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Economics Unit 1: Competitive Markets
Basic Principles of Economics
Scarcity and opportunity cost
The fundamental economic problem for any society in the world is scarcity
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This key issue
forces people to make choices of which goods and services to consume
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Opportunity cost is the value of the next-best alternative forgone
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For instance if you consider the marginal costs and benefits
of consuming a good or service before doing so
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Prices play a key role in this sort of
system, providing incentives and signals to producers and consumers
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Advantages are the range of goods
available to consumers and increased productivity due to the profit motive
• Planned economies: are ones in which the government takes on the
coordination role, planning and directing the allocation of resources
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g
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g
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Disadvantages are that there is a removal of
the profit motive and consumers may not want what the government
produces for them
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Most countries
operate a mixed economy in which firms and private sector own resources
with the aim of maximising profits but the government also owns some
resources to produce public and merit goods which won’t always be provided
by firms

Factors of production
Factors of production are resources used in the production process; inputs into
production, in particular including labour, capital, land and entrepreneurship
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Firms need to make decisions about the mix of inputs



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used in order to produce their output
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Sustainability is another issue: sustainable development is development which meets
the needs of the present day without compromising the ability of future generations to
meet their own needs
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It is used to illustrate
opportunity cost as it shows the
different combinations of
economic goods which the
economy is able to produce if all
resources in the economy are
fully and efficiently employed
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The economy cannot be outside the PPF, as by definition the PPF shows the
maximum production level of the economy
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The PPF can shift due to economic
growth, this is caused by improvements in productivity and efficiency as well as
improvements in technology
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The division of
labour is effective because individual workers become skilled at performing
specialised tasks and therefore more efficient
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e
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Normative statements are statements of Judgement that cannot be
proved or refuted (i
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opinions)
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There are many things that may impact the demand
of a good or service, therefore ceteris paribus must be assumed
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The law of demand states that as
price falls we see total demand increase this is due to the income effect and the
substitution effect
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The demand curve (left) shows how much of a good
will be demanded by consumers at any given price
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Foreign holidays for instance are an
example of a normal good because, as people’s
incomes rise, they will tend to demand more foreign
holidays at any given price
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An example
would be as incomes rise, the demand for buses will decrease as people can afford
to use taxis or own cars
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• Substitute goods: goods are said to be substitutes if the demand for one
good is likely to rise if the price of the other good rises
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For example if the price of petrol increases the
demand for cars may decrease



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Price elasticity of demand (PED)
An elasticity is a measure of the sensitivity of one variable to changes in another
variable
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The equation for PED
is % change in quantity demanded / % change in price
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When PED >1 we say the demand is
highly price sensitive (price elastic)
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If the
PED=1 then we have unit elasticity
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The PED is important in that firms will want to know the effect of a change in the
price on the quantity demanded
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If a
good is price inelastic a rise in price will lead to a rise in total revenue and a
decrease in price will lead to a decrease in total revenue
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Many things impact the elasticity of demand, the four main ones
are: availability of substitutes, whether the good is a luxury good, whether the good is
a very inexpensive item and the time period (may result in little short term effects but
in the long run consumers look for alternative solutions)
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The equation for YED is % change in quantity
demanded / % change in real income
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If YED
is >1 then it is a luxury good, if the YED is <1 then the good is a necessity
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Cross-price elasticity of demand (XED)
Cross price elasticity of demand (XED) is a measure of the sensitivity of quantity
demanded of a good or service to a change in the price of some other good or
service
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If the XED is positive the goods are substitute goods, if XED is negative the
goods are complements
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People who do not consume a good



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due to a slight increase in price are known as marginal consumers
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Supply
Firms also make decisions over how much output to
supply to the market
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A similar relationship between the
quantity supplied by firms and the price of a good can
be identified in a relation to the behaviour of firms in a
competitive market – that is a market in which
individual firms cannot influence the price of the good
or service that they are selling, because of competition from other firms
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As
firms are expected to supply more goods at a high price than a lower price, the
supply curve will be upward sloping, reflecting the positive relationship between
quantity and price
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If the costs of production are reduced, the supply curve shifts outwards
as more of a good can be produced at the same price
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Price elasticity of supply (PES)
Price elasticity of supply (PES) is a measure of the sensitivity of the quantity supplied
of a good or service to a change in the price
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If PES >1 then it is elastic, if PES <1 then it is
inelastic
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• Perfect elastic supply: a horizontal supply curve, firms are prepared to
supply any amount of the good at the going price
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For
example, if firms are operating close to the capacity of their existing plant and
machinery, they may be unable to respond to an increase in price, at least in the
short run
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Producer surplus
Producer surplus is the difference
between the price firms are willing to
charge for goods or services and the
actual market price, it is shown by the
area above the supply curve and below
the price line
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Market Equilibrium & Efficiency
Market equilibrium
If the price for a good is high then there
will be excess supply as firms are keen to
private goods at high prices
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This leads to excess supply
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However, the shortage of
supply and the high demand means there is an excess demand
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This results in a balance in the market between the quantity that consumers wish to
demand and the quantity that firms wish to supply, this is known as the market
equilibrium
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Shifts in both the supply and demand for a good
will result in a shift in the equilibrium point, for example an improvement in
technology for a good will shift the supply curve outwards and this will lead to a fall in
price of the good as the equilibrium point on the demand curve shifts downwards
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This can be
shown on an average cost curve which shows



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that total costs = variable costs + fixed costs
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However, the average cost then increases to form a C shaped curve due to the law
of diminishing returns
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We can assume
that price = marginal benefit therefore marginal allocative efficiency occurs where
price = marginal cost
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Pareto optimality is a
situation where no one could be made better off without making someone else worse
off
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So with this
unpredictable supply the prices can vary from year to year greatly
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Prices too can vary greatly
but more related to the demand side
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The amount
traded (the supply) does not differ as the supply of it is inelastic but the increased
demand will raise prices
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With some commodities, exists cartels such as in the oil industry OPEC exist with the
intention of limiting supply as to drive the prices up
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There are the rental markets and the owner-occupier markets
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The limit to the building of houses and the cost of building them has meant the
supply has not been able to keep up with the demand and therefore there has been a
huge increase in price level
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The exchange market is an example of derived demand as people do not
want pounds for their own sake but instead they want the goods and services that
can be purchased with the pound
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’ People wanting a good return on their savings may
then purchase stocks and shares in the hope of receiving good dividends (sharing in
the profits of the firm), or capital gains if the value of the stock were to rise
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Indirect taxes
An indirect tax is a tax levied on expenditure on
goods or services
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Without the tax, the market equilibrium
would be at PQ but with the tax the firms are not
prepared to supply the good at that price so the
price increases despite no increased demand
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Effectively with indirect taxes, the
buyer pays for the tax so the incidence of tax falls partly on
the seller but mostly on the buyer
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If demand were
perfectly inelastic (so the demand will remain constant no
matter what the price is) the sellers would be able to pass
the entire burden of the tax onto the buyers by increasing the
price by the amount of the tax
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If the tax is not a constant amount but a percentage of the
price (known as an ad valorem tax), the supply curve is still affected; but now it
steepens (as shown)
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One way it
can do this is giving subsidies
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A subsidy can be regarded as a sort of negative
indirect tax that shifts the supply curve down
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If the aim of the subsidy is to increase production, it is only
partially successful – the degree of success also depends on the elasticity of
demand
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The aim of a
firm is to produce output to sell in order to generate
revenue and make profits
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This means that firms do not demand labour
for its own sake but for the revenue that is obtained,
this is an example of derived demand
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There are a number of factors that determine the position of a labour firm’s labour
demand curve
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Also if the equilibrium
price of a product falls the quantity of labour demanded will decrease at the same
wage rate as the supply is decreased and the firm’s profits decreases
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One significant effect on the elasticity of demand for labour is the extent to which
other factors of production such as capital can be substituted for labour in the
production process
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The extent to which labour and capital are substitutable varies between
economic activities, depending on the technology of production, as there may be
some sectors in which it is relatively easy for labour and capital to be substituted and
others in which it is quite difficult
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So labour demand will tend to be
more elastic in the long run than in the short run, as the firm needs time to adjust its
production process following a change in market conditions
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Labour supply
The labour supply curve is upwards sloping as more people will want to work if the
wage rate is higher
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This is another example of how the price
mechanism operates to allocate resources within a society
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Largely what effects the supply of labour is the decisions of



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individuals over whether to participate in the workforce
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This excludes those who have taken early retirement and students as well as
discouraged workers who were seeking employment but have given up
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On the diagram on the previous page, if the wage is lower than W1
employers will not be able to fill all their vacancies and will have to offer a higher
wage rate to attract more workers
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Suppose there is an increase in the demand for a firm’s product,
this will lead to a rightward shift in the demand for labour and therefore the wage rate
will rise
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Effects of government intervention
Unemployment benefits: an important influence on labour supply, particularly for
low-income workers, is the level of unemployment benefit
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In such a situation a reduction in unemployment benefit may
induce an increase in labour supply
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It is also important that unemployment benefit is not reduced to such a level that
workers are unable to leave their jobs to search for better ones, as this may effect
the flexibility of the labour market
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Most people accept that income tax should be progressive (that those
on relatively high incomes should pay a higher rate of tax than those on low incomes)
as a way of redistributing income within society and preventing inequality from
becoming extreme
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Again, however, it is
important to balance these incentive effects against the distortion caused by having
too much inequality in society
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However, critics
say it has failed all these objects as
bad employers can still pay workers by piecework rate so they are not paid by the
hour also there are criticism of the resulting increase in unemployment due to its
effect on the demand for labour
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However, there is an increased
incentive to work to there is more demand for the jobs at that wage rate
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Trade unions have three main objectives: wage bargaining,
improvement of working conditions and security of employment for their members
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From the
point of view of allocative efficiency, the problem is that trade union intervention in
the market may prevent wages from acting as reliable signals to workers and firms,
and therefore may lead to suboptimal allocation of resources
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One of the greatest criticisms of trade unions is they have affected the flexibility of
the labour market especially with the limitation of workers into a market
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Market Failure
Causes of market failure
A market failure is a situation in which the free market mechanism does not lead to
an optimal allocation of resources – for example, where there is a divergence
between marginal social benefit and marginal social cost
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However, this does not always happen due to



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•

•

externalities
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It is important that consumers understand the benefit of
consuming particular goods or services in order to assess how much they are
willing to pay (for instance people may not know the dangers of smoking)
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Public goods: they cannot be provided by a free market, there is no way that
the government could charge for these so they just make a loss on them
which is a market failure
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In some commodity
markets, there is an inherent instability that can lead to volatility in prices which
prevents prices from acting as reliable signals which is market failure an example of
which is with oil prices
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Externalities
An externality simply describes a cost or a benefit that is external to the market
mechanism
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In other words, there may be a cost or benefit to a
transaction to a third party not involved in the transaction
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Two examples
of externalities are:
•



Toxic fumes: this is a negative
externality
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The firm does
not face these costs and therefore it
leaves a private cost to the locals
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The social
cost of producing a good includes both
private and external costs and the
marginal social cost is the cost to society
of producing one extra unit of a good
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Thus MSC represents the total costs imposed on society in the
production of this good
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The market equilibrium will therefore be at QP
where firms just break even on the marginal unit sold
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The
optimal position is in fact as Q1 where social benefit is equal to marginal
social cost
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Less of the good will be consumed but less pollution will be
produced and therefore society will be better off
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•

Christmas lights: this leads to a
positive externality as people are
cheered by them
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MPB represents the
marginal private benefits gained by the
owners of the lights but MSB represents
the full marginal social benefit that the
community gains, which is higher than
the MPB
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However, if
the full social benefit received are taken into account, Q1 would be the
optimum point: if they residents do not provide enough decorations to reach
Q1 then there will be a welfare loss which is the amount of social benefit
forgone if the outcome is at Q instead of Q1

Externalities and transport
When deciding whether or not to undertake a journey, drivers will balance the
marginal private cost of undertaking journeys
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The MPC curve incorporates the cost to the motorist of joining a congested
road, and the chosen number of journeys will be at Q (on the diagram on the
previous page)
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Thus the marginal social costs (MSC) of undertaking journeys
are higher than the cost faced by any individual motorist
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Society would be better off with lower congestion: that is with the number
of journeys undertaken being limited to Q1, where marginal social benefit equals
marginal social cost
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Social cost-benefit analysis
Social cost-benefit analysis is a procedure for bringing together the information
needed to make appropriate decisions on large-scale schemes
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It would have to include economic costs and benefits, opportunity
cost, change of the quality of life for locals, social cost and benefits,
environmental costs and benefits, indirect and direct costs and benefits
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For some indirect effects as well as social and
environmental ones a shadow price would need to be made
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• Discounting the future: it is also important to remember that costs and
benefits will flow from the project at some point will need to be expressed in
terms of their value in the present
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In order to incorporate this into this calculations, we need to
discount the future at an appropriate rate, and calculate the net present value
of the future stream of costs and benefits associated with the project under
consideration
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Dealing with externalities
Externalities arise in situations where there are items of cost or benefit associated
with transactions, and these are not reflected in market prices
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One
approach to dealing with such market situations is to bring those externalities into the
market mechanism – a process known as internalising an externality
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Suppose that a chemicals firm produced toxic fumes and therefore imposed costs on
society that the firm themselves do not have to deal with
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At this point, marginal social benefit is below the marginal cost of
producing the chemicals, so it can be claimed that ‘too much’ of the product is being
produced
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The tax would be the value between the vertical distance of the MPC and the MSC
on the welfare loss
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Also there are
variations in the amount of pollution produced due to variation in technology so there



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are questions over whether taxes should be made on an individual level or as just a
flat rate
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These permits are
then tradable, so that firms that are relatively ‘clean’ in their production methods do
not need to use their full allocation of permits can sell their polluting rights to other
firms, whose production methods produce greater levels of pollution
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In this sense, the government uses the market for permits to address
the externality problem – in contrast to direct regulation of environmental standards,
which tries to solve the pollution by overriding the market
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However, the permit system does have its faults in that it is hard to enforce with
sanctions needing to be harsh in order to disincentivise firms from going over their
allowed limit
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There are also questions over the number of permits
that should be provided initially
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It does mean that some firms are able to pollute as
much as they want if they purchase enough permits but these firms will not want a
reputation as heavy polluters and therefore may strengthen incentives to reduce
pollution levels
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Property rights
One of the reasons underlying the existence of some externalities is that there is a
failing in the system of property rights
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One way of viewing this is
that the firm is interfering with local residents’ clean air
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However, the problem is that, with such a wide range of
people being affected to varying degrees (according to prevailing winds and how far
away they live from the factory), it is impossible in practical terms to use the
assignment of property rights to internalise the pollution externality
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It may also be difficult to introduce property rights
into a situation where they previously had not existed before
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Other Forms of Market Failure
Public and private goods
Private goods are goods that one consumed by one person, cannot be consumed by
somebody else; such a good has the following characteristics:
• Other people can be excluded from consuming it (excludability)
• Once consumed by one person, it cannot be consumed by another (rivalrous)
Not all goods and services have these characteristics
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In other words people cannot be excluded from
consuming them and they do not diminish through consumption
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They key feature of this market is that, once the good has been
provided, there is no incentive for anyone to pay for it – so the market will fail, as no
firm will have the incentive to supply the good in the first place
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Public goods are always supplied by the
government due to the lack of incentive for private firms to supply them
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Sometimes the responsibility is
delegated to local authorities and firms are subcontracted or taxes are raised to pay
for them but they are provided nonetheless
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Ideally all traders in a market should have the same information about
market conditions – a system known as symmetric information
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Producers need to be able to observe how consumers react to prices
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However, there are
some markets in which not all traders have access to good information, or in which
some traders have more or better access to it than others
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Examples of information failure exist in healthcare with consumers not knowing if
recommended treatment is necessary
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These information failures can be solved by improved information flow
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New international competitors present new challenges for domestic



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producers, and domestic firms develop new skills and specialisms
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A critical part of this
process is that factors of production need to be redeployed over time, from sectors
producing goods that are no longer in strong demand to sectors that are expanding
in the face of increasing demand
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There may be barriers to this process if factors of production do not
switch readily between activities, and such barriers may constitute another form of
market failure
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There are many reasons for labour immobility such as: training is needed
before people have the skills required for employment in the expanding sectors,
geographical immobility (queues on council house lists in certain areas) also
information failure
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Firms are unwilling to provide training schemes themselves due to
the free rider problem as people may use the training and then work for another firm
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The
government can also offer relocation subsidies as well as subsidising economic
activity in struggling areas
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The onions would have a very steep supply curve
due to very limited time onions can be stored for
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The solution to this and to
years when the supply is vast and the equilibrium price is very low are buffer stock
schemes which are used to make prices stable
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This scheme can be effective in stabilising
prices: indeed it can also stabilise the quantity traded through time
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If the price is too high then
the buffer scheme will find itself buying up more grain than it sells
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On the other hand if the price is set too
low a level, the scheme will not have sufficient stocks to be able to prevent prices
rising in times of poor harvest
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This occurs when price is not set equal to marginal cost, or where
marginal social benefit is not equal to marginal social cost
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In other words, market failure is often viewed as a
valid reason for governments to intervene in the economy
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For example, this might be done by making sure that firms that
cause pollution face the true costs of their production activities
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Public goods: the problem with public goods arises from the free-rider problem
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In such circumstances, some sort of intervention is needed to ensure that the
correct quantity of such public goods is produced
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Imperfect market information: a natural way of dealing with this is by spreading
correct information
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Labour immobility: depends on the cause of the immobility
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Education and training may also be used to solve
problems of structural unemployment and occupational immobility
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Government failure
Policies are often introduced by the government with the aim of correcting a market
failure
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Indeed, in some cases government
intervention may introduce new market distortions, leading to a phenomenon known
as government failure
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Minimum wage: by introducing a minimum wage it will have two effects on the
market situation
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Second, more workers will be prepared to offer themselves for
employment at the higher wage, so labour supply will rise
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So the workers who keep their job and their wage rises are
better off, however, those who are now unemployed are worse off
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This has the effects that firstly landlords
cannot afford to supply as much housing to the supply falls
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Sales tax: governments like to raise money through indirect taxes such as VAT or
exercise duties on such items such as alcohol or tobacco
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This means that this is
not the perfect allocation of resources as the government has moved it away from its
market equilibrium
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For instance with drugs such as cocaine: there will be people who
would take it if it were legal for recreational use and there are addicts whose demand
is highly inelastic
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Price instability and the Common Agricultural Policy (CAP): the government
provides a lot of attention to agriculture as they do not wish to import food from
overseas
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It guaranteed prices for their crops, however, these prices were higher than the
prices that usually existed in world markets
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The policies
have been set up in order to tackle the growing problems in Europe
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As many farmers
migrate to the cities, the supply curve shifts to the left and the demand curve shifts to
the right which further increases the dependency on imports
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There have also been issues with the EU accused of
having butter mountains and wine lakes as they have been forced to buy up all this
stock and farmers can produce as much as they want knowing the EU will purchase
their goods
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