Unit 1 Flashcards
In the process of Developing Models, what do economists need to do?
Make Assumptions
What is Ceteris Paribus?
A key assumption that is made is assuming that events occur with ceteris paribus.
This assumption is that other things are being held equal or constant, so nothing else changes.
Why do Economists use Models?
Economists cannot conduct scientific experiments, like in the natural sciences, so models are devised.
Economists then use real-life scenarios to build these models upon, and assumptions are made with the models.
What are Positive Statements?
Statements based on quantitative/reliable data, which isn’t influenced by opinion (objective)
What are Normative Statements?
Subjective judgements based on opinion rather than factual evidence
What is the role of Value Judgements in influencing economic decision + policy?
Normative statements are based on ‘value judgments’
Value judgements can influence economic decision making + policy
Different economists can make different judgements from the same statistic
(e.g. the inflation rate can lead to different conclusions)
What is the Basic Economic Problem?
Our wants and needs is unlimited, but resources are finite (scarce)
What are Non-Renewable Resources?
Non-renewable resources cannot be renewed.
The stock levels decreases over time as it is consumed.
e.g. things produced from fossil fuels; such s coal, oil and natural gas, are non-renewable.
Methods like recycling and finding substitutes (e.g. wind farms) can reduce the decline of the resource.
What are Renewable Resources?
Renewable resources can be replenished; so their stock level can be maintained over a long time period.
e.g. Oxygen, fish + solar power are renewable; assuming the rate of consumption < rate of replenishment
How can Renewable resources be Managed?
They can be managed by limiting/preventing deforestation, imposing fishing quotas, etc.
What is our Current Consumption of renewable goods?
We currently consume more renewable goods at a faster rate than replenishment.
The Worldwide Fund for Nature claims that 2 planets will be needed to meet global demand by 2050.
What does Opportunity Cost mean?
Giving up one thing for the next best alternative.
The loss of other alternatives when one alternative is chosen.
What are the Factors of Production?
Land
Labour
Capital
Enterprise
What are Capital Goods?
Goods used to produce consumer goods (eg machinery)
What are Consumer Goods?
Produced goods that can be sold to consumers.
What does the PPF usually show?
- How much of two goods you can make with the given resources.
- The opportunity cost for if you give up one of more than the other
Why is the PPF diagram usually curved?
There usually isn’t a constant opportunity cost for if you use more of one than the other
What may cause the PPF Curve to Shift to the Right?
Economic Growth
What is the Importance of Opportunity Costs to the economic agents?
Consumers: choosing between 2 products
Producers: (e.g.) choosing between hiring extra staff, or investing in new machinery
Governments: (e.g.) choosing between spending more on NHS, or education
They can’t do both due to finite resources, so a choice has to be made for where the resources are best spent
What is Specialisation?
Workers become skilled in their certain field as they work on that small part so much.
Therefore they work much more efficiently and effectively.
For example, when making a doll, workers can manufacture certain parts of the doll.
What is Division of Labour?
When you divide the process of production into smaller parts, where workers take up each part.
Therefore multiple workers are involved in the process of production.
What is the Relationship between Division of Labour and Specialisation?
When division of labour occurs, work has become specialised in their field of production; and the whole production process happens much more efficiently.
What are the Advantages of Division of Labour?
- What has become specialised, and work more efficiently + quickly
- More choice for what you can work in
- Work is evenly distributed, so everyone works the same amount
What are the Disadvantages of Division of Labour?
- Work becomes boring and monotonous
- Cost money to train workers
- Interdependence: Workers depend on others for the whole production process to work
– If someone is ill and doesn’t go to work, production becomes difficult
– if someone becomes bored/tired and stops working to as high of a standard, production becomes less efficient/becomes a lower standard
Who famously stated/ came up with Specialisation and Division of Labour?
Adam Smith:
The concept was famously stated by Adam Smith, who showed how, through the division of labour, worker productivity can increase, and firms can then take advantage of increased efficiency + decreased costs of production
What are the Advantages of Specialising in certain goods and services within trade (Comparative Advantage)?
- Greater world output, so there is a gain in economic welfare
- Lower ACs, since the market becomes more competitive
- Increased supply of goods to choose from
- Outward shift in the PPF curve
What are the Disadvantages of Specialising in certain goods and services within trade (Comparative Advantage)?
- LEDCs might use up their non-renewable resources too quickly, so they might run out
- Countries could become Over-Dependent on the export of 1 commodity (e.g. wheat) - Commodities have unstable prices, so the economy would suffer.
What are the Functions of Money?
A medium of exchange
A measure of value
A store of value
A method of deferred
How is money a medium of exchange?
Without money, transactions were conducted through bartering; goods + services were traded with other goods + services.
But people didn’t always get exactly what they wanted or needed, and the goods traded weren’t always of the same value. Exchange could only take place if there was a double coincidence of wants
How is money a measure of value?
Money provides a means to measure the relative values of different goods and services. Money also puts a value on labour.
e.g. Jewellery might be considered more valuable than a tablecloth; represented by it costing more money.
How is money a store of value?
Money has to hold its value to be used for payment. It can be kept for a long time without expiring.
However, keep in mind that the quantity of G+S that can be bought with a certain amount can change, due to supply + demand
How is money a method of deferred payment?
Money can allow for debts to be created. This means people can pay for things without having money in the present, but can pay for it later.
This relies on money storing it value.
What are free-market economies also known as?
Laissez-faire economies
What happens in a Free Market Economy (What/How/To Whom)?
What to produce: determined by what the consumer prefers
How to produce it: producers seek profits
For whom to produce it: whoever has the greatest purchasing power in the economy, and is therefore able to buy the good
What are the Advantages of a Free Market Economy?
More Efficient:
Due to wanting higher demand from consumers, firms are likely to lower prices and make more efficient use of scarce resources
The bureaucracy from government intervention is avoided
(Bureaucracy: a system of government in which most of the important decisions are taken by state officials rather than by elected representatives.)
More personal freedom
What are the Disadvantages of a Free Market Economy?
Ignores Equality, as firms only want profit
May lead to the overconsumption of Demerit Goods which have large Negative Externalities
Public Goods are not provided
Merit Goods are Underprovided
There could be Monopolies which could exploit the market
What Happens in a Command Economy?
The Government decides/ determines what goods should be produced, how much should be produced, and the price at which the goods will be offered for sale
What are Some Countries that are in a Command Economy?
China, Cuba + North Korea
What are the Objectives of a Command Economy?
Consumers, workers and the government are all assumed to be working for the ‘common good’.
How much Competition will there be in a Command Economy?
Very Little
What are the Advantages of a Command Economy?
The planner tries to be fair in distributing the output of the economy. Wages are determined by the planners, as are the prices of the goods produced.
Prevents Mass Unemployment
Command economies could produce goods which benefit society..
and ensure everyone has access to basic necessities.
What are the Disadvantages of a Command Economy?
Asymmetric Information: The government are unaware of what is actually happening in Businesses, etc.
Unable to Respond to Consumer Preferences
Power: Command economies create a very Powerful Government, which Threatens Democracy.
Also, the government could end up Controlling Other Aspects of People’s Lives
What is a Mixed Economy (What/How/For Whom)?
What to produce: determined by both consumer and government preferences
How to produce it: determined by producers making profits and the government
For whom to produce it: both who the government prefers, and the purchasing power of private individuals
What is the Role of the State in a Mixed Economy?
The market is controlled by both the government, and the forces of supply and demand
Governments often provide public goods (street lights, roads, police), and merit goods (healthcare, education)
What do Consumers aim to maximise?
Consumers aim to Maximise Utility
What is meant by a Customer’s Utility?
A customer’s utility is the total satisfaction from consuming a good or service
What do Firms aim to maximise?
Firms aim to Maximise Profits
What is the Two-System Model that explains how decisions are made?
Made by Daniel Kahneman; a Nobel Prize winner for his work in behavioural economics
First System: based on common sense estimates, and emotional responses to the choice made. It uses short cuts, and quick decisions are made. This is the dominant system.
But the bias + potential for error in the system could leads to irrational decisions being made
Second System: uses thoughts + reflections, and avoids bias and errors in the first system. This takes longer than the first. -
But the system can be easily manipulated, and so the decisions made could be harmful to the consumers / others
What is the Rational Decision Making Model?
1) Identify the problem: For a firm, this might be falling profits.
2) Find and identify the decision criteria: The firm might have to find information or criteria that will increase their profits. The firm’s criteria might include, for example, keep a certain number of employees or to not change the price of their goods. The criteria might include how the decision will affect stakeholders (the customer and the staff, for instance), and how the quality might be affected.
3) Weigh the criteria: The firm will have to rank the criteria based on their relative importance. They might think keeping all of their employees is the most important, for example.
4) Generate alternatives: The firm might consider some alternative options. For instance, they might think that moving their premises somewhere else will reduce costs and hence increase profits. Perhaps they will consider a loyalty scheme or a promotion for the consumer. Alternatively, the might decide to reduce the size of their workforce.
5) Evaluate alternative options: The firm might now consider which of the alternatives meet their criteria the best, and help them increase their profits the most.
6) Choose the best alternative: Now the firm will choose the alternative they think meets their criteria.
7) Carry out the decision: The firm can now see what the consequences of the decision are.
8) Evaluate the decision: After seeing what effect the decision has on the firm, they can consider whether this was the best option or not.
What are Limitations to the Rational Decision Making Model?
This is not always the best or most realistic way for firms to make decisions.
Although it might be fairer than making an intuitive decision, it takes significantly longer to decide, which is not practical in a firm with strict time constraints.
What is Demand?
The amount of goods and services people choose to buy at any price over a given period of time.
What is meant by Diminishing Marginal Utility?
The falling satisfaction for every additional unit consumed.
The more you have of something, the less satisfied you are with it
This explains why it is a downward slope, as you end up demanding less.
What is the Law of Demand?
There is an inverse relationship between the price of a good or service, and the quantity demanded. (Ceteris Paribus)
What is another reason for the demand curve being downward sloping?
When the price of the good is lower, more can afford it and/or are willing to buy it.
What Factors Affect Demand?
Substitutes
Taxes
Income
Price
Population
Advertising + Fashion
How do changes in prices affect the demand curve?
You go along the demand curve, but it doesn’t shift
What is meant by Responsiveness?
Switching from one good to another
e.g. Lemons to Limes
What is PED?
Price Elasticity of Demand
The demand of a product in relation/response to the price of it.
What is the PED Formula?
%change Quantity Demanded
______________
%change Price
What are the factors of PED?
- Availability of Substitutes
- Degree of Necessity
- Proportion of Consumer Budget it takes up
- Cost of Switching Between Products
- Peak/ Off Peak Demand
- Addictiveness
How do you Work Out the Change?
New Price- Old Price
________________
Old Price
(x 100)
What are the Coefficients of PED?
0 = Perfectly Inelastic
(+/-) 0-1 = Inelastic
(+/-) 1+ = Elastic
(+/-) Infinity = Perfectly Elastic
Which one has a Steeper Demand Curve: Elastic or Inelastic?
Inelastic
A decrease in price leads to a less than proportionate increase in Qd
Why is PED Significant to Firms and the Government?
The burden of an Indirect Tax falls directly on the consumers and the Firms
Inelastic Good:
Firms will put most of the tax burden on the Consumer (because they know the price increase won’t majorly affect demand)
Demand will fall slightly
This is most effective for raising government revenue.
Elastic Good:
Firms will put most of the tax burden on the Producer (because they know the price increase will majorly affect demand)
Demand will fall significantly
This is not as effective for raising government revenue, but is highly effective if the government wants to reduce the demand of a particular good.
What is the Relationship between PED and Total Revenue?
Total Revenue = AR x Quantity
Goods with Elastic Demand:
If firms raise its price, the quantity sold will fall significantly. This reduces total revenue.
Good with Inelastic Demand:
Firms can raise its price, and quantity sold will not fall significantly. This increases total revenue
What is YED?
A measure of Responsiveness of quantity demanded to a Change in Income
What is the YED Formula?
% Change in Income
What are the Coefficients of YED?
(+/-) 1+ = Income Elastic
(+/-) 0-1 = Income Inelastic
Positive = Normal Good (downward sloping curve)
Negative = Inferior Good (upward sloping curve)
Positive Elastic = Luxury Good
Why is YED significant to Firms?
During periods of prosperity (e.g economic growth) when real incomes are rising, firms might switch to producing more Luxury goods and fewer inferior goods.
This is because the demand for luxury goods will be increasing
What is XED?
The Responsiveness of Demand of one good to the changes in price of another good
What are the Coefficients of XED?
(+/-) 0-1 = Cross Inelastic
(+/-) 1+ = Cross Elastic
Positive XED = Substitute Goods
Negative XED = Complimentary Goods
0 XED = Unrelated Goods
Which Way does the XED Curve Go?
Upwards - Substitutes
Downwards - Complimentary
( X axis = Price of A)
( Y axis = Quantity of B)
How do you calculate XED?
|> Quantity of good A / |> Price of Good B
Why are Firms Interested in the XED of their product?
It allows them to see how many competitors they have.
Therefore, they are less likely to be affected by price changes by other firms, if they are selling complimentary goods or substitutes
What Way does the Supply Curve go?
Upwards
As price rises, it encourages firms to produce more so they can make a bigger profit
What is Supply?
The quantity of a good or service that firms are willing to sell at a given price over a given time period.
What Makes a Move Along the Supply Curve?
A change in the Cost of Production
What Affects Supply?
Productivity Technology Weather Supply of Complimentary Goods (Number of firms) Cost of Production Amount of Resources Subsidies / Indirect Tax
What is Joint Supply?
When a production process can result in multiple outputs
- E.g. Producing more lamb also leads to an increase in wool
What is PES?
The Responsiveness of Supply to Changes in Price
What are the Major Factors that Impact PES?
Change in Cost of Production
Change in Time of Production
What are the Factors of PES?
- Time Scale
In the short run, supply is more price inelastic, because producers cannot quicklyincrease supply. In the long run, supply becomes more price elastic - Spare Capacity
If there are spare resources (e.g. in a recession) there are lots of spare and unemployed resources, supply can be increased quickly - Barriers to Entry
Higher barriers to entry means supply is more price inelastic, because it is difficult for new firms to enter and supply the market - Levels of Stocks
If goods can be stored (such as CDs) firms can stock them and increase market supply easily.
If the goods are perishable, such as apples, firms cannot stock them for long so supply is more inelastic. - How Suitable factors (LLCE) are
If labour and capital are mobile, supply is more price elastic because resources can be allocated to where extra supply is needed (e.g. transferable skills)
What is the PES Formula?
% Change in Quantity Supplied / % Change in Price
What does an Inelastic PES Suggest?
An increase in supply will be expensive at first and take a long time
High Cost to Increase Production
What does an Elastic PES suggest?
Firms can increase supply quickly at little cost
If demand changes, firms can easily / quickly adjust their supply
What are the Coefficients of PES?
> (+/-) 1 = Elastic Infinity = Perfectly Elastic
< (+/-) 1 = Inelastic 0 = Perfectly Inelastic
1 = Unitary
How is the Equilibrium Price and Quantity Determined?
Where supply meets demand.
What is meant by the Market Clearing Price?
At market equilibrium, price has no tendency to change, and it is known as the market clearing price.
What is meant by Excess Supply?
(Also known as an economic surplus)
When the amount of a good supplied > the quantity demanded
Occurs when the price of a good rises
How is Excess Supply shown on a diagram?
When the price rises to P1, take that horizontal line across.
Where it hits the D line and the S line shows the quantity of Excess Supply.
What is Excess Demand?
(Also known as an economic shortage)
When the demand of a product > the supply of a product
Occurs when the price of a good decreases
How do you show Excess Demand on a Diagram?
When the price falls to P1, take that horizontal line across.
Where it hits the D line and the S line shows the quantity of Excess Demand.
How do market forces Eliminate Excess Demand?
Excess demand means there’s a shortage in the market
This pushes prices up, causing firms to supply more. Also, higher prices contract demand.
How do market forces Eliminate Excess Supply?
Excess supply means there’s a surplus in the market
This pushes prices down, causing firms to supply less. Also, lower prices increase demand.
What are the Functions of the Price Mechanism?
Signalling
Incentive
Rationing
What is Signalling?
When Price acts as a SIGNAL to new firms entering the market. It may signal where resources are needed in the market
e.g. High prices signal firms to enter the market, as it will maximise profit. However it also encourages consumers to reduce demand and thus leave the market. The supply + demand curves shift.
What is Incentive?
Encourages a Change in the Behaviour of a Consumer/Producer
e.g. A high price would encourage firms to supply more of that product to maximise profit
What is Rationing?
When there are scarce resources/low supply
Price increases due to excess demand -> the good is rationed out only to those who can afford it
What is the Difference between Signalling and Incentive?
Price signals to firms showing where resources are needed in the market
Price gives firms an incentive (or encouragement) to change their behaviour
What did Adam Smith say about the Price Mechanism?
Adam Smith called this the ‘Invisible Hand of the Market’
Resources are allocated through the price mechanism in a free market economy.
The economic problem of scarce resources is solved through this mechanism.
The price moves resources to where they are demanded or where there is a shortage, and removes resources from where there is a surplus.
What is a Consumer Surplus?
The difference between the price of a product and what consumers are willing to pay for it.
This is based on what the consumer perceives their private benefit will be from consuming the good.
Inelastic demand curves give a larger consumer surplus. This is because consumers are willing to pay a much higher price to consume the good.
What is a Producer Surplus?
The difference between the price of a product and what firms are willing to sell it for.
It is the private benefit gained by the producer that covers their costs, and is measured by profit
How is a Consumer and Producer Surplus shown on a Diagram?
Consumer Surplus: the area above market price and below the demand curve.
Producer Surplus: the area below the market price and above the supply curve.
What Increases and Decreases a Consumer Surplus?
Increases: Increase in Demand
Decreases: Decrease in Supply
What Increases and Decreases a Producer Surplus?
Increases: Increase in supply, Increase in Demand
Decreases: Decrease in demand
What is Economic Welfare?
Producer Surplus + Consumer Surplus
The total benefit society receives from an economic transaction
It is important when considering the effects of government policies, which could affect either producer or consumer surplus.
What is Direct Tax?
Tax directly from the Government to Households
What is Indirect Tax?
Tax from the Government to Households, but through Another Party
What is Ad Valorem Tax?
Tax levied as a Certain Percentage of the Good
What is Specific Tax?
A Certain Value of Tax which Doesn’t Change
Also known as Unit Tax
What are the Effects of Tax?
Price Increases
Consumption Reduces
Producer and Consumer Surplus Changes
What Is Meant by the Incidence of Taxation?
WHO pays the tax?
(Top Box = Tax on Consumers
Bottom Box = Tax on Producers)
(For the diagram, it’s like the welfare loss triangle is excluded)
What is the Burden of Indirect Tax on goods with different PEDs?
Elastic: More tax on the supplier
Inelastic: More tax on the consumer
What is the Effect of Ad Valorem Tax?
Inelastic Demand: Government revenue from the tax is higher than if demand is elastic. This is because demand will only fall slightly with the tax.
Eg. the duty on tobacco and fuel raises a lot of government revenue, because they have inelastic demand.
If the tax is implemented with the intention of internalising the externality, it is hard to put a monetary value on the externality.Internalising the externality means the individual or firm which causes the negative externality, for example pollution, pays for the damage.
Taxes could be expensive for the government to collect.
Some taxes could be regressive, so they impact those on low and fixed incomes the most.
Taxes could be inflationary.
What do Subsidies do?
- Encourage suppliers to offer more at any price
- The effect of the subsidy is to reduce the price and increase the amount available
What will the Government do with Subsidies to Intervene with Markets?
- The government may intervene due to Positive Externalities
- Subsidies will move the Private Benefit of the good Nearer to its Social Benefit. This eliminates the Negative Externality.
What are the Positives of Subsidies?
- Subsidies increase output and lower prices for consumers, which could help families on low and fixed incomes.
- They increase the employment rate, by making workers more skilled through apprenticeship schemes and lowering the cost of employing workers.
- They reduce inequality in society, if the subsidy is progressive.Subsidies could help control inflation, by keeping costs of production low.
- They could help boost demand during periods of economic decline.
- Subsidies could encourage the consumption of merit goods, which creates positive externalities.
- Long run aggregate supply could increase if the subsidy is aimed towards a capital project.
- If demand is price inelastic, the subsidy will have a large effect on equilibrium price. This give a greater consumer gain than when demand is elastic.
What are Negatives of Subsidies?
- There could be government failure, if the government provides an inefficient subsidy or if the subsidy distorts the market price.
- Government revenue could be better spent elsewhere. The opportunity cost of the subsidy should be considered.
- It is usually the tax payer who pays for the subsidy, and they might not receive any direct benefit from the subsidy.
What do Producer and Consumer Subsidies do?
A consumer subsidy encourages consumers to purchase more of a particular good or service. It could be a direct grant or a loan without interest, for example.
Consumer subsidies affect demand and do not shift the supply curve.
Producer subsidies lower the cost of production and shift the supply curve.
How are Producer and Consumer Subsidies shown on a Diagram?
Producer Subsidies on the top box
Consumers Subsidies on the bottom box
(For the diagram, its like the welfare gain triangle is included)
What are the Reasons Consumers may not Behave Rationally?
The influence of other people’s behaviour
The importance of habitual behaviour
Consumer weakness at computation
How can the Influence of other People’s Behaviour lead to irrational behaviour?
The behaviour of other people affects how the consumer acts.
Other people’s behaviour creates a bias within the consumer. This social pressure encourages consumers to do things they would not otherwise do, or that they know could be harmful.
Consumers become unwilling to change, even if it is of benefit to them, if it goes against the norms of their society.
Assume there are two restaurants; one is empty whilst the other has a long queue. Consumers are more likely to queue for their food than go straight into the other restaurant.
How can Habitual Behaviour influence a consumer’s rational behaviour?
Habits reduce the amount of time it takes to do something, because consumers no longer have to consciously think about their actions.
For example, a commute to work becomes a habit over time.
Habits create a barrier to making a decision. They limit or prevent consumers considering an alternative.
A commuter who is familiar with one route to work is unlikely to consider an alternative route, because they would have to re-familiarise themselves with it.For example, it is hard for consumers to give up smoking, even if they know it is good for them, because they are habituated to it.
Similarly, consumers might find it hard to save for the future, such as for a pension, because they have a habit of spending in the present.
Breaking a habit causes withdrawal symptoms in the consumer, which may make them feel uncomfortable, so they continue to commit the irrational action.
How can Consumer Weakness at Computation influence Consumers’ rational behaviour?
Making Bad Decisions:
Consumers are unable to exercise self-control with some decisions.
The law of diminishing marginal utility suggests that every extra unit consumed provides a smaller benefit to the consumer. Some consumers, however, don’t do this
e.g. some consumers will still eat more than gives them optimal benefit.
How can Consumers’ rational behaviour be influenced by the short/long run?
Consumers know that it will benefit them in the long run if they save for their pension, but this will limit their spending in the short run.
Spending less in the short run instils fear in the consumer, even if they are aware that unless they save, they will not be able to consume as much in the long run.
With the long run view, consumers feel as though they ‘could always start saving tomorrow’.
It is this procrastination which leads to consumers making irrational decisions by not having self-control.
What is Market Failure?
When there is an Inefficient Misallocation of Resources within a free market economy.
What is meant by Benefit?
The advantages of a transaction
Private Benefit: The benefit derived by an individual/firm Directly Involved in a Transaction
External Benefit: The benefit derived from Third Parties
Social Benefit: Private Benefits + External Benefits
What is meant by Cost?
The disadvantages of a transaction
Private Cost: The drawbacks derived by an individual/firm Directly Involved in a Transaction
External Cost: The drawbacks derived from Third Parties
Social Cost: Private Costs + External Costs
What is Asymmetric Information?
Where one party in a transaction has More/Less Information compared to the other
What are Public Goods?
Non-rival, Non-excludable goods provided by the government
What are Non-Rival Goods?
Consumption of that good/service does not prevent another person from also consuming it.
e.g. a streetlight: if one person uses the light provided by the streetlight it does not prevent another person from also benefiting.
However, if a person eats a chocolate bar, then someone else cannot also eat the same chocolate bar.
What are Non-Excludable Goods?
Once a good is provided, it’s impossible to stop people from using it
eg once a lighthouse is provided, then ships at sea cannot be prevented from benefiting from it.
However, if a new car model is on the market, people can be excluded from purchasing one if they do not have enough money to buy the car.
What are Quasi-Public Goods?
Goods that are either non-rival OR non-excludable, but not both
Who are Free-Riders?
People who use public goods without paying for them
this is the free rider problem
What is meant by Internalising an Externality?
The act of making a change in private costs or benefits in order to make them equal to the social costs or benefits.
What are the Types of Market Failure?
- Externalities:
An externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism. In other words, it is the spill- over effect of the production or consumption of a good or service. - Under-provision of Public Goods:
Public goods are non-excludable and non-rival, and they are underprovided in a free market because of the free-rider problem. - Information Gaps:
It is assumed that consumers and producers have perfect information when making economic decisions. However, this is rarely the case, and this imperfect information leads to a misallocation of resources.
What is meant by Imperfect Information?
Imperfect information is where information is missing, so an informed decision cannot be made.
What is meant by Symmetric Information?
Symmetric information means that consumers and producers have perfect market information to make their decision. This leads to an efficient allocation of resources.
What is the ‘Principal-Agent Problem’?
Asymmetric information can be linked with the principal-agent problem.
This is when the agent makes decisions for the principal, but the agent is inclined to act in their own interests, rather than those of the principal. For example, shareholders and managers have different objectives which might conflict. Managers might choose to make a personal gain, rather than maximise the dividends of the shareholders.
How can imperfect information lead to a misallocation of resources?
Consumers might pay too much or too little, and firms might produce the incorrect amount
eg monopolies exploiting consumers
What are Externalities?
Costs/Benefits that a Third Party receives from an economic transaction Outside of the market mechanism
What are Positive Externalities?
External benefits (positive externalities) exist when the social benefits of an economic action are greater than the private benefits.
What are Negative Externalities?
External costs (negative externalities) exist when the social costs of an economic action are greater than the private costs.
What is Welfare Loss and Welfare Gain?
Loss: The economic welfare that is lost as a result of too much or too little production and consumption of a good or resource.
Gain: The economic welfare that is gained as a result of increasing or decreasing the production and consumption of goods or resource.
What does a Positive Externality Diagram look like?
https://image.slidesharecdn.com/microrevisiontutor2upositiveexternalities-150201023334-conversion-gate01/95/tutor2u-market-failure-positive-externalities-5-638.jpg?cb=1422771320
What does a Negative Externality Diagram look like?
https://s3-eu-west-1.amazonaws.com/tutor2u-media/subjects/economics/negative_externalities_production_market_failure.png
What Government Policies are used for Negative Externalities?
Indirect taxes: to reduce the quantity of demerit goods consumed. This increases the price of the good. If the tax is equal to the external cost of each unit, then the supply curve becomes MSC rather than MPC, so the free market equilibrium becomes the socially optimum equilibrium. This internalises the externality. In other words, the polluter pays for the damage.
Subsidies: encourage the consumption of merit goods. This includes the full social benefit in the market price of the good.
Regulation: to enforce less consumption of a good. For example, the minimum school leaving age. If there was a compulsory recycling scheme, it would be difficult to police and there could be high administrative costs. Bans could be enforced for harmful goods, although they can still be consumed on the black market. Bans are only useful where MSC > MPB (the MSC curve is above MPB).
Provide the good directly: The government could provide public goods which are underprovided in the free market, such as with education.Provide information: so there is no information failure, and consumers and firms can make informed economic decisions.
Property rights: this encourages innovation because entrepreneurs can create new ideas, which are protected, and earn profit.
Personal carbon allowances: They could be tradeable, so firms and consumers can pollute up to a certain amount, and trade what they do not use.
What is Maximum Pricing?
Governments could introduce a maximum price, where goods cannot be sold at a price above this. A maximum price may be set by a government to encourage consumption of a particular good.
Pmax is the maximum price and is set below
the market price, P. Compared to the market equilibrium firms have contracted supply due to the lower prices but consumers have extended demand. Qd-Qs gives an excess demand/shortage.
What is Minimum Pricing?
Governments could introduce a minimum price, where goods cannot be sold at a price below this. A minimum price may be set by a government to discourage consumption of a particular good.
Pmin is the minimum price and is set above
the market price. Compared to the market equilibrium, firms have extended supply due to the higher prices but the consumers contracted demand. Qs-Qd
gives an excess supply/surplus/glut.
What are Trade Pollution Permits?
Used to tackle negative externalities, the government decides the desired level of pollution and releases a number of permits.
These permits can be traded by firms so that low polluters can sell to high polluters for profit.
What is meant by the State Provision of Public Goods?
The government provides a good or service, using tax revenue to fund it. These goods are not provided by the private sector due to the free rider problem.
+ This makes merit goods more accessible, possibly increasing their consumption which will yield positive externalities
- It could be expensive for gov’s to provide education; leading to opportunity costs
What is Provision of Information?
The government provides information to consumers to correct any problem of information gaps
.- This could be expensive to police
What are the Reasons for Maximum Pricing?
- The good is Essential for Daily Living:– without maximum pricing some may be unable to afford the good. Reducing the price helps reduce relative poverty.
- Monopoly Exploitation: If firms have monopoly power, they can charge high prices to consumers – Maximum pricing helps reduce ‘monopoly prices’ and also increases allocative efficiency.
- Inelastic Supply: If supply is very inelastic, then a maximum price will not reduce the supply of the good, therefore, there will be no fall in the quantity supplied.
What are the Problems with Maximum Pricing?
- Shortage: A maximum price distorts the market and leads to disequilibrium. The demand is greater than supply meaning many consumers will be unable to get the product at all. Cheap rents are no good, if it leaves many people homeless.
- Encourages Black Market. Because of the shortage, it creates the incentive to develop a ‘black market’ where people illegally trade the good. People could buy the good at the low maximum price and then resell to those customers who were unable to buy. This is potentially quite lucrative as some of those customers who missed out may be willing to pay a very high price.
- Less Profitable for Firms: In the long-term this may lead to less investment and also decrease supply in the long-term. For example, rent controls may be a way to deal with the short-term problem of expensive housing. But, reducing rents will discourage some landlords from letting out property. It may also discourage people from building houses.
What are the Advantages of Trade Pollution Permits?
- This should benefit the environment in the long run, by encouraging firms to use green production methods.
- The government could raise revenue from the permits, because they can sell them to firms. This revenue could then be reinvested in green technology.
- If firms exceed their permit, they will have to purchase more permits from firms which did not use their whole permit. This raises revenue for greener firms, who might then invest in green production methods.
What are the Disadvantages of Trade Pollution Permits?
It could lead to some firms relocating to where they can pollute without limits, which will reduce their production costs.
Firms might pass the higher costs of production onto the consumer. Competition could be restricted in the market, if the permits create a barrier to entry for potential firms.
It could be expensive for governments to monitor emissions.
How can Regulation aid Market Failure?
The government could use laws to ban consumers from consuming a good. They could also make it illegal not to do something.
(e.g. the min school leaving age means young people have to be in school until the age of 16, and education or training until they turn 18.)
This has positive externalities in the form of a higher skilled workforce.If there was a compulsory recycling scheme, it would be difficult to police and there could be high administrative costs. Bans could be enforced for harmful goods, although they can still be consumed on the black market.
+ Firms which fail to follow regulations could face heavy fines, which acts as a disincentive to break the rule.
- It could raise costs of firms, who might pass on the higher costs to consumers.
How can Taxes aid Market Failure?
Indirect taxes could reduce the quantity of demerit goods consumed, by increasing the price of the good. If the tax is equal to the external cost of each unit, then the supply curve becomes MSC rather than MPC, so the free market equilibrium becomes the socially optimum equilibrium.
This internalises the externality. In other words, the polluter pays for the damage.
How can Subsidies aid Market Failure?
Subsidies encourage the consumption of merit goods. This includes the full social benefit in the market price of the good. Therefore, the external benefit is internalised.
For example, the government might subsidise recycling schemes so it is cheaper for consumers to recycle waste, which will yield positive externalities for the environment.
What is Government Failure?
Governments can fail when they intervene in markets. They could worsen the market failure already present or a new failure might occur.
This results in a net welfare loss to society.
The loss could be from having ineffective intervention or when harm is caused.
What are the Causes of Government Failure?
Distortion of price signals
Unintended consequences
Excessive administrative costs
Information gaps
How can the Distortion of Price Signals lead to Government Failure?
Government subsidies could distort price signals by distorting the free market mechanism.
A free market economist would argue that this could lead to government failure. There could be an inefficient allocation of resources because the market mechanism is not able to act freely.
For example, the government might end up subsidising an industry which is failing or has few prospects.
How can Unintended Consequences lead to Government Failure?
The actions of producers and consumers have unexpected, or unintended, consequences.
With government policies, consumers react in unexpected ways. A policy could be undermined, which could make government policies expensive to implement, since it is harder to achieve their original goals.
How can Excessive Administrative Costs lead to Government Failure?
The social benefits of a policy might not be worth the financial cost of administering the policy. It might cost more than the government anticipated.
The government has to consider whether the policy is good value for money.
How can Information Gaps lead to Government Failure?
Some policies might be decided without perfect information. This might require a full cost-benefit analysis, and it could be time-consuming and expensive.
For example, government housing policies are long term, and have failed several times in the past.
However, it is impractical for governments to gain every bit of information they need, so assumptions are made.
Who was Adam Smith?
Famous free market economist
Smith’s famous theory of the Invisible Hand of the Market: Describes how prices are determined by the ‘spending votes’ of consumers + businesses. (This is the Price Mechanism)
This theory can be applied to free market economies + price mechanism
Smith recognised some of the issues with monopoly power that could arise from a free market
Smith argued that economies function most efficiently and fairly when individuals are allowed to pursue their own interests; the great threat to economic growth is government intervention.
Who was Karl Marx?
Saw the free market as unstable
Saw profits created in the free market economy as coming from the exploitation of labour, and by not paying workers to cover the value of their work
He argued for the ‘common ownership of the means of production’
Marx considered the flaws of free market economies; he argued that the free market economy would break down because the owners of business made huge profits at the expense of workers.
Who was Friedrich Hayek?
Hayek argued that government intervention makes the market worse
E.g. After the 1930s crash, he argued that the Fed caused the crash by keeping interest rates low, and encouraging investments which weren’t ‘economically worthwhile’ (malinvestments)
Hayek was critical of command economies; he was concerned about the information required to distribute resources effectively and argued it was impossible for the government to process this information effectively.
What are some Similarities between the Economic Thinkers?
Smith + Hayek are free market economists
Marx + Smith saw the issues with a free market economy
What are some Examples of the Basic Economic Problem?
Water scarcity in India + China
Food scarcity globally
What Examples of industries have seen a Right Demand Shift?
UK Housing
Fast Food in France
Coffee/Make-up in India
What Examples of industries have seen a Left Demand Shift?
Landline Phones in UK
Newspapers in U.K.
What Examples of industries have seen a Right Supply Shift?
Oil (fracking)
Indias Subsidies for rice and gas
What Examples of industries have seen a Left Supply Shift?
Gas/Electricity due to poor weather across Europe, freezing the pipes
Europe freeze affecting commodities
What are some Examples of Products with an Inelastic PED?
Cigarrettes,
Alcohol,
Fuel
Fast Food
What are some Examples of Products with an Inelastic PES?
Electricity/Gas
Commodities
Housing
Cereals
What are some Examples of XED Complements?
Razors/Blades
Printers/Ink
What are some Examples of XED Substitutes?
Trainers
Fast Food
Phones
(Examples of each are substitutes of each other)
What are some Examples of YED Normal Goods?
Designer Clothing
Restaurant Dining
What are some Examples of YED Inferior Goods?
Own Brand Food
Cheap Clothes
What are some Examples of Indirect Taxes?
Specific:
Fuel Duty
Cigarette Duty, Alcohol Duty
Sugar Tax
Ad Valorem:
VAT
What are some Examples of Subsidies?
Solar Panels Electric Cars In Work Training R+D (UK) Fuel/Gas/Rice (India)
What are some Examples of Minimum Price Schemes?
Alcohol in Scotland (planned to be implemented this year)
Cocoa + Cashews in Ivory Coast
Min Wage
What are some Examples of Maximum Price Schemes?
Food in Venezuela
Rent Control in New York, and U.K. if Labour wins
Energy Caps if Conservatives win
What are some Examples of Negative Externality?
(Always say whos the agent, whos the third party, and how do they suffer)
Driving Cars Deforestation Cigarettes Alcohol Sugary Drinks
What are some Examples of Positive Externality?
Always say whos the agent, whos the third party, and how do they benefit)
Vaccination
Education
Healthcare
Research and Development
What are arguably Quasi Public Goods?
Roads
Bridges
What are some Exemplar products that get Subsidised?
Solar Panels
Electric Cars
Vaccinations (Hong Kong)
What are some Examples of Regulation?
There are tons, btw
Bans Age Limits Time Restrictions Warnings Quotas Things that are Compulsory (vaccination, recycling)
What are some Examples of State Provision?
School’s
Health
Various public goods
What are some Examples of Tradable Pollution Permits?
Kyoto Protocol
ETS
What are some Examples of Minimum Pricing in Market Failure?
Alcohol in Scotland
What are some Examples of Maximum Pricing in Market Failure?
Rent Control (proposed by labour) Energy Caps (proposed by conservatives)
