Economics Theme 1 Revision

• ceteris paribus - other things being equal
• Positive statement - one which is verifiable or testable using facts
• Normative statement - involves a value judgement about what ought to be
• For any society in the world, the fundamental economic problem faced is that of scarcity - a situation that arises when people have unlimited wants in the face of limited resources
• Goods that are scarce are known as economic goods
• The key issue that arises from the existence of scarcity is that it forces people to make choices. Each individual must choose which goods and services to consume. Everyone needs to prioritise the consumption of whatever commodities they need or would like to have, as they cannot satisfy all their wants. At the national level, governments have to make choices between alternative uses of resources.
• Opportunity cost - the loss of alternatives when one alternative is chosen. Assuming the best choice is made, it is the cost injured by not enjoying the benefit that would be had by taking the second best choice available - the value of the next-best alternative forgone.
• Marginal analysis - an approach to economic decision making based on considering the additional (marginal) benefits and costs of a change in behaviour.

• Factors of production - resources used in the production process:
• Labour - the human input into the production process
• Enterprise/Entrepreneurship - the people who organise production
• Capital - inputs that are the product of a manufacturing process (machines, roads, factories which humans have produced in order to produce other goods and services)
• Land - the natural resources available for production
• The factors of production can be remembered using the acronym CELL.
• Renewable resources - natural resources that can be replenished
• Non-renewable resources - natural resources that once used cannot be replenished

• Production possibility frontier (PPF) - a curve showing the maximum combinations of goods or services that can be produced in a given period with available resources
• Division of labour - a process whereby the production procedure is broken down into a sequence of stages, and workers are assigned to a particular stage

Advantages of specialisation

• Higher output - total output of goods and services is raised and quality can be improved 
• Variety - consumers have improved access to a greater variety of higher quality products
• A bigger market - offering opportunities for economies of scale
• Competition and lower prices
• Raises output per person, thereby reducing costs per unit
• Low unit costs allow firms to remain competitive in the markets in which they operate

Disadvantages of specialisation

• May eventually reduce efficiency and increase unit costs because unrewarding, repetitive work lowers worker motivation and productivity
• Diseconomies of scale
• If one machine breaks down then the entire factory stops
• Some workers may receive very narrow training and may not be able to find alternative jobs if they find themselves out of work
• Mass-produced standardized goods tend to lack variety
• Some products cannot be mass produced
• Limited by the size of the market

• The problem with a barter economy is that you need to find someone who wants what you have and who has what you want - a double coincidence of wants.
• Hence the importance of money as a 'medium of exchange'
• Money acts as a store of value - it can be used as one way of storing wealth for future purchases
• It allows the value of goods, services and other assets to be compared - it provides a unit of account
• Prices of goods reflect the value that society places on them so money is also a measure of value
• It acts as a standard of deferred payment - e.g. when making contracts.

• Market economy - an economy in which market forces are allowed to guide the allocation of resources. Prices pay a key role in this sort of system, providing signals and incentives to producers and consumers. Adam Smith argued that in such a system resources would be allocated effectively through the operation of an 'invisible hand'. This guides firm to produce the goods and services that consumers wish to consume. Karl Marx argued that in a capitalist society in which there is private ownership of productive resources, the owners of capital woud exploit their position at the expense of labour.

• Command economy - an economy in which decisions on resource allocation are guided by the state
• Mixed economy - an economy in which resources are allocated partly through price signals and partly on the basis of intervention by the state

• The assumption is made that rational consumers set out to maximise their utility and that firms aim to maximise profits.
• Demand - the quantity of a good or service that a consumer is willing and able to buy at a given price in a given period
• Market demand is the total quantity of a good or service that all potential buyers would choose to buy at a given price
• Diminishing marginal utility - describes the situation where an individual gains less additional utility from consuming a product, the more of it is consumed. 
• Law of demand - a law that states that there is an inverse relationship between quantity demanded and the price of a good or service, ceteris paribus
• The demand curve slopes downward because:
• Substitution effect - if the price of a commodity goes up, consumers may find other goods more attractive and choose to buy something else
• Income effect - as the price of a commodity falls, it increases the real income of the consumer who can then buy more of all goods

• As the PRICE of a good changes, a MOVEMENT along the demand curve will occur, as consumers adjust their buying pattern in response to the price change - extension or contraction.
• If any of the other influences (income, prices of other goods, preferences) on demand change, you would expect to see a SHIFT of the whole demand curve.
• It is sometimes argued that for some goods a 'snob effect' may lead to the demand curve sloping upwards. The argument is that some people may value certain goods more highly simply because their price is high, especially if they know that other people will observe them consuming these goods.

• Normal good - one where the quantity demanded increases in response to an increase in consumer incomes, e.g. foreign holidays
• Inferior good - one where the quantity demanded decreses in response to an increase in consumer incomes, e.g. bus journeys

• Substitutes - two goods are said to be substitutes if the demand for one good is likely to rise if the price of the other good rises, e.g. two similar breakfast cereals
• Complements - two goods are said to be complements if an increase in the price of one good causes the demand for the other good to fall, e.g. breakfast cereals and milk or cars and petrol

Demand, consumer preferences and other influences

• This refers to whether you like or dislike a good
• Firms may try to influence your preferences through advertising
• Your preferences may be swayed by other people's demand
• Change in popularity of a good
• Expectations about future price changes also influence demand

• Price elasticity of demand (PED) - a measure of the sensitivity of quantity demanded of a good or service to a change in its price. It is measured as:
• % change in quantity demanded / % change in price
• Because the demand curve is downward sloping, the elasticity will always be negative. The minus sign can be ignored.
• When the demand is highly price sensitive, the percentage change in quantity demanded will be large relative to the percentage change in price. Relatively elastic - a term used when the PED if greater than 1 but less than infinity.
• When demand is not very sensitive to price, the percentage change in quantity demanded will be smaller than the original percentage change in price. Relatively inelastic - a term used when the PED is less than 1 but greater than 0.
• At the halfway point of a demand curve the elasticity is exactly -1, and demand is referred to as unitary elastic
• For an elastic good, a price increase will mean a fall in total revenue. For an inelastic good, a price increase will mean a rise in total revenue. Thus, if a firm is aware of the PED for its product, it can anticipate consumer response to its price changes, which may be a powerful strategic tool.

Influences on the PED

• Availability of substitutes - goods that have close substitutes available will tend to be more elastic
• Necessity or luxury - if a good is a necessity, then demand for it will tend to be inelastic, whereas if a good is regarded as a luxury, consumers will tend to be more price sensitive
• The relative share of the good or service in overall expenditure - inexpensive items tend to have relatively inelastic demand, but consumers will tend to be much more sensitive to price when a significant proportion of their income is involved
• Time period - consumers may respond more strongly to a price change in the long run than in the short run

• Income elasticity of demand (YED) - a measure of the sensitivity of quantity demanded to a change in consumer incomes. It is defined as:
• % change in quantity demanded / % change in consumer income
• The YED can be positive or negative. 
• For NORMAL goods the YED will be POSITIVE
• For INFERIOR goods the YED will be NEGATIVE
• Luxury good - one for which the YED is positive, and greater than 1, such that as income rises, consumers spend proportionally more on the good. 
• Necessity - a good for which the YED is positive, and less than 1, such that as income rises, consumers spend proportionally less on the good

• Cross-price elasticity of demand (XED) - 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. It is defined as:
• % change in quantity demanded of good X / % change in price of good Y

• If XED is POSITIVE, then the goods are regarded as SUBSTITUTES. 
• If XED is NEGATIVE, then the goods are likely to be COMPLEMENTS.
• If the XED were seen to be zero, this would indicate that the goods were unrelated.
• A high value for XED indicates that two goods are strong substitutes/complements.

• Supply - the quantity of a good or service that firms choose to sell at any possible price in a given period
• Competitive market - a market in which individual firms cannot influence the price of the good or service they are selling, because of competition from other firms
• As firms are expected to supply more goods at a higher price than at a lower price, the supply curve will be upward sloping.

• If any of the influences on supply change, the supply curve can be expected to shift:
• Production costs - an increase in production costs induces firms to supply less output at each price
• The technology of production - if a new technology of production is introduced, which means that firms can produce more cost-effectively, this could have the opposite effect, shifting the supply curve to the right
• Taxes and subsidies - if the government imposes a sales tax (e.g. VAT), the price paid by consumers will be higher than the revenue received by firms, as the tax has to be paid to the government. This means that firms will (ceteris paribus) be prepared to supply less output at any given market price. The supply curve shifts to the left. If the government pays firms a subsidy to produce a particular good, this will reduce their costs, and induce them to supply more output at any given price. The supply curve shifts to the right.

• Prices of other goods - if a product which is a substitute in supply becomes more profitable to supply than before, producers are likely to switch from the first good to this alternative. A firm may produce a range of goods jointly, e.g. if one good is a by-product of the production process of the other. An increase in the price of one of the goods may mean that the firm will produce more of both goods.
• Firms' expectations about future prices - a firm may allow stocks of a product to build up in anticipation of a higher price in the future, perhaps by holding back some of its production from current sales.

• If there is a change in the market price, this induces a movement along the supply curve.
• A change in any of the other influences on supply will induce a shift of the whole supply curve.

• Price elasticity of supply (PES) - a measure of the sensitivity of quantity supplied of a good or service to a change in the price of that good or service. It is defined as:
• % change in quantity supplied / % change in price
• If the elasticity is greater than 1, supply is referred to as being relatively elastic.
• If the value is between 0 and 1, supply is considered relatively inelastic.
• Unitary elasticity occurs when the PES is exactly 1.
• The value of the PES will depend on how able and willing firms are to respond to a change in price.
• If a firm is currently running below full capacity, then it may be able to respond quickly to an increase in price.
• If the firm is holding stockpiles of goods ready to be sold, then it may be able to respond quickly to an increase in the selling price of the good.
• If the firm needs to pay overtime to its workers, or to rent new buildings or hire additional machinery in order to expand production, then the increase in costs may not justify responding to the increase in price.
• The willingness of the firm to expand output may also depend on whether the firm expects the change in price to be permanent or temporary.

• It may be more feasible for firms to change their supply decision in the long run than in the short run. 
• E.g. 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.
• Supply can be expected to be more elastic in the long run than in the short run.
• An important issue here is whether the nature of the good is such that it is possible for firms to hold stocks of the good, which might allow them to expand sales in the short run even if it takes time to expand production. The extent to which goods can be stored in this way will reflect the nature of the good concerned, e.g. depending on whether or not the good is perishable, or costly to store.
• However, firms can become more flexible in the long run by installing new machinery or building new factories, so supply can then become more elastic. 

• Market equilibrium - a situation that occurs when the price is such that the quantity that consumers wish to buy is exactly balanced by the quantity that firms wish to supply
• Consumer surplus - the difference between the total amout that consumers are willing and able to pay for a good or service and the total amount they actually do pay
• Marginal social benefit (MSB) - the additional benefit that society gains from consuming an extra unit of a good
• Producer surplus - the difference between the price received by firms for a good or service and the price at which they would have been prepared to supply that good or service

• Price mechanism - describes the means by which decisions taken by consumers and businesses interact to determine the allocation of scarce resources between competing uses.
• The price mechanism ensures that an equilibrium point is reached between demand and supply in a free market.

Signalling function - associated with shifts in either demand or supply:

• Price changes send contrasting messages to consumers and producers about whether to enter or leave a market.
• A rightward shift of the demand curve leads to an increase in the equilibrium price, which encourages producers to supply more of a good - there is movement along the supply curve. Producers find it profitable to expand their output at that higher price. The price level is thus a signal to producers about consumer preferences.
• Producers in a market receive signals from consumers in the form of changes in the equilibrium price, and respond to these signals by adjusting their output levels.
• Marginal cost - the cost of producing an additional unit of output
• Rising prices give a signal to consumers to reduce demand or withdraw from a market completely, and they give a signal to potential producers to enter a market. This in turn will tend to shift the supply curve to the right, as there will then be more firms prepared to supply. As a result, the equilibrium market price will tend to drift down again, until the market reaches a position in which there is no further incentive for new firms to enter the market.
• Conversely, falling prices give a positive message to consumers to enter a market while sending a negative signal to producers to leave a market.

Incentive function - associated with an extension/contraction along the supply curve

• A rightward shift of the demand curve leads to an increase in the equilibrium price, which encourages producers to supply more of a good - there is movement along the supply curve. Producers find it profitable to expand their output at that higher price. The price level is thus a signal to producers about consumer preferences.
• Producers in a market receive signals from consumers in the form of changes in the equilibrium price, and respond to these signals by adjusting their output levels.
• Marginal cost - the cost of producing an additional unit of output
• Higher prices act as an incentive to raise output (extension) because the supplier stands to make a better profit - as demand is now higher
• When demand is weaker (shift to the left) in a recession then supply contracts as producers cut back on output

Rationing function - associated with extension/contraction along the demand curve

• Prices serve to ration scarce resources when demand in a market outstrips supply.
• When there is a reduction in supply, the price is bid up - leaving only those with the willingness and ability to pay to purchase the product. The price keeps increasing until a point where demand = supply..
• The rationing function 'clears the market' of any consumers who do not have a willingness and ability to pay for a product, leaving only those consumers that are able to.

• In tackling the fundamental problem of scarcity, a society needs to find a way of using its limited resources as effectively as possible. 
• On one hand, there is the question of whether society is operating on the PPF curve, and thus using its resources effectively.
• On the other hand, there is the question of whether society is producing the balance of goods that consumers wish to consume. This aspect of efficiency is known as allocative efficiency - achieved when society is producing an appropriate bundle of goods relative to consumer preferences.

• Tax - a compulsory contribution to state revenue, levied by the government
• Direct tax - a tax which is levied/charged on the income or profits of the person who pays it, rather than on goods or services
• Indirect tax - a tax levied on expenditure on goods or services. It involves an intermediary (retailer) to collect the tax, before the government receives it.
• Indirect taxation shifts the supply curve to the left because it increases the costs of production.
• Indirect tax effectively adds to the cost of production, as the producer has to ensure it gets paid.
• Although the producer may be responsible for the mechanics of paying the tax, part of the tax is effectively passed on to the consumer in the form of the higher price.
• Incidence of tax - the way in which the burden of paying a sales tax is divided between buyers and sellers
• Two types of indirect taxation:
• Specific tax - a tax that is defined as a fixed amount for each unit of a good or service 
• Ad valorem tax - a tax whose amount is based on the value of a transaction - the tax is a percentage 

• Evaluation: the effectiveness of taxes is dependent on the PED of the good or service. When the demand curve is inelastic, the tax is less effective.
• For products with an inelastic PED, the incidence of tax will be placed mostly upon the consumer. Consumers will still buy the product, despite the tax, so the producer chooses to pass most of the tax burden onto the consumer.
• For products with an elastic demand curve, the incidence of tax will be placed mostly upon the producer. Producers are conscious of increasing tax for consumers so they absorb a lot of it themselves. If consumer tax was high, people would stop buying the product.

• Subsidy - a grant given by the government to producers to encourage production of a good or service.
• For a good with an inelastic demand curve, producers know that they will have to pass on a large amount of the subsidy, in order to get a reasonable change in Q (quantity).
• For a good with an elastic demand curve, producers know that they only have to pass on a small amount of the subsidy, to get a larger change in Q. The rest of the subsidy would be kept by the firm. 

• Market failure - a situation in which the free market mechanism does not lead to an optimal allocation of resources, e.g. where there is a divergence between marginal social benefit and marginal social cost
• Externality - a cost or a benefit that is external to a market transaction, and is thus not reflected in market prices
• Causes of market failure:
• Externalities
• Information failure (information gaps) 
• If markets are to perform a role in allocating resources, it is essential that all relevant economic agents (buyers and sellers) have good information about market conditions; otherwise they may not be able to make rational decisions.
• Public goods
• Because of their characteristics, these goods cannot be provided by a purely free market, e.g. street lighting.
• Merit and demerit goods
• There are some goods that the government believes will be underconsumed in a free market. If people do not fully perceive the benefits to be gained from consuming a good, then they will demand less than is socially desirable, e.g. education. There are also some goods that the government believes will be overconsumed in a free market, e.g. drugs.

Externalities

• An externality will lead to a form of market failure becuase, if the cost or benefit is not reflected in market prices, it cannot be taken into consideration by all parties to a transaction.
• There may be costs (or benefits) resulting from a transaction that are borne (or enjoyed) by some third party not directly involved in that transaction.
• Externalities can affect either demand or supply in a market: they may arise in consumption or production.
• Private cost - a cost that is experienced by the individual/firm that has consumed the product or service.
• External cost - a cost associated with an individual's (a firm or household's) production or other economic activities, which is borne by a third party and is not reflected in market prices.
• Social cost - a cost experienced by third parties as a result of consumption of a product or service by another individual (private cost + external cost)
• Marginal social cost - the cost to society of producing an extra unit of a good

• Evaluation: we are never sure what the quantity Q* is exactly and therefore it is difficult for the government to intervene, as they do not know how much they need to intervene. 

• Private good - a good that, once consumed by one person, cannot be consumed by somebody else; such a good has excludability and is rivalrous
• Other people can be excluded from consuming it - excludability
• Once consumed by one person, it cannot be consumed by another - rivalrous
• Public good - a good that is non-exclusive and non-rivalrous in consumption - consumers cannot be excluded from consuming the good, and consumption by one person does not affect the amount of the good available for others to consume, e.g. street lighting, a lighthouse and a nuclear deterrent
• Free-rider problem - when an individual cannot be excluded from consuming a good, and thus has no incentive to pay for its provision
• So the marktet will fail, as no firm will have an incentive to supply the good in the first place.
• There are many goods that have some but not all of the required characteristics of a public good - they are either non-rivalrous or non-excludable but not both. These are called quasi-public goods. e.g. toll roads can exclude users from consuming it.
• For some public goods, the failure of the free market to ensure provision may be regarded as a serious problem. Some government intervention may thus be needed to make sure that a sufficient quantity of the good or service is provided.

• This does not necessarily mean that the government has to provide the good itself. It may be that the government will raise funds through taxation in order to ensure that a good is provided.
• In the UK, it may be that the government delegates the responsibility for provision of public goods to local authorities, which in turn may subcontract to private firms.

• If markets are to be effective in guiding resource allocation, it is important that economic decision-makers receive full and accurate information about market conditions. 
• Ideally, all traders in a market should have the same information about market conditions - a situation known as symmetric information.
• Asymmetric information - a situation in which some participants in a market have better information about market conditions than others - a source of market failure.
• There are some goods that the government believes will be undervalued by consumers, so that too little will be consumed in a free market. In other words, individuals do not fully perceive the benefits that they will gain from consuming such goods, or do not have enough information to take decisions that are best for society. These are known as merit goods.

• Markets fail when the price mechanism causes an inefficient allocation of resources within a society, e.g. when marginal social benefit is not equal to the marginal social cost.
• Government failure - a misallocation of resources arising from government intervention that causes a divergence between marginal social benefit and marginal social cost.
• E.g. in the case of externalities, the government may choose to tackle pollution by a tax, or by regulation. However, if it is not possible to identify the appropriate amount of the tax that is needed to correct the market failure, or if it is not known how many pollution permits need to be issued to reach the optimum outcome for society, then it will not be possible to get the policy exactly right.

• Governments need to raise funds to finance the expenditure that they undertake. One way of doing this is through expenditure taxes such as value added tax (VAT) or excise duties on such items as alcohol or tobacco. 
• The government has raised revenue as a result of the tax, so we might argue that the funds rasied can be used in a way that benefits society as a whole. 
• However, a market reaches an equilibrium such that the price of a product is equal to the marginal cost of producing it. By imposing a tax, the market has been moved away from the ideal state of affairs. By imposing a tax to raise funds for correcting market failure in one part of the economy, the government introduces a misallocation of resources elsewhere.

• Internalising an externality - an attempt to deal with an externality by bringing an external cost or benefit into the price system, e.g. the London congestion charge
• In the case of pollution, this principle would entail forcing the polluting firms to face the full social cost of their production activities. One approach would be to impose a tax on firms. However, there is another possibility - to impose environmental standards, and to prohibit emissions beyond Q*. This amounts to controlling quantity rather than price; and, if the government has full information about marginal costs and marginal benefits, the two policies will produce the equivalent result.

• The marginal social benefits of reducing pollution cannot be measured with great precision, for many reasons. It may be argued that there are significant gains to be made in terms of improved health and lower death rates if pollution can be reduced, but quantifying this is not straightforward. e.g. quantifying the direct improvements to quality of life.
• The measurement of costs may also be problematic. It is likely that there will be differences in the efficiency between firms. Those using modern technology may face lower costs than those using relatively old capital equipment. If authorities set a flat-rate tax, then the incentives may be inappropriate.

• Pollution permits - the government issues or sells permits to firms, allowing them to pollute up to a certain limit. 1 carbon unit = 1 tonne of CO2. These permits are then tradeable, so that firms that are relatively 'clean' in their production methods and 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.
• Advantages:
• Firms that pollute because of their relatively inefficient production methods will find they are at a disadvantage because they face higher costs. Rather than continuing to purchase permits, they will find that they have an incentive to produce less pollution.
• In this way, the permit system uses the market to address the externality problem - in contrast to direct regulation of environmental standards, which tries to solve pollution by overriding the market.
• The overall level of pollution can be controlled by this system, as the authorities control the total amount of permits that are issued.
• Disadvantages:
• For the system to be effective, sanctions must be in place for firms that pollute beyond the permitted level, and there must be a operational and cost-effective method for the authorities to check the level of emissions.

• It may not be straightforward for the authorities to decide upon the appropriate number of permits to issue in order to produce the desired reduction in emission levels.
• The very different levels of pollution produced by different firms may seem inequitable - as if those firms that an afford to buy permits can pollute as much as they like.

• Global warming is widely seen to require urgent and concerted action at a worldwide level. The Kyoto Summit of 1997 laid the foundations for action, with many of the developed nations agreeing to take action to reduce emissions of carbon dioxide and other greenhouse gases that are seen to be causing climate change.
• The absence of the USA is significant as the USA was the world's second largest emitter of CO2, responsible for about 1/4 of the world's greenhouse gas emissions.
• Countries agreed to reduce greenhouse gas emissions by 5%, 2008-2012, compared to 1990 levels.
• The method chosen was based on a tradable pollution permit system.
• China was reluctant to negotiate beyond Kyoto, which is significant, as China is the world's largest emitter of greenhouse gases.

• NIMBY (not in my back yard) - a syndrome under which people are happy to support the construction of an unsightly or unsocial facility, so long as it is not in their own area

• In some markets, governments have been seen to intervene to regulate price directly. 
• If the government regards the level of rent as excessive, to the point where households on low incomes may not be able to afford rented accommodation, then, given that housing if one of life's necessities, it may regard this as unacceptable. The temptation for the government is to move this market away from its equilibrium by imposing a maximum price (level of rent) that landlords are allowed to charge their tenants. 
• Firstly, landlords will no longer find it profitable to supply as much rental accommodation, and so will reduce supply. Second, at this lower rent there will be more people looking for accommodation, so that demand for rented accommodation will increase.
• The government failure occurs in that there is less accommodation available and subsequently, more people are left homeless. 

• Prohibition - an attempt to prevent the consumption of a demerit good by declaring it illegal

• Provision of information is when the government attempts to close the information gap and create symmetric inforrmation, e.g. passing a law to force suppliers to include information about a product or paying for advertisement campaigns.