CIMA REVISION CARDS Economics for Business Steve Adams Certificate Level Paper C4
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OXFORD TOKYO
Elsevier Butterworth-Heinemann Linacre House, Jordan Hill, Oxford OX2 8DP 30, Corporate Drive, Burlington, MA 01803 First published 2005 Copyright ß 2005, Elsevier Ltd. All rights reserved No part of this publication may be reproduced in any material form (including photocopying or storing in any medium by electronic means and whether or not transiently or incidentally to some other use of this publication) without the written permission of the copyright holder, except in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London, England W1T 4LP. Applications for the copyright holder’s written permission to reproduce any part of this publication should be addressed to the publisher. Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone: (+44) 1865 843830, fax: (+44) 1865 853333, e-mail:
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TABLE OF CONTENTS 1. 2. 3. 4.
The The The The
economy and the growth of economic welfare ................................ 1 market system and the competitive process .................................. 13 macroeconomic framework ...................................................... 55 open economy ..................................................................... 89
The Economy and the Growth of Economic Welfare The economic problem, the nature of economic welfare and the sources of economic growth
Topics
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Scarcity and the economic problem Factors of production and resource allocation The nature of economic growth The sources of economic growth Policies to promote economic growth 1
The Economy and the Growth of Economic Welfare
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Scarcity and the economic problem Resources required to produce goods and services are scarce. Human wants (not needs) are unlimited. Result is scarcity of goods and services. If goods or services are scarce they will have a price. Thus consumers must choose how to allocate their scarce income between competing uses. Most economic decisions are about choosing in conditions of scarcity.
Definitions The Economic problem: this is the problem of allocating scarce resources to maximise economic welfare. Economic welfare is the overall standard of living of a population.
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Scarcity and the economic problem
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Opportunity cost The real cost of goods and services is opportunity cost. Opportunity cost arises because resources are scarce and have alternative uses. The real cost of making one good is the value of the other goods that could have been made with the scarce resources. If goods have no opportunity cost they will not command a price in the market.
Definition Opportunity cost of a good is the value of the best foregone alternative good or service
Study tip Opportunity cost is measured in terms of the foregone volume of output of the alternative good or service, not in terms of financial value
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Factors of production and resource allocation
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Factors of production Factors of production are those real resources required to produce an output. These resources are scarce and therefore command a price. Factors and their prices are: Land Labour Capital Entrepreneurship
rent wages interest profits
Remember this! Money is not a factor of production! Capital means the stock of capital goods (e.g., machines) and therefore is a factor of production.
And also Technology can be labour (capital) intensive if it uses lots of labour (capital) and wages (interest) are the biggest cost.
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Factors of production and resource allocation
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Resource allocation means which goods and services to produce. where to produce these goods and services. how to produce these goods and services. for whom to produce these goods and services.
The price system provides signals to consumers and to producers in order to allocate resources.
Study tips Prices are determined by supply and demand and thus send signals in the resource allocation process. If consumers want more oil, they attempt to buy and thus the price rises. This acts as a signal to oil companies to produce more oil. A great deal of economics is about these price signals.
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The Economy and the Growth of Economic Welfare
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The nature of economic growth Economic growth means increasing the capacity of the economy to produce goods and services. The capacity to produce is determined by the amount of resources (factors of production) available, e.g., capital and labour, and their productivity. Thus, economic growth occurs if more resources become available, or if output per unit of resource is raised. This is demonstrated in the production possibility curve, which shows all those combinations of goods that can be produced with the available resources. In the diagram opposite, combinations C, D, F and E are all possible. G is only possible if economic growth pushes out the production possibility curve.
Production possibility curve
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The nature of economic growth Economic welfare refers to the overall quality of life in a country. This is not just a matter of income per head. Other issues that matter include: the uses to which income is put (consumption raises welfare, investment raises future welfare). the distribution of income between different income groups. externalities where society may gain (e.g., education) or lose (e.g., pollution). the effort involved in producing output (e.g., working hours).
Study tips Economic welfare is not the same as Gross National Product. Economic welfare does not refer to provisions through state welfare services. Think in terms of yourself: what determines your quality of life?
And also This may have policy implications, e.g., taxes on motoring to reduce external costs of congestion.
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The Economy and the Growth of Economic Welfare
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Sources of economic growth Economic growth requires resources, especially of capital and labour. Capital equipment is created by investment by business and governments. The supply of labour is affected by the population and its age structure. But the productivity of capital and labour is also important. Therefore growth can come from: technological progress; improved education and training; better organisation and management; economies of scale.
Study tips Remember that economic growth cannot come about directly from raising aggregate demand: this raises the utilisation of capacity but not capacity itself. But a high level of demand might encourage business investment and thus promote economic growth. Working longer hours may raise economic growth but will not necessarily raise economic welfare.
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Sources of economic growth Modern economic growth is largely the result of increased productivity. Capital productivity has been raised by:
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more intensive use of equipment; technological change; more skilled workers. Labour productivity has been raised by: education and training; increasing amounts of capital per worker; technological change.
Definition Productivity is a measure of the output of goods/ services per unit of resource used. Labour productivity is output per worker or per hour of work. Capital productivity is output per unit of capital employed. Land productivity is output per hectare of land.
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Policies to promote economic growth Government policies to promote economic growth can only work if they lead to:
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more resources being available, and/or higher productivity. Policy might try to increase the capital stock by encouraging investment via:
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lower interest rates; tax relief on investment. Policy might try to raise productivity by:
Remember this There is an important difference between policies to promote growth and policies to manage the economy through the level of aggregate demand. The former is about the long term output of the economy. The latter is about the short–medium term level of output and employment.
higher spending on education and training; tax relief to encourage R & D effort by business.
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Policies to promote economic growth Economic growth may have negative external costs, e.g., environmental damage. Measures of national income may therefore be misleading as to the ability to sustain output in the long run. Policies to promote growth may have to be modified in the light of environmental damage, e.g.:
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Kyoto agreement to reduce carbon dioxide emissions. Taxes to discourage pollution-creating activities, such as the London congestion charge.
Definition The Index of Sustainable Economic Welfare (ISEW) measures gross national product minus various costs, including depreciation of the environment, the costs in dealing with pollution. For the UK 1996 – 2000, real GNP rose by 2.0% pa. But the figure of ISEW for the UK only rose at 0.5% pa over the same period.
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The Market System and the Competitive Process
Topics
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Demand Costs and supply The growth of firms Competition Government and competition policy 13
The Market System and the Competitive Process
Demand
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The demand for goods and services Demand means the intention and ability to purchase goods and services. Demand exists because goods and services confer utility or satisfaction on the purchaser. The amount of utility derived from extra units of a good or service declines as more and more of it is consumed. Thus, an individual’s demand for a particular product is limited. Demand will change if one of the determinants of demand changes. Demand can be illustrated in a demand curve.
Definitions The law of diminishing marginal utility states that, for normal goods, increases in consumption raise total utility but at a diminishing rate. A demand curve shows the amount of a good or service that would be bought, at different prices, in a given period of time. For normal goods, the demand curve slopes down left to right, showing that, the lower the price the more units will be bought.
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Demand
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The conditions of demand The conditions of demand are all those factors which influence the demand, except the price of the good. The conditions of demand thus determine the position of the demand curve, which shows how many units of a good will be bought at different prices. The main conditions of demand for an individual are:
A change in quantity demanded and a shift in demand
income; tastes and preferences; the prices of substitutes and complements.
Remember this! A change in conditions of demand will lead to a shift in the demand curve. In the diagram opposite, a rise in income would lead to the demand shifting from D1 to D2 15 —————————————————————————————————————————
The Market System and the Competitive Process
Demand
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Price elasticity of demand 1 If the price of the good changes, so will the demand for it. A price rise (fall) leads to a contraction (expansion) of demand. The extent of the change in demand, resulting from a change in price, is called the price elasticity of demand (PED). A high (low) PED means that a given price change leads to a larger (smaller) than proportionate change in demand. The PED for a good is illustrated by the slope of the demand curve: the lower the PED, the steeper is the demand curve.
Definitions The price elasticity of demand is a measure of the responsiveness of demand for a good to a change in its price. It is measured as: percentage change in quantity demanded percentage change in price.
Remember this! The numerical value of the PED for normal goods is always negative.
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Demand
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Price elasticity of demand 2 The main factors which determine the PED for a good are:
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the proportion of income spent on the good; the availability and closeness of substitutes; the time period under consideration; the definition of the market: wide (e.g., food) or narrow (e.g., peas).
Study tip If the PED for a good is low (less than 1), a price rise (fall) will increase (decrease) the total expenditure on it and total revenue of the firm. If the PED for a good is high (more than 1), a price rise (fall) will decrease (increase) the total expenditure on it and total revenue of the producer.
PED is important, because it shows how the total amount spent on a good would change if the price of the good was changed.
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Demand
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Income elasticity of demand The quantity of demand will change if income changes. The extent to which demand changes, in response to a given change in income, is called the income elasticity of demand (YED). There are three types of goods:
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inferior goods: YED is negative; normal goods: YED has positive value up to 1; superior goods: YED has a value above 1.
Definitions Income elasticity of demand measures the responsiveness of demand for a good to changes in consumer income. It is measured as: percentage change in quantity demanded percentage change in income.
The main factors determining YED are: level of income; necessity/luxury distinction.
Remember this! The value of YED can be negative (inferior goods); or positive (normal goods).
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Demand
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Cross elasticity of demand Demand for goods may be affected by changes in the prices of related goods. The extent to which demand changes, in response to a given change in the price of another good, is called the cross elasticity of demand (XED). Substitute goods are goods used instead of the first good; a rise in their price leads to a rise in demand for this good. Complements are goods in conjunction with the first good; a rise in their price leads to a fall in demand for this good.
Definitions Cross elasticity of demand measures the responsiveness of demand for one good to changes in the price of another good. It is measured as: percentage change in demand for good A percentage change in price of good B.
Remember this! Substitutes have positive XED, complements have negative XED.
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Costs and supply
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The nature of supply Supply refers to the quantity of goods/services that producers are willing to sell at different prices. The main objective of firms is to make profits; they will supply goods if it is profitable to do so. Profits are determined by the costs of producing goods and the price for which they can be sold. Since unit costs tend to rise as output rises, the supply curve slopes upwards to the right.
Definitions A supply curve shows the amount of a good or service that would be offered for sale, at different prices, in a given period of time. A firm will have a supply curve based on its costs; the market supply curve is all the supply curves of firms in that industry added together.
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Costs and supply
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The conditions of supply Conditions of supply are all those factors which influence supply, except the price of the good. The essential condition of supply is costs:
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if costs fall the supply curve will shift outwards to the right; if costs rise the supply curve will shift inwards to the left.
Remember this! A change in conditions of supply will lead to a shift in the supply curve. In the diagram below a rise (fall) in costs would lead to the supply shifting from S3 to S1 (from S1 to S3).
Shifts in supply
Costs will include: labour/capital/raw materials/other inputs/indirect taxes.
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Costs and supply
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Elasticity of supply If the price of the good changes, so will its supply. A price rise (fall) leads to an expansion (contraction) of supply. The extent of the change in supply, resulting from a change in price, is called the price elasticity of supply (PES). A high (low) PES means that a given price change leads to a larger (smaller) than proportionate change in supply. The PES for a good is illustrated by the slope of the supply curve: the lower the PED, the steeper is the supply curve.
Definitions The price elasticity of supply is a measure of the responsiveness of supply of a good to a change in its price. It is measured as: percentage change in quantity supplied percentage change in price
Remember this! The PES always has a positive value.
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Costs and supply
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The price mechanism 1 Prices are determined by the interaction of supply and demand; the equilibrium price is where demand and supply are equal. Prices fulfil important functions:
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signals to producers; signals to consumers; incentives to producers. Since producers react to price changes by raising/ lowering output, prices are central to the process of resource allocation.
Study tips If prices are not allowed to settle at the equilibrium level, then resource misallocation will occur. Example: if governments fix: a minimum price above the equilibrium price, surpluses will result; a maximum price below the equilibrium price, shortages will result.
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Costs and supply
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The price mechanism 2 If the demand curve or the supply curve shifts, price and the quantity bought/sold will change. If supply shifts, the resulting change in price will depend on the price elasticity of demand. If demand shifts, the resulting change in price will depend on the price elasticity of supply. Example: an indirect tax: will shift the supply curve rightwards; the price rise will be greatest where the PED is lowest, e.g., tobacco, alcohol, petrol.
Study tip Remember the difference between: a movement along a demand or supply curve is caused by a price change; a shift of a demand or supply curve is caused by a change in the conditions of demand or supply. This is illustrated below.
Old and new equilibrium position
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Costs and supply
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Short run costs 1 Fixed costs are those costs which do not vary with the level of output, e.g., factory rent. Variable costs are those costs which do vary with the level of output, e.g., raw materials. Total costs are fixed costs þ variable costs. All measures of costs can be calculated as an average: costs per unit of output. In the short run at least one cost is fixed; in the long run all costs are variable.
Study tips If you have data on output, fixed costs and variable costs, you can calculate average costs AVC:
total variable costs output
AFC:
total fixed costs output
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fixed costs þ variable costs output
And also In the short run, a firm must cover at least its variable costs to stay in business.
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Costs and supply
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Short run costs 2 Average cost is total cost divided by output. Marginal cost is the additional cost incurred in raising output by one unit. In the short run:
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the average cost curve will be U-shaped; the marginal cost curve will cut it at its lowest point.
Study tip The diagram below shows the typical cost curves for a business.
The relationship of AC to MC in the short run
This is because of the law of diminishing returns. The optimum output will be where average costs are lowest.
Definition The law of diminishing returns to a fixed factor states that, if more units of a variable factor are added to a fixed factor, output rises but at a diminishing rate. 26 —————————————————————————————————————————
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Costs and supply
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Costs and revenue
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Revenue can be measured as: total revenue (TR): price sales average revenue (AR) :
total revenue sales
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marginal revenue (MR): extra revenue gained when sales are raised by one unit. Firms are assumed to wish to maximise profits. Profits are maximised at that level of output where marginal cost and marginal revenue are equal, i.e., MC ¼ MR.
Remember that, at any level of output, total profit will be equal to total revenue minus total cost. This is the same as (AR AC) output. Some profit is included in costs (profit is cost of getting entrepreneurs to do their job); this is called normal profit. Any profit above this level is called excess or abnormal profit.
And also Businesses may have objectives other than profit: security, growth, market share.
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Costs and supply
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Long run costs
‘Normal’ long-run AC curve
In the long run, all factors are variable, so the law of diminishing returns to a fixed factor does not apply. The long run average cost curve (LRAC) is a combination of short run average cost curves (SRAC). The LRAC may be: falling – economies of scale stable – constant returns to scale rising – diseconomies of scale.
Study tip The diagram opposite illustrates the long run average cost curve, Remember, some firms may never reach the point where the LRAC begins to rise. 28 —————————————————————————————————————————
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Costs and supply
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Economies of scale Long run costs will fall if there are economies of scale present. The main groups of economies of scale are: technical economies, e.g., large oil tankers; commercial economies, e.g., bulk buying; financial economies, e.g., access to cheaper finance; managerial economies, e.g., same number of directors, even when the business grows.
Definition Economies of scale are all those processes that lead to a fall in the average costs of production, as the scale of output is increased in the long run.
Remember this! Economies of scale are only concerned with costs, never with sales and revenue. Just because costs fall as output rises does not mean that profits will rise. The business may not be able to sell the extra output!
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Costs and supply
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Diseconomies of scale At some point average costs may rise as the business increases the scale of its output. Diseconomies of scale occur because the business gets too big and: managerial control is lost; communications and information flows become difficult; managerial slack develops; central management can no longer control costs.
Definition Diseconomies of scale are all those processes that lead to a rise in the average cost of production, as the scale of output is increased in the long run.
And also Businesses may react to diseconomies of scale by changing their organisational structure from a centralised structure to a divisional structure.
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Costs and supply
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External costs and benefits External costs and benefits can arise from production, e.g., pollution or from consumption, e.g., passive smoking. The producers and consumers do not take these external effects into account. Thus, the price mechanism may lead to over or under production and consumption of these goods and services. This is an example of market failure, where the price mechanism does not produce an efficient allocation of resources.
Definitions An external cost is a cost that is borne, not by the producer or consumer, but by society as a whole. An external benefit is a benefit that is not received by the producer or consumer, but by society as a whole.
And also Governments may use taxes to offset external costs and subsidies to reflect external benefits.
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The growth of firms
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Firms may grow by internal growth via increased sales. This may be constrained by:
Study tips Firms may have a variety of motives for growth:
lack of financial resources; market saturation; competition.
profits;
external growth by mergers and acquisitions. This may involve:
economies of scale.
horizontal integration; vertical integration; diversification.
market share; stability; But small firms have some advantages: flexibility; closeness to customers; ease of managerial control.
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The growth of firms
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Horizontal integration The benefits of horizontal integration for businesses include:
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increased market share; reduced competition; economies of scale. Customer may benefit from lower prices arising from economies of scale. But customers may lose from reduced choice and higher prices resulting from reduced competition.
Definition Horizontal integration is the merger of firms in the same industry and at the same stage of production.
Remember this The ability of firms to merge horizontally may be constrained by governments, if they believe that the reduction in competition is unacceptable.
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The growth of firms
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Vertical integration The benefits of vertical integration for firms include:
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the elimination of transaction costs; securing supplies/outlets; commercial economies of scale; increasing entry barriers for competitors. Customers may gain from regularity of supplies and better quality of products. But customers may lose if barriers to entry reduce competition and choice.
Definitions Vertical integration is the merger of firms in the same industry but in different stages of production. Forward integration occurs when a firm merges with firms which are its customers/distributors. Backward integration occurs when a firm merges with firms which are its suppliers.
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The growth of firms
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Diversification Motives for diversification include:
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saturation/decline of existing product markets; to exploit underused assets/byproducts; to minimise risks; commercial/administrative economies of scale.
Definition Diversification occurs when a firm merges with another in a different industry. This is also known as a conglomerate merger.
Diversification can lead to problems of: diseconomies of scale; lack of knowledge expertise in new product areas.
And also Because of problems occurring in conglomerate companies, de-mergers sometimes occur, so that each of the new companies can concentrate on its core business.
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The growth of firms
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Small firms Most firms are small; they have a high birth rate but also a high death rate. Advantages of small firms:
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low initial capital cost/start up cost; flexible/responsive to customer needs; meeting needs of niche markets; easy control/management. Small firms face problems of: access to capital; burdens of regulations; lack of technical/managerial expertise.
Study tips Many large companies start out as small companies. Small companies are typically labour intensive and are therefore important for job generation. For these reasons, many governments have policies to support small firms, including tax concessions and sources of capital.
And also The size of firms is important in understanding the competitive process; the next section deals with this.
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Competition
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Barriers to entry Barriers to entry restrict potential competition within an industry. Barriers may be natural, including:
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economies of scale; special skills/resources needed in an industry; transport costs.
Definition A barrier to entry is any process, or form of behaviour, which limits the entry of new producers into an existing industry or market.
Study tips
Barriers may be artificial, including: vertical integration within the industry; control of raw materials/distribution; trade barriers; pricing policies of firms.
There is a distinction between actual and potential competition. There may be few producers in an industry, but if there are low barriers to entry, their behaviour may be constrained by the potential competition from possible new entrants.
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Competition Market structures
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Markets refer to the process of buying and selling of goods. The structure of these markets will reflect: the number of producers in the industry; the degree of differentiation/homogeneity in the products produced; the degree of knowledge of producers and consumers about the products and prices available in the market; the degree to which firms can leave or enter the industry.
Study tips In studying market structures, we are concerned with efficiency. This has two aspects. Technical efficiency: securing production at the lowest economic cost. Allocative efficiency: the best use of resources to produce the goods and services that customers want. Which market structures are best at doing this?
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Competition
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Business motivation To understand the process of competition we need to know what motivates business decision taking. Assumption: the motive of firms is to maximise profits. Real businesses may have more complex motives, which include: profits; growth; security and stability; prestige, power, influence.
Remember this The profit maximising level of output for a firm will be where: Marginal cost ¼ marginal revenue or MC ¼ MR. At this level of output total profit will be: Profit per unit multiplied by total output or (AR AC) Q
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Competition
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Perfect competition 1 Perfect competition occurs when:
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there are large numbers of sellers and buyers; products are homogeneous; there is perfect knowledge; there are no barriers to entry to the industry. The market price is determined by supply and demand; at this price the single firm can sell as much as it wishes. The firm will produce where MC ¼ MR in order to maximise profits. If abnormal profits are earned, new firms will enter the industry.
Study tips In the long run, under perfect competition, no excess profits can be earned. This is because new firms enter, the market price falls and profits are reduced to normal.
Remember this Normal profits are a cost and therefore are included in average costs. Abnormal profits are any profits above this level.
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Competition Perfect competition 2
Study tips In the short run, abnormal profits are made at output Q1. In the long run the entry of new firms depresses the price to P1 and output to Q1, where only normal profits are earned.
Long-run equilibrium with normal profits
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Competition
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Monopoly 1 Monopoly occurs when there is only one producer of a good or service. Sources of monopoly:
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economies of scale; horizontal mergers; legal barriers, e.g., patents; nationalised industries; technological expertise. The firm attempts to maximise profits; it will produce where MC ¼ MR.
Study tips Monopolies may not always be against the public interest. Monopolies may have: lower prices because of economies of scale; more R & D effort financed by abnormal profits.
Remember this Pure monopolies are rare; firms only need a significant share of a market to have some degree of monopoly power.
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Competition
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Monopoly 2
Equilibrium in (pure) monopoly
In monopoly there are barriers to entry for new firms. Abnormal profits may therefore persist in the long run. The equilibrium price/output is thus the same in the long run as it is in the short run. But if prices are too high, potential competitors may attempt to overcome entry barriers in pursuit of abnormal profits. In the diagram, Q1 is the short and long run outputs and the shaded area represents abnormal profits.
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Competition
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Monopolistic competition This market shows features of both perfect competition and monopoly. There are many firms, each producing a differentiated product with a normal downward sloping demand curve. There is freedom of entry of new firms into the industry. Abnormal profits may exist in the short run, but, in the long run, the entry of new firms depresses prices and eliminates these profits. This is shown in the diagram where, at Q1, AC ¼ AR and only normal profits are earned.
Remember this Monopolistic competition is not the same as monopoly; the former has many firms, the latter only one.
Long-run equilibrium for a firm in monopolistic competition
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Competition
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Oligopoly 1 An oligopoly market is one where there are a few large producers. This is often the result of:
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economies of scale; mergers. There are significant barriers to entry. Oligopoly is thus characterised by a high degree of interdependence between firms. Oligopoly firms may collude (co-operate) to minimise the risk of damaging price wars. Alternatively, oligopolies may avoid price competition and adopt non-price methods of competition: product differentiation, marketing, advertising.
Definition Interdependence means that the effect of a decision by one company (e.g., a price change), will be influenced by how rival firms react to it. Thus, firms must take into account the reactions of rivals when making decisions about price, output, competition, etc.
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Competition
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Oligopoly 2 Oligopoly is often characterised by the avoidance of price competition. This is explained by the kinked demand curve model. Above the current price, the firm expects to lose sales if it raises its price, because rivals will not follow suit; the demand curve is price elastic. Below the current price, the firm does not expect to gain sales by reducing its price, because it expects rivals to also reduce prices; the demand curve is price inelastic.
Study tips This demonstrates the principle of interdependence: the firm’s decision about price is influenced by how it expects its rivals to react to price changes.
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Competition
47 —————————————————————————————————————————
The Market System and the Competitive Process
Competition Price discrimination KKKK
Price discrimination can be by: time; customer; income; place.
K
K
Successful price discrimination requires that: markets are separate and no seepage of goods between them can occur; the price elasticity of demand is different in each market.
Definition Price discrimination is the changing of different prices for the same good or service. Examples include: peak and off peak fares; different prices for members and clubs and non-members; lower bus fares for pensioners and students.
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Government and competition policy Nationalised industries
Natural monopolies are those industries where economies of scale are so large, and duplication of facilities so costly, that it can only be efficient to have one producer.
K
K
K
K
K
Arguments for nationalisation: economies of scale, especially in public utilities, which may be natural monopolies; capital cost exceeding likely private sector sources; provision of uneconomic, but essential, services for consumers, especially public goods; support for sunrise industries, the infant industry argument; support/managed decline for sunset industries.
Definition
Study tips Nationalised industries are not profit maximisers and, therefore, face particular problems of how to determine their prices and how much investment to undertake.
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The Market System and the Competitive Process
Government and competition policy Privatisation
K
KKK
Arguments for privatisation: profit motive will encourage efficiency; more response to consumer wants; competition will encourage lower prices and better quality products; wider share ownership.
K
K
Problems of privatisation: creation of private monopolies that need regulation; unwillingness to produce important but unprofitable services.
Definition Privatisation is the sale of public sector assets to the private sector.
And also Privatisation is associated with other measures in the move to market forces. These include deregulation, compulsory competitive tendering and internal markets in public services.
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Government and competition policy
This leads to the free rider problem: persons can take advantage of the good or service without paying for it. Thus, private firms cannot supply these public goods and the state has to do so instead.
K
K
K
K
Some goods have to be produced in the public sector because of: non-rivalry, where one person’s consumption does not reduce someone else’s, e.g. defence. non-exclusivity – one person cannot stop another from benefiting from the good or service, e.g. street lighting.
Some goods can be produced in the private sector, but are nearly always provided in the public sector as well, because: K
Public goods and merit goods
there are external benefits that private producers would ignore, e.g. education; it is accepted that all consumers should have access to these services, irrespective of their income, e.g. health services; there may be significant economies of scale in their production.
Thus, the state supplements or replaces the private production of these merit goods.
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The Market System and the Competitive Process
Government and competition policy Competition policy 1
K
KK
K
One aspect of competition policy is mergers and acquisitions. Mergers might produce monopolies, which lead to allocative inefficiency. The important issue is the public interest. Mergers are considered on a case by case approach, because some mergers may lead to consumer benefits, e.g. lower prices as a result of economies of scale. Governments have the power to prevent mergers if they are deemed to be against the public interest.
Remember this In the UK, competition policy is conducted by the Office of Fair Trading (OFT) and by the Competition Commission (CC). The OFT can refer a proposed merger to a detailed investigation by the Competition Commission.
Mergers may also be subject to EU competition policy and may be investigated by EU competition authorities.
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Government and competition policy Competition policy 2
KKKKKK
The second aspect of competition is the prevention of anti-competitive practices. These may include: price fixing; market sharing; exclusive trading deals; cartel arrangements; abuse of market power; withholding of information from customers and potential competitors.
Definition A cartel is an agreement between the producers in an industry to limit and share output, in order to raise the price of the good or service. The most famous example is OPEC in the oil industry.
And also There are regulators for privatised utilities, e.g. OFCOM for the media and telecommunications industries.
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The Macroeconomic Framework Investigating the economic environment in which business operates
Topics
. . . . .
National income Inflation and unemployment The financial sector The conduct of economic policy Approaches to managing the economy 55
The Macroeconomic Framework
National income
K
K
K
The measurement of national income Expenditure method: adding together consumer, investment and government spending, plus net exports. Income method: adding together wages and salaries, company profits, income from self-employment and trading surpluses of government industries. Output method: adding together the value of all final output of goods and services.
Remember this When calculating national income, transfer payments, e.g. pensions, are not included. Also taxes are deducted and subsidies added.
And also Gross national product is a measure of the standard of living. Gross domestic product is a measure of the productivity of the economy.
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National income The uses of national income data
In economics the real value of something is the nominal value plus an allowance for inflation. Thus, if nominal GDP has risen by 5% and prices have risen by 2%, real GDP has risen by 3%. KKK
Other examples include: real and nominal interest rates; real and nominal changes in wages; real and nominal changes in the exchange rate.
K
K
K
K
K
National income data tells us about the standard of living, but: allowance must be made for changes in prices over time; the data says nothing about the distribution of income; the data says nothing about the sort of goods produced (guns or butter?); the effort required to produce the output is not recorded; social costs of producing the output, e.g. pollution, may not be reflected in the data.
Study tips
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The Macroeconomic Framework
National income
K
K
The circular flow model 1 The circular flow model shows the flow of money transactions between different parts of the economy. The most important parts are:
Definition Equilibrium national income is where the level of income in the circular flow is constant, with no tendency to rise or fall.
K
K
households; firms; the government; financial institutions; overseas. In the model, real things (goods, services, work) flow one way, payments for these (prices, wages) flow in the opposite direction. The level of income in the model (national income) will remain the same unless there are injections or withdrawals.
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National income
K
The circular flow model 2 A withdrawal is any income received that is not passed on in further spending in the circular flow. Withdrawals are
K
savings (S); taxation (T); imports (M).
Remember this National income is in equilibrium when injections and withdrawals are equal, i.e. when IþGþX¼SþTþM
An injection is additional spending from outside the circular flow. Injections are investment (I); government spending (G); exports (X).
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The Macroeconomic Framework
National income Simple model of circular flow withdrawals and injections in a five sector model
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National income
K
K
Consumption Expenditure on consumer goods and services is the biggest component in the circular flow of income. The main determinants of the level of consumption are: the level of income; wealth; the cost and availability of credit; price expectations; government policy.
Definitions The average propensity to consume (APC) is the proportion of total income that is spent. The marginal propensity to consume (MPC) is the proportion of an extra unit of income that is spent.
And also Governments may wish to change the pattern of consumption, as well as the level. Indirect taxes, e.g. on petrol and tobacco, discourage consumption and subsidies, e.g. on public transport, encourage consumption.
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The Macroeconomic Framework
National income
K
K
Saving Saving is the amount of income not spent. It can be done by households, companies and government. The main influences on household savings are:
K
the extent of contractual savings, e.g. pension schemes; the level of interest rates; inflation. But savings is a residual: it is income left over after consumption has been determined.
Definitions The average propensity to save (APS) is the proportion of total income that is saved. The marginal propensity to save (MPS) is the proportion of an extra unit of income that is saved.
And also Since all income must be either saved or spent: APC þ APS ¼ 1 MPC þ MPS ¼ 1
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National income
K
K
Investment Investment is the purchase of capital goods. It is undertaken by companies and by the government. The main determinants of private business investment are:
Definition The net present value of an investment project is the cash flow that the project will produce over time, discounted to produce a current value. The discounting is done using the rate of interest.
K
expectations of future profit flows; the cost of the investment, that is the rate of interest. Investment is important because it is: an injection into the circular flow in the short run; an important source of economic growth in the long run.
And also The level of investment may also be determined by changes in the demand for the good or service produced by the investment. This is called the accelerator theory.
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The Macroeconomic Framework
National income The government sector
K
K
The government is responsible for: an injection into the circular flow – government expenditure (G); a withdrawal from the circular flow – taxation (T).
K
K
Thus, the government can alter the level of national income; it can:
Definitions When government taxation exceeds government expenditure, the government is running a budget surplus. When the government taxation is less than government expenditure, the government is running a budget deficit.
raise national income by increasing G and/or decreasing T; lower national income by decreasing G and/or increasing T.
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National income
K
K
K
K
The multiplier Injections (withdrawals) into the circular flow raise (lower) the level of national income. But the change in national income is greater than the injection or withdrawal; this is called the multiplier. The multiplier works because an increase in income is passed on in the form of extra spending, thus forming a further increase in income. The value of the multiplier depends on the proportion of extra income passed on in the circular flow; the larger the proportion, the higher the value of the multiplier.
Remember this The value of the multiplier (K) is given by: K¼
1 1 MPC
And also In conducting fiscal policy, governments need to know the value of the multiplier, in order to judge by how much to change taxes, or expenditure, to effect a given change in national income.
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The Macroeconomic Framework
Inflation and unemployment Inflation: measurement KK
To measure inflation it is necessary to know: the rise in prices of all goods and services; the relative importance of each good or service in the consumption patterns of the population (the weightings).
KK
The result is a measure of the percentage increase in the price level for: consumers – the retail price index the whole economy – the GDP deflator.
Study tips The rate of Inflation is normally shown as a percentage increase in the price level per year. This does not mean that all prices rise at the same rate, or even that all prices have risen. The price of personal computers has fallen steadily in recent years. Since inflation is the process of rising prices, it has the effect of reducing the purchasing power of money.
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Inflation and unemployment Inflation: effects
K
K
K
KK
Inflation has the following effects: shifts wealth from creditors to debtors; reduces the real income of those living on fixed incomes; damages the price mechanism and interferes with the allocation of resources; reduces national competitiveness of countries with fixed exchange rate; distorts investment towards inflation proof investments, such as real estate.
Study tips Inflation does not itself reduce average incomes, because a higher price for a good means higher income for the producers. But inflation does distort the economy, including the distribution of income, especially if inflation is very rapid.
Remember this Inflation will not automatically lead to unemployment. But policy to reduce inflation may do so.
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The Macroeconomic Framework
Inflation and unemployment Inflation: causes
KKK
Cost push inflation may be caused by autonomous cost rises, e.g.: rising oil prices; increased indirect taxes; rising import prices.
KKKK
Demand pull inflation may be caused by excess aggregate demand in the economy, e.g.: consumer expenditure; investment expenditure; government expenditure; exports.
Definitions Demand pull inflation is caused by aggregate demand in the economy exceeding aggregate supply at the current price level. Cost push inflation is caused by autonomous (that is independent of demand) increases in costs.
And also Aggregate demand also influences unemployment and the relationship between unemployment and inflation is called the Phillips curve.
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Inflation and unemployment
K
Seasonal unemployment occurs when the demand for certain occupations varies over the year. Frictional unemployment results from the time taken between leaving one job and starting another. Voluntary unemployment is when workers are unwilling to work at the current wage rate. Structural unemployment occurs as the result of the long-term decline in the demand for the products of a particular industry. Technological unemployment is where employment falls because of technical change.
Study tips Structural unemployment can occur whatever the level of aggregate demand; it results from a long-term fall in demand for the output of an industry. This may be the result of replacement by: cheaper imports; substitute goods and services; technically superior goods.
KKK
K
K
K
K
Unemployment: types and causes 1
And also Because these types of unemployment are not caused by lack of aggregate demand in the economy, fiscal policy will be ineffective. 69
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The Macroeconomic Framework
Inflation and unemployment
K
reducing taxation; increasing government expenditure. But increasing aggregate demand might also increase demand pull inflation.
Recessions and booms are part of the trade cycle. A recession is characterised by: KKK
Cyclical (or demand deficient) unemployment is the result of insufficient aggregate demand in the economy. This typically occurs in the recession phase of the trade cycle. Appropriate policy is to raise aggregate demand by fiscal policy:
Study tips
rising unemployment; falling inflation; an improving international trade balance.
A boom is characterised by: KKK
K
K
K
Unemployment: types and causes 2
falling unemployment; rising inflation; a worsening international trade balance.
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Inflation and unemployment
K
K
K
K
The Phillips curve
Phillips Cuve
The Phillips curve shows the negative relationship between unemployment and inflation. This is because unemployment affects the rate of increase in wages, which is the major element in inflation. Governments may, therefore, be unable to secure both low unemployment and low inflation. Supply side policy is an attempt to improve the Phillips curve trade-off, thus making full employment without excessive inflation a possibility.
Definition The Phillips curve shows the negative relationship between the level of unemployment and the rate of change in money wages.
And also Some economists argue that the long run Phillips curve is vertical at the natural rate of unemployment. 71
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The Macroeconomic Framework
The financial sector The functions of money KKKK
The main functions of money are: a a a a
medium of exchange; store of value; unit of account; standard of deferred payment
Definition Money is any financial asset which fulfils the function of money. The demand for money is the willingness to hold a stock of those assets at any one time.
KKK
The demand for money (liquidity preference) reflects: the transactions motive; the precautionary motive; the speculative motive.
Remember this Money and income are not the same thing: money is a stock of financial assets at a point in time, income is a flow of purchasing power over a period of time.
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The financial sector
K
K
K
K
The supply of money The supply of money is a measure of the stock of assets, fulfilling the functions of money, which are in the economy at any given moment. There are various measures of money supply, reflecting the different sorts of assets which can act as money. These assets are of differing liquidity, cash being the most liquid. Governments try to control the supply of money, because they believe that excessive stocks of money will be spent, thus increasing aggregate demand and causing inflation.
Study tip It is not necessary to remember all the different measures of money supply (M0, M1, M3, etc.) but you should be aware of the difference between: Narrow money: the most liquid assets of cash and current accounts. Broad money: all financial assets which could fulfil the functions of money.
And also Money supply and money stock mean the same.
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The Macroeconomic Framework
The financial sector The banking system: central banks
KKKKKKK
The main functions of central banks, such as the Bank of England, are: banker to the commercial banks; banker to the government; issuer of notes and coins; supervisor of the banking system; lender of the last resort; management of foreign exchange reserves; conduct of monetary policy.
And also Banking supervision is undertaken by central banks. This involves a range of issues, including liquidity, provision for bad debts and procedures and control systems. Most important is capital adequacy. This involves ensuring that commercial banks have a minimum ratio of capital to risk assets, to ensure that banks can meet the problems that arise from bad debts.
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The financial sector The banking system: commercial banks
KK
K
K
The main functions of commercial banks are: accepting/safeguarding customers’ deposits in current and deposit accounts; transferring money from one account to another via the cheque clearing system; lending money; facilitating trade via trade credit. Overall, these functions are concerned with financial intermediation.
Definition Financial intermediation is the function of bringing together net borrowers and net lenders in an efficient manner.
And also Banks maintain a portfolio of assets. They must balance liquidity with profitability. The most (least) liquid assets are the least (most) profitable for banks.
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The Macroeconomic Framework
The financial sector Sources of finance
K
K
K
For a business, the sources of finance are: internally generated funds, for example via retained profits; equity generated by the issuing of additional shares in the company; debt finance, by borrowing funds from financial institutions.
The important decision is debt versus equity as sources of finance. Both of these sources come from the capital market.
Definitions The capital market consists of those institutions that are involved in the provision of medium-and long-term finance for business. The most important of these institutions are: Commercial banks Merchant banks The stock market
The stock market is the market for shares in publicly quoted companies and brings together companies seeking finance and financial institutions providing long-term finance.
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The conduct of economic policy Economic policy: objectives KKKKK
The main objectives of economic policy are: full employment; price stability – the avoidance of inflation; economic growth; equilibrium on the balance of payments; an acceptable distribution of income.
Remember this It may not be possible for governments to achieve all objectives at the same time; there may be trade-offs between objectives. The Phillips curve shows a potential trade-off between the achievement of price stability and full employment.
KK
But governments may differ over: which objectives are the more important; what constitutes an acceptable level of unemployment, rate of inflation, distribution of income, etc.
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The Macroeconomic Framework
The conduct of economic policy Economic policy: instruments
KKK
The instruments of economic policy are those means by which governments attempt to achieve the objectives of economic policy. The most important are: fiscal policy, including taxation policy; monetary policy; direct intervention via regulation, nationalised industries, competition policy.
The relative importance of these changes over time.
Remember this Instruments of economic policy are the means by which governments achieve their desired objectives of economic policy.
And also Objectives and instruments of economic policy sometimes get mixed up. Is a low rate of income tax an objective of policy, or an instrument for encouraging work and enterprise?
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The conduct of economic policy
Monetary policy is conducted by the central bank. Monetary policy is designed to alter the level of aggregate monetary demand in the economy. It does so by influencing:
K
either the availability of money and credit; or the price of credit – the rate of interest. The Bank of England has independent authority to alter interest rates in pursuit of an inflation target, currently 2% rise in prices per year.
Study tips You do not need to know the details of changes in monetary policy over the years. But you should be aware of some of the problems of monetary policy. These include: KKK
K
KK
Monetary policy
which measure of money supply to target? how to control bank lending? the effect of interest rate changes on the exchange rate.
Remember this Monetary policy is mainly designed to control the rate of inflation.
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The Macroeconomic Framework
The conduct of economic policy
K
Fiscal policy also involves taxation policy: the level and structure of taxes.
You will not need to know details of the government’s taxation revenue and expenditure. But you should be aware of some of the issues concerning fiscal policy: These include: K
government taxation revenue; government expenditure.
Study tips
K
Fiscal policy is conducted by the central government, usually the Treasury or Ministry of Finance. Fiscal policy is designed to alter the level of aggregate monetary demand in the economy. It does this by changing the balance between: KK
K
K
K
Fiscal policy
does fiscal policy mainly affect prices, or the level of output and employment? does it matter if governments are in deficit and have to borrow?
Remember this Fiscal policy is often referred to as budgetary policy; these effectively mean the same thing.
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The conduct of economic policy Public expenditure
K
K
K
Public (i.e. government) expenditure can classified by: function: what the money is spent on, e.g. defence, pensions, education; real and transfer spending; real spending is on goods and services (e.g. education) and transfer spending is redistributing income from one group to another (e.g. pensions). capital and current expenditure; capital expenditure involves the acquisition of productive assets (e.g. schools), current expenditure is the cost of running them (e.g. teachers’ salaries).
Study tips You will not need to know the details of government expenditure. You should be aware of the broad areas of public expenditure and the distinctions listed on the left.
Remember this The public sector refers to the government sector, as distinct from the private sector of individuals and private companies. Thus, public expenditure is spending by the government, not by the public in general.
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The Macroeconomic Framework
The conduct of economic policy Taxation: direct taxes KKKKK
The main direct taxes are: income tax; national insurance/social security contributions; corporation tax; inheritance tax; capital gains tax.
Definitions A direct tax is one where the burden falls on the person who is legally liable to pay the tax. A progressive (regressive) tax is one where the proportion of income paid in tax rises (falls) as income rises.
KK
Direct taxes tend: to be progressive in impact; to involve disincentive effects to work and effort.
And also If the disincentive effect of taxation is strong, a rise in tax rates might reduce the total tax revenue; this is known as the Laffer curve.
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The conduct of economic policy Taxation: indirect taxes KKK
The main indirect taxes are: value added tax (VAT); excise duties; customs duties.
Definitions An indirect tax is one where the burden of tax may be partly passed on to someone other than the person who is legally liable to pay the tax.
KK
K
Indirect taxes tend: to be highest on goods with low price elasticity of demand, such as petrol, tobacco, alcohol; to be regressive in impact; to involve weaker disincentive effects than direct taxes.
And also Not all of the burden of indirect taxes can be passed on to consumers.
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The Macroeconomic Framework
The conduct of economic policy
The Keynesian consumption function St Price S
3.30
a
3.00 2.30
b D D1
17
20
Producer burden
Price 1 2 3 4 5 6 7
Quantity supplied (S)
Quantity supplied after tax (St )
10 15 20 25 30 35 40
5 10 15 20 25 30 35
Quantity
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The conduct of economic policy
K
K
K
K
Government borrowing If government taxation revenue is less than its expenditure, the government has a budget deficit. This deficit can be financed by government borrowing. The amount of borrowing is known as the public sector net cash requirement (PSNCR). Governments typically borrow by selling government securities (e.g. Gilt Edge) to financial institutions. To correct a deficit, the government will have to raise taxes or reduce public expenditure.
Remember this A government budget deficit is quite different from a balance of payments deficit, which is concerned with international trade, not the government finances.
And also There are different ways of measuring the budget deficit. An earlier measure was called the public sector borrowing requirement (PSBR).
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The Macroeconomic Framework
In order to manage the economy the following are necessary:
Without the economic theory, governments would not know which instruments to use, and how, in order to achieve their objectives.
K
objectives to be achieved; instruments by which objectives can be achieved; economic theory about how the economy works.
K
Debates about economic policy arise because there are disagreements:
KKK
Managing the economy
K
Approaches to economic policy
over what are the appropriate objectives of economic policy; over the distinction between instruments and objectives; between economists over how free market economies work.
An example of this is the debate between monetarists and Keynesians over the management of the economy.
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Approaches to economic policy The Keynesian approach
K
K
Keynesians also tend to believe that:
K
a belief that the economy tends to be unstable, with the possibility of persistent recessions; a belief that the level of aggregate monetary demand in the economy is the most important variable in determining unemployment and inflation; that fiscal policy should be the main instrument of economic policy and governments should run budget deficits in recessions and surpluses in boom periods.
And also
K
K
K
The main features of the Keynesian approach are:
a larger public sector is not necessarily a bad thing; government intervention and regulation can help to keep the economy stable; free markets do not always produce desirable outcomes in terms of efficiency and equity.
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The Macroeconomic Framework
Approaches to economic policy The monetarist approach
K
K
Monetarists also tend to believe that:
K
a belief that the economy is relatively stable and self-correcting; a belief that the most important thing that governments can control is the rate of inflation; an emphasis on the idea that inflation is always the result of excessive demand, caused by over-expansion of the money supply; that the control of the money supply through a combination of fiscal and monetary policy should be the main instrument of economic policy.
And also
K
K
K
K
K
The main features of the monetarist approach are:
lower public expenditure and taxation are sound objectives of government; tax policy should be designed to minimise the disincentive effects of taxation; governments should minimise intervention and regulation; free markets are generally much better at allocating resources than government intervention.
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The Open Economy Examining the impact on business of the international economy
Topics
. . . . .
Globalisation Multinational companies International trade Foreign exchange The balance of payments 89
The Open Economy
Globalisation The global economy
K
K
K
Globalisation is the process by which economies become ever more interlinked and interdependent. Economic entities become global rather than national: global markets, global products, global prices. As interdependence increases, the functioning of one economy becomes more affected by events and processes in other economies. Government economic policy becomes less effective, because it can only influence the domestic economy, not the external forces operating on that economy.
Definitions Economic independence means that the economy’s performance is unaffected by the performance and economic policy of other economies. Economic interdependence means that the economy’s performance is affected by and also affects the performance and economic policy of other economies.
And also Governments may have to take into account the effect of their economic policy on other countries: thus policy coordination becomes important. 90
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Globalisation The links between economies
K
KK
K
In a globalised world, the main links between economies are: international trade in goods and services; the ratio of trade to national income has risen in virtually all economies; international movements of capital and labour; the development of international markets for resources, including capital and for foreign exchange; the growth of multinational companies (MNCs).
Definition Trade liberalisation is the process by which barriers to trade have been progressively reduced, thus making economies more open. The trade liberalisation process has been promoted by international bodies, originally the General Agreement on Tariffs and Trade (GATT) and now by its successor, the World Trade Organisation (WTO).
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The Open Economy
Globalisation
K
As well as goods and services, factors of production move between economies, including capital and labour. Capital is the most internationally mobile factor of production. The main mechanisms for international capital movement are: international capital markets, e.g. the Eurocurrency market; foreign direct investment (FDI) conducted by multinational companies.
And also The main factors that encourage international capital flows are: KK
K
K
International factor movements
the abolition of capital controls; the growth of international integrated production, encouraging FDI.
Short-term capital will flow to where interest rates are highest, or where currencies are expected to appreciate.
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Multinational companies Why do companies go multinational?
K
K
K
Companies may locate in other countries, in order to: seek sources of raw materials, e.g. the oil companies; exploit new markets, especially if they are protected by trade barriers, e.g. Japanese car companies in Europe; reduce production costs, especially for labour, e.g. manufacturing companies moving to SE Asia.
Definition A multinational company is one which owns or controls production facilities in more than one country.
And also The traditional model of foreign direct investment by MNCs is now being supplemented by new forms of multinationality, such as joint ventures, strategic alliances, licensed production and franchising.
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The Open Economy
Multinational companies
K
K
K
K
Forms of multinational companies Some MNCs are horizontally integrated, with similar production facilities in a range of countries. Horizontal integration is often the result of market seeking behaviour. Other MNCs are vertically integrated, with the production process broken up into separate stages, with each stage located in a different country. Vertical integration is often the result of cost-reducing behaviour.
Definitions The New International Division of Labour is the process by which MNCs locate different stages of the production process in those countries whose resources are best suited to that stage. Thus, the research and design stage may be located in economies well endowed with educated labour, e.g. the USA, and the labour intensive production stage may be located where wage costs are low, e.g. China.
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International trade The theory of international trade
K
KK
The theory of comparative advantage (cost) shows that countries benefit from trade by specialising in the production and export of those goods and services whose opportunity cost of production is lowest. The result is: international specialisation; all countries benefit from trade, even if one is more absolutely efficient in the production of all goods and services; the benefits are higher output and incomes.
Study tips You will not need to know detailed numerical examples of the comparative cost principle. You will need to know the general principles of the theory, especially the concept of opportunity cost.
And also The benefits of free trade are independent of the policies of other countries. Thus, a country will benefit from adopting free trade, even if none of its trading partners does so.
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The Open Economy
International trade Benefits of international trade
K
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In addition to the benefits derived from specialisation through the principle of comparative advantage, international trade also: reduces costs through economies of scale in export industries; provides access to products which might otherwise be unavailable; increases competition in domestic markets, thus giving consumers more choice and encouraging domestic producers to become more efficient.
Remember this The case for free trade rests on the comparative advantage principle and does not depend on these additional benefits of international trade. Specialisation is the result of engaging in international trade and is not the reason for international trade to take place. Since the real benefits of trade come from imports, there is no particular benefit from a country running a trade surplus.
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Definition The terms of trade measure changes in the relative prices of a weighted average of imports and exports.
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The balance of trade and the terms of trade K
International trade
The balance of trade is the balance of exports of goods and imports of goods; the balance could be surplus or deficit. The terms of trade measure the relative prices of typical imports and typical exports and changes in those prices. Thus, if average export prices rise (fall), relative to average import prices, the terms of trade are said to have improved (deteriorated).
The terms of trade are measured as follows: index of export prices 100 index of import prices
And also If a country’s terms of trade improve, it raises its benefits from international trade, but reduces its international competitiveness.
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International trade Trade policy 1 KKKK
Countries might try to limit imports by: import taxes (customs duty); quotas; non-tariff barriers, such as safety regulations; subsidies to domestic producers.
Definition The ‘new protectionism’ is the term used to describe the growth of non-tariff barriers as the major form of trade policy, in place of tariffs which were declining as a result of the work of GATT and the WTO.
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Governments attempt to justify this trade protection as: protecting employment in contracting (sunset) industries; protecting infant (sunrise) industries; preventing ‘unfair’ competition; protecting the balance of payments.
Remember this Just because governments justify trade policy on the grounds described, it does mean that these are valid grounds for limiting imports, or even the real reason why governments do it.
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International trade
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inefficiency is encouraged, because competition is limited; prices are raised, thus reducing living standards; retaliation on the country’s exports may occur; resources are misallocated; industries which do not have a comparative advantage expand and those which do contract. income distribution is altered, with income being shifted from consumers to producers.
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Using protectionism to limit imports may have disadvantages:
Why then does trade protectionism exist? Most trade policy exists because producers put pressure on governments for protection from import competition:
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Trade policy 2
producers gain because they can charge higher prices; consumers lose because they have to pay higher prices.
Remember this Trade protection will reduce the economic welfare of a country in general, even if those in the protected sectors gain.
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International trade Regional integration
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Countries may integrate to form trade blocs. Free trade area; internal barriers to trade in goods and services are removed. Custom union: free trade area, plus the establishment of a common external tariff; Common markets: customs unions, plus the free movement of labour and capital within the market. Economic unions: common markets, plus some common economic policies and possibly a common currency. The European Union (EU) is an example of an economic union. The North American Free Trade Area (NAFTA) is an example of a free trade area.
And also Regional integration is the result of a desire to reap the benefits of free international trade. But these groups are often protectionist, with respect to the rest of the world, thus reducing some of the benefits of free trade.
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Foreign exchange
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The foreign exchange market Foreign exchange is bought and sold in foreign exchange markets (FOREX). The exchange rate is determined by the demand and supply of the currency in the FOREX. Demand for a country’s currency comes from:
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the demand for its exports; the inflow of capital into the country. Supply of a country’s currency comes from: the demand for its imports; the outflow of currency.
Definition The exchange rate for a currency is the price of that currency, expressed in terms of another currency. If that price rises, the currency is said to have appreciated. If that price falls, the currency is said to have depreciated.
Remember The exchange rate for a currency is a price and, therefore, is always determined by the supply and demand for it.
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Foreign exchange
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The importance of exchange rates Exchange rates translate domestic prices into foreign prices and foreign prices into domestic prices. If the exchange rate rises (appreciates) then:
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the domestic price of imports falls; the foreign exchange price of exports rises. International competitiveness has been lost. If the exchange rate falls (depreciates) then: the domestic price of imports rises; the foreign exchange price of exports falls. International competitiveness has been gained.
Definition International competitiveness is affected by the exchange rate and by domestic inflation. The real exchange rate is a measure of the impact of nominal exchange rate changes and domestic inflation. Thus, if the market exchange rate has depreciated by 3%, but domestic prices have risen by 3% over the same period, the real exchange rate has remained the same and international competitiveness has remained unchanged.
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Foreign exchange
Under fixed exchange rate systems there is a target exchange rate. The government and the central bank must manage economic policy and intervention in FOREX to keep the exchange rate close to the target rate. The advantages of a fixed exchange rate system are: certainty for businesses, thus encouraging international trade; constraint on domestic economic policy, preventing governments from adopting inflationary policies.
Remember this! Exchange rates are determined by supply and demand, even under fixed exchange rate systems. Therefore, governments must adopt policies to keep supply and demand at the appropriate level. These policies include: KK
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Fixed exchange rate systems
domestic policies, especially interest rates; intervention in FOREX to buy and sell the currency.
And also Because the currency must be managed, the central bank must hold large reserves of foreign exchange.
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Foreign exchange Flexible exchange rate systems
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Under flexible (floating) exchange rate systems, there is no target exchange rate and the government allows the exchange rate to be determined by supply and demand in the FOREX. The advantages of a flexible exchange rate system include: automatic adjustment of balance of payments disequilibria; freedom for governments to adopt any domestic policies they wish; no need for large reserves of foreign exchange.
Remember this! Few governments allow completely free floating for their currencies. This is because the exchange rate is important in influencing international competitiveness and the domestic inflation rate.
And also The exchange rate is not only important for trade; it also influences domestic inflation, because it influences the price of imports. For countries with high trade ratios this is an important factor in the determination of inflation.
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Foreign exchange The disadvantages of this are:
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Twelve members of the European Union have adopted a single currency, the Euro. The advantages of this are: K
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removes transaction costs of buying and selling currency; removes exchange rate uncertainty and encourages international trade; increases competition through price transparency; makes foreign direct investment easier.
there is only one monetary policy for all countries, whatever their economic circumstances; countries cannot change their exchange rate if they lose international competitiveness. limits have to be put on countries’ fiscal policies, as this has implications for monetary policy.
And also The necessary condition for the UK to join the Euro is convergence in economic performance.
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The balance of payments Definition
The balance of payments has two main elements:
The balance of payments accounts are a statement of all transactions between a country’s residents and the rest of the world.
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The structure of the balance of payments
the current account: all trade in goods, services and payments for factor services; the capital and financial account: all transactions in external assets and liabilities, such as capital inflows and outflows.
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The balance of payments always balances: there may a surplus or deficit on the current account; this is financed by a deficit or surplus on the capital and financial account.
Remember this! The balance of payments is a set of accounts and always balances. The balancing item is merely a measure of the extent to which imports or exports have not been accurately measured. The balancing item may be positive or negative.
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The balance of payments The determination of the balance of payments
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The current account balance for a country will be affected by: its international competitiveness, influenced by:
Remember this! A deficit or surplus on the current account is financed on the capital and financial account. It cannot be financed through the government budget.
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the productivity of its businesses; inflation compared to other countries; the exchange rate; the level of aggregate monetary demand, since a high level of AMD will lead to a high level of imports; the trade policy of the government.
And also The current account tends to move towards a deficit in boom periods (rising inflation and higher AMD) and towards a surplus in recessions (falling inflation and lower AMD).
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The balance of payments Balance of payments policy 1
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A government might wish to correct a current account deficit on the balance of payments. It can do this by a policy of expenditure reduction. This involves a deflationary policy of reducing AMD in the economy. If the country has a very high trade ratio, much of the reduction in aggregate demand will fall on imports. The disadvantages of such a policy are: increased unemployment; slower economic growth if business investment is discouraged.
Study tip A government can improve the current account by reducing imports. It can only do this by reducing incomes, thus reducing the demand for everything, including imports, or by encouraging consumers to buy domestic goods instead of imports. You can judge any balance of payments policy by the effect it has on incomes or consumer choice.
And also Under fixed exchange rate regimes, expenditure reduction is the only policy open to governments, since they cannot alter the exchange rate.
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Balance of payments policy 2
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A government can also correct a current account deficit on the balance of payments by a policy of expenditure switching. This involves making exports cheaper and imports dearer, by allowing the currency to depreciate, which reduces the price of exports and raises the price of imports. This is very effective if the country has: a high price elasticity of demand for exports and imports; a relatively low trade ratio.
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The balance of payments The disadvantages of such a policy are: it reduces consumer incomes, because the terms of trade worsen; higher import prices may cause inflation, thus offsetting the competitive advantage.
Remember this! There are no free lunches in economics: any policy designed to correct a current account deficit on the balance of payments reduces the living standards in the country.
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