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:

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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.

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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/

http://tutor2u.net/economics/revision-notes/a2-macro-balance-of-payments-deficits_clip_image008.gif