AQA Economics Unit 1- Markets & Market Failure


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  • Created on: 17-05-12 06:48

Economic Problem

Economics= - Study of how people make choices

                     - How to produce

                     - Whom to produce

in a world where resources are limited

Ultimate purpose/ objective= Increase economic welfare (peoples happiness)

Fundamnetal economic problem= Scarcity (wants= infinite, resources= limited)

- Increase consumption generally increase economic welfare (known as 'Utility'), although can lead to reductions in welfare.

- Increased production can increase economic welfare if it increases consumption, but can lead to 'Depletion' (using scarce resources) & 'Degradation' (pollution/ destruction of natural enviornment)

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- Land (Anything above/ below earth's surface)

- Labour (Humans)

Human capital, refers to the value of workers, due to skills/ productvity

- Capital (Machinery/ equipment)

- Enterprise (refers to individuals who organise production or shareholders)


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Consumer Goods= Goods bought for direct consumption (e.g. food)

Capital Goods= Good bought for indirect consumption/ bought to produce other goods (e.g. machinery)

Free Goods= Not scarce/ not payed for (e.g. air)

Economic Goods= Any other good (e.g. personal electronics)

Public Goods=are non-exludable/ non- rivalrous, meaning open for consumption by anyone (e.g. lighthouses)

- Pure public goods occur when it's impossible to exclude 'free-riders)

- Non- pure means that methods can be devised to convert the goods to private

Private Goods=  are exludable (allowing firms to prevent those who have not payed for the good to enjoy it's benefits) and rivalrous (consumption by one, prevents consumption by another) (e.g. cars)

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Opportunity Costs

Opportunity Costs are the cost, which emerges from choosing one good over another (Free goods have no opportunity cost)

A PPF ( production possibility frontier) is a visual represenation of the basic economic problem

- A PPF shows the various combinations of consumer/ capital goods that an economy can produce when all available economic resources are used to the full.

- There is no ideal point on the curve

- If an economy is not producing goods efficiently ( due to unemployed workers/ idle factories) it'll be at a point within the PPF curve.

- The economy can't be operating outside of its PPF curve, with it's current level of resources

- Economic Growth causes the PPF curve to shift outwards

- Trading- Off occurs when chosing between two goods

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Value Judgements

Economics concerns two types of investigation:

- Positive statements: Statements that can be proven true or false

e.g. The UK economy is currently operating on its production possibility boundary- economists can search for evidence and thus prove it's legitimacy.

- Normative Statements: Statements which can be supported or refuted (often containing the words, 'ought to', 'should' and 'might'. They're ultimately opinions about how the economy should operate

e.g. The government should increase pension funds- this statement is a clear opinion.

Normative statements are often backed up by positive statements

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Economic Objectives

- Firms= Profits

- Workers= To maximise their own welfare at work (higher earnings/ fringe benefits)

- Households= Utility (Consumers aiming to maximise their economic welfare)

- Governments= Maximise public interest/ social welfare

People are assumed to be rational (always trying to choose best possible outcome)

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Economic Systems

Free market economies:

Decisions are made largely by private individuals and firms. They decide what to produce, how to produce and for whom to produce. E.g. private hospitals provide health care and can chose who to treat/ how much to charge

Planned/ Command Economies:

Decisions are made by the government. The government makes plans about what/ how/ whom to produce, therefore resources are allocated by the government through a system of planning. E.g. the government would provide hospitals which would probably be free

Mixed Economy

Some decisions are made by private individuals/ firms, and some are made by the government. Therefore some resources are allocated by the forces of supply/ demand and others by the state planning system.

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Demand curve= Quantity of a good that consumers plan to purchase at a price, drawn under the assumption that all conditions remain constant except the price

Demand= What consumers would like to buy

Effective demand= What consumers are willing/ able to buy

Conditions of Demand:

P opulation

I ncome

R elated products (substitute/ complementary goods)

A dvertising

T astes/ fashions

E xpectations (of consumers for the good)

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Supply Curve= Quantity producers plan to supply at different prices, drawn under the assumption that all conditions remain constant except the price

Movement= Change in price

Shift= Change in any of the other conditions

Conditions of Supply:

S ubsidies/ taxes

C osts of production (wages/ commodity prices etc.)

R elated products (substitute/ complementary goods)

E xpectations

W eather (for crop yields etc.)

S ocial factors

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Markets exist in the market sector of an economy, and is the meeting of buyers/ sellers for the purpose of exchanging goods/ services

- Excess supply= Planned supply> Planned demand

- Excess demand= Planned demand> Planned supply

We assume firms respond to excess supply by lowering prices, whilst consumers respond to excess demand by building up prices- until market equilibrium's achieved.

- Composite demand= Demand for good with multiple uses (e.g. barley for beer/ animal feed)

- Derived demand= Demand that increases due to other goods (e.g. the demand for labour increases when consumption increases)

- Joint supply= When production of one good affects the production of a byproduct produced from he same material (e.g. beef/ leather)

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Price Elasticity of Demand

Measure consumers' responsiveness to a change in the price of a good

PED= % change in quantity demanded divided by % change in price

- If the value if greater than 1, it's price elastic

- If the value is less than 1, it's price inelastic

- If it's 1 it's unitary


- Substitutability (when substitute goods exist, consumers can easily switch goods)

- % of income (goods which households spend large portions of their income on will be more elastic)

- Width of market (is the change on just single companies, or whole industries)

- Time (It takes time to respond to price changes)

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Income Elasticity of Demand

Measures how demand responds to a change in incomes

YED= % change in quantity demanded divided by % change in incomes

- Inferior goods are always negative (e.g. cheap cars/ public transport)

- Normal goods are always positive (holidays/ branded fashions)

- Superior/ Luxury goods have a high income elasticity (yachts/ private jets)

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Cross Elasticity of Demand

Measures the change in quantity demanded cause by a change in price of another good.

CED= % change in quantity demanded of good x divided by % change in price of good Y

- Substitute goods will have a positive cross elasticity

- Complement goods will have a negative cross elasticity

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Price Elasticity of Supply

Measures the responsiveness of firms in output to a change in the price

PES= % change in quantity supplied divided by % change in price


- Length of production period (faster production time are more productive)

- Existence of spare capacity (allowing firms to produce quickly in the short run)

- Ease of accumulating stocks (unsold/ stored stocks increase elasticity)

- Ease of factor substitution (increases elasticity)

- Number of firms in the market (more firms increases elasticity)

- Time (firms are generally inelastic in the short-run, but elastic in the long-run)

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Community Surplus

Total economic welfare/ Community surplus= Consumer surplus + Producer surplus

Consumer surplus is a measure of consumer welfare (the difference between what consumers are willing to pay, and what they actually pay). It's illustrated by the area under the demand curve and above the market ruling price.

- Inelastic demand= High consumer surplus

- Elastic demand= Low consumer surplus

Producer surplus is a measure of producer welfare (the difference between what producers are willing/ able to supply a good for, and the price they actually receive). It's illustrated by the area above the supply curve and below the market ruling price.

The minimum price that a firm requires to supply to the market is shown by where the supply curve cuts the Y axis.

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Specialisation and Exchange

Specialisation= the production of a limited range of goods by an individual/ firm/ country, in corporation with others, so that together a complete range of goods is produced.

Specialisation by individuals is called 'the division of labour'.

The division of labour has it's limits, for example if jobs are divided up too much, the work can become tedious/ monotonous.

Exchange= the exchange of goods between businesses in order to complete a range of goods. E.g. the USA may exchange cars for bananas with Honduras.

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Prices/ Resource Allocation

The price mechanism:

A term used to describe the means by which millions of decisions are made every day by consumers and producers to determine the allocation of resources between competing uses. Adam Smith's 'Invisible hand' is the workings of price mechanism.

The signalling function:

Market prices adjust to demonstrate where resources are required and where they are not, reflecting surpluses and scarcities. E.g. if market prices are rising because of stronger demand, this signals producers to expand supply.

The rationing function:

Prices serve to ration scarce resources (e.g. prices rise leaving only those with the sufficient willingness/ ability to purchase the product)

The incentive function:

Incentives matter enormously- economic agents must respond to price signals

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Economies of Scale

Economies of scale= when a firm experiences falling average costs as it increases in size

- Technical economies of scale occur when, e.g. storage capacity increases

- Managerial economies of scale occur when large firms employ specialists

Diseconomies of scale= when average costs begin to rise once at a certain size

Productively efficient level of output= Highest level of output at lowest average cost of production

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Market Failure

Market failure occurs when a market/ absence of a market, leads to a misallocation of resources. Failure occurs when markets function badly, e.g. producing too much of a demerit good.

- Public goods can lead to market failure, due 'free riders' receiving benefits of the good.

- Externalities resulting in a misallocation or resources can result in market failure

- Over-consumption of merit goods/ under-consumption of demerit goods can cause market failure

- Immobility of Labour can lead to market failure (e.g. if economic resources are not fully utilised in areas of high unemployment, whilst other regions' economic growth is being held back by resource shortages)

- Monopolies exploiting prices resulting in a misallocation of resources can lead to a misallocation or resources

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Externalities are third party affects arising from production/ consumption of a good/ service (with no appropriate compensation paid). Externalities cause market failure if the price mechanism doesn't account for the social costs/ benefits.

Externalities arise when private costs/ benefits differ from social costs/ benefits

Market failure will occur if market prices/ profits don't accurately reflect the costs/ benefits to society

E.g. If a chemical plant is setting prices, these prices won't reflect their true cost to society, because the private cost of production is lower than the social cost. Therefore consumption will be higher than if the full social cost were charged, whilst water companies suffering from chemical pollution in water, will have to charge higher prices- making demand for water less than it would've been without this externality.

The greater the externality, the greater the market failure and the less the market prices/ profits provide accurate signals for optimal allocation of resources.

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Externalities (2)

Negative externalities occur when the a good/ service has negative effects on society, and therefore are often associated with demerit goods such as alcohol or smoking.

Positive externalities can also exist when the good/ service has positive effects on society and are often associated with merit goods however can also occur in other ways, for example: a company putting up a beautiful building may give more pleasure to society than the private benefit of the building's functions.

Private cost/ benefit (MPC/ MPB) = The cost/ benefit of an activity to an individual economic unit (producers/ consumers). E.g. firms paying: workers, for raw materials & plants/ machinery, or the effects of smoking for smokers.

Social cost/ benefit (MSC/ MSB) = The private cost/ benefit and the cost/ benefit to the rest of society. E.g. a chemical manufacturer may make little/ no payment for the pollution it generates, or ships may make no payment for lighthouse guidance.

External cost/ benefit (MEC/ MEB)= The cost/ benefit affecting third parties

MSC= MPC+ MEC            MSB= MPB+ MEB

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Production Externalities

Negative Externality in Production: e.g. Pollution/ burning of fossil fuels from factories

MSC> MPC                  MSB= MPB (assuming no other externalities)

Socially optimal equilibrium: MSC= MSB

Free market equilibrium: MPC= MPB

Positive Externality in Production: e.g. Bees pollinating near by crops on honey farms

MSC< MPC                 MSB= MPB (assuming no other externalities)

Socially optimal equilibrium: MSC= MSB

Free market equilibrium: MPC= MPB

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Consumption Externalities

Negative Externality in Consumption: e.g. Passive smoking from smokers

MPB> MSB                      MPC= MSC

Socially optimal equilibrium: MSB= MSC

Free market equilibrium: MPB= MPC

Positive Externality in Consumption: e.g. Healthcare reducing society's risk of disease

MSB> MPB                      MPC= MSC

Socially optimal equilibrium: MSB= MSC

Free market equilibrium: MPB= MPC

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Merit Goods

Merit Goods= Deemed as beneficial to society, due to social benefits of consumption exceeding private benefits for the consumer. Positive externalities therefore exist.

e.g. Healthcare, medicine can protect you from disease; Education & training, can improve human capital, by protecting people from crashes.

Merit goods will be under-consumed in the free market, because of an information problem, meaning that people only consider their short-term utility maximisation rather than the long term- merit good's long-term benefits exceed the short-term.

Demerit Goods= Deemed as having negative effects on society, due to social costs exceeding the private costs of consumption for the consumer. Negative externalities therefore exist.

e.g. Smoking & alcohol, both have adverse health effects although have positive effects in the short run.

Here the long- term costs exceed the short-term costs, and therefore information problems again exist.

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