Economics Midterm Notes 1) Economic Growth

What is meant by economic growth?

Economic growth is a long-term expansion of a country’s productive potential

Short term growth is measured by the annual % change in real national output – this is mainly driven by the level of aggregate demand (C+I+G+X-M) but is also affected by shifts in SRAS

Long term growth is shown by the increase in trend or potential GDP and this is illustrated by an outward shift in a country’s long run aggregate supply curve (LRAS)

There are big variations in average growth rates for different countries and evidence for this is shown in the chart above which tracks real GDP changes for China, India, the UK, USA and average growth for nations inside the Euro Zone.

China and India are examples of very fast-growing countries. Their annual growth has far exceeded that for most advanced economies; China has out-paced India although both have experienced a slowdown in growth over the last couple of years

For nations such as the USA and the UK, “normal growth” is of the order of 2 – 3% per year – depending on where each economy is in their business (trade) cycle. The Euro Zone growth rate is similar but keep in mind that this is an average, there are seventeen countries at present who share the same currency, some have been growing quite quickly and others have struggled to escape from a deep recession and the persistent risk of a depression.

Economic Growth and the Production Possibility Frontier

An increase in long run aggregate supply is illustrated by an outward shift in the PPF

In our diagram we see how a rise in a nation’s productive capacity causes the PPF to shift out and this allows increased supply both of consumer and capital goods.

Where the economy ends up depends on the decisions made about the allocation of scarce resources between products to be bought and consumed today and the production of capital goods such as new technology, plant and equipment and buildings.

Key drivers of growth

There have been numerous research studies in what determines long term GDP growth

Every country is different, each factor will vary in importance for a country at a given point in time

Remember too that in our increasingly inter-connected globalizing world, economic growth does not happen in isolation. Events in one country and region can have a significant effect on growth prospects in another

Advantages of Economic Growth

1. Higher living standards – i.e. an increase in real income per head of population

2. Employment effects - growth stimulates more jobs to help new people as they enter the labor market

Virtuous circle of growth

Disadvantages of economic growth

There are economic and social costs of a fast-expanding economy.

Inflation risk: If demand races ahead of aggregate supply the scene is set for rising prices. Many fast growing developing countries have seen high rates of inflation in recent years, a good example is India

Working hours – sometimes there are fears that a fast-growing economy places increasing demands on the hours that people work and can upset work-life balance

Structural change – although a growing economy will be creating more jobs, it also leads to structural changes in the pattern of jobs. Some industries will be in decline whilst others will be expanding. Structural unemployment can rise even

though it appears that a country is growing – the labor force needs to be occupationally mobile.

Environmental concerns:

Fast growth can create negative externalities for example higher levels of noise pollution and lower air quality arising from air pollution and road congestion

Increased consumption of de-merit goods which damages social welfare It can leads to a huge increase in household and industrial waste which

again creates external costs for society

Growth that leads to environmental damage may lower the sustainable rate of growth. Examples include the destruction of rain forests through deforestation, the over-exploitation of fish stocks and loss of natural habitat and bio-diversity created through the construction of new roads, hotels, retail malls and industrial estates.

Deforestation releases more CO2 into the atmosphere each year than all of the world's planes, trains and automobiles put together. Globally, an area almost the size of England and Wales is cut down every year releasing billions of tons of CO2 into the atmosphere.

Using-up scarce resources

The world’s resources are limited, and recognizing this fact and trying to preserve them for future generations is vital for sustainable growth. Our rampant use of oil has run many reserves dry and each year it becomes more difficult to find new oil fields.

Even water, which so many people take for granted will become a scarce resource, like many other raw materials. According to the United Nations, by 2025 1.8bn people will be affected by water scarcity. The pollution caused by economic growth is another concern.

The Stern Report highlighted the dangers of our disregard for the environment, especially large CO2 emissions. It is predicted that many species will become extinct as forests and jungles, homes for many animals, are cut down to pave way for the growing world population.

Evaluation: What are the main constraints or limits on economic growth?

The Importance of Infrastructure “Infrastructure systems – transport, electricity, telecommunications, water, etc. – play a vital role in economic and social development. Increasingly interdependent, they are a means towards ensuring the delivery of goods and

services that promote economic prosperity and growth, and contribute to quality of life” Source: OECD Report, 2008

In this section we outline some of the possible constraints or limitations on the sustained growth of a country. Some of these factors apply mainly to developed countries and some are focused on the growth potential of lower-income emerging economies many of whom have enjoyed rapid growth in recent years.

Remember that economic growth is a long-term concept referring in the main to a nation’s productive potential and international competitiveness – the factors discussed below are some of the demand and supply-side issues that can hold back potential output growth for a country.

What can limit the rate of economic growth?

Infrastructure – infrastructure includes capital such as ports, transport networks, energy, power and water supplies and telecommunications networks. Poor infrastructure hampers growth because it causes higher costs and delays for businesses, reduces the mobility of labor and hits the ability of export businesses to get their products to international markets. A good example is India whose future growth is often said to be threatened by structural weaknesses in her infrastructure. Many countries will need to increase their spending on infrastructure in the years ahead to adapt to and deal with the consequences of climate change.

Dependence on limited exports – many nations still relying on specializing and then exporting low value added primary commodities and the prices of these goods can be highly volatile on world markets. When prices fall, an economy will see a sharp reduction in export incomes, a higher trade deficit and a growing risk that a nation will not be able to finance investment in education, healthcare and core infrastructure. Over-specialization can make a country vulnerable to the global economic cycle.

Corruption and poor governance – this is a crucial factor for many developing countries. High levels of deeply embedded corruption and bureaucratic delays can harm growth in many ways for example inhibiting inward investment and also making it more likely that domestic businesses will invest overseas rather than at home. Governments need a stable and effective legal framework to collect taxes to pay for public services. Look at deficit and debt problems facing countries such as Greece. In India, there are 15 times more phone subscribers than taxpayers. If a legal system cannot protect private property rights then there will be less research and development & innovation.

Declining and/or ageing population – in some countries the actual size of the population is declining partly as a result of net outward migration. If a nation loses many younger workers, this can have a damaging effect on growth. The changing age-structure of a population also matters, leading for example to a fall in the ratio of workers to dependants.

Rising inflation – fast growing countries may experience an accelerating rate of inflation which can have damaging economic consequences – these are covered in the chapter on inflation. Two effects in particular can hit growth, namely falling real incomes and profits together with higher costs and reduced competitiveness in international markets. In our chart below we track real GDP growth and inflation rates in India – notice the steep rise in inflation in recent years. Many other developing countries have seen high rates of inflation in large part because of booming food and other commodity prices.

Sustainability “Anyone who believes exponential growth can go on forever in a finite world is either a madman or an economist.” Kenneth Boulding, economist

Persistent trade deficits due to rising imports – Some countries may experience large and widening deficits on the current account of their balance of payments. This means that the value of imported goods and services is greater than the value of exports and net investment incomes leading to an outflow of money from their economy. High trade deficits might have to be covered by foreign borrowing or a reliance on inflows of capital investment from overseas multinationals. And large trade gaps can eventually lead to a currency crisis and possible loss of investor confidence.

Inadequate investment in human capital – to sustain growth requires longer-term improvements in productivity, research & development and innovation. Whilst physical capital such as factories and technology plays a role, so too does the quality of the human input into production. Economic growth might be limited by skills shortages as businesses seek to expand which forces up average wages and labor costs. High level skills and qualifications are also needed to help businesses (and ultimately countries) to move up the value chain and supply products that can be sold for higher prices in the world economy.

Weaknesses in promoting and supporting entrepreneurship – a thriving enterprise culture is crucial to encouraging new business start-ups and supporting them through the early growth stage.

2) Economies of Scale

Introduction

Here we focus on long run costs, the effect of economies of scale on unit costs, prices and competition in markets.

What are economies of scale?

Economies of scale are the cost advantages that a business can exploit by expanding the scale of production

The effect is to reduce the long run average (unit) costs of production. These lower costs are an improvement in productive efficiency and can

benefit consumers in the form of lower prices. But they give a business a competitive advantage too!

Numerical example of economies of scale – falling long run average cost as output increases

Long Run Output (units per month)

Total Costs (£s)

Long Run Average Cost (£s per unit)

1,000 8,500 8.5

2,000 15,000 7.5

5,000 36,000 7.2

10,000 65,000 6.5

20,000 120,000 6.0

50,000 280,000 5.6

100,000 490,000 4.9

500,000 2,300,000 4.6

3) Inflation

What is inflation?

Inflation is a sustained increase in the cost of living or the average / general price level leading to a fall in the purchasing power of money.

The opposite of inflation is deflation which is a decrease in the cost of living or average price level.

How is the rate of inflation measured?

The rate of inflation is measured by the annual percentage change in consumer prices.

The British government has set an inflation target of 2% using the consumer price index (CPI)

It is the job of the Bank of England to set interest rates so that aggregate demand is controlled, inflationary pressures are subdued and the inflation target is reached

The Bank is independent of the government with control of interest rates and it is free from political intervention. The Bank is also concerned to avoid price deflation – we return to this a little later.

4) Unemployment

Who is unemployed?

The unemployed are people able, available and willing to work at the going wage rate but cannot find a job despite an active search for work

Unemployment means that scarce human resources are not being used to produce goods and services to meet people’s needs and wants

Persistently high levels of joblessness have damaging consequences for an economy causing both economic and social costs

Problems caused by unemployment occur across a country but are often very bad and deep-rooted in local and regional communities and within particular groups of society – for example in the UK, more than one in six young people are out of work. The figure is much higher in Greece and Spain.

5) Breakeven

Introduction

Break-even analysis is a technique widely used by production management and management accountants. It is based on categorizing production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production).

Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the "break-even point").

The Break-Even Chart

In its simplest form, the break-even chart is a graphical representation of costs at various levels of activity shown on the same chart as the variation of income (or sales, revenue) with the same variation in activity. The point at which neither profit nor loss is made is known as the "break-even point" and is represented on the chart below by the intersection of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of production activity ("output"). OB represents the total fixed costs in the business. As output increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output, Costs are greater

than Income. At the point of intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made.

Fixed Costs

Fixed costs are those business costs that are not directly related to the level of production or output. In other words, even if the business has a zero output or high output, the level of fixed costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of investment in production capacity (e.g. adding a new factory unit) or through the growth in overheads required to support a larger, more complex business.

Examples of fixed costs: - Rent and rates - Depreciation - Research and development - Marketing costs (non- revenue related) - Administration costs

Variable Costs

Variable costs are those costs which vary directly with the level of output. They represent payment output-related inputs such as raw materials, direct labor, fuel and revenue-related costs such as commission.

Breakeven Assumptions and Limitations

All costs are classified as either fixed or variable. If not impossible or impractical, dividing costs into the variable and fixed cost elements as an extremely difficult job. This is attributable to the inherent nature or characteristics of the cost per se.

Fixed costs remain constant within the relevant range. Fixed costs remain unchanged at any level of activity within the relevant range, even at the zero level.

The behavior of total revenues and total costs will be linear over the relevant range, i.e. will appear as a straight line on the BE chart. This is based on the idea that variable costs vary in direct proportion to volume; the fixed costs remain unchanged, hence drawn as a straight horizontal line on the graph within the relevant range; and that selling price is constant.

In case of multiple product companies, the selling prices, costs and proportion of units (sales mix) sold will not change. This cannot always be correct. Sales mix ratio may be due to the change in the consuming habits

of customers. Selling prices of the individual products may likewise change due to competition, popularity and salability of the products, etc.

There is no significant change in the inventory levels during the period under review. Stated in another way, production volume is assumed to be almost (if not exactly) equal to the sales volume, which causes an immaterial (or none at all) difference between the beginning and ending inventories.

Other assumptions which have already been discussed in the preceding numbers, are again credited and highlighted here as follows:

Unit selling price will remain constant. Unit variable cost will not change. (This may include

prices of the factors of production like material costs, labor costs etc.)

There will be no change in efficiency and productivity. The design of the product will not change.(A change in

the design of the product may bring about a change in production costs, selling price and production volume.

6) Circular Flow of Income

Savings and Investment

The simple circular flow is, therefore, adjusted to take into account withdrawals and injections. Households may choose to save (S) some of their income (Y) rather than spend it (C), and this reduces the circular flow of income. Marginal decisions to save reduce the flow of income in the economy because saving is a withdrawal out of the circular flow. However, firms also purchase capital goods, such as machinery, from other firms, and this spending is an injection into the circular flow. This process, called investment (I), occurs because existing machinery wears out and because firms may wish to increase their capacity to produce.

7) Aggregate Supply

The total supply of goods and services produced within an economy at a given overall price level in a given time period. It is represented by the aggregate-supply curve, which describes the relationship between price levels and the quantity of output that firms are willing to provide. A

shift in aggregate supply can be attributed to a number of variables. These include changes in

the size and quality of labor, technological innovations, increase in wages, increase in

production costs, changes in producer taxes and subsidies, and changes in inflation. In the

short run, aggregate supply responds to higher demand (and prices) by bringing more inputs

into the production process and increasing utilization of current inputs. In the long run,

however, aggregate supply is not affected by the price level and is driven only by improvements in productivity and efficiency.

8) Aggregate Demand

The total amount of goods and services demanded in the economy at a given overall price level and in a given time period. It is represented by the aggregate-demand curve, which describes the relationship between price levels and the quantity of output that firms are willing to provide. Normally there is a negative relationship between aggregate demand and the price level. Aggregate demand is the demand for the gross domestic product (GDP) of a country, and is represented by this formula: Aggregate Demand (AD) = C + I + G + (X-M) C = Consumers' expenditures on goods and services. I = Investment spending by companies on capital goods. G = Government expenditures on publicly provided goods and services. X = Exports of goods and services. M = Imports of goods and services.

9) GDP and GNP

To measure how much output, spending and income has been generated we use national

income accounts. These accounts measure the:

1. Total value of the output of goods and services produced in the UK

2. Total amount of expenditure taking place in the economy

3. Total amount of income generated through production of goods and services

National Income is a term used to measure the monetary value of the flow of output of

goods and services produced within the economy over a period of time. Measuring the

level and rate of growth of national income (Y) is important to economists when they are

considering:

The rate of economic growth and where the economy is in the business cycle

Changes to overall living standards of the population

Looking at the distribution of national income (i.e. measuring income and wealth

inequalities)

Gross Domestic Product (GDP)

GDP measures the value of output produced within the domestic boundaries of the UK. It

includes the output of the many foreign owned firms that are located in the UK following

the high levels of foreign direct investment in the UK economy in the 1980s and 1990s.

Read this article on 100 years of UK GDP

There are three ways of calculating GDP - all of which should sum to the same amount

since by identity:

National Output = National Expenditure (Aggregate Demand) = National Income

Under the new definitions introduced in 1998, GDP is now known as Gross Valued

Added.

i) The Expenditure Method (Aggregate Demand)

This is the sum of the final expenditure on UK produced goods and services measured at

current market prices. The full equation for GDP using this approach is

GDP = C + I + G + (X-M)

C: Household spending (consumption)

I: Capital Investment spending

G: General Government spending

X: Exports of Goods and Services

M: Imports of Goods and Services

ii) The Income Method (Sum of Factor Incomes) Here GDP is the sum of the final incomes earned through the production of goods and

services.

Main Factor Incomes

Income from employment and self-employment

Added to Profits of companies

Added to Rent income

= Gross Domestic product (by factor income)

Only factor incomes generated through the production of output are included in the

calculation of GDP by the income approach. Therefore, we exclude from the accounts the

following items:

Transfer payments (e.g. the state pension, income support and the Jobseekers' Allowance)

Private Transfers of money from one individual to another

Income that is not registered with the Inland Revenue (note here the effects of the Black

or shadow economy where goods and services are exchanged but the value of these

transactions is hidden from the authorities and therefore does not show up in the official

statistics!)

iii) The Output Method This measures the value of output produced by each of the productive sectors in the

economy using the concept of value added. Value added is the increase in the value of a

product at each successive stage of the production process. We use this approach to avoid

the problems of double-counting the value of intermediate inputs. The main sectors of the

economy are the service industries, manufacturing and construction, and extractive

industries such as mining, oil together with agriculture

The Difference between GDP and GNP Gross National Product (GNP) measures the final value of output or expenditure by UK

owned factors of production whether they are located in the UK or overseas. GDP is only

concerned with incomes generated within the geographical boundaries of the country. So

output produced by Nissan in the UK counts towards our GDP but some of the profits

made by Nissan here are sent back to Japan - adding to their GNP.

GNP = GDP + Net property income from abroad (NPIA)

NPIA is the net balance of interest, profits and dividends (IPD) coming into the UK from

UK assets owned overseas matched against the flow of profits and other income from

foreign owned assets located within the UK.

In recent years following the abolition of exchange controls in 1979 there has been an

increasing flow of direct investment into and out of the UK. Many foreign firms have set

up production plants in the UK whilst UK firms have expanded their operations overseas

and become multinational (or trans-national) organizations.

10) Real and Nominal GDP Growth

Nominal and Real - Measuring Real National Income

When we want to measure growth in the economy we have to adjust for the

effects of inflation Real GDP measures the volume of output. An increase in real output means that

AD has risen faster than the rate of inflation and therefore the economy is

experiencing positive growth. Consider this example

11) NNP

It is equal to GNP – Depreciation where depreciation is a product’s loss of value due to wear and tear effects.

12) Simplified Definitions/Clarifications List

Gross domestic product (GDP) is the total money value of all final goods and services produced in an economy in one year.

Gross national product (GNP) is the total money value of all final goods and services produced in an economy in one year, plus net property income from abroad (interest, rent, dividends, and profit).

Net national product (NNP) is GNP minus depreciation (capital consumption). Nominal GDP is GDP, not adjusted for inflation. Real GDP is GDP, adjusted for inflation. Aggregate demand (AD) is the total spending in an economy consisting of

consumption, investment, government expenditure and net exports. Consumption is spending by households on consumer goods and services over a

period of time. Investment is the addition to the capital stock of the economy in the form of

factories, offices, machinery and equipment which is used to produce goods and services, a fast food retailer, for example, builds a new outlet.

Aggregate supply (AS) is the total amount of domestic goods and services supplied by businesses and the government, including both consumer goods and capital goods.

Unemployment is a situation that exists when people who are willing and able to work cannot get a job.

Inflation is a sustained increase in the general level of prices and a fall in the value of money.

Circular flow of income refers to a simple economic model which describes the reciprocal circulation of income between producers and consumers and leakages and injections.