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ECONOMICS.
COURSE GUIDE
tool kit
Key concepts, diagrammatic representations.
structure
History - cyclic, de-agriculturalisation, de-industrialisation.
Micro
Unemployment
Macro - policy potential?? global competition??
core analytical units
Behaviour
Consumption
Production
Supply & demand
Balance of payments
Firm's costs
Perfect competition & monopoly
Labour
Unemployment
Aggregate supply & demand
COURSE THEMES
change & transformation
international dimension
theory & policy
markets & planning
(dynamic)
(global)
(opportunism)
(ignorance)
PERSPECTIVES ON THE ECONOMY
1. LONG WAVES?
Innovation.
ORIGINS.
Fluctuations and economists' explanations, Kondratiev. Capital accumulation.
Prosperity, recession, depression, recovery.
DO THEY EXIST, EVIDENCE? THE DATA.
Look at data & then formulate a theory.
* real & nominal variables = physical quantity (what money will buy) & money value, measurables are data
until a theory is formed then they can become variables. Inflation? Do people respond to real or nominal
variables (the money illusion)? Wages? Prices? Real or nominal?
* economic growth = measure of total output, per capita; the trend, not cyclic change. Saturation has often
been predicted but all capitalist economies have grown. Technology & institutions change as output grows.
ENTREPRENEURS & INNOVATORS? THE THEORY.
Two theories Schumpter & Mensch.
Inventions accumulate but are applied as innovations, in swarms or bunches, when investment confidence is high, or
when profits are low, or when leaders emerge. As competitors imitate, costs are driven down the learning curve and there is
general growth, resulting in cycles. Schumpter = imitation of innovation eventually becomes necessary & confidence
overcomes risk (agent force); Mensch = low profits force action (structural force). Necessity is the mother of inventions but
application (innovation) waits until propitious for profit. I = f (  ).
Wave generators - iron smelting, steam engines, transport systems, computers.............
But confidence will return to different people at different times, and similarly in different sectors and different
locations? East Asia? Investment also fluctuates because of different experience and propensities (knowledge not lack of it).
But innovation is into new niches, declining industries continue to decline, the clutter of history is deep rooted. You
can plan but you cannot change history.
But the direction of causality is in doubt, complexities of timing & diffusion abound, how is impact measured, why is
the nature recurrent?
The simple explanation is best and most often correct (as in all science).
Intuitive extrapolation, results in boom optimism and bust depression, exacerbating the cycle. But rational experience
will encourage activity during depressions in anticipation of the upturn and the benefits of being first.
The theories fail to impress when their predictive capacity is zilch! The basis for all economic models is the
behavioural function.
* functions = depends on, e.g. behaviour of agents, innovation, could depend on structural forces, profit. The
dependant variable (usually only 1) is the effect, the independent variable(s) is the cause, the input into the
decision making process.
The economy is a process, moving, dynamic, going somewhere, doing something; it is not a quantified aggregate
result, but activities.
The economy is a system, millions of interacting agents, interlinked historically as well as currently, concerned with
production, exchange and distribution. There is NO monocausality!
Information, rumour, bubbles, risk, there's nowt so queer as folk!
innovation
investment
specialisation
scale
science.
2. SHORT CYCLES.
Investment.
FLUCTUATIONS IN AGGREGATE DEMAND.
Keynes (& Beveridge) developed a model of the economy which was sensitive to fluctuations in investment, which
itself depended on 'irrational' expectations. An attractive belief that suggested that demand could be manipulated to avoid
'intolerable' unemployment. Matthews described the consensus theory in 1959 - 'The Trade Cycle'.
Model building behaviour - consumption
then extend to other expenditure functions
then use the equilibrium concept to derive output theory
then the causes of changes (shifts) in output can be predicted.
Aggregate demand = consumer goods + capital goods + government purchases + (exports - imports).
e = c + i + g + (x - h)
Differences are important because different people take the decisions through different motivations.
* planned & actual, demand & supply = firms plan to maximise their profits but if customers don't demand,
actual output is different!
The concept of spare capacity makes the firm responsive in the short term.
DEMAND FOR CONSUMER GOODS.
* consumption function = depends on how much money people have & price level
* flows & stocks = quantity per unit time, & lump of quantity; income & wealth!
Demand (the main cause) = output (the real interest). The assumption is that although firms plan to supply, what they
actually produce depends on demand. What they actually do, is to provide better value than the competition at minimum cost.
Profit follows success.
Is spare capacity a waste? or just customers not getting value at a price they are willing to pay?
Full capacity is the output which maximises profit.
Consumption is 60% of demand. Demand = wishes, given the circumstances i.e. limited resources. or the 'customer
value equation'.
C = f ( Z, Pc ) nominal terms, or c = f (z) real terms.
or c = f ( y, M / Pc ) real terms. i.e. z = money resources, y = income, M / P c = money wealth.
i.e. aggregate demand for consumer goods depends on how much money consumers have and the price of such goods.
What about the 'cushioning' effect of other assets - houses??
c = f (y) is Keynes' fundamental function, the psychological law that consumption depends on income, not wealth.
Friedman extended this to include real money balances.
Keynesians manipulating investment expectations and monetarists manipulating the money supply, both use the
same model.
AUTONOMOUS EXPENDITURE.
Exogenous variables. Items not effected by income.
* endogenous & exogenous variables = within & outside of the model.
We can't deal with everything at the same time! Exogenous variables SHIFT the curve.
AGGREGATE DEMAND & OUTPUT.
Summarising:c depends on y & therefore aggregate demand depends on national income, defined by the theory, the equation.
q=y
i.e. output = income, we always pay somebody for everything! Wages, profit or rent.
But at equilibrium demand will always equal supply, e = q. Thus at one place only, demand & supply are in
equilibrium and this must be where the economy is! Where demand = output, demand = supply!
But this equilibrium may be below the firms full capacity so it is not an equilibrium for them & they would do
something! The economy would not get stuck below full capacity.
Two theories Keynes & Friedman.
EXPECTATIONS.
Keynes' theory is that fluctuations are due to 'irrational' investment. But too much is exogenous, too much
simplification. The money supply changes consumption & investment .....
MONEY SUPPLY
Directly effects consumption through the cushioning effect of wealth.
PRICES & OUTPUT
Money supply can effect both output and prices, can we distinguish? If the money supply was a cause of output
fluctuations through demand, output and prices rise together. If supply was the trigger, surely output and prices would move in
opposite directions. NB demand hike output & prices go up but with supply shift output goes up but prices fall.
The aggregate demand model was developed by Keynes because he was concerned with low output but it is of little
value as a theory of prices.
cycles
aggregate demand
output
e
optimistic
pessimistic
time
output/income
NATIONAL INCOME
Today a TV costs less than 20 years ago and it is a very different quality.
Non marketed output is excluded.
* national income = all goods & services (but NOT housework) generated by the countries residents. Don't
double count all output (only value added) or all income.
GDP = incomes generated in producing goods & services in the UK. i.e. the cost of inputs + wages & profits.
Excluding state benefits and tax.
GNP = GDP + net income from overseas. Domestic product is production within the UK. National is world
wide production by UK residents
NNP =NI = GNP - depreciation = national expenditure by definition
Disposable income = national income -/+ transfer payments.
CONCLUSION
Value limited because the models ignore complex system dynamics and individual behaviour.
Cause and effect are the drivers for reductionism in science but cannot be applied to macro economics, in principle.
BIG problems result from the initial good idea of modelling the economy. If we assume our model reflects reality we
will implement policy with disastrous effects., because reality is, and always will be, different. Even if we could get the
complexity right today it would be wrong tomorrow.
Models must be used to assist understanding not as policy drivers.
THE CHANGING ECONOMY
3. GROWTH, CHANGE AND STRUCTURE.
ONE WORLD OR THREE.
1st World
2nd World
3rd World
capitalist
socialist
non aligned
service
industry
agriculture
NORTH...............................................................
SOUTH
RICH.............................................
POOR
GNP per capita $10,000......>...............
$5,000...........>................. $1,000
Growth rate...... ...................>..........................................>.............................
Nothing to do with natural resources all to do with the process of wealth production. Difficult to measure when 'self
consumption' is high.
DIVISION OF LABOUR.
specialisation
Follows from inequalities of luck, risk, investment and skill.
Adam Smith's famous pin factory.
No one dominates in a dynamic system. Venice was a leader once, and everyone needs customers and better quality
suppliers. Joe cannot be squeezed if he has a better mouse trap to sell or if his dollar can be spent with the competition.
Participation also; as a customer, or an owner, or an investor, anyone anywhere can buy a share in Unilever.
Specialisation implies more participation not more control i.e. more subcontracting.
GROWTH.
Two theories Rostow & Harrod - Domar.
Output  capital stock (& workers)
Output must be sold!!
Output = consumption + investment Consumption is a constant proportion of income.
Harrod - Domar g = ( 1 - c ) / v c = propensity to consume or the proportion of output consumed.
v = capital per unit of output.
Smooth, continuous growth with output from investment matching demand.
INDUSTRIALISATION.
Productivity
growth
level
Labour will produce more where productivity is highest and will move to such sectors. Productivity is highest where
investment capital gears production.
Rostow
traditional - no science, a long run fatalism, constant fending off of diminishing returns.
preconditions - use of science and extended markets in a competitive environment,
willingness to take risks and invest, institutions for capital mobilisation,
breakdown of feudalism.
take off - death of vested interests, incentive to profit from saving, innovation starts.
drive to technological maturity - extension, self reinforcing.
maturity of high mass consumption - a way of life, not just food, shelter, but the car!
Aid don't work, behaviour has to be learned. Leadership and example!
Capital, skill and ideas are all essential for growth. Rostow rated capital as the crucial bottleneck.
Investment needs to reach 10% of NNP for take off.
The idea of extension or spread or linkage or competitive imitation of methods and technology is key.
Output to capital ratios are different for different industries, leading to different sector growth rates.
Specialisation/division of labour results in 3 improvements
dexterity
time from streamlined flow/organisation
investment/mechanisation
PRODUCTION FUNCTION.
* production function - q = f( k, l ) summarises all the technically efficient combinations of inputs which are
available to produce different levels of output with a given technology. It describes a technology.
production function (a given technology)
relative price
capital
all methods 1 output
improved technology
1 method
all outputs
cheaper labour
labour
+ tools + workers
+ tools same workers
labour
new technology
same output
capital
output
labour
For one production method ( i.e. the same k / l ratio) technical efficiency is achieved at the corner of the L shape
where inputs are minimum. A technology involves a range of production methods ( i.e. different k / l 's). For several methods
with substitutable capital & labour isoquants can be drawn. If production technology changes the production function changes.
The isoquant shifts.
q = f1 ( k, l ) at one technology level
q = f2 ( k, l ) at another technology.
Choice of production method depends on relative prices and new technology. Capital or labour against output is a
flattening curve. Technologies are not fixed.
q = f ( k, l, t1, t2 ) where t1 = capital technology
t2 = method of organising labour.
4. INDUSTRIALISATION OF BRITAIN.
WORKSHOP OF THE WORLD.
Capital, skill, ideas, 'gadgets' and hard work, are ALL scarce. Capital needs skill and effort to exploit it and investment
quality is key. Gelling of many, locally, evolution not revolution.
INVESTMENT.
Savings:- forced savings = tax = Concorde, private savings = new factories in Vietnam.
Low savings = low investment = low productivity = low real income!!!!!
Also institutions for channelling savings to investments, banks and jsc’s.
Investment diverted from decentralised stocks to centralised production (factories). Also better transport
communication, and middle men. Thus, not necessarily more investment maybe just better investment. Embodied technical
change.
Investment is in fixed assets, working capital & foreign assets.
Growth from - more workers with tools more capital & labour same method
more tools per worker
more capital different method
improved technology
isoquant shift
improved methods
isoquant shift
scale economies
In all cases investment is needed!
* returns to scale = the same incremental increase in inputs produce an increasingly large increase in output.
PHYSICAL QUANTITIES.
Capital and labour quality matter.
The key to growth, diverting capital (from stocks), overcoming reluctance to invest in risky fixed assets (resulting in
embodied technical change & increasing returns to scale), and more, of more intensive, skilled labour, and above all better
organisation. In the UK it was probably flexibility & ingenuity rather than risky investment (uncertain markets) which led to
take off (the relative price of labour fell as the population exploded).
* economies of scale = internal due to cubes and squares, bulk purchases, division of labour (specialisation)
& the learning curve; lower unit costs - external due to location, education, services & infrastructure.
MONEY VALUES
LEADING SECTORS
The state cannot select and force a leading sector on a country. It is because investment is so painful and difficult that
time and trouble is spent to get it right. If it is subsidised it leads simply to more of the same please!
A single ripe thrust and through linkages others are dragged competitively into copying. The extended network.
Urbanisation reduces costs of communication & transport.
LINKS TO THE WORLD.
Competition led Britain to expand markets geographically not innovatively.
Germany and the US invested in capital intensive methods, although inflexible in comparison to Britain there was no
need for responsiveness the world was waiting. In the US a big population & plentiful natural resources led to different
developments; standardisation, interchangeable parts, & mass production.
Powerless political pawns prohibit progress.
A whole complex of factors.
Competition, help or hinder?
Importing your own exports? Think interdependency, think change.
Variety (responsiveness) v. standardisation (mass production)
Britain industrialised first but it's expertise was always in finance. Stock markets to raise finance, credit for overseas
trade, placing of foreign investments.......
5. DEINDUSTRIALISATION.
DEINDUSTRIALISATION.
Relative decline in manufacturing, a repeat of de-agriculturalisation, no one could anticipate the growth of the new
service industries because they were new. Output, employment, exports/imports & services growth.
Employment can decline even though the industry is prospering as productivity increases, as agriculture.
NB.
mercantilism
ignored the process of wealth creation.
16th cent?
anti Corn Law league
established the merits of free trade
1840?
Manufacturing exports declined as NIC's took over.
TRADE UNIONS.
Craft, general, industrial and white collar unions all peaked in 1979 and have since declined.
Correlation does not necessarily imply cause. Other things are NEVER equal, the cause could be in the opposite
direction or through a 3rd factor or the reality of complex interrelations in complex systems.
High labour costs could spur investment and productivity and innovation.
High labour costs could inhibit investment if profits are lower.
FINANCE AND INVESTMENT.
Industrialisation involved high investment, de-industrialisation involves low investment. So what, what has changed
are perceived opportunities for profitable investments. Investment is now in human capital.
Investment involves both saving and spending.
* investment function - i = f ( r )
Expectations shift the curve.
Capital / output ratio is not fixed.
Rates of returns on assets will be higher for the marginal new investments as avant guarde customers desires are
satisfied with innovative technology.
Shortage of profit opportunities NOT shortage of finance! Shortage due to tax and price control; socialism!!
SERVICES.
Productivity can increase in services as software can write software, but it is generally believed that there is less scope
for productivity increases.
Non marketable output, the Bacon/Ellis thesis explains de-industrialisation, the growth of government, the increases
in tax, the resulting wage inflation and pressure on corporate profits and investment. It is NOT Kaldor's explanation of
industrial 'maturity'.
INTERNATIONAL SPECIALISATION.
It's a system. There is NO cause and effect and therefore NO policy implications!!
Absolute advantage due to factor endowments, technology, tastes & incomes i.e. supply and demand. But all
endowments are mobile and change. All endowments have to be sold to customers.
Comparative advantage results from specialisation where relative efficiency is greatest, where relative price is lowest;
even if there is an absolute advantage in everything, specialisation still takes place where relative costs are lowest and this
leaves 'holes' for the others. There is always room for everyone as everyone is different.
BERNARD FOLEY
About manufacturing
Was agriculture different?
Primary
secondary
tertiary
= agriculture
labour
= manufacturing capital
= services
information
Are other countries different?
STATISTICS
output, employment, ratio to services & balance of trade / NIC's
- current
visible food, RM's -ve
manufactures +ve
invisible bank charges, insurance +ve
- capital
direct investment
portfolio
asset transactions of banks
EXPLANATION
cost of labour
rate
productivity
i.e. cost per unit of output
depends on
efficiency of labour & management
quantity & quality of investment
if real wage costs are too high prices rise / profits fall.
POLICY
incomes policy!!??
TRADE AND EXCHANGE
6. PATTERNS OF TRADE.
Specialisation leads to:improved skill and efficiency through practice (dexterity), time saving & mechanisation
trade and interdependence
inequality.
The pattern is the result of :INSTITUTIONS?????
Endowments
natural and personal
land, capital, labour.
technology.
customers wishes
tastes & incomes.
The mechanism is price = supply and demand = money
GROWTH OF TRADE.
Primary products then post 1950 manufactures, next services????
Disrupted by protectionism - tariffs, quotas, foreign exchange restrictions,
NB Trade as a % of output and in real terms gives added insights,
* terms of trade = prices of exports/prices of imports; prices measured in nominal terms mean they can move
in different directions, Improvement if export prices rise!!
CHANGING PATTERNS.
Endowments = advantage = trading pattern. Heckscher - Ohlin theory.
But..... some countries trade more
due to exploitation or protectionism?
not just land, labour, capital
Leontief Paradox = endowment of human capital?
similar countries trade more
trust = obligation, differences within a common culture!!!!!!!!!!! Xianity
does it!!!! or is it technology and taste differences???
Innovative technology to gain advantage, not only production methods but the products themselves.
is the technology gap permanent? = success breeds success; 1st in = economies of scale & plough back (R
& D expenditure).
or is there a product cycle?
= imitation = erosion of advantage.
or are they sequential?
Tastes and incomes
with higher incomes consumption shifts to marginal sophisticated innovative new products & more
trade/more choice.
UK TRADE PATTERN.
No comparative advantage in manufactures, no innovative technology, tastes go for Japanese design!
PRICES.
Advantage is reflected in price, relative price (how much one product swops for another), derived from the supply
conditions, endowments & technology, & the demand conditions , tastes & incomes.
Absolute advantage compares products one at a time, but with specialisation the decision is based on comparing the
efficiency of producing one or another, or comparative advantage.
* comparative advantage = where the relative price is lower,
International prices will be different from the relative prices, but trade will take place as long as the international price
is higher than the relative price, fluctuations in the international price alter the terms of trade.
Prices influence trade, supply and demand influence prices.
Endowments and technology (and alternatives) = supply
Tastes and income (and alternatives) = demand
But things are always changing, advantages come & go, countries can imitate & factors/technology are mobile.
Mutual interaction is a fact of life, does unemployment cause crime or crime cause unemployment!? or are both causes
AND effects of a wider system?
7. COMMODITY PRICES.
PRIMARY COMMODITIES.
Foodstuffs and raw materials grown or extracted with land.
Developed countries trade more but LDC's are more dependant on primary commodity trade. Export earnings depend
on price and quantity.
DEMAND.
Planned wants AND ability to pay.
* demand curve = if all other things are constant, people will plan to demand less as price rises.
Total revenue can go up or down depending on how much volume falls as price rises.
* elasticity of demand = proportional change in the quantity demanded ( q/q) / proportional change in the
price (p/p) = responsiveness. Own price elasticity - moves along the demand curve. cf income and cross
price shifts the demand curve, as do changes in tastes.
Determined by availability of substitutes and the time customers have to adjust to change.
Own price
q*p/p*q
if <1 = demand inelastic
% change in quantity < % change in price, ie below midpoint.
TR and price move in the same direction
if >1 = demand elastic
% change in quantity > % change in price, ie. above midpoint.
TR and price move in the opposite direction.
Income
q*y/y*q
normal
good if elasticity is > 0 and inferior
if elasticity is < 0
r
r
Cross price
q*p /p *q
substitute
good if elasticity is > 0 and complementary if elasticity is < 0
SUPPLY AND DEMAND MODEL.
Importance of elasticities = effects on total revenue.
Also supply elasticity, generally supply is inelastic as it takes time to increase supply.
Change in own price
= movement along the demand curve.
Change in income, cross price, tastes
= shifts the demand curve
ie change in conditions
= shifts the curve.
Demand conditions
income, cross price, tastes, population, credit, expectations.......
Supply conditions
technology, input prices (costs)......
Equilibrium price and gluts and queues.
Demand conditions
Supply substitutes
- income substitutes, taste, population, credit.
- technology, other costs.
INELASTIC
demand - supply shift
prices
ELASTIC
output
output
supply - supply shift
prices
output
output
demand - demand shift
prices
output
output
supply - demand shift
prices
output
output
RISK AND PRICE FLUCTUATION - COMMODITY MARKETS.
floor price – buying
ceiling price - selling
prices
D
D1
S
output
S1
output
AGRICULTURAL SUPPLY & DEMAND.
Supply shift.
prices
D
S
P
S1
p1
q
q1
output
price support.
ceiling price – selling
prices
D
floor price – buying
D1
S
S
S1
D
p
p
output
output
CAP.
Consumer tax & levy.
D
Consumer tax & surplus purchase.
S
price
D
PS
PS
PW
PW
q home
qw
output
Deficiency payments.
price
D
S
ps
pw
q home
q
S
output
7A prices
DEMAND, SUPPLY & THE MARKET.
The supply and demand model explains how a commodity price is determined but the price system is another matter!!
Elastic supply lines intersect the y axis, inelastic supply lines intersect the x axis.
PRICE SYSTEMS.
Hayek and the communication of knowledge through prices. Dispersed knowledge is co-ordinated.
What is the message of the price level??
8 MONEY & TRADE.
Barter first then money, what are the differences? What is it? What are it's properties?
medium of exchange, store of wealth, unit of account.
INTERNATIONAL MONEY.
C > M, then M > C, ie C > M > C, or C > C!! The purpose is to exchange goods and services NOT to end up with a
treasury full of $$$$$$$'s!! Mercantilism!!
MONEY IS AS MONEY DOES??
Money is confidence, obligation!!
Treasure is ALSO a store of wealth as it can be ultimately used to purchase goods, in the meantime it represents
POWER.
As a store of wealth money is not UNIQUE and it is not always SECURE.
A unit of account could be anything but it is CONVENIENTLY money.
MONEY FORMS.
* assets & liabilities = net wealth = assets - liabilities (what I have - what I owe).
credit & money are distinct, one a liability the other an asset.
Banks function is to channel money from savers to investors of capital by making loans.
Clearing (clearers of cheques), Overseas, Acceptance (merchant underwriting commercial bills and advising),
Discount (buyers of treasury bills).
Bank of England is both an arm of the state and the representative of the banks.
WHY MONEY?
Liquidity - cheap to use (low transaction costs), certain value, generally acceptable. Double coincidence of wants,
thus search cost are high. Money is a general futures contract a medium of exchange.
Store of wealth - people want wealth but not necessarily money, other assets compete with money.
There is a demand for money in it's own right and therefore a reason for it to exist.
* demand for money = depends on national income (ie more trade = more exchange) + interest rates (ie
more reward for bonds = less money held).
MD = f ( y, r )
MONEY & PRICES.
Money price of goods and services = what changes hands.
Relative price = how much of another commodity can be obtained in exchange = exchange ratio = ratio of money
prices.
Price level = RPI.
Nominal output = money value = quantity * price
Q=q*P
DOES MONEY MATTER?
Money reflects but does not influence the real economy
only medium of exchange.
Money has an independent role and influences the real economy
also store of wealth.
Say's Law - total supply = total demand i.e. supply creates its own demand. But if money is wanted as a store of
wealth people may choose to save more or less, the 'idle' balances!! But more saved more lent...... money lubricates, speeds up
the real economy.....??....
EXCHANGE RATES/BALANCE OF PAYMENTS.
Rates are determined by supply and demand.
nominal = currency for currency (bilateral rates).
effective = trade weighted.
real = price adjusted.
Items in balance of payments = visible trade invisible trade
investments
official finance
+ balancing item.
Presentation changed in 1987 = visible
invisible
transactions in assets/liabilities
+ balancing item
because interest rates were used to balance flows instead of reserves.
and if exchange rates float the process must be self balancing so money only influences if it is interfered
with by Governments!!!
9 MONEY & TRADE - EXPERIENCE.
BALANCE OF PAYMENTS THEORY.
B 1= X - H
B1 = Y - A
A=C+I+G
expenditure switching increases Y to encourage exports - tariffs, quotas, subsidies, devaluation - TR depends on
elasticities and time to adjust, hockey stick curve.........
expenditure reducing reduces Y to reduce imports - C = f ( Y - T ) - - - - increase tax, reduce spending, raise interest
rates, reduce money supply..........
1931 GOLD STANDARD.
Accumulating gold is a mugs game (mercantilism!!) it is only a yellow metal; it is the production of innovation that
matters! Accumulated treasure can only lead to inflation if spent!! Pax Britannia involved investing surpluses overseas, with
sterling the key currency.
Confidence, obligation, culture and cowry shells!!
1914 90% of trade expansion was financed by Sterling paper and multilateral settlements, as good as gold because of
obligation.
Rules:- gold the only form of money for settlement, but increasingly sterling was acceptable
exchange rates were fixed
expenditure reducing was the only policy allowed, devaluation was out.
Thus prices fluctuated locally, but not exchange rates, and Trades Unions and the greed of politicians vainly set their
face against reality with predictable consequences.
1930'S.
Competitive blocs and devaluation as protectionism, controls and vanity ruled. Free trade era ended.
1946 BRETTON WOODS.
Protectionism out (GATT was later), capital from the World Bank, exchange rate set by Governments via the IMF. In
the end, once again, it was scuppered by reality of the production of innovation and the trade pattern which resulted.
Keynes believed exchange was inhibited by storing wealth.
$ surplus turned into a deficit in 1950 spurred by fear of communism and military spending.
Was money effecting trade as endowments, technology, income and tastes did??
1973 FLOATING.
In 1971 Nixon abandons gold as UK had done in 1931, trading realities dictate not some designed system! Surplus oil
$'s confuse and countries borrow too much, with no discipline from the IMF 'cos the loans are in Eurodollars!!
MONEY & TRADE.
As a medium of exchange money follows trade.
But as a store of wealth people choose to 'hold' money on a whim which forces changes in prices, of either goods or
exchange rates!!
BUT if prices are free and not interfered with, the system is self correcting as balances held will increase the cost of
money, ie interest rates, which will encourage lending and idle balances become active again!!
FIRMS AND ENTERPRISES
Performance depends on cost structure.......& the market, quality & price......
technical constraints as defined by the production function
costs
time period, short term (at least 1 input is fixed) or long term (all variable)
costs
market structure, perfect competition or monopoly
size
objectives, profit maximisation depending on ownership and competition.
innovation
10 THE STRUCTURE OF PRODUCTION.
STRUCTURE.
The big decisions - pricing & investment.
If planning don't work why firms???????? - transaction costs.
Conversion process, important because of materialism.
Performance depends on OWNERSHIP. Limited liability is very new, confirmed in 1825, after being illegal since the
bubble in 1720.
11 COSTS, EFFICIENCY AND ECONOMIES OF SCALE.
EFFICIENCY.
* technical efficiency = minimum in, maximum out in PHYSICAL terms
allocative efficiency (effectiveness??)= minimum cost, maximum value ie. benefits. Pareto criteria = can a
rearrangement of inputs & outputs lead to more output?
COSTS.
Total, average or marginal?
* short run = when one input is variable and the others fixed. After some point the marginal product of 1
input, the others being fixed, will start to decline = the law of diminishing returns.
long term = all inputs are variable.
* marginal change = the output resulting from a SMALL change in input.
SHORT TERM.
Costs:- variable = w l / q, fixed = c k / q, total = ( w l + c k ) / q, marginal = w  l / q.
Diminishing Returns, or diminishing marginal product.
LONG TERM.
Short run curves are always 'higher' than the long run curve. The long run curve is for a given technology.
Economies Of Scale. Plant, multi plant or firm level?
Scale can also be diseconomic or constant.
LRAC minimum when (w *  l + c * k ) / q = 0 or - w * l. = c * k or the marginal cost of the contribution of
capital & labour are the same.
ql
marginal product of labour
increasing
decreasing
or
q1 = maximum profit where MC = MR
w *  lp *  q
q/l=w/p
w/p
l1
labour time
short run costs
long run costs ( a given technology)
costs
MC
w * l. = c * k
AC
SRAC' s
LRAC
TC
equipment capacity
output
output
OPPORTUNITY COSTS.
* opportunity costs = the cost of the best alternative foregone.
12 GROWING CONCENTRATION OF PRODUCTION.
Performance = ownership, size, short term diminishing returns, long term economies of scale AND competition and
market structure. So concentration?? & barriers to entry??
NATURE & MEASUREMENT OF MARKET STRUCTURE.
Only competition ensures that firms are efficient and satisfy customers.
Concentration will be predicted from static models but the reality is perpetual insecurity from change and competition.
Is there a dominant firm??
Is the market regional, national or global????
How do you measure concentration??
A market has goods with no substitutes?
An industry has inputs, process & outputs?
Is it market or industry concentration??
Existing markets, however defined, will always tend to concentrate; but new markets continually emerge. The debate
is futile.
Barriers to entry are costs a new entrant will have to incur prior to participation.
Economies of scale
start up investment, advertising,
Absolute costs
R&D, supply chain, distribution channels,
Product differentiation
quality,
Reputation
Static market
WHY DOES THE STRUCTURE OF PRODUCTION CHANGE?
Mergers by taking over competitors or for diversification.
Spur is to
lower costs
lower risk
Joint stock (1825) & limited liability (1856) were privileges conferred by government but the idea originated in
Venice.
Regulations and tariffs are the biggest cause of anti competitive practice.
Economies of scale in
construction
1 & 2/3 rule.
operation
& supplies??????
MEPS
LRAC
also long production runs and learning effects.
Learning effects are dexterity, practice makes perfect, and experience, once bitten twice shy.
13 MARKET STRUCTURE AND PRICING.
An information system! How else do we know what Joe wants??
PROFIT MAXIMISATION.
If 'we' don't maximise profits the Japanese will and we will go out of business. So whatever our stated objectives the
supply of investment funds depends on profit performance.
Total revenue
TR
=q*p
Average
AR
= TR / q = p
Marginal revenue MR
=  TR =  q * p. - Marginal revenue depends on competition.(elasticity).
economic profit = total revenue - total costs ... including all the alternatives foregone, opportunity costs.
* profit maximising output level = when MR = MC
Concentration, barriers and product differentiation determine a firm's behaviour.
PRICE THEORY.
Demand slopes down to the right as marginal utility & income & substitution effects make it more attractive to buy at lower
prices. Although all customers are different all customers happy otherwise they would buy the alternative.
price = mu.
Supply slopes up as opportunity costs make it more profitable & encourage more suppliers at higher prices. Suppliers are
happy as profit is maximised.
mr = mc
if mr > mc - profit = q * (ar - ac ) is rising.
mc = minimum ac
if marginal cost is > average cost, average cost is rising, and vice versa, therefore the line
cross where total cost is minimum. Also if mc is positive total cost is rising and vice versa.
Perfect Competition = large no. of buyers and sellers, homogeneous product, no barriers to entry & exit, perfect information.
No vested interest can fix. For the individual firm mr is horizontal. Price takers.
price = mr = ar = D
price fixed by markets; customers have no reason to pay more, & supplies no reason to
charge less!
price = mc = S
supplier still has to decided how much to produce, & will increase supply until mr = mc.
price = minimum ac
the long run equilibrium
A consumer shift to D1 produces a higher price p1 & output q1 & excess profits = q * (ar - ac). NB. ac are above minimum.
BUT new investment will flow into the industry shifting supply to S1 until ‘excess’ profits are reduced to a 'normal' return.
Profit motive moves supply to Pareto optimal & minimum costs. Both allocative & production efficiency.
Consumers get what they want at the lowest cost with ‘no hands’ !!
mu = p = mr = mc.
Crucially output is valued by consumers at what it costs to produce !!
mu = mc.
Perfect Competition - all firms
prices
D
Single Firm
S
mc
ac
mr = ar = price = Demand.
= mc = Supply.
= ac at equilibrium
increasing decreasing returns
output
Excess Profits - all firms
D1
D
S
prices
output
Single Firm
mc
ac
p1
new ar
S1
p
output
q
q1
output
MONOPOLY.
Monopoly = a single firm is the sole supplier of a good with no close substitutes and is protected in the long run by entry
barriers. Price makers.
price = ar > mr the firm is the market, customers still decide the quantities purchased, more can only be sold if the price is
reduced, mr declines, thus, ar the demand curve slopes down!!
mr = mc still applies but ar > ac, but there is no incentive to minimise ac!
mu = p > mr = mc.
Output is worth more than it costs so Pareto inefficient.
Monopoly
Monopoly
Natural Monopoly
prices
mc
elastic
p
ac
inelastic
mr
ar
=D
q
lrac
lrmc
output
Profits are higher the more inelastic is demand. Different elasticities = different prices there is no supply curve for the
monopolist.
Natural monopolies face economies of scale have continuing declining mc, so the bigger the better, competition increases
costs! mc < ac always!!
But there is still competition for capital!!
Oligopoly = few competing firms with power to influence price by changing output, with differentiated products protected by
entry barriers.
Firms activities have an effect, but competitors react.
Unless they form a cartel and behave like monopolists, oligopolists will tend to reduce prices to the perfect
competition level. COLLUSION or COMPETITION?? The only alternative is product differentiation.
Incentives for collusion when
inelastic demand, entry barriers, similar technology.
Interdependence recognised when
seller concentration, low cross elasticity = no product. differentiation.
Coordination easy when
seller concentration, cooperative history, public price lists.
High price maintenance easy when entry barriers, no large buyers, no excess capacity = high marginal costs.
Collusion
restrictive agreements are they cartels? or informal agreements on price or perhaps market
sharing, specifications, output......
price leadership is it an informal cartel? or a dominant firm, collusive or barometric.......
Usual when there are only a few firms, same products, same costs, entry barriers, inelastic demand.
Entry barriers
'limit pricing' deterrence to new entrants.
Easy entry
no cost advantages have been established.
Ineffective barrier
gains from limit pricing < short term profit pricing.
Effective barriers
gains from limit pricing > short term profit pricing.
Blockade
no entry.
but it all depends on strategies and reactions, no single assumption will capture the variety of actual behaviour. NB
monopolists can behave the same way, there is always a threat of competition unless legally restricted. Contestable markets
and hit and run entrants.....(Baumol '82)....profit competed away, not only new start up plc's but also Unilever's geographic
spread......
PRICES PRACTICE.
summary
perfect competition
oligopoly
monopoly
no. of sellers
many
few
one
product type
homogeneous
differentiated
unique
entry conditions
easy
barriers
exclusive
knowledge
perfect
price determination
takers
influence
fixers, makers
Assumptions
profit maximisation, MC = MR??
Costs production function, short or long term (diminishing returns or economies of scale).
Revenue  market structure & competition.
Firms don't know the shapes of the curves. In reality decisions are brain processes, the Theory Of Overtaking Lorries
doesn't apply, the brain don't work that way!!!!!!!!!!! Size up and your gut will tell you!! When asked business men
regurgitate the accepted theory because following guts is socially unacceptable. NB Unilever's CP process!!
Volume discounts, money off promotions, product differentiation, customer value equations...........
Cost plus?
VC + FC + profit = price.
Price discrimination:elastic demand
inelastic
total market
prices
p2
MC
p1
AC
q1
q2
q
output
Transfer pricing? Tax or realistic measurement? Exchange restrictions or good citizens? Realism or predictive
power?????????????
Government?
Competition policy, anti-inflation.....
Monopolies taking advantage of economies of scale maybe in the best interests of the customer - as long as noone is
legally barred from entry.......
14 FIRMS AS ORGANISATIONS.
OBJECTIVES.
Not a democracy but economic decision criteria.
If you don't maximise profits the Japanese will and you go out of business!
You never know for sure so the best strategy is to improve responsiveness.
The 5 balls; production, stocks, sales, share, profit. Conflict unless profit is overarching.
CONTROL.
Managers or owners? In the end financial markets will ensure the profit maximising goal. Share prices will decline as
people opt out to better (more profitable) firms and borrowing will become difficult and expensive, or, alternatively a takeover
will be launched to work the assets harder.
RESOURCE ALLOCATORS.
Why firms? Why do they do what they do, why not use the market?
* transaction costs = cost of markets = negotiating, low economies of scale, less specialisation, bureaucracy,
quality guarantees & specifications, deceit, information.....
Are transaction costs about information?
LABOUR & PRODUCTIVE PROCESSES.
Production functions are not enough, labour has a will of it's own!
Control implies control over intensity and it implies measurement, both are problematical.
Organisation as a factor of production?
Capital can be specialised but labour can be skilled, both are in short supply!!
* x - inefficiency = < 100% efficient always because 1) the labour contract can never be fully specified,
2)some factors of production cannot be purchased e.g. organisation, 3) profit making is a discovery process
nobody knows the best way, and 4) there is always interdependency, the world is a system.
Thus, monitoring, but it is costly, and doesn't (always) work.
Efficiency usually depends on the level of competition.
PROFITS.
Max revenue min costs. But how do you measure costs? Opportunity costs are the KEY.
It is not the quantity of capital that is important but the quality.
Not assets but future dividends. But uncertainty? So how do you value a firm? and how does a firm take decisions?
Evaluate options, yes and lessen risk, yes.
FINANCIAL CONSTRAINTS.
Capital has an opportunity cost.
There is a limit to expansion = gearing.
Why take over? operating improvements, synergy, dividend policy.....
15 MERGERS AND INVESTMENT.
Theme = efficiency is about problems with information.
Risk, uncertainty, complexity, rapid change......prices are inadequate......
Markets are expensive when transaction costs are high and impossible when property rights are not defined.
TYPES OF INVESTMENT.
= a better future
we have all evolved to invest in our children.
Investment choice is risky nobody knows.....there are always opportunity costs....
Investment brings inequality, some are right, some are wrong, some don't......
Collective investment may be wrong......difficult decisions must be dispersed....
Physical, financial or information investment.......
Investment = depreciation + growth.
Internal or external financing?
the tax distortions
the separation of owners and managers.
Speculators and insider dealers improve the efficiency of the market by channelling all available information asap into
the share price.
Information investment = education, advertising, R&D.
Information investment is subject to externalities.
INTEGRATION STRATEGIES.
Vertical?
technically different process are usually handled in the market,
when transaction costs are high,
when opportunism and risk are problems,
but bureaucratic costs balance......
Horizontal?
economies of scale,
common indirects, technology,
monopoly profits attempt...
DIVERSIFICATION.
Market or technology based diversification?........ or geographic?
Anti specialisation? risk reduction? is specialisation vulnerability?
Market saturation is a figment, it is simply lack of innovation!
Markets = distribution, sales force, advertising....
Technology = buildings, equipment, labour, R&D........
Culture = law, language, politics, economics, social......
are the links there??
Multinationals or licenses??? transaction costs are high for licenses??
MERGER AND TAKEOVER.
Often quicker and can eliminate a competitor.... but risky...
Willingness of managers is the distinction......
Do managers know more, if so why have they not communicated this info'.....?
Managers face :- loss of status, loss of job, being classified as inefficient..
Disinvestment is practised as well...
INNOVATION AND R & D.
Scientific knowledge for its own sake = basic research....... benefits cannot be recovered, externalities rife, BUT the
state cannot do it, no expertise and no money......Bell discovered the transistor and biotechnology firms are doing basic
research, they will prosper as long as intellectual property rights are sorted! Can it be contracted out ....... fixed price or cost
plus.....
Market competition delivers allocative efficiency but does it deliver innovation?
More money can be made out of technical progress than price reduction = Schumpter.....'gales of creative
destruction....'
Process innovation = cost curves
Product innovation = revenue curves
Traditional economic models based on maximising behaviour are useless when confronting the unknown
innovation.....?
Technology push or demand pull innovation?
IMPLICATIONS FOR FIRMS.
Information!
Knowledge is key not ownership.....ALERTNESS
ERIC NEIL
COMPETITION PLOICY
1973 Fair Trading Act = 1948 Monopolies Act + 1956 Restricted Practice Court
focus in US on market structure
antitrust
focus in UK on market conduct
History of 1000's of cartels never overcome the benefits of competition! Globalisation has confirmed the competitive
benefits.
M&MC is an oligopoly commission. Costs, prices, profits, R&D investment, import penetration, market behaviour,
predatory pricing, exclusive dealing.......all considered.
Mergers are about what is expected to happen in the future & therefore more difficult. Lawful private property must
get the benefit of the doubt. But during two year investigations firms become less profitable as management time is diverted.
Valuation difficulty. Asset stripping or inefficient management stripping.
INCOME AND WEALTH
Why are people rich?
How can we change it?
If we do how can we generate investment growth?
16. DISTRIBUTION AND INEQUALITIES.
DISTRIBUTION AND GROWTH.
y=c+i
y-c=s
thus s = i
at any level of output.
At full employment, what adjusts to deliver growth? y = w + BUT more savings out of  than w??!
If
investment goes up, output cannot respond so profits must go up if savings are to correspond! ie. Kaldor suggests income
distribution changes....(through a change in price level).
g=s/v
v = the capital output ratio, could also adjust....
PERSONAL DISTRIBUTION.
yg = yo + b
is money flow different from money stock? Is money stock different from quality of life? Are we
worse of by choosing beauty, skill, accomplishment, security, power..... before money?
INCOME DISTRIBUTION.
*Gini coefficient - 45o perfect equality. Area = inequality measure. Lorenz curve is the cumulative plot of
income shares.
Sources of income vary with the distribution. High income = rent and profit. Low income = transfers.
High income comes from investment, the problem with averaging incomes or redistribution is that investment suffers,
the problem with State investment is to know what to invest in!!!!
WEALTH DISTRIBUTION.
Valuation and disclosure problem, marketable assets? or consumption possibility.... pensions are not transferable (but
make a big difference), houses must be kept to live in....
Fruits of investment and inheritance = no inheritance - no investment...
Inheriting wealth or wealth know how!!?? wealth can easily be spent...investment must continue, helped by enterprise
and thrift...saving is essential because of the different timing of needs and earnings during a lifetime..
Company shares are significant only for the rich; the poor have building society accounts.
Wealth gives only THE POWER NOT TO INVEST, if wealth is consumed it is no longer there....the wealthy tend to
invest it not spend it...wealth becomes more unequal than income..
income distribution
% income
log normal
households
% households
income
PRODUCTIVE FACTOR DISTRIBUTION.
Supply & demand! Marginal productivity explains the demand curve... thus explaining why it slopes down to the left...
as marginal productivity declines as more of the factor is used... a development of the production function... and the law of
diminishing returns...
Marginal product is the amount by which the total product changes when an additional unit of the variable factor is
employed......
Each factor of production is paid the value of its marginal product.
Assuming diminishing returns, factor substitution, profit maximisation, perfect competition, and given income and
prices.
ie factor rewards are linked to contribution as determined by customers...ethical, fair & just......but the other factors contribute
as well....
Payments to fixed factors is rent.... but marginal productivity theory assumes all factors are variable in the long run..
Returns from capital reflect its marginal productivity but profit is something else the variable return for
innovation/progress...risk....
Investment involves abstaining from consumption, there MUST be a reward for this otherwise most won't do it....if
people do decided to go for it inequality will result......
Not only do some have to abstain from consumption some also have to take risks.....the double whammy for
profits.........there is no contract.
marginal input cost
MIC - the addition to total costs incurred by employing one more unit
of input.
marginal revenue product MRP - the addition to total revenue due to the employment of one more
unit of input ie MPP*MR price falling.
marginal physical product MPP - the addition to output due to employing one more unit of input
while all
the other inputs are fixed.
value of marginal product VMP - what the MPP can be sold for ie MPP*p price fixed.
Labour demand depends on:objectives
price
amounts of other inputs
MIC.
Labour is employed when
MRP = MIC
for the special case of the price taker & perfect competition, MIC = VMP.
MRP depends on the output market.
Supply is ignored in this theory.
17. EARNINGS.
WHAT DO PEOPLE EARN?
Nobody says! Opportunities for overtime? Are dividends different? The result of specialisation? And the firm
concerned?
Where? Region, country, industry, size....
Who? Ability, education, training, age, qualification, male,
WHAT SHOULD PEOPLE EARN?
Ought or do in fact earn??? i.e. normative and positive..... needs, merit or value? How do you agree?? No incentives??
Is effort itself worthy of reward??? Or status??
Value is about signals!!!! Inequality is NOT unjust it is about choices of consumption, specialisation, risk or
investment....it has NOT BEEN DESIGNED!!....peoples earnings depend on what other people are prepared to pay for
them.......?
HOW IS IT DETERMINED?
Supply and demand!!!!!! Supply is determined by opportunity costs = dominated by the labour market & trade unions,
benefits & leisure........Demand is determined by marginal productivity = Keynes & technology......
* derived demand - depends on the demand for the product concerned by consumers....
W = money paid by the employer for labour, not take home pay....
NB
the amount of labour demanded by a firm will be such that the amount added to the firm's revenue is equal to the cost
of the marginal labour. It depends on the production function and the market for its product. In competitive markets where price
is taken demand for labour depends on the VMP. In monopoly & oligopoly the demand depends on MRP.
* elasticity of derived demand for labour - depends on SUBSTITUTES, whether increased costs can be passed
on to consumers or to other inputs..
Men specialise in market work, women in housework.....
As wage rates rise the opportunity cost of not working rises but incomes rise and some will wish to work less ( they
have sufficient!)!!!!!!!!!!!!!!!!!!!!
Net advantages of working:agreeableness, easy or cheapness of entering, security, trust involved, probability of success....
Net
advantages will tend to equalise with competition...thus we would expect wages rates to differ as people take different
decisions....
Human capital and investment in learning.....
There is no trading floor jobs are supplied in person heterogeneously. How do employers choose?? From the queue??
Discrimination......
Labour markets are relatively inflexible people don't change jobs often...golden handcuffs....
HOW CAN IT BE CHANGED?
Trades unions, minimum wage, equal pay, restrictive entry.........??? but if TU's increase wages & restrict entry they
decrease employment!!!
minimum wage
restricted entry
wage
employment
employment
Minimum wages Fairness
'market power' and exploitation?
Monopoly can set a price for it's product but it cannot draw it's own demand curve...people cannot be forced to
work...it will employ people when MRP = MIC but MRP < VMP = exploitation?? AR = price.
Monopsony is market power as a purchaser of labour.......paying what the market will bear up to MIC = MRP
AIC slopes up as a significant buyer has to pay more for more labour. Thus AIC < MIC = exploitation?? AIC = wages because
higher rates have to be paid for more labour and paid to EVERYONE!!
A monopsonist has no demand curve.
perfect competition
monopsony
wages
MRP
MRP
MIC
W
MIC =
AIC
AIC
W
employment
employment
Unemployment
Elasticity effects how much unemployment results..
Alleviation of poverty
Relative issue, does the increase in low pay result in increases for the highly paid? Low paid are mainly
young females.....equal pay:Discrimination is often before the labour market ie. At school?
Unprofitable discrimination if merit and profit are ignored....
Elasticities and discriminating monopsony....
less elastic = less wage
Part time female employment is on the up because of low wages, equal pay will move female employment
back...... or it will go to Phillipinos....
18. REDISTRIBUTION.
AIMS.
Poverty
in the US the poor are *50 above the average in India!!
Equality
incentives for both rich and poor? How do you measure happiness??
Needs/desserts
the ugly? the poor ball skills??? Desert from investment?
Incentives or equality? A leg up NOT a hand out!
Cash or education? Rescue or renewal?
PRACTICE.
Rent control = cheap housing for the poor or fewer houses offered for rent?
Minimum wages = better deal for the poor or fewer jobs?
TAX revenue
income
commodities
capital
25%
15% VAT
1%
20% NIC
6% alcohol, tobacco
5% corporation 5% petrol
5% oil
PSBR
10%
* marginal and average tax rates; marginal = the proportion of any extra income that goes in tax. Average =
the proportion of an individual's total income that goes on tax.
* nominal and effective tax payers; shareholders are nominal tax payers but if they can pass on the tax in the
form of a price rise, inelastic demand, the effective tax payer is the customer. With a strong Trade Unions,
wage earners may pass on tax rise to the firm.....
Which taxes are expensive to administer?
Elasticities are important in determining who pays the tax and how much revenue is raised.
commodity tax
commodity tax
price
inelastic
elastic
D
S1
S
S1
S
D
output
output
Direct and indirect tax burden can be identical but one is a tax on working the other a tax on spending....
marginal tax rates
tax
earnings trap
final earnings
earnings
original earnings
category
means tested
25% of total expenditure
10% pensions
5% supplementary
insurance
assistance
Beveridge's proposals....
Subsidies tend to favour the rich as they buy and use services more, as does VAT 'cos the rich save more..... but
people are rich because they educate themselves.........?.. it is not a static game poor today rich tomorrow.....look at my income
when I retired....no saving at all!!!!! Universal provision favours the rich....!! more purchases of subsidised goods (unless they
are inferior)
yg = yo + b
yd = yg - t = yo + b - t
yf = yd + s - c = yo + b - t + s - c = yo + b + s - t - c
TRAPS.
Tax thresholds below state benefit levels!!.
Earnings trap effects people in work where they benefit little from extra earnings.....
Employment trap effects people out of work where they benefit little from taking a job....
Work or leisure? Substitution or income effect? REPLACEMENT RATIO = unemployed income/employed income.
19. SOCIALIST INCOME AND WEALTH.
Revolutionary route to socialism in the east, the Fabians hoped for an evolutionary route via democracy......
WHAT SHOULD PEOPLE EARN?
BENEFITS
Contribution, need or merit?
Each according to his labour! Quantity and quality? Who decides? National job
evaluation? Skill structure = inequality.....ie specialisation...
Not Beveridge's guaranteed platform but the extended family.... freebies limited to education, health and basic
food.....the target is growth not poverty!!!!!
WHAT DO PEOPLE EARN?
The rouble is not convertible! Black markets!
More inequality = more specialisation + more investment + more risk (innovation)!!!!!!!!!!!!!!!!!!
Capitalism = power with ownership.
Socialism = power with bureaucrats.
HOW IS IT DETERMINED?
Demand responds to plans not market forces. Supply responds to the wishes of workers, ie supply and demand rules
OK! Skill based wages need incentivising...
Labour theory of value not what the customer is prepared to pay!
WELFARE STATE.
Tax is very different and unnecessary if wages and prices are controlled....Aim is to reinforce incentives. The poor get
short shrift. Health service investment has been massive but it has not increased life expectancy and is of the 1930's. A
meritocracy with equality of opportunity but income differentiation based on, 'to each according to his labour...' but merit based
on bureaucratic determination and planning of known realities ....... a fossilisation into the past..... the evidence is there for all to
see.....The computer industry could not be planned because nobody knew it existed!
UNEMPLOYMENT
20. UNEMPLOYMENT AND THE COST OF LABOUR.
Real wages too high!
Unemployment = poverty = waste. Demand stimulation is never mentioned nowadays.......
MEASUREMENT.
* Unemployment = ? available and seeking - inactive population is excluded.
Is only skilled labour is wanted today? Flows into and out of work are high in a dynamic economy, this leads to an increase in
'stock'. Wives want to earn, the acquisitive society ........
Frictional unemployment
E+V=E+U
between jobs?
* natural rate of unemployment = AGGREGATE market clearing rate, all unemployment is voluntary
Structural unemployment change wrong people wrong jobs
skill, regions, sectors,
Between aggregate
markets and micro markets.....
LABOUR MARKET.
* demand and supply of labour = MRP = MC = W
MPP * p = W
* real wage rates =
W/p=w
real
aggregate labour market
wages
AD1
AD
A S1
maximising firm
AS
substitutable labour & capital
other prices, capital stock, technology fixed
Demand MRP = MC = W = MPP*p
Supply  peculiar characteristics.
employment
High wages??
Growth in labour.
Minimum wages or benefits.
Unions.
AGGREGATE ANALYSIS.
labour costs??
* real product wage = real wage cost to firms using producer price index as the deflator
Productivity affects labour cost per unit of output. Depends on the amount of capital and the technology used.
Real product wage per unit of output = W / P divided by q / l. W * l is the wage bill and P * q is the value of output =
share of labour in added value.
Identification problem = disentangling cause and effect, time lags, and effects and causes.
SUPPLY SIDE.
INDIFFERENCE CURVES.
Indifference curves
- combinations of two goods which are equally preferred. Iso-satisfaction lines.
Assumes leisure & work are alternatives!! In the case of work the utility comes from real wages & leisure.
Marginal rate of substitution is the slope = mu leisure / mu income = the income given up to gain one more hour of leisure.
Marginal rate of substitution falls as the curve slopes down to the right.
Marginal utility of leisure decreases as more is possessed. More leisure = lower the value of the marginal hour.
U = f ( y, l ).
Relative price lines
- constraints. The combinations on offer. Time (168 hours) & take home pay rate.
Slope = hourly wage rate. Tangents for maximum utility. Must be below or on the budget line & on highest indifference curve.
The wage rate = price of leisure / price of work = wage rate per hour / one hour of leisure = the marginal rate of substitution
= mu leisure / mu work = Pareto efficient!
We can’t predict from theory whether more or less work will result from higher wages or less tax?! Empirical investigation.
We don’t know the shape of the curves!!!
Higher wages = less income tax
OR = less work ?
real
= more work ?
real
income
wages
I2 more utility
I1 less utility
I2
I1
leisure hours
hours worked
real wages increase same utility budget line slope changes
upward sloping curve
real wages rise, leisure opportunity cost rises, more work offered
always
 marginal rate causes distortion
policy - avoid!
Income effect
real wages constant more utility budget line shifts
backward sloping curve
(unearned
real incomes rise less work offered
leisure a normal good
income up)
real incomes rise more work offered
leisure an inferior good
 average rate
policy - increase the base not rates!
Substitution effect
Substitution effect
real
income
Income effect
less tax more work
less tax less work
income tax = both effects
maybe less work
poll tax = only income effect
less money more work
benefits = only income effect
more money less work
leisure hours
Income effect usually
= opposes the substitution effect = more money less work.
But substitution - income = + or - depending on size of effects!
TAX.
Commodity tax inelastic
D
S1
price
Commodity tax elastic
S1
p1
D
S
p1
S
Consumer tax
Supplier tax
q1
output
Suppliers or demanders with steep slopes inelastic pay more!
q1
output
Tax incidence & ‘excess burden’
Price
Tax rates
Rates
D
S1
S
marginal
p1
p
average
q
q1
Output
Income
Excess burden cannot be recovered by the IR.
Linear schedule = tax paid is linear.
Marginal tax rates
tax
Earnings trap
final earnings
earnings
original earnings
Tax benefits & utility
Tax rates
real
income
tax
marginal rate
marginal tax
average rate
standard
allowance
means tested
benefit
leisure
It all depends on the shape of the curves!
Negative income tax
final earnings
Social
wage
original earnings
income
constrained demand
wages
D
S
S1
employment
Demand for labour is constrained by how much firms
expect to sell. Therefore shifting supply won't help!
21 UNEMPLOYMENT AND AGGREGATE DEMAND.
Aggregate demand too low!
Cyclic pattern of historically rising unemployment....... high real wages or low aggregate demand or technology .......or
all 3!!
Keynes
the key is that there maybe no automatic self adjustment???
Idle balances. Saving and investment decisions are taken by different groups of people, why should they coincide? (Because
interest rates will rise or fall to self adjust!!!!!!!!?? Keynes didn't believe it!)
Thus policies are needed to ensure adequate demand.
1970'S & 1980'S.
Demand did fall and unemployment went up but so what. Effects are causes.
Demand slopes down to the left, assuming fixed capital, technology and tastes.
Supply slopes up to the right assuming higher real wages = more work is wanted i.e. The substitution effect
outweighs the income effect.
Demand reduces and there is a new equilibrium but FEWER people are employed.... at the lower clearing wages there
are some who are looking for work at the going rate there are others who choose not to work at the going rate.
SELF ADJUSTMENT IN THE GOODS MARKET.
* marginal propensity to consume and average propensity to consume = MPC = the increase in aggregate
consumption that results from an increase in income = c / y If c = a + by
MPC = b
APC = c /
y
Saving and investment decisions are taken by different groups of people, they will not result in a balance unless
interest rates do the job????
* multiplier =  y / g = 1 / ( 1 - b )
National income rises the same amount as g, leading to an increase in consumption leading to an increase in income
and a ripple effect gradually petering out. It works if there is spare capacity but maybe firms will raise prices instead!!
Thus
1) will supply respond?
2) if g is financed by tax the effect is negated, if it is borrowed private investment is crowded out.
3) does an increase in aggregate output lead to more employment? Other things are never equal!
SELF ADJUSTMENT IN THE LABOUR MARKET.
If demand shifts down there is no real wage rate which will bring employment back to the original level... but there
will be equilibrium at a lower level
What does unemployment mean??
However the labour market is not independent
1) lower wages will affect aggregate demand
2) REAL wages are determined outside the labour market by the level of prices....
Notional demand assumes firms will go on recruiting indefinitely as wages come down but in the short term they
require a certain number of men to operate their installed capacity & expected sales & are willing to pay the going rate. Thus
the actual demand is constrained and has a vertical section. But aggregate demand will not remain unchanged in the face of
lower wages....everything is interlinked
ceteris is never paribus!!
Thus in the face of lower wages firms will not move along the demand curve because the goods market has changed,
and shifts in the demand curve and lower wages will effect the goods market......
22. UNEMPLOYMENT & TECHNOLOGY.
Quantitative mismatch (lack of fit) = supply and demand
Qualitative mismatch = structural change and the product cycle ......
Mismatches in time, skills and prices......
1) interdependency
2) relative prices
3) time scale
TECHNOLOGICAL CHANGE.
The application of science in product AND process.
Massive potential but it's exploitation is difficult because of the response of the total system.
NEW TECHNOLOGY.
Micro chips...semiconductors....micro switches....
...extends mental and physical capacity.....it is all pervasive....it is very cheap....it is very reliable....it is
reprogrammeable - flexible........
Old jobs go but new jobs are created.....less packers more systems analysts...
TECHNOLOGICAL CHANGE AND THE PRODUCTION FUNCTION.
Linking the production function with supply and demand.
Labour or capital can be saved or used following the introduction of new technology.
But output level may also change........ following a change in relative prices....
SUPPLY SIDE.
With training the balance of skilled and unskilled can be readjusted to result in full employment.
DYNAMIC PROBLEMS.
With time the equilibrium can be established... but within generations ????
Technological unemployment is that which results from a fall in demand for labour due to a shift in the production
function brought about by the introduction of technical change..
Cycles.... entrepreneurship, synergy, relative prices, imitation, competition, saturation..
Dynamic competitive economies innovate = inequality = imitation = equality / progress...
TECHNOLOGICAL UNEMPLOYMENT.
Can the service sector replace the lost jobs?
Input output models?
?
?
?
?
production function
capital
improved different technology.
labour
output
same output
much less labour.
employment
23.WHO ARE THE UNEMPLOYED?
SOCIAL GROUPS.
Social groups are the result of specialisation. Poverty = unemployment = non - participation = out of date
specialisation.
Skills on offer can be physical, mental or social....mobility, flexibility.....
Remember stock and flow..... and duration....unregistered unemployed are mainly women but they are still
participating.....
Young v. Old
Men v. Women
Skilled v. Unskilled.
The skilled are not only wanted but in hard times can downgrade and still remain employed.
NOW &1930'S.
Regional.. costs more to employ people in Oban...
Industry sectors.. old sectors were big employers....
DOROTHY CLINCH
SUPPLY & DEMAND
LD = derived demand
derived from choice of product & production method.
W = money wages + social costs = price of labour.
When MC = MR
W = price * MPP.
Thus
Real wage = W / P = MPP
if real wages increase unless MPP increases as well
employment will fall.
LD for one production method diminishing returns apply slopes down to the right.
LS depends on decisions of households, a valuation issue of time & leisure. Income & substitution effects. As W / P
rises is more overtime worked or more leisure taken?
Frictional & search unemployment.
Structural unemployment
outdated skill, geography.
Voluntary unemployment NARU.
Involuntary unemployment
no demand for the product!
POLICY
Retraining, benefit cuts, social chapter, tax cuts.........?
Real wage debate = people pricing themselves out of jobs assumes
technology is fixed but scale & technology affect MPP
demand is fixed
homogeneous labour.
the issue is not high or low wages but fixed or flexible wages.
MANAGING THE ECONOMY??
24. OBJECTIVES & INSTRUMENTS.
Objectives, instruments & constraints.
FRAMEWORK.
* objectives
full employment
price stability
balance in payments
growth
* instruments
fiscal
monetary
legal
The assignment problem = which instrument affects which objective. Objective are easy and many but instruments are
short and ineffective....? The problems are interlinkage and positive and negative effects.
Are nationalisation, investment, taxation objectives or instruments??
EMPLOYMENT POLICY.
Costly, wasteful, burdensome, immoral and results in poverty.
Pre 1914
Fear of revolution = 'public works' a social problem....
Post 1914
Unemployment in basic industries = underemployment and export decline, a competitiveness
problem.
Late 1930's
Keynes, government spends, road and bridge building, a temporary problem. Conservatives rejected
on the grounds that the central bureaucracy was not available, borrowing more was not on. The demise of the gold standard and
'cheap' money...
Post war
Arrogance 'we won the war we can easily win the peace'.....? Government had also become BIG and
central and could now have a BIG effect, and national accounts were emerging.....??
`
The welfare state and the groundnut scheme, we can now legislate wealth!! We are technocrats!! Tried again in 1964!!
PUBLIC EXPENDITURE.
Government final consumption
1) employment 2) goods & services
Grants, subsidies & debt interest 3) personal
4) subsidies
5) interest
Investment
6) social
7) productive social
8) nationalised ind
1950'S TO 1970'S.
* PSBR = revenues (taxes & sales) - expenditures. It must be financed by borrowing. Ie borrow from the
banks, or sell debt, or print more - (ie increase the money supply)........
Sluggish supply side means fiscal induced growth = balance of payments difficulties.
Under the gold standard adjustments involved a flow of gold in settlement, which affected the money supply and thus
prices & wages which must adjust. Thus purchasing power parity dominates.
But with Bretton Woods came expenditure reducing & expenditure switching policies. With devaluation expenditure
switched from expensive imports to cheap home production. Later when home capacity was stretched expenditure reducing
policies had to be introduced.
Instruments effect some objectives more than others and offer the possibility of an instrument balancing act.....???
But supply side issues were thought to be benign and responsive, we now know otherwise..!? 'cos of inflation / balance of
payments!!
Thus the dreaded incomes policy.......and the float...CAPITAL movements dominate as controls are relaxed...
MS = PSBR - Gp (private lending to public)+ Lp (bank lending to private) + EF (external finance)
MS = DCE + FA
FA = MD - DCE (domestic credit expansion)
Balance of payments caused by money!!!!!!!
INFLATION & WAGE BARGAINING.
MV=Py
Phillip's curve trade off between inflation & unemployment.
In the 1970's unemployment becomes a Trades Union issue & a personal preference for leisure/work. Inflation
becomes enemy No.1. Government expenditure, debt, interest rates, crowding out, wealth effects....
Private financial global markets dominate and emasculate policy. Only money printing is left and the flight of
capital stops that....
ECONOMIC GROWTH.
Recessions become global, there's no place to hide anymore! Oil price & in 1992.....what??
Is it the direction the rivers flow??
Internal unemployment balance v. External balance of payments.
Unemployment v. Inflation.
Public expenditure v. Crowding out.
25. AGGREGATE SUPPLY & DEMAND.
Butskilism = Keynes' two BIG ideas1) unemployment is 'caused' by demand deficiency
2) government can correct the deficiency by incurring a budget
=
stop/go!!
deficit.
Blajorism = supply side = low tax/less state benefits, privatisation, deregulation (anti trust) .....
THE AS / AD MODEL.
GOODS
+
MONEY
= aggregate demand
PRODUCTION FUNCTION
+
LABOUR
= aggregate supply
= price level & real national income
AGGREGATE DEMAND.
 aggregate demand = the total of all the money people wish to spend on goods & services produced in the
domestic (domestic & foreign purchasers) economy.
 aggregate demand schedule
= how much national output will be demanded at various price levels.
if prices fall aggregate demand rises.
Goods.
q=y
- output = income
- we always pay someone for everything
e=q
- demand
= output
- @ equilibrium
e = c + i +g + (x - h)
c
i
x
h
=a
=i
=x
=h
Money.
mD = f ( y , r )
mS = mD at equilibrium
+f(y,r,M/P)
+ f ( r , expectations)
+ f ( exchange rate )
+ f ( y , exchange rate )
mD = M D / P
mD = MS / P
mS = MS / P is exogenous
More money supplied (exogenous) = more money balances = less bonds = lower interest.
Thus if prices fall real money balances increase & consumption is directly increased as people hold larger stocks of real
money. Investment & consumption also increase indirectly as larger money stocks reduce interest rates. (Less competition for
investment funds & consumers borrow more). AD slopes down to the right.
Real money increases due to lower prices moves AD along the curve. Nominal money increases shifts AD to the right.
money market
mD
mS
interest
rates
bonds
aggregate demand
prices
constant:- (i.e. short term)
autonomous consumption
consuming propensity
tax
autonomous investment
government spending
exports
autonomous imports
importing propensity
real national income
nominal money stock
money balances
AGGREGATE SUPPLY..
 aggregate supply = the total national output domestic firms wish to produce
 aggregate supply function = how much national output will be supplied at various price levels.
if prices fall aggregate supply falls.
How much a firm wishes to supply (with more RM & labour) is determined by cost structure which is determined by
the production function & the labour market. The marginal product of labour & by the real wage rate.
Production function determines the MPL curve.
q=f(l,K,T)
= production methods, supply policy.........
Labour market determines wage rates & thus the output firms supply.
w = W / P = MPL = trade unions, benefits, deregulation........
thus
q = f ( MPL , W / P )
MPL increases to a peak then declines as output expands. Thus a firms output will
MPL
only expand if real wages decline. Labour demand depends on real wages.
ql
increasing
decreasing
q1 = maximum profit where MC = MR
or
w *  lp *  q
q/l=w/p
w/p
marginal prooduct of labour is falling even though q is increasing!
q 1 = l1
labour time
All agree labour demand (derived from consumers) slopes down to the right.
With capital stock & technology constant the classical labour market indicates an upward sloping labour supply as firms have
to pay more as more labour is supplied. Thus as prices rise, real wages decline, demand for labour increases & output increases.
labour market
real
wages
aggregate supply
d
prices
= marginal costs
or MPL
s
output
constant:- (i.e. short term)
money wages
capital stock
technology
rm prices
population
leisure preference
replacement ratio
labour
output / income
3 POSSIBLE SHAPES ???
employment
If labour was the only variable costs would equal wage rate / average product of labour. At MC = MR cost & price are
equivalent & AS is the same shape as cost / output & derived from the labour market.
Shape is determined by short term response of MPL & labour supply to prices (substitution / income effects assumed
constant).
2 variables 3 possibilities.
DIFFERENCES emerge over firms responses & labour supply, supply is not always controlled by real wages - how do money
wages behave as output expands? Money wages are exogenous & fickle!
Simple Keynes.
AD is vertical because money effects are ignored - consumption depends on income alone
& investment depends ‘animal instincts’ with no interest rate effect. Demand is independent of price. Below full employment
firms respond to demand by increasing output at no extra cost because of under-utilised capacity.
AS inverted L shape as supply is entirely demand determined up to full employment.
Wages (money & real) are constant, prices are constant as more can be produced with existing labour & more can be employed
at the same wages up to full employment, i.e. involuntary unemployment. Wages that are sticky because people won’t accept
cuts!. At full employment no more labour is available.
MPL is constant. Spare capacity & ‘sticky’ wages constant. Output can increase at same prices & costs.
(demand controls output completely)
Including money.
AD slopes down to the right - prices down > real money up > c & i up.
AS slopes up to the right as MPP declines, until vertical at full employment. Money wages
constant as more can be employed at the same money wages up to full employment, still involuntary unemployment. Money
wages maybe rising but less than prices! Thus, falling real wages!! Price has no effect people work for nominal wages!!
At full employment more labour can be supplied only if higher real wages (or whatever) shift replacement ratios, leisure
propensities & population.
MPL is falling. Diminishing returns. Real wages must be falling if output is to increase as prices rise.
(Money wage / labour supplied translates into AS via labour demand & the production function, again demand controls output
up to full employment, after full employment AS is vertical with constant money wages).
In this model prices rise as output is increased through lower real wages & increased employment & demand!!!!!!!
Monetarist.
AD slopes down to the right - prices down > real money up > c & i up.
AS is vertical in the long run!!!! Money wages increase with prices, price has no effect &
AS is vertical. At full capacity output can’t expand however high the real wages, as wages go up with prices.
Financial policy (tax, bonds or treasury notes, money supply) is powerless. The supply side dominates & will be 'crowded out'.
Firms are geared up to produce at a specific output & their production cannot be increased in the short term. Thus, a demand
shift increases output, prices rise (reducing real wages) but this is not accepted by workers who push for wage hikes which
reduces output to its previous level..
MPL is falling. Real wages constant. Output won’t increase.
(supply controls output)
The monetarists suggest that as prices rise & real wages decline the supply of labour would reduce.
Thus expansionary fiscal policy at best has only a short term effect!! Prices up, real wages down, labour demand up, as firms
wish to supply more. But if more labour is required real wages must go up & if less is required real wages must go down to
compete internationally. Thus firms no longer pay above clearing rates, TU have been neutered.
simple Keynes
D2  g
Keynes including money
demand
e
D1
money
wages
D1
money
wages
q1
q2
D2
@ different price levels P1 & P2
output
employment
real wages &
MPL constant
q2
q1
output
q2
q1
l1
prices
employment
real wages &
MPL falling
labour
l1
l2
labour
q2
output/income
AS / AD model
prices
AD1 AD2
AS
AD2
AD1
P1
P2
P1
q1 q2
money
wages
output/income
Monetarist
D1 D2
q1
@ different price levels P1 & P2
S2
S1 wages adjust real wages stay the same
W2
W1
output
labour
q1
MPL falling
employment
AS / AD model
prices
AD1
AD2
LRAS
f ( y , M / p , r ) = f ( MPL , W / p )
SRAS2 @W2
SRAS1 @W1
P2
P1
q1
output/income
Key question is what is the shape of the AS curve ???
Keynes
= horizontal due to under utilised capacity.
Monetarists
= vertical due to incentives to supply, i.e. relative prices, & NARU i.e. population size ......
The key is to shift AS to the right by low tax, reduced public expenditure, innovation, technology & union bashing .....
DEMAND MANAGEMENT THEORY.
World growth is now fed by global private capital thus limiting the power of national governments.
Demand management
output & employment v. inflation & balance of payments.
* National income/expenditure = actual recorded NOT wishes or plans
e = c + i + g +( x - h ) = y !!
y = multiplier * autonomous aggregate demand.
multiplier = 1 / ( 1 - b + b t + j )
DEMAND MANAGEMENT PRACTICE.
1944 to Barber's fiasco......the 'regulator' & fine tuning....?
+ Bank rate, Minimum lending rate, Loan requests, Credit terms, Special deposits
James Callahan 1976 - 'I have to tell you in all candour that this option no longer exists.'
1) technical difficulties
only 2 instruments & 4 objectives. Time lags & policy changes. Automatic stabilisers were
suppressed. (Unemployment benefit & tax).
2) exceptional events.
Oil price. Bretton Woods collapse. Union obstinacy.
3) weakness in business & industry.
26 INFLATION & UNEMPLOYMENT.
INFLATION - EXPLANATION.
Excess demand.
* quantity of money MS * V = y * P = Y
S
If y & V are constant then P  M . But what is the transmission mechanism??
MD = z ( y * P ) thus MD = y * P / V
demand for £ is the inverse of the velocity of £.
Thus if MS increases & MD is constant, equilibrium involves an increase in p!!! People get rid of £'s they don't want by
spending them on goods & services, thus shifting AD.
But Keynes suggested output is not fixed & will respond to increases in money & also velocity is not constant increases in money supply will reduce velocity - Idle balances!!!!
(Velocity unstable MS endogenous).
But monetarists say no matter as the increase in money supply will reduce interest rates & money demand will increase
restoring equilibrium but at a higher price level.
(Velocity stable MS exogenous).
Demand pull.
In the short term more money will push demand and output up but prices will rise as firms are only willing to supply at
the higher price due to lower MPP, but in response to higher prices wages and costs rise and supply shift to the left leaving us
in the long term exactly where we were.....
Cost push.
Supply side is dominated by labour theory such that increases in say, energy, or other costs decreases the product of
labour & shifts supply to the left..
Unions shift supply to the left as well....
There is then a expansionary response....!
The greed of mankind, the class struggle..? Conflict theory ...again assumes control over events...??. BUT we are all
embroiled in the evolving web of life....
Keynesians say wage hikes result in money & price rises (endogenous money); Monetarists think money produces
price rises & then wage hikes.(exogenous money).....?????..
prices
D
demand pull
D1
cost push
S1
S
Ms2
Ms1
output/income
prices / output move in same direction
output/income
prices / output move in opposite directions
A successful prices & incomes policy would stop the AS shift.
the direction of causality ? how much real output & how much prices?????
INFLATION / UNEMPLOYMENT TRADE OFF??
* Phillips curve = 1958
- the rate of change of money wages depends on the level of unemployment
W / W = f ( u )
* Phillips two = inflation varies inversely with the level of employment & the rate of growth of labour
productivity
P / P = f ( u ) - L / L
Friedman's critique = REAL wages NOT nominal!!!!!
* natural rate of unemployment = that which is consistent with labour market equilibrium - includes,
frictional, structural in the micro markets & those not actively seeking = real variables determine the NRU
People eventually learn and are not conned into working for lower real wages as prices rise...the 'money illusion'.
* expectations augmented Phillips curve = P / P = f ( u ) + a E (P / P )
The long run Phillips curve is vertical........
money
wages
=
% price
increase
Philips curve
constant:rm imports
profits
expectations augmented
0% 5% 10%
unemployment
unemployment
UNEMPLOYMENT THE COST OF REDUCING INFLATION??
Inflation = consumption & low investment = an unreliable information system.
Permanent - temporary - vertical - horizontal ??
permanent (sticky wages)
prices
temporary (adaptive expectations)
%
vertical AS (rational expectations)
horizontal AS
output
unemployment
The key adjustment mechanism is expectations.
Adaptive expectation is based on the past trend, but is irrational.
Rational expectation uses all known variables and anticipate outcomes of for example increases in money supply. Keynesians
think established institutional wage bargaining slows the adjustment process down. Wages are sticky due to involuntary
unemployment.
Vertical assumes prices will be adjusted immediately.
Horizontal assumes prices will not respond until full capacity is reached, ie real wage aspirations dictate.
The DEA? Prices & incomes policies? Social contracts? NIC? NBPI? Everything wrecked in the end by events.
Is the money supply exogenous (monetarists) or endogenous (Keynesians)?
The key is that today economies are open & subject to global competition! Therefore the money supply is endogenous.
27. EXCHANGE RATES.
Supply & demand in the foreign exchange market.
Problems
Devaluation =
AD to the right as expensive imports decline & cheap exports increase.
AS to the left as high raw material costs inhibit production at existing prices.
I.e. prices rise output indeterminate.
But if interest rates are raised the exchange rate could appreciate & AS shift to the right,. & AD to the left - thus policy
can influence inflation or output but not both......
POLICY ISSUES.
Bilateral rates = The no. of units exchanged one for the other.
Effective = weighted average of the basket.
Real exchange = adjusted for price levels. R = e * P * / P = competitiveness.
Intervention to fix the exchange rate involves buying or selling £'s. If £'s are bought foreign currency reserves go down
but the money supply also goes down as fewer £'s circulate in the hands of private agents......thus balance of trade deficit = £'s
bought = decrease in the money supply & vice versa.....thus the Bank always acts to compensate by buying or selling bonds in
the domestic market...sterilisation....but like all buffer stocks foreign exchange reserves can't last forever...? therefore devalue
or borrow or raise interest rates...
Dirigism
Monetary policy for exchange rate control & AD manipulation
Fiscal policy for reduction in unemployment
Prices & incomes policy for anti inflation......
Markets
Floating has ensured automatic exchange rate equilibrium.
Real wage adjustments could solve unemployment.
Money also could (should) be privatised to eliminate inflation. (Monetary innovation
scuppers?????)
Then supply side for growth = low tax, privatisation & deregulation.
EXCHANGE RATES.
Balance of payments model
H = f ( y, R )
X = f ( yo/s, R )
Supply & demand for £'s. Determined by transaction flows in goods & money on the foreign exchange market.
Current account  goods = real income & exchange rate.
Capital account  money = interest rates & exchange rate expectations.
It is the overall balance of payments which must balance.
Short term money dominates but in the long term reality of PPP wins through.
Purchase of foreign assets, reserves go down as £'s are bought up by the bank, supply shifts to the right & exchange
rate goes down & fewer £'s circulate as domestic money supply reduces. Thus balance of trade deficit = £'s bought =
decrease in the money supply ..... the Bank always acts to compensate for money supply effect by buying or selling bonds
Similarly if foreigners don't want UK goods demand for £'s is low & vice versa .....
Monetary model
Exchange rates are determined by stocks of foreign currency related to interest rate differentials.
Capital flows are transitory but dominate in the short term.
In the long run Real exchange rate = quoted rate adjusted for price levels.
R = e * P / P* = competitiveness.
*
At equlibrium R = 1
e=P /P
PPP = purchasing power parity.
Prices are determined in the money markets.
balance of payments
with capital flows
exchange
rate
D(X)
S(H)
foreigners for
residents for
UK goods
imports
quantity of £'s
Floating rates.
Balance of payments must balance but it is an ex-post statistic. S & D relies on current plans. Furthermore there are only
unreliable records of invisibles which also affect S & D. IPD's (interest, profits & dividends) are important O/S investment
went from £7 bn. in '79 to £96 bn in '86!!!!!
Volatility has little effect on trade 'cos forward markets are used to eliminate the risk ?
Misalignment could result from high interest rates to curb inflation?
ERM
If interest rates are fixed by exchange rates
Contraction policy??
= reduced expenditure, higher taxes, imports down, surplus up.
But what if inflation is roaring & there is already a surplus?
Expansion policy??
= increased expenditure, lower taxes, imports up, surplus down.
But what if a recession & there is a deficit?
Prices
recession
deficit
1992
boom
deficit
1988
r
deflation
X
P inflation stable
high rates low sterling
inflation
surplus
recession
surplus
yf
boom NX = 0
surplus
income
deficit
ERM range
F balance of payments stable
low rates low sterling
e
depreciation.
Stability only if economic policies are convergent, misalignments & inflation can only be avoided by local price adjustments??
Balance of payments & inflation are only stable at one point X. With no policy instruments available the only way to hit X is
for prices to adjust!!
Comparative analysis.
Real prices are determined by global competition, thus AD is horizontal as in perfect competition. AS slopes up to the right as
prices rise real wages reduce and therefore the demand for labour rises and output rises. Money equilibrium M slopes down to
the right, as price falls mD falls so incomes must be higher to hold mD = mS.
money wage hike
prices
M
M
AS1
AS
b
c
foreign price hike
price takers
AS
a
A D1
a
P* / e
AD
output
money wage hike
AD
output
AS shifts to the left
EMS = fixed nominal rates
P* / e = P = sterling prices fixed. Thus, W up = w up & quantity must adjust & fall to Point a = stagnation.
PPP = fixed real rates (floating)
P sterling prices rise in response to the wage hike, e must accommodate & fall to keep PPP in line with P *. Point b =
inflation.
Money control = Point c = stagflation.
foreign price hike
AD shifts up.
EMS
Higher sterling prices P follow higher P* = lower real wages & output moves to Point a = boom
PPP
e would adjust to the price hike & appreciate. AD adjusts back = no change.
Money control = no change.
ERM advantages = inflation discipline & elimination of price uncertainty. The lack of instruments for manipulation becomes
transparent.
But although deficit countries are controlled as they run out of reserves, surplus countries just accumulate reserves.
International co-operation.
Global fix or pie in the sky?
In the end it is real output & productivity (costs per unit) that matter .............
28 MANAGING THE ECONOMY.
Blajorism the supply side consensus.......
Wealth comes from inputs & a conversion process. What characterises these inputs?
The position of AS.
AS assuming constant
money wages, technology, capital, material prices,
population size, leisure preferences, replacement ratios.......thus to shift the curve it is here we need to look!!
The political policy issue now becomes - do we plan these shifts or do we deregulate & leave it to the innovative
market???
SUPPLY SIDE & GROWTH.
Lab
our supply & productivity key. But also technology or perhaps ALL the interacting supply side factors and their organisation!!
The strategy & efficiency of the jsc !!!!! CANNOT be planned by the state!!!
WHAT IS THE PROBLEM?
Keynes said spend your way out of trouble but this only resulted in supply side bottlenecks, surging imports &
inflation.... others now say intervene to develop 'better' supply institutions.....others know that 'hands off' & evolution will fix
it.....!!
Cost competitiveness = exchange rate, earnings growth, productivity growth....
Non labour costs vary much less between countries as there is a global market.
Lower input costs change relative prices but do not necessarily increase output.
Investment..... private investment is surging...services investment is surging...
Tax / subsidy intervention distorts price information....investment subsidies lower investment quality
Nationalisation intervention distorts incentives & competition...
The best incentive for investment & efficiency is PROFIT. Can efficient firms go into liquidation ?? ...if they run out
of cash...? Yes but efficient firms don't run out of cash!!
Wrong products????? Quality, service, delivery dates & reliability!!!!!!
A POLICY FOR INDUSTRY & GROWTH.
1945 - Planning - nationalisation & money into traditional industries to preserve jobs & exports but never mind the
future....Trades Unions (Joe) didn't like 'planning', of course, no freedom!!
1951 - Butskillism starts - demand management. Defence industries dominate Concorde, Blue Streak......Better to buy
American!!...'Hand outs', 'picking winners' & helping 'lame ducks'.......
NEDO, DEA, IRC, NEB, Ministry of Technology......Regional planning where everybody ends up living in a
development area & cost escalates as bribes become endemic....
The change started with Jim Callahan but was it Maggie that trumped....
RECENT APPROACHES ??
'Natural' growth rates & 'natural' unemployment = a vertical AS curve. It depends on the wealth creating institutions.
Taxation is waste. Welfare pays people to be poor. Privatise the legal system. Subsidies distort the information system.
Regulation kills innovation.
OR
Higher taxes for handouts. Nationalisation. Public works for full employment. Devaluation. Spend. Planning
agreements. Worker control. Exchange control. Price control. State investment bank. Abolish the monarchy, the House of
Lords, judges........
GRAHAM SMITH
Pulls together the whole course!!
AS AD real terms per period.
Planned demand = actual output.
Original S & D assumed fixed prices this is now relaxed.
3 main policy options are g
= shifts AD to the right
M
= shifts AD to the right
tax
= shifts AD to the left
WHAT SHAPED CURVE?
demand management depends on the nature of AS
simple Keynes
= inverted L
price independent until full employment then AS vertical
Keynes including money
= slopes up to the right
vertical at full employment.
Money wage fixed, price increase = real wage down LD up.
monetarist
= vertical
output determined by supply side.