CT7 Part 3

  1. Social Efficiency
    • best allocation of resources (allocative efficiency) for society
    • achieved when marginal social benefit = marginal social cost
    • MSB = added benefit to society of an additional unit of product
    • when MSB = MSC, total welfare is at max
    • free market usually fails to achieve this
  2. Equity
    • achieved when distribution of society's resources deemed "fair"
    • different views on what is "fair" but most agree free market doesn't achieve this
  3. Externalities
    spillover or "third party" effects of particular activity
  4. External Costs (negative externalities)
    • costs borne by people other than producer or consumer
    • eg polluted rivers or passive smoking
  5. External Benefits (positive externalities)
    • benefits enjoyed by people other than producer / consumer
    • eg more efficient staff from prev employers training, improved health of nation from vaccination
  6. Social Cost
    private cost to producers PLUS net externalities of production
  7. Social Benefit
    private benefit to consumers (represented by prices they are prepared to pay) PLUS net externalities of consumption
  8. Public Goods
    • non rivalry - consumption by one doesn't prevent consumption by other
    • non excludability - impossible to prevent another's consumption
    • eg defense, streetlights, fireworks
  9. Free Rider Problem
    public goods would not be provided in free market as no one has incentive to pay for these goods
  10. Merit Goods
    • private goods that confer undervalued private benefits and large external benefits
    • e.g. education, healthcare, pensions, training
  11. Demerit Goods
    • incur undervalued private costs as well as external costs
    • e.g. cigarettes, alcohol, drugs, gambling
  12. Consumer Surplus
    • surplus of satisfaction over that which consumers paid for
    • A+B+C in PC, or A under monopoly
  13. Producer Surplus
    • Surplus revenue received over that which is necessary to maintain supply
    • In SR, = TR - TVC
    • D+E under PC, or B+D under monopoly
  14. Total (Private) Surplus
    • consumer surplus + producer surplus
    • A+B+C+D+E in PC, or A+B+D in monopoly
  15. Deadweight Welfare Loss
    • loss of consumer and producer surplus in imperfect markets when compared with perfect competition
    • C+E in diagram
  16. Main Types of Government Intervention
    • Taxes and Subsidies on G&S
    • Changes in Property Rights
    • Legislation and Regulation
    • Price Controls
    • Provision of Information
    • Direct Provision of G&S
    • Welfare Systems
  17. Taxes & Subsidies on G&S
    • corrects externalities (internalises them) and corrects monopolies (by lump sum taxes or subsidies)
    • eg if MSC > MC, tax equal to marginal external cost imposed (Thus, private costs increase to social cost)
    • eg if MSC > MB, subsidy equal to marginal external benefit should be imposed to increase production
  18. Advantages of Using Taxes & Subsidies as Government Intervention
    • market allowed to operate
    • firms forced to take into account full benefits / costs of actions
    • taxes and subsidies can be adjusted in line with scale of problem
    • incentives provided to adopt good practices
  19. Disadvantages of Using Taxes & Subsidies as Government Intervention
    • may be impractical to determine appropriate rates for each firm
    • may be impossible to measure cost and apportion blame (eg global warming)
  20. Changes in Property Rights
    By extending property rights, gvt may enable individuals to prevent others imposing costs on them
  21. Coase Theorem
    • states that 2 parties will negotiate socially efficient charge so social optimum achieved, if property rights are bestowed
    • involves "internalising" externality much like taxes and subsidies
  22. Positives and Negatives of Changes in Property Rights as form of Government Intervention
    • +: useful when few & easily identifiable culprits & sufferers
    • +: useful when easily identifiable and clearly defined costs
    • -: practical difficulties of negotiation when many suffer
    • -: time and expense of negotiation & litigation
    • -: inequality in distribution of legal services and property
  23. Legislation and Regulation
    • Laws correct market imperfections of 3 types
    • 1. those prohibit/ regulate activities that impose external costs
    • 2. those that regulate monopolies/oligopolies
    • 3. those protecting consumers from unsafe products / misleading ads
  24. Positives and Negatives of Legislation & Regulation as form of Government Intervention
    • +: simple / clear / easy to administer
    • +: safer than alternative policies like tax when danger is great
    • +: quickly implemented
    • -: do not encourage further improvements in good behaviour
  25. Price Controls (as form of Government Intervention)
    • may take form of max prices (ceilings - rent control) or in prices (floors - minimum wage)
    • Ceilings cause shortages and floors cause surpluses if below / above equilibrium price
  26. Provision of Information (as form of Government Intervention)
    • ignorance is source of market failure
    • prodviding info enables consumers and firms to make better decisions more quickly
  27. Direct Provision of Goods and Services (as form of Government Intervention)
    • Involved in three ares:
    • 1. Public Goods (eg defence, lighthouses)
    • 2. Merit Goods (eg education, healthcare)
    • 3. Publicly Owned Enterprices (eg BBC)
  28. Four Main Reasons for Government Provision of Merit Goods
    • ignorance - people may not appreciate benefits
    • large positive externalities
    • social justice (ppl's right should not be based on ability to pay)
    • dependants (ppl's right should not be based on others like parents)
  29. Welfare Systems
    address inequality by raising taxation in progressive manner and providing range of welfare benefits
  30. Problems Associated with Government Intervention
    • shortages / surpluses caused when price controls used
    • problems caused by measurement difficulties and lack of info
    • bureaucracy and inefficiency
    • negative effect on incentives
    • reduction in individual freedom of choice
    • adverse effect on efficiency if frequent change in government policy
  31. Why Market Power Against Public Interest
    • firms can make supernormal profits
    • consumers are charged higher prices compared to cost of production
    • firm has little incentive to improve efficiency
  32. Possible Benefits of Market Power
    • firms may choose not to fully exploit their market power
    • economies of scale may lead to lower prices
    • profits may be spent on R&D and capital investment
  33. Three Areas of Competition Policy
    • Restrictive practices policy
    • Monopoly Policy
    • Merger Policy
  34. Restrictive Practices Policy
    • concerned with controlling anti-competitive practices (Cartel agreements) when market dominated by small number of oligopolists
    • can impose sanctions on those guilty of collusion, such as:
    • modification to existing practices
    • ban on continuing use of particular practice
    • fines
    • compnesation to affected third parties
    • imprisonment
  35. Anti-Competitive Practices (Multiple firms - Cartel Agreements)
    • Horizontal price-fixing agreements
    • Limiting production / investment to keep supply low
    • Limiting technical development to keep costs low
    • Sharing out markets or sources of supply
    • Discriminatory pricing or trading conditions
    • Collusive Tendering
    • Forcing other firms to accept unfavourable contract terms when dealing with colluding firms
    • Agreements to boycott suppliers or distributors who deal with competitors of colluding firms
  36. Collusive Tendering
    when two+ firms secretly agree prices they will tender for a contract
  37. Resale Price Maintenance
    • manufacturer requiring retailers sell product at specified price
    • example of vertical price fixing agreements
  38. Monopoly Policy
    • concerned with abuse of market power and anti-competitive practices of firm acting alone
    • prevents firms in position of dominance to use this power to restrict competition
  39. Anti-Competitive Practices (Single Firm)
    • charging excessively high prices to generate abnormally high profits
    • paying unfairly low prices to suppliers
    • limiting production to keep supply low
    • limiting technical development to keep costs down
    • discriminatory pricing / trading conditions to generate high profits or exclude competitors
    • predatory pricing to drive out competitors
    • forcing suppliers / customers to accept unfavourable contract terms (eg tie in sales)
  40. Tie in Sales
    when firm only sells particular profit iff second product also bought
  41. Merger Policy
    purpose is to regulate mergers that result in a concentration which would significantly impede effective competition, in particular by creation or strengthening of a dominant position
  42. Competition Policy Effectiveness
    • modern policies focus on conduct and performance cf structure
    • prohibition of certain practices and fines considered effective deterrents
    • large fines and jail sentences seem successful in deterring cartels
  43. Three Stages of Technological Change
    • invention: development of new ideas / processes / products
    • innovation: implementation of new ideas in practice
    • diffusion: spread of new ideas / processes / products through economy
  44. Techonology Policy
    government initiatives to affect the process of technological change and the rate of adoption
  45. Why Market Forces Fail to Encourage Sufficient R&D
    • R&D Free riders - once findings public, firms can benefit without cost / risk
    • Monopolistic and Oligopolistic Structures (but these may fund R&D)
    • Duplication (inefficient if 2 companies research same)
    • Risk & Uncertainty (more ST projects favoured over LT ones)
  46. Forms of Government Intervention re Technological Change
    • Patent System
    • Public Provision - sponsor through institutions or universities
    • R&D Subsidies (reduces cost and risk)
    • Co-Operative R&D (reduces duplication)
    • Diffusion Policies
    • Other Policies (not directly linked to R&D but may affect it, e.g. education, competition, national defence policies)
  47. Patent
    • temporary legal monopoly awarded to inventor who registers an invention
    • careful use achieves balance between encouraging firms to participate in R&D and rapid diffusion of ideas
  48. Supply Side Policies
    designed to increase AS directly by increasing the quantity of factors of production and/or improving productivity
  49. Supply Side Policy Aims
    • reduce unemployment
    • reduce inflation
    • increase country's output and its rate of economic growth
  50. Productivity Measures
    • output per worker
    • output per hour worked
    • total factor productivity
  51. Main Determinants of Productivity
    • private investment in new physical capital (machinery and buildings) and in R&D
    • public investment in education, R&D and infrastructure
    • training of workforce
    • innovation & application of new technology
    • management of factors of production
    • creation of new firms (generally more productive than old ones)
    • competitive pressures to improve quality and reduce costs
  52. How Productivity Growth leads to Economy Growth
    • productivity improvements increase potential output
    • prices driven downwards stimulating demand leads to actual growth
    • higher profits encourage investment, which increase productivity further
    • new products & processes stimulate further tech progress from competitors
    • higher labour productivity increases wages and thus demand
    • firms with highest productivity increase market share, encourages more investment
  53. Two types of Supply Side Policy
    • Market oriented - encourage private enterprise / rewarding hard work
    • Interventionist - counteract deficiencies in free market
  54. Market Orientated Supply-Side Policies
    • aim to increase output by increasing role of markets and decreasing role of government
    • aims to "free up" markets by reducing
    • government intervention
  55. Reducing Government Expenditure (as Market Orientated Supply-Side Policy)
    • government expenditure can be cut by more efficient use of public sector resources, or reducing size of public sector
    • some argue private sector less bureaucratic / more efficient than public
    • also reduces public sector deficit
  56. Tax Cuts (as Market Orientated Supply-Side Policy)
    • affect choices individuals and firms make, depending on whether taxes are on income, savings, or profits
    • substitution and income effects of tax work in opposite ways
  57. Reducing Power of Labour (as Market Orientated Supply-Side Policy)
    • reducing workers' ability to demand high wages pushes profits up, enables more investment to fuel growth, reduces cost push inflation
    • government can do this by 1) giving employees right to not join unions, 2) enforcing secret ballots on strike proposals, 3) resisting public sector strikes
    • power of labour also reduced due to more flexible labour markets, locally (cf nationally) negotiated wage contracts, international exposure
  58. Reducing Welfare (as Market Orientated Supply-Side Policy)
    there is a danger people choose to be unemployed if difference between wage and welfare too small (reduce by reducing welfare benefits, or tie benefits to job hunting proof)
  59. Policies to Encourage Competition (as Market Orientated Supply-Side Policy)
    • Privatisation
    • Deregulation (removal monopoly rights)
    • Introducing market relationships into public sector
    • Public-Private Partnerships (PPPs - eg introduce competition through tendering process for contracts)
    • Free trade and capital movements (removes barriers)
  60. Reducing and Simplifying Regulations
    • reduces burden, especially on small firms
    • keep at minimum while maintaining protection for those affected
  61. Interventionist Supply Side Policies
    aim to increase output through government intervention that addresses failure of free market to produce at full potential level of output
  62. Types of Interventionist Supply-Side Policy
    • Nationalisation
    • Direct Provision of Capital (eg roads, railways, info highways)
    • R&D
    • Training and Education
    • Investment
    • Assistance to Small Firms
    • Advice and Persuasion
    • Information (provide technical assistance, results of public research, info on markets)
  63. Why Interventionist Policies are Necessary
    • stems from failure of free market to provide sufficient R&D, training and investment (saw reasons in Module 12)
    • likely too little of above due to "free ride" problem, substantial external benefits, firms considering investments too risky, finance too hard to obtain
  64. Globalisation
    refers to process of developing increasing political, cultural and economic ties between people all around the world
  65. What Drives Globalisation?
    • market drivers - reflect increasing similarities between consumers and hence markets in diff countries
    • cost drivers - potential for reducing prod costs, incr. tech innovation and transport advances
    • government drivers - privatisation, removal tariffs/quotas, move to more open free market economies
    • competitive drivers - firms now need global strategies
  66. Benefits of Globalisation
    • increases opportunity for specialisation and exploitation of economies of scale
    • faster diffusion of new tech
    • greater competition, lower prices and wider range of goods for consumers
    • increased investment in developing countries, leading to growth & improvements in living standards
    • closer political ties, greater political stability
    • greater cultural exchange to benefit people in different countries
  67. Drawbacks of Globalisation
    • contributes to growing inequalities between countries
    • makes poor countries even poorer as multinationals exploit dominant position in foreign markets
    • contributes to environmental problems
    • leads to political, economic and cultural domination by large multinational brands
  68. Absolute Advantage
    Country X has abs advantage over Country Y in producing a good when Country X can produce a unit of that good using fewer resources than Country Y
  69. Comparative Advantage
    Country X has a comp adv over Country Y in producing a good when Country X has a lower opportunity cost of producing that good than Country Y
  70. Law of Comparative Advantage
    when opportunity costs of producing good differs between two countries, each can gain if it produces and exports those goods for which it faces a lower opp cost and imports those it faces a higher opp cost
  71. Benefits and Limits of Specialisation
    • countries trade with each other to gain full benefits of specialisation
    • allows country's industries to take full advantage of strengths of their factors of production
    • firms can thus benefit from economies of scale
    • But diseconomies of scale likely to set in to increase opp cost of production after certain quantity
    • exchange ratio must lie between the two non-trading opp cost ratios
  72. Other Reasons for Gains from Trade
    • Decreasing costs - may choose to export goods made in small inefficient industry where no comp adv
    • Differences in Demand - export where domestic supply > demand
    • Increased Competition - with int'l competition, domestic econ benefits from lower prices, greater efficiency, incr R&D, more choice
    • Trade as "engine of growth"
    • Non-Economic Advantages (eg political, social, cultural)
  73. Terms of Trade Index
    • index of export prices / index of import prices x 100
    • increase in this index is regarded as an improvement in terms of trade
  74. Ways Government Can Restrict Trade
    • customs duties/tariffs on imports
    • import quoats
    • subsidies on domestic products
    • administrative regulations
    • favouring domestic suppliers for government purchases
    • dumping (exports sold at articially low prices often as result of gvt subsidy)
  75. Arguments in Favour of Restricting Trade
    (1-8 general, 9-10 country specific)
    • Infant Industry argument
    • to reduce reliance on goods with little dynamic potential
    • to prevent dumping and other unfair trade practices
    • to prevent establishment of foreign-based monopoly
    • to spread risks of fluctuating markets
    • to reduce influence of trade on consumer tastes
    • to prevent importation of harmful goods
    • to take account of externalities
    • (CS) to take advantage of market power in world trade
    • to protect declining industries
  76. Non Economic Arguments for Restricting Trade
    • maintaining self sufficiency in case trade denied in future
    • imposing trade sanctions on countries it disagrees with politically
    • maintaining traditional ways of life
    • maintaining diverse society based on wide range of industries
  77. Infant Industry
    • may be too small at present to withstand international competition
    • gvt may protect until it has grown sufficiently in size / expertise
    • has potential competitive adv, currently not developed enough to realize
  78. Strategic Trade Theory
    • suggests comparative advantage can be created by government policy
    • encourages support for certain domestic industries against large monopolistic overseas firms
    • supported by first four arguments in favour of restricting trade
  79. Problems with Protection
    • the costs (diagram)
    • reduced choice
    • protection as "second best" (eg retraining declining industry probably better)
    • retaliation
    • protection may allow firms to stay inefficient
    • bureaucracy
  80. WTO Rules
    • non discrimination
    • reciprocity
    • fair competition
    • prohibition of quotas
    • binding tariffs
  81. WTO Role
    attempts to reduce trade restrictions and increase benefits of world trade
  82. Balance of Payments Account
    set of accounts which records the flows of money between a country's residents and the rest of the world
  83. Current Account of BoP
    • records all trade transactions with the rest of the world plus other current income flows plus current transfers
    • four subdivisions - trade in goods accounttrade in services account, income flows (rent/div/int) and current transfers (money transfers and gvt contributions)
  84. Trade in Goods Account
    • records exports less imports of physical goods (visibles) eg cars, oil, food
    • balance called "balance of trade in goods" or "balance of visible trade" or "merchandise balance"
  85. Trade in Services Account
    • records income from less expenditure on services, eg insurance, shipping, aviation, tourism
    • balance called "services balance"
  86. Balance on Trade in Goods and Services OR Balance of Trade
    sum of trade in goods account and trade in services account
  87. Capital Account of BoP
    • records transfers of capital into and out of country
    • "capital" means assets with term > 12 months
  88. Financial Account of BoP
    • records investment transactions with rest of world
    • three subsections: investment (direct and portfolio), other investment and financial flows, flows to/from reserves
  89. Exchange Rate
    rate at which one currency trades for another on the forex market
  90. Exchange Rate Index OR Effective Exchange Rate
    weighted average of the exchange rate of a particular currency against all other currencies, where weights based off proportion of transactions
  91. Possible Causes of Depreciation of Currency
    • fall in domestic interest rates
    • higher inflation in domestic than abroad
    • rise in domestic incomes relative to abroad
    • relative investment prospects improving abroad
    • speculation exchange rate will fall
  92. Floating Exchange Rate
    • exchange rate determined solely by supply and demand
    • ensures BoP automatically balances
  93. Fixed Exchange Rate
    used when government seeks to intervene to stabalize currency
  94. Short Term Government Intervention on Exchange Rate (counter downward pressure)
    • Sell gold and foreign currency reserves to increase demand for domestic currency
    • Borrow in form of foreign currency loan in order to buy domestic currency (increase demand)
    • raise interest rates to increase deposits from overseas savers and reduce overseas deposits by domestic savers
  95. Long Term Government Intervention on Exchange Rate (counter downward pressure)
    • apply contractionary policies to reduce AD in domestic economy (contractionary FP or MP)
    • supply side policies can improve quality and/or price competitiveness of domestic goods (increase exports, increase dom currency demand)
    • government measures to control imports
    • controls on forex dealing to restrict supply
    • devaluation (refix ER at lowe rlevel) may be necessary if current account deficit persists
  96. Fixed Exchange Rate Advantages
    • international trade and investment are less risky as profits not affected by exchange rate
    • reduction in speculation on exchange rate movements if everyone believes ER not change
    • more stable economic conditions
  97. Fixed Exchange Rate Disadvantages
    • ER policy may conflict with interests of domestic business and economy as a whole
    • competitive contractionary policies leading to world depression
    • problems of international liquidity
    • inability to adjust to shocks
    • speculation (around devaluations)
  98. International Liquidity
    • supply of currencies in world acceptable for financing international trade and investment
    • needs to be enough to fund growth in trade / allow each country to maintain sufficient reserves, but not too much to fuel inflation
  99. Advantages of Free-Floating ER
    • BoP disequilibria auto corrected by movements in exchange rate
    • no problem of international liquidity and no need for central bank reserves
    • countries' currencies not tied to inflation rates of others
    • external shocks can be dealt with depr/appr ER
    • domestic macro econ policy not constrained by need to maintain fixed ER
  100. Disadvantages of Free-Floating Exchange Rate
    • unstable ER can be problem for firms with contracts with overseas suppliers / distributors
    • speculation can lead to higher volatility
    • uncertainty can discourage international trade / investment
    • governments may lack discipline of maintaining stable ER
  101. Adjustable Peg System
    • ER fixed for period of time, may be devalued / revalued if BoP deficit / surplus excessive
    • method for government to manage ER
  102. Managed Flexibility (Dirty Floating)
    • governments can intervene to prevent excessive fluctuations or maintain unofficial ER target
    • method to manage ER
  103. Exchange Rate Mechanism (ERM)
    • group of countries may agree to keep their ERs with each others within certain bands as part of this
    • currencies still float with respect to other currencies not involved
    • method for government to manage ER
Card Set
CT7 Part 3
Chapters 12-16