Economics and the 2008 crisis: a Keynesian view

Transcription

1 Economics and the 2008 crisis: a Keynesian view

2 About this free course This free course is an adapted extract from the Open University course DD209 Running the economy: This version of the content may incude video, images and interactive content that may not be optimised for your device. You can experience this free course as it was originay designed on OpenLearn, the home of free earning from The Open University There you aso be abe to track your progress via your activity record, which you can use to demonstrate your earning. The Open University, Waton Ha, Miton Keynes MK7 6AA Copyright 2016 The Open University Inteectua property Uness otherwise stated, this resource is reeased under the terms of the Creative Commons Licence v4.0 Within that The Open University interprets this icence in the foowing way: Copyright and rights faing outside the terms of the Creative Commons Licence are retained or controed by The Open University. Pease read the fu text before using any of the content. We beieve the primary barrier to accessing high-quaity educationa experiences is cost, which is why we aim to pubish as much free content as possibe under an open icence. If it proves difficut to reease content under our preferred Creative Commons icence (e.g. because we can t afford or gain the cearances or find suitabe aternatives), we wi sti reease the materias for free under a persona enduser icence. This is because the earning experience wi aways be the same high quaity offering and that shoud aways be seen as positive even if at times the icensing is different to Creative Commons. When using the content you must attribute us (The Open University) (the OU) and any identified author in accordance with the terms of the Creative Commons Licence. The Acknowedgements section is used to ist, amongst other things, third party (Proprietary), icensed content which is not subject to Creative Commons icensing. Proprietary content must be used (retained) intact and in context to the content at a times. The Acknowedgements section is aso used to bring to your attention any other Specia Restrictions which may appy to the content. For exampe there may be times when the Creative Commons Non- Commercia Shareaike icence does not appy to any of the content even if owned by us (The Open University). In these instances, uness stated otherwise, the content may be used for persona and noncommercia use. We have aso identified as Proprietary other materia incuded in the content which is not subject to Creative Commons Licence. These are OU ogos, trading names and may extend to certain photographic and video images and sound recordings and any other materia as may be brought to your attention. Unauthorised use of any of the content may constitute a breach of the terms and conditions and/or inteectua property aws. We reserve the right to ater, amend or bring to an end any terms and conditions provided here without notice. 2 of 77 Friday 16 November 2018

3 A rights faing outside the terms of the Creative Commons icence are retained or controed by The Open University. Head of Inteectua Property, The Open University Edited and designed by The Open University. Printed and bound in the United Kingdom by [name and address of printer]. Contents Introduction 5 Learning Outcomes 7 1 Keynes in context 8 2 Panned and actua vaues 9 3 The consumption function Buiding a consumption function (1) Buiding a consumption function (2) Buiding a consumption function (3) 11 4 Modeing equiibrium Modeing panned saving (1) Modeing panned saving (2) Modeing panned investment And so to equiibrium 15 5 When equiibrium is not enough Underempoyment equiibrium 15 6 The aggregate demand mode with government and fisca poicy Government expenditure (1) Government expenditure (2) Government expenditure (3) Government expenditure (4) Government revenue and taxation Stabiisation poicy Government debt and crowding out Summary 45 7 Zooming in on firms Facing the competition Microeconomics what is a firm? Production cost Cost curves Margina cost curves Using evidence 68 3 of 77 Friday 16 November 2018

4 7.7 Summary 73 8 Concusion 74 Keep on earning 74 References 75 Acknowedgements 77 4 of 77 Friday 16 November 2018

5 Introduction Introduction Decisions, decisions, decisions. Governments need to make decision about how much to spend, how to finance their debt and how much revenue to coect, in order to ensure their citizens wefare is as high as it can be, given that there is a imited amount of resources avaiabe or borrowabe against future repayments. These decisions become even more pressing and their consequences more acute in times when the economy is not growing; or worse, in moments when it is actuay shrinking. As the famous economist Pau Krugman wrote in 2012, 'times of crisis are when economists are most needed. If they cannot get their advice accepted in the cinch or worse yet, if they have no usefu advice to offer the whoe enterprise of economic schoarship has faied in its most essentia duty'. In this OpenLearn course you wi work through seven sections in which you wi engage with some of the major aspects of economic poicy: What types of probems are governments concerned with? Which poicy instruments do they have at their disposa? How do they make decisions about the effectiveness of aternative courses of action? One of the most chaenging aspects of economic poicy and decision making is the study of how changes in economic variabes infuence the more immediate and the future economic response. As Charie Bean, the deputy governor of the Bank of Engand in the eary 2010s, puts it, 'peope describe the steering of the economy ike driving a car when a you can do is ook through the rear view mirror'. 5 of 77 Friday 16 November 2018

6 Introduction Figure 1 So, any caims as to what wi happen in the future as a resut of current poicy are grounded in economic modes about how economies, peope, firms and industries within them, wi respond. In this course you wi discover that different economists have different theories about how the economy works, and different theories ead to different resuts, depending on the state of economies. This creates considerabe controversy over which poicies are right you might aready have your own views too. You wi aso earn about the ways in which John Maynard Keynes s theories revoutionised the thinking about how economic crises appear and how the government can sove them. In doing so, you wi start to buid an economic mode to expore Keynes s ideas. Keynes s thinking was very infuentia with economists and poicymakers for severa decades foowing the 1930s, but then fe out of favour for a time. The economic downturn that started in 2008 ed to a widespread reviva of interest as economic conditions seemed to resembe those seen in the 1930s. So a study of Keynes s ideas is not just of historica interest but highy reevant to modern poicymaking too. This OpenLearn course is an adapted extract from the Open University course DD209 Running the economy. 6 of 77 Friday 16 November 2018

7 Learning Outcomes After studying this course, you shoud be abe to: understand what economists mean by modes and how they can be used to inform economic poicy define the concept of equiibrium and expain how it can occur at ow eves of output begin to understand the Keynesian mode of aggregate demand and how it expains why economies can get stuck in a ow output equiibrium criticay evauate the roe of fisca poicy in changing the economy.

8 1 Keynes in context 1 Keynes in context Before we start to deveop our Keynesian mode of the economy, it is hepfu to know something about Keynes and the context that compeed him to deveop his theories, which are sti infuentia today. Beow you wi find a timeine of some of the highights in Keynes' ife, and an audio cip in which two Open University economists discuss some key economic ideas, and Keynes' infuence in shaping economics and economic poicy. Cick on the ink beow to aunch the timeine and then cick and drag your mouse to move aong the timeine for highights in the ife and career of John Maynard Keynes ( ). Cick on each entry to read some detais. Interactive content is not avaiabe in this format. Timeine of ife and career of John Maynard Keynes ( ) Now isten to the foowing audio. This audio is taken from Bock 2 of the Open University course DD209 Running the economy so there are a number of references to the bock, as we as a summary of Bock 1 of the course, which you shoud ignore. As you isten to the discussion, you may find it hepfu to note down the key points. Audio content is not avaiabe in this format. Open University economists discussing Keynes' ideas and infuence Activity 1 Thinking about the timeine and your notes from the audio cip you have just istended to, suggest one important economic egacy of Keynes. Provide your answer... Discussion Keynes remains, even today, one of the most infuentia economists. His egacy incudes his Genera Theory (see the timeine) which set out his thinking that economies do not naturay provide jobs for everyone governments may need to intervene. Keynes is aso recognised as one of the founders of the branch of economics caed macroeconomics (mentioned in the audio). You may have made other suggestions. 8 of 77 Friday 16 November 2018

9 2 Panned and actua vaues 2 Panned and actua vaues Notation in equations In the sections which foow, you wi be introduced to some simpe equations. Don t panic! Wherever they are used, we teach you step by step how to read them. A genera point to be aware of is that where one term is mutipied by another we wi foow standard maths notation and eave out the mutipication sign. For exampe, in Section 6, you wi see the equation of consumption C = a + by. We write by instead of writing b Y (with the mutipication sign ). The genera rue is that when two terms are paced side by side, they are to be mutipied. The economy as modeed by the circuar fow diagram, beow, appears to be a rather peacefu pace, where expenditure is aways identica to output and saving is aways identica to investment. But saving decisions and investment decisions are made by different peope, so it seems there is no reason why they shoud match, and Keynes s mode of change in nationa income depends precisey on expenditure being too great or too sma to match output and hence on saving being too sma or too great to match investment. Figure 2 Circuar fow of income Activity 2 Watch the video beow to see how this paradox is resoved. This video is part of the Open University course DD209, Running the economy, so there wi be references to Bock 1 of the course, which you shoud ignore. Video content is not avaiabe in this format. Panned and actua vaues Interactive content is not avaiabe in this format. 9 of 77 Friday 16 November 2018

10 3 The consumption function 3 The consumption function So far, we have been representing what happens in the economy using the circuar fow of income mode. To demonstrate Keynes s theories about equiibrium in a more quantifiabe way, we need to use what is caed the aggregate demand mode. The two main components of this mode are consumption and investment. Section 6 wi show you an extended version of this mode which incudes government expenditure, but for now, Figure 3 represents an economy with no government and no trade and reations with other countries. This section consoidates your understanding of the first eement in this mode: the consumption function. Figure 3 The aggregate demand mode 3.1 Buiding a consumption function (1) According to Keynes, there is a fairy stabe reationship between panned consumption and current income. Househods pan to spend a fairy constant proportion of each additiona pound they earn. He cas this proportion the margina propensity to consume. To present this diagrammaticay, we start with two axes at right-anges to each other. Activity 3 The horizonta axis of Figure 4 shows income (Y) and the vertica axis shows panned consumption (C). Interactive content is not avaiabe in this format. Figure 4 Potting panned consumption against income Suppose that consumers pan to spend 70 pence of each additiona pound they earn. The margina propensity to consume is 0.7. The usua symbo for the margina propensity to consume is b. So, we can say b = 0.7. Cick on three points on Figure 4 which woud ie on the consumption function. 3.2 Buiding a consumption function (2) We now have a hypothetica consumption function. 10 of 77 Friday 16 November 2018

11 3 The consumption function Activity 4 Look at Figure 5 and answer the questions that foow. Question 1 Interactive content is not avaiabe in this format. Figure 5 A consumption function (a) What is the equation of the consumption function we have drawn? Provide your answer... Answer The equation is: C = 0.7Y Question 2 (b) In what way is it unreaistic to suggest, as in this exampe that the consumption function woud start from the origin? Provide your answer... Answer Even with no income, there must be some consumption: househods need to consume basic goods so woud need to borrow or run down savings baances to finance this consumption. This bare minimum consumption that does not depend on income is known as exogenous consumption. Exogenous consumption is usuay symboised by a. Question 3 (c) How woud the consumption function be affected if exogenous consumption (usuay symboised by a) was 100? Answer by picking up and dragging the consumption ine to take account of this eve of exogenous consumption. 3.3 Buiding a consumption function (3) Activity 5 Look at Figure 6 and answer the foowing question. 11 of 77 Friday 16 November 2018

12 4 Modeing equiibrium Figure 6 A more reaistic consumption function What is the equation of this revised consumption function? Provide your answer... Answer The equation is: C = Y 4 Modeing equiibrium We have said that the economy wi be in equiibrium when panned saving matches panned investment. So we need to use our diagram to expore this reationship. First, we 12 of 77 Friday 16 November 2018

13 4 Modeing equiibrium need to show panned saving. Our diagram aready shows panned consumption at each eve of income, and of course panned saving is simpy the difference between income and panned consumption. Having shown saving, we need to go on to add investment to our mode to compete our anaysis of equiibrium. 4.1 Modeing panned saving (1) A good way to make our diagram work for us to show panned saving (the difference between income and panned consumption) is to start by refecting each vaue of income potted on the horizonta axis on to the vertica axis where panned consumption is potted. This wi make it easy to compare visuay each eve of income with its corresponding eve of panned consumption. So et s start with just the two scaed axes and imagine that each vaue of income emits a ray of ight verticay. A mirror is hed diagonay to refect that ray on to the vertica axis. Cick on each circe on the bar underneath the chart, working from eft to right to watch this process buid up step by step. Interactive content is not avaiabe in this format. Figure 7 Buiding the 45-degree ine The ine we have traced out is caed, for obvious reasons, the 45-degree ine, and it shows us at a gance how far up from the horizonta axis any vaue of income woud appear if we potted it on the vertica axis. At any point on the ine, the variabe potted on the vertica axis panned consumption is equa to the variabe potted on the horizonta axis income. 4.2 Modeing panned saving (2) If we now show our consumption function on the same diagram, we can visuay compare each eve of income with its corresponding eve of panned consumption. Activity 6 Recaing that panned saving is the difference between income and panned consumption, cick on two points on the diagram which, when joined up, wi show the amount of panned saving at an income eve of 600. Interactive content is not avaiabe in this format. Figure 8 The 45-degree ine and the consumption function 13 of 77 Friday 16 November 2018

14 4 Modeing equiibrium 4.3 Modeing panned investment At an income eve of 600, househods are panning to spend 520 on consumption and to save the remaining 80. But firms are not panning to invest at a! Let s now incorporate panned investment into our diagram. This wi mean two sight changes. 1 We re-abe the vertica axis Aggregate demand, as we are adding investment demand to consumption demand. 2 We reinterpret the 45 degree ine accordingy. Reca that at any point on the 45- degree ine the variabe potted on the vertica axis is equa to the variabe potted on the horizonta axis. So in this diagram, at any point on the ine, aggregate demand is equa to income. The Keynesian mode treats panned investment as an exogenous component of demand, that is, as not dependent on current income. It wi therefore appear as a horizonta ine on our diagram but, when we add panned investment to panned consumption, the aggregate demand ine, which at present shows ony panned consumption, wi move upwards by the amount of panned investment we introduce. Activity 7 Look at Figure 9 and compete the tasks that foow. Task 1 Interactive content is not avaiabe in this format. Figure 9 The aggregate demand mode with investment (a) At present, the panned investment ine is ying aong the horizonta axis as we have not yet shown any panned investment. Pick up and drag the ine ti it shows a eve of panned investment equa to the eve of panned saving at an income eve of 600. (Note that the scaes on the axes have been changed to make this task easier - the income eve of 600 is now towards the far right of the diagram. Task 2 (b) What is the equation of the aggregate demand function you have derived? Provide your answer... Answer The equation is: AD = Y, as there are now two constants: exogenous consumption (100) and panned investment (80). 14 of 77 Friday 16 November 2018

15 5 When equiibrium is not enough 4.4 And so to equiibrium In our diagram, panned saving is shown by the vertica gap between the consumption function and the 45-degree ine. Panned investment is shown by the vertica gap between the consumption function and the aggregate demand function. Given the assumptions we have made about exogenous consumption, the propensity to consume and the eve of exogenousy determined investment, these two vertica gaps are equa at an income eve of 600, so at this income eve panned saving = panned investment. We have therefore iustrated an economy in equiibrium at an income eve of 600. Note that the AD ine (C + I) crosses the 45-degree ine at an income eve of 600. Since at any point on the 45-degree ine AD = Y, we can say that at an income eve of 600 aggregate demand = income. Figure 10 Equiibrium at an income eve of 600 So we have two ways of ooking at equiibrium in this simpe economy. When the economy is in equiibrium: 1 Panned saving = Panned investment 2 Aggregate demand = Income 5 When equiibrium is not enough Keynes beieved that an economy may sette into equiibrium at a eve of income too ow to support fu empoyment. We can use our mode to iustrate this possibiity and to iustrate how poicy intervention to stimuate aggregate demand may bring about fu empoyment. 5.1 Underempoyment equiibrium Equiibrium occurs when aggregate demand equas income, so, in the previous activity, when AD is equa to income at 600. But it may be that AD of 800 equa to Yf is needed to support fu empoyment, so equiibrium woud need to occur at an income eve of 800. Given current consumption and investment habits, however, if income stood at 800, AD woud be ess than 800, as we can see from the fact that the C + I ine ies beneath the 45-degree ine at an income of 800. To achieve fu empoyment, a poicy intervention 15 of 77 Friday 16 November 2018

16 5 When equiibrium is not enough woud be needed to stimuate demand sufficienty to bring about equiibrium at an income eve of 800. You wi now use an Aggregate Demand too to expore how we coud move the economy to a fu empoyment equiibrium. Activity 8 Seect the ink beow to access the too. Aggregate Demand too Pace yoursef in the tab 'Cosed economy without government'. This means the economy has no government, and demand comprises ony consumption and investment. Compete the foowing tasks. Task A (a) Set the inputs to the foowing vaues: exogenous consumption (abeed 'Consumption intercept' equas 100, the margina propensity to consume is 0.7, investment is set at 80 and fu-empoyment income is 800. Answer The outputs and chart in the too shoud ook ike this. You can see that this economy is currenty in equiibrium at an income of 600 but we want to reach the fu-empoyment equiibrium of of 77 Friday 16 November 2018

17 5 When equiibrium is not enough Figure 11 Task B (b) State by how much AD fas short of the eve required to produce the fuempoyment income of 800. Provide your answer... Answer In this exampe, aggregate demand at any eve of income is cacuated using the equation: AD = Y So, if equiibrium income (Y) were to be 800: AD = x 800 = = 740 which woud fa short of income by = 60. Poicy intervention wi be needed to give a stimuus that initiay raises aggregate demand by of 77 Friday 16 November 2018

18 5 When equiibrium is not enough Task C (c) Assume that the required stimuus is going to take the form of poicy to increase investment. Use the too to change investment by the amount you cacuated in (b). Answer If you increased investment by 60, the new amount of investment shoud be 140. The outputs and chart from the too shoud now ook ike this: Figure 12 Task D (d) Describe what has happened to the equiibrium eve of income as a resut of the change you made in (c). Provide your answer of 77 Friday 16 November 2018

19 6 The aggregate demand mode with government and fisca poicy Answer The economy is now in equiibrium at an income of 800 which is the fu-empoyment eve of income. 6 The aggregate demand mode with government and fisca poicy The previous sections introduced some of the arguments made by Keynes as to why capitaist economies can become stuck in positions of high unempoyment. Though there may be a quite stabe reationship between income and consumption, private investment can anguish at eves that are insufficient for fu empoyment. The government may choose to fi the gap: an active state sector for Keynes can iron out the vagaries of voatie private investment spending. For the macroeconomy, the key probem is the faiure to reach fu empoyment owing to a shortfa in aggregate demand, and the component of aggregate demand that is most frequenty insufficient is investment demand. This section introduces some of the poicy toos that are avaiabe to a government department responsibe for coordinating pubic finance in the UK caed Her Majesty s (HM) Treasury. The Treasury is the coordinating body that aocates government spending (for transport, heath, education, defence, and so on) and oversees the coection of taxes (such as Income Tax, Vaue Added Tax (VAT) and excise duty on petro). When the government uses these spending and revenue raising activities to stabiise the economy, this comes under the purview of fisca poicy, which is the main focus of this section. It shoud be emphasised that the roe of fisca poicy is highy contested by economists and poicymakers. From a Keynesian perspective, the government has a vita roe in stabiising the macroeconomy, because there is no automatic mechanism through which the economy can recover from a recession. For critics of the Keynesian approach, however, the government shoud eave the private sector aone: it is government intervention that prevents the private sector from bringing about fu empoyment equiibrium. The purpose of this section is to introduce and expore the Keynesian point of view. Some critiques of the Keynesian approach are aso expored. Section 6 introduces government expenditure and shows its fu potentia Keynesian impact. Not ony can government spending generate demand for goods and services that may encourage firms to empoy more peope, but aso its effect on income can be much greater than the initia stimuus. The section then focuses on the more tricky issue of how government spending is financed through taxation. It aso considers how the cutting of taxes can hep to stimuate aggregate demand. These two dimensions of fisca poicy are brought together in a consideration of fisca stabiisers. The government can use fisca poicy in a discretionary way to activey intervene in times of crisis; it can aso aow what are known as automatic stabiisers to smooth out economic fuctuations. Finay, the section examines a big poicy issue that has dominated pubic poicy-making in recent years the issue of budget deficits. 19 of 77 Friday 16 November 2018

20 6 The aggregate demand mode with government and fisca poicy 6.1 Government expenditure (1) In modern capitaist economies, the pubic sector pays a key roe. In the UK, tota government expenditure was forecast to be 683 biion in the financia year , which is 43.4% of Gross Domestic Product (GDP) (HM Treasury, 2012). Government activities range across a spheres of the economy, from the provision of socia protection (such as benefits and pensions) to heath, transport and defence. A breakdown of government spending is provided in Figure 13. Socia protection is ceary the argest category, with heath and education the next argest categories. Figure 13 UK government spending, ( biion) (Source: HM Treasury, 2012, p. 1, Chart 1) Socia protection incudes the provision of transfer payments, where there is a transfer from the government to individuas that is not made in return for any services. Od-age pensions and unempoyment benefit are exampes of transfer payments. If, for exampe, a refuse coector becomes unempoyed and receives unempoyment benefit, this benefit is a transfer payment, since he is providing no direct service. By contrast, if the refuse coector is in work and paid a wage by the government, that is government spending on the service of emptying bins. As you wi see in the anaysis that foows, some economists and poicymakers may regard government expenditure as unproductive and wastefu, a drain on the weathcreating private sector, even when it takes the form of expenditure on goods and services. For Keynes, however, government expenditure represents a powerfu ever for intervention when the private sector fais to generate sufficient demand. Keynes formuated his ideas during the 1920s, making a number of attempts to persuade the UK government to increase its expenditure in order to boost aggregate demand. Athough the wartime British Prime Minister, David Loyd George, had promised that there woud be jobs for the boys when sodiers came home after the First Word War, this did not materiaise. High unempoyment in the 1920s ed to the decine of the Libera Party, of which Loyd George was the eader, and its repacement by James Ramsay MacDonad s Labour Party as the main aternative to the Conservatives a position from which the 20 of 77 Friday 16 November 2018

21 6 The aggregate demand mode with government and fisca poicy Libera Party (caing itsef the Libera Democrats at the time of writing) has never recovered. In one fina push, in the 1929 Genera Eection, Loyd George tried to regain his supremacy over the spectre of sociaism. Under his auspices, the Libera Party pubished a pamphet entited We can conquer unempoyment. He aso marshaed the support of Keynes to deveop his party s manifesto. In his address to Libera candidates on 1 March 1929, Loyd George pedged: If the nation entrusts the Libera Party at the next Genera Eection with the responsibiities of government, we are ready with schemes of work which we can put immediatey into operation, work of a kind which is not merey usefu in itsef but essentia to the we-being of the nation (Keynes, 1972, p. 88). The Conservative-dominated press rubbished these caims as the fantasies of a Wesh windbag, being far too optimistic and not based on common sense. Keynes pied in, in a pamphet entited Can Loyd George do it?, written with a poitician, Hubert Henderson. This aimed to suppement and to answer criticisms of the Libera Party pamphet mentioned above. Keynes wrote: The Libera Poicy is one of pain common sense. The Conservative beief that there is some aw of nature which prevents men from being empoyed, that it is rash to empoy men, and that it is financiay sound to maintain a tenth of the popuation in ideness for an indefinite period, is craziy improbabe the sort of thing which no man coud beieve who had not had his head fudded with nonsense for years and years. (Keynes, 1972, p. 91) In answer to the objections raised by the then Conservative Prime Minister Staney Badwin, Keynes observed: Mr Badwin and his coeagues are not more capabe of expounding the true economic science of the matter than they woud be of expaining to you the atest propositions of Einstein (Keynes, 1972, p. 91). 6.2 Government expenditure (2) Loyd George s 300 miion programme had three main panks: Transport: To modernise the rai and transport system, incuding eectrification of raiways and particuar emphasis on roads, since they were under the direct contro of the government sector. A capita sum of 145 miion for road repacement and extension over two years was proposed. Housing: To buid houses a year: a miion houses over a ten-year period woud provide for sum cearance and reduction of overcrowding. Unempoyed buiding workers woud be set to work on these road- and house-buiding programmes. Sma projects: A host of other sma deveopments, such as teephone deveopment and and drainage. A this required was a Treasury green ight for innumerabe schemes pigeonhoed in government offices (Keynes, 1972, p. 99). Simiar pubic spending programmes were announced throughout the word in response to the economic crisis of In the USA, President Obama introduced the American Recovery and Reinvestment Act of 2009, which resuted in US$831 biion of government spending on items such as infrastructure, heath and education. In the same year, 21 of 77 Friday 16 November 2018

22 6 The aggregate demand mode with government and fisca poicy Austraia aunched a Nation Buiding and Jobs Pan, costing AUS$42 biion, on items such as buiding oca community infrastructure and refurbishing schoos estimated to create jobs and to boost annua GDP by 1% after two years (Vu and Tanton, 2010, p. 129). The officia UK government position in 1929, however, as summarised by the Bafour Committee on Industry and Trade, was that a programme of this kind coud not provide empoyment in their own trades for any considerabe number of unempoyed persons (quoted in Keynes, 1972, p. 100). Against this pessimistic assessment, Keynes stated the Libera position that each miion pounds spent annuay on road improvements woud empoy, directy or indirecty, 5,000 workpeope (Keynes, 1972, p. 103). Keynes pointed out that this is four times higher than the assessment given by the Bafour Committee. The committee had faied to take into account the indirect empoyment effects of the roadbuiding programme. This error was eventuay admitted, after questioning in the House of Commons, by the Conservative Minister of Transport, Coone Ashey. After noting that for each 1 miion of road-buiding expenditure empoyment might be increased to as much as 2,500, Coone Ashey conceded that for each of these direct jobs another man woud be indirecty empoyed in producing and transporting materias in other ways, and this assumption may not be unreasonabe (quoted in Keynes, 1972, p. 104). There woud be additiona indirect empoyment created in the production and transport of the tarmac and other materias that are required for road-buiding, eading to a further possibe 2500 jobs. Activity 9 As reported above, the officia estimate was that 5000 jobs were created by each 1 miion of expenditure. Directy and indirecty, how many jobs coud have been created by the 72.5 miion earmarked for the first year of the Loyd George road-buiding programme? Answer The tota impact woud have been jobs ( ) in the first year a substantia hoe in the more than one miion unempoyed in 1929, created just by roadbuiding. For Keynes, this was not a Loyd George fantasy; it was confirmed by the government itsef after intensive pressure and anaysis. In Keynes s view the Bafour Committee had faied to take account of something much more significant than the indirect empoyment to which the Libera Party s pamphet and statements had drawn attention. By putting unempoyed peope into work both directy and indirecty, an initiative such as the road-buiding programme woud increase what he caed effective purchasing power. Newy empoyed workers in the road-buiding industry woud spend part of their wages on a wide range of goods and services, providing increased income and creating further new jobs in other parts of the economy. This in its turn woud ead to further spending, more income and more new jobs. In this way there woud deveop a considerabe rippe in the form of successive rounds of spending: the forces of prosperity [woud] work with a cumuative effect (Keynes, 1972, p. 106). This notion of cumuative increases in demand and hence in income and output is so centra to Keynes s system that it is worth quoting at some ength from the pamphet that he wrote with Henderson: 22 of 77 Friday 16 November 2018

23 6 The aggregate demand mode with government and fisca poicy It is not possibe to measure effects of this character with any sort of precision, and itte or no account of them is, therefore, taken in We Can Conquer Unempoyment. But, in our opinion, these effects are of immense importance. For this reason we beieve that the effects on empoyment of a given capita expenditure woud be far arger than the Libera pamphet assumes. (Keynes, 1972, p. 107) By the time Keynes pubished The Genera Theory of Empoyment, Interest and Money in 1936, he had refined his thinking about these cumuative effects and showed how they might be estimated using the margina propensity to consume. The anaysis that foows in the next section shows how the impact of government expenditure on output and empoyment can be modeed, using the aggregate demand framework. 6.3 Government expenditure (3) To mode the impact of government expenditure, the first step is to introduce a new term G to represent panned government spending. Whereas earier it was assumed that the economy consisted ony of private agents (househods and firms), the government sector (aso caed the pubic sector) is now incuded in the mode. Like private investment, government spending is treated in this mode as exogenous. It is important to note that the portion of government spending that takes the form of transfer payments is not incuded in G since it adds nothing directy to the demand for goods and services. However, as you wi see, transfer payments do affect the househod consumption component of aggregate demand and income. Aggregate demand (AD) in the extended mode consists of panned consumption (C) and panned investment (I ), as before, with an additiona term (G) representing panned government spending: AD = C + I + G Some eements of spending may form part of I at one time in history and part of G at another. For exampe, investment in raiways in the 1920s woud be categorised as part of private investment (I ), whereas after raiway nationaisation in the 1940s such investment woud be categorised as part of government spending (G). Keynes made the point that expenditure by the government on roads was equivaent to private investment in the raiways. In fact, since in times of stagnation, the private sector might be reuctant to invest, government spending can be required to fi the gap not just to boost aggregate demand, but aso to provide vitay needed infrastructure investment. This new roe for government spending can now be shown in the aggregate demand diagram (Figure 14). In this diagram, government spending (G) and investment (I ) are shown as exogenous eements of aggregate demand, unaffected by changes in income. The combined tota of government spending and private investment (I + G) is represented by a horizonta ine. Aso exogenous is the intercept of the consumption function (a). You may reca from earier sections that the sope of the consumption function is represented by the coefficient b. 23 of 77 Friday 16 November 2018

24 6 The aggregate demand mode with government and fisca poicy Figure 14 Government spending and aggregate demand To derive the new aggregate demand schedue, the horizonta ine for combined investment and government spending can be added to the consumption function. The new aggregate demand schedue AD = C + I + G has an intercept a + I + G and the same sope (b) as the consumption function. 6.4 Government expenditure (4) The aggregate demand mode can aso be used to iustrate what might happen under an increase in government spending, as shown in Figure 15. Let government spending increase by 300 miion money that coud be spent aong the ines of the 2009 Obama Recovery Act or the 1929 Loyd George three-point pan. This is shown by an upward shift of the intercept of the aggregate demand schedue by 300 miion due to an increase in government spending from G 0 to G 1. It is referred to in modern economics as a fisca stimuus. Using one of its key fisca powers the abiity to carry out expenditure the government is abe to boost aggregate demand. 24 of 77 Friday 16 November 2018

25 6 The aggregate demand mode with government and fisca poicy Figure 15 Modeing a fisca stimuus Activity 10 By how much does income increase in Figure 15 under a 300 miion fisca stimuus? Answer Figure 15 shows, for this particuar exampe, that the increase in income is 600 miion which is doube the fisca stimuus. In this exampe an extra 1 miion of income is created for each 1 miion of fisca stimuus an extra 1 miion of output that coud ead to doube the number of jobs initiay created directy and indirecty by the stimuus. This doube your money insight can now be expained by breaking down the effect of the stimuus into a series of rounds, as shown in Tabe 1. In Round 1, the change in income is equa to the fisca stimuus of 300 miion. Round 2 then depends on how much of this income is spent. Tabe 1 Direct and indirect impacts of a fisca stimuus Round Change in income ( m) Cumuative change in income ( m) of 77 Friday 16 November 2018

26 6 The aggregate demand mode with government and fisca poicy It is modesty assumed in Figure 15 that the margina propensity to consume the sope (b) of the consumption function is equa to 1/2. This means that in Round 2, haf of the initia increase in income from the fisca stimuus wi be spent on consumption, as shown by the 150 miion change in income. By Round 2 it therefore foows that there is a cumuative increase in income of (i) the initia direct increase in income of 300 miion, and (ii) the additiona indirect impact of 150 miion. These two items add up to a cumuative income of 450 miion in Round 2. This process continues in Round 3, with haf of the previous round s change in income ( 150 miion) spent as consumption: a new change in income of 75 miion. In each round, haf of the previous round s change in income is spent; these rounds continue indefinitey. By Round 10, however, the change in income has faen to just over haf a miion pounds, and the cumuative change approaches its fina vaue of 600 miion the doubing of income that is iustrated in Figure 15. Even by Round 3, 87.5% of the eventua cumuative change in income has occurred, so athough in theory the expansionary effect may take many rounds and a great dea of time to work itsef out, the main impact is fet quite quicky. Figure 16 shows the first three rounds. In Round 1, the injection of government demand eads to an upward shift of the aggregate demand schedue by 300 miion. Initiay, this panned aggregate demand exceeds current output. At the outset, in Round 1, ony 200 miion worth of output (income) is being produced, yet now the tota aggregate demand is 500 miion. If the key assumption is now made that there is sufficient spare capacity ide factories or machinery, and a poo of unempoyed workers then in response to the additiona demand, output can be increased by 300 miion, as depicted by the first horizonta arrow. 26 of 77 Friday 16 November 2018

27 6 The aggregate demand mode with government and fisca poicy Figure 16 Direct and indirect impacts of a fisca stimuus In Round 2, the new stimuus of 150 miion, as shown in Tabe 1, comes into pay. Once again aggregate demand exceeds current output, this time by 150 miion, and a new horizonta ine indicates the increase in output to match this demand. Simiary, in Round 3 the impact of the 75 miion boost in aggregate demand is matched by a 75 miion boost in output. These rounds eventuay peter out, as in Tabe 1, when both aggregate demand and aggregate output have increased by 600 miion. The process, iustrated in Tabe 1 and in Figure 16 is referred to by Keynes as the mutipier process, since the impact of the fisca stimuus is mutipied throughout the economy. The mutipier captures the cumuative effect of a change in spending on income. The change represented here is a change in government spending, but the mode coud aso be used to show the effect of a change in another exogenous factor such as investment. Let Δ denote the amount by which a variabe might change. The mutipier can be expressed in mathematica terms as the ratio of the eventua change in income (ΔY ) to the initia change in spending that caused it (ΔG): Activity 11 Cacuate the size of the mutipier when a 300 miion fisca stimuus increases income by 900 miion. Answer In this exampe, ΔY = 900 and ΔG = 300; hence the mutipier is equa to 900/300 = 3. Since the mutipier is 3, the fisca stimuus increases income by a threefod amount. 27 of 77 Friday 16 November 2018

28 6 The aggregate demand mode with government and fisca poicy The size of the mutipier depends on the margina propensity to consume, as expored in the box beow. It has a simpe formua: where b is the margina propensity to consume. In the exampe in Tabe 1, the propensity to consume is equa to 1/2. Hence The eventua doubing of income in the mutipier process is captured in tota by this formua for the mutipier. Since the concept of the mutipier emerged in the 1930s, economists have used statistica methods to estimate its empirica size. There is, however, considerabe uncertainty as to the mutipier s precise vaue. At the top end of estimates of the size of the mutipier, Eggertsson (2006) finds the mutipier to be as high as 3.8. In a more recent survey, Ramey (2011) pronounces that the range of pausibe estimates for the mutipier is probaby 0.8 to 1.5. Due to the uncertainty invoved, however: Reasonabe peope coud argue that the mutipier is 0.5 or 2.0. A mutipier of 0.5 woud mean, for exampe, that 1 biion of spending eads to ony haf that increase in income; whereas a mutipier of 2.0, as you have seen, woud mean a doubing of income. One probem is that estimates tend to be based on observations made during periods of economic growth, yet mutipiers are most reevant in times of contraction. Larry Summers, a eading US economist who has advised Presidents Cinton and Obama, has been very cautious about the impact of fisca stimui but argues that the specific circumstances of the economic crisis of 2008 woud point to a mutipier nearer to the top end of Ramey s range of estimates (DeLong and Summers, 2012). Deriving the formua for the mutipier To derive the formua for the mutipier, consider two equations. First, consider an income equation showing points of equiibrium between income and aggregate demand (points where the aggregate demand schedue intersects the 45-degree ine): Second, consider the consumption function, showing the reationship between panned consumption and income: Substituting the consumption function into the income equation gives a new expression: Now notice that on the right-hand side there is an expression that reates consumption to income. I can now subtract this term from both sides of the expression: Coecting 1 and b in a bracket: Dividing both sides of this equation by (1 b), this term cances out on the eft-hand side, to eave: 28 of 77 Friday 16 November 2018

29 6 The aggregate demand mode with government and fisca poicy This gives a mutipier reationship between income and exogenous spending The expression is the mutipier beow: 6.5 Government revenue and taxation This section examines the income side of the pubic sector accounts. The main source of income for the government is the coection of taxes, which in the tax year was estimated to make up 36.1% of GDP in the UK (Office for Budget Responsibiity, 2012, p. 100). Taxation and the circuar fow of income Figure 17, beow, gives a breakdown of tax receipts, showing the percentages of GDP aocated to the main types of taxation evied by the UK government. The argest part of the tax take (17% of GDP) is contributed by Income Tax and Nationa Insurance Contributions (NICs). These are direct taxes, payabe by the individuas who receive income and by their empoyers. Peope who work for an empoyer have Income Tax deducted directy from their pay each month; for the sef-empoyed, two advance payments are usuay made each financia year. Corporation Tax, which makes up 2.4% of GDP, is a direct tax paid by companies directy out of their income, as are Capita taxes (1% of GDP) paid by individuas and companies, charged on increases in the vaue of financia or physica assets. The second major source of income is VAT, making up 5.8% of GDP. This is charged on purchases of goods and services. When you buy a car, for exampe, 20% of the cost wi be contributed as VAT. In this case it wi be the company that ses you the car that pays this tax over to the government, not you personay. The tax is paid via an intermediary, and can hence be categorised as an indirect tax, as can fue excise duties, paid via your garage when you buy petro. 29 of 77 Friday 16 November 2018

30 6 The aggregate demand mode with government and fisca poicy Figure 17 Major UK taxes as percentages of GDP, (Source: Office for Budget Responsibiity, 2012, p. 100, Tabe 4.6) Taxation is a key component of fisca poicy, aongside government spending decisions, which were considered in the previous section. In a period of economic recession, the government can choose to stimuate aggregate demand by either boosting government spending or cutting taxes. This can be iustrated using the circuar fow diagram (Figure 18). Activity 12 Compare Figure 18 with the circuar fow diagram represented in Figure 19. Figure 18 Government spending and taxation in the circuar fow of income 30 of 77 Friday 16 November 2018

31 6 The aggregate demand mode with government and fisca poicy Figure 19 Circuar fow of income with investment and saving Discussion You wi see that in Figure 18 a new box has been added to show the government sector. As you have seen, government expenditure provides an injection to the circuar fow of income, as indicated by the arrows in Figure 18. For exampe, if the government-run Nationa Heath Service hires more doctors, there is a fow of money to the househod sector. Tax receipts are a eakage from the circuar fow of income. For exampe, out of incomes received by househods, a part of these are paid in Income Tax, which eaks out of the househod sector into the government sector. A reduction in Income Tax woud put money into the pockets of househods, which coud stimuate aggregate demand. Simiary, Corporation Tax is represented here by a fow of money from the firms to the government. A reduction in Corporation Tax coud stimuate the expenditure pans of firms. The eakage of taxes means that there is another important difference between the two modes. In the mode without government expenditure (Figure 19), panned consumption is the proportion of income eft after saving had been deducted; in Figure 18, consumer expenditure is the proportion of income eft after saving and aso taxes have been deducted. A tax-modified mutipier To expore how taxation works as a fisca poicy too, a modification can be made to the aggregate demand mode and mutipier. To keep things simpe, we wi assume a tax rate for the whoe economy, capturing the proportion of income raised from tax. The coefficient t can be defined as the rate of tax i.e. the proportion of nationa income evied by tax. Hence the tota revenue received by the government from tax (T) is T = ty With a nationa income (Y ) of 1200 biion, for exampe, and a tax rate of 1/3, the tota tax revenue wi be 400 biion. The amount of income avaiabe for consumption (often referred to as disposabe income) is now equa to income (Y ) minus taxation (ty ): Y ty = (1 t)y 31 of 77 Friday 16 November 2018

32 6 The aggregate demand mode with government and fisca poicy It therefore foows that the tax-modified consumption function is C = a + b(1 t)y This tax-modified consumption function, shown in Figure 20, has a shaower sope than the consumption function shown in Figure 14. This new sope is represented by a new (tax-modified) margina propensity to consume b(1 t ). Figure 20 Taxation and aggregate demand We can now consider the effect of modeing tax on the structure of the mutipier, which was shown earier in this section to take the form 1/(1 b). It intuitivey foows that instead of having a denominator 1 b, the tax-modified mutipier has a denominator 1 b(1 t). The margina propensity to consume (b) is no onger the ony determinant of the vaue of the mutipier. We now aso need to take account of the eakage of tax, as shown in Figure 20, and the new mutipier is Activity 13 Suppose that the margina propensity to consume (b) is equa to 0.75 and the tax rate (t) is 0.2. Cacuate the size of the tax-modified mutipier. Answer This cacuation invoves carrying out a number of steps. Step 1: Cacuate 1 t = = 0.8 Step 2: Cacuate b(1 t) = = 0.6 Step 3: Cacuate 1 b(1 t) = = 0.4 Step 4: Cacuate 1/(1 b(1 t)) = 1/0.4 = 2.5 The tax-modified mutipier has a vaue of 2.5. Without the eakage of taxation, using the cacuation 1/(1 b) = 1/(1 0.75), the mutipier woud be equa to 4. So instead of a fourfod increase in income, in response to a fisca stimuus, ony a 2.5-fod increase is generated once the eakage of tax is taken into account. 32 of 77 Friday 16 November 2018

33 6 The aggregate demand mode with government and fisca poicy A tax-cutting fisca stimuus It is now possibe to expore the impact of cutting the tax rate from t 0 to t 1. Since a higher proportion of income is now avaiabe for consumption (a reduced eakage of taxes in the circuar fow of income), this provides a boost to aggregate demand. This tax reduction wi be modeed in order to iustrate a key fisca poicy arm avaiabe to poicymakers: the manipuation of taxation in order to stimuate aggregate demand. In response to a tax cut, the initia reduction in tax payments ΔT is equa to ΔT = (t 0 t 1 )Y 0 where Y 0 is the eve of income before the tax change. The change to tax receipts depends on the difference (t 0 t 1 ) between tax rates before and after the change. Now et the initia eve of income (Y 0 ) be 600 miion, and et the initia tax rate (t 0 ) be 0.1. Suppose that the tax rate fas to t 1 = 0.05 (ony 5% rather than 10% of nationa income is taken in tax). Hence the initia reduction in tax receipts is ΔT = ( ) 600 = = 30 miion The reduction in the tax rate to 5% generates a 30 miion cut in tota tax receipts. This means a 30 miion increase in disposabe income. The windfa increase in disposabe income wi ead to an increase in consumption spending, but this increase wi be ess than the fu 30 miion. Assuming that the margina propensity to consume is 0.8, and remains at this vaue, househods wi spend ony 80% of their additiona income. Instead of stimuating aggregate demand, 20% of the tax windfa eaks into savings accounts in banks and buiding societies. Hence the stimuus to aggregate demand is b ΔT = miion = 24 miion Househods wi choose to save 6 miion of the 30 miion tax windfa, and spend 24 miion on additiona consumption. So aggregate demand is boosted by 24 miion. In addition, the fa in the tax rate increases the vaue of the mutipier: The reduction in the tax rate increases the mutipier from 3.57 to The combined effect of these two changes is an increase in income of miion = 100 miion Activity 14 For a mutipier of 3.57 (as in the above exampe, with initia tax rate 10% and a margina propensity to consume of 0.8), cacuate the mutipier impact on income of an increase in government spending ΔG = 30 miion. Answer This activity aows you to compare the above tax cutting exampe with a fisca stimuus based on increased government spending. With a mutipier of 3.57, the fina increase in income from the increase in government spending is m = miion. Even without the benefit of an increase in the mutipier, an increase in government spending deivers a higher boost to income than an equivaent tax cut: 7 miion more in this exampe. 33 of 77 Friday 16 November 2018

34 6 The aggregate demand mode with government and fisca poicy The key difference between these two types of fisca poicy is the eakage of part of the tax cut into saving. In the current exampe, the government spends the fu 30 miion, whereas househods spend ony 24 miion of the 30 miion windfa and save the rest. The exact outcome of the comparison does, of course, depend on the vaues of b and (t 0 t 1 ). The effect of a tax cut wi be enhanced if there is a very high margina propensity to consume, so that most of the windfa is spent, and aso if there is a substantia increase in the vaue of the mutipier owing to a arge fa in the percentage tax rate. Keynes was not very keen on stimuating aggregate demand through tax cuts. As shown by Brown-Coier and Coier (1995), he cautioned that tax cuts do not provide any future benefits to the economy; he aso thought that it woud be difficut to persuade the pubic that tax cuts shoud be reversed once they became estabished. Further issues reating to these two types of fisca poicy are considered in the anaysis that foows. 6.6 Stabiisation poicy You have seen that fisca poicy can be used, in times of economic crisis, to stimuate aggregate demand either by increasing government spending or by reducing taxes. As part of the Roosevet New Dea, and more recenty by President Obama in the USA, these types of fisca stimuus were used to stabiise the economy in response to probems of severe contraction in nationa income. In the goden years of Keynesian economics, however, during the 1950s and 1960s when the UK Conservative Prime Minister Harod Macmian pronounced You ve never had it so good governments did not have to dea with such crises. The news programmes were not reporting peope queuing outside banks (as in the 2007 coapse of Northern Rock) or the unempoyed queuing outside job centres. Far from there being a probem of unempoyment, there was a shortage of abour, which encouraged popuation movements such as the Windrush migration from the Caribbean to the UK. For most of this eary postwar period, capitaist economies enjoyed continued growth and mid business cyce fuctuations. In such circumstances, there woud be repeated periods of boom (high growth) and sowdown (ow growth); governments woud see their main responsibiity as smoothing out the peaks and troughs of the cyce, an approach referred to as fine-tuning. This period of sustained growth was attributed in part to the benefits of Keynesian intervention in sharp contrast to the pethora of disasters that befe the word economy in the 1920s and 1930s. Postwar governments bought into the Keynesian idea that it was their responsibiity to manage aggregate demand. In the USA, during the 1960s, the phrase We are a Keynesians now (Friedman, 1965) was even used by the right-wing president, Richard Nixon. In the UK, successive Conservative and Labour Chanceors of the Exchequer (Hugh Gaitske and Rab Buter) were arguaby so cose to each other that their names were combined in an approach caed butskeism : where the mixed economy, consisting of a viabe private sector and a arge wefare state, were championed. It was not unti the 1970s, when probems of infation reared their ugy head, that this postwar Keynesian consensus fe apart. Two main types of fisca poicy were deveoped during this period. First, governments can use discretionary stabiisers, activey adjusting fisca poicy in response to boom or sowdown in economic activity. If the economy is overheating (growing too fast), for exampe, the government might decide to increase tax in order to temper aggregate demand and vice versa under a sowdown. As you saw earier in this section, the impact 34 of 77 Friday 16 November 2018

35 6 The aggregate demand mode with government and fisca poicy of using this type of discretionary stabiiser wi tend to be ampified by the mutipier effect. Since for Keynes, in genera, the economy is ikey to operate at output eves ess than fu empoyment, discretionary stabiisers are required to snuff out high unempoyment. Yet if the pubic sector is sufficienty arge, in a butskeite type mixed economy, then its very presence can dampen down the business cyce. If growth sows, for exampe, and there is an increase in unempoyment, then under a wefare state workers wi receive unempoyment benefit. So athough they are not earning the wages that they earned under empoyment, unempoyed workers are sti abe to consume, abeit at a ower eve. Such a transfer payment can be thought of as a negative tax, affecting consumer expenditure in a simiar way to a tax cut. This second type of fisca poicy is referred to as an automatic stabiiser a fisca response to a sowdown in economic activity that happens without any active decisions on the part of the government. Governments, of course, have to choose to keep the system in pace to faciitate this automatic spending, but they do not have to activey direct the spending from day to day. At the same time as government transfer payments wi automaticay increase during a sowdown, tax revenue wi fa. At ower eves of income, tax receipts such as those out of income (Income Tax) and profits (Corporation Tax) wi fa. The wefare and tax systems in the economy create their own adjustments in aggregate demand, making the sowdown ess pronounced than it woud have been without the state sector. Simiary, in an upturn, as incomes increase so does the proportion of income directed to tax. In recent years, poicymakers have found these stabiisers to be very attractive, since they can smooth out both peaks and troughs of the business cyce. Tax-based automatic stabiisers provide a symmetric approach to fisca poicy, with attention paid to both sides of the business cyce. In the eary 2000s, this was the officia position of the European Centra Bank (ECB): Automatic stabiisers are the appropriate way to stabiise output, as they have foreseeabe, timey and symmetrica effects [ ] there is normay no need to engage in additiona discretionary fisca poicy-making for stabiisation purposes (ECB, 2002, pp. 41, 46, quoted by Lodewijks, 2009, p. 3). This contrasts sharpy with the Keynesian consensus of the 1960s, when it was thought that automatic stabiisers were insufficient to manage the business cyce. US President John F. Kennedy argued in 1962 for a shef of pubic works that coud be introduced if unempoyment rose together with increases in the period for which unempoyment benefits woud be paid (Lodewijks, 2009, p. 4). The probem, for the USA, is that state spending has tended to constitute a smaer part of nationa income than in European countries such as the UK, so automatic stabiisers do not have as much impact. Despite its weaker automatic stabiisers, the USA enjoyed a stronger recovery than the UK in the period immediatey foowing the economic crisis of Adam Posen, a member of the Bank of Engand s Monetary Poicy Committee, has expained this recovery as being in part due to differences in the discretionary fisca poicy: For amost the entire period since March 2007, and particuary since March 2010, the US has run a ooser overa fisca stance a more stimuative fisca poicy than the UK, even taking the fu operation of the arger automatic stabiisers in the UK into account. Cumuativey, since 2007Q1, the difference has amounted to 3 per cent of GDP. (Posen, 2012, p. 8) 35 of 77 Friday 16 November 2018

36 6 The aggregate demand mode with government and fisca poicy Whie Obama introduced a fisca stimuus, the Conservative/Libera Democrat Coaition in the UK impemented a fisca contraction. Posen pays particuar attention to the increase in VAT announced by Chanceor of the Exchequer George Osborne in his emergency Budget of 22 June 2010, from 17.5% to 20%. Posen argues that this VAT rise heps to expain the fa in private consumption since the peak of the business cyce, compared to the USA, as shown in Figure 21 by the divergence of the two ines after Quarter 10. The argument is that the increase in VAT, and its anticipation by consumers, ed to ower consumer spending, which spied over to fewer jobs and ower income throughout the economy. Figure 21 Percentage growth rates of private consumption in the UK and the USA, foowing the economic crisis of 2008 (Source: Posen, 2012) 6.7 Government debt and crowding out You have discovered that governments can boost aggregate demand either by increasing government spending or through cutting taxes. There is, however, an eephant in the room, which you must have noticed, and this section has so far studiousy ignored (just to keep things simpe): how can a fisca stimuus be paid for? Surey if the government spends more to get the country out of a crisis, it runs the risk of squeezing the private sector, or even worse, bankrupting itsef. These two issues are considered first by ooking at government debt, before turning to a consideration of how the private sector can be squeezed by government spending. The debt probem You cannot spend your way out of recession or borrow your way out of debt. (Hannan, 2009) This common sense mantra has been espoused by those on the right of the poitica spectrum in response to the economic crisis of 2008, such as the Tea Party movement in the USA. The aternative poitica position is captured in the T-shirt beow, worn by supporters of the anti-cuts movement. 36 of 77 Friday 16 November 2018

37 6 The aggregate demand mode with government and fisca poicy Figure 22 Rather than spending in a recession, the government orthodoxy (traditionay referred to as the Treasury view or sound finance ) has been to baance its budget by cutting expenditure. This sound finance view, traditionay associated with the nineteenthcentury Libera Prime Minister Wiiam Gadstone, is not imited to recessions. It more generay states that the government budget shoud be baanced at a times (or in sight surpus so as to pay down past debt). The baanced budget approach has been the cornerstone of the Conservative/Libera Democrat coaition government since coming to power in With a target to baance the budget by 2016, it introduced a programme of severe cuts in government spending. In his 2010 emergency Budget, George Osborne procaimed: This is an emergency Budget, so et me speak painy about the emergency that we face. The coaition Government have inherited from their predecessors the argest budget deficit of any economy in Europe, with the singe exception of Ireand That is why we have set a brisk pace since taking office. (Neid, 2012, p. 5) The coaition government aso argued that they inherited the argest eve of debt incurred by a British government during peacetime. As shown in the box opposite, when the ast 37 of 77 Friday 16 November 2018

38 6 The aggregate demand mode with government and fisca poicy Conservative/Libera coaition was in power, ed by Loyd George (before he became a Keynesian), a simiar austerity programme, known as the Geddes Axe, was impemented. The Geddes Axe: a brief expanation Figure 23 An unempoyed man and his famiy on the streets of Brighton in 1921 (Photo: Associated Newspapers/Daiy Mai/Rex Features) After the First Word War, Britain was gripped by enormous debts and a growing sense of panic that the Government was hugey wastefu. The nationa debt had risen dramaticay from 677 miion, about a quarter of the GDP, in By 1920 it was 7.81 biion, arger even than the country s GDP. A vast civi service, that had come together to administer the war effort, was sti operating at fu capacity, whie spending on education had increased substantiay. Many of the midde casses compained how their tax bis had shot up. The Government was under pressure to do something. The Times newspaper noted in 1922: There are signs of an astonished reaisation of the aarming bi for civi pensions that in a few years wi be a mistone on the taxpayer s neck. The Anti-Waste League, formed by Lord Rothermere, had put up candidates and won three by-eections during David Loyd George, the prime minister, acted by appointing a businessman Sir Eric Geddes to head the new Committee on Nationa Expenditure, which was soon dubbed The Great Axe. It highighted waste in a areas of pubic spending, incuding detais such as 38 of 77 Friday 16 November 2018

39 6 The aggregate demand mode with government and fisca poicy there being a ratio of one ceaner for every vehice in the Army. Between 1921 and 1922 it recommended economies totaing 87 miion, about 10 per cent of the country s entire GDP. Though the cabinet ony agreed to 52 miion of cuts, these were enormous for the time and in the end, tota cuts were arger than either of these figures. He was haied a superman by one eading businessman, but the axe hit some peope very hard and ed to a arge reduction in socia benefits, particuary secondary education. The biggest cuts were in the Army and Navy. The defence budget was cut by 42 per cent in the space of one year. But other workers were hit too. Civi Service numbers were cut by 35 per cent mosty femae staff hired during the war. At the cose of 1921, wage cuts averaging 8 shiings a week had been imposed on 6 miion workers. This equates to a 58 fa in today s money and ed to growing anger against the government. The cuts were driven by a Treasury desperate to keep a contro of its debts, but they party caused Britain s woes in the 1920s a period of far greater economic troube for the country than it ever experienced during the 1930s. The Genera Strike in 1926 can, in part, be expained by the mounting resentment caused by the cuts, though some economists argue it heped Britain exit the vicious recession of 1919 to 1921 quicker than it might otherwise have done. The Geddes Act, introduced by one of the great Libera administrations, ironicay gave impetus to a burgeoning Labour Party. The number of seats it hed rose from 59 in 1918 to 142 in 1922, refecting a new coaition across cass ines. It went on to form its first administration in (Source: Waop, 2010) It was in the aftermath of the Geddes cuts in the 1920s that Loyd George and Keynes formuated their arguments as to why governments coud spend their way out of recession. Keynes once said When the facts change I change my mind. What do you do, sir? a mantra that woud equay appy to Loyd George during this period. Keynes aso argued that a government spending programme coud be easiy paid for, without threatening government finances. Thus far this section has made reference to both a budget deficit and government debt. It is important to be cear about how these differ. Government debt, aso caed the nationa debt, is the tota amount of money owed by the government to a those from whom it has borrowed. It is a stock, that is, an accumuated amount, not an amount measured per period of time. The primary budget deficit is the excess of government expenditure over tax receipts in a given time period, usuay one year so it is a fow. In any year when there is a deficit, the nationa debt wi increase. If there is a budget surpus (tax receipts exceed expenditure), then the government may decide to use part of it to reduce its outstanding debt. If tax receipts exacty match government spending, then this is referred to as a baanced budget. Baancing the budget The poicy of baancing the budget can be ooked at from a Keynesian perspective. Suppose that the government increases its spending by 30 miion and baances this 39 of 77 Friday 16 November 2018

40 6 The aggregate demand mode with government and fisca poicy increase by raising 30 miion in taxation. To earn this additiona revenue from tax, the tax rate is increased from 5% to 10%. The economy starts at an income eve of 600 miion. The overa effect can be anaysed in three steps. Step 1 The tax increase The additiona 30m taken in tax reduces disposabe income by 30m, but 6m of that 30m woud have been saved had househods sti received it (assuming a margina propensity to consume of 0.8), so the initia fa in aggregate demand resuting from the tax increase is ony 24m. The increase in the tax rate from 0.05 to 0.1 reduces the mutipier, as you know from the earier exampe, from 4.17 to Appying the mutipier of 3.57 to the 24m fa in spending gives a fa in income due to the tax increase of m = 85.7m. Step 2 The increase in government spending The increase in government spending gives an initia boost of 30m to aggregate demand. Again appying the mutipier shows that there is an increase in income of m = 107.1m. Step 3 The net effect You have seen that the tax increase aone woud reduce income by 85.7m but that the increase in government spending woud increase income by 107.1m. To cacuate the net effect of these tax and spending changes, I need to subtract 85.7 from I concude that income increases by 107.1m 85.7m = 21.4m to a new equiibrium eve of 621.4m. So even though the increase in government spending has been backed by a tax increase, the overa impact is expansionary. The government can effectivey gather what househods woud have saved as tax revenue and spend it. It may even be possibe to spend your way out of a crisis and baance the budget. A probem, however, for poicymakers, is that a baanced budget expansion may not be very expansive. In the exampe above, 30 miion extra in government spending produced a 21.4 miion increase in income, so it coud be said that the baanced-budget mutipier was 21.4/30 = The increase in spending, once it has been covered by a tax increase, may be too sma to make much of a difference. There is aso, therefore, a Keynesian case for increasing the size of the deficit in times of recession. Keynes and government debt Keynes recognised the need, in times of crisis, for government borrowing to finance a sizeabe expansion of government spending. The government traditionay borrows by issuing oans (referred to as government bonds or gits) that it promises to pay back at a future date. In the meantime, interest is aso paid to hoders of these bonds. Let i be the rate of interest paid on government bonds. If a bond worth 100 is issued by the government and bought by a private individua or bank, then after one year the government wi pay out a percentage rate of interest. Say the rate of interest is 6%; this means that the government pays out 6 after one year. The tota vaue of bonds (debt) 40 of 77 Friday 16 November 2018

41 6 The aggregate demand mode with government and fisca poicy issued by the government can be denoted by the term D. Thus the tota interest payment made by the government is id. If the tota amount of debt owed by the government is 300 miion, for exampe, then the debt repayments in a particuar year woud be tota interest payments = 6% 300 miion = 18 miion It foows that the tota government deficit is the primary deficit (government spending minus taxation) pus these debt interest payments tota deficit = government spending taxation + tota debt interest payments This is the tota government deficit that economists and poicymakers usuay worry about. In a more compact notation, the tota deficit is G T + id In the case of Greece, during the European financia crisis that started in 2010, the main probem has been trying to service the interest payments on its debt. This probem has been compounded by the ack of confidence in Greek bonds in the word financia markets. The sound finance advice given by poicymakers, in the European Commission and beyond, has been for Greece to cut government spending and increase taxes in order to meet its debt interest payments. From the perspective of Keynes, however, the probem with this austerity approach is that the reduction in government spending wi, via the mutipier, reduce nationa income and the abiity of the economy to generate tax revenue. In the face of this type of crisis, Keynes woud have caed for the government to boost income using government infrastructure spending. Take, for exampe, the Libera spending programme of 300 miion in 1929, referred to earier in the section. Keynes assumed that the government woud have to take out a oan (i.e. issue bonds). Assuming that it had to pay interest of 6% on this oan, then in the first year of the spending programme government woud have to meet debt interest payments of 18 miion. The key question is how these debt interest payments can be covered. Using the mutipier, one can specify what happens to income and taxation receipts. The tax-modified mutipier reationship takes the form The mutipier captures the impact of a change in government spending (ΔG) on nationa income (ΔY). Activity 15 Assuming a propensity to consume (b) of 1/2 and a tax rate (t) of 1/3, cacuate the size of the mutipier. Answer The mutipier for this exampe is For the fisca stimuus of ΔG = 300m, the change in income woud be ΔY = = 450m This means, taking into account the eakage of income into taxation, that a mutipier of 1.5 eads to a 450m increase in income, in response to the 300m increase in government spending. 41 of 77 Friday 16 November 2018

42 6 The aggregate demand mode with government and fisca poicy Now what is the impact, in this exampe, on receipts from taxation? In the aggregate demand mode there are additiona receipts from taxation (ΔT) since the income out of which taxation is paid has increased ΔT = t ΔY = (1/3) 450 = 150 miion The amount of tax paid out by the nationa economy increases by 150 miion, since there is more income avaiabe out of which to pay taxes. The government has put an additiona 150 miion into its coffers. For Keynes, this shows that his pubic expenditure increase of 300 miion is affordabe. With tax receipts increasing by 150 miion, the 18 miion of debt interest payments on the government s infrastructure oan can easiy be covered. But what about the deficit? In this exampe, the deficit increases by 150 miion since ony haf of the 300 miion outay is recouped in tax receipts. There has been no increase in the tax rate to baance the budget, as before. However, Keynes distinguished between current and capita expenditures. Current expenditures are used up in the short run, when capita stock, among other things, is fixed. In contrast, capita expenditure is expenditure made on items that are avaiabe for future use, in the ong run: a period of time in which the capita stock can change. For Keynes, investment in infrastructure is not incuded as part of current expenditure or of the current fisca deficit. Investment, for exampe in transport, woud provide an increase in the assets of the country, heping the productivity of private firms, enabing them to transport their goods to customers (as woud investment in education). So for Keynes investment can be earmarked for a separate weath-creating part of the nationa accounts: It is not the miser who gets rich; but he who ays out his money in fruitfu investment (Keynes, 1972, p. 123). On this basis, the investment in infrastructure coud be cassified as improving the heath of the pubic sector accounts. If the accounts were in surpus, the new tax receipts woud add to that surpus; if the accounts were in deficit, the new tax receipts woud be used to pay off the country s debt. Out of the 150 miion tax receipts, 18 miion woud be used to cover debt interest payments, but a cean 132 miion woud be added to government coffers. For Keynes, you can spend your way out of debt, contrary to the quotation from Danie Hannan earier in this section (see 'The debt probem'). When is debt high? In modern economics, however, funding capita expenditure is usuay incuded in the cacuation of government debt and deficits. In response to this constraint in the UK, governments have introduced schemes such as the Pubic Finance Initiative (PFI), in order to cassify funding pubic infrastructure spending as private debt. But even if this orthodox cassification of capita spending is accepted, it can sti be argued that the Treasury view, under which government spending is cut in order to baance the budgets, is misguided in times of recession. Rather than viewing this approach as sound finance, it can aternativey be abeed debt aarmism or fisca scare tactics. In this vein, Neid (2012) has compared gross eves of debt in the UK since 1816, as shown in Tabe 2. Tabe 2 UK nationa debt, Year Debt to GDP ratio Gross debt ( 000m) GDP ( 000m) Unempoyment (%) of 77 Friday 16 November 2018

43 6 The aggregate demand mode with government and fisca poicy (Source: Neid, 2012, p. 2) Neid (2012) makes three main points. First, the gross debt for 2010 of miion just over one triion pounds is a arge amount of money, and can easiy make its way into the headines, but it is not so high in historica terms. To show why, Neid examines what economists ca the debt to GDP ratio (ratio of tota debt outstanding to GDP). In 1816, just after the Napoeonic Wars, this amounted to 260%; after the First Word War, in 1919, it was 127%; after the Second Word War it amounted to 225%. So the 75% of GDP in 2010 does not ook so aarming in this historica context. Keynes argued that British governments are far too unwiing to spend during times of peace. They are often wiing to wage a war on the French or Germans but when it comes to attacking unempoyment, governments are unusuay peace-oving in their expenditure pans. Second, there has not been one occasion during this period, argues Neid, when the British government has faied to borrow what it requires to meet spending requirements. Not when Napoeon was hauing cannon across Europe; not when the Kaiser transported a miion men to the French border on his newy buit raiways; not even under Hiter s Bitzkrieg. No matter how much money Britain needed to borrow to face these threats, it did not fai to raise debt. It is somewhat aarmist, Neid and others argue, to pronounce that the British government is in danger of going bankrupt. For some this is a fisca scare tactic used to justify an ideoogica prejudice against the pubic sector. Finay, Tabe 2 is used by Neid to show the dangers of cutting government expenditure in an attempt to reduce debt. In 1923, after the Geddes Axe, the ratio of debt to GDP went up to 176% from 127% in 1919, as GDP fe from 5.83 thousand miion 1919 to 4.39 thousand miion in Unempoyment, as shown in the tabe, increased from 3% to 12% over the period Simiary, a series of cuts by the Ramsay MacDonad government in the eary 1930s, which Keynes raied against, ed to a reduction in GDP from 4.73 thousand miion in 1929 to 4.26 thousand miion in The debt to GDP ratio increased from 158% in 1929 to 179% in 1933, with unempoyment rising to 20%. For Neid, as aso argued by Keynes, debt probems (as expressed in the debt to GDP ratio) are caused in peacetime by ow GDP not by wastefu spending by governments. The Keynesian argument is that cuts in government spending can ead to an increase in the fisca deficit; the best way to reduce deficits is by increasing output, and this can at times require injections of aggregate demand from discretionary fisca poicy. But this has not been the consensus among poicymakers. The European Union, for exampe, has 43 of 77 Friday 16 November 2018

44 6 The aggregate demand mode with government and fisca poicy sought to put severe constraints on fisca poicy. Under the Stabiity and Growth Pact, set up in 1996, European countries were set a target for government deficits of 3% of GDP, and coud be fined if this was transgressed. So when a recession comes aong, even the automatic stabiisers must be taken off the poicy bike if the 3% target is breached. This infexibiity ed to a reaxing of the 3% target in 2005, in order to aow for business cyce fuctuations. As shown in Tabe 3, in the economic crisis that swept across Europe, by 2010 even Germany, one of the most fiscay conservative of the European Union members, was unabe to meet the 3% target. The entry 4.3 shows that in 2010 Germany had a fisca deficit (indicated by this being a negative number) at 4.3% of GDP; in 2007 Germany had a surpus of 0.2% of GDP. In 2007, before the recession took hod, a the countries shown in Tabe 3 (apart from Greece) were either in surpus or had deficits that were within the 3% target. It was the combination of coapsing GDP and the use (automatic and discretionary) of fisca stabiisers that ed to the breaking of the target. The key question for macroeconomists is whether a more austere fisca poicy at the time woud have worsened or reduced the deficit. Tabe 3 Genera government deficit/surpus (percentage of GDP in miions of euros) Germany Greece Spain Itay UK (Source: Eurostat, 2012) Crowding out A further criticism eveed at the Keynesian fisca poicy is the risk of crowding out. This is the idea that government spending may squeeze out consumption and investment by the private sector, so that the growth in aggregate demand from an increase in G is at east partiay offset by a fa in C and/or I. A key proponent of the idea that government spending may crowd out consumption is the economist Roger Farmer. His arguments start with a way of ooking at the consumption function that is different from the famiiar Keynesian one in which consumption is determined argey by income (Farmer and Potnikov, 2012). The aternative is based on an approach deveoped by Miton Friedman caed the permanent income hypothesis (Friedman, 1957, pp. 21 2). In Friedman s view, consumption is cosey inked to weath rather than income. Peope take a ong view and set a norma eve of consumption according to their weath. This means that peope may borrow now to support a high standard of iving if they expect their earnings to rise in future (because of, say, the anticipated rewards from their education, training and experience), or they may imit their consumption now in order to save enough for a comfortabe ifestye ater when income is expected to drop (typicay after retiring). The gist of Farmer s argument is that if the government announces an increase in government spending, G, then househods wi expect this to mean a rise in taxes, T, ater (whether to bring the government s budget back into baance or to pay off government 44 of 77 Friday 16 November 2018

45 6 The aggregate demand mode with government and fisca poicy debt used to fund the increase in G). Given their ong view, househods wi offset the gain to themseves from G today against the future oss in T and so increase their savings to cover the expected future tax bi rather than increasing consumption, thus partiay or competey offsetting the rise in G. Barro (1981) aso points out that many types of government spending can be seen as cose substitutes for private-consumption goods for exampe, a pubic heath service (ike the NHS in the UK) is a substitute for private medica care, unempoyment benefits are a substitute for private insurance, pubicy funded schoos and universities are substitutes for private education, and so on. If the government increases spending on these types of items, then consumers wi cut back on the amount that they spend privatey on simiar items. Keynes offered an expanation of how government borrowing to fund a rise in G coud crowd out private investment: If, for exampe, a Government empoys 100,000 additiona men on pubic works, and if the mutipier is 4, it is not safe to assume that aggregate empoyment wi increase by 400,000. For the new poicy may have adverse reactions on investment in other directions The method of financing the poicy and the increased working cash, required by the increased empoyment may have the effect of increasing the rate of interest and so retarding investment in other directions. (Keynes, 1973, p. 119) If the government issues too many bonds, then it may have to increase the rate of interest in order to find buyers. This is what happened to Greece and Itay, from around The high interest rate in these countries woud have had an adverse impact on the eve of private investment; hence some woud argue that government overspending crowded out the private sector. However, for some countries, such as the UK and the USA, this argument may not appy. For some time after the 2008 crisis, interest rates anguished at ow eves, despite high deficits. Economies are often more compicated. A major factor determining the effectiveness of fisca poicy is the confidence that internationa markets have in government-issued debt and anima spirits. As Keynes puts it: If anima spirits are dimmed and the spontaneous optimism faters, eaving us to depend on nothing but a mathematica expectation, enterprise wi fade and die. (Keynes, 1973, p. 162) 6.8 Summary In Section 6, a ot of time has been spent on pacing Keynes s aggregate demand approach in its historica context: from the austerity of the 1920s and 1930s, to the goden age of Keynesian economics in the 1950s and 1960s, to the obsession with deficits since the 1990s. This is for two main reasons. First, it is important to have a fee for where ideas come from, and why economists and poicymakers have considered them to be important to give you a foundation in the discipine of macroeconomics and its pace in poitica economy. Unempoyment was the key prewar iness, and Keynes is the economist said to 45 of 77 Friday 16 November 2018

46 7 Zooming in on firms have deveoped the required medicine, which became the basis for postwar poicy. This is the backdrop to modern macroeconomics as we know it. Second, the spectre of unempoyment has come back with a vengeance since the economic crisis of 2008, and Keynes aso has made something of a comeback. His ideas are suddeny reevant again. The debates that took pace in Keynes s time about whether fisca poicy can work, the fisca stabiisers avaiabe to the government, whether governments can afford to stimuate aggregate demand, and whether they shoud instead cut spending in order to reduce the deficit are a highy reevant to recent debates throughout the word. 7 Zooming in on firms So far, we have concentrated on the study of macroeconomics, but have not focused on the economics of individua firms or markets. To understand microeconomic theory, we study the activities of firms, their production processes and the markets where goods and services are traded. The idea of firms and production shoud be famiiar to you, for instance, when we discussed how changes in the eve of investment by firms infuences aggregate demand and overa GDP. Section 7 wi expore the activities of firms in more detai. We wi begin to ook at activities such as how production processes can be modeed in economics, and how the prices of specific goods and services the market price depend on how much firms are wiing to suppy, but aso the quantity which consumers are wiing and abe to buy. The section examines how firms can grow by increasing output and reducing cost. It ooks at how production can be organised efficienty, and aso shows that in any market there wi be winners and osers. The economic theory in the section is cosey inked to exampes of rea firms and markets that can be used to demonstrate how you can appy microeconomic theory to everyday news and events. It wi hep you to understand why the price of fresh food rises when suppy is scarce, and why some firms make arge profits whie others strugge to survive. 7.1 Facing the competition Activity 16 Examine the three figures shown beow. Pause for a moment and consider what story they te us about how these two economies are performing. How do you think the macroeconomics reate to the performance of firms in these two countries? 46 of 77 Friday 16 November 2018

47 7 Zooming in on firms Germany GDP Index no Itay GDP Figure 24 Rea GDP performance as an index (base year = 2000) (Source: Eurostat, 2013a) Germany export Index no Itay export Figure 25 Export component of GDP as an index (base year = 2000) (Source: Eurostat, 2013a) 47 of 77 Friday 16 November 2018

48 7 Zooming in on firms 12 Labour force unempoyed (%) Itay Germany Figure 26 Unempoyment performance (Source: Eurostat, 2013b) Answer The three figures above give a brief overview of the recent performance of the Itaian and German economies. They suggest a contrasting economic performance. From 2007 the performance of Itay s GDP has faen behind Germany s, as shown in Figure 24, particuary in the period foowing the economic crisis. Over the ast decade, Germany has continued to improve its export performance, whist Itay s export eves have strugged to increase beyond the eve in Interestingy, the unempoyment rate in Germany has faen since 2005, having started at a much higher rate than in Itay. Germany s unempoyment has continued to fa, even in the period foowing the economic crisis. In contrast, unempoyment in Itay has remained between 6 8 per cent, and increased starting from The difference in performance at a macro eve may suggest some insight into the aggregate performance of firms in each country; it may suggest that German firms have some advantages over their Itaian counterparts. For instance, investment in human capita in a country shoud hep to increase the productivity of firms and make them more competitive internationay. So we might expect German firms, on average, to perform better than their Itaian peers. However, even if there are differences in the macro performance of two countries, when we ook at the micro eve, we may be abe to detect common characteristics of firm behaviour that can be reated to higher performance, whether firms are based in Itay or Germany. 48 of 77 Friday 16 November 2018

49 7 Zooming in on firms Firms in Itay and Germany Activity 17 Watch the foowing video, Facing the competition, which examines how firms in Itay and Germany are facing up to strong internationa competition. Then answer the questions beow. Video content is not avaiabe in this format. Facing the competition Question (a) (a) What are the different chaenges faced by firms in Germany compared to firms in Itay? Provide your answer... Answer The video raises a variety of issues at both the macro and microeconomic eve, so your notes may be different from those here. The video describes the story of a strong German economy with rising exports and faing unempoyment compared to a strugging Itaian economy. In Itay, the video indicates some of the macro probems reated to ack of productivity growth and a ack of investment. A ot of Itaian firms are very sma so this can be a barrier towards improving production technoogy and human capita. Being abe to increase productivity is one strategy for competing with firms based in countries with ower wages. Question (b) (b) How do macroeconomic conditions reate to firm performance? Provide your answer... Answer The direct reationship between macro and micro performance is not cear in the video. Dr Nerb emphasises the roe of change to Germany s abour market increasing fexibiity of abour by aowing firms to recruit workers on a temporary basis, which is supposed to encourage reduced unempoyment. However, Professor Mazzucato strongy disagrees, suggesting the rea change is aso due to Germany investing in research and deveopment (R&D) and human capita to make firms perform better. 49 of 77 Friday 16 November 2018

50 7 Zooming in on firms Question (c) (c) What factors determine the success of firms? How are these factors different in Itay and Germany? Provide your answer... Answer Successfu firms, whether in Germany or Itay, share simiarities: instead of trying to compete directy with ow-cost producers, they have differentiated their products, focusing on very high-quaity goods requiring speciaist expertise. So even though the macroeconomic situation in each country is different, there are simiar exampes shown for how firms can succeed. In this section, we wi investigate some of the ways we can mode how firms compete. 7.2 Microeconomics what is a firm? If we are to make sense of microeconomics, we have to examine the nature of one of the most important economic agents that make up the economy what we refer to as 'firms'. This section introduces you to the economic concept of a firm. Butchers, bakers and candestick makers In earier sections, firms were grouped together as one part of the circuar fow of income mode. But this begs the question, what is a firm? Figure 27 Different types of firm: Greggs (top eft); GaxoSmithKine (top right); First Mik mik orry (bottom eft); Amazon (bottom right). 50 of 77 Friday 16 November 2018

51 7 Zooming in on firms Activity 18 Think about the goods and services you use each week what types of firm produce them? You may aso work for a firm. Make a quick ist of at east five different firms that you have a connection with, for instance, as a customer, empoyee, investor or owner. What are the simiarities between firms on your ist? Provide your answer... Answer Your ist may show a bewidering variety of different firms, a mixture of we recognised nationa names, other oca suppiers, and some that may appear to have ony a virtua presence. The diversity of firms in the economy is enormous: from the oca corner shop, bakery or other food producers such as dairy farmers, to vast enterprises ike Microsoft or Appe producing consumer goods, or GaxoSmithKine or Pfizer producing pharmaceutica and heath care products. Major muti-product firms are bigger on most measures of size than the economies of many whoe countries, and aso operate from sites across different countries, giving them the term Muti-Nationa Corporations (MNCs). Not a firms produce goods, but some instead provide services, or a mixture of both goods and services. Services firms offer a range of activities, from the professiona services, such as tax, ega and financia advice offered by The Big Four audit firms (PWC, Ernst & Young, Deoitte and KPMG), or caring and socia services provided by a oca chidminder or nursery. Some firms are particuary we-known, capturing the attention of the media by deveoping innovative products to chaenge the status quo. In fact, firms ike Microsoft, Appe and, more recenty, Amazon and Googe began as sma enterprises before growing to become arge corporations known to househods internationay. Aside from these high-profie firms with customers a over the word, there are many firms that se directy to other businesses and provide intermediate goods and services as inputs into other firms production processes. Defining a firm Firms are interesting economic agents, being ceebrated for their achievements, and creating weath and innovative products and services unthought-of a decade earier. However, certain firms are viewed as a source of division, responsibe for increasing inequaity in society. Some firms provide us with basic goods we routiney buy every week, ike a pint of mik, to which we may give itte thought about how it is produced. Other firms are seen as a-powerfu, ike those in energy, heath care or defence, abe to move the opinion of nationa governments and sometimes, it is caimed, to ride roughshod over socia and persona needs. Firms are controversia, important, and a fascinating part of any attempt to understand economic behaviour. In spite of such variation, we can give an economic definition of a firm that takes account of this diversity. We can define a firm as an organisation that purchases, combines and transforms factor inputs (such as and, abour and capita) into outputs of goods and/or services for sae. 51 of 77 Friday 16 November 2018

52 7 Zooming in on firms 7.3 Production cost Efficiency and production costs are two issues firms pay carefu attention to. If a firm is to compete and survive, it must be an efficient organiser of different inputs into production. Firms must use production inputs ike raw materias, abour and capita efficienty as these wi reduce production cost. Cost minimisation is an important objective for a firm, as you have seen in the video, Facing the competition in Section 7.1. Reducing cost heps to increase profit, the difference between the saes vaue of output (revenue) and production cost. Higher costs are often cited as responsibe for infuencing profits in the retai sector, for exampe the popuar retaier H&M posted a smaer than expected rise in profit in 2012 because of rising input cost. H&M profits hit by higher costs Figure 28 Hennes & Mauritz is the word's third biggest cothing retaier Profits at the word's third biggest cothes retaier, Hennes & Mauritz, have edged higher. In the first quarter H&M made a net profit of 2.7bn Swedish krona ($406m; 255m), up from 2.6bn krona in the same period in the previous year. The company said that profits were hit by higher purchasing costs, which it did not pass on to customers. H&M aso announced that it wi aunch a new independent chain of stores next year. H&M chief executive Kar-Johan Persson said: "The new year has started we with a strong saes increase in the first quarter. "Despite increased purchasing costs we have continued to strengthen our customer offering." 52 of 77 Friday 16 November 2018

53 7 Zooming in on firms The company pans to open its first stores in Bugaria, Latvia, Maaysia, Mexico and Thaiand this year. BBC (2012) Criticay, if firms fai to manage costs, they risk going out of business because the cost of production exceeds the revenue received. Production cost can be reduced by increasing productivity (reducing the quantity of inputs needed to produce the same output) or using inputs with a ower price. One way to reduce input price is to make use of cheap abour in production through offshoring parts of the production process. Production: offshoring and outsourcing In the video, Facing the competition, severa Itaian cothing firms had considered changing the ocation of their production either outsourcing the work to another firm, or moving their own production faciities abroad to save on abour cost. However, such a strategy has chaenges: outsourcing reduces a firm s contro over parts of the production process and may produce quaity issues. Offshoring invoves investment in abour (training), and capita and and to set up a production faciity. It may aso take time to achieve the desired production standards. Some firms that decide either to offshore or outsource fai to consider their tota cost of production and how costs may change over time when making their decision. Activity 19 Read the artice 'Herd instinct Companies need to think more carefuy about how they offshore and outsource' from The Economist and ist at east two factors that can make firms reverse a decision to offshore or outsource. Can you think of any other factors not mentioned in the artice? Answer Here are three different issues in the artice you may have found others. 1 Labour cost increase. The artice highights that when abour cost is not a arge proportion of tota cost, firms may not gain from offshoring. If the motivation for offshoring is access to cheaper abour input, then firms that have abour cost that is a ow proportion of their product s tota cost have itte to gain from moving production overseas. Aso as increasing numbers of firms foow the same strategy, they end up producing in the same country or ocation, which pushes up oca wages, eroding the expected cost saving. 2 Quaity of production fas. If a firm has high-quaity standards, offshoring can make it difficut to maintain them or achieve simiar quaity eves of output because of a ack of experience and training in the workforce. This is aso true with outsourcing, which has further difficuties for firms to maintain contro of production processes taking pace outside the firm. The video, Facing the competition, aso highighted that some firms had these concerns about the quaity of producing goods from offshore or outsourced ocations. 3 Expected cost savings fai to materiaise. The artice aso suggests some firms fai to aow for deays and unexpected probems that arise as a resut of their 53 of 77 Friday 16 November 2018

54 7 Zooming in on firms offshoring or outsourcing decision. For exampe, consider the case of Boeing described in the artice. Some reasons not isted in the artice incude: Economies of scae cannot be reaised. Economies of scae are not discussed in the artice, but the video, Facing the competition, describes how sma textie producers acked the motivation to offshore production because they coud not gain from economies of scae their businesses were too sma and coud not reaisticay hope to increase output. Firms that ony produce a sma output wi not reaise the abour cost saving from offshoring, but wi sti face simiar issues reated to oss of contro and quaity. Increase in cost of transport. The production cost when firms offshore or outsource may invove significant transport costs that depend on factors outside the contro of the firm. Economists and time A decision to offshore or outsource production invoves a significant reorganisation of a firm s production processes, invoving new production sites and potentiay cosure of existing ones. There is aways a period of time in which some things cannot be changed, ike the ocation of production activity, or it may take time to train and recruit the appropriate abour needed for production. Microeconomists use the concept of a short run and ong run to define two periods of time. In microeconomics: In the short run, at east one input of production is fixed, and cannot be changed. In the ong run, a inputs of production can be changed. This simpe distinction between short and ong run is hepfu for thinking about the different ways firms can manage costs. In the ong run, the firm has the opportunity to achieve the minimum cost avaiabe as it can change its input of abour, capita, and, energy etc. to improve the efficiency of the firm. In the short run, some factor inputs are fixed, so the firm must make do. One probem with making a distinction between two time periods is that in reaity the firm is aways operating in the short run whist making pans for the ong run. Once ong run pans are reaised, they become part of the short run situation of the firm: the firm pans for the future again, and so the process continues. This can make the distinction between the short run and ong run appear burred. The short run and ong run capture the situation of a firm at a particuar point in time. The short run and ong run are theoretica concepts, designed to hep mode the behaviour of firms. They are particuary hepfu in an economic mode describing how costs can be expected to vary for a typica or representative firm. This mode is referred to as a cost curve. 7.4 Cost curves This section uses the concept of the short run and ong run to understand the cost curves of a firm. It ooks at ong run average cost (LRAC) curves first, and then ooks at short run average cost (SRAC) curves. 54 of 77 Friday 16 November 2018

55 7 Zooming in on firms Long run average cost (LRAC) curves In the ong run it is possibe to change a the inputs used in production. The ong run average cost curve shows the average cost for the firm at a range of different eves of output. The firm can potentiay reduce costs from: economies of scae technoogica change earning by doing. The figure beow summarises these three channes of cost reduction. Cost A D B C LRAC1 LRAC2 E F 0 Quantity Figure 29 Two LRAC curves A firm moving from point A to B is a cear exampe of economies of scae: average cost fas as output increases. If the firm were on LRAC 2, then moving from D to E woud aso be an exampe of economies of scae. Note that earning by doing cannot be shown on Figure 30. A LRACs (ike the curve used above) show output for a given period of time on the horizonta axis. However, earning by doing is gained from cumuative experience of production, which is gained over time, not necessariy as a resut of increasing output per day or per year. From point A to point D, the firm s LRAC has shifted downwards, so it is an exampe of technoogica change. Note in this exampe, at any output the firm s average cost is ower having shifted to LRAC 2 compared to LRAC 1. Diseconomies of scae ony occur when a firm experiences increases to average cost as output rises. This occurs on LRAC 1 as the firm moves from B to C, and on LRAC 2 as the firm moves from E to F. Each of the LRAC curves shown have a point which identified the minimum efficient scae (MES). For LRAC 1, this is point B, and for LRAC 2, this is point E. The MES occurs at the owest eve of output where average cost is at a minimum. Economies of scae Sources of economies of scae can be divided into different types. These types reate to how the activities of the firm are organised in order to reduce the average cost of production as output increases. Broady, there are three sources of interna economies of 55 of 77 Friday 16 November 2018

56 7 Zooming in on firms scae; two you have met aready: economies of increased dimensions, and speciaisation. Now we wi introduce one more: indivisibiities. Types of economies of scae (1) Here is a quick description of three sources of interna economies of scae: Speciaisation. As the output of the firm increases, each worker can become more speciaised in discrete parts of the production process. As each worker becomes more speciaised, their efficiency increases. Economies of increased dimensions. As output increases, the firm wi need to increase the capacity of storage, transport or production space. As the resut of a simpe geometric reationship, doubing the dimensions of a warehouse wi resut in a greater than doubing increase to capacity. The capacity of the firm wi increase more rapidy than the costs of increasing the dimensions. This can aso mean it is better for a firm to bring production to a singe ocation, as increasing dimensions of an existing production faciity may be more efficient than having two separate (and smaer) production sites. Indivisibiity. This occurs when a firm requires a minimum amount of input to operate, and as output increases, the cost of any inputs can be spread over a greater output. As a resut, average cost fas as output increases. For instance, consider a stee works: making stee invoves using a bast furnace, which has a big cost whether a sma or arge amount of stee is produced. A furnace is not divisibe, so economies of scae are gained when output is increased and the furnace is used more efficienty. Types of economies of scae (2) Activity 20 Read each case study beow and then, by dragging the abes, match each case study to the correct type of interna economy of scae. Coasta tanker (205 m) ULCC (415m) Figure 30 Exampe A: An oi firm upgrades its transport feet to bigger tankers. 56 of 77 Friday 16 November 2018

57 7 Zooming in on firms Figure 31 Exampe B: A sma firm decides to pursue a strategy of innovation to increase output. Initiay, the R&D budget comprises the majority of the firm s tota costs. Figure 32 Exampe C: A white goods manufacturer organises staff into production teams responsibe for different stages of production and assemby. Increased dimensions Exampe A Indivisibiity Exampe B Speciaisation Exampe C 57 of 77 Friday 16 November 2018

58 7 Zooming in on firms Answer Exampe A is a case of economies of increased dimensions because of the geometric reationship between voume and surface area. For instance, consider two tanker ships: the first a coasta tanker, 200 m ong, 30 m wide and 16 m deep; the second an utra arge crude carrier (ULCC) with dimensions doube the ength: 400 m ong, 60 m wide and 30 m deep. The voume (ength width depth), increases from to cubic meters. A doubing of dimensions woud increase the cost of construction, however, the voume of goods that can be transported has increased by a factor of more than seven. If the firm can increase its output to fi arger and arger carriers, then the average cost of transport fas. Coasta tanker (96 000m 3 ) ULCC ( m 3 ) Figure 33 Exampe B is a case of indivisibiity. Investment in R&D is considered indivisibe because it requires significant investment to yied resuts, and it is difficut to operate R&D beow a minimum scae. As output increases, the costs of doing R&D are spread over a greater output, so average cost fas. Exampe C is a case of speciaisation. At Miee, the washing machine production process is divided into different stages. Workers train on particuar stages, for instance, some are forkift drivers and some are engineers making sure equipment operates efficienty. Others focus on stages in the fina assemby, checking different components of washing machines and distribution of goods. This type of speciaisation woud be expected to reduce average cost as the firm s output increases. As output increases, workers can become more and more speciaised, and so the efficiency of the production process increases and resuts in faing average cost. Costs in the short run The previous activities in this section have examined LRAC curves. Now we wi ook at short run average cost (SRAC) curves. In the short run, the firm can ony change output by changing variabe factors. It has to make do with existing fixed factors. This reduces the opportunity to reduce average cost as output increases. In fact, in the short run, average cost is ikey to rise once output reaches a certain eve. The next set of activities wi hep you to understand the main features of the SRAC. 58 of 77 Friday 16 November 2018

59 7 Zooming in on firms Short run average cost (SRAC) curves (1) Activity 21 Tabe 4 shows how the tota cost of a firm changes with output in the short run. Cacuate the average cost at each eve of output (round your answers to the nearest whoe ). Tabe 4 Cacuating short run average cost Interactive content is not avaiabe in this format. Short run average cost (SRAC) curves (2) It s often easier to represent cost curves graphicay. Here the two coumns of data in Tabe 4 are shown in separate graphs. The tabe is repeated beow. Tota cost Cost ( ) Average cost (SRAC) Output Output Figure 34 Tota cost and average cost curves Quantity of output (units) Tota cost ( ) Average cost ( /unit) of 77 Friday 16 November 2018

60 7 Zooming in on firms Notice that tota cost increases with output, abeit at varying rates. The SRAC captures how average cost (or unit cost) changes with output. When output is ow, initiay average cost fas, but as output increases, average cost starts to rise. Next et s examine the components of average cost fixed and variabe cost. Fixed and variabe costs In the short run, some of the firm s costs are fixed these are costs that do not change with output. The remaining costs are variabe they change with the eve of output. The foowing video wi hep you to work through the difference between fixed and variabe costs, and aso show how we can appy these concepts to the SRAC curve. Watch the video and then attempt Activity 22. Video content is not avaiabe in this format. Fixed and variabe cost Short run cost curves (1) Activity 22 In the figure beow we have an average (tota) cost curve, an average fixed cost curve and an average variabe cost curve. Using the drag and drop boxes, abe the graph correcty. Interactive content is not avaiabe in this format. Figure 35 Short run average cost curves (1) Answer The correcty abeed figure is shown beow. 60 of 77 Friday 16 November 2018

61 7 Zooming in on firms Figure 36 The cost curve has a vertica axis showing the cost in per unit. The horizonta axis shows the quantity, or units produced per day. This is shown in thousands of units per day. The figure shows three short run cost curves. The owest curve shows average fixed cost; average fixed cost wi aways fa as output increases. Next average variabe cost; average variabe cost has a characteristic u shape due to the increasing and diminishing returns to variabe factors. Finay, the average cost curve (sometimes referred to as average tota cost curve) is the sum of average fixed and average variabe cost. This means average cost is aways greater than average variabe or average fixed cost. Notice that as output increases, the difference between average cost and average variabe cost reduces. This is because average fixed cost decreases with output. Another way to think about it is that the difference between average cost and average variabe cost equas average fixed cost. Short run cost curves (2) The next activity wi check that you can interpret the shape of the average cost, average variabe and average fixed cost curves described in the video, Fixed and variabe cost. 61 of 77 Friday 16 November 2018

62 7 Zooming in on firms Activity 23a Cick on the short run cost curve figure beow to identify the approximate point where average costs are at a minimum. Interactive content is not avaiabe in this format. Figure 37 Average cost curves (2) Discussion Look at the figure beow. The red arrow shows the correct answer for the point of minimum average cost. The brown arrow shows the point of minimum average variabe cost. The average fixed cost curve has no minimum as it decreases with every unit of output (it is not u-shaped). 62 of 77 Friday 16 November 2018

63 7 Zooming in on firms Figure 38 Short run cost curves (3) Activity 23b This time, cick on the quantity axis in the figure to identify the eve output where the difference between average cost and average variabe cost is smaest. Interactive content is not avaiabe in this format. Figure 39 Average cost curves (3) 63 of 77 Friday 16 November 2018

64 7 Zooming in on firms Discussion The difference between average cost (AC) and average variabe cost (AVC) is east when output is high, in this case at a quantity of /day (see the back arrow on the figure beow). This is the same as spotting that average fixed costs (AFC) are owest when output is high, because: AC AVC = AFC. In the short run, if output were to continue to increase beyond a quantity of /day then we woud expect AFC to become smaer and smaer, and so make a smaer and smaer contribution to AC. Figure of 77 Friday 16 November 2018

65 7 Zooming in on firms Short run cost curves (4) Activity 23c If output is at a quantity of 3000 per day, using the figure beow, pick one answer describing how the average cost wi change if output is increased to 3001 per day. Quantity 1000s/day Figure 41 Average cost curves (4) Increase Decrease Remain unchanged 65 of 77 Friday 16 November 2018

66 7 Zooming in on firms Answer If output increases from a quantity of 3000 per day, average cost wi fa. This is because at this output the average cost curve is soping downwards. Increasing output wi reduce the average cost unti it reaches a minimum at a quantity of approximatey 5000 per day. Then the average cost curve sopes upwards, so average cost increases when output increases beyond 5000 per day. Cost curve summary This section has highighted some important properties of cost curves. Because we expect the behaviour of costs to be simiar in most firms and for most production processes, we have a mode of firms costs that we can appy widey. In the ong run the firm can: vary a inputs to minimise cost reduce average cost by: adopting new technoogies increasing output to gain from economies of scae over time, reducing average cost from earning by doing achieve no further cost saving advantages from increasing output once output is at MES. In the short run: the firm is expected to have a u-shaped average cost curve the average cost curve shows how costs change at different eves of output average cost is the sum of the average fixed cost and average variabe cost average fixed costs decrease as output increases average variabe costs have a u-shaped curve because of the returns to inputs of variabe factors vary with output at ow eves of output, a firm is expected to experience increasing returns to variabe factors, and at higher eves of output there wi be diminishing returns. The u shape of the short run average cost curve aso impies something about the margina cost curve, which we ook at next. 7.5 Margina cost curves Now you have earned the properties of the average cost curve, you wi check your understanding of margina cost. Average cost and margina cost are fundamenta economic concepts in the anaysis of how firms, industries and markets behave. Average cost and margina costs (1) Watch the short video on margina cost, which describes the reationship between average and margina costs. Make sure you understand the difference between average and margina costs. 66 of 77 Friday 16 November 2018

67 7 Zooming in on firms Video content is not avaiabe in this format. Margina cost Average cost and margina costs (2) Activity 24 Task (a) (a) On the figure beow, cick on the margina cost curve to show the point at which margina costs are at a minimum. Interactive content is not avaiabe in this format. Figure 42 A firm's short run average cost and margina cost curves Task (b) (b) Determine the point where margina costs equa average cost. Interactive content is not avaiabe in this format. Figure 43 Task (c) (c) Compete the foowing: When margina cost is ess than average cost, increasing output wi mean average cost (seect one answer): Rises No, if margina cost is ess than average cost, producing an additiona unit wi reduce average cost. Fas Stays the same No, if margina cost is ess than average cost, producing an additiona unit wi reduce average cost. Answer Yes, if margina cost is ess than average cost, producing an additiona unit wi reduce average cost. Discussion When margina cost is ess than average cost, average cost wi fa. Average cost fas as output increases because the cost of producing one extra unit (the margina cost) is ower than average cost. 67 of 77 Friday 16 November 2018

68 7 Zooming in on firms Note, once margina cost is greater than average cost, then increasing output wi resut in higher average cost. For instance, at a quantity of 8000 per day, average cost is ess than margina cost, so increasing output resuts in higher average cost. Cacuating margina cost So far we have anaysed the reationship between average cost and margina cost. This activity wi check that you can cacuate margina cost. Activity 25 Imagine we have a firm producing nine units of output per day at a tota cost of It increases production to ten units per day at a tota cost of (a) Cacuate the average cost when ten units are produced per day. Interactive content is not avaiabe in this format. (b) Cacuate the margina cost of increasing production to ten units per day. Interactive content is not avaiabe in this format. 7.6 Using evidence This section is an opportunity to practise reating some of the theory of production cost to hep you anayse production activities in firms. Cost of producing a pint Producing a pint of mik is a costy business. Firms producing mik, usuay referred to as dairy farms, take inputs in the form of and, capita (the herd, miking parours and storage) and raw materias (such as feed and seed). They then use these inputs to make mik, which can aso be used to produce cheese and yogurt. Activity 26 Some farms may receive income from the government, but ike a firms, if their income doesn t cover the cost of mik production, they risk going out of business. Watch this short video on the chaenges facing mik producers, which introduces one of the main ideas covered in Section 7: reducing cost. Notice how the video uses ideas from short run and ong run cost curves. Whist watching the video, think about the key chaenges mik producers face and what they can do to reduce these chaenges. Make some notes on your thoughts here you wi need to refer back to them ater on. Video content is not avaiabe in this format. Costs of mik production 68 of 77 Friday 16 November 2018

69 7 Zooming in on firms Provide your answer... Discussion Here are some notes about the video you may have some simiar points in your notes. Costs of production are high, sometimes higher than the price dairy farmers are paid, and rising. Mik prices are faing. Farmers have difficuty investing in new equipment to repace worn or od equipment this wear and tear cost is what the presenter, John Craven, refers to as depreciation cost. Some producers are considering stopping mik production. Possibe responses to reduce cost: Invest in new technoogy to shift the farm s ong run cost curve downwards, for exampe, by buying more equipment that is more efficient to run, or updating their production process (production function) to reduce abour input. However, this is difficut if the farmer cannot afford to increase their fixed cost in the short run to purchase new equipment. Gain from economies of scae by increasing their scae of output, ike in the mega dairy exampe. If firms invest in new technoogy, not ony may they experience a downward shift in the LRAC, they may aso benefit from decreasing unit cost as output increases. This may be as a resut of economies of scae arising from indivisibiity that costs per unit of output from running and maintaining new technoogy or machinery wi decrease as output increases. Other indivisibiities may arise from the running of the farm office and administration, which have a fixed cost whether the farm has a high or ow output, but if spread over higher output, wi hep to decrease average cost. Stop producing mik. Chaenges: Most farms are sma in the UK, and and is scarce and expensive. It may not be easy to increase the scae of the business, ike in the mega dairy exampe. Some overseas producers aready produce at a ower cost per pint. Economies of scae require investment in production, which is difficut when making a oss. Issues of anima wefare reated to the mega dairy. Labour and fixed cost Did you notice anything pecuiar about the anaysis of abour cost in the video? Try Activity 27 to test your understanding. Activity 27 In the fim, abour on the dairy farm is treated, in the short run, as a (seect one option): 69 of 77 Friday 16 November 2018

70 7 Zooming in on firms Fixed cost Variabe cost Depreciating cost Discussion In many economic anayses, abour is considered to be a variabe cost. However, in the agricutura sector it is not unusua to cass abour as a fixed cost, such as in dairy production. Typicay in dairy production, empoyee costs are considered fixed, because abour use is not directy reated to the quantity of output. The number of empoyees on a farm are often ow and work needs to be done to run the dairy farm, for instance to feed the herd, regardess of the quantity of mik sod. Labour input is considered fixed in the short run and so is a fixed cost. In the ong run, farms might require more or ess abour depending on future production pans. Cost of inputs In 2012, farmers argued that income received for mik fe beow the cost of production. The video cip suggests part of the reason for this is due to rising input costs in dairy production. The next activity presents some data on dairy costs, which can be anaysed to see if this supports the materia given in the cip. Activity 28 Look at the data tabe beow, which shows an extract from the Nationa Farmers Union (NFU) 2011 report on dairy production cost. There is aso a time series chart showing the monthy price of feed cost, given in pence per itre of mik, in the years eading up to Does the data beow support the view of farmers in the video? 70 of 77 Friday 16 November 2018

71 7 Zooming in on firms Pence per itre Variabe costs of which: Purchased feed costs Bedding costs Fertiiser costs Veterinary costs Livestock costs Crop costs Other variabe costs Fixed costs of which: Empoyee costs Machinery costs Land and property costs Finance costs Other fixed costs Tota costs Apr - Mar Apr - Mar Change % % % % % % 4.6% 0.4% 0.5% 0.6% 3.0% 0.8% 0.5% 11.8% 6.0% Figure 44 Dairy production costs data Extract from NFU (2011) Report. Fixed and variabe cost of dairy production (Source: DairyCo. 2012a) Feed cost Linear (Feed cost) 6 pp March 04 Sep 04 March 05 Sep 05 March 06 Sep 06 March 07 Sep 07 March 08 Sep 08 March 09 Sep 09 March 10 Sep 10 March 11 Sep 11 March of 77 Friday 16 November 2018

72 7 Zooming in on firms Figure 45 Tota feed cost in pence per itre (pp) of mik produced over time, shown in red with a inear trend ine shown in back Source: DairyCo. 2012a, author cacuation Provide your answer... Discussion Here are some notes made on the Dairy Co. (2012a) and NFU (2011) data: The NFU (2011) tabe reports data for two years: 2009/10 and 2010/11. It reports that tota costs have increased 6 per cent over the two years. Notice that the costs are given per itre effectivey this is average cost data average cost per itre. Notaby the rise in cost is due to variabe costs having risen by 11 per cent between 2009/ 10 and 2010/11, whist fixed costs have ony risen by 0.5 per cent. In particuar, the cost of variabe inputs per pint, such as fertiisers and veterinary costs, show rises between 2009/10 and 2010/11. This woud seem to support that profits (margin) in dairy are being squeezed prices are faing whist costs are rising. However, we have to be cautious this is ony one year of data it coud be a one-off or outier year. In the short run, if dairy producers increased output, then average variabe cost coud rise as a resut of diminishing returns. The graph using DairyCo. (2012a) data shows some data on feed cost a raw materia for dairy producers. This seems partiay to support the NFU report the inear trend, as shown by the back ine, shows variabe costs, such as feed costs, rise on average over time. For instance, the price of feed in 2004 ranges from approximatey 3 pp to 4.5 pp, compared to a range of 5.5 pp to 8.5 pp in However, athough the trend is for increasing prices, the chart aso shows considerabe variabiity in the cost of feed within each year, possiby due to seasona changes in the cost of feed. There seems to be evidence that variabe costs are rising. However, notice that we have no data on how fixed costs are changing over time. Profits and cost The evidence in this section suggests mik producers are reativey hepess: dairy producer profit per itre is decining as costs rise and mik prices fa. However, not everyone agrees with this view. DairyCo., a division of the Agricuture and Horticuture Deveopment Board (AHDB) responsibe for making UK agricuture competitive and sustainabe, produced a report in 2012 which ooked at factors that infuenced producers margins (profits). It found a significant variation in the production cost per itre of different firms. Some firms coud produce mik more efficienty than others. The report stated that: The reationship between mik price and margin is actuay not that strong. Cost of production, on the other hand, is very ceary reated to margin. This represents a rea opportunity for dairy producers, as at east some of the costs of production that they face are within their contro. (DairyCo., 2012b, p. 9) 72 of 77 Friday 16 November 2018

73 7 Zooming in on firms The report aso concudes: Mik can be produced efficienty from any of the major systems that are currenty practised in Britain. Moreover, efficient mik production is possibe at amost any scae of production. Different factors drive profit for each system. The impact these factors have on returns varies consideraby. The need to fit the system that you use to your own circumstances has never been more important. (DairyCo., 2012b, p. 4 ) Activity 29 Given what you have earned so far, what options coud producers investigate to contro their production cost? Provide your answer... Answer To save cost, producers may need to consider ong run changes to their processes to become more efficient. This means trying to achieve the types of economies of scae and technoogica advances highighted in the mik video that reduce the average cost of production. However, the second quote from DairyCo. suggests that increasing scae is not necessariy a path to efficiency. The quote indicates that there are different techniques of production that firms can use, and as a resut each technique wi be associated with different shaped cost curves. Some of the techniques may have economies of scae, but ike in the mega dairy exampe in the video, may ony provide a cost saving if firms can produce at very high quantities. It suggests for firms to maximise profit, they wi need to find the right combination of technoogy and determine the optimum eve of output that maximises their efficiency. The idea of searching for maximum profit by changing the quantity of output is a key economic mode of the firm. 7.7 Summary Section 7 has examined the firm and, in particuar, different measures of cost. It has ooked at costs in the short run and the ong run. It has shown how firms might reduce average cost in the ong run, and the constraints that firms face in the short run. You have worked through activities using cost curves to show how average costs are reated to output in a period (e.g. per day or week). Understanding cost curves is key to understanding the behaviour of firms, industries, markets, and more widey, the suppy side of the economy. 73 of 77 Friday 16 November 2018

74 8 Concusion 8 Concusion In this OpenLearn course you have deveoped your understanding of how economists use modes by exporing the construction and use of macroeconomic modes to anayse the determination of income, and by seeing how the microeconomic anaysis of firms adds yet another dimension to what economists do. In Section 1, you were introduced to the founder of macroeconomics, John Maynard Keynes. In Section 2, you earnt how the circuar fow mode can be used to show either actua or panned vaues of economic variabes. In connection with this, you considered the difference between an identity (as used in the nationa income accounting system) and an equaity (as used in the Keynesian theory of nationa income equiibrium). In Section 3, you buit up a Keynesian consumption function from its components of exogenous consumption and income-induced consumption, making use of the concept of the margina propensity to consume. In Section 4, you ooked at the modeing of saving and investment, noting how investment and consumption together make up aggregate demand in the mode of a cosed economy with no government sector. You aso earnt about the importance of the 45-degree ine in anaysing equiibrium. In Section 5, you considered how equiibrium may occur at beow fu empoyment and how fu empoyment may be achieved by a stimuus to aggregate demand. The macroeconomic anaysis ended with Section 6, which showed you how fisca poicy can be used to stimuate demand, and taught you about the importance Keynes paced on the roe of the government in eading economies to better outcomes. Section 7 concuded the course by zooming in on firms and examining some of the major factors that determine their viabiity and competitiveness. Keep on earning 74 of 77 Friday 16 November 2018