micro yr12 Flashcards
the purpose of economic activity
to produce goods and services to meet our needs and wants
need
something you must have to survive or to do something
want
something you desire but is not essential
the basic economic problem
there are infinite wants and finite resources - resources are scare in relation to wants
3 choices to make when allocating resources among competitors
- what to produce
- how to produce
- for who to produce
resources / factors of production
land - natural physical resources
labour - human input
capital - man made eg machinery
entrepreneurship - the ability to organise, coordinate and take risks in the production process
rewards to factors of production
land = rent
labour = wages
capital = interest
enterprise = profit
micro vs macro
micro is a branch of economics that studies the behaviour of individuals and firms in the market - macro considers the economy as a whole
what do rational economic agents aim to maximise?
consumers - total utility
workers - wages and benefits from work
producers - profit
government - social welfare
opportunity cost
the value of the next best alternative given up when a choice is made
positive statements
describe the world as it is, without making any value judgements - based on objective facts and can be proven true or false (eg rise in minimum wage decreases employment)
normative statements
express an opinion, and are subjective (eg the gov should increase spending on healthcare)
PPF (production possibility frontier)
shows the maximum possible output combinations of two goods or services an economy can achieve when all resources are fully and efficiently employed
what causes an outward shift in the PPF?
- an increase in the quantity of the factors of production (eg discovery and extraction of new natural resources)
- an increase in the quality of the factors of production (eg increase in labour productivity due to better management)
- an advance in technology (eg a new innovation in resource use)
what causes an inward shift in the PPF?
- a decrease in the quantity of the factors of production (eg war, conflict or natural disasters)
- a decrease in the quality of the factors of production (eg loss of workers’ skills)
rational consumer behaviour
decision making process that is based on making choices that maximise utility, assuming that
- consumers make all choices independently
- consumers have fixed and consistent preferences
- consumers have full information
- consumers always make the optimal choice given their preferences
total utility
the total satisfaction the consumer gets from purchasing units of a good - rational consumers aim to maximise their total utility
marginal utility
the change in total utility from consuming an extra unit of a product
law of diminishing marginal utility
as a consumer buys and consumes more units of a good, the extra satisfaction gained diminishes, meaning at higher quantities consumers are less willing to pay a higher price which helps explain the downward sloping demand curve
how do rational consumers make decisions?
by calculating the marginal cost (change in total cost when one more unit is bought) and marginal benefit (change in total when one more unit is consumed)
information failure
occurs when people have inaccurate, incomplete, uncertain or misunderstood information and can possibly make ‘wrong’ choices
information gaps
when either the buyer or seller does not have access to the information needed for them to make a fully informed decision which can lead to a misallocation of scarce resources = market failure
symmetric information
for markets to work, buyers and sellers need to have the same perfect information
asymmetric information
buyers and sellers have different amounts of information (eg buyers often know less than sellers when buying second hand cars)
adverse selection
people taking our insurance are often those at highest risk (eg a person leading an unhealthy lifestyle is more likely to take out health insurance)
moral hazard
being insured can make you more careless (eg banks made risky decisions before the global financial crisis are that they would likely receive bail outs)
principle agent problem
goals of the principles, those who lose/gain from a decision, are different from the agents, those making the decisions (eg managers (agents) may have more information than shareholders (principles))
what can government policies do?
can improve information to help producers and consumers value the actual costs and benefits more accurately, reducing or eliminating the market failure
government policies to improve information examples…
- compulsory labelling on products
- improved nutritional information on food/drinks
- hard hitting anti speeding advertising
- campaigns to raise awareness of risks of drink driving, vaping, drug abuse
- campaigns on dangers of gambling addiction
- performance league tables for schools/OFSTED
effective demand
demand supported by intention and ability to buy
latent demand
willingness to buy but not yet ability to buy
joint or complementary demand
demand for one good is closely linked to the demand for another (eg 2 goods that go well together like phone and charger)
competitive demand
two or more goods that are close substitutes for each other
derived demand
when demand for one product drives the demand for another
composite demand
good is demanded for more than one use
individual demand
a consumer’s demand for a good/service
market demand
all consumers’ demands in the market summed together
law of demand
as price falls, the quantity demanded increases and vise versa
extension in suppy or demand demand
a movement along the curve from A to B
contraction in supply or demand
a movement along the curve from B to A
ceteris paribus
all other influencing factors are held constant
factors causing a shift in demand
- changes in tastes/preferences
- change in incomes
- change in the price of related goods
- change in size of population
- changes in interest rates
- changes in the law
- changes in expectations
why does the demand curve slope downwards
- substitution effect - consumers substitute in favour of the good that become cheaper, if price of good X falls then consumers will buy more of it
- real income effect - if the price of good X falls, the consumer buying good X will gain purchasing power and this extra ‘income’ available for spending can be used to buy more X
consumers may be irrational when using demand because…
- bounded rationality and bounded self control
- biases in decision making (rule of thumb, anchoring, availability, social norms)
- altruism
- choice architecture and framing
- nudges
- restricted choice
price elasticity of demand (PED) means…
the responsiveness of quantity demanded of a good to change in its price
PED formula
PED = %change in quantity demanded / %change in price
why is PED negative
the quantity demanded is inversely related to price - the values of PED range from 0 to -infinity
inelastic demand
quantity demanded is not responsive to price changes - the %change in QD is < the %change in P (value between 0 and 1)
elastic demand
quantity demanded is very responsive to price changes - the %change in QD is more than the %change in P (value between -1 and -infinity)
unitary demand
PED = -1
perfectly elastic demand
PED = -infinity
perfectly inelastic demand
PED = 0
PED is elastic when…
- a rise in P leads to a more than proportionate fall in QD so TR falls
- a fall in P leads to a more than proportionate rise in QD so TR rises
PED is inelastic when…
- a rise in P leads to a less than proportionate fall in QD so TR rises
- a fall in P leads to a less than proportionate rise in QD so TR falls
PED is unitary when…
TR will not change when price changes
factors influencing PED
- availability of close substitutes
- cost of switching suppliers
- breadth of product definition
- degree of necessity
- time frame when making choice
- brand loyalty
- %of income spent on product
- habitual demand
uses of PED
- determination of pricing policy/impact on revenue
- indication of competition faced
- price setting in price discrimination
- government decision on which goods to tax indirectly
income elasticity of demand (YED) means…
the responsiveness of demand for a good to a change in income
YED formula
YED = %change in demand / %change in income
what is YED positive for?
normal goods
what is YED negative for?
inferior goods
positive YED between 0 and 1 explaination
as income rises, there is only a small increase in demand (vice versa) which indicates the good is a necessity
positive YED between 1 and infinity explaination
as income rises, there is a relatively large increase (vice versa) which indicates the good is a luxury
negative YED explaination
as income rises, there’s a fall in the quantity demanded (vice versa) and indicates the good is an inferior good
normal goods
products or services where demand increases as consumer income rises - when peoples income goes up they tend to buy more of these goods (eg holidays)
inferior goods
products or services where demand decreases as consumer income rises - when peoples income increases they tend to buy less of these goods and may shift to higher quality alternatives (eg used or older cars)
cross elasticity of demand (XED) means…
the responsiveness of demand for a good to a change in the price of a related good
XED formula
XED = %change in demand for good A / %change in price of good B
XED is positive for?
substitute goods - when price of good B rises, the demand for good A increases and vice versa
YED is negative for?
complementary goods - when the price of good B rises, the demand for good A decreases and vice versa
positive XED between 0 and 1 explaination
goods are weak substitutes
positive XED between 1 and infinity explanation
goods are strong substitutes
negative XED between 0 and -1 explaination
goods are weak complements
negative XED between -1 and -infinity explaination
goods are strong complements
substitutes meaning
goods that can be used in place of each other to satisfy a similar need or desire (eg tea or coffee)
complements meaning
goods that are typically consumed or used together because they enhance each other’s value (eg tennis racket and tennis balls)
uses of YED (income elasticity)
- effect of recession/growth on demand
- business planning for product range
- helps firms anticipate future demand
uses of XED (cross elasticity)
- marketing strategies (eg selling complements together or in bundles)
- if a competitor changes its price, forms can work out the effect on their demand
joint supply
two or more goods that derive from a single production process - a change in the supply of one good leads to a change in the supply of a by product
individual supply
a producer’s supply of a good/service
market supply
all producers’ supplies to the market summed together
law of supply
as price falls, the quantity supplied decreases and vice versa - supply curve slopes upwards to the right
why does the supply curve slope upwards
- higher market prices motivate firms to supply more as they expect more profit
- producing more increases the marginal cost of production so firms need higher prices to cover these costs (assumes law of diminishing returns)
factors causing a shift in supply
- change in the costs of production (eg raw materials, wages)
- change in production technology
- change in weather/climate
- events like strikes or pandemic
- changes in indirect taxes
- changes in producer subsides
- changes in the price of substitutes in production
- changes in the number of firms supplying to the market
price elasticity of supply (PES) means…
the responsiveness of quantity supplied of a good to a change in its price
PES formula
PES = %change in quantity supplied / %change in price
why is PES positive
the quantity supplied is positively related to price
inelastic supply
quantity supplied is not responsive to price changes - value is between 0 and 1
elastic supply
quantity supplied is very responsive to price changes - value is between 1 and infinity
unitary supply
PED = 1
perfectly elastic supply
PED = infinity
perfectly inelastic supply
PES = 0
factors influencing PES
- time period
- bottlenecks in supply
- breakdowns in supply chains
- spare capacity
- stock levels
- availability of producer substitutes
- ease of entry into the market
functions of prices
prices in markets help allocate the scarce resources between their competing uses via their signalling, incentivising and rationing functions
signal meaning
prices provide key information to buyers and sellers; if the price changes because of a shift in demand, this signals to producers to adjust their output levels - if the price changes because of a shift in supply, this indicates to consumers to rethink how much they will purchase
incentivise meaning
higher prices can incentivise producers to extend supply as they anticipate more profit - lower prices can incentivise consumers to extend demand as they pay less for a good yielding the same utility (vice versa)
ration meaning
if supply is limited, the price rises, which rations the good to those who are most willing and able to pay
when may the functions of prices not work effectively?
signalling - can fail if there are externalities, if the government imposes a maximum or minimum price, if the price set by producers is not at the equilibrium or if there’s imperfect information
incentivising - may be missing for public goods
rationing - may not work if the government sets the price
customer surplus
the difference between the total amount that consumers are willing and able to pay for a good or service (indicated through the demand curve) and the total they pay (market price) - measure of consumer welfare
producer surplus
the difference between what producers are willing and able to supply a good for (indicated by supply curve) and the price they actually receive (market price) - measure of producer welfare
production converts what into output
inputs (factors of production)
factors of production
the resources used as inputs - land, labour, capital and enterprise
short run meaning
the time period where at least one factor of production is fixed
long run meaning
the time period when all factors of production are variable
what does productivity measure
efficiency of a factor input
higher productivity can lead to…
- higher profit
- higher wages
- lower unit costs
- greater international competitiveness
- better trade performance
- faster economic growth
specialisation meaning
the concentration of individuals, firms, or nations on producing a limited range of goods or services - can occur at home, in a firm or country level
what is the division of labour
a form a specialisation where the tasks needed to produce an item are divided among workers
advantages of specialisation and the division of labour
increased productivity - greater output from same resources, allows workers to become more skilled and experienced in specific tasks, leading to higher efficiency develop specialist machinery
lower costs - reduced training time and waste
economies of scale - mass production possible including assembly lines, larger quantities of identical goods can be produced more efficiently
disadvantages of specialisation and the division of labour
higher staff turnover - workers may find repetitive tasks monotonous and unrewarding, leading to job dissatisfaction
dependency - over reliance on one work/task makes unit vulnerable to staff illness or economic shocks
structural unemployment - workers trained in fewer skills, machines can replace some labour tasks
lack of variety - mass produced goods can reduce consumer choice
medium of exchange
money facilitates transactions between buyer and seller - specialisation and the division of labour requires a means of exchanging goods and services (money promotes this)
characteristics of a free market economy
- private ownership of resources
- owners of resources and producers are free to buy/sell
- economic agents are motivated by self interest
- consumers have sovereignty (determine what is produced by being willing and able to buy goods/services)
- income depends on the market value of an individual’s work
advantages of free market economy
- resources can be bought and sold
- consumer sovereignty
- freedom of choice
- profit motive and self interest incentivises
- incentive to worker harder for higher wages
- firms face competitive forces driving down prices
- incentive to innovate and invest in new ideas (dynamic efficiency)
disadvantages of a free market economy
- income/wealth inequality and poverty
- market failure can reduce social welfare
- lack of provision of public goods
- over provision of goods with negative externalities
- under provision of goods with positive externalities
- information gaps may cause market failure
- unemployment/worker exploitation/low pay for some
- resources may be wasted on advertising and marketing
- firms may develop monopoly power and push up prices
characteristics of a command economy
- government owns and allocates resources deciding what, how and for who to produce
- government sets productions targets and growth rates according to its view of people’s wants
- goods are allocated through rationing
- workers are given job by the government
- market prices do not inform resource allocation
advantages of a command economy
- resources are allocated by the government to maximise social welfare
- relatively even distribution of income/wealth
- workers are given jobs by the state/no unemployment
- adequate provision of public goods
- government should take externalities into account in decision making
- welfare safety net
disadvantages of a command economy
- danger of government failure
- difficult for the government to set and correct output planning targets and fix prices appropriately
- lack of choices for consumers
- lack of incentives to be innovative and entrepreneurial
- corruption is likely to develop
social welfare means…
the consumer surplus + producer surplus
where does allocative efficiency occur?
when price = marginal cost
when price is more then marginal cost…
it’s efficient to allocate scarce resources to the production of that good
when price is less than marginal cost…
it’s efficient to allocate scarce resources to the production of that good
market failure exists when…
the competitive outcome of markets is not efficient from the point of view of the economy as whole (eg resources are not allocated as efficiently as they could be)
complete market failure occurs when…
the market does not supply products at all - there is a missing market
partial market failure occurs when…
the market functions/exists but it supplies the wrong quantity of a product
examples of partial market failure
- negative and positive externalities from production and consumption
- some information gaps
- irrationality (linked to behavioural economics)
- merit and demerit goods
what does market failure provide?
a rationale for the government to intervene to correct the market failure (or reduce it)
examples of policies for the government to use to correct market failure
- indirect taxes
- subsides
- regulations
- bans
- price controls (max/min prices)
- competition policy
government failure meaning
if the government fails to improve the allocation of resources or makes it worse
what are private goods
goods and services supplies and sold through markets by private sector businesses
characteristics of private goods
- excludable (buyers can be excluded from benefiting from the good if they’re not will or able to pay for it)
- rival (one person’s consumption of a product reduces the amount left for others to consume and benefit from)
- rejectable (can be rejected by the consumer if their needs and preferences or their budget changes)
characteristics of public goods
- non excludable (once a good is provided it’s impossible to prevent people from using and benefitting from it; non payers can enjoy the benefits for free making a ‘free rider’ problem)
- non rival (consumption of a good by one person doesn’t prevent or reduce the benefits to another person consuming the good)
- non rejectable (the collective supply of a pure public goods means it can’t be rejected by people)
pure public good
non excludable and non rival all of the time (eg national defence or mass vaccinations)
quasi public good
technological advances can change a pure public good into a quasi public good or a quasi public good into a private good - eg TV and radio
public bads
non excludable and non rival, but provide dissatisfaction to people who consumer (eg air pollution)
free rider problem
someone who consumes a good without paying for it - because public goods are non excludable its hard to charge consumers once a good has been provided
free rider problem characteristics
- consumers don’t reveal their preferences if they think they can free ride
- no demand curve in market
- no incentive for producers to supply the good because it will not be profitable
- market is missing so resources are not allocated to produce public goods even though consumers may actually want them
possible solutions to market failure of public goods
- government provision - collective provision through taxation
- government funding - the government could fund private provision financed through taxation or charges (eg TV license)
- donations - eg RNLI
- altruism - communities pay collectively (eg private road)
advantages and disadvantages of government provision
- equity - all people, regardless of income, have access to public goods
- efficiency - collective provision allows economies of scale
- overcomes the free rider problem/missing market
- public sector investment is higher
- government may lack the information needed to provide best amount of public goods
- possible diseconomies of scale
- government funding of private sector provision if often costly and wasteful
negative production externality
a third party or spillover external costs arising from the production of a good for which no compensation is paid (eg pollution)
negative consumption externality
a third party or spillover external cost arising from the consumption of a good for which no compensation is paid (eg tobacco consumption causing passive smoking)
social benefit
private benefit + external benefit
social cost
private cost + external cost
MPC = marginal private cost
all the costs of producing one more unit of the good to the producer
MSC = marginal social cost
all the costs of producing one more unit of the good to the society
MPB = marginal private benefit
all the benefits of consuming one more unit of the good to the consumer
MSB = marginal social benefit
all the benefits of consuming one more unit to society
government policies can help reduce negative externalities so…
the externalities are internalised (eg the polluter pays principle) which reduces or eliminates the market failure
policies to address negative externalities could be…
- trade-able pollution permits
- indirect taxes
- banning/restricting output
- legislation/regulations
- ‘nudge’ policies
negative production externalities examples
- air
- noise and water pollution
- environmental damage
negative consumption externalities example
- tobacco
- alcohol
- gambling
- obesity
positive consumption externality means…
a third party or spillover external benefit arising from the consumption of a good for which no compensation is paid (eg healthcare or public transport)
positive production externality means
a third party or spillover external benefit arising from the production of a good for which no compensation is paid (eg training or education)
policies to address positive externalities could be…
- subsidies
- government provision free at the point of use
- legislation/regulations
- ‘nudge’ policies
positive production externalities example
fish industry benefitting from a dam built to store water (reservoir)
positive consumption externalities examples
- healthcare
- education
- dental care
- parks/green spaces
success of government policies to reduce/eliminate externalities depends on…
- size of externality
- the extent to which the externality can be measured
- whether there are unintended consequences from the policy
- opportunity cost of policy (some interventions are expensive)
government needs to judge whether the benefits of intervening are sufficiently high relative to the costs to make it worthwhile for social welfare
merit goods
goods/services the government judges people will under-consume, and which ought to be subsided for provided free at the point of use
- people don’t fully understand the private benefits of their consumption
- consumption of merit goods also often generates positive externalities - where the social benefit exceeds the private benefit
behavioural economics can help explain why…
consumers face information gaps; consumers do not always act on full information even when they have it
information gaps exist when…
either the buyer or seller doesn’t have access to the information needed for them to make a fully informed decision, leading to a misallocation of scarce resources = market failure
examples of information failure
- risks from using sunbeds
- addiction to painkillers and other drugs
- complexity of pension schemes
- uncertain quality of second hand goods
- knowledge of the nutritional content of food
- tourist bazaars or buying and selling antiques
factor mobility
occurs when factors of production can easily be moved from one use to another
geographical immobility of labour
in practise, labour may not be fully mobile because of regional house price variation, family and social ties, children in school etc
occupational immobility of labour
can occur because of insufficient education and training, lack of transferrable skills, inability to afford training etc
land - not geographically mobile but can be occupationally mobile
capital - can be both occupationally and geographically mobile
factor immobility can cause…
structural unemployment and regional inequality which leads to market failure
producer subsidies
payments to producers by the government to reduce the costs of production (eg subsidies for renewable energy)
consumer subsides
payments to consumers to allow them to purchase more of a good/service (eg childcare vouchers)
advantages of producer subsidies
- corrects market failures
- encourages consumption of goods that are good for us (eg fruit)
- encourages firms to invest and innovate
- helps protect producer incomes and jobs
- supports those on lower incomes
- can help tackle climate change
- can help make exports more competitive
disadvantages of producer subsidies
- cost to government (opportunity cost)
- firms may become over reliant on subsidy
- firms have less incentive to be efficient and productive
- firms may distribute extra profit to shareholders rather than reinvest
- government failure/unintended consequences
- may cause fraud
reasons for maximum price
- to make necessities more affordable, especially for those on low incomes, also reduces poverty
- to encourage consumption of goods that are good for social welfare, have positive externalities or where consumers may lack all information
- to prevent businesses profitting at the expense of consumers
maximum price
the government or an industry regulator can set a maximum price to prevent the market price rising above a certain level (price cap)
consequences of maximum price
- the maximum price causes a shortage of the good
- there is a disequilibrium at the maximum price
- the price cannot rise to remove the excess demand (lost its rationing function)
- the quantity supplied will need to be rationed in a different way (eg waiting lists)
- potential for gov failure and unintended consequences
examples of maximum prices in markets
- rent controls
- energy price cap
- cap on tuition fees
- cap on interest rates
- ticket prices for events
problems with maximum prices
- excess demand needs addressing; alternative rationing methods may not work well
- suppliers may leave the market if they cannot charge a price high enough to make profit (which would increase any shortage created by the max price)
- there may be better alternative policies the government could use if it believe the market price is too high (eg subsidies)
minimum price
the government can set a minimum price to prevent the market price from falling below a certain level (price floor)
guaranteed minimum price
the government will buy up and excess supply to guaranteed the minimum price
legal minimum price
the government sets the minimum by law; there’s a ban on sales below the price set; gov doesn’t buy up any surplus (eg minimum price of alcohol)
reasons for minimum prices
- to support the incomes and jobs of producers and encourage investment and innovation
- to discourage consumption of goods that are bad for social welfare, have negative externalities or where consumers may lack all information
- to prevent consumers abusing any monopsony power they have at expense of suppliers
consequences of minimum price
- the minimum price causes a surplus of the good
- there’s a disequilibrium at the minimum price
- the price cannot fall to remove the excess supply (lost its signalling and incentivising functions)
- for a legal minimum, firms cannot sell more than Qd so will reduce supply
examples of minimum prices in markets
- minimum price for alcohol
- national minimum/living wage
- minimum care worker price
- agricultural support where price is guaranteed to farmers
problems with minimum prices
- excess supply needs addressing
- for legal minimum price suppliers can’t sell any excess so will cut supply, output and jobs
- for guaranteed minimum price intervening to buy up the surplus can be expensive (opportunity cost) so surplus will need storing, selling on or destroying
- there may be better alternative policies the government could use if it thinks the market price is too low (eg indirect taxes, regulations)
government failure
government intervention worsens the allocation of scarce resources
- results in greater net welfare loss
- the cost of the intervention outweighs the benefits gained
- the policy fails to generate a change in behaviour by economic agents so the policy fails to achieve its aim
causes of government failure
- political self interest
- poor value for money
- conflicting objectives
- regulatory capture
outcomes of government failure
- greater inequality (eg effects on lower income households)
- high costs of compliance and implementation
- possible unintended consequences
- possible conflicts with other micro/macro objectives
- poor policy choice/ outcomes
- policy may be ineffective in changing behaviour
arguments against government intervention in markets
- the price mechanism is very efficient and can promote innovation
- when resources are scarce, higher prices are potentially a good outcome
- profit motive incentivises businesses and entrepreneurs
arguments for government intervention in markets
- allocation of property rights and legal system
- provision of public goods
- macro economic stability
- measures to reduce inequality
economic agents are rational…
- consumers aim to maximise their utility from consumption
- workers aim to maximise their wages and other work benefits
- firms aim to maximise social welfare
rational consumer behaviour is a decision making process based on making choices that maximise utility, assuming that…
- consumers make all choices independently
- consumers have fixed and consistent preferences
- consumers have full information
- consumers always make the optimal choice given their preferences
irrational consumer behaviour is when people make systematic and persistent deviations from rational choice, because of…
- humans are emotional, impulsive and lack self control
- humans are social and belong to many networks
- humans can be altruistic, generous and forgiving
- humans have limited time, energy and brain power
bounded rationality
idea that the cognitive, decision making capacity of humans cannot be fully rational because of a number of limits that we face
bounded self control
consumers have good intentions but may consume more than is rational because they value the present more than the future so want instant rewards
consumers may be irrational because they are influenced by others…
peer pressure, social norms and herd behaviour
nudges
subtle pushes to influence and guide people toward making better decisions without limiting their choices or using direct enforcement
