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UNIT 3 ECONOMICS: MICROECONOMICS
Part 1: Business Economics
Chapter 2: Introduction to Business Economics
The theory of the firm refers to a set of theories and principles which explain how firms work and operate
...
Production theory divides
into short-run and long-run theory
...
The key concept of long-run
production theory is returns to scale: Increasing returns to scale refers to a situation in which output
increases faster than the increase in inputs (factors of production) – this therefore encourages a firm to
grow and earn more money as they do so since they can produce more output with less input per every unit
of good
...
It is very easy to confuse cost theory with production theory – production theory
refers purely to inputs and outputs and makes not mention of money, whilst cost theory refers to the costs
of changing production levels
...

Increasing returns to scale leads to economies of scale in the long-run, whilst decreasing returns of scale
leads to diseconomies of scale
...

Revenue refers to the money a firm earns in selling its output
...

Objectives of Firms
(See chapter 8: aspects of the growth of firms)
The ability for a firm to make a profit depends on the competitiveness of the market it is in
...
This
means that profits sustained in perfectly competitive markets act as incentives for other firms to join the
market
...

Evaluation of different market structures
When evaluating different market structures, we do so based on the markets efficiency and on welfare
...

Based on welfare, this can refer to the two types of measuring welfare: consumer surplus and producer
surplus
...
This refers to their policy on monopolies,
oligopolies, legislation ensuring fair trading, nationalisation, privatisation and regulation
...

What is a firm?
Firms are companies that must earn revenue to cover the costs it produces
...
However there are some blurred lines between categorising a firm as one of these,
since a firm can be partly owned by the Government and partly by its shareholders
...




Incorporated enterprises (companies (owned by shareholders))
o Private companies (ltd) – issues shares to people privately (it is not available for public
purchase; liabilities are limited i
...
the bank can only take the assets of the company)
o Public companies (plc) – issues shares that any member of the public can purchase
(shares are floated on the stock exchange)
o Sole traders – Shares are not available publicly, but liabilities are unlimited (the bank can
repossess the assets of the owners of the company, as well as the company’s assets
...
Private firms are run by a board of directors who
control the company’s resources
...
They may have different policy objectives
...


Chapter 3: Production and Cost Theory
Production is a process or set of processes that converts inputs into outputs
...

The short-run refers to the time period in which one factor of production is fixed (and cannot be changed or
rescaled)
...

Short-run production theory (Law of Diminishing Returns)
This law is a short-term law which states that as a variable factor of production is added to fixed factors,
eventually the marginal returns (or marginal product) of the variable factor will begin the fall
...

Marginal product refers to the increase in output a firm produces as a result of adding one additional unit
of input into the production process
...

In the short-run, assuming capital is fixed, the only way to increase
output is to increase one of the other factors of production (e
...

Labour):

Each new worker employed produces more than the previous
worker does - there is increasing marginal productivity due to benefits
from specialisation and the division of labour
...

This states that as a variable factor of production (in this case Labour)
is added to fixed factors, eventually the marginal returns (or marginal
product) of the variable factor will begin to fall
...
Past this point, every new worker added reduces average
product
...
Each new worker
added beyond this point will have negative marginal product
...


The law of diminishing returns can be explained with reference to product and costs
...

Total cost refers to the overall cost (both variable and fixed costs) to a firm for producing at a given level of
input
...


Marginal cost refers to the increase in cost as a result of adding one additional unit of input into the
production process
...

However eventually, the law of diminishing returns sets in
...
e
...

It will continue to rise until it cuts the bottom of the average cost curve
...


Long-run production theory (Returns to Scale)
In the short-run, increasing output by increasing a factor of production (usually labour) will eventually lead
to diminishing marginal product
...
To do
so, they enter into the long-run and can increase any of their factors of production (usually capital)
...

Returns to scale describes how output changes when the scale of all the factors of production change in
the long-run
...

It is important not to get confused between returns to scale and both economies and diseconomies of
scale
...
Both of these can be portrayed on a Long-run average cost curve
(LRAC)
...

Economies of scale are defined as
falling long-run average costs as the size
or scale of a firm increases
...

Minimum efficient scale refers to the
smallest output a firm can achieve at its
lowest average costs
...
g
...

Types of internal economies of scale:
 Technical EOS: Larger businesses can afford higher costing capital in order to improve productivity;
specialisation and the division of labour; the law of increased dimensions
 Marketing/Purchasing EOS: Can purchase in bulk, reducing costs; benefits from lower supplier
prices due to bargaining power
 Financial EOS: Lower costs of borrowing due to high amount of collateral
Diseconomies of scale:
 Harder to control productivity of such large corporations
 Alienation and loss of morale (if workers do not consider themselves to be an integral part of the
business)

The LRAC curve may shift upwards or downwards for a number of reasons:
 Improvement in technology (increasing productivity and therefore reducing costs)
 External factors/economies/diseconomies of scale (e
...
Government spending on infrastructure and
transport)
Alternative shapes:
The shape of the long-run average cost curve may not always be U-shaped
...
g
...
A horizontal LRAC curve may also exist, when firms of
different sizes exist within the same industry
...
This is because:
 Firms very rarely produce enough output to pass the sufficient MES and achieve diseconomies of
scale
...

 In this current globalised world, countries can become pragmatic and move to other countries where
there is cheaper labour, or there is a larger market, so there are other alternatives to suffering
increased costs
...
Between them a series of imperfectly
competitive markets are situated, including an oligopoly
...

Perfect competition occurs within markets which contain 5
distinctive traits:
 Many buyers/sellers
 Perfect knowledge
 Price takers
 Homogenous goods
 No barriers to entry or exit in the long run
Pure monopoly occurs when one firm produces 100% of the market output
...
As a result, the phrase ‘monopoly’ is typically used more loosely to
describe firms which dominate their respective market e
...
Microsoft and the word processing market
...
It occurs when a few
independent firms dominate the market output and need to take account of its rivals’ reactions when
deciding its own marketing strategy
...
Oligopolies are divided into competitive oligopolies
where the firms compete actively against each other, and collusive oligopoly where the firms cooperate
with each other
...
In such circumstances, they
buyer often exercises excessive purchasing power to its suppliers
...

Average revenue (total revenue / output), is the average money earned from selling each good/service at
any given level of output
...

In perfect competition:
The average and marginal revenue curves are perfectly elastic because:

If a firm were to raise its price, it would lead to no sales
because perfect knowledge means customers are aware of the
homogenous goods at lower prices provided by the firm’s
competitors
...


 If a firm were to lower its price, it would make no sense
because the perfect knowledge in the market means other firms
would be forced to lower their prices in order to avoid losing all
their market share
...

 This therefore means that the average and marginal revenues
curves of a PC firm are perfectly elastic as raising or lowering the price from the market price would
result in no revenue
...
It is downwards sloping because as price falls, more is
demanded
...
Its marginal
revenue curve is downwards sloping at twice the steepness:
Q
Price/D
TR
AR
MR
1
£10
£10
£10
2
£9
£18
£9
£8
3
£8
£24
£8
£6
4
£7
£28
£7
£4
5
£6
£30
£6
£2
Monopolies face trade-offs – if monopolies sell at a set price, they cannot determine demand, and in
extension the quantity they should produce
...
Monopolies therefore can only be either price-setters or
quantity-setters, but not at the same time
...
This is where MR=MC
...
This occurs when AR=AC
...

This occurs when AR>AC
...
Here, it produces normal
profit
...
In the long-run, firms can move into a different market causing the
market and firm to change
...
It also reiterates the fact that firms are price takers and that the only things which
can affect a perfectly competitive market are external factors shifting supply or demand within the market,
or the average cost curve of the firm
...

Its profit maximising point is
q𝜋
...

AC shifts because:

Improvements in
technology, increasing
productivity, therefore









increasing output at the same cost, reducing average costs
...

Shift: The average cost curve shifts due to changes to external factors (see below)
...

Change (firm): Is the firm making a profit or a loss?
AC ...

Price-taker: Firms remaining are price takers, so they take the new price, creating a new
D=AR=MR curve
...

Equilibrium (2): Where does the market operate?
There is a new market equilibrium of S1D at P1Q1
...

 If they decrease their price, it will make no sense because the perfect knowledge in the market
means other firms would be forced to lower their prices in order to avoid losing all their market
share
...

In monopoly:
In a monopolistic market, abnormal profit is earnt by the one firm in the market
...
This is the maximum price they can sell Qπ at
...
This can be sustained into the long-run due to imperfect knowledge and barriers to entry
...


To answer questions:
 Equilibrium (1): The monopoly firm produces at Qπ,
price P
...

AC shifts:
 Shift: The average cost curve shifts down as the firm
invests abnormal profit into research and development,
thereby being productively efficient
...

Chapter 6: Evaluating Perfect Competition and
Monopoly
There are two main ways of evaluating perfect competition
and monopoly: In terms of economic efficiency (of which there are three types), and in terms of welfare
criteria (consumer surplus and producer surplus)
...

Allocative efficiency occurs when overall economic welfare is maximised via the most effective
distribution of resources
...

Dynamic efficiency occurs when technical and productive efficiency increases over time
...

FYI, static efficiency is any type of efficiency that is measured at one point in time (e
...
productive and
allocative)
...

Efficiency

Perfect Competition

Productive

YES – The firm operates at the
bottom of the AC curve

Monopoly
NO – The firm’s costs are above the average cost
curve
...


Allocative

YES – P=MC
The amount a market produces is
wholly determined by the supply
and demand of the product – which
is determined by the consumers
...


NO – P>MC
(However, many consumers may prefer investment in
innovation, technology, branded goods and Veblen
goods over allocative efficiency)
...

There is a lower incentive to be
dynamically efficient as the other
firms will eventually free-ride the
benefits due to perfect competition
...


Possibly more likely than PC – The abnormal profit
earnt by monopolies, which are protected by barriers
to entry, means they can invest in research and
development
...

There may be no incentive to lower average costs as
the monopoly firm already earns abnormal profit of
PRST and doesn’t need to lower average costs
further
...
g
...

However, companies are profit maximisers, and thus
have the incentive to increase their abnormal profit
wherever possible
...
g
...

Whether they invest or not will depend on the nature
of shareholders and whether they’re long-term or
short-term investors
...

It also depends on the market and whether research
and development will take a long time to implement or
not
...

Comparing monopolies and perfect competition
Monopolies have lower costs:
The diagram shows the differing costs of production monopolistic and
perfectly competitive markets have
...
PC firms produce where Spc=Dpc; whereas
monopoly firms produce where ARmono=MCmono
...

PC has better economic welfare:
Economic welfare is measured in two, linked, ways: via consumer
surplus and producer surplus
...

Producer Surplus – The difference between the minimum price sellers are willing and able to sell at, and
the price they actually sell at
...
Monopolies produce at its
profit-maximising point where MR=MC, while
setting a higher price of Pm
...

 PC is allocatively efficient because Ppc=MC,
while monopolies are not allocative efficient
because Pm>MC
 Under PC, the consumer surplus is larger than it
is under monopolies:
PC consumer surplus (PpcAB) > Monopoly
consumer surplus of PmAC
...

Chapter 7: Oligopoly and Concentrated Markets
Imperfect competition
Most firms are under the bracket of imperfect competition stretching from colluding duopolies, to close-toperfectly competitive firms:
Oligopoly describes a market in which there are a small number of dominant firms
...

Firms in oligopolistic and duopolistic markets possess monopolistic powers, such as the power to
determine price to some extent etc
...
g
...

Imperfect oligopoly is when the products produced by the firms are differentiated or imperfect substitutes
to each other (e
...
cars)
...


Colluding oligopoly is when rival firms within the market work together for their own benefit
...

Cartels are often formed as a result of uncertainty within the market
...
This benefits the least efficient firm which is allowed to survive in the
market as with lower prices it would have otherwise been priced out of the market; whilst also benefitting
the most efficient firms as they can extend their abnormal profit
...
These are usually illegal
...
E
...
the five-firm
concentration ratio is the percentage of output in an industry produced by the five largest firms in the
industry
...
In oligopolistic markets, firms have
the power to control its own price and output, which in turns affects its rivals’ profits
...
Oligopolistic firms must
work in a market of interdependence and uncertainty
...

Kinked Demand Theory:
Kinked demand theory aims to explain how a competitive oligopolist may be affected by its rivals’ reaction
to its price and output decisions; it also explains alleged price stickiness or rigidity in oligopolistic
markets
...

When a firm increases its price from P1 to P2, the oligopolist expects the rival firm to hold their prices
steady in order to gain more market share and a profit
...

However, when a firm lowers its price from P1 to P3, the oligopolistic firm expects rivals to act in a
different way: to lower prices themselves
...
Although overall demand should
increase as some people are willing to buy the product at this price, but not at the previous price,
demand is expected to be relatively price inelastic, as demand experiences a less than
proportionate increase from Q1 to Q3
...


However, there is no explanation as to why a firm choses to produce at point x in the first place
...

Game Theory:
Game theory is a mathematical approach to the study of
decision-making which treats such conflicts as games with set
tactics and strategies with rational players
...
The rational person
therefore determines his decisions based on the outcomes of his
decisions
...
Different
situations lead to different sentences for both prisoners illustrated
by this matrix:
It is in the best interest of both prisoners to confess in order to
avoid getting 30 years in prison
...

Similarly, the uncertainty of other firms’ decisions within an
oligopolistic market influences a firm’s behaviour in it
...
When a newly
established firm enters the market, the incumbent firm/s will set prices below costs to force new competition
out of business
...
Firms can do this because they
will most likely have savings from previously earnt profits, or can do it strategically so that some branches
make loses, which are subsidised by the earnings of other branches which experience little competition
...

Price parallelism:
Price parallelism occurs when there are identical prices and price movements within a market
...
It can
occur as a result of fierce competition where firms’ prices are close to the market price; alternatively it can
be a sign of a collusive market where the firms come together to fix prices higher or lower than the market
price
...

Another pricing technique: Price Discrimination
Price Discrimination occurs when a firm charges different prices to different groups of consumers for
identical products
...
E
...
demand would
be more price elastic in a geographical area with many competitors, and comparatively price
inelastic in isolated areas with little competition
...

 The firm must be price-setters (monopolistic/oligopolistic/imperfectly competitive firms)
...
This occurs when consumers can purchase the
good/service in a sub-market, which undercuts the monopolist’s own selling price in the market
...
In the diagram, each price shows the
price the firm is charging for each individual
consumer
...

Although this isn’t possible now, Tesco’s loyalty cards
are consistently collecting data and information about
consumers purchasing habits
...
This
will inevitably accelerate in light of future
technological advancements
...
E
...
when
hotel and airline firms sell spare rooms and seats at a last minute standby basis
...


In such a firm, the marginal cost of providing the
good/service to one additional person is negligible
until full capacity is reached, beyond which marginal
costs escalate rapidly
...

The firm initially produces where MC=MR (profit
maximisation point)
...
The firm can sell this at
a lower price in order to gain further profit since the
additional cost for providing this good/service is very
low
...


Third-degree PD:
This is the most common form of PD
...
The market is
usually separated in two ways, either by time or by geography
...
g
...
By geography, exporters may
charge a higher price in overseas markets if demand is more price inelastic than it is in home markets
...

Globalisation, the internet and closer trade integration has also led to the slowdown of this type of price
discrimination
...
This has led to market
seepage, increasing the number of imported cars in the UK
...

The diagram portrays peak
(left) and off-peak (right)
markets for rail journeys
...
However, marginal
revenue and demand does
change
...
During offpeak hours, demand
becomes more price
elastic, in turn changing the
marginal revenue curve
...
This is different in both time periods, leading to lower prices in off-peak hours
...

Winners and Losers:
Winners
 Consumers who are flexible
Flexible consumers who can demand products at offpeak hours can get their goods/services at lower
prices
...



Firms can increase revenue

Losers
 Consumers who are not flexible
Consumers with price inelastic demand must
pay more as they are charged higher prices
...

 Society will lose out
The market becomes allocatively inefficient as
there is a misallocation of resources as P≠MC
...
They
effectively reduce consumer surplus
...
E
...
profits earnt by
London-based trains can be used to subsidise trains
in rural areas which have higher costs as they are
longer distances away from each other
...

Types:
1) Structural barriers – These are often referred to as ‘innocent barriers’ as they result from
differences in cost structure between the firms
...
This might be due to economies of scale and experience and
expertise in producing the good/service for many years
...
This may include
marketing costs, research and development into the market and training
...
g
...

2) Strategic barriers – These are ‘not innocent barriers’ which are techniques used by new firms to
prevent new competition
...
Patenting
prevents other firms from using the same design, forcing them to spend money on R&D helping to
maintain an incumbent firm’s abnormal profits
...

Profit maximisation is a firm’s main objectives
...
If, however, managers believe growth will reduce profits, they will resist the urge to
pursuit growth
...

 External growth (occurs from an acquisition, either a takeover, or merger)
...
E
...
if a car assembly firm decides to produce engine parts for it to assemble
itself rather than having to purchase these parts off of other companies; or similarly if the firm sells
the cars it manufactures instead of selling it to retail companies who then sell it to consumers
...
e
...
However, it may often be better to outsource component supply to independent
suppliers as they have much more specialist knowledge in what they do which would mean higher
quality supplies at lower costs
...
E
...
if a car assembly company opens another factory in order to



increase supply
...

Lateral growth, or conglomeration (when a firm diversifies into a completely different industry and
produces different goods/services)
...
g
...


Alternative theories of the firm
Many modern economists have criticised the neo-classical theory of the firm, that the firm’s only objective is
to be profit-maximising
...

They argue a number of objectives exist at the same time
...
This is the so-called principle-agent problem, where shareholders
have different objectives from that of managers
...

Organisational or behavioural theories – The firm has different groups (called stakeholders) demanding
different objectives for the firm
...
This can cause group conflict
...
They propose this via satisficing
...

Trade off facing public companies
This refers to the trade-off of maximising control within the board of directors, which occurs within a private
company, or maximising the raising of capital (money) which occurs when the shares are sold initially to
personal shareholders, and eventually to institutional shareholders on the stock exchange
...


UNIT 3 ECONOMICS: MICROECONOMICS
Part 2: The Government and Market Failure
Chapter 9: Industrial Policy
Industrial policy aims to improve the economic performance of firms and industries on the supply-side of
the economy (i
...
increasing the productive potential of the economy)
...
From 1979 when Thatcher replaced the
prevailing Keynesian style of economics with supply-side economics, industrial policy has been largely antiinterventionist
...

Competition policy
Competition policy aims to make markets more competitive
...
There are certain organisations and groups which look at competition policy:
 The Office of Fair Trading (OFT) focuses on consumer interests and the contestability of markets
...
In order to tackle such
restrictive policies the Government/group may impose a fine
...

However, firms may just increases prices to cover the fine and regain abnormal profit at the same
time
...

In law, a monopoly (called a statutory monopoly), exists if:
 A firm has over 25% of the market share (scale monopoly)
 A number of firms have a concentration ratio of over 25% and conduct their affairs so as to restrict
competition (complex monopoly)
There are also independent regulators for each privatised industry:
OFGEM – Gas and electricity
OFWAT – Water
OFCOM – Telecommunications
These are called Quangos (Quasi-autonomous non-governmental organisations)
Intervention to encourage competition in imperfectly competitive markets:
1) Taxing abnormal profits
Monopolies or monopolistic oligopolies are sometimes seen as a market failure and the Government may
take action to correct this
...
Such a tax was
referred to as a windfall tax when introduced by Tony Blair in 1997
...

The AC curve increases, abnormal costs fall
...

However, monopolies may just raise prices further
to maintain or gain abnormal profits
...

Additionally, this could disincentivise firms to be
dynamically efficient as they have less abnormal
profit and any further profit earnt from being
innovative would just be taxed
...
A too high a windfall
tax/subsidy would be debilitating on the market and
may lead to the main firms collapse before smaller
firms have a chance to develop – a particularly problematic issue if it is an important industry such as a

utility
...
However, perhaps the fear of a
collapse is the incentive the firm needs to lower its costs
...
Furthermore, FDI may be less attractive due to high tax
rates and may discourage other, more efficient, foreign firms from entering the domestic market
...

Additionally, subsidies could cover cost barriers to entry, but barriers over knowledge and brand loyalty
cannot be overcome by subsidy so easily
...

2) Price controls (Maximum prices/price freeze)
This would ensure that imperfectly competitive firms are forced to lower prices
...
A maximum price was introduced in many privatised industries, that prices
could not exceed RPI + 2%
...

The monopoly sets price where
MCmono=MR, causing a high price of Pm
...
(This is a good diagram if I’ve
used a monopoly one already)
However, the Government has imperfect
knowledge of the market and where to set
the maximum price – they may not, for
example, know exactly where P=MC is
...

Additionally, firms may not leave due to barriers of exit (if
there are high sunk costs
...

Additionally, a black market may be an unintended
consequence of such intervention
...
The Government further loses tax
revenue it would’ve gained from taxing the sale of the higher
priced, legally sold, product
...

3) Monopoly busting
Monopoly busting occurs when a
Government legally insists that a
monopoly firm should be broken up
and sold as different independent
companies
...
E
...
British Airways
Authority owned London Heathrow,
Gatwick and Stanstead
...
Here, the market price falls
...

Additionally, it may create an oligopoly rather than a competitive market
...
Normally, share prices are bought by the Government at a fixed price
...
During the credit crunch, some banks were wholly or partly nationalised
as well
...

Privatisation occurs when an industry or company owned by the Government is sold to shareholders on
the stock exchange to become a public limited company (plc)
...

Therefore the Government may have to take additional measures to ensure this happens following
privatisation:
 The Government may deregulate barriers to entry and exit
 The Government may subsidise new or potential competitors
 The Government may breakup the monopoly into smaller companies
Arguments for nationalisation would often take the form of advantages associated with monopolies, while
arguments for privatisation would take the form of advantages associated with perfect competition:
Nationalisation
 Lower costs (dynamically efficient)
 Better management and long-term incentives
 Help to maximise net social benefit and a fairer distribution of resources
Some argue nationalisation is better for consumers because monopolies can provide services at lower
costs than perfectly competitive firms
...

Monopoly>PC diagram
...
g
...

However, due to lack of competition there is often little incentive to lower prices
...
Additionally, some fear that
diseconomies of scale could cause prices to increase on monopoly firms if a firm gets too big and harder to
control and motivate productivity levels
...
This causes firms AC curves to be higher than perfect
competition forcing prices up
...

Encouraged competition, which has led to lower costs, greater choice, and more innovation
...
PC>Monopoly diagram
...
Royal Mail has an incentive to be dynamically efficient and innovative in
order to lower average costs and stimulate abnormal profit
...
This
abnormal profit is seen by other firms in the market due to perfect knowledge, encouraging firms in other
markets to enter into the long run and enter into this market, causing supply to increase
...
Also, the fall in supply causes the price in the
market to fall
...

However, in order to convert a nationalised firm into a firm as part of a perfectly competitive market,
barriers to entry must be deregulated, and the Royal Mail could be broken up into smaller firms to prevent a
private monopoly from occurring
...
Also, Government doesn’t know perfect size of the subsidies
...

Economic liberalisation
Privatisation has come to be known in a much wider sense than simply the transferal of a firm from state to
private ownership
...
E
...
ASOS to assess
incapacity benefits claimants
...

 Deregulation: The removal of rules, controls and constraints on the freedom of economic activity
...


Chapter 10: Market Failure
Market Failure occurs when the market failed to allocate scarce resources efficiently, leading to a
misallocation of resources
...

Non-rivalry means the consumption of the good/service by an additional individual does not reduce the
goods availability to other individuals
...
E
...
streetlights
...

Quasi-public goods are either non-excludable or non-rivalry
...
g
...

For every good/service, there is a potential:
 Private cost (a producer’s cost of providing a good or service; It includes the costs of the factors of
production such as rent, wages, capital and labour costs in the form of wages
...
E
...
earthquakes caused by fracking for shale gas)
 External benefit/positive externality (a good benefit gratefully received by a third party following the
consumption of production of a good/service
...
g
...
Where the social benefit exceeds the private benefit
...
Where the social cost exceeds the private cost
...
g
...

 E (external cost/benefit ignored)
This is because the market ignores the external benefit from a-b
...

 I (if we internalise)
If we internalise the external benefit, the market will produce at MSC=MSB, at P1Q1
...

 S (socially efficient allocation/Pareto efficiency)
This is now a socially efficient allocation of resources, or Pareto efficiency, solving the misallocation
of resources, and thus the market failure
...
g
...

This argument could alternatively
be portrayed on a perfectly
competitive diagram
...
This
forces inefficient companies
within the market out, reducing
supply in the market
...
The firm has a
new profit maximising point,
meaning they produce more than
they initially used to, and the
individual market share of each firm increases; however overall supply falls, as shown in the market,
meaning there is less negative externality produced, solving the market failure
...
Of the tax,
the consumer pays the top half, and the producer pays
the bottom half
...

Additionally, the Government possess imperfect
knowledge about the perfect level of tax that should be
implemented
...
g
...

2) Pollution permits/carbon credits trading scheme
Pollution permits is a policy designed to tackle climate change by tackling the level of carbon emissions
produced by businesses
...
At the end of the term, some firms have underproduced their allocated carbon emissions, and have spare carbon credits which they can sell; in contrast
some firms have over-emitted carbon emissions and need to purchase carbon credits in order to avoid
huge fines from the EU
...
This scheme

therefore increases average costs for firms which are heavily polluting and inefficient, while providing an
additional source of income for firms which under-pollute and are efficient
...

In the diagram,
polluting firms need to
purchase more
permits
...
Thus
they start to make a
loss
...

This lowers output in
the market from Q to
Q1, thus reducing the
level of emissions
produced by the
market
...
Their additional source of income from selling credits can also be used to reinvest into the
production process to become even cleaner and more efficient in their production
...
g
...

However, there the Government (EU) lacks perfect knowledge about the best level of carbon credits to
issue
...
This has macroeconomic implications (unemployment; fuel
poverty)
...
There is therefore little incentive to become cleaner as you do not gain
much profit from selling excess credits
...

This would disproportionately hit lower-income groups’ worse
...
Could have
macroeconomic implications, unemployment, economic growth falls as firms leave the market
...

There are also quite high admin costs – to issue the permits and to monitor pollution from roughly 11,000
factories and plants in this scheme
...
; and the issue of the
budget deficit and national debt
...
Alternatively, permits regarding how much pollution plants can emit
can issued to factories and plants (which aren’t tradable and thus are very different to the carbon credits
trading scheme
...
A quota in output would simply reduce supply to the
left (S1) limiting the demerit good that is produced
...

However, this has macroeconomic implications (unemployment; hurt industry; firms may go abroad to
produce, worsening unemployment further and reducing tax revenues which is a conflict of objectives
against tackling the budget deficit/debt)
...

Additionally, imperfect knowledge
...


Chapter 11: Cost-Benefit Analysis
Government failure occurs when government intervention in the economy is ineffective, wasteful or
damaging
...

Public choice theory, as advocated by free-market economists, suggests that decisions should be made
by the private sector and the markets because the firms which make those decisions have a strong selfinterest to make correct decisions as their livelihoods depend on it, while they also possess much greater
expertise and knowledge of the market than civil servants and government planners
...

Public interest theory, as favoured by Keynesian economists, suggests that the government should act in
a benevolent way in order to eliminate waste in the economy and to achieve an efficient and socially
desirable resource allocation in markets across the economy where markets fail to do so
...
However
the large cost of such projects are sometimes viewed as government failure in itself
...

Private sector investment appraisal is a technique used by private businesses for assessing the private
costs and benefits likely to result from an economic decision, in order to give the firm an accurate indication
as to the advantages and disadvantages of pursuing and investment project
...
Identify and allocate monetary values to all social costs and benefits
...
The probability of the social benefits and costs occurring are analysed, weighting each cost/benefit
by its likelihood of occurring
...
A technique called discounting the future is used where monetary values which are allocated to
the costs and benefits of the project are adjusted based on expected values in the future
...
Compare social costs and future values with social benefits at future values and calculate the net
social benefits/net rate of return on investment to assess whether the project is desirable
...
e
...

 It is very hard to gauge the values for external benefits and costs as they are intangible and as a
result differing opinions exist over these values make them potentially inaccurate
...

 The values predicted when discounting the future is used could be wrong due to unforeseen
external events and factors or poor predictions
...

Against CBA:
 Impossible to cover all ‘spill over’ effects (social costs and benefits)
 It is extremely hard to measure and quantify the external costs and benefits leading to a lack of
government intervention possibly leading to government failure
...

 Government failure may occur due to high admin costs
...
E
...
building a local airport in a particular areas – this
is very damaging for local residents, however their concerns may be overlooked by society’s
demand for another airport (NIMBYISM)
...





Although the information could be inaccurate, it would still aid the government in making a
decision
...


UNIT 3 ECONOMICS: MICROECONOMICS
Part 3: Wages, Incomes and Wealth
Chapter 12: Labour Markets
Labour force is the number of people in work or actively seeking paid employment and available to start
work at a given time
...

Demand for Labour:
Demand for Labour refers to the total number of hours that employers are willing and able to demand at a
given wage rate at a given time
...
Initially, revenue will increase upon increasing the size of the workforce, however this
stops when adding additional units of labour leads to diminishing returns
...
This explains the demand curve for labour
...

Additionally, in times of full employment, any labour looking for work is more likely to be unskilled and
underproductive increasing the chance of falling revenue
...

 A higher demand for the final product the firm is making (increases the demand for labour in order
to produce more of the good/service to meet the increase in demand
...

 The price of a substitute input such as capital increases (increases the demand for labour as
employing more labour becomes more financially viable as an alternative to using the more costly
method of capital)
...
(%▲ in QD / %▲ in wage rate)
...

 East and cost of factor substitution – when firms can more easily substitute labour for other inputs
such as capital, and at relatively similar prices, demand is more elastic
...

Supply of Labour:
Supply of Labour refers to the total number of hours that labour is willing and able to supply at a given
wage rate at a given time
...
This increases the amount of
hours of labour available within an economy
...

However, some argue in favour of a backwards-bending supply
curve
...
However, after a
while, the wages become high enough to cover the major costs of the
workers so people are no longer willing to sacrifice their lost leisure time
for additional money, in what is known as the income effect
...

Elasticity of labour supply:
The elasticity of labour supply measures the responsiveness of the supply of labour when there is a
change in the market wage rate
...
In low-skilled occupations, the supply of
labour tends to be elastic as there is a pool of readily available labour employable at a failure low wage
rate
...

Wage determination
The wage rate is determined in the market by the point at which supply equals demand
...

 Higher pay can be a reward for workers who have spent time and money acquiring qualifications
prior to entering the labour market
...

 Higher pay can be a reward for workers whose efficiency is higher than other workers
...

 Higher pay can be awarded to workers with strong trade unions who fight for higher wages against
the employer
...

When a questions asks about the determination of wage rates in labour markets, talk about what
determines demand, then what determines supply, then how they meet in the labour market (basically,
everything above)
...
This includes gold,
property, stocks, shares, antiques, pension funds, artwork etc
...
g
...
)
 Propensity to save (lower-income groups have lower propensity to save making it harder for them to
invest in investment projects or wealth stocks)
 Luck (winning the lottery; gambling)
Income
Income is a flow of money in the form of a reward for the provision of the factors of production
...

Income inequality can be demonstrated using the Lorenz Curve
...
The
Gini Coefficient also measures income inequality, with a value of 0 (complete equality) to 1 (absolute
inequality)
...
The World Health Organisation (WHO) estimates this to be around $1/day
...
Reasons for this include family disagreements,
drug addictions, mental illnesses and illegal immigration/refugee immigration
...
It is defined as earning less than 60% of the average income which, in the UK, is roughly
£17,000
...

Fuel poverty occurs when household fuel bills exceed 10% of housing income
...

 Single parent families (Low household income; small/poor/inadequate housing; limited space to
work; hinders education; cannot afford food; also hinders education; reduces life changes; lower
wages; possibly unemployment; lower tax receipts; low investment in education etc
...
g
...
This
allows money to be spent on benefits for the poor
...
This will lead to an increase in
consumer spending and in extension aggregate
demand, shifting the AD curve to the right, causing
an increase in economic growth and demand-pull
inflation
...
Lower tax
rates for lower income also incentivise the
unemployed to get a job because it becomes
financially more attractive
...


Thus, the Government won’t have more money to
subsidise the cut in taxes for the poor
...

Additionally, due to the growing ease of moving
internationally in light of globalisation, many high-income
people may move abroad where tax rates are lower in a
process called the brain drain
...

Additionally, the brain drain diverts money out of the UKs
circular flow of income, much of it is spent or invested
into UK businesses, the removal of which would worsen
unemployment and, in extension, poverty
...

2)
National minimum wage
An increase in the minimum wage would raise
the income of lower earners, while not affecting
those of higher earners, thus income inequality
and both relative and absolute poverty will fall
...

However, this will most likely cause
unemployment as it increases the cost of labour
and subsequently companies cannot afford to
hire as much labour, and thus start to lay-off
employers
...

However, different factors can cause this, and
thus the effects of the national minimum wage
on unemployment may have been offset by other factors such as the increase in technology
...
In this situation, poverty may be reduced, but
income inequality won’t be
...
E
...
corporation tax
reduction
...
No barriers to entry and
perfect competition incentivises other firms to enter the market causing supply to increase creating
more jobs for lower-income groups
...
Also, disposable income of said families and individuals increase
causing household spending and consumer spending to increase boosting aggregate demand
...

Diagram: Perfect competition (2-diagram-thing) AC falls, supply increases
...
In the UK, firms are more likely to
be oligopolistic
...

Additionally, good/services produced may have been manufactured from overseas firms
...


OTHER:
Outsourcing:
This term is used to describe any business activity that is managed by an outside firm
...
This
makes it cheaper to outsource specialist activities
...

 If small firms outsource some of their services/products, they can do things or incorporate things
which they otherwise wouldn’t have the money to hire full-time workers to do, or the expertise to
enter that market

---

Title: Microeconomics and Business Economics (A-Level)
Description: Notes from AQA's Unit 3 - Business Economics and the Distribution of Income Syllabus: - The National and International Economy - Short-run and Long-run Production and Cost Theory - Revenue Theory - Perfect Competition and Monopolies (Profit Maximisation, Normal and Abnormal Profits, short-run and long-run equilibrium) - Evaluation of Perfect Competition and Monopolies (By Economic Efficiency and Economic Welfare) - Oligopolies (Imperfect Competition; Game Theory and Kinked Demand Theory; Pricing in Oligopolies; Price Discrimination; Barriers to Entry) - How Firms Grow - Industrial Policy - Market Failure (Public and Private Goods; Externalities; Demerit and Merit Goods) - Government Failure and Cost-Benefit Analysis - Labour Markets - Poverty and the Distribution of Income and Wealth

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