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AS Economics

Case Study - China I

Key Questions:

  • Is growth increasing incomes on the average Chinese?
  • Is growth lifting people out of poverty?
  • Is minimum wage industrialisation the best way to achieve growth?

QUALITY of growth matters

  • Average income for a Chinese worker is (USD)$8000
  • By 2020, it is estimated that average Chinese wages would have risen to (US) $14,000. This level is considered to be the upper income level that moved countries such as Singapore, South Korea, Greece and Portugal, to ‘rich’ country stats - the level that moved these countries past the boundary

Five year plan

  • China’s growth has been, on average, 9.6% over the past 30 years
  • The five year plan is the government’s 12th five-year plan used to set the future growth agenda for China
  • Renewed in 2011, the priorities for this plan are sustainable growth, industrial upgrading and the promotion of domestic consumption
  • Criticism: there is no implementation plan

  • Half of china’s growth comes from adding capital. Bear in mind that growth quality is now becoming the most important thing to think about rather than growth quantity

Total Factor Productivity (TFP) is measured by innovation, allocative efficiency (re-allocation of factors, e.g. rural to urban, state owned to private) and human capital. TFP is the contribution of all factors of production to growth. When TFP increases, the growth rate increases. This means that one or more of the factors of production has been changed.

Innovation - micro level data shows that ⅔ technology comes from imitation, most developing countries imitate first to gain enough wealth to then invest it into R&D for new product development. Imitation leads to innovation - creating an increase in growth.

Human capital - China’s investment in human capital is geographical unevenly distributed. Rural parts of China are under-invested in. If China invests in human capital all round, it has a better chance competing with other economies. Human capital is beneficial because:
  • Skill levels increase. E.g. they will be more qualified to perform tasks and will do so quicker
  • Creates a flexible economy - workers have a greater capacity to adapt to changes in the economy, i.e. seize new opportunities for wealth creation
  • Increases occupational mobility of labour and geographical mobility of labour as because of the previous point
  • High levels of education can increase a worker’s ability to use foreign technology, their ability to absorb new information and acquire technical skills

Middle Income Trap

China needs to avoid the middle income trap. The middle income trap is the trap that developing countries fall into when trying to make their transition from a developing country to a developed country. They are not low income by definition, i.e. they experience high growth rates and make money, but they are not high income countries because they do not have technological advantages. China’s wages are starting to increase, as shown here, demonstrating that what was once the most popular destination for cheap manufacturing, is now losing to countries such as Bangladesh and Singapore.

Key points:
  • Wages are increasing
  • Poverty is slowing decreasing
  • Innovation is creeping up
  • Chinese firms are expanding globally
  • Without the prospect for cheap labour, firms will be deterred from investing in China
  • Only urban members of the workforce are educated, also potentially deterring firms
  • The Chinese economy is still imitating

These points suggest that China is heading for the middle income trap, a limbo between the rich and poor, unable to progress. There are criticisms of the middle income trap, read the Economist article here to gain other perspectives, which will help you build your argument in your exam. Remember that providing alternative views are brownie points. Read the sources at the bottom as well.

The Future

  • Focus on overcoming the middle income trap
  • Increase own market reliance, e.g. US consumers are increasingly buying domestically produced goods
  • Increase domestic demand by lowering exports. E.g. exports are only a fraction in the US - China needs to get to that
  • Privatise. State owned companies are not as productive. They distort the allocation of lending and bank credit. State owned enterprises account for 30% industrial output and ¼ of urban jobs
  • Increase innovation
  • Increase opening - more Chinese firms should go global.
    • We have seen Chinese investment in African natural resources, which is a start. They are building infrastructure in poor African countries and providing jobs (however a negative is that they are competing with local firms and undercutting them, making it difficult for locals to make a living)
    • China should focus on moving up the value chain by producing things that is most competitive
    • The government should push to create Chinese multinationals
    • At the moment, Europe in particular can benefit from the additional investment that Chinese firms can offer
  • Services are important - increase job creation, create a high skilled labour force and help China rebalance
  • Raise consumption as a share of GDP, not rising it in absolute terms
  • Restructure the economy: more services, quality of growth needs to increase
  • Productivity and innovation: compete to produce the best products in the world. Join the ranks of rich countries, e.g. Samsung (South Korea) competing with Apple (US)
  • Political reforms are required to sustain a prosperous middle class

    Happy Valentine's Day everyone!

    Have you ever wondered about the economics of Valentine's Day? What does it mean?

    This video (strangely) puts into context for us:

    It explains three economic principles associated with Valentine's Day:
    1. Free markets
    2. Signalling
    3. The seen and unseen

    This video puts these key principles into context for us, hopefully you will understand them clearer after watching it.

    Case Study/ Example of Public Sector and Private Sector Cooperation

    The UK Driving Standards Agency recently set out plans to run driving tests from Halfords branches around the UK. 15 Halfords branches are set to become test centres to improve accessibility to those who do not live close to a test centre. The driving tests will still be conducted by DSA examiners, so Halfords is simply playing host.

    This provides a good example of private firms contributing to social welfare in a positive way, and has been the first for a long time (e.g. remember G4S?). Both examples can be used to describe the benefits and costs of PPPs or private sector involvement with government.

    Another Contribution to the Business Cycle

    Read an interesting article on the BBC about the cost of bank holidays, according to research from The Centre for Economics and Business Research (CEBR).

    Each bank holiday costs the economy £2.3m and that means the economy could gain an extra £19bn if bank holidays were scrapped. This can be a contribution to the business cycle (see here) because bank holidays reduce GDP. If the economy was suffering a downturn, the loss of GDP can cause the economy to worsen from a downturn to a recession. For the UK, especially at a time where we are not experiencing strong growth, forecasters are predicting the worst from the working days that are lost.

    15% of the economy, which includes pubs, clubs, restaurants, cafes and visitor attractions, do well on bank holidays and 45% of the economy suffers, which includes offices, factories and building sites, where people do not go to work on the bank holiday. The areas that benefit do not balance out the loss of productivity from the services sector of the economy.

    Do read the full article for more information.

    Quantitative Easing

    QE causes a change in the money supply. Steps:

    1. The Bank of England (BoE) purchases assets such as government bonds and corporate bonds
    2. Pays for these assets by creating money electronically and crediting the accounts of the companies that it bought assets from
    3. These accounts are called reserves. All banks hold reserves at the BoE and the essence of QE is that it builds up these reserves
    4. QE is likely to lead to inflation because banks lend more and increases the money supply (see Quantity Theory of Money). Another reason for inflation is, holding everything else equal (ceteris paribus), more people have more money that they supposedly use for consumption, creating demand pull inflation

    Explained by Stephanie Flanders

    Stephanie Flanders in the BBC’s economics editor, the link above provides a short video RSAnimate of QE. A summary of the video is as follows:

    ·         The Bank of England creates money and spends it so that there is “extra cash” flowing into the economy. They spend it by buying government bonds or IOU’s (formal definition: documentation confirming that the debt is owed) from financial institutions such as pension funds or insurance companies.
    ·         This puts more money into the economy (higher money supply) because these financial institutions that sold these bonds have more money to spend on new businesses or on housing for example.
    ·         Because of this, it is cheaper for the government to borrow as the BoE pushes up demand for the Treasury’s IOUs and supply of bonds has been reduced. Long term interest rates are lower than they should be making it cheaper for everyone else to borrow as well, because higher demand means more spending and this leads to faster growth.

    The last point explains the theory WHY the government uses QE even with the risk of inflation, particularly during recessions. If demand rises, consumption may increase and the economy begins to recover. 

    Unemployment Notes

    Full employment is, according to the Beveridge definition, when 3% or less of the work force is unemployed. At current, the unemployment rate is 8.4% of the labour force, indicating that the UK is performing far from full employment and full productive capacity. More detail can be found from notes published on 5th August.

    The Natural Rate of Unemployment (NRU) is the rate of unemployment that occurs even when the aggregate labour market is in equilibrium (ADL = ASL). Below is a diagram illustrating NRU.

    Point X is the equilibrium, ADL = ASL, the market going wage rate is WFE and full employment occurs when EFE workers are hired. ASLN shows how many more workers are willing and able to work at different wage rates but cannot due to frictional (geographical immobility) and structural unemployment (lack of skills). The NRU can be calculated by EFE – E1.

    NRU can also be linked with inflation. NRU is also known as the Non- Accelerating Inflation Rate of Unemployment (NAIRU). This means that it is the only rate of unemployment that does not alter the rate of inflation.

    Causes of unemployment

    ·     Frictional unemployment relates to the time taken to find a new job, the period between switching from one job to another. Frictional unemployment is caused by:

    Ø  Occupational immobility of labour: Workers need more time to switch between jobs because they don’t have new skills to offer new employers. Lack of training courses, for example, makes the search period longer. Along with that, the longer the search period, the less employable the worker gets because they are losing their employability skills (work ethics, behaviour…).
    Ø  Furthermore, new employment practices such as laws on equality (race, gender, sexual orientation...) can prevent perfectly capable workers from finding a job. This is one case against government intervention in the economy.

    Ø  Geographical immobility of labour: The difficulty of moving to another location to find a new job. For example, the North South divide in the UK means house prices are too high in the South where more jobs may be available. Other reasons that cause difficulties are family ties and attitudes towards moving to new and unknown locations.

    Ø  Search theory of unemploymentThose who are unemployed will continue to look for the ‘right’ job, comparing their old job with the other jobs available, for example, pay, travelling distance….etc. Because of this, workers may reject job offers, leading to a longer period of unemployment.

    ·   Structural unemployment means that workers lose their jobs due to changes in the structure of the economy. For example, the UK’s economy moved from an industrial one in the early 1900s to one based on providing financial services now. This led to the loss of jobs in the manufacturing sector (read this article:

    ·   Seasonal unemployment occurs because of changes in the weather. When the UK’s climate changes, it affects the agricultural and tourism industries, leading to job losses in the winter.

    ·   Cyclical unemployment is caused by deficient aggregate demand. Also known as Keynesian unemployment or demand deficient unemployment, the diagram below displays a fall in  ADL after a fall in AD. This causes employment to drop from EFE to E2. See a more detailed explanation as posted on 3rd October.

    ·   Real wage/classical unemployment is caused by wage stickinessCollective bargaining by trade unions (see here) causes wages to remain high, causing unemployment.

    Ø  The diagram shows that point X is the equilibrium point. The real wage rate is WFE and employment is EFE. When trade unions cause the real wage rate to rise, wages become W1. This causes an excess supply of labour because at W1, E1 workers are willing and able to work at this wage rate. However, demand for labour is only E2, more workers are willing to work than firms wish to hire, thus creating unemployment equal to E1 – E2. Wis known as the disequilibrium wage rate.

    Ø  Free market economists believe that labour market competitiveness would drive down wage levels in time, however trade unions cause wage rigidity preventing it from going back to equilibrium.

    It is important to note that unemployment is a waste of human capital. The disadvantages of unemployment are shown in the table below.

    One positive of unemployment that classical economists believe is that it brings a downward pressure on inflation. But that’s up to you to decide whether you agree and be sure to write your opinion in the exam. See tomorrow’s post on government policies aimed at reducing unemployment.

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