Markets & Market Failure - Year 1 Microeconomics

Question 1

term

Answer 1

definition

Question 2

What are the advantages to information provision?

Answer 2

• Helps consumers act more rationally, causing market to work in favour society• Improved decision-making in markets• Can incentivise firms to produce, stimulating growth• Public health and safety (ie. effects of smoking)• Empowerment of consumers as there is less information asymmetry between parties

Question 3

What are the three major assumptions made in all (free-market) economic models?

Answer 3

1. Rational Decision-Making by Consumers: Assumes that consumers make choices that maximise their utility or satisfaction.2. Rational Decision-Making by Producers: Assumes that producers aim to maximise their profits.3. Rational Decision-Making by Government: Assumes that the govenment seeks to maximise social welfare.

Question 4

Define opportunity cost.

Answer 4

Opportunity cost refers to the value of the next best alternative forgone when a choice is made.

Question 5

Why may consumers not behave rationally?

Answer 5

Consumers may not behave rationally due to factors like limited information, cognitive biases, emotional influences, time constraints, social pressures, and individual preferences

Question 6

What are the four functions of money?

Answer 6

• Medium of Exchange: Money serves as a widely accepted means of payment, facilitating transactions by acting as a medium for exchanging goods and services.• Measure of Value: Money provides a standardized measure of the worth or value of goods, services, and assets, allowing for comparisons and pricing.• Store of Value: Money allows individuals to store and preserve wealth over time, maintaining its value for future use and preventing loss of purchasing power.• Standard of Deferred Payment: Money serves as a reference point for settling debts and fulfilling financial obligations at a later time, establishing a standard for credit transactions and contractual agreements.

Question 7

Why is there a positive association between price and quantity supplied?

Answer 7

The law of supply states that higher prices encourage production, leading to a higher quantity supplied, while lower prices disincentivize production, resulting in a lower quantity supplied.

Question 8

Define price elasticity of supply.

Answer 8

Price elasticity of supply is defined as the responsivess of quantity supplied following a change in price.PED = (Δ%Qs)/(Δ%P)

Question 9

Why is supply price inelastic in the short run?

Answer 9

Supply price is inelastic in the short run due to limited production capacity and constraints in adjusting inputs promptly.

Question 10

Provide an example of a good with a relatively elastic supply, and a good with a relatively inelastic supply.

Answer 10

• Elastic: Sports car• Inelastic: Housing in UK

Question 11

Two goods have a positive cross elasticity of demand, this means that they are…

Answer 11

Substitutes - a rise in price of good A leads to an increase in demand for good B)

Question 12

Explain the difference between partial and complete market failure.

Answer 12

Partial market failure occurs when the forces of supply and demand fail to efficicently allocate resources, while complete market failure refers to the total absence of goods or services provision by markets.

Question 13

Define social costs and benefits (MSC / MSB)

Answer 13

Social costs (MSC) refer to the total expenses or negative consequences borne by society as a whole due to an economic activity, including both private costs and external costs. MSC = MPC + MEC.Social benefits (MSB) are the overall advantages or positive outcomes received by society as a whole from an economic activity. MSB = MPB + MEB.

Question 14

What does it mean to internalise an externality?

Answer 14

To ensure that the costs or benefits associated with an economic activity are accounted for by the parties involved in the transaction, rather than being externalized towards society.

Question 15

Define demerit good with an example.

Answer 15

Demerit goods are goods or services that provide negative externalities of consumption (external costs to society, leading to social welfare loss), and are typically overprovided by the market, such as alcohol, which can lead to health issues, addiction, and social problems.

Question 16

What is meant by the ‘free rider problem’?

Answer 16

Where individuals benefit from a public good without contributing to its production or funding, taking advantage of the fact that the consumption of the good cannot be restricted.

Question 17

Why do ad valorem supply curves diverge from the original supply curve?

Answer 17

Tax imposed as a percentage of the product’s price increases the cost of production for suppliers, leading to a higher price required for suppliers to be willing to produce the same quantity, resulting in a diverging shift of the supply curve.

Question 18

Explain the concept of tradable pollution permits.

Answer 18

Tradable pollution permits are market-based instruments that set a limit on pollution and allow entities to buy, sell, or trade permits, incentivising pollution reduction and the efficient allocation of emissions.

Question 19

What are the disadvantages to state provision of public goods?

Answer 19

• Free-rider problem• Potential inefficiencies may arise as there is a lack of innovation and competition• Risk of monopoly power

Question 20

Define government failure.

Answer 20

When the costs of government intervention outweigh the benefits intended by the action, can lead to a misallocation of scarce resources.

Question 21

Define normative statement.

Answer 21

Subjective statements that contain value judgement, and can not be tested by empirical means.Eg. The government should increase minimum wage to improve the standard of living.

Question 22

Define value judgement.

Answer 22

This type of judgement cannot be tested. This judgement is based off that person’s opinion or values.

Question 23

Define positive statement.

Answer 23

Objective statements that can be tested by emprical means.Eg. The current unemployment rate is 5%

Question 24

Explain what is meant by the ‘basic economic problem’.

Answer 24

The basic economic problem states that there are infinite wants in society, but only a small and finite amount of scarce resources are available to satisfy those wants.

Question 25

Define ceteris paribus.

Answer 25

Assuming all other variables are equal. This helps economic assumptions as unlike hypothesis tests in natural sciences, it isn’t possible to keep an invariant control variable.

Question 26

State the four factors of production.

Answer 26

• Land: Natural resources used in the production of goods and services• Labour: Effort exerted by individuals in the production process, including the skills, abilities, and time they contribute• Capital: Goods that have the potential to generate additional goods or contribute to the production process, eg. machinery• Enterprise: Risk-taking abilities of individuals who manage business ventures and drive economic productivity.

Question 27

What is the difference between the long-run and the short-run in economics?

Answer 27

The short run refers to a period of time during which at least one factor of production is fixed, while the long run represents a timeframe in which all of the factors of production can be adjusted or varied.

Question 28

What are the drawbacks to the three major assumptions made about consumers, producers and the government?

Answer 28

They include unrealistic assumptions, information limitations, behavioral biases, external factors, and the dynamic nature of real-world conditions - such as • Behavioural biases in consumer behaviour• Non-profit and charitable organisations.• Corrupted governments and politicians.

Question 29

Explain the difference in economic ideologies between Adam Smith, Karl Marx and Friedrich Hayek regarding the efficient allocation of scarce resources.

Answer 29

Adam Smith advocated for free markets and the invisible hand, Marx supported central planning and collective ownership, while Hayek emphasized decentralized decision-making and market competition as means to efficiently allocate scarce resources.

Question 30

What economic concepts does the Production Possibilities Frontier display?

Answer 30

• Opportunity cost: Favouring the production of one good has an opportunity cost of not being able to produce as much of another good• Scarcity: Downward slope of the PPF, indicating limited resources compared to the potential production of goods or services, necessitating trade-offs in resource allocation.• Allocative efficiency

Question 31

Why is it not possible to produce beyond the PPF curve?

Answer 31

The PPF represents the maximum potential output given the available resources, technology, and production efficiency, indicating the limits a firm, or economy’s maximum productive capacity

Question 32

How is it possible to shift a PPF curve outwards?

Answer 32

Advancements in technology, increase in availability of resources, increased investment into capital goods.

Question 33

What is a command economy, provide one advantage and disadvantage.

Answer 33

A command economy is an economic system in which the government owns all of the factors of production.• Advantage: Maximum welfare, low unemployment and minimal income inequality• Disadvantage: Lack of innovation, risk-taking and efficiency (no incentive for profits)

Question 34

What is a free-market economy, provide one advantage and disadvantage.

Answer 34

A free-market economic is an economic system in which there is no government intervention in the production of goods and services, allowing only the forces of supply and demand to allocate resources.• Advantage: Greater allocative efficiency since firmshave the incentive to produce goods in the most efficient way• Disadvantage: Monopolies may emerge as a result of no government intervention

Question 35

What is meant by specialisation and division of labour?

Answer 35

Specialization refers to the focus of individuals, firms, or regions on specific tasks while division of labor involves breaking down the production process into separate tasks performed by different individuals to increase efficiency and productivity.

Question 36

Who founded the idea of the specialisation and division of labour?

Answer 36

Adam Smith founded the ideology of specialisation and division of labour.

Question 37

Provide two advantages and two disadvantages to the specialisation and division of labour.

Answer 37

• Advantage: Lower unit costs as workers become more skilled at their jobs –> Internal economies of scale• Advantage: Increased efficiency and greater productivity• Disadvantage: Boredem due to repetitiveness can cause a decline in productivity• Disadvantage: Dependency on others areas of production - if one part of process is disrupted, this can lead to a fail in the supply chain.

Question 38

Define market demand.

Answer 38

The quantity of a good or service that consumers are willing and able to purchase at a given price level.

Question 39

Explain what is meant by the law of diminishing marginal utility.

Answer 39

The law of diminishing marginal utility states that as the consumption of a good or service increases, the additional satisfaction or benefit derived from each additional unit gradually decreases.

Question 40

Explain what is meant by a derived demand, with an example?

Answer 40

Derived demand refers to the demand for a good or service that arises from the demand for another good or service, typically linked in the production process or as complementary goods.Eg. Steel demand in the construction industry is derived from the demand for new buildings and infrastructure projects

Question 41

Explain what is meant by a composite demand, with an example?

Answer 41

Composite demand refers to a situation where a good or resource is demanded for multiple uses or purposes, making it challenging to allocate resources effectively between different uses. Eg. Sugar is demanded by both the food industry, and the beverage industry.

Question 42

What are the shifters of demand?

Answer 42

• Population: Higher population, moredemand• Incomes: Higher incomes, more demand• Related goods: Price of compliments and substitutes• Advertisements: Increase in brand loyalty, more demand• Tastes: If preferences shift toward product, more demand• Expectation: Speculation on future price changes• Season: Dependent on time of year

Question 43

Why is there an inverse association between price and quantity demanded?

Answer 43

The law of demand states that higher prices discourage consumption, leading to a lower quantity demanded, while lower prices incentivize consumption, resulting in a higher quantity demanded.

Question 44

Outline three factors that affect the price elasticity of demand.

Answer 44

• Availability of susbsititutes: Lots of substitutes = Elastic demand• Percentage of income spent on good: Large proportion = Elastic, Small proportion = Inelastic• Necessity: Addictive = Highly inelastic

Question 45

Define price elasticity of demand.

Answer 45

Price elasticity of supply is defined as the responsivess of quantity demanded following a change in price.PED = (Δ%Qd)/(Δ%P)

Question 46

What is the impact on total revenue if the price of a good who’s PED is inelastic is increased?

Answer 46

Total revenue will increase, as the decrease in quantity demanded is proportionately smaller than the increase in price.

Question 47

What is the impact on total revenue if the price of a good who’s PED is elastic is increased?

Answer 47

Total revenue will decrease, as the decrease in quantity demanded is proportionately larger than the increase in price.

Question 48

Provide an example of a good with a relatively elastic demand, and a good with a relatively inelastic demand.

Answer 48

• Elastic: Clothing• Inelastic: Petrol

Question 49

Define market supply.

Answer 49

The quantity of a good or service that suppliers are willing and able to produce at a given price level.

Question 50

What are the shifters of supply

Answer 50

• Productivity: Higher productivity, more supply• Indirect taxes: More taxes = Lower costs of production, more supply• Number of firms in industry: More firms, more supply• Technological advancements: Better technology, more supply• Subsidies: More subsidies, more supply• Weather: (only applicable for agriculture and housing industry). Better weather = more supply• Costs of production: Lower costs of production = more supply

Question 51

Explain what is meant by a joint supply?

Answer 51

Joint supply refers to a situation in which the production of one good results in the simultaneous production or availability of another good as a byproduct

Question 52

Outline three factors that affect the price elasticity of supply.

Answer 52

• Availability of resources: Greater availability, more elastic• Production time lag: Low time lag, more elastic• Mobility of factors of production: More mobile factors, more elastic

Question 53

Define income elasticity of demand.

Answer 53

The responsiveness of demand to a change in income.YED = (Δ%Qd)/(Δ%Y)

Question 54

What is a normal good, and why is their income elasticity of demand positive?

Answer 54

A normal good is a good whose demand increases as incomes rise. This means their YED = +/+ = Positive.

Question 55

Provide an example of a normal good.

Answer 55

Clothing.

Question 56

What is a luxury good?

Answer 56

A good which is not essential for survival, such as a sports car, and its YED > 1.

Question 57

Provide an example of an inferior good.

Answer 57

Off-brand food products.

Question 58

What is an inferior good, and why is their income elasticity of demand negative?

Answer 58

An inferior good is a good whose demand falls as incomes rise. This means their YED = -/+ = Negative.

Question 59

Define cross elasticity of demand.

Answer 59

The responsiveness in the quantity demanded of good A following a change in price of good BXED = (Δ%Qd(A))/(Δ%P(B))

Question 60

Two goods have a negative cross elasticity of demand, this means that they are…

Answer 60

Complements - a rise in price of good A leads to a decrease in demand for good B)

Question 61

Explain Adam Smith’s theory of the invisible hand.

Answer 61

Describes the unseen forces of self-interest that impact the free market for the most optimal level of resource allocation.

Question 62

Explain the functions of the free-market price mechanism.

Answer 62

1. Signals to producers that prices are too high/low22. Incentivises producers to increase/decrease prices3. Rations excess supply and demand4. Allocation of scarce resources

Question 63

Explain how the price mechanism reduces excess demand.

Answer 63

1. Excess queueing, waiting lists and competition between buyers to purchase good (Signal is sent to producers that prices are too low)2. Higher price and make more revenue and profit (Incentive sent to producers)3. Extension in supply, contraction in demand - market has re-established equilibrium (Excess demand is rationed away)4. Resources reallocated at the free-market equilibrium, where there is no excess supply or demand.

Question 64

Explain how the price mechanism reduces excess supply.

Answer 64

1. Excess unsold stocks on shelves (Signal is sent to producers that prices are too high)2. Lower price and make more revenue and profit (Incentive sent to producers)3. Contraction in supply, extension in demand - market has re-established equilibrium (Excess supply is rationed between consumers)4. Resources reallocated at the free-market equilibrium, where there is no excess supply or demand.

Question 65

Define consumer surplus.

Answer 65

The difference between the price that consumers are willing and able to pay, and the price they actually pay.

Question 66

Define producer surplus.

Answer 66

The difference between the price at which producers are willing and able to sell a good or service and the price they actually receive.

Question 67

Define externality.

Answer 67

An externality occurs when the production or consumption of a good or service has unintended consequences on a third party for which no compensation or payment is made in the market

Question 68

Define external costs and benefits. (MEC / MEB)

Answer 68

External costs (MEC) are negative consequences or expenses imposed on society due to an economic activity, with the responsible party not bearing the full cost. External benefits (MEB) are positive effects or advantages experienced by others or society from an economic activity, with the responsible party not providing the full benefit.

Question 69

Define private costs and benefits (MPC / MPB)

Answer 69

Private costs (MPC) are the expenses that a person or firm pays in order to buy, or produce goods and servicesPrivate benefits (MPB) are the benefit derived by an individual or firm directly involved in a transaction as either buyer or seller

Question 70

Define merit good with an example.

Answer 70

Merit goods are goods or services that provide positive externalities of consumption (external benefits to society, leading to social welfare gain), and are often underprovided by the free-market, such as the National Health Service (NHS) in the UK, which provides essential healthcare services to the population.

Question 71

Why is the social-optimal level of output not equal to the free-market equilibrium for all merit and demerit goods and services?

Answer 71

The free-market does not consider the full social costs or benefits of merit and demerit goods. Positive externalities of merit goods are underproduced due to undervaluation, while negative externalities of demerit goods result in overproduction. Government intervention is necessary to align market outcomes with the socially optimal level of output.

Question 72

What is the triangle of deadweight loss / net social welfare loss?

Answer 72

The triangle of net social welfare loss represents the inefficiency and loss of overall societal welfare when the quantity of a good or service produced and consumed deviates from the socially optimal level due to externalities.

Question 73

Which direction does the triangle of net social welfare loss point towards.

Answer 73

The social optimum level of output, where MSC = MSB.

Question 74

Define public good with an example.

Answer 74

A public good is a good or service that is non-excludable and non-rivalrous, meaning that its use by one individual does not diminish its availability to others. An example of a public good is street lighting, as it benefits the entire community and cannot be easily restricted or used up by one person’s consumption.

Question 75

Define quasi-public good.

Answer 75

A good or service that possesses characteristics of both public and private goods, exhibiting partial rivalry or partial excludability.

Question 76

Define information failure.

Answer 76

Where one, or both parties of a transaction possesses incomplete, inaccurate, or asymmetric information, leading to suboptimal decision-making and market inefficiencies.

Question 77

What is meant by asymmetric information.

Answer 77

Where one party in an economic transaction has more information or knowledge than the other party, creating an imbalance in the information available.

Question 78

Define government intervention.

Answer 78

Government intervention refers to the actions taken by the government to regulate economic activities in order to correct market failures

Question 79

Define indirect tax.

Answer 79

A tax levied on spending rather than directly on income, profit or commission, typically imposed at the point of production, sale, or consumption

Question 80

What is the difference between ad valorem and excise duty, give 3 examples of each.

Answer 80

An Ad valorem tax is a tax levied as a percentage of the price of the good or service, while excise duty is a set amount of tax imposed on goods and services.

Question 81

What are the advantages to indirect tax intervention?

Answer 81

• Generates fiscal dividends for the government which can be reinvested into public infrastructure and development• Market failure corrected as the external cost of negative externalities is internalised• Behaviour changes can be made if indirect taxes are imposed, discourage consumption of demerit goods.

Question 82

What are the disadvantages to indirect tax intervention?

Answer 82

• Regressive impact on those on lower incomes• May encourage black-market activity• Can cause cost-push inflation

Question 83

Why are indirect taxes considered to be regressive?

Answer 83

They tend to impose a proportionately higher burden on lower-income individuals or households compared to higher-income individuals, as the tax burden represents a larger share of their income.

Question 84

How do you determine the distribution of tax burden between consumers and producers on a supply and demand analysis?

Answer 84

Top rectangle represents incidence of indirext taxation on consumers. If demand is inelastic, burden of tax will fall mainly on consumers.Bottom rectangle represents incidence of indirext taxation on producers. If demand is elastic, burden of tax will fall mainly on producers.

Question 85

Evaluative statements for effectiveness of indirect tax intervention.

Answer 85

• Magnitude of the tax (hard to determine)• Price elasticity of demand/supply• Workers may lose their jobs, firms may shut down or migrate to a different nation• Consumers may switch to untaxed substitutes• Black markets can reduce the total tax revenue

Question 86

Define subsidy.

Answer 86

A government grant to firms producing merit goods, which aims to reduce production costs and encourages an increase in output.

Question 87

What are the advantages to subsidy intervention?

Answer 87

• Market failure corrected, level of production increased to match social optimum.• Can incentivise research and development• Has the potential to create job opportunities

Question 88

What are the disadvantages to subsidy intervention?

Answer 88

• Can pose as a budgetary burden on the government• Firms may become overly dependent on the subsidy• Can discourage innovation and efficiency

Question 89

How do you determine the distribution of subsidy benefit between consumers and producers on a supply and demand analysis?

Answer 89

Top rectangle represents benefit of subsidy on producers. If demand is inelastic, benefit of subsidy will fall mainly on consumers.Bottom rectangle represents benefits of subsidy on consumers. If demand is elastic, benefit of subsidy will fall mainly on producers.

Question 90

Evaluative statements for effectiveness of subsidy intervention.

Answer 90

• Magnitude of the subsidy (hard to determine)• Price elasticity of demand/supply• Opportunity cost - can the money be better used elsewhere• Dependence/reliance on subsidy• Producers may not pass down the benefit of the subsidy

Question 91

What are the advantages to tradable pollution permits?

Answer 91

• Government gains revenue from selling permits and fining firms who exceed their pollution quotas• Incentivises investment into greener technology (economic sustainability)• Guaranteed that pollution will fall because supply of limits is perfectly inelastic

Question 92

What are the disadvantages to tradable pollution permits?

Answer 92

• Can be costly to monitor (government failure if costs are greater than benefits)• Difficult to determine how many tradable permits should be sold• Raises costs for firms, causing higher prices for consumers

Question 93

What are the advantages to maximum and minimum prices?

Answer 93

• Protects markets from externalities • Maximum prices can protect consumers from price exploitation by ensuring that essential goods remain affordable• Minimum prices ensure that producers receive a fair return on their investments• Reduced market price volatility

Question 94

What are the disadvantages to maximum and minimum prices?

Answer 94

• Distortion to price signals and causes excess supply or excess demand• Difficult to determine where to set prices• Can lead to the creation of black markets

Question 95

What are the advantages to market regulation?

Answer 95

• Consumer protection from exploitation and fraud• Regulation policy prevents monopolistic competition• Can achieve public interest and social objectives by addressing externalitise and other sources of market failure

Question 96

What are the disadvantages to market regulation?

Answer 96

• Monitoring firms for the compliance of passed regulation and laws can be costly - fiscal opportunity cost• Excessive regulation can reduce competition and allocative efficiency in markets by increasing bureaucracy and reducing innovation• Costs may be passed onto consumers in the form of higher prices

Question 97

What are the advantages to state provision of public goods?

Answer 97

• Market failures such as non-excludability and non-rivalry corrected as the free-market is not willing to provide public goods• Reduces inequality and improves standards of living• Ensures the stability and security of a nation (ie. nuclear defense system)

Question 98

What are the disadvantages to information provision?

Answer 98

• Can be costly to enforce information provision• The government may not possess perfect information themselves• Consumers may behave irrationally, or follow behavioural and cultural biases instead

Question 99

Define government bureaucracy.

Answer 99

Government bureaucracy refers to the administrative officials within a government that are responsible for implementing policies, regulations, and public services.

Question 100

Define regulatory capture.

Answer 100

Regulatory capture refers to a form of political corruption in which regulatory agencies, tasked with protecting public interest, become influenced or controlled by the industries or entities they are supposed to regulate, leading to biased or ineffective regulation.

Question 101

Why may government failure occur?

Answer 101

1. Imperfect information2. Red tape effect3. Costs of regulating and monitoring4. Costs of administrating5. Regulatory capture6. Time lags from time of intervention to time of effect

Question 102

Provide 3 examples of government failure by unintended consequences.

Answer 102

1. Minimum wage laws intended to improve workers’ welfare may lead to job losses and reduced employment opportunities, particularly for low-skilled workers.2. Price controls imposed to make goods more affordable can result in shortages and black markets as suppliers are disincentivized to produce and distribute the goods at artificially low prices.3. Agricultural subsidies aimed at supporting farmers and ensuring food security may distort market incentives, leading to overproduction, environmental harm, and inefficient allocation of resources.