Economics Today 15 1

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Regular Features

As an Economy nears Full Employment will Inflation have to Increase?Jonathan Mace 2

What is Opportunity Cost?Paul Hoang 10

Should Smokers be made to Pay Extra for Using the National Health Service?Tom Allen 14

Is the Indian Restaurant Market an Example of Monopolistic Competition?Nigel Watson 22

Prize Competition for AS Students Inside front cover

Economics of the InternetThe Market for BroadbandPeter Cramp 7

View from the CityIs the Global Economy Heading for a Fall?Neil MacKinnon 19

Multiple Choice Question and AnswerRobert Nutter 20

Current Topics in EconomicsWhat are the Implications of American Ownership of Premiership Football Clubs?Stephen Romer 26

Data Question and AnswerRising Tortilla Prices in MexicoTony Emery 30

Back to BasicsWhat are the Effects on the Market of Taxes and Subsidies?Rachel Cole 32

Making Sense of Economic DataAgeing Population in the United KingdomAndrew Reeve 36

Stop PressNigel Tree 40

Prize Competition for A2 Students Inside back cover

The Economy TodayNigel Tree 8 page supplement

Jonathan Mace of MalvernCollege considers some keyaspects of macroeconomics.

As an Economy nearsFull Employmentwill Inflationhave toIncrease?

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efore Gordon Brown made theshort journey from No. 11

Downing Street as Chancellor ofthe Exchequer to No. 10 as PrimeMinister, he had spent 10 years presidingover a very NICE (A non-inflationaryconsistent expansion) economy.1

Inflation in the UK has remained low andstable, growth of the national incomehas continued at a sustainable pace andat the same time unemployment hascontinued to fall. The UK economyseems to have punched traditionaleconomic theory in the teeth andemerged laughing. What does traditionaleconomic theory suggest will happen toprices as the economy nears fullemployment? How and why has the UKeconomy achieved stable prices andfalling unemployment?

What is full employment?Like many areas of the subject there isno one agreed definition of fullemployment. For the purposes of thisarticle we will assume that everyone whowants to work at the given wage rate inan economy is working. (The labourmarket is in equilibrium – labour supply= labour demand.) Therefore the onlytype of unemployment that exists at thispoint is voluntary unemployment. This isknown as the natural rate of unemploy -ment. Economic theory would suggestthat as the economy gets closer to fullemployment inflation will rise. There isan economic trade off. But will thisalways be the case? Evidence examinedlater in the article will show that inflationis not an inevitable consequence of theeconomy approaching full employmentbut a starting point must be a theoreticalunderstanding of why this trade off canoccur.

Phillips CurveIn 1958 a New Zealand born economistfrom the London School of Economics,A.W. Phillips published a significantpiece of work examining the relationshipbetween the rate of change of moneywages in an economy and the level ofunemployment. He used UK data from1861 to 1913. The original Phillips curvecan be illustrated using Figure 1.

Since the original publication of hisfindings the curve proposed in Figure 1has been adapted into many forms butthe one most commonly used byeconomists is shown by Figure 2. Wageinflation in an economy has been

replaced by the economy’s inflation rate– i.e. the increase in prices. This is dueto the fact that since wages make up alarge proportion of firms’ costs, changesin wages feed directly through tochanges in the price level.

A ‘trade off’ exists between inflationand unemployment. If as in Figure 2 thegovernment decides it wants to reduceunemployment from 6% to 4% it willincur a rise in inflation from 3% to 5%.

If a government wished to reduce thelevel of unemployment in the economythey should, according to Phillips,expect a trade off in terms of higherlevels of inflation. This relationshipbegan to break down in the 1970s, theUK began to experience ‘stagflation’ –rising inflation and unemployment. Wewill return to this later in the article. Forthe purposes of building your analysisyou should also consider this argumentin terms of AD/AS analysis.

Aggregate Demand and SupplyBased on Figure 3, if the economy isoriginally in equilibrium P1Y1 and it feelsthat the current level of unemploymentis too high (the output gap is too large(YFE – Y1) (spare capacity exists in theeconomy) they may engage in countercyclical demand management. Demandmanagement means trying to adjust thelevel of Aggregate Demand (AD) nearerto full employment, in order to reflate theeconomy. These policies are known asexpansionary or reflationary economicpolicies. These can take the form offiscal or monetary policies.

As the output gap falls (YFE – Y2) (andhence unemployment falls) there isincreased pressure on prices (P2). Theeconomy begins to experience demand-pull inflation. So in this case as theeconomy nears full employment inflationwill rise.

B Rate ofChange

of Wages

0Unemployment Rate

Phillips Curve

Figure 1: The original Phillips Curve

InflationRate (%)

0Unemployment Rate (%)

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PC

Figure 2: The amended Phillips Curve

1. http://www.bankofengland.co.uk/publications/speeches/2003/speech204.pdf

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Aside from the AD/AS analysis ofinflation other reasons why as unem -ploy ment falls inflation will rise couldinclude:� An increased number of workers in

work increases the bargaining powerof workers and hence they push forhigher wages. Higher wages = higherunit costs which could potentially leadto higher prices.

� As unemployment falls in an economythere is a risk that the economy willsuffer skills shortages. This in turn candrive wages and earnings higher,leading to increased unit costs.

� A booming economy (as in the caseof China) might cause a rise indemand for commodities. This canlead to further cost push inflation.

� If actual unemployment falls belowthe NAIRU (non-accelerating rate ofunemployment) inflation may rise.

What is NAIRU and how does it explainthe trade off between inflation andunemployment?

NAIRU and the Long RunPhillips CurveAs stated earlier in the article theexistence of the trade off betweeninflation and unemployment was sup -ported by data up until the 1970s. Butthe model began to break down andmonetarist economists under theleadership of Milton Friedman adaptedthe model to create the ExpectationsAugmented Phillips Curve and theconcept of NAIRU. Figure 4 can be usedto explain the Expectations AugmentedPhillips Curve.

Assume that the economy is in long-run equilibrium at point A on the SRPC1

(Short Run Phillips Curve). We canassume that at this point the economy isat full employment and therefore inFigure 4 a natural rate of unemploymentof 7% exists, economic agents in theeconomy expect inflation of 3%, andtherefore will negotiate pay increases tothis level.

The government decides that this levelof unemployment is too high anddecides to target aggregate demand. ADincreases and this in turn causes anincreased demand for labour. Thisthough increases inflation to 7%. In theshort run, workers are attracted back towork because they believe higher wageswill be on offer and the economy movesfrom A to B. Workers though havesuffered money illusion, nominal wages

PriceLevel

0Real GDP

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Y2

Figure 3: Aggregate demand moving closer to full employment

P Rate(%)

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LRPC

SRPC1

SRPC33

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Figure 4: The Expectations Augmented Phillips Curve

A booming economy such as China’s may cause arise in demand for commodities leading to inflation.

S E P T E M B E R 2 0 0 7 5

have risen but real wages have not done so. These workers now leave theirjobs and unemployment goes back tothe natural rate, but now with inflation at7%.

The economy does not return to pointA. People will expect prices to continueto rise at 7% and will negotiate wageincreases to this level. The economy willbe at point C, on a new SRPC2. Thisprocess will continue and any attempt touse demand management again will onlyresult in higher inflation (C to D to E), ona new SRPC3. Based on this analysismonetarist economists say that the longrun Phillips Curve (LRPC) is vertical atthe natural rate of unemployment (NRU).If the economy has settled at this naturalrate (NRU), as long as governments donot use expansionary policies, inflationwill not increase. The natural rate ofunemploy ment is the unemploymentthat occurs when the economy is at fullemployment and the labour market is inequilibrium.

Whether inflation will always increasedepends upon the level of NRU with anygiven economy.

The OECD recently published someresearch that tried to calculate changes

in the NRU in a variety of economies. Aselection of these rates is summarisedin Table 1. Long run unemployment orthe natural rate can be reduced but thisrequires supply side rather than demandside policies. Economies that have ahighly flexible labour force, with strongoccupational and geographical mobilityare likely to have a very low NRU. This would have come about through

strong investment in the supply side.Supply side policies therefore aim to

shift the LRPC to the left as in Figure 5.This reduces the level of natural unem -ployment, e.g. Australia in Table 1.

The conclusion that can be drawn hereis that all economies may experience atrade off but they will experience it atdifferent rates depending upon the levelof NRU that exists in the economy.

InflationRate (%)

0Unemployment Rate (%)

LRPC2 LRPC1

Figure 5: Reducing NRU

Technological change and globalisation may keepinflation down as a country reaches full employment.

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Other reasons why it is notinevitable inflation willaccelerate� There may be rising productivity in the

economy which would offset theimpact of rising wages and henceleave unit labour costs unchanged.

� Effective monetary policy can helpkeep inflation down as unemploy mentfalls. This being the case in the UKwhere since 1997 Gordon Brown (now Alistair Darling) and the Bank of England have been engaging in‘Third Way’ economics. Through thesuccess of monetary policy house -holds and firms’ price expectationshave fallen. This feeds throughdirectly to wage demands. Likewisefirms are more willing to investbecause they do not expect suddenchanges to interest rates andhouseholds are more willing toconsume. The UK has thereforeexperienced the phenomenon of low-inflationary growth.

� Other external factors may also workin an economy to keep inflation downas an economy approaches fullemploy ment e.g. technologicalchange and the impact ofglobalisation (forcing economies tobe as price competitive as possible).

ConclusionIn summary as an economy nears fullemployment traditional economic theorysuggests inflation will increase. Thereality of strongly performing economiessuch as the UK shows this proposition isnot at present the case. The UKeconomy under a new Prime Minister isan interesting one to observe as to howlong the strong performance in bothinflation and unemployment cancontinue.

1. What are some alternative economicdefinitions of Full Employment?

2. How can the concept of stagflationbe explained?

3. Why have aspects such as trans -parency, accountability and credibilityplayed such an important role inmonetary policy in the UK since 1997.

4. What do you think has happened toNRU in the UK since 1999? Whateconomic policies do you think havecaused this?

Questions for discussion

1. The Bank of England MonetaryPolicy Committee (MPC) believesthat average earnings growth inthe UK should not rise above4.5% otherwise it will threaten theinflation target of 2% using theconsumer price index (CPI).

The graph shows the % averageearnings growth in the UK inrecent years both including and excluding bonuses. Investigate the reasonsmnwhy the MPC believes that earnings growth should be kept below 4.5%.

http://news.bbc.co.uk www.bankofengland.co.uk

2. Although in recent years both UK unemployment and inflation have been low(contradicting the Phillips Curve), many economists believe that the officialLabour Force Survey figures underestimate the numbers unemployed. It hasbeen argued that many of the people ‘economically inactive’ (those ofworking age who are either not working nor actively seeking work) are inreality unemployed.

(a) Who are the economically inactive?

(b) Why do they not compete in the labour market?

www.statistics.gov.uk

www.telegraph.co.uk (How 8m people dropped out of the labour market14/06/07)

www.cesi.org.uk (Who are the economically inactive?)

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Summary of key points� Full employment is when the labour market is in equilibrium and

everyone who wants to work is working. Only a level of voluntaryemployment exists.

� Traditional economic theory, as demonstrated by the Phillips Curve,would suggest that as unemployment fell in an economy inflation willrise.

� The breakdown of this model, in the 1970s, led to its adaptation by themonetarists and the creation of the Expectations Augmented PhillipsCurve and the concept of the Natural Rate of Unemployment (NRU).

� Inflation is not always the inevitable outcome of falling unemployment.Governments can take steps to reduce its likelihood, e.g. reducing NRUand price expectations within an economy.

with Chief Examiner,Robert Nutter

Table 1: OECD Estimates of Natural Rate

Country NRU 1995 NRU 1999

UK 6.9% 7.0%US 5.3% 5.3%Japan 2.9% 4.0%Australia 7.1% 6.8%

Source: OECD – http://www.oecd.org/dataoecd/27/46/18464874.pdf

S E P T E M B E R 2 0 0 7 7

ccess to the internet haschanged beyond recognition in

recent years. Most users stillconnect to the internet using theirtelephone line, but rather than doing sothrough a relatively slow ‘dial-up’modem which causes the line to beengaged when the internet is being used(unless there is a dedicated secondphoneline), they increasingly do sothrough a broadband connection.Broadband ‘splits’ the telephone line sothat both voice and data can betransmitted along one line and enablesdata to be transmitted at rapid speed.This makes it possible to download hugefiles in seconds, a great advantage tothose who wish to access music andvideo from the internet. Broadbandconnections have the additionaladvantage that they are ‘always on’. Ifthe computer is turned on, the user isconnected to the internet.

The UK market for broadband isgrowing rapidly, and Figure 1 shows bigincreases in all parts of the UK in the

take-up of broadband in 2006. In the firstquarter of 2007, the market grew by astaggering 6.4%. This implies an annualgrowth rate of 25% plus. In Ireland firstquarter growth was 15%! At the end ofMarch 2007, there were 14 millionbroadband subscribers in the UK.

Market structureThe ‘big two’ broadband providers in theUK are BT and Virgin Media. In the firstquarter of 2007, BT gained 440,000customers to regain its position asmarket leader. This gave it 3.7 millionbroadband subscribers and a marketshare of 26%. Virgin Media had3.4 million subscribers at this time. Thecombined market share of the two firms(the two-firm concentration ratio) stoodat around 50%.

There are a number of other firms withsignificant market shares (Figure 2shows the UK’s top ten broadbandproviders in June 2007) and a largenumber of smaller players. In total thereare at least 70 internet service providers

In this new regular feature Peter Cramp of NottinghamHigh School reviews the nature of competition betweeninternet service providers.

TheMarket forBroadband

A

8

(ISPs) competing in the broadbandmarket.

So the market for broadband isconcentrated but with a large number ofsmaller firms on the fringes. Inconcentrated markets, firms are inter -dependent. The best strategy for anyone firm to follow is not uniquely defined,but instead depends partly on theactions and reactions of its rivals,especially those of the biggest playersin the market.

Price competitionA relevant distinction can be drawnbetween collusive and competitiveoligopoly. Under conditions of collusiveoligopoly, the uncertainty generated byinterdependence and the wish to avoidthe damaging effects of price wars leadfirms to cooperate in price setting. Theoutcome of the market tends towardsthat of a monopoly. In contrast, thebroadband market is best characterisedas a competitive oligopoly, with firmsseeking to win market share from theirrivals by offering lower prices tocustomers. Adverts such as that shownin Figure 3 are common.

Relatively intense price competition is

a feature that the broadband marketshares with those of a number of otherhousehold utility markets such as thosefor gas, electricity and telecoms. Pricecompetition is the likely outcome ofinterdependence when there are a largenumber of players in the market (makingcollusive activity difficult to organise),where the chief factor influencing thecustomer’s choice of supplier is the priceof the product and where the customeris willing to switch suppliers in search ofa lower price. These conditions allprevail in the market for broadband. Inparticular, the following points underpinprice competition in the market:� Homogeneity. The service of one

broadband provider is generally avery good substitute for another,resulting in a high cross-priceelasticity of demand between theservices of different ISPs. This isdespite attempts by providers todifferentiate their services from each

other (see the following section onnon-price competition),

� Fast and trouble-free switching. FromFebruary 2007, OFCOM have insistedthat ISPs must provide any customerwishing to switch providers with aMigrations Authority Code (MAC). Thecustomer then simply quotes theMAC to his new provider. The maindifference the customer notices arethat his bills for internet services nowcome from a different company.Beyond quoting the MAC, the onlything the customer has to do to startusing broadband with his newprovider is to turn on his computer!There is no break in service leavingthe customer temporarily without aninternet connection.

� Improved customer information. Thebewildering array of pricing structuresfrom different ISPs might be expectedto deter customers from switching.However, price comparisons aremade easy by dedicated websitessuch as Uswitch which find thecheapest deals for customers.

Price competition may intensify furtheronce the market is saturated. At currentrapid growth rates, it will not be longbefore there are few homes left who wish to have a broadband connectioninstalled. The only way that a broadbandprovider can then grow is by takingmarket share from its rivals.

This analysis presents a picture of amarket which in general functionsefficiently and in the interests of theconsumer, but it remains true that somecustomers remain with their currentbroadband provider for no other reasonthan inertia. Uswitch estimates thatusers could make a collective saving of£13 million a year by switching tocheaper providers who would offer

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Figure 1: The increased market for broadband in 2006

Source: ofcom, The Communications Market 2007: Nations & Regions

Figure 2: Top ten UK broadbandproviders in June 2007

1. BT 6. Tiscali2. Virgin Media 7. Eclipse3. PlusNet 8. Orange4. TalkTalk 9. Be5. AOL 10. Sky

Source: www.top10-broadband.co.uk

Figure 3: TalkTalk engages in price competition

Join our broadbandrevolution and saveover £230.

S E P T E M B E R 2 0 0 7

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comparable or improved service in termsof factors such as connection speeds.

It is also true that some customerssuffer as a result of opting for whatappears to be the cheapest deals. It iscommon for the lowest prices to beaccompanied by restrictions on usage,such as the amount of data that can bedownloaded each month. Heavy users,such as those who download completemovies, may find themselves incurringhefty charges for any usage beyond thelimit. Restrictions on usage are oftenonly specified in the ‘small print’ of acompany’s promotional materials. Lackof customer information then becomes alikely source of market failure in theprovision of broadband services.

Non-price competitionIt is an important part of the strategy ofthe bigger players in the broadbandmarket to create customer loyalty. Thisreduces, but does not remove, the needto respond to price cuts from other ISPsand serves to lower price and cross-price elasticity of demand for the firm’sservices. Examples of such non-pricecompetition include:� Unlimited usage on services at the top

of the price range, with no restrictionson downloading of data, even at peaktimes.

� High specification equipment, suchas BT’s ‘home hub’ which wirelesslyconnects up to 10 devices around thehome.

� Connection speeds. Virgin Mediaclaim that “our top broadband con -nection speed is four times faster thenBT’s”.

� Technical support for customers. Forexample, BT boasts “a 24/7 helplineand free on-line technical support toall our customers”.

� ‘Bundling of services’. This refers tooffering customers packages ofservices covering two or more frombroadband, fixed line telephone,mobile telephone and digital television.In 2007, Virgin Media became the firstprovider to offer ‘Quadplay’, the nick -name for packages covering all fourservices. There are obvious advan -tages of convenience to the customerin taking multiple services from thesame firm and bundling is a key reasonfor the position of BT and Virgin as thetwo largest firms in the broadbandmarket. Bundling also offers theconsumer value for money as the priceof the bundle is lower than that ofpurchasing each service separately.

ConclusionThis brief review of the broadbandmarket shows that:� The market for broadband is growing

rapidly.� This market is a competitive oligopoly.� Firms compete mainly on price

because of the high degree ofsubstitutability of their services.

� This results in a market that generallyfunctions well, with consumerinterests also well served by non-price competition.

� Despite this, the market may stillsometimes fail. A lack of customerinformation, for example about usagerestrictions, is one potential source ofmarket failure.

Figure 4: A top of the range ‘bundle’

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Can the bigger broadband players create customer loyalty?

Paul Hoang of Sha Tin College, Hong Kong, discussesa number of illustrations of the first concept introducedto a new student of economics.

What isOpportunity Cost?

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hese quotes refer to theeconomic costs of raising

children in today’s society. Butbefore we consider this example ofopportunity cost we need to define thisconcept. Opportunity cost is defined asthe best alternative that is foregonewhen making a decision. Due tounlimited resources, such as time andmoney, we are confronted with choices.The study of economics assumes thatpeople are rational decision makers, i.e.they choose the option that gives themthe most benefit. Opportunity costdiffers from ‘accounting costs’ in thataccounting costs do not look at the cost(or value) of foregone choices. Forexample, if a student decided to go intohigher education, the accounting costwould include the tuition fees and othercosts associated with studying atuniversity. However, opportunity costalso considers the foregone income thatcould have been earned had the personchosen to work (the best alternativechoice) instead of studying. Of course,the student would hope that by studyingfor a degree that he or she would earn ahigher salary in the future to offset boththe accounting and opportunity costsassociated with studying. Hence, theconcept of opportunity cost is usefulwhen assessing the true costs andbenefits of competing choices.

We now look at various applications ofopportunity cost.

The economics of children…Children represent an economic cost.This not only refers to the cost of havingand raising children but also theopportunity cost of having children, i.e.what else parents could have done withthe money had they chosen the next bestalternative. Instead, parents havechosen to spend their time and moneyon children. Such decisions benefitbusinesses that are involved in toys,clothing, computer games andaccessories, stationery, education andsports. There is a huge market to beexploited and companies such asToys R Us and Mattel have becomemajor global businesses as a result.

The opportunity costs of children have

become more apparent as can beobserved through demographicchanges. One demographic change thatcan be observed in most developedcountries is the decline in birth rates.This is largely due to the growing numberof women who are choosing to havechildren at a later age due to their careeraspirations. However, the other majorreason is to do with the opportunity costof having and raising children. Some ofthe expenses that parents might need tofund include a combination of the itemsin Box 1.

The concept of opportunity costapplies to high income earners as well

as those with low incomes. In fact, thosewith high incomes may have fewerchildren because of the high opportunitycost of a working parent spending timeon a young child’s upbringing. There is alarger opportunity cost to the person(such as famous sports women andfemale celebrities) as they could haveearned a lot of money in their profession.

The opportunity cost of timeThe phrase ‘Time is money’ is ofabsolute relevance in the businessworld. For example, there can be a hugeopportunity cost of being late for a jobinterview, delays caused by traffic

T❝The idea that buying a house is the biggest investment mostpeople are likely to make does not take into account theinvestment Australian parents make in raising their children. ❝

All you need is love …andaround AUS$450,000 (that’sover £191,000!)

Source: AMP (www.amp.com.au), an Australian financial institution

Box 1: The economic costs of having children

� Hospital fees – a private maternal ward at the Matilda Hospital in HongKong costs HK$56,000 for three days (that’s over £1,300 per day!). InPortland Hospital, London, the cost is between £7,000 and £10,000depending on the level of service required.

� Groceries – from baby nappies and milk powder to lunchboxes for school.

� Hobbies – many sporting and leisure activities can prove very expensivefor participants (and their parents).

� Private tuition – such as private music lessons or academic tuition forexams.

� Compulsory Education: kindergarten, primary and secondary. Costs might include: uniforms, stationery and textbooks. According toMoneyCentral.com, the cost of education accounts for 7-11% of theaverage American household income. Private sector education, inboarding schools say, will obviously inflate the costs for parents. Britishmedia sources reported that private schooling costs an average of£71,050 for a day student (who returns home at the end of the school day)and an extra £130,450 for a boarding student (who stays on campus).

� Tertiary education: University fees and maintenance costs, such as rent.In November 2006, The Independent reported that “steep rises inuniversity fees have pushed the average cost of bringing up a child tomore than £180,000.” University tuition fees were also reported to haveincreased three times more than the rate of inflation.

� Deposit for a car/home.

� Gap year expenses.

� Holidays – additional cost of flights, accommodation and entertainment.Most airlines will charge for children aged 2 and above for a ‘seat ticket’.

� Health services – a visit to a private doctor costs HK$350 (approx. £25) fora general consultation that might last no more than 2-3 minutes.

� Wedding – the average cost of a wedding is AU$36,234 (£15,400) inAustralia (Source: Bride to be magazine, Cost of Love Survey 2004) andUS$19,000 (£9,600), excluding the honeymoon, in the USA (Source: Bridesmagazine).

12 S E P T E M B E R 2 0 0 7

congestion or missing paymentdeadlines to a bank. Businesses realisethat customers do not like to wait.Minimising waiting time is not alwaysfeasible, such as queues at a doctor’sclinic. Nevertheless, there are plenty ofexamples of how businesses put theconcept of opportunity cost intopractice.� Mirrors have long been used in places

with lifts (elevators), such as in hotelsand department stores. Customersdo not necessarily notice the waitingtime – and hence refrain from beingannoyed at the business – as theystare at themselves in the mirror! Thesame reasoning applies whencustomers enter the lift – there aremirrors inside too.

� Music and entertainment is a majorfeature at many theme parks. TheDisneyland Company tries to reducetime-conscious customers byproviding music, live entertainmentand use of large movie screens todistract customers whilst they wait inline for thrill rides and otherattractions. This all helps to provide abetter overall experience for theircustomers.

� Whilst waiting at the checkouts at any

supermarket, you may notice the‘bins’ next to the counter. These are alast minute attempt by the super -markets to lure customers to buymiscellaneous items (hence the term‘bins’) such as confectionery andbatteries. The other purpose is, again,to distract people waiting in thequeue.

� In many countries, the multinationalPizza Hut offers their customers freepizza if their order is not deliveredwithin 30 minutes. This practice maygive Pizza Hut a competitiveadvantage over its rivals, initially, butrivals simply copy the idea.Nevertheless, the principle ofopportunity cost is again at the centreof this business decision.

� Airline companies often overbook thenumber of seats of a flight. This isbecause, statistically, flights are rarelybooked at full capacity. However, as aresult of the policy, sometimes airlinesface the problem of overbooking andwill need to ‘bump’ customers, i.e. tooffer them compensation for havingto wait for the next available flight. Tothe person who values time lessconscientiously, they may purchase astand-by ticket which is cheaper butmore inconvenient.

� Public transport has also beentargeted by the business world.Television advertising is now quitecommon on buses and trains. Thisnot only helps the transport com -panies, such as Virgin Trains, toreceive advertising revenue, but mayalso distract travellers from ‘countingthe minutes’ on a journey, therebymaking the experience a little moreenjoyable.

� Women’s clothes retailing is amassive business. However, womenare often accompanied by theirhusbands and boyfriends who tend tohave less patience in a shopping mall– look out for this trend next time youare out shopping! Marketers havenoticed this fact and have responded.Many retail outlets now providenewspapers and male-orientatedpublications (such as motor vehicleor male fashion magazines) so thatthe girlfriend or wife can shop inpeace! The retail outlets, of course,hope that this strategy will then allowthe customers to spend much longerin their shops, thereby increasing thechance of more sales.

� Banks make their money mainly bylending the deposits from theirsavers. Hence, they will reward thesavers that can ‘lend’ the bank moneyfor a longer period of time. Savingsaccounts that are instant access(savers can take their money outwithout any notice) attract a lowerinterest than deposits made in a long-term savings account. At the time ofwriting, a HK$1,000,000 deposit(approx. £70,000) at HSBC in HongKong will give a return of 2.75%whereas the same deposit for twoyears gives the saver 3.55% perannum. So, time really is money in thebusiness world. Similarly, Table 1shows the various rates of interest forsavings with Halifax plc (one of theUK’s largest mortgage providers). Ascan be seen, the longer someone

Table 1: Interest rates for HalifaxStepped Income Reserve savings

accounts, from 1st June 2007

Year 1 4.95%Year 2 5.20%Year 3 5.45%Year 4 5.70%Year 5 8.00%Source: http://www.halifax.co.uk/savings/personalrates

Those who buy stand-by tickets are valuing cost savings more than convenience.

S E P T E M B E R 2 0 0 7 13

saves their money, the greater thereturn on their money.

� 7-Eleven stores, the Japanese-ownedmultinational company, chargeshigher prices than supermarkets forthe same products. The surcharge is‘justified’ as most of their stores areopen 24-7 and so customers areexpected to pay for this convenienceand the opportunity cost of having topay higher wages to staff who workunsociable hours. Customers are alsolikely to be willing to pay more for theirown convenience of being able topurchase items from 7-Eleven whenother retail outlets are closed.

� Opportunity cost also extends to thehealth care industry. There are hugewaiting lists in the National HealthService, which is funded by taxpayersand provided by the public sector.However, if a patient chooses to ‘goprivate’ then he or she may even beseen right away by a doctor. This, ofcourse, comes at a price but again theexample shows that the concept ofopportunity cost is at play.

� London congestion charging cameinto effect in February 2003. Thismeant that drivers entering thecontrolled zone at peak times inLondon were charged £5 per day.Within a few months, traffic had fallenby around 20%. The charge (or tax)has since been raised to £8 per day.Motorists, as a result, have to askthemselves whether the congestioncharge is a price worth paying. Theopportunity cost may be that the £8could have been better spent onsomething else, such as a meal – inwhich case the rational motoristwould choose not to drive into CentralLondon. However, if the opportunitycost was delivering valuable stocksto an important client, then the £8charge may be minuscule.

� Supermarkets in the UK realised theopportunity cost of being ‘closed’ onSundays. It was not until the mid-1990s that supermarkets wentagainst government advice andbegan to trade on Sundays. Theywere fined for such actions, aslicensing to trade on Sundays had notbeen enacted, but the fine was soinsignificant compared to therevenues that they were earning byopening on Sundays that thesupermarkets continued with thispractice. Banks in Hong Kong arecurrently contemplating opening onSundays.

� Even governments are waking up tothe opportunity cost of neglecting theenvironment. In February 2006, TheDaily Telegraph discussed whetherparents who use reusable nappies fortheir babies should receive cashbenefits. This could give parents anincentive to switch away fromdisposable nappies which are notbiodegradable. The Republic ofIreland has used a ‘plastic carrier bag’tax since 2002. The opportunity costof not bringing your own bag (i.e. notrecycling carrier bags) is the tax paidon each bag issued by a retailer. TheBBC reported that this act has led tomillions of euros in tax revenues anda 95% fall in the use of plastic carrierbags.

1. What is meant by the concept ofopportunity cost?

2. Why do children present an oppor -tunity cost to their parents?

3. If opportunity cost cannot beaccurately measured, does thismean it has limited use?

4. Why do banks tend to offer higherrates of interest for customers whocannot have instant access to theirsavings?

5. To what extent does an understand -ing and awareness of opportunitycost help to reduce environmentaldamage?


Summary of key points� Opportunity cost is the cost measured in terms of the next best option

that is foregone when making a decision.

� Opportunity cost is at the heart of decision making, whether there is aconscious or subconscious awareness of the concept.

� Due to scarce resources, including time and finance, competingdecisions need to be made and any decision that involves a choicebetween options will incur an opportunity cost.

� Children are big business in today’s modern society. Parents are morethan willing to make sacrifices for their children. These sacrificesrepresent the opportunity cost of choosing to have children; the moneythat could have been spent on the best alternative if parents did nothave children.

� Knowledge of opportunity cost, even if it cannot be calculated precisely,allows decision makers to gain better insight into the real costs of theirchoices and not just their monetary costs.

1. Investigate the importance ofindifference curves and budgetlines in consumer preferencetheory, and relate them toopportunity cost.

2. The Office of Health Economicshas a schools website entitled:The Economics of Health Care(www.oheschools.org). Using thesite research the importance ofopportunity cost in health careand how quality adjusted life years (QALYs) can be used by healthprofessionals to make decisions on treatment.


Am

usem

ent

Par

k Ti

me

(hou

rs)

U

I

Beach Time (hours)

Tom Allen, of Eton College,discusses market failure,government intervention andgovernment failure, all of whichform an integral part of any A/SMicroeconomics course.

Should Smokers be made toPay Extra forUsing the NationalHealth Service?

AQA ✓ 1(10.5)

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WEJC ✓ 1(C)

CCEA ✓ 1

Int. Bacc. Standard 2.4


S E P T E M B E R 2 0 0 7 15

Economic efficiencyany economists argue that

their role is to ensure themaximisation of economic

efficiency within their particular sphereof influence. All economies are blessedwith a factor endowment comprisingland, labour, capital and enterprise, andthe role of the economist is to ensurethat these resources are used asefficiently as possible. The 2 main formsof efficiency studied at A/S Level areproductive efficiency, which will occurwhen firms produce using a minimumamount of factor inputs per unit ofoutput, and allocative efficiency, whicharises when the output that is producedis that which is desired by citizens.

Market failureA free market or market economy (onewhere government intervention isrestricted to the maintenance of law,order and property rights) may result invarious economic inefficiencies. Theexamples that are typically studied are:� Underconsumption (and hence under -

provision) of merit goods� Overconsumption (and hence over -

provision) of de-merit goods� Excessive externalities in production� Non-provision of public goods� Abuse of monopoly power� Imperfect information for economic

agents� Inequitable (unfair) distribution of

income and wealth.

All of the above may result in aninefficient allocation of resources. Thisquestion concerns health care (a meritgood) and smoking (cigarettes are a de-merit good) and possible ways in which

government can minimise the respectivemarket failures.

Healthcare as a merit goodA merit good can be defined as a goodthat:

(i) is desirable for the welfare of citizens;

(ii) confers a positive externality (or‘marginal external benefit’) ontoothers;

(iii) is underprovided in the free market.

Healthcare meets all three of theserequirements. Suppose you fell ill andwere unable to work. By consuming thehealthcare, i.e. by going to your medicalpractitioner, firstly you clearly hope togain a benefit known as your ‘marginalprivate benefit’, and secondly, thirdparties may also gain an external benefit,such as your hastened presence back at work (or a reduced risk of infection ifyour illness was contagious). The thirdpoint is a little trickier and is shown byFigure 1.

The demand curve for healthcare in afree market reflects the benefit that theconsumer believes s/he will gain fromconsumption; i.e. the marginal privatebenefit, MPB. It is downward slopingsince more will be consumed at a lowerprice. Supply of healthcare by medicalpractitioners is upward sloping, showingthat more will be provided at higherprices. The free market (FM) equilibriumis therefore at point A, showing that QFM

healthcare is consumed in a free marketat a price of PFM. However, this freemarket equilibrium fails to take intoaccount the positive externality (alsoknown as marginal external benefit,MXB) received by third parties resultingfrom the bought healthcare. An

economist would describe the freemarket equilibrium of point A as a marketfailure. A far better equilibrium known asthe social optimum (SO) would be onethat takes into account not only theprivate benefits of an economic action,but also any external benefits. These twobenefits added together are depicted bythe higher demand curve D = MSB,where MSB = marginal social benefit =marginal private benefit + marginalexternal benefit. Thus QSO healthcareshould be provided and a higher price of PSO would better reflect the total value to society of consuming thathealthcare.

The free market underprovision ofhealthcare by (QSO-QFM) represents amisallocation of resources, since too fewresources are being devoted to the goodin the free market. In addition,consumers might well suffer fromimperfect information and under -estimate their MPB from seekingmedical advice (how often do we seepeople fail to consult their GP when theyhave potentially dangerous conditions?).If consumers underestimate their MPBthen this will be reflected in reduceddemand, which will be even further leftthan the D = MPB curve depicted inFigure 1, thus heightening the marketfailure. A final, but no less important,point is that in the free market eachperson is compelled to pay PFM forhealthcare. This may prevent poorincome groups from consuming theproduct, which is both inequitable anddisadvantageous to the rich, whose owninterests would be better served if thepoor were treated.

Government interventionGovernments around the world areaware of these market failures and somost have intervened to a greater orlesser extent in the markets forhealthcare. In the UK the National HealthService, NHS (founded in 1948), is apublic service that is governmentprovided, funded largely by taxation,that seeks to deliver the majority ofhealthcare free at the point of use.Charges do exist for prescriptions, eyeand dental check-ups, although low-income groups can receive these free as‘benefits-in-kind’ (indeed, over 80% ofprescriptions are exempt from usercharge). Our demand and supplyanalysis can again be of use whenattempting to evaluate the outcome ofthis approach.

Figure 2 is a modified version of

M

P/£

0Quantity

PSO

PFM

QSOQFM

BMXB

S

D = MSB

D = MPB

A

Figure 1: Healthcare – merit good

Figure 1. It shows government supply ofhealthcare as being fixed at QSO, whichcorresponds to the social optimum asportrayed in Figure 1. This expensiveprovision of healthcare (projected£104bn for the tax year 2007-8,representing 8% of UK GDP) is anattempt to resolve the underprovisionand inequity that one would see in a freemarket. Unfortunately, it would appearas though governments can neversupply enough healthcare, especially

when it is free (P = 0). A growing andageing population, improvements indrug treatment for a variety of previouslyuntreatable conditions, the decline of theextended family and heavily raisedexpectations of healthiness by even theoldest of citizens result in an insatiabledemand for healthcare. Demandinvariably exceeds supply, as shown bythe excess demand of (Q1-QSO) in Figure2. There is no financial incentive forpatients to ration their own demand.

Government failure?The government now has a differentproblem on its hands. How is it to rationthis scarce (QSO) amount of healthcarebetween the various consumers? Avariety of solutions exists, all of whichmay result in government failure, to agreater or lesser degree.� First come, first served. This method

appeals to the traditional sense of fairplay: you are placed on a waiting listand await your turn. But aneconomist would regard this aseconomically inefficient as it takes noaccount of the patient’s age, earningcapacity (should a high earner betreated early so that s/he can returnto work to continue contributing tothe nation’s wealth?), or propensityto require further treatment, forexample by continuing to smoke. TheUK government’s ‘Hospital WaitingList Statistics’ show that approxi -mately 24% of patients have beenwaiting 3 months or more foradmission for hospital treatment.

� ‘Postcode lottery’. England is coveredby 152 Primary Care Trusts (PCT),each of which is allocated money fromthe central Department of Health.They control around 80% of the total

P/£

P = 0QuantityQSO Q1

D

S

(Q1-QSO) =excess demand

when P = 0

Figure 2: Healthcare – merit good

The need to ration healthcare may result in government failure.

S E P T E M B E R 2 0 0 7 17

NHS budget. 2006 research by thethink tank, The King’s Fund, hasrecently found “stark differences” inthe level of spending across PCTs. Inconsequence, a patient’s chances ofreceiving treat ment may very welldepend upon which PCT funds theirtreatment; i.e. a postcode lottery. Priorto 2006 the availability of the drugHerceptin for the early treatment ofbreast cancer ranged from 10% ofpatients in some areas to 90% inothers (the drug is now available toall). Critics described this as being aninequitable way of rationing healthcare.

� Discrimination. Here treatment is tobe decided on the grounds of a factorsuch as severity of condition or ageof patient. This is a contentious area.Should doctors have the right toprioritise patients, knowing thatsome may not survive sufficientlylong to receive treatment, especiallyin the case of organ transplants orheart operations?

� Charging. This takes us backtowards the free market equilibriumbut the charge to the patient can bemeans-tested, i.e. based upon eitherthe consumer’s ability to pay, ordependent upon the extent to whichthey have contributed to their owncondition. Smoking-related diseaseswould fall under this latter category.

Cigarettes as a de-merit goodA de-merit good can be defined as agood that:(i) is undesirable for the welfare of

citizens;(ii) confers a negative externality (or

‘external cost’) onto others;(iii) is overprovided in the free market.

Figure 3 shows the overprovision ofcigarettes in a free market.

Again, the consumer derives amarginal private benefit, MPB, fromsmoking: s/he may well enjoy theexperience or the social cachet that isderived from smoking with friends. Assuch, the free market equilibrium occursat point A, where supply intersects withthe D = MPB curve, resulting in QFM

cigarettes being consumed at a price ofPFM.

But this market equilibrium ignorestwo factors: firstly, the smoker may beinflicting onto third parties negativeexternalities such as passive smoking,resultant healthcare costs and increasedfire risks; secondly, consumers(smokers) may also suffer from failure ofinformation and hence over-estimatetheir MPB. This problem is especiallylikely to occur with young smokers, whomight be unaware of the long-termhealth implications of their habit. Both ofthese factors result in the MPB ofsmoking exceeding the MSB, with aresultant overprovision of cigarettes inthe free market by (QFM-QSO), againrepresenting a misallocation ofresources.

The UK government is aware of thismarket failure and adopts a variety ofmeasures to reduce the equilibriumoutput towards the social optimum. Onthe supply side, it imposes both VAT andexcise duties onto the producer, thusshifting the supply curve verticallyupwards by the amount of the unit tax.HM Revenue and Customs also limitsthe amount of the good that privateconsumers are allowed to import into theUK. On the demand side, legislationimposes a minimum legal age for

smoking (rising from 16 to 18 fromOctober 2007). Smoking in public placeswas outlawed in England from July 2007,having been banned in Scotland sinceSpring 2006. The advertising ofcigarettes has been banned in theEuropean Union since 2005 on radio,television, internet or printed publica -tions, and health awareness campaignsattempt to encourage smokers to giveup and dissuade non-smokers fromstarting.

Should smokers pay for their treatment?The number of UK smokers has declinedsteadily over the years and thegovernment has set a target for a furtherreduction in the number of smokers from26% of the population in 2002 to 21%by 2010. This would relieve some of thepressure on the NHS. A ‘user charge’ forsmoking-related healthcare wouldpresumably act as a deterrent tosmokers and hence reduce demand.Why has such a charge not beenintroduced? We can identify at least sixreasons to explain the absence of a usercharge:

� A charge contradicts the originalNHS ethos of free healthcare “fromthe cradle to the grave”. Voters haveshown that they are very protectivetowards the notion of the NHS in itscurrent form.

� A charge would be regressive:smoking rates have declined fastestamong higher income households.

� Such healthcare can be veryexpensive – cancer treatment can beprotracted and involves chemo -therapy, radiotherapy and drugtreatment.

� Some consumers suffer fromeconomic myopia (short-sighted -ness): they may enjoy the pleasuresof cigarette consumption today andput less weight on future implicationssuch as paying for their eventualtreatment.

� The money that the governmentsaves on reduced pension paymentsfor those who die early added to thetax on cigarettes may exceed themoney spent on treating smokers.

� Where would one draw the line?Should charges also be levied forobesity-related illnesses, cirrhosis ofthe liver and mountaineers’ brokenlimbs?

P/£

0QuantityQSO QFM

B

S

D = MPB

D = MSB

APFM

PSO

Figure 3: Cigarettes – de-merit good

18 S E P T E M B E R 2 0 0 7

The initial logic suggests that the policymight kill two birds with one stone(reducing the demand for both tobaccoand healthcare) but the above pointsshow that the outcome is fraught withdanger and uncertainties. Perhaps weshould look to other countries forexamples?

An alternativeNo policy is perfect, but lessons can belearnt from abroad. A large number ofWestern countries, including France,Germany and USA have a system ofhealth insurance to pay for healthcare.Households and employers paypremiums to insurance companies, whowill then meet the cost (the majority ofthe cost in France’s case) of thehealthcare. In France the insurance take-up is 85% of the population and in theUSA it is 84%. Those too poor to pay theinsurance premiums will still receivetreatment in the USA via Medicare (forthe elderly) or Medicaid (for the poor),and in France by the CouvertureMaladies Universelle. The insurancepremiums can be made higher for thosemore likely to require healthcare, basedon parameters such as age, gender, pastmedical history, family history andwhether the consumer smokes, drinksor is overweight. After all, a UK motoristreadily accepts that he will pay a highermotor premium if he is young, male anddrives a fast car. There is no reason whysuch a system cannot be extended toUK healthcare. Those consumers wholie to lower their premiums (for exampleby claiming that they do not smoke)could be refused the insurance payoutto cover their healthcare if they weresubsequently found to have beenuntruthful. There would now be arealistic financial incentive not to smokeand the very poorest would still becovered by the state.

1. Define ‘market failure’, ‘governmentintervention’ and ‘governmentfailure’.

2. The price elasticity of demand fortobacco is estimated at around –0.7.What does this mean?

3. Why has the UK government notprohibited smoking, as it has donefor other narcotics?

4. Do you think that the governmentshould charge smokers for theirhealthcare?


1. Access the web site of Actionon Smoking and Health(www.ash.org.uk). Using theirfact sheet number 16investigate the economics oftobacco.

2. The pressure group ‘Forest’supports the rights of smokers(www.forestonline.org). Fromtheir ‘key issues’ link look atsuch topics as tobacco taxation and advertising comparing their views withnmthose of ASH.

3. Using the Office of Health Economics web site schools section download‘The Economics of Health Care’. Investigate the terms ‘moral hazard’ and‘adverse selection’ in relation to private health insurance.

www.ohe.org/page/knowledge/schools.cfm)


80

0

%

70

60

50

40

30

20

MenWomen

10

Neversmoked

Used tosmoke

occasionally

Used tosmoke

regularly

Currentcigarettesmoker

Summary of key points� The demand for healthcare exceeds supply at zero price and so some

form of rationing is therefore required.

� A possible solution would be to charge smokers for their healthcare,but this is fraught with difficulties.

� An alternative solution is to introduce healthcare insurance, thusproviding a financial incentive to reduce risk-increasing behaviour.

Source: The Scottish Executive on smoking rates in Scotland.

If government can cut the number of smokers it should reduce pressure on the NHS.

S E P T E M B E R 2 0 0 7 19

he global economy looks in remarkably good shape.Economic growth rates have been maintained around

levels that are amongst the highest seen in the post-WW2 era. In spite of higher oil and commodity prices, inflationrates generally remain quite low allowing short term interestrates (both nominal and real) to remain at subdued levels.America’s huge trade deficit has not triggered a crash in theUS dollar and foreign investors have been very willing tofinance the deficit by buying US bonds. If anything, exchangerate volatility has declined to very low levels and investor riskappetite is very high.

Is everything in the garden rosy?Does all this sound too good to be true? Perhaps. There is nodoubt that economic liberalisation and deregulation in thelast twenty years or so has contributed to supply-sideimprove ments and an increase in productive potential.Clearly, in some cases (like the eurozone) there is more workto be done in terms of structural reform in terms of taxationand removing labour market rigidities. Likewise, protectionisttendencies from wherever they arise should be resisted. Inaddition, the trend towards globalisation has expanded trade.The opening up of China and the expansion in economies likeBrazil, India and Russia has generally been a boon for theworld economy. Consumers are benefiting from lower costmanufactured goods in those countries and lower priceshave, so far, contained global inflation. Also, the macro policyframework in the major economies with its emphasis oninflation targeting and ‘sound’ fiscal policy has also played itspart in generating low volatility in both output and inflation.

A major cause for concernBehind all of this though is a big worry in my opinion. In recentyears, we have witnessed much more in the way of financialmarket volatility and what seem to be pervasive asset pricebubbles. I think you can trace this to the collapse of the‘dotcom’ bubble in 2000 which then caused the FederalReserve (America’s equivalent of the Bank of England) topursue an ultra-expansionary monetary policy in order toavoid recession and deflation. American official short terminterest rates dropped to 1.0%. The medicine worked.America avoided deflation and recession but at a cost. Cheapmoney resulted in soaring asset prices whether it be realestate, commodities, equities or art. In the US, house pricessoared and canny householders unlocked equity (calledmortgage equity with drawal) and spent it on cars and holidayscontributing to a sharp rise in consumer spending. This in

turn resulted in America’s trade deficit reaching record levelsas consumption fed its way into higher imports. For the restof the world, the rising trade gap meant more liquidity for theglobal economy. In addition, because many Asian economieshad pegged their currencies to the US dollar, they found thathigher trade surpluses on their part resulted in the acquisitionof massive foreign exchange reserves. China and Japan noweach have reserves amounting to $1 trillion and they haveinterestingly recycled those reserves back into Americathrough purchases of US bonds. Indeed, China and Japanare the largest holders of US Treasuries. What this means isthat China and Japan are America’s key creditors and havehelped keep interest rates in America lower than theyotherwise would be. Some commentators have characterisedthe current international monetary system as ‘Bretton Woods2’ and what might be described as an ‘unstable equilibrium’partly explains why the dollar avoided a crash.

As the bubbles burst, will recession follow?Nevertheless, this huge build-up in global liquidity has createda series of bubbles with investors accessing cheap credit andleveraging this credit through an ever-increasing variety offinancially sophisticated instruments. The problem ariseswhen asset prices fail to keep on rising or when there arefinancial market shocks in various parts of the global financialmarkets. Greed then turns to fear and leveraged investors areforced to rush to the exits in order to repay borrowings andavoid investment losses from spiralling out of control. One ofthe major bubbles – the US housing market – has alreadyburst and the real estate sector is in recession. Falling houseprices is resulting in debt default as borrowers fail to makemortgage repayments. In addition, lenders who ‘over-lent’ topoor credit quality borrowers (the ‘subprime market’) are introuble. The spillover effects from the housing recession inAmerica could turn out to be considerable and the bubblesarising from cheap money are now popping. This invites theprospect of financial market turbulence which could seedeclines in equity prices, higher bond yields and a collapse inhigh yielding currencies. Rising risk aversion on the part ofinvestors will almost certainly put an end to the ‘mis-pricing’of risky assets which appears to have been a key feature ofthe financial market landscape in recent years. It also meansthat global liquidity will inevitably be tightened resulting inless appetite for borrowing and a more circumspect attitudeto investment risk. Not a bad thing but let’s hope the burstingof global bubbles does not pull the rug on the global economyand raise the spectre of recession.

Is the Global EconomyHeadingfor a Fall?

T

Neil MacKinnon is Chief Economist at The ECU Group,a currency hedge fund in the City.

20 S E P T E M B E R 2 0 0 7

1. Given constant technology, if a country invests ininsufficient capital goods to replace worn out capitalequipment then its production possibility will

A. shift to the right

B. become convex to the origin

C. shift to the left

D. become a straight line

2. Which one of the following is a normative statement?

A. The UK government’s spending has grown too quicklyin recent years.

B. Slovenia joined the Euro in January 2007.

C. The national minimum wage in the UK is £5.35 perhour.

D. The pound reached its highest rate against the dollarin 2007 since the early 1980s.

3. Elasticity estimates Premiership Coca Colaof match day Club League 2 Clubticket prices (Man. Utd.) (Barnet)

Price elasticityof demand –0.4 –1.4

The above date shows the price elasticity of demand formatch day tickets at two professional football clubs indifferent divisions. If both clubs raised their prices by 10%what would happen to their revenue from match day ticketsales?

Premiership Club League 2 ClubA. Rise RiseB. Fall RiseC. Fall FallD. Rise Fall

4. A piano player gives regular daily lessons to children for£20 per hour. One day she helps out for three hours at aconcert at a local theatre and is paid £300. If it is assumedthat she has no costs in her activities which one of thefollowing is true?

A. Economic profit is £300.

B. Accounting profit is £240.

C. Economic profit is £240.

D. Accounting profit is £360.

E. Economic profit is greater than Accounting profit.

5. In 1998 Daimler-Benz paid $36 billion for Chrysler.However, in 2007 Daimler sold Chrysler to a private equitygroup stating that the clash of management cultures andorganisational difficulties had been a major reason for thefailure of the merger of the two car manufacturers. Fromthis information it can be deduced that the merger was anexample of

A. horizontal integration which resulted in diminishingreturns.

B. conglomerate integration which resulted in disecono -mies of scale.

C. vertical integration which resulted in diseconomies ofscale.

D. horizontal integration which resulted in diseconomiesof scale.

E. conglomerate integration which resulted in diminishingreturns.

6.

The above diagram shows the labour market for fruitpickers in equilibrium at w and q. Which one of thefollowing will cause the demand curve for labour to shiftto the right?

A. A fall in the price of fruit.

B. A rise in the productivity of fruit pickers.

C. A change in the wages of other comparable occupa -tions.

D. Increased inward migration of fruit pickers.

E. A rise in the national minimum wage.

In this regular feature Chief Examiner Robert Nutter of Watford Girls’

Grammar School, looks at AS and A2 questions which in this volume will

aim to reflect the order that schools and colleges cover topics from the

specifications. There are three AS (1-3) and three A2 (4-6) questions per

edition plus explained answers.

Quantity

WageRate

DL

SL

q

W

0

Questions

In Q5, what resulted from the failedDaimler-Benz merger with Chrysler?

1. Capital goods are machines, vehicles, computers etc.,which are used to produce consumer goods. Over timecapital goods depreciate due to age, wear and tear etc.,and need replacing otherwise the productive capacity ofthe economy will shrink. Hence if new capital goods fail toreplace those that are no longer serviceable the economywill have a reduced productive potential as witnessed bya shift to the left of the production possibility frontier. Theanswer is C.

2. A normative statement expresses an opinion on an issue.It is essentially a value judgement which cannot be provedright or wrong by an appeal of facts. A positive statementcan be shown to be right or wrong by looking at facts(options B, C and D). Whether the government shouldspend more or less is largely a matter of opinion and thusthe answer is A.

3. Price elasticity of demand for tickets is inelastic atManchester United as it is less than 1. Hence a rise inprices of say 10% will only reduce demand by 4%meaning that such a price rise would lead to an increasein the club’s revenue. For Barnet a similar rise in ticketprices would reduce demand by 14% and lead to a fall inrevenue. For them the increase in revenue from each ticketsale is outweighed by the bigger drop in spectators attheir games. The answer is thus D.

4. When calculating profit accountants in the business worldwill always subtract costs from revenue. Economists

consider the opportunity cost of resources as a cost, i.e.what the resources could earn in their next best alternativeemployment. In the above example the woman could haveearned £60 from piano lessons while she was being paidto help at the concert. This would be added to other costsby an economist meaning that her economic profit wouldbe £240 (£300 – £60 = £240). The answer is thus C.

5. As Daimler-Chrysler was the result of the merger of twocar manufacturers this was the result of horizontalintegration (two companies making the same product).The failure of the merger was the result of managerialdiseconomies of scale. The two companies’ manage -ments did not work together successfully and the gainsexpected from the increased company size did notmaterialise. If a larger company cannot create a manage -ment structure to minimise costs and rationalise productlines then efficiency gains may be more likely with twosmaller companies. The answer is thus D.

6. The demand curve for labour also represents marginalrevenue product (MRP). MRP is calculated by multiplyingthe marginal physical product (the extra output producedby an additional worker) by the price the product is soldfor. A rise in productivity (output per head) will raise theMRP and shift the demand curve for labour to the right. Afall in the price of fruit will reduce the MRP shifting it to theleft. Options C and D shift the supply curve for labourwhile the national minimum wage does not directly shifteither curve. The answer is thus B.

Answers

A failure to replace capital goodsin Q1, will shift the PPF to the left.

Nigel Watson of St Catherine’s School,Guildford, considers the nature ofcompetition in a market within theservice sector of the economy.

Is the IndianRestaurant

Market anexample of

Monopolistic Competition?

AQA

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OCR ✓ 2884(5.4.2)

WEJC ✓ 4(D)

CCEA ✓ 3

Int. Bacc. Standard 2.1 / Higher 2.3


S E P T E M B E R 2 0 0 7 23

onopolistic competition is amarket structure made up of a

very large number of smallfirms. Competition is imperfect becauseeach firm within the market attempts tosell a differentiated product. One firm’sproduct is not a perfect substitute foranother’s. This means that firmsoperating in monopolistically competi -tive markets are not price takers. Firmsthat sell popular differentiated productscan charge slightly higher prices thantheir competitors. Any abnormal profitmade in the short-run tends to becompeted away in the long-run by newentrants. In a monopolistically com -petitive market there are few barriers toentry and exit.

The UK Indian restaurant market issurprisingly older than one might think.Indian food has been consumed inBritain for over three centuries. The firstIndian restaurant was opened in Londonin 1773. The Hindostanee Coffee Houseoffered its customers “Indian dishes ofthe highest perfection” and, rathersurprisingly, the opportunity to smoke“Hookha with real Chilm tobacco”!1 Forthe next two hundred years the marketgrowth was consistently slow. At thebeginning of the 1960’s Indian food wasa niche market business as there wereonly 500 Indian restaurants in the wholeof the UK. As Table 1 illustrates, in thetwo decades that followed the UK Indianrestaurant market grew at spectacularrate. In more recent times the market hascontinued to grow, however the rate ofgrowth has declined. Today, the Indianrestaurant market is firmly established.The industry is one of Britain’s largest,employing over 60,000 people.2

It could be argued that the Indianrestaurant market is monopolisticallycompetitive. To judge whether this is thecase we will need to review thecharacteristics of this type of marketstructure.

Many buyers and sellersDuring the 1960’s, as Table 1 shows,there was a rapid increase in the numberof Indian restaurants in Britain. Thesingle most important reason for thischange was the arrival of Asianimmigrants into Britain. Many of thesenew comers encountered discrimina -tion, especially within the jobs market.One way of earning a living was tobecome a self-employed restaurateur.Most of these new restaurants were

concentrated around the GreaterLondon area because that is where mostof the new immigrants chose to live.Gradually, over time the Indianrestaurant concept has spread all overBritain, even though the chefs cookingthe food were usually not Indian at all. Infact over three quarters of ‘Indian’restaurants in Britain are owned bypeople who are of Bangladeshi orPakistani origin! In the early days themenus were fairly simple offering diners a limited choice. In an attempt to keep start up costs down the food was often served in basic sur -roundings.

A monopolistically competitive marketis made up of hundreds of consumersthat are supplied by hundreds ofrelatively small businesses. The Indianrestaurant market is extremely decen -tralised. The market is made up ofthousands of small independentoperators. In most British high streetsthere are several Indian restaurants thatcompete aggressively against eachother. Indian food is very popular; over23 million portions of Indian food aresold in restaurants each year. The levelof market concentration is very low. Interms of the number of buyers andsellers it could be argued that the UKIndian restaurant market is mono -polistically competitive.

Product differentiationProduct differentiation is the degree towhich consumers perceive that aproduct is unique, and in some waysuperior to products of a similar typeoffered by the competition. Firms thatoperate in perfectly competitive marketssell an identical product. This is not thecase in monopolistic competition. Firmsoperating in monopolistically competi -tive markets try to produce differentiatedproducts that are not perfect substitutesfor each other. As a result the demand

curve facing each firm in monopolisticcompetition is not perfectly elastic like it is in perfect competition. Firms inmonopolistic markets produce dif -ferentiated products. Firms operating inmonopolistic competition can raise theirprices without losing all their customers.This is why the average revenue curve inmonopolistic competition is downwardsloping.

In the 1960s and 1970s, the growingaffluence and cosmopolitan nature of theBritish public boosted takings at mostIndian restaurants. Indian restaurateursbegan to enjoy rising profitability. Mostowners chose to use some of the profitmade to upgrade their facilities.Gradually the Indian restaurant scenebecame more sophisticated e.g.luxurious looking tables, chairs and tablecloths, piped Indian music, air condition -ing, dinner-jacketed waiters and flockwallpaper. Thirty years ago Indianrestaurants tended to look the same.Most had fairly similar menus too. As aresult Indian restaurants were forced intocompeting against each other on price.Unfortunately, intense price competitionled to falling profit margins. According totextbook theory firms operating inmonopolistically competitive marketscan make abnormal profit in the shortrun by differentiating their products.Indian restaurateurs began to realise theimportance of product differentiation asa competitive weapon. According toPeter and Colleen Grove, in their book:Curry, spice and all things nice, the firstreal attempt to create differentiationoccurred in the early 1960’s when a fewforward-looking Indian restaurants, suchas the Gaylord in Mortimer Street inLondon, imported Tandoors. A Tandooris a special type of oven made from claythat gives the food cooked inside theoven a distinctive taste. Restaurantsusing Tandoor ovens found that theycould charge slightly higher priceswithout emptying their restaurants. AsFigure 1 shows restaurants with

M Table 1: The number of Indian restaurants in the UK

Year Number of Market growth raterestaurants since previous year

1960 500 –1970 1200 140%1980 3000 150%1990 5100 70%2000 7940 56%2004 8750 10%

Source: http://www.menu2menu.com/indfact.html

1. http://www.menumagazine.co.uk/book/restauranthistory.html2. http://www.menu2menu.com/indfact.html

24 S E P T E M B E R 2 0 0 7

Tandoori ovens were able to makeabnormal profits.

A pioneering restaurant equipped witha Tandoori oven in the early 1980swould, according to economic theory,choose to profit maximise at the outputlevel where marginal cost equalsmarginal revenue. On the diagram theprofit maximising number of mealssupplied is OQ1. The productdifferentiation created by the Tandoorioven restaurant meant that it waspossible to charge a price of P1 for eachmeal sold. The average cost of sellingeach meal is AC1, resulting in anabnormal profit of ABCD.

Freedom of entry and exitA third characteristic of monopolisticcompetition is that there are few, if anybarriers to entry and exit. Does the Indian

restaurant market conform to this featureof monopolistic competition? There arethree potential barriers to entry to theIndian restaurant market. The first is theavailability of authentic ingredients. Inthe 19th Century ingredients had to betransported slowly from the Indian sub-continent by ship. At that time theavailability and price of ingredientsneeded to cook a decent curry wasundoubtedly a significant barrier to entryto the Indian restaurant. The secondpotential barrier to entry is the availabilityof skilled labour. The UK government hasadopted a relatively liberal approachtowards immigration for many years.Today, entrepreneurs that want to enterthe industry find it relatively easy to findthe talent needed to do so. A furtherpotential barrier to entry is the cost of setting up. If set-up costs are

prohibitively high new entrants to anindustry are likely to be discouraged.Set-up costs in the Indian restaurantmarket are relatively low. Premises neednot be bought, they can be leasedinstead. There is also a healthy second-hand market for the fixtures and fittingsrequired to open up an Indian restaurant,keeping entry and exit costs down. A fiveminute trawl on the internet revealed thatit is possible to buy an established Indianrestaurant operating from a leaseholdproperty in South London lock stock andbarrel for the modest sum of £89,500.3

In conclusion, it could be argued that theabsence of significant barriers to entryand exit to the Indian restaurant marketdoes conform to the monopolisticallycompetitive model.

Only normal profit is possible in the long-runOver time more and more Indianrestaurants switched to Tandoori cookingin an attempt to boost profit. Firms thatmade abnormal profits through productdifferentiation find it difficult to hold ontothese profits in the long-term. Figure 2shows a firm in monopolistic competitionthat makes only normal profit. Newentrants to the market and existingincumbent restaurants that decided toswitch to Tandoori cooking pushedprices down to PO.

In an attempt to create more abnormalprofit in the short run restaurateurs havebeen forced to find new innovations andsources of product differentiation to stayahead of their rivals.

New attempts to achieveproduct differentiationExamples of new innovations that canenable Indian restaurants to try to chargepremium prices include:� Décor and design. In recent times

several now famous London-basedIndian restaurants such as ‘TheCinnamon Club’, opened in 20014 ata cost of £2.6m5 in the Old West -minster Library, ditched the old styletraditional Indian restaurant décor(including the flock wallpaper!) infavour of a more up-market lookingmodern minimalistic interior designstyle. This change inspired manyother Indian restaurants up and downthe land to upgrade their fixtures andfittings in the hope that they too couldcharge Cinnamon Club style premiumprices e.g. Smoked rack of lamb withRajasthani corn sauce and pilau ricefor £22.

3. http://www.daltonsbusiness.com/business.asp?businessID=93848&BTAsource=77&ID=7134. http://www.timesonline.co.uk/article/0,,1147-1866130,00.html5, http://observer.guardian.co.uk/life/story/0,,489885,00.html

£

0Meals

P1

AC1

Q1

MCAC

A B

D C

Figure 1: Monopolistic competition – the short run

£

0Meals

P0

Q1

MCAC

MR AR

Figure 2: Monopolistic competition – the long run

S E P T E M B E R 2 0 0 7 25

� Exotic-sounding premium-pricedmenu items such as Seabass Kaylilanprepared with fenugreek and tamarind.

� Other restaurants have adopted adifferent approach. For example, TheKhyber in Croydon has tried to wincustomers by stressing theirauthenticity. The restaurant’s websiteinforms the reader that The Khyberwon the Carlton TV London IndianRestaurant award in 1997 and that“Our success is based on moretraditional recipes”. The slogan “It’sjust how Mum would cook it backhome” also features prominently ontheir internet menu.

� Balti cooking including the super-sized big-as-your-table Naan breads!

� A prestigious imported German lageron draught or a selection of fine wines

� Flying in celebrated Curry chefs fromthe Indian Subcontinent for a limitedperiod to cook up special food for aCurry Festival – the equivalent of anightclub flying in a celebrity DJ.

ConclusionsThe Indian restaurant market is in aconstant state of flux. Abnormal profitscreated by product and servicedifferentiation tend to be only temporarybecause it is relatively easy forincumbents to copy successful ideas.However, this highly competitive anddynamic competitive market createssignificant benefits for consumers.Firstly, the products offered by firms inthe industry are varied. There is plenty ofchoice for the consumer. Secondly,Indian restaurants have to be innovativeif they are to make abnormal profits,ensuring that there is always somethingnew for the consumer to sample.

Monopolistic competition is a verycommon market structure. In addition toIndian food it can be argued that themarkets for hairdressing, newspapershops and pubs share many of thecharacteristics of monopolistic competi -tion. However, it could also be arguedthat in some parts of the country themarket for Indian restaurant food mightnot conform to the mono polisticallycompeti tive model. The author’s localIndian restaurant in Bramley, Surrey is agood example. It is the only one for milesaround. A lack of competition locallyenables this restaurant to charge veryhigh prices. These high prices almostcertainly create an abnormal profit forthe owner of the restaurant. Here thispar ticular restaurant enjoys a localmonopoly.

1. How does the market for hairdressingalso illustrate the characteristics ofmonopolistic competition?

2. Is it true that many examples ofmonopolistic competition are serviceindustries whose economies of scalebarely exist?

3. To what extent is product differentia -

tion a unique feature of monopolisticcompetition?

4. What distinguishes monopolistic com -petition from oligopolistic markets?

5. Is there any tension betweenassuming the existence of productdifferentiation and at the same timeassuming ease of entry?

Summary of key points� The Indian restaurant market appears to meet the requirements to be

called a monopolistically competitive market.

� This market is generally characterised by many suppliers (due to easeof entry) who try to differentiate their product offering.

� In some particular parts of the UK local Indian restaurants may be closeto the market structure of a monopoly supplier.

In the early years of the twentieth century economists began to develop theorywhich explained the structure of major industries better than perfect competitionand monopoly. Monopolistic competition and oligopoly were the marketstructures that emerged as being more relevant to developed economies suchas the UK and the USA. The theory of monopolistic competition was developedby Edward Chamberlin and Joan Robinson in the 1930s.

Research the work of both Edward Chamberlin and Joan Robinson in relation totheir 1930s work on imperfect competition, especially monopolistic competition.


Over time more and more Indian restaurantsswitched to Tandoori cooking.


26 S E P T E M B E R 2 0 0 7

Stephen Romer discusseswhy foreign investors havebecome interested in buyingsome of England’s leadingfootball clubs.

What are theImplications of

American Ownership ofPremiership Football Clubs?

The scene: Passport Control. A trans-Atlantic Jumbo Jet has just landed.

Customs Officer: Good morning, Sir. Welcome to Heathrow.

Arriving passenger: Why, good morning, y’all. Howdy doody.

CO: Could I look at your passport please, Sir?

Why, you surely can. I’m a Good Ol’ Boy from Dallas, Texas, the home of theDallas Cowboys. Name’s J.R. Sanders, folks call me the Colonel.

CO: And what seems to be the purpose of your visit to the UK, ColonelSanders? Opening another Kentucky Fried Chicken emporium?

Colonel Sanders: No, I’m over here for sacker.

CO: Sacker?

CS: Why, yes. It’s what y’all call ‘football’ over here. I’m interested in yourLimey football.

CO: If you are interested in football, Sir, can you tell me who won the Cup in1970?

CS: The Cup?

CO: Yes, Sir. The FA Cup. It’s rather like your World Series of Basketball.

CS: Baseball. The World Series? Why, that’s as American as Mom’s apple pie.

CO: In 1970, Sir, Chelsea beat Leeds 2-1 in a replay. I will never forget it.

CS: A replay? Didn’t they have field goals in overtime?

CO: (singing) Blue is the colour, football is the game…

CS: (interrupting) Chelsea? That darned Russki, Roman Abramovich, got inbefore me. You mention Leeds. Could I buy Leeds? D’you think there’s aBuck in it?

CO: I’m afraid Leeds is in Administration, Sir.

CS: Administration?

CO: Yes, Sir, Administration. Or Chapter 11 Bankruptcy, as you Yankeecarpetbaggers would call it.

S E P T E M B E R 2 0 0 7 27

Show me the moneyChelsea 1 Manchester United 0In May 2007, another excellent chapterwas written in the long, distinguishedhistory of the FA Cup, football’s oldestand most prestigious knock-out compe -ti tion. Following apparently interminabledelays, a rebuilt Wembley Stadium wasat last ready. And what a remarkablereopening it was, one which broke all therecords in the book. Not only could youqueue for longer to get into the stadiumthan anyone had ever queued foradmission to a football ground before,but there was also the opportunity tospend record sums on match pro -grammes (£10) and ‘rip-off’ pricerefreshments.

But easily the most impressive recordset by the new national football stadiumis its number of toilets: there are twothousand, six hundred and eighteentoilets at Wembley Stadium. For theAmerican sports fan, this is a trulyimpressive statistic. It means thatWembley has more rest rooms than SheaStadium and the Meadowlands (homegrounds of the Mets and the Jets)combined; more comfort stations thanFenway and Comiskey Park (the RedSocks and the White Socks) puttogether; more bathrooms than Arlingtonand Jacobs Ball Park (the Cowboys andthe Indians) aggregated.

But I am afraid it is not simply a questfor a surfeit of euphemisms which hasstimulated the sudden new interest inEnglish sacker on the part of theAmerican sports entrepreneurs. And nor,we can safely assume, is it a wish to jointhe fans behind the goal chantingobscenities at the referee on a Saturdayafternoon, let alone a desire to paystaggeringly high prices for football

programmes, hot dogs and weak beer.

But why are the US billionaires overhere? What has brought Glazer andSons to Manchester United? Why is

Randy Lerner at Aston Villa? What doTom Hicks and George Gillett see inLiverpool? Is there an explanation for

Stan Kroenke’s interest in Arsenal?And why has the co-founder of

Microsoft, Paul Allen, the world’s19th richest man, emerged as theSaint with £50 million to rescueSouthampton?

It would seem that the answerto these questions is remarkably simple:as businesses, major football clubs inEngland are undervalued and thusrepresent an excellent investmentoppor tunity.

We won’t come back ’till it’sover over-thereLet me ask you a question: what is thedifference between Liverpool FootballClub and Weetabix? The answer,according to Tom Hicks, is nothing.There is no real distinction to be madefrom an investment point of viewbetween the five times European Cupwinners from Anfield and the well-knownbreakfast cereal. In a remarkably frankinterview on the eve of Liverpool’s 7thEuropean Cup Final appearance (againstAC Milan in Athens), the Texan billionairesaid: “When I was in the leveragedbuyout business, we bought Weetabixand we leveraged it to make our return.You could say that anyone who waseating Weetabix was paying for ourpurchase of Weetabix. It was justbusiness. It is the same for Liverpool;revenues come in from whatever sourceand go out to whatever source, and, ifthere’s money left over, it is profit” (TheGuardian, 22 May 2007).

The term ‘leverage’ refers to debt, andthe idea of a leveraged buyout of acompany is that the acquisition isfinanced by borrowing the necessaryfunds. After the takeover, the resultingdebt is a liability of the acquiredcompany. And what is interesting is thatthe current wave of football acquisitionsby Americans began in 2005 whenManchester United was bought byMalcolm Glazer using debt to facilitatethe takeover.

The total cost of Glazer’s purchase ofMan U was reportedly £830 million,comprised of £790 million for the sharesplus a further £40 million in associatedfees. The acquisition was controversial

chiefly because it depended onborrowings of £559 million. In turn, thisdebt would have to be serviced by thefootball club to the tune of approximately£60 million per annum. And eventuallythe principal would also have to berepaid.

In a takeover of this kind, the victim isessentially paying for the privilege ofbeing taken over. And in the Glazer-Man U case, the loans raised to pay forthe acquisition came at a particularlyhigh price: according to reports, theaverage cost of capital was 14% –although this was subsequently reducedby refinanc ing in 2006. So it is notparticularly surprising that the Glazertakeover stirred much opposition amongthe fans. For the man in the street inDorking and Tunbridge Wells and otherhotbeds of Man U support, Mr Glazer’stakeover was unwelcome. The feelingwas that although the Tampa BayBuccaneers may have won the AmericanSuperbowl – gridiron football – underMalcolm Glazer’s ownership, anAmerican corporate raider would haveabsolutely nothing whatsoever tocontribute to the kind of football you playwith a round ball and without the use ofcheerleaders, time outs, crash helmetsand the whole nine yards.

The fans fought an ultimately futilecampaign to oppose Glazer. Theirargument was that Glazer’s is the kind oftakeover in which it is not the purchaserwho pays. On the contrary, the debt isplaced onto the balance sheet of thefootball club, implying that the lattersuddenly finds itself in a potentiallyprecarious financial situation in which itsvery survival depends on its ability tohandle the servicing of the debt withwhich it has been saddled. You only haveto look at the plight of Leeds United in2007 (in administration and relegated tofootball’s third tier) to see that debt caneventually all but destroy a major footballclub.

However, we can be reasonably safein predicting that Man U will survive inspite of the new debt burden. Frequentlyreferred to as the richest football club inthe world, Man U was ranked 4th in theDeloitte Football Money League Table, alisting of clubs’ annual turnoverpublished in 2007. Real Madrid was topof this particular championship with a turnover in season 2005-6 of€292.2 million. But Man U’s total salesrevenue (€242.6 million) is a reminder ofthe sheer size of the club, its 76,000 gatefor home matches, vast worldwide fan

28 S E P T E M B E R 2 0 0 7

base and associated merchandisingincome, and its ability to raise revenuethrough sponsorship by majormultinationals (Vodafone, AIG).

Over-leveraged, over-indebtedand over hereEverybody knows that Man U isexceptional in terms of financial scale.But what if the leveraged acquisition ofclubs were to become the norm in thePremiership? Critics argue that youcannot assume that the average topflight football club could survive the newdebt burden such a development wouldimply. And even for Man U, there are realcosts of the Glazer takeover.

The thousands of supporters whoremain hostile are keen to point out thatthe opportunity cost of every £1 millionspent on paying interest (or making debtrepayments) is £1 million which couldhave been spent in the transfer market:what the fans want to see is each andevery £1 million spent on improving the strength of the squad, and notsquandered on interest payments tobanks.

And what about ticket prices? I wouldhate you to accuse me of being aMonday morning quarterback (as theysay in the US), but I remember remarkingquite clearly and at a relatively earlystage that the consequences of a Glazer-type takeover would almost certainly

include significant increases in the priceof match tickets. I don’t want to say I toldyou so, but I am afraid that this is theunfortunate reality. Summer 2007 was apoint at which Blackburn Rovers, amongother Premiership clubs, was planningreduced admission prices, but it was atime when Man U’s supporters wereexpressing very real feelings of outrageabout excessive price increasesannounced for the 2007-8 season.

Of Old Trafford’s 76,000 seats, 57,000were sold to season ticket holders in the2006-7 season. Hoping to renew for2007-8, fans were angry to discover thattheir season tickets would cost up to14% more. As a matter of fact, the priceincrease is effectively rather more than14% because, under new conditions,fans buying a season ticket coveringPremiership matches will now be obligedto book for all home cup matches aswell, an imposition necessitating severalhundred pounds in additional expendi -ture.

Is this new tie-in sale an illegal anti-competitive practice under the lawsupon which UK competition policy isfounded? It is difficult to say, but whatwe do know is that there was a furiousfan response as season ticket renewalforms dropped through the letter boxesof Manchester United’s legions ofsupporters in all four corners of theHome Counties. The fans were

apoplectic, protesting that theseoutrageous prices and conditions werenecessitated purely and simply to enable the football club to service the£660 million debt.

I’m a Yankee Doodle DandyLike the Glazer takeover of ManchesterUnited, Tom Hicks and George Gillett’s£178 million acquisition of Liverpool wasfinanced by borrowing, and the intentionis that the profits of Liverpool will beused to pay the interest – amounting to£21 million per annum. But theremarkable thing about the Liverpooltakeover was that it did not seem to begreeted with hostility by the club’s fans.Where an American’s leveraged buy-outof a football club stirred up opposition inManchester, a mere 38 miles away inLiverpool a similar acquisition wasapparently given a warm welcome.

Hicks and Gillett had the advantage oflearning from the Glazer-Man Usituation, effectively a case study of hownot to win friends and influence peoplewhen you take control of a football club.Above all, there were important lessonsin public relations, and it can be nocoincidence that no sooner hadLiverpool’s new owners arrived thanannouncements were being made aboutinvestment of £200 million in thefootball-related activities of the club.This is investment which will help to payfor a new stadium and to enlarge thetransfer budget, both necessary stepson the road to winning the firstChampionship in 18 years, say the fans.More gate money from a larger stadiumwill give Rafael Benitez the financialclout in the transfer market to competewith Chelsea and bring the galacticos tothe Mersey.

Chelsea is owned by a Russian,Manchester United and Liverpool byAmericans. And in mid-2007, it waslooking as if the ownership of Arsenal,the other member of the Premiership’sBig Four, would also soon fall into foreignhands. Yet another American billionaire,Stan Kroenke, emerged in April 2007 aspurchaser of 9.9% of Arsenal’s shares.The seller was ITV which, like Sky andNTL, had acquired a 9.9% shareholdingin a number of leading football clubs inthe late 1990s, a period in which it wasthought by TV companies that suchshare ownership would reinforcebargaining power as regards theacquisition of television football rights.

The ITV share sale was widelyassumed to be the first stage in what

The purchases of Weetabix and Liverpool were both downto business and profit according to Tom Hicks.

S E P T E M B E R 2 0 0 7 29

would eventually be an outrightAmerican takeover of Arsenal. LikeLiverpool’s American acquirers, MrKroenke is an experienced sports ownerin the US. Tom Hicks owns the DallasStars Ice Hockey team (winners of theStanley Cup) and the Texas RangersBaseball Club, purchased in 1998 from aconsortium led by the then Governor ofTexas, George Dubya Bush. Arsenal’ssuitor, Stan Kroenke, is the proprietor ofa number of US sports teams, includingthe Colorado Rapids (American football)and the Denver Nuggets (basketball).

“Take me out to the ball game,” croonsBing Crosby at Yankee Stadium andCamden Yards, Wrigley Field andCandlestick Park, and baseball stadiumsthroughout America during the ‘seventhinning stretch’ (vaguely similar to halftime in football). But how can oneaccount for the Americans’ suddeninterest in being taken out to the ballgame at Old Trafford, Anfield orAshburton Grove? Why are the Americansports entrepreneurs over here? Whatdo Hicks, Gillett, Kroenke and theGlazers hope to get out of Premiershipfootball? What’s in it for them? Why isan experienced owner of sportsfranchises like Stan Kroenke preparedto pay a 50% premium price for the ITVArsenal shares? Why are 7 of the 20Premiership clubs foreign-owned, anumber which may soon be increasedwith foreigners taking over Arsenal andManchester City?

We know that the ownership of aPremier League club can be profitablefrom the example of Sir Alan Sugar whopaid £8 million for a 42% stake inTottenham Hotspur in 1991. Selling his remaining holdings (14.6% for£25 million) in 2007, the Amstradentrepreneur reportedly showed a profitof about £40 million overall. This isserious money, and we cannot besurprised that the attention ofinternational sports businessmen hasbeen increasingly directed towards theEnglish Premiership.

The American DreamA number of Premiership clubs havebecome global brand names with all ofthe potential for increased profitabilitythat this implies. As a matter of fact,Premier League football has come to beregarded as the wealthiest and mostprofitable football in the World.According to the Deloitte rankings, thePremiership has eight of the top twentyclubs valued by turnover. In contrast,

Italy has four, Germany three, Spain twoand Scotland, France and Portugal onlyone each.

For investors, this alone might besufficient to give rise to thoughts ofmaking a takeover bid. But, as if toreinforce the general assumption thatthe share prices of many football clubsunderstate value from an investmentpoint of view, Premiership soccer stoodin the Spring of 2007 on the eve of yetanother remarkable financial windfall:the new television contract. For the threeseasons starting in 2007-8, BSkyB andSetanta will be paying an astonishing£1.7 billion for live coverage of PremierLeague matches, a hefty increase on theprevious £1.1 billion contract. And thereis a further sum in excess of £600 millioncoming in from the sale of overseastelevision rights.

New owners are attracted by thePremiership’s ever-expanding financialboom. It is a boom in which the televisionbillions are playing a fundamental role, arole which should be emphasised.Investors see Premiership clubs asunder valued in the light of the TVrevenues and the wide range ofopportunities which exist for the growthof profits. Revenue streams can beopened by building new stadiums withtheir potential for increased gate moneyand corporate hospitality, not to mentionthe proceeds from the sale of stadiumnaming rights. The latter is standardpractice in the US where stadiumsnamed after sponsors range from theexotic Tropicana Field (home of theTampa Bay Devil Rays) to the prosaic USCellular Field (new venue for the ChicagoWhite Sox) to the embarrassing EnronField (the Houston Astros).

And investors assume that revenuecan be vastly expanded by exploiting thegrowing global Premiership fan base in

China and the US, potentially vastmarkets in which interest in soccer isincreasing. This suggests almost limit -less growth opportunities for merchan -dising revenue and broadcasting rightsfor the big ‘brand name’ Premiershipclubs. And when it comes to newrevenue streams for football clubs, wemust not overlook the current expansionof gambling in the UK. It is fairly safe toassume that various forms of gamblingincluding casinos, otherwise known as alicence to print money, will increasinglybecome associated with the growth offootball clubs.

Are football clubs crucial institutionsplaying an indispensable role in socialcohesion in the towns and cities of theUK, embodying the collective hopes andaspirations of their local communities?Or are they profit-maximising businesscompanies providing investment oppor -tunities for footloose global sportsentrepreneurs? Where once upon a timethey were the former, today the latter isincreasingly the reality.

1. What is a leveraged buy-out?

2. Identify, explain and discuss theconsequences for a football club ofbeing subject to a leveraged buy-out.

3. Compare the Glazer takeover ofManchester United with theHicks/Gillett acquisition of Liverpool.

4. Under what circumstances is itprofitable to own a football club?

5. Outline the factors attracting foreignsports owners to the Premiershiptakeover market.

6. Which team do you support? Underwhat circumstances would you likeyour team to be acquired by anoutside investor?


Summary of key points� In two years from May 2005, five Premiership clubs were acquired by

foreign owners, of which three are American.� The Manchester United and Liverpool acquisitions depended on large

scale borrowing.� The new owner of Liverpool feels there is no essential difference from

a business point of view between the acquisition of a football club andany other leveraged buy-out.

� Fans of Manchester United complain that higher ticket prices are adirect consequence of Glazer’s takeover.

� The new TV contract from 2007-8 has increased the appeal ofPremiership clubs as attractive investment vehicles.

� Investors see much potential for the growth of profitability ofPremiership clubs.

30 S E P T E M B E R 2 0 0 7

Rising TortillaPrices in Mexico

(a) Why might rising tortilla prices have been a cause for concern in Mexicoin 2007? (5 marks)

(b) Using demand and supply diagrams, analyse what might be expected if itis assumed there is a fall in the demand for petrol in the US on the marketfor tortillas in Mexico. (10 marks)

(c) Comment on the President of Mexico’s actions to counter the tortilla pricerise. (5 marks)

(d) Explain the meaning of the conclusion that ’tortillas are an inferior good’. (2 marks)

(e) Discuss the view that this case helps to prove the argument againstglobalisation. (8 marks)

n January 2007 newspapers in the United States reported on the rising price oftortillas in Mexico. This prompted newspapers in the UK to mention this situation.

Tortillas are an important staple of the diet of Mexico’s poor and provide 40%of their protein needs. They fulfil a similar role to that of rice and noodles in lowincome economies of Asia. An average urban Mexican consumes 250 grams oftortillas each day, while a rural Mexican’s daily consumption can be much higher – upto a kilo. The national minimum wage in early 2007 was $4.50 per day, with manyfamilies having income of less than twice the national minimum wage. Between 2006and 2007 the average price of tortillas per kilo rose from 63 cents to between $1.36and $1.82 and was expected to continue rising.

The President of Mexico responded to the price rise by arranging with businessleaders a voluntary price cap of 78 cents per kilo and allowing duty free imports from

the US of 800,000 tons of corn, which is the main ingredient oftortillas.

The majority of Mexicans blamed theprice rise on the increased demand

in the US for corn to makeethanol for fuel. This

followed US legislationincreasing the propor tion

of ethanol to beincluded in petrol. This

legislation was intended toreduce the demand for ever

more expensive crude oil and tohelp with the future sustainability of

fuel supplies. Other commentators drewattention to the actions of Grupa Gruma

which controls over 70% of the Mexican tortillamarket and the possibility of speculative buying

by corn dealers.Following an earlier tortilla price crisis in the 1990s one economist investigated the

nature of the demand for tortillas in Mexico and concluded that there was evidencethat tortillas were an inferior good but not a Giffen good.

Tony Emery, PrincipalExaminer for UK andInternational Exams,discusses the implicationsof a rise in the price of abasic foodstuff in Mexico.

I

S E P T E M B E R 2 0 0 7 31

(a) Why might rising tortilla prices have been a cause forconcern in Mexico in 2007? (5 marks)

The standard of living of Mexico’s poor would have beenreduced. This might have implications for their health andproductivity. It might be seen as undesirable in terms of equity.Falling demand for tortillas would affect producers and sellersand might lead to higher levels of unemployment. As animportant element of the national diet expenditure on tortillascould be expected to have a significant weighting in theconsumer price index of Mexico and contribute to a rise inthe rate of inflation.

Try to go beyond the most obvious effect of the price rise.

(b) Using demand and supply diagrams, analyse the linkbetween a fall in the demand for petrol in the US andthe market for tortillas in Mexico. (10 marks)

A fall in demand for petrol would lead to a fall in its price (OP-OP1) and quantity traded (OQ-OQ1). This would resultfrom a leftward shift in the demand curve (D-D1) in the USpetrol market. This would lead to a fall in the demand forethanol and so a fall in the demand for corn for makingethanol. A diagram with the same change applies to petrol,ethanol and corn. A leftward demand shift would occur in themarket for corn, meaning a lower price for corn. Suppliers oftortillas would now face lower production costs leading to arightward shift in the supply curve of tortillas in the Mexicanmarket (S-S1). A fall in demand for petrol could thus beexpected to lead to a lower price for tortillas (OP-OP1) with agreater quantity traded (OQ-OQ1). This analysis makes theusual ceteris paribus assumption.

Be sure to offer a commentary which matches the changesshown in the diagrams.

(c) Comment on the President of Mexico’s actions tocounter the tortilla price rise. (5 marks)

A voluntary agreement has some problems. Since it isvoluntary there is no legal backing to enforce it so it may notbe effective. This seems to be backed up by the statementthat prices were predicted to continue rising. Secondly, if

effective, a price below the market price operates like amaximum price. This might be expected to create a shortage(demand > supply). Black markets may develop which workto the advantage of the better off who are able and willing topay higher prices. This would undermine efforts to help poorergroups. The increase in corn imports would only help in theshort run and have implications for Mexico’s balance ofpayments.

Although not asked for a diagram, illustrating the shortagewould help to clarify the reasoning.

(d) Explain the meaning of the conclusion that “tortillasare an inferior good”. (2 marks)

An inferior good is one with a negative income elasticity ofdemand. This means that the quantity demanded decreasesas the consumer’s income increases. This is not unusual forbasic goods which can be replaced by more desirable goodswhen they become affordable. Normal goods have positiveincome elasticity of demand.

Learn central definitions precisely.

(e) Discuss the view that this case helps to prove theargument against globalisation. (8 marks)

Globalisation refers to the process by which the worldeconomy has experienced increasing integration andinterdependence. This has involved improved transport andcommunication, greater international trade and movement ofcapital and increased importance of multinational companies.The case against globalisation is that there are losers as wellas winners and the losers include many of the poorestcountries. Even the governments of relatively developedcountries have found that they have less ability to control thecourse of their economy when faced by forces on a globalscale.

This case study shows how a decision by the governmentof the world’s most powerful economy had a harmful knock-on effect in a neighbouring poorer country, which is a fellowmember of a trade bloc (NAFTA). The desire to reduce oilconsumption and imports and the use of finite resources inthe US influenced the living standards of the poorest groupsin Mexico.

This reasoning overlooks any potential benefits that havearisen from globalisation. In the case of the two countriesMexico has probably benefited in terms of employment andliving standards from its increasing links and trade with theUS. A decision about the overall benefit or harm would needto consider a far wider range of issues. In terms of theassertion it is more correct to say that the example supportsthe case against globalisation but it does not prove it.

Keep up to date with economic trends by reading economiccommentaries.

Suggested approaches to this question

Additional tasks1. With reference to the text, explain the other possible influences on the tortilla price rise.2. Use the ‘Mexico at a glance’ and the ‘Mexico country data profile’ on the World Bank website to study recent

economic events in Mexico.3. Look up the law of unintended consequences in Wikipedia and apply it to this case.4. Identify the data needed to judge the nature of demand for a product by viewing the research at

http://economicsbulletin.vanderbilt.edu/2002/volume15/EB-01O10003A.pdf5. Establish the meaning and history of the idea of the Giffen good.

Quantity

Price

Q1Petrol / Corn

Q

DD1

P1

P

S

Quantity

Price

Q1Tortillas

Q

D

P1

P

S S1

0 0

S E P T E M B E R 2 0 0 7

Rachel Cole of Cheltenham Ladies’College, and an Edexcel principal examiner,

outlines the impact of governmentintervention to alter market prices.

What are theEffects on

the Marketof Taxes andSubsidies?

overnments intervene inmarkets in many ways:

sometimes they want todiscourage production or

consumption, in which case theyraise a tax; and sometimes they

want to encourage production orconsumption and might choose to

offer a subsidy. There are manyother ways in which governments

can try to alter our levels ofproduction and consumption, butin this Back to Basics we will look

specifically at taxes and subsidies,illustrating them with simple

diagrams, analyse who is payingthe tax or receiving the benefit of

the subsidy (incidence), anddiscuss the contexts in which they

are likely to be most effective.Finally we will evaluate them by

asking whether they are the bestmeasures to achieve government

objectives.

G

32

S E P T E M B E R 2 0 0 7 33

TaxesTaxes are a requirement by law to paymoney to government. There are twomain types. Most of this article focuseson indirect taxes, but we take a quicklook at direct taxes first:

Direct taxes are taxes on income, suchas income tax, which are taken directlyor straight out of incomes. Ratherperversely, direct taxes can have anindirect impact on market prices. Forexample, when income tax falls to 20pper pound in April 2008, then I’m sure Iwon’t be the only person feeling a littlebit better off at the end of the month, andplanning to increase demand for luxuryproducts. This will affect prices if enoughof us do that. So a cut in taxes is likely toput upward pressure on some prices.Similarly the cut in corporation tax to20% (a proportion of a firm’s profits)might allow firms to cut prices. So whileit is true that direct taxes can have verysignificant effects on prices, the issue isnot likely to come up on an Economicspaper trying to apply the tax system tothe way in which markets work.

Indirect taxes are taxes on expendi -ture, such as value added tax (VAT). Theyare paid by any firm which sells anything,unless it’s a small firm or a charity. Whenthe government wants to alter produc -tion and consumption patterns the mainway to do this is by indirect tax ratherthan direct tax, as this will affect prices.The reason that it is called indirect tax isthat the consumer does not pay themoney directly to the government, butthe firms which sold the goods orservices must pay. The consumers doend up paying at least part of thesetaxes, as the cost of the tax is passedonto the consumer.

Indirect taxes come in two versionstoo: specific taxes, which are a fixed sumper unit sold, and ad valorem taxes,which are added on as a percentage ofthe price. The specific tax on wine in theUK currently depends on the amount ofalcohol, not the price at which it sells.This is shown in Table 1.

It doesn’t matter whether you buy vinde grotsville or chateaux de poshville,the tax is the same per volume andstrength. A specific tax is one whichvaries not with the price but with anotherfactor, such as alcohol strength.

The second type of indirect tax is thead valorem tax. Ad valorem is the Latinfor corresponding to the value. The moresomething costs the higher the tax rate.VAT is the most well known example. If Ibuy anything which might be seen as a

luxury then I’m likely to have 17.5% taxhidden in the price.

The main difference between aspecific and ad valorem tax is that thespecific tax is not trying to gain morerevenue from people who are preparedto pay more. It is a tax which is nottargeting redistribution of spendingpower in the economy but instead tryingto target something else, such asdrinking. The ad valorem tax by contrastis a good money earner for thegovernment, in that it taxes the peoplewho are prepared to spend more. An advalorem tax is redistributive – but thismakes a critical assumption that it is thehigher income groups who spend moreand thus are taxed more. In fact as apercentage of income it is often the casethat the poor pay much more in terms ofindirect taxes, relative to the higherincome groups, and for this reason wesay that most indirect taxes areregressive – that is, taxing lower incomegroups more in proportionate terms.

The tax on cigarettes is a mix betweenthe two – 22% of the retail price plus£109 per 1000 cigarettes (2007 Budget).Then there is VAT. £4.10 of the £5.50 costof a packet of cigarettes goes to thegovernment. So if you smoke a lot andsmoke expensive brands you are payinga lot of both types of tax.

SubsidiesA subsidy is a grant given to producers(or consumers). There are two mainreasons that a government might offer asubsidy to affect market prices:� It may be that the government thinks

that the market price is too low forfirms, and may want to support thefirms’ incomes to stop the firmsshutting down. This will encourageproduction, which not only keepsfirms in business, but can mean thatsupplies of services are guaranteed,especially in the case of somefoodstuffs which are consideredessential. Another advantage is thatjobs are not lost in the industry. Forexample the government subsidisesagriculture production via the EU’sCommon Agricultural Policy.

� By contrast it may be that thegovernment thinks that the marketprice is too high for consumers, andthat if prices were lower people wouldconsume an amount which moreaccurately reflects the value they willgain from consumption. This is asituation where there are positiveexternalities. For example the govern -ment subsidises train opera tingcompanies heavily (which maysurprise you considering some fares),helping to ensure unprofitable routesare kept running. That is, there is asocial benefit.

The effect of subsidies is to lower pricesbut the cost to the government of doingthis is high, as is shown in the followingdiagrams. The consumer might feelbetter off because of lower prices butthere may be an opportunity cost to bepaid through taxes. These can destroyincentives in an economy such as thedesire to work long hours, and theeffects of the subsidy can be seen asworse than if the government hadn’t gotinvolved in the market at all. The amountpaid and the amount that benefits theconsumer and the producer is shownneatly with a diagram showing theincidence of taxation.

Figure 1 shows the difference betweenan indirect tax and a subsidy. Theindirect tax is the vertical distancebetween the supply curves, and pushesprices and costs upwards. The subsidyis again the vertical distance betweenthe supply curves but instead pushes thecosts or prices downwards. Whencalculating the total tax revenue thegovernment receives as a result of a tax,you need to multiply the tax per unit bythe number of units sold.

Figure 2 shows the incidence of aspecific tax. Consumers pay the amountof tax per unit equal to the change fromthe old price to the new price. We drawa vertical line at the new equilibriumpoint. Producers pay the amount of taxper unit which is the difference betweenthe amount they now receive after taxand the amount they would havereceived at that output. So in this case

Table 1: The specific taxes per litre of wine since the March 2007 Budget

Wine (not sparkling): Exceeding 5.5% – not exceeding 15% alcohol by volume £1.77

Wine (not sparkling): Exceeding 15% – not exceeding 22% alcohol by volume £2.37

Source: www.hmrc.gov.uk

34 S E P T E M B E R 2 0 0 7

consumers pay P1P2 whereas producerspay a larger proportion of the tax. Thereis a greater vertical distance betweenP1 – t and P1 than between P1 and P2.

The dynamics of the diagram work injust the same way for the ad valorem tax(except for the steeper slope for the newsupply curve). In Figure 2 the demand isdrawn quite flat, implying that it is fairlyprice elastic – this means that if priceschange a little then demand changesproportionately more. So when taxes putthese prices up, the quantity reducessignificantly, and the producer ends uppaying most of the tax.

Contexts in which indirecttaxes are likely to be mosteffectiveBefore you can say whether a tax iseffective you must first decide what youwant to achieve. Are you considering the

amount that consumption or productionchanges, or are you thinking in terms ofgovernment revenue? If the governmentwants to raise a lot of money, it shouldtax a product which has a low priceelasticity of demand – such ascigarettes or fuel. But in taxingcigarettes there is also a socialobjective. Research by Ash, the antismoking lobby, estimates that taxingcigarettes is the only method which hasany effect on the amount smoked –education does not seem to work tochange demand at all.1 The tax raises

£9.3bn a year – more than four times the cost of treating smoking-relateddiseases.

Contexts in which subsidiesare likely to be most effectiveSubsidies are effective in expandingoutput when the demand is elastic (andalso supply, but discussing this goesbeyond Basics). If government wants toincrease output then it should offer asubsidy where the price elasticity ofdemand is high. But usually the demandfor foodstuffs and other commonlysubsidised goods is inelastic soalthough there is a major subsidy theoutput doesn’t increase much at all. Forexample the government is trying toencourage the output and use of biofuels, but because you need a differentcar to use them demand has notresponded quickly to lower prices ormore output. Often the subsidy does notincrease output at all – it just stops theoutput from falling. In the 1970s the UKgovernment was keen on subsidisingailing firms such as car producers, andwhile in the short run some job losseswere prevented, in the long run it seemsthis was money wasted.

What are the problems withindirect taxes and subsidies?There are three main problems withindirect taxes. Firstly, they make goodsand services more expensive. The resultis that our cost of living rises – that is ourbasket of goods as measured byinflation will cost more. Secondly, as acountry we may be uncompetitive ifindirect taxes abroad are lower – whichmight lead to illegal smuggling ofcigarettes for example. Thirdly, that thereis a disincentive for firms to set up orinvest in our country – one of the maincauses of growth in an economy.

There are three main problems withsubsidies. Firstly, they are veryexpensive to operate, and must befunded out of tax payers’ money (forwhich there is an opportunity cost).Secondly, while they may lower pricesfor the consumer and guarantee a

P

0Q

P2

P1

P3

Q2 Q1 Q3

D

S + tax

S

S + subsidy

tax

subsidy

Figure 1: An indirect tax and a subsidy

P

0Q

P2

P1

P1 - t

Q2 Q1

D

S + tax

S

Figure 2

1. www.ash.org.uk

Table 1: The incidence and output effects of an indirect tax

Demand is price elastic Demand is price inelastic

Effect on Output falls greatly but Prices rise greatly but consumers prices change little output changes little

Effect on Output and profits fall Very little change to firms producers output or profits

S E P T E M B E R 2 0 0 7 35

higher income for producers, the levelof that income is not guaranteed – itdepends what the market price wasbefore the subsidy was given. If in oneyear prices fall very low the subsidymight not be enough to maintainincomes; whereas in another year theproducer might do a little too well out ofthe government handout. Thirdly, theydistort the market, and the economyfails to enjoy the benefits of comparativeadvantage. If we can get cheaper foodsfrom outside the EU rather than thesubsidised food from within it, trade willbe created, and everyone can be madebetter off without anyone being madeworse off. The EU Common ExternalTariff is one of the key reasons whyinternational trade talks with developingcountries break down.

In conclusion, taxes and subsidies canbe used to change output and pricelevels, and the effects depend on theways in which they are applied and onthe elasticities of demand and supply.The side effects of taxes can be tochange levels of welfare, equality andinternational competitiveness. Theyhave a large but often hidden effect onour daily lives, and for that reason arefavourite topics for politicians, greenactivists, but perhaps most important ofall, economics examiners.

1. Draw a summary table similar toTable 1, but this time for subsidies.What pattern emerges?

2. If you have been studying macro -economics you may have got theimpression that subsidies are asupply side policy. The reason forsaying this is that subsidiesencourage firms to produce moreand at a lower price. However whatis the difference between subsidiesand a supply side policy?

3. The price elasticity of demand is of

crucial importance when consideringthe incidence of taxes and subsidies,as discussed above when looking atthe shift in supply curves. But is theprice elasticity of supply important?Remember that the shift in the supplycurve is a vertical movement so if itis very steep it will not move left orright very much.

4. If indirect taxes are the only way tostop people smoking, why notdouble the tax on cigarettes? Or isthe smoking ban (since 1st July 2007)going to have more effect, with finesranging from £30 to £2500?


Key terms� Direct tax – taxes on income, e.g. income tax, which come directly or

straight out of incomes.

� Indirect tax – taxes on expenditure, e.g. value added tax (VAT), tax on petrol.

� Specific tax – tax based on quantity not value.

� Ad valorem tax – tax based on value not quantity.

� Subsidy – a grant given to producers.

� Incidence – who pays the tax (or receives benefit of the subsidy).

� Price elasticity – a measure of response by consumers or firms when priceschange.

� Common External Tariff – The EU imposes some taxes on outside countrieswhich all member countries impose at the same rate. These vary from 7%(footwear) to 236% (food products).

EU agricultural subsidies will distort the market and may lead to higher prices.

y 2025, more than one third of the United Kingdom’s popula tion willbe over 55 years old.1 One of the fundamental develop ments of the

past 150 years has been the increase in the average length of life. Inthe 1850’s, the average life expec tancy at birth in England was only 42 years,

by 1911 it had risen to 50 years and today it is over 80 years for a male and 84 for a female.2 The Govern ment’s Actuary Department (GAD) estimate

that a male retiring at the age of 60 in 2026 will live for a further 24 years and a female will live for 27 years on average. Demo graphic change and

population ageing is a global phenom enon that has attracted considerableattention throughout the world. This article examines the research which

has been carried out into how the ageing population will impact on the United Kingdom’s economy.

Andrew Reeve, Head ofEconomics and BusinessStudies, King’s School,Macclesfield, reviews somekey implications of a largerproportion of older people in the UK’s population.

AgeingPopulation

in the UnitedKingdom

B

S E P T E M B E R 2 0 0 7 37

DefinitionsBefore we examine some of theempirical evidence, it is important toconsider some of the indicators ofpopulation ageing:1. The Dependency Ratio. This is the

number of persons under the age of15 plus persons aged 65 or older perone hundred persons 15 to 64. It isthe sum of the youth dependencyratio and the old-age dependencyratio.

2. The Youth Dependency Ratio is thenumber of persons 0 to 14 per onehundred persons 15 to 64.

3. The Old-Age Dependency Ratio isthe number of persons 65 years andover per one hundred persons 15 to64 years.

4. The Labour Force ParticipationRate consists of the economicallyactive population in a particular agegroup as a percentage of the totalpopula tion of that same age group.The active population (or labour forceas it is also known) is defined as thenumber of persons in employmentand unemployed persons seekingemployment.

What is an ageing population?The age profile of the United Kingdomhas shifted over the last one hundredyears. Over time there has been adecline in the size of the average family.Women born in the 1930s had, onaverage, 2.45 children. However, it ispredicted that women who were born inthe mid-1970s and therefore arecurrently of child bearing age, will haveon average only 1.74 children. This fall infertility has occurred at the same time asan increase in longevity. Together, thetwo factors cause an upwards shift in theage structure which is termed as anageing population.

This decline in fertility levels issignificant. Across the developed worldfertility levels are falling. The UnitedKingdom’s current estimated level of1.74 children per women is higher, forexample, than the average EU15 level ofonly 1.4 children. It has been estimatedthat a fertility level of 2.08 children perwoman is needed in the United Kingdomto simply maintain the population at its

current size. This is known as thereplacement level. We can clearly seethen that the country’s fertility level issubstantially below this level andtherefore there is a reliance on netmigration into the nation to fill the gap.

Old-age dependencyTable 1 shows the trend of a risingdepen dency of older people on thelabour force for all countries shown.Although the United Kingdom is in amore favourable position than a countrysuch as Italy or Japan, we can clearlysee that there is predicted to be asignificant worsening in the ratio.

However, these figures show only thebasic facts. They do not highlight if anyof the people within the age range 16-64are economically inactive. Many peopleare in full time education, havedisabilities which prevent work or areenjoying early retirement. Equally, weshould not think that all people agedover 65 years are economically inactive.Many continue to work, especially on apart time basis and a recent BBC reportsuggested that 35% of those aged 75+regularly give up some of their free timeto help others in a voluntary capacity.3

Figure 2 is taken from a research paperby Garry Young of the Bank of England.It clearly illustrates the extent of thepredicted demographic change in theUnited Kingdom in the next 60 years. Inhis research, Young uses the age range15-60 rather than 65. He concludes thatin 2001, those aged 60+ equated to 33%of the 15-60 age group but by 2030 the60+ age group is expected to equate to55%.4

The impact on healthcareHaving considered the extent to whichthe United Kingdom’s economy isageing, we now turn our attention to howthis process might impact on health andsocial care expenditure over the comingyears.

Recent figures published in the BritishMedical Journal suggest that the United

150

801971

140

130

120

110

100

90

1981 1991 2001 2011 2021 2031 2041 2051

Ind

ex 2

001

= 1

00 (%

)

Number at pension ageNumber of childrenNumber at working ageTotal population

Figure 1: Population changes in Great Britain, 1971-2051

Source: House of Lords Select Committee on Economic Affairs, 4th Report – Aspects of the Economics of an Ageing Population, (2003)

Table 1: Old-age dependency ratios in G7 nations

2000 2025 2050Italy 26.7 40.6 68.1Japan 25.2 49.0 71.3Germany 24.1 39.0 54.7France 24.5 36.2 46.7United Kingdom 24.4 32.8 39.2EU 15 24.5 37.1 54.7United States 18.6 29.3 34.9

Source: Department of Work and Pensions, 2004

❝“In other words, taking 60 as theretirement age, the number ofworking age people perpensioner is due to fall fromaround 3 now to 2 in 30 yearstime.”4

1. BBC online, www.newsvote.bbc.co.uk, ChristineJeavans, 29 November 2004.2. Government Actuary’s Department, National Popula -tion Projections, 2000 and 2004.3. BBC online, 29th November 2004, Christine Jeavans.4. Garry Young, ‘The implications of an ageing popula -tion for the UK economy’, Bank of England WorkingPaper, 159, July 2002.

S E P T E M B E R 2 0 0 7

Kingdom’s ageing population willimpose considerable workload andfinancial pressures on the NHS. It isexpected that by 2031, the number ofcases of coronary heart disease willincrease by 44%, the number of casesof heart failure will increase by 54%, andthe number of cases of atrial fibrillationwill increase by 46%. If these predictionsmaterialise, there will be an increase inthe provision of statins, which havebecome the single largest component ofthe NHS prescribing budget. There willalso be a significant increase in the costsof diagnostic tests, surgical proceduresand regular monitoring of patients.5

However, the correlation between oldage and health care expenditure may notbe so straightforward as outlined above.In 1999 and again in 2000, two studies(one British and the other Swiss)concluded that the link between anageing population and an increase inhealth care expenditure was suspect.The larger of the two studies, that inSwitzerland, found that it was not theage of a patient but their proximity todeath that was the influential factor. Inother words, health care expenditure isconcentrated towards the end of life, andthat the relationship between age andhealth expenditure is weak. However,these findings only consider the medicalor health care expenditures. They do notexamine the cost of social and nursingcare, which is expected to risedramatically as the population under -goes the process of ageing.

Ageing populations andpension provisionIn May 2007, Michelin, the French tyremaker, announced it plans to close itsfinal salary pension scheme to existingand new members in the UnitedKingdom and transfer their funds to amoney purchase scheme. Despite beingattacked by unions for their actions, themanagement of Michelin defended thepolicy stating “factors outside ourcontrol could cause the liabilities toballoon in the future”. They were ofcourse referring to the ageing populationprocess. Examining the accounts of theMichelin pension fund, it can be seenthat there was a significant deficit of£260 million in 2006, as retired workerslive longer and therefore take morepension from the fund.

Michelin are not unique in closing theirfinal salary fund, they join a growing list

1961 ’66 ’71 ’76 ’81 ’86 ’91 ’96 ’01 ’06 ’11 ’16 ’21 ’26 ’31 ’36 ’41 ’46 ’51 ’56 ’61 ’66

75

0

60

45

30

15

%

Figure 2: Ratio of over-60s to 15-60s in the UK

Source: G. Young, ‘The implications of an ageing population for the UK economy’, Bank of England Working Paper, 159, July 2002

5. British Medical Journal, 9 December 2005.6. BBC online, 1 May 2007.

38

S E P T E M B E R 2 0 0 7 39

Many companies are now closing their final

salary pension schemes.

’05-’06

10

0

9

8

7

4

Per

cent

age

of n

atio

nal i

ncom

e

6

3

5

2

1

’10-’11

’15-’16

’20-’21

’25-’26

’30-’31

’35-’36

’40-’41

’45-’46

’50-’51

’55-’56

Housing Related BenefitsPension CreditAttendance Allowance and Disability Living AllowanceOther Pension BenefitsState Second Pension/State Earnings-Related PensionBasic State Pension

Figure 3: Projections of transfer payments to pensioners in the UKas a percentage of national income by benefit type

Notes: ‘Other pension benefits’ comprise winter fuel payments, over-75s’ TV licences, and Christmas bonus; ‘Housing-related benefits’ comprise housing benefit, council tax benefit in Great Britain, rate rebate in Northern Ireland anddiscretionary housing payments. Projections are based on those underlying HM Treasury’s Long-Term Public FinanceReport, 2005.

Source: Department for Work and Pensions, Benefit Expenditure Tables(http://www.dwp.gov.uk/asd/asd4/long_term.asp

of large companies such as HBOS andWH Smith which have also closedtheirs.6

Just as private firms are concernedabout their pension fund provision, theGovernment must also considerthe conse quences of an ageingpopulation on the nationalaccounts. Recently there have beenpartial reforms of final salary publicsector pension schemes which meanthat in pro fessions such as teaching,new entrants now have to work until theyare 65 rather than 60. There has alsobeen a review of the state pension age,leading to a phased increase from 65 to68 years old.

However, the concern amongst someeconomists that the nation will not beable to pay for its retired population isnot universally accepted. In a report

by the Institute of Fiscal Studies, it wasstated that the UK currently transfers6.3% of national income in transfer

payments to state pensioners and thiswill only rise to 8% of national incomeby 2056 as shown in Figure 3. Thissuggests that the payment to eachpensioner will only be 80% of the currentamounts payable. The reason for this isthat reforms of pension provision overthe last twenty years has made them lessgenerous, such as shifting statepensions away from an earning indexapproach to a price index.

SummaryThis article has considered one of themajor economic issues that this countryfaces. Like many of the world’sdeveloped nations, the UK is undergoinga significant ageing population effect.Clearly, there will be widespreadconsequences for the economy,including the effect upon health carespending and pension provision. It ishoped that this article has presented abalanced case, in terms of suggestingthe detrimental effects but alsoexplaining how news headlines on thetopic of ageing populations might paintan overly negative picture.

40 S E P T E M B E R 2 0 0 7

Inward migration tailing off?The Department for Work and Pensions tracks the number ofoverseas nationals that apply for a National Insurance numberin the UK. Without this number migrants would be unable towork legally within the UK or claim benefits. According tofigures published in July 2007 the number of theseregistrations in 2006-07 reached 713,000. This was up 51,000or 7.7% on the previous year. However, this rate of growthwas well down on the rise seen in 2005-06, which was 51%up on the previous year.

The recent trends can be seen in Figure 1.

As Figure 1 shows, Poland is far and away the major sourceof new national insurance registrations, followed by India andthe Slovak Republic. As a number of the former communistcountries of eastern Europe have joined the EU in recentyears, there has been an increased flow of migrants seekingwork in the UK.

On 1st May 2004 ten countries joined the EU and thesewere Poland, Czech Republic, Slovakia, Hungary, Slovenia,Latvia, Lithuania, Estonia, Malta and Cyprus. This wasfollowed by Bulgaria and Romania joining on 1st January2007. There were 321,200 registrations from these accessioncountries in 2006-07, which made up 45% of all registrations.But the influx from these countries appears to be tailing off.

However, when looking at the total number of economicmigrants, we have to take account of those here illegally. Areport published by the Institute for Public Policy Researchthis year argued that half a million illegals in the UK should beallowed to stay, as the cost of deporting them would be£4.7bn and take 30 years, whilst they would be paying £1bnper year to the Treasury if they were allowed to stay. The UK government itself has said that there could be up to570,000 illegal immigrants in the UK but a pressure group,MigrationWatch UK, estimates that the total could be as highas 870,000.

Only here for the hand outs?According to the Department of Work and Pensions, of the562,000 arrivals into the UK in 2005-06, only 16,000 or 3%,were actually claiming any type of out-of-work benefit withinsix months of registration.

A report by professional services company Harvey Nash inconjunction with the Centre for Economic and BusinessResearch in November 2006, suggested that dispensing withthe UK’s migrants would cost us approximately £54bn. This isthe estimate of the additional value added by migrants to theeconomy. The report noted that the benefits supplied werenot only in terms of plugging skills gaps, but through themultiplier effect of their consumer spending. It was also notedthat over 30% of NHS nursing roles are held by recentmigrants to the UK.

Also, according to John Philpott, chief economist of TheChartered Institute of Personnel and Development (CIPD):“On balance, the benefits (of immigration) have outweighedthe cost, mainly because a bigger pool of foreign labour hashelped keep wage inflation in check and enabled a faster rateof economic growth than would otherwise have beenachieved. CIPD research shows that a third of UKorganisations employ workers from EC accession countries.Many (employers) point to their willingness to work as well astheir skill levels as key reasons for hiring them.”

Although the UK has put strict limits on migrant entry fromthe two new EU states of Bulgaria and Romania, it wouldappear on balance that the UK is continuing to gain frominward migration although future growth in numbers willprobably be reduced.

Inward Migration begins to SlowIn this occasional feature, Nigel Tree looks at the economicsignificance of inward migration into the UK.

800

’02-’03

Total (’000)

600

400

200

0’04-’05

’06-’07

’03-’04

’05-’06

Poland

India

Slovak Rep.

Pakistan

Australia

Lithuania

France

South Africa

Germany

China

0 50 250100 150 200

Top 10 countries in 2006-07(’000)

Source: Department of Work and Pensions, Financial Times, 25 July 2007

Figure 1: Overseas nationals entering the UK andallocated a national insurance number

Over 30% of all economic migrants are currently from Poland.

Nigel Tree

In this supplement we look at the majorchanges in the UK economy over the

past year and their likely impact on theUK’s economic future.

Economic GrowthAfter three years of increasing growth rates the UK economy slowed to 1.8% in 2005 but then recovered to 2.8% in2006, as can be seen in Figure 1.

The economy continued to grow in 2007 with growth of 0.7% in the first quarter of 2007 and 0.8% in the secondquarter. Compared to the second quarter of 2006 this meant a rise in GDP of 3%. This increase reflected a bounceback in the manufacturing sector with the production industries growing 0.6% in the second quarter. However, theservice sector which accounts for 74% of the UK economy and has been the dominant factor behind recent growth,was up 0.8% – although this was slightly down on the previous two quarters. Figure 1 shows that the government iscurrently forecasting a growth rate for 2007 of between 2.75-3.25%.

One significant fact is that the economy has been growing above its trend rate of growth for six consecutive quarters.The trend rate of growth is a figurecalculated by the Treasury which shows therate at which output can grow, on asustained basis, without exerting anyinflationary pressures. This is based ongrowth in output per hour, which is ameasure of productivity, growth in averagehours worked and changes in theemployment rate and the size of theworking-age population. This figure iscalculated by the Treasury to be 2.75%. Ithad previously been at 2.5% but was revisedupwards in 2006 due to increases inproductivity and the impact of inwardmigration.

What are the implications of the economy running above its trend figure? A major implication concerns the amount ofspare capacity in the economy which can be measured using the output gap. This can be defined as the differencebetween the actual level of GDP and its estimated level, shown as a percentage of the latter figure. This can be seen inFigure 2.

According to the Treasury there was a smallnegative output gap running from the firstquarter of 2005 to the first quarter of 2007,since when the output gap has beenforecast to be zero and to continue at zero.A negative output gap means the economyhas spare capacity but a positive gap wouldshow signs of labour shortages, inflationand overheating in the economy. A zero gapshows that the economy has very littlelatitude and that continued strong growthwill build up inflationary pressure.

The Bank of England has responded byraising interest rates five times since August2006. There is a possibility of at least one

more rate rise before the end of the year, but whether this, coupled with the rise in the value of sterling will serve toput a brake on growth and inflation remains to be seen.

InflationIn 2004 the government changed its primary target for inflation. Prior to that it had targeted a measure called RPIX,which was the Retail Price Index excluding interest payments, which was know as underlying inflation.

However, in 2004 the Chancellor fell into line with the inflation measure most widely used in the EU and introducedthe Consumer Prices Index. In fact, the index used within the EU is known as the Harmonised Index of ConsumerPrices (HICP). The Monetary Policy Committee of the Bank of England has been set a target of keeping the CPI within

2 The Economy Today Economics Today Supplement – September 2007

Figure 1: Economic growth: annual change in gross domestic product (%)

Source: ONS

4

5

3

2

1

0’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09

Forecast ranges

Forecast

Figure 2: The output gap (%)

Source: HM Treasury

2

4

0

-2

-4’90 ’92 ’94 ’96 ’98 ’00 ’02 ’04 ’06 ’08 ’10 ’12

Forecast

one percentage point of 2%. How well theyhave fared can be seen in Figure 3.

It can be seen from Figure 3 that the CPIrose fairly steadily from March 2006, whenit was below the 2% target, to December2006 when it reached 3.0%. This was a risefrom 2.7% in November and was the fastestrate at which prices have been rising for 11years. The main reasons for the rise wererising petrol prices and increased furnitureprices which rose by a record 8.7%.

The CPI then fell in January but rose to 2.8%in February and then reached 3.1% inMarch. Again this was due to a 10% monthlyincrease in furniture and furnishings and anincrease in petrol. However, the major significance was that this breached the one percentage point either side of 2%barrier, and forced the Governor of the Bank of England to write an explanatory letter to the Chancellor. See thesection on Monetary Policy and Interest Rates below for more details.

After March prices started to fall steadily,reaching 2.5% in May and 2.4% in June2007, mainly due to falls in gas andelectricity bills. Figure 4 shows the changesin goods and services price inflationcompared to the CPI itself. It can be seenthat inflation in the service sector is at amuch higher level, reaching 3.7% in June2007, but that increases in goods priceshave risen rapidly up to March this year, butfell back over the next three months to reach1.4% in June.

In a speech in June 2007, Mr King, Governorof the Bank of England, said that he feared inflationary pressures might provepersistent and that the 2% CPI target mightbe hard to hit, unless there were falls inbusiness and consumer spending and thegrowth of the money supply.

Economics Today Supplement – September 2007 The Economy Today 3

Figure 3: Annual inflation rates, 12 month percentage change

Source: ONS

5

6

4

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0Jun’05

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Sep Dec Mar’06

Jun Sep Dec Mar’07

Jun

RPICPI

Figure 4: Inflation in goods and services

Source: Bank of England

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Per

cent

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chan

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on a

yea

r ea

rlier

2002 2003 2004 2005 2006 2007

6

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Electricity and gas bills have started to fall.

EarningsIn March 2007 it was announced that the national minimum wage would be raised for more than one million workersby 3.2% from October 2007. This would give an increase in the adult minimum wage rate from £5.35 to £5.52 perhour. The chairman of the Low Pay Commission which recommended the rise said that it had decided upon a more‘cautious’ approach this year because it was felt that a larger rise would hinder the growth in jobs.

This was the first year since 2002 that the increase in minimum wage lagged behind the growth in average earnings.In fact, since 2002 the minimum wage had increased by 27% compared with a rise of only 17% in average earnings.

Figures published in June 2007 which canbe seen in Figure 5, show that Britain’sminimum wage is the third highest out of20 EU countries. The UK rate is belowLuxembourg and Ireland, but is twice therate in Spain and the US. What is interestingis to see what percentage of the populationis covered by these monthly figures. Whilstonly 1.8% of UK employees receive theminimum wage, this figure rises to 11% inLuxembourg and 16.8% in France.

In January 2007 pay settlements rose totheir highest level for six years, with themedian level of settlements rising to 3.5%

in the three months to the end of January. Pay settlements had not reached this level since 2001. These settlementshave served to raise the level of average earnings far above the level of CPI inflation, and the recent trend can be seenin Figure 6.

The Governor of the Bank of Englandwarned in January that the Bank would actto ensure that “self-defeating” pay rises“did not lead to a persistent rise in inflation.”However, the spring pay round was a moremodest one with the result that averageearnings excluding bonuses, or regular pay,rose by 3.5% in the year to May 2007. Thiswas down on the 3.6% recorded in April.

Private sector pay deals have been runningwell ahead of settlements in the publicsector, with average earnings rising at just below 5% in March 2007, compared with just above 3% in the public sector. The biggest pay rises have been in privatesector firms which are heavily unionised,particularly in the electricity and gas sectors,but also for network rail and BT staff.


Average earnings have been rising faster than inflation.

Figure 5: National Minimum Wage January 2007

Source: Eurostat

Country Monthly % EmployeesRate (€) Receiving

Luxembourg 1,570 11.0Ireland 1,403 3.3UK 1,361 1.8Netherlands 1,301 2.2Belgium 1,259 n/aFrance 1,254 16.8Greece 668 n/aSpain 666 0.8Malta 585 1.5Slovenia 522 2.8

Figure 6: Comparison of growth in average earnings and CPI (%)

Source: ONS

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5

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2

1

0May’05

Aug Nov Feb’06

May Aug Nov Feb’07

May

Including bonusExcluding bonusCPI

Monetary Policy and Interest RatesBetween August 2006 and July 2007 the Monetary Policy Committee of the Bank of England made five increases ininterest rates, raising them in quarter-point increments from 4.5% to 5.75%. Recent changes in interest rates can beseen in Figure 7.

The reasons behind the rises was to counter a persistent surge in inflation which peaked at 3.1% in March 2007, andled to the Governor of the Bank of England, Mervyn King, having to write an explanatory open letter to the Chancellor,explaining why inflation had been allowed to slip from the parameters set down.

The Bank’s concern is whether the recentincreases in interest rates will be sufficientto slow domestic demand. Whilst there has been a fall in utility prices consumerspending on the high street has beengathering pace. Consumer spending rose by2.1% in 2006, compared with only 1.5% in2005, and was growing at 3% in the firstthree months of 2007. How can this bewhen household disposable income is at itslowest level for 25 years, as can be seen inFigure 8.

It looks as though consumers are not‘maxing out’ their credit cards but areinstead running down their savings. In fact,the household saving ratio, defined as theproportion of disposable income not spentby consumers, fell to 2.1% in the firstquarter of 2007, which compares with 3.9%in the last quarter of 2006. In fact this latestfigure represents the lowest saving ratiosince the start of the 1960s.

One major concern for the Bank is whetherinflationary expectations have settled at alevel above the Bank of England’s target. Aslittle is known about how such expectationsare formed, the Bank is obliged to actquickly before a more prolonged slowdownis required to get inflation down.


The Bank of England raised interest rates five times in twelve months.

Figure 7: Changes in Bank of England Base Rates (%)

Source: Bank of England

8

7

6

5

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3’07’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06

Figure 8: Real household income and expenditure (Annual Percentage Change)

Sources: Thomson Datastream; ONS, from Financial Times, 3/8/07

6

7

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2000 2001 2002 2003 2004 2005 20072006

Household disposable incomeConsumer spending

There is also a concern about the currentlevels of money supply growth. In the yearto March 2007, the broad measure ofmoney, M4, grew by 12.8%. This can beseen in Figure 9.

Some UK monetarists believe that this couldhave a significant upward effect on inflationin the next 12-18 months. However, this issomething of a chicken and egg situation. Itis very difficult to determine whether therise in the amount of money swishingaround the economy is due to demand orsupply. Some economists believe that easyaccess to money is encouraging spendingand will therefore be inflationary. Others

hold that it is an increased demand for money which is being accommodated by monetary growth. This debate willcontinue.

Charles Bean, the Bank of England’s chief economist, said in a speech in June that on the positive side there are threereasons why a situation where demand was outstripping supply might not lead to increasing inflation. Firstly,globalisation has created intense competition between markets and stopped domestic retailers freely raising prices.Secondly, the competition which is coming from India and China should stop workers pushing for above inflationwage rises, as they will be concerned about losing their jobs overseas. And, finally, the current rate of inward migration

is giving firms access to relatively cheaplabour which removes the need for them toraise wages to attract workers.

However, Mervyn King has suggested thatborrowers should expect even higher ratesof interest before the end of 2007 unlessbusiness and consumer spending slows andinflationary pressures abate.

Taxation, Expenditure andGovernment BorrowingIn May 2007 the Chancellor, Gordon Brown,presented his 11th and final Budget, beforetaking the post of Prime Minister. TheBudget was basically a fiscally neutral one.Mr Brown did cut the rate of income tax by2p to 20p in the Pound which will cost theTreasury £9.6bn by 2009-10, but at thesame time abolished the 10p lower rate oftax and increased the upper limit of nationalinsurance contributions, which would clawback £8.6bn. A similar 2p cut in corporationtax from 30p to 28p will cost £2.23bn, butat the same time a change in capital reliefswill bring in an extra £2.31bn.

Total public spending is expected to bearound £587bn in 2007-2008 which will beoffset by total receipts of £553bn. The£34bn difference will have to be made upby borrowing. Figure 10 shows where taxpayers money is coming from and where itwill be spent.


Figure 9: UK money supply growth. Annual % change in M4

Source: Thomson Datastream

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2’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07

14

12

10

8

6

4

Figure 10: Planned government receipts and expenditure, 2007-2008

Source: HM Treasury

Other expenditure £59bnHousing andenvironment £22bn

Social protection £161bn Public orderand safety £33bn

Industry, agriculture,employment andtraining £21bnDebt interest £30bn

Defence £32bn

Education £77bn

Transport £20bn

Health £104bn

Personal socialservices £28bn

Where taxpayers’ money is spent

Business rates £22bn

VAT £80bnOther £84bn

Corporationtax £50bn

Excise duties £41bn

National insurance £95bn

Income tax £157bn

Council tax £23bn

Where taxes come from

Total managed expenditure: £587 billion

Total receipts: £553 billion

The government had forecast in the Budgetthat net borrowing would be £35bn in2006-2007, but because of an underspendby government departments the actualfigure was only £30.5bn. This can be seen in Figure 11 together with the forecastborrow ing requirements for the next fiveyears.

Although the government has reducedcorporation tax, the UK is still charginghigher rates than most European countries,as can be seen in Figure 12.

According to the Confederation of BritishIndustry the UK’s corporate tax system isboth complex and unpredictable as to thefinal tax burden. They claim that it is“damaging the prospects of the UK as aplace to do business.”

The average EU corporate tax rate is 25%and some UK companies are moving theirdomicile to lower rate countries. Thequestion is whether globalisation is makingit more feasible for multinational companiesto gravitate towards countries with thelowest tax rates.

In fact, the UK treasury has seen the amounttaken by corporation tax rise from £32bn to£48bn over the past five years, and everypercentage cut in the corporation tax ratewould only cost the exchequer £1.5bn.Some analysts have suggested that therewill be a race to the bottom in Europe, withtax rates falling to around 15%. However,as far as the UK is concerned we are stillseeing a large chunk of inward investmentcoming into the country (see Figure 13)which has not been put off by our highertax rates. And, it is very expensive for acompany to move lock, stock and barrel toanother country plus there is a risk ofdamage to its reputation if it is not in a majorfinancial centre.

Labour MarketsThe labour market continues to show signsof tightening, with employment rising,unemployment falling or remaining stable(depending on which measure is used) and the number of vacancies increasing.However, given the fact that averageearnings are increasing at only a moderaterate it seems that there is still some slackleft in the market.


Figure 11: Public sector net borrowing (£bn)

Source: HM Treasury

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’05-’06

’06-’07

’07-’08

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’10-’11

’11-’12

Forecast

Figure 12: Combined corporate income tax rate for selected Europeancountries (%)

Source: OECD40302010

Germany

0

Italy

UK

Netherlands

Denmark

Finland

Austria

Czech Rep.

Switzerland

Poland

Slovakia

Iceland

Hungary

Ireland

Spain

France

Belgium

Figure 13: UK share of European inward investment (%)

Source: Ernst & Young European Investment Monitor

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The number of people in employment in the three months to the end of May 2007 was 29.08m. This reflects anincrease of 93,000 over the quarter and 180,000 over the previous year. This gives the highest figure for those inemployment since records began in 1971, partly fuelled by immigration. The employment rate, as a percentage of theworking population, was 74.5% in the three months to the end of May.

There are two measures of unemployment. The Labour Force Survey measure shows an unemployment rate of 5.4%which is unchanged over the year. However, the number of unemployed fell by 35,000 over the quarter ending in May2007, but increased by 2,000 over the year to reach a total of 1.66m.

The claimant count measure of unemployment shows a much healthier picture. In June 2007 it measured 864,100,which was a fall of 13,800 over the previousmonth and 91,100 over the year. This meansthat the claimant count has fallen for elevenof the previous twelve months. The recenttrends in employment and unemploymentcan be seen in Figures 14 and 15.

The reason that the claimant count may befalling could be due to the fact that therewas a large increase in the demand for part-time workers in 2006 which has now fallen.Many of these workers were not previouslyin the labour market, and many of themwere women or were previously retired, andmay be unwilling or unable to claimunemployment benefit.

There is also evidence that the number ofpeople working past the state pension ageis now at record levels. Half of the increasein employment in the 12 months to the endof May 2007 was accounted for by men over the age of 65 and women above theage of 60. There are now 1.2m people ofpensionable age working in the economyand two-thirds of these are women.

However, according to The Age andEmployment Network, many of theseworkers are taking jobs which are belowtheir qualifications and abilities, whichamounts to a waste of resources.


© Economics Today Ltd. ‘The Economy Today’ is a free supplement published with the September 2007 issue of Economics Today.Economics Today Ltd., Stocksfield Hall, Stocksfield, Northumberland NE43 7TN.

Figure 14: Unemployment (000s)

Source: ONS

1,200

1,100

1,000

900

800

700

1,800

1,200

1,700

1,600

1,500

1,400

1,300

’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07

Claimant count (LHS,000s)ILO (RHS, 000s)

Figure 15: Employment as a percentage of the working population

Source: ONS

75.0

74.5

74.0

73.5

73.0

72.5

72.0

71.5

71.0

70.5

70.0’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07’99’98’97’96’95’94’93

The number of those in employment is up180,000 over the previous year.

WHAT IS OPPORTUNITYCOST?

SHOULD SMOKERS BEMADE TO PAY EXTRAFOR USING THE NHS?

IS THE INDIANRESTAURANT MARKETAN EXAMPLE OFMONOPOLISTICCOMPETITION?

ECONOMICS OF THE INTERNETThe Market forBroadband

BACK TO BASICS:Taxes and Subsidies

As an economy nears full employment will inflation have to increase?

IN THIS ISSUE:


�


September 2007

Volume 15 · Number 1

T H E E S S E N T I A L M A G A Z I N E F O R ‘A’ L E V E L E C O N O M I C S

etE C O N O M I C S T O D A Y

et


T H E E S S E N T I A L M A G A Z I N E F O R ‘ A’ L E V E L E C O N O M I C S

etImprovement in the Balance of Trade

Balance on Balance on Totaltrade in goods trade in balance

services

EU Non-EU World

2007 Jan -3.0 -3.7 -6.7 2.8 -3.92007 Feb -2.9 -4.1 -7.0 2.8 -4.12007 Mar -3.3 -3.9 -7.2 2.8 -4.32007 Apr -3.3 -3.9 -7.1 2.8 -4.32007 May -2.9 -3.5 -6.4 2.7 -3.72007 Jun -2.9 -3.4 -6.3 2.7 -3.6

Seasonally adjusted, £ billion

The UK’s deficit on trade in goods and services

was £3.6bn in June 2007, which was a marginal

improvement on the £3.7bn deficit in the previous

month, and was the narrowest deficit for 20 months.

This deficit was made up of a surplus on trade in

services of £2.7bn, and deficit on trade in goods of

£6.3bn. There was an increase in exports of £0.9bn in

May and rise in imports of £0.7bn.

Although these figures show only marginal changes

and are subject to revision the trend line shown in the

chart above does emphasise a gradual improvement

in the UK trade deficit over the past 15 months. What

is particularly pleasing is the improvement in exports

even though the value of sterling has continued to rise

on foreign exchange markets. There was also a

surprising increase in the output of North Sea oil, with

the UK recording a surplus on oil in June to the tune of

£257m compared with a deficit of £76m in May.

The table above shows that the deficit on trade in

goods with the 27 countries of the EU was £2.9bn in

June, whilst the deficit with the rest of the world has

diminished over the past five months to fall from £4.1bn

to £3.4bn.

The deficit on the balance of trade in goods and

services was the equivalent of -4.9% of GDP in the

second quarter of 2006, but this had improved to

-3.7% of GDP in the first quarter of 2007. One thing to

look out for is whether global demand for UK exports

continues at its current level. If this slows down then it

may put a brake on the UK’s economic growth.

0

-0.5

£ b

illio

n

-1.0

-1.5

-2.0

-2.5

-3.0

-3.5

-4.0

-4.5

-5.0

-5.5

-6.0

-6.5A M J J A S O N D J F M A M J

2006 2007

Trend

Source: ONS

For

AS StudentsPrize Competitionfor AS Students

Smokers and the NHSRead the article on ‘Should Smokers be made to Pay Extra for Using the NationalHealth Service?’ on pages 14 to 18 and then answer the questions. The numbers inbrackets tell you how many letters there are in each word of the answer. All you haveto do is send your 10 answers to us by 14th December 2007. The first out of the hatwill win £25 in music tokens.

1. We will get this when firms produce using a minimum amount of factor inputs perunit of output. (10,10)

2. A free market or market economy in which there are economic inefficiencies willsuffer from _ _ _ _ _ _ _ _ _ _ _ _ _ . (6,7)

3. What type of good is health care? (5,4)

4. The demand curve for health care reflects the benefit that the consumer believesthey will gain from consumption and is called the _ _ _ _ _ _ _ _ _ _ _ _ _ _ __ _ _ _ _ _ _ . (8,7,7)

5. The free market equilibrium for health care fails to take into account the _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ which is also known as the marginal externalbenefit. (8,11)

6. An equilibrium which takes into account both the private benefits and the externalbenefits is known as the _ _ _ _ _ _ _ _ _ _ _ _ _ . (6,7)

7. What is it called when smokers inflict these onto third parties through passivesmoking? (8,13)

8. If the government imposes taxes such as VAT and excise duties onto theproducer, how will this shift the supply curve? (10,7)

9. Because smoking rates have declined fastest among higher income households,a charge on smokers to use the NHS would be _ _ _ _ _ _ _ _ _ _ . (10)

10. A large number of western countries and the USA have a system of _ _ _ _ _ __ _ _ _ _ _ _ _ _ to pay for health care. (6,9)

Send your answers to: Economics Today Ltd., Stocksfield Hall, Stocksfield,Northumberland NE43 7TN, marking your envelope ‘Prize Competition’.

The winners of our two competitions in the January 2007 edition were Ms E. Wade ofEssex and Mr A. Gopee of London. The winners of our two competitions in the March2007 edition were Pamela Ei-Leen Yeung of London and Natasha Footman of St Albans.

£25 in musictokens to be won!

Prize Competitionfor A2 Students

For

A2 Students

£25 in musictokens to be won!

Full Employment and InflationRead the article on ‘As an Economy nears Full Employment will Inflation have toIncrease?’ on pages 2 to 6 and then answer the questions. The numbers in bracketstell you how many letters there are in each word of the answer. All you have to do issend your 10 answers to us by 14th December 2007. The first out of the hat will win£25 in music tokens.

1. If labour supply equals labour demand, what is the only type of unemploymentthat exists? (9,12)

2. What is it called when inflation and unemployment both rise at the same time? (11)

3. This exists in the economy if there is an output gap. (5,8)

4. A.W. Phillips found a significant relationship between the level of unemploymentand this other variable. (3,4,2,6,2,5,5)

5. Demand management to reflate the economy means trying to adjust the level ofAggregate Demand nearer to this. (4,10)

6. As unemployment falls there is a risk that an economy may suffer from this. (6,9)

7. Monetarist economists adapted Phillips’ model after the 1970s to create this. (12,9,8,5)

8. Workers will suffer this if nominal wages have risen but real wages have not. (5,8)

9. According to monetarist economists the Long Run Phillips Curve will be this atthe natural rate of unemployment. (8)

10. One reason why accelerating inflation is not inevitable is that if these can bereduced wage demands will fall. (5,12)

Send your answers to: Economics Today Ltd., Stocksfield Hall, Stocksfield,Northumberland NE43 7TN, marking your envelope ‘Prize Competition’.

The winners of our two competitions in the January 2007 edition were Ms E. Wade ofEssex and Mr A. Gopee of London. The winners of our two competitions in the March2007 edition were Pamela Ei-Leen Yeung of London and Natasha Footman of St Albans.

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