ECONOMICS BY MUJTABA

SPECIALISATION

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SPECIALISATION

Specialization is when we concentrate on a product or task.

Privatization

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PRIVATIZATION

Privatization is the process of transferring a public property to private by passing a law.

Advantages / Uses:

1) Development would be faster(due to competition with the other private parties)

2) Innovative solutions (due to again competition with the other private parties)

3) Effective & time bound results

4) Cost cuttings (to reduce the average cost of production)

5) Improves quality in work (of each individuals)

6) In turn more services to public are possible (goods service means more sale)

7) Increase the productivity (labour, machine)

8) Significant Growth in the business & economy

9) Controlled monitoring of public property gives public in turn good services

10) Less burden to government (Government partially involved in monitoring of privatized firms)

11) Income to government (Income to government)

Disadvantages / Possible Losses:

1) Un-employment increases

2) If the private party is inefficient, there is every possibility of the business winding up.

3) More restrictions on many things

4) Purely commercial in nature and lacks ethical / human morals at times.

5) Exploitation of resources for more profit

6) External cost increases

Nationalisation

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Nationalisation is the process of taking a private industry or private assets into public ownership by a national government or state by passing a law.

Nationalisation “taking over private property by state or national government” is usually done for the welfare of general public example: for building roads, dams or public buildings.

Advantages of nationalization

Economies of scale: advantages due to increase in size of firm. When firm become nationalized it would have better control so that this benefits can be enjoyed by all people

They benefit from economies of scale (Bigger is better) which means that the prices to consumers is relatively lower than if we had a number of small firms.

Consumption of resources than exploitation: Government will conserve the resources whereas in private sector resources will be exploited to get profit

Increase in employment opportunities: public sector may not think of redundancy of employee if the firm doesn’t give the profit where as private firms they make workers redundant if firm is in loss

A monopoly owned, run and controlled by the government will stop the consumers being exploited.

The government can manage the economy by controlling the important industries.

The government can invest money and make their service more efficient.

Companies owned and run by the people for the people take social costs (pollution etc.) into account and the profit goes back to the people.

The disadvantages of nationalization

When the ownership is in public sector, the employs do not work for profit there performance and efficiency of the employs remains poor, they lack skill, interest and ability.

It will not increase the skills interest and ability of workers as there is no incentive for extra work. Whereas private firms will give promotions, higher salaries, fringe benefits for workers who show ability, interest, and performance.

Government may not complete the work in time as it may take a long time to take decisions hence there will be delay in work. Whereas in private firms decisions are taken quickly making work fast

The government may not take proper actions to utilize all the resources hence many resources will be unutilized.

Government may not be able to handle many affairs at a time which will lead to improper management and losses creating a burden to government.

Competition is necessary for development and increasing the production. Nationalization has decreased the spirit of competition. So the quality products will not be available

The management of nationalized firms will provide jobs to their favored persons because the political leaders have influence upon the state authorities.

Money

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The Barter System

Barter system refers to the direct exchange of goods for goods without the use of money. People preferred Money Economy over Barter Economy due to the inconveniences in the Barter system.

Need for double coincidence of wants
Lack of common measure of value
Indivisibility of certain goods
Lack of store of value
Difficulty in transferring wealth
Difficulty in making deferred payments

Evolution of Money

Money is anything which is generally acceptable in exchange for goods and services and in the settlement of debts.

Present day Money Economy came into existence in three different stages.

1. Commodity Money

In the primitive societies, some commodities such as animal skin, beads, shells, arrows, tobacco, wheat etc were used as commodity money. But, soon it they were abandoned as they did not possess some essential qualities of money such as acceptability, divisibility, portability etc.

2. Metallic Money

After sometimes, people started using some metals such as bronze, nickel, copper, silver, gold etc in their transactions. Difficulties faced in weighing and scarcity of these metals led to the development of Coinage. Later, the ruling authorities replaced unstandardized coins with standardized coins. Still there were problems of trimming and debasing.

3. Paper Money

Early goldsmiths used to accept the deposit of gold and silver. They issued receipts for the precious metals deposited with them. These receipts were paper claims to gold. It can be exchanged for gold at any time. People realized that these receipts were far easy for the payments of debt and other transactions than carrying gold. As these receipts were accepted by people in the process of exchange, these receipts became the first paper money in the history of money. At present, each country issues its own paper notes, but they are not convertible into gold.

Features of Money

1. Acceptability (money must be generally acceptable)

2. Durability (it must be last longing but not perishable)

3. Divisibility (it must be divisible without losing its value)

4. Uniformity (it must be similar in quality and its intrinsic value)

5. Portability (it must be easy to carry)

6. Scarcity (it must be limited in supply)

7. Stability (it must be stable in value)

Functions of Money

1. Medium of Exchange

Money is acceptable by everyone. It has removed the difficulties of barter economy.

2. Measure of Value

The value of goods and services are now measured in terms of money.

3. Store of Value

Money helps to store wealth for a longer period. But it is not a good store of value during inflation.

4. Standard for Deferred Payments

Goods and services can now be obtained and payment of debt can be settled sometimes later.

Types of Money

Money is generally classified into three forms;

1. Metallic Money

Metallic money consists of coins made up of gold, silver, copper etc. It varies in weight and value.

a) Full bodied money (face value of the coin equals its intrinsic value, that is the value of metal contained in it)

b) Token Money (the face value of the coin is greater than its intrinsic value. Modern coins are examples)

2. Paper Money

Receipts (paper claims) issued by the goldsmiths were the first form of paper money. The modern paper money is called as Legal Tender. It means that the paper money is recognized by law, issued by the central bank and authorized by the state. Modern paper money is not backed up by gold and is referred as Fiat or Fiduciary money.

3. Bank Money

Bank money consists of cheques, drafts, traveler’s cheques, bills of exchange etc.

Human Development Index

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A tool developed by the United Nations to measure and rank countries' levels of social and economic development based on four criteria: Life expectancy at birth, mean years of schooling, expected years of schooling and gross national income per capita.

The HDI makes it possible to track changes in development levels over time and to compare development levels in different countries.

In 2013, the index ranked Norway, Australia, United States, Germany and the New Zealand, at the top of its list for "very high human development." The countries that fell at the bottom of its "low human development" list were Mozambique, Burkina Faso, Niger, Congo, Chad, Haiti, Moldova

The index also shows that countries with lots of income do not always spend that money in ways that create high life expectancies or education levels.

Developed & Developing Country

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DEVELOPED COUNTRIES AND DEVELOPING COUNTRIES

Developed countries

Ø Slow population growth due to low birth rate and low death rate.

Ø Availability of good education and medical facilities.

Ø A large percentage of labour force employed in the secondary and tertiary sectors.

Ø Highly educated and largely trained labour force resulting in high output and income.

Ø Advanced technology resulting in high output and productivity.

Ø Low unemployment level

Ø Faster economic growth and higher standard of living.

Developing countries

Developing countries are countries which has the characteristics of high birth rates and death rates, fast population growth rate, low GNP per head, large agricultural sectors and over dependence on the export of agricultural commodities.

In a developing country, the birth rate and death rate will be very high. The reason why the birth rate is very high is because people are not educated regarding various birth control techniques such as use of contraceptives and less education given on family planning. Most of the families do not have a proper family planning. As a result, the average fertility rate of these countries will tend to be higher causing a very high birth rate. Similarly, the death rate of these countries will be high as well due to poor medical facilities available. The average number of child death in these countries will be high. Also, the life expectancy of the people in developing countries will tend to be lower causing the death rate to be high.

Since the birth rate and death rate is high, the population growth rate of developing countries will be very high as well. The growth is mainly contributed by the more than proportionate increase in the birth rate as compare to death rate of such countries.

Most of the developing countries will produce agricultural commodities or primary commodities. They will have a very small secondary sector and tertiary sector. Most of the households will engage in the production of the agricultural commodities. And in the market, the agricultural commodities will have a very low value. As a result of this, the export earning the developing countries receive will be very low as well.

The small secondary and tertiary sector along with getting a low level of income makes the total Gross National Product (GNP) of developing countries to be small. And as when the GNP per capita is calculated, it is very low due to large population against the low level of GNP. This makes the country poorer as per head GNP is poor.

Developing countries have a very low health and education standards. The number of hospitals and health centers available for the population is limited and there are very few doctors and other professionals to give the services. Education is poor and not every child is given the education as well. The teachers available are as well untrained and a very few trained teachers.

Due to the low income developing countries receive, their development projects are as well very few. Investment by government on building infrastructure and other development activities are low as well.

The following table shows the characteristics of a developing country.

GDP Per Head	Infant Mortality	Birth Rate	Death Rate	Literacy Rate	Fertility Rate
Low	High	High	High	Low	High

If these characteristics are seen, then the standard of living of these countries will be low as well.

Developed and developing nations and the standard of living

Standard of living refers to the quantity and quality of goods and services consumed by households during a given period of time. The more availability of goods and services per person, the greater will be his standard of living and vice versa.

Ø A developed country is one in which the real income per person and the average standard of living is very high compare to living standard of the developing countries.

Ø A developing country can be defined as one in which the real income per person and the average standard of living of the people is very low compare to living standards in developed countries like UK, USA, Japan etc.

Features common to most developing and developed countries

Developing countries

Ø High rate of population growth due to very high birth rate and death rate.

Ø Lack of good education and medical facilities.

Ø Large percentage of labour force employed in the primary sector.

Ø Poorly educated largely untrained labour force resulting in low output and income.

Ø Technologically backward resulting low output and productivity.

Ø Large scale of unemployment due to lack of skills and immobility of labour.

Ø Slow economic growth and low standard of living.

Ø Narrow secondary and tertiary sectors.

Reasons for high rate of population growth between developed and developing country

§ In developing country the natural increase in population will be higher due to more birth rate compared to death rate whereas in a developed country the natural increase in population will be lower due to of low birth rate and relatively high death rate as compare to the birth rate.

§ In developing country birth rate will be higher because of lack of education, early marriage and very less knowledge of using contraceptives. Large family size is also treated as tradition in developing countries, and in developed country death rate will be higher because of high aged population.

Occupational Distribution of population

Occupational distribution of population refers to the percentage of population employed in particular sector of production. The three sectors of production are primary, secondary and tertiary.

In a developing country more people will be in primary sector and in developed countries most people are working in secondary and tertiary sector.

Why do developing countries spend more on health education?

Health educations in developing countries are under taken to reduce the level of health hazards and consequences that arises in those countries. Majority of these health education programmes will focus on the following

- Family planning: they educate people on the importance of family planning in a attempt to reduce the number of births in the country.

- They provide information regarding HIV/AIDS. Most of developing countries have the problems of HIV/AIDS. As people are less educated on this issue the number of HIV/AIDS cases is increasing. Therefore to prevent this, the government of these countries has taken various health education programmes to cover it. In some developing countries information regarding the spread of HIV/AIDS is a part of national curriculum.

Reasons for underdevelopment of an economy

§ High population growth: Developing countries have a large growing population which means goods and services have to be shared among more people, hence the standard of living becomes low.

§ Dependence on agricultural products: In developing countries people mostly rely on agricultural products. If they export this agricultural product they get very less and if they want to import they have to pay more for secondary or tertiary sectors products.

§ Poor Infrastructure: Developing countries have very poor communication and transportation networks.

§ Lack of capital: Income of people in developing countries is finished in buying basic necessary products as a result economy cannot buy all the technology and capital required for further production hence they remain poor.

Problems faced by a developing country

The following are the problems a developing country faces

1. The problems of high birth rate and death rate

2. Over dependence on agricultural sector

3. Large population migrating to industrial areas (overcrowding of cities)

4. wide distributed poverty

5. wide spread HIV/AIDS cases

Consequences to developing countries due to these problems

1. The increased birth rate causes a large dependent population in the country. As a result of this, the working population suffers in terms of supporting this population. Less income is saved causing future development of these countries even difficult. The government as well has to spend on building schools and other facilities needed for this large dependent population below 16 years old.

2. Over dependence on agricultural sector makes the development process slower. The developing countries receive a very small amount of income by exporting these commodities. And often the price fluctuation in world agricultural market makes their income often very uncertain. This hindrances the future development of the country as government cannot spend much of their income on development related activities.

Problems faced to developed country

1. Increase in ageing population

2. The problem of deindustrialization

Cost of Production and Revenue

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Production: It is a process of transforming inputs to output.

Product/Output: The numbers of goods produced. For example if 1 car is produced, it is one unit of output, if 100 cars are produced, its 100 units of output.

Factors involved in production

The factors involved in the production can classified as fixed factors and variable factors.

Fixed Factors: The factors whose supply cannot be quickly or easily changed over a short period. It can only be changed over the long run. Example: Factory Building, Heavy specialised machinery and Fixtures and Fitting
Variable Factors: The factor supply can be easily changed both in short run and long run. Example: Labour, Raw materials, fuel, power and hand tools.

There are two time periods in Economics, short run and long run.

1. The short run

- Short run refers to a short period of time over which at least one factor would be fixed.

- If a firm wants to change its output in the short run, they would be able to change only its variable factors to bring a change in its output.

- There are fixed factors in the short run.

2. The long run

- Long run refers to a period of time over which the firm can change all its factors.

- If a firm wants to change its output in the long run, they would be able to change all its factors.

- There are no fixed factors in the long run. In the long run all the factors are variable.

Costs

Costs are expenses a firm has to bear during the process of the production. There are three types of costs. They are:

Fixed Costs: These are the costs of fixed factors of production. The cost of production does not vary with the change in the output. As firm increases or decreases the fixed always remain unchanged. Fixed costs are also known as indirect or overhead costs. Examples: Rent, insurance premium, Managers Salary and interest payment on a loan. The diagram represents the fixed cost schedule a firm faces:

Variable costs: Variable costs are cost of production which varies directly with the change in output. If more goods are produced cost of production is likely to increase. It is also known as direct costs. Examples: raw material costs, power linked in production, wages linked to production. The following diagram represents variable costs.

Total Cost: Total cost of producing a given amount of goods and services.

- When output increases the total cost also increases and vice-versa.

- This is because when output increases, variable cost increases. So this increase in VC is also shown in the total cost.

Total cost can be calculated as follow:

Total Cost = Fixed Cost + Variable Costs

In a diagram it can be represented as follow:

Average Total Cost (AC/ATC)

ATC is the total cost per unit of output produced. It can be calculated by the following formula.

Average Fixed Cost (AFC): AFC is the fixed cost per unit of output. It can be calculated by the following formula:

Average Variable Cost (AVC): AVC is the average cost per unit of output. . It can be calculated by the following formula:

Marginal Cost (MC) : Marginal cost incurred by employing an additional unit of factor of production. . Marginal cost measure the change in total cost for an increase in one unit of output. The following two examples depict marginal costs of an increase in scale of production.

MC can be calculated by the following formula.

EXAMPLE 1:

Output

Total Cost

Marginal Cost

132

143

152

163

177

199

Always deduct the 2^nd Number from the first number (143 – 132) to get the marginal cost. Write your answer between the two numbers.

Fr example, 143-132

1-0

= 11/1

= 11

EXAMPLE 2:

Output

Total Cost

Marginal Cost

142

35.5

1.6

188

193

223

342

484

Here MC was calculated as:

The graph of Marginal cost can be shown as below.

There are various features of MC curve to be noted. First it goes down till it reaches a minimum point and then keeps on increasing.

The Nature of the Marginal Cost (MC) and Average cost (AC) Curves

- The marginal cost and the average cost is in “U” shape.

- Initially, as output increases, MC and AC will be falling as cost can be shared among an increased number of outputs.

- But if the output continues to increase after some point, the productivity starts to decline which increases the cost as more output is produced, hence MC and AC starts increasing.

Profit Maximisation

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Principle of profit maximization

Profit maximization is achieved when the difference between the total revenue and the total cost is at its greatest.

- Profit maximization point is where the vertical distance between the TR curve and TC curve is the maximum and also at the point where marginal cost is equal to marginal revenue.

- In the long run, firms will continue to produce if it’s making a profit.

Exercise

Complete the table and draw the TR and TC curves MR & MC curves

Output	Price	TR	TC	Profit	Average Profit	MC	MR
0	550		1000
1	550		1350
2	550		1560
3	550		1740
4	550		2000
5	550		2400
6	550		3000
7	550		3850
8	550		4960

a) What is the range of output the firm makes a profit?

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b) What is the profit maximization output?

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c) What is the break-even output?

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The Optimum point of production

The optimum point of production is where the average cost of producing each good is at the lowest level possible. It is said to be the best level of production. At this point the entrepreneur has managed to organize and combine the factors of production in the most cost effective or efficient way.

Break Even Point

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Break-even point

- Break-even point is the point where, Total Revenue (TR) equals Total Cost (TC). At this point, profit and loss both will be equal to zero.

- This is the point where the producer covers the cost of producing that particular product. After the break-even point, the producer starts earning profit. Before the break-even point, the producer has loss.

Break-even Point – TR=TC

Returns to Scale

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Returns to scale

The concept of returns to scale explains the change in output due to change in inputs.

Increasing returns to scale: increasing returns to scale occurs when it brings a more than proportionate change in output compared to change in its inputs. For an example, an increase in input by 20% leads to an increase in output by 30%.

Consider the following example.

	Input	Output
Year 1	70	10,000
Year 2	120	25,000

The input (factors of production) in the second year has been increased from 70 to 120 (an increase of 71%). This has increased the output from 10,000 to 25,000 units, which is an increase of 150%. Hence, there is an increasing returns to scale as the change in output is more than the change in input.

Decreasing returns to scale: decreasing returns to scale occurs when it brings a less proportionate change in output compared to change in its inputs. For an example, an increase in input by 20% leads to an increase in output by 15%.

	Input	Output
Year 1	55	12000
Year 2	110	20000

The above example shows decreasing returns to scale. An increase in input from 55 to 110 (an increase of 100%) increased the output from 12,000 to 20,000, which is an increase of 67%.

Constant returns to scale: constant returns to scale occur when the change in input brings an equal change in its output. For an example, an increase in input by 50% leads to an increase in output by 50%.

	Input	Output
Year 1	65	9,000
Year 2	130	18,000

The above example shows constant returns to scale. An increase in input from 65 to 130 (an increase of 100%) increased the output from 9,000 to 18,000, which is also an increase of 100%.

Economies of scale

Economies of scale refer to a fall in the long run average cost of a firm due to expansion in its scale of production. A firm enjoys economies of scale when the percentage increases in its output is greater than the percentage increase in its input.

The diagram shows that the firm enjoys economies of scale till output 120. Firm’s average cost goes on declining until 120 units. Between 120 to 220 units, the firm is having constant returns to scale, that is average cost remains same between these range of output. However, when the firm increases its output more than 220, the firm’s Average cost starts to increase showing diseconomies of scale. Diseconomies of scale occur when the firm’s long run average cost increases as it increase it output.

Economies of scale can be classified as two:

- Internal economies of scale

- External economies of scale

Internal economies of scale

Internal economies of scale refer to the advantages enjoyed by the firm individually in the form of reduced average cost, due to the expansion of its scale of production. A large firm’s total cost is higher than that of small firms, but its average would be lower than that of a small firm. This is due to the different types of internal economies the large firm is able to enjoy due to expansion of its scale of production.

Types of Internal Economies of Scale

Technical economies: cost savings caused by the methods of production used.

§ Large firms can make more use of division of labour, which would increase the output thereby reducing the average cost

§ Large firms can make more effective use of large units of machinery. These machineries can be operated at low average cost when they are used to their full capacity by large firms.

§ Large firms ill have the resources to maintain a research and development department to help improve the quality of its products and introduce new methods of production.

Marketing economies: cost saving resulting from the way in which firms sell their products.

§ A large firm has enough working capital – they can place large orders with their suppliers to buy the materials in bulk quantities, and able to get preferential treatment by getting resources at lower prices.

§ A large firm will be able to employ specialist workers – they can employ specialist salesmen to maintain and expand in its markets, and specialist buyers to ensure that it obtains good quality and low-cost supplies of raw materials.

§ Handling and packaging costs are very low – in large firm as the cost would be divided among a large quantity of output. So the cost per unit of output will be very low. Therefore large firms can sell their products at low prices.

§ Advertising cost per unit is very low – as large firms’ output is greater than small firms so the advertising cost per unit sold is likely to be much less than that of a small firm. Therefore, the large firms can spend more on advertisement to increase its demand.

Financial economies: cost saving that arises from the way in which large firms raise money.

§ As the large firms have more valuable assets and are better known than the small firms, lenders believe that there is less risk in making a loan to the large firms. Therefore, the large firms can obtain finance more cheaply and easily than small firms.

§ They have more sources of finance, e.g. raise money by selling shares thorough the stock exchange.

Risk-bearing economies: cost savings that result from the way in which firms try to reduce the risk of fall in demand for some of their products.

§ Large firm scan avoid risk through diversification. Diversification means producing a wide variety of products to increase security. Even if one product’s demand decreases the firm would still have other products to depend on.

Managerial economies: large firms can employ the most professional managers who are attracted by high salaries, prestige and power of responsible positions in a large firm. The employment of specialist mangers in charge of purchase, administration, sales, accounts etc … brings the advantage of division of labour, including increased efficiency of the firm.

External Economies of Scale

External economies of scale arise when there is a growth in the size of the industry and are available for many firms in it.

1. Economies related to a particular industry. They are derived from the concentration of the industry in one place and differ between industries. They might involve cheaper training facilities if many firms want to train their employers or marketing economies when several firms want the same kind of raw material. They can be realized through trade associations which are producers' unions, which can e.g. advertise the industry generally, thus raising the revenue of all the firms included.

2. Economies related to industrialization. If there is a great concentration in specific place, e.g. many people come to look for job there. Usually the communication expenses (maintenance of roads) can be shared. The activities of the essential services sector multiply, providing more advantages to firms in the industrialized area.

3. Economies related to society. The provision of roads, schools etc. is largely the responsibility of the state. As industrialization increases the provision of these items increases giving further advantages to firms in the area.

Profit

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Profit

Profit is the money that is left after paying all the costs from the revenue earned. Total profit can be calculated as follows.

Total profit= Total Revenue - Total cost

A firm may also make a loss. A loss occurs when the total revenue is less than the total cost.

Average Profit (AP): Average profit refers to the profit earned per unit of output.

Average Profit = Profit

Output

Exercise: Assume that a product is sold for $550. Fill in the following table.

Output	Total Cost	Total Revenue	Total Profit	Average Profit	Marginal profit
0	1000
1	1350
2	1560
3	1740
4	2000
5	2400
6	3000
7	3850
8	4960

Banking

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Bank is a financial intermediary. It is a deposit-taking institution who acts as a repository for money deposited by other economic agents. Each country has a state owned Central Bank to regulate the banking system.

Commercial Banks

Commercial Banks accept deposits of money for safekeeping and provide them with a payment transmission service (cheques), together with saving and loan facilities.

Functions of Commercial Banks

1. Accepting Deposits

Bank deposits are of two types.

a) Sight deposits/ Demand deposits/ Current Account deposits

· It is withdrawable on demand

· It is used to finance day-to-day transactions

· It can be used to make regular payments

· Most banks now pay interest on outstanding current account balance

b) Time deposits/ Fixed deposits/ Deposit Accounts

· It is not withdrawable on demand

· It requires notice of withdrawal

· It is usually used to finance irregular one-off payments

· It gets interest in return

· It is deposited for a fixed period of time

· It provides the bank with a more stable financial base

2. Making Payments

Current Account holders have access to the following payment making services.

· Cheque System :

· Standing Orders: It is an instruction given to the bank to make regular payments of fixed amounts. For example; rent.

· Direct Debits: It is an instruction given to the bank to make regular payments but varying amounts. Electricity, Gas, Telephone bills are examples.

· Bank Giro Credit: It enables to use only one cheque to pay several bills.

· Credit Cards: It helps the cardholders to buy goods and services from those shops who have joined the scheme.

· Cash Dispensers / ATM card: It enables the cardholder to get cash from the machine set outside walls of certain banks. It provides customers with 24 hours service in supplying cash. Each customer is given a secret code number and a plastic card which can be used to obtain cash up to an agreed limit.

· Travelers Cheque and Foreign Currency: Those traveling abroad and households and firms making payments to other countries can use travelers cheque.

3. Advancing Loans

Lending money is the most profitable activity of commercial banks. Interest charged on money lent is the source of their income.

a) Bank Loans

Commercial banks provide short-term and long-term loans
It is not necessary to be an accountholder
Borrowers pay interest on the amount borrowed

b) Bank Overdrafts

It is provided only to current accountholders
The accountholder is entitled to overdraw an agreed amount
Interest is charged only on the amount overdrawn

4. Other Services

Commercial Banks also provide the following services;

Advice on investment
Acting as Executors of will
Insurance Service
Unit Trust investment
Share purchase and sales etc.

Central Bank

Maldives Monetary Authority (MMA) - The Central Bank

Each country has a central bank. It is the leading bank generally responsible for overseeing the banking system acting as a clearing banker for the commercial banks and for implementing monetary policy. In addition, many central banks are responsible for handling the government’s budgetary accounts and for managing the country’s external monetary affairs, in particular the exchange rate.

Functions of Central Bank

1. It is the government’s bank

It receives government’s income from taxation and makes necessary payments on behalf of the government.

2. It is the banker’s bank

Commercial banks keep accounts at the central bank and use them to settle debts between themselves.

3. It manages the national economy

It influences the rate of interest and the amount of bank lending to achieve the objectives of the government.

4. It is the sole note issuing authority

In the UK Bank of England issues notes and its satellite Royal Mint issues coins.

5. It is the lender of last resort

It helps the commercial banks when there is a shortage in the banking system.

6. It holds the official stocks of foreign currency and the gold reserves.

Money Supply

Money supply refers to the amount of money in circulation in an economy. The government tries to control the money supply for several reasons. The size of money supply is an important determinant of the level of spending in the economy and its control is a particular concern of monetary policy. An increase in money supply raises consumer spending and hence inflation. A fall in money supply reduces investment and hence economic growth. Therefore, the central bank has to adopt various policies to eliminate the drawbacks.

1. Changes in the Bank Rate

Bank rate is the rate of interest charged by the central bank on its loans and advances given to the commercial banks. A rise in bank rate reduces lending power of commercial banks and so does money supply and vice versa.

2. Changes in the Rate of Interest

Rate of interest is the cost of borrowing. Any changes in the rate of interest will influence consumer borrowing which in turn affect consumer spending. A rise in the rate of interest makes borrowing expensive. It reduces borrowing and hence money supply. On the other hand, a fall in the rate of interest makes borrowing cheaper. It raises borrowing and hence money supply.

3. Changes in the Cash Reserve Ratio

Cash reserve ratio is the proportion of commercial bank’s total assets that it keeps in the form of highly liquid assets to meet the day-to-day currency withdrawals by its customers and other financial commitments. The central bank can influence the cash reserve ratio of commercial banks to control the monetary base of the economy.

4. Open Market Operations

It refers to sale or purchase of government treasury bills and bonds as a means of controlling the money supply. Selling securities will reduce money in circulation. Buying securities from the general public will increase money in circulation.

5. Special Deposits

The central bank has the power to order commercial banks to make payments into a special account at the central bank. Payments into these special deposits reduce the commercial banks’ supply of liquid assets. It reduces their ability to lend and create bank deposits. Release of these special deposits increase commercial banks’ cash reserves.

6. Making Directives

The central bank also has the right to issue instructions to the commercial banks regarding their lending activities. It can request them to restrict certain types of lending when necessary.

National Income

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National Income

The total net value of all goods and services produced within a nation over a specified period of time, representing the sum of wages, profits, rents, interest, and pension payments to residents of the nation.

To discuss the concept of economic growth, it is essential to measure economic output and then examine how that output has changed over a period of time.

Economic growth

It refers to the increase in the amount of goods and services the whole economy can produce over and above what they produced in the last year.

The total output of goods and services has an important influence on the standard of living and on the number of people employed

There are three different measures to find the national income.

1) Gross Domestic Product (GDP): It describes the total output produced by the factors of production located in a country. [some of these factors (capital) may be owned by foreign firms]

2) Gross National Product (GNP): It is the total output produced by the factors of production of a country whether at home or abroad.

This is measured as….

Gross National Product = Gross Domestic Product + Net Property income from abroad.

Where Net property income from abroad = Property income earned abroad – Property income paid abroad

3) Net National Product (NNP): It is market value of nation’s goods and services (GDP/GNP) minus depreciation (amount of GNP required to purchase new goods to maintain existing stock)

Net National Product (NNP) = Market value of finished goods and services – Depreciation

Net National Product (NNP) = Gross National Product (GNP) – Depreciation.

Example

Let's assume Country XYZ's companies, citizens and entities produce $1 trillion worth of goods and $3 trillion worth of services this year. The assets used to produce those goods and services depreciated by $500 billion. Using the formula above, Country XYZ's NNP is:

NNP = $1 trillion + $3 trillion - $0.5 trillion = $3.5 trillion

Why It Matters:

NNP is a measure of how much a country can consume in a given period. Note that NNP measures output regardless of where that production takes place (in other words, it includes the value of goods and services that American companies produce, supply or create abroad).

In the 1990s, net domestic product replaced NNP as "the" macroeconomic measure of output, much as "gross domestic product" replaced "gross national product." The Bureau of Economic Analysis (BEA) still releases all four measures, however.

Calculate National Income:

National Income is measured for over a period of one year. Following are methods to measure national income.

1. Output or Production Method: This method measure the value of the outputs (goods and services) produced. Its equation can be written as:

NATIONAL INCOME = G.N.P – COST OF CAPITAL – DEPRECIATION – INDIRECT TAXES

2. Income Method: This method measures the total income received by the factors of production. Equation wise the method can represent national income as:

NATIONAL INCOME = Income from RENT + WAGES + INTEREST + PROFIT

3. Expenditure Method: This method gives national income by adding up all public and private expenditures made on goods and services during a year.

Importance of National Income

1. It provides the government with essential information

2. To indicate changes in the standard of living

3. To compare the standards of living in different countries

Economic growth

It refers to the increase in the amount of goods and services the whole economy can produce over and above what they produced in the last year.

Economic Growth means an increase in real GDP. This increase in real GDP means there is an increase in the value of national output / national expenditure.

This can be represented by using production possibility curve. As economy grows, the production possibility curve shift towards right, which shows that the economy can afford and is possible to produce more of capital as well as consumer goods and services.

Benefits of economic growth

1) Higher Incomes: This enables consumers to enjoy more goods and services.

2) Improved standard of living: Economic growth enables developing countries to reduce poverty levels and afford to higher living standards.

3) Improve firms' and consumers' confidence: (positive outlook) which may lead to an increase in investment.

4) Increased employment: With higher output firms tend to employ more workers creating more employment.

5) Lower Government borrowing. Economic growth creates higher tax revenues and there is less need to spend money on benefits such as unemployment benefit. This help to reduce government borrowing.

6) Improved public services. With increased tax revenues the government can spend more on the National Health Service, education, infrastructure projects, such as better roads and railways.

7) Money can be spent on protecting the environment. Countries with higher living standards can afford the luxury of protecting the environment.

Disadvantages of economic growth

1) Resource depletion [exhaustion] Excessive use of non-renewable resources such as petroleum, minerals and metals etc., collapse the stock of our planet's natural resources.

2) Environmental impact Increase in pollution (noise and congestion).

3) Inequitable distribution opportunities for factors will be different due to discrimination (colour, disability, racism, ethnicity, gender, etc.)

4) Implications of global warming there are close correlations of economic growth with carbon dioxide emissions across nations which cause global warming.

Steps for economic growth

1) Promote economic growth through innovation: Develop indigenous technologies which suit the requirement of domestic production as well as for export, using the available resources.

2) Strategic immigration: It Reduce unwanted immigrants and improve the domestic human resource by providing better education and training.

3) Cut down costs: Production process should be made more efficient so as to cut down unwanted costs.

4) Accumulation of capital: Promote the habit of saving and provide the necessary facilities for investment in the society

5) Risk-taking and good management: Provide the necessary education and training to the people so that they can become entrepreneur with better risk taking capacity with good management techniques

Evaluation of Economic Growth

It depends on the type of economic growth. If growth is too fast and unsustainable, it will probably cause inflation.

It depends on the equality of distribution - does everyone benefit from growth or is it focused on a few individuals?

Is economic growth environmentally sustainable? or does growth come from exploiting non-renewable resources?

Causes for unsustainability in growth

Renewable resources are also being depleted because of over consumption. Examples include the destruction of rain forests, the over-exploitation of fish stocks and loss of natural habitat created through the construction of new roads, hotels, retail malls and industrial estates.

Among the main environmental threats, we can identify the following:

• Depletion of global resource base and the impact of global warming
• A huge expansion of waste arising from both production and consumption
• Over-population (particularly in urban areas) putting increased pressure on scarce land
• Pollution of the environment by producers and consumers including reductions in air quality
• Species extinction

Inflation

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Inflation

Definition

Inflation is the consistent and persistent rise in the general price level of most of the goods and services in a country leading to a fall in the value of money and purchasing power.

Types of Inflation

There are three types of Inflation:

1) Creeping Inflation:

Creeping inflation is when the rise in price level is very low usually 1% to 6% per year. This type of inflation is good for the economy. Creeping Inflation usually means that the country is experiencing economic growth.

2) Galloping/Hyper/Runaway Inflation:

This is a very high increase in the general price level, even more than 100% causing a huge fall in the value of money. During this type of inflation people lose confidence in money.

3) Suppressed Inflation:

This type of inflation occurs when the aggregate (total) demand in the economy is more than the aggregate supply causing a rise in the general price level. This type of inflation can be controlled by the government by imposing maximum price control and through rationing.

Causes of Inflation:

There are mainly four causes for Inflation:

1) Demand-pull Inflation

2) Cost-push Inflation

3) Increase in money supply Inflation

4) Imported Inflation

Demand-pull inflation

Demand pull inflation occurs when the aggregate demand is more than the aggregate supply, pulling up the price level of most goods and services.

*full employment is when the country uses up all its resources and can no longer produce any more. The supply of all the country will be perfectly inelastic in the long run.

Reasons for demand-pull inflation:

• War time condition:

Every country has limited resources and basically the goods that every country produce are categorized into consumer goods and capital goods and during war time military goods, and if the country has to produce more of one good then they have to forgo the productions of other goods.

• More exports:

If a country exports more goods, income of the people increases as well as the supply of goods available to use in the home country becomes less.

• Economic growth:

In order for the country to economically grow they need to produce more of capital goods which means consumer goods would be produced less resulting in a shortage (AD greater than AS) leading to rise in the general price level.

• Increase in Government spending:

When government spending increase especially at full employment level, it would increase the aggregate demand of the people and the government, which would result in an increase in the general price level since at full employment level country cannot produce further goods to meet the demand since supply would be perfectly inelastic.

Cost-Push Inflation:

When prices of factors of production like (wages, rent, raw materials…etc.) increases it increases the cost of production, which means it is more costlier for the producer to produce goods now so it reduces the aggregate supply pushing up the general price level.

Diagram

When cost of production increases the aggregate supply decreases from AS to AS1 causing the general price level to increase from P1 to P2 resulting in a decrease in national input/output.

Reasons for cost-push inflation:

Increase in wage rate:

When wage rate increase more than the increase in productivity, it would increase the cost of production since wage is one of the major cost of production. This would decrease aggregate supply hence, increasing the price level.

Increase in the price of raw material:

When prices of raw materials increase it increases the cost of production causing aggregate supply to decrease increasing the general price level.

Indirect tax:

Indirect taxes are taxes which are directly added to the prices of goods and services like VAT. When indirect tax increases it naturally increases the general price level.

Increase in money supply Inflation

If the money supply in the economy is more than the output of goods and services, this would increase the general price level. When money supply increases it means everybody has more money with them to spend causing an increase in aggregate demand leading to inflation.

Imported Inflation

If the country is depending mainly on imports for its raw materials and other goods and services, and if the price of imported goods increase this will cause the general price level to rise, because the cost of producing these goods would increase raising the prices leading to imported inflation.

Effects of Inflation

Inflation might have an effect on the following:

• Effect on different income group

• Effect in production

• Effect on borrowers and lenders

• Effect on balance of payment.

Effect on different income group

Basically the income group is divided into three types which are fixed income group, business class, and the varied income group. And all these three types are affected differently during inflation:

• Fixed income group:These are those people whose incomes are fixed (like pensioners and salaried employees) and would not change with the change in prices. During inflation these people would be affected most since their purchasing power falls with the rise in price level

• Business class: These are the people who run the businesses, that is, people who sell the goods and services. During inflation these people would be most benefited since their income increases with the inflation.

• Varied income group: In some sectors in the economy the worker’s salaries get an automatic increase in their wages or salaries and in some industries the trade union are strong enough to persuade the employer to raise the wages during inflation. So varied income group is the group which is least affected during inflation.

Effect on production

Inflation affects the production depending on the cause of inflation.

Demand pull inflation: Production will increase to earn more profit

(If the inflation is caused by demand pull inflation and if the country is operating below full employment level, the production will increase in order to meet with the demand and also to earn more profit, since the aggregate demand has pulled up the price level which means producers can earn more revenue if they increase supply.)

Cost Push Inflation: The production will decrease as production cost is more

(On the other hand if the cause of inflation is cost-push, then production would decrease. Because in cost-push inflation the prices of factors of production increases increasing the cost of production, which means it is now more costlier for the producers to produce so they reduce the supply. In short, during a demand-pull inflation the production will increase if it’s not operating at full employment level and during a cost-push inflation production will decrease.)

Effect on borrowers and lenders

Borrowers are people who take loans and lenders are people who give out loans. During inflation borrowers gain and lenders lose. When borrowers borrow money to pay back at a later time, they actually gain during inflation, because the amount they pay at a later date has less value than the amount that they have borrowed.

(For example Mr. A borrowed Rf 5000 in December 2006 from Mr. B to be paid back on December 2007. But during 2007 the country experienced an inflation rate of 20% which means by the time Mr. A returns money the value of that Rf 5000 has gone down since now we can’t buy the same amount of goods and services that we were able to buy before inflation, in other words the purchasing power has gone down. So Mr. A is actually gaining here since he is now paying a Rf 5000 which is less in value, but Mr. B will lose since he is receiving his money with a less value.)

Effect on Balance of payment Balance of payment is the difference between exports and imports. If export is greater than imports then the country would have a surplus balance of payment (since export means country receiving money while import means expense to the country) and if the imports are greater than export then the country would have a deficit balance of payment. One of the main economic objectives of the government of every country is to have a surplus balance of payment.

During inflation exports becomes more expensive because inflation means rise in the general price level so when prices of our goods increases, exports would decrease since other countries would not demand out goods because of higher prices, and on the other hand during inflation it is cheaper to import goods from other countries since our own good’s prices are expensive. This will result in high imports and less exports resulting in a deficit balance of payment which is not good for the country since it means the country’s expenses are more than the country’s income.

Measuring Inflation

Inflation is measured in order to find the rate of inflation. Rate of inflation means the percentage change (increase or decrease) in general price level in a country over a period of time.

In the UK, there are two widely used measures of the price level; Retail Price Index (RPI) and Consumer Price Index (CPI).

The retail price index (RPI) measures the changes in prices of a fixed basket of goods and services commonly consumed by the majority of households. There are two ways of calculating the RPI, namely:

1) Simple index number

2) Weighted index number

There are some key terms that need to be focused, which are as follows:

Family expenditure survey: The survey asks about a sample of 7000 ‘typical’ households to record their expenditure on over 650 categories of goods and services known as the ‘basket of goods’ and surveys over the period of a fortnight.

• Basket of goods: large number of commonly used goods would be taken. Basket of goods shows the true representative of household purchases.

• Base year: the year from which the index begins. In the base year the index will always be 100 so that we can compare it with the current year.

• Current year: the year for which inflation is calculated.

• Index value: index value is the percentage change in the price compared to the base year. In the base year index value would be 100. Index value = current year’s price / base year’s price × 100

• Weight: the importance given to each product. Goods which household spend more would be given a high weight.

Simple Index Method

Ø In simple index method we take a basket of goods and measure the changes in price level by calculating index value.

Ø To calculate index value we divide the current price by base year’s price and multiply it by 100.

Ø Then we find the average price index by adding all the index value and dividing it by the total number of commodities so that it can be compared to the base year’s average.

And this difference is the change in inflation rate which would be stated as a percentage. This can be explained with a numerical example:

(Average price index current year = 200+80+110 = 390/3 = 130)

(Average price index base year = 100+100+100= 300/3 = 100)

(Therefore, change in price index (% rise in price level) = 130 – 100 = 30%)

Weighted Index Method

In Weighted Index Method we give each product a weight depending on the usage of the product by the people of the country. The higher the weight of an item the more it will be consumed

Ø Sometimes when calculating RPI in the simple index method the real inflation rate might not be shown since we are not giving a weight to the good.

Ø People spend more on commodities like food, housing, clothing, electricity…etc. than on luxury items. So if inflation rate is calculated based on the consumer usage of the good then it will show a true inflation rate.

Ø That is the reason why in most countries RPI is calculated by the weighted index method.

How to calculate

Ø In weighted index method we take a basket of goods, give them a weight according to the usage and measure the changes in price level by calculating weighted index value.

Ø To calculate the weighted index value we divide the current price by base year’s price, multiply it by 100 and multiply the answer by the weight given.

In other words, calculate the index value same as in Simple Index Method, then multiply the index by the given weight to get the weighted index.

Ø Then we find the average price index by adding all the weighted index value and dividing it by the total weight given to the commodities so that it can be compared to the base year.

Ø And the difference between average weighted index of base year and average weighted index of current year is the change in inflation rate which would be stated as a percentage.

This can be explained with a help of a numerical example:

Average price index current year = 200+160+330 = 690/6 = 115

Average price index base year = 100+200+200= 600/6 = 100

Therefore, change in price index (% rise in price level) = 115 – 100 = 15%

Consumer price Index (CPI)

CPI is the measure of the price level used across European Union (EU) and used by the Bank of England to measure inflation against its target since 2003. The CPI has only been calculated in the UK since 1996.

There are variety of differences between CPI and RPI.

CPI excludes a number of items relating to housing, whereas these are included in RPI. Excluded from the CPI is Council tax, mortgage interest payments, house depreciation, building insurance, and estate agents’ conveyance fees

Although the price of a good or service may rise, this may be accompanied by an improvement in quality of the good. It is hard to make price comparisons of, for example, electrical goods over the last 20 years because new audio-visual equipment is so different from its predecessors. In this respect, the CPI may over-estimate inflation. The CPI is slow to respond to the emergence of new products and services.

‘Policies to deal with inflation’

Following measures can be taken to reduce the inflation…..

1) Monetary policy

Inflation occurs when too much money chases too few goods. To control the inflation, Central Bank can take the following measures……

a) Increase the bank rate.

b) Increase the (CRR) commercial reserve ratio of commercial banks.

c) Sell bonds and securities.

All this measures reduce the money supply in the economy which will reduce the inflation.

2) Fiscal policy

Fiscal policy refers to the regulation of government expenditure and taxation in order to control the level of spending in the economy. To control the inflation, government can

a) Increase income tax and corporation tax.

b) Reduce government spending

All this measures reduce the consumer income and inflation.

3) Income policy

Income policy refers to application of control on the factor rewards such as wages. This policy will help reduce cost of production and thereby inflation.

4) Supply side policy

Increase in supply overcomes the problem of excess demand. Government can take following measures to increase supply.

a) Training and retraining workers to make them more productive.

b) Provide subsidies and grants to enhance investments.

c) Improving telecommunication, transportation network in the country.

d) Promote horizontal integration.

All this measures may help in increase in supply and reduce demand pull inflation.

5) Price control

Government sometimes directly controls the price to reduce inflation….

TAXATION

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TAXATION

Taxation

It is a sum of money (fee) demanded by a government for its support or for specific facilities or services, levied upon incomes, property, sales, etc.

Taxation is the main source of finance for the government. Taxes may be levied on

§ Income (Income Tax, Corporation Tax etc..)

§ Expenditure (Value Added Tax i.e., VAT)

§ Wealth (Inheritance Tax)

Reasons for Taxation

There are various reasons for the imposition of tax. The following are some of them…

§ To raise government revenue:

Imposition of tax raises revenue for the government to pay for public goods and services and merit goods and services.

§ To reduce purchasing power:

Lower earnings due to taxation reduces consumer spending in the economy. It helps to keep price stability

§ To reduce inequalities in the distribution of income and wealth:

Transfer payments made to the poor out of tax revenue from the rich helps reduce the gap between the rich and the poor.

§ To protect domestic infant industries:

Imposition of tax helps reduce stiff foreign competition by reducing imports

§ To improve the balance of payments position:

Imposition of duties to restrict imports helps reduce balance of payments deficit.

§ To discourage the consumption of harmful goods:

Imposing taxes on harmful goods like cigarette, alcohol will reduce the consumption of harmful goods.

Features of good tax

§ A good tax system should lead to fair and equal distribution of wealth in the community.

§ It should be composed in such a way that it yields sufficient revenue to the government.

§ The cost on collection of taxes should not be excessive.

§ The burden of taxes should be distributed in proportion to the ability of the tax-payer.

§ A tax should not discourage to work, save and invest.

Types of taxes

There are two types of taxes…

1) Direct Taxes

2) Indirect Taxes

Direct Taxes

A tax that is paid directly by an individual or organization to the (government).

Direct tax is levied on income (Income Tax), profits or gains (Corporation Tax), properties or assets (Inheritance Tax)

Advantages of Direct Tax

§ Equitable (Fair and Impartial):

Direct tax is equitable as it is imposed on person as per the property or income.

§ Certain:

Time, procedure and amount of tax paid to be paid is known with certainty.

§ Economical:

The cost of collection of direct taxes is small. There is no intermediary between the tax payer and the state.

§ Elastic:

Direct taxes have a high degree of elasticity. There rate can be change according to the needs of the country.

§ Enhance consciousness among citizens:

Taxpayers feel burden of tax and so they can insist the government to spend their contributions for the welfare of the community.

Disadvantages of Direct Tax

§ Chance of dishonesty:

To avoid from direct tax, the tax payer submits false statements of his income and revenue of state reduces.

§ Inconvenient:

The tax payer has to prepare lengthy statements of his income and expenditure. It is very laborious for the tax payer to prepare and keep these records.

§ Painful for the Tax Payer :

It pinches the tax payer that hid hard earning money is being taken by the government.

§ Lump sum Payment :

Direct tax is to be paid in lump sum every year so it becomes very difficult for the tax payer to pay large amount in one installment.

§ Reduction in Savings :

Direct tax discourages the rate of saving because the major portion of the income is paid to the government.

Indirect Taxes

Indirect tax is a tax levied on goods or services rather than on persons or organizations.

Indirect taxes are collected by the seller on behalf of the government in the form of

§ Value Added Tax (VAT)

§ Excise Duty

The impact of an indirect tax is on the person who pays it first. Its incidence is on the person who pays it last (consumer).

Advantages of Indirect Tax

§ Convenient in Payment :

It is very easy to pay because they are included in prices. The consumer often does not know that he is paying the tax.

§ No One can Evade the Tax :

Anyone who will purchase the taxed commodity will pay the tax. So it is not possible to evade indirect tax.

§ Contribution from Every Citizen :

Indirect tax is very useful because every member of the society contributes something towards the revenue of the state.

§ Elastic :

Indirect tax is also elastic to a certain extent. The state can increase its revenue within limits by increasing the rate of taxes.

§ Control on Harmful Goods :

If the state wishes to discourage the consumption of harmful drugs, it can raise their prices by increasing the taxes on them.

§ Tax on Luxury Items :

The indirect tax satisfied the canon of equality for luxury products. If it is imposed on luxury goods, then rich people will pay more taxes and poor will not pay because they do not purchase it.

Disadvantages of Indirect Taxes

§ Unfair Profit :

The traders may increase the prices more than the rate of taxes and they earn abnormal profits. A consumer suffers a loss.

§ Not an Economical :

Indirect tax is uneconomical. The government spends a large amount of money on the collection of taxes.

§ Uncertain :

The revenue from indirect tax is uncertain. The government cannot correctly estimate as how much money will it receive from this tax.

§ Civic Consciousness cannot be Created :

It does not create the civic consciousness because the tax is wrapped up in prices.

§ Does not Satisfy the Canon of Equality :

This tax is imposed on all the classes according the same ratio for necessary goods also. The burden of tax falls more on poor people than on the rich.

§ Low Standard of Living :

When the tax is imposed on the consumption of goods, it increases the prices and lowers the standard of living in the country.

UNEMPLOYMENT

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Unemployment

In labour market we have studied that labour market consists of all those people who are willing to work i.e. employees (supply side) and those who are willing to hire i.e. employers (demand side).

If supply side is greater than demand side i.e., if there are more people to work and less people to hire them it will lead to unemployment.

Full employment:

When we are referring full employment to inflation it means *full employment is when the country uses up all its resources and can no longer produce any more. The supply of all the country will be perfectly inelastic in the long run.

Here, full employment refers to a situation where the demand for labour is equal to the supply of labour. At full employment, the number of job vacancies is equal to number of people out of work. It means frictional employment is evident.(see in frictional unemployment)

Unemployment:

It refers to a situation where people who are actively seeking for job are unable to find it at current wage rate within a reasonable time.

The rate of unemployment:

The unemployment rate is the number of people on the claimant count (registered as unemployed)

Unemployment rate = registered unemployed X 100 / Labour force.

Types, Causes and remedies of Unemployment

There are four main types of unemployment… They are as follows………..

1) Frictional unemployment

2) Structural unemployment

3) Seasonal unemployment

4) General unemployment

Frictional unemployment

Meaning:

Frictional unemployment occurs when people move from one job to another job.

Causes

Frictional unemployment is caused by immobility of labour. People remain unemployed either they don’t wants to change the location (geographically immobile) or lack sufficient skills (occupationally immobile)

It is also called as search unemployment as some workers always will be in process of changing job for reasons like better salary, immobility, optimism of getting better job etc.. Therefore full employment is almost impossible at any given point of time.

It is also referred as casual unemployment as some workers will quit the job for family commitments, holidays, or to take a break etc….

Remedies

This type of unemployment can be reduced by

a) Providing better information of available jobs

b) Reforming the unemployment insurance programme

c) Providing job advisory services regarding most appropriate jobs

Structural unemployment

Meaning

Structural unemployment occurs when workers have job skills that do not match the skills required by available jobs.

For example, if a steel mill closes, for example, the steelworkers are likely to become structurally unemployed. There may not be enough jobs in other steel mills for all of the people who are trained to work in the production of steel.

Causes

Industry concentrated in one particular area may suffer regional unemployment. If such industry is facing decline in income generation it will affect the employment as the region is dependent on such industry.

Technological unemployment occurs, as the employees who are adapted to traditional way of work and lack knowledge of improved technology will be unemployed.

When an industry becomes less competitive and loose its export market the workers will be unemployed leading to international unemployment.

Remedies

This type of unemployment can be reduced by

a) Improve the ability of these workers to acquire additional education, skills and training.

b) Government should assist and protect the workers

c) Promoting occupational or geographical mobility of workers

Seasonal unemployment

Meaning

It occurs due to seasonal changes that affects the jobs in certain industries like tourism, fishing, construction etc.

For example: Tourist guides are unemployed during off-season

Causes:

It will be of no use to employ in off season as there will be very less or no business in off season hence this jobs are there in peak seasons only.

Remedies:

Seasonal unemployment can be eliminated by following measures

a) By providing training to take up alternative jobs

b) By organising job centers

c) Through financial assistance to get self employed

Cyclical unemployment

Meaning

It occurs when aggregate demand for the product falls leading to recession in the country.

Causes

As the aggregate demand for the product decreases the demand for the labour is less, it is therefore also called as demand deficiency unemployment. It is also called as General Unemployment.

Following are reasons for cyclical unemployment

a) Fall in demand for exports

b) Fall in government spending

c) Lack of technological progress in production

d) Rise in the export price due to cost-push inflation

Remedies

a) Increase in government spending

b) Promoting private spending through fiscal and monitory instruments (see policies to reduce inflation)

c) Granting production subsidies

d) Import substitution and export promotion

Changes in pattern of employment

There are tremendous changes took place in the recent years in the nature of the labour force around the world. Over time, patterns of employment change. Some industries go into decline and jobs disappear while new types of industries emerge developing new jobs. Following are some changes in pattern of employment:

1) A rise in the part time employment: Students attending college and university are available for part time jobs like, receptionist, cashiers, tutors etc… and females who wish to work only part time as they have family commitments resulted in huge increase in part time labour force..

2) More skilled workers: As there is development in education and training programs more number of people are seen taking up professional careers.

3) Rise of service sector: Over years’ service sectors has gained its importance.. sectors like tourism, insurance, banking etc.. has increased.

4) Participation of women at work: As there is change in social attitude of women working now many women are available for work.

Consequences of unemployment

a) Increase in crime rate: unemployed person has nothing to do hence can easily indulge in crimes.

b) Lower standard of living: People who lose their jobs suffer a fall in their standard of living, and so far do their dependents.

c) Mental trauma: Unemployment can have damaging effects on the morale of those out of work, who can be made to feel rejected and unwanted.

d) Loss of Skill: Workers who are unemployed for long periods of time may lose their skills.

e) Effect on government spending: As there is less revenue collected in the form of income tax government has less to spend.

Measuring of unemployment

The number of people unemployed [in the UK] is measured by the government each month. The job seekers allowance claimant count is the number of people who are claiming unemployment benefits from government.

The rate of unemployment is usually expressed as parentage of the working population or labour force

Unemployment rate = Registered unemployed x 100

Labour force

This enables to compare the unemployed situation in different countries.

UNEMPLOYMENT SUMMARY
TYPE	DESCRIPTION	CAUSE	REMEDY
FRICTIONAL	Workers temporarily between jobs	Delays in applying interviews and accepting jobs	Improve job information, example computerized job centers
STRUCTURAL	Workers have the wrong skills in the work place	Declining industries and the immobility of labour	Subsidies and improve the mobility of labour
CYCLICAL	All firms need fewer workers	Low total demand in the economy	Increased government spending or lower taxes
SEASONAL	Unemployment for part of the year	Seasonal variation in demand	Retraining

TYPE	DESCRIPTION	CAUSE	REMEDY
TECHNOLOGICAL	Firms replace workers with machine	Automation and information technology	Retraining
INTERNATIONAL	Overseas firms replace countries producers	High priced / low priced goods	Tarrifs quotas or money depreciation
REGIONAL	High unemployment in one area	Local concentration of declining industries	Regional aid, example: relocation and grants
VOLUNTARY	Workers choose to remain unemployed	Family commitments, more unemployment benefits etc..	Reforming unemployment benefit program, provide job assistance etc..

Some of the important features of unemployment in most of the countries at present are……

ü Rate of unemployment is growing at a faster rate.

ü The number of long term unemployment is increasing.

ü The unemployment rate among young people is very higher.

ü Unemployment of unskilled workers is higher than skilled workers (with professional qualifications).

Price Mechanism

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Price Mechanism

Price Mechanism: It is a system which allocates scarce resources for the production of goods and services according to the forces of demand and supply.

Price mechanism is the point which equilibrates supply and demand within a market. It is a mechanism of pricing. The price mechanism is one which allows the prices of goods and services to be decided by the interplay between supply and demand. There is no centralized price fixing.

The price mechanism is the concept that the free market, when left to its own devices, will formulate fair prices of the goods or services on its own by the natural laws of supply and demand.

It is the process by which changes in prices guide and shape changes in the value and types of the goods and services that are produced. The price mechanism will determine: “WHAT IS PRODUCED, HOW MUCH IS PRODUCED AND FOR WHOM A GOOD OR SERVICE IS PRODUCED FOR.”

The shoe market is an example of a competitive market where a number of firms compete to meet the demand for certain products or services. Two kinds of participants operate in it: those who have money and want shoes (demanders) and those with shoes who want money (suppliers). The ceteris paribus assumption applies in drawing the demand curve¹and the supply curve.²If any one of these variables should change, the demand curve and the supply curve for shoes would be altered.

Both producers and consumers base their respective production and consumption plans on the prevailing market price. When consumers pay a price for a commodity, they motivate the producer of that commodity and hence more of the same is produced and vice versa. The price paid becomes a vote for more production. Thus resources are channeled there.

Suppose consumers decide that they want to spend more on shoes. More consumers show up at stores hoping to buy shoes. The stores see the higher demand, raise their prices, and also order more shoes from producers. Higher profits from making shoes induce firms to expand production. Higher prices for shoes curb demand. Thus the system returns to a stable point with more production and purchase of shoes, and less production and purchase of other goods. Thus “prices” act as a “mechanism” that guides the allocation of productive resources--machines and workers--to different sectors of the economy.

The plans of the buyers and the plans of the sellers are balanced at a point, at which a transaction can take place, by the operation of the price mechanism (market mechanism or Invisible Hand). This balancing of forces, this perpetual tendency toward equilibrium, is the Law of Supply and Demand.

The concept of the equilibrium is of the utmost importance in economic theory. Equilibrium is a state of rest, when there is no reason for anything to change unless disturbed by an outside shock. At the equilibrium price quantity supplied equals the quantity demanded. Q_S= Q_Dis the equilibrium condition.

If intended supply > intended demand, price will fall

If intended supply < intended demand, price will rise

If intended supply = intended demand (equilibrium)

The Functions of the Price Mechanism

The Rationing Function

When consumers and firms respond to the information and incentives provided by prices, scarce resources are rationed between competing uses. Prices function as a mechanism for allocation. For example, say the price for a pair of shoes is ₩40,000 and say this is well below the market clearing price. In a free market situation prices will rise to eliminate this disequilibrium. This illustrates the rationing function.

The Signaling Function: Prices must convey sufficient information to all traders in the market for their economic activities and plans to be coordinated. The signaling function of the price mechanism can be illustrated by looking at the market for trainers. Assume that some advertising campaign has recently made such goods popular thus shifting the demand curve to the right.

The initial shift to the right would act as a signal for other firms in other markets.

An incentive: is something that motivates a producer or consumer to follow a course of action or to change behaviour. Higher prices provide an incentive to producers to supply more, or to enter the market, because they provide the possibility or more revenue and increased profits. Example In response to an incentive signaled by the high price, firms would shift their resources into the production of training shoes.

The Allocative Function

The price mechanism will also ensure that goods will be allocated efficiently. If prices are set above equilibrium, suppliers will find themselves with a surplus of stock. Prices will fall to clear the market and allocate resources efficiently.

Labour Market

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Labour Market

What determines the wage rate in a labour market?

In a competitive labour market the wage rate is determined by the interaction of demand and supply. The demand for labour is undertaken by firms, which require workers to help produce goods and services. The supply of labour comes from the general population and, in particular, the workforce of an economy.

In practice there are many different types of labour market: for example, shop assistants, kitchen chefs and lawyers. Labour markets also include public sector workers where the government is a major employer of labour: for example, teachers, nurses and police officers.

The demand for labour

The demand for labour is a derived demand. It is derived from the demand for the goods and services it makes. For example, the demand for building workers is derived from the demand for new housing.

The figure below shows how an increase in demand for new housing will cause an increase in demand for building workers, such as bricklayers and carpenters. The effect is to increase the wage rate from We to W₁ and the quantity employed from Ne to N₁.

There are several key determinants of the demand for labour:

● Demand for the final product. An increase in demand for a good or service is likely to cause an increase in demand for the labour involved in making it. Firms have a profit incentive, if demand and prices increase, to supply more of a good or service.

● The wage rate. A fall in the wage rate means that labour becomes more affordable and so firms are likely to demand more labour.

● Other labour costs. For example, a fall in employers’ national insurance contributions on behalf of their staff is likely to raise the quantity demanded.

● Price of other factor inputs. An increase in the price of capital might encourage firms to employ more labour and cut back on the use of machinery and equipment where possible. This is because labour and capital may be substitutes in the production process.

● Productivity of labour. An increase in output per worker may lead to higher revenue and profits, encouraging firms to employ more people.

● Government employment regulations. The fewer the number of regulations, the greater the demand for labour is likely to be. For example, if it becomes easy to hire and fire staff or to change working conditions, then the increased labour flexibility may encourage firms to employ more people. However, a national minimum wage (NMW) set above the free-market wage may cause a decrease in the quantity of labour demanded.

The supply of labour

This refers to the quantity and quality of labour hours offered for work over a given time period. There are various factors which determine the supply of labour, namely:

● The wage rate. An increase in the wage rate will encourage more people to offer their services for work. A higher wage rate means the opportunity cost of leisure time increases, encouraging people to work longer hours.

● Other net advantages of work. Improvements in working conditions will also tend to increase the supply of labour: for example, a good pension, paid holidays, job security and promotion prospects.

● Net migration. Over recent years the UK has experienced a significant increase in immigration from central and eastern Europe, helping to boost the economy.

● Income tax. A reduction in income tax will increase disposable incomes and so offer a greater incentive for people to work. Many people will substitute work for leisure time, increasing the supply of labour.

● Benefit reform. A reduction in benefits (e.g. incapacity benefit, housing benefit and the jobseeker’s allowance) may provide a greater incentive for people to look for work and so increase the supply of labour.

● Trade unions. Trade unions act to increase wage rates and improve other working conditions through collective bargaining with employers. This may encourage an increase in the supply of labour.

● Government regulations. An increase in employment protection or the introduction of a national minimum wage will tend to improve working conditions and so increase the supply of labour. However, it is also possible that government regulations reduce the supply of labour (for example, the EU Work Time Directive limits the maximum hours of work per week to 48 for most employees).

● Social trends. There has been a significant increase in the number of women in the workforce over the past 40 years. This reflects an improvement in equal opportunities, childcare facilities and social attitudes.

Labour market and wage determination

The price of labour is known as the wage rate. If wages are too high, then there is more labour supplied than demanded — we have unemployment. If this occurs in a free labour market, then workers will have to accept lower wages or go without a job; thus the wage rate will tend to fall to the market clearing rate. If wages are too low, then demand for labour will be high but supply will be low so there will be a labour shortage, ie workers will not work if they are paid too little (an hour of their leisure time is more valuable than a hour of work). Firms will have to pay workers more as an incentive to work, and so the wage rate will be bid up to the market clearing wage.

National Minimum Wage

National Minimum wage is the legal minimum pay that employers must pay to workers. Minimum wage is imposed by the government in order to raise the income of the very low people to a minimum level. A minimum wage will lead to increase in the workers incentive to work. However, it will also lead to increase in cost of production of the sellers.

Cost & Benefit Analysis

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Cost and benefit analysis is a finding of what is best for the society by calculating total cost and total benefits

Example:

Steel Manufacturing factory: Cost Value = $ 100000

Benefit value = $ 1100000

So analyzing this cost and benefit value it is decided whether to do this activity or not.

The cost and benefits are of different types

Cost

1) Private Cost:

A) Amount of money individual spend over a product is private cost. Example cost of cigarette is MRF2

B) Disadvantage to individual due to economic activity is private cost. Example Smoking leads to Asthma or Cancer.

2) External Cost: Disadvantages to third person who are not involved either production or consumption of goods. Example the smoke emitted from cigarette may harm to other person around who does not smoke.

3) Social Cost: It means disadvantages to whole society due to production of goods and services. It includes Private Cost + External Cost. Example producer who produce cigarettes has to live in the same environment. Consumer who smoke will have to face the problems of smoking and the third person who is around is also having disadvantage due to this economic activity.

Benefits

1) Private Benefit: These are the advantages to a person / individual due to an economic activity. Example Producers get profit by selling cigarette and consumer’s gets satisfaction after smoking.

2) External Benefits: These are advantages to 3^rd person due to economic activity. Example employment increase.

3) Social Benefits: It is the advantages to whole society due to economic activity. Private + External benefits = Social Cost.

Conclusion: Government calculates cost and benefit analysis and based on reports give permission / license to start any project.

Marginal Cost and benefits

The difference between social costs and social benefits changes as the level of output changes. This can be shown using marginal analysis. The margin is a possible point of change. So the marginal cost of production is the extra cost of producing an extra unit of output. The marginal benefit is the benefit received from consuming an extra unit of output.

The marginal cost of production will first decrease, as more output is produced indicating greater efficiency. However, as more output is produced, marginal cost will increase. This may be because the firm may have to pay more for the acquisition of factors of production. (Producing beyond capacity, hiring more labour)

In contrast, marginal benefit will decrease as more goods are consumed the marginal benefit curve is also same as demand curve.

The social optimum and free market optimum through external cost or external benefit.

Negative externalities/External Cost

External costs are costs incurred to third parties not involved in a trisection. It is the difference between social cost and private cost. Exist when the social costs of an economic action are greater than the private costs. For example, a toy manufacturer located on the banks of a river will incur a number of private costs of production (example raw materials, labour, running machinery etc) but may also impose costs on third parties, such as noise from delivery lorries and an ugly factory affecting the quality of life of local residents or pollution being pumped into the river. Social costs = private costs + external costs.

X is free market optimum level of output

Y is the social optimum level of output

The free market optimum level of output is where marginal social benefit is equal to marginal private cost. This is also known as market equilibrium. However, social optimum output is less than free market level of output. It is output Y. the production and consumption takes places at OX, which is higher than the social optimum level creating a welfare loss to the society. The loss is the vertical difference between MSC and MSB. The triangle which forms in this distance is called welfare loss triangle.

Positive Externalities/ External Benefits.

Positive externalities or external benefits are benefits enjoyed by the third parties not involved in a transaction. It is the difference between social benefits and private benefits. It exists when the social benefits of an economic action are greater than the private benefits. For example, the education received by a child means that he or she can get a job which pays a reasonable income (i.e. there is a private benefit to education); however, that child’s education may also benefit wider society if he or she become a doctor and is able to treat people so that they can return to work (i.e. there is also a social benefit).

Introduction to supply

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Definition

Supply refers the amount of goods and services producers are willing and able to supply at a given price.

Law of supply

Law of supply states that assuming Ceteris Peribus, more will be supplied at higher price. Therefore between quantity supplied and price, there is a positive relationship.

The supply curve

The supply curve is an upward sloping curve which represents the producers willingness and ability to supply a good.

Upward sloping supply curve does not apply. For e.g. too much of what is produced by government

As shown supply curve is upward sloping. This positive slope between market price and quantity supplied are for three reasons:

· Profit Motive:When the prices increases (for example a rise in market demand), it becomes more profitable for business to increase their output. Hence for example the higher price signals the producers to increase the output since the scope of their profit has risen.

· Production and cost:When the production of a firm increases, the required cost of production increases as well. Therefore a higher price is needed to justify the extra cost business faces.

· New entrants coming into the market:The higher prices will attract new entrants to enter into the market causing the supply to increase.

Movement along the supply curve and movement of supply curve

Movement along the supply curve refers to change in quantity demanded when the market price changes. It can be in the form of expansion of supply – increasing quantity supplied when price increases or contraction of supply – fall in quantity supplied as a result of price decline.

Movement of supply curve refer to shift of supply curve . A supply curve can shift to right (increasing supply or to left (reduction in supply)

Factors that cause shift of supply

Changes in cost of production: When cost of production reduces more of the good can be supplied at a lower price. Any direct or indirect affect to cost of production can affect the supply.

Changes in production technology: When technology improves it increase the supply of goods and services because it mean more can be produced using the resources

The Price of other goods:When there is change in price of other goods it affect the supply of particular good.

Example: if the price of beef rise there will be rise in demand of beef and more cows will be slaughtered which increase the leather supply

Other Changes :

1)Govt. Legislation

2)Weather

3)Expectation of future events

Government Intervention to correct externalities

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Government Intervention to correct externalities

Government can use wide range of policies that it could use to bring an efficient allocation of resources where externalities exist.

1) Regulation: it is a method used by government to control externalities. Methods like

a) Government could lay down maximum pollution levels.

b) Government could ban pollution creating activities.

For instance: In the UK, the Environmental Protection Act 1989 laid down maximum environmental standards for emission for more than 3500 factories involved in chemical process, waste incineration and oil refining. Government banned burning of ordinary coal in urban areas.

2) Extending property rights: If a chemical company lorry destroyed your home, you would expect the chemical company to pay compensation. If the chemical company polluted air in atmosphere and the tree in your garden died, it would be unlikely that you would gain compensation, particularly if the chemical plant is in the UK and the dead trees were in Germany.

Externalities often arise because property rights are not fully allocated. Nobody owns the atmosphere, oceans, and rivers. Government can give water companies right to charge companies polluting water which dump waste in sea and rivers. It can give local residents the right to claim compensation if the pollution levels are more than a certain amount.

· However there are some problems for extending property rights. If the polluter is in another country and sufferer is in another country. For example. If Brazil is cutting its forest which will lead to global warming and western countries are being affected. Western countries can pay Brazil for not cutting down the forest.

· Another example could be of asbestos sheet worker who have the right to claim if his health is damaged working in the company due to asbestos. Company will not pay him until it is clear that his health is damaged due to asbestos. This could take longer time and the worker can even die until his reports come.

· If there is a tree in your garden and your friends garden and the road contractor wants to cut down the roots coming out. You may be having much value for the tree where as your friend may be fairly unaffected by cutting down the trees root. Hence it is difficult to measure the exact cost of the property.

3) Taxes: Government can set extra taxes on the externalities equal to the amount of externalities. This will result in fall in demand and less will be produced causing less externalities. For example government can impose tax on petrol equal to the amount which is required to clear pollution it creates.

4) Subsidies: Assume government wants to control emissions of sulphur in to the environment. It will issue permits to pollute. The total of which equals the maximum amount of sulphur it wishes to be emitted for a period of time.

Diagram to illustrate government intervention

· In the diagram, regulation fix output to V where externalities are less

· Extending property rights attempts to equal MPC & MSC by shifting

MPC upwards

· Taxation again helps to equal MPC & MSC. The tax should be

levied in such a way that at output V MPC

=MSC.

· Permits acts like regulation permitting pollution up to a level

where production limits to V

Government Failure

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Government failure exists when the government intervenes to correct a market failure, but this result in a more inefficient allocation of resources. All over the world there are main causes of government failure. Some examples are….

1) Mexico City and emissions from cars – tackling transport market failure.

A good example of government failure is Mexico’s approach to reducing co2 emissions in Mexico City. Their policy was very simple. Cars with even/odd number plates were allowed into the city on alternate days, which in theory should have reduced the number of cars entering the city by a half. However, the reality was very different. Car owners sold their nice cars and bought two, older and more polluting cars one with an even number plate and one with an odd number plate, resulting in inefficient use of government money and government failure.

2) The common agricultural policy (CAP) – tackling agricultural market failure.

The aim of CAP is to stabilize agricultural prices and provide a satisfactory level of income for farmers in the European Union (EU). However, the outcome is inefficient. Farmers produce too much, and excess supply is bought by the EU and stored (causing ‘wine lakes’ and ‘butter mountain’) so the EU has to pay subsidies to farmers and pay for warehouses and storage. Result an inefficient use of government money and government failure.

3) The national minimum wage – tackling labour market failure.

This was introduced to protect workers who received low pay, by making it illegal for employers to pay a wage below the NMW. However those workers who managed to retain their job ended up with higher pay, but some workers would lose jobs and therefore be worse off.

4) Rent control – tackling housing market failure.

Any people in the UK struggle to pay for ever more expensive housing, especially with the increasing housing shortage in the south east. If the government were to consider the level of rent to be unacceptable high, then they could impose a maximum rent. Maximum prices are set below the market equilibrium price; so that in this case demand for houses exceeds supply of houses causing housing shortage some people will be worse off.

If market fails government intervene to correct market failure. However if market fails so too can government. GOVERNMENT FAILURE occurs when it intervenes in the market but this intervention lead to loss of economic welfare rather than gain.

There are number of reasons why government failure occurs.

± Inadequate information: Government may not have complete information on which to base a decision. In some cases information may be misleading. The government may make a wrong policy response with the available information or misleading information. For instance government has to take decision whether to fund a selective school (A selective school is a school that admits students on the basis of some sort of selection criteria, usually academic.) or comprehensive school (comprehensive school is a state school that does not select its intake on the basis of academic achievement or aptitude.). The issue is important as education is the key determinant of the long term competitiveness of a country. It also affects every child.

± Conflicting objectives: government often faces conflicting objectives. For instance, they may want to cut taxes but increase spending on defense. Every decision made by government has opportunity cost. Similarly in case of education assume those who receiving a selective education receives better education in contrast those who fails to get into selective schools achieves less. Government may fail to decide or do it purposely for rewarding their supporters in electorate.

± Administrative cost: Sometimes correcting market failure may be too costly that it may outweigh the welfare benefit to correct market failure.

± Market distortion: In some cases government intervention to correct one market failure leads to the creation of far more serious market failure. One example is national minimum wage.

Public Choice Theory

It is generally assumed that government act for maximizing economic welfare and they may not succeed in this due to lack of information, conflicting objectives, cost etc. However PUBLIC CHOICE THEORY suggests that government may not attempt to maximize economic welfare at all. Public choice theory analyses how public spending and taxation decision are made. Consumers or customers are voters in system. The vote for politicians and political parties whore are the producers in the system. Producers make decisions about how public money should be spent, about taxes and about law.

Voters want to maximize the benefits they get from state. Politician wants to retain power. Hence they will benefit their supporters

Public Choice Theory explains why government often fails

Local interest: The politicians may work for their own benefit and to retain power and they may not go according to economic welfare but try to take care of the people who vote them for example. If a government decide to close a factory or move a factory which is near residential area. Local MP can force government not to do so as if the factory is closed all the employ who are working will be unemployed and the politician may lose that votes.
Favoring minorities: It is seen that minorities would cast their votes and they are too important for politicians as they can change the scenario and hence they may put some of the policies favoring minorities and leave majority of people away from the benefits
Conflicting personal interests: Politicians, parties and government may be prone to corruption. Apart from wishing to gain votes and power politicians may be willing to gain wealth too. Hence the decisions may be made in their own personal interest instead of being made for the welfare of the society.
Short – termism: Government may lay down some policy for the economic welfare but these policies may be long term policies and if the government changes within some period of time then they may not be able to continue with the welfare policy as the new government may or may not continue the policy.
Regulatory capture: Government is responsible for regulating many areas, such as monopolies, or the environment. Regulatory capture means that groups such as monopolists earning abnormal profit or polluters damaging the environment can strongly influence the way they are being regulated to their own advantage.

MONOPOLISTIC COMPETITION

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It is a market structure where a large number of small firms produce non-homogenous products and where there are no barrier to entry and exit

Monopolistic competition is a type of imperfect competition such that one or two producers sell products that are differentiated from one another as goods but not perfect substitutes (such as from branding, quality, or location). In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms.

Monopolistic competition is a type of competition within an industry where:

1. All firms produce similar yet not perfectly substitutable products.
2. All firms are able to enter the industry if the profits are attractive.
3. All firms are profit maximizers.
4. All firms have some market power, which means none are price takers.

Assumptions:

1. There are large number of buyers and sellers in the market and acts independently.

2. No barriers to entry and exit

3. Firms are short run profit maximizers. (MR=MC)

4. Products can be similar but with slightly differentiated but highly substitutable

The downward sloping demand curve:

If a firm produces a product with a slight difference from that of competitor, it will gain some market power. It can raise the price up to a certain level without losing its customer, but if it increases its price too high it will lose its market as there are many firms making close substitute of the product. Small change in price can result to large change in quantity demanded as consumer switch to close substitutes. Hence the demand is relatively elastic and downward sloping.

Short Run:

· There is the possibility of short run supernormal profits or losses.

· This is shown on the graph, where the shaded area represents supernormal profits.

Long Run:

· Lack of significant barriers to entry and exit → only normal profits being made in the long run.

· Short-run supernormal profit will induce new entry.

· This means that the demand curve will shift to the left until it is tangential to the average cost curve (AR = AC).

· Similarly, if losses are being made in the short run, some firms will leave the market, restoring long run equilibrium.

Game Theory of Oligopoly

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Game Theory of Oligopoly

Game theory is mainly concerned with predicting the outcome of games of strategy in which the participants (for example two or more businesses competing in a market) have incomplete information about the others’ intentions.

Game theory explores the reactions of one player to change in strategy by another player. It is therefore necessary in any theory of oligopoly, to understand the consequences of those reactions. One method / tool to analyze oligopolistic behavior is Game Theory.

1) Dominant Strategies: A dominant strategies is where a single strategy is best for players irrespective of what strategy the other player adopt.

Consider this table

DOMINANT STRATEGIES
Firm ‘A’s Strategy	A Profit in Millions £	B Profit in Millions £	Firm ‘B’s Strategy
Price Raise	+£ 5	+£ 5	Price Raise
Price Raise	+£ 3	+£ 3	Leave Price Unchanged
Leave Price Unchanged	+£ 2	+£ 1	Price Raise
Leave Price Unchanged	£ 0	£ 0	Leave Price Unchanged

ﻡ If a firm ‘B’ choose to raise the price firm ‘A’ will earn extra £ 5 if it raises its price too better than £ 2 extra if it choose to keep the price unchanged.

ﻡ If firm ‘B’ choose to keep its price same, firm ‘A’ can make extra £ 3 m profit by raising its price. If both firms keep the price same then they will not be getting any extra profits.

ﻡ Which strategy should firm ‘B’ choose?

2) Nash equilibrium: Neither player is able to improve their position given the choice of the other player.

Consider this table

Nash Equilibrium
Firm ‘A’s Strategy	A Profit in Millions £	B Profit in Millions £	Firm ‘B’s Strategy
Lower Price	+£ 5 m	+£ 2 m	Lower Price
Lower Price	-£ 1 m	-£ 1 m	Leave Price Unchanged
Leave Price Unchanged	-£ 2 m	-£ 1 m	Lower Price
Leave Price Unchanged	£ 0 m	£ 0 m	Leave Price Unchanged

Dominant strategy equilibria don’t occur that often. In most games the strategy of one firms depend on the strategy by other firm adopt.

ﻡ Assume that firm ‘B’ choose to lower its price, the best strategy for firm ‘A’ will be to lower its price too, as it will increase the profit by £5m. if it keeps its price same there will be a fall of £2 m. Therefore the best strategy for firm ‘A’ is to reduce price if firm ‘B’ reduce its price

ﻡ What is the best strategy for firm ‘B’ if firm ‘A’ chooses to lower its price?

Both firms lowering price is a Nash Equilibrium, named after a US mathematician John Nash. In Nash equilibrium, neither player is able to improve their position given the choice of the other player.

However in this example there may be more than one Nash Equilibrium. If both firm leave their price unchanged is a Nash Equilibrium.

If a firm is sticking to one single policy (Pure Strategy) then there will be no Nash Equilibrium.

Price Stability: In oligopoly firms maintain price stability over a pricing season, which may last for 6 months or one year.

If oligopolistic firm raise price it has the risk of losing the market share, if other competitor did not raise price. This move will reduce firm’s profit.

If oligopolistic firm lower its price it starts price war. However it may gain market share but the profit of the firm falls. As the profit will fall down the firm may not be able to compete in the market and hence again at a time it has to increase its price leading to more loss of market share than before.

Hence price change is the risky strategy.

A zero sum game which leads to price stability
Firm ‘A’s Strategy	A Profit in Millions £	B Profit in Millions £	Firm ‘B’s Strategy
Price Raise	+£ 10	-£ 10	Price Raise
Price Raise	-£ 2	+£ 2	Leave Price Unchanged
Leave Price Unchanged	+£ 1	-£ 1	Price Raise
Leave Price Unchanged	£ 0	£ 0	Leave Price Unchanged

This table shows a particular type of game “Zero Sum Game”. In this game the profits / gains of one player are matched by equal and opposite losses for other player. When gains and losses are added it equals Zero.

Q. Explain why and what strategy should firm A pursue?

Q. Explain why and what strategy should firm B pursue?

Non Price Competition: Price competition is absent in oligopoly. Price war can be damaging for firms in oligopoly. Firms in oligopoly may adapt different methods like advertisement.

For instance: If firm A launches an advertisement and has gained some extra market share due to advertisement, firm B will be provoked to make advertisement. If firm B makes more successful advertisement and gains more market share than firm A it will be like a back fire for firm A. This explains in oligopoly firms may not try to drive out other firms as it can be risky and they themselves can be victim of such move.

Branding: Ideally oligopolistic firms would like to turn themselves into monopolists with full control over the market. One way of doing it is Branding their product.

Strong brand is difficult to create and consumes more time; hence firms prefer to take over firm and their branded product at high cost too. For example: Jaguar Cars, Arcellor.

Collusion: Another way in which oligopolists can turn itself into a monopoly is by colluding with other firm. Forming Cartels was the practice carried out in British manufacturing industry before 1950s then this was made illegal.


Firm ‘A’s Strategy	A Profit in Millions £	B Profit in Millions £	Firm ‘B’s Strategy
Low Price	+£ 15	+£ 10	Low Price
Low Price	+£ 25	+£ 5	High Price
High Price	+£ 10	+£ 20	Low Price
High Price	+£ 20	+£ 25	High Price

In this table if firm ‘A’ will lower its price against high price strategy of firm ‘B’ as they will get maximum benefit but firm ‘B’ will not let it happen as its profit will be only £5m. however a high price strategy by firm A will be worse of when firm ‘B’ will lower its price as it will make the lowest possible profit of £10m. In fear of opponent firms strategy both the firm will stick to low price strategy. The best strategy for both firms will be to collude and come to a conclusion that both firms will raise price so as they will earn maximum profit.

Same situation can be analyzed by the example of what is often called the Prisoner’s Dilemma. Substitute profits for prison sentences and prices for pleading guilty or not guilty. If 2 prisoners kept apart in different cells plead not guilty, then they will be released through lack of evidence. However, if one prisoner pleads guilty, then he will get reduced sentence and the other will get a heavier sentence. If both plead guilty they will get heavy sentences. If they could get together (i.e. collude) they would choose to plead not guilty. But in isolation they cannot trust the other prisoner, so each chooses to plead guilty and they both suffer.

Cartels are usually unstable because it would normally be in the interest of one of the player to attempt to cheat on the agreement made. In the table if firm ‘A’ secretly lower its price directly or in the form of offers he can get £25m which is £5m extra.

The firm who can be cheated by other firms must be able to enforce the rules agreed by the cartel. For example OPEC, in 1980s and 1990s was beset by some countries cheating by some countries. Prices and output quota was given to each country in Cartel. But some countries secretly produced more and sold at lower price which increased their market and profits. But this step lowered the price of oil in world market. In 1986, Saudi Arabia which had tended to agree to production cuts in OPEC punished the cheating countries in OPEC suddenly increased production. Prices collapsed and all other countries were worse off. It subsequently cut down the production to raise oil prices, but it had shown what could happen to cheats if they refused to stick to policies laid down by Cartel.

Multi – firm, multi – strategy options

Till now we were discussing two firm two option situations. In reality there are likely to be more than two firms and more than two policy option. For example if there are two firms and 6 options the possible situation would be (6x6=36). If there are 3 firms and 6 options the possible situations available will be (6x6x6=216). Hence it is difficult to provide one unified model which would explain price and output decision in industry.

Contestable Markets

2012-10-02T11:47:00.000+05:30

Contestable Markets

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Contestability

William Baumol (1980s) – theory that the number and size of not only competitors but potential competitors can affect a firm’s behaviour.

Contestability is measured by the extent to which the gains from market entry for a firm exceed the cost of overcoming barriers to entry, with the risks of failure taken into account (affected by barriers to exit).

In other words, a contestable market exists when a market is said to have low sunk costs and therefore low barriers to entry and exit – this means that new firms can quickly enter an industry to exploit supernormal profits before leaving the industry – ‘hit and run’ profits.

Types of competition:

· Perfect competition: perfect competition is perfectly competitive.

· Monopolistic competition: this type of competition has minimal entry barriers although small firms need to build up a customer base and meet certain government regulations – it is highly but not perfectly contestable.

· Oligopolies: these are much less contestable due to high barriers to entry and exit.

· Monopolies: these are not very contestable at all, for example in a legal monopoly such as the Post office (to an extent) the market is not contestable. This can also be an issue where a firm has the protection of a patent.

What is a sunk cost?

· A sunk cost is a cost which cannot be recouped on exiting the industry.

· The main examples of sunk costs are advertising, research and development etc.

· In other words, sunk costs are the costs of anything which cannot be sold second hand.

How the threat of new entry influences the behaviour of firms

Firms may alter their behaviour with the threat of new entry, causing them to use price or non-price strategies to deter new entry.

Price strategies:

1. Predatory Pricing:

· This is an anti-competitive strategy in which a firm sets price below average variable cost in an attempt to for a rival or rivals out of the market and achieve market dominance.

· This is an extreme strategy because firms generally shut down when they don’t cover their average variable cost.

· The consumer might benefit in the short-run, however in the long run the firm would be likely to try to make up for the losses made by significantly increasing price (once competitors had been driven out).

· In some cases even the threat of predatory pricing will be enough to drive out competition, if credible.

· Whether entry will be deterred may depend on the potential entrant – a new firm may think that if the dominant firm is willing to risk such losses then it must be worthwhile to dominate the market – it may therefore decide to sacrifice short-term profit in order to enter the market (especially if it is diversifying from other markets and has resources at its disposal).

· It is illegal under EU law.

· One example of predatory pricing is with easyJet in 1996:

- easyJet was a relatively new low-cost budget airline trying to establish itself

- when they started flying the London-Amsterdam route the incumbent firm (KLM) reacted aggressively, driving its price below easyJet’s

- easyJet responded by launching legal action against KLM

2. Limit Pricing:

· This is less extreme.

· The limit price is the highest price that an existing firm can set without enabling new firms to enter the market and make a profit.

· If a firm is making supernormal profits in an industry, this will be attractive to potential entrants.

· If a new firm joins the market, producing on a relatively small scale (so as just to cover AC) the price will go down.

· As the new firm is just covering AC it is making normal profits, and the previous firm’s supernormal profits decrease.

· The firm could have guarded against entry by charging a lower price to begin with – this way the new firm would have driven price down to a lower level, and without the benefits of economies of scale it would make losses and exit the market.

· If the existing firm has been in the market for some time it will have learned in the process, and will have a lower AC than the new entrant – this means that limit pricing can be used more easily.

· Therefore, by setting a price below the profit maximising level, the original firm is able to maintain its market position in the longer run.

· This may happen in an oligopoly as well as a monopoly, as existing firms may group together to limit price.

Non-price strategies:

Advertising and publicity:

- Component of fixed costs – advertising does not vary much with output.

- If firms spend heavily on advertising, it increases barriers to entry for new firms as they must also heavily advertise in order to increase demand for their product.

- Firms may spend heavily on achieving a well-known brand image and therefore consumer loyalty – they may invest in the design and packaging of their merchandise, e.g. the TV campaign run by Sunny Delight when trying to gain entry into the soft drinks market in the early 00s.

- Such costs are also sunk costs, therefore they make the market less contestable by raising barriers to exit too.

Research and development:

- In some markets there is heavy expenditure on research and development.

- E.g. the pharmaceutical industry, which spends a lot of money researching new drugs.

- This is another component of fixed costs – it does not vary with the volume of output.

- New firms know that they will need to invest heavily in research and development if they are going to keep up with the new better drugs constantly coming onto the market.