Opportunity cost is.....

Revision Video V2

Real Ale & Binge Drinking!

a. summarise the article in your blog

“Real ale is the only type of beer now seeing its sales grown in the UK pubs, helped by an increasing number of women enjoying the drink, a study has said. While all other beer types, such as lager and keg bitters, saw their sales fall in the first half of 2009, sales of real ale grew 1%, it said. The independent study, which is backed by a host of brewers, said the number of women drinking real ale has doubled. The increase in real ale sales might come as a lifetime opportunity for pub-owners. Most pubs are currently facing harsh times (as a result of the recession) and more pubs are going out of business every day. The sale of real ales could be a turning point for them.”

b. link to the article

http://news.bbc.co.uk/1/hi/business/8290264.stm

c. list the determinants of demand and the determinants of supply

The determinants of demand are: disposable income, taste & preferences, the prices of substitutes and complements, expectations of the future and, finally, population.

The determinants of supply are: technology, factor prices, the number of suppliers, expectations of the future and, finally, environmental conditions.

d. draw the demand curve for real ale

(The demand is rather steep as the demand is quite inelastic.)

e. explain whether the demand for real ale is elastic or inelastic

The demand for real ale is inelastic, as the recession did not affect the demand for real ales in a negative way.

f. explain why the demand for real ale has increased

The article describes that woman prefer to drink real ale above other beers. This is a question of taste (one of the determinants of demand). Because the amount of women drinking in pubs has increased, the demand for real ales has increased as well.

g. explain - with diagrams - whether binge drinking is a positive or negative externality

I think binge drinking is a positive externality, as alcohol brings people together. When someone is under influence of alcohol (read: extremely drunk), he or she has contact with other people very easily, as the alcohol takes away any form of hesitation or shyness. This causes people to broaden their social network. This would mean more and more people will become good friends. This would not only improve transfers on the job market, as people find new jobs because of their new friends. For example: person A says: “Oh man I got fired, I really need to find a job!”. Person B (a friend of person A which he met when he was really drunk as a result of binge drinking) says: “Oh man I know that my mate (Person C, also met as a result of binge drinking) is looking for someone to work in his shop!”. It also increases productivity of the employees. Someone might not be willing to do that extra work for his ‘boss’, but he might just be willing to do it for his ‘friend’ (his boss who became his friend as a result of binge drinking). You can conclude that binge drinking is a positive externality. This is because binge drinking causes some good social advantages (new friends and a loose atmosphere) which will result into lower unemployment and bigger output! In a diagram this would be shown as following:

MPC = Marginal Private Costs = The person putting effort, time and money into getting drunk.

MPB = Marginal Private Benefit = The person having a good time from binge drinking!

MSB = Marginal Social Benefit = The benefits to society and the economy from binge drinking: better productivity & faster transfers on the job market.

Green area = Profit.

P1/Q1 = Social Optimum

P/Q = Market Outcome

h. advise on government policy in the light of your answer to (g)

The government should encourage binge drinking by decreasing the taxes on alcohol and by giving subsidies to people who take part in binge drinking. The government could also stimulate binge drinking by having campaigns in order to promote it!

Homework: Output Gap & Declined Demand

This post contains my answer to the following question:

“The immediate problem facing the UK economy is a large output gap and decline in aggregate demand. So - what can be done? ”

If I interpreted the given source correctly, an output gap occurs when the actual output is not equal to the potential output. We speak of a negative output gap if the actual output is bellow the potential output and we speak of a positive output if the actual output is above the potential output. In a production possibility curve, this would be shown as the following:

In this diagram, point C would be indicating a negative output gap and point D would be indicating a positive output gap. It seemed worth mentioning that points A and B are indicating cases of potential output (the line on which they are situated).

Once again, If I interpreted the given source correctly, I don’t see any problems to our economy if there is a negative output gap combined with a decline in aggregate demand. As the aggregate demand declines, people consume less. If that’s the case, there is no need for an optimal efficiency in output. As long as the total output meets the aggregate demand, things are fine!

When a positive output gap occurs in combination with a decline in aggregate demand, we are producing more than we need. This could cause problems. If the producers have a surplus of their product and are not able to sell them (as the aggregate demand goes down) the supply is too big. This could cause major deflation. Unless the economy is operating near full employment (which seems barely plausible when demand is declining), a deflation as result of demand pull goes hand in hand with an decrease in real GDP. This means the economy faces a negative economic growth, if the decrease sustains for two consecutive quarters. There is no need to tell that this is dangerous / bad for an economy.

One of the solutions I’ve come up with is for the government to stimulate the exports of its’ nation. That way, the surplus in products can be resolved, even though it’s combined with a decline in aggregate demand. The government can stimulate exports by giving subsidies on exporting companies, or by reducing taxes on exports. If the government stimulates exports, the problem might be resolved.

Revision Video V2 & More

I have finished my revision video on supply & demand, increase & decrease, extension & contraction. However, the WiFi is terribly slow right now! The uploading is stuck at 10% and the time remaining is 7 hours and 3 minutes! Please bare with me, the video is coming!

Also, as of tomorrow, I will be starting on the 29 topics you provided me with.

Thanks,

Have a nice weekend!

Demand & Supply: Again and again and again!

So I decided to write some more on demand and supply, as apparently some people still find it a bit difficult! Read this and stuff it in your minds. It is really easy if you JUST REMEMBER:

If demand increases, supply extends.

If demand shifts to the right, supply extends.

If demand decreases, supply contracts.

If demand shifts to the left, supply contracts.

If supply increases, demand extends.

If supply shifts to the right, demand extends.

If supply decreases, demand contracts.

If supply shifts to the left, demand contracts.

PLEASE PEOPLE, REMEMBER:

Increase = Shift to the right --> EXTENSION

Decrease = Shift to the left --> CONTRACTION

PRACTICE THIS AS OFTEN AS YOU CAN!

-xxx- Tom

True or False? My answer!

I could not respond to the post without authorization, so here's my answer!

It's true, I think.. =)

The angle that is formed by the line of Demand and the line that indicates price A will be 90 degrees for a perfectly inelastic demand (vertical line) and would be 0 degrees for a perfectly inelastic demand (horizontal line). Therefore, I think, if the angle being formed between price line A and Demand is smaller than 45 degrees, the demand is elastic. If the angle is bigger than 45 degrees, the demand is inelastic.

Demand 1 is inelastic. The angle formed between line A and Demand 1 is bigger than 45 degrees, as line AC is bigger than line Q1Q2. Because the angle is bigger than 45 degrees, Demand 1 is inelastic.

Demand 2 is elastic, for sure. The angle formed between line A and Demand 2 is smaller than 45 degrees, as line AB is smaller than line Q1Q2. Because the angle is smaller than 45 degrees, Demand 2 is elastic.

Therefore it's true!

This is a mathematical explanation to this question I came up with.. I hope it makes sense!

My Revision Vid (First Attempt)

AS REVISION: Chapter Four

Aggregate demand is the total demand for a country’s goods and services at a given price level and in a given time period.

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

Price level is the average of each of the prices of all the products produced in an economy.

Consumer expenditure is the spending by households on consumer products.

Investment is spending on capital goods.

Government spending is spending by central government and local government on goods and services.

Exports are products sold abroad.

Imports are products bought from abroad.

Net exports is the value of exports minus the value of imports.

Transfer payments is money transferred from one person or group to another not in return for any good or service.

Job seeker’s allowance is a benefit paid by the government to those unemployed and trying to find a job.

Trade surplus is the value of exports exceeding the value of imports.

Trade deficit is the value of imports exceeding the value of exports.

Consumer confidence is how optimistic consumers are about future economic prospects.

Rate of interest is the charge for borrowing money and the amount paid for lending money.

Average propensity to consume (APC) is the proportion of disposable income spent. It is consumer expenditure divided by disposable income.

Net savers are people who save more than they borrow.

Wealth is a stock of assets, e.g. property, shares and money held in a savings account.

Distribution of income is how income is shared out between households in a country.

Inflation is a sustained rise in the price level.

Saving is real disposable income minus spending.

Average propensity to save (APS) is the proportion of disposable income saved. It is saving divided by disposable income.

Target savers are people who save with a target figure in mind.

Dissave is spending more than disposable income.

Savings ratio is savings as a proportion of disposable income.

Capacity utilization is the extent to which firms are using their capital goods.

Corporation tax is a tax on firms’ profit.

Retained profits are profits kept by firms to finance investment.

Unit cost is the average cost per unit of output.

Real GDP is the country’s output measured in constant prices and so adjusted for inflation.

Gross Domestic Product (GDP) is the total output of goods and services produced in a country.

Exchange rate is the price of one currency in terms of another currency.

Tarrif is a tax on imports.

Government bond is a financial asset issued by the central or local government as a means of borrowing money.

Aggregate supply is the total amount that producers in an economy are willing and able to supply at a given price level in a given time period.

Productivity is output, or production, of a good or service per worker per unit of a factor of production in a giver time period.

Privatisation is the transfer of assets from the public to the private sector.

Macroeconomic equilibrium is a situation where aggregate demand equals aggregate supply and real GDP is not changing.

Circular flow of income is the movement of spending and income throughout the economy.

Factor services are the services provided by the factors of production.

Leakages are withdrawals of possible spending from the circular flow of income.

Injections are additions of extra spending into the circular flow of income.

Multiplier effect is the process by which any change in a component of aggregate demand results in a greater final change in real GDP.

Overheating is the growth in aggregate demand outstripping the growth in aggregate supply, resulting in inflation.

Output gap is the difference between an economy’s actual and potential real GDP.

Trend growth is the expected increase in potential output over time.

AS REVISION: Chapter Three

Market failure occurs where the free market mechanism fails to achieve economic efficiency.

Productive efficiency is where production takes place using the least amount of scarce resources.

Economic efficiency is where both allocative and productive efficiency are achieved.

Inefficiency is any situation where economic efficiency is not achieved.

Free market mechanism is the system by which the market forces of demand and supply determine prices and decisions made by consumers and firms.

Information failure is a lack of information resulting in consumers and producers making decisions that do not maximise welfare.

Asymmetric information is information not equally being shared between two parties.

Externality is an effect whereby those not directly involved in taking a decision are affected by the actions of others.

Third party are those not directly involved in making a decision.

Private costs are the costs incurred by those taking a particular action.

Private benefits are the benefits directly accruing to those taking a particular action.

External costs are the costs that are the consequence of externalities to third parties.

External benefits are benefits that accrue as a consequence of externalities to third parties.

Social costs are the total costs of a particular action.

Social benefits are the total benefits of a particular action.

Negative externality exists where the social cost of an activity is greater than the private cost.

Positive externality exists where the social benefits of an activity exceeds the private benefit.

Merit goods are goods that have more private benefits than their consumers actually realise.

Demerit goods are goods that have a more harmful consumption than is actually realised.

Public goods are goods that are collectively consumed and have the characteristics of non-excludability and non-rivalry.

Non-excludability is the situation existing where individual consumers cannot be excluded from consumption.

Free rider is someone who directly benefits from the consumption of a public good but who does not contribute towards its provision.

Non-rivalry is the situation existing where consumption by one person does not affect the consumption of all others.

Quasi-public goods are goods having some but not all of the characteristics of a public good.

Direct tax is one that taxes the income of people and firms and that cannot be avoided.

Indirect tax is a tax levied on goods and services.

Polluter pays principle is any measure, such as a green tax, whereby the polluter pays explicitly fro the pollution caused.

Subsidy is a payment, usually from the government, to encourage production or consumption.

Tradable permit is a permit that allows the owner to emit a certain amount of pollution and that, if unused or only partially used, can be sold to another polluter.

AS REVISION: Chapter Two

Market is where or when buyers and sellers meet to trade or exchange products.

Sub-market is a recognized or distinguishable part of a market. Also known as a market segment.

Demand is the quantity of a product that consumers are able and willing to purchase at various prices over a period of time.

National demand is the desire for a product.

Effective demand is the willingness and ability to buy a product.

Ceteris Paribus (Latin: other things being equal) is assuming that other variables remain unchanged.

Demand curve shows the relationship between the quantity demanded and the price of a product.

Demand schedule is the date that is used to draw the demand curve.

Movement along the demand curve happens in a response to a change in the price of a product.

Consumer surplus is the extra amount that a consumer is willing to pay for a product above the price that is actually paid.

Disposable income is the income after taxes on income have been deducted and state benefits have been added.

Real disposable income is the income after taxes on income have been deducted and state benefits have been added and the result has been adjusted to take into account changes in the price level.

Normal goods are goods for which an increase in income leads to an increase in demand.

Inferior goods are goods for which an increase in income leads to a fall in demand.

Substitutes are competing goods.

Complements are goods for which there is joint demand.

Change in demand happens where a change in a non-price factor leads to an increase or decrease in demand for a product.

Supply is the quantity of a product that producers are willing and able to provide at different market prices over a period of time.

Profit is the difference between the total revenue of a producer and total cost.

Supply curve shows the relationship between the quantity supplied and the price of a product.

Supply schedule is the data used to draw up the supply curve of a product.

Producer surplus is the difference between the price a producer is willing to accept and what it is actually paid.

Change in supply occurs when a change in a non-price influence leads to an increase or decrease in the willingness of a producer to supply a product.

Price is the amount of money that is paid for a given amount of a particular good or service.

Equilibrium price is the price where demand and supply are equal.

Clearing price is the same as the equilibrium price.

Equilibrium quantity is the quantity that is demanded and supplied at the equilibrium price.

Disequilibrium is any position in the market where demand and supply are not equal.

Surplus is an excess of supply over demand.

Shortage is an excess of demand over supply.

Elasticity is the extent to which buyers and sellers respond to a change in the market conditions.

Price elasticity of demand is the responsiveness of the quantity demanded to a change in the price of the product.

Price elastic is where the percentage change in the quantity demanded is sensitive to a change in price.

Price inelasticity is where the percentage change in the quantity demanded is insensitive to a change in price.

Income elasticity of demand the responsiveness of demand to a change in income.

Normal goods are goods with a positive income elasticity of demand.

Income inelastic goods are goods for which a change in income produces a less than proportionate change in demand.

Income elastic goods are goods for which a change in income produces greater than proportionate change in demand.

Inferior goods are goods for which an increase in income leads to a fall in demand.

Cross elasticity of demand (XED) is the responsiveness of demand for one product in relation to a change in the price of another product.

Price elasticity of supply (PES) the responsiveness of the quantity supplied to a change in the price of the product.

Efficiency is where the best use of resources is made for the benefit of consumers.

Allocative efficiency is where consumer satisfaction is maximised.

AS REVISION: Chapter One

Economics is the study of how to allocate scarce resources in the most effective way.

The so-called economic problem of scarcity and choice is central to economics as a subject. The economic problem is how to allocate scarce resources among alternative uses. The resources are scarce in relationship to wants that are unlimited, leading to choices having to be made.

Household is a group of people whose spending decisions are connected.

We roughly divide the economy into two fields. The first field is microeconomics: the study of how households and firms make decisions in markets. The second field is macroeconomics: the study of issues that affect economies as a whole.

Model is a simplified view of reality that is used by economists as a means of explaining economic relationships.

Available resources in an economy are known by economists as factors of production. These are used to produce the goods (tangible products) and services (intangible products) to meet the need of the population. There are four different factors of production:

1. Land: natural resources in an economy.
2. Labour : the quantity and quality of human resources.
3. Capital: man-made aids to production.
4. Entrepreneurship: the willingness to take risks and organize production.
(Entrepreneur: someone who bears the risks of a business and who organizes production.)

Factor endowment is the stock of factors of production.

Production is the output of goods and services.

A want is anything you want, irrespective of whether you have the resources to purchase it.

Three fundamental economic concepts are scarcity, choice and opportunity cost.

Scarcity is a situation where there are insufficient resources to meet all wants.
Choice is the selection of appropriate alternatives.
Opportunity cost is the cost of the next best alternative foregone.

Specialisation is the concentration by a worker or workers, firm, region or whole economy on a narrow range of goods and services.

Exchange is the process by which goods and services are traded.

Subsidy is a payment by a governing body to encourage the production or consumption of a product.

Division of labour is the specialisation of labour where the production process is broken down into separate tasks.

Productivity is the output, or production of a good or service, per worker.

The production possibility curve shows the maximum quantities of different combinations of output of two products, given current resources and the state of technology.

Developed economy is an economy with a high level of income per head.

Developing economy is an economy with a relatively low level of income per head.

Trade-off is the calculation involved in deciding on whether to give up one good for another.

Economic growth is a change in the productive potential of an economy.

Productive potential is the maximum output that an economy is capable of producing.

Economic system is the way in which production is organised in a country or group of

countries. There are three main kinds of economic systems

1. Free market economy: an economic system whereby resources are allocated through the market forces of demand and supply.
2. Command or centrally planned economy: an economic system in which most resources are state owned and also allocated centrally.
3. Mixed economy: an economic system in which resources are allocated through a mixture of the market and direct public sector involvement.

In a free market economy you will meet the following definitions:

Price system is a method of allocating resources by the free movement of prices.

Supply is the quantity of a product that producers are willing and able to provide at different market prices over a period of time.

Demand is the quantity of a product that consumers are able and willing to purchase at various prices over a period of time.

Economy Essay No. 10: The price of cocaine

The task: “Using supply and demand analysis, explain the reasons for a rise in the price of cocaine.”

In may of this year, the BBC covered a story on the decline in the market for the hard-drug cocaine. The Serious Organised Crime Agency claimed that the international cocaine market was “in retreat” as a result of a year of successful operations around the world. The price per kilo has risen from £39,000 in 2008 to £45,000 in 2009.

Those increases in price are a result of a huge decrease in supply. The supply has decreased as a result of intensive police and narcotic brigades against the traffic and selling of drugs. The intensity of their operations has caused a lower supply of cocaine.

A simply supply-demand curve can show us what happened in figure:

As shown, a decrease in supply causes a increase in price if everything else remains the same (ceteris paribus – remember?). So the increasing of anti-cocaine actions are the explanation for the rising prices of cocaine, as the supply decreases.

References:

http://articles.latimes.com/2007/nov/09/world/fg-drugs9

http://www.opposingviews.com/articles/opinion-phony-stats-on-cocaine-prices-hide-truth-about-war-on-drugs

http://news.bbc.co.uk/1/hi/uk/8044275.stm

http://kristianseconomics.blogspot.com/ (for supply-demand curve, nice graph Kristian!)

Economy Essay No. 9: The Marshall-Lerner Theorem

Introduction:

In class, Chris briefly mentioned the Marshall-Lerner theorem, which got me both curious and interested! I browsed the web and tried to get a good understanding of this theorem. Here are my results: an essay on the Marshall-Lerner theorem. Enjoy guys and girls! By the way, don’t worry, if I am right, this is only on the A2 syllabus and not on the AS!

First of all, here is some terminology that we might already have been talking about in class. You really need to understand the meaning of the following words in order to understand the rest of this essay:

1. Current account balance – equals the balance of trade (total exports of goods and services minus the total imports of goods and services) plus the net unilateral transfers from abroad (which basically means the gifts and transfers from individuals or transfers from governments from abroad) plus the net factor income from abroad (which basically means the net flow of property income and the net flow of compensation of employees). If you want to learn more about Current Account Balance, there is a poster in the hallway that will give you some information.

2. Depreciation – means the reduction in value of assets. This can happen because of usage, passing of time, outdating of technology and many other things. Sometimes depreciation is also used as a synonym for devaluation of a currency.

The basics of the Marshall-Lerner theorem:

The Marshall-Lerner Theorem exists of a condition. This condition states that, if we want the devaluation of a currency (simplified: the exchange rate goes down) to have a positive impact on the current account balance (which means either a increase in the current account surplus or an decrease in the current account deficit), the sum of price elasticity of exports and imports must be bigger than 1. Thus if the sum (of the absolute values) of price elasticity of exports and imports is bigger than 1, the devaluation of currency has a positive impact in current account balance. If that sum is less than 1, the impact is not positive. So briefly said, the best explanation of the theorem is:

The Marshall-Lerner condition states that: “Following a fall in the value of a country’s currency or depreciation there will be an improvement in the economy’s current account position if the sum of elasticities of exports and imports is greater than one.”

So, a necessity for this condition is the following:

|PED exports| + |PED imports| > 1

You will get a better understanding of the Marshall-Lerner condition by the following. If you want to show the result of the Marshall-Lerner condition in an image, you use the J-curve. A J-curve is a graph that shows a successful improvement in the current account balance as a result of devaluation of the currency or depreciation. It looks like this:

This image shows a clear improvement in the current account balance after the depreciation (depreciation in this case as am example, could just have been devaluation of currency). This means that the sum of the price elasticity of exports and imports was bigger than 1. You can also see that the improvement does not take place immediately. It takes some time. I will try to illustrate the Marshall-Lerner theorem by the following example:

------

Country X is facing a devaluation of its currency.

The PED Exports of country X = +3

|PED Exports| = 3

The PED Imports of country X = -1.8

|PED Imports| = 1.8

|PED Exports| + |PED Imports| = 3 + 1.8 = 4.8

4.8 > 1

Therefore the Marshall-Lerner theorem states that the current account balance of country X will improve as a result of the devaluation of its currency.

However, the J-curve shows us that this will not happen immediately, it will take some time for the improvement to take place.

-------

The Marshall-Lerner theorem is named after two famous economists Alfred Marshall and Abba Lerner.

On a side note:

In 1992 the British government made a huge mistake. On the 16th of september, they were forced to withdraw the pound (GBP) from the European Exchange Rate Mechanism, because the devaluation of the sterling had continued for too long: it fell below its agreed lower limit. This event is nowadays referred to as "black wednesday".

The way the Marshall-Lerner theorem works:

So now that you hopefully know what the basic meaning of the Marshall-Lerner theorem is and you know how the theorem works, we are going to find out why it works the way it does.

The devaluation of a currency means that the exchange rate goes down. This also means that the prices for exports go down and the prices for imports go up. Do you remember? (S.P.I.C.E.D. = Strong Pound Import Cheap Export Dear) As a result, the quantity demanded for exports will increase and the quantity demanded for imports will decrease.

This will cause an improvement in the current account balance if the exported goods are elastic. Being elastic, the demand for the goods will proportionately increase more than the price will decrease. This means that the current account balance will improve as it causes the total revenue of exports to increase. Also if the imported goods are elastic, the demand will decrease proportionately more than the price will increase. Therefore the total import expenditure will decrease.

The J-curve can be explained too. Goods seem to be inelastic in the short term, because it takes some time to change consuming patterns. This means the devaluation will worsen the current account balance at first, as seen in the J-curve: the graph lowers. In the long term, consuming patterns will adapt to the new prices and the trade balance will improve: the graph rises. This is how the J-curve will get its shape.

A numerical example of the Marshall-Lerner theorem:

At a given moment is the exchange rate between the sterling and the American dollar the following:

£1:$2

The total exports of England exist of just one good, namely 100,000 wooden tables a year, which are being sold to a company in the USA for £50 ($100) each. The total imports of England exist of just one good as well, namely 100,000 wooden chairs a year, which are being bought from a company in the USA for £30 ($60) each. We will ignore the net unilateral transfers from abroad and the net factor income from abroad, just to keep things simple. We can than conclude:

[BEFORE DEVALUATION]

Total exports: £5,000,000

Total imports: £3,000,000

England’s current account balance: a £2,000,000 surplus.

Given is the following:

PED wooden tables (exports) = -2

PED wooden chairs (imports) = -1.5

[DEVALUATION]

Later, the exchange rate for the sterling goes down. The exchange rate between the sterling and the American dollar is than:

£1:$1,80

Which is a decrease of 10% in the value of the sterling compared to the first exchange rate.

With the new exchange rate given, the prices for the wooden tables, which are England’s export, will decrease. Therefore the quantity demanded will increase as shown:

PED exports = -2 = (% ch. demand) / (% ch. price)

(% ch. price) = 50 * 1.8 = 90 = -10%

PED exports = -2 = (% ch. demand) / (-10%)

(% ch. demand) = -2 * -10% = +20%

New demand = 120,000

New price = £50 = $90

Total exports = 120,000 * £50 = £6,000,000

With the new exchange rate given, the prices of the wooden chairs, which are England’s import, will increase. Therefore the quantity demanded will decrease as shown:

PED imports = -1.5 = (% ch. demand) / (% ch. price)

(% ch. price) = 60 / 1,8 = 33.33 = +11.11 %

PED imports = -1.5 = (% ch. demand) / (+11.11%)

(% ch. demand) = -1.5 * +11.11% = -16.665%

New demand = 83,335

New price = $60 = £33.33

Total imports = 83,335 * £33.33 = £2,777,555.55

[AFTER DEVALUATION]

Total exports: £6,000,000

Total imports: £2,777,555.55

England’s current account balance: a £3,222,444.45 surplus.

As you can clearly see, as a result of the devaluation of the sterling, there was an improvement in the current account balance. This is being described by the Marshall-Lerner theorem.

Another numerical example of the Marshall-Lerner theorem:

Again, at a given moment is the exchange rate between the sterling and the American dollar the following:

£1:$2

The total exports of England still exists of just one good, namely 100,000 wooden tables a year, which are being sold to a company in the USA for £50 ($100) each. The total imports of England exists of just one good as well, namely 100,000 wooden chairs a year, which are being bought from a company in the USA for £30 ($60) each. We will ignore the net unilateral transfers from abroad and the net factor income from abroad, just to keep things simple. We can than conclude:

[BEFORE DEVALUATION]

Total exports: £5,000,000

Total imports: £3,000,000

England’s current account balance: a £2,000,000 surplus.

Given is the following:

PED wooden tables (exports) = -0.6

PED wooden chairs (imports) = -0.6

[DEVALUATION]

Later, the exchange rate for the sterling goes down. The exchange rate between the sterling and the American dollar is than:

£1:$1,80

Which is a decrease of 10% in the value of the sterling compared to the first exchange rate.

With the new exchange rate given, the prices for the wooden tables, which are England’s export, will decrease. Therefore the quantity demanded will increase as shown:

PED exports = -0.6 = (% ch. demand) / (% ch. price)

(% ch. price) = 50 * 1.8 = 90 = -10%

PED exports = -0.6 = (% ch. demand) / (-10%)

(% ch. demand) = -0.6 * -10% = +6%

New demand = 106,000

New price = £50 = $90

Total exports = 106,000 * £50 = £5,300,000

With the new exchange rate given, the prices of the wooden chairs, which are England’s import, will increase. Therefore the quantity demanded will decrease as shown:

PED imports = -0.6 = (% ch. demand) / (% ch. price)

(% ch. price) = 60 / 1,8 = 33.33 = +11.11 %

PED imports = -0.6 = (% ch. demand) / (+11.11%)

(% ch. demand) = -0.6 * +11.11% = -6.66%

New demand = 93,330

New price = $60 = £33.33

Total imports = 93,330 * £33.33 = £3,110,688.9

[AFTER DEVALUATION]

Total exports: £5,300,000

Total imports: £3,110,688.9

England’s current account balance: a £2,189,311.1 surplus.

As you can clearly see, as a result of the devaluation of the sterling, there was an improvement in the current account balance, even though both the imports and exports were inelastic! This is being described by the Marshall-Lerner theorem.

The Marshall-Lerner theorem in chart:

This link shows a chart that shows the result of the Marshall-Lerner condition. You can see that when the currency depreciates (exchange rate goes down), the current account balance improves, which is exactly what the Marshall-Lerner theorem states. The value of the currency (the USD in this case) is indicated with the blue graph while the value of the current account balance (as a percentage of the GDP) is indicated with the red graph. This chart is a good way to show the results of the Marshall-Lerner condition. I hope it helps you to understand the condition.

Important addition:

Please notice the following:

If the imports and exports are both inelastic, and if (AND ONLY IF) "|PED imports| + |PED exports| > 1", (for example: 0.6 + 0.6 > 1) the Marshall-Lerner theorem does certainly apply. Any devaluation of currency will have a positive impact on the current account balance. If the sum of the elasticities is not bigger than one, the Marshall-Lerner theorem does not apply.

A few things to mention:

I really hope I gave a good explanation of the Marshall-Lerner theorem and made you learn something! I am not sure though, as I never learned about it before! Please comment to tell me if I am correct or need to adjust some of the information given. Thanks for reading and remember, this is in the A2 syllabus.

References:

http://en.wikipedia.org/wiki/Current_account

http://www.oppapers.com/essays/Net-Factor-Income-Abroad/129921

http://business.baylor.edu/Tom_kelly/2307ch19.htm

http://en.wikipedia.org/wiki/Marshall-Lerner_Condition

http://www.bized.co.uk/virtual/dc/trade/theory/th12.htm

http://tutor2u.net/blog/index.php/ib-diploma/comments/marshall-lerner-and-the-j-curve/

http://www.economyprofessor.com/economictheories/marshall-lerner-principle.php

http://www.economicshelp.org/blog/trade/testing-marshall-lerner-condition/

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