All themes: Excellent you tube page

Click here to access an excellent you tube site dedicated to all things economics. I will also put it on the revision websites section of my blog (right hand side), so it will always be there for you.

MUST WATCH - FOR PAPER 1 NEXT WEEK

Thank you to Geoff and the team for producing these excellent revision videos on theory of the firm.

Click here to access. I would like to go through them next week.

Theme 2: Macro economic Videos

Click here to access several revision videos on macro economics.

Theme 1: Revision videos from tutor2u

Click here to access 10 videos on all aspects of micro economics for AS. An excellent revision tool.

Theme 1: Market Failure Presentations

Externalities introduction from mattbentley34

Economic efficiency market_failure from mattbentley34

Negative externalities from mattbentley34

Government failure from mattbentley34

Theme 3: Updated presentation on Monopoly

Basics of the Economics of Monopoly from tutor2u

Unit 2: Macro-Economic study notes

Here is a topic-by-topic listing of the available study notes for the macroeconomics topics for Year 1 (AS) A Level Economics here on tutor2u.

Unit 2 - Macro study notes

Unit 2 - Macro playlist

Unit 1 & 2: Evaluation skills for AS Micro - A good listen

In this revision webinar we look at ways in which students can build effective evaluation, where required, into their responses to AS Micro exam questions.

 

 Here are the slide that go with the podcast:
 

AS econ webinar micro evaluation skills from mattbentley34

Unit 3: Barriers to Entry - presentation

This is an updated revision presentation on Barriers to Entry in Markets

Students should be able to:

• Understand the meaning & types of barriers to entry and exit and how they affect the behaviour of firms.
• Discuss the significance of barriers to entry and exit to firms operating in different market structures.

Barriers to Entry in Markets from tutor2u

Unit 3: Monopolistic Competition - Revision Presentation

Monopolistic competition is a form of imperfect competition. It can be found in many real world markets ranging from clusters of sandwich bars, other fast food shops and coffee stores in a busy town centre to pizza delivery businesses in a city or hairdressers in a local area. 

Monopolistic competition is similar to perfect competition, some economist regard it as more realistic, because the products are differentiated.

Monopolistic Competition from tutor2u

Unit 3: Contestable Markets - Revision material

This is a revision presentation on aspects of contestable markets. A contestable market is one that is open to actual & potential competition. A market is contestable where an entrant has access to all production techniques available to existing businesses and when entry decisions can be reversed without cost i.e. there are no sunk costs.

Contestable Markets from tutor2u

Unit 2 (& 4): Revision material

Thank you to Geoff and his team from tutor2u for these exam revision notes on macro-economics. Really useful stuff to give you the edge in this months examinations.

Unit 4: Essential watching - The UK Economy

Similar thing here, only specific to UK economy.

Unit 4: Essential reading

Here is the recording of Geoff's webinar for A2 Econ students which focused on key aspects of the international & global economy, including a focus towards the end on development economics.



Click here to access the slides from the above presentation.

Unit 4: Inequality & Economic development

This is an updated revision presentation covering aspects of inequality and economic growth/development - it is designed for specifically for the Unit 4 paper.

Inequality, Economic Growth and Development from tutor2u

Unit 3: Government Regulation

Regulation of Markets

The government may wish to regulate monopolies to protect the interests of consumers. For example, monopolies have the market power to set prices higher than in competitive markets. The government can regulate monopolies through price capping, yardstick competition and preventing the growth of monopoly power.

Why the Government Regulates Monopolies

1. Prevent Excess Price. Without government regulation, monopolies could put prices above. This would lead to allocative inefficiency and a decline in consumer welfare.
2. Quality of service. If a firm has a monopoly over the provision of a particular service, it may have little incentive to offer a good quality service. Government regulation can ensure the firm meets minimum standards of service.
3. Monopsony power. A firm with monopoly selling power may also be in a position to exploit monopsony buying power. For example, supermarkets may use their dominant market position to squeeze profit margins of farmers.
4. Promote Competition. In some industries, it is possible to encourage competition, and therefore there will be less need for government regulation.
5. Natural Monopolies. Some industries are natural monopolies – due to high economies of scale, the most efficient number of firms is one. Therefore, we cannot encourage competition and it is essential to regulate the firm to prevent the abuse of monopoly power.

How the Government Regulate Monopolies

1. Price Capping by Regulators RPI-X
For many newly privatised industries, such as water, electricity and gas, the government created regulatory bodies such as:

• OFGEM – gas and electricity markets
• OFWAT – tap water.
• ORR – Office of rail regulator.

Amongst their functions, they are able to limit price increases. They can do this with a formula RPI-X

• X is the amount by which they have to cut prices by in real terms.
• If inflation is 3% and X= 1%
• Then firms can increase actual prices by 3-1 = 2%

If the regulator thinks a firm can make efficiency savings and is charging too much to consumers, it can set a high level of X. In the early years of telecom regulation, the level of X was quite high because efficiency savings enabled big price cuts.

RPI+/- K – for water industry

In water the price cap system is RPI -/+ K.

K is the amount of investment that the water firm needs to implement. Thus, if water companies need to invest in better water pipes, they will be able to increase prices to finance this investment.

Advantages of RPI-X Regulation

1. The regulator can set price increases depending on the state of the industry and potential efficiency savings.
2. If a firm cuts costs by more than X, they can increase their profits. Arguably there is an incentive to cut costs.
3. Surrogate competition. In the absence of competition, RPI-X is a way to increase competition and prevent the abuse of monopoly power.

Disadvantages of RPI-X Regulation

1. It is costly and difficult to decide what the level of X should be.
2. There is danger of regulatory capture, where regulators become too soft on the firm and allow them to increase prices and make supernormal profits.
3. However, firms may argue regulators are too strict and don’t allow them to make enough profit for investment.
4. If a firm becomes very efficient, it may be penalised by having higher levels of X, so it can’t keep its efficiency saving.

2. Regulation of quality of service

Regulators can examine the quality of the service provided by the monopoly. For example, the rail regulator examines the safety record of rail firms to ensure that they don’t cut corners.
In gas and electricity markets, regulators will make sure that old people are treated with concern, e.g. not allow a monopoly to cut off gas supplies in winter.

3. Merger Policy

The government has a policy to investigate mergers which could create monopoly power. If a new merger creates a firm with more than 25% of market share, it is automatically referred to the Competition Commission. The Competition commission can decide to allow or block the merger.
More on mergers.

4. Breaking up a monopoly.

In certain cases, government may decide a monopoly needs to be broken up because the firm has become too powerful. This rarely occurs. For example, the US looked into breaking up Microsoft, but in the end the action was dropped. This tends to be seen as an extreme step, and there is no guarantee the new firms won’t collude.

5. Yardstick or ‘Rate of Return’ Regulation

This is a different way of regulating monopolies to the RPI-X price capping. Rate of return regulation looks at the size of the firm and evaluates what would make a reasonable level of profit from the capital base. If the firm is making too much profit compared to their relative size, the regulator may enforce price cuts or take one off tax.
A disadvantage of rate of return regulation is that it can encourage ‘cost padding’. This is when firms allow costs to increase so that profit levels are not deemed excessive. Rate of return regulation gives little incentive to be efficient and increase profits. Also, rate of return regulation may fail to evaluate how much profit is reasonable. If it is set too high, the firm can abuse its monopoly power.

6. Investigation of Abuse of Monopoly Power.

In the UK, the office of fair trading can investigate the abuse of monopoly power. This may include unfair trading practises such as:

• Collusion (firms agree to set higher prices)
• Collusive tendering. This occurs when firms enter into agreements to fix the bid at which they will tender for projects. Firms will take it in turns to get the contract and enable a much higher price for the contract.
• Predatory pricing (setting low prices to try and force rival firms out of business)
• Vertical restraints – prevent retailers stock rival products
• Selective distribution For example, in the UK car industry firms entered into selective and exclusive distribution networks to keep prices high. The competition commission report of 2000 found UK cars were at least 10% higher than European cars

Related Exam Question:

Jun 2009 Unit 3, Q11 - The rail industry

Unit 3: Monopoly Revision Notes

Monopoly

Definition of Monopoly:

• A pure Monopoly is defined as a single seller of a product. i.e. 100% of market share.
• In the UK a firm is said to have monopoly power if it has more than 25% of the market share. For example, Tesco @30% market share or Google 90% of search engine traffic.

Monopoly Diagram

A monopoly maximises profits where MR=MC. It sets a price of Pm and quantity Qm.

Problems of Monopoly

1. Higher Prices. Firms with monopoly power can set higher prices than in a competitive market. (Green area is supernormal profit)

2. Allocative Inefficiency. A monopoly is allocatively inefficient because in monopoly the price is greater than MC. (P > MC). In a competitive market the price would be lower and more consumers would benefit. A monopoly results in dead-weight welfare loss indicated by the red triangle.
3. Productive Inefficiency A monopoly is productively inefficient because output does not occur at the lowest point on the AC curve.
4. X – Inefficiency. – It is argued that a monopoly has less incentive to cut costs because it doesn’t face competition from other firms.Therefore the AC curve is higher than it should be.
5. Supernormal Profit. A Monopolist makes Supernormal Profit Qm * (AR – AC ) leading to an unequal distribution of income.
6. Higher Prices to suppliers - A monopoly may use its market power and pay lower prices to its suppliers. E.g. Supermarkets have been criticised for paying low prices to farmers.
7. Diseconomies of acale - It is possible that if a monopoly gets too big it may experience diseconomies of scale. – higher average costs because it gets too big.
8. Lack of incentives. A monopoly faces a lack of competition and therefore, it may have less incentive to work at product innovation and develop better products.
9. Charge higher prices to suppliers. Monopolies may use their supernormal profits to charge higher prices to suppliers.
   • see also: Disadvantages of Monopolies

Advantages of Monopoly

1. Economies of scale

• If there are significant economies of scale, a monopoly can benefit from lower average costs. This can lead to lower prices for consumers.
• In the above example If there were 3 firms producing 3,000 units at an average cost of £17, average costs would be higher than a monopoly producing 10,000 units. Therefore, for natural monopolies and industries with significant economies of scale, monopolies can be more efficient.

2. Research & Development.
Monopolies make supernormal profit which can be invested in Research & Development. This is important for industries like medical drugs.
3. A Firm may gain monopoly power because it is the most efficient.
Google gained monopoly power through offering innovative new products. It is hard to argue google has x-inefficiency because of its monopoly power.

• see also: Advantages of Monopolies

Evaluation of Monopolies

• It depends on the industry in question. For example, a monopoly is needed in a natural monopoly like tap water. However, for restaurants, there are not significant economies of scale and it is important to have choice. Therefore monopoly would be very inappropriate for restaurants.
• Some industries need a lot of research and development (e.g. building new aeroplanes, research drugs). Therefore, a monopoly may be needed in this industry.
• A government may be able to regulate monopolies to gain benefits of economies of scale, without the disadvantages of higher prices.

How Monopolies can develop

1. Horizontal Integration. Where two firms join at the same stage of production, e.g. two banks such as TSB and Lloyds
2. Vertical Integration. Where a firm gains market power by controlling different stages of the production process. A good example is the oil industry, where the leading firms produce, refine and sell oil.
3. Legal Monopoly. E.g. Royal Mail or Patents for producing a drug.
4. Internal Expansion of a firm. Firms can increase market share by increasing their sales and possibly benefiting from economies of scale. For example, Google became a monopoly through dominating the search engine market.
5. Being the First Firm e.g. Microsoft has created monopoly power by being the first firm.

Monopolies also need barriers to entry to protect them from new firms entering the market. Barriers to entry can include – brand loyalty through adverstising and economies of scale

Regulation of Monopolies

Governements can regulate monopolies through

• Price capping RPI-X to limit price increases
• Prevent mergers
• Investigating abuse of monopoly power, e.g. collusion

Unit 3: Perfect Competition - Revision Notes

Perfect competition – a pure market

Perfect competition describes a market structure whose assumptions are strong and therefore unlikely to exist in most real-world markets. Economists have become more interested in pure competition partly because of the growth of e-commerce as a means of buying and selling goods and services. And also because of the popularity of auctions as a device for allocating scarce resources among competing ends.
Assumptions for a perfectly competitive market

• Many sellers each of whom produce a low percentage of market output and cannot influence the prevailing market price.
• Many individual buyers, none has any control over the market price
• Perfect freedom of entry and exit from the industry. Firms face no sunk costs and entry and exit from the market is feasible in the long run. This assumption means that all firms in a perfectly competitive market make normal profits in the long run.
• Homogeneous products are supplied to the markets that are perfect substitutes. This leads to each firms being “price takers” with a perfectly elastic demand curve for their product.
• Perfect knowledge – consumers have all readily available information about prices and products from competing suppliers and can access this at zero cost – in other words, there are few transactions costs involved in searching for the required information about prices. Likewise sellers have perfect knowledge about their competitors.
• Perfectly mobile factors of production – land, labour and capital can be switched in response to changing market conditions, prices and incentives.
• No externalities arising from production and/or consumption.

Evaluation – Understanding the real world of imperfect competition!
It is often said that perfect competition is a market structure that belongs to out-dated textbooks and is not worthy of study! Clearly the assumptions of pure competition do not hold in the vast majority of real-world markets, for example, some suppliers may exert control over the amount of goods and services supplied and exploit their monopoly power.
On the demand-side, some consumers may have monopsony power against their suppliers because they purchase a high percentage of total demand. Think for example about the buying power wielded by the major supermarkets when it comes to sourcing food and drink from food processing businesses and farmers. The Competition Commission has recently been involved in lengthy and detailed investigations into the market power of the major supermarkets.
In addition, there are nearly always some barriers to the contestability of a market and far from being homogeneous; most markets are full of heterogeneous products due to product differentiation – in other words, products are made different to attract separate groups of consumers.
Consumers have imperfect information and their preferences and choices can be influenced by the effects of persuasive marketing and advertising. In every industry we can find examples of asymmetric information where the seller knows more about quality of good than buyer – a frequently quoted example is the market for second-hand cars! The real world is one in which negative and positive externalities from both production and consumption are numerous – both of which can lead to a divergence between private and social costs and benefits. Finally there may be imperfect competition in related markets such as the market for key raw materials, labour and capital goods.
Adding all of these points together, it seems that we can come close to a world of perfect competition but in practice there are nearly always barriers to pure competition. That said there are examples of markets which are highly competitive and which display many, if not all, of the requirements needed for perfect competition. In the example below we look at the global market for currencies.
Currency markets - taking us closer to perfect competition

• The global foreign exchange market is where all buying and selling of world currencies takes place. There is 24-hour trading, 5 days a week.
• Trading volume in the Forex market is around $3 trillion per day – equivalent to the annual GDP of France! 31% of global trading takes place in London alone.
• Most trading in currencies is ‘speculative.’

The main players in the currency markets are as follows:

• Banks both as “market makers” dealing in currencies and also as end-users demanding currency for their own operations.
• Hedge funds and other institutions (e.g. funds invested by asset managers, pension funds).
• Central Banks (including occasional currency intervention in the market when they buy and sell to manipulate an exchange rate in a particular direction).
• Corporations (for example airlines and energy companies who may use the currency market for defensive ‘hedging’ of exposures to risk such as volatile oil and gas prices.)
• Private investors and people remitting money earned overseas to their country of origin / market speculators trading in currencies for their own gain / tourists going on holiday and people traveling around the world on business.

Why does a currency market come close to perfect competition?

• Homogenous output: The "goods" traded in the foreign exchange markets are homogenous - a US dollar is a dollar and a euro is a euro whether someone is trading it in London, New York or Tokyo.
• Many buyers and sellers meet openly to determine prices: There are large numbers of buyers and sellers - each of the major banks has a foreign exchange trading floor which helps to "make the market". Indeed there are so many sellers operating around the world that the currency exchanges are open for business twenty-four hours a day. No one agent in the currency market can, on their own influence price on a persistent basis - all are ‘price takers’. According to Forex_Broker.net "The intensity and quantity of buyers and sellers ready for deals doesn't allow separate big participants to move the market in joint effort in their own interests on a long-term basis."
• Currency values are determined solely by market demand and supply factors.
• High quality real-time information and low transactions costs: Most buyers or sellers are well informed with access to real-time market information and background research analysis on the factors driving the prices of each individual currency. Technological progress has made more information immediately available at a fraction of the cost of just a few years ago. This is not to say that information is cheap - an annual subscription to a Bloomberg or a Reuter’s news terminal will cost several thousand dollars. But the market is rich with information and transactions costs for each batch of currency bought and sold has come down.
• Seeking the best price: The buyers and sellers in foreign exchange only deal with those who offer the best prices. Technology allows them to find the best price quickly.

What are the limitations of currency trading as an example of a competitive market?

• Firstly the market can be influenced by official intervention via buying and selling of currencies by governments or central banks operating on their behalf. There is a huge debate about the actual impact of intervention by policy-makers in the currency markets.
• Secondly there are high fixed costs involved in a bank or other financial institution when establishing a new trading platform for currencies. They need the capital equipment to trade effectively; the skilled labour to employ as currency traders and researchers. Some of these costs may be counted as sunk costs – hard to recover if a decision is made to leave the market.

Despite these limitations, the foreign currency markets take us reasonably close to a world of perfect competition. Much the same can be said for trading in the equities and bond markets and also the ever expanding range of future markets for financial investments and internationally traded commodities. Other examples of competitive markets can be found on a local scale – for example a local farmers’ market where there might be a number of farmers offering their produce for sale.
The internet and perfect competition

• Advances in web technology have made markets more competitive. It has reduced barriers to entry for firms wanting to compete with well-established businesses – for example specialist toy retailers are better able to battle for market share with the dominant retailers such as ToysRUs and Wal-Mart.
• One of the most important aspects of the internet is the ability of consumers to find information about prices for many goods and services. There are an enormous number of price comparison sites in the UK covering everything from digital cameras to package holidays, car insurance to CDs and jewellery. 
• That said the price comparison web sites themselves have come under criticism. For example the sites offering to compare hundreds of different motor insurance policies or mortgage products draw information from the insurance and mortgage brokers but might use limiting assumptions about the different types of consumers looking for the best price – the result is a range of prices facing the consumer that don’t accurately reflect their precise needs – and consumers may only realise this when, for example, they make a claim on an insurance policy bought over the internet which turns out not to provide the specific cover they needed.
• And in the market for price comparison sites there is monopoly power too! Moneysupermarket.com currently has around 40% of the overall comparison site market, with Confused.com its nearest rival with a share of about 10%.

Price and output in the short run under perfect competition

• In the short run, the interaction between demand and supply determines the “market-clearing” price. A price P1 is established and output Q1 is produced. This price is taken by each firm. The average revenue curve is their individual demand curve.
• Since the market price is constant for each unit sold, the AR curve also becomes the marginal revenue curve (MR) for a firm in perfect competition.
• For the firm, the profit maximising output is at Q2 where MC=MR. This output generates a total revenue (P1 x Q2). Since total revenue exceeds total cost, the firm in our example is making abnormal (economic) profits.
• This is not necessarily the case for all firms in the industry since it depends on the position of their short run cost curves. Some firms may be experiencing sub-normal profits if average costs exceed the price – and total costs will be greater than total revenue.

The adjustment to the long-run equilibrium in perfect competition

• If most firms are making abnormal profits in the short run, this encourages the entry of new firms into the industry
• This will cause an outward shift in market supply forcing down the price
• The increase in supply will eventually reduce the price until price = long run average cost. At this point, each firm in the industry is making normal profit.
• Other things remaining the same, there is no further incentive for movement of firms in and out of the industry and a long-run equilibrium has been established. This is shown in the next diagram.

We are assuming in the diagram above that there has been no shift in market demand.

• The effect of increased supply is to force down the price and cause an expansion along the market demand curve.
• But for each supplier, the price they “take” is now lower and it is this that drives down the level of profit made towards normal profit equilibrium.

In an exam question you may be asked to trace and analyse what might happen if

• There was a change in market demand (e.g. arising from changes in the relative prices of substitute products or complements.)
• There was a cost-reducing innovation affecting all firms in the market or an external shock that increases the variable costs of all producers.

Adam Smith on Competition
 “The natural price or the price of free competition ... is the lowest which can be taken. [It] is the lowest which the sellers can commonly afford to take, and at the same time continue their business.”
Source: Adam Smith, the Wealth of Nations (1776), Book I, Chapter VII
Characteristics of competitive markets
The common characteristics of markets that are considered to be “competitive” are:

• Lower prices because of many competing firms. The cross-price elasticity of demand for one product will be high suggesting that consumers are prepared to switch their demand to the most competitively priced products in the marketplace.
• Low barriers to entry – the entry of new firms provides competition and ensures prices are kept low in the long run.
• Lower total profits and profit margins than in markets which dominated by a few firms.
• Greater entrepreneurial activity – the Austrian school of economics argues that competition is a process. For competition to be improved and sustained there needs to be a genuine desire on behalf of entrepreneurs to innovate and to invent to drive markets forward and create what Joseph Schumpeter called the “gales of creative destruction”.
• Economic efficiency – competition will ensure that firms move towards productive efficiency. The threat of competition should lead to a faster rate of technological diffusion, as firms have to be responsive to the changing needs of consumers. This is known as dynamic efficiency.

The importance of non-price competition
In competitive markets, non-price competition can be crucial in winning sales and protecting or enhancing market share.
Perfect competition and efficiency
Perfect competition can be used as a yardstick to compare with other market structures because it displays high levels of economic efficiency.

1. Allocative efficiency: In both the short and long run we find that price is equal to marginal cost (P=MC) and thus allocative efficiency is achieved. At the ruling price, consumer and producer surplus are maximised. No one can be made better off without making some other agent at least as worse off – i.e. we achieve a Pareto optimum allocation of resources.
2. Productive efficiency: Productive efficiency occurs when the equilibrium output is supplied at minimum average cost. This is attained in the long run for a competitive market. Firms with high unit costs may not be able to justify remaining in the industry as the market price is driven down by the forces of competition.
3. Dynamic efficiency: We assume that a perfectly competitive market produces homogeneous products – in other words, there is little scope for innovation designed purely to make products differentiated from each other and allow a supplier to develop and then exploit a competitive advantage in the market to establish some monopoly power.

Some economists claim that perfect competition is not a good market structure for high levels of research and development spending and the resulting product and process innovations. Indeed it may be the case that monopolistic or oligopolistic markets are more effective long term in creating the environment for research and innovation to flourish. A cost-reducing innovation from one producer will, under the assumption of perfect information, be immediately and without cost transferred to all of the other suppliers.
That said a contestable market provides the discipline on firms to keep their costs under control, to seek to minimise wastage of scarce resources and to refrain from exploiting the consumer by setting high prices and enjoying high profit margins. In this sense, competition can stimulate improvements in both static and dynamic efficiency over time.
The long run of perfect competition, therefore, exhibits optimal levels of economic efficiency. But for this to be achieved all of the conditions of perfect competition must hold – including in related markets. When the assumptions are dropped, we move into a world of imperfect competition with all of the potential that exists for various forms of market failure

Revision Notes on all areas of AS & A2 Economics

Click here to access excellent revision material for all syllabus content. This shoulkd be a must look at at every day in the run up to exams.

Unit 2 & 4: Aggregate Demand - Revision Notes (with Links)

Updated revision notes on aggregate demand - there are several links for you to research further. Essential for Unit 2 & a really good refresher for Unit 4 students.
Aggregate demand(AD) = total spending on goods and services

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

C: Consumers' expenditure on goods and services: Also known as consumption, this includes demand for durables e.g. audio-visual equipment and vehicles & non-durable goods such as food and drinks which are “consumed” and must be re-purchased.

I: Capital Investment – This is spending on capital goods such as plant and equipment and new buildings to produce more consumer goods in the future. Investment includes spending on working capital such as stocks of finished and semi-finished goods.

Capital investment spending in the UK accounts for between 15-20% of GDP in any given year. Of this investment, 75% comes from private sector businesses such as Tesco, British Airways and British Petroleum and the remainder is spent by the government – for example building new schools or in improving rail or road networks. Investment has important effects on the supply-side as well as being an important component of AD. A small part of investment spending is the change in the value of stocks. Producers may find either than demand is running higher than output (i.e. stocks will fall) or that demand is weaker than expected and below current output (in which case the value of stocks will rise.)

G: Government Spending – This is spending on state-provided goods and services including public goods and merit goods. Decisions on how much the government will spend each year are affected by developments in the economy and the political priorities of the government.

Government spending on goods and services is around 18-20% of GDP but this tends to understate the true size of the government sector in the economy. Firstly some spending is on investment and a sizeable amount goes on welfare state payments. Transfer payments in the form of benefits (e.g. state pensions and the job-seekers allowance) are not included in current government spending because they are a transfer from one group (i.e. people paying income taxes) to another (i.e. pensioners drawing their state pension having retired, or families on low incomes).

X: Exports of goods and services - Exports sold overseas are an inflow of demand (an injection) into our circular flow of income and spending adding to aggregate demand.

M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the circular flow of income and spending.

Net exports measure the value of exports minus the value of imports. When net exports are positive, there is a trade surplus (adding to AD); when net exports are negative, there is a trade deficit (reducing AD). The UK has been running a large trade deficit for several years now.

The main components of aggregate demand are shown in the table above

Remember that

AD = C + I + G + X – M

Shocks to aggregate demand

Many unexpected events cause changes in the level of demand, output and employment. These events are called “shocks”. Some of the causes of AD shocks are as follows:

1.A large rise or fall in the exchange rate – affecting export demand and second-round effects on output, employment, incomes and profits of businesses linked to export industries.

2.A recession in main trading partners which affects demand for exports of goods and services.

3.A slump in the housing market or a big change in share prices

4.An event such as the credit crunch (global financial crisis) – involving a fall in the amount of credit available for borrowing by households and businesses.

5.An unexpected cut or an unexpected rise in interest rates or change in government taxation and spending – for example deep cuts in government spending as part of fiscal austerity

These shocks will bring about a shift in the aggregate demand curve

Factors causing a shift in AD

Changes in Expectations

Current spending is affected by anticipated income and inflation

When confidence falls, we see an increase in saving and businesses postpone investment projects because of worries over weak demand and lower expected profits.

Changes in Monetary Policy – i.e. a change in interest rates

If interest rates fall – this lowers the cost of borrowing and the incentive to save, encouraging consumption & investment

There are time lags between changes in interest rates and changes in AD

Changes in Fiscal Policy

Fiscal Policy refers to changes in government spending, taxation and borrowing

The Government may increase its expenditure e.g. financed by a higher budget deficit - this directly increases AD

Income tax affects disposable income e.g. lower income tax raises disposable income and should boost consumption.

Economic events in the world economy

International factors such as the exchange rate and foreign income

A depreciation in a currency makes imports dearer and exports cheaper - the net result should be that UK AD rises

An increase in overseas incomes raises demand for exports. In contrast a recession in a major export market will lead to a fall in exports and an inward shift of aggregate demand.

Changes in household wealth

Changing share and property prices affect the level of wealth

Declining asset prices can hit confidence / a fall in expectations

Changes in the supply of credit

The availability of credit is vital for the smooth functioning of most modern economies

Many banks and other lenders are now more reluctant to lend

Interest rates on different loans have become more expensive

Extension Reading for Contextual Knowledge

Here is a selection of articles for extension / enrichment reading on this topic

UK house prices see annual growth, Nationwide says - how might a recovery in house prices affect the different components of aggregate demand?

Budget 2013: Infrastructure spending boosted by £3bn a year - will this expansion in investment spending be sufficient?

Britain, the world and the end of the free lunch? - Britain's trade deficit increased in 2012, what does this mean for aggregate demand and prospects of a stronger recovery from recession?