THE NATURE AND SCOPE OF ECONOMICS................................................................... ......... .............. ..... 3 3 The scope of economics.................................................................................................... .................................................................................................................... .................. 3 3 The tools of economic analsis.......................................................................................................... .......................................................................................................... ! ! Alte"nati#e economic sstems.................................................................................................. ........ .......... $ $ Cons%me" &eha#io%"........................................................................................................................ .. ' ' PRICE THEOR() SUPP* SUPP*( ( AND DEMAND...................................................................................... +, +, Ma"-ets an competition................................................................................................................. +, +, Deman........................................................................................................................................... ........................................................................................................................................... . +/ +/ S%ppl..................................................................................................... ................................................................................................................................... ....................................... ........... .. ,+ ,+ The p"ice mechanism..................................................................................................................... .. ,! ,! Elasticit Of Deman An S%ppl....................................................................................................... ,0 ,0 P"ice elasticit of eman ................................................................................................................ ................................................................................................................ ,0 ,0 Othe" elasticities of eman............................................................................................................. 3, 3, Elasticit of s%ppl............................................................................................................... ......... ........... .. 33 33 Ma"-et Fail%"e1 E2te"nalities An Inte"#ention.............................................................................. ..... 3 3 Ma"-et impe"fections an ma"-et fail%"e......................................................................................... 3 3 E2te"nalities an p%&lic 4oos ........................................................................................................ . 30 30 P"ice "e4%lation.............................................................................................................................. .. 3' 3' Ini"ect ta2es an s%&siies.............................................................................................................. /, /, Theo" Of The Fi"m1 P"o%ction An Costs........................................................................................ / / Costs of p"o%ction an the fi"m ...................................................................................................... / / A#e"a4e costs) ma"4inal costs an iminishin4 "et%"ns ............................................................ ....... ....... /' /' P"ofit ma2imisation.......................................................................................................................... !+ !+ Economies of scale an lon45"%n costs ............................................................................................ ............................................................................................ !/ !/ Facto" Ma"-ets An Facto" Re6a"s.......................................................................................... ........ .......... !$ !$ Facto"s of p"o%ction an thei" "e6a"s................................................................................. ........ .......... !$ !$ Capital an inte"est............................................................................................................. ........................................................................................................................... .............. !' !' *a&o%" an 6a4es...................................................................................................... ................................................................................................................ .................. ............ .... 7 7 *an an "ent........................................................................................................ .................................................................................................................... .................... ............... ....... 07 07 Ent"ep"ene%"ship an p"ofit ............................................................................................................ 0, 0, Ma"-et St"%ct%"es1 F"om Pe"fect Competition To Monopol............................................................. 0/ .0/ E8%ili&"i%m %ne" pe"fect competition ............................................................................................ 0! 0! E8%ili&"i%m fo" a monopol............................................................................................................. 00 00 Monopol an pe"fect competition compa"e............................................................................ ..... $7 $7 P"ice isc"imination.................................................................................................................... ..... $, $, P%&lic polic to6a"s monopolies .................................................................................................. . $3 $3 P"i#atisation of nationalise in%st"ies........................................................................................ .... $ $ Monopolistic Competition An Oli4opol ................................................................................. ........ .......... $0 $0 Monopolistic competition an non5p"ice competition.................................................................... . $0 $0 Oli4opol.............................................................................................................. .......................................................................................................................... .................... ............... ....... '7 '7 Mone an 9an-in4......................................................................................................... ......................................................................................................................... .................... .... '/ '/ Moneta" a44"e4ates.................................................................................................... .................................................................................................................... .................... .... '0 '0 Flo6s of f%ns 6ithin an econom.................................................................................................. .................................................................................................. '$ '$ 9an-in4......................................................................................................................................... ......................................................................................................................................... . +7+ +7+ The &%ilin4 &%ilin 4 societies............................................................................................................... ..... +7 +7 The Cent"al 9an- An The Fin An Cial Ma"-ets............................................................................... +70 +70 The f%nctions of the 9an- of En4lan ....................................................................................... .... +70 +70 The 9an- of En4lan En 4lan as a &an-e" ........................................................................................... ....... +7$ +7$ The capital ma"-ets an the mone ma"-ets.................................................................................. .................................................................................. ++7 ++7 NATIONA* NA TIONA* INCOME ANA* (SIS.................................................................................................. ++! ++! Meas%"in4 the c"eation of economic 6ealth ........................................................................ ......... ........... ++! ++! The ci"c%la" flo6 of income........................................................................................................... ++ ++ National income statistics.................................................................................................... ........ .......... .. ++$ ++$ NATIONA* NA TIONA* INCOME AND UNEMP*O(MENT........................................................................... +,3 +,3 A44"e4ate eman an s%ppl an e8%ili&"i%m national income.................................................. +,3 +,3 Cons%mption) sa#in4s an in#estment........................................................................................... +, +, Unemploment An Inflation....................................................................................................... ..... +3+ +3+ Unemploment............................................................................................................................... +3+ +3+ The Phillips c%"#e..................................................................................................................... ..... +3, +3,
Inflation an its conse8%ences................................................................................................ ....... +3! +3! P"ices an incomes polic.............................................................................................................. +30 +30 The Deman Fo" An S%ppl of Mone............................................................................................ +3' +3' The 8%antit theo" of mone........................................................................................................ +3' +3' :enesian #ie6s on the eman fo" mone........................................................................... ....... +/3 +/3 The moneta"ist #ie6point............................................................................................................... +/! +/! A compa"ison of the t6o #ie6s...................................................................................................... +/$ +/$ Fiscal Polic...................................................................................................... ....................................................................................................................................... ................................. +!7 +!7 Fiscal polic) national income an eman mana4ement.............................................................. .............................................................. +!7 +!7 Ta2ation Ta2 ation polic an its effects........................................................................................................ +!/ +!/ Inte"national T"ae..................................................................................................... ...................................................................................................................... ........................ ....... +!' +!' A&sol%te an compa"ati#e a#anta4e................................................................................. ........ ........... ... +!' +!' F"ee t"ae an its a#anta4es..................................................................................................... .... ++ ++ F"ee t"ae an p"otection.................................................................................................... ................................................................................................................ ............ +, +, The 9alance Of Paments. E2chan4e Rates..................................................................................... . +$ +$ The &alance of paments.................................................................................................... ................................................................................................................ ............ +$ +$ Components of the &alance of paments............................................................................... ........ ........ +' +' The Te Te"ms "ms of T"ae........................................................................................................................ ........................................................................................................................ +0, +0, E2chan4e "ates.......................................................................................................................... ..... +03 +03 E2chan4e "ate policies of 4o#e"nments.............................................................................. ........ ........... ... +0 +0 E%"opean moneta" coope"ation............................................................................................. ....... +00 +00
Inflation an its conse8%ences................................................................................................ ....... +3! +3! P"ices an incomes polic.............................................................................................................. +30 +30 The Deman Fo" An S%ppl of Mone............................................................................................ +3' +3' The 8%antit theo" of mone........................................................................................................ +3' +3' :enesian #ie6s on the eman fo" mone........................................................................... ....... +/3 +/3 The moneta"ist #ie6point............................................................................................................... +/! +/! A compa"ison of the t6o #ie6s...................................................................................................... +/$ +/$ Fiscal Polic...................................................................................................... ....................................................................................................................................... ................................. +!7 +!7 Fiscal polic) national income an eman mana4ement.............................................................. .............................................................. +!7 +!7 Ta2ation Ta2 ation polic an its effects........................................................................................................ +!/ +!/ Inte"national T"ae..................................................................................................... ...................................................................................................................... ........................ ....... +!' +!' A&sol%te an compa"ati#e a#anta4e................................................................................. ........ ........... ... +!' +!' F"ee t"ae an its a#anta4es..................................................................................................... .... ++ ++ F"ee t"ae an p"otection.................................................................................................... ................................................................................................................ ............ +, +, The 9alance Of Paments. E2chan4e Rates..................................................................................... . +$ +$ The &alance of paments.................................................................................................... ................................................................................................................ ............ +$ +$ Components of the &alance of paments............................................................................... ........ ........ +' +' The Te Te"ms "ms of T"ae........................................................................................................................ ........................................................................................................................ +0, +0, E2chan4e "ates.......................................................................................................................... ..... +03 +03 E2chan4e "ate policies of 4o#e"nments.............................................................................. ........ ........... ... +0 +0 E%"opean moneta" coope"ation............................................................................................. ....... +00 +00
THE NATURE AND SCOPE OF ECONOMICS Your objectives
Afte" completin4 this chapte" o% sho%l &e a6a"e of ;a<
the p"o& p"o&lem lemss 6hich 6hich the the social social scie science nce of of econom economics ics atte attempt mptss to a"e a"ess= ss=
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the &asic tools of economic analsis=
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the alte" alte"nat nati#e i#e sst sstems ems 6hic 6hich h ha#e &een &een e#i e#ise se to to tac-le tac-le econo economic mic p"o& p"o&lem lems= s=
;< the ass%mptions a&o%t cons%me" &eha#io%" 6hich shape the sol%tions to economic p"o&lems.
The scope of economics A social science eals 6ith some aspect o" aspects of h%man societ. societ. Economics is a social science 6hich is conce"ne 6ith the allocation of sca"ce "eso%"ces to p"o#ie 4oos an se"#ices 6hich meet the nees an 6ants of cons%me"s. Rationality
One of the impo"tant ass%mptions in economics) an one on 6hich m%ch economic theo" is &ase) is the "ationalit of h%man &eha#io%". In o"e" to ma-e p"eictions a&o%t thei" economic &eha#io%") economists ass%me that h%man &eha#io%" is >"ational> an that cons%me"s an p"o%ce"s act "ationall. Fo" e2ample) p"o%ce"s an cons%me"s 6ill ma-e "easone ecisions a&o%t ho6 m%ch to p"o%ce o" &% at an 4i#en p"ice. The optimum
The ass%mption of the "ationalit of h%man &eha#io%") an that people 6ill ta-e ecisions an actions 6hich a"e i"ecte to6a"s a "ational o&?ecti#e) leas %s to the concept in economics of the optim%m. The optim%m means the &est possi&le) an the follo6in4 a"e %ne"lin4 ass%mptions in m%ch economic analsis. ;a< ;a<
P"o P"o%c %ce" e"ss 6ill 6ill see see- to ma2i ma2imi mise se thei thei"" p"of p"ofit itss an an "et "et%" %"ns ns..
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Cons%me"s 6ill see- to ma2imise the &enefits the o&tain ;thei" >%tilit>< f"om %sin4 the income at thei" isposal.
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@o#e"n @o#e"nmen ments ts 6ill 6ill seesee- to ma2imi ma2imise se the 6ell 6ell &ein &ein4 4 of of thei thei"" pop% pop%lat lation ion ;fo" e2ampl e2ample) e) & ma2imisin4 the national income pe" hea of the pop%lation<.
Positive and nomative e!onomi!s
(o% mi4ht al"ea ha#e st"on4 pe"sonal #ie6s a&o%t 6hat so"t of economic societ 6e sho%l ha#e) e.4. 6hethe" a f"ee ma"-et >capitalist> econom is esi"a&le) o" 6hethe" a cent"all planne >comman> econom is p"efe"a&le. In the st% of economics) it is eas fo" %s to &e infl%ence in o%" #ie6s & o%" ieas of >6hat o%4ht to &e>. Economists also ha#e #ie6s on these s%&?ects) an some economic 6"itin4 is aime at infl%encin4 ecision ma-e"s & p"esc"i&in4 actions) 6hich) in the opinion of the a%tho") 6ill lea to ens) 6hich he o" she consie"s esi"a&le. Othe" economic "esea"ch) ho6e#e") is i"ecte p%"el to finin4 o%t 6hat the conse8%ences 6ill &e if ce"tain actions a"e ta-en) 6itho%t e2p"essin4 an #ie6 on the esi"a&ilit of those conse8%ences. These t6o iffe"ent app"oaches a"e "efe""e to as no"mati#e economics an positi#e economics.
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No"mati#e economics is conce"ne 6ith the e2p"ession of #al%e ?%4ements & economists) of 6hat the 6o%l li-e to happen 5e.4. 6hat so"t of economic societ the 6o%l li-e to see in ope"ation.
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Positi#e economics is conce"ne 6ith o&?ecti#e statements a&o%t 6hat oes happen o" 6hat 6ill happen. A positi#e app"oach is mo"e o&?ecti#e) an mo"e scientific) an it is the app"oach 6e shall t" to ta-e in o%" st% of economics he"e.
Mi!oe!onomi!s and ma!oe!onomi!s
The st% of economics is i#ie into t6o hal#es) mic"oeconomics an mac"oeconomics. ;a<
>Mic"o> comes f"om the @"ee- 6o" meanin4 small) an mic"oeconomics is the st% of ini#i%al economic %nits o" pa"tic%la" pa"ts of the econom 5e.4. ho6 oes an ini#i%al ho%sehol ecie to spen its income Ho6 oes an ini#i%al fi"m ecie 6hat #ol%me of o%tp%t to p"o%ce o" 6hat p"o%cts to ma-e Ho6 is the p"ice of an ini#i%al p"o%ct ete"mine Ho6 a"e 6a4e le#els ete"mine in a pa"tic%la" in%st"
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>Mac"o> comes f"om the @"ee- 6o" meanin4 la"4e) an mac"oeconomics is the st% of >4lo&al> o" collecti#e ecisions & ini#i%al ho%sehols o" p"o%ce"s. It loo-s at a national o" inte"national econom as a 6hole 5e.4. total o%tp%t) income an e2penit%"e) %nemploment) inflation) inte"est "ates an the &alance of inte"national t"ae etc) an 6hat economic policies a 4o#e"nment can p%"s%e to infl%ence the conition of the national econom.
In this te2t) 6e shall st% mic"oeconomics fi"st &efo"e 4oin4 on to loo- at the mac"oeconomic en#i"onment in late" chapte"s. The "undamental po#lem o" e!onomi!s
A f%namental concept in economics is the sca"cit of "eso%"ces. The"e a"e not eno%4h "eso%"ces to meet the nees of cons%me"s an p"o%ce"s. ;a<
In the case of cons%me"s) the sca"cit of 4oos an se"#ices mi4ht seem o&#io%s eno%4h. E#e"one 6o%l li-e to ha#e mo"e 5anothe" ca") a &i44e" home) mo"e omestic 4oos) &ette" foo an "in-) mo"e holias) mo"e t"ips to the cinema o" theat"e) a &oat) a p"i#ate plane) mem&e"ship of mo"e cl%&s an societies) mo"e clothes an so on. The"e simpl isn>t eno%4h to 4o "o%n to satisf the potential eman.
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In the case of p"o%ce"s) the"e a"e fo%" sca"ce "eso%"ces1 ;i< ;ii< ;iii< ;i#<
nat%"al "eso%"ces) "efe""e to collecti#el as >lan>= la&o%"= capital 5e.4. e8%ipment an tools= ente"p"ise o" ent"ep"ene%"ship.
Sca"ce "eso%"ces mean that p"o%ce"s cannot ma-e %nlimite B%antities of 4oos an se"#ices. Since "eso%"ces fo" p"o%ction a"e sca"ce an the"e a"e not eno%4h 4oos an se"#ices to satisf the total potential eman) choices m%st &e mae. Choice is onl necessa" &eca%se "eso%"ces a"e sca"ce. ;a<
Cons%me"s m%st choose 6hat 4oos an se"#ices the 6ill ha#e.
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P"o%ce"s m%st choose ho6 to %se thei" a#aila&le "eso%"ces) 6hat 4oos an se"#ices to p"o%ce) an in 6hat 8%antities.
The f%namental p"o&lem of economics is the allocation of these sca"ce "eso%"ces. hat 6ill &e p"o%ce hat 6ill &e cons%me An 6ho 6ill &enefit f"om the cons%mption
The tools of economic analysis In 4oin4 a&o%t thei" 6o"- economists ha#e to eal 6ith a n%m&e" of #a"ia&les. To the economist) a #a"ia&le is anthin4 that infl%ences the &asic ecisions) 6hich a"e the s%&?ect of his science1 6hat 6ill &e p"o%ce) 6hat 6ill &e cons%me an 6ho 6ill &enefit f"om the cons%mption Economic #a"ia&les the"efo"e incl%e) amon4st man othe"s1 ;a<
p"ices of commoities an of se"#ices=
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8%antities of p"o%ction "eso%"ces a#aila&le=
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n%m&e"s of s-ille an %ns-ille 6o"-e"s=
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cons%me" attit%es ;since these can affect ecisions a&o%t spenin4 an sa#in4<)
To assist them in thei" analsis of #a"ia&les) economists nee to acc%m%late ata a&o%t them1 p"ice le#els) stoc- co%nts) emploment statistics) cons%me" s%"#es an so on. Often it 6ill &e con#enient to "ep"esent the #a"ia&les %ne" isc%ssion & means of a moel. At its simplest) this p"ocess ma mean no mo"e than "a6in4 a 4"aph an inee o% 6ill fin that the %se of 4"aphs is a #e" common techni8%e in economics. 9%t economists also %se m%ch mo"e comple2 moels than this. *ate" in this &oo-) fo" e2ample) 6e e#elop a moel) 6hich attempts to sho6 the 6a in 6hich income ci"c%lates amon4 the ho%sehols an fi"ms in an econom. One point 6hich ma al"ea ha#e st"%c- o% is that no matte" ho6 comple2 the moel &ecomes) no matte" ho6 man #a"ia&les the economist t"ies to inco"po"ate) the en "es%lt 6ill ne#e" &e mo"e than an app"o2imation of the "eal 6o"l. This is t"%e e#en of the complicate comp%te"ise moels %se & 4o#e"nment economists in thei" attempts to p"eict economic t"ens. The comple2it of a "eal5life econom is simpl too 4"eat to &e sim%late in a moel. Despite this) economic moels ;e#en the simplest 4"aphs an e8%ations< a"e of 4"eat #al%e. The #e" comple2it of a "eal econom is a &a""ie" to %ne"stanin4. 9 %sin4 moels) economists a"e a&le to isolate) f"om the 4"eat mass of "a6 economic acti#it) the #a"ia&les that appea" "ele#ant to an pa"tic%la" p"o&lem. Moels ena&le the economist to %ne"stan an analse a sit%ation an) e#ent%all) to ma-e p"eictions a&o%t f%t%"e economic e#ents. The podu!tion possi#ility !uve
e 6ill &e4in o%" e2amination of the f%namental p"o&lem of economics & %sin4 a #e" simple moel1 that of a societ 6hich can spen its mone on t6o p"o%cts) 4%ns an &%tte". The societ>s B%antit "eso%"ces a"e limite1 the"efo"e the"e a"e "est"ictions on the amo%nt of 4%ns an &%tte" that can &e of 4%ns mae) 6hich can &e sho6n & a p"o%ction possi&ilit c%"#e o" t"ansfo"mation c%"#e. P"o%ction @+ possi&ilit P f"ontie" @, ( @ &
@a
B
@3
7
9
9
9
9 9
The c%"#e f"om @) "o%n to 9) sho6s the #a"io%s com&inations of 4%ns an &%tte" that a societ can ma-e) if it %ses its limite "eso%"ces efficientl. ;a<
The fi"m can choose to ma-e %p to1 ;i< @+ %nits of 4%ns an no &%tte"= ;ii< 9+ %nits of &%tte" an no 4%ns= ;iii< @, %nits of 4%ns an 9, of &%tte" ;point p on the c%"#e<= ;i#< @3 %nits of 4%ns an 93 of &%tte" ;point B on the c%"#e<.
Points P an B on the c%"#e a"e chosen at "anom. An othe" point on the c%"#e 6o%l inicate p"o%ction of anothe" possi&le com&ination of 4%ns an &%tte" . ;&<
The com&ination of @a %nits of 4%ns an Ha %nits of &%tte" plotte at point is 6ithin the p"o%ction possi&ilit c%"#e. Mo"e than these B%antities can &e mae of eithe" o" &oth 4%ns an &%tte". Point is the"efo"e an inefficient p"o%ction point fo" the econom) an if the societ 6e"e to ma-e onl @ a of 4%ns an Ha of &%tte") it 6o%l &e %ne"5%tilisin4 its "eso%"ces.
The p"o%ction possi&ilit c%"#e ill%st"ates the nee to ma-e a choice a&o%t 6hat to p"o%ce ;o" &%< 6hen it is not possi&le to ha#e e#e"thin4 5i.e. 6hen the"e is sca"cit. Altho%4h 6e ha#e cha"acte"ise the p"o%cts of o%" hpothetical econom as 4%ns an &%tte") 6e can 4ene"alise the p"o%ction possi&ilit c%"#e to sho6 the p"o%ction possi&ilities fo" iffe"ent tpes of 4oo) as fo" >4oo > on one a2is an >all othe" 4oos> on the othe" a2is. Choice in#ol#es sac"ifice. If the"e is a choice &et6een ha#in4 4%ns an ha#in4 &%tte") an a co%nt" chooses to ha#e 4%ns) it 6ill &e 4i#in4 %p &%tte" to ha#e the 4%ns. The cost of ha#in4 4%ns can the"efo"e &e "e4a"e as the sac"ifice of not &ein4 a&le to ha#e &%tte". The"e is a sac"ifice in#ol#e in the choices of cons%me"s an p"o%ce"s) as 6ell as the choices of 4o#e"nments. S%ppose a cons%me" has a limite amo%nt of mone) an chooses to &% some e44s. One meas%"ement of the cost of the e44s is thei" mone p"ice. Anothe" 6a of loo-in4 at the cost is to consie" the sac"ifice in#ol#e in choosin4 e44s "athe" than) sa) mil-. If the cons%me" has some e44s) he o" she is 4i#in4 %p the oppo"t%nit to ha#e some mil-) an the &enefits that the mil- 6o%l ha#e p"o#ie. The cost of an item meas%"e in te"ms of the alte"nati#es fo"4one is calle its oppo"t%nit cost. Th%s the oppo"t%nit cost of &%in4 si2 e44s can &e meas%"e as the t6o pints of mil- o" the one &%s "ie that co%l ha#e &een &o%4ht instea. Simila"l) the oppo"t%nit cost of a co%nt" ha#in4 a n%clea" missile co%l &e meas%"e in te"ms of the n%m&e" of schools that co%l ha#e &een &%ilt an staffe 6ith the same amo%nt of "eso%"ces At the le#el of the fi"m) the p"o%ction possi&ilit c%"#e can &e seen as sho6in4 the ma2im%m o%tp%t of iffe"ent alte"nati#e 4oos 6hich the fi"m can p"o%ce 6hen all of its "eso%"ces a"e f%ll %se 5fo" e2ample) a fi"m mi4ht ope"ate p"o%ction lines capa&le of p"o%cin4 6ashin4 machines o" "ef"i4e"ato"s. P"o%cin4 mo"e 6ashin4 machines &ea"s the oppo"t%nit cost of a lo6e" le#el of p"o%ction of "ef"i4e"ato"s. Shi"ts in the podu!tion possi#ility !uve
hen the a#aila&ilit of "eso%"ces chan4es) o" the"e is a e#elopment in technolo4) the p"o%ction possi&ilit c%"#e ma shift. Chan4es a"e mae possi&le & e#elopments s%ch as a &i44e" la&o%" fo"ce) mo"e efficient methos of 6o"-in4) mo"e efficient machine") o" a ne6 isco#e" of nat%"al "eso%"ces) s%ch as oil) nat%"al 4as o" mine"als.
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If the the p"o%ct p"o%ction ion pos possi& si&ili ilit t c%"#e c%"#e mo# mo#es es o%t6a" o%t6a"s) s) to the the "i4ht) "i4ht) it mean meanss that that the econom econom is capa&le of p"o%cin4 mo"e 4oos an se"#ices in total than it co%l &efo"e) an the"e is economic 4"o6th.
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If it mo#es to the left ;in6a"s< it means that the econom cannot p"o%ce as m%ch as &efo"e ;e.4. &eca%se of a si4nificant ecline in pop%lation o" the e2ha%stion of a nat%"al "eso%"ce<.
B%antit of 4%ns A (
@, 9
@+
9 7
9
A
9
In Fi4%"e ,) c%"#e AA "ep"esents 4"eate" p"o%ction possi&ilities than c%"#e 99. If a societ>s p"o%ction possi&ilit c%"#e shifts o%t f"om 99 to AA) the"e is economic 4"o6th. The societ societ co%l no6 s6itch f"om ma-in4 @ + of 4%ns an 9 + of &%tte" ;point < to ma-in4 @ , of 4%ns an 9 , of &%tte" ;point (<. E$!han%e value
hen a "eso%"ce is sca"ce ;that is) 6hen less of it is a#aila&le than is neee to satisf the 6ants an nees of p"o%ce"s an cons%me"s<) it has an economic #al%e o" an >e2chan4e> #al%e. P"o%ce"s 6ill 4i#e somethin4 in e2chan4e fo" the nat%"al "eso%"ces) la&o%" an e8%ipment that the nee to help them to p"o%ce 4oos an se"#ices. Cons%me"s 6ill 4i#e somethin4 in e2chan4e fo" the 4oos an se"#ices that the can o&tain. In an a#ance econom) #al%e is meas%"e in mone te"ms 5e.4. the p"ice of 4oos) 6a4e le#els) an the cost of "a6 mate"ials. 9%t simila" p"inciples appl in a p"imiti#e &a"te" econom. ;A &a"te" econom is one in 6hich 4oos a"e t"ae fo" othe" 4oos) 6itho%t the %se of an e2chan4e mei%m s%ch as mone.< Fo" e2ample) if a potato 4"o6e" 6e"e to as- someone to help him to i4 %p the potatoes he ha 4"o6n) he mi4ht offe" some of the potatoes potatoes to the helpe" in e2chan4e fo" the la&o%" the helpe" p%ts in. Fo" "eso%"ces to ha#e an e2chan4e #al%e) the"e is a p"es%pposition that e2chan4e can ta-e place. In a ma"-et econom) this is 6hat oes happen. ;a<
Reso%"c Reso%"ces es a"e o6ne) o6ne) som someti etimes mes & soci societ et as a 6hole) 6hole) an often often & & ini ini#i #i%al %als) s) o" 4"o% 4"o%ps) ps) o" o"4anisations. Ini#i%als) fo" e2ample) o6n thei" o6n la&o%". P"ope"t o6ne"s o6n lan) an the mine"als in them.
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O6ne"s of "eso%"ces 6ill 4i#e some of thei" "eso%"ces in e2chan4e fo" othe"s. Ini#i%als) fo" e2ample) 6ill 4i#e thei" la&o%" in e2chan4e fo" a 6a4e. In a &a"te" econom) a fa"me" mi4ht 4i#e %p some lan in e2chan4e fo" some ho"ses o" co6s.
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In an a#ance ma"-et econom) econom) an impo"tant mei%m of e2chan4e is notes an coin.
The division o" la#ou
Si4nificant feat%"es of all >moe"n> economies a"e specialisation an the i#ision of la&o%") &oth of 6hich inc"ease the nee fo" e2chan4e. ;a<
Specialisation of la&o%" occ%"s 6he"e a 6o"-e" ma-es ?%st one tpe of p"o%ct o" p"o#ies one tpe of se"#ice 5e.4. a fa"me") a octo") an acco%ntant) a &%tche") an ente"taine") an so on. Ini#i%als a"e not self 5s%fficient an o not each ma-e themsel#es all the p"o%cts an se"#ices the "e8%i"e fo" thei" pe"sonal 6ants. Instea) ini#i%als specialise in ma-in4 a pa"tic%la" 4oo o" se"#ice.
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The i#ision of la&o%" "efe"s to specialisation 6ithin a sin4le in%st". in%st". The man%fact%"e of one p"o%ct sometimes calls fo" the 6o"- to &e i#ie %p into >s%&5 >s%&5 specialities>= fo" e2ample) in the ma-in4 of moto" ca"s) the"e a"e ca" &o &%ile"s) paint sp"ae"s an en4ine t%ne"s.
The e2istence of specialisation an i#ision of la&o%" necessitates e2chan4e in a moe"n ma"-et econom) econom) &eca%se specialists a"e not self 5s%fficient) an the m%st e2chan4e 6hat the p"o%ce in "et%"n fo" othe" 4oos an se"#ices the nee. In p"actice) most 6o"-e"s sell thei" la&o%" to a fi"m ;o" to the 4o#e"nment< in e2chan4e fo" mone 6a4es. Mone is the mei%m of e2chan4e) 6hich pe"mits them to &% othe" 4oos an se"#ices.
Alternative economic systems Means o" allo!atin% esou!es
Sca"cit of "eso%"ces means that choices m%st &e mae a&o%t ho6 the "eso%"ces 6ill &e allocate. The"e a"e th"ee &asic "eso%"ce allocation ecisions. ;a<
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hat 4oos an se"#ices sho%l &e p"o%ce This 6ill epen on 6hat cons%me"s 6ant to &%) an 6hat 6hat the 6ill pa fo" each p"o%ct o" se"#ice. The ecisions ecisions a&o%t 6hat 6ill &e p"o%ce "elate to eman an s%ppl1 ;i<
ema eman n mea means ns the the em eman an f"om f"om c%s c%sto tome me"s "s o" o" cons cons%m %me" e"s) s) an an sat satis isfi fie e em eman an is act%al cons%mption=
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s%ppl of 4oos an se"#ices is "efe""e to as p"o%ction.
Ho6 6ill these 4oos an se"#ices &e p"o%ce The p"o%ce"s o" s%pplie"s of 4oos an se"#ices mi4ht &e small companies) la"4e companies) monopolies) state5o6ne ente"p"ises o" the 4o#e"nment itself. The choice a&o%t 6ho 6ill p"o%ce the 4oos an se"#ices) an 6hat mi2 of "eso%"ces the p"o%ce"s 6ill %se) 6ill epen on the costs of of "eso%"ces an the efficiencies of "eso%"ce "eso%"ce %tilisation.
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To 6hom 6hom 6ill 6ill the the 4oos 4oos an se"#ic se"#ices es &e ist ist"i& "i&%te %te Some 4oo 4oos s an se"#ic se"#ices es a"e p"o#i p"o#ie e f"ee & the state ;e.4. in the U:) some health ca"e an e%cation< &%t othe"s ha#e to &e pai fo". The ist"i&%tion of 4oos an se"#ices 6ill the"efo"e epen on the ist"i&%tion of income an 6ealth in societ. This in t%"n 6ill epen on 6hat ini#i%als an o"4anisations ea"n) an the theo" of ist"i&%tion in economics is conce"ne 6ith 6hat "e6a"s a"e ea"ne & the o6ne"s of sca"ce economic "eso%"ces1 lan) la&o%") capital an ent"ep"ene%"ship.
The 6a in 6hich these "eso%"ce ecisions a"e "esol#e epens on the tpe of econom 6e a"e ealin4 6ith. In this conte2t) a n%m&e" of te"ms a"e e2plaine &"iefl &elo6 an 6ill &e e#elope mo"e f%ll in late" chapte"s. ;a<
In a f"ee ma"-et ma"-et econom econom ) the the ecis ecision ionss an an choice choicess a&o% a&o%tt "eso% "eso%"ce "ce alloca allocatio tion n a"e a"e left left to ma"-et fo"ces of s%ppl an eman) an the 6o"-in4s of the p"ice mechanism. In othe" 6o"s) 6hat p"o%ce"s 6ill ma-e an 6hat cons%me"s 6ill &% a"e -ept in &alance & the p"ice that p"o%ce"s 6ill 6ant fo" thei" o%tp%t an the p"ice that cons%me"s cons%me"s a"e 6illin4 to pa. pa.
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In a cent"all planne econom o" comman econom) econom) the ecisions an choices a&o%t "eso%"ce allocation a"e mae & the 4o#e"nment. Mone #al%es a"e attache to "eso%"ces an to 4oos an se"#ices) &%t it is the 4o#e"nment that ecies 6hat "eso%"ces sho%l &e %se) ho6 m%ch sho%l &e pai fo" them) 6hat 4oos sho%l &e mae an 6hat thei" p"ice sho%l &e.
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In a mi2e econom the ecisions an choices a"e mae pa"tl & f"ee ma"-et fo"ces of s%ppl an eman) an pa"tl & 4o#e"nment ecisions. All national economies a"e mi2e economies) altho%4h 6ith iffe"in4 p"opo"tions of f"ee ma"-et an cent"all planne ecision5 ma-in4 f"om one co%nt" to the ne2t.
Consumer behaviour In this section 6e loo- at ho6 cons%me"s ma-e economic choices) so that 6e can then 4o on to e2amine ho6 those choices inte"act to4ethe" in economic ma"-ets. A -e concept in the st% of cons%me" &eha#io%" is %tilit. Utilit is the 6o" %se to esc"i&e the pleas%"e o" satisfaction o" &enefit e"i#e & a pe"son f"om the cons%mption cons%mption of 4oos. Total Total %tilit is then the total satisfaction that a pe"son e"i#es f"om spenin4 his income an cons%min4 4oos. Ma"4inal %tilit is the satisfaction 4aine f"om cons%min4 one aitional %nit of a 4oo o" the satisfaction fo"4one & cons%min4 one %nit less. If someone eats si2 apples an then eats a se#enth) total %tilit "efe"s to the satisfaction he e"i#es f"om all se#en apples to4ethe") 6hile ma"4inal %tilit "efe"s to the aitional satisfaction f"om eatin4 the se#enth apple) ha#in4 al"ea eaten si2. Assumptions a#out ationality
e nee to ma-e some aitional ass%mptions a&o%t the "ational &eh a#io%" of the cons%me") 6hich 6as isc%sse ea"lie"1 ;a<
4ene"all the cons%me" p"efe"s mo"e 4oos to less=
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4ene"all the cons%me" is 6illin4 to s%&stit%te one 4oo fo" anothe" p"o#ie its p"ice is "i4ht=
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choices a"e t"ansiti#e. This means that if at a 4i#en time a commoit &%nle A is p"efe""e to &%nle 9 an &%nle 9 is p"efe""e to &%nle C then 6e can concl%e that commoit &%nle A is p"efe""e to commoit &%nle C.
Actin4 "ationall means that the cons%me" attempts to ma2imise the total %tilit attaina&le 6ith a limite income. hen the cons%me" consie"s 6hethe" an %nit of a 4oo is 6o"th &%in4 he is eciin4 6hethe" the ma"4inal %tilit of &%in4 anothe" %nit of the 4oo e2cees the ma"4inal %tilit that 6o%l &e iele & an alte"nati#e %se of the same amo%nt of mone. If a pe"son has ma2imise his total %tilit) it follo6s that he has allocate his e2penit%"e in s%ch a 6a that the %tilit 4aine f"om spenin4 the last penn on each of the commoities he &%s 6ill &e e8%al) i.e. the cons%me" 6ill spen his income in s%ch a 6a that he 4ets the same ma"4inal %tilit f"om the last penn spent on each commoit. commoit. Diminishin% ma%inal utility
As a pe"son cons%mes mo"e of a commoit) the total satisfaction he 4ains 6ill contin%e to inc"ease) &%t the ma"4inal %tilit e"i#e f"om inc"easin4 cons%mption cons%mption 6ill fall 6ith each aitional %nit cons%me. The ea"lie" e2ample of a man on holia p"o#ies as ill%st"ation of this. The total satisfaction he 4ains 6ill inc"ease as his holia 4ets lon4e". He is %nli-el) ho6e#e") to e"i#e as m%ch %tilit f"om the secon a as m%ch as the fi"st) o" the thi" as m%ch as the secon) an so on. The la6 of iminishin4 ma"4inal %tilit states that) all othe" thin4s &ein4 e8%al) the aitional satisfaction e"i#e f"om cons%min4 aitional %nits of a commoit 6ill iminish 6ith each
s%ccessi#e %nit cons%me. Total %tilit 6ill contin%e to "ise as each s%ccessi#e %nit is cons%me) &%t at a ec"easin4 pace.
Ine2 of %tilit
Total %tilit
Ine2 of %tilit
B%antit cons%me
Ma"4inal %tilit
The >la6> applies onl if the ass%mptions of fi2e ho%sehol income an fi2e tastes o" fashion a"e #ali. If eithe" chan4es) the >la6> 6ill &e tempo"a"il inapplica&le %ntil a sta&le sit%ation is "e5 esta&lishe. ;a<
Income1 if income chan4es) the %tilit a cons%me" o&tains f"om a commoit 6ill &e affecte & the chan4in4 cons%mption of othe" commoities. Fo" instance) someone ma "in- instant coffee an s6itch to &%in4 f"esh54"o%n coffee. B%antit cons%me
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Tastes1 a chan4e in tastes) fashion o" attit%es ma occ%" as mo"e of a commoit is cons%me an ma"4inal %tilit ma inc"ease 6he"e s%ch a chan4e is ta-in4 place. Fo" e2ample) a pe"son ma p"o4"ess f"om an occasional &%e" of pict%"es into an o&sessi#e a"t collecto".
Consume e&uili#ium' ma%inal utilities and elative pi!es
e state ea"lie" that a cons%me" 6ill ma2imise his total %tilit) 6ith a 4i#en income an tastes) at a le#el of cons%mption 6he"e the ma"4inal %tilit f"om the last penn spent is the same fo" each commoit &o%4ht. This p"oposition can &e e#elope into an al4e&"aic fo"m%la. S%ppose that a ho%sehol &%s t6o commoities) an (. *et the ma"4inal %tilit of a %nit of &e MU 2 an the ma"4inal %tilit of a %nit of ( &e MU *et the p"ice pe" %nit of ;in pence< &e P 2 an the p"ice pe" %nit of ( &e P The ho%sehol 6ill attain a %tilit5ma2imisin4 e8%ili&"i%m 6he"e the ma"4inal %tilit f"om the last penn spent is the same fo" an () i.e. 6he"e
C"oss m%ltiplin4 4i#es1
MU2 MU P2 P
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MU2 P2 MU P
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This is t"%e fo" an pai" of commoities &o%4ht & the ho%sehol. The la( o" e&ui)ma%inal etuns In o"e" to ma2imise thei" total %tilit) people 6ill ist"i&%te thei" e2penit%"e in s%ch a 6a that the "atio of ma"4inal %tilities fo" all the 4oos the cons%me ;MU 21 MU1 MUG etc< of 4oos is e8%al to the "elati#e p"ice of the 4oos ; i.e. the "atio of p"ices P 21 P1 PG<. This is sometimes calle the la6 of e8%i5 ma"4inal "et%"ns. It is a statement of the p"inciple that a %tilit5ma2imisin4 ho%sehol 6ill allocate its e2penit%"e so that the ma"4inal %tilit of that last penn spent on each 4oo is e8%al fo" each 4oo that it &%s. This is ho6 the ho%sehol ecies 6hat 8%antities of each 4oo it 6o%l 6ant to &%) 4i#en the e2istin4 p"ices of all 4oos.
e can %se the concept of e8%i5ma"4inal "et%"ns an the e8%ili&"i%m "elationship e2p"esse in e8%ation ;,< a&o#e to p"eict 6hat 6ill happen to cons%me" spenin4 patte"ns 6hen the"e is a chan4e in the p"ice of a commoit. Pi!e ises and !han%es in in!ome
In spea-in4 of a p"ice "ise) 6e mean a "ise in the "eal p"ice) as istinct f"om the mone p"ice o" nominal p"ice of a commoit. If all p"ices "ise in the same p"opo"tion &eca%se of inflation) the"e 6o%l &e a "ise in the nominal p"ices) &%t "eal p"ices 6o%l "emain the same &eca%se "elati#e #al%es 6o%l &e %nalte"e. If the p"ice of a 4oo has "isen mo"e than those of othe" 4oos an incomes 4ene"all) then a "eal p"ice "ise has occ%""e. e sa6 a&o#e that the ho%sehol is in e8%ili&"i%m 6hen the "atio of ma"4inal %tilities of commoities is e8%al to the "atio of thei" p"ices. e can the"efo"e p"eict that if the p"ice of a commoit "ises) the ma"4inal %tilit of the commoit pe" penn spent 6ill fall) i.e. if the p"ice of a commoit "ises 6hile the p"ice of "emains the same) MU 2P2 6ill fall. The"efo"e MU2P2 MUP an so MU 2MU P2P ;note1 means >is less than><. The p"ice "ise alte"s the cons%me">s e8%ili&"i%m. This analsis leas to a &asic p"eiction of eman theo") 6hich 6e shall &e e2aminin4 in the ne2t chapte". ;a<
If the p"ice of a commoit "ises ;6ith income) tastes an all othe" p"ices constant<) eman & each ho%sehol fo" that commoit 6ill fall.
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If the p"ice of a commoit falls ;6ith income) tastes an all othe" p"ices constant<) eman & each ho%sehol fo" that commoit 6ill "ise.
PRICE THEOR*' SUPP+* AND DEMAND Your objectives
Afte" completin4 this chapte" o% sho%l1 ;a<
%ne"stan that the s%ppl of an eman fo" commoities is infl%ence & competiti#e facto"s
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&e a6a"e of the facto"s that stim%late o" ep"ess s%ppl of an eman fo" a commoit
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%ne"stan ho6 the p"ice of a commoit is ete"mine & the inte"action of s%ppl an eman
Markets and competition Intodu!tion
In mic"oeconomics) the theo" of cons%me" &eha#io%") the theo" of the fi"m an p"ice theo" see- to e2plain ho6 economic ecisions a"e "eache. ;a<
hat ma-es cons%me"s ecie 6hat the a"e 4oin4 to &%) an in 6hat 8%antities
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hat ma-es fi"ms ecie 6hat 4oos an se"#ices the a"e 4oin4 to p"o%ce) an in 6hat 8%antities
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Ho6 a"e the ma"-et p"ices fo" &%in4 an sellin4 a""i#e at
The !on!ept o" a ma,et
The concept of a ma"-et in economics 4oes &eon the iea of a sin4le 4eo4"aphical place 6he"e people meet to &% an sell 4oos.J It is a te"m %se to "efe" to the &%e"s an selle"s of a 4oo 6ho infl%ence its p"ice. Ma"-ets can &e 6o"l6ie) as in the case of oil) 6heat) cotton an coppe") fo" e2ample. Othe"s a"e mo"e localise) s%ch as the ho%sin4 ma"-et o" the ma"-et fo" secon5han ca"s. Ma"-ets fo" iffe"ent 4oos o" commoities a"e often inte"5"elate. All commoities compete fo" ho%sehols> income so that if mo"e is spent in one ma"-et) the"e 6ill &e less to spen in othe" ma"-ets. F%"the") if ma"-ets fo" simila" 4oos a"e sepa"ate 4eo4"aphicall) the"e 6ill &e some p"ice iffe"ential at 6hich it 6ill &e 6o"th6hile fo" the cons%me" to &% in the lo6e" p"ice ma"-et an pa shippin4 costs) "athe" than &% in a 4eo4"aphicall nea"e" ma"-et. De!ision)ta,es in a ma,et
The"e a"e t6o ma?o" 4"o%ps of ecision5ta-e"s in a ma"-et) namel &%e"s an selle"s) o" mo"e acc%"atel1 ;a< ;&<
p%"chase"s an 6o%l5&e p%"chase"s= s%pplie"s an 6o%l5&e s%pplie"s.
S%pplie"s an 6o%l5&e s%pplie"s a"e "efe""e to in economics as fi"ms. 9%e"s an 6o%l5 &e &%e"s a"e often "efe""e to in economics as ho%sehols. e often "efe" to >ho%sehols> "athe" than to ini#i%al cons%me"s pa"tl &eca%se economic ata that is collecte "efe"s to ho%sehol financial t"ansactions "athe" than ini#i%al cons%me"s> spenin4. e can then i4no"e all p"o&lems of ecision5 ma-in4 6ithin the ho%sehol ;i.e. 6hich mem&e" of the ho%sehol ma-es the spenin4 ecisions< an "e4a" the ho%sehol as tho%4h it 6e"e a sin4le ini#i%al.
Some ma"-ets ha#e &%e"s 6ho a"e not ho%sehols at all) &%t 6ho a"e othe" fi"ms o" 4o#e"nment a%tho"ities. Fo" e2ample) a man%fact%"in4 fi"m &%s "a6 mate"ials an components to 4o into the p"o%cts that it ma-es. Se"#ice in%st"ies an 4o#e"nment 4o#e"nment epa"tments m%st simila"l &% in s%pplies in o"e" to o thei" o6n 6o"-. Ho6e#e") the eman fo" 4oos f"om fi"ms an 4o#e"nment a%tho"ities is a e"i#e eman in the sense that the siGe of thei" eman epens on the nat%"e of the eman f"om ho%sehols fo" the 4oos an se"#ices that the in t%"n p"o%ce an p"o#ie. To &e4in 6ith) 6e shall concent"ate on p"o%ct ma"-ets) 6hich a"e ma"-ets in 6hich a 4oo o" a se"#ice to cons%me"s is &o%4ht an sol. *ate") 6e shall 4o on to loo- at "eso%"ce ma"-ets. 6hich a"e the ma"-ets in 6hich p"o%ction "eso%"ces 5especiall la&o%" an capital 5a"e &o%4ht an sol. Pi!e theoy
P"ice theo" ;o" eman theo" as it is sometimes calle< is conce"ne 6ith ho6 ma"-et p"ices fo" 4oos a"e a""i#e at) th"o%4h the inte"action of eman an s%ppl. The economist istin4%ishes &et6een pe"fect an impe"fect competition in ma"-ets. All ma"-ets ha#e some impe"fections) &%t the pe"fect ma"-et p"o#ies a %sef%l theo"etical &enchma"- o" sta"tin4 point fo" assessin4 the cha"acte"istics of a ma"-et in the >"eal 6o"l>) Pe"e!t !ompetition
In a pe"fect ma"-et fo" a p"o%ct1 ;a<
the"e the"e is is a la"4e la"4e n%m n%m&e" &e" of &%e &%e"s "s an an a la"4e la"4e n%m n%m&e" &e" of sell selle"s e"s an no ini ini#i #i%al %al &% &%e" e" o" o" selle" can infl%ence the ma"-et p"ice. An ini#i%al fi"m m%st accept the p"e#ailin4 ma"-et p"ice 5i.e. it m%st &e a >p"ice ta-e">=
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the"e is pe"fect comm%nication so that all &%e"s an selle"s ha#e the same info"mation a&o%t p"ices th"o%4h the ma"-et) an &%e"s an selle"s can can o&tain this info"mation 6itho%t cost=
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the cons%me" 6ill act "ationall an 6ill the"efo"e t" to pa the lo6est p"ice at 6hich a p"o%ct is offe"e..
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the p"o%ct is homo4eneo%s) Ke it is %nifo"m ac"oss the ma"-et an the"e is no p"o%ct iffe"entiation so that one fi"m cannot sell a p"o%ct simila" to its competito"s> p"o%cts & emphasisin4 o" a#e"tisin4 its iffe"ences o" &"an ima4e=
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the"e is f"eeom of ent" into the ma"-et & ne6 selle"s=
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the"e the"e is is an an a&sen a&sence ce of t"an t"anspo spo"t "t cost costss in in t"a#e t"a#elli llin4 n4 &et6 &et6een een one pa"t pa"t of the ma"-et ma"-et an anothe anothe"" .
These conitions ens%"e that p"ice iffe"ences 6ithin the ma"-et a"e "apil eliminate an a sin4le p"ice is esta&lishe th"o%4ho%t the ma"-et fo" all p"o%cts sol sol in the ma"-et. Ma,et impe"e!tions
Altho%4h o"4anise ma"-ets come close to the theo"etical moel of a pe"fect ma"-et) pe"fect ma"-ets o not e2ist in the >"eal 6o"l>) an act%al ma"-ets a"e all impe"fect to some e4"ee. The"e a"e the follo6in4 "easons fo" this. ;a<
9%e"s an selle"s %s%all ha#e incomplete info"mation a&o%t p"ices "%lin4 in all othe" pa"ts of the ma"-et. Fo" instance) a shoppe" ma fin it incon#enient to chec- the p"ice of st"a6&e""ies in e#e" local shop) an mi4ht as a "es%lt &% at a p"ice a&o#e the lo6est o&taina&le.
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P"o%ce"s can c"eate the imp"ession that thei" 4oos a"e &ette" than those of thei" competito"s) altho%4h the a"e "eall 8%ite simila". S%ch p"o%ct iffe"entiation is achie#e not onl & iffe"ences in p"o%ct esi4n &%t also & means of a#e"tisin4 an &"anin4.
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C%stome" loalt o" ine"tia sometimes p"e#ents "ational ecisions & &%e"s. C%stome"s mi4ht contin%e to 4o to a s%pplie" 6ho has 4i#en 4oo se"#ice in the past "athe" than t"o%t a ne6 an cheape" competito".
;<
Man ma"-ets a"e not pe"fectl competiti#e. Pe"fect an impe"fect competition 6ill &e isc%sse in a late" chapte". Ho6e#e") the essence of the istinction is that in an impe"fect impe" fect ma"-et the"e is an im&alance in economic po6e". A 4"o%p of s%pplie"s o" &%e"s ma &e a&le to infl%ence total ma"-et 8%antities s%pplie o" emane an the p"ice of the p"o%ct.
Fo" o%" immeiate p%"pose) ho6e#e") a pe"fect ma"-et is ass%me to e2ist. Altho%4h this is an o#e"5 simplification) it helps to p"o#ie %sef%l insi4hts into p"ice ete"mination. The ass%mption of pe"fect ma"-ets 6ill &e "ela2e in late" chapte"s. e shall no6 loo- at eman an s%ppl in t%"n) an then consie" ho6 eman an s%ppl inte"act th"o%4h the p"ice mechanism.
Demand The !on!ept o" demand
Deman "efe"s to the B%antit of a 4oo that potential p%"chase"s 6o%l &%) o" attempt to &%) if the p"ice of the 4oo 6e"e at a ce"tain le#el. It is impo"tant that o% sho%l app"eciate the concept of eman p"ope"l. Deman oes not mean the 8%antit that potential p%"chase"s 6ish the co%l &%. Fo" e2ample) potential p%"chase"s mi4ht esi"e to ha#e one million %nits of a 4oo) &%t the"e mi4ht onl &e act%al attempts to &% one h%n"e %nits at a 4i#en p"ice. Deman is 6hat 6o%l &e the act%al attempt to &% at a 4i#en p"ice. Deman mi4ht &e satisfie) an so act%al B%antities &o%4ht 6o%l e8%al eman. On the othe" han) some eman mi4ht &e %nsatisfie) 6ith mo"e 6o%l5&e p%"chase"s t"in4 to &% a 4oo that is in ins%fficient s%ppl) an so the"e a"e not eno%4h %nits of the 4oo to 4o a"o%n. Se#e"al facto"s infl%ence the total ma"-et eman fo" a 4oo. One of these facto"s is o&#io%sl its p"ice) &%t the"e a"e othe" facto"s too) an to help o% to app"eciate some some of these othe" facto"s) o% nee to "eco4nise that ho%sehols &% not ?%st one 4oo 6ith thei" mone &%t a 6hole "an4e of 4oos an se"#ices. The facto"s on 6hich the 8%antit of eman fo" an ini#i%al 4oo is epenent incl%e1 ;a<
the p"ice of the 4oo=
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the p"ice of othe" 4oos ;p"o%cts an se"#ices<=
;c<
the siGe of ho%sehol income=
;<
tastes an fashion=
;e<
e2pectations=
;f<
the ist"i&%tion of 6ealth amon4st ho%sehols 5i.e. ho6 6ealth is sp"ea amon4st the pop%lation.
Each of these facto"s is isc%sse at 4"eate" len4th in the pa"a4"aphs that follo6. follo6.
The total 8%antit emane is "efe""e to as the ma"-et eman. he"eas facto"s ;a< to ;e< can affect &%in4 ecisions & ini#i%al ho%sehols) facto" ;f< impo"tant &eca%se &eca%se it infl%ences the potential a44"e4ate siGe of the ma"-et as a 6hole. Demand and the pi!e o" a %ood
In the case of most 4oos ;some e2ceptions) s%ch as @iffen 4oos) 6ill &e isc%sse late"<) the hi4he" the p"ice) the lo6e" 6ill &e the 8%antit emane) an the lo6e" the p"ice) the hi4he" 6ill &e the 8%antit emane. It is common sense that at a hi4he" p"ice) a 4oo oes not 4i#e the same #al%e fo" mone as it 6o%l at a lo6e" p"ice) an so ho%sehols 6o%l not 6ant to &% as man. This epenence of eman on p"ice applies to all 4oos an se"#ices) f"om &"ea an salt to ho%ses an space "oc-ets. The demand !uve
The "elationship &et6een eman an p"ice can &e sho6n 4"aphicall as a eman c%"#e. The eman c%"#e of a sin4le cons%me" is e"i#e & estimatin4 ho6 m%ch of the 4oo the cons%me" 6o%l eman at #a"io%s hpothetical ma"-et p"ices. S%ppose a cons%me" has the follo6in4 eman sche%le fo" soap po6e". Price per kilogram
Quantity demanded (kilos)
L + , 3 / !
;-ilos< ' $ / , +
e can sho6 this sche%le 4"aphicall) 6ith1 ;a< ;&<
p"ice on the #e"tical a2is= an 8%antit emane on the ho"iGontal a2is.
A
9
!
/ 3
D
E
,
+
7
+ C
,
3
/
!
0
$ F
'
+7
The a"ea of each "ectan4le "ep"esents cons%me"s> total mone o%tla at the p"ice in 8%estion. Fo" e2ample) at a p"ice of L) eman 6o%l &e + -ilo4"am an total spenin4 6o%l &e L) "ep"esente & "ectan4le A9CO. Simila"l) at a p"ice of L,) eman 6o%l &e $ -ilo4"ams an the total spenin4 of L+ is "ep"esente & "ectan4le DEFO. If 6e ass%me that the"e is complete i#isi&ilit) so that p"ice an 8%antit can &oth chan4e in infinitel small steps) 6e can "a6 a eman c%"#e & ?oinin4 the points sho6n in Fi4%"e + & a contin%o%s line) DD. This is the cons%me">s eman c%"#e fo" soap po6e" in the pa"tic%la" ma"-et 6e a"e loo-in4 at.
D
!
/ 3
,
+
D
7
,
+
/
$
'
He"e the eman c%"#e happens to &e a st"ai4ht line. St"ai4ht line eman c%"#es a"e often %se as an ill%st"ation in economics &eca%se it is con#enient to "a6 them this 6a. In "ealit) a eman c%"#e is mo"e li-el to &e a c%"#e line con#e2 to the o"i4in. A con#e2 eman c%"#e 6ill mean that the"e a"e p"o4"essi#el la"4e" inc"eases in B%antit emane as p"ice falls.
!
/ 3
,
+
7
+
,
3
/
!
0
$
'
+7
Chan4es in eman ca%se & chan4es in p"ice a"e "ep"esente & mo#ements alon4 the eman c%"#e) f"om one point to anothe". The p"ice has chan4e) an the 8%antit emane chan4es) &%t the eman c%"#e itself "emains the same.
In this simple e2ample) 6e a"e loo-in4 at the eman sche%le of a sin4le ho%sehol. A ma"-et eman c%"#e is a simila" c%"#e) "a6n f"om a eman sche%le) e2p"essin4 the e2pecte total B%antit of the 4oo that 6o%l &e emane & all cons%me"s to4ethe") at an 4i#en p"ice. Ma"-et eman "efe"s to the total B%antities of a p"o%ct that all ho%sehols 6o%l 6ant to &% at each p"ice le#el. A ma"-et eman sche%le an a ma"-et eman c%"#e a"e the"efo"e simpl the s%m of all the ini#i%al eman sche%les an eman c%"#es p%t to4ethe". Ma"-et eman c%"#es 6o%l &e simila" to those in Fi4%"es , an 3) &%t 6ith B%antities emane &ein4 hi4he" 5i.e. total ma"-et eman. The ma"-et eman c%"#e 4ene"all slopes o6n f"om left to "i4ht &eca%se1 ;a<
fo" the ini#i%al cons%me") a fall in the p"ice of the 4oo ma-es it "elati#el cheape" compa"e to othe" 4oos an 6ith his limite &%4et) e2penit%"e 6ill &e shifte to the 4oo 6hose p"ice has fallen. It is the "elati#e p"ice of the 4oo that is impo"tant. A fall in the "elati#e p"ice of a 4oo inc"eases eman fo" it. This is "efe""e to as the s%&stit%tion effect=
;&<
a fall in the 4oo>s p"ice means that people 6ith lo6e" incomes 6ill also &e a&le to affo" it. The o#e"all siGe of the ma"-et fo" the 4oo inc"eases. The con#e"se a"4%ment applies to an inc"ease in p"ices= as a p"ice 4oes %p) cons%me"s 6ith lo6e" incomes 6ill no lon4e" &e a&le to affo" the 4oo) o" 6ill &% somethin4 else 6hose p"ice is "elati#el cheape") an the siGe of the ma"-et 6ill sh"in-. This is "efe""e to as the p"ice effect.
This analsis inicates that the "elationship &et6een p"ice an 8%antit emane is an in#e"se one1 as p"ice "ises) eman falls= as p"ice falls) eman inc"eases. A eman c%"#e sho6s ho6 the 8%antit emane 6ill chan4e in "esponse to a chan4e in p"ice p"o#ie that all othe" conitions affectin4 eman a"e %nchan4e 5i.e. p"o#ie that the"e is no chan4e in the p"ices of othe" 4oos) tastes) e2pectations o" the siGe of ho%sehol income. ;This ass%mption) that all othe" #a"ia&les "emain %nchan4e as 6e e2amine chan4es in the #a"ia&le that inte"ests %s) is often "efe""e to & %se of the *atin ph"ase cete"is pa"i&%s 5othe" thin4s &ein4 e8%al.< Su#stitutes and !omplements
A chan4e in the p"ice of one 4oo 6ill not necessa"il chan4e the eman fo" anothe" 4oo. Fo" e2ample) 6e 6o%l not e2pect an inc"ease in the p"ice cocoa to affect the eman fo" moto" ca"s. Ho6e#e") the"e a"e 4oos fo" 6hich the ma"-et eman is in some 6a inte"5 connecte. These inte"5 "elate 4oos a"e "efe""e to as eithe" s%&stit%tes o" complements. ;a<
S%&stit%te 4oos a"e 4oos that a"e alte"nati#es to each othe") so that an inc"ease in the eman fo" one is li-el to ca%se a ec"ease in the eman fo" anothe". S6itchin4 eman f"om one 4oo to anothe" >"i#al> 4oo is s%&stit%tion. E2amples of s%&stit%te 4oos a"e1 ;i< ;ii< ;iii< ;i#<
"i#al &"ans of the same commoit) e.4. Coca5Cola an Pepsi5Cola= tea an coffee= &%s "ies an ca" "ies= iffe"ent fo"ms of ente"tainment.
S%&stit%tion ta-es place 6hen the p"ice of one 4oo "ises o" falls "elati#e to a s%&stit%te 4oo. ;&<
Complements a"e 4oos that ten to &e &o%4ht an %se to4ethe") so that an inc"ease in the eman fo" one is li-el to ca%se an inc"ease in the eman fo" the othe". E2amples of complements a"e1 ;i< ;ii< ;iii<
c%ps an sa%ce"s= &"ea an &%tte"= moto" ca"s an moto" spa"es.
Demand and household in!ome
The amo%nt of income that a ho%sehol ea"ns 6ill affect the eman fo" a 4oo. As o% mi4ht ima4ine) mo"e income 6ill 4i#e ho%sehols mo"e to spen) an the 6ill 6ant to &% mo"e 4oos at e2istin4 p"ices. Ho6e#e") a "ise in ho%sehol income 6ill not inc"ease ma"-et eman fo" all 4oos an se"#ices. The effect of a "ise in income on eman fo" an ini#i%al 4oo 6ill epen on the nat%"e of the 4oo. Deman an the le#el of inc"ease ma &e "elate in iffe"ent 6as ;see Fi4%"e /<. ;a<
A "ise in ho%sehol income ma inc"eases eman fo" a 4oo. This is 6hat 6e mi4ht no"mall e2pect to happen) an 4oos fo" 6hich eman "ises as ho%sehol income 4ets &i44e" a"e calle no"mal 4oos.
;&<
Deman ma "ise 6ith income %p to a ce"tain point &%t then falls as income "ises &eon that point. @oos 6hose eman e#ent%all falls as income "ises a"e calle infe"io" 4oos) e.4. t"ipe) cheap 6ine. The "eason fo" fallin4 eman is that as incomes "ise) eman s6itches to s%pe"io" p"o%cts e.4. &eef instea of t"ipe) &ette" 8%alit 6ines instea of a cheape" #a"iet.
Deman 8%antit
Deman 8%antit
No"mal 4oo
Infe"io" 4oo
Income
Income
The "esponse of eman fo" a 4oo to a chan4e in the cons%me">s income is inicate & the income elasticit of eman. This 6ill &e isc%sse f%"the" in the ne2t chapte". Tastes' "ashion and e$pe!tations
A chan4e in fashion 6ill alte" the eman fo" a p"o%ct. Fo" e2ample) if it &ecomes fashiona&le fo" mile class ho%sehols in the U: to "in- 6ine 6ith thei" meals) e2penit%"e on 6ine 6ill inc"ease. The"e ma &e passin4 >c"aGes>) s%ch as "olle" s-ates o" s-ate&oa"s. If cons%me"s &elie#e that p"ices 6ill "ise) o" that sho"ta4es 6ill occ%". the ma attempt to stoc- %p on the p"o%ct) the"e& c"eatin4 e2cess eman in the sho"t te"m 6hich 6ill inc"ease p"ices. This can then lea to panic &%in4. E2amples incl%e fea" of 6a") the &%4et) the effect of st"i-es o" a "%mo%".
Ma,et demand and the disti#ution o" national in!ome Ma"-et eman fo" a 4oo is infl%ence & the 6a in 6hich the national income is sha"e &et6een ho%sehols. Consie" the follo6in4 patte"ns of income ist"i&%tion1
*o6
Mile
Hi4h
*o6
Mile
Hi4h
In Fi4%"e !;a<) 6hich has man "ich an poo" ho%sehols an fe6 mile income ones) the"e sho%l &e a la"4e eman fo" l%2%" ca"s an achts an also fo" staple foos s%ch as &"ea an potatoes. In case ;&<) the"e sho%l &e hi4h eman fo" mei%m5siGe ca"s an T sets) an othe" >mile income> 4oos. To s%mma"ise) the ma"-et eman c%"#e "elates the total 8%antit of a commoit emane to its o6n p"ice) on the ass%mption that all othe" p"ices) ho%sehol ho%sehol incomes) the ist"i&%tion of total income amon4 ho%sehols) assets an e2pectations an othe" facto"s a"e hel constant. Chan%es in demand
If the p"ice of a 4oo 4oes %p o" o6n) 4i#en no chan4es in the othe" facto"s that i"ectl affect p"ice) then the"e 6ill &e a shift in the B%antit emane alon4 the eman c%"#e. hen the"e is a chan4e in othe" facto"s that affect eman) the "elationship &et6een eman 8%antit an p"ice 6ill also chan4e) an the"e 6ill &e a iffe"ent p"ice8%antit eman sche%le an so a iffe"ent eman c%"#e. e "efe" to these chan4es as a shift of the eman c%"#e. This is an impo"tant istinction) 6hich &ea"s "epetition in a sli4htl iffe"ent fo"m to consoliate o%" %ne"stanin4 of it. ;a<
Mo#e Mo #eme ment ntss alo alon4 n4 a ema eman n c%" c%"#e #e fo" fo" a 4oo 4oo a"e a"e ca% ca%se se & chan chan4e 4ess in its its p"i p"ice ce
;&<
Shifts in the eman c%"#e fo" a 4oo a"e ca%se & an of the othe" facto"s 6hich affect eman fo" a 4oo) othe" than its p"ice.
Shi"ts o" the demand !uve
P
P
7
D
D
D
D
(
7
9
A
Fi4%"e ;a< epicts a "ise in eman at each p"ice le#el) 6ith the eman c%"#e shiftin4 to the "i4ht) f"om D7 to D+. Fo" e2ample) at p"ice P + ) eman fo" the 4oo 6o%l "ise f "om to (. (. This shift co%l &e ca%se & an of the follo6in41 ;a<
a "ise in ho%sehol income=
;&<
a "ise in the p"ice of s%&stit%tes=
;c<
a fall in the p"ice of complements=
;<
a chan4e in tastes to6a"s this p"o%ct=
;e<
an e2pecte "ise in the p"ice of the p"o%ct. If the p"ice "ise late" fails to occ%") the shift in eman 6o%l &e tempo"a". If the p"ice "ise oes occ%") the eman c%"#e 6o%l "e#e"t to its p"e#io%s position) &%t fe6e" 4oos 6o%l no6 &e emane emane &eca%se the p"ice is no6 hi4he". hi4he".
Fi4%"e ;&< epicts a fall in eman at each p"ice le#el 6hich is "ep"esente & a shiftin4 to the left of the eman c%"#e) f"om >ol> c%"#e D 7 to >ne6> c%"#e D +.This shift ma &e ca%se & the opposite of the chan4es esc"i&e in the p"e#io%s pa"a4"aph Fo" e2ample) at p"ice P, the eman 6ill fall f"om A to 9. To s%mma"ise1 ;a<
a shift of the eman c%"#e to the "i4ht po"t"as an inc"ease in the 8%antit emane at an 4i#en p"ice le#el=
;&<
a shift of the c%"#e to the left po"t"as a "e%ction in the B%antit emane at an 4i#en p"ice le#el.
Supply The !on!ept o" supply
S%ppl "efe"s to the 8%antit of a 4oo that e2istin4 s%pplie"s o" 6o%l5&e s%pplie"s 6o%l 6ant to p"o%ce fo" the ma"-et at a 4i#en p"ice. In this conte2t) an an %s%all in economics) the te"m >4oo> incl%es se"#ices as 6ell as tan4i&le p"o%cts. The 8%antit of a 4oo that can &e s%pplie to a ma"-et #a"ies %p o" o6n) eithe" &eca%se1 ;a<
e2istin4 s%pplie"s inc"ease o" "e%ce thei" o%tp%t 8%antities) o"
;&<
fi"ms fi"ms sstop top p"o%c p"o%cin4 in4 alto4et alto4ethe" he" an lea#e lea#e the the ma"-et ma"-et)) o" ne6 fi"ms fi"ms ente ente"" the the ma"-e ma"-ett an an &e4in &e4in p"o%cin4 the 4oo.
If the B%antit that fi"ms 6ant to p"o%ce at a 4i#en p"ice e2cees the B%antit that p%"chase"s 6o%l eman) the"e 6o%l &e an e2cess of s%ppl) 6ith fi"ms competin4 to 6in 6hat sales eman the"e is. O#e"5s%ppl an competition 6o%l then &e e2pecte to "es%lt in p"ice5competiti#eness an a fall in p"ices. As 6ith eman) s%ppl "elates to a pe"io of time 5e.4. an ann%al "ate of s%ppl 8%antities o" a monthl "ate. As 6ith eman) a istinction sho%l &e mae &et6een1 ;a<
ma"-et ma"-et s%p s%ppl pl)) 6hich 6hich is the total total B%an B%antit tit of the the 4oo 4oo that that all all fi"ms fi"ms in the the ma"ma"-et et 6o%l 6o%l 6ant 6ant to s%ppl at a 4i#en p"ice= an
;&<
an ini#i%al fi"m>s s%ppl sche%le 6hich is the 8%antit of the 4oo that the ini#i%al fi"m 6o%l 6ant to s%ppl to the ma"-et at an 4i#en p"ice.
Fa!tos (hi!h in"luen!e the supply &uantity
The 8%antit s%pplie of a 4oo epens on1 ;a<
the p"ice o&taina&le fo" the 4oo=
;&<
the p"ices of othe" 4oos. An inc"ease in the p"ice of othe" 4oos 6o%l ma-e the s%ppl of a 4oo 6hose p"ice oes not "ise less att"acti#e to s%pplie"s=
;c<
the cost of ma-in4 the 4oo) 6hich in t%"n epens on the p"ices of facto"s of p"o%ction 5ie 6a4es) inte"est "ates) lan "ents an p"ofit e2pectations. A "ise in the p"ice of one facto" of p"o%ction ;sa la&o%"<) 6ill ca%se p"o%ce"s to shift a6a f"om s%pplin4 s%pplin4 4oos 6hose costs an p"ofits a"e closel "elate to the p"ice of la&o%") to6a"s the s%ppl of 4oos 6he"e the cost of la&o%" is less si4nificant=
;<
chan4es in technolo4. technolo4. Technolo4ical Technolo4ical e#elopments 6hich "e%ce costs of p"o%ction ;an inc"ease p"o%cti#it< 6ill "aise the 8%antit of s%ppl of a 4oo=
;e<
chan4es in the 6eathe" ma affect the a#aila&ilit of s%ppl ;e.4. a4"ic%lt%"al 4oos<.
The facto"s that affect s%ppl can &e s%mma"ise &"iefl as p"ices an costs) an so p"ofits. In this chapte") o%" main inte"est is 6ith the infl%ence of p"ice on s%ppl an eman. The infl%ence of cost on o%tp%t ecisions & fi"ms) an so on s%ppl to the ma"-et) 6ill &e isc%sse mo"e f%ll in a late" chapte".
Supply and the pi!e o" a %ood
In 4ene"al) s%pplie"s 6ill 6ant to s%ppl a 4"eate" 8%antit of thei" o%tp%t at hi4he" p"ices. Fo" e2ample) if the p"ice of p"o%ct is L! pe" %nit) a s%pplie" mi4ht &e 6illin4 to s%ppl +)777 %nits of the p"o%ct to cons%me"s in the ma"-et at that p"ice. If the p"ice of p"o%ct no6 4oes %p to L+7) the s%pplie" 6ill &e 6illin4 to s%ppl mo"e than +)777 %nits of the p"o%ct. Q%st ho6 man mo"e than +)777 he 6o%l 6ant to s%ppl 6o%l epen on ci"c%mstances. h 6o%l a s%pplie" &e 6illin4 to s%ppl mo"e o%tp%t at a hi4he" p"ice It mi4ht seem lo4ical to s%ppose that hi4he" p"ices sho%l mean hi4he" p"ofits) an so the fi"m 6o%l &e att"acte & the p"ospect of &i44e" p"ofits into s%pplin4 mo"e %nits of o%tp%t. This is not the f%ll ans6e") tho%4h. e m%st also as- 6h) in o%" e2ample) the s%pplie" 6as onl 6illin4 to s%ppl +)777 %nits of p"o%ct at a p"ice of L!. The ans6e" m%st p"es%ma&l &e that it 6o%l not &e 6o"th6hile) an that the %nit cost of ma-in4 e2t"a o%tp%t 6o%l e2cee the sales p"ice of L! pe" %nit. This mi4ht &e) fo" e2ample) &eca%se the s%pplie">s capacit is al"ea f%ll e2tene) an the costs of inc"easin4 capacit ;anthin4 f"om o#e"time p"emi%ms to the cost of a ne6 facto"< 6o%l not &e co#e"e & the L! pe" %nit sales p"ice. At a hi4he" sellin4 p"ice pe" %nit) the o%tp%t limit 6he"e %nit costs &e4in to e2cee %nit p"ices 6ill &e at a hi4he" le#el) an so the s%pplie" 6o%l no6 &e 6illin4 to p"o%ce mo"e at the ne6 hi4he" p"ice. The supply !uve
A s%ppl sche%le an s%ppl c%"#e can &e "a6n1 ;a<
fo" an ini#i%al s%pplie"= o"
;&<
fo" all fi"ms 6hich p"o%ce the 4oo. ma"-et s%ppl c%"#e. This total s%ppl c%"#e of all s%pplie"s is the
E$ample
S%ppose that the s%ppl sche%le fo" p"o%ct is as follo6s. Price per unit
+77 +!7 377 !77
Quantity that suppliers would supply at this price Units +7)777 ,7)777 37)777 /7)777
A s%ppl c%"#e is const"%cte in a simila" manne" to a eman c%"#e ;f"om a sche%le of s%ppl 8%antities at iffe"ent p"ices< &%t sho6s the 8%antit s%pplie"s a"e 6illin4 to p"o%ce at iffe"ent p"ice le#els. It is an %p6a"5slopin4 c%"#e f"om left to "i4ht) &eca%se 4"eate" 8%antities 6ill &e p"o%ce at hi4he" p"ices. Cont"ast the in#e"se "elationship &et6een p"ice an B%antit emane 6hich 6e e2amine in o%" analsis of eman. In the case of s%ppl) the "elationship &et6een p"ice an B%antit s%pplie is positi#e1 as p"ice "ises) so too oes the B%antit that p"o%ce"s a"e 6illin4 to s%ppl. The "elationship &et6een o%tp%t an p"ice) %sin4 the ata in o%" e2ample) is sho6n as a s%ppl c%"#e in Fi4%"e 0.
S
!77
377
+!7 +77
7
+7)777
,7)777
37)777
/7)777
A s%ppl c%"#e sho6s ho6 the 8%antit s%pplie 6ill chan4e in "esponse to a chan4e in p"ice) p"o#ie that all othe" conitions affectin4 s%ppl "emain %nchan4e ;cete"is pa"i&%s<. If s%ppl conitions ;the p"ice of othe" 4oos) o" costs of facto"s of p"o%ction) o" chan4es in technolo4< alte") a iffe"ent s%ppl c%"#e m%st &e "a6n. In othe" 6o"s) a chan4e in p"ice 6ill ca%se a shift in s%ppl alon4 the s%ppl c%"#e. A chan4e in othe" s%ppl conitions 6ill ca%se a shift in the s%ppl c%"#e itself. This co""espons to the impo"tant point mae ea"lie" a&o%t eman c%"#es) an a4ain &ea"s "epetition. ;a<
Mo#ements alon4 a s%ppl c%"#e "ep"esent chan4es in the total 8%antit of a 4oo that s%pplie"s 6o%l 6ant to s%ppl 6hen the"e is a chan4e in the p"ice of the 4oo.
;&<
Shifts of the s%ppl c%"#e "ep"esent chan4es in the total 8%antit of a 4oo that s%pplie"s 6o%l 6ant to s%ppl at all p"ices) &eca%se of a chan4e in the cost of s%ppl 5e4 technolo4ical p"o4"ess) o" a chan4e in the p"ice of othe" 4oos.
Shi"ts o" the ma,et supply !uve
The ma"-et s%ppl c%"#e is the a44"e4ate of the s%ppl c%"#es of ini#i%al fi"ms in the ma"-et. A shift of the ma"-et s%ppl c%"#e occ%"s 6hen s%ppl conitions 5i.e. facto"s infl%encin4 s%ppl) othe" than the p"ice of the 4oo itself 5alte" ;e.4. the p"ice of facto"s of p"o%ction) the p"ices of othe" 4oos) technolo4 etc<. Fi4%"e $ sho6s a shift in the s%ppl c%"#e f"om S 7 to S+. A "i4ht6a"s shift of the c%"#e sho6s on e2pansion of s%ppl an ma &e ca%se &1 ;a<
a fall in the cost of facto"s of p"o%ction=
;&<
a fall in the p"ice of othe" 4oos. The p"o%ction of othe" 4oos &ecomes "elati#el less att"acti#e as thei" p"ice falls. e the"efo"e e2pect that ;cete"is pa"i&%s< the s%ppl of one 4oo 6ill "ise as the p"ices of othe" 4oos fall ;an #ice #e"sa<=
;c<
technolo4ical p"o4"ess 56hich "e%ces %nit costs an also inc"eases p"o%ction capa&ilities.
In effect) a shift of the s%ppl c%"#e is the "es%lt of chan4es in costs) eithe" in a&sol%te te"ms o" "elati#e to the costs of othe" 4oos.
S7 S+
P+
7
B7
B+
If the p"ice of the 4oo is P + ;Fi4%"e $<) s%pplie"s 6o%l &e 6illin4 to inc"ease s%ppl f"om B 7 to B+ %ne" the ne6 s%ppl conitions. Note that 6e nee to istin4%ish &et6een sho"t "%n an lon4 "%n "esponses of &oth s%ppl an eman. In the sho"t "%n &oth s%ppl an eman a"e "elati#el %n"esponsi#e to chan4es in p"ice) as compa"e to the lon4 "%n. In the case of s%ppl) chan4es in the 8%antit of a 4oo s%pplie often "e8%i"e the lain4 off o" hi"in4 of ne6 6o"-e"s) o" the installation of ne6 machine". All of these chan4es) &"o%4ht a&o%t & mana4ement ecisions) m%st ta-e some time to implement. In the case of eman) it ta-es time fo" cons%me"s to a?%st thei" &%in4 patte"ns) altho%4h eman 6ill often "espon mo"e "apil than s%ppl to chan4es in p"ice o" othe" eman conitions. In some ma"-ets) s%ch as the ma"-et fo" chocolate &a"s) "esponses to chan4es in p"ice a"e "elati#el "api. In othe"s) s%ch as the ma"-et fo" milita" ai"c"aft) "esponse times a"e m%ch lon4e".
The price mechanism If eman fo" a 4oo e2cees s%ppl) cons%me"s m%st eithe" stop emanin4 6hat the cannot ha#e) o" the m%st &e p"epa"e to pa mo"e fo" the 4oo. At a hi4he" p"ice) fi"ms 6ill &e p"epa"e to s%ppl mo"e of the 4oo. On the othe" han) if the p"ice of a 4oo is s%ch that fi"ms 6ant to s%ppl mo"e than cons%me"s a"e 6illin4 to &%) p"o%ction m%st &e c%t &ac- in #ol%me o" the p"ice m%st &e "e%ce so as to stim%late eman. The e&uili#ium pi!e
The p"ice mechanism &"in4s eman an s%ppl into e8%ili&"i%m an the e8%ili&"i%m p"ice fo" a 4oo is the p"ice at 6hich the #ol%me emane & cons%me"s an the #ol%me that fi"ms 6o%l &e 6illin4 to s%ppl a"e the same.
S%ppl
A P+ 9
P
P7 C
7
D
Deman
B
At p"ice P+ the"e is an e2cess of the 8%antit that s%pplie"s 6ant to p"o%ce o#e" the 8%antit emane at that p"ice) e8%al to the istance A9. The "eaction of s%pplie"s as %nsol stoc-s acc%m%late 6o%l &e to1 ;a<
c%t o6n the c%""ent le#el of p"o%ction in o"e" to isacc%m%late %n6ante stoc-s ;i.e. e5 stoc-<= ano"
;&<
"e%ce p"ices in o"e" to enco%"a4e sales.
The opposite 6ill happen at p"ice p o 6he"e the"e is an e2cess of eman o#e" s%ppl sho6n & the istance CD. O%tp%t an p"ice 6o%l inc"ease. At p"ice p the amo%nt that selle"s a"e 6illin4 to s%ppl is e8%al to the amo%nt that c%stome"s a"e 6illin4 to &%. The"e 6ill &e no %n%s%al #a"iation in stoc-s an) %nless somethin4 else chan4es) the"e 6ill &e no chan4e in p"ice. p is the e8%ili&"i%m p"ice. At the e8%ili&"i%m p"ice P) cons%me"s 6ill &e 6illin4 to spen a total of P 2 B 5i.e. PB 5 on &%in4 B %nits of the p"o%ct) an s%pplie"s 6ill &e 6illin4 to s%ppl B %nits to ea"n "e#en%e of P 2 B. The fo"ces of s%ppl an eman p%sh a ma"-et to its e8%ili&"i%m p"ice an 8%antit.
;a<
If the"e is no chan4e in conitions of s%ppl o" eman) the e8%ili&"i%m p"ice 6ill "%le the ma"-et an 6ill "emain sta&le.
;&<
If the e8%ili&"i%m p"ice oes not "%le) the ma"-et is in ise8%ili&"i%m) &%t s%ppl an eman 6ill p%sh p"ices to6a"s the e8%ili&"i%m p"ice.
;c<
Shifts in the s%ppl c%"#e o" eman c%"#e 6ill chan4e the e8%ili&"i%m p"ice an 8%antit.
The >la6> of s%ppl an eman is that in a f"ee ma"-et) the e8%ili&"i%m p"ice an o%tp%t le#el of a 4oo is the p"ice an o%tp%t le#el at 6hich the ma"-et eman c%"#e an the ma"-et s%ppl c%"#e inte"sect. In a f"ee ma"-et) p"ice acts as a mechanism 6hich si4nals eman an s%ppl conitions to p"o%ce"s an cons%me"s. It the"efo"e ete"mines the acti#ities of &oth p"o%ce"s an cons%me"s) infl%encin4 the le#els of eman fo" an the s%ppl of 4oos. >The p"ice sstem 6as not conscio%sl c"eate. It oes not "e8%i"e that anone conscio%sl fo"esee an co5o"inate the necessa" chan4es= a?%stments occ%" a%tomaticall as a "es%lt of the sepa"ate ecisions ta-en & a la"4e n%m&e" of ini#i%als) all see-in4 thei" o6n &est inte"est.> ; R G Lipsey<
Elasti!ity O" Demand And Supply Your objectives
Afte" completin4 this chapte" o% sho%l1 ;a<
%ne"stan the concept of elasticit in "elation to &oth s%ppl an eman=
;&<
&e a6a"e of some of the facto"s that infl%ence elasticit of s%ppl an eman in the cases of pa"tic%la" p"o%cts.
Price elasticity of demand The !on!ept o" elasti!ity
So fa" 6e ha#e isc%sse the i"ection of chan4es in eman an s%ppl 6hen p"ices chan4e. hen p"ice 4oes %p) the 8%antit emane 6ill fall) an the 8%antit s%pplie"s 6ill &e 6illin4 to p"o%ce 6ill 4o %p. 9%t 6e ha#e not et consie"e the e2tent of these chan4es. Fo" e2ample) if p"ices 6ent %p & +7) 6o%l the 8%antit emane fall & !) ,7) !7 o" 6hat An 6o%l the 8%antities that s%pplie"s 6o%l 6ant to p"o%ce 4o %p & !) +7) +! o" 6hat The e2tent of these chan4es is meas%"e & the p"ice elasticit of eman an the elasticit of s%ppl. e ha#e also isc%sse shifts in the eman c%"#e %e to chan4es in the p"ice of s%&stit%tes an complements an chan4es in ho%sehol income) &%t a4ain 6e ha#e not et consie"e the e2tent of the shifts in eman a"isin4 f"om shifts in the eman c%"#e. The e2tent of these chan4es is meas%"e &1 ;a< the c"oss elasticit of eman) in the case of s%&stit%tes an complements= ;&< the income elasticit of eman. in the case of ho%sehol income. The pi!e elasti!ity o" demand
P"ice elasticit of eman ;often enote & the @"ee- sm&ol ) p"ono%nce >eeta>< is a meas%"e of the e2tent of chan4e in ma"-et eman fo" a 4oo in "esponse to a chan4e in its p"ice. It is meas%"e as1
chan4e in B%antit emane) as a pe"centa4e of eman chan4e in p"ice) as a pe"centa4e of the p"ice
Since the eman 4oes %p 6hen the p"ice falls) an 4oes o6n 6hen the p"ice "ises) the elasticit has a ne4ati#e #al%e) &%t it is %s%al to i4no"e the min%s si4n. Elasti! and inelasti! demand
As mentione al"ea) the elasticit of eman 6ill 4 ene"all ha#e a ne4ati#e #al%e since eman c%"#es a"e no"mall o6n6a" slopin4. Ho6e#e") since the min%s si4n is often i4no"e) an elasticit of 5+ is %s%all "efe""e to as elasticit of l) o" %nit. The #al%e of eman elasticit ma &e anthin4 f"om Ge"o to infinit. Deman is1 ;a< inelastic if the a&sol%te #al%e is less than I= an ;&< elastic if the a&sol%te #al%e is 4"eate" than I. he"e eman is inelastic) the B%antit emane falls & a smalle" pe"centa4e than p"ice) an 6he"e eman is elastic) eman falls & a la"4e" pe"centa4e than the pe"centa4e "ise in p"ice.
Pi!e elasti!ity and the slope o" the demand !uve
@ene"all) eman c%"#es slope o6n6a"s. Cons%me"s a"e 6illin4 to &% mo"e at lo6e" p"ices than at hi4he" p"ices. E2cept in ce"tain cases ;6hich a"e "efe""e to late"<) elasticit 6ill #a" in #al%e alon4 the len4th of a eman c%"#e. At >hi4h> p"ices ;the top of the eman c%"#e<) small pe"centa4e p"ice "e%ctions can &"in4 la"4e pe"centa4e inc"eases in 8%antit emane. This means that eman is elastic o#e" these "an4es) an p"ice "e%ctions &"in4 inc"eases in total e2penit%"e & cons%me"s on the commoit in 8%estion. At >lo6e"> p"ices ;the &ottom of the eman c%"#e <) la"4e pe"centa4e p"ice "e%ctions can &"in4 small pe"centa4e inc"eases in 8%antit. This means that eman is inelastic o#e" these p"ice "an4es) an p"ice inc"eases "es%lt in inc"eases in total e2penit%"e. Elasticit is "a"el the same at all p"ice le#els. Fo" e2ample) the p"ice elasticit of eman fo" a 4oo mi4ht &e elastic ;4"eate" than +< at some p"ices an inelastic ;less than +< at othe" p"ices. It is not possi&le me"el & loo-in4 at the slopes of an t6o c%"#es to state thei" compa"ati#e elasticits o#e" othe") iffe"ent p"ice "an4es) e#en if the"e is the same a&sol%te fall in p"ice. This is &eca%se the elasticit of a eman c%"#e is not constant o#e" the enti"e c%"#e. Ho6e#e") it is possi&le to sa that if a eman c%"#e &ecomes steepe" o#e" a pa"tic%la" "an4e of 8%antit) then eman is &ecomin4 mo"e inelastic. Con#e"sel) a shallo6e" eman c%"#e o#e" a pa"tic%la" "an4e inicates mo"e elastic eman. This is ill%st"ate in Fi4%"e + ;a< an + ;&< &elo6.
P
D Relati#el small "ice chan e
D
B Relati#el la"4e p"ice in 8%antit emane
P D
Relati#el la"4e p"ice chan4e
D B Relati#el small p"ice in 8%antit emane
Spe!ial values o" pi!e elasti!ity
The"e a"e th"ee special #al%es of p"ice elasticit of eman= 7) + an infinit. 7. Deman is pe"fectl inelastic ;Fi4%"e ,;a<. The eman c%"#e is a #e"tical st"ai4ht line an the"e is no chan4e in 8%antit emane) "e4a"less of the chan4e in p"ice. A close e2ample to this in "eal life is the eman fo" ta&le salt 6hich 6ill &e la"4el %naffecte & p"ice chan4es= 6e 6o%l not e2pect people to eman mo"e salt if the p"ice hal#e no" less salt if the p"ice o%&le.
P"ice D
D
B%antit
Unit elasticit of eman1 + ;Fi4%"e ,;&<. The eman c%"#e of a 4oo 6hose elasticit is lo#e" its enti"e "an4e is a "ectan4%la" hpe"&ola.
P"ice D
E
9 A The si4nificance of this is that the "ectan4les OA9C) ODEF) O@HQ in Fi4%"e ,;&< all ha#e the same a"ea. The a"ea in each case is calc%late & m%ltiplin4 the %nit p"ice & the 8%antit sol1 in othe" H 6o"s) it "ep"esents @ the total amo%nt of e2penit%"e on the p"o%ct 6hich) in the case of a p"o%ct 6ith %nit elasticit of eman at all p"ice le#els) is the same at all p"ice le#els. Pe"fectl elastic eman1 ;infinitel elastic< ;Fi4%"e ,;c<<. The eman c%"#e is a ho"iGontal st"ai4ht line. Cons%me"s 6ill 6ant to &% an infinite amo%nt) &%t onl %p to p"ice le#el P 7. An p"ice Q B%antit C F 7 inc"ease a&o#e this le#el 6ill "e%ce eman to Ge"o.
P"ice
P7
D
B%antit
The "an4es of p"ice elasticit at iffe"ent points on a o6n6a"5slopin4 st"ai4ht line eman c%"#e a"e ill%st"ate in Fi4%"e 3.
P"ice P
V+
7.!P
+
+
7
7.!B
7 B%antit
9 st%in4 Fi4%"e 3 o% ma &e a&le to see the ?%stification fo" the follo6in4 impo"tant "%les. ;a<
Fo" a commoit 6hose p"ice elasticit is 4"eate" than one o#e" the "an4e of the p"ice chan4e1 ;i< ;ii<
;&<
a "e%ction in p"ice p"o%ces an inc"ease in total e2penit%"e on the commoit= a "ise in p"ice p"o%ces a "e%ction in total e2penit%"e on the commoit. Fo" a 4oo 6hose p"ice elasticit is less than
;i< ;ii<
a "e%ction in p"ice p"o%ces a "e%ction in total e2penit%"e on the commoit= an inc"ease in p"ice p"o%ces an inc"ease in total e2penit%"e on the commoit.
9%siness people can ma-e %se of info"mation on ho6 cons%me"s 6ill "eact to p"icin4 ecisions) not least &eca%se of the effect of this on p"ofits. @o#e"nment polic ma-e"s can %se info"mation a&o%t elasticit 6hen ma-in4 ecisions a&o%t ini"ect ta2ation. Items 6ith a lo6 p"ice elasticit of eman) s%ch as ci4a"ettes an alcohol) ten to &e ta"4ets fo" hi4h ta2ation since & inc"easin4 ta2es on these) total "e#en%e can &e inc"ease. If ci4a"ettes 6e"e p"ice elastic) inc"eases in ta2ation 6o%l &e co%nte"5 p"o%cti#e as the 6o%l "es%lt in lo6e" 4o#e"nment "e#en%e.
Fa!tos in"luen!in% pi!e elasti!ity o" demand "o a %ood
Facto"s that ete"mine p"ice elasticit of eman a"e simila" to the facto"s othe" than p"ice that affect the #ol%me of eman. Elasticit is "eall a meas%"e of the st"en4th of these othe" facto"s on eman. The main facto"s affectin4 p"ice elasticit of eman a"e1 ;a<
the a#aila&ilit of s%&stit%tes=
;&<
the time ho"iGon=
;c<
the p"icin4 policies of competito"s.
The availability of close substitutes . The mo"e s%&stit%te 4oos the"e a"e) especiall close s%&stit%tes) the mo"e elastic 6ill &e the p"ice elasticit of eman fo" a 4oo. Fo" e2ample) in a 4"een4"oce">s shop) a "ise in the p"ice of one #e4eta&le s%ch as ca""ots o" c%c%m&e"s is li-el to "es%lt in a s6itch of c%stome" eman to othe" #e4eta&les) man #e4eta&les &ein4 fai"l close s%&stit%tes fo" each othe". A4ain the elasticit of eman fo" a pa"tic%la" &"an of &"ea-fast ce"eals is m%ch 4"eate" than the elasticit of eman fo" &"ea-fast ce"eals as a 6hole) &eca%se the fo"me" ha#e m%ch close" s%&stit%tes. This facto" is p"o&a&l the most impo"tant infl%ence on p"ice elasticit of eman. The time period . O#e" time) cons%me"s> eman patte"ns a"e li-el to chan4e. If the p"ice of a 4oo is inc"ease) the initial "esponse mi4ht &e #e" little chan4e in eman ;inelastic eman< &%t then as cons%me"s a?%st thei" &%in4 ha&its in "esponse to the p"ice inc"ease) eman mi4ht fall s%&stantiall. The time ho"iGon infl%ences elasticit la"4el &eca%se the lon4e" the pe"io of time 6hich 6e consie") the 4"eate" the -no6le4e of s%&stit%tion possi&ilities & cons%me"s an the p"o#ision of s%&stit%tes & p"o%ce"s. Competitors' policies . If the "esponse of competito"s to a p"ice inc"ease & one fi"m is to -eep thei" p"ices %nchan4e) the fi"m "aisin4 its p"ices is li-el to face elastic eman fo" its 4oos at hi4he" p"ices. If the "esponse of competito"s to a "e%ction in p"ice & one fi"m is to match the p"ice "e%ction themsel#es) the fi"m is li-el to face inelastic eman at lo6e" p"ices. This is a sit%ation 6hich p"o&a&l faces man la"4e fi"ms 6ith one o" t6o ma?o" competito"s ;i.e. oli4opolies<. Other factors influencing elasticity of demand . @ene"all spea-in4) the hi4he" p"opo"tion of a cons%me">s income that a commoit ta-es %p) the 4"eate" 6ill &e the elasticit of eman. Th%s moto" #ehicle eman can &e e2pecte to &e mo"e "esponsi#e to a +7 p"ice chan4e than) sa) the eman fo" posta4e stamps o" fo" mil-.
Other elasticities of demand In!ome elasti!ity o" demand
The income elasticit of eman fo" a 4oo inicates the "esponsi#eness of eman to chan4es in ho%sehol incomes. It is meas%"e as1 chan4e in 8%antit emane) as a pe"centa4e of eman chan4e in ho%sehol income) as a pe"centa4e of ho%sehol income ;a< A 4oo is income elastic if income elasticit is 4"eate" than I so that 8%antit emane "ises & a la"4e" pe"centa4e than the "ise in income. Fo" e2ample) if the eman fo" compact iscs 6ill "ise & +7 if ho%sehol income "ises & 0) 6e 6o%l sa that compact iscs a"e income elastic. ;&< A 4oo is income inelastic if income elasticit is &et6een 7 an + an the 8%antit emane "ises less than the p"opo"tionate inc"ease in income. Fo" e2ample) if the eman fo" &oo-s 6ill "ise & if ho%sehol income "ises & +7) 6e 6o%l sa that &oo-s a"e income inelastic. 9oth of these cate4o"ies a"e sai to &e no"mal 4oos) 6hich means that eman fo" them 6ill "ise 6hen ho%sehol income "ises) an so the ha#e a positi#e income elasticit of eman. If income elasticit is less than 7) income elasticit is ne4ati#e an the commoit is sai to &e an infe"io" 4oo since eman fo" it falls as income "ises. Coss elasti!ity o" demand
C"oss elasticit of eman "efe"s to the "esponsi#eness of eman fo" one 4oo to chan4es in the p"ice of anothe" 4oo. C"oss elasticit of eman
chan4e in 8%antit of 4oo A emane) as a pe"centa4e of 8%antit emaneW chan4e in the p"ice of 4oo 9) as a pe"centa4e of p"ice
W;4i#en no chan4e in the p"ice of A< ;a<
If the t6o 4oos a"e s%&stit%tes) c"oss elasticit 6ill &e 4"eate" than O an a fall in the p"ice of one 6ill "e%ce the amo%nt emane of the othe".
;&<
if the 4oos a"e complements) c"oss elasticit 6ill &e ne4ati#e an a fall in the p"ice of one 6ill "aise eman fo" the othe" .
C"oss elasticit in#ol#es a compa"ison &et6een t6o p"o%cts. C"oss elasticit is si4nificant 6he"e the t6o 4oos a"e close s%&stit%tes fo" each othe") so that a "ise in the p"ice of 9) sa) is li-el to "es%lt in an inc"ease in the eman fo" A. C"oss elasticit of eman &et6een t6o complementa" p"o%cts can also &e si4nificant &eca%se a "ise in the p"ice of 9 6o%l "es%lt in some fall in eman fo" A &eca%se of the fall in eman fo" 9. Demand elasti!ity and time Elasticit of eman fo" an 4oo 5p"ice elasticit) income elasticit an c"oss elasticit 5can an oes chan4e o#e" time. @ene"all) the"e a"e some s%&stit%tes fo" all 4oos.
Elasticity of supply The elasticit of s%ppl inicates the "esponsi#eness of s%ppl to a chan4e in p"ice It is meas%"e as1 chan4e in B%antit s%pplie) as a pe"centa4e of 8%antit s%pplie chan4e in p"ice) as a pe"centa4e of p"ice The elasticit of s%ppl 6ill #a" &et6een the th"ee ill%st"ate in Fi4%"e / ;a<) ;&< an ;c<
P"ice S
S B%antit s%pplie
he"e the s%ppl of 4oos is fi2e 6hate#e" p"ice is offe"e) e.4. in the case of anti8%es) #inta4e 6ines an lan) s%ppl is pe"fectl inelastic an the elasticit of s%ppl is 7 ;Fi4%"e /;a<<. he"e the s%ppl of 4oos #a"ies p"opo"tionatel 6ith the p"ice) elasticit of s%ppl e8%als one ;Fi4%"e /;&<<. 9oth s%ppl c%"#es in the follo6in4 ia4"am ha#e %nit elasticit &eca%se the a"e st"ai4ht line c%"#es passin4 th"o%4h the o"i4in. ;Note that a eman c%"#e 6ith %nit elasticit alon4 all of its len4th is not a line) &%t a s%ppl c%"#e 6ith %nit elasticit is a st"ai4ht line.<
P"ice
S
S
S S B%antit s%pplie he"e the p"o%ce"s 6ill s%ppl an amo%nt at a 4i#en p"ice &%t none at all at a sli4htl lo6e" p"ice) elasticit of s%ppl is infinite) o" pe"fectl elastic ;Fi4%"e /;c<<.
P"ice
S
S
B%antit s%pplie S%ppl is elastic 6hen the pe"centa4e chan4e in the amo%nt p"o%ce"s 6ant to s%ppl e2cees the pe"centa4e inc"easeec"ease in p"ice. S%ppl is inelastic 6hen the amo%nt p"o%ce"s 6ant to s%ppl chan4es & a smalle" pe"centa4e than the pe"centa4e chan4e in p"ice. Elasti!ity o" supply and time
As 6ith elasticit of eman) the elasticit of s%ppl of a p"o%ct #a"ies acco"in4 to the time pe"io o#e" 6hich it is meas%"e. Fo" analtical p%"poses) fo%" len4ths of time pe"io ma &e consie"e1 ;a<
the ma"-et pe"io 6hich is so sho"t that s%pplies of the commoit in 8%estion a"e limite to e2istin4 stoc-s. In effect) s%ppl is fi2e=
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the sho"t "%n is a pe"io lon4 eno%4h fo" s%pplies of the commoit to &e alte"e & inc"eases o" ec"eases in c%""ent o%tp%t) &%t not lon4 eno%4h fo" the fi2e e8%ipment ;ie plant) machine") etc< %se in p"o%ction to &e alte"e. This means that s%pplie"s can p"o%ce la"4e" 8%antities onl if the a"e not al"ea ope"atin4 at f%ll capacit= the can "e%ce o%tp%t fai"l 8%ic-l & means of la5offs an "e%nancies. A common 6a of "efe""in4 to this is to sa that the sho"t "%n is a pe"io %"in4 6hich at least one of the facto"s of p"o%ction is fi2e in s%ppl=
;c<
the lon4 "%n is a pe"io s%fficientl lon4 to allo6 fi"ms> fi2e e8%ipment to &e alte"e. The"e is time to &%il ne6 facto"ies an machines) an time fo" ol ones to &e close o6n. Ne6 fi"ms can ente" the in%st" in the lon4 "%n=
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the sec%la" pe"io is so lon4 that %ne"lin4 economic facto"s s%ch as pop%lation 4"o6th) s%pplies of "a6 mate"ials ;s%ch as oil< an the 4ene"al conitions of capital s%ppl ma alte". ;>Sec%la"> is e"i#e f"om the *atin 6o" >saec%la> meanin4 >cent%"ies>.< The sec%la" pe"io is i4no"e & economists e2cept in the theo" of economic 4"o6th.
These tpes of time pe"io 6e"e post%late & Alf"e Ma"shall in his P"inciples of economics ;+',7<. The p"ice elasticit of s%ppl can &e seen as a meas%"e of the "eainess 6ith 6hich an in%st" "espons to a chan4e in p"ice follo6in4 a shift in the eman c%"#e. An e2ample 6ill help to sho6 6hat this means. S%ppose that the"e is an inc"ease in the eman fo" "esta%"ant meals in a cit) sho6n & the "i4ht6a" shift in the eman c%"#e in Fi4%"e ! &elo6 f"om D + to D,. The capacit of the in%st" is limite in the sho"t "%n & the n%m&e" of "esta%"ants in ope"ation. The "esta%"ants can &e %se mo"e intensi#el to a ce"tain e2tent) an so s%ppl is not pe"fectl inelastic) &%t s%ppl is "elati#el inelastic &eca%se of the limit to this p"ocess. As a "es%lt) in the sho"t "%n the"e is a la"4e inc"ease in the p"ice f"om P + to P,.
D+
S+
D,
P3
S,
P,
P+
D+
D,
S+
B+
B,
B3
B%antit
The "ise in p"ice in the sho"t "%n 6ill enco%"a4e ent"ep"ene%"s to open ne6 "esta%"ants to ta-e a#anta4e of the p"ofits to &e ea"ne. In the lon4 "%n) s%ppl is conse8%entl mo"e elastic an is sho6n & s%ppl c%"#e S, .The e2pane o%tp%t in the in%st" leas to a ne6 e8%ili&"i%m at a lo6e" p"ice P 3 6ith the ne6 le#el of o%tp%t &ein4 B 3. Elasti!ity o" supply and the !ost o" "a!tos o" podu!tion
The cost of facto"s of p"o%ction 6ill affect the elasticit of s%ppl. If eman inc"eases) the s%pplie" mi4ht att"act mo"e facto"s of p"o%ction. If the cost of att"actin4 ne6 amo%nts of the facto" is hi4h) the s%ppl c%"#e 6ill &e mo"e inelastic than if this cost is lo6) &eca%se s%pplie"s 6ill nee a hi4he" p"ice "ise to co#e" these costs) in o"e" to ?%stif an inc"ease in s%ppl.
Ma,et Failue. E$tenalities And Intevention Your objectives
Afte" completin4 this chapte"1 ;a<
&e a6a"e of the "easons 6h f"ee ma"-ets ma not lea to an ieal allocation
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%ne"stan the concepts e2te"nalities) p%&lic 4oos an me"it 4oos
;c<
%ne"stan 6h) ho6 an fo" 6hat p%"pose a 4o#e"nment ma inte"#ene in a ma"-et in o"e" to imp"o#e the allocation of "eso%"ces
Market imperfections and market failure Intodu!tion
In this chapte") 6e shall &e conce"ne 6ith 6h a f"ee ma"-et 6o%l "es%lt in an allocation of "eso%"ces that is not optimal. If a f"ee ma"-et has ce"tain 6ea-nesses an "a6&ac-s) the 8%estion a"ises of 6hethe" the"e o%4ht to &e some "e4%lation of the ma"-ets & the a%tho"ities ;ie a mi2e econom<) in o"e" to imp"o#e the allocation of "eso%"ces. In the case fo" a f"ee ma"-et A#ocates of a f"ee ma"-et econom a"4%e that the ma"-et fo"ces of s%ppl an eman 6ill "es%lt in an efficient allocation of economic "eso%"ces. ;a<
Cons%me"s 6ill ecie 6hat the 6ant to &% & "elatin4 the p"ices of 4oos to thei" ma"4inal %tilities.
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P"o%ce"s 6ill ecie 6hat 4oos to p"o%ce) an in 6hat 8%antities) & "elatin4 thei" p"ices to the costs of p"o%ction ;an the costs of the sca"ce "eso%"ces neee to p"o%ce them<.
Ma,et "ailue
Ma"-et fail%"e "efe"s to a sit%ation in 6hich the ma"-et mechanism fails to p"o%ce the &est ;the >optimal>< allocation of "eso%"ces. Ma"-et fail%"e is ca%se & a n%m&e" of facto"s) 6hich mi4ht &e liste as1 ;a<
impe"fections in the ma"-et=
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a i#e"4ence &et6een p"i#ate costs an social costs ;e2te"nalities<=
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p%&lic 4oos=
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the nee to consie" non5ma"-et 4oals) s%ch as >social ?%stice>.
Externalities and public oods So!ial !osts and pivate !osts
In a f"ee ma"-et) s%pplie"s an ho%sehols ma-e thei" o%tp%t an &%in4 ecisions fo" thei" o6n p"i#ate &enefit) an these ecisions ete"mine ho6 the econom>s sca"ce "eso%"ces 6ill &e allocate to p"o%ction an cons%mption. P"i#ate costs an p"i#ate &enefits the"efo"e ete"mine 6hat 4oos a"e mae an &o%4ht in a f"ee ma"-et. It can &e a"4%e that a f"ee ma"-et mechanism 6o%l "es%lt in a satisfacto" allocation of "eso%"ces) p"o#ie that p"i#ate costs a"e the same as social costs) an p"i#ate &enefits a"e the same as social &enefits. hen p"i#ate &enefit is not the same as social &enefit) o" 6hen p"i#ate cost is not the same as social cost) an allocation of "eso%"ces) 6hich "eflects p"i#ate costs an &enefits onl ma not &e sociall accepta&le. P"i#ate cost meas%"es the cost to a fi"m of the "eso%"ces it %ses to p"o%ce a 4oo. ;This economic cost) as 6e shall see in a late" chapte") is the oppo"t%nit cost of the "eso%"ces %se<. Social cost meas%"es the cost to societ as a 6hole of the "eso%"ces that a fi"m %ses An e2ample 6he"e p"i#ate cost an social cost iffe" is 6he"e a fi"m p"o%ces a 4oo) an %"in4 the p"o%ction p"ocess) poll%tion is ischa"4e into the ai". The p"i#ate cost to the fi"m is the cost of the "eso%"ces neee to ma-e the 4oo. The social cost consists of the p"i#ate cost pl%s the aitional >costs> inc%""e & othe" mem&e"s of societ) 6ho s%ffe" f"om the poll%tion. P"i#ate &enefit meas%"es the &enefit o&taine i"ectl & a s%pplie" o" & a cons%me" . Social &enefit meas%"es the total &enefit o&taine) &oth i"ectl & a s%pplie" o" a cons%me") an ini"ectl) at no e2t"a cost) to othe" s%pplie"s o" cons%me"s. An e2ample 6he"e p"i#ate &enefit an social &enefit iffe" is 6he"e c%stome"s at a cafe in a piaGGa in Ital &enefit f"om the ente"tainment p"o#ie & p"ofessional m%sicians) 6ho a"e hi"e & the cafe. The c%stome"s of the cafe a"e pain4 fo" the se"#ice) in the p"ices the pa) an the o&tain a p"i#ate &enefit f"om it. At the same time) othe" people in the piaGGa) 6ho a"e not c%stome"s of the cafe) mi4ht stop an listen to the m%sic. The 6ill o&tain a &enefit) &%t at no e2t"a cost to themsel#es. The social &enefit f"om the m%sicians> se"#ice is 4"eate" than the p"i#ate &enefit to the cafe>s c%stome"s. E$tenalities An >e2te"nalit> ma &e efine as a iffe"ence &et6een the p"i#ate an the social costs) o" &enefits) a"isin4 f"om an acti#it. *ess fo"mall) an >e2te"nalit> is a cost o" &enefit 6hich the ma"-et mechanism fails to ta-e into acco%nt &eca%se the ma"-et "espons to p%"el p"i#ate si4nals.
The conse8%ence of e2te"nalities is ma"-et fail%"e to achie#e a sociall satisfacto" allocation of "eso%"ces) 6hich p"ope"l "eflects social costs an &enefits. e can %se eman an s%ppl analsis to ill%st"ate the conse8%ences of e2te"nalities. Ho6e#e") o% nee to accept that if an a#e"se e2te"nalit e2ists) so that the social cost of s%pplin4 a 4oo is 4"eate" than the p"i#ate cost to the s%pplie" fi"m) then1 ;a<
a s%ppl c%"#e 6hich "eflects total social costs 6ill &e to the left of the ;p"i#ate cost< ma"-et s%ppl c%"#e= an
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the #e"tical istance &et6een the p"i#ate cost s%ppl c%"#e an the social cost s%ppl c%"#e "ep"esents the siGe of the e2te"nalities
B L
s%ppl c%"#e "eflectin4 the
S R
P2
s%ppl c%"#e "eflectin4 the p"i#ate cost fo" the
P R
e2te"nalit
R D
(
O%tp%t
;a<
if a f"ee ma"-et e2ists) the amo%nt of the 4oo p"o%ce 6ill &e ete"mine & the inte"action of eman ;c%"#e D< an s%ppl c%"#e S. He"e) o%tp%t 6o%l &e () at p"ice P =
;&<
if social costs 6e"e ta-en into acco%nt) an the ma"-et ope"ate s%ccessf%ll) the amo%nt of the 4oo p"o%ce sho%l &e ?%st ) at p"ice P 2.
@i#en a f"ee ma"-et) o%tp%t of the 4oo 6ill e2cee 6hat it ieall sho%l &e) an so "eso%"ces 6ill ha#e &een o#e"5allocate to p"o%ction of this pa"tic%la" 4oo. Pu#li! %oods
Some 4oos) & thei" #e" nat%"e) in#ol#e so m%ch >spillo#e"> of e2te"nalities that the a"e iffic%lt to p"o#ie e2cept as p%&lic 4oos 6hose p"o%ction is o"4anise & the 4o#e"nment. In the case of s%ch 4oos) the cons%mption of the 4oo & one ini#i%al o" 4"o%p oes not si4nificantl "e%ce the amo%nt a#aila&le fo" othe"s. An if one ini#i%al ma-es %se of the 4oo) it oes not "e%ce the a#aila&ilit of the 4oo an its &enefits to othe" ini#i%als. F%"the"mo"e) it is often iffic%lt o" impossi&le to e2cl%e anone f"om its &enefits) once the 4oo has &een p"o#ie. E2amples of s%ch 4oos a"e1 ;a<
efence an the a"me fo"ces=
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the police se"#ice=
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the fi"e se"#ice=
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the Thames floo &a""ie" in En4lan) an the As6an Dam in E4pt.
Defence an policin4 a"e pe"haps the most o&#io%s e2amples of >nat%"all> p%&lic 4oos. It is not p"actica&le fo" ini#i%als to &% thei" o6n efence sstems o" policin4 a""an4ements. Meit %oods and demeit %oods
The"e a"e some tpes of 4oos 6hich) in the a&sence of inte"#ention) the ma"-et 6o%l not s%ppl at all) o" 6o%l s%ppl in inapp"op"iate 8%antities. This is &eca%se ini#i%als o not al6as "ealise 6he"e thei" &est inte"ests lie) an so mi4ht fail to p%"chase 4oos 6hich 6o%l &enefit them o") alte"nati#el) mi4ht p%"chase 4oos 6hich o not &enefit them.
A 4o#e"nment ma inte"#ene to "i the ma"-et of this pe"cei#e inefficienc. ;a<
The 4o#e"nment enco%"a4es) o" insists %pon) the p%"chase of 4oos ;me"it 4oos< 6hich it &elie#es cons%me"s sho%l &%. Fo" e2ample) if o% %se a moto"&i-e o% a"e compelle & la6 to p%"chase a helmet.
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The 4o#e"nment isco%"a4es) o" p"ohi&its) the p%"chase of 4oos ;eme"it 4oos< 6hich it &elie#es sho%l not &e &o%4ht & cons%me"s. Fo" e2ample) chil"en a"e not allo6e to p%"chase ci4a"ettes) an no&o ;othe" than meical p"actitione"s etc< is allo6e to p%"chase aicti#e "%4s.
Price reulation Ma,et "ailue and the !ase "o e%ulation o" the ma,et
Ma"-et fail%"e) "emem&e") "efe"s to the fail%"e of a f"ee ma"-et to "es%lt in an optimal allocation of "eso%"ces. The e2istence of ma"-et fail%"e an of e2te"nalities s%44ests the nee fo" "e4%lation of the ma"-et & the 4o#e"nment) in o"e" to imp"o#e the allocation of "eso%"ces. The main 6as in 6hich a 4o#e"nment mi4ht choose to "e4%late o" cont"ol ma"-ets a"e as follo6s1 ;a<
cont"ol the means of p"o%ction ;i.e. ha#e state5o6ne in%st"ies<=
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p"o#ie p%&lic 4oos=
;c<
p"o#ie some 4oos ;e.4. e%cation) health< in 4"eate" 8%antities than the"e 6o%l &e if an enti"el f"ee ma"-et ope"ate=
;<
infl%ence ma"-ets th"o%4h le4islation an "e4%lation ;e.4. "e4%lation of monopolies) &ans on an4e"o%s "%4s) enfo"cement of the %se of some 4oos s%ch as ca" seat &elts) la6s on poll%tion cont"ol) an so on<=
;e<
"e5ist"i&%te 6ealth) pe"haps & ta2in4 "elati#el 6ealth mem&e"s of societ an "e5 ist"i&%tin4 this ta2 income so as to &enefit the poo"e" mem&e"s=
;f<
infl%ence ma"-et s%ppl an eman th"o%4h1 ;i< ;ii<
;iii< ;4<
p"ice le4islation= ini"ect ta2ation 5fo" e2ample) the lo6e" ta2 on lea5f"ee pet"ol in the U: compa"e 6ith leae pet"ol is aime at enco%"a4in4 4"eate" eman fo" %nleae pet"ol so as to "e%ce en#i"onmental poll%tion= s%&siies=
inte"#ene in the ma"-et to c"eate a eman fo" o%tp%t that is la&o%"5c"eatin4. A f"ee p"ice mechanism 6ill "es%lt in a total eman fo" 4oos an se"#ices that 6o%l &e met & a matchin4 total s%ppl) &%t this total s%ppl 8%antit mi4ht &e ins%fficient to c"eate f%ll emploment 6ithin the econom. @o#e"nment mi4ht the"efo"e 6ish to inte"#ene to c"eate a eman fo" o%tp%t in o"e" to c"eate mo"e ?o&s.
Pi!e e%ulation
The 4o#e"nment mi4ht int"o%ce "e4%lations eithe"1 ;a<
to set a ma2im%m p"ice fo" a 4oo) pe"haps as pa"t of an anti5inflationa" economic polic ;e.4. a p"ices an incomes polic<= o"
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to set a minim%m p"ice fo" a 4oo. Fo" e2ample) OPEC ;the O"4anisation of Pet"ole%m E2po"tin4 Co%nt"ies< has t"ie in the past to impose minim%m p"ices fo" oil on the 6o"l ma"-ets.
Ma$imum pi!e le%islation
The 4o#e"nment ma t" to p"e#ent p"ices of 4oos "isin4 & esta&lishin4 a p"ice ceilin4. If the p"ice ceilin4 is hi4he" than the e8%ili&"i%m p"ice) settin4 a p"ice ceilin4 6ill ha#e no effect at all on the ope"ation of ma"-et fo"ces. The p"ice ceilin4 is a&o#e the e8%ili&"i%m ma"-et p"ice an is the"efo"e ineffect%al &eca%se the e8%ili&"i%m p"ice an o%tp%t is "eache & the f"ee ma"-et inte"action of s%ppl an eman. If the ma2im%m p"ice M is lo6e" than 6hat the e8%ili&"i%m p"ice 6o%l &e) the"e 6ill &e an e2cess of eman o#e" s%ppl ;Fi4%"e ,<. The lo6 p"ice att"acts c%stome"s) &%t ete"s s%pplie"s.
S
D
P"ice
He"e the p"ice ceilin4 M is &elo6 the e8%ili&"i%m p"ice P. P"o%ce"s 6ill the"efo"e "e%ce the 8%antit E8%ili&"i%m P"ice of 4oos s%pplie to the ma"-et place f"om B to A. The 8%antit emane 6ill inc"ease f"om B to 9) P o6in4 to the fall in p"ice. The e2cess 8%antit emane is the"efo"e A9. To p"e#ent Ma2im%m P"ice an %nfai" allocation of theMA %nits of the 4oo that a"e a#aila&le the 4o#e"nment mi4ht ha#e to int"o%ce "ationin4) e.4. pet"ol co%pons) o" a 6aitin4 list ;as fo" co%ncil ho%ses<. Rationin4 an &lac- ma"-etee"s ten to 4o to4ethe". In Fi4%"e , cons%me"s eman 8%antit 9 &%t can onl 4et A. 9%t fo" 8%antit A the a"e p"epa"e to pa p"ice X) 6hich is 6ell a&o#e the official p"ice M. The &lac- ma"-etee"s step in to e2ploit the 4ap. The commoit ma &e sol at the official p"ice M) &%t &lac- ma"-etee"s ma sell at p"ice X. A
B
9
B%antit
Minimum pi!e e%ulations
Minim%m p"ice le4islation o" "e4%lations aim to ens%"e that s%pplie"s ea"n a minim%m p"ice fo" each %nit of o%tp%t the sell. Minim%m p"ices a"e %se in the E%"opean Comm%nit ;EC<) an fa"me"s a"e 4%a"antee a minim%m p"ice fo" thei" o%tp%t & the a%tho"ities if the cannot 4et a hi4he" p"ice on the f"ee ma"-et. If the minim%m p"ice is set &elo6 the ma"-et e8%ili&"i%m the"e is no effect. 9%t if it is set a&o#e the ma"-et p"ice) it 6ill ca%se an e2cess s%ppl of A9 ;as in Fi4%"e 3<. This has &een a "ec%""in4 p"o&lem fo" the EC) "es%ltin4 in the so5calle >&%tte" mo%ntains> an >6ine la-es>)
P"ice
S
Minim%m P"ice If the minim%m p"ice M is set a&o#e the e8%ili&"i%m p"ice P the 8%antit emane falls f"om B to A &%t the 8%antit s%pplie inc"eases to 9. The"e is e2cess s%ppl e8%al to the 8%antit A9.
hen the"e is an e2cess of s%ppl o#e" eman) the"e is a an4e" that mo"e of the 4oo 6ill &e p"o%ce than can &e sol at the minim%m p"ice an so s%"pl%s 8%antities 6ill &%il %p) 6hich s%pplie"s mi4ht sell off at lo6 p"ices ?%st to 4et "i of them. To p"e#ent D o#e"5s%ppl an %mpin4 of e2cess s%ppl at lo6 p"ices) a sstem of 8%otas mi4ht &e int"o%ce 6he"e& each s%pplie" is allo6e to p"o%ce %p to a ma2im%m 8%antit an no mo"e.
A
B
9
B%antit
!ndirect taxes and subsidies Indie!t ta$ation
An alte"nati#e fo"m of p"ice an o%tp%t "e4%lation is ini"ect ta2ation. ;i.e. ta2ation on 4oos o" se"#ices as appose to i"ect ta2ation on incomes< An ini"ect ta2 6hich is impose on some 4oos &%t not on othe"s is calle a selecti#e ini"ect ta2. If an ini"ect ta2 is impose on one 4oo) the ta2 6ill shift the s%ppl c%"#e to the left. This is &eca%se the p"ice to cons%me"s incl%es the ta2) &%t the s%pplie"s still onl "ecei#e the net5of 5ta2 p"ice. Fo" e2ample) in Fi4%"e /1 ;a< the s%ppl c%"#e net of ta2 is So= ;&< the s%ppl c%"#e incl%in4 the cost of the ta2 is S +. So if eman is fo" + %nits) sa) the p"ice to s%pplie"s 6ill &e P , &%t the p"ice 6ith ta2 to the cons%me" 6o%l &e P+ an the ta2 6o%l &e ;P + 5P,<.
P"ice
S+ S7
A P+ itho%t the ta2) o%tp%t 6o%l &e 7 an p"ice P 7. Total e2penit%"e is sho6n & the "ectan4le OP 7T7=
;c<
P
C
T
7 Afte" the ta2 has &een impose) o%tp%t falls to + an p"ice 6ith ta2 "ises to P + Total e2penit%"e is OP+A+ of 6hich P,P+A9 is ta2 "e#en%e an OP D ,9+) is p"o%ce"s> total P "e#en%e= ,
9
;<
At the ne6 e8%ili&"i%m1 ;i< ;ii< ;iii<
p"ice to the c%stome" has "isen f"om p o to p + = 7 + B%antit a#e"a4e "e#en%e "ecei#e & p"o%ce"s has fallen f"om Po to P,= the ta2 &%"en is the"efo"e sha"e &et6een the p"o%ce"s an cons%me"s) 6ith C9 &o"ne & the s%pplie" an AC &o"ne & cons%me"s.
Cons%me"s pa P7P+)AC of total ta2 "e#en%e an p"o%ce"s pa P ,P7C9. The p"opo"tion of the ta2 6hich is passe on to the cons%me" "athe" than &ein4 &o"ne & the s%pplie" epens %pon the elasticities of eman an s%ppl in the ma"-et.
Fi4%"es !;a< an !;&< &elo6 ill%st"ate the e2t"eme cases of pe"fectl elastic eman an pe"fectl inelastic eman "especti#el.
S+
S+
D S
S P,
t
t
D P+
D
D P+
S+
S+ S
S 8,
8+
8+
The elasticit of s%ppl is also "ele#ant. Fi4%"e sho6s that fo" a 4i#en eman c%"#e) the mo"e inelastic is the s%ppl c%"#e) the 4"eate" is the p"opo"tion of the ta2 that is &o"ne & the s%pplie". Fi4%"e ;a< sho6s a "elati#el inelastic s%ppl c%"#e SS. The ta2 pe" %nit of t shifts the s%ppl c%"#e #e"ticall %p6a"s to S +S+ an the e8%ili&"i%m p"ice "ises f"om p + to p,. The p"ice to the cons%me" "ises & a& pe" %nit) 6hile the s%ppl p"ice to the p"o%ce" falls & &c pe" %nit. Th%s) the 4"eate" &%"en is &o"ne & the s%pplie". Fi4%"e ;&< in cont"ast sho6s a "elati#el elastic s%ppl c%"#e S +S+) 6ith a ta2 pe" %nit of t) the same amo%nt of ta2 pe" %nit as in Fi4%"e ;a<. The s%ppl c%"#e shifts to S +S+ an the e8%ili&"i%m p"ice "ises to p,. The p"ice to the cons%me" "ises & a& pe" %nit) an the s%ppl p"ice to the p"o%ce" falls & &c pe" %nit. It can &e seen f"om Fi4%"e that the cons%me" &ea"s a 4"eate" p"opo"tion of the ta2 &%"en the mo"e elastic is the s%ppl c%"#e. Fi4%"e also sho6s that) fo" a 4i#en eman c%"#e) the p"ice "ise an the fall in the e8%ili&"i%m 8%antit 6ill &oth &e 4"eate" 6hen the s%ppl c%"#e is mo"e elastic.
S+
D
D S S+
t
a
P,
P,
a
S
&
P+
&
P+
t
S+ c S
S+
c
D
D
S 8,
8+
8,
8+
In 4ene"al) the 4"eate" the elasticities of eman an s%ppl) the 4"eate" 6ill &e the effect of a ta2 in "e%cin4 the 8%antit sol in an the"efo"e p"o%ce fo" the ma"-et)
It can &e sho6n that1 cons%me"s> sha"e of ta2 p"o%ce"s> sha"e of ta2
elasticit of s%ppl elasticit of eman
;A p"oof of this is &eon the scope of this &oo- 5tho%4h not &eon the po6e"s of a mathematicall nim&le st%ent. (o% ma ca"e to t" it as an aitional e2e"cise.< Th%s if a selecti#e ini"ect ta2 of l7p is place on a p"o%ct 6he"e s%ppl elasticit is +., an eman elasticit is 7.$) the p"ice of the 4oo 6o%l "ise & p) i.e.1 ;a<
the cons%me" 6o%l pa p of the l7p ;"atio +.,1 7.$<=
;&<
the s%pplie" 6o%l pa /p &eca%se the p"ice inc"ease of p is ins%fficient to pa the f%ll ta2 of l7p pe" %nit.
F%"the" points to note a"e that1 ;a<
since s%ch a ta2 "e%ces o%tp%t) it ma &e ha"mf%l to an in%st". Fo" some companies) the "e%ction in 8%antities p"o%ce ma lea to si4nificant "ises in the %nit costs of p"o%ction. This co%l ha#e a#e"se conse8%ences on the competiti#e position of the fi"m if it competes in omestic o" o#e"seas ma"-ets 6ith fo"ei4n fi"ms 6hich a"e not s%&?ect to the same ta2=
;&<
ini"ect ta2ation ma &e %se to c"eate an imp"o#ement in the allocation of "eso%"ces 6hen the"e a"e ama4in4 e2te"nalities.
Su#sidies
A s%&si is a pament to the s%pplie" of a 4oo & the 4o#e"nment. The pament is mae1 ;a<
to enco%"a4e mo"e p"o%ction of the 4oo) & offe"in4 a f%"the" incenti#e to s%pplie"s= o"
;&<
to -eep p"ices on the ma"-et lo6e". S%&siise 4oos a"e cheape" to the cons%me". S%&siise 4oos a"e the"efo"e sociall esi"a&le 4oos 6hose p"o%ction the 4o#e"nment 6ishes to enco%"a4e= o"
;c<
to p"otect a #ital in%st" s%ch as a4"ic%lt%"e) 6hen c%""ent eman in the sho"t te"m is lo6 an th"eatenin4 to ca%se an e2cessi#e cont"action of the in%st".
A s%&si is "athe" li-e ini"ect ta2ation in "e#e"se. In Fi4%"e 01 ;a<
s%ppl c%"#e S7 is 6hat the s%ppl c%"#e 6o%l &e if no s%&si e2iste=
;&<
s%ppl c%"#e S+ to the "i4ht of S7) is the s%ppl c%"#e 6ith the s%&si.
P"ice S7 S+ A P7 P, P+
9 S%&si
D
B7
B+
B%antit
If the"e 6as no s%&si) the f"ee ma"-et e8%ili&"i%m p"ice 6o%l &e P 7) an o%tp%t B7 ith a s%&si pe" %nit e8%i#alent to A9) s%pplie"s 6o%l &e 6illin4 to p"o%ce B 7 .If o%tp%t 6e"e B7 then cons%me"s nee onl &e cha"4e P +) &eca%se the s%pplie" 6ill "ecei#e a s%&si of A9 pe" %nit p"o%ce. This "eflects the fact that the s%ppl c%"#e shifts f"om S to S+. 9%t) 4i#en the position of the eman c%"#e) the"e 6ill &e a shift in the e8%ili&"i%m 8%antit p"o%ce to B ,) 6hich can &e sol on the ma"-et fo" P,. Th%s the effect of the s%&si 6ill &e to1 ;a<
inc"ease the amo%nt s%pplie in e8%ili&"i%m= an
;&<
ec"ease the p"ice) &%t the ec"ease in p"ice 6ill &e less than the #al%e of the s%&si itself .
S%&siies can &e %se to c"eate an imp"o#ement in the allocation of "eso%"ces 6hen the"e a"e &eneficial e2te"nalities. hen the"e is a &eneficial e2te"nalit) 6ith the social &enefits f"om s%ppl of a 4oo e2ceein4 the p"i#ate &enefits) the >ieal> e8%ili&"i%m p"ice is at1 ;a<
a hi4he" o%tp%t= .an
;&<
a lo6e" p"ice=
than the f"ee ma"-et e8%ili&"i%m p"ice an o%tp%t. The effect of a s%&si is to shift the ma"-et e8%ili&"i%m to1 ;a<
a hi4he" o%tp%t= an
;&<
a lo6e" p"ice.
If the amo%nt of the s%&si 6e"e mae e8%al to the siGe of the &eneficial e2te"nalit) the effect of the s%&si 6o%l &e to "e4%late the ma"-et in s%ch a 6a that an ieal allocation of "eso%"ces to the 4oo is achie#e. hen the state oes this) it mi4ht &e sai to &e >inte"nalisin4 the e2te"nalit>.
Theoy O" The Fim. Podu!tion And Costs Your objectives
Afte" completin4 this chapte" o% sho%l1 ;a<
%ne"stan the concepts of total costs) a#e"a4e costs an ma"4inal costs an &e a6a"e of thei" effects on sho"t5"%n ecision5ma-in4=
;&<
%ne"stan the concept of economies of scale an ho6 it affects ecision5 ma-in4 in the lon4 "%n.
Costs of production and the firm Intodu!tion
In this chapte" 6e shall loo- at the costs an o%tp%t ecisions of an ini#i%al fi"m. In othe" 6o"s) 6e shall loo- at 6hat the costs of p"o%ction a"e fo" a sin4le fi"m) an ho6 these a"e affecte & &oth sho"t5"%n an lon45"%n facto"s. e shall then 4o on to consie" p"ofit an ho6 m%ch o%tp%t a fi"m 6ill p"o%ce at a 4i#en ma"-et p"ice. The a44"e4ate amo%nt of 4oos s%pplie & e#e" ini#i%al fi"m as %p to the ma"-et s%ppl= & st%in4 an ini#i%al fi"m 6e a"e loo-in4 at the >&%ilin4 &loc-s> of ma"-et s%ppl. The fi"m is a 6ie te"m fo" an o"4anisation 6hich ca""ies on &%siness. In spite of thei" st"%ct%"al iffe"ences) fi"ms 6ill &e t"eate as sin4le) consistent ecision5ta-in4 %nits) an 6e shall i4no"e an iffe"ences in ecision5ma-in4 p"oce%"es an economic st"%ct%"es &et6een them. In pa"tic%la") 6e 6ill ass%me that the -e o&?ecti#e of a fi"m is to ma2imise its p"ofits. P"o%ction is ca""ie o%t %sin4 the facto"s of p"o%ction 6hich m%st &e pai o" "e6a"e fo" thei" %se. The cost of p"o%ction is the cost of the facto"s that a"e %se.
Factor of production
It’s cost
*an *a&o%" Capital Ent"ep"ene%"ship
"ent 6a4es inte"est no"mal o" Yp%"e p"ofit
Fi2e an #a"ia&le inp%ts an costs Fi"ms com&ine #a"io%s inp%t "eso%"ces to p"o%ce a 4i#en le#el of o%tp%t. 9 #a"in4 the amo%nts of inp%t %se) the le#el of o%tp%t can &e alte"e. Ho6e#e" not all inp%ts a"e e8%all fle2i&le. Ene"4) "a6 mate"ials) the n%m&e" of la&o%" ho%"s an so on can &e com&ine 6ith each othe" 6ith a 4"eat eal of fle2i&ilit) &%t the siGe of the facto" o" n%m&e" of machines cannot &e #e"ifie so 8%ic-l. Economist ta-e the #ie6 that in the sho"t "%n some facto"s of p"o%ction ;o" p"o%ction inp%ts< a"e #a"ia&le in s%ppl an so ha#e #a"ia&le costs. Tpicall la&o%" is "e4a"e as a #a"ia&le cost item. On the othe" han some facto"s of p"o%ction a"e fi2e in s%ppl an so ha#e fi2e cost item. Mo"e p"ecisel) fi2e costs a"e those costs 6hich o not #a" i"ectl 6ith o%tp%t) &%t 6hich "emain constant 6hethe" anthin4 is p"o%ce o" not. a"ia&le costs a"e those 6hich o #a" i"ectl 6ith the le#el of o%tp%t.
In the lon4 "%n ho6e#e" the s%ppl of sho"t te"m fi2e cost items can &e mae to #a" an so all facto"s of p"o%ction a"e #a"ia&le. Mo"e lan an &%ilin4s can &e o&taine) mo"e capital o&taine an mo"e ent"ep"ene%"ship stim%late. In the sho"t "%n) p"ofit ma2imisin4 ecisions m%st &e ta-en 6ithin the "est"iction of ha#in4 some "eso%"ces in fi2e s%ppl. In the lon4e" "%n ho6e#e" most cases a"e #a"ia&le &eca%se the s%ppl of s-ille la&o%") machine") &%ilin4s an so on can &e inc"ease o" ec"ease. P"ofit5ma2imisin4 ecisions in the lon4 te"m a"e the fo"e s%&?ect to fe6e" "est"ictions a&o%t "eso%"ce a#aila&ilit. Shot)un !osts. total !osts' avea%e !osts and ma%inal !osts
*et %s no6 t%"n o%" attention to sho"t5"%n costs 5i.e. costs of o%tp%t %"in4 a time pe"io in 6hich onl some "eso%"ces of p"o%ction a"e #a"ia&le in a#aila&ilit an some "eso%"ces of p"o%ction a"e fi2e in 8%antit. The"e a"e th"ee aspects of cost to &e consie"e. ;a<
Total cost 5TC.
;&<
A#e"a4e cost 5AC. A#e"a4e cost is simpl the total cost i#ie & the total 8%antit p"o%ce ;i<
A#e"a4e cost is mae %p of an a#e"a4e fi2e cost pe" %nit pl%s an a#e"a4e #a"ia&le cost pe" %nit. AC
TC n
TFCZ n
TC n
;he"e n is the n%m&e" of %nits p"o%ce< In othe" 6o"s) AC AFC Z A C ;ii<
A#e"a4e fi2e cost pe" %nit ;AFC< 6ill 4et smalle" as mo"e %nits a"e p"o%ce. This is &eca%se TFC is the same amo%nt "e4a"less of the #ol%me of o%tp%t) so as n 4ets &i44e") AFC m%st 4et smalle".
;iii<
A#e"a4e #a"ia&le costs pe" %nit ;A C< 6ill chan4e as o%tp%t #ol%me inc"eases.
;c<
Ma"4inal cost 5MC. This is the e2t"a cost of p"o%cin4 one mo"e %nit of o%tp%t. Fo" e2ample) the ma"4inal cost fo" a fi"m of p"o%cin4 the !7th %nit of o%tp%t is the e2t"a cost of ma-in4 the !7th %nit) ha#in4 al"ea mae the p"e#io%s /' %nits. In othe" 6o"s the MC of the !7th %nit is the total cost of ma-in4 the fi"st !7 %nits min%s the total cost of ma-in4 the fi"st /' %nits.
Numei!al illustation o" TC' AC and MC
*et %s s%ppose that a fi"m emplos a 4i#en amo%nt of capital 6hich is a fi2e ;in#a"ia&le< inp%t in the sho"t "%n1 in othe" 6o"s) it is not possi&le to o&tain e2t"a amo%nts of capital 8%ic-l. The fi"m ma com&ine 6ith this capital iffe"ent amo%nts of la&o%") 6hich 6e ass%me to &e an inp%t 6hich is #a"ia&le in the sho"t te"m. Th%s fi2e capital an #a"ia&le la&o%" can &e com&ine to p"o%ce iffe"ent le#els of o%tp%t. He"e is an ill%st"ation of the "elationship &et6een the iffe"ent efinitions of the fi"m>s costs1 ;the fi4%"es %se a"e hpothetical<. Ta&le + Units o" output n
Total !ost TC -
+ , 3 / ! 0 $ ' +7
Avea%e !ost AC -
+.+7 +.7 +.0! ,.77 ,.!7 3.+, 3.'' !.+, .37 $.77
+.+7 7.$7 7.!$ 7.!7 7.!7 7.!, 7.!0 7./ 7.07 7.$7
Ma%inal !ost MC +.+7 7.!7 7.+! 7.,! 7.!7 7., 7.$0 +.+3 +.+$ +.07
;+.7 5+.+7< ;+.0!5 +.7< ;,.77 5+.0!< ;,.!75 ,.77< ;3.+,5 ,.!7< ;3.''5 3.+,< ;!.+, 53.''< ;.37 5!.+,< ;$.775 .37<
;a<
Total cost ;TC< is the s%m of la&o%" costs pl%s capital costs) since these a"e & ass%mption the onl t6o inp%ts.
;&<
A#e"a4e cost ;AC< is the cost pe" %nit of o%tp%t) i.e. AC
;c<
Ma"4inal cost ;MC< is the total cost of p"o%cin4 n %nits min%s the total cost of p"o%cin4 one less %nit) i.e. ;n5l< %nits.
TC o%tp%t
TC n
Note the follo6in4 points on this set of fi4%"es. ;a<
Total cost. Total costs of p"o%ction ca""on "isin4 as mo"e an mo"e %nits a"e p"o%ce.
;&<
A#e"a4e cost. AC chan4es as o%tp%t inc"eases. It sta"ts & fallin4) "eaches a lo6est le#el) an then sta"ts "isin4 a4ain.
;c<
Ma"4inal cost. The MC of each e2t"a %nit of o%tp%t also chan4es 6ith each %nit p"o%ce. It too sta"ts & fallin4) fai"l 8%ic-l "eaches a lo6est le#el) an then sta"ts "isin4.
;<
AC an MC compa"e. At lo6est le#els of o%tp%t) MC is less than AC. At hi4hest le#els of o%tp%t) tho%4h) MC is hi4he" than AC. The"e is a >c"oss5o#e"> point) 6he"e MC is e2actl e8%al to AC. In this small e2ample) it is at ! %nits of o%tp%t.
E!onomists/ and a!!ountants/ !on!epts o" !ost
To an economist) cost incl%es an amo%nt fo" no"mal p"ofit 6hich is the "e6a" fo" ent"ep"ene%"ship. To an acco%ntant) the"e is no p"ofit element 6ithin cost. Anothe" feat%"e of cost acco%ntin4 is that costs can &e i#ie into fi2e costs an #a"ia&le o" ma"4inal costs. Total fi2e costs pe" pe"io a"e a 4i#en amo%nt) "e4a"less of the #ol%me of p"o%ction an sales. The #a"ia&le cost pe" %nit is a constant amo%nt) so that the total #a"ia&le cost of sales is i"ectl p"opo"tional to the #ol%me of sales.
Economists o not ta-e this #ie6. In the sho"t "%n) the"e a"e fi2e costs an #a"ia&le o" ma"4inal costs) &%t the ma"4inal cost of ma-in4 each e2t"a %nit of o%tp%t nee not &e the same fo" each e2t"a %nit that is mae. In othe" 6o"s) the ma"4inal cost pe" %nit is not a >stana"> #al%e fo" e#e" %nit p"o%ce. The follo6in4 points a"e 6o"th st"essin4. ;a<
To the economist) cost incl%es an element fo" >no"mal> p"ofit.
;&<
To the economist) cost means oppo"t%nit cost. No"mal p"ofit) 6hich is the cost of ent"ep"ene%"ship) is an oppo"t%nit cost) &eca%se it is the amo%nt of p"ofit that an ent"ep"ene%" co%l ea"n else6he"e) an so it is the p"ofit that he m%st ea"n to pe"s%ae him to -eep on 6ith his in#estment in his c%""ent ente"p"ise.
;c<
The sho"t5"%n ma"4inal cost pe" %nit can chan4e as mo"e o%tp%t is p"o%ce.
Averae costs" marinal costs and diminishin returns The elationship #et(een AC and MC
The "elationships &et6een a#e"a4e an ma"4inal costs a"e impo"tant. ;a<
hen the a#e"a4e cost sche%le is "isin4) the ma"4inal cost 6ill al6as &e hi4he" than the a#e"a4e cost. This ma-es sense. If the ma"4inal cost of ma-in4 one e2t"a %nit of o%tp%t e2cees the a#e"a4e cost of ma-in4 all the p"e#io%s %nits) then ma-in4 the e2t"a %nit 6ill clea"l ca%se an inc"ease in the a#e"a4e %nit cost.
;&<
hen the a#e"a4e cost c%"#e is fallin4) the ma"4inal cost lies &elo6 it.
;c<
hen the a#e"a4e cost c%"#e is ho"iGontal) ma"4inal cost is e8%al to it.
The ma"4inal cost c%"#e al6as c%ts th"o%4h the a#e"a4e cost c%"#e at the lo6est point of the a#e"a4e cost c%"#e ;Fi4%"e +<.
MC ;ma"4inal cost<
AC ;a#e"a4e cost<
The sho"t5"%n a#e"a4e cost ;SAC< c%"#e is al6as li-el to &e U 5shape. e no6 consie" 6h. Fi2e costs pe" %nit of o%tp%t) i.e. a#e"a4e fi2e costs) 6ill fall as the le#el of o%tp%t "ises. Sp"eain4 fi2e costs o#e" a la"4e" amo%nt of o%tp%t is a ma?o" "eason 6h ;sho"t5 "%n< a#e"a4e costs pe" %nit fall as o%tp%t inc"eases. *o6est point of AC c%"#e
a"ia&le costs a"e mae %p f"om the cost of the facto"s of p"o%ction 6hose %se can &e #a"ie in the sho"t5"%n ;fo" e2ample 6a4es) f%el &ills an "a6 mate"ial p%"chases<. Total #a"ia&le costs the"efo"e #a" 6ith o%tp%t in the sho"t "%n as 6ell as in the lon4 "%n. ;a< The stana" ass%mption a&o%t sho"t5"%n #a"ia&le costs is that %p to a ce"tain le#el of o%tp%t) the #a"ia&le cost pe" %nit is mo"e o" less constant ;e4 6a4es costs an mate"ials costs pe" %nit of o%tp%t a"e %nchan4e<. If the a#e"a4e fi2e cost pe" %nit is fallin4 as o%tp%t "ises an the a#e"a4e #a"ia&le cost pe" %nit is constant) it follo6s that the a#e"a4e total cost pe" %nit 6ill &e fallin4 too as o%tp%t inc"eases. ;&<
Ne#e"theless) the"e is e#ience that a#e"a4e #a"ia&le costs "ise 6hen o%tp%t inc"eases &eon a no"mal capacit le#el. 9eon this le#el 4"eate" o%tp%t can &e attaine onl & %sin4 la"4e" 8%antities of the #a"ia&le facto"s of p"o%ction) &%t this 6ill lea to p"o&lems s%ch as o#e"c"o6in4) mana4e"ial p"o&lems) an mo"e f"e8%ent &"ea-o6ns of machine" f"om intensi#e %se. A#e"a4e #a"ia&le costs 6ill the"efo"e &e4in to "ise at some point) e#en ass%min4 that the"e a"e no o#e"time paments o" %se of mo"e s-ille la&o%". ith a#e"a4e #a"ia&le costs pe" %nit "isin4 as o%tp%t inc"eases) the a#e"a4e total cost pe" %nit 6ill "ise too.
Com&inin4 fi2e an #a"ia&le costs 4i#es %s the no"mal U 5shape sho"t5"%n a#e"a4e cost c%"#e. The la( o" diminishin% etuns
Diminishin4 "et%"ns e2plain 6h a sho"t5"%n a#e"a4e cost c%"#e &e4ins to "ise at a ce"tain le#el) an the a#e"a4e cost pe" %nit of p"o%ction 4ets hi4he" as mo"e o%tp%t is p"o%ce. The la6 of iminishin4 "et%"ns states that) 4i#en the p"esent state of technolo4) as mo"e %nits of a #a"ia&le inp%t facto" a"e ae to inp%t facto"s that a"e fi2e in s%ppl in the sho"t "%n) the "es%ltin4 inc"ements to total p"o%ction 6ill e#ent%all an p"o4"essi#el ecline. In othe" 6o"s) as mo"e %nits of a #a"ia&le facto" a"e ae to a B%antit of fi2e facto"s) the"e ma &e some inc"easin4 "et%"ns o" constant "et%"ns as mo"e %nits of the #a"ia&le facto" a"e ae) &%t e#ent%all) iminishin4 "et%"ns 6ill set in. The la6 of iminishin4 "et%"ns can also &e e2p"esse as the la6 of #a"ia&le p"opo"tions) 6hich states that as the p"opo"tions of a #a"ia&le inp%t facto" to a fi2e inp%t facto" a"e alte"e) an mo"e of the #a"ia&le facto" is ae to the fi2e facto") the ma"4inal p"o%ct att"i&%ta&le to each e2t"a %nit of the #a"ia&le facto" 6ill inc"ease at fi"st) &%t 6ill late" iminish an ma e#ent%all &ecome ne4ati#e. T6o impo"tant points to note a&o%t the la6 of iminishin4 "et%"ns a"e as follo6s. ;a<
It "elates to the sho"t5"%n sit%ation) 6hen some inp%ts a"e in fi2e s%ppl. It oes not "elate to the lon4 "%n.
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It is not a la6 that can &e p"o#e) &%t it has &een fo%n to appl f"e8%entl in p"actice
Ma%inal podu!tivity
Diminishin4 "et%"ns can &e e2plaine & the ma"4inal p"o%cti#it of e2t"a B%antities of a #a"ia&le facto" of p"o%ction. Total phsical p"o%ct is the total o%tp%t) meas%"e & 8%antit "athe" than #al%e) that is p"o%ce & a 4i#en 8%antit of ;fi2e pl%s #a"ia&le< p"o%ction facto"s. If 6e com&ine a fi2e facto" of p"o%ction ;capital) sa) o" lan< 6ith inc"easin4 8%antities of a #a"ia&le facto" ;la&o%") sa< the total #ol%me of o%tp%t sho%l inc"ease as mo"e an mo"e %nits of the #a"ia&le facto" a"e emploe. In othe" 6o"s) total phsical p"o%ct 6ill inc"ease as e2t"a %nits of the #a"ia&le facto" a"e emploe. The a#e"a4e phsical p"o%ct ; APP < of the #a"ia&le facto" of p"o%ction 6ill &e1
In the sho"t5"%n) to p"o%ce mo"e o%tp%t) a fi"m m%st ac8%i"e e2t"a 8%antities of #a"ia&le facto"s of p"o%ction) &%t fi2e facto"s of p"o%ction cannot &e inc"ease. a"ia&le facto"s 6ill &e com&ine 6ith fi2e facto"s to p"o%ce the fi"m>s o%tp%t. ;a<
The e2t"a phsical o%tp%t p"o%ce & an e2t"a %nit of #a"ia&le facto" is calle the ma"4inal phsical p"o%ct ;MPP<. At lo6 #ol%mes of o%tp%t) e2t"a %nits of a #a"ia&le facto" mi4ht s%ccee in p"o%cin4 an inc"easin4 MPP.
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E#ent%all e2t"a %nits of #a"ia&le facto" 6ill no lon4e" &e as p"o%cti#e an MPP 6ill sta"t to 4et smalle". Ret%"ns f"om the 8%antities of #a"ia&le facto" 6ill the"efo"e 4et smalle" o" iminish [ hence the name Yla6 of iminishin4 "et%"ns
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A eclinin4 MPP ;an a eclinin4 a#e"a4e phsical p"o%ct APP< e2plains 6h ma"4inal costs of e2t"a %nits of p"o%ction 6ill e#ent%all inc"ease an 6h a#e"a4e costs 6ill sta"t to inc"ease &eon a ce"tain le#el of o%tp%t.
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This is 6h the la6 of iminishin4 "et%"ns e2plains the U shape of the sho"t "%n AC c%"#e.
Ma2im%m MPP
Ma2im%m APP
APP
MPP
Profit maximisation e can efine p"ofits as total "e#en%e min%s total economic costs at an le#el of o%tp%t. P"ofits a"e at a ma2im%m 6he"e the ;#e"tical< istance &et6een the total "e#en%e ;TR< an total cost ;TC< c%"#es in Fi4%"e 3 is 4"eatest TC
TR A
Total phsical p"o%ct B%antit of #a"ia&le facto" %nits emploe 9
M
Total evenue0 avea%e evenue and ma%inal evenue
9efo"e loo-in4 at ho6 a fi"m ecies its p"ofit5ma2imisin4 o%tp%t) 6e m%st loo- at its "e#en%es. The"e a"e th"ee aspects of "e#en%e to consie" . ;a<
Total "e#en%e ;TR< 6hich is the total income o&taine f"om sellin4 a 4i#en B%antit of o%tp%t. e can thin- of this as B%antit sol m%ltiplie & the p"ice pe" %nit1 TR P 2 B.
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A#e"a4e "e#en%e ;AR< 6hich 6e can thin- of as the p"ice pe" %nit sol1 AR TR n
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Ma"4inal "e#en%e ;MR< 6hich is the aition to total "e#en%e ea"ne f"om the sale of one e2t"a %nit of o%tp%t1 MR p AR.
hen a fi"m can sell all its e2t"a o%tp%t at the same p"ice) the AR >c%"#e> 6ill &e a st"ai4ht line on a 4"aph) ho"iGontal to the 2 a2is. The ma"4inal "e#en%e pe" %nit f"om sellin4 e2t"a %nits at a fi2e p"ice m%st &e the same as the a#e"a4e p"ice. ;See Fi4%"e /<. hen the AR is fallin4 as mo"e %nits a"e sol. the MR m%st &e less than the AR. In othe" 6o"s) if the p"ice pe" %nit m%st &e lo6e"e to sell mo"e %nits) then the ma"4inal "e#en%e pe" %nit o&taine f"om sellin4 the e2t"a %nits 6ill &e less than the p"e#io%s p"ice pe" %nit. ;See Fi4%"e !<.
P"ice AR MR P N
AR p"ice MR
Note. In Fi4%"e !) all %nits a"e sol at the same p"ice. The fi"m has to "e%ce its p"ice to sell mo"e) &%t the p"ice m%st &e "e%ce fo" all %nits sol) not ?%st fo" the e2t"a %nits. This is &eca%se 6e a"e ass%min4 that all o%tp%t is p"o%ce fo" a sin4le ma"-et) 6he"e a sin4le p"ice 6ill p"e#ail. Ill%st"ation1 AR an MR This simple ill%st"ation sho6s ho6 MR falls as AR falls) an MR is less than AR 6hen this happens. . Units of sale 1
+ , 3 / !
Price per unit AR 0.7 .! .7 !.! !.7
Total revenue 2AR $ 13 0 +3 +$ ,, ,!
arginal revenue MR 0 ! / 3
Ma%inal evenue and pi!e elasti!ity o" demand
Ma"4inal "e#en%e an p"ice elasticit of eman can &e "elate mathematicall th"o%4h the follo6in4 fo"m%la. MR P \+ 5 + ] ^ 6he"e MR is ma"4inal "e#en%e P ^
is p"ice is the a&sol%te #al%e of p"ice elasticit of eman ;ie i4no"in4 the min%s si4n<.
The fo"m%la is %sef%l &eca%se it sho6s that ;a< ;&< ;c< ;<
6hen ^ MRP 6hen ^ MRO 6hen ^ V MR is positi#e 6hen ^ MR is ne4ati#e.
hen the p"ice pe" %nit has to &e "e%ce in o"e" to inc"ease the fi"m>s sales the ma"4inal "e#en%e can &ecome ne4ati#e. This happens in Fi4%"e ! at p"ice PN 6hen a "e%ction in p"ice oes not inc"ease o%tp%t s%fficientl to ea"n the same total "e#en%e as &efo"e. In this sit%ation) the p"ice elasticit of eman 6o%l &e inelastic. Ma%inal analysis
Ma"4inal ecision5ma-in4 is &ase on the p"inciple of meas%"in4 the chan4e in &enefits ano" costs that 6o%l a"ise as a conse8%ence of a ecision. The chan4e 6o%l &e 6o"th ha#in4 if the e2t"a &enefits e2ceee the e2t"a isa#anta4es. Ma"4inal analsis is &ase on some fai"l simple "%les an a"ithmetical "elationships. R%le +. hen the"e a"e no "eso%"ce limitations) the scale of an acti#it sho%l &e inc"ease if the ma"4inal &enefits f"om the chan4e o" inc"ease e2cee the ma"4inal costs. Essentiall) an acti#it is 6o"th %ne"ta-in4 if it as mo"e &enefits than it oes cost. In the case of a fi"m) fo" e2ample) it 6o%l &e 6o"th spenin4 e2t"a mone on a#e"tisin4) 4i#en no "est"ictions on the cash a#aila&le to spen on a#e"tisin4) p"o#ie that the e2t"a p"ofits f"om the "es%ltin4 e2t"a salesW 6e"e hi4he" than the e2t"a cost of the a#e"tisin4. ;W i.e. e2t"a p"ofits &efo"e e%ctin4 a#e"tisin4 costs<) R%le ,. @i#en no "eso%"ce const"aints) it follo6s that the scale o" amo%nt of an acti#it sho%l &e inc"ease if the ma"4inal net iel is positi#e. R%le 3. hen the"e is a sho"ta4e of "eso%"ces) the scale of acti#it 6ill &e "est"icte to a le#el 6he"e ma"4inal &enefits still e2cee ma"4inal costs. In this sit%ation) the ecision p"o&lem 6ill often &e to choose &et6een alte"nati#e competin4 co%"ses of action) ie &et6een m%t%all e2cl%si#e options. In the case of a fi"m 6ith limite "eso%"ces) sho%l the "eso%"ces &e p%t into ma-in4 an sellin4 p"o%ct A o" p"o%ct 9 o" p"o%ct C Fo" e2ample) if a fi"m has L+ to spen) an can spen it on a#e"tisin4 to iel e2t"a p"ofit of L,) o" on e2t"a staff to iel e2t"a p"ofits of L+.!7) the choice 6o%l o&#io%sl &e to spen the mone on a#e"tisin4. To achie#e optimisation) each acti#it sho%l &e ta-en to the le#el 6he"e the ma"4inal ;net< iel is the same fo" e#e" acti#it. A ecision in fa#o%" of a co%"se of action sho%l &e ta-en if the inc"emental "e#en%es a"isin4 f"om the chosen action e2cee the inc"emental oppo"t%nit costs. This is an application of ma"4inal analsis.
Po"it ma$imisation. MC 4 MR
As a fi"m p"o%ces an sells mo"e %nits) its total costs 6ill inc"ease an its total "e#en%es 6ill also inc"ease ;%nless the p"ice elasticit of eman is inelastic an the fi"m faces a o6n6a" slopin4 AR c%"#e<. ;a<
P"o#ie that the e2t"a cost of ma-in4 an e2t"a %nit is less than the e2t"a "e#en%e o&taine f"om sellin4 it) the fi"m 6ill inc"ease its p"ofits & ma-in4 an sellin4 the e2t"a %nit.
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If the e2t"a cost of ma-in4 an e2t"a %nit of o%tp%t e2cees the e2t"a "e#en%e o&taina&le f"om sellin4 it) the fi"m>s p"ofits 6o%l &e "e%ce & ma-in4 an sellin4 the e2t"a %nit.
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If the e2t"a cost of ma-in4 an e2t"a %nit of o%tp%t is e2actl e8%al to the e2t"a "e#en%e o&taina&le f"om sellin4 it) &ea"in4 in min that economic cost incl%es an amo%nt fo" no"mal p"ofit) it 6ill &e 6o"th the fi"m>s 6hile to ma-e an sell the e2t"a %nit. An since the e2t"a cost of et anothe" %nit 6o%l &e hi4he" ;the la6 of iminishin4 "et%"ns applies< 6he"eas e2t"a "e#en%e pe" %nit f"om sellin4 e2t"a %nits is ne#e" hi4he") the p"ofit5ma2imisin4 o%tp%t is "eache at this point 6he"e MC MR.
In othe" 6o"s) 4i#en the o&?ecti#e of p"ofit5ma2imisation1 ;a<
If MC is less than MR p"ofits 6ill &e inc"ease & ma-in4 an sellin4 mo"e.
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If MC is 4"eate" than MR p"ofits 6ill fall if mo"e %nits a"e mae an sol) an a p"ofit5 ma2imisin4 fi"m 6o%l not ma-e the e2t"a o%tp%t.
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If MC MR) the p"ofit5ma2imisin4 o%tp%t has &een "eache) an this is the o%tp%t B%antit that a p"ofit5ma2imisin4 fi"m 6ill ecie to s%ppl.
Economies of scale and lon#run costs Intodu!tion
e ha#e not et consie"e a fi"m>s lon45"%n costs of o%tp%t. In the lon45"%n) all inp%ts a"e #a"ia&le) so the p"o&lems associate 6ith the iminishin4 "et%"ns to #a"ia&le facto"s o not a"ise= in othe" 6o"s) the la6 of iminishin4 "et%"ns applies onl to sho"t5"%n costs an not to lon45"%n costs. he"eas sho"t5"%n o%tp%t ecisions a"e conce"ne 6ith iminishin4 "et%"ns to scale 4i#en fi2e facto"s of p"o%ction) lon45"%n o%tp%t ecisions a"e conce"ne 6ith economies of scale 6hen all facto" inp%ts a"e #a"ia&le. O%tp%t 6ill #a" 6ith #a"iations in inp%ts) s%ch as la&o%" an capital. ;a<
If o%tp%t inc"eases in the same p"opo"tion as inp%ts ;e.4. o%&lin4 all inp%ts o%&les o%tp%t< the"e a"e constant "et%"ns to scale.
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If o%tp%t inc"eases mo"e than in p"opo"tion to inp%ts ;e.4. o%&lin4 all inp%ts t"e&les o%tp%t< the"e a"e economies of scale an in the lon4 "%n a#e"a4e costs of p"o%ction 6ill contin%e to fall as o%tp%t #ol%me "ises.
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If o%tp%t inc"eases less than in p"opo"tion to inp%ts ;e.4. t"e&lin4 all inp%ts onl o%&les o%tp%t< the"e a"e iseconomies of scale an in the lon4 "%n a#e"a4e costs of p"o%ction 6ill "ise as o%tp%t #ol%me "ises.
Ret%"ns to scale a"e) in effect) conce"ne 6ith imp"o#ements o" eclines in p"o%cti#it & inc"easin4 the scale of p"o%ction ;e.4. & mass5p"o%cin4 instea of p"o%cin4 in small &atch 8%antities<.
E!onomies o" s!ale
Fi4%"e sho6s the shape of the lon45"%n a#e"a4e cost c%"#e ;*AC< if the"e a"e inc"easin4 "et%"ns to scale %p to a ce"tain o%tp%t #ol%me an then constant "et%"ns to scale the"eafte". It ma &e that the flat pa"t of the *AC c%"#e is ne#e" "eache) o" it ma &e that iseconomies of scale a"e enco%nte"e.
*RAC Economies of scale
Constant "et%"ns to scale
Diseconomies of scale mi4ht a"ise 6hen a fi"m 4ets so la"4e that it cannot ope"ate efficientl o" it is too la"4e to mana4e efficientl) so that a#e"a4e costs &e4in to "ise.
Economies of scale
Diseconomies of scale a&o#e a 4i#en o%tp%t #ol%me1 *RAC c%"#e "ises
A p"ofit5ma2imisin4 fi"m 6ill t" to minimise its a#e"a4e costs in the lon45"%n) an to o this it 6ill t" to p"o%ce o%tp%t on a scale 6he"e the *AC c%"#e is at its lo6est point. hile the"e a"e economies of scale) a fi"m 6ill al6as &e t"in4 to 4"o6. The economies of scale attaina&le f"om la"4e5scale p"o%ction ma &e cate4o"ise as1 ;a<
inte"nal economies of scale1 economies a"isin4 6ithin the fi"m f"om the o"4aniGation of p"o%ction= an
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e2te"nal economies of scale1 economies attaina&le & the fi"m &eca%se of the 4"o6th of the in%st" as a 6hole.
Inte"nal economies of scale a"ise f"om the mo"e effecti#e %se of a#aila&le "eso%"ces) an f"om inc"ease specialisation) 6hen p"o%ction capacit is enla"4e. ;a<
Specialisation of la&o%"1 in a la"4e %ne"ta-in4) a hi4hl s-ille 6o"-e" can &e emploe in a ?o& 6hich ma-es f%ll %se of his s-ills. In a smalle" %ne"ta-in4) ini#i%als m%st o a #a"iet of tas-s) none of 6hich the ma o #e" 6ell ;>Qac-5 of 5all5t"aes 5maste" of none><.
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Di#ision of la&o%"1 &eca%se the"e is specialisation of la&o%" the"e is also i#ision of la&o%") i.e. 6o"- is i#ie &et6een se#e"al specialists) each of 6hom cont"i&%tes his sha"e to the final p"o%ct. A &%ilin4 6ill &e const"%cte) fo" e2ample) & la&o%"e"s) &"ic-lae"s) pl%m&e"s) elect"icians) plaste"e"s) etc. S6itchin4 &et6een tas-s 6astes time) an i#ision of la&o%" a#ois this 6aste.
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*a"4e %ne"ta-in4s can ma-e %se of la"4e" an mo"e specialise machine". If smalle" %ne"ta-in4s t"ie to %se simila" machine") the costs 6o%l &e e2cessi#e &eca%se the machines 6o%l &ecome o&solete &efo"e thei" phsical life ens ;i.e. thei" economic life 6o%l &e sho"te" than thei" phsical life<. O&solescence is ca%se & fallin4 eman fo" the p"o%ct mae on the machine) o" & the e#elopment of ne6e" an &ette" machines.
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Fo" a simila" "eason) la"4e %ne"ta-in4s can %se specialise tools 6hich small %ne"ta-in4s 6o%l fin too costl. Economists "efe" to la"4e capital items that a"e onl economicall ?%stifia&le at hi4h #ol%mes of o%tp%t as ini#isi&les.
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Dimensional economies of scale "efe" to the "elationship &et6een the #ol%me of o%tp%t an the siGe of e8%ipment ;e.4. sto"a4e tan-s< neee to hol o" p"ocess the o%tp%t. The cost of a containe" fo" +7)777 4allons of p"o%ct 6ill &e m%ch less than ten times the cost of a containe" fo" ?%st +)777 4allons.
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9%in4 economies ma &e a#aila&le) "e%cin4 the cost of mate"ial p%"chases th"o%4h &%l p%"chase isco%nts.
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Ini#isi&ilit of ope"ations1 the"e a"e ope"ations 6hich1 ;i<
m%st &e ca""ie o%t at the same cost) "e4a"less of 6hethe" the &%siness is small o" la"4e= these a"e fi2e costs an a#e"a4e fi2e costs al6as ecline as p"o%ction inc"eases=
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#a" a little_ &%t not p"opo"tionatel) 6ith siGe ;i.e. ha#in4 >semi5fi2e> costs<=
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a"e not 6o"th consie"in4 &elo6 a ce"tain le#el of o%tp%t ;e.4. a#e"tisin4 campai4ns) ma"-etin4 st"%ct%"es<.
Set5%p costs fo" &atch p"o%ction a"e an e2ample of >fi2e cost> items fo" 6hich a#e"a4e %nit costs &ecome lo6e" as the siGe of the p"o%ction "%n 4ets &i44e" . ;h<
Specialisation of la&o%" an machines "es%lt in simplification an stana"isation of ope"ations ;i.e. #a"iet "e%ction< 6hich themsel#es "es%lt in lo6e" costs. ;i<
Stoc- holin4 &ecomes mo"e efficient. The most economic 8%antities of in#ento" to hol inc"ease 6ith the scale of ope"ations) &%t at a lo6e" p"opo"tionate "ate of inc"ease.
E2te"nal economies of scale occ%" as an in%st" 4"o6s in siGe. Fo" e2ample1 ;a<
a la"4e s-ille la&o%" fo"ce is c"eate an e%cational se"#ices can &e 4ea"e to6a"s t"ainin4 ne6 ent"ants=
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specialise ancilla" in%st"ies 6ill e#elop to p"o#ie components) t"anspo"t finishe 4oos) t"ae in &5p"o%cts) p"o#ie special se"#ices etc. Fo" instance) la6 fi"ms ma &e set %p to specialise in the affai"s of the in%st".
The e2tent to 6hich &oth inte"nal an e2te"nal economies of scale can &e achie#e 6ill #a" f"om in%st" to in%st") epenin4 on the conitions 6ith "espect to that in%st". In othe" 6o"s) &i4 fi"ms a"e &ette" s%ite to some in%st"ies than othe"s. Te!hnolo%i!al po%ess and shi"ts in the lon%)un !ost !uve
The % 5shape *AC c%"#e p"eicte & the economic theo" of e#ent%al iminishin4 "et%"ns to scale ma not e2ist in fact &eca%se of technolo4ical p"o4"ess. Technolo4ical p"o4"ess 6o%l shift the *AC c%"#es o#e" time) as sho6n in Fi4%"e $) so the *AC c%"#e o&se"#e f"om empi"ical ata o#e" time 6o%l &e the *5shape c%"#e sho6n & the ashe line. !igure "
The LC curve shifts over time from LC ! to LC " to LC # as technical progress is made bringing further economies of scale *RAC +
*RAC ,
*RAC 3
O&se"#e *RAC
The "easons 6h technolo4ical p"o4"ess "e%ces lon45"%n costs a"e that ne6 technolo4 "e%ces sho"t5 "%n costs) an since the lon45"%n a#e"a4e cost c%"#e "ep"esents a se"ies of sho"t5"%n cost c%"#es at iffe"ent o%tp%t #ol%mes) the"e 6ill &e "e%ctions in the *AC too. Shot)un !osts (ill "all #e!ause.
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the ne6 technolo4 mi4ht help in achie#in4 4"eate" economies of scale= it 6ill imp"o#e la&o%" p"o%cti#it too) meas%"e as o%tp%t pe" emploee o#e" time=
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the"e mi4ht &e a shift to %sin4 cheape" machines f"om "elati#el mo"e e2pensi#e la&o%". In othe" 6o"s) ne6 technolo4 can "es%lt in lost ?o&s.
Fa!to Ma,ets And Fa!to Re(ads Your objectives
Afte" completin4 this chapte" o% sho%l1 ;a< &e a6a"e of the facto"s of p"o%ction an the ma"-et of the "e6a"s acc"%in4 to each of them= ;&<
%ne"stan the application of s%ppl an eman theo" to facto"s of p"o%ction.
$actors of production and their re%ards In the p"e#io%s chapte" 6e sa6 that the facto"s of p"o%ction co%l &e analse into fo%" cate4o"ies1 lan) la&o%") capital an ent"ep"ene%"ship. In this chapte" 6e e#elop that analsis mo"e f%ll. Each sca"ce economic "eso%"ce has a #al%e) an the o6ne" of the "eso%"ce o" facto" of p"o%ction is "e6a"e fo" 4i#in4 it %p to someone else. Fi"ms a"e "e6a"e fo" the 4oos an se"#ices the p"o%ce & the p"ice c%stome"s 6ill pa fo" them. The "eso%"ces %se in p"o%ction a"e also "e6a"e) & the p"ice that fi"ms pa fo" them. ;a<
*an is "e6a"e 6ith "ent. Altho%4h it is eas to thin- of lan as p"ope"t) the economic efinition of lan is not 8%ite 6hat o% mi4ht s%ppose. *an consists not onl of p"ope"t ;the lan element onl1 &%ilin4s a"e capital< &%t also the nat%"al "eso%"ces that 4"o6 on the lan o" that a"e e2t"acte f"om the lan ;i.e. the nat%"al "eso%"ces of the soil an 6oolans an e2t"acte mine"als s%ch as coal<.
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*a&o%" is "e6a"e 6ith 6a4es. *a&o%" consists of &oth the mental an the phsical "eso%"ces of h%man &ein4s. ;Sala"ies as 6ell as 6ee-l5pai 6a4es a"e efine collecti#el as >6a4es> in economics.<
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Capital is "e6a"e 6ith inte"est. It is eas to thin- of capital as financial "eso%"ces) an the "ate of inte"est is the p"ice mechanism in &alancin4 the s%ppl an eman fo" mone. Ho6e#e") capital in an economic sense is not >mone in the &an->. Capital "efe"s to man5mae items s%ch as plant) machine" an tools 6hich a"e mae an %se not fo" thei" o6n sa-e) &%t to ai the p"o%ction of othe" 4oos an se"#ices. The cost of %sin4 machine" an plant an so on is >inte"est>)
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Ent"ep"ene%"ship o" ente"p"ise is the fo%"th facto" of p"o%ction. An ent"ep"ene%" is someone 6ho %ne"ta-es the tas- of o"4anisin4 the othe" th"ee facto"s of p"o%ction in a &%siness ente"p"ise) an in oin4 so) &ea"s the "is- of the #ent%"e. He c"eates ne6 &%siness #ent%"es an the "e6a" fo" the "is- he ta-es is p"ofit.
The cost of p"o%ction ;"ent) 6a4es) inte"est an p"ofit< is the s%m total of the "e6a"s fo" all the facto"s of p"o%ction that 4o into ma-in4 a 4oo. Disti#ution theoy
Dist"i&%tion theo" is conce"ne 6ith ho6 m%ch "e6a" each facto" of p"o%ction 4ets. hat ete"mines the amo%nt that is pai fo" lan) la&o%") capital an ent"ep"ene%"ship Ho6 is the total income >ca-e> i#ie &et6een them The total income ea"ne & all facto"s of p"o%ction 6ithin a national econom e8%als the national income. National income is the s%&?ect of a late" chapte".
Fa!to pi!es
The p"ices pai to each facto" of p"o%ction a"e sometimes "efe""e to as >facto" p"ices>. The p"ices fo" lan) la&o%" an capital a"e ete"mine & s%ppl an eman. Ent"ep"ene%"ship an p"ofit a"e iffe"ent) an these 6ill &e isc%sse late". Fa!to demand as a deived demand
The eman fo" facto"s of p"o%ction is a e"i#e eman. 9 this 6e mean that the facto"s of p"o%ction a"e not emane fo" thei" o6n sa-e. The a"e emane &eca%se a fi"m nees them to ma-e 4oos) 6hich a"e then sol to ho%sehols. It is the eman & ho%sehols fo" 4oos f"om 6hich the eman & fi"ms fo" the facto"s of p"o%ction is e"i#e.
Capital and interest Inte"est is the "e6a" fo" capital. Capital as a facto" of p"o%ction consists of1 ;a<
stoc-s of finishe 4oos=
;&<
p"o%ce" 4oos ;i.e. machines) tools) &%ilin4s) office e8%ipment etc<.
The "ate of inte"est acco"in4 to t"aitional economic theo" is ete"mine & s%ppl an eman. ;a<
the eman fo" capital comes f"om fi"ms 6hich e2pect to in#est in stoc-s an e8%ipment so as to c"eate mo"e o%tp%t) ma-e mo"e sales an ea"n mo"e p"ofit
;&<
the s%ppl of capital ;i.e. finance to ac8%i"e stoc-s an e8%ipment etc< comes f"om in#esto"s
The ma%inal e""i!ien!y o" !apital
The eman & fi"ms to &o""o6 capital is e2plaine in t"aitional economic theo" & the ma"4inal efficienc of capital. It is "easona&le to ass%me that if fi"ms &o""o6 mo"e an mo"e capital to in#est the aitional in#estments that the ma-e 6ill &ecome less an less p"ofita&le. Fi"ms sho%l al6as see- to in#est in the oppo"t%nities that offe" the &i44est "et%"ns an once these ha#e &een in#este in "emainin4 oppo"t%nities 6ill not offe" "et%"ns 8%ite as &i4. As mo"e in#estments a"e mae the "et%"ns f"om aitional capital in#estments 6ill 4"a%all ecline. The ma"4inal efficienc of capital "efe"s to this eclinin4 siGe of "et%"n as the #ol%me of in#estment inc"eases.
" + " ,
Ma"4inal efficienc of capital ;MEC< B+
B,
The MEC c%"#e fo" all the fi"ms in an in%st" is the in%st">s eman c%"#e fo" capital) an it is the s%m of the eman c%"#es ;MEC c%"#es< of all the ini#i%al fi"ms in the in%st". An in%st">s MEC c%"#e an an ini#i%al fi"m>s MEC c%"#e ha#e the same &asic shape) as sho6n in Fi4%"e I. The supply o" !apital
The "ate of inte"est also epens on the s%ppl of capital f"om in#esto"s) an the inte"action of s%ppl an eman esta&lishes inte"est "ates. The s%ppl of capital comes f"om sa#e"s. Sa#in4s a"e the "eso%"ces that a"e neee to p"o%ce capital ;i.e. to pa fo" the mate"ials an la&o%" that p"o%ce the capital< an 6hich co%l ha#e &een %se fo" c%""ent cons%mption instea. Sa#in4s lea to in#estment an the c"eation of capital) &%t sa#in4s a"e onl mae & >sac"ificin4> some c%""ent cons%mption. Sa#e"s choose to sa#e in o"e" to ma-e possi&le the p"o%ction of e#en mo"e o%tp%ts in the f%t%"e) an so the amo%nt of sa#in4s is ete"mine & compa"in41 ;a<
6hat the a#aila&le 6ealth co%l &e %se to o&tain no6 f"om the c%""ent cons%mption= an
;&<
ho6 m%ch e2t"a 6ealth 6ill &e o&taine in the f%t%"e f"om sa#in4.
This e2t"a 6ealth in the f%t%"e) 6hich ma-es sa#e"s p"efe" to sa#e "athe" than cons%me thei" 6ealth no6) is "ep"esente & inte"est. Hi4he" inte"est 6ill ma-e sa#in4 mo"e att"acti#e) an the s%ppl of sa#in4s 6ill the"efo"e inc"ease. The p"ice of capital ;the inte"est "ate< sho%l the"efo"e &e ete"mine & the inte"action of s%ppl ;sa#in4s< an eman ;ma"4inal efficienc of capital<. In Fi4%"e ,) the e8%ili&"i%m inte"est "ate 6o%l &e " 6ith 8%antit B of capital s%pplie & sa#e"s an emane & fi"ms.
Sa#in4s
"
MEC
B
&abour and %aes The demand "o la#ou and ma%inal podu!tivity theoy
A simila" eman an s%ppl analsis can &e mae fo" la&o%" an the p"ice of la&o%" ;ie 6a4es<. ;a<
*i-e the eman fo" capital) the eman fo" la&o%" & fi"ms is a e"i#e eman) a"isin4 f"om cons%me" eman fo" the fi"ms> o%tp%t.
;&< ;c<
*a&o%" is emploe to help to ma-e the 4oos an se"#ices of the fi"m) an the mo"e la&o%" that is emploe) the 4"eate" sho%l &e the total #ol%me of 4oos o" se"#ices p"o%ce. Ho6e#e") 6ith la&o%" the la6 oiminishin4 "et%"ns applies) &eca%se as mo"e an mo"e la&o%" is hi"e) the p"o%cti#it of the e2t"a 6o"-fo"ce 6ill 4"a%all ecline. A fi"m cannot -eep on hi"in4 e2t"a la&o%") in the sho"t te"m at least) an e2pect e#e" aitional "ec"%it to cont"i&%te the same e2t"a o%tp%t to the fi"m as othe"s in the 6o"-fo"ce.
In o%" &asic analsis of ma"4inal p"o%cti#it theo") 6e shall ass%me that the amo%nt of othe" facto"s of p"o%ction is in fi2e s%ppl) so that an aitions to a fi"m>s o%tp%t an "e#en%e can onl come f"om aitions to the la&o%" fo"ce. In othe" 6o"s) la&o%" is a #a"ia&le facto" of p"o%ction. The ma"4inal phsical p"o%ct ;MPP< of la&o%" is the aitional %nits of o%tp%t f"om one e2t"a %nit of la&o%". In acco"ance 6ith the la6 of iminishin4 "et%"ns) the MPP of la&o%" 6ill ecline as mo"e an mo"e o%tp%t is p"o%ce. The ma"4inal "e#en%e p"o%ct ; MRP < of la&o%" is the ma"4inal "e#en%e #al%e of the ma"4inal phsical p"o%ct of la&o%". This is the e2t"a "e#en%e that fi"ms in the in%st" 6o%l o&tain f"om the e2t"a o%tp%t p"o#ie & each e2t"a "ec"%it to the 6o"-fo"ce. *i-e the MPP) the MRP 6ill &e 4"a%all eclinin4. Ta&le + &elo6 ill%st"ates this "elationship &et6een MPP an MRP . Ta&le + Num#e o" units o" la#ou
Total output units
+ , 3 /
7 ++7 +!7 +$7
Revenue value o" this output 077 +),77 +)!77 +)077
Ma%inal physi!al podu!t
5 !7 /7 37
Ma%inal evenue podu!t -
!77 377 ,77
The MRP of la&o%" is simila" in concept to the ma"4inal efficienc c%"#e of capital. It also "ep"esents the eman c%"#e fo" la&o%" & a fi"m ;o" & fi"ms in the in%st" as a 6hole<. Fi"ms sho%l &e 6illin4 to pa fo" la&o%" p"o#ie that the ma"4inal "e#en%e p"o%ct of la&o%" e2cees the cost of emploin4 the la&o%". B%ite simpl) if a fi"m can ma-e an e2t"a L+!7 pe" 6ee- f"om hi"in4 an e2t"a emploee) it sho%l &e 6illin4 to hi"e the emploee p"o#ie that the 6ee-l 6a4e oes not e2cee L+!7. In Fi4%"e 3) if the MRP of la&o%" fo" a ce"tain tpe of ?o&) ?o& tpe A) is as sho6n) an the 6a4e le#el fo" ?o& tpe A is ) then the in%st" 6o%l 6ant to emplo emploees in ?o& tpe A) &eca%se the MRP of la&o%" e2cees the 6a4e "ate %p to .
MRP of la&o%") ?o& tpe 9
MRP of la&o%") ?o& tpe A
In cont"ast) ?o& tpe 9 has a hi4he" ma"4inal p"o%cti#it #al%e than ?o& tpe A) an so the in%st" 6o%l &e 6illin4 eithe"1
;a<
to pa a hi4he" 6a4e fo" the same 8%antit of emploees as ?o& tpe A= o"
;&<
to emplo mo"e emploees into ?o& tpe 9 than ?o& tpe A if the 6a4e "ate fo" &oth 6e"e .
This analsis of the MRP of la&o%" onl consie"s the eman & fi"ms fo" la&o%" of iffe"ent tpes an s-ills. It oes not consie" the s%ppl of la&o%". Acco"in4 to ma"4inal p"o%cti#it theo") 6a4e le#els a"e ete"mine & the inte"action of the eman fo" an the s%ppl of la&o%". The s%ppl of la&o%" is infl%ence & 6a4e "ates. Hi4he" 6a4es 6ill att"act mo"e people 6illin4 to o the 6o"-. The s%ppl c%"#e fo" la&o%" can the"efo"e &e sho6n as the ma"4inal cost of the la&o%") i.e. the e2t"a total 6a4e paments neee to inc"ease total la&o%" s%ppl & each ma"4inal e2t"a amo%nt. Fo" e2ample) s%ppose that at a 6a4e le#el of L+7 pe" 6ee-) the s%ppl of la&o%" into a ?o& 6o%l &e $ men. At a 6a4e le#el of L+07 pe" 6ee-) the 6illin4 s%ppl 6o%l &e ' men) an at L+$7 pe" 6ee-) +7 men 6o%l &e 6illin4 to o the ?o&. The ma"4inal cost of the 'th an l7th men 6o%l &e as in Ta&le ,. Ta&le , 5a%e 4 Avea%e !ost o" la#ou 2 AC +3 L
Supply 2num#e o" men3
+7 +07 +$7
$ ' +7
Total (a%es
L
Ma%inal !ost o" la#ou 2MC+3 L
+,$7 +!37 +$77
5 ,!7 ;+!375+,$7< ,07 ;+$775+!37<
Altho%4h the e2ample is small) the fi4%"es o sho6 that 6hen hi4he" 6a4es m%st &e pai to att"act mo"e la&o%"1 ;a<
the s%ppl c%"#e fo" la&o%") 6hich is the ma"4inal cost c%"#e fo" la&o%" ;MC*<) 6ill &e positi#e an the"efo"e "isin4= an
;&<
MC* 6ill &e hi4he" than the 6a4e le#el ;i.e. hi4he" than the a#e"a4e cost of la&o%" AC*<.
Ret%"nin4 to ma"4inal p"o%cti#it theo" ) 6e the"efo"e ha#e 6a4e le#els ete"mine & the inte"action of s%ppl an eman) 6hich is 6he"e the MC* c%"#e inte"sects 6ith the ma"4inal "e#en%e p"o%ct c%"#e fo" la&o%" ;MRP*<. In a pe"fectl competiti#e in%st") all e2t"a 8%antities of la&o%" can &e o&taine f"eel at a constant 6a4e "ate ;fo" e2ample) if a fi"m o" an in%st" can hi"e limitless 8%antities of la&o%" at a 6a4e of L,!7 pe" 6ee-<.
!igure #
Competition among firms for labour $age level $% employment level in the industry Li and in an individual firm Lf
MRP*
D
S MC* AC*
*i
*f
Fi4%"e / sho6s that an ini#i%al fi"m 6ill contin%e to hi"e mo"e la&o%" at 6a4e "ate %ntil the MRP of la&o%" falls to this le#el. The ini#i%al fi"m 6ill the"efo"e hi"e * f %nits of la&o%". Total emploment in the in%st" ;*i< is the s%m of the emploment of la&o%" & the ini#i%al fi"ms. If the in%st" is ominate & a sin4le fi"m) this fi"m is the onl) o" the main) >&%e"> of la&o%" in the in%st". S%ch a fi"m is sai to &e a >monopsonist> &%e" of la&o%". MRP* In this sit%ation) the fi"m 6ill pa lo6e" 6a4es if it nees fe6e" emploees) an hi4he" 6a4es if it nees to att"act mo"e la&o%". The AC* c%"#e "ises 6ith o%tp%tn%m&e"s emploe) an mo"e si4nificantl) the MC* c%"#e ;the s%ppl c%"#e fo" la&o%"< is also "isin4.
MC
AC
MRP
* Deman an s%ppl analsis sho6s that the n%m&e" emploe 6ill &e *) 6hich is the le#el 6he"e MC* MRP*. +imitations o" ma%inal podu!tivity theoy
The ma"4inal p"o%cti#it theo" of 6a4es cannot acco%nt 6holl fo" the ete"mination of 6a4e "ates an 6a4e iffe"entials &eca%se the ass%mptions on 6hich it is &ase o not appl in "ealit. ;a<
It is often impossi&le to calc%late the ma"4inal p"o%cti#it of la&o%") especiall in aminist"ati#e 6o"- o" se"#ice in%st"ies e.4.) &an- cle"-s an shop assistants o not p"o%ce a meas%"a&le phsical o%tp%t.
;&<
Ma"4inal p"o%cti#it theo" fo" la&o%" ass%mes that all othe" facto"s of p"o%ction a"e hel in constant s%ppl. This is %nli-el to &e so) especiall in the case of capital. As the amo%nt of la&o%" emploe chan4es) so too 6o%l the amo%nt of capital.
;c<
A f%"the" ass%mption of the ma"4inal p"o%cti#it theo" of 6a4es is that la&o%" is f"ee to ente" the ma"-et o" lea#e it fo" alte"nati#e emploment else6he"e. In p"actice) this mi4ht not &e the case) an the"e mi4ht &e impe"fections in the la&o%" ma"-et.
/Impe"e!tions/ in the la#ou ma,et
>Impe"fections> in the la&o%" ma"-et p"e#ent a f"ee ma"-et in la&o%" f"om ope"atin4) &eca%se of "est"ictions on the f"ee s%ppl of la&o%". These la&o%" s%ppl "est"ictions incl%e the follo6in4. ;a<
Societ) la6s an c%stoms. ;Fo" e2ample) the social c%stom mi4ht &e fo" 6omen to 6o"-) o" not to 6o"-= o" fo" chil"en to 6o"- f"om a ce"tain a4e. Some ?o&s mi4ht &e mo"e >sociall accepta&le> than othe"s.<
;&<
*a&o%" immo&ilit. ;This "efe"s to the mo#ement of la&o%" f"om one in%st" to anothe" an f"om one 4eo4"aphical "e4ion o" co%nt" to anothe".<
;c<
9a""ie"s to ent" into the t"ae o" p"ofession.
;<
*ac- of f"eel a#aila&le info"mation a&o%t ?o&s an 6a4es)
;e<
T"ae %nion infl%ence on the s%ppl of la&o%" an 6a4e "ates.
e shall no6 consie" some of these in mo"e etail 5a%e di""eentials
a4e iffe"entials a"e iffe"ences in the "ate of pa &et6een one tpe of ?o& an anothe" . Some ?o&s a"e mo"e att"acti#e than othe"s. If 6a4es 6e"e e8%al in all occ%pations the i"t an isa4"eea&le ?o&s 6o%l att"act fe6 6o"-e"s 6hile most people 6o%l see- emploment 6he"e conitions 6e"e pleasant. The tenenc 6o%l the"efo"e &e fo" the 6a4es in the isa4"eea&le an i"t ?o&s to "ise 6hile 6a4es in the mo"e pleasant occ%pations 6o%l fall. A theo"etical e2planation of 6a4e iffe"entials can &e &ase on st"ai4htfo"6a" eman an s%ppl analsis1 ;a<
the eman fo" a pa"tic%la" tpe of 6o"-e" comes f"om emploees ;o" c%stome"s<
;&<
the s%ppl of a pa"tic%la" tpe of 6o"-e" comes f"om the ini#i%als 6ho a"e a&le an 6ho choose to o that tpe of 6o"-. MCs ACs MC%
MRP
MRPs
AC% %
B%
Bs
S-ille 6o"-e"s a"e mo"e p"o%cti#e an a mo"e #al%e to a fi"m>s ma"4inal "e#en%e p"o%ct than %ns-ille 6o"-e"s. In Fi4%"e ) 6e ass%me that emploe"s effecti#el fo"m a &%e"s> ca"tel o" >monopson>. The MRP of a s-ille la&o%" fo"ce is sho6n & MRP s) an the MRP of an %ns-ille la&o%" fo"ce is sho6n & MRP % .
S-ille 6o"-e"s e2pect to &e pai mo"e fo" thei" s-ills. In o"e" to att"act a &i44e" s%ppl of s-ille 6o"-e"s) i.e. mo"e people 6illin4 to ac8%i"e the necessa" t"ainin4) s-ills an 8%alifications) hi4he" 6a4es m%st &e pai) an the s%ppl c%"#e of s-ille la&o%" ;MCs< 6ill the"efo"e lie to the left of the s%ppl c%"#e of %ns-ille la&o%" ;MC %<. The s%ppl of s-ille 6o"-e"s 6ill also &e mo"e inelastic) &eca%se the &a""ie"s to ent" ;e.4. the nee to o&tain s%ita&le t"ainin4 an 8%alifications< a"e hi4he") o" the a#aila&ilit of ini#i%als 6ith s%ita&le talent 6ill &e "est"icte. As a conse8%ence) the"e 6ill &e a 6a4e iffe"ential &et6een the s-ille an the %ns-ille 6o"-e"s) 6ith s-ille 6o"-e"s ea"nin4 s an %ns-ille 6o"-e"s ea"nin4 %. Ho6 mi4ht 6a4e iffe"entials &e eliminate If a 4"o%p of lo65pai 6o"-e"s 6ishe to eliminate the 6a4e iffe"entials &et6een themsel#es an mo"e hi4hl pai s-ille 6o"-e"s) the mi4ht t" st"i-e action) o" e#en as- fo" 4o#e"nment s%ppo"t ;minim%m pa le4islation) o" income cont"ols <. Ho6e#e") acco"in4 to ma"4inal p"o%cti#it theo") the sol%tion 6o%l &e to inc"ease p"o%cti#it. If %ns-ille la&o%" can &ecome mo"e p"o%cti#e) thei" MRP c%"#e 6ill shift to the "i4ht) an so the can ?%stif hi4he" 6a4es. a4e iffe"entials 6ith othe" 6o"-e"s 6o%l &e "e%ce an pe"haps eliminate. This is 6h) in some hi4hl p"ofita&le in%st"ies) %ns-ille 6o"-e"s mi4ht ha#e s%ch a hi4h MRP that the ea"n hi4he" 6a4es than s-ille 6o"-e"s in an %np"ofita&le in%st". Ma"4inal p"o%cti#it theo" is not the onl 6a to e2plain 6a4e iffe"entials. Othe" facto"s affectin4 la&o%" s%ppl mi4ht help to infl%ence 6a4e le#els fo" s-ille 6o"-e"s 5 s%ch as the 6illin4ness of some s-ille la&o%" to 6o"- fo" lo6 6a4es) espite thei" s-ills an t"ainin4 ;e.4. n%"ses an social 6o"-e"s<. Tade unions and the #a%ainin% theoy o" (a%es
Altho%4h 6e ha#e loo-e at ma"4inal p"o%cti#it theo" an the #ie6 that 6a4e le#els a"e set & eman an s%ppl facto"s) it sho%l also &e "eco4nise that t"ae %nions t" to ne4otiate hi4he" 6a4es fo" la&o%". The"e is a >&a"4ainin4 theo"> of 6a4es 6hich states that 6a4e le#els a"e set & ne4otiation &et6een %nions an mana4ement. Collecti#e &a"4ainin4 is a te"m 6hich "efe"s to the p"ocess & 6hich %nions ne4otiate an "each a4"eements 6ith emploe"s. It is common fo" collecti#e &a"4ainin4 to in#ol#e a sin4le monopolist selle" of la&o%" ;the t"ae %nion< an one &%e" o" monopsonist ;a sin4le fi"m o" an emploe"s> fee"ation<. As s%ch) ann%al 6a4e claims ma &e one of a t"ial of st"en4th &et6een t6o >4iants>. The "ole of t"ae %nions) in economic te"ms) has t6o aspects1 ;a<
to e"ect an maintain &a""ie"s to ent" into ?o&s in the in%st") th%s ens%"in4 hi4h ea"nin4s fo" the e2istin4 mem&e"s=
;&<
to monopolise the s%ppl of la&o%" in the in%st". If the eman fo" la&o%" is in the hans of a sin4le emploe" o" emploe"s> fee"ation) this can infl%ence the p"ice at 6hich la&o%" is &o%4ht. If the s%ppl of la&o%" is in the hans of a collecti#e &o as oppose to ini#i%als) this can infl%ence the p"ice at 6hich it can &e sol.
9 "est"ictin4 ent" to the la&o%" fo"ce) t"ae %nions can fo"ce 6a4es to mo#e f"om 7 to +) ;see Fi4%"e 0< & effecti#el chan4in4 the s%ppl c%"#e f"om S 7 to S+.This 6ill ho6e#e" "es%lt in fe6e" ?o&s. The n%m&e" emploe 6ill fall f"om * 7 to *+.
S+ S7
+ 7
D*
*+
*7
Ho6e#e") once 6a4e "ates ha#e &een 4i#en an initial inc"ease & the %nionisation of the 6o"- fo"ce) an f%"the" pa "ises) 4i#en no chan4e in the ma"4inal "e#en%e p"o%ct ;MRP< of la&o%") 6ill p"o&a&l "e%ce the total eman fo" la&o%" & emploe"s.
, + MRP, MRP+
*,
*+
hen 6a4es "ise f"om ) to ,) the eman fo" la&o%" 6ill fall f"om * + to *, ;Fi4%"e $<) 4i#en no chan4e in the MRP of la&o%" ;initiall MRP +<. Ho6e#e") if the la&o%" fo"ce a4"ees to an imp"o#ement in p"o%cti#it so that the ma"4inal "e#en%e p"o%ct of la&o%" shifts to MRP ,) an inc"ease in 6a4es f"om + to , co%l &e achie#e 6itho%t chan4in4 the total 6o"-fo"ce emploe f"om * +.
a4e "ises an inflation A 6a4e inc"ease can ha#e one of t6o effects ;a<
As ill%st"ate in Fi4%"e ' if the emploe" cannot "aise the p"ices of his final p"o%ct the ma"4inal "e#en%e p"o%ct of la&o%" cannot &e inc"ease an so the amo%nt of la&o%" emane & the emploe" 6ill fall f"om * + to *,.
, +
MRP, MRP+
*, ;&<
*+
If the emploe" can pass the e2t"a la&o%" costs on the en c%stome" & "aisin4 the p"ice of the en p"o%ct the MRP of the la&o%" 6ill &e inc"ease an so the same 8%antit of la&o%" *+ can &e -ept in emploment at the ne6 6a4e le#el as sho6n in fi4%"e '
Minimum (a%es
In some in%st"ies of some co%nt"ies) the"e is a minim%m 6a4e a4"eement 6hich means that all 6o"-e"s in the in%st" m%st ea"n at least the minim%m 6a4e. Some t"ae %nionists ha#e a"4%e fo" a national minim%m 6a4e. The p%"pose of a minim%m 6a4e is to ens%"e that lo65 pai 6o"-e"s ea"n at least eno%4h in 6a4es to ha#e a ce"tain stana" of li#in4. If a minim%m 6a4e is enfo"ce & le4islation o" ne4otiate nationall fo" an in%st" & a t"ae %nion the minim%m 6a4e 6ill p"o&a&l &e a&o#e the c%""ent 6a4e le#el fo" the ?o&s conce"ne. The conse8%ences of a minim%m 6a4e 6o%l then &e1 ;a<
to "aise 6a4e le#els fo" 6o"-e"s emploe to a le#el a&o#e the >e8%ili&"i%m> 6a4e "ate= &%t
;&<
to "e%ce the eman fo" la&o%" an so ca%se ?o& losses.
SMC* in f"ee la&o%" ma"-et
DMRP*
Minim%m 6a4e M
Bm
B6
itho%t a minim%m 6a4e) OB 6 6o"-e"s 6o%l &e emploe at 6a4e "ate ;Fi4%"e +7<. 6a%ainin% theoy o" (a%es. !on!lusion
It is p"o&a&l fai" to concl%e that the &a"4ainin4 theo" of 6a4es) that %nions can fi2 a 6a4e le#el & ne4otiatin4 pa 6ith emploe"s) is not inconsistent 6ith ma"4inal p"o%cti#it theo" an the p"inciples of eman an s%ppl. The le#el of 6a4es &a"4aine & %nions 6ill help to ete"mine emploment le#els ;eman an s%ppl< an 6hen conitions in the in%st" >fa#o%"> the emploe" 6ith la&o%" ha#in4 lo6 ma"4inal "e#en%e p"o%cti#it) %nions 6ill fin it iffic%lt to &a"4ain fo" hi4he" 6a4es o" to p"ese"#e ?o&s in the in%st". Fa!tos in"luen!in% demand "o la#ou
As 6e ha#e seen) eman fo" la&o%" is infl%ence & the ma"4inal p"o%cti#it of la&o%". e no6 looat specific facto"s infl%encin4 eman an ma"4inal p"o%cti#it. These a"e1 ;a< ;&< ;c<
the efficienc o" p"o%cti#it of la&o%"= the s-ills of la&o%"= the s%&stit%ta&ilit of capital fo" la&o%".
The e""i!ien!y o" la#ou
Imp"o#ements in p"o%cti#it 6ill inc"ease the eman fo" la&o%") an p"o%cti#it in t%"n epens on1 ;a<
the attit%es of the ini#i%al=
;&< ;c< ;< ;e< ;f< ;4<
the intelli4ence an s-ills of ini#i%als= the attit%es of the 6o"- 4"o%p to 6hich the ini#i%al &elon4s= esta&lishe 6o"- p"actices an t"ae %nion infl%ence= the s-ill of mana4ement in 4ettin4 the &est o%t of a 6o"-fo"ce= effecti#e %se of othe" facto"s of p"o%ction= possi&l) 4"eate" specialisation ;i.e. an inc"easin4 >i#ision of la&o%"><.
+a#ou s,ills. spe!ialisation o" la#ou Specialisation of la&o%" helps to inc"ease la&o%" p"o%cti#it. o"- is i#ie %p into small %nits) an specialist la&o%" concent"ates on a pa"tic%la" %nit of the o#e"all 6o"-. Plant an e8%ipment can &e specialise too) an a%tomation helps to inc"ease la&o%" p"o%cti#it. o"- can &e o"4anise effecti#el & assi4nin4 specialists to each aspect of 6hat has to &e one) an time is sa#e &eca%se 6o"-e"s o not ha#e to -eep s6itchin4 f"om one ?o& to anothe". The su#stituta#ility o" !apital "o la#ou
S%&stit%tion &et6een facto"s of p"o%ction ;e.4. &et6een la&o%" an capital< 6ill ta-e place1 ;a<
p"o#ie that s%&stit%tion is p"actical o" technolo4icall feasi&le ;e.4. that machines can &e mae to o the 6o"- p"e#io%sl ca""ie o%t & la&o%") o" that la&o%" can phsicall o the 6o"- of machines<=
;&<
6hen the p"ice o" p"o%cti#it of one facto" of p"o%ction "ises "elati#e to anothe" . If 6a4es 4o %p) the ma"4inal cost of la&o%" 6ill "ise) an fi"ms 6ill 6ant less la&o%" at this hi4he" cost. *a&o%" 6ill also &ecome mo"e e2pensi#e in "elation to capital) an the"e 6ill &e some s%&stit%tion of capital fo" la&o%". The net "es%lt of an inc"ease in 6a4es 6ill &e a "e%ction in the B%antit of la&o%" emploe 5%nless the p"o%cti#it of la&o%" can &e inc"ease at the same time) to st"en4then the eman fo" la&o%".
The elasti!ity o" demand "o la#ou
The chan4e in eman fo" la&o%" in "esponse to a chan4e in 6a4e "ates can &e meas%"e & the elasticit of eman fo" la&o%". This is1 chan4e in n%m&e"s emploe chan4e in 6a4es The facto"s infl%encin4 the e4"ee of elasticit of eman fo" la&o%" a"e1 ;a<
the technical ease 6ith 6hich emploe"s co%l s%&stit%te othe" facto"s of p"o%ction ;mainl capital< fo" la&o%"=
;&<
the elasticit of eman fo" the final p"o%ct. If the p"o%ct mae & the 6o"- fo"ce has an inelastic eman) p"o%ce"s can pass on hi4he" 6a4e costs mo"e easil to cons%me"s & "aisin4 p"ices. Ho6e#e") if eman fo" the en5p"o%ct has a hi4h p"ice elasticit) an inc"ease in 6a4es 6ill "es%lt) th"o%4h hi4he" p"ices) in a sha"p fall in eman f o" la&o%"=
;c<
the elasticit of s%ppl of alte"nati#e facto"s of p"o%ction. E#en if it is technicall possi&le to s%&stit%te la&o%" 6ith) sa) capital) it mi4ht &e too costl fo" p"o%ce"s to o so if the elasticit of s%ppl of capital is lo6. An inc"ease in s%ppl 6o%l then onl &e achie#e & pain4 si4nificantl mo"e fo" the s%&stit%te facto" ;capital<) an so in spite of hi4he" 6a4es costs) it mi4ht still &e less costl to %se la&o%" than to s6itch to capital as a s%&stit%te facto"=
;<
the p"opo"tion of la&o%" costs to total costs.
&and and rent Rent
The p"ice of lan) 6hich is "ent) is also ete"mine & s%ppl an eman. In isc%ssin4 lan) it is impo"tant to 4et o%" &asic efinitions clea". In e#e"a lan4%a4e) if a pe"son &%s some lan) 6e p"o&a&l mean that he &%s some &%ilin4s 6ith a s%ppl of 6ate") elect"icit an so on. To the economist) &%ilin4s an 6ate" s%ppl a"e capital= lan is the ea"th an its nat%"al "eso%"ces. It is also common to spea- of "entin4 a ho%se) a ca" o" a tele#ision. This is >comme"cial "ent> pai to the lanlo" 6ho is an o6ne" of capital. Comme"cial "ent is not the same as the mo"e specific concept of economic "ent) 6hich "efe"s to a pament mae in e2cess of the pament neee to -eep a facto" of p"o%ction) s%ch as lan) la&o%" o" capital) in c%""ent %se. e shall "et%"n to this a little late". The pi!e o" land The special efinitions of lan an "ent 6hich a"e %se & economists e"i#e f"om those fi"st %se & Da#i Rica"o in the +'th cent%". Rica"o 6as conce"ne) not 6ith ho6 m%ch "ent is pai fo" lan %se fo" a pa"tic%la" p%"pose) &%t ho6 m%ch "ent is pai fo" lan as a 6hole. He a"4%e that1
;a<
the total amo%nt of lan a#aila&le is fi2e) the"efo"e the s%ppl of lan is inelastic) "e4a"less of ho6 m%ch "ent is pai fo" it=
;&<
since the s%ppl of lan is inelastic) the amo%nt of "ent 6ill &e ete"mine & the p"ice of the 4oos p"o%ce f"om the lan fo" sale to ma"-ets.
E$ample. land and ent
As a simplifie e2ample) let %s s%ppose that a piece of lan ;fi2e in siGe< has onl one %se) 6hich is to 4"o6 ca""ots. S%ppose also that this fi2e amo%nt of lan) 6hich can onl &e %se fo" 4"o6in4 ca""ots) has a pe"fectl elastic la&o%" fo"ce to 6o"- on it an that no capital is emploe. Fi4%"e ++ sho6s1 ;a<
the 6a4e "ate of la&o%") ) 6hich is constant "e4a"less of the n%m&e" of 6o"-e"s emploe) &eca%se la&o%" s%ppl is pe"fectl elastic=
;&<
the ma"4inal "e#en%e p"o%ct of la&o%" c%"#es fo" t6o iffe"ent p"ice le#els) Po an p + of a p"o%ct) sa ca""ots. R
B S
T
MRP+
MRP7
P"ice le#el P
;P"ice le#el P
*
M
hen the p"ice of ca""ots is P 7) O* 6o"-e"s &e emploe at the 4i#en 6a4e "ate1 ;i< ;ii<
the total cost of la&o%" 6ill &e "ep"esente & the a"ea OS*= the total "e#en%e f"om the sale of ca""ots 6ill &e OBS*=
;c<
;iii< the iffe"ence) BS) is "ent= if the p"ice of ca""ots "ises to P) ) the MRP of la&o%" 6ill imp"o#e. OM 6o"-e"s 6ill &e emploe) an= ;i< ;ii< ;iii<
the total cost of la&o%" is no6 OTM== the total "e#en%e is ORTM the"efo"e "ent has "isen to RT=
e concl%e that 6hen lan is in fi2e s%ppl) the siGe of the "ent epens on the p"ice of the 4oos p"o%ce on the lan. The pi!e o" land "o spe!i"i! uses
e can e2ten this p"inciple to co#e" the sit%ation 6he"e the s%ppl of lan is not pe"fectl elastic. This sit%ation a"ises 6he"e 6e a"e consie"in4 the s%ppl of lan fo" a pa"tic%la" p%"pose) fo" e2ample) office e#elopment o" a4"ic%lt%"al %se. Since it is %s%all possi&le to chan4e the %se of a piece of lan) the s%ppl of lan fo" a pa"tic%la" p%"pose sho%l not no"mall &e consie"e fi2e. If the p"ice of a4"ic%lt%"al lan in the U: 6ent %p 6e 6o%l e2pect a t"ansfe" of lan f"om ;sa< the omestic ho%sin4 secto" to the a4"ic%lt%"al secto". In fact) the s%ppl c%"#e of a4"ic%lt%"al lan slopes %p6a" f"om left to "i4ht. The e8%ili&"i%m p"ice an 8%antit of a4"ic%lt%"al lan a"e ete"mine & the inte"section of the eman c%"#e ;e"i#e f"om the p"ice of 4oos p"o%ce on the lan< an the s%ppl c%"#e ;e"i#e f"om the p"ice p 6hich p"e#ents a 8%antit of lan 8 &ein4 t"ansfe""e to an othe" %se<
S
Rent
MRP ;Ma"4inal "e#en%e p"o%ct of o%tp%t
B
Entrepreneurship and profit The "un!tion o" the entepeneu
The f%nction of ent"ep"ene%"s) as the fo%"th facto" of p"o%ction) is to com&ine the othe" th"ee facto"s) lan) la&o%" an capital) so as to ma2imise the efficienc of "eso%"ce %tilisation an to ma2imise the fi"m>s p"ofits. 9%siness ente"p"ise in#ol#es "is- an %nce"taint) an act%al p"ofits mi4ht &e hi4he" o" lo6e" than e2pecte= an it is the ent"ep"ene%">s "ole to &ea" the &%"en of this %nce"taint. His "e6a") p"ofit) is 6hat is left o#e" afte" the othe" th"ee facto"s of p"o%ction ha#e &een "e6a"e) an if the"e is nothin4 left o#e" the ent"ep"ene%" 6ill ma-e no p"ofits o" e#en a loss. e can ientif t6o aspects to the "ole of the ent"ep"ene%"= ;a< ;&<
he o"4anises p"o%ction an ma-es ecisions a&o%t ne6 &%siness #ent%"es= he ea"ns the "e6a" of p"ofit.
These %al aspects of ent"ep"ene%"ship a"e possi&l most appa"ent in pa"tne"ships an small p"i#ate limite companies) 6he"e the o6ne"s of the &%siness ;pa"tne"s o" sha"ehole"s< a"e often also the senio" mana4e"s. The o"4anise p"o%ction) ma-e the ecisions) an ea"n the p"ofits fo" themsel#es. The natue o" po"it
Unli-e lan) la&o%" an capital) 6hich a"e "e6a"e & "ents) 6a4es an inte"est "especti#el) the ent"ep"ene%" cannot &e s%"e of 4ainin4 a "e6a" ;ma-in4 a p"ofit< &eca%se his &%siness mi4ht ma-e %nanticipate losses. P"ofit is the "e6a" of the ent"ep"ene%" fo" the "is-s he ta-es. The ent"ep"ene%" &ea"s the &%"en of &%siness "is- an %nce"taint. Nomal po"it The"e o%4ht to &e an amo%nt of >p%"e> p"ofit 6hich an ent"ep"ene%" sho%l e2pect as a "e6a" fo" the "is-s that he o" she ta-es. This e2pecte o" app"op"iate p"ofit is -no6n as >no"mal> p"ofit) an it is an economic cost of p"o%ction.
No"mal p"ofit is ea"ne 6hen total "e#en%es e8%al the total oppo"t%nit costs of all inp%t "eso%"ces. If "e#en%es a"e ?%st eno%4h to e8%al oppo"t%nit costs) this means that the inp%t "eso%"ces a"e &ein4 %se as 6ell as the co%l &e %se an6he"e else. If act%al economic p"ofit is &elo6 no"mal p"ofit ;i.e. a >loss> in economic te"ms< the fi"m 6o%l o &ette" to lea#e the &%siness it is in an p%t the "eso%"ces at its isposal to &ette") mo"e p"ofita&le %se. Supenomal po"its
hen total "e#en%es e2cee the total oppo"t%nit costs of inp%t "eso%"ces) the fi"m 6ill &e ea"nin4 p"ofit in e2cess of no"mal p"ofits) an so "eso%"ces a"e ea"nin4 mo"e than the co%l in an alte"nati#e occ%pation. These e2cess p"ofits a"e calle s%pe"no"mal p"ofits) o" monopol p"ofits ;&eca%se monopol fi"ms a"e &est a&le to e2ploit oppo"t%nities fo" ea"nin4 s%pe"no"mal p"ofits<. The s%pe"no"mal p"ofits of the monopolist a"e isc%sse in mo"e etail in the ne2t chapte". Fi"ms 6ill o&#io%sl &enefit f"om an s%pe"no"mal p"ofits that e2ist) an 6ill 6ish to en?o them if the a"e a#aila&le. hen a fi"m ma-es s%pe"no"mal p"ofits) ho6e#e") othe" fi"ms 6ill 6ant to ente" the in%st" if the can) to 4"a& a sha"e of the hi4h p"ofits that a"e a#aila&le. In competiti#e in%st"ies) s%pe"no"mal p"ofits the"efo"e ten to &e tempo"a") &eca%se the a"e e#ent%all e"oe & competition. Monopolies) ho6e#e") mi4ht &e a&le to ea"n s%pe"no"mal p"ofits inefinitel.
;a< ;&<
;c<
Ent"ep"ene%"s of &ette" a&ilit sho%l al6as &e a&le to ea"n s%pe"no"mal p"ofits 6hen othe"s a"e ma-in4 onl no"mal p"ofits. Monopolists can ma-e s%pe"no"mal p"ofits & const"%ctin4 ent" &a""ie"s 6hich p"e#ent o" ete" "i#al fi"ms f"om ente"in4 the ma"-et as competito"s. S%pe"no"mal p"ofits can inicate to ent"ep"ene%"s the &est ma"-ets fo" ne6 in#estments o" fo" a s6itch of thei" e2istin4 in#estments.
Nomal po"it and is, and un!etainty
Fi"ms in hi4h5"is- in%st"ies sho%l e2pect to ea"n a hi4he" "et%"n than fi"ms in lo65"is- in%st"ies. The hi4he" the "is-) the hi4he" the >"is- p"emi%m> "e8%i"e. ;Ris- p"emi%m can &e efine as the aitional "et%"n in e2cess of a "is-5f"ee "et%"n neee to compensate an in#esto" fo" ma-in4 the "is- in#estment<. hen the oppo"t%nit costs of a &%siness a"e meas%"e) the oppo"t%nit cost of capital tie %p ;i.e. the oppo"t%nit cost of alte"nati#e in#estments< 6ill &e hi4he" fo" hi4he" "is- fi"ms. Since >no"mal p"ofit> means a s%fficient "et%"n to p"e#ent the fi"m>s o6ne" f"om li8%iatin4 his in#estment an in#estin4 it else6he"e) no"mal p"ofit m%st ma-e allo6ance fo" the "is- cha"acte"istics of the &%siness) an 6hat co%l &e ea"ne f"om an alte"nati#e in#estment of compa"a&le "is-. Th%s) no"mal p"ofit 6ill &e hi4he" in a mo"e "is- ma"-et than in a less "is- ma"-et.
Ma,et Stu!tues. Fom Pe"e!t Competition To Monopoly
Your objectives
Afte" completin4 this chapte" o% sho%l1 ;a<
%ne"stan the "an4e of ma"-et st"%ct%"es that ma e2ist=
;&<
%ne"stan the main feat%"es of t6o e2t"eme ma"-et st"%ct%"es1 pe"fect competition an monopol.
Pe"e!t and impe"e!t !ompetition
In Chapte" , 6e set o%t the cha"acte"istics of a hpothetical pe"fect ma"-et. Consie"ation of s%ch a ma"-et is %sef%l espite the fact that it ne#e" e2ists in p"actice. The "eason fo" this is that the %ne"lin4 theo" can &e st%ie 6itho%t the complicatin4 facto"s that ma-e "eal5life ;impe"fect< ma"-ets so comple2. In this chapte" 6e loo- at &oth pe"fect competition an its opposite) monopol) an e2amine the effects of these ma"-et st"%ct%"es on the o%tp%t ecisions of fi"ms. In the ne2t chapte" 6e loo- at t6o less e2t"eme ma"-et st"%ct%"es1 monopolistic competition an oli4opol. Chaa!teisti!s o" impe"e!t !ompetition
One o" mo"e of a n%m&e" of facto"s ma ma-e competition conitions >impe"fect> ;a<
The"e ma &e one o" ?%st a fe6 la"4e fi"ms ominatin4 the ma"-et. ;i<
A sin4le fi"m ominatin4 the ma"-et is calle a monopolist) o" monopol fi"m.
;ii<
hen t6o o" se#e"al fi"ms ?ointl ominate the ma"-et) the"e is an oli4opol an fi"ms a"e "efe""e to as oli4opolists. ;A special case of oli4opol is %opol1 this is 6hen p"ecisel t6o fi"ms ominate the ma"-et.<
hen onl one o" a fe6 fi"ms ominate the ma"-et) most of the ma"-et eman 6ill &e fo" thei" p"o%cts an the fi"m can ha#e a si4nificant infl%ence on the ma"-et p"ice. The fi"m can ma-e ecisions on p"ice as 6ell as o%tp%t an the fi"m is a p"ice ma-e" . ;&<
The"e ma &e sho"ta4es of info"mation a&o%t p"ices an p"ofit oppo"t%nities amon4 some cons%me"s o" p"o%ce"s.
;c<
In some ma"-ets) fi"ms s%ccee in c"eatin4 iffe"ences) "eal o" ima4ine) &et6een thei" o6n p"o%ct an simila" p"o%cts of competito"s. The see- to c"eate c%stome" eman fo" thei" o6n p"o%cts in p"efe"ence to competito"s> p"o%cts & emphasisin4 these iffe"ences. T6o 6as of c"eatin4 iffe"ences a"e &"anin4 an a#e"tisin4 . Anothe" is small #a"iations in p"o%ct esi4n. C"eatin4 s%ch iffe"ences is calle p"o%ct iffe"entiation. an it ena&les fi"ms to &ecome li-e monopolists o" oli4opolists in thei" o6n special co"ne" of a la"4e ma"-et. This tpe of competition is "efe""e to as monopolistic competition.
;<
F"ee ent" into the ma"-et mi4ht &e p"e#ente & e2istin4 fi"ms in the ma"-et.
E'uilibrium under perfect competition E&uili#ium in the shot un Ho6 a"e p"ice) o%tp%t an the ma2imisation of p"ofit ete"mine in the case of the fi"m ope"atin4 %ne" conitions of pe"fect competition in the sho"t "%n
The sho"t "%n "efe"s to a pe"io in 6hich the n%m&e" of fi"ms in the ma"-et is tempo"a"il fi2e. In these ci"c%mstances it is possi&le fo" fi"ms to ma-e s%pe"no"mal p"ofits o" losses as the follo6in4 ia4"ams sho6. MC
P
C
6
A
ATC D MR
D
B Fi4%"e + sho6s the cost an eman c%"#es of a fi"m in the sho"t "%n ma-in4 s%pe"no"mal p"ofits. The eman c%"#e is the ho"iGontal line D + at p"ice P + .The c%"#e is a ho"iGontal line inicatin4 that the fi"m ma not infl%ence the p"ice of the 4oos an has to accept the p"ice that the ma"-et as a 6hole fi2es fo" them. If the fi"m 6e"e to cha"4e a hi4he" p"ice it 6o%l lose all its sales an the"e is no point cha"4in4 a lo6e" p"ice as it can sell all its o%tp%t at the 4i#en p"ice. The eman c%"#e is th%s also the ma"4inal "e#en%e c%"#e= e#e" ne6 %nit sol at p"ice P + inc"eases total "e#en%e & an amo%nt P +. Fi4%"e + also sho6s the a#e"a4e total cost c%"#e ;ATC< an the ma"4inal cost c%"#e ;MC<) 6ith the MC c%ttin4 the A TC at the lo6est point of the ATC. @i#en these cost c%"#es an the eman c%"#e D + ) the fi"m 6ill p"o%ce the o%tp%t B + ) 6he"e the MC c%"#es c%ts the MR ho"iGontal c%"#e at the point C. This is the p"ofit ma2imisin4 point. If the fi"m 6e"e to p"o%ce fe6e" %nits it 6o%l &e p"o%cin4 at a point 6he"e MR 6as hi4he" than MC an all aitional %nits p"o%ce %p to the point 6he"e MR MC 6o%l simila"l ha#e MR 4"eate" than MC. The fi"m sho%l p"o%ce these %nits &eca%se so lon4 as MR is 4"eate" than MC) each %nit sho6s a p"ofit ;aitional "e#en%e is 4"eate" than aitional costs<. Simila"l it sho%l not e2pan p"o%ction past MR MC &eca%se it 6ill &e p"o%cin4 6he"e MC is 4"eate" than MR) in othe" 6o"s 6he"e the aitional costs fo" each %nit e2cee the aitional "e#en%e ea"ne. At the o%tp%t B + the fi"m is ma-in4 s%pe"no"mal p"ofits inicate & the "ectan4le A9CD. This 6ill att"act ne6 fi"ms into the in%st" an the p"ice 6ill &e &i o6n) possi&l to p"ice P , as sho6n in Fi4%"e ,. He"e the fi"m ma-es a loss sho6n & the "ectan4le (X. Once a4ain the fi"m p"o%ces 6he"e MC MR 4i#in4 an o%tp%t of B ,
MC ATC
P
(
D MR
X
B In the lon4 "%n) 6hene#e" p"ofits a"e &ein4 mae ne6 fi"ms 6ill ente" the in%st" an the p"ice 6ill fall. Simila"l) 6hen losses a"e mae fi"ms 6ill lea#e the in%st" an the p"ice 6ill "ise. E&uili#ium in the lon% un
In a pe"fectl competiti#e ma"-et in the lon4 "%n) the fi"m cannot infl%ence the ma"-et p"ice an its a#e"a4e "e#en%e c%"#e is ho"iGontal. The fi"m>s a#e"a4e cost c%"#e is %5 shape. The fi"m is in e8%ili&"i%m an ea"ns no"mal p"ofits onl ;i.e. no s%pe"no"mal p"ofits< 6hen the AC c%"#e is at a tan4ent to the AR c%"#e as sho6n in Fi4%"e l;&<. In othe" 6o"s) lon45te"m e8%ili&"i%m 6ill e2ist 6hen s%pe"no"mal p"ofits an losses a"e eliminate. The"e is no incenti#e fo" fi"ms to ente" o" lea#e the in%st" an the p"ice 6ill "emain at p 6ith the fi"m ma-in4 no"mal p"ofits onl.
MC D
S AC
P
P MR AR
Bm
Bf
Note the follo6in4 points a&o%t Fi4%"e 3. ;a<
The ma"-et p"ice p is the p"ice 6hich all ini#i%al fi"ms in the ma"-et m%st ta-e)
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If the fi"m m%st accept a 4i#en MR ;as it m%st in conitions of pe"fect competition< an it sets MR MC) then the MC c%"#e is in effect the ini#i%al fi"m>s s%ppl c%"#e ;Fi4%"e 3;&<. The
ma"-et s%ppl c%"#e in Fi4%"e 3;a< is e"i#e & a44"e4atin4 the ini#i%al s%ppl c%"#es of e#e" fi"m in the in%st". *on45"%n e8%ili&"i%m 6ill) then) occ%" in the in%st" 6hen the"e a"e no mo"e fi"ms ente"in4 o" lea#in4 the in%st" &eca%se no ne6 fi"m thin-s it co%l ea"n hi4he" p"ofits & ente"in4 an no e2istin4 fi"m thin-s it co%l o &ette" & lea#in4. In the lon4 "%n) then) all fi"ms in the in%st" 6ill ha#e MR MC AC AR as in Fi4%"e 3;&<.
E'uilibrium for a monopoly The monopoly ma,et
The lon45"%n e8%ili&"i%m of a fi"m in a pe"fectl competiti#e ma"-et is at a p"ice an o%tp%t le#el 6he"e onl no"mal p"ofits a"e ea"ne. P"ice MR MC AC) an the fi"m p"o%ces at the minim%m a#e"a4e cost pe" %nit. Monopol is the con#e"se to pe"fect competition. In a monopol) the"e is onl one fi"m) the sole p"o%ce" of a 4oo 6hich has no closel competin4 s%&stit%tes) so that the total ma"-et s%ppl is ientical 6ith the sin4le fi"m>s s%ppl. In monopol the fi"m faces a o6n6a"5slopin4 a#e"a4e "e#en%e c%"#e &eca%se its a#e"a4e "e#en%e c%"#e is the same as the total ma"-et eman c%"#e. If a#e"a4e "e#en%e is fallin4) ma"4inal "e#en%e 6ill al6as &e lo6e" than a#e"a4e "e#en%e= if the monopolist inc"eases o%tp%t & one %nit the p"ice pe" %nit "ecei#e 6ill fall) so the e2t"a "e#en%e 4ene"ate & the sale of the e2t"a %nit of the 4oo is less than the p"ice of that %nit. The monopolist the"efo"e faces a o6n6a"5slopin4 AR c%"#e 6ith an MR c%"#e &elo6 the AR c%"#e. The"e is a %sef%l techni8%e fo" "a6in4 the AR >c%"#e> an the MR >c%"#e> of a monopolist. ;a<
Fo" simplicit) ass%me that the monopolist>s AR c%"#e) 6hich is the ma"-et eman c%"#e too) is a st"ai4ht line.
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D"a6 this AR c%"#e f"om a point on the a2is ;point A in Fi4%"e / &elo6< to a point on the 2 a2is ;point 9 in Fi4%"e /<.
(o% can no6 "a6 the MR c%"#e f"om the same point on the a2is ;point A< to a point on the 2 a2is 6hich is half 6a to point 9. This is sho6n as point C in Fi4%"e /) an OC is one half the len4th of O9 ;i.e. OC C9<.
A AR 9 MR 9 AR (
AR MR ( C
9
( MR
The ma"4inal "e#en%e can &e ne4ati#e. This is 6hen the p"ice elasticit of eman is inelastic an so altho%4h lo6e"in4 the p"ice inc"eases sales eman) the #ol%me inc"ease is small an so total "e#en%e falls. It is o&#io%sl impo"tant that o% sho%l %ne"stan 6hat the MR an AR ;eman< c%"#es a"e sho6in4 %s. In Fi4%"e /1 ;a<
at o%tp%t 8%antit ) the ma"4inal "e#en%e ea"ne f"om the last %nit p"o%ce an sol is MR) &%t the p"ice at 6hich all the %nits 6o%l &e sol is P. This is fo%n & loo-in4 at the p"ice le#el on the AR c%"#e associate 6ith o%tp%t =
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simila"l) at o%tp%t 8%antit () the ma"4inal "e#en%e f"om the last %nit p"o%ce an sol is MR ) &%t the p"ice at 6hich all %nits 6o%l &e sol on the ma"-et is) f"om the AR c%"#e fo" o%tp%t) P.
Po"it)ma$imisin% e&uili#ium o" a monopoly
The conition fo" p"ofit ma2imisation is) as 6e ha#e seen) that ma"4inal "e#en%e sho%l e8%al ma"4inal cost. This is t"%e fo" an fi"m. As lon4 as ma"4inal "e#en%e e2cees ma"4inal cost) an inc"ease in o%tp%t 6ill a mo"e to "e#en%es than to costs) an the"efo"e inc"ease p"ofits. A monopolist mi4ht ma2imise p"ofits ;a<
&%t ma-e no s%pe"no"mal p"ofits= o"
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ma-e s%pe"no"mal p"ofits.
Fi4%"e ! sho6s a monopol e8%ili&"i%m 6he"e the monopolist is ea"nin4 ?%st no"mal p"ofits) an so AC AR. At this point ;B< the AC c%"#e to%ches the AR c%"#e at a tan4ent) at e2actl the same o%tp%t le#el 6he"e MC MR. Since AC AR an AC incl%es no"mal p"ofits) the monopolist 6ill &e ea"nin4 no"mal p"ofits &%t no s%pe"no"mal p"ofits in this sit%ation.
MC
AR
P
AR ;Deman c%"#e
B
B+ MR
In this sit%ation. the monopol 6ill ma-e a loss & p"o%cin4 at o%tp%t hi4he" than B. an so it 6ill ha#e to p"o%ce at an o%tp%t le#el 6hich is &elo6 the capacit at 6hich its a#e"a4e costs a"e minimise ;o%tp%t B+ <.
Monopolies a"e %s%all a&le to ea"n >monopol> o" s%pe"no"mal p"ofits in the lon4 te"m as 6ell as the sho"t te"m) an the sit%ation ill%st"ate in Fi4%"e ! 6ill &e "a"e fo" a monopol) altho%4h ;as 6e shall see late"< it is a lon4 "%n e8%ili&"i%m sit%ation fo" fi"ms in >monopolistic competition>. It mi4ht. ho6e#e") "ep"esent the lon45te"m e8%ili&"i%m of some monopolies) 6he"e &a""ie"s to ent" into the in%st" a"e lo6) an competition 6o%l &e att"acte into the ma"-et if s%pe"no"mal p"ofits 6e"e achie#a&le. It mi4ht also &e the case fo" a 4o#e"nment5"%n monopol 6hich is "e8%i"e to co#e" costs "athe" than &ein4 "e8%i"e to ma-e p"ofits. In pe"fect competition) a fi"m sho%l not &e a&le to ea"n s%pe"no"mal p"ofits in the lon4 "%n &eca%se the 6o%l &e >compete a6a> & ne6 ent"ants to the in%st". In monopol) ho6e#e") the fi"m can ea"n s%pe"5no"mal p"ofits in the lon4 "%n as 6ell as in the sho"t "%n) &eca%se the"e a"e &a""ie"s to ent" 6hich p"e#ent "i#als ente"in4 the ma"-et. Fi4%"e sho6s a fi"m ea"nin4 s%pe"no"mal p"ofits) e8%al to the shae a"ea) 6hich "ep"esents ;P 5AC< 2 B %nits p"o%ce an sol
MC AC
P AC
This is an impo"tant ia4"am that o% sho%l &e a&le to "ep"o%ce o%"self an e2plain clea"l. ;a<
Fi"st of all "a6 a U5shape sho"t5"%n a#e"a4e cost c%"#e) AC) an a ma"4inal cost c%"#e MC) that is mainl %p6a"5slopin4 an that c%ts th"o%4h the AC c%"#e at the lo6est point on the AC c%"#e. AR ;Deman c%"#e
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Ne2t) "a6 a o6n6a"5slopin4 eman c%"#e ;AR c%"#e<) as a st"ai4ht line) that c%ts th"o%4h the AC c%"#e. D"a6 a o6n6a"5slopin4 ma"4inal "e#en%e c%"#e) MR 5also a st"ai4ht line) as e2plaine in Fi4%"e /.
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B le#el B is 6he"e MR MC 5i.e. 6he"e these t6o lines c"oss. The p"ofit5ma2imisin4 o%tp%t MR
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The p"ofit5ma2imisin4 sellin4 p"ice p is fo%n & "efe"ence to the eman c%"#e ;i.e. AR c%"#e< at that o%tp%t le#el.
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The a#e"a4e cost at this o%tp%t le#el) AC) is fo%n & "efe"ence to the AC c%"#e.
;f<
(o% 6ill fin that at this le#el of o%tp%t) the p"ice) AR) e2cees a#e"a4e costs) AC) an so s%pe"5no"mal p"ofits a"e ea"ne ; %nit p"ice min%s a#e"a4e cost 2 #ol%me of o%tp%t in %nits<.
Monopoly and perfect competition compared If the"e a"e no economies of scale fo" a la"4e o%tp%t5#ol%me fi"m. then o%tp%t 6ill &e lo6e") an costs an p"ice hi4he") %ne" monopol as compa"e 6ith pe"fect competition.
MC s%ppl
AC PM X PC *et %s s%ppose that the"e a"e t6o in%st"ies ientical in e#e" "espect e2cept that one has a monopol ( s%pplie" an the othe" has conitions of pe"fect competition. The eman c%"#e of each in%st" is the same) an the ma"4inal costs of p"o%ction a"e the same) so that the MC c%"#e of the monopolist an the s%ppl c%"#e of the pe"fectl competiti#e in%st" a"e the same. ;a<
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Deman In the competiti#e in%st". e8%ili&"i%m is "eache at a p"ice le#el 6he"e the eman c%"#e an s%ppl c%"#e inte"sect. All fi"ms 6ill sell thei" 4oos at p"ice Pc. an total o%tp%t fo" the in%st" 6ill &e BC. ;Each fi"m ini#i%all. "emem&e". faces a ho"iGontal eman c%"#e.< BM BC In the monopol) the p"ofit5ma2imisin4 e8%ili&"i%m is 6he"e MC MR) so that p"ice 6ill &e PM an o%tp%t BM .
Th%s) a fi"m in a monopol in%st" 6ill p"o%ce less an sell at a hi4he" p"ice than fi"ms in a pe"fectl competiti#e in%st". It is also si4nificant that1
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in the pe"fectl competiti#e in%st") e8%ili&"i%m is "eache 6hen fi"ms minimise thei" a#e"a4e costs ;AC is at a minim%m<. Position X is then the o%tp%tp"ice le#el that 4i#es an optimal allocation of "eso%"ces=
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in the monopol in%st") p"ofit5ma2imisin4 e8%ili&"i%m is not at the o%tp%t le#el 6he"e AC is minimise ;&%t at a lo6e" o%tp%t le#el 6ith a hi4he" AC<. At the monopolist>s p"ofit5ma2imisin4 o%tp%t) the iffe"ence &et6een p"ice an ma"4inal cost is (. It co%l &e a"4%e that if the fi"m 6e"e to p"o%ce mo"e o%tp%t) it 6o%l p"o#ie mo"e ma"4inal %tilit fo" cons%me"s ;as "ep"esente & the eman c%"#e< than it 6o%l c"eate ma"4inal cost fo" the fi"m. The"e is a social cost that occ%"s &eca%se a monopol p"o%ces onl BM of o%tp%t at p"ice _) "athe" than BC of o%tp%t at p"ice Pc. The loss of social 6elfa"e) o" social cost) is "ep"esente & the a"ea (X in Fi4%"e 0) an is sometimes "efe""e to as the ea6ei4ht &%"en of monopol. These concl%sions mi4ht not &e #ali) ho6e#e") if the monopolist is a&le to ta-e a#anta4e of its monopol position to achie#e economies of scale that pe"fectl competiti#e fi"ms co%l not achie#e) o6in4 to thei" "elati#e smallness in te"ms of the total ma"-et o%tp%t. This is an impo"tant p"o#iso) &eca%se it is a theo"etical a"4%ment in fa#o%" of monopolies.
Price discrimination Pi!e dis!imination and ma,et se%mentation
The te"m p"ice isc"imination "efe"s to a sit%ation in 6hich a fi"m sells the >same> p"o%ct at iffe"ent p"ices in iffe"ent ma"-ets. Ma"-et se4mentation ma in#ol#e elements of p"o%ct iffe"entiation ;e.4. iffe"ent &"an names< in o"e" to satisf pa"tic%la" se4ments of the ma"-et. Th"ee &asic conitions a"e necessa" fo" p"ice isc"imination to &e effecti#e an p"ofita&le. •
•
•
The selle" m%st &e a&le to cont"ol the s%ppl of the p"o%ct. Clea"l) this 6ill appl %ne" monopol conitions. The monopol selle" has cont"ol o#e" the 8%antit of the p"o%ct offe"e to a pa"tic%la" &%e" . The selle" m%st &e a&le to p"e#ent the "esale of the 4oo & one &%e" to anothe". The ma"-ets m%st) the"efo"e) &e clea"l sepa"ate so that those pain4 lo6e" p"ices cannot "esell to those pain4 hi4he" p"ices. The a&ilit to p"e#ent "esale tens to &e associate 6ith the cha"acte" of the p"o%ct) o" the a&ilit to classif &%e"s into "eail ientifia&le 4"o%ps. Se"#ices a"e less easil "esol than 4oos 6hile t"anspo"tation costs) ta"iff &a""ie"s o" impo"t 8%otas ma sepa"ate classes of &%e"s 4eo4"aphicall an th%s ma-e p"ice isc"imination possi&le. The"e m%st &e si4nificant iffe"ences in the 6illin4ness to pa amon4 the iffe"ent classes of &%e"s. In effect this means that the elasticit of eman m%st &e iffe"ent in at least t6o of the sepa"ate ma"-ets so that total p"ofits ma &e inc"ease & cha"4in4 iffe"ent p"ices
e can see ho6 the monopolist selle" p"actisin4 p"ice isc"imination can ma2imise "e#en%e %sin4 a ia4"ammatic ill%st"ation ;Fi4%"e $<.
A
MC
P+ P, 9 P E
C
MR
B+
B,
Be
Bf
Deman
B4
Fi4%"e $ emonst"ates fi"stl the e8%ili&"i%m position of a monopolist that oes not isc"iminate. He p"o%ces at the point C 6he"e ma"4inal cost e8%als ma"4inal "e#en%e) p"o%cin4 o%tp%t B e an sellin4 at p"ice P. His total "e#en%e is 4i#en & the "ectan4le OP9B e. Fi4%"e $ also ill%st"ates ho6 the
isc"iminatin4 monopolist can imp"o#e on this position) &oth f"om the point of inc"ease "e#en%e an inc"ease p"ofits. The isc"iminatin4 monopolist oes not cha"4e the same p"ice fo" all %nits sol. If 6e ass%me that the monopolist can isc"iminate pe"fectl) then he can sell each %nit fo" a iffe"ent p"ice as inicate on the eman c%"#e. Th%s he can sell the fi"st %nit B + at the p"ice P +) an the secon %nit B , at the p"ice P ,. This follo6s fo" all %nits sol so that the eman c%"#e &ecomes the ma"4inal "e#en%e c%"#e= each e2t"a %nit sol is sol fo" the p"ice inicate on the eman c%"#e) each p"e#io%s %nit &ein4 sol fo" the hi4he" p"ice "ele#ant to that %nit. The pe"fectl isc"iminatin4 monopolist 6ill still ma2imise p"ofits 6he"e MC MR) &%t the ma"4inal "e#en%e c%"#e is no6 the c%"#e D) the eman c%"#e. He th%s p"o%ces at the point E 6he"e ma"4inal cost e8%als the ne6 ma"4inal "e#en%e) p"o%cin4 B f %nits. The aitional "e#en%e of the isc"iminatin4 monopolist is "ep"esente & the a"eas AP9 pl%s B e9EBf . The isc"iminatin4 monopolist has th%s ma2imise his "e#en%e ;consistent of co%"se 6ith ma2imisin4 his p"ofit<. If the monopolist i not 6ish to ma2imise p"ofit &%t 6ishe simpl to ma2imise "e#en%e he 6o%l e2pan p"o%ction to the point B 4 6hen his total "e#en%e 6o%l &e the a"ea OAB 4. Ta-e ca"e not to conf%se ma2imisin4 "e#en%e 6ith ma2imisin4 p"ofit. Inc"easin4 o%tp%t &eon B f in the e2ample 6ill not inc"ease p"ofit as ma"4inal costs e2cee ma"4inal "e#en%e fo" each aitional %nit sol. P"ice isc"imination often "es%lts 6he"e the ma"-et is sepa"ate & t"anspo"t costs an ta"iffs= hence fi"ms ma sell thei" p"o%cts a&"oa cheape" than at home. An e2t"eme e2ample of this is -no6n as %mpin4= this occ%"s 6hen e2po"ts sell in fo"ei4n ma"-ets at p"ices &elo6 the cost of p"o%ction. This p"icin4 st"ate4 is esi4ne to "i#e omestic p"o%ce"s o%t of the in%st" so that the fo"ei4n p"o%ce" ma achie#e monopol po6e". The p"ice iffe"ential cannot) of co%"se) e2cee the cost of t"anspo"tin4 the 4oo &ac- to the home ma"-et pl%s an ta"iff on impo"ts. P"ice isc"imination also occ%"s 6he"e it is possi&le to sepa"ate &%e"s into clea"l efine 4"o%ps. In%st"ial %se"s of 4as an elect"icit a"e a&le to p%"chase these f%els mo"e cheapl f"om 9"itish @as an elect"icit companies than a"e omestic %se"s. Simila"l mil- is sol mo"e cheapl to in%st"ial %se"s) fo" e2ample fo" ma-in4 into cheese o" ice c"eam) than to p"i#ate ho%sehols.
Public policy to%ards monopolies Pu#li! poli!y to(ads pivate entepise monopolies
Monopolies mi4ht &e ha"mf%l o" &eneficial to the p%&lic inte"est. ;a<
A &eneficial monopol is one that s%ccees in achie#in4 economies of scale in an in%st" 6he"e the minim%m efficienc scale is at a le#el of p"o%ction that 6o%l mean ha#in4 to achie#e a la"4e sha"e of the total ma"-et s%ppl.
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A monopol a4ainst the p%&lic inte"est 6o%l &e one in 6hich cost efficiencies a"e not achie#e) o" a"e ne4li4i&le. Oli#e" illiamson s%44este that inefficienc in monopolies mi4ht occ%" if >ma"-et po6e" p"o#ies the fi"m 6ith the oppo"t%nit to p%"s%e a #a"iet of othe"5than5p"ofit o&?ecti#es.>
The"e a"e othe" "easons fo" t"in4 to cont"ol monopol 4"o6th. A monopol fi"m ma &e a m%ltinational) 6ith its hea office in anothe" co%nt". M%ltinational fi"ms a"e iffic%lt to cont"ol 6ithin the conte2t of a 4o#e"nment>s economic polic "e8%i"ements an so a 4o#e"nment mi4ht p"efe" to see mo"e >national> fi"ms in a position of some st"en4th in the co%nt">s home ma"-ets. Monopolies mi4ht also t" to p"ese"#e thei" monopol position & actin4 to p"e#ent competition. The mi4ht c"eate &a""ie"s to ent" into the in%st" a4ainst othe" potential "i#als ;e.4. & ta-in4 o#e" small
ne6 competito"s o" p%"chasin4 patents to sec%"e a p"o%ction monopol<. hen competition &et6een fi"ms is >-ille off> in this 6a) the p%&lic inte"est is ha"me. A monopol ma t" to e2ploit its position & %sin4 p"ice isc"imination) to cha"4e hi4he" p"ices fo" the same 4oo in a iffe"ent se4ment of the ma"-et. Ce"tain pha"mace%ticals man%fact%"e"s) fo" e2ample) ha#e &een acc%se of %nfai"l cha"4in4 hi4he" p"ices in one co%nt" than in anothe". This too can &e a4ainst the p%&lic inte"est. 7ovenment !ontol ove monopolies' me%es and esti!tive pa!ti!es
The"e a"e se#e"al iffe"ent 6as in 6hich a 4o#e"nment can attempt to cont"ol monopolies. ;a<
It can stop them f"om e#elopin4) o" it can &"ea- them %p once the ha#e &een c"eate. In the past) the"e has &een a histo" of >t"%st5&%stin4> in the USA. P"e#entin4 monopolies f"om &ein4 c"eate is the "eason 6h a 4o#e"nment mi4ht ha#e a p%&lic polic on me"4e"s.
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It can ta-e them o#e". Nationalise in%st"ies a"e often 4o#e"nment5"%n monopolies) an cent"al ano" local 4o#e"nment also ha#e #i"t%al monopolies in the s%ppl of othe" se"#ices) s%ch as health) the police) e%cation an social se"#ices. @o#e"nment5"%n monopolies a"e potentiall a#anta4eo%s &eca%se1
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the nee not ha#e a p"ofit5ma2imisin4 o&?ecti#e so that the 4o#e"nment can ecie 6hethe" o" not to s%ppl a 4oo o" se"#ice to a ho%sehol on 4"o%ns othe" than cost o" p"ofit=
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the 4o#e"nment can "e4%late the 8%alit of the 4oo o" se"#ice p"o#ie mo"e easil than if the in%st" 6e"e ope"ate & p"i#ate fi"ms=
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-e in%st"ies can &e p"otecte ;e.4. health) e%cation<.
It can allo6 monopolies o" oli4opolies to ope"ate) &%t t" to cont"ol thei" acti#ities in o"e" to p"otect the cons%me". Fo" e2ample) it can t" to p"ohi&it the 6o"st fo"ms of "est"icti#e p"actice) s%ch as p"ice ca"tels. O" it ma set %p "e4%lato" &oies to p"otect cons%me"s> inte"ests 6he"e conitions of nat%"al monopol appl) as in the "ecentl p"i#atise %tilit in%st"ies of the U:. The p"icin4 of p"o%cts in s%ch in%st"ies ma &e cont"olle1 in the U:) man of the la"4e %tilities ha#e &een "e8%i"e to limit p"ice inc"eases to a specifie pe"centa4e &elo6 the Retail P"ices Ine2 o#e" a n%m&e" of ea"s.
The"e a"e t6o &asic tenets in the thin-in4 &ehin cons%me" p"otection policies. ;a<
Cont"ol o#e" ma"-ets can a"ise & fi"ms eliminatin4 the opposition) eithe" & me"4in4 6ith o" ta-in4 o#e" "i#als o" stoppin4 othe" fi"ms f"om ente"in4 the ma"-et. The p"o&lem he"e is that 6hen a sin4le fi"m cont"ols a &i4 eno%4h sha"e of the ma"-et it can &e4in to &eha#e as a monopolist e#en tho%4h its ma"-et sha"e is &elo6 +77.
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Se#e"al fi"ms co%l &eha#e as monopolists & a4"eein4 6ith each othe" not to compete. This co%l &e one in a #a"iet of 6as ;fo" e2ample & e2chan4in4 info"mation) & settin4 common p"ices o" & splittin4 %p the ma"-et into 4eo4"aphical a"eas an ope"atin4 onl 6ithin allocate &o%na"ies<.
In a pe"fect monopol) the"e is onl one fi"m that is the sole p"o%ce" of a 4oo that has no closel competin4 s%&stit%tes) so that the fi"m cont"ols the s%ppl of the 4oo to the ma"-et. The efinition of a monopol in p"actice is "athe" mo"e e2tensi#e than this) &eca%se 4o#e"nments see-in4 to cont"ol the 4"o6th of monopol fi"ms 6ill p"o&a&l choose to "e4a" an fi"m that ac8%i"es a ce"tain sha"e of the ma"-et as a potential monopolist. The Monopolies and Me%es Commission in the U8
In the U:) the Monopolies an Rest"icti#e P"actices Act +'/$ p"o#ie that an fi"m cont"ollin4 mo"e than one thi" of the ma"-et fo" its 4oos sho%l &e in#esti4ate as a potential monopol 6hich 6as a4ainst the p%&lic inte"est. Une" the Fai" T"ain4 Act +'03) the Di"ecto" @ene"al of Fai" T"ain4 is
allo6e to "efe" cases to the Monopolies an Me"4e"s Commission if an fi"m cont"ols one 8%a"te" of the ma"-et) o" if an p"opose ta-eo#e" o" me"4e" 6o%l c"eate a fi"m that cont"olle mo"e than one 8%a"te" of the ma"-et. The Commission 6ill then in#esti4ate the p"opose me"4e" o" ta-eo#e" an "ecommen 6hethe" o" not it sho%l &e allo6e to p"ocee. Anothe" aspect of the 6o"- of the Monopolies an Me"4e"s Commission ;MMC< is to in#esti4ate cases 6he"e a monopol is s%specte of ope"atin4 a4ainst the p%&lic inte"est an to "ecommen to the 4o#e"nment the steps that sho%l &e ta-en to ma-e the monopol alte" its p"actices. In +''+) an in8%i" into the ca"&onate "in-s in%st" 6as p%&lishe. At the time of 6"itin4 ;A%4%st +''3< an in8%i" is e2pecte into the m%sic in%st") p"ompte & a 6iesp"ea feelin4 that compact iscs a"e p"ice too hi4hl in the U:. U8 %ovenment poli!y on monopolies and me%es
It is si4nificant) ho6e#e") that a 4o#e"nment epa"tment) the Office of the Di"ecto" @ene"al of Fai" T"ain4 has the po6e" to "efe" cases to the Commission) 6hich can then p"e#ent a me"4e" o" ta-eo#e" f"om ta-in4 place if it is consie"e to &e a4ainst the p%&lic inte"est. The st"en4th of anti5monopol an anti5ta-eo#e" acti#it the"efo"e epens on the attit%e of the 4o#e"nment of the a) as e2p"esse & the acti#ities of the office of the Di"ecto" @ene"al of Fai" T"ain4. The office of the Di"ecto" @ene"al has the help of the Cons%me" P"otection A#iso" Committee 6hich a#ises the Di"ecto" @ene"al an the Ministe" 6hethe" t"ain4 an comme"cial p"actices "efe""e to it a"e ha"mf%l to the inte"ests of the cons%me"s. ;The acti#ities of this Committee a"e not i"ecte a4ainst monopolies as s%ch) &%t it is a foc%s of cons%me" p"otection acti#it 6hich is one of the "easons 6h anti5monopol cont"ols mi4ht &e "e8%i"e.< Me%es
Me"4e"s) o" p"ospecti#e me"4e"s) can also &e "efe""e to the MMC if the a"e tho%4ht li-el to c"eate o" st"en4then a monopol. Companies o not ha#e to see- pe"mission &efo"e me"4in4) no" can pe"mission &e 4i#en in a#ance of the f%ll etails &ein4 -no6n. 9%t it is common p"actice these as fo" me"4e"s to &e p"opose s%&?ect to MMC app"o#al. Pu#li! poli!y in "avou o" monopolies and me%es
One aspect of the U: 4o#e"nment>s polic has &een an attempt to cont"ol the e#elopment of monopolies that a"e >a4ainst the p%&lic inte"est>. 9%t opinions iffe" a&o%t 6hat monopolies 6o%l &e 4oo fo" the co%nt" an 6hich ones 6o%l &e ha"mf%l. Anothe" aspect in "ecent ea"s has &een the esta&lishment of >cons%me" 6atcho4> &oies to "e4%late the "ecentl p"i#atise %tilit in%st"ies 6he"e the"e a"e %s%all conitions of nat%"al monopol. In the moe"n 6o"l of m%ltinational companies) companies nee to &e &i4 to s%"#i#e an p"ospe". A"4%a&l) the U:>s in%st"ial st"en4th has ecline o#e" the ea"s &eca%se the co%nt" has faile to n%"t%"e eno%4h m%ltinational companies ;st"en4thene & #i"t%al monopolies in thei" o6n co%nt"< to compete s%ccessf%ll in 6o"l ma"-ets. Compa"e Ro#e" ca"s) as ?%st one e2ample) a #e" small ca" man%fact%"e" in 6o"l te"ms) 6ith Fiat of Ital) the la"4est compan in Ital) a &i4 m%ltinational 6ith a #i"t%al monopol in the Italian ca" ma"-et. The"e ha#e &een si4ns in "ecent ea"s that the U: 4o#e"nment has 6ante to enco%"a4e the 4"o6th of companies in the U:) an man of the p"opose >me4a5me"4e"s> ;i.e. me"4e"s &et6een &i4 companies< ha#e not &een "efe""e to the Monopolies an Me"4e"s Commission. @o#e"nment anti5monopol polic in the U: has acco"in4l &een "elati#el mil in "ecent ea"s. Euopean Community e%ulations on me%es
Une" a "e4%lation int"o%ce %"in4 +''7) the E%"opean Commission has the po6e" to inte"#ene an to eithe" &loc- o" to a%tho"ise la"4e" me"4e"s.
The "e4%lation p"o#ies that me"4e"s 6ith a 6o"l 6ie a44"e4ate t%"no#e" of o#e" ! &illion ec% ;app"o2imatel L3.! &illion< &et6een %ne"ta-in4s 6ith EC56ie t%"no#e" of o#e" ,!7 million ec% ;app"o2imatel L+0! million< "e8%i"e p"io" clea"ance f"om the E%"opean Commission. If the Commission fins that the me"4e" "aises se"io%s o%&ts as to its compati&ilit 6ith the E%"opean common ma"-et) it 6ill initiate p"oceein4s to &loc- the me"4e".
Privatisation of nationalised industries Pivatisation ta,es thee #oad "oms0
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The e"e4%lation of in%st"ies) to allo6 p"i#ate fi"ms to compete a4ainst state5o6ne &%sinesses 6he"e the 6e"e not allo6e to compete &efo"e ;e.4. e"e4%lation of &%s an coach se"#ices) possi&le e"e4%lation of postal se"#ices<.
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Cont"actin4 o%t 6o"- to p"i#ate fi"ms) 6he"e the 6o"- 6as p"e#io%sl one & 4o#e"nment emploees ;e.4. "ef%se collection) hospital la%n" 6o"-<.
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T"ansfe""in4 the o6ne"ship of assets f"om the state to p"i#ate sha"ehole"s ;e.4. the enationalisation of 9"itish Telecom an 9"itish @as<.
The U: 4o#e"nment has ca""ie o%t a polic of enationalisation in "ecent ea"s. 9"itish @as) 9"itish Telecom an the main ate" A%tho"ities ha#e &een amon4 the ente"p"ises 6hich ha#e &een p"i#atise. P"i#atisation ma imp"o#e efficienc) &%t the"e a"e othe" possi&le a#anta4es of p"i#atisation. ;a<
Denationalisation p"o#ies an immeiate so%"ce of mone fo" the 4o#e"nment.
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P"i#atisation "e%ces &%"ea%c"atic an political melin4 in the in%st"ies conce"ne.
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The"e is a #ie6 that 6ie" sha"e o6ne"ship sho%l &e enco%"a4e. Denationalisation is one 6a of c"eatin4 6ie" sha"e o6ne"ship) as the sale of sha"es in 9"itish Telecom) 9"itish @as an some othe" nationalise in%st"ies p"o#e in the U:.
The"e a"e a"4%ments a4ainst p"i#atisation too. ;a<
State5o6ne in%st"ies a"e mo"e li-el to "espon to the p%&lic inte"est) ahea of the p"ofit moti#e. Fo" e2ample) state5o6ne in%st"ies a"e mo"e li-el to c"oss5 s%&siise %np"ofita&le ope"ations f"om p"ofita&le ones= e.4. the Post Office 6ill contin%e to eli#e" lette"s to the isles of Scotlan e#en tho%4h the se"#ice mi4ht &e #e" %np"ofita&le.
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Enco%"a4in4 p"i#ate competition to state5"%n in%st"ies mi4ht &e ina#isa&le 6he"e si4nificant economies of scale can &e achie#e & monopol ope"ations.
The a#anta4es of ha#in4 a cont"olle o" cent"all planne econom) "athe" than a f"ee ente"p"ise econom) can also &e a#ance as "easons in fa#o%" of ha#in4 nationalise in%st"ies.
Monopolisti! Competition And Oli%opoly
Your $bjectives
Afte" completin4 this chapte" o% sho%l1 ;a<
%ne"stan the main feat%"es of monopolistic competition an thei" implications fo" fi"ms ma"-etin4 an o%tp%t ecisions.
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%ne"stan the main feat%"es of oli4opol an thei" implications fo" fi"ms ma"-etin4 an o%tp%t ecisions.
Monopolistic competition and non#price competition Monopolisti! !ompetition
Act%al ma"-et st"%ct%"es %s%all o not co""espon 6ith eithe" of the e2t"eme cases of pe"fect competition an monopol. This leas to a isc%ssion of fo"ms of impe"fect ma"-et st"%ct%"e) incl%in4 a fo"m -no6n as >monopolistic competition>. Fi"ms in monopolistic competition ;as 6ell as oli4opol) isc%sse late" in this chapte"< 6ill t" to a#oi competition on p"ice in o"e" to p"ese"#e thei" position as a p"ice ma-e". The 6ill often "eso"t to non5p"ice competition instea. This can ta-e se#e"al fo"ms) incl%in41 ;a<
p"o%ct iffe"entiation=
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&"anin4=
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a#e"tisin4 an sales p"omotion=.
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c"eatin4 >a5on> se"#ices
Podu!t di""eentiation
P"o%ct iffe"entiation esc"i&es a sit%ation in 6hich the"e is a sin4le p"o%ct &ein4 man%fact%"e & se#e"al s%pplie"s) an the p"o%ct of each s%pplie" is &asicall the same. Ho6e#e") the s%pplie"s t" to c"eate iffe"ences &et6een thei" o6n p"o%ct an the p"o%cts of thei" "i#als o" &et6een iffe"ent &"ans of the p"o%ct 6hich the sell. These iffe"ences mi4ht &e "eal ;e.4. small o" la"4e esi4n iffe"ences< o" ima4ina") c"eate la"4el & a#e"tisin4 an &"an ima4e. Diffe"entiation ma ta-e a n%m&e" of fo"ms) incl%in41 ;a<
iffe"ent phsical o" technical cha"acte"istics) satisfin4 iffe"ent &%e" nees) o" the same nees in iffe"ent 6as=
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iffe"ent pac-a4in4=
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iffe"ent conitions of sale 6ith "espect to 4%a"antees) afte"5sales se"#ices) an so on=
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iffe"ent 4eo4"aphical location=
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iffe"ent pe"ceptions of the p"o%ct c"eate th"o%4h a#e"tisin4 an p"omotion. This incl%es &"anin4 of 4oos.
Othe" fo"ms of non5p"ice competition The"e a"e othe" 6as in 6hich non5p"ice competition can &e e#elope. As the te"m implies) non5p"ice competition in#ol#es competition &et6een fi"ms fo" c%stome"s in the same ma"-et) &%t not on the &asis of lo6est p"ice ;o") at least) not on the &asis of lo6 p"ice onl<. ;a<
A#e"tisin4 an sales p"omotion) o" &"an ima4e" ;i<
The aim of a#e"tisin4) sales p"omotions o" &"an ima4e is to inc"ease eman fo" the 4oo) often at the e2pense of eman fo" the 4oos of othe" fi"ms in the ma"-et.
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hen one fi"m a#e"tises) othe"s 6ill "etaliate. As a "es%lt) an a#e"tisin4 o" sales p"omotion campai4n mi4ht ha#e little o" no effect on eman) an so inc%" cost fo" little o" no &enefit.
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Inciental se"#ices. Inciental se"#ices a"e `e2t"a> se"#ices that come as an `a5 on> to the &asic 4oo. A fi"m mi4ht ma-e its p"o%ct mo"e att"acti#e than its "i#als> & means of) fo" e2ample) s%pe"io" sales se"#ices o" pe"sonal attention. Ri#al fi"ms can "etaliate & offe"in4 inciental se"#ices too.
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Inno#ation an technical iffe"ences. A fi"m ma enhance its ma"-et sha"e & c"eatin4 4en%ine iffe"ences th"o%4h inno#ation1 9"an is mae to ha#e mo"e >feat%"es> than 9"an () so that c%stome"s fo" 9"an (a"e enco%"a4e to s6itch. He"e) the oppo"t%nit fo" "etaliation & othe" fi"ms m%st &e limite &eca%se inno#ation is easil the most effecti#e fo"m of non5p"ice competition= ho6e#e") it is not easil a#aila&le to fi"ms 6hich p"o%ce a &asic commoit) s%ch as pet"ol o" fa"m p"o%ce. e.4. mil- o" 6heat.
Po"it)ma$imisin% e&uili#ium o" a "im in monopolisti! !ompetition
A fi"m 6hich ope"ates in conitions of monopolistic competition1 ;a<
has a o6n6a"5slopin4 eman c%"#e. The 8%antit emane "espons to the p"ice at 6hich the fi"m is p"epa"e to sell. The o6n6a"5slopin4 c%"#e is possi&le &eca%se of p"o%ct iffe"entiation=
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%nli-e a monopol fi"m) is often %na&le to c"eate &a""ie"s to ent" to othe" fi"ms. ;Inee) the fi"m al"ea competes 6ith "i#als) 6hich can ta-e "etaliato" competiti#e action if the fi"m ma-es &i4 p"ofits<.
A fi"m 6ill the"efo"e ha#e1 ;a<
a sho"t5"%n e8%ili&"i%m) in 6hich it can ma-e s%pe"no"mal p"ofits= an
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a lon45"%n e8%ili&"i%m.
In the lon45"%n. the monopolistic competito" cannot ea"n s%pe"no"mal p"ofits since the"e a"e no ent" &a""ie"s. Its sho"t5"%n s%pe"no"mal p"ofits 6ill &e compete a6a & ne6 ent"ants. So the fi"m 6ill e#ent%all &e a&le to achie#e no"mal p"ofits onl. The sho"t5"%n e8%ili&"i%m fo" a fi"m in monopolistic competition is ill%st"ate in Fi4%"e I &elo6. This ia4"am is the same as a ia4"am 6hich sho6s the e8%ili&"i%m of a monopol fi"m ea"nin4 s%pe"no"mal p"ofits. The fi"m ma-es s%pe"no"mal p"ofits of ;P5AC< 2 B %nits) sho6n & the shae a"ea.
MC AC AR P AC
The lon45"%n e8%ili&"i%m fo" a fi"m in monopolistic competition is ill%st"ate in Fi4%"e ,. This ia4"am is the same as a ia4"am 6hich sho6s the e8%ili&"i%m of a monopol fi"m 6hich ea"ns no s%pe"no"mal p"ofits) an so no"mal p"ofits onl ;Fi4%"e ! of the p"e#io%s chapte"<.
AR B MR
MC
AC
P
P"ice is hi4he" an o%tp%t lo6e" than in pe"fect competition fo" the same "easons esc"i&e ea"lie" 6hen compa"in4 monopol 6ith pe"fect competition. 9eca%se p"ofit5ma2imisin4 o%tp%t is lo6e" in a ma"-et 6ith monopolistic competition) an at a point 6he"e a#e"a4e costs a"e not minimise) monopolistic competition) li-e monopol) is a"4%a&l mo"e 6astef%l of "eso%"ces than pe"fect competition. AR B MR
Chaa!teisti!s o" monopolisti! !ompetition. a summay
Monopolistic competition is cha"acte"ise & the follo6in4. ;a<
E8%ili&"i%m o%tp%t &elo6 the le#el at 6hich a#e"a4e costs a"e a minim%m) in the lon45 "%n. Monopolistic competito"s a"e sai to ha#e e2cess o" %n%se capacit.
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Since fi"ms in monopolistic competition cannot e2pan thei" o%tp%t to the le#el of minim%m a#e"a4e cost o%tp%t 6itho%t ma-in4 a loss) the e2cess capacit theo"em p"eicts that in%st"ies ma"-e & monopolistic competition 6ill al6as ten to ha#e e2cess capacit. Chec- this in Fi4%"e ,) 6he"e p"ofit is ma2imise at o%tp%t B) an o%tp%t B is lo6e" than the o%tp%t le#el 6he"e AC 6o%l &e minimise.
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A hi4he" p"ice an lo6e" o%tp%t than in pe"fect competition.
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An e8%ili&"i%m p"ice a&o#e ma"4inal cost.
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P"o%ct iffe"entiation.
;f< Othe" fo"ms of non5p"ice competition s%ch as a#e"tisin4 an sales p"omotion. Is monopolisti! !ompetition (aste"ul o" e!onomi! esou!es9
The"e a"e se#e"al "easons fo" s%44estin4 that monopolistic competition is 6astef%l of economic "eso%"ces. ;a<
It can &e a"4%e that it is 6astef%l to p"o%ce a 6ie #a"iet of iffe"entiate #e"sions of the same p"o%ct. If a sin4le #e"sion of the same p"o%ct 6e"e mae) fi"ms mi4ht &e a&le to achie#e economies of scale 6ith la"4e5#ol%me p"o%ction ;an so shift thei" cost c%"#es to the "i4ht<.
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Some methos that a"e %se to c"eate p"o%ct iffe"entiation a"e a 6aste of "eso%"ces. A#e"tisin4 costs a"e a"4%a&l an e2ample of this) altho%4h some 6o%l a"4%e that p"omotional acti#it is info"mati#e to potential c%stome"s an act%all as %tilit to a p"o%ct.
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Fi"ms in monopolistic competition) li-e monopolists) p"o%ce at an o%tp%t le#el &elo6 that at 6hich 6he"e AC is minimise.
Oliopoly The natue o" oli%opoly
Oli4opol iffe"s f"om monopol in that the"e is mo"e than one fi"m in a ma"-et) altho%4h the n%m&e" of fi"ms is small. Oli4opol iffe"s f"om monopolistic competition &eca%se in oli4opol the n%m&e" of "i#al fi"ms is small. An oli4opol consistin4 of onl t6o fi"ms is sometimes "efe""e to as a %opol. Oli4opolists ma p"o%ce a homo4eneo%s p"o%ct ;e4 oil< o" the"e ma &e p"o%ct iffe"entiation ;e4 ci4a"ettes) ca"s<. The essence of oli4opol is that fi"ms> p"o%ction ecisions a"e inte"5epenent. One fi"m cannot set p"ice an o%tp%t 6itho%t consie"in4 ho6 its "i#als> "esponse 6ill affect its o6n p"ofits. Ho6 an oli4opolist 6ill act%all set his o%tp%t an p"ice epens on 6hat ass%mption fi"ms ma-e a&o%t thei" competito"s> &eha#io%" .
Pi!e !atels #y oli%opolist podu!es
A p"ice ca"tel o" p"ice "in4 is c"eate 6hen a 4"o%p of oli4opol fi"ms com&ine to a4"ee on a p"ice at 6hich the 6ill sell thei" p"o%ct to the ma"-et. The ma"-et mi4ht &e 6illin4 to eman mo"e of the p"o%ct at a lo6e" p"ice) 6hile the ca"tel a4"eement attempts to impose a hi4he" p"ice ;fo" hi4he" %nit p"ofits< & "est"ictin4 s%ppl to the ma"-et to a le#el 6hich is consistent 6ith the #ol%me of eman at the p"ice the 6ish to cha"4e. Each oli4opol fi"m co%l inc"ease its p"ofits if all the &i4 fi"ms in the ma"-et cha"4e the same p"ice as a monopolist 6o%l) an split the o%tp%t &et6een them. This is -no6n as coll%sion) 6hich can &e tacit o" openl amitte. Ca"tels a"e iffic%lt to o%tla6. The"e mi4ht still &e coll%si#e p"ice leae"ship. This occ%"s 6hen all fi"ms "ealise that one of them is initiatin4 a p"ice chan4e that 6ill &e of &enefit to them all) an so follo6 the leae" an chan4e thei" o6n p"ice in the same 6a.
S, S+ P, P+
D
B,
B+
X
Fi4%"e 3 sho6s that1 ;a<
in a competiti#e ma"-et) 6ith a ma"-et s%ppl c%"#e S+ an eman c%"#e D) the p"ice 6o%l &e P+ an o%tp%t B + =
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a ca"tel of p"o%ce"s mi4ht a4"ee to fi2 the ma"-et p"ice at p ,) hi4he" than p + .9%t to o so) the ca"tel m%st also a4"ee to c%t ma"-et s%ppl f"om B + to B, ) an so fi2 the ma"-et s%ppl c%"#e at S,.
Esta&lishin4 a ca"tel epens on1 ;a<
the fi"ms in the ca"tel &ein4 a&le to cont"ol s%ppl to the ma"-et=
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a4"eein4 on a p"ice ;P, <=
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a4"eein4 on ho6 m%ch of the o%tp%t each fi"m sho%l p"o%ce. In Fi4%"e 3) if the ma"-et p"ice is fi2e at P,) fi"ms 6o%l 6ant to s%ppl o%tp%t X in a f"ee ma"-et. This cannot &e allo6e to happen= othe"6ise ma"-et p"ice P , co%ln>t &e s%staine.
The main 6ea-ness 6ith ca"tels is that each fi"m is still see-in4 the &est "es%lts fo" itself) an so the"e is an incenti#e fo" an ini#i%al fi"m to &"ea- the ca"tel a4"eement & sec"etl inc"easin4 its o%tp%t an sellin4 it at the fi2e ca"tel p"ice.
Ho6e#e") if all fi"ms inc"ease thei" o%tp%t in this 6a) the ca"tel 6o%l collapse &eca%se the hi4h p"ice co%l not &e s%staine 6itho%t a "est"icte o%tp%t) an e2cess s%ppl on the ma"-et 6o%l fo"ce o6n the p"ice.
This has &een the e2pe"ience in "ecent ea"s amon4st the oil5p"o%cin4 co%nt"ies of OPEC ;the O"4anisation of Pet"ole%m E2po"tin4 Co%nt"ies<. Attempts to a4"ee on a "est"icte o%tp%t 8%ota fo" each co%nt" in o"e" to p%sh %p oil p"ices ha#e often &"o-en o6n &eca%se some mem&e" co%nt"ies e2ceee thei" 8%ota) o" sol &elo6 the ca"tel>s a4"ee p"ice. The s%ccess of a p"ice ca"tel 6ill epen on1 ;a<
6hethe" it consists of most o" all of the p"o%ce"s of the p"o%ct=
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6hethe" o" not the"e a"e close s%&stit%tes fo" the p"o%ct. Fo" e2ample) a p"ice ca"tel & ta2i "i#e"s mi4ht lea to a shift in eman fo" t"anspo"t se"#ices to &%ses) ca"s an t"ains=
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the ease 6ith 6hich s%ppl can &e "e4%late. ;In the case of p"ima" commoities) s%ch as 6heat) "ice) tea an coffee) total s%ppl is epenent on 6eathe" conitions an e#en political e#ents in the p"o%cin4 co%nt"<=
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the p"ice elasticit of eman fo" the p"o%ct. An attempt to "aise p"ices mi4ht "es%lt in s%ch a la"4e a fall in eman that the total income of p"o%ce"s also falls ;i.e. p"ice elasticit is 4"eate" than +<=
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6hethe" p"o%ce"s can a4"ee on thei" ini#i%al sha"es of the total "est"icte s%ppl to the ma"-et. This is often the 4"eatest iffic%lt of all.
The ,in,ed oli%opoly demand !uve
P"ice ca"tels) 6hethe" >official> o" tacit an coll%si#e) o not al6as e2ist in an oli4opol ma"-et. So ho6 oes an oli4opol fi"m 6hich is competin4 6ith a "i#al oli4opol fi"m ecie on its p"ice an o%tp%t le#el A feat%"e of oli4opol ma"-ets) "emem&e") is that each fi"m>s p"icin4 an o%tp%t ecisions a"e infl%ence & 6hat the fi"m>s "i#als mi4ht o. hen eman conitions a"e sta&le) the ma?o" p"o&lem conf"ontin4 an oli4opolist in fi2in4 his p"ice an o%tp%t is ?%4in4 the "esponse of his competito";s< to the p"ices he has set. An oli4opolist is face 6ith a o6n6a" slopin4 eman c%"#e) &%t the nat%"e of the eman c%"#e is epenent on the "eactions of his "i#als. An chan4e in p"ice 6ill in#ite a competiti#e "esponse. This sit%ation is esc"i&e & the -in-e oli4opol eman c%"#e in Fi4%"e /) in 6hich the oli4opolist is c%""entl cha"4in4 p"ice P) fo" o%tp%t OB) 6hich is at the -in- on the eman c%"#e DD. :in- in eman c%"#e
D P
MC MR
(
D B
MR
The -in-e eman c%"#e is %se to e2plain ho6 an oli4opolist mi4ht ha#e to accept p"ice sta&ilit in the ma"-et. If the oli4opolist 6e"e to "aise his p"ices a&o#e P) his competito"s 6o%l -eep thei" p"ice lo6e" an so man cons%me"s 6o%l &% f"om them instea. An e2ample is the iffic%lt 6hich ini#i%al pet"ol companies ha#e in "aisin4 the p"ice of pet"ol at 4a"a4es. If competito"s o not "aise thei" p"ices too) the fi"m %s%all soon has to "esto"e its p"ices to thei" p"e#io%s le#el. The eman c%"#e 6o%l the"efo"e &e 8%ite elastic at these hi4he" p"ices. If) on the othe" han) the oli4opolist 6e"e to "e%ce his p"ices &elo6 P) competito"s 6o%l p"o&a&l o the same. Total ma"-et eman mi4ht "ise) &%t the inc"ease in eman fo" the oli4opolist>s p"o%cts 6o%l p"o&a&l &e 8%ite lo6) %nless eman in the ma"-et as a 6hole is elastic. The elasticit of eman at p"ices &elo6 p 6ill &e less than the elasticit at p"ices a&o#e p ;hence the -in- in the eman c%"#e<. The MR c%"#e is iscontin%o%s at the o%tp%t le#el 6he"e the"e is the -in- in the eman c%"#e. The -in- in the eman c%"#e e2plains the nat%"e of the ma"4inal "e#en%e c%"#e MR. At p"ice P) o%tp%t OB) the MR c%"#e falls #e"ticall &eca%se at hi4he" p"ices the MR c%"#e co""espons to the mo"e elastic eman c%"#e) an at p"ices &elo6 p the MR c%"#e co""espons to the less elastic eman. A fi"m ma2imises its p"ofit at the point 6he"e MR MC. The"e is a st"on4 p"o&a&ilit that the MC c%"#e 6ill c%t the MR c%"#e some6he"e &et6een points an ;the iscontin%o%s pa"t of the MR c%"#e <. The mo"e inelastic the eman c%"#e is &elo6 p"ice P) the lon4e" the iscontin%o%s po"tion ;(< of the MR c%"#e 6ill &e. The oli4opolist>s cost st"%ct%"e can chan4e) 6ith 6o"senin4 o" imp"o#e efficiencies) &%t as lon4 as the MC c%"#e c%ts the MR c%"#e th"o%4h its #e"tical po"tion () the oli4opolist>s p"ice an o%tp%t ecision sho%l not alte". Hence) the"e 6ill &e p"ice an o%tp%t sta&ilit) 6ith cost chan4es fo" the oli4opol fi"m) 6hich chan4e its MC c%"#e) not affectin4 o%tp%t an p"ice. Onl if ma"4inal costs "ise fa" eno%4h fo" the MC c%"#e to pass th"o%4h the MR c%"#e a&o#e point in Fi4%"e / is the"e a case fo" "aisin4 p"ice) an onl if MC falls fa" eno%4h to pass th"o%4h the MR c%"#e &elo6 point is the"e a case fo" lo6e"in4 p"ice. In 4ene"al) oli4opol p"ices 6ill "ise onl if all the fi"ms follo6 the lea of a "i#al in "aisin4 its p"ice) so that the AR c%"#e shifts o%t6a"s. The -in- "ises to the ne6 common p"ice le#el) 6hich is a4ain sta&le. The con#e"se hols fo" p"ice falls) pe"haps occ%""in4 &eca%se of technolo4ical a#ance. Pi!e leadeship and pi!e (as in oli%opoly ma,ets
In oli4opol ma"-ets the"e is a tenenc fo" one fi"m to set the 4ene"al in%st" p"ice) 6ith the othe" fi"ms follo6in4 s%it. This is calle p"ice leae"ship. It is one so%"ce of sta&ilit in a ma"-et 6he"e the"e ma &e ca"tels 6hich ten to &e %ne"c%t) an p"ice 6a"s. hen eman conitions chan4e) the sit%ation &ecomes some6hat iffe"ent an p"ice sta&ilit mi4ht no lon4e" e2ist. ;a<
If total ma"-et eman falls) oli4opolists mi4ht t" to inc"ease thei" sha"e of the ma"-et & c%ttin4 p"ices.
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Simila"l) if one oli4opolist &e4ins to lose his sha"e of the ma"-et) he mi4ht t" to "esto"e it & c%ttin4 p"ices. The conse8%ence 6o%l &e a p"ice 6a". In the U: in "ecent ea"s the"e ha#e &een p"ice 6a"s & s%pe"ma"-ets an oil companies) fo" e2ample. The effect of p"ice 6a"s is %s%all &eneficial to cons%me"s) &%t the a"e of limite %"ation &eca%se it is not in the inte"ests of oli4opolists to s%stain them fo" lon4.
Oli%opoly. !on!lusion
e can concl%e that oli4opol 6ill lea to e8%ili&"i%m p"ices an o%tp%t in &et6een the le#els that 6o%l a"ise f"om monopol an pe"fect competition) %nless the"e is coll%sion) in 6hich case the"e 6ill &e the same "es%lts as in monopol.
Money and 6an,in%
(o%" o&?ecti#es ;a<
%ne"stan the nat%"e an f%nction of mone
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&e a6a"e of the main moneta" a44"e4ates an ho6 the a"e mae %p
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%ne"stan the "ole of &an-s in c"eatin4 c"eit
Money and its "un!tions
Mone is %se as a means of pain4 fo" 4oos an se"#ices) an pain4 fo" la&o%") capital an othe" "eso%"ces. Mone is impo"tant in an econom &eca%se1 ;a<
it >oils the 6heels> of economic acti#it) & p"o#iin4 an eas metho fo" e2chan4in4 4oos an se"#ices ;i.e. &%in4 an sellin4<=
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the total amo%nt of mone in a national econom ma ha#e a si4nificant infl%ence on economic acti#it an inflation.
In this chapte") 6e shall consie"1 ;a<
the f%nctions of mone=
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iffe"ent means of 8%antifin4 the amo%nt of mone in an econom= an
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ho6 mone is lent an &o""o6e) to mo#e it f"om people 6ho ha#e mo"e mone than the can %se to people 6ho 6ant to %se it.
The "un!tions o" money
Attempts to efine mone ha#e t"aitionall sta"te 6ith ientifin4 6hat mone oes) ie 6hat a"e the f%nctions of mone e can ientif fo%" iffe"ent f%nctions of mone. Mone acts as1 ;a<
a means of e2chan4e=
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a %nit of acco%nt=
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a stana" of efe""e pament=
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a sto"e of #al%e.
Money as a means o" e$!han%e
itho%t mone) the onl 6a of e2chan4in4 4oos an se"#ices 6o%l &e & means of &a"te" ) ie & a i"ect e2chan4e of 4oos o" se"#ices. If a shoema-e" 6ante to &% a ho"se) he 6o%l ha#e to eithe"1 ;a<
fin a ho"se5o6ne" p"epa"e to e2chan4e a ho"se fo" a s%fficient 8%antit of shoes of e8%al #al%e to the ho"se= o" else
;&<
fin othe" people 6illin4 to e2chan4e iffe"ent 4oos ;e.4. foo) clothes etc< fo" shoes) an then t"ae these 4oos in e2chan4e fo" a ho"se f"om the ho"se5o6ne". A moneta" econom is the alte"nati#e to a &a"te" econom) an it p"o#ies a means of enco%"a4in4 economic e#elopment an 4"o6th. ;a<
People a"e p"epa"e to o"4anise an 6o"- fo" an emploe") an in "et%"n "ecei#e mone 6a4es.
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A &%siness 6ill e2chan4e its 4oos o" se"#ices fo" mone in "et%"n.
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People 6ill pao%t mone in o"e" to o&tain 4oos o" se"#ices.
Money as a unit o" a!!ount
This f%nction of mone is associate 6ith the %se of mone as a means of e2chan4e. Mone sho%l &e a&le to meas%"e e2actl 6hat somethin4 is 6o"th. It sho%l p"o#ie an a4"ee stana" meas%"e & 6hich the #al%e of iffe"ent 4oos an se"#ices can &e compa"e. Fo" e2ample) s%ppose that onl fo%" p"o%cts a"e t"ae in a ma"-et1 pi4s) sheep) hens an co"n. The "elati#e #al%e of these p"o%cts m%st &e a4"ee &efo"e e2chan4e can ta-e place in the ma"-et. It mi4ht &e ecie that1 ;a<
+ pi4 has the same #al%e as 7.0! sheep) 3 hens o" +.! &a4s of co"n=
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+ sheep is the same #al%e as +.33 pi4s) / hens o" , &a4s of co"n=
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+ hen is 6o"th 7.33 pi4s) 7.,! sheep o" 7.! &a4s of co"n=
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+ &a4 of co"n has the same #al%e as 7.0 pi4s) 7.! sheep o" , hens.
The f%nction of mone in the econom 6o%l &e to esta&lish a common %nit of >#al%e meas%"ement> o" >acco%nt> & 6hich the "elati#e e2chan4e #al%es o" p"ices of 4oos can &e esta&lishe. Money as a standad o" de"eed payment
hen a pe"son &%s a 4oo o" se"#ice) he mi4ht not 6ant to pa fo" it st"ai4hta6a) pe"haps &eca%se he has not et 4ot the mone. Instea) he mi4ht as- fo" c"eit. Sellin4 4oos on c"eit is not an essential feat%"e of an econom) &%t it ce"tainl helps to stim%late t"ae. The f%nction of mone in this "espect is to esta&lish) & a4"eement &et6een &%e" an selle") ho6 m%ch #al%e 6ill &e 4i#en in "et%"n at some f%t%"e ate fo" 4oos p"o#ie"ecei#e no6. Simila"l) 6hen a &%e" an selle" a4"ee no6 to ma-e a cont"act fo" the s%ppl of ce"tain 4oos in the f%t%"e) the f%nction of mone is to esta&lish the #al%e of the cont"act) ie ho6 m%ch the &%e" 6ill e#ent%all pa the selle" fo" the 4oos. In o"e" to p"o#ie an accepta&le stana" fo" efe""e paments) it is impo"tant that mone sho%l maintain its #al%e o#e" a pe"io of time. S%ppose) fo" e2ample) that a c%stome" &%s 4oos fo" an a4"ee s%m of mone) &%t on th"ee months> c"eit. No6 if the #al%e of mone falls in the th"ee5month c"eit pe"io) the s%m of mone 6hich the selle" e#ent%all "ecei#es 6ill &e 6o"th less than it 6as at the time of sale. The selle" 6ill ha#e lost #al%e & allo6in4 the c"eit. hen the #al%e of mone falls ;o" "ises< o#e" time) selle"s ;o" &%e"s< 6ill &e "el%ctant to a""an4e c"eit) o" to a4"ee the p"ice fo" f%t%"e cont"acts. Mone 6o%l then &e failin4 to f%lfil its f%nction as a stana" fo" efe""e paments. Mone can lose #al%e as the "es%lt of p"ice inflation. hen inflation is hi4h1
;a<
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selle"s 6ill &e "el%ctant to allo6 c"eit to &%e"s. Fo" e2ample) if a &%e" as-s fo" th"ee months> c"eit) an inflation is "%nnin4 at ,7 pe" ann%m) the >"eal> #al%e of the e&t that the &%e" o6es 6ill fall & a&o%t ! o#e" the th"ee month c"eit pe"io= selle"s 6ill &e "el%ctant to a4"ee to a fi2e p"ice fo" lon45te"m cont"acts. Fo" e2ample) a ho%se5 &%ile" mi4ht "ef%se to 8%ote a p"ice fo" &%ilin4 a ho%se o#e" a t6el#e month pe"io) an instea insist on as-in4 a p"ice 6hich is >ine25lin-e> an "ises in step 6ith the 4ene"al "ate of inflation.
Money as a stoe o" value
Mone acts as a sto"e of #al%e) o" 6ealth. So too o man othe" assets ;e4 lan) &%ilin4s) a"t t"eas%"es) moto"ca"s) machine"< some of 6hich maintain o" inc"ease thei" mone #al%e o#e" time) an some of 6hich ep"eciate in #al%e. This means of co%"se that mone is not the onl asset 6hich acts as a sto"e of 6ealth) an 6e nee to e2ten o%" efinition of this f%nction of mone. Mone is mo"e p"ope"l esc"i&e as actin4 as a li8%i sto"e of #al%e. This efinition has t6o pa"ts to it. ;a<
Mone is a sto"e of #al%e o" 6ealth. A pe"son can hol mone in the ce"taint that its #al%e oes not fall an that it 6ill ha#e the same e2chan4e #al%e in the f%t%"e that it oes no6) in >no"mal> te"ms at least ;i.e. i4no"in4 inflation<.
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Mone is a li8%i asset.
The e"osion of the #al%e of mone %e to inflation p"o#ies one 4oo "eason 6h someone 6ith 6ealth to sto"e sho%l hol assets 6hich a"e not mone. +i&uidity
A li8%i sto"e of #al%e means that the 6ealth can &e con#e"te immeiatel ;o" at least #e" 8%ic-l< into a means of e2chan4e fo" o&tainin4 4oos o" se"#ices. *i8%iit is the"efo"e >the a&ilit to t"ansfo"m 6ealth holin4 into an fo"m 6itho%t loss of face #al%e o" ela>. *i8%iit is sometimes efine as >"eail con#e"ti&le into cash>) an the most li8%i asset of all is cash itself . The"e a"e t6o pa"ts to this efinition of li8%iit. A li8%i asset is one 6hich can &e con#e"te into cash ;o" into a means of e2chan4e fo" 4oos o" se"#ices1 ;a<
6itho%t si4nificant ela= an
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6itho%t si4nificant penalt o" loss of face #al%e.
*et>s loo- at each pa"t of the efinition in t%"n. Dela) *i8%iit is the a&ilit to t"ansfo"m an asset into a means of e2chan4e 6ith minim%m ela. A li8%i sto"e of 6ealth can the"efo"e &e "a6n on & its o6ne" to o&tain 4oos an se"#ices 6hene#e" he 6ants) an 6itho%t ha#in4 to 6ait to con#e"t the sto"e of 6ealth into a means of e2chan4e. A paintin4 is a sto"e of 6ealth) &%t if its o6ne" 6ishes to %se this 6ealth to &% somethin4 else) he m%st fi"st sell the paintin4 an then %se the p"ocees f"om the sale to ma-e his p%"chase. Since sellin4 a paintin4 ta-es time) a paintin4 is not a li8%i asset ;an no" is a ho%se<. *oss of face #al%e. o" si4nificant penalt. A non5cash asset is li8%i if it can &e con#e"te into cash 6ithin a sho"t pe"io of time 6itho%t si4nificant penalt. Si4nificant penalt means1 ;a<
loss of capital #al%e) o" face #al%e= o"
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loss o" fo"feit of a s%&stantial amo%nt of inte"est) ;sa) loss of +/ as> inte"est o" mo"e<.
+i&uidity and inteest
An alte"nati#e to holin4 mone as &an-notes) o" mone in a non5inte"est5&ea"in4 c%""ent &anacco%nt) is to hol on to an inte"est5&ea"in4 financial asset. E2amples of s%ch assets a"e1 ;a<
a time eposit 6ith a &an-) o" an inte"est5&ea"in4 c%""ent acco%nt=.
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a &on o" e&ent%"e
These p"o#ie the hole" 6ith1 ;a<
an inte"est iel on the #al%e of the asset=
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the ce"taint of a mone "epament to the hole" of the asset at the en of a ce"tain pe"io of time o" afte" a ce"tain pe"io of notice has &een 4i#en & the asset hole" .
The hole" of a financial asset sac"ifices some li8%iit in e2chan4e fo" an inte"est iel on his sto"e of 6ealth. Nao( money and #oad money
It is not al6as eas to ecie 6hethe" a pa"tic%la" financial asset ;e.4. a &an- eposit< is mone o" not. In efinin4 mone) 6e can istin4%ish &et6een na""o6 mone an &"oa mone. Na""o6 mone. >Na""o6 mone> "efe"s to financial assets ;incl%in4 cash< 6hich pe"fo"m the f%nctions of mone 6hen a fai"l na""o6 efinition of li8%iit is applie. Financial assets m%st ha#e a hi4h e4"ee of li8%iit to &e "e4a"e as na""o6 mone. A efinition of na""o6 mone is >mone &alances 6hich a"e "eail a#aila&le to finance c%""ent spenin4) that is to sa fo" `t"ansactions p%"poses`>. 9"oa mone. In cont"ast) &"oa mone incl%es financial assets 6hich a"e "elati#el li8%i) &%t not as li8%i as na""o6 mone items. A financial asset 6hich 6o%l &e "e4a"e as na""o6 mone 6o%l also fall 6ithin the efinition of &"oa mone= &%t &"oa mone) as its name implies) e2tens the "an4e of assets 6hich a"e "e4a"e as mone. 9"oa mone "efe"s 4ene"all to >mone hel fo" t"ansactions p%"poses an mone hel as a fo"m of sa#in4. It p"o#ies an inicato" of the p"i#ate secto">s holin4s of "elati#el li8%i assets 5assets 6hich co%l &e con#e"te 6ith "elati#e ease an 6itho%t capital loss into spenin4 on 4oos an se"#ices>.
Monetary areates Intodu!tion
The mone s%ppl is the total amo%nt of mone in the econom. It is also "efe""e to as the mone stoc-. A moneta" a44"e4ate is a total of the mone stoc- o" mone s%ppl. In the U:) the"e a"e fo%" iffe"ent moneta" a44"e4ates 6hich a"e p%&lishe & the 9an- of En4lan. These a"e1 MO) M,) M/ an M3H) a"io%s othe" a44"e4ates) incl%in4 M+) M3 an M! ha#e &een p%&lishe at #a"io%s times in the past. The main p%"pose of meas%"in4 a moneta" a44"e4ate is to isco#e" & ho6 m%ch ;an ho6 "apil< the mone s%ppl is "isin4 in the econom) an ;a<
to p"eict f"om this "ise 6hat f%t%"e chan4es in economic acti#it mi4ht &e=
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also to isco#e" 6hethe" past chan4es in the mone s%ppl help to e2plain chan4es in economic acti#it 6hich ha#e al"ea occ%""e. The"e is also the #ie6 that & cont"ollin4 the "ate of inc"ease in the mone s%ppl. inflation can &e &"o%4ht %ne" cont"ol an economic conitions mae mo"e s%ita&le fo" achie#in4 economic 4"o6th an f%lle" emploment.
$lo%s of funds %ithin an economy Intodu!tion
The flo6 of f%ns esc"i&es the mo#ement of f%ns o" >mone> &et6een one 4"o%p of people o" instit%tions in the economic sstem an othe" 4"o%ps. If 6e &e4in & i4no"in4 impo"ts an e2po"ts an fo"ei4n in#estments) 6e can sta"t to &%il %p a pict%"e of the flo6 of f%ns & ientifin4 th"ee secto"s of the econom1 ;a<
the pe"sonal secto" ;i.e. ini#i%als<=
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the &%siness secto" ;o" >in%st"ial an comme"cial secto"><) i.e. companies an othe" &%sinesses=
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the 4o#e"nment secto" ;i.e. cent"al 4o#e"nment) local 4o#e"nment an p%&lic co"po"ations <.
ithin each of these th"ee secto"s) the"e is a contin%al mo#ement of f%ns. Fo" e2ample1 ;a<
ini#i%als 6ill 4i#e mone o" len mone to othe" ini#i%als=
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companies 6ill &% 4oos an se"#ices f"om othe" companies) an ma occasiona+l len mone i"ect to othe" companies= cent"al 4o#e"nment 6ill p"o#ie f%ns fo" local 4o#e"nment a%tho"ities an loss. ma-in4 nationalise in%st"ies.
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As 6ell as mo#ements of f%ns 6ithin each secto") the"e is also a flo6 of f%ns &et6een iffe"ent secto"s of the econom. Pesonal Se!to
6usiness Se!to
7ovenment Se!to
9%t >"ealit> is not 8%ite so simple) an o%" analsis of the flo6 of f%ns in the U: has to ta-e acco%nt of1 ;a<
the o#e"seas secto" i.e. &%sinesses) ini#i%als an also 4o#e"nments in othe" co%nt"ies 6ho1 ;i< sell 4oos o" se"#ices to the U:= ;ii< &% 4oos o" se"#ices f"om the U:= ;iii< in#est capital in the U:= o" ;i#< o&tain in#estment capital f"om ini#i%als o" &%sinesses in the U:=
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financial inte"meia"ies.
Finan!ial intemediaies
An inte"meia" is a 4o5&et6een) an a financial inte"meia" is an instit%tion 6hich lin-s lene"s 6ith &o""o6e"s) eithe" ;as p"incipal< & o&tainin4 eposits f"om lene"s an then "e5lenin4 them to &o""o6e"s o" ;as &"o-e"< a""an4in4 a t"ansaction. He"e) 6e a"e conce"ne 6ith the fo"me" tpe of inte"meia". The &asic p"ocess of financial inte"meiation can &e sho6n & simple ia4"ams. ;a<
If no financial inte"meiation ta-es place) lenin4 an &o""o6in4 6ill &e i"ect.
Suplus Unit
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De"i!it Unit
If financial inte"meiation oes ta-e place) the sit%ation 6ill &e1
Suplus Unit
Finan!ial Intemediay
De"i!it Unit
Financial inte"meia"ies mi4ht also len a&"oa o" &o""o6 f"om a&"oa) an a final #e"sion of the ia4"am of the flo6 of f%ns is no6 as follo6s1
Pesonal Se!to
Oveseas Se!to
Finan!ial Intemediay
6usiness Se!to
7ovenment Se!to
In the U: financial inte"meia"ies incl%e1 ;a<
&an-s
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&%ilin4 societies
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ins%"ance companies) pension f%ns) %nit t"%st companies an the in#estment t"%st companies
The impotan!e o" #an,s as "inan!ial intemediaies
In spite of competition f"om &%ilin4 societies) ins%"ance companies an othe" financial instit%tions) &an-s a"e still the ma?o" financial inte"meia"ies. ;a<
The clea"in4 &an-s ominate the "etail &an-in4 ma"-et altho%4h competition f"om the &%ilin4 societies has &een 4"o6in4 in the U:.
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The"e is 4"eate" competition &et6een iffe"ent &an-s ;o#e"seas &an-s an the clea"in4 &an-s especiall< fo" &%siness in the >6holesale> lenin4 ma"-et.
Ris, edu!tion and matuity tans"omation
It is %sef%l to %ne"stan 6hat the &enefits of financial inte"meiation a"e. ;a<
Financial inte"meia"ies p"o#ie o&#io%s an con#enient 6as in 6hich a lene" can sa#e mone. Instea of ha#in4 to fin a s%ita&le &o""o6e" fo" his mone) the lene" can eposit his mone 6ith a &an-) &%ilin4 societ) pension f%n) in#estment t"%st compan) National Sa#in4s scheme etc. All the lene" has to o is ecie fo" ho6 lon4 he mi4ht 6ant to len the mone) an 6hat so"t of "et%"n he "e8%i"es) an he can then choose a financial inte"meia" that offe"s a financial inst"%ment to s%it his "e8%i"ements.
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Financial inte"meia"ies a44"e4ate ;i.e. pac-a4e %p< the amo%nts lent & sa#e"s an len on to &o""o6e"s in &i44e" amo%nts.
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P"o#ie that the financial inte"meia" is itself financiall so%n) the lene" 6o%l not "%n an "is- of losin4 his in#estment. 9a e&ts 6o%l &e &o"ne & the financial inte"meia" in its "e5lenin4 ope"ations.
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The p"o#ie a "ea so%"ce of f%ns fo" &o""o6e"s. E#en 6hen mone is in sho"t s%ppl) a &o""o6e" 6ill %s%all fin a financial inte"meia" p"epa"e to len some. Financial inte"meia"ies) most impo"tantl) p"o#ie mat%"it t"ansfo"mation= in othe" 6o"s the &"i4e the 4ap &et6een the 6ish of most lene"s fo" li8%iit an the esi"e of most &o""o6e"s fo" loans o#e" lon4e" pe"ios. The o this & p"o#iin4 in#esto"s 6ith financial inst"%ments 6hich a"e li8%i eno%4h fo" the in#esto"s> nees an & p"o#iin4 f%ns to &o""o6e"s in a iffe"ent lon4e" te"m fo"m.
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(ankin The #an,s and the #an,in% system
9an- eposits a"e an impo"tant feat%"e 6ithin most efinitions of the mone s%ppl. The"e a"e iffe"ent tpes of &an-s) an o% 6ill p"o&a&l ha#e come ac"oss a n%m&e" of te"ms 6hich esc"i&e them. ;a<
Clea"in4 &an-s a"e the &an-s 6hich ope"ate the so5calle >clea"in4 sstem> fo" settlin4 paments ;e.4. paments & che8%e & &an- c%stome"s<.
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The te"m >"etail> &an-s is %se to esc"i&e the t"aitional Hi4h St"eet &an-s. The te"m >6holesale> &an-s "efe"s to &an-s 6hich specialise in lenin4 in la"4e 8%antities to ma?o" c%stome"s. The clea"in4 &an-s a"e in#ol#e in &oth "etail an 6holesale &an-in4 &%t a"e commonl "e4a"e as the main >"etail> &an-s.
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Me"chant &an-s a"e &an-s 6hich offe" se"#ices) often of a specialise nat%"e) to co"po"ate c%stome"s.
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Comme"cial &an-s "efe" to an &an-s 6hich ma-e comme"cial &an-in4 t"ansactions 6ith c%stome"s. The a"e istinct f"om the co%nt">s cent"al &an-.
Cedit and #an,in%
9efo"e 6e 4o on to consie" the "ole of &an-s in c"eatin4 c"eit) it is 6o"th 4i#in4 some attention to the impo"tance of c"eit in the econom. C"eit means o6in4 mone o" &ein4 o6e mone ;a<
Ta-in4 o" o&tainin4 c"eit in#ol#es an a""an4ement 6he"e& someone eithe"1 ;i<
&o""o6s mone) 6ith an %ne"ta-in4 to pa it &ac- in time 6ith inte"est=
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&%s 4oos o" se"#ices 6itho%t pain4 fo" them immeiatel) &%t 6ith an %ne"ta-in4 to pa fo" them in the f%t%"e. Fi"ms often &% 4oos f"om each othe" %ne" this so"t of c"eit a""an4ement) 6hich is then "efe""e to as >t"ae c"eit>.
*enin4 o" 4i#in4 c"eit is the othe" sie of the t"ansaction. The pe"son o" o"4anisation 4i#in4 c"eit is the >c"eito"> an the &o""o6e" is the >e&to">.
O%" main inte"est in c"eit fo" the p%"pose of this chapte" conce"ns lenin4 an &o""o6in4 mone) "athe" than 6ith &%in4 4oos on t"ae c"eit. The "un!tions o" !edit
The f%nctions of c"eit can &e seen f"om the point of #ie6 eithe" of the &o""o6e" o" the lene" . ;a<
Fo" the &o""o6e") the "eason fo" &o""o6in4 mone is to &e a&le to p%"chase 4oos o" se"#ices >no6> that he 6o%ln>t othe"6ise &e a&le to affo". The &o""o6e" 6ants to &% no6 an pa late" .
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Fo" the lene") the "eason fo" lenin4 mone is that the"e is nothin4 that he pa"tic%la"l 6ants to spen his mone on) an & lenin4 it) he can ea"n some inte"est.
The &o""o6e" can &e esc"i&e as a >eficit %nit> 6ith not eno%4h mone to &% all the 4oos an se"#ices he 6ants. The lene" can &e esc"i&e as a >s%"pl%s %nit> 6ith mo"e mone at the moment than he nees to spen. C"eit in#ol#es the t"ansfe" of mone f"om a s%"pl%s %nit to a eficit %nit) in "et%"n fo" a p"omise to pa inte"est. 6an, deposits and the !eation o" money
9an-s a"e ma?o" p"o#ie"s of c"eit. 9an-s c"eate mone 6hen the 4i#e c"eit) an so &an- lenin4 has t6o aspects 6hich a"e impo"tant fo" the econom1 ;a<
c"eit an the"efo"e e2penit%"e in the econom=
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inc"eases in the mone s%ppl.
hen a &an- lens mone) most of the mone 6ill fin its 6a &ac- into the &an-in4 sstem as ne6 c%stome" eposits. This as to the mone s%ppl if 6e incl%e &an- eposits 6ithin o%" efinition of the mone stoc-. S%ppose) fo" e2ample) that in a co%nt" 6ith a sin4le &an-) c%stome" eposits total L+77)777. The &an-) 6e 6ill ass%me) "e5lens all these eposits to othe" c%stome"s. The c%stome"s 6ill %se the mone the ha#e &o""o6e to &% 4oos an se"#ices an the 6ill pa #a"io%s fi"ms an ini#i%als fo" these p%"chases. If the fi"ms an ini#i%als "ecei#in4 pament then p%t the mone into thei" o6n acco%nts 6ith the &an-) the &an->s eposits 6ill ha#e o%&le. It is this fact that most aitions to &an- lenin4 en %p as mone in someone>s &an- acco%nt) ain4 to total c%stome" eposits 6ith the &an-s) that 4i#e &an-s this special a&ilit to c"eate mone. It is an a&ilit that is also sha"e in the U: & &%ilin4 societies) since &%ilin4 societ eposits a"e incl%e in efinitions of the mone s%ppl ;e.4. M, an M/<. Fa!tional eseve systems
A &an- co%l) in theo") 4o on "e5lenin4 all the eposits it "ecei#es) an if all the mone "e5lent then fins its 6a &ac- into &an- acco%nts) the"e is theo"eticall no limit to the amo%nt of e2t"a mone that &an-s can c"eate. >This seemin4 po6e" of the &an-in4 sstem to c"eate appa"entl %nlimite 8%antities of mone has t"o%&le economists an &an-in4 p"actitione"s fo" man ea"s. The ha#e hel %p the spect"e of an %ncont"olle &an-in4 sstem c"eatin4 mone in s%ch 8%antities that inflation 6o%l "%n "iot an the #al%e of mone &ecome e&ase.> ;C"oc-ett) Mone) theo") polic an instit%tions<
This theo"etical sit%ation oes not e2ist in p"actice) an the"e a"e t6o ma?o" "easons 6h this is so. ;a<
9an-s o not "e5len all the e2t"a eposits the "ecei#e. One o&#io%s "eason fo" this is that the nee some li8%iit to meet emans fo" 6ith"a6als & c%stome"s. One 6a of ens%"in4 ae8%ate li8%iit is to maintain a safe p"opo"tion of the &an->s assets in the fo"m of cash o" li8%i assets. If a &an- oes t" to maintain a minim%m "atio ;f"action< of cash o" li8%i assets to total assets) it is sai to &e ope"atin4 a f"actional "ese"#e sstem) o" is sai to &e %sin4 a >cash "atio> o" >"ese"#e asset "atio>. A >"ese"#e asset> "atio is the "atio of a &an->s "ese"#e assets to its total assets. Rese"#e assets can &e tho%4ht of as li8%i assets o" nea"5li8%i assets) an so a "ese"#e asset "atio is simila" to a cash "atio.
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Not all the mone lent as &an- loans to c%stome"s fins its 6a &ac- into the &an-in4 sstem1 the"e a"e >lea-a4es> ;isc%sse late" in this chapte"<.
A simplifie ill%st"ation of a f"actional "ese"#e sstem cannot sho6 the comple2it of the financial sstem an the 6ie "an4e of li8%i an nea"5li8%i assets a &an- can in#est in. In the ill%st"ation 6hich follo6s) simplifin4 ass%mptions ha#e ha to &e mae fo" the sa-e of cla"it. Minimum !ash atio system illustated. !edit !eation
e shall ass%me fo" simplicit that the"e is onl one &an- in the &an-in4 sstem) an that all mone lent & the &an- is "e5eposite & #a"io%s c%stome"s. A c%stome" epositin4 L+)777 in cash 6ith the &an- c"eates an asset fo" himself) in the sense that the &an-) in "et%"n fo" the eposit) 4i#es the c%stome" an IOU) i.e. a p"omise to pa on eman) o" s%&?ect to notice) the L+)777 eposite. The IOU is) "eflecte in the acco%nt opene %ne" the name of the client. To the &an-) the eposit is a lia&ilit . Ho6e#e") the eposit p"o#ies f%ns fo" the &an- to ac8%i"e assets. e shall &e4in & ass%min4 that the &an- hols these assets enti"el in the fo"m of cash. If the &an- -eeps the f%ll L +)777 an oes nothin4 6ith it) then it 6o%l simpl ope"ate as a >cloa-"oom> fo" the client an the mone so eposite. Ho6e#e") if the &an- &elie#es that the client is %nli-el to claim the f%ll L+)777 fo" some time) the"e 6ill &e some incenti#e to %se the mone "athe" than to -eep it ile. On possi&ilit 6o%l &e to len it= the &an- 6o%l &e ta-in4 a "is- that it 6ill not ha#e the cash 6hen its c%stome" 6ants to ha#e it &ac-) &%t at the same time it 6o%l e2pect to ma-e a p"ofit & cha"4in4 inte"est on the s%m of mone so lent. Th%s the"e is the li8%iit sec%"it p"ofita&ilit conflict in the moti#es of the &an-. On one han the eposit of the L+ )777 c"eates the oppo"t%nit fo" the &an- to ma-e a p"ofit in the fo"m of the inte"est that it can cha"4e on the mone it lens ;the incenti#e &ein4 all the st"on4e" if the &an- is pain4 inte"est on the eposits it accepts<) &%t on the othe" han the"e is a "is- that 6hen the mone is o%t on loan the client ma claim it &ac-. The &an- 6ill then &e %na&le to meet its o&li4ation to "epa the cash to the client %nless it can "ecall the loan instantl) 6hich is %nli-el. As lon4 as the &an- feels that the li-elihoo is small that its eposito"s 6ill eman a s%&stantial p"opo"tion of thei" eposits in cash) then it faces an accepta&le "is- in lenin4 some of the mone. In othe" 6o"s) the"e is a &alancin4 act &et6een the esi"e to pla it safe an -eep the cash an the esi"e to ma-e p"ofits & lenin4. In p"actice) &an-s can &e confient that in no"mal times) p"o#ie that the"e is not a se"io%s loss in confience in the &an-in4 sstem) eposito"s o#e"all 6ill not eman s%&stantial p"opo"tions of thei" eposits as cash. In the e2ample in the ta&le &elo6) it is ass%me that the &an- has ecie on the &asis of past e2pe"ience an o&se"#ation to -eep !7 pence in cash fo" e#e" L+ eposite) an then len o%t the othe" !7 pence. In othe" 6o"s) the &an- in this e2ample is ope"atin4 a !7 cash "atio.
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&an's liabilities ; c%stome" eposits<
&an's assets ; cash o" loans to c%stome"s<
L+)777 eposits
L+)777 cash
The &an- has L+)777 in cash. This is eno%4h to s%ppo"t total assets of L,)777 an maintain a !7 cash "atio. If the &an- no6 lens L+)777) an if all of that L+)777 is then spent & the &o""o6e"s &%t ens %p &ac- 6ith the &an- as eposits of othe" c%stome"s) the ne6 sit%ation fo" the &an- 6ill &e as in ;,< &elo6. ;,<
L,)777 eposits
L+)777 cash L+)777+oans
Money !eation and the !ash atio. !edit multiplie
If the &an- ecie that the !7 cash "atio 6as too conse"#ati#e an "e%ce it to ,! then fo" L+)777 cash eposite 6ith the &an- eposits co%l &e e2pane fo%"fol. It is impo"tant to %ne"stan that &an-s in the p"ocess of lenin4 a"e also potentiall c"eatin4 mone &eca%se clients eithe" &o""o6in4 o" "ecei#in4 the p"ocees of &o""o6e"s> e2penit%"e can %se thei" eposits to ma-e mone t"ansactions. In a moe"n econom a la"4e p"opo"tion of mone t"ansactions a"e & che8%e o" othe" &an- t"ansfe" s%ch as i"ect e&its o" stanin4 o"e") th%s t"ansfe""in4 &an- eposits f"om pe"son to pe"son o" f"om fi"m to fi"m. Cons%me"s an p"o%ce"s th%s %se the lia&ilities of a p"i#ate instit%tion ;6hich is 6hat &aneposits a"e< as mone. The fact that &an-s o not nee to -eep a +77 cash "atio a%tomaticall implies that the ha#e the capacit to c"eate mone o%t of nothin4. The siGe of this c"eit e2pansion epens on the siGe of thei" cash "atio. e can s%mma"ise the 8%antitati#e sie of c"eit c"eation in &an-s & 6"itin4 the c"eit m%ltiplie" as1 Deposits
cash cash "atio
o"
Dc "
The smalle" the cash "atio the &i44e" the siGe of the eposits that a 4i#en amo%nt of cash 6ill &e a&le to s%ppo"t. This theo"etical esc"iption of the c"eit m%ltiplie" applies to some e2tent in p"actice &%t the"e a"e othe" facto"s 6hich ope"ate to "est"ict the #ol%me of e2pansion in &an- eposits. In othe" 6o"s) if a &anecies to -eep a cash "ese"#e "atio of +7) an it "ecei#es aitional eposits of L+)777) the total inc"ease in &an- eposits 6ill not &e L+)777 Z +7 L+7)777) &%t consie"a&l less than this.
The const"aints on the 4"o6th of a &an->s eposits a"e1 ;a<
lea-a4es of cash o%t of the &an-in4 sstem=
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the nat%"e of c%stome" eman fo" loans. C%stome"s mi4ht not 6ant to &o""o6 at the inte"est "ates the &an- 6o%l cha"4e=
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p"%ent mana4ement of lenin4 ope"ations & the &an-s themsel#es. 9an-s sho%l not len to hi4h5"is- c%stome"s 6itho%t 4oo sec%"it.
+ea,a%es' edu!in% the si:e o" the !edit multiplie
*ea-a4es a"e ca%se & a fe6 facto"s incl%in4 the ecision & the p%&lic ;fi"ms an ini#i%als< to hol some of thei" e2t"a mone in cash ;i.e. notes an coin in thei" hans<. Fo" e2ample) if a &an- lens L+7)777 to a c%stome") 6ho then %ses the mone to &% a ca") the ca" eale" 6ho is then pai the L+7)777 mi4ht ecie to hol some of his e2t"a mone in cash instea of p%ttin4 it all into the &an-. If 6e ass%me that the total amo%nt of cash hel & the p%&lic inc"eases o" ec"eases as the total #ol%me of &an- eposits "ises o" falls) it can &e sho6n mathematicall that the effect of the c"eit m%ltiplie" on total &an- eposits is D
C cZ"
6he"e D C " c
is the e#ent%al total inc"ease in &an- eposits is the initial inc"ease in &an- eposits is the &an-s> cash "ese"#e "atio is the "atio of cash hel & the p%&lic to the #ol%me of &an- eposits.
Fo" e2ample) if the &an-s aim to ha#e a cash "ese"#e "atio of +7 an the p%&lic chooses to ha#e a cash1 &an- eposits "atio of one5si2teenth ;.0<) then the total inc"ease in &an- eposits a"isin4 f"om an initial inc"ease of L+)777 6o%l &e1 L+.777 7.70 Z 7.+7
L)777
The c"eit m%ltiplie" is no6 onl times ) not times +7. Cedit !ontol and %ovenment poli!y
If the 4o#e"nment is 6o""ie a&o%t 4"o6th in the mone s%ppl) o" inflation in the econom) it mi4ht consie" the 4"o6th in c"eit to &e a ma?o" ca%se of the p"o&lem. This mi4ht s%44est that all a 4o#e"nment has to o to cont"ol inflation an 4"o6th in c"eit spenin4 is to stop &an-s f"om lenin4 too m%ch) ie to place cont"ols o#e" &an- lenin4. C"eit cont"ol policies ha#e &een attempte in the past in the U:) 6itho%t an lon45te"m s%ccess. The main p"o&lems in applin4 i"ect cont"ols o#e" &an- lenin4 a"e as follo6s. ;a<
Enfo"cin4 the cont"ols co%l &e iffic%lt. Financial instit%tions mi4ht t" to >&en> o" a#oi the "%les) in o"e" to contin%e lenin4. The"e mi4ht also &e mo"e i"ect lenin4 &et6een in#esto" an &o""o6e".
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The e#elopment of a st"on4 capital ma"-et in the U: 6ill &e ama4e & 4o#e"nment "est"ictions on lenin4) 4i#en the li&e"alisation of capital ma"-ets a"o%n the 6o"l in "ecent ea"s.
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Rest"ictions on ce"tain fo"ms of lenin4 ;e.4. in#estment loans to small companies) o" mo"t4a4e lenin4 to ho%se &%e"s< co%l ha#e ha"mf%l economic o" social conse8%ences.
The buildin societies The &%ilin4 societies e#elope in the U: as m%t%al o"4anisations to ena&le mem&e"s to sa#e o" to &o""o6 mone to finance ho%se p%"chase. 9%ilin4 societies a"e no6 allo6e & the 9%ilin4 Societies Act +'$ to p"o#ie ce"tain &an-in4 se"#ices as 6ell) s%ch as pe"sonal lenin4 to c%stome"s fo" p%"poses othe" than ho%se &%in4. 9%ilin4 societies no6 offe" che8%e &oo- acco%nts) cash ca"s an man othe" facilities that compete i"ectl 6ith the >"etail> &an-s. The 4"o6in4 simila"it &et6een &an-s an &%ilin4 societies is f%"the" e#ient in1 ;a<
the incl%sion of &%ilin4 societ eposits in the &"oa moneta" a44"e4ates M/ ;as 6ell as M,<
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the a&ilit of &%ilin4 societies to &ecome p%&lic limite companies an) in effect) &an-s. The A&&e National 6as the fi"st U: &%ilin4 societ to o this in +'$'.
The p"e#io%s esc"iption of &an-s) an the a&ilit of &an-s to c"eate mone & 4i#in4 c"eit) the"efo"e applies to a la"4e e2tent to &%ilin4 societies too. Ho6e#e") &%ilin4 societies a"e still mainl en4a4e in mo"t4a4e lenin4 fo" ho%se p%"chase) an a"e not et f%ll compa"a&le 6ith &an-s.
The Cental 6an, And The Fin An Cial Ma,ets The functions of the (ank of Enland Intodu!tion
A cent"al &an- is a &an- 6hich acts on &ehalf of the 4o#e"nment to s%pe"#ise) "e4%late an cont"ol the co%nt">s &an-in4 sstem. In the U:) the cent"al &an- is the 9an- of En4lan. The 9an- of En4lan is a nationalise co"po"ation an is the cent"al &an- of the U:. It is "%n & a Co%"t of Di"ecto"s) consistin4 of the @o#e"no") Dep%t @o#e"no") an some E2ec%ti#e Di"ecto"s an pa"t5time Di"ecto"s. The 9an- of En4lan) as the U:>s cent"al &an-) has a #a"iet of f%nctions. ;a<
It acts as &an-e" to cent"al 4o#e"nment an hols the >p%&lic eposits>. P%&lic eposits incl%e the National *oans F%n) the Consoliate F%n an the acco%nt of the Pamaste" @ene"al) 6hich in t%"n incl%es the E2chan4e E8%alisation Acco%nt.
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It is the cent"al note5iss%in4 a%tho"it in the U:= it is "esponsi&le fo" iss%in4 &an- notes.
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It is the mana4e" of the National De&t ;ie it eals 6ith lon45te"m an sho"t5te"m &o""o6in4 & cent"al 4o#e"nment an the "epament of cent"al 4o#e"nment e&t<.
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It is the mana4e" of the E2chan4e E8%alisation Acco%nt ;ie the U:>s fo"ei4n c%""enc "ese"#es<.
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It acts as the aminist"ato" of an e2chan4e cont"ol "e4%lations that mi4ht &e in fo"ce.
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It acts as a#iso" to the 4o#e"nment on moneta" economic polic.
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It acts as a4ent fo" the 4o#e"nment in ca""in4 o%t its moneta" policies.
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It is the s%pe"#iso" of the &an-in4 sstem.
It acts as the info"mal s%pe"#iso" of othe" financial instit%tions s%ch as the Stoc- E2chan4e. In 4ene"al te"ms) it is the cent"al &an->s f%nction to co5ope"ate 6ith the cent"al 4o#e"nment in ca""in4 o%t the 4o#e"nment>s moneta" polic. In the U:) the 9an- of En4lan is also1 ;a<
a &an-e" to the comme"cial &an-s. Each of the comme"cial &an-s -eeps acco%nts 6ith the 9an- of En4lan=
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a lene" to the &an-in4 sstem. hen the &an-in4 sstem is sho"t of mone) the 9an- of En4lan 6ill p"o#ie the mone the &an-s nee at an app"op"iate "ate of inte"est. As 6e shall see) it oes this mainl & p%"chasin4 >eli4i&le &ills> f"om the isco%nt ma"-et) an it mi4ht #e" occasionall len i"ect to the isco%nt ho%ses as a lene" of last "eso"t. ;The isco%nt ho%ses a"e special &an-s 6hich ha#e the p"i#ile4e "ole of actin4 as 4o5 &et6eens &et6een the 9an- of En4lan an all the othe" comme"cial &an-s in the U:.< This aspect of the 9an->s acti#ities is #e" impo"tant) &eca%se it p"o#ies the means & 6hich the 4o#e"nment can infl%ence o" cont"ol the le#el of inte"est "ates.
The (ank of Enland as a banker The 9an->s c%stome"s a"e1 ;a<
the @o#e"nment=
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othe" &an-s in the financial sstem) an in pa"tic%la" the clea"in4 &an-s an isco%nt ho%ses.
As al"ea mentione) each comme"cial &an- has a &an- acco%nt 6ith the 9an- of En4lan. 9an-s %se these eposits to settle e&ts &et6een each othe". The also %se these eposits to pa amo%nts %e to the 4o#e"nment) an 6hen the 4o#e"nment ma-es paments to the &an-s) the"e 6ill &e a t"ansfe" of f%ns f"om the 4o#e"nment>s acco%nt 6ith the 9an- to the &an-s> acco%nts 6ith the 9an-. A feat%"e of the 9an->s "ole as a &an-e" is the"efo"e1 ;a< ail t"ansfe"s of f%ns &et6een the eposits of the &an-s as inte"5&an- e&ts a"e settle= ;&< ail t"ansfe"s of f%ns &et6een the 4o#e"nment>s p%&lic eposits an the &an-e"s> eposits. The 6an, o" En%land as the !ental note)issuin% authoity in the U8
The 9an- of En4lan is the cent"al a%tho"it in the U: fo" the iss%e of &an-notes. The p"ofits f"om note iss%es a"e pai to the E2che8%e". These p"ofits a"ise f"om the fact that notes a"e inte"est5f"ee) &%t the f%ns o&taine & the 9an- f"om the comme"cial &an-s as pament fo" the iss%e of notes a"e %se to ac8%i"e inte"est5&ea"in4 sec%"ities. The 6an, o" En%land as mana%e o" the National De#t
The 9an- of En4lan iss%es 4o#e"nment sec%"ities to "aise f%ns on &ehalf of the 4o#e"nment) an is acti#e in the 4ilt5e4e ma"-et an mone ma"-ets) &%in4 an sellin4 4o#e"nment ;an othe"< sec%"ities. The 9an- also aministe"s the "epament of 4o#e"nment e&t 6hen these e&ts "each thei" mat%"it ;"eemption ate<. *on45te"m 4o#e"nment e&t inst"%ments a"e "efe""e to collecti#el as 4ilt5e4e sec%"ities o" 4ilts. @ilts a"e inte"est5&ea"in4 sec%"ities 6hich a"e iss%e & the 4o#e"nment an &o%4ht & in#esto"s. Sho"t5 te"m 4o#e"nment e&t ta-es the fo"m of T"eas%" &ills) 6hich a"e iss%e & the 4o#e"nment an &o%4ht la"4el & the isco%nt ho%ses. The 6an, o" En%land as mana%e o" the E$!han%e E&ualisation A!!ount
This acco%nt "ep"esents the eposits of the nation>s 4ol an fo"ei4n c%""enc "ese"#es. The E2chan4e E8%alisation Acco%nt can &e %se to infl%ence the e2chan4e "ate of ste"lin4 a4ainst othe" fo"ei4n c%""encies. The e2chan4e #al%e of ste"lin4 is allo6e to float ;ie "ise o" fall in #al%e< a4ainst othe" c%""encies in "esponse to ma"-et s%ppl an eman) &%t 6hen the 4o#e"nment consie"s that ste"lin4>s #al%e is too hi4h o" too lo6) the 9an- 6ill inte"#ene. The 9an- of En4lan is th%s a ma?o" acti#e pa"ticipato" in th"ee ma"-ets1 ;a<
the 4ilt5e4e ma"-et=
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the mone ma"-et ;mo"e specificall) the isco%nt ma"-et<= an
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the fo"ei4n e2chan4e ma"-et.
The 6an, o" En%land/s ole as administato o" e$!han%e !ontols and othe duties
E2chan4e cont"ols a"e "est"ictions on the flo6 of mone into o" o%t of a co%nt". At the moment) the"e a"e no s%ch cont"ols at all in fo"ce in the U: &eca%se the 6e"e "emo#e & the 4o#e"nment in +'0'.
Ho6e#e") sho%l the e#e" &e "e5int"o%ce) the 9an- 6o%l ha#e the "esponsi&ilit fo" aministe"in4 them. Simila"l) the cent"al &an- of an co%nt" 6he"e e2chan4e cont"ol "e4%lations a"e in fo"ce 6o%l ha#e the "esponsi&ilit of enfo"cin4 them. The impo"tant f%nction of the 9an- as aminist"ato" o" a4ent fo" the 4o#e"nment>s moneta" polic 6ill &e esc"i&e late". The 9an- has the "esponsi&ilit %ne" the 9an-in4 Act fo" the s%pe"#ision of the &an-in4 sstem. It m%st t" to ens%"e that ini#i%al &an-s "etain s%fficient li8%iit an o not %ne"ta-e #ent%"es that a"e too "is-. The 6an, o" En%land as lende o" last esot to the !omme!ial #an,in% system
In the U:) the isco%nt ma"-et p"o#ies a lin- &et6een the &an-in4 sstem an the 4o#e"nment ;9anof En4lan< 6he"e& the 9an- of En4lan lens mone to the &an-in4 sstem) 6hen &an-s 6hich nee cash cannot 4et it f"om an6he"e else ;e.4. f"om othe" &an-s<. ;a<
The 9an- 6ill s%ppl cash to the &an-in4 sstem on as 6hen the &an-s ha#e a cash sho"ta4e. It oes this & &%in4 eli4i&le &ills f"om the isco%nt ho%ses in e2chan4e fo" >cash>. Eli4i&le &ills a"e &ills ;i.e. e&t inst"%ments<) 6hich the 9an- 6ill &e p"epa"e to &% f"om the isco%nt ho%ses. Most of these a"e &ills that ha#e &een iss%e & &an-s) 6hich a"e on the 9an->s list of >eli4i&le> &an-s.
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The 9an- 6ill "emo#e e2cess cash f"om the &an-in4 sstem on as 6hen the &an-s ha#e a cash s%"pl%s. It oes this & sellin4 &ills to the isco%nt ho%ses) so that the isco%nt ho%ses o&tain inte"est5&ea"in4 &ills in place of the cash that the o not 6ant.
The p"ocess 6he"e& this is one c%""entl is -no6n as open ma"-et ope"ations. This simpl esc"i&es the &%in4 an sellin4 of eli4i&le &ills &et6een the 9an- an the isco%nt ma"-et. Open ma,et opeations and shot)tem inteest ates
One aspect of open ma"-et ope"ations is that the ena&le the 4o#e"nment) th"o%4h the 9an- of En4lan) to infl%ence sho"t5te"m inte"est "ates. hen &ills a"e &o%4ht an sol) the a"e t"ae at a isco%nt to thei" face #al%e) an the"e is an implie inte"est "ate in the "ate of isco%nt o&taine. Inte"est "ates on &ills t"ae in open ma"-et ope"ations ha#e an immeiate infl%ence on othe" mone ma"-et inte"est "ates) s%ch as the *onon Inte"59anOffe"e Rate ;*I9OR<) an these in t%"n infl%ence the &an-s> &ase "ates. Th%s) if inte"est "ates in the isco%nt ma"-et>s open ma"-et ope"ations 6ent %p) the"e 6o%l #e" soon &e an inc"ease in othe" mone ma"-et "ates) an then the &an-s> &ase "ates) an so lenin4 "ates on &anloans an o#e""afts. Open ma"-et ope"ations a"e an impo"tant feat%"e of the 4o#e"nment>s moneta" polic) 6hich the 9animplements on its &ehalf. (o% mi4ht sometimes hea" on tele#ision o" "aio ne6s that &an-s ha#e lo6e"e o" inc"ease thei" &ase "ates in "esponse to a >si4nal> f"om the 9an- of En4lan. S%ch a si4nal comes f"om a chan4e of inte"est "ate at 6hich the 9an- of En4lan 6ill eal that a in its open ma"-et ope"ations. The elationship #et(een the 6an, o" En%land and the dis!ount houses
The histo" of the isco%nt ma"-et ates &ac- to the ea"l nineteenth cent%". A #e" si4nificant feat%"e of the isco%nt ma"-et) as it has e#elope) is the special "elationship 6hich e2ists &et6een the 9an- of En4lan an the isco%nt ho%ses. This "elationship still e2ists) altho%4h since Octo&e" +'$$) the 9anof En4lan has &een 6illin4 to 4"ant a "elationship 6ith othe" instit%tions) simila" to its "elationship 6ith the isco%nt ho%ses) p"o#ie that these instit%tions meet ce"tain conitions fo" &ein4 consie"e >accepta&le> & the 9an-.
The 9an- 6ill act as a lene" of last "eso"t to the &an-in4 sstem as a 6hole #ia the isco%nt ho%ses. In oin4 so) the 9an- ;an 4o#e"nment< is a&le to %se the isco%nt ho%ses as a 4o5&et6een th"o%4h 6hich it can infl%ence the amo%nt of cash ;an infl%ence sho"t5 te"m inte"est "ates< in the U: &an-in4 sstem. The 9an->s aim is t6o5fol1 ;a<
to p"o#ie a mechanism 6he"e& the 9an- can "e4%late the cash position of the &an-in4 sstem=
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an in oin4 so) to cont"ol o" infl%ence the le#el of sho"t5te"m inte"est "ates.
Ho( does the 6an, in"luen!e shot)tem inteest ates9
9 ope"atin4 as a >lene"> of cash in the isco%nt ma"-et) the 9an->s state aim is to infl%ence #e" sho"t5te"m inte"est "ates) an so ini"ectl infl%ence the 4ene"al le#el of inte"est "ates. The isco%nt ho%ses m%st compete 6ith each othe" to sell &ills to the 9an- 6hen the a"e sho"t of mone) o" &% &ills f"om the 9an- 6hen the ha#e a cash s%"pl%s. The isco%nt ho%ses m%st the"efo"e select the inte"est "ates ;i.e. "ates of isco%nt< at 6hich the 6ish to &% o" sell) an offe" this "ate to the 9an-. The 9an- 6ill sa es o" no) i.e. it 6ill a4"ee to &% o" sell) o" it 6ill "ef%se. ;If it "ef%ses) the isco%nt ho%ses can offe" a ne6 p"ice.< 9 "e?ectin4 offe"s) the 9an- 6ill infl%ence mone ma"-et inte"est "ates. If the 9an- is content 6ith the patte"n of "ates implie & the offe"s) it is 4ene"all p"epa"e to accept s%fficient to &alance the ma"-et. 9%t if the "ates 6hich a"e offe"e conflict 6ith the 9an->s inte"est "ate o&?ecti#e) all o" pa"t of the offe"s ma &e "e?ecte. Open ma"-et ope"ations occ%" ail) altho%4h 4ene"al la"4e inte"est "ate chan4es occ%" ?%st occasionall. (vent
;a< 9an- of En4lan &%s eli4i&le &ills fo" cash. Inte"est "ate implie in the p%"chase p"ice isco%nt. ;&< Comme"cial &an-s) sho"t of cash) "a6 on eposits 6ith isco%nt ho%ses. ;c< Cash ente"s the &an-in4 sstem f"om the 9an- of En4lan. ;< Disco%nt ho%ses compete 6ith &is to sell eli4i&le &ills to the 9an- of En4lan.
The capital markets and the money markets Intodu!tion
A istinction is %s%all mae &et6een1 ;a<
capital ma"-ets) 6hich a"e financial ma"-ets fo" "aisin4 an in#estin4 lon45te"m capital= an
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mone ma"-ets) 6hich a"e financial ma"-ets fo" lenin4 an &o""o6in4 sho"t5te"m capital.
>*on45te"m> an >sho"t5te"m> a"e "athe" a"&it"a" istinctions. hat o 6e mean & lon45 te"m an sho"t5 te"m capital ;a<
9 sho"t5te"m capital) 6e mean capital that is lent o" &o""o6e fo" a pe"io 6hich mi4ht "an4e f"om as sho"t as o#e"ni4ht %p to a&o%t one ea") an sometimes lon4e".
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9 lon45te"m capital) 6e mean capital in#este o" lent an &o""o6e fo" a pe"io of a&o%t fi#e ea"s o" mo"e) &%t sometimes sho"te".
The"e is a >4"e a"ea> &et6een lon45te"m an sho"t5te"m capital) 6hich is lenin4 an &o""o6in4 fo" a pe"io f"om a&o%t one to t6o ea"s %p to a&o%t fi#e ea"s) 6hich is not s%"p"isin4l sometimes "efe""e to as mei%m5te"m capital. It is not ?%st the te"m of the lenin4 an &o""o6in4 that istin4%ishes the capital ma"-ets f"om the mone ma"-ets. Anothe" impo"tant iffe"ence is the financial inst"%ments that a"e ealt in & each ma"-et. ;a<
The >capital ma"-ets> is a te"m %se to esc"i&e the instit%tions 6hich e2ist to p"o#ie lon45 te"m an mei%m5te"m finance) an the >financial inst"%ments> 5i.e. the fo"ms that s%ch finance ta-es.
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These a"e istinct f"om the >mone ma"-ets> 6hich a"e the ma"-ets fo" sho"t5te"m &o""o6in4) &%t 6he"e the amo%nt lent an &o""o6e in one t"ansaction 6ill &e la"4e.
Fi"ms o&tain lon45te"m o" mei%m5te"m capital in one of the follo6in4 6as1 ;a< as sha"e capital ;&< as loan capital. The 4o#e"nment &o""o6s f"om a #a"iet of so%"ces) &%t the t6o ma?o" 6as of capital &o""o6in4 & cent"al 4o#e"nment a"e1 ;a<
iss%in4 4ilt5e4e sec%"ities o" >4ilts>. These a"e 4o#e"nment loan stoc-) on 6hich inte"est is pai %ntil mat%"it of the loan) 6hen the capital is then "epai in f%ll=
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National Sa#in4s. The National Sa#in4s 9an- is a 4o#e"nment instit%tion set %p to &o""o6 on &ehalf of the 4o#e"nment) mainl f"om the non5&an- p"i#ate secto" of the econom. The National Sa#in4s 9an- ope"ates th"o%4h Post Offices th"o%4ho%t the co%nt".
Capital ma,ets in the U8
The"e a"e se#e"al >ma"-et places> fo" "aisin4 capital. In the U: the"e a"e1 ;a<
the Stoc- E2chan4e. The Stoc- E2chan4e p"o#ies the >main ma"-et> 6he"e1 ;i<
8%ote companies ;i.e. p%&lic limite companies 6hose sha"es a"e 8%ote on the Stoc- E2chan4e< can "aise ne6 f%ns & iss%in4 ne6 sha"es o" loan stoc-=
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in#esto"s can &% an sell >secon5han> stoc-s an sha"es 5i.e. stoc-s an sha"es that a"e al"ea in iss%e=
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the >4ilts> o" 4ilt5e4e ma"-et. This is the ma"-et fo" the 4o#e"nment>s lon45te"m e&t sec%"ities=
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the Unliste Sec%"ities Ma"-et o" USM. This is a ma"-et 6he"e companies that a"e not &i4 eno%4h to o&tain a f%ll listin4 on the Stoc- E2chan4e can "aise ne6 capital & iss%in4 sha"es. *i-e the Stoc- E2chan4e) the USM is also a ma"-et fo" >secon5han> sha"es. The USM is "e4%late & the Stoc- E2chan4e. At the time of 6"itin4 ;A%4%st +''3< the f%t%"e of the USM is %nce"tain=
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&an-s. 9an-s can &e app"oache i"ectl & fi"ms an ini#i%als fo" mei%m5te"m an lon45 te"m loans as 6ell as sho"t5te"m loans o" o#e""afts=
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&%ilin4 societies. This is a capital ma"-et 6he"e ini#i%als can o&tain capital to &% a home 6ith a mo"t4a4e) as 6ell as pe"sonal loans=
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National Sa#in4s. This is a capital ma"-et 6he"e the 4o#e"nment o&tains capital & &o""o6in4 f"om p"i#ate in#esto"s.
The !onti#ution o" the Sto!, E$!han%e to the e!onomy
The Stoc- E2chan4e is an o"4anise capital ma"-et 6hich plas an impo"tant "ole in the f%nctionin4 of the U:>s capitalist econom. It is the main capital ma"-et in the U:. ;a< ;&<
It ma-e ma-ess it easie" easie" fo" la" la"4e 4e fi"m fi"mss an an the the 4o#e" 4o#e"nme nment nt to to "aise "aise lon45te lon45te"m "m capi capital tal)) & p"o#i p"o#iin4 in4 a >ma"-et place> fo" &o""o6e"s an in#esto"s to come to4ethe". The Stoc- E2chan4e p%&licises the p"ices of 8%ote ;o" >liste>< sec%"ities) 6hich a"e then "epo"te in ail national ne6spape"s s%ch as the Financial Times. In#esto"s can the"efo"e -eep an ee on the #al%e of thei" stoc-s an sha"es) an ma-e &%in4 an sellin4 ecisions acco"in4l.
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The StocStoc- E2ch E2chan4e an4e t"ies t"ies to enfo enfo"ce "ce ce"tai ce"tain n "%les "%les of con con%ct %ct fo" its liste liste fi"ms fi"ms an an fo" fo" ope"ato"s in the ma"-et) so that in#esto"s ha#e the ass%"ance that companies 6hose sha"es a"e t"ae on the E2chan4e an t"ae"s 6ho ope"ate the"e a"e "ep%ta&le. Confience in the StocE2chan4e 6ill ma-e in#esto"s mo"e 6illin4 to p%t thei" mone into stoc-s an sha"es.
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The ine2 ine2 of sha" sha"ee p"ice p"icess on the StocStoc- E2chan E2chan4e 4e acts acts as an ini inicat cato" o" of of the the stat statee of the co%nt">s econom. econom.
Shae pi!es on the sto!, ma,et The p"ice of sha"es on a stoc- ma"-et fl%ct%ate %p an o6n
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The The p"ice p"ice of of sha" sha"es es in in a pa"ti pa"tic% c%la la"" comp compan an 6hic 6hich h a"e not not t"ae t"ae m%ch m%ch mi4h mi4htt "ema "emain in %nchan4e fo" 8%ite a lon4 time= alte"nati#el) a compan>s sha"e p"ice mi4ht fl%ct%ate contin%all th"o%4ho%t each a.
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The 4ene"a 4ene"all le#el le#el of sha" sha"ee p"ice p"ices) s) as as meas% meas%"e "e & some some fo"m of ine ine2 2 ;e.4. ;e.4. in the the U:) U:) & & the the All5Sha"e Ine2 an the FT 5SE +77 Ine2 o" >Footsie> Ine2) 6hich incl%es loo leain4 sha"es<) 6ill 4o %p o" o6n each a.
Stoc- ma"-ets a"e no6aas >inte"national> in cha"acte") 6ith ma?o" in#esto"s &%in4 an sellin4 sha"es on stoc- ma"-ets in iffe"ent pa"ts of the 6o"l ;e.4. Ne6 (o"-) (o"-) To-o) Hon4 :on4) *onon<. Sha"e p"ice mo#ements the"efo"e "eflect inte"national #ie6s on the pe"fo"mance of a pa"tic%la" co%nt">s econom an in%st"ies. +endes o" !apital. institutional investos as "inan!ial intemediaies
The lene"s of capital incl%e p"i#ate ini#i%als) 6ho &% stoc-s an sha"es on the Stoc- E2chan4e) o" 6ho in#est in National Sa#in4s o" &%ilin4 societies. Ho6e#e") the"e a"e some impo"tant instit%tional in#esto"s) i.e. instit%tions 6hich specialise in lenin4 capital in o"e" to ma-e a "et%"n. These instit%tions) 6hich a"e financial inte"meia"ies themsel#es) incl%e the follo6in41 ;a<
pension f%ns. Pension f%ns in#est the pension cont"i&%tions of ini#i%als 6ho s%&sc"i&e to a pension f%n) an of o"4anisations 6ith a compan pension f%n=
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ins%"ance companies. These in#est ins%"ance p"emi%ms pai on ins%"ance policies & polic hole"s. If o% thin- a&o%t it) ins%"ance companies) li-e pension f%ns m%st o somethin4 6ith the p"emi%ms the "ecei#e) an in p"actice) the in#est the mone to ea"n a "et%"n=
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in#estment t"%st companies. These a"e companies 6hose &%siness is in#estin4 in the stoc-s an sha"es of othe" companies an the 4o#e"nment. In othe" 6o"s) the t"ae in in#estments=
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%nit t"%st companies. These a"e simila" to in#estment t"%st companies) in the sense that the in#est in stoc-s an sha"es of othe" companies. The then sell po"tions o" >%nits> of these in#estments to ini#i%al in#esto"s= #ent%"e capital o"4anisations. These a"e o"4anisations that specialise in "aisin4 f%ns fo" ne6 &%siness #ent%"es) s%ch as >mana4ement &%5o%ts> ;i.e. p%"chases of fi"ms & thei" mana4ement staff<. staff<. These o"4anisations a"e a"e the"efo"e p"o#iin4 capital fo" fai"l "is- #ent%"es. A #ent%"e capital o"4anisation that has ope"ate fo" man
ea"s in the U: is >In#esto"s in In%st"> o" >the 3i 4"o%p>. In "ecent ea"s) man mo"e #ent%"e capital o"4anisations ha#e &een set %p) an the"e is an acti#e 9"itish ent%"e Capital Association of s%ch o"4anisations. The e""e!tiveness o" the !apital ma,ets as povides o" !apital to #usinesses
The f%nctions of the capital ma"-et a"e to ena&le in#esto"s to len mone an &o""o6e"s to "aise mone) in s%ch a 6a that ne6 in#estments can ta-e place 6hich help to stim%late o" a 4"o6th to the econom. econom. Altho%4h the ma"-et e2ists an is acti#e) it is pe"haps o%&tf%l 6hethe" it is as effecti#e as it sho%l &e in p"o#iin4 a means of "aisin4 mone fo" ne6 in#estments. ;a<
In "ecent ea"s) hi4h "ates of inte"est ha#e mae it iffic%lt fo" companies to iss%e ne6 loan stoc-. This ma chan4e no6 that inte"est "ates ha#e fallen an this -in of capital has &ecome cheape".
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P%&lic limite companies ha#e &een a&le to "aise ne6 f%ns f"om sha"e iss%es on the StocMa"-et) &%t the Stoc- Ma"-et "emains mainl a ma"-et fo" secon5han sha"es "athe" than ne6 iss%es. Onl p%&lic limite companies a"e pe"mitte to iss%e sha"es in this 6a) an in spite of the USM) smalle" fi"ms ha#e m%ch mo"e iffic%lt in finin4 in#esto"s 6ho 6ill s%&sc"i&e fo" ne6 sha"es. ent%"e ent%"e capital o"4anisations a"e not s%fficientl la"4e to s%ppl the #ol%me of e8%it finance to small fi"ms that 6o%l p"o&a&l &e neee fo" an effecti#e capital ma"-et
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Se#e"al la"4e fi"ms e2pe"ience iffic%lties %"in4 the economic "ecession of the ea"l +'$7! an 6e"e ta-en into >intensi#e ca"e> & thei" &an-. To this e2tent) the capital ma"-et f%nctione effecti#el to p"e#ent an e#en eepe" "ecession.
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9an- lenin4 an lenin4 & othe" financial instit%tions a"e often acc%se of &ein4 e2cessi#el conse"#ati#e) a#oiin4 "is- in#estments. Since economic 4"o6th 6ill p"o&a&l epen on the s%ccess of "is- #ent%"es) a conse"#ati#e app"oach is li-el to "e%ce the p"ospects of s%ccessf%l #ent%"es in la"4e n%m&e"s. Ho6e#e") the la"4e n%m&e" of "ecei#e"ships in the "ecent "ecession s%44est that this "ep%tation of the &an-s fo" conse"#atism ma not &e 6holl ese"#e. D%"in4 the economic &oom pe"io of +'$ to +'$$) the &an-s lent to n%me"o%s &%sinesses 6hich face se"io%s financial financial iffic%lties in the ea"s that follo6e.
The money ma,ets
The >mone ma"-ets> in the U: a"e ope"ate & the &an-s an othe" financial instit%tions. Altho%4h the mone ma"-ets la"4el in#ol#e 6holesale &o""o6in4 an lenin4 & &an-s) some la"4e companies an the 4o#e"nment a"e also in#ol#e in mone ma"-et ope"ations. The mone ma"-ets consist of1 ;a<
the isco%nt ma"-et. This is a ma"-et 6he"e some &an-s ;the isco%nt ho%ses< &% an sell &ills of e2chan4e. An impo"tant aspect of t"ain4 in &ills is the ail t"ain4 in ce"tain ce"tain >eli4i&le &ills> fo" cash &et6een the isco%nt ho%ses ho%ses an the 9an- of En4lan. The 4o#e"nment %ses %ses this t"ain4) -no6n as open ma"-et ope"ations) &oth to cont"ol o" infl%ence the le#el of sho"t5 te"m inte"est "ates an also to ens%"e that the &an-in4 sstem as a 6hole has an ae8%ate ail s%ppl of cash to ope"ate 6ith=
;&<
the inte"&an- ma"-et. This is the >ma"-et> in 6hich &an-s len sho"t5te"m f%ns to one anothe") an is a #e" impo"tant mone ma"-et. A -e inte"est "ate in the U: mone ma"-et is the *I9OR) o" *onon Inte"59an- Offe" Rate) 6hich is the "ate of inte"est at 6hich the la"4est *onon &an-s 6ill len to each othe" sho"t5 te"m. The le#el of the 35month *I9OR infl%ences clea"in4 &an-s> &ase "ates) an m%ch >&i4 mone> ;o" >6holesale>< lenin4 of sho"t5te"m f%ns to &an-s> c%stome"s is fi2e at a ce"tain ma"4in a&o#e *I9OR ;e.4. + a&o#e the 3 month *I9OR<=
;c<
the e%"oc%""enc ma"-et. This is the ma"-et ope"ate & &an-s fo" lenin4 an &o""o6in4 in fo"ei4n c%""encies. Most of the t"ain4 is one & &an-s. Fi"ms 6ishin4 to &o""o6 in a fo"ei4n c%""enc 6ill %s%all o so f"om a &an-=
;<
the Ce"tificate of Deposit ma"-et. This is a ma"-et fo" t"ain4 in Ce"tificates of Deposit=
;e<
the local a%tho"it ma"-et. This is a ma"-et in 6hich local a%tho"ities &o""o6 sho"t5 te"m f%ns f"om &an-s an othe" in#esto"s) & iss%in4 an sellin4 sho"t5te"m >e&t inst"%ments>=
;f<
the finance ho%se ma"-et. This "efe"s to the sho"t5te"m loans "aise f"om the mone ma"-ets & finance ho%ses ;e.4. hi"e p%"chase finance companies<= companies<=
;4<
the inte"5compan ma"-et. This "efe"s to i"ect sho"t5te"m lenin4 &et6een companies) 6itho%t an financial inte"meia". This ma"-et is #e" small) an "est"icte to the t"eas%" epa"tments of la"4e companies) an has la"4el &een s%pe"see & the ste"lin4 CP ma"-ets=
;h<
the comme"cial pape" MTN ma"-et. This is a ma"-et in 6hich companies iss%e e&t sec%"ities) -no6n as comme"cial pape" ;CP< an mei%m5te"m notes ;MTNs<. The pape" ca""ies a "ate of inte"est) an is p%"chase & in#esto"s.
A istinction is sometimes mae &et6een the isco%nt ma"-et an all the othe" mone ma"-ets ;&< to ;4< 6hich a"e "efe""e to collecti#el as the pa"allel ma"-ets o" >6holesale> ma"-ets.
NATIONA+ INCOME ANA+ *SIS
Your objectives
Afte" completin4 this chapte" o% sho%l1 ;a<
&e a6a"e of the iffe"ent 6as of meas%"in4 a nation>s economic 6ealth=
;&<
%ne"stan the 6a in 6hich income flo6s &et6een ho%sehols an fi"ms=
;c<
%ne"stan ho6 national income is meas%"e.
Measurin the creation of economic %ealth Intodu!tion
e sta"t o%" analsis of iss%es in mac"oeconomics & loo-in4 at ho6 6e meas%"e the total amo%nt of economic acti#it in a co%nt". Th"ee -e meas%"es a"e1 ;a<
national income=
;&<
4"oss national p"o%ct ;@NP<=
;c<
4"oss omestic p"o%ct ;@DP<.
These a"e "elate &%t iffe"ent meas%"es of the economic 6ealth that a co%nt" c"eates o" ea"ns o#e" a pe"io of time) %s%all one ea". 5hy is national in!ome so impotant9
National income is an impo"tant meas%"e &eca%se it is an a44"e4ate of pe"sonal incomes. The &i44e" the national income in a co%nt") the mo"e income its ini#i%al inha&itants 6ill &e ea"nin4 on a#e"a4e. Mo"e income means mo"e spenin4 on the o%tp%t of fi"ms) an mo"e spenin4 ;i4no"in4 inflation< means mo"e o%tp%t of 4oos an se"#ices. National income p"o#ies info"mation of 4"eat impo"tance to 4o#e"nments in settin4 thei" mac"oeconomic o&?ecti#es. S%ch o&?ecti#es tpicall incl%e1 ;a<
f%ll emploment. In the U: in "ecent ea"s emploment has &een at le#els 6a a&o#e the th"ee pe" cent 6hich is sometimes a"4%e to &e the i""e%ci&le minim%m fo" this co%nt". Some commentato"s &elie#e the "eason fo" this to &e the lo6 p"io"it acco"e & the p"esent Conse"#ati#e 4o#e"nment to f%ll emploment as a mac"oeconomic o&?ecti#e=
;&<
economic 4"o6th. This is an %p6a" t"en in the total o%tp%t of a nation. Most 4o#e"nments 6ill t" to achie#e a satisfacto" "ate of 4"o6th & aoptin4 policies to enco%"a4e in#estment) "esea"ch an e#elopment an so on=
;c<
sta&le p"ices. Rapi "ates of p"ice inc"eases a"e tho%4ht to &e %nesi"a&le fo" "easons isc%sse in a late" chapte". @o#e"nments aim to maintain p"ices at a sta&le le#el o") if that is not possi&le ;an it "a"el is<) at least to -eep inc"eases to a minim%m=
;<
a satisfacto" &alance of paments. This is isc%sse in etail in a late" chapte".
5ho !eates e!onomi! (ealth9
Economic 6ealth is c"eate &1 ;a<
the people o" o"4anisations that spen mone to &% the 4oos an se"#ices1 ;i< ;ii< ;iii<
;&<
cons%me"s ;o" >ho%sehols><= the 4o#e"nment= an fo"ei4n &%e"s ;the >o#e"seas secto"><= o"
the people 6ho ea"n the 6ealth1 ;i< ;ii< ;i#< ;#<
la&o%") 6ho ea"n 6a4es fo" the 6o"- the o= p"o#ie"s of capital) 6ho ea"n inte"est on the capital the in#est= o6ne"s of >lan>) 6ho ea"n "ent on the lan the p"o#ie fo" economic %se= ent"ep"ene%"s) 6ho ea"n p"ofits fo" the &%siness "is-s that the ta-e.
As has often &een st"esse ea"lie" in this &oo-) the sca"cit of these facto"s of p"o%ction) an the nee fo" ecisions on thei" allocation) is the f%namental p"o&lem of economics= ;c<
the c"eato"s of 6ealth can also &e ientifie as the fi"ms ;o" 4o#e"nment epa"tments an co"po"ations< 6hich p"o%ce the 4oos o" se"#ices in the national econom.
The th"ee app"oaches ;a<) ;&< an ;c< 4i#e "ise to th"ee 6as of efinin4 economic 6ealth1 ;a< the e2penit%"e app"oach= ;&< the income app"oach= an ;c< the o%tp%t app"oach. These a"e efine an isc%sse late" in this chapte".
The circular flo% of income Intodu!tion
Income in a co%nt">s econom flo6s &et6een ho%sehols an fi"ms. ;a<
The income of fi"ms is the sales "e#en%e f"om the sales of 4oos an se"#ices.
;&<
The income of ho%sehols is the income a"isin4 f"om the o6ne"ship of the facto"s of p"o%ction.
Fi"ms m%st pa ho%sehols fo" the facto"s of p"o%ction) an ho%sehols m%st pa fi"ms fo" 4oos. This c"eates a ci"c%la" flo6 of income an e2penit%"e) as ill%st"ate in Fi4%"e I. 9
HOUSEHO*DS
FIRMS
C
A
The total sales #al%e of 4oos p"o%ce ;o%tp%t< sho%l e8%al the total e2penit%"e on 4oos) ass%min4 that all 4oos that a"e p"o%ce a"e also sol. The amo%nt of e2penit%"e sho%l also e8%al the total
income of ho%sehols) &eca%se it is ho%sehols that cons%me the 4oos an the m%st ha#e income to affo" to pa fo" them. Ho%sehols ea"n income. The ea"n income &eca%se the ha#e p"o#ie the facto"s of p"o%ction 6hich ena&le fi"ms to o%tp%t 4oos an se"#ices. The income ea"ne is %se as e2penit%"e on these 4oos an se"#ices that a"e mae. 5ithda(als and in;e!tions into the !i!ula "lo( o" in!ome
O%" simplifie ia4"am of the ci"c%la" flo6 of income nees to &e amene to allo6 fo"1 ;a<
6ith"a6als f"om the ci"c%la" flo6 of income. These a"e mo#ements of f%ns o%t of the ccle of income an e2penit%"e &et6een fi"ms an ho%sehols=
;&<
in?ections into the ci"c%la" flo6 of income. These a"e mo#ements of f%ns in the othe" i"ection.
The"e a"e th"ee tpes of 6ith"a6al f"om the ci"c%la" flo6. ;a<
Sa#in4s ;S<. Ho%sehols on>t spen all thei" income. The sa#e some) an these sa#in4s o%t of income a"e 6ith"a6als f"om the ci"c%la" flo6 of income 8%ite simpl &eca%se sa#in4s a"e not spent.
;&<
Ta2ation ;T <. Ho%sehols m%st pa some of thei" income to the 4o#e"nment) as ta2ation. Ta2es cannot &e spent & ho%sehols) &eca%se the f%ns 4o to the 4o#e"nment.
;c<
Impo"ts ;M<. hen 6e consie" national income) 6e a"e inte"este in the economic 6ealth that a pa"tic%la" co%nt" is ea"nin4. Spenin4 on impo"ts is e2penit%"e) &%t on 4oos mae & fi"ms in othe" co%nt"ies. The paments fo" impo"ts 4o to fi"ms in othe" co%nt"ies) fo" o%tp%t c"eate in othe" co%nt"ies. Spenin4 on impo"ts the"efo"e 6ith"a6s f%ns o%t of a co%nt">s ci"c%la" flo6 of income.
The"e a"e also th"ee tpes of in?ection into the ci"c%la" flo6 of income. ;a<
In#estment ; I <. In#estment in capital 4oos is a fo"m of spenin4 on o%tp%t) 6hich is aitional to e2penit%"e & ho%sehols. Q%st as sa#in4s a"e a 6ith"a6al of f%ns) in#estment is an in?ection of f%ns into the ci"c%la" flo6 of income) ain4 to the total economic 6ealth that is &ein4 c"eate & the co%nt".
;&<
@o#e"nment spenin4 ;@<. @o#e"nment spenin4 is also an in?ection into the ci"c%la" flo6 of income. In most mi2e economies) total spenin4 & the 4o#e"nment on 4oos an se"#ices "ep"esents a la"4e p"opo"tion of total national e2penit%"e. The f%ns to spen come f"om eithe" ta2ation income o" 4o#e"nment &o""o6in4.
;c<
E2po"ts ; <. Fi"ms p"o%ce 4oos an se"#ices fo" e2po"t. E2po"ts ea"n income f"om a&"oa) an the"efo"e p"o#ie an in?ection into a co%nt">s ci"c%la" flo6 of income.
Th"ee app"oaches to meas%"in4 national income As al"ea mentione) these a"e1 ;a<
The e2penit%"e app"oach. The economic 6ealth c"eate in a pe"io can &e meas%"e & the amo%nt of e2penit%"e on the 4oos an se"#ices that a"e p"o%ce & the nation>s econom. ;i<
The e2penit%"es 6ill &e inc%""e & cons%me"s) the 4o#e"nment an fo"ei4n &%e"s ;i.e. e2po"ts<. E2penit%"es on impo"ts "ep"esent 6ealth c"eate & othe" co%nt"ies) an so the #al%e of e2penit%"e on impo"ts m%st &e e%cte f"om the total e2penit%"e fi4%"e.
;ii<
E2penit%"es & fi"ms ;e.4. companies< a"e e2cl%e) to a#oi o%&le5co%ntin4.
;&<
The income app"oach. This app"oach meas%"es the income of ini#i%als f"om emploment an f"om self 5emploment) the p"ofits of fi"ms an p%&lic co"po"ations an "ent on p"ope"t. ;Inte"est ea"nin4s 6ill &e incl%e 6ithin the p"ofits of companies o" the income of ini#i%als.<
;c<
The o%tp%t app"oach. This app"oach is to meas%"e the ;sales< #al%e of o%tp%t p"o%ce & fi"ms an othe" o"4anisations in the pe"io.
All th"ee app"oaches 6ill in theo" "es%lt in the same total amo%nt fo" economic 6ealth c"eate in the pe"io) 6hich 6e call @"oss Domestic P"o%ct o" @DP. In p"actice) statistical isc"epancies a"ise 6hich ca%se iffe"ences &et6een the alte"nati#e fi4%"es. The %ovenment and national in!ome
The 4o#e"nment has se#e"al f%nctions 6ithin the national econom) an so plas se#e"al iffe"ent "oles in the ci"c%la" flo6 of income. ;a<
It acts as the p"o%ce" of ce"tain 4oos an se"#ices instea of p"i#atel5o6ne fi"ms) an the >p"o%ction> of p%&lic aminist"ation se"#ices) e%cation an health se"#ices) the police fo"ce) a"me fo"ces) fi"e &"i4ae se"#ices) an p%&lic t"anspo"t a"e all aspects of o%tp%t. The 4o#e"nment in this "espect acts) li-e fi"ms) as a p"o%ce") an m%st also pa 6a4es to its emploees.
;&<
It acts as the p%"chase" of final 4oos an se"#ices an as to total >cons%mption> e2penit%"e. National an local 4o#e"nment o&tain f%ns f"om the fi"ms o" ho%sehols of the econom ;e.4. in the fo"m of ta2ation< an then %se these f%ns to &% 4oos an se"#ices f"om othe" fi"ms.
;c<
It in#ests & p%"chasin4 capital 4oos ;e.4. &%ilin4 "oas) schools an hospitals<.
;<
It acts as a means of t"ansfe""in4 6ealth o" income f"om one section of econom to anothe" e.4. & ta2in4 6o"-e"s an pain4 pensions) %nemploment &enefits an social sec%"it &enefits ;>t"ansfe" paments>< to othe" mem&e"s of societ.
Items ;a<) ;&< an ;c<) &%t not ;<) cont"i&%te to the c"eation of national income.
)ational income statistics 5hat is national in!ome9
The U: national income can &e efine as >the s%m of all incomes of "esients in the U: 6hich a"ise as a "es%lt of economic acti#it) that is f"om the p"o%ction of 4oos an se"#ices. S%ch incomes) 6hich incl%e "ent) emploment income an p"ofit) a"e -no6n as facto" incomes &eca%se the a"e ea"ne & the so5calle facto"s of p"o%ction1 lan) la&o%" an capital.> ;CSO < National income is also calle net national p"o%ct. ;a< The te"ms >income> an >p"o%ct> a"e ?%st t6o iffe"ent aspects of the same ci"c%la" flo6 of income. ;&< The te"m >net> means >afte" e%ctin4 an amo%nt fo" capital cons%mption o" ep"eciation of fi2e assets>. e shall "et%"n to this point late". 7oss domesti! podu!t 27DP3
Most U: national income is e"i#e f"om economic acti#it 6ithin the U:. Economic acti#it 6ithin the U: is "efe""e to as total omestic income o" omestic p"o%ct. It is meas%"e >4"oss> ;ie &efo"e e%ctin4 an amo%nt fo" capital cons%mption o" ep"eciation of fi2e assets< an the te"m 4"oss
omestic p"o%ct the"efo"e "efe"s in the U: to the total #al%e of incomep"o%ction f"om economic acti#it 6ithin the U:. 7oss national podu!t 27NP3 >Some national income a"ises f"om o#e"seas in#estments 6hile some of the income 4ene"ate 6ithin the U: is ea"ne & non5"esients. The iffe"ence &et6een these items is net p"ope"t income f"om a&"oa.> ;CSO< @"oss national income o" 4"oss national p"o%ct ;@NP< is the"efo"e the 4"oss omestic p"o%ct ;@DP< pl%s the net p"ope"t income f"om a&"oa o" afte" s%&t"actin4 the net p"ope"t income f"om a&"oa) if it is a ne4ati#e #al%e. The elationship #et(een 7DP' 7NP and national in!ome
The "elationship &et6een @DP) @NP an national income is the"efo"e as follo6s.
plus e)uals minus e)uals
@DP Net p"ope"t income f"om a&"oa @NP Capital cons%mption National Income ;net<
The e$penditue appoa!h to measuin% national in!ome
P"o&a&l the most 6iel %se meas%"e of national income is the meas%"ement of total spenin4 o" e2penit%"e an it is 6o"th loo-in4 at this _n some etail. U: NATIONA* INCOME +''+1 EPENDITURE APPROACH -#n
t current maret prices Cons%me"s> e2penit%"e @ene"al 4o#e"nment cons%mption @"oss omestic fi2e capital fo"mation al%e of inc"ease;ec"ease< in stoc-s an 6o"- in p"o4"ess Total omestic e2penit%"e E2po"ts of 4oos an se"#ices Impo"ts of 4oos an se"#ices @"oss omestic p"o%ct at ma"-et p"ices Ta2es on e2penit%"e ;ini"ect ta2es<
S%&siies Statistical isc"epanc @DP 54"oss omestic p"o%ct at c%""ent facto" cost Net p"ope"t income f"om a&"oa @NP 54"oss national p"o%ct at c%""ent facto" cost
30.' +,+.' '!./ ;!.3< !0'.' +3!.+ ;+/7./< !0/. ;$3.7< /'+. !.' ;7./< /'0.+ 7.3 /'0./
Note the follo6in4 points. ;a<
National income is calc%late & s%&t"actin4 a fai"l a"&it"a" amo%nt fo" ep"eciation f"om a total #al%e -no6n as @"oss National P"o%ct) o" @NP .
;&<
@NP itself is calc%late & meas%"in4 total e2penit%"e 6ithin the national econom ;6hich 6e call @"oss Domestic P"o%ct o" @DP< an then ain4 on amo%nt fo" income f"om p"ope"t ;assets< a&"oa.
;c<
The th"ee meas%"es) national income) @NP an @DP a"e the"efo"e closel "elate. hen 6e istin4%ish &et6een the e2penit%"e app"oach) the income app"oach an o%tp%t app"oach) 6e a"e "eall tal-in4 a&o%t th"ee app"oaches to calc%latin4 @DP .
;<
e mi4ht "efe" to an of the th"ee meas%"es) national income) @NP o" @DP. he"e a 4o#e"nment see-s to inc"ease national income) it is also see-in4 inc"eases in @DP an @NP. Notes on the e$penditue appoa!h Total spenin4 then) consists of cons%mption spenin4) 4o#e"nment spenin4) in#estment spenin4) spenin4 & fo"ei4ne"s on o%" 4oos an se"#ices min%s spenin4 & %s on fo"ei4n 4oos an se"#ices. This is often sm&olise as C Z I Z @ Z ; 5M< 6he"e1 C I @ M
cons%mption e2penit%"e in#estment e2penit%"e 4o#e"nment e2penit%"e e2penit%"e on o%" e2po"ts & fo"ei4ne"s e2penit%"e & %s on impo"ts
F"om the ta&le it can &e seen that 6hen 6e calc%late C Z I Z @ Z ; 5M< the total 6e a""i#e at is calle the 4"oss omestic p"o%ct at ma"-et p"ices. This meas%"e ;@DP at ma"-et p"ices< is one 6a of e2p"essin4 the le#el of economic acti#it in the U:. If a 4o#e"nment is plannin4 its economic polic) an 6ishes to inc"ease the co%nt">s @DP an @NP) it mi4ht 6ish to t%"n its attention to an of these items) i.e.1 ;a<
t"in4 to inc"ease cons%me" spenin4) C=
;&<
t"in4 to inc"ease p"i#ate in#estment) I=
;c<
eciin4 to inc"ease 4o#e"nment spenin4) @ ano" I=
;<
t"in4 to imp"o#e the &alance of paments on o#e"seas t"ae) ; 5M<.
Since the p"ices of man 4oos an se"#ices a"e isto"te & sales ta2es ;e4 alcohol an ci4a"ettes< an some a"e isto"te & s%&siies ;e.4. man a4"ic%lt%"al p"o%cts< 6e often 6ish to #ie6 the sit%ation 6itho%t these isto"tions an con#e"t @DP at ma"-et p"ices to @DP at facto" cost1 ;a<
e2penit%"e at ma"-et p"ices) i.e. the act%al amo%nts pai fo" the 4oos & thei" &%e"s= an
;&<
e2penit%"e at facto" cost) i.e. e2penit%"e at ma"-et p"ices min%s ini"ect ta2es pl%s an 4o#e"nment s%&siies.
As o% can see f"om the ta&le this is still not the en of the sto". Man statisticians) economists) 4o#e"nments an inte"national a4encies li-e to incl%e p"ope"t income f"om a&"oa to 4i#e a f%lle" pict%"e of 6hat is happenin4 in the omestic econom. hen this e2t"a item is incl%e 6e no6 ha#e a meas%"e calle 4"oss national p"o%ct o" @NP. Altho%4h technicall national income has a pa"tic%la" efinition) 4ene"all o% 6ill fin &oth meas%"es ;@DP an @NP< loosel "efe""e to as >national income>.
The in!ome appoa!h to measuin% national in!ome
The secon metho of calc%latin4 national income is the income metho. Since mone spent & an ini#i%al o" fi"m m%st &ecome income to anothe" 6e sho%l not &e s%"p"ise to fin that e2cept fo" a "esi%al e""o" the "es%lts of the t6o methos a"e the same. U: NATIONA* INCOME +''+1 INCOME APPROACH -#n
t current prices Income f"om emploment ;6a4es an sala"ies) pl%s emploe"s> NI cont"i&%tions< @"oss t"ain4 p"ofits of companies @"oss t"ain4 s%"pl%s of p%&lic co"po"ations @"oss t"ain4 s%"pl%s of 4o#e"nment ente"p"ises Othe" income *ess stoc- app"eciation @DP 5income &ase Statistical isc"epanc @DP 5e2penit%"e &ase Net p"ope"t income f"om a&"oa @NP
3,'.$ 7.0 3.+ 7.+ +7.+ ;,.$< /'0.7 7.+ /'0.+ 7.3 /'0./
Moe a#out the in!ome #ased appoa!h
hen 6e "efe" to >national income>) it mi4ht seem mo"e o&#io%s to consie" the income5 &ase app"oach "athe" than an e2penit%"e5 &ase app"oach to meas%"in4 the statistics. The ta&le sho6in4 the income5 &ase app"oach sho6s as sepa"ate items1 ;a<
income f"om emploment ;i.e. 6a4es an sala"ies &efo"e e%ctin4 ta2 an incl%in4 emploe"s> National Ins%"ance cont"i&%tions<=
;&<
p"e5ta2 p"ofits of companies=
;c<
p"e5ta2 p"ofits of p%&lic co"po"ations ;incl%in4 nationalise in%st"ies<=
;<
the p"e5ta2 >s%"pl%s> of othe" 4o#e"nment ente"p"ises.
Inte"est ea"ne & ini#i%als an companies on an in#estments the hol is incl%e in the fi4%"es fo" ;a< an ;&<. (o% mi4ht notice that these income fi4%"es o not incl%e1 ;a<
income f"om 4o#e"nment pensions o" social sec%"it paments=
;&<
an #al%e fo" 6o"- one & ini#i%als fo" no moneta" "e6a") s%ch as ho%se6o"- one & ho%se6i#es o" o5it5o%"self home imp"o#ements. These a"e acti#ities fo" 6hich no mone #al%e can &e 4i#en) an so a"e not >economic> acti#ities.
Tans"e payments 2tans"e in!omes3 T"ansfe" paments a"e paments that a"e mae an cont"i&%tion to o%tp%t in "et%"n. The 6ealth) "athe" than a "e6a" fo" c"eatin4
T"ansfe" paments o not lea i"ectl to an inc"ease in ma"-eta&le o%tp%t of 4oos. Most t"ansfe" paments a"e mae & the 4o#e"nment) 6hich collects ta2es an %ses some of its ta2 income to ma-e paments fo"1 ;a<
ol a4e pensions) an
;&<
social sec%"it paments
T"ansfe" paments a"e not incl%e in @NP &eca%se the o not a to >ma"-eta&le> o%tp%t of 4oos. to someone) 6he"e the "ecipient oes not ma-e a"e paments 6hich in#ol#e the t"ansfe" of ne6 economic 6ealth. @o#e"nment e2penit%"e fi4%"es 6ithin @NP a"e net of t"ansfe" paments. Rent
Rent is one component of >othe" income> in the list of income ea"ne ;othe" components incl%e income f"om self5emploment<. It is the p"ofits ;o" >ope"atin4 s%"pl%s>< f"om the o6ne"ship of lan an &%ilin4s. It also incl%es >a #al%e fo" >imp%te "ent> fo" o6ne"5 occ%pie homes. This is e2plaine &elo6. Imputed in!ome and e$penditue
Altho%4h the income fi4%"es e2cl%e most 6o"- that is one fo" no moneta" "e6a" ;e4 ho%se6o"an o5it5o%"self acti#ities< the efinition of p"o%ctioneconomic acti#it in the U: oes incl%e some acti#ities 6hich a"e not ca""ie o%t fo" a mone "e6a". The main one of these acti#ities is the p"o#ision of o6ne"5occ%pie ho%ses. hen a pe"son &%s his o6n home an li#es in it) no mone 6ill &e e2chan4e &et6een the o6ne" an the occ%pie" &eca%se the a"e one an the same pe"son. Ho6e#e" >the se"#ices of the ho%se o ne#e"theless ha#e a #al%e e8%i#alent to the net income 6hich co%l ha#e &een o&taine & lettin4 it comme"ciall. A fi4%"e &ase on this app"oach is incl%e in the national income. In effect) the o6ne"5occ%pie" is i#ie into t6o sepa"ate t"ansacto"s. It is s%ppose that as o6ne") he lets the ho%se to himself as occ%pie" fo" a ce"tain "ent.> ;CSO< This p"ocess of >in#entin4 a t"ansaction> is -no6n as imp%tation. In the case of o6ne"5 occ%pie 6ellin4s an imp%te amo%nt of "ent is incl%e in the income statistics as "ent ;income5&ase app"oach< o" cons%me"s> e2penit%"e ;e2penit%"e5&ase app"oach<. The output method o" measuin% national in!ome
The thi" metho of calc%latin4 national income is the o%tp%t metho. Since the 4oos an se"#ices 6e spen o%" mone on m%st ha#e &een p"o%ce & some in%st" o" anothe" it is not s%"p"isin4 to fin the amo%nt 6e ha#e all spent is the same as the #al%e of the 4oos an se"#ices p"o%ce ;e2cept fo" a "esi%al statistical isc"epanc<. Estimates ha#e to &e mae 6hen acc%"ate fi4%"es a"e %no&taina&le) an the"e a"e omissions in o&tainin4 some fi4%"es) an eli&e"ate e""o"s in othe"s 5fo" e2ample) filin4 ta2 "et%"ns mi4ht occ%" on a la"4e scale. 9eca%se of e""o"s) the th"ee app"oaches 6ill p"o%ce sli4htl iffe"ent fi4%"es) an one of them m%st &e ta-en as >co""ect>. In p"actice) the e2penit%"e &ase fi4%"es a"e consie"e most "elia&le) an the income &ase an o%tp%t &ase @DP fi4%"es a"e a?%ste to the e2penit%"e &ase @DP fi4%"e) & inse"tin4 a &alancin4 item -no6n as a "esi%al e""o". National in!ome and in"lation
Inflation is a pa"tic%la" p"o&lem in %sin4 national income as a meas%"e of national 6ealth. P"ice inflation inc"eases the mone #al%e of national income. e sho%l &e ca"ef%l not to inte"p"et this as meanin4 that the"e is mo"e economic acti#it 4oin4 on in o%" econom. All that has happene is that the p"ices of the thin4s 6e a"e meas%"in4 ha#e inc"ease. To see if the"e has &een an >"eal> chan4e in the le#el of acti#it 6e m%st e%ct an infl%ence %e to inflation. Altho%4h this is not a simple ope"ation) the stana" metho fo" t%"nin4 >mone> @DP o" @NP into >"eal> meas%"es is to %se 6hat is calle the >@DP eflato"> in o"e" to ta-e inflation o%t of the fi4%"es. If 6e a"e compa"in4 one ea">s national income 6ith anothe" it is #e" impo"tant that 6e %se >"eal> fi4%"es if 6e a"e to "each an 6o"th6hile concl%sions) &eca%se 6ith >"eal> compa"isons of national income f"om one ea" to the ne2t) 6e a"e compa"in4 li-e 6ith li-e.
NATIONA+ INCOME AND UNEMP+O*MENT
Your objectives
Afte" completin4 this chapte" o% sho%l1 ;a<
%ne"stan the "elationship &et6een a44"e4ate eman) a44"e4ate s%ppl an e8%ili&"i%m national income=
;&<
%ne"stan the impact of cons%mption) sa#in4s an in#estment on national income=
;c<
%ne"stan the lin- &et6een the le#el of national income an the le#el of emploment.
Areate demand and supply and e'uilibrium national income Intodu!tion
(o% ma 6ell &e a6a"e that the"e has &een some iffe"ence of opinion &et6een economists as to ho6 "eal economic 4"o6th can &e achie#e. 9"oal spea-in4) economists can &e i#ie into t6o camps) the >:enesians> an the >moneta"ists>. These t6o camps ha#e ha iffe"in4 ieas a&o%t ho6 national income can &e mae to 4"o6) ho6 f%ll emploment can &e achie#e an ho6 &ooms an sl%mps of t"ae ccles can &e smoothe o%t. The iffe" in thei" #ie6s a&o%t the ca%ses of inflation) the e2tent to 6hich inflation c"eates %nemploment an p"e#ents economic 4"o6th) an the effecti#eness of 4o#e"nment meas%"es to stim%late the econom) fo" e2ample & &o""o6in4 an spenin4 hea#il to c"eate ne6 in#estment an ?o&s. In this chapte" 6e loo- at the &asic elements of the :enesian moel fo" national income ete"mination an e8%ili&"i%m. :enesian economics o"i4inate 6ith Qohn Mana" :enes) an En4lish economist 6hose &oo- The @ene"al Theo" of Emploment) Inte"est an Mone ;+'3<) "e#ol%tionise economic analsis. :enes p%t fo"6a" his ieas follo6in4 a pe"io in 6hich the"e 6as an economic &oom ;afte" the Fi"st o"l a"<) follo6e & the all St"eet C"ash in +',') an the @"eat Dep"ession in the +'37s 6hen %nemploment le#els soa"e. A%%e%ate demand and a%%e%ate supply
:enes a"4%e that the le#el of o#e"all o%tp%t an emploment epens on the le#el of a44"e4ate eman in the econom. His &asic iea 6as that eman an s%ppl analsis co%l &e applie to mac"oeconomic acti#it as 6ell as mic"oeconomic acti#it. ;a< ;&<
A44"e4ate eman means the total eman in the econom fo" 4oos an se"#ices. A44"e4ate s%ppl means the total s%ppl of 4oos an se"#ices in the econom.
A44"e4ate s%ppl epens on phsical p"o%ction conitions 5the a#aila&ilit an cost of facto"s of p"o%ction an technical -no65ho6. :enes 6as conce"ne 6ith sho"t5"%n meas%"es to affect the econom) an he also 6"ote in a pe"io of hi4h %nemploment 6hen the"e 6as o&#io%sl no const"aint on the a#aila&ilit of facto"s of p"o%ction. His analsis the"efo"e concent"ate on the eman sie. >S%ppl sie> economics ;isc%sse late"< esc"i&es the #ie6s of economists 6ho o not s%&sc"i&e to the :enesian app"oach to ealin4 6ith the p"o&lem of national income an emploment) an p"efe" instea to concent"ate on >s%ppl sie> i.e. p"o%ction facto"s<.
The a44"e4ate s%ppl c%"#e 6ill &e %p6a" slopin4) fo" the "easons applin4 to the >mic"oeconomic> s%ppl c%"#es mentione in ea"lie" chapte"s. A hi4he" p"ice means that it is 6o"th6hile fo" fi"ms to hi"e mo"e la&o%" an p"o%ce mo"e &eca%se of the hi4he" "e#en%e5ea"nin4 capa&ilit. So at the mac"oeconomic le#el) an inc"easin4 p"ice le#el implies that man fi"ms 6ill &e "ecei#in4 hi4he" p"ices fo" thei" p"o%cts an 6ill inc"ease thei" o%tp%t. In the econom as a 6hole) s%ppl 6ill at some point "each a la&o%" const"aint) 6hen the enti"e la&o%" fo"ce is emploe. hen the"e is f%ll emploment) an fi"ms cannot fin e2t"a la&o%" to hi"e) the cannot p"o%ce mo"e e#en 6hen p"ices "ise) %nless the"e is some technical p"o4"ess in p"o%ction methos. The a44"e4ate s%ppl c%"#e 6ill the"efo"e "ise #e"ticall 6hen the f%ll emploment le#el of o%tp%t is "eache ;AS in Fi4%"e I<. A44"e4ate eman ;AD< is total esi"e eman in the econom) fo" cons%me" 4oos an se"#ices) an also fo" capital 4oos) no matte" 6hethe" the &%e"s a"e ho%sehols) fi"ms o" 4o#e"nment. A44"e4ate eman is a concept of f%namental impo"tance in :enesian economic analsis. :enes &elie#e that national econom co%l &e >mana4e> & ta-in4 meas%"es to infl%ence a44"e4ate eman %p o" o6n. A44"e4ate eman is the total esi"e eman) ?%st as a >mic"oeconomic> eman c%"#e "ep"esents the esi"e eman fo" a pa"tic%la" 4oo at an p"ice le#el. The AD c%"#e 6ill &e o6n6a"5 slopin4 &eca%se at hi4he" p"ices total 8%antities emane 6ill &e less. :enes a"4%e that a national econom 6ill "each e8%ili&"i%m 6he"e the a44"e4ate eman c%"#e an a44"e4ate s%ppl c%"#e inte"sect.
ADF
AD
AS
The econom "eaches f%ll emploment le#el an so cannot p"o%ce mo"e 4oos an se"#ices
PF Deflationa" 4ap
P
(
(F
i.e.) e2panin4 eithe" AD o" AS in the econom. As s%44este al"ea) :enesian economists concent"ate on shifts in AD. The :enesian economic a"4%ment is that if a co%nt">s econom is 4oin4 to mo#e f"om one e8%ili&"i%m to a iffe"ent e8%ili&"i%m) the"e nees to &e a shift in the a44"e4ate eman c%"#e. To achie#e e8%ili&"i%m at the f%ll emploment le#el of national income) it ma the"efo"e &e necessa" to shift the AD c%"#e to the "i4ht ;%p6a"< o" the left ;o6n6a"s<. De"lationay and in"lationay %aps
In a sit%ation 6he"e the"e is %nemploment of "eso%"ces the"e is sai to &e a eflationa" 4ap ;Fi4%"e +<. P"ices a"e fai"l constant an "eal o%tp%t chan4es as a44"e4ate eman #a"ies. A eflationa" 4ap can &e esc"i&e as1 >the e2tent to 6hich the a44"e4ate eman f%nction 6ill ha#e to shift %p6a" to p"o%ce the f%ll5emploment le#el of national income>. *Lipsey+ n introduction to positive economics , In a sit%ation 6he"e "eso%"ces a"e f%ll emploe) the"e is sai to &e an inflationa" 4ap) fo" chan4es in a44"e4ate eman 6ill ca%se p"ice chan4es an not #a"iations in "eal o%tp%t. An inflationa" 4ap can &e esc"i&e as1 >the e2tent to 6hich the a44"e4ate eman f%nction 6o%l ha#e to shift o6n6a" to p"o%ce the f%ll emploment le#el of national income 6itho%t inflation >. *Lipsey, The /ideal/ e&uili#ium national in!ome
If one aim of a co%nt">s economic polic is f%ll emploment) then the >ieal> e8%ili&"i%m le#el of national income 6ill &e 6he"e AD an AS a"e in &alance at the f%ll emploment le#el of national income) 6itho%t an inflationa" 4ap i.e. 6he"e a44"e4ate eman at c%""ent p"ice le#els is e2actl s%fficient to enco%"a4e fi"ms to p"o%ce at an o%tp%t capacit 6he"e the co%nt">s "eso%"ces a"e f%ll emploe. This is sho6n in Fi4%"e ,) 6he"e e8%ili&"i%m o%tp%t 6ill &e ;f%ll emploment le#el< an p"ice le#els P.
AS Demand mana%ement
Fo" :enesian analsis to ha#e p"actical #al%e fo" the mana4ement of a national econom) it is necessa" to esta&lish ho6 a44"e4ate eman can &e shifte. P To %ne"stan shifts in AD) 6e nee to t%"n o%" attention to e2penit%"e in the econom. Satisfie a44"e4ate eman is the act%al le#el of national income) an one 6a of e2p"essin4 national income is as the total e2penit%"e in the econom. AD A fo"m%la fo" the @NP ; total national e2penit%"e< 6hich 6as esc"i&e in the p"e#io%s chapte" is1 E C Z I Z @ Z ; 5M< >Deman mana4ement> in#ol#es the manip%lation of E ;e.4. achie#in4 economic 4"o6th< & infl%encin4 ( C) I) @ o" net e2po"ts.
If 6e i4no"e capital cons%mption) 6e can e8%ate E ;@NP< 6ith national income. This is 6hat 6e shall o in o%" analsis of the :enesian moel. 5ithda(als and in;e!tions into the !i!ula "lo( o" in!ome
Fo" a national econom) the"e a"e ce"tain 6ith"a6als f"om an in?ections into this ci"c%la" flo6 of income. ith"a6als i#e"t f%ns o%t of the ci"c%la" flo6 an in?ections a f%ns into it. :enes a"4%e that fo" an e8%ili&"i%m to &e "eache in the national income) not onl m%st AD AS) &%t also total planne 6ith"a6als f"om the ci"c%la" flo6 of f%ns m%st &e e8%al to total planne in?ections. In othe" 6o"s) fo" e8%ili&"i%m1 Q an so M Z T Z S Z @ Z I. In the lon45te"m 6ill al6as e8%al Q. ;a<
;&< ;c<
The iffe"ence &et6een the #al%e of impo"ts M an the #al%e of e2po"ts is the &alance of paments eficit. E#en in the sho"t5te"m) this iffe"ence m%st &e &alance & &o""o6in4 o" lenin4 a&"oa) as 6e shall see in a late" chapte". The iffe"ence &et6een 4o#e"nment spenin4 an ta2ation can onl &e mae %p & 4o#e"nment &o""o6in4. *oans a"e e#ent%all "epai. In the lon45"%n) sa#in4s 6ill also e8%al in#estments) e#en tho%4h the people 6ho sa#e an the fi"ms 6ho in#est a"e not the same >people>. e shall loo- mo"e closel at sa#in4s an in#estment late" .
Ho6e#e") altho%4h an Q 6ill &e e8%al "et"ospecti#el an in the lon4 "%n) it oes not follo6 that planne Q an planne 6ill e8%al each othe" in the sho"t "%n) since in?ections an 6ith"a6als a"e mae & iffe"ent people. It is p"ecisel this >f"%st"ation of plans> in the sho"t "%n that ca%ses national income to chan4e o#e" time. The im&alance &et6een Q an c"eates facto"s 6hich can ma-e the le#el of national income chan4e. :enes a"4%e that the im&alance &et6een planne 6ith"a6als an planne in?ections e2plaine t"ae ccles) i.e. &ooms an sl%mps in the econom 6hich p"e#ent an econom f"om settlin4 o6n at an e8%ili&"i%m le#el.
Consumption" savins and investment Consumption and savin%s 2C and S3
*et %s no6 4o into a &it mo"e etail of :enesian analsis) an concent"ate pa"tic%la"l on cons%mption) sa#in4s an in#estment. To simplif o%" analsis) 6e shall i4no"e 4o#e"nment spenin4) ta2ation) impo"ts an e2po"ts fo" the time &ein4. 9 i4no"in4 impo"ts an e2po"ts) 6e a"e concent"atin4 on a close econom. i.e. a national econom 6hich is not in an 6a epenent on fo"ei4n t"ae. If 6e i4no"e @) T) ) an M) 6e can loo- at a ci"c%la" flo6 of income in 6hich ho%sehols i#ie all thei" income &et6een t6o %ses1 ;a<
cons%mption on 4oos an se"#ice= o"
;&<
sa#in4.
P"o#ie that national income is in e8%ili&"i%m) 6e 6ill ha#e1 ( CZ S ;i.e. ( is the same as C Z S< 6he"e
( national income) C cons%mption an S sa#in4
This sho%l seem lo4ical to o%. Income can onl &e eithe" spent o" sa#e. Since 6e ha#e a close econom) cons%mption m%st &e of 4oos p"o%ce & the econom itself. Savin%s hat people o not spen o%t of thei" income) the 6ill sa#e. The"e a"e t6o 6as of >sa#in4>. One is to hol the income as mone ;&an-notes an coin) o" in a c%""ent &an- acco%nt<. The othe" 6a is p%t mone into some fo"m of inte"est5&ea"in4 >in#estment>. In the lon4 "%n) the"e is no "eason fo" people to hol &an-notes o" -eep mone in a c%""ent &anacco%nt) %nless the inten to spen it fai"l soon. If this is so) income that is not spent 6ill &e sa#e an income that is sa#e 6ill) e#ent%all) &e in#este. e can the"efo"e concl%e that in conitions of e8%ili&"i%m fo" national income1 ( ( I
b b b
CZS CZI S
an an so
In the sho"t5"%n) ho6e#e") sa#in4s an in#estment mi4ht not &e e8%al an so the"e mi4ht not &e e8%ili&"i%m. The popensities to !onsume and save
In a44"e4ate) the pop%lation 6ill spen a ce"tain p"opo"tion of total income on cons%mption. This p"opo"tion is -no6n as the a#e"a4e p"opensit to cons%me ;APC<. If the"e is an inc"ease in total income some of the e2t"a income 6ill &e spent an the "est sa#e. The p"opo"tion of the aitional total income is calle the ma"4inal p"opensit to cons%me ;MPC<. Since in o%" analsis ;i4no"in4 @) T) an M< sa#in4 an cons%mption a"e the onl t6o %ses fo" income) MPC Z MPS +. It is often ass%me that the ma"4inal p"opensit to cons%me an the ma"4inal p"opensit to sa#e a"e constant p"opo"tions an that the ho%sehol 6ill spen ;cons%me<1 ;a< ;&<
a fi2e amo%nt of mone e#e" pe"io ;La< pl%s a constant pe"centa4e of its income ;& of (<
Simila"l a national econom as a 6hole 6ill spen a fi2e amo%nt a pl%s a constant pe"centa4e *b-, of national income (. e can then state a cons%mption f%nction as C a Z &(. This can &e ill%st"ate ia4"ammaticall ;Fi4%"e 3 &elo6) in 6hich C "ep"esents the inc"ease in cons%mption a"isin4 f"om an inc"ease of ( in the national income< C a Z &(
C (
a
@i#e a cons%mption f%nction C a Z &(1 ;a<
the ma"4inal p"opensit to cons%me is &) 6he"e & is the p"opo"tion spent on cons%mption of each e2t"a L+ ea"ne.
;&<
the a#e"a4e p"opensit to cons%me 6ill &e the "ation of cons%mption to income) i.e.1
C a Z &( ( ( Fo" e2ample if an ini#i%al ho%sehol has fi2e spenin4 of L+77 pe" month pl%s e2t"a spenin4 e8%al to $7 of its monthl income1 ;a< 6hen its monthl income is L$77) its cons%mption 6ill &e1 L+77 Z $7 of L$77 L0/7 ;&< 6hen its monthl income is L +)777 its cons%mption 6ill &e1 L+77 Z $7 of L+)777 L'77. Chan4es in the ma"4inal p"opensit to cons%me an the ma"4inal p"opensit to sa#e 6ill in#ol#e a chan4e of p"efe"ence & ho%sehols &et6een c%""ent cons%mption an sa#in4 f o" f%t%"e &enefits. A ca%se of s%ch a chan4e mi4ht &e a chan4e in inte"est "ates) 6hich ma-es the in#estment of sa#in4s mo"e o" less att"acti#e than &efo"e. Investment 2I3
The total #ol%me of esi"e in#estment in the econom epens on s%ch facto"s as the "ate of inte"est on capital) the ma"4inal efficienc of capital in#este) e2pectations a&o%t the f%t%"e) &%siness confience an the st"en4th of cons%me" eman fo" 4oos. The multiplie
:enes 6ante to s%44est 6h the #ol%me of national income mi4ht chan4e) & ho6 m%ch) an 6hat 6o%l &e the conse8%ences of s%ch a chan4e. hen national income 4"o6s) 6e ha#e economic 4"o6th. Since economic 4"o6th mi4ht &e an economic o&?ecti#e of 4o#e"nment) the "easons fo" economic 4"o6th 6ill o&#io%sl &e of c"%cial impo"tance fo" the 4o#e"nment>s economic planne"s. The le#el of national income mi4ht inc"ease o" ec"ease fo" a n%m&e" of "easons= fo" e2ample) the"e mi4ht &e a pa "ise fo" 6o"-e"s o" an inc"ease in the co%nt">s e2po"ts. :enes sho6e that if the"e is an initial chan4e in e2penit%"e) sa an initial inc"ease in e2po"ts) o" 4o#e"nment spenin4 o" in#estment o" cons%me" spenin4) a ne6 e8%ili&"i%m national income le#el 6ill &e "eache. The e#ent%al total inc"ease in national income 6ill &e 4"eate" in siGe than the initial inc"ease in e2penit%"e. This is an impo"tant point. A small initial inc"ease in e2penit%"e 6ill "es%lt in a &i44e" total inc"ease in national income &efo"e e8%ili&"i%m is "e5esta&lishe. The "atio of the total inc"ease in national income to the initial inc"ease in national income is calle the m%ltiplie" . M%ltiplie"
Total inc"ease in national income Initial inc"ease in national income
The m%ltiplie" can th%s &e efine as a meas%"e of the effect on total national income of a %nit chan4e in some component of a44"e4ate eman) in pa"tic%la") I) @ o" i.e. in#estment spenin4) 4o#e"nment spenin4 o" e2po"ts. Numei!al illustation o" the multiplie
A n%me"ical ill%st"ation of the m%ltiplie" mi4ht help to e2plain it mo"e clea"l. In this e2ample) 6e shall a4ain i4no"e ta2es) 4o#e"nment spenin4) e2po"ts an impo"ts) an ass%me a simple close econom in
6hich all income is eithe" spent on cons%mption ;C< o" sa#e ;S<. *et>s s%ppose that in this close econom) ma"4inal p"opensit to cons%me ;MPC< is '7 o" 7.' i.e. o%t of an aition to ho%sehol income) '7 is cons%me an +7 sa#e. ;a<
If income 4oes %p & L,77) L+$7 6o%l &e spent on cons%mption) an L,7 sa#e.
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The L+$7 spent on cons%mption inc"eases the income of othe" people) 6ho spen '7 ;L+,< an sa#e L+$.
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The L+, spent on cons%mption in t%"n &ecomes aitional income to othe"s) so that a sno6&all effect on cons%mption ;an income an o%tp%t< occ%"s) as follo6s1 Increase in e.penditure 0
Sta4e
Increase in savings */ithdra/als, 0
+
Income "ises
,77.77
5
,
'7 is cons%me
+$7.77
,7.77
3
A f%"the" '7 is cons%me
+,.77
+$.77
/
`
+/!.$7
+.,7
!
`
+3+.,,
+/.!$
,)777.77
,77.77
Total inc"ease in income
In this e2ample) an initial inc"ease in income of L,77 "es%lts in a final inc"ease in national income of L,)777. The m%ltiplie" is +7. This m%ltiplie" is the "ecip"ocal of the ma"4inal p"opensit to sa#e. Since MPC 7.') MPS 7.+. M%ltiplie"
+ MPS
Inc"ease in national income Initial inc"ease in e2penit%"e MPS
L,77 7.+
L,)777
Note that at the ne6 e8%ili&"i%m) sa#in4s of L,77 e8%al the initial inc"ease in e2penit%"e of L,77 &%t national income has "isen L,)777. If the ma"4inal p"opensit to cons%me 6e"e $7) the ma"4inal p"opensit to sa#e 6o%l &e ,7 an the m%ltiplie" 6o%l onl &e !. 9eca%se people sa#e mo"e of thei" e2t"a income) the total inc"ease in national income th"o%4h e2t"a cons%mption 6ill &e less. The m%ltiplie" in a national econom 6o"-s in the same 6a. An initial inc"ease in e2penit%"e 6ill ha#e a sno6&all effect) leain4 to f%"the" an f%"the" e2penit%"es in the econom. A >o6n6a" m%ltiplie"> o" >e5m%ltiplie"> effect also e2ists. A "e%ction in in#estment 6ill ha#e "epe"c%ssions th"o%4ho%t the econom) so that a small isin#estment ;" e%ction in e2penit%"eo%tp%t< 6ill "es%lt in a m%ltiplie "e%ction in national income. The impotan!e o" the multiplie
The impo"tance of the m%ltiplie" is that an inc"ease in one of the components of a44"e4ate eman 6ill inc"ease national income & mo"e than the initial inc"ease itself. The"efo"e if the 4o#e"nment ta-es an action to inc"ease e2penit%"e ;e4 & "aisin4 4o#e"nment c%""ent e2penit%"e) o" lo6e"in4 inte"est "ates to "aise in#estment< it 6ill set off a 4ene"al e2pansiona" p"ocess) an the e#ent%al "ise in national income 6ill e2cee the initial inc"ease in a44"e4ate eman.
This can ha#e impo"tant implications fo" a 4o#e"nment 6hen it is plannin4 fo" 4"o6th in national income. 9 an initial inc"ease in e2penit%"e) a 4o#e"nment can >en4inee"> an e#en 4"eate" inc"ease in national income) ;p"o#ie that the co%nt">s in%st"ies can inc"ease thei" o%tp%t capacit<) epenin4 on the siGe of the m%ltiplie". The siGe of the m%ltiplie" epens on1 ;a<
the ma"4inal p"opensit to sa#e ;MPS<=
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the ma"4inal p"opensit to impo"t 5&eca%se impo"ts "e%ce national income) an if ho%sehols spen m%ch of thei" e2t"a income on impo"ts) the >sno6&all> inc"ease in total national income 6ill &e "est"icte &eca%se impo"ts a"e a >6ith"a6al> o%t of the ci"c%la" flo6 of income. One of the "easons fo" a lo6 m%ltiplie" in the U: is the hi4h ma"4inal p"opensit to impo"t that e2ists in the U:= an
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ta2 "ates 5&eca%se ta2es "e%ce the a&ilit of people to cons%me an so a"e li-el to affect the ma"4inal p"opensit to cons%me an the ma"4inal p"opensit to sa#e.
Unemployment And In"lation
Your objectives
Afte" completin4 this chapte" o% sho%l1 ;a<
&e a6a"e of some of the main cate4o"ies of %nemploment an thei" ca%ses
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%ne"stan the "elationship &et6een %nemploment an inflation
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&e a6a"e of the main e2planations of 6h inflation occ%"s
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&e a6a"e of the a"4%ments fo" an a4ainst p"ices an incomes policies
*nemployment One of the p"o&lems that a national econom mi4ht face is a hi4h le#el of %nemploment. Hi4h %nemploment means that the"e is a la"4e amo%nt of 6aste la&o%" "eso%"ce) an 4o#e"nments 6ill often t" to "e%ce %nemploment to an >accepta&le> le#el. To %ne"stan 6h %nemploment a"ises) an in o"e" to s%44est "emeies) it is impo"tant to istin4%ish &et6een a n%m&e" of iffe"ent cate4o"ies of %nemploment. ;a<
F"ictional %nemploment. It is ine#ita&le that some %nemploment is ca%se not so m%ch &eca%se the"e a"e not eno%4h ?o&s to 4o "o%n) &%t &eca%se of the f"iction in the la&o%" ma"-et) i.e. the iffic%lt in 8%ic-l matchin4 6o"-e"s 6ith ?o&s) ca%se pe"haps & a lac- of -no6le4e a&o%t ?o& oppo"t%nities. F"ictional %nemploment occ%"s 6he"e the"e is a sho"ta4e of a 4i#en tpe of 6o"-e" in one "e4ion) &%t a s%"pl%s of the same tpe in anothe" ;e4 cle"ical staff ma &e plentif%l in ales &%t in sho"t s%ppl in *onon<. In 4ene"al) it ta-es time to match p"ospecti#e emploees 6ith emploe"s) an ini#i%als 6ill &e %nemploe %"in4 the sea"ch pe"io fo" a ne6 ?o&. F"ictional %nemploment is tempo"a") lastin4 fo" the pe"io of t"ansition f"om one ?o& to the ne2t.
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Seasonal %nemploment. This occ%"s in ce"tain in%st"ies) e4 &%ilin4) to%"ism an fa"min4) 6he"e the eman fo" la&o%" fl%ct%ates in seasonal patte"ns th"o%4ho%t the ea".
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St"%ct%"al %nemploment occ%"s 6he"e lon45te"m chan4es in the conitions of an in%st" occ%") e.4. an in%st" ma ecline lea#in4 man 6o"-e"s "e%nant an "el%ctant to mo#e to a ne6 in%st" ;la&o%" immo&ilit<. The feat%"e of st"%ct%"al %nemploment is hi4h "e4ional %nemploment in the location of the in%st" affecte.
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Technolo4ical %nemploment. This is a fo"m of st"%ct%"al %nemploment) 6hich occ%"s 6hen ne6 technolo4ies a"e int"o%ce. ith a%tomation) emploment le#els in an in%st" can fall sha"pl) e#en 6hen the in%st">s total o%tp%t is inc"easin4.
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Cclical %nemploment. It has &een the e2pe"ience of the past that omestic an fo"ei4n t"ae 4o th"o%4h ccles of &oom) ecline) "ecession) "eco#e") then &oom a4ain) an so on. Cclical %nemploment can &e lon45te"m) an a 4o#e"nment mi4ht t" to "e%ce it & oin4 6hat it can to minimise a "ecession o" to enco%"a4e faste" economic 4"o6th.
Seasonal emploment an f"ictional %nemploment 6ill &e sho"t5te"m. St"%ct%"al %nemploment) technolo4ical %nemploment) an cclical %nemploment a"e all lon4e"5te"m) an mo"e se"io%s. 7ovenment poli!ies to in"luen!e employment
@o#e"nments a"e an2io%s to infl%ence %nemploment le#els fo" a n%m&e" of "easons. Unemploment is a 6aste of economic "eso%"ces) an it leas to ini#i%al ha"ship. Politicall) the le#el of %nemploment is seen as a -e inicato" of a 4o#e"nment>s s%ccess o" fail%"e. A 4o#e"nment>s policies to infl%ence emploment 6ill p"o&a&l &e aime eithe" at "e%cin4 the total n%m&e" of %nemploe people o6n to an >accepta&le> le#el) o" at c"eatin4 mo"e ?o&s. Qo& c"eation an "e%cin4 %nemploment sho%l often mean the same thin4) &%t it is possi&le1 ;a<
to c"eate mo"e ?o&s 6itho%t "e%cin4 %nemploment. This can happen 6hen the"e is a 4"eate" n%m&e" of people ente"in4 the ?o&s ma"-et ;school5lea#e"s etc< than the"e a"e ne6 ?o&s &ein4 c"eate. Fo" e2ample) if !77)777 ne6 ?o&s a"e c"eate %"in4 the co%"se of one `ea") &%t 0!7)777 e2t"a school5lea#e"s a"e loo-in4 fo" ?o&s) the"e 6ill &e an inc"ease in %nemploment of ,!7)777 e#en tho%4h !77)777 ne6 ?o&s ha#e &een c"eate=
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it is also possi&le to "e%ce the official %nemploment fi4%"es 6itho%t c"eatin4 ?o&s. Fo" e2ample) in the U:) ini#i%als 6ho en"ol fo" one of the 4o#e"nment finance Qo& T"ainin4 Schemes is ta-en off the %nemploment "e4iste") e#en tho%4h he o" she oes not ha#e a f%ll5time ?o&.
A 4o#e"nment can t" to c"eate ?o&s o" "e%ce %nemploment &1 ;a<
spenin4 mo"e mone i"ectl on ?o&s) i.e. hi"in4 mo"e ci#il se"#ants=
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enco%"a4in4 4"o6th in the >p"i#ate secto"> of the econom. hen a44"e4ate eman is 4"o6in4) fi"ms 6ill p"o&a&l 6ant to inc"ease o%tp%t to meet eman) an so 6ill hi"e mo"e la&o%"=
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enco%"a4in4 t"ainin4 on ?o& s-ills. The"e mi4ht &e a hi4h le#el of %nemploment amon4st %ns-ille 6o"-e"s) an at the same time a sho"ta4e of s-ille 6o"-e"s. A 4o#e"nment can help to finance t"ainin4 schemes) in o"e" to p"o#ie a >pool> of 6o"-e"s 6ho ha#e the s-ills that fi"ms nee an 6ill pa fo".
The Phillips curve Unemployment and in"lation
The p"o&lems of %nemploment an inflation ha#e &een #e" se#e"e fo" man co%nt"ies o#e" "ecent ea"s. It has &een fo%n f"om e2pe"ience that1 ;a<
f%ll emploment is %nachie#a&le 6itho%t some p"ice inflation) an to inc"ease the le#el of emploment mi4ht ca%se a hi4he" "ate of inflation=
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4"o6th in %nemploment mi4ht sometimes &e associate 6ith a "isin4 "ate of inflation. Inflationa" 4aps an eflationa" 4aps
In"lationay %aps and de"lationay %aps
As 6e sa6 in Chapte" +, on the :enesian moel) one metho of sho6in4 e8%ili&"i%m national income 6as & means of1
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an a44"e4ate eman c%"#e ;AD<) 6he"e AD is the total eman fo" all 4oos in the econom) at iffe"ent p"ice le#els= an
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an a44"e4ate s%ppl c%"#e ;AS< 6he"e AS is the total s%ppl of all 4oos in the econom) at iffe"ent p"ice le#els.
The ieas of a eflationa" 4ap an an inflationa" 4ap 6e"e also esc"i&e in Chapte" +,. Acco"in4 to :enes) eman mana4ement & the 4o#e"nment co%l &e &ase on 4o#e"nment spenin41 ;a<
to eliminate a eflationa" 4ap an c"eate f%ll emploment=
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to eliminate an inflationa" 4ap) to ta-e inflation o%t of the econom.
A si4nificant point to note f"om the :enesian analsis is that 6hen the"e is %nemploment ;a eflationa" 4ap< :enesians accept that "e%ctions in %nemploment can onl &e achie#e if p"ices a"e allo6e to "ise) i.e. "e%cin4 %nemploment 4oes han in han 6ith allo6in4 some inflation. Relationship #et(een unemployment and in"lation. the Phillips !uve
A Phillips isco#e"e ;+'!$< a statistical "elationship &et6een %nemploment an the "ate of mone 6a4e inflation 6hich implie that) in 4ene"al) the "ate of inflation fell as %nemploment "ose an #ice #e"sa. A c%"#e) -no6n as a Phillips c%"#e) can &e "a6n lin-in4 inflation an %nemploment ;Fi4%"e +<.
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7
5
T6o points sho%l &e notice a&o%t the Phillips c%"#e. ;a<
The c%"#e c"osses the ho"iGontal a2is at a positi#e #al%e fo" the %nemploment "ate. This means Ge"oassociate inflation 6ill &e associate 6ith some %nemploment= it is not possi&le to Hi4he" that inflation 6ith achie#e Ge"o inflation an Ge"o %nemploment at the same time. lo6e" %nemploment
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The shape of the c%"#e means that the lo6e" the le#el of %nemploment) the hi4he" the "ate of inc"ease in inflation.
Ho6e#e") the Phillips c%"#e "elationship &et6een inflation an %nemploment &"o-e o6n at the en of the + '7s 6hen 9"itain &e4an to e2pe"ience "isin4 inflation at the same time as "isin4 %nemploment. In othe" 6o"s) the ne6 c%"#e seeme to &e %p6a" slopin4. *o6e" inflation associate 6ith hi4he" %nemploment
In"lationay e$pe!tations. e"inements to the Phillips !uve
An e2planation of "isin4 inflation "ates com&ine 6ith "isin4 %nemploment 6as p%t fo"6a") &ase on inflationa" e2pectations. This >nat%"al "ate h pothesis> is s%ppo"te & moneta"ist economists. >Inflationa" e2pectations> a"e the "ates of inflation that a"e e2pecte in the f%t%"e. The inflationa" e2pectations of the 6o"- fo"ce 6ill &e "eflecte in the le#el of 6a4e "ises that is emane in the ann%al "o%n of pa ne4otiations &et6een emploe"s an 6o"-e"s. ;a<
If the 6o"- fo"ce e2pects inflation ne2t ea" to &e 3) the 6ill eman a 3 6a4e inc"ease in o"e" to maintain the "eal #al%e of thei" 6a4es.
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If 6e no6 accept that an inc"ease in 6a4es 6ill "es%lt in p"ice inflation ;6hich is the moneta"ist a"4%ment<) then a 3 pa "ise to co#e" e2pecte inflation 6ill "es%lt in an act%al "ate of inflation of 3.
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The 6o"- fo"ce mi4ht also t" to achie#e some inc"ease in the "eal #al%e of 6a4es. If inflation ne2t ea" is e2pecte to &e 3) the 6o"- fo"ce mi4ht eman a pa "ise of ) sa) /. Acco"in4 to moneta"ist economists) a pa "ise of / 6o%l simpl mean inflation of /. If 6o"-e"s 6ish to achie#e a + inc"ease in "eal 6a4es each ea" ) then %"in4 each s%ccessi#e pe"io the "ate of inflation 6ill &e4in to accele"ate f"om ! to to 0 an so on) an the "eal inc"eases in 6a4es 6ill not happen.
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To compo%n the p"o&lem of inflation still f%"the") it is a"4%e that if mista-es a"e mae o#e" e2pectations) then mone 6a4es 6ill &e a?%ste %p6a"s ne2t pe"io in o"e" to "ectif the mista-e mae last pe"io.
The e2ample %se he"e is simplifie &eca%se e2pectations chan4e an aapt an the"e a"e &oth economic an stat%to" limits as to chan4es in &oth p"ices an 6a4es. Ho6e#e") man economists &elie#e that e#ents in the U: f"om a&o%t +'0 6ell into the +'07s follo6e a se8%ence of e#ents not %nli-e that esc"i&e a&o#e. The natual ate hypothesis
The nat%"al "ate hpothesis inco"po"ates these #ie6s on inflationa" e2pectations) to p"o%ce a "efinement of the Phillips c%"#e. S%ppose that the econom is cha"acte"ise & the Phillips c%"#e PC + in Fi4%"e ,. Initiall) sa) that is at an %nemploment "ate of / an Ge"o p"ice an 6a4e inflation.
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S%ppose no6 that the 4o#e"nment e2pans a44"e4ate eman so as to "e%ce %nemploment to) sa) , of the la&o%" fo"ce. The"e is a mo#ement alon4 the Phillips c%"#e) an the ne6 %nemploment le#el t%"ns o%t to &e associate 6ith / inflation.
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As emploe"s "ealise that the a"e pain4 hi4he" 6a4es as 6ell as "ecei#in4 hi4he" p"ices) an as 6o"-e"s "ealise that the "eal #al%e of thei" 6a4es has not "isen) the %nemploment "ate "ises to / a4ain.
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9%t in the meantime the pe"io of positi#e inflation has 4ene"ate inflationa" e2pectations an / %nemploment is no6 associate 6ith 3 inflation) &eca%se the Phillips c%"#e has shifte f"om PC) to
In effect) the sho"t5"%n Phillips c%"#e has shifte o%t6a"s f"om PC + to PC, in Fi4%"e ,) Moneta"ist economists state that the lon45"%n Phillips c%"#e is #e"tical at the nat%"al "ate of %nemploment. In o%" e2ample) moneta"ists 6o%l claim that the lon45"%n Phillips c%"#e is NN in Fi4%"e , so that the"e is a nat%"al %nemploment "ate of / ;&%t note that this fi4%"e of / is simpl &ein4 %se as an e2ample he"e<.
In the lon45"%n) %nemploment 6ill "e#e"t to6a"s its nat%"al le#el. The "ate of inflation) ho6e#e") 6ill &e ete"mine & the sho"t5"%n Phillips c%"#e) 6hich 6ill shift %p6a"s as inflationa" e2pectations inc"ease. The istinction &et6een sho"t an lon45"%n Phillips c%"#es can help e2plain the o&se"#ation that in 9"itain %nemploment an inflation ha#e often &oth "isen at the same time. Moneta"ist economists a"4%e that1 ;a<
the onl 6a to "e%ce the "ate of inflation is to 4et inflationa" e2pectations o%t of the sstem. In oin4 so) e2cessi#e emans fo" 6a4e "ises sho%l &e "esiste & emploe"s=
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a fi"m app"oach to "e%cin4 the "ate of inflation co%l mean ha#in4 to accept hi4h le#els of %nemploment fo" a 6hile=
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attempts to 4et the %nemploment le#el &elo6 its nat%"al "ate ;6hate#e" this is< 6ill onl "es%lt in the lon4 "%n in hi4he" inflation.
!nflation and its conse'uences Inflation has a n%m&e" of %nesi"a&le conse8%ences ;a<
Reist"i&%tion of income an 6ealth. Inflation leas to a "eist"i&%tion of income an 6ealth in 6as 6hich ma &e %nesi"a&le. Reist"i&%tion of 6ealth mi4ht ta-e place f"om c"eito"s to e&to"s. This is &eca%se e&ts lose >"eal> #al%e 6ith inflation. Fo" e2ample) if o% o6e L+)777) an p"ices then o%&le) o% 6o%l still o6e L+)777) &%t the "eal #al%e of o%" e&t 6o%l ha#e &een hal#e. In 4ene"al) in times of inflation those 6ith economic po6e" ten to 4ain at the e2pense of the 6ea-) pa"tic%la"l those on fi2e incomes.
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9alance of paments effects. If a co%nt" has a hi4he" "ate of inflation than its ma?o" t"ain4 pa"tne"s) its e2po"ts 6ill &ecome "elati#el e2pensi#e an impo"ts "elati#el cheap. As a "es%lt) the &alance of t"ae 6ill s%ffe") affectin4 emploment in e2po"tin4 in%st"ies an in in%st"ies p"o%cin4 impo"t5s%&stit%tes.
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Unce"taint of the #al%e of mone an p"ices. If the "ate of inflation is impe"fectl anticipate) no one has ce"tain -no6le4e of the t"%e "ate of inflation. As a "es%lt) no one has ce"tain -no6le4e of the #al%e of mone o" of the "eal meanin4 of p"ices.
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Reso%"ce costs of chan4in4 p"ices. A fo%"th "eason to aim fo" sta&le p"ices is the "eso%"ce cost of f"e8%entl chan4in4 p"ices. In times of hi4h inflation s%&stantial la&o%" time is spent on plannin4 an implementin4 p"ice chan4es. C%stome"s ma also ha#e to spen mo"e time ma-in4 p"ice compa"isons if the see- to &% f"om the lo6est cost so%"ce. The te"m >men% costs> is sometimes applie to the costs of "e#isin4 p"ices= the te"m all%es to the costs of chan4in4 p"ices on "esta%"ant men%s.
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If p"ice "ises incl%e "ises in the "ate of inte"est) people 6ill hol less of thei" 6ealth in the fo"m of cash) an mo"e in the fo"m of inte"est5&ea"in4 assets. Cash holin4s 6ill nee to &e "eplenishe mo"e "e4%la"l) an this too ca%ses a financial cost ;sometimes "efe""e to as a >shoe5leathe" cost>) the ima4e &ein4 that of an ini#i%al 6ea"in4 o%t his shoes 6ith f"e8%ent t"ips to the &an-<.
The !auses o" in"lation
The ca%ses of inflation a"e comple2) &eca%se the"e 6ill &e se#e"al facto"s ope"atin4 sim%ltaneo%sl) each ha#in4 some effect on p"ice le#els. The ca%ses of inflation mi4ht &e1 ;a<
eman5p%ll facto"s=
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cost5p%sh facto"s=
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e2pectations=
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4"o6th in the mone s%ppl.
Deman5p%ll inflation occ%"s 6hen the econom is &%oant an the"e is a hi4h a44"e4ate eman 6hich is in e2cess of the econom>s a&ilit to s%ppl. ;a<
9eca%se a44"e4ate eman e2cees s%ppl) p"ices "ise.
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Since s%ppl nees to &e "aise to meet the hi4he" eman) the"e 6ill &e an inc"ease in eman fo" facto"s of p"o%ction) an so facto" "e6a"s ;6a4es) inte"est "ates) an so on< 6ill also "ise.
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Since a44"e4ate eman e2cees the o%tp%t capa&ilit of the econom) it sho%l follo6 that eman5p%ll inflation can onl e2ist 6hen %nemploment is lo6. A feat%"e of inflation in the U: in the +'07s an ea"l +'$7s) ho6e#e") 6as hi4h inflation co%ple 6ith hi4h %nemploment.
T"aitionall :enesian economists sa6 inflation as &ein4 ca%se & eman5p%ll facto"s. Ho6e#e") the no6 accept that cost5p%sh facto"s a"e in#ol#e as 6ell. Cost5p%sh inflation occ%"s 6he"e the costs of facto"s of p"o%ction "ise "e4a"less of 6hethe" o" not the a"e in sho"t s%ppl. This appea"s to &e pa"tic%la"l the case 6ith 6a4es1 6o"-e"s anticipate inflation "ates an eman 6a4e inc"eases to compensate) th%s initiatin4 a 6a4e5p"ice spi"al. Inte"est "ate "ises can also a to the "ate of inflation) &eca%se mo"t4a4e costs 6ill "ise. A f%"the" p"o&lem is that once the "ate of inflation has &e4%n to inc"ease) a se"io%s an4e" of >e2pectational inflation> 6ill occ%". This 6as isc%sse ea"lie" in this chapte". The moneta"ists a"4%e that inflation is ca%se & inc"eases in the s%ppl of mone. The"e is a consie"a&le e&ate as to 6hethe" inc"eases in the mone s%ppl a"e a ca%se of inflation o" a smptom of inflation. The moneta"ists a"4%e that since inflation is ca%se & an inc"ease in the mone s%ppl) inflation can &e &"o%4ht %ne" cont"ol & "e%cin4 the "ate of 4"o6th of the mone s%ppl. Hi%h inteest ates and in"lation
A 4o#e"nment ma aopt a polic of hi4h inte"est "ates as a means of t"in4 to "e%ce the "ate of inflation) 6hen inflation is &ein4 ca%se & a &oom in cons%me" eman ;i.e. 6ith eman "isin4 faste" than the a&ilit of in%st" to inc"ease its o%tp%t to meet the eman<. If inte"est "ates a"e hi4h eno%4h) the"e sho%l e#ent%all &e a "e%ction in the "ate of 4"o6th in cons%me" spenin4. This "e%ction sho%l occ%" &eca%se1 ;a<
people 6ho &o""o6 m%st pa mo"e in inte"est o%t of thei" income. This 6ill lea#e them less income) afte" pain4 the inte"est) to spen on othe" thin4s=
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hi4h inte"est "ates mi4ht ete" people f"om &o""o6in4) an so the"e 6o%l &e less spenin4 6ith &o""o6e f%ns=
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hi4h inte"est "ates sho%l enco%"a4e mo"e sa#in4) 6ith ini#i%als the"efo"e spenin4 less of thei" income on cons%mption=
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hi4h inte"est "ates 6ill ten to ep"ess the #al%es of non5moneta" assets) s%ch as ho%ses) an the "e%ction in people>s pe"cei#e 6ealth ma ma-e people feel >poo"e"> an conse8%entl "e%ce the amo%nts the spen on cons%me" 4oos.
Prices and incomes policy The fi"st p"ices an incomes polic 6as int"o%ce in 9"itain & the then p"ime ministe" ) Ha"ol Macmillan) in +',. The"e ha#e &een se#e"al attempts to fin a s%ccessf%l polic since then) the last &ein4 the >social cont"act> %ne" the *a&o%" 4o#e"nment of Qames Calla4han. The need "o !o)odinated pi!es and in!omes !ontols
If p"ices &%t not 6a4es a"e cont"olle the "es%lts 6o%l &e a p"ofit s8%eeGe) ano" a "ise in %nemploment) 6ith fi"ms shein4 la&o%" in o"e" to "emain p"ofita&le. This s%44ests that 6a4es o%4ht &e -ept %ne" cont"ol as 6ell as p"ices. This 6o%l &e pa"tic%la"l impo"tant if 6a4e "ises a"e a ma?o" ca%se of cost5p%sh inflation. The st"%ct%"e of a p"ices an incomes polic can ta-e #a"io%s fo"ms) &%t it is %s%all possi&le to ma-e a clea" istinction &et6een tpes of incomes cont"ol an tpes of p"ice cont"ol. In!omes<(a%es !ontols
The &"oa tpes of 6a4e cont"ols 6hich co%l &e attempte & a 4o#e"nment a"e1 ;a<
stat%to" "est"ictions on the amo%nt of 6a4e inc"eases allo6e=
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4o#e"nment 6a4e polic 4%ielines) 6hich it is hope that 6a4e ne4otiato"s 6ill ahe"e to #ol%nta"il=
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a >social cont"act> &et6een the 4o#e"nment an t"ae %nions 6he"e& the %nions accept a #ol%nta" "est"aint on 6a4e inc"eases in "et%"n fo" othe" >fa#o%"s> f"om the 4o#e"nment.
Stat%to" cont"ols a"e mo"e i"ect) an if enfo"cea&le) mo"e li-el to 6o"- effecti#el. ol%nta" cont"ols epen on the 6illin4ness of t"ae %nions an ini#i%al 6o"-e"s to accept the cont"ols) an a social cont"act) if a4"ee) is li-el to &e mo"e mo"all &inin4 on them than 6a4e polic 4%ielines. Po#lems (ith (a%e !ontols
P"o&lems 6ith 6a4e cont"ols incl%e1 ;a<
non5compa"a&le 6a4es &et6een 6o"- 4"o%ps. Some 4"o%ps a"e li-el to feel >cheate>=
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e"osion of pa iffe"entials=
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"e6a"in4 p"o%cti#it imp"o#ementd. Imp"o#e p"o%cti#it sho%l &e enco%"a4e) &%t 6a4e cont"ols mi4ht p"e#ent this=
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e#ain4 the cont"ols=
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t"ae %nion "esistance.
Pi!e !ontols
A polic of cont"ollin4 6a4es cannot 6o"- %nless p"ices a"e cont"olle as 6ell) &eca%se 6o"-e"s 6ill not "eail accept enfo"ce cont"ols on thei" ea"nin4s 6hen p"ices a"e "isin4 mo"e "apil. In 9"itain it has al6as p"o#e to &e m%ch easie" to cont"ol p"ices than 6a4es. Fo" e2ample) the P"ice Commission in 9"itain) %ntil is&ane & the Thatche" 4o#e"nment in +'$7) ha some s%ccess in "e%cin4 ano" elain4 p"ice "ises. A polic fo" cont"ollin4 p"ices also has pa"tic%la" p"o&lems to o#e"come ;a<
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The 4o#e"nment m%st ecie 6hat p"ices sho%l &e cont"olle. It is aminist"ati#el impossi&le to cont"ol all p"ices cha"4e & all fi"ms) especiall small fi"ms) an cont"ols m%st the"efo"e &e applie to selecte p"o%cts) companies o" ma"-ets) in the hope that if these p"ices a"e cont"olle) othe" p"ices 6ill "emain in chec- too. It mi4ht &e necessa" to allo6 e2ceptions to the "%le) so that ce"tain p"ices can "ise in e2cess of the 4o#e"nment>s no"ms o" limits.
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Man "a6 mate"ials) p"o%cts an se"#ices a"e impo"te. If the p"ices of these impo"te 4oos 4o %p ;e.4. &eca%se of a fall in the #al%e of the omestic c%""enc< fi"ms m%st &e allo6e to pass on thei" inc"ease costs into thei" p"ices. R%les fo" pe"missi&le p"ice inc"eases m%st the"efo"e &e esta&lishe.
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If p"ice cont"ols a"e too "i4i) the 4o#e"nment mi4ht face the p"o&lem that a &lac- ma"-et econom mi4ht e#elop in ce"tain 4oos) 6ith p"ices on the &lac- ma"-et "isin4 to le#els that a"e fa" in e2cess of the 4o#e"nment>s limits.
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The"e is the eno"mo%s p"actical p"o&lem of esta&lishin4 a policin4 a4enc o" a4encies to monito") cont"ol an app"o#e inc"eases in p"ices ;an this applies e8%all to cont"ols on incomes<.
The Demand Fo And Supply o" Money
(o%" o&?ecti#es Afte" completin4 this chapte" o% sho%l1 ;a<
%ne"stan the main feat%"es of the moneta"ist #ie6 of mone s%ppl an eman
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%ne"stan the main feat%"es of the :enesian #ie6 of mone s%ppl an eman
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%ne"stan the implications of these #ie6s fo" inte"est "ates an inflation
The 'uantity theory of money The"e a"e t6o &"oa schools of tho%4ht a&o%t moneta" theo" 6hich o% nee to -no6 a&o%t) an economists a"e not in %nanimo%s a4"eement. The t6o &"oal iffe"in4 #ie6s a"e1 ;a<
the moneta"ist #ie6. The moneta"ist #ie6 of mone s%ppl an eman) an of the infl%ence of mone on inte"est "ates an inflation) e"i#es f"om the so5calle 8%antit theo" of mone=
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the :enesian #ie6. :enes e#elope a theo" of the eman fo" mone in the +',7s) -no6n as li8%iit p"efe"ence theo") 6hich challen4e the 8%antit theo" of mone.
The &uantity theoy o" money
Moneta"ist economists st"ess the si4nificance of the "ole of mone in the 6o"-in4s of the econom) an &ase thei" a"4%ments on the ol 8%antit theo" of mone. The classical 8%antit theo" of mone 6as e#elope & I"#in4 Fishe" in +'++ at a time 6hen 9"itain 6as on the 4ol stana") an the 8%antit of mone the"efo"e chan4e little. It 6as the 4ene"all accepte #ie6 %ntil the +'37s a&o%t the "elationship &et6een the amo%nt of mone in the econom an the le#el of p"ices. It is a theo" a&o%t ho6 m%ch mone s%ppl is neee to ena&le the econom to f%nction. The 8%antit theo" too- the #ie6 that mone 6as %se onl as a mei%m of e2chan4e) to settle t"ansactions in#ol#in4 the eman an s%ppl fo" 4oos an se"#ices. This is 8%ite impo"tant to "emem&e". he"eas the 8%antit theo" states that the eman fo" mone is simpl fo" spenin4 on fo"eseea&le t"ansactions ;an moneta"ist economists a4"ee 6ith this #ie6< :enesian economists a"4%e that the"e a"e othe" "easons fo" 6antin4 to hol mone) as 6e shall see late". If the n%m&e" of t"ansactions in the econom is fi2e) an inepenent of the amo%nt of the mone s%ppl) then1 The total mone #al%e of t"ansactions 6ill &e PT he"e
P is the p"ice le#el of 4oos an se"#ices &o%4ht an sol= an T is the n%m&e" o" 8%antit of t"ansactions.
The amo%nt of mone neee to pa fo" these t"ansactions 6ill epen on the #elocit of ci"c%lation. Mone chan4es hans. A pe"son "ecei#in4 mone can %se it to ma-e his o6n p%"chases. Fo" e2ample) if A pas 9 L, fo" t"ansaction ) 9 can %se the L, to pa C fo" t"ansaction ( an C can %se the same L,
to pa D fo" t"ansaction X. If the th"ee t"ansactions ) () an X all occ%" 6ithin a 4i#en pe"io of time then the mone #al%e of the t"ansactions is PT L,) 2 3 t"ansactions L. The total amo%nt of mone is the same L, in ci"c%lation fo" all th"ee t"ansactions &%t this mone has e2chan4e hans th"ee times. The #elocit of ci"c%lation is 3 an M( he"e
M is the mone s%ppl= an is the #elocit of ci"c%lation.
This &"in4s %s to the >ientit> of the 8%antit theo" of mone1 M( PT. M m%st e8%al PT &eca%se the a"e t6o iffe"ent 6as of meas%"in4 the same t"ansactions. In p"actice) the #elocit of ci"c%lation is calc%late as the &alancin4 fi4%"e 6he"e1
PT M
Con!lusion "om the &uantity theoy o" money
The ientit ;o" >e8%ation>< of the 8%antit theo" of mone oes not "eall sa #e" m%ch. It is ass%me that M is &oth the 8%antit of eman fo" mone an also the mone s%ppl. ;a< An inc"ease in M 6o%l "e%ce o" inc"ease eithe" p o" T. ;&< An inc"ease in 6o%l "e%ce M o" inc"ease eithe" p o" T. ;c< An inc"ease in p 6o%l "e%ce T o" inc"ease eithe" M o" . ;< An inc"ease in T 6o%l "e%ce p o" inc"ease eithe" M o" . Ho6e#e") th"ee f%"the" ass%mptions can &e mae. ;a<
has a "o%4hl constant #al%e. The #elocit of ci"c%lation of mone "emains the same at all times) o" at least onl chan4es #e" slo6l o#e" time. The"e 6e"e "easons fo" ma-in4 this ass%mption 6hich 6e nee not el#e into he"e. hethe" is constant o" not is isc%sse late"
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T is eithe" 4i#en o" it is inepenent of the amo%nt of mone) M. The "eason 6h T sho%l &e a 4i#en total 6as that the s%ppo"te"s of the B%antit theo" a"4%e that in the econom) f%ll emploment of "eso%"ces is the no"m an if all "eso%"ces a"e f%ll %tilise the #ol%me of t"ansactions T m%st &e a constant #al%e.
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The amo%nt of M is ete"mine & othe" facto"s an is inepenent of ) T o" ;most si4nificantl< P. The mone s%ppl co%l &e cont"olle & 4o#e"nment a%tho"ities ;e4 the cent"al &an-<.
@i#en these ass%mptions) the 8%antit theo" of mone &ecomes a theo" of p"ice le#els &eca%se) since M( PT then
P
M( T
If an T a"e "o%4hl constant #al%es) p 6ill #a" i"ectl 6ith inc"eases o" ec"eases in the amo%nt of M an it is chan4es in the mone s%ppl M that ca%se p"ices p to chan4e) not chan4es in p"ice that ca%se chan4es in the mone s%ppl. In othe" 6o"s) inflation 6o%l &e i"ectl "elate to the mone s%ppl) an a +7 inc"ease in the mone s%ppl) sa) 6o%l "es%lt in +7 inflation.
The money supply and in"lation
The"e is an a"4%ment that the lin- &et6een the mone s%ppl an inflation is a misleain4 one. 9%t &efo"e 6e loo- at this co%nte"5a"4%ment) let>s s%mma"ise the points mae so fa". Impo"tant concl%sions f"om the 8%antit theo" of mone e8%ation a"e that1 ;a<
if the #elocit of ci"c%lation of mone) ) is mo"e o" less constant) then an 4"o6th in the mone s%ppl) M) o#e" an a&o#e the potential in the econom to inc"ease T ) 6ill ca%se inflation=
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if o%tp%t in the econom) T) is 4"o6in4 an if the #elocit of ci"c%lation) ) is constant) then a matchin4 4"o6th in the mone s%ppl) M) 6o%l &e neee to a#oi eflation ;ie fallin4 p"ices<.
A f%"the" concl%sion f"om the 8%antit theo" is that 4o#e"nment>s moneta" polic sho%l &e to allo6 some 4"o6th in the mone s%ppl if the econom is 4"o6in4) &%t not to let the 4"o6th in the mone s%ppl 4et o%t of han. The e2tent to 6hich these concl%sions a"e #ali epens la"4el on 6hethe" the #elocit of ci"c%lation of mone is "o%4hl constant o" not. Fo" e2ample) if the mone s%ppl inc"eases & +7) an the >"eal 4"o6th> in the econom 5i.e. the inc"ease in the #ol%me of t"ansactions 5is 3) 6e co%l p"eict that inflation 6ill &e a&o%t 0 &%t onl if the #elocit of ci"c%lation is constant Is the velo!ity o" !i!ulation !onstant9
The #elocit of ci"c%lation can &e meas%"e. It is meas%"e in the U: as the "atio of @"oss National P"o%ct at c%""ent ma"-et p"ices ;this is PT< to the a#e"a4e mone stoc- fo" the 8%a"te" ;this is M<. The mone stoc- is meas%"e & the #a"io%s moneta" a44"e4ates) e4 in the U:) as MO) M, an M/. The"e is a iffe"ent meas%"e of the #elocit of ci"c%lation fo" each efinition of the mone stoc-. Meas%"ements of the #elocit of the ci"c%lation of mone in the U: sho6 that is s%&?ect to contin%al #a"iations %p an o6n. The follo6in4 ta&le 4i#es some inication of these #a"iations o#e" a si2 ea" pe"io. 1elocity of circulation ratios Fourth )uarter of year +'$3 +'$! +'$0 +'$'
2oney stoc 23 24 ,/., +.$, ,!.$ +./ ,$.+ +./0 ,'.0 +.,0
Moneta"ist economists ha#e a"4%e that in spite of sho"t5te"m fl%ct%ations) the #elocit of ci"c%lation is constant in the lon4 te"m. :enesians economists isa4"ee) an a"4%e that is #a"ia&le an so the"e is no i"ect connection &et6een the mone s%ppl an inflation. In the U:) statistics sho6 that the #elocit of ci"c%lation inc"ease %"in4 the +'0Os &%t slo6e o6n %"in4 the +'$Os e2cept fo" MO. E#en so) it is p"o&a&l "easona&le to s%ppose that o#e" a lon4e" pe"io of time. sho%l "emain fai"l sta&le. Anothe vie( o" the money supply and in"lation
It 6as mentione ea"lie" that the"e is a co%nte"5a"4%ment to the #ie6 that 4"o6th in the mone s%ppl ca%ses inflation. The e8%ation o" >ientit> M( PT m%st &e co""ect) &%t instea of inc"eases in M ca%sin4 inflation) some economists 6o%l a"4%e that it is inflation 6hich happens fi"st) ca%sin4 the mone s%ppl to "ise in step. An if the mone s%ppl oesn>t inc"ease at once) 6ill inc" ease instea. The economists 6ho
&elie#e in this a"4%ment concl%e that the a%tho"ities sho%ln>t e2pen so m%ch effo"t on cont"ollin4 the mone s%ppl &eca%se the 6ill &e tac-lin4 a smptom of inflation "athe" than its ca%se. In the same 6a) if the mone s%ppl M is inc"easin4) the"e mi4ht &e no chan4e in PT ) an inee) it co%l &e that is ec"easin4. 5hat ma,es the money supply %o(9
e ha#e loo-e at the eman fo" an s%ppl of mone 6itho%t et as-in4 6hat it is that ma-es the mone s%ppl 4"o6 in the fi"st place. If 6e efine mone &"oal) to incl%e &an- eposits) the main facto"s that cont"i&%te to mone s%ppl 4"o6th a"e1 ;a<
4o#e"nment &o""o6in4 ;the P%&lic Secto" 9o""o6in4 Re8%i"ement o" PS9R<=
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6ho the 4o#e"nment &o""o6s f"om) &an-s o" non5&an-s=
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&an- lenin4= an
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flo6s of mone &et6een the co%nt" an fo"ei4n t"ae"sin#esto"s.
The PS9R is %s%all a positi#e amo%nt) ain4 to the 4"o6th in the mone s%ppl) &eca%se in most ea"s) the 4o#e"nment has &een a net &o""o6e" of mone. In some pe"ios in the late +'$7! ho6e#e") the U: 4o#e"nment &o""o6e less than the amo%nt of e&t it "epai an so the"e 6as a ne4ati#e PS9R. A ne4ati#e PS9R has a cont"actiona" effect on the mone s%ppl. App"oaches to cont"ollin4 the 4"o6th of the &"oa mone s%ppl The &"oa app"oaches that a 4o#e"nment mi4ht ta-e to cont"ol the 4"o6th of the mone s%ppl) if this 6e"e to &e pa"t of its moneta" polic) a"e1 ;a<
to "e%ce o" cont"ol the siGe of the PS9R=
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to finance as m%ch 4o#e"nment &o""o6in4 as possi&le & &o""o6in4 f"om the U: non5&an p"i#ate secto" ;e.4. & enco%"a4in4 National Sa#in4s in p"efe"ence to iss%in4 4ilts<=
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to cont"ol the inc"ease in &an- lenin4. The"e a"e #a"io%s 6as in 6hich the 4o#e"nment can t" to o this) some of 6hich 6e"e mentione in Chapte" '=
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to cont"ol e2te"nal an fo"ei4n c%""enc items 5e.4. & -eepin4 the &alance of paments %ne" cont"ol.
The 4o#e"nment can p%"s%e a polic of t"in4 to limit the PS9R) pe"haps & c%ttin4 4o#e"nment e2penit%"es altho%4h possi&l also & inc"easin4 ta2 "e#en%es. To the e2tent that the 4o#e"nment m%st &o""o6) it can t" to sell as m%ch e&t as possi&le to the non5 &an- p"i#ate secto") an achie#e o#e" f%nin4. 9oth of these policies ha#e &een p%"s%e & the U: 4o#e"nment in fai"l "ecent times. The demand "o money. (hat do (e mean #y /money/9
e shall no6 loo- mo"e closel at the eman fo" mone) 6hich 6ill ta-e %s f%"the" into the conflictin4 theo"ies of :enesian an moneta"ist economists. It helps to sta"t & 4ettin4 a clea" iea of 6hat 6e mean & mone. hen 6e consie" the theo"ies of eman fo" mone) 6e ta-e mone to mean a non5inte"est &ea"in4 sto"e of 6ealth. ;a<
9an- notes an c%""ent ;&an-< acco%nts ;>si4ht eposits>< a"e mone.
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F%ns in a &an- time eposit acco%nt a"e not mone. No" a"e &%ilin4 societ eposits.
O%" efinition of mone has no6 the"efo"e s6itche f"om a &"oa mone efinition ;M/< to a na""o6 mone efinition.
+eynesian vie%s on the demand for money +i&uidity pe"een!e
>*i8%iit> means assets in the fo"m of cash o" >nea"5cash>) in pa"tic%la" notes an coin an mone in a c%""ent &an- acco%nt. *i8%iit p"efe"ence "efe"s to the p"efe"ence of people to hol on to thei" sa#in4s as mone ;i.e. in li8%i fo"m< "athe" than in#estin4 it. :enes %se the concept of li8%iit p"efe"ence) 6hich "efe"s to the eman fo" mone) to e2plain1 ;a< ;&<
ho6 sa#in4s an in#estment mi4ht &e tempo"a"il iffe"ent an= ho6 inte"est "ate le#els in the econom a"e a""i#e at.
In aition) :enes a"4%e that if ho%sehols i not hol thei" sa#in4s in the fo"m of mone) the 6o%l in#est it to ea"n inte"est. The choice 6as &et6een mone an &ons. ;This is a #ie6 since isp%te & moneta"ist economists.< :enes ientifie th"ee "easons o" moti#es 6h people hol 6ealth as mone "athe" than as inte"est5 &ea"in4 sec%"ities. These 6e"e1 ;a<
the t"ansactions moti#e1 ho%sehols nee mone to pa fo" thei" a5to5a p%"chases. The le#el of t"ansactions eman fo" mone epens on ho%sehol incomes=
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the p"eca%tiona" moti#e1 people choose to -eep mone on han o" in the &an- as a p"eca%tion fo" a >"ain a> 6hen it mi4ht s%enl &e neee=
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the spec%lati#e moti#e1 some people choose to -eep "ea mone to ta-e a#anta4e of a p"ofita&le oppo"t%nit to in#est in &ons 6hich ma a"ise ;o" the ma sell &ons fo" mone 6hen the fea" a fall in &ons> ma"-et p"ices<.
The spec%lati#e moti#e fo" holin4 mone nees e2plainin4 a &it f%"the". ;a<
The "eason fo" holin4 mone instea of in#estin4 in &ons is that inte"est "ates a"e e2pecte to 4o %p. If inte"est "ates 4o %p) &on p"ices 6ill fall. Fo" e2ample) if the c%""ent ma"-et p"ice of &ons 6hich pa ! inte"est is L+77) an inte"est "ates o%&le to +7) the ma"-et #al%e of the &ons 6o%l fall) pe"haps to L!7. So if inte"est "ates a"e e2pecte to 4o %p) an &ons hel no6 6ill &e e2pecte to lose #al%e) an &on hole"s 6o%l ma-e a capital loss. Th%s) it ma-es sense to hol on to mone) fo" in#estin4 in &ons late") afte" inte"est "ates ha#e 4one %p.
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hat ca%ses ini#i%als to ha#e e2pectations a&o%t inte"est "ate chan4es in the f%t%"e :enes a"4%e that each ini#i%al has some e2pectation of a no"mal "ate of inte"est. This pe"ception of a no"mal inte"est "ate "eflects past le#els an mo#ements in the inte"est "ate) an e2pectations of the f%t%"e "ate le#el) o&taine f"om a#aila&le ma"-et info"mation.
:enes a"4%e f%"the" that people 6ill nee mone to satisf the t"ansactions moti#e an p"eca%tiona" moti#e "e4a"less of the le#el of inte"est. It is onl the spec%lati#e moti#e 6hich alte"s the eman fo" mone as a "es%lt of inte"est "ates. ;a<
If inte"est "ates a"e hi4h) people 6ill len mo"e mone ;e.4. & &%in4 4o#e"nment stoc-s< hol little cash) an 6ill ha#e lo6 li8%iit p"efe"ence.
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If inte"est "ates a"e lo6 an people e2pect them to "ise) the"e is a an4e" that c%""ent &on p"ices 6ill fall 6hen inte"est "ates 4o %p. People 6ill the"efo"e hol mone to satisf the spec%lati#e moti#e) i.e. 6ant to in#est late" in &ons) an thei" li8%iit p"efe"ence 6ill &e hi4h.
The concl%sion is that the eman fo" mone 6ill &e hi4h ;i.e. li8%iit p"efe"ence 6ill &e hi4h< 6hen inte"est "ates a"e lo6. This is &eca%se the spec%lati#e eman fo" mone 6ill &e hi4h 6hen inte"est "ates a"e lo6. Simila"l) the eman fo" mone 6ill &e lo6 6hen inte"est "ates a"e hi4h) &eca%se the spec%lati#e eman fo" mone 6ill &e lo6. The"e is a minim%m fi2e eman fo" mone ;t"ansactions an p"eca%tiona" moti#es< an some eman fo" mone that #a"ies 6ith inte"est "ates ;spec%lati#e moti#e<. 8eynesian vie( on inteest ates and money demand and supply
If the mone s%ppl is ass%me to &e fi2e & 4o#e"nment ecision) the siGe of the mone s%ppl is pe"fectl inelastic 6ith "espect to chan4es in the "ate of inte"est. :enes a"4%e that the le#el of inte"est "ates in the econom 6o%l then &e "eache & the inte"action of mone s%ppl ;fi2e< an mone eman ;li8%iit p"efe"ence<) as follo6s ;Fi4%"e +<.
* Mone s%ppl ;fi2e<
If the mone s%ppl is fi2e it then follo6s that inte"est "ates in the econom 6o%l &e ete"mine & the eman fo" mone.
"
*i8%iit p"efe"ence
Minim%m eman fo" mone
Mone s%ppl
MS+
MS,
" + " ,
*i8%iit p"efe"ence eman fo" mone
If the"e is an inc"ease in the mone s%ppl f"om M + to M, in Fi4%"e ,) inte"est "ates 6ill fall f"om " + to " ,. The"e 6ill &e some inc"ease in the le#el of in#estment spenin4) since it no6 &ecomes mo"e p"ofita&le fi"ms to in#est in ne6 capital. Acco"in4 :enesians) the"efo"e) an inc"ease ;o" ec"ease< in the mone s%ppl onl affects the eman fo" 4oos an se"#ices ;an hence the le#el of income< ini"ectl #ia a chan4e in the "ate of inte"est. If the "ate of inte"est is at a point 6he"e the eman fo" mone is in the so5calle li8%iit t"ap) an inc"ease in the mone s%ppl 6o%l ha#e a #e" small effect on inte"est "ates. In#estment 6o%l then &e ha"l affecte at all. :enes e2plaine this & sain4 that the inc"eases in the mone s%ppl 6o%l &e offset & a "e%ction in the #elocit of ci"c%lation) so that the inc"ease in the mone s%ppl 6o%l ha#e a ne%t"al effect on the econom. :enesians the"efo"e a"4%e that moneta" polic to cont"ol the mone s%ppl 6o%l possi&l) tho%4h not al6as) ha#e an effect on inte"est "ates ;an inc"ease in the mone s%ppl 6itho%t an inc"ease in the eman fo" mone 6o%l ma-e ini#i%als %se the e2t"a mone a#aila&le to &% mo"e &ons) an the hi4he" eman fo" &ons 6o%l p%sh o6n inte"est "ates< an chan4es in inte"est "ates mi4ht in the lon4e" te"m affect in#estment. In othe" "espects) ho6e#e") moneta" polic 6o%l not "eall affect the econom an national income) &eca%se inc"eases in the mone s%ppl 6o%l &e ne%t"alise & "e%ctions in the #elocit of ci"c%lation) lea#in4 PT %naffecte.
The monetarist vie%point Intodu!tion
Moneta"ist economists s%ch as P"ofesso" F"ieman "e#i#e the 8%antit theo" of mone an a"4%e that the"e is a m%ch mo"e i"ect lin- &et6een the mone s%ppl an national income. In othe" 6o"s) 6he"eas :enes a"4%e that an inc"ease in the mone s%ppl 6o%l me"el "es%lt in lo6e" inte"est "ates) 6ith no immeiate effect on national income) moneta"ists a"4%e that an inc"ease in the mone s%ppl 6ill lea i"ectl an B%ic-l to chan4es in national income an PT) 6ith the #elocit of ci"c%lation "emainin4 fai"l constant. F"ieman>s fi"st ma?o" 6o"-) entitle The )uantity theory of money+ a re5statement 6as p%&lishe in +'!. F"ieman a"4%e that mone is ?%st one of fi#e &"oa 6as of holin4 6ealth. The fi#e 6as a"e1 ;a<
mone=
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&ons=
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e8%ities=
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phsical 4oos=
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h%man 6ealth.
;H%man 6ealth he"e is a special concept of 6ealth an ma &e i4no"e fo" the p%"pose of o%" analsis.< Each metho of holin4 6ealth &"in4s some fo"m of "et%"n o" iel to the hole". ;a<
The iel f"om mone mi4ht incl%e some inte"est) s%ch as on &an- eposit acco%nts) &%t the main iel f"om mone is a con#enience iel. This is the con#enience of ha#in4 "ea
mone 6hen it is neee instea of ha#in4 to 4o to the &othe" of con#e"tin4 othe" assets into cash. The con#enience iel cannot &e meas%"e in mone te"ms. ;&<
9ons stan fo" fi2e5inte"est in#estments. The "et%"n on &ons is not ?%st the inte"est iel &%t also the capital 4ain o" loss as a conse8%ence of a chan4e in ma"-et inte"est "ates.
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E8%ities a"e financial assets 6hich sho%l p"o#ie a iel ;i#iens an capital 4"o6th< 6hich -eeps ahea of the "ate of inflation ie a "eal "et%"n to in#esto"s.
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Phsical assets a"e ho%ses) cons%me" %"a&les s%ch as f%"nit%"e) paintin4s etc. These a"e all phsical assets 6hich o not 6aste a6a th"o%4h %se ;&eca%se assets 6hich a"e cons%me cannot &e a sto"e of 6ealth<.
F"ieman a"4%e that the eman fo" mone is "elate to the eman fo" holin4 6ealth in its othe" fo"ms. Mone is a i"ect s%&stit%te fo" 6ealth in the fo"m of &ons) e8%ities o" phsical 4oos. In this "espect) he a"4%e a4ainst the :enesian #ie6 that holin4 mone is onl a s%&stit%te fo" holin4 financial assets ;&ons<. he"eas :enes &elie#e that if people i not 6ant to hol mone) the 6o%l in#est it to ea"n inte"est) moneta"ists &elie#e that people 6o%l possi&l in#est it to ea"n inte"est) &%t the mi4ht also %se it instea to &% e8%ities o" phsical assets. F"ieman a"4%e that mone 4i#es a con#enience iel &%t it is not an asset 6hich is hel fo" its o6n sa-e. It is a >tempo"a" a&oe of p%"chasin4 po6e"> 6aitin4 to &e spent on othe" tpes of financial o" phsical asset. The >po"tfolio> of assets hel & an pe"son sho%l &e a &alance &et6een mone) &ons) e8%ities an phsical assets) i.e. the f%ll "an4e of financial assets an phsical assets) so that the ma"4inal inte"est o" iel f"om the last L+ in#este in e#e" tpe of asset is the same. The eman fo" mone is the"efo"e a f%nction of the iel on mone an the iel on othe" fo"ms of holin4 6ealth. Remem&e") ho6e#e") that the iel as efine he"e incl%es non5 moneta" iel s%ch as con#enience an en?oment. Moneta"ists 6o%l a"4%e) f%"the") that the eman fo" mone is fai"l inte"est5elastic. The eman fo" mone is "elate to a t"ansactions moti#e) &%t not to an spec%lati#e moti#e. An e2pecte "ise in inte"est "ates mi4ht pe"s%ae ini#i%als to sell &ons an &% othe" assets) &%t not to hol spec%lati#e moneK Monetaists and the loana#le "unds theoy o" inteest ates
Acco"in4 to :enesians) the le#el of inte"est "ates is ete"mine & the inte"action of the eman fo" mone an the mone s%ppl. Moneta"ists isa4"ee1 afte" all) the hol the #ie6 that the "easons fo" emanin4 mone a"e fo" t"ansactions onl) not spec%lation a&o%t f%t%"e in#estment. Moneta"ists a"4%e instea that inte"est "ates a"e ete"mine & the eman an s%ppl of loana&le f%ns.
S
" e
D
Be
An inc"ease in the mone s%ppl) 6itho%t an inc"ease in eman fo" mone) 6ill inc"ease the amo%nt of loana&le f%ns a#aila&le. Inte"est "ates 6ill fall) an in#estment 6ill "ise. Monetaists' the tansmission and im#alan!es #et(een money supply and demand
So 6hat is the connection &et6een the eman fo" mone) the mone s%ppl an national income) acco"in4 to moneta"ists This can &e e2plaine & the t"ansmission mechanism. The t"ansmission mechanism esc"i&es the p"ocess 6he"e& an e2cess of mone eman o#e" mone s%ppl) o" an e2cess of mone s%ppl o#e" mone eman) ca%ses a chan4e in the a44"e4ate e2penit%"e in the econom ;i.e. a chan4e in national income<. Sta"tin4 f"om a position of e8%ili&"i%m holin4 of assets of all -ins) an inc"ease in the mone s%ppl 6o%l lea#e ini#i%als holin4 an e2cess of mone &alances. In o"e" to "esto"e the le#el of mone holin4s to its esi"e le#el) ini#i%als 6ill s%&stit%te assets of all -ins fo" mone) i.e. the eman fo" all commoities 6ill inc"ease) not ?%st eman fo" financial assets. ;a<
The inc"ease in the p"ice of financial assets means a fall in the "ate of inte"est. This 6ill not lea to an inc"ease in the eman fo" mone) acco"in4 to the moneta"ists) &eca%se the &elie#e that the eman fo" mone is inte"est5inelastic.
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The inc"ease in i"ect spenin4 on 4oos an se"#ices 6ill) ho6e#e") lea to a "ise in the le#el of mone national income.
9 ass%min4 that mone is a s%&stit%te fo" all assets) the moneta"ists concl%e that #a"iations in the mone s%ppl ha#e a 4"eat infl%ence on the le#el of national income. In te"ms of the 8%antit theo" of mone) if M 4oes %p) an M( PT) the"e 6ill &e an inc"ease in PT) &%t this co%l mean an inc"ease in eithe" "eal o%tp%t ;T< o" in p"ices an inflation ;P<. S%ppose that the eman fo" mone 4oes %p) &%t the a%tho"ities stop the mone s%ppl f"om inc"easin4) so that the"e is an e2cess eman fo" mone. The t"ansmission mechanism 6ill 6o"- the othe" 6a. Ho%sehols 6ill sell &ons) e8%ities an "e%ce cons%mption on othe" 4oos in o"e" to ac8%i"e mo"e mone. Inte"est "ates 6ill 4o %p. The"e 6ill &e a ecline in total spenin4 in the econom %ntil mone s%ppl an eman a"e a4ain in e8%ili&"i%m. Since M( PT) a ecline in PT 6ill ha#e one of t6o effects1 ;a<
if the econom is ope"atin4 &elo6 its f%ll emploment national income le#el) a ecline in T ;i.e. e#en less o%tp%t an so mo"e %nemploment<=
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if the econom has an inflationa" 4ap) a ecline in p ;i.e. inflation 6ill &e &"o%4ht %ne" cont"ol<.
Concl%sion. Fo" moneta"ists) chan4es in the mone s%ppl ca%se chan4es in national income. This cont"asts 6ith the :enesian #ie6 that chan4es in the mone s%ppl a"e ca%se & chan4es in national income) not #ice #e"sa. The monetaist vie( o" money supply and in"lation in the e!onomy
Moneta"ists a"4%e that since mone is a i"ect s%&stit%te fo" all othe" assets) an inc"ease in the mone s%ppl) 4i#en a fai"l sta&le #elocit of ci"c%lation) 6ill ha#e a i"ect effect on eman fo" othe" assets &eca%se the"e 6ill &e mo"e mone to spen on those assets. If the total o%tp%t of the econom is fi2e) then an inc"ease in the mone s%ppl 6ill lea i"ectl to hi4he" p"ices. Moneta"ists the"efo"e "each the same &asic concl%sion as the ol 8%antit theo" of mone. A "ise in the mone s%ppl 6ill lea to a "ise in p"ices an p"o&a&l also to a "ise in mone incomes. ;It is also
ass%me & moneta"ists that the #elocit of ci"c%lation "emains fai"l constant) a4ain ta-in4 a #ie6 simila" to the ol 8%antit theo".< In the sho"t "%n) moneta"ists a"4%e that an inc"ease in the mone s%ppl mi4ht ca%se some inc"ease in "eal o%tp%t an so an inc"ease in emploment. In the lon4 "%n) ho6e#e") all inc"eases in the mone s%ppl 6ill &e "eflecte in hi4he" p"ices %nless the"e is lon4e"5 te"m 4"o6th in the econom. 5ea,nesses in monetaist theoy
The"e a"e ce"tain complications 6ith the moneta"ist #ie6s. Fo" e2ample1 ;a<
the #elocit of ci"c%lation is -no6n to fl%ct%ate %p an o6n & small amo%nts=
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inc"eases in p"ices 6ill not affect all 4oos e8%all. Some 4oos 6ill "ise in p"ice mo"e than othe"s an so the "elati#e p"ice of 4oos 6ill chan4e. Fo" e2ample) the p"ice of ho%ses mi4ht e2cee the a#e"a4e "ate of inflation &%t the p"ice of elect"onic 4oos mi4ht "ise mo"e slo6l=
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a hi4he" "ate of inflation in one co%nt" than anothe" mi4ht affect the co%nt">s &alance of paments an c%""enc #al%e) the"e& int"o%cin4 complications fo" the econom f"om inte"national t"ae mo#ements=
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p"ices in the econom mi4ht ta-e some time to a?%st to an inc"ease in the mone s%ppl.
Ne#e"theless) moneta"ists 6o%l still a"4%e that inflation has &een a ma?o" p"o&lem fo" man national economies) incl%in4 that of the U:. Hi4h "ates of inflation a"e impossi&le 6itho%t a compa"a&le inc"ease in the mone s%ppl. an T cannot a?%st 8%ic-l eno%4h) 4i#en the ientit M( PT. Inflation cannot &e &"o%4ht %ne" cont"ol %nless the mone s%ppl is also cont"olle.
A comparison of the t%o vie%s 5hi!h vie( o" money is !oe!t9
:enesians an moneta"ists isa4"ee an one -e point of iffe"ence is the s%&stit%ta&ilit of mone fo" &ons) 6ith li8%iit p"efe"ence infl%ence & the "ate of inte"est on &ons. S%"el) the"efo"e) it is a simple matte" of testin4 empi"icall 6hethe" this is the case In othe" 6o"s) all 6e nee to o is to fin o%t 6hethe" the"e is a si4nificant statistical "elationship &et6een the 8%antit of mone an the "ate of inte"est. The"e mi4ht &e some p"actical iffic%lties in settin4 %p the test in the fi"st place) fo" e2ample efinin4 mone an efinin4 &ons) &%t this sho%l not &e &eon the &o%ns of possi&ilit. As o% mi4ht ima4ine) tests ha#e &een ca""ie o%t to fin o%t 6hethe" the i"ect "elationship &et6een mone s%ppl an inte"est "ates e2ists ;in 6hich case :enesians a"e co""ect< o" oes not ;in 6hich case moneta"ists a"e co""ect<. Unfo"t%natel) empi"ical tests ha#e not &een concl%si#e. A "elationship oes e2ist) &%t it is not ce"tain 6hethe" it is statisticall si4nificant o" not. @i#en the #ie6 of the moneta"ists that in the sho"t "%n inte"est "ates mi4ht fall 6hen the mone s%ppl is inc"ease) some fall in inte"est "ates afte" an inc"ease in the mone s%ppl 6o%l still &e consistent 6ith moneta"ist theo"K The :enesian #e"s%s moneta"ist a"4%ment is the"efo"e %n"esol#e. 9oth app"oaches a4"ee that1 ;a<
4"eat economic %nce"taint e2plains the hi4h cost of capital in "ecent ea"s=
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hi4h "ates of inflation a"e la"4el "esponsi&le fo" hi4h nominal inte"est "ates=
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4o#e"nment moneta" polic has some effect on the "ate of inflation an so on the cost of capital=
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altho%4h the ha#e iffe"ent #ie6s a&o%t >the spee an the mechanism & 6hich inte"est "ate a?%stments occ%") the"e is 4ene"al a4"eement that inte"est "ates a"e sometimes "athe" stic-.
Smooth a?%stment of inte"est "ates to chan4in4 economic conitions epens on the pa"ticipants in capital ma"-ets "eco4nisin4 the chan4es that a"e "e8%i"e>. ;ilson Committee< It is p"o&a&l also 4ene"all a4"ee that the inte"est "ate 6hich p"o%ces an e8%ili&"i%m &alance &et6een the s%ppl an eman fo" in#estment ;flo6 of f%ns app"oach< an the inte"est "ate 6hich &"in4s into &alance the s%ppl an eman fo" mone ;li8%iit p"efe"ence app"oach< 6ill ten to mo#e to6a"s each othe" an in the lon4e" te"m &ecome the same inte"est "ate an6a. The li8%iit p"efe"ence app"oach) ho6e#e") is pe"haps mo"e conce"ne 6ith sho"t te"m mo#ements in inte"est "ates.
Fis!al Poli!y
Your objectives
Afte" completin4 this chapte" o% sho%l1 ;a<
%ne"stan ho6 a 4o#e"nment can infl%ence the econom & mana4in4 the amo%nts it spens an the amo%nts it collects in ta2ation.
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%ne"stan ho6 a 4o#e"nment can %se ta2ation to p"omote its polic aims
$iscal policy" national income and demand manaement Intodu!tion
The 6o" >fisc> means the state t"eas%" o" the p%&lic p%"se. Fiscal polic "elates to matte"s conce"nin4 the state t"eas%". Mo"e specificall) fiscal polic is action & the 4o#e"nment to spen mone) o" to collect mone in ta2es) 6ith the p%"pose of infl%encin4 the conition of the national econom. Remem&e" that 4o#e"nment spenin4 is an in?ection into the econom) ain4 to a44"e4ate eman e2penit%"e national income) 6he"eas ta2es a"e a 6ith"a6al. A 4o#e"nment mi4ht inte"#ene in the econom &1 ;a<
spenin4 mo"e mone an financin4 this e2penit%"e & &o""o6in4=
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collectin4 mo"e in ta2es 6itho%t inc"easin4 p%&lic spenin4=
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collectin4 mo"e in ta2es in o"e" to inc"ease p%&lic spenin4) th%s i#e"tin4 income f"om one pa"t of the econom to anothe" .
Deman mana4ement) o% 6ill "emem&e") is a te"m %se to esc"i&e the economic polic of a 4o#e"nment 6hen it attempts to infl%ence the econom & chan4in4 a44"e4ate eman. Fiscal polic co%l &e %se as an inst"%ment of eman mana4ement. @o#e"nment spenin4 an ta2ation le#els co%l &e %se to eliminate an inflationa" 4ap o" eflationa" 4ap in the econom. A "e%ction in ta2ation 6o%l 4i#e ho%sehols a la"4e" income) an so omestic cons%mption ;C< 6o%l "ise1 con#e"sel) an inc"ease in ta2ation 6o%l "e%ce omestic cons%mption. E2t"a 4o#e"nment spenin4 ;@< sho%l c"eate a m%ltiplie" effect on national income) altho%4h p%&lic secto" spenin4 mi4ht >c"o6 o%t> p"i#ate secto" in#estment) &eca%se of hi4he" "ates of inte"est in the capital ma"-ets. E( AD AD LT
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An inc"ease in ta2ation & LT) 6itho%t an matchin4 inc"ease in 4o#e"nment e2penit%"e) 6o%l "e%ce the a44"e4ate e2penit%"e in the econom f"om AD + to AD, an so the mone #al%e of national income 6o%l fall f"om + to ,. This 6o%l "es%lt in eithe" a fall in "eal o%tp%t o" it 6o%l ampen inflationa" p"ess%"es. Simila"l) a "e%ction in ta2ation 6itho%t an "e%ction in 4o#e"nment spenin4 6o%l inc"ease the mone #al%e of national income. This 6o%l eithe" ca%se "eal o%tp%t to inc"ease) o" it 6o%l 4i#e a &oost to p"ice "ises an inflation. Thee elements o" pu#li! "inan!e
9"oal) the"e a"e th"ee elements in p%&lic finance. ;a<
E2penit%"e E2penit%"e & the 4o#e"nment) at a national an local le#el) has se#e"al p%"poses ;fo" e2ample) to f%n p%&lic se"#ices s%ch as a health se"#ice) o" to pa pensions an %nemploment &enefits<.
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Income E2penit%"e m%st &e finance) an the 4o#e"nment m%st ha#e income. Most 4o#e"nment income comes f"om ta2ation. Othe" income is o&taine f"om i"ect cha"4es to %se"s of 4o#e"nment se"#ices ;e.4. cha"4es to cons%me"s & nationalise in%st"ies) an National Health Se"#ice cha"4es<.
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9o""o6in4 To the e2tent that a 4o#e"nment>s e2penit%"e e2cees its income) it m%st &o""o6 to ma-e %p the iffe"ence. The amo%nt that the 4o#e"nment m%st &o""o6 each ea" is "efe""e to as the P%&lic Secto" 9o""o6in4 Re8%i"ement o" PS9R.
Ta$ation as a deteent to e!onomi! %o(th
Fiscal polic sho%l &e fo"m%late 6ithin the 4%ielines that1 ;a<
ta2es sho%l &e hi4h eno%4h to allo6 the 4o#e"nment to ca""on its f%nctions= &%t
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the sho%l not &e set so as to ete" p"i#ate in#estment an initiati#e.
Fis!al poli!y and ma!oe!onomi! o#;e!tives
Fiscal polic is conce"ne 6ith 4o#e"nment spenin4 an ta2ation. Refe" &ac- to the isc%ssion of the ci"c%la" flo6 of income if o% fin the follo6in4 analsis %nclea". ;a< If 4o#e"nment spenin4 is inc"ease) the"e 6ill &e an inc"ease in the amo%nt of in?ections) e2penit%"e in the econom 6ill "ise an so national income 6ill "ise ;eithe" in "eal te"ms) o" in te"ms of p"ice le#els onl= i.e. the inc"ease in national income mi4ht &e >"eal> o" inflationa"><. ;&< If 4o#e"nment ta2ation is inc"ease) the"e 6ill &e an inc"ease in 6ith"a6als f"om the econom) an e2penit%"e an national income 6ill fall. A 4o#e"nment mi4ht eli&e"atel "aise ta2ation to ta-e inflationa" p"ess%"es o%t of the econom. Achie#in4 4"o6th in national income 6itho%t inflation has &een a p"o&lem &ee#illin4 4o#e"nments fo" man ea"s. Ce"tainl) 4o#e"nment spenin4 an 4o#e"nment ta2ation policies can affect economic 4"o6th ;i.e. the national income le#el in "eal te"ms< &%t it can also stim%late f%"the" inflation. Fiscal polic can &e %se to "e%ce %nemploment an p"o#ie ?o&s. Fo" e2ample) mo"e 4o#e"nment spenin4 on capital p"o?ects 6o%l c"eate ?o&s in the const"%ction in%st"ies= lo6e" >emploment ta2es>
;s%ch as National Ins%"ance< 6o%l possi&l ma-e emploe"s mo"e 6illin4 to ta-e on e2t"a n%m&e"s of emploees. @o#e"nment spenin4 co%l ho6e#e" c"eate inflationa" p"ess%"es) an inflation tens to c"eate mo"e %nemploment. Fiscal polic m%st &e %se 6ith ca"e) e#en to c"eate ne6 ?o&s. 6ud%et suplus= #ud%et de"i!it= #alan!ed #ud%et
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It can inc"ease eman i"ectl & spenin4 mo"e itself;e.4. on the health se"#ice o" e%cation) an & emploin4 mo"e people itself<. ;i<
This e2t"a spenin4 co%l &e finance & hi4he" ta2es) &%t this 6o%l "e%ce spenin4 & the p"i#ate secto" of the econom &eca%se the p"i#ate secto">s afte"5ta2 income 6o%l &e lo6e".
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The e2t"a 4o#e"nment spenin4 co%l also &e finance & e2t"a 4o#e"nment &o""o6in4. Q%st as ini#i%als can &o""o6 mone fo" spenin4) so too can a 4o#e"nment.
It can inc"ease eman ini"ectl & "e%cin4 ta2ation an so allo6in4 fi"ms an ini#i%als mo"e afte"5ta2 income to spen ;o" sa#e<. ;i<
C%ts in ta2ation can &e matche & c%ts in 4o#e"nment spenin4) in 6hich case total eman in the econom 6ill not &e stim%late si4nificantl) if at all.
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Alte"nati#el) ta2 c%ts can &e >finance> & mo"e 4o#e"nment &o""o6in4.
Q%st as a44"e4ate eman in the econom can &e &ooste & eithe" mo"e 4o#e"nment spenin4 o" & ta2 c%ts) finance in eithe" case & a hi4he" PS9R) so too can eman in the econom &e "e%ce & c%ttin4 4o#e"nment spenin4 o" & "aisin4 ta2es) an %sin4 the sa#in4s o" hi4he" income to c%t 4o#e"nment &o""o6in4. E2penit%"e chan4es an ta2 chan4es a"e not m%t%all e2cl%si#e options) of co%"se. At the time of 6"itin4 ;A%4%st +''3<) the U: @o#e"nment is consie"in4 a pac-a4e of meas%"es) possi&l to incl%e ta2 inc"eases an "e%ce @o#e"nment spenin4) in o"e" to "e%ce the c%""ent hi4h PS9R. hen a 4o#e"nment>s income e2cees its e2penit%"e) an the"e is a ne4ati#e PS9R) i.e. a P%&lic Secto" De&t Repament o" >PSDR> 6e sa that the 4o#e"nment is "%nnin4 a &%4et s%"pl%s. hen a 4o#e"nment>s e2penit%"e e2cees its income) so that it m%st &o""o6 to ma-e %p the iffe"ence) the"e is a PS9R an 6e sa that the 4o#e"nment is "%nnin4 a &%4et eficit. hen a 4o#e"nment>s e2penit%"e an income a"e the same) so that the PS9R is nil) the"e is a &alance &%4et. Fis!al poli!y and the 6ud%et
A 4o#e"nment m%st plan 6hat it 6ants to spen) an so ho6 m%ch it nees to "aise in income o" & &o""o6in4. It nees to ma-e a plan in o"e" to esta&lish ho6 m%ch ta2ation the"e sho%l &e) 6hat fo"m the ta2es sho%l ta-e an so 6hich secto"s of societ ;fi"ms o" ho%sehols) the "ich o" the poo" etc< the mone sho%l come f"om. This fo"mal plannin4 of fiscal polic is %s%all one once a ea". ith effect f"om +''3) the ann%al 9%4et statement is to ta-e place in No#em&e" o" Decem&e") an 6ill incl%e the @o#e"nment>s plans fo" &oth spenin4 an ta2ation. This ann%al "e#ie6 of ta2ation means that a f%ll "e#ie6 of the 4o#e"nment>s fiscal polic can onl &e one once a ea". In &et6een 9%4ets) a 4o#e"nment m%st "eso"t to othe" non5 fiscal polic inst"%ments to cont"ol the econom) s%ch as infl%encin4 inte"est "ate le#els.
The National De#t
The National De&t is the amo%nt of e&t o6e & the cent"al 4o#e"nment of a co%nt" to its #a"io%s c"eito"s. C"eito"s ma &e nationals of the co%nt" ;e.4. in#esto"s in 4o#e"nment loan stoc-< o" fo"ei4n nationals ;pe"haps fo"ei4n &an-s o" e#en the Inte"national Moneta" F%n<. hen the National De&t is hi4h) inte"est "epaments 6ill acco%nt fo" a la"4e p"opo"tion of cent"al 4o#e"nment e2penit%"e. It is the"efo"e impo"tant that 6hen a 4o#e"nment &o""o6s mone) it sho%l &e in#este o" spent in s%ch a 6a as to ens%"e that s%fficient income is e#ent%all 4ene"ate to "epa the inte"est an e&t capital. If a 4o#e"nment is %na&le to o this ;as in the case of man e#elopin4 an less e#elope co%nt"ies at the moment< it 6ill lose its c"eit6o"thiness an fin f%t%"e loans m%ch ha"e" to come &. The a&ilit to "epa is p"o&a&l the ma?o" facto" in settin4 an effecti#e limit to the siGe of a national e&t. The National De&t e2ists in the fo"m of e&t >inst"%ments> 6hich consist of1 ;a<
ma"-eta&le e&t ;mainl lon45te"m e&t) 6hich consists of 4ilt5e4e sec%"ities) 6hich a"e sol to in#esto"s an t"ae on The Stoc- E2chan4e<= an
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non5ma"-eta&le e&t ;incl%in4 National Sa#in4s an an non5ma"-eta&le loans "aise & the 4o#e"nment<.
To se"#ice the National De&t) a 4o#e"nment m%st1 ;a<
pa inte"est on the e&t= an
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ma-e capital "epaments 6hen the fall %e
Ho6e#e") the p"o&lem of ma-in4 capital "epaments can &e o#e"come) if "e8%i"e) & ta-in4 o%t ne6 loans 6hen ol loans mat%"e ;e.4. to "epa a loan of L +77 million) a 4o#e"nment can &o""o6 a f%"the" L+77 million<. If the loan is o&taine f"om the p"i#ate secto" of the co%nt">s econom) the National De&t an se"#icin4 the e&t in#ol#e the t"ansfe" of f%ns &et6een iffe"ent sections of societ. hen the 4o#e"nment &o""o6s) it ta-es mone f"om one 4"o%p an spens it on othe" sections of societ. hen the 4o#e"nment pas inte"est) it 6ill "aise mone in ta2es f"om the "est of societ an pa this mone to its e&to"s. Once a4ain) this in#ol#es a t"ansfe" of the f%ns. The National De&t an se"#icin4 the National De&t th%s in#ol#e1 ;a<
a "eist"i&%tion of f%ns 6ithin societ) th"o%4h 4o#e"nment &o""o6in4 an spenin4) o" th"o%4h ta2ation to pa e&t inte"est=
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&o""o6in4 to spen >no6> an onl "epain4 the e&t 6ith inte"est >late">. In othe" 6o"s) societ &enefits no6) an the pament &%"en falls on societ in late" ea"s) pe"haps in some cases as lon4 as a 4ene"ation o" so late".
hen mone is &o""o6e f"om a&"oa) the flo6 of f%ns in o&tainin4 the mone an in "epain4 the e&t c"osses national &o%na"ies) an so the"e a"e implications fo" the &alance of paments an the e2chan4e "ate of the omestic c%""enc. Pu#li! e$penditue !ontol and the PS6R
The p%&lic secto" &o""o6in4 "e8%i"ement o" PS9R is the ann%al e2cess of spenin4 o#e" income fo" the enti"e p%&lic secto") not ?%st cent"al 4o#e"nment. If the enti"e p%&lic secto" ha a &alance &%4et) the PS9R 6o%l &e nil. hen the"e is an ann%al e2cess of income o#e" e2penit%"e) as the"e 6as in the U: a fe6 ea"s a4o) some of the National De&t can &e "epai an the"e is a P%&lic Secto" De&t Repament ;PSDR<.
@o#e"nment spenin4 on &oth "e#en%e an capital items has to &e finance & eithe"1 ;a<
ta2ation an othe" >c%""ent> "e#en%es= o"
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&o""o6in4.
:enesian economists a"4%e the nee fo" mo"e 4o#e"nment spenin4 in a "ecession to &oost eman in the econom an c"eate ?o&s. An a"4%ment p%t fo"6a" is that it ma-es so%n financial sense to %se c%""ent "e#en%es f"om ta2ation etc. to meet c%""ent e2penit%"es an inte"est paments on e&t) &%t to %se &o""o6in4 fo" capital e2penit%"e nees. Since ta2ation "e#en%e e2cees c%""ent spenin4) the a"4%ment concl%es that the 4o#e"nment sho%l &o""o6 mo"e fo" the capital spenin4. The U: 4o#e"nment "e?ecte this a"4%ment) an &elie#e that the %p6a" spi"al of p%&lic e2penit%"e has mae the &%"en of ta2ation on companies an ini#i%als intole"a&le. >The"e can &e no p"ospect of &"in4in4 the &%"en of ta2 &ac- to tole"a&le le#els 6itho%t fi"m cont"ol o#e" p%&lic e2penit%"e 4"o6th) & eciin4 fi"st 6hat can &e affo"e then settin4 plans fo" ini#i%al p"o4"ammes consistent 6ith that ecision.> ;The Chancello">s A%t%mn Statement) No#em&e" +'$3<. The cent"al 4o#e"nment in the U: has also &een 4"eatl conce"ne 6ith local a%tho"it spenin4) an its policies to cont"ol the 4"o6th of spenin4 ha#e "aise a ma?o" political sto"m &et6een the 4o#e"nment an opposition pa"ties) especiall in #ie6 of the la"4e n%m&e" of *a&o%"5cont"olle co%ncils.
Taxation policy and its effects Intodu!tion
The f%nctions of ta2ation incl%e the follo6in41 ;a<
to "aise "e#en%es fo" the 4o#e"nment. local a%tho"ities an simila" &oies ;e.4. the E%"opean Comm%nit<. The "e#en%es a"e %se to p"o#ie 4oos an se"#ices that the ma"-et econom eithe" oes not p"o#ie at all ;e.4. efence< o" 6ill not p"o#ie in s%fficient 8%antities ;e.4. e%cation< an to pa fo" the %p-eep of 4o#e"nment aminist"ation=
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to isco%"a4e ce"tain acti#ities "e4a"e as %nesi"a&le. The imposition of De#elopment *an Ta2 in the Unite :in4om in the mi5 0Os 6as pa"tiall in "esponse to the 6ell5p%&licise 4"o6th in p"ope"t spec%lation=
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to ca%se ce"tain p"o%cts to &e p"ice to ta-e into acco%nt thei" social costs. Fo" e2ample) smo-in4 entails ce"tain social costs) incl%in4 the cost of hospital ca"e fo" those s%ffe"in4 f"om smo-in45"elate iseases) an so the 4o#e"nment sees fit to ma-e the p"ice of to&acco "eflect these social costs=
;< to "eist"i&%te 6ealth. The hi4he" "ates of income ta2 %p to +'0' an capital t"ansfe" ta2 ;no6 "eplace & inhe"itance ta2< 6e"e esi4ne to t"ansfe" 6ealth f"om the &ette" off to the less 6ell off th"o%4h hi4he" social sec%"it &enefits. Some politicians fa#o%" a 6ealth ta2= ;e< to p"otect in%st"ies f"om fo"ei4n competition. If the 4o#e"nment le#ies a %t on all impo"te 4oos m%ch of the %t 6ill &e passe on to the cons%me" in the fB"m of hi4he" p"ices) ma-in4 impo"te 4oos mo"e e2pensi#e. This has the effect of t"ansfe""in4 a ce"tain amo%nt of eman f"om impo"te 4oos to omesticall p"o%ce 4oos= ;f< to p"o#ie a sta&ilisin4 effect on national income. Ta2ation "e%ces the effect of the m%ltiplie") an so can &e %se to ampen %ps6in4s in a t"ae ccle 5ie hi4he" ta2ation 6hen the econom sho6s si4ns of a &oom 6ill slo6 o6n the 4"o6th of mone @NP) an so ta-e some inflationa" p"ess%"es o%t of the econom.
Ta2ation can &e %se to achie#e the same p%"poses as 4o#e"nment e2penit%"e. In aition) it can &e %se to affect pa"tic%la" secto"s of the econom. Fo" e2ample) ta2es on 6ealth) capital an income a"e potentiall effecti#e tools fo" "eist"i&%tion of 6ealth. 1ualities o" a %ood ta$
Aam Smith in his ealth of nations ;+00< asc"i&e fo%" feat%"es to a 4oo ta2 sstem. ;a<
Pe"sons sho%l pa acco"in4 to thei" a&ilit.
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The ta2 sho%l &e >ce"tain> an easil %ne"stoo & all conce"ne.
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The pament of ta2 sho%l ieall &e "elate to ho6 an 6hen people "ecei#e an spen thei" income ;e.4. PA (E is e%cte 6hen 6a4es a"e pai) an AT is cha"4e 6hen 4oos a"e &o%4ht<.
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The cost of collection sho%l &e small "elati#e to the iel ;& this c"ite"ion) the ca" "oa ta2 is an inefficient ta2<.
Re4"essi#e) p"opo"tional an p"o4"essi#e ta2ation ma &e istin4%ishe. ;a<
A "e4"essi#e ta2 ta-es a hi4he" p"opo"tion of a poo" pe"son>s sala" than of a "ich pe"son>s. Tele#ision licences an "oa ta2 a"e e2amples of a "e4"essi#e ta2 since the a"e the same fo" people of all 6ealth classes. A poll ta2 o" comm%nit cha"4e is also a "e4"essi#e ta2 &eca%se it ta-es a 4"eate" p"opo"tion of the income of a poo" pe"son than a "ich pe"son) e#en tho%4h ini#i%al cha"4es can #a" f"om one local a%tho"it to anothe") an in spite of some "e&ates fo" the least 6ell5off 4"o%ps.
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A p"opo"tional ta2 ta-es the same p"opo"tion of income in ta2 f"om all le#els of income. Sche%le E income ta2 6ith a &asic of ta2 at ,! is p"opo"tional ta2) &%t onl 6ithin a limite "an4e of income.
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A p"o4"essi#e ta2 ta-es a hi4he" p"opo"tion of income in ta2 as income "ises. Income ta2 as a 6hole is p"o4"essi#e) since the fi"st pa"t of an ini#i%al>s income is ta2 f"ee %e to pe"sonal allo6ances an the "ate of ta2 inc"eases in steps f"om ,7p in LI to /7p in LI as ta2a&le income "ises.
Advanta%es o" po%essive ta$ation
The"e a"e se#e"al a"4%ments in fa#o%" of p"o4"essi#e ta2es. ;a<
The a"e le#ie acco"in4 to the a&ilit of ini#i%als to pa. Ini#i%als 6ith a hi4he" income a"e mo"e a&le to affo" to 4i#e %p mo"e of thei" income in ta2 than lo6 income ea"ne"s) 6ho nee a 4"eate" p"opo"tion of thei" ea"nin4s fo" the &asic necessities of life. If ta2es a"e to &e "aise acco"in4 to the a&ilit of people to pa ;6hich is one of the feat%"es of a 4oo ta2 s%44este & Aam Smith< then the"e m%st &e some p"o4"essi#eness in them.
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P"o4"essi#e ta2es ena&le a 4o#e"nment to "eist"i&%te 6ealth f"om the "ich to the poo" in societ. It is li-el that the"e 6ill &e little "eist"i&%tion of 6ealth amon4 the mile5income "an4es of societ) &%t the"e sho%l &e some "eist"i&%tion of 6ealth f"om the "ichest mem&e"s of societ to the poo"est. S%ch a "eist"i&%tion of 6ealth mi4ht &e "e4a"e as a matte" of social ?%stice &%t it 6ill also alte" the cons%mption patte"ns in societ since the poo"e" mem&e"s 6ill spen thei" ea"nin4s an social sec%"it &enefits on iffe"ent tpes of 4oos than if the income ha "emaine in the hans of the "iche" people.
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Ini"ect ta2es ;e.4. ta2es on e2penit%"e< ten to &e "e4"essi#e an p"o4"essi#e ta2es a"e neee to co%nte"&alance "e4"essi#e ta2es in the ta2 sstem) an so ma-e the ta2 sstem as a 6hole mo"e fai" .
The disadvanta%es o" po%essive ta$ation
The"e a"e some a"4%ments a4ainst p"o4"essi#e ta2es. ;a<
Some 6o%l a"4%e that in an affl%ent societ the"e is less nee fo" p"o4"essi#e ta2es than in a poo"e" societ) an the"e is less nee to "eist"i&%te 6ealth f"om the #e" 6ealth to the fai"l 6ell5to5o.
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hen p"o4"essi#e ta2es a"e ha"sh) an eithe" ta2 hi4h income ea"ne"s at #e" hi4h "ates on ma"4inal income) o" ta2 the 6ealth at hi4h "ates on thei" 6ealth) it is a"4%e & some that the 6ill act as a ete""ent to initiati#e.
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It is also sometimes a"4%e that ini#i%als an fi"ms s%ffe"in4 f"om hi4h ta2es mi4ht t"1 ;i<
to fin loopholes so as to a#oi pain4 ta2 ;e.4. non5ta2a&le pe"-s<=
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to e#ae ta2es) i.e. 6ithhol info"mation a&o%t thei" income o" 6ealth f"om the a%tho"ities=
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to t"ansfe" thei" 6ealth to othe" co%nt"ies) o" esta&lish companies in ta2 ha#ens 6he"e co"po"ate ta2 "ates a"e lo6.
9%t of co%"se some people 6ill t" to a#oi o" e#ae ta2 6hethe" it is hi4h o" not so hi4h. Advanta%es and disadvanta%es o" a popotional ta$
The a#anta4e of a ta2 6hich is p"opo"tional to income is p"ima"il that of fai"ness. The isa#anta4es of a p"opo"tional ta2 a"e` ;a<
the la"4e aminist"ati#e sstem neee to calc%late pe"sonal ta2 lia&ilities on a p"opo"tional &asis. Income ta2) fo" e2ample) can &e a costl ta2 to collect 6he"e ini#i%als ;especiall self5emploe people< "e8%i"e etaile ta2 assessments=
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the ta2 "%les ma nee to &e 8%ite comple2 in o"e" to &e p"opo"tional=
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the o not cont"i&%te to6a"s a "eist"i&%tion of 6ealth amon4 the pop%lation.
Advanta%es and disadvanta%es o" a e%essive ta$
The main isa#anta4e of a "e4"essi#e ta2 is that it is not e8%ita&le) &eca%se a 4"eate" ta2 &%"en falls on those least a&le to affo" it. An a#anta4e of a "e4"essi#e ta2 is that it can &e "elati#el eas to aministe" an collect. Ho6e#e") a "e4"essi#e ta2 co%l also &e e2pensi#e to collect. A"4%ments a4ainst a poll ta2 ;comm%nit cha"4e< in the U: ha#e &een that it is &oth "e4"essi#e ;an so %nfai"< an also e2pensi#e to aministe" . Die!t and indie!t ta$es
A i"ect ta2 is pai i"ect & a pe"son to the Re#en%e a%tho"it. E2amples of i"ect ta2es in the U: a"e income ta2) co"po"ation ta2) capital 4ains ta2 an inhe"itance ta2. A i"ect ta2 can &e le#ie on income an p"ofits) o" on 6ealth. Di"ect ta2es ten to &e p"o4"essi#e o" p"opo"tional ta2es. The a"e also %s%all %na#oia&le) 6hich means that the m%st &e pai & e#e"one. An ini"ect ta2 is collecte & the Re#en%e a%tho"it ;e.4. C%stoms E2cise< f"om an inte"meia" ;e.4. a s%pplie"< 6ho then passes on the ta2 to cons%me"s in the p"ice of 4oos the sell. Ini"ect ta2es incl%e A T ) e2cise %t on spi"its an &ee") an c%stoms %ties on 4oos impo"te f"om co%nt"ies o%tsie the Common Ma"-et. Ini"ect ta2es ten to &e "e4"essi#e ;%nless the a"e cha"4e e2cl%si#el on l%2%" items<. The a"e also %s%all a#oia&le) 6hich means that people can choose not to pa the ta2) & not &%in4 the 4oos o" se"#ices on 6hich the ta2 is le#ie.
Die!t ta$ation. advanta%es and disadvanta%es
The main a#anta4es of i"ect ta2es on income a"e that the a"e fai" an e8%ita&le &eca%se the a"e %s%all p"o4"essi#e o" p"opo"tional ta2es. The can &e le#ie acco"in4 to a&ilit to pa. 9eca%se of thei" 4ene"all p"o4"essi#e nat%"e the also ten to sta&ilise the econom) a%tomaticall ta-in4 mo"e mone o%t of the sstem %"in4 a &oom an less %"in4 ep"ession. Mo"eo#e") &eca%se the a"e mo"e iffic%lt to pass on) the a"e less inflationa" than ini"ect ta2es. Ta2pae"s also -no6 6hat thei" ta2 lia&ilit is. Ho6e#e") ta2es on income a"e often c"iticise fo" ca%sin4 ha"mf%l isto"tions) especiall on incenti#es to 6o"-. 9%t as al"ea inicate) empi"ical "esea"ch is not concl%si#e on this matte". Hi4h ma"4inal "ates of ta2 ma enco%"a4e ta2 a#oiance ;i.e. finin4 le4al loopholes in the ta2 "%les so as to a#oi pain4 ta2<. In 9"itain) this le to a 4"o6th of ma-in4 income paments5in5-in & 6a of f"in4e &enefits) fo" e2ample) f"ee meical an life ins%"ance) p"efe"ential loans an fa#o%"a&le pension "i4hts. The 4o#e"nment has "espone to this & &"in4in4 an inc"easin4 n%m&e" of f"in4e &enefits into the ta2 net ;fo" e2ample) the p"i#ate %se of a compan ca"<. A i"ect ta2 on p"ofits is li-el to act as a isincenti#e to "is-5ta-in4 an ente"p"ise. The ta2 6ill "e%ce the net "et%"n f"om a ne6 in#estment an an isincenti#e effects 6ill &e 4"eate" 6hen the ta2 is p"o4"essi#e. In aition) a ta2 on p"ofits 6ill "e%ce the a&ilit to in#est. A consie"a&le pa"t of the finance fo" ne6 in#estment comes f"om "etaine p"ofits so an ta2 on co"po"ate p"ofits 6ill "e%ce the a&ilit of fi"ms to sa#e an the"efo"e limit the so%"ces of f%ns fo" in#estment. Indie!t ta$ation. advanta%es and disadvanta%es
Ini"ect ta2es a"e >hien> in the sense that the ta2pae" is la"4el %na6a"e of the amo%nt of ta2 he is pain4 ;e.4. the ta2 on &ee" an spi"its<. This has consie"a&le a#anta4es f"om the 4o#e"nment>s point of #ie6. Ini"ect ta2es a"e 4ene"all mo"e iffic%lt to e#ae than i"ect ta2es It is sometimes a"4%e that ini"ect ta2es a"e p"efe"a&le to i"ect ta2es in that the lea#e the ini#i%al 6ith a choice of not pain4 the ta2 & not cons%min4 the ta2e commoit. Ini"ect ta2ation can &e %se to enco%"a4e o" isco%"a4e the p"o%ction o" cons%mption of pa"tic%la" 4oos an se"#ices an ma hence affect the allocation of "eso%"ces. Fo" e2ample) the p"o%ction of 4oos that p"o%ce en#i"onmental poll%tion ma &e ta2e as a means of "aisin4 the p"ice in o"e" to "e%ce eman an o%tp%t. Simila"l ) the cons%mption of ci4a"ettes can &e isco%"a4e & hi4h ini"ect ta2ation. The cons%mption of impo"te 4oos can &e isco%"a4e & hi4h impo"t %ties) 6hich a to thei" p"ice in omestic ma"-ets. Ini"ect ta2ation is a fle2i&le inst"%ment of economic polic. The "ates of ini"ect ta2es ma &e chan4e 8%ic-l an easil an can ta-e effect immeiatel. Fo" e2ample) if the Chancello" 6ishe to &oost a44"e4ate eman in the econom he co%l "e%ce "ates of ini"ect ta2ation an this 6o%l ha#e a "api effect on p"i#ate cons%mption. Ini"ect ta2es o ha#e isa#anta4es ho6e#e" ;a<
The can &e inflationa". In the U:) a s6itch f"om i"ect ta2 to ini"ect ta2 in the &%4et of +'0') 6hen A T "ates 6e"e inc"ease) "es%lte in a la"4e inc"ease in the "epo"te "ate of inflation. This is) ho6e#e") la"4el a one5off effect.
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As al"ea state) ini"ect ta2es ten to &e "e4"essi#e)
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Ini"ect ta2es a"e not impa"tial in thei" application in othe" 6as. Fo" e2ample) someone 6ho see-s to "ela2 6ith a ci4a"ette in a p%& is 4oin4 to &e m%ch mo"e hea#il hit & ini"ect ta2es than someone 6ho li-es 6al-in4 an "eain4.
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The isincenti#e effects of ini"ect ta2es a"e often claime to &e less than those of i"ect ta2es) la"4el &eca%se ini"ect ta2es a"e not as #isi&le as i"ect ta2es an a"e the"efo"e less li-el to &e ta-en into acco%nt in ecision5ma-in4.
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As 6e sa6 in an ea"lie" chapte") fi"ms 6ill ma2imise thei" p"ofits at a lo6e" #ol%me of o%tp%t than if the"e 6e"e no ta2es.
The in!iden!e o" ta$ation
The incience of a ta2 is the ist"i&%tion of the ta2 &%"en. A ta2>s fo"mal incience can &e istin4%ishe f"om its act%al incience. ;a<
In the case of income ta2) fo"mal an act%al incience a"e the same %nless 6o"-e"s ne4otiate a hi4he" post5ta2 6a4e) in 6hich case emploe"s &ea" some of the ta2 &%"en. Emploe"s mi4ht then "aise thei" p"o%ct p"ice an pass some of the ta2 &%"en on to cons%me"s.
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Co"po"ation ta2 falls fo"mall on p"ofits an so on sha"ehole"s= &%t the ta2 co%l &e passe fo"6a" to cons%me"s in the fo"m of a p"ice "ise follo6in4 on a "e%ction in s%ppl an the act%al incience of the ta2 6o%l then fall on the cons%me"s.
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Acco"in4 to economic theo") p"o%ce"s 6ill not pass the &%"en of a p"ofit ta2 on to cons%me"s &eca%se the a"e al"ea p"o%cin4 at a p"ofit5ma2imisin4 le#el of o%tp%t an the ma"4inal conition MR MC is not affecte & a ta2. Ho6e#e") it mi4ht &e mo"e pla%si&le to s%ppose that p"o%ce"s 6o%l "e4a" the ta2 as an aitional cost) in 6hich case it 6o%l ?%stif a "e%ction in o%tp%t an "ise in p"ice. The cons%me"s 6o%l in this case &ea" some of the &%"en.
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A 4ene"al ini"ect ta2 on all 4oos 6o%l &e &o"ne f%ll & cons%me"s) since the cannot &% alte"nati#e 4oos 6hich a"e not ta2e. A T is the closest e8%i#alent to a 4ene"al ini"ect ta2 in 9"itain. Onl necessities a"e e2empt f"om A T o" Ge"o5"ate) e4 foo) f%el an po6e" ;fo" the time &ein4<) t"anspo"t) health se"#ices 5an &oo-sK
Ta$ation and the edisti#ution o" (ealth
Anothe" aspect of ta2ation is the e2tent to 6hich it can &e %se to "eist"i&%te 6ealth) an the conse8%ences this 6o%l ha#e fo" economic acti#it. S%ppose) fo" e2ample) that a co%nt" has no ta2ation) an most national income is ea"ne & a #e" small an 6ealth p"opo"tion of the pop%lation. The e2penit%"e patte"n 6ithin the co%nt" 6o%l p"o&a&l &e1 ;a<
fai"l s%&stantial spenin4 & the 6ealth fe6 on l%2%" 4oos an specialist se"#ices ;e4 omestic se"#ants<=
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s%&stantial spenin4 & the poo" ma?o"it on cheap &asic necessities fo" li#in4) s%ch as simple foo an cheap clothin4.
No6 s%ppose that a p"o4"essi#e income ta2 is impose) 6hich s%ccessf%ll "eist"i&%tes 6ealth amon4 the pop%lation) so that 4ene"al income le#els "ise. The "es%lt sho%l &e a 4ene"al "ise in li#in4 stana"s) 6ith1 ;a<
4"eate" eman fo" some items= an
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some s6itch in eman f"om cheap 4oos to &ette" 8%alit) mo"e e2pensi#e s%&stit%tes.
Intenational Tade
(o%" o&?ecti#es Afte" completin4 this chapte" o% sho%l> ;a< %ne"stan the theo" of compa"ati#e a#anta4e an its implications fo" the e#elopment of inte"national t"ae= ;&< %ne"stan the -ins of "est"ictions 6hich ma &e applie to the f"ee mo#ement of inte"national t"ae) an the "easons fo" an a4ainst aoptin4 s%ch meas%"es.
Absolute and comparative advantae Reasons "o intenational tade
In the moe"n econom) p"o%ction is &ase on a hi4h e4"ee of specialisation. ithin a co%nt" ini#i%als specialise) facto"ies specialise an 6hole "e4ions specialise. Specialisation inc"eases p"o%cti#it an "aises the stana" of li#in4. Inte"national t"ae e2tens the p"inciple of the i#ision of la&o%" an specialisation to co%nt"ies. Inte"national t"ae o"i4inate on the &asis of nations e2chan4in4 thei" p"o%cts fo" othe"s 6hich the co%l not p"o%ce fo" themsel#es. 9"itain fo" e2ample impo"ts tea an coffee an e2po"ts oil to non5oil p"o%cin4 co%nt"ies. Inte"national t"ae a"ises fo" a n%m&e" of "easons) ;a<
Diffe"ent 4oos "e8%i"e iffe"ent p"opo"tions of facto" inp%ts in thei" p"o%ction)
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Economic "eso%"ces a"e %ne#enl ist"i&%te th"o%4ho%t the 6o"l.
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The inte"national mo&ilit of "eso%"ces is e2t"emel limite.
Since it is iffic%lt to mo#e "eso%"ces &et6een nations) the 4oos 6hich >em&o> the "eso%"ces m%st mo#e. Hence nations 6hich ha#e an a&%nance of lan "elati#e to la&o%" 6ill concent"ate on lan intensi#e commoities s%ch as a4"ic%lt%"al p"o%cts. These 6ill &e e2chan4e fo" >la&o%"5intensi#e> p"o%cts s%ch as man%fact%"e 4oos mae & co%nt"ies 6hich ha#e an a&%nance of la&o%" an capital "elati#e to lan. The main "eason fo" t"ae the"efo"e is that the"e a"e iffe"ences in the "elati#e efficienc 6ith 6hich iffe"ent co%nt"ies can p"o%ce iffe"ent 4oos an se"#ices. Economists istin4%ish the concepts of compa"ati#e a#anta4e an a&sol%te a#anta4e. To e2plain this istinction 6e ma-e the follo6in4 ass%mptions in 6hat follo6s. ;a<
The"e a"e onl t6o co%nt"ies) co%nt" an co%nt"
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Onl t6o 4oos a"e p"o%ce) lo""ies an 6heat.
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The"e a"e no t"anspo"t costs an no &a""ie"s to t"ae.
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Reso%"ces 6ithin each co%nt" a"e easil t"ansfe""e f"om one in%st" to anothe".
A#solute advanta%e
A co%nt" is sai to ha#e an a&sol%te a#anta4e in the p"o%ction of a 4oo 6hen it is mo"e efficient than anothe" co%nt" in the p"o%ction of that 4oo) i.e. 6hen it can p"o%ce mo"e of a pa"tic%la" 4oo 6ith a 4i#en amo%nt of "eso%"ces than anothe" co%nt". It is a common sit%ation fo" one co%nt" to &e mo"e efficient than anothe" in the p"o%ction of a pa"tic%la" 4oo.
Ass%min4 that p"o%ces 6heat mo"e efficientl than co%nt" ) 6hile co%nt" has an a&sol%te a#anta4e in p"o%cin4 lo""ies) a simple a"ithmetical e2ample can ill%st"ate the potential 4ains f"om t"ae. The ta&le &elo6 sho6s the amo%nts of lo""ies an 6heat that each co%nt" can p"o%ce) ass%min4 that each co%nt" has an e8%al 8%antit of "eso%"ces an e#otes half of its "eso%"ces to lo"" p"o%ction an half to 6heat p"o%ction.
Co%nt" Co%nt" ( o"l total
Lorries ,7 +7 37
$heat *tons, +77 +!7 ,!7
The "elati#e o" compa"ati#e cost of lo"" p"o%ction is lo6e" in co%nt" than co%nt" () &%t the sit%ation is "e#e"se in the case of 6heat p"o%ction. Co%nt" has an a&sol%te a#anta4e in lo"" p"o%ction an co%nt" has an a&sol%te a#anta4e in 6heat p"o%ction. @"eate" specialisation 6ill) ho6e#e") inc"ease total o%tp%t of &oth lo""ies an 6heat. In o"e" to o&tain the &enefits of specialisation these co%nt"ies m%st e2chan4e some pa"t of thei" ini#i%al o%tp%ts. It is not possi&le to specif the e2act "ate of e2chan4e &%t the limits of the e2chan4e "ate m%st &e some6he"e &et6een the omestic oppo"t%nit cost "atios of the t6o co%nt"ies. One co%nt" 6ill not &enefit f"om inte"national t"ae if the e2chan4e "ate is not &et6een these "atios. Compaative advanta%e
hen t6o co%nt"ies p"o%ce the same t6o 4oos) as in the e2ample a&o#e) an each has an a&sol%te a#anta4e in the p"o%ction of one 4oo) then it is eas to sho6 that specialisation 6ill lea to an inc"ease in thei" com&ine o%tp%t. Specialisation an t"ae can still &e m%t%all a#anta4eo%s) ho6e#e") e#en if one co%nt" has an a&sol%te a#anta4e in the p"o%ction of &oth 4oos. This 6ill &e the case if each co%nt" has a compa"ati#e a#anta4e in the p"o%ction of one 4oo. This is s%mme %p in the la6 of compa"ati#e a#anta4e ;o" compa"ati#e costs< 6hich states that t6o co%nt"ies can 4ain f"om t"ae 6hen each concent"ates on the p"o%ction of that 4oo in 6hich it has 4"eatest compa"ati#e a#anta4e. Compa"ati#e cost "elates to the oppo"t%nit costs of p"o%cin4 the 4oos an not the a&sol%te costs. The p"inciple of compa"ati#e costs can &e sho6n & an a"ithmetical e2ample. It is no6 ass%me that co%nt" is mo"e efficient in the p"o%ction of &oth lo""ies an 6heat. If each co%nt" e#otes half its "eso%"ces to each in%st" the ass%me p"o%ction totals a"e sho6n &elo6.
Co%nt" Co%nt" ( o"l total
Lorries ,7 +7 37
$heat *tons, ,77 +!7 3!7
In te"ms of "eso%"ces %se) the costs of p"o%ction in &oth in%st"ies a"e lo6e" in co%nt" . If 6e consie" the oppo"t%nit costs) ho6e#e") the pict%"e is "athe" iffe"ent. In co%nt" the >cost> of one lo"" is ten tons of 6heat) i.e. in e#otin4 "eso%"ces to the p"o%ction of one lo"" in co%nt" the"e is a sac"ifice in te"ms of ten tons of 6heat fo"4one. The oppo"t%nit cost of one lo"" in co%nt" is fifteen tons of 6heat. Co%nt" the"efo"e has a compa"ati#e a#anta4e in the p"o%ction of lo""ies. In co%nt" the cost of a ton of 6heat is ++7 of a lo"") 6hile in co%nt" the cost is ++! of a lo"". In te"ms of the o%tp%t of lo""ies fo"4one) 6heat is cheape" in co%nt" than in co%nt" 2. Co%nt" has a compa"ati#e a#anta4e in 6heat. If each co%nt" completel specialises in the p"o%ction of the 4oo 6he"e it has a compa"ati#e a#anta4e) the fi4%"es &elo6 sho6 that total o%tp%t of lo""ies inc"eases) &%t the total o%tp%t of 6heat falls.
Co%nt" Co%nt" ( o"l total
Lorries $heat *tons, /7 7 7 377 /7 377
The fi4%"es a&o#e sho6 that the 6o"l total of lo"" p"o%ction has "isen & ten lo""ies &%t that the 6o"l p"o%ction of 6heat has fallen & fift tons. It is possi&le to sho6 that the inc"ease in the o%tp%t of lo""ies) in #al%e te"ms) mo"e than offsets the fall in the o%tp%t of 6heat. This is not necessa") ho6e#e") &eca%se & onl pa"tiall specialisin4 in the mo"e efficient co%nt" 5co%nt" 5it is possi&le to ha#e mo"e of &oth commoities. Total o%tp%t of &oth 4oos is 4"eate" than that 6hich 6as o&taine 6hen &oth co%nt"ies 6e"e p"o%cin4 onl fo" omestic cons%mption. Since the oppo"t%nit cost "atios a"e iffe"ent in the t6o co%nt"ies) &eneficial t"ae is possi&le. If the oppo"t%nit cost "atios 6e"e the same in the t6o co%nt"ies) the co%nt"ies 6o%l not &enefit f"om specialisation an inte"national t"ae. @ene"alisin4 f"om this e2ample) 6e can state the la6 of compa"ati#e a#anta4e1 Each co%nt" sho%l e2po"t 4oos in 6hich it has a compa"ati#e cost a#anta4e. In the e2ample a&o#e 6e ha#e ass%me that t"anspo"t costs fo" inte"national t"ae a"e ne4li4i&le. Hi4h t"anspo"t costs) ho6e#e") can ne4ate the a#anta4es of specialisation an inte"national t"ae. Does the la( apply in pa!ti!e9
The la6 of compa"ati#e a#anta4e oes appl in p"actice) an co%nt"ies o specialise in the p"o%ction of ce"tain 4oos. Ho6e#e") the"e a"e ce"tain limitations o" "est"ictions on ho6 it ope"ates. ;a<
F"ee t"ae oes not al6as e2ist. Some co%nt"ies ta-e action to p"otect omestic in%st"ies an isco%"a4e impo"ts. This means that a co%nt" mi4ht p"o%ce 4oos in 6hich it oes not ha#e a compa"ati#e a#anta4e.
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T"anspo"t costs can &e #e" hi4h in inte"national t"ae so that it is cheape" to p"o%ce 4oos in the home co%nt" "athe" than to impo"t them.
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Co%nt"ies mi4ht p"o%ce simila" 4oos) &%t 4i#e them s%fficientl %ni8%e cha"acte"istics to ma-e them competiti#e in an co%nt" of the 6o"l. Fo" e2ample) companies in F"ance) Ital) Spain) @e"man an the U: all man%fact%"e ca"s) &%t the"e a"e s%fficient #a"ieties of esi4n that each co%nt" can e2po"t its o6n ca"s to the othe" co%nt"ies. Fo" e2ample) the U: impo"ts Fiats) ol-s6a4ens an Cit"oens) &%t e2po"ts Ro#e" ca"s to othe" EC co%nt"ies.
$ree trade and its advantaes The main advanta%es
The la6 of compa"ati#e a#anta4e states pe"haps the ma?o" a#anta4e of enco%"a4in4 inte"national t"ae. Ho6e#e") the"e a"e othe" a#anta4es to the co%nt"ies of the 6o"l f"om enco%"a4in4 inte"national t"ae. These a"e as follo6s. ;a<
Some co%nt"ies ha#e a s%"pl%s of "a6 mate"ials to thei" nees) an othe"s ha#e a eficit. A co%nt" 6ith a s%"pl%s ;e.4. of oil< can ta-e a#anta4e of its "eso%"ces to e2po"t them. A co%nt" 6ith a eficit of a "a6 mate"ial m%st eithe" impo"t it) o" accept "est"ictions on its economic p"ospe"it an stana" of li#in4.
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Inte"national t"ae inc"eases competition amon4st s%pplie"s in the 6o"l>s ma"-ets.
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@"eate" competition "e%ces the li-elihoo of a ma"-et fo" a 4oo in a co%nt" &ein4 ominate & a monopolist. The 4"eate" competition 6ill fo"ce fi"ms to &e competiti#e an so 6ill inc"ease the p"ess%"es on them to &e efficient) an also pe"haps to p"o%ce 4oos of a hi4h 8%alit.
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Inte"national t"ae c"eates la"4e" ma"-ets fo" a fi"m>s o%tp%t) an so some fi"ms can &enefit f"om economies of scale & en4a4in4 in e2po"t acti#ities. Economies of scale imp"o#e the efficienc of the %se of "eso%"ces) "e%ce the o%tp%t costs an also inc"ease the li-elihoo of o%tp%t &ein4 sol to the cons%me" at lo6e" p"ices than if inte"national t"ae i not e2ist.
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The"e a"e political a#anta4es to inte"national t"ae) &eca%se the e#elopment of t"ain4 lin-s p"o#ies a fo%nation fo" close" political lin-s. An e2ample of the e#elopment of political lin-s &ase on t"ae is the E%"opean Comm%nit.
Fee movement o" !apital
F"ee t"ae is associate 6ith the f"ee mo#ement of 4oos ;an se"#ices< &et6een co%nt"ies. Anothe" impo"tant aspect of inte"national t"ae is the f"ee mo#ement of capital. ;a<
If a U: compan o" in#esto" 6ishes to set %p a &%siness in a iffe"ent co%nt") o" to ta-e o#e" a compan in anothe" co%nt") ho6 easil can it t"ansfe" capital f"om the U: to the co%nt" in 8%estion) to pa fo" the in#estment
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Simila"l) if a Qapanese compan 6ishes to in#est in the U:) ho6 easil can it t"ansfe" f%ns o%t of Qapan an into the U: to pa fo" the in#estment
Some co%nt"ies ;incl%in4 the U: in "ecent ea"s< ha#e allo6e a fai"l f"ee flo6 of capital into an o%t of the co%nt". Othe" co%nt"ies ha#e &een mo"e ca%tio%s) mainl fo" one of t6o "easons. ;a<
The f"ee inflo6 of fo"ei4n capital 6ill ma-e it easie" fo" fo"ei4n companies to ta-e o#e" omestic companies. The"e is often a &elief that ce"tain >-e> in%st"ies sho%l &e o6ne & "esients of the co%nt". E#en in the U:) fo" e2ample) the"e a"e "est"ictions on the total fo"ei4n o6ne"ship of sha"es in companies s%ch as 9"itish Ae"ospace an Rolls Roce.
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*ess e#elope co%nt"ies especiall) &%t othe" mo"e a#ance economies too) a"e "el%ctant to allo6 the f"ee flo6 of capital o%t of the co%nt". Afte" all) the nee capital to come into the co%nt" to e#elop the omestic econom.
Fo" co%nt"ies 6ith a la"4e an contin%in4 &alance of t"ae eficit) s%ch as the U: an the USA) it is essential that capital sho%l come into the co%nt" to finance the eficit. The &alance of paments is isc%sse in etail in the ne2t chapte".
$ree trade and protection Intodu!tion
F"ee t"ae e2ists 6he"e the"e is no "est"iction on impo"ts f"om othe" co%nt"ies o" e2po"ts to othe" co%nt"ies. In p"actice) ho6e#e") man &a""ie"s to f"ee t"ae e2ist &eca%se 4o#e"nments 6ish to p"otect home in%st"ies a4ainst fo"ei4n competition. Pote!tionist measues
P"otection can &e applie & a 4o#e"nment in se#e"al 6as. The incl%e1 ;a< ;&< ;c< ;< ;e< ;f<
ta"iffs o" c%stoms %ties= impo"t 8%otas= em&a"4oes= hien s%&siies fo" e2po"te"s an omestic p"o%ce"s= impo"t "est"ictions= 4o#e"nment action to e#al%e the nation>s c%""enc 5ie to "e%ce its fo"ei4n e2chan4e #al%e.
Tai""s o !ustoms duties
Ta"iffs o" c%stoms %ties a"e ta2es on impo"te 4oos. The effect of a ta"iff is to "aise the p"ice pai fo" the impo"te 4oos & omestic cons%me"s) 6hile lea#in4 the p"ice pai to fo"ei4n p"o%ce"s the same) o" e#en lo6e". The iffe"ence 4oes to the 4o#e"nment. Fo" e2ample) if 4oos impo"te to the U: a"e &o%4ht fo" L+77 pe" %nit) 6hich is pai to the fo"ei4n s%pplie") an a ta"iff of L,7 is impose) the f%ll cost to the U: &%e" 6ill &e L+,7) 6ith L,7 4oin4 to the 4o#e"nment.
D omestic eman S s%ppl c%"#e fo" omestic p"o%ction
PZT
P"ice Z ta"iff T ta"iff Ma"-et p"ice 6itho%t ta"iff
P
B+
B3
B,
B/
In Fi4%"e + the ma"-et p%"chase p"ice of the 4oo is P. At that p"ice) omestic s%pplie"s a"e 6illin4 to s%pplB+ &%t cons%me"s a"e 6illin4 to &% B /. The iffe"ence B+ 5B/ is then the amo%nt of impo"ts. An impo"t ta"iff 6ill "aise the p"ice to the cons%me" to p Z T. The omestic s%pplie"s nee not) of co%"se) "aise thei" p"ices) &%t at the hi4he" p"ice) cons%me"s eman B , . If the omestic p"o%ce"s 6e"e to "aise thei" p"ices to p Z T then the 6o%l e2pan thei" o%tp%t to B 3 Impo"ts 6o%l fall f"om ;B/ [B+< to ;B, 5B3<. The en "es%lt of imposin4 the ta"iff is that1 ;a< ;&< ;c< ;<
omestic cons%me"s &% fe6e" %nits= omestic p"o%ce"s s%ppl mo"e to the ma"-et= fo"ei4n s%pplie"s p"o#ie less to the ma"-et= the 4o#e"nment ea"ns some ta2 "e#en%e.
In s%ch cases) impo"t %ties &enefit the omestic p"o%ce"s an the 4o#e"nment) &%t the ha"m the cons%me". The 4o#e"nment "aises "e#en%e an omestic p"o%ce"s e2pan thei" sales) &%t cons%me"s eithe" pa hi4he" p"ices if the &% impo"te 4oos) o" a"e fo"ce to &% omestic 4oos. In the latte" case the"e m%st &e some loss of 6elfa"e &eca%se p"e#io%sl cons%me"s 6e"e not &%in4 omesticall5 p"o%ce 4oos at the 6o"l p"ice) P. No6 the a"e fo"ce to &eca%se of the hi4he" p"ices) p Z T. Note that the p"ice elasticit of the eman an s%ppl f%nctions ma &e impo"tant in ete"minin4 & ho6 m%ch a ta"iff 6ill "e%ce impo"ts. If eman an s%ppl a"e p"ice inelastic) a ta"iff 6ill ha#e a fai"l small effect on impo"t #ol%mes.
Impot 1uotas
Impo"t 8%otas a"e "est"ictions on the 8%antit of a p"o%ct that is allo6e to &e impo"te into the co%nt". The 8%ota has a simila" effect on cons%me" 6elfa"e to that of impo"t ta"iffs) &%t the o#e"all effects a"e mo"e complicate. ;a<
9oth omestic an fo"ei4n s%pplie"s en?o a hi4he" p"ice) 6hile cons%me"s &% less at the hi4he" p"ice.
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Domestic p"o%ce"s s%ppl mo"e
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The"e a"e fe6e" impo"ts ;in #ol%me<.
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The 4o#e"nment collects no "e#en%e.
An em&a"4o on impo"ts f"om one pa"tic%la" co%nt" is a total &an) i.e. effecti#el a Ge"o 8%ota. Hidden e$pot su#sidies and impot esti!tions
An eno"mo%s "an4e of 4o#e"nment s%&siies an assistance fo" e2po"ts an ete""ents a4ainst impo"ts ha#e &een p"actise) s%ch as1 ;a<
fo" e2po"ts 5e2po"t c"eit 4%a"antees ;i.e. 4o#e"nment5&ac-e ins%"ance a4ainst &a e&ts fo" o#e"seas sales<) financial help ;s%ch as 4o#e"nment 4"ants to the ai"c"aft o" ship&%ilin4 in%st"< an state assistance #ia the Fo"ei4n Office=
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fo" impo"ts 5comple2 impo"t "e4%lations an oc%mentation) o" special safet stana"s emane f"om impo"te 4oos an so on.
hen a 4o#e"nment 4i#es 4"ants to its omestic p"o%ce"s) e.4. "e4ional e#elopment 4"ants fo" ne6 in#estments in ce"tain a"eas of the co%nt") o" 4"ants to in#estments in ne6 in%st"ies) the effect of these 4"ants is to ma-e %nit p"o%ction costs lo6e". These 4i#e the omestic p"o%ce" a cost a#anta4e o#e" fo"ei4n p"o%ce"s in e2po"t ma"-ets as 6ell as omestic ma"-ets. 7ovenment a!tion to devalue o depe!iate the !uen!y
If a 4o#e"nment allo6s its c%""enc to fall in #al%e) impo"ts 6ill &ecome mo"e e2pensi#e to &%. This 6ill "e%ce impo"ts & means of the p"ice mechanism) especiall if the eman an s%ppl c%"#es fo" the p"o%cts a"e elastic. Fo" e2ample) if the e2chan4e "ate &et6een ste"lin4 an the US olla" is L+ d+.7) a 4oo impo"te f"om the USA to the U: at a cost of d$)777 6o%l cost the U: &%e" L!)777. No6 if the 4o#e"nment ta-es action to "e%ce inte"est "ates) sa) 6hich has the effect of 6ea-enin4 the #al%e of ste"lin4) the e2chan4e "ate mi4ht chan4e to L+ d+.!7. The same 4oo costin4 d$)777 6ill no6 cost a U: &%e" L!)333 i.e. L333 mo"e than &efo"e. At this hi4he" p"ice) the total U: eman fo" the US 4oo 6ill p"o&a&l fall. The e2tent of the fall in impo"ts 6ill epen on the p"ice elasticit of eman in the U: fo" the US 4oo. The a%uments in "avou o" pote!tion
The a"4%ments fo" p"otection a"e as follo6s. ;a<
P"otectionist meas%"es can &e ta-en a4ainst impo"ts of cheap 4oos that compete 6ith hi4he"5 p"ice omesticall5p"o%ce 4oos) an so p"ese"#e o%tp%t an emploment in omestic in%st"ies.
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Meas%"es mi4ht &e necessa" to co%nte" >%mpin4> of s%"pl%s p"o%ction & othe" co%nt"ies at an %neconomicall lo6 p"ice.
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P"otectionist meas%"es & one co%nt" a"e often implemente in "etaliation a4ainst meas%"es ta-en & anothe" co%nt" that a"e tho%4ht to &e %nfai".
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The"e is an a"4%ment that p"otectionism is necessa") at least in the sho"t te"m) to p"otect a co%nt">s infant in%st"ies that ha#e not et e#elope to the siGe 6he"e the can compete in inte"national ma"-ets.
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P"otection mi4ht also help a co%nt" in the sho"t te"m to eal 6ith the p"o&lems of a eclinin4 in%st".
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P"otection is often seen as a means fo" a co%nt" to "e%ce its &alance of t"ae eficit) & imposin4 ta"iffs o" 8%otas on impo"ts.
The a%uments a%ainst pote!tion
The a"4%ments a4ainst p"otection a"e as follo6s. ;a<
9eca%se p"otectionist meas%"es ta-en & one co%nt" 6ill almost ine#ita&l p"o#o-e "etaliation & othe"s) p"otection 6ill "e%ce the #ol%me of inte"national t"ae. This means that the &enefits of inte"national t"ae 6ill &e "e%ce.
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9eca%se of "etaliation & othe" co%nt"ies) p"otectionist meas%"es to "e#e"se a &alance of t"ae eficit a"e %nli-el to s%ccee. Impo"ts mi4ht &e "e%ce) &%t so too 6o%l e2po"ts.
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It is 4ene"all a"4%e that 6iesp"ea p"otection 6ill ama4e the p"ospects fo" economic 4"o6th amon4st the co%nt"ies of the 6o"l) an p"otectionist meas%"es o%4ht to &e "est"icte to >special cases> 6hich mi4ht &e isc%sse an ne4otiate 6ith othe" co%nt"ies.
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P"otection c"eates political ill56ill amon4st co%nt"ies of the 6o"l an so the"e a"e political isa#anta4es in a polic of p"otection.
As an alte"nati#e to p"otection) a co%nt" can t" to stim%late its e2po"t competiti#eness & ma-in4 effo"ts to imp"o#e the p"o%cti#it an lo6e" the costs of omestic in%st"ies) th%s ma-in4 them mo"e competiti#e a4ainst fo"ei4n p"o%ce"s. Hien s%&siies an e2chan4e "ate e#al%ation o" ep"eciation a"e e2amples of ini"ect p"otectionist meas%"es) &%t othe" meas%"es) s%ch as f%nin4 in%st"ial t"ainin4 schemes an e%cational policies) mi4ht in the lon4e" te"m "es%lt in imp"o#ements in omestic p"o%cti#it. 7eneal A%eement on Tai""s and Tade 27ATT3
This a4"eement 6as si4ne & ,3 co%nt"ies in +'/0 as an attempt to p"omote f"ee t"ae. The aims of @ATT a"e1 ;a<
to "e%ce e2istin4 &a""ie"s to f"ee t"ae=
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to eliminate isc"imination in inte"national t"ae=
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to p"e#ent the 4"o6th of p"otection & 4ettin4 mem&e" co%nt"ies to cons%lt 6ith othe"s &efo"e ta-in4 an p"otectionist meas%"es.
The >most5fa#o%"e nation> p"inciple applies 6he"e& one co%nt" ;6hich is a mem&e" of @ATT< 6hich offe"s a "e%ction in ta"iffs to anothe" co%nt" m%st offe" the same "e%ction to all othe" mem&e" co%nt"ies of @ATT. @ATT no6 consists of a&o%t +77 mem&e"s. @ATT has s%cceee in "e%cin4 6o"l ta"iffs) &%t the"e a"e se"io%s p"o&lems 6hich can a"ise.
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A co%nt" 6ishin4 to ?oin @A TT m%st consie" the effect of "e%cin4 ta"iffs on its &alance of paments an omestic econom.
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Special ci"c%mstances ;e.4. economic c"ises) the p"otection of an infant in%st") the "%les of the EC< ma &e amitte 6he"e& p"otection o" special lo6 ta"iffs &et6een a 4"o%p of co%nt"ies a"e allo6e.
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A co%nt" in @A TT ma p"efe" not to offe" a ta"iff "e%ction to anothe" co%nt" &eca%se it 6o%l ha#e to offe" the same "e%ction to all othe" @A TT mem&e"s.
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P"otectionist meas%"es ;an the th"eat of f%"the" p"otection< a"e 6iesp"ea) an @A TT has se"io%s iffic%lties in pe"s%ain4 mem&e" co%nt"ies to "emo#e them
The EC and the sin%le Euopean ma,et >??@
The E%"opean Comm%nit ;EC< constit%tes a localise f"ee t"ae a4"eement amon4 mem&e" co%nt"ies inco"po"atin4 p"otectionist meas%"es a4ainst othe" t"ain4 nations. The en of +'', ma"-e the "emo#al of man phsical) technical an fiscal &a""ie"s amon4 mem&e" states) th%s c"eatin4 a la"4e m%ltinational E%"opean >Sin4le Ma"-et>. This o&?ecti#e 6as em&oie in the Sin4le E%"opean Act of +'$!. It ma &e %sef%l to loo- &"iefl at 6hat the +'', chan4es mean. ;a<
Man of the technical &a""ie"s to the f"ee mo#ement of 4oos &et6een co%nt"ies in the EC ha#e &een "emo#e. Technical &a""ie"s f"a4ment the ma"-et) an fo"ce p"o%ce"s to man%fact%"e moifie 4oos) at hi4he" cost) fo" each sepa"ate f"a4ment. The &a""ie"s a"e c"eate &) fo" e2ample) iffe"in4 national p"o%ct stana"s fo" the B%alit an safet of 4oos) iffe"in4 foo la6s an iffe"in4 "e4%lations fo" cont"ollin4 the access of pha"mace%ticals ;meicines< to the ma"-et.
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P%&lic p%"chasin4. P%&lic cont"acts a"e often l%c"ati#e fo" companies that 6in them. In the past the"e has &een a tenenc fo" cont"acts to &e a6a"e & 4o#e"nments to >national> companies. EC "%les 6ill open %p the ma"-et fo" 4oos p%"chase & 4o#e"nments of mem&e" co%nt"ies) & ma-in4 s%"e that all companies in the Comm%nit ha#e an e8%al chance to seeini#i%al p%&lic cont"acts.
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Telecomm%nications. The EC aims to open %p telecomm%nications ma"-ets to 4"eate" competition) & eliminatin4 iffe"ences in national stana"s fo" telecomm%nications e8%ipment.
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Info"mation technolo4. The EC is p"omotin4 the c"eation of a common set of stana"s fo" IT e8%ipment ;OSI stana"s<) so that IT e8%ipment can &e lin-e an 6o"- to4ethe") "e4a"less of 6ho man%fact%"es each item.
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Financial se"#ices. The"e is a contin%in4 p"ocess of a&olition of national &a""ie"s 6hich "est"ict the p"o#ision of financial se"#ices &et6een EC co%nt"ies.
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Capital mo#ements. The EC see-s to achie#e the complete li&e"alisation of mo#ements of capital 6ithin the Comm%nit.
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T"anspo"t. Meas%"es to li&e"alise t"anspo"t se"#ices 6ill inc"ease competition an ma-e it easie" fo" companies in one EC co%nt" to compete in othe" EC co%nt"ies. *i&e"alisation meas%"es a"e &ein4 applie to "oa ha%la4e) shippin4 an ci#il a#iation.
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P"ofessional se"#ices) in the past p"ofessionall 8%alifies people in one co%nt" ha#e %s%all &een "est"icte f"om p"actisin4 in anothe" EC co%nt" %nless the "e8%alif. It is p"opose to "emo#e all s%ch "est"ictions
The 6alan!e O" Payments0 E$!han%e Rates
(o%" o&?ecti#es Afte" completin4 this chapte" o% sho%l1 ;a<
%ne"stan 6hat is meant & the &alance of paments an &e a6a"e of the components in its ma-e5%p=
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&e a6a"e of the effects of s%"pl%ses o" eficits in the &alance of paments
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%ne"stan the meanin4 an the effects of a co%nt"s te"ms of t"ae
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&e a6a"e of the impo"tance of e2chan4e "ates an %ne"stan ho6 the ma &e ete"mine
The balance of payments The natue o" the #alan!e o" payments
The &alance of paments is a statistical >acco%ntin4> "eco" of a co%nt">s inte"national t"ae t"ansactions ;the p%"chase an sale of 4oos an se"#ices< an capital t"ansactions ;the ac8%isition an isposal of assets an lia&ilities< 6ith othe" co%nt"ies %"in4 a pe"io of time. Une" the c%""ent metho of p"esentation of the U: &alance of paments statistics the &"oa classifications of t"ansactions a"e1 ;a<
c%""ent acco%nt t"ansactions. These a"e s%&5i#ie into t"ansactions in >#isi&les> ;i.e. 4oos< an t"ansactions in >in#isi&les> ;i.e. se"#ices<. The c%""ent acco%nt is the"efo"e the "eco" of a co%nt">s t"ain4 in e2po"ts an impo"ts of 4oos an se"#ices=
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chan4es in the U:>s e2te"nal assets an lia&ilities.
The sum o" the #alan!e o" payments a!!ounts is :eo
The s%m of the &alance of paments acco%nts m%st al6as &e Ge"o ;i4no"in4 statistical e""o"s in collectin4 the fi4%"es<. This is &eca%se e#e" t"ansaction in inte"national t"ae has a o%&le aspect. In the &alance of paments) e#e" >pl%s> item sho%l ha#e a matchin4 >min%s> item. If the &alance of paments in p"inciple s%ms to Ge"o) o% ma 6one" 6hat is meant & a s%"pl%s o" eficit on the &alance of paments. hen ?o%"nalists o" economists spea- of the &alance of paments the a"e %s%all "efe""in4 to the eficit o" s%"pl%s on the c%""ent acco%nt. o" possi&l to the s%"pl%s o" eficit on #isi&les onl. To app"eciate these te"ms) it is helpf%l to loo- at &alance of paments items in a &it mo"e etail. 9elo6) 6e %se U: statistics to ill%st"ate p"inciples 6hich appl e8%all to the &alance of paments of e#e" othe" co%nt" too.
Components of the balance of payments The !uent a!!ount
e 6ill no6 consie" the components of the &alance of paments in mo"e etail) sta"tin4 6ith the c%""ent acco%nt. The #isi&le an in#isi&le sections of the &alance of paments to4ethe" ma-e %p the &alance on c%""ent acco%nt. The visi#le #alan!e
The #isi&le &alance is sometimes "efe""e to as the >&alance of t"ae>. the #isi&le &alance is the iffe"ence &et6een the #al%e of e2po"te 4oos f"om the an impo"te 4oos to the. The invisi#le #alan!e
The in#isi&le &alance consists of se"#ices) inte"est) p"ofit an i#iens) an t"ansfe"s. The ann%al in#isi&le &alance is in#a"ia&l in s%"pl%s fo" the U:. The net s%"pl%s on financial se"#ices is a ma?o" "eason fo" this. Se"#ices incl%e t"anspo"t ;& sea an ai") &oth passen4e" an ca"4o <) to%"ism) financial ;&an-in4) ins%"ance) &"o-e"a4e) etc< an 4o#e"nment se"#ices ;chiefl %e to milita" an iplomatic p"esence o#e"seas<. These a"e impo"tant in4"eients in o%" in#isi&les section of the acco%nt an ha#e 4"o6n in impo"tance in "ecent ea"s) pa"tic%la"l in6a" to%"ism an ea"nin4s f"om financial se"#ices. Inte"est) p"ofits an i#iens consist of items s%ch as1 ;a<
i"ect in#estment ea"nin4s. These a"e the sha"e of p"ofits in o#e"seas &"anches) o#e"seas s%&siia" companies an o#e"seas associate companies. Di"ect in#estment ea"nin4s mi4ht &"in4 income into the co%nt" ;e.4. the p"ofits of U: &an-s ope"atin4 o#e"seas< o" ca%se o%tflo6s ;p"ofits of o#e"seas fi"ms in#estin4 in the U:<=
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po"tfolio in#estment ea"nin4s 5i.e. inte"est an i#iens on stoc-s an sha"es hel in o#e"seas sec%"ities & U: "esients) o" hel in U: sec%"ities & o#e"seas "esients=
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inte"est on &o""o6in4 an lenin4 a&"oa & U: &an-s
U8 e$tenal assets and lia#ilities
T"ansactions in U: e2te"nal assets an lia&ilities "eco" the inc"eases o" ec"eases in1 ;a<
fo"ei4n assets) incl%in4 fo"ei4n c%""enc) that a"e hel & U: "esients ;incl%in4 the U: 4o#e"nment<=
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the lia&ilities of U: to "esients of othe" co%nt"ies. These a"e inc"eases o" ec"eases in U: assets) incl%in4 ste"lin4) that a"e hel & ini#i%als) fi"ms o" 4o#e"nments in othe" co%nt"ies.
Tansa!tions in o""i!ial eseves An item %ne" the heain4 of ;t"ansactions in< assets in the &alance of paments is >"a6in4s on o" aitions to the official "ese"#es>.
The official "ese"#es consist of mainl 4ol an con#e"ti&le fo"ei4n c%""encies) hel in the 4o#e"nment>s E2chan4e E8%alisation acco%nt 6ith the 9an- of En4lan. ;Othe" co%nt"ies simila"l ha#e official "ese"#es) 6hich a"e -ept an mana4e on &ehalf of the 4o#e"nment & the cent"al &an-.< @o#e"nments %se these "ese"#es to &alance the o#e"seas acco%nts an also to eal in the fo"ei4n e2chan4e ma"-ets.
In past ea"s) mo#ements on the official "ese"#es 6e"e 4i#en 4"eate" p"ominence in the U: &alance of paments statistics) &%t othe" inte"national capital t"ansactions a"e so la"4e that the no6 >6a"f> an chan4es in official "ese"#es) an so chan4es in the official "ese"#es a"e no lon4e" 4i#en the same p"ominence as &efo"e. Instea) the a"e incl%e as ?%st anothe" item in the assets section of the &alance of paments acco%nt. Political p"ess%"e mi4ht &%il %p 6ithin the impo"tin4 co%nt"ies to impose ta"iffs o" impo"t B%otas. It mi4ht the"efo"e &e a"4%e that a co%nt" has a 4oo &alance of paments position if) in the lon4 "%n) it has neithe" s%"pl%s no" eficit on its c%""ent acco%nt) o" at least if) in the lon4 "%n) its c%""ent acco%nt eficit is matche & inflo6s of i"ect in#estment ;ie lon45te"m< capital. CAUSES AND CONSEBUENCES OF A TRADE DEFICIT Causes •
Poo" e2po"ts ca%se & o a hi4h e2chan4e "ate -eepin4 p"ices of e2po"t 4oos in fo"ei4n ma"-ets too hi4h o inefficient p"o%ction) -eepin4 costs of o%tp%t too hi4h an %ncompetiti#e in fo"ei4n o ma"-ets
•
E2cessi#e impo"ts cons%me" 4oos
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Impo"ts of "a6 mate"ials an capital 4oos & fi"ms) see-in4 to e2pan thei" o6n o%tp%t
Conse)uences •
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The co%nt" is impo"tin4 mo"e 4oos than it e2po"ts) an so the co%nt">s 4ene"al stana" of li#in4 is &ein4 imp"o#e The co%nt" m%st impo"t capital f"om a&"oa. Fo"ei4n in#esto"s a"e onl li-el to in#est fo" hi4h inte"est "ateshi4h p"ofits an o if the still ha#e confience in the co%nt">s economic p"ospects o Unless s%fficient fo"ei4n in#estment is fo"thcomin4) the"e 6ill &e p"ess%"es on the co%nt">s c%""enc to ep"eciate) &eca%se of e2cess s%ppl o#e" eman fo" the c%""enc in the fo"ei4n e2chan4e ma"-ets
P"actical 6as of "ectifin4 a c%""ent acco%nt eficit The 4o#e"nment of a co%nt" 6ith a &alance of paments eficit 6ill %s%all &e e2pecte to ta-e meas%"es to "e%ce o" eliminate the eficit. A eficit on c%""ent acco%nt ma &e "ectifie & one o" mo"e of the follo6in4 meas%"es1 ;a<
a ep"eciation o" e#al%ation of the c%""enc=
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i"ect meas%"es to "est"ict impo"ts) s%ch as ta"iffs o" impo"t 8%otas o" e2chan4e cont"ol "e4%lations=
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omestic >eflation> to "e%ce a44"e4ate eman in the omestic econom.
If a co%nt" impo"ts "a6 mate"ials an e2po"ts man%fact%"e 4oos 6hich a"e mae 6ith those mate"ials) the cost of impo"te "a6 mate"ials 6ill "ise) an so p"o%ce"s 6ill ha#e to p%t %p thei" p"ices to co#e" thei" hi4he" costs. The"e 6ill &e a net fall in e2po"t p"ices) as e2plaine a&o#e) &%t pe"haps not & m%ch. 9eca%se the effect of ep"eciation o" e#al%ation epens on p"ice elasticities of eman in this 6a) it mi4ht &e the case that ep"eciation of the c%""enc on its o6n 6o%l &e ins%fficient to "ectif the &alance of paments eficit) %nless an e2t"emel la"4e ep"eciation too- place.
The e""e!ts o" a "all in the e$!han%e ate
e can no6 consie" 6hat 6o%l happen to the U: c%""ent acco%nt &alance if the"e 6e"e a fall in the #al%e of ste"lin4. ;a<
The immeiate effects 6ill epen on the elasticit of eman fo" impo"ts. In the sho"t "%n) eman is li-el to &e fai"l inelastic an so total e2penit%"e on impo"ts 6ill "ise.
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E2po"ts 6ill &e cheape" in o#e"seas ma"-ets ;in fo"ei4n c%""enc<) &%t in the sho"t "%n U: e2po"te"s mi4ht &e %na&le to inc"ease thei" o%tp%t to meet the hi4he" eman.
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Until U: in%st" a?%sts to the chan4e an inc"eases its o%tp%t of e2po"te 4oos an home5 p"o%ce s%&stit%tes fo" impo"te 4oos the"e 6ill &e a ete"io"ation in the c%""ent acco%nt of the &alance of paments.
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Afte" a time la4) p"o%ction of e2po"ts an impo"t s%&stit%tes 6ill "ise) so that1 ;i< the #ol%me of e2po"ts 6ill "ise) the"e& inc"easin4 the ste"lin4 #al%e of e2po"ts ;"e4a"less of ste"lin4>s lo6e" e2chan4e "ate<= ;ii< the #ol%me of impo"ts 6ill fall f%"the". This 6ill imp"o#e the c%""ent acco%nt &alance. The e2tent of this imp"o#ement 6ill epen on the p"ice elasticit of eman fo" U: e2po"ts a&"oa an the p"ice elasticit of eman fo" fo"ei4n impo"ts in the U:.
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The imp"o#ement in the &alance of paments 6ill ha#e some limit) an the c%""ent &alance sho%l e#ent%all le#el off. The effect of the fallin4 e2chan4e "ate on the c%""ent &alance can &e sho6n & a. Q> c%"#e ;Fi4%"e +<.
S%"pl%s
9alance on c%""ent acco%nt
Deficit
Effect of a fall in the e2chan4e "ate of the omestic c%""enc
The Terms of Trade Intodu!tion
The &alance of t"ae fo" an co%nt" epens on t6o thin4s ;a< ;&<
the #ol%me of 4oos e2po"te an impo"te an the "elati#e p"ices of e2po"ts an impo"ts
The te"ms of t"ae can &e efine as the 8%antities of omestic 4oos that a co%nt" m%st 4i#e %p to o&tain a %nit of impo"te 4oos. ;a< If ci"c%mstances chan4e so that m%st p"o%ce an e2po"t +.! %nits of its 4oos to o&tain I %nit of 4oos f"om () the te"ms of t"ae 6ill ha#e shifte a4ainst an in fa#o%" of (. ;&< If ci"c%mstances chan4e so that m%st p"o%ce an e2po"t onl + %nit of its 4oos to o&tain + %nit of 4oos f"om () the te"ms of t"ae 6ill ha#e shifte in fa#o%" of an a4ainst (. The "atio of e2po"t to impo"t p"ices ;the te"ms of t"ae< ete"mines the #ol%me of e2po"ts necessa" to pa fo" a 4i#en #ol%me of impo"ts o") meanin4 the same thin4) the #ol%me of impo"ts that can &e p%"chase 6ith the p"ocees of a 4i#en #ol%me of e2po"ts. Othe" thin4s &ein4 e8%al) if the p"ice of e2po"ts falls "elati#e to that of impo"ts ;a fall in the te"ms of t"ae< the t"ae &alance 6ill ete"io"ate) o" #ice #e"sa. Note that the t"ae &alance epens not ?%st on the phsical #ol%me of e2po"ts an impo"ts) &%t also on the p"ices at 6hich the a"e t"ae. Measuin% the tems o" tade and !han%es in the tems o" tade
The te"ms of t"ae) a"e meas%"e as1 %nit #al%e of e2po"ts %nit #al%e of impo"ts In p"actice economists a"e %s%all conce"ne) not 6ith a meas%"a&le #al%e fo" the te"ms of t"ae) &%t 6ith a meas%"e of chan4es in the te"ms of t"ae) ;e.4. f"om one ea" to the ne2t<. Usin4 inices fo" the a#e"a4e p"ices of impo"ts an e2po"ts) the mo#ement in the te"ms of t"ae &et6een +'', an +''3 6o%l &e comp%te as1 P"ice of e2po"ts +''3p"ice of e2po"ts +'', P"ice of impo"ts +''3p"ice of impo"ts +'', Chan4e in a co%nt">s te"ms of t"ae occ%" &eca%se of1 ;a<
a chan4e in the composition of e2po"ts o" impo"ts. In the U: t6o main thin4s ;fe6e" oil e2po"ts an man%fact%"e"s t"ain4 %p to hi4he"5p"ice p"o%cts fo" e2po"t< ha#e imp"o#e the U:>s te"ms of t"ae since +'$!=
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lo6e" o" hi4he" p"ices of impo"tse2po"ts ;e.4. the oil p"ice collapse in +'$!) 6hich 6o"sene the te"ms of t"ae fo" the U:<.
A 4o#e"nment has limite >po6e"s> to infl%ence its co%nt">s te"ms of t"ae) since it cannot i"ectl infl%ence the composition no" the p"ices of impo"ts an e2po"ts altho%4h it can affect the te"ms of t"ae th"o%4h a "e#al%ation o" e#al%ation of the c%""enc 6hich 6o%l alte" "elati#e impo"te2po"t p"ices.
5hat does a !han%e in the tems o" tade mean 9
If a co%nt">s te"ms of t"ae 6o"sen) the %nit #al%e of its impo"ts 6ill "ise & a &i44e" pe"centa4e than the %nit #al%e of its e2po"ts. The te"ms of t"ae 6ill 6o"sen 6hen the e2chan4e "ate of the c%""enc ep"eciates in #al%e a4ainst othe" c%""encies. If a co%nt">s te"ms of t"ae imp"o#e) the %nit #al%e of its e2po"ts 6ill "ise & a &i44e" pe"centa4e than the %nit #al%e of its impo"ts. The te"ms of t"ae 6ill imp"o#e 6hen the e2chan4e "ate of the co%nt">s c%""enc app"eciates in #al%e a4ainst othe" c%""encies. It 6o%l seem lo4ical to ass%me that an imp"o#in4 te"ms of t"ae is >4oo> fo" a co%nt" an a 6o"senin4 te"ms of t"ae is >&a>. 9%t this is not necessa"il the case. hat is the effect of a chan4e in the te"ms of t"ae This sho%l &e consie"e in the conte2t of the co%nt">s &alance of paments. The e""e!t o" !han%es in the tems o" tade
If the te"ms of t"ae 6o"sen fo" a co%nt") the co%nt" 6ill &e %na&le to affo" the same #ol%me of impo"ts) o" else its &alance of pament position 6ill ete"io"ate. In cont"ast) a co%nt" 6ith imp"o#in4 te"ms of t"ae 6ill &e a&le to affo" mo"e impo"ts o" 6ill imp"o#e its &alance of paments. Chan4es in the te"ms of t"ae affect a co%nt">s &alance of paments #ia the p"ice elasticit of eman fo" the 4oos t"ae. If a co%nt">s te"ms of t"ae imp"o#e) so that the p"ice of its e2po"te 4oos "ises "elati#e to the p"ice of its impo"te 4oos) the"e 6ill &e a "elati#e fall in the #ol%me of 4oos e2po"te an a "ise in the #ol%me of impo"ts. The siGe of this fall in e2po"ts an inc"ease in impo"ts 6ill epen on the p"ice elasticities of eman fo" e2po"te 4oos in fo"ei4n ma"-ets an impo"te 4oos in the co%nt">s omestic ma"-ets.
Exchane rates e ha#e al"ea mentione e2chan4e "ates se#e"al times. In simple te"ms) the concept of an e2chan4e "ate is familia" to anone 6ho has e#e" ta-en a a t"ip ac"oss the Channel. 9%t in this section 6e looat the impo"tance of e2chan4e "ates in some etail. An e2chan4e "ate is the "ate at 6hich one co%nt">s c%""enc can &e t"ae in e2chan4e fo" anothe" co%nt">s c%""enc. Altho%4h it is con#enient to "efe" to the >e2chan4e "ate> fo" c%""enc 5e.4. the e2chan4e "ate fo" ste"lin4 5e#e" t"ae c%""enc in fact has man e2chan4e "ates. The"e is an e2chan4e "ate 6ith e#e" othe" t"ae c%""enc on the fo"ei4n e2chan4e ma"-ets) so that the"e is an e2chan4e "ate fo" ste"lin4 6ith the US olla") the Canaian olla") the en) the De%tschma"-) the F"ench f"anc) an so on. Fo"ei4n e2chan4e eale"s ma-e thei" p"ofit & &%in4 c%""enc fo" less than the pa fo" it an so the"e a"e "eall t6o e2chan4e "ates) a sellin4 an a &%in4 "ate e.4.
LUS olla" e2chan4e "ate
&an's buying rate d+.!7,7
&an's buying rate d+.!7$7
hen e2chan4e "ates a"e 8%ote in the p"ess) the >mile "ate> &et6een the sellin4 an &%in4 "ates 6o%l &e %se. In the e2ample a&o#e) the ste"lin4US olla" e2chan4e "ate 6o%l &e mi56a &et6een d+.!7,7 an d+.!7$7) i.e. d+.!7!7 to L+.
Spot ates and "o(ad ates
9"oal spea-in4) the"e a"e t6o 6as in 6hich fo"ei4n c%""enc is &o%4ht an sol1 ;a< spot 5i.e. fo" immeiate >eli#e">.
;&< fo"6a"5 i.e. fo" eli#e" at a ate in the f%t%"e. Th%s) a U: fi"m mi4ht "ecei#e USd+77)777 f"om a US c%stome") an sell it >spot> to a &an-) to "ecei#e ste"lin4 immeiatel ;in p"actice th"ee as afte" the cont"act is mae<. If the e2chan4e "ate is d+.$777 to L +) the U: fi"m 6o%l "ecei#e L!!)!!!.!. If a fi"m -no6s that it is 4oin4 to "ecei#e some fo"ei4n c%""enc in the nea" f%t%"e) 6hich it 6ill 6ant to sell in e2chan4e fo" omestic c%""enc) it can ma-e a fo"6a" e2chan4e cont"act 6ith a &an-) at an e2chan4e "ate that is specifie in the cont"act. Th%s) if a fi"m -no6s that it is 4oin4 to "ecei#e USd+77)777 in th"ee months> time) it can ma-e a fo"6a" e2chan4e cont"act >no6> to sell the US olla"s in th"ee months> time at a specifie e2chan4e "ate. If the >spot> "ate is d+.$777 to LI) the >fo"6a"> "ate ma &e hi4he" o" lo6e" than d+.$777 ;epenin4 on compa"ati#e inte"est "ates in the USA an the U:<. Fa!tos in"luen!in% the e$!han%e ate "o a !uen!y
The e2chan4e "ate &et6een t6o c%""encies 5ie the &%in4 an sellin4 "ates) &oth >spot> an fo"6a" 5is ete"mine p"ima"il & s%ppl an eman in the fo"ei4n e2chan4e ma"-ets. Deman comes f"om ini#i%als) fi"ms an 4o#e"nments 6ho 6ant to &% a c%""enc an s%ppl comes f"om those 6ho 6ant to sell it. S%ppl an eman in t%"n a"e infl%ence &> ;a<
the "ate of inflation) compa"e 6ith the "ate of inflation in othe" co%nt"ies= inte"est "ates) compa"e 6ith
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inte"est "ates in othe" co%nt"ies=
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the &alance of paments=
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spec%lation=
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4o#e"nment polic on inte"#ention to infl%ence the e2chan4e "ate.
Pu!hasin% po(e paity theoy
If the "ate of inflation is hi4he" in one co%nt" than in anothe" co%nt") the #al%e of its c%""enc 6ill ten to 6ea-en a4ainst the othe" co%nt">s c%""enc. P%"chasin4 po6e" pa"it theo") 6hich e#elope in the +',7!) attempte to e2plain chan4es in the e2chan4e "ate e2cl%si#el & the "ate of inflation in iffe"ent co%nt"ies. The theo" p"eicts that the e2chan4e #al%e of a fo"ei4n c%""enc epens on the "elati#e p%"chasin4 po6e" of each c%""enc in its o6n co%nt". As a simple e2ample) s%ppose that the"e is onl one commoit) 6hich costs L++7 in the U: an $$7 f"ancs in F"ance. The e2chan4e "ate 6o%l &e L+ $ f"ancs. If) as a "es%lt of inflation) the cost of the commoit in the U: "ises to L+,7) the e2chan4e "ate 6o%l a?%st to1 ;$ 2 ++7< 2 L+ 0.33 f"ancs +,7 If the e2chan4e "ate "emaine at L+ $ f"ancs) it 6o%l &e cheape" to impo"t mo"e of the commoit f"om F"ance fo" L++7 an the U: 6o%l ha#e a &alance of t"ae eficit. This 6o%l onl &e co""ecte & an alte"ation in the e2chan4e "ate) 6ith the L 6ea-enin4 a4ainst the f"anc.
P%"chasin4 po6e" pa"it theo" states that an e2chan4e "ate #a"ies acco"in4 to "elati#e p"ice chan4es) so that >ol> e2chan4e "ate
p"ice le#el in co%nt" A p"ice le#el in co%nt" 9
>ne6> e2chan4e "ate
The theo" 6as soon fo%n to &e inae8%ate to e2plain mo#ements in e2chan4e "ates in the sho"t te"m) mainl &eca%se it i4no"es paments &et6een co%nt"ies ;i.e. eman an s%ppl t"ansactions< an the infl%ence of s%ppl an eman fo" c%""enc on e2chan4e "ates. Inteest ates and the e$!han%e ate
It 6o%l seem lo4ical to ass%me that if one co%nt" "aises its inte"est "ates) it 6ill &ecome mo"e p"ofita&le to in#est in that co%nt") an so an inc"ease in ;mainl sho"t5 te"m< in#estment f"om o#e"seas 6ill p%sh %p the e2chan4e "ate &eca%se of the e2t"a eman fo" the c%""enc f"om o#e"seas in#esto"s. This is t"%e) &%t the"e is a limit to the amo%nt of in#estment capital that 6ill flo6 into a co%nt" &eca%se of hi4he" inte"est "ates. A ma?o" "eason this is that in#esto"s ma e2pect a >"is- p"emi%m> fo" in#estin4 in a hi4h inte"est "ate c%""enc if the fea" that the c%""enc 6ill ep"eciate in #al%e. The #alan!e o" payments and the e$!han%e ate
P%"chasin4 po6e" pa"it theo" is mo"e li-el to ha#e some #aliit in the lon4 "%n) an it is ce"tainl t"%e that the c%""enc of a co%nt" 6hich has a m%ch hi4he" "ate of inflation than othe" co%nt"ies 6ill 6ea-en on the fo"ei4n e2chan4e ma"-et. In othe" 6o"s) the "ate of inflation "elati#e to othe" co%nt"ies is ce"tainl a facto" 6hich infl%ences the e2chan4e "ate. Altho%4h this infl%ence is o&#io%s) it is not p"eominant. This is appa"ent f"om the fact that if e2chan4e "ates i "espon to eman an s%ppl fo" c%""ent acco%nt items) then the &alance of paments on the c%""ent acco%nt of all co%nt"ies 6o%l ten to6a"s e8%ili&"i%m. This is not so) an in p"actice othe" facto"s infl%ence e2chan4e "ates mo"e st"on4l. 7ovenment intevention
The 4o#e"nment can inte"#ene in the fo"ei4n e2chan4e ma"-ets1 ;a<
to sell its o6n omestic c%""enc in e2chan4e fo" fo"ei4n c%""encies) 6hen it 6ants to -eep o6n the e2chan4e "ate of its omestic c%""enc. The fo"ei4n c%""encies it &%s can &e ae to the official "ese"#es=
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to &% its o6n omestic c%""enc an pa fo" it 6ith the fo"ei4n c%""encies in its official "ese"#es. It 6ill o this 6hen it 6ants to -eep %p the e2chan4e "ate 6hen ma"-et fo"ces a"e p%shin4 it o6n.
The 4o#e"nment can also inte"#ene ini"ectl) & chan4in4 omestic inte"est "ates) an so eithe" att"actin4 o" isco%"a4in4 in#esto"s in financial in#estments 6hich a"e enominate in the omestic c%""enc. P%"chases an sales of fo"ei4n in#estments c"eate a eman an s%ppl of the c%""enc in the F ma"-ets) an so chan4es in omestic inte"est "ates a"e li-el to ca%se a chan4e in the e2chan4e "ate.
Exchane rate policies of overnments E$!han%e ate poli!y options
e shall no6 4o on to consie" in mo"e etail the iffe"ent e2chan4e "ate policies 6hich a"e open to 4o#e"nments. These ma &e cate4o"ise as1 ;a<
fi2e e2chan4e "ates=
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f"ee floatin4 e2chan4e "ates=
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ma"4ins a"o%n a mo#a&le pe4=
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mana4e floatin4.
Fi$ed e$!han%e ates
A polic of "i4il fi2e e2chan4e "ates means that the 4o#e"nment of e#e" co%nt" in the inte"national moneta" sstem m%st %se its official "ese"#es to c"eate an e2act match &et6een s%ppl an eman fo" its c%""enc in the F ma"-ets) in o"e" to -eep the e2chan4e "ate %nchan4e. Usin4 the official "ese"#es 6ill the"efo"e cancel o%t a s%"pl%s o" eficit on the c%""ent acco%nt an non5official capital t"ansactions in thei" &alance of paments. A &alance of paments s%"pl%s 6o%l call fo" an aition to the official "ese"#es) an a eficit calls fo" "a6in4s on official "ese"#es. The official "ese"#es co%l in theo" consist of an fo"ei4n c%""enc ;o" 4ol< 6ithin the fi2e e2chan4e "ate a4"eement. The e2chan4e "ates of the #a"io%s c%""encies in the sstem mi4ht all &e fi2e a4ainst each othe". Ho6e#e") fo" simplicit an con#enience) it is mo" e app"op"iate to fi2 the e2chan4e "ate fo" e#e" c%""enc a4ainst a stana". The stana" mi4ht &e1 ;a<
4ol. If e#e" c%""enc is #al%e in te"ms of 4ol) official "ese"#es 6o%l consist mainl) o" e#en enti"el) of 4ol=
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a ma?o" c%""enc) s%ch as the US olla"=
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a &as-et of ma?o" t"ain4 c%""encies. Fo" e2ample) as e2plaine &elo6) the ec% ;E%"opean C%""enc Unit< is an >inte"national c%""enc> 6hich is &ase on a >&as-et> of c%""encies of EC co%nt"ies.
A fi2e e2chan4e "ate sstem "emo#es e2chan4e "ate %nce"taint an so enco%"a4es inte"national t"ae. It also imposes economic isciplines on co%nt"ies in eficit ;o" s%"pl%s<. Ho6e#e") this "est"icts inepenence of omestic economic policies. A 4o#e"nment mi4ht &e fo"ce to -eep inte"est "ates hi4h o" to "e%ce eman in the omestic econom ;e.4. & "aisin4 ta2es an so c%ttin4 the eman fo" impo"ts< in o"e" to maintain a c%""enc>s e2chan4e "ate an a#oi a e#al%ation. If le#els of inflation iffe" 6iel in co%nt"ies s%&sc"i&in4 to a fi2e e2chan4e "ate "e4ime) the "e4ime ma not s%"#i#e fo" lon4. The hi4h inflation co%nt"ies 6ill &e fo"ce to e#al%e in o"e" to -eep thei" e2po"ts competiti#e an to "e%ce impo"ts. Fee "loatin% e$!han%e ates
F"ee floatin4 e2chan4e "ates a"e at the opposite en of the spect"%m to "i4il fi2e "ates. E2chan4e "ates a"e left to the f"ee pla of ma"-et fo"ces an the"e is no official financin4 at all. The"e is no nee fo" the 4o#e"nment to hol an official "ese"#es) &eca%se it 6ill not 6ant to %se them. Floatin4 e2chan4e "ate sstems ;f"ee floatin4 an mana4e floatin4< ha#e &een c"iticise in the past &eca%se the allo6 6ie fl%ct%ations in e2chan4e "ates. Ce"tainl) in the fo"ei4n e2chan4e ma"-ets
toa) the"e a"e la"4e fl%ct%ations 6hich a"e %nsettlin4 fo" inte"national t"ae. Floatin4 e2chan4e "ates a"e the onl option a#aila&le to 4o#e"nments 6hen othe" sstems &"ea- o6n an fail. A mova#le pe% o ad;usta#le pe% system A mo#a&le o" a?%sta&le pe4 sstem is a sstem of fi2e e2chan4e "ates) &%t 6ith a p"o#ision fo"1 ;a< ;&<
the e#al%ation of a c%""enc) e.4. 6hen the co%nt" has a pe"sistent &alance of paments eficit= the "e#al%ation of a c%""enc) e.4. 6hen the co%nt" has a pe"sistent &alance of paments s%"pl%s.
Ma%ins aound a mova#le pe%
A mo#a&le pe4 sstem p"o#ies some fle2i&ilit. E2chan4e "ates) altho%4h fi2e) a"e not "i4il fi2e) &eca%se a?%stments a"e pe"mitte. E#en so) it is still fai"l infle2i&le) &eca%se 4o#e"nments onl ha#e the choice &et6een a "e#al%atione#al%ation o" holin4 the e2chan4e "ate stea. A mo"e fle2i&le sstem 6o%l allo6 some mino" #a"iations in e2chan4e "ates. Fo" e2ample) the e2chan4e "ate &et6een ste"lin4 an the US olla" mi4ht &e fi2e at d, to L+) &%t 4o#e"nments mi4ht onl &e "e8%i"e to maintain the e2chan4e "ate 6ithin a ma"4in of) sa) , on eithe" sie of this "ate. If this 6e"e the case) the U: 4o#e"nment 6o%l %ne"ta-e to -eep the e2chan4e "ate fo" ste"lin4 &et6een d+.' an d,.7/ to L+. Ho6e#e") if the U: 6e"e to "%n into a f%namental &alance of paments ise8%ili&"i%m) a e#al%ation ;o" "e#al%ation< of ste"lin4 6o%l occ%" an the U: 4o#e"nment 6o%l then %ne"ta-e to maintain e2chan4e "ates 6ithin the "e8%i"e ma"4ins of the ne6 e2chan4e "ate. The E%"opean e2chan4e "ate mechanism ;ERM< is an a?%sta&le pe4 sstem
European monetary cooperation The Euopean Monetay System 2EMS3
The E%"opean Comm%nit opte fo" a >local> inte"national a4"eement on e2chan4e "ates) o"i4inall -no6n as the E%"opean Sna-e &%t amene in +'0' to the EMS sstem. In the EMS1 ;a< ;&<
the"e is a scheme of ma"4ins a"o%n a cent"al pe4 fo" e2chan4e "ates &et6een the c%""encies of the co%nt"ies in the EMS= &%t a polic of mana4e floatin4 &et6een thei" c%""encies an the c%""encies of co%nt"ies o%tsie the sstem.
The E2chan4e Rate Mechanism ;ERM< is the e2chan4e "ate a4"eement of the E%"opean Moneta" Sstem) fo"me on +3 Ma"ch +'0'. The Unite :in4om has &een a mem&e" of the EMS since then) &%t i not ?oin the e2chan4e "ate mechanism of the EMS %ntil Octo&e" +''7 an left the mechanism in +'',. The main feat%"es of the EMS a"e as follo6s. ;a< ;&<
;c<
;<
It p"o#ies fo" the sstem of e2chan4e "ates fo" mem&e" c%""encies commonl -no6n as the >ERM>. Each c%""enc has a >cent"al pa"it> "ate a4ainst the ec%. The EMS c"eate the ne6 c%""enc) the E%"opean C%""enc Unit o" ec%. An ec% is a %nit of c%""enc &ase on a >&as-et> of the c%""encies of the pa"ticipatin4 co%nt"ies. The #al%e of the ec% the"efo"e epens on the 6ei4htin4s 4i#en to each ini#i%al c%""enc in the &as-et) an these 6ei4htin4s 6e"e &ase on the "elati#e impo"tance of each c%""enc in E%"opean Comm%nit t"ae at the time the ec% 6as e#ise. ithin the ERM the e2chan4e "ate of the c%""enc of each mem&e" co%nt" is pe"mitte to #a" 6ithin a ma"4in of pl%s o" min%s a specifie pe"centa4e a4ainst its cent"al pa"it. Each c%""enc m%st also -eep 6ithin the same limit of each othe" c%""enc 6ithin the sstem. The e2chan4e "ate of each c%""enc is the"efo"e pe44e a4ainst the ec% an also a4ainst e#e" othe" ERM mem&e" c%""enc.
