Notesale: Turn your study into money

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Theme 1: Markets and
Market Failure
Economics Y1 Study Guide Summary

Economics as a Social Science
● Social science - study of human activity
...
E
...
London tube
map
...

● Ceteris paribus: “all other things being equal” - focusing on one variable
only
...

● Variables are always changing so economists find it difficult to test them
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● Consumers who demand goods/services
...

FIRMS
● Produce goods/services
...

GOVERNMENT
● Undertakes expenditure
...


Positive and Normative Statements
Positive Statements
● Factual
...

● “Value free”

Normative Statements
● Based on our values and personal judgements
...

● Not testable
...


● Value Judgement: an assessment made by an individual based on their
opinions and priorities
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● Opportunity Cost: the next best alternative foregone when a decision is made
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● Not scarce resources: free goods
...

Capital
Enterprise
Land
Labour

Production Possibility Frontiers (PPFs)
PPF: a diagram showing the maximum possible combination of 2 goods that a
country can produce within a specific time period with all of its resources fully and
efficiently used
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Assumptions:
1
...

2
...

3
...


Shape of the PPF
Downwards sloping because there is an
opportunity cost at any point due to scarcity
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As more of one good is produced,
resources that would have been more
suitable for another good starts getting
used up
...

Straight line - constant opportunity cost
...

An increase or decrease in the productive potential of an economy
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g
...

2
...

4
...


Investment in capital goods
Immigration (extra labour)
Discovery of raw materials
Technological innovation - better machines increase labour and capital productivity
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Investment in capital goods: more capital → more consumer and capital goods can be produced in the
future → curve shifts outwards → increase in potential economic growth
...

● Enables firms to operate on a larger scale
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● Labour → different skills and functions can be employed
...

Over-specialisation:
● Workers find work tedious → demotivation, reduced productivity
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● Fragile structure: production stops if one worker is missing
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‘Double Coincidence of Wants’
⤷ both people in the trade must be selling something the other person wants
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Characteristics of Money:
1
...

2
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Durable - must retain its value over time
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Recognisable
5
...
Medium of exchange - solves the ‘double coincidence of wants’ problem
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Measure of value - easy to compare the value of goods/services
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Store of value - non-perishable
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Standard of deferred payment - used to provide credit (promise to pay in the future)
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● All economics decisions are taken by households and firms
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✓ ‘Consumer sovereignty’ - resources are allocated according to
the wishes of consumers
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✓ Efficiency and hard work encouraged due to incentives
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Χ Lack of equality - e
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in the distribution of wealth
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Χ Monopolies arise - higher price, lower choice
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decides how resources are allocated
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✓ Income distributed equally
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g
...

✓ The government could direct resources towards
long-term goals
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X Less incentive to work hard
...


Karl Marx

Mixed Economy
● Resources are allocated partly by the government and
partly by the market mechanism
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E
...

↠ Interfering with prices: taxes and subsidies
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↠ Directly providing some goods, e
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educational goods
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g
...
g
...


John Maynard Keynes

Rational Decision Making
● Assumption that economic agents such as consumers, firms and
governments behave rationally
...

● They can fully weigh up the costs and benefits of their decision in order
to maximise their utility
...


Diminishing Marginal Utility
●
●
●
●
●
●

Marginal utility - the additional satisfaction a consumer gains from consuming one
additional unit of a good/service
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The marginal utility is likely to decrease as consumption rises (for each unit)
...

Diminishing marginal utility - when the additional unit consumed adds less to the
total utility than the previous unit consumed
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⤷ If MU < price of the good, the consumer will stop buying the good and demand will
fall
...

● The theory of demand: an inverse relationship between price and the
quantity demanded of a good/service
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Demand Curve
● The curve illustrates the rationing function of money
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⤷ Substitution Effect - people will switch to
cheaper alternatives when goods become
expensive
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A shift is caused when there is a change in anything other than the price:
Population
Advertising
Substitutes
Income
Fashion/tastes
Income tax
Complements
Speculation

Price Elasticity of Demand (PED)
PED: the responsiveness of demand to a change in price
...
Increase in
price leads to a larger than proportionate decrease in Qd
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Increase
in price leads to a smaller than proportionate decrease in Qd
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A firm with elastic PED should cut prices to increase
revenue by winning lots of new customers
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Supply
Supply: willingness/ability of producers to produce a quantity of a good/service at
a given price and time
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● Assumes ceteris paribus
...

● Higher prices incentivises firms to enter the market for potential profits
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Movements & Shifts to the Supply Curve
● Movement caused by a change in prices
...

Determinants:
● Change in the Cost of Production
(COP):
↪ FOP costs
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↪ subsidies and taxes
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●

●

●

Composite Demand
↪ demanded for 2+ purposes? An increase
in Qd of one might lead to a reduction in Qs
of a composite
...


Price Elasticity of Supply (PES)
PES: the responsiveness of quantity supplied to a change in price
...
An increase in price would cause a larger than
proportionate change in Qs
...
An increase in price would cause a less than
proportion change in Qs
...

Spare Capacity (small - inelastic PES; large - elastic PES)
...

Interpreting values of YED:
● +ve = Inferior good
⤷ any good where if our income rises, we reduce our
spending on it
...

⤷ 2) Necessary good (YED between 0-1) - demand
increases by a smaller proportion than the increase in
income
...

● It is used to determine the relationship between two goods
...
+ve = Substitutes
⤷ 0 - 1 = distant (weak) substitutes
⤷ >1 = close (strong) substitutes
1
...

● 3 Main Functions of Prices in an Economy:
1
...

2
...
Sends a message to producers that demand is
probably high and that they should increase production or new
producers enter the market
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3
...
E
...
govt
...


Consumer and Producer Surplus
Market: where consumers (demand) and producers (supply) meet to exchange
goods and services
...

Excess demand
Caused when prices are set too low - consumers are encouraged to enter the
market and producers want to leave due to low potential profits
...


Alternative Views of Consumer Behaviour
● Bounded rationality - economic agents do the best they can given the
information available
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● Psychologists have identified a set of clear ‘cognitive biases’ that make humans
‘predictably irrational’
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Habitual behaviour - persistent patterns of consumption develop over time
which do not shift, even if it becomes increasingly costly for us
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Consumer weakness at computation - due to lack of mathematical ability
to work out the best deal; hard to gather the info required, and interpret and
analyse it; there is often much uncertainty about the future
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Herding behaviour - we are influenced by the behaviour of people in our
surroundings and worry about missing out so we tend to follow the actions of
others
...
These are:
1
...
‘Availability bias’ is
behaviour influenced by the recent activities of a person - therefore, it affects
consumption decisions
...
Anchoring - human tendency to make decisions by comparing with a nearby
reference point
...

3
...
E
...

subscriptions, middle pricing, etc
...

Market failure - when the free market/price mechanism fails to provide goods and services, or
provides them in the wrong quantities, leading to a misallocation of resources in the economy
...
Externalities - when the costs/benefits of an economic activity are not fully reflected in the
price
...

2
...
g
...
Thus, the
govt
...

3
...
- so we can make wrong decisions on what to consumer (demand)
and firms can supply wrong goods (supply), leading to a misallocation of resources in the
economy
...
failure which ends up
making the resource allocation worse
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● Can lead to the overproduction or underproduction of goods and services
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Arise when the social costs of an activity are greater than the private costs
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Social cost - full cost to society of production
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EVALUATION:
1
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2
...

3
...

4
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intervention
right → will usually only reduce it rather than
correct welfare loss
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Consider the external benefits of the activity
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● Arise when the social benefits of an activity are greater than the private
benefits
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● Social benefit - the full benefit to society of consumption
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Imperfect knowledge
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Quantifying/measuring private and
external benefits
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Size of the potential welfare gain is only
an estimate
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Consider the external costs of an
activity
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It is rival - consumption of the good reduces the amount available to others
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People can be excluded from consuming it, e
...
if they can’t afford it
...
Non-rivalry - means that consumption by one person does not reduce the amount
available to others
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Non-excludability - anyone cannot be prevented from using it
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Public goods tend to be underprovided or not provided at all by free markets - so govt
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Public goods must be provided by the govt
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Even
if it is provided, the non-excludability of the good leads to the ‘free rider problem’
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Asymmetric information - when buyers and sellers have different amounts of information e
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producers know more than consumers
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This can lead to inefficiencies and market failure
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g
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Other causes of imperfect information:
1
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2
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g
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Govt
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Main ways of intervention:
1
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Subsidy
3
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Advertising/Information campaigns

Public choice theory - Free market economists believe that the price mechanism
allocates resources efficiently and any govt
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Public Interest Theory - Keynesians support govt
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Taxation
● Works through the price mechanism - COP↑,
S↓
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● Discourages production of goods with -ve
externalities
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EVALUATION:

1
...
This is difficult to measure due to
imperfect knowledge
...
Ineffective at decreasing Qs and Qd if PED is
inelastic
...
Can be regressive - the burden of the tax can
fall disproportionately on the poor
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● Encourages production and consumption of goods with external benefits/+ve
externalities
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EVALUATION:
1
...
- opportunity cost
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❖ More govt
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2
...

3
...

4
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There will be need for monitoring the subsidy scheme - futher costs
for the govt
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This eliminates the free-rider problem
Consumers have common standards
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EVALUATION:
1
...

2
...

3
...


Ad + Info
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EVALUATION:
1
...

2
...
Need to think of more
innovative ways
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EVALUATION:
1
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2
...

3
...

4
...


Extending Property
Rights
● The govt
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g
...

● Internalises the externality
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Intervention
...


EVALUATION:
1
...

2
...

3
...


Tradable Pollution Permits
1
...

3
...


Agree on a socially efficient level of CO2
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Each polluting firm is issued with a quota of these permits
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This creates a market in the rights to pollute and internalises the externality
...
Difficult to set the right (socially efficient) number of permits due to imperfect knowledge
...
Risk of govt
...
- too many permits may be issued, causing their prices to fall, reducing
the incentive for firms to reduce their emissions; it would be cheaper to simply buy lowpriced permits than invest in ‘clean’ capital equipment
...
Cost of monitoring the scheme - however, this is not too significant as it is mainly run by
the market
...
Environmental groups argue that some large firms can make lot of money by trading ‘free’
permits given by the govt
...


Govt
...
intervention in markets leads to an inefficient allocation of
resources leading to a net welfare loss to society
...
Distortion of price signals - e
...
govt
...
- excess/too
little supply, lower quality, opportunity costs
...
Unintended consequences - unintended adverse consequences which the
policy did not intend to create
...
g
...

3
...
measures may be so high they exceed any benefit gained
...
Information gaps - when the govt
...
- e
...
it’s difficult to know
in advance the effects on tax evasion and avoidance of an increase in tax rates
...
Failure - Applied Examples
Example 1: Mexico City and emissions from cars - tackling transport market failure
● Aim: o reduce carbon emissions; simple policy - cars with even/odd numbers plates were
allowed into the city on alternate days so the number of cars entering the city halves
...

● Result: an increase in emissions + govt
...


Example 2: The Common Agricultural Policy - tackling agricultural market failure
● Aim: stabilise agricultural prices and provide a satisfactory level of income for farmers in the
EU
...
So the
EU has to pay subsidies and pay for warehouses and storage
...
money + govt
...

Example 3: The National Min
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● However, some workers retain their jobs with higher pay while other lose their jobs - firms
would be reluctant to pay higher wages
...
failure
...
often conducts a cost-benefit analysis to fully weigh up the full costs
and benefits of a major project or policy before it is implemented
...

It applies monetary/financial values to every cost and benefit
...

If social benefits > social costs = project might go ahead
...
External costs and benefits are difficult to measure
...
There are administrative costs and delays - separate from estimations
...
Future costs and benefits are difficult to measure - due to uncertainty of the
effects in the long run

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