Ebook Economics (7th edition): Part 2

(BQ) Part 2 book Economics has contents: Government policy towards business, the national economy, the roots of modern macroeconomics, money and interest rates, fiscal and monetary policy, economic problems of developing countries, global and regional interdependence,...and other contents.

ECON_C13.qxd 3/04/2009 11:20 Page 367 Chapter 13 Government Policy towards Business CHAPTER MAP 13.1 Competition policy 368 Competition, monopoly and the public interest The targets of competition policy Oligopolistic collusion: restrictive practice policy Competition policy in the European Union UK competition policy Assessment of competition policy 368 368 369 369 370 373 13.2 Privatisation and regulation 375 Nationalisation and privatisation How desirable is privatisation? Regulation: identifying the short-run optimum price and output Regulation: identifying the long-run optimum price and output Regulation in the UK Increasing competition in the privatised industries 375 375 377 378 378 382 In this chapter we continue our examination of government policy to tackle market imperfections The focus here is on the problem of market power We examine various policies the government or its agencies can use to prevent firms abusing a monopolistic or oligopolistic position In section 13.1 we examine ‘competition policy’ We will see that the targets of such policy include the abuse of monopoly power, the problem of oligopolistic collusion, and mergers that will result in the firm having a dominant position in the market Then in section 13.2, we look at privatisation and the extent to which privatised industries should be regulated to prevent them abusing their market power We also consider whether it is possible to introduce enough competition into these industries to make regulation unnecessary The relationship between government and business is always likely to be complex Governments face the twin pressures of having to ensure consumer protection while needing a dynamic and profitable business environment that will ensure high levels of employment, output and growth In this chapter we see the conflicts that can arise as a consequence ECON_C13.qxd 3/04/2009 11:20 Page 368 368 13 GOVERNMENT POLICY TOWARDS BUSINESS 13.1 COMPETITION POLICY Competition, monopoly and the public interest Most markets in the real world are imperfect, with firms having varying degrees of market power But will this TC power be against the public interest? This question has p24 been addressed by successive governments in framing legislation to deal with monopolies and oligopolies It might be thought that market power is always ‘a bad thing’, certainly as far as the consumer is concerned After all, it enables firms to make supernormal profit, thereby ‘exploiting’ the consumer The greater the firm’s power, the higher will prices be relative to the costs of production KI 20 Also, a lack of competition removes the incentive to p164 become more efficient But market power is not necessarily a bad thing Firms may not fully exploit their position of power – perhaps for fear that very high profits would eventually lead to other firms overcoming entry barriers, or perhaps because they are not aggressive profit maximisers Even if they make large supernormal profits, they may still charge a lower price than more competitive sectors of the industry because of their economies of scale Finally, they may use their profits for research and development and for capital investment The consumer might then benefit from new or improved products at lower prices Competition policy could seek to ban various structures For example, it could ban mergers leading to market share of more than a certain amount Most countries, however, prefer to focus on whether the practices of particular monopolists or oligopolists are anti-competitive Some of these practices may be made illegal, such as price fixing by oligopolists; others may be assessed on a case-by-case basis to determine whether or not they should be permitted Such an approach does not presume that the mere possession of power is against the public interest, but rather that certain uses of that power may be ? Try to formulate a definition of ‘the public interest’ The targets of competition policy There are three possible targets of competition policy Abuse of the existing power of monopolies and oligopolies: monopoly policy KI 20 p164 Monopoly policy seeks to prevent firms from abusing their economic power Although it is referred to as ‘monopoly’ policy, it also applies to many large oligopolists acting on their own The approach has been to weigh up the gains and losses to the public of individual firms’ behaviour As we saw in Figure 6.10 (on page 176), faced with the same cost curves as an industry under perfect competition, a monopoly will charge a higher price, produce a lower output and make a larger profit On the other hand, a monopolist may achieve substantial economies of scale, with the result that its price is below the competitive price (see Figure 6.11 on page 178) It may also use a proportion of its profits for investment and for research and development (R&D) This may result in better products and/or lower prices Thus the government (or regulatory authority, if separate from the government) has to work out, if it insisted on a reduction in price, whether R&D and other investment would thereby suffer, and whether the consumer would lose in the long run The growth of power through mergers and acquisitions: merger policy The aim of merger policy is to monitor mergers and prevent those that are considered to be against the public interest The gains and losses to the public must be weighed up, and the authorities must then decide whether or not a prospective merger should be allowed to proceed On the plus side, the merged firms may be able to rationalise Horizontal mergers in particular may allow economies of scale to be gained It may be possible to concentrate production on fewer sites, with a more intensive utilisation of capital and labour Also, a more efficient use may be made of transport fleets, with distribution in greater bulk Savings may be made in warehousing costs too There may also be some scope for rationalisation with vertical mergers It may be possible to concentrate various stages in the production process on one site, with consequent savings in transport and handling costs Then there are cost savings that apply to all types of merger: horizontal, vertical and conglomerate One of two head offices may be closed down Greater financial strength may allow the merged firm to drive down the prices charged by its suppliers The combined profits may allow larger-scale investment and R&D Finally, if two relatively small firms merge, their increased market power may allow them to compete more effectively against large firms On the negative side, mergers lead to a greater concentration of economic power, which could be used against the consumer’s interests This is particularly true of horizontal mergers, which will result in fewer firms for the consumer to choose from But even conglomerate mergers can lead to certain anti-competitive activities In particular, a conglomerate can use large profits gained in one market where it already has monopoly power to cross-subsidise prices in a competitive market, thereby driving out competitors ECON_C13.qxd 3/04/2009 11:20 Page 369 13.1 COMPETITION POLICY ? TC p50 What are the possible disadvantages of vertical mergers? What is more, rationalisation may lead to redundancies While this may be a potential Pareto gain, it is unlikely that the redundant will be fully compensated by the gainers In deciding how tough to be with mergers, the government must consider how this will affect firms’ behaviour If the government has a liberal policy towards mergers, the competition for ownership and control of other companies may force firms to be more efficient If the managers of a firm are afraid that it will be taken over, they will need to ensure that the firm is economically strong and that it is perceived by shareholders to be more profitable than it would be under alternative ownership This competition for corporate control (see pages 178–9) may lead to lower costs and thereby benefit the consumer It may, however, make firms even more keen to exploit any monopoly power they have, either in their battle for other firms, or in the battle to persuade shareholders not to vote for being taken over Government policy towards this market for corporate control will need to ensure that mergers and the possibility of mergers encourage competition rather than reducing it Oligopolistic collusion: restrictive practice policy In most countries, the approach towards cases of oligopolistic collusion, known as restrictive practices, tends to be tougher After all, the firms are combining to exploit their joint power to make bigger profits They could this by jointly trying to keep out new entrants; or they could agree to keep prices high and/or restrict output; or they could divide up the market between them, agreeing not to ‘poach’ on each other’s territory For example, two or more supermarket chains could agree to open only one supermarket in each district Banning formal cartels is easy Preventing tacit collusion is another matter It may be very difficult to prove that firms are making informal agreements behind closed doors Competition policy in the European Union Relevant EU legislation is contained in Articles 81 and 82 of the Amsterdam Treaty and in additional regulations Definitions Cross-subsidise To use profits in one market to subsidise prices in another Restrictive practices Where two or more firms agree to adopt common practices to restrict competition 369 covering mergers, which came into force in 1990 and were amended in 2004 Article 81 is concerned with restrictive practices and Article 82 with the abuse of market power The articles mainly concern firms trading between EU members and not cover monopolies or oligopolies operating solely within a member country The policy is implemented by the European Commission If any firm appears to be breaking the provisions of either article, the Commission can refer it to the European Court of Justice EU restrictive practices policy Article 81 covers agreements between firms, joint decisions, and concerted practices that prevent, restrict or distort competition In other words, it covers all types of oligopolistic collusion that are against the interests of consumers Article 81 is designed to prevent not oligopolistic structures (i.e the simple existence of co-operation between firms), but rather collusive behaviour No matter what form collusion takes, if the European Commission finds that firms are committing anti-competitive practices, they will be banned from doing so and possibly fined (up to 10 per cent of annual turnover), although firms have the right of appeal to the European Court of Justice Practices considered anti-competitive include firms colluding to any of the following: • Fix prices (i.e above competitive levels) • Limit production, markets, technical development or investment • Share out markets or sources of supply • Charge discriminatory prices or operate discriminatory trading conditions, such as to benefit the colluding parties and disadvantage others • Make other firms that sign contracts with any of the colluding firms accept unfavourable obligations which, by their nature, have no connection with the subject of such contracts In recent years, the Commission has adopted a tough stance and has fined many firms Case Study 6.4 in MyEconLab looks at the case of Microsoft, a firm whose abuse of its monopoly position has been the subject of ongoing investigations by both the US and EU authorities EU monopoly policy Article 82 relates to the abuse of market power and has also been extended to cover mergers As with Article 81, it is the behaviour of firms that is the target of the legislation The following are cited as examples of the abuse of market power As you can see, they are very similar to those in Article 81 • Charging unfairly high prices to consumers, or paying unfairly low prices to suppliers • Limiting production, markets or technical developments to the detriment of consumers ECON_C13.qxd 3/04/2009 11:20 Page 370 370 13 GOVERNMENT POLICY TOWARDS BUSINESS • Using price discrimination or other discriminatory practices to the detriment of certain parties • Making other firms that sign contracts accept unfavourable obligations which, by their nature, have no connection with the subject of such contracts Under Article 82, such practices can be banned and firms can be fined where they are found to have abused a dominant position A firm need not have some specified minimum market share before Article 82 can be invoked Instead, if firms are able to conduct anti-competitive practices, it is simply assumed that they must be in a position of market power This approach is sensible, given the difficulties of identifying the boundaries of a market, either in terms of geography or in terms of type of product EU merger policy The 1990 merger control measures tightened up the legislation in Article 82 They cover mergers where combined worldwide annual sales exceed a5 billion; where EU sales of at least two of the companies exceed a250 million; and where at least one of the companies conducts no more than two-thirds of its EU-wide business in a single member state Relevant mergers must be notified to the Commission, which must then conduct preliminary investigations (Phase 1) A decision must then be made, normally within 25 working days, whether to conduct a formal investigation (Phase 2) or to let the merger proceed A formal investigation must normally be completed within a further 90 working days (or 110 days in complex cases) The process of EU merger control is thus very rapid and administratively inexpensive The regulations are also potentially quite tough Mergers are disallowed if they result in ‘a concentration which would significantly impede effective competition, in particular by the creation or strengthening of a dominant position’ But the regulations are also flexible, since they recognise that mergers may be in the interests of consumers if they result in cost reductions In such cases they are permitted The merger investigation process is now overseen by a Chief Competition Economist and a panel which scrutinises the investigating team’s conclusions One concern of this panel is that the Commission, in being willing to show flexibility, is not too easily persuaded by firms so that it imposes conditions that are too lax and that rely too much on the firms’ co-operation Indeed, in the first 19 years of the merger control measures, 3917 mergers were notified, but only 185 proceeded to Phase and only 20 were prohibited In many cases (too many, claim critics), the Commission accepted the undertakings of firms There is considerable disagreement in the EU between those who want to encourage competition within the EU and those who want to see European companies being world leaders For them, the ability to compete in world markets normally requires that companies are large, which may well imply having monopoly power within the EU ? To what extent is Article 82 consistent with both these points of view? UK competition policy There have been substantial changes to UK competition policy since the first legislation was introduced in 1948 The current approach is based on the 1998 Competition Act and the 2002 Enterprise Act The Competition Act brought UK policy in line with EU policy, detailed above The Act has two key sets (or ‘chapters’) of prohibitions Chapter I prohibits various restrictive practices, and mirrors EU Article 81 Chapter II prohibits various abuses of monopoly power, and mirrors Article 82 The Enterprise Act strengthened the Competition Act and introduced new measures for the control of mergers Under the two Acts, the body charged with ensuring that the prohibitions are carried out is the Office of Fair Trading (OFT) The OFT can investigate any firms suspected of engaging in one or more of the prohibited practices Its officers have the power to enter and search premises, and can require the production and explanation of documents Where the OFT decides that an infringement of one of the prohibitions has occurred, it can direct the offending firms to modify their behaviour or cease their practices altogether Companies in breach of a prohibition are liable to fines of up to 10 per cent of their annual UK turnover Third parties adversely affected by such breaches can seek compensation through the courts The Competition Act also set up a Competition Commission (CC) to which the OFT can refer cases for further investigation The CC is charged with determining whether the structure of an industry or the practices of firms within it are detrimental to competition If a case is referred to the Competition Commission, the CC will carry out an investigation to establish whether competition is adversely affected If it finds that it is, it will decide on the appropriate remedies, such as prohibiting various practices UK restrictive practices policy Under the 2002 Enterprise Act, it is a criminal offence to engage in cartel agreements (i.e horizontal, rather than vertical, collusive agreements between firms), irrespective of whether there are appreciable effects on competition Convicted offenders may receive a prison sentence of up to five years and/or an unlimited fine Prosecutions may be brought by the Serious Fraud Office or the OFT Under the Act, the OFT can enter premises, seize documents and require people to answer questions or provide information But what practices constitute ‘cartel agreements’? These involve one or more of the following agreements by firms: price fixing; limiting supply, perhaps by each firm agreeing to an output quota; sharing out markets by geographical area, type or size of customer or nature of outlet (e.g bus ECON_C13.qxd 3/04/2009 11:20 Page 371 13.1 COMPETITION POLICY BOX 13.1 371 CASE STUDIES AND APPLICATIONS A LIFT TO PROFITS? Record EU fine for operating a lift and escalator cartel As we have seen, EU competition policy applies to companies operating in two or more EU countries The policy is implemented by the European Commission and it has the power to levy substantial fines on companies found to be in breach of the legislation In February 2007, the Commission imposed a record fine of a992 million on four lift and escalator manufacturers for operating a price-fixing cartel According to the EU Commission, the companies – ThyssenKrupp of Germany, Otis of the USA, Kone of Finland and Schindler of Switzerland – sought to freeze market share and fix prices ‘Projects that were rigged included lifts and escalators for hospitals, railway stations, shopping centres and commercial buildings.’1 The Commission last year passed new fining guidelines that will allow Brussels to further increase the financial pain on abusive companies in all new cases Officials have argued that the new rules will mean that more companies will be hit with the maximum penalty – a fine equivalent to 10 per cent of their annual global turnover The lift cartel operated in Germany, the Netherlands, Belgium and Luxembourg between at least 1995 and 2004 According to the Commission, the groups coordinated their bids to ensure that a designated group would win specific contracts ‘[To agree on bids] they usually met in bars and restaurants, they travelled to the countryside or even abroad, and they used pre-paid mobile cards to avoid tracking,’ the Commission said.2 companies agreeing not to run services in each other’s areas); collusive tendering for a contract, where two or more firms put in a tender at secretly agreed (high) prices; or agreements between purchasers (e.g supermarkets) to keep down prices paid to suppliers (e.g farmers) ? Are all such agreements necessarily against the interests of consumers? In the case of other types of agreement, the OFT has the discretion to decide, on a case-by-case basis, whether or not competition is appreciably restricted, and whether, therefore, they should be terminated or the firms should be exempted Such cases include the following: • Vertical price-fixing agreements These are price agreements between purchasing firms and their suppliers An example of this is resale price maintenance This is where a manufacturer or distributor sets the price for According to Jonathan Todd of the EU, ‘the result of this cartel is that taxpayers, public authorities and property developers have been ripped off big time These companies ensured that, by rigging the bids [i.e collusive tendering] and sharing the markets, the prices paid both for the installation and the maintenance were way above what they would have been if there had been a competitive market.’3 Neelie Kroes, the EU Competition Commissioner, said that ‘the national management of these companies knew what they were doing was wrong, but they tried to conceal their action and went ahead anyway The damage caused by this cartel will last for many years because it covered not only the initial supply but also the subsequent maintenance of lifts and escalators.’4 Of the four companies, ThyssenKrupp was given the largest fine (a480 million), and the biggest ever for a single company, because it was a ‘repeat offender’ It had received a previous fine of a3.2 million in 1998 for fixing stainless steel prices Under guidelines issued in 2006, repeat offenders face an automatic 50 per cent increase in fines ? What factors determine the likelihood that firms will collude to fix prices – despite the prospect of facing fines of up to 10 per cent of their annual global turnover? Europa Press release, http://europa.eu/rapid/pressReleasesAction.do?reference=IP/07/209 ‘Brussels imposes a992m fine on lift cartel’, Financial Times, 22 February 2007 ‘Record EU fine for lift “cartel” ’, http://news.bbc.co.uk/1/hi/business/ 6383913.stm Ibid retailers to charge It may well distribute a price list to retailers (e.g a car manufacturer may distribute a price list to car showrooms) Resale price maintenance is a way of preventing competition between retailers driving down retail prices and ultimately the price they pay to the manufacturer Both manufacturers and retailers, therefore, are likely to gain from resale price maintenance Definitions Collusive tendering Where two or more firms secretly agree on the prices they will tender for a contract These prices will be above those that would be put in under a genuinely competitive tendering process Resale (or retail) price maintenance Where the manufacturer of a product (legally) insists that the product should be sold at a specified retail price ECON_C13.qxd 3/04/2009 11:20 Page 372 372 13 GOVERNMENT POLICY TOWARDS BUSINESS BOX 13.2 CASE STUDIES AND APPLICATIONS MORE THAN A COINCIDENCE? School fees in the UK In November 2005 the Office of Fair Trading announced that 50 independent schools had been found guilty of operating a fee-fixing cartel The OFT found that schools had exchanged details of their planned fee increases between 2001 and 2004, in direct contravention of the 1998 Competition Act Bursars of all the schools had participated in an annual round-robin message and the OFT found that ‘this regular and systematic exchange of confidential information was anti-competitive and resulted in parents being charged higher fees than would otherwise have been the case’ The investigation took nearly two years and uncovered evidence which showed that schools routinely exchanged both cost and pricing information when preparing fee recommendations to governors One email, sent with details of over 20 competitor schools’ proposed fee increases, contained the message ‘Confidential please, so we aren’t accused of being a cartel’ Coincidence or cartel? Having been found guilty, the schools could have faced large fines, totalling 10 per cent of their turnover However, for the first time in a case of this nature the OFT negotiated a final settlement, allowing schools to pay a nominal penalty of £10 000 per school and to set up a charitable trust fund, to total £3 million, for the benefit of those who had been pupils at the relevant time The schools also had to admit that their participation in the exchange of information distorted competition However, stepping back from their initial judgement, the OFT did not make any finding about the effect of the cartel This final ruling acknowledged the schools’ adamant defence that the sharing of information had not resulted in higher fees; indeed some of the schools involved maintained that the exchange of information resulted in lower rather than higher fees If this argument is plausible, then what could explain the fact that independent schools’ fees rose by almost identical amounts each year? The answer lies in their cost • Agreements to exchange information that could have the effect of reducing competition For example, if producers exchange information on their price intentions, it is a way of allowing price leadership, a form of tacit collusion, to continue ? What problems are likely to arise in identifying which firms’ practices are anti-competitive? Should the OFT take firms’ assurances into account when deciding whether to grant an exemption? UK monopoly policy Under the Chapter II prohibition of the 1998 Competition Act, it is illegal for a dominant firm to exercise its market power in such a way as to reduce competition Any sus- structure; the major input to schools is labour, and wage inflation for teachers will be determined by salaries offered in the (much larger) state sector In addition, the top schools are likely to have very similar staff/student ratios The result is that all the independent schools are likely to face very similar increases in wage costs; the schools claimed that this was the cause of the very similar increases in fees In fact they went further and claimed that sharing good practice actually maximised operational efficiencies, something that is explicitly encouraged by the Charity Commission Charitable status Government scrutiny of independent schools did not end with the OFT investigation In 2006 the Charities Act was passed and under this Act various organisations, including independent schools and hospitals, lost their automatic right to charitable status They now have to prove that ‘people in poverty’ benefit from their services even if they cannot afford their fees The loss of charitable status would cost the schools £100 million a year in lost tax breaks In January 2008 the Charity Commission produced a landmark document which contained a series of recommendations for independent schools Guidelines were designed to enable the schools to meet the ‘public benefit’ test to allow them to hold onto their charitable status Amongst the proposals were suggestions that schools should offer bursaries to fund pupils from lowincome households and that they should share facilities and staff with local state schools In the guidance the Commission suggested that schools should still be able to charge ‘reasonable and necessary’ fees, but suggested that those keeping fees to a minimum would be more likely to benefit the public ? What costs, other than wages, would independent schools face? Would these costs support the schools’ claim that identical fee increases are driven by identical costs, rather than by collusion? pected case is investigated by the OFT, which uses a twostage process in deciding whether an abuse has taken place The first stage is to establish whether a firm has a position of dominance The firm does not literally have to be a monopoly ‘Dominance’ normally involves the firm having at least a 40 per cent share of the market (national or local, whichever is appropriate), although this figure will vary from industry to industry Also, dominance depends on the barriers to entry to new competitors The higher the barriers to the entry of new firms, the less contestable will be the market (see pages 179–83), and the more dominant a firm is likely to be for any given current market share If the firm is deemed to be dominant, the second stage involves the OFT deciding whether the firm’s practices constitute an abuse of its position As with restrictive practices, ECON_C13.qxd 3/04/2009 11:20 Page 373 13.1 COMPETITION POLICY Chapter II follows EU legislation It specifies the same four types of market abuse as does EU Article 82 (see above) Within these four categories, the OFT identifies the following practices as being overtly anti-competitive: • Charging excessively high prices These are prices above those that the firm would charge if it faced effective competition One sign of excessively high prices is abnormally high rates of profit • Price discrimination This is regarded as an abuse only to the extent that the higher prices are excessive or the lower prices are used to exclude competitors • Predatory pricing This is where prices are set at lossmaking levels, so as to drive competitors out of business (see page 210) The test is to look at the dominant firm’s price in relation to its average costs If its price is below average variable cost, predation would be assumed If its price is above average variable cost, but below average total cost, then the Director-General would need to establish whether the reason was to eliminate a competitor • Vertical restraints This is where a supplying firm imposes conditions on a purchasing firm (or vice versa) For example, a manufacturer may impose rules on retailers about displaying the product or the provision of after-sales service, or it may refuse to supply certain outlets (as with perfume manufacturers refusing to supply discount chains such as Superdrug) Another example is tie-in sales This is where a firm controlling the supply of a first product insists that its customers buy a second product from it rather than from its rivals The simple existence of any of these practices may not constitute an abuse The OFT has to decide whether their effect is to restrict competition If the case is not straightforward, the OFT can refer it to the Competition Commission (CC) The CC will then carry out a detailed investigation to establish whether competition is restricted or distorted If it is, the CC will rule what actions must be taken to remedy the situation UK merger policy Merger policy is covered by the 2002 Enterprise Act It seeks to prevent mergers that are likely to result in a substantial lessening of competition A merger or takeover will be investigated by the OFT if the target company has a turnover of £70 million or more, Definitions Vertical restraints Conditions imposed by one firm on another which is either its supplier or its customer Tie-in sales Where a firm is only prepared to sell a first product on the condition that its customers buy a second product from it 373 or if the merger results in the new company having a market share of 25 per cent or more The OFT conducts a preliminary investigation to see whether competition is likely to be threatened If it is, and if there is unlikely to be any substantial compensating benefit to consumers, the OFT refers the case to the Competition Commission If reference is made to the CC, it conducts a detailed investigation to establish whether the merger is likely to lead to a significant reduction in competition If so, it can prohibit the merger Alternatively, it can require the merged firm to behave in certain ways in order to protect consumers’ interests In such cases, the OFT then monitors the firm to ensure that it is abiding by the CC’s conditions CC investigations must normally be completed within 24 weeks The 2002 Act tightened up merger legislation In the past, the vast majority of mergers were not referred to the CC (or its predecessor, the Monopolies and Mergers Commission) Yet studies had shown that mergers were generally not in the public interest Mergers had contributed to a growing degree of market concentration in the UK and few benefits from cost reduction and research had occurred The 2002 Act sought to rectify this problem Between 2005 and 2008 a number of mergers were referred to the CC; these included the merger of Heinz and HP Foods, the purchase of 115 Morrisons stores by Somerfield, and Sky’s purchase of a 17.9 per cent stake in ITV However, in the autumn of 2008, following the announcement that a merger was proposed between Lloyds TSB and the troubled bank HBOS, the government said that it would overrule any objections raised by the competition authorities This highlights the fact that governments may sometimes prefer to take a pragmatic view of competition policy, particularly in times of economic crisis ? If anti-monopoly legislation is effective enough, is there ever any need to prevent mergers from going ahead? Assessment of competition policy With UK competition legislation having been brought in line with EU legislation, it is possible to consider the two together It is generally agreed by commentators that it is correct for the policy to concentrate on anti-competitive practices and their effects rather than simply on the existence of agreements or on the size of a firm’s market share After all, economic power is a problem only when it is abused When, by contrast, it enables firms to achieve economies of scale, or more finance for investment, the result can be of benefit to consumers In other words, the assumption that structure determines conduct and performance (see ECON_C13.qxd 3/04/2009 11:20 Page 374 374 13 GOVERNMENT POLICY TOWARDS BUSINESS BOX 13.3 CASE STUDIES AND APPLICATIONS WHAT PRICE FOR PEACE OF MIND? Exploiting monopoly power in the sale of extended warranties on electrical goods If you go into Currys, Comet, PC World or virtually any other high street retailer to buy an electrical good, such as a DVD player, a fridge or a computer, the sales assistant will probably be very keen to sell you an extended warranty (EW) These EWs are typically for three to five years and sometimes merely extend the product’s guarantee against breakdown beyond its normal one- or two-year expiry date Sometimes they go further and provide cover against other risks, such as accidental damage or theft These EWs are highly profitable for the retailer In 2002 they accounted for approximately 40 per cent of Dixons’ profits and 80 per cent of Comet’s It’s hardly surprising that retailers are very keen to sell them to you! In 2002 the Office of Fair Trading (OFT) published a report on EWs and concluded that ‘there is insufficient competition and information to ensure that consumers get good value, and that many electrical retailers may make considerable profits on the sale of EWs’ Research conducted by the OFT indicates that customers can feel pressurised to rush to a decision to buy an extended warranty when they buy their new appliance A high percentage of consumers had not thought about buying an extended warranty before they arrive at the store Buyers should think whether extended warranties offer them value for money OFT research found that the average washing machine repair costs between £45 to £65 So if a five-year extended warranty costs £150 on a £300 washing machine, it would need to break down four times for a consumer to benefit A recent Which? report highlights that modern domestic appliances are generally reliable It found that 81 per cent of washing machines didn’t break down at all in the first six years Some sales staff are paid commission on each extended warranty they sell, so may be keen for a customer to sign on the dotted line.1 The OFT was concerned that retailers were using their market power at the point of sale and benefiting from consumers’ ignorance It decided, therefore, to refer the case to the Competition Commission (CC), which published its report in December 2003 The CC report found that there was a ‘complex monopoly’2 in the market, worth £900 million per year, page 164) is not necessarily true, and certainly it is not necessarily true that market power is always bad and competitive industries are always good Also, most commentators favour the system of certain practices being prohibited, with fines applicable to the first offence This acts as an important deterrent to anticompetitive behaviour A problem with any policy to deal with collusion is the difficulty in rooting it out When firms all their deals which was working against the public interest It concluded that there had been an abuse of monopoly power, stating: Were this market fully competitive such that the top five EW retailers’ returns were no greater than their cost of capital,3 we estimate that EW prices would have been, on average, up to one-third lower Many of the practices that we have identified during the course of our investigation operate or may be expected to operate against the public interest They result in lack of choice, excessive prices, insufficient information, insufficient competition at point of sale, limited but not insignificant sales pressure, some terms which could be disadvantageous, and lack of information about the scope of protection under service-backed schemes.4 Despite these findings, the Competition Commission did not recommend banning shops from bundling warranties with electrical goods at the point of sale, despite many of the EWs being ‘unfair and uncompetitive’ Instead, it recommended that retailers should display prices for EWs alongside the price of the goods, both in shops and in advertisements It also recommended that the shops should provide information about customers’ rights and that customers should get a full refund on the EW if they cancelled within 45 days The government minister, the Secretary of State for Trade and Industry, accepted these findings and ruled that they should be implemented – which they were in April 2005 What features of the market for EWs distort competition? ? To what extent will the ruling by the government make the market for EWs competitive? OFT News Release, PN 68/02, October 2002 A complex monopoly is where several companies separately (i.e not collusively) are in a position to exploit a particular market advantage to the detriment of the consumer A measure of ‘normal profit’ Summary to Extended Warranties on Domestic Electrical Goods: A Report on the Supply of Extended Warranties on Domestic Electrical Goods within the UK, Competition Commission, Dec 2003 (http://www.competitioncommission.org.uk/rep_pub/reports/2003/485xwars.htm summary) ‘behind closed doors’ and are careful not to keep records or give clues, then collusion can be very hard to spot The cases that have come to light, such as that of collusive tendering between firms supplying ready-mixed concrete, may be just the tip of an iceberg ? If two or more firms were charging similar prices, what types of evidence would you look for to prove that this was collusion rather than coincidence? ECON_C13.qxd 3/04/2009 11:20 Page 375 13.2 PRIVATISATION AND REGULATION 375 Section summary Competition policy in most countries recognises that monopolies, mergers and restrictive practices can bring both costs and benefits to the consumer Generally, though, restrictive practices tend to be more damaging to consumers’ interests than simple monopoly power or mergers European Union legislation applies to firms trading between EU countries Article 81 applies to restrictive practices Article 82 applies to dominant firms There are also separate merger control provisions UK legislation is covered largely by the 1998 Competition Act and the 2002 Enterprise Act The Chapter I prohibition of the 1998 Act applies to restrictive practices and is similar to EU Article 81 13.2 The Chapter II prohibition applies to dominant firms and is similar to Article 82 The 2002 Act made certain cartel agreements a criminal offence and required mergers over a certain size to be investigated by the Office of Fair Trading, with possible reference to the Competition Commission Both the OFT and the CC were made independent of government The focus of both EU and UK legislation is on anti-competitive practices rather than on the simple existence of agreements between firms or market dominance Practices that are found after investigation to be detrimental to competition are prohibited and heavy fines can be imposed, even for a first offence PRIVATISATION AND REGULATION Nationalisation and privatisation One solution to market failure, advocated by some on the political left, is nationalisation If industries are not being run in the public interest by the private sector, then bring them into public ownership This way, so the argument goes, the market failures can be corrected Problems of monopoly power, externalities, inequality, etc can be dealt with directly if these industries are run with the public interest, rather than private gain, at heart Most nationalisation in the UK took place under the Labour government of 1945–51, when coal, railways, gas and steel were nationalised The Labour Party at the time saw nationalisation not just as a means of correcting market failures, but as something that was morally desirable It was seen to be much fairer and less divisive to have a society based on common ownership of the means of production than one where people were divided into separate classes: workers and capitalists This policy reflected the views of a population which had been through a long and hard war from 1939 to 1945; they were not prepared to return to the unequal society that had survived the end of the First World War and the hard economic times of the 1920s and 1930s By the mid 1970s, however, it became increasingly clear that the nationalised industries were inefficient and also a source of much industrial unrest A change of policy was introduced from the early 1980s, when Conservative governments under Margaret Thatcher and then John Major engaged in an extensive programme of ‘privatisation’, returning virtually all of the nationalised industries, including telecommunications, gas, water, steel, electricity and the railways, to the private sector By 1997, the year the Conservatives left office, the only nationalised industry remaining in the UK was the Post Office Other countries have followed similar programmes of privatisation in what has become a worldwide phenomenon Privatisation has been seen by many governments as a means of revitalising inefficient industries and as a golden opportunity to raise revenues to ease budgetary problems In 2008, however, many governments returned to the use of nationalisation This involved the full or part nationalisation of banks which were at risk of going bankrupt The use of nationalisation in this macroeconomic context of national or international economic crises is examined in section 23.4 How desirable is privatisation? Arguments for privatisation Market forces The first argument is that privatisation will expose these industries to market forces, from which will flow the benefits of greater efficiency, faster growth and greater responsiveness to the wishes of the consumer There are three parts to this argument • Greater competition in the goods market If privatisation involves splitting an industry into competing parts (for example, separate power stations competing to sell electricity to different electricity distribution companies), the resulting competition may drive costs and prices down • Greater competition for finance After privatisation a company has to finance investment through the market: it must issue shares or borrow from financial Definition Nationalised industries State-owned industries that produce goods or services that are sold in the market ECON_C13.qxd 3/04/2009 11:20 Page 376 376 13 GOVERNMENT POLICY TOWARDS BUSINESS institutions In doing so, it will be competing for funds with other companies, and thus must be seen as capable of using these funds profitably • Accountability to shareholders Shareholders want a good return on their shares and will thus put pressure on the privatised company to perform well If the company does not make sufficient profits, shareholders will sell their shares The share price will fall and the company will be in danger of being taken over The market for corporate control thus provides incentives for private firms to be efficient There has been considerable takeover activity in the water and electricity industries, with most of the 12 regional electricity companies and several of the water companies being taken over, often by non-UK companies Reduced government interference In nationalised industries, managers may frequently be required to adjust their targets for political reasons At one time they may have to keep prices low as part of a government drive against inflation At another they may have to raise their prices substantially in order to raise extra revenue for the government and help finance tax cuts At another they may find their investment programmes cut as part of a government economy drive Privatisation frees the company from these constraints and allows it to make more rational economic decisions and plan future investments with greater certainty Financing tax cuts The privatisation issue of shares earns money directly for the government and thus reduces the amount it needs to borrow Effectively, then, the government can use the proceeds of privatisation to finance tax cuts There is a danger here, however, that in order to raise the maximum revenue the government will want to make the industries as potentially profitable as possible This may involve selling them as monopolies But this, of course, would probably be against the interests of the consumer Potential problems with privatisation The markets in which privatised industries operate are unlikely to be perfect What is more, the process of privatisation itself can create problems Natural monopolies The market forces argument for privatisation largely breaks down if a public monopoly is simply replaced by a private monopoly, as in the case of the KI 20 water companies Critics of privatisation argue that at least p164 a public-sector monopoly is not out to maximise profits and thereby exploit the consumer Some industries have such great economies of scale that there is only room for one firm in the industry They are natural monopolies The best examples of natural monopolies are the various grids that exist in the privatised utilities: the national electricity grid, the national gas pipe network, the network of railway lines These grids account for a relatively high proportion of the total costs of these industries Figure 13.1 Natural monopoly The more intensively the electricity and gas grids are used, however, the lower their cost will become per unit of fuel supplied Similarly with railways: the relatively high costs of providing track and signalling, etc will become smaller per passenger, the more passengers use the railway In the short run, these costs are fixed Average fixed costs must necessarily decline as more is produced: overheads are being spread over a greater output In the long run, when new (electricity, gas, railway) lines can be built, these costs become variable It is still likely, however, that the costs per unit of output will decline, the higher the output becomes A pylon carrying ten lines does not cost five times as much as one carrying two This means that long-run average costs fall as more is produced In Figure 13.1, assume that the total industry output is Q With just one company in the industry, long-run average cost is therefore LRAC1 Now assume that the industry is split into two equal-sized companies, each with its own grid If total output remains at Q 1, the two firms will produce Q each at the higher long-run average cost of LRAC It is potentially more efficient, therefore, to have a single monopoly supplier whenever there is a natural monopoly It avoids wasteful duplication The problem is that the monopoly producer in a free market could use its power to drive up prices The long-run profit-maximising position is illustrated in Figure 13.2 The monopolist produces Q m at a price Pm and at a cost of LRACm There is a misallocation of resources If, however, the industry remained nationalised, or if it was privatised but regulated, it could be run as a monopoly and thus achieve the full economies of scale And yet it could be directed to set a price that just covered costs (including normal profits), and thus make no more profit than a highly competitive industry In Figure 13.2, it would produce Q n at a price of Pn We examine regulation later in this section Planning and the co-ordination of industry Road use and road construction affect the demand for railways and vice versa ECON_Z06.qxd I:6 3/04/2009 11:29 Page INDEX economic growth (continued) new growth theory 405 output gaps 398, 399 potential growth 398, 399, 408 potential output 398, 403 and productivity 641, 646–7 rate of economic growth 388 savings rate 643–4, 645, 648 short-term 398–403 stagflation 466, 592–4, 598, 622–3 steady-state growth path 645 supply-side policies 651 without technological progress 642–5 with technological progress 645–9 trend growth 399, 400 workforce increase 644 see also business cycle; growth economic interaction 23 economic models 25– demand equations 36–8 equilibrium prices 45 supply equations 42 economic and monetary union (EMU) 693, 748–55 economic profit 159 economic rent 241 economic shocks asymmetric 753 fixed exchange rates 716–17 floating exchange rates 721–2, 723, 731–4 random shocks 41, 499, 569 reverse shocks 631 supply shocks 558–9, 617 economic systems classifications 16–8 command economy 18–20 free-market economy 20–4 mixed economy 24, 323–8 economies of scale 136–8, 139, 150–1, 171–2, 221, 680, 681 and customs unions 695 EU single market 699 mergers 222 monopolies 173–4, 178 economies of scope 138, 174 ECOWAS 696 education 349–50, 643, 662–3, 777 efficiency 10, 23, 305–13 allocative 306, 310 of capital equipment 482 in consumption 10, 306 externalities 306, 313–15, 322, 323–4, 331 in factor markets 312 in goods markets 311–12 large machines 137 Pareto improvement 305, 306, 308 Pareto optimality 305, 306, 308, 317 private 305, 306, 307–8, 311 productive 139 social 305–8, 310–13 efficient market hypothesis 266–7 efficient wage hypothesis 251–5 EFTPOS 528 elasticity of demand 58, 59, 60–1 income elasticity 67–9, 115, 717, 768 labour markets 244 price elasticity 57– 65 elasticity of supply financial capital 737 labour markets 240–1 price elasticity 65–7, 78 elections 448, 600, 625 electricity industry 380–1 eliminating inflation 622 embargoes 683 emission reductions 334–5 emissions charges 348 emissions trading 352, 354 EMU (economic and monetary union) 693, 748–55 endogenous growth theory 648 endogenous money supply 526, 546–7 endogenous variables 475 energy efficiency 343 Enron 224 Enterprise Act 370 envelope curve 148 environment 342–66 command-and-control (CAC) systems 348–9 and developing country debt 786–7 ecocide 786–7 education 349–50 energy efficiency 343 and free trade 683 Gaia philosophy 345 game theory 354–6 global warming 344 government actions 354–6 grandfathering 354 green taxes 348, 350–1 legislation 348–9 market failures 346 market-based policies 347–8 optimum decision making 345–6 population growth 342–3 public opinion 343, 352–3 sustainability 345–6, 787 tradable permits 350– traffic congestion 256–61 urban transport policies 361–5 voluntary agreements 349 waste disposal 343 environmental charges 348 equality 244–5, 252–3 equation of exchange 458 equations A:8–9 equi-marginal principle 101–2 equilibrium circular flow of income 393 economic models 45 in exchange rates 532–3, 706, 723–5, 731, 744 general equilibrium 307, 308–10, 312 in goods and money markets 531–2, 551–2 interest rate 574, 583 in international trade 680 macroeconomic 427 national income 486, 642–3, 706 perfect competition 167–8, 169 price and output 225 prices 20, 42–5 monopolies 175–6 and monopolies 175 partial equilibrium 44 unemployment 420–421, 423–5, 454, 632–3 wages 20, 423, 615 equities see shares equity 10 ERM (exchange rate mechanism) 586, 596, 749 –51 ethnic groups 420 Euribor 506 euro 572, 724–5, 751–2 European Central Bank (ECB) 511, 580–1, 602–3 see also central banks European Union (EU) agricultural policy 88–90, 697 business finance 265 carbon trading system 355 competition policy 369 –70, 697, 699 EMU (economic and monetary union) 693, 748–55 ERM (exchange rate mechanism) 596, 749–51 free movement of people 241 history 697 and inflation 752 investment 752 ECON_Z06.qxd 3/04/2009 11:29 Page INDEX European Union (EU) (continued) merger policies 370 monetary aggregates 521 monetary policy 580–1 monopolies 369–70 mutual recognition principle 698, 699 new member states 701, 703 oligopolies 700 regional policy 697 restrictive practices 369 Single European Act 660, 698–703 social policy 698 social protection benefits 300 Stability and Growth Pact 572–3, 575, 751–2 tax harmonisation 697, 701 excess burden of tax 325 excess capacity 188 exchange controls 683, 756–8 exchange equalisation account 515 exchange rate bands 714–15, 758 exchange rate index 442 exchange rate mechanism (ERM) 586, 596, 749–51 exchange rate overshooting 726 exchange rate regimes 707, 709 –10 intermediate 710, 714 –15 exchange rates 389, 442–7 adjustable peg system 714, 729–30 appreciation 444 Asian currency crisis 748 and the balance of payments 445, 706 –28 adjustable peg 729–30 fixed rates 710, 712, 716–20 floating rates 712–14, 720–8 bands 714–15, 758 Bretton Woods system 729–30 controlling transactions 683, 756– crawling peg system 714 currency union 751 demand and supply curve shifts 444 –5 depreciation 444, 465, 540, 713–14 determination 443–5 devaluation 714, 729–30 dollar 724–5, 744 equilibrium 444, 532–3, 706 fixed 446, 457, 541, 592, 709–12, 716–20, 737–9 floating 443, 541, 593, 709–714, 720–8, 730–6, 739–40 fluctuations 445–6, 727, 735–6, 742, 755–9 and GDP (gross domestic product) 394 –5 government intervention 515, 710 –12 import substitution 771 and interest rates 446, 540, 586 J-curve effect 729–30 joint float system 714 Keynesian economics 468, 719–20 and the money supply 524–5, 541, 710 new classical theories 719 nominal 707, 717 overshooting 726 real rates 709, 717 revaluation 714 speculation 530, 718–20, 725–7, 731, 755 sterling 731–5 targeting 595–6, 601, 706, 714 –15, 758 Tobin tax 756–8 total currency flow balance 706 transmission mechanism 536, 539 – 41 yuan 775 Exchequer account 514 excise duties 291 exogenous money supply 526, 546 –7 exogenous variables 475 expansion path 149 expansionary fiscal policy 438 expectations 49, 105, 471, 633–4 adaptive hypothesis 620, 622–3, 626, 627, 635 and aggregate supply 614, 627–30 of asset price changes 530–1 and consumption 477 and the demand for money 530–1 and inflation 435, 594, 619–20 and investment 482, 484–5 and markets 455–6 of output 616 of price changes 35, 41, 71–5 rational 469–70, 626, 627, 628–9, 635 expectations-augmented Phillips curve 619–26 expenditure changing 712, 713–14 expenditure method of GDP calculation 394, 412–13 expenditure reducing 712 expenditure switching 712–13 explicit costs 131 exploitation of cheap labour 676 I:7 exports and aggregate demand 393 circular flow of income 392, 483 developing countries 772–6 income elasticity of demand 717 primary exports 767–9 substitution effect 426 world multiplier effects 689 extended warranties 374 extensive-form games 204 external balance of payments 706–7 external benefits 313, 314, 315 external costs 313, 314 external diseconomies of scale 139 external economies of scale 139, 170 external policy objectives 706 external shocks fixed exchange rates 717 floating exchange rates 723, 731– externalities correction by taxation 323–4 efficiency 306, 313–15, 322, 323–4, 331 privatised industries 377–8 extreme Keynesians 470 factor price equalisation 767 factors of production 4, 13, 15, 21 factor price equalisation 767 fixed factors 124, 125, 128, 135 and international trade 677 market efficiency 312 non-human 258–9 variable factors 124 fairness 10, 378 fallacy of composition 84, 492 family behaviour 116–17 farmers 83–4 Federal Reserve 566, 579, 602–3 see also central banks final expenditure 563 financial account of the balance of payments 439, 441–2 financial capital 258, 263, 777 elasticity of supply 737 imperfections in capital markets 661, 664 and investment 264–7, 661, 664 financial crowding out 460, 461, 545 financial deregulation 506, 659–60 financial economies 138 financial flexibility 254 financial interdependence 744–5 financial intermediaries 504 ECON_Z06.qxd I:8 3/04/2009 11:29 Page INDEX fine tuning 562, 565–6 demise of in 1960s 592–4 Keynesian view 590–2, 600–1 firms 14–15 alternative theory of the firm 124 circular flow of income 390–1 competitive rivalry 682 interdependence 613 market valuation 223 organisational structure 214–15 theory of the firm 124 first-best solution 323, 377 first-degree price discrimination 206, 208 first-mover advantage 205 fiscal drag 565 fiscal policy 438, 562 –73 automatic stabilisers 565–7, 575 and the business cycle 562 deflationary 438, 446, 459, 465, 562 discretionary 565–7, 567 effectiveness 588–9 fixed exchange rates 718, 737–8 floating exchange rates 728, 739 and the Great Depression 460 and inflation 438 ISLM analysis 588–90 Keynesian economics 464, 589 political manipulation 600 pure fiscal policy 568 reflationary 438, 465, 562, 593 stimulus packages 566 supply-side 562, 565 timing problems 569–71 in the UK 571–3, 590–9 see also taxation fiscal rules 571–3 fiscal stance 563– fixed costs 131, 132, 133–4, 182 fixed exchange rates 446, 457, 541, 592, 709–12, 716–20, 737–9 advantages 718–19 disadvantages 719–20 external shocks 717 fiscal policy 718, 737–8 internal shocks 716–17 international liquidity 719–20 ISLM analysis 737–9 long-term balance of payments problems 717–18 monetary policy 718, 719, 738–9 speculation 718–19, 720 totally fixed exchange rates 709–10 fixed factors 124, 125, 128, 135 flat organisations 215 flexibility aggregate supply 455 financial 254 labour market 254–5 prices 233, 454–5, 457, 626 wages 454–5, 615, 626 flexible firm 254 flexible working 255 floating exchange rate see free-floating exchange rates flow diagrams 15, 390–3 see also circular flow of income flow of goods 260 flow-of-funds equation 525– food prices 777 foreign currency reserves 441, 442, 446 foreign exchange markets see exchange rates foreign-based monopolies 684 forward markets 76, 727 foundation trusts 660 franchising 224, 382 free capital movement 660 free movement of people 241 free trade 660, 671, 676, 683 and the environment 683 and market power 686 free-floating exchange rates 443, 541, 593, 709–714, 720–8, 730–6, 739 – 40 advantages 727 carry trade 721–2 disadvantages 727 equilibrium 723–5, 731 external shocks 723, 731–4 fiscal policy 728, 739 internal shocks 721–2 ISLM analysis 739–40 monetary policy 728, 739–40 purchasing power parity (PPP) 395, 396, 721, 722–3, 733 speculation 725–6, 727, 731 UK experience 731–5 uncertainty 727 volatility 735–6 free-market 16, 20–4, 323, 457–8 advantages 337–8 Keynesian economics 468 and sustainability 345 free-rider problem 316 free-trade areas 693, 696 freedom of market entry 165, 170–1, 186 see also barriers to market entry frictional unemployment 423–4, 657 Friedman, Milton 466, 619 FSA (Financial Services Authority) 514 full-employment level of national income 492, 493 functional distribution of income 276, 280 –2 functional flexibility 254 functional relationships A:8 –9 funding the national debt 578 future payments 504 futures markets 76 G7 meetings 749 G8 meetings 748–9 G20 meetings 749 Gaia philosophy 345 game theory 201–6, 215, 354–6 compromise strategy 204 decision tree 204–5 dominant strategy games 202 first-mover advantage 205 maximax strategy 202, 354 maximin strategy 202 multiple-move games 204 prisoners’ dilemma 202, 203, 354 single-move games 201–4 threats and promises 204 timing 204–5 GATT 690–1 GDP (gross domestic product) 393–7 calculation 394, 409–14 convergence in GDP per head 640, 641 and crime 397 and the distribution of income 397 exchange rates 394–5 GDP at market prices 411 inflation 394 nominal GDP 394, 395 per-capita GDP 394, 396, 644 real GDP 394, 395 standards of living 395–7, 410–11 and taxation 411, 412 underground economy 396, 397 unrecorded goods and services 395 – see also national income gender differences inequality and poverty 253, 282 unemployment 419–20 general equilibrium in international trade 680 in markets 307, 308–10, 312 general government debt 562 general government deficits and surpluses 562 ECON_Z06.qxd 3/04/2009 11:29 Page INDEX geographical distribution of income 282 –3 Germany and inflation 430 Giffen goods 119 gilts and bonds 265, 508–9, 514, 525, 575 Gini coefficient 278 global growth strategy 225 global warming 344 globalisation 454–5, 556, 669, 690, 743 –7 GNY (gross national income) per capita 763–6 gold reserves 441, 442, 446 gold standard 457, 459 Golden Rule 571–3, 575 golden-rule savings rate 644 Goodhart’s Law 585, 604 goods in joint supply 41 goods markets 544–56, 629 changes money supply 544–7 efficiency 311–12 equilibrium 551–2 Gorbachev, Mikhail 19 government borrowing Bank of England role 514 and interest rates 460 national debt 562, 578 public sector net cash requirement 563, 571, 575 government expenditure balanced budgets 460 capital expenditure 563 circular flow of income 392, 460–1, 483 cost-benefit analysis 329–36 current expenditure 563 deficits and surpluses 525, 562, 563–5, 575, 708 in the US 744–5 effects of changes in 567–8 final expenditure 563 Golden Rule 571–3, 575 public works programmes 460–1 reducing 654 structural deficits and surpluses 564–5 transfers 563 see also state benefits government intervention 16–17, 24, 313–22, 456, 661–6 advantages 313–22, 661 collective bargaining 250–1 direct provision of goods and services 328, 664 disadvantages 337, 667 exchange rates 515, 710–12 forms of 323–9 grants 664 industrial reorganisation 665 by information provision 328 by legislation 327–9 national economic planning 664 protection of people’s interests 320, 327 protectionism 688–9 rationalisations 664 rejection of market allocation 80–1 research & development 665 selective intervention 664–7 small firms assistance 665 by taxation 323–6 see also legislation government policies 26–7, 52–3, 389, 499 in the 1950s and 1960s 464–5, 591–2 in the 1970s 592–4, 731–2 in the 1980s 467, 594–6, 654, 711, 734 –5 1990 onward 596–9, 735 agriculture 82–91 competition 370–3 contractionary 712 demand management 591–2 deregulation 506, 659–60 devolved budgeting 660 discretionary 595, 600, 604–5 distribution of income 288 economic growth 408 and elections 448, 600, 625 failure 336–9 Great Depression 459–60, 689 industrial 661, 666 inequality and poverty 285, 286 internal market in the NHS 660 international co-ordination 745–7 mergers 368–9, 370, 373 monopolies 372–3 nationalisation 328, 375, 664 prices and incomes 51–4, 327–8, 592 Private Finance Initiative (PFI) 658–9, 660 privatisation 375–82, 659 regional 666–7 restrictive practices 370–2 rules-based approach 598, 600–7 urban 666–7 see also fiscal policy; monetary policy government surplus 325 I:9 grandfathering 354 grants 664 graphs A:5, A:8 Great Depression 459–60, 689 green taxes 348, 350–1 greenhouse effect 342, 344 Greenspan, Alan 566 gross domestic product see GDP gross national income 413 see also GNY gross value added at basic prices 409, 411, 412 growth consortium 224 diversification 222 franchising 224 global strategy 225 internal expansion 221–2 joint ventures 223 maximisation 221 mergers 222–3, 226–7 networks 225 price and output equilibrium 225 strategic alliances 223, 225 subcontracting 224–5 vertical integration 221–2 of world trade 672 see also economic growth H-form organisations 215 Hall, R.L 199 harmful goods 685 harmonisation of policies 746–7, 748 –9 harmonisation of taxes 697, 701 Hayek, Friedrich von 338–9 health care 80–1, 322, 660 heavily indebted poor countries (HIPC) 788, 790 Heckscher-Ohlin theory 767, 778 Hicks-Kaldor criterion 333, 336 HICP (harmonised index of consumer prices) 428 hire-purchase controls 576 historic costs 131 Hitch, C.J 199 homogenous labour 237–8 horizontal equity 288 horizontal mergers 222, 368 ‘hot money’ 731–2, 736, 744–5 Hotelling, Harold 269 hours of work 284 supply of hours curve 238, 239 households 14–15 circular flow of income 390–1 composition 282, 285 ECON_Z06.qxd I:10 3/04/2009 11:29 Page 10 INDEX households (continued) disposable income 413, 477, 480–1 sources of income 280–1 housing market 46–7 human capital 257, 643 human development index (HDI) 765, 766 human life, value of 332 human resources human wants 4, hyperinflation 430–1, 432 hysteresis 468, 616, 633 IBOR (inter-bank offer rate) 506, 516 identical products 165 identification problem 50–51 idle balances 529 illegal goods 81–2 illiquid assets 506, 508–9, 524 imperfect competition 164, 185 imperfect information 105–6, 627 imperfections in capital markets 661, 664 implicit costs 131 import-substituting industrialisation 766, 769 –72 imports 593, 768 and aggregate demand 393 circular flow of income 391–2, 480–1 controls 446 determinants of the level of 480–1 harmful goods 685 income elasticity of demand 717, 768 levies see tariffs licensing 683 and the standard of living 688 substitution effect 426, 766, 769–72 world multiplier effects 689 incentives 50, 217, 289, 294–6, 337, 565, 655–6 under socialism 339 incidence of tax 78 income and the balance of payments 440 and car ownership 358 and demand 35 diminishing marginal utility 106–7, 279 disposable income 413, 477, 480–1 distribution see distribution of income earnings statistics 279–80 of farmers 83–4 flow diagrams see circular flow of income and house prices 47 income-consumption curve 114–5 indifference analysis 112–13, 114 –15 price elasticity of demand 58–9 real income 114 redistribution 276, 288, 292–4, 298–9, 429 rich and poor people 245, 257, 270 and share prices 49 sources of household income 280–1 spending patterns 279–80 see also distribution of income; wages income effect 32, 116, 117–18, 139, 295, 425–6 income elasticity of demand 67–9, 115 exports 717 imports 717, 768 income method of GDP calculation 394, 411–12 income tax 289–90, 293–4 negative income tax 298 income-consumption curve 114, 115 increasing opportunity costs 13 increasing returns to scale 136, 140–1 independence 186 of the Bank of England 511–12, 574 independent risks 109 index numbers A:6 –7 indicative planning 664 indifference analysis 109–22 budget line 112–13 income changes 112–13, 114–15 labour market 240 optimum consumption point 113 –14 price changes 113, 115, 116–19 taxation 298–9 indifference curves 110–11, 298–9 indifference map 111 indifference set 110 indirect taxes 77–9, 289, 290–1, 294 individuals’ demand curve 115–16 indivisibilities 137 Indonesia 786–7 induced investment 496 induction 25 industrial action 250 industrial relations 138 industry concentration 166 declining 684, 686 effective rate of protection 771 government policies 661, 666 infant industries 684 infrastructure 139, 777, 782 inward and outward-looking industrialisation 772–3 reorganisation 665 size 139 inefficiency 178 inelastic demand 58, 59– 60 for loans 584 inequality and poverty 245, 252–3, 276–87, 321 in the 1800s 284 analysis of poverty 276–7 causes 284–6 earnings statistics 279–80 G8 summits 748–9 gender differences 282 government policies 285, 286 household composition 282, 285 inflation rate of the poor 279 poverty trap 298, 301 types of inequality 276–7 and wealth 284 see also state benefits infant industries 684 inferior goods 35, 69, 118 infinitely elastic demand 60–1 inflation 6, 388–9, 393, 428–38, 447–9, 556 –9 in the 1950s and 1960s 591 accelerationist theory 620, 621 aggregate demand and supply 393, 556 –9, 616 –19 balance of payments 431, 717 in China 435 classical theories 458–9, 626–32 cost-push 432–3, 593, 617–19 costs 429–32 death of inflation 434–5 demand-pull 432, 434, 464, 616–17, 618 demand-shift 434–5 demand-side policies 438 eliminating 434–5, 622 in eurozone countries 752 expectations 435, 594, 619–20 fiscal policies 438 GDP (gross domestic product) 394 German 430 hyperinflation 430–1, 432 and investment 429–30 Keynesian economics 463–4, 467, 492–5, 632–5 labour market 629–30 ECON_Z06.qxd 3/04/2009 11:29 Page 11 INDEX inflation (continued) and the money supply 438, 466, 471, 575–6 and the poor 279 rate of inflation 389, 428, 556 redistribution of income 429 in Serbia 430 stagflation 466, 592–4, 598, 622–3 structural 434–5 supply shocks 558–9 supply-side policies 438, 652 targeting 470, 544, 556, 596–7, 600–7, 618–19, 625 and uncertainty 429–30 and unemployment 436–7, 471, 494, 620–1, 632–5 in Zimbabwe 430–1 inflationary gap 493– informal sector 17–18 information asymmetric 217 imperfect 105–6, 627 lack of 214–15 infrastructure 139, 777, 782 injections 392, 482–3, 486–9, 491, 544 –5 and the money supply 544–5 inner circular flow of income 391 innovation 179, 404, 651 input costs 132 input-output analysis 18 –19 insider dealing 266–7 insiders 250, 468 insurance 107–9 integrated transport policy 364 inter-bank markets 506, 515, 518, 524 Interbrew 191 interdependence 21, 308–10 of firms 190, 613 international trade 743–5 interest rates 264, 457, 531–2, 583–6 and aggregate demand 426, 586 Bank Rate 508, 584, 592 central bank control 583–6 and the demand for money 528, 537–8, 545–6, 551 equilibrium 574, 583 and exchange rates 446, 540, 586 and government borrowing 460 IBOR (inter-bank offer rate) 506, 516 and import substitution 771 and investment 482, 538–9, 546, 549 and the money supply 526–7, 582 –3 portfolio balance 541, 542–3 and the credit crisis 602–3 transmission mechanism 536–9 intermediate exchange rate regimes 710, 714 –15 internal balance of payments 706–7 internal expansion 221–2 internal market in the NHS 660 Internal Market Scoreboard 700, 702 internal policy objectives 706 internal rate of return 262 internal shocks 716–17 free-floating exchange rates 721–2 international business cycle 746 international co-ordination 745–7 international liquidity 719–20, 730 International Monetary Fund (IMF) 729, 787–8 international trade 23 absolute advantage 673 comparative advantage 672–6, 767–9, 771 definition 673 and terms of trade 677– competition 681 competitive advantage of nations 681–2 costs of production 672, 680–1 developing countries 766–76 economies of scale 680, 681 factor markets 677 free trade 660, 671, 676 and the environment 683 and market power 686 general equilibrium diagrams 680 globalisation 454–5, 556, 669, 690, 743 –7 growth of world trade 672 interdependence 743–5 multiplier 743 opportunity costs 674–5, 677 preferential trading 692–7 restrictions 683–92 specialisation 672, 677 terms of trade 677–9, 769 trade creation 693–4, 699 trade cycle 400–1 trade diversion 694–5, 700 US trade imbalance 744–5 welfare gains 679–80 intervention price (CAP) 86–7, 88 interventionist policies 424, 653, 661–7 intimidation 175 inventories see stocks of goods investment 14, 261 and aggregate supply 613–14 I:11 and the balance of payments 441 and the business cycle 497 in China 774–5 circular flow of income 392, 482–3 and economic growth 403, 408, 497 in eurozone countries 752 and expectations 482, 484–5 financing 264–7, 661, 664 imperfections in capital markets 661, 664 and increased consumer demand 482 induced investment 496 and inflation 429–30 instability 496–7 and interest rates 482, 538–9, 546, 549 internal rate of return 262 net present value 262 present value 261–2 rate of return 261 risks 263 tax incentives 656 investment banks 505–6 inward-looking industrialisation 772 –3 ISEW (Index of Sustainable Economic Welfare) 410–11 ISLM analysis 548–56 fiscal policy 588–90 fixed exchange rates 737–9 free-floating exchange rates 739–40 monetary policy 588–90 money markets 548–56 isocost approach 143 isoquant analysis 140, 142, 148–9 issue of banknotes 512, 514 J-curve effect 729–30 Japan, flexible working 255 Jevons, William Stanley 102 joint float system 714 Joint Implementation (Kyoto Protocol) 352, 355 joint ventures 223 just-in-time 229–30, 255 Kaldor, N 333 Keynesian 45 degree line 475–6, 491, 494 –5 Keynesian economics 454, 462–5, 615 –16 aggregate demand 468, 590–2, 612 aggregate supply 612 business cycle 495–500 deflationary policies 635 ECON_Z06.qxd I:12 3/04/2009 11:29 Page 12 INDEX Keynesian economics (continued) exchange rates 468, 719–20 extreme Keynesians 470 fiscal policy 464, 589 free market 468 government and industry cooperation 468 inflation 463–4, 467, 492–5, 632–5 labour market 462, 615–16 market for loanable funds 462–3 moderate Keynesians 470 Monetarist-Keynesian debate 466–9, 470, 589–90, 592, 595 monetary policy 464, 589 new Keynesians 470 post-Keynesians 471 reflationary policies 634 structural policies 467, 468 supply-side policies 652 unemployment 422, 463–4, 467, 492–5, 632–5 kinked demand theory 199–200 Kyoto Protocol 347, 352–3 labour market aggregate demand 420–1 aggregate supply 420–1, 614–15 classical theories 614–15 demand for labour 242–4 discrimination 256–7 division of labour 137 and economic growth 403–4 elasticity of labour demand 244 elasticity of labour supply 240–1 flexibility 254–5 homogenous labour 237–8 indifference analysis 240 and inflation 629–30 marginal cost of labour 242 marginal revenue of labour 242 mobility of labour 240–1, 424 movement of labour 237 natural wastage 248 output per employed person 639–40, 646 participation rate 644 perfect knowledge 237 perfect labour market 237–8 primary labour market 254–5 secondary labour market 255 shirking 252–3 skilled workers 282 supply of hours curve 238, 239 supply of labour curve 238–41, 423 and tax cuts 654–6 turnover rates 253 workforce increase 644 see also trade unions; wages labour movement 249–51 labour theory of value 238 Laffer, Art 295 Lagrangian multipliers 114, 144 laissez-faire policies 456 lamb consumption 36–8 Lancaster, Kelvin 120 land 4, 258–9, 268–70 and economic growth 404 property rights 324 reform 777 large numbers, law of 109 law of comparative advantage 673 law of demand 32 law of diminishing returns 125, 126, 128, 142 law of large numbers 109 leakages 391 least-cost combination of factors 139–40, 143–4 legal protection 174 legislation anti-competitive 369–73 Charities Act 372 environmental 348–9 price-cap regulation 379 privatised industries 377–82 trade union 250–1 traffic congestion 362 lender of last resort 515 lending by banks 507–9, 576 central banks 577 inelastic demand for loans 584 maturity gap 510 maturity transformation 505 risk transformation 505 wholesale loans 505, 506 liabilities of banks 506–7 libertarian theories 338–9, 652 LIBOR 506, 516 limit pricing 175 linear functions A:8–9 liquidity banks 509–10, 515–18, 522–3, 574 – international 719–20, 730 liquidity preference 528, 540 liquidity ratio 510 liquidity trap 538 LM curve 550–1 loanable funds 263–4, 457, 457–8 loans see lending by banks location of production 138 lock-outs 250 logistics 160 London Club 786 London Congestion Charge 363–4 London Inter-bank Offered Rate (LIBOR) 508, 516–7 long run aggregate supply 613–16 average cost curve 146–7 equilibrium 186–7 marginal cost 147 neutrality of money 575– under perfect competition 166 production 124, 136–50 profit maximisation 218–19 shut-down point 159, 160 long-term finance 264–5 long-term loans 508 long-term monetary control 574–5 Lorenz curve 277– loss minimising output 159 Lucas, Robert 627 M-form organisations 214–215 Maastricht Treaty 572, 698, 751 macroeconomics MacSharry reforms 90 Malthus, Thomas Robert 126–7 managed floating 714, 730–5 managerial utility maximisation 219 manufactured resources marginal benefits 9–10, 310 marginal capital/output ratio 496 marginal consumer surplus 99 marginal costs –10, 13, 133, 134–5, 147–8, 310, A:10 of labour 242 marginal disutility of work (MDU) 238 marginal efficiency of capital 262, 403 marginal external benefit 313–5, 323–4, 330 marginal external cost 313–5, 323–4, 346 marginal physical product 127, 129, 141 marginal private benefit 314–5 marginal private cost 314 –5 marginal product approach 139–40, 144 marginal productivity theory 242, 251 marginal propensity to consume 477, 479, 490–1 to import 480 to save 479 marginal rate of factor substitution 111, 142 marginal rate of transformation 311–2 ECON_Z06.qxd 3/04/2009 11:29 Page 13 INDEX marginal revenue 151–2, 153–4 of labour 242 marginal social benefit 308–9, 311–2, 314–5, 323–4, 346, 348, 359 marginal social cost 308–9, 311–2, 314–5, 323–4, 345–6, 348, 359–60, 377–8 marginal tax propensity 479 marginal utility theory 96 –104 demand curves 100–1, 104 marginal rate of substitution 111 mark-up cost pricing 231– market clearing 43 market demand schedule 33 market distortion and taxation 289 market failure 313, 320–2 environmental 346 and property rights 326 see also government intervention; social efficiency market for loanable funds 457, 462–3 market loans 508 market power 32, 164, 317–19, 368 and free trade 686 and wages 246–8 market share 193 market valuation 223 market-based policies environmental 347–8 supply-side 652, 654–61 unemployment 424 markets 15, 44 contestable 179–83 costless exit 182 entry barriers 173–5, 189, 222 and expectations 455–6 freedom of entry 165, 170–1, 186 general equilibrium 307, 308–10, 312 interdependence 21, 308–10 perfect markets 32 social efficiency 306, 308 social objectives 24 underground 53, 54 see also free-market Marx, Karl 102, 238 maturity gap 510 maturity transformation 505 maximax strategy 202, 354 maximin strategy 202 maximisation of growth 221 maximum price 52, 53, 54 maximum/minimum point of a curve A:11–12 May Committee 460 mean A:5 – means-tested benefits 298, 299 median A:6 medium of exchange 503 medium-term finance 264 Menger, Carl 102, 338 menu costs of inflation 429 mergers 174 government policies 368–9, 370, 373 and growth 222–3, 226–7 monopolies 223 takeover constraint 221 takeovers 174, 199 merit goods 320 microeconomics 5–6, 7–11 choice 7–8, 9, 10–11 definition flow diagrams 15 marginal costs and benefits 9–10 objectives 10 opportunity costs 8, 9, 11, 13–14, 130–1 minimum efficient plant size 150–1 minimum efficient scale 150–1, 699 minimum prices 51, 52–4, 86–7 minimum reserve ratio 574 –5, 578, 580 minimum wage 52, 287 minimum/maximum point of a curve A:11–12 Mises, Ludwig von 338–9 mixed economies 16, 24 mobility of labour 240–1, 424 models see economic models moderate Keynesians 470 moderate monetarists 470 Monetarist-Keynesian debate 466–9, 470, 589–90, 592, 595 monetary aggregates 521 monetary base 520 monetary base control 581–2 monetary policy 438, 542, 574–87 aggregate demand 586, 590–2 effectiveness 588–9 in Europe 580–1 fixed exchange rates 718, 719, 738 –9 floating exchange rates 728, 739–40 ISLM analysis 588–90 Keynesian economics 464, 589 medium and long-term 574–6 and national income 536–44 policy targets 574 political manipulation 600 short-term 576 in the UK 590–9 I:13 Monetary Policy Committee (MPC) 515, 574, 583, 602 money 4, 503–4 demand for money 527–31 long-run neutrality 576 multiplier 522–4, 523, 582 printing extra money 460 quantity theory 458, 460, 462–3, 466, 536 money illusion 436, 614, 616 money markets 515–18, 548 Bank of England operations 515–18 equilibrium 531–2, 551–2 ISLM model 548–56 money supply 463, 466, 471, 520–27 broad money (M4) 520 changes in 536, 541–4 controlling 576–83 credit creation 520–3 economic growth 466 endogenous 526, 546–7 and exchange rates 524–5, 541, 710 exogenous 526, 546–7 flow-of-funds equation 525–6 goods market changes 544–7 increase in injections 544–5 inflation 438, 466, 471, 575–6 interest rates 526–7, 582–3 long-run neutrality of money 576 and national income 503 portfolio balance 541–2 public-sector deficits see budgets quantity theory of money 458, 460, 462–3, 466, 536 rise in the money supply 524–5 sterilisation 710, 712 targets 585, 601 velocity of circulation 536, 542–4 money transfers and the balance of payments 440 monopolies 164, 173–9, 368 advantages 178–9 barriers to entry 173–5 correction by taxation 324–5 costs 174 cross-subsidising prices 368, 369 deadweight welfare loss 319 definition 173 disadvantages 176–8 economies of scale 173–4, 178 equilibrium prices 175–6 EU policies 369–70, 700 foreign-based 684 import substitution 771 mergers 223 natural monopolies 173–4, 181, 376 ECON_Z06.qxd I:14 3/04/2009 11:29 Page 14 INDEX monopolies (continued) network economies 174 price discrimination 179 public interest 176–9, 188–9 regulatory bodies 327 UK policies 372–3 vertical restraints 373 monopolistic competition 164, 189–9 monopsony 246, 247, 686 Mont Pelerin Society 338–9 moral hazard 108, 512 morale 253–5 mortgages 47 motoring costs 357–8 movement of labour 237 multinational companies 215, 223–5, 684, 770–2, 777–9 multi-stage production 137 multiple aims (of firms) 228–30 multiple-move games 204 multiplier effects 463, 497 bank deposits 522, 577 international trade 689, 743 money multiplier 522–4, 523, 582 national income 486–91, 569 formula 488, 490 regional multiplier 666, 700 mutual recognition principle 698, 699 NAFTA (North American Free Trade Association) 696 Nash equilibrium 198–199, 202 national debt 562, 578 national economic planning 664 national income 393–7, 486–92 aggregate demand 475 effect of monetary changes 536–44 equilibrium 486, 642–3, 706 flow concept 503 full-employment level 492, 493 gross national income 413 Keynesian 45 degree line 475–6, 491, 494–5 and the money supply 503 multiplier effect 486–91, 569 multiplier formula 488, 490 net national income 413 steady-state level 643 see also GDP (gross domestic product) National Loans Fund 514 nationalisation 328, 375, 664 natural level of output 615 natural level of unemployment 421, 423–5, 615, 621 natural monopolies 173–4, 181, 376 natural resources natural wastage 248 near money assets 523 negative income tax 298 neo-Austrian school 652 neoclassical theory 238, 242, 309, 336–7, 652, net national income 413 net present value 262 network economies 174 networks 225 new classical theories 469, 626–32 exchange rates 719 growth 405 supply-side policies 652–3 wages 238 new Keynesians 470 new products 179 NHS (National Health Service) 80–1, 322, 660 NI (National Insurance) 290 nominal exchange rate 707, 717 nominal GDP 394, 395 nominal values A:6 non-accelerating inflation rate of unemployment (NAIRU) 621 non-bank private sector 523, 524 non-collusive oligopolies 190, 196 –200 non-excludability 315–16 non-human factors of production 258 –9 non-linear functions A:9 non-monetary externalities 331 non-price competition 188, 200 non-renewable resources 269, 343 non-rivalry 315 non-tariff barriers 683, 698 normal goods 35, 69, 117 normal profit 157–9 normal rate of return 264 normative statements 27 Northern Rock 503, 517 number unemployed 416 numerical flexibility 254 occupations 281–2 odds in gambling 106–7 OECD Environmental Outlook 343 OFT (Office of Fair Trading) 370, 372–3, 374 oil prices 59, 593, 731, 731–2, 734, 783 – oligopolies 164, 189–201, 368, 369 barriers to entry 189 Bertrand model 198–9 cartels 190, 192, 194–5, 196, 370 –1 collusive 190–6, 369 countervailing power 200 Cournot equilibrium 198 Cournot model 197 duopoly 197 and the EU single market 700 health care 322 interdependence of firms 190 kinked demand theory 199–200 Nash equilibrium 198–199, 202 non-collusive 190, 196 –200 price leadership 192–3 public interest 200 quotas 192 reaction functions 197 regulatory bodies 327 restrictive practices 369 tacit collusion 192, 193 oligopsony 246 OPEC 194–5 open economies 439, 440 open-market operations 577, 578, 579, 710, 712 opportunity costs 8, 9, 11, 13–14, 130–1 and international trade 674–5, 677 optimal currency area 753, 754 optimum level of consumption 98–9, 101–2, 113 –14 optimum production point 143–4 optimum savings rate 643–4 optimum tariff 686, 687 organisational economies 137 organisational slack 229–30 organisational structure 214–15 output classical theories 457–8 and expectations 616 input-output analysis 18–19 loss minimising 159 marginal capital/output ratio 496 maximisation and costs 144 natural level of output 615 per employed person 639–40, 646 under perfect competition 168 potential output 398, 403 and prices 42–51, 225 output gaps 398, 399 outsiders 250, 468 outward-looking industrialisation 772 –3 overheads 137–138 overheating 744–5 overshooting (exchange rates) 726 ECON_Z06.qxd 3/04/2009 11:29 Page 15 INDEX Paish, Frank 570 paradox of thrift 492 parallel money markets 515, 518 Pareto criterion 333 Pareto improvement 305, 306, 308 Pareto optimality 305, 306, 308, 317 Paris Club agreements 784–5 parking restrictions 362 partial derivative A:13 partial differentiation A:12–13 partial equilibrium 44 participation rate 644 Paulson Plan 517 peak-load pricing 206, 207 per-capita GDP 394, 396, 644 perfect competition 32, 164, 165 –73 compared to monopolistic competition 188–9 economies of scale 171–2 long run equilibrium 169 long run supply curve 169–70 long run under perfect competition 166 and output 168 and pricing 167 and profit 168 public interest 172 short run equilibrium 167–8 short run supply curve 168–9 short run under perfect competition 165 wages 237–45 perfect knowledge 165, 170, 237 perfect markets 32 labour markets 237–8 perfectly contestable markets 179– 80 performance measurement 230 perks 219 petrol sulphur content 334–5 PFI (Private Finance Initiative) 658–9, 660 Phillips curve 436–7, 465, 466–7, 494 clockwise Philips loops 622–3 expectations-augmented 619–26 rightward shifts 623 physical capital 263 picketing 250 pie charts A:4 planned economies 16, 18–20, 338–9 planning 18–20, 664 plant economies of scale 137 point elasticity 63–5 police service 316 policy harmonisation 746–7, 748–9 taxes 697, 701 policy objectives external 706 internal 706 see also government policies; targeting political business cycle 448, 625 poll taxes 290 polluter pays principle 324–5, 348, 350 –1 pollution 347, 362 pooling risks 107, 109 population growth 126–7, 342–3, 779 portfolio balance 541, 542–3 positive statements 27 post-Keynesians 471 post-war libertarianism 338–9 potential demand and supply potential growth 398, 399, 408 potential output 398, 403 poverty see inequality and poverty Poverty Funds 790 poverty trap 299, 301, 565, 657 power, market see market power precautionary motive for holding money 528–9 predatory pricing 210–11, 373 predictions 25–6 preferential trading 692–7 Premier League 177 present value 261–2 price benchmarks 196 price discrimination 179, 206–11, 373 price elasticity of demand 57–65 arc elasticity 61–3 average (midpoint) formula 63 consumer expenditure 59–61 cross-price elasticity 69–70 elastic demand 58, 59, 60–1 incomes 58–9 inelastic demand 58, 59– 60 marginal revenue 154 motoring 357 point elasticity 63–5 proportionate (percentage) measurement 58 substitute goods 58 taxation 78 time periods 59, 71 unit elasticity of demand 58 price elasticity of supply 65–7 arc method 67 costs 67 taxation 78 price index A:6–8 see also consumer prices index (CPI) price leadership 192–3 I:15 price makers 154 price mechanism 20, 20–1, 363 supply and demand 32–51 price takers 32, 152, 154, 165 price-cap regulation 379 price-consumption curve 115 price-fixing agreements 371–2 prices 20–1, 425–8 aggregate demand 425–9, 471 agricultural 82–3 average cost pricing 196, 231–3 Bank of England survey 232–3 benchmarks 196 of capital 261 classical theories 458–9 and consumption 32 control 51–4, 327–8, 592 cost-based pricing 231–3 and demand 32–3 equilibrium prices 20, 42–5 and monopolies 175 partial equilibrium 44 expectations of price changes 35, 41, 71–5 flexibility 233, 454–5, 457, 626 food prices 777 indifference analysis 113, 115, 116 –19 limit pricing 175 mark-up cost pricing 231–4 maximum price 52, 53, 54 minimum price 51, 52–4, 86–7 output determination 42–51 peak-load pricing 206, 207 under perfect competition 167 relative prices 24 resale price maintenance 371 and supply 39 prices and incomes policies 51–4, 327–8, 592 primary care trusts 660 primary exports 767–9 primary labour market 254–5 primary stock market 265 principal-agent problem 216–17 principle of diminishing marginal utility 96 printing extra money 460 prisoners’ dilemma 202, 203, 354 private efficiency 305, 306, 307–8, 311 Private Finance Initiative (PFI) 658–9, 660 privatisation 375–82, 659 problem of the second best 323 procurement policies and free trade 684 ECON_Z06.qxd I:16 3/04/2009 11:29 Page 16 INDEX producer surplus 306–8, 319, 325, 688, 694 producers rational behaviour 124 share of tax on goods 78 total producer surplus 307 product development 188 product differentiation 174, 186 product method of GDP calculation 394, 409–11 production 4, 475 average physical product 127, 129 Cobb-Douglas production function 140, 141 and consumption 396 costs international trade 672, 680–1 long run 146–50 short run 130–6, 148 external benefits 314 external costs 314 industry size 139 isocost approach 143 isoquant approach 140, 142, 148–9 just-in-time 229–30, 255 law of diminishing returns 125, 126, 128, 142 location 138 long run theory 124, 136–50 loss minimising output 159 marginal physical product 127, 129, 141 marginal product approach 139–40, 144 optimum production point 143–4 productive efficiency 10 scale of production 136–8, 139, 150–1 short run theory 124–36, 145 shut-down point 159, 160 and social efficiency 306–7 subsistence production 17–18 total physical product 125–7 very long run production 145 very short run production 145 see also factors of production production function 125–30 production possibility curve 11–14 and macroeconomics 14 and microeconomics 12–14 production quotas 89 productive efficiency 10, 139 productivity 132, 404 and economic growth 641, 646–7 marginal productivity theory 242, 251 total factor productivity 646 productivity deals 247 profit maximisation 41, 124, 155–61, 163 difficulties 214–16 employment levels 242–3 land and capital 258–9 long run 218–19 price discrimination 208–10, 211 time periods 215–16 profit maximising rule 156 profit satisficing 216, 228, 230 profitability 123 of banks 509, 510, 520 and capital 264 definition of profit 157–9 goods in joint supply 41 logistics 160 under perfect competition 168 rate of profit 166–7 progressive taxes 292 property owner-occupiers 410–11 property rights 324, 326, 347 proportional taxes 292 proportionate values A:5 protection of people’s interests 320, 327 protectionism see trade restrictions prudential control 514 public goods 315–16, 328 public interest alternative maximising theories 225 contestable markets 182–3 monopolies 176–9 monopolistic competition 188–9 oligopolies 200 perfect competition 172 price discrimination 210–11 and satisficing 230 public limited companies 216 public sector budget balance 708 public sector deficits 525, 562, 563–5, 575, 708 in the US 744–5 public sector net cash requirement (PSNCR) 563, 571, 575 public transport 357–8, 361–2, 365 public works programmes 460–1 purchasing power parity (PPP) 395, 396, 721, 722–3, 733 purchasing power standard (PPS) GDP 395 pure fiscal policy 568 pure profit 159 qualifications 284 quantiles 277 quantitative easing 577, 586, 587 quantity demanded 33 quantity theory of money 458, 460, 462–3, 466, 536 quintiles 277 quotas 89, 192, 446, 683 racial discrimination 256–7 radical left policies 471 raising taxes 296–8, 569 random shocks 41, 499, 569 random walk theory 267 Rank Xerox 174 rate of discount 262 rate of economic growth 388 rate of exchange see exchange rates rate of inflation 389, 428, 556 rate of interest see interest rates rate of profit 166–7 rate of return 261, 528–9 rational behaviour 305 choices consumers 96, 99–100, 306 decision making 9, 10 producers 124 rational expectations 469–70, 626, 627, 628–9, 635 rationalisation 137, 664 rationing 54 raw materials 4, 404 see also resources reaction functions 197 Reaganomics 655, 734 real balance effect 426 real business cycle theory 469, 630–1 real exchange rate 709, 717 real GDP 394, 395 real income 114 real values A:6 real-wage unemployment 421–2 recession 6, 499, 539, 639, 719 see also business cycle recessionary gap 492–3 rediscounting bills of exchange 515 redistribution of income 276, 288, 292–4, 298–9, 429 reflationary policies 438, 465, 562, 593 Keynesian economics 634 regional multiplier effects 666, 700 regional policies 666–7, 697 regional unemployment 419, 424, 424 regression analysis 38 regressive taxes 292 regulation of banks 514 ECON_Z06.qxd 3/04/2009 11:29 Page 17 INDEX regulatory bodies 327, 379 see also legislation regulatory capture 382 rejection of market allocation 80–1 relative prices 24 rent 258, 268–70, 410–11 repeated games 204 replacement costs 131 repo markets 507, 515, 516–17, 584 reverse repos 508 resale price maintenance 371 rescheduling debt 784–7 research & development 665 reserves banks 508, 574–5, 577, 578, 580 government 441, 442, 446 resource crowding out 460, 461 resources 4, 13, 342–3 common resources 316–17, 318 competitive advantage of nations 681 full use 6, 14 non-renewable 269, 343 productivity 404 raw materials 4, 404 restrictive practices 369 EU policy 369 UK policy 370–2 see also trade restrictions retail banking 505 returns to scale 136, 141–2 revaluation of the exchange rate 714 revenue 150–5 and logistics 160 sales revenue maximisation 219–21 reverse repos 508 reverse shocks 631 Ricardo, David 102 rich and poor people 245, 257, 270 risk 75 – attitudes 217–18 in cost-benefit analysis 332–3 and demand 105–9 and investment 263 transformation 505 see also uncertainty risk averse people 106 risk loving people 106 risk neutral people 106 road building 361 road pricing 363–5 Rowntree Foundation 285 RPI minus X formula 378–9 rules-based policies 598, 600–7 rural-urban migration 779, 781 salaries see wages sale and repurchase agreements 507 sales revenue 150–5 and logistics 160 maximisation 219–21 Sargent, Thomas 627 satisficing 216, 228, 230 saving 391, 392, 457, 478–9 and consumption 480–1 and economic growth 643–4, 645, 648 golden-rule saving rate 644 optimum saving rate 643–4 paradox of thrift 492 Say’s law 458 scale of production 136–8, 139, 150 –1 scarcity 4, 5, 8, 13 school fees 372 Scottish & Newcastle 191 search unemployment 423– seasonal unemployment 425 Seattle 690 second derivative A:12 second derivative test A:12 second-best solution 323, 324, 377 second-degree price discrimination 206 secondary labour market 255 secondary marketing 510, 511 secondary stock market 265 secondary union action 251 securitisation 510–11, 512 selective intervention 664–7 selective use of data A:5 self-fulfilling speculation 72 selfish behaviour 103 semi-strong stock market efficiency 266 sensitivity analysis 332 Serbia 430 set-aside 89–90 Setanta 177 shares 265 short selling 74 speculation 527–9 yield on a share 267 see also stock market shirking 252–3 shocks see economic shocks short run aggregate supply 612–13 equilibrium 186 production 124–36, 145 shut-down point 159, 160 under perfect competition 165 I:17 short selling 74 short-term economic growth 398–403 short-term finance 264 short-term loans 508 short-term monetary policy 576 short-termism 266 shut-down point 159, 160 sight deposits 507 Singapore 364 Single European Act 660, 698–703 single-move games 201–4 size distribution of income 276, 277– 80 skills 282 deskilling 467, 468 Sky 177 small firms assistance 665 Smith, Adam 22, 102 Snowdon, Philip 460 social benefit 314 Social Charter 698 social cost 313 social efficiency 305–8, 310–13 and production 306–7 and sustainability 345, 346 social implications of choice 10–11 social indifference curves 311–3 social justice 328 social objectives 24 social policy, European Union (EU) 698 social protection benefits 300 social rate of discount 333 social security contributions 290 social-impact standards 349 socialism 18–19, 50, 339 socially efficient road space 360 socially efficient road usage 359–60 Soviet Union 18–19, 50 Special Liquidity Scheme 577 Special Purpose Vehicles (SPV) 511 specialisation 137, 672, 677, 774 specific taxes 77, 291 speculation 47, 71–5, 528–30 and exchange rates 530, 718–20, 725–7, 731, 755 in futures markets 76 in shares 528–30 short selling 74 stabilising speculation 72–3 spending patterns 279–80 spot prices 76 stabilising speculation 72 –3 stability of economic growth 401–2 Stability and Growth Pact 572–3, 575, 751–2 ECON_Z06.qxd I:18 3/04/2009 11:29 Page 18 INDEX stagflation 466, 592–4, 598, 622–3 stakeholders 228, 229 Stalinist system 18 standardised unemployment rate 417 standards of living 395–7, 410–11, 688 state benefits 286, 298–301 benefits in kind 298 and the circular flow of income 391 equity between recipients 288 income redistribution 298–9 means-tested 298, 299 poverty trap 299, 301, 565, 657 tax credits 301 unemployment 565, 657 universal 298 statistics A:1–A:13 absolute values A:5 bar charts A:4 base year A:6 consumer prices index (CPI) 428, A:7 cross-section data A:4 diagrams A:1–3 differentiation A:9 –14 equations A:8–9 functional relationships A:8 –9 graphs A:2–4, A:8 index numbers A:6 –7 linear functions A:8–9 maximum/minimum point of a curve A:11–13 mean A:6 median A:6 nominal values A:6 non-linear functions A:9 partial derivative A:13 partial differentiation A:14, A:15 pie charts A:4 proportionate values A:5 real values A:6 second derivative A:12 second derivative test A:12 selective use of data A:5 tables A:2–4 time periods A:6 time-series data A:2 – weighted average A:7– steady-state growth path 645 steady-state level of national income 643 sterilisation 710, 712 sterling exchange rate 731–5 Stern Report 344 stimulus packages 566 stock appreciation 410, 412 stock market 48–9, 265–7, 661 Big Bang 659–60 efficient market hypothesis 266–7 random walk theory 267 see also shares stocks of goods 260, 269, 409–10 fluctuations in 497, 499 stop-go policies 465, 592, 730 straight-line demand curve 65, 154 strategic alliances 223, 225 strategic behaviour 190 strategic trade theory 684, 685 strong stock market efficiency 266 structural deficits and surpluses 564–5 structural inflation 434–5 structural policies 467, 468 structural reforms 787–8 structural unemployment 424, 632 –3 sub-prime mortgages 511, 512 –13 subcontracting 224–5 subsidies 288, 323–6, 689 agricultural 85–6, 89 subsistence production 17–18 substitute goods 34, 58, 69 substitutes for cars 357–8 substitutes in supply 40–1 substitution effect 32, 116, 117, 118, 239, 426 and the balance of payments 712 –13 exports 426 imports 426, 766, 769–72 and taxation 295, 565 sugar production 90 sunk costs 131, 182 supernormal profit 159, 169 supplier numbers 41 supply 5, 39–42 agricultural 83, 85, 87 of capital services 259–63 change in quantity supplied 41 change in supply 21, 41, 45 determinants of 40–1 economic models 42 of finance 263 goods in joint supply 41 and price 39 price elasticity of supply 65 –7 of road space 358–9 substitutes in supply 40 –1 see also aggregate supply supply curve 39– 40, 41, 43–4 identification problem 50–51 labour market 420–1 perfect competition 168–70 shifts 444–5 supply of labour 238–41, 423 supply of hours 238, 239 supply schedule 39 supply shocks 558–9, 617 supply-side policies 7, 102, 446, 455, 467, 631 competition policies 658–60 and economic growth 651 fiscal policy 562, 565–7 and inflation 438, 652 interventionist 653, 661–7 Keynesian approach 652 link with demand-side policies 653 – market-oriented 652, 654–61 new classical approach 652–3 Reaganomics 655, 734 Third Way 653, 658–9, 667 and unemployment 651–2, 665 and wages 656–7 support prices 88–9, 90 surpluses agricultural 88 on the balance of payments 719, 722 consumer surplus 98 –9 surveys 417 survival strategy 217–18 sustainability 345–6, 787 swapping debt 789 Sweezy, Paul 199 tables A:8 tacit collusion 192, 193 takeover constraint 221 see also mergers targeting exchange rates 595–6, 601, 706, 714–15, 758 by firms 228 inflation 470, 544, 556, 596–7, 600–7, 618–19, 625 money supply 574, 585, 601 tariff escalation 770 tariffs 291, 446, 683, 687–8 agricultural 86 –7, 89 carbon tariffs 685 optimum tariff 686, 687 tastes 34, 477, 481, 685, 768 tax allowances 289, 297–8 tax avoidance 289, 293 tax credits 301 tax cuts 239, 296–7, 568, 654–6 tax evasion 289, 293 ECON_Z06.qxd 3/04/2009 11:29 Page 19 INDEX taxation 323–6 balance of types of tax 291–2 capital gains tax 290 circular flow of income 391, 479–80 corporate tax 290, 656 correction of externalities 323–4 correction for monopolies 324–5 cost of collection 288 customs duties 291 cutting taxes 239, 296–7, 569, 654– deadweight loss of a tax 294, 325 direct taxes 289–90 disincentive effects 289, 294–6 distribution of income 277 and employment 654–6 excess burden 325 excise duties 291 and GDP calculation 411, 412 government surplus 325 green taxes 348, 350–1 harmonisation 697, 701 horizontal equity 288 incentives 289, 294–6, 565, 655–6 income effect 295 income redistribution 288, 292–4 income tax 289–90, 293–4 negative income tax 298 indifference curve analysis 298–9 indirect taxes 77–9, 289, 290–1, 294 labour supply 654–6 marginal tax propensity 479 market distortion 289 monopolies 324–5 of motorists 363 poll taxes 290 price elasticity of demand 78 price elasticity of supply 78 progressive taxes 292 proportional taxes 292 raising taxes 296–8, 568 regressive taxes 292 requirements of a good tax system 288 –9 social security contributions 290 subsidies 288, 323–6 substitution effect 295, 565 traffic congestion 363 VAT (Value Added Tax) 291, 701 vertical equity 288 wealth taxes 290 windfall tax 324 see also fiscal policy Taylor rule 604, 606–7 teamwork 255 technical inefficiency 178 technological unemployment 424 technology 147, 594, 642–9, 651, 768, 777–9 technology-based standards 349 terms of trade 677–9, 769 Thatcher, Margaret 594–5, 654 theory of the firm 124 Third Way supply-side policies 653, 658–9, 667 third-degree price discrimination 206, 208, 210 threats and promises 204 thrift 492 Thurow, Lester 685 tie-in sales 373 time costs 104 time deposits 507 time lags in the business cycle 499 in demand elasticity 59, 71 in factor markets 320 in fiscal policy 569–71 time-series data A:2 – tit-for-tat 204 tobacco taxes 79 Tobin tax 756–8 tolls 363–5 total consumer expenditure on a product 59 total consumer surplus 99, 319 total costs 132–3, 135 total currency flow balance 706 total factor productivity 646 total physical product 125–7 total private surplus 308 total producer surplus 307 total quality management (TQM) 255 total revenue 150, 152, 154 total revenue per period of time 59 total social surplus 308 total utility 96, 97–8 totally inelastic demand 60 tradable permits 350– trade blocs 692–3, 696 trade creation 693–4, 699 trade cycle 400–1 trade diversion 694–5, 700 trade in goods account 439 trade restrictions 683–92 arguments in favour 684–7 methods of restricting trade 683–4 problems with 687–9 retaliation threats 684, 689 strategic trade theory 684, 685 and unemployment 688 I:19 World Trade Organisation (WTO) 689 –92 see also international trade trade in services account 439–40 trade unions 249, 656–7 closed-shop agreements 250 collective bargaining 248–51 industrial action 250 legislation 250–1 productivity deals 247 restrictions on 657 secondary action 251 union monopoly or oligopoly 247– traffic congestion 256–61 allocation of road space 357–9 atmospheric pollution 362 complementary services 358 costs 360–1 demand for road space 357–8 environmental damage 360 integrated transport policy 364 new road building 361 parking restrictions 362 public transport provision 357–8, 361–2, 365 regulation and legislation 362 restricting car access 362 socially efficient road space 360 socially efficient road usage 359 – 60 substitutes for cars 357–8 supply of road space 358–9 taxation 363 time costs 359–60 tolls 363–5 tragedy of the commons 317, 318 train fares 207 training 253, 662–3, 666 transactions demand for money 527–31, 541 transfer payments 391, 412 transfers 563 transmission of funds 505 transmission mechanisms exchange rates 536, 539–41 interest rates 536–9 transport costs 138 transport policies 256–61, 361–5 transposition deficit (EU) 700–1 Treasury bills 508, 515, 577 trend growth 399, 400 turning points in the business cycle 631 turnover rates in the labour market 253 ECON_Z06.qxd I:20 3/04/2009 11:29 Page 20 INDEX U-form organisations 214, 215 uncertainty 75–6, 221–2 floating exchange rates 727 and inflation 429–30 and mergers 223 see also risk underemployment 779 underground economy 396, 397 underground markets 53, 54 unemployment 7, 388, 416–25, 447–9 in the 1950s and 1960s 591 age groups 420 aggregate demand 393, 471, 634 business cycle 416, 418 claimant 417 classical theories 457–8, 459–60, 626–32 command economies 19 costs 420 cyclical 422–3 definition 416–17 demand deficient 422–3, 633 in developing countries 779–81 disequilibrium 421–3, 454 disguised 779 duration 417–19 equilibrium 420– 421, 423–5, 454, 632–3 ethnic groups 420 frictional 423–4, 657 gender differences 419–20 geographical differences 419, 424 hysteresis 468, 616, 633 and inflation 436–7, 471, 494, 620–1, 632–5 inflow and outflow rate 418 interventionist policies 424 Keynesian economics 422, 463–4, 467, 492–5, 632–5 market-oriented policies 424 natural level 421, 423–5, 615, 621 non-accelerating inflation rate (NAIRU) 621 number unemployed 416 and protectionism 688 real-wage 421–2 regional 424 search 423– seasonal 425 standardised rate 417 stock concept 417 structural 424, 632–3 supply-side policies 651–2, 665 surveys 417 and taxation 654–6 technological 424 unemployment benefits 565, 657 unemployment rate 417 unit elasticity of demand 58, 61 United States trade imbalance 730, 744 –5 universal benefits 298 unrecorded goods and services 395–6 urban policies 666–7 traffic congestion 256–61 transport 361–5 Uruguay Round 691 user charges 348 util 96 utility managerial utility maximisation 219 marginal utility theory 96 –104 vacancies 423, 454 value chain 682 value for money variable costs 132, 133, 134 variable factors of production 124 variable road pricing 363–5 VAT (Value Added Tax) 291, 701 velocity of circulation 458, 536, 542–4 vent for surplus 767 vertical equity 288 vertical integration 221–2 vertical mergers 222, 368 vertical restraints 373 very long run production 145 very short run production 145 volatility of floating exchange rates 735 – voluntary environmental agreements 349 voluntary interaction 23 wage setters 246 wage takers 237 wages distribution by occupation 281–2 efficient wage hypothesis 251–5 equality 244–5, 252–3 equilibrium wages 20, 423, 615 exploitation of cheap labour 676 firms with market power 246 flexibility 454–5, 615, 626 in imperfect markets 247–58 and import substitution 771 labour with market power 247–8 managerial utility maximisation 219 minimum wage 52, 287 and morale 253–5 neoclassical theory 238 under perfect competition 237–45 real-wage unemployment 421–2 rises in wage rates 238–9, 614–15 substitution effect 239 supply-side policies 656–7 tax cuts 239 see also income; inequality and poverty; labour market Walras, Léon 102 wants 4, waste disposal 343 Ways and Means advance 514 weak stock market efficiency 266 wealth 49, 276, 283–4, 477, 503 idle balances 528 and inequality 284 medium of storage 503–4 Wealth of Nations 22 wealth taxes 290 weighted average A:7– welfare gains from international trade 679 – 80 Whitbread 191 wholesale banking 505 wholesale deposits and loans 505, 506 Williamson, John 758 Williamson, O.E 219 windfall tax 324 withdrawals 391, 478–82, 486–9, 491 marginal propensity to withdraw 482 total withdrawals function 481–2 women equality 253, 282 unemployment 419–20 workforce increase 644 Working Families Tax Credit 301 working population 403–5, 423 Working Tax Credit 301 working to rule 250 world multiplier effects 689 World Trade Organisation (WTO) 689 –92 X inefficiency 178 Yeltsin, Boris 19 yield on a share 267 yuan exchange rate 775 Zimbabwe 430–1 ... 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