Econplusdal Theme 1 Flashcards
Basic Economic Problem
How to allocate scarce resources (factors of production) given unlimited wants
Factors of Production
Capital (manmade aids to production e.g. machinery, factories, schools etc.)
Enterprise (people who innovate)
Land (farmland, rainforest etc. - where goods can be produced and resources can be taken)
Labour (workers who produce goods and services)
Choices in allocation of resources and how markets decide
What to produce (businesses decide based on consumer demand)
How to produce (businesses decide based on what’s most cost-effective)
For whom to produce (who has the highest income)
Opportunity Cost
The cost of the next best alternative foregone when a choice is made
Measures if choices are good or bad
Production Possibility Frontiers
Maximum possible production of 2 goods/services with given factors of production
The various combinations of 2 goods/services that can be produced with given factors of production
Macro PPF shows maximum possible output of all goods and services, or consumer goods and capital goods
Curved PPF
Increasing opportunity cost
As a firm moves towards heavy specialisation in Good A, remaining factors of production are more suited to Good B, so they have to give up more of Good B to make Good A
Straight-line PPF
Constant opportunity cost
Efficiency on PPF curve
Productive: points on the curve (maximum output/use of resources). Inside the curve is productively inefficient (unemployment on a macro scale)
Allocative: not shown
Pareto: points on the curve (someone can only be made better off if someone is made worse off)
PPF - increasing production
1) Shift point from within curve further out
2) Reallocating factors of production (move along curve)
3) Shift curve outwards (improve quality or quantity of factors of production - Q2CELL)
Reasons for PPF shifting outwards
Technology
Investment/Immigration
Government Training
Education
Resources
Reasons for PPF shifting inwards
Natural Disaster
War
Emigration
Recession
Demand
The quantity of a good/service consumers are WILLING AND ABLE to buy at a given price in a given time period
Law of Demand
There is an inverse relationship between price and quantity demanded. As price increases, Qd decreases and vice versa assuming CETERIS PARIBUS
Income Effect: when prices rise, income doesn’t stretch far enough for us to afford the same amount of the good (less able)
Substitution Effect: when prices rise, other goods and services become more price competitive, so we switch
Factors shifting the demand curve
Population
Advertising
Substitute’s Price
Income
Fashion/tastes
Interest Rates
Complement’s Price
(Legislation)
Supply
The quantity of a good/service producers are willing and able to produce at a given price in a given time period
Law of supply
There is a direct relationship between price and quantity supplied. As price increases, Qs increases and vice versa, assuming CETERIS PARIBUS (because of profit motive)
Factors shifting the supply curve
Productivity
Indirect tax
Number of firms
Technology
Subsidy
Weather
Costs of production (Transport, Labour, Oil, Raw materials, Utilities, Regulation)
Market
Any place where buyers meet suppliers to exchange goods/services
Equilibrium (market clearing price/quantity)
Where demand = supply in a market
Functions of the Price Mechanism
Allocates scarce resources (4)
Rations excess demand/supply (3)
Signals that price is too high/low (1)
Incentives to change price and increase profit (2)
Consumer Surplus
The difference between the price consumers are willing to pay for a good/service and the price they actually pay
Triangle below the demand curve
Producer Surplus
The difference between the price producers are willing to supply a good/service for and the price they actually receive
Triangle above the supply curve
Society Surplus
CS+PS
Joint Demand (complements)
Goods that are usually bought together e.g. Printers/Ink, Razors/Blades, Coffee Machines/Capsules
When price of one increases, demand for it contracts, causing demand for the other to shift to the left (and vice versa)
Competitive Demand (substitutes)
Goods that can be bought instead of the other e.g. Coke/Pepsi, Big Mac/Whopper, iPhone/Galaxy
When price of one increases, demand for it contracts, causing demand for the other to shift to the right (and vice versa)
Derived Demand
When the demand for a good/service comes from the demand for something else e.g. Cars/Aluminium, G&S/Labour, Holiday/Airline Travel
When demand for one good shifts, demand for the other shifts correspondingly
Composite Demand
Two goods require the same goods to make them e.g. Bread/Livestock (Wheat), Cheese/Butter (Milk)
If demand for one good shifts to the right, production increases, reducing the availability of the input for the other good, causing supply to shift to the left (and vice versa)
Joint Supply
When one good is produced, another good is also produced e.g. Honey/Beeswax, Crude Oil/Petroleum
If demand for one good shifts to the right, production increases, which directly increases the production of the other good (and vice versa)
Price Elasticity of Demand
The responsiveness of quantity demanded to a change in price (%changeQ/%changeP)
Always negative
PED/PES=0
Perfectly inelastic
PED/PES<1
Inelastic
PED/PES=1
Unitary elastic
PED/PES>1
Elastic
PED/PES=∞
Perfectly elastic
Factors affecting PED
Substitutes (number)
Percentage of income
Luxury or necessity
Addictive/habit forming
Time
Relationship between PED and Revenue
Elastic Opposite, Inelastic Same
(Elastic only irritates skin)
Elasticity along the demand curve
Top half is elastic (%changeQ always > %changeP), bottom half inelastic (%changeQ always < %changeP), midpoint unitary elastic (maximum revenue) - if curve is linear
Price Elasticity of Supply
The responsiveness of quantity supplied to a change in price (%changeQ/%changeP)
Always positive
Factors affecting PES
Production Lag
Stocks
Spare capacity
Substitutability of FoPs
Time
(Barriers to entry)
XED
The responsiveness of quantity demanded of a good/service to a change in price of another (%changeQa/%changePb)
Positive Substitutes Negative Complements (Party Season Near Christmas)
XED>1
Elastic (strongly related)
XED<1
Inelastic (weakly related)
XED=0
Unrelated goods
YED
The responsiveness of quantity demanded to a change in income
Positive YED >1
Normal luxury
Negative YED >1
Inferior luxury
Positive YED <1
Normal necessity
Negative YED <1
Inferior necessity
PED Business use
Pricing decisions for total revenue
Predictions e.g. if they know Q will rise –> Employment, Stocks, Output
PES Business use
Find ways to make supply price elastic (flexibility)
XED Business use
Pricing decisions (Epson cut printer prices, hike ink prices)
Non-price competition (avoids price war; reduce similarities)
Employment, Stocks, Output
YED Business use
Plan for recessions/booms
Pricing decisions
Employment, Stocks, Output
Problems with using elasticity
Figures are only ESTIMATES (surveys, competitors collect information, past data)
Assume Ceteris Paribus
PED varies along the demand curve
Impact of indirect taxation on the market
S curve shifts up
Price increases, Quantity decreases
Government generates revenue
Consumer burden on top, Producer burden on bottom
Producer revenue falls
Consumer and producer surplus fall
Lower output –> unemployment
Creates Deadweight Loss (triangle to right of tax box)
Impact of subsidies on the market
S curve shifs down
Price decreases, Quantity increases
Government loses money (Opportunity cost)
Consumer income on bottom, Producer income on top
Consumers don’t benefit fully because firms keep a lot of money
Distorts the free market
DWL to society (triangle above new supply curve)
Minimum price
A price floor below which the price of a good or service is not allowed to decrease
Impact of a minimum price on the government
Intervention Buying (can store but expensive, can destroy but wasteful, can dump but makes foreign countries unhappy)
Substantial opportunity cost when intervention buying
Lowers popularity with voters
DWL to society (triangle below demand curve)
Impact of a minimum price on producers
Revenues rise because of intervention buying (protects them) –> greater investment/employment?
Excess supply if not bought up
Impact of a minimum price on consumers
Higher prices
Less consumption of harmful goods e.g. alcohol
Minimum wage reduces exploitation
Hardship for those on low incomes
Maximum price
A ceiling price set by the government on a good or service, above which it cannot rise. It may be enforced through government legislation.
Impact of a maximum price on the government
Deal with excess demand (shifting supply)
…but huge opportunity cost
Could create a black market (e.g. Venezuelan food, black market from foreign countries) –> government failure
DWL to society (triangle under demand curve)
Impact of a maximum price on producers
Lower prices
Lower quantities (Fewer jobs)
Lower revenue –> lower investment
Lower supply worsens the market in the long term - fewer houses being built etc.
Impact of a maximum price on consumers
Salary cap reduces inequality
Lower prices e.g. for essentials - housing (reduces monopolistic exploitation)
…but excess demand creates waiting lists that makes them unhappy
Allocative Efficiency
S=MPC=MSC; D=MPB=MSB
Maximisation of society surplus (CS/PS) - D=S
Maximisation of net social benefit - MSB=MSC
Resources perfectly follow consumer demand - D=S
Allocational or allocative efficiency is an efficient market whereby all goods and services meet the needs and wants of society.
Assumptions underpinning free market equilibrium being allocatively efficient
Many buyers/sellers
Perfect information
No barriers to entry/exit
Firms are profit maximisers
Consumers are utility maximisers
Market Failure
When the free market fails to allocate scarce resources at the socially optimum level of output
On diagram, welfare loss points towards social optimum
Causes of market failure
Positive/Negative externalities (firms/consumers act in self-interest, ignoring these)
Merit/Demerit goods (Information failure, so consumers make irrational decisions)
Public goods (Free rider problem & Profit motivated firms)
Common Access Resources/Tragedy of the Commons (negative externalities, self-interest)
Income inequality (inequity)
Monopoly power (exploits consumers)
Factor Immobility
Information gaps
Negative Externalities
Detrimental third party effects as a result of actions of another agent
Positive Externalities
Positive third party effects as a result of actions of another agent
Merit Goods
Goods deemed more beneficial to consumers than they realise (Imperfect information - information failure; asymmetric information)
Positive externalities in consumption
e.g. healthcare, education, exercise
Demerit Goods
Goods deemed more harmful to consumers than they realise (Imperfect information - information failure, asymmetric information)
Negative externalities in consumption
e.g. cigarettes, alcohol, gambling
Public Goods
Non-rival (quantity does not diminish upon consumption) and non-excludable (no price can be charged for the good [the benefits of consuming the good cannot be confined to the individual that has paid; there is no cost efficient way to price])
e.g. flood defences, road signs, street lights, roads, beaches
Free rider problem; missing market
Free rider problem
The rational consumer would wait until someone else pays for the good as once a public good is provided, it is automatically provided for everyone. Therefore, there would be lack of demand for them and lack of supply as it would not be a profitable market. This would therefore be market failure as the goods would be underprovided
State Provision of Public Goods
Due to the free-rider problem, the government will intervene and provide public goods using taxes e.g. flood defense, criminal justice system, refuse collection
Quasi-Public Goods
Shows some, but not all, characteristics of public goods
e.g. Roads (tolls; diminishing road space), Beaches (access restricted by hotel; diminishing beach space)
Information gap
Where consumers, producers or the government have insufficient knowledge to make rational decisions e.g. second-hand cars
Symmetric Information
Where consumers and producers have access to the same information about a good or service in the market
Asymmetric Information
Where producers and consumers have unequal access to information about a good or service e.g. second-hand car market and cosmetic surgery market or insurance market
State Provision of Information
Government may intervene to prevent/reduce information gaps e.g. through social media, TV adverts, newspapers, school education; Drink driving/smoking ads, seat belt ads, anti-drug ads, cigarette packets
Common Access Resources
Natural resources over which no private ownership has been established
e.g. Forests, Seas, Air
Tragedy of the Commons
The unsustainable exploitation of common access resources because it cannot be controlled
Self-interest –> Resource depletion (overproduction)
Government Failure
When the costs of intervention outweigh the benefits. The end result is a worsening of the allocation of scarce resources harming social welfare
Indirect Tax
A tax levied on goods/services. They increase a firm’s costs of production BUT can be transferred
Indirect Tax to correct Market Failure
Increases costs of production
Internalises the externalities (polluter pays)
Solves overconsumption/production
Promotes allocative efficiency whilst generating government revenue
BUT
Price inelastic demand
Setting tax at right level
Regressive
Black markets
Types of Government Failure
Information Gaps (Valuing externalities is difficult; what’s the right level of policy required?)
Administration and Enforcement costs very high (Regulation, Subsidies, State Provision, Price Controls)
Unintended Consequences (Black Markets, Impact on Poor, Impact on Firms, Employment)
Regulatory Capture (when regulating monopoly power)
Distortion of price signals
Distortion of price signals (Government Failure)
The action of government which distort the price mechanism and so misallocate resources
Minimum Price causes excess supply (Government may have to buy these - opportunity costs, wastage of products)
Maximum Price causes excess demand e.g. in rental market leaving many people homeless
Unintended consequences (Government Failure
Indirect taxes may lead to illegal markets e.g. smuggling alcohol and tobacco. This leads to an increase in crime which will result in using taxpayers’ money to deal with this crime
Subsidies may lead to firms becoming too dependent on them and therefore more inefficient
Maximum wage could lead to a shortage of highly skilled workers as they move to other countries e.g. workers in the banking sector
Increase in unemployment as if minimum wage increases employees become too expensive for firms to employ
Excessive Administration Costs (Government Failure)
Admin costs incur in order to implement taxes, subsidies, regulation, pollution permits
Employees need to be paid to implement these
Is it worth these extra costs to the government?
Information gaps (Government Failure)
This is when the government has insufficient knowledge to take a rational decision e.g. fishing quotas were set too high by EU and so fish depletion is still an issue
Increased tax might lead to tax evasion which might lead to less tax in the long run
Specific Tax
Doesn’t change with the value of the goods but with the amount/volume of the goods purchased
Ad Valorem Tax
The tax levied increases in proportion to the value of the tax base (price of the good). Most goods in the UK carry a 20% VAT charge
Subsidy
Money grant given to producer by the government to lower costs of production and encourage an increase in output
Subsidy to correct Market Failure (benefits and costs of subsidies)
Lowers costs of production
Reduces price, increases quantity
Solves underconsumption/production
Allocative efficiency, welfare gain
Boosts employment
Protect infant industries
BUT
COST FOR TAXPAYER/OC
Setting subsidy at the right level
How will firms use subsidy?
No certainty of success
Price inelastic demand
Distortion of free market
Risk of fraud
Cannot discriminate between firms
Regulation
Rule/Law enacted by the government that must be followed by economic agents to encourage a change in behaviour
State Provision to correct Market Failure
Resource allocation improves
No price exclusion
All social benefits are likely to be considered
BUT
Opportunity cost
State run organisations tend to be wasteful (no profit motive)
Ignores the private sector completely
How to ration the excess demand? (Bring in the private sector?)
Tradable Pollution Permits
Government sets level of pollution allowed
Permits are issued to match this level
If permits aren’t used, they can be sold
If a firm breaks the pollution limit, they’re fined
Costs of production for firms increase
Effectiveness depends on level of information government has; number of firms able to reduce pollution
Regulation to correct Market Failure
Easy to understand and enforce
Revenue from fines can be used to compensate victims
Reduce asymmetric information (age restriction)
Non-Market based approach
Command & Control approach
Incentive to change behaviour
Solve issues in free market
Allocative efficiency; Welfare gain
BUT
Very expensive (Admin costs, enforcement costs)
Setting the right regulation
Black Markets; Unintended consequences e.g. cheating the system
Equity between firms e.g. pollution caps
Very paternalistic
Makes firms uncompetitive (higher CoP)
Benefits of TPPs
Incentive to reduce pollution (can sell permits for profit)
Reduces level of pollution to social optimum (welfare rises, more allocative efficiency, Q=Q*)
Can be adjusted over time e.g. in 2008 the EC cut them by 5%
Market based solution
Efficient and equitable for firms
Problems with TPPs
Deciding level of pollution allowed?
High admin costs; difficult to enforce
Fines may not be strict enough
Geographical distribution (after Kyoto, pollution concentrated in USA)
Need for international cooperation
Minimum Price to solve Market Failure
Contracts demand from Q to Q*
BUT
Price inelastic demand
Regressive
Black Markets
Set at right level?
EXCESS SUPPLY NOT RELEVANT BECAUSE GOV DOESN’T BUY IT UP
Maximum Price to solve Market Failure
Reduces prices, promoting equity e.g. rent prices
BUT
Shortage
Black markets
Enforcement
Setting the right level
Cost
Property Rights to solve Market Failure
Incentive not to exploit common access resources
Negative externalities internalised
If enforced, will reduce quantity to the socially optimum level
BUT
Can property rights be efficiently distributed?
Enforcement needed - COST
Equity - who gets the rights? e.g. chemical factory vs villagers rights to a river
Specialisation
The concentration of a worker, firm, region or country to produce a narrow range of goods and services
Advantages of specialisation
Reduces problem of scarcity
Larger range of goods and services
Greater output & greater quality
Trade and growth
Economies of scale
Disadvantages of specialisation
Requires trade to be successful
Finite resources (overdependence)
Over-reliance on good weather
Changing tastes/fashions –> structural unemployment
Nation interdependence
De-industrialisation
Division of Labour
Occurs when specialisation has taken place where the production process is broken down into separate tasks
Advantages of DoL
Increased productivity as worker becomes skilled in one particular task due to repetition (increased output; feel valued)
No time is wasted moving from one task to another
Capital Equipment can be used
Less time is required for training as workers only need to be trained in one particular task
Consumers benefit via lower prices
Disadvantages of DoL
Repetition may lead to boredom (higher staff turnover & higher recruitment costs and higher absenteeism; feel devalued –> quality suffers)
Workers could be easily replaced with machines to do these respective jobs - this could lead to structural unemployment
Payments are low
Working conditions are poor
Too much reliance on other countries
Functions of Money
A Medium of Exchange
A Measure of Value
A Store of Value
A Method of Deferred Payment
Money as a Medium of Exchange
Money is used to buy goods and services
There is no money in a barter (swapping one good or another) economy, making it difficult to trade
Without trade there would be no specialisation and without specialisation there would be little or no increase in living standards
Money as a Measure of Value
Money acts as a Unit of Account. It allows a comparison to be made between goods and services in order to value them
At times of very high inflation e.g. Germany in 1923 and Zimbabwe, money fails to act as a unit of account as prices may change by the hour
Money as a Store of Value
Money not spent can be saved for future spending which means money can be saved for the future
However, high inflation can destroy this link as money can become less valuable over time
Money as a Method of Deferred Payment
Money can be used to settle a debt. Money links different time periods e.g. Mortgage loans
If money stops to have this function credit and borrowing collapses and this can damage investment and economic growth
Total Utility
The total satisfaction from a given level of consumption
Utility
A measure of the satisfaction that we get from purchasing and consuming a good or service
Marginal Utility
The change in satisfaction from consuming an extra unit
Diminishing Returns
Marginal utility declines as more is consumed
Reasons why consumers may not behave rationally
Influence of other people’s behaviour - “social norms”
The importance of habitual behaviour
Consumer weaknesses at computation
Accelerator effect
The accelerator effect happens when an increase in national income (GDP) results in a proportionately larger rise in capital investment spending.
