Cambridge IGCSE and O Level Economics PDF

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Cambridge
IGCSE®and O Level
Economics
Paul Hoang
Margaret Ducie
/. HODDER
'EDUCATION
Economics
Paul Hoang and

Margaret Ducie
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Contents
lntroductioo
Acknowledgements
l!l!IIJI Basic economic problem: choice and the a llocation of resources
l Thebasiceconomicproblem
IEllmlJI The allocation of resources: how the market works; market failure 11
2 Economic systems 12
3 Demandandsupply 20
4 Priceelasticity 34
5 Markerfailure 49
1!1!111 The individual as producer, consumer and borTower 59

6 Money 60
7 Labourmarkers 71
8 Tradeunions 88
9 Income andexpendirnre 96
l!llmJ The private firm as producer and employer 109

10 Businessorganisation 110
11 Production 126
12 Costs,revenuesandprofits 135
13 Perfect competition and monopolr 142
14 Businessgrowrh 151
lmmll1! Role of government in an economy 163

15 Gm·ernmcmaimsandinfluences 164
16 Gm·ernmempolicies 172
17 Taxation 181
lmlm:JI Economic indicators 189

18 Inflation 190
19 Employment 205
20 Economicgrowth 216
Developed and developing economies: trends in production,

population and living standards 225
21 Srandardsofliving 226
22 Population 239
lmlm!I International aspects 25 1

23 Specialisation 252
24 Balanceofpaymems 258
25 Exchangerates 267
26 Trade and trade protectionism 276
Glossary 284
Index 293
Introduction
Economics can help to explain real-world e,'ems, issues and problems, such as why:
• the most expensive can of Coca-Cola, made fbrasuonauts, is $1250 per can!
• the world's fastest car, the Bugatti Vcyron, is priced at a cool €1.95 million ($2.57m)
• the price of a bus fare is relatively low
• the a\·eragc doctor, lawyer, pilot or demist has high earnings
• private -sector firms do nor supply street lighting and public roads
• Zimbabwe has no official currency
• diamonds (a non-essential product) are expensive whereas water (a viral good) is not
• farm workers (who harvest products essential for life) are paid low wages whereas bankers (who produce
nothing of real substance) are paid high salaries.
Economics helps to explain everyday issues that occur in a consramly changing global environment. It is a
'live' subject and you are encouraged to watch the news and read newspapers to refresh the case studies you
learn in class. Up-to-date, real-life examples greatly enhance your answers in examinations.
How this book ca n help you

TI1is book has been written with the international student in mind.
• It explains economic theory using real-life examples and case studies from around the world.
• The suggested activities encourage you to investigate real-life applications of economics as a dynamic
subject in your local environment as well as globally. They enable you to extend your learning of the
subject, both within and beyond the classroom environment.
• The 'Study tips' encourage critical thinking and emphasise the need to be able to present and justify an
opinion, underpinned by economic principles and theories.
• The 'Exam pract ice' questions are designed for you to experience the types of question you arc likely to
get in an examination.
• The end·of·chapter review q uestio n s, which correspond with the chronological order of the text, are
intended to encourage you to read, reflect and write your own answers. Therefore, there arc no suggested
answers for these comprehension-type questions.
• Defin ition s of key terms feature throughout the book and are collated at the end of each chapter as a
glossary.
W ha t's a n th e CD-ROM?
TI1c CD·ROM contains:
• suggested answers to all the exam practice questions*
• wcblinks for you to explore the topics and companies mentioned further
• a glossary of all key terms con rained in the book, as a useful revision tool
• interactive activities to test the ke y terms of the syllabus
• exam techniques and further tips and advice for success.
Enjoy studying this course and using this courscbook!
Paul Hoang and Margaret Ducie
·The questions. example answe". marks awarded and/or comments that appear in this book and CD were written by the aultio« . In eumir,ation.
•
the way marks would be awarded to ar,swers like these may be di fferent
Acknowledgements
The authors would like to dedicate this book to their children:
Salvador, Gino and lsidora Boon
Jake and Luke Hoang
The authors would like to thank:
Their spouses, Derek Boon and Kin Hoang, for their patience, understanding and
support.
So-Shan Au, their Commissioning Editor at Hodder Education, for her advice,
support and dedication. This textbook would not have been possible without her
guidance and hard work.
The publishers would like to thank the following for permission to reproduce
copyright material:
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t= top r= right I= left c= centre b= bottom
Text:
p.15 Table 2.1, from www.toplOfacts.com; p.16 Figure 2.2a: The five 'freest
economics 2013', from Highlights of the 2013 Index of Economic Freedom, published
by The Heritage Foundation; Figure 2.2b: Regional leaders 2013, published by The
Heritage Foundation; p.18 Table: UK education sixth in global rankings by Sean
Coughlan, from www.bbc.eo.uk/news/education-20498356 (27 November, 2012);
p.22 Table 3.1: Top 10 fashion brands for Chinese females, from Hurun Chinese
Luxury Consumer S11rvey 2013. Hurun Report:-, p.41 Case Study: Toyoko Moror
Corporation, adapted from Wafl Street Journal and TIME Business; p.54 Case Study:
Sheila Pulham, Eric Hilaire, Chris Fenn, Guardian Research depanmem,
The Deepwatcr Horizon disaster, adapted from BP oil spill: an interactive timdine
(28 September 2010, copyright (Cl Guardian News & Media Ltd, 2010, reproduced
by pennission of Guardian NC'.vs & Media Ltd; p.63 Case Study: The Federal
Reserve, from ww11>ftderalreservudueation.org; p.65 Figure 6.1: from Matthew
O'Brien, 'The Biggest Bank Bailouts in H istory(#2 ls Happening Right Now)',
published in The Atlantic, www.imforg/extenial/pubs/ft/wp/2012/wpl2l63.pdf, p.66
Table 6.1: The world's largest initial public offerings, adapted from Re11ters.com and
Forbes; p.68 Table 6.2: The world's largest commercial banks, 2012, reproduced by
•
permission of Banks around the world, www.relbanks.com; p.73 Table 7.2: Earnings
by age, full-time workers (UK, 2010 -2012), adapted, Office for National Statistics
(ONS), http://goo.glCgoWo; Table 7.3: After-tax earnings by educational attainment
(USA, 2011-2012), from Comumer F.xpenditure Survey, U.S. (March, 2013),
published by the United States Department of Labor, Bureau of LaOOr Statistics;
Table 7.4: Minimum wage rates per hour in Australia, 2013 in US$, from The Fair
Work Commission, http://www.fwc.gov.au/, reproduced by pern1ission ofFair Work
Ombudsman; p.78 Table 7.6: Labour Participant rates, selected coumries, adapted,
published by The World Bank, IJttp.//googl/ORrqc; p.79 Skills shortages, data from
BBC News, Business, http./!goog/YfjCK; p.81 Table 7.7: Earnings for selected
occupations in the UK, April 2012, adapted, Office for National Statistics, http.//goo.
gl/selpm; p.82 Table 7.8: Difference in male and female working hours and earnings
(UK, 2011 -2012), adapted, Office for National Statistics, http://googl/JWMVs;
p.84 Table 7.9: Difference in private and public sector earnings (UK, 2012), adapted,
Office for National Statistics, http.//googl/JWMVs; p.84 Table 7.10: Hourly earnings
in selected industries (UK, 2012), adapted, Office for National Statistics, http.J!goo.
gl/JlVMVs; p.91 'Bharat bandh: Kerala remains paralysed as strike enters second day',
adapted, NDTV (February 21, 2013); p.93 Exam Practice: adapted from World
Socialist Web, IJttp.//googl/BvY14; p.107 Exam Practice: Household debt to
disposable income' ratio in South Korea, published by Reuters, IJttp.//googl/rn/SM;
p.119 Cooperatives: data published by lmernational Cooperative Aliiance, http.//goo.
gl/oBJpA; p.94 Figure 8.2: Trade union membership in China and the UK (2000 to
2010), International Labour Organization, http;//googl/jfmt5; p.98 Figure 9.1: from
Kerry M.cQueeney, 'Revealed: How the poor, middle class and rich spend their
money in America ... and the 1% aren't so different after all', Mail Online (2 August,
2012); Figure 9.2: Real household disposable income in the USA, UK, Japan and the
Eurozone, OECD Factbook 2013; p.99 Figure 9.3: Consumer spending in the United
States (2008·2013), published by Trading Economics, http.//bit.fy/YU011mP; Figure
9.4: Consumer spending in the United Kingdom from (2008-2013), published by
Trading Economics, http.//bit.fy/llUhPOF; Figure 9.5: Consumer spending in Japan
(2008-2013), published byTrading Economics, http.//bit.ly/11F4S11M; p.101 Figure
9.6: Consumer spending in Mauritius (2008-2013) from Trading Economics, http://
bit.fy/ZQUZ9i; Figure 9.7: Inflation rates in Mauritius (2008 -2013), published by
Trading Economics, http.//bit./y/XZmXDt; p.103 Figure 9.9: Office for National
Statistics, from Living Costs and Food Survey, December 2012, http.J!googf/y961h;
p.105 Figure 9.10: Household net savings rates, from National Accounts at a Glance,
published by OECD, http.//googf/lTMHq; p.128 Table 11.1: Top earners in football,
Forbes, http://goo.gl/B6nDv; p.152 Table 14.1: The The world's largest companies,
Forbes; p.171 Table 15.1: The world's richest people', from Forbes maga::;ine,
www.forbes.com/bilfionaires; Case Study: Cheung Chi-fai, from 'Government
eyes extension of plastic bag le,1'', adapted,Sout/J China Mon1ing Post;
p.191 Figure 18.2: US inflation rates (2000 -2013), published by Trading Economics,
www.tradingeconomics.com; p.198 Table 18. 3: The 5 wealthiest hip-hop artists, Forbes
Rich List 2013, http./!googl/EBXfif; p.199 Table 18.4: The world's most expensive
cities, from Worldwide Cost of Living Index 2013, published by Economist
Intelligence Unit, http://goo/gljbnvry; Table 18.5: Inflation rate in Iran, Reuters,
•
http://goo.gl/2yGLB; p.200 Table 18.6: Deflation rates around the world, 2013,
published by Trading Economics,www.tmdinguonomics.com; p.203 Figure 18.9:
Japan Inflation Rate, published by Trading Economics, www.tmdingeconomics.com/
japanjinjlation-cpi; p.205 Table 19.l: Output by sector(%), selected countries, CIA
World Factbook, http./!goo.gl/DRrOh; Figure 19.2: US unemployment (2000 -2013),
published by Trading Economics, www.tradingeconomics.com/united-states/
unempluymmt-rate; p.208 Figure 19.2: Nigeria's unemployment rate, 2006 -2013,
published by Trading Economics, www.tmdingeconomics.com; p.222 Table 20.l:
GDP per capita - selected countries, adapted, CIA Factbook; p.227 Table 21. 1: GDP
for four countries, published by Trading Economics, www.tradingeconomics.com;
Table 21.2 H DI classification of countries (selected countries), HDI Report 2013,
United Nations Development Programme (UNDP); p.222 Figure 20.3: China's
GDP Growth, lmp.j/lvww.uonomist.com.hk/blogs!graphicdctail/20I2/12/daily-
chart-18; p.229 Table 21. 3: Internet users around the world, adapted, The World
Bank, http://data.worldbank.org; p.230 Table 21.4: Government debts around the
world (2012), CIA World Factbook; Table 21.5: Output of the economy by sector,
selected countries (2012), adapted, CIA World Factbook; p.231 Figure 21.l: Selected
economic development indicators: Congo, published by The World Bank,http.//data.
worfdbank.org; p.232 Table 21. 6: Number of mobile phones in use, top 5 and
bottom 5 countries, adapted, Wikipedia from http.//goo.gl/UFrWb; p.233 Case
Study: The most livablc cities in the world, from Global LiPeability Report, http./!goo.
gl/Zrj4; p.234 Table 21.7: The world's richest and poorest (2012), CIA Factbook,
http./!goo.gl/u2Y2d; p.235 Case Study: Sierra Leone, adapted from CIA World
Factbook; p.24 1 Figure 22.l: The world's population 1973-2033 (predicted),
adapted, from www.ibiblio.org/lunarbin/worldpop; p.242 Tables 22.l and 22.2: The
world's least populous countries 2013, published by Trading Economics, www.
tradingeconomics.com; p.243 Figure 22.2:Ghana's age distribution (population
pyramid), from http./!goo.gl/oHbHQ; Figure 22.3: Japan's age distribution
(population pyramid), from http.j!goo.gl/Wd7IP; p.246 Table 22.3: Countries with
highest and lowest population growth rates (%), adapted, CIA Worldfactbook, http.//
goo.gl/EGU]y; p.247 Table 22.4: Comparison of employment by sector (for selected
countries), adapted, CIA World Factbook, www.da.gov/index.html; p.249 Figure
22.5: Nigeria Population, published by Trading Economics, www.tradingeconomics.
com/nigeria/population; Britain's ageing popufation: data adapted from Office for
National Sratistics,ww»>.ons.gov.11k/dcpl71776_ 258607.pfd; p.253 Table 23.l: The
world's three largest producers of selected products, The Economist P()(.kct Book;
p.259 Table 24.l: The current account balance, selected countries (top and bottom 5
ranks),CIA Factbook 2012 (http.//googl/llmxl); p.261 Figure 24.l: Sri Lanka Balance
of Trade, published by Trading Economics, www.tradinguonomics.com/sri-fanka/
balance-of-trade; p.265 Figure 24.2: Kuwait Current Account, published by Trading
Economics, www.tradingeconomics.com/kuwait/c11rrent-acco11nt-to-gdp.
(D The basic economic problem
By the e nd of this cha pte r, you sho uld be able to:
• define the nature of the economic problem {finite resources and unlimited
wants)
• define the factors of production (land, labour, capital, enterprise)
• define opportunity cost and analyse particular circumstances to illustrate the
concept
• demonstrate how production possibility curves can be used to illustrate choice
and resource allocation
• evaluate the implications of particular courses of action in terms of
opportunity cost.
Taken from Cambridge International Examinabom S),1tabus (IGC SE 0455/0 Ll'Vel 228 1)
0 Cambfklge International Examifliltioo,
Th e na ture of the eco no mic pro blem

In e~·ery country, resources arc limited in supply and decisions have to be made
by governmems, firms (businesses) and individuals about how to allocate scarce
resources to satisfy unlimited needs and \\'ants. This is the basic economic problem
that exists in every economy: how to allocate scarce resources to satisfy unlimited
needs and wants (see Figure 1.1 ).
Figure 1.1 Therealcauseoftheeconomicproblem
An economic good is one that is limited in supply, such as oil, wheat, cotton, housing
and cars. Free goods are unlimited in supply, such as the air, sea, rain water, sunlight
and public domain web pages.
Activity
Make a list of ten goods which are limited in supply (economic goods) and a second list of
goods which are unlimited in supply (free goods). How many goods can you think of that
are unlimited in supply?
Economics is the study of how resources are allocated to satisfy the unlimited needs
and wants of individuals, governments and firms in an economy.
The three main economic agents or decision-makers in an economy are:
• individuals or households
• firms (businesses that operate in the private sector of the economy)
• the government.
0
The basic economic problem
The three basic econo m ic q uestions addressed by economic agents are:

l Whattoproduce.
2 How to produce it.
3 For whom to produce it.
Firms and individuals produce goods and services in the private sector of the
economy and the go\·ernment produces goods and services in the pu blic sector.
Governments, firms and individuals both produce and consume goods and services.
For example, the government might provide education and health care services for
the general public.
Goods are physical items such as tables, clothing, roothpaste and pencils. Ser vices
are non-physical items such as haircuts, bus journeys, telephone calls and internet
Activity
1 Make a list of the goods and services provided by the public sector of your economy.
2 ldentifythegoodsandservicesthatarefreetoindividualsandthoseforwhichyouhave
to pay.
l List which goods/services could be provided by a private firm as well as by the public
(government)sector.
4 Compare and contrast the aims and objectives of a government-funded swimming pool
andaprivatehealthandleisureclub.
N eed s are the essential goods and services required for human survival. These include
nutritional food, clean water, shelter, protection, clothing and access to health care
and education. All individuals have a right to have these needs met and this is stated
in Articles 25 and 26 of the United Nations Universal Declaration of H uman Rights,
which was drafted in December 1948.
Article25
Everyone has the right to a standard of living adequate for the health and
well-being of himself and of his family, including food, clothing, housing and
medical care and necessary social services, and the right to security in the event
of unemployment, sickness, disability, widowhood, old age or other lack of
livelihood in circumstances beyond his control.
Article26
Everyone has the right to education. Education shall be free, at least in the
elementary and fundamental stages. Elementary education shall be compulsory.
Technical and professional education shall be made generally available and higher
education shall be equally accessible to all on the basis of merit.
\\'a nts are goods and services that are not necessary for survival. An individual's
wants, or desires, tend to be unlimited as most people are rarely satisfied with what
they have and are always striving for more. Wants are a matter ofpersonal choice and
humannarure.
World Bank figures (2012) suggest that 3 billion of the world's inhabitants Jive on
less than $2 .50 per day and that their basic needs are not being met. In contrast, the
richest 20 per cent of individuals recei\·e 75 per cent of world income. The study of
economics can help to explain why this happens and offer possible solutions to the
basic economic problem.
0
Basic economic problem: choice and the a/location of resources
Activity
1 Makealistofyourwantsandneeds.
2 Arethereanyneedsthatyoucouldactuallysurvivewithout?
3 Arethereanywantsthatmightbeconsideredasneeds?
4 Identify a shortage of any good or service in your economy. Explain why the shortage
has occurred.
Factors of production
Production of any good or service requires resources. These are divided imo four
categories, known as the factors of production:
l Land refers to the natural resources required in the production process (such as
oil, coal, water, wood, metal ores and agricultural products).
2 Labour refers to the human resources required in the production process (such as
skilled and unskilled labour).
3 Capital refers to the manufactured resources required in the production process
(such as machinery, tools, equipment and ~·chicles).
4 Enterprise refers to the skills a business person requires to combine and manage
successfully the other three factors of production and the ability to undertake risk.
Factorsofproduction:land,labour,enterprise andcapital
The factors ofproduction required in the production ofa can of Coca-Cola are as
follows:
Study tips
The first letters of • Capital: machinery, tools, a factory building and trucks to transport the
the four factors drinks.
of production • Enterprise: the skills necessary to organise the production process successfully and
spell the word to motivate workers so that they work to the best of their ability.
CELL.This is a • Labour: people to work on the production line, perform administrative tasks and
useful way of
remembering manage the company.
thesefourfactors. • Land: the natural resources required to make Coca-Cola (such as sugar, water and
caffeine).
•
Production of all goods and services requires the four factors ofproduction in varying
proportions. For example, in a school, capital resources and Jabour arc required in
greater quantities than land (natural resources). By contrast, production of soft drinks,
such as Coca-Cola, requires a large amount of machinery and therefore this process
is capital inten sive (sec Chapter 11) as it requires more machinery (a capital resource)
than labour.
An architectural practice designs buildings. It requires qualified architects
to design the buildings and technicians, skilled in using computer-aided design
software , to produce drawings. Computers, software, office space and enterprise
arc required to design high-quality crcati\'c buildings and to attract customers. It
is labou r inten sive (sec Chapter 11) because it requires a larger amount ofhuman
resources compared with technological resources and equipment.
Primary, secondary and tertia ry sectors of industry

An economy is divided imo three sectors of industry (see Figure 1.2):
• P rimary sector - this contains firms that extract raw materials from the Earth
(e.g. farming, fishing and mining).
• Secondary sector - this contains firms that:
O manufacture goods and change raw materials imo finished products
O constrnct buildings, roads and bridges.
• Tertiary sector - this contains firms that pro\'idc scn'iccs to the general public and
other firms (such as retail shops, doctors, demists, schools, hairdressers, advertising
agencies, lawyers, financial advisers, insurance companies and banks).
Figure 1.2 Thethreesectorsofindustry
The primary, secondary and tertiary sectors of an economy are interdependent (the y
are dependent upon each other), as a firm cannot operate without using goods and
services from all three sectors ofindusuy to make its goods or services and to sell
them to the final customer. The three sectors of industry arc linked together in what
is known as a chain of productio n .
•
Consider the textbook that you are

currently using. What is the chain of
production ofa book and which of the
sectors does each stage of the process
use? The raw material for the book comes
from forests and trees. The growing and
cutting down of the trees is a primary
industry. The wood is formed into pulp
and turned into paper in a paper mill,
which is a secondary sector industry.
The paper is then used when the book is
primed, which is another secondary sector
industry. The book is transported to shops
where it is sold, both processes being ,,-.,= .--,"'- Booksbeing
tertiary sector industries (see Figure 1.3). ooldinashop
Figure 1.3 The chain of production of a book
Case Study: Ye llow Moon

Yellow Moon is an independent jewellery shop that is located in Pondicherry, India.
The business owners design and make the jewellery in their workshop and it is sold to
customers from its store and via the internet through the firm's website.
The following table shows examples of goods and services from the primary, secondary
and tertiary sectors that are necessary for Yellow Moon to operate successfully. The firms in
eachsectorrepresentlinksinthechainofproduction.
Activity/Sector IExamp les ofgoods/servicesrequ ired I
Primary l silver,goldand5emi-preciousstones I
Secondary I Des.igners and jewellery makers to create the jewellery products I
Tertiary
Activity
Refertothecasestudyabove.
1 Identify the factors of production required by Yellow Moon to operate its business.
2 Produce a table li ke the one above for :
a) amobilephonemanufacturer
b) afastfoodrestaurantchain
c) ashopsellingkitchenequipment.
0
Oppo rtunity cost

Oppo rtunity cost is a very important concept in economics. Opportunity cost is
the cost measured in terms of the next best choice given up when making a decision.
Every choice made has an opportunity cost because in most cases there is an
alternative. Some examples of opportunity cost arc as follows:
• The opportunity cost of taking !GCSE Economics is the other subject you could
be studying instead.
• The opportunity cost of visiting the cinema on Saturday night is the sum of money
you could ha\·e earned from babysitting for your neighbour instead of going to the
cinema.
• The opportunity cost of building an additional airport terminal is the public
housing for low-income families that the same gm·emment funds could have been
used for.
• The opportunity cost ofa school purchasing 100 laptops for use in the classroom
might be the science equipment that cannot be bought as a result.
Case Study: Govern me nt s pending in Ho ng Ko ng

lnthe2013 HongKongBudget,thegovernmentannouncedthefollowing:
• 17percentofthebudgetwouldbespentoninfrastructure
• 17percentoneducation
• 14percentonsocialwelfare
• 12percentonhealthcare.
The government raises a finite amount of taxation revenue and must decide how much
of the budget to allocate to each area of public spend ing. The re is an opportunity cost
attached to the decisions made, as increased spending in o ne area may lead to decreased
spendin g in another.
Opportunity cost can be represented on a diagram known as a production

possibility curve (PPC). The PPC represents the maximum amount of goods
and services which can be produced in an economy, if all resources arc used
efficiently. It represents the productive capacit y (maximum output) ofan economy.
Assume a country called Tullassa can only produce two types of good: wooden
furniture and olive oil. Tullassa has a limited amount of land, labour and capital.
In Figure 1.4, ifproducerswish to increase production of olive oil from 0 1 to Di
then the amount ofwooden furniture manufactured will have to decrease from
W1 to W2 • The opportunity cost ofproducing an extra 0 1 - Di litres of olive oil is
therefore W 1 - W2 tonnes of wooden furnimre. The production possibility curve is
usually drawn concave as, in order to produce more litres of olive oil, it is necessary
to give up an increasing amoum of wooden furniture, thus reflecting the increasing
oppormnity cost.
0
The 1ncreasedarnooo1d
oive o ll ~ produced a t
1heexpem.elopportlX1ify
c05llof woodenh..-nl1Jre
01 0., B
Ol"°'oil llite,1
Key:
A - Al resouce,dedmled1o1heprod,ctk, n olwoodooh..-ni1Jre
B - Al l re=esded1coled 1o 1he prod,c11oo dd"°' c. l
g=~~:::j::tt~:::~~r:.7at~1~:";1:t 1
f - Thhpol nt hbep,d thefl'OOuctionp=lbll fy ctKVe(ll)<] l1e,ow.de t.epoductiveoopocifyofth e

ocooomy, so it hL.M11o iooble
F - Th~po1n11,v,;th1n 1heproo.,dtvecopocry ol1heecooomyondfl'OOucttondbcthd1veo j ondwoodoo
fu rn ru reco ni ncroosew rhoo onyoppor1lx1 ifyco,;1rnsome!ocb,, dproduc11ooorenol00ingu!OO
Figure1.4 Theproductionpossibilitycurve(PPC)ofTullassa
Increases in the productive capacity o f a country

There has been advancement in technology in Tullassa, which means that yields
of olive oil and the productivity of furniture makers have increased. In Figure 1.5,
the PPC shifts outwards, from PPC 1 and PPCi, and represents an increase in the
l,&
productive capacity ofTullassa. \Vith the same amount offuctors of production, more
can be produced.
r,, we,
PK,
O Ol"°'oil llite,1
Figure1.5 AnoutwardshiftoftheP PC
Decrease in productive capac ity o f a country

A powerful storm hits Tullassa and destroys a large percentage of the fuctories and
buildings. Much of the olive crop is destroyed and transport links are imermpted.
In Figure 1. 6, the PPC shifts inwards from PPC 1 to PPC 2 and represents a decrease
in the productive capacity ofTullassa.
0
ji~ ~.
LJl
O Olr,oec. l [litrrul
Figure1.6 AninwardshiftofthePPC
Exam practice
Low-lying areas of Bangladesh are prone to flooding each year. Crops are lost and
thousands of people lose their homes. During times of severe flooding, roads and
railways are damaged and farmers find it impossible to get their dwindled crops to
market.
1 Draw a PPC diagram to show the impact of flooding on the productive capacity
of Bangladesh. (4)
2 On the diagram, draw a point where some of the factors of production will
~~ ru
3 On the diagram, draw and label a point that is unattainable. (1)
Figure 1. 7 summarises the basic economic problem.
- - - -"' ll mlOOreSOJraa>
/ ~,w
I
BASIC ECONOMIC PROBLEM
I
LX1il mi8lwont,
>earcity
leodslooppo<tu nlty=!
Figure 1.7 Summary: the basic economic problem
0
Chapter review questions

1 What is the difference between a need and a want?
2 What is meant by the basic economic problem?
How is the term 'opportunity cost' defined?
What factors of production are required to construct a road?
5 How would a f irm producing running shoes answer the three basic economic
questions?
6 What are the three sectors of industry?
7 What is meant by productive capacity?
8 What is a production possibility curve used to show?
Ke y terms
The basic economic problem is how to allocate scarce resources to satisfy unlimited needs
and wants.
The chainof production describeshowbusinessesfromtheprimary,secondaryandtertiary
sectors work interdependently to make a product and sell it to the final customer.
Economicagents arehouseholds(privateindividualsinsociety),firmsthatoperateinthe
private sector of an economy and the government (the public sector of an economy).
Econom lcgoods arethosewhicharelimitedinsupply.
Free goods are goods which are unlimited in supply, such as air or sea water.
Goods arephysicalitemssuchastables,cars,toothpasteandpencils.
lnterdependence meansthatthethreesectorsofindustryaredependentuponeachother
andcannotoperateindependentlytoproducegoodsandservices.
Needs aregoodsthatareessentialforsurvival.
Opportunity cost is the cost of the next best opportunity foregone when making a
decision.
The product ion poss ib ility curve (PPC) represents the maximum amount of goods
and services which can be produced in an economy, i.e. the productive capacity of the
economy.
Services arenon-physicalitemssuchashaircuts,busjourneys,telephonecalls,andinternet
Wants are goods and services that are not necessary for survival but are demanded by
economic agents.
@ Economic systems
By t he e nd o f this cha pter, you should b e able to:

• describe the allocation of resources in market and mixed economic systems
• evaluate the merits of the market system.
Taken from Cambridge International Examir,abom 5),1\abus (IGCSE 0455/0 Level 1281 )
0 Cambridge lntemabonal Examinatioo,
Economic systems
An economic system describes the ,1ray in which an economy is organised and run,
including alternative views of how resources are best allocated. A key question in
economics is the extent to which a government should intervene in the economy or
leave economic agents (households and firms) to operate freely.
There arc three main categories of economic system (see Figure 2.1).
Ma rket Muted • Planned
Figure2.1 Economicsystems
l Market economy -This economic system relics on the market forces of demand
and supply to allocate resources, with minimal go,·ernment intervention.
Hong Kong is widely accepted as the world's freest market economy
2 Planned economy - This economic system relies on the government allocating

resources. It is often associated with a communist political system that strives for
social equality. Examples include North Korea, Laos and Cuba.
3 Mixed economy - As its name suggests, this economic system is a combination of
the planned and market economic system, with some resources being awned and
controlled by private individuals and firms whilst others are owned and controlled
by the government in the public sector. Examples include the UK, Germany
and Canada.
Economic systems
Study tips \Vhiche,'Cr economic system is used, all countries must address three fllndamental
economic questions:
Countries rarely
fall into the 1 What production should take place? This question is about deciding which gcods
categories of and services should be provided in the economy.
planned or market For example, is it better for the economy to haw more roads and airports or to
economies-these have more schools and hospitals? As resources are limited in supply, decision-makers
are theoretical realise there is an opJX>rmnity cost (see Chapter 1) in ans\\'Cring this question.
extremes. In
reality.most 2 H ow should production take place? This question is about the methods and pro-
countries tend cesses used to produce the desired goods and services.
to be mixed For example, decision-makers have to decide which combination offuctors of
economies, production should be used in the production process.
with a stronger 3 Fo r who m should production take place? This question is about which economic
element of either
commandorfree-
agents receive goods and services.
marketpolicies. For example, should any goods and services be pJ"O\'ided free to everyone in the
economy, irrespecti\·e of their willingness and ability to pay for these? Or should
goods and services only be produced for those who can pay?
Planned economic system

The planned economic system is sometimes referred to as the socialist or command
system. I n the past, China and the fonner USSR \\'Cre often used as the best examples
of planned economies, with O\·cr 95 per cent of economic activities state controlled.
The main features of such an economic system are:
• Production decisions (what, how and for whom production should take place) arc
decided by the government.
• Hence, resources are controlled by the government on behalf of its citizens.
• Production schedules are devised on a long-term basis, such as 5 -year plans.
• Wage differentials are minimal (i.e. Jabour is paid almost equally due to the belief
in equality).
• There is minimal engagement in international trade (i.e. the gowrnmem prefers
the economy to be self-sufficient).
Adva ntages of the pla nned system

The planned system has a number of advamages:
• Econo mies of scale - Large state monopolies can achie,'C huge cost savings known
as economies of scale (sec Chapter 14). This is achieved by operating on a very
large scale, such as a national supplier of electricity or postal services.
• Prevent was tage - Economists believe that competition can be wasteful in some
instances and so should be eliminated (for example, that national defence should
be placed under go.·crnment control). The state will only provide the goods and
services deemed necessary, so there is Jess wastage of scarce resources.
For example, some economists argue that excessi\·e ad\·enising is wasteful;
ultimately it is the customer who pays for the marketing costs of a business (see
the Super Bowl case study below). A lack of competition also arnids the drawbacks
of bankruptcies (the collapse of businesses).
• Social equality - A planned economic. system enables basic needs to be met for
C\'Cf','One in society. For example, everyone in society has access to education, health
care and employment. By contrast, in capitalist (free -marlcet) economies, production is
geared disproJX)rtionarely towards those with high incomes and wealth.
The a/location of resources: how the market works; market failure
Prices do nor need to be excessively high either, as private firms do nor exist to
maximise profits (see Chapter 12 ). Hence, in command economies, t here is far less
inequality in income and wealth distribution.
• Social pro tectio n - In a planned economic system, government rules and
regulations are used to protect consumers and producers. For example, there
may be strict laws rhar constrain economic growth in order to protect the
environment by conserving non-renewable resources, or to minimise the
impact of negative externalities such as pollution (see Chapter 5 ) caused by
economic activity.
• Employment of resou rces - Careft1l stare control and planning can ensure rhar
factors of production (see Chapter 1) are fully utilised. Thus, full employment of
resources can be maintained and economic growth can be planned.
For example, the People's Bank of China controls the counrry's money supply
(see Chapter 6) by limiting the amount of money that individuals can transfer each
day (currenrly capped ar 20000 yuan - or approximately $3180) per individual
customer per day.
Case Study: The Super Bowl

The say ing that 'time is money' really does apply in the world of advertising. The 2013
Super Bowl -America's biggest sporting bona nza - demanded a record S4 million for
companiestoairtheir 30-secondcommercial!
Activity
Refer to the case study above. Discuss how d ecision-makers could possibly justify spending
S4 million on a 30-second a dvertising commercial.
Disadvantages of the pla nned system

The planned system suffers from a number of disadvantages:
• Lack o f econo m ic freedom - As the stare plans all production decisions,
individuals do nor ha\'e economic freedom to choose from competing goods and
services. They also Jack career choices, as the government allocates jobs based on
production schedules and Jong-term plans for the economy. As the go\·crnment
prefers robe self-sufficient by having strict controls on imports, this causes
retaliation from other countries, which restrict exports from the command
economy.
• Lack of incentives - As resources, jobs, goods and services are determined
(planned) by the government, there is a lack ofincentive to be innovative. For
example, the lack of competition orrhc absence ofa profit motive for firms means
there is less of an incentive to produce more goods and services or to produce
these at a higher quality. Much of economics assumes rhar economic agents react
to incemh'es. The lack of incentives can therefore limit the standard of living (see
Chapter 21) for people in command economics.
• Bu reaucracy - For a planned economy to work effectively, many officials are
needed to administer and operate the system. Bureaucrats (official 80\'·crnmem
administrators) are responsible for decisions, bur they do nor rake entrepreneurial
risks - unlike private owners of businesses in marker economies. Hence, production
Economic systems
decisions can be very inefficient when price docs nor determine the allocation of
resources (sec Chapter 3), leading to shortages in some industries and surpluses
in others.
Case Study: Top-paid jobs

Some jobs a re paid more than others - see Ta ble 2.1 for data from the USA . Due to the vast
complexities of the job, the world's highest-paid profession in 2013 was surgeons, with the
average surgeon at the top end of the pay scale in the USA ea rn ing S181850.
Table 2.1 Topfivehighest-paidjobsintheUSA,2013
Ra nk Profess ion Annual sa lary(topend) Tra iningtime (yea rs)

Surgeon $181850
Chief executive officer $140890 Variable
En9ineeringmanager $140210
4 Airlinepilot $134090
$132702
Sou,ce, w -.top10facts .com
Activity
Refer to the case study above. Discuss the incentive s for people wanting to become
dentists,pilotsandsurgeons.
Ma rket syste m
This economic system relics on the marker forces of demand and supply to allocate
resources. The private sector decides on the fundamental questions of what, how and
for whom production should rake place. The marker economic system is also known
as the free m arket system or the capitalist economy. Features of the marker system
include the following:
• No government interference in economic activities - resources are owned by
private economic agents who are free to allocate them without imerfurence from
the government.
• Resources are allocated on the basis of price - a high price encourages more supply
whereas a low price encourages consumer spending. Resources are sold to those
who have the willingness and ability to pay.
• Financial incentives allocate scarce resources - for example, agricultural land is
used for harvesting crops with the greatest financial return, whilst unprofitable
products arc no longer produced.
• Competition creates choice and oppormnitics for finns and private individuals.
Consumers can thus benefit from a variety of innovative products, at compctith'C
prices and of high quality.
The market economy is central to su pply-side econo m ics (sec Chapter 16 ) and the
associated gains from free international trade (sec Chapter 26).
The H eritage Foundation compiles an annual economic freedom index for all
countries. Hong Kong has topped the league table as the world's freest economy
since records began in 1995, with Singapore being ranked second during the same
time period (sec Figures 2.2a and 2.2b).
•
Soorce:TheHe,itagefoundation,1013
Figure2.2a Thefive'freest'economies,2013
l+IIJ
Et Ill...
=~= :: ~ t mrlan d ~ngKong
Soorce:TheHelitagefoundation,2013
Figure2.2b Regionalleaders,2013
According to the Heritage Foundation, there is a high correlation between a

country's level of economic freedom and its standard of living (see Chapter 20).
Its research data suggest that market economies substantially outperform others in
terms of economic growth, health care, education, protection ofrhe environment
and the reduction ofpoverry.
Adva ntages of the market system

The marker system has the following benefits:
• Efficiency - Competition helps to ensure that private individuals and firms pay
attention to what customers want. This helps to stimulate innovation, thereby
making marker economies more responsive and dynamic.
• Freedom of choice - Individuals can choose which goods and services to purchase
and which career to pursue, without being restricted by go,ernment regulations.
• Incentives - The profit motive for firms and the (X)Ssibility for individuals to earn
unlimited wealth creates incentives to work hard. This helps to boost economic
growth and living standards in the country.
Disadvantages of the market system

The marker system also has a number of disadvantages:
• Enviro nmenta l issues - There are negative consequences of economic prosperity
under the marker system, such as resource depletion, pollution and climate change.
• Income a nd wealth ineq ualities - In a marker system, the rich have far more
choice and economic freedom. Production is geared to meet the needs and wams
of those with plenty of money, thus basic services for the poorer members of
society may be neglected.
• Social hardshi p - The absence of government control means the provision of
public goods (see Chapter 15) such as streerlighting, public roads and national
defence may not be provided. Reliefof(X)Yerry in society might only be done
through voluntary charities.
Economic systems
• \Vasteful competition - Competitive pressures can mean that firms use up

unnecessary resources to gain competitive advamages over their rivals, such
as excess packaging and advertising clutter. Consumers might be exploited
by marketing tactics such as pester power (see the activity below). The lack of
go,·ernment im•olvemem could also mean that products are Jess safe for consumers.
Activity
Pesterpower isthemarketingtermusedtodescribetheabilitythatchildrenhaveto
persuadetheirparentstomakecertainpurchasingdecisions,perhapsbyconstantnagging
or annoyance.
Use the internet to find examples of pester power and be prepared to share your
findings with the class.
Mixed system
The USA is often given as an example of a modern capitalist society. However, the
State and Federal governments do get involved in providing some basic services.
In reality, the USA is a mixed economy but with a much larger private sector
proportionally than most nations.
The mixed economic system is a combination of both the planned economy
and the market economy. The degree of public and prh'ate sector ilffol,·emem in
economic activity is determined by the go,·ernment. Essemial services are provided
by the public sector, such as state education, health care and postal services. 111e
government exists to redistribute income by providing unemployment benefits and
state pensions, for example. In the private sector, profit acts as the motive for firms to
provide the goods and services demanded by consumers.
I n the UK, the public sector accounts for around 45 per cent of gross domestic
product (GDP) whereas in France this figure is around 43 per cent, so both are good
examples of mixed economies. Other examples arc Australia, Japan, Iceland, Sweden
and Italy.
The mixed economic system obtains the best of both the planned and market
systems. For example, necessary services are provided for everyone whilst most other
goods arc compctith'Cly marketed. Producers and workers have incentives to work
hard, to invest and to save. There is large degree of economic freedom with plenty of
choice for private individuals and firms.
The disadvanrages of the extreme economic systems also apply to the mixed
economy. For example, consumers still pay higher prices due to the profit moth'C of
private sector businesses. Public sector activities must also be funded by taxes and
other government fees and d1argcs.
Activity
Use the internet to find relevant economic data for two different countries (such as North
Korea and Hong Kong) to distinguish between the two main types of economic system.
You might also find it useful to look at newspaper articles on current topics related to
economic systems.
Case Study: Education systems

The Economist Intelligence Unit rankings of the world's top education systems, which
combine international test results and data such as graduation rates, showed that two
contrastingeconomiestoppedtheleaguetablefor2006-10: FinlandandSouthKorea .The
report concluded that, while the amount of spending on education is important, it is less
influentialthananeconomyhavingaculturethatissupportiveoflearning.
EducationinFinlandis100percentstatefundedandisratherunorthodoxgiventhat
students do not start schooling until the age of seven and rarely have tests or homework
untiltheirteenageyears. lnSouthKorea,educationiscrucialforsuccesssohugepressures
areplacedonstudents,whostartschoolagedthree. Testing is regular and rigorous,
makingafter-schoolprivatetuitionclassesextremelypopular.
According to the report, the top ten countries were ranked as follows:
1 Finland
2SouthKorea
3 Hong Kong
4Japan
SSingapore
6 UK
7 Netherlands
8 NewZealand
9 Switzerland
10Canada
Sou,ce:adaptedfrom -.bbc.co.uk/news/education-10498356
E1<am practice
1 Describe how scarce resources are allocated in a mixed economy. (3)
2 Discuss whether education should be funded by the government. [7)
Economic systems
Chapter review q uestions

1 What is meant by an economic system?
2 What are the three fundamental economic questions that any economic
system seeks to answer?
3 How are resources allocated in a market economic system?
4 How are resources allocated in a planned economic system?
5 What are the merits of the market system?
Key t e rms
An econo mic system is the way in which an economy is organised and run, including how
besttoallocatesociety'sscarceresources.
The fundamental economic question, are the key questions that all economic systems strive
to answer: what, how and for whom production should take place.
A mariiet tKOnOfflY is a type of economic system that relies on the market forces of demand
and supply to allocate resources with minimal government intervention.
A mi11.ed economy is a type of economic system that combines elements of both the
planned and market economic systems, with some resources being owned and controlled by
private individuals and firms while others are owned and controlled by the government.
A pl.nned econo my is a type of economic system that relies on the government allocating
scarce resources. It is often associated with a communist political system that strives for
social equality.
0 Demand and supply
By the end of this chapter, you should be able to:

• demonstrate the principle of equilibrium price and analyse simple market
situations with changes in demand and supply
• describe the causes of changes in demand and supply conditions and analyse
such changes to show effects in the market.
The meaning of demand

Demand refers to both the willingness and the ability of customers to pay a given
price to buy a good or service. This is sometimes referred to as effective demand to
distinguish genuine demand from a wam or a desire to buy something. TI1e amount
ofa good or service demanded ar each price le,'Cl is called the quantity demanded.
In general, the quantity demanded falls as price rises, whilst the quantity
demanded rises at lower prices. Therefore, there is an inverse relationship between the
price ofa goa:l or service and the demand. This rule is known as the law of demand.
There are two reasons for this relationship:
• As the price ofa good or service falls, the customer's 'real' income rises (i.e. with
the same amoum ofincome, the customer is able to buy more products at lower
prices).
• As the price of a good or service falls, more customers are able to pay, so they are
more likely to buy the product.
Demand curves
Diagrammatically, the demand curw is shown as a downward-sloping curve to show
the in\'erse relationship between price and quantity demanded (see Figure 3.1).
A, he price Id~ from

§;P, -
~ p~ -
::.:;,~;;,~;~%
Q, b Oi
0.00,d
Q, a,
O...OOtifydemooded
Figure l .1 Thedemandcurve
Demand and supply
The market demand curve refers to the sum of all individual demand for a product.
It is found by adding up all individual demand at each price level (see Figure 3.2).
For instance, supix,se that a cinema charges $10 for its movie tickets and the demand
from male customers totals 500 per week while 400 females purchase tickets at that
price per week. The market demand for cinema tickets at $10 per ticket is therefore
900 tickets per week.
:1=c1x·t=L
0 500 QO
Figure 3 .2 Themarketdemandcurve
400 Q O 900 Q
Activity
Chooseanitemthatyoucanbuyinyourcountry.
1 Whatarethefactorsthataffectthedemandforthisproduct?
2 Which factor is the most important? Why?
Produce your findings in an Al poster format for displaying in the classroom.
Determinants of demand
Although, price is regarded as the
key determinant of the level of
demand for a good or service, it
is not the only factor that affects
the quantity demanded. Other
factorsthataffectaperson'sle\'el
Study tips of demand for goods and services
Some of the are listed below:
non-price
determinants • Habits, fashion and tastes -
of demand can Changes in habits, fashion and
be remembered taste can affect the demand for Fashionable products lead to an increase in demand
by the acronym all types of goods and services.
MISC:marketing,
income, Products that become fashionable (such as smartphones) enjoy an increase in
substitutes and demand, whereas those that become unfashionable (such as last season's clothes)
complements. experience a fall in the level of demand. Luxury fashion brands from France are
highly popular amongst women in China (see Table 3.1).
Tabl e3 .1 ToptenfashionbrandsforChinesefemales
Rank Bran d
Chanel(France)
LouisVuitton(France)
Cartier(France)
Tiffany&Co. (USA)
Apple(USA}
Montblanc(Germany)
Gucci(ltaly)
Prada(ltaly)
Dior(France)
Burberry(UK)
Source: Hurun(hjne,eluxuryConsume,Survey.2013
• Income - Higher le,-els of income mean that customers are able and willing to buy
more goods and services. For example, the average person in America has a higher le,-el
of demand for goods and services than the average person in Vietnam or Turkey.
• Substitutes and complements - Substitutes are goods or services that can be
used instead of each other, such as Coca-Cola or Pepsi and tea or coffee. If the
price of a product falls, then it is likely the demand for the substitute will also fall.
Complements are products that are jointly demanded, such as tennis balls and
tennis racquets or cinema mo\'ies and popcorn. If the price ofa product increases,
then the demand for its complement is likely to fall.
• Ad ver tising - Marketing messages are used to inform, remind and persuade
customers to buy a firm's products. Companies such as Coca-Cola, McDonald's,
Apple and Samsung spend hundreds of millions of dollars each year on their
advertising budgets to increase the demand for their products.
• Government policies - Rules and regulations such as the imposition of taxes on
tobacco and alcohol will aflcct the demand for certain products. Sales taxes cause
prices to increase, thereby reducing the level of demand. By contrast, government
subsidies for educational esrablishmems and energy-efficient car-makers encourage
more demand for education and environmentally friendly cars due to the rclath·cly
lower prices.
• Economy - The state of the economy (whether it is in an economic bcom or a
recession ) also has a huge impact on the spending patterns of the population.
O The global financial crisis of2008, for example, caused the demand for most
goods and services around the world to decline because households and
businesses lacked confidence in the economy.
0 By 2013, the financial crisis had caused unemployment to exceed 26 per cem in
both Greece and Spain - the highest unemployment figures ever experienced in
the European Union. This undoubtedly reduced the level of demand for goods
and services in these counuics.
There arc many other factors that can influence the level of demand for a particular
good or service.
• For example, the weather can aflcct the demand for ice cream, beach resort
holidays, winter jackets and umbrellas.
Demand and supply
• The size and the demographics (such as age, gender, ethnicity or religious beliefs)
of the population can also ha\·e an effect on the le\·el of demand for goods and
services. For example, males and females can have very different buying habits.
Activity
Visityournearestshoppingmall.
1 Investigate the number of stores which cater specifically (or primarily) for women and
compare this with the number of stores which cater only (or mainly) for men.
2 Usingdemandtheory,explainwhythereissuchadifference.
The demographics of a population can have an effect on the level of demand for goods
and services
Moveme nts and shifts in demand

A change in price
A change in the price ofa good or service causes a movement along the demand
curve. A price rise will cause a decrease (contraction) in the quantity demanded of
the product, whereas a reduction in price will cause an increase (expansion) in the
quantity demanded, as shown in Figure 3.3.
··.··~········ ,. ~ .-=
-----------r------, ~ "'""'
------------r-----r------1 ~00
QI Qi Qi
O..O nti!ydemaoded
Figure l .3 Movementsalongthedemandcurve
An increase in demand
A movement along the demand curve is caused by price changes only. A change in all
other (non-price) factors that affect demand, such as income le\"els, will cause a shift
in demand.
An increase in demand (rather than an increase in the quantity demanded) is
represemed by a rightward shift of the demand curve from Di to D 3 in Figure 3.4.
Acha nge lna oon-pte

foclortharaliecr,
demandw1 ll .sh1h the
demandCIJM!
G;, QI Qi
OJa ntitydemooded
Study tips Figure l .4 Shiftsinthedemandcurve

Remember
the difference For example, BMW experienced record profits in 2012 when an increase in demand
between changes from China and other emerging markets boosted its car sales. Hence demand for
in demand BMW cars became higher at all price levels. At Pi the quamity of cars demanded was
and changes previously Qi but has now increased to QJ-
inthequantity By contrast, a decrease in demand (rather than a fall in the quamity demanded )
demanded.
is shown by shifting the demand curve to the left, from Di to D 2 , resulting in
• Ashiftin
Jess quamity being demanded at all price lewis. For example, at a price of Pi,
demand is
caused by demand was previously Qi, but has now fallen to 0- Financial problems and rising
changes in unemployment across Europe led to a 16. 5 per cem decline in the demand for
non-price Peugeot Citroen cars in 2012.
factors that
affect demand .
• A movement
along the
demand curve
iscausedby
changes in the
price of the
product.
BMW saw record profits when increasing demand in China and other emerging markets
boosted its car sales
Demand and supply
Activity
France is the most visited tourist country in the world, with over 80 million visitors each
year; the USA is second with 63 million visitors.
1 lnvestigatethemostpopulartouristcitiesinEurope.
2 Using demand theory, explain the factors that make these cities so popular.
Exam practice
Using an appropriate demand diagram, explain the impact on the demand for Apple
smartphones in the following cases:
1 An increase in the price of Apple smartphones. [4]
2 An increase in the price of Samsung smartphones. [4]
3 An increase in consumer incomes. (4)
4 A successful advertising campaign promoting Samsung's latest smartphones. (4)
The meaning of supply

Supply is the ability and wWingness of firms to provide goods and services at given
price levels. Firms will have more incentives to supply their products ar higher prices~
the higher the price, the greater supply tends to be (see Figure 3.5). There are mu
reasons for this relationship:
• Existing firms can earn higher profits if they supply more.
• New finnsare able to join the marker ifrhe higher price allows them to co\'errheir
production costs.
Figure3.5 The supplycurve

The market supply curve is the sum of all supply at each price level, as shown in
Figure 3.6. Suppose that at a price of$300000 Airbus is willing and able to supply
300 aircraft per time period while its rival Boeing supplies 320 aircraft. At this price,
the total market supply is 620 aircraft per time period.
~11 '.0 300QO
Figure l .6 Themarketsupplycurve
""1 (
320QO
', l1··: 620Q
Tolalwpply
Activity
1 lnvestigatethefactorsthataffectthesupplyofoneofthefollowingproducts:
a) coffee
b) chocolate
c) tea
d) sugar
• l oil
2 Organise your findings as a PowerPoint document and be prepared to present it to
the class.
Determinants of supply
Although price is regarded as the key determinant of the level of supply ofa good or
service, it is not the only factor that affects the quantity supplied. Non-price factors
that affect the level of supply ofa product include the following:
• Costs of production - If the price of raw materials and the cost of other factors
of production fall, then the supply curve will shift to the right, assuming all other
things remain unchanged. There is an increase in supply at each price level as the
costs of production fall and vice versa.
• Taxes - Taxes imposed on the supplier ofa product add to the costs of production.
Therefore the imposition of taxes on a product reduces its supply, shifting the
supply curve to the left.
• Subsidies - Subsidies are a form of financial assistance from the go,emmem to
help encourage output by reducing the costs of production. Subsidies are usually
given to reduce the costs of supplying goods and services that are beneficial to
society as a whole, such as education, training and health care.
Demand and supply
• Techno logical progress - Technological advances such as automation,

Study tips
computers and wireless internet mean that there can be greater levels of output at
Some of the
non-price every price level. Hence, technological progress will tend to shift the supply curve
determinants of to the right.
supply can be • Price and profitability of other products - Price acts as a signal to producers
remembered by to move their resources to the provision of goods and services with greater levels
using the acronym of profit. For example, if the market price of corn falls while the price of rapeseed
WITS: weather,
ICT(technology), increases, then funners are likely to reduce their supply of corn and raise their
taxes and supply of rapeseed.
subsidies. • T ime - The shorter the time period in question, the Jess time suppliers have to
increase their output, so the lower the supply tends to be. Over time, output can
be increased. For example, it is not possible for a farmer to increase the supply of
agricultural products in a short time period.
• \ Veather - The supply of certain goods and sen'ices can also depend on the
weather. Agricultural output will clearly depend on whether suppliers ha~·e
fuvourable or unfavourable weather conditions. Similarly, some service providers
may also limit or close their operations during adverse weather conditions, thereby
shifting the supply cun•e to the left.
Moveme nts a nd shifts in supp ly

Movements in supply
A change in the price ofa good or service causes a movement a lo ng the supply
curve. A price rise will cause an increase (expa nsio n) in the quantity supplied ofa
product, while a price fall will cause a decrease (cont ractio n) in the quantity supplied
(see Figure 3.7).
Figure3 .7 Movementsalongthesupplycurve
Shifts in supply
By contrast, a change in all non-price fuctors that affect the supply of a good or
service will lead to a shift in the supply curve. In Figure 3.8, a rightward shift of
the supply curve from S1 to S2 is described as an increase in supply (rather than an
increase in the quantity supplied) whereas a leftward shift of the supply curve from Si
to SJ results in a decrease in supply (rather than a fall in the quantity supplied).
For example, Japan's tsunami in March 2011, the country's worst natural disaster,
reduced the supply of major manufacturers such as Sony, Panasonic, Toyota and
Honda (see the case study below).
hlnaeaseln wpply l,
shownbfarg hM<Jrds hlft
;;. oltheS1Jpplyrurvelrom
• s, o ~ . s,a,boy, ofuh
~ ~·~tdt.e>ad~
rurvelromS1105:J
O O...,.,tityS1JpplOO
Figure 3.8 Shiftsinthesupplycurve
Study tips
• Ashiftin Case Study: Effect of Japanese earthquake and tsunami , 20 11
supply is In March2011,a9.03magnitudeunderseaearthquakehitT1:ihoku,Japan-themost
caused by powerful on record . This triggered a tsunami with waves reaching 40.5 metres (133 feet) .
changes in Manufacturers such as Toyota, Honda, Panasonic and Sony had factories completely
non-price wipedout,haltingproduction.
factors that Toyotalossthetopspotinglobalcarsalesin2011,butreclaimedthetitlefromGeneral
affect supply, Motors in 2012 when it met global demand for its cars by getting its supply back on track.
such as taxes The World Bank estimated the economic damage at S235 billion, making this the world's
and adverse most costly natural disaster.
weather.
• Amovement
in supply is
caused only
Activity
by changes in Discuss as a class how supply theory can be used to explain the way natural disasters, such
prices. asthetsunamiinJapan,affecttheoutputofmanufacturedgoodssuchasToyotacars.
Demand and supply
Exam practice
1 Using an appropriate supply diagram, explain the impact on the supply of
educational computer games in the following cases:
a) The government provides subsidies for the purchase of educational
computer games. [4]
b) There is an increase in the rate of commission paid to creators and the
fee paid to distributors of educational computer games. [4)
c) The government introduces a 15 per cent sales tax on all computer games. [4)
d) There are technological advances in the production of educational
computer games. [4]
2 Using an appropriate diagram, explain how the following changes affect the
supply or the quantity supplied in each scenario:
a) Beijing raises the minimum wage for factory workers by 20 per cent. [4]
b) Drought causes vegetable prices to soar in France. [4]
c) New technology boosts productivity at Tata Motors, India's largest
car-maker. [4]
d) The US government subsidises the output of hybrid cars. [4]
e) South Korea's Samsung launches new tablet computers to rival
Apple's iPad. [4]
Ma rke t eq uili brium

The equilibrium price (also known as the ma rket-clearing price) is determined
where the demand for a product is equal to the supply of the product. This means
that there is neither excess quantity demanded nor excess quantity supplied at the
equilibrium price (see Figure 3.9).
l--::c~-
0 Eqc lli b-lumq oor11fy troded
O...OOtifytroded
Figure 3 .9 Equilibriumprice
Changes in a non-price factor that affects demand or supply will tend to cause a
change in the equilibrium price and therefore quantity traded. For example, in Figure
3.10, a gm-crnment sales rax imposed on tobacco will shift the supply cun-c for
cigarettes to the left. This raises the market-clearing price from Pi to Pi and reduces
the equilibrium quantity traded from Qi to Qi.
Figure l .1 0 lmpositionofasalestax
In contrast, favourable weather conditions will shift the supply of agricultural

output outwards to the right (see Figure 3. 11 ). The increase in supply reduces the
equilibrium price of agricultural output from P 1 to Pi but increases the quantity
traded from Qi to Qi-
~ ('
~ p~
0 ~bi
Gooriify t oded
Figure l .11 Favourableweatherconditions
Activity
lnvestigatehouseprices inacityofyourchoice.
1 Do you think that the phrase 'what goe s up must come down' applies to house p rices?
2 Usedema ndandsupplydiagramstojustifyyouranswer.
Demand and supply
If price is set too high (above the market-clearing price), then supply will exceed
demand, as shown in Figure 3. 12. This results in surplus production known as excess
supply. In order for firms to get rid of their excess supply (shown by the distance
between Q, and Q 4 ) , the y will need to reduce price (from P 1 to P,). This is a key
reason why leftO\W stocks of Christmas cards are reduced in price after 25 December
and why unsold summer clothes go on sale during the autumn.
Su-ph1> lsaooted
~P, =~:t:
~P. ~~.:;:::" "'
0 Q,j a. Q,
O...OOti!ytmded
Figurel .1 2 Excesssupply(surplus)
By contrast, if the selling price of a product is set too low (i.e. below the equilibrium
price), the demand will exceed the supply. This creates a shortage in the market,
caused by the ei:cess de mand (see Figure 3. 13). At a price of P1, the demand is Qd
while supply is only Q, so demand exceeds supply. The excess demand causes prices
to rise back to the equilibrium price of P,.
When Apple launched its iPhone 5 in Hong Kong in late 20 12, demand
outstripped supply so much that the price of the smartphone increased from
H K$5588 to almost H K$8000 - an increase of43 per cent!
Ashoooge = •
;;;: 'NOOndemaodexceed,
:L 0
;~.~-,.:;,..
marle!equ lli b-ilXll
P,
0 Q, a. G.!
O...OOti!ytmded
Figurel .13 Excessdemand(shortage)

Exam practice
1 Using an appropriate demand and supply diagram, explain the impact on the
market price and quantity traded in each of the following cases:
a) The market for air travel following the imposition of higher fuel taxes. [5]
b) The market for Pepsi Cola following a fall in the price of Coca-Cola. [5]
c) The market for sushi following a successful marketing campaign
promoting the health benefits from eating rice and rcHJ fish. [5]
d) The market for Samsung digital cameras following new technologies that
improve productivity in its factories. [5]
2 In 2012, Danish toymaker LEGO launched LEGO Friends to appeal primarily to girls.
The products include mini-doll figu res, pink and purple toy sets and pets.
Founded in 1949, LEGO's popular toy construction bricks were targeted mainly at
boys with popular LEGO theme sets such as LEGO Racers, LEGO Star Wars, LEGO
Batman and LEGO Ninjago.
In early 2013, the San Francisco Chronicle reported that LEGO had sold twice as
many of the LEGO Friends toys as was expected. The company said that demand
from children and their families was overwhelmingly positive. Business Week
reported that LEGO had spent $40 million in its global marketing of LEGO Friends.
a) Define the term 'demand'. [2]
b) Explain two possible reasons for the higher than expected demand
for the LEGO Friends toy construction bricks. [6]
3 Below is a demand and supply schedule for carrots in a country.
Priteperkg Quantitydemanded Quantity supplied per
(S) permonth (kg) month(kg)
a) Plot and label the demand and supply curves on a suitable graph.
Establish the equilibrium price and quantity traded. [6]
b) Using your graph, determine the excess demand at a price of $5 per kilo. [2]
c) Using your graph, determine the excess supply at a price of $8 per kilo. [2)
Demand and supply

1 Whatismeantby'demand'?
2 Whatismeantby'supply'?
3 Outline the factors that affect the level of demand for a product.
4 Outline the factors that affect the level of supply for a product.
S How is equilibrium price and quantity traded determined?
6 What is the difference between excess demand and excess supply?
7 What is the difference between a shift and a movement in demand and supply
analysis?
Key te r ms
Cotnp lements areproductsthataredemanded(fortheiruse)togetherwithotherproducts.
For example, tea and milk or the cinema and popcorn are jointly demanded.
Demand refers to the willingness and the ability of customers to pay a given price to buy a
good or service. The higher the price of a product, the lower its demand tends to be.
Equil ibrium occurs when the quantity demanded for a product is equal to the quantity
suppliedoftheproduct(i.e. therearenoshortagesorsurpluses).
Exnn demand occurs when the demand for a product exceeds the supply of the product at
certainpricelevels. Thishappenswhenthepriceissetbelowtheequilibriumprice,resulting
in shortages.
bc1Hs supply occurs when the supply of a product exceeds the demand at certain
price levels. Thisresultsinasurplusbecausethepriceistoohigh(i.e. abovethemarket
equilibrium price).
5ubstltut•s areproductsthatareincompetitivedemandastheycanbeusedinplace
of each other. For example, tea and coffee or McDonald's and Burger King meals are
substitute products.
Si.Jpply is the willingness and the ability of firms to provide a good or service at given prices.
Thehigherthepriceofaproduct,thehigheritssupplytendstobe.
@ Price elasticity

• define price elasticity of demand and supply and perform simple calculations
• demonstrate the usefulness of price elasticity in particular situations such as
revenue changes and consumer expenditure.
Taken from Cambridge International ExamiJlabom ~la bus (IGCSE 0455/0 Level 228 1)
O Camb<odgelntematiooalExaminatioo,
Price elasticity of demand

The law of demand (see Chapter 3) states that as the price ofa product increases, the
quantity demanded of that product will rend to full. H owever, the responsiveness of
change in the quamiry demanded may vary depending on the customer's degree of
ability and willingness to pay. For example, a rise in the price of a product with plemy
of substitutes (such as bananas, greetings cards or chocolate bars) will have a larger
impact on its lewl of demand than a rise in the price ofa product that has fewer
substitutes (such as petrol, roothpaste or haircuts).
Price elasticity of dema nd (PED) measures the degree of responsiveness of
quantity demanded for a product following a change in its price. !fa price change
causes a relatively small change in the quantity demanded, then demand is said to
be price inelaHic: that is, buyers are not highly responsive to changes in price. For
example, if the price of rice increases slightly, it is unlikely seriously to affect the
demand for rice in countries like China, Vietnam and Thailand.
By contrast, demand is said to be price elastic if there is a relath·ely large change
in the quantity demanded of a product following a change in its price: that is, buyers
are very responsive to changes in price. For example, a small rise in the price of Pepsi
Cola is likely to reduce its demand quite drastically as customers switch to buying
rival brands such as Coca-Cola.
Demandforsoftdrinksispriceelasticbecausethereare Asastaplefoodforbillionsofpeople, ricei shighlyprice

many substitute products inelasticinAsiaandtheWestlndies
Price elasticity
Exam p ractice
Explain whether the price elasticity of demand for the following products is likely to
be price elastic or price inelastic. Justify your answers.
1 Pineapples (4)
2 To~ ~
3 Overseas holidays (4)
4 Textbooks (4)
The uses of price elasticity of demand

Knowledge of PED can give firms valuable information about how demand for their
products is likely to change if prices are adjusted. This information can be used in
se\·eralways:
• Helping firms to decide on
their pricing strategy - for
example, a business with price
inelastic demand for its
products is likely to increase
its prices, knowing that
quantity demanded will be
hardly affected. Therefore, the
firm will benefit from higher
revenue from selling its
products at a higher price.
• Predicting the impact on
firms following changes in the
exchange rate - for instance,
firms that rely on exports will Theme parks charge different prices for essentially the
generally benefit from lower same service. The difference is explained by PED
exchange rates (as the price
of exports become cheaper) and thus will become more price competitive. l11is
assumes that the PED for exports is elastic, of course.
• Price discrimination - this occurs when firms charge different customers different
prices for essentially the same product because of differences in their PED. For
example, theme parks charge adults different prices from children and they also
offer discounts for families and annual pass holders.
• Deciding how much ofa sales tax can be passed on to customers - for example,
products sud1 as alcohol, tobacco and petrol are price inelastic in demand, so
government taxes on these products can quite easily be passed on to customers
without much impact on the quantity demanded.
• Helping governments to determine taxation policies - for example, the
government can impose heavy taxes on demerit goods (see Chapter 5) such
as petrol and cigarettes, knowing that the demand for these products is price
inelastic. While demerit goods are harmful to society as a whole, the high level
ofraxes on such products does not significantly affect the level of demand (with
minimal impact on sales revenues and jobs), but the go\·ernment can collect large
sumsoftax revenues.
Activity
Discuss in pairs some examples of the ways in which multinational companies such as
McDonald's, Microsoft, IKEA and Audi use PED in their businesses.
Calculating price elasticity of demand

Price elasticity of demand is calculated using the formula:
percentage change in quantity demanded
PED percentage change in price
which can be abbreviated as:
PED =%b.QD
"p
For example, ifa cinema increases its ticket price from $10 to $11 and this leads to
demand fulling from 3500 to 3325 customers per week, then the PED for cinema
tickets is calculated as:
332 500
• percentage change in quantity demanded= : - ~ x 100 = - 5%
50
11 10
• percentage change in price = ; x 100 = + 10%
0
• PED = ~ =-0.5
10
Worked example: Calculating PED

Assumethedemandforfootball
matchticketsatSSOisSOOOO
perweek. lfthefootballclub
raisesitspricetoS60perticket
and demand subsequently
fallsto45000perweek,what
isthevalueofpriceelasticity
of demand?
• First,calculatethe
percentage change in
thequantitydemanded -
demandfellby10percent
from50000to45000match
tickets per week.
• Next,calculatethe
percentage change in the
priceofmatchtickets -
pricesincreasedby20per
centfromSSOtoS60per
match ticket.
• Then, substitutethesefiguresintothePEDformula:
~ m- 0.5
20
As the PED for match tickets is less than 1 (ignoring the minus sign), the demand for match
tickets is price inelastic: in other words, football fans are not very responsive to the increase
inmatchticketprices. Consequently,thereisarelativelysmallfallinthequantitydemanded
comparedwiththepricerise.
Price elasticity
Interpreting PED calculations

So what does a PED value of -0.5 actually mean? The cinema ticker example suggests
that the demand for cinema tickers is price inelastic (i.e. relatively unresponsive to
changes in price). This is because a 10 per cent increase in the price (from $10 to $11)
only caused quantity demanded to drop by 5 per cent (from 3500 tickers per week
to3325 ).
The value of PED is negative due to the law of demand - an increase in the
price of a product will rend to reduce its quantity demanded (see Chapter 3). The
inverse relationship between price and quantity demanded also applies in the case
of a price reduction - rhar is, a price fall rends to lead to an increase in the quantity
demanded.
The calculation of PED generally has rwo possible outcomes:
• If the PED for a product is less than l (ignoring the minus sign), then demand
is price inelastic (i.e. demand is relatively unresponsive to changes in price).
This is because the percentage change in quantity demanded is smaller than the
percentage change in the price (see Figure 4.1).
• If the PED for a product is greater than 1 (ignoring the minus sign), then demand
is price elastic (i.e. demand is relatively responsive to changes in price). This is
p~lLti~~t~
because the percentage change in quantity demanded is larger than the percentage
change in the price of the product (see Figure 4.2).
§;
i i P1 ;:i~~ : n,!~"'ceeci
~~~~;i:1~:~
0 G)., QI
Gm nti!ydernooded
Figure4.1 Thepriceinelasticdemandcurve
. j''E f:cr~~:;::;a:
] p~ =:~Jm~ta•"'ci chocda1ebcn, .drdmls.
mu and ai rline travel
0 QI Gi
Gm nti!y demaoded
Figure4.2 Thepriceelasticdemandcurve
However, there are three special cases which are theoretical possibilities:
• If the PED for a product is equal to 0, then demand is perfectly price inelastic:
that is, a change in price has no impact on the quamity demanded. This suggests
that there is absolutely no substitute for such a product, so suppliers can charge
whatever price they like (see Figure 4.3).
• If the PED for a product is equal to infinity ("") then demand is perfectly price
elastic: that is, a change in price leads to zero quantity demanded. This suggests
that customers switch to buying other substitute products if suppliers raise their
price (see Figure 4.4).
• If the PED for a product is equal to l (ignoring the minus sign), then demand has
unitar}' price elasticity: that is, the percentage change in the quamity demanded
is proportional to the change in the price (see Figure 4.5 ).
~(~
1
r r__~~i~:f"
P, ~~1t~1ceevel.
~~~"'t~
0 a. '"'"""
Qoor111ydemanded
Figure4.3 Theperfectlypriceinelasticdemandcurve
C
~~,:~nex~a~~
§op kocislo oo lnfini1echan'1hln
0
] ~i:"~1:=i1t+:re
~:1::'~'"ti= ~ify
0 Gloo ntifydemaoded
Figure4.4 Theperfectlypriceelasticdemandcurve
i[j~~ o Qi a,
E~~'i"~
~nded
Figure4.5 Theunitarypriceelasticdemandcurve
Price elasticity
Ac t ivity
Many governments around the world raise taxes on tobacco, alcohol and petrol, on a
regular basis.
1 Asaclass,discu5Stheeconomicreasonsfordoingso.
2 Usetheconceptofpriceelasticityofdemandinyourarguments.
Exam practice
1 Assume the price of a sack of rice falls from $25 to $24, resulting in an increase in
quantity demanded from 850 sacks to 875 sacks per month. Calculate the value
of price elasticity of demand for the product and comment on your fi nding. (4)
2 Explain two reasons why the demand for rice is price inelastic in countries like
India, Vietnam and China. (4)
Determinants o f price elasticity of dema nd

There are many interlinked determinants of the PED for a product:
• Su bstitutio n - This is the key determinant of the PED for a good or service. In
general, the greater the number and availability of close substitutes there are for
a good or service, the higher the value of its PED will tend to be. This is because
such products are easily replaced if the price increases, due to the large number
of close substitutes that are readily available. By contrast, products with few
substitutes, such as toathpicks, private education and prescribed medicines, have
relatively price inelastic demand.
• Income - The proportion of a consumer's income that is spent on a product also
affects the value of its PED. lf the price of a box ofroothpicks or a packet of salt
were to double, the percentage change in price is so insignificam to the consumer's
overall income that quantity demanded would be hardly affected, if at all.
By contrast, if the price of an overseas cruise holiday were to rise by 25 per cent
from $10000 to $12 500 per person, this would discourage many more customers
because the extra $2500 per ticket has a larger impact on a person's disposable
income (even though the percentage increase in the price ofa cruise holiday is
much lower than that of the box of toothpicks or packet of salt).
Therefore, the larger the proportion ofincome that the price of a product
represents, the greater the value of its PED tends to be. Of course, those on
extremely high levels of income (such as Carlos Slim, Bill Gates and Warren
Buffet - the three richest men on the planet) are probably not responsive to any
change in the market price of goods and services!
• Necessity - The degree of necessity of a good or service will affect the value of its
PED. Products that are regarded as essential (such as food, fuel, medicines, housing
and transportation) tend to be relath'ely price inelastic because households need these
goods and services, and so will continue to purchase them even if their prices rise.
Demand for fresh By contrast, the demand for luxury products (such as Gucci suits, Chanel handbags
flowers on special and Omega watches) is price elastic, as these are not necessities for most households.
days like Valentine's The degree of necessity also depends on the timeframe in question. For example,
Day and Mother's
Day is relatively price demand for fresh flowers on Valentine's Day and on Mother's Day is relatively price
inelastic compared inelastic compared with other days. It also applies to peak and off-peak times. For
with other days example , many countries operate public transport systems that charge more for
tra\'Clling during peak time. This is partly due to overcrowding problems during
such times, but also because the transport operators know that peak·time travel is
more of a necessity than off-peak travel.
• H abits, add ictio n s, fashio n and t astes - !fa product is habit forming (such as
tobacco) or highly fashionable (such as smartphones in many coumries), its PED
tends to be relatively price inelastic. Similarly, people who are extremely devoted to
a particular hobby, such as sports or music, are more willing to pay, e\·en at higher
prices. Hence, the demand from these people is less sensitive to changes in price.
• Ad vertising an d brand loyalty - Marketing can have a huge impact on the buying
habits of customers. Effectiw advertising campaigns for certain products nor only
help to shift the demand curve outwards to the right, but can also reduce the
price elasticity of demand for the product. Customers who are loyal to particular
brands are less sensitive to a change in their prices, partly because these brands are
demanded our of habit and personal preference - rhar is, they are the default choice
over rival brands. Examples of brands with a loyal customer following include
Coca-Cola, Apple, Samsung, Chanel, Toyota and Mercedes-Benz.
• Time - The period of time under consideration can affect the value of PED
because people need time to change their habits and behavioural norms. Over
time, they can adjust their demand in response to more permanent price changes
by seeking out alternath·e products. For example, parems with children in private
fee -paying schools are unlikely to withdraw their children from school if these
establishments raise school fees because this would be very disruptive to their
children's learning. Similarly, owners ofprivare motor \·chicles are nor likely to
get rid ofrheir vehicles simply because of higher fuel prices. H owever, if there is
a continual hike in prices o\·er time, both parents and vehicle owners may seek
alternarh·es. H ence, demand rends to be more price elastic in the long run.
• D u rab ility - Some products, such as fresh milk, are perishable (do nor last \'cry
Jong) and need to be replaced, so will continue to be bought even if prices rise.
By contrast, if the price of consumer durable products (such as household furniture,
LCD televisions or motor vehicles) increases, then households may decide to posq:one
replacing these items due to the high prices involved in such purchases. Therefore, the
more durable a product is, the more price elastic its demand tends to be.
• T he costs o f switching - There may be costs inrnh'ed for customers who wish
to switch benveen brands or products. In the case of high switching costs, the
demand for the product is Jess sensitive to changes in price - rhar is, it tends to be
Study tips
price inelastic.
Although
there are many For example, manufacturers ofsmartphones, laptops and digital cameras
determinants make it more difficult for their customers to switch between rival brands by
ofP ED,thekey supplying different power chargers, memory cards and software. Similarly,
factors can be mobile phone users and satellite television subsc.ribers are bound by length}'
remembered by contracts, which makes switching between rival brands or services less easy.
THIS acronym:
Such barriers to switching therefore make customers less responsi\·e to higher
• Time product prices.
• Habits,
addictions and • T h e br ead th of definition o f th e prod uct - !fa good or service is very broadly
defined (such as 'food' rather than fruit, meat, apples or salmon), then demand
• Income will be more price inelastic. For example, there is clearly no real substitute for
• Substitutes food or housing, so demand for these products will be very price inelastic.
(ava ila bi lity H owever, it is perhaps more useful to measure the price elasticity of demand for
and price of).
specific brands or products, such as carbonated soft drinks, Australian beef and
!GCSE textbooks.
Price elasticity
Case Study: Toyota Motor Corporatio n

Japanesecar-makerToyotahasseen its
fairshareoftroublesinrecenttimes. It
hashadtodealwithseveralcasesof
global productrecallsforitscarsdueto
safety concerns. The global financial crisis
of2008alsoharmedglobalsalesfor
severalyears. Ontopofthat,muchofthe
world's largest car-maker's stocks of new
carsweredestroyedinthetsunamiof
March 2011 .
Nevertheless,customerloyaltyremains
strong in the USA, China and many other
parts of the world. Toyota's closest rival,
General Moto rs (GM), estimated the value of customer loyalty at S700 million for every
percentage point of improvement in customer retention rates.
Market research from Experian Automotive revealed that 47.3 per cent of Toyota's
current customers from the USA would purchase a Toyota, Scion or Lex us model as their
nextcar. Globally,thisfigurestandsat58percentforToyotaand52percentforGM.
Toyota'suseofmarketingsloganssuchas'Thebestbuiltcarsintheworld'cancertainly
go a long way to reassure Toyota's loyal customers about their cars.
SourcPS:adaptl'dfromW.JI/Sm>etJouma/andT/Mf8u5ines,
Discusshowtheconceptofpriceelasticityofdemandanditsdeterminantscanhelpto
explain why Toyota Motor Corporation is the world's largest car-maker.
PED, consumer expenditure and revenue changes

Knowledge of the price elasticity of demand for a product can be used to assess the
impact on consumer expenditure and therefore sales revenue following changes in
price. Sales revenue is the amoum of money received by a supplier from the sale ofa
good or service. It is calculated by multiplying the price charged for each product by
the quamitysold, i.e.
Rc~·enue = price x quantity demanded
Note that this is not the same as profit, which is the numerical difference between a
firm's sales revenues and its total costs of production.
For example, if Leno.•o sells 5000 laptops at $700 each in the first quarter of the
month, its sales revenue is $3.5 million. Suppose that the computer maker reduces its
price to $650 and quantity demanded rises to 5200 units in the following quarter.
Was this a gcxxi business decision?
A quick calculation of PED reveals that the demand fur Lenom laptops is price elastic:
550
• percenrage change in quantity demanded= ~~000 x l 00 = +10%
65 7
• percenrage change in price= $ ~; ~ 00 x 100 = - 7. 14%
0
• thus, PED= 1.4
This means the PED fur Lenovo laptops is price elastic. Hence a fall in price causes a
relatively larger increase in the quantity demanded, so sales revenues should increase.
This can be checked as follows:
original sales revenue = $700 x 5000: $3 500000
new sales revenue = $650 x 5500 = $3 575 OOO
difference in sales revenue= $3.575m - $3.5m = +75000
Given that demand fur LenO\'O laptops in the above example is price elastic, a reduction
in price was a sensible business decision. Therefore , it can be seen that knowledge of PED
fur a product can infurm firms about their pricing strategy in order to maximise sales
revenues. These relationships are summarised in Table 4. 1 and and Figures 4.6 and 4.7.
Ta ble4.1 TherelationshipbetweenPEDandsalesrevenue
Price chan ge Inel a sti c Unita ry Elas ti c

Increase price No change in revenues Revenues fall
Reduce price Revenues fall No change in revenues
Figure4.6 Price inelasticdemandandsalesrevenue
=~~tj.!.,vfu
p resporu;M!1ochange, ln ~el . A
1
~ j p~
de
:~r.:~:~,*:=C:.&f 1oa
contra.ll. lfp<tewera1olocreose
:=.-;:~~:::
ne! b. ln><Jle:sreveo.ie
Q QI G:i
Qw~
Figure4.7 Priceelasticdemandandsales revenue
Price elasticity
Activity
In small groups, discuss why firms use peak and off-peak pricing strategies, such as airline
ticketsbeingfarmoreexpensiveduringschoolholidays.
1 How many examples of price discrimination based on time (peak and off-peak) can your
group come up with?
2 Does your group believe that price discrimination is beneficial? Justify your argument.
Exam practice
Suppose Sharma Fabrics sells 1350 units of wool per month at $4.00 each. Following
an increase in price to $4.60 per unit, the firm discovers that the quantity demanded
falls to 1215unitspermonth.
1 Calculate the price elasticity of demand for wool sold at Sharma Fabrics. (3)
2 Calculate the change in the total revenue following the increase in price of
wool. (3)
l Explain how knowledge of price elasticity of demand can be of use to Sharma
Fabrics. [4)
Price elasticity of supply

Price elasticity of supply (PES) measures the responsh'Cness of the quantity supplied
ofa product following a change in its price. Supply is said to be price elastic if
producers can quite easily increase supply without a time delay if there is an increase
in the price of the product. This can help to gi\'c such finns a compctiti\'c advantage,
as they arc able to respond to changes in price.
By contrast, supply is price inelastic if firms find it difficult to change production
in a gi\'cn time period when the market price d1angcs.
Calculating price elasticity of supply

Price elasticity of supply is calculated using the formula:
percentage change in quantity supplied
PES percentage change in price
whid1 can be abbreviated as:
%t.QS
PES = %K]>
For example, if the market price of beans increased from $2 per kilo to $2.20 per
kilo, causing quantity supplied to rise from 10000 units to 10 500 units, then the
PES is calculated as:
105
• percentage change in quantity supplied= ~~~000 x lOO = +5%
2 2
• percentage change in price= $ .2~ ~ $ .0 x 100 = +1 0%
20
• PES=~=0.5
+10%
CD
What this means is that the supply of beans is hardlyaflectcd by the change in price -
supply is relatively price inelastic. Note that the value of PES is fX>Sirive due to the law of
supply - that is, an increase in price rends to increase the quantity supplied (and vice versa).
The value of PES reveals the degree to \\11ich the quanrity supplied ofa product
responds to changes in price. The calculation of PES generally has two possible outcomes:
• If PES > 1.0 supply is price elastic, i.e. supply is responsive to changes in price
(the percentage change in quantity supplied is greater than the percentage change
in price-see Figure4.8).
• If PES < 1.0 supply is price inelastic, i.e. quanriry supplied is relatively
unresponsive to changes in price (percentage change in quantity supplied is less
than the percentage change in price - sec Figure 4.9).
Qxi ntitywppled
Figure4.9 Thepriceinelasticsupplycurve
H owever, there are three special cases which are theoretical possibilities for PES:
• If the PES ofa product is equal to 0, then supply is perfectly price inelas t ic: that
is, a change in price has no impact on the quanrity supplied. This suggests that
there is absolutely no spare capacity for suppliers to raise output, irrespective of
increases in price (see Figure 4.10).
• If the PES of a product is equal to infinity ("") then supply is perfectly pr ice
elas t ic: that is, the quanriry supplied can change without any corresponding
change in price. For example, a software developer selling products online can very
easily increase supply to match higher levels of demand, without any impact on the
price level. Due to the spare capacity that exists, suppliers are able to raise output at
the current price level (see Figure 4.11).
•
Price elasticity
• If the PES for a product is equal to l then supply has unitar y price elas t icity: that
is, the percentage change in the quamit y supplied matches the proportional change
in price (see Figure 4. 12). Any upwards sloping supply c.urve that starts at the
origin will have unitary price elasticity.
LL
=.':'1b'.:=C::e"
chooge.,the fl rmcooooly'1Jpp/y
=1 ! I~~ :~h?"
1
p~
p1 =~
~:::m
;l:~~t!;l'ru-m0<:
1
ooocertha l rhotoo nnol

occoo,moda1emoretha n t.e
0
In
,ooting COfDC l")I
0 o.
Qu:rntity..,ppled
Figure4.10 Theperfectlypriceinelasticsupplycurve
~ e k ~ . ~ ~ ~ ot
" P.
o,
~t:V':;, ~ :,~~,:;' ~
r= lh mareD,mx:ell bdleoo,b..ng
~ ~:,'~~q.xi~ti~ : bs.J c~~·

locroo>e fr001Q1 1ot1ne,pec:11""of a
p<1cechonge. 1hePfS - oo
0 QI Qi
~..,ppled
Figure4.11 Theperfectlypriceelasticsupplycurve
My..,pplyru-ve that slo rtsot

rl,,"'9,[wclrns, . ~os,1
§: 00.aPfSvolieeqoo llo l.
"' Th1,thecre11oo l ootooie
~ rneoo, that ochooge ln p<ba
oouse,the"'meproro<11o1Kl l
cho nge ln qoo ntityWflP.ad
Study tips
lnreality,supply
curves are likely 0 Gloorlty'1Jppli00
to be non-linear, Figure4.12 Theunitarypriceelasticsupplycurve
so will have a
differentPES
Activit y
value at different
points. Supply is Discuss in pairs why the price elasticity of supply of the following products will d iffer:
more elastic at 1 Smartphones
lower prices and 2 Organicvegetables
more inelastic at 3 Freshflowers
higher prices. 4 Hotels
Exam practice
Angry Birds is a highly popular video game created by Finnish company Rovio in
December 2009 for the iPhone. Since then, over 12 million customers have paid $0.99
each to download the game from Apple's App Store. The game has become available
for other platforms such as the Android and Windows operating systems and available
for both video games consoles and personal computers.
Rovio has since launched variations of the video game, such as Angry Birds Seasons,
Angry Birds Rio, Angry Birds Space and Angry Birds Star Wars. According to its
website, the Angry Birds games have been downloaded over 1 billion times across all
platforms, making it the most downloaded app of all time.
--
1 With the use of an appropriate diagram, explain why the high level of demand
for Angry Birds games has no effect on the selling price. [6)
2 Explain how knowledge of price elasticity of supply can help businesses such
~
Determinants of price elasticity of supply
There are several interlinked determinants of the PES for a product:
• The degree of spare productive capacity-Ifa firm has plenty of spare capacity
then it can increase supply with relative ease: that is, without increasing its costs
of production. This means that supply is relatively price elastic. For example,
Coca-Cola's bottling plants can produce 10 OOO cans of soft drink in just 60
seconds, so it is \·ery easy for the world's largest beverage company with plenty of
spare productive capacity to respond to changes in price. In general, the supply
of goods and services is highly price elastic during an economic recession (see
Chapter 20) when there are spare (unused ) resources such as land, capital and
labour.
• The level of stocks - Ifa firm has unused raw materials, components and finished
products (collectively known as stocks or ln\·enwries) that are available for use,
then the firm is more able to respond quickly to a change in price, as it can supply
these stocks on to the market. Not all inventories are sold to consumers - raw
materials and components (pans used in the production process, such as gearboxes
and motars for cars) are used in the production process. In addition, some types of
stock (such as pencils or ball bearings) are easier to store than others (such as fresh
milk or organic vegetables), so it will be easier to increase supply if prices increase.
This means that the higher the level of stocks offinished goods (such as cars) that
are ready for sale, the more price elastic supply tends to be.
• The number of producers in the industry - The more suppliers ofa product
there are in the industry, the easier it tends to be for firms to increase their
output in response to a price increase. For example, there is plenty of competition
in the restaurant trade, so suppliers will be highly responsive to increases in price.
Hence, the greater the number of firms in an industry, the more price elastic
supply tends to be. By contrast, high barriers to emry in the pharmaceutical
industry mean that there are \·ery few suppliers in the industry, so supply tends to
be price inelastic.
Price elasticity
• The time period - In the short run, most firms are not able to change their factor
inputs, such as the size of their workforce or the fixed amount of capital equipment
they employ. For example, in agricultural farming, the supply of fresh frnir and
\·egerables is dependent on the rime it rakes to han-est the products and climatic
conditions beyond the control of the suppliers. Hence, supply is Jess responsi\·e to
changes in price in the short nm. Supply is more likely to be price elastic in the
long run because firms can adjust their levels ofproduction according to price
changes in the market.
• The ease and cost of factor su bstitutio n - This refers to the exrem to which it is
possible to introduce factor resources (such as labour and capital) to the production
process. If capital and labour resources are occupatio nally mobile, this means
they can be substituted into the production process easily. An example ofcapiral
being occupationally mobile is a publishing company that can switch production
quite easily between priming textbooks, magazines, trade journals, calendars or
greetings cards. This means the ease of factor substitution in the publishing firm
makes supply highly price elastic. By comrasr, the PES for a product where capital
equipment and labour cannot easily be switched, as the pnxluction process is
inflexible, will be very low: that is, supply is price inelastic.
The va lue of PES to firm s

In general, it is preferable for firms to haw a high PES - to be highly responsive
to changes in price (a nd other market conditions). This can help to make the finn
more competitive and therefore to generate more sales revenue and profits. Firms can
become more responsive to changes in market price in sc\·eral ways, including:
• creating spare capacity
• keeping large volumes of srocks (inventories)
• impro\'ing storage systems to prolong the shelf-life of products
• adopting or upgrading to the latest technology
• improving distribution systems (how the products ger to the customers)
• developing and training employees to impro\-e labour occupational mobility (to
perform a range of jobs).
Exam practice
Explain whether the price elasticity of supply (PES) of the following products is
relatively elastic or inelastic.
1 Bananas [4)
2 Fresh flowers [4)
3 Computers [4)
•= ~

1 What is meant by price elasticity of demand (PED) and how is it calculated?
2 How might knowledge of PED be of value to firms?
3 How might knowledge of PED be of value to the government?
4 Why should firms raise prices for products with price inelastic demand?
5 Use a diagram to show the difference between perfectly price elastic demand,
unitary PED and price inelastic demand.
6 What are the key determinants of PED?
7 What is meant by price elasticity of supply (PES) and how is it calculated?
8 Use a diagram to distinguish between price elastic PES and price inelastic PES.
9 If a product has a PES value of 0, what does this actually mean?
10 What are the key determinants of PES?
Key t e rms
Price d l1crlmlnatlon occurs when firms charge different customers different prices for
essentiallythesameproductbecauseoftheirdifferences inPED.
Price elastic dem1md describes demand for a product that is relatively responsive to changes
inprice,usually duetosubstitutesbeingavailable.
!"ke elasticity of det11and (PED) me asures the extent to which demand for a product
changesduetoachangeinits price.
Priceela1tldtyof1upply (PES)measures theresponsiveness ofquantity supplied of a
productfollow ingachangeinitsprice.
Price inelastk demand describes demand for a pro duct that is relatively unrespo nsive to
changes inprice, ma inly becauseofthelack o f substitutes forthe pro duct .
Stocki (o r inventories) are the raw materials, components and finished goods (ready for
sale)usedintheproductionprocess.
U,,ltaryprkee laJtlcity occurs w henthepercentagechangeinthequantity demanded
(o r supplied) is pro portio nal to the change in the price, so there is no change in the sales
0 Market failure
By t he end of this chapter, you should be able to:

• describe the concept of market failure and explain the reasons for its occurrence
• define private and social costs and benefits and discuss conflicts of interest in
relation to these costs and benefits in the short term and long term through
studies of the following issues:
O conserving resources versus using resources
o public expenditure versus private expenditure
TakenfromCambridgelnternationalExaminationsSyllabo,~GCSE045S/Olevel2281)
C CambfidgelnternationalExamiriabom
Ma rket fai lure

Market failure occurs when the production or consumption ofa good or service
causes additional posith'e or negative externalities (spillover efTccu) on a third parry
not involved in the economic activity. In other words, the market forces of demand
and supply fail to allocate resources efficiently.
Market failure may be caused by the following:
• Production of goods or services which cause negative side-effects on a third parry.
For example, the production of oil or the construction of offices may cause damage
to the environment and a loss of green space.
• Production of goods or services which cause a positive spillm-er effect on a third
parry. An example is training programmes, such as first-aid or coaching skills for
employees, which create benefits that can be enjoyed by others.
• Consumption of goods or services which cause a negath-e spillover effect on a third
parry. Such goods are known as deme rit goods and include cigarettes, alcohol,
gambling and driving a car.
• Consumption of goods or services which cause a positive spillmw effect on a third
parry. Such goods are known as merit goods and include education, health care
and vaccinations.
• Failure of the private sector to provide goods and services such as street lighting,
road signs and national defence due to a lack ofa profit moth-e. Such goods and
services are known as pu blic goods (see Chapter 15 ).
• The existence ofa firm in a monopoly market (see Chapter 13) that charges prices
which are too high and exploits customers.
Private a nd socia l costs

The private costs of production and consumption are the actual costs of a firm,
individual or gm-ernmem. For example, the driver of a car pays for the insurance,
road tax, petrol and cost of purchasing the car. The external costs are the negative
side -effects of production or consumption incurred by third parties, for which no
compensation is paid. For example, a car driver does not pay for the cost of the
congestion and air pollution created when driving the car. This is an example of
market failure because the private costs (of driving) do not represent the trne costs
(of driving) to society. The true cost ofa car journey is called the sod:i.l cost.
Social costs = private costs + external costs

Other examples of external costs are:

• air pollution caused by fumes from a factory
• noise pollution from a night club
• cigarette smoke
• litter
• too much advertising, which causes visual blight.
Government intervention
Governments uy to solve market failure in a number ofways, such as by placing a rax
on the price ofa demerit good with the aim of reducing demand for the good.
Study tips
Remember
""j
f-
2 p~
that the level
of taxation is
measured by the P1
vertical distance
between the two
supply curves.The
0 Qi Q,
consumer pays
the increase in °""'11i!y d ctgarel1es
price(P,-P,)and FigureS.1 Theimpactofanindirecttaxoncigarettes
the producer pays
the remainder.
The more price In Figure 5.1, the tax (sec Chapter 3) imposed on a packet of cigarettes causes the
inelastic the supply curve to shift from S1 to S.... The tax is the vertical distance between the two
demand for supply curves. As a result, price increases from P 1 to P2 and the quamity of cigarettes
the product, demanded decreases from Q 1 to Qi. The demand for cigarettes tends to be price
the greater the inelastic (sec Chapter 4) and therefore the percentage change in quantity demanded is
proportion of the
tax paid by the Jess than the percentage increase in price.
The advantages and disadvantages of imposing a tax on a good or service arc
shown in Table 5.1.
Tab le 5.1 Advantages and disadvantages of taxing a good or service
Advantages Disadvantages
It increases the price Thedemandforcigarettes,alcoholandpetrol(gasfor
and therefore should acar)tendstobepriceinelastic(seeChapter4),which
decrease the quantity meansthattheincreaseinpricemayhavelittleimpacton
demanded. consumption. The nicotine in cigarettes makes smoking
It creates tax revenue highlyaddictiveandthereforesmokerswillpaythehigher
forthegovernment priceandconsumptionwillchangeonlyslightly.
whichcanbeused Theindirecttaxwillberegressive(seeChapter17)andhave
on other goods and a greater impact on low-income earners than high-income
Exam practice
Traffic congestion in central London has decreased since the introduction of
a congestion charge for drivi ng into the central business district. It costs £10
(approximately $15.20) each day to drive into the restricted area during peak hours
Market failure
(between 7a.m. and 6p.m. on weekdays). There is a penalty of between £60 (around
$90) and £187 ($285) for late payment of the charge.
1 Explain, using an example, an external cost of driving a car. (2)
2 Assess the advantages and disadvantages of the congestion charge for two
different groups in society. (6)
3 Discuss whether you think the congestion charge is a long-term or short-term
solution to the problem of traffic congestion in London. [7)
Governments can also impose rules and regulations in an attempt to solve market
failure. For example, imposing a minimum age that a person must be before they arc
legally allowed to purchase cigarettes or alcohol may reduce the consumption of such
demerit goods (sec Figure 5.2). Laws can also restrict where a person can smoke. In
many countries, smoking is banned in public places such as shopping centres, bars,
restaurants, airports, railways stations and even the beach!
J- - -e
~-----i, ~
s
~~ P, :'\ :'
d: : : D,
: o; :
0 Gi Q)
Glu:, ntityo!cigarelle:I
Figure5.2 lmpactofrulesandregulationsonthedemandforcigarettes
Figure 5.2 illustrates the impact ofa ban on smoking in public places on the demand
curve for cigarettes. The demand curve shifts from D 1 to D 2 , resulting in the
quantity of cigarettes demanded falling from Q 1 to Q 2 •
Other examples of laws and regulations imposed to correct market failures include:
• laws regulating where people can drive, cycle and gamble
• regulations imposed to make sure children are vaccinated against certain diseases
• laws making it illegal for people to smoke, eat or talk on a mobile phone while
driving
• motorcyclists being made to wear a helmet and car passengers having to wear scat
belts at all times
• airport authorities regulating the number of night flights
• banning of alcohol sales in Iran, Bangladesh, Brunei and Saudi Arabia.
Case Study: Compulsory education

ParentsintheUKarefined iftheydonotsendtheirchildrentoschool . Thisruleisdesigned
to improve the uptake of education. From 2015, full-time education in the UK will be
compulsory for ch ildren upto 18years of age.
Activity
Investigate the laws and regulations in your country which are used to correct market
failures . Howeffectivehavetheselawsandregulationsbeen?
The advantages of imposing rules and regulations to correct market failures are as
follows:
• Consumption of the good or service may be reduced.
• Awareness of the negative impacts of demerit goods (such as drinking and driving)
may change the behaviour ofpeople in the long term.
• Awareness of the positive impacts of consumption of merit goods (such as
education) is raised.
The disadvantages of imposing rules and regulations to correct market failures are as
follows:
• Restrictions cause underground (illegal) markets to develop where the good or
service can be purchased, often at a very high price.
• The go,,ernment has no control over the quality of the goods produced in
underground markets, which in some cases can be dangerous for consumption, as
with illegally distilled vodka and tainted baby milk powder.
• People break the rules: for example, under-age smokers and drinkers of alcohol
can bypass the law by obtaining false identification cards. ln the case of smoking,
people may d1oose to smoke outside buildings and therefore inflict second-hand
smoke on people entering and leaving the building.
• The fine or punishment for ignoring the ban must be enforced and set sufficiently
high to discourage consumption of the good or service.
A third approach to correcting
marketfailuresistouse
education and ad\·enising.
Many schools educate students
about the negative side-effects
of smoking and passive
smoking. In many countries,
cigarette packets must carry a
government health warning
that dearly explains the
dangers of smoking. The
Australian government has
made it a legal requirement for
cigarettes to be sold in packets Cigarettes in Australia are sold in identical ol ive-brown
covered in negative images packetswiththesametypefaceandcoveredwith
graphicimagesandhealthwarnings. lntheUK,aban
about smoking. The images
ontobaccoproductsbeingdisplayed in shops came
are graphic, aiming to educate intoeffectin2012
and shock people in order to
discourage them from smoking. If such methods are successful, the raised aw"J.reness
of the dangers of smoking should reduce the demand for cigarettes (or any other
demerit gocxl), as shown in Figure 5.2.
Another example is the government using informative ad\·ertising and education
to explain to people the benefits of eating at least five portions of fruit and
vegetables each day. In Figure 5.3, the demand for fresh fruit and vegetables
increases from D 1 to D 2 and the quantity demanded increases from Qi to Qi.
Healthier people in an economy should mean less absence from work and school,
with fewer people using health services. Therefore healthy eating produces an
external benefit for society.
Market failure
!~O 0.>ooti!y d fruttmidveget,ble.

Figure5.3 Theimpactofadvertisingondemandforfruitandvegetables
Schools around the world educate students about issues such as healthy caring, the
ncg.i.tivc impacts of driving gas/petrol-fuelled cars and the importance of conserving
energy and recycling. Successful educational programmes should change the pattern
of demand, thus helping to correct marker failures.
Advantages of education and advertising to combat the problems of market failure
• Behaviour and consumption patterns of individuals and firms change - there is a
rise in the consumption of merit goods and a fall in the demand for demerit goods.
For example, people learn aOOut the dangers of smoking, so fewer people smoke.
• Successful advertising may lead to a cultural change in the long term, such as
healthier diets, an increase in use of electric cars, recycling, w·asrc reduction and
use of renewable energy.
Disadvantages of education and ad\·crtising to combat the problems of market failure
• Education and advertising have an oppornmity cost - in other words, the money
could have been spent on something else deemed more beneficial to the economy.
• Not all advertising and education is effective. For example, shock advertising tactics
may not necessarily work on smokers and may be ignored.
• It can take a Jong time to educate people and for the advertised message to be
accepted and acted upon.
Activity
Consider whether smoking is a problem in your country. Assess the degree of effectiveness
of the measures taken by the government to red uce the number of smokers. What possible
improvementscouldbemadetothecurrentsituation? Takeactionbywritingalettertoa
local politician or a newspaper explaining your suggestions.
Conserving reso urces versus using reso urces

All economic activities invoke social costs and benefits, at least to some extent, and
every decision has an opportunity cost (see Chapter 1). For example, the decision to
allow a firm to build a factory on a green field has a cost to the cnvironmcm through
the Joss of green space, increased road traffic and potcmial pollution, bur it also
brings jobs to the area and creates business for related firms.
Production and consumption of goods and services uses the Earth's resources
and can cause damage to the environment. It is therefore important that economic
de\'elopmem is sustainable, which means that de\'elopmem today does not
compromise the lh-es offumre generations so that they cannot meet their own needs.
Therefore, there is a potential conflict between the production of goods in the short
term and the conservation of resources in the long term.
Case Study: The Deepwater Horizon disaste r

On20April2010anexplosionon
anoilrigcalledDeepwater
Horizon,ownedbythecompany
BP,causedapproximately4million
barrelsofoiltospillintotheGulf
ofMexico. Elevenoilrigworkers
diedintheaccident. Therig
sankandtheimpactonthe
environment,peopleand
businessesintheregionwas
immense.
Manypeople,including
fishermen.dockworkers,
restaura nt owners and their
employees,losttheirlivelihoods
and jobs.
The damage to the surrounding coastline and wild life was dramatic. There were
endangeredspeciesofturtleandararespeciesofseahorselivinginthearea,someasures
hadtobetakentoensuretheirsurvival.
Around 100000 people have attempted to claim compensation from BP and many claims
are still unresolved today. BP estimated that total damages would cost the firm S42 billion,
anditwasalreadycommittedtopayS32billion.
Sou,ce:adaptedfromtheGuardi,.,,.July2010
Activity
Read the Deepwater Horizon disaster case study and identify as many examples of market
failureandeconomicconceptsaspossible .
Exam practice
In Sri Lanka, economic growth has seen the increased use of pesticides and chemical
fertilisers to increase the amount of crops produced. The growth of the tourism
industry has brought about an increase in the construction of roads, hotels and guest
houses. This has created jobs but at a cost to natural wildlife habitats.
1 Identify the social costs and benefits of economic growth in Sri Lanka. [4]
2 Discuss the potential long-term impacts of economic growth in Sri Lanka and
whether the benefits outweigh the costs. [7]
Market fail ure
Case Study: The Brazilian rainforests
Accordi ng to Greenpeace,
Brazilian supermarkets have
bannedthesaleofmeat
produced from animals raised
inrainfo rests.Thisisamoveto
reduce th e amount of
ra inforest destroyed to make
pastu reforanimalsandsoy
plantations.
Private an d socia l be nefits

Prh·ate benefits arc the benefits of production and consumption incurred by a firm,
individual or government. For example, a car owner gains the benefits of driving the
car and owning a means of private transport. Similarly, a person who owns a garden
enjoys the personal benefits of having green space and plants, flowers and possibly
vegetables to enjoy.
External benefits are the positive side-effects ofproduction or consumption
incurred by third panics, for which no money is paid by the beneficiary. For example,
the sight and smell of a well-kept garden gives pleasure to a neighbour or a person
walking past. The plants and trees also absorb cartxm dioxide and therefore are good
for the environment. Other examples of external benefits arc education, training,
hcalthcareandlawcnforccmcm.
When a person has a vaccination against tuberculosis, they receive the private
benefit of being immune to the disease , but other people arc also protected from this
highly contagious disease. To eradicate diseases, many governments make it a legal
requirement for children to be vaccinated against certain diseases before they can
start school. Many governments provide such vaccinations free of charge to children.
This is an example of market failure because there arc external benefits to society
ofvaccination programmes. Ifvaccinations were left to the choice of individuals, they
would be under-consumed, mainly due to the price that would be charged for them.
The uue benefit of the \'accination is called the social benefit.
Social benefit = private benefit + external benefit
Activity
Discuss with a partner which of the following a re examples of negative externalities and
whichare examplesofpositiveexte rna lities:
• dentalhealthcheck-ups
• artmuseums
• consumptionofsoda/fizzyd rinks
• overuseofantibiotics
• apersond rivi ngwhilesmo kingoreating
• familyplanningcl inics
Go\'ernmems often subsidise goods and services to encourage consumption. For

Study tips
example, public transport might be subsidised to encourage people to use buses
Remember
that the level and trains rather than private cars. Figure 5.4 shows the impact ofa subsidy on the
of a subsidy is demand for public transport. The bus and railway firms receive a sum of money
measured by the from the government which Jowers their production costs and causes the supply
vertical distance curve to shift from S1 (pre -subsidy) to S, (post-subsidy). Price falls from P 1 to P, and
between the two the quantity demanded increases from Q 1 to Q,. An increase in the use of public
supply curves. The
transport should lower congestion and reduce the amoum of pollution caused by
producer receives
payment from driving cars. Therefore the subsidy reduces external costs created by driving.
"[~ ' , .
the government
and passes some
of this income to
consumers in the i ~
form of lower
prices(shown
'
i:iP1 --------------------
- ~
by the distance
P, - P,inFigure
5.4)andkeepsthe
!p~ ------------ ------ --
eJ Scb.idy i
remainder. ~ ! ! D
Q QI Q.,
O.., ntityof pcb'K to nsport
FigureS.4 Theeffectsofaproducersubsidy
Case Study: Vaccinations in Hong Kong

TheHongKonggovernment subsidisesthecostofannualfluvaccinesfortheveryyoung
andtheelderlytoencouragepeopleinhigh-riskagegroupstogetvaccinated.Theaim
istoreducetheamountoffluinthewidercommunitybytargetingtheseagegroups,so
that fewer people need to be hospitalised for the treatment of flu . Vaccinations immunise
peopleagainstcertaindiseasesandthereforecreatepositivespillovereffectsfortherestof
theeconomy,resultinginlesspressureonhealthcareservices.
Public expenditure versus private expenditure

In many countries, governments provide certain goods and services free of charge
to their citizens (see Chapter 2), who may have paid for them indirectly through
personal taxation. Examples include education, health care, public libraries, parks,
museums, public roads and moronvays (higJrnrays), garbage or refuse collection, street
lighting, street signs and national defence.
Battleships are funded by the public sector from its national defence budget. HMS Belfast
was used during the Second World War but has been decommissioned now and is used as a
Market failure
There is a conflict between the provision of goods and services directly to people
and asking them to pay for the goods and services. The Jaw of demand (see Chapter
3) dictates that, as the price of a good or service rises, less of it will be consumed.
Health care and education are under-consumed in some coumries because people
cannot afford to pay. In the short term this has a negative effect directly on the
quality of their lives, and in the long term it causes a potential decrease in life
expectancy and earnings potential (see Chapter 7 ). This impacts upon the whole
of society because it means that human resources are not being used to their full
capacity.
The ad\'antages of government provision of goods and services are that:
• the goods and services are accessible to all people, regardless of their income or
social status
• consumption of the goods and services has private benefits to the individual and
external benefits enjoyed by third parties in society.
The disadvamages of go,·ernment provision of goods and services are that:
• there is an opportunity cost, as the money could have been spent on something
else, such as paying off government debt or possibly lowering the rate of
taxation
• goods and services that are free of charge may be over-consumed, so long queues
or shortages may arise (for example, the waiting list for a hip replacement operation
in a go~·ernment hospital may be very Jong)
• in the case ofa shortage of supply due to excess demand, it can be difficult to
decide who should be able to take advantage of the free gm-crnment service
• some people (k nown as free riders) arc able to take advamagc of free goods and
services without contributing to go,·crnment revenue through paying taxes.
Exam practice
Scientific research has demonstrated the widespread social benefits of investment
in health education and health care programmes to economies across the world,
particularly in less economically developed countries such as Bangladesh.
1 Define the term 'social benefits'. [2)
2 Discuss the short-term private costs and long-term social benefits of investing in
health care in countries such as Bangladesh. [7)

1 When and why does market fa ilure occur?
2 What are the differences between merit and demerit goods?
3 How does traffic congestion cause a negative externality?
How can consumption of demerit goods be decreased?
What are the advantages and disadvantages of using taxation to deal with
market failure?
6 How can a subsidy increase the demand for public transport?
7 What are the social benefits of the public provision of education?
8 What is the debate concerning the conservation of resources and the use of
resources?
9 How do social benefits differ from private benefits of consumption or
production?
10 What is the debate concerning public and private sector provision of goods
and services?
Key te rm s
Demerit goods are goods or services which, when consumed, cause negative spillover
effects in an economy (e.g . cigarette smoking, alcohol and gambling). Demerit goods are
over-consumed due to imperfect consumer information about such goods.
Externa l b1H1aflts arethepositiveside-effectsofproductionorconsumptionincurredby
thirdparties,forwhichnomoneyispaidbythebeneficiary.
Externa lcosts arethenegativeside-effectsofproductionorconsumptionincurredbythird
parties,forwhichnocompensationispaid.
Ext•nalltifl (or spillovereffects)occurwheretheactionsoffirmsandindividualshave
eitherapositiveornegativeeffectonthirdparties.
free liders are people who take advantage of the goods or services provided by the
governmentbuthavenotcontributedtogovernmentrevenuethroughtaxation.
Marii:et failu re occurs when the market forces of demand and supply fail to allocate
resourcesefficientlyandcauseexternalcostsorexternalbenefits.
Merit goods are goods or services which, when consumed, create positive spillover effects
in an economy (e.g . education, training and health care). Merit goods are under-consumed
sogovernmentinterventionisoftenneeded .
l>rtvale benefits are the benefits of production and consumption enjoyed by a firm,
individual or government.
l"rtvilte wsts of production and consumption are the actual costs of a firm, individual or
government.
Sodill benefits are the true (or full) benefits of consumption or production: that is, the sum
ofprivatebenefitsandexternalbenefits.
Sociill costs are the true (or full) costs of consumption or production: that is, the sum of
privatecostsandextemalcosts.
A subs idy is a sum of money given by the government to a producer to reduce the costs of
production or to a consumer to reduce the price of consumption.
(!) Money
By the end of this cha pter, you sho uld be able to:
• describe the functions of money and the need for exchange
• describe the functions of central banks, st ock exchanges and commerci al
banks.
The mea nin g of mo ney

Mo ney is any commodity which can be used as a medium of exchange that is
accepted for the purchase of goods and services. In today's modern society, money
includes officially issued banknotes and coins (collecth·ely called legal tender), gold
and bank account deposits. Money has the following characteristics:
•~~~:,b:~:r.1~ :o;~;;/~~gal::~~;~,~;e:a:~i
replaced ifit becomes worn. Coins are highly
I""_,_.,..... .
durable and modern-day banknotes arc made
from polymer rather than paper. Polymer
banknotes, first introduced in Australia in
1988, are significamly more durable and so are
used extensively in countries such as Bermuda,
New Zealand, Romania and Viemam. Even
so, a US dollar bill can be folded forward and Polymer banknotes are widely used
back up to around 4000 times before it will in Singapore, Brunei, Hong Kong
tear. According to the USA's Federal Reserve, and Australia
the typical $50 bill and $100 bill lasts 9 years
before it needs replacing and its coins survive in circulation for about 30 years.
• Accep tability - Money is widely recognised and accepted as a medium of payment
for goods and services. Legal tender is the official money of a coumry (such as
Canada's dollar or the UK's pound sterling).
Study tips
Other forms of money might also be accepted,
Money is not
simplycash(notes such as tourists using US dollars. Gold is universally
andcoins)in accepted as a form of money. By contrast, the
circulation . In Zimbabwean dollar ceased to be accepted as a
fact,mostofan medium of exchange in 2009 when the country, whid1
economy's money had been suffering from civil unrest, experienced
does not exist
in the form of
hyperinflation (see Chapter 18). I n October 2008,
cash,butasbank Zimbabweans needed Z$262 1 984228 to purchase
deposits. US$1 worth of goods. Hyperinflation peaked a
month later in No,,ember 2008 when average prices
in Zimbabwe rose by 79600000 per cem within
a month!
• Divisibility - As money is a measure of the value
~{~~;s::1~n~r;ii~t~;i~tn~1~;~i:,~ed~~~:i~~:~1~:;7the ;~~df~r~n~7~~~~ccepted
Money
oldest form of money, with cows being used for trade as far back as 9000 BC.
Cattle were still used as money in some African nations during the latter half of
the twentieth century. However, cattle and livestock do not make 'useful' money as
they arc not truly divisible (a third ofa cow is not really useful for any trader! ).
• Uni formity - For money to be easily recognisable there must be uniformity
within a country. This means all $50 banknotes will look virtually identical
in terms of shape, size and design. The same applies to all legal tender
denominations of banknotes and coins. Cows come in many sizes and shapes
and each has a different value; cows arc not a very uniform form of money.
The first consistent form of money, cowry shells, was used in China over
3200 years ago. These seashells were used for mainly trading food, livestock
and textiles.
• Scarcity - Money must be limited in
supply in order for it to keep its value.
Both seashells and salt have been used
as money in the past, although the
high level of supply mcam that they
soon Jost much of their value as a
medium of exchange. By contrast, silver
and gold arc better forms of money due
to their scarcity. The supply of money,
including banknotes and coins, is
regulated by the counuy'sccntral
bank so that the money retains its value Cowry shells were used as money in
overtime. sixteenth-century China
• Portability - Money must be
c011\'cnicntly portable. For example, the approximate weight of a banknote,
regardless of its denomination, is just one gram. Whilst almost every country
uses government-issued banknotes and coins as their official currency, there arc
other forms of money. For example, money in bank accounts and the use of credit
cards enable payment to be made electronically, without the customer having
to use cash. The first coins used as money appeared around 2000 BC. In those
days, the value of coins ,vas determined by their weight, which hindered their
cffuctivcncss as money due to the difficulties of portability.
Activity
1 Use the internet to find out about the hyperinflation experienced in Zimbabwe, which
lastedaroundSyears.
.) Why did the Zimbabwean dollar cease to be used as money?
b) Why do Zimbabweans today prefer to use currencies from other nations, such as the
US dollar?
2 Discuss with a partner or as a class why the following products would not make 'good'
money. Try to rank these in order of how many functions of money these products meet.
Remembertojustifyyouranswers.
a) Milk
b) Cloth
c) Fish
d) Cigarettes
The individual as producer, consumer and borrower
The functions of money

Economists suggest that there arc four key functions of money:
• Money acts as a medium of excha nge - For something to be considered as
money it must function as a way to conduct trade. Money is widely recognised and
accepted as a means ofpaymcnt for goods and services.
• Money isa measure of value - Money isa unit of account, as it measures the
market value of different goods and services. It is fur more efficient for trading
purposes to express the price of goods and services in dollars (or another monetary
value) rather than using pro::lucts such as cloth, shells, salt or livestoek - all of
which have been unsuccessful forms of money in history.
• Money is a sto re o f value as it can be stored and used at a later date in the
future. This means that money must be able to hold its purchasing power
O\'cr time. Money therefore gives firms and households flexibility in the
timing of their sales and their purchases, thus removing the urgenc y to trade
straightaway.
• Money is a standard o f d eferred paym ent - This means that money is used as
the standard for future (deferred ) payments of debt. For example, Joans taken
out today arc repaid in money at some time in the foreseeable future. Both
the US dollar and the euro have been widely accepted standards for settling
international debts.
Activity
To appreciate the need for money, try to explain why many economists argue that the
invention of money is certainly one of the greatest inventions of all time.
Barterin g and the need for exchange

In the absence of money, people have to use a barter system in order to trade goods
and services. Bartering is the act of swapping items in exchange for other items
through a process of bargaining and negotiation. For example, someone might trade
five sacks of rice for one cow, or four chickens for a sheep.
• The key problem with a barter system is the need for a double coincid ence of
wa nts - the person with chickens must find a trader who wants chickens in
exchange for their sheep. As two pt'Ople engaged in a trade must both want what
the other person is offering, bartering is highly inefficient.
• A second problem with bartering is that of divisibility - half a sheep or two-thirds
of a chicken is not very useful for traders.
• A third problem is that of portability - compare the portability ofa sheep or fish
with that of paper money (banknotes).
The problems associated with bartering meant that coumries around the world
eventually developed the use of commodity money, such as cowry shells, grain and
cloth. For much of history, precious metals such as gold and silver have served a
monetary role.
Activity
Bartering still takes place in some parts of the world today. Discuss with a pa rtner the
problems associated with bartering as a means of trade and exchange in modern societies.
Money
ThisprintshowsScandinavianandRussiantradersbarteringtheirwares
Exam practice
1 Define the term 'bartering'. (2)
2 With reference to the functions of money, explain why bartering is an
ineffective method of trading. (6)
The functions of central banks

The centra l ba nk ofa country is the monetary authority that oversees and
manages the nation's money supply and banking system. Examples of central
banks are the European Central Bank (for the Eurozone coumries), the USA's
Federal Reserve, the Bank of England, the People's Bank of China and the
Reserve Bank of India. These banks are responsible for overseeing the monetary
policies (see Chapter 16) of their respective countries, including being responsible
for the nation's entire money supply and the manipulation ofimerest rates to affect
the economy.
Case Study: T he Federal Reserve

The Federal Reserve (also known informally as the 'Fed') is the central bank of the USA.
It was formed in December 1913, mainly in response to financial crises around that time.
The main shareholders of the Federal Reserve are the major banks in the USA, although the
exact shareholdings are not made public. According to the Federal Reserve's educational
website:
• The dollar was officially used as the USA's unit of currency in 1785, although the first
dollarcoinwasissuedin1782.
• The Federal Reserve produces approximately 26 million banknotes each day, with a face
valueofaroundS907million.
• Over90percentofcurrencyused intheUSAconsistsofFederalReservebanknotes.
• The Secret Service was created during the USA's Civil War to fight against counterfeit
money.
• It costs the US government only about 6 .4 cents to produce each banknote.
• Theaveragelifespanofa Federal ReserveS1 banknoteisjust21 months whereas the
lifespanofaS100banknoteaverages7.5years.
Source: adapted Imm - w.fedualreservuducation .org
Activity
Whatinterestingfactsandfigurescanyoufindoutaboutthecentral bank in your
country?
Central banks tend to have the following four key functions:

• The sole issuer of ba nkno tes and coins - In almost e\·ery country, the central
bank has the sole right to issue legal tender in its own coum11·: in other words, it
is the only authority that can prim banknotes and mint coins. This helps to bring
uniformity to, and improves public confidence in, the country's monetary system.
One rare exception to this function is in Hong Kong where three commercial
banks (Standard Chartered, HSBC and Bank of China) have note-issuing rights,
although the Hong Kong Monetary Authority maimains overall control of the
country's banking system, including the circulation of banknotes and coins.
• The government's bank - The central bank operates as a banker to the
government, performing the same functions as a commercial bank does for its
customers. Hence, as the government's bank, it maimains the bank accoums of
the central government, such as receiving deposits from government, making
short-term loans to the government and making payments for items of government
expenditure (see Chapter 16). The central bank also manages public-sector debt
and represents the government in the international financial markets, such as
foreign exchange. TI1is has become an imporram function of central banks because
such intervention can help to stabilise the external value of a nation's currency (see
Chapter 24).
• The bankers' bank- The central bank acts as the bank for other banks in the
country. This function includes overseeing the cash reserves of commercial banks.
This means that all banks in the country must have their accounts with the central
bank, enabling the central bank easily to manage the claims made by banks against
each other. For example, payment made by a Citibank customer writing a cheque
to another customer with an HSBC account goes through the central bank's
clearing system - the cemral bank debits the account of the Ciribank customer
and credits the account of the HSBC customer. This cheque clearing function of
the central bank reduces the need for cash withdrawals, thus enabling commercial
banks to function more efficiently. I n addition , it also allows the central bank to
have a better overview of the liquidity position (the ability to convert assets into
cash) of the coumry's commercial banks.
• The lender of last resort - Gi\·en that the authorities require all commercial
banks to keep a certain percenrage of their cash balances as deposits with the
central bank, these cash reserves can be used by the country's banking system
during financial emergencies. This function helps to build public confidence in
the coum11·'s banking system. For example , ifa certain commercial bank fuces
temporary financial difficulties, it can, as a last resort, seek financial assistance
from the central bank. This helps to ensure the bank does nor collapse , protects
jobs and thus safeguards the nation's banking system and economic welfare.
Money
Case Study: Bank bailouts

A ba il out refers to a loan or financial assistance provided to a company (or country) which
facesmajorfinancialdifficultiesorthethreatofbankruptcy. Theglobalfinancialcrisesof
1997and2008causedthecollapseofhundredsofbanksallovertheworld,overanumber
of years. Thefinancialbailoutofmanybanksbycentralbankswasseenasanecessityto
preventhugejoblossesandsocioeconomicfailuresonamassscale.
Centralbankscanbailoutbanksthroughvariousmeans,suchasprovidingsubsidies
or low-interest loans to commercial banks in need of liquidity (cash assets). Bailouts in
lndonesia(1997)andCyprus(2012)provedtobethemostexpensiveineconomichistory,
withthelattercountryspendingS10billionbailingoutitsbanks-thisrepresentsahuge
S6percentofCyprus'sS18billionGDP(seeFigure6.1).
Figure6.1 Thebiggestbankbailouts
Ac tivity
1 Discussasagroupthereasonsforandagainstcentralbanksbailingoutcommercial
banksfacingafinancialemergency.
2 ProduceA3colouredpostersofthearguments(forandagainst)andusetheseas
classroom displays.
The functions of stock exchanges

A stock exchange (also known as a bourse) is an institutional marketplace for
trading the shares of public limitt>d companies (sec Chapter 10). lt provides a
platform for individuals, organisations and govcrnmcms to buy and sell shares.
Examples of stock exchanges arc the New York Stock Exchange (NYSE), London
Stock Exchange, Frankfurt Stock Exchange, Shanghai Stock Exchange and Bombay
Stock Exd1angc. The efficient functioning ofa stock exchange helps to create
business and consumer confidence, thereby boosting investmcm opportunities in
the economy.
The Bom bay Stock Exchange
Func tions of a srock exchange include t he following:

• R.a.ising share capital for businesses - As a marketplace for buying shares, the
srock exchange provides public limited companies (see Chapter 10) with the
facility to raise huge amounts of finance for business growt h and expansion (see
Figure 6.2). This is done by selling shares in the company to t he general public.
Share capital (the money raised from selling shares in the company) is the main
source of finance for public limited companies.
Many businesses decide to 'go public' by selling their shares on a stock exchange
for the first time - a practice known as an initial public offerin g (IPO). Popular
I POs are heavily o,,ersubscribed (the quantity demanded outstrips the quantity
suppliL>d ) and this forces up the share price. Existing companies that are listed on
a stock exchange can raise more share capital by selling additional sales in a share
issue (or a share placement). Howe~w, by issuing more shares, ownership and
control of the company become weakened.
Tab le6.1 Thewo rld'slargestinitialpublicofferings
Compa ny Share ca p ita l

ra ised(US$bn)
Agriculture Bank of China
lndustrialandCommercialBankofChina
AmericanlntemationalA11urance
Nn Mobile Communications Network

Source: ad"!'led from Reute" .com ar>d ~orbes
• Facilitating company g rowth- In addition to making an !PO, existing

companies can choose to sell additional shares to raise funds to finance their
growth. T his process is known as a share issue. For example, Perrobras - Brazil's
largest oil company - managed to raise $70 billion from selling additional shares to
the general public in September 2010.
Money
The stock exchange also functions to facilitate the growth of companies through
mergers and acquisitions (see Chapter 14 ). For instance, Walt Disney Company
acquired Lucasfilm (creators of the best-selling Star Wars franchise) via the New
York Stock Exchange in 2012 for $4.05 billion.
Darth Vader and other Star Wars characters ring the opening bell at the New York Stock
Exchange
• Faci litating the sale of government bonds - Gm·ernments can raise capital to
fund their development projects via the stock exchange, which sells securities
known as bonds (a type ofloan). Bondholders do not ha\·e ownership rights, but
earn interest based on the number of bonds bought and the prevailing interest
rate. Government bonds can be bought and sold through the stock exchange by
the general public, such as individuals, companies and other governments. The
finance raised is often used to fund infrastructure projects such as the construction
of mororways (higln\'ays), sewage and water treatment systems, and public housing
projects.
• P rice mechanism for t rad ing shares - Share prices are generally determined by
the relati\'e forces of demand and supply (see Chapter 3). Price fluctuations and the
valuation of share prices are handled by the stock exchange. This ftmction of the
stock exchange provides imix,nam and up-to-date information to both buyers and
sellersinthestockmarket.
• Safet y o f t ra nsactio n - All companies that trade on a stock exchange are
regulated. The share dealings of public limited companies are defined in
accordance with the country's legal framework. This helps to boost the level of
confidence in buying and selling shares. Thus, this function of a stock exchange
can have a large impact on the economic growth prospects of a count!)' as it
facilitates capital formation (investment).
Activity
Usetheinternettofindouttheworld'sfivelargeststockexchanges. Whatarethe
benefitstobusinessesthatarelisted(tradetheirshares)onlarge,well-knownstock
exchanges?
Exam practice
In May 2012, social media giant Facebook's initial public offering (IPO) on the
New York NASDAQ Stock Exchange raised $16 billion (the third largest amount in
US history) from investors buying shares at $38 apiece. This led to the company's
valuation standing at $104 billion, the largest valuation of a newly listed public limited
company to date.
1 Define the term 'initial public offering'. [2)
2 Explain two functions of a stock exchange such as the NASDAQ Stock
Exchange. (4)
3 Comment on why Facebook might have decided to float its shares on the New
York Stock Exchange. [4)
The functions of commercial banks

A commercial ban k is a retail bank that provides financial services to its customers,
such as accepting savings deposits and approving bank loans. Examples of commercial
banks are listed in Table 6.2.
All commercial banks are responsible for maintaining the deposits of their account
holders. Their transactions are socially and legally governed by the central bank.
Commercial banking started over 200 years ago when goldsmiths (metal workers
specialising in precious metals such as gold) operated as banks. Banking itself can be
traced as fur back as 2000 BC when merchants in Assyria and Babylonia used grain
Joans to farmers and other traders. Modern commercial banking using the internet
(c -banking) did not start until 1995.
Tab le6.2 Theworld'slargestcommercialbanks,2012
Rank Bank Country

lndustrialandCommerdalBankofChina(ICBC} China
China Construction Bank China
Well~Fargo&Co
HongKongandShanghaiBankingCorporation(HSBC}
Agricultural Bank of China China
6 JPMorgan Chase
Bank of China China
ltauUnibanco Brazil
Citigroup
10 Commonwealth Australia
The functions of commercial banks can be split into two categories: primary and
secondary (or general utility) functions.
The primary functions of commercial banks include the following:
• Accepting deposits - Commercial banks accept deposits from their customers,
including private individuals, businesses and governments. Examples include
sight deposits (which arc payable on demand ) and time deposits (which
arc deposits that are payable after a fixed time period such as 6 months or a
Money
year). Time deposits tend to attract higher rates of interest for deposit holders
than sight deposits. Businesses deposit their cash in commercial banks for the
convenience of their own financial operations, such as paying their suppliers and
employees.
• Makin g adva nces - Commercial banks provide advances (loans) to their
customers. These advances include overdrafts (a banking service that allows
registered customers to withdraw more money than they actually have in their
account) and mortgages (long-term secured Joans for the purchase of assets such as
commercial and residential property).
• Credit creatio n - This describes the process by which banks increase the supply
of money in an economy by making money available to borrowers. Credit allows
the borrower (or debtor) to gain purchasing power (money) now with the promise
to pay the lender (or creditor) at a future time. Credit creation enables commercial
banks to generate considerable additional purchasing power from their cash
deposits. \Vhile central banks can prim money, they do not create credit; this is a
key function that distinguishes commercial banks from other financial institutions,
such as insurance companies and investment banks.
The secondary functio ns (or general utility functions) of commercial banks include:
• collecting and clearing cheques on behalf of their clients
• offering additional financial services, such as rax advice, foreign exchange dealings
and the buying and selling of shares
• providing safety deposit boxes for customers to safeguard highly valued
possessions, including items of jewellery and important documents such as wills
• providing money transfer facilities, such as transferring money to an overseas
bank account or paying various bills, such as telephone, electricity, gas and
water bills
• providing credit card fucilities for the convenience of customers - both private
individuals and commercial clients
• providing internet banking facilities, such as online bill payments, online bank
transfers between bank accounts and the online purchase of shares and foreign
currencies.
Credit cards allow customers to buy now and pay later,

so are widely used as a medium of exchange
Exam practice
According to The Economist, China's economy is expected to overtake the USA's by as
early as 2018. Multinational companies hoping to make the most of this opportunity
have been investing in China via the Shanghai Stock Exchange. Commercial banks
such as the Industrial and Commercial Bank of China (ICBC) and the Hong Kong and
Shanghai Banking Corporation (HSBC) also have an increasingly important role in the
development of the Chinese economy. Nevertheless, the trading of the renminbi,
China's official currency, is still closely monitored by the People's Bank of China - the
central bank.
1 Describe the functions of a commercial bank such as ICBC or HSBC. [4]
2 Explain the key functions of central banks such as the People's Bank of China. [4]
3 Explain how the Shanghai Stock Exchange can play a key role in the economic
development of the Chinese economy. [4]
C h apter review questions

1 What is meant by money and what are its main characteristics?
2 What are the key functions of money?
3 What is a central bank and what are its key functions?
4 What is a stock exchange and what are its main functions?
What are commercial banks and what are their main functions?
How does a central bank differ from commercial banks?
Key te rms
Barte ring istheactofswappingitemsinexchangeforotheritemsthroughaprocessof
bargaining and negotiation.
A centra l ba nk is the monetary authority that oversees and manages the supply of money
andthebankingsystemofthenation .
Co mme rc.la lba nk s areretailbanksthatprovidefinancialservicestotheircustomers,suchas
accepting savings account deposits and approving bank loans.
Functions of money describes the role that money plays in the economy: money is a
medium of exchange, a store of value and a measure of value (or unit of account).
Mon ey isanythingthatiswidelyacceptedasameansofexchange(andactsasameasure
and store of value).
Mo ney supp ly refers to the amount of money in the economy at a particular point in time.
Astockexchangeisaninstitutional marketplacefortradingthesharesofpubliclimited
companies.
0 Labour markets

• identify the factors affecting an individual's choice of occupation (wage factors
and non-wage factors)
• describe likely changes in earnings over time for an individual
• describe the differences in earnings between different groups of workers
(male/female; skilled/unskilled; private/public; agricultural/manufacturing/
services)
• describe the benefits and disadvantages of specialisation for the individual.
TakenfromCambriclgelnternational fxamiMtionsSyllabo,~GC5f0455/0l.evel2281 )
C CambfidgelnternationalExaminabom
Influ ences o n a n individual 's choice of occupatio n

Most people work at some point in their lives. An individual's choice of occupation
depends on many factors, which can be categorised as wage and non-wage factors.
Wage facto rs affecting cho ic e of occupation

T he lc\'el of sa lary or wage that a person receives in return for their labour is a major
influence on their choice of occupation. Table 7.1 outlines t he different methods of
payment by which a worker may be paid in return for their labour.
Ta ble 7.1 Different methods of payment for labou r

Method s of payment Explana tion Examples
Wages Wages are paid hourly or Wei!kly, 10 Part-time workers in a shop or
are avariableco1ttofirms restaurant(e.g. $7 per hour}
Salary Salariesarepaidmonthlyatalixed Full-timejob{e.g.teachers,shop
value,!;Oarefixedco1ts managersandnur~s)
A fixed amount paid per item Workers producing individual items
produced or sold inafactory{e.g.S2pergarment
completed)
Apercentageofthevalueof Realestateagentsearning1%of
product:5or1ervicessold thevalueofeac:hpropertythat
they sell
Anadditiooallumpsumofmoney RoyalBankafScotlandand
paidduringyear,usuallydependent 8ardayspaid523staffmembers
upon performance morethan£1m(S1.56m}in
bonusesin2013
Profit-related pay Payment related to the profits A partner in a law firm may receive
earned by a firm 20%oftheannualprofits
Share options Workers receive shares in the firm, Public limited companies
1otheyhavean incentivetowork
hardsothatthefirmi1profitable
Fringebenefits(orperks) Additionalbenefits,whichhavea Pensions,healthinsurance.
monetary value companyrnr,laptop,mobile
phone,educ.ationforchildren,or
membershipofahealthdub
Non-wage factors
Non-wage fuctors are also a major influence on an individual's choice of occupation,
as a person may be motivated by money in the short term but in the long term the y
will also wam to feel happy and motivated at work. Non-,vage factors that influence
an individual's choice of occupation include the following:
• Level of challenge - does the job require thinking skills or is it repetitive and boring?
• Career prospects - will there be progression within the firm or will a person have
to change jobs to be promoted?
• Level of danger involved - is the job dangerous? For example, some people face
a high degree of risk at work, such as lifeboat rescue teams, firefighrcrs, window
cleaners and scaffold erectors.
Worker erecting bamboo scaffold ing in Hong Kon g
• The leng th of training required - Some jobs require few skills, such as cleaners
and shop assistams. By conuast, ot her jobs require years of training, such as
electrical engineers, plastic surgeons, pilots, accounrams, lawyers and demists.
• The level of education required - Some jobs require no or minimal education
whereas other jobs require post-graduate le\'els of education (such as university
professors).
• Recognition in the jo b - does the worker get praise and recognition for t heir
performance at work? !fa worker feels respected at work, they may be motivated to
work harder.
• Personal satisfa ction gained from the job - This is imporram because if a worker
feels satisfied and happy in their work, they may work harder and stay in t he job
longer. Volumary work might be carried out by people who are happy to work for
no pay, as the reward they get is the personal satisfanion of,,vorking for a d1arity,
such as taking care of the elderly or sick.
• The level of ex perience required - Some jobs require no or minimal experience
whereas other jobs require a minimum amount of experience (such as judges and
Jaw-makers).
Labour markets
Activity
lnterviewseveraladultsandaskthemthefinancialandnon-financialreasonswhythey
chosetheiroccupation. Shareyourfindingswiththerestoftheclass.
Changes in earning s over a lifetim e

Earnings change over a person's lifetime (see Table 7.2) for the following reasons:
• The level of education a person has tends to affect, in most cases, their earnings
and earning potential (see Table 7.3).
• I nexperienced workers, such as graduates in their first year of work, earn Jess than
experienced workers.
• Salaries and wages usually increase with experience and rime spent working ar a firn1.
• After workers reach the peak of their career, their salaries and wages tend to remain
fairlyconsram.
• After retirement, earnings full and people are dependent on their pensions and
savings to co\'er their living expenses.
Table7.2 Earningsbyage,full-timeworkers(UK,2010-2012)
Age category 2010(£) 2011 (£) 2012(£)

Allempl(lf)'ees
Sou,ce: adaptedfromOlhcelmNabooalStabstics
Ta bl e 7.3 After-taxearningsbyeducationalatta inment(USA,2011-2012)
Less than college graduate College graduate

Master's,
Bachelor's
p,ofm;oaal,
degree
I doctoral degree
Mean income after

taxes{Sl
I 45 903
I
Sou,ce:~daptedfromUSDepartmentf<lflabor
Exam practice
1 With reference to Table 7.2, explain why the potential earnings of an
individual fall after the age of 60. [2]
2 With reference to Table 7.3, explain how education impacts upon earnings
ofan individual. (4)
Study tips Wage determ ination

When you are Wages are determined by the interaction of demand for labour and the supply of
answering workers in an industry. For example, the combination of the high demand (ability
questions about
the demand for,
and willingness to pay) for, and the low supply of, neurosurgeons means their pay is
and supply of, very high.
labour.remember
that workers The demand fo r labour
supp/ylabourto The demand for labour is a derived demand . This means that labour is demanded
firms and firms
demand workers
for the goods and services it produces and not for itself. For example, bakers are
to produce goods demanded for the bread they bake, not for the sake of hiring bakers.
and services.
·[~- "-
~!! W1 -------------,
lj W2 --------------r-----:
! ! Dt
0 N1 N2
NCXTiberolworke<s
Fi g ure7.1 Thedemandforlabourcurve
Figure 7.1 shows a downward-sloping demand for Jabour (Di,) curve. When the wage
rate falls from W1 to tt~, the number ofworkers employed increases from N 1 to N 2 •
This is because firms (employers) can affi:mi to hire more workers when the wage rate
is lower.
The factors that influence the demand for Jabour include the following:
• The level oftoral demand in the economy (known as aggregate demand ) -
During a boom or period of economic growth, the demand for goods and services,
and therefore the demand for labour to produce them, is higher than during a
recession or period of declining growth.
• An increase in the producth'ity oflabour (output per worker m·er a period of
time ) - The demand for workers increases as their productivity increases through
training and changes to production methods (see Chapter 11). For example,
allowing workers to make suggestions about how their working practices can be
impro,·ed and putting the suggestions into practice can motivate workers, as they
feel empowered to make changes. Recognition ofworkers' achie,'emems can also
be motivational and increase productivity. Consider how praise from your teachers
or parents can impact upon your own attitude to learning!
• The cost of labou r as compared with the cost of machinery and technology that
could replace the labour - Although technology and machinery are expensive to
purchase in the short run, they can save money for the business in the Jong run.
For example, many firms have replaced security guards with security cameras.
Cameras are cheaper in the Jong run and they do nor need toiler breaks, although
they do break down occasionally! Car manufacturers use robotic equipment and
machinery that can operate 24 hours a day.
Labour markets
Securitycamerascanbemorecost-effectivethansecurityguardsinthelongrun
N ational minimum w age leg islation

A national minimu m wage (NMW) is the lowest amount a firm can pay its workers,
as set by the government. Any firm that pays workers less than the legal minimum
wage is breaking the law.
Since May 2013, the NMW in Hong Kong has been H K$30 (around $3.85 ) per
hour for all workers. In Australia, the NM\V is AUD15.96 (around $16.21) per hour
or AUD606.4 (around $625.35 ) per week. For those aged below 21, the NM\V is
slightly lower (see Table 7.4).
Ta bl e 7.4 Minimum wage rates per hour in Australia, 2013 (USS)
Age of w orker NMW( USS)
Under16
Sou,ce:Fai,WO<tOmbodsmao.Australia
In Figure 7.2 the equilibrium wage rate before the national minimum wage is H'i
and Ni workers are demanded and supplied. If the government introduces a NMW
which is aOOve the equilibrium wage at \Vi then the quantity oflabour supplied to
the market increases from Ni to N 2 as more workers are prepared to work for a higher
wage rate.
Howe,'er, the quantity oflaOOur demanded falls from N 1 to NJ because firms

(employers) are less able or willing to pay as many workers at a higher wage rate. As
the quantity supplied of labour is greater than the quantity demanded, there is a
surplus oflabourat a wage rate ofli';. Thus, if the NM\V is set too high, this may
lead to unemployment in the economy.
' ::
!i w
l'
Figure 7.2
Activity
N3
- N1 Ni
N1JT1berolworl:.e<.
National minimum wage
1 Suggest reasons why the min imum wage in Austral ia may be less for younger workers
than for workers aged 2 1 and over. Discuss poss ible reasons why the NMW is lower in
HongKongthaninAustralia.
2 Find out the minimum wage in you r country or a country of your choice and consider
whether a job paying the NM W is sufficient to live on.
The advantages and disadvantages ofa national minimum wage are listed in Table 7.5.
Ta ble 7.5 The advantages and disadvantages of a national minimum wage
Adva ntages Di sadvanta ge s

• Workersreceiveafairwageforanhour's • Workers who eam more than the minimum wage
workandarenotexploitedbyemployers. {perhap1duetotheirseniority)mayrequestahigher
wage rate to maintain the wage differential between
• Unemployedpeoplemayhavean
them and workers who earn less than they do. For
incentivetowon<.,asthewagemaybe
example,whencleanersinanofficereceiveapay
moreattractivethanrelyingonwelfare
riseasaresultofaninueaseintheNMW,other
payments
officestaffmayaskforawageinc:reasetomaintain
• Low-income earners may have more thedifferenc:ebetV!le{!ntheirwagesandthatofthe
moneytospendandthismayincrease deaners.Thiscausesanevenlargerincreaseinthe
consumptionintheeconomy,thuseasing cmtoflabourforfirm1.
anyfearsthathigherwage1{costsof • Unemployment might increase becau,;e firms c:ould
production} might cause unemployment
facehigherwagebillsasaresultofincrea5edwage
rates. Thereforn,theirdemandforlabour(abilityand
Vllillingne11 to employ workers) will fall. Alternatively,
firms might purchase machinery and equipment to
reducethenumberofworkersrequired. Thismight
cause technological unemployment in the economy
{1eeChapter19)
Labour markets
Government interference in labour market

• Employment rights - Go.'crnmcnts impose laws to protect the rights of workers
and employers, and these laws vary between countries. Laws arc designed to prevent
discrimination against workers due to gender, race, religion and disability, and also
to protect the rights of employers and their ability to hire and fire workers.
• Trade union legislation - Governments can reduce the powers ofrradc unions
in order to make labour markers more flexible and cfficiem (sec Chapter 8).
This happened in the UK during the 1980s when Margaret Thatcher was prime
minister, and many coumrics have followed her lead. Trade unions now ha\·e less
bargaining power and arc Jess powerful generally.
1 May is still celebrated around the world as International Workers' Day. Indonesian workers
holdapeacefulrallyinJakartaduringtheannualMayDaymarch,demandingbetterpayand
conditions of employment
Activity
lnvestigatetherightsandresponsibilitiesofemployersandemployersinyourcountry.
Shareyourfindingswiththerestoftheclass.
Factors affecting the supply of labour

The lalx>ur supply in an economy consists of people w!XJ are ofworldng age and
who are willing and able to work. This docs nor include those who are in full -time
education or those who do not work by choice, such as housewives or houschusbands.
Figure 7.3 shows an upward-sloping supply oflabour (Si.) curve. Ifrhc wage rate
in an industry increases from W1 to W2 the number of workers willing to work will
increase from N 1 to N 2 because workers arc attracted by higher wages.
t.w,[ / '
ji w, ~
0
Figure7.3
--
N1 ~
Numbe<ol'Mlo'ffi"
Thesupplyoflabourcurve
It is possible, ar least in theory, that the Si, curve can be backward bending. Figure
7.4 shows that high \\'age rates will cause workers to work longer hours to increase
their earnings up to a cenain point. As wage rates increase from W1 to Wi the
number of hours worked increases from H 1 to Hi. However, as wages increase from
w; to WJ the number of hours worked falls from H 2 to H 3 because there is a rrade-
off berween work and leisure rime . Ar W3 a person can work fewer hours yet have a
higher income than at Wi. The back wa rd-bending supply of labour cur ve therefore
occurs when wage rates rise to a high enough point to allow people to work less and
enjoy more leisure hours.
Figure7.4 Thebackward-bendingsupp lyoflabou r cu rve
The st ructure of the labour supply varies between countries and depends on the
following factors.
Labour force participatio n rate
The labour force participation rate is the percentage of the working population that
is working, rather than unemployed. It is influenced by:
• the number of full -time and pan-time workers in the Jabour force
• the number ofwomen in the workforce
• the age distribution of the workforce (also see Chapter 22)
• the official retirement age of the country.
Table 7.6 shows examples of the labour participation rate, female labour participation
rare (percentage of females working) and male labour participation rate in various
countries.
Table7.6 Labourparticipationrates,selectedcountries:
Labour participation Male labour Female labour
Country rate(%) participationrate(%) participationrate(%)
Bangladesh
Nigeria
Hong Kong
Soorce: adaptedfromthe World!lank
Labour markets
Availability and level of welfare benefits

Welfare benefits are paid to the unemployed. However, ifwelfare benefits are
high and readily available, this can discourage people from seeking work because
the opportunity cost of not working and receiving welfare payments is roo high.
Go\·ernments uy to regulate who can receive benefits to prevent disincentives to
work. For example, in the UK a person must prove that they are actively seeking work
if they are to continue to receiw welfare payments.
Changing social climate

In many countries, more women are entering the workforce and delaying having
families while more men are looking after the home and children. As a result of
falling birth rates, some countries have ageing populations (see Chapter 22). These
factors affect the composition of the workforce. Such countries may have to rely on
immigration to ensure that they have workers with the required skills in the future.
Geographical mobility
Geographical mobilit y refers to the willingness and ability ofa person to
relocate from one part of a country to another for work. Some people may not be
geographically mobile for the following reasons:
• Family commitments - People may nor want to relocate as they \\'ant to be near
their family and friends. There may be other commitments such as schooling
arrangements for children (it can be highly disruptiw to the education of children
who have to move to a school in a different town or country).
• Costs of living may vary between regions- If costs ofliving are too high in
a another location, it may be uneconomical for a person to relocate there. For
example, a bus driver may find it impossible to relocate from the countryside to
the city because house prices are much higher in the city and therefore they would
nor be able to purchase a home. By contrast, a banker may be offered a relocation
allowance to move to another city and his or her potential earnings are much
higher, so the banker has greater geographical mobility than the bus driver.
Exam practice
In some countries around the world there are shortages of people with particular
skills. For example:
• There is a global shortage of doctors and nurses.
• Belgium and the UK have a shortage of chefs.
• Nordic countries have a shortage of psychologists.
In 2013 there were 200 million international migrants, including nurses trained in
the Philippines, who were prepared to relocate to take advantage of employment
opportunities.
1 Suggest two reasons why there is a global shortage of doctors and nurses. (4)
2 Analyse the reasons why nurses trained in the Philippines may relocate
to take advantage of employment opportunities. (6)
3 Examine how countries can attract individuals to professions in which they
have a shortage of workers. (6)
Occupational mobility
Occupational mobility refers to the ease with which a person is able to change
between jobs. The degree of occupational mobility depends on the cost and length of
training required to change profession (see the case study below).
Activity
UsetheBBClnteractiveGuide(w -.bbc.co.uk/news/b usiness-21938085)toinvestigate
global employment opportunities in selected countries around the world.
Case Study: Occupational mobility

These cases demonstrate how varied people's occupational mobility can be:
• A banker decides to retrain as an economics teacher. He takes a 12-month postgraduate
teacher training course, which typically involves two 7-week blocks of teaching in a
school. The banker is able to fund his training through savings earned while working in
the banking industry.
• An 18-year-old student decides to apply to university to become a doctor. She is willing
totakeoutastudentloantopayforthe7-yearcourseandcoverherlivingexpenses
whilesheisatuniversitybecauseofhercareerprospectsandhighpotentialearningsin
the future .
• A coal miner loses his job in Chile when the mine closes. Having worked in the mine
forover30years,heneedstoconsiderretraining . Hemayfinditdifficulttobe
occupationally mobile as he lacks other sk ills and there are few jobs in the local area .
Wage determination
For the vast majority of jobs, wages are detennined by the interaction of the demand
for, and supply of, labour (see Figure 7.5).
Figure7.5 Equilibriumwagerateinanindustry
The equilibrium wage rate is determined when the wage rate workers are willing
to work for equals the ·wage rate that firms (employers) are prepared to pay: that is,
the demand for labour is equal to the supply of labour. In Figure 7.5 the equilibrium
wage rate is W. and N, workers are employed. Changes in the demand for, or supply
of, labour in an industry will therefore change the equilibrium wage rate.
Labour markets
Differences in ea rning s
Activity
lnsmallg roups, investigatethedifferencesinearningsbetweendifferentoccupationsin
yourcountry,oracountryofyourchoice. Eachgroupcouldre searchthediffere ncesin
earningsbasedononeofthefollowing:
• skilledversusunskilledworkers
• maleversusfemaleworkers
• privatesectorversuspublicsectorworkers
• primaryve rsussecondaryve rsustertiarysectorsofp roduction.
Compa reyourfindingswith t hoseoftheothe r groupsinyourclass.
Differences in earnings between skilled and unskilled workers

In general, skilled workers earn more than unskilled workers due to their relatively
higher demand and relatively lower supply. Table 7.7 shows some of the highest- and
lowest-paid occupations in the UK (all figures expressed as pre-tax weekly earnings
for the median full-time worker).
Table7.7 EarningsforselectedoccupationsintheUK,April2012
~~~~~~~~~~
Hig he st-pa id profess ions Lowest pa id professions

Week ly Weekly
Rank Occupa tion w age(£) Rank Occupation w age(£)
Aircraft pilots and flight 1558.B Leiwreandthemepark 245.0
engineers attendants
2 Chief executives and Hairdres1ersandbarbers
~nior offic:ials
3 Marketing and sales 3 8ar1taff
directors
4 Information technology 4 Waiting1taff.launderers
andtelK01Timunications and dry cleaners
directors
S Airtra/fic(Olltrollersand Kitchen and catering
legalprofes§iooal1 as§istants
Sou,ce:adaptedfromOIIKefmNationalStabstKs
T he data in Table 7.7 show that unskilled occupations (such as bar staff and waiters)
earn Jess on average than skilled workers (such as medical practitioners and air traffic
controllers). This is because there is a large supply ofpeople able to work as waiters
due to few skills being required, but to be a doctor requires a universit y degree and
professional training. T herefore, the supply of doctors is lower t han that of waiters.
T his is illustrated in Figure 7.6.
Figure 7.6 The difference in the equilibrium wage rates of waiters and doctors
Figure 7.6 shows the demand for, and supply of, waiters and doctors in an economy.
Waiters are elastic in supply (S,.,.,,,.,) because if the demand for waiters increases from
Du to Du the percentage change in quantity supplied (w1 to w2 ) will be greater than
the increase in wages ( W.,.1 to W..,.2 ) , as indicated by the red arrows. This is because the
job requires few skills and therefore it will be relath·ely easy to increase the supply of
waiters in the short term.
By contrast, doctors are inelastic in supply (Soocron)· If demand for doctors
increases from Du to Du the percentage change in quantity supplied (d 1 to di) of
doctors in the short term will be less than the increase in wages ( ll'd 1 to W<12 )- This
is because the level of qualifications and length of training required make it difficult
to increase the supply of doctors in the short term. A relatively large increase in
wages is required to attract people to study and train as doctors, as illustrated by the
blue arrows.
Differences in ea rnin gs between male and female workers

In literally all countries, the average earnings ofmales differ from the average
earnings of females. Table 7.8 shows the differences in mean gross annual earnings
(average pre-tax income) between male and female workers in the UK. The figures
are fur full -time workers.
Ta ble 7.8 Differences in male and female working hours and earnings (U K, 201 1-2012)
Gender Ma le s Females
Median gross annual earnings{£)

Mediangrosswei!klyeamings(£)
Meanhourlyeamings(£)
Mediantotalweeklypaidhoun
Soorce: ad"!'ledfromOffkelorNatiooalStatistic,
Labour markets
Table 7.8 shows that there is a noticeable difference between the average wage of male
and female workers. This pattern occurs throughout the world. Possible reasons for
the difference in male and female earnings include the following:
• There are more women in pan-time work than men, so their earnings are lower on
a\·erage.
• Women rake career breaks to have children and therefore miss out on promotional
opportunities.
• Women may accept low-paid and part-time jobs, as hours are flexible and can fit in
with childcare arrangements.
• \\'omen may face discrimination at work.
However, times are changing for females, especially those in more economically
developed countries such as the UK:
• I n the UK's Financial Time Stock Exchange (FTSE) JOO firms, 17.3 per cent had
female directors in April 2013 - an increase from 12.5 per cent in 20 11.
• There are more females than males in the UK enrolled on veterinary science
courses and in subjects associated with medicine at unh'ersity.
• More than half of the headteachers (principals) in the UK are now females.
Femaleparticipationratesareincreasinginmanypartsoftheworld
Differences in earni ngs between private and public sector workers

\Yorkers in the private and public sectors tend to earn different wages. Table 7.9
shows the differences in earnings between full -time workers in the public and private
sectorsofthe UK in 2012.
Ta ble7.9 Differencesinprivate-andpublic-sectorearnings(UK,2012)
Public sector
I 2012 I 2012
Median gross annual earnings{£} l 2S240 1 28930
Median gross weekly earnings(£) I I
Median hourly earnings{£} I I
Soorce: adaptedfromOfficeforNationajStatistk,
In theory, people in the private sector can earn more than workers in the public
Study tips
sector. In many coumries, salaries in the public sector are typically less than those
As Ta b le7.9
shows, itis
which can be earned in the private sector, but public-sector jobs are more secure
and arc accompanied by a pension in retirement. Examples of public-sector jobs are
assume that teachers, nurses, police officers, fire service officers and ci\'il servants.
those in the Private-sector jobs typically have higher earning potential as private individuals and
private sector firms strh'C fur profit maximisation (see Chapter 10). For example, Lloyd Blankfein,
get paid more the chief executive of the Goldman Sachs Group, rcceh'ed a 75 per cent pay rise in
than those in
the public sector. 2012 and earned $21 million, which included pay ($2 million), bonus ($5.7 million)
This depends on and shares ($13.3 million).
many variables, However, this comes with more risk as jobs are Jess secure in the private sector and
such as the level workers often have to s:ffc up fur their own pensions in retirement. For example, the
of qualifications, global financial crisis whicl1 started in late 2008 had caused over 11 OOO job losses
skills and
experience of the
atCitibank Group by the end of 2013. US investment bank JPMorgan Chase cut
workers. 19 OOO jobs during the same period.
Differences in ea rn ings between ind ustria l sectors

Table 7.10 shows the differences in per-hour earnings between full -time workers in
the three industrial sectors (primary, secondary and tertiary) of the UK in 2012.
Ta ble7.1 0 Hourly earn ings in selected industries(UK,2012)
Prima ry sector(£) Secondary sector(£) Tertia ry sector(£)

Agriculture, forestry Wholesale and retail
andfohing trad,
Mining and Manufacturing Accommodation and
food services
Electridty,ga1, Information and
steam and air
conditioning supply
Water supply; Financial and
sewerage.waste
management
Soorce; adaptedfromOffkeforNationajStatistk,
Table 7.10 shows that workers in the agricultural, fishery and forestry industries
in 20 12 earned the lowest wages in the UK with the exception of occupations in
accommodation and food services, which generally offer unskilled work. The main
reason fur the low earnings in these industries is that the products produced, such as
fish and food products, have a low sales value. In general, as the value of a good or
service increases, so does the wage of the person who produces it.
Labour markets
Table 7. 10 also shows that occupations in the finance , insurance, information and
communication industries typically earn the highest wages. These tertiary sector
occupations produce ser.ices of a higher value than those in the primary sector.
A rise in the price of minerals and metals in recent years may help to explain the
high earnings of people working in mining and quarrying. Skilled trades such as
electricians and gas technicians ha\·e been in short supply in recem years in the UK,
partly due to the lengthy rraining period required, and this may have Jed to increased
earnings for workers in these occupations.
People in tertiary sector professions tend to have high earnings because to
become a fully qualified accountant, doctor or lawyer requires postgraduate level
study, professional examinations and many years of experience. The reward for this
time and effort is higher wages, which attract people to those professions. In many
economies, studems have to take out Joans for unh-ersity and postgraduate training
and they ·would only be prepared to do this because of the potential reward of high
fumreeamings.
Activity
Discuss in small groups the possible reasons why people who produce food, which is
essential for life, get paid the lowest wages on Earth, while bankers, who produce nothing
ofsubstance,getpaidthehighest.
Earning s of peo ple with spec ial tal ents o r cele brity status
There are some people with special talents or qualities who earn exceptionally high
wages. Examples are supermodels, top footballers and tennis players, and fumous
jL.l l
celebrities and actors. This is because their skills are exceptional and are in short
supply, thus their labour supply curve is price inelastic, as shown in Figure 7.7.
0 N0
Numberclmc,;;e .s1or,
Figure 7.7 Price inelastic supply of Hollywood movie stars
There are only a finite number of top Hollywood movie stars (N, ), so the equilibrium
wage rate will be relatively high ( W.J Such special talents allowed Johnny Depp to be
paid $35 million for the movie Pirates of the Caribbean in 201 1, and J. K. Rowling,
the author of the Harry Potter OOOks, to earn £45.4 million ($7 1m) in 2012.
J. K. Rowling earned £45.4 million (S71m) in 2012. She earns money from box-office takings,
HarryPotterbookrightsandmerchandisingspin-offs
Activity
1 lnvestigatethehighest-earningmaleandfemale:
a) filmstars
b) tennisplayers
c) pop singers
d) individualsinanothercategoryofyourchoice.
2 Discussthepossiblereasonsforanydifferencesintheirearnings.
Specialisation of labour
Specialisation of labour occurs when a worker becomes an expert in a particular
profession, such as a landscape architect, a psychiatric nurse, an electrical engineer or
an economics professor.
Specialisation of labour can also occur when a worker becomes an expert in a
part of a production process. Examples arc supermarket checkout operators, waiters
serving people in a restaurant, and factory workers who operate machinery.
Advantages of specialisation for the individual (worker) include the following:
• Workers become experts in their field, so their productivity increases.
• The quality of the product or service increases.
• Workers can become very skilful, so their earning potential may increase.
Disadvantages of specialisation for the individual include the following:
• The \\urk may become rcpctith-e and boring.
• Workers may become alienated, especially those specialising in low-skilled work.
• The production process may become overspecialised - that is, roo dependent on an
individual \\urkcr or group ofworkcrs.
• The \\Urkcrs may become dcskillcd in other areas - in other \\Urds, there is a lack
of flexibility.
The advantages and disadvantages of specialisation for regions and countries arc
outlined in Chapter 23.
Labour markets
Cha pte r r eview questio n s

1 What are the wage and non-wage factors that affect people's choice of
occupation?
2 Why do an individual's earnings change over their lifetime?
What are the factors that affect the demand for labour?
What are the factors that affect the supply of labour in an economy?
5 What are the advantages and disadvantages of a national minimum wage?
6 How might the government intervene in labour markets?
7 What is meant by geographical and occupational mobility?
Why do male workers in general earn more than female workers?
Why might a public-sector worker earn less than a worker in the private sector?
10 What are the advantages and disadvantages of specialisation of labour?
Key terms
Demand for labo ur is the number of workers firms are willing and able to employ at a given
wage rate.
Derived demand means the demand for labour is not demanded for itself but for the goods
andserviceslabourisusedtoproduce.
The equ ili bri um wage rate is determined when the wage rate workers are willing to work
forequalsthewageratethatfirmsarepreparedtopay.
Geographical mob il ity occurs when a person is prepared to relocate to another area for a
job.
The labourforce participat lonrate isthepercentageoftheworkingpopulationthatis
working.
Labour supp ly consists of people who are of working age and are willing and able to work
at prevailing wage rates.
A nationa l min imum wage is the lowest amount a firm can pay its workers and is set by the
government.
Occupational mobility is when a person can easily move from one type of job to another.
A sa lary isafixedmonthlypaymentinreturnforlabourservices.
Specialisation of labour occurs when a worker becomes an expert in a particular profession
or in a part of a production process.
A wage is the return for labour services, paid hourly or weekly. Payment depends on the
amount of time worked.
(!) Trade unions
• describe trade unions
• analyse the role of trade unions in an economy.
TakenfromCambfidgelnternationalExamiJlabomSyj!abus (IGCSE 0455/0level2281)
0 Cambridge lntematKlf\al Examiflatioo,
The ro le of tra de unio ns

A trade union (or labou r unio n) is an organisation that exists to protect the
rights ofworkcrs. Trade unions originated in the nineteenth century in the UK
and the USA. Workers often worked in very poor conditions, so trade unions were
created to bargain for better terms and working environments for their members. A
worker becomes a member of a trade union by paying a weekly, monthly or yearly
subscription fee. The membership fees help to pay for the administrative and legal
expenses of the union.
Employees (workers) and employers often have different aims and objectives. For
example, in addition to maintaining a happy and well-motivated workforce, employers
maywamto:
e maximiseprofits
e minimisecosts
e maximisesales.
On t he other hand, employees may wanr to:
• maximise wages/salaries
• work in a safe and healthy environment
• have good terms and conditions at work
• maximise their non-wage benefits
• enjoy job security.
There is often a conflict between the aims of employees and employers. For example,
Study tips an increase in ,vages along with a decrease in working hours will increase costs to
It is possible for employers but impro,'e the terms of employment for workers.
the a ims of both
. . .,"'·""'~ ,,ro,~·T"~ "

employees and l~com rnmcdl oos
employers to 00\tlce 1f d~mlssed betweenempb/ee,;a nd
be met at the
instance.firms
may agree to the
demands of trade
unions in return I ~ woolng BENEFITS OF JOINING - - - -
for productivity cond itloos --- A TRADE UNION : - - - - _ <><Mee tf unfa irly
~I ~
gains from thei r
workforce.
,eroc,,.oochru pos,; lble inlk>eoceoo lm~cond itloos d

lnscrn nce . =lai gayernmentd oc~ ioo. empk,yrrent
locilitle,
FigureB.1 Thebenefitsofjoiningatradeunion
Trade unions
Article 23 of the United Nations Universal Declaration of H uman Rights supports

trade unions and decrees that all people should work in a safe environment for a fair
amount of pay. It states the following:
1 Everyone has the right to work, to free choice of employment, to just (fair) and
favourable conditions of work and to protection against unemployment.
2 Everyone, without any discrimination, has the right to equal pay for equal work.
3 Everyone who works has the right to just and favourable remuneration (pay
and benefits), ensuring for himself and his family an existence worthy of human
dignity.
4 Everyone has the right to form and to join trade unions for the protection of his
interests.
According to the declaration, membership of trade unions is therefore a basic
human right and individuals should have freedom of association - they cannot
be discriminated against for being a member ofa trade union. Ho\\'C\'er, firms
(employers) are not obliged to recognise and negotiate with trade unions. Instead,
they can set their own terms and conditions and rates ofpay. In some countries, such
as the United Arab Emirates, the law does not allow trade unions to exist.
Ty pes of trad e un io n
Trade unions can be classified as follows:
• Craft unio ns - These are the oldest type of labour unions, which were originally
formed to organise workers according to their particular skill. For example,
engineers and primers formed their own unions, as did carpenters, plasterers
and electricians. Craft unions try to restrict membership to only those with the
panicularskills.
• I ndust ria l unions - These trade unions represent all workers in their industry,
irrespective of their skills or the type ofwork done. An oil workers' Jabour union
would include workers involved in exploration, extraction, storage, refining and
any other jobs associated with the oil industry. The United Amo Workers Union of
the United States (UAW) is an example ofan industrial union.
• General unio ns - These trade unions are usually prepared to accept anyone into
membership regardless of the place they work, the nature of their work or their
industrial qualifications. These labour unions have a very large membership of
unskilled workers. The Transport and General Workers' Union (TGWU ) is a
very large general union in the United Kingdom. Its members include drivers,
warehouse workers, hotel employees and shop workers. In Australia the largest
general union is called the Australian Workers' Union.
• '\Vhite collar' unio n s - These labour unions recruit professional, administrative
and clerical staff (salaried workers) and other non-manual workers. They are
common in teaching, banking, the civil service and local government.
Some professions, such as law, accountancy, engineering and medicine, do not ha\·e
trade unions because their work is gm'Crned by a professional txxiy which sets entry
requirements in terms of examinations, training and le\·el of experience. The entry
requirements are high and therefore the number of workers in each profession is
controlled.
The ro le of tra de unio ns

The primary role of a trade union is to protect the interests of its members. Examples
oflabour union roles and responsibilities include:
• bargaining with employers for pay rises and better terms and conditions
• ensuring that equipment at work is safe to use (supported by health and safety
legislation) and that workers are given sufficient rraining to enable them to perform
their role at work safely
• ensuring members are gh-en legal advice when necessary
• giving support to members when they are made redundant
• pl"O\'iding financial and legal support to workers who may have been unfairly
dismissed or disciplined
• persuading the government to pass legislation in fu,·our ofworkers, such as la\\'S
covering minimum wages, maximum working hours, pension rights and the
retirement age.
Trade unions act as a means of communication and negotiation between employers
and employees through a process called collective bargaining. This occurs when a
trade union representative, who is voted into the position by colleagues, negotiates
on behalf of the union's members (the workers) with the employer for better pay and
working conditions. A collecth·e voice is more JX)Werful than each worker negotiating
individually with the employer. Trade unions can therefore be an effective means of
communication between the employer and employees.
Trade unions with high membership tend to be more powerful than unions
with a small number of members. If trade unions make full use of their bargaining
strength, they could succeed in getting larger and/or more frequent wage increases
than the weaker unions. This highlights the importance of'unionisation' to trade
unions: the larger and more united the union, the better its bargaining position
tends to be.
Unions may be affiliated to a larger organisation which negotiates with the
go,·ernment: for example, the Trade Union Congress (TUC) in the United
Kingdom and the American Federation of Labor and Congress of I ndustrial
Organisations in the USA. These organisations push for legal protection of rights
for workers, such as the imposition of a national minimum wage or an increase in
its le,·el (see Chapter 7 ).
The basis for wage claims

Trade unions normally base claims for higher wages on one or more of the
following :
• A rise in the cost of living due to inflation (see Chapter 18 ) has reduced the real
income of trade union members.
• Workers in comparable occupations have receh'ed a wage increase.
• The increased profits in the industry justify a higher return to labour.
• The productivity oflabour has increased, again possibly justifying an increase
in wages.
Trade unions
Types of industrial action

As pan of the collective bargaining process, trade unions can call upon their
members to rake indu strial action . Table 8.1 outlines some of the actions in
which trade union members can engage, in order to get what they wam from their
employers.
TableB.1 Typesofindustrialaction
Type of indu strial Definition lmpactonemployers lm pacto n worke rs
act ion
Strike Trade union members Production of goods Workers do not get
refusetowork,i.e and services ceases paid when they do
they stop working temporarily and this has not work. so they lose
an immediate impact wage<;/eamings
on the firm
Work-to-rule Trade union members Bus drivers drive Workersaremel1ting
literallyworkto extremely slowly and their contractual
fulfil the minimum stop at every bus responsibilities and
requirements of their stopregardles1of therefore cannot be
jobandwillnotdo whether there are any disciplined
anythingoullide passengers who wish
what is written in togetonoroff.A
their contract of schoolteacher does not
employment. takepartinanyextra-
curricularactivitie1or
refusestomel1twith
students outside of
lesson time
Go-slow Trade union members Productivity and Moralemaydropasa
oomplete their work efficiency fall result of low targets
very slowly. and productivity.
Trade union members Productionofgood1 Thereisal055inwages
tumuptoworkand andservicesceases and,asaconsequence,
occupy the premises temporarily and this has living standards fall
but do not undertake an immediate impact
their normal work on the firm .
Exam practice
In February 2013 the region of Kerala in India came to a standstill due to a nationwide
strike called by a central trade union. The members of the trade union belonged to
all sectors of the workforce, from banking to transport. Workers demanded price
controls to bring a halt to the increasing price of necessities, enforcement of labour
laws in all places of work and an increase in the minimum wage.
Sou,ce:adaptedfromNDTV
1 Identify the factors that have caused the trade union members in Kerala to
strike. [3)
2 Discuss how effective you think the strike will be in successfully getting the
demands of the trade unions met. (6)
Trade unions and the economy

Trade unio ns can have both positive and negative impacts on the economy, as
outlined in Table 8.2.
Tab le8.2 Pos itiveandnegativeeffectsoftra deu nions

Pos itive im pacts Negative imp acts
Actasachannelofcommunicationbetween Tradeu nionsare oftenportrayedinthemedia
employers and employees. Through ashavinga neg ativeroleinaneconomywhen
negotiations andcollectivebarga ining,they they takei ndustrialactionwhichresultsin
helptosolvedi1pute1and1ettlepaydaims lo1tprocluctivity. Strikes arethemost extreme
efficiently. formof industrialactionandcancause serious
OfferlPgalsupportandadvice toemployees disruptionto thewidereconomy.
From an employer's point of view, a trade
Negotiateonbehalfoftheirmembers
union"s demands for better pay and working
withemployersforbetterpayandworki ng
conditiomandcanthereforehelptoraise conditionsfori11workersmayincrea1ethe
livingstandard1 co1tstothefirm andthereforereduceprofits .
However,othersmight argueth at increase1 in
Negotiatewith thegovernment for payandimprovementsinworkingconditions
an increase in the minimum wage, which leadto a bettermotivatedworkforce andthus
canalsohelptoincrea1e1tandardsof living. anincreaseinproductivity andprofi ts
On 28 March 2013 a gro up of workers belonging to the Unio n of Hong Ko ng Docker s

wentonstrikebecausetheirdemands forapayincreaseof20per centhadbeenrejected
by Ho ng Kong Internatio nal Terminals (HIT). The workers had demanded the pay rise to
maintain a reasonable standard of living at a time of ri sing prices. HIT, their employer,
offeredapay rise o fbetween3and5percent.
HIT is part of the Hutchinso n Whampoa Group o f companies, wh ich belongs to Li
Ka-shing, Asia 's richest man. On 18 April the dock workers protested outside the office
building o f Li Ka-shing .
ThelnternationalTransportWorkers'Fede ration, whichrepresents theinterests of4.5
million transport workers worldwide, became involved in discussions to see ho w it could
support the strike. A small gro up of Australian dock workers flew to Hong Ko ng to support
theworkers andtoshowsolidaritywiththestrikers.
Trade unions
Activity
lnvestigatethenumberandtypesofunionsthatexistinyourcountry. Finda recent
example of industrial action that has taken place and determi ne whether the action was
successfulornotinachieving its aim.
Exam practice
In September 2012, the Australian Education Union (AEU) in the state of Victoria
called upon teachers working in the public sector to take part in two 1-day strikes.
The teachers had asked the government for a 30 per cent pay increase over a
3-year period. The union, without consulting its members, decreased the teachers'
demands and asked the government to increase wages by 12 per cent over 3 years.
The government did not agree to the demands and instead introduced a maximum
pay increase of 2.5 per cent per year for public-sector workers and called for the
introduction of performance-related pay and further increases in productivity. The
wage ceiling was part of a government strategy to decrease public-sector spending in
the Victoria region.
S.OO,ce:adaptedfromtheWorldSodalis!WebSite
1 Suggest two reasons why the trade union decreased the demands for a pay
increase without consulting with its members. (4)
2 Explain the impact of a strike on the teachers, school children and the wider
economy. [6]
3 Discuss reasons why the government did not agree to the 30 per cent pay
increase. [7)
Trade union membership

T rade union membership is growing in some countries, such as China. In others,
such as the United Kingdom, membership is declining (see Figure 8.2). Possible
reasons for increasing uade union membership in some countries include:
• growth in manufacturing jobs, as manufacturing industry is typically unionised
• an increasing number of workers experiencing low pay and poor working
conditions in manufacmring
• an increasing wealth gap and higher costs ofliving, which have caused workers to
petition for higher wages and better working conditions.
Possible reasons for declining trade union membership in some countries include:
• changing government legislation, which seeks to reduce union influence
• a decline in manufacturing, which is traditionally unionised
• growth in part·time employment, as pan-time workers are less likely to join a trade
union
• firms independently agreeing fair terms and conditions wit h their employees
without negotiating with trade unions
• an increase in unemployment (see Chapter 19)
• an increase in employment in small firms, as it is more difficult to organise unions
within such finns
• an increase in the number of self-employed people (people who work for

themseh·es and nor for a firm), who are therefore nor trade union members.
In response to fulling membership in some countries, unions have tried to improve
their image by making their services more appealing and relevant to today's world.
For example, the Association of Teachers and Lecturers (ATL) in the United
Kingdom has a 'no strike' policy to which all members agree. Many unions now offer
their members financial services such as loans, mortgages, insurance, credit cards,
discount holiday vouchers and discount car hire as incentives to join. Some trade
unions also provide grams for college courses or arrange retraining programmes (to
develop new skills) for their members who ha\'e been made redundant.
China
Source:lntemabonallabOIJ,O,ganisation
Figure8.2 TradeunionmembershipinChinaandtheUK,2000- 10
Exam practice
1 With reference to Figure 8.2, suggest two possible reasons for the changes in the
number of female members of trade unions in the UK and China. [4)
2 With reference to Figure 8.2, describe and account for the trends in trade union
membership in the UK and China. [6)
Trade unions
Chapter review questio ns

1 What are the reasons why a worker might join a trade union?
2 Why might the aims of employees and employers conflict?
3 What are the main types of trade union?
4 What are the main roles of trade unions?
S What are the key reasons why trade unions demand higher wages?
6 What are the different types of industrial action?
How do trade unions affect the economy?
Why has trade union membership decreased in many countries?
Ke y terms
Collectivebargaln ing occurswhenatradeunionrepresentativenegotiatesonbehalfofthe
union's members with the employer to reach an agreement that both sides find acceptable.
A go -s low occurs when workers decide to complete their work in a leisurely way and
therefore productivity falls .
lndustri al actlon isanydeliberateacttodisrupttheoperationsofafirminordertoforce
the management to negotiate better terms and conditions of employment, e.g. strike
A sit-i n is when union members go to their place of work, occupy the premises but do not
undertake their normal work.
A str ike occurs when union members withdraw their labour services by refusing to work.
A trade un ion is an organisation that aims to protect the interests of its members: namely,
the terms of pay and conditions of employment.
Wo rk-t o -r ule means that workers literally work to fulfil the minimum requirements of their
job and do nothing outside what is written in their contract of employment.
C!) Income and expenditure
• analyse the different motives for spending, saving and borrowing
• discuss how and why different income groups have different expenditure
patterns (spending, saving and borrowing).
Consumer spending
Consumer spending and income

Consumer spending - the amount that individuals spend on goods and services -
largely depends upon their level ofincome. Most people exchange their Jabour
services for wages or salaries (see Chapter 7), bur people may also earn income from
the other factors of production, for example:
• interest on savings (return on capital)
• rem earned from leasing property (return on land)
• dividends (a share ofa company's profits) from shares owned in a company (return
on enterprise)
• profits earned from running a business (return on enterprise).
Dis posable income refers to the income earned by an individual after income rax and
other charges such as pension comributions and trade union fees (see Chapter 8) have
been deducted. It is therefore the amount of income a person has available to spend
on goods and services. There is a posith'C relationship between the level of spending
and the income earned - higher levels of disposable income usually lead to higher
spending.
There is a positive relationship between the level of spendin g and the income earned
Income and expenditure
Direct taxation (see Chapter 17 ) reduces the amount of income a person recei\·es.
So higher income tax rates can lower the le\·el of disposable income and therefore
consumption. Table 9.1 shows the reasons why different income groups have different
expenditure patterns (spending, saving and borrowing).
Table9.1 Reasonsfordifferentexpenditurepatterns
Spending Saving Borrow ing
Spend most of Tends to below Borrow to fund their

their income on as there is not expenditure on capital items
necessities(e.g . much income (e.g . furniture,carsand
food,dothingand leftover after computers)
housing) spending on In extreme circumstances.
peoplemayborrowtofund
current expenditure on
necessities
Bankslesslikelytolend
money to low-income
earners as they represent
higher risk
Spend on necessities Able to save Borrow money to fund
and some luxuries expenditure on capital items
Spend a lower from their wages (e.g . furniture,carsand
proportion of their o r salaries computers)
income on food and Usecreditcardstopayfor
Middle
other necessities both capital and current
expenditure
Takeouta mortgage
(long-termsecuredloan)to
purchase a home
Spend the smallest High level of Borrowing occurs but there
proportion savings possible isonlyasmallriskofnot
of income on Save a greater beingabletorepayloans
necessities proportion of and mortgages
(compared with their income than Banks lend money rather
High
other income other income easilytohigh-incomeearners
earners) Generally,thereislessof
Purchase luxury a need to borrow money
goods and services tofunditemsofcapital
expenditure
Low-income earners spend a greater proportion of their income on fuod and

necessities, whereas high -income earners will spend a lower proportion of their
income on fuod and necessities.
Activity
Ident ify all your source s of income and li st the factors that influence how muc h of your
income you spend.
71% 't?)~"'"'
"'',,.
29 2% 267%
2 1 3%
3.2% 8.2%
Poor: SIS000-$19000 Middle Clam SS0000-$69000
D Fooda1home
O Ea11ngout
O Hau:l1ng
. Ui lihe,
D 0athe,&,fioe,
OTranspart/W
• Hed!h C<Ye/lnwra nce
0 En1er1alnmeo1
• E®mtton
E3 Savingfcxddage
Rich: $150000+
Soorce:DailyMaj/
Figure 9.1 What Americans spend their money on (2012)
Figure 9.1 shows the proportion of income spent by low- and high-income
households on food eaten at home in the USA (10.2 per cent and 5.4 per cent
respecti~·ely). A low·income household spends 54. l per cent ofits income on
necessities (fixxl, housing, utilities, clothing and shoes) and only 2.6 per cent on
savings for retirement. By contrast, a high-income earner is able to sa\·e 15.9 per cem
of their salary and spend 4.4 per cent on education. Remember that 15.9 per cent ofa
$150000 income is much greater than 2.6 per cent ofa $19000 income!
Figures 9.2- 9.5 show the recent trends in real household disposable income and
consumer spending in the United States, Japan and the United Kingdom.
- USA
- UK
- .k,p:m
- Eurozooe
Soorce: adapted from OKD Facrbook 1013
Figure 9.2 Real household disposable income in the USA, UK, Japan and the Eurozone,
2008-11(%annualgrowthrates)
9400
.!l
Joo/12
Sou,ce:T,aOng&ooomks
Figure9.3 ConsumerspendingintheUnitedStates(USSbn),2008-13
li230CXXl
Sou,ce:T,aOng&ooomks
Figure9.4 Consumerspend ingintheUnitedKingdom(£bn),2008-13
J(ln/12
Sou,ce: T,aOngfrooomks
Figure9.5 ConsumerspendinginJapan(¥bn),2008-13
Study tips Act;v;ty

When revising for 1 With reference to Figures 9.2-9.5, compare the trends in real household disposable
I
the examination, income in the United States, Japan and the United Kingdom from 2008 to 2012 with
try to make sure consumerspendinginthesecountries.
you can:
2 Determine whether there is a positive relationship between the two variables.
e describethe
overall trend
from the The wealth ofan individual is measured by the amoum of assets they own minus
beginning of their liabilities (the amoum they owe). When the value of assets, such as property and
the period to other im'Cstmems, increases there is said to be a positive wealth effect. This causes
theendofthe people to spend more and, in some cases, causes owners of assets to borrow against
period the value of their assets such as residential or commercial property. Alrernatiwly, if
e describeany
variations in
the value of an asset decreases, the wealth effect can become negath'e. For example,
the trend a se,'Cre recession can cause some people to experience negative equity - when the
e describethe value of their secured Joan or mortgage exceeds the value of the property.
magnitude Conspicuo us consum ptio n occurs when people purchase gcods and services
(size)ofany that they feel increase their starns or image. For example, a person may buy a very
variations in expensive car, yacht, diamond ring or designer handbag as a status symbol. Wealthy
the trend .
people tend to engage in conspicuous consumption.
The Chinese are known for their love of luxury brands like Louis Vuitton, Gucci and Burberry.
Conspicuous consumption in China shows no sign of a slowdown
Case Study: Negative e quity

LouisChowboughtanapartmentinLosAngelesforS900000intheyear2000. He
borrowed $850000 from the bank and paid a deposit of SSOOOO. In December 2008 the
property market crashed due to the global financial tsunami, causing Louis's apartment to
fall invaluetoS700000. LouisstillowesthebankS800000.Heisinnegativeequityasthe
valueofthemortgageisgreaterthanthevalueoftheproperty.
Activity
Withreferencetothecasestudyabove,inpairs:
1 Disruss the impact of negative equity on Louis's consumer spending, saving and borrowing.
2 Investigate the options available to Louis to repay his mortgage.
Other determinants of consumer spending

Aparr from levels of income, there are several other determinants of consumer
spending, saving and borrowing.
Inflation
The general level ofprices in the economy influences consumer spending because an
increase in inflation (see Chapter 18) reduces the purchasing power of individuals.
Therefore , inflation tends to cause reduced spending, less savings and more
borrowing, and vice ~·ersa (see Figures 9.6 and 9.7 ).
70000
CO OOO
i55CXX)
•
~ 50CXXl
~
45000
J] n/12
Sou,ce:Tradingfrnnomics
Figure 9.6 ConsumerspendinginMauritius,2008-13
J] n/ 10 }00/ 12
Sou,ce:Tradingfconomics
Figure9.7 lnflationratesinMauritius,2008-13
Activity
With reference to Figures 9.6 and 9.7, compare and contrast the trends in consumer
spendinginMauritiuswithinflationratesbetween2008and2013.
Interest rates
The imerest rate refers to the cost of borrowing or lending money. An increase
in interest rates (sec Chapter 16) may lead to decreased consumer spending, Jess
borrowing and more saving because:
• borrowing has become more expensive and therefore the demand for loans falls,
which leads to less consumer spending
• saving may become more anracti\·e due to the higher return, so individuals may
save more and spend Jess
• ifan individual has a loan or mortgage, the increase in interest repayments may
lead to a decrease in demand for other goods and services, so spending falls.
/~c /:~~=~
( ''"- I"~ \
'":( ,=~ 17,;:
"" ~ · ~dng
·~: / lioc-
' Repaymenlloo
--- ex~trig 00!1,
Figure9.8 Theeffectsofachangeininterestratesonconsumerspending
Confidence levels
The level of personal spending in an economy is heavily influenced by the level of
consumer and business confidence. During a recession or a periOO of low economic
growth (see Chapter 20), people may prefer to save rather than spend as they lack
confidence about the future of the economy - for example, fearing that they may
lose their job. By contrast, during an economic boom or a period of high economic
growth, people and firms feel confident about the future and therefore purchase
more goc:xls and services. The sale of luxury items such as restaurant meals, spa
treatments and foreign holidays increases. Firms may invest more in new equipment
and technology because they feel confident about the future. This creates jobs and
fuels spending, borrowing and savings.
The sale of luxury items such as bespoke jewellery increases during an economic boom or
period of high economic growth
Age
A person's age impacts upon their level of consumer spending. A young single person
may earn a relatively low income and may spend most of it on goods and services to
support their lifestyle. As a person gets older, their earnings will typically rise and
they may start to save a greater proportion of their income to buy a property or in
anticipation of marriage and children. During the family stage ofa person's life they
will spend more of their income on their children but will also have to save to build
up a pension to supix,rt them when they retire. They may also be saving fur their
children's university education. After retirement, people dissave as they have no
earned income and so must spend from their savings.
Activity
Copy and complete the following table using the wo rds: high, low or moderate.
Age Spending Saving Borrowing Dissaving
16-25 High
Moderate
Moderate
Moderate
6Sonwards
The size of households

The average size of households has changed o.'er time. In economically developed
countries, birth rates are falling (see Chapter 22) as people choose to marry and
have children later in life. 111ere has also been an increase in single households. This
influences expenditure patterns as a family with three children will usually consume
more goods and services than a single -person household.
Exam practice
Resi:Jtro nt,&ho1e!.
Mlscellaoeoo:sgoods&servk:e,;
Hou.ehok:Jgoods&servk:e,;
t====-~
Cbti1ng&foctwoor
Ako/10l cd-1n ks . tlocco &narcolb

Educa100
Hoolth
Sou,ce: L.,ingCrntsandFoodSu,vey. December2012 (0fficelorNatkmalStatistics)
Figure g_g The amount spent on goods and services in a week in the UK, 2011
1 With reference to Figure 9.9, discuss how spending patterns might be different
in a less economically developed country such as Haiti or Bangladesh. [4)
2 Spending on education and health is a small proportion of overall spending in
the UK. Explain two reasons why this might be the case. [4)
Savings
Saving occurs when a person puts away pan of their current income for future
spending. Reasons for saving include the following:
• A person may decide to sacrifice current spending so that they have funds to spend
in the future. For example, people may saYc for a holiday or for their retirement.
Parents may save money for their children's education.
• A person may choose to save a portion of their income in a bank or other
financial institution in order to earn imcrest. Banks also provide a secure place for
depositing savings.
• A person may sa\·c for precautionary reasons so that they have money put aside
in case of an emergency, such as an accident, job Joss or unforeseen event in the
future.
The level of savings is affected by the following factors:
• Age - In many modern economics, people from about the age of25 stanto save
for their future. They will be likely to haYc secured permanent employment and
paid off any student loans. The amount a person will save is influenced by the
amount of support a goYcrnmcm gh-cs its citizens in terms of old-age pensions and
health care provision. If people have to fund their own health care and pensions,
they will haw to save more during their working Jives.
• Attitude to saving- As c\·cry person is different, they each haYc a different
attitude to saving. For example, in the USA and the UK many consumers borrow
to fund expenditure by using credit cards to make purchases or by getting Joans to
buy large item such as cars. In other coumrics, such as
Japan, the use of credit cards is low. The Chinese also
tend to be cautious and conservative with money, so
like to sa\·c for a 'rainy day' (u nforeseen emergencies).
• Consumer and business confidence - If people
and firms ha\·c confidence in the performance of the
economy, the level of savings will usually fall as people
will be more willing to spend money. Savings tend to
rise during recessions when consumers are feeling less
optimistic about the future.
• Interest rates - A rise in interest rates means that
people with existing debts haw higher repayments to
make to the lender. This will therefore reduce their
level of spending in other areas. At the same time,
people may save more in a bank to rake advantage of
the higher rate of return. \\'hen interest rates are low,
people ha\·c a disinccmh·c to save and may choose
to spend their money instead or find an alternative
means of increasing the value of their savings - by
purchasing shares in a firm, for example.
Case St udy: Saving in China

lnChinathelevelofpersonalsavingsasapercentageoftotalhouseholdincomewas
approximately20percentin2013. PossiblereasonsforChina'shighlevelofsavingsare:
• Household incomes have risen due to China's phenomenal economic growth over recent
decades. Manypeoplehaveasurplusofincomeovertheirexpendituresoareableto
• Theone-childpolicy hasbeeninplacesince 1979andthishasreducedfamilysizeand

thereforethelevelofhouseholdspending(andhenceencouragedhigherlevelsof
saving).
• People are accustomed to saving up to buy large items they wish to own instead of
borrowing money from banks in order to do so. Culturally, Chinese people buy what
they can afford and do not wish to get into debt to make purchases.
Exam practice
Figure 9.10 shows the net savings rates of households in Canada, France, Germany,
Japan and the United States.
1- Gmodo
- Germany
- UnitedSla1es
'8
S.OU,ce :Na riona/ Accounrs a raG/ance. 20H(O ECD)
Figure 9.10 Hou sehold net sav ings rates, 1999- 2010 (% of ho useho ld dispo sable income)
1 St udy Figure 9.10 and analyse the similarities and differences in t he net savings
rate between t he countries. (6)
2 Explain possible reasons for the changes in t he net savings rate in Japan. (4)
Borrowing
Borrowin g occurs when an individual, firm or the government takes out a loan
from a bank or financial institution, paying it back over a period of time with
imerest. Borrowing leads to debt, which is manageable ifmomhly repaymems are
affordable and interest rates are relatively low. An increase in imerest rates causes
repayments to rise and this can affect the purchasing power of individuals, firms
and governments.
Case Study: The cost of borrowing

LauraBrownborrowsSSOOOOO
tobuyapropertywhencurrent
mortgage interest rates are
6percent. lnthefirstyear,
interestrepaymentsareS30000
(orS2500permonth). lnthe
secondyearoftheloan,interest
ratesincreaseto7percent
and interest repayments rise
toS35000,whichincreases
Laura Brown's monthly loan
repaymentstoaroundS291). The
highercostofborrowingwill
therefore reduce her disposable
Individuals and firms may OOrrow for different reasons, including:

• to fund cxpensh-e items, such as a car, a motorcycle or an overseas holiday
• to purchase property or land, such as a factory, office or home
• to start up a new business
• to fund large projects such as a business expansion in foreign countries
• to fund private and tertiary education
• to fund current expenditure in the C\"Cnt of job losses or economic decline.
Factors that affect the level of borrowing in an economy include the following:
• Availability of fund s - Banks and other financial institutions lend money to
individuals and firms in the form of loans. The central bank (sec Chapter 6 ) ofa
country conuols the amount of ftmds which arc available for borrowing by setting
the cash reserve ratio (the percentage ofa bank's assets which must be kept in
cash in bank vaults or with the central bank). A decrease in the cash reserve rate
ratio means that more funds arc available for lending and an increase in the money
supply can therefore lead to an increase in borrowing.
• C redit cards - Credit allows people to purchase goods and services with deferred
paymcm. People or firms take ownership ofthc goods and services immediately
and must repay the amoum to the credit card company several weeks later - in
other words, they 'buy now and pay later'. If the full amount owed to the credit
card company is repaid in full each month then no interest is charged, but if only
a portion is repaid then interest is charged on the remainder. !merest rates on
credit card borrowing arc exucmely high: for example, the annual percentage rate
charged on Citibank credit cards in 2013 was 35.81 per ccm.
• Store cards - These are issued to regular customers of large retail stores in many
countries to encourage spending. Store cards act as a credit card that can be used
only in the individual retail outlet. Firms offer discounts and free gifts as an
incentive for people to sign up for a store card. Customers can also accumulate
loyalty points on the card, which can be used in the fumre to purchase goods and
services in the store. Store cards can give people an incentive to o\·erspend and can
raise their level of debt. If debts are cleared when payment is requested, no interest
is charged - but just as in the case of credit cards, if repayments are not made then
interest is charged on the outstanding debt.
• \ Vealth- The wealth ofa person may affect their level ofborrowing, as a bank
will be more willing to lend money to wealthier individuals or highly profitable
firms. This is because they have valuable assets and so are more likely 10 repay the
loan, whereas less wealthy customers have a higher risk of defaulting on the loan
(being unable to repay their borrowing). To avoid bad d ebts (debts that cannot
be repaid), banks often make sure that they have some guarantee of getting their
money back. A large business may own se\'eral stores or have valuable assets that
can be taken as collateral (security) for a Joan. In the case ofa mortgage, the
property purchased provides security for the loan and if the borrower defaults on
the Joan, the bank will rake ownership of the property.
Exam p ractice
The household debt-to-disposable income ratio in South Korea is one of the highest
in the world. In 2012, disposable income rose by 5.8 per cent and debt rose by an
average of 1.7 per cent. This lowered the debt-to-disposable income ratio to 152.3 per
cent from 158.5 per cent.
The reasons for the high levels of debt are, f irstly, that in the early 2000s the
South Korean government lent money to small fi rms to encourage their growth
and development and, secondly, because there was a housing boom in 2011. The
acceleration in house prices provided an incentive for people to increase borrowing to
buy property, as they believed that prices would continue to rise.
There is a low savings ratio in South Korea, which means that banks have a limited
amount of f unds to lend to borrowers. As a result they have borrowed from overseas.
Households are worried about their level of debt, despite the recent growth in real
disposable income.
1 Identify two reasons why borrowing might have increased in South Korea in the
early2000s. (2)
2 Analyse the effect on the economy of a high borrowing-to-disposable income
ratio. (6)
3 Explain two problems which may arise because of a low savings ratio in South
Korea. (4)
4 Discuss reasons why some people spend more of their income and others save
more of their income. [7)
Chapter review questio n s

1 What are the main factors that affect the level of consumer spending in an
economy?
2 How might the spending, borrowing and saving patterns of a young family
with two children under the age of 5 compare with those of an old-aged
pensioner?
3 How do spending and savings patterns of low-income earners differ from
those of high-income earners?
4 How does wealth affect a person's level of spending, saving and borrowing?
S How do changes in interest rates influence consumer spending, saving and
borrowing?
What are t he main determinants of the level of savings in an economy?
What factors affect the level of borrowing in an economy?
8 Why might one person save more of their income than another?
Key te rm s
Bad de bts occurwhenpeopleandbusinessescannotrepayaloan .
Borrowing occurs when an individual, firm or the government takes out a loan from a
financial institution,payingbackthedebtwith interestoveraperiodoftime.
Collate ra l meanssecurityfora loan,e.g . propertyinthecaseofamortgage,orthecar
pu rchasedinthecaseofacarloan.
Consp icuous co nsumpti on occurs when people purchase highly expensive goods and
servicesduetostatusoradesiredimage.
Consume r spend ing refers to the amount of household e xpenditure per time period.
Disposab le income refers to the earnings of an individual after income tax and other
charges have been deducted.
Dissav ing occurswhenpeoplespendtheirsavings .
Income is the total amount of earnings an individual receives in a period of time. It may
consistofwages,interest,dividends,profitsandrentalincome.
Mo rtgage isasecuredloanforthepurchaseofproperty.
Saving occurs when a person puts aside some of their current income for future spending .
Savings ratio refers to the proportion of household income which is saved instead of
consumed in an economy.
Wea lth is measured by the value of assets a person owns minus their liab ilities (the amount
they owe to others).
@ Business organisation

• describe the types of business organisation in the public and private sectors:
sole proprietors, partnerships, private limited companies, public limited
companies, multinationals, co-operatives and public corporations
• describe and evaluate the effects of changes in the structure of business
organisations.
Taken from Cambridge Interna ti onal Examir,abom Sy!labus (IGCSE 0455/0 Level 2281)
0 Cambridge lntematkmal Examir>atiom
Types of business organisations

The main types ofbusiness organisation in the private sector are classified as:
• soleuaders
• partnerships
• private limited companies
• public limited companies
• multinationals
• co-operatives.
Public corporations exist in the public sector. Each type of organisation has its merits
and drawbacks, which help the owners to determine the best type oflegal form for
their business organisation.
Sole traders
A sole trader is a business owned by a single person, also known as a sole proprietorship.
This person can employ as many people as needed, but remains the only owner of the
business. Examples of sole proprietors are market traders, hairdressers, physiotherapists,
and owners of small shops such as a bakery, cafe or stationery shop.
AfoodstallinChina isanexampleofasoletrader
Business organisation
The advantages of being a sole trader are detailed in Table 10. l.

Ta ble10.1 Advantagesofbeingasoletrader
Adva nta ge Explanation

Can1etupthe Soleproprietorshipsarethecheapestandeasiesttypeofbusinesstosetup. There
busine11easily areveryfewlegalproceclure1neededto1tartthebusine1s
Hasautonomy in Theowneristhebossanddoesnotneedtoconsultanyoneabouttheirdecisions.
dedsionmaking Thi1makesthebusinessrelativelyea1ytorun
Keeps all the This gives an incentive for the sole trader to work hard as they are rewarded with
profits made by more profits as the business becomes more successful
the business
Enjoys tax In many countries mi all businesses pay a lower rate of tax on profits than large
advantages companies
Enjoys privacy Thebusinessdoesnotneedtopubli1hitsaccountstothegeneralpublic.Only the
taxauthoritiesneedtoseethelinancialinformationofthesoletrader.
Can be flexible For example, the owner has some flexibility in the choice of working hours. Also,
in what the ifonebusinessideadoesnotworkout,thesoletradercanquiteeasilyintroduce
busine11 doe1 new trading activitie1 or dose down the business and start another one
Has a sense of Sole traders are motivated by running their own busin~. There is a real 1eme of
achievement personalachievementifthebusinessi:ssua:essful
The disadvantages of being a sole t rader are listed in Table 10.2.

Table10.2 Disadvantagesofbeingasoletrader
Disadvantage Explanation
Bears all the risks Thereisnooneelsetosharetheburden.problems,decisionmakingor
re1ponsibilities
Has added workload and A1 the only penon in the bu1iness, the sole trader often has to work long
prernire1fromhavingto houn,especiallyduringtheearlystagesaherthebusinesshasbeenset
runthebminessasasole
proprietor
Limited specialisation Unlike large companies, sole traden cannot rely on the marketing,
finance, production and human resource management expertise of
others. Thi1limit1theextenttowhichsoleproprietorscanbenefitfrom
large-sc:alespecialisationandthedivisionoflabour(seeChapter7}.
Limitedaa:esstosources 8eingasmallbusiness,thesoleproprietor1hiprepresentshighrisk. This
offinance limitstheextenttowhic:hthesoletradercanraisefinancefrombanks
and other sources
Lack of continuity If the owner is sick or wi1he1 to go on hol iday. the business will struggle
tocontinue. lftheownerdies,thebusine11willc:ea1etooperateinits
current legal form
·~·
Has restricted ability to Largebusinessesareuruallyabletoenjoy econom iesofscale {see
exploit economies of Chapter 14), i.e. lower unit costs of production r~lting from large-1eale
operation1. Thismeamthatsoletrader11truggletogainrostadvantages
andthereforehavetochargehigherprice1fortheirproducts.
Has unlimited li ability Thi1meansthat if thebu1inessgoesintodebtandmakesaloss,the
soletraderispersonallyliableforrepayingthedebts,evenifthismeans
personalbelongingshave tobesoldtodoso.Thisisbecausethereisno
legal difference between theowner{thesole trader}andthe business
itself(lhesoleproprietorship)
The private firm as producer and employer
Pa rtn erships
A partnership is a business organisation owned by more than one person. In an
ord inar y partnership, there are between 2 and 20 owners, known as pa rtners (the
co-owners of the partnership). At least one of these partners will ha\·c unlimited
liability, although it is usual practice for all the partners to share responsibility for any
losses made by the business. The go.·crnmcnt docs allow some businesses, such as law
and accountancy firms and health clinics, to operate with more than 20 partners.
Examplesofbusinessesthatarerunaspartnerships
It is possible for a partnership to have a sleeping partner (or silent partner) who
invests money in the partnership bur docs not rake part in the daily management of the
business. It may also be possible for a partnership to be a limited liability partnership
( LLP) where the partners have limited liability and the partnership has a legal identity
separate from its owners. An example is KPMG, an accoumancy firm rhar operates
globally. The rules governing this rypc of partnership vary between countries.
To prevent potential misunderstandings and conflict, most partnerships draw
up a legal contract bcnvccn the partners, known as a d eed of par tnership. The
contents ofthis agreement include the names of all partners, the amount of capital
itJYcsrcd by each partner, their responsibilities, voting rights, arrangements for
dismissing a partner or approving a new partner, and how profits are to be shared
between the owners.
The advantages of partnerships are as follows:
• As there are up to 20 owners, a partnership is usually able to raise far more capital
than a sole trader.
• Similarly, as there are more owners, the business can benefit from having more
ideas and expertise. Most partnerships can therefore benefit from specialisation and
division oflabour.
• Like sole traders, the business aflairs of partnerships are kept confidential. Again,
only the tax authorities need to know about the financial position of the business.
This makes the partnership an appropriate fonn of organisation for businesses such
as private health care providers, accoumancy firms and law firms, as they need to
keep their business affairs confidential.
• As partnerships tend to be small businesses, there tend to be good working
relationships with both colleagues and customers. One ofrhc potential drawbacks
of being a large organisation is the lack of clear communication between staff,
because there are simply too many of them (sec Chapter 14 - diseconomies of scale).
• There is more continuit:y than for the sole trader, as the parmcrship can remain in
business if a parmcr is ill or goes on holiday.
• In some cases, additional finance can be raised from silent partners. These parmcrs
simply invest in the business without raking an active role in the running ofit.
The disadvantages ofpanncrships include the following:
• As there is more than one owner, there might be disagreements and conflict
between the owners. This can undoubtedly harm the running ofrhc
partnership.
• Although the business can operate on a larger scale than a sole trader, any profits
made must be shared between all the owners.
• In most cases, the partners have unlimited liability. Although it is possible to
haw limited liability parmerships, limited liability usually applies only to sleeping
parmers, as they arc nor directly im'Olvcd in the daily running of the parmership
and so are nor personally liable for any debts incurred.
Limited liability companies

Limited liability companies arc owned by shareholders. The owners ha~·e the benefit
of limited liability, which means rhar in the event of the company going bankrupt
they would not lose more than the amount they had invested in the company - they
cannot be forced to sell their personal belongings to repay the debts of the company.
In legal terms, there is a divorce of ownership and control, since the 011>ners
(shareholders) are treated as separate legal entities from those who control and run the
business (the directors and managers).
Limited liability companies can raise finance by selling shares. However, a private
limited company cannot sell shares to the general public whereas a public limited
company can raise finance in this way. When a firm becomes a public limited
company it offers shares to the general public in an Initial Public Offering (IPO) on
a stock exchange. To attract im•esrors the firm will publicise the IPO in newspapers
and on media websites.
Table 10.3 outlines the ke y differences between public and private limited
companies. Examples ofprivare limited companies are IKEA, Mars, Ernst &
Young, LEGO, Rolcx, Toys R Us and rhe Virgin Group. Examples of public
limited companies are Walman, Toyota, Samsung, Apple and the Walt Disney
Company.
Examplesofprivatelimitedcompanies
Examplesofpubliclimitedcompanies
Study tips
Do not use the
term'company'
when referring
to a sole trader
or partnership.
These are
businesses
whereas
companies are
owned by their
shareholders.
There are two
types of company
- private limited
companies and
public limited
companies.
On 19 August 2004 Google Inc. became a public limited company through an IPO. Prior to
the firm's flotation on the NASDAQ stock market, its shares were valued at SSS each. In
2013thesharestradedforoverS800.
All limited liability companies must be registered with a gm'Crnment agency that
keeps records of all public limited and private limited companies in the country. In
the UK, for example, the agency is called the Registrar of Companies, and to set up a
limited liability company, the owners must submit two important documents:
• The Memorandum of Association - a document that records the name,
registered business address, amount of share capital and outline of the company's
operations (what it docs).
• TI1e Articles of Association - a lengthier document that contains information about:
O the details and duties of the directors of the company
O shareholders' voting rights
O the transferability of shares
0 details and procedures for the company's Annual General Meeting
0 how profits are to be distributed (dividend policy)
0 procedures for winding up (closing) the company.
Once the Registrar of Companies (or equivalent ) is satisfied with the papen\'Ork, a
Certificate of Incorporation is issued to the limited liability company so that it can
srantrading.
The shareholders elect a Board of Directors (BOD) to represent their interests.
The BOD is in charge of the strateg ic management of the company on behalf of its
shareholders. The top director on the BOD is known as the Managing Director (MD) or
Chief Executive Officer (CEO), who oversees the operations of the company. It is at the
Annual General Meeting that shareholders vote in the BOD to represent their interests.
A private limited company selling beads in Hong Kong
Table 10.l Differences between private and public limited companies in the UK
Private limited company Public limited company
Legal statu s Canimtheinitials'Ltd'afteritsname Carriestheinitials'PLC'afteritsname
in offic:ial business communication in official business communication•
Buying shares Sharesarenotil'lailableonanopen Sharesaretradableonastock
stockexchange,therebylimitingthe exchange,50thegeneralpublic:can
amount of funds buyshare1inthecompany
Selling shares Sharescanonlybesoldtofamily, Shar!!Scanbe!iOldinstantaneousJy
lriendsandemployeeswiththe toanyoneviaastockexchangesoch
priorapprovalofthemajorityolthe asthelondonStockExchangeorthe
~areholders; hence it can be difficult New York Stock Exchange
tosellsharesinthecompany
Minimum sta rt-up $3.04{£2) $76219(£50000)
share capital
Number of Noupperlimit,butlikelytohavefar Noupperlimit,butlikelytohavefar
shareholders fewer~areholdersthanapublic moreshareholdersthanaprivate
limiteclrompany limited company
Raising further Thes.aleofmore~aresinthe A§Ubsequent'~arei1rne"canbe
finance companymustfir1tbeapprovedby u'iedto,;ellmore~aresandrai,;e
the directors more funds
•pu~ic limited companies in othe, rounlfies haw difle,ent initials after the company name . Examples ind ude
• USA - lnc.orC0<p.(shortfm "in rorporated "m"ro, poration")

• Germany - AG (short fo, "AktienGe sellschaft". meaning "sharehokler CO<J>Ofation")
• Swl'den - AB (short Im "Aktie llolag·. meanir,g 1imited liab<lity company")
• Australia - l'ly Ltd (short for "proprieta,y limited company")
Activity
Produce a table like Table 10.3 for public and private limited companies in your country.
The following website: www.corporateinformation.com/Company-E .. tensions-Security-
ldentifien.aspx will help you complete the task .
The advantages of limited liability companies are as follows:

• Since shareholders ha\'e limited liability, it is usually easier to raise a large amount
of finance from selling shares. For example, the Agriculmral Bank of China raised
a record $22 billion its initial public offering in the summer of2010.
• The vast sum of money that can be raised from selling shares allows limited
liability companies to enjoy the benefits of being large, such as economies of scale
(see Chapter 14 ), market power and market presence/dominance.
• Additional finance can be raised through a share issue, which is the process of
selling more shares in the company. In 2010, Brazil's state oil company Peuobras
raised $70 billion in the \vorld's largest share issue.
The disadvantages of limited liability companies include these:
• Companies have to file their financial accounts and have these audited (checked) by
an external accountant. This is both time consuming and potentially expensive.
• These completed documents can be accessed and examined by all shareholders and
the general public - the affairs of the business cannot be kept private.
• Companies are more administratively difficult, time consuming and expensive to
set up compared with sole proprietorships and partnerships.
• The preparation, publication and distribution of company annual reports to
shareholders can be highly expensiw. The internet has gone some way to reducing
this cost to companies that offer online annual reports (although shareholders can
demand a printed \·ersion of the report).
For public limited companies, there are further potential drawbacks. These include
the following:
• There are high costs in complying with the rules and regulations of the stock
exchange.
• There is a potential threat of takeo,er by a rival company that purchases a majority
stake in the business (as shares are openly available for purchase on the stock
exchange).
• As they tend to be the largest form of business organisation, there is the
possibility that they will become too large to manage efficiently and therefore
will suffer from d isecono mies of scale - that is, higher average costs of
production (see Chapter 14).
• The firm is subject to fluctuations in value caused by investor speculation (buying
and selling of shares to make a profit) on the stock market.
Mu ltinatio na ls
A multinational corporation (MNC) is an organisation that operates in two or
more countries. For example, Levis Strauss & Co. sells its products in over 55 OOO
locations in 110 countries. It also has 1500 of its own retail stores across the
globe.
Various factors have made it easier for businesses to operate on a global scale. These
include lower uansportation costs, advances in technology such as e-commerce , more
efficient communication systems, and trade liberalisation (the removal of barriers to
international trade - see Chapter 26).
The advantages of being a multinational company include the following:
• MNCs operate on a very large scale, so they are able to exploit economies of scale.
This means that the ,\IINC can pass on cost savings to customers in the fonn of
lower prices, thereby enhancing its international competith·eness.
• Through job creation, MNCs are able to help improve standards of living in the
countries where they operate. For example, Walman, the world's largest retailer,
employs over 2.1 million people worldwide.
• By operating in overseas markets, MNCs are able to generate more profit by selling
to a larger customer base.
• MN Cs are able to spread risks by operating in o,erseas markets. For example,
adverse trading conditions in one pan of the world can be offset by more
favourable circumstances in other pans of the world.
• By producing in a foreign country, a MNC is often able to avoid any uade restrictions.
For example, Japan's Honda is able to avoid import taxes in the European Union
because it has manufacturing plants in the UK, Belgium, Italy and France.
• The MNC can set up factories in new markets and benefit from lower transport
costs. For example, the Japanese car manufacturers Honda, Nissan and Toyota all
have factories in China - the world's largest market for private cars.
• Multinationals might choose to move or expand operations in foreign countries to
benefit from lower rates of corporation tax. For example , corporation tax rates in
Japan, Australia and the UK are far higher than those in Hong Kong, Singapore
and Bahrain.
A Levi's store at AlphaOne shopping mall in Amritsar, Ind ia

Multinational coqx,rations suffer from the following disadvantages:

• MNCs face an array of issues to deal with, such as different legal systems, tax
regulations and environmental guidelines. The lack of local knowledge can also
cause major problems for an MNC.
• The sheer size and geographic spread ofan MNC makes it harder to manage the
overall business. It becomes more difficult for managers to ensure everyone works
well together and to the same standard. Effecti\·e communication can also be an
issue if workers are located in countries with different languages, national cultures
and time zones.
• Fluctuating exchange rates (see Chapter 25) can make it difficult to measure and
compare the value ofan MNC's sales and profits in overseas markets.
• Multinational corporations ha\"C often been criticised for their cost-cutting
practices, resulting in poor working conditions and low wages paid to workers in
some coumries.
• Since many MNCs earn far more revenue than the gross domestic product
(see Chapter 15 ) of the host coumry, they are often in a powerful negotiating
position with foreign governments over location decisions and access to finance
(go,ernmem subsidies, grams and loans).
• While jobs might be created, MNCs can force local firms that are Jess competith·e
to close down. Their huge market power and ability to exploit economies of scale
(see Chapter 14) mean that local firms might struggle to compete.
• The overreliance on MNCs in low-income countries means that there are major
consequences should an MNC d1oose to relocate its operations to another country.
For example, in 2010 French supermarket chain Carrefour pulled out ofThailand,
Malaysia and Singapore, creating unemployment in these coumries.
• MNCs may be unsuccessful in a coumry as the goods and services offered may not
appeal to local tastes and customs. For example, British retailer Tesco dosed all of
its US 'Fresh & Easy' supermarkets in April 2013.
Activity
Researchtheglobaloperationsofan MNCthatoperatesinyourcountryandassessthe
advantages and disadvantages to the firm and the host country. Make a judgement about
whetherthebenefitstothehostcountryoutweighthecosts.
Exam practice
MNCs are attracted to the United Arab Emirates (UAE) because of low taxes, political
stability and high GDP per capita. Examples of MNCs in the UAE are Microsoft,
Marriott Group, DHL and Ericsson, along with a number of international engineering,
law and accountancy firms. An influx of MNCs to the area brings workers from many
countries and this creates a demand for international goods, services and schools.
There are many shopping malls filled with international brands and Dubai (one of
the seven Emirates that make up the UAE) has gained a reputation as a destination
for shopping. This has attracted many tourists who visit Dubai for a shopping and
leisure trip.
1 Describe the characteristics of a multinational corporation. [3]
2 Discuss the benefits and costs of MNCs locating in the UAE. [6)
Co-operatives
Co-operatives are business organisations that are owned and run by their members
(who may be employees or customers) and ha,'e a common aim of creating value
for their members in a socially responsible way. The employees (members) work
together towards a shared goal and each has a vote, so they can contribute to decision
making. Co-operath'es share profits between their members and they are distributed
according to how much each person contributes to the co-operative.
Co-operatives operate in many areas of business, such as retail shops, financial
services, credit unions, child care services, housing and agriculture. For example,
Canada has approximately 8500 co-operatives and credit unions, and more than
17 million co-operative members.
Co-operatives around the world follow the values and principles set out by the
International Co-operative Alliance. These are:
• volunrary and open membership
• democratic member control
• member economic participation
• autonomy and independence
• education, training and infonnation
• co-operation among co-operatives
• concern for community.
Sou,ce: lntematkmalCo·ope<atiwAlliaoce
Examples of co-operatives include:

• CrCdit Agricole Group - France's largest bank and credit union
• Xinjiang Quanliang - a dairy farmers' co-operatiw in China
• Aurora Wine Cooperative - a producer co-operative in Brazil
• Sunkist Growers - farmer -based co-operative in the USA that produce the famous
Sunkist brand of fruit juice
• Ocean Spray - a leading producer of cranberry and grapefruit juice drinks, owned
by a grower-owned cooperative.
At the Ocean Spray Plant in Middleboro, Massachusetts, USA

Types of co-operative
Consumer co-operatives are co-operatives that arc owned by the customers who
purchase the goods or services. Examples arc child care, housing, health care services,
telecommunications and utilities. The members of these co-operatives can get access
to goods and services at prices usually Jess than those charged by a for -profit firm.
\Vorker co-operatives arc co-operatives set up, owned and organised
democratically by the employees. Examples include small shops, cafes, printers and
other business enterprises. Mondragon Corporation is a Spanish co-operative rhar
produces fuod and industrial products. It is one of the largest business organisations
in Spain with approximately 50 OOO members.
Producer co-operatives exist when firms co-operate and support each other in
several ways. For example, farmers might create a co-operative to buy equipment,
fertiliser and seeds, and to marker and sell their produce collective!}'.
Activity
lnvestigatewhetherthereareanyco-operativesinyourcountryorinacountryofyour
choice. Choose one co-operative and research its aims and objectives and how it operates.
Create a table of the differences and similarities between a co-operative and a similar-sized
profit-seeking firm .
The advantages and disadvantages of co -operatives arc listed in Table 10.4.
Table 10.4 Advantagesandd isadvanta gesofco-operatives

Advantages Disadvantages
• Employee1havea~reinthebusine11and • Decision making may be s)(M' as all members
thereforeareinterestedinhowitperform1.This oftheco-operatM!cancontributetothe
mayleadtohighlel'l!lsofstaffmotivationand decision-makingproce1sandthismaybetime
engagement in their work
• Theemployeesal5ahal'l!asayinh(M'the • ltcanbedifficulttosettledispute1because
businessisrun(votingrightsareequalbetWl'{!n ofthenumberofpeopleinvolvedindecision
member5)andh(M'thecapitalinthebusiness making
i1used.Thi1,too.mayleadtohigherlevelsof • Co-operativesmaysufferfromalackof
commitment and motivation.
capital a1theycannotraisefundsthrough
• Productivitymaybehighasworkersare sellingsharesandsoarelimitedtotheamount
motivatedbythe valumoftheco-operativeand contributedbytheirmemberr;.
thedesiretoaddvaluetotheirmembersand • Productivityandprolitabilitymaybel(M'al
the wider community
peoplearenotmotivatedbyself-interest
• Co-operatives tend to be run on socially
• Theremaybeineffic:ientmanagersbec.ause
responsibleprinciplesandthereforemaycreate theco-operativeisunabletousehigh1alaries
positiveexternalitiesthatareenjayedbythe
topfl'.lYideinc:entivestoworkharder.
wider society.
• Onlyasmallamountoftheprofitsisshared
between members a1 the rest is re-invested in
the co-operative
Public corporations
Public corporations (or public-sector organisations) are wholly owned by the
government and are therefore funded through rax revenues. TI1cy are organisations
that provide goods and services for the general public. Examples of public-sector
organisations arc: water suppliers, sewerage providers, utilities (electricity and gas
boards), the post office and state-owned news and broadcasting organisations (such
as ABC in Australia).
It should be noted that in the USA 'public corporation' is another tenn for a public
limited company that can trade shares on the stock exchange. In the USA, public
corporations are referred to as public-sector organisations.
Case Study: The Ba nk o f Eng la nd
TheBankofEnglandbecame anindependent publicorgani sation in1998.Thismea ns

it is wholly owned by the Treasury Solicitor on behalf of the UK government, with
independenceinsettingmonetarypolicy(seeChapter 16).
In some countries, some goods and services are supplied by private -sector firms. For
example, water, electricity and gas are all supplied by the private sector in the UK. In
other countries they are supplied by the government, as in the case of Amtrak, the
state -owned railway in the USA. Education and health care in many counuies are
provided by both the private and public sectors (see Chapter 2).
The advantages ofpublic·sector corporations include the following:

• Essential goods and services, such as housing and education, are under the conuol
ofrhc stare, ensuring adequate provision for the general public.
• Prices can be regulated by the government and therefore essential goods and
services, such as health care,are made affordable to all.
• Gm-crnmcnt can fund unprofitable services so that cvcrylx>dy has access to essential
services such as ix,stal services or bus services to remote areas of the country.
• Public corporations can generate revenue for the go,crnmcnt. For example,
Pcu6lcos de Venezuela (PDVSA) is rhc state-owned oil company of Venezuela. All
profits made by PDVSA form pan ofrhc Venezuelan go~·crnmcnt's rc\"Cnuc.
( Activity
Find some examples of public corporations in your country or a country of you r choice. )
The disadvantages of public sector corporations include the following:
• Public corporations arc funded using taxpayers' money, so there is an opporruniry
cost (sec Chapter l ) - in other words, the money could have been used for other
purposes, such as welfare benefits, government debt repayment or to improve the
cconomy'sinfrasrrucmrc.
• A public-sector corporation could be inefficient, as there is little incentive to
maximise profits because the aim of the organisation is to provide a service to the
general public.
• A public corporation may be a monopoly (see Chapter 13), so it could charge high
prices and provide a poor service as it is nor subject to any competition.
Activity
lnvestigatethenumberofpub liccorporat ionsinyourcountryoracountryofyourchoice.
Consider whether there are any goods and services which are p rovided by both the private
a ndpublicsectorsofthe e conomy.
N ationalisation
Nationalisation is the process of raking assets into state ownership - it is when the
government rakes o,cr private -sector corporations. For example, this occurred during
the global financial crisis of2008- 09 when sc\"Cral banks were partially or entirely
nationalised and taken into government ownership in the UK (sec Table 10.5 ).
These have since been privatised - that is, sold back to private investors. For example,
Northern Rock was nationalised on 22 February 2008 but sold to rhc Virgin Group
on l January 2012.
Ta bl e 10.5 NationalisedbanksintheUK
Bank Governme nt ow ne rship(%)
Northern Rock
Royal Bank of Scotland
Lloyds
Fa cto rs a ffecting the choice of business o rga nisa tion

People setting up a business have to decide which legal form of business organisation
they wish to establish. This will depend on numerous factors, as outlined below and
in Table 10.6:
• Ownership - Does the owner wam to be in complete control of the business?
Can the owner(s) afford to risk having unlimited liability? Do they want to be held
accounrable to the shareholders of the company?
• Contro l - How many people will own the business? Do they wam complete
privacy of their financial accoums? Do the owners prefer to work alone or with
others, perhaps to share the workload?
• Sources of finan ce - How much money is needed to set up the business? Do
the owners ha\'e the necessary money to start the business or arc additional funds
required? Are the owners prepared to share the profits in return for greater soun::es
of finance to fund the organisation's business operations?
• Use of profits - Does the owner·wam to keep all the profits of the business? Are
the profits going to be reinvested in the business or distributed to shareholders?
Table10.6 Choiceofbusines.sorganisation
Type of Access tofinance Liability Privacy Control

orga nisation
Sole trader Owner's capital Unlimited Owner has full
control
Partnership Partners'capital Unlimited Partners share
control
Private limited Sharessoldto lim ited Financialacrountsare Oivorceofcootrol
company(Ltd) privateindividuals preparedandaudited andownership,
butdonothavetobe runbydirectorsof
made available to the
general public
Public limited Shares sold to Limited Financial accounts Divorce of control
company(PLC) general public areprepared,audited andownersh ip,
andmadeavailableto runbydirectorsof
theger.eralpublic
Co-operative Capital invested by Limited Financial accounts Controlledbythe
members areprepared,audited members,whohave
andmadeavailableto onevoteeach
members
Public corporation Government funded Unlimited Financial accounts Controlled
areprepared,audited bydirectors
andmadeavailableto (individuals)
the general public appointedbythe
government
Activity
Conductasurveyofalocalbusinessareaandrecordthenumberofsoletraders,
partnerships, private and public limited companies, multinationals and co-operatives.
Analyse your findings . What is the dominant type of business organisation? Why do you
thinkthatthisisthecase?Bepreparedtoshareyourfindings.
Exam practice
Water supplies in the USA are provided by both private firms and public corporations.
Housing is provided in the public sector and the private sector, and by housing co-
operatives.
1 Distinguish between the aims of a public limited company and a public
corporation. (3)
2 Discuss how housing provided by a housing co-operative might differ from that
provided by a private-sector firm. [6)
C h apter review q uestions

1 What are the benefits of being a sole trader?
2 Why might a sole trader decide to become a partnership?
3 What are the disadvantages of being an ordinary partnership?
4 What are the differences between a public limited company and a private
limited corporation?
S What are the benefits of limited liability?
6 How does a business change from being a private limited company to a public
limited company?
7 What are the two documents that limited liability companies must register
with the government before trading?
8 What are the characteristics of a co-operative?
9 Why might a firm wish to operate in more than one country?
1 O Why are some goods and services provided by a public-sector organisation?
Key te rms
Co-operatives are business organisations set up, owned and run by their members, who
may be employees and/or customers.
Lim ited liabil ity means that in the event of a company going bankrupt the owners would
not lose more than the amount they had invested in the company.
Mult in at ional corporations are businesses that operate in two or more countries. Examples
are Apple, BMW, HSBC, Marks & Spencer, Nike and Sony.
Natio nalisation is the process of taking assets into state ownership. A nationalised
organisationisalsoknownasapublic-sectororganisation.
Partnerships are businesses owned by between 2 and 20 owners, who pool funds and take
riskstogether,buthavetoshareprofitsbetweenthemselves.
A private limited oompany has limited liability and can sell shares to raise finance, but not
to the general public.
Pub lic corporations (public-sector org a ni sations) are organisations that are wholly owned
andfundedbythegovernment,suchasthepostaloffice.
Ap ubliclimitedcompany haslimitedliabilityandcansellsharestothegeneralpublicto
raise finance .
A sole trader is a person who owns and runs a business as a single proprietor. Sole traders
takealltherisksbutkeepanyprofitmadebythebusiness.
Unlimited liabi lity means that if a business goes bankrupt, the owner(s) is (are) personally
liableforthedebts,evenifitmeansthatpersonalbelongingshavetobesold.
@ Production
By the end of this cha pter, students should be able to:

• describe what determines the demand for factors of production
• distinguish between labour-intensive and capital-intensive production
• define productivity and recognise the difference between productivity and
production.
The dema nd fo r facto rs of productio n

Fact ors o f production (see Chapter 1) are the resources used to produce goods and
toprovide services. The four factors of production, or facto r inputs, are:
• Land - natural resources used in the production process, such as raw materials,
fish and physical land.
• Labou r - the physical and mental human input imo the production process. This
includes the level of skills, qualities and qualifications of the workforce, and not
only the number of workers.
• Capital - manufactured goods used to produce other goods and to provide
services, such as tools, machinery, ,-chicles, computers, factories, roads and money.
• Enterprise - risk-takers who provide the ideas and resources to organise the other
three factors of production in the pursuit of profit.
In general, the demand for any factor of production is a derived demand. This means
that the demand for factors of production depends on the demand for the goods
and services that they will be used to produce. For example, economics lecturers at
university arc hired only if there is demand for economics courses from undergraduates.
On a macroeconomic scale, the demand for the fuctors of production in a country
resu lts from the total level of demand for goods and services in an economy. For
instance, during an economic recession (see Chapter 20), fim1s will demand less labour.
In addition to the derived demand for fuctors ofproduction, the demand for land,
Jabour and capital also depends on t heir cost, availability and quality.
• T he cost offactors of production - The higher the cost of land, latxmr and capital,
the lower their demand tends to be. For example, Apple outsources the production
ofits iPhoncs and iPads to Foxconn, a Taiwanese manufucturcr based in China,
due to the relatively lower costs of land and labour.
Similarly, if labour costs arc relatively high compared with the cost of capital
then workers might be replaced by machinery and technology. Also, the demand
for capital depends on the cost of borrowing money - that is, interest rates.
• T he quantity (or availability) of land, labour and capital - The greater the
availability of fuctors of production, the lower t heir cost tends to be, and hence
the higher their demand. For example, the relat ively large size and availability
of t he workforce in India and China has boosted the demand for labour from
multinationals seeking to expand their operations. In general, t he greater t he
quantity ofa fuctor of production, the lower its cost tends to be.
• T he qualit y ofland, labour and capital - H ighcr·quality resources tend to demand
a higher price. For example, surgeons, pilots and barristers are in high demand
Production
due to their highly valued skills and qualifications. China, India, Vietnam and
Thailand have good-quality land to grow rice, whereas Scandinavian countries do
not have the natural climate to do so.
WorkersonanassemblylineataFoxconnplantinShenzhen,China
Activity
Foxconn is a Taiwanese company that makes electronics prod ucts such as the iPhone,
PlayStation, Kind le and Wii. It has operations throughout th e world, includ ing in China,
Brazil, lnd ia,MalaysiaandMexico.
Investigate the various reasons why companies such as Apple, Sony, Amazon and Nintendo
might choose to use manufacturers such as Foxconn to make products on their behalf.
Labo ur-intensive and ca pita l-intensive productio n

T he production or provision of different goods and services requires varying amounts
of factors of production. In labour·intcnsive industries, the use and cost of labour
is proportionately higher than the cost of other fuctors of production. Examples arc
teaching, psychiatry, sports coaching and management consultancy.
By contrast, in capital-inten sive industries the use and cost of capital is more than
that of any ot her factor of production. Examples are car manufacturing, soft drinks
production and oil extraction.
Labour-inte nsive pro duc tio n

A labour-intensive firm is one that spends proportionately more on labour as a
percentage of its total costs of production. Traditional forms ofagriculmral farming
and fishing arc examples oflabour-intcnsive production. It is also commonplace
in economically developed nations that specialise in the output of services, such as
accountancy, physiotherapy, real estate services and tourism.
Labour-intensive production can be very expensive . For example , in private fee -
paying schools and health clinics, Jabour costs accoum for the largest proportion of
production costs, so the price charged to customers is relatively high.
Labour-intcnsi\·c production processes tend to be used to pnxlucc individual or
personalised pnxlucts (such as a Hollywood movic or a custom-made wedding dress)
onarclativelysmallscalc.
Study tips
Theterm'labour
costs'doesnot
refer only to a
person's wage
orsalary,butto
the overall pay
package.This
could include
other financial
benefits such as
overtime pay,
bonuses.paid
holidays.housing
allowance and
company cars. It
also includes the
costs of hiring Fishingfor scallopsislabourintensiveinChina
and training
workers.
Professionalfootball(soccer)ishighlylabour
intensive. Thetop-earningplayersintheworldenjoy
celebritystatusandarerewardedgenerouslyfortheir
services. Thetenhighest-paidfootballersduringthe
2012-13seasonarelistedinTable11 .1.
CristianoRonaldoandlionelMessiconsistentlyfeatureinthehighest-paidfootballerslist
Tab le 11.1 Highest-paidfootballers,2012-13
Ra n k Pl aye r Club Tota l ea rni ng s
David Beckham LA Galaxy S46m
CristianoRooaldo Real Madrid S42m
LionelMes!.i Barcelona S39m
Ww,neRooney Manchester United $24m
Kaka Real Madrid S21m
John Terry Chelsea S18m
YayaToure Manchester City S18m
Fernando Torres Chel~a S17m
Franklampard Chel~a S16m
Steven Gerrard Liverpool S16m
Production
Exam practice
Study the hypothetical data below for two firms and answer the questions that
follow. The figures show the amount of money spent by each industry on factors of
production.
Labourcosts(S) Capital costs ($) Othercosts (S)
1 What is meant by labour-intensive production? (2)

2 Use the data in the table to explain why Firm A might be considered to be more
labour intensive than Firm B, despite the latter spending twice as much on
labour costs. (4)
Capital-intensive pro ductio n

Capital-intensive production takes place ifa firm spends more on capital costs than
on any other factor ofproduction. This will include the expendimre on capital
equipment such as rools, equipment, machinery and \'ehicles. Capital-intensive firms ,
such as aircraft and moror vehicle manufacmrers, therefore need a lot of money to
fund their operations. This can act as a barrier to entry into the industry, since it is
difficult for new firms to enter such industries.
Therearesignificantentrybarriers intothecarandaircraftmanufacturing industries
Despite the initially high costs of capital-intensive production, there are potentially
huge cost savings in the form of techno logical econo mies of sca le in the long
run (see Chapter 14 ). Firms that become more capital intensi\'e usually do so to
increase the levels of output and productivity by mass producing their products. In
this situation, unit costs of production are relatively low. As countries such as I ndia
and China industrialise, their production is also tending to become more capital
intensi\'e.
Exam practice
Educational services are exploiting the use of technology in the twenty-first century.
For example, long-distance learning technology (such as e-learning and video
conferencing) allows students to study courses from the comfort of their own homes
without physically attending a university campus, replacing the traditional lecture-style
experience.
1 Outline two benefits of capital-intensive technologies in the provision of
educational services. [4]
2 Discuss whether technology could ever replace the traditional labour-intensive
nature of teaching and learning. [8]
Whether firms choose more capital- or labour-intensive production methods depends

on several related fuctors:
• T he cost of labou r compared with the cost of capita l - Firms will tend to
choose more capital-intensive methods of production if labour costs are relatively
high (assuming that it is possible to substitute fuctors inputs in the production
process),and vice versa.
• T he size of the market - Capital-intensive production tends to take place for
mass-market products such as soft drinks, passenger vehicles and consumer
electronics. Labour-intensive methods are often used for personalised services, sucl1
as a private tutor, counsellor, adviser, instructor or coach.
• T he fi r m's o bjecti ves - Profit-maximisers operating in mass markets tend to opt
for capital-intensive production methods in order to minimise their unit costs of
production. Other firms might choose to use labour-intensive methods as they
operate on a smaller scale or to safeguard jobs. Black & Decker, operating in
Shenzhen, China, uses labour-intensive production methods to create jobs in the
special economic zone (see Chapter 16), benefiting from tax incentives from the
government.
Productivity
Productivity is a measure of how well resources are used in the production process:
that is, the economic efficiency of land, labour, capital and enterprise. For example,
labou r productivit y measures the efficiency of the workforce in terms of output per
worker. It can be improved by having a better-skilled workforce (through education
and training) or by allowing workers to use better, more efficient technologies to
increase their output.
By contrast, the use of automation, such as the robotics and specialised computer
equipment used in car manufacturing, can help to raise capital productivity without
the need to hire more workers.
Figure 11.1 Theinput-outputprocess

Production
Higher productivity is imporram for an economy for several reasons:

• Economies of scale - Higher levels of output, whether through capiral-intensive
or labour-imensive methods of production, help to reduce unit costs of production
(see Chapter 14). These cost-saving benefits can be passed on to consumers in the
form of lower prices. For example, the mass production of flat-screen televisions
and digital cameras has made these products much more affordable to many
customers around the world. In addition, cost savings from higher productivity
levels can help firms to earn more profit on each item sold.
• Higher profits - Productivity gains are a source of higher profits for firms. These
efficiency gains can be reinvested in the business to fund research and development
or used to expand the operations of the business. Either way, higher profits help to
fund the long-term survival of the firm.
• Higher wages - Highly productive finns that enjoy cost savings and higher
profirability can afford to pay higher wages to their workers, especially if they
become more efficient. Such firms also tend to attract the best workers, as people
prefer to work for firms with better prospects and profirability.
• Improved competitiveness - Productive firms can gain advantages beyond
Study tips economies of scale. For example, they are more efficient, so they can compete
Higher more effectively on a global scale. Samsung's efficiency gains during the late 2000s
productivity ensured that the South Korean company took market share from Nokia and Apple
increases the to become the market leader in the smartphones industry.
output of goods
and services. • Economic growth - Productivity is a source of economic growth because it
However, increases the productive capacity ofan economy, thus shifting its production
increasing the possibility curve outwards (see Chapter 1). This helps to raise employment and
number of srandards of living in the economy. Higher wages, from improved efficiency of
workers or any firms and higher labour productivity, also mean that the government collects more
other factor
input does not
tax re\·enues to fund its expenditure on the economy (see Chapter 16).
necessarily
increase output The difference between productivity and production
unless these
Productivity is a measure of the degree of efficiency in the use of factor inputs in
used efficiently. the production process. It rakes an a\'Crage measure of this efficiency, such as output
Firms that operate per worker, re\·enue per sales person or output per machine hour. Alternatively,
on a larger scale productivity can be measured as a ratio, such as the value of output compared with
can suffer from the cost of the inputs (factors of production).
diseconomies
ofscale(see By contrast, production refers to the total output of goods and services in the
Chapter14). production process. Production can be increased either by using more factor inputs or
by raising the productivity of existing factors ofproduction.
Exam practice
Study the data below for two real estate firms selling residential property over a
typical weekend. The number of units sold and the number of sales staff involved are
also shown.
Tota l sa le s($) Units so ld Sales staff
Charnley Realty 3950000
Tsang Realty
1 Calculate the labour productivity as measured by sales per worker for both
Charnley Realty and Tsang Realty. (3)
2 Use the information in the table to comment on why it might be difficult to
decide whether Charnley Realty or Tsang Realty is the more productive firm. [4)
Determin a nts of pro d uctivity

The five main determinants of productivity growth are as follows:
• Inves tm ent - This is the expenditure on physical capital such as machinery, vehicles
and buildings. For example, investment in the latest technologies generally helps
workers to do their jobs better - that is, to produce more output and of better
quality. The degree ofinvestmem in turn is determined by the le\-el ofimerest rates
(see Chapter 16). In general, the higher the interest rate, the more expensh'e capital
expenditure will be, thus discouraging im-estmem in the economy.
• Innovation - This refers to the commercialisation of new ideas and products.
The invention of tablet computers and smanphones has transformed the way
many people work, as they are able to conduct their business while mobile rather
than at the office. Such innO\'ations have increased the speed of work, improved
communications and enhanced organisation at work. Thus, innovation helps to
boost productivity.
Innovation has helped business people boost productivity by working while on the move
Production
• Skills a nd experience - The productivity of labour is determined by its quantity

and quality. The latter can be increased by improving the skills and experience
of the labour force. Education and training, tor example, enhance the hnman
capita l (skills and experience of the workforce) in the economy, thus boosting
productivity.
• Entreprencn ria l spirit - Entrepreneurs take risks in the production process in
the pursuit of profit. They plan and organise the \'arious factors of production
in the production process. Productivity is dependent on the drive (motivation)
of entrepreneurs, such as their willingness and ability to exploit new business
opportunities.
• Competitio n - This creates an incenth'c tor firms to be more productive. \Vithout
competition, firms might Jack the incentive to be efficient or innovative (sec the
Exam Practice below). By conrrast, competition forces firms to be more efficient,
thus helping to boost the economy's overall productivity.
Exam practice
Kodak, once the largest firm supplying photographic camera film, became complacent
as rival firms switched to the production of digital camera technology from the late
1990s.
Founded in 1888, the American firm had dominated throughout most of the
twentieth century, with its market share reaching 90 per cent in 1976. Having failed to
make any profit for five consecutive years, however, Kodak ceased its output of digital
cameras and filed for bankruptcy in early 2012.
1 What is meant by 'market share'? [2]
2 Explain why productivity is important for the survival of firms such as Kodak. (4]
Activity
Investigate the ways in which the level of productivity in your school might be improved.
Try to make your recommendations realistic and be prepared to share your suggestions
withtherestoftheclass.

1 What is meant by the 'derived demand' for factors of production?
2 What are the main factors that determine the demand for factors of production?
3 Distinguish between capital-intensive production and labour-intensive production.
4 What are the factors that determine whether firms choose more capit al- or
labour-intensive production methods?
5 What is meant by 'productivity' and how does it differ from 'production'?
6 Why is productivity important for the economy?
7 What are the main determinants of productivity in an economy?
Key te rms
Cap ital -in tensive production happens when a firm spends pro po rtion ately mo re money on
capitalcost s thanonanyotherfa ctor ofproductio n.
Derived demand mea ns that facto rs of productio n a re no t dema nded for their ow n sake,
butforthe goods and serv ice s thatthey areu sedto produce.
Innovation is the commercialisation o f new ideas a nd produ cts. It is a vital source o f
pro d ucti vity.
Labour-intensive production o ccurs when la bou r costs account for pro po rtio nate ly more o f
a firm's costs tha n any o the r co st of productio n.
Production refers to the total o utput of goo ds a nd services in the productio n process.
Productivity is a measure of efficien cy that involves calculating the a mo unt o f output per
unit of a factor input (s uch as o utput per worker or o utput per ma chine hour).
@ Costs, revenues and profits
• define total and average cost, fixed and variable cost, and perform simple
calculations
• analyse particular situations to show changes in total and average cost as
output changes
• define total and average revenue and perform simple calculations
• describe the principle of profit maximisation as a goal and recognise that
business organisations may have different goals.
TakenfromCambridgelnternationalfxam;MtionsSyllabo,~GC5f0455/0l.evel2281 )
O CambfidgelnternationalExam ir,abom
Costs of production
Costs are the payments made by firms in the production process. Examples of costs
of production include:
• wages and salaries paid to employees
• rem paid to landowners for hiring of business premises
• advertising expenses
• purchases of raw materials and components from suppliers
• utility bills for telephone, gas and electricity services
• dividend payments to shareholders (see Chapter 10)
• taxes paid to the government based on the value of company profits made.
Costs of production can be categorised in four differ em ways.
Fixed costs
Fixed costs are the costs ofproduction that have to be paid regardless of how much a
firm produces or sells. For example, salaries for senior managers, insurance payments
and rem all have to be paid regardless of the firm's output level. This relationship is
illustrated in Figure 12.1.
Figure12.1 Fixed costsforafi rm (withS4000offi xed costs)

Va riable costs
Variable costs are costs of production that change when the le,eel of output changes.
Examples are the costs of raw materials or components needed to build houses - the
more houses that are built, the higher these variable costs become. The total variable
,v--.
cost line (see Figure 12 .2 ) starts at the origin because when there is no output, no
variable costs are incurred.
O OJflY M
Figure1 2.2 Variablecostsofafirm
Total costs
As the name suggests, the total costs of production arc the sum of all fixed and
variable costs. The total cost line, shown in Figure 12.3, starts at the same value as
fixed costs because even when nothing is produced, fixed costs still ha,·e to be paid
by the firm.
Total costs = fixed costs + variable costs
'-~ 0 °"""""'
Figure1 2.3 Totalcostsforafirm
Ave rage costs

Average costs refer to the total cost of making one product - it is the unit cost of
production.
Average costs= total costs+ output level
Firms that operate on a large scale arc able to reduce their average costs of production
(sec Chapter 14). For example, Coca-Cola's bottling planrs can produce 10 OOO cans
of soft drinks per minute. This enables Coca-Cola to benefit from lm,eer unit costs of
production, as shown in Figure 12.4. Here, the firm is able to enjoy econo mies of
Costs, revenues and profits
sca le (lower average costs as it expands output from O a to Ob). If the firm becomes
to0 large, by operating beyond Ob, it will suffer from inefficiencies, thus leading to
disecono mies of scale (sec Chapter 14).
Figure 12.4 Ave ra gecostsofafi rm
needediooobJale OOlp maooger,1o

profit ordk,s,~ ma ke dec1,1oo.s
/
Figure 12.5 Summary of business costs
Exam practice
1 The table below shows a firm's fixed and variable costs of production at different
levels of output. Calculate the level of output where average costs are at their
lowest. (2)
Output(units) Fixedoosts(S) Variableoosts(S)
20 300 40
2 Johnson's Candles has fixed costs of $4000 each month. Its average variable costs
are $3 per candle. The firm's current level of demand is 2500 candles per month.
The average price of its candles is $6.
a) Using an example, explain what is meant by a fixed cost of production. (2)
b) Calculate the firm's current average costs. (2)
c) Calculate the firm's current total costs of production each month. (2)
d) Calculate the profit if demand increases to 3000 candles per month. [3)
3 Juke Engineering produces batteries for a major car-maker. Juke's monthly cost
structure is shown in the table below. Assume that the firm's average variable
costs of production remain constant at all levels of output shown.
Outputlevel (batteries) Totalcosts (S)
1000 50000
a) Calculate the average variable costs of production for Juke Engineering. [2)
b) Calculate the value of its monthly total fixed costs. [2)
c) Calculate the change in average costs of production if Juke Engineering
increases its production from 1000 batteries per month to 3000 batteries
per month. [2)
Revenu es
Revenue refers to the money payable to a business from the sale of its products.
For example, Nike and Adidas receive most of their revenues from the sale of sports
apparel and sports equipment. According to its website, McDonald's - the world's
largest restaurant chain, with o,er 34 OOO restaurants worldwide - earned around
$28 billion of revenue in 2013 from the sale of fast fuod.
McDonald's has over 34 OOO restaurants worldwide and earned around S28 bi llion of revenue
in2013. ThisisabranchinTokyo,Japan
Revenue is often referred to as sales revenue or sa les turnover. It is calculated by

using the formula :
Revenue ::: price x quantity sold
For example, ifa cinema charges an a\'erage price of$IO for a movie and manages to
sell 5500 tickets in a week, its total revenue will be $55 OOO (that is, $ 10 x 5500).
Ave rage revenue refers to the typical price received from t he sale ofa good or
service. It is calculated using the formula:
Average re\·em1e = total revenue + quantit y sold
So, if instead the cinema earns $60 OOO from the sale of 7500 tickets, the average
revenue (or average price) would be $60 OOO+ 7500 = $8 per ticket.
Profit and profit maximi satio n

A firm earns profit if its total revenues exceed its total costs of production. Profit is
calculated by using the formula :
Profit=toral revenue -total costs
Study tips
Students Profit provides an incentive for entrepreneurs to take risks. Wit hout profit, firms will
often use the struggle to survive in the long run .
and'revenue'
intercha nge ably,
although the
terms have
different
meanings.
Firms always
paythe'cost'
(of prod uction)
whereas
customers always
paythe'price'. To
make a profit.a
prod uct's price
must exceed its
ExxonMobil, the world's la rgest oi l company, earns annual profits in excess of S41 billion
Profit maximisation and business o bjectives

Profit maximisation is the goal of most prh•ate-sector firms. Profits arc maximised
when the positive difference between a firm's sales revenues and its costs of
production is at its greatest.
Exam practice
1 Copy and complete the information below for a firm that sells pizzas. [5)
Un it ssold(p izzas Sa le s Tota l fixed Tota l variab le Tota l Profit/
per w eek) revenue($) costs($) costs($) costs ($) loss($)
2 The following data refer to the monthly costs and revenues of M intjens Curtains
Ltd when operating at 300 units of output per month.
Cost/reve nu e($)
Raw materials per unit

Advertising costs
Salaries
a) Explain why advertising costs are an example of fixed costs of production

for MintjensCurtainsLtd. [2)
b) Calculate Mintjens Curtains Ltd's monthly total fixed costs of production. [2)
c) Calculate Mintjens Curtains Ltd's total cost of producing 300 units per
month. [2)
d) Calculate the profit made by Mintjens Curtains Ltd if it sells all its output. [2)
3 The table below shows the total costs of a firm.
Output(units)
Totalcosts(S) 120 1SO 190 230
a) Calculate the total revenues at each level of output if the selling price is $5. [4)
b) From the above calculations, identify the number of units that the firm
should produce in order to maximise profits. [1)
4 On Valentine's Day 2013, US Airways and American Airlines merged in a deal
worth $11 billion to create the largest airline on the planet, with 6700 daily flights
and annual revenues of around $40 billion. Critics of the merger were concerned
that with less competition, the US airline industry would have fewer incentives to
keep prices at a competitive level. Others believed that the intensity of competition
between Delta Air Lines and United Airlines would simply force American Airlines
to offer better customer service for passengers.
a) Define the term 'sales revenue'. [2)
b) Discuss whether the merger between American Airlines and US Airways
would lead to lower costs and higher profits for the firm. [8)
Alternative business objectives

Businesses have a variety of objectives and do not necessarily strive to maximise
profit. Other business objectives include:
• Survival - While business survival is a vital objective for new businesses, even
well-established firms will need to focus on this, especially during unfavourable
ttading times. To survive in the long run, firms need to earn a profit.
• Market share - TI1is refers to a firm's sales rc,'Cnucs as a proportion of the
industry's total sales re,·enue. An increase in sales revenues will, other things being
constant, lead to greater market share for the firm. Higher market share has several
advantages, such as economics of scale (sec Chapter 14) and customer loyalty.
• Image and reputatio n - Businesses mig ht aim to improve how the ge neral
public perceives them. A bad image can turn suppliers and customers against
the firm's produc ts and services. For example, German car-maker BM\V recalled
720000 cars worldwide in 2013 due to potential electrical problems. Resolving
such pro blems, altho ug h costly to BMW, pre \·ents problems for the firm in the
long run.
• E th ical objecti ves - This refe rs to the moral principles (values and beliefs)
that g uide business activity. These o bjecth·es fo cus on what is considered to
be socially responsible . Ethical businesses strive to impro\·e the t reatment of
wo rkers, customers, shareho lders and the natural environment. Not-for -profit
o rganisatio ns such as charities a im to provide services to enha nce the welfa re of
people in societ y.
Activity
Investigate the objectives of any two organisations of your choice. Compare and contrast
yourfindingsandbepreparedtosharethesewiththerestoftheclass.

1 Using examples, distinguish between total, average, fixed and variable costs of
production.
2 How might total and average costs chan ge wh en the level of ou tput changes?
3 Wha t is the difference between total and average revenue?
4 Wha t is profit maximisation?
S Explain the alternat ive objec tives that businesses might have.
Key te rms
Averagecost isthetotal costofmakingoneunitofproduct - thatis,theunitcostof
production.
Costs refers to a firm's expenditure on, for example, wages, salaries, rent, loan repayments,
fuelbills,marketingexpenses,taxes,accountancyfeesandlegalcosts.
Fixed costs are costs that a firm has to pay irrespective of how much it produces or sells,
suchasmanagementsalaries,administrativecosts,bankloanrepaymentsandrent.
Objectives are the goals or targets of an organisation, such as business survival, growth,
highermarketshareandprofitmaximisation.
Profit is the positive difference between a firm's total revenues and its total costs of
production: thatis,profit=totalrevenue - totalcosts.
Sales revenue is the payment received by a firm from the sale of its goods and/or services.
Totalcosts arethesumofallfixedcostsofproductionandallvariablecostsofproduction.
Va ri ab lecosts arethosethatchangeasthelevelofoutputchanges,suchasrawmaterial
costs, payment for components used in production and the payment of wages.
@ Perfect competition and monopoly

• describe the characteristics of perfect competition and monopoly
• describe pricing and output policies in perfect competition and monopoly
• discuss the advantages and disadvantages of monopoly.
Perfect competition
In economics, the term market structure refers to the key characteristics ofa
particular market. These features include the number and size of firms in the
market, the degree and imensiry of price and non-price competition, and the nature
of barriers to entry. 111c rwo extreme marker structures in economics arc perfect
competition and monopoly.
The model of perfect competition describes a marker where there is immense
competition. A real world example is the wet markets (fresh fuod markets)
commonly found in Asian countries such as Hong Kong, Singapore, South Korea,
Taiwan and Macau.
A wet market in Hong Kong - an example of perfect competition
The main characteristics of firms in perfect competition are as follows:

• There arc many buyers and sellers in the industry, none ofwhich has any
significam market power to influence the market supply or demand (sec
Chaptcr3).
Perfect competition and monopoly
• Hence, firms arc said to be price takers - the price they charge is dctcnnined by
the market forces of demand and supply rather than firms setting their own prices.
• As there arc literally no barriers to ent ry in perfect competition , there is freedom
of entry to, and exit from , the market.
• Firms produce a ho mogeneous product. This means that the products being sold
are identical, such as bananas or strawberries being sold in fresh fruit markets.
• Both buyers and sellers have perfect k nowledge. This means that customers and
firms have case of access to information about the product and the prices being
charged by competitors.
However, perfect competition is a theoretical possibility only and in reality the vast
majority of markets are imperfect. For example:
• I nmost indusrries, there are market leaders (those with a high market share)
who have significant power to influence the market supply and hence prices. An
example is Apple and Samsung, which dominate the tablet computer industry.
Hence, these firms are price makers (or price setters) rather than price takers.
• I n reality, barriers to entry exist in virtually all markets. For example, there may
be legal entry barriers to some industries, such as the professional qualifications
needed to practise law and medicine, or the high set·up costs to enter other
markets, such as the airline or pharmaceutical industries.
• Consumers and suppliers arc likely to have imperfec t k nowledge rather than
perfect knowledge. This means that customers and rival firms do not have
easy access to information about the products and the prices being charged by
competitors. For example, mobile phone nen\!ork providers use very confusing
pricing packages for their scl"\!ices. Similarly, banks offer a variety of interest rate
charges for their various types ofloan.
• Firms are likely to produce d ifferentiated product s, rather than homogeneous
ones. For example, sports apparel firms such as Adidas and Nike use branding,
different product designs, colours and slogans to differentiate their products. Many
successful and large businesses develop memorable slogans (catchphrases) as a form
of product differentiation (sec Table 13. l ).
Ta bl e 13.1 Someexamplesofbusinessslogans
Slog an
lmpoH.ibleisnothing Adida1
The ultimate driving mach ine
Theworld'sonlinemarketpli!Ce eBay
The world on time FedEx
The world's loeal bank
Because I'm worth it L'Oreal
I'm lovin' It McDonald's
Wheredoyouwanttogo today? Mic:rosoft
Just do it Nike
Ideas for life
ldon"twannagrowup ToysRUs
lt"severywhereyouwanttobe
Always low prices Walmart
Pricing and output policies in perfect competition

A high degree of competition in a market can benefit consumers. T his is because
they get good-quality products and good customer service, all ar the right prices.
In addition, competition brings about greater choice, higher output and more
competiti ve prices (sec Figure 13 .1).
loc"""""c=e,"=,hih,
~l l
tOO markelsu CIJM!
1
Pi :::,t1o!!t~1o.' fa ll
p~ from P1 1oP~. th ereby=ng
theqoantltydemandoo1o
lnaea.,,fr001Q 1 1oQi
D
0 Q, Qi
(hmtity troded
Figure 13.1 Impact of competition on market price and output
Exam practice
Supermarket chains such as Walmart. Carrefour and Tesco use an extensive range of
pricing and non-pricing strategies to compete. Market research published by Which?
(a consumer campaigning organisation in the UK) showed that most shoppers
believe supermarkets deliberately try to mislead them by using confusing pricing
strategies.
The Which? findings showed that supermarkets often use poor labelling and puzzling
prices for their products. For instance, a 600 g jar of mayonnaise might be priced at
£3.49 while a 400g jar of the same brand is priced at £2.35 - so which one offers
better value? Similarly, pre-packed fruits and vegetables are found to have very
different prices compared with loose varieties of the same produce.
1 Price is one way in which supermarkets compete. Explain three non-pricing
strategies that supermarkets use to compete with each other. [6)
2 To what extent do supermarkets operate in a competitive market? [6)
3 Do consumers benefit from the competitive strategies used by supermarkets?
Give reasons for your answer. [8)
Monopoly
There are different interpretations ofwhat is mcanr by a monopoly. In general, a
monopoly is a marker structure where one supplier dominates the market. Examples
arc Coca-Cola (ca rbonated soft drinks), YKK (zi p fasteners) and Mabuchi (which
makes around 90 per cent ofrhc micro-morors used to adjust rear-view mirrors
in cars).
A pure monopoly exists if only one firm supplies the whole market. In the USA,
this would include the United Stares Postal Service (the only service provider of first
class postage) and the Federal Reserve (the sole supplier ofbanknores and coins).
The word 'monopoly' comes from the Greek language, with monos meaning one
and polein meaning to sell. Hence, monopoly can be defined as a market structure
where there is only one supplier of a good or service.
Microsoft enjoyed a monopoly position in the software industry during the 1990s
Features of monopoly include:

• Sing le su pplier - As its name suggests, a monopolist is the sole supplier of a
product in a given market. This is due to high barriers to entry (see below), which
result in a lack of substitutes.
• P rice maker (or price setter) - The monopolist has significant market power,
controlling enough of the market supply (see Chapter 3) that it can charge higher
prices yet produce lower output than would be the case if it faced real competition.
• I mperfect kn owledge - A monopolist is able to protect its prestigious position
because customers and rivals ha\"e imperfect knowledge, partly as a result of the
monopolist's ability to protect its trade secrets.
• H igh barriers to entry - A monopolist can remain so only if in the long run there
Study tips
are wry high barriers to entry. These obstacles effectively prevent other firms from
It is incorrect
to claim that
entering the market. Examples include: economies of scale of existing firms, O\\'tlership
monopolists can of essential resources, the existence ofintellectual property rights (namely, patents,
charge'whatever' trademarks and copyrights), advertising expenditure and legal barriers to entry.
price they want
because they
are the single Exam practice
supplier of a good The advertising budgets of large firms can act as a barrier to entry. America's most
or service. While watched sporting event, the annual Super Bowl, is a magnet for firms with huge
monopolists have
advertising budgets. The average cost of a 30-second advert during the Super Bowl
the ability to
control market was $4 million in 2013. Marketers believe that the best Super Bowl adverts earn a
supply,they permanent place in history, being broadcast on television and internet websites such
cannot control as Youlube for years to come.
the level of
1 Define the term 'barriers to entry'. (2)
market demand .
Customers will 2 Explain why advertising expenditure can act as a barrier to entry. (4)
switchto,orseek,
alternatives if
prices rise too Pric ing a nd output polic ies in mo nopoly
high. Hence,
monopolists must Due to the lack of competition, the monopolist is able to restrict market supply.
lower prices if This is shown in Figure 13.2 by the shift in supply from S1 to S2 , which reduces
they want to sell output from 2 to Qi. Alternatively, we can say that supply would be higher at S1 in
the absence of monopoly power. As the monopolist limits the supply of its good or
service, the price is higher (at P2 rather than P 1) .
Ooo nti1ytroded
Figure 13.2 Impact of monopoly power on market price and quantity traded
Monopolists are also able to use price discrimination. This is the practice of
charging different prices to different customers for essentially the same product.
For example, public transport operators, theme parks and cinemas charge students
different prices compared with other adults. Another example, often used by
supennarkets, is price discrimination based on the quantity sold. For example,
supennarkct customers who buy ' multipacks' of a product usually get to enjoy a
lower price for each unit bought. This discriminates against those who buy in smaller
quamities.
Exam practice
Theme parks such as Disneyland, Universal Studios and SeaWorld are experts at using
price discrimination. An example of such pricing policies is shown below.
Admission prite(S)
Adult(aged 12andabove)
Child (aged 3-11)
Famil y(2ad ults,2thildren)
Famil y(1 ad ult,2children)
Annualpass(adult)
Annualpass(child)
Freeadmissionisgrantedtochildrenunderlyearsoldandlocalsenior
residentsaged65yearsoldorabovewithproofofidentityandage.
1 Define the term 'price discrimination'. [2)

2 Using examples of the above data, explain how organisations such as theme
parks use price discrimination. [6)
Other pricing policies that might be used by firms include:

• Cost-plu s pricing- This involves working out the average cost of each unit
of output and then adding a certain amount or certain percentage on top to
earn profit.
For example, if the cost of producing a commercial aeroplane is $120 OOO and
the fim1 wants a 100 per cem profit margin, the selling price will be $240000.
Whilst cost-plus pricing is easy to calculate, the price setter must ensure that the
chosen price is still competitive.
• Competitio n -based pricing - This occurs when a firm sets its price according
to the prices being charged by its rivals. This allows the firm to be competitive in
terms of price, but also means it may need to rely on non -price factors to maintain
its market share.
For example, many airline companies will set similar prices for their flights but
choose to compete on other aspects of their sel"\'ice, such as baggage allowance,
amount of leg room (space), flight times and connection times, the quality of the
food, the variety of their in-flight enterrainmem, and the overall level of customer
service.
• Penet ra tio n pricing - This im·olves setting a low price in order to enter a new
market. This pricing policy is often used by firms when launching new products in
untested markets in order to gain market recognition and market share. It can help
to give a product a competitive edge.
• Loss leader pricing - This happens when the price is set below the costs of
production, thus making a loss in the short run.
Supermarkets often use loss leader pricing for some of their products (such as
toilet tissue or carbonated soft drinks) in order to attract more customers to buy
other products sold at the supermarket.
• Price skimmi ng - This pricing policy involves a firm setting an initially high price
in order to maximise profits and to recover its pre-launch costs, such as marketing
and R&D (research and development). Price skimming is often used when selling
new innovati\·e products with few, if any, substitutes. The price is continually
reduced (or 'skimmed') as competitors enter the market to launch rival products
and compete for market share.
While novelty for a new product can cause high demand and hence a high price,
customers eventually look for newer \·ersions or better alternatives. For example,
when Apple launched the iPhone 4S it was priced at $399 in the USA, although
the launch ofthe iPhone 5 in 2012 Jed to the price of the iPhone 45 fulling to
just $99.
• P romotiona l pricing - This commonly used pricing policy involves firms
temporarily reducing their prices to attract more customers. Promotional pricing
can be used to clear excess stoek when a product is being withdrawn from the
market or to boost demand for products in a new market.
This pricing policy is often used to encourage brand loyalty (when customers
stick to a certain brand due to their personal preference) and can thus increase the
firm's market share in the long run.
Note that if monopolies exploit their market power and act against the public
interest, perhaps by deliberately charging unreasonably high prices, then the
go\·ernment can imen-ene to break up their monopoly powers. For example, a merger
between the two largest firms in a market can be prohibited by the gm-crnmem if
there is reason to believe that the monopolist's resulting gain in market share (or
m arket do minance) will act against the interest of the general public. In 2013, Visa
and Mastercard were fined a record $7.25 billion for colluding to fix the credit card
fees that they charged retailers.
Case Study: Prices through the roof

With a large deg ree of monopoly power, firms are able to charge astronomical prices for
some of their products. For example:
• ThemostexpensivecanofCoca-Cola,madeforastronauts, ispricedatS1250percan.
• The world's fastest car, Bugatti's Veyron World, costs a cool €1 .95 million, before taxes
are appl ied .
• The most expensive Barbie doll, which comes with a one-carat pink diamond, sold in
2010forarecordpriceofS302500.
• The world's most expensive barbecue is the 24-karat gold-plated BeefEater Barbecue,
andforthatprivilegeyouhavetopayS165000.
• AtS25000theworld'smostexpensivedessertisachocolatesundae,containinggold
flakes, sold with a golden spoon! Customers can keep the spoon, which is made by
luxury jeweller Euphoria New York.
Disadvantages of monopoly
Monopolies have a number of disadvantages:
• Private -sector monopolies can be inefficient in terms of resource allocation. In
pursuit of profit maximisation, the monopolist can resukt the output of a product
and/ or charge a higher price for it. This creates a Joss in the welfare of consumers
(see Figure 13.2).
• High barriers to emry prevent new firms from entering the market. This limits the
degree of competition and ensures monopolists can continue to charge relatively
high prices.
• As there are no substitutes for the products supplied by monopolists, demand is price
inelastic (sec Chapter 4). Howe\·er, as monopolists are price makers, they can charge
higher prices to maximise profit from the relatively low PED (see Figure 4.6).
• Imperfect knowledge about prices and products means that consumers may not
necessarily make rational choices. For example, the confusing pricing policies used
by utilities companies (gas, telephone, water and electricity) mean that customers
find it troublesome to switch between suppliers, especially as they might not know
if they would be better off. Thus, imperfect knowledge enables monopolists to

maintain market power.
• Monopolists may have less incentive to innovate than firm s in competitive markets.
I nnovation is the commercial exploitation of an invention. The lack of competitive
pressures means that monopolists can become complacent (as there is no need to
be worried about competition), rather than focus on innovations to ensure their
survival.
Adva ntages of monopoly

• As monopolists control market supply, they operate on a very large scale , thus
benefiting from huge economies of scale (see Chapter 14) - that is, lower average
costs of production. This means that monopolists can actually supply larger
quantities of output and at lower prices. This market power can be a source of
international competitiveness against foreign competitors.
• Monopolists ha\·e the financial resources to invest in innovation. Research and
development expenditure can help to generate new ideas, products and production
processes. Innovation can therefore act as a source ofprofit and improve the
productive capacity of the economy. For example, Apple's innovative products, such
as the iPhone and iPad, have made the company the most valuable business on
the planet. Only Boeing and Airbus have the financial resources to commercialise
passenger aircraft such as the 787 Dreamliner and A380.
• Some monopolies can eliminate wasteful competition. For example, it makes more
economic sense to have one monopoly supplier of posral services in a rown, state
or country rather than allowing private-sector firms to compete to provide such
services. This is because profit-seeking firm s may not have much ofa financial
incentive to provide services to remote areas of the country and a single provider
can gain huge economies of scale. The same applies to suppliers ofwater pipes,
railway tracks, telephone lines and elecuicity grids.
Activity
According to Wikipedia, the top five suppl iers in the sugar a nd tobacco industries account
for99percentofthemarketintheUK .
1 Use the internet to resea rch the industries which are most dominated by monopolists in
your own country.
2 In small groups, discuss whether monopolies offer more or less choice for customers.
Think of real-world examples to aid your discussions. Is choice a good thing?
3 Discuss the information you would need in order to assess whether a particular
monopolist benefits consumers.

1 What is meant by 'perfect compet ition'?
2 What are the main characteristics of a perfectly competitive market?
3 What is meant by a 'monopoly'?
What are the main characteristics of a monopoly?
How do barriers to entry to an industry limit the degree of competition in a
market?
6 What are the advantages and disadvantages of a monopoly?
Ke y te rms
Barrierstoentry aretheobstaclesthatpreventotherfirmsfromeffectivelyentering
themarket.Examplesaretheexistenceofintellectualpropertyrights,largeadvertising
budgets of existing firms, and legal constraints to prevent wasteful competition.
Marketstructure referstothekeycharacteristicsofaparticularmarket,suchasthe
numberandsizeoffirmsinthemarket,thedegreeandintensityofpriceandnon-price
competition,andthenatureofbarrierstoentry.
Monopoly is a market structure where there is only one supplier of a good or service, with
thepowertoaffectmarketsupplyorprices.
Perfect co mpetition describes a market where there is immense competition due to the
absence of barriers to entry. This means there are many small firms competing in the
market, none of which has any power to influence market supply or price.
Pricediscrimination isthepracticeofchargingdifferentpricestodifferentcustomersfor
essentially the same product.
A price maker is a firm with significant market power, which means that it can control
enoughofthemarketsupplytoaffectthepricelevel.
Price takers are firms that set their price according to the market forces of demand and
supply,ratherthandeterminingtheirownprices.
@ Business growth

• describe the main reasons for the different sizes of firms (size of market,
capital, organisation)
• describe and evaluate integration, economies and diseconomies of scale.
TakenfromCambriclgelnternationalfxamiMtionsSyllabo,~GC5f0455/0l.evel2281)
O CambridgelnternationalExamiflilbom
Size of fi rm s
In every economy there are firms ofdiffercm sizes. Small firms, such as local grocery
stores or sole proprietors (see Chapter 10), co-exist alongside large multinational
companies such as Walman and Apple. It may be the objective of a fim1 to increase
its market share or to operate in several coumries, and it will therefore put strategies
in place to achieve these aims. A business may start as one store and grow over time.
For example, Starbucks opened its first coffee shop in Seattle, USA, in 1971 and now
has around 20 890 stores in 62 countries. Alternatively a business may choose to stay
small, such as a wedding dress designer, a hairdresser or an owner of a small gift shop.
The size ofa firm can be measured in the following ways:
• The number of employees - In 2013, GlaxoSmithKline, a large pharmaceutical
company, had O\'cr 100000 employees. A small local grocery shop may ha\'C only
five employees.
• The size of the m arket (market share) - For example, Hertz, Enterprise and
Budget car hire companies collectively had 95 per cent of the car hire market in the
USA in 2013. Nestle dominates the food and be\·cragcs market in Pakistan, as it
is the leading company in milk production and related products including yogurt,
milk powder and butter. It also dominates the bottled water market in Pakistan.
• The capita l employed in a firm - This is the difference between the assets of a
firm (what it owns) and its liabilities (what it owes). For example, in January 2013
Walman's capital employed was $203.1 billion, making it the world's largest
retailer.
• The sales tur nover (sales revenue) of the firm. This is measured by multiplying
the unit price ofa product by the quamity sold (see Chapter 12). For example, in
20 12 ExxonMobil had sales tuftlCJ','Cr of $433.5 billion and was the world's largest
firm by this measure.
Firms of all sizes exist in local, national and international markets, and industries arc
often dominated by large firms. For example:
• The SJX)rtS clothing industry is dominated by Nike, Adidas and Puma.
• The tennis racket industry is dominated br Wilson, Prince and Head.
• The chocolate industry is dominated by Kraft, Mars, Nestle and Ferrero Rocher.
The strucmrc ofa firm influences its size. Small businesses tend to be sole traders
or partnerships, while large fim1s tend to be public limited companies that can sell
shares on stock markets to obtain finance (see Chapter 10).
Exam practice
Study Table 14.1.
Ta bl e 14.1 Theworld'slargestcompanies
Profits Ass ets Ma rket va lu e
Ra nk Co mpa ny Co unt ry Sales(S bn) (S bn) (S bnl (billio n)
ExxonMobil 433.S 4407.4
JPMorgan Chase
General Electric
Royal Dutch Shell Netherlands
ICBC China
HSBC Holdi ngs
PetroChina China
1 With reference to the data in the table, identify the industries within
which the world's largest firms operate. [3]
2 Explain why you think these industries can support very large firms. [6)
How do firm s grow?

lntemal growth (organic growth)
• Firms can grow by increasing the num ber of bra nches (stores) within a particular
country or by opening branches in different counuies. They can also expand
by selling their products in a greater number of countries and can finance this
expansion using profits earned within the business. Coca-Cola now sells its cola
drink in all but two countries in the world: North Korea and Cuba.
• Firms can grow by fra nchising. l11is means that an individual or a firm purchases
a licence from another firm to trade using the name of the parent company. The
Subway sandwich chain, established in the USA, has approximately 14 1 stores in
the United Arab Emirates (UAE) and this expansion is due to franchising.
• Firms may attract invest ment fro m larger businesses. For example, the sandwich
chain Pret a Manger funded its expansion through investment in the company by
the fast-food giant McDonald's. Innocent, originally a small UK-based fresh fruit
juice and smoothie manufacturer, is now large enough to supply supermarkets in
the UK and some overseas shops through investment funding from Coca-Cola,
which owns 90 per cent of the drinks company.
Business growth
External growth (inorganic growth)

• Takeovers - A firm can instantly increase its size by buying a majority stake (share)
in another business. For example, the Indian car-maker Tata M.orors rook over the
UK-owned Jaguar and Land Rover in 2008. Tata M.orors is part of the much larger
Tata Group of companies. Kraft Foods took over Cadbury in 201 1 and now has
Cadbury's share of the global chocolate market in addition to its existing share.
Microsoft bought Skype in 201 1 and the purchase enabled the software giant to
gain a larger share of the internet communications industry. Takem-crs can be
hostile, which means that the firm being taken over does not agree to the buyout.
Takeovers can also be agreeable to 00th firms.
• Mergers - Two firms can merge together to form one new company. For example,
the MTRC and KCRC railway companies in Hong Kong merged in 2007 to
become one company, which now is the only provider of railway and underground
raihvays services in Hong Kong. They haw formed a natural monopoly (see
Chapter 13) and any fare increases must be appro,-cd by the government. Another
example of a merger is pharmaceutical giants Glaxo Welkome and SmithKline
Beecham (forming GlaxoSmithKline) in a deal worth $75.96 billion back in 2000.
Microsoft'spurchaseofSkypeenabledthesoftwaregianttogainalargershareofthe
internet communications industry
Types of integration
Integration refers to the combining of two or more firms, either through a merger or
a takeover.
Horizontal integration
Horizontal integration occurs when two fim1s in the same sector ofindusuy
integrate together, by either a merger or a rakem'er. For example, AG Barr is a
Scottish manufucrnrer of the soft drinks Im Bru, Tizer and Rubicon, and wishes to
merge with Britvic, another soft drinks manufacturer that makes Robinsons Barley
Water, J20 and Fruit Shoots.
The proposed merger of Barr and Brit vie would create one of Europe's largest soft
drinks companies
The two combined businesses can benefit from:

• getting an increased market share
• gaining skilled employees from one another
• operating with fewer employees (as there is no need to hire two finance
departments, for example), so this may reduce costs
• raking advantage of economies of scale.
However, the potential costs or drawbacks include the following:
• There may be duplication of resources and therefore some workers may be made
redundant - that is, Jose their jobs. Redundancies can cause anxiety, lead to
demotivated staff and cause a decrease in productivity.
• The newly formed larger firm may fuce increasing costs arising from diseconomies
of scale (see below).
• The combined firm may suffer from a culture clash if the two businesses are very
different. This may initially cause communication and organisational problems.
Vertical integration
Vertical integration occurs when a firm from one sector ofindusuy merges with,
or is taken over by, a firm from another sector of industry. 111ere are two types of
vertical integration: backward and fonvard.
Business growth
Backward vertical integration
Backward vertical integratio n occurs when a firm from the secondary sector of
industry merges with a firm from the primary sector, or a firm from the tertiary
sector merges with a fim1 from the secondary sector. For example, a factory in China
that makes chicken nuggets for McDonald's might buy a chicken farm. The chicken
farm supplies the factory directly with live chickens and the eggs produced arc sold to
McDonald's outlets for their breakfast products.
The benefits of backward \·cnical integration in the previous example include the
following:
• The firm in the secondary sector has conuol o\·cr the quality of raw materials with
which it is supplied.
• There is no wastage as all produce from the primary sector can be used.
• The price of raw materials falls as the manufacmrcr docs not have to pay another
(cxtcrnal) firmforthcrawmaterials.
However, there arc also costs of backward vertical integration in the example:
• Costs of running the farm in the primary sector increase total costs as more land,
labour and capital resources arc required.
• Transport costs increase for the integrated firm as raw materials were previously
delivered by external suppliers.
Fo r ward vertical integratio n occurs when a firm from the primary sector of
industry integrates with a firm from the secondary sector, or a firm from the
secondary sector integrates with a firm from the tertiary sector. For example, Apple,
Levi's and Replay all own shops in which to sell their manufactured products. Shell,
the global oil company, owns its entire chain of production: oil mines, oil processing
plants and the petrol stations where consumers purchase fuel for their cars.
Apple has shops all over the world dedicated to selling its own goods. Here is its flagship
storeinlondon'sRegent'sStreet
Activity
In groups, think of examples of how firms grow globally. What about in your home country
or a country of your choice? Can you identify examples of internal growth, external growth
and types of integration?
Exam practice
Tyrrells is a UK manufacturer of hand-cooked crisps (chips) which are made from
potatoes and other root vegetables. The owner of the business, Will Chase, was
originally a potato farmer, who sold his crop to supermarkets. The price of potatoes
started to fall and he decided to add value to his potatoes by making them into
packaged snacks in 2002. He invested in capital equipment and employed more staff
to make the product. and his decision led to an increase in revenue and growth of the
business, which is now worth over $28.4 million.
1 Identify the method of growth used by Tyrrells. [1)
2 Explain two advantages of Tyrrells expanding into manufacturing industry. [4)
3 Explain two reasons why production costs may have fallen after the expansion. [4)
Conglomerate integration
Conglomerate integration (also known as lateral integration or diversification)
occurs when finns from different sectors ofindusrry, which operate in unrelated
areas of business, merge or are taken over by another firm. They may form a single
company or be pan ofa large group of companies. For example, ifa clothing
manufacturer merges with a chocolate producer, the two firms are in the secondary
sector of industry but operate in different areas of manufacturing. They can
rake advantage of risk-bearing economies of scale (see below), as diversification
spreads risk.
Business growth
An example ofa conglomerate is the Tata Group, which has over 100 different
companies in its portfolio, ranging from hotels and hospitality enterprises to mining
and air conditioning. Another example is the Swire Group, which owns businesses
that operate in many different markets, including retailing, beverages, aeronautical
operations, property de,-clopmem, mining and car trading.
Diversification spreads risks because the firm has a number ofbusinesscs in different
sectors of industry and therefore a fuiling business, which is pan of a larger group, may
be protected by the successful businesses within the group's larger portfolio.
However, the conglomerate may become too diverse and this may cause problems
with the management of capital and human resources. !fa segment of the diversified
firm is under-performing, it may drain resources from other areas of the business.
Pacific Place, a shopping mall complex in Hong Kong, is one of the core holdings
of the Swire Group's property portfolio
lnlema l lcxgan lcl g""""1h
I
HOW BUSINESSES
GROW
Figure 14.1 How businesses grow

Study tips Why do small firm s co-exist beside large firm s?

Although it is Large firms arc able to take advantage of economies of scale (see below) and
the aim of many therefore their average costs of production arc lower than those of a small firm.
firms to expand In many economics there arc small grocery stores alongside large supermarkets.
andincreasetheir
marketshare,it
Supermarkets provide customers with:
is not always the • a wide choice of particular products, such as various types ofyogurt, cheese or
casethat'bigis wine
best'. Afirmthat
becomes too • a wide product range, as in one store you can buy fresh milk, a pair of shoes, a tea
large may lose potandahairdryer.
its appeal and Modern supermarkets often have other facilities for customers, such as a cafC, a petrol
its products may
become mass (gas) station and a cash point (ATM). Supermarkets also have free parking facilities
produced and and therefore provide one -stop shopping.
therefore lack Small grocery stores have to find a way to compete with supermarkets and they do
character. Large so by providing a range of goods which cannot be bought in a supermarket, such as
hotel chains can specialty cheeses and wines.
guaranteealevel
of service which
The small grocery store may be located in a remote area and be the only local seller
is of high quality ofprovisions. It may provide a personal shopping experience, as compared with the
and matches self-service style of a supermarket. Smaller shops can also adapt quickly to changing
their4-or5-star consumer tastes: for example, a small bakery may make more brown bread to cater
rating,butthe for an increase in demand, and a small, independently run , magazine shop will order
experience for titles for individual customers.
the consumer
is the same Examples of products and services provided by small shops are made -to-measure
regardless of clothing and custom-made furniture. They tend to focus on smaller markets and may
country location. cater for specific tastes and for people with higher incomes.
There will always
be a place in Econo mies of sca le
the market for
small or boutique One meaning of the word 'economy' is reduced expenditure or saving, while the
hotels offering word 'scale' refers to size. Therefore the phrase 'economies of scale' means that
a high-quality average costs of production fall as a firm grows or increases output.
and unique
experience.
Internal economies of scale
Internal economics of scale arc cost savings that arise from within the business.
• Purchasing or bulk-buying economics of scale occur when the cost of raw materials
falls as they are bought in large quamities.
• Technical economics of scale occur as large firms can affurd to purchase expensive
pieces of machinery and automated cquipmcm for the manufacturing process.
Large firms also produce in large quantities and therefore the high initial cost of
the equipment can be spread across the high quamity of goods produced.
• Financial economies of scale occur as large firms arc able to borrow money from
banks more easily than small fim1s because they arc perceived to be Jess risky to
financial institutions. A large firm will also have a greater number of assets that
canactassecurityforaloan.
Business growth
• Managerial economies of scale occur as large firms have the resources to employ
specialists to undertake functions within the firm: fur example, accounrams, engineers
and human resources specialists. H igh salaries paid by large firms will attract experts.
• Risk-bearing economies of scale occur as large firms rend to produce a range of
products and operate in many locations. This diversity spreads risks as weak sales in
one coumry can be supported by strong sales in another. Samsung makes a range
of products and if one product is experiencing decreasing sales then this Joss can be
balanced by increased sales of another product.
• Research and development economies of scale occur as large firms may be able
to fund research and development, and therefore can be innovative and create
products that enable them to be leaders in their area of business. For example,
GlaxoSmithKline is a large pharmaceutical company rhar invests heavily in research
and development (R&D), spending around 15 per cent ofirs sales revenue (or
around $6.26 billion) on ir.
• Marketing economies of scale occur as big firms tend to have a large advertising
budget and therefore can spend large amoums of money on promoting their
products. For example, a Nike or IKEA advert exposes all products under the Nike
brand and all products sold in I KEA in a cost-effective way.
Activity
1 a) Look for examples of bulk buying economies of scale in your local supermarket. For
instance, compare the cost per g ram of a large bag of rice with that of a smaller bag
of rice.
b) Study the labels on the supermarket shelves to find three more examples of
purchasingeconomiesofscale. Bepreparedtoshareyourfindings.
2 11) Make a list of the names of businesses that advertise using b illboards and on
television.
b) Consider what the firms have in common. Are they large or small firms?
c) Do the firms tend to be public limited companies (see Chapter 10) or smaller, privately
owned firms?
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ECONOMIES OF SCALE
Figure 14. 2 Economiesofscale
Ex terna l economies of scale

External economies of scale are economies of scale that arise due to the location of
the firm and are therefore external to the business. Examples of external economies
of scale are:
• Proximity t o relat ed firms - Tirupur in India is renowned for textile and
garment manufacturing. A garment manufacturer will benefit from having firms
that produce zippers, buttons, thread and fabrics located nearby, as this will give it
easy access to its suppliers and reduce transport costs.
• Ava ilab ility of skilled labou r - In Tirupur there is a pool of skilled mad1inists
and pattern cutters. This should make recruitment of textile workers with the
necessary skills relatively easy.
• T he rep utatio n of the geograph ica l area - This provides a firm with free
publicity and exposure. For example, Silicon Valley in California, an area with a
worldwide reputation for software creation and the development ofinformation
technology systems, has a large number of suitable skilled workers.
• Access to t ra nsport - Manufacturing firms benefit from being located near to
major road nenvorks, pons and cargo facilities. A cafe or restaurant will benefit
from being close to other shops, public transport links and parking facilities.
China has in\·ested heavily in developing its infrastructure to facilitate efficient
transportation offinished goods to ports and airports. l11is gives it a competitive
advantage over India, where road and rail networks are less developed.
Disecono mies of scale DISECONOMIES

OF SCALE
Diseconomies of scale arise
when a firm gets roo large and
average costs of production
stantorise. Therefore, the I
/ -··-r-·
these rai se
disadvantages of growth start to
outweigh the advantages. ~
Reasons for increased average pcore<comITTJnlootioo ,bwerded,on maki ng bclo!mdlvatioo
costs of production include the
Figure 14.l Diseconomiesofscale
following:
• Communication issues may arise when a firm becomes toO large. There may be too
many branches to control and communicate with effectively, and decision making
may be slow due to the number of people in the communication chain. This may
lead to increased costs of production.
• A merger between two firms may be unsuccessful due to a clash of cultures, so it
may be beneficial to demerge. In 2010 the Fosters Group, which produces beer,
sold off its Jess profitable wine business as the merger had not brought about
benefits of economies of scale. The demerger allowed Fosters to focus on beer
production again.
• It may be necessary to employ more employees for all the branches of the firm,
or a new factory may need to be built to accommodate the increased level of
production. This will add to total costs ofprcxluction and average costs of
production may rise.
Business growth
Study tips • Workers within a large organisation may find it difficult to fuel parrofa large firm,
In the real world
so this may lead to a lack of motivation and reduced productivity. Thus average
it can be difficult costswilltendtorise.
for firms to • The business may become too diverse and start to operate in areas in which it has
determine when less expertise. Reduced conuol and co-ordination may cause costs to increase.
they have reached Again, this can lead firms to demerge.
their lowest
average cost
and therefore
their ideal level Ecooomie,cl=ile D;socooomles dscole
of production.
Many factors
influence costs, Bu l b...y~ Avemgecos1' ~ roo nl catk:J n problem,
and firms operate i\o\orke!lng doshclC1J l1.J re,
in a constantly
changing
environment. A
""""""'
Flnanck:J I
Rlskboo ri ng
Need1o 1n creo,eploot.s.1ze
lossclooffmorole
Redx:edcrn~Ofldcooo:J inatlon
Toch nl ca l
firm's decision RW
to downsize or
demergefrom
anotherfirmmay
bebasedonnon- Figure 14.4 Economiesanddiseconomiesofscaleandaveragecosts
costreasons,such
as difficulties in
control and co- Exam practice
ordination, high
In 2010 two telecommunications companies, T-Mobile and Orange, merged and
staff tu rnover or
alossoffocus. became one firm. After the merger, customers of Orange and T-Mobile could switch
between networks and the combined firm was able to reduce the number of aerial
masts required and have an increased share of the market.
The two brands are owned by a company called Everything Everywhere, which in
September 2012 changed its name to EE. EE will provide 4G services to its customers and
T-Mobile and Orange will continue to serve their own segments of the market. T-Mobile
is considered to be a value-for-money brand and Orange a more premium brand.
1 Identify and explain three types of economies of scale which could be
achieved by the merger. (6)
2 Explain two diseconomies of scale which may arise in the future. (4)
3 Discuss the advantages and disadvantages of the merger between the two
telecommunication firms. [7]
Chapter r eview q uestions

1 What are the two ways in which a fi rm can grow?
2 How can the size of a firm be determined?
3 Why do small firms co-exist beside large firms in all economies?
4 What are the six main types of internal economies of scale?
What is meant by the term 'diseconomies of scale'?
Which types of external economies of scale could be experienced by several
car manufacturers located in a region of a country?
7 What are the advantages and disadvantages of two supermarket chains merging?
8 What are the advantages and disadvantages of a film production company
merging with a chain of cinemas?
Keyt'erms
Averagecosts arecakulatedbydividingtotalcostsbythenumberofunitsproduced.
Backward vertical integration occurs when a firm from the secondary sector of industry
merges with a firm from the primary sector, or a firm from the tertiary sector merges with a
firmfromthesecondarysector.
Cong lomerate integration occurs when a merger or takeover occurs between two firms
fromunrelatedareasofbusiness .
A demerger occurs when two previously merged firms decide to break up and become two
separate firms .
Diseconomies of scale occur when average costs of production start to increase as the size
of a firm increases.
Economies of scale occur when average costs of production fall as the size of a firm increases.
External economies of sca le are economies of scale that arise from factors outside of the firm,
such as the location of the firm, proximity to transport and availability of skilled workers.
Financial economies of scale occur as large firms are able to borrow money from banks more
easilythansmallfirmsbecausetheyareperceivedtobelessriskytothefinancialinstitutions.
Forward vertical integration occurs when a firm from the primary sector of industry merges
with a firm from the secondary sector, or a firm from the secondary sector merges with a
firmfromthetertiarysector.
Horizonta l integration occurs when two firms in the same sector of industry and the same
industry merge.
Internal economies of scale are economies of scale that arise from the internal organisation
ofthebusiness-forexample,financial,bulk-buyingandtechnologicaleconomiesofscale.
Managerial economies of scale occur as large firms have the resources to employ specialists
toundertakefunctionswithinthefirm,suchasaccountants,engineersandhuman
resources specialists.
Marketing economies of scale occur as big firms tend to have a large advertising budget
and therefore can spend large amounts of money on promoting their products.
A merger occurs when two firms join together to make one firm .
Purchas ing or bulk-buying economies of sca le occur when the cost of raw materials falls as
theyareboughtinlargequantitiesthusreducingtheaveragecosts.
Researchanddevelopmenteconom iesofscale occuraslargefirmsmaybeabletofund
researchanddevelopment,andthereforecanbeinnovativeandcreateproductsthat
enablethemtobeleadersintheirareaofbusiness.
Risk-bearingeconomiesofscale occuraslargefirmstendtoproducearangeofproducts
andoperateinmanylocations.
A takeover occurs when a firm is taken over by another firm . A takeover may be hostile or
thetwofirmsmayhaveagreedtothetakeover.
Techn ica l economies of scale occur as large firms can afford to purchase expensive pieces of
machinery and automated equipment for the manufacturing process.
Vertical integration occurs when a takeover or merger takes place between two firms from
different sectors of industry.
@ Government aims and influences
• describe the government as a producer of goods and services and as an employer
• discuss the government's influence (regulation, subsidies, taxes) on private
producers
• describe the aims of government policies, such as full employment. price
stability, economic growth, redistribution of income, balance of payments
stability
• discuss the possible conflicts between government aims.
Taken from Cambridge International Examir,abom 5';11abus (IGCSE 0455/0 Level 2281)
0 Camb<klge lntematkmal Examir,atioo,
The ro le of governm en t in a n econo my

The government plays a key role as a producer of goods and services and as an
employer.
As a producer, the go\·ernmem supplies goods and services to the general public.
For example, it will provide:
• Public goods - These products are non-excludable and non-rivalrous in
consumption. Examples are national defence, law and order, street lighting, flood
control systems, public fireworks displays, lighthouses, online search engines and
public roads.
• Merit goods - These products are deemed to ha~·e social benefits yet are
under-consumed without gm-ernmem imen-emion or provision (see Chapter 5).
Examples are education, health care services, work-related training schemes and
public libraries.
Servicesprovidedbythegovernment
Exam practice
1 Distinguish between public goods and merit goods. (3)
2 Analyse the reasons why a government might choose to provide public goods
and merit goods. [6)
Government aims and influences
• Public services - In many countries, the go,'ernmem also directly provides other
essential public services, such as postal services, public transport systems, the
emergency services (fire, police and ambulance) and immigration services. In some
countries, the gm'Crnment goes further to provide public utilities services (such
as gas, electricity and telecommunications) and terrestrial television broadcasting
services. These services are not run in the same way as they would be if private-
sector firms were seeking to maximise profits.
• \Velfare ser\'ices - In mixed economic systems (see Chapter 2), the government
provides social and welfare services to people in need. These include transfer
payments such as unemployment benefits and state pension schemes for the elderly.
The New Zealand government, for example, spends about NZ$12 billion
($9.88bn) each year on transfer payments.
In order to pfO\'ide these goods and services, the go,·emment must employ factors
of production (see Chapter 1), including Jabour. Thus, the go,'Crnment can ha\·c a
significant role as an employer - especially those governments that operate a mixed
or a planned economic system (sec Chapter 2). For example, in countries such as
Australia, France, the USA and the UK, the government is a large employer of
teachers, health care workers (such as surgeons, doctors and nurses) and urban
planners.
Government influence on private producers

Governments influence private producers through the use of regulation, subsidies
and taxation policies.
Regulation
Go\·ernmcnt regulatio ns determine the boundaries within which private producers
can operate. Examples are the use of employment legislation, consumer protection
laws, environmental protection, competition laws and intellectual property rights.
• Employment legislation - These regulations protect the interests and safety
of employees. For example, privatc·sector producers should comply with anti-
discrimination laws which help to ensure that firms treat their workers fairly,
regardless of their age, gender, race or religion.
Activity
Research the employment laws that exist in your country or a country of your choice. How
dotheselawsimpactonprivate-sectorproducers?
• Con sumer protection laws - These regulations require private -sector firms to
provide truthful descriptions of their goods and services, which must also meet
minimal quality standards. Finns that pfO\'ide demerit goods and services such as
gambling, tobacco and alcohol are also heavily regulated to protect consumers. For
example, cigarette advertising is banned in countries such as South Africa, Pakistan
and Australia. Tobacco ad,'Crtising has been banned throughout Singapore since
1971. In most countries, cigarette packaging must also carry highly noticeable
health risk warnings.
Role of government in an economy
• Environmenta l protectio n - Laws exist to prevent or reduce the damage to the

environment caused by private -sector firms , such as pollution and the depletion
of scarce resources. For example, Japan's government has imposed several types of
fishing ban to preserve the world's supply offish and whales. Regulation of carbon
emissions also limits the potential damage to the environment caused by private
producers.
TheEuropeanParliamentvotedtobackfishingpolicyreforminFebruary2013,banningthe
wasteful practice of throwing away healthy fish at sea. Here, Green Party members hold up
bannersshowingfishsaying'thankyou'
• Competitio n law - GcNemmenr regulation is used to prevent anti-competitive

practices of private-sector monopolists (see Chapter 13). This helps to protect
consumers and smaller firms that are less competitive. For example, in most
countries, it is illegal for firms to engage in price fixing to raise prices and thus
charge consumers unjustifiably high prices.
• Intellectua l property rig hts - To encourage innm'ation and to safeguard the
imerest of producers, the government can use copyright, trademark and patent Jaws
to protect the intellectual property of firms. These give private-sector firms legal
protection against rival firms copying or imitating their products or inventions.
Recent high-profile cases include Apple versus Samsung smartphone battles
(see the Activity below) and Cadbury versus Nestle on whether you can copyright
a colour.
Activity
Use the internet to investigate the legal battle between Apple and Samsung in the
smartphone industry, following accusations that they were copying each other's
technologies. Why do firms such as Apple and Samsung seek to protect their intellectual
property?
S ubsidies
A su bsidy is financial assistance provided by a government to reduce the costs of
production for firms. Subsidies are used to encourage output and consumption of
certain goods and services. Governments often provide subsidies for educational
services, employment purposes, public transport, tourism and agricultural ourpur.
Subsidiesareoftenusedfortheprovisionofeducation
Exam practice
The Mass Transport Railway (MTR) is Hong Kong's railway system and runs both
underground and overground services. Founded in 1979, the MTR offers an efficient
and affordable public transport system, serving t:Ner 4 million passengers on an average
weekday. The government provides subsidies for travellers, including young children and
the elderly. All retailers that operate at MTR stations pay rent to the MTR Corporation,
thus allowing the organisation to keep fares at a low rate for all MTR travellers.
1 Whatisasubsidy? (2)
2 Explain why the Hong Kong government might want to subsidise public
transport systems such as the MTR. (4)
Taxes
A tax is a levy or charge imposed by a government to raise costs of production and
to reduce consumption of certain goods or services. Governments can use direct
ta xes (imposed on income, wealth or profits) to reduce income inequalities in the
economy. They can also use indirect taxation (imposed on spending) to affect
consumer expendimre. Indirect taxes include sales taxes and excise duties on items
such as petroleum, alcohol, tobacco and air passenger travel. The government can
also impose tariffs (import taxes) to discourage the purchase of foreign goods and
services in order to protect domestic businesses and jobs.
The government can then spend its tax revenues to fund items ofpublic·sector
expenditure including: social security, national defence, law-and-order systems,
transport, infrastructure, health care and education (see Chapter 16). Taxes are
covered in more derail in Chapter 17.
Aims of government policies

Go\·ernmem policies tend to be aimed at achieving the five key macroeconomic
(economy-wide) objectives: full employment (or reduced unemployment), controlled
inflation (price stability), sustainable economic growth, the redistribution ofincome
(lo\\'Cf income inequality) and balance ofpaymems stability.
Full employment (or low unemployment)

Unemployment refers to people who are out of work, but who are of working age, are
physically and men rally able to work, and are actively looking for work. Governments
strive to reduce the unemployment rate - the proportion of a country's workforce
who are unemployed. Chapter 19 co,aers employment in more derail.
Price stabili ty (co ntrol of inflation)

Inflation refers to a persistent rise in the general level of prices in the economy.
Low and sustainable rates of inflation are viral to achieving economic stability and
social wellbeing. For example, inflation reduces the imernational competitiveness of
a country as its prices will be relatively higher. T his will lead to lower export sales,
thus causing potential job losses. Inflation can be caused by excessive aggregate
demand (total demand ) in the economy. This is known as d emand-pull inflatio n .
By contrast, cost-push inflation is caused by higher costs of production. Chapter
18 co\·ers price stability in more detail.
Econo mic g row th

Econo m ic growth is the increase in a country's gross domestic. product (GDP)
o\·er time. Achieving economic growth brings greater prosperity to an economy and
therefore tends to raise the standard ofliving for most people. Economic growth can
be achieved by increasing the quantity and/or quality of factors of production, such
as through education and training. Discovering resources such as oil will increase the
potential output ofan economy. Chapter 20 covers economic growth in more derail.
Exam practice
Most countries face the ongoing problem of striving to achieve economic growth and
reducing unemployment. For example, Spain and Greece experienced unemployment
rates of around 27 per cent in 2013 due to the continuing global financial crisis. In
2008, Zimbabwe's inflation soared to an astronomical 231 million per cent!
1 Define the terms 'economic growth' and 'unemployment'. [4)
2 Explain why the control of inflation is a key macroeconomic objective. [4)
Begging has been outlawed in Greece since 2003, but the recent unemployment hike has
increased levels of occu rrences
Redistribution of income
As an economy grmirs, the gap between top and bottom income earners tends to
widen. For example, huge bonuses are often awarded to executives in the finance
industry. This causes greater income inequalities in the economy. The go~·ernment
might therefore intervene by using progressive taxes (see Chapter 17) to redistribu te
income to low-income households. In some cases, the government could even cut
taxes for low-income groups to improve their standard ofliving.
Exam practice
In 2013, two British banks, Barclays and the Royal Bank of Scotland, awarded a total
of 521 employees more than £1 million ($1.Sm) each, despite the world still recovering
from the global financial crisis. By contrast, US investment bank JP Morgan Chase
announced 19000 job cuts between 2013 and 2014.
1 Explain what is meant by 'income equality'. (2)
2 Suggest why a government might want to redistribute income within its country. [4)
Study tips Balance of payments stability

The five main The balance of payments is a record of a country's financial transactions with other
government nations. This includes the money flows into and out of a country from the sale of
objectives can be eX(X)rtS and the purchase ofimports. If the money inflows exceed the outflmirs,
remembered by then a balance of payments surplus exists. I fthe outflows exceed the inflows, the
using the acronym
GETUP - growth, country has spent more than it has earned, so a balance ofpaymems deficit occurs.
environment, While a deficit drains money from the country, a balance of payments surplus can be
trade(balanced), inflationary in the long nm due to the excess amount of money entering the coumry.
unemployment Gm·ernments therefore tend to aim to achie~·e a balance ofpaymems equilibrium.
(low)andprice Chapter 24 co.·ers the balance ofpayments in greater derail.
stability.
Conflicts between government aims
As it is not possible simultaneously to achieve all five macroeconomic objectives,
there is said to be a trade-off or conflict between these targets. Examples ofpossible
conflicts between a government's macroeconomic goals are considered below.
• Economic growth versus low inflation - !f an economy grows due to excessive
consumer demand, this will force prices to increase, thus creating inflation in
the economy. Similarly, the government might choose to deflate the economy to
control inflation, but this limits the ability to achieve economic growth. Therefore,
it is rather difficult to achieve both macroeconomic objectives at the same time.
• Low unemployment (or full employment) versus inflation - In theory,
there is an inverse relationship between the le\·el of unemployment and the rate
of inflation. For example, an attempt to reduce unemployment via the use of
expansionary fiscal policy (see Chapter 16), such as lowering taxes or increasing
gm·ernment spending, can cause demand-pull inflation (see Chapter 18). Similarly,
when the government tries to control inflation by using deflationary policies such
as higher taxes or higher interest rates (see Chapter 16), the resulting fall in both
consumer spending and investment will result in job losses.
• Econo m ic grow th versus a bala nce of payments equilibrium - Consumer

spending and business im·estmems tend to be high during an economic boom.
However, if this is fuelled by a significant rise in spending on imports relative
to exports, this leads to a worsening trade deficit on the coumry's balance of
paymems.
• Econo m ic grow th versus protection of the environment - Economic growth
often leads to environmental problems such as land degradation, climate change ,
pollution and the depletion of non-renewable resources.
Case Study: Jakarta's traffic congestion
Jakarta, Indonesia's capital city, is renowned for having one of the world's worst traffic
problems. The government tried to build a mass rail transit system in the city in 2004 to
dealwiththecongestionproblems,butthelackoffundsputtheprojectonhold. The
problems of congestion and poor air quality do not seem to be slowing down as Indonesia
sawa27percentincreaseinthedemandfornewcarsbetween2012and2013.
• Econo m ic grow th versus the redist ributio n of income a nd wealth - As an

economy grows, there tends to be a widening income and wealth gap between the
rich and the poor (see the Case Study on page 171 ).
Study tips Case Study: T he wo rld 's ric hest people

It is possible for TheForbes Richlisti s anannual listofthe world's wealthiest billiona ires. The top ten
a government wealthiest people o n the planet in 2013 had a combined wealth of S4S1 .S billion - that is
to achieve its more than the combined GDP of the United Arab Emirates, Sri Lanka and Mauritius, and
macroeconomic onlyslightlylessthanthe combinedGDPofNigeriaandPakistan!
objectives Mexican telecoms tycoon, Carlos Slim, is the richest man in the world with a total wealth
without conflicts of Sn billion - or the equivalent of the average annual salary of over 6.94 million people in
occurring .For the country!
example.it
is possible to Table 15.1 Thetenwealthiestpeopleintheworld,2013
achieve low Ra nk Wealth(Sbn) Co mpa ny/indu stry
inflation along
with economic Carlos Slim Telecoms
growth through Bill Gates Microsoft
theuseofsupply-
Amancio Ortega
sidepolicies(see
Chapter16). Warren Bullett BerbhireHathaway
Similarly.if Larry Ellison Oracle
economic growth
Charles Koch Diversified
isexport-led(as
in the case of David Koch Diver!.ilied
China's growth LiKa-shing Diversified
over the past
three decades), LilianeBettenc:ourt l'Oreal
itwillnotleadto 10 BernardAmault
a deficit on the
current account
of the balance of
payments.
Cha pte r r eview questio n s
1 What does it mean by the government being a producer and an employer?
How do regulat ions, subsidies and taxation affect private-sec tor firms?
Wha t are the five major macroeconomic aims?
4 Explain how t here might be possible conflic ts between th e macroeconomic
aims.
5 Why might it be possible for a government to achieve its macroeconomic
objectives without conflicts occurring?
Ke y t e r ms
An emp loyer is a person or a firm that hires other workers to an organisation.
A producer is any firm that deals in the production and/or provision of goods and services.
Regulatio n referstotherulesandlawsthatgovernbusinessbehaviourintheeconomy,
such as employment laws, consumer protection legislation and environmental protection
laws.
Subsidies arefinancialsupportfromthegovernmenttoreducethecostsofprivate-sector
firms . They are used to encourage output and consumption of certain goods or services,
such as public transport.
Taxes areleviesorchargesimposedbyagovernmenttoraisethecostsofproduction
andreducetheconsumptionofcertaingoodsorservices,suchastobacco,alcoholand
petroleum.
@ Government policies
• explain fiscal, monetary and supply-side policies
• analyse the use of fiscal, monetary and supply-side policies.
TakenfromCambfidgelnternationalExamiJlabomSyj!abus (IGCSE0455/0level2281 )
Fisca l policy
Fiscal policy is the use of taxation and government expenditure strategics to
influence the Je~·el of economic activity and macroeconomic objecti\'es such as
employment, economic. growth and the control of inflation. For example, taxation
(sec Chapter 17 ) can be used to redistribute income and wealth to benefit less
wealthy members of society. Gm'Crnmem spending can be used to improve standards
ofliving, such as building schools, hospitals and uansponation networks.
Gover nment
spending
Corporation tax ""'";o,

. . . . . . . . °""""
Import taxes Roads
Figure1 6.1 Taxrevenuesandgovernmentspending
There are other sources of government revenue (such as go\·ernmenr OOrrowing and
the proceeds from privatisation, the selling of state assets) but tax revenues are by far
the most significant source. lf the government manages to balance its re\·enues and
its spending, then a ba lanced budget is said to exist.
Howe\-cr, if the government spends more than it collects from its revenues then
a bud get deficit exists. And if there is more government revenue than is spent, the
government has a budge t su rplus.
In the long run, governments strive to balance their budgets. This is partly
because increasing government revenues by raising raxes is highly unpopular, while
government borrowing to fund a budget deficit is hugely expensive due to the
amount ofimerest owed on such loans.
Activity
Investigate the latest government budget in your country or a country of your choice.
Evaluateitsstrengthsandweaknessesandthe impactonvariouseconomicagents,suchas:
• fixed-incomeearners
• theelderly
• families
• businesses
• home-owners.
Government policies
lntheUK,aredcaseisusedtorepresentthebudgetboxandis
held up for a photo shoot outside 11 Downing Street, when the
ChancelloroftheExchequerannounceshisannualbudgetplans
Use of fiscal policy

Fiscal policy can be used either to expand or to contract economic activity in order to
achieve macroeconomic objectives and to promote economic stability.
Expansionary fiscal policy is used to stimulate the economy, by increasing
government spending and/or lowering taxes. For example, by increasing social
security payments (such as unemployment benefits or state pensions), domestic
consumption should increase. This type of fiscal policy is used to reduce the effects
of an economic recession (see Chapter 20), by boosting gross domestic product and
reducing unemployment.
By contrast, contractionary fiscal policy is used to reduce the le\'el of economic
activity by decreasing go\"ernment spending and/or raising taxes. For example,
countries such as China and the USA have used property raxes to slow down
escalating house prices. Contractionary fiscal policies are used to reduce inflationary
pressures during an economic boom (see Chapter 20).
Case St udy: China's housing bubble

China's phenomenal economic -----
growth rate fuelled the demand
for housing, making house prices
skyrocket. Lowinterestratesand
increasedbanklendingwere
furthercausesoftheso-called
'hous ingbubble'inChina. The
governmentsteppedintoslow
down the housing market. In 2013,
government measures included
higherstampduties(propertysales
taxes)andtherequirementtohave
aminimum60percentdepositfor
existinghomebuyerswishingto
purchase a second property. Contractionaryfiscal policieshavebeenusedin
Mainland Chinese homebuyers China to slow down the housing market
wishing to purchase property in
neighbouring Hong Kongalsofacedhigherbarriers,includinganadditional
1Spercentsalestaxfornon-permanent residents.
Fiscal policy is also used to redist ribute incom e and wealth in the economy. Some
countries have quite high rates of income tax to reallocate resources from wealthier
individuals to the poorer members of society. Examples include Austria, Belgium,
Cuba and Senegal, which all have a top tax rate of SO per cent. H igh income tax rates
can, however, cause severe distortions to the Jabour market.
Fiscal policy can also be used in conjunction with supply-side po licies (sec below)
to afrect the productive capacity of the economy, thus conuibuting to long-term
economic growth. Examples of how fiscal policy can impact the supply side of the
economy include:
• Incentives to wo rk - Cuts in income tax can be used to create incentives for
people to seek employment and to work harcler. Some economists argue that
reducing social wclfure assistance such as unemployment benefits can also create
incentives for people to seek employment. Go,ernment support for business start·
ups can also create incentives for cmreprcncurs and business creation.
• Inves tment expenditure - Government capital expenditure on infrastrucmre
(such as railroads, mororways, schools and hospitals) helps to boost imcsm1cnt in
the economy. Lower rates of corporation tax can also help to attract foreign direct
investment in the country, thereby boosting the economy's potential output.
• Human capital expend iture - This refers to government expenditure on the
workforce by investing in education and training. Such fiscal policies arc designed
to boost the productivity oflatxmr (or the human capital of the workforce).
H uman capital expenditure is often accompanied by government spending on
health care and transportation networks, as these help to raise labour productivity
(sec Chapter 11).
Limitations o f fi scal policy

There are three main limitations ofusing fiscal policy to control the level of
economic activit y: problems with the timing (time Jags), conflicting macroeconomic
objectives and political considerations.
There are three problems with the timing of fiscal policy:
• Recognitio n lags - There is a time lag in recognising that government
intervention is needed to affect the level of economic activity. This is because
governments do not necessarily know if the economy is growing too fust (or
declining roo quickly).
• Administ rative lags - There is a time delay between recognising the need for
fiscal policy inteffention and actually implcmcntings appropriate action, such as
approving tax changes or alterations to the go\-crnmcnt budget.
• Impact lags - There is a time lag between implementing fiscal policy and seeing
the actual efrects on the economy. A cut in income tax, for example, will take time
to have a significant impact on the spending habits of households.
A second limitation of fiscal policy is that of conflicting macroeconomic objectiws
(sec Chapter 15 ). For example, the use of expansionary fiscal policy can certainly help
to achieve economic growth, but a combination of tax cuts and increased government
spending can ft1cl domestic inflation. By contrast, contractionary fiscal policy can
help to control inflationary pressures but might cause unemployment in the economy.
A final limitation of fiscal policy is its associated political problems. The political
cycle (of re-electing political leaders and political panics) can cause artificial shocks
Government policies
to the business cycle (see Chapter 20). For example, expansionary fiscal policy might
be used prior to a general election to boost the votes of the governing parry, rather
than to tackle fundamental economic problems. Such practices can lead to higher
government debts due to tax cuts and increased government spending.
Exam practice
1 Explain why expansionary fiscal policy can cause a budget deficit for the
government. (4]
2 Examine how fiscal policy can be used to promote long-term economic
growth. [6]
Mo netary policy
Monetary policy is the manipulation ofimerest rates, exchange rates and the money
supply to control the amount of spending and im·estment in an economy. !merest
rates can refer to the price of borrowing money or the yield from saving money at
a financial institution. The money supply refers to the entire quantity of money
circulating an economy, including notes and coins, bank loans and bank deposits
(seeChapter6).
Direct control ofthe mo ney supply is relati\"ely difficult, as the definition
of money is quite loose and banks can create credit quite easily (see Chapter 6).
Manipulation of excha nge rates (see Chapter 25) is also rather difficult for
many countries due to the reliance on imernarional trade and compliance with
the regulations of the World Trade Organization (see Chapter 26). Hence, most
governments rely on interes t rate policy to achie,-e economic stability. In most
countries, the central bank or monetary authority (see Chapter 6) is responsible for
o.·erseeing exchange rate changes.
Monetary policy is used to control spending and investment in an economy
Use of mo netary policy

Like fiscal policy, monetary policy can be used either to expand or to contract
economic activity in the economy.
E xpa n sio nary monetary policy, also known as loose mo netary policy, aims
to boost economic activity by expanding the money supply. This is done mainly by
lowering interest rates. This makes borrowing more attractive to households and
Study t ips firms because they are charged lower interest repayments on their loans. Those with
existing loans and mortgages have more disposable income, so they have more money
There is no single
interest'rate'in available to spend.
an economy but With contractionary monetary policy, also known as tight monetary policy, an
a structure of increase in interest rates rends to reduce spending and im'estment in the economy.
different interest Thus, this slows down economic activity. Tight monetary policy is used to control
rates. This is the threat of inflation, although it can harm economic growth and therefore cause
because there is
no single market
job losses in the long run.
forloans,suchas
bank overdrafts, Case Study: Quantitative easing
credit cards Following the global financial crisis of 2008, the UK and US central banks made significant
and mortgages cuts to interest rates to encourage people to spend money, rather than to save it. However,
-financial with interest rates at their lowest levels in history - near O per cent - they could not go
institutions any lower.
charge different TheBankofEnglandandtheFederalReservehadonlyoneotheroption-quantitative
rates of interest easing (QE). This form of monetary policy directly injects money into the economy. This is
for all of these. donebythecentralbankbuyingbonds(adebtsecurityorapromisetopayalenderata
Borrowers also later date). The in stitutions selling these bonds, such as commercial banks and insurance
have different companies, then have 'new' money in their accounts, thus helping to boost the money
levelsofrisk: for supplyandtopromotelending(andhencespending).
example,lending
to governments
and large
multinationals
tends to be Activity
less risky than Japan'sinterestratesaveragedjust3.26percentbetween1972and2013,andhaverarely
allowing private gonebeyondOpercentsince 1999.
sole traders or Use the internet to investigate the reasons behind Japan's policy of extremely low
partnerships to interest rates. Here's a starting point: www.tradingeconomics.com/japan/interest-rate.
borrow money.
Ex am practice
1 Explain how monetary policy can be used to influence the level of economic
activity. [4)
2 Explain how the use of interest rate policy can help a country to control its
inflation rate. [4)
Limitations of monetary policy

As with fiscal policy, there are time Jags to the reaction to interest rate changes in
the economy. This can make the effectiveness of monetary policy less certain or even
destabilising for the economy.
Furthermore, economic activity is not totally and only dependent on interest rates.
Other factors, such as consumer and business confidence levels, have an impact on
gross domestic product. The global financial crisis of 2008 proved that, de spire
interest rates being close to, or equal to, 0 per cent in countries such as Japan,
the USA and Hong Kong, the lack of business and consumer confidence led to a
prolonged economic recession.
Government policies
Japan has used a zero interest rate policy. ltsinterestratesaveragedjust3.26percent

between 1972and2013.
Some economists argue that the use of monetary policy can be coumerproducti\'e
because it restricts economic activity and discourages foreign direct investment in the
country. For example, higher interest rates raise the costs of production for firms, as
existing and new loans become more expensive. This has negative impacts on profits,
job creation, research and development expenditure, and innovation. Hence, higher
interest rates (used to combat inflation) can conflict with other macroeconomic
objecth'Cs, especially with economic growth and employment.
Supply-side policies
Supply· sid e policies are long-tenn strategies aimed at increasing the productive
capacity of the economy by using policies to improve the quality and/or quantity
of factors of production (see Chapter l ). This means that the economy can produce
more goods and services at all price le,'Cls. This can be shown as an ounv.ud shift of
the country's production possibility curve (see Chapter 1). Examples of supply-side
policies are gi\·en below.
Privatisation
Privatisation is the policy of selling off stare-owned assets (sud1 as property or
public-sector businesses) to the private sector, if they can be run more efficiently. This
is because private -sector firms are motivated by profit and can, in theory, develop
better products and deliver better services. Competition, productivity and efficiency
are essential componems of the private sector, which help to boost the productiw
potential of the economy.
For example, during the 1980s and 1990s, the UKgovernmem privatised British
Steel, British Petroleum, Rolls-Royce and British Airways. In Hong Kong, the
government privatised its rail services in October 2000.
Deregulation
Deregulation refers to the removal of barriers to entry, thereby making markets
more competith'e. For example, labour market reforms can make the labour force
more competitive and more productive. Such reforms invoh'C the removal oflaOOur
market imperfections, such as decreasing the power of trade unions (see Chapter 8)
and reducing the national minimum \vage (see Chapter 7 ).
In the Republic of Ireland, the raxi industry was deregulated to allow for more
competition, leading to a dramatic increase in the number of taxis. In New Zealand,

postal services and the banking industry have been deregulated, allowing for both
domestic and foreign competition.
Capital investment
Some supply-side policies focus on the importance of investment in new technologies,
infrastructure and research and development ( R&D), thus conuibuting to the
economic development of an economy. In the Jong run, capital im•estmem helps to
increase the productive capacity and productivity ofthe economy.
Expenditure on new technologies and R&D can help to generate new products for
consumption, such as smanphones, tablet computers and environmentally friendly
cars. On an international scale, innovation can also be a good source of competitive
advantage for a coumry.
According to the IMF's Wur/d Economic Outlook, China's capital investment as a
proportion ofits annual GDP is expected to average 47.25 per cem between 2013
and 2016, whereas the rate for the USA is around 15 per cent. This should, in theory,
help China's quest for continual and sustainable economic growth.
Human capital investment

Human capital is the collective knowledge, skills and experiences ofa country's
workforce. Supply-side policies are used to improve the quantity and/or quality of the
workforce in the economy. These policies can be used to create incemives to work.
For example, go.•ernment-funded retraining schemes can help the unemployed to
improve their chances of finding paid employmem. Increased go.•ernmem spending
on education and training are further examples.
Some counuies spend a relatively large amoum of their GDP on education, such
as Finland (6.4 per cent), Sweden (7.7 per cent), Denmark (8.5 per cent) and Brunei
Darussalam (9.1 per cem), whereas others, such as Botswana (2.2 per cent) and
Bangladesh (2 .4 per cem), spend rather less.
Tax reforms
Lower taxes can create incentives for work (see Chapter 17), especially for people on
low wage rates. Over time, this can provide a l:oost to consumption. Tax cuts can also
encourage firms to invest in the economy, as they strive to maximise profits.
Enterprise zones
These are areas with relatively
high raresofunemployment \Vhere
the government creates financial
incenth'es for firms to relocate.
These incentives include tax
rebates and reduced regulations
inordertoattractprivate-sector
investments. Enterprise zones are
common in the UK, USA, China
and India.
AnewlyestablishedenterprisezoneinShenzhen
City.China
Government policies
The main criticism of supply-side policies is the rime that it takes to reap the benefits.
For example, it might take decades for a nation to enjoy the benefits of an improved
education system or better infrastructure in the country.
=ng~ \ ~~ ~~ge
I/
=::.nt
ln1erei rale,
mooelmyfX) k y
GOVERNMENT
ECONOMIC POLICIES
I
.si,wy-,klepd ky
----------
oop11a l 1nve~ lvat~ OO~ edccalloo
lrirmlrudlxe, new en1erp<lseza>e, progra mme,;lo,waL,r,
1edrdog1e,, RW
Figure 16.2 Government economic policies
Activity
1 lnvest igatethesupply-sidepoliciesinyourhomecountry,oracountryofyourchoice.
2 How have these policies helped or hindered the productive capacity of the economy?
The merits of supply-side policies

The advantages of using supply-side policies to achie\'e economic stability include:
• Improved econo m ic grow th - Supply-side policies can be used to achieve
sustainable economic growth by increasing the producti\'e capacity ofthe economy.
• Lower inflatio n - As supply-side policies increase the productive potential ofthe
economy, they help to prevent the general price level from rising beyond control.
• Lower unemployment - An increase in the economy's productive capacity will
tend to increase national output, thereby creating jobs in the economy in the long
term. Also, supply-side policies can help to reduce both frictional and structural
unemployment (see Chapter 19).
• Improved bala nce of payments - Since supply-side policies can improve
productivity and national output without increasing the general price level, the
international competitiveness of the country should impro\·e. For example, firms
should become more productive and competitive, which will help to boost the
economy's export earnings. Therefore, supply-side policies tend to improve a
coumry's balance ofpaymems (see Chapter 24).
Exam practice
1 Define the term 'supply-side policies'. (2)
2 Examine how supply-side policies can help to achieve any two macroeconomic
objectives. (6)
C h apter r eview questions

1 Whatis fiscalpolicy?
2 What is the difference between a budget deficit and a budget surplus?
3 What are t he differences between expansionary and contractionary f iscal
policy?
Why might a government choose to use fisca l policy?
What is monetary policy?
6 Explain t he differences between expansionary and cont ractionary monetary
policy.
7 Why might a government choose to use monetary policy?
8 What are supply-side policies?
9 Why might a government choose to use supply-side policies?
10 What are t he limitations of using fiscal, monetary and supply-side policies to
control economic activity?
Ke y te rms
Dereg ul atio n is a supply-side policy of making markets more competitive by removing
barrierstoentryandothermarketimperfections.
Fiscal po li cy is the use of taxes and government spending to affect macroeconomic
objectives such as economic growth and employment.
Mo netary po licy refers to the use of interest rates, exchange rates and the money supply to
control macroeconomic objectives and to affect the level of economic activity.
Priva tisat lo n isasupply-sidepolicyofsellingoffstate-ownedassetstotheprivatesector.
Supp ly-sidep o li ci es arethelong-termstrategiesaimedatincreasingtheproductive
capacity of the economy by improving the quality and/or quantity of factors of production.
@ Taxation

• describe the types of taxation (direct, indirect, progressive, regressive and
proportional)
• describe the impact of taxation.
TakenffomCambrjdgelnternationalfxaminationsSy11abo,~GCSE045Stol.evel2281)
O CambfidgelnternationalExamir,abom
Taxa tion
A t ax is a gm>ernmem levy on income or expenditure. There are various reasons why
the government imposes raxcs. For example:
• Taxes on salaries and profits raise go~·ernmem revenue and can be used to
redistribute income and wealth in the economy.
• Taxes on goods and services raise the costs ofproduction and therefore can
limit the output of certain demerit products (see Chapter 5 ), such as alcohol and
tobacco.
• Tariffs imposed on foreign goods and services help to protect domestic firms from
overseas rivals (see Chapter 26).
Before the go\·ernment can spend money on the economy, it must first take the
money from taxpayers (both indh,iduals and firms). In addition to other sources of
government finance, tax revenues are spent on se\·eral key areas, including social
security, education, health care, transport, infrastrncrure and national defence.
t•l!lt _
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Taxesareusedbygovernmentstopayforinfrastructure,healthcareandnationaldefence
The tax burden is the amoum of tax that households and firms have to pay. This can
be measured in three ways. For a country, the tax burden is measured by calculating
total tax revenues as a proportion of gross domestic product (G DP). For individuals
and firms, the tax burden can be measured by the absolute value of tax paid or by the
amount of tax paid as a proportion of their income or profits.
Activity
At the end of 2012, economists described the situation faced by the US government as a
'fiscal cliff'. Investigate what this means and its potential impact on the economy in the
shortrunandthelongrun . Bepreparedtoshowtheresultsofyourinvestigationtoothers
in the class.
Types of taxation
Study tips
It is incorrect There are various classifications of taxes, including the following:
to define a
• Direct taxes - This type of tax is paid from the income, wealth or profit of
progressive tax
system as one in individuals and firms. Examples are raxes on salaries, inheritance and company
which the rich pay profits.
more tax than the • lndirec t taxes - These are taxes imposed on expenditure on goods and services.
poor. This would For example, coumries such as Australia and Singapore use a goods and services
be the case even tax (GST), whereas the European Union uses value added tax (VAT ). Other
if there were a
flat-rate income examples are taxes on petrol, alcohol and cigarettes.
tax,underwhich • P rogressive taxation - Under this tax system, those with a higher ability to
everyone paid the pay are charged a higher rate of tax. This means that as the income, wealth
same rate. The or profit of the taxpayer rises, a higher rate of tax is imposed (see Figure
amount paid by 17. 1). Examples of progressive taxation are income tax, capital gains tax and
a higher-income
stamp duty.
earner would still
be greater than
the amount paid
by a low-income
earner. What is
important is the
rate(percentage) .,,,bi_-----------------------,"'""'""''"=
j1
i.
: lnaea>es fromY 1 toY2,
fleraledbxrt,e,/rom
:
of tax paid rather
than the amount.
!' ,, _______________ ! r,or,
0 Y1 Y2
«=""'
Figure17.1 Progressivetaxes
Exam practice
Suppose in a country the progressive tax rates are 10 per cent (for those earning
between $10001 and $40000 per year) and 15 per cent (for those earning over
$40 OOO per year).
1 By copying and completing the table below, calculate the total amount
of tax paid by an individual who earns $75000 per year. [4)
lnoomelevel(S) 1Taxrate( %) IAmountoftax paid(S)
10000 I o I
10001 - 40000 I I
I I
Total tax:
2 Show how the average rate of mcome tax paid by the mdividual is 11 per cent. [2)
Taxation
• Regressive taxation - Under this tax system, those with a higher ability to pay are
actually charged a lower rate of tax: that is, the wealthier the individual, the lower
the tax paid as a percentage ofincomc (sec Figure 17.2). For example, although
a high-income earner pays the same amount ofairpon tax or television licence
fee as a less wealthy person, the amount of tax paid is a smaller proportion of the
wealthier person's income.
w,s ,,poc,1<,-,
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~ """"lk.rpropo,11oocl1a<
.ll T2 ~7, "1t::~ WOO

1
0 Y1 Y2
Income le,..,,!
Figure 17. 2 Regressivetaxes
• Proportional taxation - Under this tax system, the percentage of tax paid srays
the same, irrespective of the taxpayer's lc\'cl of income, wealth or profits (sec
Figure 17.3). An example ·would be a flat rate sales tax, sud1 as VAT or GST. Sales
taxes vary considerably from country to country: for example, Denmark has a
25 per cent GST, whereas sales taxes in India and Japan arc as low as 5 per cent.
Another example is an income rax which is 20 per cent for all individuals regardless
oflcvcl of income.
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-
~ 20
the,amerale dbxls
cOOrged,,cchasthe
!! 20'.tVAT ln AJ,tm,
,- Mt:xocco.Senegaland
"'"
0 Y1 Y2
Figure 17.3
'- "'"
Proportional taxes
Activity
Copythetablebelow. Placeticksinthecorrectboxestoidentifywhetherthetaxisdirect
orindirect.Thefirstonehasbeencompletedasanexample.
Ind irect
Airport tax
Capital gain~ tax
Carbon tax
Corporation tax
Customs duties
Excis.edutie1
lnheritanc:etax
Stamp duty
Tariff1
Windfall tax
Exam practice
1 Study the data below and answer the questions that follow.
lncome(S Tax pa idpe r year(S)
per yea r)
a) Identify the tax (A, B or C) that is progressive. [1)

b) Identify the tax (A, B or C) that is proportional. [1)
c) Distinguish between a regressive and a proportional tax. [2)
2 Study the tax system for the three countries below. Calculate the
percentage of tax paid on each level of income and identify whether
the tax systems are progressive, regressive or proportional. [6)
Tax syste m A Taxsystem B TaxsystemC
in~ ~ ~a~S) I ~;:~; ;~ in~;~ ~a(~) I ~;:~~J;~ in~;~ ~a~S) I :::~~dt (~~
I I I
I I I
20000 I 2800 30000 I 4500 45000 I 11250
Taxation
Ta bl e 17.1 Examplesoftaxes
De finiti o n
Leviedonpersonalincomes{wages,interest,rentanddividends}. lnmost
countries,thisi1themainsourceoftaxrevenues
Corporation tax Adirecttaxontheprofitsofbu5ine55es.
Sales tax Anindirecttax,suchasVAT,chargedonanindividual'sspending
EX(iseduties lndirectinlandtaxesimposedoncertaingoodsandservices,suchasalcohol,
tobaa:o,petrol.~ftdrinksandgambling
Custom duties Indirect cross-border taxes on foreign imports.
Capital gains tax A tax on the earnings made from investments such as buying shares and
private property
Inheritance tax A tax on the tram fer of income and wealth such as property when pas1ed on
to another person
Stamp duty A progressive tax paid on the sale of commercial or residential property.
Carbon tax A tax imposed on vehide manufacturers or firms that produce excessive
carbon emissions
Windfall tax Ataxchargedonindividualsandfirmsthatgainanunexpectedone-off
amountofmoney,suchasapersonwinningthelotteryoralirmgaining
from a takeover bid
Passengers shop in the Duty and Tax Free Shop at Cointrin airport in Geneva, Switzerland
Exam practice
Countries such as Saudi Arabia, Gibraltar and Hong Kong do not have a sales tax
(a type of indirect tax).
1 What is an indirect tax? [2]
2 Examine the advantages and disadvantages for countries that do not
impose sales taxes. (6)
The impact of taxation

Taxation has varying impacts depending on the type of tax in question. The impact
of raxation on economic agents and the economy are considered below.
• Impact on price and quantity - The imposition ofa sales tax will shift the supply
curve of a product to the left (see Chapter 3) due to the higher costs of production.
This will increase the price charged to customers and reduce the quantity produced
and sold.
• Impact on economic growth - Taxation tends to reduce incentives to work and
to produce. By contrast, rax cuts can boost domestic spending, thus benefiting
businesses and helping to create jobs. Nevertheless, tax revenues are essential to
fund go.·ernment spending (for the construction of schools, hospitals, railways,
airports, roads and so on), which fuels economic growth.
• Impact on inflation - As taxation tends to reduce the spending ability of
individuals and the profits of firms , it helps to lessen the impact ofinflation (see
Chapter 18). By contrast, a cut in taxes boosts the disposable income of households
and firms, thus fuelling inflationary pressures on the economy.
• Impact on business location - The rate of corporation tax and income tax
will affect where multinational businesses choose to locate. For example, high
corporation tax rates in Argentina (35 per cent), Pakistan (35 per cent) and
Cameroon (38.5 per cent) can put off some companies thinking of locating in
these countries. As a result, foreign direct investment in these countries might
be lower than otherwise. By contrast, it might be easier to attract workers in low
income tax countries such as Bulgaria (10 per cent), Macedonia (10 per cem),
Belarus (12 percent) and Hong Kong (15 per cent).
• Impact on social behaviour - Taxation can be used to alter social behaviour with
the intention of reducing the consumption of demerit goods (see Chapter 5 ). For
example, taxing tobacco and alcohol should, in theory, reduce the demand for such
products. Taxes are also used to protect the natural environment by charging those
who pollute or damage it. For example, countries such as the UK and China tax
cars based on the engine size because vehicles with larger engines tend to cause
more pollution.
Exam practice
In March 2013, inflation in the Czech Republic slowed to 1.7 per cent, partly due to
the reduced spending caused by an increase in the national sales tax.
1 Explain how taxes can be used to reduce the rate of inflation in the Czech
Republic. [4)
2 Analyse how an increase in taxation can conflict with any two macroeconomic
objectives of the Czech Republic government. [6)
Taxation
Case Study: Plastic bag levy
Prior to July 2009, Hong Kong used an average of 30 million plastic carrier bags every day!
For a relatively small population of 7 million people, this meant the average person in
Hong Kong was using more than four plastic carrier bags every day, often on a single-use
basis.Thisstaggeringfiguremeantthatthecountry'slandfillswouldbeunabletocope
with the bags when they were thrown away.
Hong Kong's introducton of a HKSO.S tax (6 .5 US cents) on the use of carrier bags has
encouragedpeopletouserecycledshoppingbags.lnfact,demandforplasticcarrierbags
fellby8Spercentwithinthefirst2daysofthetaxbeingintroduced .
This follows similar moves made by other countries such as China (in 2009) and Ireland
(in2002).
SoUfce: adapted lfom Sourh 0,jn~ Momjr,g Posr
• Impact on incentives to work - lftaxcs arc too high, this can create disinccmh-cs
to work. For example, France tried to imroducc a 75 per cent income tax rate in
2012 for individuals earning incomes in excess of€1 million ($1.28 million per
year). However, the proposals were o~·crturncd, with some economists arguing that
the government would actually receive more tax rc\·cnucs by cutting tax rates. This
is because lower rates of tax can create inccmives to work and also help to reduce
tax avoidance and tax evasion (sec below).
• Impact on tax avoidance and tax evasion - Some taxes arc prcvcmablc. Tax
avoid ance is the legal act ofnot paying taxes: for example, non-smokers do not pay
tobacco tax and non-overseas travellers do not pay air passenger departure taxes.
However, tax evasio n is illegal as it refers to non -payment of taxes due, perhaps
by a business under-declaring its level of profits. High levels of taxation will tend
to encourage both tax avoidance and tax evasion. By contrast, low rates of taxation
create fur fewer incentives for households and firms to defraud the govcrnmem.
• Impact on the distribution of wealth - The use of taxes can help to redistribute
income and \\"Calth from the relatively rich to the poorer members of society. For
example, \\"Calthicr indh,iduals will pay more income tax, sales taxes and stamp duty
on their pri\'atc properties. These funds can be used by the gm-crnmcm to support
education, health care and social benefits for less affiucm individuals in the economy.
Exam practice
In November 2008, following the recession caused by the global financial crisis, the
UK government reduced the rate of value added tax (VAT) from 17.5 per cent to 15
per cent. However, by January 20 11 the government's escalating debt problems forced
VAT to increase to 20 per cent.
1 Explain how the reduction in VAT from 17.5 per cent to 15 per cent might
help to reduce the effects of a recession. [4)
2 Examine three impacts of the increase in VAT to 20 per cent. [6)
Activity
Some countries, such as Andorra, Brunei Darussalam, Oman and Qatar, have a zero rate of
income tax. Other countries, such as Bahamas and Estonia, have a zero rate of corporation
tax.
1 Which other countries have a zero rate of income tax?
2 Investigate the reasons behind such government decisions. Be prepared to share your
findingswiththerestoftheclass .
Chapter r eview questions

1 What is the difference between direct and indirect taxes?
2 State two examples of direct taxes and two examples of indirect taxes.
What is the difference between progressive, regressive and proportional taxes?
How do taxes affect: economic growth, inflation and incentives to work?
S What is the difference between tax avoidance and tax evasion?
Key terms
Direct taxes are government charges imposed on income and wealth, such as income tax
and inheritance tax .
lndirectt axes aretaxesimposedonexpenditure-forexample,salestaxessuchasvalue
addedtax(VAT).
Prog ressive taxa tio n is a tax system that deducts a greater proportion of tax as a person's
incomelevelincreases. Progressivetaxesincludeincometaxandcapitalgainstax.
Pro portiona l ta xa tio n is a tax system that deducts the same proportion of tax at all income
levels.
Regressive taxa tion is a tax system that deducts a smaller proportion of tax as a person's
incomeincreases. Regressivetaxesincludesalestaxesandstampduties.
Taxavoida nce isthelegalactofminimisingpaymentoftaxes,suchasbyavoidingspending
onitemswithalargesalestax.
The tax bu rden is the amount of tax that households and firms have to pay.
Taxes are government levies on income and expenditure, used to fund government
expenditureandtoaffecteconomicactivity.
Tax evas io n istheillegalactofnotpayingthecorrectamountoftax,perhapsduetoafirm
under-declaring its profits.
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@ Inflation

• describe how a consumer prices index/retail prices index is calculated
• discuss the causes and consequences of inflation
• discuss the causes and consequences of deflation.
Inflation
Inflation is a sustained rise in the general price level in an economy over time. This
docs not mean that the price of every good and service increases, but that on average
the prices are rising.
Governments aim to control inflation because it reduces the value of money
and the spending power of households, governments and firms. For example, the
inflation rare in the western Asian coumry of Syria (see Figure 18.1) was around 48
per cent in 2013, meaning that the general price lc,'Cl in Syria increased by an a\'cragc
of 48 per ccnr in a year. This means that a product priced at 100 Syrian pounds
would increase to 148 Syrian pounds by the end of the year. This makes conditions
fur Jess economically stable in Syria than in other counrrics with low and stable rates
ofinflarion, such as Canada, the UK and the USA (sec Figure 18.2).
Jlflatloo rale[%1
Soorce:T,adingfronomk,
Figure18.1 lnflationratesaroundtheworld: selectedcountries,2013

Inflation
Study tips
Low rates of
inflatio n,of1
or 2 per cent,
i'
!,
~ 6~
I ,_ _
- i
__
'
6
,
a re not usually
harmful to the § o I o
e conomy because
higher prices can
encourage firms j~ ~
to supply more
output. ltiswhen ~~ ~
inflation rises too J{ln/02 J{ln/04 }00/06 J{ln/08 J{ln/ 10 P n/ 12
quickly that it can Sou,ce:Trad ng Economics
di srupt decision
making for Figure18.2 USinflationrates,2000- 13
households.firms
and governments.
Case St udy: Hype rinfla tion in Zimbabwe
Major economic problems in 2imbabwe caused
thecountrytosufferfromextremelyhighrates
ofinflation - knownas hyperinflation - between
2003and2009.l nJune2006,theCentralBank
introduced a new 100000 Zimbabwean dollar
banknote (less than USS1 back then) . However,
byJuly200B, inflationhadreachedawho pping
231000000percent! People carried large bundles
ofcashtobuytheirgroceries(pictured).
Severalmonthslater,inJanuary2009,
theZimbabweangovernmentlaunchedthe
100trillionZimbabweandollarbanknote
(ZWD100000000000000)!This meantthe
currency becameworthless,anditwaseventually
abandoned.
Today, Zimbabwe still does not have its own
officialcurrency,withmanypreferringtousethe
US dollar. With GDP per capita at S487 (about Sl .33
perday),around80percentofthecountry's 12.6
millionpeopleliveinextremepoverty.
Exam practice
The hypothetical data below show t he inflation rates for a country over three years.
Iv...
Infl at io n rate( %)
1 Define the mean ing of 'inflation rate'. [2]

2 Explain why inflation was at its highest in the third year. [3]
Economic indicators
The consumer price index

The consumer price index (CPI ) is a common method used to calculate the
inflation rate. It measures price changes of a representative basket of goods and
services (those consumed by an a\·erage household) in the country. For example,
items such as staple food products, clothing, petrol and transportation are likely
to be included. Howe\'er, different weights are applied to reflect the relative
importance of each item in the average household's expenditure. For example, a
10 per cent increase in the price of petrol will affect people far more than a 50 per
cent increase in the price oflight bulbs, batteries or tomatoes. Changes in the CPI
therefore represent changes in the cost ofliving for the average household in the
economy.
The statistical weights in the CPI are
based on the proportion of the average
household's income spent on the items
in the representative basket of goods
and services. For example, if the typical
household in a country spent 15 per
cent of its income on food, then 15 per
cent of the weights in the index would
be assigned to food. TI1erefore, items
of expenditure that take a greater
proportion ofthe typical household's
:i;~~lil~g~r~~:~~:: ~:~~~~: and ~~~~g~:ti~/~1!d:~~~~~:~~nb~~:bt;~i:s:;e
trends, such as a hike in household expenditure on smartphones, online apps and
tablet computers, require a review (or update ) of the weights in the CPI.
The CPI versus the RPI

Both the consumer price index and the retail price index (RPI ) can be used to
calculate the rate of inflation. Both indices follow a similar pattern (see Figure 18. 3).
However, there are three key differences to these price indices:
• The items included in the calculations - The main difference is that the RPI
includes the cost of housing, such as mortgage interest payments and other
housing costs. The RPI also includes m-erseas expenditure by domestic. households.
The CPI includes costs paid for financial services.
• The population base - Both price indices try to measure changes in the cost of
Jiving for the average household. However, the RPI excludes low-income pensioner
households and \'ery high-income households, as it is argued that these do not
represent the 'average' household or the expenditure of the average family.
• The method of calculation - The RPI is calculated using the arithmetic mean
whereas the CPI uses the geometric mean. What this means is that the RPI
tends to be lower than the CPI (un less interest rates for mortgage repayments are
extremely low). For example, suppose the price changes for a product in the last
three months were 1 per cent, 2 per cent and 3 per cent. The arithmetic mean
( RPI ) would average these changes to 2 per cent, i.e. + ~ + : 2. However,
1 3
the geometric mean (CPI ) would average these changes to just 1.8 per cent, i.e.
3.Jl x 2 x3 .
Inflation
,:~
]
j•
f -.
3
~
-
.
'
. ~
_L
I
-
• -1
2
- 2CXXl 200 ) 2002 2003 2004 2005 2006 20072008 2009 20 1020)) 2012
Figure 18.3 The CPI and RPlfortheUKeconomy,2000-12
A key political and economic reason for calculating both price indices is that inflation
affects the whole economy and can have major impacts on certain stakeholders.
For example, payments for state-funded pensions and welfare benefits are Jinked to
inflation, so the use of the CPI will usually save the government money compared
with using the RP I. By contrast, the taxes imposed on fuel, alcohol and tobacco are
linked to the RP I, thus generating the government more revenue than ifit used the
CPI. The RP I is also used by trade unions and firms as a starring point for wage
negotiations (see Chapter 8).
The CPI is the preferred method for international comparisons ofinflarion. This
is partly because it uses a wider sample of the population when calculating and
assigning statistical weights to the index. The CPI, as the key measure ofinflation for
most countries, is also important as a benchmark when the government sets interest
rates (see Chaprer l 6 ).
Calculating the CPI or RPI

A price index is used to indicate the average percentage change in prices compared
with a starring period called the base year. The CPI and RPI compare the price
index of buying a representative basket of goods and services with the base year,
which is assigned a value of 100. Hence, a price index of 115.2 means that prices
have in general increased by 15.2 per cent since the starring period. If prices were
to rise by another 5 per cent in the subsequent year, the price index number would
become 120.96 (that is, 11 5.2 x 1.05), or 20.96 per cem higher since the base year.
Price changes in the CPI and RP I are measured on a monthly basis bur reported for a
12-momh period.
Calculating changes in the CPI or RP I gh'Cs the rate of inflation. To do so, rwo
steps are involved:
• collection of the price data on a monthly basis
• assigning the statistical weights, representing diffurent patterns of spending over rime.
The simplified example in Table 18. 1, with three products in the representath'C basket
of goods and services, shows how the total basket price is calculated. Assume 2012 is
the base year, when the total basket price was $20.
Economic indicators
Tab le 18.1 Calculatingthetotalbasketprice

Product Pritein2013($) Pritein2014 ($)
9 10
Cinema ticket
Petrol
Total basket price
To calculate inflation between 2013 and 2014, first calculate the price indices for the
two years in question:
• 2013: ~ x 100 = 110 (prices in 2013 were 10 per cent higher on average than
in 2012).
e 2014: s:;oS X 100:: 122. 5 (prices in 2014 were 22.5 per cent higher on average
than in 2012).
The inflation rate between 2013 and 2014 is the percentage change in the price
indices during these two periods:
122.5-110 X 100 = 11.36%

110
However, the products measured in the CPI are of different degrees of importance to
the typical household, so weights are applied to reflect this. Suppose, for example, in a
particular coumry food consumption accounts for 40 per cent of average household
spending whereas entertainment represents 20 per cem, transport represents 25 per
cent and all other items represent the remaining 15 per cent. To create a weighted price
index, economists multiply the price index for each item (in the representatiw basket
of goods and services) by the statistical weight for each item of expenditure. Applying
these weights gives the results shown in Table 18.2.
Table18.2 Creatingaweightedpriceindex
Product Price index Weight Weighted index
Study tips Food
Although the
CPI and RPI are Transport
the most widely
used price indices Other!
for measuring Weighted index
inflation,they
only take an While the price offood has increased the least (only 10 per cent) since the base year,
average measure. spending on fcx:xi accounts for 40 per cem of the typical household's spending. This
They therefore has a much larger impact on the cost of living than the 15 per cent increase in the
hide the fact that price of entertainment, which accounts for only 20 per cent of the average household
the prices of some
products increase expenditure. Without using weights, the average price index would be 116.18: that
more rapidly than is, 110 + 115 + ~16.4 + 123.3. However, the statistical weights reduce the price index
others,whilethe
price of other to 114.6 because the relatively higher prices ofnon-fcx:xi items account for a smaller
products might proportion of spending by the typical household. This shows that prices have, on
have actually average, increased by 14.6 per cent since the base year. Therefore, a weighted price
fallen .
index is more accurate in measuring changes in the cost of living, and hence inflation.
Inflation
Exam practice
1 a) Calculate the inflation rate if the consumer price index changes from 123.0
to 129.15. (2)
b) Calculate the price index if there is 3.0 per cent inflation during the year
and if the index was previously at 130. (2)
c) Calculate how much a basket of goods and services which is currently
priced at $1200 would cost if the CPI increased from 125 to 135. [3)
2 The data below are for a hypothetical country, Jukeland.
Reta ilprices index Wei g ht
Clothing 10
Food
Housing
Others
a) Define what is meant by a 'retail price index' (RPI). [2]

b) 'The typical household in Jukeland spends more money on housing than on
food or clothing.' Explain this statement. [3)
c) Use the data above to calculate the weighted retail price index (RPI) in
Jukeland. [4)
Th e causes of infl ation

There are two main causes of inflation. These relate to demand-pull inflation and
cost-push inflation.
Cost-push inflatio n is caused by higher costs of production, which makes fim1s
raise their prices in order to maintain their profit margins. For example, in Figure 18.4,
higher raw marerial costs, increased wages and soaring rents shift the aggregate supply
(total supply) curve for the economy to the left from AS1 to ASi, forcing up the general
price level from P 1 to Pi and reducing national income from Y1 to Yi.
j1 1:f~ .
0 Y.;..__!,
Natiooo ll ncooie
Higherrentsinpopularlocationscancausecost-pushinflation Fi gure 18.4 Cost-push inflation
Economic indicators
Demand-pull inflation is caused by higher levels of aggrt."gate demand (total demand in

the economy) driving up the general price level of gcx:xls and services. For example, during
an economic txx:m (see Chapter 20), household consumption of gcx:xls and services
increases due to higher GDP per capita and higher levels of employment. In Figure 18.5,
this is shown by a righrn1·ard shift of the aggregate demand curve from A.D1 to AD2 ,
raising national income from Y1 to Yi and forcing up the general price le,·el from P 1 to P2 •
N<11oo all ncome
Figure18.5 Demand-pullinflation
In general, inflation can be controlled by limiting the factors that cause demand-pull
inflation and cost-push inflation. For example, the government can raise raxes and
interest rates to limit consumption and investment expenditure in the economy. Some
countries, sud1 as Iran and France, have used subsidies for food and fuel to reduce prices
in the economy. Chapter 16 co,-ers in more derail the various government policies that
can be used to control the level of economic activity and hence the rate of inflation.
Other possible causes ofinflation are:
• Mon et ary cau ses of inflatio n are related to increases in the money supply (see
Case Study on Zimbabwe) and easier access to credit, e.g. loans and credit cards.
• Im port ed inflatio n occurs due to higher import prices, forcing up costs of
production and therefore causing domestic inflation.
Exam practice
Study Figure 18.6, which shows the inflation rates in India between 2003 and 2013,
and answer the questions that follow.
l j -'---------o-j~~~~[!'.
Joo/04
Source:T,adingfronomics
Figure1 8.6
J]n/06
lnflationratesinlndia,2003- 13
J]n/08 }00/ 10 J] n/ 12
Inflation
1 Identify when the rate of inflation was at its highest and lowest in India. (2)
2 Distinguish between cost-push inflation and demand-pull inflation. (4)
3 Explain why the global financial crisis of late 2008 would have caused a fall in
India's rate of inflation. (4)
Activity
Discuss in small groups of two or three the economic strategies you would use to control
demand-pull inflation and cost-push inflation. You may want to refer to Chapter 16 to help
withthisactivity.
The consequences of inflation

Inflation can complicate planning and decision making for households, firms and
governments, with many consequences as outlined below.
• Menu costs - Inflation impacts on the prices charged by finns. Catalogues, price lists
and menus have to be updated regularly and this is costly to businesses. Of course,
workers also have to be paid for the time they take to reprice goods and services.
• Consumers - The purchasing power of consumers goes down when there is
inflation - there is a fall in their real income because money is worth less than
before. Therefore, as the cost of living increases, consumers need more money to
buy the same amount of goods and services.
• Shoe leather costs - Inflation causes fluctuations in price levels, so customers
spend more time searching for the best deals. This might be done by physically
visiting different firms to find the cheapest supplier or searching on line. Shoe
leather costs represent an opportunity cost for customers.
• Savers - Savers, be they individuals, firms or governments, lose out from inflation,
assuming there is no change in interest rates for savings. This is because the money
they have sa\'ed is worth less than before. For example, ifinterest rates average 2
per cent for savings accounts in a country but its inflation rate is 3 per cent, then
the real interest rate on savings is actually - I per cent. Hence, inflation can act as
a disincentive to save. ln turn, this leads to fewer funds being made available for
investment in the economy.
• Lenders - Lenders, be they individuals, firms or governments, also lose from
inflation. This is because the money lent out to borrowers becomes worth less than
before due to inflation.
• Borrowers - By contrast, borrowers tend to gain from inflation as the money they
need to repay is worth Jess than when they initially borrowed it - in other words,
the real value of their debt declines due to inflation. For example, ifa borrower
takes out a mortgage at 5 per cent interest but inflation is 3.5 per cent, this means
the real interest rate is only 1. 5 percent.
• Fixed income earners - During periods ofinflation, fixed income earners (such
as pensioners and salaried workers whose pay do not change with their level of
output) see a fall in their real income. Thus, they are worse off than before as
the purchasing po·wer of their fixed income declines with higher prices. Even if
employees receive a pay rise, the rate of inflation reduces its real value. For example,
if workers get a 4 per cent pay rise but inflation is 3 per cent, then the real pay
increase is only I percent.
Economic indicators
Exam practice
Study the following data and answer the questions that follow.
Infl a ti o n ra te( %) Wag e in crea se(%)
1 In which year was there the largest increase in real wages? Explain your answer. [3)
2 Explain why average wages were higher in Year 3 than Year 2. (3)
• Low income earners - Inflation harms the poorest members of society far
more than those on high incomes. Low income earners tend to have a high price
elasticity of demand (see Chapter 4) for goods and services. By contrast, those on
high incomes and accumulated wealth, such as hip -hop artists (see Table 18.3), are
not so affected by higher prices.
Ta bl e 18.3 Thefivewealthiesthip-hopartists
Ra nk Net w ealth(Sm)
Sean 'Oiddy'Combs
Shawn "Jwt·Z" Carter
Andre 'OrOre ' Young
8ryan'Birdman ' W1lliams
Curtis"S0 Cent' Jackson
Soorce: ForbesRichList,201J
• Exporters - The international competitiveness of a country tends to fall when

there is domestic inflation. In the long run, higher prices make exporters less price
competitive, thus causing a drop in profits. This leads to a fall in export earnings,
lower economic growth and higher unemployment.
• Impo rters - Imports become more expensive for individuals, firms and the
government due to the decline in the purchasing power of money. Essential imports
such as petroleum and food products can cause imported inflation (higher import
prices, forcing up costs of production and thus causing domestic inflation). Hence,
inflation can cause problems for countries without many natural resources.
• Employers - Workers are likely to demand a pay rise during times of inflation in
order to maintain their level of real income. As a result, Jabour costs of production
rise and, other things being equal, profits margins fall. Those in highly skilled
professions such as surgeons, doctors, pilots and barristers are in a suong
bargaining position because their skills are in short supply and high demand. This
can create a wage- price spiral whereby demand for higher wages to keep in line
with inflation simply causes more inflation.
Inflation also harms employers located in expensive areas. Table 18.4 shows the
world's most expensive cities, which means employers in these areas have to pay
relatively high .,,.,ages to attract workers. Tokyo has been the most expensive city in
the annual Economics Intelligence Unit (EIU ) Worldwide Cost ofLiving Index a
total of 14 times in the past 20 years.
Inflation
Ta bl e 18.4 Theworld'smostexpensivecities
Ra nk City
Tokyo.Japan
Osaka.Japan
Sydney.Australia
O!.lo,Norway
Melbourne.Australia
Singapore
Zurich.Switzerland
Paris.France
Caracas, Venezuela
10 Geneva.Switzerland
S.OO,ce:EIUWotldwideC05tofUvinglndex,2013
• Bu siness confidence levels -

I nflation also causes business
uncertainty. The combination of
uncertainty and the lower expected
real ratesofremrnon im·esm1enr
(due to higher costs of production) Tokyo tops the most expensive cities index
rends to lower the amount of
planned im•estmenr in the economy.
Exam practice
Iran's inflation rate climbed above 30 per cent in 2013, reaching 31.5 per cent at the
end of the Islamic country's calendar year (Table 18.5). The country, with a population
of 74.8 million, had experienced double-digit inflation rates for most of the previous
decade. At the end of 2010, the government reduced food and fuel subsidies, thereby
fuelling inflation. In addition, international sanctions due to Iran's disputed nuclear
programme forced down the value of the Iranian rial, the country's official currency.
This added upward pressure on prices in the economy.
Ta bl e 18.5 lnflationratein lran

Infl ati o n (%)
March2012
March2013
1 With reference to the data in Table 18.5, explain why prices in Iran were
generally higher in 2013 than in 2012. (4)
2 Explain two reasons why the Iranian government might aim to control the level
of inflation in its economy. (4)
3 Examine how some Iranians are likely to have been more affected than others
by the double-digit inflation rates. (6)
Economic indicators
Activity
Discuss the impact of an increase in oil prices on the rate of inflation in your country or a
countryofyourchoice. Whichstakeholdersareaffectedthemost?Why?
Study tips Defl atio n

A fall in the While the prices of goods and services tend to rise, the prices of some products
rate of inflation actually fall over time. This is perhaps due to technological progress or a fall in
(known as
dis inflat ion)
consumer demand for the product, both ofwhich can cause prices to fall. Deflatio n
means that is defined as a persistent fall in the general price level of goods and services in the
prices are still economy - in other words, the inflation rate is negative. The nine countries that
rising,onlyat experienced deflation during 2013 are listed in Table 18.6.
a slower rate.
Be clear about Ta bl e 18.6 Deflationratesaroundtheworld,2013
the meaning of
defl at io n -an Country De fl ati o n rate(%)
actualfallinthe Somalia
general price
Chad
level.
Libya
Georgia
Ukraine
Japan
Switzerland
Liechten~tein
Sweden
Soorce: T,a<ling&xmom;c;
Technologicaladvancescancausethepricesof
many products to fall
The causes of deflation
The causes of deflation can be categorised as either demand or supply factors.
Deflation is a concern if it is caused by falling aggregate demand for goods
and services (often associated with an economic recession and rising levels of
unemployment).
[.., !"'
p P,
N)
0 Y
:._.!2
Natiooo ll ncome
Fi gure 1B.7 Deflationcausedbysupplyfactors
Inflation
Aggregate supply
Deflation can be caused by
higher levels of aggregate supply,
increasing the productive capacity
of the economy (sec Chapter 11).
This drives down the general price
level of gcxxis and services while
increasing national income. Such
deflation is called benig n defl atio n
(non-threatening deflation). For
example, supply-side policies such
as im'estmcnt in education and
infrastructure (sec Chapter 16 ), China's high-speed rail
higher productivity, improved
managerial practices, technological advances and government subsidies for major
industries all help to raise national income in the long run.
I n Figure 18.7, this is shown diagrammatically by a righrward shift of the
aggregate supply curve from ASi to ASi, reducing the general price level from P 1
to P2 • This happened in China during the past three decades with the Chinese
government pouring huge amounts ofinvestmcm funds into building new roads and
rail networks (the country spent $104 billion on railway invesm1em in 2013).
Natiooo l lnoome
Figure 18.8 Deflationcausedbydemandfactors
Aggregate demand
Deflation can also be caused by lower levels of aggregate demand in the economy,
driving down the general price level of goods and scn'ices due to excess capacity
in the economy. This causes what is known as ma lign deflatio n (deflation that is
hannful to the economy). For example, during an economic recession (see Chapter
20), household consumption of goods and services falls due to lower GDP per capita
and higher levels ofuncmploymcnt. In Figure 18.8, this is shown by a leftward shift
of the aggregate demand curve from AD1 to A Di, reducing national income from
Yi to Y2 , and forcing down the general price level from Pi to P2 • This happened
in Japan for much of the past two decades as the Japanese suffered from severe
economic recession. This cause of deflation is a concern as it is associated with a
decline in national income and standards ofliving.
Economic indicators
Case Study: Swine flu HIN I
Women officials of the Railway Protection Force (RPF) and passengers wearing masks at
Guwahatirailwaystation, lndia,duringtheheightoftheoutbreakin2009
In 2009 the world suffered from a pandemic of swine flu, a highly contagious respiratory
diseasec.ausedbytheH1N1 influenzavirus,whichisfoundinpigsbuthasthepotentialto
affect humans.
Theoutbreakoftheinfectiousdiseasein Northernlreland,theUSA,Chinaandlndia
slowed down economic activity to the extent that it caused deflation in all four countries,
andfallingratesofinflationinotheraffectednations,suchasAustralia,thePhilippines
and Britain.
The consequences of deflation

The consequences of deflation depend on whether we are considering benign deflation
or malign deflation. The consequences of benign deflation are ix,sitive as the economy
is able to produce more, thus boosting national income and employment, without
causing an increase in the general price level. This therefore boosts the international
competitiveness of the country. However, malign deflation is generally harmful to the
economy. The consequences of malign deflation include the following:
• Unemployment - As deflation usually occurs due to a fall in aggregate demand in
the economy, this causes a fall in the demand for labour - that is, deflation causes
job losses in the economy.
• Bankruptcies - During periods of deflation, consumers spend less so firms tend
to have lower sales revenues and profits. This makes it more difficult for firms to
repay their costs and liabilities (money owed to others, such as outstanding Joans
and mortgages). Thus, deflation can cause a large number of bankruptcies in the
economy.
• Wealth effect -As the profits of firms fall, so does the value of their shares during
times of deflation. This means that dividends and the capital returns on holding
shares fall, thus reducing the wealth of shareholders.
• Debt effect - The real cost of debts (borrowing) increases when there is deflation.
This is because real interest rates rise when the price level falls. For example, if
interest rates average 1.0 per cent but the inflation rare is - 1.5 per cent, then
the real inreresr rare is 2.5 per cenr (imagine the situation of falling house prices
while having to pay interest on mortgages taken out when prices were higher).
Thus, with deflation and the subsequent rising real value of debts, both consumer
and business confidence levels fall, further adding to the economic problems in
thecounrry.
Inflation
• Gove rnment debt - \Vith more bankruptcies, unemployment and lower levels
Study tips
of economic activity, tax revenues fall while the amount of government spending
The extent
to which an rises (due to the economic decline associated with malign inflation). This creates
economy is a budget deficit for the government, meaning that it needs to borrow money even
affected by though the real cost of borrowing rises with deflation.
malign deflation • Con sumer confidence - Deflation usually causes a fall in consumer confidence
will depend on levels, as consumers fear that things will get worse for the economy. Thus, they
the severity of
the deflation.
may postpone their spending, especially on consumer durable goods such as cars
Portugal's and ft1rnimre, as they expect prices to fall even further in the future or wait umil
experience of the economy improves. TI1is clearly docs not help the economy to recover, thereby
zero-rate inflation causing a downward deflationary spiral.
in2013would It is difficult to break out of a downward deflationary spiral. To do so would
have been very require a significant boost to aggregate demand. Business and consumer
different from
Somalia's - lS.35 confidence lc,'Cls would also need to increase. !merest rates (sec Chapter 16) could
percent inflation be cut to encourage consumer spending and increased investment expenditure in
rate in the same the economy.
Exam practice
For much of the past 20 years, Japan has suffered from deflation (see Figure 18.9).
:.~
,,~
!
!
0
'
.,
0
e, - 2 , -2
~
• -4 -4
J]n/95 }00/98 J] n/0 1 J] n/04 J] n/07 J] n/ 10 }00/ 13
Sou,ce:TradngEconomics
Figure1 8.9 Japan'sinflationrate,1994- 2013
1 Define the term 'deflation'. (2)
2 Explain what evidence there is in the chart to suggest that Japan has suffered
deflation for most of the past 20 years. (2)
3 Analyse the impact of prolonged deflation on the Japanese economy. (6)
Economic indicators

1 What is meant by 'inflation'?
2 What is the consumer price index and how does it differ from a retail price
index?
Why are weights used in the calculation of a CPI or an RPI?
Whatisabaseyear?
5 What are the two key causes of inflation?
6 Outline the main consequences of inflation.
7 Whatisdeflation?
8 What are the two main causes of deflation?
9 Differentiate between malign deflation and benign deflation.
10 Outline the main consequences of deflation.
Key terms
The baseyear referstothestartingyearwhencalculatingapriceindex.
The consume r prices ind ex (CPI) is a weighted index of consumer prices in the economy over
time. ltisusedtomeasurethecostoflivingforanaveragehousehold.
Cos t-pu sh inflation isinflationtriggeredbyhighercostsofproduction,forcingupprices.
Deflation isasustainedfall in the general price level in an economy overtime-the
inflation rate is negative.
Demand-pull inflation isinflationtriggeredbyhigherlevelsofaggregatedemandinthe
economy,drivingupthegeneralpricelevel.
Disinfl ation occurs when the rate of inflation falls, but is above zero - prices are generally
stillrising,onlyataslowerrate.
Hyperinflation referstoveryhighratesofinflationthatareoutofcontrol,causingaverage
pricesintheeconomytoriseveryrapidly.
Importe d inflation is triggered by higher import prices, forcing up costs of production and
thus causing domestic inflation.
lnfl at ion isasustainedriseinthegenerallevelofpricesofgoodsandservicesovertime,as
measuredbyaconsumerpriceindex.
The retai lpri ces ind ex (RPl)isusedtocalculatetherateofinflation . UnliketheCPl,theRPI
includes the cost of housing, such as mortgage interest payments and other housing costs,
but excludes low-income pensioners and high-income households.
A wage-price spira l occurs when trade unions negotiate higher wages to keep income in
line with inflation but this simply causes more inflation as firms raise prices to maintain
their profit margins.
@ Employment

• describe the changing patterns and levels of employment
• discuss the causes and consequences of unemployment.
TakenfromCambridgelnternationalExaminationsSyllabo,~GCSE045S/Olevel2281)
0 Camb<idge lntemational Examinabom
Changing pa tterns a nd levels of employment

Employment refers to the use offactors of production, such as labour, in the
economy. For example, people may work in the primary, secondary or tertiary sectors
of the economy (sec Chapter 1). It also includes those who arc self-employed.
Emp~em patterns change O\'er time with changes in economic trends. For example,
there have been large pb losses in manufacturing industries in the USA and the UK as
many firms have shifted thciroperatkxl.sro India and China. On the other hand, other job
opporrunities in the tertiary secror have been created in the USA and the UK.
Some changing employment patterns in modern economies include:
• Employment sector - As a country de,'Clops, the number of people employed in
the primary industry tends to full and the majority ofworkers are employed in the
tertiary sector. Forexample,agriculruraloutputaccoumsforlessthan 1.5 percent
of the gross domestic pnxluct in Denmark, whereas over 76 per cent comes from
the servicessector (see Table 19.1).
Table 19.1 Outputbysector(%): selectedcountries,2012
GDP - oomp os itionby secto r(%)

Country
Primary Seco nd ary Terti ary
Denmark
Luxembourg
Ethiopia
Nepal
Somalia
SoUfce:CIAv.'orl<lfacrbook.2011
• Delayed entry w wor kforce -

As more people study to tertiary
education level, the average age of
employees entering the workforce
rises. Graduates could be aged
around 25 by the time they
complete their first degree and
master's degrees. ,\llore females
and mature students have also
entered tertiary education, again
limiting the potential size of the
economr's workforce.
Economic indicators
• Agei ng populatio n - This occurs when the a\'erage age of the population rises,
Study tips
partly due to lower birth rates and longer life spans in developed economies. The
Not all people
of working age lower labour supply means that firms are more willing to employ older employees
are willing to and hire people beyond their retirement age. The economic consequences of an
participate in ageing population are examined in Chapter 22.
employment. • Flexible workin g pattern s - Changes in the world economy have meant that
This depends firms need to be far more flexible in order to compete internationally. Examples of
on the country's
flexible working patterns include firms hiring more part-time staff, firms allowing
welfare benefits
scheme and social employees to work from home, flexible working hours and outsourcing non-
attitudes such as core functions (such as accounting, cleaning, security and JCT) to other service
attitudes towards providers.
women in the
workforce. Governments strive to ensure that everyone who is able and willing to have a job is
able to find employment.
Une mployme nt
Unemployment occurs when people of working age are both willing and able
to work but cannot find employment. The United Nation's International Labour
Organisation (I LO) states the lower age limit for employment as 15 years old. While
there is no official upper limit, many countries use an age limit of between 65 and
70. For example, the official retirement age for females in the UK is 66 years and 5
months, while this figure is 67 years for all workers in Norway, Poland and the USA.
Figure 19. l shows unemployment rates in the USA from 2000 to 2013.
1:1 }00/02 J:] n/ 04 J] n/ 06 }00/08 J] n/ 10 J] n/ 12
Soorce: T,adingfrooomic,
Figure19.1 USunemployment,2000 - 13
The unemployment rate shows the percentage of the country's workforce (those of
working age) that is unemployed. It is calculated by the fonnula:
unemployment rate = numbe~,::k:::tployed x 100
Alternath·ely, this can be expressed as:
unemployment rate= number ofunemployed x 100

number of unemployed + employed + self-employed
Employment
The ! LO measures a country's unemployment based on the number of people

who are:
• willing to work, bur unable to find it
• actively looking for work - that is, they have looked for a job in the last 4 weeks
• able to start work within the next 2 weeks or waiting to start a new job within in
the nen2weeks.
Job-seekers look at employment advertisements at a labour market in China
Ac ti vity
Find out the rates of unemployment in your country or a country of your choice for the
past 5 years. A good starting point is w -.tradingeconomics.com or the International
Labour Organisation website c-w.ilo.org). What trends can you identify? Investigate the
possiblecausesoftheseunemploymenttrends.
Exam practice
1 Calculate the unemployment rate in a country with a population of 65 million
people, of whom 36 million are employed and 4 million are unemployed. (2)
2 Calculate the number of unemployed people in a country with an unemployment
rate of 8.5 per cent and the follow ing population data:
• population : 46 million
• age 0-14 = 17 million
• age 15-64 = 20 million
• age~ 65 = 9 million. [2]
Economic indicators
Exam practice
With a population of around 163 million, Nigeria is one of the most populated
countries in Africa. Over 42 per cent of the population is aged below 15 and Nigeria
has a large dependency ratio of almost 86 per cent. Gender inequalities mean the
country has one of the lowest female employment rates in the world, with less than
45 per cent of working age females in employment. Most people are employed in
primary industries. Nigeria is a large producer of crude oil - about 90 per cent of its
export earnings come from the sale of oil. Figure 19.2 shows unemployment rates in
Nigeria between 2006 and 2013.
5 +-~~~~c;=~~~~~~~~~~~~
J]n/06 J]n/08 J] n/ 10 Joo/12

Soorce: T,a<ling &xmom;c;
Figure19.2 Nigeria'sunemploymentrate,2006-13
1 Describe the changing pattern of employment in Nigeria from 2006 to 2013. [2]
2 Nigeria's working population (workforce) is around 87.7 million. With an
unemployment rate of 23.9 per cent, calculate the number of unemployed
people in the country. [2]
3 Explain two possible factors contributing to the trend described in the previous
question. [4]
Employment as a macroeconomic objective

High employment, or low unemployment, is a key macroeconomic objective of all
governments. 1l1ere are se\·eral reasons for this, as high employment helps to:
• raise standards of living for the a\·erage person in the country (see Chapter 21)
• increase economic growth - another key macroeconomic objective (see Chapter 20)
• raise rax revenues (due to higher levels of income and spending in the economy) to
finance go\'ernmem spending
• reduce the financial burden and opportunity cost for the government, as spending
on welfare benefits falls
• prevent 'brain drain' from the economy - this can occur during periods of high
unemployment when highly skilled workers leave the coumry in search of job
opportunities elsewhere
• reduce income and wealth inequalities - poorer people are more affected by
unemployment, as they lack savings and wealth.
Employment
Exam practice
According to the International Monetary Fund (IMF), Pakistan's annual unemployment
rate between 2007 and 2013 was kept steady at between 5 and 6 per cent. This,
according to the Central Intelligence Agency (CIA), meant that Pakistan's gross
domestic product grew by 3.7 per cent in 2012 and another 5 per cent in 2013. These
changes have helped to reduce some of the poverty in the country.
1 Explain why it might be difficult at t imes to know the exact rate of
unemployment in a country. [3)
2 Examine the possible consequences of low unemployment for the Pakistani
economy. [6[
Causes of unemployment
There are many potential causes of unemployment. These causes can be explained by
examining the various types ofunemploymem.
• Frictional unemployment is transitional unemployment that occurs when people
change jobs, due to the time delay between leaving a job and finding or starting a
new one. Therefore, frictional unemployment always exists in the economy because
it takes time for the labour market to match available jobs with the people looking
for jobs.
• Seasonal unemployment is caused by regular and periodical changes in demand
for certain pnxlucts. For example, fruit pickers are in high demand during the
summer months while retailers tend to hire more temporary workers during the
Christmas season (the busiest time of the year for most retailers).
Seasonal workers
• Technological unemployment occurs when workers Jose their jobs due to firms
opting to use capital-intensive technologies (see Chapter 11 ). This can cause large·
scale unemployment in certain industries. For example, supermarkets in Europe
introduced self-service checkouts in 2009. Their huge success and cost sa\'ings for
supermarkets and other retailers mean that fewer workers need to be hired.
Economic indicators
• Yo uth unemployment affects members of the working population aged 2 1

and below. They have relatively fewer skills and less experience, so they are the
most likely to be affected during an economic downturn. For example, youth
unemployment in Greece hit a record of58.4 per cent in 2012 (the highest rate
ever recorded for an EU nation) and Spain's youth unemployment reached a
historic high of55.7 per cent in 2013.
• Regio n al unemployment occurs when unemployment affects specific geographical
areas ofa country. \Vhile busy central business districts tend to have higher rates
ofemploymem, remote rural areas have relatively high rates ofunemployment. In
the USA, unemploymem averaged 7.7 per cent in March 2013. However, the rate
was higher in some states such as Mississippi and Nevada (both at 9.6 per cent) and
much lower in other districts such as Nebraska (3.8 per cent) and North Dakota
(3.3percent).
• St r uctu ra l unemployment occurs when the demand for products produced in a
particular industry falls continually, often due to foreign competition. There are
suuctural and Jong-term changes in demand for the products of certain industries.
The UK, for example, has suffered from structural unemployment in shipping,
textiles, steel pnxluction, coal mining and car manufacturing. Those who suffer
from structural unemployment usually find it quite difficult to find a new job
without rcuaining.
• Voluntary unemploym ent occurs when workers choose not to work. Voluntary
unemployment usually exists in economies with relatively generous welfare benefits
for the unemployed as well as high rates of income tax, thus creating disincentives
to work at current market (equilibrium) wage rates.
• Classical (real-wage) unemployment occurs when real wage rates are set above
the market-clearing le\·el, such as in the case ofa national minimum wage (see
Chapter 7 ). This leads to excess supply of labour, as the number of job-seekers
exceeds the demand for Jabour. In Figure 19.3, the imposition ofa minimum
wage raises the cost oflabour from W1 to tt'i. At the higher wage rate, demand
for labour is N, but the supply of labour is N 2 ; the difference represents
unemployment, as firms arc unable and/or unwilling to pay workers more than
their market (equilibrium) value.
jr: ~
0 N3 N1 N2
Errpoyme!l1of b 00<.f
Figure19.3 Classicalunemployment
Employment
• Cyclical unemployment, also known as dem and·deficient unemployment, is

the most severe type ofunemploymem because it can affect every industry in the
economy. It is caused by a lack of aggregate demand, which causes a full in national
income. In Figure 19.4, the full in aggregate demand in the economy from AD1 to
AD2 causes national income to full from Y1 to Y2 , creating mass unemployment.
Demand-deficient unemployment is experienced during an economic downturn -
that is, in recessions and slumps.
j11:]-- -* ··
0 L_Y,
Natiooo l Income
Figure 19.4 Demand-deficientunemployment
\Vhile Spain and Greece saw record unemployment rates of26.6 per cent and 27 per
cent respectively in 2012, these are relatively modest compared with the countries
with the world's highest unemployment rates (see Figure 19.5).
Zim babwe 1-------------~
"""'" § ~ -
Se"'9" I
=e~
Nee,I
8"'sn laa00Herzego,ina
S>=~:""" I======
S.OO,ce:Thel-leritageFoundatioo.2013
Figure 19.5 Theworld'shighestaverageunemploymentrates,2013
Activity
Findreal-worldexamplesoffrictional,seasonal,technologicalandstructural
unemployment, and use an image or picture to represent each type of unemployment.
Economic indicators
Co nseq uences o f unemploy ment

Unemployment affects a range of stakeholders: the unemployed themselves;
their families; employers and firms; the gm'ernmcnt; and society as a whole. The
consequences of unemployment include the following:
• The unemployed suffer from stress, low self-esteem, homelessness, depression and
other health problems. In extreme cases, unemployment has Jed to suicide.
• Family and friends may also suffer from lower incomes and this often leads to
arguments and even separation or divorce.
• The local community can suffer if there is mass unemployment - for example, there
may be po\·crty, falling house prices (and hence asset values) and increased crime
rates in the ncighbourhcod.
• Firms lose out as there arc lower lc\·els of consumer spending, investment and
profits. Business failures and bankruptcies arc more likely to occur during periods
of high unemployment.
• The go.•crnmcnt may face higher expenditure on welfare benefits and health
care for the unemployed. Prolonged periods of high unemployment can lead to
increased go\·ernmcnt debts.
• Taxpayers stand to Jose due to the opportunity costs of unemployment - the
expenditure projects forgone due to increased spending on unemployment and
welfare benefits.
• The economy suffers from being less internationally competitive, due to falling
levels of spending and national output.
Policies to deal w ith unemployment

Governments can try to deal with the problems of unemployment in a number of
ways. This panly depends on the causes of unemployment in the economy. As there
arc many types and causes of unemployment, the government needs to identify the
best policies to deal with the problem. There are four general ix,licics for reducing
unemployment: fiscal policy, monetary policy, supply-side policy (sec Chapter 16) and
protectionist measures (sec Chapter 26).
• Fiscal policy - This is the use of
taxation and go\·crnmcnt spending
policies to influence the level of
economic activity. It can be used to
tackle unemployment caused by
demand-side issues, such as cyclical
and structural unemployment. The
use of expansionary fiscal policy (tax
cuts and increased government
spending) can boost aggregate
demand and real national income, as
shown in Figure 19.6. In turn, this Ncilooa ll ncome
will lead to more cmplormcnt Figure 19.6 Expansionaryfiscalpolicy
opportunities.
Employment
• Monetary policy - This refers to the use ofimerest rates to affect the level of
economic acti\'iry. By lowering interest rates, the cost of borrowing falls, thus
encouraging households and firms to spend and invest. In Figure 19.7, higher
aggregate demand boosts the demand for Jabour c.urve from Du to IJu. This
results in higher levels of employment in the economy, as shown by the move from
N 1 to N 2 • The resulting rise in real wage rates from Wi to Wi also helps to attract
more labour, causing an expansion along the supply of labour (Si.) curve. Like fiscal
policy, monetary policy tackles demand-side causes ofunemploymem.
Figure 19.7 Monetarypolicyandthelabourmarket
• P rotectio nist measures such as tariffs and quotas (see Chapter 26) can be used
to safeguard domestic jobs from the threat of international competition. For
example, the Japanese government imposes up to 778 per cent import taxes
on rice - the highest rate in the world - in order to protect agricultural jobs in
the country.
• Su pply·sidc policies - These government strategies arc used to deal with
imperfections in the labour market and to reduce unemployment caused by
supply-side factors. Tlu1s, these policies arc aimed at addressing frictional,
voluntary and classical unemployment, although they can also be used to help
reduce structural and cyclical unemployment. Examples of supply-side policies arc
as follows:
O I nves tment in educatio n a nd t raining helps unemployed people to gain
new skills so they can find employment. An example is retraining structurally
unemployed manufacturing workers to help them find work in the tertiary
sector. Education and uaining expenditure should also help future generations
to become more skilled and employable.
O A red uctio n in t rade unio n tx>Wers means rhar laOOur unions arc not in such a
strong bargaining position to obtain higher wages (see Chapter 8). Strong trade
unions ha\·e often been able to demand annual pay rises in excess of inflation
and the marker equilibrium level. H ence, government intervention to reduce
the influence and po\\-er of trade unions can help to reduce classical (real-wage)
unemployment.
Economic indicators
0 Employment incentives can be offered to firms for training and hiring

the long-term unemployed. For example, the govemmem can offer firms
tax allowances and/or subsidies to reduce their costs ofttaining and hiring
workers. Similarly, enterprise zones (see Chapter 16) could be set up in areas
of high unemploymem to create jobs. However, firms might be reluctam to do
so because of the lower pnxluctiviry and higher risk of hiring the Jong-term
unemployed.
0 A review of welfare benefits ensures that there are incemh-es to seek
employment rather than to rely on state welfare benefits. !fit is made more
diffic.ult for people to claim unemployment benefits, they become more
proactive in searching for jobs. This could significamly help to reduce
unemployment.
While supply-side policies tend to have more permanent impacts on employment,
these effects take longer to accomplish compared with demand-side policies aimed at
reducing unemployment in the economy.
Exam practice
In June 2010, Tesco opened Britain's first supermarket without any checkout
workers. Instead, one person is hired to supervise the five checkouts, mainly to assist
customers who have not used a self-service checkout before. The UK's largest retailer
employs around 221 OOO workers in the UK, but critics argue that such technological
advancement will cause mass job losses.
Soorce;adaptl'dfromDailyMai/Online
1 Define the term 'technological unemployment'. [2)

2 Analyse the WclfS in which the UK government could reduce technological
unemployment. [6)

1 How does the pattern of employment in the three production sectors change
as an economy develops?
2 Why has there been a delay in most developed countries for labour to enter
the workforce?
3 How have ageing populations in developed economies affected employment
patterns?
4 How does the International Labour Organisation measure unemployment?
5 How is the unemployment rate calculated?
6 Why is employment a macroeconomic objective of all governments?
7 Outline the main types (and hence the causes) of unemployment.
What are the consequences of high unemployment in the economy?
What are the four main government policies that can be used to reduce
domestic unemployment?
10 Give three examples of supply-side policies that can be used to reduce
unemployment.
Employment
Key terms
Employment refers to the use of factors of production in the economy, such as labour.
Unemp loyment occurs when people of working age are both willing and able to work but
cannot find employment.
The unemployment rate is a measure of the percentage of a country's workforce that is out
of employment.
The w ork ing po pu lation (or labour force) is the number of people in an economy who are
of working age and who are willing and able to work.
@) Economic growth
• define 'gross domestic product' (GDP)
• describe and have a general understanding of the causes and consequences of
economic growth
• define the term 'recession'
• describe and evaluate measures and indicators of comparative living standards,
such as GDP per head and human development index (HDI).
Taken from Cambfidge International Examir>abom Syllabus (IGCSE 0455/0 Level 2281 )
O Cambridgelntematkm~IExamir,atioo,
Gross domestic product and economic growth

Gross domestic product (GDP) measures the monetary value of goods and
services produced within a country for a given period of time, usually one year. The
comix,nems of GDP are as follows:
• Consumptio n expenditu re (C ) - This refers to the total spending on goods and
services by individuals and households in an economy. Examples of consumer
expenditure are the economy's spending on housing, transport, food, clothing and
domestic. holidays.
• Investment expenditure (I) - This refers to the capital expenditure of firms
whicl1 is used to further production and expand the economy's producth·e capacity.
Examples are the spending on new machinery and the constrnction of new fuctories.
• Go ve rnment ex penditure (G) - This is the total consumption and investment
expenditure of the government. Examples are the spending on infrastrucrnre (such
as rail and road networks) and the construction of new schools and hospitals.
• Export earnings (X ) -This measures the monetary value of all exports sold to
foreign buyers. For example, France exports a huge amount of wine, dairy products
and fruits, so the earnings from these exports are calculated in the measure of GDP.
• Import expenditure (M ) - This measures the monetary value of the payments
made for all imports. France imports a lot of cars, oil and smartphones. The
spending on these items means that money leaves the French economy, so this
must be deduned from its calculation ofGDP. The difference between the value of
a country's exports and imports (X - M ) is called net ex ports.
Therefore, GDP is calculated using the formula:
GDP:C+l+G+ (X-M )
A ctivity
Discussinpairsthereasonsforthefollowing:
1 Whygovernmentspendingoninfrastructure(suchasroadandrailnetworks)and
training programmes for the unemployed are examples of investment expenditure.
2 Whythespendingbyforeigntouristsin ParisrepresentsexportearningsforFrance.
l Why investment is important for a country's economic growth.
Economic growth
Econo mic g rowth

Econo mic growth is the increase in the level of national output - rhar is, the annual
percentage change in GDP. Hence, in theory, an increase in any of the components
of GDP (consumption, inwsunent, government spending and net exports) can cause
economic growth.
An increase in the quantity and/or the qualit y of f.tctors of production (see
Chapter 1) can also create economic growth, such as an increase in the Jabour supply
or improvements in the state of technology.
Economic growth increases the Jong-term productive capacity of the economy,
shown by an outward shift of the production possibility curve (see Chapter l and
Figure 20. 1).
Ec=c gow,h=oo,oo=
~ dKJg r<llllrmllm lly by an ooM<J rd
1 ~1:::;~=-1ncr~o~1
ose~~~-
ocC>ff"t> nat1on don r1 the
~ qoo nlity andri ityol fodor,of
~ =~hi ~~;:"'.;:
prod,ce<oodcon""'1le<goo6
0 C:00.Umergoods
Figure20.1 Economicgrowth
Causes of economic growth

T he f.tctors rhar accoum for the differences in the economic growth rates of different
countries include variations in the following:
• Factor endowments - This
refers to the quantity
and quality of a counuy's
factorsofproduction . For
example , Saudi Arabia is
'
well endowed in the supply
of oil, France has plenty of
~ ~'"'·_ "=
arable land for its agricultural
output, and Australia has
many natural resources such
.,. ,_;:;::~ - :
-=------- ~
as coal, gold and iron ore .
These countries can therefore ~________.;I!~-
specialise production on a
large scale , rhus benefiting Saudi Arabia is the wo rld's largest supplie r of oil
from economies of scale
(see Chapter 14), and export their lower-priced products to O\'erseas marke ts. By
contrast, countries rhar Jack natural resources, land and productive Jabour rend to
struggle to achieve economic growth .
Economic indicators
• 1l1e labour force - The size, skills and mobility of the economy's workforce has an
impact on the country's economic growth. For example, India's large laOOur force
and Germany's highly skilled workers have contributed to the economic growth of
these countries. The mobility of labour refers to the extent to which workers can
change between jobs (known as occupational nx:,bility) and the extent to which
they are willing and able to move to different locations for employment (known
as geographical mobility). Generally, the more occupationally and geographically
mobile workers arc in a country, the greater its economic growth is likely to be.
• Labo u r producti vity - This refers to the amount of goods and services that
workers produce in a given time period. It is often referred to as output per
worker, expressed as a monetary value (GDP divided by the country's labour
furce). Labour productivity (the productive use oflabour) is a key detenninant of
economic growth. This is determined by several interrelated factors, such as the
qualifications, experience and training, and motivation of the laOOur force.
Technological advances, sud1 as the use of internet technology in e-commerce
(online trading), can also enhance labour productivity. An increase in the labour
productivity of a country helps to impro,e its imernational competitiveness and
hence its prospects fur economic growth.
• Investment expenditure - In order to remain comperith-e in the long run, countries
must invest in capital resources. Investment is a component of aggregate demand, so any
increase in investment
slx:,uld help to bcost
the country's GDP.
lmcstmenthclpsto
boost the country's
producti,-ecapacity
in the long nm.
Investment expenditure
onphysicalcapital, such
as the use of computers
inproduction (see
Chapter l l ) canalso
help to imprm-e laOOur
producthity. Policies
roencouragcfurcign
direct im·esm1ent (the Japan's Honda, Nissan and Toyota production plants in the UKhelp
invesm1ems made by to create jobs in the UK and therefore boosts its GDP
furcignmultinational
companies in overseas markets) can also help a coumry's economic growth and
dC\-elopment. For example, Japan's Honda, Nissan and Toyota have production plants in
the UK, which helpstocrearejobsin the UK and thercfureto bcx:Jst its GDP.
Adva ntages of economic growth

In general, economic growth is desirable due to the advantages that it brings fur
members of society. These advantages include:
• Im proved st andard s of living - Economic. growth tends to lead to a higher
standard of living fur the a\-erage person. H igher income levels in a country enable
people to spend more money to meet their needs and wants (see Chapter 1). This
helps to eliminate absolute poverty in the country.
Economic growth
• Employment - Economic growth leads to higher levels of employment in the

Study tips
economy. This helps to raise consumption and encourages further invcsnncnt in
While economic
growth is capital, helping to sustain economic growth.
generally seen • Tax revenues - Economic growth is associated with higher lc\·cls of spending in
as a desirable the economy. This generates more tax rc\'Ctntcs for the government. For example,
macroeconomic the government can collect more from sales taxes (on consumption), corporation
objective, tax (on the profits offirms) and import taxes. Hence, there are more funds for the
remember that
government to use to sustain the growth of the economy.
individuals do not
benefit equally
from economic
growth. Exam practice
According to the Economist Intelligence Unit, the economy of Macau grew by 14.3
per cent in 2013 - the highest economic growth rate for any country in the year.
The island nation had enjoyed 9.8 per cent growth in 2012, with gambling revenue
increasing by approximately 14 per cent to about $38 billion, making it the world's
biggest gambling market- ahead of Las Vegas. In 2011, Macau enjoyed a stunning
20.7 per cent growth rate.
The country is also investing huge amounts of money to attract a wider range of
tourists, with casino giants such as Sands and MGM Resort also investing large sums
of money in the economy.
1 What is meant by 'economic growth'? [2)
2 Explain how investment in Macau helps to boost its economic growth. (4)
Disadva ntages of econo mic g rowth

Despite the advantages of economic growth, there arc also potential drawbacks:
• Environmental consequences - H igh rates of economic growth can create
negative externalities such as pollution, congestion, climate change and land
erosion (sec Chapter 2 ). Such environmental impacts can damage the wcllbcing of
people and their quality of life in the long run.
• T he risk of inflatio n - If the economy gmws due to excessive demand in the
economy, there is the danger of demand-pull inflation (sec Chapter 18). This
can lead to prices of goods and services rising to unstable levels, with negative
consequences on the economy sucl1 as a decline in the country's international
competitiveness.
• Inequ alities in income and wealth- Although a country might experience
economic growth, not c\·eryonc will benefit in the same way. Economic growth
often creates greater disparities in the distribution of income and wealth - the rich
get richer and the poor get relatively poorer, creating a widening gap between rich
and poor.
Forbes magazine reix,ncd that in 2012, the top 10 billionaires in the USA had a
combined wealth of over $347 billion - the equivalent of2.3 per cent of the USA's
gross domestic product. Put another way, their wealth was 2.5 times larger than
Vicmam's GDP or 24 times greater than the GDP of Cambodia!
Economic indicators
• Resou rce depletio n - Economic growth often ilwolvcs using up the world's
scarce resources at rates that arc not sustainable. For example, deforestation and
overfishing have led to problems in the ecosystem.
Hence, economic growth docs not necessarily resolve a country's sociocconomic
problems, such as resource depletion, market failures (sec Chapter 5) and income
inequality.
Pollution-anegativeconsequenceofrapideconomicgrowthinChina
Activity
In small groups, research the economic problems of overfishing. Websites such as
http: //overfishing.org and http: //ocean.nationalgeographic.com willhelp. Beprepared
topresentyourfindingstotherestoftheclass.
The busin ess cyc le

Economic growth occurs when t here is an increase in the Jc,eel of economic activity in
a country over time. The term business cycle (also known as the t rad e cycle) describes
the fluctuations in economic activity in a counuy over time. These fluctuations create
a Jong-term trend of growth in the economy, as shown in Figure 20.2.
Economic growth
The va rio us stages in the business cycle are shown in the same diagram.
A11hepaokdt.etrode
C)de. ocooomlc oclfvlty
1sa1 1,h19 h...iM
~ 1 1 o l o w•
....ti1~coruume<,md
oosoo.. coriidence
~are high
' ""'
There i. alal rn GO!' dLXlngon

ecooomlc roceMlon. Tochn rnlfy. a
races,· ocam when a coonty',
GOP /al, lo, MO coosea,~ve
qoo r'er,.D..trlng an,ce,.ion.flere
1,a docl lne ln <n'1"'"1ptbn.
lrwe,tmen1and r.e! e"f)OO'ldieb
!dli ngexpo<1earn"9']
Figure20.2 Thebus iness cyc le
Case St udy: Recession in the PIGS econo mies

Following the glo bal financial crisis of 2008, the economies of Portugal, Ireland, Greece and
Spain faced a major economic downturn in their business cycle.
By 2013, both Greece and Spain were experiencing record unemployment ra tes of 26.8
percentand26.6percentrespectively. Spain'syouthunemploy mentrate(amongthose
aged21andbelow)wasS5percent - thehighestinEUhisto ry.
Under such extreme economic circumstances, the government needs to intervene to
help the economies to recover. All four PIGS eco nomies received financial bailo uts:
• Portugal~ S114billion
• Ireland~ S113 billion
• Greece = S159billion
• Spain~ S130 billion
Economic indicators
Mea su res a nd indicato rs of living sta nda rds

Economists belie,>e that sustained economic growth is an important macroeconomic
objective because it is the most practical measure of sta ndards of living in a country.
For example, China's phenomenal economic growth over the past three decades has
Jed to an increase in the standard ofliving for the majority ofits population. With
an average growth of 10 per cem per year, the average Chinese citizen would double
their income every seventh year (see Figure 20.3).
The t\\O main measures or indicators of living standards are GDP per head (or
GDP per capita) and the Human Development Index ( HD I).
Figure 20.3 China's GDP growth, 2000 - 13
One problem in using GDP figure s to measure standards of living is that the size of
the population is ignored. For example, China's GDP is significantly larger than that
of Luxembourg or Sweden. Howe,·er, China's much larger population means rhar the
GDP per head of Sweden and Luxembourg is greater (see Table 20. 1). Hence, GDP
per capita (per person) is a better measure of standards of living.
Table20.1 GDPpercapita - selectedcountries

Country GDP (Sbn ) GDP per capita (S) Po pulation (million)
China 6094
Sweden
Luxembourg
Soorce: adaptedfromCIAFa,cr/xxJk
Another consideration is inflation - a persistent increase in the general level of prices

over rime (see Chapter 18). Inflation erodes the value of GDP because the value of
money falls if there is inflation.
For example, ifa country's G DP increases by 5 per cent in a year bur inflation also
increases by 5 per cent, then the real value of GDP has nor changed. Hence, for a
more accurate measure of GDP as an indicator of standards of Ji,,ing, the monetary
value of GDP must be adjusted for price changes. This adjusted measure is known as
real GDP. Hence, real G DP per capita is a better measure of standards of living.
Economic growth
An alternative measure of standards ofliving that looks at factors beyond real GDP
is called the Human Development Index (H DI ). This is a composite indicator of
living standards in a country, obtained by measuring three dimensions of human
development:
• H ealth care - this indicator measures life expectancy at birth. The better the
health care in a country, the greater social and economic wellbeing tends to be.
• Edu catio n - this indicator measures the mean years of schooling and the expected
years of schooling in the country.
• Incom e levels - the higher the national income (or GDP) ofa country, the greater
human de\·elopment tends to be.
H ence, poor countries such as Mozambique, Afghanistan, Sudan and Rwanda have a
low H D I. Wealthy countries such as Norway, New Zealand and Canada have a high
H D I.
HOl: HumonCleYdopm..,tl<><b(HOI)""""
(2012)
. >0.536
O o.1 12 - 0.sJo
oo.796 - 0.712
D< o .796
o~""'
Figure 20.4 Human Development Index rankings
H owe\·er, there are limitations in using the H D I to measure standards of living:

• Q u a litative factors - the H D I ignores qualitative measures affecting standards of
living, such as gender inequalities and human rights.
• Incom e d istrib utio n - the H D I does not take account of inequitable income
distribution, thus being less accurate in measuring Jiving standards for the 'average'
person.
• Environmental issues - the H D I ignores environmental and resource depletion
resulting from economic growth.
• C ultu ra l d ifferences - although the H D I is a composite indicator, it ignores
cultural differences and interpretations of the meaning of standards of living.
Activity
1 UsetheinternettoresearchthetoptencountriesasmeasuredbytheHDI .
2 Discuss whether the HDI is a good measure of standards of living in these countries.
Economic indicators
Exam practi ce
The follow ing table gives the HDls for Australia, Ethiopia, Russia and Viet nam .
Determine which country has which HDI. Explain the reasoning behind your
[6]
Country Co un try
C h apter review questions

1 What is meant by 'gross domestic product' (GDP)?
What is economic growth and how is it calculated?
What are the causes of economic growth?
4 What are the consequences, both positive and negat ive, of economic growth?
5 What is meant by 'a recession'?
6 How do calculations of GDP per head help to measure living standards?
7 What are the advantages and disadvantages of using t he Human Development
Index (HDI) to measure standards of living?
Key terms
Businesscycle describesthefluctuationsintheeconomicactivityofacountryovertime,
thus creating a long-term trend of economic growth in the economy.
Consumpt ion expenditure is the value of all private household consumption within a
country.
Econom ic growth istheincreaseinthelevelofnationaloutput-thatis,theannual
percentage change in GDP.
GDP per head (or GDP per capita) is the gross domestic product of a country divided by the
populationsize. ltisakeymeasureofacountry'sstandardsofliving.
Government expenditure is the total value of a government's consumption and investment
spendingandtransferpayments,suchasunemploymentbenefitsandstatepension
schemes.
Gross domestic product (GDP) is the monetary value of goods and services produced within
acountryinagivenperiodoftime,usually1 year.
Human Development Index (HDI) is a composite indicator of living standards in a country,
obtained by measuring three dimensions of human development: education, health care
and income.
lnvestmentexpend iture isthesumofcapitalspendingbyallbusinesseswithinacountry.
Net exports refers to the monetary value of the difference between a nation's exports
earningsanditsimportexpenditure.
Rea l GDP refers to the value of national income (GDP) adjusted for inflation to reflect the
truevalueofgoodsandservicesproduced in a given year.
Rec:ession occursinthebusinesscyclewhenthereisafall inGDPfortwoconsecutive
quarters.
@ Standards of living
• describe w hy some count ries are classi fied as developed and others are not
• discuss differences in standards of living w ithin co unt ries and between
countries, both developed and developing
• describe the d ifference between absolute and relative poverty
• recognise and discuss policies to alleviate poverty.
Taken from Cambridge International Examinabom S),1tabus (IGC SE 0 455/0 Ll'Vel 228 1)
0 Cambfklge International Examifliltioo,
Classificatio n of co untries
The World Bank classifies economies using the criterion of gross natio na l income
(GNI) per capita. This calculates the total expenditure in the economy (gross
domestic product) plus net income from assets abroad, divided by the population
size. Based on a coumry's GN I per capita, it is classified as a low-income,
middle-income (further divided into lower-middle and upper-middle), or
high-income country.
Case Study: Examples of Wo rld Bank classifications

Examples of the World Bank's classification of countries a re shown below:
• Low -income countries (G NI of S1025 per capita or less): Afghanistan, Bang ladesh,
Liberia, Malawi, Nepal and Zimbabwe.
• Low er-middle income co untries (G NI of $1026 to $4035 per capita): Fiji, Ghana,
Indonesia, Pakistan,Sudanand Ukraine.
• Upper-middle income co untrie s (G NI of $4036 to S1247S per capita): Argentina, Brazil,
China,Jamaica,Mexico, PeruandVenezuela .
• High-in come co untrie s (G NI of $12476 per capita and above): Belg ium, Greenland, Hong
Kong, Kuwait, Monaco, Switzerland and the United Arab Emirates.
Low- and middle -income countries are often referred to as d evelo ping econo mies
or less economically developed countries (LEDCs). In these conmries, the
per capita income is low and standards of living are generally poor. H igh-income
coumries are also referred to as d eveloped econo mies or more economically
developed countries (MEDCs). In these coumries, GDP per capita is high and
there is widespread access to goods and services, and thus a high degree of
economic prosperity.
Act ivity
Visit the World Bank website (http://data.worldbank.org/about /count ry-dassifications/
country-and -lending -groups) to see whether your country is classified as an LIC, LMC, UMC
or HIC. What are the advantages and disadvantages of using GNI as the key measure to
classifytheeconomicdevelopmentofcountries?
Standards of living
Exam practice
Examine the data for four countries shown in Table 21.1.
Table21.1 Grossdomesticproducta ndpopulation data: selectedcountries,2013
Country Gross domesticproduct(Sbn) Population(million)
China
Ja pan
Germany
S.OU, ce : Trad ngfcooomics
cl-
1 Define the term 'gross domestic product'. [2]
2 Explain which of the above countries is most likely to have the highest standard
~
However, the classification of countries by income docs not necessarily or accurately
reflect economic de~·elopment or standards ofliving. An alternative to the World
Bank classification of countries is the Human Development lndex ( HDI ) produced
by the United Nations Development Programme (UNDP).
Rat her t han using only GDP per capita, t his method uses several criteria: life
expectancy, educational attainment and income per capita. Although H DI is slightly
more complicated than GN I per capita to measure, it takes not o nly income bur
also life expectancy and literacy rates into consideration when measuring economic
development and standards of living in a coumry.
The index for each coumry is scored between O and 1, with l being the most
developed . T he UNDP classifies countries imo four broad human development
categories, wit h 47 counuies in each classification of human de~·elopmem: very high
(top percentile), high (percentiles 51-75), medium (percentiles 36- 50) and low
(bottom percentile). Examples are shown in Table 21.2 .
Table21.2 HDl classificationofcountrie s(selectedcountries)
Very high human development High human development
Country UNDPRank Country UNDPRank
Bahrain
Australia Bahamas
Belarus
Netherlands Uruguay
Germany Montenegro
Medium human development Low human development
Country UNDPRank Country UNDPRank
Tonga Congo
Belize Solomonl'ilands
Dominican Rep Sao Tomt> andPrincipe
Fiji Kenya
Bangladesh
S.OU,ce : UNOP.HDIR"(X)(T.1013
Developed and developing economies: trends in production, population and living standards
There are three main criticisms of using the H DI to classify countries. First, the
Study tips
components ofrhc H D I (life expectancy, education and income) are weighted
sometimes equally, although they do not necessarily contribute to human d evelopment in an
disagree about equal way. Second, the three components arc too narrow as an indicator of living
the classification standards. For example , the H DI ignores political and economic freedom, which
of countries many consider crucial to the standards of living in a country. A third criticism
because the is rhar the H D I docs not take imo account inequalities in income and wealth
definition and
within and between coumries, so comparisons of living standards become Jess
of economic meaningful.
development
and standards of Characteri stics of developing countries
living are rather Less economically developed countries have common characteristics. These are
subjective in explained below.
nature.
• Low G DP per capita - For economists, this is probably the key characteristic
of developing countries. GDP per capita is calculated by dividing the gross
domestic product of a coumry by its population to find the income level of the
average person. The lower the GDP per person, the poorer the country rends
to be. According to the World Bank, Luxembourg has the highest GDP per
head at $114508 , whereas the Democratic. Republic of Congo has the lowest at
just$231.
• Low life expectancy - Life expectancy measures the number ofyears that the
average person in a country is anticipated to live for, based on statistical trends.
The lower the life expectancy, the poorer the country rends to be. Dara from the
World Bank support this, with the likes ofSierra Leone, Congo, Zambia and
Swaziland all having life expectancy ofbcrwecn 48 and 49 years.
• Low literacy rates - Literacy rates measure the proportion of the population
aged 15 and above who can read and write. Low-income countries have
insufficient investment in education and training, so their literacy rates rend
to be low. This has major consequence for employment, production and
productivity, thus negatively impacting on the GDP of the country. H igh -income
countries have 100 per cent literacy rates whereas low-income coumries have
very low literacy rates, such as Mali (3 1 per cent), Chad (34 per cent) and Guinea
(41 percent).
• Hig h populatio n g rowth- Population growth measures the annual
percentage change in the population ofa country. Poorer countries tend to
have high population growth rates for many reasons: a lack of family planning
and sex education, poor access to contraception and cultural norms (it is
common and widely accepted to have many children in some countries and
cultures).
• Poor infras t r uctu re - Infrastructure refers to the system of transportation
and the communications networks necessary for the efficient functioning of
an economy, such as buildings, mass transportation, roads, \irater systems, JCT
systems including the internet, airports and power supplies. According to the
World Economic Fomm, countries with very poor infrasrrncture include Bosnia
and Herzegovina, Angola, Mongolia, Nepal, Lebanon and Chad. Table 21. 3 shows
the number ofinterner users per 100 people in 2012.
Standards of living
Table21.3 lnternetusersaroundtheworld,2012
Most connected countries Least connected countries

Internet users Internet users
Country Country
(per100people) (per100people)
Iceland
Myanmar
Netherlands Ethiopia
Sweden Burundi
luicembourg Congo,Oem.Rep.
Sou,ce: adaptedfromtheWorldBank
• Low foreign direct investment - The lack of capital resources also limits the
ability ofa country to create income and wealth. Foreign direct im·estment
(FDI) refers to cross-border investment made by multinational companies and
other investors. Poor coumries, with their lack of economic growth and poor
infrastructure, do not tend to attract FDI due to the expected high risks and low
financial returns.
• Poor health care - Insufficient im·cstmem in health services hinders the ability of
a coumry to de\·clop. Health care expenditure per capita is low in LEDCs. Their
governments are unable to provide preventive and curative health care services
for the mass JX)pulation. According to the World Bank, the United States spends
$8362 per person on health care services, whereas this figure is only $21 in
Burundi, $18 in Niger, $16 in Ethiopia and just $12 in Eritrea.
• Low lalxmr productivity - Labour productivity is a measure of the efficiency of
labour in the production process, such as output per worker (see Chapter 11). Due
to the combination of low literacy, low capital investment and poor health care ,
labour productivity in LEDCs also tends to be low.
• Hig h public debt - Public debt refers to the money owed by the government
(public sector). In general, LEDCs are far more likely to borrow money to
finance their public sector expenditure, so the higher the public debt, the lower
a country's standard of living tends to be. This is because the government
will need to repay its loans, along with interest payments, rather than using
the funds for investment in the economy. However, the huge impact of
the global financial crisis has harmed MEDCs and not only LEDCs (sec
Table 21.4 below). Japan tops the chart, largely due to the country's devastating
earthquake and tsunami of March 2011, the country's worst natural disaster
in history.
Ta bl e 2 1.4 Government debts around the world, 2012
Most ind e bted co untries Least ind e bted co untrie s

Country Publi c debt as%ofGDP Co untry Publi c de bt as%ofGDP
Japan Libya
Zimbabwe
Equatorial Guinea
St Kitts and Nevis Liberia
Antigua and Barbuda Azerbaijan
Lebanoo
Italy Gibraltar
Portugal
Iceland Algeria
In reality, it is common for LEDCs to pay more for financing their public debts,
panly due to the high interest rates imposed and partly due to a fall in the value of
their currency. This makes repayment of public debt increasingly unsustainable for
LEDCs, leading to funher borrowing and ever-increasing debts.
• Relia nce o n prima r y-sector o utput - Low-income countries tend to over-rely
on the production and export of primary-sector output, such as agricultural
products. These tend to ha\'e poor terms of trade in comparison with the export of
manufactured products or tertiary-sector services. Table 2 1. 5 compares the output
from the three sectors of the economy for selected coumries.
Ta ble 21.5 Outputoftheeconomybysector: selectedcountries,2012
Secto rofthe e oo nomy(%)

Co untry Primary Secondary Tertiary
Central African Republic
Chad
Ethiopia
HongKoog
Luxembourg
United Kingdom
Germany
Denmark
Soorce:adaptedfromCIAWorldFacrbook
• Corru ptio n - A final characteristic ofLEDCs is their high degree of corruption.

There are huge opporumity costs of civil war, dishonest go~·ernment officials,
fraudulent behaviour and the purchase of arms and weapons. Corruption
therefore hinders economic development and results in hugely unequal income
distribution.
Standards of living
GO!'pe<copi1:1[Sl374
Uleexpociancyo!bir'l11yeo,,l • 4B
r r
M..l! lilerocyrole ('XI• 42
P~gowrii {Xl2.2
GO!'pe< capi1ol $]374

Lle expecbncy atbi rth [yeor,1 • 57
A,M l1erocy-[%1 6 1
l'opubtio n g'°"'*1 ('Xl 3.J
GO!'pe<copii:J[Sl, 23 1 GO!'pe<capi1:1[SJ365
Uleex;,ect,ncyo1birf11yea r,l 4B Uleexpociancyo!bir'l1 1year,l54
M..l! lilerocyrole ('XI 67 M..lt lilerocyrole ('Xl 75
Pop.i,bgowrii [l:1:27 P~gowrii {XIJ.2
Figure 21.1 Selectedeconomicdevelopmentindicators,2012
Sta nda rds of livi ng

The term standard of living refers to the social and economic wellbeing of
individuals in a country at a point in time. Living standards can vary within
a country and between countries, whether they are developed or developing
countries. There are numerous ways to measure the standard of living in a country,
including:
• G DP per capita - I n general, the higher the level ofan individual's income, the
better off he or she is. However, this figure is an average of the population and
does not reveal anything about inequalities in income and wealth.
• T he cost of livi ng - While some coumries like Japan and Hong Kong have a
high GDP per capita, their cost of living is \'ery high, so this tends to adjust the
standards of living downwards. In other counuies, like Vietnam and Nicaragua,
the opposite happens.
• Material wealth - This indicator looks at ownership of consumer durable
goods by the average person, such as cars, jewellery, televisions, mobile phones
(see Table 21.6), washing machines and home computers. This is measured
as a percentage of the population. In theory, the higher the percentage of the
population with material wealth, the better the standard ofliving tends to be.
Ta bl e 21.6 Number of mobile phones in use -top five and bottom five countries
Ra nk Co unt ry Number Pop ula ti o n % of
of mo bile po pul ati on
pho nes in use
1 HongKong
2 SaudiArabia
4 Lithuania
59 Bangladesh
Lebanon
61 Ethiopia
62 Cuba
63 NorthKorea
Soorce,adaptedfromWikipedia
Hong Kong ranks top in the table for the percentage of its population who own a mobile
phone. Mobile phones can even be used underground on the MTR network
• H ealth indicators - These look at a range of measures related to health care

provision, such as life expectancy, infant mortality rates (the number of children
who die each year per thousand of the population), the number ofpatiems per
doctor and the average food imake per person.
• Educatio n indicators - These measures look at educational atrainmem in terms
of literacy rates (the percentage of the population who can read and write) and the
proportion ofpeople who graduate from high school and tertiary education.
• Social and environmenta l indicators - These quality oflifc measures look at
the impact that scxieral norms and the natural environment have on standards of
Jiving. Such indicators include the level of suess, the average hours worked in a
week, the number of days off from work each year, traffic congestion, pollution
levels and crime rates.
Activity
1 In small groups, use the internet to compare and contrast the United Nation's Happiness
Index with the New Economics Foundation's Happy Planet Index (HPI).
2 Whichindicatorofstandardsoflivingdoesyourgroupthinkisthebestmeasure?Why?
Standards of living
Exam practice
The London-based New Economics Foundation's Happy Planet Index (HPI) is a
measure of human well -being and environmental impact. Introduced in July 2006,
the index challenges th e traditional idea that economic growth leads to better living
standards. Instead, the HPI is weighted to give progressively higher scores to countries
with lower ecological foot prints and thus sustainable economic growth. Supporters
of the HPI argue that people ultimately aim to be happy and healthy rather than to be
rich and wealthy. Costa Rica, where people beyond 100 years of age commonly live
active and happy lives, tops the HPI whereas Botswana is right at the bottom.
cl-
1 Outline why GDP per capita is used an indicator of standards of living. (2)
2 Explain why environmental factors are important in measuring standards
3 Discuss wheth er economic growth always resu lts in higher living standards.
~
[7)
Case Study: The most liveable cities in the wo rld

The world's top ten most liveable cities, according the Economist Intelligence Unit's Global
Liveability Report are:
1 Melbourne,Australia
2 Vienna.Austria
3 Vancouver.Canada
4 Toronto.Canada
5Calgary,Canada
5 Adelaide.Australia
7 Sydney,Australia
8 Helsinki, Finland
9 Perth,Australia
10 Auckland, New Zealand
At the bottom, ranked 140th, Dhaka in Bangladesh is rated the least liveable city.
Therankingsarebasedon awiderange o ffacto rsthataffect standardsofli ving,
sucha s thewidespreada vailabil ityofgo odsandservi ces, personal safety and effective
infrastructure.
' - n • ~h-L ' I

Absolute and relative poverty

Poverty is a condition that exists when people lack adequate income and wealth
to sustain a basic standard ofliving. The eradication ofpoveny is a fundamental
macroeconomic objective for many governments around the world. This is because
poveny creates many social and economic problems. For example, there are costs of
poor health (such as malnutrition and famine ), deaths, crime, high unemployment,
welfare provision and Jost national output.
The United Nations defines o,etall poverty as 'a lack of income and productive
resources to ensure sustainable livelihoods'. This includes:
• hunger and malnutrition
• ill health and mortality from illness
• limited or lack of access to education and other basic services
• homelessness and inadequate housing
• unsafe environments
• social discrimination and exclusion.
Table 21.7 shows the counrries with the highest and the lowest GDP per capita
for 2012. According to the CIA World Factbook, Qatar in the Middle East had the
highest GDP per capita (around $281 per day) while the Republic of Congo had the
lowest (at just$1.09 per day).
Ta bl e21.7 Theworld'srichestandpoorest,2012
Th e world 's ri chest co un t ri es The wo rld 's poo rest co un t ries

GDP per
Ra nk Co un t ry
cap ita(S)
Qatar 102800 Congo
2 Liechtenstein Zimbabwe
3 Luxembourg Somalia
Burundi
S Bermuda Liberia
Study tips
6 Singapore
Poverty exists
in all countries, 7 Jersey 7 CentralAflicanRepublic:
although it is B Falklandlslands Malawi
more visible
9 Norway Niger
in poorer
countries with 10 HongKong 10 5outhSudan
mass poverty.
Eveninwealthy
nations,economic
Exam practice
natural disasters
According to the US Census Bureau, 15 per cent of individuals in the United States
widespread live below the poverty line. The aftershock of the global financial crisis meant rising
poverty. It unemployment and related economic problems. This resulted in over 46 million
is therefore people living in poverty in America, more than at any point in the nation's history.
assume that 1 Define the term 'poverty'. [2)
only low-income 2 Explain why poverty is a concern for the American government. [4)
countries suffer
from poverty. 3 Discuss whether the standard of living is always higher in developed than in
developing countries. [7)
Standards of living
There are two categories ofpoven:y: absolute poverty and relative poverty.
Absolute poverty
Absolute poverty exists when there is exueme, outright poverty. People in absolute
poverty are undeniably poor. Their income, if any, is spent entirely on minimal
amounts offuod, clothing and shelter - that is, the basic human needs necessary for
survival. For many, absolute poverty can mean being unable to eat and drink, and
have clothing and shelter.
There is more than one way to measure absolute poverty. The most common
method is to calculate the number of individuals living below a certain level of
income (called the income threshold or the poverty line). A common threshold for
poverty is $1.25 a day-many people around the world still Jive below this amoum,
which means they are unable to buy enough food to survive.
Since 1995, the United Nations has adopted the definition of absolute poven:y
as follows:
A condition characterised by severe deprivation of basic human needs, including
food, safe drinking water, sanitation facilities, health, shelter, education and
information. It depends not only on income but also on access to services.
Case Study: Sierra Leone

Sierra Leone is one of the poorest countries on the planet, with around 70 per cent of its
population of S.6 million people living below the poverty line. GDP per capita in the West
African country is a meagre $374 (or Sl.02 per day), with 58.5 per cent of its GDP coming
from agriculture. Sierra Leone has a staggering infant mortality rate of 76.64 deaths per
1000 live births; one of the highest rates in the world . The median age is only 19.1 years
andlifeexpectancyisjustS6.5Syears.
Sou,cecadaptedlfomCIAWorldfacrbook
Study tips Relative poverty

It is possible for Relative povert y is a comparative measure, rather than an absolute measure, of
people to be poverty. People in absolute poverty arc undeniably impO\wished, whereas those
relatively well-off in relath·e poverty have a lower standard of living in comparison with the average
butstilltolivein member of society. For example, it is rather i:oimless to compare what is meant by
absolute poverty.
This is because poverty for someone living in Singapore or Luxembourg with someone living in
these people poverty in Sierra Leone or Niger.
Relative poverty measures the extent to which a person's financial resources fall
than the average below that of the a\'erage income for the population. Although real national income
person yet still (see Chapter 20) and standards ofliving have grown over time, these gains are not
face financial e\·enly distributed across the population.
difficulties in
meeting their
basic human Policies to alleviate poverty
needs. In theory, all go\·emmems ha\·e a range of policies to alle\'iate poverty, although
achieving this in practice is fur more difficult. Such policies can be categorised as
fiscal, monetary and supply-side policies (see Chapter 16).
Case Study: The Unite d Na tio ns Mille nnium De ve lo pme nt Goa ls

In 2000, the United Nations devised the anti-poverty Millen n ium Development Goals
(M DGs), consisting of eight international development goals to achieve by 2015:
2 ..2_3[E
·4
Lt1 ACHIEV(UNIVDISAL
~RIMAlll'EDUCATION
l!QUM.ffl'AMI
.,....,._
R(DUCE
CHILD MORTALITY
[!Jll[!J
Source: www.un.org/mi1lenniumgoals
Fiscal policies
These policies arc used to redistribute income and wealth by using a combination of
taxation and government spending policies. For example:
• Progressive rax systems (sec Chapter 17 ) to reduce the wide gap between the rich
and pcor members of the coumry. Higher-income groups pay a higher percemage
of their incomes in tax, with the tax proceeds being used by the go\'ernmem to
support the lower-income groups or those without any income.
• Government transfer payments (sec Chapter 15) give the unemployed and
disadvamaged financial assistance to mee t their basic needs. Examples of transfer
payments are unemployment benefit, state pension funds for the elderly and child
benefit (to reduce child poverty). This helps to provide a social safety net to ensure
that every citizen has access to basic necessities.
• Government provision of basic services such as health care sen'ices, education
and housing. This helps to improve access to such basic services for e\'eryone and
narrows the gap between the rich and the (X)Or.
Monetary policies
These policies arc used to comrol the money supply by manipulating imercst rates
and exchange rates:
• Low imercst rates can encourage borrowing and investmem to increase spending
in the economy. In the long nm, this can help to create more jobs and alleviate the
problems of poverty.
• Low exchange rates (sec Chapter 25) can encourage export sales as the price for
foreign buyers is lower. As higher export earnings help to boost GDP, this can also
help to create more jobs and wealth in the economy over time.
Standards of living
Supply-side policies
These policies are used to OOOst the long-run producth'e capacity of an economy (see
Chapter 16). For example:
• Policies to reduce unemployment (see Chapter 19 ), because unemployment is a
major cause of po\·eny and inequality. Examples include go...ernment incenti\"es
to attract foreign direct investment and government-funded job creation and
retraining schemes.
• Policies to increase the quantity and quality of education in the economy. Over time,
this will help to improve the human capital and productive capacity of the country.
• Sustained economic gro\\'th, which helps to create more income and wealth for
the country (see Chapter 20). This can then be redistributed to the deprived and
underprivileged members of society.
• Labour market reforms to improve the efficiency and productivity of the workforce
(see Chapter 11). The introduction ofa national minimum wage , or imposing a
higher minimum wage rate, can improve the standards of living for low·income
households.
Foreign aid
A fourth and final policy that can be used to alleviate poverty is foreign :iid . Fiscal,
monetary and supply-side policies tend to be internal methods: that is, they are
within the control of the domestic gowrnment. Ho\\-cver, with foreign aid there
is a huge reliance on the donor - something that cannot be conuolled by the
government. Foreign aid can be a stimulus for reducing po,-eny, inequalities and
unemployment in the economy. Successful foreign aid programs help to increase
the country's producth-c capacity, thus shifting out its production possibility curve
(see Chapter 1). There are various forms offoreign aid that can be used to tackle the
problems ofpoveny:
• Bilateral foreig n a id - This is official financial assistance from one government
to another, usually due to political and economic interests. It provides immediate
access to aid.
• Multil:iteral foreig n a id - This is official financial assistance from more than
one source, such as foreign gm·ernments, international organisations such
as the \Vorld Bank, and non-governmental organisations such as Oxfam and
Unicef.
• Development aid - This is official financial assistance from SO\'·ernments and
agencies such as the World Bank to fund the economic developmem of a country,
thus helping to alleviate po,·erty in the long nm.
• Humanitar ian aid - This is philanthropic (charitable) financial assistance for
saving lives and maintaining human dignity. It is often used in response to major
crises such as natural disasters and outbreaks of infectious diseases. Examples
include medical aid, food aid and emergency relief assistance.
Activity
lnpairs,researchtherolesoftheWorldBankandthelnternationalMonetaryFund(IMF)
in promoting economic development. What are the terms and conditions of the loans that
they make to countries? How does the World Bank differ from the IMF? Be prepared to
presentyourfindingstotheclass.

1 How does t he World Bank classify countries in terms of economic
development?
2 Distinguish between more economically developed and less economically
developed countries.
3 What is the Human Development Index?
4 What are the criticisms of using the HDI as a measure of standards of living?
S What are the main characteristics of less economically developed countries?
6 Define the term 'standards of living'.
Why do standards of living vary within and between countries?
Distinguish between absolute poverty and relative poverty.
9 What is the poverty line?
10 What are t he main policies that can be used to alleviate poverty?
Ke y te rms
Absolute poverty is an extreme form of poverty indicating the number of people who
cannot afford minimal standards of basic human needs (food, clothing, health care and
shelter).
Foreign aid is a form of financial assistance for economic development from other countries
or non-government organisations such as Oxfam and Unicef.
The Human Development Index (HDI) is the UN's measure of wellbeing, obtained by using
threecriteria: lifeexpectancy,educationalattainmentandincomepercapita .
Less economically developed countries (LEDCs) are developing countries with low GDP per
capita,sotheirstandardsofliving are generally poor.
More economically developed countries (MEDCs) are developed countries with high GDP
percapita,sotheirstandardsoflivingaregenerallygood .
Poverty isaconditionthatexistswhenpeoplelackadequateincomeandwealthtosustain
basic standards of living.
Relativepoverty isacomparativemeasureofpoverty. Thoseinrelativepovertyhavea
lower standard of living in comparison with the average member of society.
Standards of living refer to the social and economic wellbeing of individuals in a country at
a point in time.
@ Population

• describe the factors that affect population growth (birth rate, death rate,
fertility rate, net migration)
• discuss reasons for the different rates of growth in different countries
• analyse the problems and consequences of these population changes for
countries at different stages of development
• describe the effects of changing size and structure of population on an
economy.
TakenfromCambriclgelnternationalfxamiMtionsSyllabo,~GC5f0455/0l.evel2281)
O CambfidgelnternationalExamir,abom
Factors that affect population growth

Population refers to the total number of inhabirams of a particular country.
Economists are interested in population size because people are essential for the
economic prosperity of a country and also responsible for the depletion of the Earth's
scarce resources. Population growth refers to the rate of change in the size of a
country's population. Change in population size can have huge and long-lasting
effects on the world's economy and the natural environment.
Thehigheracountry'sbirthrate,thegreateritspopulationgrowthtendstobe
Changes in four key factors affect the rate of population growth.
Birth rate
The birth rate measures the number of li\'e births per thousand of the population
in a year. lt is measured by dividing the total number of births in a country by the
population size, expressed per thousand of the population. For example, in 2012
Swaziland had a population of around 1386915 and about 36280 live births. Thus, its
birth rate was equal to 26.16 per thousand of the population. The higher a coumry's
birth rare, the greater its population growth will tend to be. According to the CIA
World Factbook, Niger, Mali and Uganda ha\·e the highest birth rates (of 47.6, 46.6
and 45.8 respectively) whereas Monaco, Hong Kong and Japan have the lowest birth
rates (of6.85, 7.54 and 7.72 respectively).
Death rate
The death rate measures the number of deaths per thousand of the population in
a year. It is measured by dividing the total number of deaths in a country by the
population size, expressed per thousand of the population. For example, in 2012
Canada had a population of around 34 300 085 and about 277 490 deaths, meaning
that its death rate was 8.09 per thousand of the population. The lower a country's
death rate, the greater its population growth will tend to be. According to the CIA
World Factbook, South Africa, Ukraine and Lesotho have the highest death rates (of
17.23, 15.76 and 15.18 respectively) whereas Qatar, the United Arab Emirates and
Kuwait have the lowest death rates (of 1.55, 2.04 and 2.13 respectively). The death
rate is dependent on factors that affect the quality of life, such as income levels, health
technologies, nutrition and housing.
Fertili ty rate
The fertility rate measures the average number of children born per woman, thus
indicating the potential for population change in a country. Economists consider a
fertility rate of two children per woman to be the minimum replacement fertility
rate for a srable JX)pulation (the number of children that the average women must
have to replace the existing population). Fertility rates above nvo children indicate
a growing population, with a declining median age for the JX)pulation. By contrast,
lower fertility rates indicate a falling population, with the average age of the
population increasing. Fertility rates tend to fall as an economy develops, due to the
higher opportunity costs of raising children. According to the CIA World Factbook,
Niger, Mali and Somalia have the highest fertility rates (of7. 16, 6.35 and 6.26
respectively) whereas Singapore, Macau and Hong Kong have the lowest fertility rates
(of0.78, 0.92 and 1. 09 respectively).
N et migration rate
The size of a population can also cl1ange due to the physical movement of people
Study tips in and out of a country. I mmigratio n occurs when people enter a country to live
The net migration and to work. Emigratio n occurs when people leave a country to work and live
rate measures abroad. The net migration rate measures the difference between the number of
theoveralllevel
of population people entering and leaving a country per thousand of the JX)pulation in a year. It is
change resulting calculated using the formula:
from the
movement of Net migration rate : immigration - emigration
migrants. It does
not distinguish
between worker If more people enter a country than leave in the year, there is said to be net
migrants, immigratio n . For example, in 20 12 Qatar, Zimbabwe and the British Virgin Islands
refugees and had net immigration rates of40.62, 23.77 and 18.56 respectively. By contrast,
undocumented if more people leave a country than enter the country, there is said to be net
migrants.
emigratio n . For example, in 2012 Jordan, Syria and Micronesia had net emigration
rates of-33.42, -27.82 and -20.97 respectively.
Population
,o@ ~
" BCXXJ
] 6CXXl
j 4CXXl
j 2CXXl
0
1973 1983 19932003201320232033
Sou,ce: adapted from www.ibiblio.org
Figure22 .1 The world's population, 1973-2033(projected)
Activity
What do you think is the exact size of the world's population? Take a look here to see how
accurate or imprecise you were: www.ibiblio.org/lunarbin/worldpop
Other factors that affect the size of a population, and hence the potential gro\\'1:h of
the population, include the following:
• Life expectancy - This measures the number of years an average person in
the country is expected to Jive. The longer the life expectancy, the greater the
population size tends to be . Monaco, Macau and Japan have the world's longest
life expectancy (at 89.68, 84.43 and 83.91 respectively). By contrast, Chad,
Guinea-Bissau and South Africa have the lowest life expectancy (at 48.69, 49. 11
and 49.4 1 respectively).
• Social changes - In economically developed countries, women are choosing to
haw children at a later age, partly due to the high cost of raising children but
Study tips
also because more women opt to ha\·e a professional career. In China, the one -
Changes in any
combination of child policy has significantly reduced the population growth of the world's most
the factors that populous country.
affect the size • N atura l disasters, d iseases and war - These unpredictable e\·ems can cause a
of a population significant change in population size. For example, in 2003 the outbreak of severe
will also have acute respiratory syndrome (SARS) in H ong Kong spread to 37 countries and
an impact on
caused 775 deaths worldwide. On a much larger scale, the Tohoku eanhquake and
population
growth. tsunami in Japan in March 2011 pro\·ed to be the country's worst natural disaster,
claiming 15881 lives.
Japan has an ageing population in which around 30 per cent of the populatio n are aged over 60
Table22.1 Theworld'smostpop ulouscountries,2013
Rank Country Population(millions)

China
2 India
4 Indonesia
5 Brazil
Source, T,adingfronomics
Table22.2 Theworld'sleastpop ulouscountries,2013
Rank Country Population

(millions)
Liechtenstein
Caymanl1lands
Seychelles
:iaoTom~andPrlnc:ipe
Source,T,adingfronomic,
Activity
lnvestigatethecostsofraisingachilduptotheageof18inyourcountryoracountryof
your choice. Try to be as accurate as possible by including and itemising the costs of food,
clothing, education, health care, recreation and holidays. Compare results with others in
yourclass. Whymightsuchfindingsbeofinteresttoeconomists?
Population
Population distribution
Apart from the population size and population growth rates, economists also
look at demographics - the study of population distribution and ucnds. Such
demographics include differences in the composition of gender, age distribution and
the dependency ratio.
Gender
This refers to the number of males compared with the number offemales in the
population. For the vast majority of countries, the gender split is quite even. Dara
Study tips from the CIA World Factbook for Denmark, for example, show the following
Population gender ratios:
pyramids can
provide insights • at birth: 1.06 male(s) per female
into the social, • under 15 years: I.OS malc(s) per female
political and • 15- 64 years: 1.01 malc(s) per female
economic stability • 65 years and o\·cr: 0.8 male(s) per female
of a country.
The population • total population: 0.97 male(s) per female.
distribution is
shown along the Age distribution
x-axis,withmales This refers to the number of people within different age groups in the
shown on the population. Low-income countries tend to have a relatively larger proportion of
left and females
ontheright,and their population in the younger age groups. For example, around 39 per cent of
the population the population in Ghana arc aged 14 and below, with only about 4 per cent of
is broken down the population aged 65 and m'cr. By contrast, wealthier countries tend to have an
intoS-yearage ageing population with a growing number of elderly people. For example, only
groups,withthe 13.5 per cent of people in Japan arc aged 14 and below, while 38 .8 per cent arc
youngest age
aged 55 and above. Population pyramids arc a graphical representation of the
group at the
bottom. age and gender distribution ofa country's population (sec Figures 22.2
and 22.3).
Qll~ rilli l
2 1.6 1.2 0.8 0.4
PopuKltion[lnml lioml
0 0 0.4 0.8 \ .2 1.6 2
Pfl"group PopJKl11on[rim1liloru]
Figure22.2 Ghana'sagedistribution(population
pyramid)
6 4.8 3.6 2.4
PopJKl11on[ri m1liloru]
1.2 0 0 l .2 2.4 3.6 4.8 6
Pf}f'group
Figure22.3 Japan'sagedistribution(population
pyramid)
Pop..biool lnmJlirn,I
Dependency ratio
The dependency ratio is a comparison of the number of people who are not in the
labour force with the number ofpeople in acth'C paid employment. For economists,
the dependent population will typically include all those aged between O and 14
(those below the schcx:,l leaving age) and those aged 65 and abo.•e (those abo,'C the
retirement age). However, it also includes fttll -time students and the unemployed.
The dependency ratio measures the dependent population as a proportion of the
working population: rhar is, the total active Jabour force (those aged between 15
and 65). It is therefore calculated using the formula:
Dependency ratio = dependent population + working population
The higher the dependency ratio, the greater the rax burden on the working
population to support those who are nor economically active (nor in active paid
employment). The dependency ratio can rise due to several reasons, such as:
• high birth rates, mainly in less economically developed countries
• a higher compulsory school leaving age, thus keeping school srndems as part of the
dependent population for longer
• social changes such as workers entering the labour force at a later srage due to
the demand for higher education, or more people choosing early retirement (thus
reducing the size of the \\urking population).
Exam practice
Study the data below from the CIA World Factbook for the gender ratios in China,
and answer the questions that follow.
• at birth: 1.13 male(s) per female
• under 15 years: 1.17 male(s) per female
• 15-64 years: 1.06 male(s) per female
• 65 years and over: 0.92 male(s) per female
• total population: 1.06 male(s) per female
1 Briefly explain how China's one-child policy might have influenced the gender
ratios in China. [2)
2 Outline two economic implications for a country that has an uneven
gender ratio. [4)
The optimum population

While there are reasons for different population sizes and different rates of population
growth in different countries, economists argue that there is an optimal ( best or
ideal) population for each country. The optimum population exists when the output
of goods and services per head of the population is maximised (sec Figure 22.4).
Population
]1 ~
!~
0 Under-pop.,Klt1oo 0--pop.,Kltioo
F'opJKltloo.stze
Figure 22.4 The optimum population
A country is under·populated ifit does not ha~·e sufficient labour to make the
best use of its resources. In this situation, GDP per head of the population could
be funher increased if there were more human resources. Feniliry rates below the
replacement le\·el can lead to under·population, causing potential economic decline.
In this case, to reach the optimum population, the government could intnxluce
measures to increase the population size, such as encouraging immigration.
A country is over·populated if the population is roo large, given the available
resources of the country. Fertility rates above the replacement level can lead to
potential over·population, with negath-e economic consequences such as famine,
housing shortages, energy shortages and diseases. This causes a fall in GDP per
capita as there are insufficient resources to sustain the population. In this case, to
reach the optimum population, the government could either introduce measures
to reduce the population size or introduce measures to boost inwsm1ent and
productivity in the economy.
Over·populationinBraziliancitieshasresultedinvastslumsdueto
housing shortages
Tab le 22 .3 Countries with the highest and lowest population growth rates(% )
Hi g hest po pul at io n g rowth Lowest pop ula ti o n gro w t h

Ra nk Co untry Gro w t h Ra nk Co un try Gro w t h
1 Qatar 1 Cool<.l1lands
2 Zimbabwe 2 MoldOYa
3 Niger 3 Saint Pierre and Miquelon
4 Uganda 4 Jordan
5 TurhandCaicosl5'ands 5 Northern Mariana Islands
Soorce: adaptedfromCIAWarldfacrbook
C o nsequences o f po pulatio n chang es

The world's population reached 1 billion people around 1804. This doubled to
2 billion people by 1927 and reached 5 billion in 1987. The United Nations claims
that the world's population exceeded 7 billion people in October 2011 and will reach
9 billion by 2050. This phenomenal and unprecedented population growth offers
both opportunities and challenges for economists.
T he economic conSL"qUences of population growth were first presented by
Re\'erend T homas R. Malthus (1766-1834). H is Malthusia n g rowth theor y
suggested that uncontrolled population growth would put pressures on the resources
of rhe country, thus negatively impacting living standards. This is because, according
to Malthus, population growt h occurs at a geometric rate: rhar is, it grows at a
common ratio of2 (1, 2, 4, 8, 16, 32 and so forth) whereas food production only
grows at an arithme tic rate (1, 2, 3, 4, 5 ). If the theory materialised, t his would mean
that population growth would eventually exceed food output for the population. This
has not happened in reality for two main reasons:
• T here have been slower population growth rates than expected, especially in
more economically developed countries, due to social changes such as the high
opportunity costs of raising children .
• There has been a geometric progression in food production due to advances in
food technology, such as improved farm machinery, irrigation systems, genetics,
pesticides and fertilisers .
Economists have found that t he core concern about the continuing depletion of
the planer's finite resources by rising populations can be met by improved efficiency
in the production of food and the developmem of alternative renewable energy
T here are, nevertheless, varying consequences of these population changes for

countries at different srages of economic development. In particular, employment
patterns are likely to change. There are three basic sectors of employment in the
economy: the primary, secondary and tertiary sectors.
• Prima r y-sec tor output is concerned with the extraction of raw materials and
other natural resources. Employment in this sector includes work in agriculture,
fishing, mining and oil exploration. T he primary sector rends to dominate in less
economically developed countries.
• Secondary-secto r output invol\·es manufacturing - that is, the use ofnarnral
resources to produce man -made resources such as machinery, vehicles, buildings
and other capital resources. Examples of employment in this sector are jobs
Population
in car manufacturing, textile production, chemical engineering and textbook

publishing. This is the dominam sector in most industrialising and developing
countries.
• Tertia ry sector output refers to the provision of services. Examples of jobs in this
sector are accountants, teachers, doctors, lawyers, financial advisers and retailers.
The tertiary sector tends to be the most importam in high-income economies.
As an economy develops, there rends to be a shift away from reliance on primary-
and secondary-sector production towards tertiary output (see Table 22.4). In
general, countries with a low level of GDP per capita are at their early stages of
economic development, so most people work in the primary sector. As these
countries advance, the majority of their gross domestic product is generated from the
secondary sector. Finally, in economically developed coumries with a high income
per capita, the tertiary sector accoums for the largest share of employmem and of the
coumry'sGDP.
Tabl e22.4 Comparison of employment by sector: selected countries, 2013
Co untry Primary(%) Second ary (%) Terti ary( %)

Kenya 24.2 14.8 61.0
China
Luxembourg
S.00,ce : adapted from CIA Wand Facrbook
The changing size and strncrure of the population also has effects on an economy.
It has an impact on the following:
• Consumers - The demand for goods and services changes with variations in
population trends. Customers have different demands based on their age, gender,
religion, ethnic group and family size. For example, elderly people in a coumry with
an ageing population might spend proportionately more of their money on health
care and related pnxlucts. By contrast, parents of young children might spend more
of their income on housing, education, clothing, family vacations and toys. Firms
will seek to exploit these changes in demand for different goods and services.
• Fir ms - The demand for, and supply of, Jabour will change following Jong·term
changes in population trends. For example, rapid population growth should
increase the future supply of labour. By contrast, the combination of low birth
rates and net emigration will reduce the future supply of workers in the coumry.
According to the World Health Organization, a staggering 2 billion people will
be aged 60 years and over by 2050 - more than triple the number in 2000. By the
end of 2012, only Japan had more than 30 percent of its population aged at least
60, but some 64 countries are expected to have reached this figure by 2050. The
ageing population of these nations, especially in the case ofhigh-income countries,
will have profound impacts on the future supply of labour.
• Gove rnment - A growing population can bring about benefits if it means the
government is able to collect more tax revenues from a larger workforce. However,
it can also mean added pressure for the government to provide more public
services, welfare benefits and state pensions. As a result, many go.·ernments have
introduced compulsory pension savings schemes and have raised official retirement
ages. For example, France increased the retirement age from 60 to 62 years in
20 11 , with plans to increase this gradually to 68 years of age.
• T he econo my - Continual population growth puts more pressure on an

economy's scarce resources. This can lead to inflationary pressures or an increase
in the demand for imports if the country cannot produce enough to meet
the needs and wants of the population. For example, land in prime locations
is scarce , so a larger population in these areas is likely to force land prices to
soar. Inflation can create problems for the economy (see Chapter 18) and cause
economic growth to slow.
• T he n atural environment - An increase in the size ofa population also
puts strain on the environment. Non-renewable resources are depleted in the
production process and the increased level of prcx:luction also puts strain on the
natural environment. For example, pollution and traffic congestion are by-products
of overpopulated regions of the world.
Activity
1 Usetheinternetto investigatetheeffectsofthechangingsizeandstructureof
population on a country of your choice. Consider the impact of these changes on
households, firms and the government in the country.
2 Inve stigate China's one-child po licy and answer the following questions:
a) Why was the one-child policy introduced?
b) Whataretheexemptionstothepolicy?
c) Whatarethepositiveandnegativeconsequencesofthepolicyforfuture
generations?
A good starting point is to watch this video clip on YouTube:
www.youtube.com/watch?v=lVEx5ifxtro
China's army of 'little emperors' is seen as a consequence of the one-child policy

Population
Exam practice
1 According to World Bank statistics, the population of Nigeria has increased from
around 45 million back in 1960 to over 163 million in 2013, an increase of over
262 per cent. Figure 22.5 illustrates the growth in Nigeria's population.
Sou,ce:Tril0 n9fcooomics
Figure22.5 Nige ria's population, 1960-2013
a) Explain two possible causes of the rise in the size of Nigeria's population. (4)
b) Identify and briefly explain two economic problems that could be associated
with the rise in the size of Nigeria's population. (4)
c) Discuss two measures that the Nigerian government could use to overcome
the problems of population growth in its country. [8)
2 The median age of the UK population back in 1985 was 35.4 years, but it had
climbed to 39.7 by 2010. It is projected that the median age will reach 42.2 by
the year 2035. The percentage of people aged 65 and above also increased in the
same time period, from 15 per cent of the population to 17 per cent (an increase
of 1.7 million people). By 2035 the percentage of the UK population aged 65 and
over is expected to reach 23 per cent.
Sou,ce:adaptedffomONS
a) What is meant by an 'ageing population'? (2)

b) Explain three causes of the increase in the percentage of people aged 65
and above in the UK. (6)
c) Examine the effects of an ageing population on:
i government expenditure and revenue (6)
ii economic growth. (6)

1 What are the four key factors affecting the rate of population growth?
2 How is the net migration rate calculated?
3 How do social changes impact on the population size and potential population
growth?
4 How might economists use population pyramids?
S What are the economic consequences of an ageing population?
6 What is the dependency ratio and why is it important?
7 What is the optimum population and why do governments strive to reach this?
What is the Malthusian growth theory?
How does employment in the three sectors of the economy change as an
economy develops?
10 What are the economic consequences of rapid population growth for the
economy and the natural environment?
Key terms
The birth rate measures the number of live births per thousand of the population in a year.
The death rate measures the number of deaths per thousand of the population in a year.
Demographics is the study of population distribution and trends .
The dependency ratio is a comparison of the number of people who are not in the labour
force with the number of people in active paid employment.
The fertility rate measures the average number of births per woman. It is used as a
component in the measurement of population growth.
Lifeexpectancy measuresthenumberofyearsanaveragepersoninthecountryisexpected
to live.
The net migration rate measures the difference between immigration and emigration rates
for a country, thus indicating the physical movement of people into and out of the country.
Optimum population exists when the output of goods and services per head of the
population is maximised.
Population referstothetotalnumberofinhabitantsofaparticularcountry.
Populationgrowth referstotherateofchangeinthe sizeofacountry'spopulation.
Populationpyramids areagraphicalrepresentationoftheageandgenderdistributionofa
country's population.
The replacement fertility rate is the number of children whom the average women must
havetoreplacetheexistingpopulationandmaintainastablepopulationsize.
Workingpopulation referstotheactivelabourforceagedlS- 65,i.e. thosewhoarewilling
and able to work. This consists of those in paid employment, the self-employed and the
unemployed.
® International aspects
Chapters
23 Specialisation
24 Balance of payments
25 Exchange rates
26 Trade and trade protectionism
@ Specialisation
• describe the benefits and disadvantages of specialisation at regional and
national levels.
Taken from Cambfidge International Examir>abom Syllabus (IGCSE 0455/0 Level 2281 )
0 Cambridge lntematKlf\al Examir,atioo,
Specia lisation
Specialisation occurs when individuals, firms, regions or countries concentrate on
the production of a particular good or service. For example:
• Individ ua ls - People might specialise, for example, as accountants, bankers,
construction workers, demists or engineers. Specialisation allows workers to
become more skilled and efficient ar their jobs, thus increasing the quantity and
quality ofrhe goods or services being provided. Chapter 7 examines the advanrages
and disadvantages of specialisation for individuals.
Activity
Discuss why primary school teachers are less speci a lised than secondary school teachers,
whoarelessspecialisedthanuniversitylecturers.
• Firm s - McDonald's, Burger King, KFC and Pizza H ut specialise in the output
offast food, whereas O H L, FedEx and TNT specialise in the provision of courier
services. Further examples appear in Table 23.1.
Ta ble23.1 Theworld'sthreelargestproducersinselectedindustries
Rank
Indu stry
2,d 3,d
Account;mcy Deloitte Ernst&Young
Airline{freight} FedEx Express UPS Airlines Cathay Pacific:
Airline{passenger) American Airlines Delta Airlines Un itedAirline1
Carmanufacturen Toyot a General Moton Volbwagen
Alibaba.com eBay
Samsung Sooy
Mobile network operators China Mobile Vodafone Airtel
Mobile phones Samsung Nokia Apple
Personal computers HP D,11
Restaurantchaim{sale1} McDonald"s Subway Burger King
Socialnetworkwebs.ites Facebook Linke din
Specialisation
• Regions - Silicon Valley in northern California, USA, specialises in the provision

ofhigh-tech information communication technologies; London, Tokyo and
Shanghai are financial districts; Paris and Milan are major world cities for fashion
and design. These are examples of regio nal specialisation .
• Countries - Bangladesh and India are major producers and eXJX)rters of textiles;
Scotland is famous for its whisky; Thailand and Vietnam specialise in the
production of rice; and Caribbean countries such as Jamaica and Tobago specialise
in tourism. Other examples are outlined in Table 23.2.
Internatio nal specialisation occurs when certain countries concentrate on the
production of certain goods or services due to cost advantages - perhaps arising from
an abundance of resources.
Table 23 .2 The world's three largest producers of selected products
Ra n k
Prod uct
3 ,d
Aluminium China '"' Canada
Coal China Australia
Coffee Brazil Indonesia
Copper Chile
China India
Study tips China India Brazil
While this chapter China Brazil
examines the
advantages and Oil Saudi Arabia Venezuela
disadvantages Rubber Thailand China Indonesia
of specialisation Sugar Brazil India China
at regional and
national levels, China India Kenya
remember that Vegetables China India
specialisation can
also be applied
to individuals,
firms.machinery Activity
and technology Discuss how specialisation might work in schools, restaurants and supermarkets. What are
(capital theadvantagesanddisadvantagesofspecialisationtotheemployeesandfirmsinthese
equipment). markets?
Benefits of specialisation
The benefits of specialisation at regional and national le\-cl include the following:
• Efficiency gains - Specialisation makes better use of scarce resources. As a result,
productivity increases, thereby increasing the coumry's gross domestic product.
Taiwan and South Korea, for example, have been able to raise their standards
of living by specialising in the production of manufactured consumer electronic
devices. Taiwan's Foxconn is the world's largest manufacturer of smartphones and
tablet computers. South Korea's Samsung is the world's largest maker of LCD
televisions.
International aspects
• Labour producti vity - Workers become more skilled in the jobs they do because
they are able to concentrate on what they do best. Therefore , it improves labour
productivity (see Chapter 11) and enables better-quality products to be produced.
Thus specialisation can benefit firms, regions and the country.
• Increased productive capacit y - International specialisation can help to shift
the production possibility curve of a coumry outwards due to its increased
productive capacity, as shown in Figure 23. l. Thus, specialisation leads to
increased national output.
~~t"t :'~ :\~i~:'. ~~ will

] ~o;;'.7J'.::::J!':'~I~~::,
,h1fr abig thex-ax~ rnthe eoooomy
ma,e,/ramPPC, 1off'C2
'
0 -·
Figure2 3.1 SpecialisationandthePPC
• Economies o f scale - Specialisation increases national output and global uade.

Therefore, firms are able to enjoy cost-saving benefits from large-scale operations,
known as economies of scale (see Chapter 14). This can help to keep prices down
and therefore helps to keep inflation under control (see Chapter 18).
• I mproved competiti ve ness - Specialisation helps to enhance international
trade and exchange. Competitive prices also improve the international
competitiveness ofa country, thereby boosting its economic growth. After
all, specialisation and trade are essential for improving a country's standard of
Jiving (see Chapter 2 1).
Activity
Investigate the economic reasons behind China's rising domina nce in o ne of the following
industries (or another one of your choice): coal mining, oil, steel, automobi les, commercial
bank ing, insurance, e-commerce, tourism or telecommunications. Be prepared to share
yourfindingswiththerestoftheclass.
Exam practice
1 Explain how the concept of specialisation can explain why nations trade with
each other. [4)
2 'Specialisation in international trade always benefits nations.' Discuss this
statement. [6)
Specialisation
Disadva ntages of specialisation

The benefits and disadvantages of specialisation for the individual are covered in
Chapter 7. Despite the potential benefits of regional and national specialisation, there
are several drawbacks.
• Overspecialisatio n in a region can cause structural and regional unemployment
(see Chapter 19). The Full Monty, the highest grossing British movie, which cost
only $3.5 million to produce but made over $250 million at the box office, was
aOOutsix unemployed men in Sheffield, UK, which used to be a major producer
of steel. Although the film was produced as a comedy, it featured some key
consequences of the collapse of steel production in the UK, such as regional
unemployment, stress, depression and suicide.
Countries that m-erspecialise also suffer the most during an economic
downturn, as they do not have a variety of goods and services that they can rely
on to survive. For example, Liberia is highly dependent on its agriculmral output,
which accounts for around 61 per cent of its GDP. Adverse weather conditions
could wipe out much of its agricultural production, thus severely harming the
economy.
• Hig h labou r turnover occurs iflots ofworkers choose to Jea\·e their jobs in
search of more challenging and less boring ones. In a country that has a labour
turnover rate of 12.5 per cent, one worker in e\·ery eight changes jobs each year.
The higher this rate, the more expensive it is for the economy, as firms have to
continually hire and train workers. Industries that suffer from high labour
turnover tend to pay low wages to low-skilled workers, such as those working in
call centres, retailing, catering (including fast-food restaurants), supermarkets
and hotels.
• Low labo ur mo bility - Low-skilled
and poorly paid workers tend to
receive little training, so they may
not dewlap the necessary skills to
find alternative jobs. Again, this can
lead to structural unemployment.
H ighly skilled workers, such as
pilots, demists, software dewlopers,
financial advisers and attorneys can
also find it extremely difficult to
change to altematiw professions and
careers.
Job specialisation also makes
cross-functional training difficult
- in other words, workers only
haw a narrow understanding of
the overall business. By contrast,
cross-functional training would
help to make workers more versatile
and expand their skills. This lack
of Jabour market flexibility can
reduce the economic efficiency and Staffordshireusedtohaveathrivingpottery
international competitiveness of the industry(anotherexampleofoverspecialisation)
country. -nowtheareaisfullofderelictfactories
• Lack of varie t y for consumers~ Specialisation often leads to standardised,

mass-produced goods. An example is Foxconn, which manufactures the iPhone
and iPad for Apple. These de,,ices Jack variety and only come in one of two
colours. Domestic customers may look at alternative imported products from
foreign suppliers, thereby reducing the competitiveness of domestic finns that
overspecialise.
• Cost ~ Firms that employ workers with highly specialised skills tend to face very
high salary demands. For example, Forbes magazine estimates that the earnings of
the world's top ten highest-paid supem1odels exceeded $100 million, with Gisele
Biindchen earning about $45 million. Wayne Rooney was reported to be paid a
stunning $300 192 ($456292) per week at Manchester United Football Club!
This can have a negative impact on the profits of firms and potentially reduce their
competitiveness.
In 2013, David Beckham topped the list of the best-paid footballers in the world (€36 million),
€1 million ahead of Lionel Messi in second place and a further €5 million more than Ronaldo
in third . Wayne Rooney made a respectable seventh place, earning €18 million (Source:
France Football)
Exam practice
1 Define the term 'specialisation'. [2]
2 Explain why, during a recession, highly specialised firms are less likely to survive
than diversified firms. [4]
Specialisation
Cha pter review questio ns

1 What is meant by 'specialisation' at regional and national levels?
2 Give two examples of regional specialisation.
3 Give two examples of national specialisation.
What are the advantages of regional and national specialisation?
What are the disadvantages of regional and national specialisation?
Key terms
lnternat ionalspecialisation occurswhencertaincountriesconcentrateontheproduction
of certain goods or services due to cost advantages, perhaps due to their abundant
Overspecial isatio n occurs when an individual, firm, region or country concentrates too
much on producing a very limited number of goods and services. This exposes the economic
agenttoafarhigherdegreeofrisk.
Regionalspecia ll sation occurswhencertainareasconcentrateontheproductionofcertain
goods or services. For example, Hollywood, in Los Angeles, is famous for its motion pictures
industry.
Speciall sation occurswhenindividuals,firms,regionsorcountriesconcentrateonthe
productionofaparticulargoodorservice.
@ Balance of payments
• describe the structure of the current account of the balance of payments
• discuss the causes and consequences of current account deficits and surpluses.
TakenfromCambfidgelnternationalExamiJlabomSyj!abus(IGCSE0455/0level2281)
Study tips The ba la nce of payments

The full balance The bala nce of payments is a financial record ofa country's transactions with
of payments is the rest of the world for a given time period, usually over I year. This includes the
made up of three
country's trade in goods and services with other countries.
accounts: the
current account, In theory, the balance of payments must always balance over time. This is because
the capital a country, like an individual, can only spend (on imports, for example) what it earns
account an d the (from exportearnings,fbrexample).
financial account.
However,the The c urrent account
scope of this
IGCSE/O l evel One of the components ofthe balance ofpayments is the current account , which is
syllabus means a record of all exports and imports of goods and services between a country and the
that you only rest of the world. The current account is strnctured in three parts.
need to know
about the Visible trade balance
The visible trade balance is a record of the export and import of physical goods. It
is also known as the balance of t rad e in goods. It is the trade in goods, such as raw
materials, semi-manufactured products and manufactured goods. Visible ex ports
are goods that are sold to foreign customers, with money flowing into the domestic
economy. For example, the export ofToyma cars results in an inward flow of money
to Japan's visible balance. Visible impo rts are goods OOught by domestic customers
from foreign sellers, such as Japanese residents buying German-made cars. This
results in money flowing out of the Japanese economy.
Toyotacarsareanexampleofvisibleexports
Balance of payments
Invisible trade balance

The invisible trade balance is a record of the export and import of services
(intangible products), such as banking, insurance, shipping and tourism. It is
sometimes called the bala nce of t rad e in services. For example, American tourists
in France would represent export earnings (or an invisible export) for the French
economy. By contrast, French customers who fly on American Airlines represent an
invisible import for the country.
Net income flows and transfers
Net income flows and transfers arc a record ofa country's net income earned from
capital flows. Examples include:
• interest, profits and dividends paid to foreigners who own assets in the country
• income earned on foreign assets owned by domestic residents and firms
Examples of transfers include:
• money spent on foreign aid
• money sent home by people working abroad
• taxes received by the government from foreign residents and firms
• bank deposits held in overseas banks.
The sum of the visible and invisible trade balances gives what is known as the balance
of t rade or simply the t rad e balance - the difference between a country's total
CXJX)rt earnings and its total import expenditure. The trade balance is the largest
component of the current account. It is often referred to as net expor ts. Therefore,
the current account is calculated as follows:
Current = visible trade + invisible trade + net income flows

account balance balance and transfers
Net income flows income flows and income flows and

and transfers transfers earned overseas - transfers sent o.'crscas
Study t ips
Theeasiestway Ta ble24.1 Thecurrentaccountbalance,selectedcountries(topandbottomfiveranks)
to distinguish
between invisible Rank Country Sb, Rank Country Sb,
exports a nd China
imports is to Germany India
consider flows of
money(where Saudi Arabia Brazil
the money comes 4 Japan Canada
from or goes to)
Turkey
rather than the
flows of services. Sou,ce:CIAFacrbook.2012
Activit y
Investigate the main exports and imports for your country, or a country of your choice.
Doesyou r chosencountrycurrentlyhaveapositiveornegativetradebalance?
Exam practice
1 Classify t he followi ng transact ions by using a tick (.r) in t he correct column, from
th e perspect ive of the UK economy.
Visibl e In vis ibl e

Expo rt Impo rt Export Imp o rt
a) ThepurchaseofUK-producedchemical
productsbyaGermancompany
b) American tourists flying to the UK on
British Airways
c) UK supermarketspurchaseofFrench
w ine and cheese
d) UKgovernmentmaintainingforeign
embassies overseas
e) Germantouristsbuytheatreticketsto
seeLesMiserab/esinlondon
f) ABritishfirmbuysafleetoflorries
(trucks)fromJapan
g) Global sales of Harry Potter books by
BritishauthorJ .K. Rowling
[8]
2 Study the dat a below and answer the questions that follow.
Trade balance for Country B (Sbn), 2013
Exports 85
Goods 57
Services 28
Impo rts
Goods 88
Services 15
Visible balance
Invisible balance
Trade ba lance
a) Define t he term 't rade balance'. [2]
b) Calculate the missing fi gures in the data above. [4]
C urrent acco unt deficits

A country is said to have a current account d eficit if its fin ancial o utflows are
greate r tha n its financial inflows. Hence, the current account has a negative
balance . By contrast , a current account surplus exists if the fin ancial inflows are
g reate r than its financial o utflows. This means the count ry will have a positive
ba la nce o n its c urrent account.
Balance of payments
Causes of cu rrent account deficits

A deficit on the current account can occur due to a combination of two factors:
• Lower demand for exports - This could be caused by a decline in manufacturing
competitiveness, perhaps due to higher Jabour costs in the domestic economy.
Another factor is declining incomes in foreign markets, perhaps due to an
economic recession. This means households and firms have Jess money available
to spend on another coumry's exports. A third cause oflowcr demand for exports
is a higher exchange rate (sec Chapter 25 ). This makes exports more expensive for
foreign buyers, so it reduces the volume and value of exports.
• Increased dem and for imports - Domestic buyers tend to buy more imports if
they are cheaper or of better quality. For example, a higher exchange rate means the
domestic currency can buy more foreign currency, so this makes it cheaper to buy
imports. Alternatively, domestic inflation means that imix,rts are relath·cly cheaper,
so more domestic residents and firms will tend to buy foreign goods and services.
l'~.~~
Exam practice
Examine Figure 24.1, which shows the balance of trade for Sri Lanka, and answer the
questions that follow.
§: - 1000 - · - -1 000
r:: -I- n[ 1::°500

i~ - ~
- 3000 3000
J]n/04 J]n/06 }00/08 }00/ 10 )an/12
Figure24.1 ThebalanceoftradeforSrilanka,2004-13
1 Define the term 'balance of trade'. (2)
2 Explain two possible causes of the trend in Sri Lanka's balance of trade. (4)
Consequences of current accou nt defi cits

There arc consequences of current accoum deficits for the domestic economy. Like
an individual, a country cannot spend more (on imported goods, services and capital
flows) than it earns (from the export of goods, services and capital).
The severity of these consequences depends on the size and duration of the deficit.
Ncvcnhcless, a current account deficit is generally considered to be unfavourable for
the economy for the reasons outlined below:
• Red uced aggrega te demand - A trade deficit means the economy is spending
more money on imix,rts than it receives from the cxix,n of goods and services. This
can cause aggregate demand in the economy to fall, thus triggering a recession (sec
Chapter 20). The USA's trade deficit with China (sec the Exam Practice question
below) has been blamed for much of the country's recent economic problems.
• Unemployment - As the demand for Jabour is a derived demand (sec Chapter

7), a fall in aggregate demand is likely to cause unemployment in the economy.
Workers may also have to take a pay cut in order to correct the deficit. For
example, the UK has experienced a decline in manufacturing jobs as there has
been a fall in the demand for British exports of coal, steel, textiles and motor
Study tips vehicles.
A manageable • Lower standards of living- Ifrhc currenr account deficit is caused by a negative
deficit on the balance on net income flows and uansfers, this means monetary outflows exceed
monetary inflows for the counrry. An economy with less income is likely to suffer
is not necessarily from lower standards of living. In addition, to cut the current account deficit,
a bad thing .
households and firms may need to reduce their spending.
For example,
the deficit • Increased borrowing- Just like an indh,idual cannot spend more than he or
might be the she earns in the Jong run, countries need to borrow money or attract foreign
resu lt of strong im·csrmcnt in order to rcctif)• their current accounr deficits. In addition, there is an
economic growth, opportunity cost of debt repayment, as the government can nor use this money to
with residents stimulate economic growth.
purchasing more
foreign goods • Lower exchange rate - A fall in demand for exports and/or a rise in the demand
and services. for imports (causing the current account deficit) reduces the exchange rare.
This allows While a lower exchange rate can mean exports become more price competitive,
the country's it also means rhar essential imports (such as oil and foodstuffs) will become
residents to more expensive. This can lead to imported inflation (see Chapter 18). The
enjoy a higher
consequences of fluctuating exchange rates arc covered in more derail in
standard of living,
as they are able Chapter 25.
to benefit from In general, large and persistent current account deficits arc a sign that the counrry is
access to a range
of good-quality internationally uncompetitive, which has more se\·cre consequences for the domestic
imports. economy. These deficits will have a negative impact on economic growth and
standards of living.
Exam practice
Despite the USA exporting more to Ch ina than ever before, the USA's trade
deficit with China is at its highest level (Table 24.2). The imports include consumer
electronics, clothing and machinery (such as power generation), toys, sports
equipment, furniture and footwear.
Table24.2 TradebetweentheUSAandChina,2011-12
2012($bn) 2011($bn)
US exports to China
USimport1fromChina
Soorce: adaptedfromUSCensu,
1 Explain how it is possible that 'the USA's trade deficit with China is at its highest
level' even though the USA reported record export sales to China. [2)
2 Calculate the trade balance for the USA with China for 2011 and 2012. [2)
Balance of payments
Dea ling w ith current accou nt defic its

There are four main policies that can be used to impro.'e a country's current accoum
balance: fiscal and monetary policies (which tackle demand-side issues), supply-side
policies and protectionist measures. These macroeconomic policies are cm-cred in
more detail in Chapter 16.
• Fiscal policies - These measures use a combination of higher taxes and reduced
go,·ernment spending in order to reduce the amount of money available to spend
on imports. In theory, this helps to reduce the current account deficit.
• Monetary policies - H igher interest rates make new and existing loans more
expensive for households and firms. Therefore, this reduces their demand for
imports. Alternatively, the central moneraryauthorit y ofa country (see Chapter 6)
might decide to devalue the exchange rate to improve the nation's competitiveness.
This also has t he effect of reducing the price of exports and making imports more
expensive.
• Supply-side po licies - These policies strive to raise the productive capacity of the
economy. Examples are :
0 investment in education and health care to improve t he economy's human
capital, productivity and international competitiveness
O investment in infrasrrucrnre to support businesses and industries, especially
those engaged in export markets
0 measures to encourage export-driven business start-ups and industries, such as
go,·ernment subsidies and tax incenti\-cs.
• Pro tectio nist measures - These measures reduce the competiveness of imports,
thereby making domestic consumption more attractive. For example, tariffs
(import raxes) raise the price ofimpons while quotas (see Chapter 26) limit the
amount of imports available.
Exam practice
'A current account deficit on the balance of payments is undesirable during a
recession but is not really a problem during periods of economic growth.'
1 Define the term 'current account deficit'. [2]
2 Explain the validity of the above statement. (4]
C urrent a ccount surpluses

Causes of current account surpluses
A surplus on the current account can occur due to a combination of two factors:
• Higher d emand for expor ts - This could be caused by an impro,·emem in
manufacturing competitiveness, perhaps due to higher Jabour productivity in the
domestic economy. Another factor is higher incomes in overseas markets, meaning
that foreign households and firms ha\'e more money to spend on the country's
exports. A third cause of higher demand for exports is a lower exchange rate (see
Chapter 25), which makes exports less expensive for foreign buyers.
• Red uced dema nd for imports - Domestic buyers rend to buy fewer imports if
they are more expensi\'e or of lower quality than those provided by domestic firms.
For example, a lower exchange rare means the domestic currency can buy less
foreign currency, so this makes it more expensh'e to buy imports. Another reason
is that inflation in overseas countries causes imports to be more expensi\·e, so
individuals and firms buy more home-produced goods and ser\'ices.
Consequences o f current account surpluses

The consequences ofa country having a c.urrenr account surplus include the
following:
• Employment - A sustained current account surplus can be desirable, as higher
export sales help to create jobs. Howe\'er, a consequence of this is rhar job losses
are created in other countries. For example, the USA has blamed China's large
current account for causing large-scale unemployment in America.
• Standa rds of living - A furnurable current account balance means the
country receh'es a higher income because domestic firms ha\'e a competitive
ad\'antage in the products they export. This can lead to a higher standard ofliving
(see Chapter 21).
Study tips
A surplus on the
current account
is not necessarily
a good thing . For
example.former
communist nation Oil exporting countries such as Saudi Arabia, Kuwait, Qatar and the United Arab Emirates
Romania had haveconsistentlyenjoyedcurrentaccountsurpluses,thusboostingtheirGDPandstandards
a trade surplus of living
by using trade
protectionism
(seeChapter26). • Inflationary - H igher demand for exports can lead to demand-pull inflation (see
This limited access Chapter 18). Therefore, the current account surplus can diminish the international
to foreign goods competitiveness of the country over time as the price of exports rises due to
and services, inflation.
thus causing
living standards • Hig her exchange rate - The higher demand for exports can cause the currency to
to be lower. appreciate in value (sec Chapter 25). Subsequently, foreign buyers will find it more
expensive to import goods into their countries.
Balance of payments
Exam practice
Examine Figure 24.2, which shows the current account balance for Kuwait, and
answer the questions that follow.
J] n/02 }00/04 J] n/06 J] n/08 }00/10 J]n/ 12

Source: Tra<lin9 Economics www.tradingeconomics.com/kuwait/current-account-to-gdp
Figure24.2 CurrentaccountbalanceforKuwait,2001-12
1 Define the term 'current account surplus'. (2)

2 Explain three consequences of Kuwait's continual current account surplus
during the twenty-first century. (6)
Chapte r r eview questio n s

1 What is the balance of payments?
2 What is the difference between the visible trade balance and the invisible
trade balance?
3 What does the 'net income flows and transfers' component of the current
account record?
4 How does a current account deficit differ from a current account surplus?
5 What are the two main causes of a current account deficit?
How might a government deal with a current account deficit?
How might a current account surplus be detrimental to the country?
Key terms
The balanteofpayments isafinancialretordofacountry'stransactionswiththerestofthe
worldforagiventimeperiod,pertimeperiod.
The balanteoftrade (orsimplythe tradeba lante)isthedifferencebetweenacountry's
totalexportearningsanditstotal import expenditure.
The turrentactount isacomponentofthebalanceofpaymentsthatrecordsallexports
and imports of goods and services and net income flows and transfers with other countries
betweenacountryandtherestoftheworld.
A current account deficit occurs when a country's financial outflows are greater than its
financial inflows.
A cu rrent account su rplus occurs when a country's financial inflows are greater than its
financial outflows.
lnvlsibleexports refertotheearningsfromsellingservicestoforeigncustomers.
lnvis iblelmports refertothespendingonservicesprovidedbyfirmsinoverseascountries.
The invisib letradebalante isarecordofthetradeinservices,suchastransportationand
financial services.
Net income flows are a record of a country's net income earned from capital flows .
Transfers are money flows from one country to another, e .g . income sent by a foreign
worker to their home country, or a gift of money from one government to another.
Visib le exports are goods that are sold to foreign customers.
Vis ib le imports are goods bought by domestic customers from foreign sellers.
The visibletradeba lance isarecordoftheexportand import of physical goods.
_J
@ Exchange rates

• define exchange rates
• discuss the causes and consequences of exchange rate fluctuations.
Taken from Cambridg<' International haminations Syllabus ~GCSE 0455/0 Level 2281)
0 Camb<idge lntemational Examinabom
Exc ha nge ra tes

An excha nge rate is the price of one currency measured in terms oforher currencies.
For example, the exchange rate of the US dollar in terms of the JX>Und sterling
might be $1.5 = £1 (or $1 = £0.67). This means that a British tourist spending
$600 on hotel accommodation in the USA would have spent the equivalent of £400
($600 + 1. 5).
Exchange rates can change o.'er time, so ifrhe US dollar full against the pound
sterling to $1.60 = £1, then the tourist would pay £375 ($600 + 1.6) for staying at
the hotel in the USA. The British tourist would pay the same price in US dollars but
this equates to fewer pounds sterling.
Activity
1 Use www.oanda.com (or another relevant internet website) to find out which countries
use the following currencies:
ii) ringgit d) won
b) dong e) kwacha
c) lek f) rufiyaa
2 How many countries can you find that use the following currencies?
il) peso d) franc
b) real e) dollar
c) pound f) rupee
Exam practice
1 Suppose the exchange rate between the Australian dollar (AUD) and the
Chinese yuan renminbi (CNY) is AUD1 = CNY6.5. Calculate the price for
customers in China of buying textbooks priced at AUD65 from Australia. [2)
2 Suppose that the exchange rate between the Canadian dollar (CAD) and the
British pound (GBP) is CAD1 = GBP0.65 and the exchange rate between the
Canadian dollar and the euro {EUR) is CAD1 = EUR0.75. Calculate the exchange
rate of the British pound against the euro. [2)
The importance of exchange rates

Since different countries use different forms of money, exchange rates are fundamental
in facilitating international trade (see Chapter 25). In theory, the demand for exix,rts
of goods and services increases if exports become cheaper. Likewise, the demand for
imports falls if the price of imports becomes more expemh-e.
Consider Table 25.1 as an example. The table shows that the price ofa 64 GB iPad
in Hong Kong is H KD6000 (Hong Kong dollars). Srndy the impact that fluctuations
in the exchange rate of the pound sterling haw on the price of the il'ad for British
tourists in Hong Kong.
As the price of the pound sterling increases from $10.5 to $13.5, the price of
the il'ad falls from £571.43 to £444.44 for the British tourist in Hong Kong. This
means that as the \'alue of a country's currency rises, its demand for imports tends to
increase. Hong Kong's exports to the UK should therefore increase.
Looking at this from the perspective of Hong Kong, the full in its exchange rate
(from $10.5 =£1 to $13.5 =£1) means that imports will become more expensive.
To illustrate this, suppose that a Hong Kong supermarket imports supplies from
the UK. An order valued at £50000 used to cost the Hong Kong firm $525 OOO
(i.e. £50000 x $10.5), but will now cost $675 OOO (i.e. £5000 x $13.5). This means
that as the value of a coumry's currency falls, its demand for imix,rts tends to full.
The UK's exports to Hong Kong should therefore full.
Tab le25 .1 The price of an iPadatdifferentexchangerates(GBP:HKD)
Exchange rat e HKDpri ce GBPpri ce

(G BP:H KD)
£1 = $10.5 $6000
£1 ~ $11.5 $6000
£1 = S12.5 $6000
fl = SB.5 $6000
Exchange rates
However, the demand for some imports is price inelastic because they are not readily
available in the domestic economy yet are essential for production (such as oil and
other viral raw materials). Therefore, domestic firms have to spend more on these
important imports when the exchange rate falls in \•:tlue. For example, if the Mexican
peso (MXN ) falls against the Canadian dollar (CAD) from 12.5:1 to 14:1 , then
Mexican firms buying Canadian oil at a price of CAD100 per barrel pay a higher
price of MXN 1400 per barrel instead of the previous price of MXN1250 per barrel.
This means Mexican firms may need to reduce their price by around 12 per cent to
remain competitive, despite their higher costs of production due to the fall in the
value of the Mexican peso.
In the same way that changes in the exchange rate can affect the demand for
exix,ns and imports, they can also affect the amount of tourism revenue and the
profitability ofbusinesses, and can therefore impact upon unemployment and
economic growth.
Floating exchange rate systems

There are two broad types of exchange rate system: floating and fixed.
In the floatin g exchange rate 11ystem , the value ofa currency is determined
by the market forces of demand for the currency and supply of the currency. For
example, overseas tourists buy (demand ) the foreign currency by selling their
domestic currency. Countries that adopt this system allow the value of their currency
to be determined by the market. Examples are Belgium, Chile, Luxembourg, Spain,
Japan, New Zealand, Sweden and the United Kingdom.
If banks in New Zealand offer investors higher interest rates than those in the UK,
this can cause investors to take advantage by buying the NZD. This will increase the
demand for the NZD, thus shifting its demand from D 1 to Di in Figure 25.1. This
raises the price (or exchange rate ) of the NZD from £0.55 to £0.65. Bycomrast, a
fall in interest rates is likely to drive investors a\\'aY as they search for investments that
generate a better financial return.
1)~
~, O Oiootify[NZDI
Figure 25.1 Changesininterestratesandtheimpactonexchangerates
In a floating exchange rate system, there is an appreciatio n in the exchange

rate if the exchange rate is rising against other c.urrencies. By comrast, there is a
d epreciatio n of the exchange rate ifits value falls against other currencies.
Fixed excha nge rate syste ms

Under the fixed exchange rate system, the government intervenes in foreign
exchange markets to maintain its exchange rate at a predetermined level. For
example, the Hong Kong dollar has been pegged (fixed ) against the US dollar
since 1972. Since 1983 the H KD has been pegged to both the USD (at a rate of
H KD7.8 = USD1) and the Macanesc pataca (ata rate of H KD l =MOPl.03).
The main advantage of fixing exchange rates is that it reduces uncertainties for
international trade. This allows firms, both foreign and domestic, to be certain about
future costs and prices, thereby encouraging international trade and exchange.
1J~
-~
0 O...OOtify
Figure 25. 2 Thefixedexchangesystem
In Figure 25.2, the exchange rate between the USD and the H KD is pegged at
H K$7.8 = US$1 (although it is allowed to flucmatc within a small range of H K$7.75
to H K$7.85 ). This is achie\'Cd by the respective go,'ernmcnts buying and selling
foreign currencies to maintain this 'peg'.
For example, if the H KD declines against the pegged USD, the Hong Kong
Monetary Authority (H KMA) can raise the \'alue by increasing the demand for its
currency. To prevent the H KD falling from 7.8 to 7.7, perhaps due to speculators
selling the H KD, the H KM.A imen'Cncs in the foreign exchange market by buying
enough H KD (thus raising its price) to maintain the exchange rate at the fixed rate of
7.8. Similarly, the H KMA would sell H KD if the excl1ange rate were to approach 7.9
(increasing the supplr of H KD in order to reduce its price). This function of central
banks (sec Chapter 6) requires careful management and plenty of currency reserves.
There are two main criticisms of a fixed exchange rate system. First, it reduces
the country's ability to use monetary policy changes in order to affect the economy
(which is particularly useful during an economic recession). Second, there is a huge
opportunity cost in using large amounts of foreign exchange resen'Cs to maintain the
fixed rate.
It is possible to change the pegged rate o.•cr time. For example, the H KD
was originally fixed at H K$5.65 = USD I back in 1972. As the USA's economy
developed, it currency was revalued to H K$7.8. In a fixed exchange rate system,
there is a revaluation of the exchange rate ifit is rising against other currencies. By
contrast, the exchange rate is devalued under a fixed exchange rate system if the
value of the currency falls against other currencies.
Activity
Prepare a presentation on why a government might want to have lower exchange rates.
Considerwhetherthisisasustainableeconomicpolicy.
Exchange rates
Causes of exchange rate fluctuations

Any factor that influences the demand for a currency or its supply will ha\·e an impact
on the exchange rate. These factors include the following:
• Changes in demand for exports -An increase in the demand for exports,
perhaps due to impro\·ed quality or successful ad\·enising, will also increase the
demand for the country's currency. Therefore this increases the exchange rate.
• Changes in demand for imports -An increase in the demand for imports,
perhaps due to an increase in the competitiveness offoreign firms, will raise the
value of the foreign currency in order to facilitate the purchase of foreign goods
and services.
• Prices and inflation - An increase in the price of goods and services caused by
domestic inflation will tend to decrease the demand for exports. This will therefore
tend to cause the exchange rate to full in value.
• Foreign direct investment (FDI ) - Globalisation and the economic activity of
multinational companies mean that investment in o\'erseas production plants
requires the use of foreign currencies. For example, Nissan's car manufucmring
plant in India requires the Japanese car-maker to buy Indian rupees to pay for
the materials, Jabour and other production costs. Thus, inward FDI will boost
the demand for a currency. By contrast, outward FDI will increase the supply of
a currency.
ANissancarplantinChennai,lndia
• Specu lation - Foreign exchange traders and investment companies move money
around the \\urld to take advamage of higher inte rest rates (sec Figure 25.l) and
variations in exchange rates to earn a profit. As huge sums of money arc involved
(known as 'hot money' ), this can cause exchange rate fluctuations, at least in
the short nm. Speculators might also Jack confidence in certain economics and
therefore withdraw their investments, thereby depreciating the currency (sec the
Case Study below).
• Government intervention - All the abo\·e factors can affect the exchange rate
under a freely floating exchange rate system. In addition, government imervcmion
in the foreign exchange market can affect the exchange rate. For example, if greater
demand for American goods causes an appreciation of the dollar, the US Federal
Rcsen·c can sell its dollar reserves (thereby increasing the supply of dollars), leading
to a fall in thcvalucofitscurrcncy.
The Chinese government limits currency flows by only allowing individuals to
change up to 20 OOO yuan (around $3185) each day.
Case Study: The collapse of Landsba nki a nd Kaupthin g

The global financial crisis of 2008 saw the collapse of Iceland's major banks, including
Landsbanki(foundedin1886)andKaupthing(foundedin1930).lnvestorsacrossEurope
fearedthelcelandicbankswoulddefaultontheirdebts.Thisresultedinasellingfrenzy
whichcausedarapidfallinthevalueofthekrona(lceland'scurrency).
Exam practice
The value of a currency will change if the demand for and/or supply of the currency
changes. Explain, with the use of a demand and supply diagram, the effects of the
following events from the perspective of the USA:
1 The USA buys more imports from Brazil. [4]
2 Millions of American tourists visit France. [4]
3 There is an increase in American exports to Russia. [4]
4 The Federal Reserve (the USA's central bank) raises the rate of interest. [4]
5 Speculators feel that the US dollar will rise in value against other major currencies. (4)
Consequences of exchange rate fluctuations

Exchange rate fluctuations affect different srakcholdcrs in different ways, depending
on whether the consequences arc seen from the perspective of customers or producers
(importers and exporters).
The following is an analysis ofa strong US dollar, due to either a currency
appreciation or a currency revaluation. The opposite results would apply in the case of
a currency depreciation or devaluation.
• Customers have greater purchasing power when the exchange rate increases. For
example, if the exchange rate changes from $1.6 =£1 to $1.4 =£1, then Americans
would require fewer dollars to buy British goods and services. Thus, American
firms and individuals arc likely to buy more British goods and services.
• Exporters face more difficult trading conditions when the exchange rate increases.
This is because the price of their goods and services will become more expensive
for foreign customers. For example, if the exchange rate changes from $1.5 = €1
to $1.3 = €1 then customers from the European Union will need to spend more
money to buy American goa:ls and services. Therefore, demand for US exports is
likely to drop.
• Importers potentially gain from a strong dollar because this makes it cheaper for
US firms to import raw materials, comJX>ncms and finished goods from abroad.
For example, if the exchange rate appreciates from $1.5 = €1 to $1.3 = €1, the
American importers only need to spend $1300 on each €1000 order of goods and
services from Europe, rather than $1500. While this is bad for US firms trying
to compete with American imports, it can help to reduce cost-push inflation
(sec Chapter 18).
Exchange rates
Exchange rate fluctuations also have consequences for macroeconomic objectives.

An increase in the exchange rate will have the following effects on the balance of
payments, employment, inflation and economic growth:
• Balance of payments - !fa currency appreciation has a larger impact on exports
than imports (that is, there is a net full in the value of exports), then the balance of
payments will worsen. This is because a strong currency will make it more difficult
for exporters to sell their goods and services in (J','erseas markets.
• Employment - A fall in net exports and deteriorating profits will, in the long
run, cause job losses in export-oriented businesses. This will therefore cause
unemployment in the economy.
Greece and Spain suffered from high unemployment in 2012- 13 due to the
strength of the euro, with unemployment reaching record levels of26.8 per cent
and 26.l per cent respectively. In Spain, youth unemployment (among those aged
21 and below) reached a historic high of 55 per cent.
• I n flatio n - Lower le\·els of spending in the economy, caused by higher
unemployment, will rend to reduce the rate of inflation. In addition, if the country
relies heavily on certain imports, such as oil or food supplies, then the higher
exchange rate will help to reduce the general price le,'el even further.
• Econo mic growth - In the long run, economic growth is likely to fall due to the
combination of lower export sales and higher unemployment caused by the higher
exchange rate.
PeoplequeuingoutsideajobcentreinSpain
Exam practice
Since China's admission to the World Trade Organization in November 2001, the USA
has complained that the Chinese government has deliberately kept its exchange rate
artificially low. The low value of the yuan compared with the dollar has contributed to
the economic problems of the US economy.
1 Define the term 'exchange rate'. [2)
2 Explain two advantages of a weak yuan for the Chinese economy. [4)
Coping with a strong exchange rate

Firms can deal with a higher or strong exchange rate in a number of ways, such as:
• cutting export prices to maintain their price competitiveness against foreign rivals,
which means the domestic firms will have to accept lower profit margins
• seeking alternative overseas suppliers of cheaper raw materials and components
• improving productivity (efficiency) gains to keep a,·erage lalxmr costs under control
Study tips
• focusing on supplying more price inelastic and income inelastic products because
customers become less sensitive to exchange rate fluctuations
It is possible
for some firms • focusing on non-price factors that are important to m'Crscas customers, such as
to gain from brand awareness and social responsibility
a stronger • relocating production processes o,·erseas, where costs of production are relatively
currency while low and where operations are less exposed to exchange rate fluctuations.
others lose out.
Review the
main points Exam practice
in this chapter
to make your 1 Explain, with the aid of a numerical example, what is meant by an 'appreciation'
own judgement in thevalueofacurrency. (3)
on this .
2 Examine the likely effects of a country's currency appreciation on its exports
and imports. [6)
Chapter r evie w ques tions

1 Whatisanexchangerate?
2 What is the likely impact on a country's exchange rate following an increase in
the demand for its exports?
3 What is the likely impact on a country's exchange rate following a decrease in
the rate of interest?
4 What are the causes of exchange rate fluctuations?
S What are the consequences of exchange rate fluctuations for importers,
exporters and customers?
6 How does a strong currency impact upon a country's macroeconomic
objectives?
Exchange rates
Ke y terms
Appreciation of a currency occurs when there is an increase in the value of the exchange
raterelativetoanothercurrencyoperatinginafloatingexchangeratesystem.
Depreclation ofacurrencyoccu rswhenthereisafallinthevalueoftheexchangerate
relativetoanothercurrencyoperatinginafloatingexchangeratesystem.
Devaluation occurs when the price of a currency operating in a fixed exchange rate system
isofficiallyanddeliberatelylowered.
The exchangerate isthepriceofonecurrencymeasuredintermsofothercurrencies.
A fixed exchange rate system exists when the central bank (or monetary authority) buys
andsellsforeigncurrenciestoensurethevalueofitscurrencystaysatthepeggedvalue.
A floating exc hange rate syste m means that the currency is allowed to fluctuate against
other currencies according to market forces without any government intervention.
A foreign exchange market is the marketplace where foreign currencies can be bought and
sold.
Reva luatio n occurswhenthepriceofacurrencyoperatinginafixedexchangeratesystem
isofficiallyanddeliberatelyincreased.
@ Trade and trade protectionism
• discuss the merits of free trade
• discuss the merits of protection
• describe methods of trade protection.
Taken from Cambridge International ExamiJlabom ~la bus (IGC SE 0455/0 Level 228 1)
Free trade
Inte rnatio nal t rade is the exchange of goods and services beyond national borders.
It emails the sale of ex po rts (gcods and services sold to o,erseas buyers) and imports
(foreign goods and services bought by domestic households and firms).
Free t rade means that international trade can rake place without any forms of
protection (barriers to trade), sud1 as quamitati\'e limits or taxes being imposed on
ex pons.
The merits of imernational trade (that is, the reasons wh y countries trade with one
another) include the following:
• Access to resou rces - l mernational trade enables firms and consumers to gain
access to goods and services that they cannot produce themseh·es. For example,
countries without a manufacturing industry, like the Maldives, can purchase laptop
computers, motor vehicles and Hollywood movies produced around the world.
Theselaptopsa remadeinChinabutcanbepurchasedbypeopleincountriesthatdonot
haveamanufacturingindustry,thankstointernationaltrade
Trade and trade protectionism
• Lower prices - Free trade reduces the costs of trading, whereas protectionism
Study tips
increases the costs of uading. For example, it is cheaper for Germans to purchase
Make sure you
can distinguish foreign -produced smanphones made in China and Taiwan because of the high
between the labour costs in Germany. Unfavourable weather conditions in Sweden mean it is
merits of better off importing tropical fruits from Jamaica. By conuast, the imposition of
in ternat io na l trade barriers would mean that 001:h domestic firms and consumers have to pay
trade and the more for imported goods and services.
merits of free
trade-they are
• Economies of scale - By operating on a larger scale in global markets, firms can
not quite the benefit from economies of scale (see Chapter 14). These cost savings can be passed
same,asnotall on to consumers in the form oflower prices and/or kept by the firms in the form
international ofhigher profits.
trade entails free • Greater choice - Free trade enables consumers and finns to access a larger variety
trade. Thus.the of goods and services from different producers around the world. For example,
merits of free
trade(without while Germans can choose from domestic moror vehicles such as Audi, BMW or
any trade barriers) Mercedes-Benz, they are also able to choose from foreign suppliers such as Lexus
are greater than (Japan), Jaguar ( India) and Cadillac (USA).
the benefits of • Increased market size - lmernational trade enables firms to earn more revenues
international and profits. For example, US firms can sell products to a domestic market of 300
trade(whichmay
entail some trade
million people, whereas they can sell to a larger market of more than 2 .4 billion
barriers). potential customers by selling their products to China and India.
• Efficiency gains - Free trade forces domestic firms to focus on improving the
quality of their output due to foreign competition. For example, Japanese car-
makers and South Korean electronics firms have forced US producers such
as General Motors and Apple to create better-quality products. By contrast,
protectionist measures give domestic firms a fulse sense of security, which can
make them inefficient.
• Improved international relatio ns - The absence of trade barriers encourages
imernational trade and cooperation ben\·een coumries. By contrast, if a country
uses international trade barriers, other nations are likely to retaliate by doing
the same.
Activity
1 Have a look at the products you have at home, such as your family's computer,
television, watch, car and clothes. How many have these products have been imported?
Why might this be?
2 Usetheinternettoinvestigatethetypesofgoodsandservicesthatareexportedand
imported from one high-income country and one low-income country of your choice.
Find out the main trading partners of these countries. As a starting point, you may want
to use The Economist's country briefs (www.econom ist .com) and/or the CIA website
(www.cia.gov/library/publications/the -wortd -factbook/).
Exam practice
Bangladesh is one of the world's largest producers of rice and tropical fruits. In Brunei
Darussalam, crude oil and natural gas account for around 90 per cent of the country's
gross domestic product. This makes Brunei Darussalam one of the leading producers
of oil in SoutheastAsia.
1 Explain two reasons why countries such as Bangladesh and Brunei Darussalam
trade with each other. [4)
2 Outline one problem for Brunei Darussalam in relying on oil exports. [2)
3 Explain how Bangladesh's export of rice and tropical fruits helps its farmers to
achieve economies of scale. [4)
Trade protection
Despite the benefits of international trade, there are drawbacks that mean there could
be a need for trade protection. Trade protection refers to the use of trade barriers
to restrain foreign trade, thereby limiting overseas competition. There are a variety
of restrictive government measures designed to discourage imports and to prevent
competition in domestic markets.
Reasons for trade protection
• Protectionist measures help to protect infant industries (new, unestablished

businesses) from foreign competition. The Chinese 80\'crnment, for example,
only allows 20 Holl ywood movics to enter the country's cinemas each year, thus
allowing the Chinese movie industry to develop.
Lost in Thailand is China's highest-grossing homegrown film . Trade protection enables the
Chinesemovieindustrytodevelop
• Protection from free trade can also help to protect domestic jobs. French
car-ma ker Renault announced that it would have to make 7500 workers
unemployed between 2013 and 2016, partly due to the higher sales ofJapan's
Toyota across Europe as a result of free trade. In extreme cases, fierce competition
from foreign rivals can even force domestic firms out of business.
• It prc,-cms foreign coumrics from d umping their goods in the domestic economy.
Dumping occurs when foreign firms sell their products in large quamities at prices
deliberately below those charged by domestic firms, often even below the cost
of production . This clearly gives the foreign firms an unfair price advantage, so
protectionist measures may be needed. The European Union has recently accused
China of dumping its glass solar panels and the USA has accused Vietnam of
dumping its shrimps.
• Protection can also be a source of gove rnment revenue. For example, India
imposes a $535 per 10 gram tariff on t he imponofgold, thus helping to raise rax
revenue for the governmem.
• Protection might also be required to overcome a balance of payments deficit
(sec Chapter 24). !fa coumry's expenditure on imports exceeds the revenue
earned from its exports, the coumry will experience problems as it spends more
than it earns. Protectionist measures to restrict imports would help to deal with
this imbalance .
• I n terms of strategic arg uments, the government might use protectionism
to safeguard the country against being roo depcndem on goods and services
from other countries. For instance, if a war were to break out then protectionist
measures give the country the ability and capacity to produce all the goods and
services that it needs, rather than having to rely on foreign countries. A country
such as Canada or the UK might wam to have more oil production in order to be
less reliant on imports from oil-rich nations that have the ability to distort world oil
prices and oil supplies.
Arguments against protectionism

Despite the merits of protectionism, there arc potential drawbacks:
• Governmem intervention disto rts market sig nals and therefore can lead to a
global misallocation of resources. For example, domestic consumers may not be
able to purchase lower-priced imports which arc of higher quality than those
produced domestically. Protected firms and industries can become roo reliant on
the government and thus become incfficiem.
• Protec tion can lead to increased costs of pro ductio n due to t he lack of
competition and ofincemh-cs to be efficient or innovative. Domestic producers
may need to pay higher prices for viral imported raw materials and components,
so this could lead to imported inflation (sec Chapter 18), thus leading to higher
domestic prices.
• Other countries are likely to react by retaliating and imposing their own trade
barriers. For example, in October 2012 the US International Trade Commission
imposed tariffs on imports of solar cells from China, and by January 2013 Beijing
had imposed a 5 -year anti-dumping tariff on two chemicals (ethylene glycol and
diethylene glycol) from the USA. Such actions may hinder global economic growth
and prosperity.
TheBananaWarswasatradedispute
betweentheEuropeanUnionandlatin
Americancountriesthatlastedfortwo
decades, makingitoneofthelongest
tradedisputessincetheSecondWorld
War. LatinAmericanbananaexporters
complainedaboutEUtariffsimposed
againstthem. Thesewereintroduced
to protect banana growers in former
European colonies, which were exempt
from the tariff.
Theformalagreementendingthe
disputewassignedinlate2012between
the EU and ten Latin American countries. The EU agreed gradually to reduce its tariffs on
imported bananas from €176 (S230) per tonne to €114 (S148) over 8 years.
Types of trade protection

The most common furm ofrrade protection is the use of tariffs. 111e other types of trade
protection are collecth'ely known as non-tariffbarriers. These are explained below.
• Tariffs -A tariff is a rax on imports. For example, the USA has recently placed a
35 per cemtariffon all tyres imported from China. Tariffs increase the costs of
production to importers, thus raising the price of foreign goods in the domestic
market and lowering the amount of products imported (see Figure 26.1).
11,,boff,o ,•m»
§; Pi
~ i~~:1"'~"'~
from S1 b .5:i. Th~
] P1 =~:~=ITTXTI.d~b
P2.<Jfld o<.tp.Jtki l1ng
fromQ11oQ,
Q 0i QI
Figure26.1
°"""
Theimpactoftariffs
• Quotas - An imporrquora sets a quantitative limit on the sale ofa foreign good
into a country. For example, the Indonesian government imposes import quotas on
fruits and vegetables from Thailand. The quota limits the quantity imported and
thus raises the market price of foreign goods (sec Figure 26.2).
~m~~~mt:,the
Sl!p fX"/d the lm po<tlrom
~ P2 ~ l;:;e.=t
~ ,, :::·,;;;~.:,;. i::,~
lo P2• ood D<iPJ1!alrng
fromQ11oQi
0 ~ Q,
' "'""
Figure26.2 Theimpactofquotas
• Subsidies - Governments can provide subsidies (lump-sum payments or cheap

loans to domestic pnxluccrs) to help local firms to compete against foreign
imports. Subsidies lower the costs ofproduction for home firms, thereby helping to
protect local jobs (sec Chapter 15). For example, the European Union subsidises its
farmers to encourage agricultural output (see Figure 26.3).
::i::;1oo:1i':.'so
~ Pi ~~$ J,:t~n
d: P2 ei~heP;.~
~~t ~'.'°"''lrom
Q QI Qi
"'""
Figure26.3 Theimpactofsubsidies
• Administrative barriers - Countries often use bureaucratic rules and regulations

as a form of protection. Examples include strict rules regarding food safety,
environmental standards and product quality. Complying with these rules and
regulations consumes a lot of time, and increases the costs for overseas finns.
• Embargo - An embargo is a ban on uade with a certain countf}', often due to a
trade dispute. An embargo rarely benefits local consumers, who suffer from a lack
of choice and higher prices (due to the lack of supply). For example, Malaysia has
imposed trade embargoes on the Philippines while the USA has uade embargoes
with Cuba.
Exam practice
1 British beef is sold throughout the world. Using an appropriate demand and
supply diagram, explain the consequences for the following if an import tariff is
imposed on British beef:
a) the price of British beef [4]
the quantity demanded of British beef [4]
b) producers and consumers of British beef [8]
2 China accounts for over 25 per cent of the world 's output of car tyres. Since 2009,
China has been the world's largest producer, consumer and exporter of tyres. The
China Passenger Car Association reported that over 20 million new cars were sold
in China in 2012, with annual sales growth of over 10 per cent over the next few
years. According to the USA's Bureau of Labor Statistics, the average US employer
had to pay about $35 per hour (salary and benefits) to hire a production line
worker whereas an employer in China could do the same for just $1.36 per hour.
The USA simply could not compete, thus prompting the need for protectionist
a) With reference to the above informat ion, explain two reasons why countries
use protectionism. [4)
b) Discuss which method of trade protection would be best for the USA to
impose. Justify your answer. [8)
Activity
Usetheinternetto investigatethefollowing:
1 WhatistheWo rldTradeOrganization?
2 What a rethem a infunctionsofthe WTO?
3 How effe cti vehas theWTObeeni n encoura gingfreeinternationaltra de?
Chapte r revie w questio ns

1 What is meant by 'free trade'?
2 Outline the merits of free trade.
3 What is trade protectionism?
4 Outline the merits of protection.
5 Distinguish between tariff and non-tariff trade barriers.
Ke y te rms
Barriers to trade are obstructions to free trade, imposed by a government to safeguard
nationalinterestsbyreducingthecompetitivenessofforeignfirms.
Dumping is the act of selling exports at artificially low prices. below those charged by
domesticfirms,andoftenlessthanthecostsofproduction.
An emba rgo isatypeofprotectionthat involvesplacingabanonthetradeofacertain
goodorwithaparticularcountry.
Exports are goods and services sold to overseas buyers.
Freetrade isinternationaltradewithoutanyprotectionistbarriersbetweencountries.
Imports are foreign goods and services bought by domestic households and firms.
International trade refers to the exchange of goods and services beyond national borders.
A quota is a type of protection that sets a numerical limit on the number of imports
allowed intoacountryoveraspecifiedtimeperiod.
Subsid ie s are a form of financial support from the government to lower the production
costsofdomesticfirms,therebyraisingtheircompetitiveness.
Ta ri ffs areimporttaxesthatareimposedonforeigngoods.
Tradeprotection istheuseoftradebarrierstosafeguardacountryagainstexcessive
internationaltradeandforeigncompetition.
Glossary
A bsolute povert y is an extreme form of poverty; Borrow ing occurs when an individual, finn or the
it indicates the number of people who cannot government takes out a loan from a financial
afford minimal standards of basic human needs institution, paying back the debt with imerest
(food, clothing, health care and shelter). over a period of time.
App reciatio n of a currency occurs when there Bus iness is an organisation that sells goods and/or
is an increase in its value relative to another services.
currency operating in a floating exchange rate Bus iness cycle describes the fluctuations in the
system. economic activity ofa country o~·er time, thus
Average cost s are calculated by dividing total costs creating a long-term trend of economic growth
by the number of units produced. in the economy.
Backward ver t ical integratio n occurs when a firm Capital refers to manufactured resources used to
from the secondary sector of industry merges further the production process, e.g. tools,
with a firm from the primary sector of indusuy machinery and buildings.
or a firm from the tertiary sector of industry Capital·inten sive produ ction happens when a firm
merges with a firm from the secondary sector spends proportionately more money on capital
ofindusrry. costs than any other fuctor of production.
Bad d ebts occur when people or businesses cannot Centr al bank is the term used to describe the
repay a loan. monetary authority that oversees and manages
Balance o f paym ents is a financial record of a the supply of money and the banking system of
country's uansactions with the rest of the the nation.
world for a given time period, per time period. C h a in o f prod uctio n describes how businesses
Balance o f trade (or simply the t rad e b alan ce) is from the primary, secondary and tertiary
the difference between a country's total export sectors work interdependently to make a
earnings and its total import expenditure. product and sell it to the final customer.
Barriers to entr y are the obstacles that prevent Collat eral means security for a Joan, e.g. property
other firms from effectively entering the in the case of a mortgage, or the car purchased
market. Examples include the existence of in the case of a car Joan.
imellecmal property rights, large advertising Collective barg aining occurs when a trade
budgets of existing firms and legal constraints union representative negotiates on behalf of
to prevent ,1rasteful competition. its members with the employer to reach an
Barriers to trade are obstntctions to free agreement which both sides find acceptable .
trade, imposed by a So\'ernment to C ommer cial b anks are retail banks that provide
safeguard national interests by reducing the financial services to their customers, such
competitiveness offoreign firms. as accepting savings account deposit s and
Bartering is the act of swapping items in approving bank loans.
exchange for other items through a pro:ess Complem en ts are products that are demanded
of bargaining and negotiation. (for their use ) together with other products.
Base year refers to the starting year when For example, tea and milk or the cinema and
calculating a price index. popcorn are jointly demanded.
Basic econ o m ic p roblem is how to allocate scarce Con g lo m er at e integration/ lat eral integr atio n/
resources to satisfy unlimited needs and wants. d ivers ificatio n occurs when a merger or
Birth rat e measures the number oflive births per takeover occurs bet\\-een two firms from
thousand of the population in a year. unrelated areas of business.
Glossary
Cons picuous cons ump tio n occurs when people Demerger occurs when two previously me rged
purchase highly expensive goods and services firms decide to break up and become rno
due to status or a desired image. separate firms.
Cons ume r prices index (CPI ) is a ,,~ighted index Demerit goods are goods or services which when
of consumer prices in the economy O\'er time. consumed cause negative spillo.•ereffi-cts
It is used to measure the cost ofli"ing fur an in an economy, e.g. cigarettes, alcohol and
average household. gambling. Demerit goods are c,.•er-consumcd
Cons ume r spend ing refers to the amount of due to imperfect consumer information about
household expenditure per time period. such goods.
Cons umpt ion is the value of all private household Demograph ics is the study of population
consumption within a country. distribution and trends.
Co-operati\'es arc business organisations set up, Dependency ra tio is a comp:trison of the number
owned and run by their members, who may of people who arc not in the labour furcc
be employees and/or customers. with the number of people in acti\'C paid
Cost-push inflatio n is a cause ofinflation, employment.
triggered by higher costs of production, which Depreciation ofa currency occurs when there is
force up prices. a fall in its value rclati\'e roanothcrcmrcncy
Costs arc the payments made by firms during operating in a floating exchange rare system.
the production process, e.g. the cost of Deregulation is a supply-side policy of making
land , Jabour, capital and enterprise. markers more competitive by removing barriers
to entry and other market impcrft.-ctions.
Cu rrem accoum is a component of the balance of
payments that records all exports and imports Derived dem and means that the demand for
of goods and services between a country and f.tctors of production occurs not for their own
the rest ofthe world. sake but for the goods and services that they
Cu rrent acco unt deficit occurs when a cou ntry's are used to produce.
financial outflows arc greater than its financial De\'aluatio n occurs when the price of a currenc y
inflows. oper:ating in a fixed exchange rate system is
Current acco unt surplus exists ifa country's officially and deliberately lowered.
financial inflows arc greater than its financial Direct taxes are government charges imposed on
our flows. income and wealth, such as income tax and
Death ra te measures the number of deaths per inheritance rax.
thousand of the population in a yea r. Diseco11om ies of sca le occur when average costs
Deflation is the sustained full in the general price ofproducrion start to increase as the size ofa
level in an economy o,·er time, i.e. the inflation firm increases.
rate is negative. Disinflatio n occurs when the rate of inflation f.tlls,
Dem and refers to the willingness rmd the ability of but is above zero, i.e. prices arc generally still
customers ro p:iy a given price to buy a good rising, only at a slower rate.
or service. The higher the price ofa product, Disposable income refers to the earnings ofan
the lower its demand tends to be. individual after income t:tx and other charges
Dem and for labour is the number ofworkcrs firms have been deducted.
arc willing and able to employ at a gh•cn wage Dissaving occurs when people spend their savings.
Di\'ersification is when a merger or takt.'0,-cr
Dem and -pull innario n is a cause of inflation , occurs between fim,s from different sectors
triggered by higher le\'Clsofaggregatc demand of industry that operate in unrelated areas of
in the economy, which drive up the general business.
price level.
Glossary
Divisio n of labou r is the specialisation of labour Exchange rate refers to the price of one currency
by getting workers to focus on one aspect of measured in terms of other currencies.
the production process. Expor ts are goods and services sold to overseas
Dumping is the act of selling exports at artificially buyers.
low prices, below those charged by domestic External benefits arc the positive side effects of
firms, and often less than the costs of production or consumption incurred by third
production. parties for which no money is paid by the
Econo m ic agents are households (private beneficiary.
indh,iduals in society), firms that operate Extern al cost s are the negative side effects of
in the private sector of an economy and the production or consumption incurred by third
government (the public sector of an economy). parties for which no compensation is paid.
Econo mic good s are those which are limited in External econo mies of scale are economies of
supply. scale that arise from factors outside of the
Econo m ic growth is the increase in the level of firm, for example, the location of the firm,
national output, i.e. the annual percentage proximity to transport, availability of skilled
change in GDP. workers.
Econo m ic system describes the way in which an Extern alities (or spillover effects) occur where the
economy is organised and run, including how actions offirms and individuals have either a
to best allocate society's scarce resources. positive or negative effen on third parties.
Econo mies of scale occur when average costs of Fertility rate measures the average number of
production fall as the size of a firm increases. births per woman. It is used as a component
Embargo is a type of protection by placing a to measure population growth.
ban on the trade of a certain good or with a Financial economies of scale occur as large firms are
particular country. able to borrow money from banks more easily
Employer refers to a person or a firm that hires than small firms because they are percei,'ed to be
other workers to an organisation. Jessriskytothefinancialinstirntions.
Employment refers to the use of fuctors of Fiscal po licy is the use of taxes and government
production in the economy, such as Jabour. spending to affect macroeconomic objectives
Equilibrium occurs when the quantity demanded such as economic growth and employment.
for a product is equal to the quantity supplied Fixed exchange rate system exists when the
of the product, i.e. there are no shortages or central bank (or monetary authority) buys and
surpluses. sells foreign currencies to ensure the value of
Eq uilibrium wage rate is determined \\11en the its currency stays at the pegged value.
wage rate workers are willing to work for equals Floating exchange rate system means that the
the wage rate that firms are prepared to pay. currency is allowed to fluctuate against other
currencies according to the market forces
Excess dema nd occurs when the demand for a
product exceeds the supply of the product without any government intervention.
at certain price levels. This happens when Foreig n aid is a form of financial assistance for
the price is set below the equilibrium price, economic development from other countries or
resulting in shortages. non-gm'ernment organisations such as Oxfam
Excess supply occurs when the supply of a and Unicef.
product exceeds the demand at certain price Foreig n exchan ge m ar ket is the marketplace
levels. This results in a surplus because where foreign currencies can be bought
the price is roo high, i.e. above the market and sold.
equilibrium price. Forwa rd vertical integratio n occurs when a firm
from the primary sector of industry merges
Glossary
with a firm from the secondary sector of H yperinflatio n refers to very high rates ofinflation
industry or a firm from the secondary sector of that are out of control, causing average prices
industry merges with a firm from the tertiary in the economy to rise very rapidly.
sector of industry. Imported inflation is a cause of inflation triggered
Free good s are goods which are unlimited in by higher import prices, forcing up costs
supply, such as air or seawater. of production and thus causing domestic
Free riders are people who take advantage of the inflation.
goods or services provided by the go\'ernment Imports are foreign goods and services bought by
but have not contributed to government domestic households and firms.
re\·enue through taxation. Income is the total amoum of earnings an
Free trade refers to international trade without any individual receives in a period of time. It may
protectionist barriers between coumries. consist ofwages, interest, dividends, profits
Functions of money describe the role that money and rental income.
plays in the economy: money is a medium of Indirect taxes are taxes imposed on expenditure,
exchange, a store ofvalue and a measure of i.e. sales taxes such as value added tax (VAT).
value (or unit of account). Industria l action is any deliberate act to disrupt
Fundamental economic questions are the key the operations of a firm in order to force the
questions that all economic systems strive to management to negotiate better terms and
answer: what, how and for whom production conditions of employment, e.g. strike action.
should take place. Inflatio n is the sustained rise in the general level
GDP per head (or GDP per capita) measures the of prices of goods and services over time, as
gross domestic product of a coumry divided measured by a consumer price index.
by the population size. It is a key measure ofa Innovation is the commercialisation of new ideas
country's standards of living. and products. It is a vital source of productivity.
Geographica l mobility occurs when a person is Interdependence means that the three sectors of
prepared to relocate to another area for a job. industry are dependent upon each other and
Go·slow occurs when \\orkers decide to complete cannot operate independently to produce
their work leisurely and therefore productivity goods and services.
fulls. Internal economies of scale are economies of scale
Goods are physical items such as tables, cars, that arise from the internal organisation of the
tomhpaste and pencils. business, for example, financial, bulk-buying
Government expenditure is the total value ofa and technological economics of scale.
government's consumption and im'esunent International specialisation occurs when certain
spending and transfer payments, such as coumries concentrate on the production of
unemployment benefits and state pension certain goods or services due to cost advantages,
schemes. perhaps due to their abundant resources.
Gross domestic product (GDP) measures the International trade refers to the exchange of
monetary value of goods and sen'ices produced goods and services beyond national borders.
within a country for a gi\·en period of time, Investment expenditure is the sum of capital
usually one year. spending by all businesses within a country.
Horizontal integratio n occurs when two firms in Investments are goods that are purchased not to
the same sector ofindusuy and same industry be consumed but to create wealth.
merge together.
Invisible exports refer to the earnings from selling
Human Development Index (HD1) is the UN's services to foreign customers.
measure ofwellbeing which uses three criteria: Invisible imports refer to the spending on services
life expectancy, educational attainment and provided by firms in overseas countries.
income per capita.
Glossary
Invisible rr:ide b:-.1:mce is a record of the trade in Merger occurs when rno firms join together to
services, such as transponatioo and financial make one firm.
Merit goods arc goods or services which when
Labour force p:-.rricip:-.tion rnte is the percentage consumed create positive spillover effects in
of the working-age population that is working. an economy, e.g. education, training and
Labour-intens ive productio n occurs when labour health care. Merit goods arc under-consumed
cosrs account for proportionately more of a so government intervention is often needed.
finn's costs than any other cost of production. M ixed econo my is a rype of economic system that
L:-.bour supply oonsisu of people who are of combines elements of both the planned and
working age and are willing and able to work market economic systems, with some resources
at prevailing wage rates. being owned and controlled by private
Less econo mic:-.lly d eveloped countries (LEDCs) individuals and firms whilst others arc owned
arc developing countries, with low GDP per and controlled by the government.
capita, so standards of living arc generally poor. Monetary policy refers to the use ofintcrcst
Life expectancy measures the number of years an rares,cxchangc rates and the money supply to
a,·cragc person in the cou ntry is expected control macroecono mic objectives and to affect
roli,·e. the level ofeconornicacrivity.
Limited compan y is a company owned by Money is anything that is widely :-.cccptcd as a
shareholders who have limited liability. means of exchange (and acts as a measure and
store ofvalue).
Linlited liability means that in the evem ofa
company going bankrupt, the owners would Money s upply refers to the amount of money in
not lose more than the amount they invested the economy at a particular J>Oint in time.
in the company. J\lonopoly is a market structure where there is only
Managerb l econom ies of scale occur as large one supplier of a good or service, with the
finns have 1he resources t0 employ specialim power to affect market supply or prices.
to undenake functions within the firm , e.g. Mo re econo mic.1 lly d evelo ped countries
accountants, engineers, human resources (MEDCs) are developed count ries, with high
specialists. GDP per capira, so srandards of living arc
Managers are responsible for controlling all or pan generally good.
of a company. J\longage is a secured loan for the purchase of
M:-.rket economy is a type of economic system property.
that relics on the market forces of demand Multinational corpo r:-.tions arc businesses that
and supply to allocate resources with minimal operate in rno or more countries. Examples
gmwnment intent:nttOO. include Apple, BMW, HSBC, Marks &
Market fa ilu re occurs when the market forces of Spencer, Nike and Sony.
demand and supply fail to allocate resources National minimum wage is the lowest amount
efficiently and cause cxrcrnalcostsorexrernal a firm can pay its workers and is set by the
benefits. gm•ernmenr.
Market strucrurerefcrstothckeycharacteristics Nationalisation is the process of taking assen into
ofa particular market, such as the number and stare ownership. A nationalised organisation is
size offinns in the market, the degree and also known as a public-sector organisation.
intensity ofprice and non-price competition, Needs are goods that arc essential for survival.
and the nature of"barricrsrocntry. Net exports refers to the monetary value of the
Marketing economies of scale occur as big firms difference between a nation's export earnings
rend to have a large advertising budget and and its imJXXt expenditure.
there lore can spend large amounts of money
on promoting their products.
Glossary
N et income flows are a record ofa country's net Price is the amount of money expected or gh-cn in
income earned from capital flows. payment for something.
N et migratio n rate measures the difference Price d iscriminatio n is the practice of charging
between immigration and emigration rates diffcrentpricestodifferentcustomersfor
for a country, and thus indicates the physical essentially the same product. It occurs because
mm-cment of people in and out ofa coumry. of the customers' differences in PED.
Occupatio nal mo bility is when a person can easily Price elast ic d em and describes demand for a
mm-c from one type of job to another. product that is responsive to changes in price,
O pportunit y cost is the cost of the next best usually due to substitutes being available.
opportunity foregone when making a Price elasticity of demand ( PED) measures the
decision. extent to which demand for a product changes
Optimum populatio n exists when the output of due to a change in its price.
goods and services per head of the population Price elasticity of su pply (PES) measures the
is maximised. degree of responsiveness of quantity supplied
Overspecialisation occurs when an individual, of a product following a change in its price.
firm, region or country concentrates too much Price inelastic de mand describes demand for a
on producing a very limited number of goods product that is unresponsi\·e to changes in
and services. This exposes the economic agent price, mainly because of the lack of substitutes
to afar higher degree of risk. for the product.
O wner s have a legal right to the possession of Price ma ker (or set ter) describes a firm with
something. significant market po\\-cr so it can control
Partnerships are businesses owned by between enough ofthe market supply in order to affect
two and t\\"Cnty owners, who pool funds and the price level.
take risks together, but have to share profits Price stability means that inflation is under control
betweenthemsel\"Cs. so that price movements are predictable.
Perfect competitio n describes a market where Price takers are firms that set their price according
there is immense competition due to the to the market forces of demand and supply,
absence of barriers to entry. This means there rather than determining their own prices.
are many small finns competing in the market, Pr ivate benefi ts are the benefits of production and
none ofwhich have any power to influence consumption enjoyed by a firm, individual or
market supply or price. government.
Planned econo my is a type of economic system Private costs ofproduction and consumption are the
that relies on the government allocating actual costs of a firm, individual or government
scarce resources. It is often associated with such as wages and raw material costs.
a communist political system that strives for Pr ivate limited compan y has limited liability and
social equality. Also referred to as the socialist
can sell shares to raise finance but not to the
or command system.
general public.
Population refers to the total number of Pr ivatisatio n is a supply-side policy of selling off
inhabitants of a particular coumry. state -owned assets to the private sector.
Population grow th refers to the rate of change in
Producer refers to any firm that deals in the
the size of a country's population.
production and/or provision of goods and
Po pulatio n pyramids are a graphical sen'ices.
representation of the age and gender
Productio n refers to the total output of goods and
distribution of a country's population.
services in the production process.
Poverty is a condition that exists when people lack Productio n possibility cu rve (PPC) represents
adequate income and wealth to sustain a basic the maximum amount of goods and services
standard of living.
Glossary
which can be produced in an economy, i.e. the Regulatio n refers ro the rules and laws t hat
producti\'C capacity of the economy. govern business behaviour in the economy,
Prod ucti vity is a measure of efficiency arrived at e.g. employment laws, consumer protection
by calcu lating the amou m o f omput per unit legislation and environmental prote<:tion
ofa flctorinpm (such as output per work.er or laws.
output per machine hou r). ReL1tive pown y is a comparative measure of
Profit is the positive numerical difference between poverty. Those in relative poverty have a lower
revenues and cosu. Jc is the reward for risk~ standard ofliving in comparison with the
rak.ingin business. average member of society.
Progressh'e taxation is a tax system that deducts a Replacement fe rtility rare is the number of
greater proportion ofra,: as a person's income children that the an~rage woman must haw
lc\·el increases, e.g. income tax and capital to replace the existing population in order to
gains ta ,:. maintain a stable population size.
Proportional taxatio n is a tax system that deducts Research and development economics of scale
the same proportion ofr-.tx at all income levels. occur as large firms may be able to fund
Protection is the use of trade barriers to safeguard research and dc\'clopmenr and therefore can
a counrry from cxcessi\·e international trade be inno\'ath'c and create products that enable
and foreign competition. them to be leaders in their area of bu siness.
Public limited company is a firm that can sell its Retail prices index ( RP I) is used to calculate
shares on a stock exchange, e.g. M icrosoft, the rare of inflation. Unlike the CPI, the
HSBC and Samsung. RPI includes the cost of hou sing, including
mortgage imerest payments and other housing
Public corpor:u ions ( public sector organisations) costs but excludes low-income pensioners and
are organisations that arc wholly owned and high-income hou seholds.
funded by a government, such as the posral
office. Revaluation occurs when the price ofa currency
operating in a fi xed exchange r.tte system is
Pu rchasing or bu lk buying econo m ies of scale officially and deliberately increased.
occur when the oost of raw materia ls falls when
bought in large quamities thus reducing the Risk-bearing econo mies of scale occur as large
average costs. firms tend t0 produce a range of products and
operate in many locations.
Quorn isa type of protection that sets a numerical
limit on the number ofimpons allowed into a Salary is a fixed monthly paymcm in return for
country over a specified time period. labour services.
Real G DP refers to the value of national income Sales reven ue refers to the money a firm earns from
{GDP) adjusted for inflation to reflect the its sales, before deducting costs of production.
true value of goods and services produced in a Saving occurs when a person puts aside some of
gfrcn year. their current income for future spe nding.
Recessio n occurs in the business cycle when there Savings ratio refers to the proportion of household
is a full in GDP for two consecutive quarters. income which is sa\'C d instead of consumed in
Regional specialisation occurs when certain areas an economy.
concentrate on the production of certain goods Services are non-physical items such as haircuts, bus
or services, e.g. Hollywood , in Los Angeles, is journcys, telcphonc calls and inremeracccss.
famou s for its motion pictures industry. Shareho lders arc the pan-owners ofa limited
RJ!gressh'e raxado n is a n.x system that deducts a liability compan y.
smaller proportion of tax as a person's income Sit-in is when union members go to their place
increases, e.g. sales n.xes and stamp duties. of work, occupy the premises but do not
undertake their normal work.
Glossary
Social benefits are the true (or full) benefits of Su pply·side policies are the Jong-term strategies
consumption or production, i.e. the sum of aimed at increasing the producti\·e capacity of
private benefits and external benefits. the economr by improving the quality and/or
Social cost s are the true (or full) costs of quantity of factors of production.
consumption or production, i.e. the sum of Takeover occurs when a firm is taken over by
private costs and external costs. another firm. A takeover may be hostile or the
Sole t rader is a person who owns and runs a two fim1s may have agreed to the rakem-er.
business as single proprietor. S/he takes all the Tariffs are import taxes that are imposed on
risks but keeps any profit made by the business. foreign goods.
Specialisatio n occurs when individuals, firms, Tax avoida nce is the legal act of minimising
regions or countries concentrate on the paymenr ofraxes, such as by arniding spending
production ofa particular good or service. on items with a large sales tax.
Specialisatio n of\abo ur occurs when a Tax bu rd en is the amounr ofrax that households
worker becomes an expert in a particular and firms have to pay.
profession or in a pan of a production process. Tax evasion is the illegal act of nor paying the
Stake ho lders are any economic agents with a correct amount of rax, perhaps due to a firm
vested inrerest in the operations of a business, under-declaring its profits.
e.g. shareholders, employees and customers. Taxes are government levies on income and
Standards of livi ng refer to the social and expenditure, used to fund gm·emment
economic wellbeing of individuals in a counrry expenditure to affect economic activity.
ataJX)intintime. Technical econo mies of scale occur as large firms
Stock exchange is the term used to describe an can afford to purchase expensive pieces of
institutional marketplace for trading the shares machinery and automated equipment for the
ofpublic limited companies. manufucruringprocess.
Stocks (or im·entories) are the raw materials, T rade protectio n is the use of trade barriers
components and finished goods (readr for sale) to safeguard a country against excessh'e
used in the production process. inrernational trade and foreign competition.
St rike occurs when union members withdraw their T rade unio n is an organisation which aims to
labour services by refusing to work. protect the inrerests of its members, namely the
Subsid ies are a form of financial support from terms of pay and conditions of employment.
the government to lower the production Tran sfers are money flmirs from one country to
costs of domestic firms, thereby raising their another, e.g. income sent by a foreign worker
competitiveness. to their home country, or a gift of money from
Su bsidy is a sum of money given by the government one government to another.
to a producer to reduce the costs of production Unemployment occurs when people ofworking
or to a consumer to reduce the price of age who are both willing and able to work
consumption. cannot find employment.
Substitutes are products that are in competitive Unemployment rate is a measure of the percentage
demand as they can be used in place of of a counrry's workforce that is out of
each other. For example, tea and coffee or employment.
McDonald's and Burger King meals are Unitary price elas ticity occurs when the
substitute products. percentage change in the quantity demanded
Su pply is the willingness and the ability of firms to (or supplied) is proportional to the change in
provide a good or service at given prices. The the price, so there is no change in the sales
higher the price of a product, the higher its
supply tends to be.
Glossary
Unlimited liability means that if a business goes Wage is the return for labour services, paid hourly
bankmpt, the owncr(s) is/arc personally or weekly. Payment depends on the amount of
liable for the debts, even if it means personal time worked.
belongings ha\·c to be sold. \Vants arc goods and services that arc not necessary
Vertical integration occurs when a takeover or for survival but arc demanded by economic
merger takes place between two firms from a agents.
diffurcnt sector ofindusny Wealth is measured by the value of assets a person
Visible exports arc gOOOs which arc sold to foreign owns minus their liabilities (the amount they
owe to others).
Visible imports arc goods bought by domestic Work·to·r ule means that workers literally work to
customers from foreign sellers. fulfil the minimum requirements ofthcir job
Visible trade balance is a record of the export and and do nothing outside what is written in their
import ofphysical goods. comract of employment.
Wagc·pricc spiral occurs when trade unions Working population (or latxmr force) is the
negotiate higher wages to keep income in line number of people in an economy who arc of
with inflation but this simply causes more working age and arc willing and able to work.
inflation as firms raise prices to maintain their
profit margins.
Index
ob,olut<pove,tyl35 exompril<ti<e 1111,124
':i';;:,'~:,'::w.6!.,ntt, 2s1
f•<tonaffe<ting<hoi<eof
or9• ni>otion 123
,urpl.,.... 260,263--4
w,ton,du,iu 185
odmini>tra,Wolog, 174 limitedliabil,t}'<Off"4),lniei 113- 16,123 cycli<al(demand-defi<iont)
adv..rti,ic,g 22,40,52- l mu!tirli>tion..oh 116.--18 unemployment 211,212
a,gg,egotedemand 74,201,211,218,261 partner,hipo 112-13,123
a,gg,egote,upply 201 publi<corporation, 1.I0---3
reYiewqumiomll<eyterm, 124--.5
::i:.::t!';:..!:,ion
114
-a,gero,t,136- 7,158
,oletra.den 110--11,123
dobtoffo<t 202
dobu 107,203,219- 30:,.., a ko
bor,o..;ng;lending
aveu,gerev,,nuu U9 upitol 4,126,151
upiul9,0imtax 185 :::i'!t~!,;'"'~~~hip m
:~:.:!"";~~calinteg,atioo 155 upihl -intemWop,oduction 5,129- 30
copiulinve>tment 178
b alancodOOd9ot 172 <• ·urst«onomy,,oemart.otoconomy
bolancoofp.ymeot, 169, 179,258- 66, ::.:::::d2t32
::~:~:"axodu1~~Yicy BO
"'
andocooomicg,<>Wth 170
<Hhf<>ttV<efali<><l06
celebfitie, 85- 6,128,256
mar1<otequilibfium 29--31
:::::n~f~ 3
in 23--5
exampractico 2'0,2(;1,26.l,263,265 CHl(copiul,entffpfi..,,labour,la nd) 4 roviewque,tion,lkoytttm>33
ondexch-rotefluctuat,on,273 centralbank,63- 5,106 domond<Urv1'! 20-1,23- 4,37- 8,42
,ov;.wqoestion.,\eytum, 265-6 CEO,(ChiofhecutiveOfficor,) 115 dom and-dofitient(cycliu l)
Certifi<ateofln,orporation 115 1
::~·:: ::.J.;;d; (~rode balam) 258-9
8 ch aimofproduction 5- 6 dom and ~=::::,m~~/ • m
bonkboilout, 65 d aHi<ol~:;i-w•90)unemploymont 210, domand-pullinflation 168,196,264
BankofEngland 63,121,176 domo,geu 160,161
bonkruptcin 202 domefitgood, 35,49,50,51,52,53,186
bar,iontoentry 143,145,148 dom09,aphi« 23,IOl,104,206:«oa l,o
b.-tuing 62- 3 popul ation
ba,ic«ooomicpmblom 2-10 dopendoncyr• tio244
ca,e>tudie.6,7 dop,o<i • tion 269
exampu ctico 9 competition 15, 17,132, 142- 4, 150 deregulation 177- 8
:::::::"'i~uctioo -
oppornm,tycost, 6---9
competition -N,odpri<ing 147
con,petitionlaw 166
competitiYfl><!< 131,254
dorWoddemand, 74,126
dovolopmentaid 237
«v..,wqoestion.,\eytem» 10 complomentl 22 different;..t edprodu,t, 143
~nefit, 55- 6,79,214,236 confiden;~;ev•I• !02, !04, 176,199,202, di,octtaxotion 97,167,182
~nigndeflation 201,202 di,economiuof,ulo 116,137,160-1
~~h·;:;:"';~~:~d m
conglomerate'nte9r•t'on(later•l 'nteg,at· n,
divenifkation) 156- 7
,on,p'cuou,con,umpt'on 100
di<p<»a bl,in,ome 96- 100, 106
::~~;,1o;;enon(BOD) 115 di5>aving 103
<<>n<umtt<o-ope,atWo, 120 d'venT,aion(on9lome,ate·n,eg,at·on,
borrowi~ 97,10.2,106- 7,197,202, ,on,ume,priaeindex(CPI) 192-4 lateulintegution) 156- 7
2 ,on,ume,prote<tionlaw, 165 dumping 279
bouoo,(nocku<hang«) 65- 7 coo,ume,,pending 41 - 3,96- 103,216
b<aindroin 208 <ontractiono,yfocalpolicy 173,174 ,arnif'l9• 73,81 - i:,ee ~/,ow09.,
b<a ndloya!ty40 controctiono,y(ti9ht)monotorypolicy 176
bodgetdefkit/,u,plu, 172 co-operative, 119- 20,123 :~::::: : : ~ : . 2- :4
bulk-buy;~,C:,:·~;n9) «onomie, corpo,ationt;ox 185,186 «onomi,9()0(l, 2
corrnption:lEDC, BO «onomi;:;owth 168, 170, 174, 216- 24,
«><tofliving 231
::::,:·:~Ii~~! level, 199 «>>t-plu,priting 146 a.dv•nt09<.rdi,a,dvont09«of 218--20
bolinu,(tra de)cydc 220- 1 «>>t-pu,hinflation 168,195,272 and~;:r><•ofpaymont,oquilibfium
"''" 135- 8,158
boli:;;:,:;.,';:'.:1,~11:6~-1 «>illofproduction 26,135--7,279
exampu<ti<e 152,156,161 137
exlem.ol(in<>fgani<)iirowth 153 ::0".':.1""4tso ~ oxampracti« 219,224
imegution 153--7 ofloboor 74 ~P':,"n~i, ,atefluctuatiom 273
imem.ol(or9,0ni<)g,owth 152 privat<hociol49--53 6
~::"';;:~~_;·= 161- 2
,fflewquestiomll<oyterm,
~;~t::::=.•r; " • index)
141
192-4
livingnandord>:mea,ure,/indi<aton
222- 3
boline11loution 186 andlowinflation 169
boline .. objectWe, 139- 41 <fOdit<afd>69,106 andproduciv,tylll
boline11orgon;,ati<>n< 110- 25 roviewque>tion,lkoytorm>l24
c.o><ltudiei 114,121 :::i:::"r;tpoli<io, 179
,_rotiYe>119--20,12l
Index
«onomi,,yn•mi 12- 19 grondom•rticprodo<t(GOP),,uGOP

' '""' "odi« 14,15,18 g ron ""tional in<om•(GNl)porcopita 226
exompriKtia, 18
mo,hternr.omy 12,lS-17 o.<1ern.l«onomi«ol1<al• 160 HOl(HomanO.,v,lopm<'ntlndex} 223,227- 8
mixedttor>omy 12,17- 18 ext<m.lit,.,(,pillovu•lfem) 49 he althcare 55,56,223,229,232,236
plonned«or.omy 12,13--15 Horit ago found ation 15- 16
••Yiewqoe<tioosll<<yterm, 19 facu,r,olprodo<tion 44.,47,126-7,217 h<>m<>ll""'°"'P'Odo<U 143
e<onomiuolKalo 13,111, 136- 7, fDl(foroigndi,o<tinvonment) 218,229,237 horizontalinteg,ation 154
1511---61,254,277 federalR«uw, 63,176 hou,ing 236
5 homancapiul{,kill,lexperieoco) 132,174,178
~;:i~:.;::,~~·.:~ « a l• 158
monopoli .. ond 149 focalpolici« 172- 5,212,236,261
~i;;:;itc:",t."~':,;•;;~ndex(HOI) m, 227- 8
andprodoct,Vjty 131 fixodco,t, 135,136
t«hnologiu.1129,1511
•docation 3,51,52- 3,55,223,232,236,237 :::: ~~:g:.::.:: ·~~;mi 170
lloxibleworkingpattem, 206
ILO~ntemationalLabourO.goniwtion) 206--7
immigra,ion 240
lloa,ingoxd>ango,a,e,,y,t<m, 269 impa<tl ag , 174
forb«m ag ozin• 171,219,256 impe,f«lknowledg e 143,145,148- 9
•ffi<ien<y 16 foroignaid237 impoft<dinllation 198
effidoncygain, 253,277 fo«igndiro<tinv<>tm<nl(fDI) 177, impom 193,216,261,164,171,172,276
embo,goe, 231 186,218,229,237,271 impofttAXH (Urilh) 167,181,213,280
emigration 240 /oro,igne,c<har.gemo,keu 270 in«nti""' 14,16,18,214
<mploym<M 168,169,205- 15 /orwo,dv<fti<alintogrotion 1554. in«nti=towort. 174,186,187
<hangingpattern<llev•k 20'HI
<<>"f<ntiK<<><.<>t,o,pl..,..ond 264
e<onomi<gr,-thand 219
z::!'!"i,~!~"
ffoegood, 2
16 con,omer,pending a nd %---100
and«onomicg,owth 170,223
=mpriKtia, 207--6,209,214 1,.., market «onomy ••• ma,~ t economy rediltfibutionol 169,170,174
andex<hang<ratolloct..,..tiOM 173 ffttfider,57 ,eeaboincomeande,:pendit.. •
a,ma.croecor.om·cobje<t· • l08 in,ome a ndupenditor< 96- 108
,eviewqoe<tiomll<<yterm, 214-15 ffi<tionolon<mployment 209 00frmvir.g97,102,106--7,197,202,2(;l
,..,. . 1,0..,..,mployment ffir.geMnolit<(p•rt.•) 71 ca,o,todi« 100,105,106
employmootin<<ntive, 214 fund am<nUl«onomi<qo«tion, 1l <omomer,ponding 96--103
employmontl<gn.lation 165 uampracti<• 103--4,105,107
employm<ntpattorn,205- 8,246---7 GOP(gmndom«ti<prodo<t) 17, revi<wqo«tionsll<ey te,m, IDB
<mploym<ntrighti 77 216- 17,218,221 wving, 97,102,104--5,197
eote,prii<4,126 GOPpercapita(head) 222,228, in,omodimibotion 223
eote,pri«zonu 178,214 231,234,245 in,omoin<qoaMin 16
eotr<preneonhip 132 g<nffalonion, 119 in,omet~ 185,186,187
eovi,onmentali<,ou 16,219,220,223 g<<>11rophicalmobility 79,218 in,ome th,nhold(povertylino) 235
1,:<,nc,mi<gr,-thand170 GETUP(growth,envi,onmeol,trad•, indir«tuxation 167,182
environmentalpr<>tedion 16',170 onemploymenl,pri«>Ubiljty) 169
pollution 4<}-5(),186 GNl(gro .. ,...tionalincome)p..-capita 226
andpopola,ion <hange 248 good, 2,3 indus,rialonion, 89
..,.... inability 54 demeritgood,35,49,50,51,52,Sl,186 inlantindo,trie, 278
<qoilibriom(markel-dearing) pri<• 29-31 mer>t9(>00, 49,52,53,16.4 inlla,ion 101,174,179,190- 204,219,172
p<ibli,9(>00, 16,164
:;i.."i~~~r~;n:::~ ra;: 75- 6, 80, 82
1 go..Jow, 91
excu,dema nd(iho,t ag•Y"'PPi)'{lo,plo,) 31 gove:i::~~;~~ and inflo•n<« 16.4- 71 con,eqoen<«ol 197- 9
exd>ange,ate, 175,236,262,167- 75
,...e ,tudi« 172 ~:::::::; pr;~~/ndox 192--4
<<X«ntam,,.,,,o,plo«<ond 164 oxompradia, 16.4,167,1611,169
eumprK tia, 268,272,274 ~~:;::<';";.;"rpl"'"' ...-.d 26.4
inlloen<eonprWat<prodo<en 165--7
liud,yrtem, 270 reviewq....,t ionsll<oyt<m,, 171 andemployment/or.omployment 169
:::!i:::~1-;'9
impo,Un<eol 26.S-9
roloin<oor.omy 16.4--S
governmeotbond, 67
governmeotd,bt 203
~,
ou.mpradi<• 191,195,1%---7,198,199,
: ~:~X:-"f2/~•lloctuation, 273
,eYiewqoe<tiomll<<yterm, 274-5 governmeotexpendito,o 216
ltfongoxd,ange,ot« 274 governmontinterv<ntion 50- 3,77, pri<«and 271
ex<l••dot,., 185 147,237,171 - 2
:::':t":ionsll<eytem,, 204
expa n,iona ry/i,ca lpoli<ylH,174,175
gove:i:::;' ~~~; ll, 172- 80
expan,ionary (loooe)mon <tarypoli<y 175- 6
npend>to,o <M<,t<Jd ... 173,176
«>momo,,p<r.ding 41 - 3,96--103,216 exampradia, 175,176,179 lniti alPublicOllering(IPO) 6',113
g<>Y<rnment 172,216 li<calpolid« 172--S,212,236,263 inn<>¥ation 132,133,149,1711
homancapital 178 mor.et..-ypolicie, 17S-7,213,2l6,2'3 integration 153- 7
i<W<flment 174,216,218 prote<tion~tpolidn 167,181,213,263, intelle<tuolprop<rtyfighu 166
pobli<JprWato S6---7 280,281 intudependen« 5
>tt a /roincome...-.doxpondito,o reviewq....,tionsll<<ytttm< 180 inttt<>trotepoli<iH 175
expori<n«Milh(homa ncapital) 132, ,opply-,idepoli<ie> 174,177--'1,213- 14, inttt«tratu 102,104,176,177,203,
174,178 236,237,261
govemmeotr,gol,niom 165- 6 intttn a1!!!;,~iuo/,calo 1511---9
Index
ordino,ypa nnonhip, 111

: : ~:: :~~:·:,,-·~;- 5:9- 11 <>'llr-population245
,....,,rud;e, 51,54,55,56 °"""l>•dali,otion 255
comervir,glu,ingre>ourcei 53--4
if>Vfl>l<>rio,(,tocb) 46 examoractico 50--1,54,57 partnorihip, 112- 13,123
inw,itmcnt 132,152,174,178,213,216,218 g<>'ttmmontintOfVflltion 50--3 pon.,rat ivooricing 147
invi, iblooxpon,/impoft, 259 orivat<hocialbonc,fir, 55---6 porloctrompotition 142- 4,150
invi, iblotradebol or.co(bal anco of orivat<hocialco,t< 4<}-53 porloctknowlodge 143
tradein,orvices) 259 public/prWateoxpondituro 56---7 porloctlyori« ola>li<linola,ticde mand 38
IPO(lnrtialPublicOttefing) 66,113 reYiewqueniomlkoyterm, 53 puloctlyori«ola>li<line la nic,upply 44,45
ma,k.,ing oconomin ol>< ale 159 pofk,(lringo boneliu)71
mafk.,,hare 140,147,151 pHtOfpowU 17
pio<e,ate, 71
labou,lof<o{worklof<o,working monopolio, 122,144-50 P1GS(Portugol,l,oland,G,.. co,
population) 205,208,218,244 podoctcompotrtion 142--4 Spain)«onomio, 221
labou, lo,copoftidpation,at.,.78 mafk.,,upplycu,vo, 26 planned(commond,,ocial~t)rconomy 12, 13- 15
MO.(ManagingDi,o<ton) 115 pollution 49--50
:::::;-;:;;;::i;,~ron 5,127- 8,130
MEDC,(more«onomica llyd..,,.,lopod population 239-50
c.o,e<tudin80 countrio,) 226 <hange,,ron,oquor.co,of 246--,8
<hoiceofoccupation 71 - 2 oxomoracti« 244,249
eamir.g, 73,81---6 ~:!::.:!:,'~:7.:oc:'!:i~ 114 roviowqueition.,\oytof!ni250
examoroctico 73,79 mo,g en 67,147,153- 7 popul ationd~,ribution 243
g<>Yttnmerrtintoderencoin 77 merrt good, 49,52,53,164 popul otiong,owth 228,239-41
labour,dom...-.dlor74--6 Millonnium Oevelopmont Goa l, 236 populationl>)'famid, 243
labour,,petiolisationol 86 MISC (ma,ketir,g, incomo, ,ubnrtuto,, po,itivowealth,ll«t 100
::i;:~,"'~,fa<tonafloctir,g 77--l!O comploment<) 21 povorty234- 7
mixod«onomy 12,17- 18 povortylino(in,omoth,o,hold) 235
«v..,wqoeotion.,\,eyterm, 87 MNC, (multination alco,porotion,) 11t- 18 Pl'C,(p,oductionponibilitycu,vo,)7- 9,217
wa,godoto,min~ion 74,80 monetarypolidei< 175- 7,213,236,263 ori«d~uiminotion 35,146
labou,mobility 255 mon,ey 60- 70 oricool ani,dom andrurvo, 37,38,42
labou,oroductivity 130,218,229,254 u,o,rudi.., 63,65 pri«ola.,i,wpplycu,...., 44,45
:: :::;:~:'~:"";7;•fffftir,g 77- 80 pric:: ~:~:.:o;de;;• nd(PEO) 34-43
1
labou,unior,,,,utradeunion, commerdalbank, 6S---9
<Of"dUmtt""!>O"'dinxo...-.drovonuo
;;:~~:...-;·6;3,68,70
lattta l'diY1eni;ic. ,(.ro) 1156- 7to'nto g,d:>n,
lawonlom,ment 55
mcaningo/60--3
money/low, 169
dot.!:=.. :t~1
oxomoracti« 35,J9,43
,oviewquenionslkoyterm, 70 ~::: q';tion.,\oy tof!ni 48
1...,. of,upply 25 >lock exchange, 65- 7
lEDC, (loHoronomicallydovelopod mon,ey,upply 61,63,175
pric:: ~:~:.:o;•urr-'!(PES) 43- 7
countri ...) 216,228- 31 1
mon;.:1~":i,!22, :4- 50
1
::~:~:·;,d1::, .::,,, 64 di<advantage,/advanta,ge, 148---9 oxomoracti« 46,47
li ability 111,112,113- 16 oxamoroctico 145,146 reviowquntion.,\oytttm,48
lifeexpeclancy 227,228241 oricing policiH 145--ll pri«inolani,domandcurvo, 37,38,42
limiledli abilitycompanio, 113- 16, 123 ,oviewquenionslkoyterm, 150 ori«inola>lic,upplycurvo, 44,45
limi,edli abilitypa nnonhip,(lll',) 112 monopolym a,kot 49 oricoinola>li<ity 34,35,148
li,eracy,a••• 227,228,232 moro«onomkallydovolopod pri« ma kon(p,ico « tton) 143,145,148
livingnanda,d, 3,16,117,226- 38,262 countrio,(MEDC.) 226 pri«, 15,18,27,186,197,271,277
;:.~:'!':. ;,2!;.~!.!35,}:__31
m<>nga,ge, 97,100,102,106,107
multilatualforeign oid 237
oquilibrium(mafket-dH rir,g)prico .n-31
pri«lkimming 147
cur,on, ac<ount,,...pl.,,.., and264 multin ationa l,orpora,iom(MNC,) 116---18 pri«nability 168
oronomic growth and 218 pri«takor, 143
pri<ingpoli<io, 144,145- 8
: : : r .t .::~h22;1:::,214 prim a,y,ecto, 5,84- 5,1S5,230,246
m•=r«lindic.oton 222- 3 orivatebonofrt, 55- 6
poYtttyl34-7
,oviowqoestion.,\,eyterm, 238
~=:~•
1
,itrond PEO 39- 40 orivate,_, 49- 53
private oxponditure 56- 7
llP,(limrtodliabilitypartnc,r,hip,) 111 nogativo oquity 100 orivatelimrtodrnmpanin 113,114- 16,123
looso(oxpan,ionary)monetorypolicy 175- 6 ""'emigration 240 private,octor 3,17,18,83- 4
::: :~:!:.':~
':;:.. 1~~ " "' npofti 216,259
~: ::~:71'.:. .~41uan,lrn 259

priva,~ation 177
orodu« r<o -opuativo, 120
production 126- 34
maligndolla,ion 201,202,203 ""'mig,otion,ate 240
:::t~~·;::,"'~;oroduction 5, 129--30
Maltho,ian g rowththoory 246 NMW (nationol minimum wa,go) 75 - 6, 237
monageri al oconomin ol>< • I• 159 not-fo,-pmlitorg ani,aUom 141 oxamoriKti« 129,130,132,133
Man a,g ingDirecton(MO.) 115 lactonolproruction 126---7
occupotionolmobility 80,218 labou,-inten, ivoproduction 5,127---3,130
: : ~::-~1:;·~~: ~:;:;!l'.b'~~m) ori« 29- 31
opportunitycosu&---9,197 productivity 130--3
mafkotoronomy 12,15- 17 optimumpopulat ion 244-5 reviowqueition.,\oyte,m,134
Index
producti<><> po.,.ibilitycu,....,.(PPC,) 7-9, 217

produd;,..•<•poc ;ty 7-9, 237,254
produu;,..<ty B0- 3,218,229,254
prolitability27 ,o<ioloquality 13- 14 ondoc0flomy91 - 2
pmlit-«latedpay71
pm/it, 139
eump,octi<e 139---40
,o<iolhard<hip 16
,o<iolproto<tion 14
,o<ioli<t«0<>omy,1<oplannedec0<>omy
:=::ti:::.:,,.9\~3,
1091<1.o,ionn
94
ondprndoct;,..ity 131 «>lotroder,(,oleproprieton) 110--11, membeuhip 93---4

pm/it moximi..,ti<>fl lN---41, 1411 m r,,ductioninpowon 213
,e.,;ewq<l<'>tiomll<oyterm, 141
;:~•; q~~7'1,hy torm, 95
prog,.,,i,,.,tuati<>fl 169,182,236
promotior,alpri<ing 147 di,advant.111<' 255-6 typno/89
propoftion•ltuotion 183 .,...,.p,o<li« 254,257 w;,ged oim, 90
pmtocti<>fli<m 167,181,213,263,27!1- 81 roviewqlJ<'ltion<lloytorm, 257 troining 55,213,255:,ooo/,ooducation
publi<corporati0<>1(publi<-se<tor <p<rulotion 271 tromlerpoymont, 236
organi, otion,) 120- 3 ,pillovuolle<ti(extornaliti«) 49
publi<dobt:LEDC, 229- 30 <tampduty 185 unlimi,edliability 111
publi<ex~nditu,e 56- 7 <tock i(inv,,ntorie,)46 under-population 245
publi<good> 16,164 <tor•<•rd, 107 unemployment ll,76,179,202,206- 7,
publi<limitodoompani<1 113,114- 16,123 237,262
publi<,o<to,3,17,18,83- 4 ltru<turolunemploymont 210,211
publk-<e<toror90ni,ati0<>1(publi< ,ubsidiu l l,26,56,166- 7,281 COOHqueflCO,o/ 212- 14
corporotior») 120- 3 ..,b.,ituto,22,39 ,~~•/ ,employmen,
publi<Hrvi<« 165
pur<ha,i;::,c::'~k-~;"lll«<><>omiH
,upp!.. !:::ie, 28
unomploymentrato, IG.8,206- 7,208,210
unitarypri,eolarti<ity 38,45
Uni,edN otion,
oxomp,o<lia, 2',,32 lntornationolLobourOrgoni,ation
u,..,..,pp1y 31 ~LO) 20&-7
quontitativ,,Hiing(OE} 176 mort.otoquilibrium 2.,_31
quontitydem oOOed lfJ ~~1~:~~~~;~~! 236
quolo, 213,281 :=~~,h~;6in 2HI Right, 3,89
roviewqlJ<'lt ion<lloytorm, H Uni,edNotion,Oev,,lopmon,Progrommo:
,upplyrnrv<1 25- 6,27- 8 Hum•n Development Index
,upply-,idopoli<in 15,174,177- 9, (HOI) 223,227- 8
213--14,237,263 unlimi,odliability 111
,urplu,(ex«H>upply) 31
;:~:~~~;!a<J'i5t4
regionol,pe<ioli,ation 253
,u,uinobility54
,wit<hingco,u 40
varioblecom 136
,,.,r,i<.olin,egration 154- 5
v~ibleoxport</importl 258
rogionolunomploymont 210 ukoovou 153- 7 v~ibletrodebalan« (bol.on«ol
rogro,>i""l"""ti<>fl 183 tarill,(impofttoxe,) 167,181,213,280 trode inooods) 258
rolatiV<epo¥orty 235 toxation 18,26,30,35,50,172,179,181 - 8 voluntoryunemploymont 210
roplacemontlortil;tyrate 240
,.,..,,eh:t~:~""::m•nt oconomi., diroctiindiro<t 97,167,182
uomp,o<lia, 182,184,185,186,188
'"'""""' 14,15,53--4,2lfJ,276
:;::::•."111~6--7
;::·,~r:;".~•nin~~(RPI) 192- 4 oquilibriumw"'9"rate 75-6,80,82
roviewq-"i<><><lleytorm, 188
rovonuo,41 - 2,138- 9,141,151 18 NMW 75-6,237
ri<k-bHrin90<0nomi.. ol1<olo 159 tox:=a~« 1~i w;,gedotormination 74,80
want> 3,62
w~lo90 13,17
,.1.,,l!Yfl>uo,,1<erovonuo, UXfOVfl>U ... 219 w,,alth 100,107
,ol.,toxu 22,30,35,185 to<hnkoloconomie,ol«•le 129,158 ondli.,;ng>t.ondard, 231 - 2
.alesturnovor,,eor<vonu« to<hnologi<•lprogr<H 27 rodiruibuti<>flol 170,174,187
,o.,;ng, 97,102.104- 5,197 to<hnologi<•lunomploymont 76,209
,a.,;ng,ratio 107 tortiary1«tor5,84-5,155,247 w,,althinoqu ol~iH 16,219
,oa<<><>olunomploymont 209 THIS(nmo,Hobiu,oddi<tiom ondtaite,, :::;::::::;:e~' 17J'S214,236
i«ond..,y>e<tor 5,84- 5,155,246- 7 ln,ome,Sul»titutu) 40
1<11-,uffi<iency 1l ti9ht(<0ntroctionory)monourypoli<y 176 whito<<>llarunion,89
1<rvia,, 3,17
:::,~=•it;3668- 9 WITS(wuthor,ICT,ux.,,iub,idi.,) 27
<ho«optiom 71
m..,e,65- 6,67,113,115,116 trod• 276- 83 wort.orco-opor-o,;,..u 120
<hort•ge(excn,dem ond) 31 wort.lor«(l.obo<Jrlor<e,workin9
,ightdopo,it, 68- 9
,ilent(sloeping)partnon 112 ~:'::::''':1~;8, 282 wort.-to-i:::f.':la~;"') lfJ5,208,218,244
World8ank 3,226
:~~:~1i•n 145 prot;~o;t 167,181,213,263,
WorldTrodeOr9anizotion(WTO) 175
<l<ill<loxperion«(hum...,,•phl) 132, roviewqueotion<lloytorm, 282- 3
174,178 trodobal.once(balanceoltrode)25S-9

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Paul Hoang and

Althougheveryeffurthasbeenmadetoe11surethatwebsite addttssesareco1Tect attimeofgoingto

Impression number 54321

Cmu photo C Oleksandr Dibron - Fotolia

1!1!111 The individual as producer, consumer and borTower 59

l!llmJ The private firm as producer and employer 109

lmmll1! Role of government in an economy 163

lmlm:JI Economic indicators 189

Developed and developing economies: trends in production,

lmlm!I International aspects 25 1

How this book ca n help you

Paul Hoang and Margaret Ducie

Th e na ture of the eco no mic pro blem

Figure 1.1 Therealcauseoftheeconomicproblem

The three basic econo m ic q uestions addressed by economic agents are:

Primary, secondary and tertia ry sectors of industry

Figure 1.2 Thethreesectorsofindustry

Consider the textbook that you are

Figure 1.3 The chain of production of a book

Case Study: Ye llow Moon

Oppo rtunity cost

Case Study: Govern me nt s pending in Ho ng Ko ng

Opportunity cost can be represented on a diagram known as a production

f - Thhpol nt hbep,d thefl'OOuctionp=lbll fy ctKVe(ll)<] l1e,ow.de t.epoductiveoopocifyofth e

Increases in the productive capacity o f a country

Decrease in productive capac ity o f a country

Figure 1. 7 summarises the basic economic problem.

Chapter review questions

By t he e nd o f this cha pter, you should b e able to:

Ma rket Muted • Planned

Hong Kong is widely accepted as the world's freest market economy

2 Planned economy - This economic system relies on the government allocating

Planned economic system

Adva ntages of the pla nned system

Case Study: The Super Bowl

Disadvantages of the pla nned system

Case Study: Top-paid jobs

Ra nk Profess ion Annual sa lary(topend) Tra iningtime (yea rs)

According to the Heritage Foundation, there is a high correlation between a

Adva ntages of the market system

Disadvantages of the market system

• \Vasteful competition - Competitive pressures can mean that firms use up

Case Study: Education systems

Chapter review q uestions

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

The meaning of demand

A, he price Id~ from

Moveme nts and shifts in demand

Acha nge lna oon-pte

Study tips Figure l .4 Shiftsinthedemandcurve

The meaning of supply

Figure3.5 The supplycurve

~11 '.0 300QO

• Techno logical progress - Technological advances such as automation,

Moveme nts a nd shifts in supp ly

Ma rke t eq uili brium

In contrast, favourable weather conditions will shift the supply of agricultural

Figure l .11 Favourableweatherconditions

Figurel .13 Excessdemand(shortage)

Chapter review q uestions

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

Price elasticity of demand