Transcript for:
Micro and Macro Economic Concepts

Microeconomics Econs 🩷 Theme 1: The Central Economic Problem Ceteris paribus is an assumption that all other factors remain unchanged. The ceteris paribus assumption is important in describing cause-and-effect relationships because in any experiment, if event A causes event B to happen, then everything else that can cause event B to happen must remain constant. In reality, the assumption of rationality is unlikely to hold. (Many definitions in Econs have ceteris paribus) A positive statement is a objective statement whose accuracy can be tested. A normative statement contains value judgement and whose accuracy cannot be proven or disproved by looking at evidence. Factors of production are resources that are used in the production of goods and services. FOP: (CELL) 1. Capital →refers to man-made goods used to produce other goods and services over a period of time. Often referred to as capital goods, such as machinery and equipment, they do not directly yield utility but do generate future utility indirectly. 2. Entrepreneurship →refers to the factor of production that takes overall responsibility for the decision-making process in the firm so that other factors of production can be combined to produce a good or service. 3. Labour →refers to human beings as factors of production (either physical or intellectual). Quality of labour depends on skills and abilities of workers. 4. Land →refers to all natural resources available. Both renewable and non-renewable. Scarcity → choice →opportunity cost i) Explain the central economic problem of scarcity Scarcity is a situation where human wants are unlimited whereas the resources available to satisfy these wants are limited. Consumers aim to maximise their utility; producers aim to maximise profit; government aims to maximise social welfare. Consumers do not have the wealth to satisfy every want and producers cannot produce all the good and services to satisfy human wants, because most resources have alternative uses. Scarcity is not shortage, shortage can be solved, but scarcity cannot be! → Unless we have an unlimited amount of resources to satisfy the unlimited wants, scarcity is a problem that cannot be solved. As producers buy more machines and produce more of good A, more resources are allocated to the production of good A. This means fewer resources available for other goods and services. ii) Explain the concept of opportunity cost and nature of trade-offs in the allocation of resources Opportunity cost is defined as the value of the next best alternative that has to be forgone to satisfy a particular want. Hence, choices need to be made as there are many different uses of resources. (the value that people place on a benefit that results from a choice made varies) Eg. Imagine you have $10, and you're trying to decide between buying a book or buying a movie ticket. If you buy the book, your opportunity cost is the enjoyment you could have had from watching the movie. And if you choose the movie, your opportunity cost is the knowledge and enjoyment you could have gained from reading the book. It's basically what you miss out on when you choose one option over another. * ChatGPT Note: the next best alternative is what a consumer could be doing other than the chosen choice which would bring a benefit to them iv) illustrate the concepts of scarcity, choice and opportunity cost using a PPC diagram The PPC shows all the combination of two goods that a country can produce within a given time period, with all its resources fully and efficiently utlilised at a given state of technology. Assumptions made: (from definition) * All available resources are fully and efficiently utiltised * Output is based on a fixed time period * Quantity, quality of resources and state of tech is fixed What different combinations mean: Productive efficiency is a situation where goods and services are produced at the lowest possible average cost of production. Allocative efficiency is a situation where resources are allocated to produce a combination of goods and services that maximise social welfare. * Combi G (inside PPC), is attainable but productively inefficient. Goods and services are not produced at lowest possible average cost of production. This could be caused by: * Resources not being fully employed → FOP not used to maximum capacity due to various reasons eg. unemployment during recession * Under-utlisation of resources →more emphasis on how FOP are being used at a level below their full capacity eg. factory operating below its max. Capacity Combi A, B, C, D, E and F are all productively efficient but only 1 is allocatively efficient, where society’s welfare is maximised and the combi produced is fully aligned with society’s taste and preference. Illustration of concepts: Scarcity is illustrated by points outside PPC. (unattainable) Society is constrained by current amt. of available resources and its level of tech, hence faces scarcity. Choice illustrated by points on PPC which are attainable. Only 1 combi can be produced at a fixed time period Opportunity cost illustrated by downward sloping nature of the PPC. A PPC concave to the origin reflects increasing opportunity cost. As the country produces more consumer goods, it has to sacrifice increasing amounts of capital goods. (eg. at point D, to produce an additional 5 million units of consumer goods, 20 million units of capital goods have to be given up) →because some resources are better suited for production of some goods than others. As an economy concentrates more on the production of one type of good, it has to start using resources that are less suitable →more resources diverted from the production of the other good in order to produce more of this good →cost of additional output increases (For example, if a country heavily relies on a certain type of metal for manufacturing, the increased demand for that metal may lead to scarcity, forcing producers to use less suitable or more expensive alternatives. Increasing demand can also drive up price of the metal -ChatGPT) Why is a shift in the PPC not always parallel? →More resources of certain goods are discovered, hence there is an increase in the production of that good while the production of the other good remains constant. →The type of resources that improves in quantity/ quality are more suited to produce a certain type of good. Actual and potential growth on PPC: Actual economic growth is defined as the realised increase in real national output for a given period of time. It is illustrated by a movement of a point within the PPC to a point nearer to or on the boundary of the PPC. (eg. movement from combi G to combi D) Potential economic growth is defined as an increase in the economy’s productive capacity over a given time period. It’s illustrated by an outward shift of the PPC, economy could potentially produce more goods and services →higher consumption and higher SoL. Note: PPC shows types of goods that can be produced, NOT types of resources. v) explain why and how changes in the quantity and quality of resources and technology can cause PPC to shift 1. Increase in the quantity of FOP (eg. discovery of new resources, increased working population) →increase utilisation of resources →increase productive capacity →outward shift 2. Increase in quality of FOP (eg. increase productivity of workers through higher education and training, improvement in tech) →increase utilisation of resources → increase productive capacity →outward shift vi) explain the marginalist approach to decision-making The marginalist principle involves weighing the marginal benefits and marginal costs of any activity in the pursuit of maximising self-interest. Marginal benefit: the increase in total benefit that results from carrying out 1 additional unit of the activity. Marginal cost: the increase in total cost that results from carrying out 1 additional unit of the activity. MB > MC: increase the level of activity as additional units add more to benefits than cost MB = MC: self-interest is maximised; no further action needed MB < MC: decrease the level of activity as additional units add more to costs than benefits Trade-off between current and future consumption: 1. Country produces more capital goods in current time period (point A) Benefit Cost Increase capacity of the economy to produce more goods and services (consumer goods) for future consumption Less resources allocated to produce consumer goods for current consumption →sacrifice current SoL Hence PPC shifts from PPC1 to PPC 3 in the future 2. Country produces more consumer goods in current time period (point B) Benefit Cost More resources allocated to produce consumer goods for current time periods →increase current SoL Increase in capacity of the economy to produce goods and services is less significant compared point A Hence, PPC shifts from PPC1 to PPC2 in the future The higher the level of investment in capital goods, the higher the rate of potential economic growth and greater increase in future consumption. vii) Explain the rational decision-making process economic agents adopt with the aid of examples Econ agents →consumers, producers, govt * Constraints * Benefits and costs →rational econ agents consider the benefits of a decision and weight them against opportunity cost. Consider how their decision maximises self-interest * Information →attain fairly accurate understanding of costs and benefits * Perspectives →consider how their decision impacts others In order to maximise self-interest, econ agents have to review their decisions if the intended consequences are not achieved, if there are adverse unintended consequences or if they experience changes in their decision-making considerations over time. * Intended consequences →assuming econ agents make decisions with perfect info, behave rationally and econ conditions remain unchanged →intended consequence occurs * Unintended consequences →May be due to an inability by econ agents to access complete info or consider all perspectives * Changes →decision made may no longer be optimal →need to for decision-making process to be revisited such that intended outcomes can be achieved Theme 2.1: The Price Mechanism and its Applications 💸 Assumptions made: * Markets are perfectly competitive * There is no market failure Invisible hand theory →price mechanism works and choices are made due to the actions of producers and consumers without govt intervention i) Explain the concept of effective demand and supply ii) Explain the law of diminishing marginal utility iii) Explain the determinants of demand and supply iv) Distinguish between changes in quantity demanded/supplied and demand/supply; DEMAND: Demand is the quantity of a good that consumers are willing and able to purchase in a given time period at every price level, ceteris paribus. The law of demand states that when the price of a good rises, its quantity demanded will fall and vice versa, ceteris parbius. ( Hence, there is an inverse relationship between price and quantity demanded. ) The law of diminishing marginal utility states that beyond a certain point of consumption, as more and more units of a good or service are consumed, the additional utility a consumer derives from successive units decreases. Analogy: The more cupcakes I eat, the less I want to eat more cupcakes. The demand curve is downward-slopping because in the case of most goods and services, the marginal utility decreases with each additional unit of consumption, thus the price that a consumer is willing to pay falls correspondingly. The market demand curve is the horizontal summation of all individual buyer’s demand curves for the good at each and every price. Change in own price of good →change in quantity demanded, which is illustrated by a upward/ downward movement along the demand curve. A change in factors other than its own price of the good →change in demand of good, which results in a leftward/ rightward shift of the demand curve. Decrease → leftward Increase → rightward How does a change in demand relate to a change in quantity demanded? → Eg. A decrease in demand will cause the demand curve to shift leftwards from D1 to D3. This means that at any given price, the quantity demanded decreases. If the price is $4, the quantity demanded decreases from 50 units to 20 units. Non-price determinants of demand: (EGYPT) (8) * Expectation of future prices If the price is expected to increase, buyers bring forward their purchases and buy more of the good before price increases, thus demand increases. (eg. before GST increased, ppl went to buy what they wanted). If price of good is expected to decrease, buyers hold back their purchases and only buy the good when the price lowers, hence current demand decreases. * Govt policies * Income level Normal good is a good whose demand rise as people’s income rises, ceteris paribus. When income rises, purchasing power increases and demand for normal goods rises, ceteris paribus. Normal goods are divided into necessities and luxury goods. For necessities, increase in income will result in less than proportionate increase in demand. For luxury goods, an increase in income will result in a more than proportionate increase in demand. When income rises, people spend less and reduce demand on inferior goods to switch to higher quality goods. (a goof whose demand falls as people’s incomes rise, ceteris paribus. * Price of related goods Substitutes are goods which are considered to be alternatives to each other. Substitutes are in competitive demand. An increase in the price of one will lead to an increase in the demand for the other, ceteris paribus. Complements are goods that when consumed together, give rise to a higher combined utility than if the goods were consumed individually. Complements are in joint demand. An increase in the price of one good will lower the demand for the other, ceteris paribus. * Tastes and preference Eg. advertising, change in product quality, fashion trends, weather (eg. consumers want to purchase cold drinks) * Ease of acquiring credit Consumers often borrow finances as they often do not have enough cash or savings to purchase big-ticket items such as property and furniture. Easier credits, such as lower interest rates which result in a lower cost of borrowing or a relaxation of financing rules, wld encourage borrowing for consumption. This would cause demand for goods and services to increase, ceteris paribus. * Population * Exchange rates An appreciation (strengthening) of the domestic currency makes imported substitutes relatively cheaper, causing a decrease in demand for locally produced goods. A depreciation of domestic currency makes imported substitutes relatively more expensive, thus causing an increase in the demand for locally produced goods. SUPPLY: Supply is defined as the quantity of the good that producers are able and willing to sell in a given time periods at every price level, ceteris paribus. The law of supply states that when the price of a good rises, its quantity supplied will rise. When its price falls, quantity supplied falls too, ceteris paribus. →direct relationship When the price of a product/ service increases, producers are typically more motivated to produce more of that product because they earn more profit. Producers aim to maximise profit. Reasons for direct relationship: 1. The higher the price of the good, the greater the revenue earned, hence more profitable to produce this good. Hence, firms will be encouraged to produce more of this good by switching away from the production of less profitable goods. 2. Increasing amounts of a good produced results in total cost of production increasingly rapidly. (workers have to be paid overtime, maintenance cost of machines increase as they are used continuously for longer time periods) If higher output = higher marginal cost, then producers need to get higher price (more revenue) to want to produce extra output. Hence supply curve shows the minimum price that the producers expect to receive for each additional unit of output. Market supply curve is the horizontal summation of all individual firms’ supply curves for the good A change in the own price of the good will result in a change in its quantity supplied, ceteris paribus. This is illustrated by a movement along the supply curve. A change in factors other than the own price of the good will result in a change in teh supply of the good. This is illustrated by a shift in the supply curve. Non-price determinants of supply: (7) * Change in input prices Increases cost of production → production less profitable →level of output producers are willing and able to produce at each price level would decrease →supply decrease * Change in technology Improvement in tech →higher productivity →more output can be produced with same amount of resources →lowers cost of production →more profitable * Government policies Indirect subsidies help to offset cost of production →production more profitable Indirect taxes increases cost of production because producers have to incur additional cost for paying taxes→profits reduced * Number and size of firms * Price of related goods Goods are in joint supply when the production of one goods leads to the production of the other good. Joint supply: An increase in price leads to increase in supply of the other. (eg. cows produce both leather and beef) Goods in competitive supply compete for the use of the same inputs. Competitive supply: Increase in price of one good decreases the supply of the other. * Expectation of future prices * Supply shocks * Due to unexpected events such as wars and natural disasters that destroy resources eg crops, livestock, labour capital while industrial disputes and financial crisis disrupt product —> adverse impact on supply (v) analyse how market equilibrium price and equilibrium quantity are determined via the interaction of demand and supply Equilbrium price and quantity occurs when quantity demanded = quantity supplied. At this equilibrium, the market price and quantity have no tendency to change since there is no shortage or surplus. Shortage is a situation which exist at any price below the equilibrium price where quantity demanded exceeds quantity supplied. At equilibrium P0, quantity demanded exceeds quantity supplied, resulting in a shortage. This puts an upward pressure on price. As price increases, quantity demanded decreases and quantity supplied increases (illlustrated by arrows) until the new equilibrium point E1 is reached. Surplus is a situation which exist at any price above the equilibrium price where quantity supplied exceeds quantity demanded. At equilibrium E0, quantity supplied exceeds quantity demanded, resulting in a surplus. This puts a downward pressure on price. As price decreases, quantity supplied decreases and quantity demanded increases until the new equilibrium E1 is reached. Effects of changes in both market demand and market supply: Fig 16 (a): Demand increases more than the increase in supply. Fig 16(b): Supply increases more than the increase in demand. From observations, it can be seen that a change in the same direction of demand and supply leads to the same effect on equilibrium quantity. Effect on equilibrium price is indeterminate. Fig 17(a): Demand decreases more than increase in supply Fig 17(b): Supply increases more than decrease in demand From observations, it can be seen that a change in the opposite direction of demand and supply means that equilibrium price can be determined. Equilibrium quantity cannot be determined. Resource allocation: 1. Signaling function →Price changes signal to consumers and producers on what they should do 2. Incentive function →The motivation of producers and consumers to maximise self-interest 3. Allocative function →for producers →prices serve to direct producers on how to allocate resources away from overcrowded markets, where there are surplus, and towards markets with shortages. 4. Rationing function →occurs when there is a shortage →ration goods to consumers who are willing and able to pay for them. (vi) analyse how the price mechanism allocates resources Price mechanism describes the process by which consumers and producers interact to determine the allocation of scarce resources between competing uses. →look at notes pg 26-27 Theme 2.1: Elasticity of Demand and Supply 💹 (i) Explain the concepts of price elasticity of demand, income elasticity of demand, and cross elasticity of demand. PED: →use when words like surge, greatly, sharp increase/decrease etc in price show up in qns Price elasticity of demand measures the degree of responsiveness of quantity demanded of a good (effect) to a change in its price (cause), ceteris paribus. Eg. if PED = -2, that means a 1% fall in price leads to a 2% increase in quantity demanded. The sign of PED is always negative because price of goods and quantity demanded are inversely related by the law of demand. If PED > 1, the demand for a good is price elastic as a given change in its prices causes a more than proportionate change in its quantity demanded, ceteris paribus. (Eg. if PED = -5, then 1% fall in price leads to a 5% rise in quantity demanded.) If PED < 1, the demand for a good is price inelastic as a given change in price results in a less than proportionate increase in quantity demanded, ceteris paribus. (Eg. if PED = 0.5, a 1% fall in price leads to a 0.5% increase in quantity demanded.) D1 →price inelastic D2 →price elastic Elasticity of a good varies along the demand curve A perfectly price elastic demand curve means that consumers are prepared to buy all they can at price P and none at all at a higher price. PED = infinity. Eg. A brand of bottled water that has many close substitutes. If the price were to increase slightly, consumers would opt for other brands of botted water. A perfectly price inelastic demand curve means that a given change in the price of the good does not bring a change about quantity demanded. Eg. Taylor Swift concert tickets Determinants of PED: (4) * Availability and closeness of substitutes The greater the closeness of substitutes, the more price elastic a good. (eg. a brand of sugar has many substitutes) The narrower the definition of a good, the greater the degree of substitutability and the more price elastic (Eg. sugar may not have close substitutes because there isn’t much of anything else that tastes similar to sugar. However, a brand of sugar has multiple substitutes) * Time to respond to price change PED increases with time. It takes time for consumers to recognise and to respond fully to a change in the price of a good and to change their spending habits. Consumers need time to gather information, such as whether the price change is going to last or to discover alternatives before altering their consumption patterns in response to the change in price. * Degree of necessity The greater the degree of necessity, the more price inelastic the good is. * Proportion of income Assuming the income of people remains constant, the larger the proportion of income spent on a good, the more price elastic the demand. Consumers are more likely to shop around to find cheaper substitutes when the good is expensive. (iii) Analyse how elasticity concepts can affect the magnitude of change in equilibrium price and quantity Total expenditure/ revenue: Consumer’s total expenditure = total amt of money that consumers spend on a good or service Total expenditure = Price per unit x quantity bought Producer’s total revenue = total amt of money producers receive from the sale of a good or service Total revenue = Price per unit x quantity sold In the absence of govt subsidies and indirect taxes, total revenue of firm = total expenditure by consumers. →In fig 5a, the demand is relatively price inelastic. A decrease in price from p1 to p2 causes a less than proportionate increase in quantity demanded from q1 to q2. The gain in revenue from selling more of the good is less than the loss in revenue from having to sell all previous units at a lower price. Hence, total revenue decreases. →(Hence, for a good with high necessity, the producer of the good should increase its prices in order to increase total revenue.) →In fig 5b, the demand is relatively price elastic. A decrease in price from p1 to p2 causes a more than proportionate increase in quantity demanded from q1 to q2. The gain in revenue from selling more of the good is more than the loss in revenue from selling previous units at a lower price. Hence, total revenue increases. (ii) Explain the concept of price elasticity of supply PES: Price elasticity of supply measures the degree of responsiveness of quantity supplied of a good (effect) to a change in its price (cause), ceteris paribus. As price and quantity supplied of a good are directly related, the sign of PES is positive. Magnitude: The supply of a good is more price elastic if a given change in price results in a more than proportionate change in its quantity demanded. Eg. PES = 5, hence 1% fall in price →5% fall in quantity supplied The supply of a good is said to be more price inelastic if a given change in price results in a less than proportionate change in its quantity supplied Eg. PES = 0.5, hence 1% fall in prices →0.5% fall in quantity supplied S1: price inelastic S2: price elastic Fig 7 shows a supply curve where supply is perfectly price elastic →producer willing to supply infinite amt of the goods at the existing price and none at all at a lower price. (Quite rare in reality.) Fig 8 shows a supply curve where the supply is perfectly price inelastic. Quantity supplied completely unresponsive to price changes. This could be due to there being limited supply and it would be impossible to produce more of the good. Eg. artworks Determinants of PES: * Length and complexity of production process A lengthy and complex production process results in more price inelastic supply. When price increases, producers cannot increase quantity significantly because it takes time to acquire FOP and complete stages of production. Eg. production of cars, a multi-staged process which requires skilled labour, large supplier network etc. * Stock/ inventory levels When a good can be stored w/o loss of quality or undue expenses, supply of good is price elastic as they can release stocks when price increases or hold back stocks when price decreases, at least while stocks last. * Availabilty and substitutability of inputs If FOP easily acquired, then supply of good is price elastic. (availability) If a producer producing 1 good can easily switch resources and put it towards the creation of a product in demand, supply of good is price elastic. (substitutability) Some firms have spare capacity. * Time to respond to price changes Takes time for firms to respond to a change in price of the good or service. In very short run: supple is fixed since it is limited to existing stocks →supply perfectly price inelastic In the short run: firm can employ more FOP (mostly labour) →supply relatively inelastic In the long run: FOP are all variable so supple becomes more price elastic YED: Income elasticity of demand measures the degree of responsiveness of the demand for a good to a change in the income of consumers, ceteris paribus. For inferior good, when income increases →demand decreases. (Inverse relationship) Hence, the sign of YED is -ve. Consumers want to switch away from lower quality goods to higher quality ones as they can afford better alternatives. For normal goods, when income increases →demand increases. (Direct relationship) Hence, the sign of YED is +ve. What are normal goods? (+ve YED) 1. Necessities →demand is income inelastic, an increase in income causes a less than proportionate increase in demand, ceteris paribus. Hence YED < 1. 2. Luxury goods →demand is income elastic, an increase in income causes a more than proportionate increase in demand, ceteris peribus. Hence YED > 1 Determinant of income elasticity of demand (2) * Degree of necessity →differentiating inferior goods, necessities and luxury goods Suppose income rises in a developed country (eg. Singapore). The demand for necessities such as rice may increase less than proportionately to the increase in income. However, the demand for luxury goods such as taxi services may increase more than proportionately to the increase in income. Consider the country in question. * Income level of consumers Whether a good is perceived as an inferior good, necessity or luxury good depends on the country’s level of economic development and the income level of consumers. Income elasticity of demand and shifts of the demand curve For normal good, increase in income will lead to LTP increase in demand of good →smaller rightward shift For luxury good, increase in income will lead to MTP increase in demand of good →larger rightward shift For inferior good, increase in income leads to decrease in demand →leftward shift XED: Cross elasticity of demand measures the degree of responsiveness of the demand for a good to a change in the price of another good, ceteris paribus. For substitutes, goods that are in competitive demand, XED is +ve. A change in the price of a substitute will cause the demand for the good to change in the same direction. For complements, goods that are in joint demand, XED is -ve. A change in price of the complement will cause the demand for the good to change in the opposite direction. Eg. when price of pancakes increases, less consumers want pancakes. Since maple syrup pairs well with pancakes, the demand for maple syrup decreases. When XED = 0, the 2 goods are unrelated D: A change in price of one good does not affect the demand for the other. Magnitude of XED: XED > 1, price elastic : the 2 goods are strong substitutes/ complements XED < 1, price inelastic : the 2 goods are weak substitutes/ complements Determinants of XED: * Closeness of relationship Eg. Pepsi and Coke are strong substitutes since they taste similar. Hence, magnitude of XED for these 2 goods > than that of orange juice and coke. The closer the relationship between the 2 goods, the larger the magnitude of XED and the larger the change in the demand for one good when the price of the other good changes. Impact of Elasticity Concepts on Equilibrium Price and Quantity 1. Impact of PED on the market D1 shows a more price inelastic demand than D2. Suppose supply increases. For D1, there is a sharp decrease in equilibrium price P1 and a relatively small increase in quantity Q1. For D2, there is a relatively small decrease in equilibrium price P2 and sharp increase in quantity Q2. Hence, the more price inelastic the demand, the greater the change in equilibrium price and the smaller the change in equilibrium quantity for a given change in supply. 2. Impact of YED on the market For normal goods: The more income elastic the demand, the higher the magnitude of income elasticity of demand →the greater the extent of increase in demand →greater increase in equilibrium price and quantity For inferior goods: The more income elastic the demand, the higher the magnitude of income elasticity of demand →the greater the extent of decrease in demand →the greater the decrease in equilibrium price and quantity. 3. Impact of XED on the market A higher degree of substitutability/ complementarily causes a greater change in the demand. And thus a larger change in equilibrium price and quantity of the good when the price of its substitue/ complement changes. 4. Impact of PES on the market The more price inelastic the supply, the greater the change in equilibrium price and smaller the change in equilibrium quantity for a given change in demand. Impact of price elasticity on consumer expenditure/ producer revenue Consumer expenditure revenue are shown by “Price x Quantity” in the absence of taxes and subsidies. CE = PR Price elastic demand: MTP rise in Qdd in response to fall in price. →rise in PR/ CE from buying more units > fall in PR/ CE from buying all previous units at a lower price Price inelastic demand: LTP rise in Qdd in response to fall in price →rise in PR/ CE from buying more units < fall in PR/ CE from buying all previous units at a lower price (Hence if PED < 1, it’s not very smart to increase supply because PR will drop. However, producers should increase supply if PED > 1.) If demand rises and supply is price elastic, PR/ CE will rise. If demand rises and supply is price inelastic, PR/ CE will rise as well. How does a firm apply elasticity concepts? When PED < 1, a firm may consider increase the price of its products in order to increase total revenue. Since an increase in price causes a LTP decrease Qdd. When PED > 1, a firm may consider decreasing its prices to increase total revenue. As the fall in price is MTP than the rise in Qdd, total revenue increases. From theme 2.2: firms may also choose to differentiate their products in order to make their products price inelastic so they can increase its prices to make more revenue and increase profitability as Qdd would decrease, hence decreasing the cost of production. Application of YED in the real world YED helps profit-maximising firms to decide on the type of goods to sell under different economic conditions. Eg. When a country is facing strong econ growth, firms shd sell more normal goods, especially luxury goods, where demand is expected to increase MTP to increase in income, ceteris paribus. During econ downturn, the demand for normal goods is expected to decrease. The decrease in demand for necessities is expected to be LTP to decrease in income while it wld be MTP for luxury goods. Hence, firms may decide to produce more necessities, or maket its good as value-for-money instead of selling luxury goods. Application of XED in the real world Data on XED with respect to diff goods and services helps firms better predict how the demand for its products would be affected by a change in the pricing of its competitors (substitutes) or partners (complements). For example, for a firm selling a good with a positive cross elasticity of demand with respect to another good; the two goods are substitutes, the magnitude of cross elasticity of demand enables the firm to predict the extent of the fall in demand for its own products when a rival firm were to decrease price. If the magnitude of the positive cross elasticity of demand is small, the fall in demand for its own products is expected to be minimal. The firm may decide not to react and just accept the marginal loss in sales since the impact is negligible. However, if the magnitude of the positive cross elasticity of demand is large, the fall in demand for its own products is expected to be significant. The firm has to decide whether to correspondingly reduce the price of its own products which may potentially trigger a price war, or engage in other measures to boost its demand (such as advertising more aggressively) in order to compete more effectively. Limitations of applying demand elasticity concepts: (4) * Difficult to estimate the magnitude of elasticities Firms need to spend sig resources in order to collect data on its own prices and quantity sold and also the income level of the country and prices of its competitors and partners. Smaller firms don’t have these resources. They can only observe and draw relevant insights to make informed decisions. Hence, the lack of info on all magnitude of elasticity concepts may prevent firms from adopting successful strategies. (However, companies are increasingly leveraging on tech to collect info) * Estimates based on past data Estimates may be inaccurate due to changing business environment. However, they are still useful as they are a source of info. * No information on cost changes We assume firms aim to maximise revenue. However, a more common objective is to maximise profit. To determine the profit level fo producers, one has to consider to cost of production. Profit = revenue - COP. * Ceteris paribus assumption When using PED, YED and XED, all other factors are assumed to be constant except its own price, income and price of another goods respectively. However, in reality, many diff factors affecting the demand of a goods may be changing simultaneously. For example, when the price of Pepsi falls, the demand for its substitute good Coke, may not decrease as predicted by the cross elasticity of demand of the two goods. This is because Coke may have employed superior advertising strategies which could have changed the taste and preferences of the consumers towards its product, and hence increased the demand for its good. Look at pg 31 and 32 of notes Theme 2.1: Government Interventions in Markets Refer to notes Theme 2.3: Market Failure 😱 Key causes of market failure: 1. Externalities (-ve or +ve) 2. Imperfect information - asymmetric info 3. Public goods 4. Factor Immobility 5. Market dominance →Theme 2.2 ✨ Govt intervention: 1. Taxes 2. Subsidies 3. Quotas 4. Tradable permits (air pollution) 5. Joint and direct provision (public goods) 6. Rules and regulations 7. Public education (a) explain the meaning of market failure and the criterion (i.e. efficiency) used to assess the performance of markets; Efficiency is the key criterion used to assess the performance of markets. Market failure refers to the failure of the free market to allocate resources efficiently. When allocative efficiency (can be from the pov of either consumers or producers) is achieved, resources are allocated to produce the combi of goods and services most wanted by society. →welfare is maximise Tips for this theme: When discussing market failure, we often use marginal social benefit (MSB) and marginal social cost (MSC). MSB →the addional benefit to society from the consumption or production of an additional unit of a good or service. MSC →the additional cost to society from the consumption or production of an additional unit of a good or service. Using the marginalist principle, the good with be consumed or produced at Q*, where MSB = MSC, maximising social welfare. Q* is known as the social optimal quantity. Private benefits and private costs are enjoyed and incurred by the consumer/ producer only. MPB →additional benefit to consumers (or producers) from the consumption (or production) of an additional unit of a good or service. MPC →additional cost to consumers (or producers) from the consumption (or production) of an additional unit of a good or service. Using the marginalist principle, consumers will consumer Qp, where MPC = MPB. Qp is known as the private optimal quantity. When there is no market failure: However, the private and social curves are unlike to coincide in some markets in reality. Such an outcome is allocatively inefficient →social welfare X maximised (Note: dynamic efficiency is achieved when quality/ range of products improve and/ or when improved production processes decrease in COP.) Hence, why do governments intervene? They intervene mainly to improve equity in the market. Theme 2.1 →price mechanism is able to allocate resources efficently across diff. Markets but goverments may use subsidies/ price ceilings to decrease price and improve affordablity for consumers, or price floors to protect producers’ income and revenue Theme 2.3 →revisiting policies such as subsidies but instead, governments intervene to deal with inefficiency issues rising from market failure. Market dominance →Theme 2.2 (b) explain why the existence of negative externalities lead to market failure; i. explain how the use of taxes, rules and regulations, and tradable pollution permits (in the case of pollution arising from production activities) can help to correct market failure caused by negative externalities; (govt intervention) Negative externalities, also known as external costs, of a good or service are the spillover cost to third parties who are not directly involved in the consumption or production of the good or service itself. →These costs are not internalised (taken into account) by the consumers or producers of the good are are borne by 3rd parties Hence, Social costs = Private costs + External costs MSC =MPC + MEC MEC refers to the additional cost to third parties from the consumption/ production of an additional unit of a good or service. Answer technique!! →PET DQQD In production: (same format for consumption) In the production of steel, producers consider their private costs such as wages paid to steel workers and the cost of mining iron ore. Every additional unit would also produce private benefits to a firm, in the form of greater revenue. However, the production process may result in external costs such as medical bills incurred by third parties who are not involved in the production process, such as residents staying near the factories due to health hazards (e.g. noise, air and/or water pollution), which are all ignored by the producers when making production decisions. The presence of marginal external cost (MEC) creates a divergence between the marginal social cost (MSC) and marginal private cost (MPC), where MSC > MPC. Diagrammatically, the MSC curve lies above the MPC curve by the amount of the MEC as shown in Figure 5. Assuming that there are no positive externalities, the marginal private benefit (MPB) = marginal social benefit (MSB). If left to the free market, the firms produce Qp units of steel, where MPB = MPC as they only consider their own private costs and benefits. However, the social optimal level of production is Qs units, where MSB = MSC. Since Qp > Qs, there is an overproduction of steel and an over-allocation of resources to the production of it. At Qp, MSC > MSB. The additional unit of output adds more to society’s costs than to society’s benefits. From Qp to Qs units, the total social costs (area QsacQp) exceeds the total social benefits (area QsabQp). The area abc represents the deadweight loss which is the welfare loss to society when output is not produced at the social optimal level. There is market failure as the private optimal quantity of Qp is allocative inefficient and social welfare is not maximised. Since pollution is undesirable, is the social optimal output of pollution 0? No D: Social optimal level of pollution is the level that corresponds to the social optimal output of steel. Production of steel could generate benefits as well eg. revenue for seller. If 0 pollution means that there is 0 production of steel, it would be too extreme and potential benefits could not be gained as this may not maximise society’s welfare. True True False False Government intervention for -ve externalities: 😀 1. Indirect taxes Levying taxes on activities that generate external costs on third parties to make producers or consumers internalise the -ve externalities. →producers/ consumers face higher private costs. Levying a tax equal to MEC at social optimal output level, Qs, will lead to a rise in MPC of producing steel by that amount, forcing producers to internalise the MEC to third parties. This is depicted by an upward shift of the MPC curve by the amount of the tax from MPC to MPC’. Hence, Qp’ = Qs. Fall from Qp to Qs eliminates deadweight loss 🥳. Allocative efficiency is achieved and social welfare is maximised. On the other hand, in the context of consumption activities, governments generally levy taxes on the producers, who would pass on the tax to consumers in the form of higher prices. In other cases, the government can levy the tax directy on consumers. Hence, taxes incentives producers and consumers to reduce production and consumption by forcing them to internalise the negative externalities in their decision-making. (Eg. producers are incentivised to reduce output and hence pollution generated, or to find cleaner ways of production. Likewise, consumers are incentivised to reduce their consumption of the good that generates -ve externalities, and are encouraged to turn to other alternatives.) Government considerations 🧐 (Limitations) 1. Info gap As info is incomplete in the real world, govts are likely to have difficulty attaining monetary value to the amt of MEC occurred →over-estimation of MEC occurs →impose excessively high taxes depicted my MPC > MSC →govt failure, where welfare loss is greater after govt intervention. If MEC is under-estimated, govt levies too low a tax rate, MPC < MSC. Hence, production/ consumption wld not be at social optimal level →allocative efficiency is not achieved and social welfare is not maximised. 2. High administrative costs →Unsustainable in the long term. Manpower resources are needed to collect taxes from firms and consumers, to monitor whether taxes have been paid and to enforce accurate and timely paying of taxes. →high administrative costs →unsustainable →ineffective in long term 3. Uncertainty and time lag After implementing tax, there may be uncertainty and time lag in correcting the market failure, as producers and consumers may require time to fully respond to the disincentives of taxes. →may not eliminate market failure 4. Sunk cost fallacy This particularly focuses on consumers, and is not necessarily monetary. It sounds like “I have invested too much too quite now” or “I’ve been in this relationship for 3 years, I shouldn’t leave it since it’s been so long”. A more specific example would be why Singaporeans use their car so often, thinking that it better justifies the high price they paid for owning a car. This could worsen congestion and pollution problems which goes against its original intent, limiting the effectiveness of these policies. Unintended consequences of indirect taxes 😣 1. Inequity (only for essential goods) Taxes are generally politically unpopular. They can be deemed too high. When levied on necessities, consumers bear a greater burden of the tax →lower income groups may no longer be able to afford these essential goods →greater inequity 2. Opp cost of implementation Opp cost incurred if implementation and enforcement of tax is financed through reducing spendings in other areas. →incurring opp costs in terms of the benefits that could have been gained from spending more in the other sectors. Additionally, if administrative costs are implemented, monitoring and enforcing the laws are substantial, causing it to outweigh the intended welfare gain →govt failure Other arguments: * Revenue collected from tax can be used by govt to address external damages from production or consumption of the good or service. (eg. when chemical fire dumps waste in a river, the revenue collected from the tax can be used to clean up the river + can use revenue to fund R&D research) * Consumers’ cognitive biases such as loss aversion, which is a cognitive bias where for individuals, the pain of losing is psychologically twice as powerful as the pleasure of gaining. Eg. stay in a relationship to avoid the pain of breaking up. Pain and loss is more effective. 2. Rules and regulations →MEC decrease →MSC decreases →new socially optimal output increases towards the private optimal output , firms and consumers are forced from producing or consuming more than Qs. What forms does legislation take? 1. Quotas (legal limits on output or pollution level) Govt cld set quota on the ouput produced, eg at the social optimal level, Qs. Directly limits production/ consumption to Qs, achieving allocative efficiency. Quota on emissions produced directly limits the ext. Costs generated, reducing MEC and MSC →Qs increases, reducing the extent of overproduction and hence social welfare. (eg. limiting pollution levels by setting max lermitted level of pollution that firms are allowed to emit) Rules can help enforce the quota be having punishments that deter firms from exceeding the limit. 2. Complete Ban Only used in severe cases where large amounts of -ve externalities are generated (MEC very large) →govts may impose a complete ban. The imposition of a ban would be socially optimal when MEC is very large such that MSB intersect MSC where Qs is close to or at zero. A ban eradicates all negative externalities and benefits generated from the production/ consumption of the good or service. Eg. banning production of chorofluorocarbon (CFC) as it depletes the ozone layer The smaller area A is, the more effective the ban. 3. Rules and regulations (on production or consumption methods) Will cause a fall in MEC →MSC decreases →Qs increases and be closer to Qp. This reduces the extent of over-consumption/ over-production, hence reducing deadweight loss generated, achieving greater allcoative efficiency. Government considerations 🧐 (Limitations) 1. Info gap Info difficult to obtain →difficult to implement policy. Due to imperfect info, govt may not know optimal level of output or emissions. If legal output is too low, it could lead to greater deadweight loss. → govt failure Due to imperfect info, govts may not know level of penalty or consequence that is harsh enough to deter firms * Not harsh enough →consumer and firms not deterred from violating regulation * Too harsh →penalties will result in unintended consequences 😣 Ban: govt may not have perfect info on extent of -ve externalise to help decide if such an extreme measure is required. If MEC is not significant, a ban can result in greater welfare loss than no intervention at all → govt failure 2. High administrative costs Unsustainable in long run. Can incur high administrative and monitoring costs, including deploying inspection teams, installing of monitoring equipment and the prosecution of offenders. →unsustainable →ineffective in long run Unintended consequences of rules and regulations 😣 1. High costs to firms Legal restrictions require all firms to be subjected to the same rules. Hence, some firms may face more costs than others as they may not be able to produce as much as before. (Eg. for firms that incur high pollution abatement costs, they are subjected to the same limit on emissions as firms with lower abatement costs →lower pollution levels at a relatively high cost to the industry) 2. Trade-off with macroeconomic aims If penalties are too harsh, firms may be chased away to other countries, driving away potential investments. →slow down econ growth and increase unemployment. (Theme 3.2) 3. Opp cost of implementation Opp cost if enforcement of rules and regulation is financed through reducing spendings in other areas. →→incurring opp costs in terms of the benefits that could have been gained from spending more in the other sectors. Additionally, if administrative costs are implemented, monitoring and enforcing the laws are substantial, causing it to outweigh the intended welfare gain →govt failure Other arguments: * Laws compel producers and consumers to take actions to limit the level of production or consumption to the socially optimal level. More straightforward to devise, easily understood by firms, easier to implement compared to taxes * Outcomes are more certain and can be achieved faster as compared to taxes and tradable pollution permits. As long as penalities are harsh enough and there is effective monitoring, rules and regulations can serve as an effective deterrent to prevent violation of the legislation and the desired reduction within the stipulated time frame could be achieved. 3. Tradable Pollution Permits (Pollution 🌫️) The government decides on a permissible level of pollution for the entire industry and sets a quota on the level of emissions produced. Ideally, this should coincide with the social optimal level of production. The permissible level of pollution is then divided into smaller units and corresponding permits are issued to firms based on certain criteria, for example, firms’ past output or emissions level. These permits can be traded between firms, where the permit price is determined by the market demand and supply of such permits. A firm whose pollution abatement (i.e. reduction) costs exceed the current permit price will find it cheaper to buy more permits to pollute than to reduce its level of pollution. On the other hand, a firm that faces lower pollution abatement costs than the current permit price will choose to reduce its level of pollution and sell its excess permits to other firms. This gives firms the incentive to adopt cleaner production techniques to avoid an increase in their cost of production due to the larger number of permits required, or to increase their revenue through the sale of their permits. When firms adopt cleaner methods of production, external costs are also reduced, causing MSC to shift downwards towards MPC in the long run, reducing deadweight loss, as illustrated in Think About It! – Qn 5 above. In summary, firms can 1. Sell permits →increase revenue 2. Buy permits * Increase limit on emissions of own pollution bc it’s cheaper to buy these permits than to reduce pollution Some firms may be incentivised to adopt cleaner methods of production instead so they can sell their permits/ buy lesser permits and increase revenue On the other hand, some firms may find it more difficult to change their method of production to be greener compared to other firms, hence, buying permits benefit them. Govt considerations 🧐 1. High administrative costs →Unsustainable in long term Difficult to measure and monitor firms’ adherence to their respective pollution limits →high admin costs →unsustainable thus ineffective in long term 2. Info gap Due to imperfect info, govt may not know social optimal output of pollution. If govt underestimates the optimal level of pollution, too few permits are introduced →underproduction of goods and service →welfare loss 3. Increased pollution in certain regions Emissions may be concentrated in certain geographical areas if many firms there have the purchasing power to buy excess permits. →severe air pollution →lower SoL there Unintended consequences 😣 * Trade-off with macroeconomic aims Need to purchase permist increase firms’ COP →fall in investment, employment and econ growth. Some firms who firm the permit too costly may relocate their production to other countries. * Opp cost of implementation Implementation of the permit may be financed through reducing spendings in other areas, →incurring opp costs in terms of the benefits that could have been gained from spending more in the other sectors. Additionally, if administrative costs are implemented, monitoring and enforcing the laws are substantial, causing it to outweigh the intended welfare gain →govt failure →greater allocative inefficiency in those areas. Other arguments: * Firms with lower pollution abatement costs wld have financial incentive to reduce externalities produced as they can increase revenue by selling permits →motivated to develop methods to reduce pollution (in contrast to rules and regulations, where firms may not get this incentive) * By allowing trading of the permit, pollution abatement is carried out by firms that can do so at the lowest cost. These firms, by by cutting down emissions, will be left with unused permits that they can sell to offset their costs. Other firms that find it costly to cut pollution can buy the unused permits. This way, the target can still be met but at a much lower total cost as compared to rules and regulations, where all firms regardless of pollution abatement costs, have to reduce their pollution levels. * Compared to taxes, outcome can be achieved with more certainty with strict monitoring and enforcement. There is a case study in the package from page 23 to 28 about COEs. (c) explain why the existence of positive externalities lead to market failure; i. explain how the use of subsidies, rules and regulations, and direct and joint provision can help to correct market failure caused by positive externalities; (govt intervention) Positive externalities, also known as external benefits, of a good or service are the spillover benefits to third parties who are not directly involved in the consumption or production of the good or service itself. Hence, Social benefits = Private benefits + External benefits MSB = MPB + MEB MEB refers to the additional benefit to third parties from the consumption or an additional unit of a good or service. Answer technique ‼️ → PET DQQD Consumption: In the consumption of education, positive externalities are generated. Consumers only consider their private benefits, such as the future income that they may potentially receive from better employment opportunities. Potential students would also consider the private costs that will be incurred from the consumption of education, such as the school fees and money required for textbooks and learning resources. However, consumers will ignore the external benefits to third parties such as the profit that future employers will receive from more innovative and productive employees and the higher tax revenue that the government can spend on future generations, resulting in their higher standard of living. The presence of marginal external benefit (MEB) creates a divergence between the marginal social benefit (MSB) and marginal private benefit (MPB), where MSB > MPB. Diagrammatically, the MSB curve lies above the MPB curve by the amount of the MEB as shown in Figure 12 below. Assuming that there are no negative externalities, the marginal private cost (MPC) = marginal social cost (MSC). If left to the free market, the consumers consume Qp units of education, where MPB = MPC as they only consider their own private costs and benefits. However, the social optimal level of consumption is Qs units, where MSB = MSC. As Qp < Qs, there is an underconsumption of education. At Qp, MSB > MSC. The additional unit of education consumed adds more to society’s benefits than to society’s costs. From Qp to Qs units, the total social benefits (area QpabQs) exceeds the total social costs (area QpcbQs). The shaded area abc represents the deadweight loss which is the welfare loss to society when education is not consumed at the social optimal level. There is market failure as the private optimal quantity is allocative inefficient and social welfare is not maximised. Same format for production Government intervention for +ve externalities 😀 1. Subsidies In context of consumption activities, the govt generally grants the subsidy through producers. The producers would then pass on the subsidy to consumers in the form of lower prices. In other cases, govt can give subsidy directly to the consumers. In both scenarios, the consumers face lower private costs, thus internalising the external benefits. Granting a subsidy equal to the MEB at Qs will lead to a fall in MPC of consuming education by that amount, forcing consumers to internalise the MEB to third parties. This is depicted by a downward shift of the MPC curve from MPC to MPC’. The new private optimal quantity Qp’ now coincides with Qs. Rise in consumption from Qp to Qp’ has eliminated deadweight loss. →allocative efficiency is achieved and social welfare is maximised. In the context of production activities, govt can grant subsidy to producers, leading them to enjoy lower private costs. Same explanation as figure 14. Hence, subsidies incentivise producers and consumers to increase production and consumption by forcing them to internalise the +ve externalities in their decision-making. This is done by producers and consumers having lower costs incurred due to subsidies granted by the govt, encouraging them to increase production/ consumption. Government considerations: 🧐 1. Info gap Due to imperfect info, govt is likely to have difficulty in attaching monetary value to the amount of external benefits enjoyed. Over-estimation of MEB →grant excessively high subsidies →over-production/ consumption of good. Can cause deaweight loss to be larger compared to a case w/o intervention →govt failure Under-estimation of MEB →grant subsidy lower than necessary, causing production/ consumption to be below Qs. →allocative inefficiency & welfare not maxmised. 2. High expenditure by govt Unsustainable in long term. Subsidies require high expenditures →can put strain on govt budget →unsustainable in long run →become ineffective 3. Uncertainty and time lag Govt needs time to determine amt of external benefits generated, hence subsidy to be provided. In addition, aft implementing the policy, there may be uncertainty and time lag in correcting the market failure as producers and consumer may require time to fully respond to incentives of subsidies. →allocative ineffiency may persist. Unintended consequences 😣 1. Productive inefficiency in firms Subsidies given to firms lower their COP →may breed productive inefficiency in firms in the long run as if reduces the incentive for firms to stay efficient by producing at the lowest cost possible. (Theme 2.2) 2. Inequity Subsidies may increase producers’ profits due to lowering their COP →unequal distribution of income between consumers and producers which may be deemed unfair and politcally unpopular. 2. Rules and regulations →Ensure good or service is consumed/ produced at Qs + comes with penalty to enforce. Legislation could also be put in place to enhance the private benefits of production or consumption. (Eg. enforcement of patents due to firms not being incentivised to engage in innovation through R&D for fears of exploitation or imitation by competing firms →upward shift of MPB curve from MPB to MPB’ such that MPB’ = MSB→MEB eliminated) New private optimal quantity where MPB’=MPC, Qp’, coincides with Qs where MSB = MSC. →allocative efficiency is achieved and social welfare is maximised. Government considerations 🧐 1. High administrative costs Unsustainable in the long term. The high costs are incurred in sending govt officials to households and firms to check and monitor that laws are being followed. →unsustainable →ineffective in long term 2. Info gap Due to imperfect info, difficult to gather necessary info. Level of penalty may be too harsh or not harsh enough. (Theme 2.2) Other arguments: * Laws compel producers and consumers to increase the level of production or consumption to the socially optimal level. →more straight forwards to devise, easier to understand and implement compared to subsidies. * Outcomes in terms of increasing production and consumption are more certain and achieved faster compared to subsidies. As long as the penalties are harsh enough and there is effective monitoring →effective deterrent to prevent violation 3. Direct and Joint Provision →increase availability of goods that generate +ve externalities in market to be closer to the social optimal level Direct provision is the situation where the govt provides the good or service either by producing or outsourcing production (ie govt is still paying for the production) to a private firm which can produce it at a lower cost, with the objective of maximising social welfare. →the good or service provided could be free or be charged for a price Joint provision occurs when the government and profit-maximising private firms both provide the goods/ services in the market. →eg, Singapore’s education system →there are both public schools and private schools. & Singapore’s healthcare system →public hospitals & private hospitals Joint provision also occurs when the govt and private firms with profit-maximising objectives are involved in diff parts of the production process. →eg, bus contracting model in SG where govt provides infrastructure and bus services are provided while private bus operatkrs bid for the right to operated the bus service. Govt considerations 🧐 1. Info gap Due to imperfect information, the govt lacks necessary information about Qs, hence may provide too much or too little of the goods or services. If too much is provided, there’ll be over-allocation of resources →greater deadweight loss →greater allocative inefficiency →govt failure. However, providing too little can cause allocative inefficiency to persist. 2. Political pressure Electorial pressures may lead to governments to provide beyond Qs →over-allocation of resources →greater deadweight loss Unintended consequences of direct and joint provision 😣 1. Improve affordability of essential good (+ve) If production of this good or service was left entirely to the private firms who aim to maximise profit, the higher prices charged might cause the lower income earners to be left out of the market. Having the govt provide these goods or services that are necessities free of charge or at a lower cost could increase its affordability to all →inequity reduced 2. Productive inefficiency of government Absence of profit motive →lack of incentive to keep costs low. A sense of complacency may arise, knowing that losses will be covered by taxpayers’ money →productive inefficiency. Govts may not have the incentive to improve on its production and quality of the service →fall in quality in long run (possibly) 3. Productive and/or dynamic inefficiency of firms Due to lack of contestability and competition. Private firms may become complacent after winning the contract since they would be given exclusive rights to produce the good or service for a specified time frame →higher costs than necessary being incurred, and/ or deterioration in the quality of service provided or goood produced, hence causing a fall in consumer welfare. Other arguments for direct and joint provision: * With direct intervention by the govt, outcomes in terms of increasing production and consumption are more certain and can be achieved faster compared to subsidies. For joint provision: * If production of services (eg. healthcare) was left entirely up to the public sector (ie. direct provision), limited capacity and budget constraints of govt might result in insufficient investment into the infrastructures necessary to meet the increasing demand for the service. Allowing part of the production to be supported by private firms can boost the production of services →better meet high demand for service. * Public-private partnerships could allow the government to tap on the expertise and experience of private firms + encourage greater innovation the public sector. →better quality services + adopt more cost-effective production strategies. d) explain why information failure can lead to market failure; i. explain how the use of rules and regulations and public education can help to correct market failure caused by information failure (govt intervention) Information failure, also known as imperfect information, is a concept that is rather intuitive. Consumers may not have complete or correct information about the costs or benefits of consuming a particular good. Asymmetric info →in certain markets, either the sellers or buyers have more info than the other. Causes of imperfect info: 😮‍💨 1. Myopic decision-making Happens when consumers only consider the costs and benefits in the immediate term, and are unaware of the costs or benefits in the long run. →eg. Cigarettes and smokers →short term stress relief, long term detrimental health effects Econ agents underestimated MPC, hence MPCpercieved < MPCactual →Qp > Qs. Hence there is an overconsumption/ overproduction of the good or service. →deadweight loss, total social costs > total social benefits →market failure Since MPCactual is not fully accounted for, there is a distortion of price signals. Hence, the price mechanism fails to bring about socially optimal allocation of resources. MPBperceived < MPB actual →Qp < Qs. There is an underconsumption/ underproduction od the good or service →deadweight loss because total social benefits > total social costs →market failure Since MPBactual is not fully accounted for, there is a distortion of price signals. Hence, the price mechanism fails to bring about socially optimal allocation of resources. 2. Addiction Consumers may be addicted to consuming a good, causing MPCperceived < MPCactual. Eg. Smoking addicts →may experience short-term high, but does does fully recognise the health risks. Refer to fig. 17. 3. Product complexity When shopping with technical products such as laptops, consumers may not be familiar with technical terms such as ‘processor speed’ and ‘RAM’ →overestimation of MPB(may go for higher specifications/ additional features) →eg. Unethical doctors may prescribe services or medicine that may be more than a patient actually requires. 4. Persuasive advertisement Overestimation of MPB For both product complexity and persuasive advertisement, econ agents overestimate MPB, hence MPBperceived > MPBactual. Hence, MPBactual curve lies below MPBperceived curve →Qp > Qs, hence there is overconsumption/ production of the good or service. Hence, total social costs > total social benefits. →market failure →As MPB is perceived to be higher than what it actually is, there is a distortion of price signals →the price mechanism fails to bring about social optimal allocation of resources. Is -ve externalities a source of market failure caused by consumers/ producers having imperfect info abt the external costs? No, -ve externalities are due to consumers/ producers not taking into account the spillover costs on third parties. This is not due to imperfect info. Government intervention: 😀 1. Rules and regulations Govt places measures to provide consumers with relevant information. These measures provide consumers with accurate information of the private costs and/ or benefits of consuming a good or service →reduce extent of over or under-cosumption →reduce extent of allocative inefficiency. →eg. SG food companies must declare significant amount of basic information, such as name and description of food and ingredients, on the labels of pre-packed food →allows consumers to more accurately consider the private costs and benefits. If regulations are not complied, offenders may be subjected to a fine and/ or imprisonment not exceeding 3 months. Government considerations for rules and regulations 🧐 1. High administrative costs →unsustainable in long term. Costs incurred in setting up structures and deploying government officials to check whether consumers and producers are complying with the laws →unsustainable →ineffective in long run Unintended consequences 😣 1. Higher prices/ poor quality of goods Requiring firms to provide more info to consumers may raise their COP →firms may pass on these additional costs to consumers in the form of higher prices, or compromise on the quality of their good or service, negating gain in consumer welfare of having more info. 2. Opp cost of implementation May have to channel public funds from other public projects →incurring opp costs in terms of the benefits that could have been gained from spending more in the other sectors. Additionally, if administrative costs are implemented, monitoring and enforcing the laws are substantial, causing it to outweigh the intended welfare gain →govt failure 2. Public education 📑 →solves root cause of imperfect info. It aims to provide more info to consumers about the actual private costs and benefits of consuminig a good to allow them to make a more informed choice. This is reflected by a shift of MPCpereived curve upwards to coincide with MPCactual curve (Fig 17) and shift of MPBperceived curve downwards to coincide with MPBactual curve (Fig 18 and 19) →Qp = Qs →deadweight loss eliminated. →eg. Education fairs, education on preventive healthcare, anti-smoking campaigns, COVID-19 vaccine education campaign. Government considerations 🧐 1. Time lag Takes time for education to take effect, does not offer immediate solution for pressing, urgent problems. Allocative inefficiency continues in the market, hence market failure persists. 2. Uncertainty of outcome Outcome subjected to receptivity of the public, People may not heed the advice due to stubbornnes and ingrained habits that are hard to change. Unintended consequences 😣 * Opp cost of implementation Education campaigns are expensive and may require substantial public funding. Govt may channel public funds from other public projects→incurring opp costs in terms of the benefits that could have been gained from spending more in the other sectors. Other arguments: * Education is a long term solution to raise awareness of the actual costs and benefits of consuming certain goods and services. By reducing extent of imperfect info, it directly targets the root cause of market failure →reduce gap btw Qp and Qs. * More politically favourable option as consumer sovereignty is preserved. (consumers still can decide their level of consumption) * Success of public education is dependent on govt’s knowledge of consumers’ cognitive biases such as salience bias. (our tendency to focus on things that are more obvious) eg. obesity is a more visible problem compared to other health issues, hence campaigning an active lifestyle is likely to be more successful if they were to focus on how regular exercises can help with immediate weight loss rather than long term benefits of exercising. Asymmetric information is a specific case of imperfect information, and can be thought as a subset of it. Asymmetric info occurs when 1 party has more information than the other party in an economic transaction. (It matters WHEN asymmetric info happens) BEFORE TRANSACTION: Adverse selection is the process by which ‘undesirable’ members of a population of buyers or sellers are more likely to participate in a voluntary exchange.It happens due to hidden characteristics of the good or service before the transaction. →eg. Sellers might be tempted to withhold information about second-hand goods that might cause buyers to have lower willingness to pay for the product ANS TECHNIQUE 1. Define (adverse selection/ moral hazard) 2. Who has more info? 3. Why does a party withhold more info have an incentive to withhold it? 4. How are high quality buyers/ sellers driven out of the market? 5. Why do only low quality buyers/ sellers remain in the market? 6. Why is there a missing market present, which results in deadweight loss? Eg: Adverse selection in the second-hand car market 🚗 Used car dealers often have more information regarding the condition of the used cars being sold than potential buyers. For instance, dealers would probably have knowledge of the true mileage of the car, whether the car has met with any road accidents (and if so, how many and to what extent), as well as whether the car has any defects that are unnoticeable by the naked eye. In order to profit from the sale of used cars and to fetch the highest possible selling price for their cars, used car dealers might have the incentive to hide some of the information that they have about the condition of their used cars from potential buyers. When used car buyers do not know whether the cars they are buying is of high or low quality, the tendency is for the market to be dominated by low quality cars that need frequent repairs, also known as the ‘lemons’. Facing lack of information as to whether a car is a ‘cherry’ (i.e. high quality) or a ‘lemon’, a buyer treats all cars to be of medium quality and will only be willing to pay the average price for a car of medium quality. As a result, the sellers willing to sell the higher quality cars at higher prices will exit the market, which reduces the average quality of used cars in the market. Over time, the increased presence of low-quality cars in the market will further lower the prices that consumers are willing to pay. The decrease in price will further decrease the number of high-quality cars supplied. In this case, asymmetric information results in a market where some high-quality cars are sold, but fewer than what would be sold in a market with perfect information, thus resulting in welfare loss. In the most extreme case, the downward spiral in prices may continue, causing the number of high-quality cars supplied to drop to zero, resulting in no possible trade of high-quality used cars. There is a missing market – ‘cherries’ are pushed out of the market, leaving only ‘lemons’. The market fails and is allocative inefficient as welfare loss arises when mutually beneficial trade of high-quality used cars cannot take place. The sellers and buyers cannot overcome the information gap to trade at the prices that satisfy both their willingness to pay and sell. Therefore, adverse selection occurs as the uninformed buyers end up having to choose from an undesirable or adverse selection of goods, which is not socially optimal. Adverse selection in the health insurance market ⛑️ In the case of the health insurance market, buyers of health insurance have greater information over sellers, i.e. insurance companies. Consumers of health insurance might not have the incentive to divulge sufficient and accurate information about their health conditions (e.g. how long they have been smoking, or if they have any persisting ailments) to insurance companies, as that would mean that they are likely to have to pay higher premiums on their insurance. Consumers with higher risks are more likely to buy health insurance and choose higher levels of coverage. Thus, insurance companies risk providing insurance coverage to those with higher health risks. Facing a lack of information as to whether a consumer of health insurance is healthy, the insurance company treats all consumers to be of average health and will only be willing to charge an average price for health insurance. As a result, the healthy consumers who are only willing to buy a cheaper plan will exit the market, which reduces the average health quality of consumers in the market. Over time, the increased presence of less healthy consumers in the market will further increase the prices that the insurance company charges, to cover the potentially higher costs of insuring these people. The increase in price will further decrease the number of relatively healthier consumers, as they drop out of the market. As the process continues, eventually, the remaining consumers left dominating the health insurance market will be the unhealthy ones. This leads to adverse selection, where the unhealthy people are the only ones buying health insurance. Private insurance companies find it unprofitable to provide insurance, as nearly all the people who want to buy insurance are unhealthy to a certain extent. This could lead to a missing market where no insurance companies are willing to sell insurance. As transactions that could potentially increase society’s welfare are not realised, there is a deadweight loss, leading to market failure AFTER TRANSACTION: Moral hazard is a situation where econ agents take greater risks than they normally would, because the costs that would result would not be borne by the econ agent themselves. It arises due to the presence of hidden actions taken by the economic agent after the transaction has been completed. Moral hazard in the health insurance market After purchasing health insurance, an individual might have the incentive to pursue an unhealthy lifestyle of excessive smoking and alcohol consumption since his medical bills will be covered by insurance payouts. There is no way for the insurance company to monitor the buyer’s behaviour after the policy is purchased. This may result in excessive insurance payouts as the insured is likely to take on greater risks and engage in undesirable behaviour, which increases the probability that claims are made. As it would be too unprofitable to provide insurance in this case, no insurance companies would be willing to do so, thus leading to a missing market. This results in allocative inefficiency and hence market failure, as mutually beneficial transactions between the insurance company and the potential customers do not take place, leading to deadweight loss. In which scenarios are adverse selection, moral hazard, or both likely to arise? 1. Car insurance market →Both * More reckless drivers are more willing to buy car insurance →adverse selection * After buying car insurance, drivers may take on more risks when they drive since costs of accident can be covered by insurance company, causing more accidents →moral hazard 2. England’s National Health Service, a national healthcare system where UK residents are provided with free healthcare. →Moral hazard * Individuals may be less incentivised to care for their own health, leading to more health issues since healthcare cost is covered by the England government. Government Intervention 👾 →Rules and regulations Laws to reduce adverse selection: Government can enact laws to regulate the quality of goods and services produced by the firms. →Eg. Second-hand car market, the govt may make it compulsory for used care dealers to send their cares for inspection and certification, allowing buyers of the car to have similar info possessed by sellers of it, alleviating asymmetric info problem. →better cars can be sold at higher prices, and ‘lemons’ can be sold at lower prices →mutually beneficial transaction, eliminates deadweight loss Government can set in place laws to protect consumers from poor quality goods even after the transaction is complete. →Eg. Lemon law →protects consumers against goods that do not conform to contract or are not of satisfactory quality or performance standards at the time of delivery. A consumer is able to make a claim for a defective product. Laws to reduce moral hazard: Govt can regulate insurance plans to ensure that moral hazard us reduced and there is no unnescessary wastage of resources. →Eg in 2019, SG govt passed a law that removed full riders on new insurance policies. Previously, people could purchases insurance policies with full riders - effectively allows people to pay nothing for hospital bills. Full riders presented a moral hazard problem as it diluted to responsibility for personal health. →cld lead to wastage of resources. New law reduced moral hazard as patients will be required to pay 5% of their hospital bills. —> promotes greater personal responsibility —> less likely to participate in risky behaviour Government considerations 🧐 (Limitations) 1. Increased government expenditure →unsustainability. In context of health insurance scheme, it’s necessary to build up a reserve to manage the volatility of claims made by the high-risk insured →premium rates of the low-risk individuals will increase + growth in aging population causes medical insurance claims to rise →upward pressure on MediShield Life premiums + increased govt spending on subsidies in order to keep premium affordable. 2. Info gap Govt may not have sufficient info to determine the level of co-payment that is sufficiently high to incentivise the insured consumers to take responsibility for their own actions, yet not too high such that consumers end up bearing a large part of the costs. Application of Adverse Selection and Moral Hazard to MediShield Life MediShield Life is a basic and compulsory health insurance plan for all Singaporean Citizens and Permanent Residents, with the aim of lowering healthcare costs at both the individual and state level. With MediShield Life, the private insurance companies will help to foot a part of the bill when an individual incurs large hospital bills or have to go for selected costly outpatient treatments, such as chemotherapy for cancer. As with all insurance policies, the issues of adverse selection and moral hazard are taken into account in designing this nationwide policy. To tackle the problem of adverse selection, the government has made it mandatory for everyone to purchase MediShield Life. Through the enforcement of such a mandatory insurance for the population, a win-win situation can be created where insurers can spread the risk of insurance among both risky and less risky consumers (i.e. risk-pooling), consumers who are more susceptible to ailments have access to insurance at a cheaper price, and the government can save on expensive healthcare subsidies. To reduce the moral hazard problem, MediShield Life makes use of deductible and co-payment to incentivise people to take better care of their health. With a deductible and co-payment clause, the buyer of the insurance is required to pay a portion of any claim made. This will reduce moral hazard on the part of the insurance buyer, as the buyer will now bear part of the costs of his risky behaviour, and hence think twice about taking excessive risks after the insurance is bought. Private solutions to asymmetric information: * Reduce adverse selection * 1. Signalling * Refers to the more informed party’s attempt to convey information about product quality to the less informed party. As sellers of high quality goods would like to charge high prices, they have the incentive to convince buyers their goods are of high quality through various ways. eg guarantees and warrants allow sellers to convince buyers their goods are of high quality as sellers are liable to repair or replace a defective product. With this info obtained through signalling, buyers are assured the product is of good quality and would be willing to pay a higher price for it —> adverse selection prevented and mutually beneficial transactions occur —> allocative efficient * 2. Screening * Refers to actions taken by less informed party to make it mandatory for more informed party to provide info before the transaction takes place. Eg. for health insurance, companies can gather information such as medical history or make it mandatory for customers to go for health checkups, in order to determine the risk level of potential customers before selling the insurance. Having ascertained customers of high risk, the firm can charge higher premiums to compensate for the higher risk.—> necessary info provided to less informed party —> adverse selection prevented and mutually beneficial transactions occur —> allocative efficient. * Reduce moral hazard * Make the agent that has a tendency to engage in more risky behaviour bear a portion of the cost Such that they make more responsible decisions and are discouraged from engaging in risky behaviour. Terms and conditions can also be included. Eg, Insurance companies are incentivised to make the insured bear a portion of the claim through co-payments and deductibles and a fire insurance company may insist that a firm install sprinkler system in warehouse to offset any increased carelessness once the policy is in place. e) explain the characteristics of public goods and why markets for such goods fail; i. explain how direct provision can help to correct market failure in markets for public goods; A good is a public good if it possess non-excludability and non-rivalry. They are often also non-rejectable. This is contrast to a private good, which is excludable, rivalrous and rejectable. * Non-excludability refers to the situation in which it’s impossible or very costly to exclude non-payers from the consumption or use of a good or service once it has been provided, i.e. the provision to any one person automatically makes it available to others. →free rider problem leading to non-provision * Non-rivalry means that consumption or use of a good or service by one consumer does not reduce the quantity and/ or quality available to the others. →to maximise society’s welfare, it should be provided for free * Non-rejectability is the inability of consumers to refuse the consumption of a good once it has been produced. HOW DO PUBLIC GOODS LEAD TO MARKET FAILURE? When a good or service is non-excludable, ppl cannot be prevented from enjoying it even if they do not pay →free-rider problem where ppl have no incentive to pay for the good or service →no effective demand →absence of price signal in the market mechanism to allocate public goods →non-provision of public goods and goods are hence not provided in free market. Once produced, a good or service that is non-rival in consumption can be provided for and enjoyed by additional users at no additional cost to the producer. Hence, marginal cost of providing the good for additional users = 0. Since allocative efficient quantity to supply is MB=MC, the allocative efficient price to charge for the use of the public good shd be 0! Private firms, which are assumed to be profit maximising, will not be willing to supply the good. Though the marginal cost of providing the public to an additional user is 0, the marginal cost of producing an additional unit of the good is not 0! If public goods were left to the free market, they would not be provided at all. There is hence a missing market for such goods. The market has failed bc no resources will be alloacted to their production D: →market failure. Hence, the govt needs to provide public goods as they will not be provided by the free market. Examples of public goods: * National defence →National defence is non-excludable as others who did not pay for the defence (e.g. tourists) still enjoys the same level of protection. It is also non-rivalrous because once the defence system is established, everyone in the country enjoys the same security against foreign threats. Additionally, it is also non-rejectable as no one in the country can refuse to be defended by the military * Street lighting Network →Street lighting is non-excludable because once a street lamp network is built on a public street, there is no effective way of excluding anyone who walks on the street at night from enjoying the illumination provided. It is also non-rivalrous as it will continue to provide the same illumination for every person that walks on the street. Additionally, it is also non-rejectable as no one is able to reject or refuse the benefits of the street lighting. Government interventions: : Direct provision Assuming perfect info, governments may provide public goods at Qs, maximising social welfare. Assuming govt is non-profit oriented, it does not need to charge a price to cover the COP. The govt can then finance the provision of public goods through tax revenue. (though, in some cases, the govt may charge a price, citing the payment for the production or provision of the public good as a reason) Government considerations: 1. Info gap Due to imperfect info, the govt lacks the necesssary info needed on Qs of public goods to provide. Due to the free-rider problem, consumers do not express their demand for public goods. The govt doesn’t know how much consumers value the public good, hence how much to provide. If govt provide too little →allocative inefficiency + social welfare not maximised If govt provide too much, welfare losses will result →govt failure Unintended consequences: 1. Opp cost of implementation Opp cost incurred if provision of public goods is financed through reducing spendings in other areas. →incurring opp costs in terms of the benefits that could have been gained from spending more in the other sectors. Govt also has to consider the costs and benefits to decide how much to spend. Do the benefits of spending more outweight the cost? 2. Productive ineffiency by the govt Administrative costs could be higher than necessary bc of administrative red tape, ocer-bureaucratic govt organisation and lack of incentives to keep costs low. →not productively efficient (public goods could have been provided at a lower cost, requiring less taxpayers’ money and govt budget) →Govt failure Other arguments * Political/ National security arguments →their senitive nature is such that the govt might be best suited to be in control of provision, instead of leaving it to the free market. Is it true that in the absence of govt intervention, there will necessarily be missing markets in the cases of public goods and asymmetric info? False. For asymmetric info, buyers and sellers have the incentive to facilitate the flow of info btw parties such that mutually beneficial transactions occur. For public goods, the implications of the characteristics of non-excludability and non-rivalry mean there wld be a missing market if the govt does not intervene. f) explain why factor immobility can lead to market failure; i. explain how the use of subsidies and the provision of training can help to correct market failure caused by factor immobility Factor immobility refers to the inability of a FOP to shift from one use to another and can result in the price mechanism no longer efficiently allocating resources to maximise social welfare. Hence, producers are not able to re-alloacte FOP to produce qty and type of goods and services that generate the most utility for consumers. Factor immobility can be due to: 1. Occupational immobility Occupational immobility is the inability of FOP to move from one occupation or sector to another. Labour often experiences occupational immobility due to mismatch of skills btw the unemployed workers and those required by the jobs. There could be tech advancements or changes in the structure of the economy leading to an increase in demand for the skills in new and growing industries and a decrease in demand for the skills in declining industries. Workers in declining industries may lack the relevant skillsets or education to take on jobs in expanding industries. →lack of info of jobs available →workers can only make good choices abt what jobs to apply for and what training to embark on only if they are aware of the job 2. Geographical immobility Geographical immobility occurs due to the inability or lack of willingness of FOP to move from one geographical area to another. Eg. when a large firm moves its physical location from one region to another, there wld be a fall in demand for labour in1 region and an increase in the other. There is geographical immobility when workers are unable or unwilling to move to expanding regions with greater or/ and better job opportunities. →tend to exist in large countries where there are barriers to ppl moving from one region to another in response to change in labour market, such as social costs eg time spent with family and financial costs eg. high relocation costs and high costs of living. HOW DOES FACTOR IMMOBILITY LEAD TO MARKET FAILURE? Factor immobility results in the price mechanism no longer efficiently allocating resources to maximise social welfare ie it impedes the allocative function of prices. Producers are not able to re-allocate FOP to produce the quantity and type of goods and services that generate the most utility for consumers →Optimal amount of the right good or service is not produced →allocative inefficiency →market failure Government intervention Occupational immobility: (Long term solution!) 1. Invest in increased provision of training schemes for its labour force. This can be done through subsidising the provision of vocational training by private sector firms to raise the skills level of their employees, or by subsidising workers who attend such courses. →price of edu decreases →household willingness to upgrade skills increases →more employable * Investment in training helps to boost the human capital of employees to give them new skills and skills that can be transferred from one occupation to another →Occupational immobility decreases and labour market becomes more flexible in responding to changes in market conditions. * Set up agencies to facilitate info sharing on jobs to help with lack of info on jobs available →facilitate job matching * →Eg SkillsFuture Geographical immobility: 1. Subsidies workers who move into areas where there are labour shortages through relocation grants. →reduces the cost of relocation 2. Develop transport infrastructure such as expanding transport network both within the city and across cities. Helps with personal ties and commitments workers have in current location. Government consideration: 1. Time lag Time taken for retraining, skills upgrading and infrstructural development is long →effects take long time to surface →significant time lag involved →occupational + geographical immobility persists 2. High expenditure →Unsustainable in long term. Govt wld need to spend significant amount of its budget to provide subsidies to employers and/ or employeers to encraouge the take-up of such programmes. This spending is likely to be more than one-off occurance as training of skills require time and training would be needed for different batches of employees. Infrastructural development is also very costly. Info is also required to accurately match workers to the relevant training centres and job placements. Additionally, a lot of info wld be required to accurately determine the costs and benefits from any infrastructual development. 3. Resistance of workers Effectivenss of policies depend on the willingness of workers to continue acquiring new skills or relocate to meet up with the needs of the changing economy. Costs may have to be incurred to conduct advertising or educational campaigns to change the mindsets of these workers. +ve unintended consequences: * Achievement of macroeconomic aims Training wld result in an improvement in the quality of labour (human capital) which will raisie productivity, increasing output produced per worker. Increased labour productivity results in potential growth in the economy, which could lead to higher material SoL in the future. Maecroeconomics Theme 3.2: Macroeconomic Objectives and Policies Framework Causes Consequences (+ve/-ve) Policies to overcome Economic Growth (i) Explain the difference between actual and potential growth, sustained growth, sustainable growth and inclusive growth (in the case of SG) (ii) Explain the causes of actual and potential growth, sustained growth, sustainable growth and inclusive growth (in case of SG) Actual growth → realised increase in real national output for a given period of time Caused by: * Increase in aggregate demand (AD) * Increase in aggregate supply (AS) Increase in AD: Reverse multiplier effect full explanation for 3.2: Increase in _____(eg. I) increases AD from AD0 to AD1. Assuming spare capacity in the economy, there will be a multiplier effect where there are multiple rounds of increase in income-induced consumption due to initial increase in AD, leading to further increase in AD from AD1 to AD2. As AD rises, firmes experience unplanned fall in inventories which will signal to them to step up production and demand for more factors of production (particularly labour) in order to produce more output. In turn, households receive increased factor income from firms, and households increase induced consumption, increasing AD further. This process repeats, with each successive round of increased induced consumption being smaller than the previous round because the rest are withdrawn via savings, taxes and spending on imports. The process continues until intitial autonomous increase in AD = total withdrawals. (Additionally, an increase in I or G would lead to increase in capital goods/ infrastructure leading to increase in productive capacity of the economy, thus an increase in long-run AS, depicted by rightward shift of AS curve.) This results in: EG: an increase in the equilibrium general price level from P0 to P2, and a multiplied increase in real output from Y0 to Y2. This increase in real output from Y0 to Y2 indicates actual economic growth. Unemployment: Price stability: Increase in AS * Fall in UCOP (eg. fall in global energy prices) →firms incur lower UCOP →firms’ profitability increases →more willing and able to produce more at each GPL, causing AS to increase + AS curve shifts downwards from AS0 to AS2. This results in a decrease in equilibrium GPL from P1 to P2 and an increase in the real output from Y1 to Y2, → actual growth Actual growth depicted by movement of a point within the PPC to another point close to the PPC (A to B) Potential growth refers to an increase in the productive capacity of an economy over a given time period. Caused by: * Increase in quantity of FOP * Increase in quality of FOP 1. Increase in the quantity of FOP (eg. discovery of new resources, increased working population) →increase utilisation of resources →increase productive capacity and AS in the long run, represented by a rightward shift of the vertical range of the AS curve from YF1 to YF2 → potential growth 2. Increase in quality of FOP (eg. increase productivity of workers through higher education and training, improvement in tech) →increase utilisation of resources → increase productive capacity and AS in the long run, represented by a rightward shift of the vertical range of the AS curve from YF1 to YF2 → potential growth Potential growth depicted by outward shift of a country’s PPC Sustained growth is where there is positive and stable growth rate, without significant upward pressure on the general prive level over an extended period of time. Caused by: * AS increases in tandem with increases in AD → real output increases from Y1 to Y3 while there is only slight increase in GPL from P1 TO P3 Why is sustained growth growth important? If AD keeps increasing while the economy’s productive capacity does not → increase in real output will cease and actual growth will stop as full employment of the economy is reached →GPL keep rising → demand-pull inflation If productive capacity keeps growing (LRAS) while AD does not → too much excess capacity in the economy → high unemployment of FOP (demand-deficient unemployment) Sustainable economic growth indicates a rate of growth that can be sustained without creating other significant economic problems, particularly for future generations. How to ensure sustained growth? SG context → sustainable growth involves growing the city state in a clean and green manner. This means to develop without placing too much pressure on water, land and energy resources + minimise negative externalities through polllutive activities, so the environment can be protected for future generations to enjoy Government action → ‘car-lite’ Singapore, development of ‘eco-smart’ towns, making recycling more convenient and improving waste collection infrastructure to achieve goal of zero-waste nation. Inclusive growth indicates a rate of growth that is sustained over a period of time, is broad-based across economic sectors, and creates productive employment opportunities for majority of a country’s population. SG context → Take into account income distribution, ensure growth does not worse income inequality. Inclusive growth in SG could include an upgraded and restructured economy that support sustained growth * with the creation of better jobs in every vocation to enable all Singaporeans to earn higher incomes * more assistance to children from poorer homes to overcome early disadvantages, find their strengths and develop to their fullest potential, so that there are more avenues for upward social mobility * Stronger support for the elderly and Singaporeans with disabilities to live better Causes of EG Demand-side factors Components of AD → consumer expenditure C, investment expenditure I, government expenditure G and net export revenue (X-M) Assuming spare capacity in the economy, increase in components of AD will lead to a multiplied increase in the equilibrium level of real output due to multiplier effect (see above) Component of AD Determinant Consumption expenditure C * Wealth * Interest rates and availability of credit * Consumer confidence * Expectation of future prices Investment expenditure I * Business confidence * Interest rates and availability of credit * Government measures * Capital cost and productivity Government expenditure G * Macroeconomic aims Net export revenue (X-M) * Economic performance of trading partners * Relative inflation rates (foreign price levels) * Exchange rates → can show up as limitations to policies too SS factors * UCOP (SRAS) * Quantity and quality of FOP (LRAS) Weak (low) actual growth → real output is increasing but at a very low rate Caused by: * Slower than expected growth in any component of AD Negative actual growth → real output is falling → recession occurs when real output falls over 2 consecutive quarters Eg. Weak AG:(DD) Due to less positive business outlook in second quarter, I could have increased by a lesser amount compared to first quarter. Ceteris paribus, AD will increase but by a smaller extent → smaller increase in real output in Y2 to Y3 compared to Y1 to Y2 → weak actual growth (SS) Weak AG can also occur if there is insufficient resources to sustain growth, such as capital and skilled labour or when there are structural rigidities that constrain the economy’s ability to achieve actual growth in LR Negative AG:(DD) Pessimistic business outlook could have led to a decrease in I → reverse multiplier effect, where there are multiple rounds of decrease in income-induced consumption due to intital fall in AD → decrease in I and reverse multiplier effect causes AD to decrease → leftward shift of AD from AD1 to AD2 → real output falls → negative AG (SS) Can also result from rising UCOP + fall in productive capacity Causes for negative actual growth: 1. Increasing UCOP (SRAS) Rising demand for raw materials , labour and capital in emerging economies eg. China, India, the global prices of such FOP increases. → UCOP increases → firms’ profitability lowered and they reduce production → AS falls and AS curves shifts upwards from AS1 to AS2 → real output falls from Y1 to Y2 → negative AG 2. Shrinking labour force (LRAS) As countries develop, wages rise, hence opp cost of spending time to raise children increases → HH may have fewer children For developed countries, fertility rates have eventually fallen below replacement rates. In absence of immigration, the population of these countries, thus labour force, decreases. This reduces the quantity of labour and the productive capacity of the economy, causing long-run AS to fall, reducing potential growth. As AS curve shifts leftwards, real output falls → negative AG 3. Brain drain (LRAS) Brain drain refers to the emigration of highly educated workers to richer countries. When brain drain occurs, this reduces the quality of the labour force, leading to decreases in the productive capacity of the economy and hence negative potential growth. 4. Capital depreciation and accumulation (LRAS) Capital depreciation refers to the wear and tear of capital goods, while capital accumulation refers to the increase in capital stock as firsts invest in capital goods. Every yr, econ’s stock of capital goods decreases due to capital depreciation and increases due to capital appreciation. If capital depreciation > capital appreciation → capital stock decreases → decrease in productive capacity → negative PG → negative AG 5. Reduction in savings rates and investments (DD) If econ faces fall in savings rates over time, total pool of funds available for financial institutions eg. banks to lend to businesses falls. With lower supply of funds, the interest rates and hence cost of borrowing increases → expected profitability for firms decreases → I decreases → decreases in AD → reverse multiplier effect → negative AG * Fall in I reduces quantity of capital goods → reduces productive capacity → fall in AS in LR → PG decreases (iii) Analyse the consequences of desirable and undesirable rates of economic growth from the perspectives of economic agents (consumers, producers and governments) (iv) Analyse the significance of sustainable and inclusive economic growth as a government’s macroeconomic objective Benefits of AG 1. Higher material SOL Actual growth increases country’s material SOL as higher output and income provide HH with higher purchasing power to consume more and higher quality G&S. If AG > population growth → real income per capita increases → material welfare of average individual rises as C increases. Increase in domestic income level would mean a greater ability to consume both domestically produced goods and imported goods → consumers are able to enjoy greater quantity, wider variety and higher quality G&S. As income increases with AG, households also experience higher savings as they spend only a proportion of their additional income on consumption. This increase in savings can allow consumer to maintain their consumption levels and maintain future material SOL when econ is not doing so well. 2. Higher non-material SOL AG raises country’s nmSOL as higher employment rates and incomes could lower stress rates and reduce the crime rates due to higher opp cost of committing crime → safer society Higher incomes also lead to increase in tax revenue for govt even when tax rates remain unchanged → govt can increase spendings on public schools to increase literacy and on public healthcare facilities that ca increase life expectancy rates. 3. Lower unemployment AG creates jobs and reduces unemployment. AG → more output has been produced due to increase in components of AD. [Multiplier effect explanation] → reduction in demand-deficient unemployment 4. Sustained growth Current AG can promote PG, leading to sustained growth. Higher AG generally boosts producers’ confidence in business outlook, leading to higher I due to higher expected rates of returns from investments. AG also increases income → higher absolute amt of savings and tax revenue, ceteris paribus. Hence, more funds available to finance both private and public investments, resulting in increase in I and faster capital accumulation. The increase in investment leads to increase in AD (insert multiplier effect) in SR + raises capital stock → increase in productive capacity and long run AS. As AS increases in tandem with AS, sustained growth is achieved. 5. More funds to redistribute for inclusive growth With higher national income, govt is able to collect more tax revenue even when tax rates remain unchanged. With more funds, govt has higher budget to spend on programmes for low-income HH. This makes it easier for governments to implement income redistribution policies to reduce income inequality + provide more support for less advantaged in society. Without AG, increase spending on such programmes would likel be financed by increasing personal income taxes which would reduce disposable income available for consumption and hence reduce mSOL. Costs of AG Depends on (can consider for evaluation) * Rate of AG * How AG is pursued by govt eg. increasing G, restructuring economy * Type of AG pursued * Existing state of econ 1. Lower non-material SOL To achieve AG, individuals could be working harder and for longer hours → higher stress levels, fall in leisure time and fatigue despite increase in productivity due to assistance of tech → accumulated stress and fatigue could lead to health deterioration → worsening nmSOL If AG is achieve by restructuring economy eg. shift from manufacturing lower value-added goods to higher value added goods, can cause great stress to individuals who are unable to adapt due to occupational immobility, whereby there is mismatch of skills between the skillsets workers possess and those required by employers. 2. Depletion of natural resources (unsustainable growth) Excessive AG often results in unsustainable growth because of the depletion of resources and environmental degradation. AG is often associated with increase in energy demand and consumption as individuals are able to enjoy more luxurious G&S with higher real incomes. Eg. fossil fuels are burnt to generate electrical energy for various recreational and industrial activities, making them a major contributor to global warming. Amount of natural resources such as metal and minerals are finite. As AG uses up non-renewable resources, there is less of such resources for future use. 3. Increasing income inequality Rapid AG can lead to increasing income inequality in both developed and developing nations. When economy restructures due to industrialisation strategies, AG is often unevenly distributed between the rich and the poor. With growth of jobs and pay in high-knowledge industries such as biotech, aerospace engineering, individuals with higher skills who are in greater demand tend to receive higher income increments while decline of low value-added industries results in lower demand for lower-skilled workers, thus reducing their income. EG. in China, rise of majoy high-tech industries eg. transportation and financial services in eastern provinces that are export-oriented led to rising incomes among workers and entrepreneurs. However, lower-skilled workers tend to receive lower incomes, contributing to rising income inequality → non-inclusive growth Non-inclusive growth may lead to political instability becuase of unhappiness generated by unevenness of growth. 4. Conflict with other macroeconomic goals AG results in higher real income levels, thus higher C, increasing AD. If AD increases while econ is approaching full employment, real output may not increase further in SR. However, GPL will continue to increase →demand-pull inflation → conflict with price stability When econ restrutures to achieve growth, changes in the structure of econ will lead to emergence of sunrise industries and decline in sunset industries. Demand fo certain skills eg. maintaining computer systems will intensity whereas demand for other skills eg. sewing clothes may decline or even vanish. Workers who find that their skills and experience have become obsolete will find they have no marketable talents → occupational immobility, where there is mismatch between skills that workers offer and skills demanded by firms → structural unemployment until they adapt or develop skills that employers want. →confict with full employment Rise in domestic income level due to AG → higher import expenditure M → worsens BOT in current account of country’s BOP → conflict with favourable BOT Costs of negative growth (opp of AG) On government: 1. Impact on other macroeconomic objectives * If economic slowdown is due to fall in AD →GPL falls + inflation rates could be reduced if econ originally producing at full employment output level but could trap econ in deflation, whereby GPL are constantly falling → reduces consumer and business confidence → further decline in C and I (reverse multiplier effect) → further negative growth rates * Could lead to fall in HH’s C as lower demand for G&S → lower demand for labour (multiplier effect) → decrease in demand-deficient unemployment → conflicts with full employment * Loss of business confidence → prevent foreign firms from setting up plants in the country because of the expected lower returns to investment → fall in FDI + long-term capital flows into the country. Individual and corporate investors could also withdraw short-term capital from the country → worsen capital and financial account in country’s BOP. 2. Less funds to sustain actual growth and redistribute income * Negative actual growth causes real national income to fall. HH earn less income and firms earn less revenue, thus profits → even though tax rates remain unchanged, tax revenue decreases. * Govt might increase pay-outs on unemployment benefits to raise citizens’ SOL. Decrease in government revenue and increase in expenditure could worsen govt’s budget position With less funds, govt may reduce the size of programmes and spending on infrastructure development → fall in AD + AS → multiplier effect → adversely affect AG + PG, thus sustained growth. Fall in tax revenue would also decrease funds available for govt to spend to implement redistribution policies in the form of subsidies and transfer payments, and perhaps less support for the less advantaged in society so that they are included. This increases income inequality, worsening inclusive growth. 3. Political instability Fall in mSOL and increased difficulting for govt to sustain growth could triggere political instability. Eg. Indonesis when pres was forced to resign in 1998 On consumers: 1. Decrease in mSOL + loss on employment As AD falls → less demand of labour as firms cut down on their production → individual maye be retrenched and become unemployed. Those earning flexible wages (eg. property agents) could experience fall in their incomes → individuals’ purchasing power decreases → consume fewer G&S → C decreases and mSOL falls. Some individuals who may tap on their savings to spend basic necessities will experience a fall in their savings. This reduces the amount of saving available for future consumption → future mSOL decreases. Some individuals may also resort to borrowing to maintain their current consumption levels. The repayment of these loans may compromise future mSOL. On producers 1. Decline in revenue & profits Assuming firms generally produce normal goods with positive income elasticity of demand (YED>0), fall in income lvls of consumers due to -ve growth → reduce demand for G&S due to decrease C→ fall in firms’ revenue and erode their profit margins → reducing returns to entrepreneurship. 2. Reduction in investment expenditure With lower profits, producers could become more pessimistic about future profits/ have less funds to replace worn out capital + if there is negative growth, businesses are likely to have a poor business outlook → decrease in I in current time period → less excess capacity to expand production when econ recovers and demand for G&S increases → lose out on opportunities to reap larger profits in the future. However, for firms that have been reaping supernormal profits, a period of slow or negative growth could be a gd opportunities to carry out investment expenditure as they take advantage of lower prices of capital goods brought abt by lower demand. Policies 5 types of policies: * (Contractionary/ Expansionary) Fiscal Policy * (Contractionary/ Expansionary) Monetary Policy * Supply-Side policies * Policies to achieve sustainable and inclusive growth * Trade Policies Terms Govt budget can be * Balanced → expenditure = revenue * Budget surplus → expenditure < revenue * Budget deficit → expenditure > revenue Can be considered during evaluation Government expenditure → the total spending by govt on G&S, can be catergorised into govt operating expenditure and govt development expenditure Govt operating expenditure refers to govt expenditure on operation of govt services, includes rent for land supplied by HH in its operations and wages for public servants → day-to-day recurrent spending → changes affect AD Govt development expenditure includes spending on roads, hospitals and schools → increase productive capacity → changes affect AD and AS Govt spends to * Achieve efficiency → supply G&S that are under-consumed in free market, eg merit goods, or G&S that private sector fail to provide, eg. defence * Incease equitability → increase access to basic necessities through transfer payments (eg. CDC vouchers) * Achieve sustainable and inclusive growth * Reduce unemployment Budget revenue can come from taxation, profits of state-owned enterprises, grants from other countries, return from financial investments and from borrowing. Take note of these factors in extracts and preambles. Read pg 7-8 for diff types of taxes Demand side policies (always pair with SS policy in essay) * Fiscal policy * Monetary policy 1. Fiscal policy involves altering the level of government expenditure and/or direct tax rates. It is a demand-management policy that uses the main tools of government expenditure and direct taxes to influence the level of real output, employment and general price level. (refer to diagram) Expansionary fiscal policy can be used to combat * weak/ negative AG Expansionary fiscal policy: * By G → involve spending on infrastructure like transportation, public utilities and telecommunication, and on merit goods such as education and healthcare. (give examples of how eg. build new university) * By decreasing direct tax rates - Reduce personal income taxes → raise HH’s disposable income → purchasing power increases → C increases - Reduce corporate tax → firms’ post-tax profits increase → encourage increase in I Increase in G/ C and I boosts AD directly and AD increases from AD1 to AD2. When there is spare capacity in the economy, there will be a multiplier effect, triggering multiple rounds of increase in income-induced consumption, further increasing AD from AD2 to AD3. This is because as AD rises, firms experience an unplanned fall in inventories which signal for them to step up production and demand for more FOP, particularly labour, to produce more output. Hence, increase in G/reduction of direct taxes can boost AD in the form to increase C and I. Due to multiplier effect, AD curve shifts rightwards from AD1 to AD3. There is a multiplied increase in real output from Y1 to Y3, indicating AG. Note: Cutting taxes have a smaller effect on real output income than raising G. Cutting direct taxes increases people’s disposable incomes, of which only part will be spent on domestically-produced G&S (depending on MPC). (and part will be withdrawn into extra savings, imports and other taxes, depending o MPW) Hence, not all tax cuts will go towards increasing AD. Thus, it is better to suggest change in G in essays. Limitations of expansionary fiscal policy: 1. Crowding out effect Occurs when increase in G decreases I. Assuming govt borrows to finance its expansionary fiscal policy, it will compete with firms for funds → demand for loans increases → higher i/r → higher COB →discourage firms to undertake investments → fall in I. This limits increase in AD in boosting EG 2. Tax/ i/r insensivity! Depends on state and outlook of the economy. Decreasing corporate income taxes during recession or economic downturn may fail to encourage investments as firms may be too pessimistic about prospects of higher future profits. Similarly, a decrease in personal income taxes may fail to increase consumption as HH are too pessimistic about earning higher future incomes. This limits effectiveness of expansionary fiscal policy in boosting EG. Additionally, multinational companies also consider many other factors other than COB such as wage rates and labour skills, corporate tax rates, transport and communication infrastructure, the potential for growth as well as political instability. These factors affect rate of returns from investments → tax insensitive 3. Debt burden Expansionary fiscal policy may result in a government running a budget deficit and govt debt. High lvls of debt → future tax revenue will be needed to pay off such debts and the interest incurred → less funding available for social services and infrastructure. Future welfare sacrificed for the sake of raising current welfare. Excessive fiscal debt may result in capital flight and sovereign debt defaults which can create severe macroeconomic instability. To avoid this, country may need to undertake austerity measures to restore investor confidence. 4. Size of multiplier! To achieve same lvl of AG, an economy with a larger multiplier will require a smaller increase in G or a smaller reduction in taxes, as compared to a country with a smaller multiplier. Size of multiplier is inversely proportional to MPW. An Increase in MPW reduces the size of the multiplier, vice versa. → in SG context → multiplier size tends to be small due to relatively high savings rate (MPS) and high import reliance (MPM). Due to compulsory savings in the form of CPF, where employees aged 55 and below are required to save 20% of their income, MPS is large. SG’s small domestic sector and lack of natural resources mean that most consumer goods and industrial raw materials are imported from overseas, and this contributes to a high MPM. → large MPW → small MPC (MPC+MPW=1) → small multiplier size → increase in G or cut in direct taxes have to be very significant if expansionary fiscal is applied. Likely to be constrained by budget. 5. Time lag! May not take effect immediately. Takes time to recognise the problem of negative or weak AG (recognition lag), and for govt to intervene and adjust govt development expenditure and/or tax rates (implementation lag). After adjusting development expenditure and/or tax rates, it takes time for HH and firms to respond and change their consumption and investment patterns. (impact lag) Lags associated with this policy actions can give rise to complications. Suppose central banks sees tha AG is negative and intervenes to bring about a fall in i/r. By the time it takes effect, economy might have already recovered from the recessions and to have economy expanding at this point would bring about the trade-off between stable prices and EG as GPL would rise rapidly. Unintended consequences of expansionary fiscal policy 1. Conflict with other macroeconomic goals When economy is operating near or at full employment, whereby current equilibrium is at the intermediate to vertical range of the AS curve, further increases in AD may not increase output levels, but instead cause GPL to increase, leading to demand-pull inflation. Time lags during implementation could also mean that the effect of the policy comes into effect only when economy has already recovered and is experiencing a boom → large increase in GPL and demand-pull inflation → conflicts price stability Rise in domestic income level tends to lead to higher import expenditure (M), worsening BOT through current account. If BOT worsens due due to increase in M → conflicts favourable BOT. 2. Attainment of other macroeconomic goals If there is increase in development expenditure, workers training or R&D → potential growth → sustained growth as AG also occurs. Eg. Development of Circle line, Downtown line by LTA has improved transport infrastructures in Singapore, allowing workers to get to work to to work almost anywhere with greater convenience, boosting productivity of labour. 2. Monetary policy involves altering the supply of money in the economy or manipulating the interest rates. Singapore employed e/r-based monetary policy Interest rate monetary policy involves regulating the money supply in the economy or manipulating the rate of interest to influence the level of economic activity. Expansionary i/r monetary policy can be use to combat * weak growth or negative AG Fall in i/r will reduce COB + returns to savings for consumers and firms. As HHs are now more incentivised to borrow more to purchase big-ticket items and less incentivised to save, this will encourage more consumption (C) + increase I due to increased expected profitability on investments. If there is spare capacity in the economy, there will be a multiplier effect…(multiplier effect)→ rise in C and I and the multiplier effect will increase AD → AD curve shift rightwards from AD1 to AD2. AG achieve when real output increases from Y1 to Y2. In LR, increase in I will increase quantity of capital stock → increase in productive capacity → rightward shift of AS from AS1 to AS2 → potential growth → sustained growth Note: increase in G will have the most certain and direct effect on AD compared to decrease in direct taxes and i/r as the latter are dependent on decisions of firms and HHs. (MPC) Limitations of i/r monetary policy: 1. Interest insensitivity (same explanation as tax insensitivity) Depends on state and outlook of the economy. Decreasing i/r during recession or economic downturn may fail to encourage investments as firms may be too pessimistic about prospects of higher future profits. Similarly, a decrease in i/r may fail to increase consumption as HH are too pessimistic about earning higher future incomes. This limits effectiveness of expansionary fiscal policy in boosting EG. Additionally, multinational companies also consider many other factors other than COB such as wage rates and labour skills, corporate tax rates, transport and communication infrastructure, the potential for growth as well as political instability. These factors affect rate of returns from investments → tax insensitive 2. Liquidity trap (unique to i/r) There is a lower bound for i/r (zero) and hence a limit to how far i/r can fall. Nominal i/r cannot fall below 0 bc this indicates that an individual who saves is effectively being charged to deposit their money in the bank → individual wld rather hold onto cash which is more liquid than savings. When i/r are already very low ie. almost or at 0, expansionary monetary policy may not longer be effective → liquidity trap. Any rise in money supply to reduce i/r would only result in extra liquidity being kept in idle balances as firms and households are unwilling to spend. This is made worse when economy is performing poorly with consumers an producers having pessimistic business outlook → AD, production and employment may be ‘trapped’ at low levels, limiting effectiveness of policy in boosting AD. https://www.youtube.com/watch?v=p47uvsjB5E0 3. Size of multiplier To achieve same lvl of AG, an economy with a larger multiplier will require a smaller cut in i/r, as compared to a country with a smaller multiplier. → in SG context → multiplier size tends to be small due to relatively high savings rate (MPS) and high import reliance (MPM). Due to compulsory savings in the form of CPF, where employees aged 55 and below are required to save 20% of their income, MPS is large. SG’s small domestic sector and lack of natural resources mean that most consumer goods and industrial raw materials are imported from overseas, and this contributes to a high MPM. → large MPW → small MPC (MPC+MPW=1) → small multiplier size → increase in G or cut in direct taxes have to be very significant if expansionary fiscal is applied. Likely to be constrained by budget. Size of multiplier is inversely proportional to MPW. An Increase in MPW reduces the size of the multiplier, vice versa. 4. Time lag May not take effect immediately. Takes time to recognise the problem of negative or weak AG (recognition lag), and for govt to intervene and adjust i/r (implementation lag). After adjusting development expenditure and/or tax rates, it takes time for HH and firms to respond and change their consumption and investment patterns. (impact lag) Lags associated with i/r monetary policy actions can give rise to complications. Suppose central banks sees tha AG is negative and intervenes to bring about a fall in i/r. By the time it takes effect, economy might have already recovered from the recessions and to have economy expanding at this point would bring about the trade-off between stable prices and EG as GPL would rise rapidly. Unintended consequences of i/r monetary policy Same as fiscal monetary policy * In an economy which allows free international capital mobility, decreasing i/r may increase short-term capital outflows (hot money). As locals move their funds out of the country to take advantage of higher i/r in other countries. If country adopts freely floating exchange rate system, currency will depreciate → increase price of imported inputs → price of imported raw materials, intemeidate goods and other products increase → higher UCOP → cost-push inflation → conflict with price stability Exchange rate monetray policy + diff e/r regimes Exchange rates refer to the rate at which one currency can be traded for another on the foreign exchange market. 1. Freely floating exchange rate regime * No govt intervention in FOREX * Exchange rate flucturates according to market forces of demand and supply of currency * Rise in e/r is an appreciation, fall in e/r is a depreciation Explanation of demand and supply of currency: From US perspective According to Law of demand → price of currency and its qty demanded (shift on DD curve) are inversely related. The lower the value of the US dollar relative to a foreign currency, the cheaper it will be for the foreigners to buy assets or G&S produced in US. To do so, foreigners wld need to use their currency to exchange for more US dollars. Therefore, as the value of US dollar falls, qty demanded for US dollars increases → hende demand curve slopes downwards. According to law of supply → price of currency and qty supplied are directly related. The higher the value of the US dollar relative to foreign currency, the cheaper it will be for Americans to buy more foreign assets or G&S. Americans wld need sell their US dollars in exchange for more foreign currency. Hence, as value of US dollar rises, qty supplied for US dollar increases. Hence, supply curve slopes upwards. Factors affecting Demand of currency Supply of currency * Foreigners increasing their purchase of G&S produced in US * Forigners increasing their purchase of US assets (either through FDI or foreign portfolio investment) * Speculators anticipating rise in value of the US dollar in future, hence increasing current demand for US dollars * US government selling its foreign reserves to purchase more US dollars ( increases DD for US dollars) * US residents increasing their demand for foreign G&S * US residents increasing their demand for foreign assets ( either through investment in other countries or portfolio investments in other countries) * Spectators anticipating fall in value of US dollars in future * US govt sells US dollars to purchase foreign currencies to increase its foreign reserves Look at pg 24 think abt it 5 2. Managed float exchange rate regime SINGAPORE MAS employs this to promote price stability as a basis for sustainable growth. In 2016, MAS has changed its policy stance to that of 0 appreciation for SG dollar. * e/r allowed to fluctuate within an undisclosed band, central bank does not intervene here * When e/r reaches boundaries of band, central bank intervenes by selling or buying the domestic currency to ensure e/r does not fluctuate beyond band Know how to explain change in e/r using DD and SS concepts Hence, SG’s e/r depends on * Actions of HH and firms in FOREX * Foreign exchange interventions of central bank Reasons for adapting e/r monetary policy in SG! 1. SG’s dependence on trade SG has no natural resources, thus is highly dependent on imports for consumption gds and factor inputs + Given small size of economy, SG is a price taker on the global market → high import content of output and consumption → changes in exchange rate would have significant and direct influence on price lvl in SG’s economy → e/r used to mitigate imported inflation to attain price stability Due to small domestic market, SG’s economy is highly dependent on exports to generate enough demand for its G&S → SG highly export-oriented Highly dependent on trade→ managing e/r enables SG govt to have greater control over prices of imports and exports, directly influencing net exports and the AD. Eg. can reduce inflation by appreciating SG dollar → reduce (X_M) → fall in AD 2. SG as a global i/r taker As Singapore is a financial centre, she is very open to capital flows in and out of the country. However, due to relatively small size of SG’s economy as compared to other countries, SG has little influence in global i/r, thus is an i/r taker. What is the Open Economy Trilemma? Take for example: If SG’s domestic i/r are allows to be diff from i/r of other countries, short-term capital can rapidly move in and out of SG (depending on which country has more favourable i/r) Huge capital movements into and out of SG can cause fluctuations in exchange rates → lowers business confidence as this results in uncertain costs and revenues for businesses that are dependent on external sector. Hence, SG sticks to e/r monetary policy due to its free trade capital mobility. Suppose SG tries to increase its i/r by reducing money supply. Ceteris parbius, with free capital mobility, there will be hot money inflows as foreigner move their funds to Singapore to take advantage of higher i/r. This would create an increase in demand for SG dollars in FOREX, causing upward pressure on e/r → appreciation If SG wishes to control e/r, it would increase supply of SG dollars, negating initial reduction in money supply. How to determine whether a country functions by changing i/r or e/r? Characteristics Prioritise i/r Prioritise e/r Econ. stability goal Inflation control, EG e/r stability, trade competitiveness Monetary policy control High control over domestic i/r Limited control over i/r Trade and export dependence Less dependent on exports Heavily reliant on trade and exports Eg. UK, US, Canada, Austrailia China, Hong Kong, SG, Saudi Arabia 3. Fixed exchange rate regime Refers to an exchange rate policy where a country fixes (pegs) the value of its currency to that of another country’s currency. * Rise is called revaluation * Fall is called devaluation * Persistent maintenance of a strong e/r can lead to overvalued e/r, vice versa * When the market conditions change, free market equilibrium e/r moves away from pegged rate, thus central bank will have to intervene by either selling or buying its own currency in FOREX to keep e/r pegged at existing lvl Expansionary e/r can be used to combat * Deflation and negative growth, SG tends to depreciate SG dollar How? MAS could adjust the band of managed float downwards to allow market to float at lower level OR sell SG dollars on FOREX, increasing supply of SG dollars Depreciation of SG dollar Impact on AD: Increase Price of exports become cheaper in terms of foreign currency → increase in qdd for SG exports. Price in imports become more ex in terms of domestic currency → fall in qdd for imports as consumers switch to buy more domestically produced goods instead of imported goods. Assuming that absolute sum of price elasticities of demand for exports and imports are greater than 1 ie Marshall-Lerner condition holds, a depreciation will increase net exort revenue, increasing AD. Assuming spare capacity …(multiplier effect)... →increase in AD and multiplied increase in real GDP Impact on AS: Decrease in SRAS Depreciation → prices of imported inputs increases in terms of domestic currency → UCOP increases → AS decrease in SR, AS curve shifts upwards Signifcantly affects producers in SG as they are import reliant. Overall if increase in AD > decrease in AS → AG Limitations of expansionary e/r monetary policy 1. Economic conditions abroad When trade partners are facing recession or downturn, depreciating currency may not be effective in increasing net export revenue (X-M) and boosting AD because thought exports become cheaper, they may still be relatively unaffordable in foreign countries when their income lvl falls. Assuming goods or normal gds, fall in income lvls of trading partners will lead to fall in demand for exports, hence may not increase expenditure on exports → smaller increase in (X-M) → smaller extent of increase in real GDP thus AG 2. Prices elasticities for exports and imports The more price inelastic the demand for a country’s exports, the smaller the rise in qdd for its exports given a depreciation, vice versa → limits extent of increase in (X-M) and hence AD 3. Time lags See last page Unintended consequences of e/r monetary policy 1. Conflict with macroeconomic goals A depreciation of currency for country with high import reliance like SG would mean higher production cost bc of higher costs of imported inputs → cost-push inflation → conflicts with price stability, hence SG usually doesn’t depreciate SG dollar A depreciation of the currency can lea to initial worsening of BOT (J-curve effect). In SR, demand for exports and imports are price inelastic as time is required for economic agents to search for substitutes in response to the change. This results in fall in net export revenues Prolonged depreciation of currency to boost price competitiveness may breed complacency in exporting firms and prevent them from being dynamically efficient to improve quality of goods to stay relevant in international market → hinder innovation and PG ‘Beggar-thy-neighbour’ → means to remedy its country’ economic problems tend to worsen economic problems in other countries Run risk of retaliation by other countries like trade restrictions eg. tariffs → worsening BOT and negate expansionary effects 2. Attainment of other macroeconomic goals If absolute sum of price elasticies of exports and imports is greater than 1 ie Marshall-Lerner condition holds, a depreciation of the currency can improve BOT as there will be a more than proportionate change in qdd for exports and imports when their prices change due to depreciation → Improvement in (X-M) Supply-side policies They affect aggregate supply by affecting costs (SRAS) or productivity (LRAS) * Market-oriented → ‘freeing up’ market and improving market incentives eg. tax cuts, privatisation, deregulation * Interventionist → count inadequacies of markets through direct govt provision eg. of transport infrastructure, training or R&D, or financial support for private provision Market-oriented SS policies: * Tax cuts → reduce UCOP/ incentivise increase in quantity/quality of resources * Policies to encourage competition → increase efficiency and remove barriers to competition in markets 1. Tax cuts * Cut in indirect tax eg. GST→ lowers UCOP → increase firms’ profitability → increases AS in SR, shifting AS downwards from AS1 to AS2 → increases real output from Y1 to Y2 → actual growth → movement along AD curve * Cut in direct tax eg. personal income tax rates → increases after-tax wages and thus disposable income → larger diff between after-tax wage rates and unemployment benefits → motivate people who were initially out of labour force to enter the workforce → quantity of labour increase, ceteris paribus, increasing producitive capacity of economy → LRAS increases, depicted by rightward shift → increase in real output from YF1 to Y2 → AG 2. Policies to encourage competition (see more in firms and decisions) Leads to AG, dynamic efficiency and PG 1. Privatisation * Transfer of ownership and control of publicly run company to the private sector * Introduction of private services into public sector With stronger profit motive found in private sector, privatisation lowers cost of provision of these services. Fall in UCOP will increase AS, thus AS curve shifts downwards from AS1 to AS2 → increase in real output from Y1 to Y2 → AD 2. Deregulation * Removal of govt laws and regulations in the industry to promote greater competition * Eg. SG’s telecommunication industry in 1990s → privatised to create Sintel and competition from MobileOne and Starhub introduced in ate 1990s * Firms incentivised to be productively efficient and lower their COP Interventionist SS policy Direct govt intervention to counteract deficiencies of the market Typically occurs when there is too little R&D, training and investments due to * Uncertainty of returns * High fixed costs Hence, these policies help to reduce macroeconomic instability by lowering production costs or directly manage prices of necessities. Additionally, factor immobility can be enhanced by promoting job retraining. 1. Developing tech → PG * Increase productivity, thus quality of FOP → increases LRAS and shifts AS curve rightwards * Developed by: 1. Engaging in R&D 2. Importing more technologically advanced capital goods from other countries 3. Adopting more productively efficient management and workplace organisation * Success in R&D → process innovation → improves productivity and lowers UCOP * However, during times of low EG or poor business climate, firms may cut back on R&D activities to reduce overall COP → hinder technological progress. Thus, govt can subsidise R&D efforts * R&D can increase AS by lowering UCOP and increasing quality of FOP, depicted as rightward shift of AS → increase in real output → AG + increase in productive capacity → PG ----- sustained growth * Firms can also establish production sites in local economies (FDI) → boost tech → PG * Eg. ASTAR → not only conducts its own research, but also partners with local enterprises to provide funding and support for R&D. 2. Developing FOP → allows for sustained growth 1. Subsidising education programmes For lower-income HH and providing training for its ppl → raise productivity of workers Eg. SkillsFuture provides Singaporeans with opportunity to develop their skills through subsidies workshops and courses that allows them to become more productive workers Increase in G on education and training will increase AD in SR → real output increases from Y1 to Y2. In LR, increase in quality of labour and productivity bc of investment in human capital will raise LRAS → AS curve shifts rightwards → PG Sustained growth achieved as real output increases from y2 to y3 without significant inflationary pressures as price only increase to p3 in LR. 2. Infrastructure development Govt can develop national infrastructure such as public transport, roads and telecommunications → increase quantity/ quality of capital goods in the economy → increased productivity (+reduced commuting time) → diagrammatically… Limitations of SS policies 1. Low certainty of outcome Giving grants to encourage R&D efforts and attract FDI do not guarantee success in improving productivity and increasing productive capacity . 2. Time lag Effects tend to only be felt in the LR as time is needed to train workers and increase capital stock in the economy, and reduce structural rigidities in the market → very long time lag, may not be suitable if economy requires urgent attention eg. recession Unintended consequences of SS policies Usually have huge G, affecting fiscal sustainability. For govts with huge budget deficits, SS policies may have to be funded via increasing taxes or even borrowing. Can result in * Future increases in taxes to funs present-day borrowing * Future reductions in govt spending Additionally, if economy is below full employment output and there is a lot of spare capacity, SS policies will do little for AG → cld lead to greater unemployment of resources Policies to achieve sustainable and inclusive growth SG Policies to achieve sustainable growth Aim: to protect environment or conserving finite natural resources → future growth is protected as future generations will continue to enjoy access to FOP of same quantity and quality as current generation. Ensure true long term sustained growth is possible across all generations. 1. Vehicle Emission Scheme → affects consumers Aims to reduce vehicular pollution by getting consumers to switch from more pollutive vehicles to more environmentally friendly vehicles to reduce pollution. Under the scheme, the amt of susbidy or tax that a vehicle owner must pay when purchasing a new vehicle will depend on amt of pollutants thst vehicles releases when operated. Consumers who choose to purchases vehicles which produce less pollution could qualify for subsidies, incentivising C, vice versa. 2. Carbon taxes → affects firms All facilities producing 25,000 tonnes or more of greenhouse gas emissions have to pay a carbon tax of $5 per tonne of greenhouse gas emitted. Will increase to $10-15 per tonne by 2030. (-ve consequence) Additionally, stringent emission regulations and taxes could deter potential investors. Increased COP from taxes and difficulties in complying with local regulation cld reduce expected returns from investments in country, thus reduce I → AD decreases → AG decreases. In LR, lower investment in capital goods could reduce or slow down PG, affecting sustained growth 3. Water price policies * Increased water price * Introduction of Water Conservation Tax Aims to increase cost of drinking water and reduce water consumption to conserve precious resource. Limitations of policies to achieve sustainable growth 1. Difficulty in assigning monetary value to negative impact of pollution 2. Administrative cost of implementing the policy 3. Time lags 4. Politically unpopular Unintended consequences: Increase UCOP → producers produce less → decrease in AS in SR → upward shift of AS curve from AS1 to AS2. Real output decreases from y1 to y2 and GPL increases from p1 to p2 → -ve AG and inflation * -ve consequence) Additionally, stringent emission regulations and taxes could deter potential investors. Increased COP from taxes and difficulties in complying with local regulation cld reduce expected returns from investments in country, thus reduce I → AD decreases → AG decreases. In LR, lower investment in capital goods could reduce or slow down PG, affecting sustained growth SG policies to achieve inclusive growth Aim: upgrading workers’ skills or redistributing income 1. SkillsFuture Every Sgrean aged 25 and above will be eligible to receive $500 in subsidies to be used on approved SkillsFuture courses. Subsidies incentivise consumers to consume more skills training and further education → promote lifelong learning and skills upgrading of the workforce so as to develop a more productive workforce to improve the adaptability of the workforce to future challenges. SkillsFuture Level-Up Programme → provides greater structural support for mid-career SGreans aged 40 yrs and above to pursue substantial skills reboot and stay relevant in changing economy. Done through SkillsFuture credit top up of $4000. 2. Pioneer Generation Package MOH implemented and manages this for any SGrean born on or before Dec 1949. Package consists of medical subsidies for outpatient services ad medication, Medisave top-ups to further subsidies medical treatments, and MediShield Life subisdies on hospitalisation insurance and dsiability assistance → ensure elderly receive support fro healthcare related costs for life → redistributive policy 3. Workfare Skills Supprot Scheme 4. Redistributive policies Aims to: reduce income inequality by reducing the incomes of higher income earners through progressive income taxes, while increasing the incomes of lower income earners through transfer payments Progressive taxation system → higher income earners are taxed a higher proportion of their income than lower income earners while lower income earners see an increase in their income via higher amt of transfer payments This reduces income gap btw higher and lower income earners → reduction in income inequality → inclusive EG Limitations of policies to achieve inclusive growth 1. High costs Eg. SkillsFuture cost around $1 billion a yr and pioneer generation package around $9 billion a yr → large strain placed on government’s budget → unsustainable in LR 2. Time lags Education and skills training are inherently slow processes as it takes time for th workforce to improve in terms of productivity + short courses may not result in visible increases in skills, thus several courses may be required to achieve tangible improvements in productivity. Changing mindset of workforce to embrace lifelong learning is also necessary to convince them to take up such courses. Marketing and public awareness of the scheme takes time to develop and influence masses → greater time lag Unintended consequences (+ve) As workforce productivity increases, returns on investment cld increase → greater I from both domestic and foreign consumers → increase AD in SR + increase capital goods → increase productive capacity in LR → AG + PG = sustained growth Skills training also increase adaptability of labour to structural changes in the economy. Workers become better equipped to take on new roles in growing industries during economic restructuring → reduce structural unemployment Trade policies Influence AD and/or AS. Involvces interactions with international econ through protectionism or free trade policies eg. FTA Summary of limitations for DD policies 1. Crowding out effect → for expansionary fiscal Occurs when increase in G decreases I. Assuming govt borrows to finance its expansionary fiscal policy, it will compete with firms for funds → demand for loans increases → higher i/r → higher COB →discourage firms to undertake investments → fall in I. This limits increase in AD in boosting EG 2. Tax insensivity! → for expansionary fiscal, expansionary i/r Depends on state and outlook of the economy. Decreasing corporate income taxes during recession or economic downturn may fail to encourage investments as firms may be too pessimistic about prospects of higher future profits. Similarly, a decrease in personal income taxes may fail to increase consumption as HH are too pessimistic about earning higher future incomes. This limits effectiveness of expansionary fiscal policy in boosting EG. Additionally, multinational companies also consider many other factors other than COB such as wage rates and labour skills, corporate tax rates, transport and communication infrastructure, the potential for growth as well as political instability. These factors affect rate of returns from investments → tax insensitive 3. Debt burden → for expansionary fiscal Expansionary fiscal policy may result in a government running a budget deficit and govt debt. High lvls of debt → future tax revenue will be needed to pay off such debts and the interest incurred → less funding available for social services and infrastructure. Future welfare sacrificed for the sake of raising current welfare. Excessive fiscal debt may result in capital flight and sovereign debt defaults which can create severe macroeconomic instability. To avoid this, country may need to undertake austerity measures to restore investor confidence. 4. Liquidity trap (unique to i/r) There is a lower bound for i/r (zero) and hence a limit to how far i/r can fall. Nominal i/r cannot fall below 0 bc this indicates that an individual who saves is effectively being charged to deposit their money in the bank → individual wld rather hold onto cash which is more liquid than savings. When i/r are already very low ie. almost or at 0, expansionary monetary policy may not longer be effective → liquidity trap. Any rise in money supply to reduce i/r would only result in extra liquidity being kept in idle balances as firms and households are unwilling to spend. This is made worse when economy is performing poorly with consumers an producers having pessimistic business outlook → AD, production and employment may be ‘trapped’ at low levels, limiting effectiveness of policy in boosting AD. https://www.youtube.com/watch?v=p47uvsjB5E0 5. Size of multiplier! → for expansionary fiscal, expansionary i/r To achieve same lvl of AG, an economy with a larger multiplier will require a smaller increase in G or a smaller reduction in taxes, as compared to a country with a smaller multiplier. Size of multiplier is inversely proportional to MPW. An Increase in MPW reduces the size of the multiplier, vice versa. → in SG context → multiplier size tends to be small due to relatively high savings rate (MPS) and high import reliance (MPM). Due to compulsory savings in the form of CPF, where employees aged 55 and below are required to save 20% of their income, MPS is large. SG’s small domestic sector and lack of natural resources mean that most consumer goods and industrial raw materials are imported from overseas, and this contributes to a high MPM. → large MPW → small MPC (MPC+MPW=1) → small multiplier size → increase in G or cut in direct taxes have to be very significant if expansionary fiscal is applied. Likely to be constrained by budget. 6. Economic conditions abroad → expansionary e/r When trade partners are facing recession or downturn, depreciating currency may not be effective in increasing net export revenue (X-M) and boosting AD because thought exports become cheaper, they may still be relatively unaffordable in foreign countries when their income lvl falls. Assuming goods or normal gds, fall in income lvls of trading partners will lead to fall in demand for exports, hence may not increase expenditure on exports → smaller increase in (X-M) → smaller extent of increase in real GDP thus AG 7. Prices elasticities for exports and imports → expansionary e/r The more price inelastic the demand for a country’s exports, the smaller the rise in qdd for its exports given a depreciation, vice versa → limits extent of increase in (X-M) and hence AD 8. Time lag! May not take effect immediately. Takes time to recognise the problem of negative or weak AG (recognition lag), and for govt to intervene and adjust govt development expenditure and/or tax rates (implementation lag). After adjusting development expenditure and/or tax rates, it takes time for HH and firms to respond and change their consumption and investment patterns. (impact lag) i/r and e/r: Lags associated with this policy actions can give rise to complications. Suppose central banks sees tha AG is negative and intervenes to bring about a fall in i/r. By the time it takes effect, economy might have already recovered from the recessions and to have economy expanding at this point would bring about the trade-off between stable prices and EG as GPL would rise rapidly. Time lags for monetary policies are likely to be shorter compared to fiscal as there are more administrative bottlenecks For SG e/r: Hence, MAS formulates and conducts e/r policy in forward-looking manner by evaluating impact of the policy over the medium term based on reasonable assumptions of economic outlook and possible negative shocks.