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Title: Microeconomics A-Level Notes
Description: Complete notes for Microeconomics AQA A-Level (reformed). Made by a current Economics and Management Oxford Student, who got an A* in Economics at A-Level. email philippe.grimshaw@keble.ox.ac.uk for confirmation of this.
Description: Complete notes for Microeconomics AQA A-Level (reformed). Made by a current Economics and Management Oxford Student, who got an A* in Economics at A-Level. email philippe.grimshaw@keble.ox.ac.uk for confirmation of this.
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MICROECONOMICS
3
...
1/4
...
1 Economic methodology and the economic
problem
The Economic Problem
A finite number of resources available in our world and a set of people who have infinite wants
...
-Scarcity means that choices have to be made about how scarce resources are allocated between
different uses
...
-Purpose of Economic activity to maximise people’s happiness, or economic welfare, involving the
production of goods and services to satisfy needs and wants
...
But when someone buy’s a product, there is an opportunity cost
...
E
...
work-leisure choices,
government spending priorities, investing today for consumption tomorrow
...
e
...
What Types of goods are there?
Capital goods: goods which are used to make consumer goods and services
...
There are three kinds of consumer good
...
g
...
g
...
g
...
-There are 4 factors of production:
•
•
Land
- Everything locked into the earth’s surface, e
...
waterways, oil, fields, minerals, ores
...
Split into two
categories, renewables (reproducible and maintainable e
...
forests and water) and nonrenewables (finite e
...
oil, gas, minerals)
- Rental income to owners of the land the cost
Labour
•
•
- The capacity of humans in the production process
- Pay wages and salaries to those employed
Capital
- Goods used to make consumer goods and services
- For example, have to pay dividends to shares ( a cost )
Enterprise
- The process of managing how factors should be combined and what they should be used
to produce
...
g
...
Receive profits
...
Markets allocate resources, driven by the profit motive and price
mechanism, limited role for the state, private sector dominates
-Mixed Economy
...
Mix of state and private ownership
...
Mix varies from country to country
...
Most resources are state owned
...
Littles role for
market prices
...
g
...
g
...
g
...
g
...
Key agents in an economy & their objectives
1) Individuals/Consumers
...
E
...
give to charity or
watch a movie at the cinema (choose whichever one makes them happier)
2) Firms
...
To seek re-election and to (hopefully) fulfil manifesto promises for the good of
the country
How do we measure the success of an economic system?
1) Efficiency
...
2) Equity
...
Positive and Normative Statements and Value Judgements
-
Positive Statements
...
Doesn’t have to be true, but can be proven
...
Subjective statements
...
e
...
One person my think a policy reducing unemployment at
the expense of more pollution is good
...
Thus, value judgments of political
leaders influence policies in a state
...
The final use of a good or service in order to provide utility
Production
...
Scarcity
...
Opportunity Cost
...
Production Possibility Frontier
It shows the different possible combinations that can be produced using available resources,
assuming all available resources are fully utilised (represented by the line)
...
The more
machinery allotted to good 1, the less can be used to
make good 2
...
Unemployed, or underemployed,
-
resources
E: impossible to achieve, unless the PPF shifts outwards due to an increase in available
resources (an increase in FoP, e
...
increased workforce, technological progress)
-The PPF boundary reflects productively efficient points, but not necessarily allocatively efficient
points
...
Why the PPF is concavely shaped
-
-
When we produce at point A, everything is used to produce good 1
...
As we continue increasing production of good 2, we are taking more and more useful
units from good 1 so the opportunity cost rises
...
-Here, increasing production of capital goods
increases potential to produce consumer goods,
resulting in an outwards shift of the PPF, thus leading
to economic growth
-So, whether to produce more capital or consumer
goods is an example of a conflicting objective
...
-So, PPF diagrams illustrate different features of the fundamental economic problem, such as:
resource allocation, opportunity cost, unemployment of economic resources and economic growth
...
1
...
Total utility: The total satisfaction from a given level of consumption
...
e
...
If marginal utility is falling, than consumers will only be prepared to pay a lower
price
...
Rational economic decision making and economic incentives
Economic agents respond to incentives, which can allocate scarce resources to provide the highest
utility to each agent
...
g
...
When
incentives are not given properly, resources will be misallocated
...
Social awareness,
norms and pressures also influence people’s decisions
...
E
...
binge drinking or eating at times of personal insecurity
...
Important, because it
allows consumers to keep thinking ahead
...
Imperfect information
Information failure occurs when people have inaccurate or incomplete data and so make potentially
‘wrong’ decisions
...
There are many causes of information failure:
-
Long term consequences: Information gaps about long term benefits and costs of
consuming a product
Complexity: Information failure where a product is highly complex e
...
understanding
the best pension to buy
Asymmetric knowledge: When with the buyer or seller knows more than the guy they
are dealing with (seller and buyer respectively)
Price information: When consumers are unable to quickly/cheaply find sufficient info on
the best prices for different products
...
If they had better information – in this case on the benefits,
rather than costs – of consuming a good or service, the marginal
private benefit curve, in this case, would shift outwards leading to a
higher equilibrium quantity
...
Examples include:
-
Landlords who know more about their properties than tenants
Car insurance companies cannot tell the risks associated with selling premiums to each
single driver – have to pool risks
A used-car dealer knows more about vehicle quality than the buyer
Some students have superior knowledge about how to get into elite unis
...
action can improve information to help consumers and producers value the actual cost/benefit
of a good or service
...
g
...
g
...
In reality, people
adopt ‘bounded rationality’, adopting simple and intuitive ‘rules of thumb’ instead of calculating
optimal solutions for every decision we face
...
-
-
-
-
-
-
Heuristics: Mental shortcuts or rules of thumb to help people make a quick, satisfactory
(but not always perfect) decision
...
Default biases in choices: People prefer to carry on behaving as they previously have
done
...
Choice architecture: Describes how decisions are affected by the layout, sequencing and
range of choices available
...
g
...
Choices influenced by social norms: E
...
social stigma of drink-driving and speeding
...
Herd behaviour: Often make decisions based on what those around us choose to do
...
Some anchors establish in our mind a low price – and vice
versa
...
g
...
Priming: Our behaviour by cues that work subconsciously and prime us to behave in
certain ways
...
g
...
Framing: Framing a question in a different way often generates a new response by
changing the comparison set it is viewed in
...
E
...
people’s perception of the risk of flying
will increase just after an airplance crash
...
Commitment contracts and choices
There is often a divide between intention and choices
...
People fell more strongly about activities where they have made a personal commitment
Are behavioural nudges effective?
It may encourage govt
...
In fact, consumers using well-practiced rules of thumb may be operating rationally
...
May be able to change minor behviours, but not depp rotted
phschological problems e
...
alcoholism
...
g
...
3
...
2/4
...
3 Price Determination in a competitive
market
Demand Theory
Effective demand is the willingness and ability to purchase an article
...
g
...
-Economists classify factors that influence your decision as to whether or not to buy a good into two
categories: 1) the price (reflects the value we place on a product, linked to its usefulness, the
enjoyment we can derive from it – referred to by economists as a good’s ‘utility’) of a good 2)
everything else, known as the non-price determinants of demand
...
-Thus as the price fall, the good’s price falls below more and more
people’s reservation price, so demand increases
...
(Demand can be called ‘quantity demanded’)
-A change in price leads to a movement along the demand curve
...
-A change in a non-price determinant of demand shifts the demand curve
...
g
...
Factors which affect Demand
1) Price
- Normally, as price falls, demand rises
...
1
...
When prices are seen as a signal for future price rises
3
...
(competitive demand) Price of good X goes up, demand for good Y ( a
substitute) goes up
- Complements
...
- Income effect
...
3) Income
- As income rises, quantity demanded usually rises
- There are some exceptions
...
4) Tastes
- Advertising is important in influencing tastes
5) Cost and availability of Credit
- As the cost of credit rises (i
...
higher interest rates) then the quantity demanded falls
6) Population
- An increase in population leads to an outwards shift the demand curve
7) Income Distribution
- Different sectors (in terms of wealth) spend different amounts on different goods
...
8) Seasonal Demand
Supply Theory
Supply is the quantity firms are willing & able to supply to the market at a given price
...
1) The price of a good 2) non-price
determinants of supply
...
-It is upwards sloping for three main reasons 1) Profit motive – if
prices rise, it becomes more profitable to increase output 2)
Production and costs – When output expands production costs may
rise (perhaps due to law of diminishing returns) so a higher price is
needed to cover these extra costs 3) New entrants into the market –
higher prices create an incentive for businesses to enter the market, increasing total supply
...
-A movement along the supply curve is caused only by a change in price (look at diagram)
-A shift of the supply curve occurs when productivity or costs of production change
Reasons for shifts in the supply curve
-ROTTEN: resource (production) costs, other goods prices, taxes and subsidies, technological change,
expectations, number of sellers
...
In Perfect competition, the supply curve is the marginal cost curve
Markets
-Prices are determined in a free market by the interaction of demand and supply
...
-In traditional market theory, buyers are rational utility maximisers with perfect knowledge, and
sellers are profit-maximising, competitive firms (see later for problems with these assumptions)
...
I
...
where the two curves cross is therefore the market equilibrium
...
E
...
At P2 there is a disequilibrium caused by excess supply
...
Since more is supplied
than is demanded, the price falls, until the excess supply is eliminated
...
Causes of Changes in Equilibrium market prices
price
quantity
Increase in supply
Decreases
Increases
Increase in demand
Increases
Decreases
Decrease in supply
Increases
Decreases
Decrease in demand
Decreases
Increases
Note that increase/decrease mentioned in left hand column refers to a shift, not a movement along
of the respective curve
...
g
...
1
...
11), revenue, tax revenue and deadweight loss
Consumer surplus: the difference between what consumers are willing to pay (shown by the
demand curve) and what they actually pay
...
The blue area is the consumer surplus
...
Firms sell products for more
(they sell at price P1) then they would be willing to sell them for
(shown by a point on the supply curve)
...
Similarily,
producer surplus represents the extra the producer gets
compared to what he would have settled for
...
Revenue: price multiplied by quantity sold
Indirect taxes: a tax placed on a good or service
...
1) A specific tax – a specific amount on
each unit (e
...
£10 on a flight) 2) ad valorem – a % of a good’s value (e
...
VAT at 20%)
-A specific tax will shift the curve by the amount of the
tax
...
g
...
-the shift increases the price
...
-The price does not rise by as much as the tax (so
consumers and producers share the cost of the tax, the burden of the tax is called the incidence of
tax)
...
After the tax, it shrink to area A
Producer surplus in example: Before the tax, it was area DEF
...
Before the tax, it was 0 (depends on elasticities of supply and demand)
Deadweight loss: -the deadweight loss is the loss in overall economic welfare as a result of a given
policy (in this case a tax)
...
The
deadweight loss here is incurred because people substitute away from the good because of the tax
...
This deadweight loss causes
productive inefficiency
...
In effect, opposite to a tax
...
A
given % change in price causes a smaller % change in quantity demanded
...
A given % change in
price causes a proportional % change in quantity demanded
3) If the value of PED is less than -1 then the demand curve is said to be price elastic
...
Fig
...
2 – Elastic demand
Fig
...
g
...
4 – Perfectly elastic demand, PED = -infinity, even if price
rose by a penny, demand would fall to 0
...
Demand would be huge
...
If the price is doubled from £15,000 to £30,000, the fall in
demand would be much larger, despite the same % increase in
price as before
...
Thus, regardless of the gradient of the demand curve, price elasticity of demand gets more
elastic as the price rises, and vice versa
...
Wrong, will
always become inelastic/elastic
-The more inelastic demand is (the closer PED IS TO 0) the more revenue increases as the price
increases (and vice versa)
...
Thus, the greater the need, the lower the price elasticity of demand (more
inelastic)
3) Time – in the shprt run, car owners have to bear the cost of increased oil prices
...
Thus, the longer the time period, the higher the
price elasticity of demand
...
Income Elasticity (YED) and Cross Price Elasticity (CED) of Demand
YED = % change in quantity demanded
% change in income
-
If the value of IED is between 0 & 1 the good is a necessity good
...
A given % change in
income causes a greater % change in demand
...
A given % change in income
causes a negative % change in demand (e
...
as people’s income rises, they switch from
Tesco’s own brand cookies to Maryland)
Economists group together necessity and luxury goods together as normal goods (since demand for
them rises as income rises)
CED = % change in quantity demanded of good X
% change in price of good Y
-
-
If the value of CPE is above 0 the two goods are substitutes
...
The higher the value of CPE, the
more substitutable the two goods are
...
g
...
Increasing the price of 1 good
causes a fall in demand for the other good
...
Giffen Goods
-goods with an upwards sloping demand curve
...
(For example,
people buying goods because they are expensive, for status)
...
A given
% change in price causes a smaller % change in quantity supplied
...
A given % change in price
causes a proportional % change in quantity supplied
...
A given % change in
price causes a larger % change in quantity supplied
...
Factors influencing elasticity of supply
1) Time – in the short run, difficult to switch from producing one type of good to another
...
So spare capacity leads to a higher PES
5) Perishability and ease of accumulating stocks – if stocks can be stored easily, and at low
cost, firms can respond quickly to a change in demand (elastic)
...
6) No
...
Interrelated Goods and Markets
Joint Demand – the price of one market affects the demand in complement/substitute markets,
dependant on CPE
a) Complements – the price of good X rises, meaning the demand for good Y falls
...
b) Substitutes – the price of good X falls, which means demand for good Y also falls
Composite Demand – When several different groups demand the same good for different purposes
...
g
...
An increase in demand for the good from one particular group
decreases supply for other sectors who demand the good, increasing the price for them
...
Derived Demand – Means that demand of one good occurs as a result of demand for another
...
Thus, here an increase in the Quantity (demand or supply
driven) leads to an increase in demand for its inputs
Competitive Demand – state of affairs observed between the markets for goods that can be readily
substituted for one another
...
g
...
Joint Supply – When two goods are predominantly produced from the same input
...
E
...
Cows are used for beef and leather
...
How Markets Work – The Price Mechanism (3
...
5
...
1
...
1 of syllabus)
-
Adam Smith’s Invisible Hand (‘Invisible hand of the price mechanism’) is where the
hidden hand of the market operating in a competitive market through the pursuit of
self-interest allocated resources in society’s best interests
...
1) Signalling Function
- Prices signal to economic agents (consumers, firms and factor owners) changes in
preferences and needs / scarcities and surpluses to demonstrate where resources are
required
...
Allowing buyers/sellers to plan economic activities around changing
market conditions
...
- Likewise, if there is excess supply, the price mechanism will price mechanism eliminates
the surplus by allowing prices to fall
...
When demand and thus prices are low, an incentive is provided to cut back
on output (wait for future higher prices)
- For example, high wages create incentives for people to acquire new skills and supply
labour
3) Rationing Function
- Given scarcity of resources, rationing is required
...
The
price thus rations demand
4) Allocative function
- Allocative function directs resources from markets experiencing excess supply (low
prices) into markets with excess demand (higher prices)
...
(shown by AB)
To get rid of excess demand, the price rises to P2
Increase in price reduces quantity demanded from B
to C (rationing function)
...
Also encourages existing firms to produce more shown
by G to F due to higher profits (incentive function)
...
-While the price mechanisms should produce a productively efficient outcome, this is not the only
consideration that needs to be taken into account
...
Market Imperfections (4
...
8
...
Can get prices to
high, low or volatile because of these imperfections
...
1) Monopoly
- Exploitation of consumers by producers
...
’ May for example restrict supply to increase the price and thus their profit
...
The signalling
function requires entrepreneurs know of all possible profit making opportunities
...
3) Immobility of Factors of Production
- Even if we do know all the available opportunities, it isn’t always possible to change the
purpose of factors of production easily
...
Maximum and Minimum Prices (part of 4
...
8
...
g
...
g
...
g
...
-Price Elasticity of demand and supply can affect the consequences of the imposition of a maximum
or minimum price
...
1
...
1
...
A measure of the efficiency of production
...
Real Life Applications:
-
-
UK showed strong GDP growth in 2014 – 2
...
Didn’t translate into labour productivity
growth as the economic recovery was primarily fuelled by longer hours and the creation
of jobs
...
7%, so labour productivity only grew 0
...
In part due to banking crisis affecting lending to businesses, low levels
of market competition and skill shortages in key industries
...
5% on 2014, in part due to slow
investment growth, low levels of innovation, and a lack of efficiency gains
...
Specialisation, Division of Labour & Exchange
Specialisation: A worker only performing one or a narrow range of tasks
...
Necessitates an efficient means of exchanging goods and services, such as the use of money as a
medium of exchange
...
Division of Labour
-
Different workers perform different tasks in the course of producing a good or service
Can occur locally, regionally or internationally (see Ricardo’s theory of comparative
advantage
...
Gains in productivity lower supply costs per unit, lowering prices for consumers, leading
to gains in consumer welfare
...
Disadvantages: 1) dull and repetitive work lowers motivation and thus hits productivity, 2)
unmotivated workers leads to higher rates of absenteeism – those who can may move jobs,
3) some workers receive little training meaning they cannot not find alternative jobs and
then suffer from structural unemployment, 4) mass produced standardised goods lack
variety for consumers
...
Money is also a store of value, a unit of account, and a
standard of deferred payment
...
1
...
3)
Short Run: The short run is a time period where there is at least one fixed factor input - usually
capital but sometimes land
...
The length of the short run will vary by industry
Long Run: In the Long run, all factors of production can change, allowing firms to change the scale of
its operations
...
We assume the quantity of plant and machinery is fixed and that production can be
changed by altering variable inputs such as labour, raw materials and energy
...
Hence in the short run we make a distinction between fixed and variable costs of
production
...
Total, Average and marginal Product:
-
Total Product: The total output produced by factors of production
Average Product: The output per unit of the variable factor
-
Marginal Product: The amount of extra total product produced by adding an extra unit
of the variable factor
...
Normally assumed the quantity of capital inputs is the factor that is fixed
...
In the short run, the law states as we add more units of variable input to fixed
amounts of land and capital, the change in total output will at first rise and then fall
What happens to marginal product is linked to the productivity of each extra worker
...
Beyond a certain point, fixed factors of production become scarcer, and
capital input becomes diluted among the larger workforce
...
If Marginal Product is positive, Total Product is rising
...
Total Product is at its max when Marginal Product is zero
...
A à diminishing returns
B à negative returns
(Long Run) Returns to Scale
In the Long run, all factors of production can be changed, so the law of diminishing returns does not
apply
...
Looks at how the output of a business responds to a
change in all factor inputs
...
g
...
In the long run businesses will be looking for an output that combines labour and capital in a way
that maximises productivity and reduces unit costs towards their lowest level – this may involve
capital-labour substitution
...
g
...
Some of these costs relate to the opportunity cost of production – the next best
alternative rate of return in this money is treated as part of the economic cost of
production
...
•
•
Total Costs:
Variable Cost: Costs that vary directly with output e
...
wages of part-time staff, raw
materials, electricity, depreciation of capital inputs
Fixed Cost: Business expenses that do not vary directly with output, treated as independent
of production e
...
rent, wages for full-time staff, and interest payments on loans
...
Average Costs (AC):
•
•
•
Ave
...
Idea of diminishing returns
shown by increasing cost
...
Fixed Cost (AFC): total fixed cost divided by output
...
Total Cost (ATC/AC): total cost divided by output
Marginal Cost: The change in total costs from increasing output by one extra unit (shown in graph to
the left)
...
The shape of MC is what determines the shape of AC and AVC
...
I
...
(Replace AC with AVC to get relationship between
AVC and MC)
...
In the long run all factors of production are variable
...
The Long run average cost curve is derived from all
the short run cost curves (at different levels of
output) and is known as an envolope curve
...
Is linked to the idea of returns to scale
and dis/economies of scale
...
Economies of scale = increasing returns to scale
2
...
The lowest level of production where all internal economies of
scale have been exploited
...
Comprises a range of output levels
...
e
...
-Higher MES relative to size of market demand – the closer the industry to a monopoly
...
Likely to result in a oligopoly or monopoly, as economies of scale act
as barriers to entryas existing firms, having achieved more cost savings, lower prices to prevent
other newer firms coming in
-Lower MES relative to size of market demand – the closer the industry is to being competitive
...
Thus more competitive, with more
competitors able to achieve MES
...
g
...
1
...
Moreover, machinery only
efficient (fully utilised) once output is large enough –indivisibilities
...
- Vertical Integration
...
(no need to pay excess to firms (looking for profits) when out-sourcing
...
Managerial Economies of Scale
- The larger the firm,the larger the benefit of specialisation within management, e
...
sales
director, H
...
3
...
Purchasing Economies of Scale
- When large businesses receive a discount because they are buying in bulk
5
...
’ In a position where they can borrow from
banks at lower rates than smaller firms
...
6
...
Network Economies of Scale
- There is no cost for taking on another consumer once you have the infrastructure
required
...
E
...
Facebook,
Amazon
...
For example, a company’s management structure, administration
system and marketing departments are capable of carrying out their functions for more than one
product
...
Consider the way Cadbury has rapidly widened the range associated with Dairy
Milk chocolate bars in recent years
...
-
-
-
-
Increased Dimensions: Amazon invested in enormous warehouses to stock it’s
inventory
...
External Economies of Scale in the rapid advance of the internet and increased internet
penetration provides more customers for the firm
...
Examples include Amazon Kindle and
CreateSpace, a self-publishing platform for books, music and video
...
1
...
Communication failure
- Too much micromanagement means stuff can feel remote from business objectives and
instructions can become confused
3
...
Economic power of CEO’s
may lead to a sense of alienation, while repetitive, specialised labour can become dull
...
Control
- Monitering the productivity and quality of output from thousands of workers in big
corporations is imperfect and costly
All the above are internal dis/economies of scale
...
Geographical concentration: Where firms from the same industry re clustered and as such
the area is geared towards the needs of that industry
...
Technological Breakthrough
These lead to a shift in the LRAC curve (see right,
showing the shift caused by external economies of
scale), where as internal economies of scale lead to a
movement along the curve
...
Average Revenue, total revenue and profit
Revenue: The income generated from the sale of output in product markets over a given time period
•
•
•
Total Revenue: price x quantity demanded
Average Revenue: total revenue divided by output (so in effect price per unit)
...
Marginal Revenue: change in revenue from selling one extra unit of output
Average revenue is equal to price charged, so long as the price charged is
equal for all levels of output
...
This is at the midpoint of the demand (AR) curve for a business with a downward sloping AR –
and when MR is zero, the price elasticity of demand is 1
...
When demand is price elastic, a fall in price will lead to an increase in total revenue
...
1
...
7)
There are three types of profit, 1) accounting 2) normal 3) abnormal
-Accounting costs are just the normal costs
incurred, such as wages and money spent
on raw materials, and when taken away
from total revenue, give us accounting
revenue
...
If a firm is making a normal
profit, it is covering its accounting costs
and any opportunity cost
...
-Supernormal profit is any profit in excess of normal profit
...
This
means abnormal/economic profit can only exist in the long run in imperfect markets
...
Marginal Profit: The increase in profit when one more unit is sold
...
Profit maximisation in the short run:
A firm profit maximises where MC=MR
...
Supernormal profit here is equal to P1 – C1
...
Reward: provides a reward for bearing the uncertainty
associated with business risk
2
...
Alternatives such as
issuing shares (equity) or bonds may not be as attractive depending on the state of the
financial markets especially in the aftermath of the credit crunch
...
Market entry: abnormal profits signal to other firms that profitable entry may be possible
4
...
Rising profits
could reflect supply-side improvement (e
...
higher productivity or lower costs through
innovation)
...
Falling profits could
indicate a macroeconomic downturn
5
...
Acts as a signal for firms, playing a role in the allocation of
resources
Technological change
Innovation: Innovation is slightly different to invention because it involves putting a new idea or
approach into action
...
e
...
There are 2 types of innovation:
-
Product innovation: Small scale and frequent subtle changes to the characteristics and
performance of a good or service
Process innovation: Changes to the way in which production takes place or is organised
...
Smaller disruptive businesses often disrupt existing firms
with market power
...
g
...
o Now most businesses (and increasingly consumers) want to store their data on the
cloud rather than a single device
...
g
...
g
...
1
...
1
...
There are a variety of factors used to distinguish between different market structures
...
2
...
4
...
The number of firms
The market share of the largest firms
The nature of cost (including the ability of businesses to exploit economies of scale)
The degree to which the industry is vertically integrated
The extent of product differentiation i
...
to what extent to firms try to make their product
different to those of competing firms
...
6
...
The turnover of customers i
...
how many customers are prepared to switch their supplier
over a given time period when market conditions change
8
...
These cost factors include:
-
-
-
Entry costs into a market
o Capital costs vary from industry to industry
o E
...
a natural monopoly such as energy or power networks
Sunk costs / exit costs
o These are costs which aren’t recoverable if a business leaves
o E
...
advertising and marketing, depreciation of capital
o High sunk costs make a market less contestable
Natural costs advantages
o Location advantages, ownership of raw materials
Market Power
o
o
o
Market power occurs when businesses can influence market price without losing a high
proportion of sales
When there are only a few close substitutes in a market then the cross price elasticity of
demand will be low
...
Barriers to entry and exit then help to sustain the market power of existing firms in the long
run and allow abnormal profits to be sustained
...
Public sector businesses are wholly or partly state owned
...
Alternative business objectives:
-
Sales maximisation
...
e
...
e
...
Maximisers and Satisficers
Maximisers behave in a traditional economic way and always try to make the best possible choice
from the available alternatives
...
Probably
the most common approach that businesses take
...
g
...
There is no unique profit satisficing output – it can occur at any point between profit maximisation
(MC = MR) and sales maximisation (AR = AC)
...
Stakeholders and Shareholders
-
Stakeholders: Any individual or organisation which has a vested interest in the activities
and decision making of a business
Shareholders: Any individual who owns – has an equity stake – in the business
...
Rewards, including basic pay and other financial
incentives
...
Promotion opportunities + job satisfaction &
status
Value for money
...
Continued, profitable trade with the business
...
Can the business repay loans? Profitability and
cash flows of the business
...
g
...
Helping the business to grow –
creating jobs
...
Compliance with local laws
and regulations (e
...
noise, pollution)
...
E
...
job cuts to reduce costs will likely be
supported by shareholders and the bank, but not by employees and the local community
...
I
...
the owners of the business may not be the people who are
taking the key day-to-day decisions
-
Agency Problem: Possible conflicts of interest that may result between shareholders
(principle) and the management (agent) of a firm
Stakeholder Conflict: Occurs when there are many different stakeholders
...
The owners of a firm often cannot observe the day-to-day decisions
of management, and so as the principle hire an agent (management) to look after these decisions
...
Strategies to align these aims involve:
-
-
-
Employee share ownership schemes
o John Lewis, for e
...
have a highly regarded partnership model
o Stock options might led to perverse behaviour – e
...
deliberate attempts to hike up
share prices through illegal action
Long term employment contracts for senior management
o Security of tenure might encourage managers to take decisions in the long term best
interests of the business
Long term stock commitment
o
Apple’s new policy (2013) requires senior executives at Apple to hold three times
their annual base salary in stock, and executives have to keep this salary in stock for
a min
...
Short-termism
Short termism is where a commercial business prioritises short-term – rather than long-term –
performance
...
The price is determined by the interaction of supply and demand
...
Profit maximisation is the assumed objective
Revenue Curves in Perfect Competition
In a perfectly competitive market, total revenue (TR) is a diagonal straight line passing through the
origin
...
Market demand and supply determine the price and each firm is a price taker
...
Assumption
made that each firm’s aim is to profit
maximise
...
Important to note: In the short run firms in perfect competition can make losses – if the ruling
market price is less than the AC of a particular firm
...
Will cause an outwards
shift in the supply curve, pushing down the market price, until eventually it equals average cost (so
that AR drops until AR=AC=MC)
...
This is called the shutdown price in a
competitive market (so in monopolistic markets as well)
...
P2 is the shutdown price
...
Productive efficiency: Occurs when the equilibrium profit maximising output is supplied
at minimum average cost
...
X-inefficiency is where a
lack of competition leads to inefficiency as incentives to be productive are weakened
Dynamic efficiency: Assume that a perfectly competitive market produces homogenous
goods – meaning there is little scope for innovation differentiating their product, as then
the market wouldn’t be perfectly competitive
...
Lower prices because there are many competing firms – which is helped by low barriers to
entry – which means smaller profit margins
2
...
Evaluating the Assumptions of the Perfect Competition model
1
...
2
...
3
...
Patents and control of intellectual property are ignored by the competitive model
...
Rare for entry and exit in an industry to be costless
...
Production and consumption often produce some externalities – ignored here
...
g
...
Is similar to perfect
competition, and is more realistic – as products are differentiated, giving businesses a degree of
price setting power (so AR slopes downwards)
Assumptions/Characterisitics of the model:
-
There are many producers and consumers in the market
Consumers are aware there is product differentiation – non-price competition and
consumers regularly switch between producers
Producers have some degree of price setting power, but price elasticity of demand is
higher than it would be monopoly (and corss-elasticity of demand is high)
Barriers to entry and exit are low – meaning profits in the long run are competed away
Revenue curves in monopolistic competition
Firms have downward-sloping demand curves as they have some degree of price-setting power –
but if there are lots of close substitutes and the cost of consumers switching is low, the AR curve for
each product will be highly elastic
...
Assumed that firms are profit maximises where MC = MR
...
In the long run supernormal profits act as a signal, attracting
new producers, shifting the demand curve of the firm (its AR
curve) inwards as more customers opt to buy the newly
available products
...
Though in reality, a stable
equilibrium may not be reached since new products come and go, and some naturally do better than
others
...
Examples of non-price competition include quality of service, free upgrades to products,
exclusivity/loyalty schemes, branding and sales promotions
...
Prices are above marginal cost – meaning that the equilibrium is not allocatively efficient
2
...
Critics of heavy spending on marketing and advertising argue that much of this spending is
wasteful and an inefficient use of scarce resources
4
...
Oligopoly
An oligopoly is an imperfectly competitive industry where there is a high level of market
concentration
...
Assumptions of the model
-
A market dominated by a few large firms
High market concentration ratio
Each firm supplies branded products
Barriers to entry and exit
Interdependent strategic decisions by firms
In oligopoly there is a high degree of uncertainty
Strategic interdependence means that one firm’s output and price decisions are influenced by the
likely behaviour of competitors
...
Causes
oligopolistic industries to be at high risk of tacit or explicit collusion
...
The concentration
ratio measures the combined market share of the top ‘n’ firms in the industry
...
E
...
Studio market share (Aug 2015) – Universal 35%, Disney 26%,
Warner Bros 14%, Fox 7%, Paramount 6%
...
1% (Tesco, Asda, Sainsbury’s, Morrison’s, and Co-op), making it an oligopoly, a
state of limited competition, in which a market is shared by a small number of dominant
producers
...
E
...
in chewing gum in the US
(2015), Red Bull North America and Monster Beverage Corporation had a combined
market share of 80%
...
These can vary:
-
Maintaining a satisfactory rate of profitability
Protecting market share
Growing their user base
Reacting to decisions of rival firms
There are several models of oligopoly
...
-
-
Rivals are assumed not to follow a price increase
by one firm, so the acting firm will lose market
share – therefore demand will be relatively elastic
(see AR1) and a rise in price will lead to a fall in
revenue
Rivals are assumed likely to match a price fall by
one firm to avoid a loss of market share
...
The MR is always twice as steep as the AR,
and the kink in AR means there will be 2 MR’s – at Q1 the 2
curves do not actually intersect
...
This increases the importance of nonprice competition, e
...
advertising and marketing, quality of service, product differentiation, brand
and loyalty schemes
...
Although, another feature of non-collusive oligopoly is that periodic and fierce price wars can be a
characteristic of market competition
...
Such agreements can cover prices, output, formal division of markets, limits on
promotion and product development
...
Is often explained by a desire to achieve joint-profit maximisation or prevent price and revenue
instability (others an alterntive theory to kinked demand for oligopoly price stability)
...
Usually illegal, but do exist e
...
OPEC
...
Effectively gives them
monopoly power in setting prices
...
Key aims of business collusion:
1
...
2
...
g
...
Collusion reduces uncertainty in a market – and higher profits increases producer
surplus/shareholder value – leading to higher share prices
...
E
...
Limit pricing: existing
firms set price below monopoly profit maximising level ata price just low enough to deter new entry
...
e
...
Practices are not prohibited if the respective agreements ‘contribute to improving the
production or distribution of goods or to promoting technical progress’
...
Development of improved industry standards of production and safety which benefit the
consumer – a good example is joint industry standards in Europe for mobile phone chargers
3
...
Research joint ventures and know-how agreements which seek to promote innovation
...
Although the Cartel as a whole is
maximising profits, the individual firm’s output
quota is unlikely to be at their profit
maximising point
...
1 – Q2 = output
quota for firm)
So, this means that for any one firm, expanding output
and selling at a price that undercuts the cartel price
can achieve extra profits – shaded in red section in
figure 2
...
However, if one firm
does this , it is in each firms interests to do exactly the
same, and as every firm does it the result is excess
supply and a sharp fall in price (see oil drop and OPEC)
– and the cartel agreement has broken down
...
$3
...
5bn in the EU
Non-cartel firms enter the industry
Collusion and efficiency
The UK competition and Markets Authority (CMA) believes that cartels are damaging to economic
efficiency and welfare
...
laws can face fines of up to 10% of
their worldwide turnover, and those convicted of a cartel offence can face 5 years in prison and
unlimited fines
...
e
...
e
...
g
...
The price leader will generally
set a price high enough that the least cost-efficient firm in the market may earn some return above
the competitive level
...
It is rare for a firm to have a pure
monopoly, except where the firm is state-owned and has a legally protected monopoly
...
Monopoly Power is a slightly looser definition of monopoly, referring to a market in which there is a
dominant firm, but there are also other firms in the market
...
A dominant firm is a firm with at least 40%
market share
...
-Until now, assumed free market mechanism causes both
allocative and productive efficiency
...
-In a competitive market, price forced down to cost of
production due to large number of firms
...
-Monopolies don’t have this competitive pressure
...
-By restricting supply, the monopolist causes a movement
left along the demand curve, causing prices to rise and
quantity to fall
...
Since the original price P1 was allocatively
efficient, monopolies by restricting supply diverge from this
and can therefore become allocatively inefficient
...
92% in Juy 2015
Monopoly and profit maximisation
Monopolies are able to achieve supernormal profits
...
Key features of conduct in a monopoly
-
A monopoly has price-setting power, and thus a
downwards sloping AR and MR curve
Potential for using price discrimination between customers
Firms can set prices or quantity but not both
Barriers to entry help maintain supernormal profit in the long run
Imperfet information is assumed
Natural monopoly
Several interpretations of what a natural monopoly is:
-
Occurs when a business can supply a market at a lower price than smaller businesses
A situation in which there cannot be more than one efficient provider of a good
...
An industry where the MES is a large share of market demand and there is only room for
one firm to fully exploit all available internal economies of scale
...
e
...
Potentially digital platforms are too
(such as web search, messaging, e-commerce, taxi apps, the sharing economy)
...
Profit
maximising output is likely to be highly allocatively inefficient
since price is significantly above MC and output is restricted –
and will produce supernormal profit (red shaded in area)
...
Product differentiation: making a product different to others in the market can aid firms
gain monopoly power
...
g
...
2
...
3
...
E
...
takeover, headhunting, predatory pricing, exerting pressure on suppliers/consumers
Why can Monopolies be seen as market failure? (Part of 3
...
5
...
2) Monopoly price is assumed to be higher than marginal cost leading to a loss of allocative
efficiency and market failure
...
3) Absence of competition can lead to production inefficiencies and X-inefficiencies such as
wasteful production and advertising spending
4) Protected markets leads to a lower incentives to innovate
5) Monopolistic firms can grow so big they lead to diseconomies of scale
Monopoly and Efficiency
The economic case against monopoly is very strong:
i)
ii)
iii)
iv)
v)
Prices are higher than under competitive conditions
a
...
Regressive effects on lower-income households
Absence of genuine market competition leads to X-inefficiencies (occurs when a
business produces at a higher unit cost than it would if there was genuine competition)
such as wasteful advertising spending
...
All push costs down and therefore increase efficiency
...
E
...
range of products in Tesco Vs
...
3) Monopolies often make large profits potentially leading to greater incentives to invest in
R&D, leading to increased dynamic efficiency
...
GlaxoSmithKline uses this argument to
justify their monopoly position, via patents, in the provision of some drugs
...
5) Natural monopolies can exploit economies of scale
...
Policies to regulate Monopoly Power
Intervention
Tax on monopoly profits
Liberalisation of markets
Introduce price capping
policies
Nationalisation
Reasoning
A one-off windfall on
supernormal profits from
monopoly power
Break up monopolies – allow
smaller businesses to enter
and increases contestability
Encourages cost efficiency +
increases consumer surplus
Take some monopoly utilities
back into public ownership
Evaluation
Risk of tax avoidance / loss of
capital investment spending
Smaller businesses may
struggle to scale up and
compete
Monopolists may find
revenues in other ways
Possible loss of productive
efficiency
Liberalisation of markets: When policies seek to lower the entry barriers into a market to make an
industry more contestable
...
But, not always
successful and can lead to regulatory failure
...
Ppc is price in perfect
competition
...
Means consumer surplus is reduced to the blue
area, and producer surplus increases to the green area
...
Price discrimination
Is defined as a business charging different consumers different prices for the same product – price
variations which don’t match the MC of supplying a product
...
Firms must have sufficient monopoly (market) power
2
...
I
...
groups of consumers with different price elasticities of demand
3
...
No secondary markets where arbitrage can take place at intermediate prices
Main aim of price discrimination are to gain extra revenue, higher profit, improving cash flow, use
up spare capacity
...
g
...
g
...
g
...
g
...
Dec 2015, Australian court finds Nurofen guilty of misleading customers by selling
the same painkiller at different prices
...
Hyper-personalised pricing
3rd Degree Price discrimination analysis
Involves segmenting consumers into groups
...
When PED<1, firms can then increase
their prices and extract consumer surplus
...
At peak times, MC may be higher as capacity
limits are reached – but higher prices can also be charged (P2) – a key
way of increasing profits and revenue
...
e
...
e
...
More focus
is given to credible threat of entry from rivals
...
Contestable markets often show high dynamic efficiency – challenger brands attacking established
operators
...
2
...
4
...
e
...
When sunk costs are high then a market
becomes less contestable – acting as a barrier to entry because of the risk of making significant
losses
Examples of sunk costs:
-
Asset write-offs – e
...
writing-off the value of plant and machinery, or stocks
Closure or project cancellation costs e
...
redundancy costs, contracts with suppliers
Loss of business reputation and goodwill – a decision to leave a market can seriously affect
goodwill among previous customers
Hit and Run Entry: When a business enters an industry to take advantage of temporarily high
(supernormal) market profits
In the long run if the market is highly contestable, output should always go back to the level where
price=AC and normal profit is being made – as soon as a firm begins to profit maximise, new entrants
will engage in ‘hit and run’ competition, lowering prices once more
...
Economic Efficiency
Economic efficiency is about society making optimal use of scarce resources to help satisfy our
changing wants and needs
...
Static efficiency
Incorporates allocative and productive efficiency, it is concerned with the most efficient
combination of resources at a given point in time
...
Means a loss in
consumer surplus and welfare)
Productive efficiency
o Occurs when a firm is operating at the lowest point on its average cost curve i
...
unit
costs have been minimised
...
Concerned with improvements in technology and working
practices to increase the efficiency of production over time
...
1: Productively efficient – operating at the lowest point of
their average cost curve
...
1
...
The demand for labour, as with any factor, is derived from the demand
for the final product
...
Determined by the marginal physical product (MPP) and the price of the final product
...
A profit maximising firm will equate the marginal cost of labour to MRPL
...
Because firms are wage takers (workers won’t accept lower wages),
with wages determined by the interaction between supply and
demand in the industry as a whole (so market forces determine
wage rates), the supply curve of labour is perfectly elastic –
therefore AC = MC
...
The firm
employs labour up to where MC = MRPL, but wages are set by the AC
curve
...
W2-W1 equals the underpayment by the employer due to
employer monopsony power
...
A potential cause of labour market failure
...
This is because:
-
Compensating wage differentials – a reward for risk-taking, working in poor conditions and
during unsocial hours
Reward for human capital
Different skill levels, and in labour productivity
Trade unions might use their collective bargaining power – to achieve a mark-up on wages
compared to non-union members
Evaluating MRP
In the theory of the labour market, MRPL is taken as the basis for the labour demand curve
...
Measuring labour productivity/efficiency can be difficult – especially in e
...
consultancy,
education
...
Firms are unlikely to be sensitive to price or productivity changes in the short term
3
...
It depends on:
-
-
Labour costs as % of total costs: The larger the proportion of total costs which are labour
costs, the more wage elastic labour demand is
Ease and cost of factor substitution: The easier and the cheaper it is, the more elastic labour
demand is
Price Elasticity of Demand for the final product: This determines whether a firm can pass on
higher labour costs to consumers in higher prices
...
g
...
A rise in consumer demand which means a business has to
take on more workers
2
...
An increase in the productivity of labour which makes
labour more cost efficient than capital
4
...
employment subsidy
5
...
Is upwards sloping – as wages rise, incentives to enter the industry rise
...
Change in relative pay/earnings of substitute occupations
Changes in entry barrier to an industry
Demographic changes
Change in non-monetary rewards a job/substitute job offers
Key factors affecting labour supply to a job/occupation:
-
-
Real wage rate on offer plus extra pay – e
...
overtime payments, productivity pay, share
options
...
Can restrict supply and increase wages
Improvements in the occupational mobility of labour and stock of human capital e
...
as a
result of expansion of apprenticeships and other types of work experience – increases
numbers who can work in a given job
...
g
...
Determinants of Elasticity of Labour Supply:
-
-
-
-
Nature of skills and qualifications required to work in an industry
o Specific skills and educational requirements make labour supply inelastic
o Lengthy and costly training periods makes labour supply wage inelastic
Vocational nature of work
o In strongly vocational jobs such as nursing, people are less sensitive to changes in
wages when deciding whether to work and how many hours to work
Time period
o In the short run, the supply curve tends to be relatively inelastic
...
Discrimination can be on the basis of:
-
Gender
Ethnicity / racial profile
Faith
Sexuality
Age
Height
Age Height
Social background
Analysis of Labour Market Discrimination
LD1 represents non-discriminated workers, while LD2
represents the discriminated against group
...
April 2014 stats showed wage gap (median weekly earnings)
small for thos in their twenties – 5%
...
Factors that may cause a gender pay gap:
-
-
-
-
Breaks from the labour market
o When women take maternity leave to raise a family, it is harder to achieve
promotion when re-entering the jobs market
o Age at which many women take a break from the labour force os often the point at
which careers take off
Access to education
o In many developing countries opportunities for women to gain qualificiations is
limited – social norms, high fertility tates
Patterns of employment
...
g
...
2013 ONS data shows women make up 77% of
administrative and secretarial jobs, and only 12% of science, engineering and
technology jobs
...
Gender pay gap may represent compensating differentials
...
Equal Pay legislation – already in place in the UK
2
...
E
...
encouraging male child care – shared parental leave from
2014
...
3
...
E,g, Amicus,
Unison, the National Union of Teachers
...
Protecting and improving th real living standards / real wages of their members
2
...
e
...
Promoting improvements in working conditions, work-life balance and related health and
safety issues
4
...
e
...
Protection of pension rights for union members
Union tactics include strikes, go-slows, overtime bans, working to rule, taking and supporting legal
action, exerting political pressure
The bargaining power of a trade union will depend on: monopsony power of employer; elasticity of
demand for final product; degree of unionization; state of economy and labour market; govt
...
Unions may force labour supply in – via adopting a closed shop (can only enter a profession if a
member of the union – which requires certain qualifications to join) or exerting pressure on
government to impose regulations
...
to impose protectionist
policies (e
...
tariffs on imports) to expand labour demand – rising labour productivity may also do
this
...
Other aims, by increasing the cost of
labour (perhaps by improving working conditions) also increase unemployment
Alternatively, trade unions may bid for employers to pay a premium wage above the normal
competitive wage (through collective bargaining), leading to an excess supply of labour and a
contration of total employment
Labour Market failures and govt
...
g
...
1
...
The diagonal line
shows a situation of perfect equality of income i
...
50% of population has 50 % of income
...
2 – High inequality
...
33, BHC)
...
Ranges from zero, where everyone has the same
income, to 1, when a single individual receives all the
income
...
g
...
Causes of Absolute Poverty
-
Population growing faster than GDP in low income countries
Severe savings gap – families unable to save and living on less than $1
...
/ public services
Effects of endemic corruption in govt
...
90 a day (PPP)
Relative poverty
o A level of household income that is considerably lower than the median level of
income within a country
o The official UK relative poverty line is household disposable income of less than 60%
of median income
The official poverty line
o An income level that is considered minimally sufficient to sustain a family in terms of
food, housing, clothes, medical needs, etc
...
To encourage competition and effort among the workforce
2
...
In poor economies, inequality also helps to build up market demand for certain consumer
goods that require a minimum purchasing power – e
...
cars, household appliances
Govt
...
spending
-
-
Redistributive Welfare state transfers
o Universal child benefits (currently £20
...
70 for the
rest) / unemployment benefit
o Public pensions – triple lock on state pensions
o Conditional welfare transfers e
...
g
...
spending more efficient
...
50 for 1 child each week in child
care tax credits
...
Taxation
-
Progressive income, consumption and welfare taxes
o Higher taxes on property
...
g
...
g
...
50
from 2017
Brief Analysis
Boosts work
incentives and take
home pay
Evaluative Comment
Might cost some jobs
and lead to higher
prices
Free provision of
services
NHS, state education
Higher rates of
income tax
45% top rate of
income tax may be
raised back up to 50%
Investment in training Subsidies for
workplace training /
internships
Subsidies for child
2014 – max govt
...
1
...
1
...
It is when markets fail to deliver an
efficient allocation of resources and the result is a loss of economic and social welfare – there is a
misallocation of resources
...
This
is linked with the idea of merit and demerit goods
Complete Market Failure: when the free market fails to produce any of the good at all,
i
...
the good would not exist if a party did not step in and produce the good
...
Types of Market Failure and their consequences
Types of Failure
1
...
Factor Immobility
3
...
Positive Externalities/Merit goods
5
...
Lack of Competition/Monopoly power
7
...
Instability of Prices
Consequence of failure if left to free market
-Market over-provided with lemons
-Inappropriate pricing of goods
-Structural unemployment
-Inefficient allocation of resources, productivity
diminished and capital deterioration
-Over consumption or production
-Under consumption or production
-Free-rider problem, as non-excludable, so
missing market created, requiring govt
...
e
...
Public goods have two main characteristics, which distinguish them from private goods:
-
Non excludability: Once a public good is provided to one person, it is impossible to stop
someone else from consuming it
...
Because of these two characteristics, you cannot charge people to use the good, and
therefore it’s impossible to cover the costs through revenue
...
Thus the government or
a charitable organisation has to provide it
...
Satellite encryption,
for example, has meant that television broadcasting is now excludable
...
The free-rider problem leads to under provision of a good and therefore market failure
...
e
...
1
...
Eventually, they become crowded, diminishing utility/enjoyment
...
Semi-non-excludable: It is possible but often difficult and expensive to prevent non-paying
consumers
...
g
...
Changing Nature of Public Goods
-
Advances in tech are blurring the distinction between public & private goods e
...
encryption allows suppliers to exclude non payers, while the product remains non-rival
...
The open source/creative commons
movement has made much information a public good in nature
...
Public Bads
A public bad has negative effects (externalities) on people and their communities leading to a
significant loss of social welfare
...
Illustrates the invisible hand does not always work
...
As such, individuals
have little incentive to take care of and maintain it, but rather have an incentive to extract as much
personal utility as possible, leading to unsustainable practices, creating concerns for
intergenerational equity
...
g
...
-
They are a common resource, in that they’re non-excludable (no property rights), but
rivalrous
...
As there are no
property rights, there is no incentive to conserve
...
Solutions:
-
Command and Control: rules and regulations limiting usage, such as quotas
Shift cultural norms: towards conservation, and a shift towards social disapproval of over
fishing
Creating property rights: make it excludable
Positive and Negative externalities of Consumption and Production + Merit and Demerit Goods
-
-
Externalities are third party effects arising from production and consumption of goods
and services for which no appropriate compensation is paid
...
e
...
Known as spill over effects, where there
is a divergence between private and social costs/benefits
...
e
...
When social cost > private cost (production) and private benefit > social benefit
(consumption)
There is a difference between private costs and social costs:
-
Marginal Private Cost (MPC): The cost that have been paid by the firm that are
producing a particular good for an additional unit in output
...
So, Social Cost = Private Cost + External Cost
...
Negative Externalities from production:
Divergence of MSC and MPC means we assume MEC
increases with each additional unit of output
A =negative externality (MEC)
B = deadweight loss (welfare loss) because market output
supplied is higher than social optimum
...
Allocatively inefficient
...
Here, negative externalities of production such as
pollution aren’t eliminated, but recognised in the price of
the product
...
Negative externalities are associated with Demerit goods:
-
Demerit goods are ‘bad’ for you, as consumption can lead to negative externalities
Consumers may be unaware of the negative externalities that these goods create – they
have information failure
The govt
...
Key point: Arguments about what is a demerit good involves making value judgements
...
e
...
g
...
MPC > MSC
Positive externalities from consumption:
E
...
education
...
P2, Q2 the socially efficient level of output
...
Merit goods are provided by both the state and the private sector
...
e
...
A product society values & judges people should have regardless of ability to pay
...
Education a long-term investment decision
...
Education
provides external benefits such as rising incomes and productivity for current and future
generations and an increase in occupational mobility to help reduce unemployment
...
Other external benefits include
encouragement of a more enlightened and cultured society
...
Merit Goods and Public Goods
Merit Goods
Pure Public Goods
-Provided by the public and private
sector
...
-Marginal cost close to zero
...
-Limited in supply, opportunity cost
-Largely unconstrained in supply
...
e
...
Valuing Externalities
A key aspect to externalities is the difficulty assigning values
1
...
g
...
g
...
Compensation: estimate the cost of ‘putting right’ an externality e
...
the cost of installing
double glazing in houses affected by increased road noise from a new motorway
...
Revealed preferences: how much people are willing to pay to avoid an externality (conduct
a survey to find the values)
...
g
...
g
...
PP prices have generally declined in real terms over recent decades, but in the short term
have been subject to considerable volatility
...
Inelasticity of Supply: Supply is inelastic because of a) agricultural growing season b)
variable costs are often only a small proportion of total costs e
...
oil platform or coal mine c)
food is perishable so there is a lack of spare capacity
...
2
...
If demand
elasticity is low, a small change in supply can result in a large change in prices
...
Changes in Supply: Mainly unplanned supply shocks, in agriculture, fishing and mines
...
Cobweb theory: Price fluctuations may result from supply changes which are themselves the
lagged response to previous price changes
...
Cobweb theory explained
...
Initial equilibrium is P1Q1
...
As such, they’ll raise planned supply to Q3 the
next year, only to find the only way they can sell off all their
produce is to charge P3
...
… Red line shows cobweb shape that begins to emerge
...
Whether these oscillations get bigger or smaller demands in D &
S price elasticities
...
Vice-versa,
oscillations will be destabilising (divergent)
...
Producers may anticipate price
fluctuations
...
May be a lag in demand adjustment as well as in supply
adjustment
...
Cn lead to various problems:
-
-
Risk: Makes incomes and profits for producers unpredictable and may inhibit
investment because suppliers are concerned about expected profits
...
Poverty: Sharp falls in prices and incoems can cause hardship and poverty and also
unemployment, especially in regions dependent on cash from exporting
...
Market Imperfections
Information failures
Occurs when people have inaccurate, incomplete, uncertain or misunderstood data and so make
potentially ‘wrong’ choices/decisions
...
g
...
Uncertainty about costs and benefits: E
...
should younger workers be buying into
pensions when we can only guess at economic conditions in 40 years’ time?
Complex Information: E
...
choosing between makes of computers requires specialist
knowledge of software
...
g
...
Addiction: E
...
drug addicts may be unable to stop consumption of harmful substances
...
g
...
For markets to work fully, there needs to be symmetric information i
...
consumers and producers
have to same level of knowledge
...
Asymmetric information occurs
when there is an imbalance in information between the buyer and seller which can distort choices
...
In Insurance markets, there are two aspects of asymmetric information:
1) Moral Hazard
- Occurs when insured consumers are likely to take greater risks, knowing that a claim will
be paid for by their cover
...
2) Adverse selection
- Occurs whenever asymmetrical info makes it difficult for trading partners to distinguish
between high-risk and low-risk transactions
...
Insurance company knows this, and this raises the ave
...
This prices healthy consumers out of the market, meaning only
high risk individuals gain insurance
...
Functioning (Peaches) and defect-ridden (lemons)
cars
...
Buyer’s best guess in average quality – and that is what they are willing to pay for a
second-hand car
...
Sellers know whether a car is a peach or a lemon
...
Thus, the proportion of lemons being sold in the market grows, and the likelihood of a
consumer buying a lemon increases
...
However, in reality, some FoP’s can’t easily move between industries
...
In stopping scarce resources being used optimally, it leads to a loss of
economic efficiency and social welfare
...
- Some capital is specific to the industry it’s been designed for
...
Can lead to a mismatch
between the skills of the unemployed and the skills employers are looking for – resulting
in structural unemployment
...
- Include things such as family ties, constraints of infrastructure, migration controls,
regional variations in house prices, language barriers
...
Monopoly bit for this section on pg36
Competition Policy
Sometimes market imperfections lead to market failure and therefore necessitate market
intervention
...
regulators
The aims of competition policy in countries such as the UK are to promote competition; make
markets work better and contribute towards improved efficiency in individual markets and
enhanced competitiveness of businesses in overseas markets
...
Anti-trust and cartels
a
...
Market liberalisation
a
...
State aid control
a
...
Merger control
a
...
Can block an acquisition if they find the merger will lead to a “significant lessening of
competition” in one or more markets at local, regional or national level
2
...
Examples of recent CMA investigations:
-
Gyms: 14 Aug 2015 the CMA cleared the acquisition by Pure Gym Limited of the LA
fitness business
Telecoms: British Telecom and EE
...
Cinemas: Cineworld / Picturehouse merger (2015) cleared after Cineworld sold three
cinemas to the Light cinema chain
...
In the long run, the thrust of regulation has been to encourage competition by easing the
entry of new suppliers and making markets more contestable
Price capping is being phased out now, as most utility markets have become more competitive, but
it is:
-
An alternative to rate-of-return regulation, in which utility businesses are allowed to
achieve a given rate of profit on capital
UK price capping is known as ‘RPI – X’
...
e
...
Diagrammatic analysis is the same as that for a maximum price
E
...
of price capping – EU Competition Committee intervened so that, after June 15,
2017, those travelling within the EU will be able to use their mobile internet abroad at
no extra charge
Arguments for price capping:
-
-
Capping is an appropriate way to curtail the monopoly power of natural monopolies or
dominant firms, preventing them from making excessive profits
...
Cuts in the real price levels are good for household and industrial consumers – leading to
higher consumer surplus and living standards
Helps stimulate productive efficiency because lower costs are needed to maintain profits
Can be used as a tool for controlling CPI
...
Can also intervene against govt
...
Public ownership, privatisation, regulation and deregulation
Increasing the contestability of markets is widely regarded as an important micro-economic supplyside economic policy
De-regulation of markets:
-
Involves attempts to liberalise a market and encourage new entrants – by lowering
barriers to entry
...
g
...
The fully privatised in 2013
...
g
...
g
...
Potential advantages of deregulation include:
1
...
Increased comp
...
Comp
...
By forcing them to charge closer
to MC, improves allocative efficiency
4
...
The case for:
-
The discipline of free market forces are a better incentive for businesses to be run
efficiently and thereby achieve improvements in economic welfare
A way of reducing trade union power, widening share ownership and increasing
investment – as privatised firms are free to raise finance through the capital market
Important tool to drive competition and improve productive and dynamic efficiency
...
can typically raise investment finance at a lower cost than private firms
The UK mail industry
Can be looked at to illustrate examples of different types of competition:
1
...
40% of mail now covered via this mechanism
2
...
E
...
TNT Post
...
part privatised the Royal Mail – govt
...
10% of shares in Royal Mail were transferred to an employee share scheme designed
to boost incentives for those who work for the business
The royal mail is also a good example of a business that faces increasing competitive pressures not
just from rival businesses but also from substitute forms of competition, as technology changes the
shape of the industry:
-
-
Retailers and e-retailers
o Amazon own-delivery network adds capacity equivalent to a new operator
o Retailers e
...
Tesco developing in-house Click & Collect / returns services
Contestable parcels industry – rival firms
o DPD, Hermes, Yodel
Other challenges to Royal Mail volumes and revenues
o E-mail and cloud storage – substitutes for mail
o 3D printing at home – may reduce parcel volume
Competition tendering and contracting out
In recent years there has been strong growth in the number of private sector businesses that are
used to provide public sector businesses – outsourcing
...
Also managers leisure centres, Ofsted school inspections and prisons
...
6bn
...
Claims they overcharged the govt
...
May also be more innovative, less
hierarchical and less prone to diseconomies
The case against:
-
Businesses bidding to win contracts might sacrifice quality of service as a way of
lowering costs
Doubts about employment practices e
...
low wages, poor conditions
Outsourcing requires proper monitoring which itself involves extra spending
Impact of govt
...
Judging the effectiveness of regulation
1
...
3
...
5
...
7
...
g
...
failure
Cost of meeting regulations can discourage
smaller businesses and lower competition in
markets
Regulatory failure
Different to regulatory capture, where regulators are in the sway of producers, examples of
regulatory failure include:
Examples:
Regulators may limit innovation in fast-growth markets
Capping prices might prevent new firms entering the market
Regulation becomes bureaucratic and costly
Regulators may lack the power to be truly effective in protecting consumers
Frequent rule changes can stifle business investment
Banking – HBOS – Market Failure and Regulatory Capture (2015):
A report from the BofE and the FSA published 2015 suggested that up to 10 executives that worked
for HBOS should be banned from working in the City in the future
...
Moreover, report suggested that the BofE’s own regulatory body at the time did not investigate the
issues with enough stringency and relied too heavily on information from senior managers within
organisations like HBOS
...
E
...
Energy – Possible Regulatory capture in the UK energy market
A news report argued OFGEM, the energy market regulator, had been convinced by the big 6 energy
firms to abandon its former procedure of publishing data about the difference paid to suppliers and
charged to consumers for energy
...
However, it
may not be the case that energy companies are over-charging consumers
...
Government intervention in markets
Intro to government intervention
Laissez faire economics
-
In a free market system, governments take the view markets are better suited to
allocate scarce resources
...
then mainly to protect property rights, uphold the rule of law and maintain
the value of the currency
...
But, sometimes markets fail and potentially require govt
...
Intervention in the market
The main reasons for policy intervention are:
-
To correct for market failure
To achieve a more equitable distribution of income and wealth
To improve the performance of the economy
Governments influence the allocation of resources in a variety of ways, including through public
expenditure, taxation and regulation
...
intervention
a) Value judgements: People’s views depend on issues they (subjectively) give the most
weight to
...
intervention cannot be easily calculated beforehand
...
e) The power of the markets: Ask, is government intervention necessary here?
f) The law of unintended consequences: Events may interfere with a particular policy, or
consumers and businesses may not behave in the way the govt
...
Checklist for judging the effects of intervention
1
...
2
...
3
...
4
...
5
...
Indirect tax should equal the external cost
...
P1-9(2-t) is the producer’s burden of tax
-
*Evaluation*
Can be difficult to calculate the appropriate value of the tax
Inflationary effects
...
Politically unpopular
Affects the poor most – a regressive tax
Won’t have much of an effect on inelastic goods (especially cigarettes, alcohol and
petrol) – although the more inelastic demand is, the higher govt
...
Could be a guaranteed payment on the
factor cost of a product, or input subsidy for A-Level purposes
...
Subsidies lower the price of a good, therefore increasing consumption
and bringing it in line with the socially optimum level
...
Can also be represented by diagram below
...
When we subsidise the good in question, the supply curve now shifts out to MPC1, and we now
produce at MPC1 = MPB, which is engineered to be at Q* - allocative efficiency is restored
...
When drawing the diagram, must make sure that the new MPC
curve (MPC1) intersects the MPB curve at the same quantity that
the old MPC curve intersects the MSB curve
...
– opportunity cost
If supply or demand is inelastic, subsidy may have little
effect
...
Could be advertising campaigns (e
...
cigarette advert), health warnings, and increasing information
available about the benefits of a product
...
Arguably the best though – seat belt campaign
People can choose to ignore the advice
Opportunity cost – money spent on campaigns could be spend elsewhere
State provision – Public goods and merit goods
E
...
education, healthcare, public infrastructure
...
State provision designed to increase consumption, and to allow
low earners to consume a good who otherwise would have been priced out of the market
...
Some taxpayers do not consume the good and yet pay for it
...
However, firms can
contract out private firms which should help improve efficiency
...
Regulation – merit, demerit and public goods
Govt
...
Severity will
depend on the extent the govt
...
g
...
Designed to increase consumption of some goods and decrease the consumption of others to bring
in line with the socially optimal level
...
g
...
know where to set the level of regulation
Expensive to set up, monitor, enforce
Application: Tradeable pollution permits
Govt
...
If a firm pollutes less
than its permit, it has the right to sell the excess to firms that pollute over their permit – therefore
incentivising firms to reduce pollution levels as they can make money through the sale of their
permits
...
Big firms will just buy up permit – no incentive to reduce pollution unless permit price
set high enough
...
may get pollution levels wrong – too lax/too tight
...
Application: Defining and extending property rights
Market failure can exist when property rights are not clear: who owns the sea, air, rivers etc
...
Therefore,
extending property rights gives people the right to protect these areas and claim compensation if
said areas are polluted
...
g
...
Advantages
Directly compensates the victims
Disadvantages
Can be difficult who created the problem – in terms of
claiming compensation
...
g
...
Price Controls – Maximum Prices
The government or an industry regulator can set a maximum price in an attempt to prevent the
market price from rising above a certain level
...
However, also involves a normative judgement on the behalf of the govt
...
One example may be when food shortages threaten large price increases, or to impose rent controls
on properties (e
...
in Manhattan)
...
E
...
the EU introduced price caps for
roaming charges on consumers made by mobile phone service providers
...
imposes max price of
Pmax
...
Black Markets – an illegal market in which the market price is
higher than a legally imposed price ceiling - may, however, develop,
as excess demand means some consumers are prepared to pay
higher prices in black markets in order to get the good they want
Price controls – Minimum prices
A minimum price is a price floor below which the market price
cannot fall
...
The best example is the minimum wage in the
labour market – employers cannot legally undercut this wage level
...
05
...
50
...
is a diagram showing the possible effects of a minimum
wage
...
If a min
...
The main aims of a minimum wage:
-
The equity justification: every job should offer a fair rate of pay commensurate with the
skills and experience of an employee
Labour market incentives: the NMW is designed to improve incentives for people to
start looking for work – thereby boosting the economy’s labour supply
Labour market discrimination: A tool designed to offset the effects of persistent
discrimination of many low-paid female and younger employees
...
Small
businesses may struggle to make a profit
Effect on relative poverty: Is it the best way to reduce relative poverty? Tends to boost
the incomes of middle-income households with more than one household member in
work – whereas the greatest risk is among the unemployed, elderly and single parent
families where the parent isn’t employed
...
Moreover, the efficiency wage argument states raising pay levels for low-paid
employees may boost their productivity, and it may encourage businesses to invest in more
productive processes and machinery – in reaction to increased labour costs
...
E
...
inelastic demand
means a minimum wage above the market equilibrium will not have much of an effect on
employment
Policy Intervention Alternative
Living Wage
Income tax reform
Benefit reform
Evaluative Comment
An optional alternative to the minimum wage
that firms can sign up to
Cutting the basic rate of income tax or raising
the tax free allowance to boost work incentives
Linking benefits to participation on work
programmes – politically controversial
Measures to raise labour productivity
Most important in the long run – boosts wages
/ incomes
Price Controls – Buffer Stocks
The prices of commodities (and especially agricultural products) tend to fluctuate more than the
prices of manufactured products
...
One way to smooth at the fluctuations in prices is to operate
price support schemes through the use of buffer stocks –
though they have a history of failure
...
In a buffer stock scheme, the market is free to vary between
the upper (P2) and lower (P1)
band – see diagram to the right
...
intervenes to protect producers by buying up supplies
to maintain the price – and vice versa if the price rises above P2
...
to intervene to protect consumers
...
Note that in the
momentary period the supply of the agricultural product is vertical
(perfectly inelastic) because of the length it time it takes for producers to supply new quantities of
that agricultural product to the market
...
However, don’t work well in
practice
...
g
...
Cost of buying excess supply can cause the scheme to run out of cash
A guaranteed min price might cause over-production and rising surpluses – causing
economic and environmental costs
...
Also requires a lot of initial capital – as money is
needed to buy up the product when prices are low
...
Too high a target price range, and it will end up buying more than it sells – until the
scheme runs out of cash
...
Strong evaluation will consider alternatives to buffer stock schemes, which also aim to stabilise
prices and incomes for farmers:
-
Investment in capital goods such as irrigation and basic storage facilities and wider
access to affordable insurance – 2 good long term policies
Mobile technology to help farmers
Encouraging processing/branding by farmers – where the larger profit margins come (as
opposed to selling the raw product)
...
They can tax,
control and regulate but the outcome may be a deepening of the market failure or even the creation
of a new failure
...
Government failure in a non-market economy
The collapse of the Soviet Union in the late 1980s marked the failure of command economies –
where the state planning mechanism decides what to produce, hoe to produce it and for whom it
would produce – as a means of allocating resources among competing uses
...
Also little incentive for workers to raise
productivity
...
Government doesn’t
have perfect information and may therefore make the wrong decision
...
Enforcement costs
may also be high and the scheme may not be value for money – if intervention is
associated with low productivity
Admin costs: Aka bureaucracy and red tape
...
Unintended consequences: When policies have unanticipated consequences
...
g
...
Self-interest (Political): Govt
...
Expertise: Govt
...
Other examples include:
-
Policy short termism/myopia: Govt
...
g
...
Conflicting objectives: E
...
cutting taxes v
...
spending
...
Disincentive effects: E
...
trying to reduce income/wealth inequalities may lead to a
reduction in incentives to seek work
...
Key points about govt
...
Free market economists are distrustful of intervention
...
2
...
Limited info – no govt
...
That is the nature of politics
4
...
failure is most likely to occur when decisions are made in the vested interest of special
interest groups, at the expense of other groups (the result of a loss of equity)
Title: Microeconomics A-Level Notes
Description: Complete notes for Microeconomics AQA A-Level (reformed). Made by a current Economics and Management Oxford Student, who got an A* in Economics at A-Level. email philippe.grimshaw@keble.ox.ac.uk for confirmation of this.
Description: Complete notes for Microeconomics AQA A-Level (reformed). Made by a current Economics and Management Oxford Student, who got an A* in Economics at A-Level. email philippe.grimshaw@keble.ox.ac.uk for confirmation of this.