Economic Terms

When the structure of an economy changes because activity shifts from the secondary to the tertiary sector.

The amount of a good or service consumers will buy at any given price over a certain period of time.

Below is a diagram to show the demand curve for a good in a specific goods market.

 

 

A curve (typically drawn as a straight line) which shows the amount of a good or service consumers would buy at any given price. The inverse relationship between the price and quantity demanded of a good or service is explained by the 'Law of Demand'.

When there is demand for a good that is cheaper but satisfies the same wants or needs as another good.

A demand curve movement is created when the price of a good or service, that the demand curve represents, changes. Because of the inverse relationship between the price and quantity demanded of a good, when the price of a good falls the quantity demanded rises, whilst in the case of a price rise the opposite occurs. This i all subject to the law of demand. If any non-price factor changes then this causes the demand curve to shift at every given price.

 

An increase in the price level due to a positive shift in the aggregate demand curve i.e. prices rise as demand pulls the AD curve up the supply curve.

The increase in AD can arise from any positive changes in: consumption, investment, government spending or net exports.

Below is a set of diagrams to highlight the two different approaches to showing demand-pull inflation in an economy. The Keynesian AS curve provides a clearer path to evaluating the impact of demand curve shifts on the inflation rate. In the classical case, the inflation is created by an outward AD shift with no change in the SRAS curve assuming ceteris paribus.

However, when evaluating this type of inflation it is important to understand the main cause of the positive AD shift. This is because if the AD shift was caused by increased consumption brought on by higher consumer confidence, then it is likely to create an inflationary spiral, in which real output remains unchanged but the price level increases significantly. This is essentially an inflationary movement up the LRAS curve without any real gains for economic agents. However, if the AD curve shift was brought about through higher investment, this is likely to have strong productivity links to the economy (e.g. increase in rate of capital accumulation). As a result, it can create pressure for the LRAS curve to outwardly shift and the economy goes through a period of disinflationary growth. So it is important to consider what factor has driven the demand-pull inflation to evaluate its impact on the performance of the economy. 

 

Also the degree and extent of demand-pull inflation introduced in the economy from an AD shift depends crucially on the level of spare capacity in the economy. This Is because if an economy is at or close to full capacity, majority of the economic resources (e.g. factors of production) are in use. Therefore, any increase in demand creates pressure on an economy's existing endowment of resources to produce a higher level of output. It is this that creates the inflationary pressure for prices to rise as factors of production demand higher rewards for the increase in effort and work they have to put in to produce the extra output. This causes the economy to overheat and creates significant rises in prices.

However, when an economy has a significant level of spare capacity (significant amount of unemployed resources) an increase in demand and output does not put pressure on the existing set of resources currently employed, as firms can increase the amount of economic resources they employ in their production to fuel the higher output. This means the strain on the economy is lessened and the inflationary pressures are not as severe. This explains why the Bank of England closely monitor labour market data when making a decision on setting the base rate, in order to control inflationary pressures (e.g. the lower the unemployment rate, the greater the chance an increase in economic activity stokes inflation).

To illustrate the impact of spare capacity on inflationary pressures, it is best to use the Keynesian AS curve. 

Changes in taxation or expenditure that are designed to influence (positive or negative) AD in the economy. 

There are two types of demand side fiscal policy:

• Contractionary Fiscal Policy - shifs AD curve to AD_2.
• Expansionary Fiscal Policy - shifts AD curve to AD_3.

This a major economic event that leads to a shift (positive or negative) in the AD curve. The event is often sudden and unexpected e.g. credit crunch leading to a demand-side shock due to an almost immediate reduction in credit availability.

Occurs when a firm decides to sell off a part of its operations in order to focus on core products, remove any diseconomies of scale, meet new regulations or meet changes in demand. This highlights that buinesses do not always decide to grow.

A good that is over-provided by the market and as a result becomes over-consumed by consumers. Tobacco, alcohol and fast food are all examples of this type of good. This is the opposite of a merit good.

The market failure created in these types of goods is caused by a divergence between the marginal private benefit and the marginal social benefit curves. This is because when individuals consume demerit goods it releases negative consumption externalities onto society. As a result, this means that the MSB curve always lies below the MPB curve and this leads to the good being over-consumed in the market. For instance, individuals that smoke cigarettes enjoy the private benefits of smoking - the satisfaction they receive from smoking today. However, it also creates several external costs, which get passed onto society (third parties) that perhaps - due to the presence of imperfect information - the smoker does not acknowledge. The external costs of smoking include: second hand smoke, smell of cigarettes and the strain it puts on a country's health service as a result of smokers developing diseases later in life such as lung cancer. It is the fact that the smoker underestimates the long run health problems they could face from smoking, which creates the over-consumption of the good.

Below is a diagram to show an example of a market for a demerit good:

It is important to consider that not all goods which create a negative externality can instantly be recognised as a demerit good. Because classing a good as a demerit good depends on the valued judgement of the consumer i.e. smokers may not class cigarette as a demerit good.

As these types of goods always create negative externalities the government will try to intervene in the market to either reduce or eliminate the externality and the dead weight loss triangle, increasing welfare in the process. The ability to implement these policies and more importantly the effectiveness of them depends on how large the externality in the market is. For some goods, the magnitude of the externality is greater than other goods and this means the level of government intervention needs to be larger as a result. For instance, in markets such as the drugs market, government impose outright bans on the good as the externality imposed on society is so large. However, if the negative externality is smaller, then the government can use an indirect tax or educational policies to internalise the externality.