Aggregate Demand

Introduction

Aggregate means ‘total’ and in this case we use the term to measure how much is being spent by all consumers, businesses, the government and people and firms overseas.

Aggregate demand (AD) = total spending on goods and services

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

• C: Consumers' expenditure on goods and services : Also known as consumption, this includes demand for durables e.g. audio-visual equipment and motor vehicles & non-durable goods such as food and drinks which are “consumed” and must be re-purchased.
• I: Capital Investment – This is spending on capital goods such as plant and equipment and buildings to produce more consumer goods in the future. Investment also includes spending on working capital such as stocks of finished and semi-finished goods.
•  
• Capital investment spending in the UK accounts for between 16-20% of GDP in any given year. Of this investment, 75% comes from private sector businesses such as Tesco, British Airways and British Petroleum and the remainder is spent by the government – for example building new schools or in improving railway or road networks. So a mobile phone company such as O2 spending £100 million on extending its network capacity and the government allocating £15 million of funds to build a new hospital are both capital investment. Investment has important effects on the supply-side as well as being an important component of AD. A small part of investment spending is the change in the value of stocks –i.e. unsold products. Producers may find either than demand is running higher than output (i.e. stocks will fall) or that demand is weaker than expected and less than current output (in which case the value of unsold stocks will rise.)

• G: Government Spending – This is spending on state-provided goods and services including public goods and merit goods . Decisions on how much the government will spend each year are affected by developments in the economy and the political priorities of the government.
•  
• Government spending on goods and services is around 18-20% of GDP but this tends to understate the true size of the government sector in the economy. Firstly some spending is on investment and a sizeable slice goes on welfare state payments. Transfer payments in the form of benefits (e.g. state pensions and the job-seekers allowance) are not included in current government spending because they are a transfer from one group (i.e. people in work paying income taxes) to another (i.e. pensioners drawing their state pension having retired from the labour force, or families on low incomes).
• X: Exports of goods and services - Exports sold overseas are an inflow of demand (an injection) into our circular flow of income and spending adding to aggregate demand.
• M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the circular flow of income and spending.
• Net exports measure the value of exports minus the value of imports. When net exports are positive, there is a trade surplus (adding to AD); when net exports are negative, there is a trade deficit (reducing AD). The UK has been running a large trade deficit for several years now.

Aggregate Demand in the UK Economy

All of the data above is expressed in £ billion at constant prices

Source: Office for National Statistics, Economic Trends 2011

The main components of aggregate demand are shown in the table above
Remember that
AD = C + I + G + X – M

The change in the value of stocks is a small component of the equation, it relates to changes in how much investment businesses are making in stocks (unsold products) to be consumed at a later stage.

• Recession: 2009 was a year of recession – what happened to each of the components of aggregate demand in 2009 compared to 2008?
• Recovery: The British economy started to recover in 2010; using the table can you explain why this happened? 

Shocks to aggregate demand

• Many unexpected events can happen which causes changes in the level of demand, output and employment
• Headwinds can alter direction with great speed leading to uncertainty about where the economy is heading
• These events are called “shocks”. Some of the causes of AD shocks are as follows:
• A big rise or fall in the exchange rate – affecting export demand and having follow-on effects on output, employment, incomes and profits of businesses linked to export industries.
• A recession in one or more of our main trading partners which affects demand for our exports of goods and services.
• A slump in the housing market or a big change in share prices.
• An event such as the credit crunch (global financial crisis) – involving a fall in the amount of credit available for borrowing by households and businesses.
• An unexpected cut or an unexpected rise in interest rates or change in government taxation and spending – for example the shock of deep cuts in state spending expected in 2011 and beyond.

These shocks will bring about a shift in the aggregate demand curve – and we turn to this next.

The Aggregate Demand Curve

The AD curve shows the relationship between the general price level and real GDP.

Aggregate Demand and the Price Level

There are several explanations for an inverse relationship between AD and the price level in an economy. These are summarised below:

• Falling real incomes: As the price level rises, so the real value of people’s incomes fall and consumers are less able to buy the items they want or need. If over the course of a year all prices rose by 10 per cent whilst your money income remained the same, your real income would have fallen by 10%
• The balance of trade: A persistent rise in the price of level of Country X could make foreign-produced goods and services cheaper in price terms, causing a fall in exports and a rise in imports. This will lead to a reduction in net trade and a contraction in AD
• Interest rate effect: if the price level rises, this causes inflation and an increase in the demand for money and a consequential rise in interest rates with a deflationary effect on the economy. This assumes that the central bank (in our case the Bank of England) is setting interest rates in order to meet a specified inflation target

Shifts in the AD Curve

• A change in the factors affecting any one or more components of aggregate demand i.e. households (C), firms (I), the government (G) or overseas consumers and business (X) changes planned spending and results in a shift in the AD curve.

Consider the diagram below which shows an inward shift of AD from AD1 to AD3 and an outward shift of AD from AD1 to AD2. The increase in AD might have been caused for example by a fall in interest rates or an increase in consumers’ wealth because of rising house prices.

Factors causing a shift in AD
Changes in Expectations Current spending is affected by anticipated income and inflation	The expectations of consumers and businesses have a powerful effect on spending When confidence falls, we see an increase in saving and businesses postpone investment projects because of worries over weak demand and lower expected profits.
Changes in Monetary Policy – i.e. a change ininterest rates	If interest rates fall – this lowers the cost of borrowing and the incentive to save, encouraging consumption. Lower interest rates encourage firms to borrow and invest There are time lags between changes in interest rates and the changes in aggregate demand.
Changes in Fiscal Policy Fiscal Policy refers to changes in government spending, welfare benefits and taxation, and the amount that the government borrows	The Government may increase its expenditure e.g. financed by a higherbudget deficit - this directly increases AD Income tax affects disposable income e.g. lower rates of income tax raise disposable income and should boost consumption. An increase in transfer payments increases AD – particularly if welfare recipients spend a high % of the benefits they receive.
Economic events in the international economy International factors such as the exchange rate and foreign income (e.g. the economic cycle in other countries)	A fall in the value of the pound (£) (a depreciation) makes imports dearer and exports cheaper - the net result should be that UK AD rises The impact depends on the price elasticity of demand for imports and exports and also the elasticity of supply of UK exporters in response to exchange rate depreciation. An increase in overseas incomes raises demand for exports. In contrast arecession in a major export market will lead to a fall in exports and an inward shift of aggregate demand.
Changes in household wealth Wealth is the  value of assets owned e.g. houses and shares	A fall in the value of share prices or a slump in the housing market can lead to a decline in household financial wealth and a fall in consumer demand Declining asset prices also have a negative effect on consumer confidence / a fall in expectations
Changes in the supply of credit	The availability of credit is vital for the smooth functioning of most modern economies We have seen in recent years how the bursting of the credit bubble in countries such as the UK and the USA has created many problems for businesses and individuals Many banks and other lenders are now more reluctant to lend Interest rates on different loans have become more expensive Instead of taking out new loans, in recent times businesses have been paying back debt. In the 5 years before the financial crisis UK companies borrowed £107m from banks every day. Since then they've been repaying £5.8m a day

Poverty & Inequality in Resource Allocation

Poverty and Inequality in Resource Allocation

Going without

“In the UK people can become poor as a result of social and economic processes, such as unemployment and changing family structures.

Poverty is not simply about being on a low income and going without – it is also to do with being denied hood health, education, good housing and social activities, as well as basic self-esteem”

Source: Child Poverty Action Group

In a market economy an individual’s ability to consume goods & services depends upon his/her income or other resources such as savings
An unequal distribution of income and wealth may result in an unsatisfactory allocation of resourcesand can also lead to alienation and encourage crime with negative consequences for the rest of society
The free-market system will not always respond to the needs and wants of people with insufficient economic votes to have any impact on market demand. What matters in a market based system is youreffective demand for goods and services.
When we are discussing inequality and poverty, we cannot escape making value judgements i.e. normative views about what is an acceptable scale of inequality and what is not

Absolute poverty

Absolute poverty measures the number of people living below a certain income threshold or the number of households unable to afford certain basic goods and services
What we choose to include in a basic acceptable standard of living is naturally open to discussion.

Relative poverty

Relative poverty measures the extent to which a household’s financial resources falls below an average income level.
Although living standards and real incomes have grown because of higher employment and sustained growth, Britain has become a more unequal society over the last 30 years

Poorer families have a lower life expectancy

People from poorer backgrounds are unhealthier and die earlier than the rich, according a study measuring the link between health and wealth.  Poorer people in their fifties were 10 times more likely to die earlier than those who are richer, according to a report from the Institute of Fiscal Studies (IFS). The poor often have to stop work early due to ill health, the group added and this increases the risk of these groups suffering income poverty during their retirement years.
Source: BBC news and Institute for Fiscal Studies

The most commonly used threshold of low income in Britain is 60% of median household income after deducting housing costs.

The distribution of income in the UK

In 2008/09, income before taxes and benefits of the top fifth of households in the UK was £73,800 per year on average compared with £5,000 for the bottom fifth, a ratio of 15 to one.
After taking account of taxes and benefits, the gap between the top and the bottom fifth was reduced with average income of £53,900 per year and £13,600, respectively, a ratio of four to one. This shows that the tax and benefits system works in a progressive way to reduce the scale of income inequality.
In the UK, the share of total income earned by the top 1% income earners rose from 6% in 1975 to 14% in 2005
The gap between lowest and higher income groups can be seen in this chart:


Another way of showing this income data is in the table below – this shows the distribution of disposable income by household income quintile. The data is for 2008-09.

	Bottom Fifth	Next Fifth	Middle Fifth	Next Fifth	Top Fifth
% share of disposable income	7	12	16	22	42

The Poverty Trap

The poverty trap affects people living in households on low incomes.
It creates a disincentive either to look for work or work longer hours because of the effects of the income tax and welfare benefits system.
For example, a worker might be given the opportunity to earn an extra £60 a week by working ten additional hours. This boost to his/her gross income is reduced by an increase in income tax and national insurance contributions.
The individual may lose some income-related welfare benefits and the combined effects of this might be to take away over 70% of a rise in income, leaving little in the way of extra net or disposable income.
When one adds in the possible extra costs of more expensive transport charges and the costs of arranging child care, then the disincentive to work may be quite strong.

Wealth inequality in the world

Credit Suisse estimates that there are 24.5 million dollar millionaires, or adults with net assets, including housing, of more than $1 million in the world today. This group equates to 0.5% of the world's adult population and owns 36% of the world's private wealth. By contrast the bottom 50% of the world's adult population owns less than 2% of world's private wealth

Government Policies to Reduce Poverty

When evaluating different policies to reduce poverty consider some of these related issues:

• Cost
• Effectiveness
• Impact on others in the economy

Changes to the tax and benefits system: For example, increases in higher rates of income tax would make the British tax system more progressive and reduce the post-tax incomes of people at the top of the income scale. The risk is that higher rates of taxation may act as a disincentive for people to earn extra income and might damage enterprise and productivity.
A switch towards greater means-tested benefits: Means testing allows welfare benefits to go to those people and families in greatest need. A means-test involves a check on the financial circumstances of the benefit claimant before paying any benefit out.  This would help the welfare system to target helpfor those households on the lowest incomes. However means tested benefits are often unpopular with the recipients.
Linking the state retirement pension to average earnings rather than prices: This policy would help to relieve relative poverty among low-income pensioner households. Their pension would rise in line with the growth of average earnings each year
Special employment measures (including New Deal): Government employment schemes seek to raise employment levels and improve the employment prospects of the long-term unemployed.
Increased spending on education and training: Unemployment is a cause of poverty and structural unemployment makes the problem worse. There are millions of households in the UK where no one in the family is in any kind of work and this increases the risk of poverty.
The National Minimum Wage: The National Minimum Wage (NMW) was introduced in April 1999 - employers cannot legally undercut the NMW.  Since 1999, the beneficial impact of the minimum wage has been concentrated on the lowest paid workers in service sector jobs where there is little or no trade union protection.

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Monetarism

Introduction

The Basics of Monetarism

The key features of monetarist theory are as follows:

1. The main cause of inflation is an excess supply of money in an economy leading to in the words of the late Monetarist economist Milton Friedman, “too much money chasing too few goods”
2. Tight control of money and credit is required to maintain price stability
3. Attempts by the government and the central bank to use fiscal and monetary policy to “fine-tune” the rate of growth of aggregate demand are ineffective. Fiscal policy has a role to play in stabilising the economy providing that the government is successfully able to control its own borrowing
4. The key is for monetary policy to be credible – in the hands of an independent central bank – so that people’s expectations of inflation are controlled

A simple way of explaining how a surge in the amount of money in circulation can feed through to higher inflation is shown in the flow chart above.

1. Excess money balances held by households and businesses can affect demand and output in several directions. Consumers will increase their own demand for goods and services adding directly to aggregate demand (although a high proportion of this extra spending may go on imports).
2. Some of the excess balances will be saved in bonds and other financial assets, or invested in the housing market. An increase in the demand for bonds causes a downward movement in bond interest rates (there is an inverse relationship between the two) and this can then stimulate an increase in investment.
3. Money that flows into housing will push house prices higher, and we know understand quite well how a booming housing market stimulates consumer wealth, borrowing and an increase in spending.

The Quantity Theory of Money

• The Quantity Theory was first developed by Irving Fisher in the inter-war years, and is a basic theoretical explanation for the link between money and the general price level.
• The theory rests on what is sometimes known as the Fisher identity or the equation of exchange.  This is an identity which relates total aggregate demand to the total value of output (GDP).

M x V = P x Y
Where

• M is the money supply
• V is the velocity of circulation of money
• P is the general price level
• Y is the real value of national output (i.e. real GDP)

Money supply (M) multiplied by the velocity of circulation (V) = the value of national output (price level (P) x volume of transactions (Y))

• Velocity of circulation represents the number of times that a unit of currency (E.g. a £10 note) is used in a given period of time when used as a medium of exchange to buy goods and services
• Velocity of circulation can be calculated by dividing the money value of national output by the money supply.

In the basic theory of monetarism expressed using the equation of exchange, we assume that the velocity of circulation of money is predictable and therefore treated as a constant. We also make an assumption that the real value of GDP is not influenced by monetary variables. For example the growth of a country’s productive capacity might be determined by the rate of productivity growth or an increase in the capital stock. We might therefore treat Y (real GDP) as a constant too.

• If V and Y are treated as constants, then changes in the rate of growth of the money supply will equate to changes in the general price level
• Monetarists believe that the direction of causation is from money to prices (as we see in the flow chart on the previous page).

The experience of targeting the growth of the money supply as part of the monetarist experiment during the 1980s and early 1990s is that the velocity of circulation is not predictable – indeed it can suddenly change as a result of changes to people’s behaviour in their handling of money. During the 1980s it was found that direct and predictable links between the growth of the money supply and the rate of inflation broke down. This eventually caused central banks in different countries to place less importance on the money supply as a target of monetary policy. Instead they switched to having exchange rate targets, and latterly they have become devotees of inflation targets as an anchor for the direction of monetary policy.

Measuring the money supply
There is no unique measure of the money supply because it is used in such a wide variety of ways. 

• M0 (Narrow money) - comprises notes and coins in circulation banks' operational balances at theBank of England. Over 99% of M0 is made up of notes and coins as cash is used mainly as a medium of exchange for buying goods and services. Most economists believe that changes in the amount of cash in circulation have little significant effect on total national output and inflation. At best M0 is seen as a co-incident indicator of consumer spending and retail sales. If people increase their cash balances, it is mainly a sign that they are building up these balances to fund short term increases in spending. M0 reflects changes in the economic cycle, but does not cause them.
• M4 (Broad money) is a wider definition of what constitutes money. M4 includes time and sight deposits saved with banks and building societies and also money created by lending in the form of loans and overdrafts.

M4 = M0 plus sight (current accounts) and time deposits (savings accounts).

Bank lending and the money supply

When a bank or another lender grants a loan to a customer, bank liabilities and assets raise by the same amount and so does the money supply. Again M4 is a useful background indicator to the strength of demand for credit.

The Bank takes M4 growth into account when assessing overall monetary conditions, but it is not used as an intermediate target of monetary policy

Its main value is as a signpost of the strength of demand which can then filter through the economy and eventually affect inflationary pressure. According to the Bank of England’s figures the amount of M4 money at the end of October 2010 was £2.19 trillion. To put this into some context, the GDP figure for 2009 was £1.4 trillion, so the amount of M4 is equivalent to about 1½ times GDP.

The Money Supply and Velocity during the Credit Crunch

Quantitative easing (QE) is a deliberate policy to boost the money supply and provide a stimulus to demand in a bid to avoid damaging price deflation.

Central banks both in the UK and the USA have certainly created a lot of money. The so-called monetary base, consisting of cash and the central banks’ deposits, has roughly doubled in the US and Britain since 2007.

However, shrinking private bank credit as the lending freeze brought about by the credit crunch has continued longer than expected has offset this.

As a result, growth in total money the world over has been slow. Put another way, most of the money ‘created’ by quantitative easing is sitting in banks’ reserves, rather than finding its way to businesses and consumers.

We are seeing a contraction in the money supply because of the credit crunch / fall in lending. If velocity of circulation is stable then this will lead to a fall in the value of GDP. Matters are made worse if velocity is also declining – households are starting to hoard cash as are companies worried about insolvency and the lack of credit and hedge funds holding onto cash because of fears over investors wanting to redeem their money.

International Trade - Introduction & Overview

What is Trade?

Trade is the exchange of products between countries
When conditions are right, trade brings benefits to all countries involved and can be a powerful driver for sustained growth and rising living standards.
One way of expressing the gains from trade in goods and services is to distinguish between static gainsfrom trade (i.e. improvements in allocative and productive efficiency) and dynamic gains (i.e. gains in welfare that occur over time from improved product quality, increased choice and faster innovative behaviour).

Gains from Trade – Understanding Comparative Advantage

First introduced by David Ricardo in 1817, comparative advantage exists when a country has a ‘margin of superiority’ in the production of a good or service i.e. where the marginal cost of production is lower
Countries will generally specialise in and export products, which use intensively the factors inputs, which they are most abundantly endowed.
If each country specializes, then total output can be increased leading to an improvement in allocative efficiency and welfare.
Because production costs are lower, providing that a good market price can be found from international buyers, specialisation should focus on those goods and services that provide the best value
In highly developed countries, comparative advantage is shifting towards specialising in producing and exporting high-value and high-technology manufactured goods and high-knowledge services.
Example of comparative advantage
Usually we take a standard two-country + two-product example to illustrate comparative advantage

• Consider two countries producing two products – digital cameras and vacuum cleaners
• With the same factor resources evenly allocated by each country to the production of both goods, the production possibilities are as shown in the table below.

OUTPUT BEFORE SPECIALISATION	Digital Cameras	Vacuum Cleaners
UK	600	600
United States	2400	1000
Total	3000	1600

Working out the comparative advantage

• To identify who should specialise in a particular product,  consider the internal opportunity costs
• Were the UK to shift resources into supplying more vacuum cleaners, the opportunity cost of each vacuum cleaner is one digital television
• For the United States the same decision has an opportunity cost of 2.4 digital cameras. Therefore, the UK has a comparative advantage in vacuum cleaners
• If the UK chose to reallocate resources to digital cameras the opportunity cost of an extra camera is one vacuum cleaner. But for the USA the opportunity cost is only 5/12ths of a vacuum cleaner.
• USA has comparative advantage in producing digital cameras because its opportunity cost is lowest.

Output after Specialisation

	Digital Cameras	Vacuum Cleaners
UK	0 (-600)	1200 (+600)
United States	3360 (+960)	600 (-400)
Total	3000 3360	1600 1800

• The UK specializes totally in producing vacuum cleaners – doubling its output  - now1200
• The United States partly specializes in digital cameras increasing output by 960 having given up 400 units of vacuum cleaners
• As a result of specialisation output of both products has increased - a gain in economic welfare.

For mutually beneficial trade to take place, the two nations have to agree an acceptable rate of exchange of one product for another. If the two countries trade at a rate of exchange of two digital cameras for one vacuum cleaner, the post-trade position will be as follows:

• The UK exports 420 vacuum cleaners to the USA and receives 840 digital cameras
• The USA exports 840 digital cameras and imports 420 vacuum cleaners

Post trade output / consumption

	Digital Cameras	Vacuum Cleaners
UK	840	780
United States	2520	1020
Total	3360	1800

Compared with the pre-specialisation output levels, consumers now have an increased supply of both goods

Key assumptions behind trade theory

This theory of trade based on comparative advantage depends on a number of assumptions:
Occupational mobility of factors of production (land, labour, capital) -this means that switching factor resources from one industry to another involves no loss of efficiency and productivity. In reality we know that factors of production are not perfectly mobile – labour immobility for example is a root cause of structural unemployment
Constant returns to scale (i.e. doubling the inputs used in the production process leads to a doubling of output) – this is merely a simplifying assumption. Specialisation might lead to diminishing returns in which case the benefits from trade are reduced. Conversely increasing returns to scale means that specialisation brings even greater increases in output.
No externalities arising from production and/or consumption – no discussion about the overall costs and benefits of specialisation and trade should ignore many of the environmental considerationsarising from increased production and trade between countries.
The standard model of trade focuses on trade between countries. In reality, most trade takes place between businesses across national boundaries – i.e. intra-industry trade. In the last twenty years we have seen huge changes in both the pattern of trade between developed and developing countries. And also the complexity of manufacturing supply chains around the world. Typically for example, a tablet computer or a smartphone will be manufactured in one or two centers but the components will have come from dozens of other countries.

Sources of Comparative Advantage

Comparative advantage is a dynamic concept meaning that it changes over time.

For a country, the following factors are important in determining the relative unit costs of production:

The quantity and quality of factors of production available for example some countries have an abundant supply of good quality farmland, oil and gas, fossil fuels. Climate and geography have key roles in creating differences in comparative advantage.

Different proportions of factors of production – some countries have abundant low-cost labour suitable for volume production of manufacturing products.

Increasing returns to scale and the division of labour – increasing returns occur when output grows more than proportionate to inputs. Rising demand in the markets where trade takes place helps to encourage specialisation, higher productivity and internal and external economies of scale. These long-run scale economies give regions and countries a significant advantage.

Investment in research & development which can drive innovation and invention

Fluctuations in the exchange rate, which then affect the relative prices of exports and imports and cause changes in demand from domestic and overseas customers.

Import controls such as tariffs, export subsidies and quotas – these can be used to create an artificial comparative advantage for a country's domestic producers.

The non-price competitiveness of producers - covering factors such as the standard of product design and innovation, product reliability, quality of after-sales support. Many countries are now building comparative advantage in high-knowledge industries and specializing in specific knowledge sectors – an example here is the division of knowledge in the medical industry, some countries specialize in heart surgery, others in pharmaceuticals.

Institutions – these are important for comparative advantage and important for growth too. Banking systems are needed to provide capital for investment and export credits, legal systems help to enforce contracts, political institutions and the stability of democracy is a key factor behind decisions about where international capital flows.

Comparative advantage is often a self-reinforcing process.

• Entrepreneurs in a country develop a new comparative advantage in a product either because they find ways of producing it more efficiently or they create a genuinely new product that finds a growing demand in home and international markets
• Rising demand and output encourages the exploitation of economies of scale; higher profits can be reinvested in the business to fund further product development, marketing and a wider distribution network. Skilled labour is attracted into the industry and so on
• The expansion of an industry leads to external economies of scale.
  

Wider Benefits of International Trade

Many countries have seen a growing share of their GDP directly linked to overseas trade, our chart below tracks data for India, one of the fast-growing BRIC nations. India joined the WTO in 1991.

Prior to joining the WTO, Indian trade as a share of GDP was low by global standards at just 15%. That figure has doubled in the last twenty years

Some of the broader gains from trade are:

Welfare gains: Supporters of trade believe that trade is a ‘positive-sum game’ – all counties engaged in open trade and exchange stand to gain

Economies of scale – trade and increased market size allows firms to exploit scale economies leading to lower average costs of production that might be passed onto consumers

Competition / market contestability – trade promotes increased competition particularly for domestic monopolies that would otherwise face little competition. Trade is a spur for higher productivity – a stimulus to higher business efficiency across many industries.

Dynamic efficiency gains from innovation - trade enhances choice and stimulates product and process innovations bringing better products for consumers and enhances the standard of living

Access to new technology and inflows of new knowledge: trade, like investment, is a mechanism by which countries can have access to new technologies. Trade is a stimulus to the exchange of ideas and inflow of human capital. Openness to trade allows imports of capital equipment at lower prices.

Rising living standards and a reduction in poverty - a growing body of evidence shows that countries that are more open to trade grow faster over the long run and have higher per capita income than those that remain closed. Growth through trade directly benefits the world's poor although free trade is not necessarily equitable

The UNDP believe that greater openness in trade can be a major factor behind reducing extreme poverty. For example in the case of Cambodia, access to markets is estimated to have contributed to a decrease in extreme poverty from 35% in 2002 to 25.8% in 2010.

Some quotes on the value of trade

“According to a recent study, one iPhone has an export value of $150 per unit in Chinese trade statistics but the value added attributable to processing in China is only $4, with the remaining value added assembled in China coming from the United States, Japan, and other Asian countries”

Pascal Lamy, Director-General of the World Trade Organisation

“The case for free trade is robust. It extends not only to overall prosperity or gross national product (GNP), but also to distributional outcomes, which makes the free trade argument morally compelling as well”

“The dramatic upturn in GDP growth rates in India and China after they turned strongly towards dismantling trade barriers in the late 1980s and early 1990s is compelling.

“In India, the shift to accelerated growth after reforms that included trade liberalization has pulled nearly 200 million people out of poverty. In China, which grew faster, it is estimated that more than 300 million people have moved above the poverty line since the start of reforms.”

Professor Jagdish Bhagwati

Buffer stock systems

          The prices of agricultural products such as wheat, cotton, cocoa, tea and coffee tend to fluctuate more than prices of manufactured products and services.

This is largely due to the volatility in the market supply of agricultural products coupled with the fact that demand and supply are price inelastic.

One way to smooth out the fluctuations in prices is to operate price support schemes through the use ofbuffer stocks. But many of them have had a chequered history.

Buffer stock schemes seek to stabilize the market price of agricultural products by buying up supplies of the product when harvests are plentiful and selling stocks of the product onto the market when supplies are low.

Analysis diagram for a buffer stock scheme

• The diagram below illustrates the operation of a buffer stock scheme
• The government offers a guaranteed minimum price (P min) to farmers of wheat
• The price floor is set above the normal free market equilibrium price
• Notice that the price elasticity of supply for wheat in the short term is low because of the length of time it takes for producers to supply new quantities of wheat to the market. (Indeed in the momentary period, we would draw the supply curve as vertical indicating a fixed supply).

If the government is to maintain the guaranteed price at P min, then it must buy up the excess supply (Q3-Q1) and put these purchases into intervention storage

Should there be a large rise in supply due to better than expected yields at harvest time, the market supply will shift out – putting downward pressure on the free market equilibrium price. In this situation, the intervention agency will have to intervene in the market and buy up the surplus stock to prevent the price from falling. It is easy to see how if the market supply rises faster than demand then the amount of wheat bought into storage will grow.

Advantages of a successful buffer-stock scheme:

• Stable prices help maintain farmers’ incomes and improve the incentive to grow legal crops
• Stability enables capital investment in agriculture needed to lift agricultural productivity
• Farming has positive externalities it helps to sustain rural communities
• Stable prices prevent excess prices for consumers – helping consumer welfare

Problems with buffer stock schemes

In theory buffer stock schemes should be profit making, since they buy up stocks of the product when the price is low and sell them onto the market when the price is high. However, they do not often work well in practice. Clearly, perishable items cannot be stored for long periods of time and can therefore be immediately ruled out of buffer stock schemes.  Other problems are:

• Cost of buying excess supply can cause a buffer stock scheme to run out of cash
• A guaranteed minimum price might cause over-production and rising surpluses which has economic and environmental costs
• Setting up a buffer stock scheme also requires a significant amount of start up capital, since money is needed to buy up the product when prices are low. There are also high administrative and storage costs to be considered.

The success of a buffer stock scheme however ultimately depends on the ability of those managing a scheme to correctly estimate the average price of the product over a period of time. This estimate is the scheme’s target price and obviously determines the maximum and minimum price boundaries. 

But if the target price is significantly above the correct average price then the organization will find itself buying more produce than it is selling and it will eventually run out of money. The price of the product will then crash as the excess stocks built up by the organization are dumped onto the market.

Conversely if the target price is too low then the organization will often find the price rising above the boundary, it will end up selling more than it is buying and will eventually run out of stocks