What is the naure of economics?
The allocation of scarce resources to provide for unlimited human wants
Scarcity arises because there are insufficient resources to provide for everyone's wants. It forces us to make choices over the use of our limited resources to provide for our material wants.
We must choose what we produce, how we produce it and for whom we produce it for.
For example if the governent has £100 million, the decision to build a new hospital has the opportunity cost of being able to build a new school.
Factors of production:
- Enterprise (brings other factors together)
Production possibility frontiers
A production possibility frontier (PPF) shows the maximum potential level of output for two goods or services that an economy can achieve when all its resources are full and efficiently employed.
The PPF is often used to illustrate scarcity and oppurtunity cost
Capital goods are important for economic growth, since capital goods are crucial for increasing production.
Consumer goods are an indication of standards of living, and so output levels fall, living standards can also decrease.
Any point on the PPF curve indicates efficient allocation of resources, since none are being wasted. If the economy is located within it's PPF, there is an inefficient allocation of resources.
An outward shift in the PPF shows economics growth, and inward shift shows a decrease in the potential output of an economy. Possibly due to a natural disaster.
Specialisation and the Division of Labour
Specialisation occurs when an individual, a firm, a region or a country concentrates on the production of a limited range of goods and services. It has led to increases in standards of living and productivity across the world.
The UK specialises in financial services, aircraft manufacture, the production of medicinal drugs and tourism.
Specialisation can have disadvantages, notably when demand for a good or service falls, leading to a significant increase in unemployment. Also, a country specialising in the production or export of minerals may face problems of resource depletion.
The division of labour is a form of specialisation, where individuals concentrate on the production of a particular good or service.
Production is broken down into a series of tasks, conducted by different workers.
Advantages and disadvantages of division of labour
- Workers become highly skilled in their particular task. E.g. tyre fitter
- No time is wasted moving from one job to another
- Capital equipment can be used continuously in production
- Less time is required to train workers for specific tasks
- More choice of jobs for workers, they can specialise in tasks that they are most suited to
- Reduced cost per unit
- Repitition causes monotony and boredom
- Increased recruitment and selection costs for staff
- Breaking down production into staffs means it is easier to replace workers with machinery, which may lead to structural unemployment
- Specialisation creates independence in production. If one group of workers goes on strike, it could halt production across the whole industry. E.g. train drivers
Free-market and mixed economies
Free-market economy - all resources allocated by the price mechanism, no government intervention
Mixed economy - Some resources are allocated by the price mechanism and some by the government
Centrally planned economy - All resources are allocated by the government. No price mechanism
There are no completely free market economies in existence today since, in every economy, the government directly controls some resources and output.
Most developed countries have a mixed economy, examples include the UK, France, Germany, Canada, Australia and Sweden.
Positive and normative economics
Positive economics is concerned with facts and is value-free. It is a scientific approach to the discipline, where economists explain the outcome of a particular policy, but are not expected to take sides. Positive statements can be tested as true or false.
Normative economics is concerned with value-judgements and is a non-specific approach to the discipline. A normative statement is an expression that something is right or wrong and so often includes the words ought, should, fair, unfair, better or worse.
What determines the demand for a good or service i
Demand is the ability and willingness to pay for something. It may be for goods, services or labour. It is also known as effective demand.
The demand curve slopes downwards from left to right. This is because as prices decreases, more of the good is demanded and vice versa.
A fall in price causes an extension in demand, and a rise in price causes a contraction in demand.
An increase in demand refers to the whole demand curve shifting outwards to the right at every price level. A decrease in demand refers to the whole demand curve shifting inwards to the left at every price level.
There are many things that could cause these shifts, these are known as factors of demand. They include: prices of other goods (substitutes and complements), fashion and tastes, advertising, real income changes, population changes, tax changes, interest rates (rates of borrowing)
Price elasticity of demand is the responsiveness in the demand for a good due to a change in its price. The formula to calculate it is:
PED = % change in QD of good A / % change in price of good A
In most circumstances, a minus number is obtained, indicating that the two variables of price and demand move in opposite directions. There is a negative gradient.
- If PED is greater than 1 - the good is price elastic, lowering price will raise revenue
- If PED is less than 1 - the good is price inelastic, raising price will raise revenue
- If PED is equal to 1 - the good has unit elasticity, % change in demand is the same as % change in price
- If PED is equal to 0 - the good is perfectly inelastic, a change in price has no effect on QD, an example: heroin for a drug addict, demand curve is vertical
- If PED is infinite - the good is perfectly elastic, a rise in price causes demand to fall to zero, the demand curve is horizontal
Elasticity varies along a straight-line demand curve, at the mid point, demand has unit elasticity.
Determinants of price elasticity of demand
- Availability of substitutes. The more narrowly a good is define, the more substitutes it tends to have and so its demand is elastic
- Luxury and necessity goods. Luxury goods such as racing cars and caviar tend to have elastic demand, whereas necessity goods, like bread and underwear, tend to have inelastic demand
- Proportion of income spent on good. The higher this is, the higher the chance of the demand being elastic.
- Addictive and habit-forming goods. Tobacco, alcohol and coffee are the types of goods that tend to be inelastic in demand
- The time period. For most goods demand is less elastic in the short run than in the long run.
Income elasticity of demand
Income elasticity of demand is the responsiveness of demand for a good or service to a change in real income.
YED = % change in demand for good A / % change in real income
Normal goods - in most circumstances YED is positive, which means the two variables of income and demand move in the same direction
Inferior goods - Occasionally, YED is negative which means the two variables of income and demand move in opposite directions. This is because people tend to demand higher-quality goods as their incomes rise, substituting them for lower-quality products. For example bus travel.
Cross elasticity of demand
Cross elasticity of demand is the responsiveness of demand for good B to a change in price of good A
XED = % change in demand for good B / % change in price of good A
Cross elasticity of demand is used to determine whether goods are complements or substitutes for each other.
Substitute goods - are in competitive demand, so have a positive XED as the two variables of price and demand move in the same direction. Examples include PCs and Macs, or Xboxs and PS3s
Complementary goods - are in joint demand, so have a negative XED ast the two variables of price and demand move in opposite directions. Examples include DVDs and DVD players or iPods and the price of music downloads.
NOTE: an XED of zero means there is no relationship between two goods, such as computers and deodorant.
What determines the supply of a good or service in
Supply refers to the quantity of a good or service that firms are willing to sell at a given price and over a given period of time.
A supply curve slopes upwards for two reasons:
- As price rises, it encourages firms to supply more of a good to make more profit
- As firms raise output in the short run, they face rising production costs. To cover the rising costs, firms need to be able to charge higher market prices to consumers.
A rise in price causes an extension in supply, and a fall in price causes a contraction in supply
Factors of supply include: technological improvements, changes in production costs, discovery of new raw materials, weather and natural disasters, subsidies and taxes, changes in legislation
Price elasticity of supply
Price elasticity of supply is the responsiveness of the supply of a good to a change in its price. The formula to calculate PES is:
PES = % change in supply of a good / % change in price of a good
In most cases a positive answer is obtained, indicating that the two variables of price and quantity move in the same direction. There is a positive gradient
- If PES is greater than 1 - the good is price elastic, the % change in supply is greater than the % change in price of the good
- If PES is less than 1 - the good is price inelastic
- If PES is equal to 1 - the good is unit elastic
- If PES is equal to zero - the good is pefectly elastic, change in price has no effect on the quantity supplied. The supply curve is vertical
- If PES is infinite - the good is perfectly elastic. The supply curve is horizontal
Determinants of price elasticity of supply
- Level of spare capacity. A high level of spare capacity in a firm means that it can raise production quickly, so supply tends to be elastic
- The state of the economy. In a recession there are many unemployed resources and so there is a high level of spare capacity - making supply elastic
- Level of stocks of finished goods in a firm. A high level of stocks means that the firm can increase supply quickly, so supply is elastic. Alternatively, a firm with low levels of stocks is unable to raise output quickly and so supply tends to be inelastic
- Perishability of the product. Some goods cannot be stockpiled: for example, some agricultural goods such as fresh fruit, vegetables and flowers are highly perishable. These goods tend to be inelastic in supply, unlike manufactured goods.
- The ease of entry to an industry. If there are high entry barriers to an industry then it will be difficult for new firms to enter, making supply restricted and inelastic
- The time period under consideration. Probably the most important determinant. In the short run firms find it difficult to increase supply, this is because they have to use their existing capacity. In the long run firms can increase capacity and therefore can more easily raise production levels. Short run - inelastic. Long run - elastic.
What determines the price of a good or service in
Equilibrium means there is a balance in the market, with no tendancy for price or output to change. The equilibrium price and quantity of a good are obtained from the point of intersection between the demand and supply curves.
When there is an excess in supply of a good or service, there is a contraction in supply and an extension in demand until the equilibrium is reached.
When there is an excess in demand of a good or service, there is a extension in supply and a contraction in demand until the equilibrium is reached.
Thus, the price mechanism automatically eliminates surpluses and shortages of a good, something that Adam Smith referred to as the 'invisible hand' of the market.
Consumer and producer surplus
Consumer surplus is the extra amount of money consumers are prepared to pay for a good or service above what they actually pay. It is the utility or satisfaction gained from a good or service in excess of that paid for it.
Producer surplus is the extram amount of money paid to producers above what they are willing to accept to supply a good or service. It is the extra earnings obtained by a producer above the minimum price required to supply the good or service.
Functions of the price mechanism
Price is the exchange value of a good or service. The price mechanism refers to the way price responds to changes in demand or supply for a product or factor input, so that a new equilibrium position is reached in a market.
The price mechanism has several functions:
- A rationing device - resources are scarce, which means that the goods and services produced from them are limited in supply. The price mechanism allocates these goods and services to those who are prepared to pay the most for them
- An incentive device - rising prices tend to act as an incentive to firms to produce more of a good or service, since higher profits can be earned
- A signalling device - The price mechanism indicates changes in the conditions of demand of supply. For example, an increase in demand for a good or service raises its price and encourages firms to expand their supply, while a decrease has the opposite effect. Consequently, more or fewer resources are allocated to the production of a particular good or service.
A tax is a compulsory charge made by the government, on goods, services, incomes or capital. The purpose is to raise funds to pay for government spending programmes. There are two types of tax: direct and indirect
A direct tax is levied directly on an individual or ogranisation. Direct taxes are generally paid on incomes: for example, personal income tax and corporation tax
An indirect tax is usually levied on the purchase of goods and services. It represents a tax on expenditure. There are two types of indirect tax: specific and ad valorem taxes.
A specific tax is charged as a fixed amount per unit of a good, such as a litre of wine or a pack of cigarettes. An excise tax is a good example.
An ad valorem tax is charged as a percentage of the price of a good: for example, VAT of 17.5% is added on to restaurant meals.
The imposition of an indirect tax raises the price of a good or service. The tax is added to the supply price, effectively causing the supply curve to shift vertically upwards and to the left. A specific tax causes a parallel shift, whereas an as valorem tax causes a pivotal rotation of the supply curve to the left.
Ad valorem tax
The incidence of an indirect tax
The tax incidence usually falls partly on consumers and partly on producers, depending on the relative price elasticities of demand and suppy for the good or service.
A combination of price inelastic demand and price elastic supply tends to place most of the tax burden on consumers; addictive goods such as tobacco and alcohol tend to be price inelastic in demand.
However, a combination of price elastic demand and price inelastic supply tends to place most of the tax burden on the producers. It may also lead to significant reductions in output and employment. Consequently, a government may be reluctant to place high indirect taxes on these types of goods or services.
Incidence of an indirect tax continued...
What determines the wage rate in a labour market?
In a competitive labour market the wage rate is determined by the interaction of demand and supply. The demand for labour is undertaken by firms, and the supply of labour comes from the general population and, in particular, the workforce of an economy.
The demand for labour is derived demand. It is derived from the demand for the goods and services it makes. For example, the demand for builders is derived from the demand for new housing.
As the demand for new housing increases, the demand for labour increases, causing the wage rate to rise.
Determinants for the demand for labour
- Demand for the final product - an increase in demand for a good or service is likely to cause and increase in demand for the labour making it, and vice versa.
- The wage rate - a fall in the wage rate means that labour becomes more affordable and so firms are likely to demand more labour
- Other labour costs - for example, a fall in employers' national insurance contributions on behalf of their staff is likely to raise he quantity demanded
- Price of other factory inputs - an increase in the price of capital may encourage firms to employ more labour to replace the capital - they are substitutes
- Productivity of labour - an increase in output per worker may lead to higher revenue and profits, encouraging firms to employ more people
- Government employment regulations - the fewer the number of regulations, the greater the demand for labour is likely to be. It becomes easier to hire and fire staff or to change working conditions. A minimum wage set above the equilibrium may cause a decrease in the quantity of labour demanded.
Determinants for the supply of labour
The supply of labour refers to the quantity and quality of labour hours offered for work over a given time period
- The wage rate - an increase in the wage rate will encourage more people to offer their services for work. Oppurtunity cost of not working increases, so more people offer their labour.
- Other net advantages of work - improvements in working conditions will also tend to increase the supply of labour. Fringe benefits (non-monetary) - a good pension, paid holidays, job security and promotion prospects.
- Net migration - over recent years the UK has experiences a significant increase in immigration from central and eastern Europe, helping to boost the economy
- Income tax - a reduction in income tax will offer a greater incentive for people to work
- Benefit reform - a reduction in benefits may provide a greater incentive for people to look for work and so increase the supply of labour
- Trade unions - trade unions act to increase wage rates and improve working conditions - this may encourage an increase in the supply of labour
- Government regulations - may increase or decrease supply of labour
- Social trends - for example increase in supply of labour of women
Why do some markets fail?
Market failure occurs when the price mechanism causes an inefficient allocation of resources; the forces of demand and supply lead to a net welfare loss in society.
There are various types of market failure, however, the Edexcel course focuses on the following: externalities, public gods, imperfect market information, labour immobility and unstable commodity markets
Externalities are those costs or benefits which are external to an exchange. They are third party effects ignored by the price mechanism.
External costs are negative externalities and external benefits are positive externalities
External costs may occur in the production or consumption of a good or service.
- An example of an external cost in production is a chemical firm pollutin a river with its waste. This causes an external cost to the fishing and water supply industries.
- An example of an external cost in consumption is a person smoking tobacco, polluting the air for others. The effect is to cause passive smoking, where non-smokers may suffer the same illnesses as smokers
Private costs are the costs which are internal to he firm, which it directly pays for. These costs inlude wage rates, rent of buildings, payment for raw materials, machinery costs, transport costs etc.
By adding private costs to external costs we obtain social costs. This means that external costs are the differece between private costs and social costs. The marginal prive cost and marginal social cost curves often diverge, indicating that external costs increase disproportionately with output.
External benefits may occur in the production and consumption of a good or service.
- An example of an external benefit in production is the recycling of waste materials such as newspapers, glass and tins. It has the benefit of reducing the amount of waste disposal for landfill sites as well as re-using materials for production.
- An external benefit in consumption is the vaccination of an individual against various diseases. Increases 'herd immunity' - reduces the chance of other people catching them.
In a free market, consumers are only concerned with the private benefits or utility from consuming a good or service. This can be measured by the price that consumers are prepared to pay. It may also refer to the revenue that a firm obtains from selling a good.
By adding private benefits to external benefits we obtain social benefits. External benefits are the difference between private benefits and social benefits. The MPB and MSB surves often diverge, indicating that external benefits increase disproportionately with output consumed.
MSB and MPB curves
External costs and the triangle of welfare loss
External benefits and the triangle of welfare gain
Public and private goods
Public goods are under-provided in a free market economy. They are:
- Examples include: national defence, street lighting and the criminal justice system
Private goods are the opposite of public goods
Public goods are under-provided because of the 'free rider problem' where people benefit from the good who havent payed, and because of the valuation problem where there is uncertainy over the value of a product.
The government, therefore, provides public goods and funds their provision through taxes on the general public. This is an attempt to correct the market failure.
How do governments attempt to correct market failu
There are various measures a government could undertake to correct market failure: for example, indirect taxation, subsidies, tradable pollution permits, the extension of property rights, regulation, buffer stocks and minimum prices.
Indirect taxation - Advantages:
- Based on the principle that the polluters pay - both producer and consumer
- They work with market forces, helping to internalise the external costs
- The level of negative externalities (e.g. pollution) should fall as output of the good is reduced - the social optimum of MSB=MSC can be achieved
- Tax funds are raised for the government - can be used to combat externalities
- Difficult to quantify negative externalities and then place a monetary value on it
- Makes firms less internationally competitive and so may be detrimental to economy
- Firms may relocate to other countries to avoid taxes
- Demand for the good may be price inelastic, so the overall reduction is small
- It may encourage the development of illegal markets to avoid high taxes
Using subsidies to correct market failure
Subsidies are often applied on goods or services with significant external benefis, such as education and healthcare. They may also be given to alternative forms of economic activity which create less pollution, such as public transport and renewable energy.
Advantages of subsidies applied to renewable energy markets:
- They reduce air pollution
- Using renewable energy sources helps to promote sustained economic growth
- The rate of consumption of non-renewable resources is reduced
- Subsidies work with the market. They help to internalise the external benefits.
- There is an opportunity cost to government subsidies. It may lead to higher taxes or cuts in spending
- Firms may become inefficient in production if they rely upon subsidies
- Wind power may be a less reliable source of energy than traditional fossil fuels
Using tradable pollution permits to correct market
Advantages of tradable pollution permits:
- A market is created for buying and selling carbon permits. In effect, the price mechanism is used to internalise the external costs associated with carbon emissions
- Pollution permits can be reduced over time as part of a coordinated plan
- National governments can raise funds by selling up to 10% of their pollution permits to industry - revenue could be used to clean up pollution
- Firms have an incentive to invest in clean technology
- Firms may be able to bank their excess pollution permits for use in future years
Disadvantages of tradable pollution permits:
- Too many may be issued, making them pointless
- Too few may be issued, raising business' production costs rapidly - less competitive
- Disagreement among firms over who should be given the most
- Firms may pass the price of the permits onto consumers - higher inflation
- Difficult to put a price on them
- Less incentives for firms to become greener if they can just buy more if they need
Using the extension of property rights to correct
This involves the government allocating property rights to organisations over the ownership of resources and regarding what uses they can be put to and what rights others have over them.
Advantages of property rights:
- Use the market mechanism to ensure an efficient use of resources
- There is an increase in the knowledge and expertise for the organisation with the property right. It takes away pressure from the government to assess the pollution
- There is a greater likelihood that the 'property' will be managed carefully
- Firms that damage the environment without permission can be prosecuted
Disadvantages of property rights:
- It may be difficult for a government to extend a property right which covers more than one country - Amazon rainforest
- It could be difficult to trace the source of environmental damage
- The legal costs of prosecution could be extremely high
- Difficult to quantify and place a monetary value on the use of a property right
The use of government regulation to correct market
There are various forms of government regulations to correct market failure. In some cases direct controls are applied.
Advantages of regulations:
- They are simple to understand, for example: age restrictions on buying alcohol
- It is possible to fine or close down companies which have abused the regulations
- Consumer protection laws offer some redress against firms that sell shoddy or unsafe goods, or which make false claims about their products. It may help to reduce the problem of asymmetric information
Disadvantages of regulations:
- It is expensive to monitor the behaviour of firms
- There may be extra costs to firms: for example, the cost of installing pollution monitoring equipment
- It may be difficult to quantify and attach a monetary value to pollution emissions
- Regulations prevent the operation of the price mechanism
- Government failure may occur is the regulations serve to misallocate resources.
The use of buffer stock schemes to correct market
A buffer stock scheme may be operated by a government agency to reduce price fluctuations of a commodity and stabilise producer incomes. It involves the agency setting a target price range (a maximum and minimum price) and it intervenes when the price strays out of this range.
Advantages of buffer stocks:
- They reduce commodity price fluctuations, helping to stabilise producer incomes
- There is greater certainty in the market, leading to more investment
- They help to ensure provision of commodities for consumers even in years of poor harvests
Disadvantages of buffer stocks:
- A series of good harvests may financially damage the government - has to buy too much stock
- Significant costs involved with storing the stock-piles and protecting them
- The stocks may be perishable and so may go to waste
- A series of poor harvests may lead to the agency running out of stocks to release onto the market. The market price exceeds the maximum price - system breaks
Using minimum pricing to correct market failure
A minimum price for a good is usually set above the market equilibrium price, this leads to a surplus in the supply of the good, which the government has to buy up.
Advantages of a minimum price:
- Reduces commodity price fluctuations
- Farm incomes are stabilised and increase, leads to greater investment in agriculture
- Employment in the countryside is maintained
- Supply of agricultural commodities is guaranteed even in times of poor harvest,due to surplus stockpiles
- Agricultural surpluses can be used as a form of foreign aid to developing countries
Disadvantages of a minimum price: Government failure
- The price of food increases - leading to hardship for poor consumers
- Government spending has an opportunity cost - less spending elsewhere
- Increases storage and security costs for surpluses
- Surpluses may be perishable so may go to waste
Government failure occurs if government intervention leads to a net welfare loss, it is where the government causes a misallocation of resources in a market.
Some examples include:
- High taxation on tobacco, alcohol and waste - encourages illegal smuggling into the UK. This leads to organised crime and huge tax revenue losses for the government
- Subsidies to bus transport - As bus transport is considered an inferior good, the subsidies may not increase passenger numbers proportionately
- Road pricing - A road congestion scheme will help reduce the external costs such as traffic congestion and air and noise pollution. However, if it is set too high it could lead to under-utilisation of road space and could be unfair on some people. May reduce trade for businesses within the zone
- Buffer stock schemes and minimum prices - waste of taxpayers' money and surpluses are often destroyed
- Allocation of fish quotas - fish quotas are set at too high a level, dead fish are thrown back to meet quotas.
- Government bureaucracy - time lags of decisions, reduces investment