Basic
Definitions
Social
Science
and
Economics
Social
Science
is
defined
as
a
branch
of
science
that
studies
the
society
and
human
behavior
in
it,
including
anthropology,
communication
studies,
criminology,
economics,
geography,
history,
political
science,
psychology,
social
studies,
and
sociology.
Economics
is
the
branch
of
social
science
that
deals
with
the
production
and
distribution
and
consumption
of
goods
and
services
and
their
management.
It
is
the
study
of
how
scarce
resources
are
allocated
to
fulfil
unlimited
wants.
Microeconomics
and
Macroeconomics
Economics
is
usually
divided
into
two
main
branches:
Microeconomics,
which
examines
the
economic
behaviour
of
individual
actors
such
as
businesses,
households,
and
individuals,
with
a
view
to
understand
decision
making
in
the
face
of
scarcity
and
the
allocation
consequences
of
these
decisions.
Macroeconomics,
which
examines
an
economy
as
a
whole
with
a
view
to
understanding
the
interaction
between
economic
aggregates
such
as
national
income,
employment
and
inflation.
Economic
growth
is
the
increase
of
per
capita
gross
domestic
product
(GDP)
or
other
measure
of
aggregate
income.
It
is
often
measured
as
the
rate
of
change
in
GDP.
Economic
growth
refers
only
to
the
quantity
of
goods
and
services
produced.
Economic
development
typically
involves
improvements
in
a
variety
of
indicators
such
as
literacy
rates,
life
expectancy,
and
poverty
rates.
It
is
a
measure
of
welfare
in
the
economy.
Human
Development
Index
(HDI)
is
one
of
the
most
commonly
used
development
measure.
Sustainable
development
is
a
pattern
of
resource
use
that
aims
to
meet
human
needs
while
preserving
the
environment
so
that
these
needs
can
be
met
not
only
in
the
present,
but
also
for
future
generations.
Economic
development
that
meets
the
needs
of
the
present
without
compromising
the
ability
of
future
generations
to
meet
their
own
needs.
Free
Goods
and
Economics
Goods
Free
goods
are
what
is
needed
by
the
society
and
is
available
without
limits.
The
free
good
is
a
term
used
in
economics
to
describe
a
good
that
is
not
scarce.
A
free
good
is
available
in
as
great
a
quantity
as
desired
with
zero
opportunity
cost
to
society.
Economics
goods
are
consumable
item
that
is
useful
to
people
but
scarce
in
relation
to
its
demand,
so
that
human
effort
is
required
to
obtain
it.
IB
Economics
City
Honors
School
2015-2016
4
Factors
Examples
Papa
Johns
Pizza
Land:
Retail
Locations/Kitchens/Stores
Labor:
Hourly
and
Salaried
Workers,
per
diem
delivery
drivers.
Capital:
Ovens,
Boxes,
Utensils
(pans,
spatulas,
etc.),
Point
of
Sales
equipment,
Ingredients,
etc.
Entrepreneur:
Papa
John
Schnatter,
Founder
CEO
Coca-Cola
Softdrinks
Land:
Factories,
Bottling
Plants,
Floor
Space
at
the
Retail
Market
Labor:
Hourly
and
Salaried
Workers
Capital:
Ingredients,
Bottling
Supplies
(Aluminum
&
Plastic),
Packaging,
Delivery
Vehicles,
etc.
Entrepreneur:
John
Pemberton,
Founder.
Today;
CEO
and
Board
of
Directors
3
Basic
Questions
Examples
What
to
produce:
Automobiles;
SUVs,
sports
cars,
sedans,
coupes?
How
to
Produce:
Factory,
USA
or
Overseas?
Union
or
Non-Union
For
Whom
to
Produce:
How
expensive
do
you
make
the
vehicle?
Chevrolet,
Buick
or
Cadillac
What
to
produce:
TAG
Heuer;
Timepieces
How
to
Produce:
Factory
and
handmade,
Switzerland
For
Whom
to
Produce:
sports,
casual
and
dress
watches
and
customers
What
to
produce:
New
Era
Hats
How
to
Produce:
Factory,
USA
or
Overseas?
Union
or
Non-Union
For
Whom
to
Produce:
MLB
Hats,
NFL
Hats,
NBA
Hats,
NHL
Hats,
Casual
Hats,
Comic
Hats
IB
Economics
City
Honors
School
2015-2016
Section
1:
Microeconomics
1.1
Competitive
markets:
demand
and
supply
(some
topics
HL
only)
1.2
Elasticity
1.3
Government
intervention
(some
topics
HL
extension,
plus
one
topic
HL
only)
1.4
Market
failure
(some
topics
HL
only)
1.5
Theory
of
the
firm
and
market
structures
(HL
only)
The
purpose
of
this
section
is
to
identify
and
explain
the
importance
of
markets
and
the
role
played
by
demand
and
supply.
The
roles
played
by
consumers,
producers
and
the
government
in
different
market
structures
are
highlighted.
The
failures
of
a
market
system
are
identified
and
possible
solutions
are
examined.
The
concepts
learned
here
have
links
with
other
areas
of
the
economics
syllabus;
for
example,
elasticity
has
many
applications
in
different
areas
of
international
trade
and
development.
What
is
Market
Market
is
a
place
where
buyers
and
sellers
meet.
In
economics,
the
concept
of
a
market
is
any
structure
that
allows
buyers
and
sellers
to
exchange
any
type
of
goods,
services
and
information.
The
exchange
of
goods
or
services
for
money
is
a
transaction.
Features
of
a
market
Market
participants
consist
of
all
the
buyers
and
sellers
of
a
good
who
influence
its
price.
There
are
two
roles
in
markets,
buyers
and
sellers.
The
market
facilitates
trade
and
enables
the
distribution
and
allocation
of
resources
in
a
society.
Markets
allow
any
tradable
item
to
be
evaluated
and
priced.
A
market
emerges
spontaneously
or
is
constructed
deliberately
by
human
interaction
in
order
to
facilitate
the
exchange
of
goods
and
services
What
is
demand?
Demand
is
defined
as
want
or
willingness
of
consumers
to
buy
goods
and
services.
In
economics
willingness
to
buy
goods
and
services
should
be
accompanied
by
the
ability
to
buy
(purchasing
power)
and
is
referred
to
as
effective
demand.
Law
of
demand
The
law
of
demand
is
an
economic
law
that
states
that
consumers
buy
more
of
a
good
when
its
price
decreases
and
less
when
its
price
increases,
ceteris
paribus.
It
states
that
when
price
increases,
the
amount
demanded
will
fall
and
when
prices
fall,
the
amount
demanded
will
rise.
Rationale
of
the
law
of
demand
There
are
two
reasons
for
a
fall
in
demand
when
the
prices
increase.
Income
effect:
People
feel
poorer.
As
the
price
of
a
good
rises
the
purchasing
power
of
people
to
buy
that
good
will
fall.
This
is
known
as
income
effect.
Substitution
effect:
Some
people
might
shift
to
cheaper
alternatives/substitutes
once
the
price
of
a
good
rise,
thus
leading
to
a
fall
in
demand
for
that
good.
IB
Economics
City
Honors
School
2015-2016
IB
Economics
City
Honors
School
2015-2016
Shift
in
the
demand
curve
Usually
demand
curves
are
drawn
based
on
the
assumption
except
for
price
all
other
factors
remain
the
same.
But
there
might
be
instances
when
demand
may
be
affected
by
factors
other
than
price.
This
will
result
in
the
change
in
demand
although
the
price
will
remain
the
same.
This
change
in
demand
may
cause
the
demand
curve
to
SHIFT
inwards
or
outwards.
Shift
of
demand
curve
OUTWARDS
shows
an
increase
in
demand
at
the
same
price
level.
It
is
known
as
INCREASE
IN
DEMAND.
Shift
of
demand
curve
INWARDS
shows
that
less
is
demanded
at
the
same
price
level.
It
is
known
as
a
FALL
IN
DEMAND.
Factors
affecting
demand
Change
in
peoples
income:
More
the
people
earn
the
more
they
will
spend
and
thus
the
demand
will
rise.
A
fall
in
income
will
see
a
fall
in
demand.
Changes
in
population:
An
increase
in
population
will
result
in
a
rise
in
demand
and
vice
versa.
Change
in
fashion
and
taste:
Commodities
or
which
the
fashion
is
out
are
less
in
demand
as
compared
to
commodities
which
are
in
fashion.
In
the
same
way,
change
in
taste
of
people
affects
the
demand
of
a
commodity.
Changes
in
Income
Tax:
An
increase
in
income
tax
will
see
a
fall
in
demand
as
people
will
have
less
money
left
in
their
pockets
to
spend
whereas
a
decrease
in
income
tax
will
result
in
increase
of
demand
for
products
and
services
because
people
now
have
more
disposable
income.
Change
in
prices
of
Substitute
goods:
Substitute
goods
or
services
are
those
which
can
replace
the
want
of
another
good
or
service.
For
example
margarine
is
a
substitute
for
butter.
Thus
a
rise
in
butter
prices
will
see
a
rise
in
demand
for
margarine
and
vice
versa.
Change
in
price
of
Complementary
goods:
Complementary
goods
or
services
are
demanded
along
with
other
goods
and
services
or
jointly
demanded
with
other
goods
or
services.
Demand
for
cars
is
affected
the
change
in
price
of
petrol.
Same
way,
demand
for
DVD
players
will
rise
if
the
prices
of
DVDs
fall.
Advertising:
A
successful
advertising
campaign
may
affect
the
demand
for
a
product
or
service.
IB
Economics
City
Honors
School
2015-2016
10
Climate:
Changes
in
climate
affects
the
demand
for
certain
goods
and
services.
Interest
rates:
A
fall
in
Interest
rate
will
see
a
rise
in
demand
for
goods
and
services.
What
is
Supply?
Supply
refers
to
the
amount
of
goods
and
services
firms
or
producers
are
willing
and
able
to
sell
in
the
market
at
a
possible
price,
at
a
particular
point
of
time.
Law
of
Supply
It
states
that
when
the
price
of
a
commodity
rises,
the
supply
for
it
also
increases.
The
higher
the
price
for
the
good
or
service
the
more
it
will
be
supplied
in
the
market.
The
reason
behind
it
is
that
more
and
more
suppliers
will
be
interested
in
supplying
those
good
or
service
whose
prices
are
rising.
11
12
13
IB
Economics
City
Honors
School
2015-2016
14
In
this
diagram
the
equilibrium
price
is
P*
and
the
quantity
supplied
Qe.
However,
the
prices
have
been
increased
to
P2.
As
the
price
has
increased
it
will
lead
to
more
suppliers
entering
the
market
and
supply
increasing
to
Qs.
At
the
same
time,
a
increase
in
price
to
P1
will
lead
to
a
fall
in
demand
(as
per
the
law
of
demand)
i.e.
Qd.
This
will
create
an
excess
supply
situation.
Now
the
suppliers
will
find
it
difficult
to
sell
their
goods
and
they
will
have
to
reduce
their
price
to
attract
more
consumers.
This
will
go
on
till
the
price
again
reaches
its
initial
level
i.e.
P*.
Hence
the
situation
is
self
righting
if
the
prices
are
raised
without
any
external
reason.
Similarly,
in
the
figure
below
15
We
can
see
that
the
prices
have
been
artificially
reduced
from
P*
to
P1.
This
leads
to
a
fall
in
supply
from
Q*
to
Qs
(as
per
law
of
supply).
As
the
prices
fall
from
P*
to
P1,
people
can
afford
to
buy
more
of
that
good
and
demand
increase
from
Q*
to
Qd.
Again
an
excess
demand
situation
is
created.
In
order
to
get
the
most
out
of
this
situation
the
suppliers
will
start
increasing
their
price.
On
the
other
hand
demand
will
start
falling
as
the
prices
increase.
This
will
all
continue
till
the
prices
settle
at
equilibrium
price
i.e.
Pe.
Hence
we
can
say
that
equilibrium
is
self-righting
Movement
to
a
new
equilibrium
The
equilibrium
price
remains
unchanged
till
the
demand
and
supply
curves
retain
their
position.
The
moment
there
is
a
shift
in
any
of
the
components,
a
new
equilibrium
will
be
formed.
Supply
Equilibrium price
Equilibrium quantity
Increase
Decrease
Unchanged
Unchanged
Unchanged
Unchanged
Increase
Decrease
Rise
Fall
Rise
Rise
Rise
Fall
Rise
Fall
16
If
there
is
a
shift
in
demand,
it
will
lead
to
a
movement
along
the
supply
curve
and
a
new
equilibrium
point
will
be
achieved.
In
figure
1,
There
is
equilibrium
at
point
E,
where
the
price
is
Pe
and
quantity
supplied
is
Qe.
There
is
a
shift
in
demand
from
D1
to
D2.
At
price
Pe,
it
will
lead
to
a
'excess
demand'
situation
(F).
In
order
to
cope
with
excess
demand
the
suppliers
will
start
increasing
the
price
and
more
will
be
supplied.
On
the
other
hand
as
the
prices
increase,
demand
will
start
to
fall.
This
phenomenon
will
continue
till
a
new
equilibrium
stage
is
reached
at
point
G.
Now
the
Price
will
be
P1
and
quantity
supplied
at
that
point
will
be
Qe1.
Hence
it
has
resulted
in
an
increase
in
price
and
quantity
demanded.
The
opposite
will
happen
if
there
is
a
shift
of
demand
curve
to
the
left.
The
price
and
quantity
demand
will
fall.
IB
Economics
City
Honors
School
2015-2016
17
In
figure
2,
the
equilibrium
point
is
E
with
Pe
as
the
equilibrium
price
and
Qe
as
the
quantity
demanded.
Now
there
is
a
rightward
shift
in
supply
curve
to
S2
i.e.
supply
increases.
This
will
lead
to
a
excess
supply.
Producers
will
find
it
difficult
to
find
consumers
and
will
have
to
reduce
their
prices
to
clear
their
inventories.
As
the
prices
fall,
more
people
will
be
interested
in
buying
the
product.
This
will
continue
till
equilibrium
is
achieved
at
G.
There
will
a
price
fall
from
Pe
to
Pe1
and
Qe
to
Qe1.
The
result
is
lower
equilibrium
price
and
lower
equilibrium
quantity.
Price
Elasticity
of
demand
The
responsiveness
of
quantity
demanded,
or
how
much
quantity
demanded
changes,
given
a
change
in
the
price
of
goods
or
service
is
known
as
the
price
elasticity
of
demand.
Negative
sign
The
mathematical
value
which
is
derived
from
the
calculation
is
negative.
A
negative
value
indicates
an
inverse
relationship
between
price
and
the
quantity
demanded.
However,
the
negative
sign
is
ignored.
IB
Economics
City
Honors
School
2015-2016
18
Range
of
PED
The
value
of
PED
might
range
from
0
to
?
Lets
take
a
look
at
various
types
of
PED.
Perfectly
Inelastic
demand
In
this
case
the
PED
=0
That
means,
any
change
in
price
will
not
have
any
effect
on
the
demand
of
the
product.
Or
in
other
words,
the
percentage
change
in
demand
will
be
equal
to
zero.
It
is
hypothetical
situation
and
does
not
exist
in
real
world.
Perfectly
elastic
demand
In
this
case
the
PED
=?
The
demand
changes
infinitely
at
a
particular
price.
Any
change
in
price
will
lead
to
fall
of
demand
to
zero.
It
is
hypothetical
situation
and
does
not
exist
in
real
world.
However
Normal
goods
have
value
of
PED
between
0
and
?.
These
can
be
classified
as
Inelastic
demand
When
a
product
has
a
PED
less
than
1
and
greater
than
0,
it
is
said
to
be
have
an
inelastic
demand.
The
percentage
change
in
demand
is
less
than
the
percentage
change
in
price
of
the
product.
Demand
for
a
product
is
said
to
be
ELASTIC
if
the
percentage
change
is
demand
is
more
than
the
percentage
change
in
price.
The
value
of
PED
is
more
than
1.
19
When
there
is
a
smaller
percentage
change
in
quantity
demanded
as
compared
to
the
percentage
change
in
its
price,
the
product
is
said
to
price
INELASTIC.
The
value
of
PED
is
less
than
1.
20
Applications
of
Price
Elasticity
of
Demand
Examine
the
role
of
PED
for
firms
in
making
decisions
regarding
price
changes
and
their
effect
on
total
revenue.
Firms
give
a
lot
of
importance
to
PED
while
setting
prices
for
their
products.
A
firm
will
be
more
willing
to
increase
the
price
of
a
product,
which
has
a
more
inelastic
demand
because
it
will
lead
to
an
overall
increase
in
their
revenue.
With
an
increase
in
price
of
the
product,
the
demand
will
not
fall
in
the
same
proportion
and
this
end
up
in
more
revenue
for
the
firm.
On
the
other
hand
a
firm
seeking
to
increase
its
revenue
and
having
elastic
demand
for
its
product
should
not
increase
its
prices
because
it
will
lead
to
a
fall
in
their
revenue.
As
the
price
increase
there
will
be
a
more
than
proportionate
fall
in
sales,
thus
pulling
down
the
overall
revenue
of
the
firm.
Explain
why
the
PED
for
many
primary
commodities
is
relatively
low
and
the
PED
for
manufactured
products
is
relatively
high.
The
PED
for
primary
commodities
is
relatively
low
due
to
the
fact
that
they
have
very
few
substitutes
whereas
manufactured
products
have
a
relatively
high
PED
because
of
the
existence
of
many
substitutes.
For
example,
the
PED
for
cow
leather
(primary
commodity)
is
relatively
lower
than
a
genuine
cow
leather
shoe
(manufactured
product).
The
reason
being
there
is
no
or
very
few
substitutes
for
leather
as
a
raw
material
for
producing
shoes.
However,
leather
shoe
may
have
many
substitutes
in
the
form
of
sheep
leather
and
other
types
of
artificial
leather
shoes
available
in
the
market.
Examine
the
significance
of
PED
for
government
in
relation
to
indirect
taxes.
PED
hold
a
lot
of
significance
for
government
while
deciding
indirect
taxes
on
goods
and
services.
Government
uses
taxes
to
reduce
the
use
of
demerit
goods
in
the
economy.
For
example
they
might
increase
taxes
on
cigarettes.
Cigarettes
are
habit
forming
or
addictive
and
have
inelastic
demand,
thus,
even
a
high
increase
in
indirect
taxes
will
not
lead
to
a
fall
in
the
consumption
of
21
cigarette
smoking.
Thus
overall
revenue
of
government
will
increase
without
drastically
harming
the
cigarette
manufacturing
industry
and
employment.
Moreover,
it
might
lead
to
some
fall
in
cigarette
consumption
due
to
increased
prices.
Cross
price
elasticity
of
demand
(XED)
Cross
elasticity
of
demand
is
the
effect
on
the
change
in
demand
of
one
good
as
a
result
of
a
change
in
price
of
related
to
another
product.
In
economics,
it
is
denoted
by
the
symbol
XED.
The
formula
for
cross
elasticity
of
demand
is
In
XED
it
is
important
to
have
the
positive/negative
sign
in
front
of
the
value.
If
the
value
of
XED
is
positive,
this
means
that
the
two
goods
being
considered
are
substitute
goods.
Close
substitutes
have
high
positive
value.
Example:
butter
and
margarine.
If
two
goods
are
complements,
an
increase
in
the
price
of
one
will
lead
to
a
reduction
in
the
demand
for
the
otherthe
XED
is
negative.
Very
close
complements
have
a
lower
negative
value.
If
two
goods
are
unrelated,
a
change
in
the
price
of
one
will
not
affect
the
demand
for
the
other
the
XED
is
zero.
The
Income
Elasticity
of
Demand
(YED)
measures
the
rate
of
response
of
quantity
demand
due
to
a
raise
(or
lowering)
in
a
consumers
income.
Normal
goods:
an
increase
in
income
leads
to
an
increase
in
consumption,
demand
shifts
to
the
right.
Thus
YED
is
positive
for
normal
goods.
Inferior
goods:
Income
elasticity
is
actually
negative
for
inferior
goods,
the
demand
curve
shifts
left
as
income
rises.
As
income
rises,
the
proportion
spent
on
cheap
goods
will
reduce
as
now
they
can
afford
to
buy
more
expensive
goods.
For
example
demand
for
cheap/generic
electronic
goods
will
fall
as
people
income
rises
and
they
will
switch
to
expensive
branded
electronic
goods.
22
Distinguish,
with
reference
to
YED,
between
necessity
(income
inelastic)
goods
and
luxury
(income
elastic)
goods.
Basic
or
necessity
goods
have
a
low
income
elasticity
i.e.,
0
<
?
<
1.
Quantity
demanded
will
not
increase
much
as
income
increases
(income
elasticity
for
food
=
0.2)
Luxury
goods
have
high
income
elasticity
i.e.
?
>
1.
Quantity
demanded
rises
faster
than
income.
For
restaurant
meals
income
elasticity
is
higher
than
for
food,
because
of
the
additional
restaurant
service.
In
different
types
of
economies,
the
demand
for
goods
and
services
are
determined
by
the
income
elasticity.
As
economies
grow,
firms
will
want
to
avoid
producing
inferior
goods.
The
reason
being
as
income
increases
more
and
more
people
will
switch
from
inferior
goods
to
superior
goods.
Elasticity
=
0:
if
the
supply
curve
is
vertical,
and
there
is
no
response
to
prices.
Elasticity
=
?:
if
the
supply
curve
is
horizontal.
Supply
is
price
elastic
if
the
price
elasticity
of
supply
is
greater
than
1,
unit
price
elastic
if
it
is
equal
to
1,
and
price
inelastic
if
it
is
less
than
1.
Supply
is
Price
Elastic
when
the
percentage
change
in
quantity
supplied
is
more
than
the
percentage
change
in
Price
of
the
commodity.
PES
is
more
than
1.
23
Supply
is
Price
Inelastic
when
the
percentage
change
in
quantity
supplied
is
less
than
the
percentage
change
in
Price
of
the
comoditity.
PES
is
less
than
1.
IB
Economics
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24
Perfectly
price
elasticity
of
supply
25
Infinite
price
elasticity
of
Supply
Price
Elasticity
of
Supply
Price
elasticity
of
supply
is
a
measure
of
the
responsiveness
of
quantity
to
a
change
in
price.
In
other
words,
it
the
percentage
change
in
supply
as
compared
to
the
percentage
change
in
price
of
a
commodity.
Factors
affecting
Price
Elasticity
of
Supply
Time:
In
the
short
run
firms
will
only
be
able
to
increase
input
of
labor
to
increase
supply
of
commodities
may
not
be
able
to
increase
the
supply
in
response
to
the
price
change
but
the
supply
change
will
be
little
because
other
factors
of
production
may
not
be
increased
in
the
same
proportion
and
may
limit
the
supply.
However,
in
the
long
run
a
firm
will
increase
the
input
of
all
factors
of
production
and
thus
the
supply
becomes
more
price
elastic.
Availability
of
resources:
If
the
economy
already
using
most
of
its
scarce
resources
then
firms
will
find
it
difficult
to
employ
more
and
so
output
will
not
be
able
to
rise.
The
supply
of
most
of
goods
and
services
will
therefore
be
price
inelastic.
Number
of
producers:
More
producers
mean
that
the
output
can
be
increased
more
easily.
Thus
supply
is
more
elastic.
Ease
of
storing
stocks:
If
goods
can
be
stocked
with
ease
and
have
a
long
shelf
life,
the
supply
will
be
elastic,
otherwise
inelastic.
For
example
perishable
goods
such
as
fresh
flowers,
vegetables
have
comparatively
inelastic
supply
because
it
is
difficult
to
store
them
for
longer
periods.
Increase
in
cost
of
production
as
compared
to
output:
In
cases
where
there
is
a
significant
increase
in
cost
of
production
when
output
is
increased,
supply
is
inelastic.
This
is
because
IB
Economics
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26
suppliers
will
have
to
have
to
do
a
significant
investment
in
order
to
increase
the
output.
It
will
take
time
and
some
suppliers
may
be
hesitant
in
doing
so.
Improvement
in
Technology:
In
industries
where
there
is
a
rapid
improvement
in
technology,
the
PES
of
such
goods
will
be
more
elastic
as
compared
to
industries
where
there
is
not
much
improvement
in
technology.
Stock
of
finished
goods:
In
industries
where
there
are
high
inventories/stocks
of
finished
goods,
the
suppliers
can
easily
supply
more
as
the
price
rises.
Thus,
the
PES
for
these
goods
will
be
elastic.
Consumer
Surplus
Consumer
surplus
measures
the
difference
between
total
benefit
of
consuming
a
given
quantity
of
output
and
the
total
expenditures
consumers
pay
to
obtain
that
quantity.
the
shaded
area
OCDE;
total
expenditures
are
given
by
the
rectangle
OBDE.
The
difference,
shown
by
the
triangle
BCD,
is
consumer
surplus.
27
Producer
Surplus
Producer
surplus
can
be
defined
as
The
difference
between
the
amount
that
a
producer
of
a
good
receives
and
the
minimum
amount
that
he
or
she
would
be
willing
to
accept
for
the
good.
The
difference,
or
surplus
amount,
is
the
benefit
that
the
producer
receives
for
selling
the
good
in
the
market.
Producers'
surplus
exists
when
actual
price
exceeds
the
minimum
price
sellers
will
accept.
Here,
total
revenue
is
given
by
the
rectangle
OBDE,
and
total
costs
are
given
by
the
area
OADE.
The
difference,
shown
by
the
triangle
ABD
is
producer
surplus.
28
Community
Surplus
is
the
welfare
of
society
and
it
is
made
up
of
a
consumer
surplus
plus
a
producer
surplus.
It
exists
when
it
is
impossible
to
make
someone
better
off
without
making
someone
else
worse
off.
When
the
consumer
surplus
is
equal
to
producer
surplus
It
exists
when
the
market
is
in
equilibrium,
with
no
external
influences
and
no
external
effects.
Market
is
said
to
be
socially
efficient
and
community
surplus
is
at
its
maximum.
IB
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29
Allocative
Efficiency
Allocative
efficiency
is
when
resources
are
allocated
in
the
most
efficient
way
from
society's
point
of
view.
In
other
words
the
market
is
said
to
be
socially
efficient.
Allocative
efficiency
exisists
where
Community
Surplus
(consumer
surplus
and
producer
surplus)
is
maximized.
At
equilibrium
where
demand
is
equal
to
suppy,
community
surplus
is
maximised.
Indirect
taxes
An
indirect
tax
is
a
tax
collected
by
an
intermediary
i.e.
seller,
from
the
person
who
bears
the
ultimate
economic
burden
of
the
tax
i.e.
consumer.
It
is
imposed
on
expenditure.
In
simple
terms,
it
is
a
tax
which
is
imposed
on
goods
and
services
sold.
It
is
usually
added
to
the
cost
of
the
good
or
service
and
charged
from
the
ultimate
consumer.
The
seller
will
then
file
a
return
to
the
government
on
all
the
taxes
he
has
collected
from
the
consumer.
Examples
are
sales
tax
and
excise
duty
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Reasons
for
imposing
taxes
The
main
reasons
for
government
imposing
taxes
can
be
To
generate
Government
revenues:
excise
duties
on
beers,
wines
and
spirits
are
price
inelastic
in
demand,
so
tax
price
increases
by
levying
specific
alcohol
and
tobacco
taxes
raise
consumer
expenditures
as
a
whole
on
these
categories
and
therefore
taxation
revenues;
To
discourage
consumption:
Government
might
use
taxes
to
discourage
consumption
of
certain
demerit
goods
such
as
cigarettes.
To
alter
the
pattern
of
consumption:
Government
might
use
direct
taxes
a
a
mean
to
alter
the
consumption
patter
of
its
population.
Certain
goods
can
be
made
more
price
attractive
through
lower
taxes
while
goods
which
have
high
marginal
social
cost
can
be
made
expensive
through
taxation.
Distinction
between
specific
and
ad
valorem
taxes
Specific
tax
is
a
flat
rate
of
tax
whereas
ad
valorem
tax
is
a
percentage
tax.
Ad
valorem
literally
the
term
means
according
to
value.
It
is
imposed
on
the
basis
of
the
monetary
value
of
the
taxed
item.
A
specific
tax
is
when
specific
amount
is
imposed
upon
a
good,
for
example
$10
on
each
mobile
phone
sold;
whereas
ad
valorem
tax
is
expressed
as
a
percentage
of
the
selling
price
e.g.
12%
of
the
sales.
The
amount
of
specific
tax
changes
in
the
same
proportion
as
the
quantity
sold
increase,
whereas,
in
ad
valorem
the
tax
collected
is
more
at
higher
prices
then
at
lower
prices.
Consequences
of
imposing
indirect
tax
Imposition
of
tax
results
in
three
economic
observations.
Incidence:
Incidence
of
tax
means
the
party
who
actually
pays
the
tax.
Government
revenue:
the
amount
of
tax
government
will
receive
as
revenue
Resource
allocation:
the
amount
of
fall
in
quantity
demanded
and
produced
created
by
the
tax.
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If
the
tax
does
not
change
the
products
price
or
factor
prices,
the
burden
falls
on
the
owner
of
the
firmthe
owner
of
capital.
If
prices
adjust
by
a
fraction
of
the
tax,
the
burden
is
shared.
The
incidence
of
tax
will
be
shared
between
the
consumers
and
producers,
depending
on
the
price
elasticity
of
demand
(PED)
for
that
product
(which
we
will
discuss
later).
If
we
assume
that
the
burden
is
equally
shared
by
both
the
consumers
and
the
producers
then
the
size
of
square
CYZPe
is
equal
to
PeZXP1.
This
means
the
incidence
of
tax
is
equally
distributed
by
both
the
consumer
and
producer.
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Government
revenue
Putting
taxes
on
goods
and
services
generates
revenue
for
the
government.
Figure
below
shows
the
shaded
region
as
tax
revenue
for
government
i.e.
CYXP1.
The
implication
will
be
a
fall
in
output
from
Qe
to
Q1
and
thus
the
consumption
and
production
of
the
commodity
will
fall.
Tax
incidence
and
price
elasticity
of
demand
and
supply
Incidence
of
indirect
taxes
on
consumers
and
firms
differs,
depending
on
the
price
elasticity
of
demand
and
on
the
price
elasticity
of
supply.
Lets
study
individual
cases.
Scenario
1:
When
PED
is
greater
than
PES
Where
PED
is
greater
than
PES,
it
implies
that
consumers
are
more
sensitive
to
price
changes
as
compared
to
suppliers.
Thus
the
incidence
of
tax
will
be
more
on
the
suppliers
because
if
too
much
burden
of
tax
is
passed
on
to
the
consumers
then
the
demand
will
fall
drastically.
Therefore,
this
time
the
price
paid
by
buyers
barely
rises;
sellers
bear
most
of
the
burden
of
the
tax.
33
Scenario
3
:
PED
is
equal
to
PES
In
this
case
both
the
producer
and
consumer
will
share
equal
burden
of
tax.
What
are
subsidies?
A
subsidy
is
a
form
of
financial
assistance
paid
by
the
government
to
a
business
or
economic
sector.
Why
subsidies
are
given?
Subsidies
might
be
given
to
Lower
the
cost
of
necessary
goods
which
might
affects
a
major
part
of
population.
Example,
subsidies
given
to
essential
food
items
and
oil
(in
India).
Guarantee
the
supply
of
merit
goods,
which
the
government
thinks
consumers
should
consume.
Help
domestic
firms
become
more
competitive
in
the
international
market,
also
known
as
protectionism.
34
Effect
of
subsidy
Subsidy
reduces
the
cost
of
production.
Thus
the
supply
curve
for
the
product
shifts
vertically
downwards
by
the
amount
of
subsidy
provided.
Impact
of
subsidies
on
Producers
Subsidies
are
monetary
benefits
provided
to
the
producer
by
the
Government
on
account
of
production
of
certain
commodity.
Subsidies
lead
to
increase
in
producer
revenue.
Due
to
subsidy
the
supply
curve
(S-subsidy)
will
shift
vertically
downwards
by
the
amount
of
subsidy.
This
reduces
the
cost
of
production
and
more
is
now
being
supplied
at
every
price.
Through
the
diagram,
we
can
see,
initially
the
market
was
at
equilibrium
with
Qe
being
supplied
&
demanded
at
Price
(Pe).
Government
provides
subsidy
WZ
per
unit.
Producers
lower
their
prices
to
P1
Increase
output
till
a
new
equilibrium
is
reached
at
Q1
The
producer
will
however
not
pass
all
the
subsidy
benefit
to
the
consumer.
Initial
producer
revenue
was
OPeXQe
which
now
increases
to
ODWQ1.
35
Impact
of
subsidies
on
Government
Government
will
end
up
paying
a
subsidy
of
P1DWZ.
Obviously,
this
will
involve
an
opportunity
cost.
Government
will
have
to
forego
investments
in
other
sectors
of
the
economy
in
order
to
provide
subsidy.
At
the
end
of
the
day,
the
burden
usually
lies
on
the
taxpayer.
36
Scenario
2:
When
PED
is
inelastic
relative
to
PES
Consumption
of
the
product
is
increased
and
so
is
the
revenue
of
the
producer.
The
consumer
benefit
from
a
relatively
large
price
fall,
but
their
demand
is
relative
inelastic,
their
consumption
does
not
increase
by
a
great
amount.
37
For
the
price
that
the
ceiling
is
set
at,
there
is
more
demand
(Q2)
than
there
is
at
the
equilibrium
price.
There
is
also
less
supply
(Q1)
than
there
is
at
the
equilibrium
price,
thus
there
is
more
quantity
demanded
than
quantity
supplied
i.e.
shortage.
Impact
of
Price
ceiling
Inefficiency:
Inefficiency
occurs
since
at
the
price
ceiling
quantity
supplied
the
marginal
benefit
exceeds
the
marginal
cost.
This
inefficiency
is
equal
to
the
deadweight
welfare
loss.
Existence
of
black
market:
Due
to
demand
exceeding
the
supply,
there
will
be
buyers
who
will
be
willing
to
purchase
the
good
at
a
higher
price.
This
will
lead
to
existence
of
black
market.
How
can
government
correct
this
situation?
Subsidies
may
be
offered
to
the
firms
to
encourage
the
production
of
such
goods.
However
it
involves
an
opportunity
cost
to
the
government
as
they
might
have
to
divert
funds
from
other
activities.
Government
may
also
consider
the
option
of
producing
the
goods
by
themselves.
38
Government
may
also
release
previously
stored
inventory
of
such
goods
to
ensure
that
there
is
no
shortage
in
the
market,
however,
it
might
not
be
possible
for
all
the
goods,
for
example,
perishable
goods.
All
these
options
will
lead
to
the
shift
of
supply
curve
to
the
right
and
thus
forming
a
new
equilibrium
at
Pmax
Minimum
Prices
or
Price
Floor
A
minimum
allowable
price
set
above
the
equilibrium
price
is
a
price
floor.
With
a
price
floor,
the
government
forbids
a
price
below
the
minimum
Price
Floors
are
minimum
prices
set
by
the
government
for
certain
commodities
and
services
that
it
believes
are
being
sold
in
an
unfair
market
with
too
low
of
a
price
and
thus
their
producers
deserve
some
assistance.
Government
might
set
Minimum
prices
To
raise
incomes
for
producers
such
a
farmers
and
protect
them
from
frequent
fluctuations
in
the
commodity
market.
39
To
protect
workers
and
ensure
that
they
get
a
enough
wages
to
sustain
a
reasonable
standard
of
living.
Examples
of
price
floors
In
many
countries
governments
assist
farmers
by
setting
price
floors
in
agricultural
markets.
Setting
Minimum
wages
for
certain
occupations
is
also
an
example
of
price
floors.
Consequences
of
a
price
floor
As
seen
from
the
diagram.
The
equilibrium
price
for
a
particular
good
is
Pe
and
the
Quantity
demanded
is
Qe.
The
government
thinks
that
it
is
too
low
for
that
good
thus
they
set
up
a
minimum
price
for
a
good
Pmin.
This
will
lead
to
a
fall
in
demand
to
Q1
and
increase
in
supply
to
Q2,
thus
creating
excess
supply
or
surplus.
Government
can
eliminate
the
surplus
by
buying
the
excess
supply
at
the
minimum
price.
This
will
result
in
the
shifting
of
demand
curve
to
the
right,
thus
creating
a
new
equilibrium
at
Pmin.
The
Government
may
store
it
or
sell
it
abroad.
However,
both
these
options
have
consequences.
Buying
the
surplus
and
storing
it
will
cost
an
opportunity
cost
for
the
government
as
they
have
to
divert
funds
from
other
important
areas
and
exporting
it
other
countries
may
be
considered
as
dumping.
What
is
Market
Failure?
In
a
market
where
there
is
equilibrium,
the
resources
are
allocated
in
the
best
possible
manner
and
there
is
'allocative
efficiency'.
Allocative
efficiency
is
when
situation
where
Marginal
cost
is
equal
to
Marginal
revenue.
40
However,
this
is
not
possible
in
the
real
world.
Market
failure
exists
when
the
resources
are
not
allocated
efficiently.
Community
surplus
is
not
maximized
and
thus
there
is
market
failure.
From
a
community's
point
of
view,
producer
surplus
is
not
equal
to
consumer
surplus.
Market
failure
is
thus
caused
by
Abuse
of
monopoly
power
Lack
of
public
goods
Under
provision
of
merit
goods
Overprovision
of
demerit
goods
Environmental
degradation
Inequality
in
distribution
of
wealth
Immobility
of
factors
of
production
Problems
of
information
Short
termism
Externalities
Externalities
are
a
loss
or
gain
in
the
welfare
of
one
party
resulting
from
an
activity
of
another
party,
without
there
being
any
compensation
for
the
losing
party.
This
activity
can
be
due
to
consumption
or
production
of
a
good
or
service.
If
the
third
party
suffers
due
to
this
activity
then
it
is
known
as
negative
externality.
When
the
third
party
gains
from
this
activity
is
it
known
as
positive
externality.
Marginal
Private
Benefit
is
the
benefit
which
is
derived
by
private
individuals
in
the
consumption
of
a
good
or
service.
Marginal
Private
Cost
is
the
cost
of
producing,
specifically
marginal
costs,
which
are
incurred
by
private
individual
while
producing
a
good
or
service.
IB
Economics
City
Honors
School
2015-2016
41
Marginal
Social
Cost
is
the
total
cost
to
society
as
a
whole
for
producing
one
further
unit,
or
taking
one
further
action,
in
an
economy.
This
total
cost
of
producing
one
extra
unit
of
something
is
not
simply
the
direct
cost
borne
by
the
producer,
but
also
must
include
the
costs
to
the
external
environment
and
other
stakeholders.
The
market
demand
and
supply
curves
therefore
reflect
the
MPB
and
MPC
accruing
to
buyers
and
sellers.
When
there
is
no
externality
then
the
intersection
MPB
(demand)
curve
and
MPC
(supply)
curve
determine
the
equilibrium
price.
The
price
and
quantity
reflected
at
this
point
are
socially
optimum
level
of
production
or
consumption
and
the
market
is
said
to
have
allocative
efficiency.
i.e.
MPC=MPB.
At
this
point
the
consumer
surplus
is
equal
to
the
producer
surplus.
However,
this
is
usually
not
the
case
in
real
world.
The
production
or
consumption
of
goods
and
services
do
produce
externalities
and
thus
the
concept
of
Marginal
social
benefits
and
Marginal
social
costs
comes
into
being.
MSB=MPB+Externality
MSC=MPC+Externality
Types
of
Externalities
Externalities
can
result
either
from
consumption
activities
or
from
production
activities
There
are
four
types
of
Externalities
1.
Negative
externality
of
Production
2.
Negative
externality
of
Consumption
3.
Positive
externality
of
Production
4.
Positive
externality
of
Consumption
Negative
Production
Externalities
Negative
production
externalities
are
the
side-effects
of
production
activities.
As
a
result
an
individual
or
firm
making
a
decision
does
not
have
to
pay
the
full
cost
of
the
decision.
Pollution
created
by
firms
due
to
production
activities
is
an
example
of
negative
production
externality.
In
an
unregulated
market,
producers
don't
take
responsibility
for
external
costs
that
exist--these
are
passed
on
to
society.
Thus
producers
have
lower
marginal
costs
than
they
would
otherwise
have
and
the
supply
curve
is
effectively
shifted
down
(to
the
right)
of
the
supply
curve
that
society
faces.
Because
the
supply
curve
is
increased,
more
of
the
product
is
bought
than
the
efficient
amount--that
is,
too
much
of
the
product
is
produced
and
sold.
Since
marginal
benefit
is
not
equal
to
marginal
cost,
a
deadweight
welfare
loss
results.
42
The
diagram
illustrates
negative
production
externality.
The
supply
curve
given
by
MPC
reflects
the
firms
private
costs
of
production
and
the
marginal
social
cost
curve
given
by
MSC
represents
the
full
cost
of
production
to
society.
The
vertical
difference
between
MPC
and
MSC
represents
negative
externality.
Therefore
for
each
level
of
output,
Q1,
social
costs
given
by
MSC
are
greater
than
the
firms
private
costs
by
the
amount
of
externality.
The
optimal
production
quantity
is
Q*,
but
the
negative
externality
results
in
production
of
Q1.
The
deadweight
welfare
loss
is
shown
in
blue.
Corrective
Negative
Production
externalities
In
order
to
correct
negative
externality
of
production
and
to
bring
down
the
production
to
the
optimal
level,
government
can
intervene
through
the
following
options:
Legislation
and
regulations
Government
can
pass
legislations
to
prevent
or
reduce
the
effects
of
production
externalities.
These
legislations
will
lower
the
quantity
of
goods
produced
and
bring
it
closer
to
the
optimal
quantity
Q*
by
shifting
the
MPC
curve
upward
towards
the
MSC
curve.
It
might
include
legislations
to
Limit
the
emission
of
pollutants
by
setting
limits
to
the
extent
of
pollutants
produced
by
a
firm.
Limit
the
production
to
a
certain
level.
Force
polluting
units
to
install
technologies
which
reduce
emissions.
Putting
Taxes
Government
may
impose
a
tax
on
the
firm
either
on
per
unit
of
production
or
per
unit
of
pollutants
emitted.
These
will
lead
to
a
shift
of
MPC
curve
upwards
towards
the
MSC
curve
and
thus
reducing
output
and
bringing
it
closer
to
socially
optimal
level
i.e.
Q*.
The
diagram
below
shows
the
impact
of
taxes
43
Tradable
permits
Tradable
permits
are
a
cost-efficient,
market-driven
approach
to
reducing
greenhouse
gas
emissions.
A
government
must
start
by
deciding
how
many
tons
of
a
particular
gas
may
be
emitted
each
year.
It
then
divides
this
quantity
up
into
a
number
of
tradable
emissions
entitlements
-
measured,
perhaps,
in
CO2-equivalent
tons
-
and
allocates
them
to
individual
firms.
This
gives
each
firm
a
quota
of
greenhouse
gases
that
it
can
emit
over
a
specified
interval
of
time.
Then
the
market
takes
over.
Those
polluters
that
can
reduce
their
emissions
relatively
cheaply
may
find
it
profitable
to
do
so
and
to
sell
their
emissions
permits
to
other
firms.
Those
that
find
it
expensive
to
cut
emissions
may
find
it
attractive
to
buy
extra
permits.
Trading
would
continue
until
all
profitable
trading
opportunities
had
been
exhausted.
Tradable
permits
will
result
in
firms
to
lower
the
quantity
of
goods
produced
so
that
it
equals
Q*
and
to
raise
the
price
of
the
goods.
IB
Economics
City
Honors
School
2015-2016
44
In
negative
consumption
externality,
the
MPB
is
not
reflecting
social
benefit
and
thus
MSB
lies
below
MPB.
The
vertical
difference
between
MPB
and
MSB
is
the
negative
externality.
The
optimal
level
of
consumption
is
where
MSB=MSC
i.e.
Q*.
However
the
negative
externality
is
being
ignored
and
thus
there
is
an
over
consumption
of
the
goods
at
Q1.
Correcting
negative
consumption
externalities
Advertising:
Government
can
using
persuasive
advertising/awareness
campaigns
to
alert
the
consumers
and
influence
them
reduce
their
consumption.
This
will
lead
to
a
shift
of
MPB
curve
to
the
left
thus
reducing
the
gap
between
socially
optimal
level
of
consumption
Q*
and
Q1.
Legislations
and
regulations:
Government
can
also
pass
legislations
or
impose
fines
on
certain
activities
which
create
nuisance
for
the
societies.
Many
countries
already
have
banned
smoking
in
public
places.
Imposing
indirect
taxes:
By
putting
taxes
on
the
production
of
goods
that
cause
negative
consumption
externalities,
government
can
reduce
the
supply.
By
putting
taxes,
the
supply
curve(MSC)
will
shift
upwards
to
MSC+tax.
This
will
reduce
the
gap
between
Q*
and
Q1.
Positive
Production
externalities
These
are
positive
externalities
created
due
to
production
of
certain
goods
and
services.
Examples
include,
when
firms
train
their
employees
which
result
in
better
manpower
or
invest
in
research
and
development
and
succeed
in
developing
new
technologies
which
benefits
the
society.
IB
Economics
City
Honors
School
2015-2016
45
Due
to
the
fact
that
positive
externality
is
produced,
the
MSC
lies
below
the
MPC.
The
diagram
below
illustrates
positive
production
externalities.
As
we
can
see
that
the
social
optimal
level
of
production
of
these
goods
should
be
Q*
,
however
there
is
under-allocation
of
resources
and
thus
there
is
output
is
at
Q1.
Corrective
positive
production
externalities
Subsidies
can
be
provided
to
firms,
which
produce
these
goods.
The
effect
will
be
the
lowering
of
MPC
and
thus
the
MPC
will
more
downward
to
MSC.
This
will
increase
the
output
to
a
level
Q2
near
to
the
socially
optimal
level
Q*.
The
price
will
also
fall
from
P1
to
P2.
Positive
consumption
externalities
Positive
consumption
externalities
occur
when
there
is
a
positive
externality
created
by
the
consumption
of
certain
goods.
Examples
include
consumption
of
education
and
health
care.
Both
these
will
lead
to
more
productive
workforce
and
hence
high
rate
of
economic
growth
for
the
society.
IB
Economics
City
Honors
School
2015-2016
46
As
the
diagram
illustrates,
the
MSB
lies
above
the
MPB
and
the
difference
between
the
two
consists
of
positive
externality.
The
socially
optimal
level
is
where
MSB=MSC
i.e
Q*,
however,
due
to
under-allocation
of
resources
the
output/consumption
is
at
Q1.
Corrective
Positive
consumption
externalities
Subsidies
By
giving
subsidies
to
the
producers
of
the
good
with
the
positive
externality
will
result
in
increasing
supply
and
shifting
the
supply
curve
downwards.
This
will
lead
to
MSC
curve
shifting
to
MSC+subsidy
which
means
high
output/consumption
at
socially
optimal
level
Q*
and
at
lower
prices
from
P1
to
P*.
Advertising
Through
positive
advertising
government
can
persuade
consumers
to
increase
their
consumption
and
thus
lead
to
a
shift
of
MPB
to
the
right
i.e.
increase
in
demand.
If
the
MPB
curve
shifts
enough,
it
will
coincide
with
MSB
and
Q*
will
be
produced
and
consumed.
47
Unit
2:
Macroeconomics
The
purpose
of
this
section
is
to
provide
students
with
the
opportunity
for
a
detailed
examination
of
the
major
macroeconomic
issues
facing
countries'
economic
growth,
economic
development,
unemployment,
inflation
and
income
distribution.
The
economic
strategies
available
to
governmentsdemand-side
policies,
supply-side
policies,
direct
interventionare
introduced
and
evaluated.
These
policies
are
applicable
to
almost
all
areas
of
macroeconomics,
international
economics
and
development
economics.
Macroeconomics
deals
with
the
economy
as
a
whole;
it
examines
the
behavior
of
economic
aggregates
such
as
aggregate
income,
consumption,
investment,
and
the
overall
level
of
prices.
Aggregate
behavior
refers
to
the
behavior
of
all
households
and
firms
together.
We
can
use
macroeconomic
analysis
to:
Understand
why
economies
grow.
Understand
economic
fluctuations.
Make
informed
business
decisions.
Lets
start
with
a
simple
model
of
how
economy
works.
IB
Economics
City
Honors
School
2015-2016
48
The
economy
is
divided
into
two
sectors
i.e.
households
and
firms
The
households
provide
factors
of
productions
(land,
labour,
capital
and
enterprise)
to
the
firms.
The
firms
in
return
pays
the
factors
of
production
(wages,
rent,
interest
and
profit).
The
firms
produce
goods
and
services
which
are
consumed
by
the
household.
The
households
spend
money
on
purchasing
the
goods
and
services
produced
by
the
firms
(consumer
expenditure).
The
clockwise
flows
of
goods
and
services
through
these
markets
are
balanced
by
counter
clockwise
flows
of
payments.
Households
make
payments
for
the
things
they
buy
in
product
markets.
Firms
make
factor
paymentswages,
interest
payments,
rents,
royalties,
and
so
onin
exchange
for
the
labour
services
and
other
resources
they
buy.
49
Financial
Institutions
This
sector
consists
of
all
those
institutions
that
are
engaged
in
the
borrowing
and
lending
of
money,
acting
as
the
intermediaries
between
those
who
save,
and
borrowers
of
money.
Financial
institutions
are
needed
for
individuals
and
firms
to
be
able
to
undertake
saving
and
investment.
They
perform
the
function
of
mobilising
savings
for
investment.
Savings:
leakage;
Investment:
injection
Government
Households
in
this
model
are
required
to
pay
taxes.
When
the
government
receives
these
taxes
they
then
spend
them
(government
spending)
on
building
roads,
paying
soldiers,
and
teachers
and
so
on.
In
this
model
the
total
amount
of
expenditure
is
equal
to
consumption
plus
investment
plus
government
spending.
50
51
GDP Deflator=
Nominal GDP
Real GDP
X 100
GDP
per
capita
GDP
per
capita
is
the
value
of
all
final
goods
and
services
produced
within
a
country
in
a
given
year
divided
by
the
average
population
for
the
same
year.
Comparisons
of
national
wealth
are
also
frequently
made
on
the
basis
of
nominal
GDP,
which
does
not
reflect
differences
in
the
cost
of
living
in
different
countries.
However,
GDP
per
capita
is
often
considered
an
indicator
of
a
country's
standard
of
living
and
often
used
as
an
economic
development
indicator.
Output
methods
IB
Economics
City
Honors
School
2015-2016
52
It
is
the
Market
value
of
all
final
goods
and
services
calculated
during
1
year.
In
other
words,
add
up
the
value
of
all
goods
and
services
produced
in
the
country.
There
are
three
stages
in
calculating
it.
First,
the
Gross
Value
of
domestic
output
in
various
economic
activities
is
estimated
Second,
the
value
of
intermediate
consumption,
i.e.,
the
cost
of
material,
supplies
and
services
used
to
produce
final
goods
or
services
is
determined.
Finally,
intermediate
consumption
figures
are
deducted
from
Gross
Value
to
obtain
the
Net
Value
of
Domestic
Output.
Income
method
In
this
methods
GDP
is
derived
by
adding
up
all
income
i.e.
wages
and
salaries,
profits,
rent
and
interest.
Expenditure
method
All
expenditure
incurred
by
individual
during
1
year.
GDP
(Y)
is
a
sum
of
Consumption
(C),
Investment
(I),
Government
Spending
(G)
and
Net
Exports
(X
M).
Y = C + I + G + (X - M)
To
derive
GDP
using
the
expenditure
approach,
we
must
look
at
each
of
the
separate
components
of
expenditures
and
then
add
them
together.
These
components
are
consumption
expenditures,
investment,
government
expenditures,
and
net
exports.
Consumption
is
spending
by
households
on
goods
and
services.
Goods
include
household
spending
on
durable
goods,
such
as
automobiles
and
appliances,
and
non
durable
goods,
such
as
food
and
clothing.
Services
include
such
intangible
items
as
haircuts
and
medical
care.
Investment
is
the
purchase
of
goods
that
will
be
used
in
the
future
to
produce
more
goods
and
services.
It
is
the
sum
of
purchases
of
capital
equipment,
inventories
and
structures.
Government
Purchases
include
spending
on
goods
and
services
by
local,
state
and
central
governments.
It
includes
the
salaries
of
government
workers
as
well
as
expenditures
on
public
works.
Net
Exports
equal
the
foreign
purchase
of
domestically
produced
goods(exports)
minus
the
domestic
purchases
of
foreign
goods
(imports).
The
net
in
net
exports
refers
to
the
facts
that
imports
are
subtracted
from
exports.
IB
Economics
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53
Business
Cycle
The
business
cycle
is
the
cycle
of
short-term
ups
and
downs
in
the
economy.
The
Alternating
periods,
of
economic
growth
and
contraction.
The
main
measure
of
how
an
economy
is
doing
is
aggregate
output
Aggregate
output
is
the
total
quantity
of
goods
and
services
produced
in
an
economy
in
a
given
period.
Explanation
of
Business
Cycle
A
recession,
contraction,
or
slump
is
the
period
in
the
business
cycle
from
a
peak
down
to
a
trough,
during
which
output
and
employment
fall.
A
depression
is
a
severe
reduction
in
an
economy's
total
production
accompanied
by
high
unemployment
lasting
several
years
An
expansion,
or
boom,
is
the
period
in
the
business
cycle
from
a
trough
up
to
a
peak,
during
which
output
and
employment
rise.
Ups
and
downs
of
the
Business
Cycle
Peak:
at
the
peak
of
the
business
cycle,
Real
GDP
is
at
a
temporary
high.
Contraction:
A
decline
in
the
real
GDP.
If
it
falls
for
two
consecutive
quarters,
it
is
said
the
economy
to
be
in
a
recession.
Trough:
The
Low
Point
of
the
GDP,
just
before
it
begins
to
turn
up.
Recovery:
When
the
GDP
is
rising
from
the
trough.
Expansion:
when
the
real
GDP
expands
beyond
the
recovery.
IB
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54
55
then
pay
to
clean
up
the
mess,
both
activities
add
to
GDP.
Environmental
degradation
frequently
looks
good
for
the
economy.
In
that
regard,
GDP
is
a
poor
welfare
measure.
The
green
gross
domestic
product
(green
GDP)
is
an
index
of
economic
growth
with
the
environmental
consequences
of
that
growth
factored
in.
Green
GDP
monetizes
the
loss
of
biodiversity,
and
accounts
for
costs
caused
by
climate
change.
Aggregate
demand
(AD)
Aggregate
demand
is
the
total
spending
on
goods
and
services
in
a
period
of
time
at
a
given
price
level.
On
the
horizontal
axis,
real
GDP
is
measured.
For
our
measure
of
the
price
level,
we
use
the
GDP
price
deflator
on
the
vertical
axis.
The
aggregate
demand
curve
is
labeled
AD.
Components
of
Aggregate
Demand
Consumption
is
spending
by
households
on
goods
and
services.
Goods
include
household
spending
on
durable
goods,
such
as
automobiles
and
appliances,
and
non
durable
goods,
such
as
food
and
clothing.
Services
include
such
intangible
items
as
haircuts
and
medical
care.
Investment
is
the
purchase
of
goods
that
will
be
used
in
the
future
to
produce
more
goods
and
services.
It
is
the
sum
of
purchases
of
capital
equipment,
inventories
and
structures.
Government
Purchases
include
spending
on
goods
and
services
by
local,
state
and
central
governments.
It
includes
the
salaries
of
government
workers
as
well
as
expenditures
on
public
works.
56
Net
Exports
equal
the
foreign
purchase
of
domestically
produced
goods(exports)
minus
the
domestic
purchases
of
foreign
goods
(imports).
The
net
in
net
exports
refers
to
the
facts
that
imports
are
subtracted
from
exports.
Aggregate
Demand
Formula
AD=C+G+I+(X-M)
Why
AD
curve
slopes
downwards
There
are
economywide
reasons
that
cause
the
aggregate
demand
curve
to
slope
downward.
They
involve
at
least
three
distinct
forces:
The
real-balance
effect:
The
change
in
expenditures
resulting
from
a
change
in
the
real
value
of
money
balances
when
the
price
level
changes,
all
other
things
held
constant;
also
called
the
wealth
effect.
A
rise
in
the
price
level
will
have
an
effect
on
spending.
Interest
rate
effect:
One
of
the
reasons
that
the
aggregate
demand
curve
slopes
downward:
Higher
price
levels
increase
the
interest
rate,
which
in
turn
causes
businesses
and
consumers
to
reduce
desired
spending
due
to
the
higher
cost
of
borrowing.
The
open
economy
effect:
One
of
the
reasons
that
the
aggregate
demand
curve
slopes
downward:
Higher
price
levels
for
an
economy
result
in
foreign
residents
desiring
to
buy
fewer
exports,
while
local
residents
now
desire
more
foreign-made
goods,
thereby
reducing
net
exports.
This
is
equivalent
to
a
reduction
in
the
amount
of
real
goods
and
services
purchased
in
the
economy.
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57
Changes
in
AD
Movement
along
the
AD
curve
is
caused
due
to
the
change
in
price
level
in
the
economy.
Any
non-price-level
change
that
increases
aggregate
spending
(on
domestic
goods)
shifts
AD
to
the
right.
Any
non-price-level
change
that
decreases
aggregate
spending
(on
domestic
goods)
shifts
AD
to
the
left.
Increase
in
any
components
of
AD
will
result
in
the
shift
of
AD
curve
to
the
right
and
a
fall
in
the
value
of
any
component
will
result
in
the
fall
of
AD
and
the
AD
curve
will
shift
to
the
left.
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58
59
Imports
are
the
goods
bought
from
foreign
country.
Imports
will
rise
when
Domestic
income
rises.
This
is
because
people
will
increase
their
consumption
and
thus
imports
will
increase.
Exchange
rate
of
the
importing
country
increase.
Now
it
becomes
cheaper
for
the
country
to
purchase
from
outside
as
their
currency
is
stronger
than
their
trading
partners.
If
the
economy
is
following
a
liberal
trade
policy
i.e.
free
trade
increases.
Inflation
rate
is
high
Aggregate
supply
(AS)
Aggregate
supply
is
the
total
amount
of
goods
and
services
that
all
industries
in
the
economy
will
produce
at
every
given
price
level.
Short
run
and
Long
run
in
Macroeconomics
Short
run
is
the
period
of
time
during
which
the
nominal
prices
of
resources,
particularly
labour
(wages)
do
not
change
in
response
to
the
changes
in
price
level.
Long
run
is
the
period
of
time
in
which
the
nominal
prices
of
all
resources,
including
the
price
of
labour
(wages),
change
so
as
to
reflect
fully
any
change
in
the
price
levels.
Short
Run
AS
(SRAS)
curve
AS
curve
is
similar
to
a
microeconomic
supply
curve.
It
is
upward
sloping
and
hence
has
a
positive
relation
between
price
level
and
amount
of
output.
Movement
along
the
SRAS
A
change
in
price
level
will
lead
to
a
movement
along
the
SRAS
curve.
60
Shift
of
SRAS
Any
factor
changes
other
than
price
level
will
lead
to
a
shift
in
SRAS.
A
rightward
shift
of
SRAS
means
an
increase
in
Aggregate
supply
at
any
particular
price
level.
An
leftward
shift
of
SRAS
signifies
a
decrease
in
Aggregate
supply
for
any
particular
price
level.
Factors
causing
a
shift
of
SRAS
Any
factor
which
causes
a
change
in
the
cost
of
production
will
result
in
a
shift
of
SRAS
curve.
These
factors
are
Changes
in
wages:
Wages
constitute
a
major
part
of
the
cost
of
production.
As
wages
increase
the
cost
of
production
increases
and
thus
the
SRAS
will
move
leftward.
Price
of
raw
material:
An
increase
in
price
of
raw
material
will
result
in
the
cost
of
production
going
up
and
thus
the
SRAS
will
shift
to
the
left.
Change
in
Taxes:
Increased
taxes
add
to
the
cost
of
production
and
thus
SRAS
moves
leftwards.
Changes
in
Subsides:
If
subsidies
are
provided,
this
will
result
in
the
lowering
of
cost
of
production
and
increase
Aggregate
supply.
Thus
SRAS
will
move
rightward.
Change
in
price
of
imports:
An
increase
in
price
of
imported
components
will
lead
to
a
increase
in
price
of
goods
which
use
a
lot
of
imported
components.
This
will
lead
to
a
fall
in
AS
Long
run
AS
curve
There
are
two
major
views
relating
to
the
shape
of
the
LRAS.
The
different
beliefs
about
the
shape
of
the
LRAS
curve
lie
at
the
basis
of
controversies
about
appropriate
policies
to
be
followed
by
governments.
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The
LRAS
curve
is
vertical
at
potential
GDP,
or
full
employment
level
of
real
GDP.
This
indicates
that
an
expansion
of
AD
will
always
lead
to
demand-pull
inflation
and
will
not,
in
the
long
run,
lead
to
growth
in
output
and
thus
employment.
The
new-classical
economists
argue
that
national
output
may
only
be
increased
by
adopting
supply-side
policies
to
shift
the
LRAS
to
the
right.
62
63
Low
unemployment
Another
macroeconomic
objective
of
the
government
is
to
maintain
a
low
level
of
unemployment
in
the
economy.
Unemployment
refers
to
the
number
of
unemployed
people,
defined
as
all
people
above
a
particular
age,
who
are
not
working
and
who
are
actively
looking
for
a
job.
Underemployment
refers
to
all
people
above
a
particular
age
who
have
part
time
jobs
when
they
would
prefer
to
have
full
time
jobs
or
have
jobs
that
do
not
make
full
use
of
their
skills
and
education.
Unemployment
rate=
unemployed
workers/total
labor
force
Cost
of
unemployment
Costs
to
the
economy
Unemployed
labor
means
utilized
factors
of
production.
This
will
result
in
lower
output
for
the
economy.
Long
periods
of
unemployment
would
lead
to
deskilling
of
labour
which
will
in
return
reduce
potential
output.
Unemployment
leads
to
greater
disparities
in
the
distribution
of
income.
Costs
to
the
government
Unemployed
people
will
not
pay
taxes
as
they
dont
have
any
running
income.
This
will
be
a
loss
of
tax
revenue
to
the
government.
Unemployment
benefits
given
out
by
the
government
to
support
the
unemployed
will
result
in
extra
burden
on
the
government
exchequer
moreover,
there
is
an
opportunity
cost
involved
as
these
funds
could
have
been
utilized
for
other
development
purposes.
Costs
to
society
Higher
unemployment
leads
to
increased
crime
and
vandalism.
Moreover,
there
is
a
cost
to
the
government
of
dealing
with
social
problems
resulting
due
to
unemployment
Costs
to
individuals
There
are
personal
costs
for
the
unemployed
in
terms
of
stress-related
illness
and
family
problems
(family
breakdown)
caused
by
the
strain
of
being
unemployed.
In
order
to
meet
daily
expenses,
an
unemployed
person
may
result
in
increased
indebtedness
64
Wage
stickiness:
The
firms
may
not
be
able
to
reduce
the
wages
may
be
as
a
result
of
the
following
reasons:
They
dont
want
to
create
discontent
among
the
workers
by
reducing
their
wages
Trade
unions
may
not
allow
the
wages
to
go
down.
Labor
contract
may
deter
the
firms
to
reduce
the
wages.
65
Equilibrium
Unemployment
Structural
unemployment
Structural
unemployment
occurs
when
certain
industries
decline
because
of
long
term
changes
in
market
conditions.
These
structural
changes
in
the
economy
might
lead
to
fall
in
demand
for
certain
sectors
of
the
economy.
This
is
usually
common
in
developing
countries
where
primary
sector
generally
reduces
in
size
and
secondary
sector
and
tertiary
sector
might
gain
more
importance.
Change
in
technology
is
also
one
of
the
major
reasons
for
structural
unemployment,
whereby
certain
kind
of
jobs
become
obsolete.
Changes
in
consumer
taste
or
preference
may
also
be
a
cause
of
structural
unemployment
Structural
unemployment
may
worsen
if
there
is
Occupational
immobility
occurs
when
there
are
barriers
to
the
mobility
of
labor
between
different
industries
and
occupations.
Geographical
immobility
exists
when
there
are
barriers
to
people
moving
from
one
area
to
another
to
find
work.
Frictional
Unemployment
Frictional
unemployment
occurs
when
people
leave
their
jobs
and
are
unemployed
while
they
are
looking
for
a
new
job,
or
just
having
a
break
from
working.
Seasonal
Unemployment
Unemployment
attributable
to
relatively
regular
and
predictable
declines
in
particular
industries
or
occupations
over
the
course
of
a
year,
often
corresponding
with
the
climatic
seasons.
66
The
meaning
of
inflation,
disinflation
and
deflation
What
is
inflation?
Inflation
is
a
rise
in
the
general
level
of
prices
of
goods
and
services
in
an
economy
over
a
period
of
time.
When
the
general
price
level
rises,
each
unit
of
currency
buys
fewer
goods
and
services.
Consequently,
inflation
also
reflects
erosion
in
the
purchasing
power
of
money.
What
is
disinflation?
Disinflation
is
a
decrease
in
the
rate
of
inflation
a
slowdown
in
the
rate
of
increase
of
the
general
price
level
of
goods
and
services
over
a
period
of
time.
For
example
if
the
annual
inflation
rate
for
the
month
of
January
is
5%
and
it
is
4%
in
the
month
of
February,
the
prices
disinflated
by
1%
but
are
still
increasing
at
a
4%
annual
rate.
What
is
deflation?
Deflation
is
a
decrease
in
the
general
price
level
of
goods
and
services.
Deflation
occurs
when
the
inflation
rate
falls
below
0%.
IB
Economics
City
Honors
School
2015-2016
67
Calculating
Inflation
Rate
of
inflation
is
measured
by
calculating
the
percentage
price
increase
in
goods
and
services
over
a
period
of
time.
Inflation
is
measured
through
a
Price
Index.
The
economists
monitor
the
price
changes
of
a
collection
of
goods
&
services
over
a
period
of
time.
There
are
different
Price
Indices
that
can
be
used,
the
most
popular
are:
Consumer
Price
Index
(CPI)
measure
the
price
of
a
selection
of
goods
and
services
for
a
typical
consumer.
Producer
Price
Index
(PPI)
measures
the
prices
for
all
goods
and
services
at
the
wholesale
level.
It
is
like
the
consumer
price
index
but
it
is
measuring
the
prices
the
producers
have
to
pay.
Price
index
consists
of
A
basket
of
goods
It
contains
goods
and
services
from
various
sectors
of
the
economy.
There
prices
are
monitored
over
a
period
of
time.
Base
year
This
is
the
first
year
with
which
the
prices
of
subsequent
years
are
compared.
The
price
of
each
commodity
is
given
the
value
of
100.
The
base
year
chosen
is
a
typical
year
in
the
sense
that
there
is
neither
very
low
or
very
high
inflation,
nor
any
extraordinary
occurrences
like
wars.
Weights
Some
commodities
are
more
important
in
the
economy
as
compared
to
other
commodities.
To
find
out
the
true
effect
of
inflation,
weights
are
added
to
different
products
and
services
according
to
their
importance
in
the
society.
A
product,
which
has
a
more
serious
affect,
is
given
a
higher
weight.
For
example
food
products,
which
form
a
staple
diet
of
the
society,
are
assigned
more
weightage
than
luxury
products
(perfumes).
As
the
pattern
of
consumers
spending
changes
over
time
so
the
Price
Index
will
have
to
change
the
weights
assigned
to
different
commodities.
Natural
rate
of
unemployment
The
natural
rate
of
unemployment
is
the
unemployment
rate
that
occurs
in
even
a
healthy
economy.
That's
because
workers
are
always
coming
and
going,
looking
for
a
better
job,
and
often
they
are
unemployed
until
they
find
that
better
job.
The
Natural
Rate
of
Unemployment
is
the
rate
of
Unemployment
when
the
labor
market
is
in
equilibrium.
The
natural
rate
of
unemployment
is
caused
by
a
combination
of
frictional
unemployment
and
structural
unemployment.
The
reason
why
the
natural
rate
can
change
over
time
(or
differ
across
countries)
is
because
of
changes
or
differences
in
economic
policies
that
impact
frictional
unemployment
(the
ease
with
which
firms
can
layoff
workers,
the
ability
and
incentive
for
laid-of
workers
to
find
jobs,
the
adequacy
of
job
retraining
programs,
the
ease
with
which
unemployed
workers
can
link
up
with
firms
that
have
job
vacancies)
or
structural
unemployment
(technological
changes
that
impact
industries,
the
education
and
retraining
programs
available
to
support
workers
in
obsolete
industries,
the
level
of
inter-generational
mobility
(how
does
the
layoff
affect
the
education
and
income
prospects
of
the
laid-of
worker's
children).
68
Policies
to
Lower
the
Natural
Rate
Lower
minimum
wages:
Helps
reduce
the
job
losing
rate.
If
we
think
about
it
from
the
firm's
point
of
view.
During
times
of
hardship,
a
firm
may
not
have
to
let
workers
go
if
they
can
pay
them
a
little
bit
less.
This
does
not
mean
that
the
minimum
wage
is
bad.
As
a
society,
we
may
be
entitled
to
set
a
wage
that
is
adequate
for
taking
care
of
basic
needs
and
set
up
a
safety
net
for
those
who
are
unable
to
find
jobs
at
that
wage.
Better
information:
Set
up
job
finding
centers
that
allow
workers
to
find
potential
matches,
quickly
and
efficiently.
Helps
increase
the
job-finding
rate.
Better
training
of
workers:
This
can
help
in
both
reducing
the
job
losing
rate
and
in
increasing
the
job
finding
rate.
Remove
disincentives
to
work:
Excessive
unemployment
benefits,
strong
labor
market
regulations,
although
improving
the
quality
of
life
of
the
employed
can
bring
about
high
unemployment
through
reductions
in
the
job
finding
rate
because
of
shortfalls
in
both
labor
supply
and
labor
demand.
Once
again
this
does
not
mean
that
unemployment
benefits
or
regulations
that
enhance
worker's
bargaining
power
with
the
employers
are
a
bad
thing
-
it
is
important
to
find
the
tradeoff
between
providing
enough
unemployment
benefits
to
provide
a
safety
net
and
providing
so
much
that
you
are
effectively
providing
a
disincentive
to
gain
employment.
Reductions
in
payroll
taxes:
Social
Security
is
paid
partly
by
the
employer
and
partly
by
the
employee.
Lower
payroll
taxes
may
help
reduce
unemployment
by
reducing
the
cost
of
hiring
workers
and
by
increasing
incentives
for
people
to
return
to
work.
Consequences
of
inflation
High
inflation
rate
may
result
in
the
following
adverse
effects
on
the
economy:
Greater
uncertainty:
There
may
be
greater
uncertainty
for
both
firms
and
households.
Firms
will
postpone
their
investment
due
to
uncertainty
in
the
market.
This
will
result
in
negative
implications
on
the
economic
growth
in
the
economy.
Redistributive
effects:
High
rate
of
inflation
will
affect
people
who
have
constant
incomes,
such
as
retired
people,
students,
and
dependents.
Moreover,
rise
in
prices
of
essential
commodities
(food
&
clothing)
will
affect
the
poor
segment
of
the
society
as
they
spend
a
major
part
of
their
income
on
these
good.
This
will
lead
to
increased
inequality
in
the
economy.
Less
saving:
High
rate
of
inflation
will
have
an
adverse
effect
on
the
savings
in
the
economy.
As
people
spend
more
to
sustain
their
present
standard
of
living,
less
is
being
saved.
This
will
result
in
less
loanable
funds
being
available
to
firms
for
investment.
Damage
to
export
competitiveness:
High
rate
of
inflation
will
hit
hard
the
export
industry
in
the
economy.
The
cost
of
production
will
rise
and
the
exports
will
become
less
competitive
in
the
international
market.
Thus,
inflation
has
an
adverse
effect
on
the
balance
of
payments.
IB
Economics
City
Honors
School
2015-2016
69
Social
unrest:
High
rate
of
inflation
leads
to
social
unrest
in
the
economy.
There
is
increase
dissatisfaction
in
among
the
workers
as
they
demand
higher
wages
to
sustain
their
present
living
standard.
Moreover,
high
rate
of
inflation
leads
to
a
general
feeling
of
discomfort
for
the
household
as
their
purchasing
power
is
consistently
falling.
Interest
rates:
The
Central
Bank
might
use
monetary
tools
to
control
high
inflation
rate
by
increasing
interest
rates.
This
will
increase
the
cost
of
borrowing
and
will
have
a
negative
effect
on
both
consumption
and
investment.
Shoe
leather
cost
refers
to
the
cost
of
time
and
effort
(more
specifically
the
opportunity
cost
of
time
and
energy)
that
people
spend
trying
to
counter-act
the
effects
of
inflation,
such
as
holding
less
cash
and
having
to
make
additional
trips
to
the
bank.
Menu
cost
is
the
cost
to
a
firm
resulting
from
changing
its
prices
Consequences
of
deflation
Consistent
fall
in
the
general
price
level
in
the
economy
(deflation)
might
not
be
good
news
for
the
economy.
Long
term
deflation
will
lead
to:
Cyclical
unemployment:
Deflation
usually
happens
to
due
to
a
fall
in
Aggregate
Demand
in
the
economy.
This
will
lead
to
businesses
cutting
the
output
levels
which
will
result
in
retrenchment/laying
off
of
workers.
Moreover,
if
consumers
delay
spending
in
anticipation
of
falling
prices
economic
activity
falls,
unemployment
increases.
Bankruptcies:
As
the
value
of
money
is
increasing,
it
becomes
difficult
for
debtors
to
repay
the
load.
Moreover,
during
deflation
firms
will
be
having
lower
profits
due
to
falling
prices
and
will
find
it
difficult
to
meet
their
liabilities.
This
might
lead
to
greater
number
of
bankruptcies.
Businesses
see
profits
fall;
as
they
do
so
dividends
and
investment
returns
fall
and
so
share
prices
fall.
Deflationary
spiral:
Consistent
fall
in
prices
may
trigger
deflationary
spiral.
As
firms
make
less
profit,
this
leads
to
less
profits,
they
might
not
be
willing
or
able
to
invest
which
will
have
negative
implications
on
the
economic
growth.
Moreover,
as
firms
cut
cost
by
lay
off
workers,
there
is
less
income
for
the
households
and
the
aggregate
demand
might
fall.
Due
to
a
fall
in
consumer
and
business
confidence
the
economy
might
fall
into
a
deflationary
spiral.
The
principle
problem
of
deflation
is
that
it
leads
to
a
rise
in
the
real
value
of
debt.
In
the
early
stages
low
interest
rates
and
low
prices
encourage
borrowing
but
as
the
real
weight
of
the
borrowing
is
recognized
so
borrowing
is
reduced.
It
is
sometimes
difficult
to
control
deflation
and
Monetary
policy
can
prove
ineffective
when
interest
rates
(nominal)
are
already
low.
IB
Economics
City
Honors
School
2015-2016
70
Demand
pull
inflation
is
caused
due
to
the
changes
in
the
determinants
of
AD.
Whenever,
any
of
the
components
of
AD
(i.e.
consumption,
investment,
government
spending
and
net
exports)
will
increase,
this
will
result
in
an
increase
in
aggregate
demand.
Cost
Push
Inflation
Increase
in
cost
of
production
will
result
in
cost
push
inflation.
As
the
cost
of
production
increases,
the
firms
will
reduce
supply.
The
aggregate
supply
will
shift
to
the
left,
from
SRAS1
to
SRAS2.
This
will
result
in
an
increase
in
the
average
price
level
in
the
economy.
Real
output
will
fall.
IB
Economics
City
Honors
School
2015-2016
71
Monetarists
view
of
inflation
As
per
monetarists
(new
classical
economists)
inflation
is
caused
due
to
the
excessive
supply
of
money
in
the
economy.
According
to
monetarists
an
increase
in
money
supply
results
in
higher
aggregate
demand
from
AD1
to
AD2.
Monetarists
assume
the
economy
to
operate
as
full
employment
level
of
output,
thus,
any
increase
in
AD
is
purely
inflationary.
IB
Economics
City
Honors
School
2015-2016
72
73
Economic
growth
can
also
be
achieved
by
increasing
the
potential
output.
This
is
achieved
through
supply
side
policies.
As
illustrated
by
the
diagram
the
outward
shift
in
the
PPC
signifies
the
increase
in
full
employment
level
of
output.
74
The
movement
of
AD
to
the
right
(or
increase
in
Aggregate
Demand)
will
result
in
filling
up
of
the
deflationary
gap
and
the
economy
will
achieve
full
employment
level
of
output.
This
is
known
as
economic
growth.
Economy
can
also
achieve
economic
growth
in
the
long
term
by
increasing
the
potential
output
by
increasing
the
efficiency
of
its
factors
of
production.
This
can
be
illustrated
by
the
movement
of
LRAS
to
the
right.
i.e.
LRAS1
to
LRAS2.
This
is
achieved
by
governments
supply
side
policies.
IB
Economics
City
Honors
School
2015-2016
75
76
Relative
poverty
As
per
European
Commission,
people
are
said
to
be
living
in
poverty
if
their
income
and
resources
are
so
inadequate
as
to
preclude
them
from
having
a
standard
of
living
considered
acceptable
in
the
society
in
which
they
live.
Because
of
their
poverty
they
may
experience
multiple
disadvantages
through
unemployment,
low
income,
poor
housing,
inadequate
health
care
and
barriers
to
lifelong
learning,
culture,
sport
and
recreation.
They
are
often
excluded
and
marginalized
from
participating
in
activities
(economic,
social
and
cultural)
that
are
the
norm
for
other
people
and
their
access
to
fundamental
rights
may
be
restricted.
Causes
of
poverty
Unemployment
or
having
a
poor
quality
(i.e.
low
paid
or
precarious)
job
as
this
limits
access
to
a
decent
income
and
cuts
people
off
from
social
networks;
Low
levels
of
education
and
skills
because
this
limits
peoples
ability
to
access
decent
jobs
to
develop
themselves
and
participate
fully
in
society;
The
size
and
type
of
family
i.e.
large
families
and
lone
parent
families
tend
to
be
at
greater
risk
of
poverty
because
they
have
higher
costs,
lower
incomes
and
more
difficulty
in
gaining
well
paid
employment;
Gender
-
women
are
generally
at
higher
risk
of
poverty
than
men
as
they
are
less
likely
to
be
in
paid
employment,
tend
to
have
lower
pensions,
are
more
involved
in
unpaid
caring
responsibilities
and
when
they
are
in
work,
are
frequently
paid
less
;
Disability
or
ill-health
because
this
limits
ability
to
access
employment
and
also
leads
to
increased
day
to
day
costs;
Being
a
member
of
minority
ethnic
groups
and
immigrants/undocumented
migrants
as
they
suffer
particularly
from
discrimination
and
racism
and
thus
have
less
chance
to
access
employment,
often
are
forced
to
live
in
worse
physical
environments
and
have
poorer
access
to
essential
services;
Living
in
a
remote
or
very
disadvantaged
community
where
access
to
services
is
worse.
Consequences
of
Poverty
Poverty
has
far
reaching
consequences
on
the
society.
People
suffering
from
poverty
will
generally
have
a
low
standard
of
living.
They
are
not
able
to
afford
education
and
lack
access
to
health
care
and
education.
This
will
lead
to
a
low
quality
of
human
capital
and
thus
compromise
economic
growth.
Poverty
takes
a
toll
on
poor
childrens
development.
For
example,
poverty
causes
malnutrition
which
would
affect
the
development
of
a
childs
mental
thinking
and
healthy
body.
Poverty
may
also
lead
to
political
instability
and
lead
to
increased
risk
of
war,
mass
emigration
of
population
and
terrorism.
77
78
Transfer
payments
Government
provide
various
kind
of
assistance
to
low
income
groups
in
the
society.
The
objective
is
to
support
them
in
maintaining
a
reasonable
standard
of
living
and
to
lower
inequality.
These
payments
are
given
directly
to
these
groups
in
the
form
of
monetary
help.
Examples
include
Social
Security,
unemployment
compensation,
welfare,
and
disability
payments.
Categories
of
taxes
Taxes
can
also
be
classified
on
the
basis
of
their
nature.
A
tax
system/structure
may
be
Progressive
A
tax
system
where
the
tax
liability
increases
with
the
increase
in
the
income.
The
idea
is
to
charge
more
tax
from
high
income
earners
and
low
tax
from
low
income
earners.
This
tax
system
is
based
on
the
principle
of
equality.
Example
Income
tax
slabs
2012-2013
for
General
taxpayers
Tax
No tax
10%
20%
30%
Regressive
This
percentage
of
tax
decreases
as
the
income
increases.
In
terms
of
individual
income
and
wealth,
a
regressive
tax
imposes
a
greater
burden
on
the
poor
than
on
the
rich
there
is
an
inverse
relationship
between
the
tax
rate
and
the
taxpayer's
ability
to
pay
as
measured
by
assets,
consumption,
or
income.
Regressive
taxes
amount
to
a
large
share
of
governments
income.
They
are
also
used
to
discourage
the
use
of
demerit
goods.
However,
indirect
taxes
promote
income
inequality.
Examples
Indirect
taxes
are
regressive
in
nature.
For
example,
if
Jane
has
$10
and
John
has
$5,
a
tax
of
$1
on
a
purchase
would
result
in
a
different
percentage
of
total
income
applied
to
taxation,
20%
for
John
and
10%
for
Jane.
Thus,
a
tax
that
is
fixed
to
the
value
of
the
good/service
would
likely,
in
effect,
result
in
a
higher
burden
of
taxation
to
people
with
less
money.
Proportional
Tax
A
proportional
tax
is
one
that
imposes
the
same
relative
burden
on
all
taxpayersi.e.,
where
tax
liability
and
income
grow
in
equal
proportion.
In
simple
terms,
it
imposes
an
equal
burden
(relative
to
resources)
on
the
rich
and
poor.
Proportional
taxes
maintain
equal
tax
incidence
regardless
of
the
ability-to-pay
and
do
not
shift
the
incidence
disproportionately
to
those
with
a
higher
or
lower
economic
well-being.
79
AD=C+G+I+(X-M)
As
we
can
see
in
the
above
equation
that
G
(Government
Expenditure)
is
a
component
of
AD,
it
can
be
used
by
Government
to
influence
AD
in
the
economy.
The
government
can
use
expansionary
or
deflationary
fiscal
policy
to
get
the
desired
results.
Lets
discuss
each
policy
in
detail.
Expansionary
fiscal
policy
Expansionary
fiscal
policy
is
used
to
increase
the
Aggregate
demand
in
the
economy.
If
the
economy
is
having
a
deflationary
gap,
the
government
can
use
expansionary
fiscal
policy
to
reduce
the
gap
or
totally
eliminate
it.
Now,
what
is
deflationary
gap?
Deflationary
gap
is
the
difference
between
full
level
of
employment
and
the
actual
level
of
output
of
the
economy.
We
can
see
in
the
diagram
below,
that
the
economy
is
operating
a
level
a
below
the
Yf
(full
level
of
employment).
80
The
consequence
is
that
due
to
deflationary
gap
all
the
resources
of
the
economy
are
not
being
used
in
the
optimum
level
and
they
are
idle.
This
results
in
unemployment
and
low
level
of
output.
This
is
not
desirable
for
any
government.
In
order
to
reduce/eliminate
the
deflationary
gap,
the
government
uses
expansionary
fiscal
policy.
Government
will
either
increase
its
spending
or
reduce
taxes
(or
both)
in
order
to
stimulate
the
aggregate
demand.
Increase
Government
spending
will
result
me
more
projects
being
funded
by
the
government
and
thus
employment
and
output
will
increase.
Even
a
lower
tax
rate
will
result
in
more
disposable
income
for
households
and
encourage
consumption.
Increased
G
and
C
will
lead
to
higher
AD.
However,
this
might
also
lead
to
higher
prices/inflation
in
the
economy.
Contractionary
fiscal
policy
Contractionary
fiscal
policy
involves
the
reduction
of
government
spending
and
increase
taxes
as
a
measure
to
control
inflation/AD
in
the
economy.
With
reduced
government
spending,
the
AD
will
fall
and
thus
reduce
pressure
on
the
economic
resources
and
the
average
price
level
in
the
economy
will
come
down.
Similarly,
increased
taxes
will
take
away
the
excess
disposable
income
from
the
households
and
result
in
a
fall
in
AD.
Contractionary
fiscal
policy
is
thus
used
to
reduce
the
inflationary
gap.
But,
what
is
inflationary
gap?
Inflationary
gap
is
when
the
Aggregate
demand
exceeds
the
productive
potential
of
the
economy.
As
we
can
see
through
the
diagram,
the
economy
is
operating
at
a
level
above
the
full
employment
level
of
the
output.
Due
the
limitation
of
the
economy
to
fulfill
this
increased
demand
the
average
price
level
in
the
economy
increases
resulting
in
inflation.
81
In
this
case
the
government
can
use
contractionary
fiscal
policy
to
control
inflation
and
bring
down
the
AD.
Evaluating
Fiscal
Policy
Fiscal
policy
is
a
powerful
tool
in
the
hands
of
the
government.
Fiscal
policy
can
promote
long
term
economic
growth
by
increased
government
spending
different
sectors
of
the
economy.
With
a
careful
planning
of
expenditure
on
capital
goods
in
the
economy
i.e.
infrastructure,
better
education
and
health
systems,
government
can
considerably
improve
the
potential
output
in
the
economy.
Better
education
and
health
will
also
result
in
improved
human
capital.
Thus,
improving
the
very
basic
factors
of
production
available
in
the
economy.
Moreover,
a
skilled
labor
force
supported
by
a
strong
infrastructure
will
create
a
positive
environment
for
firms
to
invest.
The
economy
will
find
it
easy
to
attract
foreign
capital.
All
these
factors
will
lead
to
an
increased
economic
growth.
Central
Banks
Central
Banks
are
charged
with
regulating
the
size
of
a
nations
money
supply,
the
availability
and
cost
of
credit,
and
the
foreign-exchange
value
of
its
currency.
Central
bank
Regulation
of
the
availability
and
cost
of
credit
may
be
designed
to
influence
the
distribution
of
credit
among
competing
uses.
The
principal
objectives
of
a
modern
central
bank
in
carrying
out
these
functions
are
to
maintain
monetary
and
credit
conditions
conducive
to
a
high
level
of
employment
and
production,
a
reasonably
stable
level
of
domestic
prices,
and
an
adequate
level
of
international
reserves.
Function
of
a
Central
Bank
A
central
bank
usually
carries
out
the
following
responsibilities:
Implementation
of
monetary
policy.
Controls
the
nation's
entire
money
supply.
The
Government's
banker
and
the
bankers'
bank
("Lender
of
Last
Resort").
Manages
the
country's
foreign
exchange
and
gold
reserves
and
the
Government's
stock
register;
Regulation
and
supervision
of
the
banking
industry
IB
Economics
City
Honors
School
2015-2016
82
Setting
the
official
interest
rates-
used
to
manage
both
inflation
and
the
country's
exchange
rate
-
and
ensuring
that
this
rate
takes
effect
via
a
variety
of
policy
mechanisms
Monetary
Policy
and
the
Economy
Monetary
policy
is
the
process
by
which
the
government,
central
bank,
or
monetary
authority
of
a
country
controls
the
supply
of
money,
availability
of
money,
and
cost
of
money
or
rate
of
interest,
in
order
to
attain
growth
and
stability
of
the
economy.
Monetary
policy
is
generally
referred
to
as
either
being
an
expansionary
policy,
or
a
contractionary
policy.
An
expansionary
policy
increases
the
total
supply
of
money
in
the
economy
and
is
traditionally
used
to
combat
unemployment
in
a
recession
by
lowering
interest
rates.
Lowered
interest
rates
encourage
the
household
and
the
firms
to
increase
their
consumption
and
investment
respectively.
This
will
shift
the
AD
to
the
right
and
result
in
higher
real
output
and
more
employment.
IB
Economics
City
Honors
School
2015-2016
83
Contractionary
policy
decreases
the
total
money
supply
and
involves
raising
interest
rates
in
order
to
combat
inflation.
The
result
will
be
that
investment
will
fall,
and
consumption
will
fall.
All
of
these
changes
will
shift
the
AD
to
the
left.
It
is
argued
that
an
increase
in
the
money
supply
causes
an
increase
in
the
rate
of
inflation.
Maintaining
a
low
and
stable
inflation
is
one
of
the
main
macroeconomic
objectives
of
the
Government.
Government
does
so
by
controlling
the
supply
of
money
to
the
economy.
This
policy
is
known
as
monetary
policy.
Monetary
policy
in
any
country
is
usually
controlled
by
the
Central
Bank
of
that
country.
The
Central
bank
alters
the
interest
rates
in
the
economy
after
assessing
the
inflationary
pressures
in
the
market.
Monetary
Policy
tools
Central
Bank
has
three
tools
of
monetary
policy:
Open
market
operations
Open
market
purchases:
The
central
bank
buys
government
securities
to
increase
the
monetary
base.
Open
market
sales:
The
central
bank
sells
government
securities
to
decrease
the
monetary
base.
Open
market
operations
have
a
number
of
advantages:
They
are
under
the
direct
and
complete
control
of
the
central
bank
They
can
be
large
or
small.
They
can
be
easily
reversed.
They
can
be
implemented
quickly
Discount
loans
When
a
bank
receives
a
discount
loan
from
the
central
bank,
it
is
said
to
have
received
a
loan
at
the
discount
window.
The
Central
Bank
can
affect
the
volume
of
discount
loans
by
setting
the
discount
rate:
A
higher
discount
rate
makes
discount
borrowing
less
attractive
to
banks
and
will
therefore
reduce
the
volume
of
discount
loans.
A
lower
discount
rate
makes
discount
borrowing
more
attractive
to
banks
and
will
therefore
increase
the
volume
of
discount
loans.
84
85
Interventionist
supply-side
policies
Investment
in
infrastructure
Improving
information
and
investing
in
infrastructure
will
facilitate
the
firms
to
produce
more
and
at
a
more
cost
efficient
manner.
Better
infrastructure
attracts
more
investment
both
domestic
and
foreign.
In
the
short
run
increase
government
expenditure
on
infrastructure
will
lead
to
rise
in
AD
and
will
fuel
inflation,
however
in
the
long
run
it
will
lead
to
greater
efficiencies
and
output
thus
shifting
the
LRAS
to
the
right.
Investment
in
human
capital
This
involves
investment
in
education
and
training
which
will
raise
the
levels
of
human
capital.
This
will,
in
the
short-term,
impact
on
aggregate
demand
as
consumption
of
certain
goods
will
increase,
but
more
importantly
will
increase
LRAS
as
labor
becomes
more
skilled
and
efficient.
Industrial
policies
Through
various
industrial
policies
focus
the
government
encourage
firms
to
move
to
areas
of
high
unemployment.
These
measures
might
include
subsidies
or
tax
concessions
for
firms
which
move,
the
provision
of
facilities
and
improved
infrastructure
in
the
depressed
area,
the
siting
of
government
offices
in
the
depressed
areas
and
the
prevention
of
firms
expanding
in
the
prosperous
ones.
This
will
have
a
short-term
impact
on
aggregate
demand
but,
more
importantly,
will
increase
LRAS.
Investment
in
new
technology
These
policies
encourage
research
and
development,
which
will
enhance
efficiency
and
output.
It
will
have
a
short-term
impact
on
aggregate
demand,
but
more
importantly
will
result
in
new
technologies
and
will
increase
LRAS.
Market-based
supply-side
policies
IB
Economics
City
Honors
School
2015-2016
86
Policies
to
encourage
competition
Competition
leads
to
increased
efficiency
and
eliminates
market
failure.
Government
can
adopt
various
strategies
to
reduce
its
control
over
market
and
encourage
competition.
This
includes
Deregulation:
The
reduction
or
elimination
of
government
power
in
a
particular
industry,
usually
enacted
to
create
more
competition
within
the
industry.
Privatization:
The
transfer
of
ownership
of
property
or
businesses
from
a
government
to
a
privately
owned
entity.
It
leads
to
greater
efficiency
as
it
is
thought
to
come
from
the
greater
importance
private
owners
tend
to
place
on
profit
maximization
as
compared
to
government,
which
tends
to
be
less
concerned
about
profits.
Trade
liberalization:
This
involves
the
removal
or
reduction
of
restrictions
or
barriers
on
the
free
exchange
of
goods
between
nations.
Trade
liberalization
ultimately
lowers
consumer
costs,
increases
efficiency
and
fosters
economic
growth.
Anti-monopoly
regulations
can
avoid
monopolies
being
formed
and
thus
stimulate
competition
among
firms,
leading
to
greater
efficiency.
Labor
market
reforms
These
include
reducing
the
power
of
labor
unions,
reducing
unemployment
benefits
and
abolishing
minimum
wages
in
order
to
make
the
labor
market
more
flexible
(more
responsive
to
supply
and
demand).
Incentive-related
policies
Personal
income
tax
cuts
are
used
to
increase
the
incentive
to
work,
and
cuts
in
business
tax
and
capital
gains
tax
are
used
to
increase
the
incentive
to
invest.
Evaluation
of
supply-side
policies
The
strengths
and
weaknesses
of
supply-side
policies
Time
lags:
Supply
side
policies
generally
take
time
to
implement
and
show
results
in
the
long
run.
For
example,
improving
the
quality
of
human
capital,
through
education
and
training,
is
unlikely
to
yield
quick
results.
These
policies
have
an
ability
to
create
employment
as
more
jobs
are
created
in
various
fields
such
as
education,
technology
and
health
care.
Moreover,
these
jobs
are
long
term
and
sustainable.
Supply
side
policies
have
the
ability
to
reduce
inflationary
pressure
in
the
long
term
because
of
efficiency
and
productivity
gains
in
the
product
and
labor
markets.
Supply-side
policy
is
very
costly
to
implement
and
have
severe
impact
on
the
government
budget.
For
example,
the
provision
of
education
and
training
is
highly
labor
intensive
and
extremely
costly.
The
government
has
to
carefully
plan
these
spending
over
a
period
of
time.
In
the
short
run
market
oriented
supply
side
policies
such
as
reducing
in
income
and
corporate
taxes
can
reduce
governments
main
source
of
revenue,
however
in
the
long
run
size
of
the
economic
growth
would
be
significant
enough
that
the
increased
government
revenue
from
a
faster
growing
economy
would
cause
overall
revenue
to
increase.
87
Effect
on
equity:
Many
supply-side
measures
have
a
negative
effect
on
the
distribution
of
income,
at
least
in
the
short-term.
For
example,
lower
taxes
rates,
reduced
union
power,
and
privatization
have
all
contributed
to
a
widening
of
the
gap
between
rich
and
poor.
Effect
on
the
environment:
Supply
side
policies
lead
to
more
economic
growth.
However,
it
can
lead
to
exploitation
of
natural
resources
and
environment
if
environmental
regulations
are
relaxed
thus
creating
negative
externalities
of
production.
Opposition:
Power
of
labor
unions,
reducing
unemployment
benefits
and
abolishing
minimum
wages
can
lead
to
wide
spread
discontent
among
the
labour
force
in
the
economy.
Thus
governments
are
usually
hesitant
in
taking
these
steps.
Moreover,
these
might
also
lead
to
worsening
of
working
conditions
in
the
long
run
which
will
affect
labor
productivity.
Section
3:
International
economics
3.1
International
trade
(one
topic
HL
extension,
plus
one
topic
HL
only)
3.2
Exchange
rates
(some
topics
HL
extension)
3.3
The
balance
of
payments
(one
topic
HL
extension,
plus
some
topics
HL
only)
3.4
Economic
integration
(one
topic
HL
extension)
3.5
Terms
of
trade
(HL
only)
The
purpose
of
this
section
is
to
encourage
candidates
to
understand
why
countries
trade,
the
problems
involved
and
how
these
problems
are
addressed.
Students
need
to
understand
how
exchange
rates
affect
international
trade.
The
international
trade
theory
introduced
in
this
section
should
be
related
to
real-world
examples.
What
is
Free
Trade?
Free
trade
is
a
system
of
trade
policy
that
allows
traders
to
trade
across
national
boundaries
without
interference
from
the
respective
governments.
Reasons
for
Free
Trade
Domestic
Non-availability:
A
nation
trades
because
it
lacks
the
raw
materials,
climate,
specialist
labor,
capital
or
technology
needed
to
manufacture
a
particular
good.
Trade
allows
a
greater
variety
of
goods
and
services.
Cost
effectiveness:
It
is
cheaper
to
buy
from
other
countries
rather
than
producing
themselves.
Benefits
of
Trade
Lower
prices
for
consumers:
When
there
is
free
trade,
consumers
can
free
to
buy
goods
from
the
producer
who
is
willing
to
sell
at
the
lowest
prices.
Hence
consumers
gain
from
lower
prices.
Greater
choice
for
consumers:
With
free
trade,
consumers
have
access
to
variety
of
goods
and
services
from
different
producers
across
the
globe.
This
means
more
choice.
Ability
of
producers
to
benefit
from
economies
of
scale:
Producers
have
access
to
a
larger
market
thus
they
can
produce
more
at
lower
cost
and
benefit
from
economies
of
scale.
88
Ability
to
acquire
needed
resources:
Through
free
trade
producers
can
not
only
sell
in
a
large
market
but
also
gain
from
purchasing
from
suppliers
across
the
world.
More
efficient
allocation
of
resources:
When
there
is
free
trade,
the
most
efficient
producers
get
the
opportunity
to
produce
due
to
their
cost
efficiency.
This
leads
to
productive
efficiency.
Increased
competition:
In
free
trade
producers
from
different
regions
can
compete
with
each
other
in
terms
of
price,
quality
and
variety.
Increased
competition
leads
to
efficient
allocation
of
resources.
Source
of
foreign
exchange:
Free
trade
involves
the
transaction
of
goods
and
services
between
nations.
In
order
to
purchase
goods
from
abroad
(imports),
we
need
foreign
currency.
This
is
possible
through
exporting
of
goods
to
other
countries.
Free
Trade
diagrams
IB
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89
90
Australia
can
get
more
wine
with
its
labor
by
specializing
in
wool
and
trading
the
wool
for
French
wine,
while
France
can
benefit
by
trading
wine
for
wool.
Examples
Example
1
Country
A
can
produce
one
widget
using
one
unit
of
labor.
Country
B
can
produce
one
widget
using
two
units
of
labor.
Country
A
has
an
absolute
advantage
over
Country
B
in
producing
widgets.
Example
2
Country
A
has
100
units
of
labor.
It
uses
20
to
produce
80
units
of
Parachutes,
and
80
to
produce
20
units
of
Barbie
dolls.
Country
B
has
100
units
of
labor.
It
uses
40
to
produce
100
units
of
Barbie
dolls,
and
60
to
produce
20
units
of
Parachutes.
If
the
countries
maximized
their
potential,
Country
A
could
produce
400
units
of
Parachutes,
and
country
B
could
produce
250
units
of
Barbie
dolls.
Through
trade,
the
two
countries
would
achieve
a
more
efficient
allocation
of
resources
and
increase
their
prosperity.
Comparative
advantage
The
theory
of
comparative
advantage
states
that
a
country
should
specialise
in
the
production
of
good
or
service
in
which
it
has
lower
opportunity
cost
and
it
should
import
commodities
which
have
a
higher
opportunity
cost
of
production.
Example
Suppose
for
example
we
have
two
countries
of
equal
size,
Northland
and
Southland.
Both
produce
and
consume
two
goods,
Food
and
Clothes.
The
productive
capacities
and
efficiencies
of
the
countries
are
such
that
if
both
countries
devoted
all
their
resources
to
Food
production,
output
would
be
as
follows:
Northland:
100
tons
Southland:
200
tons
If
all
the
resources
of
the
countries
were
allocated
to
the
production
of
clothes,
output
would
be:
Northland:
100
tons
Southland:
100
tons
Assuming
each
has
constant
opportunity
costs
of
production
between
the
two
products
and
both
economies
have
full
employment
at
all
times.
All
factors
of
production
are
mobile
within
the
countries
between
clothing
and
food
industries,
but
are
immobile
between
the
countries.
The
price
mechanism
must
be
working
to
provide
perfect
competition.
Southland
has
an
absolute
advantage
over
Northland
in
the
production
of
Food.
Both
countries
are
equally
efficient
in
the
production
of
clothes.
There
seems
to
be
no
mutual
benefit
in
trade
IB
Economics
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2015-2016
91
between
the
economies.
The
opportunity
costs
shows
otherwise.
Northland's
opportunity
cost
of
producing
one
ton
of
Food
is
one
ton
of
Clothes
and
vice
versa.
Southland's
opportunity
cost
of
one
ton
of
Food
is
0.5
ton
of
Clothes.
The
opportunity
cost
of
one
ton
of
Clothes
is
2
tons
of
Food.
Southland
has
a
comparative
advantage
in
food
production,
because
of
its
lower
opportunity
cost
of
production
with
respect
to
Northland.
Northland
has
a
comparative
advantage
over
Southland
in
the
production
of
clothes,
the
opportunity
cost
of
which
is
higher
in
Southland
with
respect
to
Food
than
in
Northland.
To
show
these
different
opportunity
costs
lead
to
mutual
benefit
if
the
countries
specialize
production
and
trade,
consider
the
countries
produce
and
consume
only
domestically.
The
volumes
are:
Food
Clothes
Northland
50
50
Southland
100
50
World
Total
150
100
Production
and
consumption
before
trade
This
example
includes
no
formulation
of
the
preferences
of
consumers
in
the
two
economies
which
would
allow
the
determination
of
the
international
exchange
rate
of
Clothes
and
Food.
Given
the
production
capabilities
of
each
country,
in
order
for
trade
to
be
worthwhile
Northland
requires
a
price
of
at
least
one
ton
of
Food
in
exchange
for
one
ton
of
Clothes;
and
Southland
requires
at
least
one
ton
of
Clothes
for
two
tons
of
Food.
The
exchange
price
will
be
somewhere
between
the
two.
The
remainder
of
the
example
works
with
an
international
trading
price
of
one
ton
of
Food
for
2/3
ton
of
Clothes.
If
both
specialize
in
the
goods
in
which
they
have
comparative
advantage,
their
outputs
will
be:
Food
Clothes
Northland
0
100
Southland
200
0
World
Total
200
100
Production
after
trade
World
production
of
food
increased.
Clothing
production
remained
the
same.
Using
the
exchange
rate
of
one
ton
of
Food
for
2/3
ton
of
Clothes,
Northland
and
Southland
are
able
to
trade
to
yield
the
following
level
of
consumption:
Food
Clothes
Northland
75
50
Southland
125
50
World
Total
200
100
Consumption
after
trade
IB
Economics
City
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92
Northland
traded
50
tons
of
Clothing
for
75
tons
of
Food.
Both
benefited,
and
now
consume
at
points
outside
their
production
possibility
frontiers.
Assumptions
in
Example
2
Two
countries,
two
goods
-
the
theory
is
no
different
for
larger
numbers
of
countries
and
goods,
but
the
principles
are
clearer
and
the
argument
easier
to
follow
in
this
simpler
case.
Equal
size
economies
-
again,
this
is
a
simplification
to
produce
a
clearer
example.
Full
employment
-
if
one
or
other
of
the
economies
has
less
than
full
employment
of
factors
of
production,
then
this
excess
capacity
must
usually
be
used
up
before
the
comparative
advantage
reasoning
can
be
applied.
Constant
opportunity
costs
-
a
more
realistic
treatment
of
opportunity
costs
the
reasoning
is
broadly
the
same,
but
specialization
of
production
can
only
be
taken
to
the
point
at
which
the
opportunity
costs
in
the
two
countries
become
equal.
This
does
not
invalidate
the
principles
of
comparative
advantage,
but
it
does
limit
the
magnitude
of
the
benefit.
Perfect
mobility
of
factors
of
production
within
countries
-
this
is
necessary
to
allow
production
to
be
switched
without
cost.
In
real
economies
this
cost
will
be
incurred:
capital
will
be
tied
up
in
plant
(sewing
machines
are
not
sowing
machines)
and
labor
will
need
to
be
retrained
and
relocated.
This
is
why
it
is
sometimes
argued
that
'nascent
industries'
should
be
protected
from
fully
liberalized
international
trade
during
the
period
in
which
a
high
cost
of
entry
into
the
market
(capital
equipment,
training)
is
being
paid
for.
Immobility
of
factors
of
production
between
countries
-
why
are
there
different
rates
of
productivity?
The
modern
version
of
comparative
advantage
(developed
in
the
early
twentieth
century
by
the
Swedish
economists
Eli
Heckscher
and
Bertil
Ohlin)
attributes
these
differences
to
differences
in
nations'
factor
endowments.
A
nation
will
have
comparative
advantage
in
producing
the
good
that
uses
intensively
the
factor
it
produces
abundantly.
For
example:
suppose
the
US
has
a
relative
abundance
of
capital
and
India
has
a
relative
abundance
of
labor.
Suppose
further
that
cars
are
capital
intensive
to
produce,
while
cloth
is
labor
intensive.
Then
the
US
will
have
a
comparative
advantage
in
making
cars,
and
India
will
have
a
comparative
advantage
in
making
cloth.
If
there
is
international
factor
mobility
this
can
change
nations'
relative
factor
abundance.
The
principle
of
comparative
advantage
still
applies,
but
who
has
the
advantage
in
what
can
change.
Negligible
Transport
Cost
-
Cost
is
not
a
cause
of
concern
when
countries
decided
to
trade.
It
is
ignored
and
not
factored
in.
Assume
that
half
the
resources
are
used
to
produce
each
good
in
each
country.
This
takes
place
before
specialization
Perfect
competition
-
this
is
a
standard
assumption
that
allows
perfectly
efficient
allocation
of
productive
resources
in
an
idealized
free
market.
Limitations
of
Theory
of
Absolute
Advantage
The
theory
is
based
on
unrealistic
assumptions:
Factors
of
production
are
immobile
and
fixed
Technology
is
fixed
There
is
perfect
competition
Resources
are
fully
employed
Imports
and
exports
balance
each
other
IB
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94
Impact
of
Tariffs
Tariffs
lead
to
higher
prices
for
imports
and
thus
Imports
fall
Domestic
consumers
have
to
pay
higher
prices
and
buy
less.
Domestic
producers
gain,
as
they
get
higher
prices
and
sell
larger
quantities.
As
we
can
see
in
the
diagram
domestic
production
increases
from
0Q1
to
0Q2.
Moreover
their
revenue
increases
from
PwQ1
to
Pw+TQ2
Higher
domestic
production
leads
to
increased
domestic
employment.
Government
now
gains
from
tariff
revenues,
which
can
be
represented
by
e
in
the
diagram
Tariffs
are
regressive
in
nature
and
thus
worsen
income
distribution.
Exporting
countries
lose
due
to
fall
in
exports.
Quotas
An
import
quota
is
a
type
of
protectionist
that
sets
a
physical
limit
on
the
quantity
of
a
good
that
can
be
imported
into
a
country
in
a
given
period
of
time.
This
leads
to
a
reduction
in
the
quantity
imported
and
therefore
increases
the
market
price
of
imported
goods.
Quotas,
like
other
trade
restrictions,
are
used
to
benefit
the
producers
of
a
good
in
a
domestic
economy
at
the
expense
of
all
consumers
of
the
good
in
that
economy.
Effects
of
Quotas
Domestic
production
increases
from
0Q1
to
0Q1+Q3Q4.
Domestic
consumption
fall
from
0Q2
to
0Q4
Imports
fall
from
Q1Q2
to
Q1Q3
Consumers
end
up
paying
more.
Before
quota
was
imposed
they
were
paying
Pw,
but
now
they
are
paying
Pw+Quota
Domestic
producers
gain
as
they
sell
more
at
higher
prices
(Pw+Quota)
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Effects
of
Subsidies
Consumption
of
the
good
is
not
affected.
Consumption
remains
at
Q3.
Taxpayers
lose
as
the
tax
revenue
collected
is
being
used
for
subsidies
Domestic
producers
gain
as
the
production
increases
from
0Q1
to
0Q3.
Employment
increases
as
more
is
being
produced
domestically.
Exporting
countries
are
worse
off
Global
misallocation
of
resources
as
inefficient
producers
are
now
producing
goods.
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Administrative
Barriers
Countries
are
sometimes
accused
of
using
their
various
administrative
rules
(eg.
regarding
food
safety,
environmental
standards,
electrical
safety,
etc.)
as
a
way
to
introduce
barriers
to
imports.
Embargo
An
embargo
is
the
prohibition
of
commerce
and
trade
with
a
certain
country,
in
order
to
isolate
it
and
to
put
its
government
into
a
difficult
internal
situation,
given
that
the
effects
of
the
embargo
are
often
able
to
make
its
economy
suffer
from
the
initiative.
Anti-dumping
legislation
Supporters
of
anti-dumping
laws
argue
that
they
prevent
"dumping"
of
cheaper
foreign
goods
that
would
cause
local
firms
to
close
down.
However,
in
practice,
anti-dumping
laws
are
usually
used
to
impose
trade
tariffs
on
foreign
exporters.
Arguments
in
favor
of
protectionism
Infant
industry
argument:
It
is
argued
that
government
should
go
in
for
protectionist
measure
to
protect
infant
industries,
or
else
they
will
not
get
an
opportunity
to
survive
due
to
international
trade.
Efforts
of
a
developing
country
to
diversify:
Developing
countries
need
to
protect
industries
in
which
they
want
to
diversify.
Protection
of
employment:
Protecting
domestic
industries
also
means
protecting
domestic
employment.
Source
of
government
revenue:
Tariffs
form
a
good
source
of
revenue
for
governments.
Strategic
arguments:
it
means
use
of
a
tariff
to
protect
military
capability.
The
idea
is,
to
consume
the
goods
of
our
country
to
promote
the
national
industry
and
so,
in
the
case
of
war
we
don't
have
to
buy
the
products
in
a
foreign
country
and
our
industries
have
the
capacity
to
produce
all
the
goods
that
our
country
need.
We
want
tariffs
to
reduce
the
dependence
on
international
resources.
Means
to
overcome
a
balance
of
payments
disequilibrium:
High
imports
as
compared
to
exports
might
lead
to
severe
balance
of
payments
issues.
Government
might
resort
to
protectionist
measures
such
as
tariffs
and
quotas
to
restrict
import
and
thereby
control
the
balance
of
payment
disequilibrium.
Anti-dumping:
Dumping
is
when
manufacturers
export
a
product
to
another
country
at
a
price
either
below
the
price
charged
in
its
home
market.
This
harms
the
domestic
industry
and
employment.
The
importing
country
might
resort
to
protectionist
measures
such
as
tariffs
to
control
dumping
of
these
goods.
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98
As
we
can
see
in
the
diagram
as
the
demand
for
$
from
UK
increases
it
price
in
terms
of
goes
up
from
.62
to
.63.
Similarly,
we
can
see
that
the
supply
of
dollar
in
the
market
increases
which
forces
its
price
down
from
.63
to
.62.
99
100
However,
The
volumes
and
the
actual
amount
of
income
and
expenditure
will
depend
on
the
relative
price
elasticity
of
demand
for
imports
and
exports.
Government
Intervention
in
the
exchange
rate
Fixed
Exchange
Rate
A
fixed
exchange
rate
system
refers
to
the
case
where
the
exchange
rate
is
set
and
maintained
at
same
level
by
the
government
irrespective
of
the
market
forces.
The
diagram
below
shows
a
fixed
exchange
rate
REVALUATION
AND
DEVALUATION
It
refers
to
official
changes
in
the
price
of
a
currency
in
a
fixed
exchange
rate
system.
Devaluation
is
when
the
price
of
the
currency
is
officially
decreased
in
a
fixed
exchange
rate
system.
Revaluation
is
the
official
increase
in
the
price
of
the
currency
within
a
fixed
exchange
rate
system.
Managed
Exchange
Rate
A
managed
exchange
rate
occurs
when
there
is
official
intervention
by
a
government
or
an
agency
such
as
the
Central
Bank
to
determination
the
value
of
a
countrys
exchange
rate.
Through
such
official
interventions
it
is
possible
to
manage
both
fixed
and
floating
exchange
rates.
For
example,
The
Federal
Bank
may
decide
to
enter
the
foreign
exchange
market
as
either
a
buyer
or
seller
to
stabilize
any
short-term
fluctuation
in
the
value
US$.
To
limit
a
fall
in
the
value
of
US$
(depreciation)
the
Fed
will
buy
US$,
and
to
prevent
a
rise
in
the
value
of
US$,
the
central
bank
will
sell
US$
in
the
market.
Such
intervention
by
the
central
bank
is
known
as
a
dirty
float,
or
more
correctly
a
managed
float.
IB
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101
102
Imports
are
relatively
cheaper
to
buy
due
to
overvalued
currency.
Consumers
will
go
in
for
more
imports
which
will
damage
to
domestic
industries
Undervalued
currency
Advantages
If
currency
is
undervalued,
the
exports
will
be
cheaper
and
they
will
grow
leading
to
greater
employment
in
export
industries
Undervalued
currency
will
make
imports
expensive
for
consumers,
they
will
divert
to
domestic
goods
and
thus
employment
in
domestic
industries
will
increase.
Disadvantages
As
discussed
earlier
undervalued
currency
makes
imports
expensive
which
also
leads
to
Imported
inflation
i.e.
all
the
products
using
imported
components/raw
material
will
become
expensive
thus
effecting
the
general
price
level.
What
is
Balance
of
Payments?
Balance
of
Payments
is
an
accounting
record
of
all
monetary
transactions
between
a
country
and
the
rest
of
the
world
Important
Points
BOP
is
a
record
which
countries
use
to
monitor
all
international
monetary
transactions
at
a
specific
period
of
time.
All
trades
conducted
by
both
the
private
and
public
sectors
are
accounted
for
in
the
BOP
in
order
to
determine
how
much
money
is
going
in
and
out
of
a
country
If
a
country
has
received
money,
this
is
known
as
a
credit,
and,
if
a
country
has
paid
or
given
money,
the
transaction
is
counted
as
a
debit.
Usually,
the
Balance
of
Payments
is
calculated
every
quarter
and
every
calendar
year.
Components
of
Balance
of
Payment
Balance
of
Payment
is
classified
into
three
categories.
These
are:
The
Current
Account
It
includes
Trade
in
goods:
visible
account
Trade
in
services:
invisible
account
consists
of
transport,
tourism
and
insurance
etc.
Net
Income
flows:
Income
flows
consist
of
wages,
interest
and
profits
flowing
into
and
out
of
the
country.
Current
transfers
of
money:
Government
contributions
to
and
receipts
from
international
organizations
and
international
transfers
of
money
by
private
individuals
and
firms.
The
Capital
Account
It
records
flow
of
funds,
into
the
country
(credits)
and
out
of
the
country
(debits),
associated
with
the
acquisition
or
disposal
of
fixed
assets
Transfers
of
financial
assets
by
migrants
IB
Economics
City
Honors
School
2015-2016
103
The
Financial
Account
It
records
the
flow
of
money
in
and
out
of
a
country
because
of:
Investment
(direct
and
portfolio)
Records
primarily
long
term
investments
like:
Direct
investments
if
a
foreign
company
invests
money
from
abroad
in
one
of
its
branches
or
associated
companies
a
country.
(Any
profit
from
this
investment
will
be
recorded
as
income
outflow
on
the
current
account)
Portfolio
investment-
changes
in
the
holding
of
paper
assets,
such
as
company
shares.
E.g.
If
an
Indian
buys
shares
in
an
overseas
company,
this
is
an
outflow
of
funds
i.e.
Debit
item
Other
Financial
Flows
It
consists
primarily
of
various
types
of
short-term
monetary
movement
between
a
country
and
the
rest
of
the
world.
E.g.
Deposits
by
overseas
residents
in
banks
in
the
country
and
loans
to
India
from
abroad
are
credit
items.
Deposits
by
Indians
in
overseas
banks
and
loans
by
Indian
banks
to
overseas
residents
are
debit
items.
Short
term
monetary
flows
are
common
between
international
financial
centres
to
take
advantage
of
differences
in
interest
rates
and
changes
in
exchange
rates.
Flow
to
and
from
the
reserves
Every
country
holds
reserves
of
gold
and
foreign
currencies.
Central
bank
sells
some
of
the
reserves
to
purchase
Rupee
in
the
foreign
market.
It
does
so
in
order
to
support
the
rate
of
exchange.
Drawing
on
reserves
represents
credit
item
in
the
balance
of
payment
accounts.
Money
drawn
from
the
reserves
represents
an
inflow
of
the
BOP.
The
surplus
elsewhere
in
the
balance
of
payments
can
be
used
to
build
up
the
reserves
i.e.
debits.
Balance
of
Payment
can
be
favorable
or
unfavorable
(deficit)
Theoretically,
the
BOP
should
be
zero,
meaning
that
assets
(credits)
and
liabilities
(debits)
should
balance.
But
in
practice
this
is
rarely
the
case
and,
thus,
the
BOP
can
tell
the
observer
if
a
country
has
a
deficit
or
a
surplus
and
from
which
part
of
the
economy
the
discrepancies
are
stemming.
IB
Economics
City
Honors
School
2015-2016
104
Current
Account
Deficits
and
Exchange
rate
The
current
account
is
the
balance
of
trade
between
a
country
and
its
trading
partners,
reflecting
all
payments
between
countries
for
goods,
services,
interest
and
current
account
deficit
dividends.
A
deficit
in
the
current
account
shows
the
country
is
spending
more
on
foreign
trade
than
it
is
earning,
and
that
it
is
borrowing
capital
from
foreign
sources
to
make
up
the
deficit.
In
other
words,
the
country
requires
more
foreign
currency
than
it
receives
through
sales
of
exports,
and
it
supplies
more
of
its
own
currency
than
foreigners
demand
for
its
products.
The
excess
demand
for
foreign
currency
lowers
the
country's
exchange
rate
until
domestic
goods
and
services
are
cheap
enough
for
foreigners,
and
foreign
assets
are
too
expensive
to
generate
sales
for
domestic
interests.
Implications
of
a
persistent
current
account
deficit
Exchange
rate:
As
discussed
earlier,
a
persistent
current
account
deficit
will
lead
to
a
fall
in
the
value
of
the
domestic
currency.
Another
way
is
to
draw
on
reserves,
however
if
the
reserves
are
run
down
to
rapidly,
it
may
cause
a
crisis
of
confidence
and
foreign
investment
may
withdraw
suddenly.
Persistent
current
account
deficits
will
also
lead
to
depletion
of
foreign
exchange
reserves.
Indebtedness:
If
the
combined
balance
is
a
deficit,
then
it
would
have
to
be
covered
by
borrowings
from
abroad
or
attracting
deposits
from
abroad.
It
might
mean
paying
more
interest.
Increase
in
Interest
rates:
With
a
falling
exchange
rate,
the
government
might
have
to
take
more
serious
monetary
measures
such
as
increasing
the
interest
rates.
This
will
attract
foreign
currency,
however,
the
higher
interest
rates
means
compromising
the
Aggregate
Demand
in
the
economy.
Another
alternative
is
to
attract
foreign
investments.
However,
it
leads
to
greater
outflows
in
interest
and
dividends
in
the
future.
Methods
to
correct
a
persistent
current
account
deficit
Expenditure
switching
policies
These
are
policies
implemented
by
the
government
that
attempt
to
switch
the
expenditure
of
domestic
consumers
away
from
imports
towards
domestically
produced
goods
&
services.
Devaluating
currency:
Fixing
the
domestic
currency
value
at
a
lower
price
and
thus
making
exports
more
attractive.
Moreover,
imports
will
become
more
expensive,
thus
diverting
consumption
to
domestic
goods.
However,
expensive
imports
will
lead
to
imported
inflation
Protectionist
measures:
Reducing
imports
by
levying
tariffs
and
setting
up
quotas.
IB
Economics
City
Honors
School
2015-2016
105
106
What
is
a
trade
agreement?
A
trade
agreement
is
a
contract/agreement/pact
between
two
or
more
nations
that
outlines
how
they
will
work
together
to
ensure
mutual
benefit
in
the
field
of
trade
and
investment.
Trade
agreements
are
often
regional,
involving
only
a
relatively
small
number
of
countries.
Trade
agreements
are
either
bilateral,
involving
only
two
countries,
or
multilateral,
involving
more
than
two
countries.
What
is
a
trade
bloc?
A
trade
bloc
is
a
type
of
intergovernmental
agreement,
where
regional
barriers
to
trade,
(tariffs
and
non-tariff
barriers)
are
reduced
or
eliminated
among
the
participating
states.
Types
of
trade
blocs
Preferential
Trade
agreement
A
preferential
trade
agreement,
is
a
trading
bloc
that
gives
preferential
access
to
certain
products
from
the
participating
countries.
107
This
is
done
by
reducing
tariffs
but
not
by
abolishing
them
completely.
A
PTA
can
be
established
through
a
trade
pact.
It
is
the
first
stage
of
economic
integration.
Free
Trade
Areas
A
free-trade
area
is
a
trade
bloc
whose
member
countries
have
signed
a
free-trade
agreement
(FTA),
which
eliminates
tariffs,
import
quotas,
and
preferences
on
most
(if
not
all)
goods
and
services
traded
between
them.
However
they
are
free
to
trade
with
countries
outside
of
the
free
trade
area
108
Customs
Union
An
agreement
among
countries
to
have
free
trade
among
themselves
and
to
adopt
common
external
barriers
against
any
other
country
interested
in
exporting
to
these
countries
Examples:
European
Union
East
African
Community
(Kenya,
Uganda,
Tanzania]
Mercosur
[
Brazil,
Argentina,
Uruguay,
Paraguay
and
Venezuela]
Common
Market
A
type
of
custom
union
where
there
are
common
policies
on
product
regulation,
and
free
movement
of
goods
and
services,
capital
and
labour.
Best
known
example
is
EU
All
common
markets
and
economic
and
monetary
unions
are
also
customs
unions
Economic
&
Monetary
Unions
A
common
market
with
common
currency
Where
more
than
two
countries
use
the
same
currency.
Example
Euro
Advantages
of
single
currency
Reduces
the
level
of
transaction
cost.
When
trading
among
each
other
the
countries
need
not
worry
about
possible
exchange
rate
fluctuations.
It
is
easier
to
make
price
comparisons
between
countries.
Greater
FDI
is
attracted
because
of
reduced
transactions
costs,
reduced
uncertainty
and
the
large
size
of
single
currency
market.
IB
Economics
City
Honors
School
2015-2016
109
Evaluation
of
Economic
integration
Greater
size
of
the
market
Potential
for
exports
Greater
efficiency
More
choice
Lower
prices
for
consumers
Increased
foreign
investment
Greater
political
stability
Free
trade
among
members
but
discriminatory
policies
against
non-members
which
might
not
lead
to
global
economic
integration.
IB
Economics
City
Honors
School
2015-2016
110
In
the
above
diagram,
when
Thailand
and
Malaysia
form
a
trading
bloc,
Thailand
will
remove
tariffs
from
Malaysian
imports.
Trade
will
go
to
more
efficient
Malaysian
producers.
The
blue
shaded
regions
shows
that
world
efficiency
wil
be
regained
as
now
more
efficient
producer
is
producing
the
good
and
there
are
lower
prices
which
lead
to
regaining
of
consumer
surplus.
Increased
income
resulting
from
specialization
&
benefits
of
scale
can
further
this
by
creating
increased
demand
for
imports
from
non-member
countries.
Initial
effects
are
the
increase
in
consumer
welfare
resulting
from
more
goods
and
lower
prices,
while
the
long-run
effects
include
enhance
competitive
advantage
and
increasing
specialization.
IB
Economics
City
Honors
School
2015-2016
111
Trade
Diversion
When
a
customs
union
is
created
and
tariffs
differentials
between
members
and
non-member
result
in
trade
flows
being
diverted
toward
higher
cost
producers.
In
the
upper
image,
once
the
UK
joined
the
EU,
it
had
to
place
tariffs
on
the
Palm
Oil
that
it
used
to
import
from
Malaysia
at
lower
prices.
The
trade
now
is
diverted
to
EU
nations
in
spite
of
the
fact
that
they
are
inefficient
in
producing
palm
oil.
The
blue
shaded
regions
show
a
loss
in
efficiency
due
production
by
inefficiently
European
producers.
Moreover,
the
prices
for
consumers
have
increased
from
Pm
to
Peu
which
results
in
loss
of
consumer
surplus.
In
other
words,
lower
cost
imports
from
outside
the
union
have
been
replaced
by
high
cost
imports
from
within
the
union.
World
Trade
Organization
The
WTO
is
an
international
entity
established
on
January
1st
1995,
that
sets
the
rules
for
global
trading
and
resolves
disputes
between
its
member
countries,
it
now
counts
with
149
members.
Functions
of
the
WTO:
To
administer
WTO
trade
agreements
To
be
a
forum
for
trade
organizations
To
handle
trade
disputes
among
members
countries
To
monitor
national
trade
policies
To
provide
technical
assistance
and
training
for
developing
countries
To
cooperate
with
other
international
organizations
112
The
last
round
of
negotiation
is
the
Doha
round.
The
program
called
the
Doha
Development
Agenda,
covers
many
areas
such
as:
agricultural
tariffs,
non-agricultural
tariffs,
trade
and
environment,
anti-dumping,
subsidies,
competition
policy,
transparency
in
government
procurement,
and
intellectual
property.
On
July
2006,
this
round
was
suspended
since
the
members
could
not
reach
an
agreement
based
on
two
key
concerns:
First,
he
EU
and
the
US
are
being
urged
to
reduce
their
agricultural
subsidies
to
improve
market
access
for
developing
countries
exports.
Second,
the
more
developed
countries
want
the
larger
developing
countries
such
as
Brazil
and
India
to
lower
their
barriers
to
imports
of
manufactured
goods.
Is
the
WTO
a
success
or
a
failure?
There
are
several
benefits
that
member
countries
gain
from
this
organization:
The
system
helps
to
promote
peace
in
the
world
Freer
trade
cuts
the
cost
of
living
for
the
majority
of
consumers
Trade
raises
income
and
stimulates
economic
growth
Freer
trade
provides
more
choice
of
products
and
better
quality
products
The
system
encourages
good
government
Disputes
are
now
handled
constructively
at
forums
Rules
make
life
easier
for
everyone.
Small
countries
have
an
equal
say
and
gain
from
collective
bargaining
with
the
larger
countries.
However,
there
is
some
criticism
to
consider:
In
reality,
many
important
decisions
get
made
in
informal
negotiations
between
small
groups
of
the
wealthier
nations.
Hence,
many
of
the
WTOs
developing
countries
members
are
often
excluded
from
decision-making
negotiations;
apart
from
the
fact
that
many
of
such
countries
cannot
afford
to
participate
in
all
negotiations
and
send
their
representatives.
The
WTOs
General
Agreement
on
Trade
and
Services
includes
a
long
list
of
services
that
should
be
privatized
(childcare,
sewage,
garbage
disposal,
park
maintenance,
care
for
the
aged
and
postal
services),
which
is
not
well
seen
in
developing
countries
where
the
majority
of
the
poor
population
would
not
be
able
to
afford
for
such
services.
It
is
argued
that
WTO
treaties
are
unfairly
biased
towards
the
interest
of
multinational
corporations
and
the
rich
nations.
For
example:
rich
countries
being
allowed
to
maintain
high
import
duties
and
quotas
on
certain
products
from
developing
countries;
increasing
non-tariffs
barriers
against
developing
countries;
intellectual
property
rights
banning
developing
countries
from
incorporating
technology
that
originates
in
developed
countries;
etc.
It
is
claimed
that
in
the
quest
for
free
trade,
issues
of
health,
safety
at
work,
and
environmental
protection
are
too
often
ignored
to
the
great
detriment
of
health,
safety,
and
the
environment,
at
the
forums.
Opponents
of
globalization,
and
in
particular
those
opposed
to
the
growing
power
of
multinational
corporations,
argued
that
the
WTO
infringes
upon
national
sovereignty
and
promotes
the
interests
of
large
corporations
at
the
expense
of
smaller
local
firms
struggling
to
cope
with
import
competition.
IB
Economics
City
Honors
School
2015-2016
113
114
Sources
of
economic
development
Education
leads
to
more
gender
equality,
improved
levels
of
health
Health
care
coupled
with
education
facilities
improve
the
quality
of
workforce,
leading
to
increase
in
productivity
Infrastructure
:better
facilities
and
services
such
as
roads,
transport,
communication
Political
stability
Poverty
Trap
Some
countries
there
may
be
communities
caught
in
poverty
trap
(poverty
cycle)
where
poor
communities
are
unable
to
invest
in
physical,
human
and
natural
capital
due
to
low
or
no
savings;
poverty
is
therefore
transmitted
from
generation
to
generation,
and
there
is
a
need
for
intervention
to
break
out
of
the
cycle.
The
diagram
below
illustrates
a
poverty
trap
In
order
to
escape
the
poverty
trap,
it
is
argued
that
individuals
in
poverty
must
be
given
sufficient
aid
so
that
they
can
acquire
the
critical
mass
of
capital
necessary
to
raise
themselves
out
of
poverty.
This
theory
of
poverty
helps
to
explain
why
certain
aid
programs
which
do
not
provide
a
high
enough
level
of
support
may
be
ineffective
at
raising
individuals
from
poverty.
If
those
in
115
poverty
do
not
acquire
the
critical
mass
of
capital,
then
they
will
simply
remain
dependent
on
aid
indefinitely
and
regress
if
aid
is
ended.
Diversity
among
economically
less
developed
nations
Economically
less
developed
countries
differ
enormously
from
each
other
Resource
endowment
may
differ.
Historical
background:
Most
have
been
colonized.
Geographic
and
demographic
factors
Ethnic
and
religious
breakdown
Structure
of
industry:
some
may
heavily
depend
on
primary
sector
while
other
may
not.
Per
capita
income
levels
may
differ
in
these
countries.
Political
structure
:
These
countries
might
be
having
different
political
structure,
Some
may
be
having
democracies,
monarchies,
military
rule,
single
party
states
and
so
on.
International
development
goals
The
Millennium
Development
Goals
(MDGs)
are
eight
international
development
goals
that
were
officially
established
following
the
Millennium
Summit
of
the
United
Nations
in
2000,
following
the
adoption
of
the
United
Nations
Millennium
Declaration.
All
193
United
Nations
member
states
and
at
least
23
international
organizations
have
agreed
to
achieve
these
goals
by
the
year
2015.
The
goals
are:
Eradicating
extreme
poverty
and
hunger,millennium
development
goals
Achieving
universal
primary
education,
Promoting
gender
equality
and
empowering
women
Reducing
child
mortality
rates,
Improving
maternal
health,
Combating
HIV/AIDS,
malaria,
and
other
diseases,
Ensuring
environmental
sustainability,
and
Developing
a
global
partnership
for
development
IB
Economics
City
Honors
School
2015-2016
116
117
Composite
Indicators
Human
Development
Index
The
Human
Development
Index
(HDI)
is
a
summary
measure
of
human
development.
It
measures
the
average
achievements
in
a
country
in
three
basic
dimensions
of
human
development:
a
long
and
healthy
life
(health),
access
to
knowledge
(education)
and
a
decent
standard
of
living
(income).
Data
availability
determines
HDI
country
coverage.
To
enable
cross-country
comparisons,
the
HDI
is,
to
the
extent
possible,
calculated
based
on
data
from
leading
international
data
agencies
and
other
credible
data
sources
available
at
the
time
of
writing.
A
composite
index
that
brings
together
three
variables
adopted
in
1990
developed
jointly
by
Amartya
Sen
and
Mahbub
ul
Haq.
Long
and
healthy
life
;
life
expectancy
Improved
education;
adult
literary
Decent
standard
of
living;
GDP
per
capita
Category
High Human development
Medium human development
Low human development
HDI Value
.800 and above
.500 -0.799
Less than .500
Other
composite
indices
Gender
Inequality
Index
The
Gender
Inequality
Index
(GII)
reflects
womens
disadvantage
in
three
dimensions
reproductive
health,
empowerment
and
the
labour
marketfor
as
many
countries
as
data
of
reasonable
quality
allow.
The
index
shows
the
loss
in
human
development
due
to
inequality
between
female
and
male
achievements
in
these
dimensions.
It
ranges
from
0,
which
indicates
that
women
and
men
fare
equally,
to
1,
which
indicates
that
women
fare
as
poorly
as
possible
in
all
measured
dimensions.
The
health
dimension
is
measured
by
two
indicators:
maternal
mortality
ratio
and
the
adolescent
fertility
rate.
The
empowerment
dimension
is
also
measured
by
two
indicators:
the
share
of
parliamentary
seats
held
by
each
sex
and
by
secondary
and
higher
education
attainment
levels.
The
labour
dimension
is
measured
by
womens
participation
in
the
work
force.
The
Gender
Inequality
Index
is
designed
to
reveal
the
extent
to
which
national
achievements
in
these
aspects
of
human
development
are
eroded
by
gender
inequality,
and
to
provide
empirical
foundations
for
policy
analysis
and
advocacy
efforts.
More
information
at
http://hdr.undp.org/en/statistics/gii/
Inequality-adjusted
Human
Development
Index
(IHDI)
The
Inequality-adjusted
Human
Development
Index
(IHDI)
adjusts
the
Human
Development
Index
(HDI)
for
inequality
in
distribution
of
each
dimension
across
the
population.
The
IHDI
accounts
for
inequalities
in
HDI
dimensions
by
discounting
each
dimensions
average
value
according
to
its
level
of
inequality.
The
IHDI
equals
the
HDI
when
there
is
no
inequality
across
people
but
is
less
than
the
HDI
as
inequality
rises.
In
this
sense,
the
IHDI
is
the
actual
level
of
human
development
118
(accounting
for
this
inequality),
while
the
HDI
can
be
viewed
as
an
index
of
potential
human
development
(or
the
maximum
level
of
HDI)
that
could
be
achieved
if
there
was
no
inequality.
The
loss
in
potential
human
development
due
to
inequality
is
given
by
the
difference
between
the
HDI
and
the
IHDI
and
can
be
expressed
as
a
percentage.
More
information
http://hdr.undp.org/en/statistics/ihdi/
Multidimensional
Poverty
Index
(MPI)
The
Multidimensional
Poverty
Index
(MPI)
identifies
multiple
deprivations
at
the
individual
level
in
health,
education
and
standard
of
living.
It
uses
micro
data
from
household
surveys,
and
unlike
the
Inequality-adjusted
Human
Development
Indexall
the
indicators
needed
to
construct
the
measure
must
come
from
the
same
survey.
Each
person
in
a
given
household
is
classified
as
poor
or
nonpoor
depending
on
the
number
of
deprivations
his
or
her
household
experiences.
These
data
are
then
aggregated
into
the
national
measure
of
poverty.
The
MPI
reflects
both
the
incidence
of
multidimensional
deprivation,
and
its
intensityhow
many
deprivations
people
experience
at
the
same
time.
It
can
be
used
to
create
a
comprehensive
picture
of
people
living
in
poverty,
and
permits
comparisons
both
across
countries,
regions
and
the
world
and
within
countries
by
ethnic
group,
urban
or
rural
location,
as
well
as
other
key
household
and
community
characteristics.
The
MPI
builds
on
recent
advances
in
theory
and
data
to
present
the
first
global
measure
of
its
kind,
and
offers
a
valuable
complement
to
income-based
poverty
measures.
The
2011
Human
Development
Report
(HDR)
presents
estimates
for
109
countries
with
a
combined
population
of
5.5
billion
(79%
of
the
world
total).
About
1.7
billion
people
in
the
countries
covereda
third
of
their
entire
populationlived
in
multidimensional
poverty
between
2000
and
2010.
More
information
at
http://hdr.undp.org/en/statistics/mpi/
Domestic
factors
and
economic
development
The
following
factors
contribute
to
economic
growth:
Education
and
health
Education
is
one
of
the
most
important
domestic
factors
in
any
country.
Not
only
does
it
provide
benefits
to
the
educated
individuals;
it
also
brings
benefits
to
society.
The
workforce
as
a
whole
will
be
able
to
produce
more
than
it
previously
could,
but
that
is
not
all.
Increased
level
of
education
improves
communication
and
sparks
social
debate,
which
may
help
to
reform
the
very
foundations
of
society.
Because
of
the
all-important
role
of
education
in
achieving
development,
the
U.N
has
made
universal
enrolment
in
primary
education
one
of
its
Millennium
Development
Goals
to
be
achieved
by
2015.
Improving
healthcare
in
less-developed
countries
is
another
key
in
achieving
economic
development.
Better
healthcare
means
that
the
quality
of
the
labour
factor
of
production
improves,
and
that
the
country
can
potentially
produce
more.
However,
one
of
the
most
important
aspects
of
improved
healthcare
is
perhaps
a
reduction
in
child
mortality.
Studies
show
that
a
reduction
in
child
mortality
reduces
the
long-term
need
to
have
many
children,
as
the
certainty
of
them
surviving
to
adult
age
increase.
A
reduction
in
child
mortality
is,
in
itself,
a
very
significant
IB
Economics
City
Honors
School
2015-2016
119
factor
in
achieving
development
since
it
means
that
parents
have
more
resources
to
spend
per
child,
and
this
increases
their
quality
of
life.
The
use
of
appropriate
technology
Appropriate
technology
is
technology
suitable
for
use
with
the
factor
endowments
of
particular
developing
countries.
The
factor
endowments
of
developing
countries
are
labour
intensive.
Whereas
in
more
developed
countries,
technology
is
mainly
used
in
production
in
order
to
save
firms
from
having
to
hire
more
workers,
this
would
not
be
appropriate
in
developing
countries
as
it
would
only
add
to
unemployment
rather
than
increase
the
productivity
of
each
worker.
Instead,
appropriate
technology
would
be
such
technology
that
makes
use
of
the
labour
surplus
in
order
to
increase
production.
Access
to
credit
and
micro-credit
The
limitations
of
the
formal
financial
sector
and
the
informal
financial
sector
in
providing
financial
services,
especially
credit,
encouraged
the
micro-credit
program
to
evolve.
Micro
credit
is
an
enabling,
empowering,
and
bottoms-up
tool
to
poverty
alleviation
that
has
provided
considerable
economic
and
non-economic
externalities
to
low-income
households
in
developing
countries.
Credit
creates
opportunities
for
self-employment
rather
than
waiting
for
employment
to
be
created.
It
liberates
both
poor
and
women
from
the
clutches
of
poverty.
It
brings
the
poor
into
the
income
stream.
Given
the
access
to
credit
under
an
appropriate
institutional
structure
and
arrangement,
one
can
do
whatever
one
does
best
and
earn
money
for
it.
The
aim
of
microfinance
is
not
just
about
providing
capital
to
the
poor
to
combat
poverty
on
an
individual
level,
it
also
has
a
role
at
an
institutional
level.
It
seeks
to
create
institutions
that
deliver
financial
services
to
the
poor,
who
are
continuously
ignored
by
the
formal
banking
sector.
It
is
believed
that
the
poor
are
generally
excluded
from
the
financial
services
sector
of
the
economy
so
micro
financing
Institutions
have
emerged
to
address
this
market
failure.
By
addressing
this
gap
in
the
market
in
a
financially
sustainable
manner,
an
micro
financing
institution
can
become
part
of
the
formal
financial
system
of
a
country
and
so
can
access
capital
markets
to
fund
their
lending
portfolios,
allowing
them
to
dramatically
increase
the
number
of
poor
people
they
can
reach.
The
empowerment
of
women
In
the
past
decades,
the
health
and
education
levels
of
women
and
girls
in
developing
countries
have
improved
a
great
deal--in
many
cases
they
are
catching
up
to
men
and
boys.
But
no
such
progress
has
been
seen
in
economic
opportunity:
women
continue
to
consistently
trail
men
in
formal
labor
force
participation,
access
to
credit,
entrepreneurship
rates,
income
levels,
and
inheritance
and
ownership
rights.
This
is
neither
fair
nor
smart
economics:
Under-investing
in
women
limits
development,
slows
down
poverty
reduction
and
economic
growth.
A
host
of
studies
suggest
that
putting
earnings
in
womens
hands
is
the
intelligent
thing
to
do
to
speed
up
development
and
the
process
of
overcoming
poverty.
Women
usually
reinvest
a
much
higher
portion
in
their
families
and
communities
than
men,
spreading
wealth
beyond
themselves.
This
could
be
one
reason
why
countries
with
greater
gender
equality
tend
to
have
lower
poverty
rates.
For
example,
studies
show
that
when
income
is
in
the
hands
of
the
mother,
the
survival
probability
of
a
child
increases
by
about
20
percent
in
Brazil,
and
in
Kenya,
a
child
will
be
about
17
IB
Economics
City
Honors
School
2015-2016
120
percent
taller,
because
mothers
will
invest
more
of
their
income
in
health
and
nutrition.
In
sub-
Saharan
Africa,
agricultural
productivity
could
be
raised
by
as
much
as
20
percent
by
allocating
a
bigger
share
of
agricultural
input
to
women.
Income
distribution
The
view
that
that
improved
equality
can
help
sustain
growthhas
become
more
widely
held
in
recent
years.
The
main
reason
for
this
shift
is
the
increasing
importance
of
human
capital
in
development.
Now
that
human
capital
is
scarcer
than
machines,
widespread
education
has
become
the
secret
to
growth.
"Broadly
accessible
education"
is
both
difficult
to
achieve
when
income
distribution
is
uneven
and
tends
to
reduce
"income
gaps
between
skilled
and
unskilled
labor."
A
2011
note
for
the
International
Monetary
Fund
by
Andrew
G.
Berg
and
Jonathan
D.
Ostry
found
a
strong
association
between
lower
levels
of
inequality
and
sustained
periods
of
economic
growth.
Developing
countries
(such
as
Brazil,
Cameroon,
Jordan)
with
high
inequality
(during
the
years
being
studied)
have
"succeeded
in
initiating
growth
at
high
rates
for
a
few
years"
but
"longer
growth
spells
are
robustly
associated
with
more
equality
in
the
income
distribution."
It
is
said
that
high
levels
of
inequality
might
damage
long
term
growth
by
amplifying
the
potential
for
financial
crisis,
discourage
investment
with
political
instability,
making
it
more
difficult
for
governments
to
make
difficult
choices
in
the
face
of
shocks,
such
as
raising
taxes
or
cutting
public
spending
to
avoid
a
debt
crisis.
Inequality
is
associated
with
lower
level
of
human
capital
formation
(education,
experience,
apprenticeship)
and
higher
level
of
fertility,
while
lower
level
of
human
capital
is
associated
with
lower
growth
and
lower
levels
of
economic
growth.
Inequality
is
associated
with
lower
levels
of
taxation
which
in
turn
are
associated
with
lower
level
of
economic
growth
Inequality
in
the
presence
of
credit
market
imperfections
has
a
long
lasting
detrimental
effect
on
human
capital
formation
and
economic
development.
The
political
economy
approach,
developed
by
Alesian
and
Rodrik
(1994)
and
Persson
and
Tabellini
(1994),
argues
that
inequality
is
harmful
for
economic
development
because
inequality
generates
a
pressure
to
adopt
redistributive
policies
that
have
an
adverse
effect
on
investment
and
economic
growth.
International
Trade
and
Economic
Development
Trade
problems
facing
many
economically
less
developed
countries
Dependence
on
developed
economies
Developing
nations
are
highly
dependent
on
the
advanced
or
developed
nations
in
terms
of:
Income
dependence:
A
majority
of
the
exports
of
developing
nations
go
to
the
developed
nations.
Dependence
on
Technology:
Most
imports
of
developing
nations
originate
in
the
developed
countries
(medicine,
new
machines).
Trade
among
developing
nations
is
minor.
121
Primary
products
Exports
of
developing
nations
are
primary
products
(agricultural
goods,
raw
materials,
and
fuels).
Some
countries
export
drugs
and
low
tech
military
goods
to
gain
international
currencies.
Shares
of
manufactured
exports
tend
to
be
less
than
10%
among
African
countries.
Price
volatility
of
primary
products
The
fluctuations
of
commodity
prices
remain
a
central
issue
for
developing
countries.
Often
the
collapse
of
commodity
prices
spells
disaster
for
developing
countries,
since
exports
are
needed
for
obtaining
essential
imports.
But
also,
high
commodity
prices,
particularly
of
food
and
energy,
may
be
a
significant
problem
for
least
developed
countries
(LDCs)
creating
food
and
energy
shortages.
Labor
intensive
exports
Exports
of
manufactured
goods
tend
to
be
labor
intensive
(such
as
textiles).
The
absolute
value
of
manufactured
goods
produced
by
the
developing
nations
is
low.
The
rise
in
manufactured
goods
in
developing
nations
is
due
to
a
handful
of
newly
industrializing
countries
(NICs)
such
as
Korea,
Taiwan,
and
Singapore
until
1980s.
However,
these
countries
have
lost
their
export
markets
to
China,
which
has
emerged
as
an
industrial
giant
in
the
1990s.
Over-specialization
on
a
narrow
range
of
products
In
most
of
the
least
developed
and
other
low-income
countries,
primary
products
-
incorporating
low
levels
of
processing
-
continue
to
account
for
the
bulk
of
both
national
production
and
exports.
Given
the
changing
structure
of
world
trade
described
at
the
beginning
of
this
paper,
it
is
not
surprising
that
most
of
the
countries
that
have
participated
little
or
not
at
all
in
global
integration
are
primary
commodity-dependent
countries
with
relatively
small
and
highly
inefficient
manufacturing
sectors.
As
a
result,
these
countries
are
especially
vulnerable
to
external
(or
domestic)
shocks
and
are
generally
viewed
as
having
limited
growth
prospects.
Trade
strategies
for
economic
growth
and
economic
development
Import
substitution
The
import
substitution
approach
substitutes
externally
produced
goods
and
services,
especially
basic
necessities
such
as
energy,
food,
and
water,
with
locally
produced
ones.
By
doing
so,
local
communities
can
put
their
(hard-earned)
money
to
work
within
their
boundaries.
Import
substitutes
are
meant
to
generate
employment,
reduce
foreign
exchange
demand,
stimulate
innovation,
and
make
the
country
self-reliant
in
critical
areas
such
as
food,
defense,
and
advanced
technology.
Protectionism
and
subsidies
to
domestic
industries
will
encourage
inefficiency
in
the
sense
that
domestic
firms
do
not
need
to
compete
with
other
firms
on
the
world
market.
There
will
thus
be
a
loss
of
consumer
welfare,
both
because
the
products
produced
domestically
will
be
more
expensive,
and
also
because
the
government
will
have
to
levy
higher
taxes
in
order
to
finance
the
subsidies.
Consumer
welfare
will
also
be
reduced
due
to
a
more
narrow
range
of
choices.
Furthermore,
a
policy
of
import
substitution
will
not
go
unnoticed
by
other
countries,
and
they
will
thus
retaliate
by
using
protectionist
measures
of
their
own.
IB
Economics
City
Honors
School
2015-2016
122
Export
promotion
This
involves
promoting
exports
industry.
By
promoting
exports
the
economy
can
earn
valuable
foreign
exchange
which
can
be
used
to
funding
economic
development
projects.
This
can
be
achieved
by
improving
the
competitiveness
of
domestic
firms
and
making
use
of
the
countrys
specific
factor
endowments.
Most
products
produced
by
less
developed
countries
are
primary
commodities.
Even
if
the
prices
of
such
products
are
competitive,
the
export
revenue
is
still
unlikely
to
pay
for
the
costs
of
imports.
Trade
liberalization
Trade
liberalization
refers
to
the
reduction
or
complete
removal
of
protectionist
measures
that
prevent
free
trade.
This
includes
for
example
tariffs,
quotas
and
subsidies
to
domestic
producers.
Many
developing
countries
suffer
from
the
protectionist
measures
used
by
the
more
developed
countries
as
this
reduces
the
competitiveness
of
their
exports.
For
example,
both
the
United
States
and
the
European
Union
offer
substantial
subsidies
to
farmers
who
produce
agricultural
products.
This
is
to
ensure
that
the
European
countries
remain
self-sufficient
in
terms
of
food
production.
However,
it
also
means
that
the
relatively
cheap
agricultural
imports
from
e.g.
African
countries
appear,
by
comparison,
expensive.
Many
developing
countries
are
therefore
heavy
critics
of
the
protectionist
measures
which
they
argue
act
as
a
major
constraint
on
worldwide
economic
development.
The
role
of
the
WTO
The
main
objective
of
the
WTO,
the
World
Trade
Organisation
is
to
promote
free
trade
among
its
members.
The
current
round
of
negotiations
in
the
WTO
is
known
as
the
Doha
round
negotiations,
but
it
has
been
suspended
due
to
fundamental
disagreement
and
failure
to
reach
consensus
regarding
issues
relating
to
trade
in
relation
to
less
developed
countries.
The
main
concerns
were
that
the
United
States
and
the
European
Union
refused
to
abandon
their
subsidies
on
agricultural
products
in
order
to
increase
the
competitiveness
of
exports
from
developing
countries.
On
the
other
hand,
large
developing
countries
such
as
India
and
Brazil
refused
to
get
rid
of
their
protectionist
measures
levied
against
the
import
of
manufactured
goods.
While
most
people
agree
that
such
measures
would
do
much
to
improve
economic
development,
a
compromise
currently
seems
beyond
reach.
Bilateral
and
regional
preferential
trade
agreements
By
implementing
different
trading
blocs
is
the
hope
that
world
trade,
and
thereby
world
output,
should
increase.
That
is,
it
is
hoped
that
trading
blocs
should
result
in
trade
creation
and
not
only
trade
diversion.
A
preferential
trade
agreement
(PTA)
is
an
agreement
whereby
the
products
from
one
country
become
cheaper
due
to
a
reduction,
but
not
abolition,
of
tariffs.
A
bilateral
PTA
is
an
agreement
between
two
parties,
e.g.
India
and
Nepal,
while
a
multilateral
or
regional
PTA,
as
the
name
suggests,
is
an
agreement
involving
several
countries.
Examples
of
the
latter
include
the
Asia-Pacific
Trade
Agreement
and
the
Latin
American
Integration
Association.
It
is
believed
that
more
agreements
to
promote
trade
with
reduced
protectionism,
and
eventually
completely
free
trade,
will
result
in
economic
growth
and
eventually
economic
development
as
the
standard
of
living
increases.
IB
Economics
City
Honors
School
2015-2016
123
Diversification
One
of
the
major
problems
that
many
developing
countries
face
is
their
over-dependence
on
a
narrow
range
of
agricultural
products.
As
such,
they
are
vulnerable
to
the
volatile
nature
of
the
prices
of
such
products,
originating
in
the
fact
that
both
price
elasticity
of
demand
and
price
elasticity
of
supply
for
such
products
are
low.
If
prices
fall
in
one
year,
due
to
a
good
worldwide
harvest,
the
quantity
demanded
from
any
particular
country
would
be
reduced
dramatically,
and
the
country
would
be
unable
to
rely
on
other
exports
to
make
up
for
the
loss.
Diversification
involves
broadening
the
range
of
goods
and
services
that
developing
countries
are
able
to
provide.
For
example,
production
of
manufactured
goods
(i.e.
industrialization)
would
both
reduce
unemployment
levels
and
enable
the
country
to
produce
goods
that,
because
they
are
income
elastic
(link),
would
allow
the
developing
countries
to
benefit
from
worldwide
economic
growth.
By
doing
so,
the
country
would
also
be
less
vulnerable
to
volatile
primary
product
prices
and
instead
be
able
to
stabilize
their
export
revenue.
Foreign
direct
investment
Foreign
direct
investment
(FDI)
is
direct
investment
into
production
in
a
country
by
a
company
in
another
country,
either
by
buying
a
company
in
the
target
country
or
by
expanding
operations
of
an
existing
business
in
that
country.
Foreign
direct
investment
is
done
for
many
reasons
including
to
take
advantage
of
cheaper
wages,
special
investment
privileges
such
as
tax
exemptions
offered
by
the
country
as
an
incentive
to
gain
tariff-free
access
to
the
markets
of
the
country
or
the
region.
Why
do
FDI
expand
to
Less
developed
economies?
Less
developed
countries
have
huge
untapped
natural
resources.
Moreover,
these
countries
lack
the
capital
investment
and
the
technology
to
tap
into
these
resources.
This
provides
FDI
with
a
lot
of
opportunity
to
exploit
these
resources
and
earn
high
returns
on
their
investments.
In
recent
years,
FDI
has
been
used
more
as
a
market
entry
strategy
for
investors,
rather
than
an
investment
strategy.
Despite
the
decline
in
trade
barriers,
FDI
growth
has
increased
at
a
higher
rate
than
the
level
of
world
trade
as
businesses
attempt
to
circumvent
protectionist
measures
through
direct
investments.
With
globalization,
the
horizons
and
limits
have
been
extended
and
companies
now
see
the
world
economy
as
their
market.
Additionally
for
investors,
FDI
provides
the
benefits
of
reduced
cost
through
the
realization
of
scale
economies,
and
coordination
advantages,
especially
for
integrated
supply
chains.
The
preference
for
a
direct
investment
approach
rather
than
licensing
and
franchising
can
also
been
viewed
in
terms
of
strategic
control,
where
management
rights
allows
for
technological
know-how
and
intellectual
property
to
be
kept
in-house.
Less
developed
countries
usually
have
less
stringent
labour
and
environment
laws.
This
provides
MNCs
with
an
opportunity
to
lower
their
cost
of
production
by
taking
advantage
of
these
loopholes.
Labor
is
usually
cheaper
and
available
in
abundance
in
LDCs.
The
MNCs
can
considerably
lower
their
cost
of
production.
This
gives
advantage
to
the
MNCs
to
compete
in
the
international
market.
IB
Economics
City
Honors
School
2015-2016
124
LDCs
understand
the
importance
of
FDIs
and
have
special
policies
to
attract
them.
This
might
involve
tax
holidays,
provision
of
cheaper
land
and
government
support.
All
these
factors
make
it
an
attractive
proposition
for
FDIs
to
invest
in
LDCs.
examples
include,
tax
holidays,
Duty
exemptions
and
drawbacks,
Export
tax
exemptions,
Subsidized
credits
and
Credit
guarantees.
Some
developing
countries
provide
great
promises
in
terms
of
being
emerging
markets.
Brazil
as
well
as
India
and
China
are
all
markets
with
huge
populations
and
growing
incomes.
As
incomes
rise,
the
demand
for
all
normal
goods
and
services
will
increase,
and
there
is
thus
potential
for
substantial
profits
to
be
made
by
companies
that
manage
to
establish
a
presence
in
these
markets.
Benefits
of
FDI
One
of
the
advantages
of
foreign
direct
investment
is
that
it
helps
in
the
economic
development
of
the
particular
country
where
the
investment
is
being
made.
This
is
especially
applicable
for
developing
economies.
During
the
1990s,
foreign
direct
investment
was
one
of
the
major
external
sources
of
financing
for
most
countries
that
were
growing
economically.
It
has
also
been
noted
that
foreign
direct
investment
has
helped
several
countries
when
they
faced
economic
hardship.
An
example
of
this
can
be
seen
in
some
countries
in
the
East
Asian
region.
It
was
observed
during
the
1997
Asian
financial
crisis
that
the
amount
of
foreign
direct
investment
made
in
these
countries
was
held
steady
while
other
forms
of
cash
inflows
suffered
major
setbacks.
Similar
observations
have
also
been
made
in
Latin
America
in
the
1980s
and
in
Mexico
in
1994-95.
Resource
transfer,
in
terms
of
capital
and
technical
knowledge,
is
also
a
key
motivator
that
encourages
inward
FDI.
FDI
allows
the
transfer
of
technologyparticularly
in
the
form
of
new
varieties
of
capital
inputs
that
cannot
be
achieved
through
financial
investments
or
trade
in
goods
and
services.
FDI
can
also
promote
competition
in
the
domestic
input
market.
Recipients
of
FDI
often
gain
employee
training
in
the
course
of
operating
the
new
businesses,
which
contributes
to
human
capital
development
in
the
host
country.
Profits
generated
by
FDI
contribute
to
corporate
tax
revenues
in
the
host
country.
Foreign
investment
gives
advantages
in
terms
of
export
market
access
arising
from
economies
of
scale
in
marketing
of
foreign
firms
or
from
their
ability
to
gain
market
access
abroad.
Besides
their
contributions
through
joint
ventures,
foreign
firms
can
serve
as
catalysts
for
other
domestic
exporters.
In
an
empirical
analysis,
the
probability
a
domestic
plant
will
export
was
found
to
be
positively
correlated
with
proximity
to
multinational
firms
Foreign
investment
can
aid
in
bridging
a
host
countrys
foreign
exchange
gap.
Growth
requires
investment
and
investment
requires
saving-whether
domestic
or
foreign.
Two
gaps
may
exist
in
the
economy:
insufficient
saving
to
support
capital
accumulation
to
achieve
a
given
growth
target;
and
insufficient
foreign
exchange
to
transform
domestic
to
foreign
resources.
If
investment
requires
imported
inputs,
then
domestic
saving
may
not
guarantee
growth
if
the
saving
cannot
be
converted
to
foreign
exchange
to
acquire
imports.
Capital
inflows
help
ensure
that
foreign
exchange
will
be
available
to
purchase
imports
for
investment.
IB
Economics
City
Honors
School
2015-2016
125
Disadvantages
of
FDI
Loss
of
sovereignty
by
host
nation.
MNC
have
their
parent
companies
and
shareholders
in
the
country
of
origin.
Repatriation
of
profits
by
MNC
to
the
parent
country
causes
a
flow
of
capital
out
of
the
developing
country.
This
might
also
lead
to
depletion
of
foreign
exchange
reserves
with
the
host
country.
There
is
a
chance
of
rise
in
inflation.
The
country
or
industry
that
attracts
foreign
investment
may
become
entirely
dependant
for
growth
and
increase
the
risk.
If
the
domestic
companies
are
not
competitive
and
efficient,
they
may
suffer
losses.
In
absence
of
proper
regulatory
policies,
MNCs
might
exploit
the
labour
and
natural
resources.
Foreign
direct
investment
is
an
expensive
and
risky
option
for
companies
than
licensing
and
exporting.
They
face
expropriation,
political
risk
and
currency
inconvertibility.
Capital
intensive
technology,
by
the
MNC,
rather
than
labour-intensive
technology
limits
benefits
to
host
country.
In
very
poor
nations,
MNCs
may
sometimes
exert
political
control
in
other
to
suit
their
vested
interests.
This
might
bring
about
political
stability
and
chaos
in
the
host
nation.
Foreign
aid
Foreign
aid,
the
international
transfer
of
capital,
goods,
or
services
from
a
country
or
international
organization
for
the
benefit
of
the
recipient
country
or
its
population.
Classification
on
the
basis
of
origin
Government
(official)
aid
Aid
organized
by
the
government.
It
can
Bilateral
aid
is
assistance
given
by
a
government
directly
to
the
government
of
another
country.
This
is
usually
the
largest
share
of
a
countrys
aid.
It
is
often
directed
according
to
strategic
political
considerations
as
well
as
humanitarian
ones
Multilateral
aid
is
assistance
provided
by
governments
to
international
organisations
like
the
World
Bank,
United
Nations
and
International
Monetary
Fund
that
are
then
used
to
reduce
poverty
in
developing
nations.
In
2006-7,
the
Australian
Government
committed
$400
million
in
multilateral
aid.
Non-government
(unofficial)
aid
Non-government
aid
is
assistance
provided
by
non-government
organizations
(NGOs)
like
World
Vision,
the
Red
Cross
and
Oxfam.
The
money
for
this
aid
is
mainly
provided
by
public
donations
from
individuals
and
businesses.
However,
NGOs
also
receive
some
funding
from
government.
126
127
Project
Tied
Aid:
is
given
only
for
specific
projects
and
the
recipient
country
cannot
shift
it
to
other
projects.
(ii)
Untied
Aid:
Untied
aid
is
the
aid
which
is
not
tied
to
any
project
or
nation.
It
is,
in
all
respects,
better
than
the
tied
aid
because
it
offers
more
efficient
use
of
foreign
resources.
It
is
much
desired
because
in
the
case
of
untied
aid
the
recipient
country
is
not
bound
to
spend
the
foreign
resources
on
specific
projects
or
in
the
donor
country
which
may
charge
higher
prices
than
international
market.
(iii)
Grants:
A
grant
is
that
form
of
foreign
aid
which
does
not
entail
either
the
payment
of
principal
or
interest.
It
is
a
free
gift
from
one
government
to
another
or
from
an
institution
to
a
government.
It
is
much
desired
because
it
increases
the
internal
expenditures
and
generates
income.
It
is
given
on
the
basis
of
humanitarianism,
especially
in
days
of
emergencies,
earth
quakes,
floods,
wars,
etc.
(iv)
Loans:
It
is
the
borrowing
of
foreign
exchange
by
the
poor
country
from
the
rich
country
to
finance
short-term
or
long-term
projects.
They
are
further
sub-divided
into
two
types:
Hard
Loans:
Hard
loans
are
also
called
short-term
loans.
In
order
to
finance
industrial
imports
they
are
given
usually
for
a
period
less
than
five
years,
and
they
are
paid
in
the
currency
borrowed.
It
contains
no
concessional
element
but
interest
rate
is
usually
lower
than
the
prevailing
rate
of
interest
in
the
international
market.
Soft
Loans:
Soft
loans
are
also
known
as
long-term
loans.
Soft
loans
are
made
for
10-20
years
and
it
is
repaid
in
the
currency
of
recipient
country.
Interest
on
these
loans
is
lesser
than
hard
loans
and
often
these
loans
invoice
grace
period.
Concessional
elements
are
comparatively
greater.
Commodity
Aid
Commodity
aid,
in
fact,
is
another
type
of
tied
aid,
which
relates
to
agriculture
products,
raw
materials
and
consumer
goods.
Under
commodity
aid,
the
donor
country
has
much
political
influence
on
the
recipient
country.
Commodity
aid
may
be
received
in
cash
form
or
in
the
form
of
food
grains:
In
Cash
Form:
If
it
is
received
in
cash
form
it
may
be
more
helpful
because
then
a
country
may
buy
more
commodities
from
cheaper
sources.
In
Food
Grain
Form:
It
is
a
special
type
of
commodity
aid,
which
is
given
in
the
form
of
food
grains
only.
Food
Aid
There
is
more
than
enough
food
produced
each
year
to
feed
adequately
everyone
on
earth.
However,
food
is
so
unevenly
distributed
that
malnutrition
and
hunger
exist
Food
aidin
the
same
country
or
region
where
food
is
abundant.
Critics
of
food
aid
argue
that
it
increases
dependence,
promotes
waste,
does
not
reach
the
most
needy
and
dampens
local
food
production.
Nevertheless,
the
food
aid
has
frequently
been
highly
effective.
It
plays
a
vital
role
in
saving
human
lives
during
famine
or
crisis,
and
if
distributed
selectively,
reduces
malnutrition.
Unfortunately,
poor
transport,
storage,
administrative
services,
128
distribution
networks
and
overall
economic
complex
hinder
the
success
of
food
aid
programmes,
but
the
concept
itself
is
not
at
fault.
Technical
assistance
aid
Technical
assistance
is
designed
to
disseminate
knowledge
and
skills
rather
than
goods
or
funds.
Under
this
aid
program,
training
facilities
are
provided
by
the
donor
countrys
government
and
it
bears
all
the
expenditures
involved
in
the
training
of
advisory
technocrats.
Technical
assistance
from
the
donors
point
of
view
takes
two
main
forms:
Through
Recruitment:
Technical
assistance
may
be
given
through
recruitment.
Selected
people
of
recipient
country
are
recruited
in
the
donor
country
for
service
overseas,
partly,
often
largely,
at
the
expense
of
the
donor
government.
Through
Scholarships
&
Training
Facilities:
The
second
form
of
technical
assistance
is
scholarship
and
training
facilities
in
donor
country
for
foreign
students
(from
recipient
country).
The
Role
of
NGOs
The
United
Nations
now
describe
a
Non-Governmental
Organization
as
a
Not-for-profit,
voluntary
citizens
group,
which
is
organized
on
a
local,
national,
or
international
level
to
address
issues
in
support
of
the
public
good.
Task
oriented
and
made
up
of
people
with
common
interests,
NGOs
perform
a
variety
of
services
and
humanitarian
functions,
bring
citizens
concerns
to
governments,
monitor
policy
and
program
implementation,
and
encourage
participation
of
Civil
Society
stakeholders
at
the
community
level.
NGOs
have,
since
the
end
of
the
Second
World
War,
become
increasingly
more
important
to
global
development.
They
often
hold
an
interesting
role
in
a
nations
political,
economic
or
social
activities,
as
well
as
assessing
and
addressing
problems
in
both
national
and
international
issues,
such
as
human,
political
and
womens
rights,
economic
development,
democratization,
inoculation
and
immunization,
health
care,
or
the
environment.
However,
in
the
developing
world,
the
role
of
NGOs
is
often
critical.
In
years
of
drought
or
famine,
the
non-governmental
organizations
have
been
pivotal
in
providing
food
to
those
most
marginalized.
NGOs
often
provide
essential
services
in
the
developing
world
that
in
developed
countries
governmental
agencies
or
institutions
would
provide.
Normally,
NGOs
provide
services
that
are
in
line
with
current
incumbent
governmental
policy,
acting
as
a
contributor
to
economic
development,
essential
services,
employment
and
the
budget.
In
a
wider
approach,
NGOs
are
also
the
source
and
centre
of
social
justice
to
the
marginalized
members
of
society
in
developing
countries
or
failed
states.
NGOs
are
often
left
as
the
only
ones
that
defend
or
promote
the
economic
needs
and
requirements
for
developing
states,
often
bringing
cases
to
the
International
Monetary
Fund,
World
Trade
Organization
and
World
Bank.
Developing
nations
and
NGOs
often
find
allies
in
one
another
when
opposing
legislation,
economic
terms
or
agreements
from
global
institutions.
If
the
Millennium
Development
Goals
are
to
be
achieved
in
many
of
the
developing,
the
role
of
NGOs
will
have
to
be
recognized
by
the
international
community.
Their
efforts
are
often
more
129
effective
than
much
bilateral
aid.
However,
the
role
of
NGOs
has
also
been
criticized,
as
many
international
experts
estimate
that
much
of
the
work
done
by
NGOs
is
not
harmonized
or
tailor-
made
to
the
countries
preferences
and
peculiarities,
causing
the
quality
of
aid
to
suffer.
Role
of
IMF
and
World
Bank
International
Monetary
Fund
[IMF]
The
IMF
was
founded
more
than
60
years
ago
toward
the
end
of
World
War
II.
The
founders
aimed
to
build
a
framework
for
economic
cooperation
that
would
avoid
a
IMFrepetition
of
the
disastrous
economic
policies
that
had
contributed
to
the
Great
Depression
of
the
1930s
and
the
global
conflict
that
followed.
Since
then
the
world
has
changed
dramatically,
bringing
extensive
prosperity
and
lifting
millions
out
of
poverty,
especially
in
Asia.
In
many
ways
the
IMF's
main
purposeto
provide
the
global
public
good
of
financial
stabilityis
the
same
today
as
it
was
when
the
organization
was
established.
More
specifically,
the
IMF
continues
to
provide
a
forum
for
cooperation
on
international
monetary
problems
facilitate
the
growth
of
international
trade,
thus
promoting
job
creation,
economic
growth,
and
poverty
reduction;
promote
exchange
rate
stability
and
an
open
system
of
international
payments;
and
lend
countries
foreign
exchange
when
needed,
on
a
temporary
basis
and
under
adequate
safeguards,
to
help
them
address
balance
of
payments
problems.
Key
IMF
activities
The
IMF
supports
its
membership
by
providing
policy
advice
to
governments
and
central
banks
based
on
analysis
of
economic
trends
and
cross-country
experiences;
research,
statistics,
forecasts,
and
analysis
based
on
tracking
of
global,
regional,
and
individual
economies
and
markets;
loans
to
help
countries
overcome
economic
difficulties;
concessional
loans
to
help
fight
poverty
in
developing
countries;
and
technical
assistance
and
training
to
help
countries
improve
the
management
of
their
economies.
The
IMF
collaborates
with
the
World
Bank,
regional
development
banks,
the
World
Trade
Organization
(WTO),
UN
agencies,
and
other
international
bodies.
While
all
of
these
organizations
are
involved
in
global
economic
issues,
each
has
its
own
unique
areas
of
responsibility
and
specialization.
The
IMF
also
works
closely
with
the
Group
of
Twenty
(G-20)
industrialized
and
emerging
market
economies
and
interacts
with
think
tanks,
civil
society,
and
the
media
on
a
daily
basis.
With
the
world's
economies
so
closely
connected,
having
an
organization
to
help
countries
prevent
crises
and
resolve
when
they
occur
is
more
important
than
ever.
130
World
Bank
The
World
Bank,
formed
in
1944,
is
like
a
cooperative,
made
up
of
188
member
countries.
These
member
countries,
or
shareholders,
are
represented
by
a
Board
of
World
Bank
Governors,
who
are
the
ultimate
policymakers
at
the
World
Bank.
Generally,
the
governors
are
member
countries'
ministers
of
finance
or
ministers
of
development.
They
meet
once
a
year
at
the
Annual
Meetings
of
the
Boards
of
Governors
of
the
World
Bank
Group
and
the
International
Monetary
Fund.
The
World
Bank
seeks
to
Promote
the
economic
development
of
the
world's
poorer
countries
Assists
developing
countries
through
long-term
financing
of
development
projects
and
programs
Provides
to
the
poorest
developing
countries
whose
per
capita
GNP
is
less
than
$865
a
year
special
financial
assistance
through
the
International
Development
Association
(IDA)
Encourages
private
enterprises
in
developing
countries
through
its
affiliate,
the
International
Finance
Corporation
(IFC)
Since
inception,
the
World
Bank
has
expanded
from
a
single
institution
to
a
closely
associated
group
of
five
development
institutions.
These
are
The
International
Bank
for
Reconstruction
and
Development
(IBRD)
lends
to
governments
of
middle-income
and
creditworthy
low-income
countries.
The
International
Development
Association
(IDA)
provides
interest-free
loanscalled
credits
and
grants
to
governments
of
the
poorest
countries.
The
International
Finance
Corporation
(IFC)
provides
loans,
equity
and
technical
assistance
to
stimulate
private
sector
investment
in
developing
countries.
The
Multilateral
Investment
Guarantee
Agency
(MIGA)
provides
guarantees
against
losses
caused
by
non-commercial
risks
to
investors
in
developing
countries.
The
International
Centre
for
Settlement
of
Investment
Disputes
(ICSID)
provides
international
facilities
for
conciliation
and
arbitration
of
investment
disputes.
Further
reading
The
IMF
and
the
World
Bank
How
Do
They
Differ?
http://www.imf.org/external/pubs/ft/exrp/differ/differ.htm
IMF
official
website
http://www.imf.org
World
Bank
official
website
http://www.worldbank.org
Role
of
IMF
and
World
Bank
http://da-academy.org/imf_worldbank.pdf
The
Functions
of
the
IMF
&
the
World
Bank
http://blogs.law.uiowa.edu/ebook/sites/default/files/Part_1_2_0.pdf
Excellent
articles
on
Aid
and
development
http://www.guardian.co.uk/global-
development/poverty-matters+aid
131