Aggregate demand (AD)

= total spending on goods and services In the long run, the LRAS curve is assumed to be vertical (i.e. it does There are two ways to measure GDP (total income of a country) of
The formula for calculating aggregate demand is as follows: not change when the general price level changes) different countries and compare them. One way, called GDP at
GDP or AD = C + I + G + (X-M) In the short run, the SRAS curve is assumed to be upward sloping exchange rate, is when the currencies of all countries are converted
C: Consumers' expenditure on goods and services: Also known as (i.e. it is responsive to a change in aggregate demand reflected in a into USD (United States Dollar). The second way is GDP (PPP) or GDP
consumption, this includes demand for durables e.g. audio-visual change in the general price level) at Purchasing Power Parity (PPP).
equipment and vehicles & non-durable goods such as food and drinks Short Run Aggregate Supply Curve Uses : Purchasing Power Parity (PPP) is measured by finding the values
which are consumed and must be re-purchased. A change in the price level brought about by a shift in AD results in (in USD) of a basket of consumer goods that are present in each
I: Capital Investment This is spending on capital goods such as plant a movement along the short run AS curve. If AD rises, we see country (such as orange juice, pencils, etc.). If that basket costs $100 in
and equipment and new buildings to produce more consumer goods in an expansion of SRAS; if AD falls we see a contraction of SRAS. the US and $200 in the United Kingdom, then the purchasing power
the future. Investment includes spending on working capital such as parity exchange rate is 1:2.
stocks of finished and semi-finished goods. Differences : What sets GDP (PPP) apart from other economic
G: Government Spending This is spending on state-provided goods indicators, such as GDP per capita, nominal GDP, and real GDP, is that
and services including public goods and merit goods. Decisions on how GDP (PPP) takes the costs of living into account. This explains why GDP
much the government will spend each year are affected by (PPP) is used to measure the quality of life in a country. However, when
developments in the economy and the political priorities of the measuring a country's economic power (i.e. what it can buy on the
government. world market), use GDP at exchange rate.
X: Exports of goods and services - Exports sold overseas are an inflow of Examples
demand (an injection) into our circular flow of income and spending For example, suppose that Japan has a higher GDP per capita ($18)
adding to aggregate demand. than the US ($16). That means that Japanese on average make $2 more
M: Imports of goods and services. Imports are a withdrawal of demand than normal Americans. However, they are not necessarily richer.
(a leakage) from the circular flow of income and spending. Suppose that one gallon of orange juice costs $6 in Japan and only $2 in
Net exports measure the value of exports minus the value of imports. the US; then $6 in Japan exchanges to only $2 worth of US goods, since
When net exports are positive, there is a trade surplus (adding to AD); Shifts in Short Run Aggregate Supply (SRAS) the Japanese can only buy 3 gallons while the Americans can buy 8
when net exports are negative, there is a trade deficit (reducing AD). Shifts in the position of the short run aggregate supply curve in the gallons. Therefore, in terms of orange juice, the Americans are richer,
AGGREGATE DEMAND CURVE price level / output space are caused by changes in the conditions of and in this example the US has a GDP (PPP) of $16, since the $16 can
supply for different sectors of the economy: buy 8 gallons of orange juice (by definition), while Japan has GDP (PPP)
Employment costs e.g. wages, employment taxes. Unit labour costs of only $6, since the $18 in Japan can only buy 3 gallons of orange juice,
are also affected by the level of labour productivity which represents only $6 of US goods.
Costs of other inputs e.g. commodity prices, raw materials. The
exchange rate can affect the prices of key imported products Real GDP per capita is often used as an indicator of a countrys
Impact of government e.g. environmental taxes such as carbon standard of living or level of development. Despite numerous
duties & business regulations which affect the costs of production criticisms, GDP does have some advantages as a measure of standard
of living or development:
GDP growth (as a measure of economic growth) is a major contributor
to welfare and GDP tends to be correlated with several other measures
of development, such as literacy and healthcare provision.

1. GDP does not take into account unpaid work (e.g. in household
and undertaken on a voluntary basis) or activity in the black/informal
economy even though these may contribute positively to the welfare
Shocks to aggregate demand
of a society
2. GDP does not take account of externalities and negative goods:
Many unexpected events cause changes in the level of demand,
output and employment 3. GDP ignores non-income related dimensions of
These events are called shocks. Some of the causes of AD shocks development (e.g. happiness, human rights, health, freedom (see
are as follows: other sections))
1. A large rise or fall in the exchange rate affecting export 4. GDP ignores distribution of income
demand and second-round effects on output, employment, 5. GDP ignores sustainability

incomes and profits of businesses linked to export industries. 6. Other issues
What is 'Gross National Product - GNP'
2. A recession in main trading partners affecting demand for a. GDP/GNP (and GDP/GNP growth ) should be measured on a per
Gross national product (GNP) is an estimate of total value of all the
exports of goods and services. capita basis rather than in absolute terms, otherwise they could give a
final products and services produced in a given period by the means of
3. A slump in the housing market or a big change in share prices misleading impression, especially in countries with high population and
production owned by a country's residents. GNP is commonly
4. An event such as the credit crunch (global financial crisis) growth.
calculated by taking the sum of personal consumption expenditures,
involving a fall in the amount of credit available for borrowing by b. In using cross-country comparisons of GDP/GNP as measures of
private domestic investment, government expenditure, net exports,
households and businesses. differences in standards of living, it is preferable to use Purchasing
and any income earned by residents from overseas investments, minus
5. An unexpected cut or an unexpected rise in interest rates or Power Parity (PPP) exchange rates
income earned within the domestic economy by foreign residents. Net
change in government taxation and spending for example deep c. Many developing countries have limited capacity to collect and
exports represent the difference between what a country exports
cuts in government spending as part of fiscal austerity analyse statistics properly. Therefore caution should be given when
minus any imports of goods and services.
These shocks will bring about a shift in the aggregate demand using such data to make inferences or cross-country comparisons.
GNP Formula
curve d. Although other possible measures of development (e.g.
The formula to calculate the components of GNP is Y = C + I + G + X +
------------------------------------- happiness) are often criticised for their subjectivity, GDP itself may in
Z. That stands for GNP = Consumption + Investment + Government + X
Fall in Aggregate Demand Increase in Aggregate Demand some ways be seen to be a subjective measure: for example GDP
(net exports, or imports minus exports) + Z (net income earned by
calculations make value-judgements that effectively suggest that
domestic residents from overseas investments - net income earned by
household and voluntary work are not important.
foreign residents from domestic investments.)
------
-----------
Explain why exports are added to, and imports are subtracted from,
Is GDP (or GNP) a correct index of Welfare?
aggregate expenditures in moving from a closed to an open economy.
Often GDP (real GDP) is considered as an index of welfare of the
Exports must be added to aggregate expenditures because they
people. Welfare means sense of material well-being among the people.
represent sales of current output which would not have been counted
This (i.e., well-being) depends on greater availability of goods and
elsewhere in summing up total expenditures. Imports must be
services per person for consumption. Per head availability of goods rise
subtracted from aggregate expenditures because they would be
in economic welfare. So, one may conclude that higher level of GDP
included in any summing of expenditures on final goods and services,
(GNP) is an index of Greater well-being of the people.
but they do not represent goods or services produced here. Thus, to
But this generalization may not be correct due correct due to following
have an accurate estimate of domestic production, their value must be
limitations or reasons:
Shifts in Aggregate Demand Curve subtracted from the total expenditures
(i) Distribution of GDP:

A mere rise in GDP (or GNP or National Income) may not lead in the
Evaluate the statement that for an open economy the equilibrium
economic welfare if its distribution results in concentration of income
GDP always corresponds with an equality of exports and imports.
in the hands of very few individuals or firms. A mere increase in GDP
This statement would be true only by coincidence, if ever. Equilibrium
does not mean that every individual automatically gets this much of an
GDP (in the absence of government) exists when aggregate demand
increase. Distribution of GDP might have resulted in making the rich
equals aggregate supply (GDP). Aggregate private demand consists of
richer and the poor poorer.
three components: C, Ig, and net exports. There is no reason why net
(ii) Non-monetary exchanges or transactions:
exports must equal zero. The only requirement is that the sum of the
Many non-monetary activities in the economy done out of love and
three components, C, Ig , and (X M ) sum to the same value as
affection are not evaluated in monetary terms due to back of authentic
aggregate supply. At that point GDP will be in equilibrium. C or Ig or X
data. Thus, non-market transactions like services of housewife,
Factors causing a shift in Aggregate Demand or M or any or all of these can adjust in a situation where
exchanges or transactions through barter, enjoyment from hobbies like
1. Changes in Expectations Current spending is affected by anticipated disequilibrium exists, but equilibrium doesnt necessitate net exports of
Painting, etc. which increase economic welfare, are not included in
income and inflation zero.
measurement of GDP Thus, GDP underestimates welfare and hence
2. Changes in Monetary Policy i.e. a change in interest rates
may not reflect well-being of the country
3. Changes in Fiscal Policy Fiscal Policy refers to changes in Define the multiplier. How is it related to real GDP and the initial
(iii) Externalities:
government spending, taxation and borrowing change in spending? How can the multiplier have a negative effect?
These refer to benefits or harms which a firm or an individual causes to
4. Economic events in the world economy International factors such The multiplier is simply the ratio of the change in real GDP to the initial
another but for which they are not paid or penalised. For example,
as the exchange rate and foreign income change in spending. Multiplying the initial change in spending by the
negative externalities occur such as smoke of a factory pollutes the air
5. Changes in household wealth multiplier gives you the amount of change in real GDP. The multiplier
or its industrial waste causes water pollution in the nearby river
6. Changes in the supply of credit effect can work in a positive or a negative direction. An initial increase
resulting in loss of social welfare.
--------------------------------- in spending will result in a larger increase in real GDP, and an initial
But nobody is penalised for it nor it is accounted in GDP (or GNP).
Aggregate Supply decrease in spending will result in a larger decrease in real GDP.
Similarly positive (beneficial) impact of beautiful gardens and green
Aggregate supply measures the volume of goods and
parks remains outside the realm of GDE To that extent, GDP is under-
services produced each year. AS represents the ability of an economy What is the effect of net exports, either positive or negative, on
estimated or over-estimated making GDP an unreliable index of
to deliver goods and services to meet demand equilibrium GDP? Positive net exports increase aggregate expenditures
What is short run aggregate supply? welfare.
(iv) Composition of GDP:
beyond what they would be in a closed economy and thus have an
Short run aggregate supply shows total planned output when prices expansionary effect. The multiplier effect also is at work. Positive net
In case increase in GDP is due to more production of war material like
can change but the prices and productivity of factor inputs e.g. wage exports will lead to a positive change that is greater than the amount of
tanks, weapons, etc., it will not increase economic welfare, (w) Rate of
rates and the state of technology are held constant. the initial change. Negative net exports decrease aggregate
population growth: If rate of population growth is higher than the rate
What is long run aggregate supply? expenditures beyond what they would be in a closed economy and
of growth of real GDP (or real GNP), this will lead to fall in per capita
Long run aggregate supply shows total planned output when both thus have a contractionary effect. The multiplier effect also is at work
availability of goods and services. As a result, overall welfare of the
prices and average wage rates can change it is a measure of a here. Negative net exports lead to a negative change in equilibrium
society tends to fall.
countrys potential output and the concept is linked to GDP that is greater than the initial change

the production possibility frontier






Why is there a need for an aggregate demand and aggregate supply Consumer Price Index (CPI) - A measure of price changes in consumer 2. Fiscal Measures:
model of the economy? Why cant the supply and demand model for goods and services such as gasoline, food, clothing and automobiles. Apart from monetary policy, the government also uses fiscal measures
a single product explain developments in the economy? The basic The CPI measures price change from the perspective of the purchaser. to control inflation. The two main components of fiscal policy are
reason for an aggregate model is that there are thousands of individual Producer Price Indexes (PPI) - A family of indexes that measure the government revenue and government expenditure. In fiscal policy, the
products in an economy. Single product supply and demand model average change over time in selling prices by domestic producers of government controls inflation either by reducing private spending or by
does not explain: (1) why prices in general rise or fall; (2) what goods and services. PPIs measure price change from the perspective of decreasing government expenditure, or by using both.
determines the level of aggregate output; and (3) what determines the seller. It reduces private spending by increasing taxes on private businesses.
changes in the level of aggregate output. The aggregate model is When private spending is more, the government reduces its
needed to explain these changes. It simplifies the analysis of prices by Foreign Trade Multiplier expenditure to control inflation. However, in present scenario,
combining the prices of all individual goods and services into one As mentioned above this is an opened economys analysis. So, reducing government expenditure is not possible because there may be
aggregate price level. It simplifies the analysis of quantities by compared to a closed economic model, foreign trade multiplier consists certain on-going projects for social welfare that cannot be postponed.
combining the equilibrium quantities of all individual goods and of additional factors like import and export. And the essence of the Besides this, the government expenditures are essential for other
services into a singe entity called the real domestic output. foreign trade multiplier is how the income and employment effected in areas, such as defense, health, education, and law and order. In such a
an economy due to the changes in the import and export. Foreign trade case, reducing private spending is more preferable rather than
Describe each of the following outcomes in terms of shifts in aggregate multiplier is also known as the export multiplier. decreasing government expenditure. When the government reduces
demand or aggregate supply curves. (a) A recession deepens while the i) Marginal Propensity to Save (mps) private spending by increasing taxes, individuals decrease their total
rate of inflation increases (b) The price level rises sharply while real Marginal propensity to save refers to the volume of savings which the expenditure.
output and employment remain constant (c) The rate of inflation people want to increase due to increase in income. When the export For example, if direct taxes on profits increase, the total disposable
diminishes, but the unemployment rate rises (d) Real output rises, increases, automatically domestic income will also increase. When the income would reduce. As a result, the total spending of individuals
unemployment rate falls, price level is constant people want to save additionally due to the increasing of income decreases, which, in turn, reduces money supply in the market.
(a) The aggregate supply curve has shifted to the left causing the price instead of consuming, it will create a negative impact. Why because, Therefore, at the time of inflation, the government reduces its
level to rise and output and employment levels to fall. The new saving is considering as a leakage from the national income. On the expenditure and increases taxes for dropping private spending.
equilibrium must be in the intermediate range of aggregate supply. (b) other hand, if people want to spend more income on consumption 3. Price Control:
The aggregate demand curve has shifted to the right in the vertical (mpc) due to the increment in income, it will generate a multiplier Another method for ceasing inflation is preventing any further rise in
range. (c) The aggregate demand curve has shifted leftward in the effect in the economy. So, there exists a indirect relationship between the prices of goods and services. In this method, inflation is suppressed
intermediate range. (d) The aggregate demand curve has shifted marginal propensity to save and export multiplier. by price control, but cannot be controlled for the long term. In such a
rightward in the horizontal range. ii) Marginal Propensity to Import case, the basic inflationary pressure in the economy is not exhibited in
----------------------- Import is considering as a leakage from the economy. Because when the form of rise in prices for a short time. Such inflation is termed as
The consumer price index (CPI) is a statistical estimate of the level of the volume of import increases, the domestic wealth will loss, that is suppressed inflation.
prices of goods and services bought for consumption by households. It declining in national income. As mentioned above, if people demand The historical evidences have shown that price control alone cannot
measures changes in the price level of a market basket of goods and more foreign goods, import will increase. When the volume of import control inflation, but only reduces the extent of inflation. For example,
services used by households. The CPI is calculated by collecting the becomes huge due to increasing of national income, it will also create a at the time of wars, the government of different countries imposed
prices of a sample of representative items over a specific period of bad impact in the society. So, marginal propensity to import is price controls to prevent any further rise in the prices. However, prices
time. The GDP deflator is a measure of the level of prices of all indirectly related with the export multiplier. remain at peak in different economies. This was because of the reason
new, domestically produced, final goods and services in an economy. Formula to Derive Foreign Trade Multiplier that inflation was persistent in different economies, which caused
Unlike the CPI, the GDP deflator is a measure of price inflation The following formula can be used to get the value of foreign trade sharp rise in prices. Therefore, it can be said inflation cannot be ceased
or deflation for a specific base year. multiplier. unless its cause is determined.
The GDP deflator differs from the CPI because it is not based on a fixed Foreign trade multiplier = 1 / mps + mpm
basket of goods and services. The GDP deflator "basket" changes from Where, mps = marginal propensity to save ( change in savings due to A modern economy has many different types of industries. However,
year to year depending on people's consumption change in national income) ; mpm = marginal propensity to import an economic analysis of the different firms or industries within an
and investment patterns. Unlike the CPI, the GDP deflator is not (change in import due to change in national income) economy is simplified by first segregating them into different models
impacted by substitution biases. Despite the GDP being more flexible, based on the amount of competition within the industry. There are 4
the CPI is a more accurate reflection of the changes in the cost of living. The different measures used for controlling inflation are 1) Monetary basic market models: pure competition, monopolistic competition,
Also GDP Deflator only takes into account goods that are produced Measures 2) Fiscal Measures 3) Price Control oligopoly, and pure monopoly. Because the competition among the last
domestically. It does not bother with imported goods and it reflects the The different measures used for controlling inflation are explained 3 categories is limited, these market models are often referred to
prices of all the commodities, services included. below. as imperfect competition.
1. Monetary Measures: The government of a country takes several
Deflation is when the general level of prices are falling. It is the measures and formulates policies to control economic activities. In a purely competitive market, there are large numbers of firms
opposite effect of inflation. Deflation tends to occur more rarely and Monetary policy is one of the most commonly used measures taken by producing a standardized product. Market prices are determined by
for shorter periods of time than inflation. Deflation occurs typically the government to control inflation. consumer demand; no supplier has any influence over the market
during times of recession or economic crisis and can lead to deep In monetary policy, the central bank increases rate of interest on price, and thus, the suppliers are often referred to as price takers. The
economic crises including depression. The reason for this is the so- borrowings for commercial banks. As a result, commercial banks primary reason why there are many firms is because there is a low
called deflationary spiral: when prices are going down, why would you increase their rate of interests on credit for the public. In such a barrier of entry into the business. The best examples of a purely
spend your money today, when each dollar will be more valuable situation, individuals prefer to save money instead of investing in new competitive market are agricultural products, such as corn, wheat, and
tomorrow? And why spend tomorrow when each dollar can buy more ventures. soybeans.
the day after? The result is that people stop spending and hoard their This would reduce money supply in the market, which, in turn, controls ------
money in anticipation of prices falling even further. If money is being inflation. Apart from this, the central bank reduces the credit creation Monopolistic competition is much like pure competition in that there
hoarded, it isnt being spent, so business profits collapse and people capacity of commercial banks to control inflation. are many suppliers and the barriers to entry are rather low. However,
are laid off. Increasing unemployment leaves the economy with even ------ the suppliers try to achieve some price advantages by differentiating
less spending, and the spiral continues. The monetary policy of a country involves the following: their products from other similar products. Most consumer goods, such
------------- (a) Rise in Bank Rate: as health and beauty aids, fall into this category. Suppliers try to
Disinflation is a condition where inflation is still positive, but the rate of Refers to one of the most widely used measure taken by the central differentiate their product as being better so that they can justify
inflation is decreasing for example from +3% to +2%. bank to control inflation. higher prices or to have a larger market share than the competition.
Hyperinflation is unusually rapid inflation, typically more than 50% in a The bank rate is the rate at which the commercial bank gets a Monopolistic competition is only possible, however, when the
single month. In extreme cases, this inflation gone awry can lead to the rediscount on loans and advances by the central bank. The increase in differentiation is significant or if the suppliers are able to convince
breakdown of a nation's monetary system or even its economy. One of the bank rate results in the rise of rate of interest on loans for the consumers that they are significant by using advertising or other
the most notable examples of hyperinflation occurred in Germany in public. This leads to the reduction in total spending of individuals. methods that would convince consumers of a product's superiority. For
1923, when prices rose 2,500% in one month! Likewise, in Zimbabwe, The main reasons for reduction in total expenditure of individuals are instance, suppliers of toothpaste may try to convince the public that
hyperinflation led to Z$100 trillion bills being printed that were worth as follows; their product makes teeth whiter or helps to prevent cavities or
only a few U.S. dollars. Hyperinflations have also famously occurred in (i) Making the borrowing of money costlier: periodontal disease.
th
Hungary and Argentina in the 20 century. Refers to the fact that with the rise in the bank rate by the central bank
Stagflation is the rare combination of high unemployment and increases the interest rate on loans and advances by commercial banks. An oligopoly is a market dominated by a few suppliers. A high barrier
economic stagnation along with high rates of inflation. This happened This makes the borrowing of money expensive for general public. to entry limits the number of suppliers that can compete in the market,
in industrialized countries during the 1970s, when a rocky economy Consequently, individuals postpone their investment plans and wait for so the oligopolistic firms have considerable influence over the market
was confronted with OPEC raising oil prices resulting in a demand fall in interest rates in future. The reduction in investments results in price of their product. However, they must always consider the actions
shock for oil. This sent the price of oil and all of the products and the decreases in the total spending and helps in controlling inflation. of the other firms in the market when changing prices, because they
services that use oil as an input higher, even as the economy (ii) Creating adverse situations for businesses: are certain to respond in a way to neutralize any changes so that they
slackened. Implies that increase in bank rate has a psychological impact on some can maintain their market share. Auto manufacturers are a good
Inflation is defined as a sustained increase in the general level of prices of the businesspersons. They consider this situation adverse for example of an oligopoly, because the fixed costs of automobile
for goods and services in a county, and is measured as an annual carrying out their business activities. Therefore, they reduce their manufacturing are very high, thus limiting the number of firms that can
percentage change. Under conditions of inflation, the prices of things spending and investment. enter into the market.
rise over time. Put differently, as inflation rises, every dollar you own (iii) Increasing the propensity to save: A pure monopoly has pricing power within the market. There is only
buys a smaller percentage of a good or service. When prices rise, and Refers to one of the most important reason for reduction in total one supplier who has significant market power and determines the
alternatively when the value of money falls you have inflation. expenditure of individuals. It is a well-known fact that individuals price of its product. A pure monopoly faces little competition because
generally prefer to save money in inflationary conditions. As a result, of high barriers to entry, such as high initial costs, or because the
Causes of Inflation the total expenditure of individuals on consumption and investment company has acquired significant market influence through network
There is no single theory for the cause of inflation that is universally decreases. effects, for instance.
agreed upon by economists and academics, but there are a few (b) Direct Control on Credit Creation: One of the best examples of a pure monopoly is the production of
hypotheses that are commonly held. Constitutes the major part of monetary policy. operating systems by Microsoft. Because many computer users have
Demand-Pull Inflation Inflation is caused by the overall increase in The central bank directly reduces the credit control capacity of standardized on software products that are compatible with
demand for goods and services, which bids up their prices. This theory commercial banks by using the following methods: Microsoft's Windows operating system, most of the market is
can be summarized as "too much money chasing too few goods". In (i) Performing Open Market Operations (OMO): effectively locked in, because the cost of using a different operating
other words, if demand is growing faster than supply, prices will Refers to one of the important method used by the central bank to system, both in terms of acquiring new software that will be
increase. This usually occurs in rapidly growing economies. This theory reduce the credit creation capacity of commercial banks. The central compatible with the new operating system and because the learning
is often promoted by the Keynesian school of economics. bank issues government securities to commercial banks and certain curve for new software is steep, people are willing to pay Microsoft's
Cost-Push Inflation Inflation is caused when companies' costs of private businesses. high prices for Windows.
production go up. When this happens, they need to increase prices to In this way, the cash with commercial banks would be spent on Pure Competition Is Best for the Consumer
maintain their profit margins. Increased costs can include things such purchasing government securities. As a result, commercial bank would From the consumer point of view, pure competition is the best type of
as wages, taxes, or increased costs of natural resources or imports. reduce credit supply for the general public. market, because it gives consumers the greatest consumer surplus.
Monetary Inflation Inflation is caused by an oversupply of money in (ii) Changing Reserve Ratios: From an economic standpoint, pure competition is also the easiest
the economy. Just like any other commodity, the prices of things are Involves increase or decrease in reserve ratios by the central bank to model to analyze, so this is the first market model that will be covered
determined by their supply and demand. If there is too much supply, reduce the credit creation capacity of commercial banks. For example, in depth.
the price of that thing goes down. If that thing is money, and too much when the central bank needs to reduce the credit creation capacity of
supply of money makes its value go down, the result is that the prices commercial banks, it increases Cash Reserve Ratio (CRR). As a result,
of everything else priced in dollars must go up! This theory is often commercial banks need to keep a large amount of cash as reserve from
promoted by the Monetarist school of economics. their total deposits with the central bank. This would further reduce
the lending capacity of commercial banks. Consequently, the
investment by individuals in an economy would also reduce.





Pure Competition : Long Run Equilibrium Monopolistic : Monopolistic competition is a market structure CONSTANT RETURNS TO SCALE : When our inputs are increased by m,
In the long run, firms can enter or exit a purely competitive market characterized by many firms selling products that are similar but not our output increases by exactly m.
easily. Pure competition also assumes that firms and resources can be identical, so firms compete on other factors besides price. Monopolistic DECREASING RETURNS TO SCALE : When our inputs are increased
easily reallocated in response to demand. Hence, if economic competition is sometimes referred to as imperfect competition, by m, our output increases by less than m.
profits are being made by the firms within the industry, then more because the market structure is between pure monopoly and pure The multiplier must always be positive, and greater than 1, since we
firms will enter the market, thereby lowering the market price, until competition. want to look at what happens when we increase production. An m of
the equilibrium price and quantity that allows only normal profits is Economic efficiency is also middling. Competitive markets provide 1.1 indicates that we've increased our inputs by 10% and an m of 3
obtained. If the firms are suffering losses, then some firms will leave efficient outcomes, monopoly markets exhibit deadweight losses indicates that we've tripled the amount of inputs we use. Now we will
the market, which will reduce the market supply, thereby increasing monopolistic competition is somewhere in between, not as efficient as look at a few production functions and see if we have increasing,
prices, which will allow the existing firms to make a normal profit. The pure competition but less deadweight loss than a monopoly. The major decreasing, or constant returns to scale. Note that some textbooks
long-run market price is equal to the minimum average total cost (ATC) benefit of monopolistic competition is the supply of a wide variety of use Q for quantity in the production function, and others use Y for
of producing the product. And since suppliers will produce until the goods and services. Monopolistic competition exists: 1) where there output. It does not change this analysis any, so use whatever your
marginal cost is equal to the market price, the long-run equilibrium in a are a large number of sellers, each with a small market share; 2) little professor uses.
purely competitive market can be summarized thus: interdependence among firms so that they can price their product with THREE EXAMPLES OF ECONOMIC SCALE
Average Total Cost = Marginal Cost = Price little regard to how the competition will react;3) little possibility for Q = 2K + 3L. We will increase both K and L by m and create a new
collusion to fix prices. production function Q. Then we will compare Q to Q.
Pure Competition Oligopoly Q = 2(K*m) + 3(L*m) = 2*K*m + 3*L*m = m(2*K + 3*L) = m*Q
For a constant-cost industry, the supply curve is completely elastic, An oligopoly is a market dominated by a few producers. The market After factoring I replaced (2*K + 3*L) with Q, as we were given that
because any change in the market demand will cause either an entry or can be international, national, or local. The main characteristic of an from the start. Since Q = m*Q we note that by increasing all of our
an exit of firms until the price returns to the industry's lowest average oligopoly is that they have pricing power. However, unlike inputs by the multiplier m we've increased production by exactly m. So
total cost. A constant-cost industry can only exist if there are ample a monopoly that consists of a single firm dominating the market, an we have constant returns to scale.
supplies of inputs required to produce the product that will satisfy the oligopolistic firm must take into consideration how the other producers Q=.5KL Again we put in our multipliers and create our new production
entire market; otherwise, increase demand for the product will will react to any changes in price. It is this mutual interdependence of function.
2 2
increase demand for the inputs, which will raise the prices of both the the few firms producing the product that make an oligopoly different Q = .5(K*m)*(L*m) = .5*K*L*m = Q * m
2
inputs and the product. from a monopoly. Sometimes, an oligopoly will try to increase its Since m > 1, then m > m. Our new production has increased by more
For an increasing-cost industry, the long run supply curve slopes market power by forming a cartel, which is a group of firms acting in than m, so we have increasing returns to scale.
0.3 0.2
upward because average total costs increase as new firms enter the unison. Q=K L Again we put in our multipliers and create our new
market. This occurs because there are limited quantities of inputs in An oligopolistic firm is generally a large firm that had to invest a lot of production function.
0.3 0.2 0.3 0.2 0.5 0.5
relation to the market demand for the product. Therefore, input prices capital to produce the product, such as aircraft, cars, and household Q = (K*m) (L*m) = K L m = Q* m
0.5
rise as demand increases, so a greater quantity will only be supplied if appliances. This large initial investment of capital is often a major Since m > 1, then m < m. Our new production has increased by less
the market price for the product is higher, which is in contrast to the barrier to entry to oligopolistic markets. Other barriers to entry include than m, so we have decreasing returns to scale.
constant-cost industry, where the market price remains horizontal at patents, control of strategic resources, and the ability to engage in ---------------------------------------
any quantity. retaliatory pricing to prevent firms from entering the market. Diminishing Marginal Returns vs Returns to Scale
For a decreasing-cost industry, the long run supply curve is downward An oligopoly produces products that exhibit large economies of scale, Diminishing Marginal Returns
sloping, because the price of inputs declines with increasing quantity. where the cost of producing each unit declines with large quantities. The law of diminishing marginal returns states that with every
This usually occurs when the inputs themselves are manufactured and Such economies of scale prevent other firms from entering the market, additional unit in one or two factors of production while at least one
benefit from economies of scale, where increased quantities decreases since there would be little market share that could be gained, and what factor is held constant, the incremental output per unit decreases
the average total cost of the inputs, and therefore, their prices. The could be gained would not be enough to be profitable. while all other factors remain constant. This does not necessarily
best example of this type of industry is the computer industry, since an mean negative returns when total output decreases as input in one
increase in demand for computers also increases the demand for An oligopoly can produce either homogeneous or differentiated mode of production increases.
components. However, since the fixed costs of producing computer products. A homogeneous product is one that is not distinguished by For example, a firm hiring more employees while keeping the same
components are substantial, the average total cost of manufacturing quality differences from products produced by other firms. Most often office space can increase total output, but every additional employee
the components greatly declines with increasing quantity. Therefore, such products consists of elements that are mined, such as zinc, produces less additional output than the one before him. The total
the price of personal computers declines as the quantity increases. copper, aluminum, lead, or produced from these elements, such as the output can decrease at some point, resulting in negative returns if, for
production of steel. Although these products are mined from the earth, instance, the same firm hires too many employees who get in each
Monopolistic Competition large amounts of capital are required to acquire the land, since ores other's way and eventually become unproductive.
Monopolistic competition is the economic market model with many that can be mined economically are located only in a few places. Then Returns to Scale
sellers selling similar, but not identical, products. The demand curve of there is a large expenditure for equipment required to extract the ore On the other hand, returns to scale refers to the proportion between
monopolistic competition is elastic because although the firms are and to separate the elements into a usable form. the increase in total input and the resulting increase in output.
selling differentiated products, many are still close substitutes, so if one A differentiated oligopoly produces differentiated products, much as Decreasing returns to scale is a condition when all production variables
firm raises its price too high, many of its customers will switch to in monopolistic competition. However, because the production of the are increased by a certain percentage, while resulting in a less than
products made by other firms. This elasticity of demand makes it products requires large amounts capital and exhibits steep economies proportional increase in output.
similar to pure competition where elasticity is perfect. Demand is not of scale, the entry of firms is limited. Products produced by a For example, if a soap manufacturer doubles its total input but gets
perfectly elastic because a monopolistic competitor has fewer rivals differentiated oligopoly include electronics, cereals, cigarettes, sporting only a 60% increase in total output, then it can be said that it has
then would be the case for perfect competition, and because the goods, motor vehicles, and aircraft. experienced decreasing returns to scale. If the same manufacturer ends
products are differentiated to some degree, so they are not perfect ---------------------- up also doubling its total output, then it has achieved constant returns
substitutes. Business Cycles to scale, where the increase in output is proportional to the increase in
Monopolistic competition has a downward sloping demand curve. Economic growth does not increase continually, but rather in spurts, by production input. Increasing returns to scale, meanwhile, occurs when
Thus, just as for a pure monopoly, its marginal revenue will always be cycling through peaks and recessions. Often, peaks are associated with the percentage increase in output is higher than the percentage
less than the market price, because it can only increase demand by higher prosperity, but also with higher inflation, while recessions are increase in input.
lowering prices, but by doing so, it must lower the prices of all units of associated with higher unemployment. However, business cycles are -------------------------------------------------
its product. Hence, monopolistically competitive firms maximize profits not uniform some are short, lasting for several months, while some 1. Meaning of Fiscal policy
or minimize losses by producing that quantity where marginal revenue last for several years. After the economy peaks, then there is a Fiscal policy means the use of taxation and public expenditure by the
equals marginal cost, both over the short run and the long run. downturn, lessening the amount of inflation, raising unemployment, government for stabilisation or growth. According to Culbarston, By
-------- and lowering economic productivity. Economic output reaches a fiscal policy we refer to government actions affecting its receipts and
Long Run Equilibrium : Normal Profits maximum at the peak of the business cycle, while it reaches a expenditures which we ordinarily taken as measured by the
If the competitive firms in an industry earn an economic profit, then minimum at the trough. The trend of economic growth, however, is governments receipts, its surplus or deficit. The government may
other firms will enter the same industry, which will reduce the profits generally upward. offset undesirable variations in private consumption and investment by
of the other firms. More firms will continue to enter the industry until Causes of Business Cycles compensatory variations of public expenditures and taxes.
the firms are earning only a normal profit. Many hypotheses attempt to explain the causes of the business cycle. Arthur Smithies defines fiscal policy as a policy under which the
However, if there are too many firms, then firms will start to incur Some say that major innovations are the cause of business cycles, such government uses its expenditure and revenue programmes to produce
losses, especially the inefficient ones, which will cause them to leave as the development of the railroad, motor vehicle, and computer desirable effects and avoid undesirable effects on the national income,
the industry. Consequently, the remaining firms will return to normal technology. Indeed, when fundamental innovations are made, many production and employment. Though the ultimate aim of fiscal policy
profitability. Hence, the long-run equilibrium for monopolistic business people discover how to capitalize on the new technology. For in the long-run stabilisation of the economy, yet it can be achieved by
competition will equate the market price to the average total cost, instance, the framework of the Internet as it exists today coupled with moderating short-run economic fluctuations. In this context, Otto
where marginal revenue equals marginal cost, as shown in the diagram programming languages, especially open source programming Eckstein defines fiscal policy as changes in taxes and expenditures
below. Remember, in economics, average total cost includes a normal languages, allows innovators to develop a wide variety of services which aim at short-run goals of full employment and price-level
profit. based on these fundamental technologies. stability.
--------------- --------
How a monopolist minimizes losses? Others argue that variations in the supply of money cause business 2. Objectives of Fiscal Policy
It is possible that a monopolist can actually lose money if the average cycles. Indeed, an increase in the money supply will have a stimulatory 1. To maintain and achieve full employment.
total cost is greater than the price that people are willing to pay for any effect, at least at first, but eventually it ends because people start 2. To stabilise the price level.
quantity of output. Losses can be caused by a change in consumer anticipating inflation that results when the money supply is continually 3. To stabilise the growth rate of the economy.
tastes or by changes in the cost of inputs. However, if the monopolist increasing. However, the contraction of the money supply will certainly 4. To maintain equilibrium in the balance of payments.
cannot make a profit, then it will shutdown the firm so it can put the cause a contraction of the economy, because businesses cannot make 5. To promote the economic development of underdeveloped
resources to better uses. A monopolist will only produce in the short a profit without being able to sell their wares. When money supply countries.
run to minimize losses if it perceives that market conditions will change declines, deflation sets in, which causes many people to hold onto their
or that it will be able to earn a profit in the future. money since it becomes more valuable in time. 3. Fiscal Policy for Economic Growth
In this case, the monopolist will still produce the quantity were However, the main cause of business cycles is a fluctuation in The role of fiscal policy for economic growth relates to the stabilisation
marginal revenue equals marginal cost because that is the quantity that consumer spending. As the economy recovers from recession, people's of the rate of growth of an advanced country. Fiscal policy through
corresponds to the market price that will minimize its losses. Its losses confidence increases, so their spending increases, which gives rise to a variations in government expenditure and taxation profoundly affects
will then be equal to: multiplier effect, raising the income of both individuals and businesses, national income, employment, output and prices. An increase in public
Monopoly Loss = (Average Total Cost Price) x Quantity which in turn, stimulates more spending. However, at some point, the expenditure during depression adds to the aggregate demand for
business cycle peaks because people have no more money to spend, goods and services and leads to a large increase in income via the
Monopolist maximize Revenues or profits and indeed, many people have borrowed money, so their debt load multiplier process; while a reduction in taxes has the effect of raising
In trying to maximize revenue, the monopolist has a dilemma: the forces them to stop spending at some point, since they have to repay disposable income thereby increasing consumption and investment
monopolist can only sell more product if it lowers its prices, because their debt, with the result that consumer spending declines. expenditure of the people.
it's demand curve slopes downward as demand curves generally do. ------------------------------- On the other hand, a reduction of public expenditure during inflation
Demand only increases with decreasing prices, but the marginal Increasing, Decreasing and Constant Returns of Scale reduces aggregate demand, national income, employment, output and
revenue gained by selling one additional unit will always be less than If a production function has both labor and capital as factors, how can prices; while an increase in taxes tends to reduce disposable income
the price of that unit because the monopolist will have to sell all of its you tell if it is increasing returns to scale, constant returns to scale, and thereby reduces consumption and investment expenditures. Thus
units at the lower price. or decreasing returns to scale? the government can control deflationary and inflationary pressures in
Total revenue can also be examined using demand elasticity. The These three definitions look at what happens when you increase all the economy by a judicious combination of expenditure and taxation
monopolist will increase production as long as demand is elastic, inputs by a multiplier of m. Suppose our inputs are capital or labor, and programmes. For this, the government follows compensatory fiscal
because increased quantities yields increased revenue. When demand we double each of these (m = 2), we want to know if our output will policy.
becomes inelastic, then increasing the quantity more decreases total more than double, less than double, or exactly double.
revenue, so the monopolist is going to set its price at some point where This leads to the following definitions:
demand is elastic. INCREASING RETURNS TO SCALE : When our inputs are increased by m,
our output increases by more than m.