Word of the Day

Absolute Poverty

Is when a household's income level is below a certain amount. This is in contrast to relative poverty which mustn't get confused! When all incomes grow, absolute poverty falls. If low incomes grow faster than average incomes, relative poverty will fall.

In the UK, relative poverty is mainly the concern. Absolute poverty occurs less because welfare benefits are given out to people as a minimum income and safety net.

Word of the Day

IMF

The International Monetary Fund is an IGO (Inter-Governmental Organisation) that loans money out to countries in financial instability. It loans money out with 'strings' attached where countries must agree to implement certain policies or meet the terms and conditions in order to receive the loan. Recent interference by the IMF include negotiating bail out packages for the Greece and Ireland. The IMF have also in the past given loans to developing countries such as Uganda, in order to help them develop. There are 187 member nations in the IMF, the most powerful member being the USA - with the highest voting power.

Word of the Day

OFT

The Office for Fair Trading uses market structure, conduct and performance indicators to scan the UK economy for evidence of monopoly abuse. This is used to analyse and evaluate costs/benefits of monopoly. The OFT, along with the Competition Commission, creates incentives for firms to resist temptation to exploit possible monopoly power. Firms will not want to risk getting caught by these regulatory bodies therefore uses these incentives.

Word of the Day

Trade Union

A collective association of workers whose aim is to improve the pay of workers and improve the conditions of work for its members. Some of the things they work to improve include:

• Real incomes
• Pensions
• Security
• Unfair dismissal
• Counter monopsony power that firms hold over workers (see Word of the Day)
• Protect against discrimination

Unions influence pay by:

• Collective bargaining: negotiate pay levels above the current levels that exist. This is only effective if the union has control over the entire labour supply available in the industry.

• Closed shop agreements: Employers and unions agree that all workers be part of the union. This is now illegal in the UK because it encourages labour restrictive practices. Two types, pre-entry and post-entry. Pre-entry is when workers must join the union before starting employment. Post-entry is when workers not part of a union start employment, but have to join a trade union to keep the job.
• This is to prevent free-riders benefiting from the mark-up wages bought about by trade unions.

Keynes vs Hayek (free market)

The greatest economic debate has been between the Keynesian views about government intervention in the economy and the Hayek views that markets should be left alone.

These two videos put some fun into the fact that these opposing views will always battle it out to be the best option. In your exam, it is important to form your own opinion about the economic issues you are discussing.

http://econstories.tv/2010/06/22/fear-the-boom-and-bust/

http://econstories.tv/2011/04/28/fight-of-the-century-music-video/

So which are you?

Word of the Day

Monopsony

A type of market structure where there is only ONE buyer and many sellers. An example of pure monopsony is a firm that is the only buyer of labour in an isolated town. Such a firm is able to pay lower wages than it would under competition. Although cases of pure monopsony are rare, monopsonistic elements are found wherever there are many sellers and few buyers. Monopsonies, like monopolies and oligopolies, are a form of imperfect competition.

Fall in Consumer Confidence

Consumer confidence continued to fall last month amid increased uncertainty around the UK's economic outlook and is set to dip further in August, a survey said today. The recent riots earlier this month could trigger even more deterioration in confidence as the violence hit people's willingness to spend, Nationwide Building Society warned.

Nationwide said its Consumer Confidence Index was 49, well below its average reading of 79. In June, the reading was 51.

Economists are predicting that the rest of 2011 will see no considerable improvement in consumer confidence. This may lead to even greater falls in stock markets around the world and could lead the world back into recession. Falling consumer/business confidence is the last thing we need to achieve periods of economic growth in the coming years. The LRAS curve may shift leftward if AD and (SR)AS shift leftward too.

The Government’s plan to freeze public sector pay for now and other private sector firms simply not rising wages in line with inflation (known as fiscal drag) means that the cost of living is rising, severely affecting consumer confidence.

Major purchases of big-ticket items are the hardest hit, Nationwide said, and consumers also continue to expect a fall in house prices over the next six months. This means the value of people’s assets are falling, and consumers will feel ‘poorer’ furthering the fall in consumer confidence.

Word of the Day

Backwards Bending Supply Curve

When the wage rate is W1, the number of hours worked is L1. If wages rise to W2, the number of hours worked rises to L2. This is due to something called the substitution effect. The substitution effect relates to the fact that leisure becomes more expensive compared to the other goods that money from wages can buy (for example, the worker can now start buying food from the Asda ‘Extra Special’ range rather than ‘smart price’ products). Workers prefer to work over leisure time. The worker responds to the rise in hourly wage rates by substituting more labour over leisure time.

After wages rise to W3, labour – the number of hours worked – falls to L3. This is because of the income effect. The income effect relates to the fact that a worker can achieve a target income without working so many hours and therefore prefers more leisure time once this target income level has been reached. A worker chooses to work fewer hours to enjoy more leisure time because leisure time is a normal good, rather than an inferior good. This means that as real incomes rise, demand for leisure time – the normal good – rises as well.

Word of the Day

Functions of price

1. The signalling function

Prices give information to consumers to help them decide what they should buy. A simple example would be to take the example of cameras. If a disposable camera is more expensive than a digital camera, then this conveys information to the consumer that a digital camera may have more functions, take better pictures, be easier to use…etc.

2. The rationing function

Prices can allocate resources accordingly given that consumers have a fixed income. It rations and allocates scarce resources among competing uses. For example, if my income was fixed at £20,000 per annum, I may choose not to buy a £150 handbag because my income may not support such a purchase. However if my income was £170,000 per annum, I might choose to purchase the handbag because I can afford to given my income levels.

3. The incentive function

Prices create incentives for consumers to alter their economic behaviour. For example, if a retailer cuts the price of bread by 50%, consumers are given incentives to buy a loaf of bread. This is because a loaf of bread is cheaper relative to other goods that the same amount of money can buy.

Monopoly

·     A few firms dominating the market. Actual monopolies (only one firm in the market) are very rare.

Monopoly Equilibrium

The profit maximisation point is Q1 and P1, where MR=MC. The equilibrium quantity is Q1, however the equilibrium price is not P1. Instead the firm charges P3 since P3 is the maximum price the monopolist firm can charge while succeeding at selling quantity Q1.

Therefore the total revenue gained by the firm is rectangular area P3XQ1O. The total costs the firm incurs is the rectangular area P2YQ1O. The supernormal profits that the monopoly firm makes is P3XQ1O - P2YQ1O (total revenue minus total costs), which equals P3XYP2. This profit is the monopoly profit that the firm makes.

The monopoly IS the industry and therefore there is no separate market demand and supply diagram (like with perfect competition, see here and here). They get combined and put together because the market is the monopoly. AR is downward sloping because if they set a large price, following the law of demand, the number of units they will sell will fall and vice versa.

This diagram is the long run equilibrium and the short run equilibrium. Barriers of entry prevent new firms entering the market, thus monopoly profits are sustained in the long run as well. Firms want to be monopolies because monopoly firms sustain supernormal profits in the long run.

Efficiency

For a monopolistic market, the firm is…

·     NOT allocatively efficient. The firm does not produce above quantity Q1. Price does NOT equal MC.

·     Not productively efficient because it is not producing at its cost minimising point (the lowest point on the AC curve).

Benefits of a monopoly:

·     Market can benefit from economies of scale due to lower ACs.

·     Supernormal profits can be used for R&D.

This model, like perfect competition, can be used to compare real life markets with.

Word of the Day

Positive Output Gap

Occurs when an economy is producing above its trend rate of growth. The economy is said to be in a boom. Please see the economic cycle for more about positive and negative output gaps.

Word of the Day

Normative Statement

A statement that cannot be scientifically proven, compared to a positive statement. It is useful to know the difference when examining economic views and evaluating how accurate the view is.

Word of the Day

Production Possibility Frontier

The PPF curve shows the combination of capital and consumer goods that can be produced within the economy. The PPF curve essentially shows what the economy can produce. See Production Possibility Frontier and Long Run Aggregate Supply for a more detailed view.

Word of the Day

Game Theory

A mathematical approach adopted to study the conflict and decision making of oligopolists and model the competitive behaviour of firms in oligopolistic markets. Game theory, at A Level, should be applied to oligopolies in terms of understanding why cartels are formed and broken.

Word of the Day

Perfect Competition

A type of market structure where there are many firms in the market selling a homogenous product. See perfect competition notes short run and long run to learn a more detailed view of perfect competition.

Word of the Day

Deregulation

The removal of regulations that restricted competition and freedom of market activity. In the last 30 years, the UK government has deregulated the following markets: airlines, radio stations, bus companies, televisions and telecommunications. The coalition government recently introduced 11 enterprise zones in the UK whereby these regions would be subjected to fewer planning regulations (as well as tax breaks), thus are an example of deregulation policies in the current government. For more on the enterprise zones, click here.

Word of the Day

Negative output gap

Occurs when the economy is performing below its trend rate of growth. For more detail, click here.

Word of the Day

Money Supply



The total amount of money in circulation in the economy at any given time. See the quantity theory of money for more.

The Quantity Theory of Money

The quantity theory of money

·       Explains that a rise in the money supply leads to excess demand, leading to a rise in prices, inflation. To put it simply, too much money chasing too few goods.

·       The quantity theory is a special case of demand pull inflation.

·       The Fisher Equation of Exchange provides evidence for the quantity theory of money.

MV = PT

M = money supply               

The total amount of money in circulation in the economy at any given time.

V = velocity

The number of times the money circulates around the economy at any given time. V is influenced by methods of payments such as cash, bank overdrafts, credit or debit. Methods of payments are limited therefore V remains constant.

P = price level

T = total transactions

The measure of all the purchases of goods and services in the economy. T remains constant because the theory assumes money is a medium of exchange, not a store of value, therefore people spend quickly any money they receive.

If V and T remain constant, they cancel each other out and thus a M = P. This means that a rise in M will create a rise in P, therefore explaining the theory.

Criticisms

Keynesians generally reject the theory because….

1. There are too many assumptions that the theory relies upon. They don’t believe that people quickly spend any money they receive. Instead, people hold money balances if share prices/bonds are likely to fall for example, thus V and T cannot remain constant.

2.  If there is spare capacity in the economy, Keynesians believe that real output and employment will increase, not the price level. However a counter-argument for that would be the Phillips Curve (more on that to come!).

3. If M has increased, the effect it can have on P is limited if V balances out the increase in P. Reflation of the economy can further limit the effect of a rising money supply on the price level.

4. Reverse causation: Inflation causes an increase in the money supply, not the other way round. Cost push inflation occurs and the money supply adapts (by rising) to finance a higher price level set for consumers to pay.

Word of the Day

Automatic Stabilisers

A factor that changes in such a way as to automatically stabilise AD and the economic cycle.

They reduce the contractionary multiplier effects from changes in AD. This happens because when the economy is in a recession, there is lack of AD and unemployment tends to rise. Unemployment benefits are automatic stabilisers used when the economy is in a recession. Spending on unemployment benefits increase because more people are unemployed and this causes government borrowing to rise, injecting demand into the economy/circular flow of income.

In a boom, automatic stabilisers reduce the expansionary multiplier effects on the economy. Progressive taxation is used as the automatic stabiliser. As employment and incomes rise, tax revenues increase as a faster rate than income is rising, taking out demand from the economy and preventing it from overheating.

Automatic stabilisers help reduce volatility of the economic cycle. 

Word of the Day

GDP

Gross Domestic Product measures the value of all the goods and services produced within the economy.

Word of the Day

Elasticity

Elasticity measures the responsiveness of one variable following a change in another variable. For example, we’d like to know demand for a good will change after a firm has increased the price of it. This is measured using the concept of elasticity.

1. Price elasticity of demand

PED measures the responsiveness of consumers following a change in the price of a good. It is the proportionate change in demand after the price has changed.

2. Price elasticity of supply

PES is the proportionate change in supply of a good following a change in the price of it.

3. Income elasticity of demand

Measures the change in quantity demanded of a good following a change in consumers’ income.

4. Cross elasticity of demand

Measures the proportionate change in demand for good A following a change in the price of good B.

Word of the Day

Laffer curve

The Laffer Curve shows how a government’s tax revenue changes with changes in the average tax rate.

·       When the average tax rate is 0%, tax revenues are 0.

·       Tax revenues are also 0 when the average tax rate is 100%.

·       Tax revenues are maximised at the highest point on the curve, in this case it’s at a 50% average tax rate.

·       As the average tax rate increases, tax revenues rise until a certain point whereby after, there is no longer an incentive to produce output and people work less or do more to avoid paying the tax which reduces total revenue because the opportunity cost of paying the tax rises.

·       The Laffer Curve suggests that total tax revenues will increase at a lower tax rate, therefore cutting taxes will increase total tax revenues and create a virtuous cycle.

·       Reducing the tax rate creates incentives to work and produce output, stimulating economic growth, thus increasing total tax revenues.

RSAnimate

A video by the RSA providing food for thought.... One word for it, brilliant!

Do check out the other RSAnimates, they are fantastic!

Perfect Competition Long Run Equillibrium

Long run equilibrium

Because supernormal profits can be made in the short run, new firms enter the market.

When new firms enter the market, market supply increases from MS1 to MS2 which drives the price down from P1 to P2. There is a new equilibrium of price P2 and quantity Q2. For the individual firm in the market (diagram on the right), the firm now charges price P2 leading to MR and AR moving down to P2 as well. Point Y is the profit maximisation point (MR2=MC), therefore the firm will sell at quantity Q2 and total revenue gained is the rectangular area P2YQ2O. Because AC=MC, the rectangular for the firm’s total costs is P2YQ2O as well. This means that supernormal profits are not being made, only normal profits are being made. Costs per unit are equal to revenue per unit and so the firm is unable to make supernormal profits in the long run. Price = Long run ACs as well.

Furthermore, the firm is producing fewer units of output. Because there are no supernormal profits being made by firms within the market, there is no incentive for firms to enter or exit the market and the market is said to be at rest.

Efficiency

In the LR in a perfectly competitive market, there is….

·       Productive efficiency because the firm is producing at AC’s lowest point (Q2). The firm is producing at its cost minimising point. Resources are used efficiently.

·       Allocative efficiency because firms are allocating the same amount of extra cost (MC) to customers as customers are allocating extra revenue to firms (P). Therefore P=MC, so it is allocatively efficient.

A perfectly competitive market is the only type of market structure where it is possible to be both allocatively and productively efficient.

This model of a perfectly competitive market is a theoretical extreme and is used to judge how closely real world industries approximate to this even if they are not truly competitive. This model, although unrealistic, holds the strong argument that resources are allocated efficiently and firms make beneficial exchanges which enable it to be efficient. The model provides a benchmark in which imperfectly competitive markets can be compared and contrasted.

Word of the Day

Interest Rate

The cost of borrowing and the reward for saving. The interest rate in the UK has remained 0.5% since March 2009 and is likely to remain at this rate until at least the end of the year. The US interest rate will remain 0.25% until mid-2013. A low interest rate is supposed to lead to an increase in AD, thus is the Central Bank's attempt to try and revive the economy. A high interest rate attempts to increase savings and reduce consumption, thus lowering AD.

Perfect Competition Short Run Equilibrium

Assumptions behind a perfectly competitive market (conditions):

·       Large number of buyers and sellers with insignificant market share.

·       Freedom of entry and exit into the market. There are no barriers to entry and exit in the long run, the market is open to new suppliers.

·       Consumers have perfect knowledge about prices.

·       All firms have equal access to resources (e.g. technology) – perfect factor mobility.

·       Homogenous products that are perfect substitutes for one another.

·       Independent action by firms will not influence the market price as each individual firm is too small. This means that the firm is a price taker.

·       No externalities of production or consumption.

Perfectly competitive markets are rare, however close examples include:

·       Foreign currency – homogenous product, each trader is relatively small in the market and the trader has to take the given price.

·       Fruits and vegetables – homogenous product, firms are price takers, large number of buyers and sellers…etc.

When the firm is a price taker, there is little percentage difference in prices within the market. But most firms sell at the prevailing, ruling market price.

Short run equilibrium

The market ruling price is P1, at equilibrium. The diagram on the left illustrates the whole market, while on the right is the diagram showing the individual firm in the market. As the firm is a price taker, AR=MR=P which also equals market demand because there is lack of brand loyalty, making the demand curve perfectly elastic, and because the firm cannot influence the price.

From the diagram on the right of the individual firm, the firm is producing at profit maximisation, Q1. The shaded area shows the abnormal/supernormal profits being made since the area OP1XQ1 shows total revenue and OP2YQ1 shows total costs. Profits = revenue – costs, therefore profits are equal to OP1XQ1 - OP2YQ1, supernormal profits. The firm is only able to make abnormal profits in the short run in a perfectly competitive market because new firms are attracted by the prospects of making abnormal profits in the long run and enter the market, this erodes the abnormal profits.

However, not all firms make abnormal profits in a perfectly competitive market in the short run. This depends on the position of the AC curve.

For the firm above, there are subnormal profits being made because average costs are greater than average revenues. Selling at the market ruling price of P1 will therefore only enable the firm to make subnormal profits.

Case Study for the Office of Fair Trading

The OFT has fined 9 companies a total of £50m for price fixing of dairy products in 2002 to 2003. Arla, Asda, Dairy Crest, McLelland, Safeway (now Morrisons), Sainsbury's, Tesco, The Cheese Company and Wiseman are the dairy producers/supermarkets involved who fixed the price of milk, cheese, butter and other dairy products.

This is a good case study to mention in the exam to discuss why firms would want to engage in collusive agreements (see cartel although this isn't necessarily a cartel, it displays characteristics) and the effectiveness of regulatory bodies in protecting consumers against anti-competitive practices.

UK Economic Growth

Yesterday it was announced that the US Federal Reserve (Central Bank) will keep US interest rates at 0.25% until at least mid 2013. It has been 0.25% since December 2008 and the main reasoning behind this is to try and prevent the US economy from undergoing a double dip recession. Because of this, the Bank of England are likely to keep interest rates in the UK 0.5% until the end of the year. See article for more and watch the video for what Mervyn King (Governor of the Bank of England) had to say.

There are fears that many major economies may face double dip recessions and this risk is heightened by the turmoil in the EU which poses great risk to the UK economy in terms of the banking system and how it will affect UK banks. Furthermore, the rate of inflation is likely to increase to 5% or higher at some point this year before dropping down, affecting disposable incomes and thus decreasing consumption.

Word of the Day

Recession

A fall in national output (GDP) for 2 successive quarters or more. Recessions in the UK: 1980, 1990 and 2008 lasting two years or less.

Word of the Day

Stagflation

A situation in which output is falling and inflation is rising. Unemployment is high. Some economists say that the period we were facing earlier this year was a period of stagflation because economic growth was barely above 0% and the rate of inflation was double the government's target.

Word of the Day

Relative poverty

Someone is in relative poverty when their incomes are rising at a lower rate than everyone else's. A more formal definition is, if someone is in relative poverty, their income is below a specified proportion of average household incomes (below the average incomes of the population).

Many students will "never pay back loans"

An article published this morning warns that many students will not be able to pay back their student loan regardless of whether you are being charged £6000 or £9000 for your university course. If you think you will be worse off having fees of £9000 rather than £6000 per year, then you may be wrong. This is because after 30 years your debt is written off and you still would not have finished repaying your full debt by this time.

Martin Lewis, from MoneySavingExpert, calculated that if a graduate starts earning £30,000, then the debt of fees of £6000 per year will remain unpaid. If a graduate starts earning £40,000 after graduation, the graduate will pay back their fees of £6000 per year in 24 years. This means that students that start earning £30,000 will never pay back their debt, no matter what their fees. And the likelihood of graduates paying back fees of £9000 is very low.

Whether you have to pay your £6000 fees or £9000 fees, the monthly repayments remain the same. You will have to pay 9% of everything over £21,000 and this increases as you begin to earn more. In some ways, I suppose it is a good thing that you are not debt burdened for the rest of your life (with your student loan fees that is!) and there is a chance that you never have to pay back all the money you owe. But unfortunately, you still have to pay more than the preceding years.

This article can provide thought for the law of unintended consequences. Ask yourself though, how can the government not have calculated how many debts will remain unpaid?

Beyond the crisis: lessons for the future of the eurozone

Great lecture at the LSE on 7th September. A ticket must be requested on 31st August if you want to attend. Please consider going if you want to learn more about the Eurozone crisis. Lecture is conducted by Herman Van Rompuy, Prime Minister in Belgium from 2008 to 2009. More information found on the LSE website.

Hope to see you there!

The Economic Cycle

The Economic Cycle

Also known as the business cycle, it shows how the economy fluctuates above and below its trend rate of growth.

When the economy is performing above its trend rate of growth, there is a positive output gap. During a positive output gap, the economy is in a boom whereby growth is high and unemployment is low.

When the economy is producing below its trend rate of growth, there is a negative output gap. The economy is said to be in a recession where growth is very low or even negative, along with high unemployment.

Reasons for these fluctuations

There are many theories devised to help explain fluctuations in the economic cycle. In the exam, it is important to prioritise your arguments, thus I have ordered the following according to my opinion, of course you may think otherwise:

1. Outside shocks

Outside shocks can be classified by demand shocks and supply shocks. Demand shocks affect AD in the economy, and can lead to a recession or downturn. For example, e-coli in German cucumbers supposedly sourcing from Spain led to AD for Spanish (and other European grown) vegetables, see article, to fall (from Russia in particular). 

A supply side shock affects AS within the economy. Examples include conflict in the Middle East affecting oil supplies and the Japanese earthquake affecting supply chains of manufactured goods, see article. Other evidence for this is, if you take a look at this website, you will see that Japan is currently experiencing negative growth, due to the earthquake.

2. Speculative bubbles

Rapid growth of asset prices (gold, property, shares…) leads to a bubble because people will speculate that the price will continue to rise and buy the asset. When the price is above the real value of the asset, people will start to sell and the bubble bursts. Speculation can destroy business and consumer confidence. People will stop spending, leading to a recession. This contributed to the UK recession (2008) when house prices plummeted, see article.

3. Changes in technology on the supply side of the economy

Technical progress can increase the rate of growth of total factor productivity (TFP). A change in TFP measures the change in total output when all the factors of production are changed in the economic long run. Technical progress measures how much more productive the factors of production have become over a period of time. Technology has inevitably increased the rate of economic growth in some developing countries where it is much needed, e.g. mobile phones in Uganda, and it has also led to the growth of developed countries thus creating the world’s most powerful economies, e.g. Japan.

4. Changes in inventory

Firms invest in stocks of raw materials and finished goods to smooth production and cope with changes to demand. However sometimes firms can over-anticipate demand leading to unsold stock, which can lead to a cut in current production and a slow down in the economy. Recessions in the UK and USA are made worse due to changes in inventory.

5. Political business cycle theory

Governments tend to cut taxes or implement new policies to give people more money before elections as a way a ‘buy votes’. People have more money, thus increasing spending leading to a boom period. After the election, governments deflate aggregate demand to prevent the economy from over-heating.

6. The multiplier and the accelerator

An increase in investment increases AD and leads to an increase in national income. This is known as the multiplier. Higher income leads to more investment (increasing AS), known as the accelerator. The extent to which the multiplier increases AD is down to:

a)     The marginal tax rate

b)    Marginal propensity to import

c)     Savings

Therefore this isn’t top in my list because, for the UK, the multiplier is not large since all of the above are reasonably large (the multiplier is calculated by 1 divided by the above). If the values for all of the above are high, there will be lower investment.

7. Climatic factors

El Nino/La Nina and sun spots (or lack of) can create extreme conditions resulting in   changes to harvest, affecting the agriculture market. The price of the grain and the quality of food can be damaged, leading to a fall in output in the producer country. This can lead to a fall in business confidence and thus a recession. El Nino Southern Oscillation is an event that occurs every 2 to 7 years and last 1 to 2 years. Cold water is suppressed in the Pacific Ocean, causing warm, dry weather over Southern Asia (India, Philippines…) and Oceania (Australia, New Zealand…) and increased rainfall over the America’s. El Nino can also affect the fishing industry. Sun spots can increase surface temperatures, causing warmer and drier weather.

Word of the Day

Cartel

A collusive agreement made by firms (or countries in the case of OPEC) to fix prices and sometimes fix output. Firms will want to collude to decrease the amount of uncertainty faced in the market. Cartels are illegal, and the government regards them as anti-competitive. Cartels can increase inefficiency in the market because it protects inefficient firms, while the efficient firms enjoy supernormal profits (watch up to 4.18 on this video, disregard the market structure and understand that supernormal profits are depicted by the shaded area on the video).

Word of the Day

A positive statement

A statement that can be proven to be true or false. A positive statement does not contain any bias and is simply a fact or a false fact. For example, if I say that paper is not made from wood, this is a positive statement because one can test what paper is made from (the statement will inevitably be made untrue since paper is made from wood, however that doesn't mean the statement is not a positive one).

In economics, it is useful to identify a positive statement from a normative statement.

A normative statement

A statement that is based on opinion and cannot be proven true/untrue. For example, 'fiscal policy is more effective than monetary policy at increasing aggregate demand', is a normative statement because it contains one's view and cannot be tested (because fiscal and monetary policy are frequently used hand in hand).

Production Possibility Frontier and Long Run Aggregate Supply

The PPF shows the combination of capital and consumer goods that can be produced within the economy. The PPF shows what the economy can produce. If the economy is producing inside the PPF, point X, it is in a recession. Unemployment is high and the economy is not producing at it’s full productive capacity.

When the economy is producing on the PPF, point Y, it IS producing at its full productive capacity. It is also producing on the LRAS curve, point V on the supply/demand diagram. Real national output is YFE and the price level is P1. Full employment of resources has been achieved, which means that the labour force is fully employed, see Word of the Day. The only way to increase output is by increasing investment in capital goods (which increases consumer goods) thereby increasing LRAS. If this happens, economic growth is occurring in the long run. See Word of the Day. LRAS1 moves rightward to LRAS2 and thus SRAS1 shifts rightward to SRAS2. Real national output in the economy has increased from YFE to YFE2. Assuming AD remains unchanged, the price level falls from P1 to P2.

Word of the Day

Full Employment

According to Beveridge's definition, which is perfectly acceptable to use in the exam, full employment is when 3% or less of the labour force is unemployed.

According to the free market definition, full employment occurs when ASL = ADL

Full employment also occurs when the economy is producing on the LRAS curve, see PPF and LRAS. This is because when there is no spare capacity, all workers willing and able to work are working.

It does not mean that all members of the working population are in employment, frictional and structural unemployment is always occurring.

Stock Markets take a heavy dip

The FTSE 100 and Dow Jones dropped heavily yesterday (Friday) due to the uncertainty bought about by US economic growth and it's debt ceiling, and Spain and Italy's unmanageable public finances. There are fears that Italy and Spain may need bailouts as well, which is why investors sold these stocks.  Spain has the fourth largest economy in the EU, however its bond yields (interest rates on government bonds) remain high at 6.4% and in Italy, 6.3%. Greece, Ireland and Portugal had levels of above 7% when they desperately seeked bailouts by the IMF and European Union, highlighting the risk that Italy and Spain face. Have a look at this video to learn more.

The FTSE 100 fell by almost 3.5%, it's lowest fall since the collapse of Lehman Brothers in September 2008. The Dow Jones fell by 4.3%, Japan's Nikkei fell by 3.7% and Hong Kong's Hang Seng fell by 5%. 

Only time will tell what will happen, how investors react to markets will influence economies in the way they want because speculation is a powerful tool. If things continue the way they are, the EU may have to start preparing more bailout packages. As for the USA, someone once told me that when America sneezes, the whole world catches a cold.

Conditions that affect Supply and Demand

Demand

These following conditions cause demand to fall and shift leftwards:

• Low prices of substitute goods (goods that perform the same function as each other and can be used as substitutes for one another, for example, a computer and a laptop). If substitute goods are cheaper, then demand for the original good will fall because consumers are buying the substitutes (assuming everything else remains constant – ceteris paribus).
• High prices of complementary goods (goods that are bought with each other, for example a printer and printer ink). If complementary goods are sold at high prices, consumers may decide the purchase is not worth it, ceteris paribus.
• Low personal income. This leads the household with lower disposable income for spending, therefore demand for goods and services may fall.
• Tastes and preferences for the good changes.

The reverse of these factors will cause demand to rise and shift rightwards.

Supply

The following factors cause (short run) supply to fall and shift leftwards:

• High costs of production
• Wage costs
• Rent prices
• Commodity/raw material costs
• Cost of borrowing (higher interest rates)
• Higher taxes
• Corporation tax
•  VAT
• Excise duties
• Lack of subsidies/grants

These factors can cause firms to leave the market, thus resulting in a fall of supply.

The opposite of the factors above can cause supply to increase and shift rightwards, along with the addition of technical progress.

Word of the Day

Law of Diminishing Marginal Returns

States that when a variable factor of production is added to a fixed factor of production, the result will be an increase in marginal output. However after a certain point, the marginal returns will eventually start to fall. The law only operates in the SHORT RUN

When more and more labour (variable factor) is added to machinery and equipment (fixed factor), the marginal product of labour will fall because the workers are getting in each other's way. They are not any less hard working or motivated.
The LoDMR is also the reason why the AC curve falls and then increases.

Before point A, average costs fall as output increases because the addition of variable factors cause an increase in marginal output. Also, the average variable cost (AVC) curve falls slightly , accounting for the fall in average total costs.

After point A, AC rises due to the LoDMR because variable costs to rise.
Remember AC = AVC+AFC  therefore if AVC rises, AC rises. (AFC - average fixed cost)
The spreading of fixed costs become insufficient in the short run.

Great Perfect Competition Video

Okay, so here's a really good video on Perfect competition.

The first diagram drawn shows abnormal/supernormal profits.
Second diagram drawn shows normal profits.
Third diagram shows subnormal profits.

Word of the Day

Economic Growth

An increase in the economy's potential level of real output and an outward movement in the economy's production possibility frontier (PPF).

Short run economic growth is a movement from point X, inside the PPF, to Y on PPF1. Short run growth occurs when the economy recovers from a recession and employment increases.

Long run economic growth is shown by a movement from point Y to point Z. The definition mentioned above applies to LONG RUN economic growth.

Word of the Day

Aggregate Demand

Total planned demand for goods and services produced within the economy over a given time period.

Components of AD are:
AD = Consumption + Investment + Government Spending + (Exports - Imports)

A fall or rise in any of the components of AD will cause AD to fall or rise respectively.

Exchange Rate Presentation

I know that exchange rates (as interesing as they are!) can sometimes be very difficult to get your head around so this powerpoint I made should help set things out clearly. It explains the exchange rate mechanism from freely floating to (rigidly) fixed as well as outlining the advantages and disadvantages of them.

Presentation here

Word of the Day

The Exchange Rate


The exchange rate is the price of one currency relative to another, for example 1€ is £0.88 and £1 is $1.64. There are four types of exchange rate mechanisms, shown below on the scale. Freely floating has little/no management while rigidly fixed is managed by the country's Central Bank.