Section 2- The allocation of resources Flashcards
Define microeconomics
The study of the behaviour and decisions of households and firms and the performance of individual markets
Define macroeconomics
The study of the whole economy
Define market
An arrangement which brings buyers into contact with sellers
What is the connection b/w micro + macroeconomics
Microeconomics decisions and interactions add up to the macroeconomic picture
Eg. A cut in income tax may lead to households buying more cars
Define economic agents
Those who undertake economic activities and make economic decisions
Firms (producers, employers)
Households (workers, consumers, savers)
Governments (provides benefits, taxes, regulates private sector)
Define private sector
The firms owned by shareholders and individuals
What are the aims of decision makers
Households:
- Consumers: Low prices, high quality
- Workers: Good working conditions, high pay
- Savers: Safe money, good return
Firms: Profits
Government: Strong economy
What are the 3 economic questions?
What to produce?
How to produce it?
Who is to receive the products produced?
Define an economic system
The institutions, organisations and mechanisms that influence economic behaviour and determine how resources are allocated
Describe a planned economic system
The state (government) makes the decisions about what to produce, how to produce (through directives), and who to give it to( by deciding workers’ wages and controlling the price).
The state owns the land, and capital and employs workers.
Necessities like housing, transport, education are all free of cost or extremely cheap
Define directives
A set of instructions given by the state to the state-owned enterprises
Define a mixed economic system
An economic system in which the private and public sector play an important role
Describe a market economic system
Government intervention is minimal and the land and capital is privately owned
Consumers decide what to produce and signal producers through price mechanism
Private firms decide how to produce the product (seek the lowest production cost but high quality)
Maximum influence over the market is influenced by whoever earns the most income, the most skilled, have more demand.
Define price mechanism
The way the decisions made by households and firms interact to decide the allocation of resources
The difference between labour-intensive and capital intensive
Labour intensive is when there is use of a higher proportion of labor relative to capital (vice versa)
Role of price mechanism
It acts as a sort of incentive for producers to respond to changes in market conditions (demand and supply)
Higher demand for a product typically means consumers are willing to pay more for it, this profit encourages firms to produce more of that product.
It also rations out products when the supply falls short of demand. The prices normally rise to lead to a reduction in demand as only people that can afford it will consume it.
Describe market equilibrium
When demand and supply are equal at the current price
Definition of demand
The willingness and ability to buy a product
Market demand? How?
The total demand for a product.
Found by adding up individuals demands at different prices (aggregation)
Define extension in demand
A rise in quantity demanded caused by a fall in price of a product
Define changes in demand
A shift on the demand curve
Define increase in demand
A rise in demand at any given price, causing the demand curve to shift to the right
Causes for a change in demand
- Change in income
- Changes in taste
- Changes in population
- Advertising campaigns
- Changes in related products
- Weather conditions
Difference between normal and inferior goods
Normal goods demand increases as income rises but inferior goods demand decreases when income rises
Relationship between substitute, compliment and demand
When the price of a complement product falls, demand for the product will rise along with its complement
Whereas, if the substitute of a products price rises, the products demand will rise
Define supply
Willingness and ability to sell a product
Define market supply
Total supply of a product
Define extension in supply
A rise in the quantity supplied caused by a rise in the price of the product itself
Define contraction in supply
A fall in the quantity supplied caused by a fall in the price of the product itself
Which curve slopes up from left to right? & down from left to right?
Up from L–> R: Supply curve
Down from L –> R: Demand curve
Define changes in supply
Changes in the supply conditions causing shifts in the supply curve
Define changes in supply
Changes in the supply conditions causing shifts in the supply curve
Define increase in supply
A rise in supply at any given price, causing the supply curve to shift to the right
Causes of change in supply
- Changes in costs of production
- Improvements in tech
- Taxes
- Subsidies
- Weather conditions
- Health of livestock/crops
- Disasters
- Wars
- Depletion
Why would costs of production change?
- Changes in costs of FOPs
- Changes in productivity
Define unit costs
The average cost of production which is found by dividing total cost/total output
Define equilibrium price
The price when demand and supply are equal
PED Formula
Percentage change in quantity demanded /
Percentage change in price
Define PED
A measure of the responsiveness of the quantity demanded to a change in price.
What 2 pieces of information are provided by PED?
- Sign: This tell us that there is an inverse relationship between the quantity demanded and price – a rise in price will cause a contraction in demand and a fall in price will cause an extension in demand. (Minus)
- Size of the figure. This indicates the extent by which demand will extend or contract when price changes. A figure of –2, for example, indicates that a 1% change in price will cause a 2% change in quantity demanded.
Define elastic demand
When the quantity demanded changes by a greater percentage than the change in price.
PED figure of more than 1, less than infinity
Define inelastic demand
When the quantity demanded changes by a smaller percentage than the change in price.
Describe elastic demand
Elastic demand occurs when a change in price results in a greater percentage change in quantity demanded, giving a PED figure (ignoring the sign) of more than 1, but less than infinity.
When demand is elastic, price and total revenue move in opposite directions.
In the case of elastic demand, a firm can raise total revenue by lowering the price, but it must be aware that if it raises the price, its total revenue will fall.
Describe inelastic demand
Inelastic demand is when the quantity demanded changes by a smaller change than the price and the PED is less than 1, but greater than zero.
In this case, price and total revenue move in the same direction.
If the price is raised, the quantity demanded will fall, but by
a smaller percentage than the change in price and hence more revenue will be earned. If the price is lowered, more products will be demanded, but not enough to prevent the total revenue from falling. In this case, if a firm wants to raise revenue, it should raise its price
Determinants of elasticity
- the availability of substitutes of a similar quality and price
- proportion of income spent on the product
- whether the product is a necessity or a luxury ( what were once seen as luxuries can turn into necessities as people become richer. )
- whether the product is addictive or not
- whether its purchase can be postponed
Define-
Perfectly elastic demand
Perfectly inelastic demand
Unit elasticity of demand
Perfectly elastic demand: when a change in price causes a complete change in the quantity demanded.
Perfectly inelastic demand: when a change in price has no effect on the quantity demanded.
Unit elasticity of demand: when a change in price causes an equal change in the quantity demanded, leaving total revenue unchanged
PED + Total revenue relationships
Elastic- Opposite direction
Inelastic- Same direction
Perfectly Elastic- Rise in price will cause demand to fall to zero
Perfectly Inelastic- Same direction, but also by the same percentage
Unit Elasticity- Price and the quantity demanded change by the same percentage and so total revenue remains unchanged.
Why would consumers benefit from a product being elastic?
This is because producers would be reluctant to raise the price as demand would contract by a greater percentage and revenue would fall therefore keeping the price cheap.
The quality may also be high if the elastic demand is the result of the existence of close substitutes. In this case, a producer may have to provide a good quality product to remain competitive.
Define inelastic supply
When the quantity supplied changes by a smaller percentage than the change
in price.
Define inelastic supply
When the quantity supplied changes by a smaller percentage than the change
in price.
The three main factors which determine the PES of a product are:
i the time taken to produce it
ii the cost of altering its supply and
iii the feasibility of storing it.
What can make a product supply more elastic?
- More time
- Advances in technology
Changes in PES
The supply for most of the products becomes more elastic as the time period increases.
Advances in technology, by reducing the production period and lowering costs of production, make the supply more elastic.
Why is elastic supply beneficial to all?
Consumers: Supply is responsive to consumer demand
Producers: Higher profits if they are responsive enough
Government: If governments want to encourage the output and consumption of a product they are likely to be more successful giving a subsidy to producers if supply is elastic.
Difference between public and private sector
The private sector covers business organisations which are owned by shareholders or individuals. These organisations respond to changes in market forces and are profit motivated.
The public sector is controlled by the government. It covers government run services and state-owned enterprises (SOEs), also called nationalised industries.
Define state-owned enterprises (SOEs)
Organisations owned by the government which sell products
Advantages of a market economic system
- Consumers are said to be sovereign
- Costs and prices may be low- The profit motive and competition promote efficiency
- Quality may be high
- There is choice- Consumers can choose which products to buy and which firms to buy from. Firms can also decide what they want to produce and workers can choose who to work for.
- Resources should change quickly to reflect changes in consumer demand. This is for three reasons.
1. Market economic system provides information/incentive on which products are increasing in demand and which ones are falling in demand.
2. It punishes those firms, workers, and owners of capital and land who do not respond to changing demand.
Define price mechanism
The system by which the market forces of demand and supply determine prices.
Define Market failure
Market forces resulting in an inefficient allocation of resources.
Disadvantages of a market economic system
- Consumers and private sector firms may only take into account the costs and benefits to themselves and not the costs and benefits of their decisions to others.
- A market may become dominated by one or a few firms- limited or no choice for consumers+ can raise the prices of their products and produce poor quality products
- Workers lack the right skills or are geographically immobile.
- Firms will not make products unless they think they can charge for them, e.g. defense- people can act as free riders.
- Advertising can distort consumer choice
- Uneven distribution of income which will increase over time.
Define free rider
Someone who consumes a good or service without paying for it.
How is the role of the government reduced in a market economic system?
By removing a number of government regulations, selling off SOEs and parts of SOEs (privatisation) and lowering taxation.
Define Market failure
Market failure occurs when market forces fail to produce the products that consumers demand, in the right quantities and at the lowest possible cost.
Define Third parties
those not directly involved in producing or consuming a product.
Define Social benefits:
the total benefits to a society of an economic activity.
Define Private benefits:
benefits received by those directly consuming or producing a product.
Define Social costs
the total costs to a society of an economic activity.
Indicators of market failure
shortages, surpluses, high prices, poor quality, and lack of innovation.
Define Private costs
costs borne by those directly consuming or producing a product.
e.g. buying raw materials, fuel and wages
Define External costs:
costs imposed on those who are not involved in the consumption and production activities of others directly.
e.g. noise pollution, air pollution and water pollution
Define Socially optimum output
the level of output where social cost equals social benefit and society’s welfare is maximised.
Define asymetric information
When consumers and suppliers do not have equal access to information
Define merit goods
Products which the government
- considers consumers do not fully appreciate how beneficial they are
- and so which will be under-consumed if left to market forces.
- Such goods generate positive externalities.
How can the government increase the demand of merit goods?
- Providing information on the benefits of consumption of the product
- Making the product compulsory (e.g. seat belts)
- Provide subsidies that will decrease the price
- Provide the product for free
Define demerit goods
Products which the government
- considers consumers do not fully appreciate how harmful they are
- and so which will be over-consumed if left to market forces.
- Such goods generate negative externalities.
How can the government decrease the demand of demerit goods?
- Imposing a tax on them
- Providing information about their harmful effects
- Ban them
Define a public good + Characteristics
A product which is non-excludable and non-rival and hence needs to be financed by taxation
Characteristics: Non-rival Non-excludable Non-rejectable Cost of supplying it to one more person is often zero
Define a private good
A product which is both rival and excludable
Define monopoly
A single seller
Define price fixing
When two or more firms agree to sell a product at the same price
How can governments promote competition and prevent firms from abusing their monopoly power?
- Removing restrictions on the entry of new firms into a market
- Making price-fixing illegal
- Stop firms from merging
- Regulation of monopolies
- Prohibition of limit pricing and predatory pricing
Why may private sectors under-invest?
They are keen to earn high profits in the short term
Define
- Allocative efficiency
- Productive efficiency
- Dynamic efficiency
Allocative efficiency: When resources are allocated to produce the right products in the right quantities
Productive efficiency: When products are produced at the lowest possible cost and making full use of resources
Dynamic efficiency: Efficiency occurring over time as a result of innovation and investment
Define mixed economic system
An economy in which both the public and private sectors play an important role
Advantages of government intervention in a mixed economic system?
- Govt will take into account all the costs and benefits that will arise from their decisions (if its not profitable to the private sector but the benefits to society are more than the costs, the state will maintain it)
- They can encourage the consumption of products by granting subsidies, providing information or passing legislation
- They can discourage the consumption of products by imposing taxes, providing information or passing legislation
- They can finance the production of products that cannot be charged for directly
- They can prevent private sector firms from exploiting consumers by charging high prices
- They will seek to make maximum use of resources (e.g. labour: rising employment)
- They will plan ahead to a greater extent and hence devote more resources to capital goods
- They will help more vulnerable groups ensuring they have access to basic necessities (taxing the rich at a higher rate to even out distribution of income)
How may setting a maximum price be effective?
It will enable the poor to afford basic necessities as they will be able to purchase the products at a lower price, only if its set below equilibrium price.
This can lead to shortage as at this lower price the quantity demanded exceeds the quantity supplied
Define rationing
A limit on the amount that can be consumed
Define lottery
The drawing of tickets to decide who will get the products
How may setting a minimum price be effective?
To encourage the production of goods. This is effective when it’s set above the equilibrium price however that will lead to a surplus as at that price, the quantity supplied is more than the quantity demanded.
How are firms affected by taxes?
Governments tax their profits which has an effect on their willingness and ability to invest
Indirect taxes raise a firms cost of production
Income tax reduces consumers disposable income which will affect the demand for the firms products
The effect of a subsidy given to producers is influenced by:
- The size of the subsidy
2. Price elasticity of demand
Effect of a governments tax on elastic demand/ inelastic demand?
Elastic-
The revenue will fall
Would be easier to discourage consumption of a product
Inelastic-
The revenue will rise
What is the competition policy?
It seeks to promote competitive pressures and prevent firms from abusing their monopoly power
Define limit pricing
Setting the price low enough to dicourage the entry of new firms into the market
Define predatory pricing
A firm charging a price below the cost to drive rival firms out of the market
Government measures to address market failure
- Subsidies and taxes
- Competition policies
- Environmental policies
- Regulation
- Nationalisation and privatisation
Explain tradable permits
This involves a government issuing permits to firms, allowing them to pollute up to a certain limit and to sell part of their allocated limit, if they pollute less.
This will reduce the costs of the cleanest firms, whilst raising the costs of the worst polluting firms. As a result, the cleanest firms should capture a higher market share and consequently, pollution should fall.
Advantages and disadvanatges of regulations
A:
- Backed up by the law
- Easily understood
D:
- Difficult and expensive to check whether they are being followed
- Works only if most people agree with it ( government may become unpopular)
- They do not directly compensate those who suffer as a result of market failure
- May be too restrictive- reducing market flexibility
Define nationalisation
Moving the ownership and control of an industry from the private sector to the government
Define public corporation
A business organisation owned by the government which is designed to act in the public interest
Advantages of state owned enterprises
- Base their decisions on the full costs and benefits involved
- Can be used to influence economic activity- boost countrys output
- Would not abuse market power
- Makes planning and coordination easier since everything is owned by the government
- Ensures basic industries charge low prices and produce good quality
Disadvantages of state owned enterprises
- Could be difficult to manage due to the large size
- With the guarantee that they can’t go bankrupt and the lack of competition, they may charge high prices or produce low quality
- Would need to be subsidised if in a loss- opportunity cost for the subsidy
Advantages of privatisation
- Efficient with response to market changes due to the threat of bankruptcy and reward of profits
- More choice
- Right products at good quality and low prices
- Reduced government intervention will lead to less administration costs
- Less risk of under-investment
Disadvantages of privatisation
- Monopolies- no guarantee of competition (lead them to be inefficient charging high prices for low quality products)
- May not take into account all costs and benefits to society
Disadvantages of government intervention
- Corruption- if their interest lies in getting votes
- Reducing incentives
If unemployment benefits are high, people may be discouraged to work
If there are high taxes on firms profts, entrepreneurs willingness and ability to invest is reduced
