Notesale: Turn your study into money

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Economics As A Social Science
Economic Methodology:




A natural science is where scientists observe aspects of the universe and form theories around their observations
...

Economics is the study of human behaviour and choices, and is therefore a social science
...

2
...






science,

Observe interesting patterns of human behaviour
Form a hypothesis based on their observations
Form precise predictions from their hypothesis which can be tested against evidence
Use evidence to test their predictions

4
...

If the evidence supports the predictions, the hypothesis can become a theory, which is then tested repeatedly to strengthen the theory or find
exceptions
...
In Latin, ceteris
paribus means ‘all other things being equal’
...


Positive & Normative Economics:


Positive economics is a scientific or objective study of economics, concerned with the way in which economies and markets work
...

Normative economics is concerned with value judgements, which deal with the study and presentation of economic policies
...


Economic Data
Real & Nominal Values:


Nominal values are unadjusted for inflation, and are expressed at current prices (at the level of prices existing during the time period being
measured)
...
Data is converted into index numbers, where the base period is
usually 100, and the rest of the series are compared to the value in the base period, as 100 is an easy number to work with
...


Capital is man-made aids to production (fixed capital is the stock of factories, offices and machinery, while working/circulating capital

2
...


Land is where the goods can be produced or the raw materials used within production (e
...
farmland, rainforests, oil)

4
...

Owners of the factors of production receive rewards:
1
...


Entrepreneurs may earn profits from risking their financial capital and organising productions to produce goods and services

3
...





scarce resources given unlimited wants
...
g
...
Renewable resources,
on the other hand, can be used and replaced, e
...
forests, and fish stocks
...
A forest is a
renewable resource, however it can only be classed as a sustainable resource if it survives over time despite economic activities
...
g
...


The Basic Economic Problem:


In an economy, resources are scarce but wants are infinite, therefore economic agents are forced to make
resources:
1
...

Economic goods are scarce, and therefore their use has an opportunity cost
...

2
...






choices regarding the allocation of

Production Possibility Frontiers
PPF Scarcity:


A PPF curve shows the maximum



The curve on the graph shows the maximum possible production of the 2 goods/services that the particular firm can achieve within the given
factors of production
...

Specific points on the PPF curve demonstrate the different combinations available for production of the 2 goods/services
...
g
...


capital goods (goods used in the production of other goods, e
...
factories, roads, machines)
...


Opportunity Cost:









At point a on the PPF curve, the firm can produce 50 units of good A and 75 units of good B
...

If the firm then wish to further specialise in the production of good A and produce 70 units, the units sacrificed of good B increases to 20 units
...
The more the firm produces of good A, the more of
good B is sacrificed as a consequence
...


A linear PPF diagram illustrates constant
The marginal
good B
...
With every 10 unit increase of good A, there is a 20 unit sacrifice of good B
...
Any point inside the curve (d) is productively inefficient, meaning that the factors of production are being wasted and not being
used at their maximum levels
...

PPF diagrams cannot demonstrate allocative efficiency as the curve does not show consumer demand, therefore a conclusion cannot be
made about the best combination of the 2 goods/services to produce
...
Any point on the curve is pareto
efficient; if production is moved from point a to point b, the firm will be producing more units of good A at the sacrifice of good B
...


Increasing Production:


If a firm is producing at the productive and pareto inefficient point d, their factors of production are not being maximised
...




If a firm is already productive and pareto efficient by producing at a point on the curve, they will need to increase the

quantity and/or the
quality of their factors of production by increasing training of labour, upgrading capital, hiring more workers, buying more land etc
...




It is possible for a PPF curve to shift to favour one good over the other one, by increasing the quantity and/or the quality of their factors of
production to suit only good A; the firm may have hired more labour or bought more machinery that can only produce good A, or increased
their training for workers in order to specialise in the production of good A
...
Globalisation is
currently intensifying the process of specialisation between nations
...

In the past, bartering was used as a form of trade for goods and services, however there is the problem of a lack of duplicate of wants, where
one party may not want what the other party is offering, and a lack of a common measure of value, where one party may disagree with the value
that the other party believes the good or service is worth
...


Advantages of specialisation:
1
...
Greater output and quality of goods and services
3
...
Heavy specialisation in a good or service which is dependent on a
finite resource will result in significant issues when the resource has
been depleted
2
...
Changing tastes in fashions will affect the demand for certain goods
and services that an economy produces
4
...
De-industrialisation may occur with competition in the global
markets, causing unemployment in the economy

Division Of Labour:



The division of labour, described by Adam Smith, occurs when specialisation has taken place and the production process can be broken down
into separate tasks
...


Advantages of division of labour:
1
...
Production increases as workers improve their productivity in the
certain task (productivity is defined as the output per unit of input
employed)
3
...
Capital can be used in a cost-effective way
5
...
Workers may suffer from boredom and may feel devalued, therefore
productivity and quality will decrease
2
...
There may be too much reliance on other countries for labour, and
international interdependence can be fragile
4
...
If the size of the market is small, firms may have to produce other
goods in order to survive financially
...
g
...




The secondary or manufacturing sector is where raw materials are transformed into goods, e
...
motor manufacturing and steel production
...
g
...




The public sector is the state or government sector, where the production of goods and services is achieved by government and state-owned
organisations
...




Markets


A market is any convenient set of arrangements by which buyers and sellers communicate to exchange goods and services
...
g
...


Functions Of Money:









Money must satisfy 4 functions:
1
...

2
...

3
...

4
...

Money also must fulfil the following characteristics:
1
...

2
...

3
...

4
...

5
...

Commodity money is any money with intrinsic value, e
...
gold, whereas fiat money has no intrinsic value, e
...
notes and coins, and can
therefore be eroded by inflation
...
Cash has the most liquidity, e
...
notes and coins
...
Bank deposits are highly liquid as they can be withdrawn as cash
...
Near monies are non-cash assets which can easily be converted into cash, e
...
certificates of deposits, where money is deposited into a
bank and can only be taken out after a certain time period
...

The money supply is the total amount of money circulating in the economy, however this can be complex to calculate due to the different
types of money
...
M0 is a narrow measure of the money supply which includes the total amount of notes and coins in the economy, and any bank
deposits
...
M4 is a broader measure of the money supply which adds less liquid monies into the money supply calculations, e
...
non-cash assets
with maturity dates of 5 years or less, or can be bought and sold easily for cash
...

Planning allocates resources through administrative decisions rather than through the market mechanism, e
...
the NHS is allocated resources



by the government through planning
...

A command economy (centrally planned, or socialism) is where resources are allocated by the state or government
...




Adam Smith




Adam Smith is often seen as an advocate of free market economies and laissez-faire governments
...

However, Smith recognised that the state was important when providing a framework within which free markets could operate (e
...
businesses
would attempt to combine in order to raise prices at the expense of the consumer or drive wages down as low as possible)
...


Friedrich Hayek




In his book ‘The road to serfdom’ 1944, Friedrich Hayek argued that great control of the economy by the state lead to totalitarianism and loss
of freedom, as a reaction to the situation in the Soviet Union under Joseph Stalin and Germany under Adolf Hitler
...

Hayek stated that central planning by governments leads to the will of a small minority of individuals being imposed on the whole of society
...

Marx developed the theory that inevitably, workers (the proletariat) would revolt against property owners and seize control of their factors of
production, resulting in a new, equal and democratic society where property would be owned by everyone collectively
...

Profit maximisation

Command:
The public sector (state or
government) controls and
distributes resources in the
economy
...


Due to a lack of profit motive, the
public sector will produce less of a
variety of goods and services and at
a lower quality than free market
economies
...


Response to demand

Firms want to be the first to react to
a change in demand, in order to
maximise profits
...

Due to a lack of profit motive, the
public sector will be slow to react to
changing demand
...
However, market failures can
occur and therefore cause
inefficiencies
...


Merit goods

Merit goods are underprovided due
to self-interests and a lack of
information, therefore they are
under-consumed
...

Missing market

Demerit goods

Public goods
Income distribution

Due to a lack of profit motive, the
public sector is not incentivised to
cut costs, reduce waste and
engage in economies of scale
...

Due to a lack of the market
mechanism, shortages and
surpluses can occur
...


The private sector aim to profit
maximise while the public sector
aim to maximise social welfare
...

The private sector has high
competition while the public sector
does not
...

The private sector has a high
variety and quality of goods and
services, whereas the private sector
has a low variety and quality of
goods and services due to a lack of
profit motive
...

In the private sector, response to
demand is quick, whereas in the
public sector, response to demand
is slow
...

The private sector does not have
shortages and surpluses, whereas
the public sector does
...


Demerit goods are provided at the
social optimum level
...


Allocated

Public goods are provided through
government intervention
...

Negative externalities are regulated
through government intervention
...

Risk is low due to government
intervention and provision of
necessary goods and services
...


Negative externalities

Income is unequally distributed due
to a lack of state or government
intervention
...

In the real world, there are no pure
free market economies, however
the USA and Singapore are highly
market orientated
...

In the real world, there are no pure
command economies, however
North Korea and Cuba are highly
state owned
...


Rational Decision Making
Maximisation:


In economics, rational means that economic agents are able to rank the order of different outcomes from an action in terms of their net benefit
...
Consumers are assumed to maximise their economic welfare, measured by the utility or satisfaction gain from consuming a good or
service
...
Workers are assumed to maximise their own welfare at work, by taking many factors into consideration, including pay, job security,
and commuting
...
Firms are assumed to maximise their profits
...




Governments are assumed to maximise the welfare of citizens, and therefore make decisions in order to increase welfare for the

country as a whole
...
Managers of a firm may make decisions in order to benefit them personally
rather than the shareholders, or governments may be corrupt and therefore make decisions in order to benefit their supporters at the expense of
other citizens
...


The Margin:


When making decisions, neo-classical theory assumes that the decision is considered in isolation, rather than in combination with all previous
decisions made (e
...
when considering the purchase of a good, all previous consumption decisions are not also considered)
...


Demand
Law Of Demand:


Demand is the quantity of a good or service consumers are willing and able to buy at a given price in a given time period (consumers must be
willing and able for the demand for be effective)
...




The downward



sloping demand curve demonstrates that as the price increases from P1 to P2, the quantity demanded falls from Q1 to Q2
...




With this assumption, the impact of price changes on the quantity demanded can be isolated
...





A decrease in price is a movement along the curve from a to b, which is known as an extension or expansion of demand
...
The income effect means that as prices increase, the purchasing power of incomes decrease and consumers cannot buy the same
quantity of goods and services, therefore demand contracts
...
The substitution effect means that as prices increase, other goods and services become more price competitive and therefore
consumers switch their demand towards those goods and services, therefore demand contracts
...






If a non-price factor increases the demand for a product, the demand curve will shift from D1 to D2
...

If a non-price factor decreases the demand for a product, the demand curve will shift from D1 to D3
...

The following factors can cause a shift in the demand curve, independent of price:
1
...

2
...


3
...


If the price of a substitute good increases, consumers are less willing to buy the substitute and the demand for the original good will
increase
...


5
...


6
...

If the price of a compliment good decreases, consumers are more willing to buy the original good and therefore demand will
increase
...
g
...


7
...


Diminishing Marginal Utility:


As the quantity consumed increases, the marginal



The paradox of value is the observation that goods and services critical to life, e
...
water, are very cheap compared to goods and services
which have no bearing on human existence, e
...
diamonds
...

The law of diminishing marginal utility can explain the downward sloping demand curve: the higher the quantity consumed, the lower the
marginal utility derived from consuming the product
...


Consumer Surplus:


Consumer surplus is the difference between the value of the product to consumers (the price they are willing and able to pay) and the actual
price of the product
...


Price Elasticity Of Demand
Price Elasticity Of Demand Calculations:


The price elasticity of demand (PED) measures the responsiveness of quantity



PED will always be negative due to the inverse relationship between price and quantity
...




PED =



Percentage change =



If PED is 0, demand is perfectly



If PED is more than -1, demand is price



If PED is -1, demand is unit



If PED is less than -1, demand is price



If PED is -∞, demand is perfectly
product
...

inelastic; for any given price change, there is a smaller proportion of change in quantity demanded
...


elastic; for any given price change, there is a greater proportion of change in quantity demanded
...

The greater the percentage of income that is spent on a product, the more elastic the demand curve will be for that product, due to greater
changes in price of the more expensive products
...

With addictive or habit forming products, the price elasticity of demand will be inelastic, due to habits formed by the consumer and their need
for the product despite any changes in price
...

In the long
them
...

1
...

2
...

Firms use PED to determine their quantity of workers, stocks and output for the future, depending on whether the demand for their
product is price elastic or price inelastic
...
Furthermore, elasticities assume ceteris paribus, even though there are many factors that can affect changes in
demand
...






PED Along The Demand Curve:





At the top of the demand curve, the price elasticity of demand is elastic
...

At the bottom of the demand curve, the price elasticity of demand is inelastic
...

Revenue is maximised in the middle of the demand curve, where the price elasticity of demand is unitary
...
If firms have a product which has
inelastic demand, they will raise their price in order to increase revenue until they reach unitary elasticity
...


percentage change in quantity demanded



YED =



A normal good has a positive relationship between income and demand; as income increases, the demand for a normal good or service also
increases
...

An inferior good has an inverse relationship between income and demand: as income increases, the demand for an inferior good or service will
decrease
...




percentage change in income

Normal goods:







If YED is less than 1, demand is income inelastic; for any given change in income, there is a smaller proportion of change in quantity
demanded
...


If YED is greater than 1, demand is income elastic: for any given change in income, there is a greater proportion of change in quantity
demanded
...


Inferior Goods:



If YED is greater than -1, demand is income
demanded
...


inelastic; for any given change in income, there is a smaller proportion of change in quantity

elastic; for any given change in income, there is a greater proportion of change in quantity

YED And Business Use:






Firms can use YED when planning for booms and recessions:
1
...
Employment, stocks and output should also be increased to prepare for the expected demand
...
If a firm produces an inferior good and the economy is about to hit a recession, the firm should increase prices in order to increase their
total revenue
...

However, elasticity calculations are only estimates; the data may be collected through surveys, competitor patterns or past data, which can all
be inaccurate and unreliable
...

A good can be both normal and inferior depending on the level of income
...
g
...


Cross Elasticity Of Demand Calculations:


The cross elasticity of demand (XED) measures the responsiveness of quantity

demanded of one good or service given a change in

price of another good or service
...
Therefore, XED will be positive; an increase in the price of one good will increase the
demand for the substitute good
...
Therefore, XED will be negative; an increase in the price of one good
will decrease the demand for the compliment good
...





percentage change in price (good b)

Substitute Goods:



If XED is greater than 1, demand between the goods is price elastic, meaning that they are strongly
of one good, there is a greater proportion of change in quantity demanded for the substitute good
...


related; for any given change in price

related; for any given change in price of

Compliment Goods:



If XED is less than -1, demand between the goods is price elastic, meaning that they are strongly
one good, there is a greater proportion of change in quantity demanded for the compliment good
...


XED And Business Use:






If a firm produces two closely related compliment goods, they can reduce the price of one good while increasing the price of the compliment
good in order to increase total revenue
...

If a firm produces a good which has a close substitute, they can reduce the price of their good to increase their demand, in order to increase total
revenue
...
However, the rival firm may also decide to reduce their price,
which may result in a price war
...

However, elasticity calculations are only estimates; the data may be collected through surveys, competitor patterns or past data, which can all
be inaccurate and unreliable
...


paribus, even though there are many factors that can affect changes in

Supply
Law Of Supply:


Supply is the quantity of a good or service that firms are willing and able to produce at a given price in a given time period
...




The upward



An increase in price is a movement along the curve from b to a, which is known as an extension or expansion of supply
...




The supply curve assumes ceteris paribus when the price changes, where all other factors remain unchanged of equal except for the price
...

The supply curve is upward sloping due to the profit motive:
1
...

2
...




sloping supply curve demonstrates that as the price increases from P1 to P2, the quantity supplied increases from Q1 to Q2
...
At the same price, more is being supplied
...
At the same price, less is being supplied
...

2
...

4
...

6
...


factors can affect supply and shift the supply curve
...

If there is a decrease in indirect taxes, the costs of production will decrease, therefore increasing the quantity supplied of a good or
service
...

If there is an improvement in technology, the costs of production will decrease, therefore increasing the quantity supplied of a good
or service
...

In agricultural markets, good weather will increase the supply of the good, whereas bad weather will decrease the supply of the
good
...


If there is a cartel in the market, where firms come together to restrict supply in order to increase their profits, the supply will decrease
for the good or service
...
If firms expect prices to rise in the future, they may restrict supply and stockpile goods, therefore decreasing the supply of the good in
the short run
...
Costs of production can also be affected by changes in the costs of transport, labour, raw materials, and rent, or changes in
8
...

Producer Surplus:


Producer surplus is the difference between the price producers are willing and able to supply a good or service for and the price they actually
receive
...


Price Elasticity Of Supply:


The price elasticity of supply (PES) measures the responsiveness of quantity



PES will always be positive due to the upward sloping supply curve
...


percentage change in quantity supplied
percentage change in price



price inelastic; regardless of the price change, quantity supplied will not change at all
...




If PES is 1, supply is unit



If PES is more than 1, supply is price



If PES is ∞, supply is perfectly

price elastic; for any given change in price, there is an equally proportionate change in quantity supplied
...

price elastic; supply is infinite at a specific price, and a change in price would eliminate supply for the product
...

The larger the level of stocks, the more price elastic supply will be for a good or service
...

The more substitutable the factors of production are in a firm from one good to the other, the more price elastic supply will be for a good or



service
...

run, supply is more elastic as all factors of production are variable
...

However, elasticity calculations are only estimates; the data may be collected through surveys, competitor patterns or past data, which can all
be inaccurate and unreliable
...


paribus, even though there are many factors that can affect changes in
Price Determination

Market Equilibrium & Disequilibrium:


An economic



A free



The market equilibrium or market clearing price occurs when demand is equal to supply, and there is no tendency for the price to
change
...

market has no government involvement or intervention
...

or ex-post demand) must equal what is actually sold (realised or ex-post

supply)
...

Free market forces act to reduce prices when there is excess supply and raise prices when there is excess demand in order to achieve market
equilibrium
...

Signalling is when producers can identify that their price is either too high or too low through certain signals:
1
...


2
...


As a result of the signalling, producers are incentivised to change their price in order to increase their profit margins
...
If price increases, consumers ration their demand for the product
...
If price decreases, producers ration their supply for the product
...


Indirect Taxes & Subsidies
Indirect Taxes:


An indirect tax is a tax on expenditure
...
g
...

The value of the tax is the vertical distance between the two supply curves
...


burden is the proportion of tax that the consumer pays
...

The incidence of tax measures the burden of tax upon the taxpayer
...


valorem tax is a percentage tax based on the value of the product, e
...
goods have a 20% VAT charge in the UK
...

1
...

2
...

Government revenue through taxation will be greater the more inelastic the demand is for a product
...

An indirect tax impacts economic agents in different ways:
1
...

2
...


require less labour
...


4
...


Subsidies:


A subsidy is a grant per unit, given by the government to encourage the production or consumption of a particular good or service, e
...
firms
who employ disadvantaged workers are granted subsidies
...
At any given quantity supplied, the price will be lower due to the fact that the price
charged by producers will be higher than the price paid by consumers and the difference will be paid by the subsidy
...




The government



As with indirect taxes, the full subsidy per unit is not completely passed onto consumers
...




The deadweight

cost is the value of the subsidy multiplied by the quantity produced
...


Subsidies And Elasticities:




The largest fall in price as a result of a subsidy will occur when demand is highly inelastic or supply is highly elastic
...

A subsidy impacts economic agents in different ways:
1
...

2
...


Producers benefit from increased revenue
...

Alternative Views Of Consumer Behaviour

Cognitive Biases:


Homo-economicus is the idea that using rational assessments, economic agents attempt to maximise utility when making decisions
...


Price anchoring is when a consumer has a price imprinted into their mind as a reference point to compare other prices to
...


Therefore, if a consumer recognises that the price of a product is lower than the price anchored in their minds, they believe that they
are getting a good deal
...
g
...


3
...


the actual probability of the event occurring, e
...
swimming in Australian seas and shark attacks
...
g
...


5
...

7
...






outcome is beneficial to them, e
...
investing money into a low risk savings account
...

Herding behaviour is when consumers make decisions based upon the decisions of other people around them, e
...
investors buy up
the same shares as other investors
...
g
...

Altruism is the idea of kindness or selflessness, where consumers do not expect anything in return for a certain act, e
...
charity
...


1
...


2
...


3
...


Consumers may be bounded by self-control, e
...
a consumer may know sugary drinks are unhealthy, however their self-control affects their
ability to cut down
...
Satisficing decisions may sacrifice some utility, however overall the decision will satisfy the consumer
...

Partial market failure is when there is an overproduction or an underproduction of goods or services in a market
...


Market Failure Causes:









Negative and positive externalities are unaccounted for in the free market mechanism
...
This arises from the self-interests of economic agents
...

1
...

2
...
This may lead to moral hazard,
where an individual is prepared to take more risks as they know that they will not bare the true costs of those risks, e
...
in the insurance
market, where the driver has more information about his driving style than the insurance firm
...


Common access resources are often over-consumed and over-produced, due to the lack of consideration of externalities
...

Income inequality is a source of market failure due to inequity
...

Monopoly power creates market failure as there is one dominant seller in a market and high barriers to entry, which leads to the exploitation
of consumers through high prices and low quantities available
...


Externalities
Private And Social Costs And Benefits:



Externalities, or spill over effects, arise when private costs and benefits are different from social costs and benefits
...
g
...

A social cost is the cost of an activity to third parties, as well as the individual economic agent who carried out the activity
...
g
...

The difference between the private cost and the social cost is the externality
...
Negative externalities are detrimental third party effects that arise as a result of the actions of a separate




agent
...
g
...
Positive externalities are third party benefits that arise as a
result of the actions of a separate agent
...


Market Failure:




In a market, output is fixed where demand equals supply at the point where private costs equal private benefits
...

The socially optimum position would only occur at the point where social benefits equal private benefits
...
Therefore, the greater the externality,
the greater the market failure and the less market prices provide accurate signals for the optimal allocation of resources
...





The margin is a possible point of change, therefore the marginal costs of production are the extra costs of producing an extra unit of output, and
the marginal benefits of consumption are the extra benefits received from consuming an extra unit of output
...

However, marginal costs then begin to rise as firms may be paying high prices to obtain more factors of production
...
The marginal benefit curve is the same as the demand
consumer
...




Negative production externalities occur when social costs are greater than private costs in production
...




Consumption Externalities:


Consumption externalities arise when the social benefits of consumption differ from the private benefits of consumption
...

Negative consumption externalities occur when social benefits are less than private benefits in consumption
...
Pure public goods are non-excludable, meaning that no price can be charged for the good that will exclude others that have no
paid
...
Equally, no one is able to opt out of consuming the good, known as non-rejectability
...


Pure public goods are non-rival, meaning that the quantity of the good will not diminish upon consumption
...





The marginal cost of providing an extra unit of a public good is zero
...


Free Rider Problem:




As a result of the characteristics of a pure public goods, individuals do not have the incentive to contribute towards the provision of the good, as
they can wait for others to contribute and free-ride off of their contribution
...
Consequently, the end result is a missing

market
...
g
...
Therefore, private provision may be
possible instead of government intervention, with the help of innovative technologies which make it easier to efficiently price the good or
exclude people from consuming the good
...
Welfare would be maximised for the consumer where demand with symmetric

information is equal to supply, however the consumer overestimates the benefits of the product and are therefore willing to pay a higher price



for a given level of output
...

Consequently, there is a misallocation of resources
...
Consumers underestimating the benefits of buying a good
2
...
Producers overestimating the benefits of selling a good

Second-hand Car Market:





The problem of asymmetric information was first outlined by Nobel Prize-winning economist, George Akerlof, in 1970
...

1
...

2
...

3
...
The final outcome is
therefore the disappearance of the second-hand car market
...
Consumer

protection laws state that the car must be road worthy, car dealers may off a short guarantee, consumers can make judgements of the
premises and other cars that are being sold, and they can research similar cars online to ensure the price is reasonable
...
A problem
occurs when the goals of the principals are different from the goals of the agents
...
Typically, a child may suffer from
asymmetric information as they may not understand the long-term benefits of education
...
As a result, agents for the child must encourage the child to participate fully in the education process
...

1
...

2
...
In this case, the state or
government acts as the agent, and encourages young people to remain in education for as long as possible in order to reach their full
potential
...
This can be explained through the problem of asymmetric information, where young people are not able to imagine their life when
they retire, and as a result they may ignore the loss of welfare that will come from having a low income after they retire in order to boost their
current spending
...


Drugs:


Individuals are sometimes unaware of the harmful effects of drug use and alcohol
...
Asymmetric information therefore leads to
the overconsumption of drugs and alcohol
...
Following the global financial crisis of 2008, it became
clear that financial institutions and their employees had abused their relationships with their customers, by selling mortgages to low income
households with the knowledge that the households would not be able to repay them
...

1
...
A collapse of a mortgage was the banks issue and not the
employee’s
...
Equally, senior bankers engaged in risky behaviour with the knowledge that the state would bail out the bank if it failed
...
g
...


Government Intervention In Markets
Correcting Market Failure:


Total welfare will be increased if any costs incurred through government intervention are less than the benefits gained from the intervention
...
Firms would respond by producing less as their
costs have now risen due to the tax, and therefore increase their prices
...

In order for the tax to be most effective, it should perfectly internalise the externality by forcing the firm to pay for their negative
externalities (make the marginal social cost equal the marginal private cost when the tax has been implemented)
...


Government may also impose an indirect tax to eliminate negative externalities in consumption (demerit goods), by implementing a tax
on production
...
The level
of tax should be set to eliminate the negative externalities and the marginal social costs of production should equal to the marginal social
benefits
...

There may be problems when imposing an indirect tax:

3
...
This may be due
to information failure on the part of the government, where the government may not know the exact size of the market failure or the
impact a tax will have on the market
...

Governments may use indirect taxes to raise revenues as well as reduce market failures
...

Taxes are unpopular, and may be politically opposed
...


If there is price inelastic

5
...

Black markets may arise in order to avoid paying the tax, e
...
cigarette black market is valued at £2billion per year in the UK
...


1
...


6
...


Subsidies:


Governments can correct market failure through the provision of subsidies where there are positive externalities
...
Firms would respond by producing more as their
costs have now decreased due to the subsidy, and therefore reducing their prices
...




Government may also provide a subsidy for consumption which results in positive externalities (merit goods), by providing the producers
with a subsidy
...
The value of the subsidy should be set to ensure that the marginal social costs of production should equal to the marginal social benefits
...

2
...


4
...


Firms may choose to use the subsidy to increases the wages of their workers, deleverage and pay off any debts, or pay shareholders
greater dividends, rather than reduce their costs and lower their prices for consumers
...

The subsidy may be difficult to target, and therefore may be too large or too small to correct the market failure exactly
...

Subsidies may conflict with other policy objectives
...
If the subsidy forces firms to take actions, they may raise their prices in order to maintain their profit margins, e
...
energy
companies are forced to buy their power from renewable sources, which is more expensive
...


Price Controls:






Minimum prices, or price floors, are used to discourage the consumption of demerit goods, where there are negative externalities in
consumption
...
The higher price will discourage consumption, therefore reducing the negative externality caused by consuming
the good
...
Even though the price has increased and therefore producing more should
increase their profits, they know that consumers are not willing or able to buy the good
...




The externality will become internalised, as the higher price accounts for the negative externalities that exist
...

2
...


4
...
Therefore, the
quantity may not fall enough to solve the market failure, and the producers will make much higher profits
...

Consumers may look to the black market for their goods, which can be dangerous as the quality of the goods are unknown
...

There may be unintended consequences if the minimum price is not set at the right level
...
If the price has been set too low, quantity may
not reduce to the optimum level, and the externality will not be perfectly internalised
...
By setting the



maximum price below the equilibrium, equity and consumption is promoted
...




However, there may be issues with implementing price ceilings:
1
...

3
...

5
...
Those who are able to
find and purchase the good will benefit from the lower price, however those who are not receiving the supply will suffer
...

As a result of the excess demand, a black market is created
...

Maximum prices require enforcement
...
If the price is too low, there will be a huge excess of demand, and if the
price is too high, equity and consumption will not be promoted
...


Regulation:


Regulation is a rule or law enacted by the government that must be followed by economic agents to encourage a



Regulation is a non-market based approach to solving market failure
...

Regulation is a command and control approach:



change in behaviour
...


The commands are the rules or laws, which include bans (e
...
public smoking ban), limits (e
...
age limits for buying alcohol), caps

2
...
g
...
g
...
g
...

In order for regulation to work, the government must have control
...

If both the command and the control is strong, there is the incentive for economic agents to change their behaviour and move the quantity
towards the socially optimum level
...




The end result of regulation is allocative



However, there are significant issues with using regulation:

efficiency and a welfare gain in the market
...


If either command or control break

2
...
If the government cannot afford the costs
associated with regulation, enforcement will be weak and there will be a lack of incentive to follow the rules
...
g
...
g
...

If the command is too lax, there will be a lack of incentive to change behaviour
...


4
...

6
...


There is the issue with equity, where some firms may find it much harder to follow the regulation and their costs may significantly
increase compared to others, e
...
firms who are dependent on fossil fuels may struggle to reduce their pollution
...


Trade Pollution Permits:




Tradeable pollution permits, a key element of cap and trade schemes, are used to deal with pollution market failure as a specific type of

negative externality
...




The government decides of a level of pollution allowed in the economy
...
With either solution, the costs of production for firms will increase
...




The price of tradable pollution permits can be determined by the free market, as shown in the graph above
...
By distributing permits, there is an incentive for firms to reduce
pollution
...
If the level of pollution is set correctly, the socially optimum level of
output will be achieved, welfare will be maximised, and allocative
efficiency will occur
...
As a market based solution, tradable solution permits require minimal
intervention by the government, and market forces can efficiently
allocate permits
...
Permits are an efficient and equitable solution for firms, as firms have
choices about how they wish to deal with their pollution
...




Disadvantages of tradable pollution permits:
1
...

2
...

3
...

4
...
g
...

5
...


The effectiveness of the permits depends upon:
1
...


The level

of information that the government has about the optimum level of pollution
The number of firms who are able to reduce their levels of pollution

State Provision Of Public Goods:



For merit good and public good market failure, there could be an argument for state or direct provision, where the government provide all
the resources within a certain market
...

With public goods, there is a missing market
...




With merit goods, it could be argued that state provision makes rational sense due to the fact that the goods are highly socially



Supply is vertical as the government provides a fixed amount of resources
...


of consumption, consumers do not pay for merit and public goods
...
At this price, the level of demand
demand in the market
...
Resource allocation improves with state provision, driving output
towards the socially optimum level
...
No price exclusion exists as the goods are free at the point of
consumption, and therefore everyone can benefit from the
consumption of the goods
...
All social benefits are likely to be considered by the government,
whereas the free market does not account for social benefits when
allocating resources
...
State provision is highly costly, and therefore has an opportunity cost
...
State run organisations tend to be wasteful due to the lack of profit
motive
...
State provision ignores the private sector completely
...

4
...


The effectiveness of state provision depends upon:
1
...

3
...
g
...
The advertising may be directly from the government, or
through firms who have been forced to provide information about their good, e
...
graphic imagery on cigarette packets
...




Negative advertising may be used to demote demerit goods, where there is an overconsumption due to information failure
...
The end result is a worsening of the
allocation of scarce resources, ultimately harming social welfare
...



Government failure can occur when:
1
...
Admin and enforcement costs of the intervention are high, e
...
regulation, subsidies, state provision or price controls
3
...

5
...

7
...


Intervention results in unintended consequences, e
...
black markets, negative impacts on the poor and on firms, or
unemployment
Regulatory capture occurs through regulating a monopoly power, where the regulator is influenced by the firm to reduce the
extent of the regulation and work in the interests of the firm rather than society
Governments distort price signals, e
...
raising the unemployment benefit may discourage people from looking for work, or
imposing tariffs on imports to allow domestic farmers to charge higher prices due to low competition
Governments face conflicting objectives and often make policy decisions which give lower economic welfare compared to others,
as a result of information failure or political beliefs
Public choice theory occurs, where politicians act in a way that maximises their own utility and the utility of their own electors at
the expense of other citizens
Politicians engage in rent-seeking behaviour, where those in power manipulate the distribution of resources to benefit
themselves without creating any extra wealth for society, e
...
bribes

Extra Content
Interrelated Markets:


Compliment goods are goods that are in joint



Substitute goods are goods that are in competitive demand
...
g
...


labour demand is derived from the demand for goods are services
...
g
...

Joint supply is when an increase in the production of one good will increase the supply of another good
...
g
...
g
...


Allocative Efficiency:





Allocative efficiency is the maximisation of society surplus, which is the sum of consumer and producer surplus
...

Allocative efficiency is the maximisation of net social benefit, which occurs where MSB is equal to MSC
...

Allocative efficiency involves key assumptions:
1
...


Both consumers and producers have perfect

3
...


demand, which occurs where demand is equal to supply
...

information
...

Firms are profit maximisers and consumers are utility maximisers
...
g
...

When left to the free market, often there will be no private ownership of common access resources due to the high costs involved with excluding
other producers from accessing the resources
...

This will eventually lead to the depletion of the resources
...


Property Rights:



Property rights can be issued to producers to solve the market failure of common access resources
...
Therefore, the negative externality is internalised
...


1
...


Enforcement costs are high, however without enforcement the scheme will break down
...


3
...
g
...




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