Revision - Globalisation

http://www.economicshelp.org/blog/81/trade/costs-and-benefits-of-globalisation/

http://www.economicshelp.org/2007/05/discuss-whether-globalisation-benefits.html

Revision - Inflation

http://www.economicshelp.org/macroeconomics/inflation/inflation-essay-harmful.html

http://www.economicshelp.org/macroeconomics/macroessays/should-aim-govt-be-low-inflation.html

http://www.economicshelp.org/macroeconomics/macroessays/does-devaluation-cause-inflation.html

Revision - Should the government intervene in the economy?

One of the main issues in economics is the extent to which the government should intervene in the economy. Free market economists argue that government intervention should be strictly limited as government intervention tends to cause an inefficient allocation of resources. However, others argue there is a strong case for government intervention in different fields.

Hoover Dam built in the 1930s with government funds

Summary of whether should the government intervene in the economy.

Arguments for Government Intervention

1. Greater Equality – redistribute income and wealth to improve equality of opportunity and equality of outcome
2. Market Failure – Markets fail to take into account externalities and are likely to under-produce public / merit goods.
3. Macroeconomic intervention. – intervention to overcome prolonged recessions and reduce unemployment.

Arguments against Government Intervention

1. Governments liable to make the wrong decisions – influence by political pressure groups, they spend on inefficient projects which lead to inefficient outcome.
2. Personal Freedom. Government intervention is taking away individuals decision on how to spend and act. Economic intervention, takes some personal freedom away.
3. Market is best at deciding how and when to produce.

Arguments for Government Intervention to improve equality

In a free market, there tends to be inequality in income, wealth and opportunity. Private charity tends to be partial. Government intervention is necessary to redistribute income within society.

Diminishing marginal returns to income. The law of diminishing returns states that as income increases, there is a diminishing marginal utility. If you have an income of £2 million a year. An increase in income to £2.5 million gives only a marginal increase in happiness / utility. For example, your third sports car gives only small increase in total utility.

However, if you are unemployed, and surviving on £50 a week. A 10% increase in income gives a substantial boost in living standards and quality of life. Therefore, redistributing income can lead to a net welfare gain for society, therefore income redistribution can be justified from a utilitarian perspective.

Fairness.  In a free market, inequality can be created, not through ability and handwork, but privilege and monopoly power. Without government intervention, firms can exploit monopoly power to pay low wages to workers and charge high prices to consumers. Without government intervention, we are liable to see the growth of monopoly power. Government intervention can regulate monopolies and promote competition. Therefore government intervention can promote greater equality of income, which is perceived as fairer.

Inherited wealth. Often the argument is made that people should be able to keep the rewards of their hard work. But, if wealth and income and opportunity depend on being born in the right family, is that justified? A wealth tax can reduce the wealth of the richest and this revenue can be used  to spend on education for those who are born in poor circumstances.

Rawls Social Contract. Rawls social contract stated that the ideal society is one where you would be happy to be born in any situation, not knowing where you would end up. Using this social contract, most people would not choose to be born in a free market because the rewards are concentrated in the hands of a small minority of the population. If people had no idea where they would be born, they would be more likely to choose a society with a degree of government intervention and redistribution.

Types of Government Intervention

Public Goods. In a free market, public goods such as law and order and national defence would not be provided because there is no fiscal incentive to provide goods with a free rider problem (you can enjoy without paying them). Therefore, to provide public goods like lighthouses, police, roads, e.t.c it is necessary for a government to pay for them and out of general taxation.

Merit Goods. Goods like education and health care are not strictly public goods (though they are often referred to as public goods). In a free market, provision tends to be patchy and unequal. Universal education provided by the government ensures that, in theory, everyone has the opportunity to gain an education, which has a strong social benefit.

Negative Externalities. The free market does not provide the most socially efficient outcome, if there are externalities in consumption and production. For example, a profit maximising firm will ignore the external costs of pollution through burning coal. This leads to a decline in social welfare. By contrast other forms of energy production, like solar power, are environmentally friendly and have a positive externality. By taxing production which causes pollution costs and using the subsidy to encourage other forms of energy production, there is a net gain in social welfare.

Macro Economic Intervention.

In recessions, there is a sharp fall in private sector spending and investment, leading to lower economic growth. If the government also reduce spending at the same time, there is an even bigger fall in economic growth and collapse in confidence. In a deep recession, governments can borrow from the private sector and spend the money to employ unemployed resources. If there is a collapse in the money supply, there maybe a role for Central bank or Government to print money. Similarly, the government may need to prevent an economic boom and explosion of credit. Keynesian economists argue that the government can positively influence the economy through fiscal policy. Monetarists believe monetary policy can help encourage economic stability, though an independent Central Bank may not be considered government intervention.

More on government intervention in the macro economy

Arguments against Government Intervention

• When governments spend on public goods and merit goods, they may create excess bureaucracy and inefficiency.
• State owned industries tend to lack any profit incentive and so tend to be run inefficiently. Privatising state owned industries can lead to substantial efficiency savings.
• Politicians don’t have the same market discipline of seeking to maximise the use of limited resources.
• Government intervention causes more problems than it solves. For example, state support of industries may encourage the survival of inefficient firms. If governments bailout banks, it may create moral hazard where in the future banks have less incentive to avoid bankruptcy because they expect a government bailout.
• Real business cycle theorists argue that at best government intervention makes no difference to the length of a recession, but may just create additional problems, such as the accumulation of public sector debt.

Conclusion

There is no real model of a society run in the absence of government intervention. Even the most extreme libertarian economists would accept there needs to be some state protection of property rights and spending on national defence. The debate comes on the extent of government intervention. This needs to take place on each aspect of government intervention. The arguments for and against government intervention in macro economic stabilisation are very different to the arguments for and against providing universal health care. It is not satisfactory.

Policies to correct Balance of Payments Disequilibrium

A balance of payments disequilibrium is a situation where the value of a country’s imports are greater than its exports, creating a deficit in the current account and leading to a net outflow from the country’s circular flow of income.

This current account deficit creates negative effects on the country’s economy because the outflow from the circular flow of income causes a net fall in aggregate demand.  The fall in value of exports also means that exporting firms require less labour, while the rise in value of imports means that domestic businesses lose market share to imports, so they also require less labour. This leads to more unemployment, which will become long-term unemployment if these workers are not restrained, reducing the productive capacity of the economy. Because of the reduced foreign demand for exports, there will also be a fall in business confidence and capital investment by exporting firms whose profits have fallen.

To solve these problems, expenditure switching policies aim to improve the current balance by reducing aggregate demand to encourage less expenditure on imports and more on domestic goods and export production.

Devaluation or depreciation of a country’s currency is an expenditure switching policy which causes a fall in export prices in the foreign currency, hence extending its foreign demand so that the total value of exports in the domestic currency rises. On the other hand, it also causes a rise in import prices in the domestic currency, hence contracting its domestic demand so that the total value of imports in the foreign currency falls. This therefore creates an improvement in the current account.

However, the problem with currency devaluation/depreciation is that it may cause the current balance to worsen before it improves. This is because demand is usually inelastic in the short-term, so although exports are cheaper their quantity sold does not rise by as much, while imports as become more expensive their quantity sold does not fall by as much, causing a fall in the total value of exports and rise in the total value of imports. This can be demonstrated by the J-curve:

Protectionism is another expenditure switching policy that can help to improve the position of the current account, by reducing the supply of imports. This includes tariffs (taxes on imports), quotas (limits on the quantity of imports), voluntary export agreements (unofficial, self-imposed quotas), embargoes (total ban on all imports) and red tape (imposition of regulations on imports).

Tariffs and quotas, however, can lead to a loss of consumer welfare and a retaliation of trading partners imposing their own tariffs, resulting in more loss of consumer welfare. The WTO (World Trade Organisation) is therefore set up to reduce international trade barriers and encourage free trade, and trading blocs are agreed between different groups of countries to reduce or eliminate their internal trade barriers.

Inflation is another method which can be use to correct the balance of payment disequilibrium by either by controlling excess demand within the economy to prevent demand pull or to control costs and prevent cost push inflation. By doing this, domestic products will become cheaper as cost of making is lower, this will lead to increase in the country's competitiveness as the global market will demand more of the country’s domestic product as it is cheaper compared to other countries. In addition to that, the lower price for domestic product will reduce imports and will move the balance of payment from deficit to surplus.

To control a currency is to restrict the amount of money leaving the country. This will reduce the currency from leaving the country as well as having more control over the currency. This method can help to reduce the fluctuation of exchange rate as the currency transfer is fairly stable and this could encourage foreign investor to invest within the domestic economy and they are confident about the exchange rate. But there is a limit to this method as the amount of money flowing into and out of one country is massive and makes it nearly impossible for the government to keep track on the inflow and outflow of their currency. This is why most government abandoned this method.

The aim of supply side policy is to increase the competitiveness of the country's exports within the global market. This could be done by providing training and education for labour within the workforce to increase their efficiency which would increase the productivity of the country and increase the amount of goods produced and lower the price of that product which will make domestic product become more competitive. This method may take a long time to shift the balance of payment from deficit to surplus.

Does Trade Always Follow Comparative Advantage?

Comparative advantage as a justification for free trade has seen a change in status. Until recently, it was the only basis on which economists studied trade. However, changes in the world economy and technology have led to events that make the theory appear weak and irrelevant. This paper shall examine the strengths and weaknesses of comparative advantage.

Fundamental to the theory of free trade based on comparative advantage is that there are intrinsic differences in the countries' resource endowments. While there are numerous strengths of this theory in explaining and helping us understand trade patterns, the prime justification for free trade based on comparative advantage is that it leads to efficient allocation of resources, rising incomes, and improvement in the living standards among all trading partners.

Another strength of the theory is that it allows countries to utilize and exploit their natural wealth and abundant resources. So, countries with long shorelines that are filled with marine life have a comparative advantage in producing sea food while those with mines rich with minerals gain from exporting ores and chemicals.

This theory also helps explain the bulk of the trade that takes place between advanced Western countries and the less developed world. Given the stark differences in the resource structures among the two groups - the West with advanced technology and highly-skilled workers export and the less developed countries with traditional agriculture and cheap unskilled labor - it is easy to understand why the former export sophisticated equipment and capital goods to the latter, who, in turn, export agricultural products and cheap manufactured goods. This kind of trade - involving goods produced by very different industries - is called 'inter-industry trade.'

The past two decades have seen the emergence of new trade theories that have undermined the domination of comparative advantage as the rationale for free trade. In addition, changes in technology and in the economic environment have exposed certain weaknesses in the traditional trade model and given rise to the need for modifications. As a result there are new justifications for free international trade that make the original comparative advantage theory appear rather simple and with limited relevance.

One major weakness of the comparative advantage model is that it cannot explain as to why a rising fraction of world trade is taking place among Western developed nations. Given that such nations (e.g. Western European partners of the EU) have very similar technologies and resource structures, the justification for trade has to be something other than comparative advantage. The bulk of this trade is of the 'intra-industry' variety, i.e. countries export and import similar products. There are factors related to demand and supply that cause intra-industry trade. On the demand side, for example, consumers in the U.S. might wish to buy luxury cars from Europe while buyers in the latter import cheaper cars from the former. On the supply-side, certain kinds of capital-intensive industrial technology is such that as output rises the average costs, and, hence, prices, fall due to economies of scale. As a result, European firms that produce larger quantities of luxury cars like Mercedes have comparatively lower costs and prices making them more attractive to buyers in, say, U.S.

Another trade pattern that comparative advantage fails to justify is the growing intra-industry trade that takes place between developed countries and less developed countries. This phenomenon is due to 'fragmentation' of the manufacturing process whereby parts of manufactured items like automobiles that need labour-intensive production or assembly are made in labor-rich countries and exported to capital-rich countries where the product is completed. Even though the trading countries have very different resource structures, unlike in comparative advantage, such trade involves the flow of goods within the same or related industries. A good example of such trade is within NAFTA whereby the more complicated automobile components requiring advanced technology are produced in the U.S and exported to Mexico where the manufacturing of small parts and assembly of the units takes place and the final product is shipped back to the U.S.

There are other reasons for weakness in the theory. The traditional theory of comparative advantage assumes significant differences in countries' natural endowments and available resource bases. However, new thinking is that government intervention can be used to overcome what might be called natural disadvantages by building comparative advantages in technologically sophisticated economic activities related or unrelated to their natural resource wealth. This means that governments can spend money to import technology and create modern manufacturing ability through investment even though a country did not possess these abilities. As the World Bank suggests, this way a country can acquire comparative advantage. A fine example is how India has managed to acquire a comparative advantage in IT because of huge investments in education and technology. Also, the comparative advantage theory fails to acknowledge transportation costs.

Critics of comparative advantage have focused on some of the undesired outcomes of free trade and on the theoretical shortcomings discussed above.

The central criticism against free trade is that poorer and less developed countries are really at a disadvantage if they export goods in which they have a comparative advantage. Typically, less developed nations with poor education, reliance on traditional agriculture, and lack of modern technology are restricted to the export of agricultural products, minerals, and low-end manufactured goods that require labor-intensive methods of production. Critics say that for such countries poverty is their comparative advantage and that exporting based on comparative advantage does not lead to improvement in living standards and, in fact, causes a growing gap relative to the developed world and prevents them from getting developed.

For one, the demand for the sort of goods that poorer countries is rather limited in the developed world (e.g. food products) and even if they try to export more, it leads to falling prices and therefore lower incomes. Secondly, the low-wage type of manufacturing activity does not result in improvement in technology or knowledge and it only benefits the consumers in the richer countries. The World Bank and others have stated that dependence on low-priced exports only gives rise to low-wage jobs that do not help in raising living standards.

With these issues in mind, critics have strongly rejected free trade based on comparative advantage. As mentioned by the World Bank, countries must try to forge new areas of comparative advantage by focusing on education and knowledge-intensive industries like IT. Clearly the intrinsic comparative advantage that the countries possess is considered detrimental. It is because of this that developing countries are encouraged to establish industrial zones by investment in advanced technology and manufacture of high value-added goods. The sort of goods that should be produced must be those that have a demand that rises as people's incomes rise; this way the producers do not face the sort of problems faced by exporters of primary goods.

It is clear that the way comparative advantage is defined has changed. Whereas it used to be that comparative advantage was considered 'God-given' but new thinking is that it can be created. Furthermore, not all trade patterns can be explained by this old theory and alternative theories and policies must also be considered.

Model Essay

“The Central Problem of Economics is scarcity and choice.” Is this statement true? (25)

Scarcity is defined as a situation in which resources are not enough to satisfy everybody’s wants. The outcome of satisfaction is not to the level we want it to be. Scarcity is the most fundamental concept in Economics. Scarcity is based on a few assumptions.

First, is that man’s wants are unlimited. Man is never satisfied with his current level of consumption, and he always wants more. Second, is that the world’s resources are limited. These resources are the factors of production of land, labour, capital and entrepreneurship. Land refers to natural resources and all the fruits of the earth. Labour refers to human effort and skill. Capital refers to any machine or technology that can produce things. Entrepreneurship is the ability to take risks, organize and plan production effectively. All countries have a finite amount of these.

Based on these assumptions, it is clear that it is not possible to produce all that we want. Some goods will have to be sacrificed to obtain more of other goods. This means that a choice has to be made.

To illustrate this concept, a man has a certain amount of money to spend. He decides to spend it all on sweets and chocolates. He can spend half his money on sweets, and the other half on chocolates. If he wants more sweets, he will have to give up some chocolates and vice versa. In the same way, for a firm, its resources are limited. If it decides to produce more of product A, it has to give up some production of good B. Thus, scarcity applies both to consumers and producers.


Figure 1: Production possibility curve
The Production Possibility Curve (PPC) further illustrates scarcity. The PPC shows all the possible combinations of 2 goods which a firm can produce, given a fixed amount of resources. At combination a, the producer can produce 100 units of X and 0 units of Y. While at combination b, he can produce 200 units of Y and 0 units of X. He may also choose to produce at c, 70 units of X and 150 units of Y. All these combinations are possible combinations of goods that can be produced. To produce more of one good, the other has to be sacrificed. Combinations d and e are not attainable, which also shows scarcity. It is the same at country level.

Scarcity forces us to choose. Since we cannot have everything, we have to decide on which one we will have to forgo. Since comething has to be forgone, there is a cost involved. In a world of scarcity, there is a cost of sacrifice involved in satisfying a particular want. This cost is called opportunity cost, and is defined as the highest valued alternative that had to be foregone to satisfy the particular want.

The basic economic problem is scarcity. Because of scarcity, we have to choose carefully on the use of our limited resources. The consumer faces the problem of satisfying his unlimited wants. He wants to have infinite satisfaction, from his finite purchasing power. Scarcity makes this impossible. As such, he will have to make a choice, based on relative opportunity costs, on which goods and services he will spend. He will have to decide which goods he has to forego and which he wants to consume.

For a producer, he will want to make infinite profit, using his finite resources. Likewise, scarcity makes this impossible, and he will have to make a choice, based on relative opportunity costs, on which good he wants to produce.

From a Macroeconomic perspective, the basic Macroeconomic concerns of the government are inome distribution and economic stability. The relative weightage given to these concerns will determine what type of policies the government decides to employ.

Income distribution is important to create a ‘fair’ and a ‘just’ state. This is a Macroeconomic objective, and it requires government intervention through progressive taxation, social insurance, benefits, etc. Reducing large income gaps and poverty are important goals of development and are hallmarks for civilised society. Extreme inequality and widespread poverty can result in social unhappiness and unrest, which in turn will result in political and social instablilty. The crime rate rises, illiteracy goes up, welfare costs rise, which all put a great strain on the economy.

The concept of scarcity comes into play here. Scarcity means that the resources of a counry are limited. As such, every available resource must be used to its fullest potential.The government needs to appreciate this when deciding the level of income equality it hopes to achieve.

If the poor are to be given a lot of financial aid, they may be spurred to further improve their skills, and contribute more to the economy. As the saying goes, a happy worker is a good worker. Likewise, if the poor are left behind as the country prospers, they may feel alienated. As such, they may refuse to work and may even resort to illegal activities. Since the country’s population is limited, a waste of scarce resources would be disastrous.

However, if too much aid is given to the poor, and too much money is taken from the rich, a whole new set of problems may arise. The poor may start to become over-dependent on government aid. This is the situation currently occurring in many Western developed countries. The poor live off their welfare payments and they contribute nothing in return to society. To support such high amounts of aid, the rich would have to be taxed a high amount, which may result in great unhappiness and discontent. This may result in the rich evading tax payments or even force them to migrate to other countries that tax less. This scenario too would be detrimental to the economy as the government would receive lesser tax revenue.

The concerns highlighted above mean that the government will have to make tough decisions. The government will have to decide on the best policy based on the opportunity cost of the available measures.

In a free market economy, the pricing system is prone to high unemployment, inflation and Balance Of Payments (BOP) difficulties. Hence, the government seeks to stabilise the economy. In this, it has four aims.

First, is full employment. Unemployment wastes sarce resources, as stated above, and brings hardships to those without jobs. Full employment is not equal to zero unemployment. It is the employment level asociated with some frictional unemployment.

Second, is price stability. This provides a stable environment for investment and growth. Price stability is not zero inflation, but usually refers to 2-3% mild inflation that is necessary to stimulate growth.

Third, is a healthy BOP. This is to ensure healthy reserves and a stable exchange rate. Last is economic growth, which is the increase in real national income per capita, which should ensure higher living standards.

Ideally, the government would seek to achieve all these aims. However, this is not always possible. Sometimes, to achieve one aim, another has to be compromised. For example, there is large-scale unemployment due to the lack of demand. To counter this, the government will employ an expansionary fiscal policy to boost demand. Government spending on public projects will increase to boost demand. However, this may, in turn, cause demand-pull inflation.

Thus, the concepts of choice and cost come into play again. The government will have to make choices based on the costs of the different measures available. Hence the statement “The Central Problem of Economics is scarcity and choice” is true.