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Cambridge University Press978-0-521-74434-8 - Economics for the IB DiplomaEllie TragakesFrontmatterMore information

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Preface xxi

Acknowledgments xxiii

Chapter 1 Fundamental concepts in EconomicsObjectives 21.1 Key concepts in Economics 2 Defining Economics 2 Scarcity and choice 3 Consumer choice and utility 3 Scarcity, choice and opportunity cost: the economic perspective 4 Free and economic goods 4 The factors of production 5 Understanding the economic world by use of models 5 The circular flow model 6 Microeconomics and macroeconomics 7 Ceteris paribus 7 Positive and normative concepts 8 Economic growth, economic development and sustainable development 9 Economic growth 9 Economic development 9 Sustainable development 101.2 The production possibilities model 11 The production possibilities curve (frontier) 11 Introducing the production possibilities curve 11 The production possibilities curve and scarcity, choice and opportunity cost 12 The shape of the production possibilities curve 12 Shifts of the production possibilities curve (frontier) 13 Applications of the production possibilities model 15 Economic growth and economic development 15 Environmental issues 15 Present choices and future growth possibilities 161.3 Basic economic questions, rationing systems and the mixed market economy 16 Three basic economic questions: resource allocation and output/income distribution 16 How the basic economic questions are answered by market and command economies 18 Characteristics of market and command economies 19 Evaluating the market economy 21 Key advantages 21 Key limitations 21 Evaluating the centrally planned (command) economy 22 The mixed market economy 23 Economies in transition: moving towards the mixed market 24 Eastern Europe and the former Soviet Union 24 China 25Questions for review 26






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Chapter 2 MarketsObjectives 282.1 Introduction to markets and market structures 28 Markets 28 Firms, industries and market structures 29 Perfect competition (or pure competition) 29 Monopoly 29 Monopolistic competition 30 Oligopoly 30 Market structure, competition and market power 312.2 Demand, supply and price determination 32 Demand 32 Individual demand 32 The law of demand: why the demand curve slopes downward 33 Market demand 34 Determinants of demand 35 Movement along a demand curve and shift of the demand curve 36 Exceptions to the law of demand (higher level topic) 37 Veblen goods 37 Giffen goods 38 The role of expectations 40 Supply 40 Individual supply 40 The law of supply: why the supply curve slopes upward 41 Market supply 41 The vertical supply curve 42 Determinants of supply 42 Movement along a supply curve and shift of the supply curve 43 Market equilibrium: demand and supply 44 Shortages and surpluses 44 Market equilibrium 45 Changes in market equilibrium 45 Free and economic goods revisited 462.3 Prices and efficiency in the market economy 47 The role of prices in markets 47 Price rationing and the invisible hand of the market 47 Prices as signals and incentives 48 Economic efficiency and the market economy 49 Productive (or technical) efficiency: how to produce 49 Allocative efficiency: what to produce 50 Economic efficiency: maximizing consumer and producer surplus 50 A word of caution 522.4 Government intervention in the market: price controls and market disequilibrium 53 Price ceilings: setting a legal maximum price 53 What is a price ceiling? 53 Consequences of price ceilings 53 Examples of price ceilings 54 Price floors: setting a legal minimum price 55 What is a price floor? 55 Consequences of price floors 55 Examples of price floors 55 Setting fixed prices 57 Commodity agreements and buffer stock schemes 57Questions for review 60






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Chapter 3 ElasticitiesObjectives 623.1 Price elasticity of demand (PED) 62 Determinants of the price elasticity of demand 62 Definition and formula for the price elasticity of demand 63 The formula for the PED 63 The sign of the PED 64 The use of percentages 64 Calculating the PED 64 Interpreting the price elasticity of demand 65 The range of values for the PED 65 Variable PED and the straight-line demand curve 66 PED and the relative steepness of the demand curve (supplementary material) 67 Applications of the price elasticity of demand 69 PED and total revenue 69 PED and firm pricing decisions 70 PED and price discrimination (higher level topic) 70 PED and excise taxes 71 PED and short-term price instability of agricultural products 713.2 Cross-elasticity of demand (CED) 73 Definition and formula for the cross-elasticity of demand 73 Interpreting the cross-elasticity of demand 73 Positive CED: substitutes 73 Negative CED: complements 74 Zero CED: unrelated products 74 Applications of the cross-elasticity of demand 75 Substitute goods 75 Complementary goods 753.3 Income elasticity of demand (YED) 76 Definition and formula for income elasticity of demand 76 Interpreting the income elasticity of demand 76 The sign of the income elasticity of demand (normal or inferior goods) 76 The value of the income elasticity of demand 77 Determinants of the income elasticity of demand 77 Applications of the income elasticity of demand 78 YED and the rate of expansion of industries 78 YED and sectoral change in an economy 78 YED and long-term impacts on agricultural and other primary product prices 793.4 Price elasticity of supply (PES) 80 Definition and formula for the price elasticity of supply 80 Interpreting the price elasticity of supply 81 The range of values for the PES 81 Determinants of the price elasticity of supply 83 Length of time 83 Spare capacity of firms 83 Applications of the price elasticity of supply 84 PES and short-term price instability of agricultural products 84 Short-run and long-run price elasticities of supply 853.5 Elasticities of demand and supply and incidence of taxes and subsidies (higher level topic) 85 Indirect taxes: flat rate and ad valorem 85 The incidence of indirect taxes and subsidies on consumers and producers 86 The incidence of indirect taxes 86 The incidence of subsidies 87 Elasticity of demand and supply and the incidence of indirect taxes 87 The case of demand elasticities 87 The case of supply elasticities 88Questions for review 89






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Chapter 4 Theory of the firm I: costs, revenues and profits (higher level topic)Objectives 914.1 Costs 91 Introduction to costs of production 91 Accounting, implicit and economic costs 91 The short run and the long run 93 Fixed, variable and total costs 93 Average costs 93 Marginal cost 94 Costs of production in the short run 94 Total product, marginal product and average product 94 The relationship between the marginal and average product curves 96 Generalized product curves 96 Law of diminishing marginal returns 96 Short-run costs of production: deriving the short-run cost curves 97 The law of diminishing marginal returns and the shape of the cost curves 99 Shifts in the cost curves 100 Costs of production in the long run 101 Average costs in the long run 101 Long-run average total cost curve 102 Economies and diseconomies of scale 103 Minimum efficient scale and the structure of industries (supplementary material) 1044.2 Revenues and profits 105 Revenues 105 Profits 106 Economic profit versus accounting profit 106 Normal profit 1064.3 Goals of firms 108 Profit maximization 108 Profit maximization based on the total revenue and cost approach 108 Profit maximization based on the marginal revenue and cost approach 108 Evaluating profit maximization as the firm’s main goal 109 Additional firm goals 110 Revenue maximization 110 Growth maximization 110 Managerial utility maximization 110 Satisficing firm behaviour 110 Ethical and environmental concerns 111Questions for review 112

Chapter 5 Theory of the firm II: market structures (higher level topic)Objectives 1135.1 Perfect competition 114 Assumptions of the model 114 Demand and revenue curves under perfect competition 114 The demand curve facing the firm 114 The firm’s revenue curves 114 Profit maximization in the short run 116 Short-run profit maximization based on the total revenue and cost approach 116 Short-run profit maximization based on the marginal revenue and cost approach 117 The firm’s short-run supply curve 120 Short-run equilibrium under perfect competition 120 Perfect competition in the long run 121 Role of economic (abnormal) profits and losses in adjustment to long-run equilibrium 121 Changes in demand and adjustment to long-run equilibrium 121 Changes in technology or resource prices, and adjustment to long-run equilibrium 123






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Allocative and productive (technical) efficiency 123 Allocative efficiency 124 Productive efficiency 124 Efficiency and perfect competition in the long run 124 Efficiency and perfect competition in the short run 125 Evaluating perfect competition 125 Insights provided by the model 125 Limitations of the model 1255.2 Monopoly 126 Assumptions of the model 126 Barriers to entry 127 Economies of scale 127 Natural monopoly 127 Legal barriers 127 Control of essential resources 128 Aggressive tactics 128 The demand and revenue curves under monopoly 128 The demand curve facing the monopolist 128 The monopolist’s revenue curves 129 The monopolist’s output and price elasticity of demand 129 Profit maximization by the monopolist 131 Profit maximization based on the total revenue and cost approach 131 Profit maximization based on the marginal revenue and cost approach 131 Revenue maximization by the monopolist 132 Evaluating monopoly and comparing with perfect competition 133 Criticisms of monopoly 133 Benefits of monopoly 136 Monopoly and government regulation 137 Perfect competition and monopoly as guides to understanding the real world 1375.3 Monopolistic competition 137 Assumptions of the model 137 Product differentiation and the demand curve 138 Elements of competition and monopoly 138 The roles of price and non-price competition 139 Profit maximization 139 Economic profit or loss in the short run 139 Normal profit in the long run 140 Criticisms of the model 141 Efficiency in monopolistic competition 141 Allocative and productive inefficiency 141 Excess capacity 141 Comparison of monopolistic competition with other market structures 142 Monopolistic competition and perfect competition 142 Monopolistic competition and monopoly 1425.4 Oligopoly 143 Assumptions of oligopoly 143 Collusive oligopoly 144 Formal collusion: cartels 144 Obstacles to forming and maintaining cartels 145 Informal collusion: price leadership and other approaches 145 Non-collusive oligopoly: the kinked demand curve 146 The role of non-price competition in oligopoly 148 Evaluating oligopoly 148 Criticisms of oligopoly 148 Benefits of oligopoly 148 Advantages and disadvantages of advertising (supplementary material) 149






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5.5 The theory of contestable markets 1495.6 Price discrimination 150 Definition and conditions for price discrimination 150 The single-price firm versus the price discriminating firm 150 Conditions for price discrimination 151 Types of price discrimination 152 First degree: discrimination among individual consumers 152 Second degree: discrimination among quantities 153 Third degree: discrimination among consumer groups 154 Summary of advantages and disadvantages of price discrimination 155 From the firm’s perspective 156 From the consumer’s perspective 156 From a social perspective 156Questions for review 157

Chapter 6 Market failureObjectives 1596.1 Market failure and allocative inefficiency 1596.2 Externalities 160 Diverging private and social benefits and costs 160 Negative production externalities (spillover costs) 161 Illustrating negative production externalities 161 Correcting negative production externalities 162 Evaluating alternative policies 163 Negative consumption externalities (spillover costs) 164 Illustrating negative consumption externalities 164 Correcting negative consumption externalities 165 Evaluating alternative policies 166 Environmental concerns and sustainable development 166 Environmental concerns and negative externalities 166 The meaning of sustainable development 167 Addressing the overuse of open access resources 168 Positive production externalities (spillover benefits) 169 Illustrating positive production externalities 169 Correcting positive production externalities 170 Positive consumption externalities (spillover benefits) 170 Illustrating positive consumption externalities 170 Correcting positive consumption externalities 171 Evaluating measures to correct spillover benefits 1726.3 Merit goods, demerit goods and public goods 172 Merit and demerit goods 172 Public goods 174 Public goods versus private goods 174 Public goods and the free rider problem 174 Public goods that are not ‘pure’ 174 Correcting the market’s failure to provide public goods 1756.4 Monopoly power 1756.5 Additional failures (supplementary material) 176 Imperfect information and information asymmetries 176 Coordination failures 178 Weak or missing market institutions 178 Macroeconomic objectives 179 The problem of government failure (policy failure) 179Questions for review 180






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Chapter 7 Macroeconomic concepts and measurementObjectives 1827.1 Measuring national income and output 183 The circular flow model revisited 183 The simple circular flow of income 183 Adding leakages and injections 183 National income accounting 185 The expenditure method 185 The income method 186 The output method 186 Key distinctions relating to measures of the value of output 187 Distinction between gross and net 187 Distinction between nominal and real 188 Calculating nominal and real GDP 188 Distinction between total and per capita 190 Distinction between domestic and national: GDP versus GNP 1917.2 Concepts and measurement of economic growth and economic development 192 Economic growth 192 Defining and calculating economic growth 192 The sources of economic growth 193 The significance of economic growth 194 Economic development 196 Distinguishing between developing and developed countries 196 Defining economic development 197 Relating economic growth to economic development 199 Limitations of the GDP measure in international welfare comparisons 200 Why GDP figures understate welfare (or why true welfare is greater than indicated by GDP per capita) 200 Why GDP figures overstate welfare (or why true welfare is smaller than indicated by GDP per capita) 201 Why GDP figures understate or overstate welfare (or why true welfare may be greater or smaller

than indicated by GDP per capita) 201 Purchasing power parities and welfare comparisons across countries 2027.3 Measuring economic development 204 The complexities of measuring economic development 204 Individual indicators 205 World Development Indicators (World Bank) 205 Millennium Development Goals and indicators 205 Examples of individual indicators 208 Health indicators 208 Income poverty 211 Income distribution 212 Literacy, improved water source and improved sanitation 214 Demographic indicators 214 Relative importance of primary, secondary and tertiary sectors 215 Composite indicators 215 The Human Development Index 216 Other composite indicators 217Questions for review 220






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Chapter 8 Aggregate demand and aggregate supplyObjectives 2218.1 The business (trade) cycle: economic fluctuations 222 Understanding the business (trade) cycle 222 The phases of the business (trade) cycle 222 The relationship between real GDP and unemployment 223 Actual and potential GDP 223 Why we study the business (trade) cycle 2248.2 The aggregate demand and aggregate supply model in the short run 225 Introducing the aggregate demand and aggregate supply (AD-AS) model 225 Aggregate demand and the aggregate demand curve 226 Defining aggregate demand and the aggregate demand curve 226 The downward slope of the aggregate demand curve (supplementary material) 227 Changes in aggregate demand (shifts in the AD curve) 227 Aggregate supply and the short-run aggregate supply curve 231 The short run and long run in macroeconomics 231 Defining aggregate supply and the short-run aggregate supply curve 231 Changes in short-run aggregate supply (shifts in the SRAS curve) 232 Macroeconomic equilibrium in the short run 233 Short-run equilibrium level of prices and output 233 Changes in short-run equilibrium 233 Recessionary (deflationary) gaps, inflationary gaps and short-run full employment equilibrium 234 Shifts in AD or SRAS: possible causes of the business cycle 2358.3 Macroeconomic controversies: the neoclassical perspective 237 The AD-AS model in the long run 237 Defining the long-run aggregate supply curve and long-run macroeconomic equilibrium 237 Why the LRAS curve is vertical 238 Why the LRAS curve is situated at the level of potential GDP (or why inflationary and

deflationary gaps cannot persist in the long run) 238 Why in the long run aggregate demand influences only the price level, leaving real GDP unchanged 239 Changes in long-run aggregate supply (shifts in the LRAS curve) 240 Economic growth in the AD-AS model 240 The relationship between the SRAS and LRAS curves 2418.4 Macroeconomic controversies: the Keynesian perspective 241 Getting stuck in the short run 242 Wage and price downward inflexibility 242 The inability of the economy to move into the long run 242 The shape of the Keynesian aggregate supply curve 243 The three short-run equilibrium states of the economy in the Keynesian perspective 244 Some key features of the Keynesian perspective 244 Recessionary gaps can persist over long periods of time 244 Increases in aggregate demand need not cause increases in the price level 245 Illustrating economic growth in the Keynesian perspective 2458.5 Some final observations 246 Illustrating the neoclassical and Keynesian perspectives 246 Policy implications of the neoclassical and Keynesian perspectives 246 The business cycle and government policy in the neoclassical perspective 246 The business cycle and government policy in the Keynesian perspective 247 The mainstream economic perspective 247Questions for review 248

Chapter 9 Demand-side and supply-side policiesObjectives 2499.1 Demand-side policies: shifts in the aggregate demand curve 249 Objectives of demand-side policies 249






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Fiscal policy 250 Background to government finance 250 Expansionary fiscal policy 250 Contractionary fiscal policy 251 Monetary policy 252 Determination of the rate of interest 253 Changes in interest rates and aggregate demand 254 Expansionary (easy money) policy 254 Contractionary (tight money) policy 255 Strengths and weaknesses of demand-side policies for short-term stabilization 256 Strengths of fiscal policy 256 Weaknesses of fiscal policy 256 Strengths of monetary policy 257 Weaknesses of monetary policy 257 Inability of fiscal and monetary policies to address supply-side causes of economic contractions 258 Fiscal or monetary policy? 259 Discretionary policy or a monetary rule? (supplementary material) 259 Demand-side policies and long-term economic growth 2609.2 Supply-side policies: shifts in the aggregate supply curve 261 Objectives of supply-side policies 261 Market-oriented supply-side policies 261 The theoretical justification of market-oriented supply-side policies 261 Reducing the size of the government sector and increasing competition 262 Strengths and weaknesses of these policies 263 Improving incentives by lowering taxes 264 Strengths and weaknesses of these policies 265 Making the labour market more responsive to supply and demand 265 Strengths and weaknesses of these policies 266 Liberalizing (freeing up) international trade and capital flows 266 Interventionist supply-side policies 267 Interactions between demand-side and supply-side policies 2689.3 The multiplier, accelerator and crowding-out effects (higher level topics) 269 The multiplier effect 269 Defining the multiplier effect 269 Calculating the multiplier 269 The multiplier and aggregate demand 271 The multiplier and fiscal policy 272 The multiplier in the real world: the role of leakages and the price level 272 The accelerator theory 273 Interactions between the multiplier and accelerator 275 The crowding-out effect 275Questions for review 277

Chapter 10 Unemployment and inflationObjectives 27810.1 Unemployment 278 Definitions 278 Full employment 279 Unemployment and underemployment 279 The unemployment rate 279 Difficulties in measuring unemployment 279 The costs of unemployment 280 Economic costs 280 Non-economic costs 280






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Natural rate of unemployment: structural, frictional and seasonal unemployment 281 Structural unemployment 281 Frictional unemployment 282 Seasonal unemployment 283 The natural rate of unemployment in relation to the AD-AS model 283 Unemployment in a recessionary gap: real wage and cyclical unemployment 284 Real wage unemployment 284 Cyclical unemployment 285 Summary of the five types of unemployment in relation to the AD-AS model 28610.2 Inflation and deflation 288 Introduction to inflation and deflation 288 Definitions 288 Distinguishing between changes in the price level and changes in the rate of inflation 288 Causes of inflation 288 Demand-pull inflation 288 Cost-push inflation 289 Excessive growth in the money supply 290 Consequences and costs of inflation 291 The relationship between inflation, purchasing power and nominal and real income 291 Costs of inflation 291 Costs of hyperinflation 294 Causes of deflation 294 Why deflation occurs rarely in the real world 294 Causes of deflation 295 Costs of deflation 29610.3 Measuring inflation (higher level topic) 297 Measurement of inflation and price indexes 297 Price index using a base year basket of goods and services (CPI) 297 Using the consumer price index to calculate the rate of inflation 298 A word of caution 299 Price index using current output (the GDP deflator) (supplementary material) 299 Using the GDP deflator to calculate the rate of inflation 299 Problems with measuring inflation 299 Problems with the consumer price index (CPI) 299 Problems with the GDP deflator (supplementary material) 30010.4 The Phillips curve, the NRU and the NAIRU (higher level topics) 302 The relationship between inflation and unemployment 302 The breakdown in the relationship 303 Distinguishing between the short-run and long-run Phillips curves 303 The short-run Phillips curve 303 The long-run Phillips curve 304 The natural rate of unemployment (NRU) and the non-accelerating inflation rate of

unemployment (NAIRU) 306 The NAIRU and the natural rate of unemployment (NRU) 306 The NAIRU and the NRU: building a consensus view of the inflation–unemployment relationship 306Questions for review 308

Chapter 11 Distribution of incomeObjectives 30911.1 Income distribution and redistribution 309 The meaning of income distribution and redistribution 309 Methods that can be used to redistribute income and output 310 Transfer payments 310 Subsidized provision of merit goods 310 Government intervention in markets 311 Taxation 311






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11.2 The role of taxation in income redistribution 311 Direct and indirect taxation 311 Direct taxes 311 Indirect taxes 312 The ability-to-pay principle 312 Proportional, progressive and regressive taxation 313 Understanding the principles of proportional, progressive and regressive taxation 313 Progressivity and personal income taxes 314 Other types of taxes 314 Why income redistribution is a controversial issue: an evaluation 31511.3 Measuring income inequalities: the Lorenz curve and Gini coefficient (higher level topic) 317 Presenting some data on income distribution 317 The Lorenz curve and Gini coefficient 317 Lorenz curve 317 The Gini coefficient 319 Using Lorenz curves to illustrate income redistribution 319 Income distribution and the level of economic development 31911.4 The Laffer curve (higher level topic) 320 Understanding the Laffer curve 320 Evaluating the Laffer curve 321Questions for review 322

Chapter 12 International tradeObjectives 32412.1 International trade theory 324 The benefits of trade 324 Absolute and comparative advantage (higher level topic) 326 The theory of absolute advantage 327 The theory of comparative advantage 329 PPCs, absolute advantage and comparative advantage 331 Absolute advantage as a special case of comparative advantage 331 The sources of comparative advantage 331 Evaluating the theory of comparative advantage 33212.2 International trade policy: free trade and protectionism 333 Defining free trade and protectionism 333 Free trade versus protectionism 333 Using diagrams to illustrate international trade 333 Tariffs 334 Tariffs and their impacts 334 The impacts of tariffs on consumer and producer surplus 336 Import quotas 336 Import quotas and their impacts 336 The impacts of quotas on consumer and producer surplus 337 Subsidies 338 Production subsidies and their impacts 338 Export subsidies and their impacts (supplementary material) 339 Voluntary export restraints 340 Administrative and technical regulations 341 Administrative regulations 341 Health, safety and environmental standards 341 Summary of arguments against protectionism 341






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Arguments for protectionism 343 Qualified arguments 343 Questionable arguments 345 Incorrect arguments 34612.3 Economic integration 347 Trading blocs 347 Free trade area 347 Customs union 347 Common market 347 Economic and monetary union 347 Advantages and disadvantages of trading blocs 348 Trade creation and trade diversion (higher level topic) 349 Trade creation and its impacts 349 Trade diversion and its impacts 350 The impacts of trade creation and diversion on consumer and producer surplus

(supplementary material) 351 Obstacles to achieving economic integration (higher level topic) 352 Reluctance to surrender political and economic sovereignty 352 Globalization 35212.4 World Trade Organization 353 Brief history 353 WTO objectives 354 Evaluating the WTO 354 Potential benefits 354 Evaluating the Uruguay Round 355 The Doha Development Round: inability to reach agreement 356Questions for review 357

Chapter 13 Balance of payments and exchange ratesObjectives 35913.1 The balance of payments 359 Introducing the balance of payments and foreign exchange 359 The balance of payments 359 Demand and supply of foreign exchange 360 Relating the demand and supply of a currency to the balance of payments 360 Understanding the balance of payments 361 The current account 361 The capital account 362 The financial account 362 A clarification concerning the capital account and the financial account 363 The meaning of ‘balance’ in the balance of payments 363 The statistical discrepancy 364 Understanding the balance of payments from a different perspective 36413.2 Exchange rates 366 Exchange rates 366 Exchange rates in a floating (flexible) exchange rate system 366 The exchange rate as the ‘price’ of a currency 366 The equilibrium exchange rate 366 Exchange rate changes: appreciation and depreciation 367 Causes of changes in exchange rates 369 The significance of depreciating and appreciating currencies for a country’s exports and imports 370 Relating exchange rates to the balance of payments 371 Exchange rates in a fixed exchange rate system 372 Understanding fixed exchange rates 372 How fixed exchange rates can be maintained 373 Changing the fixed exchange rate 373






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Exchange rates in a managed float 374 Understanding managed exchange rates 374 Pegging exchange rates 375 The problem of overvalued or undervalued currencies 376 Overvalued currencies 376 Undervalued currencies 376 Monetary policy and conflicting objectives in an open economy 37713.3 Topics on exchange rates (higher level topics) 377 Advantages and disadvantages of fixed and floating exchange rates 377 Advantages of fixed exchange rates 377 Disadvantages of fixed exchange rates 378 Advantages of floating (flexible) exchange rates 378 Disadvantages of floating (flexible) exchange rates 378 Evaluating the managed float (managed exchange rates) 379 Advantages and disadvantages of single currencies/monetary integration 379 Arguments in favour of a single currency 380 Arguments against a single currency 380 Adjustment mechanisms within European Monetary Union (EMU) countries 381 Purchasing power parity (PPP) theory 381 Understanding PPP theory 381 Why PPP theory does not work in practice 38213.4 Topics on the balance of payments 383 Consequences of persistent current account deficits and financial account surpluses 383 Persistent current account deficits financed by loans 383 Persistent current account deficits financed by the sale of domestic assets 384 Consequences of persistent current account surpluses and financial account deficits 384 Methods to correct persistent current account deficits 385 Marshall-Lerner condition and J-curve (higher level topic) 386 Marshall–Lerner condition 386 J-curve 387Questions for review 389

Chapter 14 Terms of tradeObjectives 39014.1 Understanding the terms of trade 390 Defining the terms of trade 390 Measurement of the terms of trade (higher level topic) 391 Causes of changes in the terms of trade (higher level topic) 39214.2 Consequences of changes in the terms of trade 394 The terms of trade and the balance of trade 394 How the terms of trade and the balance of trade are related to each other 394 The role of price elasticities of demand for exports and imports (higher level topic) 395 Consequences of changes in the terms of trade for the balance of trade 397 Changes in demand for an export product 397 Increases in supply of an export product: impacts of deteriorating terms of trade 397 Decreases in supply of an export product: impacts of improving terms of trade 398 Changes in exchange rates 398 Consequences of long-term changes in the terms of trade for the domestic economy 399 Long-term deterioration in the terms of trade in developing countries 400 Causes of deteriorating terms of trade in developing countries 400 Impacts of deteriorating terms of trade in developing countries 401 Short-term changes in terms of trade: terms of trade volatility and commodity booms

(supplementary material) 402 Causes of commodity booms and terms of trade volatility 402 Impacts of terms of trade volatility and commodity booms 404Questions for review 406






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Chapter 15 Sources of economic growth and developmentObjectives 40815.1 Factors of production and technology as sources of economic growth and development 408 Some distinctions relating to the factors of production 408 Expanding the meaning of ‘capital’ 409 Capital, investment and saving 409 Physical capital and technological factors 409 Physical capital, technology and economic growth 409 Physical capital, technology and economic development 410 Human resources (human capital) 411 Human resources and economic growth 411 Human resources and economic development 412 Natural resources (natural capital) 412 Natural resources and economic growth 412 Natural resources and economic development 41315.2 The role of institutional factors in the development of human capital and technology 414 The development of human capital: education and health services 414 The contribution of education and health services to human capital formation 414 Benefits of education and good levels of health for the individual 415 Spillover benefits (positive externalities) of education 415 Spillover benefits (positive externalities) of health 415 The importance of elementary education and universal literacy 416 Research and development, technological change and innovation (supplementary material) 416Questions for review 418

Chapter 16 Barriers to economic growth and developmentObjectives 41916.1 Domestic barriers to growth and development 419 The poverty cycle (trap) 419 Understanding the poverty cycle 419 How poverty is perpetuated across generations 420 Breaking out of the poverty cycle 421 Banking and credit 421 The importance of banking and credit in economic growth and development 421 Exclusion of the poor from access to credit 422 Infrastructure 422 The importance of infrastructure 422 Infrastructure and economic growth 422 Infrastructure and economic development 423 Lack of infrastructure as a barrier to growth and development 423 Ineffective taxation structures 424 Low levels of revenues 424 Inequities in tax systems 425 Negative impacts on resource allocation 425 Lack of property rights 426 Property rights and investment 426 Property rights and access to credit 426 Property rights and benefits for non-owners 426 Inequalities in income distribution 426 The informal economy (informal sector) 427 Definition and characteristics of the informal economy (sector) 427 The size of the informal economy 428 The failure of the formal sector to provide enough employment opportunities 428 The role of the informal sector in growth and development 428






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Political stability 429 Corruption 431 Social and cultural barriers 432 Culture and tradition in early theories of growth and development 432 Cultural factors as obstacles to growth and development 433 Gender inequalities 434 Consequences of gender inequality: deprivations faced by women and girls 434 Spillover benefits (positive externalities) of reducing gender inequalities and deprivations

faced by women 436 Population growth and the demographic trap (supplementary material) 437 The challenges of population growth 437 The vicious cycle of poverty and population growth: the demographic trap 437 Breaking out of the demographic trap 43816.2 International trade barriers 439 Too much dependence on primary products and a narrow range of exports 439 The importance of the primary sector in developing countries 439 Consequences of too much dependence on primary products 440 Protectionism 442 Tariff barriers 442 Agricultural trade and rich country subsidies 443 Other non-tariff barriers: the ‘new protectionism’ 44416.3 International financial barriers 445 Developing country indebtedness 445 Explaining indebtedness 445 Brief history of the debt problem (supplementary material) 445 Consequences of high indebtedness 446 Consequences of some policies intended to address high indebtedness in developing countries 447 Capital flight 448 Non-convertible currencies 449 Defining convertibility and non-convertibility 449 Non-convertibility for current account transactions 449 Non-convertibility for financial account transactions 450 Conditions that should be met before adopting full currency convertibility 451 Currency convertibility and financial crises 451Questions for review 452

Chapter 17 Growth models and international trade and growth strategiesObjectives 45317.1 Early growth models and strategies 453 The Harrod–Domar growth model 453 The model 453 Policy implications 454 Criticisms of the model 454 The structural change/dual sector model 455 The model 455 Criticisms of the model 455 Policy implications and policy impacts 45617.2 International trade and growth strategies 457 Import substitution/inward orientation with strong government intervention 458 The rationale of import substitution 458 Import-substitution policies and consequences 458 Export-led growth/outward orientation with strong government intervention 460 The experience of export promotion 460 Factors behind the success of export promotion over import substitution 461






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Export-led growth strategies with market liberalization: the Washington Consensus 461 The Washington Consensus 461 The impacts of economic and trade liberalization 462 Export-led growth strategies with selective government intervention: the New Development

Consensus 464 Evaluating the roles of inward-oriented and outward-oriented strategies in international

trade and economic growth and development 466 How an outward orientation to international trade can contribute to growth and development 466 Obstacles to achieving growth and development through an outward orientation 466 Can developing countries imitate the trade and growth strategies of the Asian Tigers? 467 Evaluating the roles of market-led and interventionist strategies in international trade and

economic growth and development 468 Two responses to developing country trade problems: fair trade organizations and

commodity agreements 470 Fair trade organizations 470 Commodity agreements 471Questions for review 472

Chapter 18 Strategies focusing on the savings, foreign exchange and technology constraints

Objectives 47318.1 Overview of foreign sources of finance 473 Foreign aid: concessional loans and grants 474 Non-concessional lending 474 Private investment 47518.2 Foreign aid: concessional financial flows 476 Public aid: Official Development Assistance (ODA) 476 Bilateral and multilateral aid 476 Donor motives for providing aid 477 Factors that limit the effectiveness of aid 478 The quantity of aid and poverty alleviation 479 Evaluating the aid/trade controversy 479 Arguments supporting the ‘trade, not aid’ perspective 480 Arguments supporting the ‘trade and aid’ perspective 481 Arguments supporting the ‘aid for trade’ perspective 482 Private (civil society) aid: non-governmental organizations (NGOs) 483 Understanding the role of NGOs in development 483 Evaluating the role of NGOs in developing countries 48418.3 Non-concessional financial flows: public and private lending 486 Organizations involved in multilateral (public) lending 486 The World Bank 487 World Bank activities 487 Evaluating the role of the World Bank 488 The International Monetary Fund 489 Activities of the International Monetary Fund 489 Evaluating the role of the International Monetary Fund 489 Private-sector bank (commercial bank) lending 49018.4 Private investment 491 Foreign direct investment: the role of multinational (transnational) corporations 491 The scope and growth of multinational corporations 492 Geographical distribution of foreign direct investment 493 Country characteristics that attract multinational corporations 493






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Evaluating foreign direct investment and multinational corporations in developing countries 494 Potential benefits of multinational corporations (MNCs) for host developing countries 494 Potential costs of multinational corporations (MNCs) to the host developing country 495 Measures to increase MNC responsiveness to developing country needs (supplementary material) 497 Foreign portfolio investment (supplementary material) 49818.5 Confronting poverty: micro-credit schemes 499 The importance of access to credit by poor people 499 Micro-credit schemes 500 Muhammad Yunus, the Grameen Bank, and the 2006 Nobel Prize for Peace 500 Controversial issues in micro-credit 501Questions for review 503

Chapter 19 Consequences of economic growthObjectives 50419.1 Economic growth and income distribution 504 The development of thinking on economic growth and income distribution 504 Why is income inequality increasing in many countries? 505 Policies to achieve a more equitable distribution of income 50619.2 Economic growth, environmental externalities and sustainable development 507 Distinguishing between the pollution of affluence and the pollution of poverty 507 Negative environmental impacts of increasing economic activity 508 Social costs of environmental degradation 508 Economic growth and sustainable development: conflicting or compatible objectives? 509 Economic growth and sustainability over the long term 509 Economic growth and sustainability: taking a short-term perspective 510 Strategies for sustainable development 510 Sustainable development: developing a strategy framework 511 Policies within a strategy for sustainable development 512 Green accounting methods (supplementary material) 514Questions for review 515

Glossary 516

Index 526






For Alexios and Alkeos






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Economics is a relatively new social science that touches upon many aspects of our lives and has important effects on the well-being of all people around the world. Studying it as a scientific discipline allows us to organize the way we think about the numerous economic problems faced by our own and other societies, and helps us make informed and responsible choices.

Economics for the IB Diploma has been written for students of Economics in the International Baccalaureate (IB) Diploma Programme. It covers the entire IB Economics syllabus at both standard and higher levels. Each of the five parts of the book corresponds to one of the five sections of the syllabus, and the chapters within each part correspond closely to the syllabus subsections. The book supposes no prior knowledge of Economics from the student. Every section and subsection begins with a simple presentation that gradually progresses to a more advanced level, enabling the student to gradually master complex topics. The book fully covers the needs of the IB Economics student, in terms of both breadth and depth of coverage of all items in the syllabus.

The book contains the following main features:

Learning outcomes At the beginning of each chapter, there is a bulleted list of objectives indicating what you should have learnt and what you should be able to do after studying the chapter.

Standard level and higher level material The subdivision of the book’s content into two levels is clearly demarcated. A vertical dashed bar labelled ‘HL’ runs down the margin of all higher level material, allowing you to easily distinguish higher level from standard level material.

Key points Material that is especially important, such as important concepts, laws, definitions and conclusions, is highlighted in a box shaded light blue. This helps you focus on key points of the chapter, and can facilitate reviewing.

Use of bullet points There is extensive use of bullet points where there are lists of items relating to a particular topic. These will help you keep the material well organized in your mind, and can also help you review.

Syllabus terms and glossary All syllabus terms are highlighted in blue bold font at their first appearance in the book so that you can immediately recognize them. (You should note that when a syllabus term reappears in a later section of the book, it is not highlighted in blue bold.) At the end of the book, there is a glossary that defines all the syllabus terms. In the glossary, terms that are part of higher level material are demarcated using the vertical ‘HL’ bar.

Supplementary material The book includes some material that is not part of the IB Economics syllabus and that you will not be examined on. Such material is accompanied by the heading ‘supplementary material’ so that you can readily recognize it. It is included in the book in order to provide a more rounded view of some topics that are not bounded by the rigid IB syllabus.

‘Test your understanding’ questions Each chapter contains a series of ‘Test your understanding’ questions, which appear at the end of every topic. These questions are concerned very specifically with the material of the preceding section and can help you review the section’s main points. The questions can be used as the basis for class discussions or homework assignments. You can also use them for studying and reviewing on your own. If you can answer these questions, it means you have understood the important points of the section.

End-of-chapter questions for review Each chapter ends with a set of review questions. These questions are broader in scope than the ‘Test your understanding’ questions. Many (though not all) are similar to IB Economics exam questions. Each is assigned a maximum number of marks, which is intended to






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guide you on how extensive your answer should be. The questions can help you review the chapter material, but they can also give you practice in answering IB-style exam questions. Answers to selected questions are provided in the accompanying CD-ROM (in bullet-point form). The corresponding questions have a CD-ROM icon in the margin. You should attempt to answer these questions on your own before reading the answers.

The CD-ROM contains the following main features:

Introduction This explains how the material on the CD-ROM can help you develop the skills you will need in order to perform well in your IB Economics exams and in your portfolio of commentaries. It is important that you read this introduction before proceeding to the other CD-ROM files.

Answers to the end-of-chapter questions for review There is a separate file for each of the book’s 19 chapters, in which a selected number of end-of-chapter questions have been answered (in bullet-point form). These questions (and their answers) are based on the material presented in the corresponding chapters and are intended to sharpen your analytical skills and introduce you to evaluation questions.

Case studies and data-response questions and answers This file contains a series of texts (or ‘case studies’) on topics of current interest, together with questions and answers, all of which have been modelled on the data-response questions of Standard level Paper 2 and Higher level Paper 3. These questions and answers involve definitions, economic theory and analysis, and evaluation, showing how you can make connections and find relationships between different parts of Economics, thus improving the quality of your answers.

Preparing for evaluation questions in Standard level Paper 1 and Higher level Paper 1 This file contains further evaluation questions together with answers based on material that comes from more than one chapter of the textbook.

List of Nobel Prize winners For the interested student, there is also a list of all Nobel Prize winners in Economics and a brief description of their work, beginning in 1969 when this prize was first awarded.

I would like to express my immense gratitude and debt to Julia Tokatlidou for her thorough, detailed and insightful review of the book and CD-ROM, as well as for her enthusiasm and support. Whatever merit this book may have would be less were it not for her invaluable contributions. I would also like to extend my thanks to Ann Bone for her very careful, meticulous editing of the text and her many useful suggestions. My thanks also go to K.A. Tsokos, for his great help and support, and for the guidance that his book, Physics for the IB Diploma, provided for me. Finally, I would like to thank Alexios and Alkeos for their patience, for reading and commenting on chapters of the book, and, above all, for the inspiration and motivation they gave me to write this book.

Ellie Tragakes received a BA degree in Economics from Columbia University in the USA, a Master’s from the University of Birmingham in the UK, and a PhD from the University of Maryland in the USA. She has worked in the areas of economic development of agriculture of less developed countries, financial services and health systems, in several national and international organizations, including the World Bank and the World Health Organization. She is a highly experienced teacher and author, with over forty professional publications. Many of these are in the area of health system financing and reforms in transition economies, and they have been translated into several languages including Russian and Chinese. She has been teaching in the Economics Department at the American College of Greece since 1996 and has been a consultant for the World Health Organization since 1992.






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The author and publishers are grateful for the permissions granted to reproduce texts in either the original or an adapted form. Whilst every effort has been made, it has not always been possible to identify the sources of all materials used, or to trace all copyright holders. If any omissions are brought to our notice, we will be happy to include the appropriate acknowledgements on reprinting.

Cover image: Russ Widstrand / Alamy

On occasion, the author has referred the reader to related sources (e.g. books, articles and websites) for further information. These sources have been acknowledged in footnotes on the appropriate pages.

The author has also referred to selected data from the following sources in some of the tables and graphs: United Nations Human Development Programme, Human Development Reports, available at www.undp.org; UN Conference on Trade and Development (UNCTAD), World Investment Reports; World Bank, World Development Reports and Development Indicators; Organisation for Economic Co-operation and Development (OECD). These sources have been acknowledged in footnotes on the appropriate pages.






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