Micro Economics-Production in the Short-run & Long-run,IGCSE NOTES

Production in the Short-run & Long-run

Production Functions
The production function relates the quantity of factor inputs used by a business to the amount of outputthat result. We use three measures of production and productivity.

• Total product (or total output). In manufacturing industries such as motor vehicles and DVD players, it is straightforward to measure how much output is being produced. But in service or knowledge industries, where output is less “tangible” it is harder to measure productivity.
• Average product measures output per-worker-employed or output-per-unit of capital.
• Marginal product is the change in output from increasing the number of workers used by one person, or by adding one more machine to the production process in the short run.

The length of time required for the long run varies from sector to sector. In the nuclear power industry for example, it can take many years to commission new nuclear power plant and capacity. This is something the UK government has to consider as it reviews our future sources of energy.

Short Run Production Function

• The short run is a time period where at least one factor of production is in fixed supply. A business has chosen it’s scale of production and must stick with this in the short run
• We assume that the quantity of plant and machinery is fixed and that production can be altered by changing variable inputs such as labour, raw materials and energy.
• The time periods used differ from one industry to another; for example, the short-run in the electricity generation industry differs from local sandwich bars. If you are starting out in business with a new venture selling sandwiches and coffees to office workers, how long is your long run? It could be as short as a few days – enough time to lease a new van and a sandwich-making machine!

Diminishing Returns

• In the short run, the law of diminishing returns states that as we add more units of a variable inputto fixed amounts of land and capital, the change in total output will at first rise and then fall.
• Diminishing returns to labour occurs when marginal product of labour starts to fall. This means that total output will be increasing at a decreasing rate.

What might cause marginal product to fall? One explanation is that, beyond a certain point, new workers will not have as much capital equipment to work with so it becomes diluted among a larger workforce.
In the following numerical example, we assume that there is a fixed supply of capital (20 units) to which extra units of labour are added.

• Initially, marginal product is rising – e.g. the 4th worker adds 26 to output and the 5th worker adds 28 and the 6th worker increases output by 29.
• Marginal product then starts to fall. The 7th worker supplies 26 units and the 8th worker just 20 added units. At this point production demonstrates diminishing returns.
• Total output will continue to rise as long as marginal product is positive
• Average product will rise if marginal product > average product

The Law of Diminishing Returns
Capital Input	Labour Input	Total Output	Marginal Product	Average Product of Labour
20	1	5		5
20	2	16	11	8
20	3	30	14	10
20	4	56	26	14
20	5	85	28	17
20	6	114	29	19
20	7	140	26	20
20	8	160	20	20
20	9	171	11	19
20	10	180	9	18

Average product rises as long as marginal product is greater than the average – e.g. when the seventh worker is added the marginal gain in output is 26 and this drags the average up from 19 to 20 units. Once marginal product is below the average as it is with the ninth worker employed then the average must decline.

Criticisms of the Law of Diminishing Returns

• How realistic is this assumption of diminishing returns? Surely ambitious and successful businesses will do their level best to avoid such a problem emerging?
• It is now widely recognised that the effects of globalisation and the ability of trans-national businesses to source their inputs from more than one country and engage in transfers of business technology, makes diminishing returns less relevant as a concept.
• Many businesses are multi-plant meaning that they operate factories in different locations – they can switch output to meet changing demand.

Long Run Production - Returns to Scale

In the long run, all factors of production are variable. How the output of a business responds to a change in factor inputs is called returns to scale.

Numerical example of long run returns to scale
Units of Capital	Units of Labour	Total Output	% Change in Inputs	% Change in Output	Returns to Scale
20	150	3000
40	300	7500	100	150	Increasing
60	450	12000	50	60	Increasing
80	600	16000	33	33	Constant
100	750	18000	25	13	Decreasing

• When we double the factor inputs from (150L + 20K) to (300L + 40K) then the percentage change in output is 150% - there are increasing returns to scale.
• When the scale of production is changed from (600L + 80K0 to (750L + 100K) then the percentage change in output (13%) is less than the change in inputs (25%) implying a situation of decreasing returns to scale.

• Increasing returns to scale occur when the % change in output > % change in inputs
• Decreasing returns to scale occur when the % change in output < % change in inputs
• Constant returns to scale occur when the % change in output = % change in inputs

The nature of the returns to scale affects the shape of a business’s long run average cost curve.

Finding an optimal mix between labour and capital

In the long run businesses will be looking to find an output that combines labour and capital in a way that maximises productivity and therefore reduces unit costs towards their lowest level. This may involve a process of capital-labour substitution where capital machinery and new technology replaces some of the labour input.

In many industries over the years we have seen a rise in the capital intensity of production - good examples include farming, banking and retailing.

Robotic technology is extensively used in many manufacturing / assembly industries such as cars and semi-conductors. The image above is of a Ford car assembly factory in India.

Measuring The Standard of Living

Introduction

• The standard of living is a measure of material welfare.
• The baseline measure is real national output per head of population or real GDP per capita
• Real income per capita is an inaccurate and insufficient indicator of living standards

National income data can be used to make cross-country comparisons. This requires

• Converting GDP data into a common currency
• Making an adjustment to reflect differences in the cost of products in each country to produce data expressed at ‘purchasing power parity’ standard.

The chart below tracks changes in real per capita national income adjusted for PPP for a selection of African countries. Note: not all countries have seen their absolute position improve.

Problems in using national income statistics to measure living standards

Official data on GDP understates the growth of real national income per capita over time due to theshadow economy and the value of unpaid work by volunteers and people caring for their family.

The "shadow economy" includes illegal activities such as drug production and distribution, prostitution, theft, fraud and concealed legal activities such as tax evasion on otherwise-legitimate business activities such as un-reported self-employment income.

The scale of the “shadow economy” varies across countries at different stages of their development.

According to the IMF, in developing countries it may be as high as 40% of GDP; in transition countries of central and Eastern Europe it may be up to 30% of GDP and in the countries of the OECD, the shadow economy may be in the region of 15% of GDP. 

Here are some reasons why GDP data may give a distorted picture of living standards in a country:

1. Regional variations in income and spending: National GDP data can hide regional variations in output, employment and income per head of the population.
2. Inequalities in income and wealth: Average (mean) incomes might be rising but inequality could grow at the same time
3. Leisure and working hours and working conditions: An increase in real GDP might have been achieved at the expense of leisure time if workers are working longer hours or if working conditions have deteriorated.
4. Imbalances between consumption and investment: High levels of investment as a share of GDP might be superb for creating extra capacity to produce but at the expense of consumer goods and services for the current generation.
5. Changes in life expectancy: Improvements in life expectancy don’t always show through in the GDP accounts. Putting a monetary value on the benefits of increased longevity is difficult.
6. The value of non-marketed output: Much useful and valuable work is not produced and sold in markets at market prices. The value of the output of people working unpaid for charities, self-help groups and of housework might reasonably be added to national income statistics.
7. Innovation and the development of new products: New goods and services become available because of invention and innovation that simply would not have been available to the richest person on earth less than fifty years ago. About half of what we spend our money on now was not invented in 1870. Examples include air travel, cars, computers, antibiotics, hip replacements, insulin and many other life-enhancing and life-saving drugs
8. Environmental considerations: Rising output might have been accompanied by an increase in air and noise pollution and other externality effects that have a negative effect on our social welfare.
9. Defensive expenditures: Much spending is to protect against an “economic or social bad” e.g. crime, or spending to clean up the effects of pollution and waste

Globalisation - Introduction

Introduction to Globalisation

The OECD defines globalization as

“The geographic dispersion of industrial and service activities, for example research and development, sourcing of inputs, production and distribution, and the cross-border networking of companies, for example through joint ventures and the sharing of assets.”

51 of the largest economies in the world are corporations. The top 500 TNCs account for nearly 705 of world trade.

Globalisation is best defined as a process of deeper economic integration between countries involving:

• An expansion of trade in goods and services
• An increase in transfers of financial capital including the expansion of foreign direct investment(FDI) by trans-national companies (TNCs) and the rising influence of sovereign wealth funds
• The development of global brands
• Spatial division of labour– for example out-sourcing and off shoring of production and support services as production supply-chains has become more international. As an example, the iPod is part of a complicated global supply chain. The product was conceived and designed in Silicon Valley; the software was enhanced by software engineers working in India. Most iPods are assembled / manufactured in China and Taiwan by TNCs such as FoxConn
• High levels of labour migration within and between countries
• New nations joining the trading system. Russia joined the World Trade Organisation in July 2012

Global inter-dependence and shifts in world economic influence

The shifting centre of global influence

“In 1980, North America and Western Europe produced more than two-thirds of the world’s income, so as a result, in 1980 the world’s economic center of gravity was a point in the middle of the Atlantic Ocean. By 2008, because of the continuing rise of India, China and the rest of East Asia, that center of gravity had shifted to a point just outside İzmir.”
Professor Danny Quah, LSE

Globalisation is a process of making the world economy more inter-dependent

• It is also bringing about a change in the balance of power in the world economy. Many of the newly industrializing countries are winning a rising share of world trade and their economies are growing faster than in richer developed nations especially after the global financial crisis (GFC)

Previous waves of globalisation

There have seen several previous waves of globalisation:

• Wave One: Began around 1870 and ended with the descent into protectionism during the interwar period of the 1920s and 1930s. This first wave started the pattern which persisted for over a century of developing countries specializing in primary commodities which they export to the developed countries in return for manufactures. During this wave of globalisation, the ratio of world exports to GDP increased from 2 per cent of GDP in 1800 to 10 per cent in 1870, 17 per cent in 1900 and 21 per cent in 1913.
• Wave Two: After 1945, there was a 2nd wave of globalization built on a surge in trade and reconstruction. The International Monetary Fund was created in 1944 to promote a stable monetary system and provide a sound basis for multilateral trade, and the World Bank to help restore economic activity in the devastated countries of Europe and Asia. Their aim was to promote lasting multilateral co-operation between nations. The General Agreement on Tariffs and Trade (GATT) signed in 1947 provided a framework for a mutual reduction in import tariffs. GATT eventually became known as the WTO.
• Wave Three: The most recent wave of globalisation has seen another sharp rise in the ratio of trade to GDP for many countries and secondly, a sustained increase in capital flows between counties
  

What factors have contributed to globalisation?

Among the main drivers of globalisation are the following:

• Containerisation – the costs of ocean shipping have come down, due to containerization, bulk shipping, and other efficiencies. The lower cost of shipping products around the global economyhelps to bring prices in the country of manufacture closer to prices in the export market, and makes markets contestable in an international sense.
• Technological change – reducing the cost of transmitting and communicating information - known as “the death of distance” – this is an enormous factor behind trade in knowledge products using internet technology
• Economies of scale: Many economists believe that there has been an increase in the minimum efficient scale associated with particular industries. If the MES is rising, a domestic market may be regarded as too small to satisfy the selling needs of these industries.  Overseas sales become essential.
• De-regulation of global financial markets: This has included the removal of capital controls in many countries which facilitates foreign direct investment.
• Differences in tax systems: The desire of multi-national corporations to benefit from lower labour costs and other favourable factor endowments abroad and develop and exploit fresh comparative advantages in production has encouraged many countries to adjust their tax systems to attract foreign direct investment.
• Less protectionism - old forms of non-tariff protection such as import licencing and foreign exchange controls have gradually been dismantled. Borders have opened and average tariff levels have fallen – that said in the last few years there has been a rise in protectionism as countries have struggled to achieve growth after the global finance crisis.

Average Most Favoured Nation Applied Import Tariffs (%)	1991	2001	2009
Developing Countries  (134 countries)	27.7	13.5	9.9
Low Income Developing Countries  (42 countries)	44.4	14.4	11.8
Source: World Bank

• The breakdown of the Doha trade talks dashed hopes of a globally based multi-lateral reduction in import tariffs. In its place there has been a flurry of bi-lateral trade deals between countries and the emergence of regional trading blocs such as NAFTA and MECOSUR
• Globalization no longer necessarily requires a business to own or have a physical presence in terms of either owning production plants or land in other countries, or even exports and imports. For instance, economic activity can be shifted abroad using licensing and franchising which only needs information and finance to cross borders.

Joint Ventures

Increasingly we see many examples of joint-ventures between businesses in different countries

• BMW and Toyota agreed a partnership in 2011 to co-operate on hydrogen fuel cells, vehicle electrification, lightweight materials and a future sports car. Partnership agreements between competing automakers are becoming increasingly common in the industry as manufacturers seek to pool efforts on costly technologies.
• Renault-Nissan’s joint venture with Indian firm Bajaj to produce a £1,276 car
• Alliances in the airline industry e.g. Star Alliance and One World
• Burger King, the US fast food restaurant chain plans to open 1,000 stores in China through a new joint venture with a Turkish private equity business
• Sony and Olympus agreed to form an alliance in September 2012 setting up a new company (51% owned by Sony to develop new businesses)

Our chart above tracks the annual growth of real GDP for the world economy and for developing countries as a group. In nearly every year the developing world has seen faster growth. 2009 marked a difficult year for the world economy with a recession – this was felt most severely in rich advanced countries.

Economic Growth - Development & Labour Migration

Introduction

A Global War for Talent

“A higher rate of global migration is desirable for four reasons: it is a source of innovation and dynamism; it responds to labour shortages; it meets the challenges posed by rapidly aging populations; and it provides an escape from poverty and persecution”

Ian Goldin, director of the Oxford Martin School and Professorial Fellow at Balliol College, University of Oxford

This revision note focuses on international labour migration – keep in mind that large migration can happen within a country too. In China there has been rural-urban migration in the last 20 years amounting to over 150 million people.

• Cross-border migration from one country to another has become an increasingly important feature of our globalizing world and it raises many important economic, social and political issues
• About 200-million people now live in countries in which they were not born
• Estimates compiled in 2009 suggested 580,000 to 820,000 Chinese migrants were living in Africa. In 2012 the figure is likely around 1 million

Migrant  Workers as a % of a country’s total population
Country	2010	Country	2010
Kuwait	76.6	World	3.1
Qatar	74.2	Sub-Saharan Africa (all income levels)	2.1
United Arab Emirates	43.8	Least developed countries	1.4
Singapore	38.7	Korea, Rep.	1.1
Australia	21.1	Mexico	0.6
Ireland	20.1	Philippines	0.5
United States	13.8	India	0.4
Germany	13.2	Brazil	0.4
United Kingdom	10.4	China	0.1
South Africa	3.7	Indonesia	0.1
Source: World Bank

 Factors affecting the direction and scale of migration

Many economic and social factors affect the rate of migration. In general, the incentive to migrate is strongest when the expected increase in earnings exceeds the cost of relocation.

• Differences between countries in wages and salaries on offer for equivalent jobs – reflected in differences in expected incomes over a working life
• Access to the benefits system of host countries plus state education, housing & health care
• Employment opportunities vary between nations, in particular for younger workers
• A desire to travel, learn a new language, build new skills and qualifications and develop networks
• A desire to escape political repression and corruption in the country of origin especially in failing states
• The impact of satellite television and the internet in changing people’s expectations
• The effects of cheaper trans-national phone calls and more affordable air travel and coach travel for example within the European Union
• The unwillingness of people within the domestic economy to take certain “drudge-filled” jobs such as porters, cleaners and petrol attendants

 Economic Benefits from Cross-Border Migration

Supporters of inward labour migration have argued that migration provides numerous advantages:

• Fresh skills: Migrants can provide complementary skills to domestic workers, which can raise theproductivity of both (a Brazilian child minder provides good quality child care at an affordable price which allows a highly paid female magazine editor to continue to work.)
• A driver of innovation and entrepreneurship: Inward migration can also be a driver of technological change and a fresh source of entrepreneurs. Much innovation comes from the work of teams of people who have different perspectives and experiences. Migrant networks accelerate the spread of technology.
• Pressure on government to reform: Labour migration can also put political pressure on failing governments and regimes e.g. a mass exodus of productive workers from Zimbabwe.
• Multiplier effects: New workers create new jobs, there is a multiplier effect if they find work and contribute to a nation’s GDP through a higher level of aggregate demand.
• Reducing skilled-labour shortages and expanding the labour supply: Migration can help to relieve labour shortages and help to control wage inflation. For example, recruitment of skilled workers from outside the European Union is important to many businesses in the UK, and evidence indicates they currently make a positive contribution to UK’s GDP.
• Making a country attractive to FDI: Availability and quality of labour is known to be a key investment location factor for many businesses. In a global battle for talent, if a country is not successful in attracting and keeping skilled workers then FDI in high-knowledge industries will eventually flow to other parts of the world.
• Income flows (remittances): Remittances sent home by migrants add to the gross national income of the home nations. And if these remittances boost spending in these countries, this creates a fresh demand for the exports of other nations. According to the economist Professor Ian Goldin from Oxford University, in Latin America and the Caribbean, more than 50-million people are supported by remittances, and the numbers are even higher in Africa and Asia.
• Tax revenues: Legal immigrants in work pay direct and indirect taxes and are likely to be net contributors to the government’s finances.

Supporters of allowing free movement of labour argue that labour mobility is a positive-sum game rather than a zero-sum game.

Disadvantages of inward migration

On the other side there are several pressure groups campaigning for tighter restrictions on migrant workers. Some of the arguments include:

• Welfare costs: Increasing cost of providing public services as migrants come into a country.
• Worker displacement: Possible displacement effects of domestic workers
• Social pressures: Social tensions arising from the problems of integrating hundreds of thousands of extra workers into local areas and regions.
• Pressure on property prices: Rising demand for housing which forces up prices and rents.
• Benefit claims: Many immigrants find it hard to get work
• Who really gains? The benefits of migration are focused mainly on employers, especially those who take on illegal workers at low wages.
• Poverty risk: Migration may have the effect of worsening the level of relative poverty in a society. And many migrant workers have complained of exploitation by businesses that have monopsony power in a local labour market.

Brain Drains – Human Capital Flight

Migration directly impacts the migrants, their families and their employers, and also impacts development indirectly.
Development in turn impacts migration. There is no doubt that migration is a very important driver of development.

Source: World Bank, Jan 2013

Every immigrant is also an emigrant. A brain drain is a term that describes the movement of highly skilled or professional people from their own country to another country where they can earn more money. It has been used to describe net outward migration of people from several European Union countries in recent times (notably Ireland, Greece and Spain) - another phrase for this is human capital flight.

A sizeable brain drain can bring economic costs and benefits for the sending nation. One disadvantage is that countries lose out on the benefits that might have accrued from the resources used in educating people who leave. Add to this the loss of tax revenue from those who choose to live and work overseas. A sizeable loss of skilled workers (many of whom may be younger and therefore more geographically mobile) could lead to labour shortages in the sender country, putting upward pressure on wages and labour costs. Some of this income earned overseas returns to the sender country in the form of remittances and many skilled migrants often leave only for a year or two - the percentage of permanent migration inside the EU is relatively small.

The benefits and costs of labour migration are hard to quantify and estimate. Much depends on

• The types of people who choose to migrate from one country to another.
• The ease with which they assimilate into a new country and whether they find regular jobs.
• Whether a rise in labour migration stimulates capital spending by firms and by government.
• Whether workers who come into a country decide to stay in the longer term or whether they regard migration as essentially a temporary exercise (e.g. to gain qualifications, learn some English) before moving back to their country of origin.

Economic Development - Strategies for Sustainable Development

Introduction

Which strategies and policies are best for an individual country wishing to see sustained economic growth and development? Remember that growth and development are not the same!

"Never before in history has the dream of eliminating global poverty been so attainable, yet seemed so elusive. We live in a world where the reach of technology and markets are global, and yet more than a billion men, women, and children live in abject poverty, devoid of their benefits. How can that possibly be? In an age of plenty, what deprives people of adequate food, shelter, clean water, education, good health and enough income to live on with dignity? What can governments, international agencies, and non-governmental organizations do to make the dream a reality?”

Source: Professor Dani Rodrik. Harvard

The role of the state: Throughout much of the 1960s and 1970s, traditional development thinking had been that government/state control and economic planning, high levels of public investment and protection from the volatility of the world market using protectionism was the best recipe for promoting development.

Self-sufficiency was the main goal including investment in import-substitution industries - so foreign trade was seen as a hindrance and therefore a tax opportunity to raise revenues for the government.

In the 1980s and 1990s a new pro-market doctrine gained momentum supported by the work of institutions such as the World Bank and the International Monetary Fund (IMF). This approach advocatedmarket-friendly and open-border policies including cuts in import tariffs and increasing cross-border flows of financial capital and labour.

The core idea behind increasing openness in the world economy was that developing countries stronger engagement with the developed world allows them to mimic and develop the technologies of the West, raise productivity and drive per capita incomes higher.

Development Challenges: Escaping the Middle Income Trap

The middle income trap exists for some countries that make significant progress in reducing extreme poverty and experience structural change and growth but then find it difficult to make the climb from being a middle-income country to achieve high-income fully-developed status. GDP growth rates often slow down and a country can struggle to build and maintain international competitiveness.  Research from the World Bank finds that only 13 of the 101 countries deemed to be middle-income countries in 1960 had achieved high-income levels in 2011. Different studies find different thresholds for where growth tapers off, ranging from $8,500 to $18,500 at 2010 prices, adjusted for purchasing power parity.

Possible Causes of the Middle-Income Trap

Strategies for Avoiding the Middle Income Trap

Key to avoiding the trap is for each country to find the right mix of demand and supply-side policies to sustain a further lift in their per capita incomes and to achieve balanced growth sourced from domestic and overseas markets. Every country has a different set of economic, social, cultural, demographic and political circumstances so there is no unique policy mixes to avoid the middle income trap – some of the approaches often mentioned include the following:

• The growth that brings a country out of extreme poverty is not always the type of growth that makes a country richer and lifts their per capita income above middle-income levels
• The middle income trap is largely the result of a country’s inability to continue the process of moving from low value-added to high value-added industries
• The advantages of low-cost labour and imitation of foreign technology can disappear when middle- and upper-middle-income levels are reached
• The focus switches towards improving competitiveness rather than narrow emphasis on input-driven growth (i.e. just adding more land, labour and capital into the production process)
• Many middle-income countries experience a “growth slowdown”. Leading economist, Professor Barry Eichengreen has found that growth slowdowns typically occur at per capita incomes of about $16,700 in 2005 constant international prices. At that point, the growth rate of GDP per capitaslows from 5.6 to 2.1 percent, or by an average of 3.5 percentage points

Case Study: Malaysia attempts to break the middle income trap

• The Malaysian economy achieved rapid growth during the period 1990-97 with annual increases in real GDP close to 10%. The economy then suffered a recession in 1998 because of the Asian financial crisis before starting a recovery. But growth rates since then have been substantially lower – averaging only 4.3% pa from 2001-2009.
• Our chart below confirms this and shows also that capital investment spending as a share of GDP has dropped from over 40% to 15% in 2009. Malaysia can still reach her target of becoming a high income developed country by 2020; indeed the government has an ambitious five year national economic plan that includes a target of doubling per capita incomes.

Malaysian growth potential:

• A youthful population  - 31% below the age of 14 , 5% the population older than 65
• Export driven economy spurred by high technology, knowledge-based, capital-intensive industries
• A leading exporter of semiconductor devices, hard disks, audio/video products and air conditioners
• Tourism regarded as a key growth and development industry – now supported by increased infrastructure investment. Malaysia has 32 airports with paved runways + 83 with unpaved runways
• Focus on giving the private sector a bigger role in driving growth and in attracting FDI

Malaysia ranks well in terms of global competitiveness and the chances of breaking the middle-income trap: The 2012 Global Competitiveness Index ranked Malaysia as follows (ranked out of 142 countries):

• Institutions:                               30/142
• Infrastructure:                            26/142
• Macroeconomic environment:    29/142
• Health and primary education:    33/142
• Technological readiness:           44/142
• Higher education and training:    38/142

Malaysia’s overall global competitiveness ranking for 2012 was 21 out of 142 countries

consumers surplus, IGCSE,GCEO NOTES

Consumer surplus

When there is a difference between the price that you pay in the market and the value that you place on the product, then the concept of consumer surplus becomes a useful one to look at.

• Consumer surplus is a measure of the welfare that people gain from consuming goods and services
• Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price).
• Consumer surplus is shown by the area under the demand curve and above the equilibrium price as in the diagram below.

Consumer surplus and price elasticity of demand

1. When the demand for a good or service is perfectly elastic, consumer surplus is zero because the price that people pay matches what they are willing to pay. 

2. In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Demand does not respond to a price change. Whatever the price, the quantity demanded remains the same. Are there any examples of products that have such zero price elasticity of demand?

3. The majority of demand curves are downward sloping. When demand is inelastic, there is a greater potential consumer surplus because there are some buyers willing to pay a high price to continue consuming the product. This is shown in the next diagram.

• When there is a shift in the demand curve leading to a change in the equilibrium market price and quantity, then the level of consumer surplus will change too
• In the left hand diagram, following an increase in demand from D1 to D2, the equilibrium market price rises to from P1 to P2 and the quantity traded expands. There is a higher level of consumer surplus because more is being bought at a higher price than before.
• In the diagram on the right we see the effects of a cost reducing innovation which causes an outward shift of market supply, a lower price and an increase in the quantity traded in the market. As a result, there is an increase in consumer welfare shown by a rise in consumer surplus.

Consumer surplus can be used frequently when analysing the impact of government intervention in any market – for example the effects of indirect taxation on cigarettes consumers or the introducing of road pricing schemes such as the London congestion charge or a rise in air passenger duty.

Capital Investment,IGCSE,GCEO

Capital Investment

Introduction

Investment involves buying capital goods to provide us with goods and services in the future

Investment is a decision to postpone consumption and to accumulate capital which can lift an economy’sproductive potential.

Investment is a component of aggregate demand and capital expenditure also has important effects on both the demand-side and the supply-side of any economy

Net and gross investment

• Net investment = gross investment minus replacement investment required to replace obsolete capital. The level of net investment tells us what is happening to the stock of fixed capital
• Gross fixed investment is spending on fixed assets including buildings, plant and vehicles

Factors that affect investment demand 

Profit-seeking businesses will be prepared to go ahead with an investment if they believe that it will - over its projected lifetime - yield a real rate of return greater than if the money had been invested in the next best alternative way. Opportunity cost is a useful idea to use here.
Private sector businesses usually focus on these objectives when investing in new capital inputs:

1. Improving productivity / efficiency to drive down unit costs and achieving economies of scale
2. Investing in capital embodies the most recent technological improvements
3. Expanding capacity to meet rising actual demand and to supply to new markets (e.g. exports)
4. Increasing capacity in advance of an expected increase in market demand (i.e. the accelerator)
5. Replacing obsolete capital equipment and buildings

Social cost benefit analysis

For government sector investment such as new roads, schools and prisons, priorities may be subtly different. Public sector capital projects are still subject to tests about their expected rates of return and thecost-benefit analysis will include estimates of the social costs and benefits of the investment rather than a narrow focus on private costs and benefits.

Returns to an investment project

• The expected returns from capital investment are determined by the demand for and the price of the output generated by an investment and by the costs of production
• A rise in demand will increase the revenue streams that a business can expect from a new project
• A change in the costs of purchasing capital inputs the costs of training workers to use new capital and in maintaining the capital stock will impact on the expected rate of return

The importance of business expectations and uncertainty

• One of the important lessons of Keynesian economics is the crucial role played by business ‘animal spirits’ in determining how much firms are willing to commit to capital spending
• There is always uncertainty about the expected rate of return particularly when market demand is volatile and sensitive to changes in interest rates, the exchange rate and real incomes
• The expected rate of return from an investment is also influenced by the rate at which a new capital project depreciates over time and the effects of changes in corporation tax on profits

The marginal efficiency of capital (MEC) – the demand curve for investment

The marginal efficiency of capital (MEC) is the rate of interest, which makes an investment project viable “at the margin”. In the diagram above, at lower rates of interest (i.e. R2) the cost of borrowing money is lower and the opportunity cost of using retained profits as a source of finance is reduced. A fall in interest rates should lead to an expansion along the investment demand curve. Similarly higher interest rates (R3) may lead to some projects being postponed or cancelled.

• For the UK, recent evidence suggests that the demand for new capital goods is interest rate inelastic. Partly this is because many firms prefer to use the capital market through the issue of new shares and bonds to raise funds for investment rather than relying on bank loans.
• But the rate of interest can and does affect capital investment decisions – perhaps through its effect on confidence and also expectations of changing demand and the links between interest rates and the exchange rate.

The Accelerator Model

• The accelerator suggests a positive relationship between investment and the growth of demand
• Accelerator theories assume that for a business there is a desired capital stock for a given level of output and interest rates. A rise in output or a fall in demand may prompt increased levels of investment as firms adjust to reach the new optimal capital stock level
• The accelerator model works on the basis of a fixed capital to output ratio. For example if demand in a given year rises by £4 million and each extra £1 of output requires an average of £3 of capital inputs to produce this output, then the net level of investment required will be £12 million
• Consider the diagram below that shows an outward shift of AD that then causes an expansion of production, higher profits and prompts an increase in planned investment at each rate of interest. This boost in demand and output is said to bring about a positive ‘accelerator effect’

• One criticism of this simple accelerator model is that the capital stock of a business can rarely be adjusted immediately to its desired level because of ‘adjustment costs’ and ‘time lags’. The adjustment costs include the cost of lost business due to installation of new equipment or the financial cost of re-training workers.
• Firms will usually make progress towards achieving an optimum capital stock rather than moving smoothly to a new optimal size of plant and machinery. The time lags might be caused by supply-bottlenecks in industries that manufacture buildings and items of capital equipment and technology.
• A further criticism of the accelerator model is that it ignores the spare capacity that a business might have at their disposal. At the end of a recession, businesses are operating below capacity limits and if demand then picks up in the recovery, they make more intensive use of existing capacity.

Business profitability

Business profits play an important role in allocating resources – for example, higher profits provide the funds for capital investment and also for research and development projects

Profits tend to follow a cyclical pattern – they fall during a recession or an economic slowdown. And they recover during phases of stronger economic growth

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