Balance of Payments Deficit

The balance of payments is made up of three sections:

The Current Account - Transactions in goods and services between the residents of a country and the rest of the world including:

• Imports
• Exports
• Current transfers 
• Interest
• Dividends
• Profit

The Financial Account -  Transactions in financial assets between the residents of a country and the rest of the world

The Capital Account - Transactions in physical capital between the residents of a country and the rest of the world


The balance of payments is always balanced overall. A deficit on one account is always balanced by a surplus on another. However, different accounts can be in deficit. In the UK we tend to have a current account deficit. This is because the UK tends to import a larger volume of goods than it exports. In the last quarter of 2010, the UK deficit on trade in goods was £26.8 billion. On the other hand, the UK has a productive services sector and so tends to have a surplus on its trade in services - in the last quarter of 2010 the surplus in trade in services was £12.1 billion. As you can see, although the trade in services surplus goes some way to offset the trade in goods deficit, it is not enough. The financial account of the balance of payments offsets the rest. This is maintained by inflows of 'hot money' (temporary inflows of short term capital) and open market operations sales of government securities e.g. bonds.

It is questionable whether this practice is sustainable in the long run. Selling assets or borrowing abroad to finance a current account deficit has future implications for the current account as there will be outflows of investment income and debt repayment in the future. Also if a country wishes to attract hot money it must set high interest rates. Right now, due to the financial crisis, interest rates in the UK are at a record low of 0.5% which doesn't attract inward investment and yet we still have a current account deficit to finance.

Large current account deficits can indicate that the country in question has an underlying structural weakness (for example it has not invested enough into efficient technology), or that the economy is unbalanced and there is too much consumption. If the deficit is due to a fall in output this could come with increased unemployment.

It is considered relatively unimportant for a developed country to have a balance of payments deficit, especially if the country is import rather than export driven. However a large current account deficit, if left unchecked, can lead to less investment due to adverse perception of the country. This is particularly dangerous for developing countries such as Mumbai (see article).

http://articles.economictimes.indiatimes.com/2011-02-24/news/28627846_1_current-account-deficit-private-remittances-capital-flows

Problems With Comparative Advantage and Specialisation

Comparative advantage is the ability to produce a good relatively more efficiently than a trading partner. The law of comparative advantage states that overall trade can be increased if all individuals specialise in producing the goods in which they have comparative advantage.

Even if one country has absolute advantage (the ability to produce both goods more efficiently than a trading partner) in the production of two goods over another country, they may still benefit from specialisation, as the opportunity cost of their producing one good could be markedly higher than the opportunity cost of their producing the other good (relative to another country).

The theory of comparative advantage makes several assumptions:

1. Perfect occupational mobility - all factors of production can be switched immediately from the production of one good to the production of another
2. The trading countries only produce two goods
3. Absence of transport costs
4. There are no economies of scale as a result of specialisation
5. There are no externalities in the production or consumption of either good

Of course when put into practice many of these assumptions are not met. For example, factors of production tend not to be perfectly mobile, for example - labour. Workers trained in the production of shoes could not suddenly switch to producing cars because the government decided that it would be more efficient for the country to specialise in car production, they would have to be re-trained. Also many capital goods used in shoe production may not be appropriate for computer production. The assumption that trade only occurs between two countries and with two goods is also never met.

Presence of barriers to trade may also inhibit comparative advantage. If China has a huge comparative over the USA in textile production, but the USA (wishing to protect its own textile industry) has placed a tariff barrier on the import of Chinese textiles, this weakens China's comparative advantage, as do transport costs.

Finally, countries may wish to maintain some degree of autonomy. Many countries would not like to be reliant upon another for agricultural produce production or arms production because this leaves them very vulnerable in the case of war or (when looking at agricultural produce) supply shocks in that country. Similarly specialising entirely in the production of one good leaves the country vulnerable to changes in demand for that good on the world market - diversification can help cover risk.
 

Game Theory

Game theory describes how different actions by firms (usually in oligopoly) can result in different economic outcomes for each firm, whilst neither of the firms may have intended the outcome which occurs.

An example of game theory in terms of profit of firms:
                                                        
                                                                 Firm B

                                              High Price          Low price
                                      
                                             A1: £50 mil         A3: £30 mil
                  High Price
                                             B1: £50 mil         B3: £80 mil

Firm A

                                             A2: £80 mil         A4: £40 mil

                  Low Price
                                             B2: £30 mil         B4: £40 mil


The above table (which may be slightly unclear as i can't draw lines to separate each box) shows the outcomes of different decisions taken by two firms. If the firms act in a collusive way and both set a high price, then they both make a significant level of profit (see A1, B1). However if they agree to set a high price and Firm A chooses to undercut Firm B by setting a lower price, Firm A is likely to be far more popular with consumers than Firm B (as goods are cheaper) and therefore Firm A will make a huge profit of £80 million at the expense of B which only makes £30 million (A2, B2). If both firms try to undermine one another by setting a low price (A4, B4) then both will have lost out on the £10 million profit which they would have made if they'd stuck to their original agreement of a high price.
For this situation to occur the firms don't necessarily have to in collusion, however it is much more likely to occur if they are. The most commonly used example of game theory is the prisoner's dilemma.

Game theory is commonly used in economics and can be applied to many situations e.g. advertising budget. If one firm spends lots of money on advertising and another does not, this could hugely improve the profits of the first firm. If both set high budgets then they both make good profit. If both set low budget, they both make low profit - its the same situation as above.

                                                               Firm B


                                           High Ad Budget     Low Ad Budget
                                      
                                             A1: £50 mil             A3: £30 mil
            High Ad Budget
                                             B1: £50 mil             B3: £80 mil

Firm A

                                            A2: £80 mil             A4: £40 mil

            Low Ad Budget
                                             B2: £30 mil             B4: £40 mil

What Monopoly Diagrams Can Be Used To Show

A monopoly diagram represents average revenue, marginal revenue, marginal cost and can also show average total cost, average variable cost and average fixed cost of a firm.

 

A monopoly diagram can be used to show:

1. Whether the firm is profit maximising (MC = MR), sales maximising (ATC = AR) or revenue maximising (MR = 0).  The diagrams show profit maximising firms.
2. Whether the firm is making normal profit, abnormal profit or a loss. The first diagram shows a firm making abnormal profit as average total cost is below average revenue. The vertical distance between these two curves is the abnormal (or supernormal) profit. If ATC is equal to AR then the firm is making normal profit (see diagram 2). If the ATC curve was above the AR curve, the firm would be making a loss. (see diagram 3)
3. The average total cost curve on the monopoly diagram shows whether the firm is experiencing falling long run average costs, or economies of scale. If the firm is producing on the downward sloping section of the curve, it is experiencing economies of scale. If it produces on the flat part of the curve is is experiencing constant returns to scale. If it is producing on the upward sloping section of the curve it is experiencing dis-economies of scale (rising long run average costs).
4. A monopoly diagram can show whether or not a firm should shut down. On this diagram you would have to show variable costs. If the firm is covering its variable costs and making a contribution to its fixed costs, it should stay in business even when making a loss. 

What Motivates a Firm

Profit Maximisation

The most common motive of firms is profit maximisation. Profit is maximised where the difference between total revenue and total costs is greatest (see diagram below). Where the TC and TR curves first meet, normal profit is being made. As the firm produces more from this point, total cost falls and total revenue rises. This means that more and more profit is being made with each additional unit of output. The profit maximising position is indicated by the red arrow. Beyond this point the firm is losing profit with each additional unit of output.

Profit is maximised where marginal revenue is equal to marginal cost as long as marginal cost is rising. As you can see on the below diagram, the firm is profit maximising when it produces at price Pm and quantity Qm.

Not all firms choose to profit maximise however.

Revenue Maximisation

Revenue is maximised where marginal revenue is equal to 0, therefore the firm is making as much revenue as possible. Under revenue maximisation firms are willing to sell until the last unit sold adds nothing to revenue.

The above diagram shows the difference between the profit maximising position (p1, q1) and the revenue maximising position (p2, q2) of a monopoly. Under revenue maximisation, the firm produces more output at a lower price.

Sales Maximisation

Sales maximisation occurs when a firm sells the maximum amount possible without making a loss. This is achieved when average total cost is equal to average revenue. Firms may adopt this approach to gain more market power through a larger market share.

Satisficing

Satisficing occurs due to the principal agent problem. Shareholders (principles) and managers (agents) may have different motivations when it comes to running a business. Shareholders want the maximum amount possible in terms of dividends and so often push for firms to profit maximise. Managers may want to pursue other objectives. If this is the case, managers can make sure the firm makes enough profit to satisfy shareholders, and then pursue other objectives.

Pricing strategies to gain market share

Predatory Pricing - pricing at a level low enough to drive out firms currently in the industry by reducing their profitability. A firm must have considerable market power to employ this strategy.


Limit Pricing - deterring new entrants into an industry by pricing low enough that any price they set would be uncompetitive.


Both of these practices are anti-competitive and therefore illegal as they limit consumer choice. Although consumers benefit from low prices in the short run, in the long run it is likely the firms will become monopolys in which case they can raise the price reducing consumer surplus once more.


Firms can also employ non-pricing strategies

these strategies are often employed by firms in oligopoly as the kinked demand curve shows that price competition is not worthwhile. This is because a rise in price means that people buy from other firms,  and a fall in price tends to encourage other firms to cut prices aswell leading to little overall gain. Examples of non-pricing policies are:

• Customer service
• Advertising
• Branding
• Packaging
• Product Placement

Again these strategies are used to gain the maximum amount of market share for a firm.

Poverty & Inequality

Absolute Poverty is when people are living on incomes below the minimum income to meet needs such as food, clean water, clothes and shelter - often referred to as the poverty line. The world bank has set a line of below $2 and $1.25 a day (as of 2005) in terms of the purchasing power parity.

Relative Poverty is when people are living on an income which is below 50% of the national median income. This (as opposed to absolute poverty) is not comparable internationally as what is labelled as a low income in the UK may be high somewhere with cheaper labour like India. It also differs from absolute poverty in that it is subject to change over time.


The Lorenz Curve measures the degree of inequality in a country by showing what percentage of income is earned by what percentage of the population.
                                            

The Gini Coefficient quantifies the degree of inequality using the formula:

G = A/B

(A in this diagram being the area above the Lorenz curve and below the line of perfect equality, and B being the area below the Lorenz curve)


Some factors which can cause poverty

1. Corruption - This is when government officials and civil servants look out for their own interests and not the interests of the rest of the population - they use their power for personal gain. This is an example of an unequal society where the top (say) 10% of the population earns a much larger proportion of income e.g. 70%. Aid given to these countries is not often used constructively in supply side policies, rather kept by officials.
2. Primary product dependency - This can cause a large proportion of a population to live in poverty. Firstly because soft commodities (like coffee) are hugely affected weather conditions and fluctuations in demand and so there is no guarantee of income for the producers of these goods. Secondly hard commodities like oil can cause dutch disease in the economy. This is where an oil exporter suddenly experiences a huge appreciation in its exchange rate due to the demand for their oil and speculation into the future prospects of their economy. This is great for anyone working in the oil industry in that country. However people who work in agriculture and other sectors find their goods uncompetitive on the world market, the exchange rate being so high, and subsequently can find themselves living in poverty.
3. Savings gaps - This is where a developing country does not have adequate savings to fund investment due to its population having (in general) a low GDP per capita. Investment is essential to achieving growth. Without growth it is unlikely that national income will rise, and so a country in this situation is likely to have a population high in poverty.
4. Lack of human capital - Many developing countries have poor education and low school enrollment ratios. This means that the workforce is not as efficient as it could be and therefore productivity of the economy is low. Again this would promote slow growth and wouldn't help to increase national income levels.

Limitations of the Lorenz curve:

• Income changes over time and this is not taken into account by the curve
• The amount of inequality may be misleading. If richer households are able to use their incomes more efficiently than lower income households, the amount of inequality could be understated.

Limitations of the Gini coefficient:

• The coefficient will give different results when applied to individuals or households. To be able to make a valid comparison between countries, definitions must be constant across countries.
• different countries may have different systems of benefits and these are not accounted for by the Gini coefficient

Practice Essay: Examine the role of comparative advantage in determining what a country produces for international exchange.

Comparative advantage is the specialisation of a country in one product – the product in which there is the lowest opportunity cost of production. Opportunity cost is the cost of the next best alternative forgone. If we consider a country that only produces two goods (hypothetically), the more they produce of one, the less they can produce of another (see diagram). This is called the countries production possibility frontier and shows the output of an economy when it is using all of its resources.

As you can see from the diagram to the left, by forgoing the production of 50 guns, 10 more units of butter can be produced.  Because of this, countries may choose to specialize in the production of one good or service and trade with another country to receive the other. So if country A has a lower opportunity cost in producing guns and country B has a lower opportunity cost in producing butter, the two can then use all their resources in the production of one and trade with each other.

Of course, in reality, countries tend to produce more then two products, and there are many reasons why countries may not choose to specialize entirely in the production of  products in which they have comparative advantage. Firstly, they may wish maintain a degree of autonomy. The production of only one good leaves a country very dependent on other countries for their goods. If the UK was completely reliant on Country A for supply of agricultural produce, and the two countries then went to war, the UK would not be able to sustain its population and would be vulnerable. Likewise many countries choose to produce their own weapons despite not having comparative advantage, as they don’t want to be left defenceless in the event of war. An example of subsidising the agricultural industry is the common agricultural policy. The EU is a monetary union which practices free trade internally and imposes external tariffs. The EU subsidises its farmers so that they can be guaranteed a minimum price and imposes tariffs and quotas on produce from many other countries. This practice is anti competitive but without it the EU would not be able to maintain a vital industry. The extent to which the countries may want to protect an industry depends on the degree to which the population could live without it – e.g. people have inelastic demand for food and can’t live without it, however the government probably wouldn’t mind only importing (not exporting) something less vital, like ribbon.

Secondly, the rules of comparative advantage break down when product differentiation is considered. With goods such as light bulbs, there’s very little differentiation between the products regardless of where they’re produced. However in other goods, e.g. cars, branding is also an important factor to consider when looking at the international competitiveness of goods. Germany may not have comparative advantage over, say, Japan in the production of cars, but many importers may prefer the quality and design of German cars over Japanese cars. In fact it could be the money and resources used in making the cars in Germany better quality that makes them have a higher opportunity cost then those in Japan. Maybe in this case comparative advantage is less relevant to what the country produces. In terms of quality, some countries have less stringent legislation then others, and so other countries would not want to trade with them regardless of comparative advantage, due to the sub standard goods they produce. This leads to countries blocking the import of goods from these countries (a form of protectionism).

Lastly the government in a democratic country such as the UK, can’t force people to work in the industry in which the country has comparative advantage. Labour is not perfectly mobile and people may be trained in other areas. The government could perhaps provide means of support for those industries however it all depends on the responsiveness of labourers to this. Also people may not be located in the right area to work in these industries e.g. mining can only take place in certain areas. It is hard to shift labour to the necessary areas as people are unable or unwilling to move.

In conclusion, although comparative advantage may maximise a country’s efficiency in producing the good in which they have comparative advantage, it may also leave it vulnerable, and may be impractical for governments to impose on their labour forces so they tend to also look at other factors when considering what to produce for international exchange.