Where is the money in the economy spent?

Readers Question: Why is public money (taxes) only 47% of the UK’s GDP spent on public spending?, where is the rest of my money being spent. This is a genuine question from a 58 year old who has no real concept of how it all works,but has an innate understanding that I am being screwed.

GDP is total national income. This is also the same as the total national output. In the UK total GDP is around £1.6 trillion. The government spend around £700bn (2012/13) or 43% of GDP.  See: UK government spending

It means the rest 57% £900bn is spent by the private sector – business investment and consumer spending.

To answer the question. After you have paid all the taxes to the government, the rest of the money is being spent by yourself.

In a very simple model, assume the average income in society is £10,000. The government collect £4,300 from you in tax, and then the government spend £4,300 on health, education, welfare benefits e.t.c. The government is spending 43% of average income. It leaves you £5,700 to spend on consumer goods and services.


Government spending as a % of GDP has fluctuated around 40% of GDP since the mid 1960s.


Government spending is financed by

  1. Tax
  2. Borrowing from the private sector – selling bonds to investment trusts e.t.c.

If government spending increases, it means they will have to finance it through higher taxes or borrowing.

Tax revenue as a % of GDP


Pre the First World War, government spending was a lower percentage of GDP. Perhaps around 10-15% around 1900. (this is a guess). In 1900, taxes were much lower. Income tax was relatively low and VAT hadn’t been introduced. This meant the government had much lower revenue. But, also there were few public services. If you were unemployed, there were no benefits, but you were probably sent to the workhouse.

Government spending as a % of GDP varies around the world.

For example, US public spending is around 35% of GDP. This is lower than many Western European economies, e.g. France 52%. But, the downside is that in the US you will have to spend considerable sums on private health care.

(List of government spending by country)

It is debatable whether you are better off paying higher taxes to the government  -or paying lower taxes + high private health insurance premiums.

Government spending as a % of GDP is no guarantee as to whether you are being ripped off or not.



Should University Education be Free?

In recent years, the government has sought to increase the amount students pay for studying at university. In the UK, the government have phased out grants and introduced top-up fees. With tuition fees and rising living costs, students could end up paying £50,000 for a three year degree, and leave university with significant debts.


Radcliffe Camera in Oxford, but should students expect to study for free?

Some argue this is a mistake. Charging for university education will deter students and leave the UK with a shortfall of skilled labour – and arguably this will damage the long term prospects of the UK economy. Furthermore, charging for university will increase inequality of opportunity as students with low income parents will be more likely to be deterred from going to university.

Arguments for Free University Education

  1. Positive externalities of higher education. Generally, university education does offer some external benefits to society. Higher education leads to a more educated and productive workforce. Countries with high rates of university education generally have higher levels of innovation and productivity growth. Therefore, there is a justification for the government subsidising higher education.
  2. Equality. There is also a powerful argument that university education should be free to ensure equality of opportunity. If students have to pay for university education, this may dissuade them. In theory, students could take out loans or work part-time, but this may be sufficient to discourage students from studying and instead may enter the job market earlier.
  3. Increased specialisation of work. The global economy has forced countries, such as the UK to specialise in higher tech and higher value added products and services. The UK’s biggest export industries include pharmaceuticals, organic chemicals, optical and surgical instruments, and nuclear technology (see: what does the UK produce?). Therefore, there is a greater need for skilled graduates who can contribute to these high-tech industries.

Arguments against free university education

  1. Opportunity Cost. If we spend billions on free university education there is an opportunity cost of higher taxes or less spending elsewhere. Arguably, there is a greater social benefit from providing vocational training – e.g. so people could become plumbers, electricians e.t.c. There is often a real shortage of these skills in an economy. The UK commission for skills and education report significant skills shortages in the basic ‘core generic skills’ such as literacy, numeracy and communication skills. This skill shortages are prominent in industries like building, health care, plumbing, social care and construction. Generally, the problem is not a shortage of graduates with art degrees, but lower level vocational skills. (See: BBC – skills shortage in the UK) Therefore, there is a case for charging for university, but greater public spending to tackle this lower level skill shortages. Continue Reading →

Economics of the Pound shop

When I was young (let say the 1980s) a Pound shop was a bit of a novelty.


Visiting Morecambe, a seaside resort, there would be one or two Pound shops. I only remember being struck how low quality everything was, they were a bit tacky, mainly some useless novelty items and a stick of Blackpool Rock. No self-respecting middle class consumer would consider doing the bulk of their weekly shop at a Pound shop. But, in recent years, Pound shops have emerged as one of the fastest growing retail outlets in the UK. Suddenly the High Street is awash with shops offering everything for a £1. It raises some interesting economic questions:

  • How do Pound shops manage to sell so many goods for £1?
  • Why have they become so successful in recent years?
  • To what extent can they challenge traditional retail, like the Supermarket Giants?
  • Are they good for society or should we be worried about the proliferation of Pound Shops?
  • Is there growth sustainable?
  • What happens when inflation reduces the value of a Pound?

The success behind the Pound shops

The reason Pound shops can sell so many goods so cheaply is due to basic economic principles.

  • Buying in bulk. Bulk buying is a classic economy of scale. The more that you purchase, the lower the average costs involved. Large global Pound shop chains can buy whole containers directly from China at a much lower price than buying through distributors.
  • Cutting out distributors. Typically, retail shops will buy from a distributor, who in turn buys from the source. This saves shops having to deal with many suppliers. But, Pound shops can buy in sufficient bulk to be able to get direct from the manufacturers, often in China / Asia.
  • Small margins. Pound shops run on very small margins. Small margins only work with high volume and a tight control of costs. The high volume in turn enables firms to continue bulk buying at low cost.
  • Low cost encourages more purchases. On the BBC series about Pound Shop Wars – I liked the quote from one customer who said his ‘Pound shop was most expensive shop in town. – I always see something more to buy.’

Why have Pound shops become so successful in recent years?

  • Changing consumer patterns. The difficult few years have encouraged consumers to seek bargains and low prices. In the past five years, we have experienced cost -push inflation, stagnant real wages and falling living standards. The squeeze on disposable incomes have made Pound shops increasingly attractive.
  • Strength of Chinese manufacturing. The relentless growth of low cost Chinese manufacturing has enabled an increase in the choice of low cost manufactured goods.
  • External economies of scale. The growth of the whole industry has encouraged manufacturers to consider producing specifically for the Pound shop market. Manufacturers are increasingly prepared to prepare products which can fit in with the Pound Shop model. Also, the growth of Pound shop chains have enabled them to gain internal economies of scale as they grow – leading to lower average costs for the big chains.
  • Little internet competition. In contrast to big ticket items, like electronic goods, Pound shops face little competition from the internet. Amazon do relatively little trade for items costing a £1 – Post and packaging become a bigger % of the price the cheaper the good is. Many retail shops have closed down due to internet competition, these retail spaces have often been taken by Pound Shops.

Can they challenge the Supermarket Giants?

At £1, Pound shops are limited. They don’t sell fresh produce. They cannot offer a comprehensive range of goods. But savvy consumers will begin to cherry pick doing half their shop in Pound shops and buying the remainder elsewhere. It will definitely reduce the profits of supermarkets, though I can’t see them being replaced.

What is the impact on the growth of Pound shops?

  • For consumers, generally they are good for keeping prices low. They offer a range of cheap goods, but also put pressure on other supermarkets to match the low prices. It is reducing the market power of the big Tescos and Sainsbury’s
  • Big Pound retail shops are squeezing smaller independent retailers who cannot compete with the costs of Pound shops. Though they face competition from a range of other sources, such as supermarkets.
  • Pound shops can actually be controversial. Some towns, e.g. Harrogate have seen protests against Pound shops for fear that it ‘reduces the value of the town’. Pound shops give an impression of being low quality, cheap and cheerful. Not everyone likes the idea of a High Street being dominated by Pound shops, squeezing out higher class traditional shops.
  • They put pressure on suppliers to keep reducing their costs to remain competitive. It squeezes the profit margins of big traditional firms.  Continue Reading →

Threats and opportunities of Chinese growth on UK economy

Readers Question: Hello I recently saw a programme How China Fooled the World – with Robert Peston and I was wondering what threats and opportunities does the growth of economies like China and India provide to the UK economy?

According to the IMF, in 2010, the Chinese economy was $5,878 billion – second only to the US economy. If we use GDP at purchasing power parity (PPP), the size of the Chinese economy is estimated to be even larger, at around $10,119 billion.

China also has a growth rate, averaging close to 10% a year. Even if there is a slowdown in this record rate of economic growth, China is forecast to become the dominant world economy within 10 or 20 years. India is another sleeping giant. Although India’s growth rate is slower than China it is the second most populous country and is still catching up with the rest of the world.

Opportunities of Chinese / Indian growth on UK economy

Low cost of manufactured goods. One major consequence of economic growth in China is that the UK has benefited from lower prices of many manufactured goods, imported from China. If you have ever wondered how Pound shops can sell so many goods for £1 – the answer is directly importing from China. China’s success in keeping costs low has created a downward pressure on prices. This helps to keep inflation in the UK low and improve living standards for UK consumers.

Growing consumer class. So far China’s growth has mostly concentrated on export led growth, leading to a large current account surplus. However, the next stage of Chinese economic development will likely see a growing consumer class who wish to purchase more luxury goods and services. This provides a significant opportunity for UK exporters of goods and services. Because of the size of the Chinese economy, there is strong latent demand. This could benefit UK exporters of  high value added goods, such as nuclear technology, chemicals, cars (see: what UK exports). Also, there will be growing demand for UK services, such as university education / learning English. So far China’s growth has been somewhat one-sided – we have seen UK manufacturing firms squeezed out of business, but the other side of the equation is that British firms will have a strong growing market in China.

Lower costs of production. Another big advantage of the development of the Chinese and Indian economy is that it provides UK firms with potential lower costs of production. For example, many UK service centres have been shifted to English speaking centres in India. This dramatically reduces labour costs, leading to lower costs for telephones e.t.c. Also, an English firm which innovates a new product can use the low cost manufactured process of China to bring the product to the market at a competitive price. This is speeding up the globalisation of production. Increasingly we see a product produced in different sections of the world. e.g. the most famous is probably ‘Apple – designed in California, produced in China.’

Alternative to US / Europe. Traditionally, the UK economy has been reliant on exports to the EU and US. With the EU and US economy relatively stagnant, growth in exports to non-EU countries suggests the economy will become more diversified and less reliant on the EU trading block.  (see: UK exports to non-EU countries)


Threats of Chinese growth

Increased competition for raw materials. Chinese growth has come at a cost of seeing rising price of raw materials. For example, during the recession of 2008-13, we saw periods of rising oil prices. This is unusual – usually during a recession in the West, oil prices fall. But, due to the growing demand from China and Asia, oil prices have been rising. This has squeezed living standards in the West. We faced both recession and rising prices. As the China and India economy grows, the pressure on raw materials is likely to exacerbate. Continue Reading →


The effects of an appreciation

An appreciation means an increase in the value of a currency. It means a currency is worth more in terms of foreign currency.


A example of an appreciation in the value of the Pound 2009 – 2012

  • Jan 2009  If £1 = €1.1
  • June 2012 £1 = €1.27
  • In this case we can say there was a 15% appreciation in the value of the Pound against the Euro – between Jan 2009 and June 2012


Effects of an appreciation on the UK economy

  1. Exports more expensive. The foreign price of UK Exports will increase Europeans will find British exports more expensive. Therefore with a higher price, we would expect to see a fall in the quantity of UK exports.
  1. Imports are cheaper. UK consumers will find that £1 now buys a greater quantity of European goods. Therefore, with cheaper imports we would expect to see an increase in the quantity of imports.
  1. Lower (X-M) With lower export demand and greater spending on imports, we would expect fall in domestic Aggregate Demand (AD), causing lower economic growth.
  1. Lower inflation. An appreciation tends to cause lower inflation because:
    • import prices are cheaper. The cost of imported goods and raw materials will fall after an appreciation, e.g. imported oil will decrease, leading to cheaper petrol prices.
    • Lower AD leads to lower demand pull inflation.
    • With export prices more expensive, manufacturers have greater incentives to cut costs to try and remain competitive.

Impact of appreciation on AD/AS


Assuming demand is relatively elastic, an appreciation contributes to lower AD (or a slower growth of AD), leading to lower inflation and lower economic growth.

Impact of an appreciation on the current account

Assuming demand is relatively elastic, we would expect an appreciation to worsen the current account position. Exports are more expensive, so we get a fall in eXports. Imports are cheaper and so we see an increase in iMports. This will cause a bigger deficit on the current account.

However, the impact on the current account is not certain:

  1. An appreciation will tend to reduce inflation. This can make UK goods more competitive, leading to stronger exports in the long term, therefore, this could help improve the current account.
  2. The impact on the current account depends on the elasticity of demand. If demand for imports and exports is inelastic, they the current account could even improve. Exports are more expensive, but if demand is inelastic, there will only be a small fall in demand. The value of exports will increase. If demand  for exports is price elastic, there will be a proportionately greater fall in export demand, and there will be a fall in the value of exports. Continue Reading →

How can the government avoid public sector failure?

Readers Question: how can the government avoid public sector failure?

Firstly, it makes a change to consider a question like this. Usually the question is – Why is the government inefficient? Why do we get government failure? Should we privatise public services? But, here we can examine whether the tendency to government failure can be overcome.

Public sector failure / government failure

Public sector failure occurs when government intervention in the economy leads to an inefficient allocation of resources and leads to an overall decline in economic welfare. Government failure can occur for various reasons, such as.

  • Lack of profit incentive in the public sector. People working for the government may not have same profit motive to cut costs / work hard/ increase efficiency. Therefore, this causes the government sector to be inefficient compared to the private sector.
  • Greater bureaucracy in public sector.
  • Conflict between political and economic objectives.

How can the government avoid public sector failure?

1. Introduce profit incentives / performance targets into the government sector. There is no reason why those working in the public sector can’t be given performance targets. For example, schools can be given targets to achieve minimum exam standards and climb up the league tables of exam performance. People working in the public sector can be paid piece meal – rather than per hour. For example, rather than pay refuse collectors £8.00 an hour. They could be paid £64 a day to do a job estimated to take 8 hours. This gives them an incentive to work faster and not dawdle on the job.

Evaluation. It can be difficult to introduce the profit motive into many areas of the public sector. For example, education and health care do not lend themselves so well to performance targets and profit motives. Schools which target better exam results may do so at the cost of excluding less intelligent pupils. They may sacrifice other aspects of an all-rounded education to get better exam results. Managers in a hospital may be able to cut costs, but the consequence may be to put greater pressure on nurses and doctors – it may compromise the standards of health care.

The problem is that the government tends to get involved in public services which are either not provided by the free market or are under-provided (e.g. merit goods and public goods). The problem of these public services is that they are not natural profit oriented industries. Continue Reading →


Dual economy

Readers question: What is a ‘dual economy’?

A dual economy refers to the existence of two distinct types of economic segments within an economy. This involves:

  1. A capitalist based manufacturing sector (geared towards global markets)
  2. Labour intensive agricultural sector (low productivity, geared towards subsistence farming or  local markets)

The British economist W. Arthur Lewis wrote an influential paper on the ‘dual economy’ in 1954. He observed that in many developing economies (usually a former colonial country) that the economy was split into these different two segments.

The bulk of the economy was a labour intensive agricultural sector producing primary products. Lewis observed that in the agricultural sector, productivity was often very low, and farmers often lacked the traditional profit incentive and dynamism usually found in a free market economy.

Alongside this agricultural sector was a smaller manufacturing sector, which tended to have higher productivity. Firms in the manufacturing sector were often set up by foreign colonial powers.

It was not just that developing economies had different sectors, but that the different sectors had different economic motivations. Labourers in the agricultural sector usually lacked education, access to capital and had poor prospects for income growth. Agriculture was also focused on meeting the needs of local markets or subsistence farming and was insular in outlook. In the other manufacturing sector of the economy, there was a greater dynamism and an incentive to increase profits through expansion and investment. The manufacturing sector also faced greater global competition which spurs efficiency growth.

The dual nature of the economy may have been  heightened by the fact manufacturing firms were set up / managed by owners from  developed capitalist economies in the northern hemisphere.

Lewis argued that given the disparity in productivity, developing economies could make substantial economic growth by encouraging labour to move from the unproductive agricultural sector to the more profitable and productive manufacturing sector. Developing countries which concentrated on just agriculture were doomed to low savings, low productivity and low growth.

Another issue with a dual economy was that there is a potential problem from concentrating on agriculture exports. Agricultural goods tend to have a low income elasticity of demand, and are price inelastic. If a developing economy increases output of agricultural products, this increase in supply is likely to depress prices and lead to lower export revenue. Because demand is so price inelastic, they would make more revenue through restricting supply and keeping prices high. This is another reason to diversify out of agriculture and not just concentrate on agricultural output. Continue Reading →


Vertical barriers to entry

Readers question “If a firm does not have access to the supply of a good then the market will not be contestable. E.g. Oil firms could restrict the supply of petrol to petrol stations, making it difficult for new firms to enter. E.g. for airlines a big issue is whether you can get a landing slot at a big airport.” Could you please explain?

bp petrol station

BP petrol station

A contestable market has freedom of entry and exit, and low sunk costs.

In economics, vertical integration refers to a firm gaining control over different stages of a supply chain.

For example in the petrol industry, we could simplify the industry to four different stages of production

  1. Oil drilling. – When firms build an oil well and pump out raw crude oil.
  2. Oil refining – the process where the crude oil is refined into petrol / diesel.
  3. Transport – where the petrol is transported to retail markets.
  4. Retail – Where petrol stations sell petrol / diesel to customers at the different petrol stations, such as Esso, Shell, BP, Tesco, Asda, and independent petrol retailers.

Suppose, you want to set up a petrol station to sell petrol in your local town. The costs of buying a premise to sell petrol is relatively low. The big difficulty will be buying petrol from the large oil companies who produce and refine petrol. There are very significant economies of scale in drilling and refining oil so that market is not very contestable. It is dominated by a small number of large firms.

The big oil companies, like Shell, BP, Esso may decide to collude and sell petrol to independent retailers at a very high price making it unprofitable for independent retailers  to sell petrol in a petrol station. Continue Reading →


The effect of a current account surplus

Readers Question: how does a current account surplus affect domestic employment ?

A current account surplus means an economy is exporting a greater value of goods and services than it is importing. A country with a current account surplus will have a deficit on the financial / capital account. i.e. a country with a current account surplus will have surplus foreign exchange it can use to invest in other countries.

There is no hard and fast rule about what will happen if a country has a current account surplus. It depends on the size of the current account and the reasons for the current account surplus.

In theory, you could expect a current account surplus (X-M) to boost employment because it is indicative of higher domestic demand.

  • High exports (X) leads to increased employment in the export sector.
  • Lower import spending may mean people are spending more on domestic goods rather than buying foreign goods. Greater demand for domestic goods helps domestic employment.

Current account surplus in fixed exchange rate

One reason for a current account surplus is when a country has a relatively undervalued exchange rate. This may be a country in a fixed exchange rate. For example, Germany is in the Euro, but due to better German competitiveness than its European neighbours, Germany has had more competitive exports. The German export sector has helped strengthen the German economy.

Ceteris paribus, this current account surplus is helping to boost domestic employment. Because German exports are competitive, Germany is selling a lot of exports and this is leading to higher domestic employment in the exporting sector. Without the strong export demand, the German economy would be weaker and we would be liable to have higher unemployment.

If you compare it to countries with a large current account deficits in the Euro, the German economy has done relatively better in terms of economic growth and employment.


For example, in the mid 2000s, Euro member countries like Greece, Spain and Portugal were uncompetitive in the Euro, this was one factor leading to lower economic growth and lower employment in these countries.

Economists have often argued that Germany should boost consumer spending to help economic growth in other Euro countries.

Current account surplus and domestic demand

A current account surplus is partly due to high exports, but the other side of the equation is imports and domestic demand.

A country may have a large current account surplus because of relatively weak domestic demand. This weak demand leads to lower consumer spending, and lower spending on imports. Therefore, in this case, domestic employment will suffer from the weak economy.

The current account is often cyclical. In a boom, we see a rise in the current account deficit because consumer spending rises, leading to an increase in imports. During a boom unemployment falls and inflation rises.

But, in a recession, consumer spending falls leading to lower imports, lower inflation, and an improvement in the current account. The deficit may convert to a surplus, but this is due to the recession, and therefore leads to higher unemployment

Examples of current account surplus – China, Japan


China had a record current account surplus in the mid 2000s, this was mainly due to greater competitiveness, helped by an undervalued Yuan. This was a factor in China’s record economic growth, and it led to higher employment.

Japan’s current account surplus was due to weak domestic demand, and a reluctance to buy imports. Japan’s export sector was still one of strongest sectors of the economy, but this period of a current account surplus was  a period of low growth and weak employment growth.

A current account surplus will tend to boost domestic employment if:

  • It is due to an improvement in competitiveness, leading to higher demand for exports.
  • If domestic demand is still relatively strong, but consumers are buying domestic goods, rather than importing.

A current account surplus could lead to lower domestic employment if:

  • The surplus is caused by a recession which has hit domestic demand and led to a fall in import spending.
  • In a global recession where a surplus is caused by falling exports and an even bigger fall in imports



Flood defences as a public good

Here in Oxford, there is water everywhere. Yesterday, the a main road into town (Abingdon Road) was closed due to flooding, and the cost to business and householders will be quite significant. There is danger of even worse flooding to come. In one sense, it is an act of God. No one can do anything about the weather, but flooding is becoming an increasing problem, and many want the government to intervene to improve flood defences.


Flood defences are in many ways a classic example of a public good.

They have the two characteristics of public goods.

  • Non-excludability. Once you provide flood defences for a city, everyone in that city will benefit and be protected. (People will be protected whether or not they have have contributed towards the cost).
  • Non-rivalry. If you enjoy a city defended from rising flood waters, it doesn’t reduce the amount of flood defences for other people. (It’s not like eating emergency rations, which do reduce the amount available for other people.)

Failure of the free market

  • Difficulty in provision. There is little, if any, incentive for a firm to provide flood defences through charging local residents. There is a big free rider problem. People on flood plains may have a vested interest in better flood defences, but there is temptation to avoid paying and hoping someone else will pay.
  • Another difficulty is that flooding has no predictability. Building roads (a quasi public good) gives a predictable return. Spending money on police and justice also give a predictable return. But, you could spend millions on flood defences and not need it for 30 years.
  • Another difficulty is that flood defences can be quite difficult to build. Dredging rivers done annually is expensive, though at least manegable. But, other flood defences may be more difficult, such as building relief canals to take excess water. This may need government help to purchase the necessary land.

Occasions where public good can be provided by the free market

Despite the limitations of public goods, it is still possible local residents may club together in a spirit of solidarity to provide local flood defences. Many of the flooding in England is along the affluent banks of the River Thames. Many of these householders are wealthy and their property iss worth a lot (or at least was worth a lot). It is easier to create a private initiative if there are many wealthy people involved, as they will have more spare cash to pay for flood defences, and also they have a bigger vested interest in defending the value of their properties. If the floods affected rented property of low income workers, it would be much harder to provide flood defences. But, these local initiatives may be limited as many flood defence projects require very substantial capital investment.

At a local level, parish councils or local authorities may be able to pay for certain amounts of flood defences.

The role of the government

Flooding has significant economic costs:

  • Personal cost of those stressed by flood levels
  • Economic cost of business not being able to trade normally
  • Transport links adversely affected hitting productivity
  • Higher insurance premiums for everyone. Because we have not paid for flood defences, the whole country will be paying higher insurance premiums to pay the cost. It would be cheaper to have paid for flood defences and not the higher insurance costs.
  • Loss of property value for those living in flooded areas.

This makes a clear case for the government to spend money on flood defences and pay for it out of general taxation.

Evaluation of government spending

  • There is a danger of moral hazard. If the government promise to secure all land from flooding, it may encourage people to build and move onto flood plains. If people wish to live on flood plains / near rivers, arguably they should be prepared to pay part of the cost.
  • Many of those affected by the floods are relatively more prosperous than the rest of the country. There is an argument about limiting the transfer of funds from the average tax payer, to wealth homeowners living by the River Thames.
  • But, it should be remembered flooding doesn’t just affect rich people with mansions on the Thames – it is a rather lazy generalisation. I know every income bracket in Oxford is being hit by flooding.

Flooding and austerity

In the political blame game, some are criticising the governments policy of austerity. In a recession, government capital spending would help increase aggregate demand and boost economic growth. Spending on flood defences is exactly the kind of ‘shovel ready’ projects which the government could have been spending on – rather than cutting spending. The capital spending would not only increase aggregate demand, but help boost productivity by avoiding lost output and economic activity due to the flood damage.