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Transcript
OHP MASTERS of LECTURE PLANS and KEY DIAGRAMS in ESSENTIALS OF ECONOMICS John Sloman Introduction Economic Issues ii WH A T D O ECONOMISTS STUDY? Economic problems • production and consumption • scarcity: the central economic problem Macroeconomic issues • growth • unemployment • inflation • balance of payments problems • cyclical fluctuations Microeconomic issues • choices: what, how and for whom • the concept of opportunity cost • rational economic decision making: marginal costs and marginal benefits iii Introduction The production possibility curve • what the curve shows • microeconomics and the p.p. curve – choices and opportunity cost – increasing opportunity cost • macroeconomics and the p.p. curve – production within the curve – shifts in the curve The circular flow of income • firms and households • real and money flows • goods and factor markets • macroeconomics: the total flows • microeconomics: individual iv markets v Chapter 1 Markets, Demand and Supply 6 1.1 ECONOMIC SYSTEMS Classifying economic systems • methods of classification • classification by degree of government control • other methods of classifying economic systems The command economy • features of a command economy • planning: – consumption and investment – matching of inputs and outputs – distribution of output Advantages of a command economy • high investment, high & stable growth • social goals pursued • low unemployment Problems of a command economy • problems of gathering information • expensive to administer • inappropriate incentives • shortages and surpluses 7 1.1 (cont.) The free-market economy • demand and supply decisions • the price mechanism: – shortages and surpluses – equilibrium price – response to changes in demand and supply • the interdependence of markets – effect of a rise in demand • in market for that good • in factor markets • in other goods markets • in other factor markets Competitive markets • perfectly competitive markets • everyone is a price taker • why study perfect markets? 8 1.2 DEMAND The relationship between demand and price • the law of demand • the income effect • the substitution effect The demand curve Other determinants of demand • tastes • number and price of substitute goods • number and price of complementary goods • income • distribution of income • expectations Movements along and shifts in the demand curve 9 1.3 SU PPL Y The relationship between supply and price The supply curve • why supply curves generally slope upwards Other determinants of supply • costs of production • profitability of alternative products (substitutes in supply) • profitability of goods in joint supply • nature and other random shocks • aims of producers • expectations of producers Movements along and shifts in the supply curve 10 1.4 THE DETERMINATION OF PRICE Equilibrium price and output • response to shortages and surpluses • significance of 'equilibrium' Demand and supply curves • effect of price being above equilibrium • effect of price being below equilibrium • equilibrium: where D = S Effects of shifts in the demand curve • movement along supply curve and new demand curve Effects of shifts in the supply curve • movement along demand curve and new supply curve 11 1.5 THE FREE-MARKET ECONOMY Advantages of a free-market economy • transmits information between buyers and sellers • no need for costly bureaucracy • incentives to be efficient • competitive markets responsive to consumer wishes Problems of a free-market economy • competition may be limited: problem of market power • inequality • the environment and other social goals may be ignored The mixed economy • types of intervention – taxes and subsidies – legislation and regulation – direct provision by government 12 Chapter 2 Markets in Action 13 2.1 PRICE ELASTICITY OF DEMAND Defining price elasticity of demand (Pd) • The responsiveness of demand to change in price Measuring price elasticity of demand • %QD / %P • use of proportionate or percentage changes • the sign (positive or negative) • the value (greater or less than one) Determinants of price elasticity of demand • number and closeness of substitute goods • the proportion of income spent on the good • the time period 14 2.2 PRICE ELASTICITY OF DEMAND AND CONSUMER EXPENDITURE Defining total consumer expenditure • TE = P ×Q • Illustrating TE graphically Effects of a price change: elastic demand • P rises: TE falls • P falls: TE rises Effects of a price change: inelastic demand • P rises: TE rises • P falls: TE falls Special cases • Pd = 0 • Pd = • Pd = –1 Applications to price decisions 15 2.3 PRICE ELASTICITY OF SUPPLY Meaning of price elasticity of supply Measuring price elasticity of supply • %QS / %P • elastic and inelastic supply Determinants of price elasticity of supply • amount that costs rise as output increases • time period 16 2.4 OTHER ELASTICITIES Income elasticity of demand • measurement • determinants – degree of “necessity” – rate at which people are satisfied – level of income • applications Cross-price elasticity of demand • measurement • determinants • applications 17 2.5 MARKETS AND ADJUSTMENT OVER TIME Short-run and long-run adjustment • short- and long-run demand and supply curves Speculation • stabilising speculation • destabilising speculation Uncertainty and risk • defining risk and uncertainty • reducing risks by holding stocks 18 2.6 MARKETS WHERE PRICES ARE CONTROLLED Equilibrium price and the absence of shortages and surpluses Minimum prices • justification • effects • dealing with resulting surpluses Maximum prices • justification • effects • dealing with resulting shortages • rationing • black markets 19 Chapter 3 The Supply Decision 20 3.1 SHORT-RUN COSTS Short-run and long-run changes in production • fixed and variable factors • the short run • the long run Production in the short run • the law of diminishing returns Costs and inputs • costs and the productivity of factors of production • costs and the price of factors • fixed and variable costs 21 3.1 (cont.) Total cost • total fixed cost (TFC) • total variable cost (TVC) • total variable cost and the law of diminishing returns • total cost (TC = TFC + TVC) Average and marginal cost • marginal cost (MC) and the law of diminishing returns • the relationship between the marginal and total cost curves • average fixed cost (AFC) • average variable cost (AVC) • average (total) cost (AC) • relationship between average and marginal cost 22 3.2 LONG-RUN COSTS Production in the long run • returns to scale – constant returns to scale – increasing returns to scale – decreasing returns to scale • economies of scale – specialisation and the division of labour – indivisibilities – container principle – greater efficiency of large machines – by-products – multi-stage production – organisational economies – spreading overheads – financial economies • diseconomies of scale • external economies of scale • external diseconomies of scale 23 3.2 (cont.) Long-run average costs • shape of the LRAC curve • assumptions behind the curve Long-run marginal costs Relationship between long-run and short-run average costs • the envelope curve Long-run cost curves in practice • the evidence • minimum efficient plant size Decision making in different time periods • very short run • short run • long run • very long run 24 3.3 R EVEN U E Defining total, average and marginal revenue Revenue curves when firms are price takers (horizontal demand curve) • average revenue (AR) • marginal revenue (MR) • total revenue (TR) Revenue curves when price varies with output (downward-sloping D curve) • average revenue (AR) • marginal revenue (MR) • total revenue (TR) • revenue curves and price elasticity of demand Shifts in revenue curves 25 3.4 PROFIT MAXIMISATION Using total curves • maximising the difference between TR and TC • the total profit curve Using marginal and average curves • stage 1: profit maximised where MR = MC • stage 2: using AR and AC curves to measure maximum profit Some qualifications • long-run profit maximisation • the meaning of ‘profit’ • loss minimising: still produce where MR = MC • short-run shut-down point: P = AVC • long-run shut-down point: P = LRAC 26 Chapter 4 Market Structures 27 4.1 THE DEGREE OF COMPETITION Classifying markets by degree of competition • number of firms • freedom of entry to industry • nature of product • nature of demand curve The four market structures • perfect competition • monopoly • monopolistic competition • oligopoly Structure conduct performance 28 4.2 PERFECT COMPETITION Assumptions • firms are price takers • freedom of entry • identical products • perfect knowledge Short-run equilibrium of the firm • price • output • profit Long-run equilibrium of the firm • all supernormal profits competed away • LRAC = AC = MC = MR = AR Incompatibility of economies of scale with perfect competition 29 4.3 MONOPOLY Defining monopoly Barriers to entry • economies of scale • product differentiation, brand loyalty • lower costs for an established firm • ownership/control of key factors • ownership/control over outlets • legal protection • mergers and takeovers • aggressive tactics • intimidation The monopolist's demand curve • downward sloping • MR below AR Equilibrium price, output and profit • equilibrium output, where MC = MR • equilibrium price, given by D curve • measuring profit 30 31 4.3 (cont.) Disadvantages of monopoly • high prices / low output: short run • high prices / low output: long run • lack of incentive to innovate • X-inefficiency Advantages of monopoly • economies of scale • profits can be used for investment • promise of high profits encourages risk taking Contestable markets • importance of potential competition • a perfectly contestable market • contestable markets and natural monopolies • importance of costless exit Contestable markets and the public interest 32 4.4 MONOPOLISTIC COMPETITION Assumptions of monopolistic competition Equilibrium of the firm • short run • long run • under-utilisation of capacity in the long run Non-price competition The public interest • comparison with perfect competition • comparison with monopoly 33 4.5 OLIGOPOLY Key features of oligopoly • barriers to entry • interdependence of firms Competition versus collusion Collusive oligopoly: cartels • equilibrium of the industry • allocating and enforcing quotas Tacit collusion • price leadership: dominant firm • price leadership: barometric • rules of thumb Factors favouring collusion The breakdown of collusion 34 4.5 (cont.) Non-collusive oligopoly: game theory • alternative strategies: maximax and maximin • simple dominant strategy games • the prisoners' dilemma • more complex non-dominant strategy games Non-collusive oligopoly: the kinked demand curve theory • assumptions of the model • stable prices • limitations of the model Oligopoly and the public interest • advantages • disadvantages • difficulties in drawing general conclusions 35 4.6 PRICE DISCRIMINATION Meaning of price discrimination Conditions necessary for price discrimination to operate Advantages to the firm Profit-maximising prices and output under price discrimination Price discrimination and the public interest • competition • profits 36 Chapter 5 Wages and the Distribution of Income 37 5.1 LABOUR MARKET TRENDS Shift from agricultural and manufacturing to service-sector employment Rise in part-time employment Rise in female participation rates Rise in temporary employment Downsizing 38 5.2 WAGE DETERMINATION IN A PERFECT MARKET Perfect labour markets • everyone is a wage taker • freedom of entry • perfect knowledge • homogeneous labour The supply of labour • why upward sloping? • the position of the supply curve – the number of qualified people – non-wage benefits – desirability and availability of alternative jobs • elasticity of supply of labour – the mobility of labour 39 5.2 (cont.) The demand for labour: marginal productivity theory • the profit-maximising approach • the marginal cost of labour (MCL) • the marginal revenue product of labour (MRPL) • the profit-maximising level of employment for a firm • derivation of the firm's demand curve for labour Wages and profits under perfect competition 40 5.3 WAGE DETERMINATION IN IMPERFECT MARKETS Power in labour markets Firms with monopsony power in employing labour • MCL > W • effects on wages and employment Unions with monopoly power • unions facing competitive employers • effects of wage increases on employment Bilateral monopoly • no unique equilibrium • relationship between wages and employment • collective bargaining – union threats and promises – employers' threats and promises – role of government 41 5.3 (cont.) The efficiency wage hypothesis • Higher wage rates may lead to higher productivity – less 'shirking' – reduced labour turnover – self-selection – morale Flexible labour markets • the flexible firm • functional flexibility • numerical flexibility • core workers • peripheral workers • implications for the distribution of income 42 5.4 CAUSES OF INEQUALITY Inequality in the UK • income distribution before and after taxes and benefits • distribution of income by source • distribution of wages by occupation • distribution of wages by sex The causes of inequality • differences in ability • differences in attitude • differences in qualifications • differences in hours worked • differences in pleasantness of jobs • differences in power • differences in the demand for goods • discrimination • differences in household composition • inequality of wealth • degree of government support • unemployment 43 5.5 THE REDISTRIBUTION OF INCOME Taxation • progressive, regressive taxes and proportional taxes • problems in using taxes to redistribute incomes – income taxes – taxes on goods and services • taxation and incentives – income and substitution effects – raising the higher rates of tax – raising the basic rate – reducing tax allowances Benefits • cash benefits – means-tested benefits – universal benefits • benefits in kind • benefits and the redistribution of income • the problem of the poverty trap 44 Chapter 6 Market Failures and Government Policy 45 6.1 MARKET FAILURES: EXTERNALITIES AND PUBLIC GOODS Society's microeconomic objectives • equity • social efficiency – marginal social benefits and costs – production where MSB = MSC Externalities • External costs of production MSC > MC • External benefits of production MSC < MC • External costs of consumption MSB < MB • External benefits of consumption MSB > MB Public goods • non rivalry • non-excludability 46 6.2 MARKET FAILURES: MONOPOLY POWER The demand curve under monopoly Deadweight loss under monopoly • consumer and producer surplus – consumer surplus – producer surplus – total surplus • the effect of monopoly on total surplus Other problems with monopoly Possible advantages from monopoly 47 6.3 OTHER MARKET FAILURES Ignorance and uncertainty Immobility of factors and time lags in response Protecting people's interests • dependants • the principal–agent problem – the problem of asymmetric information – the need for monitoring • poor economic decision making by individuals – merit goods Macroeconomic goals How far can economists go in advising governments 48 6.4 GOVERNMENT INTERVENTION: TAXES AND SUBSIDIES The use of taxes and subsidies • to correct externalities – the optimum size of a tax – the optimum size of a subsidy • to correct for monopoly – use of lump-sum taxes Advantages of taxes and subsidies Disadvantages of taxes and subsidies • infeasible to use different tax and subsidy rates • lack of knowledge 49 6.5 GOVERNMENT INTERVENTION: LAWS AND REGULATION The use of laws and regulation Advantages of legal restrictions • simple to understand • safer when size of problem is potentially great • quick to implement • a good way of dealing with imperfect information Disadvantages of legal restrictions • a ‘blunt weapon’ 50 6.5 (cont.) Types of regulation The system of regulation in the UK • UK regulatory bodies • price-cap regulation – the RPI – X formula Advantages of the UK system • discretionary • flexible • incentive for firms to reduce costs Disadvantages of the UK system 51 6.6 OTHER FORMS OF GOVERNMENT INTERVENTION Changes in property rights • the problem of limited property rights • extending property rights • limitations of this solution Provision of information Direct provision of goods and services • the provision of public goods • need to evaluate costs and benefits of publicly provided goods • the provision of other goods and services by the government – social justice – large positive externalities – dependants 52 – ignorance 53 6.7 MORE OR LESS INTERVENTION? Drawbacks of government intervention • shortages and surpluses • poor information • bureaucracy and inefficiency • lack of market incentives • shifts in government policy • voters' ignorance • unrepresentative government • lack of freedom for the individual Advantages of the free market • automatic adjustments • dynamic advantages of capitalism • high degree of competition even under monopoly/oligopoly 54 Judging the arguments 55 Chapter 7 Aggregate demand and supply and macroeconomic objectives 56 7.1 MACROECONOMIC OBJECTIVES Distinction between microeconomics and macroeconomics The major macroeconomic issues • economic growth • unemployment • inflation • balance of payments and exchange rates – balance of payments deficits and surpluses – exchange rate movements 57 7.2 THE CIRCULAR FLOW OF INCOME The inner flow Withdrawals • net saving • net taxes • import expenditure Injections • investment • government expenditure • export expenditure 58 7.2 (cont.) The relationship between injections and withdrawals • the links between them • planned injections may not equal planned withdrawals Equilibrium in the circular flow The circular flow and the four macroeconomic objectives 59 7.3 ECONOMIC GROWTH Actual and potential growth Economic growth & the business cycle • fluctuations in actual growth • the phases of the business cycle • the business cycle in practice – the irregularity of the cycle – the length of the phases – the magnitude of the phases Causes of actual growth • aggregate demand • aggregate demand relative to potential output 60 7.3 (cont.) Causes of potential growth • increases in the quantity of factors – capital – labour – land and raw materials – problem of diminishing returns • increases in factor productivity Policies to achieve growth • demand-side and supply-side policies • market-orientated and interventionist policies 61 7.4 UNEMPLOYMENT The meaning of 'unemployment' Official measures of unemployment • claimant unemployment – do claimant statistics give a true picture of unemployment? • standardised unemployment (ILO/OECD) Unemployment and the labour market • the aggregate demand and supply of labour • equilibrium in the model • disequilibrium unemployment • equilibrium unemployment 62 7.4 (cont.) Disequilibrium unemployment • real-wage (classical) unemployment • demand-deficient (cyclical) unemployment • unemployment arising from a growth in the labour supply Equilibrium unemployment • frictional (search) unemployment • structural unemployment – changing pattern of demand – technological unemployment – regional unemployment • seasonal unemployment 63 7.5 AGGREGATE DEMAND A N D SU P PLY The aggregate demand curve Why aggregate demand curves slope downwards • import effect • interest rate effect • savings effect The aggregate supply curve Equilibrium Effect of a shift in the aggregate demand curve 64 7.6 INFLATION Defining inflation The costs of inflation • redistribution • uncertainty • balance of payments • resources used to cope with inflation Types of inflation • demand pull • cost push – wage push – profit push – import-price push • structural (demand shift) • expectations and inflation Policies to tackle inflation • demand-side policies • supply-side policies 65 Chapter 8 The Determination of National Income and the Role of Fiscal Policy 66 8.1 THE EQUILIBRIUM LEVEL OF NATIONAL INCOME Effect on national income of a change in injections and/or withdrawals • J>W • W>J The Keynesian diagram: the withdrawals and injections approach • the withdrawals curve • the injections curve • equilibrium The Keynesian diagram: the income and expenditure approach • the 45º line • the expenditure curve • equilibrium 67 8.2 THE MULTIPLIER The multiplier: introduction • the circular flow of income and effects of changes in injections • definition of the multiplier: Y/J Withdrawals and injections approach • graphical analysis: shift in the J line • the formula: 1 / mpw or: 1 / (1 – mpcd ) Income and expenditure approach • graphical analysis: shift in the E line 68 8.3 THE KEYNESIAN ANALYSIS OF UNEMPLOYMENT AND INFLATION 'Full-employment' national income 'Gap' analysis • the deflationary gap • the inflationary gap • policy implications Inflation and unemployment together • inflationary pressures before the full-employment level of income • implications for shape of AS curve The Phillips curve • the shape of the curve • the position of the curve • policy implications of the curve • the breakdown of the curve • recent relationship between inflation and unemployment 69 8.4 KEYNESIAN ANALYSIS OF THE BUSINESS CYCLE The accelerator • changes in national income and induced investment • the accelerator effect • the instability of investment The multiplier / accelerator interaction Fluctuations in stocks The course of the business cycle • why do booms and recessions persist? – time lags – 'bandwagon' effects • why do booms and recession come to an end? – – – – – ceilings and floors echo effects the accelerator random shocks changes in government policy 70 8.5 THE ROLE OF FISCAL POLICY The purpose of fiscal policy • correcting a fundamental disequilibrium • fine tuning Deficits and surpluses • central government deficits and surpluses • public-sector deficits and surpluses • the PSNCR • the national debt The use of fiscal policy • automatic fiscal stabilisers • discretionary fiscal policy 71 8.6 THE EFFECTIVENESS OF FISCAL POLICY Factors determining the effectiveness of fiscal policy • accuracy of forecasting • effect on J and W • effect of changes in J and W on national income • timing of the effects • effects on the various macro objectives Discretionary policy: problems of forecasting the magnitude of effect • effects of changes in government expenditure • crowding out • effects of changes in taxes • size of the multiplier and accelerator effects • random shocks 72 8.6 (cont.) Discretionary policy: problems of timing and time lags • various time lags • policy may be destabilising Side-effects of discretionary policy • cost inflation • welfare and distributive justice • incentives A rules-based approach to fiscal policy • a ‘steady-as-you-go’ policy • the EU Stability and Growth Pact • UK Labour government’s ‘Golden Rule’ 73 Chapter 9 Money and Monetary Policy 74 9.1 THE MEANING AND FUNCTIONS OF MONEY The functions of money • medium of exchange • means of storing wealth • means of evaluation • means of establishing value of future claims and payments What should count as money? • narrow definitions of money • broad definitions of money 75 9.2 THE FINANCIAL SYSTEM IN THE UK Role of banks in the monetary system • deposits and loans • liabilities and assets • retail and wholesale deposits and loans Liabilities • sight deposits • time deposits • certificates of deposit • repos Assets • cash and balances with the Bank of England • short-term loans • longer-term loans 76 9.2 (cont) Liquidity and profitability • profitability • liquidity • the liquidity ratio The Bank of England • note issue • management of government's borrowing programme • provides liquidity to the banks • operates monetary and exchange rate policy The London money market • the discount and repo markets • last-resort facilities • the parallel money markets 77 9.3 THE SUPPLY OF MONEY Definitions of the money supply • monetary base • broad money Definitions in the UK The creation of credit • simple illustration • the bank multiplier • the real world Causes of increases in money supply • banks reduce liquidity ratio • inflow of funds from abroad • PSNCR and its financing Money supply: exogenous or endogenous? 78 9.4 THE DEMAND FOR MONEY The motives for holding money: liquidity preference • transactions motive • precautionary motive • speculative motive Demand for money and interest rates • active balances • idle balances • the liquidity preference curve: L 79 9.5 MONETARY EQUILIBRIUM Equilibrium in the money market • equilibrium interest rate where D & S of money are equal Equilibrium in the foreign exchange market • increased money supply leads to lower interest rates • lower interest rates lead to a lower exchange rate Effects of changes in money supply on national income: • effect on interest rates • effects of changes in interest rates on investment • effects of changes in interest rates on the exchange rate and hence on imports and exports • effects of changes in I, M and X on national income 80 9.6 MONETARY POLICY Control of money supply over medium and long term • restricting size of PSNCR • problem of financial crowding out Short-term monetary control • techniques to control money supply – open-market operations – other • controlling interest rates – role of Monetary Policy Committee of Bank of England – backing up MPC decisions in repo market • rationing credit 81 9.7 EFFECTIVENESS OF MONETARY POLICY Reducing the PSNCR • the desire to cut taxes • difficulty in cutting government expenditure Short-term monetary control • problems with credit rationing • the effectiveness of changes in interest rates – inelastic demand for loans – unstable demand for money • importance of confidence in policy Using monetary policy • using interest rate to target inflation 82 Chapter 10 Unemployment and Inflation 83 10.1 MONEY AND PRICES The quantity theory of money The equation of exchange • M money supply • V velocity of circulation • P price level • Q quantity of national output • MV = PQ The link between money and prices Assumptions about the velocity of circulation (V) • the Keynesian view – the monetary transmission mechanism – the money–interest rate link – the interest rate–spending link • the monetarist view – the theory of portfolio balance – the short-run variability of V 84 10.1 (cont.) Assumptions about output and prices • monetarist and new classical views – the interdependence of markets – the flexibility of prices • the Keynesian view – the stickiness of wages and prices – the effects of investment on aggregate supply 85 10.2 INFLATION AND UNEMPLOYMENT: MONETARIST VIEWS Incorporating expectations into the analysis of the Phillips curve • adaptive expectations The accelerationist theory • accelerating inflation when unemployment is kept below the ‘natural’ level • effects of deflationary policies • the long-run Phillips curve • Phillips loops Policy implications 86 10.3 INFLATION AND UNEMPLOYMENT: NEW CLASSICAL VIEWS Assumption of flexible wages and prices Rational expectations • meaning of rational expectations • imperfect information • implications for aggregate supply and the Phillips curve • policy implications Real business cycles • explanations in terms of fluctuations in aggregate supply • causes of changes in aggregate supply • policy implications 87 10.4 INFLATION & UNEMPLOYMENT: KEYNESIAN VIEWS Changes in equilibrium unemployment • higher structural unemployment • hysteresis The persistence of demand-deficient unemployment • payment of efficiency wages • insider power Incorporation of expectations • expansion of aggregate demand • contraction of aggregate demand Keynesian criticisms of nonintervention 88 10.5 COMMON GROUND BETWEEN ECONOMISTS? Short-run effect of changes in AD • major effect on output and employment • relatively small effect on prices Long-run effect of changes in AD • relatively small effect on output and employment • relatively large effect on prices • some Keynesians disagree – stress long-run effects of changes in AD on investment Incorporation of expectations 89 10.6 DEMAND-SIDE POLICY Case against discretion • time lags • over-correction • government may ignore long-term consequences Case for rules • can reduce inflationary expectations • create a stable environment for investment and growth Case against rules • can cause severe fluctuations in interest rates and can cause greater instability • which rule to choose? • rules may conflict • rules may become unsuitable Case for discretion • helped by better forecasting and quick-acting policies • allows government to respond to changing circumstances 90 10.7 SUPPLY-SIDE POLICY The use of supply-side policies • to reduce unemployment • to reduce inflation • to increase economic growth Market-orientated supply-side policies • reducing government expenditure • tax cuts – effects on incentives – effects on imports – tax cuts for business • reducing the power of labour • reducing welfare • policies to encourage competition – privatisation – deregulation – introducing market relationships into the public sector – the Private Finance Initiative – free trade & capital movements 91 10.7 (cont.) Interventionist supply-side policy • industrial policy – rationalisation – advice and persuasion – information – finance for research and development – assistance to small firms • infrastructure development • training and education 92 Chapter 11 International Trade 93 11.1 THE GAINS FROM TRADE The law of comparative advantage • specialisation as the basis for trade • absolute advantage • comparative advantage • the gains from trade based on comparative advantage The limits to specialisation and trade The terms of trade • PX/PM Other reasons for gains from trade • decreasing costs • differences in demand • increased competition • trade as an ‘engine of growth’ • non-economic advantages 94 11.2 ARGUMENTS FOR RESTRICTING TRADE Methods of restricting trade • tariffs • quotas • administrative barriers • other Arguments for restricting trade • infant industry argument • changing comparative advantage • to prevent dumping • to prevent establishment of a foreign-based monopoly • to spread risks • externalities • pursuing national interests (but against world interests) – exploiting monopoly power – protecting declining industries • other economic arguments • non-economic arguments 95 11.2 (cont) Problems with protection • protection as ‘second best’ • world multiplier effects • retaliation • cushions inefficiency • bureaucracy 96 11.3 WORLD ATTITUDES TOWARDS TRADE AND PROTECTION History of protection • pre-war growth in protection • post-war reduction in protection and the role of GATT • re-emergence of protectionism in the 1980s – the use of non-tariff barriers • The Uruguay Round – aims of the Uruguay Round negotiations – problems in reaching agreement – the agreement The WTO • dispute settlement • conflicting interests in trade disputes 97 11.4 TRADING BLOCS Types of preferential trading arrangement • free trade areas • customs unions • common markets Direct effects of a customs union • trade creation • trade diversion Lonter-term effects of a customs union • longer-term advantages • longer-term disadvantages Preferential trading in practice • the EU • NAFTA • other examples 98 11.5 THE EUROPEAN UNION Historical background From customs union to common market • Common Agricultural Policy • regional policy • competition policy • tax harmonisation • social policy The single market • historical background • the Single European Act • completing the single market • benefits of the single market – trade creation – reduction in the direct costs of barriers – economies of scale – greater competition 99 11.5 (cont.) • criticisms of the single market – radical economic change is costly – adverse regional multiplier effects – development of monopoly / oligopoly power – trade diversion • evidence • the future of the EU – effect of new members 100 11.6 TRADE AND DEVELOPING COUNTRIES Trade strategies • primary outward looking • secondary inward looking – import-substituting industrialisation (ISI) • secondary outward looking – possibly complemented by primary inward looking Approach 1: exporting primaries • justification – exploits comparative advantage – a ‘vent for surplus’ – an ‘engine for growth’ 101 11.6 (cont.) Approach 1: exporting primaries (cont) • problems with traditional trade theory – comparative costs change – benefits may not flow to nationals – may lead to greater inequality – externalities • long-term problems – low income elasticity of demand – protection in advanced countries – technological developments – rapid growth in imports – adverse movements in terms of trade 102 11.6 (cont.) Approach 2: ISI • justifications – problems of primary exporting – dynamic potential in manufacturing • infant industries • rapid technological advance • patterns of protection – selecting industries for protection – tariff and quota escalation – attracting multinational investment 103 11.6 (cont.) Approach 2: ISI (cont.) • adverse effects of ISI – often counter to comparative advantage – tends to cushion inefficiency • encourages establishment of monopolies – artificially low interest rates • use of capital-intensive techniques – encourages rural–urban migration – adverse effects on rural sector – leads to greater inequality – environmental problems – limit to home market 104 11.6 (cont.) Approach 3: exporting manufactures • transition to from inward-looking to outward-looking industrialisation – a neutral trade approach – active promotion of exports • gains from exporting manufactures – conforms more closely with comparative advantage – increased competition – increased investment – more employment, greater equality • drawbacks of exporting manufactures – retaliation from advanced countries • but attitudes of WTO – competition from other developing countries – vulnerability to world fluctuations • trade between developing countries – trade blocs of developing countries 105 Chapter 12 Balance of Payments and Exchange Rates 106 12.1 THE BALANCE OF PAYMENTS ACCOUNT Meaning of the balance of payments The current account • trade in goods • trade in services • balance of trade in goods & services • income flows • current transfers of money • balance on current account The capital account The financial account • investment • short-term financial flows • flows to and from reserves • financial account balance Assessing balance of 107 payments figures 108 12.2 EXCHANGE RATES The rate of exchange • individual rates of exchange • exchange rate index Determination of exchange rates • the equilibrium exchange rate • appreciation and depreciation • shifts in currency demand & supply – differences in interest rates – differences in inflation rates – relative investment prospects – change in aggregate demand – speculation 109 12.3 EXCHANGE RATES AND THE BALANCE OF PAYMENTS Exchange rates and the balance of payments: no government intervention • a floating exchange rate • automatic balancing of overall balance of payments • current, capital & financial accounts may not separately balance Exchange rates and the balance of payments: government intervention • reducing short-term fluctuations – using reserves – borrowing from abroad – changes in interest rates • maintaining a fixed rate of exchange over the longer term – deflation / reflation – supply-side policies 110 – import controls 111 12.4 FIXED VERSUS FLOATING EXCHANGE RATES Advantages of fixed exchange rates • certainty • no speculation (if rate is absolutely fixed) • prevents 'irresponsible' government policies Disadvantages of fixed exchange rates • conflicts with other macro objectives • danger of competitive deflations • problems of international liquidity • difficulties in adjusting to shocks 112 • speculation 113 12.4 (cont.) Advantages of free-floating rates • automatic correction • non problem of international liquidity and lack of reserves • insulation from external events • governments free to choose their domestic policy Disadvantages of free-floating rates • possibly unstable exchange rates • speculation • uncertainty for business – but use of forward market • lack of discipline on economy 114 12.5 THE ORIGINS OF THE EURO Post-war regulation of exchange rates • the Bretton Woods system • its collapse in the early 1970s • dirty floating The ERM • features of the ERM • the 1980s • crisis in the ERM – events of 1992 – events of 1993 • a return of calm The Maastricht Treaty • background • Stage 1 • Stage 2 – the convergence criteria • Stage 3: economic and monetary union (EMU) 115 12.6 EMU Birth of the euro • meeting the convergence criteria • role of the European Central Bank Advantages of EMU • eliminating conversion costs • increased competition and efficiency • elimination of exchange-rate uncertainty between members • increased inward investment • lower inflation and interest rates Disadvantages of EMU • political arguments • adjustment to shocks – problem of asymmetric shocks • EU12 may not be an • regional problems Recent developments 116 12.7 GLOBALISATION AND THE PROBLEM OF INSTABILITY The need for policy co-ordination • the search for policy co-ordination – G7 meetings: attempts at harmonisation – but lack of convergence Difficulties in achieving harmonisation • differences in budget deficits and debts • interest rate divergence • elimination of exchange-rate uncertainty between members • different internal structures of economies • politicians more concerned with domestic issues 117 12.8 DEBT AND DEVELOPING COUNTRIES Origins of the debt problem • borrowing to finance development • the 1973/4 oil shock • the 1979/80 oil shock – world recession: fall in export earnings – fall in commodity prices – high interest rates: increased cost of servicing debt Rescheduling debt • rescheduling official loans • rescheduling commercial bank loans 118 12.8 (cont.) Dealing with debt • structural reforms • IMF structural adjustment programmes – tight fiscal policies to reduce budget deficits – privatisation and liberalisation – open trade policy – hardship from IMF programmes • debt forgiveness – HIPC initiative – pressure to cancel debts – Jubilee 2000 119