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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 • • • • • • • • • 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 • • • • • • • • • • 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 • • • • • • • • • • • • • 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 • • • • • • • • • 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. • • • • • • • • • • • • • 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 • • • • • • • • • • • • • • • 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 • • • • 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 • • • • • • • • • 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. • • • • 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 • • • • • • 1. 2. 3. 4. 5. 6. 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 • • • • • • • • • • • • 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 • • • • • • • • 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 • • • • • • 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