Intro to markets and Market failure Flashcards
What is Production Possibility Frontiers (PPF)
A PPF shows alternative combinations of two goods or services attainable when all resources are fully and efficiently employed
- Depicts the maximum productive potential of an economy,using a combination of 2 goods or services
What is Ceteris paribus ?
all other things being unchanged or constant
What is Economic Problem ?
The Problem of scarity; wants are unlimited by resources are finite so choices have to be made
What are Non-renewable resources ?
Resources which cannot be replenished or replaced
what is Normative statements
Subjective statements based on value judgements and opinions , which cant be proven or disproven
What is Opportunity cost ?
The value of the next-best alternative when a decision is made
What is Positive Statements ?
Objective statements which can be tested with factual evidence to be proven or disproven
what is Renewable Resources ?
Resources which can be replenished, so the stock of resources can be maintained over a period of time
What is Scarity ?
The shortage of resources in relation to the quantity of human wants
What is Specialisation?
Is when we concentrate on a product or task
What is a linear Production Possibility Frontier ?
A straight line PPF is an indication of perfect factor substitutability of resources.
- When its a straight line, then the marginal opportunity cost of switching resources between consumer and capital goods is constant
What happens when there is an outward shift in the PPF ?
this leads to an increase in a country’s potential output
What causes shifts in the PPF ?
- higher productivity increases the output per unit of input used in production
- Better management of factor inputs. Improved management reduces waste and improves the quality
- Increase in the stock of capital and labour supply
eg. from inward labour migration/capital investment - Innovation and invention of new products and resources, Improved production processes help to boost efficiency
- Discovery /extraction of new natural resources, Discovery of commercially viable land inputs drives extraction
What is Demand ?
Demand for a good or service is the quantity that purchasers are willing and able to buy at a given price in a given period of time.
What is the basic law of demand ?
Demand varies inversely with price - lower prices makes products more affordable for consumers
What is Utility ?
Is a measure of the satisfaction that we get from purchasing and consuming a good or a service
What is total utility
The total satisfaction from a given level of consumption
Marginal utility
The change in satisfaction from consuming an extra unit
Derived demand
Is the demand for a factor of production used to produce another good or service
Composite demand
Exists where goods have more than one use - an increase in the demand for one product leads to a fall in supply of the other
What is supply ?
Supply is the quantity of a good or service that a producer is willing and able to supply onto the market at a given price in a given time period
The basic law of supply
Is that as the price of a product rises, so businesses expand supply to the market
A supply curve
Shows a relationship between market price and how much a firm is willing and able to sell
Joint supply
Is where an increase or decrease in the supply of one good leads to an increase or decrease in supply of a by product
Equilibrium
Means a state of equality or balance between market demand and supply
Points of disequilibrium
Prices where demand and supply are out of balance are
Key Advantages from Specialisation ?
Higher labour productivity and business profits
- learning by doing increases output per hour worked
- higher productivity lowers the unit cost of supply
- increased productivity leads to higher profits for business
Specialisation creates surplus output that can then be traded internationally
- The theory of comparative advantage is key to this
- Businesses/countries specialise in areas of relative advantage
Lower prices, higher real incomes an GDP growth
- lower prices gives consumers greater real purchasing power
- higher productivity allows business to pay increases wages
- successful specialisation is one of the key causes of growth
Disadvantages of Specialisation and Division of Labour
- Unrewarding, repetitive work that requires little skill can lower motivation and eventually causes lower productivity.
- Workers may take less pride in their work and quality suffers.
- Dissatisfied workers become less punctual at work and the rate of absenteeism increases.
- Many people may choose to move to less boring jobs creating a problem of high worker turnover for businesses. The highest labour turnover is in retailing, hotels, catering and leisure, call centres and other lower-paid private sector services groups.
- Some workers receive little training and may not be able to find alternative jobs if they find themselves out of work - they may then suffer structural unemployment / occupational immobility
- Mass-produced standardized goods lack variety for consumers.
Causes of Shifts in the Demand Curve
- Changing prices of a substitute goods or services in competitive demand
- Changing price of a complements – i.e. products in joint demand
- Changes in the real income of consumers
- When real income goes up, our ability to purchase goods and services increases, and this causes an outward shift in the demand curve.
- But when incomes fall there will be a decrease in demand, except for inferior goods - Changes in the distribution of income - a more equal distribution of income can increase total demand because relatively poorer consumers spend a higher proportion of their income
- The effects of advertising and marketing
- Interest rates and demand (e.g. affecting the cost of credit)
- Changes in the size and age structure of a population
- Seasonal factors for some goods and services
- Social and emotional factors
Seasonal Demand for Goods and Services
Seasonality refers to fluctuations in output and sales related to the seasonal of the year.
For most products there will be seasonal peaks and troughs in production and/or sales
Reasoning for the Law of Supply
- The profit motive:
- If the market price rises following an increase in demand, it becomes more profitable for businesses to increase their output - Production and costs:
- When output expands, a firm’s production costs tend to rise, therefore a higher price is needed to cover these extra costs of production. This may be due to the effects of diminishing returns as more factor inputs are added to production. - New entrants coming into the market:
- Higher prices may create an incentive for other businesses to enter a market leading to an increase in total supply.
Causes of Shifts in the Market Supply Curve
- Changes in the unit costs of production
- Lower unit costs mean that a business can supply more at each price – for example higher productivity
- Higher unit costs cause an inward shift of supply e.g. a rise in wage rates or an increase in energy prices / other raw materials - A fall (depreciation) in the exchange rate causes an increase in prices of imported components and raw materials –
- Advances in production technologies – outward shift of supply
- The entry of new producers into the market – outward shift
- Favourable weather conditions e.g. for agricultural products
- Taxes, subsidies and government regulations
- Indirect taxes cause an inward shift of supply
- Subsidies cause an outward shift of supply
- Regulations increase costs causing an inward shift of supply
What is Price Elasticity of Demand?
- Price elasticity of demand (PED) measures the responsiveness of demand after a change in the good’s own price
- The basic formula for calculating the co-efficient of price elasticity of demand is:
- Percentage change in quantity demanded divided by the percentage change in price
- All normal goods with downward sloping demand curves will have a negative coefficient of price elasticity of demand
Numerical Values for Coefficient of Price Elasticity
- If Ped = 0 demand is perfectly inelastic - demand does not change when the price changes – the demand curve is vertical
- If Ped is between 0 and 1 (% change in demand is smaller than the percentage change in price), then demand is inelastic
- If Ped = 1 (% change in demand is the same as the % change in price), then demand is unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending the same at each price level
- If Ped > 1 then demand responds more than proportionately to a change in price i.e. demand is elastic. For example if a 10% increase in price leads to a 30% drop in demand. The price elasticity of demand for this price change is –3
What factors determine the PED of a product?
Number of close substitutes available for consumers
- the more close substitutes there are, the more price elastic the demand
Price of the product in relation to total income
- When the %of budget is high, demand is usually more price sensitive
Cost of substituting between different products
- When substitution/switching costs are high, demand will tend to be price inelastic
Brand loyalty and habitual consumption
- high levels of brand loyalty makes demand less price elastic
- Persuasive advertising can make demand price inelastic
Degree of necessity/luxury
- standard assumption is that necessities have a lower price elasticity of demand whereas luxuries are an optional spend
Usefulness of Price Elasticity of Demand for Producers
- The effect of a change in price on total revenue of sellers
- The price volatility in a market following changes in supply – this is important for commodity producers who suffer big price and revenue shifts from one time period to another.
- The effect of a change in an indirect tax on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer.
PED can be used by a business for price discrimination.
- This is where a supplier decides to charge different prices for the same product to different segments of the market e.g. peak and off peak rail travel or prices charged by many airlines.
- Usually a business will charge a higher price to consumers whose demand is price inelastic
- The taxi company Uber for example engages in surge pricing
What is the income elasticity of demand?
shows how responsive the demand for products is to a change in (real) income
The formula for calculating income elasticity of demand (YED)
% change in quantity demanded / % change in real income
How do we distinguish goods within income elasticity?
- Normal goods - they have a positive income elasticity
- Luxury goods - where the income elasticity > +1
- Necessities - here the income elasticity > 0 and < +1
- Inferior products - these have negative income elasticity
What is Inferior good
- a good whose demand drops when people’s incomes rise
- They are counter-cyclical goods - products whose demand varies inversely to the macroeconomic cycle - demand rises in a downtown
Normal Necessities and Normal Luxuries
Normal goods have positive YED i.e YED > 0
Normal necessities (income inelastic) : These products have a low but positive income elasticity typically necessities such as milk and fruit
Normal luxuries (income elastic) :
- These products have a high and positive income elasticity- typically these are higher-end products considered as a luxury
Inferior goods (counter cyclical products)
- they have a negative income elasticity of demand. - negative YED < 0
- When real incomes are rising during a period of economic growth, then the demand for inferior goods will fall causing an inward shift of the demand curve.
- When real incomes are falling during a period of recession or if wages are rising more slowly than prices, the demand for inferior goods will rise.
Cross Price elasticity of demand
measures responsiveness of demand for good X following a change in the price of a related good Y.
What are Substitutes?
- Substitutes are products in competitive demand.
- With Substitutes, an increase in the price of one good (ceteris paribus) will lead to an increase in demand for a rival product
- The value of XED for 2 substitutes is always positive.
What are Complements?
- Complements are products in joint demand
- A fall in the price of one product causes an increase in demand for the complementary product
- the value of Xed for 2 complements is always negative
Understanding the coefficient of cross plus elasticity
- close substitutes have a strong positive cross price elasticity of demand i.e a small change in relative price causes a big switch in consumer demand
- when there is a strong complementary relationship, the cross elasticity will be highly negative.
- Unrelated products have 0 cross elasticity e.g the effect of changes in taxi fares on the market demand for cheese
Price elasticity of supply
measures the relationship between change in quantity supplied and a change in price
Measuring Price elasticity of supply
- if supply is elastic, producers can increase their output without a rise in cost or a time delay.
- if supply is inelastic, firms find it hard to change their production in a given period of time
- % change in quantity supplied / % change in price
pes > 1, then supply is price elastic
pes < 1, then supply is price inelastic
pes = 0, supply is perfectly inelastic
pes = infinity, supply is perfectly inelastic following a change in demand
Factors affecting price elasticity of supply
- Spare production capacity - if there is plenty of spare capacity then a business can increase output without a rise in costs and supply will be elastic in response to a change in demand.
- Stocks of finished products and components - if stocks of raw materials and finished products are at a high level then a firm is able to respond to a change in demand - supply will be elastic. Perishable goods are often harder/more expensive to store.
- Ease the cost of factor substitution/factor mobility - if capital and labour are mobile then the elasticity of supply for a product is likely to be higher as resources can be mobilised to supply the extra output.
- Time period and production speed - supply is more price elastic the longer the time that a firm is allowed to adjust its production levels
Consumer surplus
is a measure of the welfare that people gain from consuming goods and services
- it its the difference between the total amount that consumers are willing and able to pay for a good or service and the total amount they actually do pay
- its the area under the demand curve and above the market price
Producer surplus
is the difference between 2 price levels
- its the difference between the price producers are willing and able to supply a good or service and the price they actually receive
- its the area above the supply curve and below the current market prices.
- Higher prices provide an incentive to supply more to the market. This is due to the profit motive.
Price Mechanism
The price mechanism is the means by which the decisions of consumers and businesses interact to determine the allocation of resources.
Rationing
where there is a shortage of a product, price will rise and deter some consumers from buying the product
Incentive function
through choices consumers send information to producers about their changing nature of needs and wants.
Signalling Function
- changes in price provides information to both producers and consumers about changes in market conditions
- they adjust to demonstrate where resources are required.
Prices rise and fall to reflect scarcities and surpluses.
- If prices are rising because of high demand from consumers, this is a signal to suppliers to expand production to meet the higher demand.
I- f there is excess supply in a market, the price mechanism will help to eliminate a surplus of goods by allowing the market price to fall.
Changes in market prices
Changes in market price act as a signal about how scarce resources should be allocated.
A rise in price encourages producers to switch into making that good but encourages consumers to use an alternative substitute product (therefore rationing the product).
A fall in price leads to an extension of demand but makes it less profitable for a business to supply the good or service affected.
Change in market conditions
- If Demand increases and supply is perfectly inelastic (PES=0) then price rises and quantity doesn’t change
- If supply increases and demand is perfectly inelastic (PED=0), then price falls and quantity doesn’t change
- If Demand increases and supply is perfectly elastic, then the price stays the same and quantity rises
- If supply increases and demand is perfectly inelastic, then the price stays the same and quantity rises
Direct Tax
An direct tax is a tax imposed by the government that increases the supply costs faced by producers
Indirect taxes in Markets
The amount of the tax is always shown by the vertical distance between the 2 supply curves.
The result is an increase in the market price and a contraction in demand to a new equilibrium output.
1. A specific tax is a set tax per unit e.g tax per unit sold
2. An ad valorem tax is a % percentage tax e.g 20% on the unit price
Examples of indirect Taxes in the UK Economy
VAT- standard rate =20%
Landfill tax - £80 per tonne for waste
Fuel Duties - Taxed at 58p per litre
Alcohol Duties - Beer tax = 41.5p per pint
Tobacco Duties - £3.76 per pack +17% VAT
Ad Valorem (indirect) Taxes
- The effect of an ad valorem tax is to cause a pivotal shift in the supply curve
- This is because the tax is a percentage of the unit cost of supplying the product.
- So a good that could be supplied for a cost £60 when VAT of 20% is applied
- The absolute amount of the tax will go up as the market price increases
Externalities
Externalities are a major cause of market failure and are likely in every market.
Externalities + Market Failure
Externalities are spill-over effects from production and consumption for which no appropriate compensation is paid/received.
Externalities lie outside the initial market transaction/price.
Externalities cause market failure if the price mechanism does not take into account the social costs and benefits of production and consumption
Externalities can be private and negative
Private costs
Private costs are the costs faced by the producer or consumer directly involved in a transaction
Private benefits
Private benefits are the benefits for producer and/or consumer directly involved in an economic transaction
The formula for Social cost and Social Benefit
Social cost - Private Cost + External Cost
Social Benefits - Private Benefit + External Benefit
Negative and Positive externalities
When negative externalities exist, social costs exceed private cost, This leads to over-production and market failure if producers do not take into account the externalities
•When positive externalities occur, social benefits exceed private benefit – this can also lead to market failure
Marginal private cost (MPC)
Cost to the producing firm of producing an additional unit of output
Marginal external cost (MEC)
Cost to 3rd parties from the production of an additional unit of output
Marginal social cost (MSC)
Total cost to society of producing an extra unit of output MSC = MPC + MEC
Marginal private benefit (MPB)
Benefit to the consumer of consuming an additional unit of output
Marginal external benefit (MEB)
Benefit to 3rd parties from the consumption of extra unit of output
Marginal social benefit (MSB)
The total benefit to society from consuming an extra unit, MSB = MPB + MEB
Public Goods
- nonexcludable and nonrivalrous
- a commodity or service that is made available to all members of a society
cause market failure due to the problem of missing markets
Public Goods characteristics
- Non-excludability: Benefits derived from pure public goods cannot be confined solely to those who have paid for it. Non-payers can enjoy the benefits of consumption at no financial cost to themselves – economists call this the ‘free-rider’ problem
- Non-rival consumption: Each party’s enjoyment of the good or service does not diminish others’ enjoyment– in other words, the marginal cost of supplying a public good to an extra person is zero. If a public good is supplied to one person, it is available to all.
- Non-rejectable: The collective supply of a pure public good for all means that it cannot be rejected by people, an example is a national nuclear defence system or major flood defence projects.
- Pure public goods are non-excludable and nonrival in consumption
- Public goods are also known as collective consumption goods
Quasi Good
A quasi-public good is a near-public good. It has some of the characteristics of a public good
Quasi-public goods are:
1. Semi-non-rival: up to a point, more consumers using a park, beach or road do not reduce the space available for others. But eventually, beaches become crowded as do parks/leisure facilities. Open-access Wi-Fi networks become crowded
- Semi-non-excludable: it is possible but difficult or costly to exclude non-paying consumers. E.g. fencing a park or beach and charging an entrance fee; or building toll booths on congested road routes
The Free-Rider Problem
Because public goods are non-excludable it is difficult to charge people for benefitting once a product is available
The free rider problem leads to the under-provision of a good and thus causes market failure
Global Public goods
Global public goods benefit every country, irrespective of which ones provide them – they have become more important recently
Public Bad
A public bad has negative effects (externalities) on people and their communities leading to a significant loss of social welfare
What are Merit Goods?
- Merit goods are goods and services the government feels that people will under-consume, and which might be subsidised or provided free at the point of use.
- Consumption of merit goods is often argued to generate positive externalities - where the social benefit from consumption exceeds the private benefit.
- A merit good is a product that society values and judges that people should have regardless of their ability to pay.
Education as a Merit Good.
- Education is a long-term investment decision. The private costs must be paid now but private benefits (including higher earnings potential over one’s working life) take many years to happen. - time lag
- Education provides external benefits including rising incomes and productivity for current and future generations and an increase in occupational mobility to help to reduce unemployment.
- Increased spending on education can provide a stimulus for higher-level research (which improves competitiveness) + a more enlightened and cultured society.
- It can lead to a more knowledgeable and skilled workforce, which can drive economic growth and development. Education can also improve income, job prospects, and overall quality of life for individuals. Additionally, education is considered important for personal growth and can help to promote social cohesion and reduce poverty and inequality. Due to these benefits, many governments provide or subsidize education to ensure that everyone has access to it, regardless of their income or financial status.
Education &. Health care as a. Merit. Good
Education spending
- May increase the skills and productivity of workers leading to. lower unit costs
- Improvement in human capital will lower structural unemployment
- more innovation/ more competitiveness
Health care spending
- improved health boosts the labour supply
- will increase productivity
- lessens risks of relative poverty
- long run - lower NHS costs/ sick pay
De-Merit Goods
a good or service whose consumption is considered unhealthy, degrading, or otherwise socially undesirable due to the perceived negative effects on the consumers themselves
Information Failures
Information failure occurs when people have inaccurate or
incomplete data and so make potentially ‘wrong’ choices/decisions
causes of information failure
- Long-term consequences: Information gaps about the long-term benefits of costs of consuming a product e.g. consumption of legal highs
- Complexity: Information failure when a product is highly complex e.g.understanding the best pension product to buy (if at all!)
= Price information: When consumers are unable to quickly / cheaply
find sufficient information on the best prices for different products
Asymmetric information: This occurs when one party has more information than the other. For example, a seller may know more about the quality of a product than a buyer.
Externalities: Externalities are costs or benefits that are not reflected in market prices. For example, the negative effects of pollution on the environment are not reflected in the cost of production.
Public goods: Public goods, such as national defense or public health, have benefits that are shared by everyone and cannot be excluded from anyone. This can result in underinvestment in these goods.
Government Failure
Government failure occurs when an intervention leads to a deeper market failure or even worse a new failure may arise
- intervention creates further inefficiencies, a
misallocation of resources + a loss of economic and social welfare
1. Policies may have damaging long-term consequences for the economy or society
2. Policies may be ineffective in meeting their stated aims
3. Policies may create more losers than winners
Moral Hazard
- Moral hazard occurs when insured consumers are likely to take greater risks, knowing that a claim will be paid for by their cover
- The consumer knows more about his/her intended actions than the producer (insurer)
Examples of unintended consequences:
- Price controls: Price controls, such as rent controls, can lead to a shortage of housing and decreased investment in the housing market.
- Subsidies: Subsidies can create a moral hazard, encouraging firms to become dependent on government support and reducing their incentives to innovate and become more efficient.
- Trade barriers: Trade barriers, such as tariffs and quotas, can lead to increased prices for consumers and decreased competitiveness of domestic firms.
- Environmental regulations: Environmental regulations aimed at reducing pollution can increase the cost of production and reduce competitiveness of domestic firms, potentially leading to offshoring of production to countries with weaker environmental regulations.
- Monetary policy: Monetary policy aimed at controlling inflation can lead to unintended consequences, such as increased unemployment or decreased economic growth.
Effectiveness of Government Intervention
Positive effects:
Addressing market failures: Government intervention can address market failures and correct market inefficiencies.
Promoting economic growth: Government investment in infrastructure, education, and research and development can help promote economic growth.
Reducing poverty: Government policies aimed at redistributing income and wealth can reduce poverty and inequality.
Protecting consumers: Government regulations can protect consumers from harmful products and deceptive business practices.
Negative effects:
Inefficiency: Government intervention can lead to inefficiency and increase the cost of production.
Reduced competition: Government intervention can reduce competition and create barriers to entry for new businesses.
New market failures: Government intervention can create new market failures, such as unintended consequences and negative externalities.
Decreased private sector investment: Government intervention can reduce private sector investment and shift resources away from productive uses.
a subsidy.
A subsidy is any form of government support—financial or otherwise—offered to producers and (occasionally) consumers
Cost-benefit analysis
Cost benefit analysis is a process used to measure the estimated net social rate of return from an investment project.
