Download AQA Unit 1 Notes

AQA Unit 1
Scarcity and opportunity cost
• The world’s resources are finite – not endless supplies of
energy, minerals, food, land, water
• Resources are SCARCE – economic agents can only
obtain a limited amount at any moment.
• Scarce resources are called economic goods.
• Not all resources are scarce eg. Air is a FREE good
• Human wants are unlimited – people always want to
improve their lifestyle
• Basic economic problem – how to allocate resources
between competing uses.
• Economics = study of how individuals and societies
choose between alternative uses of scarce resources to
satisfy innumerable wants.
Economic objectives
• People, firms and governments will have a
range of economic objectives
• People – spending or earning decisions
• Firms – making profit or protecting
environment
• Governments – what to spend on health,
army, pensions
Economic resources
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Land – for building factories,
farming, sea (oil exploration)
Labour – workers
Capital – different types
Financial capital – funds put into
firm
Physical capital – machinery,
factories
Human capital – skills, education
of workforce
Entrepreneurship – willingness to
take risks, make decisions,
organise.
Renewable resources can be
used and replaced
Non-renewable cannot be
replaced
What is an economy?
• An economy is a system
which attempts to solve the
basic economic problem:
• 3 parts to the problem
• WHAT is to be produced? –
the mix of goods and
services?
• HOW is it to be produced? –
using capital or labour?
• FOR WHOM is it be
produced? – who should
receive the output?
Positive and Normative analysis
• Economics is a social science – uses
models to study behaviour.
• Positive analysis = value free
• Objective or scientific explanations of
economy
• A statement of what is
• Eg. A rise in price of coffee will lead to a
fall in the quantity demanded of coffee
• Normative analysis = attempts to describe
what ought to be – contains a value judgement
• A statement of what should be
• Eg the government should protect incomes of
everyone in economy not just the well-off
• Mostly interested in normative aspects – how
society can be changed
• Can use positive statements to construct
normative judgement – making policy.
• Eg to know how best to help raise living
standards of poor (normative) we need to know
how economy operates and why people are
poor (positive).
Opportunity cost
• The problem of scarce resources means that choices
have to be made.
• Individuals do not have unlimited income and make
choices on what to buy – new iPod or DVD player? Do I
sacrifice leisure time to earn extra income?
• Firms have to decide whether to use profits to invest or
increase returns to shareholders
• Governments face decisions such as whether to spend
more on NHS or Education or Defence.
• Opportunity cost measures the cost of any economic
choice in terms of the next best alternative eg decision to
buy iPod means that the DVD player will have to be
given up.
Specialisation
• Specialisation by individuals is
called division of labour
• This enables workers to gain
skills in narrow range of tasks
– be more productive than
doing every task himself
• Saves time moving between
tasks
• Specialise in tasks to which
workers are suited.
• Labour productivity (output per
worker increases)
Production Possibility Curves
• Diagrams which are useful to represent
opportunity cost and what an economy
can produce using resources.
military goods
Reallocating resources creates
an opportunity cost.
choosing more output of civilian
goods means giving up output
of military goods.
civilian goods
sheep
wheat
Why is PPF bowed outwards?
• PPF shows combination of two or more goods that can
be produced using all available resources efficiently.
• Points lying inside PPF occur when there are
unemployed resources or resources not being used
efficiently
• Points outside the PPF are unattainable at the moment –
need an increase in quantity/quality economic resources.
• The curve is bowed outwards because – as resources
are transferred the extra output becomes successively
smaller whilst the amount being sacrificed becomes
successively larger.
• Why? Economic resources are not easily adaptable to
other uses.
• PPF shows the maximum production level
of an economy
• PPF gives no indication of which
combination of goods is desirable for an
economy
• All it shows is the combinations of goods
an economy could produce if output is
maximised from a given set of resources.
• Economics tries to explain why an
economy chooses to produce at one point
on PPF rather than another.
Shifts in the PPF
• The PPF will shift outwards when:
• There are improvements in efficiency or new
technology – increase in productivity of factors of
production will allow more output to be produced
• There is an increase in the quantity or quality of
economic resources/factors of production
available – eg. discovery of new energy
supplies, increase in workforce, investment in
new machinery.
services
Manufactured goods
If the whole economy productivity improves the production
possibility for all goods and services increases. This implies
an expansion in the potential output of the economy ie
economic growth
services
Manufactured goods
An improvement in new technology will not always cause a parallel
shift in PPF. Eg a new production process will only impact on the
manufacturing sector. The productive potential of the service
sector will remain unchanged
services
Manufactured goods
Similarly any decrease in the quantity or quality of the
factors of production eg a reduction in the workforce can
shift the PPF inwards. The economy has contracted.
Markets: demand and supply
• The law of demand
• Demand = the quantity of a good or service that
consumers are willing and able to buy at a given price in
a given time period.
• Law – an increase in the price of a good/service will
result in a decrease in the quantity demanded of that
good/service
• Ceteris paribus (all other things held constant)
• - a lowering of the price of a good/service will result in an
increase in the quantity demanded of that good/service
• Ie an inverse relationship between price and quantity
demanded of a good/service
Why is there an inverse
relationship between price and
quantity demanded?
• 1. substitution effect
• Substitutes=goods which satisfy similar
want/need
• Eg tea/coffee, Coke/Fanta
• If price of a good falls – it is now relatively
cheaper. The consumer will switch away from
other goods and buy this good.
• If price of a good rises – it is now relatively more
expensive. The consumer will switch away from
this good and buy other goods
• 2. real income effect
• If the price of a good falls while the
consumer’s real income and other prices
stay the same – the ability to buy more of
the good is increased ie purchasing power
has increased.
• Eg. Consumer can buy 10 pizzas at £1.50
each = £15
• If price of pizza falls to £1 – consumer can
now buy 15 pizzas for same amount (£15)
Demand curve
Price of tea
P2
P1
D
Q2
Q1
Quantity demanded of tea
Determinants of demand
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1. price – a change in price of good will change quantity demanded of that
good
2. real income – measures quantity of goods/services that a consumer can
afford to buy. An increase in real income will usually increase the demand
for a good.
This is a normal good.
However an increase in real income may decrease demand for an inferior
good
An increase in real income may not change demand for a necessity good
3. Consumer taste and preference – tastes can be volatile eg fads
4. Interest rates – a rise in interest rates will reduce demand
5. Population changes – a rise in population will increase demand. Also
structure of population eg UK has an ageing population.
6. Advertising and marketing – a successful campaign will increase demand
by affecting consumer preferences.
7. Expectations of future prices – if prices expected to rise in future,
consumer will buy more now and store (if storable good)
• 7. The price of related goods – substitutes and
complements
• Substitute good/service = a good/service in
competitive demand that satisfy a similar want
• A change in the price of a substitute good will
cause a change in the same direction in the
demand for the good under study.
• Complementary good/service = a good/service
in joint demand that is often consumed together.
• A change in the price of a complementary good
will cause a change in the opposite direction in
demand for the good under study.
Movements of the demand curve
• A change in the price of the good causes a
movement along the demand curve.
price
p1
p2
D
q1
q2
quantity demanded
• A change in one of the other determinants
of demand will cause a shift in the demand
curve.
price
p
D3
D1
D2
quantity demanded
Types of demand
• 1. Joint demand – complementary goods
• Eg rise in quantity demanded of washing machines leads
to rise in quantity demanded of washing powder.
• 2. Competitive demand – substitute goods
• Eg rise in price of Coke leads to increase in demand for
Pepsi
• 3. Derived demand – goods demanded because they
are needed for production of other goods
• Eg increase in demand for cutlery will lead to an
increase in demand for steel.
• 4. Composite demand – a good is demanded for 2 or
more distinct uses
• Eg milk for yoghurt and cheese making
Exceptions to the law of demand
• 1. Giffen goods
• Consumption of bread increased as the price of bread
increased in poorer areas of London at end 19th Century
• Explanation – when price of a good changes, quantity
demanded will be changed by sum of substitution effect
and income effect
• For a normal good – both effects work in same direction
• For an inferior good – effects work in opposite directions
• Usually substitution effect outweighs income effect BUT
with a Giffen good – income effect outweighs the
substitution effect.
• Upward sloping demand curve?
• 2. Veblen good
• An ostentatious good – image or snob
appeal
Eg diamonds, fur coats
True for individual consumers but not for
markets as a whole.
Law of supply
• Supply = the willingness and ability of producers to supply output
onto a market at a given price in a given period of time.
• Law = at higher prices a larger quantity will be supplied than at lower
prices, ceteris paribus
• Positive relationship between supply and price.
• Reasons
• 1. incentives for producing – as prices rise it becomes more
profitable for existing firms to increase output and supply may be
boosted by more firms entering the market.
• 2. theory of increasing costs – opportunity costs rises at an
increasing rate as more & more resources applied to producing a
good so only way to induce producers to produce more would be
through a higher price of the good.
The supply curve
• The supply curve is upward sloping
because:
• If the price of the good rises firms will have
an incentive to supply more to increase
revenues and profit
• As firms devote more resources to
supplying a good the opportunity cost
increases which means that price has to
rise to encourage more supply
• If price rises from P1 to P2 the quantity
supplied will increase from Q1 to Q2
S
Price of oil
P2
P1
Quantity supplied of oil
Determinants of supply
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1. Price – change in price of a good will lead to a change in the quantity supplied of
that good
2. Price of factors of production eg raw materials, components, wage levels
A fall in price of any of these will lead to an increase in supply.
3. Productivity of factors – eg. an improvement in the productivity of labour will lead
to an increase in supply.
4. Technological advances will lead to an increase in supply.
5. Prices of related goods
Rise in price of substitute good will cause a fall in supply of good under study.
Rise in price of complementary good cause a rise in supply of good under study.
6. Indirect taxes and subsidies
An indirect tax eg VAT will cause a reduction in supply
Subsidy = grant or payment from Government to encourage a producer to increase
production
A subsidy to a producer will cause an increase in supply of the good.
Determinants of supply focus on either increasing or decreasing the costs of
production.
Equilibrium prices in a market –
demand and supply together
• Equilibrium in a market = state where the
market clears with no forces acting to
change prices and quantities
• It occurs when demand equals supply
S
Price of good
Pe
D
Qe
Equilibrium price=Pe
Equilibrium quantity=Qe
Quantity demanded of good
Disequilibrium in the market
• The market is said to be in disequilibrium
when there is excess demand or excess
supply
When price is at p1 there is
excess supply ie surplus
S
p1
Quantity supplied q2 is
greater than quantity
demanded q1
Firms will have to reduce
price to cut stocks
p
D
Demand will expand along
curve
New equilibrium at p and q
q1
q
q2
S
p
p2
D
q1
q
q2
When price is at p2 there is excess demand – quantity demanded
q2 is greater than quantity supplied q1
Prices will be forced upwards as there is a shortage of the good
This causes an expansion along the supply curve and a contraction
in demand
New equilibrium is restored at price p and quantity q
P
Changes in equilibrium price and
quantity
S
P1
P
D1
D
Q
Q1
Q
At original price P this
will cause a shortage.
This will cause prices
to be bid upwards
which results in an
expansion along the S
curve until new
equilibrium established
at P1,Q1
The effect of a shift in demand
Market equilibrium is at P AND Q. Suppose there is an increase in
consumer’s real income that causes D curve to shift right (D to D1)
A shift in the D curve to the right – will raise price and increase quantity
S
P
A shift in D curve to left
will lower price and
decrease quantity
P
P1
D
D1
Q1
Q
Q
Market equilibrium is at PQ. Suppose consumer preference for buying
the good falls. This causes the demand curve to shift to the left from D
to D1.
At the original price P there is a surplus. This will cause price to fall
which results in a contraction along S curve until new equilibrium
established at P1Q1.
Effect of a shift in supply
s
p
s1
P
Shift right in S curve
will reduce price
and increase
quantity demanded.
P1
d
Q
Q1
Market equilibrium at PQ
q
Suppose a technological advance cause S curve to shift right from
S to S1. At original price there will be a surplus. Suppliers reduce
price to reduce stocks causing an expansion along demand curve.
New equilibrium established at P1Q1.
S1
p
S
P1
P
D
Q1
q
Q
Market equilibrium at PQ.
Suppose an increase in cost of raw materials causes S curve to shift
left from S to S1. At original price there is a shortage. Suppliers will
raise prices causing a contraction along D curve until new equilibrium
established at P1Q1
Shift in S curve to the left will increase price and reduce quantity
demanded.
Elasticity of Demand
• Elasticity of demand = measure of how much
quantity demanded will be affected by a change
in another variable which affects demand
• Price elasticity of demand (PED)= measures
responsiveness of quantity demanded to a
change in the good’s own price.
• PED = %change in quantity demanded / %
change in price of the good
• Elasticity figure is a real number (not% or /)
• PED for all normal goods is always negative
(sign ignored)
What elasticity tells us
• If PED is less than 1, the good is inelastic – demand is
not very responsive to changes in price (draw graph)
• If PED is greater than 1, the good is price elastic –
demand is highly responsive to changes in price
• If PED = 1, the good has unitary elasticity- demand
changes proportionately with price
• If PED =0, the good is perfectly inelastic – a change in
price will have no influence on quantity demanded
• If PED is infinity, the good is perfectly elastic – any
change in price will see quantity demanded fall to zero
Factors that determine the value of
PED
• 1. availability of substitutes within market – more substitutes, more
elastic demand will be
• Necessity goods will have more inelastic demand eg bread
• Luxury goods tend to be more elastic eg opera tickets, holiday air
travel
• 2. % of income spent on the good – smaller proportion of income
spent on good, more inelastic demand
• 3. habit forming goods – eg cigarettes, drugs tend to be price
inelastic
• 4. time period under consideration – demand tends to be more
elastic in the long run
• Consumers find alternative goods eventually
• Eg central heating. Rise in oil price – consumers have to continue
to use oil in short run but can switch to alternative forms of heating
in the long run
Elasticity and effect on revenue
• Revenue = money a firm receives from selling the
good/service
• Total revenue = selling price of each good x quantity
sold
• When a good has a high price elasticity of demand ie is
price elastic – a fall in price will cause total revenue to
increase
• When a good has a low price elasticity of demand ie is
price inelastic – a rise in price will cause total revenue to
increase.
• Total revenue = area under demand curve (p x q)
P
A
P
B
P1
D
0
Q
Q1
Demand is price elastic
At price P, total revenue = area 0PAQ
Price falls to P1, new total revenue = area 0P1BQ1
Area of gain exceeds area of loss
Q
P
B
P1
A
P
D
0
Q
Q1 Q
Demand is price inelastic
At price P, total revenue = area 0pAQ
Price rises to P1, total revenue = area 0P1BQ1
Area of gain exceeds area of loss
Price elasticity along demand curve
• Elasticity varies along a straight-line
demand curve – it is not the same as
slope!
• As price increases –demand becomes
more elastic
• As price falls – demand becomes more
inelastic
P
PED greater than 1
PED = 1
PED less than 1
Q
Income elasticity of demand
• Income elasticity of demand measures responsiveness of demand
to a change in real incomes of consumers.
• YED = % change in quantity demanded of good / % change in real
income of consumers
• For normal goods (eg mobile phones, steak, air travel, foreign
holidays) there is a positive relationship with YED +
• If YED greater than 1 – considered luxury good
• If YED less than 1 – considered necessity good
• For inferior goods there is inverse relationship with – YED –
• Firms use YED estimate when planning output.
• When good has high income elasticity of demand – demand
sensitive to living standards of consumers
• Eg in economic boom – increasing demand / rising sales
• In recession – falling demand and fall in revenue
Cross price elasticity of demand
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Responsiveness of demand for good x following changes in the price of a
related good y
=%change in quantity demanded of good x/ %change in price of good y
Rise in price of substitute good y will cause rise in demand for good x
=positive relationship
If CPED for two substitute goods is greater than 1 – the goods are close
substitutes
Eg 10% rise in price of bus travel will cause a 20% rise in demand for rail
travel. CPED = +2
Rise in price of complement good y will cause fall in demand for good x =
negative relationship
If CPED for two complementary goods is greater than one – the goods are
close complements
Eg a 10% rise in price of DVD players will cause a 12% fall in demand for
DVDs. CPED = -1.2
If no relationship between goods CPED=0. The goods are independent.
Price elasticity of supply
• Responsiveness of quantity supplied to a
change in the good’s own price.
• PES = %change in the quantity supplied of good
/ % change in the price of good
• Positive relationship between price and supply ie
+ve number
• If PES is greater than 1 the good is price elastic
• If PES is less than 1 the good is price inelastic
P
A straight line supply curve that is
elastic will cut the price axis.
S
Q
P
S
A straight line supply curve that is
inelastic will cut the quantity axis
Q
P
PES=0 Perfectly inelastic
PES=1
A change in price has no
effect on quantity
supplied-supply fixed
Eg sport stadium
PES=infinity
Perfectly elastic
Any change in price will
see quantity supplied
fall to zero.
Q
Factors influencing elasticity of
supply
• 1. level of spare capacity. If firms working below spare capacity, they
can quickly increase supply if price increases. This makes supply
more elastic
• 2. suitability of factors of production. If factors can be easily moved
into production of good, supply will be more elastic.
• 3. stock levels. If firms have low stock levels, they may not respond
quickly to change in price-therefore inelastic. with high levels of
stock, they can supply quickly.
• 4. time period under consideration. Supply becomes more elastic in
the long run as firms can alter scale of production
• 5. production lags – time between using factors and final product
becoming available eg agricultural products – supply may be
perfectly inelastic in short run
Monopoly power
• Markets for different products can be structured
in various forms
• They vary in the amount of competition that exist
within them
• Some markets are very competitive with many
firms selling their products
• Eg. Agricultural products
• Some may be dominated by just one firm
• Eg Microsoft, Post Office, National Lottery
• Such a market is known as a monopoly
• A monopoly has power over its pricing decisions ie a price maker.
• If demand is price inelastic for the good, then it can raise price to
increase revenue
• Monopoly provides goods/services which have few or no substitutes
• There is less incentive to keep costs low because it can pass on
increased costs to the consumer in form of higher prices.
• Monopoly can restrict choice of customers because of their
dependence eg limiting number of retailers who sell the good.
• A monopoly can maintain its position in the market because barriers
to entry exist preventing other firms from joining.
• Examples include:
• High initial costs eg capital and infrastructure
• Legal restrictions like patents
• Control of scarce resources
• Large advertising costs
• Economies of scale
Economies of scale
Internal economies of scale = within the business.
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As a firm expands its output and sells more of its product – the costs per unit fall
1. technical economies
E.g bulk-buying economies of scale = ordering large volumes of raw materials
enables firm to negotiate discount prices
Firms can specialise with workers becoming more productive in specific tasks
Can employ specialist machinery to reduce costs
2. marketing economies
As a firm grows it can spread its advertising and marketing budget over a larger
output
3. managerial economies
Employ specialist managers with expertise to make decisions
4. financial economies
Obtain sources of funds with lower interest from lenders – lower risk because of
reputation/collateral
5. research economies
Can devote large amounts to research and development
• External economies of scale = outside firm
but within an industry
• Cost reductions from:
• Relocation of component suppliers close
to firm
• Development of research facilities in
universities near the firm
Diseconomies of scale
• Rise in average costs caused by:
• Control
• Monitoring productivity and quality of output for
1000s of employees is costly
• Co-ordination
• Co-ordinating production in different factories
around the world is difficult
• Co-operation
• Large numbers of workers feel alienated and
productivity falls
Research and Development leading to
innovation
• Monopoly firms can
afford to devote
profits to research
and development that
leads to better
products and
production processes.
• This will benefit the
consumer in the long
run.
Securing supply
• Having monopolies
can safeguard
supplies of an
essential good,
especially in times of
war or conflict when
supplies from other
economies may be
cut off.
Function of price in market
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1. rationing
Price allocates and rations resources.
Excess demand = price will be high
Limited supply rationed to those who are prepared to pay high price
Excess supply = price will be low
Low price ensures large number of goods bought (lack of scarcity)
2. signalling
Prices reflect market conditions – decisions about buying and selling based
on those signals.
3. incentive
Demand side
Low prices encourage buyers to buy goods
High prices discourage buying
Supply side
High prices encourage suppliers to sell more
Low prices discourage firms to produce
Economic efficiency
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How well does market mechanism allocate resources?
How efficient in answering 3 basic questions?
How well used are scarce inputs to make output?
Productive efficiency = production is achieved at its
lowest possible cost
• Eg a firm which produces 1 million units at cost £10,000
would be productively inefficient if it could have produced
them at cost £9,000.
• Firms in very competitive markets are pressured into
producing outputs at low cost – to maximise profits.
• Allocative efficiency = producing the optimal mix of
goods and services which are desired by consumers.
Are the right goods available that consumers want?
• In a free market:
• consumers don’t buy goods that are worth less
to them than the price.
• Producers don’t sell goods that are worth more
to them than the price
• Therefore these transactions improve efficiency
– they make both better off.
• The value of the product to the consumer is
equal to or higher than the price.
• The cost to the producer is equal to or lower
than the price.
• Price=cost=value to consumer = allocative
efficiency
Efficiency on PPF
shoes
Any point on PPF is
productively efficient
Inside PPF can produce
more output without
affecting output of other
goods
Once on PPF cannot
produce any more output
without taking resources
away from other industries
Production must be taking place
using least amount of resources
All other goods
shoes
U
B
A
all other goods
All points on PPF must also be allocatively efficient
U = not obtainable
A = possible to gain more shoes and more of other goods for
consumer. So consumers don’t have to give up shoes to get
other goods
B = trade – off has to be made for movement to another point on
PPF
Economic Efficiency
• Main agents in a market
• Consumer – spend their money however they like. Will allocate
their resources to maximise their satisfaction or utility
• Firm – servants of consumer
• Try to maximise profits = difference between revenue and cost
• If fail to produce goods which consumers want – will not sell them
• Consumers buy from firms which produce goods they want
• Unsuccessful firms will have no/ low revenue
• If firm fail to minimise costs – fail to make profit
• Other more efficient firms will take market away from them
• Firms which fail will leave market
• Owners of factors of production – try to maximise returns eg rent for
land, rate of return on capital
Efficiency and markets
• Markets which are very competitive ie a large
number of sellers and buyers can lead to an
efficient allocation of resources
• Buyers purchase from efficient firms who are
producing at lowest cost
• Consumers vote for goods when buying –
resources transferred to successful goods.
• However markets do not always lead to
economic efficiency and this results in MARKET
FAILURE.
Productivity
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Measures the output of a worker or firm or economy
Labour productivity measures the output per worker per time period
Specialisation will increase labour productivity
Need exchange – workers only specialise if they can exchange their
services for other goods (money)
Factors which determine productivity
1. availability of economic resources ie land, labour, capital,
entrepreneurship
2. level of available technology
3. education and skills of workforce
4 methods of organising production
Advantages of higher productivity
Productivity is the main determinant of living standards
– it quantifies how an economy uses the resources it has
available, by relating the quantity of inputs to output.
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Lower average costs: These cost savings might be passed onto consumers in lower
prices, encouraging higher demand, more output and an increase in employment.
Improved competitiveness and trade performance: Productivity growth and lower
unit costs are key determinants of the competitiveness of British firms in global
markets.
Higher profits: Efficiency gains are a source of larger profits for companies which
might be re-invested to support the long term growth of the business.
Higher wages: Businesses can afford higher wages when their workers are more
efficient.
Division of labour and
productivity
• Division of labour is where production is
broken down into many separate tasks.
• Division of labour raises output per person
as workers become better at a skill
through constant repetition
• Gain in productivity lowers cost per unit
• Which can lead to lower prices for
consumers
• Limits to division of labour:
• 1. Unrewarding repetitive work lowers
motivation which affects productivity – less
punctual/high rate of absenteeism
• 2. Workers move to less boring jobs
creating higher labour turnover
• 3. Some workers receive little training and
may not be able to find another job
• 4. Mass produced, standardised goods
lack variety for consumers
Market failure
• Market failure = when
there is a
misallocation of
resources in the
market
• Ie the market
mechanism does not
work well
Reasons for market failure
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Provision of public goods
Provision of merit and demerit goods
Lack of competition ie monopoly power
Inequality of income in the economy
Mobility of economic resources
Externalities
Public goods
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A public good = a good for which the total
cost of production does not rise as more of it
is consumed
2 characteristics:
1. The good is non-rival
(the amount one person consumes does not
affect amount that other people consume)
2. The good is non-excludable
(once the good is made available for one
person, it is not possible to restrict others
from consuming it)
maybe3. the good is non-rejectable
(once the good is made available, people
are unable to abstain from consuming it)
Problem for market mechanism:
There is no incentive to produce such goods
– people will “free ride on backs” of initial
buyer.
BUT these goods are valued by society
E.g. defence, police, judiciary, street lighting
Merit goods
• A merit good is a good
which is socially desirable
but would be
underprovided if left to
the market mechanism
• People do not assess the
full private benefits that
they would derive from
consuming it
• E.g primary & secondary
education, pensions,
fresh fruit&vegetables,
opera
Demerit goods
• A demerit good is a good
which is socially
undesirable but would be
overprovided by the
market mechanism
• People do not assess the
full private costs
associated with
consuming it.
• E.g. tobacco, alcohol,
sunbeds, ectasy tablets
Monopoly power
• In a free market firms may come to
dominate and have monopoly power.
• This may lead to higher prices and lower
output.
• Monopolies can earn profits at the
expense of economic efficiency.
Inequality of income and wealth
• If left to market forces this
distribution may be
unequal.
• Owners of economic
resources can become
rich.
• Whilst market system
allocates nothing to those
who cannot afford to pay.
• This can lead to a gap in
living standards.
• Society may view a large
gap as unacceptable.
Factor immobility
• In a perfect market factors of production
are able to move easily between markets.
• In reality these are often immobile
• Eg. If shipbuilding industry declines in
Newcastle, workers (labour) will not move
to S. Wales where some industries are
booming.
• They may lack necessary skills or even
know job exists.
Externalities
• Externalities arise when private costs and
benefits are different from social costs and
benefits.
• A misallocation of resources will occur
when economic activities do not reflect the
full costs and benefits to society.
• Social cost = private cost + externality
• Social benefit = private benefit +externality
Why might these give rise to externalities?
Types of externality
• Negative externality = where a social cost is greater than private
cost
• Eg a chemical firm
• Private cost to firm = cost of workers, raw materials, machines,
factories
• Social cost to society = all above + pollution firm generates (health
costs to local community, increased washing of clothes etc)
• Marginal social cost = marginal private cost + external cost
(externality)
• Positive externality = where a social benefit is greater than private
benefit
• Eg inoculation against disease
• Private benefit to one person = protection against illness
• Social benefit to society = reduced risk of others contracting illness
• Marginal social benefit = marginal private benefit + external benefit
(externality)
• Merit goods can produce positive externalities
• Demerit goods can produce negative externalities
4 categories of externality
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1.Negative production externality
MPC + externality cost = MSC
2. Negative consumption externality
MPB + externality cost = MSB
3. Positive production externality
MPC + externality benefit = MSC
4. Positive consumption externality
MPB + externality benefit = MSB
Negative production externality
Marginal social cost MSC
Price of
chemicals
Marginal private
cost MPC
P2
P1
Marginal social
benefit MSB
Q2
Q1
If left to market mechanism – firm would produce
at Q1 with price P1
Optimum for society = output Q2 at price P2
Ie too much of the good is produced
Quantity of
chemicals
Negative consumption externality
Marginal social
cost MSC
p1
p2
Marginal private
benefit MPB
Marginal social benefit
MSB
q2
q1
An external cost is experienced resulting from consumption of a good eg
cigarette
If left to market mechanism = P1 Q1
Optimum for society = P2 Q2
Positive production externality
Marginal private cost MPC
Marginal social cost MSC
P1
P2
Marginal social benefit MSB
Q1
Q2
An external benefit derived from production of a good/service e.g a new
factory brings employment to local workers and buying of raw materials
from local suppliers
If left to market mechanism P1 Q1
Optimum for society P2 Q2
Positive consumption externality
Marginal social cost
MSC
Price of
lights
P2
P1
Marginal social benefit
MSB
Marginal private benefit
MPB
Quantity of Christmas
lights
Here society’s demand curve is greater than the individual’s who creates
something pleasurable to look at.
Q1
Q2
Ie not enough of the lights are available
Government intervention to correct
market failure
• The government may
intervene to correct
distortions in the
market mechanism
and make markets
work more efficiently
Government policies or options
Market solutions if price fluctuates or is too high or too low
1. Indirect taxation = tax on expenditure eg VAT or excise duties
Price of beer
S2
S1
D
Quantity beer
An indirect tax will shift S curve left – raising price and reducing quantity
Incidence of tax?
Total revenue? Tax revenue? Revenue to producer?
Tax and elasticity
S2
S2
S1
S1
D
D
Tax revenues for government will be greater the more inelastic the demand for
the good taxed.
UK excise duties on price inelastic goods eg alcohol, tobacco, petrol
Taxing externalities
Government assess cost to society of a negative externality
Then sets tax rates equal to value of externality
Eg tax on petrol because emissions contribute to global warming
S2
S1
D
Amount of tax = vertical distance between S curves
Government tries to internalise externality
2. Subsidies
= a grant given by government to encourage production or consumption of a good
Eg on essential goods or to firms which employ disadvantaged workers
S1
S2
P1
P2
D
A subsidy on a good will lead to an increase in supply – shifting S curve right
Amount of subsidy not lead to fall in price of this amount
Part of subsidy used by producers to increase output at higher cost of production
3. Price controls
Government may impose controls on price in a market
(i) To protect consumers from paying too much for a good/service it may impose
a maximum price (price ceiling)
eg controls on price of rented accommodation
Price of
Rented
housing
S
Pe
Ceiling
price
D
Qe
Quantity housing
If ceiling price set below equilibrium price – excess demand is created
Eg queues or a hidden economy develops
(ii) To protect producers from receiving too little from selling good/service, it
may impose a minimum price (price floor)
eg the national minimum wage or market for agricultural products
Price of
labour
S
Minimum
m
wage
i
n
Pe
D
Qe
Quantity of labour
If the price floor is set above equilibrium price – excess supply is created
Ie in case of market for labour - unemployment
4. Buffer stock schemes
• Market price of primary
commodities can
fluctuate greatly
according to supply
(yields) and demand
(similar) conditions.
• In short run, supply and
demand are inelastic.
• Government intervenes
by setting up a buffer
stock scheme.
S
Intervention
price
Intervention price above
equilibrium price – surplus of
wheat
Government will buy a-b of
wheat into its buffer stocks
This shifts D curve to right to
restore intervention price
D
a
b
S
Intervention price
a
D
b
Intervention price below
equilibrium price – shortage of
wheat
Government will sell a-b wheat
from its buffer stocks
This shifts S curve to right to
restore intervention price
Analysis of buffer stock schemes
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Government has to tie up capital
in implementing scheme
Eg administration, storage costs
Can make profit – buys below the
intervention price but sells above
If intervention price continually
above av market price – scheme
will buy more than sells and will
run out of money eventually
Scheme collapses and product will
be dumped on market at very low
prices to pay debts.
If intervention price continually
below av market price – scheme
will sell more than buys and will
exhaust supply
Other government policies
• Extending property rights
• Externalities arise because property rights are
not allocated fully
• Eg if French chemical plant pollutes trees in UK
– no compensation
• NOBODY OWNS ATMOSPHERE, OCEANS
• Give sufferers an opportunity to claim
compensation from producers of externality
• But Government may not have ability to extend
rights especially in other countries
• Regulation
• Government provides legislation which
imposes maximum pollution levels or ban
activities
• Eg car exhaust emissions, waste
incineration, burning of fossil fuels
• Easy to understand and inexpensive to
enforce
• But difficult for government to fix right level
of legislation to ensure efficiency
• ie cost to firms v benefit to society
• Pollution permits
• Government issues firms permits to pollute
based on size, output , current emission levels.
• Total of permits = total amount of pollution
government allows
• Firms which succeed in reducing pollution below
permit levels can trade permits with other firms
which are exceeding their limits.
• Benefits – lower costs to society than regulation
Firm A
Can reduce pollution emissions by
500 tonnes
Cost = £10million
Has enough permits
Firm B
Heavy polluter
Needs 500 tonnes of permits
Cost = £25 million
With regulation
Costs to society = £25 million ( no incentive to A to cut pollution and B has to
conform to laws)
With tradeable permits
Costs to society = £10 million (A sells 500 tonnes of permits to B)
Society saves £15 million
Government failure
• Some economists believe that Government interference in the
market only leads to greater failure or a new failure appearing.
• Reasons:
• Imperfect information – how does the government know what its
citizens want?
• Conflicting objectives – decisions about building new roads,
hospitals, or which industries to offer subsidies to?
• Short term solutions – building more roads may only lead to greater
congestion in long term
• Disincentive effects – decision to tax demerit goods may create
hidden economy with no tax .
• Electoral pressure – decisions taken to curry favour with voters and
not in best interest of economy in long term