PREFACE

Economics remain the dominant force of how we carry out our daily activities from home to
work places, in the markets, banks and public places. This in itself has deciphered our quest to
further streamline our content of study at Year 13. Our aim is to empower our economic students
to be astute and think like economists in whatever situation they come across.

The book is an extension of Year 11 and 12 Direct Approach to Economics. Given the practicality
and complexity of the concepts at year 13, we have decided on the title: Advanced Economics
Year 13. The contents of Year 13 Economics brings together and expands the same concepts learnt
in years 11 and 12 under the same 5 strands. Students and teachers will begin to realise now that
the learning have begun to rise very steeply at this stage.

We have introduced some special features in the textbook to assist students’ thinking and learning
and most importantly to link their learnt concepts to the world around them or the local economy.

 Lesson Objectives : The lessons open with a set of achievement indicators which must be
mastered at the end of the lesson.
 Key Terms: Each lesson is accompanied with a list of new concepts learnt with its simple
definitions for quick referencing. This is to also assist students with their knowledge based
questions.
 Exam –Type Questions : Each lesson closes with a set of exam type questions, either it be
multiple choice, short answer or essay writing questions.
 Reading between the lines: To assist the students with the skill of critical thinking, we have
developed relevant articles suitable for certain topics in which students will apply the tools
they have just learned using the articles. The article sheds more light on the concepts learnt
in reality. There is an epitome in every article which is a synopsis of the essence of the
article.
 Research: In our pursuit to cultivate rational and critical thinkers, we have devised some
research questions based on the various topic at hand. Teachers are to guide the students
with their research as this will broaden their knowledge on the potential insights of their
learning.

The dedication and commitment of the contributors must be acknowledged greatly in the final
compilation of this resource book. It is hoped that the textbook would be a great learning resource
for the year 13 students as they prepare themselves for the tertiary institution and the labour
market in general.

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 ACKNOWLEDGEMENTS

The following people‘s contribution have been recognised and duly thanked for the successful
completion of this textbook.

 Team at CDU - SEO Economics – Mrs Sikiti Saukuru

- Research Officer - Ms Ashika Lata

 A/SEO S/Science Primary – Denzil Goundar

 Members of the SED - KLA (Secondary Level)

 Economic Teachers Workgroup Members - Central HODs

-Western HODs

 Tertiary Institutions
- School of Tourism– Dr. Alexander Trupp & Ms Lynn Beckles (USP)
-School of Economics – FNU, University of Fiji and USP.

 Other Departments - Reserve Bank of Fiji - Carl Miller

I also acknowledge all those who have contributed but have not been mentioned here.

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TABLE OF CONTENTS
Preface
Acknowledgements
STRAND 1 INTRODUCTION TO ECONOMICS
Sub Strand 1.1 Nature and Scope of Economics
Lesson 1.1.1 Branches and Different Approaches in Economics 6
Lesson 1.1.2 Scope and Methodologies in Economics 9
Lesson 1.1.3 Schools of Economic Thought 17
STRAND 2 MICROECONOMICS
Sub Strand 2.1 Consumer Theory
Lesson 2.1.1 Utility, Total Utility and Marginal Utility 25
Lesson 2.1.2 Indifference Curves 37
Lesson 2.1.3 Budget Lines, Utility Maximization and Consumer Equilibrium 41
Sub Strand 2.2 Marginal Productivity Theory 51
Sub Strand 2.3 Price Mechanism 54
Sub Strand 2.4 Service Industries
Lesson 2.4.1 Tourism 57
Lesson 2.4.2 Transport Industry 70
Sub Strand 2.5 Elasticity of Supply
Lesson 2.5.1 Price Elasticity of Supply 77
STRAND 3 MACROECONOMICS
Sub Strand 3.1 Changes in Money Supply
Lesson 3.1.1 Primary Factors Affecting Money Supply 85
Lesson 3.1.2 Secondary Factors Affecting Money Supply 88
lesson 3.1.3 Effects of Interest Rate 99
Sub Strand 3.2 Income and Expenditure Analysis
Lesson 3.2.1 Income and Expenditure Analysis Model 102
Sub Strand 3.3 Labour Market
Lesson 3.3.1 Labour Market in Fiji 120
STRAND 4 INTERNATIONAL ECONOMICS
Sub Strand 4.1 Exchange Rates
Lesson 4.1.1 Exchange Rates and Foreign Reserves 128
STRAND 5 DEVELOPMENT ECONOMICS
Sub Strand 5.1 Environmental Economics
Lesson 5.1.1 Externalities 154
Sub Strand 5.2 Equity and Efficiency
Lesson 5.2.1 Equity, Equality and Distribution of Income 165

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SUBJECT OUTCOME
Explore and express relationships between people and events in relation to
their culture, resources, and environment and apply their knowledge and skills
to become responsible and productive citizens.

STRAND 1 INTRODUCTION TO ECONOMICS

Strand Outcome

Recognize, analyze and explain how people satisfy their needs and wants by
managing and making optimum use of the available resources in enterprising
ways with a commitment to ecological sustainability.

Content Learning Outcome

Explore the different approach, scope, methodology and schools of

thoughts in economics.

5
 1.1 NATURE AND SCOPE OF ECONOMICS
LESSON 1.1.1 Branches and Different Approaches in Economics

Achievement Indicators:
 Explain branches of economics.
 Explain different approaches of economics.

Economics deals with every aspect of people’s lives. Studying economics is therefore broken down
into meaningful portions, ranging from simple theories and explanations to very complex; from
actions of one person to the reaction of the whole world. It uses statistics, graphs, images, models
theories, principles, laws and reforms. It enables one to become a rational decision maker.
Moreover, we can also become critical thinkers.

The studying of economics falls into two branches.

Branches of
Microeconomics Economics Macroeconomics

Microeconomics concerns Macroeconomics is the

itself with the behavior of study of economy as a
small, individual economic whole. It is concerned
units. That is with with total or aggregate
individual household, economy. It includes
business firms, and topics such as national
industries. Example: income, unemployment in
consumption by a particular the economy, economic
household or production of growth.
a particular firm.

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There is also the normative approach to economics, as opposed to a positive approach.
NORMATIVE ECONOMICS POSITIVE ECONOMICS

 It is a statement of ‘what ought to  It is statement of ‘what is’.

be ’.  It is based on facts and supported with
 It is statement of one’s value evidence.
judgment or personal opinion of  It is a statement of a value free nature
what should be done.  Economists in general favor a positive
Example, income inequalities approach to economics, so as to preserve the
should be reduced. integrity of economic analysis and decision-
making. A positive approach gives the field
more credibility. Example, income inequality
exists in all countries.

Key Terms
No. Terms Definition
1. Economic Is any measurement that helps to determine how an economy functions
Variables e.g. population, poverty, inflation, unemployment, GDP, etc.
2. Generalization Broad statement or an idea that applies to a group of people or things.
3. Macroeconomics Is a branch of economics dealing with the performance, structure,
behaviour and decision-making of an economy as a whole.
4. Microeconomics Is a branch of economics that studies the behaviour of individuals and
firms in making decisions regarding the allocation of scarce resources
and the interactions among these individuals and firms.
5. Normative It is a statement of ‘what ought to be’.
Economics
6. Positive It is a statement of ‘what is’.
Economics
7. Rational Choice Individuals make wise and logical decisions.
8. Scarcity Fundamental economic problem of having seemingly unlimited human
wants in a world of limited resources.
9. Value Judgment An assessment of something as good or bad in terms of one’s standards
or priorities.

Activity 1.1.1

A. MULTIPLE CHOICE QUESTIONS

1. Microeconomics mainly deals with

A. price theory
B. positive economics
C. aggregate behavior
D. normative economics

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2. The unemployment rate and the economic indicator of real GDP are the economic issues that
come under
A. macroeconomics.
B. microeconomics.
C. wishful thinking.
D. fallacy of composition.

3. Macroeconomics is concerned with

A. national demand for labour.

B. price of potatoes in the market.
C. economic behavior of individuals.
D. production level in a furniture firm.

4. Which of the following is an example of a normative statement?

A. If the money supply falls, interest rates will rise.

B. If interest rates go up, then construction activity will fall.
C. The national government’s total spending should be reduced.
D. The quantity of shirts sold increases as the price of shirts decreases.

5. “Reducing inflation is a more important objective than economic growth” is an example of

A. reality economics.
B. positive economics.
C. objective economics.
D. normative economics.

B. SHORT ANSWER QUESTIONS

1. Classify the following under normative or positive economics by placing a tick () in the
appropriate box.

Statements Normative Positive

Economics Economics

Conditions seeks to forecast the impact of the changes on

observable items like production
It is used to prescribe changes in policy
It is used to evaluate the desirability of alternative outcome
according to underlying value judgment
The statement that is supported with facts and evidence
When economic choice is made there is always an opportunity
cost involved
An increase in disposable income will shift the entire demand
curve to right
Government should raise tax on those goods that have harmful
effects on the society

(7 marks)

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2. Classify the following under Microeconomics or Macroeconomics by placing a tick () in the
appropriate box.

Statements Microeconomics Macroeconomics

Increase in price of coke will lead to increase in
demand for Pepsi.
An increase in money supply erodes the purchasing
power of money.
The labour force participation rate is influenced by
the composition of labour force.
The economic growth rate for the Fijian economy
these days is quite promising.
(4 marks)

LESSON 1.1.2 SCOPE AND METHODOLOGIES IN ECONOMICS

Achievement Indicators:
 Explore the Methodology and Scope in Economics.
 Identify the different fallacies in economics.
 Define various economic concepts related to the studying of economics.

Economists use scientific methodology to study the economic behavior of mankind.

The economists derive economic principles that are useful in the formation of policies designed to
solve economic problems through Inductive and Deductive Methodology.

Inductive methodology

We begin with collection of facts which are arranged systematically, organized and analyzed to
derive economics principles, laws, theories and models. It is also called historical, empirical or
statistical method.
Inductive method deals with moving from facts to theory. (MCiver&Brue, 1997:14)

Deductive methodology

Deductive method is also called hypothetical or abstract methodology. This method moves from
theory to facts where economists go about their by beginning at the level of theory and proceeding
to the verification or rejection of this theory by an appeal to the facts. (MCiver&Brue, 1997:14)

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 Applied Economics / Economic Policy

Combining facts and theories to formulate Economics Policies

Economic Analysis / Economics Theory

Organizing facts into principles, laws, models and theories

Induction deduction

Descriptive Economics [FACTS]

Identifying and collecting the relevant facts to an economics problem

Fallacies in Economics

Fallacies are the root of the technique of thinking in economics. Financial distresses, economic,
social and political instability, in addition to concentration of wealth are the outcomes of such way
of thinking. Fallacies are simply misleading arguments which we must be aware of and avoid.

The four main fallacies are:

1. The fallacy of composition -to assume that what is true for one individual will be true
for all. (A common error to assume that government finance operates same principles
as household finance. Simply because the prudent householder balances the family
budget ,it does not necessarily follow that government should do the same
e.g. the Paradox of thrift is a notable fallacy of composition that is central to Keynesian
economics.
2. The post hoc fallacy –the Latin phrase that means ‘after this, therefore because of
this’. The error lies in assuming that, because one event follows the other, the second
must be the result of the first. E.g. because inflation follows increased in government
spending, it is erroneous to conclude that government spending is the cause of
inflation; there may be many other factors that may be responsible.
3. Wishful thinking – is believing what we want to believe, and ignoring the
information or facts that conflicts with those beliefs. e.g. Economist Irving Fisher
said that "stock prices have reached what looks like a permanently high plateau" a
few weeks before the Stock Market Crash of 1929, which was followed by the Great
Depression.
4. Generalisations – generalisations or conclusions drawn based on limited or small
samples are misleading. For logical reasoning generalisations must be based on large
samples. e.g. all consumers are non-vegetarians.

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 Important concepts in the studying of Economics:
1. Economic Law –is a general statement of what will happen given certain circumstances. It is a
statement of tendency.

2. Economic Model – is a simplified picture of reality. It gives a simplified representation of how two
or more sectors of an economy function. Models are important tool in economic analysis used to
describe, predict, and understand the complexities of the real life. E.g. Circular flow model, PPC.
Models rarely answer the questions that policy makers are confronted with therefore value
judgments are needed to make predictions regarding possible economics outcomes. Economic
models are built based on economic assumption.

3. Assumptions are generalizations based on rational behavior and logical reasoning.eg constructing
PPC one assumption is an economy involved with two goods produced.

4. Economic Theory –is deriving economic principles from relevant economic facts. It establishes
cause and effect relationship. It helps to bridge the gap between economic model and reality. Theory
is developed by building and testing economic models. E.g. The Irving Fisher theory of interest
rate is an economic theory which describes the relationship between inflation and both real and
nominal interest rates.

5. Economic Reform is a government policy aimed to improve the efficiency with which each nation
allocates its resources. E.g. In the Education Sector free textbook per child is an economic reform
implemented to enhance efficiency.

6. Economic Policy is a course of action designed by government to influence or control economic

behavior and its consequences. Examples of economic policies include decisions made about
government spending and taxation, about the redistribution of income from rich to poor, and about
the supply of money. Economic policy is the deliberate attempt to generate increases in economic
welfare.

7. Policy Objectives or Macroeconomic Policy Objective

This refers to the achievement of a desirable level of a particular economic variable - e.g.
achieving a rate of inflation of 2%.
The main economic objectives agreed by modern policy makers in Fiji are:

(i) Stable and Sustainable Economic Growth and Development

For developing economies, further development is often the primary goal, and can be
summarized as the desire to increase the longevity of the population, increase access to
education, and attain a decent standard of living. Fiji targets an annual economic growth
rate of 5%.
(ii) Price Stability and Full Employment
Stable prices mean average prices rising by only a small amount, such as Fiji aims to manage
inflation around 3%. Full employment occurs when the labour force is fully employed in
productive work.

(iii) Favourable Balance of Payment with the rest of the world

This means that a country is able to ‘pay its way’ in the world. Fiji ensures that there is
enough in foreign reserves to cover up to 4 – 5 months of imports. It also targets annual
budget deficits at less than 3% of GDP and maintaining government debt at sustainable
level.

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 (iv) An Equitable (fair) Distribution of Income
An equitable distribution of income means that the gap between rich and poor is not
excessive, but still enough to create incentives to work. One way Fiji ensures fair
distribution of income is through progressive taxation system. Another initiative of
government to reduce poverty is implementation of social wages. Social wages is the right
to enough income for living as determined by basis of citizenship rather than employment.
Social wages are those things like free bus fare, free medicine, subsidizing of your
electricity, subsidizing of water. It is one way in assisting people who are most marginalized.

8. Policy Instruments are the means by which the aims and objectives might be achieved. For example,
the main policy instruments available to meet macroeconomic objectives are monetary policy and fiscal
policy.

Key Terms
No. Terms Definition
1. Assumptions A thing that is accepted as true or as certain to happen without
proof.
2. Deductive Method Concerned with developing a hypothesis based on existing
theory and then designing a research strategy to test the
hypothesis.
3. Descriptive Economics Involves gathering and compiling data about the economy.
4. Economic Law Is a general statement of what will happen given certain
circumstances.
5. Economic Model Is a simplified picture of reality.
6. Economic Theory Deriving economic principles from relevant economic facts.
7. Economic Reform Government policies aimed to improve the efficiency with
which each nation allocates its resources.
8. Economic Policy Courses of action designed by government to influence or
control economic behavior and its consequences.
9. Fallacy of Composition The error of assuming that what is true for the part is
necessarily true for whole.
10. Inductive Method Concerned with generation of new theory emerging from the
data.
11. Policy Objective / Is the achievement of a desirable level of a particular economic
Macroeconomic Policy variable.
Objective
12. Post Hoc Fallacy The error lies in assuming that, because one event follows the
other, the second must be the result of the first.
13. Wishful Thinking Believing what we want to believe, and ignoring the
information or facts that conflicts with those beliefs.

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 Activity 1.1.2

A. MULTIPLE CHOICE QUESTIONS

“A pen writes itself” is an example of

A. wishful thinking.
B. value judgment.
C. post hoc fallacy.
D. fallacy of composition.

2. Establishing cause and effect relationship to help explain how economies function is achieved
through formulating

A. theories.
B. assumptions.
C. economics models.
D. rational behavior.

3. The notion that ‘what is true for part is necessarily true for whole’ is an example of

A. generalization.
B. post hoc fallacy.
C. wishful thinking.
D. fallacy of composition.

4. Inductive approach in economics deals with

A. economics analysis.
B. descriptive economics.
C. collecting and organizing facts into theories.
D. verification or rejection of the theory by an appeal to the facts.

5. Economic model helps to

A. give a picture of reality.

B. based on logical reasoning.
C. show the cause and effect relationship.
D. derive economic principles from relevant economic facts.

6. Theory in economics

A. bears no relation to reality.

B. involves some simplification of reality.
C. focuses on unique aspects of each situation.
D. involves so much distortion of reality that it is worthless.

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B. SHORT ANSWER QUESTIONS

QUESTION 1
a. Use the information in the flow chart given below and your knowledge to answer the
questions (i) to (iii).

Applied Economics

Economics Analysis

Descriptive Economics

i. Define Economic Analysis. (1 mark)

ii. Explain how is an Economic Analysis is developed. (1 mark)

iii. Differentiate between Applied Economics and Descriptive Economics. (2 marks)

b.
i. Economic models are used in economics to explain many concepts.
What is the significance of using models? (1 mark)

ii. Models are based on assumptions. State one economic model you have
studied this year and outline the two assumptions for that model. (1 mark)

c. State the difference between the Deduction and Induction Methods as far as the
scope and methodology is concerned. (2 marks)

d. Distinguish between an economic model and economic theory. (2 marks)

e. Define Economic Reform. (1 mark)

f. Explain why economic reform is needed in an economy. (2 marks)

g. Give an example of an economic policy and a policy objective in Fiji. (2 marks)

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QUESTION 2

a. Use the information in the flow chart given below and your knowledge to answer questions (i)
to (iv).

(Source: FSFE Economics paper, 2009)

(i) Differentiate an economic model from an economic theory (2 marks)

(ii) Why are economic models important in the study of an economy? (1 mark)

(iii) Explain why assumptions have to be stated when we construct an economic model.(2 marks)

b. Define the following terms:

(i) Fallacy of Composition

(ii) Post hoc fallacy

(iii) Wishful thinking (3 marks)

c. Do assumptions have to be realistic in order for a theory to work? (1 mark)

d. Why do economists theorise rather than attempt to describe reality exactly? (1 mark)

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QUESTION 3 MATCHING
Match the terms listed in Column A with Column B.
Column A Column B
1. Assumptions A. Concerned with the generation of new theory
emerging from the data.
2. Fallacy of Composition B. Is a branch of economics that focuses on the
description and explanation of phenomena, as well as
their casual relationships.
3. Inductive Method C. Two events occurred in succession, the former event
caused the latter event.
4. Positive Economics D. Generalizations based on rational behavior and
logical reasoning.
5. Post hoc Fallacy E. Is a branch of economics that expresses value or
normative judgments about economic fairness.
6. Normative Economics F. Researcher works from more general information to
more specific information.
7. Deductive Method G. The false assumption that something which is true for
one segment of the economy is true for the economy as a
whole.
(7 marks)

Research Question
Identify 3 recent macroeconomic policy objectives of our country and analyse its respective
policy instruments. (10 marks)

C. ESSAY WRITING QUESTION

“Government intervenes in the economy through making policy objectives, economic
reforms, policies and initiatives.”
With reference to the above statement, discuss:

 definitions of policy objective, economic reform and economic policy. (3 marks)

 any three policy objectives of the Fijian government. (3 marks)
 any three ways government tries to achieve these policy objectives. (3 marks)

16
LESSON 1.1.3 SCHOOLS OF ECONOMIC THOUGHT
Achievement Indicator:

 Explore the five major schools of thought and their contributions to the
economic literature.

The study of economics can help to solve, understand and search for solutions to some of the
world’s most pressing problems e.g. Inflation, unemployment, poverty, international monetary
problems and the operation of capitalists and socialists. The economic theory began with Aristotle
and Plato before 1643 B.C their ideas was based on historical economics.
A School of Economic Thought is a group of economic thinkers who share or shared a common perspective
on the way economies work. While economists do not always fit into particular schools, particularly
in modern times, classifying economists into schools of thought is common.

School of Basic Idea Economists Involved Main theories & Contributions

Economic
Thought
First school dominated Adam smith (1723 – -Modern free market
1. Classical economic thinking from 1790) -division of labour
1700s to 1870. Ideas on the -Principle of Invisible Hand
principle of Invisible Hand, -Price mechanism
Self Interest, and rational coordinates supply and
behavior to explain how demand
capitalist or laissez-faire -Realized importance of
economy works best labour in producing wealth
without government -Capital accumulation leads
intervention. to economic growth.
In this paradigm economic
laws derived by deductive
methods of reasoning
immersed.
2.Neo- An approach to economics Alfred Marshall -Rational Expectations
Classical that relates supply and (1842-1924) -Efficient Market Hypothesis
demand to an individual's - Real Business Cycle
rationality and his or her -Utility Maximization
ability to maximize utility or -Marginalism
profit. - Perfect Competition
They went against classical -Equilibrium
economist. -Introduced quantitative
Concept of marginal utility models and diagrams to
(microeconomics) was explain human behaviour in a
introduced. scientific manner

3.Keynesian An economic theory of total -John Maynard -macroeconomic

spending in the economy and Keynes (1883 – 1946) -Keynesian economics
its effects on output and -liquidity preference
inflation. -Spending multiplier
Keynes advocated increased -AD-AS model
government expenditures -Deficit financing
and lower taxes to stimulate -Government involvement in

17
 demand and pull the global the economy is important
economy out of the -Market forces do not ensure
Depression. full employment
-An important relationship
links consumption, savings
and investment
-Demand plays a vital role in
the economy
4.Monetarist Focuses on the Milton Friedman -Price theory
macroeconomic effects of (1912 – 2006) -Monetarism
the supply of money and -Applied macroeconomics
central banking. -Floating exchange rates
Market forces must operate -Permanent income
freely to ensure efficiency hypothesis
and choice. -Volunteer military
The role of government -Friedman test
should be very restricted. -Supply is an important
factor in the economy
-Private ownership of
resources is fundamental in
the operation of a competitive
market economy

5.Welfare It is the normative branch of Vilfredo Pareto (1848 -Pareto Optimality

economics that is concerned - 1923) -Helped develop the field of
with the way the economic Microeconomics
activity ought to be arranged -First to realize that cardinal
so to maximize economic utility could be dispensed
welfare. with and economic
equilibrium thought of in
terms of ordinal utility
- Pareto Index as a measure of
inequality of income
distribution

18
Key Terms
No. Terms Definition
1. Capitalist Is an economic system based on private ownership of the means of
production and their operation for profits.
2. Classical Economics Asserts that markets function best with minimal or no government
interference.
3. Division of Labour Separation of a work process into a number of tasks with each task
performed by a separate person or group of persons.
4. Free Market A market based on supply and demand with little or no
government control.
5. Invisible Hand Unobservable market force that helps the demand and supply of
goods in a free market to reach equilibrium automatically.
6. Keynesian Economics An economic theory of total spending in the economy and its
effects on output and inflation.
7. Marginal Revolution Development of economic theory in the late 19th century which
explained economic behaviour in terms of marginal utility.
8. Monetarist Is an economist who holds the strong belief that the economy’s
performance is determined almost entirely by changes in the
money supply.
9. Neo-classical An approach to economics that relates supply and demand to an
Economics individual’s rationality and his ability to maximize utility or profit.
10. Pareto Index Is a measure of the breadth of income or wealth distribution.
11. Price Mechanism Interaction of supply and demand determines the price of goods
and services.
12. Specialisation Method of production where a business, area or economy focuses
on the production of limited scope of products or services to gain
greater degrees of productive efficiency within an overall system.

Activity 1.1.3
A. MULTIPLE CHOICE QUESTIONS
1. A school of thought that asserts that markets function best with minimal or no government
interference

A. Classical
B. Neo-classical
C. Keynesian
D. Monetarist

2. The economist who set many principles that underlie the contemporary microeconomic theory
was

A. John Maynard Keynes

B. Milton Friedman
C. Alfred Marshall
D. Adam Smith

19
3. The economist who placed emphasis on the role of government to bring macroeconomic
equilibrium

A. John Maynard Keynes

B. Adam Smith
C. Milton Friedman
D. Alfred Marshall

4. A school of thought concerned with maximizing economic well-being

A. classical
B. welfare
C. keynesian
D. neo-classical

Use the information about the Economist given below and answer questions 5 and 6.

 Born in 1883
 20th century Economist
 Famous for
 Macroeconomic equilibrium
 Demonstrates that unemployment could persist
unless government steps in.

5. Which of the following Economic theorist is being described above?

A. Alfred Marshall
B. Adam Smith
C. Milton Friedman
D. John Maynard Keynes

6. Which school of thought does the above economist belong to?

A. Keynesian
B. Neo-classical
C. Classical
D. Monetarist

B. SHORT ANSWER QUESTIONS

1. The following table is the summary for the findings and beliefs of some of the theorist or
economist. You are required to complete the details related to the ideas and theories of the
relevant economist. (4 marks)

Economists Underlying idea or theory Literature Class or

/theorist school of
thought

Alfred Marshall Marginal analysis, marginal Principles of (i)

(1842-1924) utility, concept of demand Economics

20
 and supply
Adam Smith The principle of invisible (ii) Classical
(1723 - 1790) hands and free market
John Maynard (iii) General Keynesian
Keynes Theory of
(1883-1946) Employment,
Interest and
Money

Milton Friedman Role of money supply, Quantity (iv)

(1912- 2006) inflation, permanent income theory of
hypothesis money

2. Explain:
i. Milton Friedman’s quantity theory of money
ii. Adam Smith’s Invisible Hand Concept (4 marks)

3. Use the Resource list given below and your knowledge to answer the questions (i) to (iv).
Resource List
Adam Smith
Alfred Marshall
John Maynard Keynes
Vilfredo Pareto
Milton Friedman

Identify the name of the economists associated with each of the identities and dominant
beliefs
(i) Publisher of ‘The Theory of Foreign Trade: The Pure Theory of Domestic Values’
(ii) General theory of employment, interest and money
(iii) Used pin factory example to explain specialization and division of labour
(iv)Defender of free market and advocate of a monetary rule (4 marks)

4. Identify the economic school of thought associated with each of the distinguishing features
given below.
i. Economies would work best if left to function on its own without government regulation.
Then self-interest would lead business firm to produce only those goods that consumers
wanted, and produce them at lowest costs.

ii. The unemployment could persist indefinitely, unless government steps in to increase
government spending which would lead to increase total demand, resurgence of business
activity, and the restoration of full employment

21
 iii. It is school of economic ideas based on the writing of Marshalls that superseded the
classical economic thought. Frequently referred to as marginal revolution.
iv. It is the normative branch of economics that is concerned with the way the economic
activity ought to be arranged so to maximize economic welfare. (4 marks)

5. Use the following resource and your own knowledge to answer questions (i) to (iii).

John Maynard Keynes is an economist and a theorist in his own right. He is a renowned
economist especially for the various economic models that he has put together over the years-
one of which is the economic model that has and incorporates the underlying assumption of
the 45 degree Aggregate Supply line together with the Aggregate Demand curve.

Adapted from: An Unpublished Paper on Modern Economic Theories and Principles, 2011.

(i) Is the economist and theorist John Maynard Keynes mainly a supply or a demand-side
economist? (1 mark)

(ii) Which macroeconomic model was put together by John Maynard Keynes as in the context
of the 45 degree Aggregate Supply line and the Aggregate Demand curve? (1 mark)

(iii) Which school of thought does John Maynard Keynes belong to? (1 mark)

6. Use the resource list given below and your knowledge to answer the questions that follow:

Resource List
Economic Schools Of Thought
 Classical
 Keynesian
 Neo-classical

(Source: FSFCE Economics paper, 2010)

Identify the economic school of thought associated with each of the distinguishing features given
below. Each economic school of thought is to be only once.

(i) The market mechanism on its own could not always cure itself of a recessionary period
due to market failure or inflexible prices and wages. The implication of this was that
there was a role for active management of aggregate spending by government.
(1 mark)

22
 (ii) The movement of prices and wages would ensure that free market economies would
always restore themselves and quite quickly, after periods of ‘glut’. (1 mark)

(iii) Major contributions were the role of rational expectations, with the implication that
active policies were ineffective because people would adjust their beliefs and behaviour
accordingly and real variables are insensitive to active demand management.(1 mark)

C. ESSAY WRITING QUESTION

1. The schools of thought have been an important source of foundational knowledge

in understanding economics.
Discuss the above statement with reference to:

 three types of schools of thought you are familiar with; (3 marks)

 three respective economists in the respective schools of thoughts above with

their beliefs; (3 marks)
 three reasons why the study of Economic theorists is important. (3 marks)

2. A school of economic thought is a group of economic thinkers who share or shared a

common perspective on the way economies work to uphold rational thinking and economic
efficiency.
Discuss the above statement with reference to:
 any three economic ideas contributed by classical economics (3 marks)
 any three economic ideas contributed by neo-classical economics (3 marks)
 any three economic ideas contributed by Keynesian economics (3 marks)

23
STRAND 2 MICROECONOMICS

Strand Outcome:

Investigate the interaction between producers and consumers and evaluate

their impacts on the production of goods and services.

Content Learning Outcomes:

 Explore the theory of marginal utility and indifference curve analysis to
explain consumer behaviour.
 Explore the role of marginal productivity theory in factor employment
 Explore the Mathematical Derivation of Equilibrium Price and
Quantity.
 Discuss the significance of tourism linkages in Fiji with other productive
sectors.
 Explore the sustainability of the Tourism Industry in Fiji’s economy.
 Explore the role of transport in connectivity.
 Evaluate price elasticity of supply and justify its importance.

24
A. CONSUMER BEHAVIOUR

LESSON 2.1.1 Utility, Total Utility and Marginal Utility

Achievement Indicator:

 Define utility, total utility and marginal utility.

 Calculate and graphically illustrate total utility and marginal utility.
 Explain the significance of the Law of Diminishing Marginal Utility
 Identify optimum level of consumption.
 Explain the optimal purchase rule: Consumer Equilibrium.
 Use the optimal purchase rule to derive a person’s demand curve.

 Utility is a measure of satisfaction derived from consumption of goods and services. Utils
is arbitrary unit used to measure utility which does not have monetary value. E.g. consumed
a glass of water and utility derived is 10 utils.
 Total utility (TU) is the total satisfaction derived from consumption of a particular good or
service.
 Marginal utility (MU) is the extra satisfaction gained from consuming an additional unit
of a good or service.

The formula to calculate marginal utility is:

MU= TU2 -TU1

Total Utility and Marginal Utility in Practice – Example 1

Suppose, Tuti, a student who was very thirsty goes to the Suva Market to buy a glass of lemon
juice. That glass of lemon juice gives him immense pleasure or we say the first glass of lemon juice
has great utility for him. If he takes the second glass of lemon juice after that, the satisfaction or
utility will be less than the first one and likewise if he drinks the third one and so on.

The table below clearly shows that in a given span of time,

the first glass of lemon juice gives him 20 utils or units of
utility. With the increase in the glass of lemon juice to the
second, his extra level of satisfaction (marginal utility -
MU) will now decrease to 15 utils. Further increases in the
lemon juice consumed will result in marginal utility
dropping to zero and even a disutility of -5. As a rational
consumer, Tuti should not consume any lemon juice when
his MU is negative. This is when Tuti will be dissatisfied as
he cannot take any more glasses of lemon juice.

Source: http://ecodeclassified.com

25
Tuti’s Total Utility and Marginal Utility of Lemon Juice

Glasses of Lemon Juice Total Utility (Utils) Marginal Utility (Utils)

1st glass 20 20
2nd glass 35 15
3rd glass 45 10
4th glass 50 5
5th glass 50 0
6th glass 45 -5

Hence, the above table confirms the relationships below:

1. When total utility increases at a diminishing rate, marginal utility decreases.

2. When total utility is maximum (at the 4th glass), marginal utility is zero. It is the highest
point of satisfaction for the consumer.
3. When total utility is decreasing, marginal utility is negative (at the 6th glass).

Graph of Total and Marginal Utility of Glasses of Lemon Juice Consumed

60
ALFRED MARSHALL
50
perfected the ideas
40 and contributions on
30 utility and made it as
Utilities (TU &

Total utility a law- LAW OF

20
DIMINISHING
10 Marginal utility
MARGINAL UTILITY
MU)

Quantity (glasses of lemon juice )

As has been stated in strand 1, in economics we use the important concept of marginality to make
rational decisions and this looks at the last unit consumed. That is, given the last situation, should
one more unit of a good be consumed or not. Hence, economists have developed two important
principles based on the marginal utility analysis.

1. Law of diminishing marginal utility ( from which we derive the demand curve)
2. Law of equi-marginal utility

1. Law of Diminishing Marginal Utility

Law states that as Tuti drinks more and more glasses of lemon juice, the extra satisfaction that he
derives from drinking another glass of lemon juice will continue to fall. In economic terms we say
that the marginal utility of the lemon juice diminishes as Tuti consumes more lemon juice. It is
important to note that the marginal utility and not the total utility that diminishes. In terms of total
utility, we can say that the total utility increases at a decreasing rate.

26
 Putting a Dollar Value on Utility – The Optimal Purchase Rule

Due to the limited income earned by consumers, they need to make choices on the proper allocation
of their income in their various purchases in order to gain maximum satisfaction. Hence, a person
can put a dollar value on personal satisfaction from consuming an item which differs for different
consumers. Some consumers would treat drinking coffee in a coffee shop with a high value
regardless of the how expensive the prices are. On the other hand, other consumers would value
coffee drinking in coffee shops as of very low value and would not give up an extra dollar to go
there.

We are going to revisit the concept of marginal analysis to help in our decision making on whether
to give up an extra dollar to buy an extra unit or not. Marginal analysis = comparing the extra benefit
with the extra cost in making a decision. When deciding how many more glasses of lemon juice
Tuti would consume at the given prices, we would need to compare how much extra benefit (MU)
Tuti would gain against the extra cost (price).

Significance of the Law of Diminishing Marginal Utility

It forms the basis of the law of demand and the concept of consumer surplus. It explains the
downward sloping of the demand curve. This is the optimal purchase rule- where consumers will
consume up to the point where P = MU. A consumer will only buy extra units if their value of
personal satisfaction from the extra unit is above or equal to the price they have to pay.

Using the Optimal Purchase Rule to Derive a Person’s Demand Curve

A person’s demand curve for a good or service is defined as the amount of a good or service that
a person is willing and able to buy at each price level. Marginal utility will determine a person’s
demand for a good or service. An individual demand curve is the same as their marginal utility
(dollars) curve.

Tuti’s Derivation of Demand Curve – Table 1

Glasses of Marginal Utility (Utils) Price ($0.50)

Lemon Juice
1st glass 20 ?
2nd glass 15 ?
3rd glass 10 ?
4th glass 5 ?
5th glass 0 ?
6th glass -5 ?

The first glass of juice will give Tuti 20 units of satisfaction. If the price was 20 cents, it would fit
with the optimal purchase rule as we will pay 20 cents to get 20 utils of satisfaction. How can we
convince Tuti to buy another glass of juice?

27
If price remained at 20 cents, then the consumer would be faced with:

Marginal Utility = 15 units sacrifice of $0.20 cents will not be a worthwhile choice for Tuti. If
the consumer would have to give up 20 cents gain 15 units of satisfaction is not rational.

What do we need to do then?

We need to reduce price down to the new level of marginal utility of the second glass of lemon
juice as shown below:

Marginal Utility = 15 units Sacrifice or Price = $0.15 cents

Hence, in order to induce Tuti to buy another glass of lemon juice which will lower the marginal
utility, price must fall too. Therefore, we derive the table below:

Tuti’s Derivation of Demand Curve – Table 2

Glasses of Marginal Utility (Utils) Price ($0.50)

Lemon Juice
1st glass 20 0.20
2nd glass 15 0.15
3rd glass 10 0.10
4th glass 5 0.05
5th glass 0 free
6th glass -5

We see that to induce or persuade Tuti to buy a third glass (lowering the MU to 10 utils), and
upholding the optimal purchase rule, he needs to sacrifice and price must fall too. Otherwise Tuti,
or any rational consumer will not buy. This leads to the :

LAW OF DEMAND

(Price increase - Quantity Demand Decrease (Vice Versa), Ceteris Paribus = All else remains
the same).

The optimal purchase rule (MU=P) must hold at all times. When we rearrange the columns with
the substitution of Demand for Marginal Utility, the table would be as given below:

Tuti’s Demand Schedule - Table 3

Price ($) Quantity Demanded

(Glasses of Lemon Juice)
0.20 1
0.15 2
0.10 3
0.05 4

28
Tuti’s Demand Curve
price
$ D
0.20

0.15
Demand Curve
0.10 derived from
Marginal Utility
0.05
D

Quantity
0 1 2 3 4 (glasses)

Example 2 Ilaitia’s Marginal Utility of Ice – Cream Consumption

Figure 2.2: Law of Diminishing Marginal Utility

25 MU curve slopes
downwards, indicating
20
decrease in satisfaction
Marginal Utility of Ice Cream

with each successive

15
ice-cream.
10 Zero MU

-5 Negative MU

-10 MU
Cones of Ice Cream

As Ilaitia increases his consumption of ice-cream while keeping consumption of other products
constant, there is increase in total utility at first then reaches maximum and starts to decline.
However, there will be a decline in marginal utility derived from consuming each additional cone
of ice-cream. After consuming 5 cones of ice-cream, Ilaitia’s marginal utility is negative and
becomes entirely unfavourable to consume another cone of ice-cream.

29
2. Law of Equi-Marginal Utility – a consumer will distribute his money income between the
goods in such a way that the utility derived from the last dollar spend on each good is equal. In
other words, consumer is in equilibrium position when marginal utility of money expenditure on
each goods is the same.

Law of Equi-marginal MU A= MUB

utility =

Consumer Equilibrium

(i) In case of one good, a consumer reaches its equilibrium position when the marginal utility
derived from the last unit consumed is exactly equal to the price of commodity, i.e. P = MU.
Optimal purchase rule applies here.

(ii) In case of two or more goods, a consumer is in equilibrium when the utility derived from the
last dollar spent on each goods are equal.

 Example

 Let us assume there are only three commodities available in the market, A, B and C. Also
assume that Tom has an income of $15 to spend on three commodities.
 Product A costs $1 per unit, Product B costs $3 per unit and Product C costs $5 per unit.
 Note that diminishing marginal utility sets in immediately for each of the three products.
 Marginal utility information is described on per $ basis, because a consumers choice are
influenced not only by the amount of additional utility that successive units give him but
also how many dollars he give up to get them.

 Let us consider each dollar spent.

 Marginal utility per dollar shows that one dollar spend on Product A provides the highest
satisfaction of 20 utils as opposed to only 12 and 8 utils from products B and C, respectively.
 Second dollar spends again buys the highest utility of 15 utils.
 However, when Tom spends the third dollar, a switch to Product B promises 15 utils of
added satisfaction as opposed to 11 utils from Product A.
 Following the principle, the best combination Tom can purchase with $15 would be 4 units
of A, 2 units of B and 1 unit of C. The total utility generated would be 154 utils. $4 spent
on A give 54 utils of satisfaction; $6 spent on Product B gives 60 utils and $5 spent on C
gives 40 utils.
 This gives a total of 154 utils.
 No other combination will result in as high utility as this with an expenditure of $15.

30
 Price and Utility Information for Products A, B and C in Units
Units of Product A Product B Product C
Products Marginal Marginal Marginal Marginal Marginal Marginal
Utility Utility per $ Utility Utility per $ Utility Utility per $
1 20 20 36 12 40 8
2 15 15 24 8 35 7
3 11 11 15 5 30 6
4 8 8 9 3 25 5
5 6 6 6 2 20 4

The results from the table above can be generalised to n commodities and the following condition
should hold in equilibrium:

Example II

Nancy’s Computation of her ratios of the Law of Equi-Marginal Utility.

Units MUa ÷ Pa MUb ÷ Pb MUc ÷ Pc

1 30 ÷2=15 24÷3=8 15÷5=3
2 20÷2=10 25÷3=5 10÷5=2
3 16÷2=8 9÷3=3 8÷5=1.6
4 8÷2=4 6÷3=2 5÷5=1
5 6÷2=3 3÷3=1 1÷5=0.2
6 4÷2=2 1÷3=0.3 0÷5=0
Pa = $2 Pb = $3 Pc = $5

Consumer Disequilibrium

1) If MUA > MUB

PA PB

The consumer has to substitute to good A for good B so that the marginal utility derived from
good A will decrease in order to reach equilibrium position.

2) If MUA < MUB

PA PB
The consumer has to substitute to good B for good A so that the marginal utility derived from
good B will decrease in order to reach equilibrium position.

31
Key Terms
No. Terms Definition
1. Law of Diminishing States that as consumption of a particular good increases by
Marginal Utility successive equal additions than marginal utility generated
eventually diminishes.
2. Law of Equi-marginal States that the consumer will distribute his money income
Utility between the goods in such a way that the utility derived from the
last dollar spend on each good is equal. In other words, consumer
is in equilibrium position when marginal utility of
money expenditure on each goods is the same.
3. Marginal Utility The extra satisfaction derived from consumption of additional
unit of a good or service.
4. Optimal Purchase Rule States that a consumer should purchase more of a good until price
is equal to marginal utility.
5. Total Utility Total satisfaction derived from consumption of a quantity of
goods.
6. Utility Satisfaction derived from consumption of goods and services.
7. Utils Arbitrary unit used to measure utility which does not have
monetary value.

Activity 2.1.1

A. MULTIPLE CHOICE QUESTIONS

1. When total utility is at maximum then marginal utility
A. is zero.
B. increases.
C. decreases.
D. becomes negative.

2. An extra satisfaction derived by a consumer from consuming an additional unit of a good is

A. utils.
B. utility.
C. total utility.
D. marginal utility.

3. Utility is best defined as the

A. price of a good.
B. practical usefulness of a good.
C. satisfaction from consuming a good.
D. amount one is willing to pay for a good.

32
4. According to the law of diminishing marginal utility

A. utility is at maximum at last unit of consumption.

B. marginal utility remains same at all levels of consumption.
C. increasing units of consumption increases the marginal utility.
D. total utility will rise at a falling rate as more units are consumed.

B. SHORT ANSWER QUESTIONS

a) Define utility. (1 mark)

b) Differentiate between total utility and marginal utility. (2 marks)
c) Copy and complete the following statements

1. Marginal Utility as more donuts are consumed.

2. Total Utility as more donuts are consumed but at a

rate.

3. Total Utility will be the greatest when Marginal Utility equals .

4. Total Utility will fall if marginal utility is . (5 marks)

d). Describe: (3 marks)

i. the trend of total utility as a person consumes more and more of a product.
ii. the trend of marginal utility as a person consumes more and more of a product.
iii. the trend for quantity demand as price falls.

e). Explain why consumers increase their quantity demanded as price

falls.
(2 marks)
(f) Use the table given below to answer the following questions.

Grace’s Total and Marginal Utility of Chocolates

Bars Chocolate Total Utility Marginal Utility

1 100
2 190 90
3 270 80
4 340 70
5 400 60
6 450 50
7 490 40
8 520 30
9 540 20

33
 (i) Suppose the bars of chocolates were free, how many bars would a rational consumer
consume? ( 1 mark)
(ii) Explain the Law of Marginal Utility of Grace’s chocolate consumption. ( 2marks)
(iii) Explain the significance of the law for Grace. (2 marks)
(iv) Relate the Optimal Purchase Rule to Grace’s consumption if the price was $1.00. (2 marks)
(v) Suppose money has the equivalent utility of 1c= 1 util.
(a) Derive a demand schedule for Grace. (2 marks)
(b) From the demand schedule, derive her demand curve using marginal utility.
(2 marks)
g) Calculate marginal utility then construct total utility and marginal utility curves from the
table given: (Label all parts of the graph correctly)

Quantity (bananas) TU MU
1 48 48
2 84
3 180
4 120
5 126
6 126
7 118
(6 marks for the table and 2 marks for the graph)
h). Study the information given below and use your knowledge to answer questions
(i) to (iv).
Schedule of Total Utility and Marginal Utility
Cans of Soft Drink Total Utility (TU) Marginal Utility (MU)
(Quantity)
1 20 20
2 35 15
3 45 10
4 50 5
5 50 0
6 45 -5
(Source: FSFCE Economics paper, 2009)
(i) On a pair of x and y axes, draw the Total Utility (TU) and Marginal Utility (MU) curves.
Label the curves clearly. (3 marks)

34
(ii) Explain the Law of Diminishing Marginal Utility as defined in the table above. (1 mark)
(iii) State the optimal purchase rule using standard notations. (1 mark)
(iii) Complete the statement given below by filling in one relevant word.
Mathematically speaking, the marginal utility that one receives from consuming an extra
can of soft drink is the of the total utility curve. (1 mark)

Activity 2.1.2

B. SHORT ANSWER QUESTIONS

1) Suppose you are interested in purchasing just bottles of wine and kilograms of cheese for an
upcoming party. Assume you have only $45 to spend, the price per bottle of wine is $5 and the
price per kilogram of cheese is $10. You have estimated the utility (or satisfaction) from the
consumption of wine and cheese at the party according to the following table.
Wine Cheese
Quantity Total Utility Quantity Total Utility
0 0 0 0
1 100 1 130
2 175 2 250
3 225 3 350
4 250 4 425
5 260 5 465

(a) How many bottles of wine and kilograms of cheese should you purchase for the party?
Why?

(b) Suppose the price of cheese per kilogram falls to $7.50. Now how many bottles of
wine and kilograms of cheese should you purchase for the party? Why?

3). Jacob is a Lego maniac, but he also likes Super Soaker squirt guns. The following table shows
Jacob’s total utility and marginal utility from Legos and squirt guns measured in utils.

Quantity TU MU MU/P Quantity TU MU MU/P

of Legos of squirt
guns

1 20 20 1 50 50
2 37 17 2 75 25
3 50 13 3 90 15
4 60 10 4 100 12
5 65 5 5 102 2
(Source: www.scribd.com)
(a) Suppose the price of Legos is $5 per set and the price of a squirt gun is $8 per gun. Compute
the marginal-utility-to-price ratios for Legos and squirt guns and enter these values in the
table. (1 mark)

35
 (b) How many sets of Legos and how many squirt guns will Jacob purchase if he has $26 to
spend? Carefully explain how you arrived at your answer. (1 mark)
(c) Now suppose the price of Legos falls to $2.50 per set while the price of squirt guns stays
the same. How many sets of Legos and how many squirt guns will he purchase? Show how
you arrived at your answer. (2 marks)

5. Complete the table given below:

Vincentia ’s Total and Marginal Utility for Cadbury Chocolate Bars

Quantity Purchased Total Utility (TU) Marginal Utility (MU)
1 300
2 550
3 750
4 150
5 1000
6 50
7 0
(7 marks)
C. ESSAY WRITING QUESTION
Consumer Behaviour can be explained using the concept of marginality.
Discuss the statement with reference to:

 the concept of marginality as practiced by a rational consumer. (3 marks)

 the relationship between marginal utility, optimal purchase rule, the demand curve.
(3 marks)
 explain the achievement of the optimum level of consumption using the law of
diminishing marginal utility and law of equi- marginal utility. (3 marks)


Economic Literature on
the Concept of Utility
For Bentham, and to a large extent for Jevons too, “utility” was strongly associated with the pleasure
felt during the act of consumption. Gossen (1854) and Edgeworth (1881) reduced everything to this
pleasure alone. Actually, with Edgeworth’s Mathematical Psychics the hedonistic school of economic
behavior reached its climax. Gradually, however, economists came to realize that economic behavior
cannot be compared with that of an individual who decides whether or not to have more coffee while
drinking coffee. The modern concept of utility was worked out by Jennings (1855), who, curiously,
arrived at it after an excursion in psycho–physical parallelism far more extensive than that undertaken
by Edgeworth. Jennings pointed out that in choice the individual is guided by expected pleasure,
which in turn is based on the remembrance of the pleasures actually experienced in the past; but he
called this expected pleasure “value.

THE father of consumer choice theory, Alfred Marshall, believed that the more of something you
have the less of it you want: a phenomenon economists call diminishing marginal utility. However
this was only taken to be the case for an individual at one point in time, not over his entire life.
Addiction could prompt us to learn to like something if we consume more of it. Marshall picked out
good music as an example. The more we listen to good music, the more we want to buy.

(Adapted from: http://www.encyclopedia.com)

LESSON 2.1.2 INDIFFERENCE CURVES
INDIFFERENCE CURVE
Achievement Indicators:
 Define Indifference Curves.
 State significance of Indifference Curves.
 Outline assumptions of indifference curves.
 Sketch a simple indifference curve and explain its shape.

Hicks and Allen used ordinal utility approach for analyzing the consumer behavior. This analysis
is known as indifference curve analysis.
Indifference Curve – A curve that shows combinations of goods which gives the same level of
satisfaction to the consumers so that an individual is indifferent.

Figure 2.3 An Indifference Curve

Good Y

Indifference curve
Good X

Shape of indifference curve: usually convex to the origin, sloping from left to right.

Reason: Due to the Law of Diminishing Marginal Utility

Significance of Indifference Curves

1) It represents the potentially observable demand patterns for individual consumers over
commodity bundles.
2) Indifference curve is a better tool to classify substitutes and complementary goods.
3) It overcomes the weakness of Cardinal measurement as the satisfaction cannot be
measured objectively.
4) The cardinal approach provides the assumption of constant utility of money, which is
unrealistic. In indifference curve approach, this assumption has been dropped. Indifference

37
 curve approach is base for the measurement of 'consumer's surplus'. In a way it contributes
to the welfare economics.

Assumptions of Indifference Curves

(1) The consumer acts rationally so as to maximize satisfaction.

(2) There are two goods X and Y.

(3) The consumer possesses complete information about the prices of the goods in the market.

(4) The prices of the two goods are given.

(5) The consumer’s tastes, habits and income remain the same throughout an indifference curve.

Features (characteristics) of Indifference Curves

1) Indifference curves slope downward to the right: This property implies that an indifference
curve has a negative slope. Indifference curve being downward sloping means that when the
amount of one good in the combination is increased, the amount of the other good is reduced.
This must be so if the level of satisfaction is to remain the same on an indifference curve.

2) Indifference curves are convex to the origin: an indifference curve is that they are usually
convex to the origin. In other words, the indifference curve is relatively flatter in its right-hand
portion and relatively steeper in its left-hand portion. This property of indifference curves means
the marginal rate of substitution of X for Y (MRSxy) diminishes as more and more of X is
substituted for Y.

3) Indifference curves cannot intersect each other: they cannot intersect each other. In other
words only one indifference curve will pass through a point in the indifference map.
In Fig. 2.4 below two indifference curves are shown cutting each other at point C. Now take
point on indifference curve IC2 and point B on indifference curve IC1 vertically below A. Since
indifference curve represents those combinations of two commodities which give equal
satisfaction to the consumer the combinations represented by points A and C will give equal
satisfaction to the consumer because both lie on the same indifference curve IC2.

38
 Figure 2.4: Indifference Curves cannot Intersect Each Other

C
Good Y

R A

Q B IC2

IC1

0
M N Good X

Likewise, the combinations B and C will give equal satisfaction to the consumer; both being on the
same indifference curve IC1. If combination A is equal to combination C in terms of satisfaction,
and combination B is equal to combination C, it follows that the combination A will be equivalent
to B in terms of satisfaction. But a glance at Fig.2.4 will show that this is absurd conclusion since
combination A contains more of good Y than combination B, while the amount of good X is the
same in both the combinations. Thus, the consumer will definitely prefer A to B, that is, A will give
more satisfaction to the consumer than B. But the two indifference curves cutting each other lead
us to an absurd conclusion of A being equal to B in terms of satisfaction. We therefore conclude
that indifference curves cannot cut each other.

4) A higher indifference curve represents a higher level of satisfaction than a lower

indifference curve: a higher indifference curve will represent a higher level of satisfaction than
a lower indifference curve. Consider indifference curves IC1 and IC2 in Fig 2.5. IC2 is a higher
indifference curve than IC1. Combination Q has been taken on a higher indifference curve IC2
and combination S on a lower indifference curve IC1. Combination Q on the higher indifference
curve IC2 will give a consumer more satisfaction than combination S on the lower indifference
curves IC1 because the combination Q contains more of both goods X and Y than the
combination S.

Key Terms
No. Terms Definition
1. Indifference Curve Is the locus of various points showing different combinations of two
goods providing equal utility to the consumer.
2. Indifference Map Is a graph which shows a collection of indifference curves
representing an individual’s preferences.
3. Perfect Complement A good that has to be consumed with another good. The
indifference curve is right angle.
4. Perfect Substitute Are goods which, as a result of changed conditions, may replace
each other in use (or consumption). Indifference curve will be
straight line.

39
 Activity 2.1.3

A. MULTIPLE CHOICE QUESTIONS

1. The rate at which a consumer is able to substitute one good for another is determined by
A. consumer’s income.
B. indifference map.
C. ratio of the prices of goods.
D. marginal rate of substitution.
2. An indifference curve shows combinations of two goods that
A. a consumer could buy with their given income.
B. could be available to the consumer in a given time period.
C. could provide the consumer with similar levels of satisfaction.
D. would provide the consumer with the same level of satisfaction.

3. If bundles of goods A and B lie on the same indifference curve, one can assume

A. the individual prefers bundle A to bundle B.

B. the individual prefers bundle B to bundle A.
C. the individual enjoys bundle A and B equally.
D. bundle A contains the same goods as bundle B.

B. SHORT ANSWER QUESTIONS

1. Explain why two indifference curves cannot intersect. (2 marks)

2. Study the graph below and answer the following questions.

Mobiles

A
Aaa
X
9

Y
7

Indifference curve
3 5 Cars

40
(a) Explain the shape of indifference curve given above. (2 marks)
(b) State four features of indifference curve. (2 marks)
(c) What is the utility level at point X? (1 mark)
(d) Draw shift in indifference curves to indicate:
(i) Higher utility
(ii) Lower utility (2 marks)

LESSON 2.1.3 Budget Line, Utility Maximization and

Consumer Equilibrium
Achievement Indicators:
 Define budget line.
 Discuss features of budget lines.
 Briefly illustrate utility maximization and consumer equilibrium using budget lines
and indifference curves.

Budget Lines
Is a graphical representation of all possible combinations of two goods which can be purchased
with given income and prices, such that the cost of each of these combinations is equal to the
money income of the consumer.
A consumer’s income and its purchasing power define the budget constraint which indicates
that the income must be equal to expenditure.

Equation of the Budget Line:

I = PX.QX + PY.QY
Income = Expenditure
Budget Set
Budget set is the set of all possible combinations of the two goods which a consumer can
afford, given his income and prices in the market.

Illustrative Example of Budget Line

The graph shows possible combination of 2 goods (chocolate and music downloads) that a
consumer purchases with the given amount of income and prices such that:
(price of chocolate bar× qty)+ (price of music downloads× qty) = income of consumer

41
Figure 2.6: Graph Showing Budget Line of Chocolate bars and Music Downloads

Number of Music Downloads Budget Line

𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐ℎ𝑜𝑐𝑜𝑙𝑎𝑡𝑒 𝑏𝑎𝑟

Slope = - 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑚𝑢𝑠𝑖𝑐 𝑑𝑜𝑤𝑛𝑙𝑜𝑎𝑑

Number of
Chocolate Bars

Diagrammatic Explanation of Budget Line:

Suppose, a consumer has a budget of $20 to be spent on two commodities: apples (X) and bananas
(Y). If apple is priced at $4 each and banana at $2 each, then the consumer can determine the various
combinations (bundles), which form the budget line. The possible options of spending income of
$20 are given in Table I:

Table I. Schedule of Budget Line

Combination of Apples (X) Bananas (Y) Money spent =

Apples and ($4 each) ($2 each) Income ($)
Bananas [(PX×QX)+PY×QY)=I ]
A 5 0 (5 x 4) + (0 x 2) = 20

B 4 2 (4 x 4) + (2 x 2) = 20

C 3 4 (3 x 4) + (4 x 2) = 20

D 2 6 (2 x 4) + (6 x 2) = 20

E 1 8 (1 x 4) + (8 x 2) = 20

F 0 10 (0 x 4) + (10×2) = 20

42
 Figure 2.7 Budget Line Showing Apples and Banana Budget

Units of bananas

10 F

8 E H ( nattainable)

D Budget Line
6
C
4
G (u nderspent) B
2
A

1 2 3 4 5 6 Units of apple

In Fig.2.7, number of apples is taken on the X-axis and bananas on the Y-axis. At one extreme
(Point ‘A’), consumer can buy 5 apples by spending his entire income of $20 only on apples. The
other extreme (Point ‘F’), shows that the entire income is spent only on bananas. Between A and
E, there are other combinations like B, C, D and E. By joining all these points, we get a straight line
known as the Budget Line or Price line.

Every point on this budget line indicates those bundles of apples and bananas, which the consumer
can purchase by spending his entire income of $20 at the given prices of goods.

Important Points about Budget line (Refer Fig.2.7):

1. Budget line slopes downwards as more of one good can be bought by decreasing some units of
the other good.

2. Bundles which cost exactly equal to consumer’s money income (like combinations A to F) lie
on the budget line.

3. Bundles which cost less than consumer’s money income (like combination G) show under
spending (Underspent) they lie inside the budget line.

4. Bundles which cost more than consumer’s money income (like combination H) are not
available to the consumer (unattainable) they lie outside the budget line.

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Algebraic Expression of Budget Line

The budget line can be expressed as an equation:

I = (PX × QX) + (PY × QY)

Where:

I= income (Money Income);

Qx = Quantity of apples (X);

Qy = Quantity of bananas (Y);

Px = Price of each apple;

Py = Price of each banana.

All points on the budget line indicate those bundles, which cost exactly equal to ‘I’.

Slope of the Budget Line:

In the example of apples and bananas, slope of the budget line will be number of units of
bananas, that the consumer is willing to sacrifice for an additional unit of apple.

Slope of Budget Line = Units of Bananas (Y) willing to Sacrifice

Units of Apples (X) willing to Gain

= ∆Y
∆X

As seen in Fig. 2.7 bananas need to be sacrificed each time to gain 1 apple.

So, Slope of Budget Line = ∆Y

∆X
=-2
1
= 2
Numerator will always have negative value as it shows number of units to be sacrificed. However,
for analysis, absolute value is always considered. This slope of budget line is equal to ‘Price Ratio’
of two goods.

What is Price Ratio?

Price Ratio is the price of the good on the horizontal or X-axis divided by the price of the good on
the vertical or Y-axis. For instance, if good X is plotted on the horizontal axis and good Y on the
vertical axis, then:

PRICE RATIO = PRICE OF X (PX) / PRICE OF Y(PY) = PX / PY

44
Shift in Budget Line:
Budget line is drawn with the assumptions of constant income of consumer and constant prices of
the commodities. A new budget line would have to be drawn if either (a) Income of the consumer
changes, or (b) Price of the commodity changes.

Let us understand this with the example of apples and bananas

1. Effect of a Change in the Income of Consumer:

If there is any change in the income, assuming no change in prices of apples and bananas, then the
budget line will shift. When income increases, the consumer will be able to buy more bundles of
goods, which were previously not possible. It will shift the budget line to the right from ‘AB’ to
‘A1B1‘, as seen in Fig. 2.8. The new budget line A1B1 will be parallel to the original budget line
‘AB’.

Figure 2.8: Graph Showing Effect of Change in Income on Budget Line

Rightward Shift: Budget

B1
Line shifts to the right from
B AB to A1B1 due to increase
in income.
Bananas (B)

Leftward Shift: Budget

B2 Line shifts to the left from
AB to A2B2 due to decrease
in income.

A2 A A1 Apples (A)

(Source: www.yourarticlelibrary.com)
Similarly, a decrease in income will lead to a leftward shift in the budget line to A2B2.

Why is the new Budget line parallel to original budget line?

The new budget line ‘A1B1’or ‘A2B2’ is parallel to original budget line ‘AB’ because there is no
change in the slope. We know, the slope of a curve is calculated as a change in one variable that
occurs due to change in another variable. In case of budget line, slope = PX/PY As change in income
does not disturb the price ratio of the two commodities, the slope will not change and the budget
line, after change in income will remain parallel to the original budget line.

2. Effect of change in the relative Prices (Apples and Bananas):

If there is any change in prices of the two commodities, assuming no change in the money income
of consumer, then budget line will change. It will change the slope of budget line, as price ratio will
change, with change in prices.

(i) Change in the price of commodity on X-axis (Apples):

When the price of apples falls, then new budget line is represented by a shift in budget line (see
Fig.2.9) to the right from ‘AB’ to ‘A1B’. The new budget line meets the Y-axis at the same point
‘B’, because the price of bananas has not changed. But it will touch the X-axis to the right of ‘A’
at point ‘A1, because the consumer can now purchase more apples, with the same income level.
Similarly, a rise in the price of apples will shift the budget line towards left from ‘AB’ to ‘A2B’.

45
Figure 2.9: Graph Showing Change in Price of Apples

 Budget Line shifts from AB to A1B

due to decrease in price of Apples.
B  Budget Line shifts from AB to A2B
due to increase in price of Apples.
Bananas (B)

A2 A A1
Apples (A)

(ii) Change in the price of commodity on Y-axis (Bananas):

With a fall in the price of bananas, the new budget line will shift to the right from ‘AB’ to AB1 (see
Fig. 2.10). The new budget line meets the X-axis at the same point ‘A’, due to no change in the
price of apples. But it will touch the Y-axis to the right of ‘B’ at point ‘B1‘, because the consumer
can now purchase more bananas, with the same income level. Similarly, a rise in the price of
bananas will shift the budget line towards left from ‘AB’ to ‘AB2’.

Figure 2.10: Graph Showing Change in Price of Bananas

Bananas
B1
B

B2

Apples

46
Utility Maximisation and Consumer Equilibrium

"The term consumer’s equilibrium refers to the amount of goods and services which the
consumer may buy in the market given his income and given prices of goods in the market".

The aim of the consumer is to get maximum satisfaction from his money income. Given the price
line or budget line and the indifference map:
"A consumer is said to be in equilibrium at a point where the price line is touching the highest
attainable indifference curve from below".

Conditions:
Thus the consumer’s equilibrium under the indifference curve theory must meet the following two
conditions:

1: A given price line should be tangent to an indifference curve or marginal rate of satisfaction of
good X for good Y (MRSxy) must be equal to the price ratio of the two goods. i.e.

MRSxy = Px / Py

2: The second order condition is that indifference curve must be convex to the origin at the point
of tangency.

Assumptions:

The following assumptions are made to determine the consumer’s equilibrium position.

(i) Rationality: The consumer is rational. He wants to obtain maximum satisfaction given his
income and prices.

(ii) Utility is ordinal: It is assumed that the consumer can rank his preference according to the
satisfaction of each combination of goods.

(iii) Consistency of choice: It is also assumed that the consumer is consistent in the choice of
goods.

(iv) Perfect competition: There is perfect competition in the market from where the consumer is
purchasing the goods.

(v) Total utility: The total utility of the consumer depends on the quantities of the good
consumed.

Explanation:
The consumer’s consumption decision is explained by combining the budget line and the
indifference map. The consumer’s equilibrium position is only at a point where the price line is
tangent to the highest attainable indifference curve from below.

(1) Budget Line should be tangent to the Indifference Curve:

The consumer’s equilibrium is explained by combining the budget line and the indifference map.

47
Figure 2.11: Graphical forms of consumer equilibrium

P
Good Y

R
Consumer
Equilibrium

U
E C

IC3
S
IC2
IC1
0 T
H Good X

In the figure 2.11, there are three indifference curves IC1, IC2 and IC3. The price line PT is tangent
to the indifference curve IC2 at point C. The consumer gets the maximum satisfaction or is in
equilibrium at point C by purchasing OE units of good Y and OH units of good X with the given
money income.

The consumer cannot be in equilibrium at any other point on indifference curves. For instance,
point R and S lie on lower indifference curve IC1 but yield less satisfaction. With regards to point
U on indifference curve IC3, the consumer gets higher satisfaction but that is outside the budget line
and hence not achievable by the consumer. The consumer’s equilibrium position is only at point C
where the price line is tangent to the indifference curve IC2.

(2) Slope of the Price Line to be Equal to the Slope of Indifference Curve:

The second condition for the consumer to be in equilibrium and get the maximum possible
satisfaction is only at a point where the price line is a tangent to the highest possible indifference
curve from below. In fig.2.11 the price line PT is touching the highest possible indifferent curve
IC2 at point C. The point C shows the combination of the two commodities which the consumer is
maximized when he buys OH units of good X and OE units of good Y.
Geometrically, at tangency point C, the consumer’s substitution ratio is equal to price ratio Px / Py.
It implies that at point C, what the consumer is willing to pay i.e., his personal exchange rate
between X and Y (MRSxy) is equal to what he actually pays i.e., the market exchange rate. So the
equilibrium condition being Px / Py being satisfied at the point C is:
Price of X / Price of Y = MRS of X for Y
The equilibrium conditions given above states that the rate at which the individual is willing to
substitute commodity X for commodity Y must equal the ratio at which he can substitute X for Y
in the market at a given price.

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(3) Indifference Curve should be Convex to the Origin:
The third condition for the stable consumer equilibrium is that the indifference curve must be
convex to the origin at the point of equilibrium. In other words, we can say that the MRS of X for
Y must be diminishing at the point of equilibrium. It may be noticed that in fig 2.11, the indifference
curve IC2 is convex to the origin at point C. So at point C, all three conditions for the stable-
consumer’s equilibrium are satisfied.
Summing up, the consumer is in equilibrium at point C where the budget line PT is tangent to the
indifference IC2. The market basket OH of good X and OE of good Y yields the greatest satisfaction
because it is on the highest attainable indifference curve. At point C:
MRSxy = Px / Py

Key Terms
No. Terms Definition
1. Budget Constraint Represents all combination of goods and services that a consumer
may purchase given current prices within his or her given income.
2. Budget Line Also known as budget constraint.
3. Budget Set Is the set of all possible combinations of the two goods which a
consumer can afford, given his income and prices in the market.
4. Consumer Equilibrium The amount of goods and services which the consumer may buy in
the market given his income and given prices of goods in the market.

5. Price Ratio Is the price of the good on the horizontal or X-axis divided by the
price of the good on the vertical or Y-axis.

Activity 2.1.4
A. MULTIPLE CHOICE QUESTIONS

1. A consumption point inside the budget line

A. is unaffordable.
B. is possible to afford but has some unspent income.
C. shows that the consumer spends income on only one good.
D. shows that the consumer has chosen to spend all his or her income on both products.

2. The demand curve slopes downward due to

A. income effect.
B. more income availability to spend on lower priced goods.
C. declining additional utility as additional units are consumed.
D. change in quantity demanded resulting from change in real income.

49
3. Which of the following statements would be true if Chandra is maximising his utility in the
consumption of Goods A and B?

A. MUA = MUB
B. TUA = TUB
C. MUA/PB = MUB/PA
D. MUA/PA = MUB/PB

4. When making purchases, consumers will try to

A. always buy the cheapest goods.

B. maximise their total satisfaction.
C. buy until marginal utility is maximised.
D. spend the same amount on everything they buy.

5. If bundles of goods A and B lie on the same indifference curve, one can assume

A. the individual prefers bundle A to bundle B.

B. the individual prefers bundle B to bundle A.
C. the individual enjoys bundle A and B equally.
D. bundle A contains the same goods as bundle B.

B. SHORT ANSWER QUESTIONS

A. Define Budget Line. (1 mark)

B. State 3 features of a budget line. (3 marks)

C. Suppose a consumer buys only two goods: Fish and dalo. Suppose further that his weekly
income is $100 and the price of fish is $5/kg while the price of dalo is $2/kg.

$5/kg

$2/kg

(a) Write an equation for the budget constraint (1 mark)

(b) Sketch the equation on the graph. (2 marks)
D. Use the information given below to answer the following questions.
Mathew Williams, a worker at Malolo f has an income of
$80 a month to spend on consumption of Coke and Pizza. The price of Pizza is $8 and the
price of a carton of Can Coke is $16.

$16/carton

$8/pizza

50
 (i) Complete Mathew’s consumption possibilities schedule given below by computing the
missing figures.
Consumptions Coke(Cartons per month) Pizza( per month)
possibilities
A 0 (I)
B 1 8
C 2 (II)
D 3 (III)
E 4 2
F 5 (IV)

(4 marks)

Research Question
If Alan is indifferent between Coke and Pepsi, what would Alan’s indifference curves look like?
Explain the significance of indifference curves. (5 marks)

2.2 MARGINAL PRODUCTIVITY THEORY

Achievement Indicators:

 Define the theory of marginal productivity.

 Outline the five assumptions of marginal productivity theory.
 Identify the two types of marginal productivity.
 Identify the maximum number of workers hired by the firm.

Marginal productivity theory contributes a significant role in factor pricing. It is a classical theory
of factor pricing that was advocated by a German economist, T.H. Von Thunen in 1826. The theory
was further developed and discussed by various economists, such as J.B. Clark, Walras, Barone,
Ricardo, and Marshall. The increase in the output with the addition of one unit of factors of
production while keeping the other factors constant is known as marginal productivity.

Assumptions of Marginal Productivity Theory

i. Homogeneity of factors: assumes that all the units of a factor of production are
homogeneous in nature. Therefore, the units are perfect substitutes of each other.
ii. Full employment: refers to one of the assumptions of marginal productivity theory. Under
full employment condition, the supply of a factor of production is fixed in quantity.
iii. Same state of technology: assumes that the technology used in production is constant.
iv. Maximum profit: assumes that the main aim of every organization is to maximize their
profit.
v. Perfect competition in factor market: implies that organizations are required to purchase
the factor of production at the prevailing market price only. In case of perfect competition, all
the factors of production are perfectly mobile. In addition, the supply of factors of production
is perfectly elastic.

51
Types of Marginal Productivity

i. Marginal Physical Productivity (MPP):

Refers to an increase in output occurred due to the increase in one unit of factor of production.
According to M.J. Ulmer, “Marginal physical productivity may be defined as the addition to
total production resulting from employment of one unit of a factor of production, all other things
being constant.”
MPPn = TPPn – TPPn-1

Where: MPPn is marginal physical productivity for nth unit of labour.

TPPn is total physical productivity of n units of labour.

TPPn-1 is total physical productivity of n-1 units of labour.

ii. Marginal Revenue Productivity (MRP):

As per M.J. Ulmer, “Marginal revenue productivity may be defined as the addition to total
revenue resulting from employment of one unit of a factor of production, all other things being
constant.”
MRP = MPP × Price of the Product

If successive units of labour are employed in combination with other factors of production, the
marginal physical product of labour (MPP) will eventually diminish. In accordance with the law of
diminishing returns, the productivity of hiring extra labour will gradually decline. A firm cannot
keep on hiring extra labour, if it is to be profitable. The demand for labour depends on its marginal
productivity. Therefore, a firm will employ labour up to that point where the marginal revenue
product equals wages paid.

Example
Suppose you have a garment factory. Your firm is making shirts which you are selling at $10
each. Each worker’s wage is $90 per day. How many workers should you hire?
Number of Output per MPP Price of a MRP Wages ($)
Workers day Shirt ($)
1 15 15 10 150 90
2 27 12 10 120 90
3 36 9 10 90 90
4 43 7 10 70 90
5 48 5 10 50 90
6 51 3 10 30 90
In this case, the firm would hire up to a third worker because at that point MRP = Wages = $90.
The fourth worker will not be hired at that wage rate because his MRP is less than the wage. Hiring
a fourth worker will cost more in wages than what the worker will bring in as revenue.

52
 Activity 2.2.1
A. MULTIPLE CHOICE QUESTIONS
1. A profit-maximizing firm will hire labour until marginal revenue product equals
.

A. total product
B. marginal cost
C. marginal product
D. price of the product

2. The marginal physical product of labour is the change in when an extra worker
is employed.

A. output
B. profit
C. wages
D. sales revenue

3. Which of the following is an assumption of marginal productivity theory?

A. Technology used in production varies.

B. Imperfect competition in factor market.
C. Heterogeneity of factors of production in nature.
D. Supply of factors of production is fixed in quantity.

B. SHORT ANSWER QUESTIONS

1. Assume that a firm employing labour is operating in a perfectly competitive market so that each
unit of output sold generates revenue of $10. The firm pays $160 to each worker employed per
week.
Units of labour Total Output Marginal Price of Marginal Wages
employed per Week Physical Output Revenue Product ($)
Product ($) of Labour
1 10 $10 $160
2 24 $10 $160
3 44 $10 $160
4 60 $10 $160
5 72 $10 $160
6 84 $10 $160
7 80 $10 $160

i. Complete the table by filling in the columns for Marginal Physical Product and Marginal
Revenue Product. (7 marks)
ii. Define the term ‘Marginal Physical Product.’ (1 mark)
iii. How many workers should the firm hire? Why? (2 marks)

53
2. A garment factory is operating in Sigatoka known as A. Chandra’s Apparel. The firm is making
dresses and selling at a price of $30 each. A worker is paid $210 as wages per week.
Number of Labour Output per MPP Price of a MRP Wages ($)
Employed Week dress ($)
1 18 18 30 540 210
2 33 (i) 30 (v) 210
3 44 11 30 330 210
4 53 (ii) 30 270 210
5 60 (iii) 30 (vi) 210
6 (iv) 5 30 150 210
i. Complete the table by filling in the blank spaces from (i) to (vi). (3 marks)
ii. How many workers should the firm hire? (1 mark)

2.3 PRICE MECHANISM

Achievement Indicators:

 Define demand and supply curves using linear mathematical equations.

 Calculate equilibrium price and quantity by solving linear demand and supply
equations.
The demand curve shows the amount of goods consumers are willing to buy at each market
price. A linear demand curve can be plotted using the following equation.
Qd = a – b(P)
 Q = quantity demanded
 a = all factors affecting demand other than price (e.g. income, fashion). X intercept where
price is 0.
 b = slope of the demand curve (negative sign shows the inverse relationship between price
and quantity demanded.
 P = Price of the good.

Example
The following is the demand function for Flash drive.
Qd = 40 – 2P
Figure 2.11: Graph Showing Demand Curve of Flash drive

Price
20
$

D
0 40 Quantity (No. of Flash drive)

54
Supply curve is a graphical representation of the relationship between product price and quantity supplied.

A linear supply curve can be plotted using a simple equation:

Qs= b(P)
b = slope of the supply curve (positive slope shows the direct relationship between price and
quantity supplied).

Example
Qs = 2P
Figure 2.12: Graph Showing Supply Curve of Flash drive

Price S
$

Quantity (No. of Flash drive)

Deriving Equilibrium Price and Quantity

To derive equilibrium price and quantity from mathematical linear equations of demand and
supply set Qd = Qs and then solve for price and quantity.
Example:
Qd = Qs
40 – 2P = 2P
40 = 4P
P* = 10
To solve for equilibrium quantity, substitute price either in demand function or supply function.
Qd = 40 – 2P
Qd = 40 – 2(10)
Qd = 40 – 20
Q* = 20
Hence, equilibrium price is $10 and equilibrium quantity is 20 units. The following is the
graphical representation of equilibrium price and quantity.

55
Figure 2.13: Graph Showing Demand and Supply of Flash drive

Price
20
$ S

10

0 20 40
Quantity (No. of Flash drive)

Activity 2.3.1
SHORT ANSWER QUESTIONS

1. The following equations derive the demand and supply of mobile phones.
(Where P is price in dollars per phone, and QD and QS are quantities demanded and supplied,
respectively, in thousands per year)

QD = 100 – 2P
QS = –20 + P

i. Given the demand and supply equations above, solve for the equilibrium price and
quantity. (2 marks)
ii. Assume Government sets the price at $30 per phone.
Briefly explain one impact of this on the consumers. (1 mark)

2. The following equations describe the relationship between the price of Yaqona, quantity
sellers are willing to sell and the quantity buyers are willing to buy, where P is the price per
packet of 75g and Q is the quantity demanded and supplied. The actual price of a packet of
Yaqona is $1.00.
Demand : Q = 400 – 100P
Supply : Q = -100 + 300P

i. Solve the equations to determine the equilibrium price and quantity. (1 mark)

3. Use the following demand and supply equations to answer the question:

56
 QD = 200 – 4P
QS = -10 + 2P
i. Calculate the equilibrium price and equilibrium quantity. (2 marks)

4. The following equations describe the relationship between the price of dalo, quantity sellers are
willing to sell and the quantity buyers are willing to buy, where P is the price per bundle and Q
is the quantity demanded and supplied.

QD = 100 – 5P
QS = 80 + 10P

i. Calculate the equilibrium price and equilibrium quantity. (2 marks)

2.4 SERVICE INDUSTRIES

Achievement Indicators:
 Identify and discuss the significance of tourism linkages with other productive
sectors.
 Critically analyse the impact of the multiplier effect and tourism leakages in the
economy.
 Define sustainability in tourism.
 Identify areas in which sustainable tourism can be promoted.
 State three areas in evaluating sustainable tourism.
 Explain what is ecotourism and the principles of promoting it.

LESSON 2.4.1 SIGNIFICANCE OF TOURISM LINKAGES

Tourism is an important economic sector for many developing countries in the Pacific and set to
remain so for the foreseeable future, as visitor arrivals are forecast to rise by 6% to 7% per year
until 2019. This is expected to boost economic growth, particularly in tourism-dependent countries.
However, according to ADB's Pacific Economic Monitor of December 2015, growth could be
boosted by easing visa requirements, simplifying customs and immigration procedures, and
expanding air links. Countries also need to increase their capacity to absorb more tourists, especially
during the peak season.

57
A. Tourism Linkages with other Sectors

Significance of Tourism Linkages with other Sectors

 Strong linkages between tourism and other economic sectors including agriculture, fisheries,
manufacturing, construction and crafts production helps to reduce poverty.

 The creation of employment at all skills levels and particularly where there is existing capacity.

 Tourism leads to the development of agricultural sector such as diversification of agricultural

output in order to meet the needs of hotels and resorts. Hence, strong linkages needed between
tourism and agricultural sector.

 Visitors can potentially boost markets for a local agricultural product is through event tourism
such as sports events, festivals and conferences. Increased earnings for agriculture operators
can also be generated through tours to municipal fresh produce markets, farms, plantations and
processing plants and from accommodation on farms (farm-stays).

 Agriculture also offers opportunities to help develop visitor attractions and distinctive tourist
destination brands by creative use and marketing of local produce and scenery. To realize these
benefits the tourism industry needs to be proactive in utilizing local produce and agriculture
sites as a tourist attraction.

 Tourism flourishes, the new avenues like the modern entertainment places and entertainment
amenities become important, particularly in the urban context.

58
 Summary of Tourism Linkages with other Sectors

Direct Impacts Indirect Impacts Sectoral Impacts

Accommodation Product Suppliers Transport

Building/construction
Hotels & other Farm products
accommodation Food products and
beverages Construction
Restaurants & Catering Capital goods
IT goods
Passenger transport Consumer goods
Other manufactured Trade/Crafts
Road transport, air products, etc.
transport, maritime
Service providers
TOURSM INDUSTRY IN FIJI

transport
Business services Farming/
Production & IT services
Insurance services Fishing
Distribution of travel
Legal services
and information services
Healthcare services
Travel agencies, tour Agrifood
Public Investment
operators, tour guides

Cultural services
Information
Museums and other and
cultural services communication
technologies
Leisure & entertainment
services

Sports and recreational Education and

sports services Induced Impacts training
Direct and indirect
Other leisure and spending of tourism
entertainment industry beneficiaries
Tourism-related
Miscellaneous tourism products and
services Food and drink services

Financial and insurance Leisure

services Transport
Clothing Energy
Property rental Home equipment
Etc.

59
Multiplier effect means how money rotates or circulates in the economy.
This can be shown in 3 ways:
a. By direct spending creating income for hotels and shops
b. By indirect spending when hotels and shops pay wages or buy supplies.
c. Through induced shopping, that is when there is a general rise in consumption.

Example

TOURISM Employment money to spend on goods

INDUSTRY And services

Purchase of local goods

Increase of income to farmers Farmers & local business employ
Workers

And local business

Employment provided

The Negative Economic Effect

 High leakage effect even through a lot of foreign revenue is earned through tourism, a lot
of money flows out of the country for imports payments and profit repatriation.

B. HOW MONEY LEAKS ABROAD?

 Payments of imported foods and drinks for tourists

 Foreign ownership of tour operators
 Tourist embark on foreign owned airlines, cruise ships etc.
 Foreign ownership of hotels
 Payment of foreign loans by government
 Foreigners in top jobs sending money home.

C. Sustainable Tourism
(i) Definition of Sustainability in Tourism

It aims to maximise benefits such as job creation, foreign exchange earnings and new infrastructure
while safeguarding cultural heritage and living culture and minimising negative environmental and
social impacts (www. unesco. org). A sustainable approach to tourism means that neither the natural
environment nor the socio-cultural fabric of the host communities will be impaired by the arrival
of the tourists. The natural environment and local communities should benefit from tourism both
economically and culturally. Tourism resources and attractions should be utilised in such a way that
their subsequent use by future generation is not compromised. The special contribution of the
concept of sustainable development is that it emphasises respect for cultural values and, thus, does
not see economic indicators as the sole measure of development.

60
Rather, sustainable development represents the balanced integration of social and environmental
objectives with economic development.

(ii) How Can Tourism Be Made More Sustainable?

Tourism can be made more sustainable through several achievable measures. In a world in which
growing populations with endless consumer demands are pitted against a fragile environment, we
require more concerted effort.

1) Governments must implement policies that foster sustainable development by overcoming the
growth image. Tourism then should be developed only within sustainable development parameters.
Government must tackle the environmental limits to growth and climate change challenges we
confront. There must be integrated planning Tourism development requires integrated planning.
Integrated planning gives local governments a framework for establishing local priorities and to
link this information to operational functions.

2) Consumers should be educated for responsible travel choices. For example, few realise that all-
inclusive resorts result in economic benefits from tourism leaking out of the host economy back to
the home economies of the big multinationals and corporations that often own such resorts. Civics
education in schools could educate for responsible travel.

3) Local communities often treated as only as one stakeholder among the many, must have a right
to participate in tourism decision-making and have a say on if and how their communities become
tourism destinations.

4) Workers of tourism must have their rights respected and given decent conditions. Tourism
should not be allowed to continue as a low-wage and precarious source of employment.

5) The tourism industry needs to assume greater responsibility, submitting to local tax regimes
and regulations so its presence builds thriving communities, rather than undermining them. This is
increasingly essential as a social license to operate. The industry should also educate its clients on
responsible tourism.

6) Non-governmental organisations are essential for reporting on the abuses of tourism,

including land grabs, human rights abuses, community opposition and corruption.

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(iii) Evaluating Sustainability in Tourism

1. Appropriate Development - Economic Sustainability

...the use of various strategies for employing existing resources optimally so that a
responsible and beneficial balance can be achieved over the longer term.
… skills to earn a living as well as a sensitivity to the limits and potential of economic
growth and its impact on society and on the environment, with a commitment to assess
personal and societal levels of consumption out of concern for the environment and for
social justice. Creates Jobs and promotes local culture.

2. Conservation – Environmental Sustainability - … an awareness of the resources and

fragility of the physical environment and the effects on it of human activity and decisions,
with a commitment to factoring environmental concerns into social and economic policy
development.

3. Equity And Peace – Social Sustainability - … an understanding of social institutions and

their role in change and development, as well as the democratic and participatory systems
which give opportunity for the expression of opinion, the selection of governments, the
forging of consensus and the resolution of differences.

(iv) Examples of Sustainable Tourism Practice in Fiji

 Talanoa Treks - works with the communities, promote the natural environment, minimize
carbon footprint, practicing the 3R concept and incorporating into conservation guide
training.
 Mamanuca Environment Society - works in the field of protecting the marine and terrestrial
resources and creating awareness for a sustainable tourism.
 Nukubati Island Resort – uses clean solar power, grows its own organic vegetables and
fruits, using tropical permaculture techniques and carries out community education.

62
 D. Ecotourism

(i) Definition of Ecotourism

Ecotourism is now defined as "responsible travel to natural areas that conserves the environment,
sustains the well-being of the local people, and involves interpretation and education" (TIES, 2015).
Education is meant to be inclusive of both staff and guests.

(ii) Principles of Ecotourism

Ecotourism is about uniting conservation, communities, and sustainable travel. This means that
those who implement, participate in and market ecotourism activities should adopt the following
ecotourism principles:

 Minimize physical, social, behavioural, and psychological impacts.

 Build environmental and cultural awareness and respect.
 Provide positive experiences for both visitors and hosts.
 Provide direct financial benefits for conservation.
 Generate financial benefits for both local people and private industry.
 Deliver memorable interpretative experiences to visitors that help raise sensitivity to host
countries' political, environmental, and social climates.
 Design, construct and operate low-impact facilities.
 Recognize the rights and spiritual beliefs of the Indigenous People in your community and
work in partnership with them to create empowerment.

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Examples of Eco- Tourism Projects

1. Bouma National Heritage Park – Taveuni Island

-Promoting the conservation of our wildlife.

2. Jean-Michel Cousteau Resort – Savusavu

-Promoting the use and conservation of Fijian bures which is the traditional house of Fijians.

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Cooks MP says Rarotonga tourism becoming unsustainable
10:41 am on 30 October 2017

A member of Parliament in the Cook Islands Sel Napa is urging the government to bring in measures to
slow down tourism as she says it's not sustainable. Muri Lagoon, off Rarotonga, is one of the Cook
Islands' tourism hotspots. The Titikaveka MP said there were signs Rarotonga was under strain.
She said infrastructure and upgraded utilities must be in place to cope and the Cook Islands
administration had been warned of this in the past.
She said the Asian Development Bank had warned roads, power, water, sewerage and solid waste
disposal facilities needed to have been substantially upgraded for the island to cope with 100,000
tourists a year.

Ms Napa said between March to September this year there were more tourists each month to the Cook
Islands, mostly to Rarotonga, than the entire local resident population. “This hasn't happened yet and it
really concerns me. Here we are wanting more and more tourists, but Rarotonga just can't cope with
almost 160,000 tourists a year, our roads, water, sewerage, our solid waste disposal, our power as they
are today can't handle this burden. If we don't have the infrastructure and utilities in place, we shouldn't
be encouraging ever increasing tourism, it doesn't make sense."

Increasing tourism to Rarotonga is not sustainable says the MP. She said, as a member of the Rarotonga
Environment Authority, no large scale tourism developments should be processed by the authority REA
until the overall upgrade on Rarotonga is completed.
"We are a really special place and we should be safeguarding the very things that make us a place that
tourists want to visit, cramming as many tourists on to Rarotonga isn't the way to go," she cautioned.
She pointed out that tourism is now virtually steady throughout the year, rather than the peaks and drops
of past years.
"So this means there's constant pressure throughout the year by large numbers of visitors."
"When are we going to draw the line and say, okay, we've got enough coming here, let's maintain that
number and not go out and aggressively market for more and more tourists to come to our shores."

Source: radionz.co.nz

65
 Further Reading:

Source: Fiji Tourism 2021.

Key Terms
No. Terms Definition
1. Eco-tourism Tourism directed towards exotic natural environments, intended
to support conservation efforts and observe wildlife.
2. Leakage Effect The outflow of profits from the local hotels to the owners in
overseas.
3. Marginal Physical Addition to total production resulting from employment of one
unit of a factor of production, all other things being constant.
Productivity
4. Marginal Productivity Increase in the output with the addition of one unit of factors of
production while keeping the other factors constant.
5. Marginal Revenue Addition to total revenue resulting from employment of one unit
of a factor of production, all other things being constant.
Productivity
6. Multiplier Effect Refers to the increase in final income arising from any new
injection of spending.
7. Profit Repatriation Profit earned in a foreign country that one wishes to bring into
the borders of one’s own country.
8. Service Industry Earn revenue through providing intangible products and services
such as tourism, transport, communication, retail, etc.
9. South Pacific Tourism Direct marketing appointments with exhibitors representing
Pacific Islands hotels/resorts, inbound tour operator, airline and
Exchange (SPTE) other key tourism partners.
10. Sustainable Tourism Visiting a place as a tourist and trying to make only a positive
impact on the environment, society and economy.

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 Activity 2.4.1

A. MULTIPLE CHOICE QUESTIONS

1. A negative economic effect of tourism on economy is

A. damages our environment
B. import payments and profit repatriation.
C. causes crime, diseases and prostitution
D. disruption and erosion of the cultural identity and values.

2. Which of the following is not a positive social effect of tourism on economy?

A. Developing friendships
B. Promotes multiculturalism
C. Creates income for hotels and shops
D. Reducing negative perceptions and stereotypes

3. Eco-Tourism refers to
A. responsible travel to natural areas that conserves the environment
B. responsible travel in an airline to maintain cleanliness
C. selling of handicrafts to promote culture
D. reef walking in the open sea

4. Sustainable Tourism is
A. Utilising tourism attractions and resources sensibly so that future generations are not
compromised.
B. Utilising tourism attractions and resources sensibly for the current generation.
C. Undertaking all activities in tourism to generate revenue.
D. Realising the benefits of tourism and undertaking resources for current generation.

67
 B. SHORT ANSWER QUESTIONS

1. Study the graph given below and answer the following questions.

(i) What does the above graph show? (1 mark)

(ii) State two importance of tourism sector in Fiji’s economy. (2 marks)
(iii) Calculate percentage change in tourist arrivals from June 2016 to July 2016. (2 marks)

(iv) Which month recorded the lowest tourist arrivals? Give a possible reason. (2 marks)

2. Sustainable Tourism
Read the article below and answer the questions which follow.

Tourism is one of the world’s fastest growing industries and is a major source of income for
many countries. Being a people-oriented industry, tourism also provides many jobs which have
helped revitalise local economies. However, like other forms of development, tourism can also
cause its share of problems, such as social dislocation, loss of cultural heritage, economic
dependence and ecological degradation. Learning about the impacts of tourism has led many
people to seek more responsible holidays. These include various forms of alternative or
sustainable tourism such as: ‘nature-based tourism’, ‘ecotourism’ and ‘cultural tourism’.
Sustainable tourism is becoming so popular that some say that what we presently call
‘alternative’ will be the ‘mainstream’ in a decade. All tourism activities of whatever motivation
– holidays, business travel, conferences, adventure travel and ecotourism – need to be
sustainable.
Source: http://www.unesco.org

(a) In what way would we say that tourism is the fastest growing industries in the
world today? (1 mark)
(b) How does the tourism industry revitalise the local economies? (1 mark)
(c) Identify some of the small industries in which tourism has also developed in a
country like Fiji. (2 marks)
(d) Identify 4 ways in which tourism has caused problems as stated in the article. (4 marks)

68
 (e) Explain the concept of responsible holidays as described in the article.
(why and how) (2 marks)
(f) What has the writer recommended as the way forward for the tourism industry? (2 marks)
(g) Explain the concept of “Sustainable Tourism as used in the article above. (2 marks)

3. International Visitor Arrivals in Fiji from 2011 to 2012

(Source: Bureau of Statistics 2013).

i. What is the trend of international visitor arrivals in Fiji? (1 mark)

ii. Which month provided the greatest tourist exchange earning for Fiji? (1 mark)

iii. Explain the concept of multiplier effect in relation to the rise in tourist numbers in July.

(2 marks)

iv. Explain the leakage effect of visitor arrivals in Fiji. (2 marks)

Research Question
Why is there a need to promote sustainable tourism? How does sustainable tourism address the
issue of climate change? What is the role of tourism in economic growth and poverty reduction?
How does tourism links to other service providing sectors? What are some policies towards
sustainable tourism in Fiji? (10 marks)

69
 C. ESSAY WRITING QUESTIONS

1. Tourism plays a vital role to boost growth in Fiji.

Evaluate the above statement with reference to:

 three significance of tourism linkages with other productive sectors (3 marks)

 three ways money leaks from tourism industry in Fiji (3 marks)
 three government policies or initiatives that could reduce leakage effect of
tourism. (3 marks)

2. Over the years tourism has been a growing sector in the Fiji’s economy.

Evaluate the above statement with reference to:

 three contributions of tourism industry in Fiji (3 marks)
 three ways tourism being unsustainable in Fiji (3 marks)
 three examples of sustainable practices by tourism in Fiji. (3 marks)

3. Tourism sector is a leading contributor to Fiji’s GDP.

Evaluate the above statement with reference to:

 three importance of tourism industry in Fiji (3 marks)

 three problems faced by the tourism sector (3 marks)
 three ways tourism sector can contribute towards sustainable development (3 marks)

70
LESSON 2.4.2 TRANSPORT INDUSTRY

Achievement Indicator:

 Explain the role of transport in enhancing connectivity.

 Identify major problems in the transport industry and its impact in the economy.
 Identify and explain government policies or strategies to enhance connectivity and
sustainability in transportation.

Fiji lies in the center of the pacific and thus is a fundamental link in terms of transportation
and communication

Transportation

 Transport remains to be a vital component of the economy contributing to around 6

percent to GDP. The goal of this sector is to provide efficient transport services at
reduced costs to enhance access to services and markets. The transport sector includes
land, sea and air transport.
 A good transport system is very important for any economy. It facilitates movement from
one country to the rest of the world. The system provides an important link between the
producers, distributors and consumers.
 As a developing country, Fiji is experiencing shift in transportation preference as it becomes
more inclined towards private transportation (land transport).
 In addition to the increase in vehicle population, the decentralization of activities, change
in land use composition, rural to urban migration and informal settlements have influenced
travel patterns of the public traveling to work, school, accessing to health and recreational
facilities.

71
Roles of Transportation in enhancing connectivity
 Provides services that enables workers to report to and return from work.
 Bring raw material and semi-finished goods to manufacture.
 Delivers goods to wholesalers, retailers and consumers.
 Makes international trade possible.
 Provides an advantage to travel to different places.
 Improves the standard of living of the community by widening the market.
 Due to efficient transport systems, many retailers keep a small quantity of stock since they
can quickly replenish their supplies when needed.

Challenges faced by transport industry

 Fiji is prone to disruptive natural events such as tropical cyclones and resultant flooding.
Thus, it is costly to carry out rehabilitation work.
 In the main urban areas, lower-level municipal roads are neglected, rough and sometimes
impassable.
 Smaller jetties have been fairly neglected for many years and are in poor condition.
 Increased traffic congestion leading to increased travel times to market places and work.
 Roads and rural maritime infrastructure are publicly funded, with fewer opportunities for
private sector investment. The government is exploring public-private partnership deals, but
they are largely confined to the main ports and have yet to be extended to airports.
 Lack of funds for upgrading of roads, jetties and ports.
 Mechanical problems can delay flights.
 Increase in fuel prices will affect the cost of travelling.
 Reckless driving causes a lot of accidents.
 High cost of loading and unloading goods.
 Carbon emissions by older vehicles impacting climate change.

72
Source: Transport Infrastructure Investment Sector Project (RRP FIJ 48141)

73
Government policies or strategies to enhance connectivity and sustainability through
transportation:

 Upgrade roads and highways to reduce travelling time and faster access to markets and
production sites. Developing roads in rural and maritime zones.
 Upgrade and rehabilitation projects for jetties, ports and bridges.
 Working on Fiji Flood Rehabilitation Project ($1million).
 Traffic congestion directly impacts vehicle emission, therefore traffic volume needs to be
intelligently reduced so that fewer journeys are made. Effective partnership and paradigm
shift e.g. from diesel vehicles to unleaded vehicles is recognised by government as the
way forward.
 There is the dilemma of growth-oriented policies that generate increased transportation and
environmental policies that advocates emission reductions. The Land Transport Authority
has in place an age limit to imported second-hand vehicles. Newer engines are expected to
be more economic and made more fuel efficient.
 More funds allocated to transport and infrastructure.
 Shipping Franchise Scheme Fiji - in this scheme, the government subsidizes the
operations of private vessels to uneconomical routes. This government initiative allows for
connectivity between maritime islands to main cities and also connectivity between islands.
 There are also new ships being constructed abroad which will be delivered and registered
in Fiji in which these ships contain new technologies that will ensure greenhouse gas
emissions are minimized.
 Government is undertaking consultations with all relevant stakeholders to determine soft
and hard measures that can be put in place to improve the efficiency and sustainability of
the transport system.

74
Dream road
Sikeli Qounadovu
Wednesday, May 03, 2017

VILLAGERS of Nakida in Naitasiri and their forefathers have always dreamt of a road connecting
them to the rest of the world.This is about to come true with the Fiji Roads Authority yesterday
confirming that construction of the first phase of the Nakorosule and Nawaisomo road will begin
soon.

Being connected means the villagers won't have to repeat what they did last month — building 41
bamboo rafts and travelling over two days to transport housing materials.FRA chief executive
officer John Hutchinson confirmed tenders for the construction of the road from Nakorosule to
Nawaisomo would be out this month.

The village is accessible by foot from Nabulini in Wainibuka, hiking through the rugged terrain
crossing Nalawa district in Ra, Wainibuka district in Tailevu and ending up at the district of
Nagonenicolo in Naitasiri. Nakida Village is also the last village of Naitasiri in the district and this
route can take as long as six hours on foot. Another route is following the Waicakena river, which
feeds on to the raging Wainimala River. This trip begins on foot, or horseback or by a bamboo raft
from Nakorosule Village or Waibalavu Village where the road ends.
Epitome of the Story
Last month about 10 young men from the village helped
 With no proper road
transport housing supplies from Nakorosule following the people of Nakida were
struggling to transport
Waicakena river to reach Nakida Village."It took us one day materials, delayed their
work and had miserable
to make the bilibili (bamboo raft), two days to transport life.
 By construction of road,
the materials up, and another day to unload all the villagers will have better
transportation services to
supplies," said Laisenia Senokonoko, the village headman. access to marketplaces.

In total, Mr Senokonoko said they had to drag 41 bamboo rafts for loading housing material given
by the non-government organisation Oxford Committee for Famine Relief (Oxfam). He said the
young men braved the cold Waicakena river and the strong currents while transporting the supplies
to the village."We could not wear gumboots because it would slow us down, so we did it barefoot,
of course there were injuries but that did not stop us. "We dragged all the housing material up and
when we reached the village, it took us another two days to rest before resuming work because we
were all tired."The young men of Nakida were assisted by villagers of Nakorosule, Nawaisomo and
Wairuarua.

(Source: http://www.fijitimes.com)

75
Key Terms
No. Terms Definition
1. Air Transport The fastest form of transport which links Fiji with the rest
of the world e.g. Fiji Airways.
2. Road Transport Transport of passengers or goods on roads.
3. Tax Free Zone An economic zone of included incentives of a 13-year tax
holiday, duty exemptions on capital goods and raw
materials, and freedom to repatriate capital and profits.
4. Transportation Is the movement of people, animals and goods from one
location to another.
5. Transport Planning Unit Established as a means to strengthen the capacity of
government to better coordinates transport planning and
monitor policy and development in the transport sector.

Activity 2.4.2
A. MULTIPLE CHOICE QUESTIONS
1. Means that helps people to travel from one place to another is the mode of

A. protocol.
B. transport.
C. management.
D. communication.

2. Which of the following promotes sustainability in transport industry?

A. Carbon emissions by older vehicles.

B. More use of diesel vehicles than unleaded vehicles.
C. Placing an age limit to imported second-hand vehicles.
D. Increasing number of second-hand vehicles being imported with no age limit.

3. Through Shipping Franchise Scheme the Fijian government subsidizes the operations of
vessels to routes.

A. public, economical
B. private, economical
C. public, uneconomical
D. private, uneconomical

76
B. SHORT ANSWER QUESTIONS
Study the cartoon given below and answer the following questions.

i) Using the cartoon given above, explain the concept of connectivity as used in the transport
industry. (2 marks)

ii) State two potential benefits of transportation to the economy. (2 marks)

iii) Identify one cause of traffic congestion on roads in Fiji. (1 mark)

iv) Identify two effects of traffic congestion in the economy. (2 marks)

v) Suggest one solution to overcome the problem of traffic congestion. (1 mark)

vi) State two policies implemented by Fijian government which contributes to Green Growth by
transport. (2 marks)

C. ESSAY WRITING QUESTIONS

Transport services play a major role in connectivity.

Evaluate the above statement with reference to:
 any 3 ways transport services enhances connectivity in the economy (3 marks)
 any 3 challenges faced by transport services in Fiji (3 marks)
 any 3 policies or strategies by government to improve transport services (3 marks)

77
2.5 ELASTICITY OF SUPPLY
Achievement Indicator:
 Define price elasticity of supply.
 State the significance of price elasticity of supply.
 Calculate price elasticity of supply.

LESSON 2.5.1 PRICE ELASTICITY OF SUPPLY

Elasticity is a term used in economics to measure the responsiveness of one variable to change in
another.

Price elasticity of supply (PES) measures the responsiveness of the quantity supplied of a good to
change in its price. For example, if there is increase in price of yaqona, how will the growers be
able to respond and increase the supply to the market.

Significance of Price Elasticity of Supply

1) It helps firms to know how quickly and effectively it can respond to changing market
conditions, especially to price changes.
2) It dictates how the price will change depending on the supply offered.
3) It helps firms to make decisions, for example, if supply is elastic (i.e. PES > 1), then producers
can increase output without a rise in cost or a time delay. On the other hand, if supply is inelastic
(i.e. PES < 1), then firms find it hard to change production in a given time period.
4) It can tell the government something about what the incidence of taxes will be. For example, if
the government imposes an excise tax on goods, will the consumers pay more of that tax or will
the producers pay it.
Mid-point formula to calculate PES
{(𝑸𝟐- 𝑸𝟏) ÷ [(𝑸𝟏 + 𝑸𝟐)/𝟐]}
𝑷𝑬𝑺
{(𝑷𝟐 - 𝑷𝟏) ÷ [(𝑷𝟏 + 𝑷𝟐) /𝟐]}

Example:
Supply schedule of Computer
Price ($) Quantity (000s)
10 17
12 23
14 34
16 41
18 48
20 53

Required: calculate price elasticity of supply for a price increase from $ 12 to $ 14

PES = {(𝑸𝟐- 𝑸𝟏) ÷ [(𝑸𝟏 + 𝑸𝟐)/𝟐]}

{(𝑷𝟐 - 𝑷𝟏) ÷ [(𝑷𝟏 + 𝑷𝟐) /𝟐]}
= {(34000-23000) ÷ [( 23000+34000)÷2]}
{ (14-12) ÷ [( 12+14)÷2]}

78
=11000 ÷(57000÷2) = 2.5
2 ÷(26÷2)

Figure 2.17: Graphical Illustration of Elasticity of Supply

Price ($)
12
8

Supply

0 23 34 Qty (000)

Price Elasticity at a Point

Since elasticity is always measured at a certain point a single supply curve can have segments of
all three types simultaneously. To see how this is possible, we will have to crunch the numbers and
look at how elasticity is computed.

The price elasticity of supply is defined as the percentage change in quantity supplied divided by
the percentage change in the price of a good. This can be illustrated using the formula below.

To give an example, let's assume that an increase of 2% in the price of ice cream causes sellers to
produce 4% more of it.

According to our formula the elasticity in this case can be computed as:

4% / 2% = 2.

So the elasticity of supply equals 2.

Determinants of Elasticity of Supply

(a) Availability of raw materials

(b) Length and complexity of production
(c) Mobility of factors
(d) Time to respond-the more time a producer has to respond to price changes the more elastic the
supply. Supply is normally more elastic in the long run than in the short run for produced

79
 goods, since it is generally assumed that in the long run all factors of production can be
utilized to increase supply, whereas in the short run only labor can be increased.
(e) Inventories-a producer who has a supply of goods or available storage capacity can quickly
increase supply to market.
(f) Spare/Excess Production Capacity-A producer who has unused capacity can quickly respond
to price changes in his market assuming that variable factors are readily available.

Joint Products & Substitutes in Production

 Joint Products are those in which the production of one good yields the other good as a
byproduct e.g. wool and lamb’s meat.
 Joint products have a positive cross-price elasticity of supply. As the price of wool rises
farmers rare more lambs for their wool but this also increases the supply of lamb’s meat.
 Substitutes in production are those goods such that the production of one good reduces
the quantity produced of the other good e.g. a single assembly line that either produces
Sports Cars or Sedans.
 Substitutes in production have a negative cross-price elasticity of supply. As the price of
Sports cars goes up, the car manufacturer uses the assembly line to produce more Sports
cars. This means that fewer Sedans will be produced.

(Source: www.google.com.au)

80
Ministry works on drug supply
Luke Rawalai
Wednesday, May 03, 2017

FIJI is not alone in struggling to maintain adequate supplies of medicines across all of its health care
facilities, says the Ministry of Health and Medical Services.
The ministry said in a statement that major hospitals in developed countries such as the US, Canada
and Australia experienced frequent shortages and stock-outs of medicines, especially injectable drugs.
The statement said in Australia, the Government's Therapeutic Products Agency operated a 'Medicine
Shortages Information Initiative' which provided online information about prescription medicine
shortages.
"A recent review of the site showed that it listed 194 current shortages, the oldest of which has lasted
for more than a year," the statement said.
"World Health Organization has stated shortages of
medicines are a global problem and
the causes are not new.
"They include manufacturing issues, increased global

demand, and various supply chain disruptions."

Epitome of the Story
Last week in Parliament, Health Minister Rosy Akbar
reassured the ministry was working to improve the  Adequate supply of medicines

reliability of Fiji's pharmaceutical procurement and distribution system. is a global issue.

Members of the public raised their concerns with this newspaper claimingSthhoerytagneoowf shuappdlytoofpurchase
medicines is due to
most medicines, which were expensive, from private pharmacies. manufacturing issues
(Source: http://www.fijitimes.com) (availability of raw materials
and its cost), increase in
global demand and various
supply chain disruptions.

Key Terms
No. Terms Definition
1. Elastic Supply Quantity supplied changes proportionally more than the price.
Elasticity is greater than one.
2. Inelastic Supply Quantity supplied changes proportionally less than the price.
Elasticity is less than one.

3. Joint Products Are those in which the production of one good yields the other
good as a byproduct e.g. wool and lamb’s meat.
4. Perfect Elastic Supply The quantity supplied is infinite with no change in price.
5. Perfect Inelastic There is no responsiveness in the quantity supplied to change in

81
 Supply price.
6. Unit Elastic Supply Suppliers respond proportionally to price changes which mean the
quantity supplied will also change in the same proportion as the
price.

Activity 2.5.1
A. MULTIPLE CHOICE QUESTIONS

1. Price elasticity of supply measures the responsiveness of the

A. quantity supplied of a good to a change in price of another good.
B. price of a good to a change in quantity supplied of the good.
C. quantity supplied of a good to a change in price of the same good.
D. quantity supplied of a good to a change in income.

2. Perfect price elasticity of supply is when elasticity is

A. equal to zero.
B. less than one.
C. equal to one.
D. greater than one .

3. Which of the following is not a determinant of elasticity of supply?

A. Availability of raw materials.
B. Mobility of factors of production.
C. Proportion of consumers budget consumed by the item.
D. Length and complexity of production.

4. A vertical supply curve indicates an elasticity of supply that equals

A. 0
B. -1
C. 1
D. infinity

B. SHORT ANSWER QUESTIONS

1) Define price elasticity of supply (PES). (1 mark)
2) Provide the formula to calculate the coefficient of PES using midpoint formula. (1 mark)
3) Briefly describe the following PES:

(i) Elastic supply.

(ii) Inelastic supply.
(iii)Unitary elastic supply.
(iv)Perfectly elastic supply.
(v) Perfectly inelastic supply. (5 marks)

4) State 3 determinants of elasticity of supply. (3 marks)

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 5) Calculate the coefficient of price elasticity of supply (PES) for the following situations:

(i) The quantity supplied for a product decreased by 30% in relation to a 6% fall in
its price. (2 marks)
(ii) The price of Good X increases from $100 to $150 and quantity supplied
increases from 10,000 to 15,000. (2 marks)

6) Study the table below and answer questions that follow:

Supply schedule for cans of coke
Price( cents) Quantity(000)
80 6
90 8
100 10
110 12
120 16
130 18
Calculate PES for the following price range:
(i) price increases from $1.00 to $1.10
(ii) price decreases from $1.00 to $0.80 (4 marks)

7) Study the supply curve below and answer the questions that follows:

Price $
Supply
$1.50 C

$1.00 B

$0.80 A

10 20 40 Quantity of
Potatoes (Kg)

Calculate PES for the following range:

(i) Point A to B.
(ii) Point C to B. (4 marks)

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B. ESSAY WRITING QUESTIONS

Elasticity affects many aspects of consumer behavior.

Evaluate the above statement with reference to:
 definition of elasticity and price elasticity of supply (3 marks)
 any 3 types of price elasticity of supply (3 marks)
 3 determinants of price elasticity of supply (3 marks)

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STRAND 3 MACROECONOMICS

Strand Outcome:

Investigate how an economy operates and functions to achieve its economic

growth.

Content Learning Outcomes:

 Explore the effects of money supply in the economy.
 Analyse the effects of interest rates in the economy.
 Analyse the income and expenditure analysis.
 Explore evolving labour markets in the Fiji economy.

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3.1 CHANGES IN MONEY SUPPLY
Achievement Indicators:
 Identify and explain the factors that cause primary expansion in money supply.
 Identify and explain the factors that cause secondary expansion in the money
supply.
 Discuss the effects of secondary factors on money supply.
 Describe the secondary causes and effects of changes in the money supply.
 Draw simple and Combined Registered Bank Balance Sheet.
 Use flow diagram to illustrate the credit creation process.
 Show the effect of credit creation process in Combined Bank Balance Sheet.

LESSON 3.1.1 PRIMARY FACTORS AFFECTING MONEY

SUPPLY

Money, as we know it today, is the result of a long process and has evolved over time.

In this modern era money plays vital role with the prime function of being the medium of exchange.
The latest type of money is plastic money in the form of Credit cards and Debit cards. The aim is
at removing the need for carrying cash to make transactions.

The money supply consists of notes and coins in the hands of the public plus demand deposits with
all banks. Money supply is categorized as M1, M2 and M3.

Money supply changes due to:

(a) Primary expansion of money supply.
(b) Secondary expansion of money supply.

Primary expansion of money supply

In primary expansion changes in money supply is the result of new deposits being deposited into
the banking system. Such new deposit has effect on increasing the reserves of banks which means
the reserves will be greater than those required to support the existing level of customers deposit
therefore banks could lend out more money.

There are several factors which causes primary expansion of money supply:
(a) Public debt policy(Government borrowing)
(b) Foreign aid
(c) Remittances

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 (d) Export earnings and import payments
(e) Open market operations
(f) Interest rate
(g) Moral suasion

Effects of primary factors on money supply:

Each primary factor has effect on volume of money supply. These effects are:

(a) Government budgetary transaction –whereby the government national budget standing has
effect on money supply. This happen through :

(i) Budget deficit–to cover for deficit budget borrowing takes place in 3 ways:
 Borrowing from reserve bank. This simply means printing more money.
Thus money supply increases.
 Borrowing from overseas under floating exchange rate will alter the money
supply depending on the movement in the exchange rate.
 Borrowing from the private sector by selling bond or securities will lead to
transfer of funds from private sector to public sector. It will lead to crowding
out of investment however money supply will remain unchanged.

(ii) Budget surplus- If the government budgets for a surplus, the domestic money
supply will fall. This is because the volume of money withdrawn from the economy
exceeds the volume of money injected in form of government spending. Thus budget
surplus contracts the economy.

(b) Foreign aid- is the international transfer of capital, goods, or services from a country or
international organization for the benefit of the recipient country. Increase in foreign aid to
a recipient country will increase money supply and vice versa.
(c) Remittances- are transfer of money from a migrant worker to their families or other
individuals in their home countries. In many countries, remittance constitutes a significant
portion of the GDP. Increase in remittances will increase money supply and vice versa.
(d) Export earnings and import payments-increase in export earnings will increase money supply
on the other hand increase in import payment will decrease money supply and vice versa.
(e) Open market operations-when the reserve bank sells the government stock and bonds, the
public account balance reduces as they pay for stock and bonds, decrease in account balance
decreases reserves hence money supply decreases. Whereas when reserve bank buys bonds
and securities, the public account balance increases hence increase in money supply.
(f) Interest rate-increase in interest rate leads to decrease investment thus aggregate money
demand decreases hence money supply decrease. Whereas decrease in interest rate leads to
increase investment thus aggregate money demand increases hence increase in money supply
(g) Moral suasion- Non-official' tool of monetary policy which governments employ to persuade
financial institutions in following suggested guidelines on the availability and cost of credit.
Moral suasion is used typically by making policy announcements to induce the desired
response, before resorting to mandatory compliance through statutory regulations. Therefore
through moral suasion money supply is increased.

87
.
Activity 3.1.1
A. MULTIPLE CHOICE QUESTIONS
1. Which of the following is not a factor of causing primary expansion of money supply?

A. Foreign aid
B. Remittance
C. Interest rate
D. Credit creation

2. Purchase of bonds and securities by RBF will money supply.

A. increase
B. decrease
C. not change
D. fluctuate

B. SHORT ANSWER QUESTIONS

With reference to the picture discuss the evolution of currency.

(Source: www.google.com.au)
1. Define Remittances (1 mark)
2. Differentiate between primary and secondary money expansion. (2 marks)
3. State 3 factors causing primary expansion of money. (3 marks)
4. State 3 effects of primary expansion of money. (3 marks)
5. What is the impact on money supply if reserve bank sells the government bonds
and securities? (1 mark)
7. State the effect of decrease in interest rate on money supply. (1 mark)
8. Explain why government budget surplus reduces the money supply. (2 marks)
9. What does ‘crowding out of investment’ mean? (1 mark)
10. Explain the term ‘Moral Suasion’. (2 marks)

88
LESSON 3.1.2 SECONDARY FACTORS AFFECTING
MONEY SUPPLY
Secondary expansion of money supply results from credit creation process. Individual banks do
not create money but when they lend their excess reserves the banking system as a whole is able
to create the credit.

Credit creation model illustrates how commercial banks expand deposits through loans, advances
and investments. The banking system as a whole can create credit which is several times more
than the original increase in the deposits of a bank.

The banks also prepare a balance sheet showing the financial position of bank, hence what the
banks owns and owes. A deposit by customer is assets for the customer but for the bank it is
considered as liabilities since bank owes the customer. Detailed balance sheet of registered bank
and reserves appears like this:

Balance Sheet of combined registered banks

Assets $ Liabilities $
Cash(notes and coins) 10 Transaction accounts(public):

Deposits at reserve bank(settlement 1000 Demand deposits 2810

cash)
Reserve banks bills 100 Time deposits 2000
Government securities 500
Other investments 400
Loans(advances) 2800
$ 4810 $ 4810

Balance Sheet of combined Reserve Bank

Assets $ Liabilities $

Overseas assets 500 Bank notes on issue 400

Investments 700 Deposits:

Loan to government 400 Registered banks 1000

Government 100

Reserve bank bills 100

$ 1600 $ 1600

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A simple Balance Sheet of trading bank which appears like this.

Trading Bank Balance Sheet(simplified version)

Assets $ Liabilities $
Notes and coins x Demand deposit x
Demand deposits (RBF) x Time deposit x
Time deposits(RBF) x
Government securities x
Overseas assets x
Advances x

Balance sheet interpretation:

 Liabilities: side of balance sheet shows where the banks got the financing from. It consists
of customer’s deposit which has to be repaid to depositors.
 Assets: this side shows what the bank did with its sources of funds.
(i) Notes and coins (tilt/vault money)-notes and coins kept by the bank.
(ii) Demand deposits (with RBF)-cheques account of commercial banks kept with
RBF
(iii) Time deposits (with RBF)-act as fixed term deposit and left undistributed for fixed
term to earn interest.
(iv) Government securities-loan to government. Long term government loans/securities
known as government stock and short term as treasury bills.
(v) Overseas assets-foreign currency held by banks which gain to those who import
goods and services.
(vi) Advance-overdraft or customer loan.

Reserve Banks Balance Sheet(simplified version)

Assets $ Liabilities $
Overseas assets x Bank notes on issue x
Investment (overseas) x Deposit of commercial bank x
Loan to government x Reserve bank bill x

Credit creation process- banks do not create notes and coin but they create credit or deposits and
this requires reserve ratio. The credit creation model shows how banks can increase money supply
through lending process. The amount of credit created depends on the size of the credit multiplier.
The cycle of credit creation is called a credit multiplier. It is the level of withdrawal from the cycle
that determines the extent of the credit multiplier. The multiplier causes an increase in money
supply.

Reserve ratio is used to find credit multiplier. Reserve ratio is percentage of deposits retained by
commercial banks as requirement of RBF. Reserve ratio is also known as required reserve ratio,
prudent asset ratio or required asset ratio.

Formula for reserve ratio (RR) = Reserve × 100

Total Deposit

90
Credit multiplier-is an indicator of final changes in the bank deposit which originated from
initial change.
Formula for credit multiplier (CM) = 1_

Assumptions of Credit Creation Process

1. Loans borrowed from one bank are deposited in another bank. The second keeps its required
reserves and lends the rest. The cycle continues until no more loans can be made.

2. If money creation continues in geometric progression, then the total MS created would be:
Formula to calculate the secondary expansion

= Initial deposit (1 - RR)

RR

3. Banks must keep as minimum required reserve. All people deposit money and get loans.
4. There is no leakage.
5. People should willingly take loans.

Illustrative Example of Credit Creation Process

Assume RBF requires 20% as reserve ratio. The initial deposit is $ 1000. Therefore the initial
balance sheet of bank looks like this:
Bank 1 -Initial Balance Sheet
Liabilities $ Assets $
Deposit 1000 Reserve 200
Advance 800
1000 1000

Bank 1 holds 20% of initial deposit as reserve which is $200 (20% ×1000=200) and rest is loan out
(80% ×1000=800). This $800 is known as withdrawal, advance or short term loans. People who
take out loan or withdraw will spend $800 on goods and services and this will go as deposit in
another bank.

Bank 2 -Balance Sheet

Liabilities $ Assets $
Deposit 800 Reserve 160
Advance 640
800 800
Bank 2 hold s 20% of deposit as reserve which is $ 160(20% ×800=160) and rest is loan out
(80% ×800=640). People who again take out loan or withdraw will spend $640 on goods and
services and this will again go as deposit in another bank.

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 Bank 3 -Balance Sheet
Liabilities $ Assets $
Deposit 640 Reserve 128
Advance 512
640 640

Bank 3 holds 20% of deposit as reserve which is $ 128(20% ×640=128) and rest is loan out
(80% × 640 = 512). People will again take out loan or withdraw $640 and $640 on goods and
services and this will again go as deposit in another bank.

Thus this process continues. So from the initial deposit of $1000 the following credit is created:

 Bank 1- $800
 Bank 2- $640
 Bank 3- $512
 Bank 4… ................... continues

To find out total deposit created:

Step 1: Find out credit multiplier?

Credit multiplier (CM) = 1_
RR

= 1
0.2 (20%)

= 5 times

Step 2: How to find total increase in demand deposit? (same as total increase in MS)

Total increase in demand deposit= initial deposit × CM

= 1 000×5 =$5 000

Step 3: How to find total increase in credit created?

Total increase in credit created= increase in demand deposit- initial deposit

= 5 000 - 1 000
=$4 000

Note: 1. Primary expansion is the amount of new deposits (in this case $1 000)
2. Secondary expansion is the amount of increase in credit created by the banks.
(In this case $4 000)

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 Formula to calculate the secondary expansion

= Initial deposit (1-RR)

RR
= 1 000 (1-0.2)
0.2
= $4 000

The formula used to calculate the total increase or expansion in money supply:

Increase in money supply = primary expansion x credit creation multiplier.

= 1 000 × 5

= $5 000

At the end of total credited created by all the trading banks the combined balance sheet would
look like this:

Combined Balance Sheet of all trading banks

Liabilities $ Assets $
Deposit 5000 Reserve 1000
Advance 4000
5000 5000

Limitations to the credit creation theory:

1. In reality the total amount of credit created will be less than what the credit predicts. This is
because of the withdrawals e.g. not all money borrowed will be deposited.
2. Some is paid as tax e.g. VAT
3. The banks may not lend out all the money that is deposited.

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Credit creation process using flow diagram:
Bank 1
(Initial deposit of $ 1000)

Required Reserves
( 20%)
$200

Advanced (80%)
$800

Bank 2
(Deposit of $ 800)

Required Reserves
( 20%)
$160

Advanced (80%)
$640

Bank 3
(Deposit of $640)

Required Reserves
( 20%)
$128

Advanced (80%)
$512

This process of credit

continues………….
Total increase in MS
= primary expansion x CM
= 1000 × 5
= $5000

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Excess reserve/free reserve/floating reserve/extra reserve
-refers to extra reserve kept by bank then required reserve which is normally given to borrowers.
Excess reserve= total reserve - required reserve

Example:
Required reserve is 20%

Combined Balance Sheet

Liabilities $ Assets $
Deposit 5000 Reserve 1500
Advance 3500
5000 5000

Required: Calculate excess reserve.

Excess reserve = total reserve-required reserve
=$1500 – (20% × 5000)
=1500-1000
=$500

Interest rate is the determinant of the level of savings and investment.

a) The higher the interest rate, the higher the opportunity cost for holding money (it is better
to save or put money in the bank to earn higher interest rates/ lending).
b) At lower interest rate, the opportunity cost is lower for holding money i.e. people could
gain by buying property and borrowing.

Paradox of Thrift -is an anomaly that an individual plans to save more may result in
society actually saving less in aggregate.

Key Terms
No. Terms Definition
1. Advances Funds provided by the bank to an entity for a specific purpose, to be
repayable after a short duration.
2. Credit The ability of a customer to obtain goods or services before payment,
based on the trust that payment will be made in the future.
3. Credit Creation Is a situation in which banks make more loans to consumers and
businesses, with the result that the amount of money in circulation (being
passed from one person to another) increases. In other words it refers to
the unique power of the banks to multiply loans and advances,
and hence deposits.
4. Credit Multiplier Is an indicator of final changes in the bank deposit which originated
from initial change.
5. Demand Deposit A deposit of money that can be withdrawn without prior notice, e.g. in a
current account.
6. Excess Reserve Extra reserve kept by bank then required reserve which is normally
given to borrowers.

95
7. Foreign Aid Money, food, or other resources given or lent by one country to another.
8. Moral Suasion Used typically by making policy announcements to induce the desired
response, before resorting to mandatory compliance through statutory
regulations.
9. Money Supply The total amount of money in circulation or in existence in a country.
10. Open Market Is an economic monetary policy where central banks purchase or sell
bonds or other government securities on the open market in an effort to
Operation
regulate the money supply.
11. Paradox of Thrift Is an anomaly that an individual plans to save more may result in
society actually saving less in aggregate.
12. Primary Expansion Changes in money supply are the result of new deposits being deposited
into the banking system.
of Money
13. Remittances Transfer of money from a migrant worker to their families or other
individuals in their home countries.
14. Required Reserves Minimum amount of reserves that must be held by a commercial bank.
15. Reserve Ratio Portion of depositors' balances that banks must have on hand as cash.
16. Secondary Results from credit creation process.
Expansion of Money
17. Time Deposit A deposit in a bank account that cannot be withdrawn before a set date
or for which notice of withdrawal is required.
18. Total Reserves Are the assets that a bank has immediately available to cover its
liabilities.

Activity 3.1.1

A. MULTIPLE CHOICE QUESTIONS

1. The supply curve for money is perfectly inelastic because money supply

A. is too big to be determined.

B. is affected by the interest rate.
C. has an inverse relationship with interest rate.
D. is controlled by the central bank and that of primary liquidity.

2. An example of a secondary expansion of money would include

A. the process of credit creation.

B. customers depositing more money than withdrawing.
C. government spending more money than what they raise from tax.
D. the Reserve Bank buying government stock from the general public.

96
3. When the banking system accepts a deposit then lends this money out to borrowers,
the effect on the money supply is to
A. leave the money supply unchanged.
B. decrease it by the amount of the notes and coins deposited.
C. increase it by slightly less than the value of the money deposited.
D. increase it by an amount many times more than the original deposit.

B. SHORT ANSWER QUESTIONS

1. Define the following:

(i) Credit
(ii) Credit multiplier
(iii) Reserves
(iv) Excess reserves (4 marks)

2. Explain the process of credit creation. (2 marks)

3. RBF is requires to keep reserve. The initial deposit is $5 000. Therefore the initial balance
sheet of a particular bank looks like this:
Bank 1 -Initial Balance Sheet

Liabilities $ Assets $

Deposit 5000 Reserve 1000

Advance 4000

$5000 $5000

(i) Calculate the following :

(a) reserve ratio

(b) credit multiplier

(c) increase in demand deposit

(d) total increase in credit created (4 marks)

(ii) What is the amount of:

(a) primary expansion

(b) secondary expansion

97
 (c) increase in money supply (3 marks)

(iii) Suppose the RBF required reserve ratio is 8%. Calculate the excess reserve? (1 mark)

(iv) Explain the significance of the reserve ratio as declared by the reserve bank of Fiji.(2 marks)

(v) Construct a combined balance sheet of all the trading banks at the end of credit creation.
(2 marks)

4. Complete the table given below to show how market sales and purchases of securities by the
RBF would affect interest rates and money supply.

Reserve Bank’s Effects on Effects on

Market Activity Interest rate Money supply
Market Sales
Market Purchases

Write either “rise” or “fall” in the four blank spaces. (2 marks)

5. The following information describes the conditions in the banking system of Economy Y. Use
the information to answer questions (i) to (iii).
Transaction Account Balance $6 000
Total Reserves $2 000
Notes and Coins $1 000
(i) Calculate the Cash Reserve Ratio. (1 mark)

(ii) If there was an injection of $200 in the economy, what would be the total increase in the
money supply? (show full working) (2 marks)

98
6. Complete the credit creation process in the diagram given below.
Initial injection $ 5000. The required reserve ratio is 10%.

Step 1
Deposit________
__

Reserve_______ Advance_______
___ _____

Step 2
Deposit________
__

Reserve_______ Advance_______
___ _____

Step 3
Deposit________
__

Reserve_______ Advance_______
___ _____

99
LESSON 3.1.3 EFFECTS OF INTEREST RATE
Achievement Indicator:
 Explain the effects of interest rate in the economy.

Interest is payment from a borrower or deposit-taking financial institution to a lender or depositor

of an amount above repayment of the principal sum (i.e. the amount borrowed). It is distinct from
a fee which the borrower may pay the lender or some third party. Interest acts as a reward for saving
money in commercial banks or any financial institutions and on the other hand, it acts as a cost of
borrowing (taking loans).

Relationship between Investment and Interest Rates

The level of investment in the economy is sensitive to changes in the prevailing interest rate. In
general, if interest rates are high, investment decreases. Conversely, if interest rates are low,
investment increases. This inverse correlation is key in understanding the relationship between the
interest rate and investment.

 Low Interest Rates - investment in education, infrastructure or business expansion takes

money to accomplish. If interest rates are low, students, governments and business can
borrow the money they need more cheaply.

 High Interest Rates - when interest rates are high, investment becomes more expensive.
As money becomes more expensive to borrow, businesses, governments and individuals
start slowing their investment plans.

Relationship between Savings and Interest Rates

In theory, interest rate can affect the decision to save in two ways.

 Substitution effect of a change in interest rate – lower interest rates reduces the incentive
to save because of relatively poorer returns. There is a bigger incentive to spend rather than
keep savings.
 Income effect of a change in interest rate – lower interest rates reduce the income received
from saving, and so people may need to save more in order to gain a reasonable return from
your savings. This is important for people thinking of retirement.

You would expect the substitution effect to outweigh the income effect, with higher interest rates
encouraging people to save, and lower interest rates reducing this incentive.

Now the question arises and take a little bit of time to think on this: “Is too much savings good or
bad for the economy?”

100
 PARADOX OF THRIFT

Paradox of thrift states that increasing saving by individuals is beneficial, increased saving by all
households will reduce consumption spending and economic activity. Saving is treated as a virtue
by households as they provide a protective umbrella against bad spells but same is treated as a vice
by the economy as it retards the process of income generation. Keynes pointed out ‘paradox of
thrift’ and showed that as people become thriftier, they end up saving less or same as before. If all
the people of an economy increase the proportion of income which is saved (i.e., MPS), the value
of savings in the economy will not increase, rather it will decline or remain unchanged. Let us
understand this statement with the help of the fig. 3.1.

Figure 3.1

(Source: www.economicsdiscussion.net)

In Fig. 3.1, initial saving curve is SS and investment curve is II. Economy attains equilibrium
(Saving = Investment) at E and equilibrium level of income is OY. Now, suppose the society
decides to become thrifty by reducing consumption expenditure and increases saving by, say, AE.
As a result, saving curve shifts upward to S1S1 intersecting Investment curve II at E1.

Unplanned inventories will increase and firms will cut down production and employment and move
to new equilibrium E1. The figure shows that in the end, planned saving has fallen from AY to
E1Y1. Notice at new point of equilibrium E1, investment level and also realized saving remains the
same (E1Y1) but level of income has fallen from OY to OY1. The decline in equilibrium level of
income shows the paradox of thrift as the reverse process of multiplier has worked on reducing
consumption expenditure. In fact increased saving is virtually a withdrawal from circular flow of
income.
The deep cash pile reveals the strained caution that
many companies feel about investing, especially
in a time where economic recovery is painfully
slow and weak consumer spending data continues
to shadow high unemployment figures. Besides
generating very low returns on this untapped
reserve pool, the cash buildup is also, within good
reason, because there are relatively few
investment opportunities available. In short,
businesses seem to be playing out what Keynes’
described as the paradox of thrift.

Source: https://www.economywatch.com/economy-business-and-finance-news

101
 Activity 3.1.2
SHORT ANSWER QUESTIONS

1. Use the diagram given below to answer the following questions.

(Source: www.google.com.au)
a) Define interest rates. (1 mark)
b) Interpret the above diagram using your understanding of interest rates. (1 mark)
c) Explain the effects of increase in interest rates on:
i. investment by firms;
ii. savings by individuals (4 marks)
d) Explain the effects of decrease in interest rates on:
i. investment by firms;
ii. savings by individuals (4 marks)
2. Use the diagram below to answer questions (i) and (ii).

(Source: FSFCE Economics paper, 2012)

(i) Define interest as used in the diagram. (1 mark)
(ii) Financial institutions charge borrowers higher rates of interest than they offer to savers.
Explain why the financial institutions behave this way. (2 marks)
3. Define Paradox of thrift. (1 mark)

4. Explain an example of the paradox of thrift. (2 marks)

102
LESSON 3.2.1 INCOME AND EXPENDITURE ANALYSIS
Achievement Indicators:
 Explain the Keynesian Model of determining income.
 Define AD and AS
 Identify and explain components of AD.
 Describe and graphically illustrate consumption and savings function.
 Calculate MPC and MPS.
 Construct income and expenditure model to determine the equilibrium level of
GDP and spending.
 Graphically distinguish between inflationary and deflationary gap and identify
policies to eliminate the gaps.
 Define and illustrate business cycle.

THE KEYNESIAN MODEL OF INCOME DETERMINATION

Keynes believed that there are two major factors that determine the national income of a
country. These two factors are Aggregate Supply (AS) and Aggregate Demand (AD) of goods and
services. In addition, he believed that the equilibrium level of national income can be estimated
when AD=AS.

This model assumes that the aggregate supply curve is perfectly elastic up to the full employment
level of output after which it becomes perfectly inelastic. Hence, price level, until the full
employment level, will be determined solely by the height of the supply curve. The price level
gets less attention while the entire focus is on the determination of equilibrium level of income,
which is determined solely by the aggregate demand.

Since Keynes assumes the aggregate supply function to be stable, he concentrates his entire
attention upon the aggregate demand function to fight depression and unemployment. Thus
employment depends on aggregate demand which in turn is determined by consumption demand
and investment demand.

According to Keynes, employment can be increased by increasing consumption and/or

investment. Consumption depends on income C(Y) and when income rises, consumption also
rises but not as much as income. In other words, as income rises, saving rises.

Consumption can be increased by raising the propensity to consume in order to increase income
and employment. But the propensity to consume depends upon the psychology of the people, their
tastes, habits, wants and the social structure which determine the distribution of income. All these
elements remain constant during the short-run. Therefore, the propensity to consume is stable.
Employment thus depends on investment and it varies in the same direction as the volume of
investment.

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Definitions of Aggregate demand (AD) and Aggregate Supply (AS)

Aggregate demand refers to the quantity of national output that is purchased at given price and
represents the total demand in the economy.
Thus aggregate demand (AD) = C + I + G + (X – M).

Component of AD Symbol Description in national account

Consumption spending C Final consumption expenditure: private.
Investment spending I Gross fixed capital formation.
Government spending G Final consumption expenditure: Government.
Export receipts X Export of goods and services.
Import payments M Import of goods and services.
Gross domestic payment GDP Expenditure on gross domestic product.

Break down of components of aggregate demand

Consumption- there are two types:

(i) Autonomous consumption- the amount necessary for survival.
This consumption takes place even if there is no income.
(ii) Induced consumption- consumption that varies with income.
Higher the income, higher is the consumption.

Investment-there are two types:

(i) Intended investment /gross fixed capital formation-value of

investment goods made in the economy. Net fixed capital formation
includes all new capital goods minus depreciation.

(ii) Unintended investment/unintended disinvestment- this includes

all changes in stock.

INDUCED INVESTMENT – means increase in expenditure on capital goods in times of

increasing national income and decreasing investment with fall in national income.

Government- all spending by government on goods and services including both operating and
capital expenditures E.g. Government build new schools, paying salaries to civil servants.

Net exports- export receipts minus import payments.

Economic Stability –
occurs when there is an
absence of big swings in
prices, output and jobs.

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The Income and expenditure analysis mostly deals with aggregate supply represented by
45 ̊ line, aggregate demand and components of Aggregate demand.

Figure 3.4: Graph Showing Income line (Y)

Total

Spending

45°

0 real output

CONSUMER SPENDING

Consumer spending is the proportion of income spent on consumption expenditure. The consumer’s
income and spending is positively related i.e. as disposable income increases consumption increases
and vice versa.

Figure 3.5: Graph Showing Consumption Function

Consumption
C= a + by

di

DI

Consumption Function and MPC

MPC is marginal propensity to consume. MPC measures the slope of the consumption function. It
is calculated as follows.

MPC = in consumption

in Disposable Income
7.

In the diagram b in the equation is MPC which is induced consumption which varies with income
and a is autonomous consumption which takes place without income.

105
Consumption Function Example

C = 10 + 0.1y

Consumption function MPC Disposable income

Autonomous consumption

Calculation of MPC
Year Consumption Disposable income MPC
1980 1700 2000 -
1981 2100 2500 0.8
1982 2500 3000 0.8
1983 2900 3500 0.8

Example for 1981

MPC = Change in consumption

Change in Disposable Income
= 2100-1700
2500-2000
= 400
500
= 0.8

Savings Function

DI = C + S
S =DI - C or S=y- c

E.g. If C = 10 + 0.1y

Therefore S = y - (10 + 0.1y)

Or S = y – 10 - 0 . 1 y

Therefore S = -10 + 0.9y

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 Figure 3.6: Graph Showing Saving Function
Saving

($)
S= -10 + 0.9y

Disposable income ($)

-10

Dissaving’s are excess of consumption over Disposable income.

SAVINGS FUNCTION AND MPS
Marginal propensity to save (MPS) is the fraction of the Disposable income that is saved. It
measures the slope of the saving function.
Calculation of MPS
Year Consumption Disposable Income Savings MPS
1980 1700 2000 300 -
1981 2100 2500 400 0.2
1982 2500 3000 500 0.2
1983 2900 3500 600 0.2

Note:
MPC + MPS = 1
Therefore MPC = 1 – MPS
Therefore combination of all components gives rise to

AD = C + I + G + (X- IM)

Figure 3.7: Graph Showing Aggregate Demand Function

($)

Total

0 real output (units)

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Mathematical derivation of Equilibrium GDP
Two Sector Economy

C = 100 + 0.8y
I = 700

Calculate Equilibrium GDP

Solution Y=C+I
= (100 + 0.8y) + 700
Y =100 + 700 + 0.8y
Y – 0.8y = 800
0.2y = 800
0.2 0.2
Y = $4000

Open Economy
y = C + I + G + NX

Where C = 10 + 0.9 Yd

Yd = 0.67y

I = 60

G = 90

X = 80

M = 40 + 0.1y
Solution

Y = C + I + G + (X – M)
= (10 + 0.9yd) + 60 + 90 + [80 - (40 + 0.1y)]
= 10 + 0.9(0.67y) + 150 + 40 – 0.1y
= 10 + 150 + 40 + 0.6y – 0.1y
Y = 200 + 0.5y
Y – 0.5y = 200
Y – 0.5y = 200
0.5y = 200
0.5 0.5
Y = $400

108
 Activity 3.2.1
A. MULTIPLE CHOICE QUESTIONS
1. The marginal propensity to save is defined as

A. savings divided by disposable income.

B. disposable income divided by savings.
C. change in disposable income divided by change in savings.
D. change in savings divided by change in disposable income.

2. Which of the following is the best example of unintended investment?

A. the pre-selling of retail space in a new shopping mall.

B. the purchase of new railway rolling stock from overseas.
C. the building of a new factory in Tavua town for an overseas company.
D. a furniture manufacturer overestimates demand and has more stock on hand.

SHORT ANSWER QUESTIONS

A. Use the information given below and your knowledge to answer the questions that follows.
Consider an economy with the following characteristics. All variables are measured in millions
of dollars

C=40+0.75Y

I = 20

G=25

X=30

M= 10+0.1 Y

i. Calculate the value equilibrium level of real GDP (2 marks)

ii. Calculate the change in GDP if government spending increased by $5m. (2marks)

iii. What does the slope of the consumption function measure? (1mark)

B. Use the following data to complete the sentences below(all figures are in billions of dollars )

Y C+I+G X M
250 310 65 25
300 340 65 30
350 370 65 35
400 400 65 40
450 430 65 45
500 460 65 50
550 490 65 55

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 i. The equilibrium level of income is $ b.
ii. At equilibrium ,the level of spending on domestic goods and services is
$ b
iii. At income $300 b ,the level of net exports is $ b (3marks)

C. Use the information to answer the questions which follows.

Note: values are (000’s)
C= 200 +0.9 Y

I= 200

G=500

X=400

M=600
(i) Calculate the GDP using the expenditure approach. (2 marks)
(ii) If the MTR (Marginal Tax Rate) is 0.3Y. How much tax revenue was collected
by the government. (1 mark)
(iii) What is the slope of consumption function? (1 mark)
(iv) What special name is given to the slope of the consumption? (1 mark)
(v) Calculate the autonomous consumption and net exports. (2 marks)

INCOME AND EXPEDITURE AND MULTIPLIER ANALYSIS

Figure 3.8: Income and Expenditure Model

($)

Total y
Spending AD =C+I+G+NX

45°

0 Ye=Yf real output (units)

Inflationary or Deflationary Gap

When an economy is not producing at its full employment level it is said to be in disequilibrium
position. That is either there inflationary or a recessionary situation in the economy.

An inflationary situation arises when the full potential GDP falls short of equilibrium or actual
GDP. It is a situation where AD is higher than the Y line.

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 Figure 3.9 Inflationary Situation

Total Y

Spending

($) AD=C+I+G+NX

a Inflationary Gap

45°

0 Yf Ye real output (units )

Recessionary Situation/ Deflationary Situation

This arises when full potential GDP (Yf) lies beyond the actual GDP (Ye). In other words aggregate
demand falls short of aggregate supply at full employment level of income and output. (Evans,
2005)
Figure 3.10: Deflationary situation

Total spending ($)

Deflationary gap AD=C+I+G+NX

45°

0 Ye Yf real output (units)

Policies to eliminate inflationary and deflationary gaps

The consequence is that due to deflationary gap all the resources of the economy are not being used
in the optimum level and they are idle. This results in unemployment and low level of output. This
is not desirable for any government. In order to reduce/eliminate the deflationary gap, the
government uses expansionary fiscal policy.

Government will either increase its spending or reduce taxes (or both) in order to stimulate the
aggregate demand. Increase Government spending will result me more projects being funded by
the government and thus employment and output will increase. Even a lower tax rate will result in
more disposable income for households and encourage consumption. Increased G and C will lead
to higher AD.

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In case of inflationary gap the government can use contractionary fiscal policy to control
inflation and bring down the AD.

Multiplier is the coefficient which relates to a given change in the expenditure to a final change
in the level of income.

Multiplier effect is the notion that an autonomous change in the level of spending will give rise
to an even large change in the equilibrium level of income.

Multiplier in Simple Economy

Multiplier = 1

1 - MPC

Multiplier in Open Economy

Multiplier = 1

1 – MPC (1 – t) + m

MPC = 0.8

MPT = 0.2

MPM = 0.1

Solution

Multiplier = 1
1 – MPC (1- t) + m
= 1
1 – 0.8(1 – 0.2) + 0.1

= 2.17

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Illustrative example
Calculation of Change in GDP

Change in GDP = Change in component of GDP x Multiplier

E.g. C = 100 + 0.8y

I = 50

The Equilibrium GDP = $750 m

a. Calculate the change in GDP if exports increased by $50m and imports increase by $30m.

NX =X- M
= 50 – 30
= $20m

in GDP = in component of GDP x multiplier

= 20m x 1
1 - MPC
= 20 x 1
1 – 0.8
= $100m

b. Calculate MPC and the value of the Multiplier?

MPC = 0.8
Multiplier = 1
1 - MPC
1 = 5
1 – 0.8

c. If the potential GDP after increased in net exports is $800m. What would be the economic
situation?

There will be an inflationary situation in the economy because new Ye = $850m whereas Yf
is $800m

d. What can government do to bring about macro – economic equilibrium?

There is an inflation therefore the government will use Contractionary Fiscal Policy.

i.e. either decrease government spending to decrease AD

Or increases taxation to decease disposable income decrease consumption
expenditure to decrease AD

Fiscal Policy

Fiscal policy is actions taken by the government to influence the level of economic activity in the
economy. The main Fiscal Policy tools are government spending and taxation.

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1 Government Spending
Government can increase or decrease its government spending o change aggregate demand i.e.

G AD

G AD

2 Taxation

In taxation DI C AD

In taxation DI C AD

Formula to calculate in taxation

In taxation = IG / DG x 1
MPC

.For Example: To reduce an inflationary gap of $30m where MPC = 0.6 government would have
to change tax by:

In taxation = IG/DG x 1
MPC
= 30 x 1
0.6
= $50m

The tax should change by $50m

Activity 3.2.2
A. MULTIPLE CHOICE QUESTIONS
1. The slope of the savings function is known as the

A. marginal propensity to consume.

B. average propensity to consume.
C. marginal propensity to save.
D. average propensity to save.

2. If the government increases its fiscal deficit, which of the following is likely to occur?

A. aggregate supply will rise

B. aggregate supply will fall
C. aggregate demand will fall
D. aggregate demand will rise

3. Which of the following would shift the aggregate demand curve?

A. decreasing inflation

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 B. decreased real income
C. increased productivity
D. decreasing export receipts

B. SHORT ANSWER QUESTIONS

1. Use the information given below and your knowledge to answer the questions that follows.
Consider an economy with the following characteristics. All variables are measured in millions of
dollars.

C=1500+0.80YD
YD =Y-T
T =200+0.25Y
I = 298
G=400
X=500
M=0.15Y

i. Calculate the value of the multiplier for this economy. (1mark)

ii. Calculate the value equilibrium level of real GDP (2 marks)
iii. What is the value of Net Exports? (1mark)
iv. Suppose the full potential GDP for the above economy is $8000m, what
Would be the market situation in the economy? Use graph to explain. (2marks)
v. Explain one policy government can take to remedy the problem
faced by the above economy. (2marks)

2. Use the graph given below and your knowledge to answer the questions
that follows.

Expenditure Y AD2
($)
AD1

G{

0 Ye1 Ye2 Income Y($)

The initial equilibrium level of income is $400 billion. Given that the MPC is 0.75, calculate:

i. The value of the multiplier for this economy. (1mark)

115
 ii. The increase in equilibrium income if autonomous investment increases by $20 billion.
(1 mark)

iii. the new equilibrium level of income (Ye2) (1mark)

3. Use the data given below of a particular economy and answer the question which follows.

 Equilibrium level of income, output and Employment Ye = $500m

 Full employment level of income, output and Employment Yf = $900m
 Aggregate supply which is Y= 45° degree line
 Aggregate demand at Ye =$300m
(i) Draw the graphical representation of the above data. (2 marks)
(ii) Describe the type of economic gap experienced by the economy. (1 mark)
(iii) Calculate the value of this economic gap. (1 mark)
(iv) State the particular fiscal policy that would be used by the economy to eradicate such a
gap. (1 mark)
4. Study the diagram given below and answer the questions which follow.

Total
Spending

AD

80 100 Real GDP ($m)

(i) Explain the situation given above. (2 marks)

(ii) Calculate the economic gap. (1 mark)
(iii) Identify government policies to overcome the gap. (1 mark)

C. ESSAY WRITING QUESTIONS

In Keynesian analysis, internal balance usually does not exist and the equilibrium level of
GDP is either below or above the full employment level.

Evaluate the above statement with reference to:

 The definition of both the inflationary and deflationary gaps and another name for the
deflationary gap (3marks)

116
 The type ,direction and nature of the fiscal policy require to eliminate a deflationary gap
(3marks)
 The type, direction and nature of the fiscal policy needed to eradicate an inflationary gap.
(3marks)

Analysis of Business or Economic Cycle or Boom-Bust Cycle or Trade Cycle

A trade cycle is a regular alternation of rising and falling levels of economic activity measured
over a period of years.

Trade cycle represents variation in the level of economic activity and this variation is called a
cycle. This term originated from the famous economist Kuznet.

FIGURE 3.11 BUSINESS OR TRADE CYCLE

(Source: www.google.com.au)
The trade cycle is divided into four phases which are:
 Boom or peak – a period where the economic activity has reached a temporary maximum
level. The economy is said to be at full employment level and the economy is experiencing an
inflationary pressure.

 Recession/contraction – is a downfall in the level of economic activity i.e. decreases in the

level of income output and employment. It is a period of increase in the level of unemployment
and decline in the level of consumption and investment.

 Depression /trough /slump - is the lower turning point of trade cycle which means the level of
economic activity is at its lowest level, i.e. low level of income, output and employment.

 Recovery – an upward movement of the level of economic activity. This may have resulted
from factors such as increase in domestic population, untapped resources or up surged business
optimism.

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Key Terms
No. Terms Definition
1. Aggregate Demand The quantity of national output that is purchased at given
price and represents the total demand in the economy.
2. Aggregate Supply The quantity of national output that all firms are willing to
supply at each price level.
3. Autonomous Consumption Minimum level of consumption or spending that must take
place even if a consumer has no disposable income, such as
spending for basic necessities.
4. Boom A period where the economic activity has reached a
temporary maximum level.
5. Boom-Bust Cycle Is a process of economic expansion and contraction that
occurs repeatedly.
6. Contractionary Fiscal Policy Is a form of fiscal policy that involves increasing taxes,
decreasing government expenditures or both in order to fight
inflationary pressures.
7. Deflationary Gap The difference between potential output at full level of
employment and the actual level of output of the economy.
8. Disposable Income Income remaining after deduction of taxes and social
security charges, available to be spent or saved as one
wishes.
9. Expansionary Fiscal Policy Is a form of fiscal policy that involves decreasing taxes,
increasing government expenditures or both in order to fight
recessionary pressures.
10. Fiscal Policy Involves the government changing the levels of taxation and
government spending in order to influence Aggregate
Demand (AD) and the level of economic activity.
11. Government Expenditure Includes all government consumption, investment, and
transfer payments.
12. Gross Fixed Capital Refers to the net increase in physical assets (investment
minus disposals) within the measurement period. Is
Formation
essentially net investment.
13. Induced Consumption Portion of consumption that varies with disposable income.
14. Induced Investment Investment in inventories and equipment which is derived
from and varies with changes in final output.
15. Inflationary Gap The amount by which the actual gross domestic product
exceeds potential full-employment GDP.
16. Intended Investment Value of investment goods made in the economy.
17. Marginal Propensity to Measures the proportion of extra income that is spent on
consumption.
Consume
18. Marginal Propensity to Amount of imports increase or decrease with each unit rise
or decline in disposable income. The change in imports
Import
induced by a change in income.
19. Marginal Propensity to Save Proportion of each additional dollar of household income

118
 that is used for saving.
20. Marginal Propensity of Fraction of any change in national income that is taken in
Taxation taxation.
21. Multiplier Is the coefficient which relates to a given change in the
expenditure to a final change in the level of income.
22. Multiplier Effect An autonomous change in the level of spending will give rise
to an even large change in the equilibrium level of income.
23. Net Exports Difference between a country's total value of exports and
total value of imports.
24. Peak Also known as boom. Refer to definition of boom given
above.
25. Recession Significant decline in economic activity spread across the
economy, lasting more than a few months, normally visible in
real GDP, real income, employment, industrial production,
and wholesale-retail sales.
26. Recovery Period of increasing business activity signaling the end of a
recession.
27. Slump Lower turning point of trade cycle which means the level of
economic activity is at its lowest level.
28. Sticky-Price Are prices for goods and services that do not respond
immediately to changing economic conditions and have been
used to explain the shape of the short-term aggregate supply
curve.
29. Sticky-Wages Are when workers' earnings don't adjust quickly to changes
in labor market conditions.
30. Trough Also known as slump. Refer to definition of slump given
above.
31. Unintended Disinvestment This includes all changes in stock.

Activity 3.2.3
SHORT ANSWER QUESTIONS
A. Study the resource and answer the questions which follow.

Write a brief description on what you see in the chart of the following business cycle:

119
 1. Trough
2. Expansion
3. Peak
4. Recession (4 marks)
B. Describe the conditions in the phase of the business cycle as shown in the table. (5 marks)

Phase of Business Cycle

Indicator Trough Expansion Peak Recession
1.Interest rate
2.Consumer confidence
3. Business profits
4. Consumer spending
5.Housing construction

Research Question
Explain the relationship between savings and interest rates; and savings and investment. Is too
much savings good or bad for the economy? Explain the reason. (5 marks)

C. ESSAY WRITING QUESTIONS

The business cycle illustrates so many things and it is an economic model on its own.

Discuss the above statement in light of:

 The purpose and two alternative names of business cycle (3 marks)

 Any three phases of business cycle (3 marks)
 Use of fiscal policy to solve the problem of unemployment in the economy. (3 marks)

120
LESSON 3.3.1 LABOUR MARKET
Achievement Indicators:
 Define labour market.
 Illustrate demand and supply for labour using graphs.
 Differentiate between nominal and real wage rate.
 Describe equilibrium in labour market.
 Explain and illustrate the unusual supply curve of labour using income and
substitution concept.
 Analyze using concept of real wages, the effects of price change, and controls in
labour market.

The labour market is a resource (or factor) market. Like other market, it is buyers demand and
the seller’s supply that determines the price and quantity of labour. The price of labour is the wage
rate, the demand for labour comes from the employers and the supply comes from those who are in
the workforce. (Evans, 2005)

Labor markets may be local or national (even international) in their scope and are made up of
smaller, interacting labor markets for different qualifications, skills, and geographical locations.
They depend on exchange of information between employers and job seekers about wage rates,
conditions of employment, level of competition, and job location.

Workforce –those people who are of working age between18 to 55 and are willing and able to work.
(Evans, 2005)

Demand for labour- demand for labour is derived from demand for goods and services they
produce thus its derived demand. For instance increase in production of manufacturing industry
thus demand for more workers in manufacturing sectors.

There is a negative relationship between demand for labour and wage rate. As wage rate decreases
the demand for labor increases. The demand curve for labour slopes from left to right hence its
negative slope.

Factors affecting the demand for labour

1. The demand for labour is called derived demand. Therefore demand for labour comes for
demand for goods and services .e.g. demand for teachers come from demand for education and
demand for carpenters comes from demand for housing (Evans,2005)
2. Changes in productivity. A more productive worker is more profitable to an employer. In
productivity increases the demand for labour.(Evans,2005)
3. The level of total spending – the greater the level of spending, the greater the production in the
economy, there the greater the demand for labour.
4. The relative cost of labour and capital –the firms seeking to maximize profit use least cost
method of production. If cost of labour is low there in high demand for labour and vice versa.

121
5. Government economic policies- influences demand for labour both directly and indirectly i.e.
directly through funding job creation schemes and training programs. And indirectly through
policies that affect profitability of the firm.
(Evans,2005)
Supply of labour- the total quantity of workers who wish to work at a given real wage rate.

Factors affecting the supply for labour

1. Population sizes i.e. the birth rate, death rate and net migration.
2. Labour force participation rate
3. Wage rate and working condition
4. Education and training
5. Labour mobility i.e. occupational mobility- refers to the case which labour can move from one
occupation to another in order to take advantage of wage differentials and employment
opportunities.
Geographical mobility- refers to the case with which labour can move between different locations
to take advantage of wage differentials and employment opportunities. .
(Evans, 2005)

Figure 3.12: Graph showing Demand and Supply of Labour

Real wage SL

Rate ($)

We

DL

QL Labour

(Source: Senior Economics Workbook)

As seen in the diagram demand for labour intersects with supply of labour to determine the
equilibrium wage rate (We) which is real wage rate and the equilibrium quantity of labour (QL).

Nominal and real wage rate

Nominal wage rate is the current wage rate the worker is receiving without any adjustment whereas
real wage rate is wage at constant price and is adjusted for changes in price level and it gives
indication of purchasing power of wages. This means real wage can be used to find quantity of
goods and services that wage can afford to buy.

122
 Real wage rate (w/p) = Nominal wage rate (w)

Price level (p)

Figure 3.13: Graph Showing Backward bending supply curve

Income effect
Real wage rate SL
( per hour)
9 D

7 C

5 B

3
A Substitution
effect DL

2 4 6 8 10 12
Labour hours

As seen in the diagram above equating demand for labour and supply of labour the wage rate is
determined which is equivalent to market wage rate of $5.

Now looking at the shape of supply of labour it is said to be backward bending. The reason for such
shape of supply of labour is; initially at $6 dollar real wage rate the worker is willing to work 3
hours .As the wage rate increases to $5 worker is willing to work for 8 hours. Initially the worker
prefers leisure to work which is known as substitution effect as illustrated in diagram above. As
wage rate keeps increasing for instance increases to $9 per hour the worker prefer leisure to work
hence the supply of labour declines. This is known as income effect. Eventually it leads to backward
bending supply curve due to substitution and income effect which clearly shows workers reaction
upon changes in wage rate.

Government intervention in labour market

When the equilibrium wage rate is below the subsistence level the government intervenes to impose
minimum wage rate. A minimum wage rate is the lowest remuneration that employers may legally
pay to workers. Equivalently, it is the price floor below which workers may not sell their labor. The
minimum wage rate is fair and equitable ensuring the minimum welfare needs of consumers is
satisfied.

123
For a developing nation like Fiji's new minimum wage of $2.68 per hour announced by the
government came into force on August 1- 2017.The National Minimum Wage (NMW) Regulations
had been gazette and all relevant employers adjusts their workers’ wage levels and employment
conditions to comply with the NMW Regulations and the Employment Relations Promulgation
2007 (ERP).

Figure 3.14: Graph Showing the Impacts of Minimum Wage Rate on Labour Market

(Source: www.google.com.au)
Assume that minimum wage rate is imposed at W1. The effect of the minimum wage rate on labour
market is as follows:

Initial stage, DL and SL equate to determine the market wage which is at We.
At We the equilibrium quantity of labour employed is QL. At equilibrium condition there is 0
involuntary unemployment and voluntary employment is full employment (f) minus QL.
(voluntary employment= f- QL)
At minimum wage rate W1:
 Employment has decreased from QL to QDL
 Involuntary unemployment has increased from 0 (nothing at all) to QSL minus QDL.
 Voluntary unemployment has decreased from (f –QL) to ( f-QSL).
Note:
Involuntary unemployment –occurs when an individual is willing to work at the given wage
rate but is unable to find a suitable job.

Voluntary unemployment – occurs when an individual is willing to work but do not accept the
job unless wage rate increases.

124
Key Terms

No. Terms Definition

1. Derived Demand It depends on demand for the product the worker is producing. For
example, demand for steel leads to derived demand for steel
workers, as steel workers are necessary for the production of steel.

2. Geographical Mobility Refers to the level of freedom that workers have to relocate in order
of labour to find gainful employment that reflects their training and
occupational interests.
3. Involuntary Occurs when an individual is willing to work at the given wage
rate but unable to find job.
Unemployment
4. Labour Demand Amount of labour that an economy or firm is willing to employ at
a given point in time.
5. Labour Force Is a measure of the active portion of an economy's labor force. It
refers to the number of people who are either employed or are
Participation Rate
actively looking for work.
6. Labour Market Is the place where workers and employees interact with each
other.
7. Labour Mobility Refers to the ease with which laborers are able to move around
within an economy and between different economies.
8. Labour Supply The total quantity of workers who wish to work at a given real
wage rate.
9. Minimum Wage Rate The lowest remuneration that employers must legally pay their
workers.
10. Nominal Wage Rate The current wage rate the worker is receiving without any
adjustment.
11. Occupational Mobility Labour can move from one occupation to another in order to take
advantage of wage differentials and employment opportunities.
12. Productivity Is the output per unit of input.
13. Real Wage Rate Wage at constant price and is adjusted for changes in price level
and it gives indication of purchasing power of wages.
14. Voluntary Occurs when an individual is willing to work but do not accept
the job unless wage rate increases.
Unemployment
15. Workforce Those people who are of working age between18 to 55 and are
willing and able to work.

Activity 3.3.1
A. MULTIPLE CHOICE QUESTIONS

1. Labour as a factor of production is said to be

A. final demand
B. derived demand
C. composite demand

125
 D. perfectly elastic demand curve

2. Voluntary unemployment is a situation where

A. workers do not volunteer for work because the wage rate is too low.
B. employers have no choice but to offer a redundancy package.
C. workers voluntarily exit the domestic labour market.
D. unemployment is linked to the business cycle.

3. If the price of a unit of specialized labour is held above the equilibrium, which of the following
is not likely to be a consequence?

A. Few units of that labour resource can be hired.

B. Improved living standards for all members of this specialized labour force.
C. There will be involuntary unemployment of some of that specialized labour.
D. Members of this labour force still at work may suffer from stress and overwork.

B. SHORT ANSWER QUESTIONS

1. Use the graph given below and your knowledge to answer the questions that follow.

Graph Showing Demand and Supply of Labour

Real Wages S Full employment

12 Minimum Wages

10

S
D

8 12 16 18 Quantity of labour (000’s)

(i) State two factors influencing the demand for labour. (2 marks)
Explain the shape of supply curve of labour. (2 marks)

(ii) Explain the concept of Substitution Effect and Income Effect as

illustrated by the labour supply curve. (2 marks)

(iii) Calculate the following (at Equilibrium and minimum wage rate)

(a) Level of Voluntary Unemployment (in terms of quantity

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 of labour) (2 marks)

(b) Level of Involuntary Unemployment (in terms of quantity

of labour) (2 marks)

Research Question
Investigate the impacts of National Minimum Wage Rate on the labour market. What is the current
National Minimum Wage Rate in Fiji and the total number of people in the labour force? Is the current
Minimum Wage Rate enough for poor people to meet the basic needs and keep up with the inflation?
Give reasons for your answer. (5 marks)

ESSAY WRITING QUESTIONS

Labour is the core factors of production for economic growth and development.
With the reference to the above statement, discuss the following:

 three factors influencing demand for labour. (3 marks)

 three factors influencing supply of labour. (3 marks)
 income and substitution effects of backward bending supply curve. (3 marks)

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STRAND 4 INTERNATIONAL ECONOMICS

Strand Outcome:

Investigate Fiji’s international trade patterns to gauge its status in

the global economy.

Content Learning Outcomes:

 Explore the impacts of exchange rate on balance of payments and

investigate foreign reserves.

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4.1 EXCHANGE RATES
Lesson 4.1.1 Exchange Rates and Foreign Reserves
Achievement Indicators:
 Define exchange rate and the foreign exchange market.
 Describe and illustrate how the foreign exchange market works.
 Define and analyse the changes in floating/flexible and fixed exchange rate.
 Differentiate between revaluation and devaluation.
 Graphically Illustrate revaluation and devaluation.
 Convert one currency to another currency.
 Define foreign reserves and its importance in exchange market.

Exchange rate- is the price one currency in terms of the other currency.

Exchange rate is expressed as the foreign currency equivalent of one unit of domestic currency for
e.g. FJ$1=US$0.46.

(Source: www.google.com.au)

Exchange rate of Fiji dollar against US dollar from 2011 till 2015 is given below in the diagram.

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Forex market –is the foreign exchange market (forex, FX, or currency market). It is a situation
in which currency of one country is traded for that of another. The foreign exchange market involves
many buyers and sellers. The existence of buyers and sellers implies the operation of the market
forces of supply and demand.

Process in foreign exchange market

The process of trading the currency of one country for the currency of another occurs in forex
market. This process is necessary for international trade to take place in a world of different
currencies. The value of one currency versus another is determined by the international exchange
rate and, in most cases, is subject to fluctuations based on open trading of currency in foreign
exchange markets.

130
 Figure 4.1: Diagram showing the processes of Forex market
Sugar Machine tools
United Kingdom £UK

£UK paid for £UK to pay

exports. for imports.

Fiji exports: Fiji

Fiji imports:

Goods market Foreign Exchange Market

Goods market

Demand for $FJ Supply of $FJ to

to pay to pay for imports.
exporters.

Fiji $FJ

Sugar exported (Fiji dollar) Machine tools imported

Equilibrium in foreign exchange market

The demand for currency

The demand for currencies is derived from the demand for a country’s exports, and from
speculators looking to make a profit on changes in currency values.

The supply of currency

The supply of a currency is determined by the domestic demand for imports from abroad. For
example, when the Fiji imports Cars from Japan it must pay in Yen (¥), and to buy Yen it must sell
(supply) Fiji dollars.

Exchange rate is determined by the currency requirements of exporters and importers only. The
demand for Fiji $ is expressed by those who have overseas currencies in foreign exchange market.
The supply of Fiji $ is provided by the importers who wants to buy other currencies.

In the foreign exchange market there is both demand for a currency as well supply of the currency
for example Fiji dollar. Therefore the exchange rate is simply determined by equating demand and
supply of the currency as seen in figure 4.2

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Figure 4.2: Graph showing demand and supply of Fiji’s currency

Exchange Supply FJ$

Rate
(US currency
price of $F1)

e*

Demand FJ$

Q* Quantity of $F (billion)

Nominal and real exchange rate

The nominal exchange rate states how much foreign currency can be exchanged for a unit of
domestic currency, whereas the real exchange rate tells how much the goods and services in the
domestic country can be exchanged for the goods and services in a foreign country. Thus the real
exchange rate is the purchasing power of a currency relative to another at current exchange rates
and prices.

Activity 4.1.1
A. MULTIPLE CHOICE QUESTIONS
1. An exchange rate is the

A. amount of foreign currency that can be bought.

B. price of one currency against another currency.
C. price of one currency on the international market.
D. a situation where one currency is traded for another.

2. The situation where buying and selling of currencies is known as

A. Forex market.
B. Credit market.
C. Goods market.
D. Factor market.

3. Nominal exchange rate is the

A. purchasing power of a country in terms of another currency at current exchange rates and
prices.
B. number of units of the domestic currency that can purchase a unit of given foreign
currency.

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 C. number of times more or less goods and services can be purchased abroad than in the
domestic for a given amount.
D. amount of goods and services in the local currency can be exchanged for the goods and
services in a overseas country.

B. SHORT ANSWER QUESTIONS

1. Define the following terms:
i. Exchange rate
ii. Foreign exchange market
iii. Nominal exchange rate
iv. Real exchange rate (4 marks)
2. Explain how central bank intervention affects the exchange rate? (2 marks)
3. Explain the processes of Forex market? (2 marks)
4. State how the demand for currency is being derived? (1 mark)
5. State how the supply of currency is determined? (1 mark)
6. Match the terms given in column A with column B.
Column A Column B
1. Exchange rate A. Sets official or unofficial target rates for their currencies.
2. Currency market B. The number of units of the domestic currency that can
purchase a unit of a given foreign currency.
3. Real exchange rate C. Is the price of a nation's currency in terms of another
currency.
4. Nominal exchange rate D. Determines the foreign exchange rate.
5. Central banks E. The ratio of the price level abroad and the domestic price
level.

C. ESSAY WRITING QUESTION

The Foreign Exchange Market [FOREX] is an important market as far as international

trade is concerned.
Discuss the above statement with reference to:

 the definition of exchange rate, nominal exchange rate and real exchange rate (3 marks)
 three short-term determinants of exchange rate (3 marks)
 three long-term determinants of exchange rate (3 marks)

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TYPES OF EXCHANGE RATE REGIMES
There are two types of foreign exchange rate systems:

1. Floating Exchange Rate

This rate is determined by interaction of forces of supply and demand for currency. The rate
moves freely in response to competitive market forces. This system is also referred to as
flexible exchange rate.

2. Fixed Exchange Rate

Exchange rate is determined by the government or a central bank. It can be fixed against the
value of gold or pegged against the value of another currency such as US dollar.

Clean float versus dirty float

Clean float
Also known as a pure exchange rate, a clean float occurs when the value of a currency, the
exchange rate, is determined purely by supply and demand.

Dirty float
Floating currency exchange rate system which is not controlled entirely by the market forces
of demand and supply. Instead, it is at least partially controlled by government intervention
that limits appreciation or depreciation of the currency within a range. Also called managed
float.

FLOATING EXCHANGE RATE

Exchange rate determination in free market
Figure 4.3: Graph Showing Determination of Exchange Rate in Free Market
Exchange Rate
(US currency Supply FJ$
price of $F1)
Excess supply FJ$
$0.77

$0.47

$0.30
Demand FJ$
Excess demand of FJ $

$30 Quantity of $F (billion)

In free market equilibrium exchange rate is established by equating the demand for $FJ with the
supply of $FJ as depicted in fig 4.3, thus the equilibrium exchange rate is FJ$1= US$0.47. The
equilibrium quantity is FJ$30 billion.

134
Therefore any other exchange rate would not be maintained. An exchange rate above equilibrium
such as FJ$1=US$0.77 will result in an excess supply of Fijian Dollars (FJ$) similarly an exchange
rate below equilibrium such as FJ$1.00 = US$0.30 results in an excess demand of $FJ, so an upward
pressure would be exerted on the exchange rate until equilibrium is reached.

CURRENCY APPRECIATION AND DEPRECIATION

Currency appreciation and depreciation in floating exchange rate:
Currency Appreciation
A currency appreciation may be defined as an increase in the exchange rate of one currency in
terms of another.

For example, if the exchange rate between FJ$ and US$ is FJ$1 = US$0.47 and changes to
FJ$1 = US$ 0.67, then the FJ$ is said to be appreciated against the US dollar. Each Fijian dollar is
now worth more in terms of US currency than before.

Figure 4.4 below shows that either an increase in demand for (FJ$) Fijian dollar or a decrease in
supply (Figure 4.5) of FJ$ will lead to an appreciation of Fijian Dollar.

Both the diagrams assume an equilibrium exchange rate of FJ$1.00 = US$0.47. The new
equilibrium exchange rate in both case is FJ$1.00 = US$0.67

Figure 4.4: Graph Showing the Effects of Currency Appreciation with Increase in Demand

Exchange Rate
(US currency S FJ$
Price of FJ$1)

$0.67

$0.47

D1FJ$
DFJ$

Qe Q1 Quantity of FJ$ (billion)

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Figure 4.5: Graph Showing the Effects of Currency Appreciation with Decrease in Supply
Exchange Rate S1FJ$
(US currency SFJ$
Price of FJ$1)

$0.67

$0.47

DFJ$

Q1 Qe
Quantity of FJ$ (billion)

The impact of currency appreciation on exports and imports

1. Exports – if the Fijian dollar appreciates, Fijian exports become less competitive when priced
in other countries; and if priced in overseas dollars, they bring in fewer Fijian dollars. Thus, an
appreciation of the Fijian dollar discourages exports.
2. Imports – with the appreciation of the Fijian dollar, importers will need fewer Fijian dollars
when they are buying their goods from overseas. Consumers may find that prices of imported goods
and services decrease. Hence an appreciation of the Fijian dollar encourages imports.

Currency Depreciation
Currency depreciation - refers to a decrease in the exchange rate of one country in terms of
another. In this case, a movement in the exchange rate for FJ$1.00 = US$0.47 to
FJ$1.00 = US$0.37 means that the Fijian dollar has depreciated against the US dollar. Each Fijian
dollar now buys fewer units than before.

Decrease in demand (Figure 4.7) for Fijian dollar and an increase in supply (Figure 4.6) for Fijian
dollar leads to a depreciation of a Fijian currency. Assume an equilibrium exchange rate of
FJ$1=US$0.47 and equilibrium quantity of say FJ$20 billion.
Both diagrams indicates a fall in the new equilibrium exchange rate of FJ$1=US$0.37. Once again
the impact of this movement on quantity of Fijian dollar bought and sold at foreign exchange
market differs in each case.

136
Figure 4.6: Graph Showing the Effects of Currency Depreciation with an Increase In Supply

Exchange Rate
(US currency SFJ$
price of FJ$1)

S1FJ$

$0.47

$0.37

DFJ$

20 27 Quantity of FJ$ (billion)

The impact of currency depreciation on exports and imports

1. Exports – as a result of the currency depreciation, exports become more competitive overseas if
they are priced in Fijian dollars because they fall in price. If they are priced in overseas dollars,
exporters gain from the weaker dollar as it boosts the value of overseas sales when they are
converted back into Fijian dollars. Therefore, a depreciation of the Fijian dollar encourages exports.
2. Imports – importers need to pay more Fijian dollars when purchasing imports and they pass this
on in higher prices in Fiji, which will decrease the quantity of imports demanded. Therefore, a
depreciation of the Fijian dollar discourages imports.
Figure 4.7: Graph Showing the Effects of Currency Depreciation with Decrease in Demand

Exchange Rate
(US currency SFJ$
price of FJ$1)

$0.47

$0.37

D1FJ$ DFJ

15 20 Quantity of FJ$ (billion)

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 Figure 4.8: Graph Showing the Net Effect of Currency Depreciation

Exchange Rate
(US currency SFJ$
price of FJ$1)

S1FJ$
$0.47

$0.35

D1FJ$ DFJ$

20 22
Quantity of FJ$ (billion)

In the Figure 4.8 above shows a depreciating Fijian dollar has net effect:
-it makes exports more competitive and increases supply of Fijian dollar.
-it makes imports more expensive in Fijian dollars and decreases demand of Fijian dollar.
-with decrease in imports and increase in exports leads to increase in net exports.

Factors affecting currency appreciation and currency depreciation

1. Demand for currency

a. The demand for currency comes from our exports (visible and invisible) because foreigners
need to pay in our currency i.e. ↑ in demand for exports→ ↑in demand for currency →to
currency appreciation and vice versa.
 In order to ↑ demand for exports domestic prices should be cheap compared to other
nations
 ↑in income of overseas countries causes ↑in demand for our exports.
 Favorable taste and fashion for our product in overseas market ↑in demand for our
exports.
b. Capital Inflow -↑ in capital inflow e.g. increase in foreign direct investment → ↑ in demand
for domestic currency, and vice versa. Interest rate determines the level of capital inflow
and outflow in a country.
i.e. ↑ in int. rate ↑ capital inflow and vice versa.
c. Speculation – i.e. if the market sentiments suggests an increase in the value of domestic
currency at some future date, the demand for domestic currency will (↑) increase →
currency appreciation and vice versa.

138
2. Supply of currency- comes from local residents, who buy imported goods invest in other
countries and speculate in other currencies.
a. Demand for imports - ↑in demand for imports (visible and invisible) → ↑in supply for
domestic currency →currency depreciation.
b. Capital outflow - ↑in capital outflow (investments in overseas) →↑in supply for domestic
currency. Low interest in the domestic country relative to those in other countries →
↑capital outflow.
c. Speculation – on Forex market occurs when currencies are bought and sold for the purpose
of making profit. The value of domestic currency falls when speculators expect a future
depreciation of our domestic currency. As speculators sell their domestic dollars to avoid
future losses, the present supply of domestic currency rises causing currency depreciation
and vice versa.
Effects of Currency Appreciation and Depreciation
Item Appreciation FJ$ Depreciation FJ$
Fiji exports More expensive Cheaper
Fiji Imports Cheaper More expensive
Net Exports Decrease Increase
Capital inflow Discouraged Encouraged
Capital outflow Encouraged Discouraged
Overseas trip Cheaper Expensive
Tourists in Fiji Discouraged Encouraged

IMPLICATIONS OF FLOATING EXCHANGE RATE

Balance of payment implication under floating exchange rate

The deficit on current account always equals the surplus on capital account thus BOP is in state
balance or in equilibrium. Under a floating exchange rate, the BOP is always in equilibrium. Any
disturbance to the BOP equilibrium is automatically connected by the movement in the exchange
rate itself.

Uncertainty

Due to the exchange rate changing there is always some business firm and individual involved in
exporting and importing of overseas investment. It adds to the planning and decision making
difficulties faced by international transaction. In some cases uncertainty regarding exchange rate
movement may hamper world trade and investment at very least increases the cost of international
transaction.

139
Inflation

The movement in the exchange rate is likely to have important implication for domestic inflation.
The impact of such movement is perhaps most keenly felt when depreciation raises price of import.

Currency depreciation influences inflation in two ways:

a. The primary effect is the increases in the price paid for final goods entering in Fiji.
b. A secondary effect occurs however as higher price for important intermediate goods at cost of
production (COP) for domestic industries. This in turn forces up the price of locally produced
goods.

Domestic Employment

Variation in the exchange rate influences the level of domestic employment through their impact
on our international competitiveness. By increasing the demand for our exports and decreasing the
demand for our imported goods. Currency depreciation promotes the growth of Fijis export and this
effectively increases production in these industries.
On the other hand the currency appreciation increases the price of our export and lowers the
overseas demand for these goods. As a result international competitiveness of our export is reduced
and employment opportunities decline.

Activity 4.1.2
A. MULTIPLE CHOICE QUESTIONS
1. The type of float which is associated with a flexible exchange rate system is
A. dirty float
B. clean float
C. managed float
D. inflatable float

2. A depreciation of a currency occurs when

A. inflation falls.
B. the value of the currency falls.
C. the value of the currency increases.
D. the balance of payments improves.

3. An appreciation of the currency is likely to occur if

A. domestic interest rates fall.

B. there is an increase in demand for imports.
C. there is an increase in demand for exports.
D. there is an increase in the balance of payments deficit.

4. If the exchange rate is above the equilibrium level then in a floating exchange rate system

A. there is excess demand and the exchange rate should fall.

140
 B. there is excess supply and the exchange rate should fall.
C. there is excess demand and the exchange rate should rise.
D. there is excess supply and the exchange rate should rise.

5. Where supply and demand are allowed to determine a country’s exchange rate, then exchange
rate is
A. floating.
B. fixed.
C. pegged to the dollar.
D. pegged to the gold standard.

B. SHORT ANSWER QUESTIONS

QUESTION 1
(a) Define the term floating exchange rate? How is floating exchange rate determined? (2 marks)
(b) Define the terms currency appreciation and currency depreciation. (2 marks)
(c) State two effects of each; appreciation and depreciation of Fiji dollar. (4 marks)
(d) Illustrate currency appreciation and depreciation using appropriate graphs. (2 marks)

QUESTION 2

Consider the following scenario, its related graphical analysis and use your own knowledge to
answer questions (i) to (iv).
Scenario:
Freebeez economy has operated a flexible exchange rate system since the mid 1970s.
The following graph shows Freebeez economy’s dollar is being justified in the FOREX market and the
market for Freebeez dollars is in equilibrium.

Note: this is an incomplete graph.

The Market for Freebeez Dollar

0
i) Complete the graph by labeling the two axes and the two line graphs. (2 marks)

141
 (i) On the same graph in part (i) above, show how the following situation will affect the rate
of exchange;
“An improvement in current account caused by export earnings rising faster than import
expenditures.” (1 mark)
(ii) If Freebeez dollar is said to have depreciated in that period under review, how will this
affect its export and import sector? (2 marks)
(iii) How might this depreciation of the dollar contribute to a forecast increase in the rate of
employment growth in the future? (1 mark)

QUESTION 3
Use the information in the graph given below and your knowledge to answer questions (i) to (iv).

The Market for Buzzland Economy Dollars (BED)

Exchange Rate
S of BED
Honeyland
Economy Dollars
(HED) 1.10

D of HED

Equilibrium Quantity of Buzzland Economy

Quantity Dollars (BED) in millions

Note: On a free market the exchange rate is HED 1.10 buys BED 1.00

(i) State a price that would reflect a decrease in demand by Honeyland residents for Buzzland
dollars. (1 mark)
(ii) State a price that would reflect an increase in Buzzland dollars coming into the country as
a result of more Buzzland residents visiting Honeyland. (1 mark)

Situation:
In the 1980s the exchange rate was held at HED 0.60 = BED 1.00. Some people want
the government to restore this rate.
(iii) Draw the effect of the above situation on the graph. (1 mark)

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 (iv) Which group within Honeyland Economy would benefit most from this exchange rate
being imposed? (1 mark)
QUESTION 4
MATCHING
Match terms in Column A with Column B.

Column A Column B
1. Dirty float A. Also known as pure exchange rate.
2. Floating exchange rate B. Increase in the exchange rate of one currency in terms of
another.
3. Currency appreciation C. The exchange rate determined by forces of demand and
supply in currency.
4. Currency depreciation D. Also known as managed float.
5. Clean float E. Decrease in the exchange rate of one currency in terms of
another.
(5 marks)

C. ESSAY WRITING QUESTION

1. The foreign exchange market plays an intrinsic role in the area of the international trade

Discuss the above statement with reference to:

 the definition of exchange rate and two systems of the exchange rates (3marks)

 the impact of currency depreciation on exports and imports (3marks)

 the impact of currency appreciation on exports and imports (3marks)

2. Exchange rate is an important factor for economic performance.

Discuss the above statement with reference to:

 the definition of flexible exchange rate, currency appreciation and currency depreciation
(3 marks)
 three factors affecting currency appreciation and currency depreciation (3 marks)
 three impacts of currency depreciation on economic performance (3 marks)

143
FIXED EXCHANGE RATE

Fixed Exchange Rate system is when the value of a nation’s currency is officially set and
maintained at some particular level by the government or one of its agencies such as Central Bank.
In Fiji for instance Reserve Bank of Fiji determines the exchange rate.

In the graph given below the free market equilibrium exchange rate is FJ$1.00= US$0.50. The
equilibrium exchange rate of FJ$30 billion dollars.

Now consider what happens if the government decides to fix the exchange rate above the
equilibrium rate.
Figure 4.9: Exchange Rate above Equilibrium
Exchange Rate
(US currency SFJ$
Price of FJ$1)

$0.70 Fixed exchange rate

$0.50

DFJ$

20 $30 40 Quantity of FJ$ (billion)

Maintaining a Fixed Exchange Rate

When the government fixes the exchange rate above free market equilibrium at FJ$1.00 =
US$0.70, supply of Fijian dollar exceeds the demand for Fijian dollar creating a surplus of $F20
billion.

To maintain the fixed exchange rate FJ$1.00=US$0.70, the Central bank must enter the market
and buy $F20 billion

144
When the government decides to fix the exchange rate below the equilibrium rate

Figure 4.10: Exchange Rate below Equilibrium

Exchange Rate
(US currency SFJ$
price of FJ$1)

$0.50

$0.40
Fixed rate

DFJ$

25 $30 35 Quantity of FJ$ (billion)

When the government fixes exchange rate below the equilibrium at $1.00=US0.40. At this
exchange rate demand for Fiji dollar is greater than supply of Fiji dollar creating a shortage of FJ$10
billion.

To maintain the fixed exchange rate the government must enter the market and sell FJ$10 billion
worth of Fijian currency.

So in order to maintain a fixed exchange rate, the government or the central bank, must intervene
in the free market. It acts as a buyer or seller to ensure, that free market exchange rate coincides
with its fixed exchange rate.

Advantages of Fixed Exchange Rate

1. It promotes stability i.e. by decreasing risk and uncertainties.

2. Fixed exchange rate encourages growth of international trade and finance.
3. It eliminates disruptions caused by both short term variations in the exchange rate and
speculation.
4. Stable exchange rate and removable of uncertainty can make long term economic planning
easier.
5. Increases investment, employment and economic growth because it reassures the risk
involved as the overseas investors know that they will receive the scarce profits.

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Disadvantages
1 The level of international reserves
Fixed exchange rate affects the level of international reserves. When fixed exchange rate is
above the world market price, government has to sell international reserves (and buy its
currency). The international reserves will fall. If the international reserves falls to an
unsatisfactory level, then the governments will have to protect them by decreasing demand for
imports and capital inflow and vice versa.
2 Balance of payment
Fixed exchange rate system usually mean disequilibrium in the balance of payment. A BOP
surplus means that the flow of funds into domestic country from exports receipts and capital
inflow exceeds the flow of fund out of domestic country to pay for imported goods and capital
outflow.
While a BOP deficit means that the outflow of funds from domestic country exceeds the inflow
of fund into domestic country.
3 Domestic money supply
Fixed exchange rate influences the level of money supply simply because it creates B.O.P
disequilibrium. A BOP surplus means increase in the supply of foreign currency held by
domestic commercial banks. The RBF buys these foreign currency and sells the FJ$ to the
commercial banks increase in deposits increase in MS.
A BOP deficit means decrease in the supply of foreign currency held by domestic commercial
banks. The RBF sell these foreign currency and buy the FJ$ from the commercial banks
decrease in deposits decrease in MS.

REVALUATION AND DEVALUATION

A system of fixed exchange rate does not mean that the value of countries currency never changes.
However it means that variation in exchange rate turn to be relatively infrequent.
Generally short run fluctuations occur in the demand and supply of the currencies then the
government must compensate by buying or selling foreign currencies. But the government cannot
go on buying and selling indefinitely, so in the long run persistent market pressure may force the
government to vary the exchange rate altogether i.e. it may either revalue or devalue its currency.

Revaluation-refers to an increase in the value of the nation’s currency i.e. the result of
deliberate action by the countries government or central bank.

Assume that the exchange rate is fixed at the initial equilibrium exchange rate of $F1.00 = US$0.70.
The decrease in supply of FJ$ from S0 to S1 and an increase in demand for FJ$ from D0 to D1 results
in excess demand for FJ$ or a shortage of FJ$.

146
Figure 4.11

(Source: Introducing Economics Book 2 Barry Collier)

In a short run a decrease in the supply of the Fijian dollar from S0 to S1 in graph (a) results in excess
demand of Fijian dollars on the foreign exchange market AB. AB also occurs as initial equilibrium
rate following an increase in demand for Fijian dollar from D0 to D1 in graph (b). The Reserve
Bank can compensate in the short run by selling Fijian dollar AB.

In the long run however, the official value of the Fiji dollar may need to be increased to say FJ$1.00
= US$0.75 resulting in currency revaluation.

Such a revaluation is likely if the supply of the Fijian dollar continues to fall or demand for them
continues to rise. In this event the Fiji dollar have said to have been undervalued at FJ$1.00 =
US$0.70.

Implications of Currency Revaluation

1. Effectively increases the amount foreign currency which FJ$1.00 will buy.
2. The price of imported goods fall thereby making imports cheaper.
3. Our exports become more expensive
4. Foreign investment becomes cheaper leading to greater capital outflow.
5. Local or domestic firm become less competitive therefore demand for export decreases.

Devaluation

This refers to decrease in the value of a nation’s currency that is a result of deliberate action taken
by the countries government or its central bank.

Assume that the initial equilibrium exchange rate of FJ$1.00 = US$0.70. An increase in supply of
FJ$ from S0 to S1 and a decrease in demand for FJ$ from D0 to D1 results in excess
supply of FJ$ or surplus of FJ$.

147
 Figure 4.12

(Source: www.google.com.au)
The graphs show excess supply equal EF at the initial equilibrium exchange rate, when the demand
for Fiji dollar on the foreign exchange market decreases from D0 to D1. The reserve bank can
compensate in the short run by buying Fijian dollars equal EF.

In the long run however, the authorities may be forced to decrease the exchange rate to say FJ$1.00
= US$0.65 causing currency devaluation. This devaluation will occur if the supply of Fiji dollar
continues to rise in the foreign exchange market or if the demand for them continues to fall.

A Devaluation of the Fiji Dollar Has the Following Implications:

i. Decreases the amount of foreign currency which FJ$1.00 can buy.

ii. Increases the price of imported goods, thereby reducing the domestic demand for them.
iii. Decreases the price of exported goods, causing a rise in the demand for domestic goods
overseas.
iv. Inflow of capital occurs.
v. Domestic goods become more competitive on the international market.

Key Terms

No. Terms Definition

1. Clean Float Also known as a pure exchange rate, a clean float occurs when
the value of a currency, the exchange rate, is determined
purely by supply and demand.
2. Currency Appreciation An increase in the exchange rate of one currency in terms of
another.
3. Currency Depreciation Decrease in the exchange rate of one country in terms of
another.
4. Devaluation Decrease in the value of a nation’s currency that is a result of
deliberate action taken by the countries government or it
central bank.
5. Dirty Float When the central bank intervenes in the foreign exchange
market to artificially affect the value of domestic dollar.

148
6. Exchange Rate The price of a nation’s currency in terms of another currency.
7. Fixed Exchange Rate The value of a nation’s currency is officially set and maintained
at same particular level by the government or one of its agencies
such as Central Bank.
8. Flexible Exchange Rate Also known as clean float.
9. Floating Exchange Rate Also known as flexible exchange rate and clean float.
10. Forex Market The foreign exchange market is the market in which participants
are able to buy, sell, exchange and speculate on currencies.

11. Managed Float Is the current international financial environment in which

exchange rates fluctuate from day to day, but central banks
attempt to influence their countries' exchange rates by buying
and selling currencies. It is also known as a dirty float.
12. Nominal Exchange Rate States how much foreign currency can be exchanged for a unit
of domestic currency.
13. Real Exchange Rate Tells how much the goods and services in the domestic
country can be exchanged for the goods and services in a
foreign country.
14. Revaluation Increase in the value of the nation’s currency i.e. the result of
deliberate action by the countries government or central bank.

Activity 4.1.3
A. MULTIPLE CHOICE QUESTIONS
1. Where the government constantly intervenes into the Forex market, buying and selling its
currency, then country’s exchange rate is said to be

A. floating.
B. fixed.
C. pegged to the dollar.
D. pegged to the gold standard.

2. If a country has artificially pegged its exchange rate so that it is below the equilibrium, the
likely effects will include

A. a high demand for the over-valued currency on the world market.

B. imports that are dearer than they should be and export receipts that are increased.
C. some other way of rationing scarce overseas funds will have to be used in addition to the
ruling exchange rate.
D. the country will find it relatively easy to raise loans on overseas money markets at
relatively low rates of interest.

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 3. The pegged exchange rate is the

A. price of currencies in terms of each other as determined in the FOREX market.

B. rate that is established by demand and supply of any given economy.
C. rate which can be varied at the discretion of a country’s monetary authority.
D. rate expresses in terms of a key currency or basket of currencies.

4. If the Fiji dollar loses value against the overseas currency, which of the following is taken
by other countries to be a benchmark?

A. It will cost Fijians more to travel overseas.

B. Fiji exporters will receive more for their output.
C. Less overseas investment will take place in Fiji.
D. Foreign tourists will find it more expensive to stay in Fiji.

5. A devaluation of Fiji dollar

A. leads to the more outflow of capital.

B. increases the amount of foreign currency which FJ$1.00 can buy.
C. domestic goods becomes less competitive on the international market.
D. increases the price of imported goods, thereby reduces the domestic demand for imported
goods.

6. A revaluation of Fiji dollar

A. increases the demand for exports.

B. leads to the greater outflow of capital.
C. decreases the amount of foreign currency which FJ$1.00 can buy.
D. decreases the price of imported goods, thereby making imports cheaper.

B. SHORT ANSWER QUESTIONS

QUESTION 1
(a) Define the term fixed exchange rate? How is fixed exchange rate maintained? (2 marks)
(b) Define the term revaluation and devaluation. (2 marks)
(c) State two effects of each; revaluation and devaluation of Fiji dollar. (4 marks)
(d) Illustrate revaluation and devaluation using appropriate graphs. (2 marks)
(e) What is meant by the term international reserves? (1 mark)

150
(f) Explain the effect of BOP surplus and deficit on the level of money supply. (2 marks)

QUESTION 2
Use the flowchart given below and your knowledge to answer questions (i) to (iv).

Effect of a Fixed Exchange Rate on the Domestic Money Supply

Foreign
Foreign
Currencies
Currencies
Balance of Payments Fiji Commercial RBF
Surplus Banks

Fiji dollars

Increase in Domestic
Money Supply

Note: The above flow chart is reversed when there is a deficit Balance of Payments.

(i) How is the exchange rate determined in a fixed exchange rate system? (1 mark)
(ii) A deficit in Fiji’s Balance of Payments Account implies a decrease in the domestic money
supply. How is this possible? (1 mark)
(iii) A fixed exchange rate system means disequilibrium in the Balance of Payments Account.
Comment on this statement. (1 mark)
(iv) The official intervention in the determination of exchange rates is possible even under a
floating exchange rate system.
Name the type of exchange rate system that is referred to in this statement. (1 mark)
(v) Define the following terms:
1. Foreign exchange market
2. Dirty float
3. Clean float
4. Currency appreciation (4 marks)

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QUESTION 3
Use the information given in the graph and your knowledge to answer questions (i) to (iii).

The Market for Fiji Dollars(FJD) in terms of New Zealand (NZD)

Exchange Rate
S of FJD
($)

0.75

D for FJD

0 Q1 Quantity of Fiji Dollars (FJD)

(i) On the graph show the following:

a. The effect of a situation where there is a significant increase in imports from
New Zealand.
b. The new exchange rate as 1.00FJD = 0.70AUD. (2 marks)
(ii) A local from Fiji is visiting New Zealand and has 2000FJD to spend. Calculate the amount
of New Zealand dollars this person can buy before and after the change. (1 mark)
(iii) State one reason why a large devaluation in the FJD would be a concern to the Reserve
Bank. (1 mark)

Research Question
What type of exchange rate regime is used in Fiji? In 2009 there was devaluation of
Fiji dollar by 20 percent. Why was the Fiji dollar devalued? What were the immediate
benefits of this devaluation on various sectors such as tourism, sugar industry and other
agricultural sector? How does it affect the poor people? What the Impacts on trade;
exports and imports and economic growth of our country?
(10 marks)

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C. ESSAY WRITING QUESTIONS

1. The Foreign Exchange Rates Market plays an intrinsic role in the area of international
trade.

Discuss the above statement with reference to:

 the definition of exchange rates and the two systems of exchange rates. (3 marks)
 the features of the exchange rate and how it is determined in each of the two
systems. (3 marks)
 the effects of each system when there is an appreciation or revaluation of the
domestic country’s currency on import prices and the quantity exported. (3 marks)

2. A financial crisis will lead to a severe devaluation of a country’s currency.

Discuss the above statement with reference to:
 the definition of fixed exchange rate, revaluation and devaluation (3 marks)
 any 3 benefits of devaluation of Fiji Dollar to the economy (3 marks)
 any 3 drawbacks of devaluation of Fiji Dollar to the economy (3 marks)

http://www.rbf.gov.fj

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STRAND 5 DEVELOPMENT ECONOMICS

Strand Outcome:

Investigate different potentials and issues affecting the Fiji’s

economy.

Content Learning Outcomes:

 Explore the impacts of economic activities on natural environment

and develop strategies for sustainable environment.
 Explore how market fails to achieve equitable outcomes and how
government gets equity at cost of efficiency.

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 5.1 ENVIRONMENTAL ECONOMICS

LESSON 5.1.1 EXTERNALITIES

Achievement Indicators:

 Define externalities.
 Differentiate positive and negative externalities of production and
consumption.
 Illustrate externalities using social marginal cost curves and social marginal
benefit curves.
 Identify social equilibrium and private market equilibrium.
 Explain how subsidies, taxes, regulations and public provisions can internalize
positive and negative externalities.

We have learnt from year 11 that the principle of markets has been the usual best way of allocating
resources efficiently. This has been based and supported on Adam Smith’s 1776 Book, ‘An inquiry into
the Nature and Causes of Wealth’. Smith theorised that sectors work as if they are guided by an ‘invisible
hand’. This invisible hand then directs us to intended market outcomes.

The equilibrium above works well for private goods but not for mixed goods. Mixed goods are goods
which are neither public nor private goods. They are always produced and consumed in undesirable
quantities. This is because they are either under or over-priced and over – produced or under-produced
which causes market failure. Thus, in the midst of production and consumption, producers and consumers
have somewhat deviated from the intended outcomes which are some other unplanned by- products from
the actual production and consumption. These unplanned activities are the side effects of production and
consumption which are referred to as externalities. The externalities which emit adverse impacts are
known as negative externalities while the one which produce favourable impacts are referred to as
positive externalities.

Figure 5.1 Type and Examples of Externalities

EXTERNALITIES

POSITIVE EXTERNALITIES NEGATIVE EXTERNALITIES

POSITIVE NEGATIVE NEGATIVE

POSITIVE CONSUMPTION
PRODUCTION CONSUMPTION PRODUCTION
EXTERNALITIES EXTERNALITIES EXTERNALITIES EXTERNALITIES

TRAINING MORE EDUCATED POLLUTION PASSIVE SMOKERS

- LESS CRIME

155
In our analysis, we will look at the impacts of externalities on production and consumption
separately with how it’s internalised.

Impacts of Externalities of Production on the Market Outcomes

1. Negative Externalities of Production

We will refer to cement production to illustrate the impacts of negative externalities on the
efficiency of market outcome. Cement production contributes to greenhouse gases through the
production of carbon dioxide. It contributes to the adverse environmental and social impacts in our
society which makes it a negative externality.

Impacts of Cement Production and Training in the Efficiency of Market Outcome

Figure 5.2 Impacts of Negative and Positive Externality of Production

MSC– negative externality of production

Price

KEY
MC (Private Cost)
PSE
Deadweight loss
PE MSC’ – positive externality
of production
PSE’
External cost at
MB QSE’
0
QSE QE QSE’ Quantity
External benefit

The diagram above illustrates the impacts of externalities on the efficiency of the market outcome.
This is usually explained using the social and private costs or benefits and is illustrated using the
marginal cost curve (MC) or marginal benefit (MB).

As a result of the adverse spill-over effect from the cement production, an external cost to the
bystanders for the hazard caused is derived. Hence, the cost to society of producing the cement is
higher than the cost to the cement producers which would shift the Marginal Cost (MC) curve
leftwards by the amount of the external cost from MC to MSC as shown in figure 5.2. This results
in a welfare loss to society, as shown by the blue shaded area which is the deadweight loss. The
rational producer would choose the output where demand (MB) meets the MSC curve, which is the
social equilibrium. Hence, efficient output level will be reduced to QSE while price will be
increased to PSE.

 Internalising Negative Externality of Production

The full brunt of the costs must be borne by the producers themselves.

 Tax – Imposition of tax on producers (eg. carbon tax) which will shift the supply curve
leftwards or charges on plastic bags. This reduces the output and diminishing spill – overs while
market equilibrium is moved towards social equilibrium.
 Regulations – Banning pollutions under regulations which can incur fines.

156
 2. Positive Externalities of Production

Positive externalities refer occurs when the third party gains from the spill over production in which
he or she is not charged. Therefore, they (people who gain) are known as free riders. Positive
externalities are usually encouraged as they induce benefits which reduce the cost of production.

 Example 1: Training of Staff: - The training of staff members of a particular firm would not
only be enjoyed by the staff but the knowledge and skills gained would also be of use in
their families or in their own communities.
 Example 2: Research and Development: - which leads to new technology is also a potential
by-product of production, which other firms can benefit from.

This reduces the cost of production hence reducing the MC by the amount of the benefit. This will
shift the MC curve rightwards or downwards to MSC’ as shown in Figure 5.2. Hence, it would be
efficient to increase the output level to QSE’ and hence the price will be reduced to PSE’.

 Internalising Positive Externality of Production

1. Government can intervene by paying subsidies to encourage the production.
2. Regulations that encourage production or reward producers with other inducements can be
put in place, such as tax write-offs as in the case of research and development.

Impacts of Externalities of Consumption on the Market Outcomes

3. Negative Externalities of Consumption

A negative externality of consumption arises from the consumption of demerit goods. As for
instance: smoking cigarettes (affecting passive smokers); excessive alcohol drinking (affecting
other people’s enjoyment), noise pollution (affecting neighbour’s peace), road congestion (usage
of road will deny space from other road users).
Negative externalities of consumption will shift the MB curve to MSB (Marginal Social Benefit)
by the amount of benefits lost. At private market equilibrium E; with output QE and price PE, the
good is under-priced and over–consumed as shown in Figure 5.3 below. Rational consumers will
consume at output QSE and price PSE which is the social equilibrium.

Figure 5.3 Impacts of Negative and Positive Externality of Consumption

Price
E MSC
PSE’ Marginal Social Cost = (Marginal Cost + External Cost)
PE
MSB’- KEY
positive
PSE
externality
of Deadweight
consumption Loss
MB
MSB- negative externality of
consumption External cost at QSE’
0 QSE QE QSE’
Quantity
External benefit

157
4. Positive Externalities of Consumption
Positive consumption externalities are derived from merit goods, which beneficiaries do not pay
for. As for instance, healthcare, private treatment for contagious diseases gives benefits to the
people without any charges. Similarly, with education, the skills acquired and knowledge learnt at
university can benefit the wider community in many ways. Hence the social value of the good
exceeds the private value hence shifting the MB curve rightwards to MSB’. Social equilibrium will
now shift rightwards where rational consumer would choose output QSE’ and price PSE’.

Key Terms

No. Terms Definition

1. Demerit Goods Is a good that is regarded as unhealthy or that can negatively
affect the consumer.
2. Externalities Are costs or benefit that spill over onto other people from the
production or consumption.
3. Marginal Benefit The additional benefit received by the consumer from the
consumption of one more good.
4. Marginal Cost Is the cost of producing an additional unit of a good or service.
5. Marginal Social Benefit Is the total benefit to society, from one extra unit of a good.
6. Marginal Social Cost Incremental cost of an activity as viewed by the society, and
expressed as the sum of marginal external cost and marginal
private cost.
7. Mixed Goods Are the types of goods with both the element of private and
public goods.
8. Negative Externalities of Occur as a result of actions by consumers that reduce benefits of
others.
Consumption
9. Negative Externalities of Production occurs when production imposes additional cost on
other people.
Production
10. Positive Externalities of This occurs when consumption benefits other people.
Consumption
11. Positive Externalities of Occurs when a third party gains as a result of production e.g.
construction and operation of infrastructure projects, such as a
Production
new airport, or motorway.

158
12. Private Goods An item that yields positive benefits to people" that is excludable,
i.e. its owners can exercise private property rights, preventing
those who have not paid for it from using the good or consuming
its benefits; and rivalrous i.e. consumption by one necessarily
prevents that of another.
13. Private Marginal Benefit The benefits enjoyed by the individual consumers of a particular
good.
14. Private Marginal Cost Incurred by a household (or business) in actually consuming (or
producing) a good.

The dangers of passive smoking

Smokers don’t only put themselves at risk of serious health problems – people around them
can also be exposed to much potential danger. The smoke exhaled by someone else or
emitted by the tip of a burning cigarette is called environmental tobacco smoke, and
breathing it in is known as passive smoking.
Environmental tobacco smoke is a major source of indoor air pollution. It exposes non-
smokers to most of the same toxic gases, chemicals and fine particles that smokers inhale
directly with tobacco smoke. The particles in the unfiltered smoke that drifts from burning
cigarette tips can be finer and more concentrated, meaning that they can be inhaled deeper
into the lungs and stay longer in the body of the passive smoker than in the person who is
smoking.
Obviously, the more time people spend in close company with smokers, the more they are
exposed to environmental tobacco smoke and the worse the threat to their health. Naturally,
this often means those most at risk are the people smokers care most about their loved ones
and friends. In 1998, 128 people died of passive smoking and another 1,968 were
hospitalized.
Children exposed to environmental tobacco smoke are 40% more likely to suffer from
asthma symptoms than children who are not exposed. An estimated 8% of childhood asthma
in Australia is attributable to passive smoking and is estimated to contribute to the symptoms
of asthma in 46,500 Australian children a year.
State and Territory governments are generally responsible for regulation of environmental
tobacco smoke in Australia. Various States and Territories have implemented some form of
smoking restriction in public places usually with a small number of exemptions, (such as bar
areas where food is not being served). Some States and Territories also have, or are
planning to introduce, broader bans on smoking in enclosed public places such as
restaurants, bars and shopping centers.
(Adapted from: Report by Australian Government, Department of Health and Ageing)

159
 Activity 5.1.1

A. MULTIPLE CHOICE QUESTIONS

1. The slope of the social cost (TSC) curve is given by the

A. total social benefit notation.
B. marginal social cost element.
C. social desirable equilibrium point.
D. negative externality of consumption.

2. The real cost of environmental protection is

A. a decrease in GDP
B. increased leisure opportunities
C. an increase in positive spillovers
D. a decrease in external benefits from forests

3. When one smokes in a crowded bus, the cost imposed on others is called

A. marginal cost.
B. marginal benefit.
C. negative externalities.
D. positive externalities.

4. The negative externalities of an industrial process are its

A. social cost to society

B. private cost to society
C. total cost to the producers
D. total cost of production

5. A spillover can be defined as the

A. free-rider situation
B. effect on market equilibrium
C. cost or benefit that arises from a decision
D. amount by which market price exceeds costs

6. Which of the following illustrates the concept of external cost?

A. Smoking harms the health of the smoker

B Bad weather reduces the size of the root crop dalo
C. Smoking harms the health of non-smokers who are nearby.
D. A reduction in the size of the root crop dalo causes the income of dalo farmers to fall.

160
 B. SHORT ANSWER QUESTIONS

1. Use the information given below in the case study and answer the question that follows
A paper mills locates next to the river. Rather than pay for waste removal the firm dumps the
rubbish into the river. This kills many marine lives, creates bad order and affects livelihood
of many people living nearby. The firm faces the marginal cost of producing each unit of
paper but not the cost of dumping the waste. Thus the marginal social cost is higher than the
firm’s marginal cost of producing paper.

However taking into consideration of the extent of damage inflicted on the society, the paper
mill has decided to purchase control equipment which would cost $1 million dollars to
control and maintain the problem.

Thus, the government agrees to grant a property rights to the firm through environment
coi.urt. What type of externality is discussed in the article? (1mark)

i. State one way in which the government can internalize the type of spillover
mentioned in the article. (1mark)

ii. Describe how the allocation of property rights affects this problem. (2 marks)

2. Study the cartoon and answer the questions which follow.

(Source: www.google.com.au)

(i) What does the cartoon depict? (1 mark)

(ii) In the view of above cartoon outline contemporary government polices to eliminate or
reduce impacts of environmental externalities. (1 mark)

161
3. Use the information given below and answer the question that follows

Regulation

Public
Subsidy
provision Government
Interventions

Taxation
Transfer payment

i. Define the term public provision. (1 mark)

ii. State two problems associated with public provision. (2 marks)

iii. Explain what user pay system mean. (2 marks)

iv. Corporatization is one of the reform processes used by government to restructure the
economy. State and explain another one. (2 marks)

4. Residents living near major airports have been exposed to excessive noise levels from jet
aircrafts. The diagram below shows the private market for air travel.

Market for Air Travel

MC,MB
($)
MPC

MPB

0 Quantity (units)

(i) Define the economic term social cost. (1 mark)

(ii) On the diagram:

a) Draw a marginal social cost curve which includes noise pollution.

Label the curve MSC. (1 mark)

b) Show the free market equilibrium price and quantity.

Label price as Pf and quantity as Qf. (1 mark)

162
 c) Show the socially optimal price and quantity.

Label price as PS and quantity as QS. (1 mark)

(iii) Suggest one method of internalizing the costs of noise pollution.

Explain clearly how it would work. (2 marks)

5. Use the graph given below to answer questions (i) to (iii).

(Source: FSFCE Economics paper, 2013)

(i) Label the axes (p) and (t) and the curves (q), (r) and (s) correctly. (3 marks)
(ii) Calculate the amount of the spillover benefit per one unit of this consumption activity of
tertiary education onto a third party. (1 mark)
(iii) What is another name for ‘spillover benefit of consumption’? (1 mark)
(b) (i) What are the two essential characteristics of a private good? (2 marks)
(ii) Use the ‘free-rider’ concept to explain why public goods are unlikely to
be provided by the private sector. (2 marks)
(iii) Distinguish between demerit goods and public goods. (2 marks)

6. Use the excerpt given below and your knowledge to answer questions (i) – (iii).

163
 The economic activity of consumption has both positive and negative spillovers.
The usage of public transport can be seen as a positive spillover of consumption;
and the government of the day has put in place policy measures to assist in the
internalisation of a positive spillover of consumption such as that of public
transport.

(i) Explain why using public transport is considered to have positive externalities
of consumption. (2 marks)
(ii) State one policy measure that can be used by the government to internalise
a positive externality of consumption such as public transport. (1 mark)
(iii) Complete the following identity by using only one relevant notation:
MSB = + spillover benefits of consumption (1 mark)

7. Use the article given below and your own knowledge to answer questions (i) to (v).

Something Rotten Downtown

Rotting rubbish waiting for collection downtown is getting up the noses of the
business community. The City Council’s Works Committee Chairman has received
many complaints about refuse that is piled on pavements for up to four days before
being collected for disposal. The rubbish creates an offensive odour, attracts vermin
and other animals, and is a terrible sight in the main streets. A recent City Council’s
Works Committee meeting decided that daily collections should be investigated but
that would involve increased rates. The committee wants the council to consider
making it mandatory for businesses to store their food waste in wheelie bins until
collection day.

Adapted from :The Local Times, June, 2002.

(i) Identify the type of externality involved in the above situation. (1 mark)

(ii) What action has the business community taken in order to help minimize

the problem ? (1 mark)

(iii) Draw a graph to show the private market equilibrium output (Qm) and the socially desirable
equilibrium output(Qs), and also the corresponding market equilibrium price (Pm) and the social
equilibrium price (Ps), for the rubbish collection.

Label the graph clearly. (3 marks)

(iv) What action has the City Council taken in order to reduce the problem? (1 mark)

(v) State the other method that could be used to internalize the externality. (1 mark)

164
C. ESSAY WRITING QUESTIONS

1. All manufacturers are engaged with certain level of externalities.

Evaluate the above statement with reference to:
 differentiate positive and negative externalities of production with examples. (3 marks)
 any 3effects of negative externalities of production (3 marks)
 any 3 government policies to reduce negative externalities of production. (3 marks)

2. Externalities undermine the social benefits of individual selfishness.

Evaluate the above statement with reference to:
 differentiate positive and negative externalities of consumption with examples. (3 marks)
 any 3 effects of negative externalities of consumption (3 marks)
 any 3 strategies government can use to internalize negative externalities of
consumption. (3 marks)

165
5.2 EQUITY AND EFFICIENCY

Lesson 5.2.1 Equity, Equality and Distribution of Income

Achievement Indicators:

 Distinguish between equity and equality.

 Outline factors for equitable distribution of income.
 Describe causes of inequality.
 Illustrate distribution of income using Lorenz curve.
 Interpret Lorenz Curve.
 Identify tools for redistribution of income.
 Describe how government attempts to get equity at the cost of efficiency.

Equity means fairness or justice in a particular situation.

Equality means same or everyone. No one gets more than the other one all gets the same sized
share.

(Source: www.google.com.au)

Some factors for equitable distribution of income

(i) Accepting market outcomes- Complete reliance on market would not be tolerated for long.
There need to be equality in opportunity such needs of all should be met.
(ii) Accepting market outcomes but ensuring equity of opportunity.
(iii)Reducing inequalities with progressive taxation and transfers.
(iv) Accepting market outcomes but providing a safety net for those who cannot earn.
(v) Creating complete equality.

166
Causes of inequality
Some of the causes of inequality are:
(i) The market- market favors those resources high in demand thus different level of income
distribution in economy due to supply and demand for labour in each industry.
(ii) Life cycle- example a child will get pocket income, young adults such a professional
couple will get good income and retired couple maybe on pension.
(iii) Wealth-Those with more wealth will generate more income and vice versa.

Distribution of Income using Lorenz Curve

Figure 5.4 A Lorenz curve

100%
Cumulative % of income

50%

30%
Lorenz
10% Curve

50% 75% 100%

Cumulative percentage of households

The Lorenz curve shows degree of inequality in income distribution for an economy.

It is a square which represents on the vertical axis cumulative percentage of all income earned and
on the horizontal axis represents cumulative percentage of households. The 45 degree line
represents line of perfect income equality.

Looking at the Lorenz curve of a particular economy shown above it can be interpreted that 50%
of poorer households take home 10% of national income. Similarly 75% of poorer households take
home 30% of national income or 25% of rich people earn 70% of total national income. For this
economy the income distribution is widely uneven.

Note:
 The further away the Lorenz curve from the line of equality, the less equal income
distribution is.

167
  The closer the Lorenz curve from the line of equality, the more equal income
distribution is.

How does the Government intervene to correct unequal income distribution

Through the redistributive policy government is able to reduce the gap between rich and poor.
The Lorenz curve will shift to the left, toward the absolute equality of income.

Tools for redistribution of income

The government can use range of policy measures for redistribution of income:

(i) Taxes –government can use progressive taxes to tax rich more than the poor so the income
equalities can reduce.
(ii) Transfers-welfare benefit are transfers the government can provide the poor who cannot
provide for themselves
(iii) Public Provisions- provide goods which are free of charge such as hospital, schools etc.
(iv) Subsidies-can subsidize range of goods and services such as medicines, agricultural
equipment
(v) Regulations- such as minimum wage rate, affirmative action and equality of opportunities
such no discrimination gender, age or ethnicity.

Figure 5.6: Using Lorenz curve to show the effect of redistributive policy

Cumulative
% of
Income

Cumulative % of households

How government attempts to get equity at the cost of efficiency

Equity efficiency tradeoffs occur when redistributive policies results in reduction in economic
efficiency.
Such as:
(i) Increase progressive taxation can result in high income earners with less incentive to work
longer hours.
(ii) Welfare system can result in reduced incentive to work and people can become risk averse
and enjoy using welfare benefits only.
(iii) Tax and subsidy results in loss of allocative efficiency (deadweight loss).

168
Key Terms

No. Terms Definition

1. Equality Means same or everyone. No one gets more than the other
one all gets the same sized share.
2. Equity Means fairness or justice in a particular situation.
3. Lorenz Curve A graph on which the cumulative percentage of total
national income (or some other variable) is plotted against
the cumulative percentage of the corresponding population
(ranked in increasing size of share). The extent to which the
curve sags below a straight diagonal line indicates the
degree of inequality of distribution.
4. Perfect Income Equality Line The line at the 45º angle shows perfectly equal income
distribution. A ‘perfect’ income distribution would be one
where each % received the same % of income. Perfect
equality would be, for example, where 60% of the
population gains 60% of national income.
5. Wealth An abundance of valuable possessions or money.

Activity 5.2.1
A. MULTIPLE CHOICE QUESTIONS

1. A curve which shows relationship between the cumulative percentage of households and their
cumulative percentage of income is the

A. Lorenz curve
B. wealth-income curve
C. market income curve
D. 45 degree diagonal curve

2. Equity in income distribution means that

A. workers get a pay rise

B. disposable income is the same for everyone
C. the distribution of income is deemed and regarded as fair
D. the allocation of resources is such that inefficiency is notable feature

3. Which of the following economic issues can a Lorenz Curve can be used to evaluate

A. the degree of equity in income distribution.

B. the allocative and technical efficiency of markets.
C. the degree of specialisation and growth within countries.
D. the comparative advantage of trading partners and terms of trade.

169
B. SHORT ANSWER QUESTIONS

1. Study the information given in the graph below and answer the question that follows.

Lorenz curve: Fiji 2009-2011

Key
2009 2009
2010
2011
2010

2011

i. What is the purpose of a Lorenz curve? (1 mark)

ii. Show the combined effect that a progressive taxation plus social welfare benefit
would have on the Lorenz curve (1 mark)

iii. Comment on the Lorenz curves for Fiji from 2009-2011. (1 mark)

2. Study the picture given below and answer the questions which follow.

Picture A Picture B

(Source: www.google.com.au)
(i) Which picture depicts the concept of :
I. Equality
II. Equity (2 marks)

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 (ii) Differentiate between the two concepts contextualizing the picture
provided. (2 marks)
3. Study the cartoon and answer the questions which follow.

(Source: www.google.com.au)

What does the cartoon above depict regarding the welfare of citizens? (2 marks)

4. Use the Lorenz Curve given below to answer questions (i) to (iv).

Lorenz Curve for Economy Z

(Source: FSFCE Economics paper, 2013)

(i) Name Curve A. (1 mark)

(ii) What does the above graph reflect on the distribution of income in Economy Z? (1 mark)

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(iii) What do you expect to happen to the Lorenz Curve for Economy Z as a result of replacing a
flat taxation rate system with a progressive taxation rate system? (1 mark)

(iv) The Minister of Finance in Economy Z has announced that in order to improve equity
and inequality in income distribution, Economy Z will have to move from a flat taxation
rate system to a progressive taxation rate system.
State how a progressive taxation rate system can bring about improvement in equity and
inequality of income distribution. (2 marks)

5. Match the parts of the graph numbered 1 to 6 in the graph given below with their correct labels
from the Resource List. Write the letter of the correct label beside the matching number. Each
label is to be used only once.

(Source: FSFE Economics paper, 2009)

Resource List
A. Cumulative percentage of income
B. Line of Absolute Equality
C. Cumulative percentage of households
D. Line of Absolute Inequality
E. Lorenz curve for market income in Economy E prior to adjustment, thus has a greater
income inequality effect
F. Lorenz curve of adjusted disposable income and has a lesser income inequality effect

(3 marks)

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C. ESSAY WRITING QUESTIONS

1. Policies aim to achieve equality of welfare, but the aim is to achieve equity; ultimately,
there can be no equality without justice.
Evaluate the above statement with reference to:
 differentiate between equity and equality with examples (3 marks)
 3 causes of inequality (3 marks)
 3 government policies that creates equity at cost of efficiency (3 marks)

2. Income distribution is at the stake of equality and equity.

Evaluate the above statement with reference to:
 3 factors for equitable distribution of income (3 marks)
 3 tools for income redistribution (3 marks)
 illustrate and explain effects of redistributive policy using Lorenz curve (3 marks)

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Bibliography
Amacher, R.C. & Ulbrich, H.H. (1989), Principles of Microeconomics, fourth edition, South-Western
Publishing Co., CA.

Blyth, A. (2013), Economics ESA Study Guide, Level 2, ESA Publications Ltd, New Zealand.

Blyth, A. (2013), Economics ESA Study Guide, Level 3, ESA Publications Ltd, New Zealand.

Collier, B. (1993), Introducing Economics Book 2, second edition, Jacaranda Press.

Evans, G. (2008), Senior Economics, NCEA Level 3, second edition, Pearson, New Zealand.

Fischer, S. & Dornbusch, R. (1994), Macroeconomics, sixth edition, McGraw-Hill, Inc., United States.

Mankiw, N.G. (2015), Essentials of Economics, seventh edition, Cengage Learning, USA.

McIver, R., McConnell, C. and Brue, S. (1997), Microeconomics, eighth edition McGraw-Hill International
Book Co., Tokyo.(S338.5/155)

Stewart, J. & Rankin, K. (2008), Economic Concepts and Applications, fourth edition, Pearson, New
Zealand.

Williamson, M. (2006), NCEA Level 3 Economics, ESA Publications Ltd, New Zealand.

Websites:

http://www.rbf.gov.fj/

http://www.mitt.gov.fj/index.php/divisions/department-of-tourism

http://www.moit.gov.fj/

http://www.fijitimes.com/

https://tradingeconomics.com/fiji/indicators

http://databank.worldbank.org/data/home.aspx

https://www.adb.org/data/statistics

https://www.slideshare.net/stuartinfiji/ecotourism-in-the-soputh-pacific-what-is-what-isnt
http://www.businessdictionary.com/definition/economic-sustainability.html
http://www.yourarticlelibrary.com/notes/macroeconomics/the-keynesian-theory-of-income-
output-and-employment/31036

Cover Page Sources

winne.com
openclipart.org
financialexpress.com
gitea.org
thehackerchicblog.com
traveller.com.au

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