Microeconomics Models and Theories

Readers Question: “Microeconomics involves the study of models. These are central elements of theories”. Discuss the statement by providing examples of such models.

To be honest, when studying and teaching economics I have not really placed much emphasis on the distinction between models and theories.

The models that you use will depend on which syllabus and course you are doing. These are some of the basic models you might find in A Level economics

There is a strong relationship between theories and models

The definition of a theory suggests:

Theory n A model or framework (made up of a body of principles) to explain phenomena. The word ‘theory’ derives from the Greek word ‘theorein’, which means ‘to look at’.

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Elasticity in the Petrol Market

Readers Question: Discuss the relationship between elasticity and market power’ in terms of the retail petrol market. And then it says ’use common determinant of both’, whatever that means ??

  • Demand for petrol is quite inelastic. If you have a car, there are not many alternatives to buying petrol. This is why the increased price of petrol has failed to reduce demand for petrol significantly. (there is an estimated PED of petrol of -0.1 in the short term)
  • However, if you are a car owner you don’t really mind who you buy petrol from. Esso petrol is not really any different to petrol from Tesco. Therefore, consumers are sensitive to changes in prices for an individual petrol station.
  • If there are many petrol stations close by the petrol companies will find that there demand is elastic. Increasing price could lead to a loss of market share.
  • However, if you are the only petrol station in a rural area or if you are a petrol station on a motorway, you have a lot more market power. A motorist is not going to exit the motorway just to avoid paying motorway prices. Therefore, in these locations the petrol stations have more market power, consumers less choice, demand inelastic; and this is why petrol is more expensive.

And then it says ’use common determinant of both’, whatever that means ??

  • Maybe it means that the higher the market share the lower the PED. the less market power a petrol station has the more elastic demand is

Unemployment Levels and Inflation

Readers Question “To what extent can government use demand management policies to reduce unemployment without affecting inflation?” (60)

1. Monetary and fiscal policy can be used to increase AD and therefore increase economic growth. For example, if the MPC cut interest rates, this makes borrowing cheaper and therefore encourages investment and consumption. This will cause a rise in AD. If there is spare capacity in the economy then there will be an increase in Real Output; as firms produce more they will demand more workers and this will reduce demand deficient unemployment.

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Investment and Economic Growth

Readers Question: Discuss the Importance of Investment in Increasing Economic Growth.

Investment means an increase in capital spending, e.g. buying new machines, building bigger factories (in economics it does not mean saving money in a bank)

Investment is a component of Aggregate Demand (AD). Therefore, if there is an increase in investment it will help to boost AD and therefore economic growth.

If there is spare capacity then a rise in AD will increase economic growth. However, if the economy is close to full capacity, then rising AD will only cause inflation and not an increase in real GDP

Also, it is important to bear in mind that there are other factors that affect AD apart from investment. Therefore, if there was a fall in consumer spending or exports then a rise in investment may not actually increase AD. Investment is not the biggest component of AD, that is Consumer spending.

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Stock Exchange and the Economy

Readers Question: Hi please I will like you to help me on how stock exchange can help in increase in GDP of an economy?

The Stock exchange is a way for companies to raise finance through issuing shares. For example, if the company is valued at £400 million. A company could sell £199million shares by selling 49% of its shares. It could then use the £199 million for investment (without losing control of the company)

The stock market is a useful way for companies to borrow money when they are not making any profit. People may be willing to buy shares even without a dividend if there is the prospect of capital gains in the future.

Companies can also issue share issues, when other sources of finances are limited. For example, recently A big British Bank (I think Bank of Scotland) issued a share issue to help deal with the credit crisis.

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Inflation and the Basket of Goods

There is an interesting interactive graph here at the NYT showing the different components of the US basket of goods, used to calculate inflation.

  • It shows the relative importance of different food groups. It also shows how the different food groups have changed in importance in the past 12 months.
  • As expected food and oil related goods have become more expensive and therefore carry a bigger weighting.
  • Other goods like clothes, tvs and computers have declined in importance. Presumably because they carry are relatively cheaper and / or people are buying relatively fewer ‘luxury goods’

UK Basket of Goods

uk basket

source: ONS

The biggest weighting in the UK is transport – which accounts for 15% of the total basket.

Within transport, weights are given to different transport modes.

See also:

Exchange Rate Index Definition

An exchange rate index is a way of measuring the performance of a currency against a basket of other currencies.

US Dollar Index

For example, the US dollar index measures the US dollar against 6 main currencies.

1. Euro (EUR) – 12 members of EU.
2. Japanese Yen (JPY)
3. Pound Sterling (GBP) –
4. Loonie (CAD) – Canada
5. Kronas (SEK) – Sweden
6. Francs (CHF) – Switzerland

These are weighted. This means the exchange rate movements also depend on the relative importance of trade with these currencies. Therefore an appreciation against the Swedish Krona, only accounts for a small % of US trade. A devaluation against the Euro will have much more impact and weighting.

The Decline in the US Dollar Index.

The US dollar index is currently 77.5 (link). The index was set at 100 in 2000. Therefore, there has been a 22.5% decrease in the value of the dollar since 2000.

See: Reasons for falling dollar

AD / AS Diagrams

Diagrams showing shifts in AD and AS. Includes both SRAS and LRAS and looks at Classical and Keynesian view of LRAS curves


Increase in AD when Economy is Close to Full Capacity

This shows an increase in AD when the economy is close to full capacity, causing a significant rise in price level.



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Floating Exchange Rate and Current Account Balance of Payments

Readers Question: Q. Wouldn’t a floating exchange rate correct the deficits via the automatic stabilizer? High demands for foreign goods causes a huge supply of the US dollar and subsequently the value of the dollar should fall. A depreciated currency would mean less goods are imported since it would be more expensive, therefore, correcting the deficit.

The current account deficit causes an outflow of dollars. Without any other capital flows, this increase in supply would cause a depreciation until the deficit is solved. However, what happens, is that the US is able to attract inflow of capital flows which act as credit on the Capital account (sometimes known as Financial account) For example, Chinese bank buy US securities and Japanese firms invest in US factories. Therefore, the inflow on the capital account (and therefore demand for dollars) prevents the value of the dollar falling.
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Cutting Petrol Tax

With petrol prices rising, there is a strong pressure on the government to cut taxes.

However, cutting taxes would leave government finances with an even bigger black hole. If they did cut petrol taxes they would have to increase taxes elsewhere.

  • When people campaign for tax cuts, you rarely hear them say. “Cut Petrol Tax, Increase VAT”. “Cut petrol Tax, increase income tax”

Also there are many long term  benefits of higher petrol prices.

  1. Less congestion
  2. Greater incentives to increase fuel efficiency and find alternatives to crude oil.
  3. Less Pollution.
  4. Less Obesity, because people might actually walk / cycle the 500 metres to the shops.

As  a motorist, I don’t like paying £50 for a tank of petrol. But, at the same time, I don’t think the Government should cut tax on petrol. I hope they continue to increase tax on petrol. Other countries, especially America should definitely seek to increase tax on petrol.