Microeconomics Flashcards
Basic economic problem
That society has infinite wants an needs, but only a finite amount of resources to accommodate this
Factors affecting demand
Income, Price of other goods, tastes and preferences, and expectations of the future.
Factors affecting supply
Costs of production, subsidies/grants, taxes, price of other goods, productivity, government legislation
examples of markets that fail due to information failure
-Houses- people may not see faults within a house which would knock their value
- Second hand cars- people may not know faults involved in certain cars
- Insurance/ health insurance- You may fail to inform to inform your insurance company of underlying health conditions.
Explaining Market Failures using an externalities diagram
- Think about whether the externalities in consumption or production
- Draw the appropriate diagram
- Be clear on what the externalities are.
-Explain why this causes a difference between MPB and MSB or MPC and MSC.
-Explain why the free market will arrive at the private optimum
-Explain why the social optimum is where it is. - Identify the welfare loss
-Explain the implications of this on consumption / production
Externalities example- the market for energy drinks
The consumption of energy drinks generates negative externalities, particularly in in the healthcare system such as the UK’s, where consumers who require treatment will seek it from the NHS, thus imposing a cost to the third party of taxpayers. As a result, the marginal private benefit of energy drinks is more than the marginal social benefit. Consumers generally act in their own interest and ignore the impact upon society. In the diagram above (Externalities), this can be seen as consumers are consuming at the private optimum, where MPB is equal to MPC., rather than the social optimum where MSB is equal to MSC, and social welfare is maximised. There is a welfare loss equal to the triangle in the diagram. There is an overconsumption equal to Q1-Q2- too many resources are allocated to energy drinks, meaning that the market is allocatively inefficient and fails.
Types of government failure
- distortion of price signals- gov intervention causes prices to change
- Conflicting objectives
- Information gaps
- Excessive admin costs
- Unintended consequences
Indirect tax diagram
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Indirect tax analysis
The use of an indirect tax will increase a firms cost of production and mean that at any given price suppliers will be less able to earn profit. This means that they have less incentive to supply and the supply curve will shift leftward from S1 to S2. Excess demand at the previous market price causes the equilibrium price to increase from P1 to P2 and this causes a contraction of demand from Q1 to Q2. This reduces the quantity to the social optimum, correcting the problem of overconsumption/ production and correcting the market failure.
Indirect tax evaluative points
- It is difficult to put values on externalities
- Opportunity cost of monitoring
- Can be regressive
- Effectiveness depends on the price elasticity of demand
- Potentially inflationary
- Can be hypothecated, providing further helping to resolve the issue
Subsidy diagram
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subsidy analysis
A subsidy will decrease firms’ cost of production and mean that at any given price, suppliers will be able to earn more profit. This means they will have more incentive to supply and the supply curve will shift to the left, from S1 to S2. This decreases the equilibrium price from P1 to P2, and causes an extension of demand from Q1 to Q2. This extends the quantity to the social optimum, correcting the overconsumption/ underproduction, and correcting the market failure.
Subsidy evaluative points
- Difficult to accurately value externalities
- Firms may not use the subsidy to increase production or may become productively inefficient
- Opportunity cost
- Effectiveness depends on PED
Information provision diagram
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Information provision analysis
The provision of information enables consumers to understand the benefits/ negatives of a good, and changes their tastes and preferences towards/ away from the good. This gives consumers less/ more incentive to buy, shifting demand leftward/ rightward from D1 to D2. This lowers/ raises the equilibrium price from P1 to P2, and causes a contraction of supply from Q1 to Q2, where Q2 is the social optimum, correcting the over/ under consumption.
Information provision evaluative points
- The information does not have to be listened to by consumers
- Very expensive policy to implement- possible government failure due to excessive administration costs.
-The information may be too complex for some consumers to understand
Behavioral economics
- Bounded rationality- people may want be behave rationality, but face three critical limitation to their ability to do so: The human mind has limited ability to process and evaluate info, info available may be incomplete and often unreliable, time is limited.
- As a result, may economic agents end up utility satisficing.
- Some people lack the self discipline to pursue the best option (Bounded self control)
The four decision making biases
- Heuristics= mental shortcut or rule of thumb
- Anchoring= a particular piece of info skews a consumers perception of something, as they bases their valuation on it.
- Availability bias= Misjudges likelihood of something happening based on the most recent piece of info.
- Social norms= This means following what other people do.
Explain the following choice Architectures, and how they can be used to correct market failure: framing, Default choice, and mandated choice
- Framing= The tendency of an individual to be influenced by the context in which info is presented. For examples insurance being quoted at a day rate.
- Default choice= A pre set choice that the individual must make a conscious decision to change. For example, organ donation within the UK.
- Mandated choice= Individuals are forced to make a decision pone way or another, without a default being set- E.G the instillation of software.
Explain what the following choice architectures are and how they can be used to correct market failure: Restricted choice, nudges
- Restricted Choice= Giving people a limited number of options to prevent problems with the volume of information. EG- gov offering the top five pension schemes.
- Nudges= Encouraging individuals to change their behavior in a predictable way without actually revoking the ability to choose.
Evaluative points for choice architecture
- Freedom to choose still means to choose badly
- Therefore sometimes a shove may be more effective
- Sometimes nudges seem to assume that people are stupid
- Less effective in the case of deep rooted behavior
- But, low cost means low opportunity cost
Types of internal economies of scale
- Technical= Better machinery and production methods
- Financial= Less risky lenders
- managerial= Specialist staff
- Commercial= Bulk buying
- risk-Bearing= By operating in different markets they are able to spread the cost of a failure
Types of external economies of scale
- Geographical= areas known for a product benefit through specialist things such as college courses
- Information= Industry may conduct more research and development
How to include economies of scale into a government provision paragraph (E.G Subsidy)
(Begin with standard subsidy analysis). If the increase in quantity from Q1 to Q2 involves some firms increasing in scale of production then they may experience economies of scale, lowering the long run average costs and causing further increases in profitability and the incentive to supply, with supply shifting rightward again to S3. This causes a further fall in price to P3 and another extension of demand to Q3.
Diagram for economies of scale
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What are the other possible objectives of firms
-Survival/ break even
- Increased market share
- business growth
- Social objectives
-Sales maximisation
Possible barriers to entry
-Large set up costs
- Sunk costs
- Economies of scale
- Legal barriers
- Marketing barriers
Perfect competition diagram- long run equilibrium
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Perfect competition analysis
Under perfect competition, a market price for the good is set through the interaction of supply and demand. The equilibrium price is P1 and the output of the industry as a whole will be Q1. Demand for the firms product is perfectly price elastic, creating a horizontal demand curve, as there are many sellers of a homogenous good, so if firms were to raise prices, they would be priced out of the market. The firm does not need to cut prices in order to increase sales volume, so the demand curve is also the marginal revenue curve for the firm. As they are a profit maximiser, they will produce where marginal revenue is equal to marginal cost, which is at Q1. At this point, the firm is only able to make normal profit. The firm is productively efficient as they are producing at the lowest point on the Ac curve, and is also allocative efficient, as P= MC. Th
diagram for economic profit in the short run under perfect competition
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Analysis for economic profit in the short run under perfect competition
A firm is able to make an economic profit in the short run under perfect competition. This can be achieved either by seeing a rise in the demand curve above the average cost, or through a fall in average cost. The profit they make is given by the area C1P1AB. This economic profit acts as a signal to new firms to enter the market. They are aware of this due to perfect information, and are able to due to no barriers to entry. This causes the supply curve to shift rightward from S1to S2, which lowers the market price to P2. The firm faces a perfectly elastic demand curve therefore the demand curve will shift down from D1 to D2. The firm is a profit maximiser so will produce where MR=MC which is at Q2. At this point all the economic profit has been competed away, leaving only normal profit.
Diagram to show economic loss in the short run under perfect competition
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Diagram for monopoly
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Diagram to show negative externality in production
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Diagram to show negative externality in consumption
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Diagram to show positive externality in production
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Diagram to show positive externality in consumption
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analysis of a pure monopoly
Assuming that the monopolists objective is profit maximisation they will choose to produce where MR=MC, which is at Qm. The firm will charge the maximum price that they are able to at this quantity, which is at Pm. The total revenue is given by the area 0PmAQm, and their total cost is the area 0C1BQm. Therefore the total economic profit made by the firm is Total revenue- total cost, which is equal to the are C1PmAB.The firm is productively inefficient as it is not producing at the lowest point on the average cost curve., and is also allocatively inefficient as the price is not equal to the marginal cost.
Arguments for monopoly- evaluation
-Firms may reinvest their monopoly profits to improve their product or increase consumer choice
- Can better exploit economies of scale
-Natural monopolies can be beneficial in some industries
Evaluation- arguments against monopolies
- Always productively inefficient
- Allocatively inefficient- and there is no incentive to be efficient
- Deadweight loss of economic welfare
- Restricts choice for consumer and may lack incentive to innovate.
Natural monopolies diagram
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Natural monopolies analysis
In certain industries, where there is a high fixed cost, for instance railways or pipelines, it can be more beneficial for consumers to have one supplier, as this allows for the fixed cost to be spread across consumers, rather than being duplicated. This is a natural monopolies.
The fixed costs for a natural monopoly are so high that the minimum efficient scale of productions is not seen. The firm would profit maximise where MR=MC, at Q1, charging price P1. At this point, the economic profit made by the firm is given by the area C1P1AB.
Possible evaluation of a natural monopoly
An alternative approach may be regulation (Either on price or output, especially as natural monopolies occur so often for things that are socially useful. This would ensure that the outcome is allocatively efficient at Q2, where average revenue is equal to marginal cost. However, as AR is greater than AC, the monopolist would make a loss and a subsidy, may be needed to keep the firm ion operation.
Diagram to show monopolistic competition in the short run
- Pure monopoly diagram as the firm is able to behave like a monopolist in the short run
Diagram to show monopolistic competition in the long run
- The same diagram, but average revenue and marginal revenue have both shifted leftwards, so that AR now is tangential to the average cost curve
Diagram to show monopolistic competition in both the short and long run
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Monopolistic competition analysis short run
Monopolistically competitive markets share characteristics of both a pure monopoly, and perfect competition. They are similar to perfect competition, as there are no barriers to entry or exit, and there are a large number of firms in the market, but are also similar to a monopoly, as each firm has a slightly differentiated product. As a result of goods being somewhat differentiated, firms have a degree of price setting ability, and as a result, they face a downward sloping demand curve. In the short run, the firm will essentially behave like a monopolist, producing at the profit maximising quantity, Q1, and charging the highest price that they are able to at this point, which is P1. At this point, they are able to make an economic profit equal to the area C1P1AB.
Monopolistic competition ion the long run analysis
However, in the long run, new firms are aware of the economic profit made due to to perfect information, and they are able to enter the market due to there being no barriers to entry. The existing firms product cannot be sufficiently differentiated, that this forms a barrier to entry, and thus new entrants to the market produce relatively close substitutes. The availability of new substitutes reduces the demand for the incumbent firms products, which causes demand to shift leftward from AR1 to AR2. Firms will still produce where MR=MC, which is now at Q2, but will no longer be able to make economic profit.
Monopolistic competition evaluative points
- Behavioral- whilst monopolistic competition creates lots of consumer choice, many consumers are faced with bounded rationality, so may not be able to make the utility maximising decision.
- Although prices are kept low in the long run, the saturation of products may lead to firms not exploiting economies of scale.
Oligopoly diagram
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Oligopoly analysis
An oligopoly is a market that is dominated by a few firms, between whom there is conscious interdependence. This means that each firm is directly affected by the decisions of the other firms within the market, and that they are aware of this. An example of an oligopoly would be the market for supermarkets, as there are a small number of firms who dominate the market. Firms in an oligopoly, are profit maximisers, so will produce output where MR=MC. However at this point, firms face a kinked demand curve. If firms were to raise prices, they have a perfectly price elastic demand curve, as other firms will keep prices the same, and if they were to lower prices, demand is price inelastic, as a price war would be created. This leaves price fixed at P1. This leaves firms competing on non priced factors such as advertisement
Evaluation of an oligopoly
-Collusion- This is where rival firms collectively agree to raise prices. Whilst it is illegal, in a very small oligopoly this can very easily happen
- Prices are fixed in place, creating price stability which is beneficial for consumers.
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Explain limit pricing
This is where firms charge a price so low that it gives new firms no incentive to enter the market. Forms main incentive is to make economic profit, so be charging a price where normally profit is made, it removes incentive for new firms to enter the market.
Diagrams to show price discrimination
Draw all three diagrams and check- the market, group A (Less willing to pay), and group B (More willing to pay)
Diagram for the national minimum wage
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Analysis of national minimum wage
The national minimum wage is a legally binding price for labour that has been in force within the UK since 1999. The market is in an initial equilibrium at Qe, but the government decide that WRe is too low, so they intervene and set a national minimum wage above WRe. At this new wage there is an extension in the supply of labour from Qe to Qs, as there is more incentive for people to now work. At this new higher wage, firms hire less labour, as WR>MRP for more workers, making them less profitable, which results in a contraction of demand from Qe to Qd. The result is an excess supply of labour.
Evaluation of the National Minimum wage
- When the supply and demand for labour is price elastic, the amount of those who are unemployed is much larger.
- Whilst firms may not always reduce the size of their labour force, they make other cuts through methods such as the removal of non-pecuniary benefits for workers.
-Carrel +Krieger case study 1992 found that there was no increase to unemployment following the introduction of a minimum wage. However, this case study was heavily criticised as it was in a different country, with a much smaller sample size, and just on fast food workers.
Arguments in support of the NMW
- reduce inequality and poverty by raising the lowest paid workers wages
- Reduce gender pay differentials
- Increases incentive to work, reducing number of those claiming benefits.
-Productivity may increase
Arguments against the NMW
- Will not alleviate poverty for those who are unable to work or whose hours are restricted.
- May cause unemployment, particularly among youth and less skilled workers.
- Not everyone earning NMW lives in poverty, meaning it could be seen as poorly targeted.
- Acts as a “Pay norm” in some industries and can hold wages down, and others not on NMW may seek to rise their pay to maintain pay differentials.
Trade unions diagram
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Trade unions analysis paragraph
Trade unions are a group who provide a platform for workers to advocate for better pecuniary and non pecuniary benefits within the workplace. Under competitive conditions, the market is initially in equilibrium at WRc, with Qc labour supplied and demanded. The trade union decides that WRc is too low and that none of its’ workers will work for less than a higher wage rate (WRtu), making supply perfectly price elastic for wages below WRtu, and putting a kink in the effective supply curve. The firms profit maximising decision remains to employ workers up until it is the point where wage rate is equal to MRP. Employment now falls to Qtu and unemployment potentially increases.
Evaluation of trade unions
- Closed shops are illegal ( Although high union density for one employer is possible).
-Trade unions may offset the power of monopsony employers - It may be possible through collective bargaining for the unions to maintain employment, and increase wages by negotiating a change in working practices and/ or improvement in productivity
- Disruption to services such as the railways strikes, can have a negative impacts could be argued that it is in the publics interest for these types of strike action to be prevented
Monopsony diagram
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Monopsony analysis
A monopsony is when there is a single supplier of labour within a market. For example, many government owned services, such as the British Army and Police force, are seen as monopsony employers. The monopsonist is a profit maximiser and will therefore only hire labour up until the point where MR=MC, which is the point where MRPL=MCL. The firm would therefore hire Qm labour, which would require them to pay WRm, as the supply curve shows that this is the minimum pay required for Qm workers to be willing to work. This is different a competitive outcome, where the wage is equal to the MRPL, which means firms would employ Qc labour, and pay a wage rate of WRc. As a result, employees under a monopsony suffer a reduction in wages of WRc-WRm.
Evaluation of monopsony
- Allows companies to achieve economies of scale and lower long run average costs
- ## Monopsonist may use this extra profit to invest in R&D, creating better goods for consumers
Bilateral monopoly diagram
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Bilateral monopoly analysis
A bilateral monopoly is when there is a monopsony, but the workers are also member of a trade union. The monopsony would seek to profit maximise and would hire labour only up until the point where MRP=MC. The firm would therefore hire Qm labour, which would require them to pay WRm. However the trade union insists on a wage rate above the monopsony outcome. All of the workers that would have been willing to accept a wage rate below WRtu in a competitive labour market without trade unions and collective bargaining now insist on WRtu. The supply of labour to the firm becomes perfectly price elastic at this wage rate as no worker would be willing to accept less and the firm effectively becomes a wage taker.
Bilateral monopoly evaluation
- For all workers employed beyond the Qtu, marginal cost is greater than MRP, so the firm would actively be making a loss.
- A kink in the supply curve is created by the trade union
