Theme 1 Content Flashcards
1.1 - Nature of economics
What is the definition of PPF? (production possibility frontier)
1.1.4 - Production possibility frontiers
The maximum possible combination of goods that can be produced with current technology and resources.
1.1 Nature of Economics
What does a PPF curve show and why is it curved?
1.1.4 - Production possibility frontiers
It shows the maximum possible combination of goods that can be produced with current technology and resources. It is curved as both products depend on the same finite resource for their manufacture. Law of diminishing returns
1.1 Nature of Economics
Why is a PPF graph curved?
1.1.4 - Production possibility frontiers
Law of diminishing returns - there comes a point where an added production factor has less of an impact.
1.1 Nature of Economics
Sketch a PPF showing:
unobtainable, efficient, inefficient, firm specialising in one product:
1.1.4 - Production possibility frontiers
1.1 Nature of Economics
Define specialisation
1.1.5 - Specialisation and the division of labour
The production of a limited range of goods by an individual organisation.
1.1 Nature of Economics
Name an example of Division of Labour + EXPLAIN WHY USEFUL
1.1.5 - Specialisation and the division of labour
Production of cars. Different people produce different parts: Wheels, doors, engines.
Increasing productivity due to less time taken and reduces cost of production
1.1 Nature of Economics
4 functions of money
1.1.5 - Specialisation and the division of labour
- Medium of exchange
- Measure of value
- Store of value
- Method of deferred payment
1.1 Nature of Economics
Adam Smith (18th C)
1.1.5 - Specialisation and the division of labour
Father of modern economic theory. Described specialisation and the division of labour in a pin factory.
1.1 Nature of Economics
What are the advantages of specialisation
1.1.5 - Specialisation and the division of labour
- Increased Productivity: Specialization allows workers to become more skilled in specific tasks, leading to higher efficiency. –> leads to higher profits for businesses
- Economies of Scale: Larger quantities of identical goods can be produced more efficiently.
- Lower Costs: Reduced training time and waste contribute to cost savings –> higher real incomes and GDP growth. When successful key cause of economic growth
1.1 Nature of Economics
Disadvantages of Specilisation
1.1.5 - Specialisation and the division of labour
- Monotony: Workers may find repetitive tasks monotonous, leading to job dissatisfaction.
- Dependency: An economy heavily dependent on a single industry or export can be vulnerable to economic shocks.
- Lack of flexibility - for example, if the companies eventually move elsewhere, the workforce left behind can struggle to adapt
1.1 Nature of Economics
Advantages of Specializing for Trade
1.1.5 - Specialisation and the division of labour
- Comparative Advantage: Nations can focus on producing goods and services where they have a comparative advantage, leading to higher efficiency.
- Increased Standard of Living: Trade allows access to a wider variety of goods and services, enhancing overall living standards
1.1 Nature of Economics
Disadvantages of Specializing for Trade
1.1.5 - Specialisation and the division of labour
- Vulnerability to External Shocks: Reliance on trade exposes nations to risks, such as changes in global demand or supply disruptions.
- Income Inequality: Specialization may benefit certain industries or regions more than others, leading to income inequality.
1.1 Nature of Economics
Free Market Economy
1.1.6 - Free Market Economies, Mixed Economy and Command Economy
- Markets allocate scarce resources
- Suppliers are driven by the profit motive
- Private sector is dominant
- Consumer tastes and preferences are really important
- Key figures: Adam Smith, who advocated for the “invisible hand” of the market to allocate resources efficiently.
1.1 Nature of Economics
Mixed Economy
1.1.6 - Free Market Economies, Mixed Economy and Command Economy
- Mix of state and private ownership of businesses
- Government intervention in most markets
- The mix of state and market forces will vary from country to country
- Example: Most modern economies, including the United States, have mixed economic systems.
1.1 Nature of Economics
Command Economy
1.1.6 - Free Market Economies, Mixed Economy and Command Economy
- Most resources are state owned (nationalised)
- Government planning allocates most scarce resources
- Little role for market prices and the profit motive
- In a command economy, the government or central authority makes all economic decisions.
- Key figures: Karl Marx, who envisioned a classless society with centralized planning, and Friedrich Hayek, a critic of central planning who believed in free markets.
1.1 Nature of Economics
Advantages of a Free Market Economy
1.1.6 - Free Market Economies, Mixed Economy and Command Economy
- Efficiency: Competition incentivizes firms to produce efficiently and innovate. Competition also helps keep prices low
- Consumer Choice: Consumers have a wide range of choices in products and services.
- Economic Growth: Free markets can lead to rapid economic growth and higher living standards.
- Example: The United States’ free-market system has led to significant technological advancements and economic growth.
1.1 Nature of Economics
Disadvantages of a Free Market Economy
1.1.6 - Free Market Economies, Mixed Economy and Command Economy
- Inequality: Income and wealth disparities can be significant.
- Lack of Public Goods: Some essential services may be underprovided without government intervention (e.g., public healthcare).
- Boom-Bust Cycles: Free markets can be prone to economic cycles of booms and busts.
- Example: The 2008 financial crisis exposed some of the shortcomings of unregulated financial markets.
1.1 Nature of Economics
Advantages of a Command Economy
1.1.6 - Free Market Economies, Mixed Economy and Command Economy
- Equality: Command economies aim to reduce income inequality through central planning.
- Stability: Central control can provide stability during crises.
- Prioritizing Social Goals: Resources can be directed toward public services and social welfare.
- Example: North Korea’s command economy focuses on central planning and state control
1.1 Nature of Economics
Disadvantages of a Command Economy
1.1.6 - Free Market Economies, Mixed Economy and Command Economy
- Problems in fixing prices of goods and services - planners are unlikely to be as good as the market in determining suitable prices
- Lack of Incentives: Central planning may discourage innovation and individual initiative. Also leading to low productivity
- Resource Misallocation: Inefficient allocation of resources can lead to shortages or surpluses.
- Bureaucracy: Command economies often involve complex bureaucracies.
- Corruption
- Example: The collapse of the Soviet Union highlighted the challenges of central planning.
1.1 Nature of Economics
Roles of the State in a Mixed Economy
1.1.6 - Free Market Economies, Mixed Economy and Command Economy
[6]
- Regulation of Markets - e.g. employment protection for poeple in work and regulation of monopoly firms
- Public goods - e.g. national defencce and public service broadcast
- Welfare Services - e.g. Universal Credit, Child Benefit and State Pension
- Merit Goods - e.g. State education, NHS and social housing
- State-Owned Industries - e.g. - Network Rail and the BBC
-
Stabilisation and Economic Planning - Governments may use fiscal and monetary policies to manage economic cycles and prevent economic crises.
Example: Central banks adjust interest rates to control inflation and promote economic growth.
1.2 - How Markets Work
What are the Underlying Assumption of Rational Economic Decision Making
1.2.1 - Rational Decision Making
- Consumers Aim to Maximize Utility
- Firms Aim to Maximize Profits
- Consumer Decision-Making - Consumers make choices based on their preferences and budget constraints. Utility-maximizing consumers allocate their budgets to maximize satisfaction.
-
Firm Decision-Making - Firms produce goods and services to meet consumer demand.
Profit-maximizing firms adjust production levels and pricing to achieve the highest profit
1.2 - How Markets Work
What are some critiques of the assumptions of Rational Economic decision making
1.2.1 - Rational Decision Making
Critics argue that in reality, consumers and firms may not always behave rationally due to bounded rationality, cognitive biases, and imperfect information
Importance of the Assumptions - Despite the critiques, the assumptions of utility maximization for consumers and profit maximization for firms serve as foundational concepts in economics.
They provide a framework for understanding and analyzing economic decision-making in various contexts
1.2 - How Markets Work
What is the different between a Movement and a Shift of the Demand Curve
1.2.2 - Demand
- Movements Along a Demand Curve - Movements along a demand curve occur when the quantity demanded changes due to a change in the price of the good or service, while other factors remain constant. The law of demand states that, all else being equal, as the price of a good or service decreases, the quantity demanded increases, and vice versa.
- Shifts of a Demand Curve - Shifts of a demand curve occur when factors other than price cause a change in the quantity demanded at every price level. A shift indicates a change in overall demand, not just a response to price changes.
1.2 - How Markets Work
Factors that may cause a shift in the demand curve
1.2.2 - Demand
[5]
- Income
- Consumer Preferences and Tastes
- Prices of Related Goods
- Expectations
- Advertising
1.2 - How Markets Work
How does Diminishing Marginal Utility Influence the Demand Curve
1.2.2 - Demand
The law of diminishing marginal utility contributes to the downward-sloping shape of the demand curve. As price decreases, consumers are willing to buy more because the marginal utility of each additional unit exceeds the price. Example: If a consumer enjoys ice cream, the first scoop provides high utility, but by the fifth scoop, the satisfaction gained from each additional scoop decreases.
1.2 - How Markets Work
What is PED
1.2.3 - Price, income and cross elasticities of demand
Price Elasticity of Demand
Measures the responiveness of the quantity demand to changes in the price of a good
Formula: PED = (% Change in Quantity Demanded) / (% Change in Price)
1.2 - How Markets Work
What is YED
1.2.3 - Price, income and cross elasticities of demand
Incomne Elasticity of Demand
YED measures the responsiveness of the quantity demanded to changes in consumer income
Formula: YED = (% Change in Quantity Demanded) / (% Change in Income)
1.2 - How Markets Work
What is XED
1.2.3 - Price, income and cross elasticities of demand
Cross Elasticity of Demand
XED measures the responsiveness of the quantity demanded of one good to changes in the price of another.
Formula: XED = (% Change in Quantity Demanded of Good A) / (% Change in Price of Good B)
1.2 - How Markets Work
Values for PED
1.2.3 - Price, income and cross elasticities of demand
Perfectly Elastic (PED = ∞): Quantity demanded is extremely responsive to price changes, demand is perfectly elastic.
Relatively Elastic (PED > 1): Demand is responsive to price changes.
Unitary Elastic (PED = 1): Percentage change in quantity demanded is exactly proportional to the percentage change in price.
Relatively Inelastic (0 < PED < 1): Demand is less responsive to price changes
Perfectly Inelastic (PED = 0): Quantity demanded does not respond to price changes, demand is perfectly inelastic.
1.2 - How Markets Work
Values for YED
1.2.3 - Price, income and cross elasticities of demand
Inferior Goods (YED < 0): Demand decreases as income increases (e.g., low-quality goods).
Normal Goods (0 < YED < 1): Demand increases with income but at a decreasing rate.
Luxury Goods (YED > 1): Demand increases significantly with income (e.g., luxury cars).
1.2 - How Markets Work
Values for XED
1.2.3 - Price, income and cross elasticities of demand
Substitutes (XED > 0): An increase in the price of one good leads to an increase in the quantity demanded of the other (e.g., Coke and Pepsi).
Complementary Goods (XED < 0): An increase in the price of one good leads to a decrease in the quantity demanded of the other (e.g., cars and gasoline).
Unrelated Goods (XED = 0): The price change of one good has no effect on the other.
1.2 - How Markets Work
Factors Influencing Elasticites of Demand
1.2.3 - Price, income and cross elasticities of demand
[6]
- Degree of Necessity
- Addictiveness
- Availability of Substitutes
- Time - become more elastic over time
- Income (% of)
- Brand Loyalty
1.2 - How Markets Work
Why is Elasticities of Demand Important to Firms
1.2.3 - Price, income and cross elasticities of demand
- Firms use elasticities to set prices and predict revenue changes.
- Elastic demand means price increases reduce total revenue, while inelastic demand means price increases raise total revenue.
1.2 - How Markets Work
Why are Elasticities of Demand Important to the Government
1.2.3 - Price, income and cross elasticities of demand
- Government uses elasticities to make taxation and subsidy decisions.
- Inelastic goods can bear higher taxes, while elastic goods may see reduced consumption due to taxes.
- Subsidies can encourage the consumption of essential goods.
1.2 - How Markets Work
What is the difference between a movement along the supply curve and a shift of the supply curve
1.2.4 - Supply
- Movements Along a Supply Curve - Movements along a supply curve occur when the quantity supplied changes in response to a change in the price of the good or service, while other factors remain constant. The law of supply states that, all else being equal, as the price of a good or service increases, the quantity supplied also increases, and vice versa.
- Shifts of a Supply Curve - Shifts of a supply curve occur when factors other than price cause a change in the quantity supplied at every price level. A shift indicates a change in overall supply, not just a response to price changes.
1.2 - How Markets Work
Conditions of Supply
1.2.4 - Supply
[8]
- Productivity
- Indirect taxes
- Number of firms
- Technology - level of technology or technological advancements
- Subsidies
- Weather
- Costs
- Government policies and regulation
1.2 - How Markets Work
What is PES
1.2.5 - Elasticity of Supply
Price Elasticity of Supply
Measures the responsiveness of the quantity supplied of a good to changes in its prices
Formula: PES = (% Change in Quantity Supplied) / (% Change in Price
1.2 - How Markets Work
Value for PES
1.2.5 - Elasticity of Supply
- Perfectly Inelastic (PES = 0) - Quantity supplied doesn’t respond to price changes. Price are unable or unwilling to change supply
- Relatively Inelastic (0 < PES < 1) - a percentage change in price results in a smaller percentage change in quantity supplied. Producers have limited flexibility to adjust supply quickl
- Relatively Elastic (PES > 1) - a percentage change in price results in a larger percentage change in quantity supplied. Producers can respond to price changes by adjusting production.
- Perfectly Elastic (PES = ∞) - even a slight price change results in an infinite change in quantity supplied. This is rare and usually occurs in markets where producers can instantly and costlessly adjust production.
1.2 - How Markets Work
Factors Influencing PES
1.2.5 - Elasticity of Supply
- Availability of substitutes
- Stocks - shelf life
- Production time
- Availability of factors of production
- Capacity
- Ease of entry into the market
ASPACE
1.2 - How Markets Work
What are the Functions of the Price Mechanism to Allocate Resources
1.2.7 - Price Mechanism
- Rationing Function - Prices allocate scarce resources among competing uses. When demand is higher than supply then price rises, so only people willing to pay get the goods
- Incentive Function - Provides incentive for producers to allocate resources. Higher prices motivate proders to produce more and vice versa
- Signaling Function - Convey information about market conditions allowing consumers and producers to make informed decisions
1.2 - How Markets Work
The Price Mechanism in Local Markets
1.2.7 - Price Mechanism
In local markets, prices are determined by supply and demand conditions within a specific geographic area. Local factors, such as weather or local preferences, can influence prices. Example: The price of fresh produce at a local farmers’ market may vary based on seasonal factors and local supply.
1.2 - How Markets Work
Price Mechanism in National Markets
1.2.7 - Price Mechanism
National markets cover an entire country and consider supply and demand at a broader scale. National policies and regulations, such as taxes and trade policies, can impact prices. Example: The national housing market may be influenced by government policies related to interest rates and mortgage regulations.
1.2 - How Markets Work
Price Mechanism in Global Markets
1.2.7 - Price Mechanism
Global markets involve international trade and can be influenced by factors like currency exchange rates, global supply chains, and geopolitical events. Prices in global markets are interconnected and can impact local and national markets. Example: The price of oil in global markets affects fuel prices around the world, impacting consumers and industries in various countries
1.2 - How Markets Work
What is Consumer Surplus
1.2.8 - Consumer and Producer Surplus
Consumer surplus is the additional benefit or utility that consumers receive when they are able to purchase a good or service at a price lower than what they are willing to pay. It represents the difference between what consumers are willing to pay (their maximum price) and what they actually pay in the market.
1.2 - How Markets Work
What is Producer Surplus
1.2.8 - Consumer and Producer Surplus
Producer surplus is the additional profit that producers earn when they sell a good or service at a price higher than their minimum acceptable price. It represents the difference between the market price and the producer’s marginal cost of production.
1.2 - How Markets Work
What is a Subsidy
1.2.9 - Indirect Taxes and Subsidies
Money grant given to producers by the government to lower costs of production and encourage an increase in output
1.2 - How Markets Work
What are Indirect Taxes
1.2.9 - Indirect Taxes and Subsidies
A tax that increases a firms cost of production but can be transferred onto the consumer via higher price
Or a tax on spending
1.2 - How Markets Work
When are Subsidies used
1.2.9 - Indirect Taxes and Subsidies
PE in consumption – Used when there is an underconsumption of a good, so by lowering the cost of the production via a subsidiary there is a socially optimum quantity of the good and also a lower price level. E.g buses and rail
PE -
1.2 - How Markets Work
What is the impact of indirect taxes on consumers
1.2.9 - Indirect Taxes and Subsidies
- Increased prices
- Possible behavioural changes
- Possible regressive impact
1.2 - How Markets Work
Who gains more from a subsidy if demand is price inelastic?
1.2.9 - Indirect Taxes and Subsidies
The consumer
There is little change in output, but a large fall in price.
1.2 - How Markets Work
Who gains more from a subsidy if demand is price elastic?
1.2.9 - Indirect Taxes and Subsidies
The producer
1.2 - How Markets Work
What are some problems with subsidies for consumers
1.2.9 - Indirect Taxes and Subsidies
- Tend to be poorly targeted if everyone can buy subsidised goods as even rich households can benefit
- Economic theory would suggest that welfare would probably be higher if poor households were given cash payments instead of subsidies, as they could be targeted more effectively
1.2 - How Markets Work
What are some disadvantages of subsidies for the government and producers
1.2.9 - Indirect Taxes and Subsidies
- High opportunity cost.
- Difficult to target (exact size of externality = unknown).
- Can make firms inefficient.
- Difficult to remove.
1.2 - How Markets Work
What are some advantages of subsidies
1.2.9 - Indirect Taxes and Subsidies
- Welfare maximisation (social optimum output is reached (if pigouvian subsidy is utilised).
- Supports exports
- Changes preferences to goods that are subsidiesed, as if passed on price goes down so increase in demand
- Help an industry grow so it can become internationallly competitive
- Positve externality remains
1.2 - How Markets Work
What kind of government intervention occurs with a merit good?
1.2.9 - Indirect Taxes and Subsidies
Subsidies
(Tend to be underprovided by free market)
1.2 - How Markets Work
What kind of government intervention occurs with a demerit good?
1.2.9 - Indirect Taxes and Subsidies
Indirect taxes
1.2 - How Markets Work
What are the advantages of indirect taxation?
1.2.9 - Indirect Taxes and Subsidies
- The market produces at the social equilibrium position and social welfare is maximised.
- Raises tax revenue - which could be used to solve the externality through other ways - investment in carbon capture.
- Polluter pays principles - polluter pays external costs, fairer to society.
1.2 - How Markets Work
What are some disadvantages of Indirect Taxation
1.2.9 - Indirect Taxes and Subsidies
- Imperfect information - Difficult to know where to set the tax. May be set too high/low.
- Government might be too focused on raising revenues.
- Might lead to the creation of a black market.
- If demand for the good is inelastic, then taxes will be ineffective at reducing output.
- Taxes are politcally unpopular, so governments may be reulcant to introduce them.
- Regressive
1.2 - How Markets Work
What are the advantages of max/min prices?
- Increase social welfare (can be set where MSB = MSC / consider externalities).
- Can make goods affordable or provide a fair price (Both reduce poverty + ↑ equality).
- Can be used to prevent monopolies from exploiting customers
1.2 - How Markets Work
What are the disadvantages of max / min prices?
- Creates excess supply / demand (Caused by distortion of price signals).
- Difficult to set a new price (don’t know size of externality [Hayek’s criticism of Pigou]).
- Creates a shadow market.
1.2 - How Markets Work
What are the advantages of pollution permits?
- Guarantee that pollution will fall (Internalises externality pigou).
- Increase Gov rev
- Encourages green tech
- Preserves business autonomy
1.2 - How Markets Work
What are the disadvantages of pollution permits?
- Expensive to monitor and police (fines imposed on firms, large enough to ensure they follow regulation).
- Raises costs for businesses (could be passed on to consumers).
- Difficult to know how many to create.
- Imperfect info. means govt. don’t know optimum level of pollutions.
- Need for international cooperation (as climate change is a global issue, this = difficult).
1.2 - How Markets Work
What are the advantages of state provision of good/ services?
- Improves social welfare
- Ensures access to basic goods / corrects market failure (some goods not provided by private sector producers).
- Increases external benefits
1.2 - How Markets Work
Disadvantages of state provision of good/ services
- Expensive - high opportunity cost e.g. administrative costs.
- Gov. may provide wrong level of provision
- Inefficiencies and corruption
- Govt. may have inefficient production. (no incentive to cut costs).
1.2 - How Markets Work
Advantages of provision of information?
- Allows consumers to act rationally.
- Can be used alongside other policies. (e.g. can make demand more elastic - will increase effectiveness of indirect taxes at reducing output).
1.2 - How Markets Work
What are the disadvantages of provision of information?
- Expensive - high opportunity cost.
- Gov. may not have correct info.
- Consumers might not listen (due to irrational behaviour)
1.2 - How Markets Work
What are the disadvantages of regulation?
- Laws are expensive.
- Regulatory capture.
- Increased costs (may be passed on to consumer).
- May reduce competition - firms below shut down point / π motive limited inc. barriers
1.2 - How Markets Work
What are the advantages of regulations?
- Can consider externalities, prevent exploitation.
- (Overcoming market failure + max social welfare).
- Non-market based approach, so doesn’t suffer from problems related to elasticity etc.
1.2 - How Markets Work
What are the 4 main types of government failure?
- Distortion of price signals
- Unintended consequences - Black Markets
- (Excessive) Admin costs
- Information gaps
1.2 - How Markets Work
Outline the assumption of consumer behaviour?
1.2.10 - Alternative views of consumer behaviour
Should be rational but…
* Peer pressure - e.g. fashion trends
* Habits - such as brand loyalty
* Poor compuatation - difficult to compare value of different products and calcualting price per unit so may lead to inefficent choices
1.3 - Market Failure
What are the 3 main types of market failure?
1.3.2 - Externalities
- Externalities (under or overproduction).
- Under-provision of public goods (by the private sector, due to free-rider problem).
- Information gaps (Resources not allocated to maximise social welfare)
1.3 - Market Failure
Define externalities?
1.3.1 - Types of market failure
The cost or benefit a third party receives from an economic transaction.
1.3 - Market Failure
What are External costs / benefits
1.3.2 - Externalities
The costs / benefits to those participating in the economic transaction.
1.3 - Market Failure
What are External costs / benefits
1.3.2 - Externalities
Costs / benefits to the third party.
1.3 - Market Failure
What are Social costs / benefits?
1.3.2 - Externalities
Costs / benefits of the activity to society as a whole
1.3 - Market Failure
What is a merit / demerit good?
A good with external costs / benefits.
1.3 - Market Failure
What 2 things are public goods? Give an example
- Non-rivalrous
- Non-excludable
A fireworks display
1.3 - Market Failure
What does non-rivalrous mean?
One person’s use does not stop another person. (Both still receive benefit).
1.3 - Market Failure
What does non-excludable mean?
You cannot stop someone from accessing the good and someone cannot choose not to access the good.
(Person always receives benefit)
1.3 - Market Failure
What is the free rider problem?
You cannot charge an individual for a non-excludable good. People will use without paying therefore it will not be profitable
1.3 - Market Failure
Why are public goods not found in a free market economy?
Due to the free rider problem, public goods are not profitable - you cannot charge an individual for use of a non-excludable good
1.3 - Market Failure
What are information gaps?
Asymmetric information where one party has superior knowledge. Can be caused by advertising and leads to misallocation of resources.
1.3 - Market Failure
What is Symmetric information?
Consumers and producers have potential access to the same information.
1.3 - Market Failure
What is asymmetric information?
Consumers and producers don’t have the same information.
1.3 - Market Failure
What is an example of a merit good? (Where the social benefit > private)
Toothpaste
1.3 - Market Failure
What is an example of a demerit good (Private benefit > social)
Cigarettes
1.3 - Market Failure
What is the supply curve also known as
MPC (Marginal Private Cost)
The cost to firms to make the product
1.3 - Market Failure
What does the MSC represent?
Marginal Social Cost - the cost to society per unit.
1.3 - Market Failure
What does Pso and Qso represent?
The socially optimum price and quantity.
1.3 - Market Failure
Where should the economy produce?
Where MSB=MPC
The market produces where MPB=MPC
1.3 - Market Failure
What could the gov. provide (provision of good / service)
Any g/s where social benefits are very high.
E.g. healthcare / education
1.3 - Market Failure
What are two examples of information gaps
- Adverse Selection: In the used car market, sellers may have more information about the car’s condition than buyers. Buyers may be cautious because they fear purchasing a lemon.
- Moral Hazard: Insurance markets can suffer from moral hazard. When individuals have insurance coverage, they may take on riskier behaviors because they are protected from the full consequences of their actions.
1.3 - Market Failure
When do Positive consumption externalities occur?
Social benefits are greater than social costs.
1.3 - Market Failure
Give 2 evaluations for externalities:
- It can be difficult to work out size of externality - placed on value judgements. (Difficult to monetise external costs (Hayek’s criticism of Pigou)).
- Many externalities due to info. gaps - people unaware of implications.
1.3 - Market Failure
How does govt. intervention such as ind. taxes + subsidies inc. social welfare?
Subsidies - merit goods
Ind. taxes - demerit goods
(Helps to internalise externality - POLLUTER PAYS - moving production closer to social optimum position through pigouvian tax).
1.3 - Market Failure
What is a merit good?
A good with external benefits - greater benefit to society than the individual.
1.3 - Market Failure
What is a demerit good?
A good with external costs - the cost to society is greater than to the individual.
1.3 - Market Failure
Why can indirect taxes be bad for consumers?
The increases CoP can be transferred to them via higher prices (Consumer burden)
1.3 - Market Failure
Why might the govt. provide information?
Externalities = associated with info. gaps.
Govt. provides info. so eco agents make informed decisions + acknowledge external costs.
1.3 - Market Failure
Why is a street light a public good?
Has two characteristics: cannot stop person from using it, their use doesn’t prevent yours.
1.3 - Market Failure
What are non-pure public goods also referred to as? Define them:
Quasi-public goods.
(Goods which aren’t perfectly non-rivalrous / excludable).
1.3 - Market Failure
Why do public goods have to be provided by govt.?
Due to free-rider problem, PGs are non-excludable - cannot be sure of making a profit ∴ not provided by private sector producers.
1.4 - Government Intervention
Give the extra disadvantage to indirect taxes
If demand for a good is inelastic, the tax will be ineffective at reducing output.
(Still increases govt. rev tho).
2 Benefits of indirect taxes in essay writing:
1) Internalises externality (polluter pays [pigouvian tax]).
2) Generates govt. revenue, hypothecated tax. [Double dividend theory].
Eval: regressive, shadow markets, ineffective at reducing demand if PED is inelastic.
If an indirect tax is imposed on a good, who has to pay the majority of the tax? Consumers or producers
The tax will mainly be passed onto the consumers since they are unresponsive to price changes.
This means that the tax will not be very effective at decreasing output, but will raise revenue for government.
If an indirect tax is imposed on a good and demand is price elastic, who has to pay most of the tax burden?
The more elastic the demand curve, the lower the incidence of tax on the consumer.
When PED is elastic, a tax will only lead to a small increase in price and the supplier will have to cover the majority of the cost of the tax
Why is distortion of price signals government failure?
Price mechanism aims to allocate resources to their best use.
Distortion can keep producers allocating resources to an inefficient product.
What shape does a perfectly elastic demand curve make?
What shape does a perfectly inelastic demand curve make?
- Elastic - Flat when elastic, like the middle part of an ‘E’
- Inelastic- Vertical when inelastic, like an ‘I’
1.4 - Government Intervention
What is an ad valorem tax?
An indirect tax imposed on a good, where the value of the tax is dependent on the value of the good.
The tax is a percentage of the cost of the good.
1.4 - Government Intervention
What is a minimum price
Minimum prices are government-imposed limits on the price of a good or service.
They are typically set above the equilibrium price to support producers, ensuring they receive a fair income
Such as in agriculture
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What does a minimum price diagram look like
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What are some cons of minimum prices
- Increased prices for consumers.
- Resources are wasted when excess goods are destroyed (goods = oversupplied).
- Inefficient allocation of resources, due to excess supply.
- Higher tariffs necessary on imports. To keep minimum prices, the EU also had to put tariffs on food to keep prices artificially high.
- Could lead to less innovation and efficiency as producers are guaranteed a minimum income
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Pros of a minimum price
- Ensures fair income for suppliers.
- Boosts competitiveness and may improve allocative efficiency (AE).
- Higher profits (π) lead to increased disposable income (DE) and economic demand
- Protects vulnerable industries, preventing market collapse.
- Encourages long-term investment by stabilizing producer earnings.
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What are maximum prices
Maximum prices are government-imposed limits on the price of a good or service.
They are typically set below the equilibrium price to protect consumers from high prices.
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What does a maximum price look like
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What is an example of maximum prices
Rent Controls
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Arguments in favour of rent controls for housing
- Reduces rents, easing pressure on disposable incomes and welfare systems.
- Improves labour mobility, reducing structural unemployment.
- Curbs excessive landlord profits, protecting vulnerable renters.
- Enhances housing stability, reducing evictions and homelessness.
- Makes housing more accessible for lower-income groups, reducing inequality.
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Evaluation points – Drawbacks of rent controls for housing
- May lead landlords to replace rental homes with housing for sale, driving property prices higher in already unaffordable areas.
- Could reduce maintenance spending, lowering housing quality and increasing risks for tenants.
- Risk of landlords withdrawing investment, diminishing the supply of private rented housing.
- Encourages black market rentals, as landlords may illegally charge higher prices to bypass controls.
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What are two problems associated with rent controls
- Rent controls may have unintended consequences, such as encouraging landlords to convert rental properties to other uses or sell their properties altogether. This can make the supply shortage for rental housing even worse.
- Could lead to a deterioration in the quality of rental housing and reduced investment in maintenance and upgrades. This has external costs such as increasing risk of damp which worsens people’s health.
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What are 2 alternative government policies that might improve housing affordability in UK cities in the long-term
- Subsidies for self-build, modular housing & tax incentives to encourage co-living spaces. Changes in land-use policies. Grants for property conversions.
- Incentives for developers to build affordable housing (such as zero VAT on building materials) & allowing local councils to raise finance through bonds to expand the construction of new energy efficient social housing
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Pros of max prices
- Protects consumers from exploitation, ensuring fair pricing for essential goods.
- Increases affordability, making essential goods accessible to low-income households.
- Improves efficiency of firms, pushing them to manage costs effectively to remain profitable.
- Controls inflation, preventing excessive price hikes in critical markets.
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Cons of max prices
- Creates shortages as demand exceeds supply, leaving some consumers unable to access the goods.
- Reduces producer incentives, leading to lower supply and diminished market efficiency over time.
- Encourages black markets with illegal sales at higher prices, bypassing the price cap.
- Lowers quality, as producers may cut costs to offset reduced revenue.
- Disrupts price signals, preventing efficient resource allocation and market adjustments.
- Adds administrative burden for governments, as monitoring and enforcing price caps can be complex and costly
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What are the 8 forms of government intervention for theme 1?
- Indirect taxes
- Subsidies
- Tradable pollution permits
- Max prices
- Min prices
- Provision of good / service
- Provision of information
- Regulation
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What are tradable pollution permits?
They allow firms to produce up to a certain amount of pollution and can be traded amongst firms.
Reduces total amount of pollution.
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How are pollution permits traded?
Permits are traded through the price mechanism, where supply and demand determine their value. For example, in the EU Emissions Trading System (ETS), firms needing more permits can buy them from others, incentivizing reductions in emissions.
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What do pollution permits allow governments to do?
Governments can set an optimal limit on pollution by allocating permits to firms
EU emissions trading sysem (ETS) issues permits but annually cuts the number of permits to incentive firms to reduce emissions
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Diagram for pollution permits:
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What are the advantages of pollution permits?
- Ensure pollution reduction by internalizing externalities (Pigouvian principle).
- Increase government revenue through the sale or auction of permits.
- Encourage green technology investments, reducing emissions cost-effectively.
- Preserve business autonomy, allowing firms flexibility in meeting targets.
- Improve market efficiency by allocating pollution rights via the price mechanism.
- Facilitate global cooperation through international trading schemes.
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What are some disadvantage of pollution permits
- Expensive to monitor and enforce, requiring substantial fines to ensure compliance.
- Raises business costs, potentially leading to higher consumer prices.
- Difficult to determine the correct number of permits due to dynamic market conditions.
- Imperfect information may result in suboptimal pollution limits set by the government.
- Risk of carbon leakage - occurs when companies move production to countries with lower carbon prices, to avoid paying for carbon credits
- May disadvantage smaller firms, as larger corporations can absorb permit costs more easily, increasing market concentration.
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What are the advantages of state provision of good/ services?
- Improves social welfare by addressing societal needs directly.
- Ensures access to basic goods and corrects market failures where private firms may not provide essential services.
- Increases external benefits, like better public health or education, that benefit society as a whole.
- Promotes equity by ensuring everyone, regardless of income, can access key services.
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Disadvantages of state provision of good/ services
- Expensive with high opportunity costs: State provision requires substantial spending, which may divert funds from other crucial areas, such as healthcare or infrastructure, with administrative costs adding further strain.
- Risk of inefficiency and waste: Without profit motives or strong accountability structures, government-run services may lack incentives to minimize costs or improve productivity, potentially leading to inefficiency and corruption.
- Potential for incorrect provision levels: Imperfect information can lead to over- or under-provision of goods and services, resulting in unmet societal needs and misallocated resources.
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What is state provision of goods and services
When the government supplies essential goods and services directly to the public, often to address market failures, improve social welfare, and ensure universal access (e.g., healthcare, education, and infrastructure).
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Advantages of provision of information:
- Allows consumers to act rationally by reducing information asymmetry, leading to better decision-making.
- Can be used alongside other policies, such as making demand more elastic to enhance the effectiveness of measures like indirect taxes in reducing output.
- Encourages socially beneficial behaviors, such as healthier lifestyles or environmentally friendly choices, through public awareness campaigns.
- Leads to better allocation of resources and reduced market failures, as informed decisions improve overall market efficiency.
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What are the disadvantages of provision of information?
- Expensive with high opportunity costs: Costs of producing and distributing information may divert funding from essential areas like healthcare.
- Government may lack correct information: Imperfect knowledge can result in ineffective or misleading campaigns.
- Consumers may ignore advice: Irrational behavior or resistance to change can limit the impact of informational efforts.
- Hard to measure effectiveness: Assessing the success of campaigns can be challenging, complicating resource allocation.
- Risk of unintended consequences: Poorly designed initiatives may confuse consumers or lead to harmful actions.
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What is provision of information
A policy where the government provides accurate and accessible data to inform consumer and producer decisions, aiming to address information gaps, correct market failures, and promote socially beneficial behaviors
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What are the disadvantages of regulation?
- Laws are expensive: Significant government spending is required for drafting, implementing, and enforcing regulations.
- Regulatory capture: Industries may influence regulators, skewing rules in their favor and undermining fairness.
- Increased costs: Compliance expenses for businesses often lead to higher consumer prices.
- May reduce competition: Elevated regulatory burdens can force weaker firms out, limiting market dynamism.
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What are the advantages of regulations?
- Addresses Externalities: Regulations ensure that companies account for social costs, reducing negative external impacts.
- Prevents Exploitation: By setting enforceable standards, regulations protect consumers and workers from unfair practices.
- Promotes Social Welfare: They help overcome market failures by prioritizing maximum societal benefits over pure profit motives.
- Non-Market Approach: Operating outside the price mechanism, regulations avoid issues related to demand elasticity and market fluctuations.
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What is regulation
A set of government-imposed rules and standards designed to manage behavior in markets and society, correct market failures (e.g., externalities), and protect public welfare by preventing exploitation and ensuring fairness.
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What are the 4 main types of government failure?
Distortion of price signals
Unintended consequences
(Excessive) Admin costs
Information gaps
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Examples of possible government failure from
imposing quotas and tariffs on imported steel into the UK.
- Tariffs and quotas leads to higher costs for downstream users of steel. It might lead to higher construction costs which makes new housing less affordable or e-vehicles more expensive (unintended consequences)
- Risk of a tit-for-tat trade war – with other countries imposing retaliatory trade barriers – this can cost jobs in other export industries. You might want to introduce some game theory here.
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Examples of possible government failure from imposing rent controls in Scotland.
- Possible exit of landlords from the market due to sub-normal profits. This reduces supply and leads to a greater shortage of rental properties – increasing the risk of shadow markets operating. (Deepens existing market failure)
- Fall in the quality of the stock of rented housing as landlords find ways to cut costs. This can lead to negative externalities such as tenants experiencing worsening health + limits progress in reducing carbon emissions. (Policy conflict)
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Examples of possible government failure from banning high-caffeine drinks to people under the age of 16.
- Black Market and Illegal Sales: Prohibiting the sale of high-caffeine drinks to young people may create a black market where these beverages are sold illegally at high prices.
- Enforcement costs: Enforcing a ban on high-caffeine drinks can be expensive. Failure to impose the ban would make it less effective. + a ban does not address the underling causes of rising consumption such as inadequate nutrition education or parental guidance
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Possible causes of government
failure from imposing a minimum retail price for high-caffeine drinks
- Low PED and low effectiveness: The policy might be ineffective if demand for these drinks is price inelastic. It would take a high minimum price to have a substantial effect which might have regressive effects on lower-income families.
- Substitution Effects: Imposing a minimum retail price on high-caffeine drinks may lead to unintended substitution effects. Young people might shift their consumption to potentially unhealthy alternatives such as energy drinks that contain additives and artificial sweeteners
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How is distortion of price signals government failure
Government-set prices (e.g., minimum prices) disrupt the natural communication of supply and demand. For instance, a minimum price in agricultural markets can signal producers to oversupply, creating surpluses that go to waste, while in demerit markets like alcohol, it may send misleading signals that result in production losses. This misallocation of resources is a government failure.
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How is unintended consequences a government failure
Government interventions intended to correct market issues can backfire when producers and consumers, driven by self-interest, exploit legal or illegal loopholes. This behavior may inadvertently foster illegal markets or unplanned production and consumption patterns, undermining the original policy goals while creating additional inefficiencies.
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How is excessive administration costs a government failure
When the expenses of regulating and administering policies exceed the social welfare benefits generated, resulting in a net loss in efficiency. This failure occurs because excessive costs undermine the intended gains from government intervention.
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How is information gaps a government failure
Government decision-makers often operate with incomplete data and are influenced by cognitive biases (e.g., anchoring) as well as political pressures. This imperfect information can lead to policies that fail to fully address issues, resulting in suboptimal outcomes.
