Economic Terms

The sum of all the variable costs of production, such as materials, wages and transport.

Below is a diagram to show an example of a total variable costs curve for an individual firm. As can be seen this curve is linearly increasing at a proportionate rate because these costs are linearly increasing when more output is produced and therefore this line will indefinitely continue until the firm either has a reduction or increase in the amount of variable payments such as the amount each worker is paid or ho many workers they decide to hire.

Trade creation is the term given to the increase in economic welfare that comes from a removal/reduction in trade barriers between countries. The increase in economic welfare is stimulated by a reduction in the price at which goods can be imported into the economy. Lower prices enable consumers to purchase and import more and result in consumption increasing (welfare gain). The efficiency of the market also improves due to inefficient domestic production being replaced, to some degree, by production from the most efficient producers. This improvement in efficiency, in turn, benefits the consumers in a particular market (welfare gain).

It is important to be able to visualise the impact of trade creation on any particular market which is subject to trade barriers. Below is the market for a particular commodity, with the welfare implications under an import tariff and under free trade (removal of tariff):

The removal of the import tariff forces the world supply curve of the commodity back down to S_W and forces the price down to P_W. At this price, foreign producers have more influence over the domestic market and more foreign goods are imported by domestic consumers (Q_D - Q_S). The welfare implications of this are that the two deadweight loss triangles are eliminated and transferred to consumers via an increase in consumer surplus (due to an increase in quantity demanded and a fall in price). The tax revenue box is also transferred from the government to consumers on the basis of the same logic. This diagram shows how the removal of a trade barrier has resulted in trade being created in the market and has resulted in an improvement in total welfare. This describes the economic rationale behind joining a free trade area such as the European Union.

When a supplier allows a customer to take possession of goods before actually paying for the goods.

Trade diversion is the term given to the negative trade implications that occur when a country joins a customs union or free trade agreement. The logic is that by joining the customs union, a country will have to import goods from a less efficient country due to the common external tariff that is imposed on goods traded outside of the union.

To explain this process let's consider a simplified example of a country joining the European Union. Before joining the union, the country could import a specific commodity from the United States at the price of P_US. This results in a large number of imports from the US (Q₂ - Q₁). However, after joining the union, a common external tariff is applied to any goods being imported from the United States. This forces the US supply curve up to S_US+T and the new US imported price is equal to P_US. This means now that the cheapest import option available to domestic consumers is to import the commodity from other EU countries. The price of P_EU is lower than the price of importing the good from the United States under the common external tariff, but is above the actual price of the US commodity. This means joining the customs union, has diverted trade away from the US to the EU and overall trade has fallen in this particular commodity. This can be represented  by a net loss in economic welfare, as shown by the orange shaded region below:

 

 

 

 

Goods that are made in one country and sold in another.

 

Services that are performed by one country for individuals and firms in another country.

 

An organisation established for the welfare of workers and to negotiate collectively with employers on their behalf e.g. UNISON represents public service employees and the NUT represents teachers.

Below is a diagram to show the effect that a union would have on a perfectly competitive labour market. The union would force the wage rate above the prevailing wage rate. This will create an excess supply of labour which would later turn to unemployment as firms become reluctant to take on workers who demand higher wages. So perversely the union has increased the level of unemployment in the labour market.

Trade unions though can sometimes increase the level of employment in the industry particularly in industries where there is only one buyer of labour i.e. a monopsony. In the diagram below as long as the trade union employs a wage rate between w1 and w3, employment will increase, due to the unique nature of a monopsonist's steep marginal cost of labour curve.

However, if the trade union places too high a wage rate in the labour market i.e. at w4. Then employment will be reduced and the trade union has increased the level of unemployment in the market by creating unsustainable wage rates.

The depletion of a freely accessible resource because a rational individual will base usage decisions on their own self interests even if they know that the cumulative effect of everyone’s actions are depleting the resource. For instance, in the fishing industry each fisherman has an incentive to maximise their own profits by catching as many fishes as possible in the sea, as this is a public resource and does not have clearly defined property rights. However, if each fisherman does this then eventually the sea will become depleted of this type of fish and the industry will suffer.

Income which is not associated with the productive process and is funded by deducting taxes from the economically active and transferring this to the economically inactive via the welfare system e.g. unemployment benefits and pension payments.

 

A model that explains the impact of monetary policy on an economy. Below is a simplified version of the transmission mechanism to identify the main channels in which a change in the base rate ultimately affects the economy.

First of all it is important to identify that when the base rate changes this also affects all the other interest rates in the economy - both short and long-run - which will make changes to the availability and ease at which businesses and consumers can acquire credit. For instance if the base rate is cut this should lead to cheaper borrowing from banks to customers. Which in turn fuels higher consumption and investment contributing to higher demand.

This base rate cut will also cause asset prices to surge as asset's become more valuable when deposit interest falls.

A cut in the base rate also causes the exchange rate to depreciate and the domestic currency gets weaker relative to foreign currencies because of hot money flows out of the economy. This makes exports cheaper and imports more expensive, boosting a country's trade position and AD.

All of these effects accumulate and create inflationary pressures in the economy. Higher interest rates will have the opposite effect and will reduce inflationary pressure. Central bank's are able to influence the rate of interest in the economy and use this as the main policy tool for regulating the rate of inflation.