Institut Universitaire et Stratégique de l’Estuaire

Estuary Academic and Strategic Institute (IUEs/Insam

Sous la tutelleacadémique des Universités de Dschang et de Buea.

Academic Year: 2021/2022

Course : General Economics

COURSE FACILITATOR: M. KONJOH MICHEL

PART I: MICROECONOMICS

CHAPTER 1: THE CENTRAL PROBLEM OF ECONOMICS

 INTRODUCTION

Economics is the study of how society allocates limited resources to the production of goods and
services to satisfy unlimited human wants.

There are two main branches of economics: microeconomics and macroeconomics.

Microeconomics deals with the analysis of individual parts of the economy. It concerns factors
determining the behaviour of a consumer, the behaviour of a firm, the demand for a good, the supply
of a good, the price of a good, the quantity of a good, the performance of a market, etc.
Macroeconomics deals with the analysis of the whole economy. It concerns factors determining
aggregate variables such as aggregate demand, aggregate supply, national output, unemployment,
inflation, the balance of payments, etc. As opposed to microeconomics which focuses on the
individual parts of the economy, macroeconomics looks at the big picture of the economy.

Economists often distinguish between positive economics and normative economics. Positive
economics is concerned with facts. It tells us what was, what is or what will be. Disagreement over
positive economics can be settled by an appeal to facts. In other words, positive economics is
verifiable.

Consider the following statement:

‘A decrease in personal income tax will lead to a rise in unemployment.’

In the above statement, both personal income tax and unemployment are measurable and hence the
statement is verifiable. Therefore, the statement is a positive statement. It is important to take note that
a positive statement can be true or false. What makes the statement a positive statement is not that it is
true but that it is verifiable. In fact, the statement is false.

Normative economics is concerned with value judgments. It tells us what should be. Disagreement
over normative economics cannot be settled by an appeal to facts. In other words, normative
economics is not verifiable.Consider the following statement:

‘A redistribution of income from the rich to the poor will increase social welfare.’

In the above statement, although redistribution of income is measurable, social welfare is not and
hence the statement is not verifiable. Therefore, the statement is a normative statement. It is important
to take note that a normative statement can be true or false. Although the statement is true, what makes
it a normative statement is not that it is true but that it is not verifiable.

2 FACTORS OF PRODUCTION

In order to produce goods and services, an economy needs to have resources. The larger the amount of
resources an economy has, the larger will be the amount of goods and services it can produce.
Resources can be divided into four categories known as the four factors of production: land, labour,
capital and enterprise.

Land : Land refers to the gifts of nature that are used to produce goods and services. It includes plots
of land, natural resources, fishes in the sea and trees in the forests.

Labour : Labour refers to the physical and mental effort that people devote to the production of goods
and services.
Capital : Capital refers to the goods that are produced for use in the production of other goods. It
includes factories and machinery.

Enterprise : Enterprise refers to the ability and the willingness to take risk.

Note: Students should not mix up capital in economics, which is known as physical capital, and
capital in business, which is known as financial capital. Although financial capital refers to the money
needed to start a business, physical capital refers to factories and machinery.

3 SCARCITY, CHOICE AND OPPORTUNITY COST

Although resources are limited, human wants are unlimited, and this gives rise to scarcity. Scarcity is
the situation where limited resources are insufficient to produce goods and services to satisfy
unlimited human wants. Scarcity necessitates choice. In other words, due to scarcity and hence the
inability to produce all goods and services, society must choose what goods and services to produce.
The opportunity cost of a course of action is the benefit forgone by not choosing its next best
alternative. When a choice is made, an opportunity cost is incurred. In other words, when society
chooses what goods and services to produce, it is choosing what goods and services not to produce.

4 THE PRODUCTION POSSIBILITY CURVE

4.1 The Production Possibility Curve, Scarcity, Choice and Opportunity cost

The production possibility curve (PPC) shows all the possible combinations of two goods that can be
produced in the economy when resources are fully and efficiently employed, given the state of
technology, assuming the economy can only produce the two goods.

Possible Combinations of Good Y and Good X

Combination Good X Good Y

A 0 50
B 10 48
C 20 45
D 30 40
E 40 33
F 50 23

In the above table, A, B, C, D, E and F are the possible combinations of good Y and good X that the
economy can produce using its resources fully and efficiently.

Production Possibility Curve

The PPC reflects scarcity, choice and opportunity cost. Although the points inside and on the PPC are
attainable, the points outside the PPC are not. Scarcity is reflected by the unattainable points that lie
outside the PPC, such as point G and point H. The PPC is a series of points rather than a single point .
Choice is reflected by the need for society to choose among the series of points on the PPC, such as
point C and point D. The PPC is downward sloping. Opportunity cost is reflected by the negative
slope of the PPC which indicates that an increase in the production of one good will lead to a decrease
in the production of the other good.

4.2 Movements along versus Shifts in the Production Possibility Curve

A change in the tastes and preferences of society will lead to a movement along the PPC which
reflects a change in choice. The tastes and preferences of society may change due to several factors
such as technological advancements and campaigning. For example, the inventions of smartphones
and tablets have led to a change in the tastes and preferences of society from print publications to
digital publications. Healthy living campaigns have led to a change in the tastes and preferences of
society from non-diet soft drinks to diet soft drinks.

An increase in the production capacity in the economy will lead to an outward shift in the PPC
resulting in a decrease in scarcity, and vice versa. When the PPC shifts outwards, some of the points
which were previously unattainable will become attainable. The production capacity in the economy
may increase due to an increase in the quantity or the quality of the factors of production in the
economy. For example, education and training which will lead to greater human capital will increase
the skills and knowledge of labour and hence the production capacity in the economy. Research and
development which will lead to technological advancement will increase the efficiency of capital and
hence the production capacity in the economy.

Note: When the economy moves into a recession, the PPC will not shift, at least not immediately.
Rather, the economy will move from a point on the PPC to a point inside the PPC, assuming resources
are initially fully and efficiently employed.

A decrease in investment expenditure will not lead to a leftward shift in the PPC. Rather, it will cause
the PPC to shift outwards at a slower rate as firms are still producing new capital. However, if the
amount of new capital falls below the level necessary to replace the amount of worn-out capital, the
PPC will shift inwards.

4.3 Shape of the Production Possibility Curve

The PPC is concave to the origin because the opportunity cost of producing each good increases as its
quantity increases as resources are not equally suitable for producing different goods. As the economy
produces more and more of a good, it has to use resources that are less and less suitable for producing
the good to actually produce the good. This means that increasingly more units of resources are
needed to produce each additional unit of the good. Therefore, increasingly more units of other goods
have to be forgone to produce each additional unit of the good resulting in an increase in the
opportunity cost.

4.4 Economic Efficiency

Due to the problem of scarcity, all economies must make three fundamental economic decisions: what
and how much to produce, how to produce and for whom to produce. In making these three
fundamental economic decisions, the objective is to maximise the welfare of society. Efficiency is one
of the criteria used to determine whether this objective is achieved.

Productive Efficiency

The economy is productively efficient when it is impossible to increase the production of some goods
without decreasing the production of other goods, given the quantity and the quality of the factors of
production in the economy. This occurs when the economy is producing on the PPC where resources
in the economy are fully and efficiently employed. Resources in the economy are efficiently employed
when all firms are productively efficient and are fully employed when there is no unemployment of
resources.

Allocative Efficiency
The economy is allocatively efficient when it is impossible to change the allocation of resources in a
way that will increase the welfare of society. This occurs when the economy is producing at the point
on the PPC that is tangent to the social indifference curve where the marginal rate of transformation is
equal to the marginal rate of substitution. Productive efficiency is a necessary condition for allocative
efficiency. In other words, for the economy to be allocatively efficient, it must be productively
efficient.

Note: The economy is economically efficient when it is productively efficient and allocatively
efficient. This means that an economy which is productively efficient but allocatively inefficient is not
economically efficient.

5 ECONOMIC SYSTEM

As discussed previously, all economies face the problem of scarcity and hence are required to make
the three fundamental economic decisions of what and how much to produce, how to produce and for
whom to produce. However, economies vary in the way they make these three fundamental economic
decisions in terms of the degree of government intervention. An economic system is a way of making
the three fundamental economic decisions of what and how much to produce, how to produce and for
whom to produce. There are three types of economic systems: the market system, the command
system and the mixed system.

5.1 The Market System

The market system is an economic system in which the three fundamental economic decisions of what
and how much to produce, how to produce and for whom to produce are made by private individuals
with no government intervention. The market system is also known as the free market system, the free
enterprise system and the laissez-faire system. The market system was first advocated by Adam Smith
in his famous book, ‘An Inquiry into the Nature and Causes of the Wealth of Nations’, which was
published in 1776. He argues that the pursuit of self-interest will lead to the benefit of society.

In the market system, all the factors of production in the economy are owned by private individuals.
All economic decisions are made by private individuals. Private individuals can engage in productive
activities, choose what to buy, where to work, etc. There is total economic freedom and the role of the
government is confined to the provision of national defence, maintaining law and order, issuing
currency, etc. Private individuals pursue self-interest. Firms seek to maximise profit, consumers seek
to maximise satisfaction and owners of factors of production seek to maximise factor income.
Competition exists in all economic activities. Firms compete for resources and sales, consumers
compete for goods and services and owners of factors of production compete for employment of their
resources.

In the market system, the three fundamental economic decisions of what and how much to produce,
how to produce and for whom to produce are made by private individuals with no government
intervention.

What and How Much to Produce?

The types and amounts of goods to produce are jointly determined by consumers and firms through the
price mechanism. The price mechanism refers to the system in a market economy whereby changes in
price due to shortages and surpluses equate quantity demanded and quantity supplied. Consumers
indicate to firms the types and amounts of goods that they want by the prices that they are able and
willing to pay for them. Firms that seek to maximise profit will only produce the types and amounts of
goods that consumers are able and willing to pay for. Therefore, prices signal the types and amounts of
goods that are in demand and hence, the profitability of producing these goods. This signalling role of
prices is the essence of the price mechanism.
How to Produce?

The profit motive of firms implies that they will choose the least-cost method to produce any amount
of output and this is determined by relative factor prices. If labour is cheaper than capital, firms will
use more labour and less capital in production. However, if capital is cheaper than labour, firms will
use more capital and less labour in production. Therefore, relative factor prices determine the ways in
which goods are produced.

For Whom to Produce?

The market system distributes goods to consumers with the ability and the willingness to pay for the
goods and this is determined by their preferences and income levels.

5.2 The Command System

The command system is an economic system in which the three fundamental economic decisions of
what and how much to produce, how to produce and for whom to produce are made by the
government with no involvement of private individuals. The command system is also known as the
centrally planned system. The command system was first advocated by Karl Marx in his famous book,
‘Das Kapital’, which was published in 1867. He argues that capitalism will fall which will lead to the
rise of socialism and eventually to communism.

In the command system, all the factors of production in the economy are owned by the government.
All economic decisions are made by the government. Private individuals cannot engage in productive
activities, choose what to buy and where to work, etc. There is no economic freedom. Private
individuals cannot pursue self-interest and competition does not exist.

In the command system, the three fundamental economic decisions of what and how much to produce,
how to produce and for whom to produce are made by the government with no involvement of private
individuals. In other words, economic decision-making is centralised. To do this, the government must
choose the combination of goods that it thinks will maximise the welfare of society, direct resources to
produce the goods by planning the output level of each industry, decide on the method of production
and how the goods are to be distributed. The government can distribute goods directly which is usually
done through the issue of rationing coupons, or it can decide on the distribution of income, in which
case, it will decide who should be paid what.

5.3 The Mixed System

The mixed system is an economic system in which the three fundamental economic decisions of what
and how much to produce, how to produce and for whom to produce are partly made by private
individuals and partly made by the government. Therefore, a mixed economy is comprised of the
private sector and the public sector. In reality, every economy is a mixed economy. Due to the flaws of
both the market system and the command system, all economies in the world are a mixture of both
economic systems. Even command-oriented economies such as North Korea and Cuba rely on the
market system to some extent and market-oriented economies such as Singapore and Hong Kong have
some degree of government intervention.

In the mixed system, some of the factors of production in the economy are owned by private
individuals and some are owned by the government. Economic decisions are partly made by private
individuals and partly made by the government. Although private individuals can engage in productive
activities, choose what to buy and where to work, they are restricted by the government. Although
there is economic freedom, it is restricted by the government. Although private individuals can pursue
self-interest, they are restricted by the government. Although competition exists, it does not happen in
all forms of economic activities.
In the mixed system, the three fundamental economic decisions of what and how much to produce,
how to produce and for whom to produce are partly made by private individuals and partly made by
the government.

5.4 Advantages and Disadvantages of Economic Systems

Advantages of the Market System and Disadvantages of the Command System

In the market system, allocative efficiency may be achieved as private individuals themselves are in
the best position to know what they want. There will be incentive for workers to work hard and for
firms to be efficient as they will be rewarded with high income and profit. There will fast decision-
making as each private individual only needs to make economic decisions pertaining to their interest.
There will be liberty as private individuals are allowed to choose their ways of life.

The advantages of the market system are the disadvantages of the command system.

Advantages of the Command System and Disadvantages of the Market System

In the command system, allocative efficiency may be achieved as externalities will be taken into
consideration by the government. There will be no unemployment as the government will provide a
job for every private individual. The distribution of income will be equitable as no private individuals
will earn very high or very low income. Public goods will be produced by the government through
taxation. There will be no private firms with substantial market power which can charge high prices.

NOTE : The advantages of the command system are the disadvantages of the market system.
CHAPTER 2: DEMAND AND SUPPLY

1 INTRODUCTION

In Chapter 1, we learnt that the allocation of resources in the market system is determined by the
market forces of demand and supply. Therefore, to have a good understanding of the allocation of
resources in the market system, we need to understand the concepts of demand and supply. Indeed, as
demand and supply are two fundamental economic concepts which permeate the study of economics, a
good understanding of the concepts is essential for understanding economics.

2 DEMAND

2.1 Relationship between Price and Quantity Demanded

The demand for a good is the quantity of the good that consumers are willing and able to buy at each
price over a period of time, ceteris paribus. The quantity demanded of a good refers to the quantity of
the good that consumers are willing and able to buy. The law of demand states that there is an inverse
relationship between price and quantity demanded. When the price of a good falls, the quantity
demanded will rise. Conversely, when the price of a good rises, the quantity demanded will fall. The
demand curve of a good shows the quantity demanded of the good at each price over a period of time,
ceteris paribus. The demand curve is downward sloping due to the law of demand.

Demand Curve

In the above diagram, when the price (P) is P 0, the quantity demanded (Q) is Q0. A fall in the price
from P0 to P1 leads to an increase in the quantity demanded from Q0 to Q1.

The law of demand can be explained with the concept of diminishing marginal utility. Utility refers to
the satisfaction obtained by consumers from consuming a good. Marginal utility is the additional
satisfaction resulting from consuming one more unit of a good. The more a consumer has of a good,
the less they will value it at the margin and this is known as diminishing marginal utility. Due to
diminishing marginal utility, consumers will only increase the consumption of a good if the price falls.
The law of demand can also be explained with the concepts of substitution effect and income effect.
When the price of a good falls, the real income of consumers will rise as they will be able to buy a
larger amount of goods and services with the same amount of nominal income. This will induce them
to buy more of the good. This effect is known as the income effect of a price fall. Furthermore, when
the price of a good falls, the good will become relatively cheaper than other goods. This will induce
consumers to substitute the good for other goods. This effect is known as the substitution effect of a
price fall.

Note: Ceteris paribus is Latin which means other things being equal.

The demand curve of a consumer is downward sloping due to the law of demand. The market demand
curve is the horizontal summation of the demand curves of all the consumers in the market and hence
is also downward sloping.

2.2 Movements along versus Shifts in the Demand Curve

A change in quantity demanded occurs when quantity demanded changes due to a change in price.
This is shown by a movement along the demand curve.

In the above diagram, the quantity demanded (Q) increases from Q 0 to Q1 due to a fall in the price (P)
from P0 to P1. This is called an increase in quantity demanded.
A change in demand occurs when quantity demanded changes due to a change in a non-price
determinant of demand. In other words, quantity demanded changes at the same price. This is shown
by a shift in the demand curve.

In the above diagram, the quantity demanded (Q) increases from Q 0 to Q1 at the same price (P0) due to
a change in a non-price determinant of demand. This is called an increase in demand.

2.3 Non-price Determinants of Demand

Tastes and Preferences : A change in tastes and preferences towards a good will lead to an increase
in the demand and vice versa. Tastes and preferences are affected by a number of factors such as
technological advancements and campaigning. For example, the inventions of smartphones and tablets
have led to a change in tastes and preferences from print publications to digital publications.

Prices of Substitutes and Complements: Substitutes are goods which are consumed in place of one
another such as Coke and Pepsi. A rise in the prices of substitutes for a good will induce consumers to
buy less of the substitutes resulting in an increase in the demand for the good and vice versa. For
example, if the price of Pepsi rises, consumers will buy less Pepsi and more Coke. Complements are
goods which are consumed in conjunction with one another such as car and petrol. A fall in the prices
of complements for a good will induce consumers to buy more of the complements resulting in an
increase in the demand for the good and vice versa. For example, if the prices of cars fall, consumers
will buy more cars and more petrol

Level of Income: When consumers’ income rises, the demand for some goods will increase and these
goods are called normal goods. A normal good is a good whose demand rises when consumers’
income rises. There are two types of normal goods: necessity and luxury. A necessity is a good whose
demand rises by a smaller proportion when consumers’ income rises. Examples of necessities include
agricultural products and stationery. A luxury is a good whose demand rises by a larger proportion
when consumers’ income rises. Examples of luxuries include private cars and branded watches. When
consumers’ income rises, the demand for some goods will decrease and these goods are called inferior
goods. An inferior good is a good whose demand falls when consumers’ income rises. Inferior goods
are typically relatively low in quality.

Expectations of Price Changes : If consumers expect the price of a good to rise, they will bring
forward the purchase to avoid paying a higher price in the future. If the good can be resold such as
residential properties, consumers will also buy the good to sell it at a higher price later. When these
happen, the demand for the good will increase. Conversely, if consumers expect the price of a good to
fall, they will put off the purchase to enjoy a lower price in the future which will lead to a decrease in
the demand.

Size of the Population: An increase in the size of the population will lead to an increase in the
demand for certain goods and services. With the exception of a few countries such as Japan, most
countries have been experiencing an increase in the size of the population.

Structure of the Population

If the population is greying, the demand for pharmaceutical products will increase. An example is
Singapore. If the birth rate rises, the demand for infant products will increase.

Government Policies

The government is the biggest spender in every economy. Therefore, if the government increases
expenditure on goods and services, the demand for certain goods and services will increase and vice
versa. The government can also affect private expenditure by changing interest rates and tax rates. For
example, if the government cuts income taxes, consumers will experience a rise in their disposable
incomes which will lead to an increase in the demand for certain goods and services.

Weather Conditions

In winter, the demand for coats and sweaters will increase and the demand for ice creams will
decrease. The opposite is true in summer

3 SUPPLY

3.1 Relationship between Price and Quantity Supplied

The supply of a good is the quantity of the good that firms are willing and able to sell at each price
over a period of time, ceteris paribus. The quantity supplied of a good refers to the quantity of the
good that firms are willing and able to sell. The law of supply states that there is a direct relationship
between price and quantity supplied. When the price of a good falls, the quantity supplied will fall.
Conversely, when the price of a good rises, the quantity supplied will rise. The supply curve of a good
shows the quantity supplied of the good at each price over a period of time, ceteris paribus. The supply
curve is upward sloping due to the law of supply.

Supply Curve

In the above diagram, when the price (P) is P 0, the quantity supplied (Q) is Q 0. A rise in the price from
P0 to P1 leads to an increase in the quantity supplied from Q0 to Q1.

Note: The supply curve of a firm is upward sloping due to the law of supply. The market supply curve
is the horizontal summation of the supply curves of all the firms in the market and hence is also
upward sloping.

3.2 Movements along versus Shifts in the Supply Curve.

A change in quantity supplied occurs when quantity supplied changes due to a change in price. This is
shown by a movement along the supply curve.

In the above diagram, the quantity supplied (Q) increases from Q 0 to Q1 due to a rise in the price (P)
from P0 to P1. This is called an increase in quantity supplied.

A change in supply occurs when quantity supplied changes due to a change in a non-price determinant
of supply. In other words, quantity supplied changes at the same price. This is shown by a shift in the
supply curve.

In the above diagram, the quantity supplied (Q) increases from Q 0 to Q1 at the same price (P0) due to a
change in a non-price determinant of supply. This is called an increase in supply..

3.3 Non-price Determinants of Supply

Cost of Production

A rise in the cost of production will lead to a decrease in supply and vice versa. When the cost of
production rises, firms will increase the price at each quantity to maintain profitability. In other words,
they will reduce the quantity supplied at each price which will lead to a decrease in supply. The
converse is also true. There are several factors that can lead to a change in the cost of production. For
example, a fall in factor prices such as wages will lead to a fall in the cost of production and vice
versa. Subsidy will decrease the cost of production and tax will have the opposite effect. Labour
productivity refers to output per hour of labour. When labour productivity rises, which may be due to
an increase in the skills and knowledge of labour or the efficiency of capital, firms will need a smaller
amount of labour to produce any given amount of output. Therefore, the cost of production will fall.

Production Capacity

If the production capacity in the industry increases, which may occur due to an increase in the number
of firms in the industry or an expansion of the production capacities of the existing firms, the supply of
the good will increase. The converse is also true.

Expectations of Price Changes

If firms expect the price of a good to rise, they will hoard some of the output that they currently
produce to sell it at a higher price in the future. This will lead to a fall in the supply of the good. The
converse is also true.

Profitability of Goods in Joint Supply

Goods in joint supply refer to goods that are produced in the same production process. An example is
petrol and diesel. In the process of refining crude oil to produce petrol, other grade fuels such as diesel
are also produced. Therefore, if the demand for petrol increases which will lead to an increase in the
profitability, more petrol will be produced. When this happens, the supply of diesel will also increase.
The converse is also true.

Profitability of Substitutes in Supply

Substitutes in supply refer to goods that are produced using the same factor inputs. An example is
potatoes and tomatoes. If the demand for tomatoes increases which will lead to an increase in the
profitability, some farmers who are currently producing potatoes will switch to the production of
tomatoes which will lead to a decrease in the supply of potatoes. The converse is also true.

Disasters (Natural and Man-made)

Natural disasters such as floods and earthquakes, and man-made disasters such as wars which may kill
workers and destroy factories and machinery, may lead to a decrease in the supply of certain goods
including agricultural products.

Weather Conditions

When weather conditions become less favourable, the supply of agricultural products will fall as
harvests will decrease. The converse is also true. In the event of severe weather conditions, the supply
of air travel will fall as airlines will be forced to cancel flights.

4 demand and supply function

4.1 demand function

This is an algebraically or mathematical representation of the law of demand. A demand function in its
simplest form is; Qd = a – bp, where; Qd is the quantity demanded and p, the price. Example, suppose,
a= 50, b= 2.5, p= 10, therefore; Qd = 50 – 2.5(10) and Qd = 25units.

4.2 supply function

This is an algebraically or mathematical representation of the law of supply. A supply function in its
simplest form is; Qd = a + bp, where; Qd is the quantity supplied and p, the price. Example, suppose,
a= 15, b= 1, p= 10, therefore; Qd = 15 + 1(10) and Qd = 25units.

5 EQUILIBRIUM

5.1 Equilibrium Price and Equilibrium Quantity

An equilibrium is a state where there is no tendency to change. The equilibrium of a market is

determined by the market forces of demand and supply.

In the above diagram, given the demand (D) and the supply (S), the equilibrium price and the
equilibrium quantity are PE and QE. At a price below PE, such as P1, the quantity demanded (QD) is
greater than the quantity supplied (QS) and this results in a shortage (QD – QS). As the price rises, the
quantity demanded falls and the quantity supplied rises and this process continues until the price rises
to PE where the quantity demanded and the quantity supplied are equal at Q E. Similarly, if firms supply
more of a good than what consumers demand at a particular price, the quantity supplied will exceed
the quantity demanded. The resultant surplus will push down the price. This is because when firms
cannot sell all the output that they produce, their stocks will build up. Therefore, they will lower the
price to reduce their stocks. A fall in the price of the good will incentivise firms to decrease the
production due to the lower profitability and consumers to increase the consumption due to the lower
relative price and the higher real income. Therefore, the quantity supplied will fall and the quantity
demanded will rise. The price will continue falling until the quantity demanded is equal to the quantity
supplied, at which point the surplus is eliminated and an equilibrium is established.

5.2 Effects of a Change in Demand on Price and Quantity

Increase in Demand

An increase in demand will lead to a rise in price and quantity.

In the above diagram, an increase in the demand (D) from D 0 to D1 leads to a rise in the price (P) from
P0 to P1 and a rise in the quantity (Q) from Q 0 to Q1. Given the demand (D0) and the supply (S0), the
price and the quantity are P0 and Q0. When the demand increases from D0 to D1, although the quantity
demanded rises at the same price (P 0), the quantity supplied remains at Q 0 and this results in a
shortage. As the price rises, the quantity demanded falls and the quantity supplied rises and this
process continues until the price rises to P 1 where the quantity demanded and the quantity supplied are
equal at Q1.

Decrease in Demand

A decrease in demand will lead to a fall in price and quantity.

In the above diagram, a decrease in the demand (D) from D 0 to D1 leads to a fall in the price (P) from
P0 to P1 and a fall in the quantity (Q) from Q 0 to Q1. Given the demand (D0) and the supply (S0), the
price and the quantity are P0 and Q0. When the demand decreases from D0 to D1, although the quantity
demanded falls at the same price (P0), the quantity supplied remains at Q0 and this results in a surplus.
As the price falls, the quantity demanded rises and the quantity supplied falls and this process
continues until the price falls to P 1 where the quantity demanded and the quantity supplied are equal at
Q1.

Note: When demand changes, price and quantity will change in the same direction.
5.3 Effects of a Change in Supply on Price and Quantity

Increase in Supply

An increase in supply will lead to a fall in price and a rise in quantity.

In the above diagram, an increase in the supply (S) from S 0 to S1 leads to a fall in the price (P) from P 0
to P1 and a rise in the quantity (Q) from Q 0 to Q1. Given the demand (D0) and the supply (S0), the price
and the quantity are P0 and Q0. When the supply increases from S0 to S1, although the quantity supplied
rises at the same price (P 0), the quantity demanded remains at Q 0 and this results in a surplus. As the
price falls, the quantity demanded rises and the quantity supplied falls and this process continues until
the price falls to P1 where the quantity demanded and the quantity supplied are equal at Q 1.

Decrease in Supply

A decrease in supply will lead to a rise in price and a fall in quantity.

In the above diagram, a decrease in the supply (S) from S 0 to S1 leads to a rise in the price (P) from P 0
to P1 and a fall in the quantity (Q) from Q0 to Q1. Given the demand (D0) and the supply (S0), the price
and the quantity are P0 and Q0. When the supply decreases from S0 to S1, although the quantity
supplied falls at the same price (P0), the quantity demanded remains at Q0 and this results in a
shortage. As the price rises, the quantity demanded falls and the quantity supplied rises and this
process continues until the price rises to P 1 where the quantity demanded and the quantity supplied are
equal at Q1.

Note: When supply changes, price and quantity will change in opposite directions.

6 SURPLUS

6.1 Consumer Surplus

Consumer surplus is the difference between the maximum amount that consumers are willing and able
to pay for a good and the amount that they actually pay.

In the above diagram, consumers are willing and able to pay $10 for the first unit of the good, $9 for
the second unit, $8 for the third unit and $7 for the fourth unit. Suppose that consumers buy 4 units of
the good. When the quantity demanded is 4 units, the price is $7. In this case, although the maximum
amount that consumers are willing and able to pay is $34 ($10 + $9 + $8 + $7 = area of trapezium), the
amount that they actually pay is $28 ($7 x 4 = area of rectangle). Therefore, the consumer surplus is
$6 ($34 – $28 = area of trapezium – area of rectangle) and is represented by the area below the
demand curve and above the price.

In the above diagram, given the demand curve (D) and the price (P 0), the maximum price that
consumers are willing and able to pay for each unit of the good is higher than the price they actually
pay from the first unit to Q0. Therefore, consumers will maximise consumer surplus by consuming the
quantity (Q0) as each unit of the good from the first unit to Q 0 produces a consumer surplus. The
consumer surplus is represented by the shaded area.

6.2 Producer Surplus

Producer surplus is the difference between the minimum amount that firms are willing and able to
receive for a good and the amount that they actually receive.
In the above diagram, firms are willing and able to receive $4 for the first unit of the good, $5 for the
second unit, $6 for the third unit and $7 for the fourth unit. Suppose that firms produce 4 units of the
good. When the quantity supplied is 4 units, the price is $7. In this case, although the minimum
amount that firms are willing and able to receive is $22 ($4 + $5 + $6 + $7 = area of trapezium), the
amount that they actually receive is $28 ($7 x 4 = area of rectangle). Therefore, the producer surplus is
$6 ($28 – $22 = area of rectangle – area of trapezium) and is represented by the area below the price
and above the supply curve.

In the above diagram, given the supply curve (S) and the price (P 0), the minimum price that firms are
willing and able to receive from each unit of the good is lower than the price they actually receive
from the first unit to Q0. Therefore, firms will maximise producer surplus by producing the quantity
(Q0) as each unit of the good from the first unit to Q 0 produces a producer surplus. The producer
surplus is represented by the shaded area.

7 ELASTICITY OF DEMAND AND SUPPLY

Given any change in price, in addition to the direction of the change in quantity demanded,
economists are interested to find the magnitude of the change. In other words, they are interested to
find the degree of responsiveness of consumers to a change in price. To measure this, they use the
concept of price elasticity of demand. Furthermore, economists are also interested to find the degree of
responsiveness of consumers to a change in income and a change in the prices of related goods. To
measure this, economists use the concepts of income elasticity of demand and cross elasticity of
demand. This chapter provides an exposition of the concepts of price elasticity of demand, income
elasticity of demand, cross elasticity of demand and price elasticity of supply.

7.1 PRICE ELASTICITY OF DEMAND

7.2 Measurement and Interpretation of Price Elasticity of Demand

The price elasticity of demand (PED) for a good is a measure of the degree of responsiveness of the
quantity demanded to a change in the price, ceteris paribus.

The PED for a good is calculated by dividing the percentage change in the quantity demanded by the
percentage change in the price.

% Δ Quantity Demanded
PED = ————————————–
% Δ Price

Due to the law of demand, the PED for a good is always negative. However, the common practice
among economists is to omit the negative sign.

If the PED for a good is greater than one, the demand is price elastic which means that a change in the
price will lead to a larger percentage/proportionate change in the quantity demanded. A good with a
price elastic demand has a relatively flat demand curve. If the PED for a good is less than one, the
demand is price inelastic which means that a change in the price will lead to a smaller
percentage/proportionate change in the quantity demanded. A good with a price inelastic demand has a
relatively steep demand curve. If the PED for a good is equal to one, the demand is unit price elastic
which means that a change in the price will lead to the same percentage/proportionate change in the
quantity demanded. The demand curve for a good with a unit price elastic demand is a rectangular
hyperbola.

Special cases:
If the PED for a good is zero, the demand is perfectly price inelastic which means that a change in the
price will not lead to any change in the quantity demanded. A good with a perfectly price inelastic
demand has a vertical demand curve. If the PED for a good is infinity, the demand is perfectly price
elastic which means that a rise in the price will lead to an infinite decrease in the quantity demanded.
In theory, this means that the quantity demanded will fall from infinity to zero. A good with a
perfectly price elastic demand has a horizontal demand curve.

Note: It is important to understand that the concept of elasticity is about relative changes and not
about absolute changes.

7.3.1 Applications of Price Elasticity of Demand

The concept of PED allows a firm to determine how to change price to increase total revenue.

If the demand for the good produced by a firm is price elastic, the firm can decrease the price to
increase the total revenue as the quantity demanded will increase by a larger percentage.

In the above diagram, the initial total revenue is area A plus area B and the new total revenue is area B
plus area C. Area C is the gain in revenue resulting from the increase in the quantity demanded (Q)
from Q0 to Q1 and area A is the loss in revenue resulting from the fall in the price (P) from P 0 to P1.
Since area C is greater than area A, the gain in revenue exceeds the loss and hence the total revenue
rises.

If the demand for the good produced by a firm is price inelastic, the firm can increase the price to
increase the total revenue as the quantity demanded will decrease by a smaller percentage.

In the above diagram, the initial total revenue is area B plus area C and the new total revenue is area A
plus area B. Area A is the gain in revenue resulting from the rise in the price (P) from P 0 to P1 and area
C is the loss in revenue resulting from the decrease in the quantity demanded (Q) from Q 0 to Q1. Since
area A is greater than area C, the gain in revenue exceeds the loss and hence the total revenue rises.

If the demand for the good produced by a firm is unit price elastic, the firm cannot change the price to
increase the total revenue as the quantity demanded will change by the same percentage.

In addition to firms, the concept of price elasticity of demand may be useful to the government. The
main source of revenue for the government is tax revenue. If the government imposes a tax on a good,
the cost of production will rise which will lead to a decrease in the supply. When this happens, the
price will rise which will lead to a fall in the quantity demanded. If the demand for the good is price
elastic, the quantity demanded is likely to fall by a large extent. As the tax revenue is the product of
the tax per unit of the good and the quantity, a large decrease in the quantity demanded is likely to
limit the amount of tax revenue which the government is able to collect. Therefore, if the government
wants to collect a large amount of tax revenue from imposing a tax on a good, it should do so for a
good with a price inelastic demand. Examples of goods with a price inelastic demand include tobacco
and alcohol due to their addictive nature. The government may also impose a tax on a good to reduce
the consumption. This is generally a good which society deems undesirable and the government thinks
people should be discouraged from consuming, commonly known as a demerit good. Examples of
demerit goods include tobacco and alcohol. However, due to the addictive nature of tobacco and
alcohol which makes the demand price inelastic, a tax on these goods is likely to lead to a small
decrease in the quantity demanded. Therefore, for a tax on tobacco and alcohol to be effective for
reducing the consumption, the government should ensure that it is sufficiently high.

7.3.2 Determinants of Price Elasticity of Demand

Number of Substitutes
The PED for a good will be higher the larger the number of substitutes. Conversely, the PED for a
good will be lower the smaller the number of substitutes. For example, the demand for a brand of
smartphones is likely to be price elastic due to the large number of substitute brands in the market such
as Apple, Samsung, LG, HTC, Sony, BlackBerry, etc.

Degree of Necessity

The PED for a good will be higher the lower the degree of necessity. Conversely, the PED for a good
will be lower the higher the degree of necessity. For example, the demand for oil is price inelastic due
to the high degree of necessity, apart from lack of close substitutes.

Proportion of Income Spent on the Good

The PED for a good will be higher the larger the proportion of income spent on the good. Conversely,
the PED for a good will be lower the smaller the proportion of income spent on the good. For
example, the demand for private cars is likely to be price elastic due to the large proportion of income
spent on the goods as they are generally expensive. In contrast, the demand for stationery is likely to
be price inelastic due to the small proportion of income spent on the good as it is generally cheap,
apart from the high degree of necessity.

Time Period

The PED for a good will be higher the longer the time period under consideration. Conversely, the
PED for a good will be lower the shorter the time period under consideration. This is because
consumers need time to adjust their consumption patterns and find substitutes. For example, given any
increase in the price of petrol, the quantity demanded will not fall significantly in the short run as
people need to drive their cars. However, the quantity demanded will fall more significantly over time
as more fuel-efficient cars can be developed and people can switch to smaller cars which consume less
fuel.

7.4 INCOME ELASTICITY OF DEMAND

7.4.1 Measurement and Interpretation of Income Elasticity of Demand

The income elasticity of demand (YED) for a good is a measure of the degree of responsiveness of the
demand to a change in income, ceteris paribus.

The YED for a good is calculated by dividing the percentage change in the demand by the percentage
change in income.

% Δ Demand
YED = ———————–
% Δ Income

If the YED for a good is positive, the good is a normal good. A normal good is a good whose demand
rises when consumers’ income rises. There are two types of normal goods: necessity and luxury. A
necessity is a normal good with a YED between zero and one. In other words, the demand for a
necessity is income inelastic. An example of a necessity is agricultural products. A luxury is a normal
good with a YED greater than one. In other words, the demand for a luxury is income elastic. An
example of a luxury is private cars. If the YED for a good is negative, the good is an inferior good. An
inferior good is a good whose demand falls when consumers’ income rises. An example of an inferior
good is public transport.
7.4.2 Applications of Income Elasticity of Demand

The concept of YED allows a firm to determine the future size of the market for the good and hence its
production capacity. Suppose that the YED for a good is positive. If a firm predicts an economic
expansion which is a period of time during which national income is rising, it should increase its
production capacity in order to be able to meet the higher demand when the economic expansion
comes. Furthermore, the higher the YED is, the larger will be the increase in the demand and hence
the larger the extent the firm should increase its production capacity. Conversely, if the firm predicts
an economic contraction which is a period of time during which national income is falling, it should
decrease its production capacity to minimise excess capacity when the economic contraction comes.

The concept of YED may enable a firm to determine how to formulate its marketing strategy. Suppose
that a firm sells two goods. Further suppose that one of the goods is a normal good and the other good
is an inferior good. If the economy is expanding and hence national income is rising, the firm should
focus its marketing strategy on the normal good. Conversely, if the economy is contracting and hence
national income is falling, the firm should focus its marketing strategy on the inferior good.

7.4.3 Determinants of Income Elasticity of Demand

Degree of Luxury

The YED for a good will be higher the more luxurious the good. Conversely, the YED for a good will
be lower the less luxurious the good. For example, the YED for high-end private cars is higher than
those for mid-range and low-end private cars as high-end private cars are more luxurious than mid-
range and low-end private cars.

Level of Income

The YED for a good will be higher the lower the level of income. Conversely, the YED for a good will
be lower the higher the level of income. For example, the YED for private cars in the Philippines is
higher than that in Singapore as the level of income in the Philippines is lower than that in Singapore.

7.5 CROSS ELASTICITY OF DEMAND

7.5.1 Measurement and Interpretation of Cross Elasticity of Demand

The cross elasticity of demand (XED) for a good with respect to another good is a measure of the
degree of responsiveness of the demand for the first good to a change in the price of the second good,
ceteris paribus. Let the two goods be good A and good B.

The XED for good A with respect to good B is calculated by dividing the percentage change in the
demand for good A by the percentage change in the price of good B.

% Δ Demand for Good A

XEDAB = ————————————–
% Δ Price of Good B

If XEDAB is positive, good A and good B are substitutes. Substitutes are goods which are consumed in
place of one another such as Coke and Pepsi. If the price of good B rises, consumers will buy less of it.
Since good A and good B are substitutes, they will buy more good A. If XED AB is negative, good A
and good B are complements. Complements are goods which are consumed in conjunction with one
another such as car and petrol. If the price of good B rises, consumers will buy less of it. Since good A
and good B are complements, they will buy less good A.
7.5.2 Applications of Cross Elasticity of Demand

The concept of XED allows a firm to determine how a change in the price of a related good produced
by another firm will affect the demand for its good. For example, if a rival firm decreases its price, the
demand for the good produced by the first firm will fall due to the positive XED between substitutes.
To avoid a decrease in sales, the firm may need to decrease its price. However, if this is likely to lead
to a price war, the firm may consider engaging in non-price competition such as product promotion
and product development instead of decreasing its price. If a rival firm increases its price, the demand
for the good produced by the first firm will increase if it keeps its price constant. However, the firm
may not experience an increase in sales if it has no or little excess capacity.

The concept of XED may enable a firm that produces two or more goods which are complements to
increase total revenue. For example, a telecommunications firm may reduce the price of its mobile
devices even if the demand is price inelastic. Although the revenue from the sale of its mobile devices
will fall as the quantity demanded will rise by a smaller proportion, the demand and hence the revenue
from the provision of its mobile network services will rise due to the negative XED between mobile
network services and mobile devices. Therefore, the total revenue of the telecommunications firm may
increase.

7.5.3 Determinants of Cross Elasticity of Demand

The XED between two goods will be higher the more closely they are related. For example, the XED
between Coke and Pepsi is higher than that between coffee and tea as Coke and Pepsi are closer
substitutes than coffee and tea are.

7.6 PRICE ELASTICITY OF SUPPLY

7.6.1 Measurement and Interpretation of Price Elasticity of Supply

The price elasticity of supply (PES) of a good is a measure of the degree of responsiveness of the
quantity supplied to a change in the price, ceteris paribus.

The PES of a good is calculated by dividing the percentage change in the quantity supplied by the
percentage change in the price.

% Δ Quantity Supplied
PES = ————————————
% Δ Price

Due to the law of supply, the PES of a good is always positive.

If the PES of a good is greater than one, the supply is price elastic which means that a change in the
price will lead to a larger percentage/proportionate change in the quantity supplied. A good with a
price elastic supply has a relatively flat supply curve. If the PES of a good is less than one, the supply
is price inelastic which means that a change in the price will lead to a smaller percentage/proportionate
change in the quantity supplied. A good with a price inelastic supply has a relatively steep supply
curve. If the PES of a good is equal to one, the supply is unit price elastic which means that a change
in the price will lead to the same percentage/proportionate change in the quantity supplied.

Special Cases: If the PES of a good is zero, the supply is perfectly price inelastic which means that a
change in the price will not lead to any change in the quantity supplied. A good with a perfectly price
inelastic supply has a vertical supply curve. If the PES of a good is infinity, the supply is perfectly
price elastic which means that a fall in the price will lead to an infinite decrease in the quantity
supplied. In theory, this means that the quantity supplied will fall from infinity to zero. A good with a
perfectly price elastic supply has a horizontal supply curve.

7.6.2 Determinants of Price Elasticity of Supply

Production Time and ‘Stockability’ of the Good

When the price of a good rises, firms can increase the quantity supplied in two ways: increase
production and draw from stock. Therefore, if the production time of a good is long and if it cannot be
stocked in large quantities, the supply is likely to be price inelastic, and vice versa. The ‘stockability’
of a good depends on the size of the good and whether it is perishable. Goods that are small in size and
non-perishable can be stocked in large quantities, and vice versa. For example, the production time of
agricultural products is long due to the long gestation period and they cannot be stocked due to the
perishable nature. Therefore, the supply of agricultural products is price inelastic. In contrast, with
today’s production technology, most manufactured goods are mass produced on assembly lines which
are highly automated. Therefore, the production time of manufactured goods is likely to be short and
hence the supply is likely to be price elastic. Different types of manufactured goods, however, have
different production times. The supply of luxuries is likely to be price inelastic as the production time
is likely to be long because they are typically high quality goods that normally undergo stringent
quality control. In contrast, the supply of necessities and inferior goods is likely to be price elastic as
the production time is likely to be short due to the limited focus on the quality.

Excess Capacity

Given any increase in the price of a good, the lower the output level and hence the larger the amount
of excess capacity, the slower the marginal cost of production will rise as firms increase output. The
slower the marginal cost of production for a good rises as firms increase output in response to a rise in
the price, the larger the increase in output. Therefore, the lower the output level of a good and hence
the larger the amount of excess capacity, the more price elastic the supply. Conversely, the higher the
output level of a good and hence the smaller the amount of excess capacity, the less price elastic the
supply.

Time Period

The longer the time period after an increase in the price of a good, the more price elastic the supply as
firms are able to increase the production by a larger amount with more time. Time period can be
divided into the immediate run, the short run and the long run. The immediate run is the time period
that is so short that the output level is fixed. The supply of the good is perfectly price inelastic,
assuming firms do not keep stock of the good. The short run is the time period during which at least
one of the factor inputs used in the production process is fixed. In the short run, when the price of a
good rises, firms can increase the production only by employing more of the variable factor inputs
used in the production process. The long run is the time period after which all the factor inputs used in
the production process are variable. The supply of a good is more price elastic in the long run than in
the short run as firms can increase the production by employing more of all the factor inputs used in
the production process.

Mobility of Factors of Production

The ease with which factors of production can be moved from the production of one good to another
will influence the price elasticity of supply of a good. The supply of a good will be more price elastic
the higher the mobility of factors of production. Conversely, the supply of a good will be less price
elastic the lower the mobility of factors of production. For example, if a manufacturing firm in the city
is able to swiftly employ rural farmers to increase output, the supply of the good is likely to be price
elastic.
CHAPTER 3: GOVERNMENT INTERVENTION IN THE MARKET

1 INTRODUCTION

In the free market, the equilibrium of a market is determined by the market forces of demand and
supply. However, the equilibrium price and the equilibrium quantity may not be the optimal price and
the optimal quantity. For example, the price of food may be too high especially in times of war, the
quantity of education will be too low and the quantity of tobacco will be too high in the absence of
government intervention. Therefore, there is a role for the government in the market. This chapter
provides an exposition of government intervention in the market through tax, subsidy, maximum price
and minimum price.

2 TAX

2.1 Effects of an Indirect Tax on Price and Quantity

A tax is a levy imposed on a good, service, income or wealth by the government. Taxes are often
classified into direct taxes and indirect taxes. A direct tax is a tax imposed on income or wealth.
Examples include personal income tax and corporate income tax. An indirect tax is a tax imposed on a
good or service. Examples include goods and services tax and excise tax.

There are two types of indirect taxes: specific tax and ad valorem tax. A specific tax is an indirect tax
of a certain amount per unit sold. An ad valorem tax is an indirect tax of a certain percentage of the
price of the good.

An indirect tax will lead to a rise in the cost of production. When this happens, firms will increase
price by the amount of the tax at each quantity supplied to maintain profitability. In other words, they
will decrease quantity supplied at each price which will lead to a decrease in supply.

Consider the demand and the supply schedules of wine and the effect of a specific tax of $3 per bottle.

Price Quantity demanded Quantity supplied Quantity supplied

(before tax) (after tax)

12 6 15 9
11 7 13 7
10 8 11 5
9 9 9 3
8 10 7 1
7 11 5 —
6 12 3 —
5 13 1 —

In the above diagram, the initial price and quantity are $9 and 9 bottles. Firms pay a tax of $3 to the
government for each bottle sold and this induces them to increase the price by $3 at each quantity
supplied to maintain profitability. However, the new price is $11 instead of $12 as the quantity
supplied exceeds the quantity demanded at the price of $12. The tax revenue of $21 ($3 × 7) collected
by the government is represented by the shaded area.

Note :A progressive tax is a tax that increases more than proportionate with income. Direct taxes are
progressive taxes. A regressive tax is a tax that increases less than proportionate with income.
Indirect taxes are regressive taxes.
2.2 Tax Incidence

Tax incidence is the distribution of the burden of tax between firms and consumers.

When the government imposes a tax on a good, firms and consumers will each pay a proportion of the
tax. A tax on a good will lead to a rise in the cost of production. When this happens, firms will pass on
the rise in the cost of production to consumers in the form of a higher price in order to maintain
profitability. However, as the demand for a good is not perfectly price inelastic, the rise in the price
will be less than the rise in the unit cost of production which is the amount of the tax. Therefore,
consumers will pay the tax in the form of a higher price and firms will pay the tax as the rise in the
price will be less than the amount of the tax. In the previous example, the tax of $3 leads to a vertical
upward shift in the initial supply curve (S 0) by the amount of the tax to the new supply curve (S 1). The
vertical distance between S0 and S1 is the tax of $3. Consumers pay a higher price of $11 and firms
receive a lower effective price of $8 after paying the tax of $3 to the government. Therefore,
consumers pay two-thirds [($11 – $9)/$3] of the tax and firms pay one-third [($9 – $8)/$3] of the tax.
In this case, consumers pay a larger proportion of the tax.

In general, whether consumers or firms will pay a larger proportion of a tax on a good depends on the
price elasticity of demand relative to the price elasticity of supply. The side of the market which is less
responsive to a change in the price will pay a larger proportion of the tax. If the demand is more price
elastic than the supply, firms will pay a larger proportion of the tax. When consumers are more
responsive to a change in the price than firms, firms will not be able to pass on a larger proportion of
the tax to consumers in the form of a large increase in the price without causing a large decrease in the
quantity demanded. Conversely, if the demand is less price elastic than the supply, consumers will pay
a larger proportion of the tax. When consumers are less responsive to a change in the price than firms,
firms will be able to pass on a larger proportion of the tax to consumers in the form of a large increase
in the price without causing a large decrease in the quantity demanded.

Demand is more Price Elastic than Supply

In the above diagram, the demand is more price elastic than the supply and hence the demand curve
(D) is flatter than the supply curve (S). The proportion of the tax (t) paid by firms, which is [P 0 – (P1 –
t)]/t or B/(A + B), is greater than the proportion paid by consumers, which is (P 1 – P0)/t or A/(A + B).

Demand is less Price Elastic than Supply

In the above diagram, the demand is less price elastic than the supply and hence the demand curve (D)
is steeper than the supply curve (S). The proportion of the tax (t) paid by consumers, which is (P 1 –
P0)/t or A/(A + B), is greater than the proportion paid by firms, which is [P0 – (P1 – t)]/t or B/(A + B).

3 SUBSIDY

3.1 Effects of a Subsidy on Price and Quantity

A subsidy is a payment made by the government to a firm to lower the cost of production and
therefore increase supply.

A subsidy will lead to a fall in the cost of production. When this happens, firms will decrease price by
the amount of the subsidy at each quantity supplied to maintain competitiveness. In other words, they
will increase quantity supplied at each price which will lead to an increase in supply.

In the above diagram, a subsidy leads to a vertical/parallel downward shift in the supply curve (S)
from S0 to S1 as the amount of the subsidy is the same at each quantity supplied.
Consider the demand and the supply schedules for wheat and the effect of a subsidy of $3 per sack.

Price Quantity demanded Quantity supplied Quantity supplied

(before subsidy) (after subsidy)

12 6 15 —
11 7 13 —
10 8 11 —
9 9 9 15
8 10 7 13
7 11 5 11
6 12 3 9
5 13 1 7

In the above diagram, the initial price and quantity are $9 and 9 sacks. Firms receive a subsidy of $3
from the government for each sack sold and this allows them to decrease the price by $3 at each
quantity supplied to maintain competitiveness. However, the new price is $7 instead of $6 as the
quantity demanded exceeds the quantity supplied at the price of $6. The expenditure of $33 ($3 x 11)
on the subsidy incurred by the government is represented by the shaded area.

Note: The effects of a subsidy on price and quantity will be discussed in greater detail in economics
tuition by the Principal Economics Tutor.

3.2 Subsidy Incidence

Subsidy incidence is the distribution of the benefit of subsidy between firms and consumers.

When the government gives a subsidy on a good, firms and consumers will each receive a proportion
of the subsidy. A subsidy on a good will lead to a fall in the cost of production. When this happens,
firms will pass on the fall in the cost of production to consumers in the form of a lower price in order
to maintain competitiveness. However, as the demand for a good is not perfectly price inelastic, the
fall in the price will be less than the fall in the unit cost of production which is the amount of the
subsidy. Therefore, consumers will receive the subsidy in the form of a lower price and firms will
receive the subsidy as the fall in the price will be less than the amount of the subsidy. In the previous
example, the subsidy of $3 leads to a vertical downward shift in the initial supply curve (S 0) by the
amount of the subsidy to the new supply curve (S 1). The vertical distance between S 0 and S1 is the
subsidy of $3. Consumers pay a lower price of $7 and firms receive a higher effective price of $10
after getting the subsidy of $3 from the government. Hence, consumers receive two-thirds [($9 –
$7)/$3] of the subsidy and firms receive one-third [($10 – $9)/$3] of the subsidy. In this case,
consumers receive a larger proportion of the subsidy.

In general, whether consumers or firms will receive a larger proportion of a subsidy on a good depends
on the price elasticity of demand relative to the price elasticity of supply. The side of the market which
is less responsive to a change in the price will receive a larger proportion of the subsidy. If the demand
is more price elastic than the supply, firms will receive a larger proportion of the subsidy. When
consumers are more responsive to a change in the price than firms, firms will not need to pass on a
larger proportion of the subsidy to consumers in the form of a large decrease in the price to induce
them to increase the quantity demanded substantially. Conversely, if the demand is less price elastic
than the supply, consumers will receive a larger proportion of the subsidy. When consumers are less
responsive to a change in the price than firms, firms will need to pass on a larger proportion of the
subsidy to consumers in the form of a large decrease in the price to induce them to increase the
quantity demanded substantially.
Demand is more Price Elastic than Supply

In the above diagram, the demand is more price elastic than the supply and hence the demand curve
(D) is flatter than the supply curve (S). The proportion of the subsidy (s) received by firms, which is
[(P1 + s) – P0]/s or A/(A + B), is greater than the proportion received by consumers, which is (P 0 –
P1)/s or B/(A + B).

Demand is less Price Elastic than Supply

In the above diagram, the demand is less price elastic than the supply and hence the demand curve (D)
is steeper than the supply curve (S). The proportion of the subsidy (s) received by consumers, which is
(P0 – P1)/s or B/(A + B), is greater than the proportion received by firms, which is [(P 1 + s) – P0]/s or
A/(A + B).

4 MAXIMUM PRICE (PRICE CEILING)

4.1 Effects of a Maximum Price on Price and Quantity

A maximum price, or a price ceiling, is the highest price that firms are legally allowed to charge.

The government may set a maximum price on a good to prevent the price from rising above a certain
level in order to ensure the affordability to consumers. An example is the rent control in Canada. A
binding maximum price is a maximum price set below the equilibrium price. A binding maximum
price will lead to a fall in the price resulting in an increase in the quantity demanded and a decrease in
the quantity supplied. Therefore, a binding maximum price will lead to a shortage.

In the above diagram, the initial price (P) and quantity (Q) are P 0 and Q0. A binding maximum price
(PMAX) leads to a fall in the price from P 0 to PMAX. The quantity demanded increases from Q 0 to QD and
the quantity supplied decreases from Q0 to QS. Therefore, the quantity demanded (QD) is greater than
the quantity supplied (QS) resulting in a shortage. When a shortage occurs, a black market may
emerge. In other words, the good may be illegally sold at prices above the price ceiling which will
render it ineffective. In the extreme case where black marketeers buy up the quantity supplied at P MAX,
the price will rise from P0 to PBM.

To solve the shortage problem, the government can draw on its buffer stock, assuming it has a buffer
stock of the good. However, this can only be a short-term measure if the shortage problem is persistent
as the government will deplete its buffer stock in time to come. In this case, the government can only
solve the shortage problem by decreasing the demand or increasing the supply. The government can
decrease the demand by developing substitutes for the good or increase the supply by direct
government production or by giving a subsidy to firms to induce them to increase output..

5 MINIMUM PRICE (PRICE FLOOR)

5.1 Effects of a Minimum Price on Price and Quantity

A minimum price, or a price floor, is the lowest price that firms are legally allowed to charge.

The government may set a minimum price on a good to prevent the price from falling below a certain
level in order to protect the producers’ income. An example is the minimum price on rice in Thailand.
The government may also set a minimum price on a good to decrease the consumption. An example is
the minimum price on vodka in Russia. A non-binding minimum price is a minimum price set below
the equilibrium price. A binding minimum price is a minimum price set above the equilibrium price. A
binding minimum price will lead to a rise in the price resulting in an increase in the quantity supplied
and a decrease in the quantity demanded. Therefore, a binding minimum price will lead to a surplus.

In the above diagram, the initial price (P) and quantity (Q) are P 0 and Q0. A binding minimum price
(PMIN) leads to a rise in the price from P 0 to PMIN. The quantity supplied increases from Q 0 to QS and the
quantity demanded decreases from Q0 to QD. Therefore, the quantity supplied (QS) is greater than the
quantity demanded (QD) resulting in a surplus. When a surplus occurs, a black market may emerge. In
other words, firms may illegally sell the good at prices below the price floor to reduce their stocks
which will render it ineffective.

To solve the surplus problem, the government can buy the surplus and keep it as buffer stock.
However, this can be a costly measure if the surplus problem is persistent as it will lead to an over-
accumulation of the buffer stock. In this case, the government may want to solve the surplus problem
by increasing the demand or decreasing the supply. The government can increase the demand by
finding alternative uses for the good or decrease the supply by imposing an output quota.

Note: An output quota, or a production quota, is a limit imposed on the quantity of a good that can
be produced.

CHAPTER 4: PRODUCTION AND COSTS

1 INTRODUCTION

Production is the process by which factor inputs are transformed into output. An increase in the
quantity of factor inputs will lead to an increase in output. The theory of production is the study of
how the output level changes as the quantity of factor inputs changes. To increase output, firms need
to employ more factor inputs which will lead to an increase in costs. The theory of costs is the study of
how the cost of production changes as the output level changes. When a firm expands its scale of
production, its average cost will usually fall and this phenomenon is called internal economies of
scale, or simply known as economies of scale. However, when the scale of production of a firm
reaches a certain size, a further expansion may lead to a rise in its average cost and this phenomenon is
called internal diseconomies of scale, or simply known as diseconomies of scale. A firm may
experience a fall or rise in its average cost when the industry expands, even though its scale of
production remains unchanged, and these phenomena are called external economies of scale and
external diseconomies of scale respectively. This chapter provides an exposition of the theory of
production and the theory of costs.

2 THE SHORT-RUN THEORY OF PRODUCTION

2.1 Marginal Returns

If a firm wants to increase output, it can almost immediately employ more labour. However, it will not
be able to employ more capital in the same time frame as acquisition of capital takes time. In
economics, we distinguish between two types of factor inputs: variable factor input and fixed factor
input. Variable factor inputs are factor inputs whose quantities can be changed in the short run. An
example is labour. Fixed factor inputs are factor inputs whose quantities are fixed in the short run. An
example is capital.

The short run is the time period during which at least one of the factor inputs used in the production
process is fixed. It does not correspond to any specific number of weeks, months or years as it varies
from firm to firm and from industry to industry. For example, a web hosting firm may take only a few
weeks or even days to increase its production capacity by purchasing more servers. However, an oil
refining firm may take many years to increase its production capacity due to the long time period
needed to build oil refineries.

Suppose that a firm employs two factor inputs: capital and labour. In this case, the fixed factor input is
capital and the variable factor input is labour. As the quantity of capital is fixed in the short run, the
firm can increase output only by employing more labour.

Example

Capital Labour Total Output Additional Output

5 0 0 —
5 1 3 3
5 2 7 4
5 3 12 5
5 4 18 6
5 5 22 4
5 6 24 2
5 7 24 0
5 8 23 -1
5 9 20 -3

In the above table, from the first unit of labour to the fourth, each additional unit of labour is adding
more to total output than the previous additional unit and hence the firm is experiencing increasing
marginal returns. Increasing marginal returns occur when each additional unit of a variable factor
input (e.g. labour) is adding more to total output than the previous additional unit. This occurs due to
under-utilisation of the fixed factor inputs (e.g. capital). However, from the fifth unit of labour
onwards, each additional unit of labour is adding less to total output than the previous additional unit
and hence the firm is experiencing diminishing marginal returns. Diminishing marginal returns occur
when each additional unit of a variable factor input (e.g. labour) is adding less to total output than the
previous additional unit. This occurs due to over-utilisation of the fixed factor inputs (e.g. capital).
Diminishing marginal returns set in when the fifth unit of labour is employed. Furthermore, the
seventh unit of labour is actually redundant. Total output even falls when the eighth unit of labour is
employed.

The law of diminishing marginal returns states that if an increasing quantity of a variable factor input
is used with a constant quantity of fixed factor inputs, an output level point will be reached beyond
which each additional unit of the variable factor input will add less to total output than the previous
additional unit. To put it somewhat differently, the law of diminishing marginal returns states if a firm
increases output continually in the short run, it is a matter of time that diminishing marginal returns
will set in. If the firm starts with a small quantity of fixed factor inputs, diminishing marginal returns
will set in earlier. If the firm starts with a large quantity of fixed factor inputs, diminishing marginal
returns will set in later.

2.2 Total Product, Marginal product and Average product

Total Product

Total product (TP) is the total output produced with a given amount of factor inputs.

The total product curve is S-shaped.

Total Product Curve

In the above diagram, the TP curve shows how total output varies with the quantity of labour, given
the quantity of capital. From the first unit of labour to Q L0, the firm is experiencing increasing
marginal returns and hence total output is rising at an increasing rate when the quantity of labour
increases. After QL0, the firm is experiencing diminishing marginal returns and hence total output is
rising at a decreasing rate when the quantity of labour increases. After Q L2, the problem of diminishing
marginal returns becomes so severe that additional units of labour actually lead to a fall in total output.

Marginal Product

Marginal product (MP) is the additional output resulting from employing one more unit of labour.

Marginal product is calculated by dividing the change in total output by the change in the quantity of
labour.

ΔTP

MP = ——–

ΔQL

The marginal product curve is inverted-U-shaped.

Marginal Product Curve

In the above diagram, from the first unit of labour to Q L0, the firm is experiencing increasing marginal
returns and hence MP is rising. After QL0, the firm is experiencing diminishing marginal returns and
hence MP is falling. After QL2, the problem of diminishing marginal returns becomes so severe that
additional units of labour actually lead to negative MP.

Average Product

Average product (AP) is the output per unit of labour.

Average product is calculated by dividing total output by the quantity of labour.

TP

AP = ——–

QL

The average product curve is inverted-U-shaped.

Average Product Curve

In the above diagram, from the first unit of labour to Q L1, MP is higher than AP and hence AP is
rising. After QL1, MP is lower than AP and hence AP is falling. The above analysis does not only
explain why the AP curve is inverted-U-shaped, it also explains why the MP curve cuts the AP curve
at the maximum point.

3 THE LONG-RUN THEORY OF PRODUCTION

3.1 The Least-cost Combination of Factor Inputs

The long run is the time period after which all the factor inputs used in the production process are
variable. In the long run, if a firm wants to increase output, not only can it employ more labour, it can
also employ more capital whose quantity is fixed in the short run. Like the short run, the long run does
not correspond to a specific number of weeks, months or years as it varies from firm to firm and from
industry to industry.

The least-cost combination of factor inputs is used when the last dollar of each factor input employed
produces the same additional output. If a firm employs two factor inputs, labour (L) and capital (K),
the least-cost condition can be expressed as MP L/PL = MPK/PK, where MP denotes marginal product
and P denotes price.

Suppose that MPL/PL is twice MPK/PK. In other words, the additional output produced by the last dollar
of labour employed is twice the additional output produced by the last dollar of capital employed. In
this case, the firm can reduce the total cost of producing the same amount of output by employing
more labour and less capital. For example, if the firm employs one more dollar of labour and two
dollars less of capital, although total cost will fall by one dollar, total output will remain constant
which will lead to a fall in the total cost of producing the same amount of output. However, as the
quantity of labour increases, MPL will fall due to diminishing marginal returns. Similarly, as less
capital is employed, MPK will increase. This process will continue until MP L/PL = MPK/PK. In other
words, the additional output resulting from employing the last dollar of labour is equal to the
additional output resulting from employing the last dollar of capital.

3.2 Returns to Scale

When the quantities of all the factor inputs used in the production process are increased by the same
proportion in the long run, the scale of production expands. An increase in the scale of production will
lead to one of three scenarios: increasing returns to scale, constant returns to scale or decreasing
returns to scale.

Increasing Returns to Scale

Increasing returns to scale occur when the same percentage/proportionate increase in the quantities of
all the factor inputs used in the production process leads to a larger percentage/proportionate increase
in total output.

Constant Returns to Scale

Constant returns to scale occur when the same percentage/proportionate increase in the quantities of
all the factor inputs used in the production process leads to the same percentage/proportionate increase
in total output.

Decreasing Returns to Scale

Decreasing returns to scale occur when the same percentage/proportionate increase in the quantities of
all the factor inputs used in the production process leads to a smaller percentage/proportionate increase
in total output.

Example

Capital Labour Percentage increase Total output Percentage Returns to scale

in the quantities of increase in total
 all factor inputs output
20 4 — 100 — —
40 8 100 250 150 IRS
60 12 50 420 68 IRS
80 16 33.33 560 33.33 CRS
100 20 25 672 20 DRS
120 24 20 780 16 DRS

From the output level 100 to the output level 420, the firm is experiencing increasing returns to scale
(IRS). Increasing returns to scale occur due to greater division of labour and the use of larger
machines. Division of labour is the process whereby each job is broken up into its component tasks
and each worker is assigned one or a few component tasks of the job. An expansion of the scale of
production may enable the firm to engage in greater division of labour and hence greater specialisation
which will lead to higher labour productivity resulting in increasing returns to scale. Furthermore,
larger machines are often more efficient than smaller machines as they generally make more efficient
use of materials and labour. Therefore, an expansion of the scale of production may enable the firm to
use larger machines that are often more efficient than smaller machines which will also lead to higher
labour productivity resulting in increasing returns to scale. From the output level 420 to the output
level 560, the firm is experiencing constant returns to scale (CRS). From the output level 560 to the
output level 780, the firm is experiencing decreasing returns to scale (DRS). Decreasing returns to
scale occur due to greater division of labour. When division of labour increases to a high degree,
workers may become demotivated as performing the same task all the time may lead to boredom. This
is especially true if the task is mundane. If this happens, labour productivity will fall which will lead to
decreasing returns to scale.

4 THE SHORT-RUN THEORY OF COSTS

4.1 Fixed Costs, Variable Costs, Explicit Costs and Implicit Costs

Fixed costs are costs that do not vary with the output level. Examples of fixed costs include rent and
interest payments on loans. An increase in the output level will not lead to an increase in fixed costs.
Fixed costs will be incurred even if the firm shuts down production. Variable costs are costs that vary
directly with the output level. Examples of variable costs include the cost of labour and the costs of
materials. An increase in the output level will lead to an increase in variable costs as more variable
factor inputs are needed to produce more output. Variable costs will not be incurred if the firm shuts
down production.

Explicit costs are costs that involve monetary payments. Examples of explicit costs include the cost of
labour and the costs of materials. Implicit costs are costs that do not involve monetary payments.
Examples of implicit costs include the cost of the owner’s labour and the cost of the owner’s financial
capital. Profit is the excess of total revenue over total cost. Accounting profit is the excess of total
revenue over accounting costs. Accounting costs are costs computed by accountants which include
only explicit costs. Economic profit is the excess of total revenue over economic costs. Economic
costs are costs computed by economists which include both explicit costs and implicit costs. As
economic costs are higher than accounting costs, economic profit, which is the profit that economists
are concerned with, is lower than accounting profit.

4.2 Total Cost, Marginal Cost, Average Cost, Average Variable Cost and Average Fixed Cost

Total Cost

Total cost (TC) is the cost of the factor inputs required for the production of an amount of output.
In the short run, total cost is the sum of total fixed cost (TFC) and total variable cost (TVC) and is
positively related to the output level. The total cost curve is inverse-S-shaped.

Total Cost Curve

In the above diagram, as fixed costs do not vary with the output level, the TFC curve is horizontal.
However, as more variable factor inputs are needed to produce more output, the TVC curve is upward-
sloping. As TC is the sum of TFC and TVC, the TC curve is geometrically similar to the TVC curve,
except that the former is higher than the latter by TFC at each output level. From the first unit of
output to Q0, the firm is experiencing increasing marginal returns. Recall that this means each
additional unit of the variable factor input is adding more to total output than the previous additional
unit. Therefore, each additional unit of output requires fewer units of the variable factor input to
produce and this makes the TC curve and the TVC curve rise at a decreasing rate. After Q 0, the firm is
experiencing diminishing marginal returns. Recall that this means each additional unit of the variable
factor is adding less to total output than the previous additional unit. Therefore, each additional unit of
output requires more units of the variable factor input to produce and this causes the TC curve and the
TVC curve to rise at an increasing rate.

Marginal Cost

Marginal cost (MC) is the additional cost resulting from producing one more unit of output.

Marginal cost is calculated by dividing the change in total cost by the change in total output.

ΔTC

MC = ——–

ΔQ

The marginal cost curve is U-shaped or Nike-shaped which some like to call it.

Marginal Cost Curve

In the above diagram, from the first unit of output to Q 0, the firm is experiencing increasing marginal
returns and hence MC is falling. After Q 0, the firm is experiencing diminishing marginal returns and
hence MC is rising.

Average Cost

Average cost (AC) is the cost per unit of output.

Average cost is calculated by dividing total cost by total output.

TC

AC = ——–

The average cost curve is U-shaped.

Average Cost Curve

In the above diagram, from the first unit of output to Q 2, MC is lower than AC and hence AC is
falling. After Q2, MC is higher than AC and hence AC is rising. The above analysis does not only
explain why the AC curve is U-shaped, it also explains why the MC curve cuts the AC curve at the
minimum point.

Average Variable Cost

Average variable cost (AVC) is the variable cost per unit of output.

Average variable cost is calculated by dividing total variable cost by total output.

TVC

AVC = ——–

The average variable cost curve is U-shaped.

The relationship between average value and marginal value applies to average variable cost and
marginal cost.

Average Variable Cost Curve

In the above diagram, from the first unit of output to Q 1, MC is lower than AVC and hence AVC is
falling. After Q1, MC is higher than AVC and hence AVC is rising. The above analysis does not only
explain why the AVC curve is U-shaped, it also explains why the MC curve cuts the AVC curve at the
minimum point.

Average Fixed Cost

Average fixed cost (AFC) is the fixed cost per unit of output.

Average fixed cost is calculated by dividing total fixed cost by total output.

TFC

AFC = ——–

The average fixed cost curve is a rectangular hyperbola.

Average Fixed Cost Curve

In the above diagram, as TFC is constant, AFC falls when the output level increases.

The following diagram shows the relationships between the marginal cost curve, the average cost
curve, the average variable cost curve and the average fixed cost curve.

In the above diagram, from the first unit of output to Q 0, MC is falling due to increasing marginal
returns, and is rising thereafter due to diminishing marginal returns. From the first unit of output to Q 1,
MC is lower than AC and AVC and hence AC and AVC are falling. After Q 1, MC is higher than AVC
and hence AVC is rising. After Q2, MC is higher than AC and hence AC is rising. As AC is the sum of
AVC and AFC, the vertical distance between the AC curve and the AVC curve is equal to AFC. As
AFC falls when the output level increases, the vertical distance between the AC curve and the AVC
curve narrows as the output level increases.

5 THE LONG-RUN THEORY OF COSTS

5.1 Long-run Average Cost

The long-run average cost (LRAC) curve shows the lowest average cost of production at each output
level when all the factor inputs used in the production process are variable in the long run. Each point
on the LRAC curve is a point of tangency to the AC curve with the lowest average cost of producing
the corresponding output level.

As fixed factor inputs in the short run become variable in the long run, a firm can choose the quantity
of fixed factor inputs that achieves the lowest average cost of producing any output level. Suppose that
a firm can choose among three quantities of fixed factor inputs: small quantity, medium quantity and
large quantity. For simplicity, one can think of a small quantity of fixed factor inputs as a small
factory, a medium quantity as a medium factory and a large quantity as a large factory.

In the above diagram, the average cost (AC) curves that correspond to the three quantities of fixed
factor inputs are AC0, AC1 and AC2, where AC0 corresponds to the small quantity, AC 1 corresponds
the medium quantity and AC2 corresponds to the large quantity. As a larger scale of production
enables the firm to produce a larger amount of output, AC 1 is on the right of AC0 and AC2 is on the
right of AC1. Furthermore, AC1 is lower than AC0 as the expansion of the scale of production from the
small quantity of fixed factors to the medium quantity enables the firm to reap more economies of
scale. However, AC2 is higher than AC1 as the expansion of the scale of production from the medium
quantity of fixed factors to the large quantity causes the firm to experience diseconomies of scale.
Economies of scale and diseconomies of scale will be explained in greater detail in Section 5.2. If the
firm wants to produce an output level below Q’, the lowest-average-cost quantity of fixed factor inputs
will be the small quantity that corresponds to AC 0. If the firm wants to produce an output level
between Q’ and Q”, the lowest-average-cost quantity of fixed factor inputs will be the medium
quantity that corresponds to AC1. If the firm wants to produce an output level above Q”, the lowest-
average-cost quantity of fixed factor inputs will be the large quantity that corresponds to AC 2.
Therefore, the LRAC curve is the bold curve in the diagram.

5.2 Internal Economies of Scale and Internal Diseconomies of Scale

Internal Economies of Scale

When a firm expands its scale of production, its average cost will usually fall. Internal economies of
scale (IEOS), or simply known as economies of scale (EOS), refer to the decrease in average cost
when the scale of production expands. Economies of scale are shown by a downward movement along
the long-run average cost curve. Unless otherwise stated, economies of scale refer to internal
economies of scale which are different from external economies of scale which will be explained in
greater detail later. There are several sources of economies of scale.

Technical Economies of Scale

Recall that division of labour is the process whereby each job is broken up into its component tasks
and each worker is assigned one or a few component tasks of the job. An expansion of the scale of
production may enable the firm to engage in greater division of labour and hence greater specialisation
which will lead to higher labour productivity resulting in increasing returns to scale. Furthermore,
larger machines are often more efficient than smaller machines as they generally make more efficient
use of materials and labour. Therefore, an expansion of the scale of production may enable the firm to
use larger machines that are often more efficient than smaller machines which will also lead to higher
labour productivity resulting in increasing returns to scale. Recall that increasing returns to scale occur
when the same percentage/proportionate increase in the quantities of all the factor inputs used in the
production process leads to a larger percentage/proportionate increase in total output. When this
happens, the percentage/proportionate increase in total output will be greater than the
percentage/proportionate increase in total cost resulting in a fall in average cost.

Managerial Economies of Scale

Larger firms may be able to afford to create more specialised departments where specialists perform
specific administrative functions. These specific administrative functions include human resource,
purchasing, finance and marketing. Greater specialisation in these areas of expertise will lead to
greater efficiency resulting in a fall in average cost.

Organisational Economies of Scale

Larger firms are able to spread overheads such as marketing cost and training cost over a larger
amount of output. Spreading overheads will lead to lower overheads per unit of output resulting in a
fall in average cost. For example, as the cost of an advertisement is independent of the amount of
output produced, larger firms that produce a larger amount of output have a lower marketing cost per
unit of output.

Purchasing Economies of Scale

Larger firms produce a larger amount of output. Therefore, they require a larger amount of factor
inputs. It follows that larger firms are able to obtain a higher trade discount for the larger amount of
factor inputs that they purchase which will lead to a fall in their average costs.

Financial Economies of Scale

Larger firms are generally perceived to be more financially stable. Greater financial stability is
commonly associated with lower default risk. Therefore, larger firms generally are able to obtain loans
at lower interest rates which will lead to a fall in their average costs.

Internal Diseconomies of Scale

When the scale of production of a firm reaches a certain size, a further expansion may lead to a rise in
its average cost. Internal diseconomies of scale (IDOS), or simply known as diseconomies of scale
(DOS), refer to the increase in average cost when the scale of production expands. Diseconomies of
scale are shown by an upward movement along the long-run average cost curve. Unless otherwise
stated, diseconomies of scale refer to internal diseconomies of scale which are different from external
diseconomies of scale which will be explained in greater detail later. There are several sources of
diseconomies of scale.

Technical Diseconomies of Scale

When division of labour increases to a high degree, workers may become demotivated as performing
the same task all the time may lead to boredom. This is especially true if the task is mundane. If this
happens, labour productivity will fall which will lead to decreasing returns to scale. Recall that
decreasing returns to scale occur when the same percentage/proportionate increase in the quantities of
all the factor inputs used in the production process leads to a smaller percentage/proportionate increase
in total output. When this happens, the percentage/proportionate increase in total output will be
smaller than the percentage/proportionate increase in total cost resulting in a rise in average cost.
Managerial Diseconomies of Scale

When more specialised departments are created, coordination of the departments in the firm may
become difficult. This is especially true if a system of coordination is not put in place. If this happens,
efficiency in the various departments will fall which will lead to a rise in average cost.

5.3 External Economies of Scale and External Diseconomies of Scale

External Economies of Scale

A firm may experience a fall in its average cost when the industry expands, even though its scale of
production remains unchanged. External economies of scale (EOS) refer to the decrease in average
cost when the industry rather than the scale of production expands. External economies of scale are
shown by a downward shift in the long-run average cost curve. There are several sources of external
economies of scale.

When the industry expands, the demand for factor inputs will increase which will allow firms that
supply factor inputs to the industry to expand their scales of production. When this happens, they may
reap more economies of scale and hence charge lower prices to firms in the output industry. If this
happens, as firms in the output industry will pay lower prices for the factor inputs that they purchase,
their average costs will fall.

When an industry is small, training schools may find it unprofitable to design and conduct training
courses to cater for the industry. However, when the industry expands, these training courses may
become profitable to design and conduct. If this happens, firms in the industry will experience a fall in
their training costs which will lead to a fall in their average costs.

An expansion of the industry may induce the government to improve the infrastructure such as the
transportation network to support the industry. If this happens, firms in the industry will experience a
fall in their transportation costs which will lead to a fall in their average costs.

When the industry expands, specialist firms which supply components to the industry may be set up. If
this happens, as these specialist firms use dedicated machinery to produce the components, the costs of
production will be lower which will lead to lower prices. As a result, firms in the industry will
experience a fall in their average costs.

An expansion of the industry may lead to an increase in the number of researchers from both academia
and industry who will devote their researches to the industry. If this happens, the researches conducted
by these researchers will be published in research journals and be made accessible to interested parties
for a fee. If the researches lead to better production technologies in the industry, average cost will fall.

External Diseconomies of Scale

A firm may experience a rise in its average cost when the industry expands, even though its scale of
production remains unchanged. External diseconomies of scale (DOS) refer to the increase in average
cost when the industry rather than the scale of production expands. External diseconomies of scale are
shown by an upward shift in the long-run average cost curve. There are several sources of external
diseconomies of scale.

When the industry expands, the demand for factor inputs will increase which will lead to a rise in the
prices. When this happens, as firms in the industry will pay higher prices for factor inputs, their
average costs will rise.
An expansion of the industry may exert a strain on the infrastructure such as the transportation
network which will lead to congestion. If this happens, firms in the industry will experience a rise in
their transportation costs which will lead to a rise in their average costs.

CHAPTR 5: MARKET STRUCTURE

1 INTRODUCTION

Economists are interested to study the behaviour of firms such as whether they will charge a high or
low price, whether they will make a large or small amount of profit and whether they will produce
efficiently. The answers to these questions will depend on the market structure. Market structure refers
to the characteristics of a market such as the number of firms, the nature of their products, the
availability of knowledge and the extent of barriers to entry which affect the behaviour of the firms in
the market. For example, a firm that faces competition from many firms is likely to charge a low price,
make a small amount of profit and produce efficiently. The converse is also true. To maximise profit, a
firm may not charge the same price for each unit of a good and this practice is known as price
discrimination. Price discrimination affects the firm, consumers and society as a whole. Although
firms generally seek to maximise profit, some firms seek to maximise market share, sales revenue and
long-run profit. This chapter provides an exposition of the four types of market structures: perfect
competition, monopoly, monopolistic competition and oligopoly, price discrimination and the
alternative objectives of firms.

2 PERFECT COMPETITION

2.1 Characteristics of Perfect Competition

Large Number of Small Firms

In perfect competition, there are a large number of small firms each with a small market share.

Homogeneous Products

In perfect competition, firms sell homogenous products that are perfect substitutes.

Perfect Knowledge

In perfect competition, consumers and firms have perfect knowledge about the price, quality,
availability and production technology of the product.

Price-takers

Due to small market share, product homogeneity and perfect knowledge, perfectly competitive firms
are price-takers in the sense that they are unable to influence the market price by changing their output
levels. Therefore, perfectly competitive firms can only sell their output at the market price that is
determined by the market forces of demand and supply. In other words, perfectly competitive firms
face a perfectly price elastic demand curve at the market price. At the market price, perfectly
competitive firms can sell an infinite amount of output and hence they do not have the incentive to
charge a lower price. Furthermore, perfectly competitive firms do not have the incentive to charge a
price higher than the market price as the quantity demanded is zero.

No Barriers to Entry

In perfect competition, there are no barriers to entry which means that firms can make only normal
profit in the long run. This will be explained in greater detail in Section 2.3.

Perfect competition does not exist in reality due to the unrealistic assumption of perfect knowledge.

Market Representative firm

In the above left-hand diagram, the market price (P 0) is determined by the market demand (D) and the
market supply (S). In the above right-hand diagram, the perfectly competitive firm faces a perfectly
price elastic demand curve (D0) at P0. At P0, the quantity demanded of the good produced by the firm
is infinite. Total revenue is the amount of money received from selling a quantity of a good which is
the product of the price and the quantity. Average revenue is revenue per unit of a good. It is
calculated by dividing total revenue by the quantity. Therefore, average revenue is the price of the
good and hence the average revenue curve (AR 0) is the demand curve. Marginal revenue is the
additional revenue resulting from selling one more unit of a good. It is calculated by dividing the
change in total revenue by the change in the quantity. If the perfectly competitive firm wants to sell
one more unit of the good, it does not need to decrease the price. Therefore, marginal revenue is equal
to the price of the good and hence the marginal revenue curve (MR0) is the demand curve.

Note: The word ‘perfect’ in ‘perfect competition’ does not mean ‘the best’ or ‘the most desirable’.
Rather, when it is used with the word ‘competition’, perfect means ‘of the highest degree’.Although
perfect competition does not exist in reality, there are some markets which approximate perfect
competition, such as the agriculture market.

2.2 The Profit-maximising Condition

A firm will maximise profit when it produces the output level where marginal cost is equal to marginal
revenue.

In the above diagram, profit is maximised at Q 0 where marginal cost (MC) is equal to marginal
revenue (MR). If the firm increases output from Q 0, both total revenue and total cost will rise.
However, at an output level higher than Q0, such as Q1, MC is higher than MR. Therefore, the increase
in total cost will be greater than the increase in total revenue and hence the increase in output will lead
to a decrease in profit. If the firm decreases output from Q 0, both total revenue and total cost will fall.
However, at an output level lower than Q 0, such as Q2, MR is higher than MC. Therefore, the decrease
in total revenue will be greater than the decrease in total cost and hence the decrease in output will
lead to a decrease in profit. Since profit cannot be increased by changing output from Q 0, it must be
maximised at Q0. The profit is represented by the shaded area, assuming the firm is making
supernormal profit.

Furthermore, MC is equal to MR at two output levels, Q 0’ and Q0. At Q0’, where MC is falling, profit
is NOT maximised. Between Q0’ and Q0, MR is higher than MC. If output increases from Q 0’ to Q0, a
profit will be made on each unit of output and this means that the profit at Q 0 is higher than the profit
at Q0’. Therefore, the profit of a perfectly competitive firm is maximised at the output level where MC
is equal to MR, assuming MC is rising.
Note: Although the profit-maximising condition states that marginal cost must be equal to marginal
revenue for profit to be maximised, the condition is generally not applied in practice. This is mainly
due to the difficulty in measuring marginal cost in reality. For firms that engage in mass production
on assembly line, marginal cost is virtually impossible to measure. This is also true for firms that
provide services. In practice, most firms set their prices by adding a certain percentage mark-up to
their average costs and this is known as cost-plus pricing.

2.3 Equilibrium of a Perfectly Competitive Market

A perfectly competitive market is in short-run equilibrium when all the firms in the market are
producing the profit-maximising output level. However, this does not necessarily mean that they are
making positive economic profit. In the short run, a perfectly competitive firm can make three types of
profit: supernormal profit (positive economic profit), normal profit (zero economic profit) and
subnormal profit (negative economic profit or economic loss).

Supernormal Profit

In the above diagram, at the profit-maximising output level (Q 0) where marginal cost (MC) is equal to
marginal revenue (MR), average revenue (AR) is higher than average cost (AC). Therefore, the firm is
making supernormal profit represented by the shaded area.

Normal Profit

In the above diagram, at the profit-maximising output level (Q 0) where marginal cost (MC) is equal to
marginal revenue (MR), average revenue (AR) is equal to average cost (AC). Therefore, the firm is
making normal profit.

Subnormal Profit

In the above diagram, at the profit-maximising output level (Q 0) where marginal cost (MC) is equal to
marginal revenue (MR), average revenue (AR) is lower than average cost (AC). Therefore, the firm is
making subnormal profit represented by the shaded area.

If the firms in a perfectly competitive market are making supernormal profit, potential firms will enter
the market in the long run due to the absence of barriers to entry. As the number of firms in the market
increases, the market supply will increase which will lead to a fall in the market price resulting in a fall
in the profits of the firms. This process will continue until the firms in the market make only normal
profit.

2.4 The Shut-down Condition

If a firm is making supernormal profit (i.e. positive economic profit) which means that the total
revenue is greater than the total cost, it is obvious that it should continue production. However, if a
firm is making subnormal profit (i.e. negative economic profit or economic loss) which means that the
total revenue is less than the total cost, it does not mean that it should shut down production. In the
short run, a firm should continue production so long as the total revenue is greater than or equal to the
total variable cost. In other words, in the short run, a firm should only take into consideration variable
costs and ignore fixed costs when it is deciding whether to continue or shut down production as fixed
costs will be incurred in any case.

In the long run, as all costs are variable, there is no distinction between fixed costs and variable costs.
Therefore, in the long run, if a firm makes subnormal profit which means that the total revenue is less
than the total cost, it should shut down production and leave the market. It follows that in the long run,
a firm should continue production if the total revenue is greater than or equal to the total cost.
Note: The short-run and long-run shut-down conditions discussed above apply to firms in all market
structures.

2.5 Supply Curve in Perfect Competition

Recall that the supply of a good is the quantity of the good that firms are able and willing to sell at
each price over a period of time, ceteris paribus, and the supply curve shows the quantity supplied at
each price. The portion of the marginal cost curve above the average variable cost curve of a perfectly
competitive firm is the supply curve. As the supply curve shows the quantity supplied at each price,
this means that given the price of a good, the quantity supplied is determined entirely by the supply
curve.

In the above diagram, given the market price of the good (P 0) that is determined by the market forces
of demand and supply, the quantity supplied (Q 0) is determined entirely by the marginal cost (MC).
Intuitively, given the price of a good, the quantity supplied is determined by the marginal revenue and
the marginal cost. However, in the case of a perfectly competitive firm, price is equal to marginal
revenue. Therefore, given the price of the good produced by a perfectly competitive firm, the quantity
supplied is determined entirely by the MC curve. Furthermore, at a price below the average variable
cost (AVC), the firm will shut down production to avoid making a loss greater than the total fixed
cost. Therefore, the supply curve of a perfectly competitive firm is the portion of the marginal cost
curve above the average cost curve. The industry supply curve of a perfectly competitive industry is
the horizontal summation of the supply curves of all the firms in the industry.

2.6 Advantages and Disadvantages of Perfect Competition

Advantages of Perfect Competition

Productive Efficiency

A firm is productively efficient when it produces on its long-run average cost curve, from firm’s
perspective. This occurs when it is x-efficient and technically efficient. A firm is x-efficient when it is
not lax in cost control. In other words, it uses the most efficient production technology, it is not
overstaffed, it does not occupy premises that are larger than necessary for its output level, etc. A firm
is technically efficient when it uses the least-cost combination of factor inputs to produce its output
level which means that the last dollar of each factor input that it employs produces the same additional
output. From society’s perspective, a firm is productively efficient when it produces at the minimum
efficient scale. Due to competition in the market, perfectly competitive firms are not lax in cost
control. Therefore, perfectly competitive firms are x-efficient and hence productively efficient.

Allocative Efficiency

A firm is allocatively efficient when it cannot change the allocation of resources in the economy in a
way that will increase the welfare of society. This occurs when it charges a price equal to its marginal
cost, assuming no externalities. When the price of a good is equal to the marginal cost, the marginal
benefit that consumers place on the last unit of the good is equal to the forgone marginal benefit that
they place on the amount of other goods that could have been produced using the same resources.
Therefore, the firm cannot change its output level to increase the total benefit for consumers and hence
is allocatively efficient. In perfect competition, price equals marginal revenue and firms maximise
profit by producing the output level where marginal revenue equals marginal cost. Therefore, perfectly
competitive firms charge a price equal to their marginal cost and are hence allocatively efficient.

In the above diagram, at the profit-maximising output level (Q 0) where marginal cost (MC) is equal to
marginal revenue (MR), the price (P0) is equal to the marginal cost (MC0).
Lower Price

Firms with greater market power are able to charge a higher price relative to their marginal cost
compared to firms with less market power. Unlike a monopoly that has substantial market power,
perfectly competitive firms have no market power and hence the price charged by perfectly
competitive firms is lower than the price that would be charged by a monopoly operating in the same
market, assuming the cost structure of a monopoly is the same as that of a perfectly competitive
industry.

In the above diagram, the perfectly competitive price (PPC) is lower than the monopoly price (PM).

Income Equity

As perfectly competitive firms can make only normal profit and monopolists and oligopolists can
make supernormal profit in the long run, the distribution of income in an economy that abounds with
perfectly competitive markets will be more equitable than one that abounds with monopolistic markets
and oligopolistic markets.

No Price Discrimination

Perfectly competitive firms are price-takers and hence they are unable to exploit consumers through
price discrimination. Price discrimination is commonly considered a form of consumer exploitation as
it will convert some of the consumer surplus to the producer surplus. Price discrimination will be
explained in greater detail in Section 6.

Disadvantages of Perfect Competition

Higher Price

Firms which reap more economies of scale are able to pass on their lower average costs of production
to consumers in the form of a lower price. As a perfectly competitive firm is smaller than a monopoly,
a perfectly competitive industry reaps less economies of scale than a monopoly and hence the price
charged by perfectly competitive firms may be higher than the price that would be charged by a
monopoly operating in the same market.

In the above diagram, the perfectly competitive price (PPC) is higher than the monopoly price (PM).

Dynamic Inefficiency

Perfectly competitive firms do not engage in research and development due to lack of ability and
incentive and hence are dynamically inefficient. Research and development will lead to product
innovations and process innovations. Product innovations will lead to higher product quality and better
product features and process innovations will lead to a better production technology and hence a lower
cost of production which may be passed on to consumers in the form of a lower price. However,
research and development requires high expenditure which perfectly competitive firms are unable to
finance as they can make only normal profit in the long run. Furthermore, due to perfect knowledge,
any innovation can easily and quickly be copied by other firms.

3 MONOPOLY

3.1 Characteristics of Monopoly

Single Large Firm

In monopoly, there is a single large firm which dominates the whole market.

Unique Product

A monopoly sells a unique product that has no close substitutes.

Price-setter

A monopoly is a price-setter in the sense that it is able to set its price by setting its output level. In
other words, a monopoly faces a downward sloping demand curve.

High Barriers to Entry

In monopoly, there are high barriers to entry which means that the firm can make supernormal profit
in the long run.

Note: In reality, a monopoly is defined as a firm that has more than a certain percentage of the
market share and the percentage varies from country to country.

The demand curve of a monopoly is also the market demand curve as it is the single firm in the
market.

3.2 Barriers to Entry

A barrier to entry is an obstacle which restricts potential firms from entering a market to compete with
the incumbent firm or firms.

Economies of Scale

A monopoly may emerge naturally if it can reap very substantial economies of scale due to very high
capital costs such that the market can accommodate only one firm. In such a market where the market
demand is low which results in a high minimum efficient scale relative to the market demand and
hence the long-run average cost curve falling over the entire range of market demand, a single firm
can meet the market demand at an average cost which allows it to make supernormal profit. However,
with two or more firms, all firms will make subnormal profit as there is simply no price that will allow
any firm to cover its average cost. A monopoly that emerges in this way is known as a natural
monopoly. An example of a firm with the characteristics of a natural monopoly is an electricity utility
firm.

Financial Barriers

Some industries have high start-up costs which are difficult to finance. These high start-up costs which
make it difficult for potential firms to enter the industries may be due to expensive capital goods. They
may also be due to heavy advertising which is costly especially when there are established brand
names in the market.

Legal Barriers

A firm may have obtained its monopoly position through the acquisition of a patent or copyright. A
patent is granted to an inventor to allow him the exclusive right to produce the good or use the
production process that is patented. In the latter, potential firms cannot enter the market as they do not
have access to the technology. The aim of awarding patents is to promote research and development.
A copyright, which is similar to a patent, is granted on plays, textbooks, novels, songs, computer
software, and the like. Patents and copyrights are known as intellectual properties.

Control of Key Factor Inputs or Wholesale and Retail Outlets

If a firm controls the supply of some key factor inputs, it can deny access to these factor inputs to
potential firms which will make it difficult for them to enter the market. Similarly, if a firm controls
the outlets through which the good is sold, it can prevent potential firms from gaining access to
consumers which will make it difficult for them to enter the market.

3.3 Equilibrium of a Monopolistic Market

A monopolistic market is in short-run equilibrium when the monopoly is producing at the profit-
maximising output level as seen on the diagram below.

Unlike perfectly competitive firms, a monopoly can make supernormal profit in the long run. If a
monopoly is making supernormal profit, potential firms would like to enter the market. However, due
to high barriers to entry, they are unable to do so. Therefore, apart from normal profit, a monopoly can
make supernormal profit in the long run.

3.4 Advantages and Disadvantages of Monopoly

Advantages of Monopoly

Lower Price

Firms which reap more economies of scale are able to pass on their lower average costs of production
to consumers in the form of a lower price. As a monopoly is larger than a perfectly competitive firm, a
monopoly reaps more economies of scale than a perfectly competitive industry and hence the price
charged by a monopoly may be lower than the price that would be charged by perfectly competitive
firms operating in the same market.

In the above diagram, the monopoly price (PM) is lower than the perfectly competitive price (PPC).

Dynamic Efficiency

As a monopoly can make supernormal profit in the long run, it has the ability to engage in research
and development. Therefore, a monopoly may engage in research and development and hence be
dynamically efficient. Research and development will lead to product innovations and process
innovations. Product innovations will lead to higher product quality and better product features and
process innovations will lead to a better production technology and hence a lower cost of production
which may be passed on to consumers in the form of a lower price.

Price Discrimination

A monopoly is a price-setter and hence it may be able to practise price discrimination which may be
beneficial to consumers. Price discrimination may allow a firm to reach a market that otherwise would
not be reached or to produce a good that otherwise would not be produced. Price discrimination will
be explained in greater detail in Section 6. Furthermore, if the increase in profit from price
discrimination is ploughed back into research and development, more benefits to consumers will be
created.

Disadvantages of Monopoly
Productive Inefficiency

Recall that a firm is productively efficient when it produces on its long-run average cost curve, from
firm’s perspective. This occurs when it is x-efficient and technically efficient. A firm is x-efficient
when it is not lax in cost control. In other words, it uses the most efficient production technology, it is
not overstaffed, it does not occupy premises that are larger than necessary for its output level, etc. A
firm is technically efficient when it uses the least-cost combination of factor inputs to produce its
output level which means that the last dollar of each factor input that it employs produces the same
additional output. From society’s perspective, a firm is productively efficient when it produces at the
minimum efficient scale. Due to the absence of competition in the market, a monopoly may be lax in
cost control. Therefore, a monopoly may be x-inefficient and hence productively inefficient. However,
if a monopoly faces potential competition, it may be x-efficient and hence productively efficient to
prevent potential firms from entering the market. A monopoly may also be x-efficient and hence
productively efficient due to the pursuit of greater profit.

Allocative Inefficiency

Recall that a firm is allocatively efficient when it cannot change the allocation of resources in the
economy in a way that will increase the welfare of society. This occurs when it charges a price equal
to its marginal cost, assuming no externalities. When the price of a good is equal to the marginal cost,
the marginal benefit that consumers place on the last unit of the good is equal to the forgone marginal
benefit that they place on the amount of other goods that could have been produced using the same
resources. Therefore, the firm cannot change its output level to increase the total benefit for consumers
and hence is allocatively efficient. In monopoly, price is higher than marginal revenue and the firm
maximises profit by producing the output level where marginal revenue equals marginal cost.
Therefore, a monopoly charges a price higher than its marginal cost and is hence allocatively
inefficient.

Higher Price

Firms with greater market power are able to charge a higher price relative to their marginal cost
compared to firms with less market power. Unlike perfectly competitive firms that have no market
power, a monopoly has substantial market power and hence the price charged by a monopoly is higher
than the price that would be charged by perfectly competitive firms operating in the same market,
assuming the cost structure of a monopoly is the same as that of a perfectly competitive industry.

Dynamic Inefficiency

Although a monopoly has the ability to engage in research and development as it can make
supernormal profit in the long run, it may not have the incentive to engage in research and
development due to the absence of competition in the market. Therefore, a monopoly may not engage
in research and development and hence be dynamically inefficient.

Income Inequity

As a monopoly can make supernormal profit and perfectly competitive firms and monopolistically
competitive firms can make only normal profit in the long run, the distribution of income in an
economy that abounds with monopolistic markets will be less equitable than one that abounds with
perfectly competitive markets and monopolistically competitive markets.

Price Discrimination
A monopoly is a price-setter and hence it may be able to exploit consumers through price
discrimination. Price discrimination is commonly considered a form of consumer exploitation as it will
convert some of the consumer surplus to the producer surplus.

control of monopolies

Marginal Cost Pricing

The government can pass a pricing regulation that requires the monopoly to charge a price equal to its
marginal cost to achieve allocative efficiency, assuming no externalities, and this is known as marginal
cost pricing.

In the above diagram, marginal cost pricing leads to a fall in the price (P) from P M to PMC and an
increase in the output level (Q) from QM to QMC. As the price (PMC) is equal to the marginal cost
(MCMC), allocative efficiency is achieved. The output level (Q MC) is equal to the allocatively efficient
output level (QAE). However, to make more profit, the monopoly may provide false information about
its cost structure to the government by overstating its marginal cost. If this happens, the use of
marginal cost pricing in a monopolistic market will not achieve allocative efficiency. Furthermore,
assuming the monopoly is unable to use a two-part tariff, marginal cost pricing will cause the
monopoly to make a loss represented by the shaded area as the price (P MC) is lower than the average
cost (AC) at QMC. Therefore, the government needs to give the monopoly a lump-sum subsidy to allow
it to cover its loss. However, if the government is unwilling or unable to do so, marginal cost pricing
will not be feasible.

Average Cost Pricing

In the event that marginal cost pricing is infeasible, the government can pass a pricing regulation that
requires the monopoly to charge a price equal to its average cost to reduce allocative inefficiency and
this is known as average cost pricing.

In the above diagram, average cost pricing leads to a fall in the price (P) from P M to PAC and an
increase in the output level (Q) from Q M to QAC. As the difference between the price (P) and the
marginal cost (MC) decreases from (PM – MCM) to (PAC – MCAC), allocative inefficiency is reduced.
The output level (QAC) is closer to the allocatively efficient output level (Q AE). However, although the
use of average cost pricing in a monopolistic market will reduce allocative inefficiency, it will not
achieve allocative efficiency.

Subsidy

The government can give a subsidy to the monopoly to achieve allocative efficiency. A subsidy will
lead to a fall in the cost of production. When this happens, the monopoly will increase output which
will reduce allocative inefficiency.

Nationalisation

Nationalisation refers to the conversion of a private firm to a state-owned firm. The government can
nationalise the firm to produce the good itself. In order to achieve allocative efficiency, it can charge a
price equal to its marginal cost. However, opponents of nationalisation argue that as state-owned firms
do not need to consider factors such as profitability and survival, they are likely to be x-inefficient and
hence productively inefficient. Therefore, although nationalisation can solve the problem of allocative
inefficiency, it is likely to create the problem of productive inefficiency.

4 MONOPOLISTIC COMPETITION
4.1 Characteristics of Monopolistic Competition

Large Number of Small Firms

In monopolistic competition, there are a large number of small firms each with a small market share.

Differentiated Products

In monopolistic competition, firms sell differentiated products that are close substitutes. Differentiated
products are products that are sufficiently similar to be distinguished as a group from other products.
An example is restaurant foods.

Price-setters

Monopolistically competitive firms are price-setters in the sense that they are able to set their prices by
setting their output levels. In other words, monopolistically competitive firms face a downward
sloping demand curve.

Low Barriers to Entry

In monopolistic, there are low barriers to entry which means that firms can make only normal profit in
the long run.

Note: As monopolistically competitive firms sell differentiated products, there are no market demand
and market supply curves in monopolistic competition. Therefore, the theory of monopolistic
competition is only analysed at the level of the firm.

4.2 Equilibrium of a Monopolistically Competitive Market

A monopolistically competitive market is in short-run equilibrium when the firms in the market are
producing the profit-maximising output level. However, this does not necessarily mean that they are
making positive economic profit. In the short run, a monopolistically competitive firm can make three
types of profit: supernormal profit (positive economic profit), normal profit (zero economic profit) and
subnormal profit (negative economic profit or economic loss).

Supernormal Profit

In the above diagram, at the profit-maximising output level (Q 0) where marginal cost (MC) is equal to
marginal revenue (MR), average revenue (AR) is higher than average cost (AC). Therefore, the firm is
making supernormal profit represented by the shaded area.

Normal Profit

In the above diagram, at the profit-maximising output level (Q 0) where marginal cost (MC) is equal to
marginal revenue (MR), average revenue (AR) is equal to average cost (AC). Therefore, the firm is
making normal profit.

Subnormal Profit

In the above diagram, at the profit-maximising output level (Q 0) where marginal cost (MC) is equal to
marginal revenue (MR), average revenue (AR) is lower than average cost (AC). Therefore, the firm is
making subnormal profit represented by the shaded area.
If the firms in a monopolistically competitive market are making supernormal profit, potential firms
will enter the market in the long run due to low barriers to entry. As the number of firms in the market
increases, the demand for the good produced by each firm will decrease which will lead to a fall in the
price resulting in a fall in the profits of the firms. This process will continue until the firms in the
market make only normal profit.

In the above diagram, the supernormal profit represented by the shaded area induces potential firms to
enter the market in the long run, which leads to a leftward shift in the demand curve of each firm (D)
from D0 to D1. When this happens, the price (P) falls from P 0 to P1. At P1, as the firms in the market
make only normal profit, the incentive for potential firms to enter the market disappears.

Note: The extent of barriers to entry in a market does not only determine the type of profit made by
firms in the long run, it also determines the number of firms in the market. For example, low barriers
to entry in monopolistic competition lead to a large number of firms in the market and high barriers to
entry in monopoly result in a single firm in the market.

4.3 Advantages and Disadvantages of Monopolistic Competition

Advantages of Monopolistic Competition

Productive Efficiency

Recall that a firm is productively efficient when it produces on its long-run average cost curve, from
firm’s perspective. This occurs when it is x-efficient and technically efficient. A firm is x-efficient
when it is not lax in cost control. In other words, it uses the most efficient production technology, it is
not overstaffed, it does not occupy premises that are larger than necessary for its output level, etc. A
firm is technically efficient when it uses the least-cost combination of factor inputs to produce its
output level which means that the last dollar of each factor input that it employs produces the same
additional output. From society’s perspective, a firm is productively efficient when it produces at the
minimum efficient scale. Due to competition in the market, monopolistically competitive firms are not
lax in cost control. Therefore, monopolistically competitive firms are x-efficient and hence
productively efficient.

Lower Price

Firms with greater market power are able to charge a higher price relative to their marginal cost
compared to firms with less market power. Monopolistically competitive firms have less market power
than a monopoly and hence the price charged by monopolistically competitive firms may be lower
than the price that would be charged by a monopoly operating in the same market. The price charged
by monopolistically competitive firms may also be lower than the price that would be charged by a
monopoly operating in the same market due to low barriers to entry which does not allow them to
charge a price higher than their average cost in the long run.

Income Equity

As monopolistically competitive firms can make only normal profit and monopolists and oligopolists
can make supernormal profit in the long run, the distribution of income in an economy that abounds
with monopolistically competitive markets will be more equitable than one that abounds with
monopolistic markets and oligopolistic markets.

Variety of Choices
Monopolistically competitive firms sell differentiated products which offer consumers a great variety
of choices. In contrast, perfectly competitive firms sell homogeneous products and hence offer
consumers no variety of choices.

Disadvantages of Monopolistic Competition

Allocative Inefficiency

Recall that a firm is allocatively efficient when it cannot change the allocation of resources in the
economy in a way that will increase the welfare of society. This occurs when it charges a price equal
to its marginal cost, assuming no externalities. When the price of a good is equal to the marginal cost,
the marginal benefit that consumers place on the last unit of the good is equal to the forgone marginal
benefit that they place on the amount of other goods that could have been produced using the same
resources. Therefore, the firm cannot change its output level to increase the total benefit for consumers
and hence is allocatively efficient. In monopolistic competition, price is higher than marginal revenue
and firms maximise profit by producing the output level where marginal revenue equals marginal cost.
Therefore, monopolistically competitive firms charge a price higher than their marginal cost and are
hence allocatively inefficient.

Higher Price

Firms which reap more economies of scale are able to pass on their lower average costs of production
to consumers in the form of a lower price. As a monopolistically competitive firm is smaller than a
monopoly, monopolistically competitive firms reap less economies of scale than a monopoly and
hence the price charged by monopolistically competitive firms may be higher than the price that would
be charged by a monopoly operating in the same market. Furthermore, firms with greater market
power are able to charge a higher price relative to their marginal cost compared to firms with less
market power. Unlike perfectly competitive firms, monopolistically competitive firms have market
power and hence the price charged by monopolistically competitive firms may be higher than the price
that would be charged by perfectly competitive firms operating in the same market.

Dynamic Inefficiency

Monopolistically competitive firms do not engage in research and development due to lack of ability
and hence are dynamically inefficient. Research and development will lead to product innovations and
process innovations. Product innovations will lead to higher product quality and better product
features and process innovations will lead to a better production technology and hence a lower cost of
production which may be passed on to consumers in the form of a lower price. However, research and
development requires high expenditure which monopolistically competitive firms are unable to
finance as they can make only normal profit in the long run.

5 OLIGOPOLY

5.1 Characteristics of Oligopoly

Small Number of Large Firms

In oligopoly, there are a small number of large firms each with a large market share.

Differentiated Products

Oligopolists generally sell differentiated products such as cars and electrical appliances. Some
oligopolists, however, sell homogeneous products such as cement and steel.
Price-setters

Oligopolists are price-setters in the sense that they are able to set their prices by setting their output
levels. In other words, oligopolists face a downward sloping demand curve.

High Barriers to Entry

In oligopoly, there are high barriers to entry which means that firms can make supernormal profit in
the long run.

Strategic Interdependence (also known as Mutual Interdependence)

In oligopoly, due to the small number of large firms and hence the large market share of each firm, the
actions of one firm affect and are affected by the actions of the other firms in the market, and this is
known as strategic interdependence. When an oligopolist changes its price, it will have a significant
effect on the other firms in the market. The rival firms will hence react by changing their prices which
will affect the first firm. Therefore, when an oligopolist makes pricing and output decisions, it must
take into consideration the reactions of the other firms in the market. In this sense, the pricing and
output decisions of an oligopolist depend on the behavior of competitors. An example of oligopoly is
the pharmaceutical market.

5.2 Collusive versus Competitive (non-collusive) Behaviour

Due to strategic interdependence, oligopolists may collude or compete.

Collusive Behaviour

Formal Collusion

Oligopolists can collude openly by having a formal collusive agreement and this is known as formal
collusion. Formal collusion typically takes the form of cartelisation. In cartelisation, the firms agree on
a common target price which is higher than the prices that they currently charge. To achieve the
common target price, the firms will agree on a set of output quotas to decrease production. A likely
method to decide on the set of output quotas is to divide the market according to the market shares of
the firms. There are certain factors that favour cartelisation. Cartelisation is more likely in a market
where there are no government measures to prevent collusion, there are a small number of firms, the
firms produce homogeneous products, the firms have the same cost structure, the demand is stable and
the barriers to entry are high which will prevent disruptions to the agreement by new firms.
Cartelisation is illegal in many countries. For example, the competition policy in Singapore and the
anti-trust laws in the United States prohibit attempts to distort competition.

Tacit Collusion

In countries where cartelisation is illegal, such as Singapore and the United States, oligopolists can
collude covertly without having a formal agreement and this is known as tacit collusion. Tacit
collusion typically takes the form of price leadership. In price leadership, the price leader will set the
price and the price followers will take the price set by the price leader. The price followers will also
follow any price increase or decrease by the price leader. The price leader may be the firm with the
largest market share which is called the dominant firm price leadership. The price leader may also be
the firm with the most information about the market conditions which is called the barometric firm
price leadership. Apart from price leadership, tacit collusion may also take the form of a rule of thumb.
An example is mark-up pricing. In mark-up pricing, which is also known as cost-plus pricing, a firm
sets its price by adding a certain mark-up for profit to its average cost. Firms may engage in tacit
collusion by following the same mark-up pricing.
Competitive Behaviour

If oligopolists collude, there will be price stability. At first thought, if they do not collude, price war
will be inevitable. However, price stability has been found to be an empirical regularity in most
oligopolistic markets, even in those where the firms do not collude. This phenomenon can be
explained by the theory of the kinked demand curve.

The theory of the kinked demand curve is based on two asymmetrical assumptions. First, if a firm in
an oligopolistic market increases its price, its rivals will not follow suit because by keeping their prices
the same, they can attract consumers from the firm. Accordingly, if a firm in an oligopolistic market
increases its price, its quantity demanded will decrease by a larger percentage as consumers will
switch from the firm to the rivals which will lead to a fall in revenue for the firm. Second, if a firm in
an oligopolistic market reduces its price, its rivals will follow suit to avoid losing consumers to the
firm. Accordingly, if a firm in an oligopolistic market reduces its price, its quantity demanded will
increase by a smaller percentage as consumers will not switch from the rivals to the firm, which will
lead to a fall in revenue for the firm. Therefore, oligopolists do not have the incentive to change their
prices, assuming no substantial changes in the cost of production.

The theory of the kinked demand curve can be illustrated with a diagram. A firm in an oligopolistic
market faces a demand curve that is kinked at the equilibrium and the kink on the demand curve leads
to a discontinuity on the marginal revenue curve.

In the above diagram, as the price (P) and the output level (Q) are P 0 and Q0, the marginal cost (MC)
curve must be cutting the marginal revenue (MR) curve at the discontinuity. A change in the cost of
production will lead to a shift in the MC curve. However, as long as the MC curve lies between MC’
and MC”, the price will remain constant and this explains price stability in oligopolistic markets where
there is no collusion. In the event of a substantial change in the cost of production, the MC curve will
shift out of the range between MC’ and MC” which will lead to a change in the price and the output
level. If this happens, firms may plunge into a price war before they reach a new equilibrium and the
new demand curve will be kinked at the new equilibrium.

Although the theory of the kinked demand curve can explain price stability in the absence of collusion,
it does not explain how the price is set in the first place. Furthermore, price stability may be due to
other factors. For example, oligopolists may not want to change price too frequently to prevent
upsetting consumers.

5.3 Non-price Competition

Firms engage in non-price competition through product development and product promotion. Product
development will improve the quality and the features of the good and product promotion will increase
the awareness and the appeal. Product development and product promotion will lead to an increase in
the demand for the good. Furthermore, they will make the demand for the good less price elastic as the
good will become more different from its substitutes and this is known as product differentiation.
There are two types of product differentiation: real product differentiation and imaginary product
differentiation. Product development will lead to real product differentiation as it will result in
physical changes of the good. Product promotion will lead to imaginary product differentiation as it
will only affect the perception of consumers.

5.4 Advantages and Disadvantages of Oligopoly

Advantages of Oligopoly

Productive Efficiency
Recall that a firm is productively efficient when it produces on its long-run average cost curve, from
firm’s perspective. This occurs when it is x-efficient and technically efficient. A firm is x-efficient
when it is not lax in cost control. In other words, it uses the most efficient production technology, it is
not overstaffed, it does not occupy premises that are larger than necessary for its output level, etc. A
firm is technically efficient when it uses the least-cost combination of factor inputs to produce its
output level which means that the last dollar of each factor input that it employs produces the same
additional output. From society’s perspective, a firm is productively efficient when it produces at the
minimum efficient scale. As oligopolists face competition in the market, they are not lax in cost
control and this is true even in the presence of collusion as oligopolists which collude still face non-
price competition. Therefore, oligopolists are x-efficient and hence productively efficient.

Lower Price

Firms which reap more economies of scale are able to pass on their lower average costs of production
to consumers in the form of a lower price. As an oligopolist is larger than a perfectly competitive firm
and a monopolistically competitive firm, oligopolists reap more economies of scale than perfectly
competitive firms and monopolistically competitive firms and hence the price charged by oligopolists
may be lower than the price that would be charged by perfectly competitive firms and
monopolistically competitive firms operating in the same market.

Dynamic Efficiency

As oligopolists can make supernormal profit in the long run, they have the ability to engage in
research and development. Furthermore, competition gives them the incentive to engage in research
and development and this is true even in the presence of collusion as oligopolists which collude still
face non-price competition. Therefore, oligopolists engage in research and development and hence are
dynamically efficient. Research and development will lead to product innovations and process
innovations. Product innovations will lead to higher product quality and better product features and
process innovations will lead to a better production technology and hence a lower cost of production
which may be passed on to consumers in the form of a lower price.

Variety of Choices

Oligopolists generally sell differentiated products which offer consumers a variety of choices. In
contrast, perfectly competitive firms sell homogeneous products and hence offer consumers no variety
of choices.

Price Discrimination

Oligopolists are price-setters and hence they may be able to practise price discrimination which may
be beneficial to consumers. Price discrimination may allow a firm to reach a market that otherwise
would not be reached or to produce a good that otherwise would not be produced. Price discrimination
will be explained in greater detail in Section 6. Furthermore, if the increase in profit from price
discrimination is ploughed back into research and development, more benefits to consumers will be
created.

Disadvantages of Oligopoly

Allocative Inefficiency

Recall that a firm is allocatively efficient when it cannot change the allocation of resources in the
economy in a way that will increase the welfare of society. This occurs when it charges a price equal
to its marginal cost, assuming no externalities. When the price of a good is equal to the marginal cost,
the marginal benefit that consumers place on the last unit of the good is equal to the forgone marginal
benefit that they place on the amount of other goods that could have been produced using the same
resources. Therefore, the firm cannot change its output level to increase the total benefit for consumers
and hence is allocatively efficient. In oligopoly, price is higher than marginal revenue and firms
maximise profit by producing the output level where marginal revenue equals marginal cost.
Therefore, oligopolists charge a price higher than their marginal cost and are hence allocatively
inefficient.

In the above diagram, at the profit-maximising output level (Q 0) where marginal cost (MC) is equal to
marginal revenue (MR), the price (P0) is higher than the marginal cost (MC0).

Higher Price

Firms with greater market power are able to charge a higher price relative to their marginal cost
compared to firms with less market power. Unlike perfectly competitive firms that have no market
power and monopolistically competitive firms that have little market power, oligopolists have
substantial market power and hence the price charged by oligopolists may be higher than the price that
would be charged by perfectly competitive firms and monopolistically competitive firms operating in
the same market. Furthermore, an oligopolist is likely to be smaller than a monopoly. Therefore,
oligopolists are likely to reap less economies of scale and hence charge a higher price than a
monopoly.

Income Inequity

As oligopolists can make supernormal profit and perfectly competitive firms and monopolistically
competitive firms can make only normal profit in the long run, the distribution of income in an
economy that abounds with oligopolistic markets will be less equitable than one that abounds with
perfectly competitive markets and monopolistically competitive markets.

Price Discrimination

Oligopolists are price-setters and hence they may be able to exploit consumers through price
discrimination. Price discrimination is commonly considered a form of consumer exploitation as it will
convert some of the consumer surplus to the producer surplus.

5.5 Market Concentration Ratio

The market concentration ratio, or simply known as the concentration ratio, is a measure of the
combined market share of a specified number of the largest firms in the market. It is calculated by
summing the market shares of a specified number of the largest firms in the market. The market share
of a firm is the domestic sales of the firm expressed as a percentage of the domestic sales of all the
domestic firms in the market. The concentration ratio can range from close to 0% to 100%.

It is commonly believed that the degree of competition in a market is directly related to the number of
firms. Although this is true to some extent, the number of firms in a market is not a perfect indicator of
the degree of competition. In a market where there are a large number of firms, the degree of
competition may be low if the bulk of the market share is concentrated in the hands of a few large
firms. To overcome this problem, economists use the concentration ratio to show the extent of market
control of a specified number of the largest firms in the market and hence the degree to which the
market is oligopolistic. A commonly used concentration ratio is the four-firm concentration ratio
(CR4). The four-firm concentration ratio (CR 4) measures the combined market share of the four largest
firms in the market. A four-firm concentration ratio (CR 4) of between 0% and 50% indicates low
market concentration and a market with low concentration may be monopolistic competition or an
oligopoly. In this range, the higher the concentration ratio, the more likely the market is oligopolistic
and vice versa. A four-firm concentration ratio (CR 4) of between 50% and 80% indicates medium
market concentration and a market with medium concentration is likely to be an oligopoly. A four-
firm concentration ratio (CR4) of between 80% and 100% indicates high market concentration and a
market with high concentration may be an oligopoly or a monopoly. In this range, the lower the
concentration ratio, the more likely the market is oligopolistic and vice versa.

Apart from the four-firm concentration ratio (CR 4), the one-firm concentration ratio (CR 1) is also
commonly used. The one-firm concentration ratio (CR 1) measures the market share of the largest firm
in the market. It is used to indicate the degree to which the largest firm in the market is monopolistic.
In the United Kingdom, the largest firm is considered a monopoly if the one-firm concentration ratio
(CR1) is 25% and above. Such a monopoly is commonly known as an actual monopoly as opposed to a
pure monopoly which is a single large firm in a market. In Singapore, the largest firm is considered a
dominant firm, which can be interpreted as a monopoly, if the one-firm concentration ratio (CR 1) is
60% and above.

The concentration ratio is subject to several limitations. First, the concentration ratio does not provide
information about the distribution of the market shares among the specified number of the largest
firms in the market. For example, assuming the four-firm concentration ratio (CR 4) in a market is 80%,
the degree of competition will be lower if one firm has 70% of the market share and the other three
firms have the remaining 10%, compared to the case where each of the four firms has 20% of the
market share. Second, the concentration ratio does not provide a comprehensive picture of the market
shares of all the firms in the market as only the market shares of the specified number of the largest
firms are included. In contrast, the Herfindahl-Hirschman index (HHI), which is another measure of
market concentration, takes into account the market shares of all the firms in the market. Third, the
concentration ratio does not capture all aspects of competition in the market. For example, it does not
capture any collusive behaviour among the firms in the market or potential competition. Fourth, the
concentration ratio does not take into account the domestic sales of foreign firms as it only includes
the domestic sales of domestic firms rather than the total domestic sales. The omission of imports from
the concentration ratio causes it to understate the degree of competition in the market. Fifth, the
concentration ratio is a national total but the relevant market may be regional or local due to the
characteristics of the good or high transport costs. If this happens, the concentration ratio will
overstate the degree of competition in the relevant market.

Note: The Herfindahl-Hirschman index (HHI) is another measure of market concentration. It is

calculated by squaring the market share of each firm in the market and then summing the results. The
HHI can range from close to zero to 10,000. The U.S. Department of Justice and the Federal Trade
Commission consider a market with an HHI of less than 1500 to be an unconcentrated market, a
market with an HHI of between 1500 and 2500 to be a moderately concentrated market and a market
with an HHI of greater than 2500 to be a highly concentrated market. .

6 PRICE DISCRIMINATION

6.1 Types of Price Discrimination

Price discrimination is the practice of using a pricing scheme more sophisticated than charging the
same price for each unit of a good to increase profit. According to Arthur Cecil Pigou, although
discriminatory pricing can take many forms, it can usefully be classified into three degrees: first-
degree, second-degree and third degree.

First-degree Price Discrimination

First-degree price discrimination is the practice of charging each consumer the highest price that they
are able and willing to pay for each unit of the good. Therefore, under first-degree price
discrimination, the consumer surplus is zero.
Second-degree Price Discrimination

Second-degree price discrimination is a pricing scheme where a certain price is charged for the first so
many units of a good for which there are no substitutes, a lower price for the next so many units, and
so on. Many public utility firms use block pricing..

Third-degree Price Discrimination

Third-degree price discrimination is the practice of charging different prices for the same good in
different markets. For example, cinema operators charge different prices for the same movies to
different groups of consumers. To practise third-degree price discrimination, a firm must be able to
identify at least two distinct markets which differ in terms of their price elasticities of demand. In
addition, it must be able to prevent consumers in the lower-priced market from reselling the good to
consumers in the higher-priced market which is known as arbitrage prevention. Suppose that a good is
sold in two different markets, market A and market B, at two different prices. Under third-degree price
discrimination, profit will be maximised when the marginal revenue in market A (MR A), the marginal
revenue in market B (MRB) and the marginal cost (MC) are equal. If MR A is not equal to MR B, profit
can be increased by selling less of the good in the market with the lower MR and more of the good in
the market with the higher MR. If MC is not equal to MR A and MRB, profit can be increased by
changing the output level. The firm will charge a higher price in the market with the lower price
elasticity of demand and a lower price in the market with the higher price elasticity of demand.

In the above diagram, the sum of the output level in market A (Q A) and the output level in market B
(QB) is equal to the market output level (Q T). MRA is equal to MRB which is equal to MC. The price in
market A (PA) with the lower price elasticity of demand is higher than the price in market B (P B) with
the higher price elasticity of demand.

Note: For a firm to be able to practise price discrimination, it must have price-setting ability and this
is true for all types of price discrimination. Therefore, only a firm that operates in an imperfect market
may be able to practise price discrimination.

7 ALTERNATIVE OBJECTIVES OF FIRMS

Firms generally seek to maximise profit. However, some firms seek to maximise market share, sales
revenue and long-run profit.

Profit Maximisation

Firms generally seek to maximise profit for several reasons.

A firm generally seeks to maximise profit as it can be used to finance expansion of its scale of
production. A firm can expand its scale of production by ploughing back its profit into increasing its
production capacity. It can also expand its scale of production by using its profit to take over other
firms that produce the same good which is known as horizontal acquisition. An increase in the scale of
production will enable a firm to lower its average cost which is known as economies of scale,
assuming the firm is not producing on the upward sloping portion of its long-run average cost curve.
Due to globalisation, among other factors, the business environment is becoming increasingly more
competitive. Therefore, to ensure its survival, it is imperative that a firm increases its cost-
competitiveness to increase its price-competitiveness.

A firm generally seeks to maximise profit as it can be used to build up cash reserves for recession
years.
A firm generally seeks to maximise profit as it can be used to make dividend payments to its
shareholders

Market Share Maximisation

A firm may seek to maximise market share. For example, if a firm is a new entrant, it may want to
maximise market share to compete with the incumbent firms. In this case, although profit will not be
maximised, the larger market share may ensure the survival of the new entrant.To maximise market
share, a firm will produce the output level where price is equal to average cost, assuming it wants to
make at least normal profit.

Sales Revenue Maximisation

A firm may seek to maximise sales revenue. For example, in many large firms today, there is a
separation between ownership and management. Although it may be in the interest of the shareholders
to have the management maximise profit and hence dividend, it may be in the interest of the
management to maximise sales revenue if it is the key performance indicator. To maximise sales
revenue, a firm will produce the output level where marginal revenue is equal to zero.

Long-run Profit Maximisation

A firm may seek to maximise long-run profit. For example, one of the potential problems of a
monopoly maximising profit is that the profit-maximising price may attract potential firms to enter the
market. If this happens, the profit of the firm will fall in subsequent periods. Therefore, to maximise
long-run profit, the firm may need to practise limit pricing which is a pricing strategy where a
monopoly charges a price below the profit-maximising price with the objective of preventing potential
firms from entering the market. In this case, although profit will not be maximised, long-run profit
may be maximised.

Note: Student should not confuse limit pricing with predatory pricing. Limit pricing is a pricing
strategy where a monopoly charges a price below the profit-maximising price with the objective of
preventing potential firms from entering the market. Predatory pricing is a pricing strategy where an
oligopolist charges a price below the profit-maximising price with the objective of driving competitors
out of the market.
CHAPTER 6: GROWTH OF FIRMS

6.1 Types of Growth of Firms

Firms can grow internally or externally.

Internal Growth

A firm can expand by ploughing back its profit into increasing its production capacity. It can also
expand by increasing its production capacity through issuing shares, issuing bonds or getting bank
loans.

External Growth

A firm can expand by joining with other firms which is known as a merger. A firm can also expand by
acquiring or taking over other firms which is known as an acquisition or takeover. Merger and
acquisition are the two types of integration. In practice, however, the term ‘merger’ is loosely used to
refer to both merger and acquisition. There are three types of mergers: horizontal merger, vertical
merger and conglomerate merger.

Horizontal Merger

A horizontal merger is a merger between two firms that produce the same good at the same stage of
production.

Firms that produce the same good may merge to expand the scale of production in order to reap more
economies of scale and to reduce the number of firms in the market in order to reduce competition.

Vertical Merger

A vertical merger is a merger between two firms at different stages of production, where one firm is a
supplier or a customer of the other firm. When a firm merges with a supplier, the act is known as a
backward merger. When a firm merges with a customer, the act is known as a forward merger. An
example of a vertical merger is the merger between America Online and Time Warner in 2000. The
merger is a vertical one as Time Warner, which was a media conglomerate, supplied content to
consumers through properties like CNN and Time Magazine, while America Online, which was an
internet provider, distributed such information via its internet service.

A vertical merger is usually initiated by the customer. A firm may initiate a backward merger to
achieve greater control and stability in the supply of factor inputs, eliminate transaction costs which
include the costs of negotiating, monitoring and enforcing a contract, restrict the supply of factor
inputs to competitors and prevent leakage of vital information pertaining to the firm’s product.

Conglomerate Merger

A conglomerate merger is a merger between two firms that produce different and unrelated goods. In
the case where the two firms produce different but related goods, the act is known as a lateral merger.
For example, many of the chaebols in South Korea such as Samsung Group and LG Group were
formed through conglomerate mergers.

Firms that produce different goods may merge to reap more economies of scope, spread risk and
create an internal capital market.
6.2 Reasons for Growth of Firms

Large firms have advantages over small firms.

Cost Advantage of Large Firms

Large firms have a cost advantage over small firms due to economies of scale. Large firms have a
lower average cost than small firms because of their larger scales of production. When a firm expands
the scale of production, average cost will usually fall and this phenomenon is called economies of
scale. Economies of scale occur due to several reasons. For example, division of labour is the process
whereby each job is broken up into its component tasks and each worker is assigned one or a few
component tasks of the job. An expansion of the scale of production may enable the firm to engage in
greater division of labour and hence greater specialisation which will lead to higher labour
productivity resulting in a fall in average cost. Furthermore, larger machines are often more efficient
than smaller machines as they generally make more efficient use of materials and labour. Therefore,
an expansion of the scale of production may enable the firm to use larger machines that are often more
efficient than smaller machines which will also lead to higher labour productivity resulting in a fall in
average cost. Larger firms may be able to afford to create more specialised departments where
specialists perform specific administrative functions. These specific administrative functions include
human resource, purchasing, finance and marketing. Greater specialisation in these areas of expertise
will lead to greater efficiency resulting in a fall in average cost.

Large firms may also have a cost advantage over small firms due to economies of scope. Large firms
may have a lower average cost than small firms because of their greater financial resources which
allow them to produce more types of goods. When the types of goods produced increase, average cost
will usually fall. The decrease in average cost due to an increase in the size of the firm associated with
an increase in the types of goods produced rather than an increase in the scale of producing any one
good is called economies of scope. Economies of scope occur due to several reasons. For example, an
increase in the types of goods produced will lead to a fall in the research and development cost per
unit of output if the technologies that are used to produce the goods are related. An increase in the
types of goods produced will also lead to a fall in the marketing cost per unit of output if the goods use
the same branding.

Revenue Advantage of Large Firms

Large firms have a revenue advantage over small firms due to their greater appeal to consumers. For
example, large supermarkets carry a wider range of goods than small retail stores which makes them
more appealing to consumers who place a premium on convenience resulting in a higher total revenue.

Large firms may also have a revenue advantage over small firms due to their greater ability to practise
price discrimination, particularly third-degree price discrimination prevention. Most large firms sell
their goods in more than one country which may allow them to prevent arbitrage and hence give them
the ability to practise third-degree price discrimination. Conversely, most small firms sell their goods
in only one country which makes arbitrage harder to prevent and hence precludes them from practising
third-degree price discrimination.

Other Advantages of Large Firms

In addition to cost advantage and revenue advantage, large firms have other advantages over small
firms. First, large firms are more likely to survive a recession than small firms. Due to their great
financial resources, large firms are able to sustain losses for a long period of time. Furthermore, apart
from bank borrowings, large firms also have other sources of funds such as share issue and bond issue
and hence if banks reduce lending in a recession, such as what happened in the 2008-2009 Subprime
Mortgage Crisis, large firms can raise funds through other means to tide them over the difficult period.
In contrast, small firms are more vulnerable in a recession due to their limited financial resources and
this is particularly true if banks reduce lending. Second, as large firms have greater financial resources
and more sources of funds than small firms, they are likely to be able to undercut small firms to drive
them out of the market. Small firms, however, are much less likely to be able to do so due to their
limited financial resources and their limited sources of funds.

6.3 Survival of Small Firms

Although the advantages of large firms over small firms have driven many small firms out of the
market, there are small firms which are able to survive.

Personalised Services

Small firms that provide personalised services are able to survive. For example, small medical clinics
and small law firms exist today. In these markets, there is limited room for economies of scale due to
the nature of the services provided and this limits the cost advantage of large firms over small firms
which enables small firms to survive.

Niche Market

Small firms that cater for niche markets are able to survive. For example, small firms that sell plus size
clothing to obese women and small firms that sell organic foods to health-conscious consumers exist
today. In these markets, there is limited benefit of economies of scale due to the small sizes of the
markets which enables small firms to survive.

Supporting Role

Small firms that play a supporting role to large firms are able to survive. Many large firms outsource
certain functions and activities to small firms for several reasons such as reducing costs, increasing
flexibility and focusing on core competences. Small firms that play a supporting role through
performing these functions and activities for large firms do not face competition from large firms
which enables them to survive.

Convenience

Small firms that cater for consumers in a particular area are able to survive. For example, small retail
stores located in the neighbourhoods that cater for the residents exist today. Due to their proximity to
the residents in the neighbourhoods, these small retail stores have more appeal than large supermarkets
located further away which enables them to survive.

7 THE THEORY OF CONTESTABLE MARKETS

The theory of contestable markets was put forward in 1982 by William Baumol who was a renowned
American economist. The theory of contestable markets is commonly considered an alternative theory
to the theory of market structure. Proponents of the theory of contestable markets argue that the
behaviour of firms in a market depends on whether there is threat of competition rather than on the
structure of the market.

A perfectly contestable market is a market where there are no barriers to entry, zero exit costs and all
firms have equal access to production technology. In the words of William Baumol, “A contestable
market is one into which entry is absolutely free, and exit is absolutely costless.” By “freedom of
entry”, William Baumol was referring to absence of barriers to entry and equal access to production
technology for all firms. In reality, barriers to entry and exit costs do exist and hence what is discussed
is the degree of contestability of a market. The lower the barriers to entry and exit costs in a market,
the more contestable the market, and vice versa. As stated in the definition, the absence of barriers to
entry, the absence of exit costs and equal access to production technology for all firms are the three
key characteristics of a perfectly contestable market. The absence of barriers to entry provides
potential firms the ability to enter the market. Recall that a barrier to entry is an obstacle which
restricts potential firms from entering a market to compete with the incumbent firm or firms. In the
absence of such obstacles, potential firms are able to enter the market when a profit opportunity arises.
In contrast, high barriers to entry prevent potential firms from entering the market even if the
incumbent firm or firms are making substantial supernormal profit. The absence of exit costs provides
potential firms the incentive to enter the market. If potential firms enter the market, there is always a
possibility that they will make subnormal profit (i.e. economic loss) which will induce them to exit the
market. If they are unable to sell or transfer their capital to other uses without incurring a loss
substantially greater than the normal depreciation, their exit costs which are also known as sunk costs,
will be high which will discourage them from entering the market in the first place. In contrast, the
absence of exit costs will encourage them to enter the market. Equal access to production technology
for all firms provides potential firms both the ability and the incentive to enter the market. If potential
firms do not have equal access to production technology as the incumbent firm or firms, the former
will have a cost disadvantage over the latter which will reduce their chances of making supernormal
profit. In contrast, if potential firms have equal access to production technology as the incumbent firm
or firms, the former will be able to compete with the latter on an equal footing which will enable and
incentivise them to enter the market.

The crucial feature of a contestable market is its vulnerability to hit-and-run competition. If the
incumbent firm or firms in a perfectly contestable market are making supernormal profit, potential
transient entrants will enter the market to exploit the profit opportunity by charging prices slightly
lower than those charged by the incumbent firm or firms. When this happens, the incumbent firm or
firms will respond by reducing their prices to levels lower than those charged by the transient entrants.
This will induce the transient entrants to reduce their prices to levels lower than those charged by the
incumbent firm or firms which will prompt the latter to further reduce their prices. This process will
continue until the prices fall to the levels which correspond to normal profit, at which point the
transient entrants will exit the market. According to the proponents of the theory of contestable
markets, the prospect of such hit-and-run competition from potential transient entrants will induce the
incumbent firm or firms in the market to behave in a way which firms in a highly competitive market
do, even if there are only one or a few firms in the market. In other words, in a perfectly contestable
market, firms will be x-efficient and hence productively efficient and they will charge a price lower
than the price that would be charged if the market was less or non-contestable. The lower price will be
equal to the average cost resulting in normal profit in the long run and hence an equitable distribution
of income.

The implication of the theory of contestable markets for government policy is that the government
may increase the degree of contestability of a market to achieve results closer to those of a perfectly
competitive market. There are several measures which the government can take to increase the degree
of contestability of a market. If a firm controls the supply of some key factor inputs, it can deny access
to these factor inputs to potential firms which will make it difficult for them to enter the market.
Therefore, the government can lower the barriers to entry by preventing these key factor inputs from
being controlled by the incumbent firm or firms in the market. For example, it can block proposed
vertical mergers which may result in such a situation. The government can also lower the barriers to
entry by granting more licenses to operate in the market. For example, it can grant more licenses to
operate the same routes in the airline industry. Apart from lowering the barriers to entry, the
government can also increase the degree of contestability of a market by increasing access to the same
production technology of the incumbent firm or firms in the market. For example, it can compel the
incumbent firm or firms in the market to open up their infrastructure to other firms.
CHAPTER 7: MARKET FAILURE

1 INTRODUCTION

In the free market, the equilibrium of a market is determined by the market forces of demand and
supply. However, the equilibrium price and the equilibrium quantity of a good may not be the optimal
price and the optimal quantity. For example, tobacco and alcohol will be over-consumed and
education and healthcare will under-consumed in the absence of government intervention. Market
failure occurs when the free market fails to allocate resources efficiently or distribute goods and
services equitably. Allocative efficiency is achieved when it is impossible to change the allocation of
resources in the economy in a way that will increase the welfare of society. This occurs when marginal
social benefit is equal to marginal social cost where marginal social benefit is the sum of marginal
private benefit and marginal external benefit and marginal social cost is the sum of marginal private
cost and marginal external cost. External costs and benefits, or externalities, are costs and benefits of
consumption or production experienced by society other than the producers or the consumers.
Although the free market has numerous merits, it may not allocate resources efficiently or distribute
goods and services equitably. This chapter provides an exposition of six causes of market failure:
externalities, imperfect information, market dominance, public goods, immobility of factors of
production and income inequity.

2 EXTERNALITIES

2.1 Externalities as a Cause of Market Failure

Positive Externalities/External Benefits

Positive externalities, or external benefits, lead to under-consumption/production. For example,

healthcare will be under-consumed in the absence of government intervention due to positive
externalities. The private costs of healthcare are the costs of production incurred by firms such as the
costs of materials and labour. These costs are passed on to consumers in the form of a positive price.
Therefore, from the consumers’ perspective, the marginal private cost of healthcare is the price that
they pay for the unit of the good. Assuming no negative externalities in healthcare consumption, the
marginal social cost is equal to the marginal private cost. The private benefits of healthcare are the
satisfaction derived by consumers such as immunity to flu viruses when they get flu vaccination. The
consumption of healthcare produces positive externalities. For example, it prevents the spreading of
diseases to others. It also contributes to a healthier and hence more productive labour force which is
beneficial to the wider community. These positive externalities lead to a divergence between the
marginal social benefit and the marginal private benefit. As firms and consumers consider only private
costs and benefits, the divergence between the marginal social benefit and the marginal private benefit
of healthcare results in under-consumption.

In the above diagram, due to external benefits, the marginal social benefit (MSB) is higher than the
marginal private benefit (MPB). Therefore, the equilibrium output level (Q E) where MPB is equal to
marginal private cost (MPC) is lower than the allocatively efficient output level (Q AE) where MSB is
equal to marginal social cost (MSC). For the units of output between Q E and QAE, the MSB is higher
than the MSC. Therefore, the social welfare gain which is the area under the MSB curve is greater
than the social welfare loss which is the area under the MSC curve resulting in a net social welfare
gain. It follows that these units of output should be consumed. However, as firms and consumers do
not consider external costs and benefits, they are not consumed which results in a deadweight loss
equal to the unrealised net social welfare gain. The deadweight loss, which is the loss of social welfare
due to market failure or government intervention, is represented by the shaded area.

Negative Externalities/External Costs

Negative externalities, or external costs, lead to over-consumption/production. For example, tobacco

will be over-consumed in the absence of government intervention due to negative externalities. The
private benefits of tobacco are the satisfaction derived by consumers such as a sense of ‘high’ feeling
and the idea of looking ‘cool’ when they smoke, net of the costs of personal tobacco-related health
problems. Assuming no positive externalities in tobacco consumption, the marginal social benefit is
equal to the marginal private benefit. The private costs of tobacco are the costs of production incurred
by firms such as the costs of materials and labour. These costs are passed on to consumers in the form
of a positive price. Therefore, from the consumers’ perspective, the marginal private cost of tobacco is
the price that they pay for the unit of the good. The consumption of tobacco produces negative
externalities. For example, it leads to air pollution in the form of second-hand smoke. It also
contributes to land pollution through the littering of cigarette butts. These negative externalities lead to
a divergence between the marginal social cost and the marginal private cost. As firms and consumers
consider only private costs and benefits, the divergence between the marginal social cost and the
marginal private cost of tobacco results in over-consumption.

2.2 Measures to Correct Market Failures due to Externalities

Tax

To correct market failures due to negative externalities, the government can use tax to decrease the
supply. For example, the Singapore government imposes a tax of $427 per 1000 cigarettes which is
equivalent to $0.427 per cigarette or $8.54 per packet of 20 cigarettes. A tax on tobacco will lead to a
rise in the cost of production and hence a fall in the supply. When this happens, the price will rise
which will lead to a fall in the quantity demanded. In this way, a tax on tobacco induces consumers to
internalise the external costs.

Benefits and Limitations of Tax

Using tax to correct the market failure of tobacco has its benefits and limitations. First, a tax on
tobacco allows the government to raise tax revenue which can be used to deal with the external costs
of consumption or fund research to prevent or treat tobacco-related diseases. Second, the price
elasticity of demand for tobacco by teenagers is likely to be high due to their low incomes and hence
the large proportion of income spent on the good. Therefore, a tax on tobacco which will increase the
price is likely to substantially reduce the problem of teenage smoking. Notwithstanding the benefits,
there are several limitations. First, for a tax on tobacco to correct the market failure, it must be equal to
the marginal external cost as the purpose of the tax is to induce consumers to internalise the external
costs, assuming no other causes of the market failure. However, it is difficult to precisely measure the
external costs of tobacco consumption. Therefore, a tax on tobacco may not be equal to the marginal
external cost and hence may not correct the market failure. Second, a tax on tobacco expressed as a
percentage of income is higher for low income individuals than for high income individuals.
Therefore, a tax on tobacco is regressive and hence worsens income inequity.

Subsidy

To correct market failures due to positive externalities, the government can use subsidy to increase the
supply. For example, the Singapore government gives a subsidy to public hospitals for the provision of
subsidised healthcare. The amount of subsidy that consumers of healthcare at public hospitals will
receive depends on their income and the type of ward accommodation they choose. For non-working
consumers, the amount of subsidy that they will receive depends on the values of their residential
properties and the incomes of their immediate family members. A subsidy on healthcare will lead to a
fall in the cost of production and hence a rise in the supply. When this happens, the price will fall
which will lead to a rise in the quantity demanded. In this way, a subsidy on healthcare induces
consumers to internalise the external benefits.

Benefits and Limitations of Subsidy

Using subsidy to correct the market failure of healthcare has its benefits and limitations. First, a
subsidy on healthcare expressed as a percentage of income is higher for low income individuals than
for high income individuals. Therefore, a subsidy on healthcare benefits low income individuals more
in relative terms and hence improves income equity. Second, the use of means-testing in public
hospitals means that low income individuals receive more subsidy than high income individuals which
further improves income equity. Notwithstanding the benefits, there are several limitations. First, for a
subsidy on healthcare to correct the market failure, it must be equal to the marginal external benefit as
the purpose of the subsidy is to induce consumers to internalise the external benefits, assuming no
other causes of the market failure. However, it is difficult to precisely measure the external benefits of
healthcare consumption. Therefore, a subsidy on healthcare may not be equal to the marginal external
benefit and hence may not correct the market failure. Second, subsidising healthcare puts a strain on
the government budget which may compel the government to decrease expenditure on other important
areas such as education and infrastructure to avoid a budget deficit and this may result in adverse
consequences for the economy in the long run.

Tradable Emissions Permit Scheme (For Pollution in Production)

Under a tradable emissions permit scheme, also known as an emissions trading scheme and a cap-and-
trade scheme, the government will determine the socially optimal level of pollution caused by a
pollutant, such as carbon. To achieve this socially optimal level of pollution, it will set a limit on the
amount of the pollutant that firms are allowed to emit. The limit is then allocated or sold through
auction to firms in the form of emissions permits, which are also known as credits or allowances,
which represent the right to emit a certain amount of the pollutant. Emissions permits can then be
traded in the secondary market. For example, the emissions permits under the EU Emissions Trading
Scheme are traded in European Union Allowances. Firms are required to hold a number of emissions
permits equivalent to their emissions. Firms that need to increase their emissions beyond what their
emissions permits allow must buy emissions permits from those who have surplus emissions permits.
By limiting the amount of the pollutant that firms are allowed to emit, the government effectively
limits the amount of a good that firms are allowed to produce which will solve or reduce the problem
of over-production.

Benefits and Limitations of Tradable Emissions Permit Scheme

Using a tradable emissions permit scheme to correct market failures has its benefits and limitations.
First, the use of a tradable emissions permit scheme does not require the government to precisely
measure the marginal external cost which is a difficult task. The government simply needs to conduct
environmental studies to determine the socially optimal level of pollution caused by the pollutant.
Second, unlike education, a tradable emissions permit scheme is legally binding which means that it is
mandatory for firms to respond to it. Notwithstanding the benefits, there are several limitations. First,
an effective tradable emissions permit scheme requires effective enforcement but the cost of effective
enforcement may be very high which may render it impractical resulting in ineffective regulation.
Furthermore, the cost of enforcement may largely offset or even outweigh the benefit of the reduction
or elimination of the deadweight loss in the market. Second, opponents of the tradable emissions
permit scheme argue that such a scheme does not provide the incentive for firms to clean up the
pollution and adopt or develop more environmentally friendly production technologies as firms can
simply buy emissions permits for their pollution. This is especially true if the emissions permits are
cheap. Third, they argue that such a scheme, apart from increasing the cost of production in the
economy, also creates uncertainty as the emissions permits are traded in the secondary market and
hence their prices are subject to speculation. This may have the adverse effect of reducing the
attractiveness of the economy to foreign firms that may invest in the economy resulting in a fall in
foreign direct investments.

3 INFORMATION FAILURE

3.1 Imperfect Information as a Cause of Market Failure

Imperfect information about beneficial effects

Imperfect information about beneficial effects leads to under-consumption. For example, healthcare
will be under-consumed in the absence of government intervention due to imperfect information about
the beneficial effects. The perceived marginal private benefit of healthcare is lower than the actual
marginal private benefit as many people do not fully realise the beneficial effects. For example, many
people are not fully aware of the benefits of vaccinations against key diseases which leads to
underestimation of the private benefits. As the demand for healthcare is based on the perceived
marginal private benefit which is lower than the actual marginal private benefit due to imperfect
information about the beneficial effects, this leads to under-consumption.

3.2 Measures to Correct Market Failures due to Imperfect Information

Education

To correct market failures due to imperfect information about the beneficial effects, the government
can use education to increase the demand. For example, the Singapore government uses education to
increase the demand and hence correct the market failure of healthcare. The Singapore government
conducts health campaigns and has incorporated health education into the school curriculum to
increase the awareness of the beneficial effects of good health. Education reduces the extent of
imperfect information and hence brings the perceived marginal private benefit closer to the actual
marginal private benefit. When this happens, the equilibrium output level will move closer to the
allocatively efficient output level resulting in a reduction in allocative inefficiency. Similarly, to
correct market failures due to imperfect information about the detrimental effects, the government can
use education to decrease the demand. Furthermore, it has incorporated health education into the
school curriculum to increase the awareness of the beneficial effects of good health. Education reduces
the extent of imperfect information and hence brings the perceived marginal private benefit closer to
the actual marginal private benefit. When this happens, the equilibrium output level will move closer
to the allocatively efficient output level resulting in a reduction in allocative inefficiency.

Benefits and Limitations of Education

Using education to correct the market failure of healthcare has its benefits and limitations. First,
incorporating health education into the school curriculum may help people stay healthy from a young
age. Second, unlike regulations on healthcare, education on healthcare does not incur enforcement
costs. Notwithstanding the benefits, there are several limitations. First, education is not legally binding
which means that it is not mandatory for people to respond to it. Second, even if it is effective, the
effects will only be realised in the long run and this is particularly true for preventive healthcare whose
benefits are not immediately obvious. Using education to correct the market failure of tobacco has its
benefits and limitations. First, incorporating health education into the school curriculum may prevent
young people from getting into the habit of smoking in the first place. Second, unlike regulations on
tobacco, education on tobacco does not incur enforcement costs. Notwithstanding the benefits, there
are several limitations. First, education is not legally binding which means that it is not mandatory for
people to respond to it. Second, even if it is effective, the effects will only be realised in the long run
and this is particularly true for smoking due to the addictive nature.

4 PUBLIC GOODS

4.1 Public Goods as a Cause of Market Failure

Public goods will not be produced in the absence of government intervention. Public goods are goods
that are non-excludable and non-rivalrous. A good is non-excludable when it is impossible or
prohibitively costly to prevent non-payers from consuming the good once it has been produced. A
good is non-rivalrous when the consumption of the good by a consumer will not reduce the amount
available to other consumers. Examples of public goods include national defence and street lighting.
As public goods are non-excludable, consumers can consume them without paying for them.
Therefore, consumers will want to consume public goods without contributing to their production
which is known as the free-rider problem. As consumers have no incentive to pay for public goods,
private firms which are profit-oriented have no incentive to produce them. Therefore, in the absence of
government intervention, public goods will not be produced due to the characteristic of non-
excludability. Furthermore, as public goods are non-rivalrous, the marginal cost of provision, which is
the additional cost resulting from providing a good to one more consumer, is zero. Therefore, for
allocative efficiency to be achieved, the price should be zero, assuming no externalities. However,
private firms are profit-oriented and hence will only produce a good at a positive price which
corresponds to a quantity demanded lower than that at a zero price. Therefore, even if public goods
were produced by private firms, assuming away the characteristic of non-excludability, they would be
under-consumed in the absence of government intervention due to the characteristic of non-rivalry.

Note: Unlike public goods, private goods are goods that are excludable and rivalrous. A good is
excludable when it is possible and not prohibitively costly to prevent non-payers from consuming the
good once it has been produced. A good is rivalrous when the consumption of the good by a consumer
will reduce the amount available to other consumers. Examples of private goods include personal
computers and smartphones. Free goods are goods that exist in quantities that are more than
sufficient to meet demand at a zero price. Examples of free goods include desert sand and sea water.
Economic goods are goods that exist in quantities that are less than sufficient to meet demand at a
zero price. Examples of economic goods include cars and televisions. In addition to private goods and
public goods, economic goods include club goods and common resources. Club goods are goods that
are excludable and non-rivalrous. Examples of club goods include cable television and golf courses.
Common resources are goods that are non-excludable and rivalrous. Examples of common resources
include fishes in the sea and pastures.

Apart from very high external benefits, free direct provision can also be justified on the grounds of
non-rivalry. As non-rivalry leads to a zero marginal cost of provision, and private firms are profit-
oriented and hence will not produce a good at a zero price, free direct provision is the only measure to
achieve allocative efficiency.

4.2 Measures to Correct Market Failures due to Public Goods

To correct market failures due to public goods, the government can engage in direct provision. For
example, the Singapore government directly provides national defence and street lighting. The
expenditure on these public goods is financed through taxation. The Singapore government engages in
the direct provision of public goods as other measures such as tax, subsidy, regulation and education
do not solve the free-rider problem caused by non-excludability which is the root cause of the non-
provision of public goods. However, state-owned firms do not need to consider factors such as
profitability and survival and hence are more likely to be x-inefficient and hence productively
inefficient than private firms.
5 MARKET DOMINANCE

5.1 Market Dominance as a Cause of Market Failure

Market dominance occurs when the firm or firms in a market have substantial market power which
leads to severe under-production. An example of a firm with substantial market power is Microsoft
Corporation in the market for PC operating systems. Market dominance occurs in monopolistic
markets and oligopolistic markets due to the high barriers to entry. To maximise profit, a firm with
market power will restrict output and charge a price higher than its marginal cost which will lead to
under-production, and this problem is particularly severe when the market power is substantial. In the
case of monopoly, the demand for the good is likely to be price inelastic due to lack of close
substitutes and hence the difference between the price and the marginal cost, which is a measure of the
extent of allocative inefficiency, is likely to be large.

In the above diagram, the allocatively efficient output level where marginal social benefit (MSB) is
equal to marginal social cost (MSC), or price (P) is equal to marginal cost (MC), is Q AE. However, if
the firm increases output beyond Q0 where MC is equal to MR, the increase in total cost will be greater
than the increase in total revenue as MC will be higher than MR. If this happens, profit will fall.
Therefore, the firm restricts the output level to Q 0 which is lower than Q AE and charges a price (P 0)
higher than the marginal cost (MC0). The less price elastic the demand and hence the steeper the
demand curve is, the larger will be the difference between the price and the marginal cost. The
deadweight loss, which is the loss of social welfare due to market failure or government intervention,
is represented by the shaded area.

In addition to allocative inefficiency, market dominance is a cause of market failure due to productive
inefficiency. A firm is productively efficient when it produces on its long-run average cost curve, from
firm’s perspective. This occurs when it is x-efficient and technically efficient. A firm is x-efficient
when it is not lax in cost control. In other words, it uses the most efficient production technology, it is
not overstaffed, it does not occupy premises that are larger than necessary for its output level, etc. A
firm is technically efficient when it uses the least-cost combination of factor inputs to produce its
output level which means that the last dollar of each factor input that it employs produces the same
additional output. From society’s perspective, a firm is productively efficient when it produces at the
minimum efficient scale. Due to the absence of competition in the market, a monopoly may be lax in
cost control. Therefore, a monopoly may be x-inefficient and hence productively inefficient. Although
less of a concern than allocative inefficiency and income inequity, productive inefficiency is also a
cause of market failure.

5.2 Measures to Correct Market Failures due to Market Dominance

Marginal Cost Pricing, Average Cost Pricing, Subsidy and Nationalisation

Marginal cost pricing, average cost pricing, subsidy and nationalisation are some of the measures to
correct market failures due to market dominance and these measures have been discussed in Chapter 6.
In addition to these measures, the government can increase competition in the market or set a
maximum price to correct the market failures.

Increasing Competition

The government can increase competition in the market through increasing the number of firms to
decrease economic inefficiency due to market dominance. The entry of potential firms into a
monopolistic market will create substitutes for the good produced by the incumbent firm. When this
happens, the price elasticity of demand for the good produced by the incumbent firm will rise which
will lead to a decrease in the difference between the price and the marginal cost resulting in a decrease
in allocative inefficiency. This may occur to a large extent if there is little differentiation among the
products produced by the firms.

6 IMMOBILITY OF FACTORS OF PRODUCTION

6.1 Immobility of Factors of Production as a Cause of Market Failure

Immobility of factors of production may cause a market to be in a constant state of disequilibrium

resulting in allocative inefficiency. When the market forces of demand and supply change, firms will
respond by changing their output levels and hence the amount of factor inputs they employ. However,
owners of factors of production may be slow to respond due to immobility. For example, workers may
be slow to respond due to occupational immobility and geographical immobility. Occupational
immobility occurs when workers do not have the relevant skills and knowledge to move to the
industry. Therefore, they need time to undergo education and training to acquire the skills and
knowledge before they can move to the industry. Geographical immobility occurs when workers do
not reside in the place where the industry is located. Therefore, they need time to relocate before they
can move to the industry. As workers move to the industry over time and hence the market moves
towards the equilibrium, the market forces of demand and supply change which moves the equilibrium
and this causes the market to be in a constant state of disequilibrium resulting in allocative
inefficiency.

6.2 Measures to Correct Market Failures due to Immobility of Factors of Production

Education and Training

Education and training will reduce occupational immobility of labour. For example, the Singapore
government provides education and training directly by setting up educational institutes. Examples
include the Institute of Technical Education, polytechnics and Continuing Education and Training
campuses. It also provides education and training indirectly by giving subsidies and tax incentives to
firms to induce them to send their workers for education and training. Examples include Workfare
Training Support, Skills Programme for Upgrading and Resilience, Workforce Skills Qualifications
System and Skills Training for Excellence Programme. Business expenses on education and training
are tax deductible in Singapore.

Better Transport System

A better transport system will reduce geographical immobility of labour. For example, the Singapore
government has taken measures to improve the transport system such as building the Mass Rapid
Transit system, the Light Rapid Transit system and expressways, and improving the traffic signal
system through implementing the Green Link Determining System.

Limitations of Education and Training and Better Transport System

Education and training will equip workers with new skills and knowledge only in the long run and this
long effectiveness time lag makes it ineffective for reducing occupational immobility in the short run.
Improving the transport system puts a strain on the government budget which may compel the
government to decrease expenditure on other important areas such as education and healthcare to
avoid a budget deficit and this may result in adverse consequences for the economy in the long run.

7 INCOME INEQUITY

7.1 Income Inequity as a Cause of Market Failure

Income inequity may lead to failure of the free market to allocate some goods and services to the
people who need them more. Effective demand is the desire to buy backed by the ability to pay.
Ineffective demand is merely the desire to buy not backed by the ability to pay. The free market only
responds to effective demand which means that it only distributes goods and services to the people
with the willingness and the ability to pay for them. However, the ability to pay for a good does not
reflect the need for the good. Therefore, individuals who need some goods and services but do not
have the ability to pay for them have to go without the goods and services. In the free market, the
prices of goods and services are determined by the market forces of demand and supply. If the income
gap is large, high income individuals with a high willingness and ability to pay may push up the prices
of some goods and services to the levels which make the goods and services unaffordable to low
income individuals with a low ability to pay. This is a matter of concern particularly if the goods and
services are necessities. For example, education is a necessity particularly to low income individuals
who have a high need to increase their skills and knowledge and hence their income earning power.
Therefore, inaccessibility to education by low income individuals due to a high price which will make
it difficult for them to increase their skills and knowledge is likely to cause them to be trapped in
poverty.

PART II: MACROECONOMICS

CHAPTER 8: NATIONAL OUTPUT/NATIONAL INCOME ACCOUNTING

1 INTRODUCTION

Thus far, we have been dealing with microeconomics. Macroeconomics deals with the analysis of the
whole economy. It concerns factors determining aggregate variables such as aggregate demand,
aggregate supply, national output, national income, unemployment, inflation, the balance of payments,
etc. As opposed to microeconomics which focuses on the individual parts of the economy,
macroeconomics looks at the big picture of the economy. In order to understand macroeconomics, we
first need to understand the concepts of national output and national income which are used for many
purposes such as measuring the standard of living. This chapter provides an exposition of the concepts
of national output and national income.

2 MEASUREMENT OF NATIONAL OUTPUT, NATIONAL INCOME AND NATIONAL

EXPENDITURE

National output is the market value of all the final goods and services produced in the economy over a
period of time. National income is the total income earned by the nation over a period of time.
National expenditure is the total expenditure made on the final goods and services produced in the
economy over a period of time. National output, national income and national expenditure are
different economic variables. However, they have the same value.

When firms increase production which will lead to an increase in national output, they will employ
more factor inputs from households and hence will pay them more factor income which will lead to an
increase in national income. Therefore, an increase in national output will lead to an increase in
national income. Furthermore, as the factors of production in the economy which include labour, land,
capital and enterprise are owned by households, the increase in national income will be equal to the
increase in national output.
Although it is easy to see why national income is equal to national output, it is less obvious why
national expenditure is equal to national output. If all the final goods produced in the economy are
purchased by households, firms, the government or foreigners, then it is obvious why national
expenditure is equal to national output. However, even if some of the final goods produced in the
economy are not purchased by households, firms, the government or foreigners, national expenditure
is still equal to national output. This is because the final goods produced in the economy which are not
purchased by households, firms, the government or foreigners are considered to be purchased by firms
themselves. The value of these unsold goods, which is called stock in accounting, is known as
inventory investment in economics.

As national output, national income and national expenditure have the same value, there are three
ways to measure national output: the output approach, the income approach and the expenditure
approach.

Output Approach (Direct Approach)

Adding up the values of all the final goods and services produced in the economy and indirect taxes
net of subsidies yields national output. Final goods and services are goods and services that are
consumed by the end-users. They include consumer goods such as ice creams and cookies and capital
goods such as factories and machinery. When measuring national output, the values of intermediate
goods and services are excluded as they are already included in the values of final goods and services.
Intermediate goods and services are goods and services that are used as inputs in the production of
other goods and services. They include raw materials and semi-finished goods.

Income Approach (Indirect Approach)

Adding up the factor incomes (i.e. wages, rent, interest and profits) received by households from firms
for the provision of factors of production and indirect taxes net of subsidies yields national income
which is equal to national output.

Expenditure Approach (Indirect Approach)

Adding up the expenditures made on all the final goods and services produced in the economy yields
national expenditure which is equal to national output. In an open economy, this involves adding up
consumption expenditure, investment expenditure, government expenditure on goods and services and
net exports. The expenditure approach will be explained in greater detail in Chapter 9.

Gross Domestic Product versus Gross National Product

Gross Domestic Product (GDP) is the market value of all the final goods and services produced in the
economy over a period of time. Gross Domestic Product is commonly simply referred to as national
output. In contrast, Gross National Product (GNP) is the market value of all the final goods and
services produced by factors of production owned by the residents of the economy over a period of
time. To put it somewhat differently, although Gross Domestic Product focuses on the location of
factors of production, Gross National Product focuses on the ownership. Some of the goods and
services produced in the economy are produced by factors of production owned by foreigners. When
these foreigners earn wages, rent, interest and profit, they remit the income to their home countries.
This income is called ‘factor income to abroad’. Similarly, some of the income earned by domestic
residents comes from the ownership of factors of production located overseas. This income is called
‘factor income from abroad’. Gross National Product can be obtained by adding factor income from
abroad and subtracting factor income to abroad from Gross Domestic Product.

Net National Product at Factor Cost

By equating national income to national output, I am effectively equating national income to Gross
Domestic Product. However, it is important to note that some economists do not equate national
income to Gross Domestic Product. Instead, they equate national income to Net National Product at
factor cost. In the absence of indirect taxes and subsidies, market prices will be equal to the factor
cost. In reality, the government imposes indirect taxes which make market prices higher than the
factor cost, and gives subsidies which make market prices lower than the factor cost. When capital
goods are used to produce goods and services, they wear out over time and this is called depreciation
or capital consumption. Subtracting depreciation from gross investment yields net investment. Net
National Product at factor cost can be obtained from Gross Domestic Product in three steps; add factor
income from abroad and subtract factor income to abroad, subtract depreciation and subtract indirect
taxes and add subsidies.

Disposable Income

Economists are interested to find out how consumption expenditure varies with income. For this
purpose, instead of national income, disposable income is used. Disposable income is the income that
households have available to spend or save after paying direct taxes and receiving transfer payments.
To get disposable income from national income, we subtract undistributed corporate profits and direct
taxes and add transfer payments.

Note:Transfer payments are payments made by the government to the recipients not in exchange for
any goods or services. They include social security benefits, unemployment benefits and interest
payments on national debt. The Singapore government provides limited social security benefits and
does not provide unemployment benefits.

National output will be discussed in economics tuition by the Principal Economics Tutor in greater
detail.

3 THE BUSINESS CYCLE

The business cycle, or the trade cycle, refers to the periodic fluctuations of national output and hence
national income around its long-term trend. It involves two phases: economic expansion and economic
contraction. An economic expansion is a period of time during which national output and hence
national income is rising. An economic contraction is a period of time during which national output
and hence national income is falling.

The Business Cycle

In the above diagram, the upward sloping portions of the business cycle are economic expansions and
the downward sloping portions are economic contractions. On average, an economic expansion is
longer than an economic contraction. Therefore, national output and hence national income rises over
time. Due to several factors such as globalisation, the business cycle is getting shorter. Although the
duration between a trough and the next peak was between 10 and 15 years, it is now between 5 and 7
years. In other words, economic contraction is occurring more frequently. Nevertheless, expansion
remains the normal state of the economy.

Note: A recession is a fall in national output and hence national income for at least two consecutive
quarters. This definition of recession, which is commonly known as a technical recession, is used in
Singapore. However, the National Bureau of Economic Research (NBER) in the United States does
not define a recession in terms of at least two consecutive quarters of fall in national output and hence
national income. Rather, it defines a recession as a significant decline in economic activity spread
across the economy, lasting more than a few months, normally visible in real GDP, real income,
employment, industrial production, and wholesale-retail sales.
4 NOMINAL NATIONAL OUTPUT AND REAL NATIONAL OUTPUT

Economists distinguish between two types of national output: nominal national output and real
national output. Nominal national output is national output measured at current prices. Real national
output is national output measured at base-year prices. Similarly, economists distinguish between two
types of national income: nominal national income and real national income. Nominal national income
is national income derived from the production of national output measured at current prices. Real
national income is national income derived from the production of national output measured at base-
year prices.

The size of an economy is measured by the amount of goods and services produced in the economy.
Therefore, an economy grows when it produces a larger amount of goods and services. For the
purpose of measuring economic growth, economists prefer the use of real national output to the use of
nominal national output. As nominal national output is national output measured at current prices, an
increase in nominal national output can be due to an increase in the amount of goods and services
produced in the economy or a rise in the prices of goods and services. Therefore, when nominal
national output rises, the economy may not necessarily be producing a larger amount of goods and
services as the increase in nominal national output may be due to a rise in the prices of goods and
services. However, as real national output is national output measured at base-year prices, an increase
in real national output can only be due to an increase in the amount of goods and services produced in
the economy as base-year prices do not change unless the government changes the base year.
Therefore, when real national output rises, the economy is producing a larger amount of goods and
services, which is known as economic growth.

Example: The Republic of Coconuts

Assume that

Output (2015) = 20 coconuts

Price (2015) = $3

Output (2010) = 15 coconuts

Price (2010) = $2

The base year is 2010

Therefore,

Nominal GDP (2015) = Output (2015) x Price (2015) = 20 x $3 = $60

Real GDP (2015) = Output (2015) x Price (2010) = 20 x $2 = $40

Nominal GDP (2010) = Output (2010) x Price (2010) = 15 x $2 = $30

Real GDP (2010) = Output (2010) x Price (2010) = 15 x $2 = $30

In the above example, the nominal GDP in 2015 was $60 and the nominal GDP in 2010 was $30.
Therefore, the nominal GDP grew by 100% [($60 – $30)/$30 x 100%] from 2010 to 2015. However,
much of the increase in the nominal GDP from 2010 to 2015 was due to an increase in the general
price level. The real GDP in 2015 was $40 and the real GDP in 2010 was $30. Therefore, the real
GDP grew by only 33% [($40 – $30)/$30 x 100%] from 2010 to 2015, which was lower than the
100% increase in the nominal GDP.

GDP Deflator

With nominal GDP and real GDP, we can measure the GDP deflator. The GDP deflator is an index of
the average price of all the final goods and services produced in the economy over a period of time. It
is used by economists to monitor the general price level. The GDP deflator measures the general price
level in the current year relative to the general price level in the base year chosen by the government.

Nominal GDP (t)

GDP Deflator (t) = ————————— × 100

Real GDP (t)

From the above example, GDP deflator2015 = (Nominal GDP2015/Real GDP2015) x 100 = $60/$40 × 100
= 150, which means that the general price level rose by 50% from 2010 to 2015.

Inflation is a sustained rise in the general price level. The inflation rate is the percentage increase in
the general price level. In theory, it can be calculated as the percentage increase in the GDP deflator.

GDP Deflator (t) – GDP Deflator (t–1)

Inflation Rate (t) = —————————————————— × 100

GDP Deflator (t–1)

Note: The base year currently used to measure real GDP in Singapore is 2010.

Although the inflation rate can be calculated as the percentage increase in the GDP deflator, it is
calculated as the percentage increase in the consumer price index (CPI) in reality.

5 NATIONAL INCOME AND THE STANDARD OF LIVING

Economists often use real national income to compare the standards of living over time (intertemporal
comparison) and across space (international comparison). The standard of living refers to the material
and non-material welfare of the people.

An increase in national income may lead to a rise in the standard of living. When firms increase
production which will lead to an increase in national output, they will employ more factor inputs from
households and hence will pay them more factor income which will lead to an increase in national
income. Therefore, an increase in national income indicates an increase in national output. An increase
in national output may lead to an increase in the amount of goods and services available for
consumption. If this happens, the material standard of living will rise. Furthermore, when national
output rises, the demand for labour in the economy will rise which will lead to a fall in unemployment.
When this happens, the morale and self-confidence of the workers who were previously unemployed
but have found a job may rise which may improve their mental health and this may lead to a rise in
their non-material standards of living. In addition, the mental health of the workers who were
previously employed and have remained employed may improve as they may experience a higher
sense of job security and this may lead to a rise in their non-material standards of living.
However, due to several reasons, this is not necessarily true. Therefore, problems arise when national
income is used to compare the standard of living over time and across space.

Intertemporal Comparison (Comparison Over Time)

An increase in national output may not lead to a rise in the standard of living because it may not lead
to an increase in the amount of goods and services available for consumption due to several reasons.

First, the amount of goods and services available for consumption may not increase because the
amount of non-marketed goods and services may decrease. The value of non-marketed goods and
services is not included in national output. For example, when a baker bakes a pie, the value of the pie
is included in national output. However, when a housewife bakes a pie, it is not. When unemployment
falls due to an increase in national output, people will have less time to engage in the production of
goods and services in the household economy which will lead to a decrease in the amount of non-
marketed goods and services.

Second, the amount of goods and services available for consumption may not increase because the
amount of undeclared goods and services in the underground economy may decrease. The value of
undeclared goods and services in the underground economy is not included in national output. These
goods and services are not declared because they may be illegal, such as drugs and prostitution, or for
the purpose of tax evasion. For example, people smuggle tobacco and alcohol to evade tax. When
unemployment falls due to an increase in national output, less people will engage in the production of
goods and services in the underground economy which will lead to a decrease in the amount of
undeclared goods and services.

Even if the amount of goods and services available for consumption increases, the standard of living
may not rise due to several reasons.

First, the amount of goods and services available to domestic households for consumption may not
increase because the increase in national output may be due to an increase in exports. This is
particularly true if the economy is highly dependent on external demand. If this happens, the increase
in the amount of goods and services produced will lead to an increase in the amount of goods and
services available to foreign rather than domestic households for consumption. Similarly, if the
increase in national output is due to an increase in the amount of capital goods produced rather than an
increase in the amount of consumer goods and services produced, the material standard of living may
not rise.

Second, the amount of goods and services available to the average person for consumption may not
increase because the population may have increased. In the event that the population has increased by
a larger proportion, the amount of goods and services available to the average person for consumption
will fall.

Third, an increase in national income may worsen income inequity. When national income rises, the
incomes of high income individuals may rise by a larger proportion than those of low income
individuals and this may be due to several reasons such as high income workers receiving larger wage
raises than low income workers. If this happens, although low income individuals will be better off in
absolute terms, the wider income gap will make them worse off in relative terms which will lead to a
fall in their non-material standards of living.

Fourth, an increase in national output and hence production of goods and services may lead to an
increase in the amount of negative externalities such as carbon emissions which will result in a more
polluted environment and hence a fall in the non-material standard of living.
Fifth, an increase in national output and hence the demand for labour in the economy may result in
people working longer hours which will cause them to have a smaller amount of leisure time and
hence experience a fall in their non-material standards of living.

Contrary to what is discussed above, an increase in national output could mean a larger increase in the
standard of living. First, the quality of goods and services produced may have improved. Second, the
variety of goods and services produced may have increased.

International Comparison (Comparison Across Space)

If the national output of economy A is higher than that of economy B, the standard of living in
economy A may not be higher because the amount of goods and services available for consumption
may not be larger due to several reasons.

First, the amount of goods and services available for consumption in economy A may not be larger
than that in economy B because the amount of non-marketed goods and services in economy A may
be smaller. The value of non-marketed goods and services is not included in national output. For
example, when a baker bakes a pie, the value of the pie is included in national output. However, when
a housewife bakes a pie, it is not. The omission of the value of non-marketed goods and services from
national output understates the material standard of living as measured by national output.

Second, the amount of goods and services available for consumption in economy A may not be larger
than that in economy B because the amount of undeclared goods and services in the underground
economy in economy A may be smaller. The value of undeclared goods and services in the
underground economy is not included in national output. These goods and services are not declared
because they may be illegal, such as drugs and prostitution, or for the purpose of tax evasion. For
example, people smuggle tobacco and alcohol to evade tax. The omission of the value of undeclared
goods and services in the underground economy from national output understates the material standard
of living as measured by national output.

Even if the amount of goods and services available for consumption in economy A is larger than that
in economy B, the standard of living in economy A may not be higher due to several reasons.

First, the amount of goods and services available to domestic households for consumption in economy
A may not be larger than that in economy B because the higher national output in economy A may be
due to higher exports. This is particularly true if economy A is more dependent on external demand
compared to economy B. If this happens, the larger amount of goods and services produced in
economy A could mean a larger amount of goods and services available to foreign rather than
domestic households for consumption relative to economy B. Similarly, if the higher national output
of economy A is due to a larger amount of capital goods produced rather than a larger amount of
consumer goods and services produced relative to economy B, the material standard of living in
economy A may not be higher.

Second, the amount of goods and services available to the average person for consumption in economy
A may not be larger than that in economy B because the population of economy A may be larger.

Third, the distribution of income in economy A may be less equitable than that in economy B. If this
happens, the incomes of low income individuals in economy A may be lower than those of low
income individuals in economy B which could mean a lower material standard of living in economy
A.

Fourth, the amount of negative externalities such as carbon emissions which is produced in economy
A may be larger than that is produced in economy B resulting in a more polluted environment in
economy A and hence a lower non-material standard of living.
Fifth, the people in economy A may be working longer hours than those in economy B which means
that the people in economy A may have a smaller amount of leisure time and hence a lower non-
material standard of living.

Contrary to what is discussed above, a higher national output in economy A than in economy B could
mean an even higher standard of living in economy A. First, the quality of goods and services
produced in economy A may be higher than that in economy B. Second, the variety of goods and
services produced in economy A may be greater than that in economy B.

Purchasing Power Parity

One problem with the use of national income to compare the standards of living in different economies
is that the national income of an economy is measured in the local currency. In theory, this problem
can be overcome by converting the national income of each economy in the local currency to a
common currency such as the U.S. dollar using the market exchange rate. However, using the market
exchange rate as a conversion factor will not take into account the differences in the costs of living in
different economies. Although the World Bank does convert the national incomes of different
economies in their local currencies to the U.S. dollar using the market exchange rate, the purpose is to
compare the sizes of the economies rather than the standards of living.

The World Bank, however, also convert the national incomes of different economies in their local
currencies to the U.S. dollar using the purchasing power parity (PPP) exchange rate with the purpose
of comparing the standards of living. The purchasing power parity (PPP) exchange rate is the
exchange rate which allows the amount of money that is required to purchase a basket of goods and
services in one economy to purchase the same basket of goods and services in another economy after
exchanging it into the currency of the other economy. Suppose that S$200 is required to purchase a
basket of goods and services in Singapore. Further suppose that US$100 is required to purchase the
same basket of goods and services in the United States. In this case, the purchasing power parity (PPP)
exchange rate of the U.S. dollar against the Singapore dollar will be S$2/US$1. As the purchasing
power parity (PPP) exchange rate takes into account the differences in the costs of living in different
economies, it is a better conversion factor for the purpose of comparing the standards of living in
different economies. Needless to say, we should also take into account the differences in the sizes of
the population and a host of other factors.

Note: In addition to the factors that have been discussed in this section, in reality, the standard of
living is affected by many other factors which include housing conditions, sanitary conditions, literary
rate, life expectancy, etc.

Gini coefficient is a measure of inequality of income distribution. It has a value between 0 and 1,
where 0 corresponds to perfect equality (i.e. everyone has the same income) and 1 corresponds to
perfect inequality (i.e. one person has all the income and everyone else has zero income). Therefore, a
higher Gini coefficient indicates a wider income gap.

6 ALTERNATIVE MEASURES OF THE STANDARD OF LIVING

Due to the limitations of the use of national income as a measure of the standard of living, many
economists have turned to alternative measures for this purpose. Among them, the Measurable
Economic Welfare and the Human Development Index are the commonly used.

Measurable Economic Welfare (MEW)

Measurable Economic Welfare is a measure of the standard of living which is obtained by adding to
national income factors which increase the standard of living such as leisure hours and subtracting
factors which reduce the standard of living such as negative externalities. It is a better measure of the
standard of living than national income as it takes into consideration a larger number of factors which
affect the standard of living. A higher Measurable Economic Welfare indicates a higher standard of
living and vice versa. Measurable Economic Welfare was developed in 1972 by two American
economists, William Nordhaus and James Tobin, which they called it the Net Economic Welfare.

Human Development Index (HDI)

The Human Development Index is a composite index made up of three indices: an index for real Gross
Domestic Product per capita in purchasing power parity dollars (PPP$), an index for life expectancy
and an index for adult literacy and average years of schooling. Although it was developed as a
measure of economic development, it is commonly used as a measure of the standard of living. It is a
better measure of the standard of living than national income as it takes into consideration a larger
number of factors which affect the standard of living. A higher Human Development Index indicates a
higher standard of living and vice versa. The Human Development Index was developed in 1990 by
Pakistani economist Mahbub ul Haq and Indian economist Amartya Sen. It has been published by
United Nations since 1990.

Limitations

Although Measurable Economic Welfare and Human Development Index are better measures of the
standard of living than national income, they are subject to several limitations. For example, it is
difficult to measure the values of non-marketed ‘goods’ such as leisure hours and the values of non-
marketed ‘bads’ such as negative externalities to obtain the Measurable Economic Welfare. Although
Human Development Index takes into consideration a larger number of factors which affect the
standard of living than national income, it omits several important factors such as housing conditions
and the level of pollution.

NATIONAL OUTPUT/NATIONAL INCOME DETERMINATION

1 INTRODUCTION

In Chapter 8, we learnt that national output/national income is an important economic variable which
is used for several purposes such as measuring the size of an economy and the standard of living.

2 Aggregate Expenditure

Aggregate expenditure is the planned total expenditure on the goods and services produced in the
economy over a period of time and is comprised of consumption expenditure, planned investment
expenditure, government expenditure on goods and services and net exports. The aggregate
expenditure function shows aggregate expenditure at each national output/national income. The
aggregate expenditure function can be expressed as

AE = C + I + G + (X – M)

where AE = aggregate expenditure, C = consumption expenditure, I = planned investment

expenditure, G = government expenditure on goods and services, X – M = net exports, X = exports
and M = imports.

As expenditure on goods and services constitutes demand, aggregate expenditure is the same as
aggregate demand but with one difference. Although aggregate expenditure refers to the PLANNED
total expenditure on the goods and services produced in the economy, aggregate demand refers to the
ACTUAL total demand for the goods and services produced in the economy. This difference occurs
due to the potential difference between actual investment expenditure and planned investment
expenditure. It is also important to note that aggregate expenditure refers to the planned total
expenditure on domestic goods and services and does not include imports as imports are foreign goods
and services which are produced in other economies. However, the components of aggregate
expenditure which are consumption expenditure, planned investment expenditure, government
expenditure on goods and services and exports include imports. Therefore, imports are subtracted from
consumption expenditure, planned investment expenditure, government expenditure on goods and
services and exports to derive aggregate expenditure. Similarly, imports are subtracted from
consumption expenditure, investment expenditure, government expenditure on goods and services and
exports to derive aggregate demand.

In the above diagram, which is known as the Keynesian cross model or the 45-degree line model, the
aggregate expenditure function (AE) is upward sloping as aggregate expenditure increases with
national output/national income. The equilibrium national output/national income where aggregate
expenditure (AE) is equal to national output/national income (Y) is Y 0. Aggregate expenditure and the
equilibrium national output/national income will be explained in greater detail in the following
sections.

2.1.1 Consumption Expenditure

Consumption expenditure is the expenditure made by households on goods and services. The
consumption function shows the consumption expenditure of households at each disposable income.
The Keynesian consumption function can be expressed as

C = a + bYd

where C = consumption, a = autonomous consumption, bY d = induced consumption, b = marginal

propensity to consume out of disposable income and Yd = disposable income.

From the above equation, it can be seen that consumption is comprised of two components:
autonomous consumption and induced consumption. Autonomous consumption refers to consumption
that is independent of disposable income and is determined by consumer sentiment, the wealth of
households, interest rates, expectations of price changes, the availability of credit and the distribution
of income. Autonomous consumption is positive (a > 0). Induced consumption refers to consumption
that is dependent on disposable income. According to Keynes, consumption will increase with an
increase in disposable income (b > 0) but the increase in consumption will be less than the increase in
disposable income (b < 1).

In the above diagram, the consumption function (C) is upward sloping as consumption expenditure
increases with disposable income. The slope of the consumption function is (b) which is known as the
marginal propensity to consume out of disposable income (MPC Yd). The marginal propensity to
consume out of disposable income is the proportion of an increase in disposable income that is spent
on consumption (ΔC/ΔYd).

Savings are the excess of disposable income over consumption expenditure. The savings function
shows the savings of households at each disposable income. The Keynesian savings function can be
expressed as

S = -a + (1 – b)Yd

where S = savings, -a = autonomous savings, (1 – b)Y d = induced savings, (1 – b) = marginal

propensity to save out of disposable income and Yd = disposable income.
From the above equation, it can be seen that savings are comprised of two components: autonomous
savings and induced savings. Autonomous savings refer to savings that are independent of disposable
income and are determined by consumer sentiment, the wealth of households, interest rates,
expectations of price changes, the availability of credit and the distribution of income. Autonomous
savings are negative (a > 0). Induced savings refer to savings that are dependent on disposable income.
According to Keynes, savings will increase with an increase in disposable income [(1 – b) > 0] but the
increase in savings will be less than the increase in disposable income [(1 – b) < 1].

In the above diagram, the savings function (S) is upward sloping as savings increase with disposable
income. The slope of the savings function is (1 – b) which is known as the marginal propensity to save
out of disposable income (MPSYd). The marginal propensity to save out of disposable income is the
proportion of an increase in disposable income that is saved (ΔS/ΔYd).

As any additional amount of disposable income will either be spent or saved, the sum of the marginal
propensity to consume out of disposable income and the marginal propensity to save out of disposable
income is equal to one (MPC Yd + MPSYd = 1). The average propensity to consume out of disposable
income (APCYd) is the proportion of disposable income that is spent on consumption (C/Y d). The
average propensity to save out of disposable income (APS Yd) is the proportion of disposable income
that is saved (S/Yd). As any amount of disposable income will either be spent or saved, the sum of the
average propensity to consume out of disposable income and the average propensity to save out of
disposable income is equal to one (APCYd + APSYd = 1).

Apart from disposable income, the marginal propensity to consume and the marginal propensity to
save can also be defined in terms of national income. The marginal propensity to consume out of
national income (MPC) is the proportion of an increase in national income that is spent on
consumption (ΔC/ΔY). The marginal propensity to save out of national income (MPS) is the
proportion of an increase in national income that is saved (ΔS/ΔY). The marginal propensity to tax
(MPT) is the proportion of an increase in national income that is taxed (ΔT/ΔY). As any additional
amount of national income will either be spent, saved or taxed, the sum of the marginal propensity to
consume out of national income, the marginal propensity to save out of national income and the
marginal propensity to tax is equal to one (MPC + MPS + MPT = 1). Similarly, the average propensity
to consume and the average propensity to save can also be defined in terms of national income. The
average propensity to consume out of national income (APC) is the proportion of national income that
is spent on consumption (C/Y). The average propensity to save out of national income is the
proportion of national income that is saved (S/Y). The average propensity to tax is the proportion of
national income that is taxed (T/Y). As any amount of national income will either be spent, saved or
taxed, the sum of the average propensity to consume out of national income, the average propensity to
save out of national income and the average propensity to tax is equal to one (APC + APS + APT = 1).

Determinants of Induced Consumption

Induced consumption is positively related to disposable income. In other words, an increase in

disposable income will lead to an increase in induced consumption and vice versa. An increase in
induced consumption can be shown by an upward movement along the consumption function.

Determinants of Autonomous Consumption

Autonomous consumption is determined by consumer sentiment, the wealth of households, interest

rates, expectations of price changes, the availability of credit and the distribution of income. An
increase in autonomous consumption can be shown by a vertical upward shift in the consumption
function.
When households are more optimistic about the economic outlook, they will expect their income to
rise and hence increase consumption expenditure. Households hold their wealth mainly in the form of
bank savings, properties and financial assets such as stocks and bonds. When the wealth of households
increases due to an increase in bank savings, property prices or the values of financial assets,
consumption expenditure will increase. A fall in interest rates will decrease the incentive to save and
the costs of borrowing and this will induce households to increase consumption expenditure. When
households expect prices to rise, they will bring forward the purchases of some durable goods which
will lead to an increase in consumption expenditure. Many consumer durables are purchased on credit
and hence an increase in the availability of credit will allow households to increase consumption
expenditure. Lower income groups have a higher marginal propensity to consume than higher income
groups and hence a redistribution of income from higher income groups to lower income groups will
lead to an increase in consumption expenditure.

Note: In the Keynesian theory, the marginal propensity to consume is assumed to be constant. In
reality, the marginal propensity to consume falls when income rises. This means that higher income
individuals have a lower marginal propensity to consume than lower income individuals.

Large economies are generally more dependent on consumption expenditure than on exports. For
example, consumption expenditure accounts for the largest proportion of aggregate
expenditure/aggregate demand in the United States. In contrast, small economies are generally more
dependent on exports than on consumption expenditure. For example, exports account for the largest
proportion of aggregate expenditure/aggregate demand in Singapore.

3.1.2 Planned Investment Expenditure

Investment expenditure is the expenditure made by firms on goods produced not for their present use
but for their use in the future.

In economics, investment is comprised of business fixed investment (i.e. new factories and
machinery), residential investment (i.e. new houses, apartments and condominiums) and inventory
investment (i.e. the change in the value of unsold goods). There are two types of investment:
autonomous investment and induced investment.

Autonomous Investment

Autonomous investment refers to investment that is independent of national income and is determined
by interest rates, business sentiment, business costs, capital costs, corporate income tax, technological
advancements and the availability of credit. According to the marginal efficiency of investment
theory, originally known as the marginal efficiency of capital theory developed by John Maynard
Keynes, the marginal efficiency of investment function is the investment function. The investment
function shows the investment expenditure of firms at each interest rate. The marginal efficiency of a
type of capital is the discount rate which equates the cost of the type of capital to the present value of
its stream of expected returns. The marginal efficiency of investment is the summation of the marginal
efficiencies of all types of capital in the economy.

Consider a type of capital which will generate returns for three years.

Returns (Year 1) Returns (Year 2) Returns (Year 3)

Cost = ———————— + ———————— + ————————

(1 + r*) (1 + r*)2 (1 + r*)3

With some financial and mathematical knowledge, one can see that the marginal efficiency of a type
of capital is the internal rate of returns. The money that is invested in a type of capital can be loaned
out if it is not invested in the type of capital and hence the interest rate is the external rate of returns.
Therefore, a firm should invest in a unit of a type of capital if the marginal efficiency (i.e. internal rate
of returns) is higher than the interest rate (i.e. external rate of returns). Conversely, a firm should not
invest in a unit of a type of capital if the marginal efficiency is lower than the interest rate. It follows
that a firm should invest in a type of capital up to the unit where the marginal efficiency is equal to the
interest rate.

As the marginal efficiency of investment is the summation of the marginal efficiencies of all types of
capital in the economy, the marginal efficiency of investment function is also downward sloping.

Determinants of Autonomous Investment

A fall in interest rates which will decrease the costs of borrowing will lead to more profitable planned
investments resulting in an increase in investment expenditure and vice versa. An increase in
investment expenditure due to a fall in interest rates can be shown by a downward movement along
the marginal efficiency of investment function.

In addition to a fall in interest rates, the number of profitable planned investments and hence
investment expenditure will increase when expected returns on planned investments increase due to an
increase in business sentiment, lower business costs such as decreases in oil prices and wages or lower
capital costs such as decreases in the costs of factories and machinery. Furthermore, a decrease in
corporate income tax which will increase expected after-tax returns on planned investments,
technological advancements and an increase in the availability of credit will also lead to an increase in
investment expenditure. An increase in investment expenditure due to a non-interest rate factor can be
shown by rightward shift in the marginal efficiency of investment function.

3.1.3 Government Expenditure on Goods and Services

Government expenditure on goods and services is the expenditure on goods and services made by the
government.

Government expenditure consists of two main components: government expenditure on goods and
services and government expenditure on transfer payments. Although government expenditure on
goods and services is a component of aggregate expenditure, government expenditure on transfer
payments is not. Nevertheless, government expenditure on transfer payments does affect aggregate
expenditure through its effect on disposable income and hence consumption expenditure. Government
expenditure on goods and services is largely determined by the objective of the government. For
example, the government may increase expenditure on infrastructure to attract foreign direct
investments. In a recession, the government may increase expenditure on goods and services to
increase economic growth and hence decrease unemployment. When the economy is overheating
where aggregate demand is rising rapidly relative to aggregate supply resulting in high inflationary
pressures, the government may decrease expenditure on goods and services to reduce inflation.

3.1.4 Net Exports

Exports are the expenditure made by foreigners on domestic goods and services. Imports are the
expenditure made by domestic residents on foreign goods and services. Net exports refer to exports
minus imports.

Determinants of Net Exports

Income
An increase in foreign income will lead to a rise in exports. The converse is also true. An increase in
domestic income will lead to a rise in imports. The converse is also true.

Domestic Inflation Relative to Foreign Inflation

When domestic inflation is lower than foreign inflation, domestic goods and services will become
relatively cheaper than foreign goods and services. When this happens, exports will rise and imports
will fall. The converse is also true.

Exchange Rate

When domestic currency depreciates, domestic goods and services will become relatively cheaper than
foreign goods and services. When this happens, exports will rise and imports will fall. The converse is
also true.

Other Factors

Exports and imports are also affected by factors such as comparative advantage, trade policy, quality
of goods and services, tastes and preferences, etc.

Although exports are affected by foreign income, they are autonomous which means that they are
independent of domestic income. Imports, in contrast, consist of an autonomous component that is
independent of national income and an induced component that is dependent on national income.
According to Keynes, imports will increase with an increase in national income. Therefore, the net
exports function can be expressed as

X – M = X – (m0 + m1Y) = X – m0 – m1Y

where X – M = net exports, X = exports, M = imports, m 0 = autonomous imports, m1Y = induced

imports, m1 = marginal propensity to import (MPM) and Y = national income.

3.2 The Circular Flow of Income and Expenditure

The circular flow of income and expenditure shows the flow of income and expenditure between the
different sectors in the economy.

In the above diagram, households provide factors of production which include labour, land, capital and
enterprise to firms and in return, they receive factor income (Y) in the form of wages, rent, interest and
profits. Firms provide goods and services to households and in return, they receive payments known as
consumption expenditure on domestic goods and services (C D). However, not all the factor income
received by households return to domestic firms as revenue. Rather, some of it goes to the government
in the form of taxes (T), some of it goes to the financial sector in the form of savings (S) and some of
it goes to the foreign sector in the form of imports (M). Taxes, savings and imports are known as
withdrawals. Withdrawals are the factor income received by households that does not return to
domestic firms as revenue. Furthermore, some of the payments received by domestic firms do not
come from households. Rather, they come from the government in the form of government
expenditure on goods and services (G), the financial sector in the form of loans to finance investment
expenditure (I) and the foreign sector in the form of exports (X). Government expenditure on goods
and services, investment expenditure and exports are known as injections. Injections are the payments
received by domestic firms that do not come from households. Equilibrium is established when
injections are equal to withdrawals. This will be explained in greater detail in Section 3.3.
Note: The circular flow model which is presented above assumes that households do not receive
transfer payments from the government. In reality, households do receive transfer payments from the
government. As taxes flow from households to the government and transfer payments flow from the
government to households, we can incorporate transfer payments into the circular flow model by
subtracting them from taxes to derive net taxes.

3.3 Equilibrium National Output/National Income

The equilibrium national output/ national income is the national output/national income that has no
tendency to change and it can be determined in three ways: the expenditure-output/expenditure-
income approach, the injections-withdrawals approach and the aggregate demand-aggregate supply
approach.

Expenditure-Output/Expenditure-Income Approach

According to the expenditure-output/expenditure-income approach, the equilibrium national

output/national income is the national output/national income where aggregate expenditure is equal to
national output/national income. Recall that aggregate expenditure is the planned total expenditure on
the goods and services produced in the economy over a period of time and is comprised of
consumption expenditure, planned investment expenditure, government expenditure on goods and
services and net exports.

In the above diagram, the equilibrium national output/national income where aggregate expenditure
(AE) is equal to national output/national income (Y) is Y 0. At a national output/national income higher
than Y0, such as Y1, aggregate expenditure is less than national output/national income. When this
happens, the output produced by firms will be more than sufficient to meet the planned total
expenditure on the goods and services produced in the economy and this will result in a surplus of
goods. A surplus of goods in the economy will cause firms to experience an unplanned increase in
their inventories and hence unplanned inventory investment as they add the surplus to their
inventories. This will induce firms to decrease their inventories to achieve the desired or planned
levels. To bring their inventories down to the planned levels, firms will decrease production which
will lead to a decrease in national output. When firms decrease production, they will employ less
factor inputs from households and hence will pay them less factor income which will lead to a
decrease in national income. At a national output/national income lower than Y 0, such as Y2, aggregate
expenditure is greater than national output/national income. When this happens, the output produced
by firms will be less than sufficient to meet the planned total expenditure on the goods and services
produced in the economy and this will result in a shortage of goods. A shortage of goods in the
economy will cause firms to experience an unplanned decrease in their inventories and hence
unplanned inventory disinvestment as they draw on their inventories to meet the shortage. This will
induce firms to increase their inventories to achieve the desired or planned levels. To bring their
inventories up to the planned levels, firms will increase production which will lead to an increase in
national output. When firms increase production, they will employ more factor inputs from households
and hence will pay them more factor income which will lead to an increase in national income. At Y 0
where aggregate expenditure is equal to national output/national income, the output produced by firms
will be equal to the planned total expenditure on the goods and services produced in the economy
which will not result in any surplus or shortage of goods. Therefore, firms will not experience any
unplanned changes in their inventories and hence will not have any incentive to change output. When
this happens, national output and hence national income will have no tendency to change.

Injections-Withdrawals Approach

According to the injections-withdrawals approach, the equilibrium national output/national income is

the national output/national income where injections are equal to withdrawals. Recall that injections
are the payments received by domestic firms that do not come from households and comprise
government expenditure on goods and services, investment expenditure and exports, and withdrawals
are the factor income received by households that does not return to domestic firms as revenue and
comprise taxes, savings and imports.

In the above diagram, the equilibrium national output/national income where injections (J) are equal to
withdrawals (W) is Y0. At a national output/national income higher than Y 0, such as Y1, injections are
less than withdrawals. When injections are less than withdrawals, aggregate demand will fall which
will induce firms to decrease production resulting in a decrease in national output. When firms
decrease production, they will employ less factor inputs from households and hence will pay them less
factor income which will lead to a decrease in national income. When households’ income falls, they
will decrease consumption expenditure on domestic goods and services which will lead to a further
decrease in aggregate demand and this will induce firms to further decrease production. When this
happens, firms will employ even less factor inputs from households and hence will pay them even less
factor income. The further decrease in households’ income will induce them to further decrease
consumption expenditure on domestic goods and services resulting in a further decrease in aggregate
demand. However, each time households’ income falls, they will pay less taxes, decrease savings and
buy less imports. In other words, withdrawals will decrease when households’ income falls. When
withdrawals fall to the level of injections, equilibrium will be established and national output and
hence national income will stop falling. At a national output/national income lower than Y 0, such as
Y2, injections are greater than withdrawals. When injections are greater than withdrawals, aggregate
demand will rise which will induce firms to increase production resulting in an increase in national
output. When firms increase production, they will employ more factor inputs from households and
hence will pay them more factor income which will lead to an increase in national income. When
households’ income rises, they will increase consumption expenditure on domestic goods and services
which will lead to a further increase in aggregate demand and this will induce firms to further increase
production. When this happens, firms will employ even more factor inputs from households and hence
will pay them even more factor income. The further increase in households’ income will induce them
to further increase consumption expenditure on domestic goods and services resulting in a further
increase in aggregate demand. However, each time households’ income rises, they will pay more
taxes, increase savings and buy more imports. In other words, withdrawals will increase when
households’ income rises. When withdrawals rise to the level of injections, equilibrium will be
established and national output and hence national income will stop rising. At Y 0, injections are equal
to withdrawals. When injections are equal to withdrawals, aggregate demand will remain constant.
Therefore, firms will not have any incentive to change output. When this happens, national output and
hence national income will have no tendency to change.

Aggregate Demand-Aggregate Supply Approach

According to the aggregate demand-aggregate supply approach, the equilibrium national

output/national income is the national output/national income where aggregate demand is equal to
aggregate supply. Recall that aggregate demand is the total demand for the goods and services
produced in the economy over a period of time and is comprised of consumption expenditure,
investment expenditure, government expenditure on goods and services and net exports, and aggregate
supply is the total supply of goods and services in the economy over a period of time and is
determined by the production capacity and the cost of production in the economy

In the above diagram, the equilibrium general price level and the equilibrium national output/national
income where aggregate demand (AD) is equal to aggregate supply (AS) are P 0 and Y0. At a general
price level higher than P0, aggregate demand is less than aggregate supply. When this happens, the
output produced by firms will be more than sufficient to meet the total demand for the goods and
services produced in the economy and this will result in a surplus of goods. A surplus of goods in the
economy will induce firms to lower prices to reduce their stocks which will lead to a fall in the general
price level. When the general price level falls, firms will decrease production which will lead to a
decrease in national output. When firms decrease production, they will employ less factor inputs from
households and hence will pay them less factor income which will lead to a decrease in national
income. In addition to a decrease in aggregate supply, a fall in the general price level will lead to an
increase in aggregate demand through the substitution effect, the interest rate effect and the wealth
effect. The general price level will continue falling until aggregate demand is equal to aggregate
supply at Y0, at which point the surplus is eliminated and an equilibrium is established. At a general
price level lower than P0, aggregate demand is greater than aggregate supply. When this happens, the
output produced by firms will be less than sufficient to meet the total demand for the goods and
services produced in the economy and this will result in a shortage of goods. A shortage of goods in
the economy will induce firms to raise prices to increase their profits which will lead to a rise in the
general price level. When the general price level rises, firms will increase production which will lead
to an increase in national output. When firms increase production, they will employ more factor inputs
from households and hence will pay them more factor income which will lead to an increase in
national income. In addition to an increase in aggregate supply, a rise in the general price level will
lead to a decrease in aggregate demand through the substitution effect, the interest rate effect and the
wealth effect. The general price level will continue rising until aggregate demand is equal to aggregate
supply at Y0, at which point the shortage is eliminated and an equilibrium is established. At P 0 where
aggregate demand is equal to aggregate supply at Y 0, the output produced by firms will be equal to the
total demand for the goods and services produced in the economy which will not result in any surplus
or shortage of goods. Therefore, firms will not have any incentive to change output. When this
happens, national output and hence national income will have no tendency to change.

3.4 The Multiplier Effect and the Multiplier

The multiplier effect is the effect of an increase in autonomous expenditure resulting in a larger
increase in national output and hence national income. An increase in autonomous expenditure will
lead to an increase in aggregate expenditure and hence aggregate demand which will induce firms to
increase production resulting in an increase in national output. When firms increase production, they
will employ more factor inputs from households and hence will pay them more factor income which
will lead to an increase in national income.

In the above diagram, an increase in aggregate expenditure (AE) from AE 0 to AE1 leads to an increase
in national output and hence national income (Y) from Y 0 to Y1. Suppose that the marginal propensity
to consume domestic goods and services (MPCD) is 0.8, the marginal propensity to withdraw (MPW)
is 0.2 and the increase in autonomous expenditure (ΔAE) is $1000. When firms increase production by
$1000 in response to an increase in aggregate demand due to an increase in aggregate expenditure as a
result of an increase in autonomous expenditure of $1000, they will employ more factor inputs from
households and hence will pay them more factor income. When households’ income rises by $1000,
they will increase consumption expenditure on domestic goods and services by $800 (0.8 × $1000)
which will lead to a further increase in aggregate demand and this will induce firms to further increase
production by $800. When this happens, firms will employ even more factor inputs from households
and hence will pay them even more factor income. The further increase in households’ income of $800
will induce them to further increase consumption expenditure on domestic goods and services by $640
(0.8 × $800) resulting in a further increase in aggregate demand. Therefore, the initial increase in
aggregate demand due to the increase in aggregate expenditure as a result of the increase in
autonomous expenditure will lead to increases in consumption expenditure and hence further increases
in aggregate demand resulting in a larger increase in national output and hence national income. This
is commonly known as the multiplier effect. However, each time households’ income rises, they will
pay more taxes, increase savings and buy more imports. In other words, withdrawals will increase
when households’ income rises. When withdrawals rise by $1000, which is equal to the increase in
autonomous expenditure, injections will once again be equal to withdrawals. When this happens,
equilibrium will be restored and national output and hence national income will stop rising.

Round ΔY ΔCD ΔW
1 $1000 $800 $200
2 $800 $640 $160
3 $640 ‘ ‘
‘ ‘ ‘ ‘
‘ ‘ ‘ ‘
Sum $5000 $4000 $1000

In the above table, ΔY = $1000 + $800 + $640 + ……….

Therefore, ΔY = $1000 + (0.8)($1000) + (0.8)2($1000) + ……….

Applying geometric progression, ΔY = $1000/(1 – 0.8) = $5000 > (ΔAE = $1000).

More generally, ΔY = ΔAE/(1 – MPCD).

Therefore, ΔY/ΔAE = 1/(1 – MPCD).

Since MPS + MPT + MPM + MPCD = 1, ΔY/ΔAE = 1/MPW.

ΔY 1 1

Multiplier = ——– = —————- = —————

ΔAE 1 – MPCD MPW

In the above analysis, a $1000 increase in aggregate expenditure will lead to a $5000 increase in real
national output and hence real national income. The implicit assumption is that the increase in
aggregate expenditure will not lead to a rise in the general price level. However, recall that using
empirical evidence, economists have found out that an increase in aggregate expenditure and hence
aggregate demand always leads to a rise in the general price level which proves that the horizontal
portion of the Keynesian aggregate supply curve does not exist in reality. Therefore, when aggregate
expenditure rises, real national output and hence real national income will not rise by the full
multiplier effect as the general price level will rise.

The multiplier is the number of times by which national output and hence national income rises due to
an increase in autonomous expenditure. The multiplier is the inverse of the marginal propensity to
withdraw which is the sum of the marginal propensity to save, the marginal propensity to tax and the
marginal propensity to import. The marginal propensities to save, tax and import are the proportions of
an increase in national income that are saved, taxed and spent on imports. Therefore, the multiplier
will be larger the lower the savings, the lower the income taxes and the lower the imports.
CHAPTER 9: INTEREST RATE AND EXHANGE RATE

1 INTRODUCTION

Interest rate and exchange rate are two economic variables which influence a large number of other
economic variables such as national output and hence national income, unemployment, inflation and
the balance of payments. In some economies such as the United States, the central bank chooses to
control interest rates to manage the economy. However, in some economies such as Singapore, the
central bank chooses to control exchange rates to manage the economy. The difference in the choice of
policy instrument to manage the economy is largely due to the difference in the sizes and hence the
composition of the economies. Therefore, it is important to have a good understanding of interest rate
and exchange rate before proceeding further. This chapter provides an exposition of interest rate and
exchange rate.

2 INTEREST RATE

2.1 The Money Market

Interest rate is the cost of borrowing and the reward for lending. Interest rates are determined in two
markets: the money market and the loanable funds market.

Interest rates are determined in the money market. The demand for money is the amount of money that
people are able and willing to obtain at each interest rate over a period of time, ceteris paribus. The
supply of money is the amount of money that the central bank is able and willing to provide at each
interest rate over a period of time, ceteris paribus.

In the above diagram, given the demand for money (D M) and the supply of money (S M), the interest
rate is r0.

The Demand for Money

The demand for money consists of three components: the transactions demand for money, the
precautionary demand for money and the speculative demand for money. The transactions demand for
money is the amount of money people demand to carry out normal day-to-day transactions owing to
the time lag between the receipt of factor incomes and the payment of expenditure outlays. The
precautionary demand for money is the amount of money people demand over and above their
expected transactions needs owing to the existence of uncertainty. Some expenditure outlays such as
medical bills are unpredictable and rational people will therefore demand an amount of money over
and above their expected transactions needs to deal with such contingencies. The transactions demand
for money and the precautionary demand for money depend directly on the level of national income.
The speculative demand for money is the amount of money people demand for speculative financial
transactions if market conditions appear favourable. The speculative demand for money is inversely
related to the interest rate.

The Supply of Money

There are two approaches to measuring the supply of money: the institutions-based approach and the
monetary characteristics of instruments approach. By the institutions-based approach, only monetary
liabilities of selected deposit-taking institutions make up the money supply. By the monetary
characteristics of instruments approach, instruments that exhibit money-like characteristics are
included in the money supply. The institutions that issue the instruments are not the defining
characteristics of the money supply by this approach. In Singapore, the institutions-based approach is
adopted.

Institutions-based Approach

Narrow money, also known as M1, measures the immediate purchasing power of money in the
economy. This definition of money looks at money primarily as a medium of exchange and consists of
currency in active circulation and demand deposits with banks. Currency in circulation refers to
currency held by the public, at the central bank and in banks’ vaults. Currency in active circulation
refers to currency held by the public and excludes currency held at the central bank and in banks’
vaults.

M1 = Currency in Active Circulation + Demand Deposits with Banks

Quasi-money, also known as near money, refers to highly liquid assets that can easily be converted
into cash. It includes savings deposits, fixed deposits and negotiable certificates of deposit. Quasi-
money does not serve as a medium of exchange and hence is not included in M1. Adding quasi-money
with banks to M1 yields M2.

M2 = M1 + Quasi-money with Banks

Broad money, also known as M3, measures the potential purchasing power of money in the economy.
This definition of money looks at money primarily as a store of value and consists of M2 and net
deposits with non-bank financial institutions. Net deposits with non-bank financial institutions refer to
deposits with non-bank financial institutions minus these institutions’ deposits with banks.

M3 = M2 + Net Deposits with Non-bank Financial Institutions

When economists talk about the money supply, they are referring to broad money (M3). The measure
of broad money (M3) explained above may seem complicated to some. In essence, the money supply
which refers to broad money (M3), consists of currency in active circulation and deposits. As the
money supply is determined by the central bank based on economic conditions, it is perfectly interest
inelastic which gives rise to a vertical supply curve.

Application of the Determination of Interest Rates in the Money Market

To increase economic growth or decrease unemployment, the central bank can increase the money
supply by conducting an open market purchase. When the money supply increases, the amount of
reserves in the banking system will rise. When this happens, interbank rates will fall which will lead to
a fall in the level of interest rates in the economy. For example, the Federal Reserve increased the
money supply to lower the federal funds rate from 5.25 per cent in September 2007 to 0-0.25 per cent
in December 2008 to boost the faltering U.S. economy. Lower interest rates will decrease the incentive
to save and the costs of borrowing and this will lead to an increase in consumption expenditure.
Furthermore, a decrease in the costs of borrowing will lead to more profitable planned investments
resulting in an increase in investment expenditure. An increase in consumption expenditure and
investment expenditure will lead to an increase in aggregate demand which will induce firms to
increase production resulting in an increase in national output. When firms increase production, they
will employ more factor inputs from households and hence will pay them more factor income which
will lead to an increase in national income. An increase in national output will lead to a rise in the
demand for labour in the economy resulting in a fall in unemployment.

2.2 The Loanable Funds Market

Interest rates are determined in the loanable funds market. The demand for loanable funds is the
amount of loans that people are able and willing to obtain at each interest rate over a period of time,
ceteris paribus. The supply of loanable funds is the amount of loans that people are able and willing to
provide at each interest rate over a period of time, ceteris paribus.

In the above diagram, given the demand for loanable funds (D LF) and the supply of loanable funds
(SLF), the interest rate is r0.

The Demand for Loanable Funds

The demand for loanable funds is inversely related to interest rates. The higher the interest rates, the
lower the demand for loanable funds. The demand for loanable funds consists of the borrowings of
households, firms and the government. Households borrow to consume at the expense of higher future
consumption. A rise in interest rates will mean that a larger amount of future consumption will be
forgone for any given amount of borrowings. Therefore, the higher the interest rates, the lower the
demand for loanable funds by households. Firms borrow to invest. A rise in interest rates will lead to
higher costs of borrowing and hence fewer profitable planned investments. Therefore, the higher the
interest rates, the lower the demand for loanable funds by firms. The government borrows to finance a
budget deficit which is done through issuing securities (i.e. bonds and bills). In some economies,
despite a budget surplus, the government borrows to develop the bond market to enable the central
bank to more effectively conduct monetary policy.

The Supply of Loanable Funds

The supply of loanable funds is directly related to interest rates. The higher the interest rates, the
higher the supply of loanable funds. The supply of loanable funds consists of the savings of
households and firms. Households save to increase their future consumption. A rise in interest rates
will mean that a larger amount of future consumption will be made available for any given amount of
savings. Therefore, the higher the interest rates, the higher the supply of loanable funds by households.
Firms save when they retain part of the profits that they make. However, this does not depend so much
on interest rates. Rather, firms make decisions regarding retained profits based on factors such as the
economic outlook and investment opportunities.

3 EXCHANGE RATE

3.1 The Floating/Flexible Exchange Rate System

The exchange rate of a currency is the rate at which the currency can be exchanged for another
currency. It is also defined as the price of the currency in terms of another currency. For example, the
exchange rate of the Singapore dollar against the Malaysian ringgit is about RM2.50/S$ which means
that 2.5 Malaysian ringgits are required to exchange for or purchase 1 Singapore dollar.

Under the floating exchange rate system, or the flexible exchange rate system, the exchange rate of a
currency is determined by the market forces of demand and supply, with no central bank intervention
in the foreign exchange market. The demand for a currency is the quantity of the currency that people
are able and willing to buy at each exchange rate over a period of time, ceteris paribus. The supply of a
currency is the quantity of the currency that people are able and willing to sell at each exchange rate
over a period of time, ceteris paribus. Most of the large economies in the world operate under the
floating exchange rate system. An example is the United States.

Under the floating exchange rate system, an increase in the demand for a currency will lead to a rise in
the exchange rate (i.e. an appreciation of the currency).
In the above diagram, an increase in the demand for a currency (D DC) from DDC0 to DDC1 leads to a rise
in the exchange rate (E) from E0 to E1. The converse is also true.

Under the floating exchange rate system, an increase in the supply of a currency will lead to a fall in
the exchange rate (i.e. a depreciation of the currency).

In the above diagram, an increase in the supply of a currency (S DC) from SDC0 to SDC1 leads to a fall in
the exchange rate (E) from E0 to E1. The converse is also true.

Under the floating exchange rate system, an increase in exports or a decrease in imports will lead to a
rise in the exchange rate and vice versa. An increase in exports will lead to an increase in the demand
for domestic currency which will result in a rise in the exchange rate. A decrease in imports will lead
to a decrease in the supply of domestic currency which will result in a rise in the exchange rate.
Exports may rise and imports may fall due to several reasons. When domestic inflation is lower than
foreign inflation, domestic goods and services will become relatively cheaper than foreign goods and
services. When this happens, exports will rise and imports will fall. For example, inflation in
Singapore is generally lower than that in other economies which has led to an increase in export
competitiveness in Singapore resulting in an increase in exports and a decrease in imports. Exports
may also rise due to an increase in foreign income and imports may also fall due to a decrease in
domestic income. For example, the increase in foreign income has led to an increase in exports in
Singapore over the last few decades.

Under the floating exchange rate system, an increase in hot money inflows or a decrease in hot money
outflows will lead to a rise in the exchange rate and vice versa. An increase in hot money inflows
(HMIs) will lead to an increase in the demand for domestic currency which will result in a rise in the
exchange rate. A decrease in hot money outflows (HMOs) will lead to a decrease in the supply of
domestic currency which will result in a rise in the exchange rate. HMIs may rise and HMOs may fall
due to several reasons. A rise in domestic interest rates or a fall in foreign interest rates will lead to an
increase in HMIs and a decrease in HMOs. For example, when the central bank of Russia raised
interest rates from 10.5 per cent to 17 per cent in December 2014 to defend the weakening ruble which
was under severe downward pressure, HMIs increased and HMOs decreased. HMIs may also rise and
HMOs may also fall due to expectations of an appreciation of domestic currency. For example,
expectations of a rise in interest rates and hence the exchange rate in the United States in June 2015 as
the Federal Reserve planned to end its quantitative easing programme led to an increase in HMIs and a
decrease in HMOs earlier in the year.

Under the floating exchange rate system, an increase in inward foreign direct investments or a
decrease in outward foreign direct investments will lead to a rise in the exchange rate and vice versa.
An increase in inward foreign direct investments (FDIs) will lead to an increase in the demand for
domestic currency which will result in a rise in the exchange rate. A decrease in outward FDIs will
lead to a decrease in the supply of domestic currency which will result in a rise in the exchange rate.
Inward FDIs may rise and outward FDIs may fall due to several reasons. When the government
reduces corporate income tax, expected after-tax returns on planned investments will rise. When this
happens, inward FDIs will rise and outward FDIs will fall. For example, the decrease in the corporate
income tax rate in Singapore from 40 per cent in 1986 to 17 per cent currently has led to an increase in
inward FDIs and a decrease in outward FDIs. Inward FDIs may also rise and outward FDIs may also
fall due to other factors such as an increase in business sentiment. For example, the global economic
recovery in 2010 from the 2008-2009 Global Financial Crisis led to an increase in business sentiment
in Singapore resulting in an increase in inward FDIs.

Advantages of the Floating Exchange Rate System

Automatic Correction of a Balance of Payments Disequilibrium

Under the floating exchange rate system, any balance of payments disequilibrium will be
automatically corrected through an adjustment of the exchange rate. If the balance of payments is in
deficit, which means that money outflows exceed money inflows, the supply of domestic currency will
exceed the demand which will lead to a downward pressure on the exchange rate. Under the floating
exchange rate system, domestic currency will depreciate. When this happens, domestic goods and
services will become relatively cheaper than foreign goods and services which will lead to an increase
in net exports. Assuming the sum of the price elasticities of demand for exports and imports is greater
than one, an increase in net exports will improve the current account and hence correct the balance of
payments deficit. Similarly, if the balance of payments is in surplus, which means that money inflows
exceed money outflows, the demand for domestic currency will exceed the supply which will lead to
an upward pressure on the exchange rate. Under the floating exchange rate system, domestic currency
will appreciate. When this happens, domestic goods and services will become relatively more
expensive than foreign goods and services which will lead to a decrease in net exports. Assuming the
sum of the price elasticities of demand for exports and imports is greater than one, a decrease in net
exports will worsen the current account and hence correct the balance of payments surplus.

No Need to hold a Large Amount of Foreign Exchange Reserves

Under the floating exchange rate system, the central bank does not need to hold a large amount of
foreign exchange reserves as it does not need to intervene in the foreign exchange market. Holding a
large amount of foreign reserves incurs a high opportunity cost as they can be put to productive uses to
develop the economy.

Independent Monetary Policy

The central bank can pursue an independent monetary policy under the floating exchange rate system.
According to the Impossible Trinity or the Open-Economy Trilemma, an economy cannot have
simultaneously a fixed exchange rate, free capital mobility and an independent monetary policy. For
example, if the central bank increases the money supply to lower interest rates, hot money inflows will
decrease and hot money outflows will increase. When this happens, the demand for domestic currency
will fall and the supply will rise which will cause the exchange rate to fall. To bring the exchange rate
back to the initial level, there are two measures that the central bank can use. First, it can reverse the
monetary policy which will render it ineffective. Second, it can intervene in the foreign exchange
market to prevent domestic currency from depreciating by buying domestic currency and selling
foreign currency but this will also cause the money supply to fall back. However, under the floating
exchange rate system, the central bank will not intervene in the foreign exchange market. Therefore,
the money supply will not fall back. The Impossible Trinity will be explained in greater detail in
Chapter 12.

Dampening Effect on Inflation and Unemployment

The floating exchange rate system creates a dampening effect on inflation and unemployment. When
the external economic environment is strong, inflation will rise due to an increase in exports and a rise
in the prices of imports. Under the floating exchange rate system, domestic currency will appreciate
due to an increase in the demand which will decrease export competitiveness and hence reduce the rise
in inflation. Conversely, when the external economic environment is very weak, unemployment will
rise due to a decrease in exports. Under the floating exchange rate system, domestic currency will
depreciate due to a decrease in the demand which will increase export competitiveness and hence
reduce the rise in unemployment.

Disadvantages of the Floating Exchange Rate System

Uncertainty
The floating exchange rate system creates uncertainty for international trade and foreign direct
investment. Under the floating exchange rate system, international trade and foreign direct investment
are more risky as profits are affected by movements in the exchange rate. For example, foreign
investors in the economy may experience a substantial fall in their profit margins due to a substantial
depreciation of domestic currency against their home currencies. Such uncertainty discourages long-
term export and import contractual agreements and long-term foreign direct investments.

Speculation

Speculation is an inherent part of the floating exchange rate system which will further increase
uncertainty and hence further discourage long-term export and import contractual agreements and
long-term foreign direct investments, and this is particularly true if there is a high level of speculative
activity in the foreign exchange market..

3.2 The Fixed Exchange Rate System

Under the fixed exchange rate system, the exchange rate of a currency is fixed whereby the currency is
pegged to another currency at a particular rate, with central bank intervention in the foreign exchange
market. The fixed exchange rate system is or has been used in only a few economies. An example is
China where the yuan was pegged to the U.S. dollar at 8.28 yuan to one U.S. dollar from 1994 to
2005.

Under the floating exchange rate system, an increase in the demand for a currency will lead to a rise in
the exchange rate. However, under the fixed exchange rate system, the central bank will intervene in
the foreign exchange market by selling domestic currency and buying foreign currency to keep the
exchange rate constant.

In the above diagram, an increase in the demand for a currency (D DC) from DDC0 to DDC1 followed by
an increase in the supply (SDC) from SDC0 to SDC1 leaves the exchange rate (E) constant at E0.

Under the floating exchange rate system, an increase in the supply of a currency will lead to a fall in
the exchange rate. However, under the fixed exchange rate system, the central bank will intervene in
the foreign exchange market by buying domestic currency and selling foreign currency to keep the
exchange rate constant.

In the above diagram, an increase in the supply of a currency (S DC) from SDC0 to SDC1 followed by an
increase in the demand (DDC) from DDC0 to DDC1 leaves the exchange rate (E) constant at E0.

Advantages of the Fixed Exchange Rate System

Certainty

The fixed exchange rate system creates certainty for international trade and foreign direct investment.
Under the fixed exchange rate system, international trade and foreign direct investment are less risky
as profits are not affected by movements in the exchange rate. For example, foreign investors in the
economy will not experience a substantial fall in their profit margins due to a substantial depreciation
of domestic currency against their home currencies. Such certainty encourages long-term export and
import contractual agreements and long-term foreign direct investments.

No Speculation
Although speculation is an inherent part of the floating exchange rate system which will further
increase uncertainty and hence further discourage long-term export and import contractual agreements
and long-term foreign direct investments, this is not true for the fixed exchange rate system.

Disadvantages of the Fixed Exchange Rate System

No Automatic Correction of a Balance of Payments Disequilibrium

Under the fixed exchange rate system, any balance of payments disequilibrium will not be
automatically corrected through an adjustment of the exchange rate. If the balance of payments is in
deficit, which means that money outflows exceed money inflows, the supply of domestic currency will
exceed the demand which will lead to a downward pressure on the exchange rate. Under the fixed
exchange rate system, the central bank will intervene in the foreign exchange market to eliminate the
downward pressure on the exchange rate. In other words, the central bank will buy domestic currency
and sell foreign currency in the foreign exchange market to prevent domestic currency from
depreciating. Therefore, net exports will not rise and hence the balance of payments will remain in
deficit. Similarly, if the balance of payments is in surplus, which means that money inflows exceed
money outflows, the demand for domestic currency will exceed the supply which will lead to an
upward pressure on the exchange rate. Under the fixed exchange rate system, the central bank will
intervene in the foreign exchange market to eliminate the upward pressure on the exchange rate. In
other words, the central bank will sell domestic currency and buy foreign currency in the foreign
exchange market to prevent domestic currency from appreciating. Therefore, net exports will not fall
and hence the balance of payments will remain in surplus.

Need to hold a Large Amount of Foreign Exchange Reserves

Under the fixed exchange rate system, the central bank needs to hold a large amount of foreign
exchange reserves as it needs to intervene in the foreign exchange market to maintain the fixed
exchange rate. Holding a large amount of foreign reserves incurs a high opportunity cost as they can
be put to productive uses to develop the economy.

No Independent Monetary Policy

The central bank cannot pursue an independent monetary policy under the fixed exchange rate system.
According to the Impossible Trinity or the Open-Economy Trilemma, an economy cannot have
simultaneously a fixed exchange rate, free capital mobility and an independent monetary policy. For
example, if the central bank increases the money supply to lower interest rates, hot money inflows will
decrease and hot money outflows will increase. When this happens, the demand for domestic currency
will fall and the supply will rise which will cause the exchange rate to fall. To bring the exchange rate
back to the initial level, there are two measures that the central bank can use. First, it can reverse the
monetary policy which will render it ineffective. Second, it can intervene in the foreign exchange
market to prevent domestic currency from depreciating by buying domestic currency and selling
foreign currency but this will also cause the money supply to fall back.

No Dampening Effect on Inflation and Unemployment

The fixed exchange rate system does not create a dampening effect on inflation and unemployment.
When the external economic environment is strong, inflation will rise due to an increase in exports and
a rise in the prices of imports. Under the floating exchange rate system, domestic currency will
appreciate due to an increase in the demand which will decrease export competitiveness and hence
reduce the rise in inflation. Conversely, when the external economic environment is very weak,
unemployment will rise due to a decrease in exports. Under the floating exchange rate system,
domestic currency will depreciate due to a decrease in the demand which will increase export
competitiveness and hence reduce the rise in unemployment. However, as the exchange rate does not
change under the fixed exchange rate system, this dampening effect on inflation and unemployment
will not happen.

Note: Under the fixed exchange rate system, the central bank may re-peg domestic currency to
another currency at a different level, depending on the economic conditions. If the central bank re-
pegs domestic currency to another currency at a lower level, a devaluation is said to have occurred. If
the central bank re-pegs domestic currency to another currency at a higher level, a revaluation is said
to have occurred.

Students should not confuse depreciation with devaluation and appreciation with revaluation. A
depreciation of a currency refers to a decrease in the exchange rate under the floating exchange rate
system but a devaluation of a currency refers to a decrease in the exchange rate under the fixed
exchange rate system. Similarly, while an appreciation of a currency refers to an increase in the
exchange rate under the floating exchange rate system, a revaluation of a currency refers to an
increase in the exchange rate under the fixed exchange rate system.

3.3 The Managed Float Exchange Rate System

Under the managed float exchange rate system, the exchange rate of a currency is fixed within a range
whereby the currency is pegged to another currency or a basket of other currencies within a policy
band set by the central bank. As long as the exchange rate of the currency falls within the policy band,
the central bank will not intervene in the foreign exchange market, unless there are wide fluctuations.
Most of the small economies in the world operate under the managed float exchange rate system. An
example is Singapore.

Suppose that the demand for a currency under the managed float exchange system increases. If the
increase is small, although the exchange rate will rise, if it still falls within the policy band, the central
bank will not intervene in the foreign exchange market. However, if the increase is large, the exchange
rate will breach the upper bound of the policy band. If this happens, the central bank will intervene in
the foreign exchange market by selling domestic currency and buying foreign currency to bring the
exchange rate back into the policy band.

Advantages and Disadvantages of the Managed Float Exchange Rate System

The managed float exchange rate system is similar to the fixed exchange rate system in that the
exchange rate is fixed, although within a policy band rather than at a specific level. Therefore, the
advantages and disadvantages of the managed float exchange rate system are the same as those of the
fixed exchange rate system. However, the managed float exchange rate system is better than the fixed
exchange rate system in two ways, which explains why the former is more commonly used than the
latter. First, the exchange rate policy band under the managed float exchange rate system provides
some flexibility for the exchange rate system to accommodate short-term fluctuations in the exchange
rate. Second, the exchange rate policy band under the managed float exchange rate system provides
some buffer in the estimation of the equilibrium exchange rate, which cannot be known precisely.

Note: Under the managed float exchange rate system, the central bank may on occasions, for tactical
reasons, intervene before the exchange rate policy band is breached or allow the exchange rate to
breach the policy band before intervening.
CHAPTER 10: MACROECONOMIC PERFORMANCE

1 INTRODUCTION

The performance of an economy is often measured in terms of economic growth, unemployment,

inflation and the balance of payments. An economy with high economic growth, low unemployment,
low inflation and a balance of payments equilibrium is generally considered well performing. In
contrast, an economy with low or negative economic growth, high unemployment, high inflation and a
persistent balance of payments disequilibrium is generally considered poor performing. As the
performance of a government is often measured in terms of the performance of the economy, all
governments aim to achieve high economic growth, low unemployment, low inflation and a balance of
payments equilibrium. This chapter provides an exposition of economic growth, unemployment,
inflation and the balance of payments.

2 ECONOMIC GROWTH

2.1 Sources of Economic Growth

Economic growth refers to an increase in real national output.

The economic growth rate is calculated as the percentage increase in real national output.

Real National Output (t) – Real National Output (t–1)

Economic Growth Rate (t) = ——————————————————————– × 100%

Real National Output (t–1)

It is important to note that the economic growth rate is calculated as the percentage increase in real
national output rather than nominal national output. As the size of the economy is measured by the
amount of goods and services produced, the economy grows when the amount of goods and services
produced increases. As nominal national output is national output measured at current prices, an
increase in nominal national output may be due to a rise in the prices of goods and services rather than
an increase in the amount of goods and services produced. However, as real national output is national
output measured at base-year prices, an increase in real national output can only be due to an increase
in the amount of goods and services produced as base-year prices do not change. Therefore, real
national output is a better measure of economic growth than nominal national output. Developing
economies such as China generally have higher economic growth than developed economies such as
the United States. Singapore has a record of high economic growth. Economists distinguish between
two types of economic growth: actual economic growth and potential economic growth.

Actual Economic Growth

Actual economic growth is an increase in actual output. This basically means that the economy
actually produces more goods and services. An increase in aggregate demand will lead to actual
economic growth.

In the above diagram, an increase in aggregate demand (AD) from AD 0 to AD1 leads to an increase in
actual output (Y) from Y0 to Y1. Aggregate demand may increase due to an increase in any of its
components. Consumption expenditure is determined by several factors such as consumer sentiment,
the wealth of households, interest rates, expectations of price changes, the availability of credit and the
distribution of income. For example, when households are more optimistic about the economic
outlook, they will expect their income to rise and hence increase consumption expenditure. Investment
expenditure is determined by several factors such as interest rates, business sentiment, business costs,
capital costs, corporate income tax, technological advancements and the availability of credit. For
example, a fall in interest rates will decrease the costs of borrowing and this will lead to more
profitable planned investments resulting in an increase in investment expenditure. Government
expenditure on goods and services is largely determined by the objective of the government. For
example, the government may increase expenditure on infrastructure to attract foreign direct
investments. Net exports are determined by several factors such as the exchange rate, domestic
inflation relative to foreign inflation, domestic income and foreign income. For example, an increase
in foreign income will lead to an increase in net exports. Refer to Chapter 9 for more factors that will
lead to an increase in aggregate demand.

Apart from an increase in aggregate demand, an increase in aggregate supply due to a fall in the cost
of production in the economy independently of demand will also lead to actual economic growth.

In the above diagram, an increase in aggregate supply (AS) from AS 0 to AS1 due to a fall in the cost of
production in the economy independently of demand leads to an increase in actual output (Y) from Y 0
to Y1. The cost of production in the economy may fall independently of demand due to several
reasons. For example, firms may bargain for lower wages when they have greater bargaining power
due to a looser labour market. The prices of imported intermediate goods will fall when there is
deflation in other economies. A rise in the exchange rate will also lead to a fall in the prices of
imported intermediate goods in domestic currency. The cost of production in the economy will also
fall independently of demand due to a decrease in oil prices or the goods and services tax. An example
is the substantial fall in the cost of production in the economy due to the sharp fall in oil prices from
June 2014 to February 2016 as a result of the boom in the shale oil industry in the United States.

Potential Economic Growth

Potential economic growth is an increase in the full-employment national output which is also known
as potential output. This basically means that the economy can potentially produce more goods and
services. An increase in aggregate supply due to an increase in the production capacity in the economy
will lead to potential economic growth and to a lesser extent, actual economic growth.

In the above diagram, an increase in short-run aggregate supply (SRAS) from SRAS 0 to SRAS1 and an
increase in long-run aggregate supply (LRAS) from LRAS 0 to LRAS1 due to an increase in the
production capacity in the economy leads to an increase in potential output (Y f) from Yf0 to Yf1 and a
smaller increase in actual output (Y) from Y 0 to Y1 [description for Neoclassical economics]. In the
above diagram, an increase in aggregate supply (AS) from AS 0 to AS1 due to an increase in the
production capacity in the economy leads to an increase in potential output (Y f) from Yf0 to Yf1 and a
smaller increase in actual output (Y) from Y 0 to Y1 [description for Keynesian economics]. The
production capacity in the economy may increase due to an increase in the quantity or the quality of
the factors of production in the economy. The quantity of labour in the economy is determined by
several factors such as the retirement age, government support to working mothers to care for their
children, personal income tax, foreign worker policy and immigration policy. For example, loosening
restrictions on foreign workers will lead to an increase in the size of the labour force in the economy.
The quality of labour in the economy is determined by several factors such as education and training,
foreign worker policy and immigration policy. For example, education and training will lead to greater
human capital which will increase the skills and knowledge of labour in the economy. The quantity of
capital in the economy is determined by several factors such as interest rates, business sentiment,
business costs, capital costs, corporate income tax and the availability of credit. For example, an
increase in business sentiment will lead to an increase in investment expenditure resulting in a more
rapid increase in the size of the capital stock in the economy, assuming net investment is initially
positive. The quality of capital in the economy is determined by several factors such as research and
development and government support to firms to adopt better production technologies. For example,
research and development will lead to technological advancement which will increase the efficiency of
capital in the economy. Factors that will lead to an increase in the production capacity in the economy
and hence aggregate supply will be explained in greater detail in Chapter 12.

Note: Apart from the aggregate demand-aggregate supply analysis, economic growth can also be
illustrated with the production possibility curve. Actual economic growth can be shown by a
movement from a point inside the production possibility curve to a point nearer to it. Potential
economic growth can be shown by an outward shift in the production possibility curve.

Potential economic growth will not lead to a rise in the standard of living. However, as actual
economic growth is constrained by potential economic growth, potential economic growth is essential
for achieving sustained economic growth. Therefore, governments around the world use supply-side
policies to achieve potential economic growth.

2.3 Sustainable Economic Growth

Sustainable economic growth refers to economic growth which occurs in a manner that will not
impede economic growth in the future. There are several necessary conditions for sustainable
economic growth which include potential economic growth, conservation and development of
resources and protection of the environment.

Conservation and Development of Resources

The production of goods and services requires resources. As many resources are non-renewable such
as fossil fuels, over-exploitation of resources will result in limited resources being available for future
use which will hinder future economic growth. Therefore, the government needs to conserve resources
to achieve sustainable economic growth. There are several measures that the government can take to
conserve resources. For example, it can impose a tax on resources which are overly exploited to
discourage their use. In addition to conserving resources, the government needs to develop new
sources of energy such as solar power and wind power. As these sources of energy are renewable, they
are necessary for achieving sustainable economic growth. The government can develop new sources of
energy directly, by setting up research institutes, or indirectly, by giving subsidies or tax incentives to
firms to encourage them to develop new sources of energy.

Protection of the Environment

Economic growth may lead to an increase in the amount of negative externalities such as carbon
emissions which will result in a more polluted environment. An increasingly polluted environment
will lead to a less healthy and hence less productive labour force. A fall in labour productivity in the
economy will lead to a rise in the cost of production in the economy resulting in a decrease in
aggregate supply and hence lower economic growth. In addition, an increasingly polluted environment
will lead to a shorter life expectancy which will lead a decrease in the size of the labour force. A
decrease in the quantity of labour in the economy will lead to a decrease in the production capacity in
the economy resulting in a decrease in aggregate supply and hence lower economic growth. Therefore,
the government needs to protect the environment to achieve sustainable economic growth. There are
several measures that the government can take to protect the environment. For example, it can impose
a carbon tax or a tradable emissions permit scheme to reduce carbon emissions.

Note: Students should not confuse sustainable economic growth with sustained economic growth.
Although potential economic growth is essential for achieving sustained economic growth, sustainable
economic growth requires more than potential economic growth. Therefore, sustainable economic
growth is a broader concept than sustained economic growth.

2.4 Benefits and Costs of Economic Growth

Benefits of Economic Growth

Rapid Rise in the Standard of Living

High economic growth may lead to a rapid rise in the standard of living. Recall that the standard of
living refers to the material and non-material welfare of the people. A rapid increase in national output
may lead to a rapid increase in the amount of goods and services available for consumption. If this
happens, the material standard of living may rise at a fast rate.

Full Employment

High economic growth will help the economy achieve full employment. The labour force in the
economy is generally expanding. An increase in national output will lead to an increase in the demand
for labour in the economy. Therefore, high economic growth will ensure that sufficient new jobs are
created in the economy for the new entrants in the labour force which will help the economy achieve
full employment.

Redistributive Benefit

Economic growth will increase the ability of the government to redistribute income from high income
individuals to low income individuals. When national output and hence national income rises, the
government will automatically collect more tax revenue which can be used to finance transfer
payments to low income individuals. Therefore, the government can redistribute income from high
income individuals to low income individuals to reduce income inequity without increasing direct
taxes and hence lowering anyone’s disposable income.

Environmental Benefit

Economic growth may lead to a cleaner environment. When people’s income rises, they will become
more concerned with a clean environment. This is because pollution will become a matter of social
concern when economic growth has ensured the provision of basic necessities such as food and
housing to the majority of the population. A cleaner environment will lead to a rise in the non-material
standard of living.

Costs of Economic Growth

Lower Amount of Goods and Services Available for Consumption

Achieving economic growth may lead to a fall in the amount of goods and services available for
consumption. Economic growth may be achieved through a diversion of resources from the production
of consumer goods, such as ice creams and cookies, to the production of capital goods, such as
factories and machinery. If this happens, the amount of goods and services available for consumption
will fall which will lead to a fall in the material standard of living.

Generation of Demands

Economic growth may generate demands which may make people feel less contented. An increase in
national output will lead to an increase in the amount of goods and services available for consumption.
However, when people have more to consume, they may want to attain an even higher level of
consumption. Therefore, if economic growth generates demands and makes people more materialistic,
it may make them feel less contented which will lead to a fall in the non-material standard of living.

Environmental Costs
Economic growth may lead to environmental costs. An increase in national output may lead to an
increase in the amount of negative externalities such as carbon emissions which will result in a more
polluted environment. If this happens, the non-material standard of living will fall.

Depletion of Non-renewable Resources

Current economic growth may preclude future economic growth. Economic growth will deplete non-
renewable resources such as fossil fuels which include crude oil, coal and natural gas. When this
happens, there may be lack of resources to achieve economic growth in the future.

Worsening Income Inequity

Achieving economic growth may worsen income inequity. To achieve economic growth, the
government may cut corporate income tax to attract foreign direct investments, and it may cut personal
income tax to attract foreign talents. However, as income taxes are progressive, a decrease in these
taxes will worsen income inequity. Furthermore, to avoid a budget deficit, the government may raise
goods and services tax to offset the fall in income tax revenue. However, as goods and services tax is
regressive, an increase in this tax will also cause income inequity to worsen.

High Structural Unemployment

High economic growth may lead to high structural unemployment. High economic growth may occur
due to rapid technological advancement. However, although rapid technological advancement may
lead to high economic growth, it may lead to substantial losses of low-skilled jobs resulting in high
structural unemployment.

Balance of Payments Deficit

High economic growth may lead to a persistent balance of payments deficit. High economic growth
will lead to high import growth. However, if export growth is low, high import growth may lead to a
persistent balance of payments deficit resulting in adverse consequences such as high imported
inflation, lower national output and hence national income, higher unemployment and rising public
debt.

High Demand-pull Inflation

High economic growth may lead to high demand-pull inflation. High economic growth usually occurs
due to a rapid increase in aggregate demand. However, when aggregate demand rises rapidly, demand-
pull inflation will be high if aggregate supply does not also rise rapidly. This is particularly true when
the economy is near the full-employment equilibrium.

Note: Although economic growth brings about both costs and benefits to the economy, the benefits
generally outweigh the costs which explains why governments around the world aim to achieve high
economic growth.

3 UNEMPLOYMENT

3.1 Measurement of Unemployment

Unemployment is the state of the economy where some people who are able and willing to work are
not employed in the production of goods and services.
For the purpose of measuring unemployment, the population can be divided into the working-age
population and the non-working-age population. In Singapore, the working-age population refers to
those who are 15 years of age and over. The working-age population can be further divided into the
economically active population, which is also called the labour force, and the economically inactive
population. The labour force refers to those who are 15 years of age and over (i.e. working-age
population), who are able and willing to work, and are either employed or actively seeking
employment.

The unemployment rate is the unemployed expressed as a percentage of the labour force.

Unemployed

Unemployment Rate = ————————– × 100%

Labour Force

The labour force participation rate is the labour force expressed as a percentage of the working-age
population.

Labour Force

Labour Force Participation Rate = ———————————– × 100%

Working-age Population

Note: According to the International Labour Organisation (ILO), the unemployed are persons of
working age who are without work, are available to start work within two weeks and either have
actively looked for work in the last four weeks or are waiting to take up an appointment.

3.2 Causes of Unemployment

There are four causes of unemployment: demand-deficient/cyclical unemployment, structural

unemployment, frictional unemployment and seasonal unemployment.

Demand-deficient/Cyclical Unemployment

Demand-deficient unemployment, or cyclical unemployment, refers to unemployment which occurs

due to a deficiency in demand. A deficiency in demand usually occurs when aggregate demand falls or
when aggregate demand rises at a slow rate relative to the size of the labour force. When aggregate
demand falls, firms will decrease production which will lead to a decrease in the demand for labour in
the economy. As real wages are inflexible downwards due to factors such as the existence of
employment contracts, trade unions protecting the standards of living of their members and firms
unwilling to lower real wages to avoid decreasing the productivity of their workers, a decrease in the
demand for labour in the economy will lead to demand-deficient unemployment.

To reduce demand-deficient unemployment, the government can use policies to increase aggregate
demand.

Structural Unemployment
Structural unemployment refers to unemployment which occurs due to a change in the structure of the
economy. The structure of the economy changes when some industries expand and some industries
contract and this may be due to technological advancements, changes in comparative advantage or
changes in the pattern of demand. When this happens, the expanding industries which are typically
high value-added industries will create jobs and the contracting industries which are typically low
value-added industries will lose jobs. However, as workers who will lose their jobs in the contracting
industries possess low skills, they will not have the relevant skills and knowledge to find jobs in the
expanding industries which require high skills and this will lead to structural unemployment.
Structural unemployment always exists.

To reduce structural unemployment, the government can provide education and training directly, by
setting up educational institutes, or indirectly, by giving subsidies or tax incentives to firms to
encourage them to send their workers for education and training. Education and training will equip
low-skilled workers who are unemployed with the relevant skills and knowledge to find jobs in the
expanding industries which require high skills. However, due to the effort that has to be expended on
the part of the structurally unemployed workers who are mostly low-skilled, such measures may not
decrease structural unemployment significantly. The government can also engage in protectionism to
support declining industries to help them to phase out at a slower rate. When this happens, low-skilled
workers who are employed in the declining industries will have more time to undergo education and
training in order to acquire the relevant skills and knowledge to find jobs in the expanding industries.
However, providing protection to declining industries may reduce the incentive for low-skilled
workers who are employed in the industries to acquire new skills and knowledge. Furthermore,
providing protection to declining industries will prolong the inefficient use of resources in the
economy which may hinder the development of comparative advantage in new industries.

Frictional Unemployment

Frictional unemployment refers to unemployment which occurs due to lack of perfect information
about the job market. Firms are not fully informed about the types of labour available and workers are
not fully informed about the types of jobs available. In other words, although firms and workers have
information about the job market, the information is imperfect. Therefore, firms need time to find the
most suitable workers and workers need time to find the most suitable jobs. In other words, firms and
workers need time to explore the job market and this leads to frictional unemployment. Frictional
unemployment always exists.

To reduce frictional unemployment, the government can set up job market intermediaries to match
firms searching for workers and workers searching for jobs. Such job market intermediaries may be set
up in the form of employment agencies or job matching websites. The government may also organise
job fairs which bring together firms searching for workers to conduct a mass recruitment exercise. Job
market intermediaries and job fairs provide information about the job market to firms searching for
workers and workers searching for jobs which will reduce the searching time. However, firms and
workers may not be responsive as they may think that they are better able to assess prospective
employers and employees by themselves. If this happens, setting up job market intermediaries and
organising job fairs may not lead to a significant fall in frictional unemployment.

Seasonal Unemployment

Seasonal unemployment refers to unemployment which occurs due to the low demand for certain
types of labour during certain seasons of the year. For example, some agricultural workers are
unemployed during the off-harvest-season and some construction workers and lifeguards are
unemployed during winter. Seasonal unemployment always exists. The solution to seasonal
unemployment is the same as the solution to structural unemployment. In reality, it is difficult to
decrease seasonal unemployment significantly because a large part of it is voluntary. However,
seasonal unemployment is usually insignificant and is hence rarely a matter of social concern.
Full Employment and Natural Unemployment

Full employment is the state of the economy where there is no demand-deficient unemployment.
When the economy is at full employment, there still exists unemployment which comprises structural
unemployment, frictional unemployment and seasonal unemployment. Natural unemployment refers
to the sum of structural unemployment, frictional unemployment and seasonal unemployment. The
natural rate of unemployment in Singapore is estimated to be around 2 per cent. In the United States, it
is estimated to be around 5 per cent. In practice, to determine whether the economy is at full
employment, the government compares the actual rate of unemployment and the natural rate. If the
actual rate of unemployment is equal to the natural rate, the economy is said to be at full employment.
If the actual rate of unemployment is above the natural rate, the economy is said to be at below full
employment. If the actual rate of unemployment is below the natural rate, the economy is said to be at
above full employment. As there still exists unemployment when the economy is at full employment,
full employment is also called low unemployment. Singapore has a record of low unemployment.

3.3 Costs and Benefits of Unemployment

Costs of Unemployment

High unemployment will cause the economy to lose a large amount of output resulting in substantial
productive inefficiency as a large amount of labour is not employed in the production of goods and
services. A substantial loss in national output may lead to a large fall in the standard of living. High
unemployment will cause a large number of workers to lose income and often suffer a fall in morale
and self-confidence. Furthermore, if the unemployed workers remain jobless for a prolonged period of
time, they may lose their skills and knowledge which could make it harder for them to gain
employment. When unemployment is high, workers who are employed will also suffer a fall in income
in the form of a pay cut. High unemployment will lead to a substantial fall in the purchasing power of
households. The resultant substantial fall in the demand for goods and services will cause firms to lose
a large amount of profit. When unemployment is high, the government will lose a large amount of tax
revenue. It may also need to increase expenditure on unemployment benefits substantially. If this leads
to a persistent budget deficit, the public debt will rise persistently which may lead to adverse
consequences such as a higher tax burden on future generations. High unemployment may lead to high
social costs such as a high crime rate, a high divorce rate and a high suicide rate. In the event of very
high unemployment, social unrest could break out.

Benefits of Unemployment

Some workers leave their jobs in order to search for a better job. Although they will suffer from
temporary unemployment, they may experience a rise in income if they manage to find better
employment. If workers leave their jobs in order to search for a better job, this may lead to a better
match between workers and jobs which will result in an increase labour productivity in the economy.
Recall that labour productivity refers to output per hour of labour. An increase in labour productivity
in the economy will lead to a fall in the cost of production in the economy resulting in an increase in
aggregate supply. When this happens, economic growth will rise which may reduce unemployment,
and inflation will fall which may improve the balance of payments. If people are willing to bear with
some unemployment, inflation may be kept at a low rate. In contrast, the cost of eliminating
unemployment may be an intolerably high inflation rate. Recall that the inverse relationship between
inflation and unemployment can be shown with the short-run Phillips curve.

4 INFLATION

4.1 Measurement of Inflation

Inflation is a sustained rise in the general price level.

The inflation rate is calculated as the percentage increase in the consumer price index.

Inflation Rate (t) = (CPIt – CPIt–1)/CPIt–1 × 100%

where CPIt = ∑[(Pit/Pi base year × 100) × Wi]

The consumer price index is a price index which measures the cost of a basket of goods and services
purchased by the average household. It is calculated by choosing a basket of goods and services
purchased by the average household, dividing them into categories, assigning a weight to each
category based on the proportion of total expenditure spent on it, choosing a base year, measuring the
prices of the goods and services in the current year as well as in the base year.

Suppose that there are only two goods produced in the economy, Good A and Good B. Further
suppose that the base year is 2009 (i.e. CPI2009 = 100).

Good Price (2009) Price (2011) Price (2012) Expenditure (2009) Weight
A $8 $10 $12 20000 1/4
B $16 $15 $14 60000 3/4

CPI2012 = [(12/8 × 100) × 1/4] + [(14/16 × 100) × 3/4] = 103.125

CPI2011 = [(10/8 × 100) × 1/4] + [(15/16 × 100) × 3/4] = 101.563

Inflation (2012) = (CPI2012 – CPI2011)/CPI2011 × 100% = (103.125 – 101.563)/101.563 × 100% = 1.538%

Generally, inflation is considered low when the general price level rises by 3 per cent or less.. Inflation
that is higher than 3 per cent is called high inflation. Many developing economies such as Vietnam
have high inflation. Inflation that is substantially higher than 3 per cent is called hyperinflation. An
example of hyperinflation is the 6.5 × 10108 per cent inflation in Zimbabwe in 2008.

There are two types of inflation statistics. One is known as consumer price inflation or headline
inflation and the other is called core inflation or underlying inflation. In the measurement of core
inflation, goods whose prices are volatile or highly influenced by government policies are removed
from the basket of goods and services that is used to compute consumer price inflation. Therefore,
core inflation is better than consumer price inflation for forecasting the long-term trend of the general
price level. Unlike most economies where energy and food are removed from the basket, in Singapore,
accommodation and private road transport are removed from the basket.

4.2 Causes of Inflation

Economists distinguish between two types of inflation: demand-pull inflation and cost-push inflation.

Demand-pull Inflation

Demand-pull inflation is a sustained rise in the general price level due to an increase in aggregate
demand. An increase in aggregate demand will lead to a shortage of goods and services resulting in a
rise in the general price level. Furthermore, when aggregate demand rises, firms will increase
production which will lead to an increase in the demand for factor inputs in the economy resulting in a
rise in the prices. When this happens, the cost of production in the economy will rise which will
induce firms to increase prices to maintain profitability resulting in a rise in the general price level.
Given any increase in aggregate demand, the extent of the rise in the general price level will depend
on the state of the economy. The nearer the economy is to the full-employment equilibrium, the
smaller will be the amount of excess production capacity in the economy and hence the larger will be
the rise in the general price level.

In the above diagram, an increase in aggregate demand (AD) from AD 0 to AD1 leads to a rise in the
general price level (P) from P 0 to P1. Aggregate demand may increase due to an increase in any of its
components. Consumption expenditure is determined by several factors such as consumer sentiment,
the wealth of households, interest rates, expectations of price changes, the availability of credit and the
distribution of income. For example, when households are more optimistic about the economic
outlook, they will expect their income to rise and hence increase consumption expenditure. Investment
expenditure is determined by several factors such as interest rates, business sentiment, business costs,
capital costs, corporate income tax, technological advancements and the availability of credit. For
example, a fall in interest rates will decrease the costs of borrowing and this will lead to more
profitable planned investments resulting in an increase in investment expenditure. Government
expenditure on goods and services is largely determined by the objective of the government. For
example, the government may increase expenditure on the infrastructure of the economy to attract
foreign direct investments. Net exports are determined by several factors such as the exchange rate,
domestic inflation relative to foreign inflation, domestic income and foreign income. For example, an
increase in foreign income will lead to an increase in net exports.

To reduce demand-pull inflation, the government can use policies to reduce the growth of aggregate
demand.

Cost-push Inflation

Cost-push inflation is a sustained rise in the general price level due to a rise in the cost of production
in the economy, independent of demand. When the cost of production in the economy rises
independently of demand, firms will increase prices at the same output levels to maintain profitability.
In other words, they will decrease output at the same prices which will lead to a decrease in aggregate
supply resulting in a shortage of goods and services and hence a rise in the general price level.

In the above diagram, a decrease in aggregate supply (AS) from AS 0 to AS1 leads to a rise in the
general price level (P) from P 0 to P1. The cost of production in the economy may rise independently of
demand due to several reasons. For example, workers will bargain for higher wages to maintain
purchasing power when they expect prices to rise. They will also bargain for higher wages when they
have greater bargaining power due to a tighter labour market. The prices of intermediate goods will
rise when the world demand rises due to an expansion of the world economy. A fall in the exchange
rate will lead to a rise in the prices of imported intermediate goods in domestic currency. The
government may raise goods and services tax to avoid a budget deficit if it cuts corporate income tax
to attract foreign direct investments. Oil prices may rise due to man-made factors or natural factors.
An example is the substantial rise in the cost of production in the economy due to the sharp rise in oil
prices from October 1973 to March 1974 as a result of the oil embargo imposed by the Organisation of
Arab Petroleum Exporting Countries (OAPEC) against the United States, the United Kingdom, the
Netherlands, Japan and Canada.

To reduce cost-push inflation, the government can use policies to increase aggregate supply or reduce
the growth of aggregate demand.

Note:A substantial rise in the cost of production in the economy is likely to lead to stagflation.
Stagflation is a situation where there is high inflation and economic stagnation which leads to high
unemployment. The world first experienced stagflation in October 1973 when the Organisation of
Arab Petroleum Exporting Countries (OAPEC) imposed an oil embargo against the United States, the
United Kingdom, the Netherlands, Japan and Canada which led to a large decrease in the supply of
oil resulting in a sharp rise in the prices.
4.3 Costs and Benefits of Inflation

Costs of Inflation

Fall in the Real Value of Savings

High inflation will reduce the real value of savings. When inflation is high, nominal interest rates on
savings will not fully compensate for the substantial rise in the general price level. When this happens,
the same amount of savings will allow individuals to buy only a smaller amount of goods and services
which will reduce the real value of savings. This is undesirable particularly if the savings rate in the
economy is high. For example, the savings rate in Singapore is high due to the culture of thrift, the
compulsory savings scheme and the absence of a generous welfare system.

Fall in Net Exports

High inflation may lead to a decrease in net exports resulting in a deterioration in the balance of
payments, a decrease in national output and hence national income and a rise in unemployment. When
inflation is high, domestic goods and services may become relatively more expensive than foreign
goods and services. If this happens, net exports will fall. The balance of payments is a record of all the
transactions between the residents of the economy and the rest of the world over a period of time and
is made up of the current account and the capital and financial account. A decrease in net exports will
lead to a deterioration in the current account and hence the balance of payments, assuming the demand
for exports is price elastic. Furthermore, a decrease in net exports will lead to a decrease in aggregate
demand which will induce firms to decrease production resulting in a decrease in national output.
When firms decrease production, they will employ less factor inputs from households and hence will
pay them less factor income which will lead to a decrease in national income. A decrease in national
output will lead to a fall in the demand for labour in the economy resulting in a rise in unemployment.

Fall in Investment Expenditure

High inflation may lead to a decrease in investment expenditure resulting in a decrease in national
output and hence national income and a rise in unemployment. As high inflation tends to be unstable
due to the high variance, it will make it harder for firms to estimate the costs and the revenues of
planned investments. When this happens, firms will be less certain about the expected returns on
planned investments which will lead to a decrease in investment expenditure resulting in a decrease in
aggregate demand. This will lead to a decrease in national output and hence national income resulting
in a rise in unemployment.

High Shoe-leather Cost of Inflation

High inflation will lead to a high shoe-leather cost of inflation. High inflation will lead to high interest
rates. Metaphorically, when interest rates are high, the transactions demand for money will be low.
Therefore, people will make frequent trips to the bank to withdraw small amounts of money which
will cause their shoes to wear out rapidly resulting in a high shoe-leather cost of inflation. In reality,
the idea of wearing out your shoes rapidly implies more than making frequent trips to the bank.
Rather, when interest rates are high, people will devote more time to managing money rather than
spend more time on producing goods and services.

High Menu Cost of Inflation

High inflation will lead to a high menu cost of inflation. When prices of goods and services rise, firms
have to reprint price labels. For example, restaurants have to reprint menus to reflect the higher prices
of meals. When inflation is high, prices of goods and services will rise frequently and hence firms will
need to reprint price labels frequently which will lead to a high menu cost of inflation.
Haphazard Redistribution of Real Income and Wealth (Unanticipated Inflation)

Unanticipated inflation will lead to a haphazard redistribution of real income and wealth. Consider a
wage contract that specifies a wage increase of 3 per cent on the assumption that the general price
level will remain constant. If inflation unexpectedly turns out to be 10 per cent, the 3 per cent increase
in nominal wages will mean a 7 per cent decrease in real wages. In this case, real income will be
haphazardly redistributed from workers to firms. Furthermore, unanticipated inflation will decrease
the liabilities of debtors and the assets of creditors in real terms. In other words, when there is
unanticipated inflation, debtors will owe creditors less in terms of goods and services. In this case,
wealth will be haphazardly redistributed from creditors to debtors.

Haphazard Redistribution of Real Income (Anticipated Inflation)

Anticipated inflation will also lead to a haphazard redistribution of real income. Some private pension
plans are stated in nominal terms and others compensate for up to only 5 per cent inflation. Therefore,
even if inflation had been anticipated, people who live on fixed nominal income will see their real
income erode away over time. In this case, real income will be haphazardly redistributed from
pensioners to firms.

Benefits of Inflation

Although high inflation is undesirable for the economy, low inflation is desirable. Low inflation is
desirable for the economy as it injects some downward flexibility into real wages which leads to fewer
firm closures and hence fewer job losses resulting in lower unemployment. Due to several reasons
such as falling sales, firms may need to cut real wages to avoid closure. In the absence of inflation,
they will need to cut nominal wages in order to cut real wages. However, as cutting nominal wages is
difficult due to factors such as the existence of employment contracts and trade unions protecting the
standards of living of their members, this means that the absence of inflation will make it harder for
firms to cut real wages which will lead to more firm closures and hence more job losses resulting in
higher unemployment. In contrast, if there is some inflation, say 2 per cent, firms will be able to cut
real wages without cutting nominal wages. This is because when firms keep nominal wages constant at
a time when the prices of goods and services are rising, they are effectively cutting real wages. This
means that the presence of some inflation will make it easier for firms to cut real wages which will
lead to fewer firm closures and hence fewer job losses resulting in lower unemployment. Another way
to understand why some inflation is necessary for achieving low unemployment is through the short-
run Phillips curve. If people are willing to bear with some inflation, unemployment may be kept at a
low rate. In contrast, the cost of eliminating inflation may be an intolerably high unemployment rate.
Recall that the inverse relationship between inflation and unemployment can be shown with the short-
run Phillips curve.

In the above diagram, the short-run Phillips curve (SRPC) is downward sloping due to the short-run
inverse relationship between inflation and unemployment. When the inflation rate is p 0, the
unemployment rate is m0, which may be low. At a zero per cent inflation rate, the unemployment rate
is m1, which may be intolerably high.

Note: A nominal value is measured in terms of money. A real value is measured in terms of goods
and services. Suppose that a firm pays a worker a monthly income of $1000. Further suppose that the
only good in the economy is lipstick which costs $20 each. In this case, the nominal income of the
worker is $1000 and the real income is 50 lipsticks. Firms and workers are concerned with real
income. Similarly, lenders and borrowers are concerned with real interest rate. Suppose that a lender
charges a borrower an interest rate of 7 per cent. Further suppose that inflation is 3 per cent. In this
case, the real interest rate is 4 per cent. This means that although the borrower will pay back 7 per
cent more to the lender in terms of money, the lender will only receive 4 per cent more from the
borrower in terms of goods and services.
4.4 Costs and Benefits of Deflation

Deflation is a sustained fall in the general price level.

Benefits of Deflation

Rise in the Real Value of Savings

Deflation will increase the real value of savings. Deflation will allow individuals to buy a larger
amount of goods and services with the same amount of savings which will increase the real value of
savings. This is desirable particularly if the savings rate in the economy is high. For example, the
savings rate in Singapore is high due to the culture of thrift, the compulsory savings scheme and the
absence of a generous welfare system.

Rise in Net Exports

Deflation may lead to an increase in net exports resulting in an improvement in the balance of
payments, an increase in national output and hence national income and a fall in unemployment. When
deflation occurs, domestic goods and services may become relatively cheaper than foreign goods and
services. If this happens, net exports will rise. Recall that the balance of payments is a record of all the
transactions between the residents of the economy and the rest of the world over a period of time and
is made up of the current account and the capital and financial account. An increase in net exports will
lead to an improvement in the current account and hence the balance of payments, assuming the
demand for exports is price elastic. Furthermore, an increase in net exports will lead to an increase in
aggregate demand which will induce firms to increase production resulting in an increase in national
output. When firms increase production, they will employ more factor inputs from households and
hence will pay them more factor income which will lead to an increase in national income. An
increase in national output will lead to a rise in the demand for labour in the economy resulting in a
fall in unemployment.

Costs of Deflation

Deflationary Expectations

Deflation may lead to deflationary expectations resulting in a decrease in national output and hence
national income and a rise in unemployment. When the general price level falls, households may
expect it to fall further. If this happens, consumption expenditure will fall which will lead to a
decrease in aggregate demand. This will lead to a decrease in national output and hence national
income resulting in a rise in unemployment. This is undesirable particularly if the deflation was caused
by a fall in aggregate demand. For example, the Japanese government was concerned about deflation
in the late 1990s due to the prospect of deflationary expectations.

Widespread Bankruptcy

Deflation may lead to widespread bankruptcy resulting in a decrease in national output and hence
national income and a rise in unemployment. Firms are generally in debt. As deflation will increase
the real value of debts, it may lead to widespread bankruptcy. If this happens, investment expenditure
will fall which will lead to a decrease in aggregate demand. This will lead to a decrease in national
output and hence national income resulting in a rise in unemployment. For example, in the Great
Depression of 1930s, many farmers in the United States lost their farms through foreclosures as a
result of rising debt burden due to falling prices.

Rise in Interest Rates

Deflation may lead to a rise in interest rates resulting in a decrease in national output and hence
national income and a rise in unemployment. Deflation is a return on holding money as it will increase
the real value of money. Therefore, if deflation leads to deflationary expectations, the demand for
money will increase which will lead to a rise in interest rates. Higher interest rates will increase the
incentive to save and the costs of borrowing and this will lead to a decrease in consumption
expenditure. Furthermore, an increase in the costs of borrowing will lead to fewer profitable planned
investments resulting in a decrease in investment expenditure. A decrease in consumption expenditure
and investment expenditure will lead to a decrease in aggregate demand which will lead to a decrease
in national output and hence national income resulting in a rise in unemployment.

Redistribution of Wealth from Debtors to Creditors

Unanticipated deflation will redistribute wealth from debtors to creditors resulting in a decrease in
national output and hence national income and a rise in unemployment. Unanticipated deflation will
increase the liabilities of debtors and the assets of creditors in real terms. In other words, when there is
unanticipated deflation, debtors will owe creditors more in terms of goods and services. When this
happens, wealth will be redistributed from debtors to creditors. As debtors have a higher marginal
propensity to consume out of wealth than creditors, this redistribution of wealth from debtors to
creditors will lead to a decrease in consumption expenditure resulting in a decrease in aggregate
demand. This will lead to a decrease in national output and hence national income resulting in a rise in
unemployment.

Note: Although deflation brings about both benefits and costs to the economy, it is a serious concern
in reality due to the potential deflationary expectations which could be very detrimental to the
economy.

The Principal Economics Tutor will discuss the costs and benefits of deflation in greater detail in the
economics tuition class.

CHAPTER 11: THE BALANCE OF PAYMENTS

1 Components of the Balance of Payments

The balance of payments is a record of all the transactions between the residents of the economy and
the rest of the world over a period of time. In other words, the balance of payments records all the
money flows between the economy and the rest of the world. The balance of payments is made up of
the current account and the capital and financial account.

Current Account

The current account is the part of the balance of payments which records exports and imports of goods
and services, income remittances and current transfers. The current account balance is the sum of the
goods balance, the services balance, the primary income balance and the secondary income balance.

Goods Balance

The goods balance, which is also known as the balance on trade in goods or the visible balance, is the
exports of goods minus the imports of goods.

Services Balance
The services balance, which is also known as the balance on trade in services, is the exports of
services minus the imports of services.

Primary Income Balance

The primary income balance, which is also simply known as the income balance, is the inward income
remittances minus the outward income remittances. Income refers to wages, rent, interest and profits.

Secondary Income Balance

The secondary income balance, which is also known as the net current transfers, is the inward current
transfers minus the outward current transfers. Current transfers are government contributions to and
receipts from other economies and international transfers of money by private individuals and firms.

Capital and Financial Account

The capital and financial account is made of the capital account and the financial account. The capital
account is the part of the balance of payments which records capital transfers such as the transfers of
funds by migrants, development aid funds, the acquisition and disposal of non-produced, non-financial
assets such as land, patents, copyrights and franchises, etc. The capital account balance is the inward
capital transfers minus the outward capital transfers. The financial account is the part of the balance of
payments which records changes in the holdings of shares, government securities, corporate bonds,
deposits, loans, official reserves, etc. The financial account balance is the sum of direct investment
(net), portfolio investment (net), other investment (net) and official reserves (net).

Direct Investment (Net)

Direct investment refers to investment made with the objective of obtaining a lasting interest in an
organisation and exercising a significant degree of influence in its management. This is defined as
ownership of at least 10 per cent of ordinary shares. Direct investment (net) is the inward direct
investment minus the outward direct investment.

Portfolio Investment (Net)

Portfolio investment refers to investment in paper assets such as shares of less than 10 per cent of
ordinary shares, government securities and corporate bonds. Portfolio investment (net) is the inward
portfolio investment minus the outward portfolio investment.

Other Investment (Net)

Other investment consists mainly of short-term investments such as loans and deposits. Other
investment (net) is the inward other investment minus the outward other investment.

Reserve Assets (Net)

Reserve assets refer to the central bank’s holdings of foreign exchange reserves, gold, Special
Drawing Rights and reserves with the International Monetary Fund. Reserve assets (net) are the
change in reserve assets.

By design, the balance of payments which is the current account balance minus the capital and
financial account balance is equal to zero.
The sum of the goods balance and the services balance is referred to as the balance on goods or
services, the balance of trade or simply the trade balance. It is the exports of goods and services minus
the imports of goods and services. The sum of the services balance, the primary income balance and
the secondary income balance is referred to as the invisible balance.

In some countries such as the United Kingdom, the change in reserve assets is recorded in the
financial account which is the case presented in this book

2 Total Currency Flow

Although the balance of payments is equal to zero, it may not necessarily be in equilibrium. Whether
the balance of payments is in equilibrium depends on the total currency flow. The total currency flow
is the current account balance minus the capital and financial account balance excluding the change in
reserve assets. When the total currency flow is positive, the balance of payments is in surplus and that
occurs when money inflows exceed money outflows. When the total currency flow is negative, the
balance of payments is in deficit and that occurs when money outflows exceed money inflows.
Economists refer to these as balance of payments disequilibria. When the total currency flow is zero,
the balance of payments is in equilibrium and that occurs when money inflows are equal to money
outflows. Economists refer to this as a balance of payments equilibrium. Under the floating exchange
rate system, the balance of payments is in equilibrium. Under the fixed exchange rate system, the
balance of payments is in disequilibrium, unless by chance.

3 Net Errors and Omissions

Errors and omissions, which are also known as balancing item or statistical discrepancy, are bound to
occur in the process of constructing the balance of payments as the data for the current account and the
capital and financial account are obtained from diverse sources. Since errors and omissions always
occur, the current account balance minus the capital and financial account balance is not equal to zero.
Rather, it is the current account balance minus the capital and financial account balance plus net errors
and omissions which is equal to zero. It follows that the balance of payments is the current account
balance minus the capital and financial account balance plus net errors and omissions. Similarly, the
total currency flow is the current account balance minus the capital and financial account balance
excluding the change in reserve assets plus net errors and omissions.

Note: When the total currency flow is negative which means that the balance of payments is in
deficit, it will be matched by a decrease in reserve assets, which is recorded with a positive sign.
Therefore, the current account balance minus the capital and financial account balance plus net
errors and omissions is equal to zero. Similarly, when the total currency flow is positive which means
that the balance of payments is in surplus, it will be matched by an increase in reserve assets, which is
recorded with a negative sign. Therefore, the current account balance minus the capital and financial
account balance plus net errors and omissions is equal to zero. When the total currency flow is equal
to zero which means that the balance of payments is in equilibrium, there will be no change in reserve
assets. Therefore, the current account balance minus the capital and financial account balance plus
net errors and omissions is equal to zero.

4 Adverse Effects of a Persistent Balance of Payments Deficit

Floating Exchange Rate System

Under the floating exchange rate system, a persistent balance of payments deficit may lead to high
imported inflation and currency instability resulting in lower national output and hence national
income and higher unemployment. When money outflows persistently exceed money inflows, the
supply of domestic currency will persistently exceed the demand which will lead to a persistent
downward pressure on the exchange rate. Under the floating exchange rate system, this will cause
domestic currency to depreciate persistently. For example, the U.S. dollar which is allowed to float
freely has depreciated against the major currencies in the world over the last few decades due to the
persistent balance of payments deficit mainly caused by the persistent trade deficit in the United
States.

High Imported Inflation

A persistent depreciation of domestic currency will lead to a persistent rise in the prices of imported
consumer goods in domestic currency. This may directly lead to a substantial rise in the general price
level resulting in high direct imported inflation. Furthermore, the persistent rise in the prices of
imported intermediate goods in domestic currency will lead to a persistent rise in the cost of
production in the economy. This may indirectly lead to a substantial rise in the general price level
resulting in high indirect imported inflation or imported cost-push inflation. If high imported cost-push
inflation occurs, domestic goods and services may become relatively more expensive than foreign
goods and services which will lead to a decrease in net exports resulting in a deterioration in the
current account and hence the balance of payments, assuming the demand for exports is price elastic.
This may lead to a vicious cycle of balance of payments deficit and high imported cost-push inflation.

Currency Instability

A persistent depreciation of domestic currency may induce people to sell the currency in anticipation
of further falls in the exchange rate. If this happens, domestic currency will depreciate at a faster rate
and hence may become unstable which will lead to capital flight and a fall in foreign direct
investments. Capital flight will lead to a fall in asset prices resulting in a fall in the wealth of
households and hence consumption expenditure. When consumption expenditure and investment
expenditure fall, aggregate demand will fall which will induce firms to decrease production resulting
in a decrease in national output. When firms decrease production, they will employ less factor inputs
from households and hence will pay them less factor income which will lead to a decrease in national
income. A decrease in national output will lead to a fall in the demand for labour in the economy
resulting in a rise in unemployment.

Fixed Exchange Rate System

Under the fixed exchange rate system, a persistent balance of payments deficit may lead to rising
foreign debt and rising interest rates resulting in lower national output and hence national income and
higher unemployment.

Rising Foreign Debt

Under the fixed exchange rate system, when money outflows persistently exceed money inflows, the
central bank will continually intervene in the foreign exchange market to eliminate the persistent
downward pressure on the exchange rate. More specifically, the central bank will continually buy
domestic currency and sell foreign currency in the foreign exchange market to prevent domestic
currency from depreciating. For example, from 1984 to 2 July 1997, the Thai baht was pegged to the
U.S. dollar at 25 Thai bahts to one U.S. dollar and the Bank of Thailand continually bought Thai bahts
and sold U.S. dollars to eliminate the persistent downward pressure on the exchange rate due to the
persistent balance of payments deficit mainly caused by the persistent trade deficit. However, in time
to come, the central bank will deplete its foreign exchange reserves and hence will need to start
borrowing foreign currency which will lead to rising foreign debt. When the foreign debt rises to a
critical level, the central bank will lose its ability to borrow foreign currency and hence will have to
allow domestic currency to depreciate. When this happens, domestic currency may become unstable as
it may be subject to speculative attack which will lead to capital flight and a fall in foreign direct
investments. Capital flight will lead to a fall in asset prices resulting in a fall in the wealth of
households and hence consumption expenditure. When consumption expenditure and investment
expenditure fall, aggregate demand will fall which will lead to a decrease in national output and
national income resulting in a rise in unemployment.

Rising Interest Rates

If the central bank continually buys domestic currency in the foreign exchange market, the money
supply will fall continually which will lead to rising interest rates resulting in falling consumption
expenditure and investment expenditure. When this happens, aggregate demand will fall continually
which will lead to falling national output and hence national income resulting in rising unemployment.

Note: Foreign debt, or external debt, refers to the amount of money that a country owes to foreign
creditors.

Overheating is a situation where aggregate demand is rising rapidly relative to aggregate supply
resulting in high inflationary pressures.

5 Adverse Effects of a Persistent Balance of Payments Surplus

Lower Standard of Living

A persistent balance of payments surplus may occur due to imports of consumer goods being
persistently lower than exports of consumer goods. If the surplus had been used to purchase more
imports of consumer goods, the amount of goods and services available for consumption would have
increased which would lead to a higher standard of living.

Retaliation

When an economy has a persistent balance of payments surplus, its trading partners may be
experiencing a persistent balance of payments deficit. If this happens, in time to come, the deficit
trading partners may use protectionist measures to correct their persistent balance of payments deficits
which will reduce the exports of the economy.

Persistent Appreciation of Domestic Currency and hence Falling Export Competitiveness

Under the floating exchange rate system, a persistent balance of payments surplus will lead to a
persistent appreciation of domestic currency. When domestic currency appreciates persistently,
domestic goods and services will become increasingly more expensive than foreign goods and services
resulting in falling export competitiveness.

Persistent Increase in the Money Supply and hence High Inflationary Pressures

Under the fixed exchange rate system, a persistent balance of payments surplus will require the central
bank to continually sell domestic currency and buy foreign currency in the foreign exchange market to
prevent domestic currency from appreciating. When this happens, the money supply will rise
continually which may lead to a situation of ‘too much money chasing too few goods’ resulting in
high inflation.

Note: Although a persistent balance of payments surplus is undesirable for the economy in theory, it
is much less of a concern than a persistent balance of payments deficit in reality.

6 Measures to Correct a Persistent Balance of Payments Deficit

There are three main types of policies to correct a persistent balance of payments deficit: expenditure-
switching policies, expenditure-reducing policies and supply-side policies. Expenditure-switching
policies are policies that are used to induce domestic households and firms to switch from imports to
domestic goods and services and foreign households and firms to switch from foreign goods and
services to the country’s exports. They include devaluation and protectionism. Expenditure-reducing
policies are policies that are used to reduce consumption expenditure and hence imports. They include
contractionary fiscal policy and contractionary monetary policy.

Devaluation (Expenditure-switching Policy)

To correct a persistent balance of payments deficit, the central bank can use exchange rate policy.
Exchange rate policy is a policy that is used to control the exchange rate through central bank
intervention in the foreign exchange market. The central bank can devalue domestic currency by
selling domestic currency and buying foreign currency in the foreign exchange market. A fall in the
exchange rate will make domestic goods and services relatively cheaper than foreign goods and
services. When this happens, net exports will rise which may lead to an improvement in the current
account and hence the balance of payments, assuming the sum of the price elasticities of demand for
exports and imports is greater than one. However, if the sum of the price elasticities of demand for
exports and imports is less than one, which may happen in the short run, a devaluation of domestic
currency will lead to a deterioration in the current account and hence the balance of payments resulting
in a larger deficit. Furthermore, a fall in the exchange rate will lead to a rise in the prices of imports in
domestic currency which may lead to high imported inflation. The rise in the prices of imported
intermediate goods may also lead to high cost-push inflation which may reduce export
competitiveness and hence render devaluation an ineffective measure for correcting a persistent
balance of payments deficit.

Protectionism (Expenditure-switching Policy)

To correct a persistent balance of payments deficit, the government can engage in protectionism.
Protectionism is the use of measures by the government to protect domestic industries from foreign
competition. For example, the government can protect domestic industries by increasing tariffs to
increase the prices of imports. When this happens, households and firms will switch from imports to
domestic goods which will lead to a decrease in import expenditure resulting in an improvement in the
current account and hence the balance of payments. However, protectionism through some measures
such as increasing tariffs will lead to higher prices for consumers. Furthermore, protectionism will
reduce competition which may foster inefficiency.

In addition to the limitations of devaluation and protectionism discussed above, the policies are
criticised on other grounds. First, if the trading partners retaliate, export revenue will fall which will
worsen the current account and hence the balance of payments. Second, export revenue may also fall
in the absence of retaliation if devaluation and protectionism lead to a fall in the national incomes and
hence the imports of the trading partners. Third, if the persistent balance of payments deficit is due to a
high cost of production or low product quality in the economy, devaluation and protectionism will not
solve the root cause of the problem.

Contractionary Fiscal Policy (Expenditure-reducing Policy)

To correct a persistent balance of payments deficit, the government can use contractionary fiscal
policy. Fiscal policy is a demand-side policy that is used to control government expenditure or
taxation to influence aggregate demand. The government can decrease expenditure on goods and
services. It can also decrease disposable income to decrease consumption expenditure by increasing
direct taxes such as personal income tax and corporate income tax or decreasing transfer payments. In
addition to a decrease in consumption expenditure, an increase in corporate income tax will lead to
lower expected after-tax returns on planned investments resulting in a decrease in investment
expenditure. A decrease in consumption expenditure, investment expenditure and government
expenditure on goods and services will lead to a decrease in aggregate demand which will induce
firms to decrease production resulting in a decrease in national output. When firms decrease
production, they will employ less factor inputs from households and hence will pay them less factor
income which will lead to a decrease in national income. When national income falls, imports will fall
which will lead to an improvement in the current account and hence the balance of payments. A
decrease in aggregate demand will also lead to a fall in the general price level which may make
domestic goods and services relatively cheaper than foreign goods and services resulting in an increase
in net exports. If this happens, assuming the demand for exports is price elastic, the current account
and hence the balance of payments will improve. However, as discussed earlier, contractionary fiscal
policy will lead to a decrease in national output and hence national income. A decrease in national
output will lead to a fall in the demand for labour in the economy resulting in a rise in unemployment.
Furthermore, if the marginal propensity to import is small, the effect of a fall in national income on the
balance of payments may not be significant. In addition, contractionary fiscal policy may be subject to
limitations such as a small multiplier and inflexibility of government expenditure and taxation.
Contractionary fiscal policy will be explained in greater detail in Chapter 12.

Contractionary Monetary Policy (Expenditure-reducing Policy)

To correct a persistent balance of payments deficit, the central bank can use contractionary monetary
policy. Monetary policy is a demand-side policy that is used to control the money supply and hence
interest rates to influence aggregate demand. The central bank can decrease the money supply by
conducting an open market sale. When the money supply decreases, the amount of reserves in the
banking system will fall. When this happens, interbank rates will rise which will lead to a rise in the
level of interest rates in the economy. Higher interest rates will increase the incentive to save and the
costs of borrowing and this will lead to a decrease in consumption expenditure. Furthermore, an
increase in the costs of borrowing will lead to fewer profitable planned investments resulting in a
decrease in investment expenditure. A decrease in consumption expenditure and investment
expenditure will lead to a decrease in aggregate demand which will induce firms to decrease
production resulting in a decrease in national output. When firms decrease production, they will
employ less factor inputs from households and hence will pay them less factor income which will lead
to a decrease in national income. When national income falls, imports will fall which will lead to an
improvement in the current account and hence the balance of payments. A decrease in aggregate
demand will also lead to a fall in the general price level which may make domestic goods and services
relatively cheaper than foreign goods and services resulting in an increase in net exports. If this
happens, assuming the demand for exports is price elastic, the current account and hence the balance
of payments will improve. However, as discussed earlier, contractionary monetary policy will lead to a
decrease in national output and hence national income. A decrease in national output will lead to a fall
in the demand for labour in the economy resulting in a rise in unemployment. Furthermore, if the
marginal propensity to import is small, the effect of a fall in national income on the balance of
payments may not be significant. In addition, contractionary monetary policy may be subject to
limitations such as a small multiplier and low interest elasticity of investment and consumption.
Contractionary monetary policy will be explained in greater detail in Chapter 12.

Supply-side Policies

To correct a persistent balance of payments deficit, the government can use supply-side policies.
Supply-side policies are policies that are used to increase the production capacity in the economy and
hence aggregate supply. For example, the government can use education and training and research and
development to increase the production capacity in the economy and hence aggregate supply.
Education and training will lead to greater human capital which will increase the skills and knowledge
of labour in the economy. The government can provide education and training directly, by setting up
educational institutes, or indirectly, by giving subsidies or tax incentives to firms to encourage them to
send their workers for education and training. Research and development will lead to technological
advancement which will increase the efficiency of capital in the economy. The government can
engage in research and development directly, by setting up research institutes, or indirectly, by giving
subsidies or tax incentives to firms to encourage them to engage in research and development. In
addition to an increase in aggregate supply through increasing the production capacity in the economy,
an increase in the skills and knowledge of labour or the efficiency of capital in the economy will lead
to an increase in aggregate supply through increasing labour productivity and hence decreasing the
cost of production in the economy. Assuming aggregate demand is rising which is the normal state of
the economy, an increase in aggregate supply will lead to a smaller rise in the general price level
resulting in lower inflation and if this makes domestic goods and services relatively cheaper than
foreign goods and services, net exports will increase which will lead to an improvement in the current
account and hence the balance of payments. However, an increase in the production capacity in the
economy and hence aggregate supply will lead to an increase in national output. When firms increase
production, they will employ more factor inputs from households and hence will pay them more factor
income which will lead to an increase in national income. When national income rises, imports will
increase which will lead to a deterioration in the current account and hence the balance of payments.
Furthermore, the effects of supply-side policies will be realised only in the long run. Therefore, they
are ineffective for correcting a persistent balance of payments deficit in the short run.

Note: The J-curve effect is the effect of a devaluation of domestic currency first causing the balance
of trade to worsen and then to improve. Therefore, the graph of the balance of trade over time looks
like the letter J. This occurs because the sum of the price elasticities of demand for exports and
imports is less than one in the short run and greater than one in the long run.

Although contractionary fiscal policy and contractionary monetary policy to correct a persistent
balance of payments deficit have both expenditure-reducing effect and expenditure-switching effect,
they are called expenditure-reducing policies rather than expenditure-switching policies as the
expenditure-reducing effect is the primary objective of the policies.

Although supply-side policies to correct a persistent balance of payments deficit work through
expenditure switching, they are not called expenditure-switching policies as the effectiveness time lag
is longer than that of expenditure-switching policies which include devaluation and protectionism.

CHAPTER 12: MACROECONOMIC POLICIES

1 INTRODUCTION

Recall that the government has some macroeconomic goals: high economic growth, low
unemployment, price stability, a balance of payments equilibrium, environmental protection.
However, these goals may not be achieved due to domestic factors, external factors or both. In the
event that the macroeconomic goals of the government are not achieved, macroeconomic problems
will occur which include low or negative economic growth, high unemployment, high inflation and
persistent balance of payments disequilibrium. As these problems have adverse consequences for the
economy, the government will use macroeconomic policies to solve the problems. This chapter
provides an exposition of macroeconomic policies.
2 DEMAND-SIDE POLICIES: FISCAL POLICY

2.1 Objectives of Fiscal Policy

Demand-side policies are policies that are used to influence aggregate demand. There are two demand-
side policies: fiscal policy and monetary policy.

Fiscal policy is a demand-side policy that is used to control government expenditure or taxation to
influence aggregate demand.

Expansionary Fiscal Policy

To increase economic growth or decrease unemployment, the government can increase expenditure on
goods and services. For example, the Singapore government implemented the Resilience Package
which included an increase in expenditure on infrastructure to increase economic growth in the 2008-
2009 Global Financial Crisis. It can also increase disposable income to increase consumption
expenditure by decreasing direct taxes such as personal income tax and corporate income tax or
increasing transfer payments. In addition to an increase in consumption expenditure, a decrease in
corporate income tax will lead to higher expected after-tax returns on planned investments resulting in
an increase in investment expenditure. An increase in consumption expenditure, investment
expenditure and government expenditure on goods and services will lead to an increase in aggregate
demand which will induce firms to increase production resulting in an increase in national output.
When firms increase production, they will employ more factor inputs from households and hence will
pay them more factor income which will lead to an increase in national income. An increase in
national output will lead to a rise in the demand for labour in the economy resulting in a fall in
unemployment.

Contractionary Fiscal Policy

To reduce inflation, the government can decrease expenditure on goods and services. For example,
many European governments reduced expenditure on goods and services in the early 1980s to reduce
inflation caused by the sharp rise in oil prices. It can also decrease disposable income to decrease
consumption expenditure by increasing direct taxes such as personal income tax and corporate income
tax or decreasing transfer payments. In addition to a decrease in consumption expenditure, an increase
in corporate income tax will lead to lower expected after-tax returns on planned investments resulting
in a decrease in investment expenditure. A decrease in consumption expenditure, investment
expenditure and government expenditure on goods and services will lead to a decrease in aggregate
demand. Assuming aggregate demand and hence the general price level is rising rapidly, this will
reduce the growth of aggregate demand which will lead to a slower rise in the general price level
resulting in lower inflation.

2.2 Limitations of Fiscal Policy

Inflexibility of Government Expenditure and Taxation

Changing government expenditure and taxation involves a high degree of inflexibility as fiscal
budgets are subject to parliamentary debates and approvals which may take months. This is known as
the decision time lag. An example is the United States where lawmakers often vote along party lines
which hinders the passage of some fiscal budgets in the Congress. Furthermore, it is difficult to
decrease government expenditure on goods and services significantly as a large part of it is made on
important areas such as education, healthcare, infrastructure and national defence.

Crowding-out Effect
The crowding-out effect is the effect of an increase in government expenditure on goods and services
resulting in a decrease in private expenditure. An increase in government expenditure on goods and
services due to expansionary fiscal policy is likely to lead to a budget deficit. If the government runs a
budget deficit, it will borrow by issuing securities (i.e. bonds and bills) to finance the deficit, assuming
it does not have sufficient reserves. When this happens, the demand for loanable funds will rise which
will lead to a rise in interest rates. Higher interest rates will increase the incentive to save and the costs
of borrowing and this will lead to a decrease in consumption expenditure. Furthermore, an increase in
the costs of borrowing will lead to fewer profitable planned investments resulting in a decrease in
investment expenditure. A decrease in consumption expenditure and investment expenditure will lead
to a decrease in aggregate demand. Therefore, the increase in government expenditure on goods and
services may not lead to a significant increase in aggregate demand.

Small Multiplier

Recall that an economy with high income taxes, high savings and high imports will have a small
multiplier. For example, Singapore has a small multiplier due to the high savings and high imports.
The savings rate in Singapore is high due to the culture of thrift, the compulsory savings scheme and
the absence of a generous welfare system. The level of imports in Singapore is high due to lack of
factor endowments and the embracement of free trade. If the multiplier is small, the initial change in
aggregate demand due to the change in consumption expenditure, investment expenditure and
government expenditure on goods and services may not lead to a significant change in national output
and hence national income, unemployment and inflation.

Changing Sentiment

When disposable income rises due to a decrease in direct taxes or an increase in transfer payments,
consumption expenditure may not increase if households are less optimistic about the economic
outlook. A decrease in corporate income tax may not lead to higher expected after-tax returns on
planned investments and hence higher investment expenditure if business sentiment falls. Similarly,
when disposable income falls due to an increase in direct taxes or a decrease in transfer payments,
consumption expenditure may not decrease if households are more optimistic about the economic
outlook. An increase in corporate income tax may not lead to lower expected after-tax returns on
planned investments and hence lower investment expenditure if business sentiment rises.

Note: A budget deficit occurs when government expenditure exceeds government revenue. A budget
surplus, in contrast, occurs when government revenue exceeds government expenditure. Public debt
refers to the amount of money that the government owes. It is also known as national debt, sovereign
debt and government debt. A budget deficit will lead to a rise in public debt and a budget surplus will
lead to a fall in public debt.

Public debt-to-GDP ratio refers to public debt expressed as a percentage of Gross Domestic Product
(GDP). A persistently large budget deficit will lead to a rising public debt-to-GDP ratio. Austerity
measures refer to the measures used by the government to reduce a budget deficit which include
spending cuts and tax increases. In order to reduce the public debt-to-GDP ratio, many European
governments have been implementing austerity measures since the early 2010s.

2.3 Supply-side Effect of Fiscal Policy

Fiscal policy is referred to as a demand-side policy because it is used to influence aggregate demand.
However, apart from aggregate demand, fiscal policy may also have an effect on aggregate supply. For
example, government expenditure on education and training will lead to greater human capital which
will increase the skills and knowledge of labour in the economy. Government expenditure on research
and development will lead to technological advancement which will increase the efficiency of capital
in the economy. Government expenditure on infrastructure will lead to an increase in investment
expenditure resulting in a more rapid increase in the quantity of capital in the economy. A decrease in
corporate income tax will increase expected after-tax returns on planned investments and hence
investment expenditure resulting in a more rapid increase in the quantity of capital in the economy. A
decrease in personal income tax will increase after-tax personal income resulting in an increase in the
quantity of labour in the economy. An increase in the quantity of capital, the quantity of labour, the
efficiency of capital and the skills and knowledge of labour in the economy will lead to an increase in
the production capacity in the economy. In addition, an increase in the efficiency of capital and the
skills and knowledge of labour in the economy will lead to an increase in labour productivity resulting
in a fall in the cost of production in the economy. An increase in the production capacity and a fall in
the cost of production in the economy will lead to an increase in aggregate supply. However, when
economists talk about fiscal policy, unless otherwise stated, they are normally referring to the use of it
to influence aggregate demand..

Supply-side policies are policies that are used to increase the production capacity in the economy and
hence aggregate supply. Fiscal policy with a supply-side intent is a supply-side policy which involves
using government expenditure or taxation to increase the production capacity in the economy and
hence aggregate supply. However, not all supply-side policies involve using government expenditure
or taxation to increase the production capacity in the economy and hence aggregate supply.
Therefore, fiscal policy with a supply-side intent is a subset of supply-side policies.

2.4 Automatic Fiscal Stabilisers

Expansionary fiscal policy and contractionary fiscal policy are known as discretionary fiscal policies
as the policies involve deliberate government policy action. However, apart from discretionary fiscal
policies, there are also non-discretionary fiscal policies which are commonly known as automatic
fiscal stabilisers. Automatic fiscal stabilisers are government expenditure and taxation which reduce
economic fluctuations without involving any deliberate government policy action. Examples of
automatic fiscal stabilisers include income taxes and unemployment benefits. Income taxes and
unemployment benefits reduce economic fluctuations by decreasing the size of the multiplier and
hence the multiplier effect and the reverse multiplier effect.

Assume that the economy is at or near the full-employment equilibrium. Further assume that
autonomous expenditure decreases which will lead to a decrease in aggregate demand resulting in a
decrease in national output and hence national income. When firms decrease production in response to
a decrease in aggregate demand due to a decrease in autonomous expenditure, they will employ less
factor inputs from households and hence will pay them less factor income resulting in a decrease in
national income. When national income falls which will lead to a decrease in disposable income,
households will decrease consumption expenditure which will lead to a further decrease in aggregate
demand and this will induce firms to further decrease production. When this happens, firms will
employ even less factor inputs from households and hence will pay them even less factor income. The
further decrease in national income and hence disposable income will induce households to further
decrease consumption expenditure resulting in a further decrease in aggregate demand. Therefore, the
initial decrease in aggregate demand due to the decrease in autonomous expenditure will lead to
decreases in consumption expenditure and hence further decreases in aggregate demand resulting in a
larger decrease in national output and hence national income. This is commonly known as the reverse
multiplier effect. If the size of the multiplier and hence the reverse multiplier effect is large, the initial
decrease in aggregate demand due to the decrease in autonomous expenditure will lead to a large
decrease in national output and hence national income, causing the economy to fall into a severe
recession. Income taxes and unemployment benefits will reduce the severity of the recession by
decreasing the size of the multiplier and hence the reverse multiplier effect. When national income
falls, households will pay less income taxes and this is particularly true in view of the progressive
nature of income taxes. Furthermore, the decrease in national output will lead to a decrease in the
demand for labour in the economy resulting in a rise in unemployment and this will increase the
amount of unemployment benefits received by households. Given any decrease in national income, a
decrease in income taxes paid by households and an increase in unemployment benefits received by
them will reduce the extent of the decrease in disposable income and hence the extent of the decrease
in consumption expenditure resulting in a smaller decrease in national output and hence national
income, given any decrease in aggregate demand due to a decrease in autonomous expenditure.

Similarly, an increase in aggregate demand due to an increase in autonomous expenditure will lead to
increases in consumption expenditure and hence further increases in aggregate demand resulting in a
larger increase in national output and hence national income. This is commonly known as the
multiplier effect. In addition to an increase in national output and hence national income, an increase
in aggregate demand will lead to a rise in the general price level resulting in higher inflation. If the
size of the multiplier and hence the multiplier effect is large, the cumulative increase in aggregate
demand will be large which will lead to a substantial rise in the general price level resulting in high
inflation. Income taxes and unemployment benefits will reduce inflation by decreasing the size of the
multiplier and hence the multiplier effect. When national income rises, households will pay more
income taxes and this is particularly true in view of the progressive nature of income taxes.
Furthermore, the increase in national output will lead to an increase in the demand for labour in the
economy resulting in a fall in unemployment and this will decrease unemployment benefits received
by households. Given any increase in national income, an increase in income taxes paid by households
and a decrease in unemployment benefits received by them will reduce the extent of the increase in
disposable income and hence the extent of the increase in consumption expenditure resulting in a
smaller cumulative increase in aggregate demand and hence lower inflation, given any increase in
aggregate demand due to an increase in autonomous expenditure.

Advantages of Automatic Fiscal Stabilisers over Discretionary Fiscal Policies

Automatic fiscal stabilisers may be better than discretionary fiscal policies due to several reasons.
First, as automatic fiscal stabilisers do not involve any deliberate government policy action, they are
not subject to parliamentary debates and approvals which may take months, which is known as the
decision time lag. In contrast, discretionary fiscal policies involve deliberate government policy action
and are therefore subject to parliamentary debates and approvals and hence the decision time lag.
Second, when national output and hence national income change, income taxes paid by households
and unemployment benefits received by them will change instantly. In other words, automatic fiscal
stabilisers are not subject to the effectiveness time lag. In contrast, the full effects of discretionary
fiscal policies will be realised only after some time as it takes time for the government to change
expenditure and taxation. Therefore, discretionary fiscal policies are subject to the effectiveness time
lag. Third, automatic fiscal stabilisers are not subject to some other limitations of expansionary fiscal
policy which include the crowding-out effect and the high public debt-to-GDP ratio.

Advantages of Discretionary Fiscal Policies over Automatic Fiscal Stabilisers

Discretionary fiscal policies may be better than automatic fiscal stabilisers due to several reasons.
First, when the economy falls into a recession, although automatic fiscal stabilisers will reduce the
severity of the recession by decreasing the size of the multiplier and hence the reverse multiplier
effect, they will not steer the economy back onto the path of expansion as they will not produce any
expansionary effect on the economy. In contrast, in a recession, as expansionary fiscal policy works
through increasing aggregate demand which will boost the economy, it may steer the economy back
onto the path of expansion. This is particularly true if the economy is highly dependent on domestic
demand. Second, income taxes and unemployment benefits are known as automatic fiscal stabilisers
when the economy is at or near the full-employment equilibrium. However, when the economy is at a
below full-employment equilibrium which means the existence of a negative output gap, income taxes
and unemployment benefits are called fiscal drags. This is because in such a state of the economy,
income taxes and unemployment benefits which will decrease the size of the multiplier and hence the
multiplier effect will create a drag on the expansion of the economy in the event of an increase in
autonomous expenditure which may occur due to government policy action, making it harder for the
economy to move to the full-employment equilibrium. Third, the higher the income taxes and
unemployment benefits, the more effective the automatic fiscal stabilisers. However, high income
taxes will reduce the ability of the economy to attract foreign direct investments and foreign talents,
the incentive to work and the incentive for skills upgrading. Furthermore, high unemployment benefits
which will reduce the hardship of unemployment will induce workers who are frictionally unemployed
to spend more time looking for a job which will lead to a rise in frictional unemployment resulting in a
rise in the natural rate of unemployment.

Note: Although income taxes are progressive, the progressive nature of these taxes is not a requisite
for the automatic fiscal stabilisers to work.

Unless otherwise stated, fiscal policy refers to discretionary fiscal policy.

3 DEMAND-SIDE POLICIES: MONETARY POLICY

3.1 Objectives of Monetary Policy

Monetary policy is a demand-side policy that is used to control the money supply and interest rates to
influence aggregate demand.

Recall that the money supply consists of currency in active circulation and deposits. Currency in active
circulation refers to currency held by the public and excludes currency held in bank vaults and
currency held at the central bank. Deposits refer to the financial records of deposits kept by financial
institutions. In order to understand the transmission mechanism of monetary policy, one has to
understand the concepts of open market operations, interbank rates and the bank rate. Open market
operations, which include open market purchases and open market sales, refer to purchases and sales
of securities by the central bank to control the money supply. Interbank rates refer to interest rates
charged on loans made between banks which are determined by the amount of reserves in the banking
system. The bank rate refers to the interest rate charged on loans made by the central bank to banks. In
an economy where interbank rates are lower than the bank rate and hence banks borrow from each
other, such as the United States and Japan, the level of interest rates in the economy varies directly
with interbank rates, particularly the interbank overnight rate which is known as the federal funds rate
in the United States and the uncollateralised overnight call rate in Japan, as the bulk of the loans
between banks are made on an overnight basis. In an economy where the bank rate is lower than
interbank rates and hence banks borrow from the central bank, such as the United Kingdom and the
euro area which consists of 19 economies where the euro is adopted as the official currency, the level
of interest rates in the economy varies directly with the bank rate, which is known as the base rate in
the United Kingdom and the refinancing rate in the euro area.

Expansionary Monetary Policy

To increase economic growth or decrease unemployment in an economy where interbank rates are
lower than the bank rate and hence banks borrow from each other, such as the United States and Japan,
the central bank can increase the money supply by conducting an open market purchase. When the
money supply increases, the amount of reserves in the banking system will rise. When this happens,
interbank rates will fall which will lead to a fall in the level of interest rates in the economy. For
example, the Federal Reserve increased the money supply to lower the federal funds rate from 5.25 per
cent in September 2007 to 0-0.25 per cent in December 2008 to boost the economy. To increase
economic growth or decrease unemployment in an economy where the bank rate is lower than
interbank rates and hence banks borrow from the central bank, such as the United Kingdom and the
euro area, the central bank can lower the bank rate to decrease the level of interest rates in the
economy. For example, the Bank of England cut the base rate from 5.75 per cent in December 2007 to
0.5 per cent in March 2009 to boost the economy. Lower interest rates will decrease the incentive to
save and the costs of borrowing and this will lead to an increase in consumption expenditure.
Furthermore, a decrease in the costs of borrowing will lead to more profitable planned investments
resulting in an increase in investment expenditure. An increase in consumption expenditure and
investment expenditure will lead to an increase in aggregate demand which will induce firms to
increase production resulting in an increase in national output. When firms increase production, they
will employ more factor inputs from households and hence will pay them more factor income which
will lead to an increase in national income. An increase in national output will lead to a rise in the
demand for labour in the economy resulting in a fall in unemployment.

Contractionary Monetary Policy

To reduce inflation in an economy where interbank rates are lower than the bank rate and hence banks
borrow from each other, such as the United States and Japan, the central bank can decrease the money
supply by conducting an open market sale. When the money supply decreases, the amount of reserves
in the banking system will fall. When this happens, interbank rates will rise which will lead to a rise in
the level of interest rates in the economy. For example, the Federal Reserve decreased the money
supply to raise the federal funds rate in the 1979 oil crisis to combat inflation. To reduce inflation in an
economy where the bank rate is lower than interbank rates and hence banks borrow from the central
bank, such as the United Kingdom and the euro area, the central bank can raise the bank rate to
increase the level of interest rates in the economy. For example, the Bank of England raised the base
rate in the 1979 oil crisis to combat inflation. Higher interest rates will increase the incentive to save
and the costs of borrowing and this will lead to a decrease in consumption expenditure. Furthermore,
an increase in the costs of borrowing will lead to fewer profitable planned investments resulting in a
decrease in investment expenditure. A decrease in consumption expenditure and investment
expenditure will lead to a decrease in aggregate demand. Assuming aggregate demand and hence the
general price level is rising rapidly, this will reduce the growth of aggregate demand which will lead to
a slower rise in the general price level resulting in lower inflation.

Note: Expansionary monetary policy will not only increase aggregate demand through increasing
consumption expenditure and investment expenditure, it will also increase aggregate demand through
increasing net exports. Hot money refers to money that moves quickly between countries in search of
the highest short-term returns. A major source of hot money is bank deposits which are highly
responsive to changes in interest rates. Lower interest rates will lead to a decrease in hot money
inflows and an increase in hot money outflows and hence a decrease in the demand for domestic
currency and an increase in the supply resulting in a fall in the exchange rate. When this happens,
domestic goods and services will become relatively cheaper than foreign goods and services which
will lead to an increase in net exports and hence aggregate demand. However, students are not
required to explain this in the examination unless the question specifically asks for it.

3.2 Limitations of Monetary Policy

Liquidity Trap

In the United States and Japan, the central banks decrease the level of interest rates in the economy
through decreasing interbank rates by increasing the money supply and hence the amount of reserves
in the banking system. Therefore, when interbank rates are near zero, an increase in the money supply
and hence the amount of reserves in the banking system will not lead to a fall in interbank rates and
hence the level of interest rates in the economy, as least not significantly. When this happens,
consumption expenditure and investment expenditure will not rise, at least not significantly. This is
known as the liquidity trap. An example is the United States where the federal funds rate was 0-0.25
per cent between December 2008 and December 2015. In the United Kingdom and the euro area, a
liquidity trap occurs when the bank rate is near zero. For example, the Bank of England cut the base
rate to 0.1 per cent in March 2020 in response to the pandemic of COVID-19.

Low Interest Elasticity of Investment and Consumption

If investment is interest inelastic, a change in interest rates is likely to lead to a small change in
investment. Investment may be interest inelastic due to a problem of over-capacity in the economy or
weak business sentiment which may occur when the economy is weak. Similarly, if consumption is
interest inelastic, a change in interest rates is likely to lead to a small change in consumption.
Consumption may be interest inelastic due to weak consumer sentiment which may occur when the
economy is weak.

Credit Crunch

A credit crunch is a situation where it is difficult to obtain credit due to a substantial decrease in the
availability of credit from banks. Due to factors such as a rise in the default rate, banks may reduce
lending which may lead to a credit crunch. If a credit crunch occurs in the United States or Japan, an
increase in the money supply and hence the amount of reserves in the banking system may not lead to
a fall in interbank rates. Even if interbank rates do fall as a result of the increase in the money supply
and hence the amount of reserves in the banking system, the level of interest rates in the economy may
not fall due to the decrease in the supply of loanable funds as banks tighten credit. Therefore,
consumption expenditure and investment expenditure may not rise. In the event of a credit crunch in
the United Kingdom or the euro area, a cut in the bank rate may not lead to a fall in the level of
interest rates in the economy.

Small Multiplier

Recall that an economy with high income taxes, high savings and high imports will have a small
multiplier. For example, Singapore has a small multiplier due to the high savings and the high imports.
The savings rate in Singapore is high due to the culture of thrift, the compulsory savings scheme and
the absence of a generous welfare system. The level of imports in Singapore is high due to lack of
factor endowments and the embracement of free trade. If the multiplier is small, the initial change in
aggregate demand due to the change in consumption expenditure and investment expenditure may not
lead to a significant change in national output and hence national income, unemployment and
inflation.

Changing Sentiment

When interest rates fall due to an increase in the money supply, consumption expenditure may not
increase if households are less optimistic about the economic outlook. A fall in interest rates may not
lead to an increase in investment expenditure if business sentiment falls. Similarly, when interest rates
rise due to a decrease in the money supply, consumption expenditure may not decrease if households
are more optimistic about the economic outlook. A rise in interest rates may not lead to a decrease in
investment expenditure if business sentiment rises.

3.3 Supply-side Effect of Monetary Policy

Monetary policy is referred to as demand-side policy because it is used to influence aggregate demand.
However, apart from aggregate demand, monetary policy also has an effect on aggregate supply.
Expansionary monetary policy will lead to an increase in investment expenditure resulting in a more
rapid increase in the quantity of capital in the economy, assuming net investment is initially positive.
When this happens, the production capacity in the economy will increase at a faster rate which will
lead to a more rapid increase in aggregate supply. Conversely, contractionary monetary policy will
lead to a decrease in investment expenditure resulting in a less rapid increase in the quantity of capital
in the economy, assuming net investment remains positive. When this happens, the production
capacity in the economy will increase at a slower rate which will lead to a less rapid increase in
aggregate supply. However, when economists talk about monetary policy, unless otherwise stated,
they are referring to the use of it to influence aggregate demand.
3.4 Quantitative Easing

As discussed earlier, expansionary monetary policy is subject to the limitation of liquidity trap which
occurs when interbank rates are near zero in the United States or Japan or the bank rate is near zero in
the United Kingdom or the euro area. An example is the United States where the federal funds rate
was 0-0.25 per cent between December 2008 and December 2015. However, in the event of a liquidity
trap, monetary policy can still be effective for boosting the economy, albeit in a different way from the
conventional monetary policy explained in Section 3.1. Such unconventional monetary policy is called
quantitative easing.

Quantitative easing is an unconventional monetary policy where the central bank increases the money
supply substantially when the economy is in a liquidity trap. Unlike conventional monetary policy
which involves purchasing short-term government securities, quantitative easing generally involves
purchasing asset-backed securities in addition to purchasing short-term government securities.
Economists have put forward several reasons why a substantial increase in the money supply by the
central bank when the economy is in a liquidity trap can have an expansionary effect on the economy.

Reduce Interest Rates

As quantitative easing will increase the amount of reserves in the banking system substantially, it will
induce banks to increase lending. When this happens, the supply of loanable funds will increase which
will lead to a fall in interest rates. Lower interest rates will decrease the incentive to save and the costs
of borrowing and this will lead to an increase in consumption expenditure. Furthermore, a decrease in
the costs of borrowing will lead to more profitable planned investments resulting in an increase in
investment expenditure. An increase in consumption expenditure and investment expenditure will lead
to an increase in aggregate demand which will induce firms to increase production resulting in an
increase in national output. When firms increase production, they will employ more factor inputs from
households and hence will pay them more factor income which will lead to an increase in national
income. An increase in national output will lead to a rise in the demand for labour in the economy
resulting in a fall in unemployment.

Reduce the Exchange Rate

When interest rates fall due to an increase in the supply of loanable funds as a result of quantitative
easing, hot money inflows will fall and hot money outflows will rise. When this happens, the demand
for domestic currency will fall and the supply will rise which will lead to a fall in the exchange rate. A
depreciation of domestic currency will make domestic goods and services relatively cheaper than
foreign goods and services which will lead to an increase in net exports. When this happens, aggregate
demand will rise which will lead to an increase in national output and hence national income resulting
in a fall in unemployment.

Reduce Long-term Interest Rates (Optional but good to know)

Instead of purchasing government bills or short-term government bonds which is typically done with
conventional expansionary monetary policy, the central bank can conduct quantitative easing through
purchasing long-term government bonds. An example is the United States where the Federal Reserve
purchased 10-year US Treasury bonds for its three quantitative easing programmes. When the central
bank purchases long-term government bonds and hence increase the demand, the prices will rise.
When this happens, the effective coupon rates on long-term government bonds will fall which will
reduce interest rates on long-term loans such as housing loans. When this happens, the demand for
housing will rise which will lead to an increase in aggregate demand. This will lead to an increase in
national output and hence national income resulting in a fall in unemployment.

Limitations of Quantitative Easing

As the central bank will increase the money supply substantially under quantitative easing, this may
lead to a situation of ‘too much money chasing too few goods’. If this happens, high inflation may
ensue.

Note: In the 2008-2009 Global Financial Crisis, the Federal Reserve was aggressive in the use of
quantitative easing. In contrast, the European Central Bank started using quantitative easing much
later. This could explain why the U.S. economy started recovering from the 2008-2009 Global
Financial Crisis before the European economies did.

4 EXCHANGE RATE POLICY

4.1 Objectives of Exchange Rate Policy

Exchange rate policy is a policy that is used to control the exchange rate through central bank
intervention in the foreign exchange market.

Devaluation

To increase economic growth or decrease unemployment, the central bank can devalue domestic
currency by selling domestic currency and buying foreign currency in the foreign exchange market. A
fall in the exchange rate will make domestic goods and services relatively cheaper than foreign goods
and services. When this happens, net exports will rise which will lead to an increase in aggregate
demand. This will induce firms to increase production resulting in an increase in national output.
When firms increase production, they will employ more factor inputs from households and hence will
pay them more factor income which will lead to an increase in national income. An increase in
national output will lead to a rise in the demand for labour in the economy resulting in a fall in
unemployment.

Revaluation

To reduce inflation, the central bank can revalue domestic currency by buying domestic currency and
selling foreign currency in the foreign exchange market. A rise in the exchange rate will make
domestic goods and services relatively more expensive than foreign goods and services. When this
happens, net exports will fall which will lead to a decrease in aggregate demand. Assuming aggregate
demand and hence the general price level is rising rapidly, this will reduce the growth of aggregate
demand which will lead to a slower rise in the general price level resulting in lower demand-pull
inflation. In the face of strong external price pressures, a rise in the exchange rate will also reduce the
rise in the prices of imports in domestic currency resulting in lower imported inflation.

4.2 Limitations of Exchange Rate Policy

Devaluation

Devaluation is subject to several limitations. First, a devaluation of domestic currency will lead to a
rise in the prices of imported intermediate goods in domestic currency. When this happens, the cost of
production in the economy will rise which will lead to a decrease in aggregate supply resulting in a
decrease in national output and hence national income. Therefore, the increase in aggregate demand
due to the increase in net exports may not lead to a significant increase in national output and hence
national income. Second, a continual devaluation of domestic currency may induce people to sell the
currency in anticipation of further falls in the exchange rate. This may lead to currency instability
which will result in capital flight and a fall in foreign direct investments. Capital flight will lead to a
fall in asset prices resulting in a fall in the wealth of households and hence consumption expenditure.
A fall in consumption expenditure and investment expenditure will lead to a decrease in aggregate
demand resulting in a decrease in national output and hence national income. Third, if the sum of the
price elasticities of demand for exports and imports is less than one, which may happen in the short
run, a devaluation of domestic currency will lead to a deterioration in the current account and hence
the balance of payments.

Revaluation

Revaluation is subject to several limitations. First, a revaluation of domestic currency to reduce

imported inflation may lead to a decrease in net exports which will lead to a decrease in aggregate
demand, and this is particularly true if the external demand is weak. This will lead to a decrease in
national output and hence national income resulting a rise in unemployment Second, if the sum of the
price elasticities of demand for exports and imports is greater than one, a revaluation of domestic
currency will lead to a deterioration in the current account and hence the balance of payments. Third,
if the central bank does not have foreign exchange reserves, it may not be able to revalue domestic
currency.

5 SUPPLY-SIDE POLICIES

5.1 Objectives of Supply-side Policies

Supply-side policies are policies that are used to increase the production capacity in the economy and
hence aggregate supply. The production capacity in the economy can be increased through increasing
the quantity or the quality of the factors of production in the economy. Although supply-side policies
are used to increase the production capacity in the economy, they may also decrease the cost of
production in the economy. For example, in addition to an increase in the production capacity in the
economy, an increase in the quality of labour or the quality of capital in the economy will lead to an
increase in labour productivity and hence a fall in the cost of production in the economy resulting in an
increase in aggregate supply. As discussed in Chapter 11, potential economic growth is an increase in
potential output and actual economic growth is an increase in actual output. An increase in the
production capacity in the economy and hence aggregate supply will lead to potential economic
growth. Potential economic growth per se will not lead to a rise in the standard of living. However, as
actual economic growth is constrained by potential economic growth, potential economic growth is
essential for achieving sustained economic growth. Apart from potential economic growth, an increase
in the production capacity in the economy and hence aggregate supply will also lead to actual
economic growth, although to a lesser extent. In addition, assuming aggregate demand is rising which
is the normal state of the economy, an increase in the production capacity in the economy and hence
aggregate supply will lead to lower inflation.

Supply-side policies can be classified into interventionist supply-side policies and market-oriented
supply-side policies. Interventionist supply-side policies are policies that are used to increase the
production capacity in the economy and hence aggregate supply through government intervention that
reduces the deficiencies of the market. Market-oriented supply-side policies are policies that are used
to increase the production capacity in the economy and hence aggregate supply by freeing up the
market. The following is a list of supply-side policies that are useful for the examination.

Interventionist Supply-side Policies

Education and Training

Education and training will lead to greater human capital which will increase the skills and knowledge
of labour in the economy. The government can provide education and training directly, by setting up
educational institutes, or indirectly, by giving subsidies or tax incentives to firms to encourage them to
send their workers for education and training. For example, the Singapore government has set up the
Institute of Technical Education, polytechnics and Continuing Education and Training campuses to
provide education and training.
Research and Development

Research and development will lead to technological advancement which will increase the efficiency
of capital in the economy. The government can engage in research and development directly, by
setting up research institutes, or indirectly, by giving subsidies or tax incentives to firms to encourage
them to engage in research and development. For example, the Singapore government has set up the
Biomedical Research Council (BMRC) and the Science and Engineering Research Council (SERC)
under the Agency for Science, Technology and Research (A*STAR) to engage in research and
development.

Infrastructural Development

Government expenditure on infrastructure will increase investment expenditure which will lead to a
more rapid increase in the quantity of capital in the economy. For example, the Singapore government
has provided infrastructures such as Jurong Island for high-end chemical manufacturing and Biopolis
for pharmaceutical manufacturing which have attracted many foreign high-end chemical firms and
pharmaceutical firms to invest in Singapore.

Market-oriented Supply-side Policies

Privatisation

Privatisation refers to the conversion of a state-owned firm to a private firm. Unlike state-owned firms,
private firms need to consider factors such as profitability and survival. Therefore, privatisation will
induce firms to increase labour productivity to reduce costs. It may also lead to an increase in the
number of firms in the market and hence greater competition which will induce firms to increase
labour productivity to reduce costs. To increase labour productivity, firms will engage in research and
development, adopt better production technologies or engage in education and training. Research and
development will lead to technological advancement. Technological advancement and adoption of
better production technologies will increase the efficiency of capital in the economy. Education and
training will lead to greater human capital which will increase the skills and knowledge of labour in
the economy.

Deregulation

Deregulation refers to the removal of restrictive regulations. Deregulation will lead to an increase in
the number of firms in the market and hence greater competition which will induce firms to increase
labour productivity to reduce costs. To increase labour productivity, firms will engage in research and
development, adopt better production technologies or engage in education and training. Research and
development will lead to technological advancement. Technological advancement and adoption of
better production technologies will increase the efficiency of capital in the economy. Education and
training will lead to greater human capital which will increase the skills and knowledge of labour in
the economy.

Cuts in Income Taxes and Capital Gains Tax

A decrease in personal income tax will increase after-tax personal income resulting in an increase in
the quantity of labour in the economy. A decrease in corporate income tax will increase expected
after-tax returns on planned investments and hence investment expenditure resulting in a more rapid
increase in the quantity of capital in the economy. A capital gains tax is a tax imposed on the profit
from the sale of a certain type of asset. For example, many governments impose a capital gains tax on
the profit from the sale of properties. A decrease in capital gains tax on properties will increase the
incentive to invest and hence investment expenditure resulting in a more rapid increase in the quantity
of capital in the economy.
Labour Market Reforms

The government can implement labour market reforms to increase the quantity of labour in the
economy. For example, it can increase retirement age and incentivise firms to employ older workers
through subsidies or tax incentives. It can encourage firms to provide flexible work arrangements
which will encourage non-working mothers to enter the labour force. It can loosen restrictions on
foreign workers through increasing the dependency ratio ceiling, reducing the foreign worker levy or
lowering the eligibility criteria for the application of work pass, which will increase the number of
foreign workers. It can loosen restrictions on immigrants through lowering the eligibility criteria for
the application of citizenship or permanent residence, which will increase the number of immigrants.

Trade Liberalisation

A reduction in tariffs and non-tariff barriers will lead to greater competition which will induce firms to
increase labour productivity to reduce costs. To increase labour productivity, firms will engage in
research and development, adopt better production technologies or engage in education and training.
Research and development will lead to technological advancement. Technological advancement and
adoption of better production technologies will increase the efficiency of capital in the economy.
Education and training will lead to greater human capital which will increase the skills and knowledge
of labour in the economy.

Note: Although supply-side policies are mainly used to increase the production capacity in the
economy, many supply-side policies will also lead to a decrease in the cost of production in the
economy. For example, education and training will lead to an increase in labour productivity
resulting in a fall in the cost of production in the economy. Nevertheless, the main objective of supply-
side policies is to increase the production capacity rather than to decrease the cost of production in
the economy. In the examination, students are often required to explain how supply-side policies can
be used to increase the production capacity in the economy to achieve potential economic growth.

The effect of supply-side policies will fall more on potential output than on actual output. Indeed, if the
economy is far from the full-employment equilibrium¸ actual output may not rise, at least not
significantly.

5.2 Limitations of Supply-side Policies

The effects of supply-side policies will be realised only in the long run and this long effectiveness time
lag makes them ineffective in the short run. For example, it takes time for education and training to
increase the skills and knowledge of labour in the economy. Furthermore, although supply-side
policies can be used to increase actual output, the effect will fall more on potential output than on
actual output. Indeed, if the economy is far from the full-employment equilibrium¸ actual output may
not rise, at least not significantly. Therefore, supply-side policies may not be effective for increasing
actual economic growth.

5.3 Demand-side Effect of Supply-side Policies

Although supply-side policies are used to increase aggregate supply, they may also lead to an increase
in aggregate demand. This is particularly true for interventionist supply-side policies, although some
market-oriented supply-side policies will also increase aggregate demand. For example, to increase the
skills and knowledge of labour in the economy, the government may increase expenditure on
education and training directly. Similarly, the government may increase expenditure on research and
development directly to increase the efficiency of capital in the economy. An increase in government
expenditure on goods and services will lead to an increase in aggregate demand. A decrease in
personal income tax to increase the quantity of labour in the economy will lead to an increase in
disposable income resulting in an increase in consumption expenditure. Similarly, a decrease in
corporate income tax to achieve a more rapid increase in the quantity of capital in the economy will
lead to an increase in investment expenditure, apart from an increase in consumption expenditure. An
increase in consumption expenditure and investment expenditure will lead to an increase in aggregate
demand.

6 SHORT-TERM SUPPLY-SIDE POLICIES

6.1 Objectives of Short-term Supply-side Policies

Short-term supply-side policies are policies that are used to decrease the cost of production in the
economy in the short term and hence increase aggregate supply.

As explained earlier, the effects of supply-side policies will be realised only in the long run and this
long effectiveness time lag makes them ineffective in the short run. For example, it takes time for
education and training to increase the skills and knowledge of labour in the economy. Therefore,
supply-side policies are generally not used to deal with a recession. However, unlike supply-side
policies, short-term supply-side policies are often used to deal with a recession, as part of a policy mix.
In a recession, the government can increase economic growth by using short-term supply-side policies
to reduce the cost of production in the economy in the short term. When the cost of production in the
economy falls, aggregate supply will rise which will lead to an increase in national output. When firms
increase production, they will employ more factor inputs from households and hence will pay them
more factor income which will lead to an increase in national income. An increase in national output
will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment.

Note: Unlike supply-side policies, short-term supply-side policies will not increase the production
capacity in the economy. Rather, they will only decrease the cost of production in the economy.
Furthermore, although the cost of production in the economy will fall in the short term, it will not stay
at the lower level in the long term. For example, the Jobs Credit Scheme which was implemented by
the Singapore government to decrease the cost of production in the economy in the 2008-2009 Global
Financial Crisis was designed to last only one year.

In theory, the Singapore government can use short-term supply-side policies to reduce inflation,
although this has not been done in reality. As discussed in Chapter 11, this is because inflation in
Singapore is mainly due to external factors and hence exchange rate policy is generally effective for
reducing inflation.

6.2 Limitations of Short-term Supply-side Policies

As Singapore is a small economy that is highly dependent on external demand with the domestic
exports accounting for a large proportion of the aggregate demand, a fall in exports is likely to lead to
a substantial decrease in aggregate demand. Therefore, unless the fall in the cost of production in the
economy is large, the increase in aggregate supply is likely to only partially offset the decrease in
aggregate demand resulting in a smaller decrease in national output and hence national income.
Furthermore, these policies will lead to an increase in the profits of firms which are generally owned
by high income individuals and this may result in a less equitable distribution of income.

7 TRADE POLICY

7.1 Objectives of Trade Policy

A free trade agreement (FTA) is an agreement between two or more economies to remove or reduce
barriers to trade with the objective of increasing the cross-border movement of goods and services
between the economies.
7.2 Limitations of Trade Policy

A major limitation of trade policy in the form of signing FTAs is the long period of time it takes to
negotiate FTAs with the potential partners. For example, the USSFTA was only concluded in May
2003, about two and a half years after negotiations began in November 2000.

8 CONFLICTS BETWEEN MACROECONOMIC GOALS

Although the government has four macroeconomic goals, conflicts between the goals may occur. In
other words, when the government uses a policy to achieve a macroeconomic goal, this may conflict
with another macroeconomic goal. As the government has four macroeconomic goals, there are 12
potential conflicts. The following are some examples of the potential conflicts between the
macroeconomic goals of the government.

Example 1

Suppose that the government decreases unemployment to achieve the macroeconomic goal of low
unemployment. Further suppose that it does so through the use of expansionary demand-side policies.
An increase in aggregate demand will induce firms to increase production resulting in an increase in
national output. When firms increase production, they will employ more factor inputs from households
and hence will pay them more factor income which will lead to an increase in national income. An
increase in national output will lead to a rise in the demand for labour in the economy resulting in a
fall in unemployment. However, an increase in aggregate demand will lead to a shortage of goods and
services resulting in a rise in the general price level and hence higher inflation. Furthermore, when
aggregate demand rises which will induce firms to increase production, the resultant increase in the
demand for factor inputs in the economy will lead to a rise in the prices. When this happens, the cost
of production in the economy will rise which will induce firms to increase prices to maintain
profitability resulting in a rise in the general price level and hence higher inflation. If there are
moderate to high inflationary pressures in the economy, a rise in inflation is likely to lead to high
inflation. Therefore, achieving the macroeconomic goal of low unemployment may conflict with the
macroeconomic goal of low inflation. When national income rises, imports will increase which will
worsen the current account and hence the balance of payments. Furthermore, if a rise in inflation
makes domestic goods and services relatively more expensive than foreign goods and services, net
exports will fall which will lead to a deterioration in the current account and hence the balance of
payments, assuming the demand for exports is price elastic. If the economy has a balance of payments
equilibrium, a deterioration in the balance of payments will lead to a balance of payments deficit.
Under the fixed exchange rate system, the balance of payments deficit will be persistent, other things
being equal. Therefore, achieving the macroeconomic goal of low unemployment may conflict with
the macroeconomic goal of a balance of payments equilibrium.

If there are no or low inflationary pressures in the economy, a rise in inflation may not lead to high
inflation. Indeed, if there are deflationary pressures in the economy, a rise in inflation is likely to lead
to low inflation which is desirable for the economy. Furthermore, the use of expansionary demand-
side policies to achieve low unemployment may lead to an increase in aggregate supply in the long
run. For example, an increase in government expenditure on education and training will lead to greater
human capital which will increase the skills and knowledge of labour in the economy. An increase in
the skills and knowledge of labour in the economy will lead to an increase in the production capacity
in the economy resulting in an increase in aggregate supply. In addition, it will lead to an increase in
labour productivity and hence a fall in the cost of production in the economy resulting in an increase in
aggregate supply. If this happens, assuming aggregate demand is rising which is the normal state of
the economy, the general price level will rise at a slower rate resulting in lower inflation. Therefore,
achieving the macroeconomic goal of low unemployment may not conflict with the macroeconomic
goal of low inflation. When national income rises, imports will increase which will worsen the current
account and hence the balance of payments. However, if the economy has a persistent balance of
payments surplus, a deterioration may help correct the surplus and hence achieve an equilibrium.
Furthermore, if inflation falls due to an increase in aggregate supply, domestic goods and services may
become relatively cheaper than foreign goods and services. If this happens, net exports will rise which
will lead to an improvement in the current account and hence the balance of payments. If the economy
has a persistent balance of payments deficit, an improvement may help correct the deficit and hence
achieve an equilibrium. Therefore, achieving the macroeconomic goal of low unemployment may not
conflict with the macroeconomic goal of a balance of payments equilibrium. Expansionary demand-
side policies decrease unemployment through increasing aggregate demand and hence national output.
Therefore, achieving the macroeconomic goal of low unemployment may help achieve the
macroeconomic goal of high economic growth.

Example 2

Suppose that the government decreases inflation to achieve the macroeconomic goal of low inflation.
Further suppose that it does so through the use of contractionary demand-side policies. Assuming
aggregate demand and hence the general price level is rising rapidly, contractionary demand-side
policies will reduce the growth of aggregate demand which will lead to a slower rise in the general
price level resulting in lower inflation. However, a slower growth of aggregate demand will lead to a
less rapid increase in national output and hence national income. Therefore, achieving the
macroeconomic goal of low inflation may conflict with the macroeconomic goal of high economic
growth. When economic growth falls, the demand for labour in the economy will rise at a slower rate.
As the labour force in the economy is generally expanding, a less rapid increase in the demand for
labour in the economy may not create sufficient new jobs for the new entrants in the labour force. If
this happens, unemployment will rise. Therefore, achieving the macroeconomic goal of low inflation
may conflict with the macroeconomic goal of low unemployment.

Apart from contractionary demand-side policies, supply-side policies can also be used to reduce
inflation. When the production capacity in the economy and hence aggregate supply rises, assuming
aggregate demand is rising which is the normal state of the economy, the general price level will rise
at a slower rate resulting in lower inflation. In addition to a fall in inflation, an increase in the
production capacity in the economy and hence aggregate supply will lead to a more rapid increase in
national output and hence national income, assuming aggregate demand is rising which is the normal
state of the economy. Therefore, achieving the macroeconomic goal of low inflation may not conflict
with the macroeconomic goal of high economic growth. When economic growth rises, the demand for
labour in the economy will rise at a faster rate. As the labour force in the economy is generally
expanding, a more rapid increase in the demand for labour in the economy may create sufficient new
jobs for the new entrants in the labour force which may lead to low unemployment. Therefore,
achieving the macroeconomic goal of low inflation may not conflict with the macroeconomic goal of
low unemployment. A fall in inflation may make domestic goods and services relatively cheaper than
foreign goods and services. If this happens, net exports will rise which will lead to an improvement in
the current account and hence the balance of payments. Furthermore, when economic growth falls due
to the use of contractionary demand-side policies to reduce inflation, import growth will fall.
Assuming export growth remains constant, a decrease in import growth may improve the current
account and hence the balance of payments. If the economy has a persistent balance of payments
deficit, an improvement may help correct the deficit and hence achieve an equilibrium. Therefore,
achieving the macroeconomic goal of low inflation may help achieve the macroeconomic goal of a
balance of payments equilibrium.

Example 3

Suppose that the government increases potential economic growth in order to achieve the
macroeconomic goal of high economic growth. Further suppose that it does so through research and
development. Research and development will lead to technological advancement which will increase
the efficiency of capital in the economy. When this happens, the production capacity in the economy
and hence aggregate supply will increase which will lead to higher potential economic growth. Given
that actual economic growth is constrained by potential economic growth, higher potential economic
growth will allow higher actual economic growth resulting in a more rapid rise in the standard of
living. However, technological advancement will lead to losses of low-skilled jobs which will result in
a rise in structural unemployment. Therefore, achieving the macroeconomic goal of high economic
growth may conflict with the macroeconomic goal of low unemployment.

Apart from research and development, education and training can also be used to increase potential
economic growth in order to achieve the macroeconomic goal of high economic growth. Education
and training will lead to greater human capital which will increase the skills and knowledge of labour
in the economy. When this happens, the production capacity in the economy and hence aggregate
supply will increase which will lead to higher potential economic growth. In addition to an increase in
potential economic growth, education and training may equip the low-skilled workers who have been
displaced with the relevant skills and knowledge to find jobs in the expanding industries which are
typically high value-added industries and hence require high skills. If this happens, structural
unemployment will fall. Furthermore, if higher potential economic growth leads to higher actual
economic growth, the demand for labour in the economy will rise at a faster rate. As the labour force
in the economy is generally expanding, a more rapid increase in the demand for labour in the economy
may create sufficient new jobs for the new entrants in the labour force which may lead to low
unemployment. Therefore, achieving the macroeconomic goal of high economic growth may not
conflict with the macroeconomic goal of low unemployment.

Example 4

Suppose that the government corrects a persistent balance of payments deficit to achieve the
macroeconomic goal of a balance of payments equilibrium. Further suppose that it does so through the
use of contractionary demand-side policies. A decrease in aggregate demand will induce firms to
decrease production resulting in a decrease in national output. When firms decrease production, they
will employ less factor inputs from households and hence will pay them less factor income which will
lead to a decrease in national income. When national income falls, imports will fall which will lead to
an improvement in the current account and hence the balance of payments. A decrease in aggregate
demand will also lead to a fall in the general price level which may make domestic goods and services
relatively cheaper than foreign goods and services resulting in an increase in net exports. If this
happens, assuming the demand for exports is price elastic, the current account and hence the balance
of payments will improve. However, contractionary demand-side policies correct a persistent balance
of payments deficit through decreasing aggregate demand which will lead to a decrease in national
output and hence national income. Therefore, achieving the macroeconomic goal of a balance of
payments equilibrium may conflict with the macroeconomic goal of high economic growth. When
national output falls, the demand for labour in the economy will fall which will lead to a rise in
unemployment. Therefore, achieving the macroeconomic goal of a balance of payments equilibrium
may conflict with the macroeconomic goal of low unemployment.

Apart from contractionary demand-side policies, exchange rate policy can also be used to correct a
persistent balance of payments deficit to achieve the macroeconomic goal of a balance of payments
equilibrium. A devaluation of domestic currency will make domestic goods and services relatively
cheaper than foreign goods and services. When this happens, net exports will rise which may lead to
an improvement in the current account and hence the balance of payments, assuming the sum of the
price elasticities of demand for exports and imports is greater than one. In addition to an improvement
in the balance of payments, an increase in net exports will lead to an increase in aggregate demand
resulting in an increase in national output and hence national income. Therefore, achieving the
macroeconomic goal of a balance of payments equilibrium may not conflict with the macroeconomic
goal of high economic growth. When national output rises, the demand for labour in the economy will
rise which will lead to a fall in unemployment. Therefore, achieving the macroeconomic goal of a
balance of payments equilibrium may not conflict with the macroeconomic goal of low
unemployment. If aggregate demand and hence the general price level is rising rapidly, the use of
contractionary demand-side policies to correct a persistent balance of payments deficit will reduce the
growth of aggregate demand which will lead to a slower rise in the general price level resulting in
lower inflation. Therefore, achieving the macroeconomic goal of a balance of payments equilibrium
may help achieve the macroeconomic goal of low inflation.

Example 5

Suppose that the government decreases inflation to achieve the macroeconomic goal of low inflation.
Further suppose that it does so through the use of exchange rate policy. In times of high external price
pressures, the prices of imports will rise substantially which will lead to high imported inflation. A
revaluation of domestic currency will reduce the increase in the prices of imports in domestic currency
resulting in lower imported inflation. In addition, a rise in the exchange rate will make domestic goods
and services relatively more expensive than foreign goods and services. When this happens, net
exports will fall which will lead to a decrease in aggregate demand. Assuming aggregate demand and
hence the general price level is rising rapidly, this will reduce the growth of aggregate demand which
will lead to a slower rise in the general price level resulting in lower demand-pull inflation. However,
a decrease in net exports may lead to a deterioration in the current account and hence the balance of
payments, assuming the sum of the price elasticities of demand for exports and imports is greater than
one. Therefore, achieving the macroeconomic goal of low inflation may conflict with the
macroeconomic goal of a balance of payments equilibrium. A decrease in net exports will also lead to
a decrease in aggregate demand which will induce firms to decrease production resulting in a decrease
in national output. When firms decrease production, they will employ less factor inputs from
households and hence will pay them less factor income which will lead to a decrease in national
income. Therefore, achieving the macroeconomic goal of low inflation may conflict with the
macroeconomic goal of high economic growth. When national output falls, the demand for labour in
the economy will fall which will lead to a rise in unemployment. Therefore, achieving the
macroeconomic goal of low inflation may conflict with the macroeconomic goal of low
unemployment.

If the economy has a persistent balance of payments surplus, a deterioration may help correct the
surplus and hence achieve an equilibrium. Therefore, achieving the macroeconomic goal of low
inflation may not conflict with the macroeconomic goal of a balance of payments equilibrium. A
stronger domestic currency may induce exporters to increase labour productivity to maintain
competitiveness. For example, the revaluation of the yuan against the major currencies in the world
including the U.S dollar from July 2005 to July 2008 led to a rise in labour productivity in China. If
this happens, the cost of production in the economy will fall which will lead to an increase in
aggregate supply resulting in an increase in national output and hence national income. Therefore,
achieving the macroeconomic goal of low inflation may not conflict with the macroeconomic goal of
high economic growth. When national output rises, the demand for labour in the economy will rise
which will lead to a fall in unemployment. Therefore, achieving the macroeconomic goal of low
inflation may not conflict with the macroeconomic goal of low unemployment.
CHAPTER 13: INTERNATIONAL ECONOMICS

1 INTRODUCTION

The people in a country consume a large number of goods and services. However, no country
produces all the goods and services that its people consume. Instead, countries generally produce the
goods and services in which they are good at producing and import the goods and services in which
they are not good at producing. In other words, countries engage in international trade. One of the
major factors why international trade takes place is differences in comparative advantage. Although
international trade has been occurring for thousands of years, it has increased substantially only over
the last century and this has expanded the world economy substantially. This chapter provides an
exposition of international economics.

2 BASIS OF SPECIALISATION AND INTERNATIONAL TRADE

2.1 The Law of Absolute Advantage (Optional but good to know)

International trade is the exchange of goods and services across international borders.

The father of modern economics, Adam Smith, was the first economist who recognised and advocated
the importance and the benefit of specialisation and international trade. He put forward the law of
absolute advantage in his famous book, ‘An Inquiry into the Nature and Causes of the Wealth of
Nations’, which was published in 1776.

The law of absolute advantage states that countries can gain from international trade if each specialises
in producing the goods in which it has an absolute advantage. A country has an absolute advantage
over other countries in producing a good when it can produce the same amount of the good with a
smaller amount of resources. Suppose that there are two countries, country X and country Y,
producing two goods, good A and good B. Further suppose that there are perfect mobility of resources
within each country, constant opportunity costs of production, no economies of scale, no transport
costs, no trade barriers and no product differentiation.

Good A Good B
Country X 2 4
Country Y 1 9

The above table shows the amount of each good that can be produced in each country with one unit of
resources. In country X, one unit of resources can be used to produce either 2 units of good A or 4
units of good B. In country Y, one unit of resources can be used to produce either 1 unit of good A or
9 units of good B. In country X, 1/2 unit of resources is required to produce one unit of good A and
1/4 unit of resources is required to produce one unit of good B. In country Y, 1 unit of resources is
required to produce one unit of good A and 1/9 unit of resources is required to produce one unit of
good B. Since the amount of resources required to produce one unit of good A in country X is lower
than that in country Y and the amount of resources required to produce one unit of good B in country
Y is lower than that in country X, country X has an absolute advantage in producing good A and
country Y has an absolute advantage in producing good B.

Suppose that country X has 400 units of resources and country Y has 200 units of resources. Further
suppose that each country allocates its resources equally between the two goods.

Good A Good B
Country X 400 800
Country Y 100 900
World 500 1700

The above table shows the amount of each good produced in each country when the resources are
allocated equally between the two goods. In country X, 400 units of good A and 800 units of good B
are produced. In country Y, 100 units of good A and 900 units of good B are produced. Suppose that
each country completely specialises in producing the good in which it has an absolute advantage.

Good A Good B
Country X 800 0
Country Y 0 1800
World 800 1800

The above table shows the amount of each good produced in each country when each country
completely specialises in producing the good in which it has an absolute advantage. In country X, 800
units of good A are produced. In country Y, 1800 units of good B are produced. The world output of
good A has increased by 300 units and the world output of good B has increased by 100 units.
Suppose that country X trades 250A for 850B.

Good A Good B
Country X 550 850
Country Y 250 950
World 800 1800

The above table shows the amount of each good available for consumption in each country after
specialisation and international trade. In country X, 550 units of good A and 850 units of good B are
available for consumption. In country Y, 250 units of good A and 950 units of good B are available for
consumption. Since the amount of each good in each country available for consumption has increased,
we can conclude that countries can gain from specialisation and international trade on the basis of
absolute advantage.

2.2 The Law of Comparative Advantage

In the previous section, country X has an absolute advantage in producing good A and country Y has
an absolute advantage in producing good B. A natural question is, will the two countries gain from
specialisation and international trade if one of them has an absolute advantage in producing both
goods? This is the question that David Ricardo asked after reading ‘An Inquiry into the Nature and
Causes of the Wealth of Nations’, which was published in 1776 by Adam Smith. He answered the
question in the affirmative and put forward the law of comparative advantage in his famous book, ‘On
the Principles of Political Economy and Taxation’, which was published in 1817.

The law of comparative advantage states that countries can gain from international trade if each
specialises in producing the goods in which it has a comparative advantage. A country has a
comparative advantage over other countries in producing a good when it can produce the same amount
of the good at a lower opportunity cost. In other words, it can produce the same amount of the good by
forgoing a smaller amount of other goods. Suppose that there are two countries, country X and country
Y, producing two goods, good A and good B. Further suppose that there are perfect mobility of
resources within each country, constant opportunity costs of production, no economies of scale, no
transport costs, no trade barriers and no product differentiation.

Good A Good B
Country X 2 4
Country Y 3 9

The above table shows the amount of each good that can be produced in each country with one unit of
resources. In country X, one unit of resources can be used to produce either 2 units of good A or 4
units of good B. In country Y, one unit of resources can be used to produce either 3 units of good A or
9 units of good B. Although country Y has an absolute advantage in producing both goods, each
country has a comparative advantage in producing only one good. In country X, if one unit of
resources is used to produce 2 units of good A, the same unit of resources cannot be used to produce 4
units of good B. Therefore, the opportunity cost of producing 1 unit of good A in country X is 2 units
of good B. By the same token, the opportunity cost of producing 1 unit of good B in country X is 1/2
unit of good A. In country Y, if one unit of resources is used to produce 3 units of good A, the same
unit of resources cannot be used to produce 9 units of good B. Therefore, the opportunity cost of
producing 1 unit of good A in country Y is 3 units of good B. By the same token, the opportunity cost
of producing 1 unit of good B in country Y is 1/3 unit of good A. Since the opportunity cost of
producing good A in country X is lower than that in country Y and the opportunity cost of producing
good B in country Y is lower than that in country X, country X has a comparative advantage in
producing good A and country Y has a comparative advantage in producing good B.

Suppose that country X has 400 units of resources and country Y has 200 units of resources. Further
suppose that each country allocates its resources equally between the two goods.

Good A Good B
Country X 400 800
Country Y 300 900
World 700 1700

The above table shows the amount of each good produced in each country when the resources are
allocated equally between the two goods. In country X, 400 units of good A and 800 units of good B
are produced. In country Y, 300 units of good A and 900 units of good B are produced. Suppose that
each country completely specialises in producing the good in which it has a comparative advantage.

Good A Good B
Country X 800 0
Country Y 0 1800
World 800 1800

The above table shows the amount of each good produced in each country when each country
completely specialises in producing the good in which it has a comparative advantage. In country X,
800 units of good A are produced. In country Y, 1800 units of good B are produced. The world output
of good A and the world output of good B have each increased by 100 units. A country will only be
willing to specialise in producing a good and trade it for another good if the opportunity cost of buying
the second good is less than the opportunity cost of producing it. In country X, the opportunity cost of
producing 1 unit of good B is 1/2 unit of good A. Therefore, country X will only be willing to
specialise in producing good A and trade it for good B if 1/2 unit of good A can be exchanged for
more than 1 unit of good B (1B < 1/2A) because in this range of terms of trade, the opportunity cost of
buying 1 unit of good B from country Y is less than 1/2 unit of good A. In country Y, the opportunity
cost of producing 1 unit of good A is 3 units of good B. Therefore, country Y will only be willing to
specialise in producing good B and trade it for good A if 3 units of good B can be exchanged for more
than 1 unit of good A (1A < 3B) because in this range of terms of trade, the opportunity cost of buying
1 unit of good A from country X is less than 3 units of good B. Therefore, the range of mutually
beneficial terms of trade is 2B < 1A < 3B. The actual terms of trade depend on the demand and the
supply of the two goods and their elasticities of demand and supply in the two countries. Suppose that
given the demand and supply of the two goods and their elasticities of demand and supply in the two
countries, the terms of trade are 1A : 2.5B. Further suppose that country X trades 350A for 875B (350
x 2.5).

Good A Good B
Country X 450 875
Country Y 350 925
World 800 1800

The above table shows the amount of each good available for consumption in each country after
specialisation and international trade. In country X, 450 units of good A and 875 units of good B are
available for consumption. In country Y, 350 units of good A and 925 units of good B are available for
consumption. Since the amount of each good in each country available for consumption has increased,
we can conclude that countries can gain from specialisation and international trade on the basis of
comparative advantage.

Apart from tables, the benefit of specialisation and international trade on the basis of comparative
advantage can also be illustrated with diagrams.

Country X Country Y

In the above diagrams, in the absence of specialisation and international trade on the basis of
comparative advantage, the consumption possibility curve (CPC 0) is the same as the production
possibility curve (PPC0) in each country. In country X, 400 units of good A and 800 units of good B
are available for consumption. In country Y, 300 units of good A and 900 units of good B are
available for consumption. With specialisation and international trade on the basis of comparative
advantage, although the production possibility curve in each country remains the same at PPC 0, the
consumption possibility curve shifts out from CPC 0 to CPC1. In country X, 450 units of good A and
875 units of good B are available for consumption. In country Y, 350 units of good A and 925 units of
good B are available for consumption. Since the amount of each good in each country available for
consumption has increased, we can conclude that countries can gain from specialisation and
international trade on the basis of comparative advantage.

Note: Countries do not gain equally from specialisation and international trade, unless by chance.
The closer the terms of trade are to the pre-trade terms of trade in a country, the smaller will be the
gain from specialisation and international trade to the country. The converse is also true.

2.3 Limitations of the Law of Comparative Advantage

Trade Barriers

The law of comparative advantage assumes that there are no trade barriers. In reality, there are trade
barriers. Some countries are unable to export the goods in which they have a comparative advantage in
quantities that they would like due to trade barriers imposed by other countries. For example, Iran is
unable to export as much oil as it would like due to economic sanctions imposed by western countries,
despite its comparative advantage in producing the good. Some governments protect domestic
industries by discouraging imports through the use of protectionist measures such as tariffs, import
quotas and subsidies. As a result, some countries produce goods in which they have a comparative
disadvantage in larger quantities than in the case without government intervention. For example,
Singapore has a comparative disadvantage in producing drinkable water due to the small land area and
hence limited reservoirs and water catchment areas. However, to reduce dependence on imported
water, the government subsidises the production of drinking water through seawater desalination and
wastewater reclamation to increase self-sufficiency in water.

Product Differentiation

The law of comparative advantage assumes that there is no product differentiation. In reality,
differentiated goods are produced. Furthermore, due to factors such as intra-industry specialisation, a
country does not produce all types of a good. For example, Singapore’s top two exports are electronic
valves and refined petroleum products. However, they are also Singapore’s top two imports. This is
partly because Singapore imports and exports different types of electronic valves and refined
petroleum products.

Transport Costs

The law of comparative advantage assumes that there are no transport costs. In reality, there are
transport costs which may outweigh any comparative advantage or disadvantage. For example,
Singapore has a comparative disadvantage in producing bricks due to the small amount of low-skilled
labour. However, it produces bricks because their size and weight make them too expensive to import.

Constant Opportunity Costs of Production

The law of comparative advantage assumes that there are constant opportunity costs of production. In
reality, as a country increasingly specialises in producing a good, it will experience increasing
opportunity cost of producing the good. This is because resources are not equally suitable for
producing different goods. As a country increasingly specialises in producing a good, it has to use
resources that are less suitable for producing the good to actually produce the good. This means that
increasingly more units of resources are needed to produce each additional unit of the good. Therefore,
increasingly more units of other goods have to be forgone to produce each additional unit of the good
resulting in an increase in the opportunity cost. This will eventually lead to the disappearance of the
country’s comparative advantage in producing the good which is a reason why countries do not
engage in complete specialisation in reality.

Perfect Mobility of Resources within Each Country

The law of comparative advantage assumes that there is perfect mobility of resources within each
country. In reality, due to factors such as differences in skill requirements, resources are not perfectly
mobile in a country.

Sources of Comparative Advantage

The law of comparative advantage does not provide an explanation for the sources of comparative
advantage.
Demand-side Reason for International Trade

The law of comparative advantage does not take into consideration the demand-side reason for
international trade. In reality, apart from differences in supply conditions, countries also trade due to
differences in demand conditions. The demand-side reason for international trade will be explained in
greater detail in Section 2.5.

2.4 Sources of Comparative Advantage

Differences in Factor Endowments

Factor endowments vary among countries. For example, Argentina has much fertile land, Saudi Arabia
has large crude oil reserves and China has a large amount of low-skilled labour. As goods differ in
terms of the resources that are required to produce them, a country has a comparative advantage in
producing a good that intensively requires resources it has in abundance. For example, Argentina has a
comparative advantage in growing wheat because of its abundance of fertile land, Saudi Arabia has a
comparative advantage in producing oil because of its abundance of crude oil reserves and China has a
comparative advantage in producing textile because of its abundance of low-skilled labour.

Economies of Scale

Recall that economies of scale refer to the decrease in average cost when the scale of production
expands. A country may have a comparative advantage in producing a good through large-scale
production. This occurs in industries where production is subject to substantial economies of scale
such as the steel industry and the cement industry.

Note: Comparative advantage may not remain static. Instead, it may change over time and this is
commonly known as dynamic comparative advantage. An example is Singapore which has acquired its
comparative advantage in producing high value-added goods over time.

2.6 Advantages and Disadvantages of International trade

Advantages of International trade

Greater Amount of Goods and Services Available for Consumption

Due to differences in comparative advantage among countries, international trade increases the
amount of goods and services available for consumption in a country. Refer to Section 2.2 for the
explanation. An increase in the amount of goods and services available for consumption in a country
will lead to a rise in the material standard of living.

Greater Variety of Goods and Services Available for Consumption

Due to factors such as specialisation and lack of resources, certain goods and services are not
produced in a country. Therefore, international trade increases the variety of goods and services
available for consumption in a country. An increase in the variety of goods and services available for
consumption in a country will lead to a rise in the material standard of living.

Lower Prices of Goods and Services

Due to comparative disadvantage, some goods and services can only be produced in a country at high
costs resulting in high prices. Therefore, international trade allows consumers in a country to import
the goods and services at lower prices from other countries. As international trade exposes firms to
greater competition, it will induce them to reduce prices in order to increase competitiveness by
increasing labour productivity and decreasing productive inefficiency to lower the cost of production.
International trade increases the demand for the goods produced by some firms which will enable
them to increase their scales of production to increase output. When this happens, they may reap more
economies of scale which will lead to a fall in their costs of production resulting in lower prices.
International trade allows firms to import cheaper intermediate goods which will lead to a fall in their
costs of production resulting in a fall in prices.

Engine of Growth

Through an increase in exports, international trade increases aggregate demand in some economies.
This is particularly true in small economies with low domestic demand and developing economies
where households have low purchasing power. When aggregate demand increases, national output will
rise. An increase in national output will lead to a rise in the demand for labour in the economy
resulting in a fall in unemployment.

Technological Transfers

International trade allows some countries to import better production technologies from other
countries. This is particularly true in developing economies where the production technologies are less
advanced. When this happens, the production capacity in the economy will increase. Furthermore,
with better production technologies, labour productivity in the economy will rise which will lead to a
fall in the cost of production in the economy. An increase in the production capacity and a fall the cost
of production in the economy will lead to an increase in aggregate supply resulting in an increase in
national output. An increase in national output will lead to a rise in the demand for labour in the
economy resulting in a fall in unemployment. Assuming aggregate demand is rising which is the
normal state of the economy, an increase in aggregate supply will also lead to a smaller rise in the
general price level.

Disadvantages of International trade

Over-dependence on Other Economies

International trade may cause an economy to become susceptible to a recession in other economies.
International trade may cause an economy to become over-dependent on exports. If this happens, a
recession in other economies which will lead to a decrease in exports in the economy is likely to lead
to a large decrease in aggregate demand. When this happens, national income will fall substantially
which will lead to a sharp rise in unemployment. For example, as international trade had increased the
exports of Singapore substantially, the 2008-2009 Global Financial Crisis caused by the Subprime
Mortgage Crisis in the United States led to a fall in exports in Singapore resulting in a large decrease
in aggregate demand and hence national income. Similarly, international trade may cause an economy
to become susceptible to high inflation in other economies. International trade may cause an economy
to become over-dependent on imports. If this happens, high inflation in other economies will lead to a
substantial rise in the prices of imports in the economy. When this happens, imported inflation is likely
to rise sharply. For example, as international trade had increased the imports of Singapore
substantially, the high inflation in other economies in 2008 due to the oil price shock was a major
factor which caused inflation in Singapore to soar to 6.6 per cent which was a level not seen since
1981. International trade may also cause a country to become over-dependent on imports of vital
goods such as food, water and armaments. This is undesirable as it may put the country at great risk in
the event that international trade is disrupted which may happen in times of war.

Demise of Infant Industries

International trade may prevent infant industries from growing. Infant industries are small and hence
have a cost disadvantage over their mature foreign competitors which are bigger. Therefore, in the
face of international trade, infant industries may not be able to grow. If this happens, the number of
goods of comparative advantage and hence the range of goods produced in the economy will decrease
in the long run. When this happens, the rate of economic growth will fall and the volatility of
economic growth will rise.

Rise in Structural Unemployment

International trade may lead to a rise in structural unemployment. The production of low value-added
goods such as disk drives requires low-skilled labour. An economy may have a comparative
disadvantage in producing low value-added goods due to a small amount of low-skilled labour.
Therefore, international trade may lead to a more rapid decline in the low value-added industries. If
this happens, more low-skilled workers will not have enough time to undergo education and training in
order to acquire new skills and knowledge which will lead to a rise in structural unemployment.

Dumping

International trade may subject a country to dumping. Dumping occurs when imports are sold at prices
below their marginal costs. This is often done with the help of foreign government subsidies. A
country which engages in international trade may be subject to dumping. If dumping occurs, although
consumers will benefit from lower prices in the short run, domestic firms may be driven out of the
market in the long run which will lead to job losses resulting in a rise in unemployment. Furthermore,
in the event that foreign firms monopolise the domestic market, they are likely to raise prices to
increase profits and this may cause consumers to suffer from high prices.

Worsening Income Inequity

International trade may worsen income inequity. For example, the production of high value-added
goods such as pharmaceuticals requires high-skilled labour. Developed economies have a comparative
advantage in producing high value-added goods due to the large amount of high-skilled labour.
Therefore, international trade will lead to an expansion of the high value-added industries which will
increase the demand for high-skilled workers resulting in a rise in the wages. However, developed
economies have a comparative disadvantage in producing low value-added goods due to the small
amount of low-skilled labour. Therefore, international trade will lead to a contraction of the low value-
added industries which will decrease the demand for low-skilled workers resulting in a fall in the
wages. A rise in the wages of high-skilled workers and a fall in the wages of low-skilled workers due
to international trade will cause income inequity to worsen.

3 PROTECTIONISM

Although international trade is beneficial, free trade may be undesirable which gives rise to the
arguments for protectionism. Protectionism is the use of measures by the government to protect
domestic industries from foreign competition.

3.1 Protectionist Measures

Tariffs

Tariffs are taxes imposed on imports. The government can protect domestic industries by increasing
tariffs to increase the prices of imports. When this happens, households and firms will switch from
imports to domestic goods.
In the above diagram, the domestic demand and the domestic supply are D D and SD respectively. The
world supply is SW and hence the world price is PW. Domestic firms charge a price of P 0 to match the
world price of PW. At P0, the quantity demanded (QD0) is greater than the quantity supplied (Q S0) and
the import is (QD0 – QS0). If the government imposes a tariff (t), firms will increase the price from P 0 to
P1 where P1 is P0 + t. When the price rises from P 0 to P1, the quantity demanded will fall from Q D0 to
QD1 and the quantity supplied will rise from Q S0 to QS1 and hence the import will decrease from (Q D0 –
QS0) to (QD1 – QS1). However, a tariff will lead to a fall in the consumer surplus from the sum of area 1,
area 2, area 3, area 4 area 5 and area 6, to the sum of area 1 and area 2. Although area 3 will be
captured by firms in the form of producer surplus and area 5 will be captured by the government in the
form of tax revenue, area 4 and area 6 are not captured by any party is hence the deadweight loss.

Import Quotas

An import quota is a limit imposed on the quantity of a good that can be imported into a country. The
government can protect domestic industries by imposing import quotas which will decrease the
quantity of imports. When this happens, domestic residents will buy more domestic goods.

Subsidies

The government can protect domestic industries by giving them subsidies to decrease their costs of
production and hence prices. When this happens, households and firms will switch from imports to
domestic goods.

Procurement Policies

The government can protect domestic firms by adopting a policy of buying domestic goods and
services to decrease the quantity of imports even if domestic goods and services are more expensive or
of lower quality than imports.

Voluntary Export Restraints

Voluntary export restraints are agreements between two economies where the government of the
exporting economy agrees to limit the quantities of certain goods exported to the importing economy.
They are usually signed in the face of threatened actions by the government of the importing economy.
The government can protect domestic firms by signing voluntary export restraints with exporting
economies to decrease the quantity of imports. When this happens, domestic residents will buy more
domestic goods.

Exchange Controls

Exchange controls are limits imposed on foreign currency made available to domestic residents. The
government can protect domestic firms by imposing exchange controls to decrease the quantity of
imports. When this happens, domestic residents will buy more domestic goods.

Health and Safety Regulations

The government can protect domestic firms by setting restrictive health and safety standards of
imports to decrease the quantity. When this happens, domestic residents will buy more domestic
goods.

Embargoes
An embargo is a ban imposed on the export or the import of a good. The government can protect
domestic firms by imposing embargoes to decrease the quantity of imports. When this happens,
domestic residents will buy more domestic goods.

3.2 Arguments For and Against Protectionism

Infant Industry Argument (Sunrise Industry Argument)

Protectionism may allow infant industries to grow. Infant industries are small and hence have a cost
disadvantage over their mature foreign competitors which are bigger. Therefore, in the face of
international trade, infant industries may not be able to grow. If this happens, the number of goods of
comparative advantage and hence the range of goods produced in the economy will decrease in the
long run. When this happens, the rate of economic growth will fall and the volatility of economic
growth will rise. By providing protection to infant industries, the government can help firms in the
industries expand their scales of production. When firms in infant industries expand their scales of
production, they will reap more economies of scale. A fall in average cost will allow them to lower
their prices which may enable them to compete with their mature foreign competitors, at which point
protection can be removed. If this happens, the number of goods of comparative advantage and hence
the range of goods produced in the economy will increase in the long run. When this happens, the rate
of economic growth will rise and the volatility of economic growth will fall. However, this argument
is not without its counter-arguments. First, protectionism will reduce competition which may foster
inefficiency and this may lead to the outcome that the protected industries never become competitive.
Second, protection is hard to remove once it is given due to resistance from vested interests and this
will put a strain on the government budget which may compel the government to decrease expenditure
on other important areas such as education and infrastructure to avoid a budget deficit and this may
result in adverse consequences for the economy in the long run.

Declining Industry Argument (Sunset Industry Argument)

Protectionism allows declining industries to decline at a slower rate. Recall that the structure of the
economy changes when some industries expand and some industries contract and this may be due to
technological advancements, changes in comparative advantage or changes in the pattern of demand.
When this happens, the expanding industries create jobs and the contracting industries lose jobs.
However, as workers who lose their jobs in the contracting industries possess low skills, they do not
have the relevant skills and knowledge to find jobs in the expanding industries which require high
skills and this leads to structural unemployment. By providing protection to declining industries, the
government can help them phase out at a slower rate. If this happens, low-skilled workers who are
employed in the industries will have more time to undergo education and training in order to acquire
the relevant skills and knowledge to find jobs in the expanding industries. When this happens,
structural unemployment will be lower. However, providing protection to declining industries may
reduce the incentive for low-skilled workers who are employed in the industries to acquire the relevant
skills and knowledge to find jobs in the expanding industries. This will prolong the inefficient use of
resources in the economy which will prevent the economy from more fully reaping the benefit of
specialisation and international trade on the basis of comparative advantage.

Job Protection Argument

Protectionism may reduce job losses in an economy in a recession. Job losses occur in a recession due
to a fall in the demand for labour in the economy caused by a decrease in production. By making
imports more expensive or domestic goods cheaper, the government can induce households and firms
to switch from imports to domestic goods. When this happens, the demand for domestic goods and
services will rise which will lead to an increase in the demand for labour in the economy and this will
reduce job losses. However, this argument is not without its counter-arguments. First, if the trading
partners retaliate, the reduction in job losses in the protected industries may be offset by an increase in
job losses in other industries. Second, job losses in other industries may also increase in the absence of
retaliation if protectionism leads to a fall in the national incomes and hence the imports of the trading
partners.

Balance of Payments Argument

Protectionism may correct a persistent balance of payments deficit. A persistent balance of payments
deficit is undesirable for the economy as it may lead to high imported inflation, lower national income,
higher unemployment and rising public debt. By making imports more expensive or domestic goods
cheaper, the government can induce households and firms to switch from imports to domestic goods.
When this happens, the current account and hence the balance of payments will improve. If the
economy has a persistent balance of payments deficit, the improvement may correct the deficit.
However, this argument is not without its counter-arguments. First, if the trading partners retaliate,
export revenue will fall which will worsen the current account and hence the balance of payments.
Second, export revenue may also fall in the absence of retaliation if protectionism leads to a fall in the
national incomes and hence the imports of the trading partners. Third, if the persistent balance of
payments deficit is due to a high cost of production or low product quality in the economy,
protectionism will not solve the root cause of the problem.

Anti-dumping Argument

Protectionism is a countervailing measure against dumping. Recall that dumping occurs when imports
are sold at prices below their marginal costs which is often done with the help of foreign government
subsidies. A country which engages in international trade may be subject to dumping. If dumping
occurs, although consumers will benefit from lower prices in the short run, domestic firms may be
driven out of the market in the long run which will lead to job losses resulting in a rise in
unemployment. Furthermore, in the event that foreign firms monopolise the domestic market, they are
likely to raise prices to increase profits and this may cause consumers to suffer from high prices. By
providing protection to industries which are subject to dumping, the government can help them
compete fairly with their foreign competitors. However, this argument is not without its counter-
arguments. First, dumping is difficult to prove as it is difficult to measure marginal cost in reality. For
firms that engage in mass production on assembly line, marginal cost is virtually impossible to
measure. Second, if lower prices of imports are due to greater efficiency of foreign firms rather than
dumping with the help of foreign government subsidies, protectionism may invite retaliation which
will lead to a fall in exports resulting in a deterioration in the balance of payments and a fall in
economic growth.

Other Arguments

There are several other arguments for protectionism which include the strategic industry argument and
the diversification argument. Some industries produce vital goods such as food, water and armaments,
where over-dependence on imports may put the country at great risk in the event that international
trade is disrupted which may happen in times of war. Protectionism helps a country maintain a certain
degree of self-sufficiency in these goods. A highly specialised economy, such as Cuba with sugar, is
very susceptible to world market fluctuations which may lead to economic instability. Protectionism
helps an economy achieve greater diversification which reduces these risks.

In addition to the counter-arguments of the arguments discussed above, protectionism is criticised on

other grounds. First, protectionism through some measures such as increasing tariffs will lead to
higher prices for consumers. Furthermore, it will lead to deadweight loss as the fall in the consumer
surplus is not fully captured by firms in the form of producer surplus and captured by the government
in the form of tax revenue. Second, protectionism precludes the realisation of the benefit of complete
specialisation and international trade.
4 THE TERMS OF TRADE

The terms of trade refer to the number of units of imports that can be obtained with one unit of
exports. It is expressed as the ratio of the price of exports to the price of imports.

Price of exports
Terms of trade = ————————-
Price of imports

The terms of trade can be expressed as an index.

Price index of exports

Terms-of-trade index = ——————————— × 100
Price index of imports

If the terms of trade rise which means that the price of exports rises relative to the price of imports,
they are said to have improved or moved in a favourable direction. If the terms of trade fall which
means that the price of exports falls relative to the price of imports, they are said to have deteriorated
or moved in an unfavourable direction.

4.1 Factors Affecting the Terms of Trade

Changes in the terms of trade may be due to three factors: demand factors, supply factors and the
exchange rate factor.

Demand Factors

When the demand for exports rises, the price will rise which will lead to a rise in the terms of trade.
Conversely, a decrease in the demand for exports will lead to a fall in the price resulting in a fall in the
terms of trade. When the demand for imports falls, the price will fall which will lead to a rise in the
terms of trade. Conversely, an increase in the demand for imports will lead to a rise in the price
resulting in a fall in the terms of trade.

Supply Factors

When the supply of exports falls, the price will rise which will lead to a rise in the terms of trade.
Conversely, an increase in the supply of exports will lead to a fall in the price resulting in a fall in the
terms of trade. When the supply of imports rises, the price will fall which will lead to a rise in the
terms of trade. Conversely, a decrease in the supply of imports will lead to a rise in the price resulting
in a fall in the terms of trade.

Exchange Rate Factor

When the exchange rate rises, the price of imports in domestic currency will fall which will lead to a
rise in the terms of trade. Conversely, a fall in the exchange rate will lead to a rise in the price of
imports in domestic currency resulting in a fall in the terms of trade.

4.2 Effect of a Change in the Terms of Trade on the Balance of Trade

The effect of a change in the terms of trade on the balance of trade depends on the cause of the change.

Demand Factors
When the demand for exports rises, the price will rise which will lead to a rise in the terms of trade.
An increase in the demand for exports will also lead to an increase in the quantity. When the price and
the quantity of exports rise, export revenue will increase which will lead to an improvement in the
balance of trade. Conversely, when the demand for exports falls, the price will fall which will lead to a
fall in the terms of trade. A decrease in the demand for exports will also lead to a decrease in the
quantity. When the price and the quantity of exports fall, export revenue will decrease which will lead
to a deterioration in the balance of trade.

When the demand for imports falls, the price will fall which will lead to a rise in the terms of trade. A
decrease in the demand for imports will also lead to a decrease in the quantity. When the price and the
quantity of imports fall, import expenditure will decrease which will lead to an improvement in the
balance of trade. Conversely, when the demand for imports rises, the price will rise which will lead to
a fall in the terms of trade. An increase in the demand for imports will also lead to an increase in the
quantity. When the price and the quantity of imports rise, import expenditure will increase which will
lead to a deterioration in the balance of trade.

Therefore, when the demand for exports or imports changes, the terms of trade and the balance of
trade will change in the same direction.

Supply Factors

When the supply of exports rises, the price will fall which will lead to a fall in the terms of trade. An
increase in the supply of exports will also lead to an increase in the quantity. When the price of exports
falls and the quantity rises, if the demand is price inelastic, which means that the decrease in the price
will lead to a smaller proportionate increase in the quantity demanded, export revenue will decrease
which will lead to a deterioration in the balance of trade. However, if the demand for exports is price
elastic, which means that the decrease in the price will lead to a larger proportionate increase in the
quantity demanded, export revenue will increase and hence the balance of trade will improve.
Conversely, when the supply of exports falls, the price will rise which will lead to a rise in the terms of
trade. A decrease in the supply of exports will also lead to a decrease in the quantity. When the price
of exports rises and the quantity falls, if the demand is price inelastic, export revenue will increase
which will lead to an improvement in the balance of trade. However, if the demand for exports is price
elastic, export revenue will decrease and hence the balance of trade will worsen.

When the supply of imports falls, the price will rise which will lead to a fall in the terms of trade. A
decrease in the supply of imports will also lead to a decrease in the quantity. When the price of
imports rises and the quantity falls, if the demand is price inelastic, import expenditure will increase
which will lead to a deterioration in the balance of trade. However, if the demand for imports is price
elastic, import expenditure will decrease and hence the balance of trade will improve. Conversely,
when the supply of imports rises, the price will fall which will lead to a rise in the terms of trade. An
increase in the supply of imports will also lead to an increase in the quantity. When the price of
imports falls and the quantity rises, if the demand is price inelastic, import expenditure will decrease
which will lead to an improvement in the balance of trade. However, if the demand for imports is price
elastic, import expenditure will increase and hence the balance of trade will worsen.

Therefore, when the supply of exports (imports) changes, the terms of trade and the balance of trade
will change in the same direction if the demand for exports (imports) is price inelastic. However, if the
demand for exports (imports) is price elastic, the terms of trade and the balance of trade will change in
opposite directions.

Exchange Rate Factor

When the exchange rate rises, the price of imports in domestic currency will fall which will lead to a
rise in the terms of trade. When the price of imports falls, the quantity demanded will rise. If the
demand for imports is price elastic, which means that the decrease in the price will lead to a larger
proportionate increase in the quantity demanded, import expenditure will increase which will lead to a
deterioration in the balance of trade. Furthermore, a rise in the exchange rate will increase the price of
exports in foreign currency which will lead to a decrease in the quantity demanded. Since the price of
exports in domestic currency will not be affected by a rise in the exchange rate, a decrease in the
quantity demanded will lead to a decrease in export revenue. Therefore, even if the demand for
imports is price inelastic, which means that import expenditure will fall, if the sum of the price
elasticities of demand for exports and imports is greater than one, the decrease in export revenue will
be greater than the decrease in import expenditure which will lead to a deterioration in the balance of
trade, assuming export revenue is equal to import expenditure initially.

When the exchange rate falls, the price of imports in domestic currency will rise which will lead to a
fall in the terms of trade. When the price of imports rises, the quantity demanded will fall. If the
demand for imports is price elastic, which means that the increase in the price will lead to a larger
proportionate decrease in the quantity demanded, import expenditure will decrease which will lead to
an improvement in the balance of trade. Furthermore, a fall in the exchange rate will decrease the price
of exports in foreign currency which will lead to an increase in the quantity demanded. Since the price
of exports in domestic currency will not be affected by a fall in the exchange rate, an increase in the
quantity demanded will lead to an increase in export revenue. Therefore, even if the demand for
imports is price inelastic, which means that import expenditure will rise, if the sum of the price
elasticities of demand for exports and imports is greater than one, the increase in export revenue will
be greater than the increase in import expenditure which will lead to an improvement in the balance of
trade, assuming export revenue is equal to import expenditure initially.

Therefore, when the exchange rate changes, the terms of trade and the balance of trade will change in
the same direction if the sum of the price elasticities of demand for exports and imports is less than
one. However, if the sum of the price elasticities of demand for exports and imports is greater than
one, the terms of trade and the balance of trade will change in opposite directions.

Note: Although the terms of trade are affected by changes in the prices of exports and imports, the
balance of trade is affected by changes in the prices and the quantities of exports and imports.

5 FREE TRADE AGREEMENT

A free trade agreement (FTA) is an agreement between two or more economies to remove or reduce
barriers to trade with the objective of increasing the cross-border movement of goods and services
between the economies. Singapore has signed over 20 FTAs which is one of the highest numbers in
the world. Signing more FTAs will bring about both benefits and costs in Singapore.

Beneficial Effects: Improvement in the Balance of Payments

If Singapore signs more FTAs, the balance of payments may improve. When tariffs on Singapore’s
goods are removed or reduced in the FTA member countries, firms that import and sell Singapore’s
goods in the FTA member countries will decrease prices to maintain competitiveness. Therefore,
signing FTAs in Singapore will make Singapore’s goods cheaper in the FTA member countries. When
this happens, exports in Singapore to the FTA member countries will increase which will lead to an
improvement in the current account and hence the balance of payments of Singapore. For example, the
USSFTA which came into effect in 2004 led to an increase in Singapore’s exports to the United States.
Furthermore, firms in non-member countries that export goods to the FTA member countries and want
to circumvent the tariffs will invest in Singapore. By setting up production facilities in Singapore, the
goods that they produce in Singapore and export to the FTA member countries, which will be subject
to lower or no tariffs, will be cheaper than those that they produce in non-member countries and export
to the FTA member countries, other things being equal. This will lead to an increase in their sales and
hence profits. When this happens, the increase in foreign direct investments in Singapore will lead to
an improvement in the capital and financial account and hence the balance of payments. For example,
apart from an increase in exports, the USSFTA also led to an increase in foreign direct investments in
Singapore.

Beneficial Effects: Increase in Aggregate Demand

Signing more FTAs in Singapore may lead to an increase in aggregate demand resulting in an increase
in national output and hence national income. The increase in exports and investment expenditure in
Singapore will lead to an increase in aggregate demand which will induce firms to increase production
resulting in an increase in national output. When firms increase production, they will employ more
factor inputs from households and hence will pay them more factor income which will lead to an
increase in national income. An increase in national output will lead to a rise in the demand for labour
in the economy resulting in a fall in unemployment.

Beneficial Effects: Increase in Aggregate Supply

If Singapore signs more FTAs, aggregate supply will rise. When tariffs on imported intermediate
goods from the FTA member countries are removed or reduced in Singapore, firms that import these
goods will decrease prices to maintain competitiveness. Therefore, signing more FTAs in Singapore
will lead to a fall in the prices of imported intermediate goods. For example, Singapore has signed
over 20 FTAs and this has led to a fall in the prices of imported intermediate goods. When this
happens, the cost of production in the economy will fall which will lead to an increase in aggregate
supply. An increase in aggregate supply will lead to an increase in national output and hence national
income resulting in a fall in unemployment. Assuming aggregate demand is rising which is the normal
state of the economy, an increase in aggregate supply will also lead to a smaller rise in the general
price level resulting in lower inflation and if this makes Singapore’s goods and services relatively
cheaper than foreign goods and services, net exports will rise which will lead to an improvement in the
current account and hence the balance of payments.

Beneficial Effects: More Rapid Increase in Aggregate Supply in the Long Run

Signing more FTAs in Singapore will lead to a more rapid increase in aggregate supply in the long
run. The increase in investment expenditure in Singapore will lead to a more rapid increase in the
production capacity in the economy in the long run, assuming net investment is initially positive.
Therefore, aggregate supply will rise at a faster rate in the long run. When this happens, assuming
aggregate demand is rising which is the normal state of the economy, national output and hence
national income will rise at a faster rate which may decrease unemployment, and the general price
level will rise at a slower rate resulting in lower inflation which may improve the balance of payments.

Detrimental Effects

Although signing more FTAs in Singapore will bring about beneficial effects to the economy, it will
also bring about detrimental effects. Signing FTAs in Singapore will make goods from the FTA
member countries cheaper in Singapore due to the removal or reduction in tariffs on the goods.
Therefore, if Singapore signs more FTAs, imports from the FTA member countries will increase.
Imports will also rise due to the increase in national income. Furthermore, the rise in the general price
level due to the increase in aggregate demand may make Singapore’s goods and services relatively
more expensive than foreign goods and services which will lead to a decrease in net exports. The
increase in foreign direct investments will lead to a larger increase in outward income remittances in
the long run. For example, the increasing number of foreign firms in Singapore has led to rising
outward income remittances. If these happen, the current account and hence the balance of payments
will deteriorate, assuming the demand for exports is price elastic. Cheaper imports from the FTA
member countries in Singapore will induce households and firms to switch from domestic goods to
imports resulting in a decrease in the demand for domestic goods. When this happens, aggregate
demand will fall which will lead to a decrease in national output and hence national income resulting
in a rise in unemployment. Furthermore, foreign firms are footloose and hence if market conditions in
other economies become more favourable in the future, they may pull their operations out of
Singapore. For example, many foreign firms such as Hitachi, Sanyo and Seagate have relocated their
manufacturing plants in Singapore to China where the cost of production is lower. If this happens,
unemployment in Singapore may rise substantially. The production of low value-added goods such as
disk drives requires low-skilled labour. Signing more FTAs in Singapore will lead to a more rapid
decline in the low value-added industries if the FTA partners are developing economies which have a
comparative advantage over Singapore in producing low value-added goods due to their larger
amounts of low-skilled labour. If this happens, the rate at which low-skilled workers in Singapore are
laid off will increase which will lead to a rise in structural unemployment. Since signing more FTAs in
Singapore will increase exports and imports, the economy will become more susceptible to adverse
economic conditions in other economies, such as recession and high inflation. As the exports and
imports of Singapore are already very high, this may cause the economy to become unstable.
Furthermore, if Singapore signs more FTAs, some infant industries that produce high value-added
goods such as photonics and nanotechnology may not be able to survive if the FTA partners are
developed economies where many high value-added goods are produced in mature industries. If this
happens, the number of goods of comparative advantage and hence the range of goods produced in
Singapore will decrease in the long run which will decrease the rate and increase the volatility of
economic growth. If Singapore signs more FTAs, the more rapid expansion of the export industries
that produce high value-added goods will lead to a more rapid increase in the demand for high-skilled
workers and the more rapid decline in the low value-added industries will lead to a more rapid
decrease in the demand for low-skilled workers. This will result in a more rapid increase in the wages
of high-skilled workers and depress the wages of low-skilled workers which will cause income
inequity to worsen.

7 GLOBALISATION

Globalisation refers to the increased integration of economies through an increase in flows of goods
and services, capital and labour across international borders.

7.1 Trend Towards Globalisation

The first episode of globalisation began around the mid-19th century and ended with the outbreak of
the First World War in 1914. The second episode of globalisation began when the Second World War
ended in 1945 and continues today. There are several factors which lead to globalisation and they
include the benefit of specialisation and international trade on the basis of comparative advantage,
technological advancement, trade liberalisation and the opening up of formerly closed economies.

Benefit of Specialisation and International Trade on the Basis of Comparative Advantage

The benefit of specialisation and international trade on the basis of comparative advantage is a factor
which leads to globalisation. The law of comparative advantage states that countries can gain from
international trade if each specialises in producing the goods in which it has a comparative advantage.
A country has a comparative advantage over other countries in producing a good when it can produce
the same amount of the good at a lower opportunity cost. In other words, it can produce the same
amount of the good by forgoing a smaller amount of other goods. For example, if country X has to
forgo 2 units of good B to produce 1 unit of good A and country Y has to forgo 3 units of good B to
produce 1 unit of good A, country X is said to have a comparative advantage over country Y in the
production of good A. Assuming there are only two countries that can produce only two goods, if
country X specialises in producing good A and country Y specialises in producing good B, the amount
of each good in each country available for consumption will increase. Therefore, countries can gain
from specialisation and international trade on the basis of comparative advantage. The benefit of
specialisation and international trade on the basis of comparative advantage has been a main driver of
globalisation since the first episode of globalisation which began around the mid-19th century.

Technological Advancement

Technological advancement is a factor which leads to globalisation. Information and communications

technology has improved dramatically over the last two decades, most notably the invention of the
internet. The internet has increased the ease of access and the availability of product information
which has increased international trade. Furthermore, it has reduced the coordination costs of
multinational corporations that have production facilities in more than one country which has led to an
increase in foreign direct investment. In the past, transport costs were high. Therefore, many foreign
goods were more expensive than domestic goods even though substantial differences in comparative
advantage existed among countries which limited international trade. With the invention of faster,
larger and more fuel-efficient planes and ships, transport costs have fallen substantially which has
removed a major barrier to international trade resulting in an increase in international trade. In addition
to an increase in international trade and foreign direct investment, improvement in information and
communications technology and transportation has led to an increase in flows of labour across
international borders.

Trade Liberalisation

Trade liberalisation is a factor which leads to globalisation. Trade liberalisation refers to the removal
or reduction in barriers to trade between economies. The World Trade Organisation (WTO) which was
established in 1995, and its predecessor organisation the General Agreement on Tariffs and Trade
(GATT) which was established in 1948, provide a forum for negotiating agreements aimed at reducing
barriers to international trade. They have conducted eight rounds of negotiations from the Geneva
Round to the Uruguay Round resulting in many trade agreements involving the 161 WTO members. In
addition, individual economies have reduced barriers to trade by signing free trade agreements with
other economies on a bilateral as well as multilateral basis. For example, Singapore has signed over 20
free trade agreements which have reduced barriers to trade. These trade agreements have reduced
barriers to international trade which have led to an increase in international trade.

Opening Up of Formerly Closed Economies

The opening up of formerly closed economies is a factor which leads to globalisation. For example,
since the Chinese economy opened up in 1978, it has been importing and exporting increasingly more
goods and services. China is now the largest exporter in the world and a major importer from many
countries. Furthermore, it has become both a major destination and source of foreign direct investment
due to several factors such as its low cost of production, fast-expanding consumer market and fast-
growing firms. The opening up of formerly closed economies such as China has led to an increase in
international trade and foreign direct investment.

7.2 Costs and Benefits of Globalisation to Developing Economies and Developed Economies

Globalisation will bring about both costs and benefits to developing economies (LDEs) and developed
economies (DEs).

Beneficial Effects to LDEs: Improvement in the Balance of Payments

Globalisation may lead to an improvement in the balance of payments of LDEs. The production of low
value-added goods such as disk drives requires low-skilled labour. Due to their larger amounts of low-
skilled labour, LDEs such as China have a comparative advantage over DEs such as the United States
in producing low value-added goods. Therefore, globalisation will lead to an increase in exports of
low value-added goods in LDEs. For example, China’s exports of televisions and disk drives have
increased through globalisation. When this happens, the current account and hence the balance of
payments will improve. Furthermore, globalisation will lead to a flow of foreign direct investments
from DEs to LDEs due to the lower costs of production in LDEs. When this happens, the capital and
financial account of LDEs will improve. For example, China’s share of foreign direct investment in
Asia has generally increased through globalisation.

Beneficial Effects to LDEs: Increase in Aggregate Demand

Aggregate demand in LDEs may rise due to globalisation which may lead to an increase in national
output and hence national income. The increase in exports and investment expenditure in LDEs will
lead to an increase in aggregate demand which will induce firms to increase production resulting in an
increase in national output. When firms increase production, they will employ more factor inputs from
households and hence will pay them more factor income which will lead to an increase in national
income. An increase in national output will lead to a rise in the demand for labour in the economy
resulting in a fall in unemployment.

Beneficial Effects to LDEs: Increase in Aggregate Supply

Aggregate supply in LDEs may rise due to globalisation. The import of better production technologies
from DEs in LDEs will lead to a rise in labour productivity in LDEs resulting in a fall in the cost of
production in the economy and hence an increase in aggregate supply. For example, China imports
many advanced production technologies from the United States. An increase in aggregate supply will
lead to an increase in national output and hence national income resulting in a fall in unemployment.
Assuming aggregate demand is rising which is the normal state of the economy, an increase in
aggregate supply will also lead to a smaller rise in the general price level resulting in lower inflation,
and if this makes their goods and services relatively cheaper than those in DEs, their net exports will
rise which will lead to an improvement in the current account and hence the balance of payments.

Beneficial Effects to LDEs: More Rapid Increase in Aggregate Supply in the Long Run

Globalisation may lead to a more rapid increase in aggregate supply in LDEs in the long run. The
import of better production technologies from DEs and the increase in investment expenditure in
LDEs will lead to a more rapid increase in the production capacity in the economy in the long run,
assuming net investment is initially positive. Therefore, aggregate supply will rise at a faster rate in the
long run. When this happens, assuming aggregate demand is rising, national output and hence national
income will rise at a faster rate which may decrease unemployment, and the general price level will
rise at a slower rate resulting in lower inflation which may improve the balance of payments.

Detrimental Effects to DEs

Globalisation may bring about detrimental effects to DEs. Due to the same reasons that may lead to an
improvement in the balance of payments of LDEs, an increase in aggregate demand and a more rapid
increase in aggregate supply in the long run, the balance of payments of DEs may worsen, aggregate
demand may fall and aggregate supply may rise at a slower rate in the long run. Due to LDEs’
comparative advantage over DEs in producing low value-added goods, among other factors,
globalisation will lead to a more rapid decline in the low value-added industries in DEs. When this
happens, the rate at which low-skilled workers in DEs are laid off will increase which will lead to a
rise in structural unemployment. Furthermore, a more rapid decline in the low value-added industries
will lead to a more rapid decrease in the demand for low-skilled workers. This will depress the wages
which will cause income inequity to worsen.

Beneficial Effects to DEs: Improvement in the Balance of Payments

Globalisation may lead to an improvement in the balance of payments of DEs. The production of high
value-added goods such as pharmaceuticals requires high-skilled labour. Due to their larger amounts
of high-skilled labour, DEs have a comparative advantage over LDEs in producing high value-added
goods. Therefore, globalisation will lead to an increase in exports of high value-added goods in DEs.
For example, Singapore’s exports of pharmaceuticals have increased through globalisation. The flow
of foreign direct investments from DEs to LDEs will lead to a larger increase in inward income
remittances in DEs in the long run. For example, the increasing number of Singapore firms in China
has led to rising inward income remittances in Singapore. When these happen, the current account and
hence the balance of payments will improve. When LDEs grow, some firms will become larger. When
this happens, some of them will expand overseas to DEs due to several reasons such as the high
availability of high-skilled labour which is essential for moving up the value-added chain and this will
lead to an improvement in the capital and financial account and hence the balance of payments. For
example, Singapore has attracted thousands of Chinese firms to invest in the economy partly due to its
high availability of high-skilled labour.

Beneficial Effects to DEs: Increase in Aggregate Demand

The increase in exports and investment expenditure in DEs will lead to an increase in aggregate
demand which will lead to an increase in national output and hence national income resulting in a fall
in unemployment.

Beneficial Effects to DEs: Increase in Aggregate Supply

Aggregate supply in DEs may rise due to globalisation. The import of cheaper intermediate goods
from LDEs in DEs will lead to a fall in the cost of production in the economy and hence an increase in
aggregate supply in DEs. For example, Singapore imports many cheaper intermediate goods from
China. The cost of production in DEs will also fall due to an inflow of cheaper labour from LDEs,
both high-skilled and low-skilled, as wages in DEs are higher than those in LDEs. For example,
Singapore attracts many cheaper workers from China to work in the economy.

Beneficial Effects to DEs: More Rapid Increase in Aggregate Supply in the Long Run

Globalisation may lead to a more rapid increase in aggregate supply in DEs in the long run. The
inflow of foreign labour and the increase in investment expenditure in DEs will lead to a more rapid
increase in the production capacity in the economy in the long run, assuming net investment is initially
positive. Therefore, aggregate supply will rise at a faster rate in the long run.

Detrimental Effects to LDEs

Globalisation may bring about detrimental effects to LDEs. Due to the same reasons that may lead to
an improvement in the balance of payments of DEs, the balance of payments of LDEs may worsen.
The outflow of labour in LDEs may lead to a decrease in the supply of labour resulting in a decrease in
aggregate supply. The problem of brain drain may make it difficult for them to move up the value-
added chain which may lead to lower economic growth in the long run. The flow of foreign direct
investments made by multinational corporations into LDEs may lead to the closure of smaller
domestic firms that reap less economies of scale, and if this causes the economies to become over-
dependent on these corporations that are footloose, unemployment may rise substantially if they pull
their operations out of the economies in the future due to more favourable market conditions in other
economies. For example, many foreign firms such as Hitachi, Sanyo and Seagate have relocated their
manufacturing plants in Singapore to China where the cost of production is lower. Due to the lax
labour law and low environmental standards, the entry of multinational corporations into an economy
may lead to labour exploitation and environmental degradation which may lower the standard of
living.
Note: LDEs are likely to benefit more from globalisation than DEs due to several reasons.
Households in LDEs are poorer and hence have less purchasing power than those in DEs and this
constrains the growth of consumption expenditure in LDEs. Therefore, LDEs are more dependent on
external demand than DEs and hence LDEs are likely to benefit more from an increase in exports than
DEs. For example, China is more dependent on external demand than the United States and the high
export growth and hence high economic growth in China over the last few decades has propelled it to
the second position of the world ranking of GDP, behind the United States. However, small DEs, due
to their small domestic demand, may be more dependent on external demand than large LDEs and
hence small DEs may benefit more from an increase in exports than large LDEs. Furthermore,
domestic firms in LDEs are smaller and hence have less financial resources for investment and
research and development than those in DEs and this constrains the growth of the production capacity
and hence economic growth in LDEs. This problem in LDEs is exacerbated by the low savings due to
the low incomes which lead to a low supply of loanable funds resulting in high interest rates and
hence high costs of borrowing. Therefore, an increase in foreign direct investments which will lead to
a more rapid increase in the production capacity in the economy is likely to be more beneficial to
LDEs than to DEs. This is particularly true in view of the fact that foreign direct investments are
generally made by multinational corporations which typically have high-end production technologies,
apart from their substantial financial resources.