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OCR A level
Micro economics
0
Table of Contents
The basic economic problem
...
3
Positive economic statements
...
4
The concept of the margin
...
6
Production possibility frontiers (PPF)
...
9
Specialisation and trade
...
11
Allocation of resources
...
13
Planned economy
...
13
Mixed economy
...
15
Supply and demand
...
16
Supply
...
22
Elasticity
...
26
Using knowledge of elasticity
...
30
Cross elasticity of demand (XED)
...
31
Elasticity calculation
...
34
Types of efficiency
...
37
Costs of production
...
42
Economies of scale
...
45
Revenue
...
48
Profit maximisation
...
50
Monopolistic competition
...
56
The kinked demand curve model
...
59
Monopoly
...
63
Concentration ratios
...
65
Contestable markets
...
68
Competition policy
...
70
Labour demand
...
72
Wage determination in competitive markets
...
75
Monopsony
...
76
Occupational immobilities – lack of skills
...
77
National minimum wage
...
83
Flexible labour markets
...
84
Wealth and Income Inequality
...
88
Public goods
...
89
Negative externality
...
90
Merit good
...
92
Moral hazard
...
93
Kuznets environment diagram
...
96
Tax
...
98
Tradeable pollution permits
...
100
State provision of public services
...
102
Government Failure
...
Because of this scarcity and
limited resources, economics is concerned with:
• What to produce
• How to produce
• For whom to produce
Economic goods / free goods
•
•
Economic good – A good which imposes some cost on society to produce
...
Free good – A good which can be enjoyed without any cost to society
...
For example, air to
breathe, rain water (in most parts of the world)
...
In this
case, you got the meal for free, but it was still a cost to someone else in
society
...
It is an
economic good
...
Positive and normative economics
Positive statements are based on facts that can be tested as true or false
...
5%
...
Normative statement are based on an opinion or a value judgement
...
For example:
•
•
The government should increase taxes on alcohol to improve the
nation’s health
...
Combining positive and normative statements
•
Because oil prices have increased over $100 (fact), I believe the
government should cut petrol tax (opinion)
...
Note how the same positive economic statement (oil price increased) can lead to
different opinions (normative) on how to respond
...
A good that is required for the basic functions of life, these are
goods and services, such as food, shelter, clothing, and important services,
such as health and education
...
This refers to things that we would like to consume, but are not
essential for the basic functions of life
...
Therefore, we could say 2,000
calories of food a day are a need for most people
...
Because we don’t need these extra, expensive calories
...
Referring to resources that are limited
...
Non-‐renewable resources
...
Once used, they cannot be replaced
...
Renewable resources
...
Examples
include wind, wood, fish, solar energy, and water
...
There are some resources that, in theory,
are renewable, but if they are over-‐consumed they can become extinct
and no longer available
...
But,
if we over-‐fish, fish stocks can become depleted and no longer available
...
This occurs when we consume resources at a
rate that can be maintained in the long-‐term
...
If we plant at the same rate as
cutting, this is sustainable
...
If we continue to over-‐fish,
it means future generations may not be able to take any fish from the sea
at all
...
Governments collect taxation and spend money on
government services, such as health care and education
...
Firms
...
Firms also
employ workers (householders)
...
Households are consumers of goods and services; they are
also workers, providing labour for firms to produce goods
...
For example, coal, fish, and wood
...
Labour – workers able to participate in a productive process – turning
raw materials into finished goods
...
Capital – machines and equipment used in the productive process to
manufacture goods
...
An entrepreneur
can take a risk of setting up a new firm because of the potential profit
from creating a successful business
...
Marginal utility is the benefit / satisfaction from consuming an extra good
Utility is the concept of how much benefit / satisfaction people get from
consuming a certain good
...
The average utility for 5 goods is 7
...
Total utility
10
20
28
34
36
Marginal utility
10
10
8
6
2
Average utility
10
10
9
...
5
7
...
This means that they try to maximise their economic welfare and make decisions
to enable this
...
They may give this utility a monetary value like
£10
...
For example, they
will spend money on goods only if they believe the utility gained is
greater or equal to the cost
...
However, the second chocolate bar has a lower marginal utility –
you might feel sick if you eat too many
...
Consumers may not have the time to work out the marginal utility
...
Consumers are not always rational, but can be influenced by factors, such
as advertising and impulse buying
...
For example, a consumer may be unaware of the
marginal utility of buying a second hand car
...
For example:
• If the government spends tax income on defence spending, then this
money cannot be spent on health care
...
• If we spend our time surfing the internet, we cannot spend this time
studying economics
...
Sometimes there are two options that are
good, but we need to choose the relatively best option
...
6
Evaluation of opportunity cost
•
•
•
It can be difficult for consumers to know the next best alternative
...
But, how much would we need to currently spend?
People often don’t have time to try and work out opportunity cost, even if
they could
...
Production possibility frontiers (PPF)
A PPF shows the maximum output that an economy can produce if the economy
is maximising the use of its resources and operating efficiently
...
It is
impossible to choose more consumer
goods or environment units without an
opportunity cost
...
• If we produce more consumer goods, it leads to a depleted environment
...
7
Opportunity cost and production possibility frontier
• At point A, we have 15 goods / 22 environment
...
• If we move from point A to B, we gain an extra 3 units of the environment
...
Production possibilities frontier
Capital vs
...
• Consumer goods
...
These are things we buy
in shops like food, clothes, etc
...
These are goods that are used in the productive process – for
example, a machine
...
• If we move from A to B, there is a movement along the PPF curve enabling
more consumer goods to be produced (an extra 3)
...
• Increasing consumer goods enables higher living standards in the short
term, but in the long term we may not be able to produce as much
because of less investment in capital goods
...
8
Economic growth and a shift in the PPF curve
•
•
Economic growth enables the PPF curve to shift to the right, enabling
point C (more consumer goods and capital goods)
...
Causes of economic growth
•
•
•
•
Discovering more raw materials (e
...
discovering oil fields)
Increase in the size of work force (e
...
immigration)
Increase in capital stock (e
...
investment in new machines, factories)
Increase in labour productivity (e
...
due to better technology)
Production possibility frontier and efficiency
•
•
•
•
We say that any point on the PPF curve is productively efficient
...
However, productive efficiency is not the only criteria
...
•
•
•
An economy could use all its resources to produce capital goods (point C)
...
Allocative efficiency would involve the right combination of capital goods
and consumer goods – point A or point B
...
Countries will specialise in producing goods where they have a
comparative advantage
...
Cuba specialises in producing sugar
...
Rather than try to master all aspects of production, some workers will
specialise at a particular job
...
Adam Smith in ‘Wealth of Nations’ found that the efficiency of a pin
factory was increased if workers specialised in a particular part of the pin
production process and worked on an assembly line
...
Overall, they need less time to be trained
...
Without specialisation and the division of labour, one person may be
unable to produce a car on his own
...
Problems of specialisation
•
•
The division of labour can make jobs highly specialised and repetitive,
leading to boredom and possible diseconomies of scale
...
Therefore, there
needs to be some flexibility
...
Countries can make use of their best resources (e
...
low labour costs in
India and China or advanced technology in Germany)
...
g
...
If countries specialise in certain goods, those industries can benefit from
economies of scale as they get bigger
...
For example, if sugar prices fall, countries that rely
on sugar exports will see a fall in income
...
Money
•
•
•
Money is an object used as a medium of exchange between two parties
...
Money enables people to specialise in one job and use their earnings to
purchase goods and services from people who work elsewhere
...
Without money, we would need a barter economy, which makes
specialisation harder (e
...
a pig farmer is unlikely to sell me some pork in
return for a few hours of economics tuition)
...
Medium of exchange
...
2
...
Money measures the relative worth of goods (e
...
a TV
priced at £250, a banana at 25p)
...
Store of value
...
4
...
Money is used to pay back debt
...
11
Allocation of resources
•
•
•
Allocation of resources refers to how goods are distributed in society
...
In a command economy, resources are allocated by the government
...
This higher price makes the good more profitable
...
•
•
In the long term, firms respond to higher prices by increasing supply
...
Evaluation of incentive effects
•
•
•
There can be considerable time delays, e
...
people take time to respond to
changing consumer preferences
...
Firms may not
wish to produce goods if they are of questionable ethics
...
12
Types of economic systems
Planned economy
•
•
This is an economy where the government owns the means of production,
and the government decides what and how to produce (e
...
the former
Soviet Union)
...
Advantages of planned economies
•
•
•
•
The government can reduce inequality and make important public
services available to all
...
The government can prevent the abuse of monopoly power
...
Problems of command economies
•
•
•
•
•
There is no profit motive, so people working for the government may
have little incentive to cut costs and innovate
...
The government may be slow to respond to changing consumer
preferences; with price controls, we may end up with shortages or
surpluses
...
Consumers may face a lack of choice about goods to buy
...
The market economy
•
•
A totally free market occurs where there is no government intervention in
the economy
...
Advantages of free market economies
•
•
•
Free markets tend to result in an efficient allocation of resources because
firms have a profit incentive to produce goods that are in demand
...
Consumers have the freedom to choose the best products, which they
need
...
The incentives of a free market encourages individuals to work hard and
set up new business
...
In a free market, public goods, like street lighting, will not be provided
...
There will be overconsumption of goods with negative externalities,
leading to pollution and damage to the environment
...
Inequality will occur
...
Mixed economy
In a mixed economy, part of the economy will be left to private enterprise, but
the government will intervene in various areas
...
g
...
• Try to reduce relative poverty through redistributing income
...
• Provide services that are under-‐consumed in a free market (health care,
education, welfare state, and national defence)
...
g
...
g
...
• A mixed economy tries to get the best of free markets (efficiency,
enterprise, innovation) but deals with some of the problems of market
failure, including pollution, monopoly, and inequality
...
For example, in the UK, the government spends
approximately 40% of GDP
...
35% of GDP
...
For example, the government may lack sufficient information and
government workers may have limited incentives to be efficient and
productive
...
For example, when choosing goods, consumers will buy the
goods that give them the most satisfaction relative to the price
...
Sales maximisation occurs when firms try to increase sales and
maximise market share
...
For example, this may involve firms making less profit but
making goods cheaper for people on low income
...
This may involve consumers avoiding
the consumption of goods which cause pollution, e
...
choosing to walk
rather than drive
...
If a firm aims at profit maximisation, it may conflict with the
environment or social welfare because increasing output could lead to
more pollution
...
Government intervention may be needed to
limit behaviour of firms and consumers
...
It is possible a firm may be able to
harmonise different objectives
...
Firms
which look after environment may get better brand loyalty
...
For example, farmers will supply vegetables in the market,
and consumers will buy (demand)
...
For example, within a
vegetable market, there may be a sub-‐market of organic vegetables
...
The market demand curve illustrates the price consumers in the whole
economy are willing to pay
...
Movement along the demand curve
...
•
•
A higher price reduces demand
...
Demand Curve
•
•
For example, if there is an increase in price from 9 to 12, then there will
be a fall in demand from 30 to 22
...
If the
price is higher, this discourages people from buying the good
...
A shift to the right in the demand curve can occur for a number of reasons:
1
...
2
...
For example, mobile phones are
now more versatile and powerful, making them more attractive
...
Advertising can increase brand loyalty to goods and increase demand
...
An increase in the price of substitutes
...
5
...
For example, a lower price for Apple
apps will increase demand for Apple iPhones
...
Fashion / trends
...
g
...
Evaluation of demand
•
•
The evaluation of a change in demand depends on the type of good
...
Some goods will vary due to seasonal factors like the weather and time of
year (e
...
scarves and air conditioners)
...
The price individuals are willing to pay for goods
...
This is the sum of all individual demand curves
...
This occurs when the demand for a good depends on demand
for another product / service
...
If there was a rise in unemployment and less people working,
demand for travel would fall
...
We demand café waiters only if
there is demand for people visiting cafes and buying coffee
...
This occurs when a good has multiple different uses
...
•
•
•
For example, demand for wheat could be due to either:
o Demand to use wheat in bread or
o Demand to use wheat as a biofuel
...
With more demand for biofuels, the price of wheat will rise
causing the price of wheat for bread to also increase
...
• Steel -‐ could be used for building guns or it could be used for building
bicycles
...
This occurs when two goods are complementary and needed
together
...
Therefore, higher demand for home printers will lead to higher demand
for ink cartridges
...
A market where there are two goods offering very similar
levels of satisfaction
...
18
Relationship between price and quantity demanded
This shows the demand for a good against the price
...
The marginal utility of extra units tends to be lower, so we are willing to
pay lower prices for these extra units, e
...
fifth cake will give much lower
utility than your first
...
Income effect
...
If the price of petrol increases, then consumers will have lower disposable
income; they may not be able to afford to drive as much, leading to lower
demand
...
This looks at the effect of a price increase compared to
alternatives
...
•
The income and substitution effect shows an increase in the price of a
good effects both our disposable income and changes the relative cost of
goods
...
The market supply curve refers to the sum of all individual supply curves;
it is the total supplied to the market
...
If price changes, there is a movement along the supply curve
...
Joint supply
Joint supply occurs when two goods are supplied together from the same source
...
With an increase in the supply of beef, you also get more leather
...
g
...
This could occur for the following reasons:
•
•
•
•
•
•
•
•
A decrease in costs of production
...
Lower costs could be due to lower wages or lower raw
material costs
...
Expansion in the capacity of existing firms, e
...
investment to extend the
size of a factory
...
g
...
Favourable climatic conditions, which are very important for agricultural
products, e
...
good weather will give a good harvest
...
g
...
Lower taxes on the good, e
...
lower petrol tax
...
21
Interaction of markets
The price mechanism refers to how supply and demand interact to set the
market price and the amount of goods sold
...
Excess demand
If the price is below equilibrium (p2), demand is greater than supply (Q2 – Q1) –
causing a shortage
...
As price rises, there will be movement along the demand curve and less
will be demanded
...
Excess supply
•
•
•
If the price is above equilibrium (p2), supply is greater than demand (Q2-‐
Q1) – causing a surplus
...
The lower price also encourages more
demand
...
Impact of increase in demand
•
•
If consumers saw an increase in income, we would see an increase in
demand for goods like TV’s; the demand curve would shift to the right
...
23
Impact of increase in demand
•
•
The increase in demand causes an increase in market price (P1 to P2) and
an increase in quantity (Q1 to Q2)
...
Fall in supply
If the availability of oil decreased, we would see a fall in supply
...
Since demand for oil is inelastic, we see a relatively bigger increase in the
price
...
Previously it was too
costly to produce oil from here, but the higher price may make it
worthwhile
...
Therefore, over time, the impact of a fall in supply may vary
...
In several markets, prices are not determined by market
forces, but considerations of equity and ‘being fair’
...
Difficult to measure
...
For example, a fruit picker can be paid depending how much fruit is
picked, but a teacher or a nurse has a less measurable value
...
Some goods are quite volatile in price
...
This is because supply can vary, and demand
tends to be inelastic
...
Government set prices
...
For example, TV
licenses, train tickets, and price of prescriptions are all influenced or set
by the government
...
If price is below the equilibrium, there is
excess demand, but a firm may not want to expand
...
25
Elasticity
Price elasticity of demand (PED)
The price elasticity of demand measures the responsiveness of demand to a
change in price
...
Example of elastic demand
•
If the price of Tesco bread increases 5% and demand falls 15%, the PED is
(-‐15/5) = -‐3
...
This is price elastic
...
Competitive markets
...
For example, if the price of Tesco
bread increased, consumers could switch to several other varieties
...
With goods that are bought frequently, we are more
likely to compare prices, and switch if necessary
...
D
...
g
...
5)
...
2
Characteristics of inelastic goods
•
•
•
•
•
Few substitutes, e
...
petrol and cigarettes have few close alternatives
...
g
...
Addictive
...
g
...
Small percentage of income means you don’t worry if price rises
...
Evaluation
1
...
But demand for individual brands of coffee is likely
to be more elastic, as there are substitutes to Starbucks coffee (e
...
Costa)
...
Elasticity may change over time
...
27
Using knowledge of elasticity
1
...
Diagram: Inelastic demand and price
In this example, the price of oil rises from $110 a barrel to $190, and the quantity
falls from 9 million to 8 million
...
What is the PED of oil in this example?
•
•
% change in Q
...
1/9 = -‐0
...
1%)
% change in price 80/110 = 0
...
7%)
Therefore PED of oil = -‐11
...
7 = -‐0
...
5%
Revenue was 110 × 9 = £990
Revenue has now fallen to 4 × £130 = £520
A fall of £470
PED of this example -‐55/18 = -‐ 3
...
Advertising and elasticity
•
•
•
•
Firms have an advantage if demand for their good is price inelastic
...
This is why many firms spend money on advertising to create brand
loyalty
...
Firms can also make demand more inelastic by offering more add-‐on
features and better quality products that stand out from the competition
...
Example of YED
•
•
If your income increases by 5% and the demand for mobile phones
increases by 20%, then the YED = 20 / 5 = 4
...
25
Types of goods
•
•
•
•
Inferior good
...
Inferior goods will have a negative YED
...
As your income
increases, you buy better quality goods instead
...
This occurs when an increase in income leads to an
increase in demand for the good, therefore YED is positive >0
...
Luxury good
...
It means demand is
income elastic
...
Income inelastic
...
Therefore 0 > YED < 1
...
Demand for inferior goods will increase
...
Supermarkets may respond to a recession (falling income)
by supplying more ‘inferior’ goods
...
Developing countries who specialise in producing
primary products (with low YED) may benefit less from global growth
...
Substitute goods
...
With two
substitute goods,
•
•
•
•
With substitutes, XED will be positive
...
Tesco bread and Sainsbury’s bread are close substitutes so XED is higher
...
Therefore XED = 15/10 = 1
...
These are goods that are used together
...
For example, if the price of DVD players fall, then there will be an increase
in demand for DVD discs
...
If the price of milk falls by 10%,
demand for tea may increase 1%
...
1
Unrelated goods
...
If the price of lamb increases and
demand changes for computers, it is just a co-‐incidence and not related
...
31
Diagram: inelastic supply
•
•
•
•
•
Inelastic supply means a change in price causes a smaller percentage
change in supply (PES <1)
...
In the example on the left: % change in Q = 3/50 = 6%
% change in price = 6/60 = 10%
Therefore, PES = 6/10 = 0
...
Operating close to full capacity
...
2
...
3
...
4
...
g
...
5
...
Elastic supply
This occurs when an increase in price leads to a bigger % increase in supply,
therefore PES >1
...
32
•
•
•
•
On the left: Price increase from 60 to 63 and Q increases from 50 to 60
...
0 (elastic supply)
Supply could be elastic for the following reasons:
•
•
•
If there is spare capacity in the factory
...
If it is easy to employ more factors of production
...
• But, in the long run, supply can be more elastic as the firm is able to invest
in more capacity and therefore increase supply
...
0
...
If the price increased from £30 to £36, what will be the new Q?
•
Price increases by £6
...
2) = 20%
(PES) 2
...
For example, if a book costs £10, but the demand curve shows that they
would have paid £16, the consumer surplus is £6
...
A monopoly that can set prices will be able to reduce consumer surplus
...
Producer Surplus
•
•
Producer surplus is the difference between the price suppliers receive
and the price that they would have been willing to supply the good at
...
34
Producer surplus after fall in supply
•
•
•
If we had an increase in the cost of production, we would see the supply
curve shift to the left
...
Producer surplus also falls
...
Consumer and producer surplus after a fall in supply
...
Productive efficiency
...
It will also occur at the
lowest point on the firm’s SRAC curve
...
Allocative efficiency
...
This occurs at an output
where P=MC because, at this value, what the marginal benefit
consumers get is the same as the marginal cost
...
X-‐efficiency
...
A firm exhibits x-‐inefficiency if it lacks incentives to cut costs and so its
actual costs are higher than they could be
...
Efficiencies of scale
...
36
5
...
This refers to efficiency over time
...
Dynamic efficiency is
also influenced by investment in human capital and investment in capital
and technology
...
Static efficiency
...
7
...
This includes all external costs and benefits
...
Business objectives
1
...
Benefits of
maximising profit can include:
•
•
•
•
Higher salaries for managers and workers
...
Encourages firm to be efficient and to keep looking at cutting costs
...
37
2
...
This
could involve:
• Sales revenue maximisation – maximising total revenue (P*Q)
• Sales volume maximisation – selling as many units as possible – probably
selling goods as cheap as possible without making a loss
...
• Managers prefer to work for bigger companies, as it tends to lead to
greater prestige and higher salaries
...
Social / environmental concerns
A firm may incur extra expenses to choose products which don’t harm the
environment, or choose products not tested on animals
...
g
...
• Organisations like the Co-‐op have a different structure to share profits
amongst consumers and workers
...
Profit satisficing / divorce of ownership
•
•
•
•
•
In many firms, there is separation of ownership and control
...
This is a problem because owners may want to maximise profits, but the
managers and workers have much less incentive to maximise profits
...
Profit satisficing is also known as principle/agent problem
...
This gives
workers an incentive to think like shareholders and maximise profits, and
it could overcome the x-‐inefficiency of workers without incentives
...
38
Social welfare
•
Some businesses may be set up with aim of promoting social welfare
...
Corporate social responsibility (CSR)
•
•
This is a business model where the main stakeholders in a business are
considered – beyond the usual profit maximisation aims
...
Diagram showing different objectives
•
•
•
•
P1, Q1 – Profit maximisation -‐ because it is the output where MR=MC
P2, Q2 – Revenue maximisation -‐ because it is the output where MR=0
P3, Q3 – Marginal cost pricing -‐ P=MC (allocative efficiency)
P4, Q4 – Sales maximisation -‐ The maximum sales a firm can make whilst
making normal production
39
Factors which influence choice of objectives
•
•
•
Aims of owners
...
Entrepreneurs may set up business hoping to secure their financial
future
...
Public opinion
...
g
...
This may encourage multi-‐nationals to promote
schemes for the betterment of developing countries
...
It could be argued that making
statements of social concern and giving some profit back to charity can
enhance a firm’s long-‐term reputation and become a good marketing
strategy
...
Costs of production
•
•
•
•
•
•
•
•
Fixed costs: Costs that do not vary with output e
...
the cost of a factory
...
g
...
Total costs: Fixed + variable costs
...
g
...
Long run
...
g
...
In the long run, we can get
economies and diseconomies of scale
...
67
475
Average costs tends to be U-‐shaped in the short run
...
Total product (TP)
...
Marginal product (MP)
...
•
•
Q of workers
1
2
3
4
5
6
7
•
•
•
•
MP
2
4
6
8
10
8
5
TP
2
6
12
20
30
38
43
MC
10
5
3
...
4
2
2
...
If a worker costs £20, the MC of those 2
units is 20/2 = 10
...
The MC of those 6 units is 20/6 = 3
...
The 5th worker adds an extra 10 goods
...
After the 5th worker, diminishing returns sets in, as the MP declines
...
42
Diminishing returns explained
•
•
•
•
•
•
Diminishing returns occur in the short run, when one factor is fixed, e
...
capital
...
This is because if capital is fixed, extra workers will eventually get in each
other’s way, as they attempt to increase production
...
When diminishing returns occurs, there will be a decreasing marginal
product (MP) and increasing marginal cost (MC)
...
•
•
•
Because of diminishing returns, we get a SRAC (short run average cost),
which is U-‐Shaped
...
When the marginal cost is
higher than average, SRAC will rise
...
43
Economies of scale
•
Economies of scale occur when long run average costs fall with increasing
output
...
g
...
Examples of industries with many economies of scale include:
•
•
•
Aerospace manufacture
Railways
Car production
Internal economies of scale
Internal economies of scale occur when an individual firm becomes more
efficient
...
Specialisation and division of labour
...
With little training, they can become
very proficient in their task and this enables greater efficiency
...
2
...
If you buy a large quantity, then the average costs will be
lower
...
Technical
...
For
example, a large machine (e
...
blast furnace / combine harvester) would
44
be inefficient for small-‐scale production; for higher rates of production,
the firm gains a better rate of return
...
Financial economies
...
5
...
If a firm is undertaking a national advertising campaign, it
will be more efficient for large firms
...
Risk bearing
...
This
gives them a greater ability to avoid an economic downturn
...
•
•
For example, if the car industry gets bigger, all car firms will benefit from
better infrastructure, and access to specialised labour and good supply
networks
...
g
...
Diseconomies of scale
•
•
This occurs when long run average costs start to rise with increased
output
...
As the firm gets
bigger it will become more inefficient
...
Poor communication
...
2
...
Working in a highly-‐specialised assembly line can be very
boring, and therefore workers become de-‐motivated
...
Lack of control
...
4
...
When whole industries get too big and
suffer issues such as congestion and duplication of routes
...
Significance of minimum efficient scale
• It determines optimal number of firms in an industry
...
Therefore, the industry
would be an oligopoly
...
46
Revenue
•
•
•
Total revenue (TR)
...
TR = price ×
quantity
...
Marginal revenue (MR)
...
Q
1
2
3
4
5
6
7
P
10
9
8
7
6
5
4
TR
10
18
24
28
30
30
28
AR
10
9
8
7
6
5
4
This shows why the demand curve is the same as the average revenue
...
Normal profit
...
This is the breakeven point for
a firm
...
Supernormal profit
...
This is profit above the
breakeven point
...
This occurs where AR >AVC, when average revenue is
greater than average variable cost
...
Accounting profit
...
It is
also known as the booking profit
...
This is the total revenue -‐ total monetary costs and
opportunity costs
...
The role of profit in a market economy
1
...
Profit gives entrepreneurs an incentive to set up businesses
and produce goods that are in demand
...
Signal
...
Declining profit can provide a signal to reduce production
...
Investment
...
4
...
Governments place corporation tax on company profit to take a
percentage
...
•
•
•
•
If MR > MC, total profit rises
...
Profit is therefore maximised at Q = 5, where MR=MC
...
However, in the real world, they may not know exactly and make a
best approximation
...
Features of perfect competition include:
1
...
3
...
Many small firms
...
All firms produce an identical or homogenous product
...
5
...
Examples of perfect competition include foreign exchange markets, many
agricultural markets and walking tourist guides around cities
...
•
•
•
•
The diagram on the right shows the industry supply and demand; this sets
the market price of P1
...
Firms will maximise profits, where MR=MC (Q1)
...
50
Efficiency of perfect competition
1
...
This is because the long run equilibrium (Q1)
occurs where P = MC
...
Productive efficiency
...
3
...
Competition between firms will act as a spur to increase
efficiency and make sure firms use the best combination of inputs
...
Resources will not be wasted through advertising, because products are
homogenous
...
Therefore, the individual demand curve, and hence AR, will shift upwards
...
This will cause firms to temporarily make supernormal profits (AR-‐AC) ×
Q2
...
There are no barriers to entry, so this will encourage new firms into the
market, until normal profits are made and prices fall back to P1
...
But, if firms make a loss, they will close down, causing the market price to
rise until the industry is profitable again
...
Disadvantages of perfect competition
1
...
This is because there are many small
firms producing relatively small amounts
...
2
...
These can be boring, giving little choice to
consumers
...
Limited investment
...
4
...
With perfect knowledge, there is no incentive to
develop new technologies, because it would be shared with other
companies
...
Externalities
...
How realistic is perfection competition?
•
•
•
In the real world, it is hard to meet all the criteria, such as perfect
information and freedom of entry and exit
...
Many markets can be
considered ‘competitive’, even if not quite matching perfect competition
...
e
...
52
•
In the real world, firms are often competing on issues, such as quality of
service, quality of product and extra features – rather than price
...
The internet has helped to reduce costs of entering an industry; you don’t
need a big shop, but can spend a small amount on a website
...
Internet and lack of competition
•
•
•
However, the internet is not universally increasing competition
...
It would be difficult to challenge these firms, who have the benefit of
being the first to dominate (first mover)
...
g
...
53
Monopolistic competition
Monopolistic competition is a market structure with the following features:
•
•
•
•
Many firms
...
Freedom of entry and exit
...
Similar goods, but with brand differentiation
...
and clothing retailers
...
This enables them to set a profit,
maximising price similar to monopoly
...
This leads to supernormal
profit, because AR > AC
...
54
Monopolistic competition -‐ long run
•
•
In the long run, new firms are able to enter the market because there is
freedom of entry
...
Limitations of the model of monopolistic competition
•
•
Some firms will be better at brand differentiation and therefore, in the
real world, will be able to make supernormal profit
...
There is considerable overlap with oligopoly
...
In
the real world, there are likely to be at least some barriers, even if just
through brand loyalty
...
In monopoly, there are barriers to entry
...
Therefore, in the long run, firms in
monopolistic competition will make only normal profit
...
In monopolistic competition,
firms produce differentiated products and, therefore, they are not price
takers (perfectly elastic demand)
...
55
Oligopoly
An oligopoly is an industry which is dominated by a few firms
...
Features of oligopoly include:
1
...
2
...
3
...
Advertising and non-‐price competition are often
important in oligopoly
...
Price competitive / price wars
...
2
...
The kinked demand
curve suggests prices will be stable and firms focus on non-‐price
competition
...
Higher prices / collusion
...
This may involve collusion
...
g
...
The degree of contestability, e
...
amount of barriers to entry
...
g
...
The nature of the industry, e
...
is the industry in growth phase or decline?
A declining industry may be more prone to price competition, as firms try
to retain sales
...
For example, if a firm in oligopoly cuts
price, the outcome will largely depend on how other firms react, e
...
do
other firms also follow suit (starting price war), or do they keep prices
high? There are no guarantees in oligopoly
...
•
This model assumes firms seek to maximise profits
...
If firms cut prices, then they would gain a big increase in market share
...
Therefore, other firms
follow suit and cut prices as well
...
This suggests that increasing or decreasing prices will lead to lower
revenue and therefore prices will be rigid in oligopoly
...
Limitations of this model:
1
...
3
...
The model does not explain how prices were set in the first place
...
In the real world, firms often do cut or increase price
...
Non-‐price competition
If prices are rigid, and firms have little incentive to change prices, they will
concentrate on non-‐price competition
...
Advertising
...
Advertising can also be used as a barrier to entry
...
Product development
...
3
...
A reason for customers to come back
...
Quality of service
...
5
...
Better location for firms
...
Unless you have a good
location, you will not pick up passing trade
...
g
...
Non price strategy is some aspect of quality, service which encourages
consumption, independent of price
...
Non-‐pricing strategy -‐ advertising
The aim of advertising is to increase brand loyalty
...
Successful
advertising can make demand more inelastic, and therefore increase profits
...
g
...
Evaluation
•
•
It depends on the product
...
However, it would be
relatively ineffective for a product like petrol, where people believe it is
homogenous and price will always remain the most important factor
...
Firms like Nike use top sports
stars to wear their products
...
g
...
2
...
If demand is
elastic and sensitive to price, this could lead to an increase in sales and an
increase in profits
...
Evaluation
•
It depends how other firms react
...
58
•
It depends on the product
...
Price wars
Firms may not seek to maximise profits but have other aims, such as increasing
market share and expanding the firm
...
•
•
•
•
Price wars are more likely in a recession, when demand is falling and
markets become more competitive
...
Price wars are often selective, e
...
supermarkets have selective price
cuts on “loss leaders”
...
Price wars can be in the public interest, but only if firms don’t get forced
out of business by the low prices
...
To set price below cost, the firm will need to cross subsidise the market
from other profitable markets
...
There is legislation
which makes predatory pricing illegal
...
A cartel is a formal collusive agreement
...
Tacit collusion is an unwritten agreement where firms observe informal
rules, such as not undercutting rivals
...
Overt collusion is where firms are open about their deals to set prices and
output
...
There will be a similar price and outcome to a monopolistic industry, with
firms effectively sharing the supernormal profits
...
There is legislation against collusion and
cartels in the UK
...
If
Tesco cuts prices, whist Sainsbury has high prices, Tesco would make
even more profit (£13m) but Sainsbury would make less (£2m)
...
To keep prices high, there needs to be collusion, either overt or tacit
...
Factors favouring collusion
1
...
3
...
5
...
A dominant firm who is able to have influence in setting the price
...
Effective communication and monitoring of output and costs, and
effective punishment strategies for firms who cheat
...
g
...
Evaluation of collusion
•
•
•
Collusion enables higher profits
...
Collusion is unlikely to occur if they aim at sales maximisation
...
However, under collusions, firms may become inefficient,
because it is easy to make profit and they don’t have to try hard
...
In the UK, a firm is said to have monopoly power if it has more than 25%
of the market share
...
•
Diagram of monopoly
•
•
•
•
A monopolist maximises profit, where MR = MC
...
Firm makes supernormal profit = (AR-‐ AC) × Q
If the market was competitive, output would be Q2 and price P2 (normal
profit)
...
Productive inefficient, because output is not at lowest point on AC curve
...
Less choice for consumers
...
61
•
Monopsony power
...
This means the firm can pay
workers lower wages, and supermarkets can pay farmers lower prices
...
Economies of scale
...
Increasing output from Q1 to Q2 leads to lower average costs (P1 to P2)
...
For example, airlines and car
companies tend to have high-‐fixed costs and therefore there tends to
be only a small number of large firms
...
2
...
A monopolist can use its supernormal
profits, to invest in developing new products which may require high
investment
...
3
...
A domestic monopoly may be necessary to
compete internationally
...
4
...
A firm may gain monopoly power, because
it is efficient and innovative e
...
Google and Apple
...
62
Barriers to entry
These are factors that make it difficult for new firms to enter an industry
...
High fixed costs
...
If a new firm entered the market, it would have higher
average costs and struggle to compete
...
Vertical integration
...
For example, a new
airline may not be able to get landing slots at popular airports like
Heathrow
...
Legal monopoly
...
4
...
If a firm engages in advertising, then consumers may
develop very strong brand loyalty to a particular firm, making it difficult
for others to enter
...
Being the first firm in the industry
...
6
...
If an incumbent firm cuts price when a new firm
enters the market, it may be able to force the new firm out of business
and retain its monopoly power
...
Geographical barriers
...
8
...
If a firm has high costs to leave a market it may deter
entry
...
Natural monopoly
A natural monopoly occurs when the most efficient number of firms in an
industry is one
...
63
In this example, if the industry demand is 10,000 then, if one firm produces
10,000 units, it can have average costs of £15
...
Therefore, it makes sense for there
to be just one firm
...
A three-‐firm concentration ratio measures the combined
market share of the three biggest firms
...
Tesco 29%
2
...
Sainsbury 16%
4
...
Co-‐op 6%
Total five-‐firm concentration ratio: 79%
• Note with 29% of market share, Tesco is considered a legal monopoly
...
• We would classify this market as an oligopoly because the market is
dominated by a few firms
...
• The three firm concentration ratio would be 62%
64
Price discrimination
Price discrimination occurs when a firm charges a different price for the same
good to different groups of consumers
...
This is where the firm charges the
maximum price that a consumer is willing to pay
...
2nd Degree price discrimination
...
For example, units
of electricity become cheaper after higher levels of consumption
...
This is when consumers are grouped
into two or more independent markets
...
Conditions necessary for price discrimination
1
...
e
...
Price discrimination
can only occur in imperfect competition (oligopoly or monopoly)
...
The firm must be able to separate the market into different sections and
prevent resale, e
...
it must be impossible for an adult to use a child’s ticket
...
There must be a different elasticity of demand for the different market
sections, e
...
train firms can charge high prices at peak times because, in
this period, demand for train travel is inelastic
...
The cost of separating markets must be less than extra revenue gained
...
It usually requires low or constant marginal cost
...
•
•
We assume marginal cost is the same for both groups
...
Advantages of price discrimination
1
...
This may enable some firms, who
may have otherwise have made a loss to stay in business, e
...
train
companies need price discrimination to offer off-‐peak travel
...
Research & development
...
3
...
Some consumers, often on lower incomes, will benefit
from lower fares, e
...
pensioners can take advantage of cheaper fares on
trains
...
Higher prices
...
2
...
Often those who benefit from lower prices may not be the
poorest
...
3
...
Common examples of 3rd degree price discrimination
•
•
Student discounts
...
This is
because students have limited income and are more likely to be sensitive
to price
...
g
...
Buy in advance
...
This is because people
planning ahead have more time to choose means of travel, and will be
more sensitive to price
...
This requires low sunk costs
...
g
...
In a contestable market, incumbent firms will always have the threat of
new firms entering the industry
...
A perfectly contestable market has the following three features:
1
...
Perfect information
3
...
This means that if an industry is making supernormal profits, then
a firm can enter and take advantage of high prices
...
Therefore, in a contestable market, a firm should be satisfied with normal
profits, otherwise it would encourage hit and run tactics from other firms
...
Increased incentives for firms to cut costs
...
However, there could also be significant economies of scale, because the
theory of contestable markets doesn’t require there to be many firms
...
Regulators in the privatised industries have often focused on removing
barriers to entry, rather than breaking up big firms
...
g
...
67
Mergers
•
•
•
•
Horizontal merger / horizontal integration
...
g
...
Vertical merger / integration
...
For example, a company who produces beer could buy
a chain of pubs to sell the beer
...
This is when a firm acquires another firm at
the next stage of production, e
...
a firm like Ford which manufactures cars
could purchase a car sales room
...
When a firm acquires another firm at a
previous stage of production, e
...
a clothes retailer buying a manufacturer
of clothes, or a beer producer buying a farm which produces hops
(ingredient used for brewing beer)
...
The legal definition of a monopoly is a firm with more than 25% of the market
...
Higher prices leading to allocative inefficiency and a reduction in
consumer surplus
...
Monopolies are more likely to be productively inefficient
...
If there is less competition, complacency amongst firms can lead to lower
quality of products, less choice and less investment in new products
...
The new firm can pay lower prices to suppliers (monopsony power)
...
Mergers can lead to job losses
...
Motives for mergers may primarily be based on increasing prestige and
wages of workers concerned
...
If the firm becomes too big, it may suffer from diseconomies of scale
...
Economies of scale
...
This is important for industries with high fixed
costs
...
Mergers can help firms compete on an international level
...
Mergers may allow greater investment in R&D, because the new firm will
have more profit
...
Evaluation of mergers
The desirability of a merger will depend upon several factors, such as:
•
Is there scope for economies of scale? What is the extent of fixed costs in
the industry?
68
•
•
•
Will there be a significant reduction in competition?
Is the market still contestable (is there freedom of entry and exit for other
firms)?
The competition commission will look at each individual case and assess
its relative merits and demerits
...
Therefore,
governments are concerned to intervene and protect the interests of the
consumers
...
Anti-‐competitive practices which the government regulates include:
Collusive behaviour
•
•
•
•
•
•
•
Price fixing
...
Vertical price fixing
...
Collusive tendering
...
g
...
Agreements to limit output and split up the market
...
g
...
Charging excessively high prices; if firms are making high profits, then
this is an indication of abusing monopoly power
...
This involves cutting prices and selling below average
cost, to force rivals out of business
...
If the OFT is concerned, they
can refer the merger to the Competition Commission, which can examine
whether the merger is in the public interest
...
Within the labour market for footballers, there will
be highly specialised sub-‐labour markets, such as the ‘best strikers in
England’ – ‘goalkeepers’
Labour productivity – output per worker in a certain period of time
...
Human capital – the skills and educational attainments of workers
...
g
...
5% -‐ real wages rise 4
...
A higher wage may make workers more motivated to work
hard
...
Technology
...
Management
...
Poor labour relations can lead to lower
productivity
...
If labour becomes better educated and gains
valuable skills, they can increase their productivity
...
Can workers take on different tasks to avoid
bottlenecks
...
Wages are biggest component of unit labour costs
Taxes on labour, e
...
employer national insurance contributions
Statutory maternity / paternity paid leave
...
Labour demand
•
•
Labour is a derived demand
...
If there is more
demand for going to restaurants, then there will be more demand for
catering staff
...
This is the value that a worker can give a firm
...
MRP is effectively the
increase in revenue a firm gains from employing an extra worker
...
This is the increase in output that an
extra worker produces
...
This is the revenue that a firm gains from
selling the last unit of output
...
Factors that determine demand for labour
•
•
•
•
•
Productivity (MPP) of workers – higher productivity = higher demand
...
If there is high demand for watching footballers,
clubs will be willing to pay higher wages, because there is more money in
the sport
...
Substitutes to labour
...
g
...
Wages
...
Non-‐wage costs
...
Higher demand for labour (curve shifting to the right) could be due to:
•
•
•
Economic growth causing more demand for the product, e
...
with greater
demand for tourism, there will be increased demand for taxi drivers
...
g
...
Changes in tastes and fashion causing more demand for the good
...
Elasticity of demand for labour
The elasticity of demand for labour measures how responsive demand for labour
is after a change in wages
...
Number of people with qualifications and skills
...
Time period
...
However, over time, it becomes easier to substitute labour for capital, so
demand becomes more elastic
...
If labour is a high % of total wage costs, the
firm will be more sensitive to a rise in wages
...
Therefore, they tend to have
greater bargaining strength and can demand higher wages
...
Substitution effect of a rise in wages
...
This effect leads to more hours being worked as wages rise
...
This effect involves workers working
fewer hours when wages increase
...
Backward bending
supply curve
After a certain point,
higher wages may lead
to lower labour supply
because workers can
reach their target
income with fewer
hours
...
A worker with little expenses
may find the income effect soon dominates and higher wages encourage him to
work less and choose more leisure time
...
Wage rate
...
2
...
If there were more people qualified to be lawyers, the
supply curve would shift to the right
...
The non-‐wage benefits (non-‐pecuniary) benefits of a job
...
E
...
if tube drivers have to start
working nights, it may reduce supply of workers because it becomes a
less attractive job
...
Population / demographics
...
72
Wage determination in competitive markets
•
•
The equilibrium wage rate in the industry is set by the meeting point of
the industry supply and industry demand curves (We)
...
•
•
Because firms are wages takers, the supply curve is perfectly elastic,
therefore the wage = AC = MC
...
Diagram: comparison of wages in different industries
In diagram on left, elastic supply and demand lead to lower wages
In diagram on right, inelastic supply and demand lead to higher wages
...
This could
be an unskilled job such as a cleaner or retail assistant
...
o Also, demand is relatively elastic, because cleaners have a low MRP
...
o This could be a lawyer, where the number of qualified lawyers is
limited
...
Therefore, they have a high MRP
...
Economic rent, is anything above the transfer earnings
...
74
Market failure in labour markets
Monopsony
This occurs when there is just one buyer of labour in a market, or if the firm has
substantial market power in employing workers
...
This is because, to employ one extra worker, the firm has to
increase the wages of all workers
...
To maximise the level of profit, the firm employs Q2 of workers where
MC = D (MRP)
...
This is
less than the competitive wage of W1
...
Lack of information, and difficulties in switching jobs, gives many firms a
degree of monopsony power
...
For example, because of high living costs, it may be difficult for
workers to buy / rent a house in London
...
Government policies to deal with geographical immobilities
1
...
However, this is difficult to do,
because of limited space in places like the South East and London
...
2
...
However,
firms may be reluctant to relocate to the north, even with subsidies,
because of limited infrastructure, which makes business harder
...
Wage bonuses for expensive areas
...
However, this would become a very expensive way of dealing with the
problem
...
This leads to occupational
immobilities and structural unemployment
...
This is partly due
to the UK not valuing practical vocational jobs as much as ‘academic
qualifications’
...
Government policies to deal with skills shortages
1
...
This is important
with the greater focus on vocational skills needed by the economy
...
2
...
This
helps to overcome government failure, as the firm is likely to have better
knowledge of the skills that industry really needs
...
76
Trades Unions
Trade unions represent workers
...
Try to improve working conditions and safety of the work place
...
Impact of trade unions depends on
•
•
•
Union density
...
Type of job
...
g
...
If the workforce is more diverse,
working at different times (e
...
service sector), they have less power
...
If the job is critical to the firm or economy, threats of
strikes have more power, e
...
tube drivers can have a big impact on
London; if teachers go on strike it is less influential in the short term
...
Thus, in competitive
labour markets, trades unions can cause unemployment
...
This would reduce demand to Q2
...
However the impact of a trade union depends upon:
•
•
Elasticity of demand for labour
...
Unions could bargain for higher wages in return for increasing labour
productivity
...
Trade unions and monopsony
If a firm has monopsony power, it will be paying a lower wage of W2, and
employing just Q2
...
Demand will still be Q2
...
•
•
•
From October 2015, the national minimum wage will be £6
...
There are lower rates for young workers
...
This is an attempt to match the living wage – a level deemed necessary to
deal with current living costs
...
This is because the minimum wage of W2 reduces demand for
workers to Q1
...
g
...
A substantial rise in the minimum wage will be more likely to cause
unemployment in low wage regions, such as the north
...
79
Minimum wage and monopsony
•
A minimum wage could counter-‐act the effect of a monopsony employer,
an employer who pays lower wages and employs fewer workers
...
If the NMW increased wages to NMW 1, the demand for labour would stay
at Q2 and not cause any fall in employment
...
Do firms in the UK have monopsony power?
•
•
•
Some jobs, like firemen, only have a government employer, so that is a
classic example of a monopsony
...
There are many costs and
uncertainties in applying for a job with higher pay
...
Therefore,
arguably, many firms in the UK have a degree of monopsony power,
though it will depend on the industry and skillset of the workers
...
For example, if wages increase for the whole service sector industry, they
can pass the wage costs on to consumers
...
2
...
A minimum wage may be insufficient to provide a living
wage in London because of higher living costs
...
3
...
A minimum wage can increase the incomes of
the low paid and help reduce relative poverty
...
g
...
Also, many who get a minimum
wage could be second income earners in a family
...
For example, until 1961, there was a maximum wage for
English footballers of £20 a week!
A maximum wage can help firms avoid spiralling wage costs, but also
could be used to increase firms’ profits
...
81
Diagram of maximum wage
Discrimination in the labour market
•
In theory, discrimination on the grounds of age, sex, and race is illegal
...
To what extent are wages determined by MRP theory
MRP and supply of labour provide a good starting point for wage determination
...
Firms may not be rational, but pay some workers
different wages on the grounds of age, race, or gender
...
Difficulty of measuring MRP
...
g
...
Regional labour markets
...
In London, it is expensive to live, and there are more job
vacancies
...
Different aims of workers
...
Some workers may prefer
more leisure time or take out time from work for family reasons
...
Labour force is everyone who is working or actively seeking work
...
Dependency ratio = % of dependents (children, old people)
working age population (16-‐65)
Replacement ratio = Gross income after retirement
Gross income before retirement
Participation rate
...
Flexible labour markets
A current issue in UK labour markets is the increased flexibility of labour
markets
...
Growth in zero hour contracts
...
This means
weekly wages can fluctuate significantly
...
Decline in jobs for life, increase in self-‐employment
...
Firms were more
willing to take on new workers
...
Greater job insecurity
...
This greater job insecurity could have negative effects,
such as people becoming de-‐motivated because they have little
attachment to the firm
...
A flexible labour market could benefit workers who need to juggle looking
after children and working from home
...
However, a flexible
labour market could be damaging to unskilled workers, who find it hard
to get long-‐term job security
...
Firms can pay lower wages, but would
increase inequality and relative poverty
...
Firms may be more willing to employ
people in first place, but it can lead to greater job insecurity
...
Good in theory, but can be hard in
practise; it would definitely take time
...
Immigrants could take jobs where there are
labour shortages, but immigration can create new problems, such as
housing shortages and congestion
...
Immigration accounted for 46% of net
population growth in 2008
...
The increased supply of labour has often
filled gaps in jobs which firms have found difficult to fill e
...
cleaning and
fruit picking
...
The government has set criteria, making it easier for
skilled labour to migrate
...
Offset the impact of an ageing population
...
Net migration
of young workers helps the government’s budget situation, because they
are more likely to pay income tax and don’t receive pensions
...
Thus,
migration can be a counter-‐cyclical factor in making UK labour markets
more flexible
...
The UK experiences overcrowding, especially in parts like
the south-‐east
...
Underground economy
...
o However, there is a big difference between illegal immigration and
legal migration
...
Some people feel migrants take existing jobs
...
o However, migration also creates jobs, through the additional
demand in the economy
...
This has several impacts:
•
•
•
Relative decline in income tax revenue, relative rise in state spending on
pensions and health care
...
To meet higher pension spending it may be necessary to
increase taxes on working population, which could adversely affect
incentives
...
Firms encourage older people to keep working
part-‐time and delay retirement
...
Ageing population can be managed if real GDP continues to rise
...
85
Wealth and income inequality
Income and wealth
•
•
Wealth is a stock concept; it is the value of assets, such as savings, housing,
and shares
...
Income is the amount of money a person receives per time period, e
...
salary
...
g
...
Causes of income inequality
1
...
Workers with high levels of
skills will be able to gain higher wages
...
2
...
But, increased
labour market flexibility has increased the number of people in uncertain
job situations
...
Unemployment
...
4
...
A powerful firm with monopsony power can
pay low wages to workers and keep high profits for shareholders
...
Those who are wealthy (e
...
own a house) can gain rentable income,
which they can use to invest in the accumulation of more assets
...
Taxes on income tend to be higher than taxes on wealth
...
People need incentives
to take risks and make the effort of setting up a business
...
Therefore a
degree of inequality is needed in a free market economy
...
g
...
Benefits to the
unemployed / low paid can discourage taking work (unemployment trap
/ poverty trap)
...
The wealthy can exploit their monopoly power to make
higher profits at the expense of others, e
...
landlords have a degree of
monopoly power in setting rents, especially in places like London
...
High levels of inequality can cause social friction and
resentment in society
...
Taking more tax from high-‐
income earners has little impact on living standards, taking tax from low
earners has a greater impact because they have to cut back on essentials
...
There is a strong case for giving people an equal access to
education and the chance to gain skills
...
Government policies in the labour market
•
•
•
•
•
Raising retirement age to 67 – over time
...
It means longer working life for new
generation of workers
...
Government hope it will reduce need for welfare
payments
...
Raising income tax threshold
...
Progressive taxes to reduce inequality
...
g
...
o But, higher income taxes could create disincentives to work if
substitution effect dominates
...
Means-‐tested benefits
...
g
...
o However, there is concern that welfare benefits may create
disincentive to work / get a better paid job
...
87
Market Failure
Market failure occurs when there is an inefficient allocation of resources in a free
market
...
g
...
Partial market failure occurs when there is a market for the good, but
there is over or under consumption
...
Market failure can occur for various reasons
...
A cost or benefit imposed on a third party, leading to under
or over-‐consumption
...
Lack of complete knowledge by one party
...
g
...
Monopoly
...
Monopolies may also be more inefficient because they face less
competitive pressures
...
Geographical immobilities occur when it is difficult for
people or firms to move to another area
...
g
...
Occupational immobilities occur when it is difficult for people to retrain
and get skills in new high-‐tech industries
...
Goods that are non-‐rival and non-‐excludable
...
Inequality is a type of market failure
...
Public goods
A public good has these characteristics:
•
•
•
•
•
Non-‐rivalry/non-‐diminishability
...
g
...
Non-‐ excludability
...
g
...
Non-‐rejectability
...
Zero marginal cost
...
Examples include law and order, national defence, and street lighting
...
This means that people
can enjoy the goods without paying for it
...
Public goods usually require the government to provide the good directly
and pay for it out of general taxation
...
For example,
someone may provide a beautiful garden and not mind if people enjoy it
for free
...
g
...
If too many people use roads, it causes congestion
...
Pure public good -‐ A public good with 100% non-‐rivalry and non-‐excludability
...
The private good is rivalrous and excludable
...
If you walk under a street light, many
other people can
...
Externalities and social efficiency
Social benefit
•
•
•
•
Social benefit is the total benefit to society
...
Social marginal benefit (SMB) = the additional benefit to society of
producing an extra unit
...
Social cost = private cost + external costs
...
•
•
Negative externality of consumption occurs when a consumer enjoys a
good but causes a cost to a third party
...
If you drive into a town centre, the negative
externality is the congestion and pollution that affects other people in the
town
...
For example, if a firm produces chemicals, the external cost is the
pollution that causes damage to the river
...
Diagram of production negative externality
In a free market, the equilibrium will be at Q1, P1, where S=D
...
Q1 is socially inefficient because the SMC is greater than the SMB – this
illustrates an area of deadweight welfare loss
...
The socially efficient level of output would be at Q2, where SMC=SMB
...
For example, if you cycle to work (rather than drive), other people benefit
from reduced congestion and pollution
...
For example, if you keep bees, then a nearby apple farmer benefits
because your bees help to pollinate his apple trees
...
•
•
•
•
However, this is socially inefficient
...
With a positive externality, there is under-‐consumption
...
Externalities and absence of property rights
•
•
•
Externalities are more likely where there is an absence of property rights
...
It is similar issue with global air pollution
...
If fisherman held property rights for a river, they could receive
compensation from the chemical firm
...
•
•
•
For example, students may underestimate the benefits of studying and
therefore leave school early
...
Merit goods often have a positive externality as well
...
91
Demerit good
A demerit good occurs where people under-‐estimate or ignore the costs of
consuming a good
...
Demerit goods often have negative externalities as well (e
...
passive
smoking effect to others)
...
Information gaps
•
•
•
•
Symmetric information means both parties share the same knowledge
...
Asymmetric information occurs when one party has more information
than other parties
...
But, as a consumer, you may not know this
...
This leads to lower prices for all second hand cars and
reduces economic welfare
Imperfect information can occur when all parties lack complete
knowledge or awareness, e
...
it is difficult to measure the economic costs
of global warming
...
For example, there may be unemployment in the north,
and jobs available in the south, but workers may struggle to move because of:
•
•
Difficulty of getting housing the south,
Family ties to the north, and / or
Occupational immobilities occur when labour lacks the relevant skills for a
particular job
...
This leads to structural
unemployment
...
•
•
For example, if your bike is fully insured, it reduces the incentive to lock it
...
92
Environment
The environment can be seen as an economic resource
...
Provider of amenities – the environment is a source of leisure activities
and tourism
...
For example, countries who rely on tourism for trade
...
The environment can absorb waste
...
Alternatively we can burn, in which case
the waste gases are absorbed by the environment
...
Many economic activities cause external costs
to the environment
...
For example, producing power from burning coal causes damage to the
environment, such as pollution and global warming
•
•
Negative externality in production causes SMC to be greater than PMC
...
This output is higher
than the socially efficient level of Q2
...
93
Negative consumption externality
Negative externalities can also occur in consumption
...
This is a cost to the rest of
society
...
•
•
•
With a negative consumption externality, the social marginal benefit is
less than your private marginal benefit
...
•
•
•
As economies develop and industrialise, we see more pollution and
environmental degradation (e
...
steam power, use of fossil fuels)
...
This leads to less pollution and environmental
degradation
...
Evaluation of Kuznets environmental curve
•
•
•
•
However, not everyone agrees that economic development will inevitably
reduce environmental degradation
...
With increased economic growth, there is higher output, consumption,
and consequent pollution
...
It depends on the type of the economy
...
Not all developed economies become primarily service
sector based
...
Developed countries have the potential to
limit environmental pollution, but higher taxes and regulations to protect
the environment may be unpopular and not implemented
...
This will reduce demand
...
Diagram specific tax
•
•
•
•
A specific tax places a certain per unit tax on the good
...
In this case the specific tax is £15, and it reduces the quantity from Q1 to
Q2
...
A specific tax can be used to make consumers pay the full social cost of
demerit goods, such as alcohol and tobacco
...
For example, VAT in
the UK is 20%
...
Tax to overcome market failure
•
•
•
The ideal tax would be equal to the external marginal cost
...
Tax shifts the supply curve to S2 and reduces demand to Q2, which is the
socially efficient level (SMC=SMB)
...
Internalises the externality (tax makes people pay the full social cost)
...
Tax can also alter consumer behaviour in the long-‐term
...
Evaluation of taxes
•
•
•
•
•
If demand is inelastic, tax will only have a minimal effect in reducing
demand
...
g
...
High taxes may encourage tax evasion, e
...
cigarette tax encourages
cigarettes to be smuggled on the black market
...
They take a higher percentage of
income from the poor than high-‐income earners
...
g
...
It can be difficult to measure the external cost and how much tax should
be increased
...
•
In this example, the free market equilibrium is at Q1, P1 (S=D)
...
At this price, the quantity demanded is Q2
...
Evaluation of subsidies
•
•
•
•
•
Cost to the government
...
If demand is inelastic, a subsidy will be ineffective in increasing demand
...
A firm that receives a subsidy is more likely to be inefficient, as they
become reliant on the government subsidy
...
There may be government failure, e
...
the government has poor
information about who to subsidise
...
g
...
Tradeable pollution permits
These involve giving firms a legal right to pollute a certain amount, e
...
100 units
of carbon dioxide per year
...
However, if it produces more pollution, it has to buy permits from other
firms
...
If firms pollute a lot, there
will be low supply and high demand; therefore the price will be high for
permits
...
Problems of pollution permits
•
•
•
•
Difficult to know how many permits to give in the first instance
...
There is an
incentive for firms to hide pollution
...
Also, pollution is very much a global problem requiring global
solutions
...
99
Information provision
The government may seek to overcome market failure through providing
information about certain goods
...
These are demerit goods, where
people may not know the costs of consumption
...
Evaluation
•
•
•
Government advertising campaigns will cost money and require higher
taxes
...
Young people may choose to ignore campaigns about the
dangers of alcohol because they enjoy a sense of rebelliousness
...
Regulation
To overcome market failure, the government may use laws and regulations to
prohibit certain behaviour
...
Evaluation
•
•
Regulation is simple and can be effective in preventing damaging goods
and services from being produced
...
It depends on the enforceability
...
People kept drinking but organised
crime became more powerful and more successful because illegal alcohol
was in high demand
...
For example, the government could subsidise private doctors to treat people, but
there are advantages to the government paying for a national health service
directly:
•
•
•
•
It ensures everyone has access to this important merit good and provides
greater equality in society
...
For services like health and education, workers do not need the same
profit motive of a private manufacturing firm
...
Public goods like law and order may not be provided at all in a free
market
...
g
...
Increased demands are being placed on the public sector due to
demographic changes
...
2
...
3
...
4
...
g
...
5
...
Disadvantages of the private sector
1
...
Also, the private sector may cut costs by reducing
the quality of service, e
...
cutting back on cleaning
...
May increase inequality
...
3
...
Therefore, there is a justification for government subsidy
...
To undertake a CBA the procedure involves:
1
...
These include both monetary
and non-‐monetary costs and benefits
...
2
...
Problems with using a Cost -‐ Benefit Analysis
1
...
g
...
2
...
3
...
4
...
5
...
6
...
7
...
Even if there is a net
gain to society, some people may lose out significantly
...
Advantages of Cost Benefit Analysis
•
•
Offers wider benefits than private sector profit oriented approach
...
No alternative
...
The best solution is to improve methods of calculating
social costs and social benefits
...
g
...
Meeting forecast rise in demand for rail travel
...
Costs include
•
•
•
Environmental impact on countryside
...
Forecasts not guaranteed to occur
...
People also refer to government failure when government efforts to
overcome market failure do not succeed
...
Lack of incentives working for the government
...
Therefore managers and
workers may feel no incentive to work hard or cut costs
...
2
...
For example:
•
•
•
•
Minimum prices in agriculture were an attempt to stabilise farmers’
incomes
...
Farmers used chemicals to
maximise yields – knowing the government would buy any surplus
...
By increasing taxes on tobacco, the government made it more
profitable for people to smuggle cigarettes from Europe
...
Higher income tax may discourage people from working
...
Lack of information
...
•
•
For example, it can be difficult for a government body to calculate the net
external costs of a new airport or nuclear power
...
g
...
4
...
Any government intervention is likely to have some
administration costs and bureaucracy
...
Many areas of government spending are non-‐profit making industries,
and people are motivated by desire to offer quality of care / service (e
...
doctors, teachers)