Law of Unintended Consequences

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The law of unintended consequences refers to how economic decisions may have effects that are unexpected. Usually, this refers to an economic law which distorts consumer or producer behaviour in a way that is not expected. For example, a law may be implemented with the best intentions to help a group, but, if there are …

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Maximum Working Week – Pros and Cons

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A maximum working week is a legal limit on the standard number of hours that can be worked in a week. For example, in 2000 France passed a maximum working week of 35 hours. Additional hours could be worked, but they had to be paid at an overtime rate of +25%. At the 2019 Labour …

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Human Capital definition and importance

human-capital

Human Capital is a measure of the skills, education, capacity and attributes of labour which influence their productive capacity and earning potential. According to the OECD, human capital is defined as: “the knowledge, skills, competencies and other attributes embodied in individuals or groups of individuals acquired during their life and used to produce goods, services …

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Causes of business cycle

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The business or trade cycle relates to the volatility of economic growth, and the different periods the economy goes through (e.g. boom and bust). There are many different factors that cause the economic cycle – such as interest rates, confidence, the credit cycle and the multiplier effect. Some economists also point to supply side explanations, …

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Tips and advice for evaluation in essays

Evaluation is an important component of an advanced essay. It requires the ability to look at facts, arguments and analysis, with a degree of critical distance. Evaluation involves: Looking at what other factors may affect the outcome. Time lags involved. How it might depend on other issues, e.g. elasticity of demand Why the original statement …

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Advantages and disadvantages of devaluation

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Readers question: what are the advantages and disadvantages of devaluation? Devaluation is the decision to reduce the value of a currency in a fixed exchange rate. A devaluation means that the value of the currency falls. Domestic residents will find imports and foreign travel more expensive. However domestic exports will benefit from their exports becoming …

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Effects of slower economic growth

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Economic growth means an increase in national income/national output. If we have a slower rate of economic growth – living standards will increase at a slower rate. For example, in the post-war period, western economies grew at 2.5% to 4.% per year. However, since the early 2000s, growth rates have slowed down. This process of …

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Explaining Theories of Economic Growth

Different models of economic growth stress alternative causes of economic growth. The principal theories of economic growth include:

  1. Mercantilism – Wealth of a nation determined by the accumulation of gold and running trade surplus
  2. Classical theory – Adam Smith placed emphasis on the role of increasing returns to scale (economies of scale/specialisation)
  3. Neo-classical-theory – Growth based on supply-side factors such as labour productivity, size of the workforce, factor inputs.
  4. Endogenous growth theories – Rate of economic growth strongly influenced by human capital and rate of technological innovation.
  5. Keynesian demand-side – Keynes argued that aggregate demand could play a role in influencing economic growth in the short and medium-term. Though most growth theories ignore the role of aggregate demand, some economists argue recessions can cause hysteresis effects and lower long-term economic growth.
  6. Limits to growth – From an environmental perspective, some argue in the very long-term economic growth will be constrained by resource degradation and global warming. This means that economic growth may come to an end – reminiscent of Malthus theories.

Theories in more detail

Mercantilism

Popular at the start of the industrial revolution, Mercantilism isn’t really a theory of economic growth but argued that a country could be made better off by seeking to accumulate gold and increasing exports.

Classical model

Developed by Adam Smith in Wealth of Nations (1776), Smith argued there are several factors which enable increased economic growth

  1. Role of markets in determining supply and demand
  2. The productivity of labour. Smith argued income per capita was determined by “the state of the skill, dexterity, and judgment with which labour is applied in any nation” (Wealth of Nations I.6)
  3. Role of trade in enabling greater specialisation.
  4. Increasing returns to scale – e.g. specialisation we see in modern factories and the economies of scale of increased production

Ricardo and Malthus developed the classical model. This model assumed technological change was constant and increasing inputs could lead to diminishing returns. This led to the gloomy predictions of Malthus – that the population would grow faster than the world’s capacity to feed itself. Malthus under-predicted the capacity of technological improvements to increase food yields.

Neo-Classical model of Solow/Swan

The neo-classical theory of economic growth suggests that increasing capital or labour leads to diminishing returns. Therefore, increasing capital has only a temporary and limited impact on increasing the economic growth. As capital increases, the economy maintains its steady-state rate of economic growth.

To increase the rate of economic growth in the Solow/Swan model we need:

  • An increase in proportion of GDP that is invested – however, this is limited as higher proportion of investment leads to diminishing returns and convergence on the steady-state of growth
  • Technological progress which increases productivity of capital/labour

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