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Economic Terms

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Goods that satisfy similar needs and may be consumed as an alternative to another good e.g. olive oil spread instead of butter.

Substitution effect

When the demand for a good changes after a price change because any substitute good will become more or less attractive if their price does not change by as much.

Sunk Cost

Costs which cannot be recovered if the firm decides to leave the market.

Below is a list of examples that can lead to unrecoverable costs arising. When firms invest in capital, this capital is subject to depreciation and as a result this piece of capital loses its value over time. This is unrecoverable as there exists no firm that would be willing to buy this unit of capital at its original price as it has depreciated over time. Advertising costs are also unrecoverable as these costs never get made back, indirectly it may help boost the firm's level of profit but the firm can never make this money back. Finally niche pieces of capital that are uniquely built for the specific production process of a firm are unlikely to provide any value and use to other firms and hence this capital cost can never be recovered as it can never be re-sold.


Supernormal Profit

Often called abnormal profit, is when a firms total sales revenue exceed the total costs of production i.e. they are earning a profit above and beyond the level of normal profit. This is the level of profit that a firm can enjoy after meeting the main production costs.

The diagram below illustrates how a monopolist exploits its monopoly power to enjoy supernormal profits. By charging a price above the marginal cost the monopolist extracts a level of sales revnue equal to the blue shaded box (P*Q). However, this is not the level of profit that firms receive as they have to cover the costs that go towards producing this product i.e. normal profit. Once the costs have been taken away from the sales revenue, any revenue left over is counted as supernormal profit - as this is the money that firms are able to use flexibly for any part of the business.


The amount of a good or service firms plan to supply to the market at a given price over a certain period of time.

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

Supply side economics

Issues that impact the supply of goods and services in the economy. This covers a wide range of issues including business taxes, education, migration, support to encourage research and development, subsidies and grants for vulnerable industries and businesses and laws regulating economic activity.

Below is an example of the two schools of thinking behind supply-side economics. The first is the classical view that there is a shift in the LRAS curve which expands the productive capacity of the economy. Then there is also the keynesian viewpoint that the supply curve which has many elasticity points shifts outwards.

Supply side fiscal policy

Government policies and initiatives that aim to increase the productive capacity (supply side) of the economy. The policies will shift long run supply curves to the right and are important to produce sustainable economic growth.

Below illustrates an expansionary supply-side policy which has successfully caused the LRAS curve to expand and therefore produce a form of sustainable growth as the productive capacity of the economy has expanded preventing any inflationary problems.

Supply Side Policy

Initiatives that are intended to increase the economy's ability to produce goods and supply goods and services by creating incentives for economic agents to work, save, invest and be entrepreneurial i.e. increase the productive capacity of the economy.

The type of supply side policies implemented depends on the economic school of thought policymakers belong to. There are two types:

  • Free Marketeer
  • Interventionist

These initiatives if implemented in the economy, will create an expansion in the supply curve in the long-run, from a classical perspective this will be an outwards LRAS curve shift and in the Keynesian case it will be an expansion in the Keynesian aggregate supply curve. 

Assuming ceteris paribus, from both economic schools of thought the impact on the macroeconomic equilibrium will be for the price level to fall (inflation decelerates) and real output to increase.

These policies will help the government achieve some of their macroeconomic objectives in the long-run. Inflation will be lower as the economy becomes more efficient and productive and this helps drive costs down. Deregulation is an example of a supply side policy which can help remove constraining regulations on firms, reducing their costs. The lower costs incentivise firms to produce more and eventually these get passed onto consumers. Hence the reduced inflationary pressures in the long-run

Economic growth becomes sustainable as there is an increase in the productive capacity of the economy, which means resources do not become stretched despite higher output. For instance, privatisation can increase the size of the private sector and this will increase the level of entrepreneurial activity in the economy. This enterprise fuels hgreater economic activity without the onset of inflationary pressures. 

Unemployment is reduced as supply side policies can help remove labour market frictions and also improve the level of labour mobility in the economy. For instance, a policy to increase spending in education and training to improve skills and flexibility, will lead to long-run gains in labour productivity, which ultimately makes workers more valuable to employers. These policies in the long-run help to reduce the natural rate of unemployment.

It is important to also consider the impact that supply side policies have on the current account on the balance of payments for a country. If the economy increases its productive capacity, the lower price level will increase the competitiveness of a country's exports and this in turn should lead to an improvement in the current account position of a country. But this is subject to a few other factors such as: relative inflation rate with other countries, PED of imports and exports and the significance of the decelerating inflation rate.

However, as with the case of other economic policies, the impact and effectiveness of supply side policies on the real economy is not always an exact science. So you need to be able to evaluate these policies when dealing with an exam answer. The evaluation points around supply side policies relate to:

  • Magnitude and duration of impact?
  • Timing of impact?
  • Certainty of impact?
  • Ease of administration?
  • Equality impact?

For instance, certain supply side policies can involve significant time lags and therefore the duration and timing of the impact can depend on the type of policy implemented. For example, policies targeted towards education and training - which aim to increase the level of human capital - are likely to take 10-15 years to feed through benefits to the economy and therefore unemployment may not be significantly affected.

Also, supply side policies can be difficult for the economy to implement compared to a conventional monetary policy, in which a decision to change interest rates can be made monthly. 

Supply side policies can also have an adverse impact on the distribution of income and wealth because these policies can create a greater divergence between the wealthiest and poorest individuals. 

Therefore, as a result of some of these uncertainties, supply side policies are normally used to complement demand side economic policies (monetary and fiscal policies) to reach the desired outcome of the government i.e. sustainable economic growth. 

Supply side shock

A sudden, unexpected and significant change in the cost of a factor of production, such as changes in wage rate, commodity prices or taxes, that causes a shift in the aggregate supply curve.


In the diagram below this displays a negative supply shock in which causes the supply curve to shift inwards and this creates a negative output gap. This could of been caused by an increase in the price of a key raw material used in the production process to produce this type of good.


Sustainable economic growth

An important term indicating a rate of economic growth, which will continue in the long run and is unlikely to fall back to a lower level in a short period of time.

Below are a set of diagrams to show the impact that sustainable economic growth has on an economy. In this instance, the sustainable part of the term refers to the fact that the growth and higher output should be able to be maintained because of the increase in the productive capacity, like at point D. As a result no inflation is created.

If this LRAS curve shift was not achieved then the economy would be in a boom position. This boom period is temporary because the economy cannot continue to produce output equal to Y2, as they have insufficient resources to do so. Eventually, pressures on the factors of production (e.g. labour) forces the cost of production up (e.g. wages) and these higher costs gets passed onto the consumers via higher prices. The price level in the economy adjusts to P3 to take pressure off the economy.

In a data response question it is important to be able to decipher whether the introduction of an economic policy creates unsustainable or sustainable growth. This will help you evaluate the impact of the policy on the important macroeconomic variables.

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