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IB Economics Higher Level Revision Notes

Updated on April 15, 2014

Graphs to Microeconomics

Market Equilibrium of Supply and Demand
Market Equilibrium of Supply and Demand | Source
Negative Externality of Consumption
Negative Externality of Consumption | Source
The Law of Diminishing Returns
The Law of Diminishing Returns | Source

1. Microeconomics

- Market = an institution, which permits interaction between buyers & sellers.

- Demand Law = inverse relationship between P & QD, all other factors assumed constant. A change in price causes a movement along the curve. A change in income, price related goods, consumer preference and demographic changes causes a shift of the curve. QD = a-bP (a=shift, b=slope)

- Supply Law = positive casual relationship between P & QD, ceteris paribus. A Change in price causes a movement along the curve. A change in Factors of Production (FoP = land, labour, capital, entrepreneurship), in technology, tax, subsidies causes a shift of the curve.

- Market Equilibrium = no excess supply or demand. – Price has a signaling and incentive function. Full efficiency achieved.

- Market Efficiency

  • Consumer Surplus = The difference between how much a consumer is willing and able to pay and what the real price, which they pay is.
  • Producer Surplus – the difference between what firms earn from selling goods and services and what they would have earned at P=minimum.

- Elasticity

  • Price Elasticity of Demand = responsiveness of QD to change in P
    • %changeQD/%changeP
    • >1 elastic, <1 inelastic
    • Used for prediction, comparison, price discrimination, tax.
    • Low for primary goods
    • High for manufactured goods
  • Cross Elasticity of Demand = responsiveness of D for good X to a change in P of good Y
    • %changeQDofX/%changePofY
    • >0 substitute (X), <0 complimentary (X)
    • Used to describe markets, determine types of goods
  • Income Elasticity of Demand = responsiveness of D to a change in Income
    • %changeQD/%changeY
    • >0 normal goods, <0 inferior goods
    • Used for income determination, market understanding

      • Price Elasticity of Supply = responsiveness of QS to change in P
        • %changeQS/%changeP
        • >1 elastic, <1 inelastic
        • Determinants = time, FoPs, capacity, stocks
        • Low for primary goods
        • High for manufactured goods (many substitutes)

      - Taxation

      • Indirect Taxes = taxes on goods & services fixed or percentage value (specific or Ad Valorem)
        • To Collect Revenue, pay for public goods, decrease consumption.
          • Price Increases
          • Equilibrium Q decreases
          • Tax incidence = who pays what proportion of tax = PES/PED
      • Direct Taxes = taxes on income

      - Subsidies

      • Payment to firms by the government to lower price, increase production, consumption and revenue.
        • Market Price decreases
        • Equilibrium Q increases
        • Producer revenue increases
        • Government expenditure increase

      - Price Controls

      • Maximum prices = set if market prices is too high to protect buyers
        • Outcomes – shortage, inefficient resource allocation, welfare impact, underground market, rationing.
        • Effects – lower prices, more demand, less supply.
      • Minimum prices = set if market price is too low to protect producers ( farmers)
        • Outcomes – surplus, government buying surplus, taxpayers burdened, welfare impact, inefficient
        • Effects – higher prices, less demand, more supply

      - Market Failure – Due to failure to achieve efficiency resulting in under/over allocation of resources. Failure to achieve social optimum of MSB=MSC.

      • Marginal Private Benefits (MPB) = the benefits individuals enjoy from extra consumption.
      • Marginal Private Costs (MPC) = costs of extra production (wages, FoP, etc.)
      • Marginal Social Costs (MSC) = costs of extra production borne by society.
      • Marginal Social Benefits (MSB) = benefits society enjoys from extra consumption.

      - Externalities

      • Negative of Production – MSC lies above MPC so there is an external costs, welfare loss, and overproduction. Demerit goods and their consumption create external costs (alcohol). Possible responses = taxation, government regulation.
      • Negative of Consumption – MSB lies below MPB so there is an external loss, welfare loss, over consumption.
      • Positive of Production – MSC lies below MPC so there is a external gain. Underproduction. Merit goods and their consumption create external benefits
      • Positive of Consumption – MSB lies above MPB so there is an external benefit, under consumption. Possible responses are subsidies, legislation, education, advertisement, direct provision of goods & services.

      - Public Goods

      • Non-excludable & Non-rival consumption
      • Common access resources & sustainability threat – fishing, pastures, forest, fossil fuels, etc.
        • Difficult to exclude individuals
        • Rivalry
        • Sustainability
        • Lack of pricing for CAR – goods are overruled, depleted.
        • Government responses – legislation, taxation, trade schemes, funding.
      • Asymmetric information – market failure may occur when either the buyer/seller possesses more info. Than the other party. Government response – legislation, regulation, provision of information
      • Abuse of monopoly power – able to restrict output, charge higher prices leading to a welfare loss. Government response – legislation, regulation, nationalization, trade liberalization.

      - Theory of Firms and Market structures

      • Short run – time period during which at least one FoP is constant.
      • Long run – no constant factor of production, all adjustments are possible.
      • Total Product = Total output of a firm = Q
      • Average Product = Q/L
      • Marginal Product = changeQ/changeL

      - The Law of Diminishing Returns – As more units of a variable factor (labour) are added to a fixed factor (capital) there is a point beyond which the total product will continue to rise, but at a diminishing rater, or the marginal product will decline.

      - Economic Costs = the value of all resources that are sacrificed during the production process.

      • Explicit = production costs (wages, resources)
      • Implicit = minimum payment to secure entrepreneurship.
      • Fixed = costs, which do no vary when the level of production varies (rent, insurance)
      • Variable = vary with the level of output.
      • Marginal = the additional cost of producing an extra unit of output.
        • MC=changeTC/changeQ = changeVC/change Q
      • Average Variable = variable costs over the level of output
      • Average Total = total costs over the level of output
        • ATC = AFC+AVC
      • Average Fixed = Fixed costs over the level of output.
      • Long run production costs
        • Increasing returns to scale - %change increase in output > than %increase in all inputs
        • Constant returns to scale - %increase in all inputs
        • Decreasing returns to scale - %increase in output < than % increase in all inputs.

      - Revenue

      • Total Revenue = TR = P x Q
      • Marginal Revenue = MR = changeTR/change
      • Average Revenue = AR = P

      - Economic Profits

      • Abnormal = TR > economic costs
      • Normal = TR=Economic Costs or when TR is just sufficient enough to keep the firm in business. Π = TR – TC

      - Goals of Firm

      • Profit Maximization = MR = MC
      • Revenue maximization, growth maximization, satisficing & social responsibility.

      - Perfect Competition – Large number of firms, homogeneous product, freedom of exit/entry, perfect information, and perfect resource mobility.

      - Monopoly = a single dominant firm in the market, no close substitutes, barriers to entry – economies of scale, branding, copyright and legislation.

      • Can set price.
      • AR = D
      • Profit Maximization – more units at a lower price
      • Desirable monopolies
        • Ability to finance research and development
        • Need to innovate to maintain profit
        • Possible economies of scale

      - Monopolistic Competition – large number of firms, differentiated product, absence of barriers.

      • Product differentiation – small degree of monopoly power
      • Neither allocative or productive efficiency achieved.

      - Oligopoly – dominance of industry by a small number of firms, important interdependence, differentiated or homogeneous products, high barriers to entry. – Joint profits.

      - Perfect Competition – very many small firms, homogenous product, no barriers

      Price discrimination – charging different prices to different consumer groups for the same producer, when the price difference is not justified by difference in cost.

Graphs to Macroeconomics

Aggregate Demand
Aggregate Demand | Source
Aggregate Supply
Aggregate Supply | Source

2. Macroeconomics

- Goals

  • Satisfactory & Sustainable growth
  • Low level of unemployment
  • Price stability
  • Long –run equilibrium
  • Distribution of income

- Gross Domestic Product = GDP = C + I + G + (X-M)

  • C = consumption
  • I = investment
  • G = government spending
  • (X-M) = net exports
  • Gross National Income (GNI)

- Business Cycle

  • Recession
  • Trough
  • Recovery
  • Boom
  • Peak
  • Line of Best-fit = Long-time average annual growth

- Aggregate Demand = AD = GDP

  • Shifts due to individual components of GDP

- Aggregate Supply = AS = LRAS or SRAS

  • LRAS = long run aggregate supply = new classical
  • LRAS = long run aggregate supply = Keynesian
  • SRAS = short run aggregate supply – wages assumed fixed
  • Shifts due to change in FoPs, resource prices, taxes, subsidies, technology, unemployment reduction, institutional changes.

- Keynesian multiplier - effect on GDP of change in investment, gov. spending and exports. (Shifts)

  • 1/(1-MPC)

- Macroeconomic Objectives

  • Unemployment = actively searching for a job but cannot find one.
    • Rate = number of unemployed/labour force x 100
    • Consequences = loss of GDP, loss of Tax revenue, increased costs, loss of income, less equality, increased crime.
    • Types
      • Seasonal – predictable variation in D & S of labour
      • Frictional – people in between jobs
      • Structural – unemployment due to recovery, boom.
      • Cyclical – due to business cycle
      • Policies = training, subsidies, increase of AD
  • Low & Stable inflation
    • Inflation = sustained increase of the average price level.
    • Deflation = sustained decrease in the average price level.
    • Disinflation = a decrease in the rate of inflation.
    • Inflation = %changeCPI
    • Consequences = uncertainty, less savings, damage to exports, increase in cyclical unemployment, bankruptcies
    • Stagflation = recession with rising inflation
  • Economic Growth = Growth of (real) GDP over time
    • Increase in Output
    • Outward shift of PPC (Production Possibility Curve)
    • Increase in potential output
  • Income Distribution & low poverty
    • Lorenz Curve/Gini coefficient
    • Poverty & Taxation
      • Marginal Tax Rate = extra tax on extra income
      • Average Tax Rate = tax over income
      • Progressive = more income, more tax
      • Proportional = % of income
      • Regressive = more income, less tax

- Fiscal Policy = Government Spending and Taxation

  • Expansionary
    • May close deflationary gap
    • Increase AD & Growth
    • Increase of Gov. Spending
    • Decrease in Gov. Revenue
    • Possible increase in inflation
  • Contractionary
    • May close inflationary gap
    • Decreases AD & inflation & growth
    • Government Spending Increases
    • Government Revenue Decreases
    • Unemployment increases

- Monetary Policy = Interest Rates / Exchange Rates = Central Banks

  • Expansionary
    • Increase in AD
    • Close deflationary gap
    • Lower interest rates
    • Increase S of Money
    • C, I, (X-M) increase
  • Contractionary
    • Decreases AD
    • Close inflationary gap
    • Increase S of Money
    • C, I, (X-M) decrease
    • High interest rates

- Supply-Side Policies

  • Increased Production by: improving institutions, capacity,
  • Market based or interventionist
    • Interventionist = Investment in
      • Human Capital - Training
      • New Technology – Research and Development
      • Infrastructure - Improvement
      • Industry – Tax Cuts
      • Market based
        • Encourages competition – deregulation
        • Reforms – less union power
        • Policies – tax cuts, investment
        • Effectiveness
          • Time Lags
          • Creates unemployment
          • Greater choice
          • Requires resources
          • Efficient
          • Source of foreign exchange
          • Increased competition
          • Producer benefits

Pictures to International Economics

The WTO symbol
The WTO symbol | Source
Criticism of the WTO
Criticism of the WTO | Source

3. International Economics

- Free Trade – lower prices for consumers, producer benefits, resources, competition, foreign exchange

  • Absolute Advantage
  • Comparative Advantage

- WTO – World Trade Organization

  • 1995
  • 153 countries
  • Trade liberalization
  • Arbitrator
  • Biased for US & EU
  • Economics only no human viewpoint

- Restrictions = Protectionism

  • Tariffs
  • Quotas
  • Subsidies
  • Administrative Barriers
    • + Domestic jobs, national security, industries, health, environmental standards, anti-dumping measures, source of government revenue
    • - Inefficient use of resources, retaliation, trade wars, political tensions, corruption, costs, less imports, less export competition.

- Exchange Rates

  • Floating = free, no market, government or bank intervention
  • Fixed = set and maintained by government or bank
  • Managed = allowed to float within a certain range
  • Change in D & S
    • D for exports, D for imports, interest rates, inflation, oversea investment, speculation, and tourism.
  • Effects of D & S
    • Change in inflation rate, employment, growth, and balance of payments.
  • Appreciation = increase of price in a floating rate.
  • Depreciation = decrease of price in a floating rate.
  • Revaluation = official price increase in a fixed rate.
  • Devaluation = official price decrease in a fixed rate.

- Balance of Payments = a record of all transactions of a country with the rest of the world over a period of time.

  • Current Account
    • Goods & services = exports and imports
    • Primary income = profits, interest, rent
    • Secondary income = aid
  • Capital Account
    • Debt forgiveness
    • Non-financial assets
  • Financial Account
    • Foreign Direct Investment
    • Sale of bonds and stocks
    • Reserve assets
  • Current Account Balance = Capital + Financial

- Account Deficit – May results in downward pressure on the exchange rate

  • Implication:
    • Foreign ownership of domestic firms
    • Exchange & interest rates
    • Indebtedness
    • International credit ratings
  • Expenditure Switching - low imports, high domestic production, devaluation, depreciation of exchange rate
  • Expenditure reducing – low AD, low spending on imports, contractionary fiscal and monetary policies.
  • Increased competition – growth of domestic market.

- Marshal-Lerner condition = For devaluation/depreciation of a currency to improve a current account deficit the sum of the PED for imports and the PED for exports must be greater than 1. (J-Curve Effect)

- Economics Integration & Trade Liberalization

  • Trade Agreement – bilateral/multilateral – reduction tariffs, etc.
  • Trading Blocs
    • Free Trade Area – no barrier of trade to members
    • Customs Union – common external tariff
    • Common Market – free flow of Factors of Production
  • Economic Union – same macroeconomic policies
  • Monetary Union – same macroeconomic policies & free flow of FoPs & a common currency with a common central bank. (Euro Zone)
    • + Lower costs, greater transparency, no exchange rate, less uncertainty greater political and economic power.
    • - no independent monetary policies, no exchange rate policy, limited fiscal policy, loss of economic and political sovereignty.

- Terms of Trade = Avr. P of exports as index/Avr. P of imports as index x 100

  • Improvement = Increase in imports
  • Deterioration = Decrease in Imports
  • Short Term Changes = D for exports, imports, change in global supply of key inputs, changes in inflation rates and exchange rates.
  • Long Term Changes = world income level change, change in productivity and technological development and a Global redistribution of income.

Pictures to Dev. Economics


4. Development Economics

- Economic Growth = increase in (real) GDP over time.

- Economic Development = A multidimensional concept including the following:

  • Reducing poverty
  • Raising living standards
  • Reducing income inequalities
  • Increasing employment opportunities.

- Economic Development needs growth with few exceptions and growth does not lead to development without additional action!

- Common Characteristics of LEDCs

  • Low GDP per Capita
  • High Poverty
  • Large agricultural sector
  • Large urban informal sector
  • High birth rate

- Diversity among LEDCs

  • Variety of factors
  • Resources
  • Climate
  • History
  • Stability of the political system

- Poverty Trap/Cycle

  • No investment in human capital due to low savings
  • Transmission of poverty from generation to generation
  • Intervention needed to break
  • Aid often useless

- Millennium Development Goals until 2015

  • Eradicate Poverty/Hunger
  • Achieve universal primary educaton
  • Promote gender equality
  • Reduce child mortality
  • Improve maternal health
  • Combat HIV/Malaria
  • Ensure Environmental stability
  • Global partnership for development

- Measuring Development

  • GDP & GNI per Capita
    • No income distribution
    • No environmental degradation
    • No living standards
  • Human Development Index
    • Life Expectancy
    • Literacy Rate
    • GDP
      • No human freedom measure
      • No Gender equality
      • No environmental measure
      • No political measure
      • National average only.

- Domestic Factors & Economic Development

  • Education & Health
    • Higher labour productivity
    • Faster long-term growth
    • Improved living standards
    • Larger workforce
  • Credit & Microcredits
    • More investment
    • More business
    • More employment
    • More human capital
    • Break of poverty cycle
  • Appropriate Technology
    • Capital – physical capital, jobless growth
    • Labour – use of labour, less unemployment
  • Empowerment of Women
    • More employment
    • More family security
    • Lower mortality rate
    • Increaser health
    • Political involvement.
  • Distribution of Income - Leads to all factors
    • Poverty reduction
    • Less corruption
    • Increased trust
    • Increased health and education
    • Lower civil unrest
    • More investment
    • More demand
    • Cyclical nature of increase

- International Trade & Economic Development

  • Barriers to Development
    • Over-specialization – inelastic demand
    • Price volatility
    • No access to markets - protectionism
    • Long-Term changes
  • Trade Strategies for Economic Growth & Development
    • Import substitution
    • Export promotion
    • Trade agreements
    • Trade liberalization
    • Diversification
    • WTO
  • Foreign Direct investment FDI = long-term investment where a firm based in one nation establishes pressure in another country.

- Multinational cooperation = a firm within more that one nations.

  • In LEDCs – new resources, markets, lower costs, less rules.
  • Stable environment
  • Public policy
  • Weak regulation
  • Secure legal framework
  • High human capital
  • Large market
  • Free trade areas
  • For:
    • Investment
    • Gov. revenue
    • Less unemployment
    • Training
    • Management
    • Technology
  • Against:
    • Hurts domestic firms
    • Inappropriate technology
    • Unskilled labour
    • Inequality of income
    • Political & economic power
    • Profits may go abroad

- Foreign Aid (Official Development Aid & Non-governmental Orgs.)

  • Humanitarian Aid = Food, medical supplies, relief aid
  • Development Aid = loans, project aid, programme aid
  • NGOs – small scale aid to achieve development objectives
  • Bilateral, Multilateral, Tied Aid
  • IMF, UN, UNDP, World Bank.
  • Effective or Ineffective

- Foreign Debt = owed to non-residents of a nation. Money owed to foreign entities.

  • High levels lead to:
    • Foreign exchange earning depleted
    • No gov. funds
    • Political tensions
    • Investment decreases
    • Opportunity costs
    • Balance of payments problems

- Development to be achieved by:

  • Good governance
  • A balance of Market-based and interventionist politics

Governmental cooperation

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