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et<br />
T HE E SSENTIAL M AGAZINE FOR ‘A’ LEVEL E CONOMICS<br />
E CONOMICS<br />
T ODAY<br />
Articles<br />
What <strong>Eco</strong>nomic Effects may result from an<br />
Increase in Foreign Direct Investment into an <strong>Eco</strong>nomy?<br />
Marwan Mikdadi 2<br />
What Impact does Unemployment have on the UK <strong>Eco</strong>nomy?<br />
Ruth Tarrant 6<br />
What are the Arguments For and Against<br />
Free Trade and Protectionism?<br />
Gary Phillpott 22<br />
What Explains the UK <strong>Eco</strong>nomy’s<br />
Disappointing Productivity Performance?<br />
Ian Black 30<br />
Regular Features<br />
Making Sense of <strong>Eco</strong>nomic Data<br />
House Prices<br />
Andrew Reeve 11<br />
Back to Basics<br />
The Savings Ratio<br />
Rachel Cole 14<br />
View from the City<br />
Dear Chancellor<br />
Graeme Leach 18<br />
Subscription Details<br />
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<strong>Eco</strong>nomics <strong>Today</strong> is edited by<br />
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Multiple Choice Question and Answer<br />
Robert Nutter 20<br />
Data Question and Answer<br />
The Prospect Ahead: Deflation or Inflation<br />
Quintin Brewer 27<br />
Current Topics in <strong>Eco</strong>nomics<br />
What are the Prospects for EU Enlargement?<br />
Stephen Romer 35<br />
The Underside of the UK <strong>Eco</strong>nomy<br />
Disability and Employment<br />
Peter Cramp 40<br />
Revision Guide 2010<br />
Steve Tidball<br />
8 page supplement<br />
M ARCH 2010 1
What <strong>Eco</strong>nomic Effects may result<br />
from an Increase in Foreign Direct<br />
Investment into an <strong>Eco</strong>nomy?<br />
Marwan Mikdadi, Head of <strong>Eco</strong>nomics<br />
& Politics, St Paul’s School and<br />
former Principal Examiner,<br />
reviews the benefits<br />
and costs of foreign<br />
capital inflows.<br />
Exam Board AS Unit A2 Unit<br />
AQA ✓ 4(3.4.3)<br />
Edexcel ✓ 4(4.3.8)<br />
OCR ✓ F585<br />
WEJC ✓ EC4(G)<br />
CCEA ✓ A2(2)<br />
Int. Bacc. Standard 5.4<br />
Cambridge<br />
Pre-U<br />
International <strong>Eco</strong>nomics (e)<br />
Key words<br />
Foreign Direct Investment<br />
Multiplier effects<br />
Competition<br />
Dutch Disease<br />
Footloose
Foreign direct investment (FDI) is often associated with the building of a<br />
factory in another part of the world, such as the Honda plant built in Swindon<br />
in 1992. However FDI is more than just the building of a factory as it can also<br />
be the purchase of a company or firm already in existence such as the<br />
purchase of Abbey National by Santander in 2004 or BAA by the Spanish<br />
construction conglomerate Ferrovial in 2006. FDI can therefore be defined as<br />
the ownership of productive assets such as factories, firms or other<br />
businesses either through outright purchase of a business that currently<br />
exists or by establishing a new firm.<br />
The UK and inward investment<br />
T<br />
he UK has traditionally been<br />
the leading recipient of FDI in<br />
Europe, often coming second<br />
only to the United States of America in<br />
global terms, although China is estab -<br />
lishing a greater foothold over global<br />
FDI. Much of the UK’s success in<br />
attracting FDI has been attributed to<br />
the flexible labour laws, low levels<br />
of corporation tax and regulation.<br />
However these advantages are being<br />
steadily eroded away. The difference<br />
between UK and Irish corporate taxes<br />
has increased to 16 per cent (UK<br />
corporation tax is 28 per cent and Irish<br />
corporation tax is 12 per cent). Moreover<br />
as the UK adopts the Social Chapter<br />
and EU working time directive it narrows<br />
the gap between the UK and other<br />
EU members. According to the World<br />
Investment Report the UK received $97<br />
billion of FDI compared to the USA’s<br />
$316bn and France’s $118bn in 2008. 1<br />
However, in 2008 the credit crunch may<br />
have resulted in the decline in the UK’s<br />
leading position, which may return to<br />
above that of France in 2009. In the<br />
developing world FDI is seen as one of<br />
the ways that countries can benefit from<br />
globalisation and economic growth<br />
therefore reducing their levels of poverty<br />
and closing the gap in income distribu -<br />
tion.<br />
FDI is often seen to only have benefits<br />
and whilst it may be true that advantages<br />
outweigh the disadvantages there are a<br />
number of countries, such as India, that<br />
have put restrictions on the level of FDI<br />
to protect their domestic businesses<br />
from competition by multinational<br />
corporations. But we first consider the<br />
potentially beneficial impact of foreign<br />
capital inflows.<br />
employment, and with that increases in<br />
the levels of income received by<br />
employees, reducing the numbers reliant<br />
on state welfare schemes. As incomes<br />
increase this should result in an increase<br />
in the level of consumption, which<br />
coupled with the multiplier effect<br />
should also result in an even greater<br />
increase in national income through<br />
subsequent increases in spending.<br />
Firms will react to the increase in<br />
consumption by raising the level of<br />
output and in so doing increasing both<br />
investment and levels of employment.<br />
This increase in both consumption and<br />
investment will result in an increase<br />
in the level of Aggregate Demand in<br />
the economy, therefore resulting in<br />
economic growth as shown in Figure 1.<br />
As unemployment falls and fewer<br />
people claim social security the govern -<br />
ment should find that it receives a<br />
greater amount in tax revenue in the form<br />
of increased income tax payments and<br />
also have additional funds diverted from<br />
the social security budget to spend on<br />
other areas such as health and educa -<br />
tion, contributing to an increase in the<br />
standard of living for the population.<br />
However, depending on where the<br />
economy is operating the impact of a<br />
large influx of FDI may be very different.<br />
Price<br />
Level<br />
Figure 1: More FDI boost output<br />
Most developed economies will operate<br />
with relatively low levels of surplus<br />
labour, particularly when they are<br />
experiencing economic growth and so<br />
close to full employment. It follows<br />
therefore that an increase in the level of<br />
FDI, causing AD to shift right from AD2<br />
to AD3, in such circumstances, will result<br />
in demand-pull inflation in the economy.<br />
This is illustrated in Figure 1. If this is the<br />
case then it may necessitate an increase<br />
in the interest rate by the relevant central<br />
bank thus reducing the potential positive<br />
impact associated with the increase<br />
in FDI. However in many developing<br />
nations there is sufficient unemployment<br />
or underemployment to ensure that any<br />
FDI demanding an increase in labour is<br />
able to do so without resulting in an<br />
increase in the rate of inflation as AD can<br />
increase from AD1 to AD2, absorbing<br />
unemployed resources. In Figure 1 this<br />
increase in AD has no adverse effect on<br />
the rate of inflation.<br />
This case, of course, depends on<br />
whether the foreign investor is employ -<br />
ing domestic labour or instead bringing<br />
in its own workers. There are examples,<br />
especially in the developing world where<br />
firms have brought in their own workers<br />
to undertake many of the jobs that could<br />
not be done by unskilled domestic<br />
labour. Even in developed countries,<br />
especially as a result of an increasingly<br />
globalised labour market foreign<br />
investors will employ people from<br />
around the world and not confine them -<br />
selves to just the indigenous population.<br />
Furthermore, it is worth remembering<br />
that if a firm takes over an existing<br />
business, it may do very little to add to<br />
employment and indeed may actually<br />
reduce the size of the workforce as it<br />
seeks to obtain economies of scale and<br />
LRAS<br />
Employment and<br />
economic growth<br />
An increase in FDI is likely to result in an<br />
increase in levels of domestic<br />
1. UNCTAD World Investment Report, published 17<br />
September 2009.<br />
P2<br />
P1<br />
Y1<br />
AD1<br />
Y2<br />
AD2<br />
Y3<br />
AD3<br />
Real Output<br />
M ARCH 2010 3
Foreign investors have sometimes been<br />
accused of exploiting local labour forces.<br />
integrate the newly purchased firm into<br />
the multi-national.<br />
Increased competition<br />
In addition to these relatively obvious<br />
economic gains new investment can act<br />
as a spur to domestic business to<br />
improve their productive efficiency. New<br />
firms may employ new management<br />
techniques, which can be adopted by<br />
the whole economy, as was the case<br />
when Japanese car manufacturers<br />
arrived in the UK during the 1980s and<br />
firms adopted both Just in Time (JIT)<br />
and Total Quality Management (TQM)<br />
processes. In addition to new manage -<br />
ment techniques foreign firms may<br />
spend significant funds training workers<br />
and developing their skill set and by<br />
doing so they contribute to the overall<br />
skills within the economy. Domestic<br />
firms can benefit from the transfer of<br />
knowledge between individuals and<br />
firms.<br />
As competition increases in the<br />
domestic market prices should fall and<br />
therefore consumers will benefit as they<br />
pay lower prices and increase their<br />
consumer surplus. However this all<br />
comes with the assumption that the<br />
foreign firm doesn’t adopt capital<br />
intensive processes, too expensive for<br />
domestic firms to benefit from, whilst at<br />
the same time reducing the number of<br />
people employed in each process.<br />
Foreign firms may also force prices<br />
down so low, as to result in domestic<br />
firms folding and increasing domestic<br />
unemployment which may not be<br />
absorbed by the FDI. In the short-term<br />
this will benefit consumers but in the<br />
long-term this can result in greater<br />
monopoly power and the ability to price<br />
set for the incoming foreign firm,<br />
allowing them to exploit the consumer.<br />
What is the cost of FDI?<br />
FDI may come at a cost. What has the<br />
government had to do to attract the FDI?<br />
Has the government had to provide<br />
significant tax incentives and if so does<br />
this mean any potential benefits in terms<br />
of tax on profits is foregone for a period<br />
of time? For example at least £58 million<br />
was given in launch aid to the Siemens<br />
and then Atmel plant in Wallsend, North<br />
Tyneside. But this plant had a chequered<br />
history and operated for only 15 months<br />
between 1997 and its final demolition in<br />
early 2009.<br />
In some cases the reason that foreign<br />
investors locate in the developing world<br />
is to benefit from access to low cost<br />
labour. There are numerous instances of<br />
clothing manufacturers such as Gant,<br />
GAP, Nike and Adidas operating in South<br />
East Asia. Other firms locating in Asia<br />
and Latin America have been accused<br />
of exploitation of the labour force,<br />
making them work for long hours, in<br />
unsafe working conditions and paying<br />
them wages as low as 10p an hour.<br />
However such examples of exploitation<br />
are falling as consumers put pressure on<br />
multinationals to abide by their expecta -<br />
tions or face the potential backlash and<br />
consumer boycott.<br />
There is also the potential for<br />
environmental exploitation, as firms<br />
operating in the developing world can<br />
either get away with paying minimal fines<br />
or are faced with limited and poorly<br />
enforced regulation. The Union Carbide<br />
incident in Bhopal, India highlighted the<br />
weakness of regulation in some parts of<br />
the developing world. Despite this<br />
disaster, which is variously blamed on<br />
safety failures, sabotage and poor<br />
maintenance, resulting in between 3,500<br />
and 10,000 deaths in the immediate<br />
4 M ARCH 2010
aftermath, Union Carbide managed to<br />
settle with the Indian government for the<br />
sum of $470m or approximately $850<br />
per injury and $2,500 per death. India<br />
has also passed legislation restricting<br />
the growth of foreign retailers to protect<br />
domestic firms and avoid a loss of<br />
cultural heritage and identity. This is<br />
particularly the case in many developing<br />
nations where the growth of Western<br />
firms results in greater Westernisation of<br />
the local population and a loss in the<br />
cultural identity of the indigenous<br />
population.<br />
Whilst FDI should result in greater<br />
exports, it may also result in greater<br />
levels of imports. This could come about<br />
as a result of increased economic growth<br />
and incomes demanding imports of nondomestically<br />
manufactured goods or<br />
because the firms investing require an<br />
increase in capital equipment, which<br />
must be imported. This can clearly have<br />
a detrimental effect on the exchange rate<br />
as an increase in any current account<br />
deficit can result in a depreciation of the<br />
currency. This is particularly worrying in<br />
developing countries where the demand<br />
for imports such as oil and foodstuffs<br />
may be relatively price inelastic thus<br />
contributing to cost-push inflation.<br />
Conversely if the country does experi -<br />
ence a particularly marked increase in<br />
its exports, possibly as a result of the<br />
FDI then the value of the domestic<br />
currency will appreciate. This apprecia -<br />
tion will mean other exports become less<br />
competitive and could eventually go<br />
bankrupt. This phenomenon is known as<br />
the Dutch Disease, and is likely to<br />
happen in countries where FDI allows a<br />
nation to exploit its natural resources<br />
such as oil, copper or gold thus<br />
increasing the level of exports both<br />
quickly and significantly.<br />
FDI is also often criticised for being<br />
footloose. In other words MNC’s tend to<br />
follow the incentives and benign regula -<br />
tion. When the tax incentives disappear<br />
or the domestic regulators tighten on<br />
employment or the environ ment the firm<br />
relocates to the next favourable destina -<br />
tion exploiting their benefits until some -<br />
where else more beneficial appears.<br />
All of the effects described are<br />
dependent on the size of the FDI. In the<br />
UK FDI accounted for about 5 per cent<br />
of Gross Domestic Product in 2008 and<br />
so a doubling of this would result in<br />
significant changes. On the other hand<br />
much of the global FDI is concentrated<br />
amongst the most developed nations<br />
and involves cross-border takeovers and<br />
mergers ensuring that any gains are<br />
limited in their scope and tend to avoid<br />
the developing world.<br />
Questions for discussion<br />
1. Why has the UK been so successful<br />
at attracting FDI in the past?<br />
2. How likely is the UK to maintain this<br />
Summary of key points<br />
success in the future?<br />
3. Find a recent example of FDI in your<br />
local area – has this been a success?<br />
Has it increased levels of employ -<br />
ment, or has it reduced the work -<br />
force? Is the new company spending<br />
money in the local area or is it out -<br />
sourcing to beyond the local and<br />
national boundaries?<br />
FDI is both building a new factory or office as well as buying an existing<br />
company.<br />
UK has been a leading recipient of FDI in recent years.<br />
Global FDI flows have fallen since 2008 because of the credit crunch<br />
and global recession.<br />
FDI can increase GDP, employment, tax revenue, aggregate demand<br />
and economic growth as well as contributing to the level of exports.<br />
On the downside FDI can also result in inflation, increased competition<br />
which drives out domestic business and cost the economy large<br />
amounts in tax breaks to encourage firms to invest as well as exploit<br />
the local workforce and environment.<br />
with Chief Examiner,<br />
Robert Nutter<br />
1. Investigate the extent to which the UK’s water and energy suppliers are<br />
foreign owned.<br />
2. Read the articles by John Willman in the Financial Times and Brian Durrant in<br />
Money Week which deal with the increasing level of foreign ownership of UK<br />
firms.<br />
Break point? Why British tolerance of foreign ownership is in question by<br />
John Willman, Business Editor, published: 24 January <strong>2007</strong> (www.ft.com)<br />
Should you worry about foreign takeovers? by Brian Durrant, 19 February<br />
<strong>2007</strong> http://www.moneyweek.com<br />
3. Research the possible advantages and disadvantages for Cadbury of a<br />
takeover by Kraft.<br />
http://news.bbc.co.uk www.bloomberg.com<br />
www.ft.com/indepth/cadbury-kraft<br />
4. Investigate the controversies surrounding Shell’s investments in Nigeria over<br />
the last 20 years. Look at ‘Shell, the State and Underdevelopment of the<br />
Niger Delta of Nigeria: A Study in Environmental Degradation’ by Daniel<br />
Omoweh.<br />
www.greenpeace.org.uk http://news.bbc.co.uk<br />
www.africaworldpressbooks.com<br />
5. Research the benefits of transfer pricing to firms which buy firms in many<br />
different countries.<br />
www.pwc.co.uk/eng/services/transfer_pricing.html<br />
www.moneyterms.co.uk/transfer-price<br />
M ARCH 2010 5
What Impact does<br />
Unemployment<br />
have on the<br />
UK <strong>Eco</strong>nomy?<br />
Ruth Tarrant, The Open University, discusses<br />
how higher levels of unemployment may lead to<br />
hysteresis, a higher government budget<br />
deficit and moderate pay increases.<br />
The demand for inferior goods and<br />
education may also increase.<br />
Key words<br />
Hysteresis<br />
Budget deficit<br />
Automatic stabilisers<br />
Phillips curve<br />
Most analyses of the impact of<br />
unemployment on the economy<br />
tend to focus on the negative<br />
aspects. Whilst there are certainly<br />
significant economic costs<br />
associated with unemployment,<br />
there is plenty of evidence<br />
available to suggest that there<br />
can also be a silver lining to the<br />
dark economic cloud of unem -<br />
ployment. This article considers<br />
both the costs and benefits of<br />
unemployment for the UK<br />
economy.<br />
Exam Board AS Unit A2 Unit<br />
AQA ✓ 2(3.2.3) ✓ 4(3.4.1)<br />
Edexcel ✓ 2(2.3.1)<br />
OCR ✓ F582<br />
WEJC ✓ EC4(A)<br />
CCEA ✓ AS(2)<br />
Int. Bacc. Standard 3.5<br />
Cambridge<br />
Pre-U<br />
The National <strong>Eco</strong>nomy (c)
The state of the UK economy<br />
T<br />
able 1 shows that unemploy -<br />
ment in the UK fell in most<br />
years from 1999 to 2005. More<br />
recently, the level of unemployment has<br />
started to rise significantly again as the<br />
UK economy has experienced a deep<br />
recession. This is to be expected, since<br />
unemployment is counter-cyclical,<br />
rising in recessions and falling in times<br />
of economic growth. Table 2 allows a<br />
comparison of the unemployment rates<br />
for both men and women; in each case,<br />
the rate of unemployment has increased,<br />
but the unemployment rate for men is<br />
well above that for women.<br />
The costs of unemployment<br />
We can identify the costs of unemploy -<br />
ment as including the further deepening<br />
of a recession, hysteresis, a rising<br />
budget deficit and a moderation in wage<br />
bargaining for higher pay. We consider<br />
each of these aspects in turn.<br />
Deepening recession<br />
Unemployment is, in the first instance, a<br />
side-effect of falling output in an<br />
economy. Demand for labour derives<br />
from the demand for goods and<br />
services, so as demand for goods falls,<br />
so too does demand for labour. In turn,<br />
however, as more people become<br />
unemployed, demand for many goods<br />
continues to fall, because the unem -<br />
ployed have less disposable income to<br />
spend. So, rising unemploy ment may<br />
lead to a further fall in the level of Gross<br />
Domestic Product (GDP) (and then, in<br />
turn, a further rise in unemployment).<br />
This can both prolong and deepen a<br />
recession.<br />
This effect is particularly strong in the<br />
UK, for a number of reasons. The<br />
increasing flexibility of the workforce<br />
over the past couple of decades means<br />
that, although it is easier to hire people,<br />
it is also easier to fire them. Unlike<br />
some other European countries where<br />
employment rules are restrictive for<br />
many employers, the UK’s are much less<br />
restrictive. When demand for goods and<br />
services falls, it is relatively straight -<br />
forward to make employees redundant.<br />
Some countries, such as Germany, have<br />
focused on ‘re-channelling’ employees<br />
into taking unpaid leave, working shorter<br />
days and repairing capital stock, as their<br />
labour market laws make it both too<br />
difficult and too costly to fire employees.<br />
Whilst this may cause short-term<br />
underemploy ment and incur some<br />
costs, it does mean that those whose<br />
Table 1: Unemployment figures for the UK economy, 1999-2009<br />
Year Number of Unemployment<br />
unemployed<br />
rate*<br />
1999 1.73m 6.0%<br />
2000 1.59m 5.4%<br />
2001 1.49m 5.1%<br />
2002 1.53m 5.2%<br />
2003 1.49m 5.1%<br />
2004 1.42m 4.8%<br />
2005 1.47m 4.9%<br />
2006 1.67m 5.4%<br />
<strong>2007</strong> 1.65m 5.3%<br />
2008 1.78m 5.7%<br />
2009 (est.) 2.47m 7.9%<br />
Source: Office of National Statistics, www.statistics.gov.uk<br />
*The measure of unemployment used is the ILO measure<br />
Table 2: Unemployment figures by gender for the UK economy, 1999-2009<br />
Year Unemployment Unemployment<br />
rate of men<br />
rate of women<br />
over 16 (%) over 16 (%)*<br />
1999 6.6 5.2<br />
2000 5.9 4.9<br />
2001 5.6 4.4<br />
2002 5.7 4.5<br />
2003 5.6 4.4<br />
2004 5.1 4.3<br />
2005 5.3 4.4<br />
2006 5.8 5.0<br />
<strong>2007</strong> 5.6 5.1<br />
2008 6.2 5.1<br />
2009 (est.) 9.0 6.1<br />
Source: Office of National Statistics, www.statistics.gov.uk<br />
*The measure of unemployment used is the ILO measure<br />
jobs are more at risk are less likely than<br />
their counterparts in the UK to reduce<br />
their spending significantly, thus<br />
preventing significant worsening of the<br />
recession. So, rising unemployment<br />
levels in the UK may be a factor in<br />
prolonging a recession.<br />
An additional problem may be that of<br />
hysteresis. Hysteresis occurs when the<br />
unemployed remain out of work for a<br />
long enough period of time to lose the<br />
skills, contacts and motivation that are<br />
essential to them regaining employment<br />
in the future. Consequently, it becomes<br />
difficult for them to find employment in<br />
the future, even when the state of the<br />
economy improves. Hysteresis is<br />
particularly likely when there are<br />
significant changes in the structure of<br />
the economy (such as the shift from<br />
manufacturing activities to service<br />
provision as has occurred in the UK over<br />
the past few decades). The stagnant<br />
housing market, which had left some<br />
homeowners in negative equity, has<br />
compounded the effect since many<br />
people are unable to move house to take<br />
up new employment elsewhere. One<br />
sector that has taken a significant hit in<br />
the UK in the current recession is the<br />
construction industry, which has had<br />
knock-on effects for architects and plant<br />
hire companies.<br />
To tackle the issue of hysteresis in the<br />
UK the government has promised<br />
subsidies of £2,500 for each new person<br />
employed to firms who employ someone<br />
who has been officially unemployed for<br />
more than six months. The UK<br />
government has also attempted to make<br />
it more difficult for the unemployed to<br />
seek alternative benefits (such as<br />
disability allowance) once their unem -<br />
ployment benefits are reduced, in an<br />
attempt to motivate them to rejoin the<br />
workforce rather than rely on the state.<br />
However, such measures can only be<br />
effective if there are job vacancies to fill.<br />
M ARCH 2010 7
A rising budget deficit<br />
As unemployment rises, the amount that<br />
the government must spend on<br />
providing unemployment benefits also<br />
rises. To receive the Jobseeker’s<br />
Allowance (JSA), you must be of<br />
working age and actively seeking work;<br />
it can be received for 6 months if you<br />
have previously been working full-time.<br />
The JSA value is around £60 per week<br />
for each unemployed person who<br />
qualifies for this benefit. In September<br />
2009, the number of people claiming<br />
JSA reached 1.63m. This equates to a<br />
cost, per week, of £97.8m just on the<br />
provision of JSA. To put this into<br />
perspective the average cost of building<br />
a new school in the UK is estimated to<br />
be around £25m. So, the weekly cost of<br />
providing JSA is roughly equivalent to<br />
the cost of building four new schools.<br />
However, it is not only direct costs<br />
such as spending on the JSA that<br />
increase the amount of government<br />
spending. One study carried out by the<br />
Scottish NHS into the link between<br />
unemployment and premature mortality<br />
rates (defined as death before the age of<br />
65) showed a significant link between<br />
unemployment rates and health-related<br />
issues. The resultant increase in demand<br />
for NHS services will lead to a rise in<br />
costs for the government. There is also<br />
some evidence that crime tends to rise<br />
when the level of unemployment rises<br />
(although few formal academic studies<br />
of this relationship exist specifically for<br />
the UK). The well-known economist,<br />
Gary Becker, suggested in the 1960s<br />
that when there is little opportunity for<br />
‘honest’ work those with criminal<br />
tendencies would seek out illegal<br />
opportunities, such as burglary and<br />
theft. If these relationships hold true for<br />
the UK, then this imposes another<br />
indirect cost on the government, this<br />
time via the police.<br />
As well as rising costs, the government<br />
tends to receive less revenue from<br />
taxation at times when unemployment is<br />
on the increase. The unemployed do not<br />
have to pay income tax, and, if their<br />
spending decreases as a result of their<br />
fall in income, then they are likely to pay<br />
less VAT. Given that a rise in unem -<br />
ployment tends to be accompanied by a<br />
slowdown in economic growth or<br />
recession, then the government is also<br />
likely to receive less income from<br />
corporation tax, as business profits fall.<br />
The combination of a fall in revenue<br />
earned from tax and a rise in the level of<br />
government spending will either reduce<br />
a government budget surplus or<br />
increase a government budget deficit.<br />
Recent statistics show that in<br />
September 2009, the UK government’s<br />
budget deficit was around £175bn – a<br />
staggeringly large number. Looking at<br />
this situation from a different per -<br />
spective, statistics also show us that net<br />
national debt as a percentage of GDP<br />
reached 59% in September 2009,<br />
compared with 48.4% in September<br />
2008, which coincided with the rise in<br />
unemployment. The Conservative party<br />
announced at their October 2009<br />
conference that they would have to<br />
impose some harsh fiscal measures to<br />
rein in rising national debt should they<br />
be voted to power in the next general<br />
election. These measures include raising<br />
the retirement age, raising the rate of<br />
income tax for the highest earners and<br />
freezing public sector pay. These shorter<br />
term quick fixes will provide a small<br />
amount of relief. However, the increased<br />
borrowing that must take place to fund a<br />
budget deficit, as well as the interest<br />
incurred on that borrowing, must<br />
obviously be repaid in the future, posing<br />
a burden for future taxpayers.<br />
Effect on wages<br />
Basic economic theory tells us that<br />
should demand fall, then the market<br />
price will also fall. If we apply this<br />
approach to the labour market, then we<br />
could conclude that, should demand for<br />
labour fall, then the wage level will fall,<br />
ceteris paribus. However, the story in the<br />
labour market is not quite so simple. The<br />
UK labour market is not a competitive<br />
market. There are many dominant<br />
employers (particularly on a regional<br />
basis) and trade unions, whilst not as<br />
powerful a force as in the 1970s and<br />
Figure 1: The short-run Phillips Curve<br />
early 1980s, are still an important feature<br />
in many industries. Additionally, many<br />
workers are employed on longer term<br />
contracts, for which the terms of<br />
employment can be difficult to alter. For<br />
a number of reasons, wages are often<br />
described as sticky downwards, i.e. they<br />
are unlikely to fall, at least in nominal<br />
terms.<br />
However, in a number of industries,<br />
workers have not received their usual<br />
annual pay rises. An example that<br />
springs to mind is that of many teachers.<br />
So, nominal pay has remained constant,<br />
and, given that inflation has been very<br />
low, the effect on real wages has been<br />
minimal. In most cases, workers have<br />
had to accept this situation, since the<br />
alternative would be no pay at all if they<br />
were to be made unemployed.<br />
The benefits of unemployment<br />
With higher unemployment there is a<br />
tendency for the rate of inflation to fall.<br />
More people seek entry to courses in<br />
education and training which should<br />
help to raise their productivity in the<br />
longer term. The presence of automatic<br />
stabilisers helps to offset the effect of<br />
rising unemployment on the level of<br />
aggregate demand. At a micro level the<br />
demand for some goods, i.e. inferior<br />
goods, may rise rather than fall when<br />
unemployment rises. We consider each<br />
of these aspects in turn.<br />
Falling inflation<br />
There is significant evidence available to<br />
suggest that inflation and unemploy -<br />
ment are inversely related i.e. as<br />
unemployment rises then the level of<br />
inflation falls, and vice versa. This<br />
relationship is captured by the short-run<br />
Phillips Curve (shown in Figure 1).<br />
Rate of<br />
Inflation<br />
%<br />
Unemployment %<br />
8 M ARCH 2010
There are two plausible explanations<br />
of this relationship. Firstly, as unemploy -<br />
ment rises, then aggregate demand (AD)<br />
is likely to fall as consumers and<br />
businesses spend less on consumption<br />
and investment. This fall in AD results in<br />
a fall in the general price level, as shown<br />
in Figure 2. A second explanation is that<br />
as unemployment rises, it becomes<br />
more difficult for workers to negotiate<br />
pay rises as there is likely to be another<br />
worker available who will willingly work<br />
at the lower rate. So, if wages do not rise,<br />
then the risk of cost-push inflation<br />
reduces.<br />
Price<br />
Level<br />
P<br />
P1<br />
Figure 2: The effect of falling unemployment on AD and the price level<br />
LRAS<br />
Rising unemployment causes<br />
a fall in AD as spending falls.<br />
This leads to a fall in the price<br />
level from P to P1. Depending<br />
on the position of the AD<br />
curves, there may also be a<br />
corresponding fall in the level<br />
of GDP.<br />
AD<br />
Productivity and training<br />
For those workers who remain in<br />
employment, the threat of unemploy -<br />
ment may act as a motivator and<br />
encourage harder work, in order to<br />
reduce the chances of being selected as<br />
the next worker to be made redundant.<br />
So, whilst total productivity across the<br />
economy may fall, the productivity of<br />
individual workers may rise.<br />
In a similar vein, periods of recession<br />
and the associated unemployment often<br />
act as a catalyst for entrepreneurial<br />
activity. The newly unemployed may<br />
struggle to find alternative employment<br />
as job vacancies are rare, and instead<br />
become self-employed.<br />
Colleges and universities tend to see<br />
a rise in applications for courses as the<br />
level of unemployment rises. In many<br />
cases, those who are made unemployed<br />
aim to retrain and gain new skills that will<br />
be relevant to a different sector.<br />
Alternatively, some may choose to gain<br />
more advanced qualifications in order to<br />
boost their chances of gaining<br />
employment at a higher status once job<br />
opportunities start to become more<br />
available. School-leavers may choose to<br />
enter higher education rather than<br />
become unemployed. In the 2009 intake,<br />
British universities had to turn away a<br />
record 40,000 applicants as there was<br />
simply not enough space for them to<br />
study; there was an overall rise in<br />
applications of 7.8%. The number of<br />
applications from those over the age of<br />
24 rose by 12.6% and those aged<br />
between 20 and 24 by 12.9%. In terms<br />
of the subjects applied for, there was a<br />
rise in applications for economics<br />
degrees of 15.7% and mathematics by<br />
10.4%. 1 This rise in education enrol -<br />
ment, especially in the traditional ‘hard’<br />
1. P. Curtis, (2009) ‘Universities warn of stiff competition<br />
as recession prompts big rise in applications’, The<br />
Guardian, 16 February 2009.<br />
subjects, should certainly boost<br />
productivity in the longer term.<br />
A positive effect on<br />
aggregate demand?<br />
Previously in this article, the risk of<br />
unemployment prolonging the recession<br />
via the impact on aggregate demand<br />
was considered. However, in reality, this<br />
relationship may not be as simple or<br />
malign as this. There are two broad<br />
reasons why the existence of<br />
unemployment may actually prevent<br />
aggregate demand from falling by as<br />
much as we might expect. The first<br />
explanation relates to automatic<br />
stabilisers, and the second to a rise in<br />
spending on certain goods, such as<br />
inferior goods.<br />
Automatic stabilisers are a fiscal<br />
means of preventing too much<br />
‘turbulence’ in the economy. When the<br />
level of unemployment rises, the amount<br />
of money spent by the government on<br />
unemployment benefits ‘automatically’<br />
rises, thus boosting the government<br />
spending element of aggregate demand.<br />
At the same time, there is a fall in the<br />
value of tax receipts. As less money is<br />
leaked out from the circular flow of<br />
income, the fall in AD is cushioned. Thus,<br />
the automatic stabilisers associated with<br />
rising unemployment can help to reduce<br />
the fall in aggregate demand.<br />
Secondly, as unemployment rises, the<br />
unemployed turn to purchasing different<br />
types of goods, for example inferior<br />
goods. Suppliers of these goods face a<br />
rise in demand, and so again, the fall in<br />
AD may be cushioned. The unemployed<br />
may also turn to purchasing ‘cheap<br />
fixes’. These items are not inferior goods<br />
as such, but are a cheaper alternative to<br />
more expensive products that would<br />
Y1<br />
AD1<br />
Y<br />
Real Output (GDP)<br />
previously have been bought. Examples<br />
here include condoms and takeaway<br />
pizza (cheaper to stay in than go out!).<br />
So, whilst aggregate demand may still<br />
fall, the effect of unemployment may be<br />
to reduce the extent of that fall.<br />
Other impacts<br />
There are a number of other effects on<br />
the UK economy of unemployment, but<br />
it is too early to really establish whether<br />
these will prove to be positive or<br />
negative in the longer term. One such<br />
effect is the ‘baby boom’. Many women<br />
who have become unemployed have<br />
chosen to start families and take time<br />
out from the labour force for the next<br />
School leavers may opt for higher<br />
education rather than unemployment.<br />
M ARCH 2010 9
few years. The company Mothercare<br />
reported a rise in sales of 21% in 2009<br />
as the UK’s birth rate hit its highest<br />
levels since the early 1990s (although the<br />
opposite is true in the US economy).<br />
The migration patterns into and out of<br />
the UK have also altered as a result of<br />
rising unemployment in the UK. Fewer<br />
people are moving abroad for work, and<br />
those who are already abroad are<br />
generally staying there. Remittances<br />
back to families who have been left<br />
overseas have also fallen. Many migrants<br />
to the UK from Central and Eastern<br />
Europe have started to return home<br />
(since many of their home economies<br />
have not been as badly hit), as many of<br />
them have been employed in the<br />
construction and hospitality industries,<br />
two of the worst hit industries in the UK. 2<br />
Conclusion<br />
There is no doubt that unemployment in<br />
the UK can cause some rather serious<br />
and worrying effects on the economy,<br />
including rising budget deficits and a<br />
deepening of the recession. However,<br />
this article has also highlighted a number<br />
of potentially positive outcomes,<br />
including falling inflation and a slowing of<br />
the fall in aggregate demand. The overall<br />
impact of this current rise in unemploy -<br />
ment in the UK remains to be seen.<br />
Questions for discussion<br />
1. To what extent have the UK’s<br />
unemployment figures been mirrored<br />
by those of the euro-area and the<br />
USA?<br />
2. Explain the link between a stagnant<br />
UK housing market and geographical<br />
immobility of labour.<br />
3. Outline the role of automatic<br />
stabilisers in reducing the risk of an<br />
over-heating economy in times of<br />
economic boom.<br />
4. What are the implications of a large<br />
and rising budget deficit for the UK<br />
economy?<br />
5. To what extent is inflation likely to fall<br />
further as the level of unemployment<br />
continues to rise?<br />
6. Carry out your own research into<br />
Okun’s Law, which outlines an<br />
empirical relationship between<br />
changes in the rate of unemployment<br />
and the extent to which a country is<br />
producing close to its maximum<br />
potential.<br />
2. A. Walker, (2009) ‘Recession moves migration<br />
patterns’ http://news.bbc.co.uk/1/hi/8238527.stm.<br />
Summary of key points<br />
Unemployment levels in the UK have risen since <strong>2007</strong>, and now stand at<br />
around 8% (depending on which measure is used).<br />
Unemployment may deepen and prolong a period of recession in the<br />
UK as it causes a fall in demand for goods/services, and may lead to<br />
hysteresis.<br />
Unemployment has significantly worsened the UK government’s budget<br />
deficit, although this has also acted as an ‘automatic stabiliser’, thus<br />
preventing a further fall in aggregate demand.<br />
Unemployment in the UK has led to a near ‘pay-freeze’ for many,<br />
although this has led to a rise in demand for some goods, such as<br />
inferior goods.<br />
Unemployment and inflation are inversely related, and so as<br />
unemployment rises, inflation falls.<br />
Unemployment may prompt an increase in demand for education and<br />
training, which can benefit the economy in the longer term.<br />
with Chief Examiner,<br />
Robert Nutter<br />
1. When the present government came to power in 1997 8.5% of young people<br />
aged 16-18 were not in work, education or training (NE<strong>ET</strong>). By 2010 it had<br />
risen to 13.4%.<br />
Investigate the strategies introduced to reduce the number of NE<strong>ET</strong>s by<br />
the central government and at local level.<br />
www.dcsf.gov.uk/14-19/index<br />
2. Research the evidence of possible correlation between the recent rise in<br />
unemployment in the UK and the popularity of Butlins holiday camps.<br />
www.Butlins.com<br />
3. (i) Investigate how growth in the size of the labour force and the growth of<br />
productivity in an economy can affect the level of unemployment.<br />
(ii) In recent years on occasion both employment and unemployment have<br />
been rising. How can this occur?<br />
http://www.samuelbrittan.co.uk/text257_p.html<br />
4. Investigate the employment targets enshrined in the EU’s Lisbon Agenda/<br />
Strategy 2000.<br />
http://www.etuc.org/a/652<br />
5. The government wants to raise the UK employment rate to 80 per cent, which<br />
it believes could make a real difference to the level of poverty in this country.<br />
Number of workers needed to maintain the same proportion of the<br />
population in employment, and resulting employment rate, 2005-2051<br />
Year Population No. of Workers Working age Employment Rate<br />
(000’s) Needed (000’s) Population (000’s) Needed (%)<br />
2010 61,166 28,075 37,844 74.2<br />
2015 62,370 28,628 38,947 73.5<br />
2020 63,599 29,192 39,942 73.1<br />
2025 64,707 29,701 39,868 74.5<br />
2031 65,700 30,156 39,186 77.0<br />
2041 66,543 30,543 38,836 78.6<br />
2051 66,787 30,655 38,812 79.0<br />
Source: 2003-based United Kingdom Population Projections, 2003-based principal projection, GAD.<br />
http://www.gad.gov.uk/Population/2003/uk/wuk03cc.xls, accessed on 27/05/2005<br />
Research the thinking behind this policy and the measures that could be<br />
implemented to bring it about.<br />
10 M ARCH 2010
House<br />
Prices<br />
Andrew Reeve, Head of Sixth Form,<br />
The Grange School, Northwich, discusses the<br />
movement of house prices during the past few<br />
years and whether recovery from recession<br />
will lead to a more buoyant housing market.<br />
At the time of writing this article in the<br />
final few days of 2009, there is the<br />
inevitable forecasting as to what 2010<br />
will bring in terms of house prices.<br />
As with any forecast, there is a<br />
considerable range being speculated<br />
by differing economic pundits. The<br />
more pessimistic believe that 2010<br />
will bring a second wave housing<br />
crash whilst those who are more<br />
optimistic see a slight rise in prices<br />
throughout the year. As you read this<br />
article you will be able to view these<br />
forecasts with the benefit of three<br />
months hindsight. This article will take<br />
a historic look at house prices and<br />
explain how the housing market<br />
bubble burst. It will also consider<br />
what happened to property prices<br />
after the United Kingdom entered<br />
recession and look at regional and<br />
national differentials in domestic<br />
property prices. The article will also<br />
consider the state of the mortgage<br />
market in the United Kingdom and<br />
how interest rates play such an<br />
important role in driving the property<br />
market.<br />
Key words<br />
Property prices<br />
Interest rates<br />
Mortgage lending<br />
LIBOR
Recent movements<br />
in the price of property<br />
O<br />
n 30 December 2009, the Land<br />
Registry, the official source of<br />
data on house prices, reported<br />
that there had been another rise in the<br />
average price of property for the sixth<br />
consecutive month. The figures, which<br />
relate to November 2009, indicated that<br />
prices had risen by 0.9% during the<br />
month with the average house price in<br />
England and Wales costing £161,554, a<br />
figure £8,800 higher than at the low point<br />
in April 2009. Although the number of<br />
house purchases, or transactions, was<br />
still low, that too was increasing with<br />
55,520 transactions taking place in<br />
October 2009 compared to 50,187 in<br />
September 2008.<br />
This picture of the housing market was<br />
matched by the Nationwide Building<br />
Society when it reported on 31<br />
December that house prices had risen<br />
by 5.9% in 2009. This compared to a<br />
15.9% fall in property prices during 2008<br />
and signified an eight month consecu -<br />
tive rise in the price of domestic property<br />
to December 2009. The Nationwide data<br />
implied that the rise in house prices by<br />
0.4% in December 2009 took the<br />
average price of property in England and<br />
Wales to £162,103. According to the<br />
report, the price of property is 12.2%<br />
lower than the October <strong>2007</strong> peak but<br />
has rebounded by 8.9% from the<br />
February 2009 trough. 1<br />
The rise in house prices has surprised<br />
many economists who had expected<br />
further falls in house prices. Martin<br />
Guhbauer, economist at Nationwide,<br />
pointed to the reduction in supply of<br />
houses as vendors have been reluctant<br />
to put their property on the market, a<br />
slight increase in cash rich buyers and<br />
an environment of low interest rates as<br />
possible explanations for the buoyant<br />
housing market. However, he feels that<br />
restrictions in the amount of mortgage<br />
lending continue to suppress the market.<br />
We shall consider the aspect of interest<br />
rates and mortgage lending later on.<br />
House prices show considerable<br />
varia tion in the United Kingdom. Accord -<br />
ing to the Land Registry of England and<br />
Wales, the average price in those nations<br />
in November 2009 was £161,554.<br />
However, the average sale in London<br />
was recorded as £324,231 in the same<br />
month. According to the Halifax, the<br />
most expensive road to live on in the<br />
United Kingdom is Wycombe Square in<br />
the London borough of Kensington and<br />
Chelsea, where each property averaged<br />
£5.4 million (based on sales from 2005-<br />
2009). 2 The same survey by the Halifax<br />
showed that the most expensive place<br />
to live outside of Southern England was<br />
a road in the borough of Macclesfield in<br />
Cheshire called Withinlee, where the<br />
average sale price was recorded at<br />
£1.2 million. This is in the so-called<br />
‘Golden Triangle’ which takes in an area<br />
between Prestbury, Wilmslow and Hale.<br />
London also saw the largest growth in<br />
property values during 2009. According<br />
to the Nationwide survey the average<br />
house price in December 2009 cost<br />
£276,088 which represented a growth<br />
rate of 7% compared to 12 months<br />
earlier. At the other end of the spectrum,<br />
the average house price in Northern<br />
Ireland fell throughout the year by 6.7%,<br />
the largest regional drop within the<br />
United Kingdom. The Nationwide survey<br />
estimates that the average home in<br />
Northern Ireland cost £137,949 at the<br />
end of 2009.<br />
The state of lending<br />
The Council of Mortgage Lenders (CML)<br />
is the organisation which produces<br />
statistics on behalf of the banks and<br />
building societies in terms of the value<br />
and level of lending across the United<br />
Kingdom. In its December 2009 report,<br />
it commented that mortgage lending<br />
across the United Kingdom had dropped<br />
by 10% to an estimated £12 billion in<br />
November 2009. This is in marked<br />
contrast to the steady increases in the<br />
level of lending through the summer and<br />
Year Change, %<br />
15<br />
10<br />
5<br />
0<br />
-5<br />
-10<br />
Figure 1: UK house prices<br />
London saw the largest growth<br />
in property values in 2009.<br />
autumn. However, this fall in the winter<br />
months is common, with a 15% drop in<br />
lending in November 2008 and a 11%<br />
fall in November <strong>2007</strong>. The CML believe<br />
that the level of house purchase<br />
transactions may well remain depressed<br />
in the early part of 2010 as a seasonal<br />
depression remains and the Govern -<br />
ment’s stamp duty holiday comes to an<br />
end. This temporary suspension of<br />
stamp duty related to those properties<br />
on the market between £125,000 and<br />
£175,000. 3 However, data from the Bank<br />
of England showed that mortgage<br />
approvals for house purchase reached<br />
their highest level during November, with<br />
63,000 loans approved compared to<br />
60,000 in October. The Bank of England<br />
data generally shows lending at a higher<br />
level than the CML as the latter only<br />
consider the actual money advanced at<br />
the end of the process.<br />
The CML data show that during the<br />
Nationwide<br />
Halifax<br />
1. Nationwide Report as reported in www.ft.com,<br />
31 December 2009. The chart of house prices reported<br />
on www.bbc.co.uk.<br />
2. http://www.guardian.co.uk/money/2009/dec/29/<br />
house-prices-halifax-homes-kensington.<br />
3. http://www.cml.org.uk/cml/statistics.<br />
-15<br />
-20<br />
<strong>2007</strong><br />
Source: Halifax and Nationwide<br />
2008 2009<br />
12 M ARCH 2010
second and third quarters of 2009 there<br />
was a rise in the level of lending,<br />
compared to a low point in the first<br />
quarter of the year. However, the level of<br />
Price £000’s<br />
Source: htp://www.cml.org.uk/cml/media/press/2503<br />
360<br />
320<br />
280<br />
240<br />
200<br />
160<br />
120<br />
80<br />
40<br />
United Kingdom<br />
England<br />
London<br />
Wales<br />
Scotland<br />
Northern Ireland<br />
Table 1: Gross mortgage lending<br />
lending is still significantly lower than in<br />
recent years. What is the reason for this<br />
fall and subsequent rise? A large part of<br />
the answer has to relate to the credit<br />
Figure 2: Regional variations in house prices<br />
0<br />
1999 2000 2001 2002 2003 2004 2005 2006 <strong>2007</strong> 2008 2009<br />
Source: http://www.houseprices.uk.net/articles/odpm_regional/<br />
Rate<br />
6.5<br />
6.0<br />
5.5<br />
5.0<br />
4.5<br />
4.0<br />
3.5<br />
3.0<br />
2.5<br />
2.0<br />
1.5<br />
1.0<br />
0.5<br />
0<br />
All loans Total £m<br />
2000 119,794<br />
2001 160,123<br />
2002 220,737<br />
2003 277,342<br />
2004 291,258<br />
2005 288,280<br />
2006 345,355<br />
<strong>2007</strong> 362,635<br />
2008 253,198<br />
Aug Sep<br />
’08 ’08<br />
Oct Nov Dec<br />
’08 ’08 ’08<br />
Source: www.thisismoney.co.uk/libor<br />
Figure 3: LIBOR rate, 8 December 2009<br />
Jan<br />
’09<br />
Feb<br />
’09<br />
Mar<br />
’09<br />
Quarter Total £m<br />
2006 Q3 92,996<br />
Q4 92,404<br />
<strong>2007</strong> Q1 83,844<br />
Q2 93,846<br />
Q3 98,631<br />
Q4 86,314<br />
2008 Q1 74,181<br />
Q2 72,793<br />
Q3 60,601<br />
Q4 45,623<br />
2009 Q1 32,804<br />
Q2 32,766<br />
Q3 39,022<br />
Apr<br />
’09<br />
May<br />
’09<br />
Jun<br />
’09<br />
LIBOR Rate<br />
Base Rate<br />
Jul Aug Sep<br />
’09 ’08 ’09<br />
Oct<br />
’09<br />
crunch of 2008/2009, the subsequent<br />
tightening of credit, followed by the<br />
international rescue plans to inject more<br />
money into the circular flow and<br />
encourage banks to lend. Consumers<br />
have also responded to the falls in<br />
interest rates, especially as LIBOR, the<br />
inter-bank lending rate which determines<br />
mortgage rates, has converged with the<br />
base rate again.<br />
What is LIBOR?<br />
BBALIBOR was first developed in the<br />
1980s as demand grew for an accurate<br />
measure of the real rate at which banks<br />
would lend money to each other. It<br />
became internationally important as<br />
London developed into an international<br />
financial centre. LIBOR stands for<br />
London InterBank Offered Rate. The<br />
BBA part stands for the British Bankers’<br />
Association. (See www.bbalibor.com for<br />
more in-depth information.)<br />
Whilst the Bank of England fixes<br />
official base rates, LIBOR reflects the<br />
actual costs for banks to borrow money<br />
from each other. Many mortgages have<br />
their rates attached to the LIBOR rate<br />
and therefore it is of vital importance to<br />
many homeowners. Generally, the<br />
LIBOR rate will be marginally above the<br />
base rate. However, during the past year<br />
the LIBOR has deviated from the base<br />
rate significantly. This was in part due to<br />
the reluctance of banks to lend to each<br />
other immediately after the credit crunch<br />
due to the adverse risks from toxic debt.<br />
So what for 2010-2011?<br />
Ask five different economists what will<br />
happen to house prices in the next two<br />
years and you get at least five different<br />
answers! Some optimistic commen -<br />
tators such as Ray Boulger of mortgage<br />
brokers John Charcol believe that prices<br />
will pick up in the short term. However,<br />
the majority of commentators think that<br />
prices will remain stable at best. For<br />
example, Martin Gahbauer at the<br />
Nationwide states that:<br />
❝…after seven consecutive months<br />
of rises, a stabilisation trend has<br />
been established, but I see prices<br />
flattening out, with prices by<br />
December 2010 about the same as<br />
now.<br />
Others are more pessimistic, pointing to<br />
another housing slump in the coming<br />
year. Only time will tell!<br />
M ARCH 2010 13
The<br />
Savings<br />
Ratio<br />
Rachel Cole, teacher at Cheltenham Ladies’ College<br />
and a Principal Examiner, discusses the problem of a<br />
savings gap in the UK economy.<br />
One of the main reasons why the UK economy has been so vulnerable to the<br />
credit crisis is that its households have had a very low savings ratio in the<br />
‘noughties’ decade. For people in the UK and other rich nations there has<br />
been a ‘trend to spend’, so when the crunch came, households were over<br />
exposed financially. In this article we are going to look at the impact of growth<br />
rates on the savings ratio and vice versa, examine the size of the savings<br />
ratio over time, the multiplier, and how the current state of savings ratios will<br />
affect you. The aim is to consider how these two macroeconomic variables,<br />
consumption and saving, underlie much economic theory, without becoming<br />
wrapped up in Keynesian theories.<br />
Key words<br />
Savings ratio<br />
Savings gap<br />
Pension gap<br />
C<br />
onsumption is a measure of<br />
current expenditure on<br />
goods and services. Saving is a<br />
measure of how much is put aside for<br />
possible future expenditure on goods<br />
and services. The amount you spend<br />
relative to how much you earn will vary<br />
at different stages in your life, and also<br />
in line with your confidence in the<br />
economy. It will also depend on whether<br />
you think you’ll earn more or less money<br />
in the future and how you think your<br />
career will progress. In the UK,<br />
household saving is clearly anti-cyclical<br />
– meaning that if the economy is<br />
booming the percentage we save goes<br />
down. This doesn’t mean that the total<br />
amount we save falls, but that as a<br />
percentage we spend more and save<br />
less. In a recession people start saving,<br />
which helps restore balance in an<br />
economy that has been over-exposed to<br />
risk. But it is bad news if, like the<br />
government, you want to see sales rising<br />
and the recovery get under way. But if<br />
households stop spending too quickly<br />
this will cause other major problems<br />
in the economy. Spending keeps<br />
businesses in profit, and therefore<br />
workers in their jobs. So there is a fine<br />
line between too high and too low a level<br />
of savings for every economy, and this<br />
varies for different stages of the<br />
economic cycle.<br />
Figure 1 shows the UK savings ratio<br />
aligned with changes in GDP, that is,<br />
growth. There was continuous economic<br />
growth from the third quarter of 1993<br />
until the second quarter of 2008, the<br />
longest period of growth on record in the<br />
UK. In the same period the savings ratio<br />
just fell and fell, despite there being more<br />
money available. What happens is that<br />
as our income grows so do our spending<br />
habits and choices. This is seen in Figure<br />
2, showing that although income rises,<br />
savings do not rise as quickly.<br />
High household debt has made the<br />
economy unstable and although interest<br />
rates have been very low since 2008,<br />
insulating us from the problems of high<br />
debt repayments, things will not be so<br />
14 M ARCH 2010
easy when rates begin to rise. As<br />
consumers we have to ‘have it all now’,<br />
‘jam today’ rather than wait for jam<br />
tomorrow. The supply of credit has also<br />
been too loose. Over exposure to easy<br />
credit has been a cause of a ‘bubble’ in<br />
house prices and other assets, with<br />
banks too keen to lend to customers<br />
who may turn out to be unable to pay<br />
back in full. Over-indebtedness has been<br />
a problem in much of the Western world<br />
during the prosperous times, and overexposure<br />
to bad debts triggered by falls<br />
in house prices was the primary cause<br />
of the 2008 credit crisis.<br />
It is not the same in every country. In<br />
China for example the savings ratio rose<br />
even further as the boom went on, as is<br />
clear in Figure 3.<br />
Why do Asian nations save more, on<br />
average, as the economy grows? One<br />
factor is a culturally cautious outlook on<br />
life. Another is that as savings rise so do<br />
the benefits of saving, which in turn can<br />
fuel future growth. Chinese people may<br />
have a longer view in their consumption<br />
requirements. China uses its savings to<br />
buy much of the US debts (47% of GDP<br />
or over $7 trillion), putting China on a<br />
strong footing in international negotia -<br />
tions on trade. And for China, exports<br />
are the main source of growth, in January<br />
2010 becoming the world’s biggest<br />
exporter by value. So although in the<br />
short term savings might dampen<br />
demand, there is much to suggest that<br />
higher savings make an economy grow.<br />
The savings ratio is thought to be too<br />
high in China with the government trying<br />
to get people to save less not more. 1 By<br />
contrast, in the West, a savings gap<br />
triggers many problems that in the long<br />
run will damage the economy, not just<br />
imbalances on the macro level, but micro -<br />
economic problems such as poverty and<br />
being forced to leave your home.<br />
Financial literacy<br />
Perhaps one of the main reasons why<br />
people over-spend is that many are not<br />
financially literate. Companies selling<br />
the finance might be said to have<br />
asymmetric information because<br />
they know more about what they are<br />
selling than the buyer. We quite easily<br />
fall for what seems like cheap monthly<br />
payments not realising what they add up<br />
1. BBC World Service programme ‘Saving China’<br />
3 September, 2009. The programme is available to listen<br />
at: http://www.bbc.co.uk/worldservice/documentaries/<br />
2009/09/090903_assignment_030909.shtml.<br />
2. http://www.oecd.org/dataoecd/53/48/32023442.pdf.<br />
The correct answer is ‘never’. What is really scary,<br />
though, is that although 35% got the answer correct,<br />
one in five admitted that they had no idea.<br />
Percentage of disposable income that is saved<br />
GDP growth, quarter on previous quarter, %<br />
14<br />
12<br />
10<br />
8<br />
6<br />
4<br />
2<br />
0<br />
-2<br />
1.5<br />
1.0<br />
0.5<br />
0<br />
-0.5<br />
-1.0<br />
-1.5<br />
’90<br />
’91<br />
’92<br />
’93<br />
’94<br />
-2.5<br />
’90 ’91 ’92 ’93 ’94<br />
Source: www.statistics.gov.uk<br />
85<br />
82<br />
79<br />
76<br />
73<br />
-2.0<br />
’95<br />
’95<br />
’96<br />
’96<br />
to, and we quickly make assumptions.<br />
How many times have you fallen for the<br />
slogan ‘0% finance’ or ‘pay nothing for<br />
six months’? Try the following question<br />
from a debt literacy quiz conducted<br />
across the world in 2009. 2<br />
You owe £3,000 on your credit card.<br />
You pay a minimum payment of £30 each<br />
month. At an Annual Percentage Rate of<br />
Figure 1: Household savings ratio, UK<br />
’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09<br />
Six successive<br />
falls in GDP<br />
’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09<br />
Figure 2: Average savings and income per head, UK pounds sterling<br />
Average saved per head (lhs)<br />
Mean income (rhs)<br />
70<br />
2005 2006 <strong>2007</strong> 2008<br />
2009<br />
Source: www.nsandi.com<br />
1400<br />
1450<br />
1300<br />
1250<br />
1200<br />
1150<br />
12% (1% a month), how many years<br />
would it take to eliminate you credit card<br />
debt if you made no additional new<br />
charges? (The answer is in the footnote)<br />
Less than 5 years?<br />
Between 5 and 10 years?<br />
Between 10 and 15 years?<br />
Never?<br />
Don’t know?<br />
M ARCH 2010 15
60<br />
50<br />
40<br />
30<br />
20<br />
10<br />
0<br />
36.0<br />
’92<br />
37.8<br />
’93<br />
39.1<br />
’94<br />
Figure 3: China’s savings ratio in 1992-<strong>2007</strong> (%)<br />
38.4<br />
’95<br />
37.2<br />
’96<br />
37.7<br />
37.8<br />
And here’s another one to try:<br />
If interest rates are 20% how many<br />
years will it take to double a £100 debt?<br />
The answer is 3 years and ten months<br />
(almost) 3 but most people think it’s a lot<br />
longer. 4<br />
Some theory basics<br />
If there were no government and no<br />
foreign trade then we either consume (C)<br />
or save (S) all our income (Y), so Y = C +<br />
S. This is from the consumer’s point of<br />
view. From the firm’s perspective, all<br />
income is either used on paying to<br />
produce goods and services, or for<br />
investment in capital goods so that<br />
goods and services can be produced in<br />
the future. So for a firm, Y = C + I, with I<br />
36.6<br />
36.9<br />
37.7<br />
39.3<br />
42.1<br />
46.1<br />
47.5<br />
47.9<br />
49.9<br />
’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07<br />
Source: http://docs.google.com/viewer?a=v&q=cache:NYzVzgj02gYJ:www.bnm.gov.my/files/publication/conf/hilec2009/01_<br />
slides_zhou.pdf+statistics+savings+ratio+world&hl=en&gl=uk&sig=AHIEtbSNxYMbeSzH3rMdZnYOeva7_6z5QQ&pli=1<br />
Percentage with ‘too much debt’<br />
40%<br />
35%<br />
30%<br />
25%<br />
20%<br />
15%<br />
10%<br />
5%<br />
0%<br />
< 2 years<br />
Figure 4: How long to double debt at 20%?<br />
< 5 years<br />
(correct)<br />
5-10 years > 10 years<br />
(widely<br />
wrong)<br />
Don’t<br />
know<br />
Refuse<br />
meaning investment, the increase in<br />
capital stock. It’s not a great<br />
mathematical mystery revealed to say<br />
that if Y = C + S and Y = C + I, then, by<br />
definition, I and S must be equivalent. In<br />
other words people save the same<br />
amount that firms invest, which is an<br />
amazing observation if it means that<br />
more saving means that firms invest<br />
more. Actually, this causal relationship<br />
does not follow. Nor does it mean that<br />
more investment will mean that it<br />
will make people want to save more.<br />
What it does mean is that there is a<br />
proportion of income that is not spent,<br />
and this will have a major impact on the<br />
amount of activity or consumption in the<br />
economy.<br />
3. The formula is premium times interest rate to the power of the number of years (x). So it’s 100 x 1.2x then take logs<br />
of both sides so x log 1.2 = log 2, and divide both sides by log 1.2. X is 3.801.<br />
4. http://www.oecd.org/dataoecd/34/9/44280581.pdf OECD conference Brazil December 2009, result of independent<br />
research by phone of 1000 adults in 80 countries.<br />
5. http://www.mckinsey.com/mgi/mginews/unleashing_ chinese_consumer.asp.<br />
Grossly underestimate compounding<br />
Impact of savings on growth<br />
If people save more then firms cannot<br />
sell everything they intended to sell,<br />
leaving unsold stock that appears on<br />
their accounts as investment. The next<br />
year they will produce less (because<br />
there are unsold stocks) so there will be<br />
less money in the circular flow of income.<br />
A rise in savings slows down consump -<br />
tion so in the short run it makes the<br />
economy look worse off in GDP. Our<br />
tendency to spend or save explains the<br />
multiplier effect, and the higher the<br />
saving the lower the multiplier. But a low<br />
multiplier can be a good thing. A large<br />
multi plier makes injections have a<br />
greater boost on the economy, but in<br />
reverse a large multiplier can throw an<br />
economy into recession. A small multi -<br />
plier means that growth is on a steadier<br />
course, and the higher levels of savings<br />
keeps consumers more confident, and<br />
firms less volatile. It means capital<br />
markets are less volatile, and there is less<br />
cause for alarm concerning pensions.<br />
Savings and the multiplier<br />
Savings are a leakage out of the circular<br />
flow of income. The more we save, the<br />
less money will be spent, earned and respent<br />
in the economy, and the multiplier<br />
effect is smaller. The lower the marginal<br />
propensity to consume, the lower the<br />
multiplier.<br />
When you consider the size of the<br />
multiplier you will earn evaluation marks<br />
in your economics exam, so it is good to<br />
consider factors such as savings when<br />
considering the full impact on any shift<br />
in aggregate demand on the price level<br />
and real output. You may also argue that<br />
changes in total spending cannot be<br />
affected by changes in aggregate<br />
demand (if the aggregate supply is<br />
vertical) so the impact of changes in<br />
injections will only impact upon the price<br />
level.<br />
In the UK household consumption is<br />
65% of GDP, meaning that consumption<br />
is a highly significant part of total<br />
demand. Discussing the importance of<br />
consumption to the UK economy, for<br />
example with the contrast of 36% of<br />
China’s GDP, is another way to earn<br />
evaluation marks. 5<br />
Savings and pensions<br />
In your grandparents’ generation,<br />
pensions were something to look<br />
forward to. Many workers had their<br />
income linked to their final salaries,<br />
meaning that for the rest of their lives<br />
they could earn a good percentage of<br />
16 M ARCH 2010
the amount they got in their last few<br />
years of work, linked to average<br />
incomes, so that it would not fall in real<br />
terms. This is no longer true: 90% of final<br />
salary schemes are closed to new<br />
members, and many workers are no<br />
longer guaranteed income after they<br />
retire. Since 1980 pensions have been<br />
linked only to the price level, not to<br />
average incomes, so with accelerating<br />
incomes the gap between wages and<br />
pensions grows ever larger. Two-thirds<br />
of workers under the age of 30 have no<br />
pension at all. In many UK and US firms,<br />
the pensions deficit is causing many<br />
problems, for example in some car<br />
manufacturing plants where the pension<br />
bill is already up to 25% of the wage bill.<br />
The cost attributed to pensions in a new<br />
GM car is $1,120 (2006 figures). 6 <strong>Today</strong><br />
we need to save if we want to be<br />
guaranteed a good income when we<br />
retire, and living on the state pension<br />
alone (£95 a week) would leave you<br />
below the poverty line (£115 in 2008).<br />
According to research by the govern -<br />
ment’s National Savings and Invest -<br />
ments, more than half of the UK<br />
population (53%) do not save any extra<br />
money a month, and of the rest, 90%<br />
have an average of just above £7,000. 7<br />
Consumption may fuel growth, but<br />
savings prevent us from long-term<br />
poverty. In the short term macro -<br />
economists may like everyone to spend<br />
as much as possible to keep national<br />
income up, which will bring short term<br />
benefits to income and wealth. Savings<br />
bring longer term prosperity to a country,<br />
but if they grow too large they stifle the<br />
growth in the economy, reducing the size<br />
of the multiplier. The imbalances caused<br />
by increased household debt have been<br />
highlighted as one other main causes of<br />
the credit crisis, and this must be<br />
addressed if the future is going to avoid<br />
‘the boom and bust’ extremes. One<br />
solution is to start raising interest rates,<br />
which might slow the pace of the<br />
recovery but will stop households from<br />
taking out even more debt. Household<br />
debt is becoming the trendy credit crisis<br />
now the banking system’s credit crisis<br />
moves into history.<br />
Questions for discussion<br />
1. When household debt grows too<br />
large and there is a sudden cut in<br />
consumption, the effects can be<br />
6. http://www.bloomberg.com/apps/news?pid=20601101<br />
&sid=agvBuODXiKKs.<br />
7. http://www.nsandi.com/pdf/QSS_Autumn09.pdf.<br />
% of average earnings<br />
30<br />
25<br />
20<br />
15<br />
10<br />
5<br />
0<br />
’78<br />
Source: DWP<br />
made less damaging to the economy<br />
by a cut in the interest rates by the<br />
MPC. Why do you think interest rates<br />
were kept high in the 1990s in the<br />
Netherlands despite the sharp rise in<br />
household debt? Remember that the<br />
Netherlands is part of the Euro area.<br />
2. Why are savings anti-cyclical against<br />
economic growth in the West and not<br />
so in Asia? What do you think the<br />
pattern is in Latin America?<br />
3. Why might fixed-rate mortgages<br />
make unreliable the prediction of the<br />
effect of interest rate changes on<br />
consumption?<br />
Key terms<br />
Figure 5: How much is a state pension worth?<br />
1980 – Link between pensions and earnings cut<br />
’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 ’02 ’04 ’06 ’08<br />
4. In 2024 the pension age will phase in<br />
changes from 60 to 66 for women.<br />
This is quite a large jump, and will<br />
affect women currently under 46.<br />
What effect will this have on the<br />
supply of labour and average real<br />
wages? Do you think younger people<br />
will lose out on jobs to people who<br />
stay in work longer as they grow<br />
older? What will happen to the<br />
quality of labour as the length of the<br />
working life increases? Remember<br />
that many of your examiners are over<br />
50 before you come to sweeping<br />
conclusions!<br />
Savings – the amount of current income put aside for future expenditure<br />
on goods and services.<br />
Savings gap – the difference between actual savings and the<br />
amount of savings needed for wealth to grow in line with incomes,<br />
estimated to be between £16.5bn and £66bn according to NIESR:<br />
http://ner.sagepub.com/cgi/content/abstract/191/1/79.<br />
Saving ratio – how much we save on average out of income.<br />
Marginal propensity to consume – the amount of any extra income that<br />
is spent on goods and services.<br />
Marginal propensity to save – the amount of any extra income that is<br />
put aside for future purchases of goods and services.<br />
The multiplier – the magnified effects on income as money that is earned<br />
is re-spent in the economy repeatedly through consumption within the<br />
economy.<br />
Anti-cyclical – when a variable moves inversely with the economic cycle.<br />
Savings as a ratio go up when growth falls in western economies.<br />
Pension – a tax efficient source of post-retirement income, part of which<br />
the government provides to people who have worked in the UK.<br />
Pension gap – the difference between actual pension outcomes and the<br />
amount of pensions needed for post-retirement income to grow in line<br />
with incomes of people currently in work.<br />
M ARCH 2010 17
Dear Chancellor<br />
Institute of Directors Chief<br />
<strong>Eco</strong>nomist and Director of<br />
Policy, Graeme Leach, sets<br />
out a radical plan to boost<br />
long-term economic growth.<br />
Snapshot<br />
Received wisdom accepts the budget deficit is very large and merely<br />
poses the question as to what combination of higher taxes and/or lower<br />
spending is required to reduce the deficit?<br />
The question on the mind of the Chancellor should be very different. It<br />
should be: How should we implement fiscal policy so as to maximise longterm<br />
GDP growth?<br />
The Chancellor faces a clear choice. Squeeze public spending or tax and<br />
spend will squeeze the life out of the economy.<br />
The scale of the financial crisis provides a once in a generation opportunity<br />
to reduce the size of the state.<br />
The Chancellor should set a target of a 35 per cent spending to GDP ratio<br />
by 2020 and a 30 per cent share by 2025 – potentially the lowest share in<br />
the world by then.<br />
W<br />
eakened by financial crisis,<br />
recession, an exploding<br />
budget deficit, stifling regula -<br />
tion and a looming 50 per cent top rate<br />
of income tax, the UK appears set for<br />
economic decline.<br />
Thankfully there is<br />
an alternative path<br />
Reducing public spending down<br />
towards 35 per cent of GDP could yet<br />
transform the long-term performance of<br />
the UK economy.<br />
There is a broad acceptance that<br />
public spending must be reduced as a<br />
proportion of GDP. OECD projections<br />
show total public spending 1 in the UK<br />
increasing from 37 to 54 per cent of GDP<br />
over 2000-10. 2 Between 2000 and <strong>2007</strong>,<br />
in other words before the current<br />
economic crisis began, public spending<br />
increased by 7.5 percentage points of<br />
GDP, which was by far the fastest<br />
increase in the OECD.<br />
Net borrowing will approach £185<br />
billion in 2009-10 and worst case but still<br />
plausible forecasts suggest total public<br />
borrowing over 2009-10 to 2013-14<br />
could even reach £1 trillion.<br />
Received wisdom accepts the deficit<br />
is very large and merely poses the<br />
question as to what combination of<br />
higher taxes and/or lower spending is<br />
required to reduce the deficit. This is an<br />
inappropriate response.<br />
The question on the mind of the next<br />
Chancellor should be very different. It<br />
should be: How should we implement<br />
fiscal policy to maximise long-term GDP<br />
growth?<br />
Focusing on fiscal sustainability is<br />
likely to result in a squeeze in public<br />
spending together with a higher tax<br />
burden. There will be a lot of pain, but<br />
little or no gain in long-term economic<br />
performance. We will simply return to the<br />
position before the financial crisis. Tax<br />
and spend policies will have reversed<br />
slightly.<br />
The alternative approach is to focus<br />
on the supply-side of the economy and<br />
not just fiscal sustainability. Setting fiscal<br />
policy to maximise long-term GDP<br />
growth draws on a large economic<br />
literature from the OECD, IMF, European<br />
Commission, ECB, New Zealand<br />
Treasury and individual academics,<br />
showing higher taxes reduce long-term<br />
growth and lower public spending<br />
increases it.<br />
The policy conclusion at present is<br />
clear. The fiscal adjustment should fall<br />
on lower spending and not higher<br />
taxation. 3<br />
1. The coverage of this OECD measure differs from HM Treasury estimates for total managed expenditure. The total<br />
spending to GDP ratio hides considerable regional variation. Many UK regions have public spending to GDP ratios of 50-<br />
60 per cent plus, whilst the South East is closer to 35 per cent (pre-recession statistics). There is a need for huge<br />
structural adjustment to squeeze out the dependency culture.<br />
2. This understates the extension of the state, for example, the effective ‘transfer’ of welfare spending to the private sector<br />
through the national minimum wage. The use of alternative denominators can also increase the public spending ratio.<br />
3. Fiscal consolidations comprised largely of lower spending are also more durable than those based on higher taxes.<br />
4. Encouraged also by the development of endogenous growth modelling in the late 1980s.<br />
The academic literature in this area<br />
has flourished over the past 20 years and<br />
now provides an opportunity to quantify<br />
the trade-off between taxation and<br />
spending on the one hand and GDP<br />
growth on the other – an opportunity<br />
which wasn’t really available in the 1980s<br />
due to the thin literature which existed<br />
then. 4<br />
Empirical variation notwithstanding,<br />
some estimates suggest that a 10 per -<br />
centage point of GDP increase in public<br />
spending lowers the GDP growth rate by<br />
1 percentage point.<br />
Based on this empirical relationship,<br />
reducing the public spending to GDP<br />
ratio from 50 per cent to 30 per cent<br />
could raise the UK’s long-term GDP<br />
growth rate by 2 percentage points –<br />
from approximately 2 per cent at present<br />
to 4 per cent.<br />
Even if the gain was only half this<br />
amount, the cumulative impact would<br />
still be considerable. Viewed over a<br />
40 year period the difference between<br />
just 2 and 3 per cent compound growth<br />
is equivalent to cutting away the<br />
Scottish, Welsh and Northern Ireland<br />
economies!<br />
Attitudes need to adjust from the naïve<br />
and somewhat tired view which pre -<br />
vailed for much of the post war period –<br />
that because rising levels of prosperity<br />
had run in parallel with the expansion of<br />
the state, any relationship was benign at<br />
worst.<br />
Echoes of this worldview can still be<br />
heard. The Scandinavian economies are<br />
18 M ARCH 2010
said to epitomise how big government<br />
and economic success can run hand in<br />
hand. Closer inspection reveals a<br />
somewhat different interpretation.<br />
First, there is the counterfactual.<br />
These economies could well have<br />
achieved even faster growth in the<br />
absence of a large state. Second, many<br />
of these economies have reduced the<br />
size of the state significantly e.g.<br />
Sweden where public spending fell from<br />
71 to 51 per cent of GDP over the 1992-<br />
<strong>2007</strong> period (before the current financial<br />
and economic crisis took hold).<br />
The damaging potential impact of<br />
higher taxation (to finance higher spend -<br />
ing) on economic activity is best under -<br />
stood with the concept of deadweight<br />
cost.<br />
The deadweight cost of taxation is<br />
the loss of output which would have<br />
occurred in the absence of the tax – a<br />
loss of economic welfare above and<br />
beyond the tax revenues collected. The<br />
loss of economic welfare arises from the<br />
disincentive effect of taxation on labour<br />
supply and saving.<br />
Deadweight loss is the ultimate stealth<br />
tax. No one sees the extra output that<br />
would have been created by economic<br />
decisions made in the absence of higher<br />
taxes.<br />
This means that an extra £1 of govern -<br />
ment spending costs the economy more<br />
than £1 and hence reducing taxes by £1<br />
generates more than £1 of benefit to the<br />
economy.<br />
How should spending<br />
reduction be undertaken?<br />
Standard slicing off every departmental<br />
budget is the wrong thing to do. There<br />
needs to be a fundamental root and<br />
branch appraisal of all spending, which<br />
is also informed by public choice theory.<br />
Public choice theory highlights the<br />
self-interest of public servants who may<br />
have their own agenda and little or no<br />
incentive to roll back the state. Senior<br />
civil servants may well need to receive<br />
personal incentives in order for them<br />
actively to support reduced public<br />
spend ing and productivity increasing<br />
reforms.<br />
Whilst not a perfect illustration,<br />
Canadian experience of zero-based<br />
budgeting in the 1990s shows that<br />
deep inroads into public spending<br />
can be made. The public spending<br />
to GDP ratio fell from 53 per cent in<br />
1992 to 39 per cent in <strong>2007</strong> (before the<br />
current financial and economic crisis<br />
took hold). Indeed, between 1992 (the<br />
year of the largest deficit) and 1997 (the<br />
first year of surplus), spending fell by<br />
9 percentage points of GDP, while the<br />
tax/GDP ratio rose by just 0.3 per -<br />
centage points.<br />
When should the next<br />
Chancellor start reducing<br />
spending?<br />
The answer is sooner rather than later.<br />
The obvious immediate critique is that<br />
reducing spending during a recession<br />
or infant recovery will only reduce<br />
aggregate demand. However, the reality<br />
is more nuanced.<br />
Experience of the March 1981 Budget<br />
shows that fiscal policy can be tightened<br />
during a recession, if monetary policy is<br />
simultaneously eased.<br />
The economy may also display<br />
‘Ricardian equivalence’ – when<br />
households see rising budget deficits as<br />
a portent of future tax increases and<br />
merely raise their levels of current saving<br />
to provision for this eventuality.<br />
The academic literature is somewhat<br />
mixed, but it would appear that at certain<br />
times this effect can be much more<br />
significant and pre-announcing a<br />
credible fiscal adjustment, based on<br />
lower public spending, might actually<br />
boost activity. This may well be one of<br />
those times, given the scale of media<br />
coverage on the recession and fiscal<br />
deficit.<br />
The current fiscal crisis is presenting<br />
what may be a once in a generation<br />
opportunity to tighten dramatically<br />
public spending whilst simultaneously<br />
maintaining GDP growth during the<br />
transition phase to higher long-term<br />
growth, by retaining zero bound interest<br />
rates.<br />
Looking further into the 21st century,<br />
one can speculate that the pressure to<br />
reduce public spending – because of the<br />
negative impact of the taxation required<br />
to fund it – will steadily increase for a<br />
number of reasons.<br />
First, the effect of globalisation, with<br />
mobile factors of production and<br />
electronic commerce, threatens to<br />
heighten tax competition as part of the<br />
process to attract footloose foreign<br />
investment.<br />
Second, long term real income growth<br />
may result in future middle income<br />
households behaving more like upper<br />
income households at present. As a<br />
result, their labour supply may become<br />
more sensitive to post tax income.<br />
It is very difficult to be precise when<br />
speculating on the optimal size of public<br />
The pressure to<br />
reduce public spending<br />
will steadily increase.<br />
spending in the UK. One very robust<br />
conclusion, however, can still be drawn.<br />
The threshold at which the relationship<br />
between public spending and economic<br />
growth becomes negative is dramati -<br />
cally lower than the spending ratio at<br />
present.<br />
Given the potential trade-off between<br />
lower spending, reduced taxation and<br />
faster GDP growth, consideration of the<br />
thoughts of John Maynard Keynes might<br />
be helpful. Commenting on the tax<br />
burden required to fund public spending<br />
Keynes speculated that:<br />
❝…25 per cent as the maximum<br />
tolerable proportion of taxation may<br />
be exceedingly near the truth.<br />
When considering the size of the state,<br />
we have tolerated too much for too long.<br />
A 35 per cent target for the spending to<br />
GDP ratio by 2020 should not be seen<br />
as the full solution. We would recom -<br />
mend a policy objective of 30 per cent<br />
by 2025.<br />
Without this approach, the UK<br />
economy risks becoming the sick man<br />
of Europe, with low trend growth and<br />
high levels of public spending and<br />
taxation.<br />
M ARCH 2010 19
In this regular feature Chief Examiner Robert Nutter of Watford Girls’<br />
Grammar School, looks at AS and A2 questions which in this volume will<br />
aim to reflect the order that schools and colleges cover topics from the<br />
specifications. There are three AS (1-3) and three A2 (4-6) questions per<br />
edition plus explained answers.<br />
Questions<br />
1. In the last three years European sales of satellite<br />
navigation (sat nav) systems have nearly doubled to<br />
almost 14 million units, while UK sales of road atlases<br />
through bookshops fell in value by 17%. However, since<br />
the recent onset of recession sales of road atlases are up<br />
10% and sales of sat nav systems are down.<br />
From the above information it can be deduced that sat<br />
navs and road atlases<br />
4.<br />
£<br />
p<br />
MC<br />
AC<br />
A. have a negative cross elasticity relationship.<br />
D = AR<br />
B. are both normal goods.<br />
C. have a positive cross elasticity relationship.<br />
D. are both inferior goods.<br />
0<br />
q<br />
MR<br />
Quantity<br />
The diagram above shows a profit-maximising firm in a<br />
monopolistically competitive market. It can be deduced<br />
from the diagram that the firm is<br />
2.<br />
Price<br />
S<br />
A. making abnormal profit.<br />
B. maximising sales.<br />
60p<br />
50p<br />
S1<br />
C. productively efficient.<br />
D. making normal profit.<br />
E. allocatively efficient.<br />
40p<br />
0<br />
The diagram shows the impact of a per unit producer<br />
subsidy. What is the total amount paid out by the<br />
government in subsidy to producers?<br />
A. £12.<br />
B. £20.<br />
C. £24.<br />
D. £48.<br />
100<br />
120<br />
3. All of the following will benefit from a fall in the value of the<br />
pound against the euro and the dollar except<br />
A. UK citizens living in the eurozone who are paid their<br />
pensions in sterling.<br />
B. US firms buying assets in the UK.<br />
Quantity<br />
C. UK firms earning income from subsidiaries in the<br />
eurozone and the US.<br />
D. US firms importing components from the UK.<br />
D<br />
5. All of the following assertions about the natural rate of<br />
unemployment are true except one of them. Which is<br />
untrue?<br />
A. It is possible to reduce the natural rate of unemploy -<br />
ment but not to reduce unemployment below the<br />
natural rate.<br />
B. The natural rate of unemployment represents the level<br />
of unem ployment when the labour market is in<br />
equilibrium.<br />
C. The natural rate of unemployment can be reduced by<br />
using supply side policies.<br />
D. The vertical long run Phillips Curve represents the<br />
natural rate of unemployment.<br />
E. A shift to the left of the vertical long run aggregate<br />
supply curve represents a fall in the natural rate of<br />
unemployment.<br />
6. Which one of the following concepts is the best measure<br />
of the international price competitiveness of the UK?<br />
A. The effective exchange rate.<br />
B. The real exchange rate.<br />
C. The nominal exchange rate.<br />
D. The purchasing power parity exchange rate.<br />
E. The trade weighted exchange rate.<br />
20 M ARCH 2010
Revision<br />
Steve Tidball,<br />
Ipswich School<br />
Guide 2010<br />
However hard you try, and some people try very hard indeed, you just can’t get away from<br />
examinations. No matter how much the education system is changed, written examinations still<br />
form a large part of the assessment process in this country at all age levels. Indeed, you may<br />
well be aware that, rightly or wrongly, your age group is amongst the most frequently examined<br />
group of students in the world. Exams are a fact of life that you just have to deal with!<br />
Many myths surround examinations, so in this article, I want to show you how you can put yourself in a position to handle exams<br />
confidently and effectively. This will stand you in good stead not only for your forthcoming exams but will help you develop skills<br />
that you can use whenever you face the stress of exam-like situations in the future.<br />
The article is obviously about preparing for exams in economics but the principles and techniques can easily be adapted to any<br />
exam in any subject.<br />
A few ‘only you…’ home truths to kick off<br />
● Only you will sit for your own exams<br />
● Only you can revise for your own exams<br />
● Only you are responsible for your own life<br />
Get the point? Although articles like this can help, your final grade will ultimately be determined by your own efforts alone. This<br />
is, of course, as it should be. There is actually no big secret to exam success – if you adopt a sensible systematic approach to<br />
learning, you’ll do fine. Remember the cliché used by many sports coaches…<br />
FAILING TO PREPARE = PREPARING TO FAIL<br />
● Your own teacher remains the best source of advice about the subject matter and revision in general. Not only does your<br />
teacher have expert subject knowledge but she or he knows the specific exam requirements and also knows your own personal<br />
strengths and weaknesses.<br />
Initial self-assessment<br />
It is worth spending a few moments to reflect on how you currently approach study and revision. You may, of course, already have<br />
acquired a good understanding of the subject, your study skills may be very advanced and you may be well into a carefully<br />
structured, progressive and systematic revision programme.<br />
If that is so, great… keep going, much of what I have to say will probably appear very obvious to you. On the other hand you may<br />
not be in so fortunate a position; you may be feeling very apprehensive about the coming months; you may be feeling guilty and<br />
regretting a less than whole hearted attitude to work earlier in the course.<br />
If you have not really got into gear yet, the good news is that you are not alone and it is still not too late. There are many other<br />
students who have devoted less than 100% effort to their course. Assuming you have done some work during the course (you have<br />
done some work, haven’t you?) and have a reasonable, if somewhat superficial, understanding of the main ideas, you can still<br />
enjoy outstanding success this summer.<br />
The reality (here comes the bad news!!) is that success will not come without considerable sacrifice. Sorry, but at both A and AS<br />
level there is no substitute for hard work. If you postpone the inevitable much longer, it will be too late and you will either fail<br />
outright or fail to get the grade you need. Remember, if you are studying for AS exams but planning to carry on to A2 it is the mark<br />
not the grade that is important. Ask your teacher to explain this to you.<br />
The only place where success comes before work is in the dictionary<br />
However, hard work on its own may be insufficient, the work you do has to be of the right sort as well.<br />
Coping with exams – some general comments<br />
There are THREE fundamental features of effective study.<br />
1. Clearly established priorities and good organisation<br />
It is important to place all exams in context – these exams are important but they are not a matter of life and death. However, you<br />
have already spent a lot of time in classes and private study and the outcome of these exams has the potential to exert a powerful<br />
influence over the next few years of your life.<br />
Are you really clear on your priorities, are you really prepared to make that extra bit of effort and sacrifice to achieve success. Do<br />
you really want to succeed? “Of course I do” you will say. Do you? I often ask my students to put themselves to ‘the S-day 7 test’.<br />
Picture this, it’s seven o’clock in the morning on an S-day (Saturday or Sunday!!) – you are faced with the prospect of rolling<br />
over and having another two hours in bed or doing an extra two hours work – what do you choose to do? What about next<br />
week? The week after? Are you really so clear and focused on what you want to achieve that you are prepared to make the<br />
necessary sacrifices… consistently. What about if it’s seven o’clock on a Saturday night – would you be prepared to do some work<br />
and go out an hour later… or occasionally stay in and do revision work all evening? It is in these situations that you discover your<br />
<strong>Eco</strong>nomics <strong>Today</strong> Supplement – March 2010 Revision Guide 2010 1
eal priorities in life! Of course, if going out to have fun really is top of your list then that’s OK just don’t whinge about the<br />
consequences of this choice.<br />
If you really want to do something you’ll find a way… if you really don’t want to do something you’ll find an excuse<br />
So you must sort out your priorities and then get yourself and your life organised. You should treat your studies as a job and adopt<br />
a professional, disciplined approach to revision. So get into a regular pattern of working, this will help you to stay in control of<br />
events. Remember to allocate an appropriate amount of time to each of your subjects. You also need to give yourself breaks – so<br />
think about setting a certain amount of time aside for leisure or sporting activity, it will help you relax. Provided you are working<br />
conscientiously, you probably won’t have to stay in on a Saturday night to pass ‘the S-day 7 test’!!<br />
Life is like riding a 25 speed bike – most of us have gears we never use<br />
It might also be worth creating a vision or ultimate goal – where do you see success in this exam leading – a good job, three (or<br />
more) great years at university. Keep this private vision firmly in your mind (some people actually put it on a poster on their<br />
bedroom wall) – it will help you through days when morale is low.<br />
2. SUCCESS is an attitude of mind<br />
You need to get yourself psychologically prepared for SUCCESS. Exams produce anxiety and stress. There may be a lot of pressure<br />
on you to pass, to get certain grades or whatever. A certain amount of stress can be beneficial, but too much anxiety does not help,<br />
nor does fear, depression or constant self doubt. You can’t ignore these negative feelings but you can control them by preparing<br />
yourself effectively. So be positive in your self-talk, be positive in your actions and be positive in your dreams. Alter your attitude<br />
and you can alter your life.<br />
Losers visualise the costs of failure … winners visualise the benefits of success<br />
Also, don’t be misled into thinking that exams are a battle of wits with devious and malicious examiners who are trying to trip you<br />
up and are looking for any excuse to fail you. Quite the reverse is true – there are no trick questions. Of course, examiners set<br />
questions that test you… but questions that test you in a fair way. Every examiner is actually delighted to give well-prepared<br />
students high marks for their knowledge if it is relevant and effectively used.<br />
So, assuming you have done some work throughout the course, (you have done some work haven’t you?) your performance in the<br />
exams is determined by the quantity and quality of work you do particularly in the last 2-3 months. This should be reassuring –<br />
you were accepted onto the course because you had enough ability to pass; if you work correctly and conscientiously, you WILL<br />
do yourself justice in the exam. Of course, if you do not bother to do much work at all then you do not deserve to pass anyway<br />
and where will that lead you?<br />
What the wise do in the beginning… fools do in the end<br />
3. Planned, active, regular learning and testing<br />
Learning is more effective if it is undertaken over time with regular reviews and consolidation. So avoid last minute cramming –<br />
despite any ‘success’ you feel you may have enjoyed in the past using this approach. You will probably tire yourself out for the<br />
exam (or the next one!) and your anxiety level will increase and that will undermine recall in the exam room. Sure you will remember<br />
some material and of course if you have done no revision this last chance saloon technique may be all you’ve got. However, much<br />
will be forgotten and you will probably only be able to reproduce the material in a very list like manner which may not be what the<br />
question requires.<br />
So make sure that you spread your revision sensibly over time – the sooner you start working the better. Concentration spans are<br />
limited, so limit yourself to intensive bursts of between 35 and 45 minutes. Remember, to build in adequate breaks both between<br />
and at the end of study sessions. This will help you physically, intellectually and emotionally.<br />
You have to be active in your learning. Avoid just passive reading, rewriting or copying notes. Osmosis is actually one of the more<br />
ineffective revision techniques!!<br />
Even if you are on the right track, if you just sit there… you’ll get run over!<br />
During your revision programme, you must practise repeatedly the skills and activities that will be required in the exam. This means<br />
lots of self-testing and plenty of practise at recalling material and reorganising it in a coherent and relevant way.<br />
Remember – Practice does not make perfect it makes permanent<br />
So if you practise good techniques and important skills, these will be with you when you need them in the exam – you can be<br />
CERTAIN of that.<br />
Success is a science – if you create the right conditions, you get the right results<br />
The 4Ps of revising<br />
I like to think of any revision programme as being made up of the 4Ps.<br />
Planning, Preparing, Practising and Performing.<br />
Planning<br />
This is the stage where you get yourself and your material together to create the conditions and attitude of mind that allow you<br />
to focus clearly on the tasks in hand.<br />
1. Learn the Rules of the Examination Game<br />
In any sport or game, all the players have to acquire a reasonably good knowledge of the rules that will be applied. Very often those<br />
that have a detailed knowledge of the rules can place themselves at a big advantage. Exams are no different, you need to be very<br />
clear in your own mind about what it is that the examiners are looking for in answer scripts.<br />
All external exam questions that you will face this May/June have gone through an extensive process of checking and revising to<br />
make sure that:<br />
(i) they clearly fall within the scope of the written syllabus; and<br />
(ii) they are a fair examination of the academic skills of knowledge, understanding, analysis & evaluation.<br />
2 Revision Guide 2010 <strong>Eco</strong>nomics <strong>Today</strong> Supplement – March 2010
So get a copy of the syllabus from your teacher or directly from the exam board that is setting your examination. The syllabus<br />
shows the main concepts and terminology that you must be familiar with and the main skills (assessment objectives) and qualities<br />
that examiners are looking for in good answers. Ask your teacher to explain what these mean.<br />
This is really important. You must understand how different question commands require different styles of answer. How would<br />
you demonstrate the academic skills these directive words are seeking to elicit? On a large A3 sheet, draw up a grid like the one<br />
below – then complete it. Talk it over with your teacher and use this framework whenever you answer a question.<br />
Directive word These skills are being assessed… I can demonstrate this skill by…<br />
Describe<br />
State<br />
Compare<br />
Explain<br />
Analyse<br />
Discuss<br />
Comment upon<br />
To what extent<br />
Evaluate<br />
Assess<br />
Make use of material that is published by your exam board. The materials available for both A and AS levels are generally of very<br />
high quality so use them. Ask your teacher for a copy of recent Chief Examiner’s reports – these highlight the main strengths and<br />
weaknesses of answers to that year’s exam. Use these in conjunction with the relevant past paper to help you in your preparation<br />
and practise sessions. Some exam Boards publish graded samples of past exam scripts with comments by the Chief Examiner. These<br />
are useful to make you aware of how to get the best marks for your own answers by incorporating the key characteristics of good<br />
answers and avoiding the common mistakes of poor ones.<br />
2. Get your key resources organised<br />
Set aside a fixed place for study. Make sure it is reasonably quiet, well lit and relatively free of distractions. You need good<br />
ventilation, a desk or table large enough to spread out your materials and a chair that is comfortable but not too comfortable – you<br />
want to study not sleep remember Try to arrange the room or part of the room so that this place is clearly for study and nothing<br />
else – you may need your family’s support and co-operation here! After a while, if you are genuine in your intentions, your attitude<br />
and behaviour can be shaped by the little pre-study rituals and symbols to complement study and studying becomes the appropriate<br />
behaviour in that place. How about playing a favourite track that has an ‘inspirational’ effect on you before each session? Although<br />
it might sound a bit cheesy, my own students have regularly commented on how such an approach did have an important and<br />
positive psychological impact.<br />
Get your notes and essays ordered into topic areas. Class notes must be complete – you may have been absent on certain occasions<br />
so that there are gaps in your class notes – make sure these gaps are filled in thoroughly.<br />
Get hold of a copy of the text book that you feel most comfortable with. If you are thinking of buying a revision guide, I would<br />
strongly advise you to consult your teacher before parting with any cash. She or he will be able to identify which book, if any, is<br />
most suitable for your individual circumstances and your particular syllabus.<br />
Try to replicate exam conditions as much as possible. Although certain types of music can probably help to promote learning, at<br />
this stage, I’d advise you to work in a room that is free of distractions. Body posture is very important in maintaining your<br />
concentration and preventing drowsiness – so work at a table or desk with an upright chair with all your resources easily accessible.<br />
It often helps to go through a specific routine just before starting work since this can help to prepare you mentally for the work to<br />
be done. So turn on the CD, cue music and…<br />
3. Set yourself short, medium and longer term goals<br />
Setting clear, short term targets and longer term goals as part of a psychological contract with yourself is a very important aspect<br />
of the mental preparation for the task in hand. These goals should be clear, realistic yet demanding statements about what you are<br />
planning to learn. Try to write these down. You should then reward yourself when you have reached the target – go and do<br />
something you enjoy.<br />
Winners have two things… definite goals and a burning desire to achieve those goals<br />
So… draw up a revision programme based on the syllabus requirements and stick to it. You really should cover the whole syllabus.<br />
Remember multiple choice questions and data response questions can be drawn from any part of the syllabus. Even where you<br />
have a choice of questions, the more of the syllabus you cover, the better your chances of being in a position to answer the<br />
relatively straightforward questions that do appear each year. If your revision is very narrow you may be forcing yourself to answer<br />
questions that are quite tricky or worded in a more difficult manner… you know that Sod’s Law will prevail if you are very selective<br />
about the topics you choose to revise.<br />
4. Constructing Your Personal Revision Programme – some practical help<br />
Most students are aware of at least some of the points raised above but still find it very difficult to turn this advice into a plan of<br />
action. Below is an example of one possible revision programme for each day of a ‘typical’ two week Easter holiday. It focuses on<br />
AS basics and A2 microeconomics (excluding factor markets) and is similar to the one that my own students are usually given. It<br />
should be adapted to your own needs after consultation with your teacher.<br />
It IS challenging but it is NOT unattainable – it is structured, systematic and it includes complete time off. It does however require<br />
you to make considerable sacrifices over the Easter holiday. Of course, the extent to which you follow it depends on your own<br />
particular circumstances and how badly you want to succeed – remember the S-day 7 test.<br />
It does however give you a clearer idea of what has worked very well for Sixth Form students in the past.<br />
In times like these, it is worth remembering that there have always been times like these!<br />
<strong>Eco</strong>nomics <strong>Today</strong> Supplement – March 2010 Revision Guide 2010 3
Easter revision programme 2010<br />
● Get yourself into a positive frame of mind… YOU CAN DO IT<br />
● Break the syllabus down into manageable chunks and take each chunk in turn. The first four days activities are shown in more<br />
detail – complete the remaining days in a similar manner using the detailed information provided by your teacher or the exam<br />
syllabus itself.<br />
● If you are sitting A2 papers remember the need to review all of the course because of the so-called synoptic assessment that<br />
you will face – ask your teacher about this.<br />
● Before the holiday – get all your notes, textbooks, past papers etc. in order.<br />
Section 1<br />
Day Topic Area<br />
1 Basic ideas – scarcity, choice, opportunity cost<br />
PPF – shape/position<br />
<strong>Eco</strong>nomic systems – types/operation/strengths/weaknesses<br />
– transition economies<br />
2 Demand – theory of consumer behaviour<br />
– demand curve movements along/shifts in<br />
– elasticities of demand (PED, YED, XED)<br />
3 Supply – theory of costs (short run and long run)<br />
– supply curve movements along/shift in<br />
– elasticity of supply<br />
4 Supply & demand – equilibrium/disequilibrium<br />
– changes in equilibrium – causes/consequences<br />
– role of elasticities<br />
– ‘government’ intervention – tax/subsidy/price controls/buffer stocks etc<br />
5 Essay testing and final review of Section 1<br />
6 Break from study<br />
Section 2<br />
Day Topic Area<br />
7 Competitive and contestable markets<br />
8 Monopolistic and oligopolistic markets<br />
9 Review of all market structures<br />
10 Essay testing and final review of Section 2<br />
11 Break from study<br />
Section 3<br />
Day Topic Area<br />
12 Microeconomic policy – economic efficiency and market failure<br />
13 Microeconomic policy – ownership (privatisation/nationalisation) and competition<br />
14 Microeconomic policy – externalities/merit/demerit goods/public goods<br />
15 Essay testing and final review of Section 3<br />
● Draw up a further revision plan for factor markets, macroeconomics and international economics when you are in back in school<br />
or college.<br />
● Plan a final run-through of the whole course in the 2-3 weeks immediately before the exam.<br />
● Draw up a work programme for the period of the exams themselves.<br />
Preparation<br />
Throughout the programme, I would suggest that you allocate about two hours per day to each topic area and set some time aside<br />
for the final consolidation session. I would advise getting up early so that you get a good session before lunch.<br />
To get into the rhythm of the exam, it’s probably best to work for 40-45 minutes at a time since this matches the time that is usually<br />
available for essays in the final exam. Take a short but complete break of 5-10 minutes in between sessions.<br />
For example, the session on supply and demand (Day 4) could go something like this:<br />
8.00-8.45am Session 1 – Equilibrium/disequilibrium/causes of changes in equilibrium including government intervention.<br />
8.50-9.35 Session 2 – Elasticities and the effect of PED/PES on equilibrium changes.<br />
9.45-10.30 Session 3 – Test yourself on terminology/diagrams/essay plans or some multi-choice questions if appropriate.<br />
10.40-11.15 Final review – prepare final revision notes.<br />
11.15 onwards Do something completely different – play sport, have lunch, watch some TV.<br />
You could also adopt this format for your other A and AS levels. This would probably mean doing one subject in the morning, one in<br />
the afternoon and one in the evening. Remember, it’s very important to do something completely different before the afternoon or<br />
evening session – light physical activity is very beneficial in all sorts of ways; so go for a jog or walk until lunch or dinner time. This will<br />
be extremely hard at first but you will get into the swing of things… after all, you have to and many others have done it before.<br />
Backbone beats wishbone every time – nothing is more certain than the failure of the person who gives up!<br />
4 Revision Guide 2010 <strong>Eco</strong>nomics <strong>Today</strong> Supplement – March 2010
Active, Effective Preparation<br />
Remember that to be effective revision must be ACTIVE. It is the quality of the work that you do as well as the quantity that is<br />
important. It really is no use sitting in front of a book and reading with a wishful hope that something will stick.<br />
God gave us two ends; one to sit on and one to think with. Success depends on which one you use most<br />
A useful and effective approach is to go through each block of material from your notes or textbooks in a systematic way:<br />
(i) Survey or preview the material – skim through your notes and try to think why this particular section of the course is<br />
important; what aspect of the economy does it help you to understand. What do you already know about the topic? What<br />
additional understanding do you expect or need to get out of this section?<br />
(ii) Having set your mind up for the material, you should then read through your notes thoroughly. You will need a pen and paper<br />
for jottings. Diagrams are essential here to help focus on the key concepts that you need to understand. Jot down key words<br />
and definitions. Link points together to see how ideas develop and relate to each other.<br />
(iii) It is often more effective to read a passage two or three times relatively quickly than to read it once slowly. You can reinforce<br />
what you grasped the first time and you often find by moving on that the brain has a chance to work on the difficult part<br />
subconsciously. When you come back you will have seen the implications or extensions of the point and may be able to look<br />
at it from the other side and consider the idea in context.<br />
(iv) Put your notes to one side and test yourself. Repeat the key diagrams and write out your understanding of how they are<br />
derived and what they show. Jot down any areas that you realise still need attention. Open the book again and survey your<br />
notes to check on the accuracy. Repeat the process until you are satisfied that you have really grasped the ideas – don’t<br />
deceive yourself here.<br />
(v) Prepare a summary of the key points and diagrams in a memorable way on revision cards, tapes or wall chart. Be thorough in<br />
your initial revision noting but more imaginative, selective and original when creating the final version. Use plenty of colour<br />
and distinctive images. Many students find A3 wall-charts useful – the more bizarre the better. You can surround yourself with<br />
key ideas and walk around the room mentally rehearsing and reviewing the ideas.<br />
(vi) These memory aids will then be used for the final review sessions which will take place at the end of a topic block and should<br />
be repeated regularly right up to the final exam.<br />
Practice<br />
Examinations require you to recall information and to use it in new ways. Therefore most of your revision time must be spent:<br />
(i) proving to yourself that, without notes, you can recall the main theories and supporting evidence;<br />
(ii) re-organising, recombining and applying the material you have learned to answer specific and unseen questions.<br />
Realistic Practice<br />
Examiners unfortunately never set questions which ask you to “Write four sides on all that you know about supply” – why do you<br />
think that is? If you begin to think like an examiner you will start to answer in a more focused way.<br />
Irrelevant writing and a failure to adapt knowledge to the requirements of the specific question remain the biggest causes of exam<br />
under-performance. Last minute cramming and the rote-learning of model answers simply encourage your mind to absorb material<br />
in an inappropriate and usually irrelevant form… so don’t practise doing what will not be in the exam. Use model answers as a way<br />
of reviewing material, don’t try to memorise them; change the question title slightly – could you still cope?<br />
I repeat, practice doesn’t make perfect it merely makes permanent, so you must make sure that what you practise is both relevant<br />
and of a high quality. Remember that in the exam you are likely to face structured questions that are broken up into various<br />
sections; make sure that you practise writing answers which reflect the variety of questions you will face on the day.<br />
Practise interpreting the common question commands – remember some of these commands will not be used at AS level this<br />
summer because they will test skills that are not being tested at that level – check with your teacher on this. With that in mind,<br />
what is the difference between the following questions:<br />
● Define price elasticity of supply<br />
● How is PES calculated?<br />
● What are the key diagrams to illustrate the various values that PES can take?<br />
● What are the key determinants of PES?<br />
● What are the main applications of PES?<br />
● Go through the same questions for the various demand elasticities PED, XED, YED.<br />
● Essay practice – look back through past papers and select three or four questions on elasticity – have a go at each one – write<br />
out essay plans and try to write one in full.<br />
● Change the mark allocations for the questions you have found – how would different mark schemes affect your answer?<br />
Answer questions from past papers and refer to the comments in the Chief Examiner’s Report – plan, write and rewrite timed<br />
answers to the sort of questions you are likely to get both in full and in part especially on critical areas of the course. Review your<br />
work and rewrite if necessary – set yourself high standards. Life’s funny, if you refuse to accept anything but the best from yourself<br />
you very often get it!<br />
Certainly if you are going to have essay questions in your exam, you need to familiarise yourself with certain economic statistics<br />
(what do you think are likely to be the most useful statistics for the exam?). Remember that trends are probably going to be more<br />
useful than figures for one period of time. Get into the habit of reading the economics and business sections of at least one of the<br />
major Sunday papers. These will provide you with a good, topical range of micro and macro material which can be used also to<br />
practise data response techniques. Reading these articles gives you opportunities to recall and review what you have learned.<br />
Remember with every act of recall and review, your memory is reinforced<br />
<strong>Eco</strong>nomics <strong>Today</strong> Supplement – March 2010 Revision Guide 2010 5
Final review – links and different perspectives<br />
Turn your final review and testing sessions into opportunities to get a new view on the subject. Simulate the unpredictability of the<br />
exam by asking someone to choose your ‘test-essay’ from a selection of questions drawn from previous papers. This should help<br />
to discourage you from the ‘rote-learning’ approach – read through your answer or get a fellow <strong>Eco</strong>nomics student to do so. How<br />
did you answer the question? Be honest with yourself.<br />
Try to see how separate parts of the course can be linked together. You could use Post-it notes here – stick them on a wall and<br />
move them around to see how ideas can be linked to give the big picture. Force yourself to think how topical issues could form the<br />
base of new essay questions… then make sure you plan answers to those questions.<br />
Go though the articles in past copies of <strong>Eco</strong>nomics <strong>Today</strong> – pick out some exam related concept or diagrams. Take any article which<br />
mentions revenue. Then think of the opportunities this provides to revise a wide range of microeconomic principles.<br />
● Definitions of the various types of revenue – total, average, marginal<br />
● Diagram practice – can you draw diagrams to explain each of the above – when the firm is a price taker?<br />
– when the firm is a price maker?<br />
● Calculation practice – can you calculate each from a set of data?<br />
● Outline the factors that influence revenue.<br />
● Explain the usefulness of an understanding of revenue to a profit maximising company.<br />
● How is the concept of company revenue linked to wage theory?<br />
● What is the link between revenue and demand?<br />
● What is the link between demand and PED, XED and YED<br />
and marginal private benefit… marginal social benefit<br />
● Play around with different mark allocations for this question – how would different mark schemes affect the balance of<br />
your answer?<br />
Now do the same with costs, profit, market structures and so on. Then do macro! Think of the amount of varied revision that this<br />
offers. The scope for challenging and effective revision in this way is almost limitless – hard work I know but we are what we<br />
repeatedly do.<br />
Excellence is not an act, excellence is a habit<br />
Help each other- revision groups<br />
Working in isolation is pretty dispiriting even for the most determined student. Why not form a revision group so that you can learn<br />
from each other? In the past, students have found this sort of group work an excellent way of maintaining morale especially during<br />
the holidays when the first flush of rampant enthusiasm has turned a shade paler!!<br />
Even the ‘best’ benefit from having to explain ideas to their friends who may have not grasped ideas fully the first time around. So<br />
why not give it a go.<br />
● First of all, learn all you can on your own. Remember, the object of the study group is to share knowledge not ignorance. Identify<br />
tricky parts of the course and work through these together. Show each other your revision cards etc. and explain them – all of<br />
you will benefit.<br />
● Set yourself a few exam questions to discuss and then answer – this helps you to articulate and clarify your understanding and<br />
therefore reinforces learning. Each person could prepare a detailed essay plan for discussion – get each other to present their<br />
plan and subject each other to questions.<br />
● Review each others test answers… you will be staggered at how much progress you can all make if you work together.<br />
Sharing revision with others can actually be fun (well almost!!) and it helps you to keep a sense of proportion about the exam…<br />
you are not alone in your anxiety and working with others confirms how much progress you are actually making (and you WILL<br />
make progress).<br />
Performance<br />
This of course is what it is all leading towards. Your big chance to demonstrate what you know by answering the specific questions<br />
in a relevant and informed manner. Really, if you have worked consistently and conscientiously, the performance should not be an<br />
ordeal. You know your stuff, you’ve practised using your knowledge in a variety of ways, you can recognise and write answers to a<br />
range of specific commands and you know how to time and pace each essay so that you will avoid the crippling ‘last question<br />
syndrome’. If you are mentally and physically prepared… you know that you can cope.<br />
The day before the exam<br />
Use the last day sensibly. On the day before each exam check again the time and place. Make sure you have all the necessary<br />
materials (pens, pencils, rubber, ruler, calculator with spare battery, lucky mascot). Have a brief run through the top priority items<br />
again. Be very wary about doing any new learning at this late stage – it might simply block out things you have already studied.<br />
Break off studying well before bedtime and relax so that you don’t stay awake all night with an overactive mind.<br />
The day itself<br />
Everyone has their own set routine on the day of the exam. I would however advise you to take a tip from top athletes. Start to<br />
visualise yourself settling down to the exam a week or so before the exams start. Rehearse a set routine that you will follow<br />
at the start of the exam – set routines are calming. Although it seems a long time ago now, think back to England’s rugby world<br />
cup triumph. Look at how Jonny Wilkinson prepared for every place kick by going through exactly the same routine every time.<br />
If you are not a rugby fan, ask someone who is to demonstrate!<br />
Arrange to be woken up in good time so that you can get to the exam location early but not excessively so. Just before the exam<br />
I’d suggest that you keep yourself separate from others so as to avoid the energy-wasting, concentration-sapping nervousness of<br />
pre-exam silliness.<br />
Focus your mind clearly on the task in hand. Run through a couple of key ideas, I always used to take a few of my revision cards<br />
with me. Although this was often more for comfort than anything else, it was an important relaxation technique that worked for<br />
me. When you get into the room go through the set routine you’ve been visualising.<br />
6 Revision Guide 2010 <strong>Eco</strong>nomics <strong>Today</strong> Supplement – March 2010
The essay paper<br />
In terms of marks, this is usually a very important paper. Although at AS level, full essays do not feature, the skills, knowledge and<br />
understanding required to answer essay-type questions of any length are directly and indirectly relevant for the other papers you<br />
will sit too. In particular, in data response questions there will often be a longer question with more marks available, in effect, this<br />
becomes a mini-essay question.<br />
The main weakness on the essay paper can be divided into THREE categories. Think about how you can deal with each in turn.<br />
1. Poor exam technique<br />
Revealed by – Failure to answer fully the required number of questions<br />
– Failure to answer all parts of the question<br />
– Failure to allocate time and effort in line with the mark allocation (which is usually stated)<br />
– Failure to identify the key skills that are being tested. These are usually revealed by the question command –<br />
describe, compare, explain, analyse, discuss, evaluate, assess etc.)<br />
Make sure you know your exam board’s main command words.<br />
2. Poor subject knowledge<br />
Revealed by – Limited or inaccurate reference to economic theory<br />
– Poor or non-existent definitions<br />
– Poor or non-existent diagrams<br />
– No context, examples or factual support<br />
3. Poor writing technique<br />
Revealed by – Poor reference to key question commands<br />
– Incoherent structure with no clear beginning, middle or conclusion<br />
– Clumsy or ambiguous expression – bluffing/evasive answers are easily spotted<br />
– Points only listed often in a fragmented or random and thoughtless manner<br />
– Inaccurate or, at times, contradictory expression<br />
– Assertions rather than explanations (are you clear of the difference?)<br />
Key points<br />
● Following a pre-set routine before the exam helps keep you calm and in control… there will be questions that you<br />
can do.<br />
● Read the question paper THOROUGHLY.<br />
● Select your questions carefully.<br />
● Make sure you take notice of questions that have subsections – usually mark allocations will have been indicated and<br />
these of course should be reflected in your time allocation.<br />
● Don’t write out the whole question but identify and underline key words (terms and commands). Plan your answers –<br />
what economic theory do you need? – what diagrams do you need?<br />
● Your plan and answer will develop as you proceed and the ideas start to flow but remember to stick to your basic outline<br />
and try to be coherent and consistent.<br />
● Answer the specific question set – really you will get more credit if you attempt to do this rather than simply write<br />
wildly however many pages you cover.<br />
● Start the essay with precise, relevant definitions.<br />
● USE RELEVANT ECONOMIC THEORY WHENEVER YOU CAN.<br />
● Try to support your comments with a few relevant examples or statistics.<br />
● Try to finish with a conclusion that adds something to the essay and is not simply a summary.<br />
● Be very strict about the time allocation. Remember extra minutes extending the answer to one question are unlikely to<br />
gain you much extra credit; far better to get on and write fuller answers to the remaining questions.<br />
The data response paper<br />
This is usually the most unpredictable part of the overall exam but remember that the ability both to collect and interpret data is<br />
a critical skill for economists. Data, of course, can be in numerical form (perhaps a set of statistics) or verbal form (perhaps an<br />
article from a newspaper) or a combination of both. Use the Data Response in past copies of <strong>Eco</strong>nomics <strong>Today</strong> to help you.<br />
The main weaknesses displayed in this paper can be divided into THREE categories. How you could deal with each one?.<br />
1. Poor subject knowledge<br />
Revealed by – a reluctance to use economic theory to substantiate observations or bolster explanations<br />
– a superficial grasp of terminology and theory<br />
– poor awareness of the role that diagrams can play in aiding explanation to data response questions<br />
2. Poor awareness of basic ‘statistical’ techniques<br />
Revealed by – a lack of confidence in dealing with numerical data<br />
– an inability to detect patterns, trends and trends within trends<br />
– confusion over – relative and absolute changes<br />
– real and nominal values<br />
– correlation and causation<br />
– poor numerical understanding especially when calculating % changes/ratios<br />
3. Poor exam technique<br />
Revealed by – a failure to allocate time and effort in line with the available marks<br />
– weak writing style<br />
– excessive use of clichés, journalistic or conversational language<br />
– a lack of confidence to relate theory to the evidence provided<br />
<strong>Eco</strong>nomics <strong>Today</strong> Supplement – March 2010 Revision Guide 2010 7
Key points<br />
● If the question contains numerical data make sure you look very closely at the source of the data, the units of measurement<br />
employed and the time span of the data.<br />
● Try to identify general trends and trends within the trends.<br />
● Do some calculations – percentage changes help you to get a feel for the data.<br />
● Don’t confuse variations in rates of change with variations in absolute levels (e.g. falling inflation is not the same as falling<br />
prices).<br />
● Try to identify the key aspects of economic theory that the examiner is testing and use that theory. Although common<br />
sense helps, this is not a general knowledge paper – your answers must contain economic terms, concepts and diagrams.<br />
● You must answer the specific question set and allocate your time sensibly in line with the mark allocation.<br />
● Define economic terms precisely.<br />
● Practise interpreting data regularly.<br />
● Don’t forget to practise using your calculator and make sure you take it to the exam.<br />
The multiple choice and supported choice papers<br />
The best way to improve your performance on this paper once again is through regular practise of past questions, coupled with a<br />
fairly detailed investigation of the theory underlying questions you get wrong – see Robert Nutter’s regular feature on multiple<br />
choice in each <strong>Eco</strong>nomics <strong>Today</strong>. Very high marks (90-100%) are obtained quite frequently on the multiple choice paper and you<br />
can boost your overall grade quite sharply if you are prepared to make the effort to get this style of questioning sorted.<br />
Experience suggests the following factors contribute significantly to unnecessarily poor performance on this paper:<br />
1. Narrow and superficial revision with too much emphasis during revision/practice on memory rather than<br />
understanding<br />
Revealed by – an excessive amount of guessing<br />
– an inability to reason through questions on basic concepts that are presented in a novel way<br />
2. Misreading the question and/or the various responses<br />
Revealed by – a lack of concentration when reading questions and response options<br />
– easy marks thrown away because of silly errors and mistakes on straightforward questions<br />
3. Unwillingness to think in detail about questions that require detailed analysis<br />
Revealed by – large numbers of incorrect answers to questions that test applications of theory or policy issues<br />
– panic and wild guess responses to questions that involve numerical calculations or diagram interpretation<br />
Key points<br />
● Read each question carefully, look closely at the diagrams.<br />
● Try to work out the answers before looking at the options offered.<br />
● Use spare paper to rough out diagrams, calculations or your thoughts.<br />
● Make sure you think carefully about the theory if you have to give a reason for your answer in a supported choice exam.<br />
Write clearly using correct terminology.<br />
● Move on if you can’t answer a question. Give yourself a maximum amount of time per question – do all those that you<br />
can and mark those that you can’t and then come back – you should have time.<br />
● Make sure you answer every question – most Boards do not penalise candidates for wrong answers so if there are a few<br />
that really beat you then eliminate the options that you know are wrong and make a sensible guess.<br />
● Practise, practise, practise multiple choice questions – it really will pay off.<br />
● Don’t forget to practise using your calculator and make sure you take it to the exam.<br />
● Make sure you follow the instructions about what to do if you make a mistake and want to change an answer.<br />
Don’t look back – no post mortems<br />
After the exam do not get involved in post mortems. The exam is over and there is nothing you can do about it. Omissions or<br />
mistakes remembered in retrospect tend to be exaggerated anyway. Relax for a short while before preparing for the next exam.<br />
My students tell me that there is at least one more P… the<br />
destination en masse of almost all of the students immediately after<br />
the final exam. Enjoy your celebrations in June… OK perhaps your<br />
behavioural intent at this stage reveals at least one more P ;-)<br />
More importantly enjoy your celebrations in August when the results<br />
are released.<br />
YOU CAN DO IT<br />
I am a great believer in luck… funnily, the harder I work the luckier,<br />
I seem to get.<br />
With a sensible approach to preparation, you will also make your<br />
own luck in the exam and…<br />
…YOU WILL DO IT.<br />
So… GOOD LUCK.<br />
May you get the grade you deserve.<br />
8 Revision Guide 2010 <strong>Eco</strong>nomics <strong>Today</strong> Supplement – March 2010<br />
© <strong>Eco</strong>nomics <strong>Today</strong> Ltd. ‘Revision Guide 2010’ is a free supplement published with the March 2010 issue of <strong>Eco</strong>nomics <strong>Today</strong>.<br />
<strong>Eco</strong>nomics <strong>Today</strong> Ltd., Stocksfield Hall, Stocksfield, Northumberland NE43 7TN.
Answers<br />
1. The recession is associated with falling incomes and thus<br />
the recent rise in demand for road atlases suggests that<br />
they are an inferior good. The fall in demand for sat nav<br />
systems during a recession indicates that they are a<br />
normal good, particularly as sat nav systems enjoyed<br />
rising demand when the economy was enjoying strong<br />
growth a few years ago. Sat nav systems are a more<br />
expensive substitute for road atlases and thus their cross<br />
elasticity relationship is positive and the answer is C.<br />
2. A producer subsidy will shift the supply curve to the right<br />
as it will reduce the net production costs of firms in the<br />
industry. The subsidy per unit given to producers is the<br />
vertical distance between the two supply curves. Hence<br />
from the diagram it can be seen that the subsidy is 20p<br />
per unit. The subsidy is given on each unit produced and<br />
thus the total subsidy paid out will be 20p x 120 which is<br />
£24 and thus C is the answer.<br />
3. A fall in the value of the pound makes UK exports cheaper<br />
so US firms buying components from the UK will benefit<br />
as will US firms buying assets such as property and shares<br />
in the UK which will now be cheaper in terms of dollars.<br />
UK firms earning foreign currency such as dollars and<br />
euros from their overseas subsidiaries will find that a<br />
depreciation of the pound will result in the same foreign<br />
currency earnings converting to more in terms of pounds.<br />
However, UK citizens living abroad will find that their<br />
pensions paid in sterling will convert to fewer dollars and<br />
euros hence reducing their living standards. The answer is<br />
thus A.<br />
4. A profit-maximising firm will produce where marginal<br />
revenue (MR) equals marginal cost (MC). The firm’s level<br />
of output is below minimum average cost and thus it is<br />
productively inefficient and as price is above marginal cost<br />
it is allocatively inefficient. The firm is making only normal<br />
profit because average cost (AC) equals average revenue<br />
(AR) at the equilibrium level of output. The firm is operating<br />
at its long run equilibrium. The answer is thus D.<br />
5. As shown in the diagram below the long run aggregate<br />
supply curve is vertical when the economy produces with<br />
unemployment at its natural rate. If the natural rate of<br />
unemployment fell as a result say of the successful<br />
implementation of supply-side policies the long run<br />
aggregate supply curve would shift to the right not the<br />
left. The answer is thus E.<br />
Price<br />
Level<br />
LRAS<br />
LRAS1<br />
0<br />
Y<br />
Y1<br />
Real GDP<br />
6. The real exchange rate is the rate at which a country can<br />
trade its goods and services for goods and services of<br />
another. This means it measures the price of a basket of<br />
goods available domestically (UK price index) relative to a<br />
basket of goods and services available abroad (Import<br />
price index). The equation used to calculate the real<br />
exchange rate is<br />
Nominal exchange rate x UK price index<br />
Import price index<br />
Sat nav systems will have a positive cross elasticity with road atlases.<br />
Any changes in the nominal exchange rate (depreciation<br />
or appreciation) of the pound and/or changes in relative<br />
price levels will thus affect the UK’s price competitiveness.<br />
The answer is thus B.<br />
M ARCH 2010 21
What are the Arguments For<br />
and Against Free Trade and<br />
Protectionism?<br />
Gary Phillpott, Head of<br />
<strong>Eco</strong>nomics and Business<br />
Studies, Shrewsbury<br />
International School,<br />
Thailand, reviews the<br />
benefits of international<br />
exchange and whether<br />
protectionism can ever<br />
be justified.<br />
Key words<br />
Comparative advantage<br />
Infant industry argument<br />
Deadweight welfare loss<br />
Dumping<br />
Exam Board AS Unit A2 Unit<br />
AQA ✓ 4(3.4.3)<br />
Edexcel ✓ 4(4.3.2)<br />
OCR ✓ F582 ✓ F585<br />
WEJC ✓ EC2(D) ✓ EC4(D)<br />
CCEA ✓ A2(2)<br />
Int. Bacc. Standard 4.1 and 4.2<br />
Cambridge International <strong>Eco</strong>nomics<br />
Pre-U<br />
(a) and (c)<br />
22 M ARCH 2010
For as long as economic issues have been debated, few have proven to be<br />
more explosive or divisive than the free trade versus protectionism argument.<br />
The Boston Tea party in 1773 that helped to spark the American Declaration<br />
and War of Independence was the result of a trade dispute over tea between<br />
Britain and the American Colonies. Some sixteen years ago, a different kind<br />
of ‘war’ broke out between the USA and EU. This time the issue was<br />
protectionism in the trade for the humble banana. The so-called ‘Banana<br />
War’, the EU’s longest-running trade dispute according to the BBC, was<br />
finally ended in December 2009 after lengthy negotiations. Why are these<br />
issues such contentious ones? To understand this we first need to be clear<br />
how protectionism is a departure from free international trade. The latter<br />
implies that there is no government intervention in the free flow of goods and<br />
services between countries. Protectionism involves the introduction, by<br />
governments, of trade barriers such as tariffs, quotas, domestic subsidies<br />
and administrative controls.<br />
The case for free trade<br />
T<br />
he arguments in favour of free<br />
trade are powerful ones. Life<br />
without trade would be possible<br />
but certainly far less pleasurable.<br />
International trade allows Alaskans to<br />
enjoy mangoes, and the citizens of<br />
Ireland to travel in petrol-driven cars.<br />
Choice is increased along with the<br />
quality of life. Free trade also increases<br />
competition, forcing producers to be<br />
more efficient, more aware of consumer<br />
wants and more conscious of the need<br />
to keep costs and prices down. By<br />
opening up larger potential markets,<br />
international trade also allows for mass<br />
production thus realising economies of<br />
scale and, again, lower prices.<br />
If a country has a surplus of a product<br />
and another a shortage, international<br />
trade allows these imbalances to be<br />
corrected to the benefit of both. In this<br />
way, US grain surpluses were sold to the<br />
USSR even at the height of the Cold War.<br />
There is also a substantial body of<br />
evidence to suggest that trade can pro -<br />
mote economic growth and develop -<br />
ment. Growth in the Asian Tigers<br />
(Singapore, Taiwan, S. Korea and Hong<br />
Kong) was fuelled, at least in part, by<br />
exports. India and China are the best<br />
recent examples of countries that<br />
started with relatively protectionist trade<br />
policy regimes in the 1980s but subse -<br />
quently achieved accelerating growth<br />
while opening up their economies. From<br />
the mid-1950s through the mid-1970s,<br />
industrial countries also enjoyed rapid<br />
growth while reducing their high post-<br />
World War II trade barriers and embrac -<br />
ing new technologies. Japan offers the<br />
most dramatic example, but countries<br />
such as Denmark, France, Greece, Italy<br />
and the Netherlands showed similar<br />
patterns.<br />
Another commonly used argument is<br />
that trade brings countries closer<br />
together. John Keynes (although he<br />
certainly dabbled with protectionism)<br />
was generally of the opinion that free<br />
trade was likely to make the world a safer<br />
place. As someone who experienced<br />
both World Wars and their aftermaths,<br />
his advice should probably be taken<br />
seriously.<br />
However, and in economics there is<br />
always a ‘however’, although these are<br />
all strong arguments in favour of inter -<br />
national trade, are they sufficient for us<br />
to argue in favour of free international<br />
trade? For this, we must also consider<br />
the advantages of international special -<br />
isa tion and the Laws of Absolute and<br />
Comparative Advantage.<br />
Comparative advantage<br />
Specialisation, of course, is everywhere<br />
and usually taken for granted. You would<br />
no more want to see me, as an<br />
economist, turn up to give you an A Level<br />
Physics lesson than I would want my<br />
Growth in Singapore, and the other Asian Tigers,<br />
has been fuelled by exports.<br />
bank manager to do my root canal<br />
surgery. Internationally, the argument for<br />
specialisation is based upon the Laws of<br />
Absolute and Comparative Advantage.<br />
The Law of Absolute Advantage was first<br />
formulated by Adam Smith in 1776 in<br />
The Wealth of Nations and states that<br />
countries should specialise in the<br />
production of products in which they<br />
are most cost efficient. The Law of<br />
Comparative Advantage was first<br />
formulated by the economist David<br />
Ricardo in 1816 (probably in the first two<br />
weeks of October if you want to be<br />
precise!) and shows that even if a<br />
country is more efficient at producing<br />
everything, it may still be beneficial for<br />
specialisation and trade to take place.<br />
There is not sufficient scope in this<br />
article to give a detailed explanation of<br />
these ideas, but one important<br />
implication is worth thinking about.<br />
The consumption possibility curve<br />
allows us to show how a country that<br />
specialises and trades internationally<br />
can increase its level of consumption<br />
compared with a situation in which it is<br />
self-sufficient. Assuming only two<br />
goods, let us consider the following<br />
production possibilities for the UK (see<br />
Table 1). This can also be illustrated<br />
using a Production Possibility Curve, as<br />
shown in Figure 1. If the UK produced<br />
both products itself it could produce and<br />
consume any combination on AB, its<br />
PPC.<br />
Now imagine that the UK has a<br />
comparative advantage in wheat<br />
production and specialises in this – it is<br />
now producing 1200 units of wheat and<br />
no cars (it is producing at point A on<br />
Figure 1). However, if it can export wheat<br />
and import cars from the rest of the<br />
world at an exchange rate of, for<br />
M ARCH 2010
Wheat<br />
(1200)<br />
A<br />
Wheat<br />
Exports<br />
(750)<br />
450<br />
Maximum quantity of cars<br />
that can be produced<br />
Car Imports (250)<br />
B<br />
(200)<br />
example, 3 units of wheat for 1 car, it can<br />
consume any combination on line AC<br />
(the consumption possibility curve).<br />
Taking an extreme example, if it exported<br />
ALL of its wheat (1200 units) it could<br />
import 400 cars (point C in Figure 1).<br />
More likely, of course, it will export some<br />
wheat and import some cars. For<br />
example, if it exported 750 units of<br />
wheat, it could import 250 cars in<br />
exchange (shown by point Y on the<br />
consumption possibility curve).<br />
Is there a case for<br />
protectionism?<br />
With all of this evidence building up in<br />
favour of free international trade is it<br />
possible to make a plausible case for the<br />
introduction of tariffs, quotas and other<br />
trade barriers? Given that all govern -<br />
ments use at least some protectionist<br />
policies must we assume that they are<br />
not aware of the economic case for free<br />
trade?<br />
Certainly it would be courageous to<br />
argue that free trade is good for<br />
everyone. One ground for trade barriers<br />
is the well-known Infant Industry<br />
Argument. The case is that new<br />
industries, with the potential to achieve<br />
a competitive cost advantage in the<br />
future, may need temporary protection<br />
from foreign competition. This argument<br />
is regularly used to support protectionist<br />
policies in less developed economies,<br />
alongside the view that tariffs, by<br />
Table 1<br />
Figure 1: The consumption possibility curve<br />
Y<br />
250<br />
encouraging expenditure switching to<br />
domestically-produced goods, can lead<br />
to faster industrialisation and a more<br />
diversified economic base. Note, how -<br />
ever, the use of the word ‘temporary’.<br />
Once introduced, trade restrictions can<br />
be difficult to do away with, especially if<br />
the protected industries have a powerful<br />
political lobby.<br />
Trade barriers are also regularly<br />
introduced to protect jobs. The fact that<br />
they invariably destroy others, though<br />
more indirectly, is usually ignored. A few<br />
hundred high profile jobs saved have a<br />
higher political profile than a similar<br />
number invisibly lost. The economist<br />
Abba Lerner (the Lerner theorem)<br />
Price<br />
Pw+t<br />
Pw<br />
Maximum units of wheat<br />
that can be produced<br />
UK 200 OR 1200<br />
C<br />
(400)<br />
A B C D<br />
Q1<br />
Cars<br />
Figure 2: The welfare effects of a tariff<br />
Q2 Q3 Q4<br />
showed in 1936 that a tariff on imports is<br />
exactly equivalent to a tax on exports.<br />
As the British economist Joan Robinson<br />
noted, just because others throw rocks<br />
into their harbour, that is no reason to<br />
throw rocks into our own. Nevertheless,<br />
in September 2009, President Obama<br />
made the decision to impose tariffs on<br />
Chinese tyres after warnings from union<br />
workers about job losses, and the EU<br />
has recently extended tariffs on Chinese<br />
shoes for much the same reason.<br />
Another argument in favour of trade<br />
barriers is to prevent dumping which is<br />
the selling of imports at prices that are<br />
below production costs, so undermining<br />
domestic producers. This sounds like a<br />
powerful argument, except that it can be<br />
difficult to decide if the low prices are<br />
really the result of dumping or simply an<br />
absolute advantage on the part of the<br />
exporting country. There may also be<br />
health and safety reasons for restricting<br />
trade, as with concerns over the safety<br />
of chicken products during the peak<br />
of the bird flu crisis in 2004 and<br />
the strategic argument that certain<br />
industries, such as steel and armaments,<br />
are essential to a country’s security.<br />
Overall then, there may appear to be<br />
some plausible arguments in favour of<br />
trade restrictions, especially for less<br />
developed economies. Tariffs, for<br />
example, may be instrumental in saving<br />
jobs, aiding new industries and promot -<br />
ing industrialisation and diversification.<br />
It sounds rather too good to be true, and<br />
indeed it is!<br />
Why are tariffs undesirable?<br />
In an international market, domestic<br />
consumers can purchase goods from<br />
either domestic or foreign suppliers. We<br />
are assuming here that an infinite<br />
Domestic<br />
Supply<br />
World Supply<br />
with Tariff<br />
World Supply<br />
Domestic<br />
Demand<br />
Quantity<br />
24 M ARCH 2010
There are a number of arguments for trade barriers but can they be justified?<br />
number of foreign goods can be<br />
purchased at a constant world price Pw<br />
in Figure 2. This means that the world<br />
supply curve for the product is perfectly<br />
elastic at price Pw.<br />
With no tariff (world price Pw),<br />
domestic supply is Q1 and domestic<br />
demand is Q4. The difference is met by<br />
imports (Q1-Q4). The introduction of a<br />
tariff effectively raises the world price to<br />
Pw+t. Domestic supply expands to Q2,<br />
while demand contracts to Q3. With the<br />
tariff, the level of the imports is Q2-Q3. If<br />
there is no retaliation by other countries<br />
(and this may be assuming a great deal),<br />
this fall in imports may reduce a current<br />
account deficit.<br />
However, the rise in price reduces the<br />
level of consumer surplus by the area<br />
A + B + C + D. Not good for domestic<br />
consumers, especially if hard pressed by<br />
recession. On the other hand, although<br />
consumer welfare has been reduced,<br />
domestic producers and the government<br />
both benefit from the tariff. Producer<br />
surplus has increased by area A, and the<br />
government receives revenue from the<br />
tariff equal to area C. This is calculated<br />
by multiplying the tariff by the level of<br />
imports Q2-Q3.<br />
Part of the fall in consumer surplus is<br />
not compensated for by gains to any<br />
other group in the economy. It is<br />
common, then, to regard areas B and D<br />
as deadweight welfare losses to the<br />
economy as a whole. However, the<br />
expansion in domestic output means<br />
that producers also receive area B in the<br />
form of higher revenue so the dead -<br />
weight loss could be argued to be area<br />
D alone.<br />
Whichever approach we take, there is<br />
an overall loss of welfare to the economy<br />
Key terms<br />
and questions of equity (fairness) may<br />
have to be considered and weighed to<br />
justify this loss.<br />
What conclusions<br />
might be drawn?<br />
There would appear to be a formidable<br />
economic case for free international<br />
Absolute Advantage – This describes a situation in which, for a given set<br />
of resources one country can produce more of a particular good or service<br />
than another country.<br />
Comparative Advantage – If a country has an absolute advantage in<br />
producing both goods (in a two good example) it should specialise in the<br />
production of the good in which it has the greatest advantage.<br />
Consumption Possibility Curve – This shows all possible levels of<br />
consumption that are available to a country if it specialises on the grounds<br />
laid down by the Law of Comparative Advantage.<br />
Deadweight Loss of Welfare – In the context of the imposition of tariffs,<br />
this is the net loss of welfare to the country concerned. It is the difference<br />
between the welfare loss to domestic consumers from price increases (a<br />
reduction in consumer surplus) and the welfare gain to domestic producers<br />
(an increase in producer surplus) and the government (tax revenue<br />
increases).<br />
Infant Industry Argument – The argument that newly-formed industries,<br />
with the potential to achieve an absolute or comparative advantage in the<br />
future, should be temporarily protected from overseas competition.<br />
Dumping – The selling of goods in an overseas market at a price below the<br />
cost of production.<br />
M ARCH 2010 25
trade. Indeed, the WTO (previously<br />
GATT), has spent the past 65 years<br />
encouraging nations to reduce trade<br />
barriers through a series of rounds of<br />
talks. The last US president, George<br />
Bush, pledged that:<br />
of welfare to the country concerned,<br />
might they still be justified in terms of<br />
equity/fairness?<br />
4. Research and evaluate the argu -<br />
ments involved in (a) the ‘Banana<br />
War’, (b) President Obama’s decision<br />
to impose a tariff on the import of<br />
tyres from China.<br />
5. Is it necessarily correct to say that<br />
the imposition of a tariff will improve<br />
the balance of payments on current<br />
account?<br />
❝The United States is ready to<br />
eliminate all tariffs and subsidies<br />
and other barriers to the free flow of<br />
goods and services as other nations<br />
do the same.<br />
On 1 January 2010, China joined South<br />
East Asia to create a free-trade zone with<br />
a population of 1.9 billion people.<br />
Nevertheless, trade disputes abound<br />
and the current round of WTO talks, the<br />
Doha Round which began in 2001, still<br />
has no end in sight. Special circum -<br />
stances continue to provide govern -<br />
ments with grounds for the use of<br />
protectionist policies. For example, in<br />
November 2009, the USA imposed tariffs<br />
on Chinese oil well pipes, citing the antidumping<br />
argument. In your answers, the<br />
examiners will expect you not only to<br />
outline the arguments for and against<br />
free trade and protectionism, but to<br />
evaluate the relative strengths of these<br />
arguments.<br />
Assessing the welfare losses that<br />
result from protectionism is, of course,<br />
far from easy. However, one study has<br />
estimated that a 40% reduction in all<br />
tariffs would result in an annual increase<br />
in global GDP of $70 billion, and that<br />
around 75% of this would accrue to less<br />
developed countries. A US study has<br />
suggested that trade barriers of all kinds<br />
are costing its citizens as much as<br />
$19 billion a year in higher prices.<br />
Another study argues that agricultural<br />
subsidies in the EU, aimed largely at<br />
discouraging imports, cost $360 billion<br />
per year, ‘enough to send all of the<br />
56 million cows in the EU around the<br />
world on a first class airline ticket each<br />
year’.<br />
Questions for discussion<br />
1. What questions might we ask about<br />
the study that suggests that a 40%<br />
cut in tariffs would raise global GDP<br />
by $70 billion per annum?<br />
2. Evaluate, in greater detail, one of the<br />
arguments raised in the article in<br />
favour of protectionism.<br />
3. Although economic theory suggests<br />
that tariffs result in a deadweight loss<br />
Summary of key points<br />
There are overwhelming economic arguments in favour of free<br />
international trade, most notably those based upon specialisation and<br />
the Laws of Absolute and Comparative Advantage.<br />
A country that specialises in the production of products in which it<br />
has a comparative advantage can consume beyond its production<br />
possibility curve, as illustrated by the concept of the consumption<br />
possibility curve.<br />
Arguments in support of protectionist policies such as the infant<br />
industry argument, the industrialisation and diversification argument,<br />
the job protection argument and the anti-dumping argument, although<br />
superficially plausible, are generally flawed in economic terms.<br />
Despite the energies and achievements of the WTO and the increase in<br />
the number and size of Free Trade Areas, trade disputes involving<br />
protectionist policies continue to abound.<br />
There is an ever growing body of evidence to show that significant<br />
increases in global welfare would result from further reductions in<br />
barriers to free trade.<br />
with Chief Examiner,<br />
Robert Nutter<br />
1. The ‘Buy American’ clause in the $800bn (£567bn) economic recovery<br />
package introduced by President Obama in early 2009 caused controversy<br />
in the European Union.<br />
Investigate the details of the clause and why the EU were so opposed to it.<br />
http://news.bbc.co.uk<br />
2. China and the Association of South-East Asian Nations (ASEAN) established<br />
the world's biggest free trade area in December 2009, covering a market of<br />
1.7 billion consumers.<br />
(i) Investigate the key principles and objectives of ASEAN.<br />
(ii) What are likely to be the economic benefits of China’s agreement with<br />
ASEAN?<br />
http://www.aseansec.org<br />
3. All members of the European Union (EU) are members of the European<br />
<strong>Eco</strong>nomic Area (EEA) but there are some non-EU countries in the EEA.<br />
Research the origins of the EEA and why countries such as Norway are<br />
EEA members but not members of the EU.<br />
http://en.wikipedia.org/wiki/European_<strong>Eco</strong>nomic_Area<br />
4. Mercosur was created in 1991 by the Treaty of Asuncion and encompasses<br />
four Latin American countries: Argentina, Brazil, Paraguay and Uruguay.<br />
Investigate the aims and objectives of Mercosur.<br />
en.wikipedia.org/wiki/Mercosur<br />
26 M ARCH 2010
Key words<br />
Gross domestic product<br />
Deflation<br />
Output gap<br />
Aggregate demand and supply<br />
Commodity prices<br />
The Prospect Ahead:<br />
Deflation or Inflation<br />
Quintin Brewer, a Chief Examiner and teacher at North London Collegiate School,<br />
considers a data response question concerning the prospects for deflation or inflation.<br />
A<br />
s the UK and world economy moves out of recession and into recovery in<br />
2010, there is discussion about whether there is a danger of deflation or a<br />
likelihood of inflation. Obviously, this has important implications for monetary<br />
policy, in terms of decisions made by the Bank of England’s Monetary Policy<br />
Committee with regard to both interest rates and its policy of quantitative easing.<br />
Much of this is highly topical and you should remember that examiners are always<br />
impressed by those candidates whose responses reflect understanding of current<br />
economic issues together with an ability to apply relevant economic theory in<br />
discussing them.<br />
N.B. Although much of the material is relevant to AS, some of the answers would only be covered in your A2 course.<br />
Extract 1: The danger of deflation<br />
Reduced spending by consumers and an extended period of high unemployment mean that there is likely to be a continuation<br />
of the negative output gap (see Figure 1). In the USA that gap has been estimated to be between 8% and 10% while in the<br />
UK, it has been estimated to be over 3%. This is likely to result in significant competition for sales and for jobs and so place<br />
a downward pressure on prices. In the UK’s case the output<br />
Figure 1: The output gap and unemployment in the UK<br />
gap is bigger than in the recessions of 1981 or 1991 which led<br />
10.0<br />
to inflation falling by more than six percentage points. A<br />
repetition of these experiences would result in deep deflation.<br />
7.5<br />
It will take a considerable time to absorb the enormous<br />
surplus labour and production capacity created by the most<br />
severe recession since the 1930s. Wage rate growth has been<br />
subdued and there has been a decline in the average hours<br />
worked. Until production and employment grow enough to<br />
push up wages the most serious concern will be deflation<br />
5.0<br />
% 2.5<br />
0<br />
Unemployment<br />
rather than inflation.<br />
-2.5<br />
In conclusion, the consensus view is that there is much<br />
Output Gap<br />
slack in the economy. With factories facing lower orders,<br />
-5.0<br />
producers will not raise prices and workers will not demand<br />
’88 ’90 ’92 ’94 ’96 ’98 ’00 ’02 ’04 ’06 ’08 ’10 ’12<br />
higher wages.<br />
Source: tutor2u.net Unemployment – claimant count measure<br />
Extract 2: The threat of inflation<br />
There are several reasons for questioning the view that deflation is a real danger, the first of which is that the authorities<br />
slashed interest rates to 0.5% in March 2009 (see Figure 2) while also embarking on a programme of quantitative easing<br />
which effectively increases the money supply.<br />
Secondly, the UK’s fiscal deficit is heading for nearly 13% of<br />
GDP and the national debt is increasing at an alarming rate.<br />
Several other factors also suggest that inflation might be a<br />
problem in the future.<br />
Thirdly, rising commodity prices in 2009 coupled with the<br />
weakness of sterling have increased inflationary pressures.<br />
Fourthly, UK inflation is increasingly affected by international<br />
inflation so the UK’s output gap is less significant than the<br />
global output gap. The rapid recovery in other economies,<br />
especially those in emerging markets and in developing<br />
countries, implies that the global output gap is falling even if<br />
the output gap in the UK is not.<br />
A further factor is that the surplus labour implied by the<br />
increase in unemployment may not result in falling wages<br />
because those out of work tend to be younger and less<br />
experienced than those with jobs.<br />
Figure 2: Bank of England interest rates, Aug 2008-Jan 2010<br />
%<br />
6.0<br />
5.5<br />
5.0<br />
4.5<br />
4.0<br />
3.5<br />
3.0<br />
2.5<br />
2.0<br />
1.5<br />
1.0<br />
0.5<br />
0<br />
Aug<br />
’08<br />
Oct<br />
’08<br />
Source: tutor2u.net<br />
Dec<br />
’08<br />
Feb<br />
’09<br />
Apr<br />
’09<br />
Jun<br />
’09<br />
Aug<br />
’09<br />
Oct<br />
’09<br />
Unemployment – claimant count measure<br />
Dec<br />
’09<br />
Feb<br />
’10<br />
M ARCH 2010 27
(a) What is meant by a ‘negative output gap’?<br />
(b) With reference to the output gap, analyse why low inflation or even deflation might be expected.<br />
(c) Assess the effectiveness of interest rate policy in closing the output gap.<br />
(d) Illustrating your answer with an aggregate demand and aggregate supply diagram, evaluate the likely impact of an<br />
increase in commodity prices and weak sterling on the price level and real output.<br />
(e) Apart from the increase in commodity prices, the weakness of sterling and low interest rates, assess two reasons<br />
why inflation might be a danger.<br />
Suggested approach to the questions<br />
(a) What is meant by a ‘negative output gap’?<br />
The concept of the output gap is one which is frequently<br />
mentioned in commentaries on the state of the economy and<br />
has a superficial simplicity. However, calculating the output<br />
gap is problematic: the trend growth rate can only be<br />
determined in retrospect and the recession might have<br />
resulted in some permanent loss of capital stock.<br />
The following answer provides an adequate answer to the<br />
question.<br />
Price<br />
Level<br />
PL<br />
AD1<br />
AD2<br />
AS<br />
The output gap is defined as the difference between<br />
the actual output (GDP) and potential output (GDP)<br />
i.e. the output that the economy would have if all<br />
resources were fully employed. In 2009 the UK<br />
economy, along with many others, faced a negative<br />
output gap which is one in which actual production<br />
is lower than potential output. This is illustrated in<br />
the diagram below:<br />
Output<br />
Potential<br />
GDP<br />
Actual<br />
GDP<br />
Y1<br />
The reasoning is that with a low level of aggregate<br />
demand, there will be much competition for business<br />
which will make it very difficult for firms to push<br />
up prices. Further, high unemployment implies that<br />
there is a surplus of labour at the existing real wage.<br />
This makes it difficult for workers to demand an<br />
increase in wages. Indeed, many workers might accept<br />
wage cuts in order to preserve their jobs. Such wage<br />
reductions could ultimately lead to deflation if they<br />
persist over time.<br />
Y2<br />
Real Output<br />
Negative<br />
Output Gap<br />
Positive<br />
Output Gap<br />
(c) Assess the effectiveness of interest rate policy in<br />
closing the output gap.<br />
Time<br />
(b) With reference to the output gap, analyse why low<br />
inflation or even deflation might be expected.<br />
Given that the command word is ‘analyse’, it is important to<br />
apply economic concepts fully and it is worth considering<br />
whether a diagram can be used. The following answer<br />
includes both these elements as well as definitions of the<br />
terms used in the question.<br />
A low rate of inflation means that prices are, on<br />
average, increasing but at a relatively slow rate e.g.<br />
1-2%. Deflation refers to a continuous fall in the<br />
general price level.<br />
A large, negative output gap is associated with a<br />
significant degree of spare capacity and high<br />
unemployment. This may be explained using AD/AS<br />
analysis. The following diagram shows that, even if AD<br />
increases, there is no effect on the price level since<br />
the economy is operating on the horizontal part of<br />
the aggregate supply curve.<br />
The command word ‘assess’ implies that evaluation is required<br />
so it is important to consider how a reduction in interest rates<br />
is supposed to enable the output gap to be closed and then to<br />
discuss the reasons why a cut in interest rates may have little<br />
effect in stimulating aggregate demand. The following answer<br />
considers the possible impact of lower interest rates on<br />
consumption, investment and the exchange rate and includes<br />
some evaluation at the end of each paragraph.<br />
Figure 2 shows how interest rates have been reduced<br />
from 5% in October 2008 to just 0.5% in March 2009<br />
since when they have been maintained at that level.<br />
A reduction in interest rates makes it cheaper for<br />
consumers to borrow money and reduces the incentive<br />
to save since the opportunity cost of spending is<br />
reduced. This should cause a decrease in the marginal<br />
propensity to save and a corresponding increase in the<br />
marginal propensity to consume. A reduction in<br />
interest rates also means that people with ‘tracker’<br />
mortgage rates (i.e. those which change in line with<br />
the Bank of England’s base interest rate) will have<br />
more money available to spend. However, a reduction in<br />
consumer confidence, associated with an increased<br />
fear of unemployment may mean that there is only a<br />
limited increase in consumer spending.<br />
28 M ARCH 2010
A reduction in interest rates also makes it cheaper<br />
for businesses to borrow which should help to<br />
promote investment. However, a lack of business<br />
confidence might make firms unwilling to invest<br />
especially if they consider that the recovery will be<br />
very weak. Another important issue affecting both<br />
consumption and investment is the unwillingness of<br />
banks to lend as they try to rebuild their capital.<br />
Price<br />
Level<br />
PL2<br />
PL1<br />
AD<br />
AS2<br />
AS1<br />
Another way by which lower interest rates might help<br />
to close the output gap is via the exchange rate. Low<br />
interest rates and the expectation that they will<br />
continue make it less attractive for foreigners to<br />
place cash balances in UK banks and more attractive<br />
for UK citizens to place their cash balances in foreign<br />
banks. Consequently, the demand for sterling will fall<br />
and supply of sterling will increase causing its value<br />
to decrease. This should make UK goods more<br />
competitive since the foreign currency price of<br />
exports will fall and the price of imports into the UK<br />
will rise. However, despite a substantial fall in the<br />
value of sterling, there has not been a significant<br />
improvement in the UK’s trade in goods balance<br />
because of slack demand in the UK’s export markets.<br />
The above analysis explains why the Bank of England<br />
has embarked on a process of quantitative easing.<br />
This involves the Bank buying gilt-edged securities<br />
from the market so increasing the supply of money.<br />
However, it is, at present, uncertain about the<br />
effectiveness of this policy.<br />
(d) Illustrating your answer with an aggregate demand<br />
and aggregate supply diagram, evaluate the likely<br />
impact of an increase in commodity prices and weak<br />
sterling on the price level and real output.<br />
Once again evaluation is required and in this case it could<br />
include a discussion of some of the following issues: the<br />
magnitude of the changes; short run and long run effects; the<br />
elasticity of the aggregate demand curve; and the significance<br />
of import costs in total production costs. The following answer<br />
provides a good response to the question and includes<br />
relevant evaluation:<br />
An increase in commodity prices will raise the costs<br />
of firms. For example, copper used for plumbing in<br />
new buildings will raise costs; while a rise in sugar<br />
and cocoa prices will raise the cost of producing<br />
chocolate. This rise in costs will be reflected in a<br />
leftward shift in the aggregate supply curve. The effect<br />
of ‘weak sterling’ is similar in that when the value of<br />
the pound is low, the cost of imported raw materials<br />
will be high. The following diagram illustrates the<br />
impact on aggregate supply of the increase in<br />
commodity prices and weak sterling. In turn, this will<br />
cause an increase in the price level and a decrease in<br />
real output, creating the possibility of ‘stagflation’.<br />
The overall effect on the price level and real output<br />
depends on how much the AS curve shifts which, in<br />
turn, depends on the amount by which commodity prices<br />
rise and the weakness of sterling. It also depends on<br />
the elasticity of the AD curve: the more elastic it is,<br />
the greater will be the impact on real output while<br />
the effect on the price level will be less significant.<br />
Y2 Y1<br />
Real Output<br />
However, there is a potential benefit of the low value<br />
of sterling in that it will make UK exports more<br />
competitive so causing an increase in aggregate demand<br />
although this could also stimulate inflationary<br />
pressures. The effect on inflation will be relatively<br />
insignificant if the high commodity prices are only tem -<br />
porary and if the value of sterling recovers during 2010.<br />
(e) Apart from the increase in commodity prices, the<br />
weakness of sterling and low interest rates, assess<br />
two reasons why inflation might increase in the UK.<br />
One factor is the fiscal deficit which is expected to<br />
reach £178 billion for the year 2009/10. Part of the rise<br />
in the deficit has been caused by a fiscal stimulus<br />
(e.g. the cut in VAT from 17.5% to 15% in 2009 and the<br />
increased public expenditure on training). This implies<br />
that injections are considerably higher than withdrawals<br />
so resulting in an increase in aggregate demand. In turn,<br />
this would lead to an increase in the price level.<br />
However, part of the increase in the fiscal deficit may<br />
be explained by automatic stabilisers such as Job<br />
Seekers’ Allowance, family tax credits and housing<br />
benefits to those on low incomes. In other words, the<br />
fiscal deficit has increased partly because of the<br />
recession. If the process of quantitative easing<br />
continues then the rise in money supply could,<br />
according the Quantity Theory of Money, be inflationary.<br />
The Fisher equation of Exchange MV = PY (where M is<br />
the money stock, V is the velocity of circulation, P is<br />
the price level and Y is output) suggests that a change<br />
in the money stock will have a direct and proportionate<br />
effect on the price level if the assumptions that V and<br />
Y are relatively stable are correct. In practice, many<br />
would suggest that V is not stable. Indeed, it fell<br />
considerably during the recession. Further, Y is unlikely<br />
to be constant since the economy is operating below<br />
its full employment level.<br />
A second factor is that high unemployment might not<br />
deter inflationary wage demands. This may be explained<br />
by ‘insider-outsider theory’. This theory assumes<br />
that the firm and its employees ( ‘the insiders’ ) will<br />
set wages without regard for the interests of<br />
unemployed workers ‘outside’ the firm. Since it is<br />
costly for the firm to replace ‘insiders’ with<br />
‘outsiders’, the ‘insiders’ have bargaining power which<br />
they can use to raise the wage above the marketclearing<br />
level. It is possible, therefore, that wage<br />
inflation could occur despite the rise in<br />
unemployment, which is predicted to increase to<br />
2.8 million in the UK by the middle of 2010. In<br />
practice, wage inflation has been very subdued in the<br />
UK and fell to less than 2% by the end of 2009.<br />
M ARCH 2010 29
What Explains the<br />
UK <strong>Eco</strong>nomy’s<br />
Disappointing<br />
Productivity<br />
Performance?<br />
Ian Black, St Albans School,<br />
examines why the UK has<br />
tended to lag behind in<br />
terms of productivity.<br />
Key words<br />
Labour productivity<br />
Relative unit labour costs<br />
Strong pound sterling<br />
Non-price competitiveness<br />
Productivity gap<br />
Exam Board AS Unit A2 Unit<br />
AQA ✓ 2(3.2.2 ✓ 4(3.4.1<br />
& 3.2.3) & 3.4.2)<br />
Edexcel ✓ 2(2.3.6 ✓ 4(4.3.4)<br />
& 2.3.8)<br />
OCR ✓ F582<br />
WEJC ✓ EC2(D) ✓ EC4(C)<br />
CCEA ✓ 2 ✓ 2<br />
Int. Bacc. Standard 4.6 and 4.7<br />
Cambridge<br />
Pre-U<br />
The National <strong>Eco</strong>nomy (g)<br />
The main focus of discussion about the UK economy<br />
during the past two years has inevitably been about the<br />
recession, the state of the public finances and the<br />
prospect of tough decisions on spending by whichever<br />
government is in power later in 2010. But if we broaden<br />
our horizons then what is the picture of the UK economy<br />
as we entered the new century? In this article we<br />
consider the relevance of productivity, its measurement<br />
and measures of competitiveness which help explain<br />
productivity growth in the UK compared with other<br />
industrialised countries. We consider reasons why the<br />
gap in productivity between the UK and other G7<br />
countries persists and conclude with a review of recent<br />
policies aimed at improving the UK’s competitiveness.<br />
This article draws on material from The UK <strong>Eco</strong>nomy 1999-2009 written by the author<br />
and just published by Anforme.
The importance of<br />
productivity growth<br />
P<br />
roductivity growth is arguably<br />
the most important indicator of<br />
living standards in the economy.<br />
Nobel prize-winning economist Paul<br />
Krugman has stated that “Productivity<br />
isn’t everything, but in the long run it is<br />
almost everything.” 1 If the productivity<br />
of resources is increased then an<br />
economy can generate more income or<br />
output per worker, increasing the<br />
standard of living and helping to<br />
eradicate poverty. Higher productivity<br />
growth will increase the economy’s trend<br />
rate of growth. However, because of<br />
the difficulties of calculating the produc -<br />
tivity of certain types of capital, such<br />
as human capital, productivity tends not<br />
to be used as a measure of the standard<br />
of living, so real GDP per capita tends to<br />
be used instead. Nonetheless, there is<br />
no denying the importance of produc -<br />
tivity growth in determining living<br />
standards.<br />
But productivity growth is important<br />
for other reasons. Productivity growth<br />
keeps inflation low. If workers in the<br />
workplace operate more efficiently, then<br />
businesses are able to produce more<br />
goods and services at a lower average<br />
cost, or higher average product (produc-<br />
tivity). If businesses are able to pass<br />
these lower costs on to the consumer<br />
and lower prices, then this will reduce<br />
cost-push inflationary pressure in the<br />
economy. Furthermore, produc tivity<br />
growth drives down unit labour costs,<br />
which will improve the inter national com -<br />
petitiveness of UK goods and services<br />
on world markets.<br />
Measuring productivity<br />
Productivity measures the output<br />
produced by the economy relative to a<br />
given input, or set of inputs. The most<br />
widely-used measure of productivity is<br />
labour productivity, or output per<br />
worker. However, given the fact that over<br />
time there are changes in the structure<br />
of employment, for example between full<br />
and part-time work, or in the number of<br />
hours worked for some other reason,<br />
such as working on Sundays or number<br />
of holidays, then output per hour worked<br />
is actually the more useful measure.<br />
Figure 1 compares productivity in terms<br />
of output per hour worked in the UK with<br />
some other G7 countries. It shows that<br />
the UK performs more favourably on<br />
GDP per hour worked compared to<br />
1. P. Krugman, The Age of Diminished Expectations<br />
(1999), 3rd edition.<br />
Index (Current PPPs)<br />
Figure 1: International comparison of GDP per hour worked, <strong>2007</strong><br />
140<br />
120<br />
100<br />
80<br />
60<br />
40<br />
20<br />
0<br />
Source: ONS<br />
Index (1991 = 100 for all countries)<br />
145<br />
140<br />
135<br />
130<br />
125<br />
120<br />
115<br />
110<br />
105<br />
100<br />
Source: ONS<br />
Japan Germany Canada UK Italy France G7 exc.<br />
=100<br />
UK<br />
Italy<br />
Figure 2: Productivity growth in the G7, 1991-<strong>2007</strong><br />
France<br />
Japan<br />
countries that work longer hours, such<br />
as Japan, but less favourably compared<br />
to those who work fewer hours, such as<br />
France.<br />
However as indicated above the<br />
position in one year, <strong>2007</strong>, needs to be<br />
seen in a dynamic context – what is the<br />
growth rate of productivity over a longer<br />
period of time? Figure 2 shows that since<br />
1991 UK productivity growth of output<br />
per hour has actually outperformed all of<br />
the other G7 countries. The productivity<br />
of both manufacturing and services in<br />
the UK improved between 1999 and<br />
2008. This is shown in Figure 3 which<br />
also indicates the collapse in produc -<br />
tivity growth during the 2008-09<br />
recession. This is because output<br />
declined during the recession, but the<br />
labour market tends to lag behind the<br />
business cycle. Businesses delay<br />
adjusting their labour force because of<br />
uncertainty over the length of the<br />
downturn.<br />
Canada<br />
Germany<br />
G7 exc.<br />
UK<br />
USA<br />
USA<br />
UK<br />
Figure 2 presents an encouraging<br />
picture of productivity growth in the UK<br />
economy, at least until the 2008-09<br />
recession but we cannot overlook what<br />
Figure 1 clearly shows: a productivity<br />
gap still exists between output in the UK<br />
and that in the rest of the G7 countries.<br />
How do we account for this gap? To do<br />
this we need to look at the evidence of<br />
the UK’s international competitiveness.<br />
International competitiveness involves<br />
two aspects: price competitiveness<br />
and non-price competitiveness.<br />
Price competitiveness is determined by<br />
the economy’s inflation rate, exchange<br />
rate and unit labour costs. Unit labour<br />
costs are calculated by dividing the<br />
average wage rate by the average<br />
product, or productivity. Price competi -<br />
tive ness can be calculated by taking the<br />
real exchange rate, which is the price of<br />
domestic goods relative to the price of<br />
foreign goods multiplied by the nominal<br />
exchange rate.<br />
M ARCH 2010 31
% change on a year earlier<br />
10<br />
8<br />
6<br />
4<br />
2<br />
0<br />
-2<br />
-4<br />
-6<br />
Manufacturing<br />
Services<br />
-8<br />
’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09<br />
Source: ONS<br />
Measures of competitiveness<br />
Figure 4 shows the sterling effective<br />
exchange rate, which is a weighted<br />
index measuring the value of sterling<br />
against a basket of the currencies of the<br />
UK’s major competitors. It indicates a<br />
slow worsening of price competitiveness<br />
from 1997-<strong>2007</strong>, although inflation<br />
remained relatively low and stable. The<br />
marked fall in the value of the pound<br />
from <strong>2007</strong>-09 has recently helped to<br />
improve price competitiveness and may<br />
allow UK companies to export more to<br />
help bring the economy out of recession.<br />
We can compare unit labour costs<br />
between the UK and other countries by<br />
using a measure known as relative unit<br />
labour costs. This is calculated using<br />
the following formula:<br />
RULCs =<br />
Index<br />
110<br />
105<br />
100<br />
95<br />
90<br />
85<br />
80<br />
75<br />
70<br />
Figure 3: Growth in output per hour worked in UK<br />
Relative wage costs<br />
Relative productivity x Sterling<br />
effective exchange rate<br />
The data is given in index number form.<br />
Figure 5 shows that RULCs rose<br />
between 1997 and <strong>2007</strong>. During this<br />
period relative wage rates rose faster<br />
than relative productivity growth, revers -<br />
ing the downward trend of the 1980s and<br />
1990s. The strength of the pound also<br />
kept RULCs high. In <strong>2007</strong>-8, the fall in<br />
the value of the pound, declining growth<br />
in wages and faster productivity growth<br />
combined to reduce RULCs.<br />
Thus Figures 4 and 5 point up the<br />
crucial importance of how a strong<br />
pound has had a serious adverse effect<br />
on the UK’s international competitive -<br />
ness.<br />
Non-price competitiveness<br />
Prices and costs are not the only<br />
determinant of competitiveness. Nonprice<br />
aspects are also important. Nonprice<br />
competitiveness can be measured<br />
in a number of ways. One way is to<br />
Figure 4: The sterling effect exchange rate index (Jan 2005 = 100)<br />
’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09<br />
Source: Bank of England<br />
calculate the income elasticity of<br />
demand (YED) for UK exports and<br />
imports. The YED for imports is<br />
reckoned to be between 1.6 and 2, not<br />
significantly different to that of our major<br />
competitors, while the YED for exports<br />
is lower at between 1.0 and 1.5, which is<br />
lower than that of our competitors. This<br />
means that when world incomes rise UK<br />
imports will grow quicker than exports;<br />
this is especially true of the manu -<br />
facturing sector. The reasons for this<br />
are:<br />
During an upswing firms tend to focus<br />
on the domestic market.<br />
UK businesses have insufficient<br />
productive capacity to satisfy both<br />
domestic and foreign markets.<br />
Investment has not grown enough in<br />
industries that produce tradable<br />
products: rather, investment has<br />
occurred in banking, insurance and<br />
distribution, which are less tradable.<br />
Other measures of non-price competi -<br />
tion include product charac teristics,<br />
such as quality, design and new product<br />
development, and sales characteristics<br />
such as after-sales service and market -<br />
ing. Calculating the value per ton of<br />
exports provides an empirical measure<br />
of non-price competi tiveness as inter -<br />
national competition should make the<br />
average price per ton of exports identical<br />
if goods are identical in terms of product<br />
and sales charac teristics. UK values per<br />
ton tend to be lower than that of the US<br />
and Europe, and the UK lags behind the<br />
EU average, and well behind the US and<br />
Japan in terms of the proportion of<br />
manufactured exports in the ‘up market’<br />
unit value category. However, the<br />
widespread embodiment in the UK since<br />
the 1980s of the Japanese approach to<br />
manage ment, including initiatives such<br />
as TQM (Total Quality Management), has<br />
helped the UK improve in these areas in<br />
recent years.<br />
Why is the productivity<br />
gap persisting?<br />
Not only has the productivity gap been<br />
around for many years but also the<br />
causes of relatively poor productivity<br />
and competitiveness are the same as<br />
they have been for a number of years:<br />
A low percentage of GDP devoted to<br />
fixed capital investment spending<br />
A rise in investment increases the capital<br />
stock available for each employed<br />
worker, which should boost labour<br />
productivity.<br />
32 M ARCH 2010
Figure 6 provides clear evidence of the<br />
fact that the UK has devoted a lower<br />
share of GDP to fixed capital investment<br />
spending than that of its major com -<br />
petitors. UK workers have a lower capital<br />
stock per head than that of the US,<br />
France and Japan. This has been an<br />
ongoing problem in the UK economy and<br />
relates to the short-termism that<br />
dominates the thinking of many UK<br />
businesses.<br />
The IMF has recently defended the UK<br />
by arguing that the quality of investment<br />
spending is more important than the<br />
quantity. The IMF claims that UK<br />
investment in equipment is comparable<br />
to that of most OECD countries.<br />
However, the UK does fall short in the<br />
area of non-residential construc tion<br />
investment, however. Since 1995, the<br />
UK has increased its rate of ICT capital<br />
spending growth significantly, and has<br />
started to close the gap on the US,<br />
Germany and France.<br />
Lack of investment in human capital<br />
The OECD suggested in 2004 that the<br />
UK compared poorly relative to its<br />
competitors on both basic literacy and<br />
vocational qualifications. Nearly a<br />
quarter of the adult population lacks<br />
basic literacy skills, more than double<br />
that of Germany, while a third of 25-34-<br />
year-olds have few or no formal<br />
qualifications beyond compulsory<br />
education. While the UK compares<br />
favourably on workers with high-level<br />
qualifications, it also has a higher<br />
percentage of workers holding the<br />
lowest level of attainment. Too many<br />
people leave education early and<br />
relatively few get an apprenticeship,<br />
skilled craft or technician qualification,<br />
according to the OECD. This is another<br />
long-standing structural weakness of the<br />
UK economy that has kept productivity<br />
levels lower than its competitors for<br />
many years. This is surely the<br />
justification behind Tony Blair’s 1997<br />
election campaign that placed<br />
‘Education, education, education’ at the<br />
forefront of the political agenda.<br />
The burden of regulation<br />
The number of regulations and ‘red<br />
tape’ that the Labour government has<br />
introduced since 1997 on businesses,<br />
which increases compliance costs and<br />
reduces business efficiency. Measures<br />
include the national minimum wage and<br />
other employment laws, health and safety<br />
legislation and environmental legislation.<br />
Moreover, while the govern ment has<br />
In the UK relatively few get an apprenticeship or skilled craft.<br />
Index (2005 = 100)<br />
110<br />
105<br />
100<br />
95<br />
90<br />
85<br />
80<br />
75<br />
70<br />
Source: OECD<br />
G7 Average<br />
USA<br />
UK<br />
Japan<br />
Italy<br />
Germany<br />
France<br />
Canada<br />
Figure 5: UK relative unit labour costs<br />
’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08<br />
Figure 6: Investment as a share of GDP, 1994-2006, current prices<br />
0<br />
5 10 15 20 25<br />
30<br />
%<br />
Source: Department for Business, Innovation and Skills<br />
M ARCH 2010 33
increased spending on the public sector<br />
significantly, productivity has failed to<br />
respond, and the OECD found that<br />
productivity in education and the health<br />
service has failed to improve beyond the<br />
growth rate of the early 1990s.<br />
Policies to improve<br />
UK competitiveness<br />
Measures to boost UK fixed capital<br />
investment, such as the reduction in<br />
the rate of corporation tax<br />
The government reduced the headline<br />
corporation tax rate from 30% to 28% in<br />
the <strong>2007</strong> Budget, although it increased<br />
the tax rate for small companies from<br />
19% to 22%. Reducing corporation tax<br />
increases retained profits that firms<br />
can plough back into investment<br />
projects. This should help to boost the<br />
UK capital stock. It should also help the<br />
UK to keep attracting foreign direct<br />
investment.<br />
Improvements in education,<br />
particularly vocational, in order to<br />
increase the level of intermediate skills<br />
The government admits that there are<br />
still too many people in the UK with low<br />
literacy and numeracy skills. The<br />
government is increasing the share of<br />
GDP spent on education and ensuring<br />
that there is enough technical and<br />
vocational training such as apprentice -<br />
ships. These measures should help to<br />
boost the level of human capital, a key<br />
determinant of economic growth.<br />
Measures to encourage<br />
research and development<br />
The government already provides R&D<br />
tax credits to encourage innovation for<br />
SMEs and large firms– the R&D tax credit<br />
for large companies was introduced in<br />
2002. However, the UK lags behind many<br />
of its competitors on R&D spending.<br />
Reforms to reduce the regulatory<br />
burden on businesses<br />
Since 2005, the government has<br />
appeared to acknowledge that UK<br />
businesses are over-regulated. Regula -<br />
tion needs to be high enough to protect<br />
UK employees whilst at the same time<br />
low enough to keep costs down and<br />
retain competitiveness.<br />
Increasing government<br />
investment in infrastructure<br />
Infrastructure includes roads, school,<br />
hospitals and public science. Govern -<br />
ment investment lags behind the UK’s<br />
major competitors, and there is room for<br />
development in this area.<br />
Are policies concerning<br />
productivity working?<br />
Overall, the government has got some<br />
things right in terms of providing an<br />
environment conducive to higher<br />
productivity growth and competitive -<br />
ness. The recent improvement in<br />
productivity is most welcome. The<br />
government has helped to provide<br />
macroeconomic stability, introduced a<br />
tougher competition framework, and<br />
provided an environment generally<br />
conducive to enterprise. The UK has a<br />
world-class university base, spending<br />
on education has increased and some<br />
progress has been made in improving<br />
skills. The cut in the headline rate of<br />
corporation tax is also welcome.<br />
However, the UK still lags behind its<br />
competitors in terms of fixed capital<br />
investment, R&D spending, intermediate<br />
skills, and the double whammy of the<br />
Summary of key points<br />
rising tax and regulatory burden is not<br />
conducive to further rising productivity<br />
and competitiveness.<br />
Questions for discussion<br />
1. Examine the consequences of the<br />
productivity gap for the UK economy.<br />
2. Explain the relationship between<br />
productivity and international com -<br />
peti tiveness.<br />
3. Evaluate the extent to which the<br />
decline in the value of the pound from<br />
<strong>2007</strong>-09 could help to improve UK<br />
competitiveness.<br />
4. Evaluate the effectiveness of the use<br />
of supply side policies to increase the<br />
level of UK productivity.<br />
5. Examine the consequences to the<br />
UK economy of a lack of international<br />
competitiveness.<br />
Productivity growth is vital to increasing living standards, contain<br />
inflationary pressures and offset rising labour costs.<br />
The strong pound sterling until <strong>2007</strong> has had an adverse effect on the<br />
UK's international competitiveness.<br />
Limited spending on capital investment and R&D are two explanations<br />
for the productivity gap between the UK and some other developed<br />
countries.<br />
with Chief Examiner,<br />
Robert Nutter<br />
1. The World <strong>Eco</strong>nomic Forum ranks the competitiveness of most economies in<br />
the world and compiles a ranking position for each country in its annual<br />
global competitiveness report.<br />
(a) What criteria is used to determine a country’s level of competitiveness?<br />
(b) Investigate the UK’s 2009-10 position and why it has fallen compared to<br />
last year.<br />
http://www.weforum.org<br />
2. In March 2000, European Union (EU) governments met in Lisbon, Portugal,<br />
and declared their intention to make the EU “the most competitive and<br />
dynamic knowledge-based economy in the world, capable of sustainable<br />
economic growth with more and better jobs and greater social cohesion.” To<br />
achieve this goal by 2010, they adopted the Lisbon Strategy of political and<br />
economic reforms.<br />
(a) Investigate the targets set by the Lisbon Strategy and the progress made<br />
to date.<br />
(b) Research the EU’s aspirations in its EU 2020 strategy.<br />
http://ec.europa.eu/eu2020 http://news.bbc.co.uk<br />
34 M ARCH 2010
What are the Prospects for<br />
EU Enlargement?<br />
The membership of the European Union (EU) has frequently been expanded.<br />
In 1973, the UK, Ireland and Denmark joined the six founding members of the<br />
European <strong>Eco</strong>nomic Community (the EEC as it was then known).<br />
Subsequently, there have been a further five enlargements. Greece gained<br />
accession in 1981, followed by Spain and Portugal in 1986. Next came Austria,<br />
Sweden and Finland in 1995.<br />
Stephen Romer discusses<br />
some of the issues relating to<br />
the candidates for entry to the<br />
European Union.<br />
Key words<br />
The Stabilisation and Association Process<br />
Instrument for Pre-Accession Assistance<br />
T<br />
he most dramatic episode in<br />
the enlargement story was the<br />
‘big bang’ expansion of 2004.<br />
Cyprus and Malta joined the EU in<br />
addition to five Eastern European<br />
countries – the Czech Republic,<br />
Hungary, Poland, Slovakia, Slovenia –<br />
together with the three Baltic states,<br />
Estonia, Latvia and Lithuania. Bulgaria<br />
and Romania followed in <strong>2007</strong>.<br />
A count of the above means that the<br />
EU today is composed of 27 member<br />
states. It seems rather a lot. Is it too<br />
many? Is the enlargement process at an<br />
end? Can we expect the EU to hang up<br />
the ‘No Vacancy’ sign and refuse to<br />
entertain further membership applica -<br />
tions?<br />
In 2010, the answer to these questions<br />
is an unambiguous No. As a matter of<br />
fact, the European Commission (EC) has<br />
not even come close to the end of the<br />
enlargement process. With the admis -<br />
sion to the EU of the former Soviet<br />
satellite states in 2004 and <strong>2007</strong> such as<br />
Poland and Bulgaria, EU membership<br />
achieved a remarkable critical mass. But<br />
it was not the end, more like the end of<br />
the beginning.<br />
There is no reason why the federal<br />
superstate of 2025 or 2030, the United<br />
States of Europe, should be restricted<br />
to 27 countries. After all, its closest<br />
counterpart, the USA, is a collection of<br />
fifty member states. In 2010, the<br />
European Commission has two lists of<br />
nations to which membership will<br />
eventually be extended, other things<br />
being equal. First, there are the<br />
‘Candidate Countries’: Turkey, Croatia,<br />
and the former Yugoslav Republic<br />
of Macedonia. Secondly, there is the list<br />
of ‘Potential Candidates’. These are<br />
countries which, apart from Iceland, are<br />
located in the Western Balkans –<br />
Albania, Bosnia-Herzegovina, Kosovo,<br />
M ARCH 2010 35
Montenegro and Serbia. And what was<br />
particularly interesting in early 2010, was<br />
that Serbia was hoping to move from List<br />
Two to List One, from potential to actual<br />
candidate.<br />
When, in December 2009, the Serbian<br />
government handed in its application<br />
form to join the EU, it was a very real<br />
reminder of the most basic objective of<br />
the founding fathers of the European<br />
project in the immediate post-war period<br />
six decades ago – avoidance of new<br />
wars between European countries. The<br />
idea was that nations whose economic<br />
and social policies had become<br />
integrated through membership of the<br />
EEC could be assumed to be less likely<br />
to declare war on one-another. In this<br />
regard, the EEC/EU has been success -<br />
ful: there has not been a war between<br />
member states.<br />
But there have been European wars in<br />
recent years, notably the bloody<br />
conflicts of the 1990s following the<br />
fragmentation of Yugoslavia. And when<br />
the wars in the Balkans ended, Serbia<br />
was left as a pariah state accused by the<br />
international community of genocide,<br />
ethnic cleansing and other war crimes.<br />
Under the brutal regime of Slobodan<br />
Milosevic, Belgrade’s EU membership<br />
could not have seemed further away. But<br />
Milosevic fell in 2000, and died in 2006<br />
while facing a war crimes trial in the<br />
Hague. Now, Serbia has a democra -<br />
tising, pro-EU government under Boris<br />
Tadic, son of a leading dissident in the<br />
Tito era.<br />
But Serbian accession to the EU is by<br />
no means a foregone conclusion. There<br />
are numerous pre-entry conditions that<br />
have to be met by any country seeking<br />
EU membership, and for Serbia there are<br />
particular questions relating to cooperation<br />
with the war crimes judicial<br />
process. In the Hague of Holland, there<br />
is an International Criminal Tribunal for<br />
the Former Yugoslavia, and the EC has<br />
been insisting that Serbia hands over<br />
various notorious characters for trial.<br />
Serbia took a major step in this direction<br />
in 2008 when the leading fugitive was<br />
taken into custody. Radovan Karadzic,<br />
the former Bosnian Serb leader, was<br />
arrested while riding on a commuter bus<br />
in Belgrade disguised as a ‘new age’<br />
mystic. But the Tribunal also demands<br />
that Serbia turn in Ratko Mladic,<br />
Milosevic’s top military man in Bosnia.<br />
Mr Mladic is accused of genocide<br />
following the siege of Sarajevo and the<br />
1. ec.europa.eu/enlargement.<br />
massacre of about 8,000 Bosnian<br />
muslim males in Srebrenica in 1995. As<br />
commander of the Bosnian Serb army,<br />
Ratko Mladic is regarded in the Hague<br />
as the leading protagonist in the ‘ethnic<br />
cleansing’ in Bosnia. It was a horrifying<br />
episode in which Milosevic’s Serbia<br />
sought to eliminate the non-Serb<br />
population of Bosnia. Nothing could be<br />
further from the EC’s stated ideals:<br />
❝Liberty, democracy, respect for<br />
human rights and fundamental<br />
freedoms, and the rule of law.<br />
(europa.eu/conditions-for-enlargement)<br />
Barriers to entry<br />
The rounding up of war criminals is a<br />
major pre-requisite to progress on<br />
Serbian EU accession. But there are, of<br />
course, many other hurdles to be jumped<br />
before Serbia – or any other country – is<br />
deemed to be ready for full EU<br />
membership. In December 2009,<br />
Belgrade formally asked the Swedish<br />
government (then holders of the rotating<br />
six-monthly EU Presidency) for permis -<br />
sion to join the EU. Will the application<br />
succeed? What are Serbia’s prospects?<br />
What happens next?<br />
In the enlargement process, if an<br />
application is to move forward it has to<br />
be given a unanimous thumbs up by the<br />
European Council (i.e. the heads of<br />
government of the existing member<br />
states). The Council reviews an EC<br />
overview of the applicant country’s<br />
membership suitability before making its<br />
decision.<br />
Once the green light is given by the<br />
European Council, the aspiring EU<br />
member has to satisfy the EC’s Copen -<br />
hagen Criteria (1993) which set out the<br />
political and economic entry conditions:<br />
the stability of institutions guaran -<br />
teeing democracy, the rule of law,<br />
human rights and respect for and<br />
protection of minorities.<br />
the existence of a functioning market<br />
economy and the capacity to cope<br />
with competitive pressure and market<br />
forces within the Union.<br />
the ability to take on the obligations<br />
of membership, including adherence<br />
to the aims of political, economic and<br />
monetary union, and the admini -<br />
strative capacity to effectively apply<br />
and implement the acquis. 1<br />
The Copenhagen Criteria look exacting,<br />
difficult for the likes of Serbia, never<br />
mind still more primitive applicants –<br />
Bosnia or Albania, for instance. But if you<br />
are a Serb, Bosnian or Albanian, there<br />
is no need to panic: the European<br />
Commission is rooting for you and it<br />
wants you to join. Indeed, the bureau -<br />
crats of Brussels are going to bend over<br />
backwards to help you reach the entry<br />
standards, grooming you for member -<br />
ship and giving you lavish financial aid<br />
to pay for the necessary modernisation<br />
of your government, economy and<br />
society.<br />
The Stabilisation and Association<br />
Process (SAP) is the programme<br />
extended by the European Commission<br />
to the applicant nations of the Western<br />
Balkans. The SAP role in these obscure,<br />
war-torn territories is to help in the<br />
stabilising of society, the development<br />
of capitalist institutions and the easing<br />
of the process of adjustment to the EU’s<br />
laws and rules. The SAP includes<br />
financial aid from the European<br />
Commission, known as Pre-Accession<br />
Assistance. The EC sees this as<br />
investment in stabilisation, transition<br />
and institution building in the countries<br />
concerned. From the point of view of a<br />
Potential Candidate country, inclusion in<br />
the SAP is crucial – and not merely<br />
because EC funding will be granted.<br />
Above all, SAP inclusion means that the<br />
country is considered to be suitable for<br />
eventual full EU membership; just as<br />
soon as it has made the necessary<br />
adjustments, that country will be<br />
deemed ready to join.<br />
Formal negotiations begin with a<br />
period of ‘screening’. The applicant<br />
government and the EC meet to<br />
consider how prepared the country is for<br />
the implementation of the acquis<br />
communautaire. This is the vast body<br />
of existing EU laws and regulations to<br />
which Serbia or Turkey, Albania or<br />
Bosnia will be obligated if and when full<br />
EU membership is extended. To make<br />
the applicant’s life easier – but not that<br />
much easier – the acquis is presented in<br />
35 ‘Chapters’. These are bite-sized<br />
chunks to be chewed over one at a time<br />
in the accession negotiations. An<br />
applicant might start by considering<br />
whether it can satisfy Chapter 1 which<br />
deals with the free movement of goods<br />
throughout the EU. Then there is Chapter<br />
2: the free movement of labour. Virtually<br />
all of the current Candidates and<br />
Potential Candidates face an early<br />
barrier in the absence of the kind of civil<br />
service sector of a sufficient size,<br />
experience and expertise to handle the<br />
36 M ARCH 2010
formidable task of processing the<br />
acquis.<br />
But more specifically, a country may<br />
find particular Chapters present<br />
difficulties. Take Turkey, for example.<br />
Chapter 1, the free movement of goods,<br />
raises questions about Turkish readiness<br />
for EU entry: the Turks refuse to receive<br />
air and sea transport from Cyprus since<br />
Turkey does not recognise the legitimacy<br />
of the Greek Cypriot government. But<br />
the latter is, of course, an EU member,<br />
and without a solution to the political<br />
stalemate in Cyprus, no meaningful<br />
progress can be made in the Turkish<br />
membership negotiations.<br />
It is fairly safe to assume that several<br />
other Chapters of the acquis are going<br />
to prove particularly difficult in the<br />
Western Balkans. For example, Chapter<br />
5 insists that there must be free<br />
competition in public sector procure -<br />
ment – a requirement that will almost<br />
certainly increase local unemployment<br />
in Croatia.<br />
And Chapter 15 will necessitate a<br />
major upheaval in Bosnian energy policy:<br />
the energy sector of the applicant<br />
country must be secure, environmentally<br />
friendly and open to competition. For<br />
Albania, compliance with Chapter 27,<br />
which covers numerous acts and<br />
regulations relating to EU environment<br />
policy, will inevitably call for expensive<br />
investment.<br />
The application by Turkey<br />
for EU membership<br />
If Turkey complies with the environ -<br />
mental requirements of Chapter 27, it is<br />
expected to be very (prohibitively?)<br />
expensive. The total cost? About<br />
€150 billion. But what about Turkey and<br />
Chapters 23 and 24? These deal with a<br />
collection of issues guaranteed to<br />
provoke additional anxiety in Ankara:<br />
fundamental rights, justice and freedom,<br />
an independent judiciary, guaranteed fair<br />
trials and so on. About 20% of the<br />
population of Turkey is Kurdish. For 25<br />
years, there has been a civil war between<br />
the Kurdistan People’s Party, which<br />
wants independence for the Kurds, and<br />
the Turkish Army.<br />
Modern Turkey was founded by<br />
Ataturk in 1923 as a secular state, but<br />
today observers have often accused the<br />
governing party of wanting to turn Turkey<br />
into an Islamic state. On three<br />
occasions, the Turkish military has<br />
intervened in government. This is an<br />
exceptionally unpromising basis on<br />
which to seek EU membership.<br />
Nevertheless, formal EC accession<br />
negotiations with Turkey began in 2005.<br />
Among the Candidate and Potential<br />
Candidate countries Turkey stands out –<br />
it is significantly different from the other<br />
aspirant EU members in several<br />
respects. Unlike Iceland or the ex-<br />
Yugoslavian nations, Turkey’s desire to<br />
join the EU is not new – it goes back<br />
more than forty years. What is<br />
particularly remarkable, however, is that<br />
Turkey seeks to join Europe, but it is a<br />
country largely located in Asia.<br />
If you are in France or Germany, Italy<br />
or Spain, Turkey seems significantly<br />
more ‘foreign’ than other existing EU<br />
member states or candidates for<br />
membership. Why? Firstly, in Turkey, the<br />
Islamic religion predominates. This is in<br />
stark contrast to Europe’s Christian<br />
tradition. And where the next-door<br />
neighbours of such long-standing EU<br />
members as, say, France and Germany<br />
include Belgium, Luxembourg and<br />
Switzerland, definitively European<br />
entities and like-minded social demo -<br />
cracies, Turkey shares borders with<br />
Syria, Iran and Iraq.<br />
Some observers argue that the<br />
expansion of the EU into the Middle East<br />
– via a Turkish accession – would be<br />
dangerous and inappropriate. The<br />
prospect of Turkish EU membership has<br />
been particularly unpopular in France. In<br />
2005, to appease public opinion,<br />
Jacques Chirac went as far as to commit<br />
the government to holding a referendum<br />
on Turkish accession should the day<br />
arrive when the European Commission<br />
declares that Turkey is ready for EU<br />
membership. And as for the new<br />
Formal negotiations for Turkey to join the EU began in 2005.<br />
incumbent in the Elysee Palace, Nicolas<br />
Sarkozy is not a supporter of Turkey-inthe-EU.<br />
What does the new President<br />
have to say on the subject? Sarko says,<br />
it would be a lie to tell Turkey that it will<br />
eventually gain full EU membership just<br />
as it would be a lie to teach children in<br />
France that Europe’s frontiers extend as<br />
far as Iraq and Syria.<br />
Turkeys don’t vote for Christmas, and<br />
we can assume that the French<br />
electorate won’t vote for Turkey in a<br />
referendum. But that would be a grave<br />
mistake, say Turkey’s supporters. The<br />
latter argue that, above all, Turkey is a<br />
crucial strategic location, an important<br />
bridge between the West and the Islamic<br />
world. Thus, they say, it is important to<br />
incorporate the Turks into the EU asap.<br />
Indeed, it is for this reason that the US<br />
has offered long-standing support of<br />
Turkey’s EU bid, and it is why Turkey is<br />
regarded as an important member<br />
of Nato. Interestingly, however, the<br />
Parliament in Ankara voted to forbid the<br />
launch of the US invasion of Iraq in 2003<br />
from Turkish territory.<br />
The application by Albania<br />
for EU membership<br />
Milan, Milan, vaffanculo, chorus the<br />
Neapolitan hooligans in the San Siro<br />
stadium at an AC Milan v Napoli match.<br />
Translation: “Supporters of Milan, you<br />
are advised to go forth and multiply”. The<br />
Milanese tifosi reply with an angry chant.<br />
Albanese, Albanese, they cry. It means,<br />
“You are Albanians”. And it’s regarded<br />
as a pretty serious insult.<br />
In reality, however, the Italians are<br />
soon going to have to become accus -<br />
M ARCH 2010
tomed to Albania as a (theoretically)<br />
equal partner in Europe. For many years,<br />
the European Commission has been<br />
micro-managing and financing Albanian<br />
preparations for full EU membership.<br />
Forgotten are the four post-war decades<br />
of absolute Albanian isolation under the<br />
regime of Enver Hoxha. No sooner had<br />
Albanian Stalinism collapsed than the<br />
European Commission stepped in to<br />
begin grooming Albania, extending aid<br />
under the Phare programme from as<br />
early as 1992. In 1999, Albania was<br />
granted Autonomous Trade Preferences<br />
and by <strong>2007</strong>, about 74% of Albania’s<br />
trade was with EU member countries. In<br />
2006, the EU accounted for 79% of<br />
Albania’s FDI inflows.<br />
This raises a general point about<br />
enlargement. Before a country becomes<br />
a Potential Candidate (never mind a<br />
Candidate) for membership, the EC likes<br />
it to have developed close economic<br />
relations with the EU. Hence, the<br />
importance to its accession prospects<br />
of Albania’s economic integration with<br />
the EU through trade in the 1990s and<br />
2000s. However, the modernisation of<br />
Albania is a long and difficult process,<br />
but today, under the Instrument for Pre-<br />
Accession Assistance (IPA), there is<br />
tangible progress. In 2008, Albania<br />
received €70.7 million from the IPA.<br />
But when you are dealing with an<br />
exceptionally backward country such as<br />
Albania, you have to begin at the<br />
beginning: of the €70.7 million from the<br />
IPA in 2008, €1 million had to be spent<br />
on developing administrative facilities in<br />
Tirana adequate to the task of…<br />
managing revenues from the IPA. A<br />
further €5.5 million was allocated to<br />
expenditure on a project designed to<br />
bring the standards of the Albanian<br />
police force up to an appropriate level, a<br />
level at which – the EC hopes – the police<br />
will enjoy the trust of the Albanian public.<br />
€10 million had to be devoted to<br />
investment in new prisons. Why?<br />
Overcrowding and poor prisoner-living<br />
conditions in Albanian gaols are<br />
unacceptable to the EC which insists on<br />
prisoners being treated in a humane way.<br />
€1.1 million of EC aid was allocated to<br />
improving border controls on the<br />
Albania-Montenegro frontier, a policy<br />
intended to bring to an end illegal<br />
trafficking in both goods and people.<br />
Another €3.4 million was accounted for<br />
by investment in a new SME policy,<br />
designed to facilitate a supply of<br />
entrepreneurship in Albania. A major<br />
investment (€24 million from the IPA<br />
supplemented by €1.5 million from<br />
Albanian government funds) involves<br />
replacing the inadequate water and<br />
sewerage infrastructure in coastal<br />
regions. Water must be safe to drink, and<br />
standards of hygiene will have to be<br />
improved if a seaside tourism sector is<br />
to emerge as a significant contributor to<br />
Albanian GDP.<br />
Albania and a clean environment:<br />
these are not words that you would<br />
normally expect to find in the same<br />
sentence. Indeed, the EC claims that<br />
Tirana is the third most polluted city in<br />
the world (after New Delhi and Beijing).<br />
There is a plague of deaths due to<br />
pollution (e.g. from respiratory illness).<br />
However, inadequate Albanian statistical<br />
data meant the lack of a solid foundation<br />
Iceland is hoping that membership of the EU will help to stabilise the economy.<br />
upon which to formulate a coherent<br />
policy. Consequently, €1.8 million of<br />
funding between 2005 and 2008 was<br />
spent on environmental monitoring.<br />
The application by Iceland<br />
for EU membership<br />
Like Albania, Iceland is a Potential<br />
Candidate. But to say that Albania and<br />
Iceland are countries that differ<br />
dramatically is an understatement.<br />
Where Albania is economically and<br />
socially backward, Iceland is the very<br />
model of EU membership suitability. The<br />
population of Iceland is about 300,000.<br />
And there are many old geysers – not to<br />
mention glaciers, volcanoes, lakes and<br />
lava fields. It is an awe-inspiring<br />
landscape, and it is one in which you will<br />
find one of the most sophisticated<br />
societies on Earth.<br />
Iceland boasts the world’s highest<br />
literacy rate (99.9%). More than that, it is<br />
ranked Number One in the UN Human<br />
Development Index. And if that is not<br />
enough, Iceland is Top of the Pops – 1st<br />
out of 173 countries – in the Media<br />
Freedom Index (Guardian World Fact<br />
File, 2009). On environmental policy,<br />
Iceland seems too good to be true<br />
(rather like the high interest rates offered<br />
by Icelandic banks a few years ago): at<br />
70% of its energy consumption, Iceland<br />
has the world’s highest rate of energy<br />
generation from renewable resources.<br />
And as for the EC’s requirement that,<br />
prior to accession negotiations, an<br />
applicant country should have devel -<br />
oped extensive economic relations with<br />
the EU, Iceland passes this test with<br />
flying colours. A member of EFTA since<br />
1970, Iceland has belonged to the<br />
European <strong>Eco</strong>nomic Area since 1994<br />
(and the Schengen Area since 2000). It<br />
participates in the Single European<br />
Market, and 70% of its trade is with the<br />
EU.<br />
In a sense, Iceland has been a de facto<br />
member of the EU for many years. The<br />
question thus arises, why is formal<br />
membership now sought? The answer,<br />
of course, is the spectacular collapse of<br />
the Icelandic economy, brought to its<br />
knees by the banking crash of 2008. It is<br />
a crash which has driven Iceland into<br />
deep recession, causing rapidly rising<br />
unemployment accompanied by double<br />
digit inflation and the collapse of the<br />
currency. Essentially, Iceland is bank -<br />
rupt. It has turned to the EU in the hope<br />
that membership will stabilise the<br />
economy and provide the basis for an<br />
eventual return to growth.<br />
38 M ARCH 2010
The Icelandic saga illustrates an<br />
interesting incidental point about<br />
enlargement. Any one existing EU<br />
member can veto the admission of an<br />
accession state. We have noted, for<br />
example, that Turkish entry could run<br />
into the sand if the electorate in France<br />
were to vote No to Turkey in a<br />
referendum. The French government<br />
would be obligated to use its veto. And<br />
there is also potential for a veto on<br />
Turkey by Greece, a country with which<br />
Turkey has a time-honoured enmity.<br />
For several years until 2009, Slovenia<br />
(an EU member since 2004) had<br />
promised to veto Croatian membership<br />
due to long-standing border disputes.<br />
But with things now all quiet on the<br />
Slovenia-Croatia front and the veto<br />
threat removed, Croatia is widely<br />
assumed to be first in the Candidate<br />
queue, expected to enter the EU in 2012.<br />
But what about a veto of Icelandic EU<br />
accession? There may in some quarters<br />
be a lingering grievance about ‘the Cod<br />
Wars’ (British-Icelandic disputes about<br />
fishing limits) of long ago, but surely no<br />
country would want to torpedo the<br />
Icelanders. The trouble is, however, the<br />
Icelandic banking melt-down means that<br />
Iceland suddenly has significant debts.<br />
In early 2010, Reykjavik had second<br />
thoughts about prioritising repayment to<br />
creditor governments in London and<br />
Amsterdam. Thus, a scenario could<br />
develop which sees Iceland’s EU bid<br />
vetoed by the British and Dutch<br />
governments.<br />
EU energy policy<br />
For many years, Turkey has been<br />
regarded as a strategic location in a<br />
military context. But more recently, the<br />
European Commission has wanted<br />
Turkey to join the EU for an additional<br />
locational reason. Turkey is seen as key<br />
to European energy policy in general,<br />
and to the EC’s aim of reducing reliance<br />
on Russian supplies of oil and gas in<br />
particular. In 2009, it emerged that an<br />
agreement on a pipeline to supply gas<br />
from Central Asia was imminent, an<br />
important step in the direction of<br />
reducing Gazprom control of EU energy<br />
supply. The new pipeline, the Nabucco<br />
project, costing €9 billion, will run more<br />
than 2,000 miles from Eastern Turkey to<br />
Austria.<br />
In mid-2009, the EU invited six ex-<br />
Soviet nations to join an EU27 summit in<br />
Prague: Armenia, Azerbaijan, Belarus,<br />
Georgia, Moldova and the Ukraine. The<br />
objective of the EC’s so-called Eastern<br />
A new gas pipeline from Eastern Turkey to Austria<br />
could make the EU less dependent on Russian supplies.<br />
Partnership is to weaken Russian<br />
influence in these countries, and to<br />
increase the EU role there. The recent<br />
Russian conflict with Georgia over South<br />
Ossetia, and Russia’s dispute with the<br />
Ukraine (about gas prices) presented the<br />
EU with an opportunity. Indeed, for some<br />
observers, the Eastern Partnership is<br />
seen as the first step on the very long<br />
road to Georgian, Ukrainian and other<br />
EU membership.<br />
However, opposition within existing<br />
member states will keep the Eastern<br />
Partnership contingent out for the<br />
foreseeable future. Right now, the<br />
European Commission is offering<br />
economic integration in the shape of free<br />
trade agreements (especially in energy),<br />
but no prospect of EU membership.<br />
For example, the Eastern Partnership<br />
extends no visa deregulation for workers<br />
from Armenia and Azerbaijan, etc.<br />
wanting to look for work in the EU. That<br />
is a signal that EU membership is not on<br />
the agenda… at the moment.<br />
It would, however, be unwise to<br />
Summary of key points<br />
assume that the day will not come when<br />
the federal superstate is planning to<br />
expand enlargement policy into the<br />
Caucuses and Central Asia.<br />
Questions for discussion<br />
1. Which countries want to join the EU?<br />
2. Which aspiring EU member countries<br />
are likely (a) to succeed and (b) to fail<br />
in their applications, and for what<br />
reasons?<br />
3. Why is it assumed that the enlarge -<br />
ment of EU membership can reduce<br />
the threat of war in Europe?<br />
4. For what reasons is Iceland looking<br />
for EU membership after many go-italone<br />
decades?<br />
5. Use the europa.eu website to find out<br />
the chief characteristics of the EU<br />
membership bids of (a) Macedonia<br />
(b) Kosovo (c) Bosnia-Herzegovina<br />
and (d) Montenegro.<br />
6. Outline the advantages of enlarge -<br />
ment from the point of view of<br />
existing EU member states.<br />
By <strong>2007</strong>, the EU had expanded to a 27 nation membership.<br />
2004 and <strong>2007</strong> brought EU membership to a number of former Soviet<br />
satellite states.<br />
In 2010, there are a further nine Candidate or Potential Candidates.<br />
Future enlargement will accommodate several ex-Yugoslavian<br />
countries.<br />
Most of the countries concerned face a long difficult period of preentry<br />
negotiation.<br />
There is a significant likelihood that Turkish EU membership will be<br />
vetoed.<br />
M ARCH 2010 39
Disability and<br />
Employment<br />
Key words<br />
Market failure<br />
Efficiency<br />
Equity<br />
Activity rate<br />
Government intervention<br />
disability and employment<br />
Peter Cramp of Nottingham High School considers whether<br />
recent legislation has helped more of those with a range of<br />
disabilities to find employment.<br />
Government intervention in the labour market can try to assist those with<br />
disabilities find work when without the benefit of specific legislation such<br />
persons find it difficult to get a job. In this article we consider the extent to<br />
which recent legislation may have succeeded in preventing discrimination in<br />
the labour market against disabled persons.<br />
The Disability<br />
Discrimination Act (1995)<br />
T<br />
he Disability Discrimination<br />
Act (1995) defines a disabled<br />
person as someone with ‘a<br />
physical or mental impairment which has<br />
a substantial and long-term adverse<br />
effect on his ability to carry out normal<br />
day-to-day activities’. This is a broad<br />
definition covering a very wide range of<br />
disabilities. Examples given by the<br />
Equality and Human Rights Commission<br />
on its website (http://www.equality<br />
humanrights.com/your-rights/disability/)<br />
include: cancer; diabetes; multiple<br />
sclerosis and heart conditions; hearing<br />
or sight impediments; significant mobility<br />
difficulties; and mental health conditions<br />
or learning difficulties. The courts must<br />
decide what counts as a disability when<br />
cases are brought before them under the<br />
Disability Discrimination Act.<br />
To a greater or lesser extent, each of<br />
the disabilities covered by the Act may<br />
present difficulties in the work place for<br />
people affected by the disability. Since<br />
2005, the Act has been amended to<br />
place a legal responsibility on employers<br />
to make ‘reasonable adjustments’ to<br />
work processes, work arrangements and<br />
the working environment in order to<br />
accommodate disabled people. An<br />
example of a reasonable adjustment<br />
would be providing a sign language<br />
interpreter for meetings. Such adjust -<br />
ments inevitably impose costs on<br />
businesses, although in many cases<br />
these costs are small or negligible. In<br />
some cases, reasonable adjustments<br />
may not be possible. For example, it<br />
would be lawful to reject a man who has<br />
severe back pain and is unable to bend<br />
for a job as a carpet fitter on the grounds<br />
of his disability, because his disability<br />
means that he is unable to carry out a<br />
substantial requirement of the job.<br />
The Disability Discrimination Act is an<br />
100<br />
90<br />
80<br />
70<br />
60<br />
% 50<br />
40<br />
30<br />
20<br />
10<br />
example of government intervention in<br />
the labour market and is a form of<br />
regulation. <strong>Eco</strong>nomically, such interven -<br />
tion may be justified by the presence of<br />
a market failure, for example if unequal<br />
opportunities in the work place were<br />
inefficient (as would be the case if<br />
productive workers were unable to find<br />
employment due to discrimination) or<br />
constituted a lack of equity (as is the<br />
case if it is considered unfair that<br />
disabled workers have fewer employ -<br />
ment opportunities than those who are<br />
not disabled).<br />
<strong>Eco</strong>nomic activity<br />
and inactivity<br />
People are described as economically<br />
active when they are in work or are<br />
actively seeking employment (and<br />
therefore classified as unemployed).<br />
This implies that they are participating in<br />
Figure 1: Employment rates of disabled and non-disabled people<br />
(aged 16-64, Great Britain)<br />
Disabled part-time<br />
Disabled full-time<br />
80.1%<br />
80.2%<br />
80.0%<br />
79.9%<br />
79.7%<br />
79.5%<br />
79.6%<br />
19.0% 19.2% 19.0% 18.8% 18.4% 18.2% 18.3%<br />
61.1% 61.0% 61.0% 61.1% 61.3% 61.3% 61.3%<br />
44.5%<br />
45.4%<br />
13.0% 13.5%<br />
Non-Disabled part-time<br />
Non-Disabled full-time<br />
46.8%<br />
47.0%<br />
47.5%<br />
47.2%<br />
48.4%<br />
14.4% 13.6% 14.1% 14.4% 14.0%<br />
31.5% 31.9% 32.4% 33.3% 33.3% 32.8%<br />
0<br />
2002 2003 2004 2005 2006 <strong>2007</strong> 2008<br />
Source: Office for Disability Issues (http://www.odi.gov.uk/docs/res/annual-report/indicators/b1.pdf)<br />
34.3%<br />
40 M ARCH 2010