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B200
Understanding Business Behavior
Dr. Fatimata LY
Source: Mohammad Nader
This presentation will not replace the book at
any rate.
Understanding Business Markets

The Evolution Of The Modern World Economy
 Economic Agents
 How Markets Work
 Market Failure
 The Global Market
 Markets: Good Servants, Bad Masters
2
The Evolution Of The Modern World Economy

The global economy, AD 1400-1800:
comparisons and relations

The British Industrial Revolution
3
The global economy AD 1400-1800:
Comparisons and Relations

Asian not Europe was the center of world industry
throughout early modern times
 Japan was the world leading exporter in silver and
copper,
 China in porcelain and India in silk

Asians were preponderant in the world economy and
system
 in population, production & productivity,
 competitiveness and trade till the end of 1800AD.
4

Europe did not emerge as a Newly
Industrializing Economy (NIE) challenging Asia
until the late eighteenth century.

Europeans did not create the world economic
system itself nor develop world capitalism.

Data on global production and income are hard
to come by for this period (it is difficult to find
or construct data, few people interested).

Data on world and regional population growth
before the nineteenth century are speculative.
5

So estimates for the 17th and 18th centuries by
Carr Saunders (1936) , Walter Willcox (1931),
M.K. Bennett (1954) and Colin Clark (1977).

According to M.K. Bennett:
population grew by about 20% in the 15th
century
 and 10% in the 16th century
 Between 1650-1750 the growth rate was near 45%
  in production
 in the world supply and distribution of
money.
 World
6
According to Bennett and Clark:

During the period 1400 -1800 population grew faster
in Asia than in Europe


Standard of living, the years of expectancy of life.
During 1750-1800 Asian production was much
greater than Europe & America,
 For
example, 2/3 of people in Asia produced 4/5 of
total world output.
 Asians were more productive than Europeans.
7
The global economy, AD 1400-1800:
Comparisons and Relations

Asia was the leader in exporting esp. China and
India
 Asia earn money
 Asia was more industrious and more productive
than the rest of the world.
 Europe was not a major center in terms of exports
to the rest of the world economy.
Intermediation
place in trade because it controlled a
huge supply of billion at that time.
 1500-1800 the commodity that Europe was able to
produce and export was money.
8
Economic Agents

Households

More on Consumer Demand

Organizations
9
Economic Agents
In market economy there are 3 important kinds of
decision makers: Households, Firms and Governments
The
households
 supply
factors of production to firms on a factor or
input market.
 link the economic activities such the consumption,
production and distribution
Firms
 Private
producing units of goods and services
 sell them to households and government.
10

Firm is an organization aim to make a profit. But
family has non economic purpose.

Micro-Economy: the study of individual economic
unites. Focus on households and firm.

Macro-Economy: the study of economic
aggregates and an overview of the economy like
inflation, national income, monetary and fiscal
policies.
11
Households

Households make decisions about
 paid
and unpaid work,
 the future workforce,
 What to purchase.

Households have different
 structures:
single, family (made of two or more), friends.
 social characteristics: class, race, gender or generation
 economic
characteristics: poor, rich, work, retired.
 Consumption
and the purchasing power of people
depends on the level of income.
12
Factors of production:
Capital, land, natural resources
Income:
Money received by Households from selling labor services or
property: wages, salaries and rent
All the exchanges are done in terms of:
 Quantity: hours worked/used, month, etc.
 Prices: wages, interests, profits, etc.
 The choices made by Households are transmitted to
business by prices and quantities (levels, and changes).
13
Households
Consumption Expenditure
Factors of production
households
firms
Consumption goods and services
Income
Household circular flow of income
14

Consumption Expenditure



Food ,drinks, tobacco and housing make the largest part
This amount varied from one country to another based
on the wealth of the country (Germany and Spain)
Income is unequally distributed

between households in all countries and in the same
country
 Hierarchy of patterns of consumption between rich and
poor.
 This unequal distribution of purchasing power will
affect the markets for individual products (national
Income)
15

The household income is used in 3 ways:
 Consumer
expenditure (day to day activities),
 Saving
in order to provide security for the
family in the future and for housing,
 Taxes
used by the governments to pay social
consumption (education, roads, etc.) and to redistribute purchasing power between
household.
16
In summary

The personal sector concerns with households dividing
their income between expenditures and savings
(budgeting).

The households characteristics, the technology, the
purchasing power, preferences etc. influence our life and
consumption.

Demand: what buyers are willing and able to purchase.

Price is the most important variables considered by
economists: a transaction is done for a quantity at a
given price. What link Price to Quantity?
17
What link Price to Quantity?
 Is
there a relationship between PriceQuantity?
 Yes, “The law of Demand”.
 Does
the price affect the demand
Yes, price does affect the demand
Yes, The Elasticity
18
The Law of demand
The quantity demanded is inversely related
to the price, Ceteris Paribus.
 Represented
by the demand curve (downward
slope)
 Ceteris Paribus: other things constant (Income,
Substitutes, complement, Taste, Future expectation
regarding income and preference).
Special Goods
 Veblen
Goods: when prices goes  demand (e.g.
luxury goods)
 Giffen Goods: when prices goes  demand goes 
(e.g. inferior goods) in poor countries.
19
Households
P
Q: Quantity Demanded
P: Price
P1
P2
D1
D
0
Q1
Q2
Q
Demand curve and Demand Curve shift
20
ELASTICITY

Anyone who sells a product or service is
concerned with how a change in price affects
demand.
Price elasticity of demand, ED

It is very important to know the ED for the
economists and sellers in order to set their
prices.

And the same thing for Chancellor of the
Exchequer in order to set taxes.
21

The sensitivity of demand to price changes
varies with different items:
 For
some products ( drinks, peppers, light
bulbs, etc.) relatively small percentage
changes in price will not change the demand
for the item much more;
 For other items (cars, home loans, furniture &
computer equipment, etc.) small % changes
in price have significant effects on demand.

Price elasticity of demand is one way to
measure the sensitivity of demand to
changes in price.
22

If Q= the quantity demanded and P=the price,
 Q = the change in Q
 a percent change in demand = Q /Q

P = the change in P
 a percent change in price = P/P

ELASTICITY could be calculated by the ratio of
%change in demand to %change in price.

This ratio can be written as:
E = - (P/Q) × (Q /P)
23
How to interpret Elasticity

When E=1: the relative changes in demand
and in price are relatively equal, and the
demand is said to have unit elasticity.

If E<1: the relative change in demand is less
than the relative change in price, the demand is
called inelastic;

If E>1: the relative change in demand is
greater than the relative change in price, the
demand is called elastic.
24
Elasticity of demand measures the
instantaneous responsiveness (sensitivity) of
demand to price:
 E=0.2 for medical service
 E=1.2 for stereo equipment
 The demand of medical service is much less
responsive to price change than is the
demand for non essential commodities, such
as stereo equipment;
 the demand of medical service is inelastic;
 the demand of stereo equipment is elastic.
25
Elasticity Formula
Price elasticity of demand ED

ED =
% ED /
% PD

ED = (Q1-Q2)/(Q1+Q2)/2 / (P1-P2)/(P1+P2)/2

ED = - (P/Q) × (Q /P)
26

Factors influencing ED :
 availability of
substitutes (more elastic),
 if the products is a necessity or a luxury, proportion of
a person’s income (more elastic)
 and time the longer the more elastic.
Revenue (R) = Quantity (Q) × Price (P)
When demand is elastic, an increase in the price
will  a fall in the firm’s revenue.
Question: What if the demand inelastic?

27
More on Consumer Demand
ED > 1
ED < 1
P
P
P1
P1
D
P2
P2
D
Q
0
Q1
Q2
Elastic Demand
0
Q1
Q2
Q
Inelastic Demand
28
More on Consumer Demand
P
D
P
ED=0
D
Q
0
Q
0
Zero Elasticity
Perfectly Inelastic
Infinite Elasticity
Perfectly Elastic
29
Price Elasticity of Demand ~ Revenue
Demand is elastic:
  Price   Firm Revenue
  Price   Firm Revenue
 Demand is inelastic:
  Price   Firm Revenue
  Price   Firm Revenue
 D unit elastic:
  Price  no in the Firm Revenue

30
Price Elasticity
P
Revenue at higher prices
P1
Sales
Revenue at lower prices
D
Revenue
0
P
Q
Q1
P
P1
P1
D
P2
P2
D
Q
0
Q1
Q2
0
Q1
Q2
31
Q
Income Elasticity of Demand

To witch extent demand changes as income
changes?



Depends on the nature of the product.
Demand could be: income elastic, income inelastic etc.
EI > 1  Demand is income elastic


The percentage increase in demand is greater(>) than
the percentage increase in income;
E.g. luxuries.
32
 EI
< 1 : low income elastic, e.g. necessities
 EI < 0 : Income elasticity of demand is negative,
 ex: Inferior products
 Consumption  when Income 
Inverse relationship between income and demand
Public transport (substituted by private car).
33
 Analyze
the predictions about changes
in spending

A rise in high IED products
 eating

out, leisure, foreign holidays etc.
A slight rise in low IED products
 necessities,

bread, soap
A fall in negative IED products
 public
transport.
34
Cross Elasticity

Elasticity between 2 products: X , Y
Could a price change in product Y influence the
demand for product X ?

The % change in demand for product X divided by
the % change in price of product y.

If the value of the Cross Elasticity

EXY > 0  (X,Y) are substitutes

EXY < 0  (X,Y) are complements.
35
Cross Elasticity of demand

Formula
=  % Dx /  % Py
= (D1-D2)/(D1+D2)/2 / (P1-P2)/(P1+P2)/2
36
Chap 5: Organizations

The relationships within a firm are rarely
market relations but rather relations of
command and co-operation.
Organizations existed to make profit but
there are non profit organizations: Mosques,
Churches, Universities, PTA, Pension funds,
and Hospitals.
 Economists consider the importance of the
firm structure in order to understand



how the firm set its objectives
and why firm is complex.
37
Organizations

One of the most important function for the
company is Finance.

In order to perform well the company
needs to keep record of its day to day
transactions by the accounting system.
38
Joint Stock Company

Joint Stock Companies can raise fund by
 selling
shares to public
 or borrowing through the sale of bonds.
 E.g. in England in order to provide financial resources
for railways

The Main feature of a joint stock company:
 separate
firm-entity from the individual who own it.
 Limited liability
the owner’s responsibility is limited to the amount of
money he had invested (shares).
 the owner will not be liable on his personal assets to meet
the liabilities of the company
39
Organizations

Fund raised through the sale of shares are usually
referred to as Equity.



Equity holder receives dividends
The bond holder purchases bonds; he is a creditor and
receives interest.
There is a separation of ownership from control.


The Technostructure: the skilled managers and
professionals who work for the company and are
knowledgeable about its markets and other aspects of its
environment
Impossibly for many groups to influence the management
team to satisfy the stakeholders (owner).
40

In order to function efficiently any
organization must maintain adequate
records. That will benefit the stakeholders
(Governments, Creditors, Employees, Tax
Department, and Managers)

The Annual Report prepared at the end of
each year contains :
The Balance Sheet,
 The Income / Profit Statement,
 The Cash Flow Statement

41
The Balance Sheet

Asset = Value,
physical, not physical
right to do or to use
something
The Balance Sheet
Assets
Liabilities
Net Worth

Liability = Obligation
Assets = Liabilities
+ Net Worth
42
The Balance Sheet
Assets
Current Assets


Cash
Inventory
Liabilities
Liabilities



Fixed Assets


Equipment
Building
Total
SR 55,000
Account Payable
Notes Payable
Long Term Liabilities
Net Worth

Stockholder’s Equity

Total
Common Stock
SR 55,000
43
The Cash Flow Statement
 The
cash flow is the net amount of money
actually received during the period.
 The
Cash Flow Statement presents and
measures during one year

the cash inflows
 and cash outflows.
44
The Income Statement
Statement of Profit and Loss

Measures during a given period
 Income
Cy.

and expenses passing through the
The Income Statement total
Revenue – Expenses
 = Profit or Loss.

45
The Income Statement
Revenues: Net Sales
x
- Expenses: Cost of goods sold
-
Wages
Rent
Advertising
Other expenses
= Income before Taxes
- Taxes paid
= Net Income
(Profit after Taxes)
X
X
X
X
= Gross profit
X
X
(Loss after Taxes)
46
The Function of Production

Objectives of the production process:




how to produce efficiently / at the lowest cost
The max level of output for a given quantity of input
How to maximize economic profits
The production function summarize the
relationship between inputs and outputs
{ Q= f ( F1,F2, …..,Fn) }


The maximum output that can be produced with a
given quantity of inputs,
a mix of the production factors for a given state (of
engineering and technology).
47
Efficient Production

Efficient Production requires to optimize the use
of inputs like labor.


Division of labor means dividing up a work process
into specialized activities undertaken by different
workers in order to increase the quantity of output
available from given inputs.
Efficient Production Requires Time

In production and cost analysis 2 time periods are
distinguished:
 The
 The
Short Run
Long Run
48
Time in Production

The Short Run is

The period of time in which only some inputs, the
variable inputs, can be adjusted.

In the short run, fixed factors, such as plant and
equipment, cannot be fully modified or adjusted.

The Long Run is the period in which all factors
employed by the firm, including capital, can be
changed.

But in the long run all factors of production are
variables.
49
Production Costs

Total Cost:
 TC

= FC + VC
 ATC = AFC + AVC
On Average,
 ATC = TC/Q
 AFC = FC/Q
 AVC = VC/Q
TC: Total Cost
FC: Fixed Cost
VC: Variable Cost
Q : Quantity
A : Average
50
Economies of Scale

Economies of scale: When there is a increase
in the output level, the cost per unit falls due
this mass production, when all inputs are
changeable
 the total costs are rising (TC )
 and the average costs are falling (AC ).

Diseconomies of scale in production when the
per-unit cost of all inputs increases as a result
of an increase in output.
51
Long Run Average Cost

LRAC curve shows the lowest unit costs that can
be obtained at all levels of output.

The relationship between output and cost per unit
in the long run.

Average cost falling until Minimum efficient scale
is reached.

This curve takes L shape.

It is a representation of the factors of production.
52
Cost per
unit
Long Run Average Cost
Minimum efficient scale
Cost per unit increasing
Diseconomies of scale
Cost per unit falling:
Economies of scale
Cost per unit Constant
0
Quantity Output
When quantity of output , average cost falling until Minimum
efficient scale is reached. This curve takes L shape. LRAC
curve shows the lowest unit costs that can be obtained at all
levels of output.
53
SRAC: Short Run Average Cost
Cost
SRAC
Costs per unit rise as
maximum capacity level is
approached
Costs per unit fall as machinery
is more fully utilized
0
Quantity
54
LRAC ~ SRAC
Cost
SRAC1
LRAC
Hello
SRAC2
Long Run
Average Cost
SRAC3
Quantity
0
Diminishing returns: are short run phenomenon.
As more of the variable factors (labor) is added to the fixed factors
(capital &land), the increase in the output for every extra
increment of the variable factors gets smaller.
55
Cost
Upward shift of the
Long Run Average Cost
LRAC2
LRAC1
0
Quantity
If factor prices  , then total costs . The average cost
curve would shift upwards at any given output level to
reflect a general increase in costs.
56
Cost
The relationship between
MC & AC
MC
AC
MC: Marginal Cost
AC: Average Cost
Quantity
0
Level of Output
No. of units (Q)
Total Cost
(TC) $
Average Cost
(AC) $
Marginal Cost
(MC) $
1
100
100
100
2
180
90
80
3
240
80
60
4
300
75
60
57
Organizations


Economies of Scale are the reduction in costs
associated with expansion in output in the long run.

Internal economies of Scale are arise within the firm,
through such things as the division of labor.

External economies of Scale which the firm gains as a result
of the expansion of the industry.
MC, Marginal Cost,



The cost of additional unit produced.
Knowing the MC enable the firm to maximize its profit.
The firm remain profitable as R = AC
58
Organizations: Culture & Goals

The Human resources planning process should be
clearly tied to the organization strategic goals.

Beside the mechanical issues there are other
important features:



the workers employed : personal goals and qualities,
the power systems, information processing limitation,
etc.
Non- cultural features are vital such as the
objective conditions faced by the organization, the
knowledge and understanding of organization
members, etc.
59
Organizations

Many objectives:



The objective will change as the environment
changes.



making profit, minimizing costs, sales volume, loyal
customers, profit maximizing
and growth, controlling the environment.
E.g. changes in competitor behavior or new opportunities
If the environment become tough, the main goal of any
firm is to survive.
All decisions and changes may be done


under the Profit Constraint: a minimum level of profit that
is acceptable to the owners (satisfying level).
Considering the culture of the organization and the
60
determining variables.
Organizational Form of a Firm

The main distinction in industrial economies
has been between the U form and the M form.
 The
U, unitary hierarchical structure in which
different divisions report to Chief Executive
Officer (CEO) or managing director.
 The
M, multi divisional is larger and has a central
office to which several operating divisions report
(each division has a structure like the U form so
have its own CEO).
61
Firm Evolution

Firms begin their lives as entrepreneurial
organizations (simple & small).

Then organization became bureaucracy

jobs are specialized and standardized.
 elaborating administrative structure controlled by
Technostructure of experts.
 The bureaucracy has essentially the U form.

When environment become complex Professional
org. existed which are made of individuals who are
highly skilled (hospitals, universities, etc)
62
How Markets Work
Competition And Power In Markets

How Efficiency and Productivity are ensured
 Market Strengths and Weaknesses
 What are the Different Aspects of the Market
Process
 Different Schools
63
How Markets Work
 Capitalistic Economic
 Environment
Theory
 Competitive Markets,
 Innovation, Schumpeter
 Equilibrium, Neoclassical Model
 Signaling, Hayek
 Conflict of Interests, Sen
64
Key Words
Competition, Competitive Markets, Perfect
competition, Pure competition,
Monopolistic competition.
 Price Equilibrium, Creative Destruction
Process, Signal, Price Taker, Free Market,
Asymmetric Information, Conflict of
Interests.

65
Competition And Power In Markets

Competition promotes choice, quality and lower
prices.
Monopoly: producers become insufficient. No
choice, no quality and high prices.
 Market:





efficient coordinator of the activities of free individuals
where interplay of demand and supply in a competitive
market
is the key to prosperity for everyone.
determines the Wealth of the nation
66
Competition And Power In
Markets

Corner Shop has monopoly over his neighborhood
but has competition from hypermarkets.

As long there is freedom of entry, even local
monopolies in short period will have to face
competition from innovative units.

Natural monopoly where large scale of economies
can’t be supported by more than one supplier as this
single firm can undercut all of its rivals. (Network
industry such as telephone service or railway)
67
Competitive Markets by Innovation
Schumpeter
The process of creative destruction



Joseph Schumpeter set up a model of competitive
markets characterized by competition over new products
and new process of production.
Schumpeter stated that firms are forced to innovate in
order to stay in the race. And this view of competitive
markets as a dynamic process of continuous change.
The key to this processes is the introduction of
innovations, new products and new process like motor
car.
In the process of competition over innovation, firms
innovate or go bust.
68
Competitive Markets by Innovation
Schumpeter

Innovation often depends on advances in technological
knowledge and permit costs reductions: 2 sources
 Dynamic efficiency Process
Costs are reduced because of advances in technological
knowledge that enables new production process to be
used
 large firms have the fund and R&D.
 Economies
of scale, which relate to the scale of operations
of the firm that enable to produce cheap by spreading the
fixed costs over a large scale of output.
69
Schumpeter Mkt Structure:
 Dynamic
market competition over the L-T may
be consistent with elements of monopoly in ST
70
Competitive Market and Equilibrium
Neoclassical Model
Competition: absence of such corporate power in
the market
 Neoclassical model of competitive equilibrium or
perfect competition
 in determining prices by the Balancing of
Demand & Supply.
71
Competitive Market and Equilibrium
Neoclassical Model

Neoclassical model of competitive equilibrium
examines the influence on the price of
commodity in 2 ways:
1)
On the Supply side
Influences on the production of a commodity:
Availability of right, kind of labor, raw materials,
machinery, power and technology
2)
On Demand side
Influences affect customers demand for commodity
such as income, lifestyle, age and customer tastes. 72
Neoclassical Model

Disequilibrium  equilibrium
 If D is less than S:  P will fall for D and S to be
in equilibrium
 If D is more than S : P will increases D and S
to be in equilibrium At the Equilibrium price: D
and S are equal and everything is at rest.

The strength of the neoclassical model: shows the
equilibrium properties of a competitive markets.
73
Neoclassical Model

Does Competition  efficiency?




The model set clearly the link between competition
and efficiency: firms are price taker, they can’t
influence the market price.
Firms have to reduce its costs as possible to make
profit
Productively efficient: costs are at the minimum
possible level for any given stake of technology.
Automatic equilibrium: in order to balance


If D > S : equilibrium price have to go up 
If S > D : equilibrium price have to go down 
74
Neoclassical Model

Assumptions:




A large number of firms
Each firm supplies a small share of a homogeneous
product
No firm has an impact on the product’ s price
Perfect competition model:



Demonstration: the forces of demand and supply
leads to the determination of an equilibrium price.
the interests of consumers and producers are
harmonized
 no conflict.
75

Limitations:
 More static than Schumpeter's model
 Weak in explaining the process of price
formation on market competition.

Alternative model how mkts work
 Competition
is a process of mkt adjustment.
76
Competitive Markets and Information
Asymmetric Information  Signals
 F.A Hayek said that individuals never have complete
information when responding to economies changes
 Hayek sees changing competitive prices as signal
mechanism for transmitting information between
individuals in the market.
 By responding to these changes prices, producers
and consumers are led to respond in an appropriate
way to economic changes


Price as Signal
77
Competitive Markets and Information
Hayek
Hayek emphasizes

The importance of the process of competition
rather than the end result of equilibrium;

Information about changes in consumers tastes
or in the conditions of production, is transmitted
by changes in prices;

The importance of price system as a
decentralized mechanism for transmitting
information prices as information signals;
78
Competitive Markets and Information
Hayek
Hayek and individual freedom

Free market is the best may of guaranteeing
individual freedom

Through a decentralized market system.

Market outcomes are seen as natural outcomes
because they are the result of human actions but
not human design.

Market outcomes are not just the results of
individuals luck and judgment.
79
Competitive Markets and Information
Hayek
Limitations: Prices ~ Information
 Prices can’t always be relied upon to provide the
necessary signals and incentives to allocate
resources to their best uses.
 E.g. market prices may not transmit all the
relevant information because


they include only the costs borne by the individual
producer
and exclude the wider effects on society.
80
Competitive Markets and Information
Hayek
Limitations of Hayek Model
 Prices reflect only the individual consumer’s
satisfaction and exclude the wider benefits to
society as a whole.
 Sometimes prices don’t transmit the correct
information externalities are present when prices
don’t convey all the social costs and social benefits
arising from an economic activity.

E.g. Environment pollution and greenhouse effect are
externalities: social costs arising from an economic
activity, but are not reflected in market prices.
81
Competitive Markets and Conflicts
Sen’s approach
Sen argues that conflicts of interest are
inherent to the market transactions.
 In contrast of the neoclassical assumption.

 There
is any automatic harmonization of
interest through the mkt mechanism

Most market situations are accompanied
by large imbalances in power
82
Competitive Markets and Conflicts
Sen’s approach

The market transactions ensure the distribution
of profit
 Depends upon the relative economic power of
each party
 Market works as a “power balance” to sold
the conflicts of interest.

Interpretation of freedom as positive freedom
where material powers underlying the capability
to make choices are also significant.
83
Competitive Markets and Conflicts
Sen’s approach

Imbalance of market power means that income is
distributed unequally across the population


E. g. This inequality of income is reduced somewhat by
the operation of welfare system in UK.
Between 1979 and 1986 inequality in UK increased
and this remains after the equalizing tendency of
tax and benefit system is taken into account.
84
Competition And Power In Markets
Model of
competition
Source of
efficiency
organizations
freedom
Schumpeter's
model
Neoclassical
model
Hayek's model
Sen's model
Dynamic competition
forward-looking
competition over
innovations in
products and
processes
Perfect competition/
competitive
equilibrium,
Prices set @
Competition as a
process of
adjustment to
change;
Prices are signals
transmitting
information
Competition as a
power struggle
markets characterized
by conflict rather than
by harmony of
interests
Dynamic efficiencyinnovations arising
from technological
advances and
economies of scale
result in lower prices
and costs
Large corporations
with their
entrepreneurial
managers
Productive efficiencyprices and costs at the
minimum level given
existing technology
The decentralized
price mechanism
transmits
information about
changing
preferences and
conditions of
production
Firms respond to
price signals in an
environment where
they cannot have all
the information
Emphasis here not on
efficiency whose gains
may occur to all , but
on the unequal nature
of the gains and losses
-
-
Price system
guarantees
individual freedom ;
market outcomes
are neither just nor
unjust ;freedom as
negative freedom
Emphasis on freedom
as enabling powers
and capabilities
(positive freedom), but
markets do not ensure
this for all
equilibrium where
demand=supply
Firms are price-takers
Economic
organizations are part
of the struggle for
economic power
85
Market Failure

When Markets Fail
86
When Markets Fail
Market Failure: This term describes the failure of
the market economy to achieve an efficient
allocation of resources.
 Basic Functions of Government:



Adjust market failure
Governments are as old as organized economic
Activity.

Governments from Adam Smith’s vision: the first duty for
sovereign is that protecting the society from violence,
second protecting every member of the society from the
injustice.
87
When Markets Fail
 There
are several important
circumstances under which markets
fail to allocate resources with
reasonable efficiencies:
1) If there are resources that can be used by everyone
but belong to no one- common property resources.
2) If there are goods whose consumption cannot be
restricted to those who are willing to pay for them.
Public goods.
88
3) If people not party to some market bargain are none
the less significantly affected by it – externalities.
4) If one party to a market transaction has fuller
knowledge of its consequences than is available to
other party – asymmetric information.
5) Where needed markets do not exist
6) Where substantial monopoly power exist.
89
When Markets Fail



Non rivalries and non excludable goods:
Rivalries: if no 2 persons can consume the same unit. Apple
Excludable: if people can be prevented from obtaining it. Owner of a good give
it to who pay for it.





1) Rivalrous – Excludable: normal goods: apple, PC’s (most goods)
2) Rivalrous – Non Excludable: common property” wildlife, common land
3) Non-rivalrous – excludable: Museums, Roads
4) Non-rivalrous – Non excludable: Public goods: defense, police

- Non rivalrous: when the amount that one person consumes does not affect the
amount that other people can consume.

- Non excludable: when once produced there is no way to stop anyone from
consuming them.
90
When Markets Fail



Excludability depends on the specific circumstances and the state of
technology
Excludable goods: private agents who produce goods and services
for sale on the free market must be able to prohibit consumption of
their output by those who will not pay for the privilege. (otherwise,
the producers can’t gain the Revenue to cover their Cost). Exp.
Ordinary goods: excludable and rivalrous.
Non excludable goods:
Provides 2 sources on our list of Major Market failure (common
property resources and public goods)
Common property: non-excludable but rivalrous. Common property
resource: is one that is rivalrous but non excludable. Like fish in
oceans
91
When Markets Fail





No one has an exclusive property right to it, and it can be used by
anyone. No on owns ocean’s fish until they are caught.
The tragedy of commons: the tendency for commonly held property
to be overexploited, often to the extend of destruction.
So the solution is to agree on optimal level of use (fishing quota)
and hunting licenses
Another method is to create property rights that make the resources
excludable.
Public goods: non- excludable and non rivalrious or can be called
collective consumption goods (national defense). police force/ public
goods are non excludable private firms will not provide them. So
governments provide them and they took taxes.
92
When Markets Fail

Externalities: (beneficial or harmful):

Externalities are costs or benefits of a transaction that are incurred or
received by other members of the society but not taken into account by the
parties to the transaction. (third party effects or neighborhood effects) other
parties, other than customers and producers participated in the transaction.

When it occurs? When a factory generate pollution, social cost, profit
maximizing (harmful)
Beneficial – paint your house.
Private costs: these costs that are incurred by the parties directly involved in
some economic activities. Firms.
Social costs: costs incurred by the whole society (private costs borne by
third party).
Private benefits: benefits received by those involved in the activity. utilities
obtained by buyers.
93
Social benefits: benefits to the whale society. (Private + 3rd party)





When Markets Fail





The control of pollution:
steel, farms, house holds. How government react to this?
1) Pollution control though direct regulations:
Direct controls are common method of environmental regulation. ex.
Car emission test and laws that prohibit burnings stuff.
2) Control through emissions taxes:
Pollution taxes
internalize the externality: increasing the firms private cost by the
amount of external cost.
Asymmetric information:
markets work when everyone is well informed  people can’t make
decision without full information.
- State intervenes to impose standards and testing requirements in the
consumers own best interests.
 - Standards are also set in workplace.

94
When Markets Fail


Missing Markets:
One important set of missing markets is risk. Insure your house against burning.
If you are a farmer you can’t insure your corps against bad weather. You insure
your house against fire from ordinary purpose not war.

- Future events another set. You can buy oil or corn in future market. But not for
cars and TVs because no one knows the models.

Public policy towards Monopoly and Competition:
The law and other instruments that are used to encourage competition and
discourage monopoly practices make up competition policy and are used to
influence both the market structure and the behavior of individual firms.

Government encourages competition and employ economic regulation which
prescribe rules under which firms can do business.
95
When Markets Fail







The government can control the prices.
1) Direct Control of natural monopolies:
One firm operate at the minimum efficient scale. Natural monopolist restrict
output, raise prices, reap monopoly profit
Solution: government assumes ownership of the single firm, setting it up as a
nationalized industry. Also, regulation. By privatization (telecommunication, Gas,
water) after the Second World War.
- The very long un concept means one firm operate professionally, technology
make them disappear.
2) Direct control of oligopolies:
Government should intervene to enforce type of price and entry behavior. Airlines,
railways, steel. Deregulation and privatization in order to reduce government
control.
3) Intervention to keep firms competing:
Policies to create competitive market structure and prevent firms from reducing
competition by engaging in certain form of cooperative behavior.
Globalization: internationalization of competition (free trade)
96
When Markets Fail




-UK competition policies:
Who is responsible is the secretary of state for trade
and Industry: elements of monitoring and enforcement
delegated to: restrictive practices court (RPC)
the office of Fair Trading (OFT)
the Monopolies and Mergers Commission (MMO) by 1998
merge with OFT
The future of completion policy:
Government has an important rule as a rule maker and
referee of market economy.
97
When Markets Fail







Government objectives:
1) Protect life and property by exercising a
monopoly of violence
2) Improve economic efficiency by addressing
various cases of market failures
3) Achieve some accepted standard of equity.
4) Protect individuals from others and from
themselves
5) Influence rate of economic growth
6) Stabilize economy against income and price
level fluctuation.
98
When Markets Fail










-The distribution of income:
- Important characteristics of the markets
-People whose skills are scare relative to supply earn large income
-Differentials in earnings serve important fraction of motivating people to
adopt.
2 kind of equity; horizontal and vertical:
-Horizontal equity: persons in similar circumstances should be treated
similarly.
-Vertical Equity: different treatment of people in different economic
situations in order to reduce inequalities between them. (taxes on income)
-The distribution of wealth:
in order to reduce inequalities:
1) To levy taxes on wealth at the time is wealth transferred from one
owner to another. (gift, bequest)
2) Annual tax on the value of each persons wealth
99
When Markets Fail











Policies to protect individuals:
1) Protection from others: child labor laws from selfish parents, standards of work
2) Protection from oneself: Prohibiting use of heroin, cocaine, drugs, and seat belts in cars are
methods called paternalism.
Merit goods: goods that society operating through governments deems to be especially important or
that those in power feel individuals should be encouraged to consume. (housing, education, health
care).
The cost of government Intervention:
1) Internal cost:
When government uses resources it costs money when government inspectors visit a plant to
(compliance with standards, industry safety) judges salaries and clerks.
2) Direct External costs:
cost that government imposes on others. Direct external costs fall on agents with whom the
governments is directly interacting.
Increase in production costs (inspections)
Costs of compliance (CPAs, occupational safety and environmental control)
Losses in productivity: experiments and innovation.
3) Indirect external cost:
Costs of government action spread beyond those immediately affected by it. Externalities (Safety
100
and new drugs)
When Markets Fail

-Government Failure:
When government don’t succeed in achieving potential
benefits that exceed the full direct and indirect cost

-Rigidities:
Rules and Regulations, tax rates. Exp. Policies are hard
to change market conditions changeable.
governments slow to admit mistakes even when they
become aware of them

-Decision Makers Objectives:
Most important cause of government failure arise from
the nature of the government own objectives.
Governments need to know when to intervene
101
When Markets Fail




- Public choice theory by James Buchanan:
deals with 3 maximizing groups:
1) Elected officials: seek to maximize their votes
2) Civil servants: seek to maximize their salaries (position in hierarchy)
3) Voters: seek to maximize their own utility.
So voters want the government to provide them with goods and services
and income transfers that raise their personal utility.




- Government intervention today: little, much respond to failure.
- The role of analysis: Economy eliminates misconception.
- The role of ideology: Measure cost of intervention and classify this
intervention whether it is successful or not.
102
The Global Markets

International Trade

Protectionism And Industrialization: A
Historical Perspective

Multinational Corporations

Globalization In The Age Of Empire
103
International Trade









Economic growth will be achieved when an economy buy goods from abroad and
export other goods to generate revenue
International trade: exchanges of goods and services that take place across
international boundaries.
Open economy: An economy that is engaged in international trade. Closed is the
one that did not do so.
Autarky: a situation in which a country does no foreign trade.
Gaines from trade: the advantages realized as a result of trade
Trade will benefit individuals, groups, regions, and countries.
Without trade every person has to be self sufficient , so he/she has to produce
everything food, cloths, shelter, etc. which is impossible. Trade among
individuals allows people to specialize in such activities (doctors, carpenters, etc)
so with trade everyone can specialize in what he/she does well and satisfy other
needs by trading.
The same principles apply for regions. Each region can specialize in producing
goods and services for which it has some natural or acquired advantage (hot,
cold, mountains, forests, sandy, sunshine etc)
The same principle will apply for nations. Trade allows each individual, region,
and nation to concentrate on producing those goods and services that it produces
104
efficiently and to obtain those goods and services that it doesn’t produce well.
International Trade






Two sources of the gains from trade: 1-differences among regions of the world in
climate and resource endowment that lead to advantages in producing certain
goods and disadvantages in producing others. 2-reduction in each country’s costs
of production that comes from the greater production that specialization
encourage.
The country has an absolute advantage over another one in the production of X
when an equal quantity of resources can produce more X in the country. So the
total production can be increased if each country specializes in producing the
product for which it has an absolute advantage.
David Ricardo English Economist (1772-1823) has come with the theory of
comparative advantage. The gains from specialization and trade depend on the
pattern of comparative.
The opportunity cost tells us how much of one good we have to give up in order
to produce one or more unit of the other.
So a country has a comparative advantage over another country when the
opportunity cost of production in the country is lower.
If the opportunity cost is the same in all countries, there is no comparative 105
advantage and there is no gains from specialization.
International Trade

Production costs measured in terms of recourses used, often fall as the scale of
output increase. Smaller countries like Switzerland and Belgium could whose
domestic markets are not large enough to exploit economies of scale would find
it expensive to become self sufficient.
 Trade allows smaller countries to specialize and produce a few products at high
enough levels of output to reap the available economies of scale.
 Learning by doing: a country gain experience in producing a good over time so
it will become efficient in producing it.
 Terms of trade: measure the quantity of imported goods that can be obtained per
unit of goods exported. Terms of trade = Index of export prices * 100
Index
of import
A rise in the index referred to as a favorable
change
in the prices
country’s terms of
trade. A favorable change means that more can be imported per unit of goods
exported than previously. The unfavorable change means that the country can
import less in return for any given amount of export. For instance, a rise in oil
prices in 1970s led to large unfavorable in the term of trade oil importing
countries like USA and a favorable for oil countries like KSA
 Commercial policy: government policy towards international trade

106
International Trade

Free Trade: freedom from any interference with trade

Protectionism: giving protection to domestic industries from foreign competition

Tariffs: taxes designed to raise the price of foreign goods

Non-Tariff barriers: devices other than tariffs that are designed to reduce the flow of
imports such as quotas and customs

Free trade allows countries to specialize in producing products in which they have a
comparative advantage which enhance the maximization of world production and
this will allow consumers to consume more goods and services. Also, Free trade will
improve everyone’s living standards.
107
International Trade






The case for protectionism: there are 2 kinds.
1) The national objectives other than total income.
a) Non-economic advantages of diversification:
Due to comparative advantages this will lead government to narrow their range of
products in order to specialize. Government social advantages in encouraging more
diverse (Living Standards)
b) Risk of specialization
For small countries there is a risk in specializing in the production of few products
(technological advances may render its major product obsolete). Government
protect weak industries by the tariff to encourage diversification.
c) National Defense
UK need experienced merchant navy in case of war. It should be fostered by
protection.
d) Protection of Specific Group.
Free trade will maximize per casita GDP over the whole economy. Some groups
have higher income under protectionism protect such an industry.
108
International Trade

Tariffs tend to raise the relative income of
a group of people who are in short supply
domestically and to lower the relative
income of a group of people who are
plentiful supply domestically (free trade
does the apposite).
109
International Trade








2)
Increase one countries National Income (NI)
NI: total income earned by all people in a country.
a) To alter the terms of trade:
Trade restrictions can be used to turn the terms of trade in favor of countries that produce and
export a large fraction of the world’s supply of some product. When OPEC countries
restricted their output of oil in 1970’s they where able to drive up the prices of oil relative to
prices of other traded goods. The apposite in 1980’s
b) To protect against unfair actions by foreign firms and government.
Tariffs may be used to prevent foreign industries from gaining an advantage over domestic
industries.
Dumping: selling a good in a foreign country at a lower price than in the country where it is
produced.
c) To protect infant industries:
if an industry has large economies of scale. Cost will be high when the industry is small.
d) To encourage learning by doing:
Country develops a comparative advantage as the learning process lowers their costs.
protecting a domestic industry from foreign competition may give its management a time to
learn to be efficient and develop comparative advantages.And labor to acquire necessary
skills.
e) To create or to exploit a strategic trade advantages:
Important argument for tariffs is to create a strategic advantage in producing or marketing
110
some new product that is expected to generate profits.Small firms competing large ones (with
economies of scale) government should adopt strategic trade policies more broadly.
International Trade


Methods of protection: how government protect (tools):
There are 2 main types of protection policies. Both cause the price of the
imported goods to raise and its quantity to fall.

1) Policies that directly raise prices:
Raise prices of imported products by a Tariff (import duty) => affect
foreign and domestic product and customers.

2) Policies that directly lower quantities:
Restricts imported products:
a.Non-tariff Barrier: an implicit or explicit restriction on trade that does not
involve a tariff (quality standard, customs complications).
b.Import quota: importing county sets a maximum on the quantity of some
product.
c.Voluntary Export Restriction (VER): an agreement by an exporting
country to limit the amount of goods that it sells to the importing country. 111



International Trade











Global commercial policy:
Before 1947 any country was free to impose any tariffs on its imports. In 1930s great
depression has world protectionism in order to raise its employment  then change
GATT & WTO
1. Achievement of the post war was creation of GATT (General Agreement of Tariff &
Trade). The principle of GATT is that each member country agrees not to make unilateral
tariff increases.
2. There have been 8 rounds of global trade talks since 1948.
3. The Uruguay round created a new body, world trade organization (WTO) that superseded
the GATT in 1995 to liberalize trade.
Type of Regional Agreement :
Regional Agreement seeks to liberalize trade over a smaller set of countries than the WTO
membership.
3 standard forms of Regional trade Agreement: Free Trade Areas (FTA), Customs Unions
and Common Markets.
-Customs Union: free trade area plus an agreement to establish common barriers to trade
with the rest of the world.
- Common Market: is a customs union that also has free movement of labor and capital
112
among its members.
International Trade




1.
2.
3.



- EFTA, NAFTA:
European Free Trade Association (EFTA)(1960) by countries unwilling to join
EU. They joined EU in 1995.
NAFTA 1993: Please refer to my last summary for extra information on it.
Common Markets:
The EU (European Union) In 1945 after Second World War to avoid future
military conflict E.U created economic integration to face USA & Japan.
1952 European coal and steal community.
1957 Treaty of Rome European Economic community EEC.
1993 EU. And in 1973 UK joined.
In first 2 decades the main Economic Achievement of EEC is the elimination of
internal tariff barriers & establishment of common external tariff (customs unions)
and common agricultural policy.
The single market Program:
Signed in 1986 in order to remove all barriers to create fully integrated single
market by 1992.
The Maastricht Treaty signed in 1992 to push the integration of EU further 113
(common currency) in 1999 and to harmonize the policies.
Protectionism and Industrialization (historical perspective)

Part of the developed world, protectionism was the dominant commercial policy
.The United States, the mother country and bastion of modern protectionism. The
future Third World (and especially those countries that were colonized), liberalism
prevailed, but it was not by choice; it was enforced liberal commercial policy.
 THE UNITED STATES: MOTHER COUNTRY AND BASTION OF
MODERN PROTECTIONISM (1791-1860) :
One should not forget that modern protectionism was born in the United States.
Alexander Hamilton, the First Secretary of the Treasury. The major contribution of
Hamilton is the emphasis he put on the idea that industrialization is not possible
without tariff protection. He was apparently the first to have introduced the term
“infant industries”.

1) We divide the nineteenth century American commercial history into 3 relatively
distinct periods.
 1- 1816 – 1846 protectionist
avg. 40% tariff (nature of it)
 2- 1846 – 1861 Liberal Somehow (modest protectionism) return of democratic
party.
114
3- 1861 – End of World War II strict protectionism.
Protectionism and Industrialization (historical perspective)

THE UNITED STATES: FROM “INFANT INDUSTRIES”
ARGUMENTS TO THE PROTECTION OF AMERICAN
WAGES (1861-1914):
The 1861 tariff was the beginning of a policy that was to be
followed in the United States until the end of World War II.
Import duties were increased again during the American Civil
War, and victory by the North brought further protectionism.
1866 to 1883 imported duties avg. 45%
1913 Underwood tariffs decrease on tariffs 25% avg.
115
Protectionism and Industrialization (historical perspective)





- British Dominions: Tariff independence brings protectionism. In the 19th century
the trade policies in (Canada, Australia and New Zealand) sent through 2 main
phases:
1) Depend on the country 1867 – 88 liberal policies / exported opportunities for
agricultural products favored with early 1850’s.
2) (1867/88 and 1913) they encourage their industrial sectors through protectionist
tariff polices. The geographical location as important influence for this isolation and
far.
In the future third world:
Liberalism enforced. The future of the third world will be toward liberalism. It was
compulsory economic liberalism of two types:
1) Real colonies: the general rule consisted of free access to all the products of the
mother country. (They charge low duties for fiscal reasons) British colonies.
2)Independent or not real colonies: in 19th century Western countries imposed
treaties on Latin American, China, and Thailand that entailed a more or less total
elimination of customs duties on imports. Pressure from UK between 1810-1850.
116
Multinational Corporations




Foreign direct investment (FDI) is increasing in importance in the
world economy
They have always attracted a good deal of attention and given rise
to heated controversy.
The main distinction between direct and portfolio investments is
that in the former the investor retains control over the invested
capital. Direct investments and management go together. With
portfolio investments, no such control is exercised. Here the investor
lends the capital in order to get a return on it, but has no control
over the use of that capital.
There were 3 major elements in international capital flows in the
80s: increase in FDI in USA, Japan become a major source of FDI
and portfolio lending to LDC cause high level crisis
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Multinational Corporations
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DIRECT INVESTMENTS AND MULTINATIONAL ENTRPRISES.
Most FDI is undertaken by enterprises, and the larger part of that by
multinational enterprises (MNEs).
Multinational enterprises are essentially those that own or control production
facilities in more than one country. Their importance nowadays is as major
providers of FDI, often using capital which has been raised in the capital
markets of the country in which they are investing rather than capital market of
their home country. Direct investment is typically industry-specific. Industryspecific investments take two important forms: horizontal and vertical
integration. Large corporations wish to integrate horizontally by opening new
subsidiaries in various parts of the world. This is often done in a predatory way:
one or several existing, competing firms in the host country are simply bought
up by a large international rival. In the process, competition is often reduced.
Vertical integration is also a strong motive for direct investment. For instance,
there are only a few companies that refine and fabricate copper. It is not
surprising that they have sought control over copper mines by vertically
integrating backwards in the production process. One obvious reason for
vertical integration is a desire to reduce risk
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Multinational Corporations
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THE THEORY OF DIRECT INVESTEMENTS
Venron said that a firm tends to become multinational at a certain stage in its growth. In the early
stages of the product cycle, initial expansion into overseas markets is by means of exports. Prior to the
standardization of the production process, the firm requires close contacts with both its product market
and its suppliers.
The firm may decide to look overseas for the lower-cost locations and new markets.
Market imperfections and FDI
Advantages which some firms enjoy and on which they may be able to obtain rents in foreign markets.
Such advantages include access to panted and generally unavailable technology, team-specific
management skills, plant economies of scale, special marketing skills, possession of a brand name,
and so on. The potential gains from these advantages must of course outweigh the disadvantages of
establishing and operating in a foreign country, such as communication difficulties and ignorance of
institutions, customs and tastes, before the firm will invest abroad.
Lack of direct control of MNE will increase the likelihood of the leaking of the technology to
competitors.
These markets are imperfect because they are difficult to organize and involve considerable
uncertainty.
Barriers to trade and FDI
Transport costs offer one explanation of FDI. If transport costs are sufficiently high then they may
make the expansion of production in domestic plants and the export of that increased production less
profitable than production within the putative importing country.
Import barriers. First, they raise the price of the good within the protected market. Second, import
barriers reduce the exports of firms in other countries.
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Multinational Corporations
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Dunning`s “eclectic theory”
Dunning has suggested an eclectic theory of FDI, often referred to as the OLI paradigm.
The O, L and I in the paradigm refer to three groups of conditions that determine whether a
firm, industry or company will be a source or a host of FDI(or neither, of course). These
groups are Ownership advantage, Locational considerations, and Internalization gains.
Ownership advantages are advantages which are specific to the firm. That expansion in the
domestic market may be an alternative strategy. For example, advantages in technology and
in management and organisational skills. Others often cited are size and diversification,
access to or control over raw materials, the ability to call on the political support of their
government.
Locational considerations encompass such things as transport costs facing both finished
products and raw material, import restrictions, the ease with which the firm can operate in
another country.
Internalization gains concern those factors which make it more profitable to carry out
transactions within the firm than to rely on external markets. Such gains arise from avoiding
market imperfections (uncertainty , economies of scale, problems of control, the
undesirability of providing full information to a prospective purchaser, and soon).
The essential element in the eclectic theory is that all three types of condition must be met
before there will be foreign direct investment.
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Multinational Corporations
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Taxation and the transfer pricing problem:
 - Taxation policies in host countries will affect the flow of FDI and differences
between policies in countries encourage MNE to maximize their post tax profit on
global.
 - Other things begin equal, high rates of tax on profits will encourage firms to look
outside their home country to pay low taxes.
 - Transfer price: price which products are sold by MNE in low tax countries to that
in high tax countries. E.x. car engine.
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- The consequences of MNE activities:
 1) Control:
 · To host country this means parts of its industry will be controlled by foreigners.
Some countries didn’t accept that.
 · One of obvious aspect of control that MNE want subsidiaries to operate their
policies. (Restrictions on exports, R&D, money transfer)
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Multinational Corporations
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2) External benefits of FDI to host a country:
 MNE offer benefits on the host country (training the local labor, if it’s free and use
equipment and technology. If workers pay whether by money or law wages then
external benefits reduced also, expenditure on the R&D.
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- Policy response in host countries:
To FDI are far from uniform. Same of them with restriction and control on FDI on
the operation of MNE like Canada. Same of them with it like UK.
Export processing Zones (EPZs):
- Are designated area within the host country intended to attract investment largely
from foreign firms by offering favored treatment (absence of import controls). So
tariffs are not levied on imported goods. (exemption from domestic taxation and
industrial regulations) .
- It required public investment from host country.
- Objectives increase foreign exchange earnings, increase employments, and
encourage transfer of technology and management skills.
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Globalization in Age of Empire
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1875 – 1914 called the age of empires. It develops a new kind of imperialism
- Globalization: coming together of cultures.
There are two forces of globalizations:
1) Coercive: impose it self on others. linked to imperialism
2) Cooperative: live side by side, interacting and evolving together. (cultural
coexistence)
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- Empires: provision of public goods and military strength where able to force
globalization onto a multitude of cultures. So they foster globalization.
1) Empires built reliable infrastructure and imposed common language leading to
increase in commerce and migration. (Roman)
2) Empires imposed common religious practices (Spain in South America)
3) Empires installed a common political culture (British)
- Culture coming together intend of coercion
- Amsterdam opened its doors to scientist, philosophers, and escaping ethical
persecution. So they contribute to the city development. 1870-1939 Paris for
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writers and painters.
Markets: Good servants, Bad Masters
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The Diversity Of Capitalism
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Capitalism And Global Free Markets
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Why Did East Asia Grow So Fast
Not included in our Midterm exam
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