Differences in saving and investment

IGCSE Economics (0455) – Full Syllabus Notes

1. The Basic Economic Problem

• Scarcity: Unlimited wants but limited resources.
• The three fundamental questions:

  • What to produce?
  • How to produce?
  • For whom to produce?

• Production Possibility Curve (PPC)

  • Shows the maximum output combinations of two goods that an economy can produce with its existing resources and technology.
  • Points on the curve = efficient use of resources.
  • Points inside the curve = under‑utilisation (inefficiency).
  • Points outside the curve = currently unattainable.
  • Outward shift = economic growth (more resources or better technology).

• Opportunity cost: The value of the next best alternative foregone; illustrated by the slope of the PPC.
• Economic growth can also be shown by a right‑hand shift of the long‑run aggregate supply (LRAS) curve.

2. Allocation of Resources (Unit 2)

2.1 Demand and Supply

• Demand (D): Quantity of a good that consumers are willing and able to buy at each price (downward‑sloping).
• Supply (S): Quantity that producers are willing and able to sell at each price (upward‑sloping).
• Market equilibrium: Intersection of D and S – gives equilibrium price Pₑ and quantity Qₑ.
• Shifts in the curves:

  • Increase in demand → Pₑ ↑, Qₑ ↑.
  • Decrease in demand → Pₑ ↓, Qₑ ↓.
  • Increase in supply → Pₑ ↓, Qₑ ↑.
  • Decrease in supply → Pₑ ↑, Qₑ ↓.

2.2 Elasticities

Special cases – perfectly elastic (PED = ∞), perfectly inelastic (PED = 0), unitary elastic (PED = 1). Similar classifications apply to PES.

2.3 Market Failure

• Public goods: Non‑rival and non‑excludable (e.g., street lighting, national defence).
• Merit goods: Under‑consumed if left to the market (e.g., education, vaccinations).
• Demerit goods: Over‑consumed if left to the market (e.g., tobacco, alcohol).
• Externalities:

  • Positive – benefits to third parties (e.g., a well‑kept garden raises neighbours’ property values).
  • Negative – costs to third parties (e.g., factory pollution).

• Information failure: Consumers or producers lack full information (e.g., hidden fees, unsafe products).
• Market power (monopoly) can lead to allocative inefficiency – a classic form of market failure.
• Government intervention:

  • Taxes (to internalise negative externalities).
  • Subsidies (to encourage positive externalities).
  • Regulation and standards.
  • Direct provision of public/merit goods.

2.4 Economic Systems

• Market (capitalist) economy: Resources allocated mainly by price mechanism; private ownership.
• Planned (command) economy: Central authority decides what, how and for whom to produce.
• Mixed economy: Combines market forces with government intervention (e.g., public health care, regulation of monopolies).

3. Micro‑Economic Decision‑Makers (Unit 3)

3.1 Households

• Decide how much to consume and how much to save based on income, interest rates and expectations about the future.
• Supply labour; demand goods and services.
• Savings formula: \(S = Y - C\) (where \(Y\) = income, \(C\) = consumption).

3.2 Firms

• Choose output where marginal cost (MC) = marginal revenue (MR) to maximise profit.
• Profit = Total Revenue (TR) – Total Cost (TC).
  

  TR formula: \(TR = P \times Q\).
  

  TC formula: \(TC = TFC + TVC\) (fixed + variable costs).

• Investment = expenditure on capital goods, R&D and infrastructure that raise future productive capacity.
• Firms may also engage in mergers & acquisitions to achieve economies of scale.

3.3 Costs, Revenue and Objectives

• Average cost (AC) = TC / Q; Average revenue (AR) = TR / Q = P.
• Diagram: ATC curve (U‑shaped) with MC intersecting at the minimum AC – efficient scale of production.
• Short‑run vs long‑run: In the short run at least one factor is fixed; in the long run all factors are variable.
• Firms may aim for profit maximisation, revenue maximisation, or market‑share growth.

3.4 Money, Banking and Financial Intermediation

• Functions of money: medium of exchange, unit of account, store of value.
• Banking role: Mobilise household savings, provide loans to firms, create money through the multiplier effect.
• Interest rate set by the central bank influences the cost of borrowing and the incentive to save.
• Key monetary‑policy tools:

  • Open‑market operations (buying/selling government securities).
  • Bank rate / policy interest rate.
  • Reserve requirements.

3.5 Labour‑Market Diagram

• Demand for labour derived from the marginal product of labour (MPL); supply of labour comes from households.
• Equilibrium wage (Wₑ) and employment (Eₑ) are where the two curves intersect.
• Unemployment types:

  • Frictional – short‑term job search.
  • Structural – mismatch of skills/locations.
  • Cyclical – caused by downturns in aggregate demand.

• Unemployment rate formula: \(\displaystyle \frac{\text{Number of unemployed}}{\text{Labour force}} \times 100\)

3.6 Types of Markets

• Perfect competition: Many buyers & sellers, homogeneous product, price takers, free entry/exit.
• Monopoly: Single seller, price maker, barriers to entry (e.g., patents, natural monopolies). Often cited as a source of market failure.
• Monopolistic competition: Many sellers, differentiated products, some price‑setting power.
• Oligopoly: Few large firms, inter‑dependent decision‑making; may collude (cartel) or compete (price wars).

3.7 Economies of Scale & Diseconomies

• Internal economies of scale – lower average costs as output rises (e.g., bulk buying, specialised labour, technical efficiencies).
• External economies of scale – benefits from industry concentration (e.g., skilled labour pool, supplier networks).
• Diseconomies of scale – rising average costs when a firm becomes too large (e.g., management difficulties).

3.8 Evaluation Prompt

Assess the likely impact of a government‑imposed price ceiling on a monopolistic‑competition market. Consider consumer surplus, producer surplus, shortages and long‑run entry/exit.

4. Government & the Macro‑Economy (Unit 4)

4.1 Fiscal Policy

• Tools: Government spending (G) and taxation (T).
• Budget balance:

  • Surplus = T – G > 0
  • Deficit = G – T > 0

• Expansionary fiscal policy: ↑ G or ↓ T → ↑ aggregate demand (AD) → higher output & employment (short‑run).
• Contractionary fiscal policy: ↓ G or ↑ T → ↓ AD → lower inflation.
• Multiplier effect: \(\displaystyle \text{Multiplier} = \frac{1}{1 - MPC}\) where MPC = marginal propensity to consume.

4.2 Monetary Policy

• Conducted by the central bank (e.g., Bank of England, Federal Reserve).
• Key instruments: policy interest rate, open‑market operations, reserve requirements.
• Expansionary: ↓ interest rates → ↑ borrowing & spending → right‑shift of AD.
• Contractionary: ↑ interest rates → ↓ borrowing & spending → left‑shift of AD.

4.3 Supply‑Side Policies

• Aim to increase the productive capacity of the economy (long‑run growth).
• Examples:

  • Investment in infrastructure (roads, ports, broadband).
  • Improving education and training – raise human capital.
  • Tax incentives for research & development (R&D).
  • Deregulation to reduce red‑tape.
  • Labour‑market reforms (e.g., flexible wages, reducing trade‑union power).

4.4 Macro‑Economic Objectives

• Economic growth: Increase in real GDP (or real GDP per capita).
• Unemployment: Measured by the unemployment rate (see 3.5). Types: frictional, structural, cyclical.
• Inflation: Sustained rise in the general price level.

  • Demand‑pull inflation: AD > AS.
  • Cost‑push inflation: higher production costs (e.g., wages, oil).

• Balance of Payments (BOP):

  • Current account = (Exports – Imports) + Net income + Net transfers.
  • Capital/financial account = Net inflow of investment (FDI, portfolio).
  • Surplus = net inflow of foreign currency; deficit may require borrowing or use of reserves.

• Exchange rates:

  • Floating – determined by market supply and demand for a currency.
  • Fixed (pegged) – government or central bank maintains a set rate, intervening in the foreign‑exchange market.
  • Depreciation = fall in value of domestic currency; appreciation = rise in value.

4.5 Key Formulae

4.6 Evaluation Prompt

Discuss the extent to which supply‑side policies can reduce inflation without causing a rise in unemployment. Use the Phillips curve to support your answer.

5. Economic Development (Unit 5)

5.1 What is Development?

• Improvement in the standard of living and reduction of poverty over time.
• Involves both economic growth (more output) and qualitative improvements (health, education, environment).

5.2 Indicators of Living Standards

5.3 Poverty

• Absolute poverty – living below a fixed threshold (e.g., $1.90 a day).
• Relative poverty – earning significantly less than the median income of a society.
• Key causes: low productivity, poor education, inadequate health, weak institutions, unequal income distribution.

5.4 Population Dynamics

• Population growth rate = (Births – Deaths + Net migration) / Mid‑year population × 100.
• Four stages of the Demographic Transition Model (DTM):

  1. High birth & death rates – low growth.
  2. Declining death rate – rapid growth.
  3. Declining birth rate – growth slows.
  4. Low birth & death rates – stable or shrinking population.

• Population pyramid interpretation:

  • Broad base = high proportion of children – potential for future labour force.
  • Narrow base = ageing population – possible labour shortages.

5.5 Saving, Investment and Growth

• Saving (S) = Income not spent on consumption. In a closed economy, \(S = I\).
• Investment (I) = Expenditure on new capital goods, infrastructure and technology that raise future output.
• Saving rate \(s = \frac{S}{Y}\); Investment rate \(i = \frac{I}{Y}\).
• Higher saving provides the funds needed for investment; investment expands the capital stock and raises productivity.

5.6 Why Saving and Investment Differ Between Countries

1. Income levels – richer countries have larger absolute savings but often a lower saving rate.
2. Financial systems – depth of banks, capital markets and legal protection affect mobilisation of savings.
3. Cultural attitudes – thriftiness vs. consumption orientation.
4. Government policies – tax incentives, public‑savings schemes, subsidies for investment.
5. Political stability – attracts foreign direct investment (FDI) and encourages domestic saving.
6. External factors – remittances, aid, access to foreign capital.

5.7 Illustrative Comparison of Selected Countries

5.8 The Solow Growth Model (Simplified)

Steady‑state capital per worker (\(k^*\)) depends on the saving rate (\(s\)):

\[ k^{*}= \left( \frac{s}{\delta + n + g} \right)^{\frac{1}{1-\alpha}} \]

• \(\delta\) = depreciation rate
• \(n\) = population‑growth rate
• \(g\) = rate of technological progress
• \(\alpha\) = capital’s share of income (usually ≈ 0.3‑0.4)

A higher saving rate shifts the investment curve upward, raising the steady‑state level of capital and output per worker (y* = f(k*)), leading to a higher long‑run standard of living.

5.9 Policy Implications for Developing Countries

• Strengthen financial institutions to channel savings into productive investment.
• Maintain macro‑economic stability (low inflation, sustainable public finances) to build investor confidence.
• Use tax incentives that encourage both household saving and corporate investment without discouraging consumption.
• Invest heavily in human capital – education, health and nutrition – to improve the efficiency of investment.
• Facilitate FDI while ensuring technology transfer and linkages to domestic firms.
• Promote good governance, rule of law and secure property rights.
• Address demographic challenges through family‑planning programmes and skills‑training for a growing labour force.

5.10 Evaluation Prompt

To what extent can a high national saving rate alone guarantee rapid economic development? Discuss the role of financial intermediation, institutional quality and external factors.

6. International Trade & Globalisation (Unit 6)

6.1 Comparative Advantage & Specialisation

• A country should specialise in producing the goods for which it has a lower opportunity cost than its trading partners.
• Specialisation leads to a higher total world output and the possibility of gains from trade.
• Diagram: Production‑possibility frontiers for two countries – trade allows each to consume beyond its own PPC.

6.2 Benefits of Free Trade

• Access to larger markets → economies of scale.
• Lower prices for consumers and greater variety.
• Accelerated diffusion of technology and ideas.
• Increased competition can improve efficiency.

6.3 Trade Restrictions

• Tariffs – tax on imports; raise domestic price, protect local producers, generate revenue.
• Quotas – limit the quantity of a good that can be imported.
• Subsidies – financial assistance to domestic producers, making them more competitive.
• Voluntary Export Restraints (VERs) – agreements where exporters limit shipments.
• Reasons for protectionism:

  • Protect infant industries.
  • Safeguard national security.
  • Preserve jobs.
  • Retaliate against unfair trade practices.

• Potential downsides: higher consumer prices, reduced efficiency, risk of retaliation, limited choice.

6.4 Balance of Payments (BOP) – Detailed Structure

• Current account – trade in goods & services, net primary income, net secondary income (remittances, aid).
• Capital account – capital transfers, acquisition/disposal of non‑produced, non‑financial assets.
• Financial account – direct investment, portfolio investment, other investment, reserve assets.
• Overall BOP must balance; a deficit in the current account is financed by a surplus in the capital/financial account or by drawing down reserves.

6.5 Exchange‑Rate Regimes

• Floating (flexible) rate – determined by market forces of supply and demand for the currency.
• Fixed (pegged) rate – government or central bank maintains a set rate against another currency or a basket; may require foreign‑exchange reserves to defend the peg.
• Factors influencing exchange rates:

  • Interest‑rate differentials.
  • Inflation differentials.
  • Political stability and economic performance.
  • Speculative expectations.

• Depreciation makes exports cheaper and imports more expensive; appreciation has the opposite effect.

6.6 Multinational Companies (MNCs) and Foreign Direct Investment (FDI)

• MNCs own or control production facilities in more than one country.
• FDI can bring capital, technology, managerial expertise and access to export markets.
• Potential drawbacks: profit repatriation, crowding‑out of domestic firms, dependence on foreign capital.

6.7 Trade Blocs and Regional Integration

• Free‑trade area, customs union, common market, economic and monetary union.
• Benefits: larger market, reduced transaction costs, policy coordination.
• Criticisms: trade diversion, loss of national policy autonomy.

6.8 Evaluation Prompt

Evaluate the argument that “free trade always benefits developing countries”. Consider comparative advantage, terms of trade, the role of MNCs, and possible short‑run adjustment costs.