markets and market failure (paper 1) DONE Flashcards
1
Q
what is the process of developing economic models? (including the need for assumption)
A
The process of developing models – economics studies human interactions, this interaction is complex and is influenced by many factors. Therefore, economists create models, as they’re simpler versions of reality, and make it easier to analyse.
^The need for assumption: assumptions allow for the problem to be simplified, and thus making it easier to solve. Assumptions work well, as there are often patterns in human behaviour, which provides a foundation for predictions.
2
Q
what does Ceterius parabius mean?
A
“all other things remain the same”. This is a form of assumption. Due to its simplicity, an economist can focus on specific variables without having to worry about others.
3
Q
what is the inability in economics to make scientific experiments?
A
scientific experiments are achievable in natural sciences as there is a “control group”, meaning observations can be made with a level of certainty. Whereas economists collect data in the real world where variables are constantly changing. This makes it harder to tell whether your evidence supports or denies your hypothesis – meaning scientific methods cannot take place in economics.
4
Q
what is the difference between a positive and normative statement?
A
Positive statement – are objective statements based on evidence and have a truth value. For example, “The unemployment rate is 4%”.
Normative statement – focuses on value judgement, based on opinion. Evidence helps build this statement, yet it only acts as a guideline. For example, “the best way to tackle unemployment is to increase education”.
5
Q
what is the role of value judgement in economics?
A
a value judgement weighs up what ought to be the case, based on what we perceive as good and bad. Therefore, value judgements are usually needed in areas of high moral concern – like the healthcare system.
6
Q
what is the problem of scarcity within economics?
A
The problem of scarcity – unlimited wants and finite resources. Economic agents need to therefore make decisions on how goods should be allocated – this is achieved through the price mechanism. Scarcity in an economy means there’s excess demand for a good. Resources which are scarce are called 2economic goods2 as they have a price which is used to ration the product. Whereas goods that are not scarce are called free goods. There is no need to ration free goods as there’s an abundance of them – for example, air, sunlight, etc.
7
Q
what is the difference between a renewable and non-renewable good?
A
Renewable good – can naturally replenish itself overtime. This is good cannot be used up in the same way non-renewable goods can. For example: solar energy.
Non-renewable good – cannot replenish itself overtime. Once it is used, it is gone. For example: coal.
8
Q
what is an opportunity cost?
A
an opportunity cost is the benefit foregone when making an economic decision. For example, if I buy a laptop, the opportunity cost is I could’ve brought a new phone instead. Every choice involves a range of alternatives. Therefore, we weigh up opportunity costs by evaluating the utility gained by each option.
9
Q
what does a production possibility frontier show?
A
A production possibility frontier shows all the possible options of output for two economic good, if all factors of production were used. A point on the curve therefore shows full employment.
10
Q
draw a PPF diagram between wine and cotton
A
A – prioritising wine instead of cotton.
^The opportunity cost here, is the cotton foregone.
C – shows prioritising Cotton over wine.
^The opportunity cost here, is the wine foregone.
X – shows the economy is not at full employment.
^If more resources became employed, X would move closer to the curve.
Y – shows an unachievable output with the economy’s current resources. Y would be achievable if economic growth took place, and the curve shifted right. This is because the PPF line shows the maximum level of output with your current resources. Any point on the PPF shows resources fully employed – this is unrealistic, as workers need to go home, and machinery needs to be turned off.
11
Q
what does it mean if the PPF moves left or right?
A
If the curve moves left – this is economic decline. This is because there’s a decrease in the economies potential. For example: spread of a virus.
If the curve moves right – this is economic growth. This is because there’s an increase in the economies potential. This can occur when the quantity of resources increases. For example: more people joining the workforce.
12
Q
what is the distinction between a consumer good and capital good?
A
Distinction between capital and consumer good: A capital good is one used for the production of other goods. For example, machinery. Whereas a consumer good are goods used by consumers to satisfy their needs/wants - it has already gone through all its stages of production and is now ready for consumption. For example, an iPhone.
13
Q
what does specialisation mean?
A
Specialisation – concentrating labour and resources on the production of a specific type of good, in order to be more efficient.
14
Q
what is the division of labour?
A
The division of labour - specialisation by individuals. Adam smith described the division of labour by his pin worker’s example. He stated if each individual specialised in a specific role in the pin factory (like one purpose drawing the wire and another cutting the metal) then more pins would be produced overall. This increase in productivity comes from more output per worker.
15
Q
what are the advantages to specialisation?
A
Advantages to specialisation:
Allows for greater productive efficiency - It is cost effective as workers are only provided the specific tools they need and It is less time consuming as workers are not constantly changing tasks.
As greater efficiency means more output per worker, the cost of production is lower, and thus more profit and revenue will be generated. This extra profit maube passed back onto workers, boosting real wages and thus living standards.
As more output is present in the economy, the PPF will move right.
Economies of scale
16
Q
what are the disadvantage to specialisation?
A
Disadvantages to specialisation:
Can cause unemployment if your specific skill is no longer in demand.
Can become repetitive and boring, resulting in an unproductive workforce, as workers feel alienated from their tasks.
Specialisation creates a reliance on other companies or countries. For example, the Uks once reliance on Russia for the majority of our oil, and therefore more exposed to external shocks.
17
Q
what are the 4 functions of money?
A
The function of money – specialisation calls the need for exchange, as specialising makes us reliant on other people’s goods.
- Medium of exchange – for money to act as a medium of exchange it must be accepted by everyone to hold value. It is for this reason goods can be traded without the need for a barter system. A barter system relies on two people both demanding each other’s goods.
- Measure of value – money is a consistent denominator in the exchange of goods, so it can be used to measure the value of one product in comparison to another.
- Store of value – money holds its purchasing power over time. This means we do not need to spend our money straight away when we receive it, as it’ll be worth the same tomorrow. This allows for us to save up for more expensive goods.
- Method of deferred payment – money allows for someone to get a good but pay at a later date because money holds its value. This means it doesn’t matter when the person who gave out the loan receives the money back, as they haven’t lost anything in value. This allows for borrowing to take place.
18
Q
what is a free market?
A
Free market economy – resources are allocated through the market forces and price mechanisms rather than the government.
19
Q
what are the advantages to a free market economy?
A
Advantages: - profit incentivises motivate people to work harder as there’s higher rewards available.
-high competition leads to better quality and lower prices in order to stay in demand.
-encourages innovation and product development as there is greater rewards for such risks
-better standard of living due to the profit made
-more efficient use of scarce resources. The price mechanism will ration goods, etc.
20
Q
what are the disadvantages to a free market economy?
A
Disadvantages:
1) marker failure - externalities, provision of public goods, asymmetric information
2) monopolies can occur - which are anti-competitive and they can raise price above market equilibrium
3) inequality - due to the meritocracy mindset of the free market, the rich get richer and the poor get poorer -> resulting in income inequality + wealth inequality
21
Q
what is Adam Smiths take on the free market?
A
Resources would be best allocated in a free market, as individuals act in their own best interest.
Firms -> look to maximise profit
Consumers -> look to maximise utility
^these two concepts will come together to meet at equilibrium
^This is known as the “invisible hand” , as market forces allow for production to take place at equilibrium.
Supply and demand is the most efficient way of allocating resources, as if the good is in excess demand, this signals to producers to produce more, pushing down the price to equilibrium again.
22
Q
what is a mixed economy?
A
Mixed economy – resources are allocated through market forces and the government.
This includes both government intervention and a free market
23
Q
what is a command economy?
A
Command economy – all factors of production and resources are allocated by the state, and the government determine the scope of operation (what they’ll be producing, and what quantity).
They believe the profit incentive behind a free market does not act in the best interest of the people.
24
Q
what are the advantages to a command economy?
A
Advantages: - encourages equality as the state allocates resources in societies best interest
-low unemployment as the state decides where people work and what they’re paid
- avoids the negatives associated with marker failure (like externalities) as the government is the one allocating them instead
25
what are the disadvantages to a command economy?
- less choice as workers are taxed more leaving less money for them to make their own economic decisions
-Government failure - inefficient allocation of resources will occur, leading to unexpected consequences due to asymmetric information (For example The USSR producing loads of left shoes and no right shoes)
- lack of profit incentive. Therefore there is no need to compete, and thus no need to produce at the most efficient level. Representing a high level of moral hazard.
-small economic growth as supply isn't determined by demand, so it won't operate at market equilibrium.
26
what is the underlying assumption of rational decision making?
Consumers aim to maximise utility – as resources are scarce, they must weigh up opportunity costs. Their choices are formed by what they believe to be the best outcome for them.
Firms aim to maximise profit – in a free market, firms will look to maximise their profits. If profits are not maximised, they may go out of business.
27
what is demand?
the quantity of goods bought at a given price
28
what does a movement along the demand curve show?
Movement along the demand curve – shows how price effects demand. The curve is downwards sloping as when price increases, demand falls. This is called a contraction in demand. Whereas when price falls, demand increases, this is called an expansion in demand.
29
what does a shift of demand show?
Shift of a demand curve – illustrates a different quantity being demanded at the same price. Movement to the right shows an increase in demand. A movement to the left shows a decrease in demand.
30
what are the factors that affect demand? (PIRATES)
P - population change effect
I – income effect
R – related good effects (substitutes)
A – advertisement
T – taste/trends
E – expectations (about the price of the good in the future)
S – seasonality
31
What is the concept of marginal diminishing utility?
The concept of diminishing marginal utility – this states the benefit from consuming a good falls, the more you consume that good. This is because the more buyers are offered, the less value they see on the last one bought.
^If there are few good available, then consumers are willing to pay a higher price, as the marginal utility gained is higher. The demand curve is downwards sloping, as the higher the quantity bought, the lower the marginal utility.
32
what does PED show?
Price elasticity of demand – measures how responsive demand is to a change in price
33
what is the equation for PED?
percentage change in quantity demanded divided by a percentage change in price
34
what does it mean if demand is elastic?
(PED > 1)
A change in price will lead to a bigger change in quantity demanded.
Demand is very responsive to a change in price. PED here would be larger than - this is because there has been a bigger change in demand than the initial change in price. This can occur if there are many substitutes for such good, or if it is not an essential product.
35
What does it mean if demand is inelastic?
(PED 0-1)
Demand is inelastic if the change in price doesn’t affect the quantity demanded that much. Change in price will be larger than the change in demand. PED = 0-1
The initial change in price is larger than the followed change in demand. Firms will exploit an inelastic PED as they can pass on more of their costs of production onto consumers, as they know they’re more willing to pay.
36
what does it mean if demand is unitary elastic?
Demand is unitary elastic, as a change in price leads to the exact same change in demand. Ped = 1.
^Some good are considered important to our daily life's yet not essential, so a change in price may have a corresponding change in demand – for example, phones.
37
what does it mean if demand is perfectly inelastic?
(PED = 0)
Demand is perfectly inelastic if demand doesn’t change at all when price changes. Therefore PED = 0.
^These goods have no substitutes at all. For example: oil. Demand-pull inflation will occur when such goods prices rise, as the demand curve is perfectly inelastic.
38
What does it mean if demand is perfectly elastic?
(PED = infinity)
Demand is perfectly elastic if a change in price leads to demand falling to 0. PED = infinity. This may occur when selling a homogenous good, that is identical to any other sellers good.
^For example: foreign currency exchange. As currency is an identical good, and as there is many suppliers of it, if one firm changes its price, customers will go elsewhere - as they know they’re receiving the same good regardless. Advertisement does not work in this scenerio to distinguish the good.
This assumes however that there is symmetric, perfect information present in the market.
39
what are the factors that influence PED?
- advertisement
- substitutes available
- urgency (like peak train fair)
- addiction / distorted reality of utility
40
what is the relationship between PED and total revenue?
Revenue = price x quantity
If a firm can figure out what the PED is for their products, then they can change the price to maximise revenue.
^ if PED is inelastic, then they can rise the price, as the rise in the price will be larger than the fall in demand. This will increase their revenue.
^If PED is elastic, then they can drop the price slightly, as a fall in price will lead to an even bigger increase in demand, and thus quantity sold. This of course however depends on profit margins, to whether it’ll be worth while.
Firms can also use PED to figure out how much tax to pass onto consumers, again effecting their revenue.
41
how does PED effect indirect tax?
An indirect tax is a tax on expenditure. It can be either specific (a fixed amount) or ad volerm (a percentage tax).
*draw diagram of elastic PED with an ad volerm tax, vs inelastic PED with an ad volerm tax*
^Note: mention the producer and consumer surplus changes.
If the demand for a good is inelastic then the firm will pass on the majority of the indirect tax to the consumers as they know a change in price wont effect demand that greatly. If firm however is selling an elastically demanded good, then the producer will pay the majority of the tax as they know if they passed it onto the consumer then demand would fall.
42
what is income elasticity of demand? (YED)
how responsive demand is to a change in income
43
what is the equation for YED?
Equation : % change in QD
Divided by % change in income
44
what is the difference between a normal good, inferior good, and luxury good?
A normal good – YED = 0-1
^There is a positive relationship between income and demand. As income rises, so does demand. This is true for normal goods like: clothing, alcohol, etc. As income rise, households have more disposable income, that can now be spent on a wider variety of goods to better their standards of living.
An inferior good - YED = always negative, as it is smaller than 0. For example -2.
^Demand increases when income decreases. This can occur on cheaper, essential goods during the time of a recession. For example, smart price food - where you can still get hold of baked beans, pasta, etc just for a lower price. This takes up less of their proportion of income, allowing them to continue buying the same quantity of goods as previously.
^Equally, during a time of economic recovery, wages will begin to rise, and thus less demand for inferior goods.
Luxury good – YED is always larger than 1. For example, YED = 4. An increase in income will lead to an even bigger increase in demand for luxury goods, than it would for normal goods. This typically happens the higher pay bracket, as they are already buying better quality of goods like food, clothing, etc. Therefore, they may spend this extra income on luxury goods, as there disposable income is large enough now. For example: luxury holidays abroad, luxury handbags.
45
what is cross elasticity of demand?
measures how responsive demand for one good is when the price of another good changes.
46
what is the equation for cross elasticity of demand?
% change in quantity demanded for good A divided by percentage change in price of good B
47
what is the difference betwen a subsitittue, complemenet and unrelated good?
Substitute – where good A can be easily replaced by good B. substitutes will have a positive XED – as price increases for one, the demand for the other will also increase. If substitutes are closely interlinked, then the XED value will also be much higher. For example: chocolate and sweets. As the price for sweets rises, the demand for chocolate will also rise.
Complement – a complement good is a good typically bought alongside another good. For example, pasta and pasta sauce, or tennis rackets and tennis balls. This has a negative XED as when the price of one goes up the demand or the other falls. The full utility of good B cannot be achieved without good A, yet as good B has risen in price, there's less incentive to buy good B, and thus even less incentive to buy its complement good good A - as the perceived utility gained has fallen. If complements are closely related, then the XED will be larger (like –25).
Unrelated good – goods that are not at all related. For example: tennis balls and pasta. The XED here will be 0. As price for one increases, there is no corresponding effect on the demand for the other.
48
what is meant by supply?
the quantity a firm is willing to supply at a given price.
^The supply curve is upwards sloping, showing how the firms will supply more as price increases.
49
what does a movement along the supply curve show?
Shows how price affects supply. price acts as a incentive to firms. it signals to them whether they should enter or leave a market depending on the potential profit that could be made.
50
what does a shift in the supply curve show?
Shows a different quantity being supplied at the same price. A movement right shows an increase in supply, a movement left shows a decrease in supply.
51
what are the factors that may cause a shift in supply?
(PINTS WC)
P – productivity.
I – indirect taxes. An increase in indirect tax raises production costs.
N – number of firms.
T – technology. New tech leads to greater productivity so more is created/supplied.
S – substitutes.
W – weather.
C – cost of production. If the CoP increases, then the price rises, causing less supply to preserve profit.
52
What is meant by price elasticity of supply? (PES)
measures how responsive quantity supplied by firms is to a change in price.
53
What is the equation for price elasticity of supply?
% change in quantity supplied divided by % change in price
54
what is the difference between elastic supply vs inelastic supply?
Elastic supply – supply is relatively responsive to a change in price. The change in quantity supplied is larger than the change in price. For example: plastic bags. plastic bags manufacturing process is relatively quick, plastic is a man made resource which is in abundance - it doesn't need to be extracted from the ground - and firms across the globe have achieved economies of scale in such production, therefore the cost of production is also low. Thus firms are able to respond relatively quickly to a change in price, in order to profit maximise. Therefore, PES is large than 1 . for example PES = 2. as a change in price causes a larger effect on supply.
Inelastic supply – is relatively unresponsive to a change in price. For example, housing. If prices increase, it's difficult to supply more. The cost of production may be very expensive for firms, therefore there's a larger opportunity cost they must consider in deciding whether to produce more. this may create barriers to entry for other firms, limiting again the amount of competition and thus supply in the market. Therefore, PES is smaller than 1 - > it is between 0-1.
55
what is the difference between perfectly inelastic and perfectly elastic?
Perfectly inelastic – shows no response at all of supply when there is a change in price. For example: a dead person's paintings. PES = 0. supply cannot increase, so instead the price mechanism must ration the good through raising the price.
Perfectly elastic – means producers are willing to provide a certain supply at any given price. For example a natural resource that is in abundance and provides little manufacturing time, like sand, rocks, oxygen, etc. its supply is unlimited, and thus PES is = infinity. The resource is in abundance so there is no need to ration it and a profit can be made at any given price, so supply will be infinity.
56
What is meant by unitary elastic?
Unitary elastic – means a change in price is the same as a change in supply. PES = 1. This will most likely occur for man-made resources that don't take a lot of manufacturing time and have a relatively low cost of production. like plastic zip lock bags, etc.
57
what is the difference between short-run and long-run supply?
in the short run at least one factor of production is fixed. for example, most rent contracts are 6 months long.
in the long-run all factors of production are variable factors. this is known as the planning stage of production.
58
What are the factors that determine PES?
number of firms - a monopoly will want to purposely limit supply in the economy to maximise their supernormal profit from this increase in higher prices. thus if there's few firms in the market, PES will be more inelastic. However if there's many firms in the market, then they will all want to compete with one another to increase their market share, and thus a greater willingness to find the means to supply more quicker.
time lags - a products PES will depend on the time each stages of production take for the firm, before it is ready for consumption. This will be effected by the abundance of natural resources (and whether it'll take much time to extract such resources) how long the manufacturing process is (is it a complex process, can a machine be used to fasten up the process, etc) and shipping times - does the firm off shore stages of their production? This will all effect how quickly the firm can respond to a change in price.
legislation - there's maybe legal barriers to immediately increasing supply for a firm that they must meet first. for example, planning permission, pollution permits, etc. the decision stage in which permission is debated over, will make PES more inelastic if it takes longer. Equally the government may just say no, this will also limit the amount of supply in the economy to only a few firms that have been given permission in the past.
spare capacity - if there is spare capacity in the economy, and some resources or factors of production are set idle, then firms can increase their supply more easily. However if resources are already close to full employment in the economy, then firms will struggle to find the factors of production necessary to produce more than what they currently are.
Storage - if a firm can produce more when costs are lower and then be able to store the good somewhere for later consumption, then PES will be more elastic as the firm already has goods that have already been through all of its manufacturing stages, and are ready for consumption.
59
How do market forces eliminate excess demand and excess supply?
When there is excess supply or excess demand, the market is not operating at equilibrium.
If there is excess demand in the economy, this means too much money is chasing too few goods.
1) The price mechanism will signal to firms that they need to produce more, due to the profit there is to be made. This is why the supply curve is upwards sloping as the higher the price, the more firms are willing to supply.
2) The price mechanism will also ration the good by raising the price. This means less demand will now be demanded by consumers as less people are willing to pay this higher price. This explains why the demand curve is downwards sloping, as demand falls as price increases.
^Thus a contraction in demand will occur and an expansion in supply. *dram diagram*
if there is excess supply in the economy, this means there is not enough consumers demanding the amount of supply present in the economy.
1) the price mechanism will signal to firms that they need to supply less, and some firms may leave the market. This is because there is not as much profit to be made, and therefore little incentive to carry on producing.
2)The price mechanism will also lower the price to act as an incentive to consumers to consume more. This explains why the demand curve is downwards sloping, as when price falls demand increases.
^Thus there will be an expansion in demand and a contraction in supply.
Both result in returning the market to market equilibrium ,where demand = supply. This is allocative efficient.
60
what are the functions of the price mechanism?
The 3 functions of the price mechanism:
Rationing – due to finite resources and infinite wants, the price of a good determines its allocation as it is rationed based on who is willing to pay the price. If a good is scarce the price will go up, whereas if a good is in abundance the price will fall.
Signalling – price provides information to producer on where resources are needed to meet demand. Price reflects market conditions and therefore act as a signal to producers to produce more if price is especially high. Equally a low price will act as a signal to consumers that they should consume it now as the opportunity cost is lower for them - it will be a lower proportion of their income.
Incentive- price acts as an incentive for both buyers and consumers. A lower price has a much smaller opportunity cost for consumer so there is a higher incentive to buy it. Higher prices also indicate to producers to re-allocate resources to more profitable areas of production. It will also incentivise new firms to enter the market.
61
what is meant by consumer and producer surplus? *show on a graph*
Consumer surplus – the difference between the amount the consumer was willing to pay, vs how much they actually paid.
Producer surplus – the difference between the amount the producer was willing to sell for, vs how much they actually sold for.
^On a supply and demand graph, the top part is the consumer surplus and the bottom half is the producer surplus.
When the market is at equilibrium the producer and consumer surplus are maximised.
62
how do changes in supply and demand effect consumer and producer surplus?
increase supply - both consumer and producer surplus increase *dram diagram*
increase in demand - both the consumer and producer surplus increase *draw diagram*
decrease in supply - leads to both a decrease for producer and consumer
decrease in demand 0 leads to both a decrease for consumer vs producer
63
what is an indirect tax? *draw diagram*
An indirect tax is a tax paid on expenditure. It is a regressive tax as it doesn't take into consideration income. It is indirect in nature as you only pay it if you consumer something. Indirect taxes are typically used on demerit goods to discourage consumption, by raising the price for consumers and cost of production for producers. Equally, indirect tax has been removed on goods that provide a lot of utility - for example there is no VAT on nappies in the Uk.
There are two types of indirect tax:
1) specific tax - a fixed rate regardless of the items value. For example: the sugar tax. *draw diagram*
2) ad volerm tax - is a value added tax (percentage tax). the tax paid will increase as the value of the good increases. *draw diagram*
^equilibrium was at P1.
The price the consumer pays has risen to P2. However the price the producer receives has fallen to P3. The governments tax revenue is the area of consumer and producer surplus combined. The quantity demanded in the market has decreased, which may force firms to shut down.
64
how does PED effect the incidence of tax?
As the firm is aiming to profit maximise, they will pass on as much of this indirect tax onto the consumers as possible, in order to preserve profit margins. The amount they pass onto consumers depends on the PED of the product.
^If demand is relatively elastic, then the producer will absorb most of the burden of the tax as they know a rise in price will lead to a larger fall in demand. For example: the sugar tax -> the demand for chocolate is relatively elastic and therefore the producers decided to absorb most of this extra cost of production. This will eat into their profit margin, and thus reduce their producer surplus. Whereas consumer surplus has increased.
^if demand is relatively inelastic, then the producer knows they can pass on a higher amount of tax onto the consumer as this rise in price will be larger than the fall in demand. By passing on the tax to the consumer, this will reduce their cost of production and thus preserve their profit margins. For example: tobacco tax on cigarettes -> as cigarettes are addictive by nature of the nicotine present in them. therefore, those that are addicted, have a distorted version of the true utility such purchase will give them. Consumer surplus therefore decreases.
65
what is a subsidy? *draw diagram*
A subsidy is an amount of money given to a producer in order to increase supply.
This reduces the marginal cost of supply for a producer, and therefore they will produce more. As there is more quantity out in the market, the price mechanism will pull the price down. Subsidies are usually given on merit goods, as these are goods currently under produced and thus consumed in the market. Therefore the government will want to intervene to increase the incentive to supply.
*draw diagram*
^the amount the producer has received has increased from Pe to P2. The amount the consumer has to pay has decreased from Pe to P1.
^consumer incidence is below equilibrium and producer incidence is above equilibrium.
66
how does PED effect the incidence of a subsidy?
As firms aim to profit maximise, they will keep as much of the subsidy as possible, in order to reduce their cost of production. The amount they keep is determined by the PED of the product.
The impact of the subsidy depends on the PED. Goods that are inelastically demanded will see only a slight increase in quantity and a larger fall in price.
Goods that are elastically demanded will see a larger increase in quantity supplied than a decrease in price.
67
What are the 3 main reasons why consumers may not behave rationally?
classical economics assumes that consumers and producers behave rationally. This therefore assumes that consumers aim to maximise utility, and producers aim to maximise profit, and this results in an equilibrium. The theory therefore assumes that consumers will always rationalise an economic decision and assess its utility and associated opportunity cost.
However behavioural economics recognises the vast amount of economic decisions each economic agent must make everyday. This results in finding other, faster ways in making an economic decision that doesn't involve as much head spaced to achieve.
^influence by others behaviour
^habitual behaviour
^weakness at computation
68
what is meant by economic agents being influenced by others?
influence from the media, celebrity endorsement, friends and family, etc will influence what goods we buy, as we have an inflated sense of it's true utility. We believe it may make us more popular, or allow us to fit in better - a form of utility that the classical economist would not consider. However, this creates an emotional economic decision, rather than a rational one. In reality, the money we spend on such good may have a large opportunity cost present, that we haven't fully rationalised as we are placing faith in advertisement or word of mouth over own rational decision.
^companies recognise that behavioural economics works, and therefore play on our psychology in order to make sales. this is shown most clearly with brand advertisement and brand loyalty. Nike has created an inflated version of reality of the true utility we would gain from spending £100 on some trainers.
69
what is meant by economic agents using habitual behaviours to make economic decisions?
Consumers must make many economic decisions everyday, and this process would be a lot more complex and tiresome if we rationalised through every purchases utility and opportunity cost. in reality, as incomes have grown and standards of living have improved - we buy a lot more than we once did, and thus do not have the time (nor effort) to rationalise over a bag of sweets, for example.
Therefore habitual behaviour can be used as a tool to make sure we still buy the goods we need, without having to spend a lot of time thinking about it. We may use a rule of thumb to make a decision instead - these are general rules of guidance that allow us to make a decision. Consumers use information from the past, which may be outdated, as they habitually purchase the same products.
This shows convenience being prioritised over utility -> consumers use ifnormation from the past that maybe outdated in order to keep on making the same purchase, although other better quality options may exist instead. Sellers recognise habitual patterns and exploit them. for example, products placed at the checkout till to benefit from impulse purchasing (chewing gum).
70
what is meant by economic agents weakness at computation?
As competition in the market has increased, there are now a wider range of options for all consumers than there once were before. Consumers must therefore narrow down these options and make a decision that suits them best.
However, it is hard to fully rationalise when there is so much ifnormation about so many different products to reason over. We may do a little more research into more expensive purchases (like a washing machine) but not necessarily research and gather ifnormation over the different packets of biscuits.
This problem is exacerbated by sellers making it harder for consumers to compute. Products the seller wants to sell are often placed at eye level where computation is easy. Many products that would deliver higher benefits are placed below knee level or high on the shelf where computation is hard.
71
what is meant by market failure, and what are the 3 types?
in the free market, the price mechanism allocates resources through the laws of supply and demand. Although this is often an efficient allocation of resources on face value, it only takes into consideration the direct economic agents involved and therefore fails to allocate in society's overall interest, resulting in market failure. This therefore results in an over-provision or under-provision of a certain good, that the free market will not be able to clear through the price mechanism alone.
1. externalities
2. provision of public goods
3. information gaps
72
what is an externality?
Externalities – is an indirect cost / benefit to a third-party economic agent. That wasn't directly involved in the economic transaction.
73
what is the external cost of production? *draw externality of production diagram*
The external cost of production - when producing a good has a negative effect on a third party
Occurs when the social cost of production is greater than the private cost of production. The social cost is the private cost + external cost. The market is therefore failing as there is an over provision of these goods, as only the private costs are taken into consideration. If the external costs were taken into consideration, then the price would be higher and therefore the quantity demanded would decrease. The factors of production used to manufacture this over provision of goods represents a net welfare loss in the economy, and therefore a miss allocation of resources. The private cost therefore fails to capture the full cost.
Examples of negative externalities from production: pollution from a factory, fertilisers on crops, deforestation, microplastics, light/noise pollution, traffic congestion.
74
what is the external benefit of consumption?
*draw diagram*
The external benefit of consumption - when consuming a good it has a positive effect on a third party.
Because there is benefit from your consumption, the SMB is larger than the PMB. These goods are therefore merit goods – where consumption creates a positive not affect not only for the consumer, but others as well. The market is therefore failing as there is an under provision of these goods, as only the private benefit is taken into consideration by the price mechanism. If external benefits were taken into consideration, the quantity supplied would be larger. Factors of production could therefore be better allocated to produce this good instead, and therefore a misallocation of resources. The perceived private benefit therefore doesn't accurately capture the full amount of utility gained from consuming such good.
Examples of positive externality from consumption: vaccinations, healthy eating, exercise, etc.
75
what is a public good, and why does the free market under provide it?
market failure therefore occurs as the free market will under provide such good, or even not provide it at all. These goods are not provided by the market for two reasons: they are non-excludable and non-rivalrous.
Non-excludable: benefits gained from this good cannot be limited to the person that paid for them. This creates the free rider problem, as individuals have the incentive to use the good without paying for it, as they know it will have to eventually be supplied by someone else – this is usually the government. For example: a park.
Non-rivalrous: the good cannot be used up. By one person using it, it does not limit anyone else's ability to also use it in the future. There is no incentive to pay for the good as they can consume it without paying for it, and no one else loses out in the process. For example: Wi-Fi, once bought, anyone can use.
^A pure public good is one that has both characteristics – for example, the light emitted from a lamp post is a pure public good. They are therefore under provided by private firms, as they cannot limit who benefits from it, and therefore it is hard to make a profit as consumers will just wait until someone else buys it instead. As firms have no way of charging people for the consumption of such good, they will stop investing in its production as they will never be able to capture its full value. Therefore, the issue of public goods is that they are socially desirable but not economically viabl
76
what is the evaluation to the provision of public goods in the free market?
However, although classical economists assume the free market will not supply such good, behavioural economics suggests that individuals may have motivations other than money. People may volunteer to contribute towards the upkeep of a public good, or make donations, etc instead – out of civic pride/duty or gratitude for its maintenance. For example, donations made to the national trust. Therefore, although it maybe the “rational” decision to avoid paying, this doesn't always take place in the real world.
77
what is meant by asymmetric information, and how does it lead to market failure?
Asymmetric information – where one party has more information than the other in an economic transaction. This can be the buyer, or the seller. For example, the seller of a second-hand car will know a lot more than the buyer will about the true nature of the car. Whereas the collector of cards will know more about a rare card that someone is selling who isn't that into cards. The problem here is that the seller and buyer do not necessarily have the same interests during an economic transaction, and therefore may withhold information from one another to better achieve their own aims – either utility or profit.
^asymmetric information may occur for multiple different reasons. For example,
Persuasive advertisement / exaggeration – persuasive advertisement may exacerbate the real utility gained from its product. For example, an orange juice carton stating on the front it is “packed with vitamin C”. Yet all orange juice has vitamin C in. Customers may however buy the more expensive carton of juice that explicitly says it has more benefits, despite all of the cartons holding the same utility.
Failure to disclose all information – in many different economic transactions, the seller ay fail to disclose full information to the buyer. For example, insurance and pensions are quite hard and time consuming to understand. People will usually have loyalties to a certain bank who they trust have the correct information and are acting with integrity when advising them on certain financial decisions. However, many people use a financial advsior to combat this issue. There has also been legislation in recent years to make sure such products cannot be sold with a bias, like insurance on a new phone, etc.
Asymmetric information present in the market leads to consumers either over consuming or under consuming a product / good. For example, producers knew long before health adverts that smoking was bad for you. However, it was advertised to reduce stress, etc. If consumers had the same level of information, demand would be lower.
78
what is the evaluation to asymmetric information leading to market failure?
However, the creation of the internet has made the problem of asymmetric information much better than what it once before. Now a customer can search up competing prices, the quality, etc of certain goods on sale. However, this doesn't apply when we consider the lack of information around factors that are not as black and white – like the number of related externalities something may create, etc.
79
why may the government intervene in the market?
The government will intervene in the market to try and solve market failure. In the market there is a less than optimal allocation of resources for societies overall benefit. The government may therefore intervene by either discouraging consumption (demand) or restricting supply. This can be achieved through market-based policies or interventionist supply-side policies (more direct). Usually, multiple different forms of intervention are needed to successfully achieve the governments aims.
80
what are the 3 main types of government intervention?
1. indirect tax
2. subsidies
3. maximum and minimum prices
81
what are the 3 other types of government intervention?
1. trade pollution permits
2. state provision of public goods
3. provision of information
82
how may indirect tax be used as a form of government intervention in the market?
An indirect tax is a tax on consumption. The government may put an indirect tax on demerit goods to raise the price of them and discourage consumption. A tax will also mean a raise in revenue for the government which they can utilise to tackle to demerit good at a different angle also. Taxation can be used to tackle externalities or demerit goods – a demerit good is a good that is bad for the person consuming it, like cigarettes. The government will intervene to internalise the negative externality.
There are two types of indirect taxes: ad volerm and specific tax.
83
what is an ad volerm indirect tax *draw diagram* and what is the evaluation to its effectiveness?
Ad valorem tax – is a percentage tax. Therefore, if the good is more expensive, then the tax collected will also be more expensive. This type of tax therefore collects a proportionality higher amount of revenue on more expensive goods.
*diagram*
^the final price is higher, and the quantity supplied is lower.
However, many different factors must be considered when placing a tax on a good. For example, the tax must be large enough that it successfully tackles the externality by raising the private cost to the same as the social cost. This is known as a “Pigouvian tax”.
Equally, the government must not want unexpected consequences to occur. For example, placing a tax on alcohol to discourage the consumption of it. Yet this may just mean consumers turn to cheaper versions of the same thing they were consuming – like buying the supermarkets brand of beer rather than a well-established brand. This cheaper beer may have more sweeteners and fats in, causing a different type of externality – a strain on the NHS from different health related problems, like diabetes, etc.
84
what is a specific tax *draw diagram*, and what is the evaluation to its effectiveness?
Specific tax – a fixed amount of tax per unit. This tax has a bigger effect at reducing demand overall on relatively cheaper products. For example, the sugar tax.
*draw diagram*
^the price has risen, and the quantity supplied has fallen. If the demand for the demerit good is inelastic, then the consumer will pay a higher burden of the tax than the producer. producers know that the good/service they sell is price inelastic and therefore they know that they are able to increase their prices without suffering from a large decrease in quantity. If the demand for the good is elastic (like the demand for sweets) then the producer will pay more of the tax than the consumer, which will decrease supply be a lot – as it is now less profitable. This is because firms know that a small increase in price will reduce quantity demanded massively.
Evaluation: How specific taxes are more likely to be regressive taxes. This takes a higher percentage of tax revenue from those on lower incomes. As income increases, less of your income (percentage wise) is taken by this tax. However, this isn't always a bad thing. People in the lower income bracket have a higher propensity to gamble. The gambling tax makes sure that they will have to pay a higher percentage of their income on gambling if they wanted to still consume it. Therefore, if the Government is aware of these differences in MPC across different pay brackets, they be successful at tackling the demographic that consumes the most gambling.
Evaluation: However, this may just lead to tax avoidance. For example, when the government introduced the landfill tax to tackle negative externalities of waste, this just led to more illegal dumping of waste in fields, rivers, etc. This is an example of the free rider problem – firms will find a way to not pay for it themselves, yet get others to pay instead, as they know the government will have to eventually go and collect all this waste themselves.
Evaluation: Demand for demerit goods may also be inelastic if it is an addictive substance. For example, the addictive nature of cigarettes due to the nicotine. Therefore, consumers will be more willing to pay this higher price as they have an inflated idea of its real utility. Yet the government may use this higher revenue of tax generated to tackle to externality in a different way – like in forms of nudges. For example, there is an indirect tax on cigarettes, yet there are also nudges present – like they must be placed behind a counter, they must have photos of the effects of smoking on the packaging, etc. They may also supplement this with provision of information on the effects of smoking to your health. This has led to more people switching to e-cigarettes instead.
85
how is a subsidy used in the market to correct market failure? *draw diagram*
A subsidy is where the government pays for some of the cost of a good. This grant is given to producers to encourage production of a good, which will be passed onto the consumer in the form of lower prices. They may grant a subsidy to encourage the consumption of merit goods.
*draw diagram*
^^quantity supplied has increased and the price has fallen. some of the subsidy is kept by the firm thus increasing their profits and incentivising more firms to enter the market and those currently in the market to produce more. Some of the subsidy is also passed onto the consumer cuasing an increase in demand as prices are now lower.
Example of subsidy – the government introduced a subsidy to encourage residents to install a new, more energy efficient boiler. This will have associated benefits to the households (cheaper heating) and external social benefits, like less pollution, etc. The government also subsidies school meals in the Uk. This is to make sure children are fed with the right amount of nutrients needed for healthy growth and can work as productively in their lessons. This will have associated positive externalities – like a long term reduced strain on health services.
86
what is the evaluation to a subsidy's effectiveness in the market?
Evaluation: However, the guarantee of a subsidy may make the firm less efficient as they there is an element of moral hazard present. Producers know regardless of their output / efficiency, their costs will be subsidised by the government and they therefore do not need to worry as much about being competitive / having an edge on other producers. Producers therefore become subsidy dependent, and efficiency or even quality is reduced. Yet this has been solved in recent times by firms competing for a contract in order to produce this good. For example, catering firms must compete and present their menus, etc in order to sell foods to schools. This contract will then be renewed every 2 years, and checks will be made on their efficiency / quality.
Evaluation: However, this subsidy may become very expensive for the government – presenting an opportunity cost instead. It maybe cheaper to achieve the same result that a subsidy would by increasing the provision of information around the benefits of merit goods – like eating 5 fruits a day is now taught in primary schools.
87
how is maximum pricing used in the market to correct market failure? *draw diagram*
A maximum price is a legal limit that producers can charge for a certain good. They cannot charge above this price. This is to improve affordability of such good, especially to those on lower incomes. For example, there is an energy cap in the Uk – this limits how much a firm can charge. In times of inflation, there is an argument that price control could help to reduce inflation. For example, the government may state price can only go up by so much – this should hopefully reduce the full effects of inflation.
*draw diagram*
^The maximum price should be set below market equilibrium in order to reduce the price. However, this has consequently distorted market signals – there is now a surplus of demand. This means that now many customers won't be able to get the product at all.
88
what is the evaluation to using maximum pricing as a form of government intervention?
Evaluation: the market will become less profitable for firms. In the long-run this may lead to less investment and also decrease supply. For example, rent controls may be a way to deal with the short-term problem of expensive housing. However, by reducing rent this will discourage landlords from letting out property and may also discourage new firms from building new houses, as their rate of return is smaller. However, this may not necessarily be a bad thing if a maximum price is imposed on an industry with highly concentrated monopoly power. Firms with monopoly power can charge higher prices to consumers – prices that are higher than the marginal cost of production, and therefore higher than the price would be if the market was competitive. A maximum price can be a way of reducing monopoly prices and increase allocative efficiency.
Evaluation: creation of a black market. Because of the shortage, there will be the new incentive to buy the good at its low maximum price, and then resell it for higher for customers who are willing to pay. Therefore, some of the customers who have missed out due to the maximum price distorting market signals, will now be paying higher amounts than what they were before. However, this seems to be dependent on how good the police force is within the country creating this maximum price. If the police force is well equipped and responsive, then it is unlikely this will cause that big of an issue.
89
how are minimum pricing used to correct market failure? *draw diagram*
A minimum price is where there is a legal restriction on how low the price of a good can be. For example, there is a minimum price on alcohol to discourage binge drinking. It should hopefully discourage consumption by increasing the price.
*draw diagram*
^the minimum price is set above market equilibrium. Quantity supplied has now increased from Q1 to Q2 as there is more incentive by firms (from the higher price) to produce more – this is an example of distorted market forces. The government will have to buy this extra quantity supplied to make sure it doesn't find its way back onto the market. However, price has risen, which should hopefully discourage consumption.
90
what is the evaluation to using minimum prices in the market?
Evaluation: Demand for demerit goods may also be inelastic if it is an addictive substance. For example, the addictive nature of cigarettes due to the nicotine. Therefore, consumers will be more willing to pay this higher price as they have an inflated idea of its real utility. Yet the government may use this higher revenue of tax generated to tackle to externality in a different way – like in forms of nudges. For example, there is an indirect tax on cigarettes, yet there are also nudges present – like they must be placed behind a counter, they must have photos of the effects of smoking on the packaging, etc. They may also supplement this with provision of information on the effects of smoking to your health. This has led to more people switching to e-cigarettes instead.
However, it is important to realise how sometimes a minimum price is not always used to discourage the consumption of something. For example, the EU has a minimum price for agriculture – as it is argued that farmers' incomes are too low. Therefore, minimum prices have been imposed to increase farmers revenue and consequently income.
91
what is a trade pollution permit, and how is it used to solve market failure? *draw diagram*
Pollution permits are permits that give a company the legal right to pollute up to a certain amount. These are tradable permits – if a company feels like it is not going to use all of the permit it has been granted, it can sell it to other companies. yet if a company produces more pollution than they have been granted, they have to buy another permit from another company. The aim of a pollution permit is to nudge firms to find more environmentally friendly ways of production, so they will not have to pay for the permit to pollute. This will reduce the externality of production associated.
*draw diagram*
^diagram to show a fixed amount of supply, and demand moving up the supply.
Overtime the government should reduce the amount of pollution permits available for the scheme to be truly effective. This means companies know the price is due to increase at some point and gives them the time and incentive to innovate and find other more efficient means of production that don't pollute as much. Overtime, this should reduce the demand for pollution permits – as now firms have innovated and found new technology.
Pollution permits are a method to try and reduce output to a more socially efficient level. The aim is to make the price of pollution permits as close to the social marginal cost as possible.
92
what is the evaluation to using pollution permits as a form of government intervention?
Evaluation: information gaps maybe present - it is difficult to know how many pollution permits to give out. The government may be too generous or too tight with them. If they are too generous, this will not reduce the amount of pollution created from production. However, if the government are too tight, businesses may have to shut down as they cannot compete with other firms (who have innovated before them) - harming the economic growth. It is also hard to measure how much a firm is actually polluting. The firm may offshore parts of their production to another country in order to pollute more elsewhere, therefore avoiding their legal limit in the Uk.
Equally, it depends on how much the fine is in comparison to the cost of innovation. For example, Thames water has been fined many times by the environmental agency for pollution. yet this fine is smaller than the cost of innovation - thus there is not much incentive to innovate if the fine set for breaking your pollution permit limit is too low.
93
how is state provision of public goods as a way to tackle market failure?
including evaluation
market failure therefore occurs as the free market will under provide such good, or even not provide it at all. These goods are not provided by the market for two reasons: they are non-excludable and non-rivalrous.
Non-excludable: benefits gained from this good cannot be limited to the person that paid for them. This creates the free rider problem, as individuals have the incentive to use the good without paying for it, as they know it will have to eventually be supplied by someone else – this is usually the government. For example: a park.
Non-rivalrous: the good cannot be used up. By one person using it, it does not limit anyone else's ability to also use it in the future. There is no incentive to pay for the good as they can consume it without paying for it, and no one else loses out in the process. For example: Wi-Fi, once bought, anyone can use.
^A pure public good is one that has both characteristics – for example, the light emitted from a lamp post is a pure public good. They are therefore under provided by private firms, as they cannot limit who benefits from it, and therefore it is hard to make a profit as consumers will just wait until someone else buys it instead. As firms have no way of charging people for the consumption of such good, they will stop investing in its production as they will never be able to capture its full value. Therefore, the issue of public goods is that they are socially desirable but not economically viable.
The government will recognise the benefit gained from such public goods, and therefore supply them themselves. For example, councils pay for the street laps on our roads. This keeps society safe. The government may also provide security cameras in certain areas. This also keeps society safe as a deterrent of crime and as a means of evidence during a court hearing.
Evaluation: there may be an opportunity cost present here. Although you can't really deny the benefit of public goods, you could state that other priorities should've been met and paid for first. For example, maybe the government should focus on funding schools rather than public parks, etc.
94
how is provision of information a way of tackling market failure?
Market failure can occur when there is asymmetric information present in the market. The government may look to get rid of this by providing the information themselves – for example, the government funds the BBC. Asymmetric information present in the market leads to consumers either over consuming or under consuming a product / good. For example, producers knew long before health adverts that smoking was bad for you. However, it was advertised to reduce stress, etc. If consumers had the same level of information, demand would be lower.
The government has had multiple schemes to raise awareness on everyday information we should know. For example, the legal requirement to have photos of the consequence of smoking on the packaging of cigarettes. They also pay external bodies to come into schools to talk about safe sex. For example, all food must have the ingredients list on the packaging. Once people are given all the information necessary to make an informed decision, this should reduce the demand for demerit goods and increase the demand for merit goods over time.
95
how is regulation / legislation a way of tackling market failure?
The government has the authority to ban a good if they believe it to be in the national interest to do so. For example, Rishi Sunak's government will be banning e-cigarettes due to the amount of children consuming them.
However, the government should take into consideration unexpected consequences, or what substitutes people may turn to instead. For example, cigarette consumption may rise due to vapes being made illegal. This will have the reverse effect as to what was originally intended. However, this possible effect can be prevented through raising taxes on cigarettes to supplement the ban on e-cigarettes.
