ÇAĞ UNIVERSITY
FACULTY OF LAW
ECONOMICS
COURSE NOTES-2015
ASST. PROF. CEMİL GÜNAY
CONTENTS
1. INTRODUCTION: WHAT IS ECONOMICS?...…………………………………………………………….3
2. LAW AND ECONOMICS ………………………………………………………………………………….......11
3. PRODUCTION, ECONOMIC GROWTH AND DISTRIBUTION …………………………………..21
4. MARKET MECHANISM ………………………………………………………………………………………..31
5. MARKET TYPES …………………………………………………………………………………………………..45
6. GOVERNMENT, PRICING AND NON-MARKET ALLOCATION ………………………………….56
7. AN OVERVIEW OF MACROECONOMICS AND NATIONAL INCOME ………………………. 67
8. EMPLOYMENT AND PRICE STABILITY: UNEMPLOYMENT AND INFLATION ……………80
9. MONEY AND MONEY MARKET …………………………………………………………………………….88
10. THE TURKISH ECONOMY ……………………………………………………………………………………..95
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CHAPTER 1
INTRODUCTION: WHAT IS ECONOMICS?
In this introductory chapter, we start by giving a short story of the historical development of
economic events in order to facilitate the understanding of the subject matter and scope of
economics. Then, we try to answer the question of “what is economics”.
1.1. A SHORT STORY OF ECONOMIC EVENTS
Economics may be defined simply as the science which studies economy. But what
constitutes economy? Economic events, as a component of social events are very complex
and hence, it is not easy to fix a boundary for them. There is no unanimity among
economists about the scope and the definition of economics. Nevertheless, an overview of
the historical development of economic events would facilitate our understanding of
economics.
People have to satisfy their natural needs, such as breeding, sheltering, wearing, etc.,
to survive. But, the satisfaction of natural needs is not enough; they have to satisfy also their
cultural needs, which expand and get complicated as economic life develops. With the
progress of living standards not only cultural needs expand and get sophisticated, but the
process of satisfying natural needs also becomes more complex. Thus, economics is trying to
explain facts and events that get more complicated as time goes on.
a. Gathering and Hunting
At the prehistoric times people endeavored to satisfy their needs with the objects that
existed in the natural environment. Our primitive ancestors could survive, probably, by
gathering. They did not know producing and using tools. They were able to live by eating
natural eatables and sheltering in caverns. At the gathering era, they probably spent most of
the time to find daily food.
In time, they learned hunting. In the hunting stage, they could have been able to
produce simple tools, such as arrow and bow, for hunting. Hunting, probably, made it
possible, sometimes, to have more food than needed for daily consumption, and human
learned to keep some of the food for the future.
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b. Agrarian Revolution, Specialization, Market and Trade
The domestication of wild animals and sowing and planting followed the hunting era. That
development, which made people productive, was later called the agrarian revolution.
People started to live sedentarily and, along with permanent settlement, the agricultural
revolution brought surplus production; farmers could produce more than they needed to
satisfy their own wants for survival. Agricultural surplus made the birth of many specialized
occupations possible; such as soldiers, priests, and skilled artisans. Some people produced
other goods and services while consuming the surplus food produced by farmers. This
allocation of different jobs to different people is called specialization of labor.
Specialization must be accompanied by the division of labor and trade. People who
produce only one item must trade most of it in return for all of the other items they require.
Naturally, trading became centered in particular gathering places. These places were called
markets.
c. Saving and Investment, Social Classes
Surplus production made it possible and necessary to think of the future, and people started
to keep some of their produce for the future, hence saving and investment emerged.
Keeping some animals to increase animal population, keeping some grains as seed, and
producing tools were probably the first examples of saving and investment.
Surplus production, making possible of production of the means of production by
saving and investment, had created the problem of who would own and use the extra
products and the means of production: the ownership issue. With the emergence of
ownership people divided into social classes, the haves and have-nots.
The ability to produce surplus product made also lending and borrowing possible and
thus debtor-creditor relations arose. This development led to a new problem; what would be
the difference between barrowed and returned amounts, namely, what would be the rate of
interest.
d. State
Sedentary life and stock building created the security problem and hence the need for
making and implementation of common rules. It became a necessity to carry out these
functions by a new institution that would be constructed and maintained by community.
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Thus a prototype of authority, namely, the state was born. A part of social product had to be
allocated to maintain that authority. Which roles would the state play and how the sources
necessary to maintain it would be raised, were the new questions. Hence, the taxation and
public finance issues arose.
e. Barter, Money
When the exchange of goods started, goods were changed for goods; namely, the barter
system was applied. Barter was tiresome; for it to be realized each side must need the other
side’s goods simultaneously. A double coincidence was necessary. Double coincidence was
not, however, enough for trading. Deciding the rate of exchange between goods is a difficult
problem by itself.
People tried to overcome these difficulties by using some objects
(abalones, animals etc.) as the means of exchange and the measure of value. Later in time,
the precious metal bouillons and then metal coins were used as the means of exchange.
That development led the question of what would be the rate of exchange between
different kinds of coins. Gold and silver coins were generally accepted as the means of
exchange and the unit of value. Measurement of the values of other goods in terms of gold
or silver facilitated the exchange of goods. If a farmer has wheat and wants a hummer, for
example, he does not have to search for an individual who wants wheat. The farmer takes
gold or silver coins in exchange for wheat and then finds another individual who wishes to
trade a hammer and gives up the coins for the hammer.
In this way a new kind of unit of value and a means of exchange, very similar to
today’s money, had been created. Every country had its own currency. In this system, the
exchange rate of two countries’ currencies was determined according to which metal the
coins were made of and the weights and pureness of the metals.
f. Industrial Revolution, Workers, Unemployment, Distribution of Income
Market transactions in early economies involved mostly commodities that were provided
directly by the maker. An individual specialized in making some commodity and traded it for
all the other products that he or she required. Over the last several hundred years many
technical developments have encouraged specialization in the method of production and
made it efficient to organize agriculture and industry on a very large scale. Division of labor
made it necessary to organize production in large and expensive production units.
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For thousands of years, agriculture, handicraft and the exchange of goods (trade) had
been the main economic activities. Increases in economic activities and progress in human
knowledge and experience prepared a suitable environment for the birth of a new era in
Western Europe, during the period between the fifteenth and eighteenth centuries.
Mechanical energy was started to be used in production, in addition to organic energy;
human developed machinery that works by mechanical energy. Production increased at an
unseen speed with the usage of machinery.
Employment of machinery in production was named industrialization. During the one
hundred years after 1750 the industrialization trend had accelerated, and the developments
in that era were later called industrial revolution. Industrialization took place first in Great
Britain, and then in France. USA, Germany, Italy and Japan followed them.
The use of machinery in agriculture made millions of people working in this sector
dysfunctional. In time, agricultural lands had been collected in the hands of a small number
of land lords. People who lost their lands and jobs migrated to the fast growing cities in
which machines were used in production of manufactures. In cities, a new kind of
production unit, using machines and employing many workers, namely the factory, had been
established. Those developments created two new classes; the owners of the means of
production (capitalists) and workers who sell their labor forces to the first. Individual
laborers lost their status as independent producers and became merely members of the
“labor force”. They became dependent for their income on their ability to sell their labor to
factory owners. Since then, the owner of a factory or large farm has not personally made the
commodities that the farm or factory sells. Rather, the owner has hired the labor of others
to do so.
One of the important problems that resulted from this development was the division
of the social product (income) among land owners, capitalists (industrialists and middle men)
and workers.
Unemployment has become another significant social and economic concern. Since
generally the number of workers looking for jobs was greater than the jobs supplied them in
factories, many workers could not find jobs to live on. The number of unemployed people
increased especially in crises during which economic activities declined.
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g. Development, Backwardness, International Economic System
Division of labor and specialization happen at different levels: in a production unit, in a
locality, in a country, and in the world. Division of labor in a production unit is the
specialization of tasks within the production process of a particular commodity. If there is a
division of labor, each person does not perform all the tasks involved in making a unit of the
commodity. Instead the labor involved is divided into a series of tasks, and each individual
does repetitive tasks that represent a small fraction of those necessary to produce the entire
commodity.
Local, national or international division of labor may be in the form of producing
different parts and/or stages of a single product or producing different products.
Industrial development in some part of the world created a new division of labor
among countries. In the countries which industrialized before others, industrial production
increased rapidly. While these countries were getting richer, the income gap between the
industrialized and other countries has widened. Hence a problem of backwardness arose.
Industrialization of Western Europe had destructive effects on some backward countries,
including the Ottoman Empire. In that new era, many countries had lost their political
independence and became the colonies of the industrialized countries. Economic policies
were no more only a domestic concern. As the industrialized countries dictated economic
policies to them, they could not decide and implement their own policies, thereafter.
Those developments added new debate issues, of international character, to the
economics’ agenda. The question of “while some countries could have successfully
industrialized, why the others could not?” was an important discussion matter.
In the twentieth century the expansion and the intensification of industrialization
created the risk of the depletion of natural resources and caused environmental pollution,
leading to a dilemma: industrialization and development at all cost or a sustainable
development.
On the other hand, with a widespread industrialization movement in the World, the
economic relations among countries have increased and got complicated. Making
international common rules and building an international economic system became a
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necessity. Thereby, the questions of how international rules could be made and
implemented entered the agenda of economics, as well as policy.
As the monetary system based on precious metals had become insufficient in the
face of increasing production and the diversification of economic activities, a new kind of
money, namely the representative money, was born. In the representative money system,
the relative values of national currencies are determined by a more complicated mechanism.
The structure of the international monetary system, including determining the values of the
national currencies, has been one of the most disputable economic problems.
h. Conclusion
It is hoped that this short story of the development of the economic events would give
students some clues about the subject matter of economics. As can be seen from this story,
there is close relations among knowledge, technology and the social and economic events.
The progress of knowledge and technology provided people with various alternatives among
which they could make choices. Economics could have been developed by the birth of
different alternatives. In this context it may be said that, economics is the science of
choosing among alternatives. Where there is no alternative, there is no need for economics.
Economics aims to clarify and explain the pattern of available possibilities.
Individuals and organizations have to make choices among alternatives.
Individuals make a choice among educational and professional alternatives. They
seek ways of increasing their incomes, decide how to use their incomes, which goods and
services to be consumed, how to use savings. In summary they try to live by choosing one of
the alternatives they face at different areas of life.
At the level of organization, such as the business firm, the choice could be between
investing in a new computer system or retaining and up-grading the existing equipment. In a
health care charity the choice might manifest itself as the option of spending donations to
reduce the suffering of chronically sick people now or investing those limited funds for
research into prevention and cure in the future.
At the national level, the choice could be between increasing government
expenditure on motorways and expanding the number of National Health Service beds.
Societies decide what to produce and how to divide social product among various social
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classes. They determine the percentage of the saving and consumption. They distribute total
consumption among different goods and services. They decide how to allocate savings
among different investment alternatives. They determine the share of national income
spent by the state and who would pay the taxes, and how the state would allocate its
expenditures. Moreover, countries decide about the exports and imports, they borrow from
other countries and lend them.
1.2. WHAT IS ECONOMICS?
Having had a look at the story of the development of economic events, now, we are ready to
ask the question of “what is economics?”
Economics is a branch of the social sciences that came into being in the second half of
the eighteenth century. Hence, it is a relatively young academic discipline. Although
economic thinking has a long tradition, the economic thought from the ancient Greeks to the
scholastics may be summarized as normative, about ethics and justice rather than about
causes and effects of the economic phenomena in question.
With the developments in economic thinking in the sixteenth and eighteenth
centuries, the focus shifted from ethics and justice to production, growth and wealth and
economics became an academic discipline in the eighteenth century. British philosopher
Adam Smith’s famous book, An Inquiry into the Nature and Causes of the Wealth of Nations
(published in 1776) was generally accepted as the first scientific work about economy, and
Smith is known as the founder of the Classical School. The new science was called the
classical political economy. The one hundred years following the publication of the Smith’s
book is known as the classical period. Adam Smith considered political economy as a science
of wealth, as implied in his book title. According to Smith the subject matter of the political
economy is to inquire the factors behind the richness of societies: Why are some societies
wealthier than others?
Following Smith’s definition, classical economists typically define classical political
economy as the study of the production, distribution, exchange, and consumption of wealth.
For example, British economist David Ricardo (1772-1823) wrote that the principal problem
in political economy is the determination of the laws which regulate the division of social
product, under the names of rent, profit, and wages, among three classes of the community;
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namely, the proprietor of the land, the owner of the stock or capital necessary for its
cultivation, and the laborers.
Classical political economy, had a profound sense of the historical and the social, and
consciously incorporated this both in its concepts and in its theory. All classical writers wrote
at a time when political economy was the only identifiable social science. For most classical
writers, political economy was seen as a united social science, rather than simply as the
science of the economy.
This situation changed drastically with the emergence of the marginalist school in the
1870’s and the subsequent move from classical political economy to (neoclassical)
economics. In its methods and technical apparatus, economics has become a-social and ahistorical, in the sense of using universal categories without reference to time, place or
context. The end result of this process was the separation of economics from other social
sciences, especially economic history and sociology.
British economist Lionel Robbins (1898-1984) defined economics, in conformity to
this approach, as the “science which studies human behavior as a relationship between ends
and scarce means which have alternative uses.”
However, the attempts to keep the relationship between the economic and noneconomic alive did not cease with neoclassical economics. The work of the members of
alternative schools of thought, such as the Historical Schools and Institutionalism, was
interdisciplinary in character and emphasized a multi-disciplinary approach.
For example, American institutional economist John R. Commons (1862-1945)
defined economics as the “study of relationships among different property-owning groups
(landowners, merchants, industrialists) and these groups and their workers.”
Some textbook writers take into consideration different aspects of economic
phenomena in defining economics. For example, American economist Paul A. Samuelson
(1915-2009) defines economy as “the study of how societies use scarce resources to produce
valuable commodities and to distribute them among different people.”
After we have got a general idea about economics in this first chapter, we will discuss
the economics-law relations in the next one.
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CHAPTER 2
LAW AND ECONOMICS
In this chapter we will discuss the relations between economics and law. We will, first,
underline how economics and law are interrelated. Secondly, we will examine the effects of
risk and uncertainty in economies. Finally, we will study the roles of rules, customs and
institutions in limiting the adverse effects of risk and uncertainty, and stress how they
promote economic development.
2.1. THE RELATIONS BETWEEN LAW AND ECONOMICS
Every stage of the progress in history corresponds to a type of social relations. With the
changing material conditions of life, social relations also change. Economics and law are the
branches of social sciences studying somewhat different but with common space faces of
social relations. While the decisive factors shaping law are economic relations, this relation is
not passive; there is a dialectical interaction on law between the economic base of society
and the ideological superstructure. As society develops, the law is in a perpetual process of
change. Legal development is a part of socio-economic progress.
History shows that the cooperation of people is necessary in order to organize and
derive the benefits of the division of labor and specialization and to distribute the rewards.
The extent and type of cooperation, competition and indeed the means of handling conflicts
depend on institutional rules. Rules are vital for people coping with knowledge, ignorance
and uncertainty and institutional rules are dependent on socio-economic and political
factors.
Today, countries’ economies are based mainly on the workings of markets. All
markets require laws, customs and conventions in order to coordinate the plans of buyers or
sellers. To work effectively, markets have to provide security; people need to know that they
are not going to be cheated. Markets have to be organized, to function effectively. Markets
are heavily dependent on rules and regulations. In any economy the influence of norms and
convention intertwine with the price mechanism and economic transactions. There has to be
an element of trust in markets. Trust is the confidence that the other party will fulfill his or
her part of the bargain.
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The ordering of market transactions takes place through layers of rules. Rules emerge
through the need to mediate economic transactions. Regulation, in a broad sense, is
essential to the operation of any system of social organization. The state regulates and
legitimizes the whole of social relations. Social relations are reproduced through the
combination of private economic relations through markets and political processes
dominated by the state.
The framework of rules and institutions is made up of both formal and informal rules
and the additional rules of enforcement.
Formal rules can include a written constitution and laws created by formal legislation.
In addition, there are legal contracts between individuals, like marriage. Formal rules may
also incorporate taboos, custom and tradition of simpler societies. As economies become
more complex, so do the required rules. Formal rules are altered by studied action, and
increasing volume of laws are set and changed by State legislative process, in modern
societies. Yet, such laws are, in part, dependent on the formal and informal rules of both
past and present.
Informal rules are also significant in determining behavior. They include conventions,
norms of behavior, and codes of conduct, some often ingrained as habit and routine. But all
are based on traditions, customs and practices of the past. Certainly, the market player who
does not understand or play by rules might lose out. Ethical codes of business conduct,
indeed many voluntary standards of behavior all help to order economic life. These
standards and conventions are culturally determined, and differ from country to country.
a.
Enforcement of Rules
Both formal and informal rules require enforcement. No matter what rules exist there will be
those who break them. Given rules of the game, there has to be the means to oversee and
regulate them, to measure the extent of any breach or infringement, to police and correct.
Indeed, the setting and large-scale enforcement of formal rules are important functions of
the modern nation state and the supra-national organizations which provide international
law.
In modern societies, complex contracts or agreements are necessary for decision
making. The growing number of formal rules and the increasing number of state
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organizations operating in legal, judicial and regulatory guises go hand-in-hand. Increasingly
the multidimensional attributes of complicated goods and resources have to be set out in
exchange contracts. With the inability to identify every possible future eventuality, it is
impossible to draw up contracts setting out all provisions. There has to be a third party
adjudicator to enforce contracts, a secure and robust central government to provide
stability.
Informal constraints may be enforced by peer group pressure, by social sanction or
the prospect of retaliation in the event of transgression.
b. Rule of Law
Formal-rational principles of law developed historically with the emergence of capitalism, to
underpin the conditions of competitive exchange. Their continuing importance is seen in the
current stress on the importance for capitalist development of the ‘rule of law’. Key features
of the rule of law include:
1) an independent, impartial judiciary;
2) equality of all before the law;
3) the resolution of legal disputes through the court process;
4) the right to a fair and public trial;
5) a rational and proportionate approach to punishment, and
6) a strong and independent legal profession.
There is a strong causal link between respect for the rule of law and sustained and
robust economic development. When the rule of law breaks down, and law and institutions
cannot be relied upon to regulate the behavior of the government or its citizens, economic
development inevitably suffers. The relationship between establishing and maintaining the
rule of law and promoting economic development runs both ways. On the one hand,
ensuring that state institutions and practices are compatible with rule of law principles
provides a critical foundation for sustainable economic growth. On the other hand,
economic development brings with it increased opportunities to foster respect for the rule
of law and human rights.
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c.
Risk and Uncertainty
Economic decisions are made with imperfect foresight. There may be several possible
outcomes from any course of action and the one which will occur cannot be known in
advance. Risk and uncertainty is an important fact of life and cannot be eradicated, because
time cannot be reversed. We cannot foresee the future perfectly. The unexpected may
happen; and the existing tendencies may be modified before they have had time to
accomplish what appears now to be their full and complete work.
In an uncertain situation we cannot provide neat probability measures. We may have
no real idea of the precise structure of the problem, indeed all the possible types of
outcome, how the future may come out. There may be adverse or agreeable surprise in the
future. We have considerable ignorance of the situation and we certainly cannot measure
the likelihood or probability of an event with any confidence. Information is lacking and
expectations are unclear. People in the ordinary business of life, constantly face true
uncertainty, where they have no idea what the future will bring.
Therefore, uncertainty must be an essential element in our thinking. In reality, the
issue is about making choices in situations which embody different grades of risk and
uncertainty or indeed where we are completely ignorant.
2.2. THE MAIN FUNCTIONS OF RULES
a. Rules Help Decision Making
Laws and customs are essential integral features of any economic story. They are
indispensable for people making decisions in a world of imperfect information and
uncertainty. Rules provide the basic prerequisite affecting the way in which resources are
coordinated and the rewards distributed.
People making economic decisions require a framework of rules. We have to cope
with our own limitations in gathering, and making sense of information and dealing with
fundamental uncertainty. The major role of institutions in society is to reduce uncertainty by
establishing a stable structure to human interaction.
Whatever human society we spotlight, simple or technologically advanced, rules are
necessary to order, constraint and guide people, in fact to ensure the production and
reproduction of the system itself. There must be a set of rules to reconcile conflict between
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contrary tendencies; like self-interest and altruism. Rules exist because of the need to
reduce the difficulties involved in human transaction, where people relate to each other.
For the working of specialization and the division of labor there is a basic need for
cooperation. Cooperation is an essential requirement to ensure the gains from specialization
and exchange. Economic interactions with others, however, have some costs. These costs
arise from the information problems and uncertainty.
b. Rules Reduce Transaction Cost
Institutionalized rules can help to reduce the costs of human interaction by giving a
framework for organizing economic, social or political human exchange. Formal and informal
rules help to reduce the impact of imperfect knowledge, the problems of risk and
uncertainty. They help people to cope with their own limited ability to process the mass of
information which they actually possess and allow for that which they cannot know.
Institutions are constraints which help decision makers. Those engaged in an
economic exchange are more confident about the actions of others if there are known laws,
effectively enforced, and generally accepted conventions. These place boundaries on what
people expect, and so limit the information need for making decisions in new situations.
Rules help to define possibilities in any particular situation, in the interpersonal exchange or
interaction in a wider context. They provide economic players with a view of what is
‘normal’, so curtailing search and transaction costs. Rules reduce uncertainty by giving a
secure structure to human transactions.
Economic interaction may involve complex deals which often extend over long
periods of time. Intentions and agreements in reality cannot be perfectly mapped out, not
every eventuality can be specified. Contracts are perforce incomplete. Even in the case of
exchange, where markets are well developed and private property rights are clearly
specified and upheld, any contract always carries uncertainty. There may be shocks and
surprise. Knowledge of the formal laws or the use of habitual routines helps decision
makers, the order which rules bring helps to ensure production and the survival of the
system itself. The constraining institutional framework ensures connections between
successive periods; whether in carrying debts contracts through time, the passing of wealth
from one generation to another or the handing on of tacit knowledge.
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Moreover, laws and customs also give an important measure of security and comfort
in the face of fundamental uncertainty. Institutional rule can be a direct source of ease for
people coping in an uncertain world. Age old practices, routines, conventions help people to
cope in time of turbulence. They reassure and relax.
c. Rules Facilitate Understanding the Behaviors of Decision Makers
To understand individuals and their organizational behavior we must consider the rules of
conduct, formal and informal.
Institutionalized rules are significant for explaining individual and group economic
behavior and different levels of economic activity in economies over time. The existing rules
of an economy have a profound effect on production and exchange. They help to set the
relative costs and benefits of different forms of production and exchange. They structure
incentives and affect the coordination of resources through markets or other organizations.
Institutions ensure more than guidance for individuals. The production and reproduction of
the overall system itself depends on orderliness. Rules are themselves part of an intricate
process of cause and effect in economic evolution. These cultural constraints not only
connect the past with the present and future, but provide us with a key to explain the path
of historical change.
d. Rules Affects Economic Performance
Institutional rules are among the most important determinants of economic performance.
Together with the factors of production and technology, the rules of the game are key
elements determining the production possibilities of societies. Economic development
requires a stable underlying institutional framework which will bolster the incentives for
individuals and organizations to engage in productive activity, to expand the division of
labor, specialization and trade. These require human cooperation.
The consequences of institutions are always ‘a mixed bag’, however. While some help
to further the division of labor and cooperation, others reduce it. At any point in time the
blend of formal and informal rules is a mixture; some will facilitate and support change,
others will act as a hindrance. Every person and organization is circumscribed to a greater or
lesser extent by traditions. Traditions affect human interactions in the present and the way
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in which the future is created. Some environment may have rules of the game which foster
technological change and rapid economic growth.
In historical time, various changes in the pattern of rules have clearly facilitated the
division of labor, specialization and the growth of markets by lowering search and
transaction costs. Moreover, what is illegal and/or informally unacceptable in one society in
a particular historical time may be legal and acceptable in another. The legalization and
legitimization of some activities can have a significant impact on economic behavior.
The Agrarian and Industrial Revolutions and the eventual rise of modern societies
were associated with the development of increasingly complex formal institutional
frameworks. These were required to structure the involved exchange and production
process in a world where technological and industrial changes were moving much more
rapidly. Company, financial and labor law, indeed an evolving array of legislation was crucial
for development.
Some institutional changes enable the lowering of transaction costs, like the long
evolution of maritime and merchant law and the gradual spread of clearly defined property
rights and international laws of protection. These helped to bring about the development of
modern economic system. Rules have been designed to improve the quantity and quality of
information to buyers. Over historical time, rules have evolved to enable people to spread
the risks of their transactions, and to ensure, for example, the development of insurance
law. This is to make economic life easier and facilitating exchange.
One aspect of the institutional framework which is particularly useful in
understanding economic development are rules which relate to property, they are central
feature in economic life.
2.3. PROPERTY RIGHTS
A fundamental aspect of any legal system is the structure of property rights. While the
nature and effects of formal and informal rules in general are important, property rights
have a particular significance. Capitalism, as an expansionary economic system, demanded
the unfettered accumulation of capital based on the private ownership of the means of
production. The development of capitalist economic relations shaped the content and
structure of law in many ways. But the most fundamental concepts are private property and
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contract. The value of property rights is intertwined with the ability of parties to enter into
contracts governing the use of their property. Contract law determines whether and how
agreements among parties will be legally enforced and a major part of its function is to
increase efficiency in economic relations.
The mix of property rights, including personal, collective and communal rights, varies
over time and place. These rules alter the costs and benefits involved in coordinating activity
in different organizations. They interact in a symbiotic process of cause and effect changing
over time.
Property rights are very important in structuring exchange and production; because
they specify what people are entitled to do with resources and goods. Different property
right structures enable us to clarify situations where markets present the most appropriate
coordinator and allocator of goods and resources and where alternative organizational
responses are either necessary or more efficient. A classification of rights shows the
different prerogatives which people have over resources and goods.
a. Private rights
Private ownership is of major importance in the modern capitalist economy. It is possible to
own land, buildings, machinery, consumer goods as a private individual. And with this
ownership comes the right to exchange or to give away private property.
Private property rights provide the entitlement to use property only in circumscribed
ways. People have a claim to the only certain things with the goods they own. For example,
the purchase of a car brings with it exclusivity. No one else entitled to drive the car without
the owner’s consent. While ownership gives the right to exclude others from the use, it does
not bring rights to do exactly as the purchaser pleases. The ownership of the motor vehicle
does not give the owner the right to drive it excessive speed. There are clear rules relating to
the use of a private car. The presence of well-defined property rights and the appropriate
laws for policing such rights are of key importance and underpin market exchange and
inheritance.
If it were not possible to exclude others from the use of private goods few would be
willing to purchase them in a capitalist system. There would be adverse effects for both
production and consumption. The sanctity of private property and the traditional rules of
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private inheritance underpin the market mechanism. Private property rights are required
because of rivalry. If there were over abundance of goods and resources, there would be no
need to protect what a family might have against the actions of others. Everyone could have
exactly what they wanted. However, as a result of scarcity all desires cannot be met, so
people want to have secure rights over their property. These secure rights reduce
uncertainty.
But in many societies, particularly those in the past, private property played a very
much smaller role than it does in modern economies today. There are other types of
property rights to consider.
b. Communal rights
In some situations people hold the rights to use a resource in common with others. Common
lands used for grazing animals enable peasants to use a valuable resource. They do not own
the common, they had no legal contract but customs and practice gave them rights of use.
The common land is open to those who have prescribed rights; they do not have to ask
permission of another to use common land and cannot be excluded. Indeed, if none can be
excluded from the use of a resource it is by definition communal.
c. Collective rights
Collective rights are quite different from the private and communal rights. Given the private
or communal rights, the decisions about the use of the resource or good, are left to the
individual, providing they are made within the circumscribed limits. A collective right
involves a decision on behalf of the group. Decisions about the use of the collective rights
have to be taken by an authority. The collective ownership of a public limited company,
where shareholders leave managers to undertake the day-to-day running of organization, is
an important example.
Transaction costs are not independent of the time of the property rights in which
trade takes place. If we look back through historical time we can see how these property
rights have changed to facilitate development. In some cases ownership rights are seized.
Yet for economic growth, societies require well defined and enforceable property rights. This
reduces risk and uncertainty, and can bring peace of mind to individuals. In twentieth
century, assets have changed from private to public ownership, and then back again through
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privatization sales, motivated by economic change and the political decision-making process,
in many countries. The approximate mix of property rights for economic development is
subject to change and debate.
HOMEWORK 2
1. What are the key features of the rule of law?
2. What are the main functions of rules in economic life? Explain each one briefly.
3. Explain the significance of property rights.
4. How the property rights are classified? Explain each one.
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CHAPTER 3
PRODUCTION, ECONOMIC GROWTH AND DISTRIBUTION
Economics is concerned mainly with production and distribution problems of society. In the
production process inputs are transformed into products that people consume. Average
consumption per person of a society is one of the most important indicators of the level of
development or standard of living. Since the society cannot consume more than it produces
in the long run, the standard of living of a society is determined by its productive capacity.
The production capacity of any society is determined, first of all, by the existing
quantities and qualities of the resources used in production.
3.1. FACTORS OF PRODUCTION
All societies face a production constraint. In order to explore and clarify the nature of the
constraint and to show how it might be changed through time we must first examine the
inputs of the production process. These inputs are called the factors of production. Both the
quantity and the quality of such resources must be considered. Inputs, which are used to
produce outputs, are usually divided into three broad categories; land, capital and labor.
Land: In economics land has a much wider meaning than in everyday speech. Land refers to
natural resources, which include not simply farmland or the industrial site, but minerals
underground, oil and gas, even fish stock in the sea.
Capital: The word capital has two different meanings in economics: financial capital and
physical capital. Financial capital includes securities issued by governments and companies.
Physical capital is the produced means of production and refers to such items as plant and
equipment, factories, warehouses, or the infrastructure which includes, for example, roads,
schools and hospitals. In this lecture we will use the term capital in meaning of physical
capital; that is, capital as a factor of production.
Labor: Labor is the human resource, the people who use the land and capital to produce
output. Labor can embody very different physical and mental talents, reflecting differences
in innate abilities and large variations in the type and levels of education and training. The
labor resources are often divided into broad categories; unskilled, semi-skilled, professional
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and managerial, depending on training levels and function. There are different types of
labor, from the highly trained engineer, quantity surveyor, accountant to the manual laborer
or machine operative.
Entrepreneurs are usually singled out from the factor of “labor”, for special
emphasis. Particularly in the market economy, these are the people who organize and coordinate the other factors, take risks and innovate new ideas and make new investments in
products, machinery and people. They are alert to gaps in the market for new products and
processes and take advantage of new opportunities. Their ultimate goal is usually seen as
one of self-interest.
Entrepreneurs have to base their decisions on limited information about the present
and the future. They face uncertainty by going into uncharted fields where there is no
previous experience. They are not always successful-but they provide a key driving force
within the economy.
All of the factors of production are combined together to produce goods and services
which give satisfaction to people.
3.2. PRODUCTION CAPACITY
The production capacity of a society is determined by the quantity and productivity of labor
employed. Labor productivity is the relationship between the quantity of labor used in
production and the quantity of output produced. It is measured by output per person per
hour.
Labor productivity is determined by three factors: labor quality (how skilled the labor
force is), the quantity of capital per worker and the level of technology. Two additional
factors for labor productivity are the social-economical conditions of the society and the
living conditions of workers. The social, political and legal institutions, the custom and
practice in society affect labor productivity. These laws and customs provide the necessary
“rules of the game”. They determine, in part, how the inputs will be brought together and
hence the nature of the overall production constraint facing society. Living standards such as
health, nutrition, environmental conditions also affect labor productivity. Indeed there is an
interrelationship between labor productivity and living conditions; any increase in labor
21
productivity may raise living standards and any improvement in living conditions, in turn,
may promote labor productivity.
Economic resources are limited. The limitedness of resources in comparison with our
needs is called scarcity. Scarcity underlines the significance of the usage of resources
effectively.
Effectiveness or efficiency in production is to produce the highest possible output
using the existing resources. In other words, efficiency in production is to produce a given
amount of output using the least amount of inputs.
The purpose of societies is not, however, to maximize the quantity of production at
any cost. Some of the natural resources are not renewable; mineral reserves can be mined
once only, they cannot be recreated. With the increasing production they are depleted and
destructed. Maximization of the current production at any cost would be at the expense of
the future production and, therefore, would reduce economic possibilities of future
generations.
Because of scarcity the number and quantity of products that can be produced are
limited. Since we cannot do all we like, we have to rank needs and make choices. Making a
choice means picking up one of the options and forgoing the others. That means every
choice has a price, a cost. This is called opportunity cost. Opportunity cost is the cost of one
item (option) in terms of the best alternative foregone.
3.3. ECONOMIC GROWTH
Since the only way of increasing living standards of societies is to increase their productive
capacities, the main purpose of economic policies is to seek the ways of increasing this
capacity and the function of economics is to explain how this can be done.
Economic growth is the increase in total production of a country. The increase in total
production may be a result of an increase either in total labor employed or an increase in
labor productivity, or both.
The quantity of labor is a function of total population; with an increase in population
the quantity of labor will also increase.
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Today, most of the countries have not any problem in providing working people. The
main problem regarding labor is to increase its productivity. If there is an increase in labor
productivity, it will be possible to produce more output without any change in the quantity
of labor.
We cited the factors influencing labor productivity in the previous section. Thus,
increase in labor productivity would be possible by increase in capital per worker, and
improvement in labor quality, the socio-economical structure of the society and living
conditions of labor.
Labor quality improvement is provided mainly by education and training. Educated
and trained people are much more productive. Changes in the society’s political and social
structure can lead important changes in the ability to produce.
The total quantity of capital existing in any country at any time is called total capital
stock. In modern societies although the increase in capital stock is an important factor
augmenting productive capacities, technological advances are of primary importance.
Technology may be defined as the way of producing. Technological development enhances
productivity, results in more effective ways of production: decreases the quantity of inputs
necessary to produce one unit of output.
As a result of technological development labor productivity increases faster than
capital stock. In fact, many times, technological advances accompany increases in capital
stock.
Existing capital stock embodies a particular level of technical ‘know-how’. For
example, in any country, some capital equipment may be new or ten, twenty, thirty years
old. Parts of capital of different ages embody very different technologies; old or new. Since
the new capital goods added to capital stock embody new technologies, the higher the rate
investment the higher is the rate of renovation of capital, and therefore the higher is the
rate of technological change.
Capital stock of the society is increased by investment. When the rate of increase in
capital stock is higher than the increase in the total number of workers, capital per worker
will rise. Societies provide funds necessary for investment from their savings. National saving
is the quantity of product produced in a year but not consumed in the same year and used
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for investment. The higher the rate of saving the higher is the rate of investment and,
therefore, the higher is the rate of increase in capital stock.
Technological development may be a result of formal research and development
and/or by trial and error. Historically, technological developments before industrial
revolution were mainly the result of individual trials and errors. As the industrialization
deepening and production process getting more complicated, technological development
has become more and more dependent on the formal research and development activities
carried out by big business firms or public institutions, such as universities and scientific and
technological research centers.
We said, at the beginning of this chapter, that economics is concerned mainly with
production and distribution problems of society. The classification of these problems may be
helpful in understanding the practical working of economies and the ways of solution.
3.4. A CLASSIFICATION OF ECONOMIC PROBLEMS
Modern economies involve thousands of complex production and consumption activities.
While the complexity is important, many of the basic kind of decisions that must be made
are not very different from those made in a primitive economy in which people work with
few tools and barter with their neighbors. The great majority of the problems that studied in
economics fall within five problem areas:
a. What goods and services are being produced and in what quantities?
b. By what methods are goods and services produced?
c. How is the supply of goods allocated among the members of the society?
d. Are the country’s sources being fully utilized?
e. Is the economy’s productive capacity growing over time?
Now, we are going to discuss each briefly.
a. What goods and services are being produced and in what quantities?
This question concerns the allocation of scarce resources among alternative uses. Any
economy must have some mechanism for making decisions on the problem of resource
allocation.
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b. By what methods are goods and services produced?
Generally, there is more than one technically possible way in which a commodity can be
made. Agricultural commodities, for example, can be produced by taking a small quantity of
land applying to it large quantities of fertilizer, labor, and machinery, or by using a large
quantity of land applying only small quantities of fertilizer, labor, and machinery. Either
method can be used to produce the same quantity of crop.
Which of the many alternative methods should be adopted? An often-cited criterion
is the avoidance of inefficient methods. Production is said to be inefficient when it would be
possible to reallocate resources and, as a result, produce more of at least one good without
producing less of any other good.
c. How is the supply of goods allocated among the members of the society?
Economics is interesting in what determines the distribution of a nation’s total income
among such groups as landowners, laborers, and capitalists. It is interesting also in the
consequences of government intervention designed to change the distribution of income by
using devices such as progressive income taxes, minimum-wage laws, and programs of social
insurance.
d. Are the country’s sources being fully utilized?
Although there is scarcity and sources should be fully utilized, one of the most disturbing
characteristics of market economies is that such waste occurs. Some of the workers cannot
find jobs, the factories in which they could work may be closed or may not be working at the
full capacity.
Unemployment of resources is similar to an inefficient use of them in that both lead
to production less than full employment. They are not the same problem, however, and the
remedies are very different.
e. Is the economy’s productive capacity growing over time?
If the economy’s capacity to produce goods and services is growing, national income levels
that are unattainable today become attainable tomorrow. Clearly, in an economy in which
not nearly enough can be produced to satisfy all wants, growth will be important because
growth makes it possible to have more of all goods. Additionally, productive capacity grows
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rapidly in some countries and slowly in others, and in some countries it actually declines.
Because of the differences in the growth rates of countries, living standards diverge more
and more between the rich and poor countries.
3.5. WAYS OF SOLVING ECONOMIC PROBLEMS: ECONOMIC SYSTEMS
All economies face scarcity, and must decide how to allocate scarce goods. Whatever the
historical setting, societies have to make choices. Different methods have been used for
addressing the questions of production and distribution; what, how and for whom? Not all
economies are or were organized on the same lines. It is usual to classify economies into
different types, according to the predominant way in which they deal with the economic
problem. Economies can be categorized as; traditional, market and planned (or command)
economies.
In traditional pre-industrial societies, production and distribution decisions were
based on procedures evolved through a long course of trial and error. The procedures were
maintained rigidly by the sanctions of law, custom and belief. The bulk of the population was
working on the land meeting most of their own needs, as typified by peasant agriculture.
Markets did exist, but these were places where people came together to buy and sell a
relatively restricted range of products; where goods and services were either swapped or
exchanged for money. However, they were not the modern sophisticated markets of today.
Relatively few societies’ resources were allocated by markets. Most people produced for
their own needs, they did not supply their labor for money wages in labor markets. Parents
were followed by children into the same occupation and the role of women was heavily
determined by customs, practice and religious belief. The traditional solutions to the
question of production and distribution gave static results, with relatively little development
over time.
In modern economies market mechanism and planning are used to solve economic
problems. Economies that use mainly market mechanism are called capitalist economies,
and economies that use mainly planning are called socialist economies.
The main differences between capitalist and socialist economies can be categorized
as the differences in the ownership of resources, decision process, values, and incentive
systems.
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a. Ownership of Resources
One characteristic of the capitalism is that the basic raw materials, the productive assets of
the society, and the final goods are predominantly owned by individuals singly or in groups.
In contrast, in a socialist economy the ownership of productive assets is public. Communism
theoretically is opposed to any form of private property.
b. Decision Process
In a market system decisions are made impersonally and in a decentralized way by the
interaction of individuals in markets. In a command system, centralized decision makers
decide what shall be done and issue appropriate commands to achieve the desired results.
c. Whose Values
In the market and command systems different groups make the relevant decisions and it
follows that different people’s judgments will determine these decisions.
In a capitalistic market economy, money “vote”. The demands of consumers for
goods exert a major influence on the nature of goods produced. But since the purchasing
power is not distributed evenly among people the rich consumers have much to say than the
poor one and that firms have a great deal to say about what is and is not produced. In an
unfettered market economy, the initial distribution of income and wealth influences the
nature of economic decisions because it determines who has the money that exercises the
effective demand.
In a command economy some group must decide what is to be produced and who is
to get it. Whoever makes the decisions might do so on the basis of majority preferences,
with each person having one vote, regardless of his or her share of the income.
Alternatively, decision makers might decide on the basis of their or a particular group’s
preferences, or they might decide on the basis of “what they think is better for the people”.
The general point is that different systems are likely to reflect the values of different
groups. Planned systems have ended to reflect the values the central authorities somewhat
more strongly than have market systems.
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d. Incentive Systems
People respond to reward and punishment. There are different incentive varieties. Direct
monetary rewards are in the form of wages or profits or bribes. Indirect monetary rewards
may be in the form of special housing, vacations, or subsidized education. Nonmonetary
incentives include praise, medals, certificates, and applause. Fines, prisons terms, and other
penalties are used to motivate behavior in all societies; in some societies coercion and fear
provide even stronger motivation.
Capitalist market economies put major reliance on monetary incentives. Monetary
incentives to the individual in a socialistic society are not very different from those in a
capitalistic economy. The big difference in incentive systems is in whether those responsible
for production responds that is profitable to produce or whether they respond to what they
are directed. In the first case, profits can provide their own reward in terms of bonuses,
salaries, dividends, and perhaps the funds to permit growth and the accumulation of power.
In the second case, it is necessary to provide incentives to managers and workers to achieve
the assigned quotas.
The market economy uses the market mechanism to find solutions to questions of
production and distribution. A large number of individuals and organizations act in response
to price changes in the market. The market mechanism coordinates the factors of
production, and prices provide market signals. In market economies, apparently
uncoordinated activities of individuals and firms are reconciled by market mechanism. Selfinterest and profit provide the incentives.
Although big differences in economic systems of countries are a fact of life, every real
economy is “mixed” rather than pure. The mixture differs among countries and changes over
time.
Ownership patterns are genuinely variable. No country is found at either extreme. It
is true that some economies rely much more heavily on market decisions than do others. But
in even capitalist economies the command principle has some sway: minimum wages,
quotas on some agricultural outputs, and war time priorities are obvious examples. More
subtle examples concern public expenditures and taxes that in effect transfer command of
some resources from private individuals to public officials.
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The planned or command economy does not rely on the workings of markets to solve
the economic problem. It may have a central planning unit to decide on production and
distribution targets. Economic effort is directed towards goals administratively chosen by the
State. Major decisions about what and how to produce, and for whom, are made
administratively.
In the planned economies plans and targets, quotas and directives are important
aspects of the decision-making system and there is substantial command at work. But
markets are used too. There have been no completely communistic or socialistic societies. In
socialist economies, generally, the factories are state-owned and farms are collectivized, but
there are sectors where some significant private ownership exists: agriculture, retail trade,
and hosing. However, even a command economy is not a purely socialist economy it is
sufficiently near the public-ownership end of the spectrum to distinguish it from a capitalist
economy.
Many countries fall between two ends on the spectrum and their position changes
over time. Some European countries, for example, nationalized key industries after the
Second World War: railroads, steel, coal, gas, electricity, atomic power, postal services,
telephones, telegraphs, airlines, and some trucking. Most of these sectors were re-privatized
since 1980s.
Today, countries’ economies are based mainly on private ownership of resources and
the workings of markets; large proportions of their resources allocated by markets although
they use the market in different degrees.
However, in practice, many vital elements of planning exist in market economies,
with allocation decisions being made by governments and within business firms.
Governments affect production and distribution decisions through a variety of means; by
taxation and expenditure or by regulation of the competitive process. Governments play a
vital part in the economic system through social security or welfare payments, by taxation
on income or expenditure, the provision of goods and services such as defense or the
judiciary. Indeed, governments in any economy have an important role to play in setting
“the rules of the game”; the laws and regulatory framework of an economic system. At the
same time, the giant corporation, the huge bureaucratic firm often straddling many national
boundaries, depends on its internal planning mechanism.
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HOMEWORK 3
1. What are the factors of production? Explain each one briefly.
2. What determines the productive capacity of a society?
3. Define labor productivity and explain how it is determined.
4. Define the following concepts: scarcity, efficiency, opportunity cost and technology.
5. Define economic growth and explain by which factors it is determined.
6. What is capital stock and how it is increased? Explain the role of savings.
7. How does technological development occur?
8. What are the five problem areas of economies?
9. What are the main differences between capitalist and socialist economies? Explain.
10. Explain why every real economy is mixed?
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CHAPTER 4
MARKET MECHANISM
In this chapter we try to understand what markets are and how they solve economic
problems that we discussed in the previous chapter. We begin with the definition and an
overview of markets. Then to we explain what determines market prices and what causes
them to change. Finally, we will see how the working of the market mechanism finds
solutions for basic economic problems.
4.1. DEFINING MARKETS
The market may be defined as an area over which buyers and sellers negotiate the exchange
of commodities. The market may also be defined as a set of social institutions in which a
large number of commodity exchanges regularly take place. The buyers and sellers must be
able to communicate with each other in the market, for exchange to take place.
Organizations of the market give information about products, prices, quantities and buyers
and sellers, both actual and potential.
The key purpose of any market is economic exchange. Economic exchange requires
both buyers and sellers. There has to be a payment; exchanged for products or services. The
payment is at a price. Price is a mutually agreed and explicit exchange rate.
Market exchange essentially requires a communication and information system and
the rules of the game. Buyers and sellers may never meet; a telephone link and a means of
transporting goods and payments would suffice. There may not be a particular geographical
location, where buyers and sellers meet face to face. But markets are not simply the
summation of multitudes of individuals.
Markets are organizations themselves, inseparably intertwined with consumers and
firms, organizations which are more than a collection of separate individuals. The market is a
collection of relationships linking individuals.
While buyers and sellers have different considerations in minds, in exchange there
can be mutual benefits, even where a lower price for one person means more for another.
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Cooperation and rivalry occur in markets on different levels. Sellers in some markets, while
being rivals, may still collude with other sellers in order to do best they can for themselves.
Market organizations interlink the external relationships of private firms, consumers
and public sector organizations.
4.2. HOW THE MARKET MECHANISM WORKS
Markets are an essential feature of any modern economy. A great majority of economies
today may be categorized as market economies. Therefore, it is of great importance for us to
understand how market mechanism solves economic problems. In a market economy there
is a market for each commodity.
In markets, prices are the guiding lights; they signal where resources are best used to
meet competing ends. Prices show producers which resources to use and what product to
produce most profitably. They give vital information to buyers, because they guide and
constrain their purchasing. In short the market price mechanism works to allocate and
coordinate scarce goods and resources, and rations them between competing buyers. The
market coordinates the activities of individuals and organizations and provides incentives.
In market economies the allocation of resources is the outcome of millions of
decisions made independently by buyers and sellers. There are three groups of decision
makers, whose decisions determine market transactions: buyers, sellers, and central
authorities.
Buyers decide which goods and services to buy and how much of each. Sellers decide
which goods and services to produce and how much of each. The central authorities, often
called simply “the government”, are defined to be all public agencies, government bodies,
and other organizations belonging to or under the direct control of governments. Public
organizations have legal and political power to exert control over individual decision makers
and markets.
In market economies, most commodities are, generally, made by a large number of
independent producers in approximately the quantities that people want to purchase them.
Although, sometimes, there may be surpluses or shortages of products, market mechanism
eliminates them. In spite of ever-changing requirements in terms of geographical, industrial
32
and occupational patterns, most laborers are able to sell their labor forces to employers
most of the time.
Now we will examine first the working of the market mechanism in a simple form and
then discuss different kinds of markets in the next chapter.
4.3. PRICE THEORY
In this section we try to understand the behaviors of buyers and sellers: how they respond to
market changes. We use a theory which can explain and predict market price and quantity
movements. To do this:
a) We examine first demand and supply, the responses from the two sides of a market.
b) We then study the interaction of demand and supply to give an equilibrium price.
Equilibrium price is the price which equates the quantities supplied and demanded.
4.3.1. THE THEORY OF DEMAND
When we talk about the demand, we mean effective demand. Effective demand is the desire
to buy backed by the ability to pay. Effective demand has two essential conditions: the
ability to pay, the necessary purchasing power and the willingness to purchase.
There are many underlying variables at work determining demand: prices, incomes
and tastes. To simplify the situation, we consider the impact of each factor in isolation: we
make a ceteris paribus assumption. We take the example of the carrot and initially focus
attention on the price of carrots, to aid our understanding of buyers’ purchasing plans for
this commodity.
a. Price and its impact on the quantity demanded
Price is the quantity of money to be paid for a unit of good. Price is one determinant of
demand. It tells us what money the buyer must give up to buy the product.
The quantity demanded is the amount which buyers plan to buy in a particular time
period. There is a negative relationship between the price and the quantity demanded. This
is the law of demand: when price is high the quantity demanded is low; when price is low the
quantity demanded is high, ceteris paribus. Although the term ‘law’ is used, in fact, we may
33
say that the quantity demanded is usually inversely related to price, but this is not
immutable law for all situations.
The ‘law of demand’ enables us to predict that for any good, as price falls so there
will be a planned increase in quantity demanded. We can now clearly see the impact of a
change in price on the quantity demanded.
We can explain the inverse relationship between price and quantity demanded by
the substitution and income effects of a price change. We can begin by initially looking at the
individual consumer. When prices are very high, unless the person has a strong preference
for a good, cheaper substitutes will be bought. The consumer might buy turnips instead of
carrots, vice versa. Take the case of carrots, as their price falls individuals will be induced to
buy more carrots. The absolute and the relative price of carrots have fallen, in comparison
with substitute goods. Carrots will look a better buy when compared with substitute goods
whose prices have not fallen. There is a substitution effect in favor of carrots as a result of
the price change. And the purchasing power of TL in the pocket (real income) will increase to
buy more, because carrots are not as expensive. Imagine that the money price of carrots
falls from 70krş to 35krş per kilo. If a consumer had previously planned to purchase 10 kilos
of carrots, then this dramatic price fall, would be equivalent to an increase in income of
TL3.50, because for each kilo of carrots the consumer would save 35krş. Some of these real
income benefits might be used to buy more carrots. Such a reduction in price gives an
increase in real income. We call this the income effect of a price change.
Taken collectively, in aggregate, within the market some people who were previously
unwilling or unable to buy carrots at higher prices, will plan to purchase, as the price is
reduced. And those who already buy, even at the higher prices, want to buy more as the
good becomes cheaper. The overall result is an increase in quantity demanded. A fall in price
persuades and enables buyers to change their plans; they aim to purchase more.
We have seen the impact of a good’s own price on quantity demanded. Now we can
go further to unravel the factors at work, by considering the other determinants of demand,
by one by.
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b. Other variables affecting demand
The potential factors other than good’s own price which may affect the level of demand
include; income, the prices of related goods, tastes and other factors. A change in any one
such factor will either increase or decrease demand. An increase in demand means that at
every price more will be demanded. A decrease in demand means that at every price less
will be demanded.
To simplify we look at each of other factors one at a time to analyze their impact on
demand.
(a) Income of consumer
An increase in the level of income means that the ability of buyers to buy is increased. A rise
in income increases the demand for most of goods. The demand for a normal good will
increase when income increases, ceteris paribus. The reverse argument applies to a
reduction in income which will induce a fall in demand.
Inferior goods like bread will be less desired as income increases. Buyers, as they
become better off, may switch their purchasing power to ‘superior’ commodities like beef
steak. Less of an inferior good would be demanded at every price as people substitute
preferred goods, a substitution made possible by increased income.
(b) Distribution of income
The distribution of income can also be an important actual consideration. If there were an
increase in income inequality, then the demand for some products may increase while that
of others could fall. We may see an increase for demand for inferior goods and yet a
reduction in demand luxury items enjoyed by those on low income.
(c) Tastes or preferences
This tells us about the consumer’s relative preference for a good. The buyer with a strong
liking will demand more than one who is not so keen, other things being equal. When buyers
change their taste for certain products and this is reflected in demand. An increase in the
number of vegetarians in the community, for example, will bring an increase in demand for
vegetables. Meat is rejected and vegetables will provide a substitute. Meat demand will fall
as a result of changing tastes.
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(d) Prices of other (related) goods
Some goods are substitutes for each other. If the price of cabbage were to rise, buyers may
well switch their demands to carrots. At every carrot price, after a cabbage price increase,
some buyers will switch their demand to carrots. Despite a constant money carrot price,
carrots become a better buy, in relation to an alternative, like cabbage. The demand for
carrots increases. On the other hand, should the price of cabbage decrease, some buyers
would change their plans and switch to cabbage, now relatively cheaper. The carrot demand
might fall.
Some goods are complements, their consumption and hence respective demands are
also related. A rise in the price of tea, bringing a fall in the quantity demanded, could induce
a fall in demand for sugar. These goods are consumed together. A fall in demand for tea will
also affect the demand for sugar; the demand for sugar will fall, ceteris paribus.
(e) Other factors
There are other factors affecting demand. The weather may have an impact on
consumption. A colder winter may induce an increased demand for fuels. Hot weather, on
the other hand, may lead to an increased demand for cold drinks.
The discussion of the demand side of the market gives only half the story. We cannot
say anything about the price which will prevail in the market, until we examine the supply
side. We have to display the intentions of both sides of the market, before we can indicate
which price will rule.
4.3.2. THE THEORY OF SUPPLY
The market supply is the amount of a good that all the suppliers, in a particular market, are
willing and able to supply over a particular time period. Many factors influence what
suppliers offer to sale. First, let us examine the relationship between the price of the good in
question and the quantity suppliers plan to offer.
a. Price and the quantity supplied
Only under the ceteris paribus assumption we can isolate the relationship between price and
the quantity supplied. Any other factors which might influence supply are held constant.
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There is a positive relationship between price and quantity. Price and quantity move
in the same direction, so if price falls the quantity suppliers are willing to supply falls too,
ceteris paribus. The positive relationship between the price and the quantity supplied is
called law of supply: the higher the price, the greater the quantity suppliers are willing to
supply; the lower the price, the lower quantity suppliers are willing to supply, ceteris paribus.
Suppliers can be induced to supply different quantities depending on the level of price. Some
prices are so low that no seller would plan to offer goods for sale; they could not cover costs
and make a profit. As prices rise, suppliers will supply a higher quantity.
b. Other variables affecting supply
Price is not the only factor affecting supply. Other variables, including the prices of the factor
inputs, technology, and the number of producers in the markets may affect the ability and
willingness of producers to offer goods in the market. The effect of each factor can be
isolated and explained in turn, under ceteris paribus assumption.
(a) Input prices
The costs of the factors of production are one of the determinants of supply. An increase in
labor costs, for example, per ton of production, because of rising hourly wage rate, will mean
that the suppliers will reduce planned supply, other things being equal. At each price there
will be a fall in supply because it costs more to produce any output level. A cut in wage rates
would have the opposite effect, increasing supply. Now every unit of labor can be purchased
more cheaply, and so any output level can be offered at a lower price.
(b) Technology
Technology is the existing state of know-how about how to produce. It affects supply. The
discovery and invention of new process, for example, the introduction of mechanized farm
equipment, or a new fertilizer which increases productivity, will increase supply. At every
price, more output will be planned because productivity has increased and it is cheaper to
produce. Suppliers can make more profit.
(c) The number of producers
When the number of producers in the market increases, supply increases. The more
producers, the greater is the planned output at each price, other things being equal.
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4.4. EQUILIBRIUM PRICE AND QUANTITY
a.
How does equilibrium occur?
The price and quantity which will actually prevail can only be determined by bringing the
two sides of the market, represented by demand and supply, together. Only then we can
know which of all the possible hypothetical prices will rule and what quantity of goods will
actually be traded.
Only at the point where the quantity demanded equals the quantity supplied will we
find a unique equilibrium where the plans of demanders and suppliers are both satisfied.
The equilibrium price is the only price where the quantity demanded will equal the quantity
supplied. At this price the market is cleared, there are no unsatisfied buyers or sellers;
neither shortages nor surpluses.
Any price other than equilibrium price will bring disequilibrium. If the price is higher
than equilibrium price, then the quantity supplied exceeds the quantity demanded. This
price will not bring a balance, because producers will have goods left on their hands. There
will be surplus, an oversupply, if suppliers fulfill their plans. The reason for this is clear.
Buyers at such a relatively high price are not willing and able to buy all product supplied. In
that case, there would be a downward pressure on the price, price will fall and this will
continue until the equilibrium price is reached.
Conversely, if the price is lower than the equilibrium price, then the quantity
demanded will exceed the quantity supplied. Buyers will not be satisfied with the supply
offered in the market. There will be an excess demand and a shortage of produce. Suppliers
at the relatively low price can only be persuaded to offer a smaller quantity than buyers
want. At such a low price buyers are willing and able to buy a lot more than is on offer. In
that case, there would be an upward pressure on the price; price will rise until equilibrium
price is reached.
In both of these cases the plans of either buyers or sellers are frustrated. This is
disequilibrium; buyers’ and sellers’ plans are not harmonized. At a price higher than the
equilibrium price, suppliers’ plans to sell are not fulfilled; buyers are not able or willing to
buy all the supply at this price. At a price lower ha the equilibrium price buyers are
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prevented from fulfilling their plans because suppliers are not willing or able to meet buyers’
demands, at this price.
b. How Does Equilibrium Change?
The equilibrium price will change if the underlying demand/or supply relationships change.
Should anything upset equilibrium, it will be restored.
Given our demand and supply framework, we can now make predictions about how
price and quantity will move, given certain changes.
If the demand for any good increases while there is no change in supply, the market
price and quantity will increase. If the demand for any good falls, while there is no change in
supply, the market price and quantity will fall. If supply increases when there is no change
in demand, the equilibrium price will fall and the quantity will increase. If supply falls when
there is no change in demand, the equilibrium price will increase and quantity will fall.
When both demand and supply change, however, the matter is not so
straightforward. When both supply and demand increase or decrease simultaneously, there
will be two effects pulling price in opposite directions. The resultant equilibrium depends on
the relative size of the changes in demand and supply. If the sizes of these opposing effects
are equal, price does not change. The only impact in this case would be the change in
quantity bought and sold in the market.
If the increase in demand had been greater than supply then the equilibrium price
would rise. If the increase in supply had been greater than demand then the equilibrium
price would fall.
Now, we will examine how the equilibrium price changes as a result of changes in
demand and/or supply.
1) A Change in Demand
Assume that buyers wish to purchase more of some commodity than previously. To see the
market’s reaction to such a change, imagine a situation in which farmers find it equally
profitable to produce either of two crops, carrot and cabbages, and so are willing to produce
some of both commodities. Now imagine that consumers develop a greatly increased desire
for cabbages and a diminished desire for carrots and, whatever the reason, there has been a
major shift toward cabbages and away from carrots.
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When consumers buy more cabbages and fewer carrots a shortage of cabbages and a
glut of carrots develop. In order to unload their surplus stocks of carrots, merchants reduce
the price of carrots, in the belief that it is better to sell them at a reduced price than not to
sell them at all. Sellers of cabbages, however, find that they are unable to satisfy all their
customers’ demands for that product. Cabbages have become a scarce commodity, so the
merchants charge more for them. As the price rises, fewer people are willing and able to
purchase cabbages. Thus making them more expensive limits the demand for them relative
to the available supply.
Farmers begin to observe a rise in the price of cabbages and a fall in the price of
carrots. Cabbage production has become more profitable than in the past; the cost of
producing cabbages remains unchanged at the same time that their market price has risen.
Similarly, carrot production will be less profitable than in the past because costs are
unchanged but the price has fallen. Attracted by high profits in cabbage and deterred by low
profits or potential losses in carrots, farmers expand the production of cabbages and curtail
the production of carrots.
As the production of carrots declines, the glut of carrots on the market diminishes,
and the price begins to rise. On the other hand, the expansion in cabbage production
reduces the shortage and the price begins to fall. These price movements will continue until
it no longer pays farmers to reduce carrot production and to expand cabbage production.
When the dust settles, the price of cabbage is higher than it was originally; and the price of
carrot is lower than it was originally.
The reaction of the market to a change in demand leads to a transfer of resources.
Thus the change in the consumers’ tastes causes a reallocation of resources (land and labor)
out of carrot production and into cabbages production. Carrot producers will reduce their
production; they will therefore lay off workers and generally demand fewer factors of
production. Cabbage producers will expand production; they will therefore hire more
workers and generally increase their demand for factors of production.
Labor can probably switch from carrot to cabbage production without much
difficulty. There are, however, other resources involved. When farmers increase their
cabbage production, their demand for factors especially suited to cabbage production also
increases, and this creates a shortage of these resources and a consequent rise in their
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prices. For example, if a certain type of land that is better suited for cabbage-growing than
for carrot-growing, the demand for and hence the price of this land will be affected. On the
other hand, with carrot production falling, the demand for land and other factors of
production especially suited to carrot growing is reduced. A surplus resulted, and the prices
of these factors are forced down.
Thus factors particularly suited to cabbage production will earn more and will obtain
a higher share of total national income than before. Factors particularly suited to carrot
production, however, will earn less and will obtain a smaller share of the total national
income than before.
The important thing here to notice is how a change in the demand initiated by a
change in consumers’ tastes causes reallocation of resources in the direction required to
cater to the new set of tastes.
2) A Change in Supply
Now, consider a change originating with producers. Begin as before by imagining a situation
in which farmers find it equally profitable to produce either cabbages or carrots and in which
consumers are willing to buy, at prevailing market prices, the quantities of these two
commodities that are being produced. Now suppose that, at existing prices, farmers became
more willing to produce cabbages than in the past and less willing to produce carrots. This
shift might be caused, for example, by a change in the costs of producing the two goods, a
rise in carrot cost and a fall in cabbage costs that would raise the profitability of cabbage
production and lower that of carrot production.
What will happen now? For a short time, nothing at all; the existent supply of
cabbages and carrots on the market is the result of decisions made by farmers at some time
in the past. But farmers now begin to plant fewer carrots and more cabbages, and soon the
quantities on the market begin to change. The quantity of cabbages available for sale rises,
and the quantity of carrots falls. A shortage of carrots and a glut of cabbages result. The
price of carrots consequently rises, and the price of cabbages falls. As carrots became more
expensive and cabbages became cheaper, fewer carrots and more cabbages will be bought.
The rise in the price of carrots and the fall in the price of cabbages now act as incentives for
farmers to move back into carrot production and out of cabbage production.
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The rise in the price of carrots removed the shortage in two ways; it reduced the
quantity for carrots demanded and it increased the quantity of carrots offered for sale.
Remember that there was also a surplus of cabbages that caused the price to fall. The fall in
price removed the surplus in two ways; it encouraged the consumers to buy more of this
commodity and reduced the quantity of cabbages produced and offered for sale.
These examples illustrate a general point: The price system is a mechanism that
coordinates individual, decentralized decisions.
The signals to which households respond are market prices of products. For each
given set of prices, households make a set of choices. In so doing, they also, in the aggregate,
affect those prices. The prices also serve as signals to firms of what goods they may
profitably provide. Firms must choose among the products they might produce and sell,
among the ways of producing them, and among the various quantities (and qualities) they
can supply. By doing so, the firms too affect prices.
Firms must buy factors of production. The quantities demanded depend on the firms’
production decisions, which in turn depend on consumers’ demand. These demands for
factors in turn affect the prices of labor, managerial skill, raw materials, buildings,
machinery, use of capital, land, and all other factors. The consumers who are owners of
factors respond the factor prices and make their choices about where to offer their services.
These choices determine factor supplies and affect factor prices. Payments by firms to factor
owners provide them with incomes.
In summary, in a market economy, for most of the goods, the basic questions of what
should be produced, how they should be produced, and how the income created should be
distributed among the owners of production factors (workers, landowners and capital
owners) are solved by the working of the market system automatically.
It is possible to make the following general observations about market functions:
a) The market coordinates the actions of many buyers and sellers. The plans of buyers and
sellers are matched at the equilibrium price. All those who plan to buy or sell at this price
are able to trade. Prices are the effective signals which guide resources. When the
demand for one product increases, automatically, more resources flow into the
production of that ‘favored’ good. Resources are drawn away from the production of
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other goods; these now have smaller demands, other things being equal. The increase in
demand for one good causes a reduction in the price of these other goods. As their
prices fall, producers of such goods make reduced profits. Price changes give the signals;
they alert and inform producers either to expand or contract production. It is the change
in the conditions of supply and demand which set off these market price signals.
b) The market mechanism allocates resources by price. The market uses the prices as the
allocation device. Equilibrium price is the unique cut off. Those who are willing and able
to buy at this equilibrium price or above, purchase the amount they desire. But those
who are unwilling or unable to pay that price find themselves excluded from purchasing.
The price is too high, given their income and/or desires; their wants will not be met in
the market. Price must fall to include them.
Market allocates impersonally, on the basis of price. The equilibrium price is the
watershed. On the supply side those who are unable or unwilling to supply at prices
equal or below the equilibrium price are excluded too. Price rules them out. Those
willing and able to buy or sell at the equilibrium price can participate in market
exchange. But no individual person or group has to decide who to exclude; the market
does this automatically.
c) The market price gives incentives. Imagine that there is an increase in demand for
carrots and increased carrots demand raised carrot price. Existing suppliers will now find
it more profitable to sell greater quantities at the new higher price. This is a clear
monetary incentive to produce more from their existing capacity. Indeed, over the long
run when fixed physical and land inputs can be changed and new plant brought into
production, new suppliers will enter into market. As a result of the initial demand
increase, and price rise, more resources are drawn into production of carrots both in the
short and eventually the long run.
HOMEWORK 4
1.
Write two different definitions of the market.
2.
Define price and explain its functions in a market economy.
3.
Define effective demand.
4.
What does the law of demand say?
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5.
Explain income effect and substitution effect of a price change on the quantity
demanded of a good.
6.
List the variables other than the price of a good affecting the demand for that good.
7.
Define market supply and explain the law of supply.
8.
Explain how input prices, technology and the number of producers affect supply.
9.
What is equilibrium price and how it is determined?
10. What are the functions of market?
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CHAPTER 5
MARKET TYPES
There are different types of real markets, set in different institutional contexts and
configurations. Markets are classified by the degree and the extent of competition that they
exhibit. Market structures range from the perfect competition at one end of the spectrum, to
monopolist at the other.
In perfect competition there are many sellers and many buyers producing the same good. No
individual buyer or seller has market power to influence market price.
In monopoly there is only one seller. Here it is possible to keep would-be rivals out, by
barring entry.
An oligopolistic market is dominated by a few sellers, but also characterized by entry
barriers.
Monopolistic competition is the market form closest to perfect competition, with
many market sellers and buyers and no entry barriers. However, unlike in the perfectly
competitive market, each individual firm produces a differentiated product or offers a
slightly different, service, not exactly matched by competitors.
We assume that all firms behave as rational economic individuals with perfect
knowledge, regardless of the market structure in which they operate. All firms aim to
maximize their profits. Profit is total revenue minus total costs.
5.1. PERFECT COMPETITION
A perfectly competitive market is a useful starting point to analyze the variety of real world
markets in which people act.
The perfectly competitive market is based on the following assumptions:
1)
There are many buyers and sellers. Each produces a very small fraction of the total
industry supply, so that no firm can affect the product price by changing output.
2)
All individual firms produce identical (homogenous) products. There are no brand
distinctions or peculiar differences of any kind; so buyers regard the output of one firm
as an exact substitute for that of any other firm in the market.
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3)
Market players have perfect information about all product qualities and prices, so there
are no search or transaction costs; neither risk nor uncertainty.
4)
There are no barriers to joining or leaving an industry. Freedom of entry prevails; no
existing firms or buyers can bar new entrants. There is free exit (no potential cost of
switching production for another market); nothing to act as a deterrent to those who
wish to participate (no expensive unsalable capital equipment for the producer to be
stuck with should things go wrong).
As any firm is very small in relation to the market as a whole, it has no say in the price
it charges. The price which faces the firm is given by the market. The individual producer is
powerless. The producer can only decide the quantity of production in such a way that will
maximize its profits.
The firm, with any tiny market share, can sell everything it produces at the going
market price. If the firm tried to raise its price independently of market price and, for
example, charged slightly more than it, then it would make no sales. Buyers would purchase
the cheaper produce of other firms.
All sales would be lost to competitor firms.
Furthermore, it would be illogical to undercut the market price. The firm which charged a
lower price would earn less money.
5.2. THE MONOPOLY
A monopoly is the sole seller of a good with no close substitute and stands in sharp contrast
to the perfect competition. The monopoly firm has market power, unlike the impotent
perfect competitor.
a. Sources of monopoly power
The sources of monopoly power are diverse but a key to maintaining a monopoly position is
effective entry (and exit) barriers. For a monopoly to exist over time given that there are
higher profits to be made, potential rivals must be blocked. Barriers to entry and exit can be
considered in more detail under the following headlines.
1) Technical and cost barriers
The economies of scale may be such that only one large firm can reap them and then
undercut others by producing and selling at a lower cost. Often this may be the case in small
markets or where very large, expensive capital is an essential requirement. Small markets
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which can only sustain one profitable supplier are the locus of monopoly power. A natural
monopoly is said to exist where there is room for one firm only to survive, where two or
more firms in the industry would face insufficient revenues in total to cover the costs of all
firms. Should the market be shared by new entrant, neither the new firm nor the old one
could make a profit.
Moreover, an established firm may be able to produce at lower average cost than
any potential new entrant, because as time passes the firm has learned by experience,
knows the most reliable and cheapest ways of producing, and has acquire specialized
marketing or financial skills. Economic actors do not have all the requisite knowledge to
compete. High entry cost for the would-be competitor can act as an effective deterrent. In
the real world these may include heavy advertising and promotion costs to persuade
consumers to change their preferences.
The firm may have the ownership of unique resources, or the benefit of unique
managerial talent. A monopolist might own and/or control wholesalers and retailers, key
selling points in the market which give market power.
2) Legal barriers
The legal protection of production techniques such as patents and copyrights protects the
monopolist. A firm may have an exclusive franchise to serve a market. The imposition of
taxes, tariffs (customs duties) may be used to protect a monopoly power in home market.
3) Threats and predatory behavior as entry barriers
The existing firm in a market may threaten to undercut new entrants and to take them over
should they attempt to enter into competition. A firm may engage in predatory pricing
where it lowers the price it charges to undercut new entrants or to make entry unattractive.
b. The demand constraint
Although the monopolist can affect price, it can only choose either the price or quantity.
While there are no close substitutes for the monopolist’s product, it is still constrained by
the market demand. There are always alternatives, no matter how imperfect, and limitations
on income. When price is increased the monopolist will lose some sales. If the monopolist
sets the price, then output is dictated by the market and vice versa.
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If the monopolist wishes to sell more output, then price has to be reduced. When
price is lowered to gain more sales, the total revenue of the firm does not inevitably increase
as the firm sells more. The multiplication of total quantity and price gives us total revenue. If
the sensitivity of the quantity sold to a change in price (elasticity of demand) is low, total
revenue may decrease as a result of a price reduction. The monopolist can only increase
total revenue by reducing price if the sensitivity of the quantity sold to a price change is high.
Monopolists will choose the price-quantity combination that will maximize total
profit.
5.3. THE OLIGOPOLY
There are a few sellers in oligopolistic markets. There is no overall general theory of
oligopoly as in the case of perfect competition or monopoly. The world of oligopolist is more
complex. Interdependency of the firms is at the heart of the oligopolistic conditions.
Oligopolists compete in markets where they are conscious of their rivals, because their
future sales and profits depend, not only on their own actions, but on the policy decisions of
competitors.
The action of one firm can significantly affect the others in oligopolistic markets.
Indeed, the oligpolist may face a good deal of risk and uncertainty, which arise to a
considerable extent from the possible actions of rivals. The oligopolist may take strategic
measures in an effort to reduce both risk and uncertainty.
Barriers to entry are important features for oligopoly. It may be that there is only
sufficient room in a particular industry for, say four firms. Then, five firms could not produce
profitably and so would-be entrants, perceiving this, are deterred. The scale of advertising
required or the fears of predatory pricing threats or the barriers discussed under monopoly,
including particular rules of the game, could be deterrent.
The oligopolistic firms can take a variety of different strategies to handle
interdependency. All rivals may try to outplay their rivals to gain an advantage on them, or
they may cooperate by colluding, either formally or tacitly, with their competitors. Models of
oligopoly can be split according to whether the firm engages in cooperative behavior or not.
Here we discuss oligopoly models under two broad categories, non-collusive and collusive.
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a. Non-collusive behavior
An oligopolist who does not collude with rivals may conjecture that rivals will match price
cuts but will not match price increases. There will be a very different responsiveness in
quantity demanded to a price increase rather than a price reduction, because of the pricing
reactions of other firms. If one of the firms cuts its price its rivals would react by cutting their
prices; but if any one of the firms increases its price the other oligopolists do not follow it.
The non-collusive behavior model explains why prices are sticky. Price changes can
be expensive or could simply the result of collective behavior. Although oligopolists may
experience relatively stable prices for some periods and compete on the basis of, for
example, the quality, packaging, advertising or after sales service of their product, there may
be times when price cutting is used for raising or defending their own individual market
share.
b. Collusive behavior
Not surprisingly, oligopolists often cooperate. This may reduce the risk of a price war and
bring calm in the face of fundamental uncertainty. However, whether collusion takes the
form of explicit use of cartels or implicit collaboration, both forms are often illegal. Given
formal legal rules and their policing, oligopolists may adhere to their own informal rules and
customs. These may represent a more effective strategy for cooperation. Despite the law
and inherent problems arising from differences in costs and efficiencies between firms and
difficulties relating to the share out of profit, cartels can flourish. Indeed, any formal deal
relating to pricing, output or other aspects of a transaction comes under the heading of a
cartel. In cartels, oligopolists link up to act in concert, collaborating and sometimes acting as
if they were a single monopolist.
One form of the collusion, used extensively, is price leadership. Price leadership
involves the oligopolist in tacit collusion. There are different forms of price leadership. One
of the firms may be regarded as a good barometer of changing market conditions. When the
barometric firm changes prices the other firms in the industry follow suit. In some other
situations the dominant firm acts as a price leader. Given that the firm has a significant cost
advantage, or because of its financial strength, one particular firm dominates the market,
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with a group of price-taking firms working in its shadow. The small firms follow the leader’s
price.
5.4. THE MONOPOLISTIC COMPETITION
Monopolistic competition is a market situation where competition is notable and where
market power for firms is very limited. This situation is the closest to perfect competition.
Here there are many competitive buyers and sellers and no barriers to entry or exit.
However, their goods and services are not perfect substitutes, each firm can influence price.
Prices can be increased without the immediate loss of all customers to other sellers. Firms
compete by differentiating their products. Yet no firm is sufficiently large and powerful to
stop new entrants coming into the market and the legal rules do not provide entry barriers.
In monopolistic competition firms, while they have some control over price, are
unable to make profits above what is normal in the long run, for new entrants or enlarged
existing rivals compete supernormal profits away. Where supernormal profits are perceived
by outsiders, new entrants quickly move into the market.
5.5. AN ASSESMENT
In this section we make an assessment of the perfectly competitive market and compare it
with other market forms. Perfect competition does not describe reality; but it is an
important aid to thought. It gives a neat theoretical yardstick, an ideal type, to enable the
comparison of different and less competitive scenarios.
a. Simple but unrealistic
The perfectly competitive model is a simplification helping us to think logically and clearly
about the forces which may affect the behavior of market prices and quantities. It gives an
insight into the workings of markets and the possible impacts of price changes. But in that
process of simplification, inevitably, some features have been set aside. The perfectly
competitive market is sanitized from many important characteristics existing in real life.
People making decisions in real life do not have perfect information; they often have
to proceed by trial and error. Production takes time; plans cannot be instantaneously
changed and fulfilled. Perfectly competitive model is not a description of trade in many real
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markets. In this ideal exchange process there are no impediments, no frictions; specification
of property rights are perfect and costless; information is perfect and free. There are no
transaction costs. Prices and quantities respond smoothly and effortlessly, moving from a
stable equilibrium to another in a system of interlinked markets.
In reality, we cannot hold ceteris paribus, other things being equal. Actual price
changes are the results of many changes, often pulling in different directions. In real markets
there may be constant movement and discord. Markets may never reach equilibrium as
circumstances evolve. There may be forces at work which encourage instability.
Perfectly competitive model implies equal market power among sellers and buyers.
But in reality, one side of the market, sellers or buyers, may have the upper hand. Indeed,
supply and demand are not separate in markets where, for example, the impact of
advertising is engineered by large corporate suppliers who can affect demand. Moreover,
within groups of buyers or sellers, some may have greater income and power; the market
does not operate on the basis of one person one vote. Spending and decision-making power
can be very unequally divided.
In perfect competition there are no discussion of risks and uncertainties faced by
real-world actors. Buyers and sellers have no long term commitment to each other in the
market. People have no allegiances; they can switch their exchange transactions with ease.
Whatever the good, all products are homogenous; and whoever the buyer or seller, all
people are assumed to be the same for the purpose of market trading. It does not matter
from who you buy or to whom you sell. Exchange is impersonal, undertaken in the light of all
the relevant facts. There is no place for trust, hope or doubt, and no requirement for
necessary institutional features which exist in reality.
Actual markets, however, are set in particular historical context. The determinants of
supply and demand are not a-historical, pure, without alloy. They are fashioned in part by
the institutional characteristics of the society in question and its past evolutionary path and
social norms. There are complex issues underlying the simple model. Such complexities are
vestiges of the past, as much as they are signs of the present.
Nevertheless, there are real-world markets which display very characteristics of the
perfectly competitive type. Often agricultural and basic commodity markets, dealing with
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standard produce where many small suppliers and buyers meet, approach this ideal. Each
producer’s output is a mere drop in the ocean and there are no effective barriers to entry.
b. Inflexible prices
All markets require rules and a very large number of markets do not approximate perfect
competition where prices and quantities respond instantaneously to changes in demand and
supply. Price flexibility is not the hallmark of all markets. In theory, other market forms come
under the heading of imperfect competition. While they may sound substandard, such
markets represent reality. Indeed, while some imperfect markets give flexible prices, many
market situations are characterized by inflexible prices.
Products in the modern world are usually more complex than the simple carrot which
takes little time to consume, needs no after sale service, and has not been differentiated
from other carrots by an edible logo. In oligopolistic and monopolistic markets, there may be
situations where prices do not vary immediately in the event of market changes. The mass of
relatively sophisticated goods, which we actually buy, are sold in very different market
environments from that of perfect competition. In many markets, the very nature of goods
perforce, requires production by a large organization, to provide long-term research and
development and huge physical and human capital inputs. These are not simple goods
produced by the isolated individual artisan, or even the small-scale, low-technology, factory
environment, where small-scale enterprise could often respond very quickly to changes in
demand.
Many markets are dominated by powerful sellers who have discretionary power over
the prices they charge. They advertise and partially orchestrate market outcomes. They do
not jump to change the money price as market conditions vary; they have discretion.
Massive organizations, giant suppliers, may be slow to respond to changes in the real-world
conditions. In fact, it is often expensive to change prices. It may be cheaper to leave them
unchanged. Also, small price changes may be seen as a signal of future changes to come, so
sellers prefer to leave prices unchanged. They may be unwilling to set off price wars with
their rivals. Large market players may resort the other forms of non-price competition, like
promotional offers or changing quality and product design, rather than competing directly
through price. Money prices are ‘sticky’ and markets are not neatly cleared by price
movements.
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In labor markets there are frequently sound reasons for not engaging in wage
reductions. People often do not compete on the basis of lowering the wage for which they
will work. Many labor markets simply do not feature outright wage competition. People are
neither homogenous vegetables nor machines; reducing their wages may adversely affect
their productivity. People are not perfectly interchangeable. Wage rates and employment
levels do not of necessity move in smooth harmony from equilibrium to another, to
accommodate changes in supply and demand. Labor markets are more complex than that.
Non-price methods are often used to allocate jobs, to choose from the labor queue. This
may include competition on the basis of educational qualifications, previous job experience
or other personal attributes.
Changes in the market may not be smooth or rapid. Resources released from one
industry need not quickly flow to other productive uses. Labor might need to be retrained,
relocating or capital equipment may require modification. It may not be possible to effect
change speedily; moving towards equilibrium may take a very long period of time.
Models of imperfect competition are more realistic than perfect competition.
Oligopoly models often require the explicit handling of uncertainty. In real life firms may be
quite unsure of the rivals’ actions and reactions. They may not know how their competitors
will behave in new situations in the present and future, even when they may have colluded
in the past. There is no guarantee that the future will behave as the past. Where the action
of any one large oligopolist alters the competitive environments for others, then the impact
of
a price cut or a product
change may reverberate through time, in price wars,
promotional battles, the instigation of new products and the take-over and merger activity.
The assumption of perfect competition takes us far from the reality of the oligopolistic firm
where knowledge about competitors may be limited and uncertain. Here real-world
complexity highlights the confines of unique solutions set in perfectly competitive model.
c. Long-run results and efficiency
In perfect competition, firms cannot make supernormal profits in the long run. Moreover,
profit maximizing firms cannot endure losses in the long run. In the long run, firms will take
decisions about resource use which will eliminate both losses and supernormal profits. The
guiding light of super profit attracts other firms into the market and encourages existing
firms to build bigger plants. With the increasing capacity, the overall market supply would
53
increase. If industrial supply increases more than market demand, price falls. The process
comes to rest when all firms make normal profits, until there is a change in the market
affecting either price or costs. Normal profit is the opportunity cost of producer’s own
resources.
On the other hand, given an initial situation where firms endure losses in the short
run, they will leave the industry once there is a need to renew fixed capital. Once plant and
equipment come up for renewal and total costs exceeds total revenues then the firm must
exit. The reduction of firms in the industry will decrease the market supply and this will
continue until prices in the industry have risen, such that remaining firms can make a normal
profit. So firms will move into, or leave the market, until firms making only a normal profit.
Only when there are no supernormal profits or losses respectively, will entry or exit cease.
Since there is free entry and exit also in monpolistic competition, supernormal profit
will disappear and only normal profits will be earned in this market form too.
In contrast to perfect competition and monopolistic competition, monopolists and
oligopolists can make supernormal profits which continue in the long run. No other firm can
enter to share existing profits, so in the long-run equilibrium position supernormal profits
remain untouched. Other firms will not be able to erode such profits provided that entry
barriers hold.
In the long-run equilibrium allocation efficiency exists in perfect competition. Each
firm will produce at the minimum average cost and selling price is the lowest possible price.
When seen from a static perspective, in monopoly and oligopoly consumers would
pay a higher price for a smaller quantity of goods than would have existed given perfect
competition. Resources are misallocated. The monopolist and oligopolist restrict output and
charge too much in relation to the perfectly competitive ideal.
But this picture is too simplified. The view of the monopolist in the simple model is a
static illustration. There may be dynamic gains to be had in a world of imperfect knowledge
where the search for new processes and products is at the heart of creative enterprise.
Economies of scale may be such that only one or a few firms can realistically operate in an
industry. In these industries producers, as a result of economies of scale, would produce at
54
lower cost by pushing long-run costs down. They could use monopoly profits for research
and development to provide new processes and products.
In real life monopolists take decisions with imperfect knowledge, there are search
and transaction costs. Moreover, in reality, all competition is imperfect. We cannot choose
perfect competition; this is a hypothetical model.
HOMEWORK 5
1. How markets can be classified according to the degree of competition?
2. What are the main assumptions of the perfectly competitive markets?
3. Why are the prices in some markets inflexible?
4. What are the sources of monopoly power?
5. Why does the monopolist have to make a choice between the total sales and
price?
6. Contrast oligopolist and monopolist.
7. Compare perfect competition and monopolistic markets both in static and
dynamic perspectives.
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CHAPTER 6
GOVERNMENT, PRICING AND NON-MARKET ALLOCATION
INTRODUCTION
The purpose of this chapter is twofold. First is to clarify the role and significance of
government in a modern economy. Second, draw attention to the non-market means of
providing and allocating resources, goods and services. We have examined the workings of
market mechanism in Chapters 4 and 5. Now our main purpose is to highlight non-market
procedures of coordination and allocation, to show in what situations the market
mechanism is deemed to be inappropriate; where markets fail or simply do not exist. In
particular, we draw attention to different activities of government both within non-market
and market contexts.
We are all market players in a modern economy, but we have other roles too. We are
not just buyers and sellers, customers or business people engaged in market transactions.
Not all the goods and services we need are provided by the market. In this chapter, we
examine the types of goods and services which do not come to us via a market transaction.
The government has a significant role to play in the provision of such goods.
People can employ different methods of allocation either in addition or instead of the
market mechanism. Resources and goods can be allocated by command, administrative
procedures and by traditional means, via customs or practice. Non-market allocation
methods play a notable role in the complex modern economy.
Now we take a closer look at the role of government. Government has an important
hand not only in the provision and allocation of particular goods but in setting and policing
the rules of the game. Moreover, it acts as a major market player. More than that, the
diverse organizations of the state and civil society are entangled in a complex web of
arrangements; where market and non-market provision are entwined.
6.1. GOVERNMENT AND THE NON-MARKET ALLOCATION PROCESS
a. Government’s role
Government intervenes in the market process, interceding by imposing taxes or providing
subsidies, occasionally controlling prices or stepping in where markets fail. Moreover,
56
government is not a single institution separate from all others; it encompasses many diverse
organizations at different levels. For example, there are regional and local government
bodies presiding over multi-million lira budgets. The state plays heterogeneous roles, in a
variety of guises, inextricably involved in the economic system, not separate or apart. The
relationship between civil society and government are interwoven in a complex fashion.
While organizations of the state have a distinct identity there is mutual interdependence
with other organizations.
The state is a basic player in the evolution of the rules of the game. Political
organizations using power provide the overall rules with the power they have. State
organizations act as coordinators; they legitimize and coerce, tax and spend. They often act
as producers and market players. Sometimes governments may try to achieve social justice
through taxation and subsidies, changing the distribution of income and wealth. In some
circumstances governments may emphasize economic development and growth.
History illustrates that there are many blends of organizations, making up different
economic systems which will work. And the role of the complex organizations of state and
civil society, including the market, evolve uniquely in the time and place. It is exceedingly
difficult to isolate the impact of governments from all the other related factors in a particular
economic system.
In recent years, in the world generally, the predominant mood has been for the state
to play a much smaller part in the economy. Since the late 1970s the objective has been to
roll back the frontiers of the state. Privatization has become a watchword since 1980s.
Privatization has different strands. It includes the sale of state-owned assets to private
individuals, households and organizations. Other features include deregulation, encouraging
competition, for example, by the contracting out of services previously provided by
government organizations. Economic prices have been encouraged for services previously
provided free or at a minimal charge. Indeed, the privatization principle emphasizes private
ownership, the use of markets and competition: Business firms should supply where they
can, competition and price mechanism should be used more widely.
However, the governments still act as both regulators and market players.
Governments set legal framework, the formal rules of the game. Government organizations
57
operate as customers and competitors of business firms. Governments operate in productive
capacities in some services to households and firms.
Many functions are directly funded and controlled by governments. Organizations of
the state operate the legislative process and policing. They collect tax revenues and pay out
social security. Health and education are directly funded and overseen by the state.
In what follows we shall explore the rationale for the state’s activity in more detail.
The state has a key role to play where markets or other organizational forms cannot
effectively provide and allocate particular goods and services.
b. Public goods; communal use
Pure public or communal goods, like defense, law and order or public administration, cannot
be allocated by the price mechanism. For example, national defense, of necessity, is
communally and not individually consumed. Pure public goods are not bought and sold in
the markets. Markets simply do not exist for them. Government provides these goods. Pure
public goods are supplied to the community as a whole without direct charge related to use
to the individual, independent of an individual’s income or strength of desire. Decisions
about the amount of resources overall to devote to these goods are not decided by the
workings of the market but by a political process.
The following attributes make such public goods impossible to allocate by the
market:
1) Non-excludability
No one can be excluded from the protection of missiles. Those who do not pay still receive a
benefit. Such goods are expensive and cannot be divided up or restricted for individual use.
Both the wealthiest citizens and the poorest of the poor have the protection of the armed
forces. However, unless there are enough altruistic people in the modern world, all agreed
to look after the common good, narrow self-interest would mean that insufficient resources
would be forthcoming to provide such public goods. Too many people might be free-riders,
benefiting from the security but without paying for its provision. Indeed, there would be no
way of stopping their consumption. Certainly, private business firms could not make a profit,
for unlike any divisible good, national defense cannot be restricted to those who pay.
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2) Non-rivalry
People are not rivals in the consumption of pure common goods. When defense is supplied,
the degree of protection given to one family does not reduce the availability of such benefits
for others. There is no need to ration by the price mechanism, even if that were possible. As
we showed in the discussion of private property rights in Chapter 2, rivalry exists in the
purchase of a private good. If one person buys a bottle of milk, that is no longer available for
another. But the benefits of a protective nuclear umbrella are nation-wide; consumption by
a person does not reduce availability for another. Benefits are for everyone, whether
wanted or not.
3) Non-rejectability
The public good cannot be rejected like any private good for own consumption. Those who
do not wish to be defended by a nuclear deterrent and armed forces are not able to opt out.
For these reasons public goods are provided centrally by the government at no direct
price to people who benefit. In modern economies the cost of producing such goods are paid
from the public funds. To fulfill the defense function requires a huge input of resources
embodying modern technology and often enormous quantities of military hardware and
personnel.
Moreover, the framework of law and order is a public good provided to the citizen at
no charge at the point of consumption. The individual, for example, does not pay directly for
motorway policing or the workings of legislature. The costs of such communal services are
paid from government funds. Yet not all goods are funded and/or provided by the
government fall into the category of pure public goods. Quasi-public goods and merit goods,
both for individual use, are also important.
c. Quasi-public goods
Quasi-public goods have elements of both a public and private good. Some commodities
which potentially could be allocated by the price mechanism are nevertheless provided by
the state. These goods are supplied without a specific charge related to the amount used by
an individual. The provision of roads, pavements, public parks, and recreation grounds are
examples of such quasi-public goods. We do not pay directly for a walk in any park or our
use of any road although we pay indirectly through taxes.
59
Very often these goods do not display rivalry and excludability. But when these
facilities are used to capacity and ‘over used’, then rivalry exists. Consumption for one
person reduces what is available for others. Moreover, there may be the possibility of
excluding people although the goods are only partially divisible.
While these goods are allocated primarily by non-market means, in some situation it
would be possible to charge a price to exclude those who were unwilling and/or unable to
pay. For example, it would be possible to charge for the use of roads. People could be readily
barred if they would not or could not pay.
Both the use of roads and pavements can in some situations imply rivalry. Often
there is a great deal of jostling for limited road space as those in traffic jams and on
congested roads can witness. Here the hallmarks of excess quantity demanded over a fixed
quantity of road space are traffic jams and queues. These impose external costs in terms of
time lost, poor fuel consumption and frustration.
At certain times many roads, even the pavements in shopping centers are full.
Nevertheless, rivalry is not the rule at all times. There are elements of public good here. At
some hours roads are relatively empty. Rivalry for road space at such times does not exist
and the cost of extra motorist is zero, for he or she imposes no burden on other road users.
Although everyone might be in agreement about the need for providing and
maintaining pavements and roads, private business suppliers, in general, could not make a
profit from their provision. Firms could not effectively exclude users, divide these goods or
charge a price sufficient to make profit. Such goods confer external benefits over and above
any private benefits both in production and consumption. These advantages cannot be
wholly captured by the producer in terms of profit or the purchaser in terms of happiness or
utility. The advantages benefit the wider community. If the market mechanism were left to
provide and to allocate roads, for example, insufficient of these would be produced for the
welfare of society as a whole. Without communal provision our road and pavement network
would be insufficient to meet the needs of a modern community. Overall resources are
allocated for these quasi-public goods by a political decision.
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d. Merit goods
Merit goods, like health care and education, are consumed by individuals and can be
allocated through the market mechanism; but they have attributes of the public good. Their
acquisition improves the utility of the society as a whole. Certain choices about the
acquisition of education, for example, are rarely left in a modern economy to the free choice
of the individual. All people are expected to have a minimum level of education. Merit goods
are seen as important both for individuals and society as a whole. Left to their own devices,
people may have an inability or insufficient desire to buy enough of these goods. Also, of
course, parents make decisions on behalf of their children. People do not have full
information and may be ignorant, for example, of the benefits and nature of different types
of education. Moreover, they may not be prepared or able to buy enough of a good which
confers benefits to others. For education provides important spin-offs to third parties, the
individual purchaser cannot capture all the benefits. In such circumstances the market
mechanism would lead to an insufficient production and consumption.
Health care and education could be allocated by the price mechanism, for they are
divisible, and to a greater or lesser extent, exhibit the characteristics of both rivalry and
excludability. To take an example, one person’s occupation of a hospital bed means that no
one else can simultaneously use the bed. And indeed like private goods people may choose
to reject them. Yet there is worth in the provision and consumption of such goods. Most
countries insist on children receiving education to a certain level or the compulsory
treatment of infectious diseases. Education and health care services can provide
considerable external benefits. These benefits cannot be captured by the individual who
buys these goods, or the producer who supplies them. They are seen as important for the
development of the overall economy.
In modern economies, such goods are mostly funded by central authorities and
distributed largely independently of the ability and willingness to pay. Government has an
important hand on providing these merit goods which produce such important benefits for
society as a whole. Even where private schools exist they are often supported by public
funds in many countries. Modern societies do not rely extensively on the market mechanism
to provide and allocate education, although there are significant differences in provision and
allocation of patterns between different countries. The bulk of education provision, including
61
university education, is provided in the public sector and paid for out of government funds.
It is allocated by non-market means through administrative procedures. Moreover,
governments have a major responsibility for the funding of basic research where the
benefits cannot be completely captured by the private company and extensive expenditures
are required.
e. The absence of markets; externalities
There are no markets for public goods. Moreover, no market exists for some things, like
pollution or a good like clean air. The private car owner and the commercial lorry both
create air pollution, in part responsible for acid rain or the increase in asthma in children. Yet
in the purchase price of our vehicles and fuel we do not bear anything approaching the full
cost of creating pollution. Social costs (adverse externalities), may differ significantly from
private cost. ‘Third-party costs’ are not borne by individuals or organizations creating
pollution and congestion. Social benefits (helpful externalities) giving rise to ‘third-party’
agreeable consequences have no markets.
6.2. THE ALLOCATION OF NON-MARKET GOODS
The quantity and quality of resources devoted to the provision of pure public goods is
decided by a political process. Once provided, the pure public good presents no problem of
allocation to an individual. The protection derived from an early warning air strike
mechanism needs no rationing. There is enough for all and additions to the population add
no extra costs at the margin.
The provision of quasi-public goods overall has also often been decided through the
political process. The allocation of such goods may be made on a first-come-first-served
basis with no charge. Public parks are free. Roads are largely free of charge at the point of
use. It is only when such facilities are used to the limit that rivalry becomes an issue.
However, in contrast, merit goods display both rivalry and excludability. They have to be
allocated on an individual basis.
There is a dual system for provision of schooling in many countries. The largest part is
carried out in the state sector although some is undertaken in the private sector. While
overall education budgets are decided by government, resources eventually have to be
allocated to districts and individual schools. Primary and secondary education in the state
62
system is provided free at the point of delivery. All children have the right to primary and
secondary education. Ministries of Education are responsible for allocation of school places.
In the short run, a fixed number of places exist in any school.
Given a stock of places at a particular school, parents on behalf of their children may
express a preference for that school. State school allocates at a zero price and for an oversubscribed school there is an excess quantity demanded at this point. There has to be
rationing. Where the quantity demanded exceeds the availability of places in a school there
is rivalry. But places are assigned to individuals, so any individual who is not assigned a place
is excluded. A method to allocate limited places must be used. Some applicants will have to
be rejected given the excess quantity demanded.
There are a variety of methods which can be used to allocate school places. These
range from the simple to the involved; a straightforward first-come-first-served method or
other administrative procedures based on different criteria. School places could be allocated
by price, but the market process is not allowed to allocate here, for social justice may
require that education in a particular school is not allocated on the parent’s ability and
willingness to pay. Non-market administrative procedures are used. Professional judgment,
sometimes backed by examination, custom and practice, all may have a part to play. Parents
express a preference; they make a claim. Administrative rules and procedures are used to
select whose claims shall be met.
Now we move on from state school allocating by administrative procedures outside
the market mechanism, to the role of government in the market. Government has other
roles to fulfill beyond the provision and allocation of public and merit goods. It also sets the
framework for the market and acts as a regulator. Moreover, government operates as a
market player, in some circumstances as a buyer, at other times a seller.
6.3. GOVERNMENT’S ROLE IN THE MARKET
The government has a vital role in setting the legal framework for the market and recasting
and influencing some of the rules of the game as the economy evolves. Laws are passed
regulating the behavior of firms to reduce adverse externalities. But also government
organizations utilize markets; they may act as buyers and sellers.
63
Markets require laws, customs and conventions in order to coordinate the plans of
buyers and sellers. To work effectively markets have to provide security, people need to
know that they are not going to be cheated. Markets have a basis of institutional rules;
markets themselves have to be organized. They need rules of the game in order to function
in a well ordered fashion. The government sets a legal framework: a) laws defining property
rights; b) legal transfer of such rights; c) laws relating to the provision of market information;
d) laws to reduce market restrictions, for example, entry barriers, to encourage many buyers
and sellers; e) regulation/policing.
The rationale for this legislation and policing is that people have to have confidence in
the product or service they buy. Particular rules are maintained, whereby participants have
confidence that they will not be cheated; where there is official recourse to outside bodies
should there be a dispute. In particular where consumers are buying complex goods or
committing large amounts of money, they need protection. Market players do not have
perfect knowledge or the necessary specialized expertise to evaluate the information
available.
Government organizations have a vital role in setting the essential framework of
rules. Market players are required to abide by the rules. An objective of such rules is to
convince market traders of justice, market fairness, in short, the provision of a level playing
field.
There are many different aspects of the regulatory framework which affect markets.
The market itself is enmeshed in legalities, customs and conventions. Markets, to function
efficiently, have to be clearly based on institutionalized rules where governments (and
tradition) take an important hand. Whatever the nature of the legislation, there is a key role
for the government in providing, changing and policing the rules.
6.4. GOVERNMENTS INTERCEDING IN THE MARKET
The government sets taxes and subsidies in order to achieve a variety of ends. The primary
purpose for setting taxes in the market is to raise tax revenue. Taxation is one important way
to finance government expenditure. But taxation may be used to reduce the adverse
externalities, taxing the polluters, making it more expensive for them to supply. Subsidies
may be given to increase the production and consumption of some goods and services,
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particularly where external benefits are thought to be important. Moreover, governments
may directly intercede with price controls, setting price above or below the market
equilibrium. However, prices which are lower than equilibrium (a price ceiling) require other
methods of allocation. In the long run for private firms, price controls may have long-term
effects which reduce the overall supply and lead the problems of shortage or surplus. Usual
examples include the use of price controls in war time, with ration books to ration excess
quantity demanded, and with supplies being diverted to illegal markets.
Rent controls are other case in point. The rented sector has shrunk given the impact
of price controls. In the long run, those renting houses could not earn a sufficient profit and
so sold-off their properties or converted them to other use.
Finally, the privatization of public utilities, transferring state monopolies into the
private sector, has been accompanied by a regulatory framework, which involves price
regulation. The industry regulator curtails price setting freedom; the regulatory body puts a
limit on the percentage increase in prices allowable. Insufficient market competition is a
reason for controlling, for example, to prevent these private sector companies from
increasing prices to levels which the market might bear.
6.5. NON-MARKET PROVISION AND ALLOCATION
Finally, we turn to the very significant non-market activities of households and non-profit
organizations, like voluntary groups or charities, which do not fit an orthodox market
paradigm. People are more than simply market players.
Market and non-market provision of goods are often entwined. People consume and
produce goods and services in many different contexts and have different motivations.
While some goods are produced by private business firms and bought and sold in markets,
others are allocated directly by the agencies of state and private non-profit organizations
like charities. Some essential goods and services are produced within the household and
allocated outside the market.
In historical time and place the mix between private sector production and allocation
by market and non-market means was different. While in the modern economy a large
proportion of resources and output is allocated via the market mechanism, we still have a
significant volume of collective goods and those items for individual use where non-market
65
patterns of provision and allocation are the norm. Many goods and services consumed by
individuals are not provided and allocated by the market mechanism. They are supplied
either free of charge at the point of delivery or at a nominal price unrelated to the volume of
individual use.
HOMEWORK 6
1. What are the attributes of the public goods?
2. What are the differences between public goods, quasi-public goods and merit goods?
3. Explain the role of the state in the allocation of non-market goods.
4. Why is the legal framework important for the functioning of the markets?
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CHAPTER 7
AN OVERVIEW OF MACROECONOMICS AND NATIONAL INCOME
INTRODUCTION
Through chapters 1-6 we have studied mainly microeconomic issues. In this chapter we will
make an introduction to macroeconomics.
Microeconomics is concerned with economic issues at micro level. It is the study of
how households and firms make decisions and they interact in a specific market; how do the
prices of goods occur and change? Macroeconomics, on the other hand, is the study of
economy as a whole. The goal of macroeconomics is to explain the economic changes that
affect many households, firms, and markets at once. Macroeconomists address diverse
questions: Why is average income is high in some countries while it is low in others? Why do
prices rise rapidly in some periods of time while they are more stable in other periods? Why
the production and employment expand in some years and contract in others? These diverse
questions are all macroeconomic because they concern the workings of the entire economy.
Some examples will help us clarify the difference between microeconomics and
macroeconomics. Microeconomics considers the behavior of steel prices versus energy
prices, while macroeconomics studies the behavior of all producer and consumer prices.
Microeconomics studies individual’s job preference, while macroeconomics examines what
determines the overall unemployment rate. Microeconomics examines the individual items
of foreign trade, why we export textiles and import computers. Macroeconomics examines
the overall trends in our imports and exports.
There are interactions between microeconomics and macroeconomics. It is not
possible to explain macroeconomic events without understanding individual behavior, but
individual cannot behave independent of macroeconomic developments.
7.1. OBJECTIVES AND INSTRUMENTS IN MACROECONOMICS
Macroeconomics is a vital subject for many reasons. First of all, macroeconomic
performance is central to the success or failure of nations. As we try to explain the rises and
declines of nations, it quickly becomes clear that a very few key variables dominate the
67
analysis. In judging a nation’s performance, we encounter national income, employment,
inflation, and balance of payments. These are the central objectives or goals of
macroeconomic analysis and policy.
Table 7.1 is a list of major objectives and instruments of macroeconomic policy. We
will summarize each, thereby illustrating some key questions that confront macroeconomics.
a. Objectives of macroeconomics
Four areas are central to good macroeconomic performance; those concerning output,
employment, prices, and the foreign sector.
Table 7.1 Objectives and instruments of macroeconomics
OBJECTIVES
INSTRUMENTS
Output:
Fiscal policy:
High level, both actual and
relative to potential
Rapid growth rate
Employment:
High level of employment
Low unemployment
Price-level stability
Foreign balance:
Export and import equilibrium
Exchange-rate stability
Government expenditure
Taxation
Monetary policy:
Control of money supply affecting
interest rates
Incomes policies:
From voluntary wage-price
guidelines to mandatory controls.
Foreign economics:
Trade policies
Exchange-rate intervention
1) Output
The ultimate measure of economic success is a country’s ability to generate a high level and
rapid growth in the output of goods and services. National income is the measure of output.
Movements in national income are the best widely-available measure of the level and
growth of output.
68
Figure 7.1 National income of Turkey (1923-2010, millions of TL, 1998 prices)
120,000
100,000
80,000
60,000
40,000
20,000
0
1
6
11
16
21
26
31
36
41
46
51
56
61
66
71
76
81
86
Figure 7.1 shows the history of national income in Turkey since 1923. During the
period of 1923-2010 the Turkish national income increased about 48 times. A careful
examination of the figure will show that although the general trend is upward there are ups
and downs movements in national income. Economies don’t grow in a smooth and even
pattern. Several years of economic expansion are followed by recession, or even a crisis.
Then national output falls and unemployment rises. The ups and downs of national income
are called business cycles.
2) Employment and Unemployment
High employment, or low unemployment, is one of the main objectives of macroeconomic
policies. People want to be able to find good jobs at a high pay and to find them easily.
Attaining high employment is more than a purely economic goal. Bouts of involuntary
idleness impose financial hardships on families; but the economic stress is soon followed by
a high toll on psychological, social, and public health.
3) Prices and Inflation
The third major macroeconomic objective is to ensure price stability with free markets.
4) Foreign Balance
Countries make foreign trade; export and import goods and services. One of the main
purposes of macroeconomics is foreign trade balance. There is an interaction between the
69
exchange rate and foreign trade balance. Exchange rate is the price of a national currency in
terms of other national currencies. It is a significant factor determining the price of imported
and exported goods. Therefore, exchange rate has a critical role in reaching both foreign
trade balance and price stability.
b. Instruments of macroeconomics
1) Fiscal policy
Fiscal policy is related to total government expenditures, distribution of government
expenditures, and sources of these expenditures: taxes and other sources. Government can
affect aggregate demand (expenditures) by changing tax burden and its expenditure. At any
time, if the government wants to increase total demand, it may increase its own
expenditures and promote consumption and investment expenditures by lowering the tax
rate. If the government wants to decrease total demand it implements just the opposite
policies.
2) Monetary policy
Monetary policy is the way of influencing economy by changing the quantity of money and
interest rate. While expansionary monetary policy would lower the rate of interest and raise
total demand, a contractionary monetary policy would raise the rate of interest and lower
aggregate demand.
3) Incomes policies
Income policies are related to changing wages and salaries by the government. The main
concern may be either to control inflation and stabilize prices or to change the distribution
of income between labor incomes and capital incomes.
4) Foreign economics
Foreign economics is related to foreign trade and exchange rate policies. The main purpose
is foreign balance and exchange rate stability.
7.2. NATIONAL INCOME
7.2.1. BASIC CONCEPTS
National income is the total income of everyone in the economy. It is the basic concept in
macroeconomics. When judging whether the economy is doing well or poorly, we look at the
national income.
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In this section we examine two basic concepts relating to national income: gross
domestic product (GDP) and net domestic product (NDP).
a. Gross Domestic Product (GDP)
Gross domestic product (GDP) is the market value of all final goods and services produced
within a country in a given period of time. To simplify understanding of this definition, let’s
consider each phrase in the definition with some care.
GDP is the market value. It adds together many different kinds of products into a
single measure of the value of economic activity. To do this, it uses market prices. Market
prices measure the amount people are paying for different goods and they reflect the value
of those goods.
GDP includes all items produced in the economy and sold legally in the markets. It
excludes items produced and sold illicitly, such as illegal drugs. It also excludes most items
produced and consumed at home and, therefore, never enter the marketplace. Vegetables
you buy at the grocery store are part of GDP; vegetables you grow in your garden and you
consume at home are not.
GDP includes only the value of final goods. The reason is that the value of
intermediate goods is already included in the prices of final goods. We cannot calculate the
total output of the economy by simply adding up the output of all firms. Suppose, for
example, that we took the value of all farmers’ sales of wheat and added to it all flour mill’s
sales of flour, plus the sales of bakeries, plus the sales of bread by all retail stores. The
resulting total would be much larger than the value of the final product (bread) produced by
the economy. We would have counted the value of the wheat four times, of the flour three
times, of the bread produced by the bakery twice, and of the services of the retail store
once.
To avoid this problem of double counting, national income accountants use the
important concept of the value added. Each firm’s value added is the value of its output
minus the value of the inputs that it purchases from other firms. Thus a flour mill’s value
added is the value of its output of flour minus the value of the grain it buys from the farmer
and minus the values of any other inputs such as electricity and fuel oil that it buys from
other firms.
71
The idea of value added suggests an important distinction between intermediate and
final products. Intermediate products are all goods and services used as inputs into a further
stage of production. Final products are the output of the economy after eliminating all
double counting. In the previous example, grain, flour, electricity, and fuel oil were all
intermediate products used at various stages in the process that led to the production of the
final product, bread.
GDP measures the value of production within the geographic confines of a country.
For example, Turkey’s GDP measures only the total values of goods and services produced in
Turkey. When a Turkish citizen works temporarily in Germany, his production is part of
Germany’s GDP. When a Turkish citizen has factory in Bulgaria, the production at his factory
is not part of Turkey’s GDP. Thus, items are included in a nation’s GDP if they are produced
domestically, regardless of the nationality of the producer.
GDP measures the value of production that takes place within a specific interval of
time. Usually that interval is a year or a quarter (three months). GDP measures the
economy’s flow of income and expenditure during that interval.
b. Net Domestic Product (NDP)
A distinction between gross and net concepts of national income (or national product) would
help us understand the relation between the capital stock and national income. Gross
domestic income (or gross domestic product, GDP) is the sum of all values added in the
economy; it is the sum of the values of all final goods produced for consumption or
investment. Net domestic income (or net domestic product, NDP) is GDP minus the capital
consumption allowance (depreciation). NDP is thus a measure of the net output of the
economy after deducting from gross output an amount of necessary to maintain the existing
stock of capital intact.
National income (NI) is the term generally used in literature and daily discussions for
the market value of the total final goods and services produced within a country in a specific
interval of time. We will use this term from now on.
7.2.2. CALCULATION OF NATIONAL INCOME (NI)
NI income measures two things at once; the total income of everyone in the economy and
the total expenditure on the economy’s output of goods and services. Total income and total
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expenditure are really the same. For an economy as a whole, income must equal
expenditure for goods produced in that economy. NI can be calculated, then, by adding up
either expenditures or incomes of everyone.
a. The Expenditure Approach
When we use the expenditure approach to measure the total value of output, we calculate
the total expenditure needed to purchase the nation’s output.
Households, firms, government and foreigners purchase a part of the economy’s
output. We can write total expenditures on total output of economy as following,
Y = C+I+G+(X-M)
Y stands for national income, C consumption expenditures, I investment, G government
expenditure, X exports, M imports, and (X-M) net exports.
Consumption: Households spend most of their income to buy goods and services. The total
amount of expenditures on goods and services of household gives us consumption (C).
Investment: We may define investment (I) as the production of goods not for the present
consumption. Such goods are called investment goods. They are produced by firms and they
may be bought either by firms or by households. Most investment is done by firms. Firms
can invest either in capital goods, such as plant and equipment, or in inventories.
(a)Investment in inventories: Virtually all firms hold stocks of their inputs and their own
outputs. Such stocks are called inventories. Inventories of inputs allow production to
continue at the desired pace in spite of short-term fluctuations in the deliveries of inputs
bought from other firms. Inventories of output allow firms to meet orders in spite of
temporary, unexpected fluctuations in the rate of output or sales.
Inventories require an investment of the firm’s money since the firm has paid for
them but has not yet sold them. An accumulation of inventories counts as current
investment because it represents goods produced but not used for current consumption.
(b)Investment in capital goods: All production uses capital goods such as hand tools,
machines, and factory buildings. The total amount of capital goods in the country is called
capital stock. The act of creating capital goods is an act of investment.
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Investments are financed by saving. Saving is income not spent on goods and services
for current consumption. Both households and firms can save. Households save when they
elect not to spend part of their current income on goods and services for consumption. Firms
save both when they deduct from their gross revenues depreciation allowances which can
be used to keep their capital stock intact and when they elect not to pay out to their owners
some of the profits that they have earned. Undistributed profits are profits held back by
firms for their own uses.
Gross and net investment: The total investment that occurs in the economy is called gross
investment. Gross investment may be thought of as divided into two parts, replacement
investment and net investment. The amount of replacement investment required to
maintain the existing capital stock intact is called the capital consumption allowance or
simply depreciation. Net investment is gross investment minus the capital consumption
allowance. It is net investment that increases the economy’s total stock of capital, while the
replacement investment keeps the existing stock intact by replacing what has been worn out
or used up.
Government expenditure is given the symbol G includes government spending on goods and
services.
Table 7.2 Calculation of Turkish GDP, the expenditure approach (millions of TL)
2010
Consumption Expenditures (C)
787.270
Percentage
of GDP
71.3
Investment (private + government)(I)
219.905
19.9
Government Consumption Expenditures (G)
157.451
14.2
Net Exports (X-M)
-60.955
-5.5
1.103.750
100
Gross Domestic Product (C+I+G+X-M)
Net exports: The goods that are produced at home and sold abroad are called exports. The
goods that are produced abroad and sold at home are called imports. Part of the
expenditure on the domestic economy’s output comes from foreign firms, households, and
governments and part of the expenditure of domestic firms, households, and governments
goes to the NI of foreign countries. The value of the difference between exports and imports
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(X-M) is called net exports. A change in either X or M, not matched by a change in the other,
will cause the NI to change in the same way as would a change in C, I, or G.
Table 7.2 shows a simplified set of national income accounts for the economy using
the output-expenditure approach.
b. The Factor-Income Approach
The second approach of measuring NI is referred to as the factor-income approach. In this
approach, NI is calculated by adding factor-payments or factor-incomes.
There are four main components of factor incomes; rent, which is the payment to
landowners for the land in production; wages, which are the payment to workers; and
interest and profits, both of which are payments to capitalists. In order to obtain its capital
goods a firm requires money. This is made available by those who lend money to the firm
and by those who put up their own money in order to become the firm’s owners. Interest is
earned by those who lend money to the firm, and profits are earned by those who own the
firm.
Table 7.3: GDP of Turkey: The Income Approach (2006)
Item
Compensation of employees (labor income)
Amount
(billions of TL)
150,231
Percentage
of GDP
26
Operating surplus (rents, profits and interest)
288,516
50
NI (at factor cost)
439,747
Indirect taxes less subsidies
100,607
NDP(at market prices)
540,354
Depreciation
35,967
6
GDP(at market prices)
576,321
100
18
7.2.3. RELATED MEASURES OF NATIONAL INCOME
In this section we explain money values versus real values, per capita income, and
purchasing power parity income.
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a. Money Values versus Real Values
The NI measures the total money value of final goods produced during a year. Thus it has a
price and a quantity component. A particular change in the NI can be caused by many
different combinations of price and quantity changes. A 10 percent rise in NI might, for
example, have been caused by a 10 percent rise in prices, all quantities remaining
unchanged; a 10 percent rise in output, all prices remaining unchanged; or smaller increases
in both prices and quantities. For some purpose the money value of national income is just
the measure required. Sometimes, however, we wish to know what is happening to quantity
of output. To do this we need to separate changes in the NI that were caused by changes in
market prices from changes that were caused by variations in the quantity of output.
Changes in the quantity of output are defined as “real” changes to distinguish them from
mere “money” changes.
Table 7.4 Gross domestic product (GDP) in current and constant TL
Year
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
(1)
(2)
(3)
(4)
GDP in millions Index of prices GDP in millions Real change in
of current TL
1998=100
of 1998 TL
GDP, 1998=100
70 203
100
70 203
100
104 596
154
67 841
97
106 658
230
72 436
103
240 224
352
68 309
97
350 476
483
72 520
103
454 781
596
76 338
109
559 033
670
83 486
119
648 932
717
90 500
129
758 391
784
96 738
138
843 178
833
101 255
144
950 534
933
101 922
145
952 559
982
97 003
138
1,103,750
1,044
105,739
151
Current–TL national income tells us about the money value of output; constant-TL national
income tells us about changes in physical output. The TL figure in column (1) is divided by the
index in column (2). The resulting ratio multiplied by 100 gives the “constant-TL” figures on
column (3). Because the price index used is 100 in 1998, we say the constant-TL national income
is measured in 1998 TL. In 2010 actual GDP (in 2010 TL) was TL 1,103,750 million. But prices in
2010 were well above prices in 1998. The value of 2010 GDP at 1998 prices is estimated to be TL
105,739 million. Notice the difference between column (2) and column (4). Although the money
value of GDP in 2010 is eleven-fold of that in 1998, the real change in GDP is only 51%.
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Over any longer period of time, changes in the NI reflect both real quantity changes
and money price changes. How much of these changes result from changes in the volume of
goods and services and how much from a general rise in price?
To answer this question, the NI series has to be “deflated”. Deflation means adjusting
money values for the change in the level of prices. Deflation is done by an index number
developed for that purpose and called the national income deflator.
An example giving the relation between NI in current prices and NI income in
constant-prices is shown in Table 7.4.
b. Per Capita Income
For many purposes we want to measure of total output of a country; for example, if we wish
to assess a country’ total economic power or to know total size of its market. For other
purposes, however, we prefer per capita measures, which are obtained by dividing a total
measure by the number of persons in some group.
GDP divided by the total population gives us a measure of how much GDP there is on
average for each person in the economy. This is called per capita GDP. Per capita income is
widely used in international comparisons. It is the most important indicator of the richness
and the level of development of countries. Per capita income is also used to understand how
fast of a countries average welfare increases in time. Those countries that could raise their
per capita incomes faster than other countries could overcome the poverty and increased
the average purchasing powers of their citizens.
Note, however, that per capita income is only an average indicator; it does not say
anything about the distribution of income and wealth among individuals and social classes.
Therefore, it is possible to see that in any country, while national income and per capita
income are increasing, incomes of some people may fall.
c. National Income at Purchasing Power Parity Prices
Every country calculates its national income in terms of its own national currency. Therefore,
it is impossible to compare two countries’ national or per capita incomes without making
some transformations. One way of making international comparisons is to calculate each
country’s income in terms of a common currency, such as US dollar. In this way we can easily
compare countries’ total and per capita incomes with each other. But, in calculating a
77
country’s income in terms of another country’s currency raises some problems. In making
such a calculation, a country’s national income estimated in terms of its own currency, for
example in TL, is divided by the exchange rate between TL and US dollar. If current exchange
rates are used in such calculations, obtained results may not be reliable.
In principle, the exchange rates should indicate the relative value of currencies. The
value of a currency depends on it purchasing power. But, current exchange rate usually does
not reflect the real relative purchasing power of currencies. For exchange rate to reflect the
real relative value of currencies it must change according to the relative price changes in two
countries. This does not generally happen. Hence current exchange rates do not usually
reflect relative purchasing power of currencies; while the currencies of some countries may
be overvalued the currencies of some other countries may be undervalued. As a result,
national incomes in terms of common currency, say the dollar, may seem to be higher or
lower than what it should be.
To overcome this defect of international comparisons, countries’ national incomes
are calculated by using purchasing power parity. Purchasing power parity between two
countries’ currencies is estimated by using the values of a representative basket of goods
and services in terms of their national currencies. The relative value of the basket in each
country is taken as the purchasing power parity. For example, in 2010, per capita income
was $42.800 in the United States and TL15.051 in Turkey. The market exchange rate, was
TL1.502 per $1U.S. Using market exchange rate we calculate per capita income in Turkey as
$10,022 (=TL15,051/1.502). On these numbers, per capita income in the United States was
4.27 times that in Turkey ($42,800/$10,022 = 4.27). If we use purchasing power parity
instead of market exchange rate, we calculate per capita income in Turkey in terms of U.S.
prices. The prices of most of goods and services are higher in the U.S. than they are in
Turkey. So, per capita income in Turkey is higher in terms of the U.S prices than it was in
terms of Turkish prices. PPP was 0.97 in 2010 and per capita income in Turkey calculated
using PPP was $15,571(=TL15,051/0.97).
If we compare per capita income using PPP we see that per capita income in the
United States was 2.75 times that in Turkey, not 4.27 times.
$42,800/$15,571 = 2.75; $42,800/$10,022 = 4.27
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Therefore, to obtain a more accurate figure for the Turkish national income in terms of US
dollar we should divide the Turkish national income in terms of TL by 0.97. If every country’s
national income in terms of common currency is calculated by this way, more reliable
comparisons among countries would be possible.
HOMEWORK 7
1. List the objectives and instruments of macroeconomics and explain monetary and
fiscal policies.
2. Define gross domestic product (GDP) and explain its meaning.
3. What is the difference between GDP and net domestic product (NDP)?
4. What is the difference between nominal and real GDP? How real GDP is calculated?
5. Suppose that in a country in any year consumption (C) is 700 billion liras, government
expenditure (G) is 150 billion liras, investment (I) is 200 billion liras and net exports
(X-M) is -50 billion liras. Calculate GDP of that country in that year.
6. Data related to a country is given as follows, all million liras: wage incomes is 800,
capital incomes is 320, indirect taxes is 250 and depreciation is 180.
a. Calculate GDP in that country.
b. Which method of calculation you have used?
7. How the per capita income calculated and for what we may use it? Does it give any
idea about income distribution?
8. What is investment? How we may categorize investments? What is the difference
between gross and net investment?
9. What is purchasing power parity and how does it contribute international
comparisons of economic values?
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CHAPTER 8
EMPLOYMENT AND PRICE STABILITY:
UNEMPLOYMENT AND INFLATION
Unemployment and inflation are two important economic problems. Having a good job that
pays a decent wage is one half of a good standard of living. The other half is the cost of
living. In this lesson, we will first discuss unemployment and then inflation.
8.1. UNEMPLOYMENT
a.
Why Unemployment is a Problem?
Employment and unemployment are related to total number of jobs available and on the
number of people competing for them. Unemployment usually moves in tandem with
output. The most distressing consequence of any recession is a rise in the unemployment
rate. As output falls, firms need fewer labor inputs, so new workers are not hired and
current workers are laid off.
Unemployment is a serious personal and social economic problem. As an economic
problem, it is a waste of valuable resources. As a social problem, it is a source of enormous
suffering, as unemployed workers struggle with reduced incomes. During periods of high
unemployment, economic distress spills over to affect people’s emotions and family lives.
1) Economic impact of unemployment
When the unemployment rate goes up, the economy is in fact throwing away all the goods
and services that the unemployed workers could have produced. During recessions, it is as if
vast quantities of automobiles, housing, clothing, and other commodities were simply
dumped into the ocean. The loss of a job brings a loss of income and lost production. Lost
production means lower consumption and a lower investment in capital, which lower the
living standard in both the present and future.
2) Social impact of unemployment
The economic cost of unemployment is certainly large, but the social cost is enormous. No
money figure can adequately convey the human and psychological toll of long periods of
persistent involuntary unemployment. Unemployment is also a personal tragedy.
Unemployment leads to a deterioration of both physical and psychological health.
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b. Measurement of Unemployment
In Turkey, TURKSTAT carries out surveys to estimate employment. Every month TURKSTAT
surveys households and ask a series of questions about the age and job market status of the
members of each household. This survey is called Households Labor Force Survey. TURKSTAT
uses the answers to describe the anatomy of the labor force.
c. Labor Market Indicators
TURKSTAT calculates basic indicators of the state of the labor force. Leading indicators of the
state of the labor force are
– Non-institutional population
– Non-institutional working-age population
– Labor force
– Labor force participation rate
– Employment and employment rate
– Unemployed and unemployment rate
Non-institutional population: Non-institutional population comprises all the population
excluding the residents of dormitories of universities, orphanage, resting homes for elderly
people, special hospitals, prisons and military barracks etc.
Non-institutional working-age population: Non-institutional working-age population
indicates the population 15 years of age and over within the non-institutional civilian
population. TURKSTAT divides the working-age population into two groups: those in the
labor force and those not in the labor force.
Labor force and Labor force participation rate: Labor force comprises all employed and
unemployed people. So the labor force is the sum of the employed and the unemployed.
Labor force participation rate is the ratio of the labor force to non-institutional working age
population.
Employment and unemployment rate: Employment rate is the ratio of employed people to
the non-institutional working-age population.
Employment rate = (employed people/the non-institutional working age population) x 100
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Unemployment Rate: The unemployed comprises all people 15 years of age and over who
were not employed during the reference period and had used at least one channel for
seeking a job during the last four weeks and were available to start work within two weeks.
Unemployment rate is the ratio of unemployed persons to the labor force.
Unemployment rate = (Number of people unemployed/Labor force) x 100
Labor force = Number of people employed + Number of people unemployed.
The amount of unemployment is an indicator of the extent to which people who seek jobs
can’t find them.
TABLE 8.1: Labor Force in Turkey (000 people, August 2014)
Population(15 years old and over
Labor force:
Employed:
Unemployed:
Labor force participation rate %
(29,257/57,090)
Employment rate %
(26,313/57,090)
Unemployment rate %
(2,944/29,257)
Not in the labor force:
57,098
29,257
26,313
2,944
51.2
46.1
10.1
27,841
d. Three Kinds of Unemployment
Economists identify three different kinds of unemployment: frictional, structural, and
cyclical.
1) Frictional unemployment
Frictional unemployment arises because of the incessant movement of people between
regions and jobs or through different stages of the life cycle. Even if an economy were at full
employment, there would always be some turnover as students search for job when they
graduate from school or women enter the labor force after having children. Frictional
unemployment is a permanent and healthy phenomenon in a dynamic, growing economy.
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2) Structural unemployment
Structural unemployment signifies a mismatch between the supply of and the demand for
workers. Mismatches can occur because the demand for one kind of labor is rising while the
demand for another kind of labor is falling, and supplies do not quickly adjust. Structural
imbalances across occupations or regions are seen as certain sectors grow while others
decline.
Structural unemployment arises because changes in technology or international
competition change the skills needed to perform jobs. Structural unemployment usually lasts
longer than frictional unemployment because workers must retrain and possibly relocate to
find a job. Structural unemployment is painful, especially for older workers for whom the
best available option might be to retire early or take a lower-skilled, lower paying job.
3) Cyclical Unemployment
Cyclical Unemployment exists when the overall demand for labor is low. As total spending
and output fall, unemployment rises virtually everywhere. Cyclical unemployment occurs
during recessions, when employment falls as a result of an imbalance between aggregate
supply and demand.
8.2. INFLATION
a. Definition
A persistently rising price level is called inflation; a persistently falling price level is called
deflation. The price level is the average level of prices.
b. Kinds of Inflation
It is possible to define two different kinds of inflation according to the influences creating
inflation: demand-pull inflation and cost-push inflation.
Demand-pull inflation occurs when aggregate demand rises more rapidly than the
economy’s productive potential, pulling prices up to equilibrate supply and demand. One of
the reasons that create demand pull inflation may be an increase in the supply of money.
Growth in money supply may increase aggregate demand, which in turn increases the price
level.
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Cost-push inflation occurs when prices and wages begin to rise before full
employment is reached. In that case the aggregate demand is not higher than the productive
capacity of the economy. Inflation is resulted from rising costs during periods of high
unemployment and slack resource utilization. This kind of inflation is called cost-push
inflation. Cost-push inflation may be created by increases in wages or the prices of raw
materials such as oil. High inflation in periods of high unemployment is called stagflation.
Expectations also may play an important role creating inflation. Most prices and
wages are set with an eye to future economic conditions. When prices and wages are rising
rapidly and are expected to continue doing so, businesses and workers tend to build the
rapid rate of inflation into their price and wage decisions. High or low inflation expectations
tend to be self-fulfilling prophesies.
c. Why Inflation and Deflation are Problems
Low, steady and anticipated inflation or deflation is not a problem, but unexpected burst of
inflation or period of deflation brings big problems and costs. An unexpected inflation or
deflation: redistributes income and wealth, and affects efficiency and output negatively.
1) Redistribution of income and wealth
Workers and employers sign wage contracts that last for a year or more. An unexpected
burst of inflation raises prices but doesn’t immediately raise the wages. Workers are worse
off because their wages buy less than they bargained for and employers are better off
because their profits rise. An unexpected period of deflation has the opposite effect. Wage
rates don’t fall but the prices fall. Workers are better off because their fixed wages buy more
than they bargained for and employers are worse off with lower profits.
People enter into loan contract that are fixed in money terms and that pay an
interest rate agreed as a percentage of the money borrowed and lent. With an unexpected
burst of inflation, the money that the borrower repays to the lender buys less than the
money originally loaned. The borrower wins and the lender loses. The interest paid on the
loan does not compensate the lender for the loss in money of the money loaned. With an
unexpected deflation, the money that the borrower repays to the lender buys more than the
money originally loaned. The borrower loses and lender wins.
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2) Negative effect on total output and efficiency
Inflation affects total output and efficiency. It impairs economic efficiency because it distorts
price signals. In a low-inflation economy, if the market price of a good rises, both buyers and
sellers know that here has been an actual change in the supply and/or demand conditions
for that good, and they can react appropriately. For example, if the neighborhood
supermarkets all boost their meat prices by 50 percent, perceptive consumers know that it is
time to start eating more chicken.
By contrast, in a high-inflation economy it is much harder to distinguish between
changes in relative prices and changes in the overall price level. If inflation is running at 20 or
30 percent per month, then stores change their price list so often that changes in relative
prices get lost in the blur. Changing price list frequently has a cost.
Inflation also distorts the use of money. In inflationist periods money in pocket loses
its purchasing power, so people hold less money and they either increase their spending on
consumption goods or transform money into other assets. This may have a positive effect on
the total product and employment for some time. But this positive relationship between the
price level and total output is unsustainable in the long run.
Unpredictable inflation or deflation turns the economy into a casino and diverts
resources from productive activities to forecasting inflation. It can become more profitable
to forecast the inflation rate or deflation rate correctly than to invent a new product. People
can make themselves better off, not by specialization in the profession for which they have
been trained but by spending more of their time dabbing as amateur economists and
inflation forecasters and managing their investments. From a social perspective, the
diversion of talent that results from unpredictable inflation is like throwing scarce resources
onto a pile of garbage. This waste of resources is a cost of inflation. At its worst, inflation
becomes hyperinflation. A hyperinflation grinds the economy to a halt and causes a society
to collapse. Hyperinflation is rare, but some countries experienced it in the past.
We pay close attention to the inflation rate, even when its rate is low, to avoid its
consequences. We monitor the price level every month and devote considerable resources
to measuring it accurately.
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d. Measure of Inflation
TURKSTAT measures three price indexes: Consumer Price Index (CPI), Domestic Producer
Price Index (DPPI), and Non-Domestic Producer Price Index (ND-PPI). Price compilation is
conducted by TURKSTAT every month. Included items and their relative weights are updated
at the end of every year. Every year in December new goods and services are added, goods
and services which lost their importance are taken out and renewed weights are used in the
calculation of indexes. Results of the CPI and DPPI are announced to the public on the 3 rd or
consequent working day of the following month at 10:00 with a news bulletin. The
announcement for the results of the ND-PPI is made on the 20th day or consequent working
day of the month.
Consumer Price Index (CPI) measures the changes of the current retail prices of goods and
services purchased by consumers over a given time period. 2003 based CPI is aimed to
calculate the inflation rate by using the change of the prices of goods and services existed in
the market. For this purpose, expenditures of households, foreign visitors, constitutional
population and all of the final monetary expenditures are taken into account.
Consumer Price Index (CPI) is a measure of the average of the prices paid by
consumers for a fixed basket of consumer goods and services. Every month TURKSTAT
measures the price level by calculating CPI. For this purpose, expenditures of households,
foreign visitors, institutional population and all the final monetary expenditures are taken
into account. The CPI is defined to equal 100 for a year called the reference base year.
Index is calculated by dividing current prices to the prices of previous December, and
then chained by multiplying it with the index numbers of December.
A major purpose of the CPI is to measure changes in the cost of living and in the value
of money. To measure the changes, we calculate the inflation rate:
Inflation rate = [(CPI this year-CPI last year)/ (CPI last year)] X 100.
This formula can be used to calculate the inflation rate in Turkey in 2013. In December 2013,
the CPI was calculated as 229.01. This number tells us that the average of the prices paid by
consumers for a fixed basket of consumer goods and services was 129.01 percent higher in
2013 than it was in 2003. That is, the CPI was 100 in 2003 and it was 229.01 in 2012 and the
difference is 129.01 (=229.01-100).
86
The CPI in December 2012 was 213.23, and the CPI in December 2013 was 229.01. So the
inflation rate during the twelve months to December 2012 was
Inflation rate = [(229.01-213.23)/213.23]X100 = 7.40%
Domestic Producer Price Index (DPPI) is a measure of the change in the prices of goods and
services sold as output by domestic producers in a given reference period. It covers mining
and quarrying, manufacturing, electricity, gas and water. Prices are cash prices, excluding
VAT and all relevant taxes (Basic prices).
Non-Domestic Producer Price Index (ND-PPI) is a measure of the change in the export prices
(FOB) of goods and services sold as output by domestic producers into foreign countries in a
given reference period. It covers mining and quarrying, manufacturing. Prices are FOB prices
excluding VAT and all relevant taxes.
HOMEWORK 8
1. Why unemployment is a problem?
2. Define the following concepts: Non-institutional population, non-institutional
working-age population, labor force, labor force participation rate, employment rate,
unemployment rate.
3. Define
frictional
unemployment,
structural
unemployment,
and
cyclical
unemployment.
4. Define inflation and deflation.
5. What are the problems created by inflation and deflation? Explain.
6. What is the consumer price index and how it is constructed?
7. CPI for Turkey (2003=100) was 200.85 in December 2011 and 213.23 in December
2012. Calculate the rate of inflation for 2012.
8. Some of the Turkish labor force indicators in September 2013 were as following:
Non-institutional population: 74,643,000; population 15 years old and over: 55,790
000; employed: 25,808,000, and unemployed: 2,831,000. Calculate labor force, labor
force participation rate, employment rate, and unemployment rate.
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CHAPTER 9
MONEY AND MONEY MARKET
9.1. MONEY
Money is anything that serves as a commonly accepted medium of exchange or means of
payment. Changes in the quantity of money have enormous effects on output, employment,
and prices. The central bank can use its control over the supply of money to stimulate the
economy when growth turns sluggish, or to brake the economy when prices start to race
ahead. When money is well managed, output can grow smoothly with stable prices. But
when there are problems in the monetary system, money can grow rapidly or shrink sharply,
leading to inflation or depression.
Money serves four functions:
– Means of payment
– Medium of exchange
– Unit of account
– Store of value
a. Means of payment
A means of payment is a method of settling a debt. When a payment has been made, there
is no remaining obligation between the parties to a transaction. A medium of exchange is
any object that is generally accepted in exchange for goods and services. Without a medium
of exchange, goods and services must be exchanged directly for other goods and services. If
a good is exchanged for another good we call such exchange barter. Barter requires double
coincidence of wants. A double coincidence of wants is a situation that rarely occurs.
For example, if you want a hamburger, you might offer a CD in exchange for it. But you
must find someone who is selling hamburgers and wants your CD. A medium of exchange
overcomes the need for a double coincidence of wants. Money acts as a medium of
exchange because people with something to sell will always accept money in exchange for it.
b. Unit of Account
A unit of account is an agreed measure for stating the prices of goods and services. To get
the most out of your budget, you have to figure out whether seeing one more movie is
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worth its opportunity cost. Opportunity cost is, for example, the number of ice-cream cones,
sodas, or cups of coffee that you must give up. It is easy to make such calculations when all
these goods have prices in terms of money. We can see how much simpler it is if all the
prices are expressed in money.
c. Store of Value
Money is a store of value in the sense that it can be held and exchanged later for goods and
services. If money were not a store of value, it could not serve as a means of payment.
Money is not the only store of value. A house, a car, and a work of art are other examples.
The more stable the value of a commodity or token, the better it can act as a store of value
and the more useful it is as money. No store of value has a completely stable value. The
value of a house, a car, or a work of art fluctuates over time. The value of the commodities
and tokens that are used as money also fluctuates over time. Inflation lowers the value of
money and values of other commodities and tokens that are used as money. To make
money as useful as possible as a store of value, a low inflation rate is needed.
9.2. MONEY IN TURKEY
In Turkey, money consists of
– Currency in circulation and
– Deposits at banks.
Currency in circulation is the notes and coins held by individuals and businesses. Notes are
money because the government declares them so. Deposits of individuals and businesses at
banks are also counted as money. Deposits are money because the owners of the deposits
can use them to make payments.
The narrowest measure of money is M1. M1 consists of currency in circulation (held
by public) and sight deposits both TRY and FX. M1 does not include currency held by banks.
Sight deposits include all deposits in banks that can be withdrawn without prior notice. They
are non-interest bearing. M2 consists of M1 plus time deposits. Time deposits include TRY
deposits and FX deposits. They are interest-bearing. M3 is the broadest definition of
money.
Money stock definitions used by the Central Bank of Turkey are:
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M1 = Currency in circulation + Sight Deposits (TRY) + Sight Deposits (FX)
M2 = M1 + Time Deposits (TRY) + Time Deposits (FX)
M3 = M2 + REPOS + Money Market Funds + Debt Securities Issued
9.3. BANKING SYSTEM
The banking system consists of the central bank (CB) and commercial banks. The CB is at the
top of the system and is responsible to carry out monetary policy. The CB can influence the
economy by changing the amount of money using monetary policy tools.
a. The Central Bank’s Policy Tools
The CB influences the quantity of money and interest rates by manipulating three tools:
– Open market operations
– Loans to banks
– Required reserve ratio
1) Open Market Operations
An open market operation is the purchase of securities from commercial banks or sale of
securities by the CB to commercial banks. When the CB buys securities, it pays for them with
newly created money. When the CB sells securities, the CB is paid with money held by banks.
By open market operations, the CB changes the quantity of money.
2) Central Bank’s Loans to Banks
The CB is the lender of last resort. If a bank is short of money, it can borrow from the CB. The
CB can provide money to the banking system by making loans to banks. The CB sets the
interest rate on the last resort loans and this interest rate is called the discount rate. These
loans increase bank reserves. The CB can change commercial banks’ demands for loan by
changing the discount rate. If the CB lowers the discount rate banks may increase their loan
from the CB and their reserves increase. If the CB increase the discount rate this may lead a
decrease in loan demand of the banks from the CB and their reserves decrease.
3) Required Reserve Ratio
Commercial banks hold a part of deposits as reserves and lend the other part to firms and
households. The required reserve ratio is the minimum percentage of deposits that the CB
wants commercial banks to hold as reserves. The CB can influence the total amount of banks
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loans to firms and households by changing the required reserve ratio and thus the excess
reserves that can be used as loans.
b. Commercial Banks
A commercial bank is a firm that receives deposits and makes loans. Commercial banks
provide services such as check clearing, account management, credit cards, and internet
banking. A commercial bank holds a part of the funds it receives from depositors and other
funds that it borrows as reserves and puts the other part of funds into financial assets and
loans.
Bank’s reserves are notes and coins in the bank’s vault or in a deposit account in the
central bank (CB). These funds are used to meet depositors’ currency withdrawals and to
make payments to other banks. Loans are funds committed for a period of time to firms to
finance investment and to households to finance the purchase of goods and services.
Commercial banks provide four benefits: they create liquidity, pool risk, lower the
cost of borrowing and lower the cost of monitoring borrowers
Commercial banks create liquidity by borrowing short and lending long. They take
deposits and stand ready to repay them on short notice or on demand and make loan
commitments that run for terms of many years.
A loan might not be repaid. This is a default. If you lend to one person who defaults,
you lose the entire amount loaned. If you lend to people through a bank and one person
defaults, you lose almost nothing. Commercial banks pool risk.
Commercial banks monitor borrowers and encourage good decisions that prevent
defaults. It would be very costly for individuals that lent money to a firm monitoring that
firm directly. Commercial banks can perform this task at a much lower cost.
9.4. HOW BANKS CREATE MONEY
We defined money as the sum of currency in circulation and bank deposits. Banks create
deposits by making loans. So, banks create money. When the CB supplies the banking system
with additional reserves, deposits increase by a multiple of this amount. This is a process
called multiple deposit creation.
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When the CB supplies new reserves to the banks, their excess reserves increase by
this amount, because the CB wants banks hold required reserves only for deposits. Banks will
lend some part of their excess reserves. Borrowers will draw some part of the credit from
the banking system as cash; there will be a currency flow out of the banking system. The
other part of the credit, however, will be held in bank accounts as deposits. In this way new
money is created. Banks will hold some part of the newly created deposits as required
reserves (and probably as excess reserves). The other part of the deposits will be lent to new
borrowers. This process continues until the initial increase in reserves results in a multiple
increase in deposits. For the banking system as a whole, deposit creation will stop only when
non-desired reserves in the banking system are zero.
When the non-desired reserves are used up the quantity of new deposits (money)
created will depend on three factors: the required reserve ratio decided by the central bank,
the excess reserve ratio decided by commercial banks, and currency holding ratio decided by
the public. There is a negative relationship between each of these ratios and the quantity of
created new deposits (money); when any of these ratios rises the money multiplier falls, vice
versa. A money multiplier determines the change in the quantity of money that results from
a change in the bank reserves. The money multiplier is the ratio of change in the quantity of
money to the change in reserves. For example, if an increase of 1 million liras in reserves
increases the quantity of money by 3 million liras, the money multiplier is 3.
The sequence has the following eight steps:
1) Banks have excess reserves.
2) Banks lend some part of excess reserves.
3) The quantity of money increases.
4) New money is used to make payments.
5) Some of the new money remains as deposit.
6) Some of the new money is a currency drain.
7) Desired reserves increase because deposits have increased.
8) Excess reserves decrease.
If the CB sells securities to banks in an open market operation, the banks have negative
excess reserves; they are short of reserves. When the banks are short of reserves, loans and
deposits decrease and the process we have described above works in a downward direction
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until desired reserves plus desired currency holdings has decreased by an amount equal to
the decrease in bank reserves.
9.5. THE MONEY MARKET: DETERMINATION OF THE RATE OF INTEREST
In money market the rate of interest is determined by the supply of and demand for money.
a. Demand For Money
The quantity of money demanded is the inventory of money that people plan to hold on any
given day. It is the quantity of money in our wallets and in our deposit accounts at banks.
The quantity of money that people plan to hold depends on four main factors:
– the price level
– interest rate
– national income (GDP)
– payment technologies
1) The Price Level
The quantity of nominal money demanded is proportional to the price level, other things
remaining the same. If the price level rises by 10 percent, people hold 10 percent more
nominal money than before, ceteris paribus. If you hold 20 liras to buy your weekly needs,
you will increase your money holding to 22 liras if the prices of the goods and services (and
your wage rate) increase by 10 percent.
2) Interest Rate
A fundamental principle of economics is that as the opportunity cost of something increases,
people try to find substitutes for it. Money is no exception. The higher the opportunity cost
of money, other things remaining the same, the smaller is the quantity of real money
demanded. The nominal interest rate on the other assets, such as time deposits and bonds,
is the opportunity cost of holding money. Therefore, there is a negative relationship
between the amount of money held and the interest rate.
3) National income (GDP)
The quantity of money that households and firms plan to hold depends on the amount they
are spending. The quantity of money demanded in the economy as a whole depends on
aggregate expenditure, GDP. Again, suppose that you hold an average of 20 liras to finance
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your weekly purchases. Now imagine that the prices of these goods and of all other goods
remain constant but that your income increases. As a consequence, you buy now more
goods and services and you also keep a larger amount of money on hand to finance your
higher volume of expenditure.
4) Payment technologies
Technological change and the arrival of new financial products influence the quantity of
money held. Financial innovation decreases the need for holding money. Financial
innovations include automatic transfers between bank accounts, automatic teller machines,
credit cards and debit cards, internet banking and bill paying.
b. Supply of Money
The quantity of money supplied is determined by the actions of the central bank (CB),
commercial banks and people, as we have explained above. Although the behaviors of
commercial banks and people affect money supply, the most important determinant of
money supply is the CB, because the CB’s policies affect also the behaviors of commercial
banks and people.
c. Money Market Equilibrium
Money market equilibrium occurs when the quantity of money demanded equals the
quantity of money supplied. Any change either in money supply or demand or both changes
the rate of interest.
HOMEWORK 9
1. Define money and explain its functions.
2. What are the official measures of money in Turkey?
3. What are the economic benefits provided by commercial banks? Explain each.
4. What is the banking system and what is the role of the central bank?
5. What are the central bank’s three policy tools? Explain each.
6. How do banks create money?
7. What limits the quantity of money that the banking system can create? Explain.
8. What determines money demand?
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CHAPTER 10
THE TURKISH ECONOMY
In this chapter we will discuss the sectoral outlook, economic growth and development, and
international economic relations of Turkey.
10.1. SECTORAL OUTLOOK
Activities of national economies are classified in three main sectors: agriculture, industry and
services. Agricultural sectors include agriculture, forestry and fishing. Industrial sectors are
mining and quarrying, manufacturing, and electricity, gas, steam and air conditioning. All
other activities are collected in services.
TABLE 10.1: GDP by Kind of Economic Activity in 2014 (%, current prices)
AGRICULTURE (Agriculture, forestry and fishing)
INDUSTRY
Mining and quarrying
Manufacturing
Electricity, gas, steam and air conditioning supply
Construction
SERVICES
SECTORAL TOTAL
Financial intermediation services indirectly measured
Taxes-subsidies
GROSS DOMESTIC PRODUCT (PURCHASER'S PRICE)
Million TL
(%)
125,018
7.1
329,556 18.8
25,457
1.5
276,504 15.8
27,595
1.6
79,744
4.6
1,021,846 58.4
1,556,164 88.9
-25,063 -1.4
218,681 12.5
1, 749,782 100.0
Source: TURKSTAT.
Shares of each sector in gross domestic product (GDP) in 2014 are given in Table 10.1.
The GDP of Turkey was about 1,750 million liras at current prices in 2014. The shares of
sectors as a percentage of total GDP are: agriculture 7.1, industry 18.8, construction 4.6 and
services 58.4. These figures imply that the Turkish economy is a service and industry
economy. This is a result of a radical structural transformation in the economy.
Turkey has experienced far-reaching economic and social changes since the early
1920s. The primarily rural and agricultural economy of the early twentieth century has
transformed into a mostly urban one. In the 1920s, less than 25 per cent of Turkey’s
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population lived in urban centers. The proportion of the population living in urban centers
has increased to about 75 per cent, since then. Rapid urbanization has been accompanied by
large shifts within the labor force. Agriculture’s share in total employment had declined from
89 percent in 1920s to about 20 percent, while industry’s share had risen from about 4 to
about 20 percent, and that of services had increased from 7 to about 60 percent. Similarly,
agriculture’s share in GDP had declined from about 45 percent in 1920s to about 7 percent in
2014. The share of industry had increased from about 10 percent to about 19 percent and
the share of services had increased from 44 to 64 percent.
a. Agriculture
Agriculture includes all types of produce, animal husbandry, forest products and water
products. Although its share in total production and employment is declining, agriculture is
still a critical sector for the economy. Agricultural products are necessary for the satisfaction
of our basic needs. Industry uses them in the production of many industrial products.
Additionally, agricultural sector is an important market for industrial products; many
industrial products are used as inputs in agricultural production.
Despite the rapid decline in the share of the Turkish agriculture in GDP, this share is
still higher than developed and some developing countries. The situation is similar for the
share of agriculture in employment: it is less than 5 percent in developed countries.
Actually, about six million people are working in agriculture in Turkey.
Labor and land inputs in agriculture have declined recently, and the increase in
productivity and production is a result of increases in capital stock. But the capital stock in
agriculture is relatively lower in Turkey, compared to developed countries. The continuation
of the increase in agricultural productivity and total agricultural production necessitate much
more investment than in the past. In the past the share of the agricultural investments in
total investments has been less than the sector’s share in GDP, and has declined
continuously.
Average machinery per worker and per unit of cultivated land in Turkish agriculture is
still lower than in developed, and more importantly, some similar Mediterranean countries.
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Inputs other than capital, such as chemical fertilizers, developed seeds, pesticides,
processed animal feeds and irrigation, play a vital role for increasing the land and labor
productivity.
Organization, production structure and relatively backward technologies are the main
agricultural problems. Most of the agricultural enterprises are small-scale family businesses
using non-wage family labor and traditional techniques on farms broken to pieces.
Agricultural producers are unorganized. Despite the developments the average productivity
both in the production of soil products and animal husbandry is still lower than developed
countries. Especially production of the field products is still dependent on natural conditions.
In addition to small-scale production and dependence on natural conditions, the low
level of education of agricultural labor, backward technology, and insufficiency in the usage
of modern inputs are among the factors leading low productivity, low quality production.
Low productivity causes high costs, low agricultural income and impedes the
competitiveness of Turkey in the international markets.
b. Manufacturing Industry
The term “industry” is generally used to include manufacturing, mining, energy and gas, and
water sectors. In this section we will discuss only the manufacturing industry. The relative
size of the manufacturing sector in any economy is a significant indicator of the industrial
development. It is measured by the share of the sector in GDP and in total employment. The
compositions of the manufacturing output and employment are, however, considered as
better indicators of the level of industrialization.
Developed countries use high-tech
production methods and employ more qualified labor.
The share of manufacturing in both total employment and GDP has declined in
Turkey, in the 2000s. Its share in GDP was about 24% in 1998 and fell to 15.8% in 2014. Its
share in employment was about 13 percent in 2014. These figures show that the rate of
growth of manufacturing in the last 15 years has been slower than the growth rate of GDP.
This performance of the sector implies that the manufacturing lost its driving force function
for the economy as a whole.
After 1990s manufacturing sector in Turkey has been shaped by the international
economic developments such as the customs union with EU and the integration of China and
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India to the world economy in the process of accelerated globalization trends, increasing
competition in international markets. Both import and export dependence of the sector has
increased; now, manufacturing is using relatively more imported inputs and is exporting
relatively more output than in the past. As a result, the sensitivity of the sector to the
international economic development has increased remarkably. Rising sensitivity and
dependence is related to not only the demand and supply conditions in the international
commodity markets but also money markets; fluctuations in the exchange rates now
influence the sector much more than in the past.
Of the Turkish manufacturing enterprises about 94% are very small, with 1-19
workers; only 6% employ 20 and more workers, and only 2.50% employ 50 and more
workers. Large-scale enterprises employing 250 and more workers constitute only 0.42% of
the total. 99.5% of the total enterprises are very small, small and medium.
Very small enterprises, despite their numerical majority, have very low shares in total
value added, employment and fixed capital investments. Only about 22 of employment and
only about 12 of value added were provided by the very small enterprises.
Value added per person in small enterprises is about ¼ of that in the large
enterprises. Small enterprises are not equipped properly and their productivity is low.
The general technological level of the Turkish manufacturing is far from being enough
to increase the competiveness of the sector. Industries with low and middle technologies are
dominant in the Turkish manufacturing sector. In 2010, they provided 69% of the total
production. Their share was about 72% in employment and 63% in export incomes. The
share of high-tech industries was 8.5% in production and about 8% in export incomes.
10.2. LONG-TERM GROWTH AND DEVELOPMENT
a. Growth
In this section we will make an assessment of the long-term growth performance of the
Turkish economy. Between 1913 and 2008 Turkish GDP and PCI had increased by about 33fold and 5.5-fold, respectively. These figures imply an annual average increase of 4.2% for
GDP and 2.25% for PCI. Since PCI is a better indicator of the long–term growth of countries,
we will use it both in intertemporal and international comparisons.
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Although a relatively high rate of average growth recorded for the 1923-1939 period,
PCI had decreased during the Second World War. Economic growth has become a
permanent phenomenon after the War with some exceptional years of crisis. The average
growth rate of PCI had been 2.98% during 1950-1980 and 2.42 during 1980-2008.
Without doubt, the growth rates give valuable information about the performance of
the Turkish economy, but to make a better assessment we will compare the Turkish growth
performance with some selected countries, regions and the world as a whole.
TABLE 10.2: Relative Change in the Turkish PCI (1913-2008)
1913
1950
1980
2008
USA
437
589
462
387
30 Western European Countries
285
282
327
269
7 Eastern European Countries
140
130
144
106
Total Latin America
123
155
135
86
Total Asia
57
44
50
70
Total Africa
53
55
38
22
World
126
130
112
94
Greece
131
118
223
203
Spain
169
135
229
244
Mexico
143
146
157
99
Argentina
313
307
204
136
Brazil
67
103
129
80
China (P.R.)
46
28
26
83
India
55
38
23
37
Japan
114
118
334
283
Malaysia
74
96
91
128
S. Korea
72
53
102
243
Iran
82
106
99
86
Egypt
74
56
51
46
Turkey
1001
100
100
100
Source: Madison, Historical Statistics, our calculation. (1) GDP per capita in the area within the present-day
borders of Turkey.
Comparative growth performance of Turkey for (1913-2008) period is given in Table
10.2. We make comparison for four different dates (1913, 1950, 1980 and 2008) and
calculate PCIs of selected countries, regions and the world by taking the level of Turkish
PCI=100 for each date. The figures in the table imply that the PCI of Turkey improved about
10% relative to the USA between 1913 and 2008; the improvement relative to Western
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Europe is negligible; it deteriorated somewhat relative to Asia, and improved strongly
relative to the world average and other regions of the world. Starting from these figures we
can say that Turkey has strongly improved its position relative to some countries such as
Argentina, Mexico, India and Egypt; but its position deteriorated relative to some other
selected countries such as Greece, Spain, Brazil, China, Japan, Malaysia and S. Korea.
In summary, it is possible to say that, although Turkey has increased its PCI by 5.5-fold
in the last 100 years, it could not change its position remarkably relative to developed
countries. In other words, Turkish PCI had increased at about the same rate as those in highincome countries since 1913 and Turkey has not been able to close the existing income gap.
On the other hand, increases in average income in Turkey since 1913 have been slightly
faster than the world average.
b. Development
Although PCI may be considered the most important indicator of human development there
are other indicators. For this reason, the human development index (HDI) was introduced by
the United Nations in 1990 as a broader measure. The HDI is a summary measure for
assessing long-term progress in three basic dimensions of human development: a long and
healthy life, access to knowledge and a decent standard of living. A long and healthy life is
measured by life expectancy. Access to knowledge is measured by two indicators: i) mean
years of education among the adult population; and ii) expected years of schooling for
children of school-entry age. Mean years of education is the average number of years of
education received in a life-time by people aged 25 years and older, and expected years of
schooling is the total number of years of schooling a child of school-entry age can expect to
receive. Standard of living is measured by Gross National Income (GNI) per capita.
Turkey’s record in human development has been weaker than its record in economic
growth. Levels and improvements in life expectancy in Turkey have been comparable to
those in other developing countries with similar levels of income. However, education levels
in Turkey have been lagging behind education levels in developing countries with similar
levels of GDP. Turkey also lags behind developing countries with comparable levels of per
capita income in indices aiming to measure gender equality and the socio-economic
development of women. One other reason why many of Turkey’s human development
measures have been lagging behind is the large interregional differences.
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Countries are categorized in four different groups regarding to their human
development levels: very high human development (the first 49 countries), high human
development (countries ranking between 50 and 102), medium human development
(countries ranking between 103 and 144), and low human development (countries ranking
between 145 and 187).
TABLE 10.3: Turkey’s HDI Values for 2013 Relative to Selected Countries and Groups
Very high HDI
High HDI
Medium HDI
Low HDI
Turkey
Serbia
Azerbaijan
ECA(1)
HDI
IHDI(2)
value
0.890 0.780
0.735 0.590
0.614 0,457
0.493 0.332
0.759 0.639
0.745 0.663
0.747 0.659
0.738 0.639
GII(3)
GDI(4)
0.197
0.315
0.513
0.587
0.975
0.946
0.875
0.834
0.360
0.340
0.317
0.884
0.952
0.938
Source: UNDP. (1) Europe and Central Asia. (2) Inequality-adjusted HDI. (3) Gender Inequality index. (4)
Gender development index.
Turkey is a high-human development country with its HDI value of 0.759 for 2013 and
it is ranked at 69 out of 187 countries. HDI values of Turkey and selected countries and
groups of countries for 2013 are given in the second column of Table 10.3. Turkey’s 2013 HDI
of 0.759 is above the average of 0.735 for countries in the high human development group
and above the average of 0.738 for countries in Europe and Central Asia. Ranks of Serbia and
Azerbaijan in the Europe and Central Asia Group are comparable to Turkey regarding both
their population and proximity to Turkey: 78 and 76, respectively.
The HDI is an average measure of basic human development achievements in a
country. Like all averages, the HDI masks inequality in the distribution of human
development across the population at the country level. The Inequality-Adjusted HDI (IHDI)
takes into account inequality in all three dimensions of the HDI by ‘discounting’ each
dimension’s average value according to its level of inequality. The IHDI is basically the HDI
discounted for inequalities.
The third column of Table 10.3 gives a measure of inequalities (IHDI). The higher the
inequality the higher is the difference between HDI and IHDI, and the lower is the IHDI.
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While the loss of Turkey because of the inequalities is lower than the average of the high HDI
countries, it is higher than Serbia and Azerbaijan, and the average of the Europe and Central
Asia. Turkey’s HDI for 2013 is 0.759. However, when the value is discounted for inequality,
the HDI falls to 0.639. Losses of Serbia and Azerbaijan due to inequality are less than Turkey,
and although their HDI are lower than Turkey their IHDI are higher than Turkey, 0.663 and
0.669 respectively. The average losses due to inequality for high HDI countries and for
Europe and Central Asia are also lower than Turkey.
The fourth column of the Table 10.3 gives the Gender Inequality Index (GII) values.
The GII reflects gender-based inequalities in three dimensions: reproductive health,
empowerment, and economic activity. Reproductive health is measured by maternal
mortality and adolescent birth rates; empowerment is measured by the share of
parliamentary seats held by women and attainment in secondary and higher education by
each gender; and economic activity is measured by the labor market participation rate for
women and men. The GII can be interpreted as the loss in human development due to
inequality between female and male achievements in the three GII dimensions. The higher
the index value, the higher is the difference between the human development levels of men
and women.
Turkey has a GII value of 0.360, ranking it 69 out of 149 countries in the 2013 index.
In comparison, Azerbaijan is ranked at 62 on this index. The GII value for Azerbaijan is 0.340.
The average GII values for high HDI and Europe and Central Asia Countries are 0.315 and
0.347 respectively.
The last column of Table 10.3 gives the Gender Development Index (GDI) values. The
GDI is based on the sex-disaggregated HDI, defined as a ratio of the female to the male HDI.
The GDI measures gender inequalities in achievement in three basic dimensions of human
development: health (measured by female and male life expectancy at birth), education
(measured by female and male expected years of schooling for children and mean years for
adults aged 25 years and older); and command over economic resources (measured by
female and male estimated GNI per capita).
The lower the GDI, the higher is the difference between the human development of
males and females. The GDI for Turkey is the lowest among countries and group averages
included in the table. The GDI is calculated for 148 countries. The 2013 female HDI value for
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Turkey is 0.704 in contrast with 0.796 for males, resulting in a GDI value of 0.884. In
comparison, the GDI values are 0.952, 0.938 and 0.946 for Azerbaijan, Europe and Central
Asia Countries and HDI, respectively.
10.3. FOREIGN ECONOMIC RELATIONS
The relative importance of foreign economic relations has increased since 1980s. The foreign
trade/GDP ratio, capital movements and foreign debts have enlarged remarkably, mainly as
a result of the liberalization of foreign trade and international capital movements.
a. Foreign Trade
Foreign trade is the movements of goods and services across countries. Turkish foreign trade
has been liberalized gradually since 1980. Quantitative restrictions were rapidly phased out,
and tariff rates were reduced. The output-weighted average nominal tariff rate for the
manufacturing industry declined from 76.9 percent in 1984 to 3.3 percent in 2005. The
customs union between the EU and Turkey which came into effect in 1996 played an
accelerating role in trade liberalization, in addition to global trade liberalization trend.
Both exports and imports have risen steadily in absolute terms and relative to GDP:
The ratio of the foreign trade volume (exports plus imports) to GDP has increased from
about 15% in 1980 to more than 45% in the last 35 years.
Without any exception, Turkey has had trade deficits in all of the years. Trade deficit
enlarged in time; in fact, there is interdependence between exports and imports. Import
dependence
in
the
Turkish
industry
has
increased
further
since
2001;
the
imports/production rates in manufacturing industries have gone up.
A vital consideration for Turkish exports is to enhance the country’s competitiveness
in international markets. Turkey could not manage to reach the high-tech production level.
About two-third of its exports consist of primary and low-tech products. While it was losing
ground in competition for traditional export items, such as textiles, it could not succeed to
develop its general technological ability to such a level that would be sufficient to
compensate the lost competitiveness in traditional exporting fields with the increasing
competitive power in medium and high-tech products.
103
b. Current Account
Current account includes trade in goods and services, factor incomes and transfers. Large
trade deficit resulting in current account deficits (CAD) with the rest of the world
accumulates over time and frequently ends up with a crisis. Hence, the CAD has been one of
the main problems of the Turkish economy.
Turkey’s foreign currency revenues are higher than its expenditures in services,
mainly as a result of the tourism revenues. While its annual tourism revenues were more
than 29.5 billion dollars in 2014, tourism expenditures were about $5 billion.
Net income balance is negative; incomes are short of expenditures. Since Turkey is a
debtor country, its net interest income and transfer of profits are negative.
Balance of current transfers is generally positive for Turkey. Transfers are entries that
correspond to the provision of real resources or financial assets, without a quid pro quo, by a
resident institutional unit to a nonresident institutional unit (and vice versa).
The CAD of Turkey is mainly the result of foreign trade deficits. These kinds of deficits
are more dangerous in terms of sustainability and more prone to balance of payment crises
since they indicate structural weaknesses in international trade and competitiveness. These
are permanent problems and cannot be solved easily since changing the production process
and technological level of firms require long term planning and investments in education,
infrastructure, research and development.
c. Saving Gap in Turkey
Behind the Turkey’s structural and pertinent CAD there is saving gap. Saving gap is the
difference between the rate of total domestic savings and gross fixed investment as a ratio
to the GDP. Table 10.4 shows how the saving gap has enlarged since 2000, mainly because of
falling private savings.
The saving gap in Turkey has been financed by foreign savings in the form of capital
entry. Studies have shown clearly, however, that, investment and growth which are based
on foreign savings but not domestic savings are not sustainable.
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TABLE 10.4: The Saving Gap in Turkey: Saving and Investment as a Ratio to GDP
Public
saving
Private
saving
Total
domestic
Savings
2000-2004
-4.1
21.4
17.4
18.5
-0.9
2005-2009
2.0
13.5
15.6
20.6
-5.0
2010
1,6
12,3
13,9
19,1
-5.2
2011
3.7
10.7
14.4
24.1
-9.7
2012
2.9
11.7
14.6
20.7
-6.1
2013
3.4
9.9
13.4
20.6
-7.2
2014(1)
3.2
11.7
14.9
20.5
-5.6
Gross fixed
Investment
Saving gap
SOURCE: Ministry of Development. (1) Realization estimate
d. The Way and the Quality of Financing the Deficits
Although sustaining CAD for countries can be feasible in the short run as long as finding
external borrowing, the ability of the country to service its debt by referring to further
borrowing is likely to be questioned once the deficit become persistent. Large and persistent
CAD tends to cause more serious problems for a country creating a sustainability problem.
How and at what conditions this deficit is financed is an important concern, because a fast
growing CAD can cause fragility. Composition of foreign resources has strong influence on
the ability of an economy to sustain its deficits.
Foreign resources that are used to finance the CAD may be collected in two groups:
equity investment and loans. Equity financing does not require payments to investors in the
short run. However, debt financing require payments at specific dates. Thus, the lower the
stream of payments that is required to international investors, the longer the country can
run CAD.
There are two kinds of equity investment; foreign direct investment (FDI) and
portfolio investment. FDI are more stable and have long term structure than portfolio
investment. Higher FDI can have positive impact on sustainability whereas excessive
dependence on portfolio investment increases the potential of a crisis. However, equity
investment in the form of both FDI and portfolio investment may increase the CAD through
transferring profits, in the long run.
105
Table 10.5 shows how the CAD changed in three sub periods since 1990 and how
they were financed. The average annual CAD rose from 2,128 million dollars in 1990-2000 to
18,757 million dollars in 2001-2008, and to 48,673 million dollars in 2009-2014.
While the financing quality improved from the first period (1990-2000) to the second
period (2001-2008), it deteriorated in the last period (2009-2014). The ratio of the net direct
investment to the CAD was 26.5% in the first period, increased to 48.3 in the second, and fell
to 17.7% in the last period. The ratio of the net portfolio investment to the CAD followed an
opposite trend; first fell from 37.7% in the first period to 14.7% in the second period and
increased again to 42.0% in the last period. That is, the share of the finance creating shortterm liabilities increased remarkably between 2009 and 2013; the finance quality of the CAD
deteriorated.
TABLE 10.5: Current Account Deficit and Its Financing
Million Dollars
1990-2000
2001-2008
2009-2014
Current Account Deficit(CAD)
-23,410
-150,056
-292,039
Annual average CAD
-2,128
-18,757
-48,673
Net direct investment (NDI)
6,204
72,403
51,954
Net portfolio investment(NPO)
8,837
22,051
122,661
Net other investments(NOI)
25,483
86,449
118,524
Financing Current Account Deficit (%)
NDI/CAD
26.5
48.3
17.7
NPI/CAD
37.7
14.7
42.0
NOI/CAD
108.9
57.6
40.5
Memo: Shares of equity securities and debt securities in gross portfolio investment %)
Equity securities
18.7
43.5
12.2
Debt securities
81.3
56.5
87.8
Source: Calculated from balance of payments data of the CBRT.
This fragility would increase further in the case of an international liquidity
contraction because capital inflows have been mostly the result of ample global liquidity.
Additionally, the increase in the speculative hot money augmented the CAD by appreciating
TL. The way of financing the CAD stimulates the demand for imported inputs at the expense
of domestic inputs making economic growth more dependent on the entry of foreign
resources.
106
Two developments after world economic crisis in 2008-2009 have raised doubts
about the sustainability of the CAD in Turkey; short term debt of the private sector has
sharply increased (see Table 10.6) and the share of FDI in financing the CAD was much lower
than the previous couple of years against the portfolio investments after the crisis.
TABLE 10.6: The Term Structure of Foreign Debt Stock (Billion USD, %)
Year
1989
2012
2014
Total Debt
Short Term
Public (%)
Short Term
Private (%)
Long Term
Public (%)
Long Term
Private (%)
2
4
4
11
26
29
83
29
25
4
41
42
43,879
337,679
402,441
Source: CBRT.
During the period of seven years (2008-2014) the sum of the total net foreign
resources used has been about $403 billion. Out of this, $92 billion was the net foreign direct
investment. That means approximately $289 billion of finance is either in the form of foreign
debt or portfolio investment creating short term liabilities.
Increasing CAD and its financing mostly by debt creating foreign resources have been
resulted in higher foreign debt stock. The total foreign debt stock of Turkey has increased
continuously with exceptions in the crises. Total debt stock increased more than 800 percent
from 1989 to 2014 (see Table 10.6).
107