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When public debt increases, economists tend to open the issue to debate. Debts generated for sound economic reasons are not considered problematic but the issue of whether debts are sustainable – i.e. if they can be repaid – is often raised. Debts need to be repaid in the future so the cost will be borne by tomorrow’s taxpayers if the government borrows today. While voters may desire high levels of government spending, high debts may require future high tax rates, and hence will not be popular with voters. The effects of high tax rates on incentives to work, employment and running a business may very well create headaches for a government trying to repay future debts and could very well deepen the problem.

Some economists consider that since much of national debt is owed to domestic citizens, it may not be a problem; the most important consideration regarding debt is how it is used. Debts generated to invest in infrastructure or education that will increase future economic activity should help pay for the debt. Debts generated to pay for day-to-day costs like public sector pay or the running of government departments is more difficult to defend because such expenditures should really be met by day-to-day revenues where at all possible, since in many cases they are unlikely to generate their own revenue streams to be selffinancing in the future. Economists should be concerned with the purpose of expenditures and the efficiency of expenditure when analysing the sustainability of public debt.

5.8.1ANOTHER PERSPECTIVE ON ECONOMIC ACTIVITY: THE ECONOMY AS A PRODUCTION FUNCTION

Depending on the issue of interest, different models of economic activity are useful. Earlier the model of aggregate demand and supply was presented. For some purposes, however, it is useful to view an economy as a production function.

The production function is a relationship describing how economic activity, specifically output, depends on the factors of production and technology. It describes a technically efficient use of the factors of production and technology necessary to produce output, i.e. no resources are unemployed.

Examples of ‘standard’ production functions are:

Y = F (K, L, T )	PF1
Y /L = F (K /L, T )	PF2
Y /L = F (K /L, E)	PF3

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For each production function output, Y , is related to the factors of production, which are capital (denoted K ), Labour (denoted L) and technology (denoted T ). The term F indicates that there is some functional relationship between output and inputs but because these are general equations, the precise relationship or functional form is not specified. The above relationships hold for firms, industries and economies. If you look back to Figure 4.2, you will see a sample production function for a firm for the short run when capital is fixed. For the focus and purpose of this chapter we refer here to economies.

While the three production functions are quite similar, PF2 and PF3 are expressed in per worker terms. In PF1, output depends on inputs and technology. In PF2 output per capita depends on capital per worker (K /L) and technology. (Remember these factors of production were highlighted earlier as contributing to aggregate supply.) The capital/labour ratio (K /L) of an economy provides information on the capital intensity of the economy.

Capital intensity is the amount of capital each worker in the economy (on average) has at their disposal.

Usually in economies that generate a high level of economic activity, the K /L ratio is relatively high. In terms of policy options for government, trying to increase this ratio ranks quite high. An economy’s capital intensity rises if investment expenditures on capital machinery and equipment grow faster than what is required just to replace depreciation of an economy’s capital stock.

In PF3 output per worker depends again on capital per worker and on the efficiency of labour (E). The efficiency of labour itself depends on both technology and the efficiency of business and general market organization. Explicit inclusion of the efficiency of labour allows for the consideration of learning in the process generating economic activity. For example, the efficiency of labour can improve if nothing else in the economy changes except workers’ ability to ‘work smarter’ from using their specific knowledge of their job more efficiently. It is often only by on-the-job experience that workers figure out the best ways to achieve their work goals via learning by doing.

Output (or output per worker) can grow if factors of production increase and are used for production. If the amount of capital in an economy rises due to increased capital investment, for example, that economy can grow. This can happen only if the capital can be put to productive use to produce something in demand, i.e. for which people are willing to pay. If labour increases output can grow, once (as discussed in Chapter 2):

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1.there are jobs for the additional labour; and

2.those jobs generate sufficient return to cover workers’ wages/salaries, other business costs and the opportunity cost to the owner of the business.

If technology improves more output (or output per worker) can be produced from a given set of inputs which implies improved production methods either through innovations, invention or better management and organization. These improvements will lead to lower production costs once the technology is not too costly.

This production function approach to describing economic activity allows for analysis of many interesting questions regarding economic activity, although unlike the aggregate demand/aggregate supply approach, the aggregate price level is not an explicit feature of the approach. Hence, inflation is not directly part of the model, nor indeed is unemployment. However, the relationship between output and inputs, technology, the efficiency of labour and the role of learning can be considered using the production function approach. Hence, the most appropriate model to use when considering economic activity must be chosen based on the issue of interest and the model most suited to that issue. In Chapter 9 we return to the production function approach in discussing economic growth and its sources.

5 . 9 S U M M A R Y

•Macroeconomic or aggregate economic activity is represented by the circular flow diagram encompassing all income flows between the various markets in the economic system. These include markets for products and services, labour and other factors of production.

•Standard measures of economic activity are GDP and GNP. Methods for measuring GDP or GNP include the expenditure, income or value-added methods. All methods should lead to an equivalent measure.

•The distinction between short and long run is relevant for aggregate economic activity. In the short run, economic activity displays business cycles. In the long run, a trend growth rate can be estimated.

•The aggregate demand and aggregate supply model can be used to analyse economic activity at macroeconomic level and helps us to understand how aggregate national output (or income) and the average aggregate price level are determined.

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•The concept of the multiplier is crucial to understanding how changes in autonomous spending ultimately impact on economic activity.

•Given the various functions of government, governments affect equilibrium economic activity through a number of channels.

•For open trading economies, trade creates aggregate benefits, but costs of trade also arise for some economic units.

•A production function approach is one appropriate model for aggregate economic activity. This method can be appropriate in analysis of economic activity, depending on the issue of interest.

R E V I E W P R O B L E M S A N D Q U E S T I O N S

1.Separately in the case of firms, households and government, explain all of the transactions that they are involved in within the circular flow. Make sure to discuss their role regarding products, services, resources and money.

2.Separately in the case of resource, factor and money markets, explain how you think local, domestic and international financial systems, systems of corporate governance, legal and political environments, social and cultural background, technological capability and the myriad standards, business and personal ethics, and codes of conduct that are embedded in the economic system all play a role in understanding the circular flow.

3.a. Using data for five countries of your choice, graph their long-term growth path from 1950 to the last year of available data (use data from the Groningen Growth and Development Centre website http://www.eco.rug.nl/ ggdc/index-dseries.html). Compute the average rate of growth for the period overall and for each decade. Try to identify boom periods and recessions from your graph.

b.For the same five countries as in 3a, compare the growth rate of population with real output growth and comment on whether welfare can be argued to have improved for each country. The data are also available from the same source.

4.Go to the website of your national statistics provider. Find the section on prices and plot the trends in average consumer prices for the last five years. Has the trend been rising or falling? Compare this trend with the Harmonized Index of Consumer Prices for all EU Member States (which is available from http://www.cso.ie/principalstats/princstats.html under the Prices heading).

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5.Use an aggregate expenditure curve and an aggregate demand curve (similar to Figure 5.4) to explain what you would expect to happen to equilibrium output and the price level if the average price level fell by 5%. Explain the individual effects you would expect for aggregate demand in terms of the real wealth effect, the interest rate effect and the international trade effect.

6.a. Use the following table to compute the multiplier when the MPC is 0.90 and the tax rate is 20%.

	Multiplier:
MPC t (1 − t) MPC : MPC × (1 − t) 1 − MPC			1
	(	1	− MPC	)

0.900.20

b.Indicate in the following table what happens to the multiplier if the MPC falls to 0.85. Explain why this is so.

	Multiplier:
MPC t (1 − t) MPC : MPC × (1 − t) 1 − MPC			1
	(	1	− MPC	)

0.850.20

c.Indicate in the following table what happens to the multiplier if the tax rate falls to 15%. Explain why this is so.

	Multiplier:
MPC t (1 − t) MPC : MPC × (1 − t) 1 − MPC			1
	(	1	− MPC	)

0.850.15

d.If an MPM of 0.20 is included in the tables above, compute the new multiplier in each case.

7.For your domestic economy look up appropriate sources to find out and explain what your government has done in relation to each of the following over the last three to five years.

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•Stabilization policy, reaction to economic shocks, transfer payments, provision of public goods, taxation, resource reallocation, regulation, policies likely to encourage expansion of aggregate supply.

8.Use the latest available data from your national statistics provider or the WTO (www.wto.org) to identify the main sectors and goods that your country exports and imports. Do the same exercise for 10 years previously. What does your information reveal about your country’s comparative advantages?

F U R T H E R R E A D I N G A N D R E S E A R C H

•Two of the greatest minds in economics – Hayek and Keynes – provided theories of business cycles. See Hayek, 1975 and Keynes, 1936.

•For research on economic performance and the size of government see Slemrod, 1995.

•For analysis of trade related issues, Foreign Affairs contains topical articles. Regarding the offshoring/outsourcing debates see Drezner, 2004.

•Some good books on international integration have been published recently, including Wolf, 2004 and Bhagwati, 2004.

R E F E R E N C E S

Bhagwati, J. (2004) In Defence of Globalization. Oxford University Press, New York. Drezner, D. (2004) ‘The outsourcing bogeyman’, Foreign Affairs, May/June, 22–34. Hayek, F. (1975) Monetary Theory and the Trade Cycle [original publication 1933].

Augustus M. Kelley, New York.

Hufbauer, G. and K. Elliott (1994) Measuring the Costs of Protectionism in the United States. Washington: Institute for International Economics, 5, 13.

Keynes, J. (1936) The General Theory of Employment, Interest and Money. Macmillan, London.

Schumpeter, J. (1975) Capitalism, Socialism and Democracy [original publication 1942]. Harper & Row, New York.

Slemrod, J. (1995) ‘What do cross-country studies teach about government involvement, prosperity and economic growth?’, Brookings Papers on Economic Activity, 2, 373–431.

Smith, A. (1776) An Inquiry into the Nature and Causes of the Wealth of Nations. Wolf, M. (2004) Why Globalization Works. Yale University Press, New Haven.

C H A P T E R 6

C O M P E T I T I O N I N T H E

E C O N O M I C S Y S T E M

By EDWARD SHINNICK

L E A R N I N G O U T C O M E S

By the end of this chapter you should be able to:

Explain why competition is a complex process in the economic system.

Explain the Austrian perspective on competition as an ongoing process within an economy which includes an explicit function for entrepreneurs.

Describe the traditional models of competition (non-Austrian) using figures including demand, costs and supply.

Compare and contrast the assumptions and outcomes for consumers, producers and society as a whole, of alternative models of competition.

Compare and contrast the traditional and Austrian approaches to competition.

Use the five forces framework to highlight the factors that explain why some industries are more attractive – more profitable – than others.

Discuss what is meant by market failure, how it may arise and its implications.

Explain what is meant by the structure, conduct, performance paradigm and how it provided a foundation for competition policy. Explain the implications of changes in the formulation of the SCP paradigm for competition policy.

Provide some examples of why competition may give rise to problems for an economy.

Analyse how competition policy can be used to address competition problems.

6 . 1 I N T R O D U C T I O N

Previous chapters have outlined the demand and the supply sides of the economy and how these two elements interact within the economic system. This chapter explores this interaction further by analysing how and why firms compete in the

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marketplace. Pick up any business magazine or newspaper and undoubtedly you will find a reference to ‘competition’ in a report on the economy. The term is widely used yet we may not fully understand what it means and its importance. The role of this chapter is to explore the meaning of competition and the beneficial consequences of competition for the economy and society as a whole.

The Austrian influence is present again in this chapter with the Austrian perspective on how competition can be viewed as an ongoing process in the economic system outlined in section 6.2. This incorporates the concept of discovery and provides an explicit role for entrepreneurship as a factor of production.

This is followed in section 6.3 by presentation of the main economic models of competition that characterize different industries. These complementary perspectives on competition in sections 6.2 and 6.3 are compared and contrasted in section 6.4.

In section 6.5 the focus shifts to why markets may not always work to the satisfaction of governments and what can be done to correct such outcomes. This re-introduces the role of government in the economic system and what it can do in the form of a national competition policy to address market problems. Analysis of competition policy, its aims and how it is implemented completes the chapter.

6 . 2 C O M P E T I T I O N I N T H E E C O N O M I C S Y S T E M

When economists use the term ‘competition’ or advocate greater competition they generally have in mind some mechanism that brings about an increase in supply leading to a reduction in equilibrium price and an increase in equilibrium quantity (ceteris paribus). However, the term ‘competition’ involves much more than just an increase in supply.

The extent of competition in an economy has implications for a whole set of interacting issues such as innovation, efficiency, availability of a variety of goods and services, and prices that together influence and enhance the welfare of individual consumers. When individual consumer benefits are aggregated, the economy too is better off as a result of competition.

Within the economic system we have a series of interacting agents that act independently of each other and yet are part of a complex interrelated web. In the context of competition, the marketplace is a crucial element in this web where the interaction of different economic units, each motivated to maximize their utility, results in an outcome that benefits both these individuals and the entire economy.