unemployment is


caused by labour market imperfections. Whatever is causing the
disequilibrium would then be looked at as a cause of unemployment.
Monetarists would also stress that unemployment results from inflation
and, therefore, inflation needs to be tackled as the number one priority.
Consider how that argument works from our discussions on inflation.
Monetarists would argue furthermore that some unemployment is caused
by a combination of benefits and income tax being too high. They argue
that if this situation occurs, there is little incentive to work since the gap
between disposable income (income after tax) and the income on benefits
is too narrow.

Keynesian view of unemployment


Keynesians believe that unemployment is caused by a lack of demand in
the economy. Keynesians base their ideas on the work of John Maynard
Keynes who wrote a very influential book, the title shortened to The
General Theory, which was published in 1936. Keynes was writing during
a period of high unemployment and when the governments approach was
based on classical views that wages were too high. Keynes turned
economic theory on its head and came up with an approach to
unemployment very different to the orthodoxy of the day.

The Keynesian solution to unemployment


If unemployment was caused by a lack of demand, the solution was to
increase demand. Left to its own devices, the economy would not return to
an equilibrium that involved full employment and so the government has a
responsibility to intervene. The government would need to inject money
into the economy and Keynes referred to getting the unemployed to dig
holes and fill them in again. Keynes was highlighting that it did not matter
what the unemployed did provided there was an increase in spending
ability in the economy. If people had more income, they would spend
more, which means that firms would sell more, which means they would
need more workers, etc. Keynes realised that the solution to
unemployment was a lot more complicated than this in the real world, and
we shall study this in more depth in Unit 7.

Activity 6.1 read and reflect


Considering the Keynesian summary, can you highlight all the potential
problems with this approach to tackling unemployment?

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Activity 6.1 read and reflect answers:

Classical and monetarist solution to unemployment


As we have already seen, the classical economists believed wages should
fall to restore a full employment labour market equilibrium. Monetarists
would agree with this prescription and believe that the union power should
be reduced to allow the labour market to work more effectively. In addition,
monetarists are extremely sceptical about the Keynesian solution believing
that spending more money would just lead to further inflation. Monetarists
would stress that the most effective way to reduce unemployment would
be to reduce inflation first. If we have lower inflation, then our goods and
services will sell more easily and so we will require more workers. In
addition, if benefits are lowered and tax is lowered there will be a greater
incentive to work and voluntary unemployment would fall.

Which is the best solution to unemployment?


Well, both of the different schools of thought have their merits. A
government need not be dogmatically monetarist or Keynesian. It can
pragmatically take the best parts of both approaches. Maybe some
unemployment is caused by excessive wage growth (if wages are growing
faster than productivity) in some markets, some unemployment might
result from a generous level of benefits or excessive taxation reducing
incentives to work. Unemployment might result from a lack of international
competitiveness due to high inflation. Unemployment might also stem from
a period of recession, in which case lack of demand may be the most
significant problem to put right.

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In summary, unemployment may be caused by a number of factors and


the best solution may vary over time and circumstance. The best solution
may be a combination that varies in emphasis and detail and may need to
be part of an international approach in todays global economy.

Healthy balance of payments


The balance of payments measures the flow of money into and out of an
economy and reports the overall position as a net inflow. A negative
balance of payments means more money is leaving the country to pay for
imports than is being received as payments for exports. The balance of
payments is influenced enormously by the exchange rate, and the
exchange rate is influenced enormously by the demand and supply of
imports and exports.

Is healthy better than a surplus?


At first it might seem strange to suggest that healthy is more important,
since a surplus means more money coming into the economy and, hence,
a more prosperous situation for successful firms and consumers. But, it
depends on what has caused the surplus. If the economy relies on
importing raw materials from abroad, then a balance of payments surplus
might have been caused by a lack of production in the economy, and this
might adversely affect the balance of payments in future. A resurgent
economy may be one which has a massive demand for imported raw
materials and hi-tech machinery, which may cause an initial deficit but
provide a healthier outlook for the future.

Exchange rates
A high exchange rate means imports are relatively cheaper and exports
are relatively more expensive. If imports are cheaper, then firms face lower
costs of production (for example, cheaper raw materials) and this may be
good for reducing cost push inflation. But, cheaper imports and more
expensive exports may be bad for businesses that are competing in the
world marketplace and reduced demand for domestically produced goods
could lead to unemployment. A low exchange rate means imports
become relatively more expensive and exports become relatively cheaper.

Activity 6.2 stop and think


Explain the consequences of a low exchange rate, using the above
explanation to help you.

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Activity 6.2 stop and think answers:

Can the government influence the exchange rate?


The chief method of government influence used to be through interest
rates. If domestic interest rates were increased above rates in other
countries, hot money would flow into the economy. Hot money is globally
mobile capital that can flow around the world to wherever its investment
will yield the best return. This would increase the demand for the currency
and so the exchange rate would increase. Hot money is growing as
economic development brings opportunities and finance becomes ever
more globally minded. Interest rates are generally set by an economys
central bank, in order to provide a more stable and predictable
environment within which firms can make their investment decisions.

Healthy economic growth


Economic growth means an increase in the value of output of goods and
services over the last 12 months. It can be measured in a number of ways,
such as:

GDP: gross domestic product is the value of all the goods produced
within a countrys borders by domestic firms.

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GNP: gross national product is the value of output produced by an


economys firms, whether at home or abroad.

As we shall see shortly, economic growth can be measured through


calculating national income in one of three ways:

income method

expenditure method

output method.

Why is economic growth good?


A society experiencing economic growth will enjoy a general increase in its
standard of living. The society has a production possibility frontier (PPF)
moving outwards and there is a greater availability of goods and services,
which improves material wealth. The electorate feels wealthier and this
allows the government to bask in the glow of public opinion. Not everyone
is better off, society has inequalities that continue or may even be
exacerbated by economic growth.
Economic growth brings more general prosperity. Firms are doing well,
consumers are doing well, the government also does well. If firms are
selling more products or services to wealthier consumers, then revenues
and profits will be healthy. If consumers are earning more, they can spend
more money on holidays and other luxuries. If workers are earning and
spending more, the government gets more income through taxation. This
gives the government a greater amount of scarce resources to allocate in
the economy to develop its popularity, etc.

What causes economic growth?


Investment, investment, investment !!!
There are a number of factors that help economic growth:

a good well-researched product

a well-developed production process

an innovative approach

a stable economy within which decisions can be made with confidence

helpful government policies

successful government management of the macroeconomy.

Put these factors together for your country and compare the result with the
combination of factors enjoyed by the Germans, French and Japanese.
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Activity 6.3 stop and think


Question 1: Why does a country enjoying economic growth find it easier
to generate economic growth in the future? Why do underdeveloped
economies feel that they are falling further behind?
Question 2: For essay practice, briefly outline the importance of the
governments main economic objectives. Assess why it is difficult to
achieve them all at the same time.
Activity 6.3 stop and think answers:

Circular flow of income


Read: Begg and Ward (2013), Chapter 9, pp.223230
The basis of macroeconomics is that one persons expenditure
becomes another persons income. Looking at the circular flow of
income provides us with the opportunity to assess how income and
expenditure flows around the economy. In addition, it allows us a simple
overview of how government injections and leakages influence national
income.
Following the traditional economist approach of keeping things as simple
as possible to begin with, lets imagine an economy with no government,
no trade and no financial institutions. In addition, households spend all that
they earn. This can be represented in Figure 6.2.
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Figure 6.2: Circular flow of income


Households

Spending

Labour

Wages

Goods and
services

Firms

Firms produce goods and services, which they sell to households. The
households supply labour and other factor inputs like land and capital to
firms in return for income, which they then spend on the output produced
by firms. In this example, quite clearly we can identify that:
Income = Output = Expenditure
There is no pressure for national income to change. The money just
continues to flow around the economy. This simple diagram also suggests
that there are three different methods of calculating national income:
income method, output method and expenditure method. All should give
the same answer, since they are just alternative ways of looking at the
same thing.
If we begin to make the model more realistic by accepting that consumers
save, buy imports and pay tax, we can include the role of financial
institutions, the government and international trade. This can be
demonstrated in Figure 6.3, which has a number of important points to
examine before we begin to tie up the loose ends of the circular flow.

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Figure 6.3: Circular flow of income in the real world


Imports
Savings
Tax

Households

Spending

Income

Firms

Government spending
Investment
Exports

Injections into the circular flow


Injections are autonomous expenditures that enter the circular flow. They
increase the income flowing around the circular flow and include:

investment expenditure

government expenditure

export expenditure.

Leakages from the circular flow


Leakages are those parts of income not passed on in the form of
expenditure on domestic output. The money withdraws from the circular
flow through:

savings

taxation

import expenditure.

If injections are greater than withdrawals, then national income will


increase. As national income increases, the ability to save, pay tax and
buy imports increases. The national income will increase until the planned
leakages are equal to planned injections. If there is a sudden increase in a
leakage then national income will fall, reducing the ability to save, pay tax
and buy imports. The income will fall until the economy is back in
equilibrium. We consider these arguments in depth in the Keynesian
theory of national income in Unit 7.

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Activity 6.4 read and reflect


Read the following scenario and answer the questions that follow.

China seeks to allay renminbi slide fears


The Peoples Bank of China on Wednesday sought to dispel fears of a
prolonged fall in the renminbi, intervening to prop up the currency after a
shock devaluation spread alarm through global markets.
The Chinese currency had fallen by as much as 2 per cent earlier on
Wednesday to a low of 6.45 per dollar, before the authorities stepped in to
buttress the renminbi, which rallied 1 per cent in the final 15 minutes of the
trading day to 6.38 versus the dollar.
Chinas decision to tolerate a weaker currency has fanned concerns that
its economy, long an engine of global growth, is slowing much faster than
previously thought. Investors also worry that a sustained decline in the
renminbi and competitive currency devaluations across Asia could have a
deflationary effect, which would further weigh on global economic
prospects.
However, some have also pointed to Chinas recent disappointing trade
figures and other worsening economic indicators as reasons for the
currency devaluation. Chinese exports tumbled 8.3 per cent in July yearon-year, worse than economists had expected.
While the renminbi had been roughly flat against the dollar this year until
this week, it had risen sharply against other currencies of key trading
partners, notably the euro and the yen. That appreciation has come in
spite of the slowdown in growth, record capital outflows and four cuts to
benchmark interest rates in the past year.
(Source: Noble and Wigglesworth 2015)
Question 1: Why might the devaluation of the renminbi increase the
amount of money circumnavigating the Chinese circular flow?
Question 2: How else might China have had the same effect on the
circular flow without changing the exchange rate?

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Activity 6.4 read and reflect answers:

Summary
In this unit, we have introduced the macroeconomy and the clear idea that
much of what happens in the economy is interconnected, and that there
will always be a number of important consequences for any given change
in government policy. You should have a reasonable grasp of the
interdependence of the governments economic objectives. The next unit
will build upon this introductory work and extend our understanding of how
different economists believe that the governments objectives should best
be achieved.

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Review activity 6.5


This exercise is based on the national income of an imaginary country. It is
important to remember not to double count. Double counting occurs when
the same part of national income is counted twice. For example, suppose
a firm takes component products for 2 and adds these to a finished
product which sells for 5. The firm has added 3 of value to the product.
The total value added in the economy is 5, 3 from the second firm and
2 by the first firm. Double counting would have given an answer of 7.
Before tackling the activity, think carefully about what you expect to find.
Check back to the circular flow diagram in Figure 5.2 if you are unsure.
Imagine a closed economy that consists of just six firms: Farm, Mine, Flour
Mill, Iron Works, Bakery and Oven Factory. Each firms basic accounts are
as follows:
Farm (produces wheat)

Sales 20,000

Wages 10,000
Profit 10,000

Mine (produces iron ore)

Sales 16,000

Wages 8,000
Profit 8,000

Flour Mill (produces flour)

Sales 50,000

Wages 15,000
Profit 15,000
Wheat 20,000

Iron Works (produces iron)

Sales 36,000

Wages 10,000
Profit 10,000
Iron ore 16,000

Bakery

Sales 170,000

Wages 40,000
Profit 80,000
Flour 50,000

Oven Factory

Sales 70,000

Wages 24,000
Profit 10,000
Iron 36,000

Now work out the national income using the:

output method

income method

expenditure method.

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Activity 6.6 lecture slides and audio


Listen to: the audio for this unit and view the accompanying slides at the
same time. (Blackboard > Module Site > Module Materials > Unit 6 >
Lecture slides and audio)

Activity 6.7 multiple-choice questions


The multiple-choice questions for this unit will enable you to test your
knowledge and understanding of the key concepts covered. (Blackboard >
Module Site > Formative Exercises > Multiple-Choice Questions > Unit 6)

References
Noble, J. and Wigglesworth, R. (2015) China seeks to allay renminbi slide
fears. Financial Times, 12 August. http://www.ft.com/cms/s/0/8405dc0440a0-11e5-9abe-5b335da3a90e.html. Accessed 8 August 2015.

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Unit 7:
Evaluating Government
Economic Policy
Key reading:
1. Begg, D. and Ward, J. (2013), Chapters 11, 12 and 13
Other:
1. Unit 7 lecture slides and audio (Blackboard > Module Site > Module
Materials > Unit 7 > Lecture slides and audio)
2. Unit 7 multiple-choice questions (Blackboard > Module Site > Formative
Exercises > Multiple-Choice Questions > Unit 7) Activity 7.10
3. Unit 7 live online tutorial (Blackboard > Module Site > Collaborate)
Activity 7.11
4. Unit 7 marked formative assessment (Blackboard > Module Site >
Formative Exercises > Marked Formative Assessment > Unit 7)
Activity 7.12

Introduction
Regulating the macroeconomy is based on a firm belief that governments
are best placed to intervene in the running of the economy. Obviously, this
is a controversial view in its own right, and some economists argue that
the economy is best left alone to be regulated by the market. Whatever
your view, governments do play an important role in regulating the
economy in order to achieve their stated objectives.
In this unit, we examine the government policies that are used to regulate
the economy. We assess how realistic the theoretical arguments are likely
to be in practice. We start by developing the Keynesian model of how the
economy works and discuss some of its limitations. We move on to
examine how the government can use a combination of demand and
supply side policies to best manage the economy. This will require the
introduction of an aggregate demand and supply framework so that we
can assess the impact of government policy.

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Objectives
By the end of this unit, you should be able to:

understand the Keynesian theory of unemployment and inflation

outline the limitations of the Keynesian demand management approach


to unemployment

evaluate the use of fiscal and monetary policy

investigate the Phillips curve and how its apparent breakdown with
stagflation gave support to the monetarist criticism of the Keynesian
approach to managing the economy

debate the use of demand and supply side policies.

Keynesian theory of national income


Read: Begg and Ward (2013), Chapter 11
Keynes believed very strongly that the government had a responsibility to
intervene in the economy if it was to achieve its economic objectives.
Keynes set out to demonstrate exactly why the economy, left to its own
devices, would not bring full employment. In order to do this, he developed
the model that we now examine.
Pre-Keynesians believed that spending and savings decisions were
primarily influenced by interest rates. When interest rates were high,
savings would be high and spending would fall. Keynes recognised a
relationship but felt that income was a far stronger determinant of
consumption and saving. For Keynes, this idea was crucial and it had
important repercussions for how he viewed the workings of the economy.
We can build upon the work concerning injections and leakages in Unit 6.
Keynes made an assumption that the injections were autonomous and not
related to income. The leakages were income related. Consider Figure 7.1
showing planned injections and planned leakages.

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Figure 7.1: Planned injections and leakages in the macroeconomy

At point yx, the planned injections and planned leakages are in equilibrium.
There will be no pressure for national income to change. At yz, planned
leakages exceed planned injections and at yy, planned leakages are less
than planned injections.
Consider point yz in more detail. Planned leakages are greater than
planned injections. Remember planned injections are drawn as a
horizontal line since the injections are assumed autonomous. If planned
leakages exceed planned injections, there will be less total expenditure in
the economy on goods produced by domestic firms. Firms find that they
sell less and their stocks of unsold goods start to accumulate, with firms
investing in effect in their own stock. Firms react to this situation by laying
off workers and so national income starts to fall. As national income falls
so does the ability to save, pay tax and buy imports. Income will fall until
the planned injections are equal to planned leakages again at point yx.
Keynesians point out that the economy has returned to equilibrium but that
this equilibrium has a level of unemployment attached.
Pre-Keynesians believed that unemployment would only occur if there was
a situation of disequilibrium. For Keynesians, equilibrium occurs when
Total planned expenditure = Total income/output
And when

Planned injections = Planned leakages

So, what is the main idea here? This demonstrates that Keynesians
believe that national income changes to restore equilibrium in the
economy but that this equilibrium can have a level of unemployment
attached. Therefore, if left to its own devices the economy does not give
full employment, and it becomes the governments responsibility to
intervene.
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Activity 7.1 stop and think


Question 1: Using Figure 7.1 and the associated analysis to help, can you
explain what happens when the economy is at point yy?
Question 2: If unemployment needs to fall what should happen to
injections?
Question 3: Can you redraw Figure 7.1 but this time with a new planned
injection line called planned injections 2 that gives a new equilibrium at
point yy?
Activity 7.1 stop and think answers:

If you can answer these three questions then you are already some way
towards understanding the next part of the Keynesian model. At yy the
planned injections exceed the planned leakages in the economy. Spending
increases, firms find their stocks become depleted so they take on more
workers to increase production. National income increases and so does
the ability to save, pay tax and buy imports. National income will increase
until the planned leakages are equal to planned injections and the
economy is back in equilibrium at yx.
If unemployment exists at yx and we want it to fall then the government
should increase autonomous injections until we have full employment
equilibrium at yfe. This is demonstrated in Figure 7.2.

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Figure 7.2: Keynesian model

Keynesian solution to unemployment


revisited
Keynes believed there should be an injection of government spending into
the economy to increase aggregate demand. The greater spending that
would result in the economy would increase national income up to the
point when planned injections equal planned leakages again.
Aggregate demand = Consumer + Investment + Government expenditure
+ (Exports Imports)
AMD = C + I + G + (X M)
Consider Figure 7.3. The current level of expenditure AMD1 gives an
equilibrium output/income of yx. Unfortunately this equilibrium carries with
it a level of unemployment. We wish to be in equilibrium at yfe. If there is
an increase in government expenditure, the AMD increases from AMD1 to
AMD2. This new level of expenditure raises the national income to give a
full employment level of national income at yfe. The increased government
spending has closed the deflationary gap. The deflationary gap is the
amount by which expenditure is short to give full employment equilibrium.

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Figure 7.3: The deflationary gap

The multiplier
The increase in government expenditure will increase national income by
an amount greater than the value of the injection. The multiplier stems
from the idea that if the government injected 40 million, say, by giving the
unemployed lots of money, then they would spend it which creates income
for someone else which is spent etc. If the governments injection raised
national income by 200 million, then the multiplier would be 5.
Injection times multiplier = Change in national income
40 million 5 = 200 million
If the government knew the size of the multiplier and the increase in
national income required, then it would know how much to inject. However,
this is easier said than done! The multiplier raises national income by an
amount that will generate additional leakages so that planned injections
equal planned leakages again at equilibrium.

Problems with Keynesian theory


Many of the problems identified with the Keynesian solution to
unemployment were identified by Keynes himself. You will have identified
some of the problems in Unit 6. We discuss each problem in turn.
1. Where does the money come from? The government could raise tax to
finance the expenditure, but the outcome would be public sector
spending replacing private sector spending (crowding out). The
government could borrow by selling treasury bills at good rates of

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interest, but this might reduce private sector investment if interest rates
increase too much (financial crowding out).
2. What would happen if a lot of the extra spending in the economy goes
on imported luxuries from abroad? The extra jobs made available by the
injection may be created in foreign countries as a result. In the UK, for
example, there is a high marginal propensity to import; consumers
spend a lot of the countrys increasing income on imported goods.
3. What would happen if in the face of higher domestic demand, firms
cannot increase output quickly enough? The result would be inflation.
Firms might not have sufficient spare capacity to increase output and
may not be willing to undertake the extensive investment required to
meet the new demand unless they have the expectation that the new
level of demand will be long term and sustained.
4. There are crude elements in the Keynesian tools themselves. Working
out the amount to inject, understanding the extent of time lags and the
general difficulties of gathering up-to-date and accurate statistics mean
that the goalposts keep changing.
5. In a dynamic world economy, the success of domestic government
policy relies on the co-operation and complementary policies of
international competitors and trading partners.

Activity 7.2 stop and think


Using these five points to help you, can you draw up the dream Keynesian
scenario if the policy for reducing unemployment is to be effective? This
will be helpful for the analysis we shall undertake later in the unit.
Activity 7.2 stop and think answers:

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Monetarist criticism of the Keynesian approach


The monetarists focus upon two main arguments. Firstly, the financing of
the extra government expenditure just leads to crowding out in the
marketplace. The increased taxation or higher interest rates used to obtain
funds reduces private sector spending. Secondly, the injection of
government expenditure just leads to inflation.
The basis of the monetarist argument lies in their view of money supply.
Monetarists argue that the only way the government can finance its extra
injections into the economy is through increasing the money supply. This
inevitably leads to inflation, since money is used as a means of exchange.
This pulls up prices, since firms output decisions are influenced by interest
rates and not the artificial demand created by expansionary government
policy. The monetarist way to reduce unemployment is to reduce inflation
first. Remind yourself of the other monetarist arguments about
unemployment covered in Unit 6.

Keynesian response to this criticism


Keynesians believe that the monetarists have oversimplified the argument.
They argue that rather than the money supply determining price, the
direction of causation is the other way around. Namely, the money supply
changes to accommodate the level of spending taking place in the
economy. In addition, any influence that increasing the money supply has
on the economy is unlikely to fuel inflation if spare capacity exists. In
addition, money can be used for purposes other than as a medium of
exchange. Keynesians believe that inflation can be caused by excessive
growth of the money supply, but that it is far more complicated than the
simple causal relationship identified by the monetarists. In reality they
argue, inflation can be caused by a combination of factors that include the
excess growth of the money supply, but can also include cost-push factors
and excess aggregate demand.
Further Keynesian views on unemployment will be covered shortly in this
unit. But first we look at the Keynesian view of inflation and the Phillips
curve.

Keynesian view of inflation revisited


Keynesians believe that inflation can be caused by cost-push factors in
addition to demand-pull. When explaining demand-pull, we can adapt
Figure 7.3 which we used to explain how unemployment is tackled.
Inflation here is caused by the notion that demand in the economy is too
great for the available supply of output. Or to put it another way:
AMD or C + I + G + (X M) exceeds supply

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Consider Figure 7.4. The current level of expenditure in the economy is


AMD1. This would give an equilibrium level of income/output at yx.
Unfortunately, the economy does not have the ability to produce this level
of output. When everyone is working the maximum output is yfe. The
current expenditure exceeds the full employment expenditure by the
amount ab. This is called the inflationary gap. Spending needs to
decrease to reduce AMD1 to AMD2, to close the inflationary gap and give a
full employment level of income/output.
Figure 7.4: Inflationary gap

Economic policy tools


The government can use fiscal policy, monetary policy and direct
controls. These controls include:

expansionary policy
reduce taxation or increase government expenditure
decrease interest rates in the economy

contractionary policy
increase taxation or reduce government expenditure
increase interest rates in the economy.

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Activity 7.3 stop and think


Why do you consider expansionary policy is preferable for a government?
Activity 7.3 stop and think answers:

Monetary policy
Monetary policy generally involves:

increasing or decreasing the money supply

reducing or increasing the rate of interest

removing or imposing controls on the flow of credit.

Read: Begg and Ward (2013), Chapter 12

Money, banks and money supply


To understand the monetarist position it is necessary to define money.
Money is a good, it is traded for other goods and services, but it is unique
in that everyone understands its value. When you sell your old textbooks
you might use the proceeds to enjoy a nice meal. However, if you tried
paying for the food using the books you would quickly be turned away.
Without money these transactions could not take place. It is this
importance of money that means that everyone has an interest in its value.

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The amount of money in the economy is always changing, particularly


because of banking. When a bank accepts a deposit it will then seek to
lend a percentage of that money to someone else. For example if a
depositor places 1000 into their account and a borrower takes 800 on
loan both will think they have money. The depositor still considers
themselves to have the full 1000, and the borrower will be able to spend
800. This leads to the measures of money in the economy moving
beyond the number of notes and coins in circulation.
Table 7.1: United Kingdom money supply in June 2015
Narrow measure of money

Notes and coins

Retail deposits

Wholesale deposits

M4

65bn
1472bn
574bn
2106bn

(Source: Bank of England)


Since the financial crisis the requirements on the amount of deposits that
banks must hold as reserves has increased, meaning the amount which
may be lent out has fallen. This has resulted in a reduction in available
credit and is held by some as responsible for slowing economic recovery.
Banks themselves do not need to achieve balanced books as they are
able to trade excess deposits, or fund excess loan demand, by going to
the interbank market. Here the central bank acts like a bank for all of the
other banks, providing them with loans, or accepting their deposits. The
interest rate in operation here is set by the central bank and is heavily
linked to the policy rate. For the UK, the rate is the London Interbank
Offered Rate (LIBOR). Because of this reliance on trade with each other, it
is possible for the central bank to have a great deal of influence on the
commercial banking sector.
Money being created by the banks can be seen as a concern, since it is
outside the governments control. However, it will have a positive impact
on the economy, provided borrowers invest well. The extent to which bank
lending generates new money is known as the bank multiplier, and follows
the same idea as the other multipliers. When a borrower invests in a
business and then pays wages to workers, those workers will save some
of their wages, opening up funds to lend to someone else, but still
essentially using the money from the initial deposit. In our example the
initial borrower put in 1000, the borrower took 800 and this might then
be paid to a builder to build a factory, or a worker to increase production. If
that worker puts 400 back into the bank, then there will be 320 for
lending to another borrower.

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Banks role within the economy can thus be summarised as:

liquidity helping economy flow smoother by linking those with spare


funds with those who need money to invest

risk pooling depositors funds are pooled before lending, leaving


each saver less exposure to risky projects

risk selection deciding who to lend money to, and monitoring the
risks taken through regular screening

risk pricing rates offered on loans reflect project risk.

Many regulatory issues are raised, especially given banks are able to
create money and that lending to failed projects can exposed depositors
to risks of losing their money. The financial crisis, and bank funding of
subprime loans, meant many savers suffered exactly the loss of funds that
they should be protected against.

Demand for money


People want money for many reasons, not least paying for goods and
services. Money can also be held in case we need it, or because it is safe
compared to investments that might lose value. These motivations are
known as transactional, precautionary and asset motives, respectively.

Money market equilibrium


Figure 7.5: Money market equilibrium

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Continuing the money supply discussion, with money demand we reach


the money market equilibrium in much the same way that we did for the
product market equilibrium in Unit 4. The interest rate serves as the price
of money. Higher prices mean that you want to borrow less. Money supply
is treated as inelastic because it is the central bank that has ultimate
control, recognising the money multiplier effect.
Monetary policy can intervene by:

changing the money supply

raising the interest rate, so that the market then determines supply.

More recently a large amount of focus has been placed on quantitative


easing, the central bank buying government bonds to inject money into the
economy. The bank then owns the high-quality bonds and it can
theoretically sell them later.
Setting interest rates also allows the bank to influence the wider economy,
but this takes time. The process of feeding through is known as the
transmission mechanism. As well as the direct effects the bank rate
indicates what they expect to happen to inflation, consumers and firms will
monitor this when making economic decisions. Should consumers believe
conditions are better for saving then they will do so, but should rate falls
be likely a credit culture will begin to build up. The consequential changes
in consumption, the opportunity cost of saving, will then impact on the
GDP of the economy. Firms will have a longer term outlook but the idea is
the same, lower interest rates promote investment whilst high interest
rates see measures being necessary to deal with reduced demand and
reduce the amount of money owing to avoid interest.

Activity 7.4 stop and think


In the United Kingdom interest rates are set by the Bank of Englands
Monetary Policy Committee (MPC) independently of the government.
Minutes from MPC meetings are published allowing readers to form an
impression of likely future changes.
Question 1: Why might independence from government help the bank set
more economically suitable interest rates?
Question 2: UK inflation is low, but the economy is recovering (growing)
after the financial crisis. Why would MPC members feel a rate rise is likely
soon?

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Activity 7.4 stop and think answers:

Activity 7.5 research


Research these terms and comment briefly on how they have been made
relevant in the recent austerity (balanced budget) approach to economics.

Balanced budget

Budget surplus

Budget deficit

National debt

Public sector net cash requirements (PSNCR) or public sector


borrowing requirement (PSBR)

Activity 7.5 research answers:

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Fiscal or monetary policy, which is best?


The best response to this question is: it depends. It depends on whether
you are a monetarist or a Keynesian; it depends on the situation the
economy is in at any particular point in time; and, in any case, it may be
that both policies could best be used in conjunction with each other.

The Keynesian view


Keynesians have a preference for fiscal policy, although they also find
monetary policy to be supportive. Keynesians prefer fiscal policy because
they believe it to be more direct and the outcomes a little more
straightforward to predict.
When expanding the economy, Keynesians would increase government
expenditure or reduce tax. Increasing expenditure allows the money to be
targeted more effectively, since the government does not know what
consumers will do with their extra disposable income if taxation is reduced.
Reducing interest rates would also be helpful but cannot be relied upon.
Keynesians believe that expectations about future demand and profit are
more important than lower interest rates when firms are choosing to invest.
However, lower interest rates might just persuade the firms on the margin
of doubt about whether to invest or not. In addition if interest rates fall,
think of the likely consequence for interest payments on the national debt.
Also consider the opportunity cost of the lower interest on the national
debt.

Activity 7.6 stop and think


Using this explanation, outline how the Keynesians would use
contractionary policy. Why would higher interest rates not necessarily
deter a firms investment expenditure?
Activity 7.6 stop and think answers:

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The monetarist view


Monetarists have a preference for monetary policy although they are not
averse to using fiscal policy in a contractionary sense. When expanding
the economy, monetarists would use neither expansionary monetary or
fiscal policy. They believe the economy should be left to free market forces
and that the governments role is to create the right conditions for the free
market to flourish. Expansionary policy just leads to inflation.
When contracting the economy, monetarists would wish to control the
growth of the money supply. One of the methods of doing this is to
increase interest rates. Put in simple terms, if interest rates increase
consumers might save more, or spend less on credit or may shift
resources out of their bank is and into high interest government bonds. If
we take our money out of the bank, this reduces the banks ability to
create credit and as such the money supply growth will slow down.
Contractionary fiscal policy also helps, although increasing taxation is
frowned on since it goes against the incentive to work arguments. But
reducing government expenditure is helpful since this will reduce the size
of the budget deficit. Reducing the budget deficit will reduce the size of the
PSNCR or PSBR. Reducing the size of the PSNCR or PSBR will cut the
growth of the money supply. Cutting the growth of the money supply will
reduce inflation.

Activity 7.7 read and reflect


Read the following article which has been adapted from the Financial
Times and answer the questions that follow.

US economy: the case (in charts) for optimism


The big question hanging over the US economy is just how strongly it can
bounce back from a grim first quarter which saw the weather, a strong
dollar and a ports strike all conspire to drag the economy down.
Those, most economists agree, were all temporary factors and the 0.7 per
cent contraction therefore a blip. Get ready for a bounce back and a return
to growth in the current quarter and through the rest of the year, most
economists say. It may even be robust enough growth to justify the
Federal Reserve delivering before the end of the year on its much-flagged
lift-off and the first increase in its policy rate in nine years.
Today, I come before you as the proverbial two-armed economist, Bill
Dudley, president of the New York Fed told the Economic Club of
Minnesota on Friday.

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On one hand, the economys forward momentum has slowed sharply


during the first half of the year and inflation remains below the level the
[rate-setting] Federal Open Market Committee (FOMC) views as
consistent with price stability, Mr Dudley said.
On the other hand, I think it is also fair to say that we are still making
progress towards our dual mandate objectives [full employment and price
stability], he went on, though he added that even recent solid job gains
and a fall in the unemployment rate had occurred only because
productivity growth has slowed markedly.
(Source: Donnan 2015)
Question 1: Why might the Federal Reserve have a dual mandate of full
employment and price stability?
Question 2: How would a rise in interest rates affect the recovery of the
United States economy?
Question 3: Why is productivity an important factor in how well
unemployment reductions indicate economic growth?
Activity 7.7 read and reflect answers:

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Updating the Keynesian model


In updating the Keynesian model, we first examine a slightly different way
of approaching aggregate demand and supply before adapting the
Keynesian argument to take into account the theoretical difficulties we
have already examined in this unit.

Aggregate demand curve


Figure 7.6: The aggregate demand curve

Consider Figure 7.6. The aggregate demand curve, AD, gives the total of
all goods and services demanded at various price levels. Put another way,
the AD curve shows the relationship between the total amount of
income/output that will be purchased and the price level. The AD curve
slopes in the way that it does for three main reasons.
1. The interest rate effect. This suggests that as prices increase the
interest rates in the economy will increase since all lenders will have
add an inflation premium to the loan to compensate for the loss in real
value of the loan. As interest rates increase, the demand for interestsensitive goods will fall. Hence, there is a reduction in income/output.
2. The wealth effect. Inflation reduces our purchasing power and we feel
less wealthy. We respond by spending less, which reduces
income/output.
3. Substitution of foreign goods. The more inflation in an economy, the
less competitive the economys goods become vis--vis foreign
competition. Consumers switch from domestic to international
producers. This reduces domestic production, and GDP falls.

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The aggregate supply curve


The simple version of this concept shows the aggregate supply curve, AS,
as the relationship between real national income per year and the price
level. The higher the price level the greater the incentive for the firms to
produce. This is shown on Figure 7.7.
Figure 7.7: The aggregate supply curve

If we now put the AD and AS together we find an equilibrium level of


prices and national income/output.
Figure 7.8: Equilibrium of aggregate supply and demand

If the government decides to expand demand, you can see the effect on
the economy in Figure 7.9.

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Figure 7.9: Changes in the demand curve with increase in demand

The increase in AD shifts the demand curve to the right. This has the
effect of increasing national income/output and hence employment but at
the expense of higher prices. Whether the reduced unemployment is worth
the higher prices is difficult to establish.
If the government decides to go for supply side policies then this picture is
changed somewhat.

Supply side policies


Read: Begg and Ward (2013), Chapter 13
These are policies aimed at making the supply of goods and services in
the economy more efficient. The policies should increase income/output at
each price level. Broadly, supply side policies three types of measure.
1. Introducing more competition into the marketplace by, for example,
reducing monopoly power and encouraging competition through
privatisation.
2. Making the labour market more flexible. This involves controlling the
power of trade unions, improving education and training, and increasing
labour mobility.
3. Increasing the incentives for individuals to work and for entrepreneurs
to take risks. This could take the form of reductions in income tax and
corporation tax.
Supply side policies are essentially microeconomic policies aimed at
making the supply of goods more efficient. If they are used to tackle

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unemployment, then a micro-solution is used to tackle a macro-problem.


The monetarists embraced supply side policies with a passion. The effect
of a supply side policy is shown in Figure 7.10.
Figure 7.10: Supply side policies

Note that the national income/output has shifted to the right; hence, there
is greater employment which has resulted from a more efficient supply of
goods and services. There is reduced unemployment without inflation. Is
this too good to be true? Possibly, say the Keynesians. What if the
problem in the economy is mainly lack of demand, as in a recession; who
will buy the output? Keynesians suggest an integrated approach that uses
both supply side and demand side together. Consider such an approach
by expanding demand as much as supply will allow. This is shown in
Figure 7.11.
Figure 7.11: Supply and demand side

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Note that the new AD2 and AS2 gives a greater income/output but without
inflation. The new income/output is y2. But lets now deepen the analysis
still further. Consider the three scenarios described in Figure 7.12.
1. A situation where there is substantial spare capacity in the economy.
2. The intermediate zone, where some spare capacity exists.
3. A situation where no spare capacity exists.
Figure 7.12: Aggregate supply curve and spare capacity in the economy

In the section of the diagram where substantial spare capacity exists, firms
would find it easy to increase supply to meet increasing demand resulting
from expansionary government policy. This increase in income/output
would reduce unemployment without creating inflationary pressure. This
can be seen clearly in Figure 7.13. If there is little or no spare capacity in
the economy, then supply is very inelastic. An increase in aggregate
demand would lead directly to inflation since firms increase prices rather
than output. If this situation existed in the economy, the Keynesian
approach to unemployment would be unsuccessful.
The intermediate zone is perhaps the most realistic situation for the
economy to be in. Here spare capacity exists for some firms and
industries, while other firms and industries are at full capacity. Expanding
demand would lead to an increase in income/output and employment. It
would also lead to some inflation.
Figure 7.13 suggests that the governments demand side success is very
dependent on firms abilities to increase output. If supply side policies are
used in the economy, then the supply of output at every price will move to
the right. This is shown in Figure 7.14. Note that the new AS2 joins the
previous AS1 in the area where no spare capacity exists.
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Figure 7.13: Demand, supply and spare capacity

Figure 7.14: Supply side policies

The final diagram in this model (Figure 7.15) brings the demand and
supply side policies together. Pay particular attention to the intermediate
area. If you ignore for a moment the other parts of the diagram, do you
find something familiar about what is left? You should notice that the
intermediate zone is the same as the basic AD and AS diagram in
Figure 7.8.
If demand side policy is to be used, it should be in conjunction with supply
side policy. Perhaps the government could target expenditure at areas of
the economy in which substantial spare capacity exists. In addition, since
imports will inevitably increase as incomes go up, government expenditure
could be targeted at export firms to avoid balance of payment difficulties.

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Figure 7.15: Demand and supply side policies

Summary
In this unit, we have only touched on a number of issues that need
considering when examining how the government can influence economic
activity in the economy. You should now be developing an understanding
of how the Keynesian model of income allows an explanation of both
unemployment and inflation. The role of changing national income is
fundamental to an understanding of why Keynesians identify a role for
positive government intervention in the economy. We have also examined
the use of fiscal and monetary policy and some of the issues surrounding
each of these policies. Understanding demand side and supply side
policies becomes crucial to an understanding of how modern economists
approach the task of achieving economic objectives.
In Unit 8, we focus upon the UK and its role in the international
marketplace.

Review activity 7.8


Question 1: Outline the monetarist theory of inflation and discuss the
implications of the Keynesian criticism.
Question 2: Outline the Keynesian theory of unemployment and assess
the likely success of the Keynesian policies to tackle the problem.

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Activity 7.9 lecture slides and audio


Listen to the audio for this unit and view the accompanying slides at the
same time. (Blackboard > Module Site > Module Materials > Unit 7 >
Lecture slides and audio)

Activity 7.10 multiple-choice questions


The multiple-choice questions for this unit will enable you to test your
knowledge and understanding of the key concepts covered. (Blackboard >
Module Site > Formative Exercises > Multiple-Choice Questions > Unit 7)

Activity 7.11 live online tutorial


Live online tutorial: To access the tutorial, please go to Blackboard >
Module Site > Collaborate. To test your sound settings for the Blackboard
Collaborate virtual classroom, please go to the Blackboard Collaborate
Support site at http://bit.ly/1etRu2Y. For further support materials and
information about Blackboard Collaborate, please see the Blackboard
Collaborate Support site at http://bit.ly/1jBpgUc.
In this tutorial we will review a current economic announcement from the
Bank of Englands Monetary Policy Committee (MPC). Specific questions
for this tutorial will be posted onto the Blackboard site at the same time as
the MPC decision information (Blackboard > Module Site > Module
Materials > Collaborate). Please review the information and note down
answers to the questions posed prior to the tutorial.
Question 1: Why is the decision taken sensible given the prevailing
economic conditions?
Question 2: What policies could the UK government follow to achieve the
same effect without raising interest rates?
Question 3: Many economists believe that the interest rate will rise
through 2016. Does the evidence point to this?
Question 4: Over the coming years what is likely to happen to the UK
economy in terms of GDP, inflation and unemployment?
Should the decision be a maintaining of the prevailing rate then question 2
will be altered accordingly. Specific questions will be posted onto the
Blackboard site at the same time as the MPC decision information.

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Activity 7.12 marked formative assessment


macroeconomics
Using appropriate data for your own economy identify the important policy
concerns facing your economy. What economic policies might your
government use to manage your economy?
Use no more than 750 words and be sure to both demonstrate your
knowledge and understanding of economics.
Email your answer to your module tutor, who will advise you via
Blackboard (Blackboard > Module Site > Formative Exercises) on the
deadline for submissions in order to receive feedback on your work.

References
Donnan, S. (2015) US economy: The case (in charts) for optimism.
Financial Times, 5 June. http://www.ft.com/cms/s/0/6985393a-0b92-11e58937-00144feabdc0.html#axzz3iu16FL1r. Accessed 8 August 2015.

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Unit 8:
Economics of the
Global Economy
Key reading:
1. Begg, D. and Ward, J. (2013), Chapters 15 and 16
Other:
1. Unit 8 lecture slides and audio (Blackboard > Module Site > Module
Materials > Unit 8 > Lecture slides and audio)
2. Unit 8 multiple-choice questions (Blackboard > Module Site > Formative
Exercises > Multiple-Choice Questions > Unit 8) Activity 8.12

Introduction
It is impossible to talk about a countrys economic well-being and future
prosperity without setting it into the context of the global economy.
International competition, multinational enterprises, trade agreements and
the drive for integration have immeasurably changed the economic
landscape. Our aim is to put many of these issues into focus, and to
develop an understanding of many of the key concepts in the international
economy the balance of payments, exchange rates and comparative
advantage. We move on to show the benefits to be gained from
international trade and the cost of protectionist policies. Further, we go on
to question the extent of international trade and globalisation. Is it really as
far reaching as we think? Finally, we assess the importance of these
issues for the future competitiveness of the economy and firms in general.

Objectives
By the end of this unit, you should be able to understand:

the key concepts of international economics

the theory of comparative advantage

terms of trade

how exchange rates are determined and the influence they exert on the
economy

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the factors affecting the balance of payments

the debate surrounding protectionism

recent trends in international trade.

Benefits of international trade


Read: Begg and Ward (2013), Chapter 16, pp.400409
International trade has the potential to benefit all participating countries. As
the textbook points out, in many ways this is just an extension to the
international sphere of why we, as individuals, choose not to be selfsufficient. Most of us specialise in something for which we receive
payment. This allows us to purchase what other people have produced.
We do this because we enjoy a better standard of living in this way. You
might be a poor hunter, farmer, builder, cook, plumber, electrician and
carpet fitter. This does not matter if you can buy the things that these
trades supply from someone else. The UK might not have the right climate
to grow some foodstuffs or have the natural resources to extract some raw
materials. This doesnt matter since UK firms and consumers can buy
these products from abroad. They can pay for these by selling goods and
services to other countries. International trade allows us to enjoy a wider
range of commodities than would otherwise be the case, and at cheaper
prices.

Theory of comparative advantage


It is not difficult to understand the benefits of trade if we have two countries
producing two different products, with each country better than the other at
producing its product. But what about a situation in which country A is
better at producing good X and good Y. Surely in this situation, trade
cannot be beneficial? Well, it can! Students often find this a difficult
concept to grasp. If you start to struggle with this idea, keep thinking, I
might be both a better doctor and cleaner than my cleaner. It still makes
sense for me to concentrate on being a doctor and to employ my cleaner
to do the housework since I am comparatively a much better doctor than
my cleaner but I am only a slightly better cleaner.
If country A produces the product which it is comparatively better at, then,
provided the two countries have different opportunity costs, trade will
benefit both countries. In the example given in the textbook, USA is better
at producing both cars and shirts. The USA is comparatively better at
producing cars. The UK is comparatively better at producing shirts.

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Activity 8.1 stop and think


Make up an example of comparative advantage at work and, using the
textbook to help you, see if you can show the different opportunity costs
needed for your example to work. Can you show the gains from trade that
occur when you select your own rate of exchange between the two
opportunity costs?
Activity 8.1 stop and think answers:

Other advantages of international trade

International trade creates larger markets, helping firms to benefit from


economies of scale.

It opens up domestic markets to more competition and so reduces


monopoly power.

It increases consumer choice.

It increases interdependence between trading nations and encourages


co-operation rather than conflict.

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Activity 8.2 stop and think


Protectionism is the practice of implementing policies that make imports
more difficult. It seeks to help domestic firms compete nationally and
internationally.
Question 1: In what ways do the European Union promote free trade
within the union?
Question 2: How does the interaction between the EU and non-EU
nations fit the idea of free trade?
Activity 8.2 stop and think answers:

Balance of payments
Read: Begg and Ward (2013), Chapter 15, pp.382385
The balance of payments is the difference between a countrys imports
and exports. It is helpful to consider where the money goes in establishing
whether a payment is for an import or an export.

The visible trade balance is the difference between the value of


imported goods we can see and exported goods we can see.

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The invisible balance takes into account the difference between


imports and exports of goods that are not visible or tangible. For
example, a Japanese tourist visiting a London theatre show would be
an invisible export. (Money is coming into the UK.)

The investment earnings and transfers takes into account the net
earnings arising from overseas assets owned plus the transfer of funds
to and from the UK.

If we take visibles, invisibles and investment earnings together, we have


the balance of payments on current account. To get from the balance of
payments on current account to the balance of payments we need to
include capital account and financial account transactions. Financial
account transactions are made up of investment activity by British
people or institutions abroad; and investment activity by foreign institutions
in Britain.

Terms of trade
The terms of trade are defined as the average price of exports divided by
the average price of imports expressed as an index. If the terms of trade
rise (export prices rising relative to import prices), they are said to have
improved, since fewer exports now have to be sold to pay for imports.

Exchange rates revisited


Read: Begg and Ward (2013), Chapter 15, pp.375382
Exchange rates are determined by the interaction of demand and supply
on the foreign exchange market. Every time a UK business buys a good
from the US it supplies pounds to the foreign exchange market in order to
get dollars so that it can pay for the good. The foreign exchange market is
anywhere where pounds are exchanged for other currencies. This could
be a bank, a travel agent, etc. Every time an American imports a good
from Britain the demand for pounds increases. There is a two-way
relationship that exists between the exchange rate and the demand for
imports and exports. They are both influenced by each other.
If we assume that Americans want to purchase British goods, then they
demand pounds. The higher the price of pounds the less will be
demanded. As the price of pounds falls, more will be demanded. The
demand for pounds is a derived demand and is shown in Figure 8.1.

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Figure 8.1: Demand for pounds

If we want to purchase goods from the USA to import to Britain, we need


to supply pounds. The higher the exchange rate the more pounds we
supply, since each pound buys more dollars and so the US goods are
good value. If the exchange rate was low, then we could buy less dollars,
US products would be expensive and, therefore, the supply of pounds
would be low. This can be represented in Figure 8.2.
Figure 8.2: Supply of pounds

If we now put the demand and supply of pounds together we are able to
determine the exchange rate. This is shown in Figure 8.3.

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Figure 8.3: The exchange rate of the pound

If British goods become very fashionable in the US, then there would be
an increase in demand for pounds. The demand curve would shift to the
right. This would cause the exchange rate of the pound to increase. The
exchange rate increases from p1 to p2. This is shown in Figure 8.4.
Figure 8.4: Increase in demand

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Activity 8.3 stop and think


Using Figure 8.4 as a guide, explain what happens when US consumers
decide UK products are not worth buying any more. Construct a new
diagram to help you explain.
Activity 8.3 stop and think answers:

The Americans demand less pounds. The demand curve for pounds shifts
to the left. This reduces the exchange rate of the pound and the price of
pounds decreases from p1 to p2 as shown in Figure 8.5.
Figure 8.5: Decrease in demand

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If UK customers decide to buy more of a very fashionable US good, then


this will increase the supply of pounds on the foreign exchange market.
This has the effect of decreasing the exchange rate of the pound and is
shown in Figure 8.6.
Figure 8.6: Increase in supply

Activity 8.4 stop and think


Using Figure 8.6 to help you, can you explain what happens to the
exchange rate if people in the UK dont want to buy US goods?
Activity 8.4 stop and think answers:

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Floating or fixed exchange rate?


So far we have been assuming a floating exchange rate. In such a system,
the balance of payments must always balance. Take our earlier example
where the UK is increasing its consumption of US goods. Lets assume the
good is a luxury and has a relatively high price elasticity of demand. The
large demand for the product increases the supply of pounds on the
foreign exchange market. The supply curve shifts to the right and the
exchange rate falls. As the exchange rate falls then all US products
imported into the UK become more expensive. UK customers are likely to
respond by decreasing the demand for US goods. The supply of pounds
will shift to the left and the exchange rate will increase. The floating
exchange rate should be self-equilibrating.

Activity 8.5 stop and think


Using a freely floating exchange rate system can you explain what
happens when the US customers increase their demand for British
luxuries?
Activity 8.5 stop and think answers:

Fixed exchange rate system


A fixed exchange rate would cause a different market reaction. Under a
fixed exchange rate, if UK customers demanded more US goods they
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would just keep on demanding them because the exchange rate wont
change it is fixed. In this situation, the UK would run into balance of
payments difficulties. The exchange rate would not fall as it would with a
floating exchange rate system, so the government would need to intervene
to maintain the value of the pound. The government would do this by
buying up any excess pounds on the foreign exchange market, so
reducing UK reserves of foreign currency. This could not carry on
indefinitely since eventually the UK would have no foreign currency
reserves left. If the situation persisted, the government would have to bring
in expenditure reducing or expenditure switching policies.

Expenditure reducing policies could include contractionary policy,


leading to less income in the economy with which to buy imported
goods. Obviously this reduces the demand for domestic goods as well.

Expenditure switching policies would involve devaluation. This would


lower the exchange rate and make imports more expensive. UK
customers would react by switching from US goods to British goods
instead.

In reality, there is no freely floating exchange rate since governments are


able to influence the exchange rate in a number of ways. The government
will try to act in such a way as to iron out large short-term fluctuations in
the exchange rate. This is to provide a more stable economic environment
which, as we have seen in earlier units, is essential for business
confidence and investment decisions.

Economic and monetary union (EMU)


Read: Begg and Ward (2013), Chapter 15, pp.387390

EMU timetable
1 January 1999 establish fixed exchange rates between currencies and
a single monetary policy to be framed and implemented by European
System of Central Banks (ESCB).
1 January 2002 ESCB put euro notes and coins into circulation and
withdrew national banknotes.
1 April 2002 The changeover to the euro was completed. The
independent European Central Bank and the ESCB took over
responsibility for monetary policy and interest rates.

Monetary co-ordination advantages

Increased certainty and more effective planning.

Common counter inflationary strategy.

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Reduced EU-wide price disparities.

Increased inward investment.

Reduction in costs and time of currency exchange.

Monetary control disadvantages

Difficulty of maintaining exchange rate values.

Loss of sovereignty in economic policy making.

Freedom would still exist in fiscal policy and member states could
pursue independent budgetary policies.

One fit monetary policy limited given a continuing business cycle and
structural disparities between EU members.

Activity 8.6 stop and think


The recent Greek bailout has raised more questions about the ability of
the European Union to function effectively in its current state. Read this
adapted version of an article in the Financial Times.

Mario Draghi casts himself as guardian of


monetary union
If anyone ever doubted how much politics and the monopoly power to print
currency are irredeemably linked, look no further than the position in which
the European Central Bank has found itself over the past few weeks.
Since the regions crisis began, the unelected technocrats that head the
ECB have found themselves accused of overstepping their mandate to
guard the value of the single currency.
The ECB chief [Mario Draghi] acknowledged the single currency over
which he presides was fragile, vulnerable and doesnt deliver all of the
benefits that it could, but maintained the central bank would do its utmost
to keep it together. His institution would, he said, continue to act as though
Greece is and will remain a member of the euro area.
Mr Draghi backed this verbal intervention with action, surprising markets
by extending the Emergency Liquidity Assistance lifeline by 900m and
indicating that Athens could soon benefit from inclusion in the ECBs
1.1trn quantitative easing.
(Source: Jones 2015)

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Question 1: How might Greece benefit from being included in the


European Unions quantitative easing programme?
Question 2: What is meant by emergency liquidity assistance?
Question 3: Thinking about the topics covered so far, what benefits should
a single currency deliver?
Question 4: Why might Greece not be feeling those benefits?
Activity 8.6 stop and think answers:

Need for fiscal harmonisation

In theory, at least, fiscal harmonisation, like monetary union, is required


to ensure a single market.

The removal of tariffs alone may give an impression of a free market but
various tax differences may provide equivalent distortions.

The movement towards fiscal harmonisation is far less progressed and


just as problematical. The Stability and Growth Pact rules which limit
Eurozone member countries to budget fiscal deficits which do not
exceed 3 per cent of member countrys GDP has been breached by
Italy, Germany and France in recent years.

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Activity 8.7 stop and think


Question 1: If the UK keeps reducing income tax, how would this affect its
trading partners?
Question 2: If the UK increased taxation, how would this affect its
partners?
Question 3: How would increasing UK interest rates affect its partners?
Activity 8.7 stop and think answers:

Europe the future

Will the UK become a member of the Eurozone?

Are there any alternatives to EMU that allow further economic


co-operation by following a different path?

Can the UK afford not to be a member of the full EMU since it has gone
ahead anyway?

Will Britons be reminiscing in 25 years about the days we could go to


the football match, have a couple of beers and a bag of chips on the
way home and still have change from 20 euros?

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Trends in world trade


Activity 8.8 read and reflect
Read: Begg and Ward (2013), Chapter 16, pp.400417
Summarise the points made about both the geography of international
trade and the composition of international trade, particularly with reference
to the European Union.
Activity 8.8 read and reflect answers:

Multinational corporations
Read: Begg and Ward (2013), Chapter 16, pp.413425

Activity 8.9 stop and think


Using the knowledge gained from this unit, answer the following questions.
Question 1: What are the advantages and disadvantages to an economy,
like that of the UK, of having a large multinational sector?

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Question 2: How might the structure of a multinational differ depending


upon whether its objective of being multinational is to reduce costs or to
grow?
Question 3: If reducing costs is so important for many multinationals, why
is it that they tend to locate production not in low-cost developing
economies, but in economies within the developed world?
Question 4: Explain the link between the life cycle of a product and a
multinational business.
Question 5: Assess the advantages and disadvantages facing a host
state when receiving MNC investment.
Question 6: Debate the following: multinational investment can be nothing
but good for developing economies seeking to grow and prosper.
Activity 8.9 stop and think answers:

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Summary
In this unit, we have outlined how all economies benefit from international
trade. It is easier to see the advantages when countries have an absolute
advantage. It is more difficult, but still true, when we use the principle of
comparative advantage. You should have demonstrated how comparative
advantage works and discovered a real sense of achievement since it is a
difficult concept to explain. Firms and industries that rely on international
trade are affected significantly by the exchange rate and we have
examined what determines the exchange rate and how the exchange rate
influences the demand and supply for imports and exports.
In addition, we can identify trends in world trade and understand the
growing reliance on trade within the EU.

Review activity 8.10


Read the following article which has been adapted from the Financial
Times column feature Free Lunch and then consider the questions that
follow:

Free Lunch: Trans-Pacific opacity


Capitol Hill has been agonising over whether to give Barack Obama fasttrack authority to submit trade deals, specifically the Trans-Pacific
Partnership with 11 other Asia-Pacific nations, to a vote in Congress.
What is clear, though, is that some venerable economic arguments for the
benefits of open international commerce are being advanced to support a
pact that in the main has nothing to do with free trade as defined therein.
Back when trade deals mainly addressed import tariffs, the thrust of
economic analysis, going back to David Ricardo and Adam Smith, was
clear. Free trade allowed specialisation and comparative advantage and
thus on balance increased efficiency and prosperity.
Translating this into modern trade deals, there was usually an alliance of
convenience between mercantilists who wanted to open foreign markets to
their exports and economists who held their noses at the fetishisation of
exports but recognised that pacts led to lower tariffs all round.
(Source: Beattie 2015)
Question 1: Expand upon the alliance of convenience between
mercantilists and economists hinted at in the article.

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Question 2: In what ways does the Trans-Pacific Partnership violate the


ideas of free trade?
Question 3: Briefly outline the advantages and disadvantages for smaller
economies signing up to the Trans-Pacific Partnership.

Activity 8.11 lecture slides and audio


Listen to: the audio for this unit and view the accompanying slides at the
same time. (Blackboard > Module Site > Module Materials > Unit 8 >
Lecture slides and audio)

Activity 8.12 multiple-choice questions


The multiple-choice questions for this unit will enable you to test your
knowledge and understanding of the key concepts covered. (Blackboard >
Module Site > Formative Exercises > Multiple-Choice Questions > Unit 8)

References
Jones, C. (2015) Mario Draghi casts himself as guardian of monetary
union, Financial Times, 16 July. http://www.ft.com/cms/s/0/6ed110be2bd9-11e5-8613-e7aedbb7bdb7.html - axzz3j5r6YvEd.
Accessed 8 August 2015.
Beattie, A. (2015) Free Lunch: Trans-Pacific opacity. Financial Times,
27 May. http://www.ft.com/cms/s/3/afd460bc-fe38-11e4-be9f00144feabdc0.html#axzz3iu16FL1r. Accessed 8 August 2015.

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Unit 9:
Revision and Assessment
Key audio/video:
1. Concluding MBA Business Economics (Blackboard > Module Site >
Module Materials > Unit 9) Activity 9.1
Other:
1. Unit 9 live online tutorial (Blackboard > Module Site > Collaborate)
Activity 9.2
This module has introduced you to key economic ideas and then related
them to business. Economics is split into two areas: microeconomics and
macroeconomics. Microeconomics covers markets and competition;
macroeconomics covers the economy level topics such as inflation, GDP,
interest rate policy and fiscal policy.
In terms of assessment, microeconomics and macroeconomics are
covered by written assignments. You will find the assignment questions on
Blackboard during December. Guidance on answering economic
questions is also provided. Further information relating to a summary of
the module and approaches to answering economics questions can be
found in the talking head video.

Activity 9.1 watch and reflect


Watch: Concluding MBA Business Economics (Blackboard > Module Site
> Module Materials > Unit 9)

Activity 9.2 live online tutorial


Live online tutorial: To access the tutorial, please go to Blackboard >
Module Site > Collaborate. To test your sound settings for the Blackboard
Collaborate virtual classroom, please go to the Blackboard Collaborate
Support site at http://bit.ly/1etRu2Y. For further support materials and
information about Blackboard Collaborate, please see the Blackboard
Collaborate Support site at http://bit.ly/1jBpgUc.
During this session you will review an article covering exchange rates and
the impact on a particular industry taken from the Financial Times. The
article will be posted on Blackboard with a set of specific questions ahead
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of the tutorial (Blackboard > Module Site > Module Materials >
Collaborate). Your tutor will also go through some of the basic issues that
you need to address in the assignments. In order to get the most out of the
session please ensure that you come prepared with any questions or
queries that you may have.
Question 1: How does the change in exchange rates impact upon the
industry in question?
Question 2: How might this change in the exchange rate affect the growth
of the country being studied?
Question 3: How do changing exchange rates impact on your business
and what steps can you take to minimise risks?
Your tutor will also go through some of the basic issues that you need to
address in the assignments. In order to get the most out of the session
please ensure that you come prepared with any questions or queries that
you may have.

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Appendix A:
Module descriptor
Module Title: Business Economics
Module Credit: 10
Module Code: MAN4100M
Academic Year: 2015/6
Teaching Period: September intake programmes
Module Occurrence: A
Module Level: FHEQ Level 7
Module Type: Standard module
Provider: School of Management
Related Department/Subject Area: School of Management
Principal Co-ordinator: Dr Simon Rudkin
Additional Tutor(s):
Prerequisite(s): None
Corequisite(s): None

Aims
To educate students in the workings of the market environment within
which organisations operate. To provide students with the opportunity to
use and apply economic concepts, constructs and frameworks in support
of business problem appraisal and decision-making. To enable students to
critically evaluate business problems and collect data in the construction
and presentation of appropriate business solutions.

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Learning, teaching and assessment strategy


To gain a firm understanding of the subject area and the key issues (as
outlined in the syllabus) students will be required to access and engage
with a variety of online resources (selected readings, video and audio
resources) a designated set text and a module study book that sets out
guided reading, self-assessment exercises, case studies and links to
additional resources. This relates to module learning outcomes: 1a, 2b, 2c,
3b. Students attend four online tutorials. These sessions allow students to
reflect on their learning further applying key academic and practitioner
based models and frameworks thereby gaining a detailed understanding
of the subject area. This relates to module learning outcomes: 2a, 2b, 2c,
3a, 3b. Students have the opportunity to complete a series of online MCQ
exercises for each module unit studied. After completing the questions
students receive instant feedback on their performance. In addition to this
there is the option of completing two formative tasks. These tasks involve
answering a question(s) on a key issue/theory relating to the module.
Written feedback is provided by the module tutor. This relates to module
learning outcomes: 2a, 3b. Assessment will be by one assignment.

Study hours
Lectures:
Seminars/Tutorials:
Laboratory/Practical:

0.00
0.00
0.00

Directed Study: 95.00


Other:
5.00
Formal Exams: 0.00 Total: 100.00

Learning outcomes
1. Knowledge and understanding:
On successful completion of this module you will be able to...
a) Analyse how markets work and how market forces affect organisations,
including an understanding of micro level market forces and competition
and macro level effects stemming from national and international
economic policies and changing business environments.
2. Subject-specific skills:
On successful completion of this module you will be able to...
a) Apply economic concepts to economic sectors or industries in order to
enhance your understanding of opportunities and threats in those
sectors or industries;
b) Analyse economic business problems, collect data and construct
business assessments;

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c) Make business decisions while taking account of complex sustainability


agendas.
3. Personal transferable skills:
On successful completion of this module you will be able to...
a) Deal with business problems in an adaptable and original manner;
b) Effect solutions to complex business problems using economic insight
and incomplete data.

Mode of assessment
Assessment type: Coursework
Percentage: 100%
Description: Individual assignment (2,000 words)

Supplementary assessment
As Original.

Outline syllabus
Scarcity and choice. Resource allocation and markets: demand and
supply/cost analysis; intervention in markets. Market structure and
competition: structure, conduct and performance of companies and
markets; market concentration and public competition policy. The
determinants of national output/income and fluctuations in growth rates.
Key economic variables: output, employment and inflation. Government
fiscal, monetary and supply-side policies. Exchange rates and the balance
of payments. Globalisation, international trade and international
investment.
Version No: 8

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Appendix B:
Model Answers to
Activities
Unit 1
Activity 1.2
At point a, where all resources are used to produce capital goods there will
be an extremely unhappy electorate with little choice of home-produced
consumer goods to purchase. Consumer goods would have to be
imported; in short, a very unbalanced economy would occur. At point b,
there are consumer goods galore. A materialists paradise! But if all the
resources are used to produce consumer goods, then what will be used to
produce capital goods when current machinery becomes worn out? Can
the country import all the capital goods it needs? Would that provide a
balanced economy?
The answer to question 2 is inconclusive. It is not really possible to say
which is the better combination; they are both theoretically as good as
each other. No information is given regarding the quality of the capital and
consumer goods vis--vis the foreign competition. More resources may be
allocated to a sector either because it is extremely efficient or to make up
for its relative weakness.

Activity 1.3
Question 1: Diminishing marginal returns mean that as more of a
particular good is produced the process is less efficient and more units of
the other product must be given up to allow a unit increase in output. For
example, land can be used to graze cattle, but who will produce fertiliser
for crops. With only cattle the land never gets chance to recover in the
same way and so is less use for cattle as well. Similarly if the land is only
used for crops, the crops slowly suck nutrients from the soil and
production becomes harder. By combining the two outputs the economy
can produce more of each item and rotate fields to keep them productive.

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Figure 1: Production possibility frontier movement

Question 2: If meat can be produced in greater quantities for any given


resource allocation then the PPF shifts outwards. For example if at 10
units of crops it was possible to produce 20 units of meat, then it is now
possible to produce 40. The crops intercept does not change, but the meat
intercept doubles. Figure 1 illustrates the change.

Review activity 1.4


Question 1: This is a government investment and so the opportunity costs
are any other possible use for those funds. Examples include health,
education, welfare, policing, etc. However it may be that funding comes
from borrowing instead, in such cases the opportunity cost would be the
austerity policy that has kept borrowing low.
Question 2: The argument is that there will be greater productivity and
more opportunities for trade. This will allow the economy to produce more
of everything with its resources.
Figure 2 (see next page) illustrates this discussion. Imagine an economy
at point A, with 20 units of goods and 15 units of services. Following the
improvements to productivity the country can produce 10 more units of
service, 20 more units of goods, or some combination thereof. The PDF
will undoubtedly expand but the question for government is whether to
focus on one good or move to a point like H. Because of diminishing
returns there will be an optimal point.

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Figure 2: Government PPF with expansion

Question 3: Speed costs, the technology to cut through air at higher


speeds requires more energy input and is therefore more expensive.
Physics ensures that the return to power in terms of speed is diminishing.
But, we can also think that a 20 minute saving on a 1 hour journey might
be helpful, but a further 5 minutes is unlikely to make particular difference
or deliver the value to justify a much higher cost.
Question 4: This exercise is left open to you, but you should make sure
that you mention the opportunity cost of investment and the fact that this
investment should lead to more possibilities to do business the PPF
should extend outwards.

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Unit 2
Activity 2.1
Scenario 1: If there is an increase in the price of a complementary good,
then the demand curve will shift to the left. In Figure 2.3 this is a
movement from D2 to D1. This is because the complementary good will be
demanded less at the higher price and, since the products are jointly
demanded, your product will face a reduction in demand as a result.
Scenario 2: If there is a decrease in the price of a substitute good, then
the demand curve for your product will shift to the left since consumers will
purchase the cheaper substitute product instead. This is a movement from
D2 to D1 in Figure 2.3.
Scenario 3: If there is an increase in consumer incomes, then we would
expect the demand curve to shift to the right since consumers can afford to
purchase more of your product at every price. For a normal good, this is a
movement from D1 to D2. However for an inferior good, the demand curve
for your product would switch to the left as consumers use their higher
incomes to purchase alternative products. This is a movement from D2 to
D1 in Figure 2.3.
Scenario 4: If there is a brilliant advertising campaign by your main
competitor, then your demand will shift to the left. This is a movement from
D2 to D1 in Figure 2.3.
Scenario 5: If your product is decreased in price, then you will experience
an extension of demand. This means there will be a movement along the
original demand curve itself. See Figure 2.1. Price is a movement along
the line, all other factors, such as substitutes, income, etc, are movements
of the line.

Activity 2.2
When the demand curve is in the elastic region, a decrease in price will
increase total revenue. Note how in this region the total revenue is
increasing. When the demand curve is in the inelastic region, a decrease
in price leads to a decrease in total revenue. When we have unitary
elasticity, the total revenue will remain constant.

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Activity 2.3
Question 1: Relate income elasticity to a product/market of your choice.
Question 2: Price inelastic; unitary price elasticity; price elastic demand.
Question 3: Examples of products with close substitutes.

Activity 2.4
Question 1: Razors and blades, games consoles and games, train travel,
electricity.
Question 2: First degree.
Question 3: First degree extracts the greatest consumer surplus, but is
unlikely to be profitable. It would be very difficult to organise and
consumers may not wish to participate in such a market.

Review activity 2.5


Task 1: For this task we have constructed the demand functions in Excel.
However, it is unlikely that you will have obtained such accurate lines,
indeed all of the demand models have underlying equations that are
based on straight lines. The example in Figure 3 shows business travellers
demand for business class tickets and it can be seen that the line is
downward sloping exactly like the ones we have studied in this unit.
Figure 4 plots the remaining three on the same axis to help with the
answer to later questions. Unsurprisingly the lowest line is the demand
from tourists (T) for economy class tickets (E), this line is denoted as TE.
The equations for the lines in Figure 4 are as follows:

Business demand for economy (BE): 2500 18x

Tourist demand for business (TB): 1100 5x

Tourist demand for tourist (TE): 450 2x.

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Figure 3: Business class demand

Business Travellers Demand For


Business Class
3000
2500
2000
1500
1000
500
0
0

20

40

60

80

100

Figure 4: Demand functions

Demand Functions
1200
1000
800
BE

600

TB
TE

400
200
0
0

20

40

60

80

100

Task 2: Business class for business is the least elastic, while the economy
class demand from tourists is the most elastic. This is because quite often
business class travellers must actually make the journey as a means to an
end. Tourists, by contrast, might like extra comforts of business class but
their willingness to pay is constrained. Low prices in economy can tempt
passengers to fly, and this is the lowest priced set of tickets offered.

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Task 3: Based on the data, the revenue is maximised at 280 business


class passengers paying 1240 for each ticket. This gives a total revenue
of 347,200. It should, of course, be noted that this would be too many
passengers for one plane, even the A380 only has 76 business class
seats (source: emirates.com)
It is possible to derive this result from the demand function, but do not
worry if you are not able to do this mathematics. We know that
p = 2500 18x, where p is the price people are willing to pay and x is the
percentage of people. Hence the revenue will be equal to the price
multiplied by the quantity sold (x per cent of the 400 total, this equals 4x).
Now we have R = pq = 4x (2500 18x). It can be readily checked that this
is a quadratic function, which is strictly concave (the second order
derivative is 144). Hence there is a unique maximum which is found by
setting the first order derivative, 10000 144x, equal to zero and solving
for x. This tells us that the maximum percentage is 69.4%, which would
give a price of 1250 by substitution back into the demand function.
However, because a random element has been added into the function
this is not quite the same as the answer given by the graph.
Task 4: Using the graph from task 1 we can easily add the consumer
surplus when the price is 1300.
Figure 5: Consumer surplus

Business Travellers Demand For


Business Class
3000
2500
2000
1500
1000
500
0
0

20

40

60

80

100

A similar imposing of the consumer surplus triangle onto the TE graph will
give the second part of the answer. Although the total surplus is much
smaller it still means there will be a large number of consumers who feel
they have got a good deal.
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Task 5: This question features two parts and relates to the demand data
from Table 2.
(a) Weekends are always more popular as children are not at school and
it is easier to book a solid week off work. With a greater potential
demand prices will be higher. It is also possible that other events
cause weekend demand, and any well-reasoned argument is
welcomed here.
(b) This is an example of third degree price discrimination because
passengers are being differentiated by the day that they want to travel.
There is no difference in quantity, which is always one ticket, and as
such there is no opportunity for first, or second, degree price
discrimination here.
In reality airlines use frequent flyer rewards as a means to obtain seconddegree discrimination and get someway towards first-degree. There are
also revenue management models in place, which mean that if you were
to check the prices today you could find they are lower (not enough people
on the plane) or higher (the plane has limited-to-no seats left).
Task 6: Again this task has been split into subparts for consideration.
(a) Manchester to Dubai in first class may suffer a little bit if passengers
choose to travel to Heathrow to board the rival flight. However, if the
appeal of the regional airport is that there is no need to travel to
London, then there will be very limited effect. Manchester to Dubai and
London Heathrow to Abu Dhabi are not strong substitutes.
(b) London Heathrow to Abu Dhabi is a much closer substitute for the
London Heathrow to Dubai route and so there will be a lot more
competition faced. Emirates would look to dampen this by talking
about the other facilities offered, such as the on-board spa. It may also
talk of the convenience of having more flights.
(c) Economy class tickets are a more competitive market as passengers
are often looking for the lowest price. Here again Emirates will seek to
create differentiation. However, it should also be noted that for those
who are closer to Manchester, the extra cost of getting to London
might make the new Abu Dhabi flight less of a substitute. Etihad, as
sponsors of Manchester City football club, also has flights into
Manchester, which would be more of a substitute.

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Unit 3
Activity 3.1
Question 1:
Labour

Total product

Average
product

Marginal
product

10

10

10

24

12

14

42

14

18

56

14

14

70

14

14

72

12

Question 2: Diminishing marginal returns set in with the addition of the


fourth worker.
Question 3: The number of workers becomes too great for the capital
available and so each worker slacks off a little since they know they will
have to wait for new machinery to become available.

Activity 3.2
Output

Fixed cost

200

200

200

200

400

200

300

500

200

600

800

200

1,200

1,400

200

2,200

2,400

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Activity 3.3
Question 1:
Total
output

Fixed
cost

Variable
cost

Total
cost

Marginal
cost

Average
cost

10

10

10

12

12

10

12

22

10

11

10

20

30

10

10

26

36

10

30

40

10

32

42

10

39

49

10

54

64

15

10

71

81

17

10

10

90

100

19

10

Question 2:
Output

TFC

TVC

TC

AFC

AVC

AC

MC

40

40

40

46

40

46

40

11

51

20

5.5

25.5

40

15

55

13.3

18.3

40

20

60

10

15

40

26

66

5.2

13.2

Question 3:
Output

Price

TR

MR

FC

VC

TC

MC

Total
profit

10

10

10

10

+1

10

20

10

15

17

+3

10

30

10

24

26

+4

10

40

10

34

36

10

+4

10

50

10

53

55

19

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Activity 3.4
Question 1: New plant construction and associated planning permissions,
the creation of necessary networks and the set-up of new suppliers will all
be fixed costs that will be sunk before any production can take place. Land
and machinery might have resale value and so these two are merely fixed
costs.
Question 2: Variable costs will fall as a result of the move because there
is no shipping of finished trains from Japan. Components may be cheaper
or more expensive depending on the relative cost of buying in Japan and
shipping to Europe against the cost of sourcing in Europe.
Question 3: Nissan runs its car plant with high variable costs, importing all
of the items needed to assemble the finished car. Hitachi does not have
these shipment costs and so can enjoy lower variable costs.
Question 4: In this case the demand for trains picks up as the economy
picks up and the ridership increases. In the UK there was a long period of
not ordering new units in the period surrounding rail privatisation, but that
was a unique time. For Hitachi its investment indicates a confidence that
the initial order for the IEP and the ScotRail order are only the first of
many. Should there be a downturn then the company will be left with a
plant that is underutilised and not generating any payback on the large
fixed costs. Whether Hitachi goes past the shutdown point is questionable,
but it is usually considered that keeping the fixed cost base small in
cyclical industries is wise.
This case actually opens up a discussion about government funding and
the role that the state plays in making sure people can travel during times
of economic downturn. Such questions are avoided here.

Activity 3.5
Situation 1: If there is an increase in the cost of raw materials, the supply
curve will shift to the left since it now costs more to supply each unit of
output at each price.
Situation 2: If there is an increase in the price of the product, then there
will be an extension of supply on the original supply curve.
Situation 3: An increase in productivity will cause a shift in the supply
curve to the right since more can be supplied at every price than before.
Situation 4: An increase in wages causes the supply curve to shift to the
left since it now costs more to produce each unit of output than it did
before.
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Activity 3.6
An example that could be given to outline this situation at work is a
scenario in which house prices are increasing rapidly. In the initial period
the market supply has great difficulty in adapting much and the price of
rented accommodation will remain high. In the short term, there is a little
more flexibility since extra rooms may be made available for rent by letting
parts of large houses or taking in lodgers. In the longer term, landlords will
enter the market and adapt houses for renting and new housing may be
made available, which gives the consumer more choice. The supply curve
will become steadily more elastic as the time period becomes longer.

Activity 3.7
Consider fixed and variable inputs in the short run; ability to expand all
inputs in the long run.

Activity 3.8
Figure 3.10 summarises how economies of scale should work in theory. At
first, the expanding firm will experience economies of scale. After it
reaches a certain size, the firm will experience constant returns and after it
has grown larger it will find that the diseconomies of scale become far
more significant. Figure 3.10 is a simplified diagram and should only be
used as a starting off point. Figure 3.11 is a more detailed and informative
diagram.

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Review activity 3.9


Question 2:
Lab

Output

TFC

TLC

TMC

TVC

TC

AFC

AVC

ATC

MC

50

50

50

25

33

83

12.5

8.25

20.75

8.25

10

50

50

20

70

120

12

6.2

13

50

75

26

101

151

3.8

7.8

11.6

10.3

15

50

100

30

130

180

3.3

8.7

12

14.5

16

50

125

32

157

207

3.1

9.8

12.9

27

Working out the above table is not easy, particularly the last column where
we work out the MC. You do this by dividing the change in total cost by the
change in output.
Question 3: This is a fairly searching question. You have done well if you
completed the table in less than ten minutes.
Output

TC

MC

ATC

AFC

AVC

TVC

114

57

27

30

60

142

28

47.3

18

29.3

88

189

47.2

47.3

13.5

33.8

135

258

68.8

51.6

10.8

40.8

204

358

100

59.7

50.7

304

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Unit 4
Activity 4.1
See Begg and Ward (2013), section 4.6.

Activity 4.2
An increase in demand for doctors requires a substantial increase in
wages in order to attract a small increase in the number of doctors. This is
because doctors are relatively inelastic in supply and many years of
training are required before an individual can qualify as a doctor. A nurse is
also a skilled worker, but the wage increase is smaller since nurses can be
trained on the job and, therefore, more people can quickly enter the
market for nursing. Nurses are relatively elastic in supply vis--vis doctors.

Activity 4.3
This activity hinges entirely on the fact that a subsidy is a negative tax. So
where the taxes in the notes cause the supply curve to shift left, a subsidy
will cause it to shift right. By introducing the subsidy the government is
enabling suppliers to bring their goods to market at a lower price than they
otherwise would have done.
Question 1: In this case a subsidy is applied to the price. This causes
supply to shift right with the difference at every quantity being equal to the
per unit subsidy.
To illustrate this we assume that the subsidy is 100 and that the original
price was 2000. The quantity of solar panels installed at this price is
5000. When the subsidy is implemented the quantity rises and the price
falls, we shift right along the existing demand curve. The new price is
1980 and the new quantity 5400. This means that there will be more solar
panels in operation, good news for the environment, and that consumers
will be paying a lower price. Consumer surplus increases, which is good
news for the economy. We do not know whether profit increases, but
certainly 80 from the subsidy is not being passed on to the consumer.

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Figure 6: Subsidy in the solar panel market

Question 2: Here we use the same diagram but show what happens
when the demand curve becomes more inelastic. To make the illustration
we zoom in on the interesting area around the equilibrium. One of the
Figure 7: Elasticity and the subsidy in the double-glazing market

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great features of the diagrams is that they can be drawn with no intercepts
so there is no need to worry about scale relative to zero.
Figure 7 shows the results as demand becomes increasingly inelastic the
reduction in price becomes larger, but the gain of quantity becomes
smaller. However, in all cases the subsidy is effective at increasing the
quantity.
Question 3: For this question we just use the information to calculate that:

Question 4: Products with elastic demand are those where a small


increase in price will lead to a large reduction in demand. This will be true
of things like holidays, as discussed in earlier examples. For these three it
is harder to decide which one would have the largest elasticity. It can be
argued that people need their homes insulating, and double glazing has a
lot of uses in a cold country like the United Kingdom. With a shortage of
sunshine there is also likely to be a lack of demand for solar panels when
the price rises. However, if you are in a warmer country then the answer
would soon change. It is important to think about context.

Activity 4.4
This relates to the Harvard Business Review article The 3D Printing
Revolution. This considers the effect 3D printing is having on markets.
Question 1: 3D printing allows firms to reduce their fixed costs as it is
more flexible than the traditional injection moulding technique; the same
printer can make any number of products while moulds must be tailored
for the precise details of the product. There is also a slower printing
process to consider, and this will also raise the cost of each unit. Overall
variable costs rise and the supply curve will shift to the left. Prices will rise
and the quantity will fall. This corresponds to Figure 4.5 in the main text.
Question 2: 3D printing is heralded for its ability to create a product that
can be easily tailored to customers needs. As a result demand is likely to
rise as the product will make each customer happier, and therefore willing
to pay more. An increase in demand will cause the quantity to go up, as
well as the price. Whether the increased quantity is enough to cancel out
the lower quantity from the supply shift is questionable, and is something
that any good answer should discuss. Ultimately it will depend on the size
of the shifts and the elasticities of the curves.
Question 3: As supply becomes more inelastic the change in price
becomes smaller for any given vertical shift of the curve.
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Unit 5
Activity 5.1
The firm is making a loss since D = MR = AR is below AC when MC = MR.
Firms will move out of the industry and so the supply curve S2 will shift to
the left. This will cause an increase in market price and the price will
increase until the surviving firms are making normal profit.

Activity 5.2
Perfect competition is not very realistic. The problem with the assumptions
is that they all need to be true at the same time for a market to be perfectly
competitive. Clearly, consumers dont have perfect knowledge and
freedom of movement from seller to seller is not as straightforward as it
might sound. However, the theory is still extremely useful because it allows
an economist to compare other kinds of market structure with a market
operating free of imperfections. We are able to make meaningful
comments about monopoly power, pricing and output decisions, efficiency
and profit, if we have a yardstick to compare them with.

Activity 5.3
The monopolist is neither productively or allocatively efficient. The
abnormal profit earned by the monopolist in both the short and long run is
paid for by the consumer.

Activity 5.4
In this activity you are expected to discuss the issues surrounding the
Eurostar investment by the United Kingdom, French and Belgian
governments.
This was a large investment in a market of which no one truly knew the
size. Competing with airlines and cross channel ferries meant that rail
would have a battle to establish itself. Eurostar invested heavily in
promotion as well as helping the governments pay back the initial
infrastructure investment. By enabling an operating profit there was money
available to pay back these fixed costs.
Had the governments permitted competition then no company may have
been able to get past the short-run shutdown point and then there would
have been no return on the significant investment of building the tunnel.
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It should also be remembered that the initial ownership of Eurostar was


largely by the state and therefore the governments were keen to obtain
monies for themselves. The company also made large losses in early
years.

Activity 5.5
There are many ways of competing on a non-price basis: location,
sidelines, advertising, free gifts, special offers, happy hours, opening
hours, loyalty cards, product range, diversify product into top, mid, bottom
of range, etc.

Activity 5.6
Question 1: Supermarkets have power in the market when dealing with
suppliers, indeed this has caused a large amount of concern around the
world because many believe that this power is wielded too much. However
from the perspective of the consumer being able to obtain lower prices,
and impose standards, it is welcome.
Supermarkets also need to compete with each other and attract customers
to their marketplace. This means they offer low prices and better facilities
to make shopping easier. By contrast perfectly competitive stores are
compelled to take market size as given and so will not try to attract
consumers. This is something which is the subject of a large literature,
including Rudkin (2014) amongst others.
A wide academic literature studies supermarket competition both
theoretically and empirically, with supermarkets often shown to offer higher
utility to their shoppers than other retail formats. An empirical set of papers
consider these results and what they mean for health, access to fruit and
vegetables.
Question 2: Clearly the public in the article like supermarkets, but there
are many consequences of allowing supermarkets to grow unchecked.
Easier access to imports might make shoppers happy, but there are
knock-on effects for domestic suppliers that lose market share and for the
employees who work at those firms. Cheaper goods can mean people
consume more of what they like, this can just as easily be high fat snacks
as fruit.
In the developed world there was often a two-tier system in which the
more wealthy had access to the big format stores, while the poorer
neighbourhoods were left with no real access to supermarkets. This has
been addressed in the latest wave of development, but is something which
can have lessons for the developing nations.

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Again there is a large literature for those who are interested, but certainly
we should not just look at prices and product ranges when deciding if a
retail format is good, or whether market growth should be encouraged.

Review activity 5.7


Question 1: The firm will increase output and gain extra profits. As it does,
this marginal cost will rise and output will be held constant once marginal
cost equals 10.
Question 2: Managers may not wish to maximise profits. Measuring cost
and revenues is not costless and so profits may actually fall.

Reference
Rudkin, S. (2014) Supermarkets versus local shopping: Welfare
implications of provision mode. Economics Letters, 124(3): 396398.

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Unit 6
Activity 6.1
Where does the money come from that is injected into the economy?
What if the increase in spending is on imported goods? What if supply
cannot keep up with the increased demand in the economy?

Activity 6.2
A low exchange rate increases the price of imports and reduces the price
of exports. Exporters are pleased because they find it easier to compete in
the world marketplace. Domestic producers are happy in that they can
now compete more favourably with imported substitute goods. But, the
firms that rely on imported raw materials face an increase in their costs
and this could fuel inflation. In addition, there will be an increase in the
price of imported food and this would add to inflationary pressure.
Generally, however, the low exchange rate should move the balance of
payments towards a surplus.

Activity 6.3
Question 1: A country enjoying economic growth has several advantages:

firms are doing well from high consumer spending, giving them the
profitability to carry out future investment

high consumer spending and good profitability provides the government


with increased tax revenues that can be used for infrastructure
spending to make for a more efficient economy in the future.

Underdeveloped countries feel that no matter how quickly they grow, they
only fall further and further behind in comparative living standards. This
can be explained using a numerical example.
Country A: National income = $100 billion
Country B: National income = $5 billion
Country A: Economic growth = 2%
2% of $100 billion = extra $2 billion increase in national income
Country B: Economic growth = 10%
10% of $5 billion = extra $500 million increase in national income

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Question 2: In the first part of the essay, briefly outline the main economic
objectives and briefly explain why each is important. For the second part
of the essay, take a scenario such as high unemployment and outline how
tackling this problem may lead to other problems, such as inflation and the
balance of payments imbalances.

Activity 6.4
Question 1: By helping its domestic firms to export more China is
increasing the amount of funds flowing into the economy. Also by
devaluing its currency, the renminbi (RMB) will buy less units of other
currencies. For example Burberry has reacted to the news by reducing the
size of its Chinese operation, noting that the same RMB price now means
it is selling for fewer pounds. This means fewer imports. Exports are
injections into the flow and imports are withdrawals. Increasing the former
and reducing the latter mean there will be more funds circulating in the
Chinese economy.
Question 2: Injections into the circular flow can also be achieved through
promoting investment and government spending. China has long had
policies to achieve both of these, with infrastructure to reduce the cost of
business being a major focus of policy. Withdrawals also include taxation
and savings, so a similar effect to reduced imports could be achieved by
reducing taxation or reducing the incentive to save.

Review activity 6.5


Output method, add up all the output being careful not to double count:
240,000
Income method, remember both wages and profit are incomes: 240,000
Expenditure method, final spending on bread and ovens: 240,000

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Unit 7
Activity 7.1
If you can answer these three questions, then you are already some way
towards understanding the next part of the Keynesian model. At yy the
planned injections exceed the planned leakages in the economy. Spending
increases, firms find their stocks become depleted so they take on more
workers to increase production. National income increases and so does
the ability to save, pay tax and buy imports. National income will increase
until the planned leakages are equal to planned injections and the
economy is back in equilibrium at yx.
If unemployment exists at yx and we want it to fall, then the government
should increase autonomous injections until we have full employment
equilibrium at yfe. This is demonstrated in Figure 8.
Figure 8: Keynesian model

Activity 7.2
The UK government has no problem financing the injections into the
economy because it discovers a massive gold mine underneath Wembley
football stadium, which generates massive revenue for the government.
UK firms have substantial spare capacity and extra consumer spending
goes on British produced goods and services. The UKs international
competitors are supportive in their economic policies, and the computer
revolution allows quick and accurate up-to-date statistics on the UKs
economic performance. Not a lot to ask for!

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Activity 7.3
Expansionary policy is more popular. It is easier to find ways of increasing
spending on worthwhile projects. It is harder to find ways of making
cutbacks.

Activity 7.4
Question 1: Independence was championed as a way to take control of
the economy out of the hands of politicians and place it with experts.
When there are elections coming governments will be tempted to buy
votes, while immediately after an election they will take the chance to
recoup the give-aways. By handing control over to the Bank of England
the UK government led by Tony Blair sought to establish greater economic
credibility and ensure that future interest rate decisions would be made
based on economic fundamentals. Of course, the MPC must still react to
the economy, which can be shaped by any number of government policies.
Question 2: Demand is rising as the economy recovers and real wages
start to go up. This will inevitably bring about inflation and the MPC will be
keen to use interest rates to control any increase. Interest rate rises do
risk slowing the recovery however, and so far most developed nations
have avoided implementing rate rises for many years.

Activity 7.5
A balanced budget is one in which tax income is equal to government
expenditure.
A budget surplus refers to a situation in which generated tax income
exceeds government expenditure.
A budget deficit is a more familiar situation in which government
expenditure exceeds tax income.
The national debt is the accumulation of past budget deficits and is the
money that is owed to creditors by the government.
The PSNCR is the sum of central government borrowing (CGBR), local
authority borrowing (LABR) and the nationalised industries borrowing
(NIBR). National debt is accumulated central government borrowing over
the years. In the UK the PSNCR has replaced the PSBR as the main
measure. The PSBR was the same thing but had a slightly different
method of calculation (you do not need to know the intricacies of this).

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Activity 7.6
Reducing government expenditure would be very difficult. More
realistically the expenditure growth should be reduced. Taxation should be
increased but this is both unpopular and it can affect incentives to work.
Increasing interest rates would cut down consumer spending financed
from credit and cut back investment expenditure. The reduction in
investment may very well be counterproductive. In any case, increased
interest rates should only be used in a supporting capacity since some
firms will continue to invest even if interest rates are high as their
expectations of future demand and profitability are more important.

Activity 7.7
Question 1: Keynesian influence of the Obama government. Price stability
follows from the monetarist position that inflation is the real enemy and the
thing that must be controlled. However the link between inflation and
unemployment means that the Federal Reserve might not look at
unemployment being created if a reduction in inflation was possible. The
dual mandate ensures that a balance is struck.
Question 2: Should interest rates rise then people will borrow less and
therefore have less money to invest in new projects that would generate
flow around the economy. This would lead to reduced incomes for others
and hence reduced consumer confidence. Further the reduced investment
limits the expansion of the production possibility frontier and slows
economic growth as a result.
Question 3: Productivity pushes out the PPF, and does so without
requiring any additional inputs to the production function. As such, an
economy can grow with a given level of unemployment provided it can
increase its productivity. Productivity also helps make exports more
competitive. Many of the developed economies are now experiencing a
period where unemployment has become static and policies to promote
productivity are being implemented. Naturally this coming before
unemployment has been eliminated is causing some concern amongst
certain commentators and is part of a wider debate about whether growth,
or full employment, should be the goal.

Review activity 7.8


Question 1: The monetarist theory of inflation is built upon the quantity
theory where MV = PY. You should explain the assumptions behind the
way in which this works. V and Y are constant, or at least easily
predictable so a relationship is left between M and P. For monetarists, it is
an increase in M that leads to an increase in P. Keynesians criticise the
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assumptions. They state that V is not constant, it can change due to the
speculative demand for money. In addition, Keynesians suggest that
monetarists have got the direction of causation the wrong way around,
rather than M determining P, it is changes in PY that cause the M to
change to accommodate the level of spending taking place in the
economy. Furthermore, even if the M could cause an increase in PY then
the effect on P could be marginal if Y changed. In short, Keynesians argue
that the simple relationship between M and P identified by monetarists
needs to be replaced by a more realistic, and more complicated,
relationship.
Keynesians believe inflation is caused by cost-push and demand-pull factors.
Modern government is best advised to consider that inflation can be caused
by a variety of factors all of which vary in importance at different times and,
therefore, the solution to inflationary pressure should include a combination of
approaches as part of an integrated anti-inflationary policy.
Question 2: Start by outlining the Keynesian view on what causes
unemployment. Before explaining how the Keynesian solution would work,
you need to explain how it is possible to have equilibrium and unemployment.
Having explained the Keynesian solution to unemployment, you should outline
the difficulties with this solution. Then update the Keynesian solution by
examining demand and supply side policies together.

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Unit 8
Activity 8.2
Question 1: European Union members benefit from removal of barriers to
trade, enshrined in the notion of freedom of movement of goods and
labour. Since the founding days the growth of the finance sector has
added freedom of capital movement and therefore access to some of the
worlds largest financial centres in London and Frankfurt. The European
Union also generates a large amount of legislation designed to break
down barriers to trade and open up markets for competition.
Question 2: Trading into the European Union (EU) from outside is very
difficult as there are many barriers imposed in the form of tarrifs and
market size limitations. Perhaps the most well known is the limit that the
EU places on imports of cars, particularly from Japan. By restricting
Japanese firms to just 10% of the market, the EU has encouraged these
firms to locate within Europe, the UK being a large beneficiary from this,
such that the cars are European made and not imported. The EU also
legislates to protect local specialties, which helps producers win export
orders and fight competition from imports. Examples of protected goods
include Champagne, Stilton cheese and the Melton Mowbray pork pie.

Activity 8.3
The US consumers demand less pounds. The demand curve for pounds
shifts to the left. This reduces the exchange rate of the pound and the
price of pounds decreases from p1 to p2 as shown in Figure 9.
Figure 9: Decrease in demand

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Activity 8.4
If the UK decreases its demand for US goods, that will decrease the
supply of pounds to the foreign exchange market. This has the effect of
increasing the exchange rate of the pound.

Activity 8.5
If there is increased demand from the US for UK products, the demand for
pounds will increase. This will cause the exchange rate of the pound to
increase. As the exchange rate increases UK exports become more
expensive and imports become cheaper. If UK exports become more
expensive then the world demand for UK products will start to fall. The
demand for pounds will shift to the left causing downwards pressure on
the exchange rate of the pound. The exchange rate is self-equilibrating in
a floating exchange rate system.

Activity 8.6
Question 1: Quantitative easing involves buying government bonds; with
Greek bonds being very low rated selling any is good. There will also be
benefits from improved spending that follows. Should the easing not
include Greek bonds, it will still generate funds that can be used for Greek
benefit.
Question 2: Banks need cash to repay depositors, but often most of their
money is lent out to borrowers; therefore, bank liquidity when things go
wrong is a real issue. When the government provides assistance to banks
to help them function then this is known as emergency liquidity assistance
(ELA. This became really important for Greece as people tried hard to get
their money out of the banks as collapse loomed. Thanks to the ELA,
banks were able to resume trading after a shutdown period, but with heavy
caps on the amount of each withdrawal.
Question 3: A single currency operates with a single central bank and at a
value which all national members understand. It should therefore bring
these benefits.

Stability no exchange rate means no risk and good times in one


nation will most likely be tempered by problems elsewhere meaning
large fluctuations get averaged out.

Trading block no transaction costs of doing business as there are no


currencies to convert. The block also makes trading with the world
easier as there is a powerful group to achieve good terms of trade with
other nations.

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Reputation the combined currency will benefit from the economic


management record of the best nations in the group (provided it broadly
follows their system). This is something the EU has aimed to do by
borrowing Germanys record as being a successful stable economy.

Question 4: Greece is being forced into a series of humiliating actions by


lending governments trying to get as much collateral for their loans as
possible. As a result there is less and less under Greek government
control, making it harder to feel the benefits of quantitative easing or to
gain from improved currency credibility. Continuing to engage with the
process means that the people must believe that the future will be better
and that the access to European markets and funds are worth the pain in
the medium term.

Activity 8.7
Question 1: Expenditure by UK households would increase. Some of this
increase would be spent on imported goods. The effect on foreign firms
producing these products would depend upon the level of spare capacity
that exists.
Question 2: Increasing taxation would reduce expenditure and so foreign
firms would sell less in the UK and this could lead to unemployment.
Question 3: Increasing interest rates would reduce expenditure in the UK
and this would have an adverse affect on foreign firms. But, higher interest
rates can lead to a higher exchange rate, and this makes imports into the
UK cheaper and hence more attractive.

Activity 8.8
This section of the textbook considers the geography of international trade
and highlights the trading blocs that have formed, such as the North
American Free Trade Area (NAFTA) and the European Union (EU). Trade
is overseen by a range of bodies, such as the World Trade Organisation
(WTO) and the General Agreement on Tariffs and Trade (GATT). Section
16.3 presents a review of the EU seeking to highlight how countries have
gained from membership and being able to specialise according to
comparative advantage. For example it suggests the Greek benefit is
between 9% and 16% of GDP. Looking beyond the EU it is shown that the
collective bloc becomes the biggest single trading entity in the world, with
a share of 15.1% putting it ahead of China (13.3%) and the United States
(10.8%). These figures are though from 2011 and the picture continues to
change.

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Activity 8.9
Question 1: The advantages for the UK of having a large multinational
sector are that it provides investment, employment and growth, and, given
that many multinationals export, it contributes to the balance of payments.
A disadvantage of having a large multinational sector is that the economy
is vulnerable to these businesses deciding to leave. The recent debate
about EU membership and the benefits to MNCs of the UK as a member
has raised the spectre of such an event occurring. In addition, by having a
large multinational sector within the economy, and with multinationals
being such significant employers and investors, they may be able to exert
control over the host state. Such control might, for example, take the form
of requesting additional subsidies to help with expansion, otherwise
businesses will look to expand elsewhere. Finally, much of the profit
earned by multinationals does not remain in the country but flows back to
the multinationals country of origin.
Question 2: If the multinational was looking to expand overseas to reduce
costs, then it would be more likely to consider a vertically integrated
structure. If the multinational was looking to expand overseas to grow,
then it would probably be considering a horizontally integrated structure.
Question 3: The location of multinational corporations (MNCs) in
developed rather than developing economies, even when they are
pursuing low costs, is due to the fact that many MNCs are seeking workers
with skills, which they are more likely to find in developed markets. Hence
it is cheap skilled workers, which are the target of the MNC. Also
developed countries are more likely to offer a better transport,
communications and financial infrastructure.
Question 4: When the product reaches its mature phase, that is, the
phase when cost considerations become more important and the domestic
market becomes saturated with competition, then the business will have to
consider how to reduce costs to maintain profits, and how to continue to
sell more of the product. An answer to both of these questions might be to
locate production overseas in lower-cost production sites that give access
to new consumers.
Question 5: As considered in the answer to question 1, the main
advantages are to employment, growth, investment and the balance of
payments. In addition, a further advantage, especially to less developed
economies, might be the possibility of some technology transfer from the
MNC to the host state. The disadvantages could include the uncertainty of
MNC investment, the control and influence of the MNC over the host state,
as well as the environmental and social impacts that an MNC might have.
These problems might be significant in developing economies, where the
MNC is less restricted by environmental regulations and social restrictions,
such as worker rights.
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Question 6: Many of the arguments made above might be included in this


debate. For countries that are desperately short of capital, MNCs provide
an obvious source of investment. They often stimulate employment in local
industries that provide components and services to the MNC. On the other
hand, they may exacerbate the problem of poverty, and the uneven pattern
of development experienced by many developing countries. Many MNCs
are based in large cities. They act as a magnet to poor people, who flock
in from the countryside in numbers greatly in excess of the jobs available.
They contribute to the rapid pace of change in developing countries,
where traditional values are often displaced by the consumerist values of
the rich world. But the wants generated cannot be satisfied for vast
numbers of poor people.

Review activity 8.10


Question 1: The alliance of convenience refers to the fact that economists
believe that trade should be free to allow allocation of resources in the
most efficient possible way. Over time, the definition of efficiency has been
changed to incorporate social and environmental costs as well as the
financial cost of trade. However, the basic principle is that any transaction
costs and limitations prevent the most efficient outcome from being
achieved. Anything that breaks down barriers, such as the TPP is a good
idea. Business wants markets for its products, so anything that opens up a
new market is good for them. For this reason trade partnerships giving
better access are much better prospects.
Question 2: These partnerships work to break down barriers within the
group, but much like the European Union they serve to then put up
barriers to those nations that are not members. Whether explicitly, or
because others simply struggle to gain market access, it is not the free
trade playing field that economists espouse.
Question 3: Joining the TPP will give smaller economies access to
markets, particularly the valuable USA market. This will allow greater
specialisation. All of the benefits of free trade, lower transaction costs and
easier business conditions will come when dealing with members.
However, there are also many disadvantages as the set of nations with
whom free trade can be done is affected by the members of the
partnership. It also opens up competition among similar members for the
same benefits. There are also many other potential large markets, such as
Europe and China, which may react less favourably to tie up deals with the
USA especially if the TPP includes any measures that count against
those big markets.
There are many other advantages and disadvantages, but the main ones
are those summarised here.

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