Principle of Econs Homework
Principles of Economics
STUDY GUIDE v2.0
Copyright © 2019 Kaplan Singapore. All rights reserved. i
PRINCIPLES OF ECONOMICS
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Table of Contents
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iii
iv
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Kaplan Desired Graduate Attributes
Table of Contents
About this module
Instructions to Students
Scheme of Work
Assessment Matters
Topic 1
Introduction to Economics 1
Topic 2
Production Possibilities Frontier 10
Topic 3
Demand and Supply Model 1 22
Topic 4
Demand and Supply Model 2 35
Topic 5
GDP and Economic Growth 1 47
Topic 6
GDP and Economic Growth 2 55
Topic 7
Business Cycle, Unemployment & Inflation 62
Topic 8
Fiscal Policy 80
Topic 9
Perfect Competition & Monopoly Market Structures 89
Topic 10
Oligopoly and Monopolistic Market Structures 96
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About this module
The study of Economics generally consists of
microeconomics and macroeconomics. The
success of a business depends substantially on
both microeconomics and macroeconomics.
Microeconomics provides the tools to
understand the different market structures and
analyse a competitive market whilst
macroeconomics provides the tools necessary to
assess the macroeconomic environment within
which a firm is operating. A strong economy
spells good opportunity for growth and
expansion; whilst, a weak economy is conducive
for business consolidation, capacity building, and
augmenting labour productivity in preparation for
the next phase of growth.
In this module, students will examine various
economic concepts, economic models, and other
analytical tools that are useful for economic
analysis and economic environment research so
that they may draw conclusions about
organisations’ business performance and
implications of policies. This skill set will be of
great relevance to facilitate the development of
business plan and for overcoming business
challenges.
Module Learning Outcomes
Upon successful completion of this module, the
student should be able to:
• Explain the competitive market through the Demand and Supply model
• Compare and contrast the key elements of the various market structures
• Discuss the performance of the national economy
• Explain the economic problems of unemployment and inflation
• Explain the role of fiscal policy in overcoming economic problems
• Discuss impact of the economic environment on businesses
Overview of Learning Resources
Recommended reading:
Bernanke, B. (2009). Principles of
Microeconomics (4th Ed.) USA: McGraw-Hill
Irwin
Begg, D., & Ward, D. (2013). Economics for
Business (4th Ed.). UK: McGraw Hill Education
J. Maclolm Dowling, Ma. Rebecca Valenzuela
(2010). Economic Development in Asia (2nd
ed.). Singapore: Cengage Learning Asia Pte
Ltd.
Nellis, J., Parker, D. (2006). Principles of
Business Economics (2nd Ed.) UK: Pearson
Sloman, J. (2008). Economics and the Business
Environment (2nd Ed.) UK: Pearson
Parkin, M. (2011). Economics (11th Ed.). USA:
Pearson
Online:
Topics Online Link
Trade-offs “What is Trade-off” by Gregory-
Mankiw, N:
http://www.youtube.com/
watch?v=Ha1yV32Tyog
Opportunity
cost
“Opportunity Cost” by Kanjo video:
http://www.youtube.com/
watch?v=QMIs6ILnS30
Demand and
supply
“Demand” by khan academy
https://www.youtube.com/
watch?v=ShzPtU7IOXs
Market
equilibrium
“Market Equilibrium” by khan
academy
https://www.youtube.com/
watch?v=ShzPtU7IOXs
Oligopoly and
Monopolistic
competition
“Oligopolies & Monopolistic
Competition”
https://www.youtube.com/
watch?v=igWYdYQZ1og
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Instructions to Students
How to use this study guide
This study guide consists of written notes that
form the main treatise of the subject matter of
this module. You are strongly advised to study
these notes carefully and thoroughly, as well
as, examine the sources that have been cited.
Written quiz and examination will not test beyond
the scope of the contents found in the study guide.
However, in order to fully address the
assessment requirements of the assignment, you
will need to research beyond the confines of the
study guide. Nevertheless, the materials herein
are still a sound basis from which to build the
assignment.
Further supporting materials
The study guide is supplemented by the following:
• Reproduced PowerPoint slides used by the
lecturers
• Activity sheets
PowerPoint Slides
The PowerPoint slides are meant for the lecturers
to signpost the flow of the lesson and for you to
have a visual focus when in class. Outside of
class, they can also serve to help you recall the
activities that took place during the respective
lessons so that you might be reminded of key
learning points.
However, the PowerPoint slides must NOT
replace the need for you to read the written
notes in the study guide. The slides alone are
INSUFFICIENT for you to gain the necessary
understanding of the subject matter. As such,
they will NOT prepare you adequately for the
various summative assessment components.
Activity Sheets
It is imperative that you sincerely attempt all the
activities in class and document your responses
faithfully. These activity sheets are specially
designed to scaffold your learning; working
through the tasks is an integral part of
developing the desired skills.
Also, by making your thinking visible through the
activity sheets, it is then possible for your lecturer
to provide you with growth producing feedback
so that you may improve your performance or
have your doubts clarified.
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Scheme of Work
LESSON TOPICS
1 01 Introduction to Economics
• Definition of Economics
• Macroeconomics and Microeconomics
• Fundamental Questions on Production
• Economic way of thinking
2 02 Production Possibilities Frontier
• Production Possibilities Frontier
• Production Efficiency and Allocative Efficiency
• Economic growth
3 03 Demand and Supply Model 1
• Interaction of Firms and Households
• Circular flows through markets
• Perfect Competition or Competitive market
• Demand
4 04 Demand and Supply Model 2
• Supply
• Market Equilibrium
• Predicting Changes in Equilibrium Price and Quantity
5 05 GDP and Economic Growth 1
• Definition of GDP
• Circular Flow Model
• Two Methods for Measuring the GDP
6 06 GDP and Economic Growth 2
• Real GDP vs Nominal GDP
• GDP deflator
• Economic growth rate and GDP per capita
• Limitations of GDP as an indicator of social well-being
7 Quiz revision
8 Quiz
9 07 Business Cycle, Unemployment & Inflation
• Business Cycle
• Labour market
• CPI and Inflation
10 08 Fiscal Policy
• Definition of Fiscal Policy
• Discretionary Fiscal Policy
• Automatic Fiscal Policy
• Government budget balance
11 09 Perfect Competition & Monopoly Market Structures
• Overview of market structures
• Perfect competition
• Monopoly market structure
12 10 Oligopoly and Monopolistic Market Structures
• Oligopoly
• Monopolistic Market Structure
• Comparison of four market structures
13 Module Consolidation
14
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Assessment Matters
Assessment Overview
Assessment 1: Quiz
Weightage: 20% (40 marks)
Duration: 1 hour
Date: Lesson 8
Format:
• 20 MCQ & 2 Short Structured Questions
Assessment 2: Individual Assignment
Weightage: 40% (80 marks)
Word Limit: 2000 words
Date: Lesson 12
Citation Format: APA
References: You are required to consult and fully
reference a MINIMUM of 10 references.
Assessment 3: Examination
Weightage: 40% (80 marks)
Duration: 2 hours
Date: To be advised
Format: 4 Questions
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Topic 1 – Introduction to Economics
This is the introductory Topic. Students will be introduced to some fundamental concepts
of this module of Economics as well as the economic ways of thinking.
Learning outcomes:
The following are the learning outcomes for this Topic. At the end of the Topic, do a
self-check to ensure that you have achieved these outcomes:
• Define economics.
• Distinguish between microeconomics and macroeconomics.
• Define resources and incomes earned by resource-owners.
• Explain the key ideas that define the economic way of thinking.
1.1 Definition of Economics
Economics is the social science that studies the choices that individuals, businesses,
governments and entire societies make as they cope with scarcity, the incentives that
influence those choices, and the arrangements that coordinate the (Bade & Parkin, 2015).
Examples of such key economic questions which touch on all aspects of our lives include,
• Should you take a taxi or a bus to school? Taxi is faster and more comfortable but
bus fare is much cheaper. Which do you prefer and which would you trade-off?
Would you trade-off your time and comfort to save money?
• Should you spend two hours doing homework or watching a movie? Watching a movie
is more enjoyable but doing homework is more necessary for a student. Would you
trade-off your enjoyment to do what is more important for you as a student.
• Should you bring your own lunch or eat out with friends? If you bring your own lunch
which cost you lesser financially, you will miss out on the shared experience of having
a meal with friends.
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These everyday questions relate to us, our behaviours, our preferences and things we
have to give up in making those choices. Compare these decisions, apply some of the
models and you may be surprised by the helpfulness of the lessons you are going to
learn.
Economics is about decisions that all participants in the economy make, whether as
individuals, firms or governments. All participants face the same fundamental problem of
scarcity. Our inability to satisfy all our wants is called scarcity (Bade & Parkin, 2015).
Economics is thus, concerned with how individuals and corporations make decisions and
choices in the world of scarcity. Or in simpler term, how economic participants try to
achieve the best outcome from their limited resources.
A rational participant will make a choice taking into consideration the incentives that come
with the choice. In economic context, incentives may be the reward for a good choice
but it could also be the penalty that discourage us from a path of action. For example, in
the case of a country with an under-qualified workforce (a scarcity of educated workers),
incentives for government to offer a students’ study loan to its citizens may be to generate
a higher quality workforce (reward) but this will put a strain on government’s budget
(penalty).
1.2 Macroeconomics and Microeconomics
Economics is traditionally divided into two main branches, Microeconomics and
Macroeconomics.
Microeconomics is the study of the choices that individuals and businesses make and
the way these choices interact and are influenced by governments (Bade & Parkin, 2015).
Examples of microeconomic questions are: Will you buy an iPhone or a Samsung phone?
Will Kaplan attracts more students if it lowers the school fee?
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Macroeconomics is the study of the aggregate (or total) effects on the national economy
and the global economy of the choices that individuals, businesses, and governments
make (Bade & Parkin, 2015). Some examples of macroeconomic questions are: Why is
the economy of Singapore growing so slowly? Why are incomes growing much faster in
China and India than in Japan?
1.3 Fundamental Questions on Production
Whether in macro or micro context, economists always try to address three fundamental
questions:
• WHAT goods and services to produce,
• HOW should they be produced, and
• FOR WHOM to produce.
1.3.1 WHAT to produce
A society cannot produce all it desires. It must choose which goods and services to
produce from the available resources. Any decision about what items to produce also
implies a decision on how much to produce.
For example, for a fashion firm, they need to know WHAT clothing consumers are willing
and able to buy - trendy, comfortable and/or stylish.
1.3.2 HOW to produce
The society also has to decide how to produce the goods and services. There are many
ways of producing a particular output from the available resources. A country can choose
more labour, machines or increasingly artificial intelligence in their production of goods
and services.
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The four economic resources or factors of production are land, labour, capital and
entrepreneurship.
Land is where raw materials come from (Begg & Ward, 2016). This include physical land
as well as all naturally occurring resources such as crude oil, base metals and other
minerals, which form the raw materials for the production of many goods.
Labour is the ability of individuals to work (Begg & Ward, 2016). Labour refers to the
physical and mental effort of human being to produce goods and services. The supply of
labour is constrained by the size of population in the working age group as well as the
length of a working hours. In populous countries like China and India, value is created
from the big volume of workers. In other countries like the United States of America,
wealth is created through more highly skilled and educated workers.
Capital refers to the production machinery, computers, office space or retail shops (Begg
& Ward, 2016). Capital also includes infrastructure in a country such as the Information
Technology infrastructure and the road network. In everyday language, we talk about
money, stocks and bonds as being “capital”. These items are financial capital. Financial
capital is not used to produce goods and services and it is not a factor of production.
Entrepreneurship is the human resource that organises land, labour and capital to
produce goods and services (Parkin, 2016). Examples of entrepreneurial talents in our
generations include Bill Gates, who founded the Microsoft Empire and Jack Ma, who
founded Alibaba.com.
The four factors of production are provided either directly or indirectly by households in
the economy. When viewed individually, these resources are sources of income to the
resource-owners or the households providing them, which in turn allow them to further
consume and buy goods and services.
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1.3.3 FOR WHOM to Produce
When economists refer to FOR WHOM question, the answer boils down to what
households, firms and governments think they can consume given their earnings or
income.
Households earn their incomes by selling the services of the factors of production they
own:
• Land earns rent
• Labour earns wages
• Capital earns interest
• Entrepreneurs earns profit
Earnings under the four categories can be hard to classify as an individual can play
different roles that will affect the amount of each income s/he can earn. For example, if
you are the owner of a cafe, are your earnings classified as wages from labour or profits
from your role as the entrepreneur?
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1.4 Economic way of thinking
How do we make an economic choice? What are the principles which we typically follow
when making a rational choice?
1.4.1 Self-interest and Social-interest
When you make a choice in your self-interest, you think that the choice is the best one
available for you (Parkin, 2016).
All the rational choices that people make on how to use their time and other resources
are made in the pursuit of self-interest. For example, you order pizza delivery because
you are hungry and not because the delivery person needs a job. And when he delivers
your food, he is doing it out of his self-interest to earn a wage and not to do you a favour.
When a choice is made for social interest, it is a choice that is best for society as a whole
(Parkin, 2016). For example, Ted, an entrepreneur creates a new business. He hires a
thousand workers and pays them $20 an hour, $1 more than what they earned in their
old jobs. Ted’s business is extremely profitable and his own earnings increases by $1
million per week.
You can see that Ted’s decision to create the business is for his own self-interest. He
gains $1 million a week. You can also see that the decision of the workers to work for
Ted are in their own self-interest as they now earn more than their old job. However, as
everyone is better off and there is no loser, the element of social interest also exists.
1.4.2 Trade-off and Opportunity cost
As all of us face scarcity, we must select from the available alternatives to make a choice.
For example, you can spend this Saturday evening studying for the next Economics 1
Quiz, going out with your friends or work in a restaurant, but not all activities because of
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scarcity of time. Hence, you must choose how much time to devote to each activity.
Whatever choice you make, you have to trade-off the other activities. A Trade-off is an
exchange – giving up one thing to get something else (Bade & Parkin, 2015).
McDonalds, operating in Australia in early part of this century, traded-off shorter
preparation times and possible loss of customers for a healthier-choice menu featuring
salads and lower-fat food choices, to meet the growing demand from consumers of
healthier food.
In Singapore and many developed nations, the bid to achieve greater economic growth
come with trade-offs. The strong growth of the Singapore economy in the last fifty years
came with a trade-off of leisure time for many households.
All trade-offs come at the cost of alternatives given up and these costs are known as
opportunity costs. Opportunity cost is the sacrifice of a next-best alternative (Schiller,
2016).
For example, imagine you have $1000 to either buy a new iPhone or go for a short
overseas vacation in Vietnam. The opportunity cost of buying a new iPhone (instead of
going for a vacation), is the satisfaction and knowledge gained from the vacation in
Vietnam. The above example of opportunity cost is an all-or-nothing type, that is, you
either buy an iPhone or travel. Most real-world situations are not like this but involve
choosing how much of an activity to do.
1.4.3 Choices at the margin
We make rational choices by comparing costs and benefits in connection with the choice.
Making a choice on the margin means comparing all the relevant alternatives
systematically and incrementally (Bade & Parkin, 2015).
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In the previous example given, you can allocate the hours between studying and going
out with friends and working in a restaurant, but the choice is not all or nothing. You must
decide how much time to spend on each activity. To make this decision, you compare the
benefit of a little bit more study time with its cost involved when you make your choice at
the margin.
Marginal benefits are benefits that arise from an increase in an activity (Parkin, 2016).
For example, your marginal benefit from one more evening of study before a Quiz is the
addition marks you will score in your grade. Your marginal benefit does not include the
grade you are already getting without that extra evening of study.
Marginal costs are the opportunity costs of an increase in an activity (Parkin, 2016). For
example, the marginal cost of studying one more evening is the $50 you could have
earned if you have gone to work in the restaurant.
To make your decision, you compare marginal benefit and marginal cost. If the marginal
benefit from an extra evening of study exceeds the marginal cost of working in a
restaurant, you have incentive to study the extra evening. Incentives occur when there
is more marginal benefit than marginal cost for choosing an activity. If the marginal cost
outweighs the marginal benefit, you will not study the extra evening.
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REFERENCES
Bade, R. & Parkin, M. (2015). Essential Foundations of Economics. (7th
ed.). USA: Pearson Education Inc.
Begg, D. & Ward, D. (2016). Economics for Business. (5th ed.). USA: McGraw-Hill
Education.
Parkin, M. (2016). Economics. (12th ed.). England: Pearson Education Limited.
Schiller, B.R. (2016). Essentials of Economics. (10th ed.). USA: McGraw-Hill Education.
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Topic 2 – Production Possibilities Frontier
In this Topic, we will be going into more depth in understanding the concepts of scarcity,
opportunity cost as well as marginal cost and benefit analysis learnt in Topic 1.
Specifically, we will be studying an economic model called the Production Possibilities
Frontier (PPF).
Learning outcomes
The following are the learning outcomes for this Topic. At the end of the Topic, do a
self-check to ensure that you have achieved these outcomes:
1. Define the production possibilities frontier.
2. Differentiate between production efficiency and allocative efficiency.
3. Explain how current production choices expand future production possibilities.
2.1 Production Possibilities Frontier
The PPF is the boundary between those combination of goods and services that can be
produced and those that cannot (Parkin, 2016). To illustrate the PPF, we focus on two
goods at a time and hold the quantities of all other goods and services constant. That is,
we look at a model economy in which everything remains the same (ceteris paribus)
during this period of analysis, except the two goods we’re considering.
2.1.1 Drawing the PPF
To illustrate, let look at Country Dino which produces two goods namely Compact Discs
(CDs) and pizzas. The table below shows the production output combination possibilities
of the two products that can be produced in a year. Using the various production output
combination, the PPF can be drawn with the x-axis showing the quantity of pizzas
produced while the y-axis showing the quantity of CDs produced (Figure 1).
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Possibility CDs (million units) Pizzas (million units)
A 15 0
B 14 1
C 12 2
D 9 3
E 5 4
F 0 5
Figure 1: Production Possibilities of Country Dino
2.1.2 Interpretation of the PPF
The PPF can be used to illustrate a number of fundamental economic concepts we
have learnt in Topic 1.
The concept of choice is shown by the various points on the PPF. The PPF separates
those output choices that are attainable from those that are unattainable. We can produce
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any output combination inside the PPF and on the PPF. These combinations are, thus,
attainable.
The country can choose to produce any of the combination of CDs and pizzas
represented by point A to F, depending on its objectives. For instant, with the existing
production resources and technology, the country can choose to produce 9 million CDs
and 3 million pizzas (point D) or 14 million CDs and 1 million pizzas (point B). Moving
along the PPF from point F to point A, the country produces lesser pizzas and more CDs
while moving from point A to point F, the country produces more pizzas and lesser CDs.
Scarcity is implied by the unattainable combinations of output. Point G is unattainable
given the country’s existing productive capacity.
Unemployment and inefficiency: When the economy is operating at a point inside the
boundary such as Z, there is inefficient use or under-utilisation of available resources.
Resources could be utilised more fully and efficiently in order to increase production of
both CDs and pizzas towards the maximum combination of output represented on the
PPF.
2.2 Production Efficiency and Allocative Efficiency
2.2.1 Production Efficiency
Production Efficiency occurs when the economy is getting all that it can from its
resources. We achieve production efficiency if we cannot produce more of one good
without producing less of some other good (Bade & Parkin, 2015). In simpler term,
resources are fully utilised and there is no waste. This outcome occurs at all the output
combinations on the PPF.
At points inside the PPF, production is not efficient because we are giving up more than
necessary of one good to produce a given quantity of the other good. For example, at
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point Z in the PPF of Country Dino, the country produces 5 million CDs and 3 million
pizza, but we actually have sufficient resources to produce 5 million CDs and 4 million
pizzas. Alternatively, we can also produce 10 million CDs and 3 million pizzas.
Production inside the PPF is inefficient because resources are either unemployed and/or
misallocated. Resources are unemployed when they are idle but could be working
(Parkin, 2016). For example, some workable machine in a factory are left idle.
On the other hand, resources are misallocated when they are assigned to tasks for which
they are not the best match (Parkin, 2016). For example, when CDs workers in a factory
are assigned to work in a bakery to produce pizzas, the workers may not be so productive
in their new tasks. We would get more CDs and more pizzas if we have allocated these
workers to their respective profession.
2.2.2 Trade-off and Opportunity Cost along the PPF
Every choice along the PPF involves a trade-off. At any given time, we have a fixed
amount of labour, land, capital and entrepreneurship and a given state of technology. We
can employ these resources and technology to produce goods and services, but we are
limited in what we can produce. The negative slope of the PPF shows the concept of
opportunity cost. In Country Dino, to produce more pizzas, we have to produce lesser
CDs, vice-versa.
As we have learnt in Topic 1, opportunity cost of an action is the highest-valued
alternative forgone. Looking at Country Dino again, if we want to increase the production
of pizzas from 1 million to 2 million, the country must reduce production of CDs from 14
million to 12 million, or a reduction of 2 million CDs. The opportunity cost of the additional
1 million pizzas is 2 million CDs. In other words, the opportunity cost of 1 pizza is 2 CDs.
Conversely, the opportunity cost of 1 CD is ½ pizza. The opportunity cost of one item is
the inverse of the opportunity cost of the other item between these two output
combinations.
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As we produce more pizzas and less CDs, the opportunity cost of producing pizza
increases. The outward-bowed shape of the PPF reflects the law of increasing
opportunity cost. As society takes more resources away from 1 good e.g. CDs and
applies to produce another good e.g. pizza, the opportunity cost of each additional unit of
pizza produced increases.
When we produce a large quantity of CDs and a small quantity of pizza, between point A
and B, the frontier has a gentle slope. An increase in the quantity of pizza costs a small
decrease in quantity of CD. Specifically, an increase in 1 unit of pizza will result in a
decrease of 1 unit of CD. On the other hand, between point E and F, the frontier is steep,
when we produce a small quantity of CDs and a large quantity of pizza, an increase in
the quantity of pizza costs a large decrease in quantity of CDs. In this case, an increase
in 1 unit of pizza will result in a decrease of 5 unit of CDs, much more than between point
A and B.
Opportunity cost of producing pizzas increases as resources are not equally productive
in all activities. Some factors of production are better suited for the production of one
good than they are for other goods. For example, the CDs workers are good at producing
CDs but they are not as good in producing pizzas, hence when we reallocate more CDs
workers to pizza production, we get a small increase in quantity of pizzas but a huge drop
in quantity of CDs produced. The more of either good we try to produce, the less
productive are the additional resources we channel in to produce that good, hence, the
larger is the opportunity cost of producing one more unit of that good (See Figure 2).
2.2.3 Allocative Efficiency
The above discussion leads to the next important question of, which production output
combination of goods is the best for the country? To address this question, allocative
efficiency comes into play now. Allocative efficiency is a situation in which the
quantities of goods and services produced are those that people value most highly. In
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other words, it is not possible to produce more of a good or service without giving up
some of another good that people value more highly (Bade & Parkin, 2015).
A country or a firm achieved production efficiency at every output combinations on the
PPF, but which output choice will achieve allocative efficiency?
We have learnt in Topic 1, Marginal cost is the opportunity cost of an increase in an
activity. We can calculate marginal cost from the slope of the PPF. As the quantity of
pizzas produced increases, the PPF gets steeper and the marginal cost of a pizza
increases. Figure 3 below shows the increasing marginal cost of producing pizzas,
calculated in the shaded area when quantity of pizzas produced increases.
Figure 2: Increasing opportunity cost Figure 3: Increasing marginal cost
Marginal benefit from a good or service is the benefit received from consuming one more
unit of it. This benefit is subjective. It depends on people’s preference or what people
like and dislike, and the intensity of those feelings. Preferences describe what people
like and want while the production possibilities frontier describe the limits or constraints
on what is feasible, thus they are unrelated.
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We can measure the marginal benefit from a good or service by the most that people are
willing to pay for an additional unit of it. Marginal benefit decreases as quantity of goods
produced increases. Consumers will allocate their scarce resources in such a way that
will maximise their satisfaction. However, as more units are purchased, they will
experience diminishing marginal benefit. In other words, the more we consume of any
one good or service, we will get bored of it and hence, less willing to pay high price for it.
Imagine, if you eat pizza once a year, you will be more willing to pay high price for it.
However, if you eat pizza every day, you will be less willing to pay the same high price to
buy the pizza. Thus, marginal benefit has negative linear relationship with quantity of
goods produced as illustrated in Figure 4 below.
Figure 4: Principle of diminishing marginal benefit.
The diagrams below shows the marginal cost and marginal benefit curves of Pizzas for
Country Dino. The point where the two graphs meet represents the optimum where
marginal cost is equal to marginal benefit (Figure 5). Allocative efficiency is achieved
at this specific quantity of pizza produced, that is, 2.5 million pizzas. At this quantity, both
Producers and Consumers are in agreement on the optimal quantity of pizzas produced.
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MC
Therefore, in this situation the quantity of pizzas and CDs produced is just the right
amount to minimise waste (cost) and meet consumer preferences (benefit).
Figure 5: Allocative efficiency achieved
when MB = MC.
Figure 6: Output of allocative efficiency on
the PPF.
At any point on the PPF, we cannot produce more of one good without giving up some
other good. At the best point on the PPF, we cannot produce more of one good without
giving up on some other goods that provide greater benefit (Parkin, 2016). This is Point
B on the PPF of Country Dino in Figure 6. Before or after this point of efficiency on the
slopes, any more pizzas produced will mean increased operational cost and any less will
mean the pizzas producers are not producing enough to maximise customer willingness
to pay.
In summary, when all resources are fully employed, societies would achieve its maximum
possible output of goods and services and enjoy the highest standard of living possible.
It will thus be operating on its production possibilities frontier. All combinations on the PPF
achieves production efficiency when production of each items is at minimum cost and
we cannot produce more of one good without giving up some other good. Allocative
efficiency, however, occurs only at a particular point on the PPF where the right amount
of the right good is produced. The economy is operating at a point on the PPF with what
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is desired by the society. Allocative Efficiency is thus the most valuable point on the PPF
slope.
In summary, for a society to attain full economic efficiency, it must meet the two
conditions of production efficiency and allocative efficiency.
Production Efficiency ❖ Resources are fully employed.
❖ Society achieves its maximum possible output and
enjoy the highest possible material standard of living.
❖ Economy is operating on its PPF.
Allocative Efficiency ❖ The occurrence when no one is reaping benefits at the
expense of others.
❖ The right amount of the right goods is produced.
❖ Economy is operating at a particular point on the PPF.
❖ This particular point changes depending on the
objectives and desires of the society.
2.3 Economic growth
Economic growth refers to the ability of the economy to produce increasing quantities
of goods and services (Hubbard & O’Brien, 2015). Economic growth increases standard
of living as people earn more incomes, but it does not overcome scarcity and avoid
opportunity cost. To make an economy grow, we face a trade-off. The faster production
grows in an economy, the greater is the opportunity cost of economic growth. We will be
learning more about economic growth in Topic 6 but for now we will focus on economic
growth in relation to the PPF.
Economic growth is illustrated by the outward shift of the PPF (Figure 7). Such an
outward shift of the PPF represents potential economic growth. An outward shift in the
PPF is caused by an increase in the quantity and/or quality of resources and/or an
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advancement in the state of technology. The discovery of new resources allows an
economy to produce more of all goods. New resources include an increase in labour
supply arising from inward migration or increase in birth rate.
Figure 7: Outward shift of the PPF, representing economic growth.
Economic growth also comes from technological change and capital accumulation
(Parkin, 2016). Technological advancement is the development of new goods and/or
better way of producing goods and services. Capital accumulation is the growth of
capital resources, including physical capital and human capital (Parkin, 2016)
Technological advances and capital accumulation can expand the production possibilities
of a country or a firm by achieving greater productivity in the use of resources. However,
there is no free lunch in this world. Technological advancement and capital accumulation
come with a cost. To accumulate capital (build a road, buy a tractor, build a
manufacturing plant) and to develop new technologies, society must devote fewer
resources to produce consumer goods today. As production possibilities expand,
consumption in the future also increases. However, when a country chooses to produce
less capital goods and more consumer goods in the current period, it will experience a
slower rate of potential economic growth in the future.
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On the same note, if we replace leisure with education today, in the future we will have
more knowledge and skills and hence have greater productivity. On the same note, if a
country replaces wastage with saving today, in the future the country will have more
capital and can produce more goods and services. Thus, the choices we make today
will greatly affect future production possibilities.
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REFERENCES
Bade, R. & Parkin, M. (2015). Essential Foundations of Economics. (7th
ed.). USA: Pearson Education Inc.
Hubbard, R.G. & O'Brien, A.P. (2015). Essentials of Economics. (4th
ed.). USA: Pearson Education Inc.
Parkin, M. (2016). Economics. (12th ed.). England: Pearson Education Limited.
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Topic 3 – Demand and Supply Model 1
In the previous Topic, we have learnt about production possibilities and economic growth.
In this Topic, we will focus on the interaction between the buyers and sellers in the market,
by studying the demand and supply model.
Learning outcomes:
The following are the learning outcomes for this Topic. At the end of the Topic, do a
self-check to ensure that you have achieved these outcomes:
• Appreciate how firms and households interact with the market.
• Describe a perfect competition market.
• Define demand and the law of demand.
• Explain the influences on demand.
3.1 Interaction of Firms and Households
In order for a country to achieve economic growth, there must be some coordination
systems to work. The two extreme competing coordination economic systems that have
been adopted by governments are command (or planned) economy and market
economy.
Command economy or state-run type of economies function poorly because economics
planners are unable to gather enough data about production possibilities and consumers’
preference. Hence, production ends up inside the PPF and many times, the wrong goods
are being produced. These economies have been proven to be economically less
effective. Examples of such economies in the past include Russia and China.
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Market economy or decentralised coordination system works best but it requires the
interactions of four institutions namely firms, markets, property rights and money.
3.1.1 Four Institutions in the Market Economy
1. Firms
Firms are the institutions that organise the production of goods and services (Bade &
Parkin, 2015). For example, Apple Inc., is a world-famous technological firm that
generates billion dollars revenue every year from production to retailing of electronic
devices. Apple Inc. hires resources of production namely land, labour and capital, and
directs them to decide what goods and how much to produce. However, the goods
produced by Apple Inc. need customers to buy and they cannot produce everything
themselves thus they need to buy from other firms as well. All these trading activities
need markets.
2. Market
A market is any arrangement that brings buyers and sellers together and enable them to
get information and do business with each other (Parkin, 2016). For example, the
housing market refers to a network of developers, customers, property agencies and
brokers who buy and sell houses. A market, however, can work only when there is
property rights.
3. Property Rights
Property rights refer to the legally established titles to the ownership, use and disposal
of factors production and goods and services that are enforceable in the courts (Bade &
Parkin, 2015). Real property includes land, building and durable goods such as
equipment. Financial property includes stocks and bonds and money in the bank while
intellectual property is the intangible product of creative effort such as songs, writings,
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inventions of all kinds that are protected by copyrights and patents. With property rights,
people are motivated to specialise and produce the goods and services which they have
competitive advantage. Such property rights can be exchanged using money.
4. Money
Money is any commodity or token that is generally acceptable as a mean of payment.
All these institutions are being “coordinated” in the market. For example, firms produce
and supply televisions. Consumers are willing to pay a particular price for the television,
and this is known as the demand for television. Importantly, consumers and suppliers
accept that money is the only form to exchange for the television in the market. The
television is the property right of the firm until such time when the consumers have
traded the market price in terms of money for the television. After which, the consumer
has the property right to the television.
3.2 Circular flows through markets
Exchange of goods and services and factors of production creates flows of expenditures
and incomes between households and firms. Households supply the factors of production
namely the labour, land, capital, and entrepreneurial services in return for payments or
incomes in the forms of wages, rent, interest, and profits respectively.
Households choose how to spend their incomes on goods and services supplied by firms.
Firms supply goods and services to households for revenue and with the revenue
received, hire factors of production from households. Firms can choose the quantities of
factors of production to hire and quantities of goods and services to produce. Markets
coordinate these choices through circular flow of incomes and expenditures as illustrated
in figure 1 below.
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Figure 1. Circular flow of income and expenditures.
Market coordinates decisions through price adjustment. When the price is right, desires
and availability match. The allocation of resources in a market economy is based on the
price mechanism. The decisions of producers determine the supply while the decisions
of buyers determine demand. This interaction of demand and supply cause changes in
market price of a product. It is this movement in market price which bring about changes
in the usage of society’s resources.
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3.3 Perfect Competition or Competitive market
As we have learnt above, a market is any arrangement that enables buyers and sellers
to get information and to do business with each other. There are many types of market
such as physical markets where buyers and sellers meet to agree on price and other
transaction details. On the other hand, there are virtual markets where sellers and buyers
never meet but do their trading through online platforms such as Lazada and Shopee,
Markets vary in the intensity of competition that buyers and sellers face. In this Topic, we
will be focusing on a competitive market which is a market that has many buyers and
many sellers, so no single buyer or seller can influence the price (Parkin, 2016). Other
key features of the market include perfect information and standardised product. In this
market, a large number of producers compete with each other to satisfy the wants and
needs of a large number of consumers. No single producer, or a group of producers, and
no single consumer, or group of consumers, can dictate how the market operates. Hence,
nobody can individually determine the price of goods and services and the quantity that
is transacted in a given period of time.
A competitive market forms under certain conditions. For such a market to work
effectively, there must be no significant information failure affecting the decisions of
consumers and producers. It is assumed that the consumer of a private good or service
knows what they are getting and they are able to estimate accurately the net benefit they
are likely to derive. Net benefit is the private benefit to a consumer in terms of satisfaction
or utility, less the private cost associated with buying the product.
For example, when consumers like Michael, purchases a cup of coffee from his favourite
café, he will feel that he is clear about the net benefit he will derive. Consciously or
instinctively, he will make a calculation that buying a coffee is worth the $2 he is asked to
pay. It can be assumed that Michael’s decision to make this purchase is guided by his
rational expectations. In other words, consumers based their decision to consume on a
complete range of information gathered over the past, together with a prediction of the
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future. Michael may have bought many cups of coffee at this cafe previously, and has
always been satisfied with the quality of the coffee and the service received. Hence, the
$2 expenditure is a ‘safe bet’. In the real world, however, there may be many situations
where not all the information regarding the product is available to the consumers. In these
cases, the markets fail to work efficiently. For example, Michael may not be aware that
consuming coffee on a regular basis can increases his blood pressure and this might
trigger health problems for him subsequently.
Another feature of a competitive market is that the sellers in these markets offer
reasonably homogenous or similar goods. In other words, there is no substantial product
differentiation, branding, etc., and consumers in this market view all of the goods in the
market as being, at least to a close approximation, perfect substitutes of one another.
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3.4 Demand
Demand or effective demand refers to consumers’ wants, ability and decision to purchase
a good or service. The quantity demanded is the amount of any good, service, or
resource that people are willing and able to buy during a specified period at a specified
price (Bade & Parkin, 2015). As we attempt to derive a relationship between the quantity
demanded for a good per time period and the price of that good, we must hold every other
influencing factors such as consumers’ taste and preference, constant. In economics, we
use the term “ceteris paribus” to describe this situation. The quantity demanded is
measured as an amount per unit time, such as 3 bowls of rice per day. The quantity
demanded does not need to be the same as the quantity actually bought as it depends
on the quantity of goods available in the market at that time, or supply of the good. We
will learn more about the supply concept in the next Topic.
3.4.1 Law of Demand
Many factors influence the buying plans, and one of them is the price. The relationship
between the quantity demanded of a good and its price is illustrated by the law of
demand. The law of demand states that, other things remaining the same, if the price of
a good rises, the quantity demanded of that good decreases; and if the price of a good
falls, the quantity demanded of that good increases (Bade & Parkin, 2015).
There are two reasons that lead to this inverse relationship between price and quantity
demanded. They are substitution effect and income effect. These two effects can occur
individually or together on a good or service.
1. Substitution Effect
When the price of a product rises, other things, remaining the same, its opportunity cost
rises (Parkin, 2016). Although each product is unique, it has substitutes, which are other
products that can be used. As the opportunity cost of a product rises, the incentive to
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switch to a substitute becomes stronger. For example, Coke and Pepsi are close
substitutes for many consumers. When the price of Coke increases, people are more
inclined to purchase Pepsi which is cheaper to substitute the Coke. The quantity of Coke
demanded thus, decreases. Hence, the substitution effect takes place.
2. Income Effect
When the price of a good rises, other things remaining the same, a given income can buy
fewer units of the good. The purchasing power of income of consumers has fallen,
leading to the fall in quantity demanded of the good. For example, a can of Coke is initially
priced at $1 per can. With $10 budget you can buy 10 cans of Coke. However, if the
price rises to $2 per can, you can only buy 5 cans. Quantity of Coke demanded
decreases. Hence, the income effect takes place.
3.4.2 Demand curve
Demand curve is a graph that shows the relationship between the quantity demanded of
a good and its price when all other influences on buying plans remain the same (Bade &
Parkin, 2015). We graph the demand curve with the quantity demanded on the x-axis
and the price on the y-axis (Figure 2). The demand curve slopes downward. As the price
falls, the quantity demanded increases. The demand curve can be read in two ways. For
a given price, the demand curve tells us the quantity that people are willing and able to
pay. For a given quantity, the demand curve tells us the maximum price that consumers
are willing to pay for the last good available.
Before proceeding, we must acknowledge the important distinction between demand and
quantity demanded. Quantity demanded refers to a point on a demand curve or the
quantity demanded at a particular price. Changes in quantity demanded for a good is
shown by the movement along demand curve (Figure 2).
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Figure 2: Movement along demand curve:
Figure 3: Change in demand causing shifts of demand curve:
The term demand refers to the entire relationship between the price and the quantity
demanded of that good. Any change in demand for a good will lead to the shifting of the
demand curve (Figure 3).
When any factor that influences buying plans of a good changes, other than the price of
the good, there is a change in demand for the good. When demand for the good
increases, the demand curve shifts rightward and the quantity demanded for the good at
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each price is greater. When demand for the good decreases, the demand curve shifts
leftward and the quantity demanded for the good at each price is lower.
3.4.3 Factors that Change Demand
There are five main non-price factors that will have impact on demand. They are,
1. Consumers’ income
2. Number of consumers
3. Price of related goods
4. Consumers’ expectation
5. Consumers’ preference
1. Consumers’ income
The impact of change in consumers’ income on demand of a good depends on whether
the good is a normal good or an inferior good.
A normal good has a demand that varies directly with changes in consumers’ income. An
increase in income increases the purchasing power of consumer and increases the
willingness and ability of consumers to pay for normal goods. This leads to an increase
in the demand for normal goods. This is shown by a rightward shift in the demand curve.
On the other hand, an inferior good has a demand that varies indirectly with changes in
consumers’ income. People buy inferior goods as they are unable to afford better quality
goods. On the other hand, an increase in income reduces their willingness to pay for
inferior goods and lead to a fall in the demand for inferior goods. This is shown by a
leftward shift in the demand curve. At each possible price, fewer units of the good is
demanded. To illustrate, as income rises, the demand for budget flight will fall as people
tend to choose full-service flight when they travel. The budget flight service is deemed
inferior while the full-service flight is normal for many people.
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2. Number of Consumers
An increase in the number of consumers in a market will increase the demand for a good,
vice-versa. For example, an increase in the grey population in countries like Japan and
Singapore, will likely lead to increase in demand for nursing home service for the elderly.
3. Price of related goods
The law of demand holds true in both cases of substitute products and complements.
Substitute products are goods that can be consumed in place of another good. (Bade &
Parkin, 2015). The range of substitutability can be narrow or broad. The former could be
in terms of different products brand such as BMW or Ferrari cars. The latter could be in
terms of different product groups such as different types of transports namely MRT, buses
and cars. The closer two goods are as substitutes, the greater will be the fall in the
demand for one good, for a given fall in the price of the substitute good, vice versa.
Complement is a good that is consumed with another good (Bade & Parkin, 2015). A
typical example would be cars and petrol. A fall in the price of cars will lead to an increase
in the quantity demanded for cars, hence an increase in the demand for petrol. The closer
the two goods are as complements, the greater will be the change in demand for one
good, given the change in price of the other.
4. Consumers’ Expectation
Consumer expectations regarding future prices and future income may prompt them to
buy more or less of a good in the current period.
If consumers expect the price of houses to rise next year, they will increase their demand
for new houses in the current period to avoid paying higher prices in the future, vice-
versa.
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When consumers expect increase in future income, demand for normal goods or services
will increase as there is a tendency for consumers to spend higher predicted earnings
before consumers have received them. On the other hand, if consumers expect the
economy to perform poorly leading to a fall in future income, the demand for such good
or services will decrease as people tend to save for their rainy days.
5. Consumers’ preference
People with the same income have different demand for a good if they have different
preference or taste for the product. A favourable or unfavourable change in consumers’
preference for a product will affect demand for that product. For example, when doctors
discover that drinking tea can reduce the risk of lung cancer, there will be an increase in
demand for tea leaves in the market as consumers prefer to drink tea now.
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REFERENCES
Bade, R. & Parkin, M. (2015). Essential Foundations of Economics. (7th
ed.). USA: Pearson Education Inc.
Parkin, M. (2016). Economics. (12th ed.). England: Pearson Education Limited.
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Topic 4 – Demand and Supply Model 2
From the law of demand learnt in previous Topic, we know that the higher the price of a
good or service, the lower will be the quantity demanded for the good by consumers.
However, the higher price of the good in the market means higher returns for the suppliers
and, with other suppliers who are keen to share the pie emerging, supply of the good will
increase.
Learning outcomes:
The following are the learning outcomes for this Topic. At the end of the Topic, do a
self-check to ensure that you have achieved these outcomes:
• Define supply and the law of supply.
• Explain the influences on supply.
• Explain how demand and supply determine price and quantity transacted.
• Apply demand and supply model to predict changes in price and quantity.
4.1 Supply
Supply refers to the relationship between the quantity supplied and the price of a good
when all other influences on selling plans remain the same (Bade & Parkin, 2015). If a
firm supplies a good or service, then the firm must have the resources and the technology
to produce the good. In addition, the firm is able to make a profit and the firm has made
a definite plan to produce and sell the good.
Quantity supplied is the amount of any good, service, or resource that people are willing
and able to sell during a specified period at a specified price (Bade & Parkin, 2015).
Similar to quantity demanded, quantity supplied is measured as an amount per unit time.
The actual quantity sold may not be the same as quantity supplied, as the amount of
goods and services supplied may not be the same as quantity demanded. To isolate the
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relationship between quantity supplied and its price, we keep all other influences on
selling plans the same or ceteris paribus.
4.1.1 Law of Supply
The law of supply states that other things remaining the same, if the price of a good
rises, the quantity supplied for that good increases; and if the price of a good falls, the
quantity supplied of that good decreases (Bade & Parkin, 2015). Hence, when the price
of a good rises, other things being constant, producers are willing to incur a higher
marginal cost to increase production of the good concerned.
4.1.2 Supply Curve
The supply curve shows the relationship between the quantity supplied of a good and its
price when all other influences on producers’ planned sales remain the same. A rise in
price of a good, other things remaining the same, brings an increase in the quantity
supplied of the good. This increase in price when mapped against quantity supplied
causes the supply curve to rise towards the right-hand side. The supply curve is
illustrated in Figure 1 below.
Figure 1: Movement along supply curve
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Graphically, changes in the supply curve (just like the demand curve) reflect that any
increase in supply will shift the graph rightward and any decrease in supply will move the
graph leftward. There is a difference between movement along supply curve when there
is a change in quantity supplied and shift of supply curve when there is a change in supply
which arises as a result of other influences on the market, but not the price of the good.
The increase and decrease in supply are illustrated in Figure 2 and Figure 3 respectively.
Figure 2: Increase in Supply Figure 3: Decrease in Supply
4.1.3 Factors that Change Supply
The supply of a product may change due to a number of non-price factors, causing the
supply curve to shift. The influence of these factors are discussed below.
1. Cost of production
A rise in wages, rent or a rise in the price of a raw material will increase the unit cost of
production. Holding the price constant, a higher average cost of production would result
in a lower potential profit per unit of good produced. Hence, at each possible price, fewer
units will be supplied as producers consider alternative goods to produce. This will lead
to the supply curve shifting to the left. On the other hand, a decrease in the average cost
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of production will lead to an increase in the supply of the good and the supply curve
shifting to the right.
2. Price of related goods supplied
For the supplier of a good, the change in the price of related good in production namely
a substitute or complement can also influence his decision on the supply of his/her good.
Substitute in production is a good that can be produced in place of another good (Bade
& Parkin, 2015). The increase in the price of a substitute good means that producers are
likely to switch to producing the substitute good that use the same resources as the good
they were originally producing. An example is the decision of the producers in production
of natural rubber and palm oil. If the price of natural rubber rises due to a rise in demand
for rubber, farmers find it more profitable to produce rubber. This, thus, leads to the
diversification of resources away from the production of palm oil towards the production
of natural rubber. Hence, there will be a fall in the supply of palm oil, vice-versa.
Complement in production is a good that is produced along with another good (Bade &
Parkin, 2015). The increased profitability from producing one good will result in a rise in
supply of the complement good. An example of complements are beef and leather
produced by the cattle farmers. An increase in the price of beef due to an increase in
demand of beef increases the quantity supplied which leads to a corresponding increase
in the supply of leather in the market, vice-versa.
3. State of technology used in production
If a new method is devised to produce a good more efficiently, more output will be
produced with the same amount of inputs. If prices of factors of production remain the
same, this would lead to a lower unit cost of production. Holding the price of the good
constant, a lower unit cost of production results in a higher potential profit per unit of
output. Thus, at each possible price, more will be supplied as producer consider switching
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resources into this production. There is an increase in supply and a rightward shift in the
supply curve, vice-versa. The increased production of crude oil in USA in recent years is
a result of such advancement in “fracking” technology in the exploration of crude oil.
4. Suppliers’ Expectation
A change in the expectation of suppliers towards a good, can affect the supply of the good
at the present moment. Suppliers who expect the increase in the future price of a good
in the near future, will likely supply lesser of the good now, so as to stockpile and supply
more in the future. On the other hand, suppliers’ expectation of a fall in the future price
of the good, will lead to increase in supply of the good at the present moment.
5. Nature, random shocks or unpredictable events
Adverse changes such as bad weather, disasters, war and political events will decrease
supply of the good if the production process of the good is disrupted. As a result, lesser
quantity of the good is supplied at each prevailing price level. Such situations are
commonly known as “supply shocks”. On the other hand, favourable weather condition
and greater political stability will tend to increase the supply of a good.
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4.2 Market Equilibrium
When bargaining with a banana seller in Asia, there is a common saying that, by the end
of a negotiation, if both parties are still smiling then the price is fair one. The Seller has
received the price he is willing to sell and the Buyer is willing to buy. This happy
transaction is a simple illustration of market demand and supply at work.
After learning the law of supply and the law of demand, you would have realised that they
are opposing forces. Specifically, when the price of a good rises, quantity demanded
drops and quantity supplied rises. To determine a market price to coordinate buying and
selling plans, we have to achieve an equilibrium in the market.
Figure 4: Market equilibrium
An equilibrium is a situation in which opposing forces balance each other. Equilibrium
in a market occurs when the price balances buying plans and selling plans of both
consumers and firms (Parkin, 2016). A market moves toward its equilibrium because
price regulates buying and selling plans and price adjusts when these plans do not match.
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Market equilibrium occurs when the quantity demanded equals the quantity supplied
(Bade & Parkin, 2015). Please see Figure 4 above. The equilibrium price is the price
at which the quantity demanded equals the quantity supplied (Pe). The equilibrium
quantity is the quantity bought and sold at the equilibrium price (Qe) (Bade & Parkin,
2015).
Despite the many factors that will affect demand and supply, the market price remains
the balance by which we compare the willingness of consumer to purchase and producers
to supply. Hence, when price varies from the equilibrium price, theoretically the market
will either force the price back to the balance or a new market equilibrium may be set.
If the price of the good is higher than the equilibrium price, the quantity supplied exceeds
the quantity demanded. This leads to a surplus of the good in the market. This will force
the price down to the original equilibrium price. If the price is below the equilibrium price,
the quantity demanded exceeds the quantity supplied. This leads to a shortage of the
good in the market. This will force the price up, to the original equilibrium price.
To illustrate, suppose the price of a can of coke is $1. Consumers plan to buy 14 million
cans and producers plan to sell only 7 million cans. Consumers cannot force producers
to sell more than they plan, so the quantity that is actually offered for sale is 7 million
cans. Some producers, noticing queues of unsatisfied consumers, will start to raise the
price. The rising price reduces the shortage because it decreases the quantity demanded
and increases the quantity supplied according to laws of demand and supply. There are
movements of points along the demand and supply curve. When the price has increased
to the point at which there is no longer a shortage, the force moving the price upward stop
operating and the price comes to rest at its equilibrium price.
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4.3 Predicting Changes in Equilibrium Price and Quantity
The demand and supply model provides a powerful way to analyse the influences on
price of a good and the quantity bought and sold. According to the model, the change in
price comes from the change in demand, change in supply or change in both demand
and supply.
4.3.1 Increase in Demand
If demand for a particular good increases, its demand curve shifts rightwards (Figure 5).
The quantity supplied cannot match the quantity demanded by consumers, creating a
shortage at the original price. To eliminate the shortage, the price must rise, as
consumers are now willing to offer higher prices to obtain the good. When the equilibrium
price rises, producers are motivated to increase quantity supplied according to the law of
supply. There is an increase in the quantity supplied causing a movement along the
supply curve. The consumers also cut down on their consumption according to the law of
demand. There is a movement up the new demand curve. The adjustment process
continues until the new equilibrium is set where quantity demanded equals to quantity
supplied. Hence, an increase in demand for a good will lead to increase in equilibrium
price and equilibrium quantity of that good.
Figure 5: Increase in demand
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4.3.2 Decrease in Demand
A decrease in demand will cause the demand curve to shift leftward (Figure 6). The
quantity supplied exceeds the quantity demanded at the original price and hence a
surplus is created. A surplus causes a downwards pressure on price, as producers are
now willing to lower prices to clear their inventories. As price decreases, quantity
demanded rises and quantity supplied falls, stopping once the surplus is eliminated at the
new equilibrium. A decrease in demand for a good, thus results in a decrease in
equilibrium price and equilibrium quantity of the good.
Figure 6: Decrease in demand
4.3.3 Increase in Supply
If supply for a particular product increases, supply curve shifts rightwards (Figure 7). The
quantity supplied exceeds the quantity demanded by consumers, creating a surplus at
the original price. To eliminate the surplus, the price must drop, as producers are now
willing to drop the price to clear their stocks. When the equilibrium price drops, consumers
are more willing to increase their consumption according to the law of demand. There is
a movement along the demand curve. The adjustment process continues until the new
equilibrium is set where quantity demanded equals to quantity supplied. At the new
equilibrium, equilibrium price decreases and equilibrium quantity increases.
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Figure 7: Increase in supply
4.3.4 Decrease in supply
A decrease in supply resulting from any learnt factors, will cause the supply curve to shift
leftward (Figure 8). The quantity supplied is lesser than the quantity demanded and
hence a shortage is created. A shortage causes an upwards pressure on price, as
consumers are more willing to spend to obtain the goods. As price increases, quantity
demanded decreases and quantity supplied rises, stopping once the shortage is
eliminated at the new equilibrium. Hence, a decrease in supply will lead to an increase
equilibrium price and decrease in equilibrium quantity.
Figure 8: Decrease in supply
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In summary, for a competitive good, the change in demand or supply (assuming only one
of them changes and the other one remains unchanged) will lead to the change in the
equilibrium price and equilibrium quantity as below,
Market Force Change Equilibrium Price Equilibrium Quantity
Demand Increase Increase Increase
Decrease Decrease Decrease
Supply Increase Decrease Increase
Decrease Increase Decrease
However, in real market, both demand and supply can change together. When this
happens, to predict the changes in price and quantity of the good concerned, we must
combine the effects that you have just learnt.
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REFERENCES
Bade, R. & Parkin, M. (2015). Essential Foundations of Economics. (7th
ed.). USA: Pearson Education Inc.
Parkin, M. (2016). Economics. (12th ed.). England: Pearson Education Limited.
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Topic 5 –GDP and Economic Growth 1
Why the United States of America (USA) is ranked the biggest economy in the world?
Why is India’s economy comparatively smaller when it is such a big country with so many
rich and middle-class people? How does Singapore’s economy compare to its old rival
Hong Kong? How do we make comparison of countries’ economic performance?
This Topic will answer the above questions and mark the start of our journey into the
worldly “big picture” of Macroeconomics. We will make comparison amongst countries
using many economic statistics including GDP, economic growth rate, unemployment rate
and inflation rate. While learning this Topic, we not only must know how to calculate the
various economic indicators but also be to tell what the economic indicators can and
cannot tell us.
With this, we can begin our investigation of one key measurement of macroeconomic
strength, the Gross Domestic Product or GDP.
Learning outcomes:
The following are the learning outcomes for this Topic. At the end of the Topic, do a
self-check to ensure that you have achieved these outcomes:
• Define GDP.
• Explain why GDP equals aggregate expenditure and aggregate income using the
circular flow model.
• Explain the two typical methods used to measure GDP.
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5.1 Definition of GDP
GDP is the market value of the final goods and services produced within a country in a
given period of time (Sloman Norris & Garratt, 2013). This definition has four significant
parts.
1) Market value
Market value which involves valuing items produced at their market values or the prices
at which items are traded in the markets. For example, instead of counting 5 apples
produced in the GDP, we count them at their market value of $2 per apple or $2 x 5 apples
= $10.
2) Final goods and services
A final good or service is an item that is bought by its final user during a particular time
period. An intermediate good (or service) is an item produced by one firm, bought by
another firm, and used as a component of a final good or service. For example, a Dell
computer sold to a student for himself to use is a final good but an Intel chip used in the
computer which is produced by the semi-conductor firm, Intel Corporation is an
intermediate good. GDP only counts the values of final goods and services as their values
already included intermediate goods values. This will avoid double-counting of the
intermediate goods.
3. Produced within a country
Only goods and services that are produced within a country are counted in the country’s
GDP. Adidas, a U.S firm, produces sneakers in Vietnam. The market value of those
shoes is part of Vietnam’s GDP, not that of USA.
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4) In a given time period
GDP is measured in a particular time period, either annually or quarterly.
5.1.1 Exclusion of used goods and paper transactions
GDP is only concerned with new or current production. GDP does not count transactions
in which money or goods changes hands but no new goods and services are produced
(Case, Fair & Oster, 2017).
5.2 Circular Flow Model
A useful way of seeing how the economy works is by looking at the circular flow of income
model (Figure 1). The circular flow of income model shows the flow of payment for goods
and services around the economy. It contains a 4-sector economy where there are
domestic households, domestic firms, domestic government and the foreign sector. In
this economic model, the households and firms play specific roles.
Figure 1: Circular flow of income and expenditures model
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5.2.1 Roles of Domestic Households
• Households supply the factors of production which they own, in return for factor
payments (Y) from firms. Hence, services of land, labour, capital and
entrepreneurship are exchanged in the factor markets for rents, wages, interests
and profits respectively.
• Households then pay for goods and services produced by firms with part of the
money or incomes they have earned. This is known as consumption
expenditure (C) on domestically produced goods and services.
5.2.2 Roles of Domestic Firms
• Firms in turn supply goods and services to domestic households in the goods
markets.
• Firms also invest in new plant and machinery in the good markets. This is known
as investment expenditure (I).
• Firms may earn revenue from selling their goods to foreigners. This is known as
export earning (X).
5.2.3 Roles of Government
Governments buy goods and services from firms. This spending by government is known
as government expenditure (G). Governments finance their expenditures by collecting
taxes from households and firms and they also make financial transfers to firms and
households such as welfare benefits to households or subsidies to firms for the training
of workers. Taxes and transfers, however, are not part of the circular flow of expenditure
and income.
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5.2.4 Roles of Foreign sectors.
Firms in a country will sell goods and services to the rest of the world. The value of all
these goods and services exported in the given period are captured under Export (X).
Firms also buy goods and services from foreign sector, the value of which is captured
under Imports (M). The value of exports minus the value imports is called net exports
(X - M)
5.3 Two Methods for Measuring the GDP
GDP can be measured in two ways namely by the total expenditure on goods and
services in the economy and by the total income earned in the economy for producing
goods and services.
• Aggregate expenditure or total expenditure in the economy equals consumption
expenditure plus investment plus government expenditure plus net exports (Parkin,
2014).
• Aggregate income is equal to total amount paid for the services of the factors of
production used to produce final goods and services namely wages, rent, interest and
profit (Parkin, 2014).
These two methods lead to the same value for GDP as we have discussed in previous
part: “Every payment (expenditure) by a buyer is at the same time a receipt (income) for
the seller” (Case et al., 2O17). We can measure either incomes received or expenditures
made, and we will end up with the same total output.
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5.3.1 Expenditure approach
As discussed in the previous section, the four main groups of Spenders who buy goods
and services produced by the firms in the economy are households, firms, the
government and the rest of the world. Hence, there are four parts of expenditures:
• Personal consumption expenditure (C) refers to the expenditures by the domestic
households on goods and services produced within the country.
• Gross private domestic investment (I) refers to the spending by firms and
households on new capital such as plant and equipment, inventory and new
residential structures.
• Government consumption and investment (G) is the expenditure by all levels of
government on goods and services such as spending on national defense and building
infrastructures.
• Net exports refers to net spending by the rest of the world comprising the Export (X)
and Import (M) values (X - M).
Hence, GDP = C + I + G + (X - M)
5.3.2 The income approach
The income approach looks at GDP in terms of who receives income. It is the sum of all
the incomes that firms pay households for the services of the factors of production.
There are 2 categories of incomes:
• compensation of employees (labour income), and
• net operating surplus (capital income)
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Compensation of employees includes wages and salaries paid to households by firms
and by the government, as well as various supplements to wages and salaries such as
contributions that employers make to social insurance and private pension funds (Case
et al., 2017).
Net operating surplus is the sum of all other factor incomes including net interest, rental
income, corporate profits and proprietors’ income (Parkin, 2014).
• Net interest: The interest paid by business to households. It is the interest households
receive on the loan they make minus the interest households pay on their own
borrowing.
• Rental income: The income received by property owners in the form of rent of land.
• Corporate profits: The income of corporations, some of which are paid to households
in the form of dividends and the rest is retained as undistributed profits.
• Proprietors’ income is the income earned by the owner-operator of a business,
which includes compensation for the owner’s labour and the use of owner’s capital.
Thus, GDP is equal to the sum of compensation of employees and net operating surplus.
Statistical discrepancy is the gap between the expenditure approach and the income
approach (Parkin, 2014). The GDP calculated using the two approaches are not exactly
the same. Some incomes may not be declared accurately such as the waiters may not
report his tips when he fills out his salary report, thus it will be omitted in the income
approach but it is counted in expenditure approach when he spends the tips on goods
and services. Hence, the sum of expenditures may exceed the sum of incomes.
However, this discrepancy is usually not significant.
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REFERENCES
Case, K.E, Fair, R.C. & Oster, S.E. (2017). Principles of Economics. (12th
ed.). England: Pearson Education Limited.
Parkin, M. (2014). Macroeconomics. (11th ed.). England: Pearson Education Ltd.
Parkin, M. (2016). Economics. (12th ed.). England: Pearson Education Limited.
Sloman, J., Norris, K. & Garratt, D. (2013). Principles of Economics. (4th
ed.). Australia: Pearson Australia.
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Topic 6 –GDP and Economic Growth 2
Learning outcomes:
The following are the learning outcomes for this Topic. At the end of the Topic, do a
self-check to ensure that you have achieved these outcomes:
• Distinguish between real GDP and nominal GDP.
• Describe the role of GDP Deflator.
• Explain economic growth rate and GDP per capita.
• Explain the uses and limitations of real GDP.
6.1 Real GDP vs Nominal GDP
Nominal GDP is the value of final goods and services produced in a given year when
valued at the prices of that year (Parkin, 2014).
Real GDP is the value of final goods and services produced in a given year when valued
at the prices of a reference base year (Parkin, 2014). This price is adjusted for inflation.
To illustrate, if the reference base year is 2010, we will describe real GDP as measured
in 2010, that is, in terms of what the dollar can buy in 2010. Hence, when comparing the
real GDP or the value of production in two years at the same price, we study only the
change in production.
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To calculate the nominal GDP and real GDP of the simple economy of Country Kong
below producing only Tables and Chairs, please refer to the illustration below.
Price ($/unit) Quantity (Units)
2014
Tables $50 10,000
Chairs $10 40,000
2015
Tables $60 8,000
Chairs $15 35,000
Nominal GDP in 2014 = ($50 X 10,000) + ($10 X 40,000)
= $900,000
Nominal GDP in 2015 = ($60 X 8,000) + ($15 X 35,000)
= $1,005,000
If the base year is 2014, real GDP will be calculated by valuing the output of tables and
chairs using the prices in the base year. Hence,
Real GDP in 2014 = ($50 X 10,000) + ($10 X 40,000)
= $900,000
Real GDP in 2015 = ($50 X 8,000) + ($10 X 35,000)
= $750,000
In the base year, the real GDP and the nominal GDP is the same. Based on nominal
GDP, it will appear that production in 2015 is greater than the production in 2014. Based
on real GDP, one will be able to see that in fact the production activity in the economy
has declined between 2014 and 2015. The nominal GDP has provided an incorrect
understanding of production in the economy because, the increase in nominal GDP was
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Real GDP = Nominal GDP X 100
GDP Deflator
actually due to the increase in the prices of tables and chairs, not due to the increase in
the quantity of tables and chairs produced.
6.2 GDP deflator
Price level refers to the average level of prices of goods and services in an economy.
One measure of the price level in the economy used by the Statistics Office many
Countries is the GDP deflator, which is defined as the average of the prices of the goods
and services in the GDP in the current year expressed as a percentage of the base year
prices (Parkin, 2016). Given the nominal GDP and the GDP deflator, the real GDP can
be calculated using the formula below:
Real GDP and nominal GDP can go in opposite directions. Real GDP can rise while
nominal GDP falls in some years. This occurs when a country experiences economic
growth and deflation (falling prices) at the same time. If the rate of falling prices is greater
than the rate at which production of physical quantities is rising, real GDP will rise and
nominal GDP will decrease. This happened in Japan for many years in the 1990s.
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Real GDP Growth Rate = Real GDP (Y2) – Real GDP (Y1) X 100
Real GDP (Y1)
GDP per capita = GDP
Population
6.3 Economic growth rate and GDP per capita
Economic Growth Rate is the rate at which a nation's Gross Domestic product (GDP)
grows from one year to another. The economic growth rate tells us how rapidly the total
economy is expanding or declining. It is the annual percentage change of real GDP. Real
Economic Growth Rate considers the effects of inflation. Since inflation plays a key role
in the GDP of an economy, it is important to include the effects of inflation on GDP.
Hence, real GDP is used instead of nominal GDP, as a better indicator of economic
growth.
GDP per capita or GDP per person is a measure of a country's economic output
produced per citizen in the country in a given period of time. Real GDP per capita is
calculated by dividing the real GDP of the country in a given year by the population of the
country. Real GDP per person tells us the value of goods and services that the average
person can enjoy (Parkin, 2016). The standard of living of people in a country depends
on GDP per capita or GDP per person
The formula for GDP per capita is as follows:
By comparing real GDP per capita in different years, we can compare standard of living
over time. When a country’s economy grows faster than the population, the country will
see improvement in the average standard of living over time. People in the country will
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enjoy better value of goods and services hence increasing their material standard of
living.
GDP can also be used to compare standard of living in different countries. However, the
real GDP of one country must be converted into the same currency unit as the real GDP
of the other country. In addition the market values of goods and services in both countries
have to be at the same prices in order to make meaningful comparison. Hence, it is
problematic to use GDP to compare standard of living across countries as the market
values of goods and services in different countries cannot be the same. If the prices of
some goods are higher in Country A than Country B, the goods and services will carry a
heavier weight in Country A than in Country B.
6.4 Limitations of GDP as an indicator of social well-being
Nothing is perfect, the reliance on any one model or indicators to measure social well-
being does have some flaws. Specifically,
1. GDP does not include household production
The omission of household production from GDP means that GDP underestimates total
production. Household production includes activities that are not traded in markets such
as cooking meals, caring for a child, cutting grass etc. It also means that the growth rate
of GDP overestimates the growth rate of total production as some of the growth rate of
market production which is included in GDP in recent years is a replacement for home
production activities in the past.
2. GDP does not include underground economic activities
The underground economy activity is the part of the economy that is purposely hidden
from the government to avoid taxes or they are illegal. As such activities are unreported,
they are omitted from GDP. Underground economy can be very substantial in countries
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with big rural areas. In the rural areas, the economy is informal and many production
activities of goods and services are not recorded in the national GDP.
3. GDP does not include leisure time
The more leisure we have, the better off is our social well-being. As leisure time in a
country increases, our standard of living or social well-being increases. However, this is
not reflected in the GDP.
4. GDP does not account for the increase in quality of goods and services
As real GDP looks at price as a measure of value alone and ignores the improvement in
the quality of goods or services, real GDP underestimates production. In the real world,
many products which we purchase be it the cars we drive, the television we watch or the
sofa we sit on, have seen improvement in quality over time.
5. GDP does not account for environmental damage
Economic activities have adverse impacts on our natural environment such as resources
depletion, pollution, global warming. All these adverse impacts on natural environment
will reduce our social well-being. The costs of those impacts are not subtracted from
GDP.
6. Health
Health is a measure of welfare, but it is not directly included in real GDP. In some
countries, workers and entrepreneurs have to work very long hours. In the process, they
suffer from poor health and unhealthy lifestyles. The increase in GDP comes at the
expense of health of the people, yet it is not accounted for in the measurement of GDP.
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REFERENCES
Case, K.E, Fair, R.C. & Oster, S.E. (2017). Principles of Economics. (12th
ed.). England: Pearson Education Limited.
Parkin, M. (2014). Macroeconomics. (11th ed.). England: Pearson Education Ltd.
Parkin, M. (2016). Economics. (12th ed.). England: Pearson Education Limited.
Sloman, J., Norris, K. & Garratt, D. (2013). Principles of Economics. (4th
ed.). Australia: Pearson Australia.
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Topic 7 – Business Cycle, Unemployment & Inflation
Macroeconomics is part of our everyday lives. If the macro economy is doing well, jobs
are available, incomes of households generally will be rising and profits of corporations
will typically be high. On the other hand, if the economy performs poorly, jobs are scarce,
incomes are not growing well, and profits of firms are low.
However, the economy is not quite predictable owing to many variables and dynamisms
in the economy. Thus, the reality of real GDP when graphed over a period of time is not
a smooth line, but full of fluctuations. This variation in production activities of the economy
over time is known as the business cycle.
Learning outcome:
The following are the learning outcomes for this Topic. At the end of the Topic, do a
self-check to ensure that you have achieved these outcomes:
• Describe the business cycle.
• Define unemployment.
• Calculate unemployment rate, the labor force participation rate and the employment-
to-population ratio.
• Explain the causes of unemployment.
• Define CPI and inflation.
• Explain the causes of inflation.
7.1 Business Cycle
Potential GDP is the value of production when all the resources in the economy namely
labour, capital, land, and entrepreneurial ability are fully employed (Parkin, 2014). It is the
quantity of real GDP produced at full employment. The business cycle is a periodic but
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irregular up-and-down movement of total production and other measures of economic
activity around its long-term trend (Parkin, 2014). The business cycle fluctuates around
the potential GDP of the economy.
There are 2 phases in the business cycle:
Expansion: During this phase there is rapid economic growth and the economy is
booming. Resources are more fully used up and the gap between actual and potential
output narrows (Sloman et al., 2013). This is a period during which real GDP increases.
In the early stage of an expansion, real GDP returns to potential GDP and as the
expansion progresses, real GDP eventually exceeds potential GDP.
Recession: Periods during which aggregate output declines (Case et al., 2014). During
a recession, the real GDP decreases for at least two consecutive quarters.
There are 2 turning points in the business cycle:
Peak: An expansion ends and recession begins at a business cycle peak, which is the
highest level that real GDP has attained up to that time.
Trough: A recession ends at a trough, when real GDP reaches a temporary point and
from which the next expansion begins.
Figure 1 & 2 below show the business cycle of the United States of America (USA).
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Figure 1: Business cycle phases of the USA economy.
Figure 2: Business cycle of USA economy from 1900-2009
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As the ups and downs in the economy tends to be erratic, the business cycle is not
symmetrical in most cases. They are highly irregular. Expansion phases may be longer
than contraction phase and vice versa. Some business cycle are long while others are
short. The magnitude of the phases can also vary.
Fluctuation of business cycle determines the extent of unemployment in the economy.
Unemployment increases during the recession phase and decreases during the recovery
phase. Variations in unemployment however, lag behind the variations in real output as
firms are unable to reduce their labour force immediately due to labour contracts and
limited supply of labour.
7.2 Labour market
7.2.1 Overview of Labour Market
The labour market is a resource market where labour resource is exchanged between
households and firms. In return for providing their physical and mental effort to help firms
produce goods and services, households earn wages.
Every student is concerned about whether they will be able to find a suitable job and earn
an income after their graduation. In recent years, unemployment poses a serious threat
to some economies as population growth outstripped jobs growth. In addition, automation
also displaces many jobs rendering many people becoming unemployed. Unemployment
also changes with the business cycle as production activities in an economy fluctuates.
Referring to Figure 3, you can see how the various groups of people in the population are
being classified.
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Figure 3: Labour market of USA
The population is first divided into two groups namely,
1. Non-working-age population: Those people who are either too young to work or
are in institution care.
2. Working-age population: Those people who are at least 16 years old and not in
an institution like full-time school, jail, hospital or some other institutions. The
working-age population comprises two groups:
i. People not in the labour force or those people who are neither working, nor
looking for a job such as housewives and retirees.
ii. People in labour force which include the employed and the unemployed
people.
Labour Market (USA)
- Not working. And
- Looking for a job (in the last
four weeks)
- Not working. And
- Not looking for a job (in the
last four weeks)
-At least 16 years old, and
-Not in an institution e.g.
School, jail, hospital,
a) Less than 16 years old Or
b) At least 16 years old but in
an institution e.g. School.
jail, hospital,
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Unemployment rate = Number of people Unemployed X 100
-----------------------------------------
Labour force
The employed are those people who have a full-time or part-time job. However, being
unemployed does not simply mean you do not have a job. To be considered an
unemployed, the person must be in one of the following categories (Parkin, 2014):
1. Without work but has made specific effort to find job within the previous four weeks
2. Waiting to be called back from a job from which he or she has been laid off
3. Waiting to start a new job within 30 days
People become unemployed because they lose or voluntarily leave their jobs and search
for another job. Or they enter or re-enter the labour force to search for a job.
7.2.2 Calculation of Key Labour Market Indicators
There are 3 indicators used by the Statistics Office to study the state of the labour market.
These indicators are,
• Unemployment rate
• Employment-to-Population ratio
• Labour force participation rate
The unemployment rate is the percentage of the people in the labour force who are
unemployed.
To illustrate, in June 2017, the number of people employed was 142 million and the
number of unemployed was 13 million in Dino Republic. Hence, the labour force size in
Dino Republic was 155 million and the unemployment rate was 8.38 percent.
The Employment-to-Population ratio is the percentage of people of working age who
have jobs.
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Labour force participation rate = Labour Force X 100
----------------------------------
Working-age Population
To illustrate, in June 2017, the number of people employed was 142 million and the
working-age population was 243 million in Dino Republic. Thus, the Employment-to-
Population ratio was 58.43 percent
The labour force participation rate is an indicator of the willingness of people of working
age to work. The labour force participation rate is the percentage of the working-age
population who are members of the labour force.
To illustrate, in June 2017, there were 155 million people in the labour force and the
working age population was 243 million in Dino Republic. Thus, labour force participation
rate in Dino Republic was 63.79 percent.
7.2.3 Typical Types of Unemployment
The three typical types of unemployment in an economy are:
• Frictional unemployment
• Structural unemployment
• Cyclical unemployment
Frictional unemployment is the unemployment that arises from the normal labour
turnover or from people entering or leaving the labour force and from the ongoing creation
and destruction of jobs (Parkin, 2014). It occurs when people voluntarily leave the jobs
Employment-to-population ratio = Number of people Employed X 100
--------------------------------------
Working-age population
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or new-timers just join the labour force and both are temporarily unemployed while looking
for a new job. It is also known as search unemployment. Search Unemployment is mainly
due to poor information in the labour market, which causes time lags before people find
suitable jobs. The more imperfect the information, the longer the time lag or period of
searching. This type of unemployment is inevitable, short-term and minor, usually
accounting about 1-2% of an economy’s unemployment rate.
Structural unemployment arises when changes in technology or international
competition change the skills needed to perform the jobs or change the locations of jobs
(Parkin, 2014). Structural unemployment denotes longer-run adjustment problems that
may last for years. There are several types of structural unemployment.
1) Sector-structural unemployment
It occurs due to the fall in demand for labour in the declining industries, where labour in
those industries have skills that are no longer relevant. Sectoral Unemployment can also
be due to firms becoming less competitive, resulting in a fall in demand for labour from
that sector. Workers become unemployed due to the lack of job vacancies available in
the declining industries they currently work in and are unable to take up jobs in the new
industries due to the lack of necessary skills.
2) Technological-structural unemployment
It occurs due to the introduction of equally or more efficient labour-saving technology or
new production techniques. Technological Unemployment causes workers to be
unemployed in favour of labour-saving technical advancements, especially if they are
untrained to handle them.
3. Regional-structural unemployment
It occurs due to geographical and occupational immobility between regions. Regional
Unemployment persists when workers are unwilling or unable to undergo retraining or
relocate to other regions which still require certain skills.
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Frictional unemployment and structural unemployment are unemployment which occur
when the economy is performing normally. Economists use the term natural rate of
unemployment to refer to the unemployment rate that occurs in a normal functioning
economy (Case et al., 2014). The natural rate of unemployment of an economy typically
varies from 4 percent to 6 percent. When an economy is at its natural rate of
unemployment, Economists also describe the economy as being at “Full employment”.
Cyclical unemployment is the higher than normal unemployment at a business cycle
trough and the lower than normal unemployment at a business cycle peak (Parkin, 2014).
It occurs during periods of recession when production output declines in the economy.
Many times, labour force participation rate also falls during a recession as discouraged
workers or people available to work often do not make an effort to find work as they felt
discouraged after having searched for jobs for a long time, but not successful.
7.2.4 Negative Impacts of High Unemployment Rate
As labour is a derived demand of production output in the economy, during recession the
demand for labour is reduced when production level of the firms falls. High unemployment
rate is a major economic problem which every government needs to manage. High
unemployment rate in an economy can lead to social problems for the country as well if
it is not reduced over long period of time.
For households, unemployment leads to the fall in income and thus they are unable to
purchase goods and services. This will lead to a lowering of the material standard of
living. The unemployed people may also face other social problems like loss of self-worth
and family relationship issues that may further develop into mental illnesses. As the length
of unemployment increases, finding a new job becomes harder due to erosion of skills
and self-confidence.
For firms, as consumers demand for lesser goods and services, their revenue and
profitability will be adversely affected. The lack of job security and the fear of being
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retrenched reduces remaining workers’ morale which results in lowers productivity. This
increases unit cost of production and lowers profitability of the firm.
For government, unemployment increases government expenses on unemployment
benefits and other welfare benefits while tax revenue falls, resulting in budget deficit.
Crime levels may increase resulting in foreign investors avoiding the country due to
unstable society and economy.
7.3 CPI and Inflation
Price of goods and services has been a feature of both micro and macroeconomic study
in this study guide so far. To appreciate the value of money in our wallet or piggy bank
in relation to the amount of goods and services purchased over time, we study another
price level indicator, the Consumer Price Index (CPI).
7.3.1 Consumer Price Index
Consumer Price Index (CPI) is a measure of the average of the prices paid by urban
consumers for a fixed basket of consumer goods and services (Parkin, 2014).
The CPI is defined to equal 100 during the reference base year. For example, in June
2016, the CPI of Dino Republic was 220.5. This number tells us that the average of the
prices paid by urban consumers for the fixed market basket of consumer goods and
services was 120.5 percent higher in June 2016 than the reference base year.
The construction of the CPI involves three steps:
1. Selection of the CPI basket.
2. Conducting of the monthly price survey
3. Calculation of the CPI
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The CPI basket: The first stage in constructing the CPI is to select what is called the CPI
basket. This basket contains the goods and services purchased by consumers
represented in the index, each weighted by its relative importance. The idea is to make
the relative importance of the items in the CPI basket the same as that in the budget of
an average urban household. For example, because people spend more on food than
on bus rides, the CPI places more weight on the price of food than the price of bus ride.
The CPI basket is based on a Consumer Expenditure Survey, which is undertaken
infrequently by the Statistics Office of the country.
In the USA, every month, Bureau of Statistics employees conduct the monthly price
survey to check the prices of 80,000 goods in 30 metropolitan areas. As the CPI aims
to measure the price changes, it is crucial that the prices recorded each month refer to
exactly the same item.
Figure 4: CPI Basket of USA. (Source: Parkin, 2016)
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Figure 5: CPI Basket of Singapore. (Source: www.singstat.gov.sg)
To calculate the CPI,
1. Find the total cost of the CPI basket at the base-period prices
2. Find the total cost of the CPI basket at current-period prices
3. Calculate the CPI for the base period and the current period
Below example will illustrate how the CPI is calculated in Dino Republic. Assume that the
CPI basket of Dino Republic comprises orange and clothes only, as shown in the table
below. In the base year:
Base year: 2005
Item Quantity Price Cost of CPI basket
Oranges 10 $1.00 $10
Clothes 5 $8.00 $40
Cost of CPI basket at base period prices $50
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Now, as CPI is a comparative model, let’s take current year prices so we can compare
the total cost of the current year with that of the base year. In the current year:
Current year: 2015
Item Quantity Price Cost of CPI basket
Oranges 10 $2.00 $20
Clothes 5 $10.00 $50
Cost of CPI basket at current period prices $70
The change in CPI is expressed at the cost for the basket in the current year over the
cost of the basket in the base year expressed as points. Hence, in 2015, the CPI is
calculated as below:
CPI = ($70/ $50) x 100 = 140
The CPI in 2015 is 40 percent higher than CPI in the base year of 2005. In other words,
between 2005 and 2015, average prices of consumer goods and services in Dino
Republic have increased by 40 percent.
7.3.2 Shortcomings of the CPI
There are a few reasons that CPI cannot measure inflation rate very accurately. The
shortcomings of the CPI include:
1. New Goods Bias
New goods that were not available in the base year appear and if they are more expensive
than the goods they replace, they put an upward bias into the CPI. For example, a
typewriter used in the 1980s for typing a document, is much cheaper in absolute term,
than a laptop used today for preparing the same document.
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2. Quality change bias
Similar to the problem with measuring real GDP, CPI does not account for the change in
quality of good or service that would increase the price of a good regardless of inflation.
Quality improvement happen every year for many goods produced. For example, a
television bought in the 1980s is quite different from the television you purchase today,
as the latter will provide better sound effect, sharper images and more features to
enhance the experience of the viewers. Hence, part of the rise in prices of the goods in
the CPI, is a payment for improved quality and not inflation. CPI, however, counts the
entire price rise as inflation.
3. Commodity substitution bias
Changes in relative prices lead consumers to change the items they buy. For example,
if the price of beef rises and the price of chicken remains unchanged, people buy more
chicken and less beef. The market basket of goods used in calculating the CPI is fixed
and does not take into account consumers’ substitutions away from goods which relative
prices increase.
4. Outlet substitution bias
As the structure of retailing changes, people switch to buying from other sources. For
example, in the old days, shopping were typically done at the simple “wet” markets which
sell “dry” goods like clothing and cutleries in one section and “wet” goods like fish and
vegetables in another section. Today, we do our shopping in air-conditioned supermarket
and high-end shopping malls, which cost more to operate. The CPI, as measured, does
not take into account this outlet substitution.
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Inflation rate = CPI (Y2) – CPI (Y1) X 100
--------------------------
CPI (Y1)
7.3.3 Inflation
Inflation is a persistently rise in price level (Parkin, 2014). Inflation can be measured
using CPI. The inflation rate is the percentage change in the price level from one year
to the next year. To calculate the inflation rate, the following formula can be applied:
7.3.4 Typical Causes of Inflation
There are two main causes of inflation
Demand-pull inflation is caused by persistent increase in the aggregate demand for
goods and services (Sloman et al., 2013). There are two conditions which can trigger
demand-pull inflation. Firstly, persistent increase in aggregate demand, when an
economy is at full employment of resources and secondly, there is excess demand for
goods and services at every price level. Firms tend to respond to this situation by
increasing prices and by raising their production.
Cost-push inflation is associated with persistent rise in cost of production that occurs
independently of aggregate demand (Sloman et al, 2013). Such cost-push inflation may
be due to strong labour unions asking for rise in the wages of workers exceeding rise in
productivity. This will lead to increase in unit cost of production.
Other possible causes cost-push inflation are the rise in indirect taxes like Goods and
Services Tax, driving up firms’ unit costs of production and/or falling external value of
domestic currency making imported raw materials more expensive, hence, raising the
unit cost of production.
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7.3.5 Negative Impacts of High Inflation Rate
High inflation rate has numerous adverse effects on an economy and the society at large.
With increasing price level in the economy,
• Cost of living will increase, leading to a fall in average standard of living if the wages
of labour do not increase as much. The volume of goods and services that the same
take-home income of workers can buy is lesser.
• Fall in the value of money and the wealth (financial assets) accumulated by
households, in terms of purchasing power. This will lead to hardship for those
households relying on their savings for retirement.
• Debtors gain and creditors lose. As a result, commercial banks will reduce the amount
of loans they extend to customers or charge a high interest rate to protect themselves
against unexpected rise in inflation rate. Debtors (borrowers) loan from creditors
(lenders) a nominal amount of money. During inflation, internal value of money falls
and thus the real value of the debt is reduced. Value of money repaid by borrower is
less than the amount borrowed. Debtors gain from inflation. Creditors lose out from
inflation.
7.3.6 Inflation rate and business cycle
Inflation rate in the economy can fluctuate with the production activity in the economy.
When the economy is at the peak of the business cycle, typically, an economy will
experience high inflation rate due to shortage of resources resulting in high cost of
production. In addition, at the peak of the business cycle, unemployment is typically low.
With more incomes, aggregate demand for goods and services will increase as
households increase their spending, causing the price level in the economy to rise.
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On the other hand, when the economy is in the trough, resources are easily available,
inflation tends to subside. This trend continues into the early stage of the upswing,
primarily because of decrease in unit labour costs of production and a decrease in
aggregate demand for goods and services, as households earn lesser income.
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REFERENCES
Case, K.E., Fair, R.C. & Oster, S.E. (2014). Principles of Macroeconomics. (11th
ed.). England: Pearson Education Ltd.
Parkin, M. (2016). Economics. (12th ed.). England: Pearson Education Limited.
Parkin, M. (2014). Macroeconomics. (11th ed.). England: Pearson Education Ltd.
Singapore Department of Statistics. (2015). Rebasing the Consumer Price Index [webpage]. Retrieved from https://www.singstat.gov.sg/find-data/search-by- theme/economy/prices-and-price-indices/related-info/faq-on-cpi
Sloman, J., Norris, K. & Garratt, D. (2013). Principles of Economics. (4th
ed.). Australia: Pearson Australia.
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Topic 8 - Fiscal Policy
In macroeconomics, the active presence of government is praised by those who believe
a free market simply does not work well when left to its own devices. They believe that
the macro economy will fluctuate too much if left on its own and that the government
should smoothen out the fluctuation of the business cycle.
All governments aim to achieve short-run stability of full employment and stable price as
well as economic growth in the long-run. Following the thinking of Economist John
Maynard Keynes, the government can intervene in an economy with various government
policies to achieve the short-run stability of full employment and stable price. The focus
of this Topic would be on one such policy intervention namely the fiscal policy.
Learning outcomes:
The following are the learning outcomes for this Topic. At the end of the Topic, do a
self-check to ensure that you have achieved these outcomes:
• Define fiscal policy.
• Explain how discretionary fiscal policy can stabilise the business cycle.
• Explain the role of automatic fiscal policy in an economy.
• Describe the government budget process and the budget balance.
8.1 Definition of Fiscal Policy
All governments have three macroeconomic goals. Firstly, governments want to
achieve full employment in the economy. In other words, the economy is performing
well and there is no cyclical unemployment. Secondly, governments hope to achieve
price stability in the economy. The economy is neither experiencing high inflation rate
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or deflation problem. The third goal of governments is to achieve more economic growth
in the country, so as to raise the standard of living of the people from the increasing
households’ income.
Fiscal policy involves the government manipulating the level of government expenditure
(G) and/or rates of tax (Sloman, Norris & Garratt, 2013). By changing its fiscal stance,
government can affect the level of aggregate demand to remove any severe inflationary
or recessionary gaps so as to stabilise the business cycle in the economy. Aggregate
demand (AD) refers to the relationship between the quantity of real GDP and the price
level (Parkin, 2014).
8.2 Discretionary Fiscal Policy
Discretionary fiscal policy is a deliberate change in tax rates or the level of government
expenditure to influence the level of aggregate demand (Sloman et al., 2013). If there is
a fundamental disequilibrium in the economy or substantial fluctuation in aggregate
expenditure, the government can choose to alter the level of government spending and
rates of taxation. Governments can adopt an expansionary fiscal policy to overcome an
economy that is recessionary. On the other hand, if an economy is experiencing high
inflation rate, governments can adopt contractionary fiscal policy.
8.2.1 Expansionary Fiscal Policy
Expansionary fiscal policy is the increase in government spending and/or reduction in
taxes on households and firms. Specifically, the government concerned can increase the
spending on social projects such as healthcare, infrastructures and national defence
resulting in an increase in government expenditure. The reduction of taxes on
households will increase households’ disposable income (income after paying taxes),
hence, increasing their purchasing power. When tax cuts are permanent, consumers will
increase their consumption on goods and services. Domestic Consumption (C)
increases. Reduction in taxes on firms increases firms’ post-tax profits. Hence, firms’
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Investment (I) expenditure increases. Expansionary fiscal policy will thus, increase
aggregate demand for goods and services as AD = C + I + G + (X – M). As firms receive
more orders, they will produce more goods and services, hence increasing the real GDP
enough to return the economy to its potential GDP. This will reduce the unemployment
rate as firms hire more workers.
8.2.2 Contractionary Fiscal Policy
Contractionary fiscal policy, on the other hand, involves government reducing its
expenditure and increasing the taxes on households and firms. Government increasing
taxes on firms will decreases firms’ post-tax profits hence, decreasing firm’s Investment
Expenditure (I). The increase in taxes on households will decrease households’
disposable income and purchasing power. When tax increase is permanent, consumers
will adjust their consumption downwards. Domestic Consumption (C) decreases. As AD
= C + G + I + (X – M), when government expenditure, domestic consumption and
investment expenditure fall, aggregate demand falls. Firms in the economy will hence,
receive lesser orders and reduce their production of goods and services. As real GDP
gradually decreases to the level of the potential GDP, the high inflation rate will start to
decline as more resources are available.
8.2.3 Limitations of Discretionary Fiscal Policy
As every decision has its pros and cons, fiscal policy is no exception. Fiscal policy has
several limitations that may reduce its effectiveness and hamper its intended purposes.
Firstly, the use of fiscal policy is adversely affected by three time lags:
• Recognition lag is the time it takes the Government to figure out that fiscal policy
actions are needed (Parkin, 2014). The process involves assessing the current state
of the economy to find out what is needed to be fixed and forecasting its future state.
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• Law-making lag is the time it takes the government to pass the laws needed to change
taxes or spending (Parkin, 2014). As laws are debated in parliament and opinions
may need to be seek from the citizens, the whole process can take a long time.
• Impact lag is the time it takes from passing a tax or spending change to its effect on
real GDP being felt (Parkin, 2014). Once the decision is made and law is passed,
there is a time delay for it to take effect, depending on the efficiency of the
implementing government agency and the responsiveness of households’ and firms’
spending.
Secondly, fiscal policy is irreversible. Once the policy is implemented, it is difficult to
stop or turn back on the measures. For example, the Chinese government initiated huge
government spending on infrastructure projects all over the country in 2009 during the
period of the global financial crisis. When China experienced inflationary economy in
2011, the Chinese government was not able to stop these half-completed infrastructure
projects.
Thirdly, cutting taxes and raising government expenditure also carry a risk of the
government running into a budget deficit. Persistent budget deficit would accumulate
into debts, which the government may have to finance from borrowing. Thus, the
government may have to raise taxes on households eventually to clear the debt, which
creates disincentive to work and lowers future material standard of living due to lesser
disposable income for households.
Lastly, if increased government spending is financed by borrowing, there will be
competition with private sector firms for funds. The increase in demand for funds creates
and upward pressure on interest rates. We describe this as Crowding out effect. Higher
interest rates mean higher costs of borrowing, which deter firms from investing and
households from buying on credit. Thus, consumption and investment expenditure falls.
The fall in consumption and investment may offset the rise in government expenditure,
resulting in an overall fall in aggregate demand.
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8.3 Automatic Fiscal Policy
Automatic fiscal policy or stabilisers are mechanisms that stabilise real GDP without
explicit action by the government. Government expenditure and taxation have the effect
of automatically stabilising the economy to a certain extent (Sloman et al., 2013). There
are two items on the government budget that change automatically in response to the
state of the economy. They are tax revenues and needs-tested spending.
8.3.1 Automatic changes in tax revenues
Most of the tax revenues collected by the government is calculated by applying a
percentage tax rate decided by the government to a base that reflects the extent of the
underlying activity in the economy. For instance, income tax revenue is calculated by
applying the income tax rate(s) to different amounts of income earned by individuals or
firms. Tax revenues thus depend on the state of the economy even when the government
does not change the tax rate. As incomes vary with real GDP, tax amount paid by
households and firms depend on real GDP. Taxes that vary with GDP is called induced
taxes (Parkin, 2016). When real GDP increases in a business cycle expansion, wages
and profits rise, so tax revenues collected by the government from these incomes rise.
When real GDP decreases in a recession, wages and profits fall, so tax revenues fall.
To illustrate, corporate income tax rate for firms in Singapore is 17% of the profit earned
by the firms. When a firm earns $10,000 in a recessionary economy, it has to pay $1,700
of income tax amount. On the other hand, when the economy is performing very well, the
firm’s profit increases to $1 million, the firm has to pay a tax amount $170,000 instead.
The tax paid by the firm increases without the government changing the tax rates. Thus,
induced taxes act as an automatic stabiliser.
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8.3.2 Needs-Tested spending
Needs-tested spending refers to the programmes created by government that pay
benefits to qualified people and businesses (Parkin, 2016). The spending on these
programs results in transfer payments that depend on the economic state of individual
citizens and businesses. When the economy expands, unemployment falls, the number
of people experiencing hardship decreases, so needs-tested spending decreases. When
the economy is in a recession, unemployment is high and the number of people
experiencing economic hardship increases, so needs-test spending on unemployment
benefits increases. Such unemployment benefits provided to the unemployed will allow
them to continue spending, hence sustaining aggregate demand for goods and services
in the economy.
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8.4 Government budget balance
Every year, the Singapore government will hold an annual budget debate in Parliament
and seek feedback from the public on the proposed budget for the next fiscal year. The
word “budget” constantly puzzles many students because it has connotation of being a
very high-level managerial stuff, but if you can do simple calculation such as addition and
subtraction, you can do a budget. The more difficult question is actually where to put the
amount you plan to spend and earn. As fiscal policy is the manipulation of items in the
government budget, a discussion on the budget is highly relevant in this Topic.
Budget is an annual statement of the outlays and receipts of the government together
with the laws and regulations that approve and support them (Parkin, 2016). It lists out
in detail all the items the government plans to spend money on and all the sources of
government revenues for the coming year.
8.4.1 Purpose of a budget
The budget has two purposes:
1. To finance government programmes and activities.
2. To achieve macroeconomic objectives of full employment, stable price and economic
growth.
A government’s budget includes receipts and outlays. Receipts are the government tax
revenues while outlays are government’s pay-outs. Receipts of the government come
from several sources namely personal income taxes, social security taxes, corporate
income taxes, indirect taxes and other receipts. Outlays of the government typically
comprises transfer payments, expenditure on goods and services and debt interest.
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Budget Balance = Tax Receipt – Government Outlay
8.4.2 Calculation of the Budget Balance
The government’s budget balance is equal to:
There are three budget positions of a government at the end of the fiscal year.
Specifically,
1. If receipt exceeds outlay, the government has a budget surplus.
2. If outlay exceeds receipt, the government has a budget deficit.
3. If outlay is equal to the receipt, the government has a balanced budget.
8.4.3 Financing a budget deficit
When a government has budget deficit, it can finance the deficit in the following ways:
1. Use previous year’s budget surplus
2. Borrow by issuing government bonds in the local market
3. Borrow by issuing government bonds overseas
4. Print money
5. Sell government assets such as land, buildings and state-owned enterprises
(privatisation)
The government debt is the total amount that the government has borrowed (Parkin,
2016). It is the sum of all accumulated deficits minus surpluses over time.
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REFERENCES
Parkin, M. (2014). Macroeconomics. (11th ed.). England: Pearson Education Ltd.
Parkin, M. (2016). Economics. (12th ed.). England: Pearson Education Limited.
Sloman, J., Norris, K. & Garratt, D. (2013). Principles of Economics. (4th
ed.). Australia: Pearson Australia.
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Topic 9 - Perfect Competition & Monopoly Market Structures
Learning outcomes:
The following are the learning outcomes for this Topic. At the end of the Topic, do a
self-check to ensure that you have achieved these outcomes:
• Overview of market structures.
• Define perfect competition market structure.
• Describe the key features of a perfect competition market structure.
• Define a monopoly market structure.
• Describe the key features of a monopoly market structure.
9.1 Overview of market structures
Before we begin on this Topic, let recap the definition of market that we have learnt before.
A market is any arrangement that enables buyers and sellers to get information and to
do business with each other (Parkin, 2016). Markets are usually divided into structures
according to the degree of competition that exists between the firms within the same
industry. All the structures have many distinctive characteristics. However, to distinguish
more precisely amongst the four structures, the following must be considered (Sloman,
Norris & Garratt, 2013):
1. Freedom of entry by firms into the market
Is entry into the market free or restricted? If it is restricted, how high are the barriers to
the entry of new firm?
2. Nature of the product
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Do all firms produce an identical product, or do firms produce their own particular brand
or model?
3. Degree of control a firm has over price
Is the firm a price-taker or can it choose its price and, if so, how will changing its price
affect its business?
The market structure will determine the firm’s behaviors which in turn affects the firm’s
performance in areas such as pricing, profitability and efficiency. The collective
behaviours of all the firms in the industry will in turn affect the performance of the whole
industry.
Knowing the importance of the market structure, we will now study the four different types
of market structures (Sloman et al., 2013). The table below is a summary of the
similarities and differences amongst the four market structures in terms of typical number
of suppliers in the market.
Perfect
Competition
Monopoly Oligopoly Monopolistics
Number of
suppliers
Many
(Typically,
more than 100)
One Few Many
In this Topic, we will focus on the two extremes, perfect competition and monopoly.
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9.2 Perfect competition
The model of perfect competition is built on four assumptions:
1. Firms are price-takers. A price-taker is a firm that accepts the market price (Begg &
Ward, 2016). There are so many firms in the industry that each one produces an
insignificantly small proportion of total industry supply, therefore has no power
whatsoever to affect the price of the product.
2. There is complete freedom of entry into the industry for new firms. Existing firms are
unable to stop new firms setting up in business. Freedom of entry, therefore, applies
in the long run.
3. All firms produce an identical product. There is no branding or advertising. Common
products are primary products including minerals like gold, silver, copper and
agricultural products like palm oil and coffee beans.
4. Producers and consumers have perfect knowledge of the market or commonly
termed, perfect information. Perfect information assumes that every buyer and every
seller knows everything (Begg & Ward, 2016). In other words, producers are fully
aware of prices, costs and market opportunities. Consumers are fully aware of price,
quantity and availability of product.
Perfect competition arises if the minimum efficient scale of a single producer is small
relative to the market demand for the good or service. In this situation, there is room in
the market for many firms. In perfect competition, each firm produces a good that has no
unique characteristic, so consumers do not have to choose which firm’s good to buy.
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9.3 Monopoly market structure
The opposite extreme to perfect competition is monopoly. A firm is a pure monopoly if it
is the only supplier of a particular good or services. In practice, however, there are very
few pure monopolies but some firms have significant market power. In the United
Kingdom, the competition authorities define a monopoly to exist if one firm controls more
than 25 percent of the market (Begg & Ward, 2016).
To be more precise, we define pure monopoly as an industry with a single firm that
produces a product for which there are no close substitutes and in which significant
barriers to entry prevent other firms from entering the industry to compete for profits
(Case, Fair & Oster, 2017). In our syllabus, our focus will be on pure monopoly.
To be classified as a monopoly industry, it depends on how narrowly the industry is
defined as well. For example, a smart phone company may have a monopoly on its own
smart phone like IPhone, but it does not have a monopoly on the whole smart phone
market in general. To some extent, the boundaries of an industry are arbitrary. It all
depends on how much of monopoly power the firm has and that depends on the
closeness of substitutes produced by rival firms.
The two key reasons that monopoly market structure arises are as follows:
1. No close substitute
If a good has a close substitute, that firm effectively faces competition from the producers
of the substitute. A monopoly may arise if the firm sells a good or service that has no good
substitute. The most common example of a monopoly could be utilities such as tap water
and electricity distribution in many countries.
2. Barrier to entry
For a firm to maintain its monopoly position, there must be barriers to the entry of the new
firms to prevent potential competitors from entering the market.
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A natural barrier to entry creates a natural monopoly. This is a market in which economies
of scale enable one firm to supply the entire market at the lowest cost possible (Parkin,
2016). There may be inadequate demand in the market. Even if the market can support
more than one firm, a new entrant is not able to start up on a very large scale. Thus, the
monopolist that is already experiencing economies of scale can charge a price below the
cost of the new entrant and drive it out of business. The firms that deliver gas, water, and
electricity to our homes are common examples of natural monopoly.
Control of essential resources: Such a barrier to entry occurs if one firm owns a significant
portion of a key resource. An example of this type of monopoly occurred during the last
century when this company, De Beers controlled up to 90 percent of the world’s supply
of diamonds.
Legal barrier to entry: A legal barrier to entry creates a legal monopoly. Specifically, this
is a market in which competition and entry are restricted by the granting of a public
franchise or government license by the government or patent or copyright of intellectual
properties awarded by the legal jurisdiction.
A monopoly market structure has other key characteristics:
• Monopolist firms offer non-homogenous products or unique products. They may
also produce a variety of their products to prevent other firms from following them.
• Monopolist firm is price-maker. In contrast with perfect competition market, a
monopolist is not a price-taker because it produces all of a particular good or service.
As the sole supplier, it can raise the price of its product by supplying lesser of the
product.
• Monopolist firms earn abnormal profit. The firm is able to earn high profit
permanently because there is no competitor. This high profit is often known as
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abnormal profit, which are way higher than the profit the firm could earn if there is
competition in the market.
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REFERENCES
Begg, D. & Ward, D. (2016). Economics for Business. (5th ed.). USA: McGraw-Hill
Education.
Case, K.E., Fair, R.C. & Oster, S.E. (2017). Principles of Economics. (12th
ed.). England: Pearson Education Limited.
Parkin, M. (2016). Economics. (12th ed.). England: Pearson Education Limited.
Sloman, J., Norris, K. & Garratt, D. (2013). Principles of Economics. (4th
ed.). Australia: Pearson Australia.
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Topic 10 - Oligopoly and Monopolistic Market Structures
We have learnt about perfect competition and monopoly market structures, which are the
two extremes types of market structures in terms of the number of suppliers in the market.
In this Topic, we will turn our focus to the “in between” of the two extreme market
structures, namely oligopoly and monopolistic market structures.
Learning Outcomes:
The following are the learning outcomes for this Topic. At the end of the Topic, do a
self-check to ensure that you have achieved these outcomes:
• Define oligopoly market structure.
• Describe the key features of oligopoly market structure.
• Define monopolistic market structure.
• Describe the key features of monopolistic market structure.
• Compare and contrast the four different market structures.
10.1 Oligopoly
Oligopoly occurs when just a few firms between them share a substantial proportion of
the industry (Sloman, Norris & Garratt, 2013). Their products may vary from differentiated
products such as cars and soft drinks or it can be quite homogeneous such as airlines
service and telecommunication service. Oligopolistic firms differentiate their products
through physical qualities, sales locations and ancillary services with the product as well
as product’s perceived image in consumers’ minds.
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Despite the differences between oligopolies, there are two crucial features that distinguish
oligopoly from other market structures. They are barriers to entry and interdependence of
the firms.
1. Barriers of entry
Natural or legal barriers to entry can create oligopoly. Economies of scale and limited
demand form a natural barrier to entry, hence, creating a natural oligopoly. The size of
the barriers, however, will vary from industry to industry. In some cases, entry is relatively
easy, whereas in others it is virtually impossible.
2. Interdependence of the firms
Due to barriers of entry, oligopoly consists of a small number of firms, each of which has
a large share of the market. Such firms are interdependent, which means that each
firm’s actions influence the profit of all the other firms (Parkin, 2016). Firms recognise
this interdependence, which affects their decisions, as their actions will influence the
profits of all other firms. If a firm changes the price or specification of its product, or launch
promotion campaigns, the sales of its rivals will be affected. The rivals may in turn
respond to the changes. Hence, no firm can afford to be oblivious to the actions and
reactions of other firms in the industry.
Oligopolistic firms are pulled in two different directions. The interdependence of firms
may make them wish to collude with each other to maximise their profits. On the other
hand, they are also tempted to beat their rivals to gain a bigger share of industry profits
for themselves.
Collusive oligopoly
When firms under oligopoly engage in collusion, they may agree on areas such as
prices, market share and advertising expenditure. Such collusion reduces the uncertainty
the firms individually will face if they are to compete with each other. Collusion can thus,
reduce the fear of engaging in competitive price-cutting or retaliatory advertising, both of
which could reduce total industry profits (Sloman et al., 2013).
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When a small number of firms share a market, they can increase their profits by forming
a cartel or acting like a monopoly. A Cartel is a group of firms that gets together and
makes joint price and output decisions to maximise joint profits (Case et al., 2017).
Cartels however, are illegal in most countries. In Singapore, the government takes a firm
view on any attempt by firms to restrict competition. Such restrictions laid out under The
Competition Act (2004), include attempt which directly or indirectly fix purchase or selling
prices, attempt by firms to control production output so as to artificially inflate the prices
in the market as well as attempt by firms to control market or supporting suppliers
(Competition Commission of Singapore, 2018).
In another form of oligopoly, one firm dominates an industry and all the other firms follow.
This leads to price leadership practice among firms. Price leadership is a form of
oligopoly behaviour in which one dominant firm sets prices and all the smaller firms in the
industry follow its pricing policy (Case et al., 2017). We can think of the dominant firm
as maximising profit subject to the constraint of market demand and subject to the
behaviour of the smaller competitive firms. Smaller firms can sell all they want at this
market price. Price leadership can be ineffective if product differences exist among firms.
Sometimes, duopoly may also exist. Duopoly is an oligopoly market with two firms
(Parkin, 2016). The most popular duopoly is Coke and Pepsi, which operate in the soft
drinks market. Another example is the aircraft manufacturing industry namely the rivalry
between American Boeing and European Airbus,
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10.2 Monopolistic Market Structure
Most real-world market is competitive but not perfectly competitive because firms in these
markets have some power to set their prices. We label this type of market as
monopolistic competition.
Monopolistic competition is a common form of industry structure characterised by a
large number of firms, no barriers to entry and product differentiation. Monopolistic
competition exhibit the following characteristics:
1. There is a large number of firms, typically 30 or more. As a result, each firm only has
a small share of the market. Their actions are unlikely to affect its rivals greatly. So it
does not need to worry about the rivals’ reactions while making decisions. Collusion
to fix a high price is not possible as the number of firms is large, hence, it is difficult to
coordinate and get agreements from many firms.
2. There is freedom of entry of new firms into the industry. Monopolistic competition has
no barriers to prevent new firms from entering the industry in the long run.
3. Each firm produces a similar product or service but slightly different in some ways
from its rivals. This practice is called product differentiation strategy. Specifically, a
few will seek competitive advantage by making its products less substitutable (Begg
& Ward, 2016). Since there are differences between products or services, firms can
increase prices without fear of losing all its customers. When price rises, the quantity
demanded decreases, but it does not fall to zero. Monopolistic firms face a
considerable amount of competition from other firms and has a small dose of
monopoly power over her loyal customers.
4. Monopolistic firms compete with each other on quality, price and marketing.
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As there are many firms in the industry, they have to compete with each other in a fierce
competition. They compete by trying to outdoing the opponent’s product quality. Product
quality is the physical attributes that makes it different from products of other firms.
Quality includes the design, specification, reliability and services provided to the buyers.
However, some firms are unable to produce products with the same quality as others.
Hence, they will try to attract customers by competitive price.
Due to product differentiation in monopolistic competition, firms must market their
products and services. There are two ways of marketing namely advertising and
packaging. They can focus on their packaging of the products to attract customers. In
addition, enticing advertisement and broad scale advertising will also bring more
customers.
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10.3 Comparison of four market structures
As we have learnt about the four market structures, we are able to draw differences
among them due to their distinctive characteristics. The table below provides a summary,
comparing and contrasting the key features of the four market structures.
Monopoly Oligopoly Monopolistic
competition
Perfect
competition
Number of
firms
One firm A few firms
dominate the market
Many firms Large number
of firms
Nature of
product
No close
substitute to
compare
Products may be
differentiated or
similar
Similar but
slightly
differentiated
products
Homogeneous
Barrier of
entry
Restricted
entry of new
firms
Restricted entry of
new firms
Freedom of entry
and exit
Freedom of
entry and exit
Price
influence
Firm has full
control over
price
Firm is a price-
maker
Firm has some
control over price
as their products
are differentiated
Similar price
as each firm is
a price-taker
Strategies of
firm
Maintain
monopoly
status such
as through
innovation
of product.
• Build strong
brand name and
positive image.
• Collusion
• Price leadership
• Product
differentiation
• Advertising
• Branding
Enhance cost
efficiency
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REFERENCES
Begg, D. & Ward, D. (2016). Economics for Business. (5th ed.). USA: McGraw-Hill
Education.
Case, K.E., Fair, R.C. & Oster, S.E. (2017). Principles of Economics. (12th
ed.). England: Pearson Education Limited.
Competition Commission of Singapore. (2018). Competition Act [webpage]. Retrieved
from https://www.cccs.gov.sg/legislation/competition-act
Parkin, M. (2016). Economics. (12th ed.). England: Pearson Education Limited.
Sloman, J., Norris, K. & Garratt, D. (2013). Principles of Economics. (4th
ed.). Australia: Pearson Australia.
- copyright page.pdf
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- IDC Study Guide Cover.pdf
- PHTM_Section B_Study Guide_complete 1
- PHTM_Section B_Study Guide_complete 2
- Section B
- Topic 01-Computer Architecture_edited
- Topic 02-Memory Hierarchy_edited
- Topic 03-Base Conversions I_edited
- Topic 04-Base Conversions II_edited
- Topic 05-Matrix Algebra_edited
- Topic 06-Boolean Algebra_edited
- Topic 07-Boolean Algebra_II_edited
- Topic 08-MATLAB Intro_edited
- Topic 09-MATLAB Plotting_edited
- Topic 10-MATLAB Programming_edited