Download CHAPTER 1 INTRODUCTION: WHAT IS ECONOMICS? Economics

CHAPTER 1
INTRODUCTION: WHAT IS ECONOMICS?
Economics may be defined simply as the science which studies economy. But what is
economy?
Economic events, as a component of social events, are very complex and hence, it is
not easy to fix a boundary for them. There is no unanimity among economists about the
scope and the definition of economics. There are many different types of economic theory,
each emphasizing different aspects of complex reality, making different value judgments and
drawing different conclusions. There is no one right answer in economics. There are different
types of economic arguments to explain economic phenomena.
In this introductory chapter, we start by having a walk in our district in order to have
an idea about economic events and how economy is working. Then, we try to answer the
question of what is economics.
a. Economic Events
Start from your own household. How many people live there? What generations? Who
works outside the household and how much do they earn? How long have they been
working there? How long do they plan to keep working, and how will they support
themselves when they retire? Who performs which roles inside the household? Are there
any children? Who cares for them? Does anyone else in your home require care? Does your
family own your house or do you rent it; if you rent it, from whom? If you own it, how did
you pay for it?
Walk through your neighborhood. Are the homes or apartments all roughly the same,
or different? Does everyone have a home? Do most people have jobs? What sorts of jobs?
Are they well off? Can they comfortably pay for the things they and their families need?
Watch your neighbors going off to work, school, or other destinations. How are they
travelling: In their own cars, on public transport, or walking? How much money, time, and
physical space are devoted in your neighborhood to getting around?
Is there a school, a hospital, a library in your neighborhood? Who pays for those
buildings? Who works there? How do those facilities compare with the private homes and
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businesses around them? Are they newer, or older? Nicer, or shabbier? Is there a park in
your neighborhood? Is there anywhere else a person can go without having to pay money?
Are the streets clean? If so, who cleaned them? Is the air fresh or smoggy? Can
people in your neighborhood safely drink the water from their taps? How much do they pay
for that water, and to whom?
Walk through the nearest shopping district. What kinds of products are displayed in
the windows? Were any of them produced locally, elsewhere in your country or in another
country? Can your neighbors afford most of what is on display? Are they usually happy with
their purchases, or disappointed? Do they pay with cash, bank cards, or credit cards? Can
they afford what they buy?
Now walk to a bank branch and see what’s happening inside: deposits, withdrawals,
loans?
Apart from the places we have mentioned, what other workplaces are visible in your
neighborhood: any factories? What do they produce, and what shape are they in?
Are there any professional or government offices, or other services? Can you see any
office buildings from your neighborhood? Who works there? Can you guess what they do?
Have any new workplaces opened up recently in your neighborhood? If so, what do
they do? Did you see any “help wanted” signs posted in local workplaces? What kinds of jobs
were they advertising for?
When come back home, pull out a pencil and paper. List your approximate monthly
income. How much of it goes to the following categories: rent or mortgage; income taxes;
car payments or public transport passes; groceries; other stuff; and entertainment? Can you
comfortably pay your bills each month? Do you regularly save? Has your income increased or
decreased in the last five years, or remained the same? If you had a little more income, what
would you do with it?
Now you have conducted a composite economic profile of your own community. Just
by walking around your neighborhood, you have identified the crucial factors determining
economic affairs in your community: work, consumption, investment, finance, and
environment.
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• Work: Who works? Who works inside the home, and works outside the home? Are
they employed by someone else (and if so, who?), or do they work for themselves?
How much do they get paid? Is it hard to find a job?
• Consumption: What do people need to stay alive? What do they want to make
their lives better? How do they pay for it all?
• Investment: Private companies and public agencies must invest in maintaining and
expanding their facilities and workplaces. Who is investing, how much, and on what
types of projects?
• Finance: Most economic activity requires money. Who creates and controls that
money? Who gets to spend it? What do they spend it on?
• Environment: Everything we do in the economy requires space, air, and inputs of
natural materials. Is the natural environment being run down by the economy, or is it
being sustained?
These are the building blocks from which the most complicated economic theories
are constructed: work, production, consumption, investment, finance, and the environment.
And they are all visible, right there in our neighborhood.
b. How is Economy Working?
It is to be hoped that this short walk and observation in your district have given you a
preliminary description of the subject matter of economics. There is close relations among
knowledge, technology, and the social and economic events. People have to satisfy their
needs to survive. This satisfaction is provided with produced products. With the expanding
production capacity of the society and rising living standards of people not only needs
expand and get sophisticated, but the processes of satisfying them also become more
complex. Thus, economics is trying to explain facts and events that get more complicated as
time goes on.
The progress of knowledge and technology provided people with various alternatives
among which they could make choices. Economics could have been developed by the birth
of different alternatives. Therefore, we may say that economics is the science of choosing
among alternatives. Where there is no alternative, there is no need for economics.
Economics aims to clarify and explain the pattern of available possibilities.
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Individuals and organizations have to make choices among alternatives. Individuals
make a choice among educational and professional alternatives. They seek the ways of
increasing their incomes; decide how to use their incomes, how to divide income between
consumption and saving; which goods and services to be consumed; and how to use savings.
In summary they try to live by choosing one of the alternatives they face at different areas of
life.
At the level of organization, such as the business firm, the choice could be between
investing in a new computer system or retaining and up-grading the existing equipment. In a
health care charity, the choice might manifest itself as the option of spending donations to
reduce the suffering of chronically sick people now or investing those limited funds for
research into prevention and cure in the future.
At the national level, the choice could be between increasing government
expenditure on motorways and expanding the number of National Health Service beds.
Societies decide what to produce and how to divide social product among various social
classes. They determine the percentage of the saving and consumption. They distribute total
consumption among different goods and services. They decide how to allocate savings
among different investment alternatives. They decide the share of national income spent by
the state and who would pay the taxes, and how the state would allocate its expenditures.
Moreover, countries decide about the exports and imports. They borrow from other
countries and lend them.
c. What is Economics?
Although economic thinking has a long tradition starting from the ancient Greeks economics
came into being in the second half of the eighteenth century. Hence, it is a relatively young
academic discipline. British philosopher Adam Smith’s famous book, An Inquiry into the
Nature and Causes of the Wealth of Nations (published in 1776) was generally accepted as
the first scientific work about economy, and Smith is known as the founder of the Classical
School. The new science was called the classical political economy. The one hundred years
following the publication of the Smith’s book is known as the classical period. Adam Smith
considered political economy as a science of wealth, as implied in his book title. According
to Smith the subject matter of the political economy is to inquire the factors behind the
richness of societies: Why are some societies wealthier than others?
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Following Smith’s definition, classical economists typically define classical political
economy as the study of the production, distribution, exchange, and consumption of
wealth. For example, British economist David Ricardo (1772-1823) wrote that the principal
problem in political economy is the determination of the laws which regulate the division of
social product, under the names of rent, profit, and wages, among three classes of the
community; namely, the proprietor of the land, the owner of the stock or capital necessary
for its cultivation, and the laborers.
Classical political economy, had a profound sense of the historical and the social, and
consciously incorporated this both in its concepts and in its theory. All classical writers wrote
at a time when political economy was the only identifiable social science. For most classical
writers, political economy was seen as a united social science, rather than simply as the
science of the economy.
This situation changed drastically with the emergence of the Marginalist School in
the 1870’s and the subsequent move from classical political economy to (neoclassical)
economics. In its methods and technical apparatus, economics has become a-social and ahistorical, in the sense of using universal categories without reference to time, place or
context. The end result of this process was the separation of economics from other social
sciences, especially economic history and sociology.
British economist Lionel Robbins (1898-1984) defined economics, in conformity to
this approach, as the “science which studies human behavior as a relationship between ends
and scarce means which have alternative uses.”
However, the attempts to keep the relationship between the economic and noneconomic alive did not cease with neoclassical economics. The work of the members of
alternative schools of thought, such as the Historical Schools and Institutionalism, was
interdisciplinary in character and emphasized a multi-disciplinary approach.
For example, American institutional economist John R. Commons (1862-1945)
defined economics as the “study of relationships among different property-owning groups
(landowners, merchants, industrialists) and these groups and their workers.”
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Economics is about our life. It is simply about how we work, what we produce, and
how we distribute and ultimately use what we have produced. Economics is about who does
what, who gets what, and what they do with it.
Economics is a social subject. It’s not just technical, concrete forces like technology
and productivity that matter. It’s also the interactions and relationships between people
that make the economy go around.
Economy involves money, work, production, technology, international trade, taxes,
distribution of income and consumption. Everyone experiences the economy. Everyone
contributes to it, one way or another. Everyone has an interest in the economy: in how it
functions, how well it functions, and in whose interests it functions. And everyone has a
grass-roots sense of where they personally fit into the big economic picture, and how well
they are doing. Learning about economics will help them understand where they fit into the
bigger system, and help them fight for a better deal.
Debates over economic issues are not technical debates, where expertise alone
settles the day. They are deeply political debates, in the broad sense of that word: distinct
groups of people have distinct interests, they know their interests, and they naturally work
to promote them. This occurs everywhere in the economy.
The development of economics has paralleled the development of the economy
itself. Economists have tried to keep up with real-world economic problems, challenges, and
conflicts. Consequently, economics is not a pure science. Economists have worked to try to
understand the economy and how it functions. But they have also had usually very strong
and often hidden views about how the economy should function. The theories of economists
have always been spurred by real world debates, politics, and interests. Today, economics
continues to display its inherently political character. There is no economic policy debate
which does not involve trade-offs and conflicting interests.
WORKING QUESTIONS
1. Try to answer the questions in section (a) using your own experiences.
2. Describe the relationship between the scientific and technological developments and
the alternatives individuals and societies face.
3. Compare and make sense of the definitions for economics given in section (c).
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CHAPTER 2
BASIC PROBLEMS OF AN ECONOMY AND THE WAYS OF SOLUTIONS
In the first chapter we explained what is economy and economics. We will discuss the basic
economic problems of societies, the ways of solving these problems, and summarize the
features of a good economy, in this second chapter.
2.1. BASIC ECONOMIC PROBLEMS
Modern economies involve thousands of complex production and consumption activities.
The great majority of the problems that studied in economics fall within five problem areas:
a. What goods and services are being produced and in what quantities?
b. By what methods are goods and services produced?
c. How is the total product distributed among the members of the society?
d. Are the country’s sources being fully utilized?
e. Is the economy’s productive capacity growing over time?
Now, we are going to discuss each briefly.
a. What Goods and Services are Being Produced and in What Quantities?
This question concerns the allocation of scarce resources among alternative uses. Any
economy must have some mechanism for making decisions on the problem of resource
allocation.
b. By What Methods are Goods and Services Produced?
Generally, there is more than one technically possible way in which a commodity can be
made. Agricultural commodities, for example, can be produced by taking a small quantity of
land applying to it large quantities of fertilizer, labor, and machinery; or by using a large
quantity of land applying only small quantities of fertilizer, labor, and machinery. Either
method can be used to produce the same quantity of crop. A criterion, for making a choice
among many alternative methods, is efficiency. Efficiency means producing a given quantity
of output using the least amount of inputs.
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c. How is the Total Product Distributed among the Members of the Society?
Economics is interesting in what determines the distribution of a nation’s total income
among such groups as landowners, laborers, and capitalists. It is interesting also in how
governments may change the distribution of income by using devices such as progressive
income taxes, minimum-wage laws, and programs of social insurance.
d. Are the Country’s Sources Being Fully Utilized?
Although there is scarcity and sources should be fully utilized, one of the most disturbing
characteristics of market economies is that such waste occurs. Some of the workers cannot
find jobs, the factories in which they could work may be closed or may not be working at the
full capacity. Unemployment of resources is similar to an inefficient use of them in that both
lead to production less than full employment.
e. Is the Economy’s Productive Capacity Growing Over Time?
If the economy’s capacity to produce goods and services is growing, national income levels
that are unattainable today become attainable tomorrow. Clearly, in an economy in which
not enough can be produced to satisfy all wants, growth will be important because growth
makes it possible to have more of all goods.
2.2. WAYS OF SOLVING ECONOMIC PROBLEMS: ECONOMIC SYSTEMS
All economies face the questions cited above. Different methods have been used for
addressing the questions of production and distribution; what, how and for whom? Not all
economies are organized on the same lines. In modern economies market mechanism and
planning are used to solve economic problems. Economies that use mainly market
mechanism are called capitalist economies, and economies that use mainly planning are
called socialist economies.
The main differences between capitalist and socialist economies can be categorized
as the differences in the ownership of resources, decision process, and purposes.
In capitalism the basic raw materials, productive assets, and the final goods are
predominantly owned by individuals. And resources are allocated, in principle, by the market
mechanism. A large number of individuals and organizations act in response to price changes
in the market. Market mechanism coordinates the factors of production, and prices provide
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market signals. In market economies, apparently uncoordinated activities of individuals and
firms are reconciled by market mechanism. Self-interest and profit provide the incentives.
The demands of consumers for goods exert a major influence on the nature of goods
produced. But since the purchasing power is not distributed evenly among people the rich
consumers have much to say than the poor one and that firms have a great deal to say about
what is produced. In an unfettered market economy, the initial distribution of income and
wealth influences the nature of economic decisions because it determines who has the
money that exercises the effective demand.
In the socialist economy the ownership of productive assets is public. The planned
economy does not rely on the workings of markets to solve the economic problems. It has a
central planning unit to decide on production and distribution targets. Economic effort is
directed towards goals administratively chosen by the State. Major decisions about what and
how to produce, and for whom, are made administratively. Centralized decision makers
decide what shall be done, and resources are mostly allocated by planning units. Public
interest, not self-interest and profit, is the guiding rule in resource allocating decision
making in the planned economy.
Although big differences in economic systems of countries are a fact of life, every real
economy is mixed rather than pure. The mixture differs among countries and changes over
time. Ownership patterns are genuinely variable. No country is found at either extreme. It is
true that some economies rely much more heavily on market decisions than do others. But
in even capitalist economies the planning has some sway: minimum wages, quotas on some
agricultural outputs, transfer the command of some resources from private individuals to
public bodies by taxing and public expenditures, and war time priorities are some examples.
In the planned economies plans and targets, quotas and directives are important
aspects of the decision-making system and there is substantial command at work. But
markets are used too. The factories are state-owned and farms are collectivized, generally,
but there are sectors where some significant private ownership exists, such as agriculture,
retail trade, and housing.
Many countries fall between two ends on the spectrum and their position changes
over time. Some European countries, for example, nationalized key industries after the
Second World War: railroads, steel, coal, gas, electricity, atomic power, postal services,
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telephones, telegraphs, airlines, and some trucking. Most of these sectors were re-privatized
since 1980s.
Today, countries’ economies are based mainly on private ownership of resources and
the workings of markets; large proportions of their resources are allocated by markets
although they use the market in different degrees.
However, in practice, many vital elements of planning exist in market economies,
with allocation decisions being made by governments and within business firms.
Governments affect production and distribution decisions through a variety of means; by
taxation and expenditure or by regulation of the competitive process. Governments play a
vital part in the economic system through social security or welfare payments, by taxation
on income or expenditure, the provision of goods and services. Indeed, governments in any
economy have an important role to play in setting “the rules of the game”; the laws and
regulatory framework of an economic system. At the same time, the giant corporation, the
huge bureaucratic firm, uses an internal planning mechanism.
2.3. WHAT IS A GOOD ECONOMY?
Economics tries to explain how the economy works. But it is equally and justifiably
concerned with trying to make it work better. This inherently requires making value
judgments about what kind of economy is more desirable.
Deciding what economic goals to pursue will reflect the priorities and interests of
different individuals, communities, and classes. Although it is an inherently subjective
choice, a list of key economic goals may be as follows:
1. Prosperity: An economy should produce enough goods and services to support its
citizens and allow them to enjoy life to the fullest. Prosperity does not just mean having
more consumption. It means enjoying a good balance between private consumption,
public services, and leisure time.
2. Security: The members of an economy should be confident that their economic
conditions are reasonably stable. They shouldn’t have to worry about being able to
support themselves, to keep their home, and to pass on decent economic opportunities
to their children. The economic insecurity and turmoil experienced by billions of people
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today imposes real costs on them. Even people who may never lose their job or home
spend a great deal of time and energy worrying that they might. That fear is costly.
Economic security is valuable in its own right.
3. Innovation: Economic progress requires us to think continuously about how to make our
work more productive. This innovation includes imagining new goods and services and
better ways of producing them. An economy should be organized in a way that
promotes and facilitates innovative behavior.
4. Choice: Individuals have different preferences, hopes, and dreams. They should have
reasonable ability to make economic decisions in line with those preferences, including
the sort of work they do, where they live, and what they consume.
5. Equality: Inequality is harmful if it means that large numbers of people are deprived of
the ability to work and enjoy their lives. In this sense, the goal of equality is bound up
with the goal of prosperity. Inequality is also inherently negative in its own right. A
concentration of income and wealth at the top will undermine social cohesion,
wellbeing, and democracy. People’s emotional well-being is negatively influenced by
unfavorable self-comparisons to the lifestyles of the rich and famous. When this occurs,
inequality carries distinct negative consequences. Thus, limiting the economic distance
between rich and poor is an important economic goal. Equality also requires decent
provisions to support those members of society who cannot work.
6. Sustainability: Humans depend on their natural environment. It directly enhances our
quality of life through the air we breathe, and the spaces we inhabit. And it provides
needed inputs that are essential to the work we do in every single industry. All
production involves the application of human work to add value to something we got
from nature. Maintaining the environment is important in its own right. It is also
important in a more narrowly economic sense, since our ability to continue producing
goods and services in the future will depend on finding sustainable ways to harvest the
natural inputs we need, without continuously depleting or polluting.
7. Democracy and accountability: In economic life different people perform different
functions. Some individuals and organizations have great decision-making power, while
others have very little. How do we ensure that economic decisions, and the overall
evolution of the economy, reflect our collective desires and preferences? And how do
we monitor and ensure that people and institutions are doing the work they are
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supposed to? The answers of these questions will depend on whether we are entitled to
genuine and far-reaching forms of economic democracy and accountability.
After we have got a general idea about economics in the first two chapters, we will
discuss the relations between economics and law in the next one.
WORKING QUESTIONS 2
1. What are the five problem areas of economies?
2. What are the main differences between capitalist and socialist economies? Explain.
3. What are the peculiarities of a good economy?
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CHAPTER 3
LAW AND ECONOMICS
In this chapter we will discuss the relations between economics and law. We will, first,
underline how economics and law are interrelated. Secondly, we will examine the effects of
risk and uncertainty in economies. Finally, we will study the roles of rules, customs and
institutions in limiting the adverse effects of risk and uncertainty, and stress how they
promote economic development.
3.1. THE RELATIONS BETWEEN LAW AND ECONOMICS
Every stage of the progress in history corresponds to a type of social relations. With the
changing material conditions of life, social relations also change. Economics and law are the
branches of social sciences studying somewhat different but with common space faces of
social relations. While the decisive factors shaping law are economic relations, this relation is
not passive; there is a dialectical interaction on law between the economic base of society
and the ideological superstructure. As society develops, the law is in a perpetual process of
change. Legal development is a part of socio-economic progress.
People cooperate, compete, and conflict, in the process of production and
distribution. The extent and type of cooperation, competition and the means of handling
conflicts depend on institutional rules. Rules are vital for people coping with knowledge,
ignorance and uncertainty. And institutional rules, in turn, are dependent on socio-economic
and political factors.
Today, countries’ economies are based mainly on the working of markets. All
markets require laws, customs and conventions in order to coordinate the plans of buyers
and sellers. To work effectively, markets have to provide security; people need to know that
they are not going to be cheated. Markets have to be organized, to function effectively:
Markets are heavily dependent on rules and regulations. In any economy the influence of
norms and convention intertwine with the price mechanism and economic transactions.
There has to be an element of trust in markets: People should have confidence that the
other party will fulfill his or her part of the bargain.
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The ordering of market transactions takes place through layers of rules. Rules emerge
through the need to mediate economic transactions. Regulation, in a broad sense, is
essential to the operation of any system of social organization. The state regulates and
legitimizes the whole of social relations. Social relations are reproduced through the
combination of private economic relations in markets, and political processes dominated
by the state.
As economies become more complex, so do the required rules. Rules are significant
in determining behavior. The market player who does not understand or play by rules might
lose out.
The framework of rules and institutions is made up of formal and informal rules and
the additional rules of enforcement. Both formal and informal rules require enforcement.
No matter what rules exist there will be people who break them. Given rules of the game,
there has to be the means to oversee and regulate them, to measure the extent of any
breach or infringement, to police and correct.
In modern societies, complex contracts or agreements are necessary for decision
making. The growing number of formal rules and the increasing number of state
organizations operating in legal, judicial and regulatory guises go hand-in-hand. Increasingly
the multidimensional attributes of complicated goods and resources have to be set out in
exchange contracts. With the inability to identify every possible future eventuality, it is
impossible to draw up contracts setting out all provisions. There has to be a third party
adjudicator to enforce contracts, a secure and robust central government to provide
stability.
a.
Rule of Law
Formal-rational principles of law developed historically with the emergence of capitalism, to
underpin the conditions of competitive exchange. Their continuing importance is seen in the
current stress on the importance of the rule of law for capitalist development.
There is a strong causal link between respect for the rule of law and sustained and
robust economic development. When the rule of law breaks down, and law and institutions
cannot be relied upon to regulate the behavior of the government or its citizens, economic
development inevitably suffers.
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The relationship between establishing and maintaining the rule of law and
promoting economic development runs both ways. On the one hand, ensuring that state
institutions and practices are compatible with rule of law principles provides a critical
foundation for sustainable economic growth. On the other hand, economic development
brings with it increased opportunities to foster respect for the rule of law and human rights.
b. Risk and Uncertainty
Economic decisions are made with imperfect foresight. There may be several possible
outcomes from any course of action and the one which will occur cannot be known in
advance. Risk and uncertainty is an important fact of life and cannot be eradicated, because
time cannot be reversed. We cannot foresee the future perfectly. The unexpected may
happen.
In an uncertain situation we cannot provide neat probability measures. We may have
no real idea of the precise structure of the problem, indeed all the possible types of
outcome, how the future may come out. There may be adverse or agreeable surprise in the
future. We have considerable ignorance of the situation and we certainly cannot measure
the probability of an event with any confidence. Information is lacking and expectations are
unclear. People in the ordinary business of life, constantly face true uncertainty, where they
have no idea what the future will bring.
Therefore, uncertainty must be an essential element in our thinking. In reality, the
issue is about making choices in situations which embody different grades of risk and
uncertainty, or indeed where we are completely ignorant.
3.2. THE MAIN FUNCTIONS OF RULES
Rules help decision making, reduce transaction cost, facilitate understanding the behaviors
of decision makers, and affect economic performance.
a. Rules Help Decision Making
Laws and customs are indispensable for people making decisions in a world of imperfect
information and uncertainty. Rules provide the basic prerequisite affecting the way in which
resources are used and the rewards distributed.
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People making economic decisions require a framework of rules. We have to cope
with our own limitations in gathering, and making sense of information and dealing with
fundamental uncertainty. The major role of institutions in society is to reduce uncertainty
by establishing a stable structure to human interaction.
In all societies, rules are necessary to order, constraint and guide people, in fact to
ensure the production and reproduction of the system itself. There must be a set of rules to
reconcile conflict between contrary tendencies. Rules exist because of the need to reduce
the difficulties involved in human transaction, where people relate to each other.
For the working of specialization and the division of labor there is a basic need for
cooperation. Cooperation is an essential requirement to ensure the gains from specialization
and exchange. Economic interactions with others, however, have some costs. These costs
arise from the information problems and uncertainty.
b. Rules Reduce Transaction Cost
Rules reduce the costs of human interaction by giving a framework for organizing economic,
social or political human exchange. They reduce the impact of imperfect knowledge, the
problems of risk and uncertainty. Rules help people to cope with their own limited ability to
process the mass of information which they actually possess and allow for that which they
cannot know.
Institutions are constraints which help decision makers. Those engaged in an
economic exchange are more confident about the actions of others if there are known laws,
effectively enforced, and generally accepted conventions. These place boundaries on what
people expect, and so limit the information need for making decisions in new situations.
Rules help to define possibilities in any particular situation in social interaction. They provide
economic players with a view of what is normal: curtailing search and transaction costs.
Rules reduce uncertainty by giving a secure structure to human transactions.
Economic interaction may involve complex deals which often extend over long
periods of time. Intentions and agreements in reality cannot be perfectly mapped out, not
every eventuality can be specified. Any contract always carries uncertainty. There may be
shocks and surprise. Knowledge of the formal laws or the use of habitual routines helps
decision makers. The order which rules bring helps to ensure production and the survival of
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the system itself. The constraining institutional framework ensures connections between
successive periods; whether in carrying debts contracts through time, the passing of wealth
from one generation to another or the handing on of tacit knowledge.
Rules Facilitate Understanding the Behaviors of Decision Makers
To understand individuals and their organizational behavior we must consider the rules of
conduct, formal and informal. Institutionalized rules are significant in determining behavior
because they are binding for individual and group decisions. Therefore, these rules facilitate
the estimation and understanding of behaviors of decision makers.
c. Rules Affects Economic Performance
Institutional rules are among the most important determinants of economic performance.
Together with the factors of production and technology, the rules of the game are key
elements determining the production possibilities of societies. Economic development
requires a stable underlying institutional framework which will bolster the incentives for
individuals and organizations to engage in productive activity, to expand the division of
labor, specialization and trade. These require human cooperation.
The consequences of institutions are always a mixed bag, however. While some help
to further the division of labor and cooperation, others reduce it. At any point in time the
blend of formal and informal rules is a mixture; some will facilitate and support change,
others will act as a hindrance. Every person and organization is circumscribed to a greater
or lesser extent by traditions. Traditions affect human interactions in the present and the
way in which the future is created. Some environment may have rules of the game which
foster technological change and rapid economic growth.
In historical time, various changes in the pattern of rules have clearly facilitated the
division of labor, specialization and the growth of markets by lowering search and
transaction costs.
The Agrarian and Industrial Revolutions and the eventual rise of modern societies
were associated with the development of increasingly complex formal institutional
frameworks. These were required to structure the involved exchange and production
process in a world where technological and industrial changes were moving much more
rapidly. The law is an evolving array of legislation which is crucial for development.
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Some institutional changes enable the lowering of transaction costs, like the long
evolution of maritime and merchant law and the gradual spread of clearly defined property
rights and international laws of protection. These helped to bring about the development of
modern economic system. Rules have been designed to improve the quantity and quality of
information to buyers. Over historical time, rules have evolved to enable people to spread
the risks of their transactions. The development of insurance law, for example, made
economic life easier and facilitating exchange.
One aspect of the institutional framework which is particularly useful in
understanding economic development are rules which relate to property, they are central
feature in economic life.
3.3. PROPERTY RIGHTS
Property rights have a particular significance in capitalism. Capitalism, as an expansionary
economic system, demanded the unfettered accumulation of capital based on the private
ownership of the means of production. The development of capitalist economic relations
shaped the content and structure of law in many ways. But the most fundamental concepts
are private property and contract. The value of property rights is intertwined with the ability
of parties to enter into contracts governing the use of their property. Contract law
determines whether and how agreements among parties will be legally enforced and a
major part of its function is to increase efficiency in economic relations.
The mix of property rights, including personal, collective and communal rights, varies
over time and place. These rules alter the costs and benefits involved in coordinating activity
in different organizations. They interact in a symbiotic process of cause and effect changing
over time.
Property rights are very important in structuring exchange and production; because
they specify what people are entitled to do with resources and goods. Different property
right structures enable us to clarify situations where markets present the most appropriate
coordinator and allocator of goods and resources and where alternative organizational
responses are either necessary or more efficient.
Transaction costs are not independent of the time of the property rights in which
trade takes place. If we look back through historical time we can see how these property
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rights have changed to facilitate development. In some cases ownership rights are seized.
Yet for economic growth, societies require well defined and enforceable property rights. This
reduces risk and uncertainty, and can bring peace of mind to individuals. In the 20th century,
assets have changed from private to public ownership, and then back again through
privatization sales, motivated by economic change and the political decision-making process,
in many countries. The approximate mix of property rights for economic development is
subject to change and debate.
WORKING QUESTIONS 3
1. Why is the rule of law important for the working of economy?
2. What are the main functions of rules in economic life? Explain each one briefly.
3. Explain the significance of property rights.
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CHAPTER 4
PRODUCTION, ECONOMIC GROWTH AND DISTRIBUTION
INTRODUCTION
Economics is concerned mainly with production and distribution problems of society. Almost
everything we need requires human effort to produce it. In the production process inputs
are transformed into outputs. Outputs are products that people consume. All production
involves the application of human work to various natural materials in order to produce
goods and services. Goods are tangible products while services are intangible. Work and the
natural environment are the ultimate sources of everything produced in economy.
Average consumption per person of a society is one of the most important indicators
of the level of development. Since the society cannot consume more than it produces in the
long run, the standard of living of a society is determined by its productive capacity.
All societies face a production constraint. In order to explain this constraint we will
examine, firstly, the inputs of the production process. These inputs are called the factors of
production.
3.1. FACTORS OF PRODUCTION
Factors of production are usually divided into three broad categories: land, capital and labor.
Land: In economics land has a much wider meaning than in everyday speech. Land refers to
natural resources, which include not simply farmland or the industrial site, but minerals
underground, oil and gas, even fish stock in the sea.
Capital: The word capital has two different meanings in economics: financial capital and
physical capital. Financial capital includes securities issued by governments and companies.
Physical capital is the produced means of production and refers to such items as plant and
equipment, factories, warehouses, or the infrastructure which includes, for example, roads,
schools and hospitals. Capital as a factor of production is physical capital.
Labor: Labor is the human resource, the people who use the land and capital to produce
output. Labor can embody very different physical and mental talents, reflecting differences
20
in innate abilities and large variations in the type and levels of education and training. It can
be categorized as unskilled, semi-skilled, and skilled.
3.2. PRODUCTION CAPACITY
The production capacity of a society is determined by the quantity and productivity of labor
employed. Labor productivity is the relationship between the quantity of labor used in
production and the quantity of output produced. It is measured by output per person per
hour.
Factors determining labor productivity are: labor quality, the quantity of capital per
worker, the level of technology, the social-economical conditions of the society, and the
living conditions of workers. The social, political and legal institutions, the custom and
practice in society affect labor productivity. The laws and customs determine, in part, how
the inputs will be brought together and hence the nature of the overall production
constraint facing society. There is an interrelationship between labor productivity and living
conditions. Any increase in labor productivity may raise living standards (health, nutrition,
environmental conditions) and any improvement in living conditions, in turn, may promote
labor productivity.
Economic resources are limited. The limitedness of resources in comparison with our
needs is called scarcity. Scarcity underlines the significance of the usage of resources
effectively. Effectiveness or efficiency in production is to produce the highest possible
output using the existing resources. In other words, efficiency in production is to produce a
given amount of output using the least amount of inputs.
The purpose of societies is not, however, to maximize the quantity of production at
any cost. Some of the natural resources are not renewable; mineral reserves can be mined
once only, they cannot be recreated. With the increasing production they are depleted and
destructed. Maximization of the current production at any cost would be at the expense of
the future production and, therefore, would reduce economic possibilities of future
generations.
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3.3. ECONOMIC GROWTH
Since the only way of increasing living standards of societies is to increase their productive
capacities, the main purpose of economic policies is to seek the ways of increasing this
capacity.
Economic growth is the increase in total production of a country. The increase in total
production may be a result of an increase either in total labor employed or an increase in
labor productivity, or both. The quantity of labor is a function of total population; with an
increase in population the quantity of labor will also increase. Today, most of the countries
have not any problem in providing working people. The main problem regarding labor is to
increase its productivity.
We have learned in the previous section that labor productivity can be increased by
raising the capital per worker, technological development, improving labor quality, and
progress in the socio-economical structure of the society and living conditions of labor.
The total quantity of capital existing in any country at any time is called total capital
stock. Capital stock is increased by investment. When the rate of increase in capital stock is
higher than the increase in the total number of workers, capital per worker will rise.
In modern societies although the increase in capital stock is an important factor
augmenting productive capacities, technological advances are of primary importance.
Technology may be defined as the way of producing. Technological development enhances
productivity and results in more effective ways of production. It decreases the quantity of
inputs necessary to produce one unit of output. As a result of technological development
labor productivity increases faster than capital stock.
3.4. INVESTMENT
a. Why Investment is Important?
Investment is the most important step in the cyclical process of production, income, and
consumption. Investment in this context is a real expenditure on buildings, machinery and
equipment, or any other tangible tools used in production.
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The most important type of investment is investment in fixed capital. Fixed capital
investment includes investment in machinery and equipment, and structures such as
buildings, factories, offices, pipelines. Companies also invest smaller amounts in inventories.
Investment is made by private business, government, and households. Of all these
investment flows, private fixed investment is the largest; it is also the most important for the
rise and fall of the overall economy. The initial decision by a private profit-making firm to
invest is the first step of its activities. Governments invest mostly in public infrastructure and
in the capital assets used by public enterprises, like utilities or schools. Some part of
investment is made by individuals in their own homes.
For the overall economy investment is a very important economic force. Economic
benefits of investment include economic growth, job creation, transformation, and
productivity and competitiveness:
• Economic Growth: Investment spending is the most important source of economic growth.
When investment is strong, economies grow more quickly, and so do incomes.
• Job creation: Most of the paid jobs depend on investment. In fact, the relationship
between investment and jobs is complex, because sometimes new capital equipment can
replace workers, resulting in a decrease in employment at a particular firm. The level of
overall growth and employment, however, still depends very positively on the overall level
of private investment.
• Transformation: Economies don’t just expand, they also evolve over time: adapting to new
technology, new consumer preferences, and new social and environmental challenges. New
technologies, products, and ways of working almost always have to be embodied in new
capital; like equipment, buildings, and infrastructure. We need investment, therefore, to
allow the economy to incorporate these structural changes.
• Productivity and competitiveness: We have explained above the relationship between
investment and capital stock, and labor productivity and capital per worker. The higher the
capital per worker, the higher is the productivity. And, there is a negative relationship
between productivity and average cost. Employers can boost productivity by new
investment. As we have mentioned above, investment in new machinery and equipment is
especially important to productivity growth.
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b. What Determines Investment?
Private investment is motivated by the expectation of profit. Firms review current business
conditions to judge whether an investment will be profitable in the future. Most investments
are irreversible: once an investment is made in fixed capital, it is impossible to take it back
for a refund. This makes firms inherently cautious, and it is hard to predict private
investment. Factors that influence the expected profitability of a new investment, and hence
investment spending, are: current profits, capacity utilizations, current and expected
economic growth, interest rates, and political and legal environment.
Current profits are important, as an indication of future profits. Current profits also
provide funds for new investment. Capacity utilization is the level of utilization of existing
facilities, and it is another crucial factor. Even if current profits are high, a company will not
invest in new facilities if its existing capacity is still partly idle.
There is interdependence between investment and growth. If an economy is growing
quickly, then companies are likely to expand their investment: they are more confident that
they’ll be able to sell their output. Investment and growth thus reinforce each other: more
investment leads to more growth, which in turn leads to more investment. If investors are
optimistic about the future, they increase their investments. This stimulates growth, strong
demand conditions, and healthy profits, thus validating their original optimism. When
investors are pessimistic, they cut back their spending. But this undermines growth, sales,
and profits.
Interest rates also affect investment spending. Companies often borrow external
funds to pay for a new investment. The rate of interest determines the cost of borrowing
and affects, therefore, profitability of investment. Interest rates also indicate how much
investors could earn by buying a purely financial asset, like a bond. If investors can earn high
profits on paper assets, they are much less likely to take on the extra risk and trouble of
investing in a real business.
Finally, private investors will also take account of the broad political, economic, and
legal climate before they commit funds for a new investment. They worry about regulatory,
tax, or policy changes that might undermine future profits.
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3.5.
DISTRIBUTION OF INCOME
We have already underlined that economics is mainly the study of production and
distribution of what is produced or total income. We discussed production above. There are
two broad ways to think about the distribution of income: across the major factors of
production or functional distribution (that is, among labor, capital, and other inputs), and
across different individuals or personal distribution. These two approaches are related, of
course, since factors of production belong to quite distinct groups of people. Capital income
is concentrated among the wealthy households who own most of the national wealth.
Working households, on the other hand, receive most of their income from employment.
Thus, there is a clear overlap between the functional and personal distribution of income for
the simple reason that particular households have particular types of factor income.
a. Functional Distribution of Income
In functional distribution of income, the shares of labor income and capital income are
compared. Labor income is wages. Capital income is the sum of profit, rent, and interest.
Distribution across factors depends on the economic, political and social power of the
owners of each factor. Under capitalism, employers pay wages and salaries on the basis of
their need to attract and retain employees, and extract necessary labor effort and discipline
from them. How much they have to pay depends on broad social and institutional factors
like trade unionism, minimum wages and other labor regulations, the level of
unemployment, and the government’s social policies. Capital incomes are then determined
as the residual remaining after wages and other input costs have been paid out. Societies in
which the share of labor income is relatively higher are more egalitarian.
b. Personal Distribution of Income
Personal distribution of income measures differences in income across different individuals
or households. Most individuals receive income from more than one source: from their own
work, from government programs (like unemployment insurance, public pensions, or child
support benefits), and from capital.
The degree of equality or inequality in personal distribution of income is measured by
comparing the percentage of total income received by each percentage of households.
Calculation is generally made for five groups, each consisting of 20 percent (quintile) of
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households. In Turkey, for example, the share of the poorest quintile was 6.2 percent, while
the share of the richest quintile was 45.9, for 2014. The ratio of the share of the poorest
quintile to the share of the richest is a measure of inequality (in our example it is 7.4).
Another way of measuring inequality is the calculation of Gini coefficient, which is between
zero and 1. The higher the value of Gini coefficient the more egalitarian is the distribution of
income. Gini coefficient for Turkey in 2014 was 0.391.
c. What Determines Distribution of Income?
The main factors affecting the distribution of income are: Rights of property and inheritance;
government social policies; individual differences regarding to personal abilities, education
and training, and hard working.
Government’s spending and taxing activities, social programs and incomes policies
have significant effect on the overall distribution of income. If most taxes are progressive,
they impose a relatively higher burden on higher-income individuals. A regressive tax, on the
other hand, imposes a proportionately larger burden on lower-income individuals.
Meanwhile, many forms of public spending may make a significant contribution to the wellbeing of working and poor people.
WORKING QUESTIONS 4
1.
What are the factors of production?
2.
What determines the productive capacity of a society?
3.
What is the labor productivity and how it is determined?
4.
Define the following concepts: scarcity, efficiency, and technology.
5.
Define economic growth and explain by which factors it is determined.
6.
What is capital stock and how it is increased?
7.
What are the factors determining the amount of investment?
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CHAPTER 5
MARKET MECHANISM
In this chapter we define market and explain how the market is working. We will do this by
assuming a perfectly competitive market. There are many sellers and many buyers in a
perfectly competitive market, and individual buyers and seller cannot affect the market
price. We begin with the definition and an overview of markets. Then to we explain what
determines market prices and what causes them to change. And, we will see how the
working of the market mechanism allocates resources.
5.1.
DEFINING MARKETS
The market is an area over which buyers and sellers negotiate the exchange of commodities.
The market is also a set of social institutions in which a large number of commodity
exchanges regularly take place. The key purpose of any market is economic exchange.
Economic exchange requires both buyers and sellers. Buyers have to make a payment to
sellers for products or services bought. The payment is at a price. Price is a mutually agreed
and explicit exchange rate.
Market exchange requires a communication and information system and the rules
of the game. Buyers and sellers communicate with each other in the market, to exchange
goods and services. Organizations of the market give information about products, prices,
quantities and buyers and sellers. Buyers and sellers may never meet; a communication
system and a means of transporting goods and payments would suffice. There may not be a
particular geographical location, where buyers and sellers meet face to face.
Markets are a collection of relationships linking individual buyers and sellers. Market
organizations interlink also the external relationships of private firms, consumers and public
sector organizations.
5.2. HOW DOES THE MARKET MECHANISM WORK?
There is a market for each commodity, and there are three groups of decision makers,
whose decisions determine market transactions: buyers, sellers, and government.
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Prices are the guiding lights; they signal where resources are best used to meet
competing ends. Producers follow price movements in deciding what to produce and
choosing resources to maximize their profits. Prices give vital information to buyers, and
they guide and constrain their purchasing. In short the market mechanism works to allocate
and coordinate goods and resources, and rations them between competing buyers. The
market coordinates the activities of individuals and organizations and provides incentives.
Resource allocation is the outcome of millions of decisions made independently by
buyers and sellers. Buyers decide which goods and services to buy and how much of each.
Sellers decide which goods and services to produce and how much of each. Government
includes all public agencies, government bodies, and other organizations belonging to or
under the direct control of governments. Public organizations have legal and political power
to exert control over individual decision makers and markets.
In market economies, most commodities are, generally, made by a large number of
independent producers in approximately the quantities that people want to purchase them.
Although, sometimes, there may be surpluses or shortages of products, market mechanism
tends to eliminates them.
Now we will examine first the working of the market mechanism in a simple and ideal
form, and will discuss different kinds of markets in the next chapter.
5.3. PRICE THEORY
In this section we try to understand the behaviors of buyers and sellers: how they respond to
market changes. We use a theory which can explain and predict market price and quantity
movements. To do this:
a) We examine first demand and supply: the responses from the two sides of a market.
b) We then study the interaction of demand and supply to give an equilibrium price.
5.3.1. THE THEORY OF DEMAND
When we talk about the demand, we mean effective demand. Effective demand is the desire
to buy backed by the ability to pay. Effective demand has two essential conditions: the
ability to pay (the necessary purchasing power), and the willingness to purchase.
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The most important variables determining the demand for a particular good are: the
price of the good, prices of related goods, incomes and tastes of buyers, and other factors.
We take the example of the carrot and initially focus attention on the price of carrots, to aid
our understanding of buyers’ purchasing plans for this commodity.
a. The Price of the Good
Price is the quantity of money to be paid for a unit of good. It tells us what money the buyer
must give up to buy the product.
The quantity demanded is the amount which buyers plan to buy in a particular time
period. There is a negative relationship between the price and the quantity demanded: A
rise in the price of the good tends to lower the quantity demanded of that good; a fall in the
price of the good, on the other hand, tends to increase the quantity demanded. This is the
law of demand. The law of demand describes a general tendency, not an immutable law for
all situations: the quantity demanded is usually inversely related to price.
We can explain the inverse relationship between price and quantity demanded by
the substitution effect and income effect of a price change. We begin by initially looking at
the individual consumer. When prices are very high, unless the person has a strong
preference for a good, cheaper substitutes will be bought.
Take the case of carrots, as their price falls individuals will be induced to buy more
carrots. The absolute and the relative price of carrots have fallen, in comparison with
substitute goods. Carrots will look a better buy when compared with substitute goods whose
prices have not fallen. There is a substitution effect in favor of carrots as a result of the price
change. And the purchasing power of lira in the pocket (real income) will increase to buy
more, because carrots are not as expensive. Imagine that the money price of carrots falls
from 100krş to 75krş per kilo. If a consumer had previously planned to purchase 10 kilos of
carrots, then this price fall, would be equivalent to an increase in income of 2.50 liras,
because for each kilo of carrots the consumer would save 25krş. Some of these real income
benefits might be used to buy more carrots. Such a reduction in price gives an increase in
real income. We call this the income effect of a price change.
Taken collectively, in aggregate, within the market some people who were previously
unwilling or unable to buy carrots at higher prices, will plan to purchase, as the price is
29
reduced. And those who already buy, even at the higher prices, want to buy more as the
good becomes cheaper. The overall result is an increase in quantity demanded. A fall in price
persuades and enables buyers to change their plans; they aim to purchase more.
If the price of carrots rises, this time the quantity demanded will fall, again as a result
of substitution and income effects.
b. Incomes of Buyers
An increase in the level of income means that the ability of buyers to buy is increased. While
a rise in income increases the demand for most of goods, it may affect the demand for some
other goods negatively. For example, as the incomes of buyers rise and they become better
off, they may reduce their demand for bread and may switch their purchasing power to beef
steak.
c. Tastes or Preferences of Buyers
Taste is the consumer’s relative preference for a good. The buyer with a strong liking will
demand more than one who is not so keen. When buyers change their taste for certain
products this is reflected in demand. An increase in the number of vegetarians in the
community, for example, will bring an increase in demand for vegetables, and the demand
for meat will fall.
d. Prices of Other (Related) Goods
The effect of a change in the prices of other goods depends on whether they are substitutes
or complement goods. Some goods are substitutes for each other. If the price of cabbage
were to rise, for example, buyers may well switch their demands to carrots. At every carrot
price, after a cabbage price increase, some buyers will switch their demand to carrots.
Despite a constant money carrot price, carrots become a better buy, in relation to an
alternative, like cabbage. The demand for carrots increases. On the other hand, should the
price of cabbage decrease, some buyers would change their plans and switch to cabbage,
now relatively cheaper. The carrot demand might fall.
Some goods are complements, their consumption and hence respective demands are
also related. A rise in the price of tea, bringing a fall in the quantity demanded, could induce
a fall in demand for sugar. These goods are consumed together. A fall in demand for tea will
also affect the demand for sugar; the demand for sugar will fall.
30
e. Other Factors
There are other factors affecting demand. The weather may have an impact on
consumption. A colder winter may induce an increased demand for fuels. Hot weather, on
the other hand, may lead to an increased demand for cold drinks.
It is quite natural that, at any time, changes in more than one variable influencing the
demand for a good may have opposed effects on demand. In such cases, the direction of
change in the demand for the good would be set by the relative strengths of opposing
factors.
The discussion of the demand side of the market gives only half the story. We cannot
say anything about the price which will prevail in the market, until we examine the supply
side. We have to display the intentions of both sides of the market to understand how the
market price occurs.
5.3.2. THE THEORY OF SUPPLY
The market supply is the amount of a good that all the suppliers, in a particular market, are
willing and able to supply over a particular time period. Many factors influence what
suppliers offer to sale. These factors are: the price of the good, the prices of other goods,
cost of production, and other factors.
a. Price and the Quantity Supplied
There is a positive relationship between price and the quantity supplied. This positive
relationship between the price and the quantity supplied is called the law of supply. The law
of supply states that if the price is rising, the quantity that suppliers are willing to supply will
increase; if the price is falling, the quantity that suppliers are willing to supply will fall.
Suppliers can be induced to supply different quantities depending on the level of price. Some
prices are so low that no seller would plan to offer goods for sale; because they could not
cover costs and make a profit. As prices rise, suppliers will supply a higher quantity.
b. Cost of Production
The main purpose of a private firm is to maximize its profit. Profit is the difference between
total revenue and total cost. Any change in production cost will influence the profitability
and, therefore, supply of the good produced by the firm. There is a negative relationship
31
between the cost of production and the supply of the good: When the cost of production
increases the supply of the good will fall, and vice versa.
c. Other Factors
Some additional factors may also influence the supply of a good. Natural conditions, for
example, may have important effects on the supply of the agricultural goods.
Different variables may exert opposing effects on the supply of a good, as in the case
of demand. The supply of the good will either increase or decrease depending on the relative
strengths of these opposing factors.
5.4. EQUILIBRIUM PRICE AND QUANTITY
a.
How Does Equilibrium Occur?
The price and quantity which will actually prevail can only be determined by bringing the
demand and supply sides of the market together. Only then we can know which of all the
possible hypothetical prices will rule and what quantity of goods will actually be traded.
When the quantity demanded equals the quantity supplied there is equilibrium. The
plans of demanders and suppliers are both satisfied in equilibrium. The price which equates
the quantities supplied and demanded is the equilibrium price. At this price the market is
cleared, there are no unsatisfied buyers or sellers; neither shortages nor surpluses.
If the price is higher than equilibrium price, then the quantity supplied exceeds the
quantity demanded. This price will not bring a balance, because producers will have goods
left on their hands. There will be a surplus, an oversupply, because buyers at such a
relatively high price are not willing and able to buy all product supplied. In that case, there
would be a downward pressure on the price. The price will fall and this will continue until
the equilibrium price is reached.
Conversely, if the price is lower than the equilibrium price, the quantity demanded
will exceed the quantity supplied. Buyers will not be satisfied with the supply offered in the
market. There will be an excess demand and a shortage of produce. At such a low price
suppliers are willing to offer a smaller quantity, while buyers are willing and able to buy a lot
more than is on offer. In that case, there would be an upward pressure on the price. The
price will rise until equilibrium price is reached.
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In both of these cases the plans of either buyers or sellers are frustrated. This is
disequilibrium; buyers’ and sellers’ plans are not harmonized. At a price higher than the
equilibrium price, suppliers’ plans to sell are not fulfilled; buyers are not able or willing to
buy all the supply at this price. At a price lower than the equilibrium price, buyers are
prevented from fulfilling their plans because suppliers are not willing or able to meet buyers’
demands, at this price.
b. How Does Equilibrium Change?
The equilibrium price and quantity will change if demand or supply or both change. Should
anything upset equilibrium, there will be tendency for it to be restored.
If the demand for any good increases while there is no change in supply, the market
price and quantity will increase. If the demand for any good falls, while there is no change in
supply, the market price and quantity will fall. If supply increases when there is no change
in demand, the equilibrium price will fall and the quantity will increase. If supply falls when
there is no change in demand, the equilibrium price will increase and quantity will fall.
When both demand and supply change, however, the matter is not so simple. When
both supply and demand increase or decrease simultaneously, there will be two forces
pulling price in opposite directions. The resultant equilibrium depends on the relative size of
the changes in demand and supply. If the sizes of these opposing forces are equal, price does
not change. The only impact in this case would be the change in quantity traded in the
market. If the increase in demand had been greater than supply then the equilibrium price
would rise. If the increase in supply had been greater than demand then the equilibrium
price would fall.
The reaction of the market to a change in demand leads to a transfer of resources.
Thus a change in the consumers’ tastes causes a reallocation of resources. While the
production of products that the demand for which has increased rises, the production of
products that the demand for which has decreased falls. The producers of the first will
expand production; they will therefore hire more workers and generally increase their
demand for factors of production. The producers of the second will reduce their production;
they will therefore lay off workers and generally demand fewer factors of production.
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In this process, while the prices of the factors of production now demanded more will
increase, the prices of factors now demanded less will decrease. These changes in relative
prices of the factors of production will affect incomes of their owners and change the
distribution of income.
In summary, in an idealized market economy, for most of the goods, the basic
questions of what should be produced, how they should be produced, and how the income
created should be distributed among the owners of production factors (workers, landowners
and capital owners) are solved by the working of the market system automatically.
WORKING QUESTIONS 5
1.
Write two different definitions of the market.
2.
What is price? What is the function of the market (price) mechanism?
3.
List the factors affecting the demand for a good.
4.
What is effective demand?
5.
What does the law of demand say?
6.
Explain income effect and substitution effect of a price change on the quantity
demanded of a good.
7.
Define market supply and explain the law of supply.
8.
What is equilibrium price and how it is determined?
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CHAPTER 6
COMPETITION AND MARKET TYPES
In the previous chapter we examined the working of the market mechanism in a simple and
idealized perfectly competitive market model. In fact, there are different types of real
markets. Markets are classified by the degree and the extent of competition that they
exhibit. Here we will classify markets simply as perfectly competitive markets and
monopolistic markets.
In perfect competition there are many sellers and many buyers of the same good. No
individual buyer or seller has market power to influence market price. In monopolistic markets,
however, individual seller has the market power; it can influence the market price.
6.1. COMPETITION: HOW?
In any economy there are many private companies. The main purpose of the private
companies is to maximize their profits. To achieve this purpose they should operate
efficiently. But the efficiency and profitability of any firm depends not only on its own
policies and operations but also on the behaviors of their rivals. Thus, they also have to
consider the economic threat posed by competing firms.
Competition opens up new opportunities for individual firms: they can expand
revenues and profits by winning a larger share of sales from competitors. But competition
also poses new challenges, since other companies are also trying to capture more market
share at the expense of their competitors.
If a company can’t stand up to the competition, it won’t make quite as much profit as
other companies, and eventually it will be destroyed by these competing firms producing
better products at lower cost. Most of the company behaviors are motivated, and indeed
enforced, by competitive pressures from rival companies. This pressure leads companies to
do dramatic, innovative, often painful and even destructive things – not solely because their
owners and executives are greedy, but because they desperately want to stay in business.
Let’s explain how competition occurs using a simple example of two companies:
Company X and Company Y. They produce televisions and they sell into the same market.
Both firms also hire their workers from the same general community of worker households.
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Each firm’s owners want to see their own firm succeed and the other firm fail. The two
companies confront each other in the three distinct places: product market, labor market,
and financial market.
The most important is in the product market; market for new TVs. Here each
company must convince customers that its TV offers superior quality for a lower price. If
they can’t do this, then they won’t sell the televisions they have produced, and will never
earn a profit. Companies X and Y also compete in the labor market. And, a company’s ability
to employ and discipline its workers affects its overall performance. Finally, companies must
also compete for cheap financial capital in financial market because they finance their
operations not only by their equity capital but they also borrow from financial market.
6.2. PERFECT COMPETITION VERSUS REAL-WORLD COMPETITION
In perfect competition, there are many tiny firms. They cannot grow bigger, because their
average costs per unit of product rise as they grow. This assumption is valid, however, for
only a small part of markets. In most markets, larger companies have clear cost advantages
in producing most goods and services. As the volume of output grows average costs per unit
fall dramatically. This is a powerful stimulus for companies to grow.
The decline in the average production cost in an industry as the volume of output
grows is called economies of scale. In most cases, there is room only for just a few
manufacturers because of economies of scale. Economies of scale explains why small
companies cannot compete in most industries, and why companies always try to boost sales
and make better use of fixed capacity.
a. Perfect Competition
The main assumptions of the perfect competition are:
(a) Firms produce completely identical products, so that consumers can’t tell the
difference between one variety of a product and another.
(b) Market players have perfect information about all product qualities and prices, so
there are no search or transaction costs; neither risk nor uncertainty.
(c) There are no barriers to joining or leaving an industry. Freedom of entry prevails;
no existing firms or buyers can bar new entrants. There is free exit.
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(d) As any firm is very small in relation to the market as a whole, it has no say in the
price it charges. The price which faces the firm is given by the market. Individual
producers are powerless; they cannot influence market trends. And they cannot
try to anticipate or respond to the behavior of their competitors.
In this theory, competition is so intense and anonymous that it actually eliminates
super profits: prices are driven to such a low level that companies can only just cover the
costs of production, and earn only normal profits, in the long run. The reason is that, the
guiding light of high profit attracts other firms into the market and encourages existing firms
to build bigger plants. With the increasing capacity, the overall market supply would
increase. If industrial supply increases more than market demand, and price falls. The
process comes to rest when all firms make normal profits, until there is a change in the
market affecting either price or costs.
On the other hand, if firms make losses, they will leave the industry. The reduction of
firms in the industry will decrease the market supply and this will continue until prices in the
industry have risen up to the level where the remaining firms can make a normal profit. So
firms will move into, or leave the market, until firms making only a normal profit.
b. Monopolistic Markets
Real-world competition is very different from perfect competition. The larger a company, in
general, the lower its production costs become thanks to economies of scale. The fact that
companies are very large in no way implies, however, that competition has become less
intense. The incredible resources, technology, and managerial abilities that modern large
corporations have at their disposal allow them to compete in many ways and places.
Competition is fierce.
In contrast to perfect competition, monopolistic firms can make supernormal profits
which continue in the long run, because no other firm can enter to share existing profits.
Perfectly competitive model implies equal market power among sellers and buyers.
But in reality, one side of the market, sellers or buyers, may have the upper hand. Indeed,
supply and demand are not separate in markets where, for example, the impact of
advertising is engineered by large corporate suppliers who can affect demand. Moreover,
within groups of buyers or sellers, some may have greater income and power; the market
37
does not operate on the basis of one person one vote. Spending and decision-making power
may be very unequally divided.
In perfect competition there are no discussion of risks and uncertainties faced by
real-world actors. Buyers and sellers have no long term commitment to each other in the
market. People can switch their exchange transactions with ease. Whatever the good, all
products are homogenous; and whoever the buyer or seller, all people are assumed to be
the same for the purpose of market trading. There is no place for trust, hope or doubt, and
no requirement for necessary institutional features. Actual markets, however, are set in
particular historical context. The determinants of supply and demand are fashioned in part
by the institutional characteristics of the society in question and its past evolutionary path
and social norms.
In perfect competition prices are flexible; any change in demand, or in supply or both
influence the market price instantaneously. Monopolistic markets, in contrast, are
characterized by inflexible prices.
In monopolistic markets, there may be situations where prices do not vary
immediately in the event of market changes. In many markets, production is performed by a
large organization, providing long-term research and development and having huge physical
and human capital inputs. Products are usually more complex than the simple carrot which
takes little time to consume. They need after sale service, and have been differentiated from
others. These are not simple goods produced by the individual artisan or small-scale factory
environment, where the enterprise could often respond very quickly to changes in demand.
Many markets are dominated by massive organizations, giant suppliers who have
discretionary power over the prices they charge. They advertise and partially orchestrate
market outcomes. They do not change the money price as market conditions vary. They may
be slow to respond to changes in the real-world conditions. In fact, it is often expensive to
change prices. It may be cheaper to leave them unchanged. Sellers may be unwilling to set
off price wars with their rivals, so they may prefer to leave prices unchanged. They may
resort the other forms of non-price competition, like promotional offers or changing quality
and product design. Prices are sticky and markets are not neatly cleared by price
movements.
38
People making decisions in real life do not have perfect information; they often have
to proceed by trial and error. Production takes time; plans cannot be instantaneously
changed and fulfilled. Actual price changes are the results of many changes, often pulling in
different directions. In real markets there may be constant movement and discord. Markets
may never reach equilibrium. There may be forces at work which encourage instability.
Monopolistic may be quite unsure of its rivals’ actions and reactions. They may not
know how their competitors will behave in new situations in the present and future. There is
no guarantee that the future will behave as the past. Where the action of any one large
firm alters the competitive environments for others, then the impact of a price cut or a
product change may reverberate through time, in price wars, promotional battles, the
instigation of new products and the take-over and merger activity.
The action of one firm can significantly affect the others in monopolistic markets.
Indeed, the firms may face a good deal of risk and uncertainty, which arise to a considerable
extent from the possible actions of rivals. Firms can take a variety of different strategies to
handle interdependency. They may try to outplay their rivals to gain an advantage on them,
or they may cooperate by colluding with their competitors. A monopolist who does not
collude with rivals may conjecture that rivals will match price cuts but will not match price
increases. If one of the firms cuts its price, its rivals would react by cutting their prices; but if
any one of the firms increases its price the other firms do not follow it.
The non-collusive behavior model explains why prices are sticky. Price changes may
be expensive or could simply the result of collective behavior. Although monopolist may
experience relatively stable prices for some periods and resort the other forms of non-price
competition, there may be times when price cutting is used for raising or defending their
own individual market share.
Monopolists often cooperate to reduce the risk and uncertainty. However, collusion
is often illegal. Thus, they may adhere to their own informal rules and customs. These may
represent a more effective strategy for cooperation. Despite the law and inherent problems
arising from differences in costs and efficiencies between firms and difficulties relating to
the share out of profit, cartels can flourish. Cartels are the informal organizations of
monopolistic firms established to cooperate in pricing, output or other activities. In cartels,
39
firms link up to act in concert, collaborating and sometimes acting as if they were a single
monopolist.
6.3. THE CONSEQUENCES OF COMPETITION
Competition is generally accepted as an efficiency-enhancing force, but it is not always a
useful, beneficial force.
To be sure the competitive struggle to survive elicits some forms of business behavior
that are genuinely efficient. These can translate into broad social benefits, assuming that
new efficiency is shared, one way or another, with workers and consumers. Spurred by
competition, managers will work hard to imagine ways of producing better products, and
better processes. That is, competition may promote production of goods and services more
efficiently. This leads to more investment in both capital equipment and technology.
Competition also allows consumers some degree of choice in their purchases. It thus
imposes a particular form of accountability on companies to deliver high-quality,
competitively priced output.
At the same time, however, competition imposes many economic and social costs, as
well. Competition may also lead to irrational or destructive outcomes for the whole system.
These indicate the complex and often contradictory character of real-world competition.
Companies will respond to competition by cutting costs in any ways imaginable –
including by reducing wages or intensifying work in socially damaging ways. They may even
try to shift their costs onto others: if they can find ways to impose costs of their operations
on innocent parties. Ways of doing this include pollution, the sale of unsafe products, and
forcing consumers of their products to bear hidden or unexpected costs. Since having a
product that’s differentiated in the minds of consumers is a key source of competitive profit,
companies try to create this differentiation in ways that are wasteful, useless, or even
destructive. Some ways of similar product differentiation are: massive and often misleading
advertising, excess packaging, and artificial obsolescence where products are deliberately
designed to wear out or become useless prematurely.
Companies may not invest in innovations which they can’t patent for fear that
competitors will simply copy them. For similar reasons, private firms consistently
underinvest in on-the-job training and skills development for their workers since they worry
40
those trained workers may subsequently be hired away by competitors. Yet, they,
sometimes, spend money on attempts to frustrate or undermine their competitors’
strategies; for example, by spying, sabotaging, or needlessly duplicating their competitors’
projects. And, this spending is unproductive.
Competition may clearly be too intense. It may result in all companies in an industry
operating below their normal efficient scale of production, imposing a wasteful duplication
of excess capacity. It can drive profits too low, undermining the ability of firms to invest in
new capital or research and development (R&D). Companies which are utterly challenged
just to survive will produce inferior products, simply because they cannot invest in higher
quality. If all companies in an industry suffer from the same over-competition, then the
whole industry will be marked by shoddy, stagnant, even unsafe products. And when
companies fail, both their owners and workers suffer massive economic losses. Competition
is not, therefore, free. It constantly imposes real and substantial costs on the economy.
These costs must always be evaluated against its benefits.
WORKING QUESTIONS 6
1.
How markets can be classified?
2.
What are the main assumptions of the perfectly competitive markets?
3.
Why are the prices in some markets inflexible?
4.
Compare perfect competition and monopolistic markets.
5.
Is competition always a useful and beneficial force? Why?
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CHAPTER 7
THE ROLE OF GOVERNMENT AND
NON-MARKET RESOURCE ALLOCATION
INTRODUCTION
Market is not the only resource allocation mechanism, even in a market economy. Some
goods and services we need provided by non-market mechanisms. The government plays a
significant role in the provision of goods. It has an important hand not only in the provision
and allocation of particular goods but in setting and policing the rules of the game.
Moreover, it acts as a major market player.
We have two purposes in this chapter: to clarify the role and significance of
government in a market economy, and examine the non-market means of providing and
allocating resources. We will study non-market resource allocation and show in what
situations the market mechanism fails or simply does not exist.
6.1. GOVERNMENT’S ROLE
The state played a crucial role in the emergence of capitalism, and a strong central
government has guided it. State actively supported private-sector investment and
production. It used tariffs and trade policies, capital subsidies and public ownership,
extensive regulations, labor market measures, and military force to foster the establishment
and growth of capitalism. And it helped to establish private ownership rights. It also created
a unified market at home by: breaking down local barriers, standardizing weights and
measures, and providing passable and safe transportation routes.
The state has been a basic player in the evolution of the rules of the game. State
organizations using their power provide the overall rules. They act as coordinators; they
legitimize and coerce, tax, and spend. They often act also as producers and market players.
Governments also tried to achieve social justice through taxation and subsidies, changing the
distribution of income and wealth. They emphasized economic development and growth.
The role of the complex organizations of state and market, evolve uniquely in the
time and place. In recent years, in the world generally, the predominant mood has been for
the state to play a much smaller part in the economy. Since the late 1970s the objective has
42
been to roll back the frontiers of the state. Privatization has become a watchword since
1980s. Privatization includes the sale of state-owned assets to private individuals,
households and organizations. It includes also deregulation, encouraging competition, for
example, by contracting out of services previously provided by government organizations.
The privatization principle emphasizes private ownership, the use of markets and
competition. For this principle, business firms should supply where they can, and
competition and price mechanism should be used more widely.
However, governments still act as both regulators and market players. They set legal
framework, the formal rules of the game. Government organizations operate as customers
and competitors of business firms. Governments operate in productive capacities in some
services to households and firms.
Additionally, the Global Financial Crisis in 2008-2009 reminded us that markets by
themselves are not necessarily efficient, stable or self-correcting; and, they do not in general
lead socially acceptable outcomes. It underlined the indispensible role of the government in
the provision of economic stability and improvement of living conditions of people. Where
there is market failures there would be government intervention.
Many functions in the social life are directly funded and controlled by governments.
The role of the government in the economy may be summarized under three headings:
Government is a rule-maker (regulator), a market player, and a policy-maker and interferer.
a. Government is a Rule-Maker (Regulator)
Markets, to function efficiently, have to be clearly based on institutionalized rules; markets
themselves have to be organized. They need rules of the game in order to function in a well
ordered fashion, to coordinate the plans of buyers and sellers. Market players are required
to abide by the rules. To work effectively markets have to provide security. Rules are
expected to convince market traders of justice and market fairness.
The government makes, changes, and police the rules. It has a vital role in setting the
legal framework for the market and recasting and influencing some of the rules of the game
as the economy evolves.
The rationale for the government’s legislation and policing is that people have to
have confidence in the product or service they buy.
43
Particular rules are maintained,
whereby participants have confidence that they will not be cheated; where there is official
recourse to outside bodies should there be a dispute. In particular where consumers are
buying complex goods or committing large amounts of money, they need protection. Market
players do not have perfect knowledge or the necessary specialized expertise to evaluate the
information available.
b. Government is a Market Player
Government organizations utilize markets; they are market players; they act as buyers and
sellers. They are the producers of many goods and services, and buyers of many other goods
and services.
Public sector as a whole is the biggest buyer. In Turkey, for example, the ratio of the
total public spending to national income is about 40%. An important part of the industrial
products had been produced and supplied by the governments both in Turkey, until recently.
Additionally, state banks (Ziraat Bankası and Halkbank, for example) and other public
financial institutions play a critical role in the provision of financial services.
c. Government is a Policy-Maker and Interferer
Government intervenes in the market process by imposing taxes and providing subsidies,
controlling prices or stepping in where markets fail.
The government sets taxes and subsidies in order to achieve a variety of ends. The
primary purpose for setting taxes is to raise tax revenue. Taxation is the main way of
financing government expenditures. But taxation may be used to reduce the adverse effects
of some economic activities. Taxing the polluters, for example, may make them seek the
ways of reducing pollution. Subsidies may be given to increase the production and
consumption of some goods and services, for the interest of the society as a whole.
Moreover, governments may directly intercede with price controls, setting price
above or below the market equilibrium, especially during economic crises and war times.
Additionally, transferring state monopolies into the private sector, by the privatization of
public utilities, has been accompanied by a regulatory framework, which involves price
regulation. The industry regulator curtails price setting freedom, puts an upper limit on
prices. Insufficient market competition is a reason for price controls, to prevent private
companies from increasing prices to levels which the market might bear.
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In addition to its role of market player and rule maker, the government affects the
decisions of other consumers and producers with its economic policies that we will examine
in the following chapters.
6.2. WHY GOVERNMENT?
The market mechanism cannot provide some goods and services demanded. Additionally,
the way of provision of some other goods and services by the market may not be acceptable
for the society. Governments take the responsibility of the provision in both situations. The
goods that supplied by governments may be categorized as public goods, quasi-public goods,
and merit goods.
a. Public Goods
Pure public or communal goods, like defense, law and order or public administration, cannot
be allocated by the price mechanism. For example, national defense, of necessity, is
communally and not individually consumed. Pure public goods are not bought and sold in
the markets. In fact, markets do not exist for them. Government provides these goods. They
are supplied to the community as a whole without direct charge related to the individual
use, independent of an individual’s income or desire. Decisions about the amount of
resources allocated for these goods are made by a political process, not by the market.
The following attributes make public goods impossible to allocate by the market:
1) Non-excludability: No one can be excluded from the security provided by the
government. Those who do not pay still receive a benefit. Security services are expensive
and cannot be divided up or restricted for individual use. All of the citizens have the
protection of the armed forces. However, unless there are enough altruistic people, all
agreed to look after the common good, narrow self-interest would mean that insufficient
resources would be forthcoming to provide such public goods. Many people might
benefit from the security without paying for its provision. There is no way of stopping
their consumption. Certainly, private business firms could not make a profit, because
unlike any divisible good, national defense cannot be restricted to those who pay.
2) Non-rivalry: People are not rivals in the consumption of pure common goods. When
defense is supplied, the degree of protection given to one family does not reduce the
45
availability of such benefits for others. There is no need to ration by the price mechanism,
even if that were possible. Benefits are for everyone, whether wanted or not.
3) Non-rejectability: The public good cannot be rejected like any private good for own
consumption. Those who do not wish to be defended by a nuclear deterrent and armed
forces are not able to opt out.
For these reasons public goods are provided by the government at no direct price to
people who benefit. The cost of producing such goods is paid from the public funds.
b. Quasi-public Goods
Quasi-public goods have elements of both a public and private good. Some commodities
which potentially could be allocated by the price mechanism are nevertheless provided by
the state. These goods are supplied without a specific charge related to the amount used by
an individual. The provision of roads, pavements, public parks, and recreation grounds are
examples of such quasi-public goods. We do not pay directly for a walk in any park or our
use of any road although we pay indirectly through taxes.
Very often these goods do not display rivalry and excludability. But when these
facilities are used to capacity and over used, then rivalry exists. Consumption for one person
reduces what is available for others. Moreover, there may be the possibility of excluding
people although the goods are only partially divisible.
While these goods are allocated primarily by non-market means, in some situation it
would be possible to charge a price to exclude those who were unwilling and/or unable to
pay. For example, it would be possible to charge for the use of roads. People could be readily
barred if they would not or could not pay.
Although everyone might be in agreement about the need for providing and
maintaining pavements and roads, private business suppliers, in general, could not make a
profit from their provision. Firms could not effectively exclude users, divide these goods or
charge a price sufficient to make profit. Such goods provide social benefits over and above
any private benefits both in production and consumption. These advantages cannot be
wholly captured by the producer in terms of profit or the purchaser in terms of happiness or
utility. The advantages benefit the wider community. If the market mechanism were left to
provide and to allocate roads, for example, insufficient of these would be produced for the
46
welfare of society as a whole. Without communal provision our road and pavement network
would be insufficient to meet the needs of a modern community. Overall resources are
allocated for these quasi-public goods by a political decision.
c. Merit Goods
Merit goods, like health care and education, are consumed by individuals and can be
allocated through the market mechanism; but they have attributes of the public good. Their
acquisition improves the utility of the society as a whole. Education and health care services
can provide considerable social benefits. These benefits cannot be captured by the individual
who buys these goods, or the producer who supplies them. Certain choices about the
acquisition of education, for example, are rarely left to the free choice of the individual. All
people are expected to have a minimum level of education. Merit goods are seen as
important both for individuals and society as a whole. Left to their own devices, people may
have an inability or insufficient desire to buy enough of these goods. People do not have full
information and may be ignorant, for example, of the benefits and nature of different types
of education. Moreover, they may not be prepared or able to buy enough of a good which
confers benefits to others. In such circumstances the market mechanism would lead to an
insufficient production and consumption. This is the reason why most countries insist on
children receiving education to a certain level or the compulsory treatment of infectious
diseases.
Merit goods are seen as important also for the development of the overall economy,
and they are mostly funded by central authorities and distributed largely independently of
the ability and willingness to pay. Government has an important hand on providing these
goods which produce such important benefits for society as a whole. Even where private
schools exist they are often supported by public funds in many countries. Societies do not
rely extensively on the market mechanism to provide and allocate education. The bulk of
education provision, including university education, is provided in the public sector and paid
for out of government funds. It is allocated by non-market means through administrative
procedures.
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6.3. THE ALLOCATION OF NON-MARKET GOODS
The quantity and quality of resources devoted to the provision of pure public goods is
decided by a political process. Once provided, the pure public good presents no problem of
allocation to an individual. The protection derived from an early warning air strike
mechanism, for example, needs no rationing. There is enough for all and additions to the
population add no extra costs.
The provision of quasi-public goods overall has also often been decided through the
political process. The allocation of such goods may be made on a first-come-first-served
basis with no charge. Public parks are free. Roads are largely free of charge at the point of
use. It is only when such facilities are used to the limit that rivalry becomes an issue.
However, in contrast, merit goods display both rivalry and excludability. They have to be
allocated on an individual basis.
Primary and secondary education is provided free at the point of delivery. All children
have the right to primary and secondary education.
In the short run, there is a fixed number of places in any school. State school
allocates at a zero price and for an over-subscribed school there is an excess quantity
demanded at this point. Where the quantity demanded exceeds the availability of places in a
school there is rivalry. There has to be rationing. But places are assigned to individuals, so
any individual who is not assigned a place is excluded. A method to allocate limited places
must be used. Some applicants will have to be rejected given the excess quantity demanded.
There are a variety of methods which can be used to allocate school places. These
range from the simple to the involved; a straightforward first-come-first-served method or
other administrative procedures based on different criteria. Non-market administrative
procedures are used. Professional judgment, sometimes backed by examination, custom and
practice, all may have a part to play. Parents express a preference; they make a claim.
Administrative rules and procedures are used to select whose claims shall be met.
Households and non-profit organizations, like voluntary groups or charities, also have
a very significant role in the allocation of non-market goods and services. Their activities do
not fit an orthodox market paradigm.
48
Some essential goods and services are produced within the household and allocated
outside the market. Cooking, house cleaning, washing, bearing and growing up children, care
for elderly and disable people are some examples of goods and services provided within the
household.
WORKING QUESTIONS 7
1. What are the attributes of the public goods?
2. What are the differences between public goods, quasi-public goods and merit goods?
3. Explain the role of the state in the allocation of non-market goods.
4. Why quasi-public goods cannot be supplied sufficiently by the market mechanism?
5. Why the provision of the merit goods is not left to the free choices of individuals and
price mechanism?
49
CHAPTER 8
NATIONAL INCOME:
MEASURE OF TOTAL OUTPUT AND ECONOMIC ACTIVITY
INTRODUCTION
The most important measure of total output and economic activity in any national economy
is national income. Both its level and the rate of change give valuable information about the
past and present performance of the economy.
In this chapter we examine the two basic concepts relating to national income (Gross
Domestic Product-GDP, and Per Capita Income-PCI), the calculation of national income, and
fluctuations in it.
8.1. BASIC CONCEPTS
a. Gross Domestic Product (GDP)
Gross domestic product (GDP) is the market value of all final goods and services produced
within a country in a year. To simplify understanding of its definition, let’s consider each
phrase in the definition with some care.
GDP is the market value. It adds together many different kinds of products into a
single measure of the value of economic activity. To do this, it uses market prices. Market
prices reflect the value of those goods.
GDP includes all items produced and sold legally in the markets. It excludes items
produced and sold illicitly, such as illegal drugs. It also excludes most items produced and
consumed at home and, therefore, never enter the marketplace. Vegetables we buy at the
grocery store are part of GDP; vegetables we grow in our garden and we consume at home
are not.
GDP includes only the value of final goods. The reason is that the value of
intermediate goods is already included in the prices of final goods.
The net value of total output produced is the sum of the value added created in the
economy in a year. Each firm’s value added is the value of its output minus the value of the
inputs that it purchases from other firms.
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The idea of value added suggests an important distinction between intermediate and
final products. Intermediate products are all goods and services used as inputs into a further
stage of production. Final products are the output of the economy.
GDP measures the value of production within the geographic confines of a country.
For example, Turkey’s GDP measures only the total values of goods and services produced in
Turkey. When a Turkish citizen works in Germany, his production is part of Germany’s GDP.
When a Turkish citizen has factory in Bulgaria, the production at his factory is not part of
Turkey’s GDP. Thus, items are included in a nation’s GDP if they are produced domestically,
regardless of the nationality of the producer.
GDP measures the value of production that takes place within a specific interval of
time. Usually that interval is a year or a quarter (three months). GDP measures the
economy’s flow of income and expenditure during that interval.
b. Per Capita Income (PCI)
Per Capita Income (PCI) is value of output per person, in a country. It is calculated dividing
GDP by the total population of the country. PCI is widely used in international comparisons.
It is the most important indicator of the richness and the level of development of countries.
PCI is also used to understand how fast of a country’s average welfare increases in time.
Note, however, that per capita income is only an average indicator; it does not say
anything about the distribution of income and wealth among individuals and social classes.
Therefore, it is possible to see that in any country, while national income and per capita
income are increasing, incomes of some people may fall.
8.2. CALCULATION OF NATIONAL INCOME (NI)
From now on we will use the concept of National Income (NI) to define the total value of the
national product. NI measures two things at once; the total income of everyone in the
economy and the total expenditure on the economy’s output of goods and services. Total
income and total expenditure are really the same. For an economy as a whole, income must
equal the expenditure for goods produced in that economy. NI can be calculated, then, by
adding up either expenditures or incomes of everyone.
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a. The Expenditure Approach
When we use the expenditure approach to measure the total value of output, we calculate
the total expenditure needed to purchase the nation’s output. Households, firms,
government and foreigners purchase a part of the economy’s output. We can write total
expenditures on total output of economy as following,
Y = C+I+G+(X-M)
Y stands for national income, C consumption expenditures, I investment, G government
expenditure, X exports, M imports, and (X-M) net exports.
Consumption: Households spend most of their income to buy goods and services. The total
amount of expenditures on goods and services of household gives us consumption (C).
Investment: Investment (I) is the production of goods not for the present consumption. Such
goods are called investment goods. They are produced by firms and they may be bought
either by firms or by households. Most investment is done by firms.
Government expenditure: Government expenditures include public investment, public
consumption, and interest and transfer payments. Governments allocate a portion of their
revenues to long-lasting investments in infrastructure and other forms of physical capital
(like buildings, schools, hospitals, roads, machinery and equipment). Governments provide a
range of public services that are used by the public. Most governments have debt and they
must service that debt with regular interest payments. Governments make also transfer
payments to individuals, business, and other countries. Transfer payments to individuals
include items like unemployment insurance, welfare benefits, and public pensions. Transfer
payments to companies are business subsidies.
Net exports: Part of the expenditure on the domestic economy’s output comes from
foreigners, and part of the expenditure at home goes to the products produced abroad. The
goods that are produced at home and sold abroad are called exports. The goods that are
produced abroad and sold at home are called imports. The difference between the values of
total exports and total imports (X-M) is called net exports. A change in either X or M, not
matched by a change in the other, will cause a change in national income. Table 8.1 shows a
simplified set of national income accounts for the economy using the output-expenditure
approach.
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Table 8.1: Calculation of Turkish GDP, the expenditure approach (billions of TL)
2014
1,258
Percentage
of GDP
72.0
Investment (private + government)(I)
358
20.5
Government Consumption Expenditures (G)
209
12.0
Net Exports (X-M)
-78
-4.4
1,747
100
Consumption Expenditures (C)
Gross Domestic Product (C+I+G+X-M)
b. The Factor-Income Approach
The second approach of measuring NI is the factor-income approach. In this approach, NI is
calculated by adding factor-payments or factor-incomes.
There are four main components of factor incomes; rent, wages, interest and profits.
Rent is the payment to landowners for the land in production; wages are the payment to
workers; and interest and profits are payments to capitalists. In order to obtain its capital
goods a firm requires money. This is made available by those who lend money to the firm
and by those who put up their own money in order to become the firm’s owners. Interest is
earned by those who lend money to the firm, and profits are earned by those who own the
firm.
8.3. FLUCTUATIONS IN NATIONAL INCOME
Fluctuations in national income have been one of the main concerns in economics because
of theirs effects on living standards of people, human suffering, and political stability. At
times when the economy is growing rapidly investment is booming, production is expanding,
and personal incomes are rising. At other times when the economy is stagnant or declines
stagnant or declining production, lost jobs, poverty, and pessimism.
A recession occurs when a country’s GDP begins to shrink. Recession is defined as a
case in which a country’s real GDP declines for two straight quarters (six months). More
broadly, economy is in recession when there is an economy wide slowdown that results in
higher unemployment and falling incomes. A very severe, long-lasting recession is called a
depression. A recovery occurs when the economy stops contracting and starts growing
again.
53
Recessions and subsequent recoveries have diverse causes and features; each one is
unique. But this pattern is not simply a series of occasional, random events. Economic cycles
have clearly a systemic nature: there are inherent forces within capitalism which create and
re-create this cyclical pattern. In reality, the economy has no automatic, internal ability to
maintain full employment. Unemployment is a normal feature of capitalism.
a. How a Recession Starts?
A recession begins with a significant downturn in some part of the economy. Every recession
starts with some negative change that reduces spending, production, and eventually
employment in one particular part of the economy.
A recession is a chain-reaction resulting from the initial problem that creates a wider
economic crisis. The downturn spreads from one sector to another, following the links that
connect different industries and different kinds of spending. If conditions exist, the initial
downturn cascades into a broader decline in the total economy, far beyond the initial hardhit sector.
One of the main features of the capitalism is that economy depends heavily on new
investment spending by profit-seeking private firms. Investment generates new production
and new employment. Workers get paid. They spend their earnings on consumer goods;
which in turn generates more production, more employment, and more investment. Now
suppose that something turns negative in those initial investment decisions. Investors might
decide that profit rates no longer justify more investment. Or they may worry about political
stability, labor peace, or other risk factors.
What follows is an immediate contraction in industries which produce capital goods,
spare parts, and other supplies for the companies which cut back investment. Eventually,
those companies lay off unneeded workers. Now consumer spending begins to decline, too –
since workers who are no longer earning are no longer spending, either. Thus the recession
spreads into consumer goods industries.
Firms producing consumer goods also lay off workers. Total employment declines
further, and consumer spending takes another hit. Meanwhile, as the recession deepens and
spreads, investors become all the more pessimistic about their ability to sell new output. So
investment declines even further and the downturn is amplified.
54
Because of the dependence of production on investment, the dependence of
consumption spending on employment, and the uncoordinated nature of individual
investment and consumption decisions, a problem in one part of the economy can spread
and amplify until the entire economy is contracting.
Importantly, the whole contagious process is rooted in some essential features of
capitalism:
–
Profit-seeking investments by individual companies are required to set the
economy in motion.
–
Workers need a job to earn wages to pay for consumption.
–
Each investment decision reflects the individual judgment of that investor about
the balance of risk and opportunity that’s best for their own company. There’s
no overall coordination of the whole economy.
Its interdependent yet decentralized nature, together with its structural reliance on profitseeking private investment, explains why capitalism is inherently prone to production cycles.
Here are some of the negative events or shocks that have been important in sparking
past recessions:
1. Investment instability: Private investment spending has more influence on the direction
of the overall economy than any other category of spending. Investment spending
depends on current and expected profits, capacity utilization, interest rates, potential
risks, etc. Negative developments in any of these variables may cause an investment-led
downturn.
2. Consumer sentiment: Consumer spending is the biggest part of total demand. So it plays
an important role in the boom-and-bust cycle. Generally, consumer spending tends to
follow employment and wage trends, and an initial negative shock in any other part of the
economy can quickly cause a subsequent downturn in consumption expenditures. If that
consumer response is large, it will tip the economy into a full downturn. In some cases, a
sudden negative shift in consumer sentiment could be the initial cause of recession.
3. Supply shocks: Major price-increases or supply disruptions in key inputs used by many or
most firms may also induce an economic downturn, by undermining profitability,
investment, business confidence, and consumer spending. For example, volatility in global
55
oil supplies, and skyrocketing oil prices, contributed to the global recessions of the 1970s
and 1980s. Dramatic agricultural problems may also cause recessions.
4. Monetary policy: Very rigid monetary policies of the central banks may cause recession.
If the central banks raise interest rates too far and too fast to control inflation the
economy may slow down too much, and may even tip into outright recession.
5. Banking cycles: Banks issue loans to firms and households in order to profit from the
resulting flow of interest payments. But banks must always balance the lure of interest
income against the risk that the borrowers may default and not pay back the loans. The
formation of new credit by banks is essential to growth. Sometimes banks are confident,
and happily issue loans to new customers, at relatively low interest rates. The result is
rapid economic growth. At other times, however, banks worry intensely about default.
They quickly reduce new lending (causing a credit squeeze), and pump up interest rates.
This causes slower growth or even outright recession.
6. Financial instability: Speculative financial markets are inherently fragile, subject to
episodes of panic, contraction, and even outright collapse. A dramatic financial downturn
may have negative effects on the real economy, especially if it undermines the confidence
of investors or consumers. In a globalized financial system, financial panic often results in
the sudden flight of short-term finance away from particularly vulnerable countries, with
devastating effects on finance, banking, and real production and employment. This
mechanism caused severe recessions in Turkey in the past.
7. Foreign trade: A recession can easily spread from one country to another via its impact
on trade flows. Suppose one country suffers a major recession. If it has a trading partner
which depends heavily on export sales to that country, it too may enter recession, as its
exports decline. For example, almost one half of the Turkish exports go to the European
Union (EU). A recession in the EU, therefore, has always a negative impact on European
purchases of Turkish products. Imports can also cause a downturn. A major surge in
import competition, if it damages too many domestic industries, can throw a tradesensitive country into recession.
8. Government spending A sudden downturn in government spending might also create the
conditions for recession. This could result from some major change in government
activity, or from overly dramatic budget-cutting aimed at eliminating a deficit.
56
There are many potential causes for a recession. What all recessions have in
common, however, is that an initial downturn cascades through the consecutive links that
connect investors, consumers, and industries. This is what ultimately creates the broader
and more painful crisis.
b. Ending (and Preventing) Recessions
After a period of decline and contraction, the economy may eventually shift out of its
doldrums, and growth may commence once again. But since this automatic upturn may take
a long time, resulting in serious economic, social and even political casualties, governments
try to short-circuit recessions with proactive efforts to stop the contraction and spur
recovery. In fact, governments try to implement policies to interrupt the boom and-bust
cycle of the economy. The governmental policies most commonly implemented for this
purpose are monetary policy and fiscal policy that we will discuss in the next chapter.
WORKING QUESTIONS 8
1. Define gross domestic product (GDP) and explain its meaning.
2. How is the per capita income calculated and for what we may use it? Does it give any
idea about income distribution?
3. Suppose that in a country in any year consumption (C) is 700 billion liras, government
expenditure (G) is 150 billion liras, investment (I) is 200 billion liras and net exports
(X-M) is -50 billion liras. Calculate GDP of that country in that year.
4. What are the four main components of factor incomes?
5. Why is capitalism prone to making recession a contagious process?
57
CHAPTER 9
ECONOMIC POLICIES: OBJECTIVES AND INSTRUMENTS
Economic policy implemented by government is a critical factor influencing economic
success or failures of nations. National income, employment, inflation, and foreign balance
are the most important variables in the explanation of the rises and declines of nations.
Thus, they are the central goals of economic analysis and policy. The instruments used for
these goals are fiscal policy, monetary policy, incomes policy, and foreign economic policies.
In this chapter, we will discuss each, thereby illustrating some key questions that confront
economics and the ways of solutions.
9.1. OBJECTIVES OF ECONOMIC POLICIES
Four areas are central to good economic performance; those concerning output,
employment, prices, and the foreign economic relations.
a.
Output
As we have seen in Chapter 8, national income is the measure of output. The ultimate
measure of economic success is a country’s ability to generate a high level and rapid growth
in the output of goods and services. The principal objective of economic policies, therefore,
is to increase the total output rapidly, both in the short and long run, improving the living
standards of the society.
b. Employment
High employment, or low unemployment, is the second objective of economic policies.
People want to be able to find good jobs at a high pay and to find them easily. Attaining high
employment is more than a purely economic goal: It has also psychological, social and
political dimensions.
Employment is a relationship between employer and employee, usually based on
a contract where the work of employee is paid for by employer. In modern economies
employers are profit-seeking private firms, non-profit organizations and governments. In a
capitalist economy most of the employers are profit-seeking firms.
58
Employment and unemployment are related to total number of jobs available and on
the number of people competing for them. Unemployment usually moves in tandem with
output. Firms hire workers to produce consumption or investment goods. When the demand
for consumer and/or investment goods increases, firms hire more workers and additional
jobs are created; the number of employed people (employment) rises. As output falls as a
result of deceasing demand, firms need fewer labor inputs, so new workers are not hired
and current workers are laid off; unemployment rises. Therefore, the total level of
employment depends, first of all, on the investment and production decisions of private
firms. In other words, total employment depends on the demand for labor from investing
and producing firms. If there is not enough investment and production to employ all willing
workers, then unemployment will exist. This can occur even if national income continues to
slowly expand. Indeed, national income must grow, at least, as fast as the sum of population
growth and productivity growth, or else the unemployment rate will rise.
Unemployment is a normal feature of the capitalist labor market. Governments are
trying to prevent long-term, mass unemployment using various economy policies, such as
public spending, interest rates, and other tools.
In Turkey, TURKSTAT carries out Households Labor Force Survey every month to
estimate employment. Findings of this survey describe the age and job market status of
household members. TURKSTAT calculates basic indicators of the state of the labor force.
The main indicators of the Turkish labor force for August 2016 are given in Table 9.1.
TABLE 9.1: Labor Force in Turkey (000 people, August 2016)
Population(15 years old and over
Labor force:
Employed:
Unemployed:
Labor force participation rate %
(30,967/58,835)
Employment rate %
(27,473/58,835)
Unemployment rate %
(3,493/30,967)
Not in the labor force:
58,835
30,967
27,473
3,493
52.6
46.7
11.3
27,868
59
The rate of unemployment is calculated as a percentage of unemployed people to
the total number of people seeking a job. The amount and rate of unemployment is an
indicator of the extent to which people who seek jobs can’t find them.
c. Price Stability
The third major economic objective is to ensure price stability. Price stability is low and
stable inflation. Inflation means the rate of increase in the general price level during a
period of time.
Every marketed product has a money price (or absolute price), measured in units of
money. Prices help buyers to compare one commodity to another to see which one is the
best deal. This comparison gives buyers the relative prices: that is, the price of one
commodity relative to another. If, for example, the price of a passenger car is 60,000 liras
and the price of a personal computer (PC) is 2000 liras, a car costs 30 times as much as a PC.
The overall level of absolute prices prevailing in an economy is called the price level.
A persistent increase in the absolute price level is called inflation. Since the rates of
increases in the prices of different goods are not equal relative prices will also change. Prices
of some commodities will increase more slowly than average (thus becoming less expensive
in relative terms), while others increase more rapidly (becoming relatively more expensive).
Declines in the general price level over time are called deflation. Deflation usually
occurs during severe economic recession or crisis, when companies are desperate to sell
products. It has disastrous consequences, including escalating debt burdens for households,
firms, and government.
In Turkey, TURKSTAT measures three price indexes: Consumer Price Index (CPI),
Domestic Producer Price Index (DPPI), and Non-Domestic Producer Price Index (ND-PPI).
Price compilation is conducted by TURKSTAT every month. Included items and their relative
weights are updated at the end of every year in December: new goods and services are
added, goods and services which lost their importance are taken out and renewed weights
are used in the calculation of indexes.
Consumer Price Index (CPI) measures the changes in the retail prices of goods and services
purchased by consumers over a given time period. For this purpose, expenditures of
households, foreign visitors, constitutional population and all of the final monetary
60
expenditures are taken into account. Consumer Price Index (CPI) is a measure of the average
of the prices paid by consumers for a fixed basket of consumer goods and services.
A major purpose of the CPI is to measure changes in the cost of living and in the value
of money. The rate of inflation is the percentage change in CPI during a period. It is
measured monthly and annually.
Domestic Producer Price Index (DPPI) is a measure of the change in the prices of goods and
services sold as output by domestic producers into local market in a given reference period.
Prices are cash prices, excluding VAT and all relevant taxes (Basic prices).
Non-Domestic Producer Price Index (ND-PPI) is a measure of the change in the export prices
(FOB) of goods and services sold as output by domestic producers into foreign countries in a
given reference period. Prices are FOB prices excluding VAT and all relevant taxes.
Low, steady and anticipated inflation may not be a problem. But, high inflation may
be destructive. An unexpected burst of inflation or period of deflation may bring big
problems and costs. An unexpected inflation or deflation: redistributes income and wealth,
and affects efficiency and output negatively.
If every price and every flow of income experienced inflation at the same rate, it
would have no real economic impact, and no winners or losers. In real life, however,
inflation is never so even-handed or predictable. Some prices rise faster than others. Some
incomes keep up with inflation, or even surpass it; others lag behind. Inflation and, changes
in the rate of inflation create uncertainty in the minds of companies, investors, and
households; this can be stressful, and in some cases can impede investment.
People try to protect themselves against inflation by indexing their incomes to the
price level. But, some sectors lose from inflation:
1) Individuals who live on incomes that are fixed in money terms lose purchasing power
when overall prices rise.
2) Workers who are unable to win wage increases to keep up with inflation also lose real
purchasing power.
3) Lenders who loan money at a fixed rate of interest will see the real value of their loan
(and future interest payments) reduced by inflation.
4) Owners of financial wealth lose some of their real wealth with every increase in prices.
61
Some other sectors, meanwhile, benefit from inflation. Borrowers are the biggest
winners: the real burden of their loan is eaten away by higher prices.
Inflation distorts the use of money. In inflationist periods money in pocket loses its
purchasing power, so people hold less money and they either increase their spending on
consumption goods or transform money into other assets. This may have a positive effect on
the total product and employment for some time. But this positive relationship between the
price level and total output is unsustainable in the long run.
Unpredictable inflation or deflation diverts resources from productive activities to
speculation. It can become more profitable to forecast the inflation or deflation rate
correctly than to invent a new product. People can make themselves better off, not by
specialization in the profession for which they have been trained but by spending more of
their time dabbing and managing their financial investments. From a social perspective, the
diversion of talent that results from unpredictable inflation is like wasting valuable
resources. This waste of resources is a cost of inflation.
d. Foreign Balance
Countries make foreign trade; they export and import goods and services. One of the main
purposes of macroeconomics is foreign trade balance. There is an interaction between the
exchange rate and foreign trade balance. Exchange rate is the price of a national currency in
terms of another national currency. It is a significant factor determining the price of
imported and exported goods. Therefore, exchange rate has a critical role in reaching both
foreign trade balance and price stability.
9.2. INSTRUMENTS OF ECONIMIC POLICIES
Instruments of economic policy are fiscal policy, monetary policy, Incomes policy, and
foreign economic policies.
a.
Fiscal Policy
Fiscal policy is related to total government expenditures, distribution of government
expenditures, and how these expenditures are financed. The main sources of government
revenues are taxes. Taxing and spending is also a way of influencing economic activities, for
government. Government collects taxes from individuals and firms and uses tax revenue to
62
undertake many different functions. It can affect aggregate consumption and investment
demand by changing tax burden and its expenditure. At any time, if the government wants
to increase total demand, it may increase its own expenditures and promote consumption
and investment expenditures by lowering the tax rate. If the government wants to decrease
total demand it may lower its own expenditures and implements policies contracting private
consumption and investment expenditures.
Changes in tax rates affect the profitability of private investment, and hence
production. If taxes are too high on businesses, their investment spending is likely to
weaken, and this would influence production negatively. A part of tax income may be used
for transfer payments to low-income households and individuals. Distribution of income will
be changed by taxing and transfer payments.
The budget policy also has important consequences on the economy. A government
deficit occurs when incoming tax revenues are insufficient to pay for outgoing expenses.
And, a surplus occurs when tax revenues are larger than expenses. A short-term, low-rate
deficit is no cause for concern. On the other hand, large chronic deficits that persist year
after year are a cause for concern. A deficit in any given year must be financed by
government borrowing. Deficits, therefore, increase government’s outstanding debt. Large
consecutive deficits produce an ongoing and rapid accumulation of public debt, which can
have negative economic and financial consequences. A rapidly growing and large public debt
would create a pressure on both interest rates and the exchange rate. As the public debt
grows, interest payments eat up a larger proportion of total government revenues. This
would produce financial and economic instability; including higher interest rates, exchange
rate instability, and even an outflow of financial capital from the country. So government
debt is acceptable within limits.
b. Monetary Policy
Monetary policy is the way of influencing economy by changing the quantity of money and
interest rate. The state institution responsible for setting and implementing monetary policy
is the Central Bank (CB). Interest rate is determined in money market by the supply of and
demand for money. If the CB increases the quantity of money in the economy this would
lower the rate of interest; if it reduces money supply interest rate would rise. Since,
generally, there is a negative relationship between the interest rate and consumption and
63
investment expenditures, a fall in the quantity of money would raise the rate of interest and
lower aggregate demand. And an increase in the quantity of money would have just the
opposite effects: interest rate would fall and aggregate demand would rise.
c.
Incomes Policies
Incomes policies are related to changing wages and salaries by the government. The main
concern may be either to control inflation and stabilize prices or to change the distribution
of income between labor incomes and capital incomes.
d. Foreign Economic Policies
Foreign economic policies include foreign trade and exchange rate policies. The main
purpose of foreign policies is foreign balance and exchange rate stability.
WORKING QUESTIONS 9
1.
List the objectives and instruments of economic policy.
2.
What is price stability?
3.
What is fiscal policy?
4.
Discuss government deficit and public borrowing.
5.
Why unemployment is a problem?
6.
Define inflation and deflation.
64
CHAPTER 10
TURKISH ECONOMY
In this chapter we will discuss the sectoral outlook, economic growth and development, and
international economic relations of Turkey.
10.1. SECTORAL OUTLOOK
Activities of national economies are classified in three main sectors: agriculture, industry
and services. Shares of each sector in Gross Domestic Product (GDP) in 2015 are given in
Table 10.1. The GDP of Turkey was about 1,954 million liras at current prices. The shares of
sectors as a percentage of total GDP are: agriculture 7.6, industry 18.3, construction 4.4 and
services 58.0. These figures imply that the Turkish economy is a service and industry
economy.
TABLE 10.1: GDP by Kind of Economic Activity (2015, current prices)
AGRICULTURE (Agriculture, forestry and fishing)
INDUSTRY
Mining and quarrying
Manufacturing
Electricity, gas, steam and air conditioning supply
Construction
SERVICES
SECTORAL TOTAL
Financial intermediation services indirectly measured
Taxes-subsidies
GROSS DOMESTIC PRODUCT (PURCHASER'S PRICE)
Million TL
(%)
148,288
7.6
357,128 18.3
24,626
1.3
304,438 15.6
28,064
1.4
85,883
4.4
1,135,035 58,0
1,726,384 88.4
-29,319 -1.5
256,496 13.1
1,953,561 100.0
Source: TURKSTAT.
a. Agriculture
Agriculture includes all types of produce, animal husbandry, forest products and water
products. Although its share in total production and employment is declining, agriculture is
still a critical sector for the economy. Agricultural products are necessary for the satisfaction
of our basic needs. Industry uses them in the production of many industrial products.
65
Additionally, agricultural sector is an important market for industrial products; many
industrial products are used as inputs in agricultural production.
Despite the rapid decline in the share of the Turkish agriculture in GDP, this share is
still higher than developed and some developing countries. The situation is similar for the
share of agriculture in employment: it is less than 5 percent in developed countries.
Actually, about 5.5 million people are working in agriculture in Turkey.
Organization, production structure and relatively backward technologies are the main
agricultural problems. Most of the agricultural enterprises are small-scale family businesses
using non-wage family labor and traditional techniques on farms broken to pieces.
Agricultural producers are unorganized. Despite the developments the average productivity
both in the production of soil products and animal husbandry is still lower than developed
countries. Especially production of the field products is still dependent on natural conditions.
In addition to small-scale production and dependence on natural conditions, the low
level of education of agricultural labor, backward technology, and insufficiency in the usage
of modern inputs are among the factors leading low productivity, low quality production.
Low productivity causes high costs, low agricultural income and impedes the
competitiveness of Turkey in the international markets.
b. Manufacturing Industry
The term “industry” is generally used to include manufacturing, mining, energy and gas, and
water sectors. In this section we will discuss only the manufacturing industry. The relative
size of the manufacturing sector in any economy is a significant indicator of the industrial
development. It is measured by the share of the sector in GDP and in total employment. The
compositions of the manufacturing output and employment are, however, considered as
better indicators of the level of industrialization. Developed countries use high-tech
production methods and employ more qualified labor.
The share of manufacturing in GDP has declined in Turkey, in the 2000s. The share of
manufacturing value added in sectoral total was 24.4% in 1998, in current prices. It fell to
23.8% in 1998 in constant prices, and to 17.6% in current prices, in 2015. The remarkable
difference between the falls in current and constant prices reflects the rapid relative decline
in the prices of manufactured goods. These figures imply that the manufacturing lost its
66
driving force function for the economy as a whole. Considering that Turkey has not still
completed its industrialization process, this development may be seen as a premature
deindustrialization.
After 1990s manufacturing sector in Turkey has been shaped by the international
economic developments such as the customs union with EU and the integration of China and
India to the world economy in the process of accelerated globalization trends, increasing
competition in international markets. Both import and export dependence of the sector has
increased; now, manufacturing is using relatively more imported inputs and is exporting
relatively more output than in the past. As a result, the sensitivity of the sector to the
international economic development has increased remarkably. Rising sensitivity and
dependence is related to not only the demand and supply conditions in the international
commodity markets but also money markets; fluctuations in the exchange rates now
influence the sector much more than in the past.
The general technological level of the Turkish manufacturing is far from being enough
to increase the competiveness of the sector. Industries with low and middle technologies are
dominant in the Turkish manufacturing sector. In 2014, they provided 72% of the total
production. Their share was about 64% in manufacturing exports incomes. The share of hightech industries was 3.8% in manufacturing production and 3.5% in manufacturing exports.
10.2. LONG-TERM GROWTH AND DEVELOPMENT
a. Growth
Between 1913 and 2008 Turkish GDP and PCI had increased by about 33-fold and 5.5-fold,
respectively. These figures imply an annual average increase of 4.2% for GDP and 2.25% for
PCI. Since PCI is a better indicator of the long–term growth of countries, we will use it both
in intertemporal and international comparisons.
Although a relatively high rate of average growth recorded for the 1923-1939 period,
PCI had decreased during the Second World War. Economic growth has become a
permanent phenomenon after the War with some exceptional years of crisis. The average
growth rate of PCI had been 2.98% during 1950-1980 and 2.42 during 1980-2008. Without
doubt, the growth rates give valuable information about the performance of the Turkish
67
economy, but to make a better assessment we will compare the Turkish growth
performance with some selected countries, regions and the world as a whole.
TABLE 10.2: Relative Change in the Turkish PCI (1913-2008)
1913
1950
1980
2008
USA
437
589
462
387
30 Western European Countries
285
282
327
269
7 Eastern European Countries
140
130
144
106
Total Latin America
123
155
135
86
Total Asia
57
44
50
70
Total Africa
53
55
38
22
World
126
130
112
94
Greece
131
118
223
203
Spain
169
135
229
244
Mexico
143
146
157
99
Argentina
313
307
204
136
Brazil
67
103
129
80
China (P.R.)
46
28
26
83
India
55
38
23
37
Japan
114
118
334
283
Malaysia
74
96
91
128
S. Korea
72
53
102
243
Iran
82
106
99
86
Egypt
74
56
51
46
Turkey
1001
100
100
100
Source: Madison, Historical Statistics, our calculation. (1) GDP per capita in the area within the present-day
borders of Turkey.
Comparative growth performance of Turkey for (1913-2008) period is given in Table
10.2. We make comparison for four different dates (1913, 1950, 1980 and 2008) and
calculate PCIs of selected countries, regions and the world by taking the level of Turkish
PCI=100 for each date. The figures in the table imply that the PCI of Turkey improved about
10% relative to the USA between 1913 and 2008; the improvement relative to Western
Europe is negligible; it deteriorated somewhat relative to Asia, and improved strongly
relative to the world average and other regions of the world. Starting from these figures we
can say that Turkey has strongly improved its position relative to some countries such as
Argentina, Mexico, India and Egypt; but its position deteriorated relative to some other
selected countries such as Greece, Spain, Brazil, China, Japan, Malaysia and S. Korea.
68
In summary, although Turkey has increased its PCI by 5.5-fold in the last 100 years, it
could not change its position remarkably relative to developed countries. Turkish PCI had
increased at about the same rate as those in high-income countries since 1913 and Turkey
has not been able to close the existing income gap. On the other hand, increases in average
income in Turkey since 1913 have been slightly faster than the world average.
b. Development
Although PCI may be considered the most important indicator of human development there
are other indicators. The United Nations introduced the Human Development Index (HDI) in
1990 as a broader measure. The HDI is a summary measure for assessing long-term progress
in three basic dimensions of human development: a long and healthy life, access to
knowledge and a decent standard of living. A long and healthy life is measured by life
expectancy. Access to knowledge is measured by two indicators: i) mean years of education
among the adult population; and ii) expected years of schooling for children of school-entry
age. Mean years of education is the average number of years of education received in a lifetime by people aged 25 years and older, and expected years of schooling is the total number
of years of schooling a child of school-entry age can expect to receive. Standard of living is
measured by Gross National Income (GNI) per capita.
TABLE 10.3: HDI Values of Turkey and Selected Countries and Groups (2014)
HDI value
Very high HDI
0.896
High HDI
0.744
Medium HDI
0.630
Low HDI
0.505
Turkey
0.761
Serbia
0.771
Azerbaijan
0.751
(1)
ECA
0.748
Source: UNDP, HDR 2015. (1) Europe and Central Asia.
Countries are categorized in four different groups according to their human
development levels: very high human development (HDI value, 0.800 or greater), high
human development (HDI value, 0.700-0.799), medium human development (HDI value,
0.550-0.699), and low human development (HDI value, less than 0.550).
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Turkey is a high-human development country with its HDI value of 0.761 for 2014,
and it is ranked at 72 out of 188 countries. HDI values of Turkey and selected countries and
groups of countries for 2014 are given in Table 10.3. Turkey’s 2014 HDI of 0.761 is above the
average for countries in the high human development group (0.744) and the average for
countries in Europe and Central Asia (0.748). Ranks of Serbia and Azerbaijan in the Europe
and Central Asia Group are comparable to Turkey regarding both their population and
proximity to Turkey: 66 and 78, respectively.
10.3. SAVING GAP AND FOREIGN ECONOMIC RELATIONS
In this section we discuss the relationship between the saving gap and the foreign economic
relations of Turkey. We start with foreign trade, and proceed with current account deficit,
and saving gap and how it is financed.
a. Foreign Trade
Foreign trade is the movements of goods and services across countries. Without any
exception, Turkey has had trade deficits since the Second World War: Turkish exports have
been lower than imports. Trade deficit enlarged in time; in fact, there is interdependence
between exports and imports. Import dependence in the Turkish industry has increased
since the 1980s with the liberalization of foreign trade.
A vital consideration for Turkish exports is to enhance the country’s competitiveness
in international markets. The competitiveness of any country depends on its productivity.
And the main factor determining productivity is the level of technological development.
Turkey could not manage to reach the high-tech production level. About two-third of its
exports consist of primary and low-tech products.
b. Current Account Deficit
Current account includes trade in goods and services, factor incomes, and transfers. Large
trade deficit resulting in current account deficits (CAD) with the rest of the world
accumulates over time and frequently ends up with a crisis. Hence, the CAD has been one of
the main problems of the Turkish economy. Turkey’s foreign currency revenues are higher
than its expenditures in services, mainly as a result of the tourism revenues. While its annual
tourism revenues were 26.6 billion dollars in 2015, tourism expenditures were about $5
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billion. Net income balance is negative; incomes are short of expenditures. Since Turkey is a
debtor country, its net interest income and transfer of profits are negative. Balance of
current transfer is generally positive. Transfers are entries that correspond to the provision
of real resources or financial assets, without a give and take, across countries.
The CAD of Turkey is mainly the result of foreign trade deficits. These kinds of deficits
are more dangerous in terms of sustainability and more prone to balance of payment crises
since they indicate structural weaknesses in international trade and competitiveness. These
are permanent problems and cannot be solved easily since changing the production process
and technological level of firms require long term planning and investments in education,
infrastructure, research and development.
c. Saving Gap in Turkey
Behind the Turkey’s structural and pertinent CAD there is saving gap. Saving gap is the
difference between the rate of total domestic savings and gross fixed investment as a ratio
to the GDP. The average saving gap as a percentage of GDP was about one percent between
2000 and 2004, and increased 5 percent for the period between 2005and 2009. It has
fluctuated between about 5 and 10 percent since 2010. The saving gap has enlarged in the
last 16 years mainly because of falling private savings: saving of private firms and individuals.
d. The Way and the Quality of Financing the Deficits
The saving gap in Turkey has been financed by foreign savings in the form of capital entry.
Investment and growth based on foreign savings are not sustainable, however.
Although sustaining CAD for countries can be feasible in the short run as long as
finding external resources, the sustainability of this policy is likely to be questioned once the
deficit become persistent. Large and persistent CAD tends to cause more serious problems
for a country creating a sustainability problem. How and at what conditions this deficit is
financed is an important concern, because a fast growing CAD can cause fragility.
Composition of foreign resources has strong influence on the ability of an economy to
sustain its deficits.
Foreign resources used to finance the CAD are two groups: equity investment and
loans. Equity financing does not require payments to investors in the short run. However,
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debt financing require payments at specific dates. Thus, the lower the stream of payments
that is required to international investors, the longer the country can run CAD.
There are two kinds of equity investment; foreign direct investment (FDI) and
portfolio investment. FDI are more stable and have long term structure than portfolio
investment. Higher FDI can have positive impact on sustainability whereas excessive
dependence on portfolio investment increases the potential of a crisis. However, equity
investment in the form of both FDI and portfolio investment may increase the CAD through
transferring profits, in the long run.
While the average annual CAD was 2,128 million dollars in 1990-2000, it increased to
18,757 million dollars in 2001-2008, and to 45,391 million dollars in 2009-2015.
The financing quality improved from the first period (1990-2000) to the second
period (2001-2008), but it deteriorated after 2008. The total CAD for the 7 years between
2009 and 2015 was about 318 billion dollars, and only 20 percent of this amount was
financed by FDI. The remaining part was financed by speculative portfolio investment (34%)
and by borrowing (42.2%), both increasing the fragility of external finance.
This fragility increases further when the international liquidity contracts because
capital inflows have been mostly the result of ample global liquidity. Additionally, the
increase in the speculative hot money augmented the CAD by appreciating TL. The way of
financing the CAD stimulates the demand for imported inputs at the expense of domestic
inputs making economic growth more dependent on the entry of foreign resources.
Short term debt of the private sector and the share of FDI in financing the CAD have
sharply increased after 2008, raising doubts about the sustainability of the CAD in Turkey.
During the period of eight years including 2008 and 2015, the sum of the total net foreign
resources used has been about $392.9 billion. Out of this, $81.1 billion was the net FDI. And,
approximately $288.3 billion of finance is either in the form of foreign debt or portfolio
investment creating short term liabilities. Increasing CAD and its financing mostly by debt
creating foreign resources have been resulted in higher foreign debt stock. The total foreign
debt stock of Turkey was about 44 billion dollars in 1989. It increased continuously with
exceptions in the crises: to 118.6 billion dollars in 2000, to 281 billion dollars in 2008, and to
411.5 billion dollars in March 2016.
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