The meaning of globalisation

There is no precise definition of the term globalisation, and it is used to refer to a variety of ways in which countries are becoming more and more closely integrated, not just in the economic sense, but also culturally and politically.

However, one of the best definitions of globalisation in the economic sense is by Peter Jay, the BBC’s economics corrospondent in 1996: ‘The ability to produce any good or service anywhere in the world, using raw materials, components, capital and technology from anywhere, sell the resulting output anywhere and place the profits anywhere’.

It should be understood that globalisation is not a new phenomenon because there have been many period in history when there was considerable integration between countries: for example, during the height of the Roman empire. However, the pace of global integration has increased considerably over the last 30 years.

Characteristics of globalisation

  • An increase in trade as a proportion of GDP
  • Increased movements of financial capital between countries
  • Increased international specialism and division of labour. It is increasingly common for parts and components of products to be made in different countries and for assembly to occur in another country
  • The growing importance of MNCs and TNCs – multinational and transnational companies – and foreign direct investment (FDI)
Factors contributing to globalisation

A variety of factors have contributed to increased economic integration if countries.

One of the most significant is the fall in transport costs. In real terms, the price of transporting goods has fallen significantly, enabling good to be imported and exported more cheaply. Coupled with this has been a decline in the cost of communications. In particular, the cost of using the internet has fallen greatly over the last 20 years, and its availability has increased.

The lowering of trade barriers since the Second World War has been a major factor in the growth of world trade. The World Trade Organisation (WTO), formerly the General Agreement on Tariffs and Trade, has been responsible for negotiating reductions in tariffs and other barriers to trade in rounds of talks, the most recent of which was the Doha round.

Both the collapse of communism and the opening of China to world trade have contributed to globalisation. Countries which were previously not open to FDI became much more integrated into the world trading system. TNCs have taken advantage of the reduction in trade barriers and the development of the internet to organise trade on a global scale.

Benefits and disadvantages of globalisation


Free trade enables the application of the law of comparative advantage, which suggests that, when countries specialise in goods in which they have a comparative advantage (i.e.  goods can be produced at a lower opportunity cost) then world output and living standards will increase. It is evident that the growth in world trade in both goods and services has been associated with increased growth in real GDP.

  • For consumers, globalisation may mean a wider  choice of goods at a lower price
  • For producers, there are likely to be benefits in terms of lower production costs as a result of offshoring and also economies of scale
Disadvantages and problems
Globalisation has been criticised on the basis that it has promoted exploitation of workers, children, farmers and the environment. Similarly, health and safety laws and regulations are usually less demanding in developing countries.

The external costs associated with trade are becoming increasingly apparent, especially in relation to environmental degradation which results in global warming. Consumers are also becoming more aware of ‘food miles’. It mat be argued, therefore, that increased trade is not sustainable in terms of the environment.

Globalisation has also been associated with increased inequality. For example, rich countries have much greater access to the internet than poor countries. Given that much wealth creation is dependant on readily available information the poorest developing countries are at a severe disadvantage.

Some argue that the liberalisation of financial markets has been associated with global instability, as evidenced by the financial crisis in Asia at the end of the 1990s, and more recently the global credit crunch following the collapse of confidence in the banking system. It is also argued that the global imbalances currently experienced (i.e. the current account deficits in the USA and surpluses in China) are unsustainable.

The global financial crisis that became particularly evident in 2008 has led to a development sometimes described as deglobalisation, in which countries adopt protectionist policies in an attempt to protect domestic employment. Obviously thi leads to the decline in specialisation and trade. Examples of protectionism in 2009 include the subsidies given to the car industry in the USA; the increased tariffs on imported cars in Russia, and the EU raising duties on imported Vietnamese shoes

International trade

Globalisation has led to a phenomenal increase in world trade. One measure is to consider exports as a proportion of world GDP.

The pattern of world trade has also been greatly affected by the entry of China as a major manufacturer.

The basis of free trade law: the law of comparative advantage

The law states that, even if one country has an absolute advantage in the production of all goods, it can still benefit from specialisation and trade, if it specialises in the production of goods in which it has a comparative advantage.

A country has a comparative advantage in producing a product if the opportunity cost of producing it is less than its potential trading partner.

Say the UK take 5 hours to make cheese, and China 1. Also, the UK takes 15 hours to make cars, but China 2. China clearly has an absolute advantage in producing both cars and cheese.

However, look at the opportunity cost. The UK gives up 3 cars if it producing 1 cheese. China gives up 2 cars if its producing 1 cheese. Therefore China has a comparative advantage in cheese production.

The UK gives up 1/3 a car if it produces one cheese, and China gives up 1/2. So, the UK has a comparative advantage in car production.

Therefore, the UK should specialise in producing cars, and China should produce cheese.

For trade to be beneficial, the terms of trade must lie between opportunity cost ratios. In other words, the UK will only trade for cheese with china if the price is above 1/3 of a car, and China will only trade if it is below 1/2 of a car.

Terms of trade = (index of export prices / index of import prices) x 100

You should note that, if opportunity costs were the same, then there would be no benefit from specialisation and trade.

However, widespread acceptance of the law of comparative advantage amount economists and the benefits of free trade, various criticisms can be made:

  • Free trade is not fair trade i.e. the rich countries might exert their monopsony power to force producers in developing countries to accept low prices.
  • The law of comparative advantage is based on unrealistic assumptions such as constant costs of production, zero transport costs, and no barriers to trade.

Limits of free trade: the case for protectionism

The term protectionism refers to measures designed to limit free trade. Arguments supporting the need for protectionism might include the following:

  • To protect infant industries: this argument might be particularly relevant to developing countries that are in the process of industrialisation. Without protection, infant industries might be unable to compete because they have yet to establish  themselves and are too small to benefit from economies of scale.
  • To protect geriatric industries: these are industries that might demand protection so that they have time to restructure and rationalise production so that they can become competitive again. Typically, these occur in developed economies that are loosing their comparative advantage.
  • To ensure employment protection: cheap imports might threaten jobs in the domestic economy and workers might demand that the government takes action to limit imports.
  • To prevent dumping: the term dumping refers to goods exported to another country below at a price below the average cost of production. It is a form of predatory pricing and, if it can be proved, it is illegal under WTO rules. This is one of the few arguments in favour of protectionism that can be justified under economic theory because it unfairly distorts comparative advantage
  • To correct a balance of payments deficit on current account: restrictions on imports might help to reduce the imbalance of between the value of import and the value of exports. However, under the floating exchange rates system, it is possible that this correction will happen automatically
  • To restrict imports fro counties whose health and safety regulations and environmental regulations are less stringent: some argue that developing countries have an unfair comparative advantage because production is not under the same laws and regulations as developed countries, so enabling them to produce at lower average cost
  • For strategic reasons: a country might introduce protectionist policies on goods of strategic importance in time of war so that it is not dependant on imports. Food, defence equipment and energy are items frequently used as examples of such goods.
  • To raise tax revenues: tariffs may be an important source of tax revenue for developing countries.
  • In retaliation: barriers to trade may be imposed by a country because another country has restricted the imports of its goods.
Types of protection/import barriers

There are numerous ways by which free trade can be prevented. The most common are tariffs, quotas and subsidies to domestic producers and administrative regulations. In countries where the exchange rate is not freely floating, the authorities might also hold down the value of the currency artificially to give their good a competitive advantage. e.g. China.


Before the tarrif is imposed:

  • the price paid by consumers is P1, domestic output is Q1, imports are Q1 to Q2.
Once the tariff is imposed:
  • the price paid by the consumer increases to P2, reducing consumer surplus
  • domestic output rises to Q4,  increasing producer surplus
  • imports fall to Q4Q3
  • tax revenue collected by the government is KLMN
  • net deadweight welfare loss is the loss in consumer welfare that is not made up for by producer welfare or government revenue – X and Y

Import quotas place a physical restriction on the amount of goods that can be imported. They have a similar effect as tarrifs, in that the price of imported goods will rise and domestic producers should gain more business. However, unlike tariffs, the government does not gain any extra revenue.

Subsidies to domestic producers

Grants given to domestic producers artificially lower their production costs, so enabling their goods to become more competitive. Subsidies therefore act as a barrier to trade

Administrative regulations

These take a variety of forms, including labelling, heath and safety regulations, environmental standards and documentation on country of origin. In effect, such regulations increase the costs of foreign producers and so act as a barrier to trade.

The case against protectionism

There are several problems with protectionism including:

  • Inefficient resource allocation: trade barriers distort comparative advantage and reduce specialisation, which will result in lower world output and therefore reduce living standards
  • Higher prices and less choice for consumers
  • Less incentive for domestic producers to become more efficient in order to compete on a global scale
  • Difficulty of removing trade barriers. Once such barriers are introduced, it might prove to be difficult to remove them because of the adverse effect on domestic producers

The World Trade Organisation

The primary aim of the World Trade Organisation (WTO) is to liberalise trade i.e. to lower trade barriers. It does this by providing governments with a forum for negotiating trade agreements. Since the creation of the General Agreement of Tariffs and Trade (GATT), which was the forerunner of the WTO, there have been eight rounds of talks, with the ninth round – the Doha Development Agenda – still being negotiated (since 2001).

In addition to promoting free trade, the WTO performs other functions including:

  • Most favoured nation principle: which implies that counties cannot discriminate between trading partners. For example, a reduction in tariff for one country must be enacted for all countries
  • National treatment: imported and locally produced goods must be treated equally once the foreign goods have entered the market.

While the WTO has been successful at bringing about substantial reductions in tariffs on manufactured goods e.g. industrialised country’s tariffs averaged around 4% by the mid 1990s, it has been less successful in reducing barriers to the trade in services. Further, there has been a growth in the use of non-tariff barriers, especially administrative regulations, which has, to some extent, offset the gains from the reduction in tariffs.

Trading blocs

Regional trading blocs are intergovernmental associations that manage and promote trade activities for specific regions of the world. Trading blocs may take several forms:

  • Free trade areas. Trade barriers are removed between member countries, but individual countries can still impose tariffs and quotas on countries outside of an area. An example is in the North Atlantic Free Trade Area.
  • Customs unions. The characteristics of customs unions include free trade between member states and a common external tariff on all goods imported from outside the bloc. An example is the European Union
  • Common market. These are customs unions but with the added dimension that it is not only goods and services that can be moved freely within the area, but also factors of productions (especially labour). For example, the European Economic Area.
  • Monetary unions. These are customs unions that adopt a common currency. For example, the Eurozone

Trading blocs and the WTO

The existence of trading blocs has two significant consiquences:

  • trade creation – trade occurs that otherwise wouldn’t have happened. This is a result of the removal of trade barriers and therefore increased specialisation and trade according the the law of comparative advantage
  • trade diversion – trade changes from with members from outside of the union to inside of the union. This is due to the tariffs imposed on countries outside of the union, and the removal of tariffs inside of the union – from the lower-cost to the higher cost countries. Therefore this is an inefficient allocation of resources.

Nevertheless, it may be argues that the growth in both the number and size of trading blocs has contributed to the WTO goal of promoting free trade.


Public finance

There are four elements of public finance to be considered:

  1. Public expenditure
  2. Taxation
  3. Public sector net borrowing
  4. Public sector net debt

Public expenditure

Expenditure by central and local government can be categorised into three distinct types:

  • Current expenditure: This is the day-to-day expenditure on goods and services, e.g. salaries of teachers, nurses and drugs used by the NHS
  • Capital expenditure: This relates to expenditure on long term investment projects, such as new hospitals and roads
  • Transfer payments. These are payments that are made by the state to individuals in the form of benefits where there is no production in return.

The objectives of public expenditure include the provision of public goods, defence and internal security; the provision of goods and services which yield external benefits and/or where there may be information gaps and asymmetric information, for example health and education; the redistribution of income; and expenditure to deal with external costs such as pollution, and waste.

Analysis of pubic expenditure

The following synoptic issues arise when considering public expenditure:

  • Given the amount of pubic expenditure is likely to be restricted in any one year, then an increase in one area will involve an opportunity cost
  • Increasing expectations relating to healthcare and education are associated with real incomes, so it could be inferred that demand for these services is income elastic
  • An increase in public expenditure represents an injection into the circular flow of income and so will have a multiplier effect on GDP. Not only will aggregate demand increase but expenditure on areas such as eduction, infrastructure and health may cause an increase in LRAS.
  • Part of public expenditure might be used for dealing with external costs.
  • Public expenditure could result in government failure, where government involvement causes a net welfare loss

In addition, there is the issue of crowing out, which might result from increased public expenditure. This might take two forms: resource and financial. Resource crowding out occurs when the economy is operating at full employment and an increase in public expenditure results in insufficient resources being available to the private sector. Financial crowding out is when increased borrowing or tax cuts are funded by increased private sector borrowing, so increasing the demand for loanable funds and driving up interest rates.

The size and pattern of public expenditure

Factors influencing the size and pattern of government expenditure include:

  • The level of GDP: incomes increase, the demand for many government provided services such as health and education rises more than proportionately because demand for them is income elastic.
  • The size and age distribution of the population: an increase in the size of the population (e.g through immigration) is likely to place extra pressure on public services, while an ageing population will increase demand for medical services and social security for the elderly.
  • Political priorities: the Labour government placed a particular emphasis on improving the quality of health and education services
  • Redistribution of income: expenditure on those in relative poverty and those will disabilities has increased significantly in recent years. For example, there has been an increase in means-tested benefits such as family tax credits and pensioner’s credits.
  • Discretionary fiscal policy: the credit crunch has led to the ressurection of fiscal policy as a means of managing the economy
  • Debt interest: the massive increase in fiscal deficits from 2008 is leading to sharp rises in public sector debt. In turn this will result in higher interest payments on the national debt.


Taxes may be divided into two types: direct and indirect. Direct taxes are those levied on income and wealth and the tax burden cannot be passed onto anyone else. Indirect taxes are those levied on expenditure.

The main direct taxes are income tax, corporation tax, and capital gains tax, while indirect taxes include VAT, excise duties and tariffs.

There are three broad categories of taxes: progressive, proportional and regressive.

  • Progressive: proportion rises as expenditure increases.
  • Proportional: proportion constant as income increases.
  • Regressive: proportion declines as expenditure increases.

Analysing the effects of taxation

While analysing the effects of taxation, the following synoptic issues should be considered:

  • An increase in taxes may represent a leakage from the circular flow and so would have a downward multiplier effect in GDP
  • An increase in direct tax on a product would cause a leftward shift in the supply curve, The incidence of tax on producers and consumers depends on the PED.
  • Indirect taxes might be applied to products that cause external costs.
  • An increase in indirect taxes could cause inflation via a wage-price spiral. For example, if VAT is increased, prices rise. This could be inflationary if it results in workers demanding higher wages to compensate for the increase in prices.

A more detailed consideration of tax changes is given below:

The net effect of a change in income tax rates

If income tax rates are changed there will be a variety of effects on an economy. Given the increase in fiscal deficits and national debts of many countries, its seems likely that taxes will be raised. For example, in the UK, there will be a 50p income tax rate from April 2010, and a rise of VAT to 20% was implemented in 2011. Higher income tax rates could have the following effects:

  • Income distribution: the tax system is more progressive, making income distribution less equitable
  • Incentives to work: May create significant disincentives.
  • Tax revenues: Depends on placement on Laffer curve.
  • Level of economic activty: cause fall in disposable income. Reduction in propensity to consume, so less consumption.  Fall in AD. Disincentives of tax may cause shift in AS to left.

An increase in VAT could have the following effects:

  • On income distribution: regressive tax. Income distribution less even
  • Incentives to work. May cause people  to work harder so that they can maintain their standard of living
  • Tax revenues: Raising indirect taxes would increase tax revenues to the government so ling as the demand for products and services affected is price inelastic.
  • Rate of inflation: an increase in VAT will raise the price of most goods and services. If workers and trade unions respond by demanding wage increases to compensate for price rises, then an inflationary wage-price spiral could result.
  • Level of economic activity: a rise in VAT would act as a leakage from the circular flow, increased by the multiplier. The real incomes would fall, so causing a fall in AD. Costs would rise leading to a fall in AS.

Public sector borrowing and debt
Public sector net borrowing or fiscal deficit

Public sector net borrowing is the difference between public expenditure and tax revenue.

The PSNB is significant for the following reasons:

  • Excessive borrowing could be inflationary because AD would be increasing
  • Public sector net debt must not exceed 3% to meet the criteria of entry to the Euro
  • Taxen as a percentage of GDP given an indication of the size of the state sector relative to the whole economy. This might have some significance for foreign direct investment (FDI), since high taxes may act as a deterrent.
  • Until 2009, borrowing could only be for capital expenditure over the course of the by business cycle to meet the requirements of the Golden Rule.

Public sector net debt

PSNB, formerly known as the national debt, is the culmative total of past government borrowing.

  • To meet the sustainable investment rule, this should not exceed 40% of GDP and to meet the conditions of entry to the Euro it should not exceed 60% of GDP.
  • As with the PSNB, the absolute size of the PSND is less significant than its size relative to GDP, because this provides an indication of how readily it can be serviced.
  • Until 2007, the PSND was below 40% of GDP, but the global financial crisis had a massive effect. In 2008, it rose to 47% of GDP and is currently at 60%.

Do large national debts matter?

Some argue that, if the money is being used to finance improvements of infrastructure and other capital projects, then a large PNSD might be justified because it would keep increasing a country’s future productive potential, so making it easier to repay in the future. However, certain problems may arise:

  • There is an opportunity cost for future generations: interest payments on the national debt mean that less money will be available for public services.
  • Crowding out: if the increasing size of PSND is an indication of the increasing size of the public sector, resource or financial crowding out may occur
  • Danger of inflation: if the rising PSND has been caused by successive PSNB deficits, then there is a danger that inflationary pressures will develop, since injections will be rising relative to leakages.
In the long run, future governments might be forced to raise taxes and cut public expenditure so that the national debt can be reduced.

Macroeconomic policy instruments

Macroeconomic policies are usually divided into demands-side (monetary and fiscal policy) and supply side policies. For 30 years or so, until the financial crisis of 2008, monetary policy was geared towards combating inflation, while fiscal policy was aimed at achieving the governments fiscal objectives. Supply-side policies were used to secure economic growth and the government’s other macroeconomic objectives. In this unit it is important to adopt a critical approach to the effectiveness of these policies.

Monetary policy

Monetary policy refers to the use of interest rates, money supply and exchange rate in order to influence the level of economic activity in a country.

There are various aspects of monetary policy:

  • Inflation targets. These are used by many countries in order to maintain a low rate of inflation. In the case of the UK, there is a target of 2%, although the rate may vary up to 1% either side of this, while the European Central Bank has a target maximum inflation rate of 2%. Until 2007, inflation targeting was generally regarded as an effective way of controlling inflation, although countries without inflation targets did not seem to have significantly higher rates of inflation. However, following the financial crisis, many economists have argued that an inflation target based on the CPI is too narrow. Instead there should be targets relating to other variables, such as asset prices. In order to prevent asset price bubbles from occurring.
  • Interest rate changes. These are used to achieve the inflation target. e.g. if the inflation rate is predicted to rise above its target, then the Bank of England increases the base rate. However, the use of interest rates has various disadvantages. i.e. time lag, business costs rise, exchange rate may increase, making a countries goods less competitive.
  • Quantitative easing. This is sometimes mistakenly referred to as printing money. In practice, it relates to the action of the Central Bank in buying up government and corporate bonds from commercial banks and other financial institutions. This has the effect of increasing their deposits, thereby giving them more ability to to lend to private and business customers. However, some argue that this policy is unlikely to be effective if the banks are risk averse and remain unwilling to lend unless the loan is risk-free. There is also a danger that the increase supply of money in the economy could unleash as serious bout of inflation. An increase in the supply of money could also cause a depreciation of the exchange rate which, in turn, would result in net exports and so increase AD.

Fiscal Policy

Fiscal policy refers to the use of government expenditure and taxation in order to influence the level of economic activity in a country. From the 1980s to 2008, its primary role was to stable public finances. However, from 2008 it has once again assumed a role macroeconomic management not only in the UK, but also in China, the USA and various other countries. Some key features of fiscal policy include:

  • Automatic stabilisers: relate to the fact that some forms of government expenditure and revenues from some taxes change automatically in line with GDP and the state of the economy. These stabilisations reduce fluctuations caused by the business cycle. Examples include progressive taxation and welfare payments such as unemployment
  • Discretionary fiscal policy: refers to deliberate changes in taxes and public expenditure designed to achieve the governments macroeconomic targets. For example, the global economic crisis has led to many countries introducing a fiscal stimulus to prevent severe recession. Typically, these have included an increased public expenditure on infrastructure; green technology, targeted subsidies to distressed industries and tax cuts.

Fiscal policy might be effective if the value of the multiplier is high and can have an immediate impact if indirect taxes, such as VAT, are reduced. However, there may be significant time lags. For example, government expenditure on investment projects, such as new hospitals, is unlikely to have an impact for a considerable time because land must be purchased and planning applications approved.

Further, if there is a contractionary fiscal policy in which direct taxes are increased, there could be disincentive effects, while higher tax rates might reduce incentives to work. It is also difficult to determine the magnitude of changes in public expenditure in advance because the value of the multiplier may not be known.

Supply side policies

Supply side policies are a broad range of policies aimed at increasing aggregate supply by increasing competition, increasing incentives and cutting costs. Essentially these are microeconomic policies since they target specific markets, e.g. labour, product or capital markets.

Labour market

Policies aimed at the labour market include:

  • reduction in trade union power: e.g. making strikes without a secret ballot illegal, making sympathy strikes illegal
  • reduction in unemployment benefits: which would increase the incentive for unemployed workers to take jobs
  • improvements in human capital: increased provision and quality of education and training designed to increase the productivity of the workforce
  • reduction in employment protection legislation: making it easier to hire and fire workers, which contributes to a more flexible workforce
  • reduction in income tax rates: the aim of these tax cuts is to increase incentive to work and may be analysed using the Laffer curve

Product market

  • privatisation, deregulation, contracting out:
    privatisation –  involves the sale of state-owned enterprise to the private sector usually through the form of shares. This policy has been adopted across the globe and in the case of developing countries, privatisation has been a condition for loans given by the IMF.
    deregulation – when the government removes official barriers to competition e.g. licences and quality standards
    contracting out – when parts of services operated by the public sector are put out to tender so that the private sector can compete for the business
  • Trade liberalisation: relates to the free movement of goods and services within an economy. Removal or reduction in trade barriers, and the adoption of policies that allow free capital flow between countries, so making it more attractive for transnational companies to invest in the country.
  • promotion of new/small firms: for example, through tax breaks, short-term loans for new businesses and loan guarantees.

Capital market

  • Deregulation of the financial markets: such as the reduction of restrictive practices in the city and stock exchange
  • reduction in corporation tax: or reduction in tax allowances on investment by firms

Criticism of supply side policies

  • Increased inequality: it is argued that they are based on the premise that the rich will work harder if you pay them more, and the poor will work harder if you pay them less
  • Time lags: some of the measures take a long time to have any impact on the supply side of the economy i.e. primary education reform
  • The incentive of tax cuts may be over estimated: in the USA, tax cuts resulted in an increase in labour supply of less than 1%. Similarly, there is little evidence that tax cuts have any significant effect on productivity
  • Ineffectiveness: if aggregate demand is low, these policies may have no effect
  • Adverse effects of deregulation: competition may lead to undesirable consequences. For example, the deregulation of the financial markets resulted in excessive risk-taking, and the near collapse of the banking system

Problems faced by policy makers

Policy makers face a variety of problems when implementing policy:

  • Inaccurate information: for example, information regarding GDP, the balance of payments on current account and retail sales is notoriously inaccurate and subject to subsequent revisions
  • Risks and uncertainties: for example, there is considerable uncertainty over the effect of quantitative easing. Some monetarist economists argue that it could risk unleashing a massive bout of inflation because of the increase in money supply, while others consider the previous experiences in other countries suggests it will have little impact on the economy.

Macroeconomic objectives and policy

Objectives of macroeconomic policy

Economic growth. An increase in real GDP is often regarded as the fundamental objective of macroeconomic policy by governments, not only in developing countries where it is seen as a means of reducing absolute poverty, but also in developed economies by governments wishing to obtain popularity. Further, many economists regard this objective as being pivotal in achieving the other macroeconomic objectives.

Sustainable growth. This is usually defined as the ability to meet the needs of the present generation without compromising the needs of future generations. There have been growing concerns that rapid economic growth in countries such as China and India is unsustainable in terms of the environment and the rapid depletion of natural resources. The limitation of the external costs associated with economic growth is an objective that can only be met with global cooperation.

A low and stable inflation rate. Apart from other disadvantages, high inflation rates can damage the international competitiveness of a country’s goods, so most countries pursue policies designed to maintain a low and stable rate of inflation. As equally destructive as high inflation is deflation, which is a sustained fall of price level: experience from the 1930s suggests that deflation is often associated with depression.

Full employment.  This does not mean that every worker is employed, because there will always be frictional unemployment. However, this is usually regarded as being full employment and is referred to as the natural rate of unemployment. This objective is most likely to be fulfilled if there is economic growth.

Balance of payments equilibrium of current account.  One of the major imbalances between countries has been in relation to the balance of payments. While the UK and USA have been running large deficits, China has had persistent surpluses. Although deficits have been financed by inflows into the financial account, many have argued that they are unsustainable in the long term. Huge deficits may result in violent changes in the exchange rate of a country’s currency, contributing to an instability in the whole economy.

Redistribution of income. Most developed countries used progressive tax rates and welfare payments, especially means-tested benefits, to redistribute income from the rich to the poor.

Fiscal balance. In the same way that current account deficits may be unsustainable, the same might also be true of large fiscal deficits. This form of imbalance may prove to be a problem if countries are unable to sell government bonds to finance the deficits.

The aggregate-demand/aggregate-supply model

Aggregate demand is the relationship between the quantity of real GDP demanded and the price level. The main components of AD are consumption, investment, government expenditure and net exports. Shifts in the AD curve may be caused by changes in the folowing:

  • Asset prices
  • Interest rates
  • Foreign direct investment
  • Tax rates
  • Expectation about the future state of the economy
  • Decisions by the government on its expenditure
  • The exchange rate

The Keynesian aggregate supply curve

Keynesians consider that the economy could be in long-run equilibrium at less than the full employment level of real output. At low levels of real output it would be horizontal because there would be considerable spare capacity in the economy. As the economy moves towards full employment, bottlenecks in production occur, along with shortages on some resources, which will push up costs, causing the AS curve to rise. At full employment, the AS curve becomes vertical.
The short run AS curve

Short run aggregate supply (SRAS) is the relationship between total quantity of final goods and services supplied (real output) and the price level, holding everything else constant.

Shifts in the SRAS curve may be caused by the following:

  • Changes in wage rates: an increase in wage rates will raise costs of production and cause the LRAS to shift to the left
  • New legislation: for example, new health and safety regulations or environmental regulations which increase the costs of firms in the economy would cause the SRAS curve to shift tot the left
  • Changes in the prices of raw materials and components: a general fall in commodity prices would cause a shift to the right
  • Changes in taxation on firms: In the UK, employers (as well as employees) are required to pay national insurance contributions. These are really a tax on employment, so if employers contributions are increases then the SRAS curve will shift to the right

The long-run AS curve

Shifts in the long-run AS curve may be caused by the following factors:

  • Technological change: new and more efficient methods of production will affect the LRAS
  • The size of the labour force: this can be influenced both by the natural rate of increase or decrease in the population,but also by migration
  • Human capital: the skills, knowledge, and expertise of a workforce gained through education and training. This effects productivity
  • Capital stock: if the capital stock increase relative to the workforce, then productivity should increase
  • Raw materials: the discovery of new raw materials will cause the LRAS to shift to the right

Edexcel Economics Unit 3 Past Papers, Mark Schemes and Examiner’s Reports

I think I’ve written everything I possibly can to help with Unit 3. Check the directory to catch up on old posts if you need more revision.

Here’s all the papers, mark schemes and examiner’s reports ever created for this new Unit 3 syllabus to help you.

Sample Assessment Material:

January 2010
Mark scheme:
Examiner’s Report:

June 2010
Mark Scheme:
Examiner’s Report:

January 2011
Mark Scheme:
Examiner’s Report:

Good luck!

Summary of privatisation and regulation


  • Natural monopolies pose particular problems for policy, as setting a price equal to marginal cost causes firms to make a loss
  • In the past, many such industries were run by the state as nationalised industries
  • However, this led to large X-inefficiencies due to a massive principal-agent problem
  • Regulation was put into place to ensure that newly privatised firms did not abuse their market positions
  • Prices were controlled through the RPI – X rule
  • In some cases regulatory capture was a problem, whereby the regulators became too close to their industries
  • The authorities have also attempted to encourage efficiency through the establishment of Public Private Partnerships, such as the Private Finance Initiative

Public Private Partnerships

It has been recognised that the same arguments that apply to the impact of competition on private sector efficiency are  also relevant for public sector activity. In the case of public goods, there has to be some sort of government involvement as a free market will not ensure the provision of these goods. However, this does not necessarily mean that the public sector has to provide these good directly. A number of ways in which the public sector can ensure provision through some sort of engagement with the private sector has been developed.

The simplest firm of this is through contracting out. Under such an arrangement, the public sector issues a contract to a private firm for the supply of some good or service. Competition between firms can be encouraged through a competitive tendering service. In other words, the contract would be announced and firms invited to put in bids specifying the quality of the good or service they will provide, and at what price. The local authority will be in a position to look for efficiency in choosing the most competitive bid. One example of this is waste disposal.

More complex models of cooperation between public and private sectors have been developed, involving various kinds of Public Private Partnership. The most common partnership model is the Private Finance Initiative (PFI).

Private Finance Initiative

The PFI was launched in 1992 as a way of trying to increase the involvement of the private sector in the provision of public services. This established a partnership between the public and private sectors. The public sector specifies, perhaps in broad terms, the services that it requires, and then invites tenders from the private sector to design, build, finance and operate the scheme. In some cases, it may be that the project would be entirely free standing – for example, the government may initiate a new product such as a bridge that is taken up by a private firm who recoup their costs eventually through tolls. In some other cases, the project may be a joint venture between the private and public sectors. The public sector could get involved with such a venture to ensure wider social benefits, perhaps through reductions in traffic congestion that would not be reflected in market prices, and thus would not be fully taken into account by the private sector. In other cases, it may be that the private sector undertakes a project and sells its services to the private sector, often over a period of 25 or 30 years.

The aim of the PFI is to improve the financing of public sector projects. This is partly achieved  through a competitive element in the tender process, but in addition it enables the risk of the project to be shared between the two sectors, which allows efficiency gains to be made.

The PFI has been much debated and much criticized. One effect the PFI has is to reduced the pressures on public finances by enabling greater private sector involvement on funding. It may however increase the cost of borrowing if the public sector can borrow at more favourable rates.

The tendering process can make cost savings, but may impact on the health and safety of such projects.

As PFI switches the focus from social benefit to efficiency and cost – sometimes social welfare is sacrificed on a small scale, so more efficincy and lower costs which may maximise social benefit on a larger scale.