micro

the price of oil is very important for an economy

- oil is used in the production of a huge variety of goods and its used extensively for transportation. for example, many gods are made from, or packaged in, plastic and distributed using modes of transport that consume oil

- an increase in the price of oil can result in inflation as the price of many goods increases. recent improvements in energy efficiency and reduction, in some countries, in heavy industry are helping to reduce the impact of changes in oil prics on the price of goods

- oil prices fluctuate widely, with rapid increases and decreases over time

- demand for oil is price inelastic. its such an important and widely used resource that a change in the pric causes a relatively small change in the quantity demanded

- the supply of oil is also price inelasti. this is partly because its difficult to increase the supply of oil in the short term- the exploration for new oil and production from new wells takes time. also, although oil can be stockpiled, producers dont want to supply lots to the market and cause prices to decrease too much

lots of factors affect the demand for oil

- when the global economy is booming the demand for oil increases, but demand falls during a world recession. this is because oil is used in most economic activity

- speculators can affect the demand for oil because they buy and sell oil in the hope of making a profit from fluctuations in its price. for example, they could buy oil at $100 per barrel today with the hope of selling it next week when they predict the price will have risen to $120 per barrel- however, prices can fall and speculators can make large losses

- the value of the US dollar can affect the demand for oil. this is important because oil is priced in US dollars- if the value of the dollar is low then more oil can be purchased by speculators holding other currencies

- if the demand for products made from crude oil increases then the derived demand for oil increases

- the attractiveness of buying oil substitutes, e.g. biofuel, impacts demand for oil. as substitutes to oil become cheaper, more reliable and more readily available, this has a negative impact on demand for oil

there are several factors affecting the supply of oil in the short run

- supply-side shocks, such as war in a major oil producing country can lead to a disruption of oil supplies. this would cause a contraction the supply of oil.

- this price increase will increase costs to firms where oil is an important factor of production. these firms might increase prices to maintain their profits and this could have a knock-on effect on demand

- the organisation of petroleum exporting countries (OPEC) also has a major influence on the world supply of pil. this means that it can exert signficant control over the price of oil

- OPEC members can agree to cut oil production levels, which causes oil prices to increase. alternatively they can increase production levels to cause oil prices to decrease

different factors affect the supply of oil in the long run

- the size of remaining oil reserves- the bigger the remaining oil reserves, the higher the supply of oil will be in the long run. the estimates of the size of the world oil reserves vary

- the cost of extracting oil from reserves- some reserves are too expensive to extract oil from at the moment, but if demand and oil prices increases then it might become worth extracting this harder to reach oil. also an increase in price and demand could cause an increase in the exploration for new oil reserves

- the efficiency and cost of technology used in exploiting and refining the oil- the cheaper and more efficient the technology, the lower the cost of the oil due to the increased level of supply

a large increase in the demand for oil:

- the growth of emerging economies is driving an increased global demand for oil, the increase in demand shifts the demand curve to the right and can lead to an increase in supply. oil producers might restrict the use of reserves to keep the price high, the signalling effect of the price increase can encourage an increase in production

- there will be a delay before this additional supply is available on the market, demand for oil in the short run is price inelastic- so this, with the inelastic supply curve, will lead to a large increase in price

an expansion of fracking for oil:

- an increase in the scale of fracking activities could lead to a large increas in the supply of oil, the increase in supply shifts the supply curve to the right. this increases output and causes the price to fall. the inelasticities od supply and demand would lead to a larger reduction in price than the increase in quantity.

-however, shale oil is not a direct substitute for crude oil, so the increase in its availability may not have a major effect on global oil price

buying a house is an investment

- houses can rise in value over time and they're seen as an investment- its possible to invest in houses and make a return on the investment in the future

- however, a fall in house prices can result in negative equity- where the value of a propertys mortgage is greater than the propertys market value. this is bad for home owners- what they sell their house for wont pay off the amount they owe on it. unless they can pay off the remainer of their mortgage they cant move house

the supply of houses is the variety of houses available at a given time

- the supply of houses is made up of new build and pre-owned houses that are available for a range of prices

- the supply of new build houses is partially dependant on the costs of building them. the supply also depends on the number and size of building firms and any government policies that encourage building new houses

- an increase in the number of new houses built should lead to a fall in the price of houses

- the supply curve will shift to the right, leading to more houses being supplied at each price, a fall in the equilibrium price and a rise in the equilibrium quantity

the price of housing is determined mainly by demand factors

- the state of the economy has a big impact on the housing market- in areas of high unemployment houses have lower prices and lower demand, but areas with low unemployment tend to have high demand and high house prices

- economic growth, high levels of consumer confidence and high living standards increase demand for housing

- the substitute for buying a house is renting one. a fall in the cost of renting may decrease the demand to buy houses, but falling rents could reduce the supply of properties for rent if landlords are unwilling to offer low rents

- most properties are bought using a mortgage, so if, for example, interest rate rise, the cost of a mortgage will incresase and reduce the demand for house purchases

short run PED and PES for housing are inelastic

- there are no close substitues for housing. this means the price elaticity of demand is inelastic- so a rise in price causes a smaller reduction in demand

- the price elasticity of supply is inelastic too. the supply of houses cant be quickly increased because it takes times to build new houses. supply can also be restricted by the availability of buliding materials, construction workers and suitable land, and by government regulations

- because supply cant increase much in the short run, an increase in demand can make prices rise sharply

house prices have many knock-on effects

- if house prices rise and lots of houses are bought and sold, then this might create more jobs in the construction industry

- higher house prices increase the value of peoples assets and can increase consumer confidence- this confidence can encourage spending and increase investment

- increased house sales encourage spending on furniture, decorating and other household goods

transport is usually a derived demand

- transport is the movement of freight and passengers from one place to another

- transport is almost always a derived demand- it usually results from demand for other goods and services: people want to get to places for work, leisure activities and holidays, and shopping and other chores. firms want to bring factors of production toether, and bring goods to customers

demand for transport is income elastic and price elastic

- transport as a whole has a positive income elasticity of demand- as real incomes increase the demand for transport increases. however, each transport mode also has its own YED

- car and air travel are generally considered to have a positive YED, but bus travel is thought to have a negative YED- bus travel is considered to be an inferior good

- demand for transport is also price elastic to some extent. people might cut back on leisure travel if prices rise, but commuter travel is less likely to be affected

- theres some cross elasticity of demand between transport modes that are suitable substitues for one another

demand for car travel depends on several things, for example:

- the cost of a journey, e.g. petrol- individuals will choose whether or not to drive dependig on its cost. however, the price elasticity for travelling by car is low because people highly value the convenience and comfort of driving. this means that changes in the cost of driving might not have a large effect on demand

- income- car ownership and usage rise with real income, so economic growth causes an increase in car usage

- substitutes- there are substitues to car travel, such as travelling by bus or by train, and reduction in their prices might reduce car usage. however, there modes of transport are often considered to be poor substitutes for cars, so cross elasticity of demand is low. complements- the price of complementary goods, such as car insurance or parking, can affect the demand for driving

- in the short run the supply of roads is fixed. this can lead to excess demand for road space during bust periods, i.e. there will be congestion during rush hour. congestion can be reduced by introducing a price for using the road network. if the price is set at the right level this will reduce demand back to the level of supply

production means manufacturing something in order to sell it

- production involves converting inputs into outputs

- the inputs can be any of the four factors of production- land, labour, capital and enterpise. inputs can be: tangible- things you can touch, like raw materials or machines. intangible- 'abstract' things that cant be touched- like ideas, talent or knowledge.

- the outputs produced should have an exchangeable value, they need to be something that can be sold

productivity is the output per factor employed

- productivity is a way of measuring how efficiently a company or an economy is producing its output

- its defined as the output per unit of input employed. so if one company could take the same amount of inputs as another company, but produce more stuff, their productivity would be greater

- you can work out an overall level of productivity 

- but you can also calculate productivity for any one of the four individual factors of production, e.g. labour. improving the productivity of any one of these seperate factors should increase overall productivity

labour productivity is the output per worker or output per hour worked

- labour productivity is one example of measuring productivity for one factor of production. its the amount of output produced per worker

- to calculate labour productivity: take the amount of output produced in a particular time. divide this by the total number of workers.

- labour productivity allows workers to be compared against other workers. for example, labour productivity is calculated for whole economies, so that the productivity of the different labour forces can be compared.

- improvements in labour productivity can come about as a result of better training, more experience, improved technology, and so on. specialisation can slo improve labour productivity- if each worker performs tasks that theyre good at doing, have practised a lot or have been trained to do, then theyll produce more than if they did lots of different tasks

specialisation leads to a division of labour 

- people could make all the things they need and want themselves. they could grow their own food, make their own clothes, build their own computers, and so on. in practice though, this is very unlikely to work. what usually happens is that people and firms specialise- some people grow food, others makes clothes, etc.

- the division of labour is a type of specialisation where production is split into different tasks and specific people are allocated to each task, e.g. in making a stool- one person could make the legs and another could make the seats

- Adam Smith explained the increase in productivity that could be achieved through the division of labour. he said that one untrained worker wouldnt even make 20 pins per day, but 10 workers, specialising in different tasks, could make 48000

- there are advantages and disadvantages to specialisation, but overall an economy can produce more stuff if people and firms specialise

advantages of specialisation:

- people can specialise in the thing theyre best at

- this can lead to better quality and a higher quantity of products for the same amount of effort overall- i.e. increased labour productivity

- specialisation is one way in which firms can achieve economies of scale, e.g. a production line is a form of specialisation

- specialisation leads to more efficient production- this helps to tackle the problem of scarcity, because if resources are used more efficiently, more output can be produced per unit of input

- training costs are reduced if workers are only trained to perform certain limited tasks

disadvantages of specialisation:

- workers can end up doing repetitive tasks, which can lead to boredom

- countries can become less self-sufficient- this can be a problem if trade is disrupted for whatever reason. for example, if a country specialises in manufacturing, and imports all it fuel, then that country could be in trouble if it falls out with its fuel supplier

- it can lead to a lack of flexibility- for example, if the companies eventually move elsewhere, the workforce left behind can struggle to adapt

trade means people can buy the stuff theyre no longer making themselves

- specialisation means that trade becomes absolutely vital- economies have to be able to obtain the things theyre no longer making for themselves. this means its necessary to have a way of exchanging goods and services between countries

- swapping goods with other countries is one way a country can get what it needs, e.g. a country which mines diamonds may want oil, while another country which produces oil may want diamonds. this was of trading goods is called a barter system- its very inefficient because it takes a lot of time and effort to find traders to barter with

- the most efficient way of exchanging goods and services between countries is using money. money is a medium of exchange- its something both buyers and sellers value and that means that these countries can buy goods, even if sellers dont want the things that the buying country produces

money has three other functions too:

- a measure of value- e.g. the value given to a good can be measurd in US dollars

- a store of value- e.g. an individual who recieves a wage may wait before buying something if they know that the money they have will be of a similar value in the future

- a standard of deferred payment- money can be paid at a later date for something thats consumed now, e.g. people often borrow money to buy a car or pay university fees

firms generate revenue and incur costs

- a firm is any sort of business organisation, like a family-run factory, a dental practice or a supermarket chain

- an industry is all the firms providing similar goods or services

- a market contains all the firms supplying a particular good or service and the firms or people buying it

- firms generate revenue by selling their output

- producing this output uses factors of production, and this has a cost

- the profit of a firm makes is its total revenue minus its total costs

- in the long run firms need to make profit to survive

economists include oppurtunity cost in the cost of production

- when economists talk about the cost of production they are referring to the economic cost of producing the output

- the economic cost includes the money cost of factors of production that have to be paid for, but it also includes the oppurtuntity cost of the factors that arent paid for

- the oppurtunity cost of a factor of production is they money that you could have got by putting it into the next best use. e.g. if you run your own business the money you could earn doing other work is the oppurtunity cost of your labour

- so, in economics, cost isnt just a calculation of money spent- it takes into account all of the effort and resources that have gone into production

in the short tun some costs are fixed

- the short run is the period of time in which at least one of a firms factors of production is fixed

- the short run isnt a specific length of time- it varies from firm to firm. for example, the short run of a cycle courier service could be a week because it cant hire new staff with their own bikes quickly, but a steel manufacturer have a short run of several years because it takes lots of time and money to build a new steel-manufacturing plant

- the long run is the period of time when all factors of production can be varied

- costs can be fixed or variable in the short run

fixed costs:

- fixed costs dont wary with output in the short run- they have to be paid whether or not anything is produced

- for example, the rent on a shop is a fixed cost- its the same no matter what the sales are

variable costs:

- variable costs do vary with output- they increase as output increases

- the cost of the plastic bags that a shop gives to customers is a variable cost- the higher sales are, the higher the overall cost of the bags

- in the long run all costs are variable

total cost and average cost include fixed costs and variable costs

- total cost is all the costs involved in producing a particular level of output

- the total cost for a particular output level is the total fixed costs plus the total variable costs for that output level: TC=TFC+TVC

- average cost is the cost per unit produced

- average cost is calculated by dividing total costs by the quantity produced: AC=TC/Q

- average fixed cost= total fixed costs/quantity produced: AFC=TFC/Q

- averages variable cost= total variable costs/quantity produced: AVC=TVC/Q

marginal cost is the cost of increasing output by one unit

- marginal cost is the extra cost incurred as a result of producing the final unit of output

- marginal cost is only affected by variable costs- fixed costs have to be paid evem if nothing is produced. you can calculate it by finding the difference between the total costs at the current output level and total cost of one unit less: MC= TCn-TCn-1

- marginal cost usually means the extra cost of producig 'the final unit' of output, but there's a more general formula that gives the extra cost of the 'last few units': MC= change in TC/change in quantity

- marginal cost decreases initially as output increases, then begins to increase in the short run of the law of diminishing returns. so the MC curve is always u-shaped.

- changes in marginal cost affect average cost

- when the marginal cost is lower than the average cost, the average cost will be falling. this is because each extra unit produced will decrease the average cost

- when the marginal cost is higher than the average cost, the average cost will be rising because each extra unit produced will increase the average cost

- so the marginal cost curve meets the average cost curve at the lowest average cost, i.e. average cost will be lowest when MC=AC- this is the point of productive efficiency

- the MC curve also meets the AVC curve at the minimum AVC. this means AVC and AC curves also always form a u-shape in the short run- they both decrease until they reach a minimum, and then begin to increase.

- AFC falls as output rises because the total fixed cost is spread across the greater output

increases in output are limited by diminishing retuns in the short run

- the law of diminishing returns explains what happens when a variable factor of production increases while other factors stay fixed. because at least one factor stays fixed, the law of diminishing returns only applies in the short run

- when you increase one factor of production by one unit, but keep the others fixed, the extra output you get is called the marginal product. e.g. if you add one more unit of labour, the extra output is the marginal product of labour

- marginal product is the additional output produced by adding one more unit of a factor input

- intially, as you add more of a factor of production the marginal product will increase- each unit of input added will add more output than the one before

- this might happen because more specialisation is possible with more of a particular factor. as more people are employed, for example, they can specialise in carrying out particular tasks

- eventually, if you keep adding units of one factor of production, the other fixed factors will begin to limit the additional output you get, and the marginal product will begin to fall.  e.g. if a clothes manufacturer has only 5 sewing machines, employing a 6th machinist will probably add less output than employing the 5th did, and employing a 7th will add even less

- this is the point of diminishing returns- the point where marginal product begins to decrease as input increase

- the law of diminshing says that there is always a point where marginal product begins to decrease: if one variable factor of production is increase while other factors stay fixed, eventually the marginal returns from the variable factor will begin to decrease

economies of scale can be internal or external

- the average cost to a firm of making something is usually quite high if they dont make very many of them

- but in the long run, the more of those things the firm makes, the more the average cost of making each one falls. these falls in the cost of production are due to economies of scale

- economies of scale- the cost advantages of production on a large scale

internal economies of scale involve changes within a firm

technical economies of scale:

- production line methods can be used by large firms to make a lot of things at a very low average cost

- large firms may also be able to purchase other specialised equipment to help reduce average costs

- workers can specialise, becoming more efficient at the tasks they do, which might not be possible in a small firm

- another potential economy of scale arises from the law of increased dimensions. for example:

- the price you pay to build a new warehouse might be closely related to the total areas of the walls and roof, say. if you make the dimensions of the walls and roof twice as big, the total area of the walls and roof will be 4 times greater- so the warehouse will cost about 4 times as much to build. but the volume of the warehouse will be 8 times greater, meaning that youre getting more storage space for each pound you spend. the same is true of things like oil tankers- e.g. bigger tankers reduce the cost of transporting each unit of oil

purchasing economies of scale:

- larger firms making lots of goods will need larger quantities of raw materials, and so often can negotiate discounts with suppliers

- because large firms will be the most important customers of suppliers, theyll be able to drive a hard bargain

managerial economies of scale:

- large firms will be able to employ specialist managers to take care of different ares of the business. these specialist managers gain expertise and experience in a specific area of the business, which usually leads to a better decision-making abilities in that area

- and the number of managers a firm needs doesnt usually depend directly on the production scale- a firm probably wont need twice as many managers to produce twice as many goods. this reduces the management cost per unit

financial economies of scale:

- larger firms can borrow money at a lower rate of interest- lending to them is seen by banks as less risky

risk-bearing economies of scale:

- larger firms can diversify into different product areas and different markets. this diversification leads to a more predictable overall demand- basically, if demand for one product in one country falls, theres likely to be a different product whose demand somewhere increases

- it also means large firms are more able to take risks. if the product is unsuccesful, a large firms other activities allow it to absorb the cost of failure more easily

marketing economies of scale:

- advertising is usually a fixed cost- this is spread over more units for large firms, so the cost per unit is lower. the cost per product of advertising several products may also be lower than the cost of advertising just one, e.g. a firm could advertise several products on a single flyer

- larger firms also benefit from brand awareness- products from a well-known brand will be trusted by consumers. this might mean a larger firm doesnt need to advertise as much to get sales

external economies of scale involve changes outside a firm

- local colleges may start to offer qualifications needed by big local employers, reducing the firms training costs

- large companies locating in an area may lead to improvements in road networks or local public transport

- if lots of time doing similar or related things locate near each other, they may be able to share resources. suppliers may also decide to locate in the same area, reducing transport costs

extrememly successful companies can gain monopoly power in a market

- as a firms average cost for making a product falls, it can sell that product at a lower price, undercutting its competition

- this can lead to a firm gaining a bigger and bigger market share, as it continually offers products at prices that are lower than its competition

- in this way, a firm can eventually force its competitors out of business and become the only supplier of the product- i.e. it will have a monopoly

diseconomies of scale- disadvantages of being big

- getting bigger isnt always good though- as a firm increases in size, it can encounter diseconomies of scale

- diseconomies of scale cause average cost to rise as output rises. diseconomies can be internal or external

internal:

- wastage and loss can increase, as materials might seem in plentiful supply. bigger warehouse might lead to more things getting lost or mislaid

- communication may become more difficult as a firm grows, affecting staff morale

- managers may be less able to control whats going on

- it becomes more difficult to coordinate activities between different divisions and departments

- a 'them and us' attitude can develop between workers in different parts of a large firm- workers might put their departments interests before the companys leading to less cooperation and lower efficiency

external:

- as a whole industry becomes bigger, the price of raw materials may increase. buying large amounts of materials may not make them less expensive per unit. if local suppllies  arent sufficient, more expensive goods from further afield may have to be bought

high fixed costs create large economies of scale

- there are huge economies of scale in industries with high fixed costs but low variable costs. in some cases, the structure of whole industries can change to take advantage of this. for example, robot-based assembly lines are very expensive to set up, but reduce the labour required to produce each unit. this means fixed costs will increase, while variable costs fall

- as a firm grows by taking advantage of its large economies of scale, other firms in the industry may be forced to follow the same strategy, or shut down. this results in an industry dominated by a few large firms

in the long run firms can move onto new short run average cost curves

- in the short run a firm has at least one fixed factor of production. this means that it operates on a particular short run average cost curve. as a firm increases output in the short run by increasing variable factors of production, it moves along its short run average cost curve

- in the long run a firm can change all factors of production. when it does this it moves onto a new SRAC curve

- the minimum possible average cost at each level of output is shown by a long run average cost curve

- SRAC curves can touch the LRAC curve, but they cant go below it

- for a firm to operate on its LRAC curve at a particular level of output, it has to be using the most appropriate mix of all factors of production

- this means that it may not be able to reduce costs to this minimum level in the short run. but in the long run a firm can vary all factors of production and bring costs down to the level of the LRAC curve

the shape of LRAC curves is determined by internal economies and dieconomies of scale

- average cost falls as output increases when a firm is experiencing internal economies of scale

- average cost rises as output increases when a firm is experiencing internal diseconomies of scale

- firms may face specific economies and diseconomies of scale at the same output level- whether the firm is experiencing economies or diseconomies overall will depend on which is having the greater effect

external changes can cause LRAC curves to shift

- external economies of scale will cause the LRAC curve to shift downwards by reducing average costs at all output levels

- external diseconomies of scale will force the LRAC curve to shift upwards

- a change in taxation might cause the LRAC curve to shift up or down, e.g. an increase in fuel duty would cause a bus company's LRAC to shift up

- new technology could cause the LRAC curve to shift down if it means firms can use factors of production more efficiently at all levels, e.g. faster computers for workers

returns to scale describe the effects of increasing the scale of production

- in the long run firms can increase all of their factor inputs. returns to scale describe the effect on output of increasing all factor inputs by the same proportion

- increasing returns to scale- there are increasing returns to scale when an increase in all factor inputs leads to a more than proportional increase in output. e.g. doubling all of the factor inputs results in a tripling of output

- constant returns to scale- there are constant returns to scale when an increase in all factor inputs leads to a proportional increase in output. e.g. doubling all the factor inputs results in a doubling of output

- decreasing returns to scale- there are decreasing returns to scale when an increase in all factor inputs leads to a less than proportional increase in output. e.g. doubling all of the factor inputs results in a doubling of output

increasing returns to scale contribute to economies of scale

- returns to scale and economies of scale are not the same thing. returns to scale describe how much output changes as input is increased. economies of scale describe reductions in average costs as output is increased

- however, there is a link between the two ideas: increasing returns to scale contribute to economies of scale. decreasing returns to scale contribute to diseconomies of scale

- when returns to scale are increasing, long run average cost will fall. an increase in input leads to a more than proportional increase in output, so more output is being produced per unit of input

- when returns to scale are constant, long run average cost will stay the same- costs are increasing proportionately to output

- when returns to scale are decreasing, long run average cost will rise. less output is being produced per unit of input

long run average costs are minimised at the MES

- the minimum efficient scale of production is the lowest level of output at which the minimum possible average cost can be achieved- its the first point at which the LRAC curve reaches its minimum value. this is likely to be the optimal level of production

- there might be a range of production levels where LRAC is minimised, or the MES might be the only LRAC minimising level

- the MES varies between industries- industries with very high fixed costs have a very large MES. this affects the whole structure of an industry- industries witha large MES will favour larger firms more

revenue is the money firms recieve from selling their goods or services

- total revenue is the total amount of money recieved, in a time period, from a firms sales

- total revenue is equal to the quantity sold multiplied by the price. its also called turnover. it can be found using the formula: TR=Q x P

- average revenue is the revenue per unit sold

- average revenue is TR divided by quantity sold: AR=TR/Q

- marginal revenue is the extra revenue recieved as a result of selling the final unit of output

- marginal revenue is the difference between TR and the new sales level and TR at one unit less: MR=TRn - TRn-1

a firms demand curve determines how revenue relates to output

- demand curves show what quantity of a product a firm will be able to sell at a particular price

- price is average revenue, so the same curve shows the relationship between quantity sold and average revenue

- a firms total revenue is given by quantity x price

a firm thats a price taker has a perfectly elastic demand curve

- a firm thats a price taker has no power to control the price it sells at- price takers have to accept the price set by the market

- a price takers demand curve will be completely flat- demand is perfectly elastic. if the firm increases the price then the quantity sold will drop to 0. and theres no reason to decrease the price because the same quantity would sell at the orginial higher price

with a perfectly elastic demand curve AR=MR

- when demand is perfectly elastic the price is the same, no matter what the output level

- in this case marginal revenue=average revenue, because each extra unit sold brings in the same revenue as all the others

- when average revenue is constant, total revenue increases proportionatally with sales

a firm thats a price maker has a downward sloping demand curve

- price makers have some power to set the price they sell at. a price makers demand curve will slope downwards- to increase sales the firm must reduce the price

with a downward sloping demand curve TR is maximised when PED=-1

- if a firms demand curve is a straight line sloping downwards then price elasticity of demand will change depending on where the firm is operating on the curve

- at the midpoint of the demand curve PED=-1

- to the left of the midpoint, demand is elastic, so decreasing a products price towards the midpoint will cause more than proportionate increase in sales and total revenue will increase

- to the right of the midpoint, demand is inelastic, so decreasing a products price below the price at the midpoint will cause a less than proportionate increase in sales and total revenue will decrease

- total revenue is maximised when the firm is operating at the midpoint of the demand curve

MR=0 when TR is at its maximum

- the demand curve is also the average revenue curve

- so the maximum total revenue occurs at the midpoint of the average revenue curve

- the MR curve is always twice as steep at the AR curve

- when total revenue is at its maximum, MR=0

- profit= total revenue-total costs

- there are actually two types of profit in economics: normal profit and supernormal profit

normal profit occurs when TR=TC

- a firm is making normal profit when its total revenue equals its total costs

- so normal profit is an 'economic' profit of zero- i.e. a profit of zero if all costs are taken into account

- this means normal profit occurs when the extra revenue left, on top of whats needed to cover the firms money costs, is equal to the oppurtunity costs of the factors of production that arent paid for

- if the extra revenue is less than those oppurtunity costs, then the firm would have been better off putting the factors of production to a different use

- in other words, normal profit is the minimum level of profit needed to keep resources in their current use in the long run

supernormal profit occurs when TR>TC

- a firm is making supernormal profit when its total revenue is greater than its total costs

- this means the revenue generated from using the factors of production in this way are greater than could have been generated by using them in another way

- if firms in an industry are making supernormal profit, this will create an incentive for other firms to try to enter the industry

a firm needs to make normal profit to keep operating in the long run

- if a firm cant make normal profit it will close in the long run, because its revenue is not covering all costs. even if its making a money profit, the factors of production its using could be used to better effect elsewhere

- however, in the short run, a firm has fixed costs that it has to pay, whether or not it produces any output. so a loss-making firm may not close immediately- it all depends on how its revenue compares to its variable costs

- if a firms total revenue is greater than its total variable costs, then itll continue to produce in the short run

- any revenue generated above the firms variable costs can contribute towards paying its fixed costs. if the firm stops production immediately, itll actually be worse off

- if a firms total revenue is less than its total variable costs, then itll close immediately

- if it continues to produce, itll actually be worse off

- in the long run the firm can be released from its fixed costs and it will shut down

- shut-down points can be show diagrammatically:

- in the long run, if the price remains below P (where normal profit is being made), then the firm should exit the market. the losses the firm is making arent sustainable

- if the price is between P and P1, the firm should continue to produce in the short run

- if the price falls below P1, the firm should cease production immediately, as its variable costs arent being covered

profit is maximised when marginal cost=marginal revenue

- economists generally assume that firms are aiming to maximise their profits. to do this, they need to find the optimum level at which to operate

- if marginal revenue is greater than marginal cost at a particular level of output, the firm should increase output. this is because the revenue gained by increasing output is greater than the cost of producing it. so increasing output adds to profit

- if marginal revenue is less than marginal cost at a particular level of output, the firm should decrease output. this is because its costing the firm more to produce its last unit of output than it receives in revenue. so decreasing output adds to profit

- this means that the profit maximising output level occurs when MR=MC. this is known as the 'MC=MR profit maximising rule'

- you can use this rule to find a firms profit maximising output level from a diagram showing MR and MC

profit maximisation is assumed to be the objective of a firm

- the traditional theory of the firm is based on the assumption that firms are aiming to maximise profit

- but in reality, there are other objectives a firm might consider more important. for example, revenue maximisation and sales maximisation are other common objectives

aiming for other objectives will reduce profit in the short run

- a firm aiming to maximise profit will operate at output level Q, where MR=MC. firms that are aiming for other objectives will operate at different output levels

maximising revenue means producing where MR=0

- revenue is maximised when MR=0

- if a firm is aiming to maximise revenue they will keep increasing output past the point where profit is maximised, as long as adding more output leads to greater revenue

maximising sales means producing where AR=AC

- a firm aiming to maximise sales will produce at an output level of AR=AC

- this is the highest level of output the firm can sustain in the long run

- if sales increased further the firm would be making a loss

aiming for other objectives will reduce profit in the short run

- a firm aiming to maximise profit will operate at output level Q, where MR=MC. firms that are aiming for other objectives will operate at different output levels

maximising revenue means producing where MR=0

- revenue is maximised when MR=0

- if a firm is aiming to maximise revenue they will keep increasing output past the point where profit is maximised, as long as adding more output leads to greater revenue

maximising sales means producing where AR=AC

- a firm aiming to maximise sales will produce at an output level of AR=AC

- this is the highest level of output the firm can sustain in the long run

- if sales increased further the firm would be making a loss

maximising profit might only be an objective for the long run

- maximising profit in the long run sometimes means sacrificing profit in the short run

- a firm may try to maximise sales or revenue in the short run, e.g. a firm might maximise revenue or sales to increase its market share, or to gain monopoly power so that it can make supernormal profits in the long run. or high sales might make it easier for the firm to borrow money

- some firms may even be willing to operate at a loss in the short run in order to make a profit in the long run. a firm may expect revenue to increase in the future, for example, once theyve been in the market for a while and their brand recognition increases. or a firm might expect to reduce costs when theyre able to output at higher production levels, and so they may keep operating at a loss while they build up the business

- a firms objective may be to simply survive in the short run by achieving normal profit. then, when its established ina market, it can try to maximise profits

some firms have alternative objectives

- some firms might aim for something not directly related to profit, revenue or sales. but these objectives are usually pursued while also aiming to make at least normal profit

- for example, some organisations are 'not for profit'- they dont pay out profit to their owners and their main aim is to 'do good' or provide some kind of benefit to the public. other firms will focus on producing high quality products, at the expense of maximising profits in the short run, to gain loyal customers

- many firms are also interested in corporate social responsibility. this involves firms operating in a way that brings benefit to society, as well as trying to make supernormal profit. for example:

- a firm may try to protect the environment by using sustainable resources

- a firm may support local businesses by using suppliers in their region

- a firm may choose to pay its workers above the standard market rate

divorce of ownership from control often happens as firms grow

- in small firms, the owner often manages the company on a day-to-day basis

- as firms grow, the owners often raise finance by selling shares- the new shareholders becomes part owners of the firm. but the firm will actually be run by directors, who are appointed to control the business in the shareholders' interest

- this is known as the divorce of ownership from control- the owner of the firm are no longer in day-to-day control

- directors might have different objectives to the owners

- employees and other stakeholders in firms may also have their own objectives and might have some level of control

- the divorce of ownership from control can lead to whats known as the principle-agent problem

- this is where a principal pays for an agent to act in their interests, but instead the agent acts in their own self-interest

- for example, a firms shareholders will want a firm to maximise profits to increase the value of its shares. however, if the managing directors pay or bonus is linked to revenue or sales, then they may choose to maximise those things instead

- directors might also be keen to grow some aspect of the firm because they enjoy running a large organisation, or because being in charge of a large firm will further their career

- employees are likely to aim to increase their own pay or benefits, ahead of aiming to make profits for the firm

owners can retain control with accountability and incentives

- how much control the managers or directors of a firm have can depend on how accountable they are to the owners. by holding managers or directors accountable, owners can tackle the principal-agent problem

- shareholders can remove directors by vote if theyre not happy with them, but they often lack information that might make them do this

- accountability means managers and directors having to justify what theyve done in the past and explain their future plans and intentions

- owners might also try to encourage directors to aim for profit maximisation by offering incentives which make this an attractive objective for the for the directors to pursue- e.g. a bonus linked to profits, or free or discounted company shares

sometimes people satisfice rather than maximise to make life easier

- satisficing means trying to do just enough to satisy important stakeholders, instead of aiming to maximise a quantity such as profits. its sometimes described as 'aiming for an easy life'

- satisficing often arises when different stakeholders have different objectives, which might be conflicting

- for example, rather than maximising profit, directors might aim to make 'enough profit' to stop shareholders getting too concerned, and paying employees 'high enough wages' that they dont look for work elsewhere or threaten to go on strike

growth can increase profit and bring other benefits

- firms usually grow to increase their profit- there are several ways that growth can achieve this:

- increasing economies of scale- a firm might grow to reach the minimum efficient scale of production, where long run average costs and minimised

- increasing market share and reducing competition- if a firm controls a large part of the market they might gain some monopoly power that allows them to set prices and make supernormal profits

- expanding into new markets- a firm might try to sell its products in different countries, for example

- however, there are also other reasons why a firm might grow, such as to achieve managerial objectives- directors might seek the status of running a large firm, for example

internal growth means increasing production scale

- internal growth is growth as a result of a firm increasing the levels of the factors of production it uses. for example, increasing output by building a larger factory, hiring more workers, and increasing the amount of raw materials used

- a key advantage of internal growth is that a firm has control over exactly how this growth occurs

- however, the downside is that internal growth tends to be slow, and it can also be expensive

external growth means combining firms

- external growth is growth as a result of takeovers and mergers:

- a takeover is when one firm buys another firm, which becomes part of the first firm

- a merger is when two firms unite to form a new company

- external growth is quicker and may be cheaper than internal growth. it might also be the easiest way to gain experience and expertise in a new area of business

- external growth can happen through horizontal integreation, vertical integration, or conglomerate integration

horizontal and vertical integration happen between firms in the same market

- horizontal integration means combining firms that are at the same stage of the production process of similar products- for example, a merger between 2 pharmaceutical companies or between a bookshop and a music shop. firms can increase economies of scale, reduce competition and increase market share through horizontal integration

- vertical integration means combining firms at different stages of the production process of the same product.

- forward vertical integration happens when a firm takes over another firm that is further forward in the production process e.g. a leather manufacturer buying a shoe factory. backward vertical intergration happens when a firm takes over another firm that is further back in the production process e.g. a book printer buying a paper plany

- by taking over suppliers or retailers, a firm can gain more control of the production process. this might be in order to maintain higher quality standards, or make the overall process more efficient

-this can create barriers to entry by preventing competitors from accessing suppliers or retailers

conglomerate integration happens between firms in unrelated markets

- conglomerate integration means combining firms which operate in completely different markets. e.g. an educational stationary supplier merging with a tractor manufacturer

- conglomerate mergers allow firms to diversify, which means they can spread their risk- if one part of the new firm does badly, this can be compensated for by profit from another part of the firm

- a conglomerate merger will also allow a firm to use profits generated by one product to invest in another

growth will have disadvantages

- the growth of a firm can lead to some disadvantages, for example:

- if 2 firms merge there will be a duplication of staff, such as marketing, finance and human resources personnel. its likely that some of this staff will be made redundant. furthermore, the 2 firms will each have a leader- these leaders will either have to find a way to work together, or one will need to leave

- the merged firms may have different and incompatible objectives that will need to be resolved

- a firm can put itself in a lot of debt in order to raise the finance necessary to complete a takeover

- this new, larger firm may suffer from diseconomies of scale

- a firm that takes over another business may overestimate its value and pay far more for it than its actually worth. this makes it hard for the new larger firm to make a return on the investment

the growth of firms will affect consumers

advantages: - a larger firm may benefit from economies of scale which could lead to price reductions for consumers - the combined creativity of 2 firms working together may lead to the production of superior products

disadvantages: - consumers will have less choice, if two, or more, firms merge - the reduction in competition caused by firms merging may also lead to higher prices for consumers - 2 merged firms may produce less output than 2 seperate firms, which will lead to price increases

- governments usually monitor mergers to see if theyll lead to consumers getting an unfair deal. for example, a merger can lead to the creation of a monopoly, which have advantages and disadvantages for consumers. if a government decided that a merger isnt fair to consumers, then it can take action to block the merger

perfectly competitive markets have certain characteristics

- the model of perfect competition is a description of how a market would work if certain conditions were satisfied

- its a theoretical thing- there are no real markets that work quite like this. but understanding how perfect competition works make it easier to understand whats going wrong with real-life markets when they have undesirable results

- in a perfectly competitive market the following conditions are satisfied:

- theres an infinite number of suppliers and consumers. each of these suppliers is small enough that no single firm or consumer has any 'market power'. each firm is a 'price taker'- this means they have to buy or sell at the current market price

- consumers have perfect information- i.e. perfect knowledge of all goods and prices in a market. every consumer decision is well-informed- consumers know how much every firm in the market charges for its products, as well as the details about those products

- producers have perfect information- i.e. perfect knowledge of the market and production methods. no firm has any 'secret' low-cost production methods, and every firm knows the prices charged by every other firm

- products are identical. so consumers can always switch between products from different firms

- there are no barriers to entry and no barriers to exit. new entrants can join the industry very easily. existing firms can leave equally easily

- firms are profit maximisers. so all the decisions that a firm makes are geared towards maximising profit. this means that all firms will choose to produce at a level of output where MC=MR

perfect competition lead to allocative efficiency... usually

- the conditions for a perfectly competitive market ensure that the rationing, signalling and incentive functions of the price mechanism work perfectly. in particular: -all firms are price takers - consumers and producers have perfect knowledge of the market, and there are no barriers to entry or exit

- in perfect competition, a markets demand curve=marginal utility, because consumers demand reflects what that good is worth to them and that decreases as quantity increases due to the law of diminishing utility

- also, a markets supply curve=marginal cost, because producers marginal costs increase as quantity increases due to the law of diminsihing returns

- allocative efficiency occurs when a goods price is equal to what consumers want to pay for it, and this happens in a perfectly competitive market because the price mechanism ensures that producers supply exactly what consumers demand. so, P=MC or P=MU

- without perfect competition, a market can't achieve allocative efficiency

allocative efficiency and externalities

- perfectly competitive markets will achieve allocative efficiency, assuming that there are no extenalities

- strictly speaking, allocative efficiency occurs when P=MSC

- perfect competition results in a long run equilibrium when P=MPC

- but if there are negative externalities, say, then MPC<MSC- which means that P<MSC. this will mean that theres allocative inefficiency, and that will lead to overproduction and overconsumption

perfect competition means supernormal profits are competed away

- in perfect competition, no firm will make supernormal profits in the long run

- this is because any short-term supernormal profits attract new firms to the market. this means supernormal profits are 'competed away' in the long term- i.e. firms undercut each other until all firms make only normal profit

- suppose there's high demand for a product across an industry as a whole, leading to a firm making supernormal profits

- the firms total revenue is TR=QxP. the firms total costs are TC=QxC. subtract TC from TR to find the firms profit. here, TR>TC, so this firm is currectly making a supernormal profit of TR-TC

- in a perfectly competitive market, those supernormal profits mean other firms will now have an incentive to enter the market. and since there are no barriers to entry, they can do this easily.

- this results in a shift in the industry supply curve to the right meaning the market price falls until all excess profits have been competed away, and a new long run equilbrium is reaches at price P1

a firm will leave a market if its unable to make a profit in the long run

- if the market price (AR) falls below a firms average unit-cost (AC), the firm is making less than normal profit

- there are no barriers to exit in a perfectly competitive market, so in the long run the firm will just leave the market

- however, in the short run, there are two possibilities: - if the selling price (AR) is still aboce the firms average variable costs, then the firm may continue to trade temporarily. - if the selling price (AR) falls below the level of the firms average variable costs, then it will leave the market immediately

perfect competition leads to productive efficiency

- productive efficiency is about ensuring the costs of production are as low as they can be. this will mean that prices to consumers can be low as well

- in perfect competition, productive efficiency comes about as a direct resuly of all firms trying to maximise their profits

- at the long run equilibrium of perfect competition, a firm will produce a quantity of goods such that: marginal revenue=marginal costs. output above this level reduces profit, so firms wouldnt produce it. output below this level would meant he firm would earn more revenue from extra output than it would spend in costs- so the firm would expand output as this would increase profit

- its no accident that in a perfectly competitive market, this long run output level is at the bottom of the average cost curve- i.e. at the lowest possible cost level. in other words, firms in a perfectly competitive market will be productively efficient

- having to compete gives firms a strong incentive to reduce waste and inefficiency. in other words, firms need to keep their level of 'x-inefficiency' as low as possible- if they dont, they may be forced to leave the market

- x-inefficiency measures how successfully a firm keeps its costs down. x-inefficiency means that production costs could be reduced at that level of production. x-inefficiency can be caused by: - either using factors of production in a wasteful way - or paying too much for factors of production

- but perfectly competitive markets only achieve productive efficiency if you asume that there are no economies of scale in the industtry. - in a perfectly competitive market, theres an infinite number of firms. - this means that each firm is very small, and so cant take full advantage of economies of scale. - if there are economies of scale, then an industry made up of an infinite number of very small firms may be less productively efficient than if there was one very big firm

perfect competition doesnt lead to dynamic efficiency

- dynamic efficiency is about improving efficiency in the long term, so it refers to the willingness and eagerness of firms: - to carry out research and development to improve existing products or develop new ones. - to invest in new technology or training to improve the production process and reduce production costs

- however, these strategies involve considerable investment and therefore risk, so they will only take place if theres adequate reward

- firms in a perfectly competitive market only earn normal profits, so theres no reward for taking risks. this means dynamic efficiencies will not be achieved

- however, as long as a market is towards the 'perfect-competition end' of the spectrum, then firm can achieve a degree of dynamic efficiency without becoming too allocatively and productively inefficient. this is why firms do achieve some degree of dynamic efficiency- in real life, no market is perfectly competitive

... but does lead to static efficiency

- if allocative and productive efficiency are achieved at any particular point in time, this is called static efficiency. but static efficiency cant last forever, since technology and consumer tastes change. for example, the methods used to make cars in the 1920s might have been allocatively and productively efficient at the time, but theyd be hopelessly out of date now

- to remain allocatively and productively efficient, car makers would have need to invest in new production technology and design new models at some point

in real life theres a 'spectrum' of different market structures

- in a perfectly competitive market, all the goods produced are identical, so the only way for firms to compete is on price

- in practice, firms usually compete in other ways than on price- for example, they might use: improved products, advertising and promotion, better quality of service, nicer packaging, wider product ranges or products that are easier to use

- in the real world, markets fall somewhere on a 'spectrum' of different markt structures

- at one extreme are 'perfectly competitive markets', and at the other are 'pure monopolies'. real-life markets lie somewhere between these extremes

- the closer an actual market matches the description of a perfectly competitive market, the more likely it is to behave in the same way

governments often try to encourage competition in markets

- perfectly competitive markets lead to efficient long run outcomes in theory

- by encouraging competition, governments hope to achieve these same kind of efficiencies in real life. for example, governments want to make sure firms: - are forced to produce efficiently, reducing costs where possible. - set prices at a level thats fair to consumers

- they also hope competition will encourage firms to innovate, leading firms to create both new products and new production processes

- there are various policies a government can introduce to increase competition in the economy: - encourage new enterprises with advice and start-up subsidies. - increase consumer knowledge by ensuring that comparison information is available. - introduce more consumer choice and competition in the public sector. this might involve creating 'internal markets' in sectors such as health and schooling, for example. - privatise and deregulate large monopolistic nationalised industries. - encourage more international competitiveness- e.g. by joining the EU, countries enter into a multinational 'single market'

- a barrier to entry is any potential diffuculty of expense a firm might face if it wants to enter a market

- the 'height' of these barriers determines: - how long it will take or how expensive it will be for a new entrant to establish itself in a market and increase the amount of competition. - whether new entants can successfully join the market at all

- barriers to entry limit firms that are already in the market to make supernormal profits, before new entrants enter the market and compete these profits away. how long incumbent firms can make supernormal profits for depends upon: - the height of the barriers to entry, i.e. how long the barriers can prevent new firms entering the market. - the level of supernormal profit being earned, this is because the greater the profits to be made, the more effort new entrants will be willing to make to overcome the barriers

- perfectly competitive markets have no barriers to entry whatsoever. in a pure monopoly the barriers to entry are total. no new firms can enter, so the monopolist remains the only seller

- as usual, in real life the situation often lies somewhere between the extremes of perfect competition and a monopoly. there are normally some barriers to entry but theyre not usually total

barriers to entry can be created in various ways

- barriers to entry come about for various reasons. for example: - the tendency of incumbent firms to create of build barriers. - the nature of the industry over which incumbent firms and new entrants have little control. - the extent of government regulation and licensing

- the overall barrier to entry into a market might be made up of a number of individual barriers:\

barriers to entry due to incumbent firms' actions

- an innovative new product or service can give a firm a head start over its rivals which can be difficult for a new entrant to overcome. if the new technology is also patented then other firms cant simply copy the new design- its legally protected

- strong branding means that some products are very well known to consumers. the familiarity of the product often makes it a consumers first choice, and outs new entrants to a market at a disadvantage. a strong brand can be the result of a firm making genuinely better products than the competitor, or can be created by effective advertising. the barrier to entry is the expense and difficulty of the new entrant to the market would have in attracting customers away from the market leaders

- aggressive pricing tactics by incumbent firms can drive new competiton out of the market before it becomes established. incumbent firms may be able to lower prices to a level that a new entrant cannot match and drive them out of business. this is sometimes called 'predatory pricing'

- just the threat of a 'price war' may be enough to deter new firms from entering a market

barriers to entry can be due to the nature of an industry

- some 'capital-intensive' industries require huge amounts of capital expenditure before a firm recieves any revenue. the cost of entering these markets is huge, so smaller enterprises may not be able to break through

- if investments cant be recovered when a firm decides to leave a market, then that may make any attempt to break into a market very risky and unappealing

- if theres a minimum efficient scale of production then any new firms entering the industry on a smaller scale will be operating at a higher point on the average cost curve then established firms. this means any new entrant has higher production costs per unit, so theyd have to sell the products to consumers at a higher price

barriers to entry can be due to government regulations

- if an activity requires a license, then this restricts the number and speed of entry of new firms coming into a market. for example, pubs, pharmacists, food outets, dentists and taxis all require licences before they can operate. similarly, in a regulated industry, firms have to be approved by a regulator before they can carry out certain activities

- new factories may need planning permission before they can be built

- there will also be regulations regarding health and safety and working conditions for employees that firms will need to keep to

new entrants sometimes have their own advantages

- not all new entrants to a market are small firms trying to compete against established 'giants'

- sometimes the new entrants can be large successful companies that wish to diversify into new markets

- their large size means they have greater financial resources, so they may be more successful in breaking into new markets

a monopoly is a market containing a single seller

- in economics, a monopoly is a market with only one firm in it. in other words, a single firm has 100% market share

- even in markets with more than one seller, firms have monopoly power if they can influence the price of a particular good on their own- i.e. they can act as price makers

- monopoly power may come about as a result of: - barriers to entry preventing new competition entering a market to compete away large profits. - advertising and product differentiation, a firm may be able to act as a price maker if consumers think of its products as more desirable than those produced by other firms. - few competitors in the market, if a market is dominated by a small number of firms, these are likely to have some price-making power. theyll also find it easier to differentiate their products

- even though firms with monopoly power are price makers, consumers can still choose whether or not to buy their products. so demand will still depend on the price- as always, the higher the price, the lower the demand will be

a monopolist makes supernormal profits- even in the long run

- assuming that the firm wants to maximise profits, its level of output will be where MR=MC

- if the firm produces a quantity Qm, the demand curve shows the price the firm can set- Pm

- at this output the average cost of producing each unit is ACm

- the difference between ACm and Pm is the supernormal profit per unit

- in a monopoly market, the barriers to entry are total, so no new firms enter the market, and this means supernormal profits are not competed away

- this means the situation remains as it is- this is the long run equilibrium point for a monopolist

monopolies are productively and allocatively inefficient

- MC isnt equal to AC at the long run equilibrium point for a monopoly. this means that a monopoly isnt productively efficient

- the price charged by the firm is greater than MC. this means that a monopoly is not allocatively efficient. producers are being 'over-rewarded' for the products theyre providing

- because of the restricted supply, the product will be underconsumed- consumers arent getting as much of the product as they want

- some of the consumer surplus that would have existed at the market equilibrium price Pc is transferred to the producer

- theres a deadweight loss too. this is the potential revenue that the producer isnt earning on the quantity Qm to Qc of the product that consumers would have been prepared to pay for

monopolies have further drawbacks

- theres no need for a monopoly to innovate or to respond to changing consumer preferences in order to make a profit, so they may become complacent

- simalarly, theres no need to increase efficiency, so x-inefficiency can remain high

- consumer choice is restricted, since there are no alternative products

- monoposonist power may also be used to exploit suppliers

- some industries lead to a natural monopoly- this can mean they have a great deal of monopoly power

- industries where there are high fixed costs and/or there are large economies of scale lead to natural monopolies

- if there was more than one firm in the industry, then they would all have the same high fixed costs. this would lead to higher costs per customer than could be obtained by a single firm

- in this case, a monopoly might be more efficient than having lots of firms competing. for example, the supply of water is a natural monopoly- it makes no sense for competing firms to  all lay seperate pipes

- a natural monopoly will have continous economies of scale- i.e. LRAC always falls as output increases. a profit maximising natural monopoly will restrict output to where MR=MC

- a government might be reluctant to break up a natural monopoly as this could reduce efficiency. however, it might want to provide subsidies to the natural monopoly so that it increases output to the point where demand=supply- this is Qs. this will reduce prices to Ps

monopolies have some potential benefits

- a monopolist's large size allows it to gain an advantage from economies of scale. if diseconomies of scale are avoided, this means it can keep average costs low. a monopolist will produce more than any individual producer in a perfectly competitive market would

- the security a monopolist has in the market means it can take a long-term view and invest in developing and improving products for the future- this can lead to dynamic efficiency

- increased finacial security also means that a monopolist can provide stable employment for its workers

- intellectual property rights allow a form of legal limited monopoly that can actually be in consumers interests because theyll benefit from better quality, innovative products. - there are various types of IPRs, such as copyright and patents. these allow a firm exclusive use of their innovative ideas for a limited time. - during this time, supernormal profits may be possible, but this is seen as a reward for innovation and creativity. - without the protection of IPRs, firms would have little incentive to risk their resources investing in innovative products or processes- other firms would simply be able to copy those ideas

a monopsony is a market with a single buyer

- a monopsony is a situation when a single buyer dominates a market

- a monopsonist can act as a price maker, and drive down prices. for example, supermarkets are sometimes accused of acting as monopsonists when buying from their suppliers. some people claim supermarkets use their market power to force suppliers to sell their products at a price that means those suppliers make a loss

- this could be seen as a monopsonist exploiting its suppliers, but it could be in the interests of consumers if the supermarkets pass on those low prices

- if a firm is the single buyer of labour in a market, it can exploit its power and lower the wages of its employees

- price discrimination occurs when a seller charges different prices to different customers for exactly the same product. - its not price discrimination if the products arent exactly the same. - so business-class and standard-class plane tickets are not an example of price discrimination, since it costs more to provide the comfier seats and extra legroom is business class

- several conditions need to be satisfied for a firm to make use of price discrimination: - the seller must have some price-making power. so monopolies can price discriminate. - the firm must be able to distinguish seperate groups of customers who have different price elasticities of demand. in fact, the more groups that the market can be subdivided into, the greater the gains for the seller. - the firm must be able to prevent seepage, it must be able to prevent customers who have bought a product at a low price re-selling it themselves at a higher price to customers who could have been charged more

- examples: - theatres and cinemas offer 'concession' prices for certain groups. - window cleaners could charge more in a smart neighbourhood than in a lower-income area. - train tickets at rush hour cost more than the same train ticket at other times of the day. - pharmaceutical drugs may be sold at different prices in different countries

price discrimination transfers consumer surplus from consumer to producer

- a consumer surplus is the difference between the actual selling price of a product and the price a consumer would have been willing to pay. for example, if the price of a cinema ticket was $8, but a consumer would have been willing to pay $10, then the consumer surplus is $2

- price discrimination attempts to turn consumer surplus into additional revenue for the seller

- there are different degrees of price discrimination: first, second and third degree

- 1st degree price discrimination: - 1st degree price discrimination is where each individual is charged the maximum they would be willing to pay. - this would turn all the consumer surplus into extra revenue for the seller. - however, the cost of gathering the required information to do this, and the difficulty in preventing seepage, makes this method unlikely to be used in practice

- 2nd degree price discrimination: - 2nd degree price discrimination is often used in wholesale markets, where lower prices are charged to people who purchase large quantities. this turns some of the consumer surplus into revenue for the seller, and encourages larger orders. - by charging some customer P2, some is turned into additional revenue for the firm

- 3rd degree price discrimination: - 3rd degree price discrimination is when a firm charges different prices for the same product to different segments of the market. these different segments could be: >customers of different ages. >customers who buy at different times. >customers in different places. - for example, a seller can identify 2 groups of customers with different price elasticities of demand. - to maximise profit, the seller would set the price for each group where MC=MR, this means: >it will charge a higher price to the group with a more inelastic PED. >it will charge a lower price to the group with a more elastic PED. - the total supernormal profit is greater than if the same price were charged to everyone

price discriminations is good for sellers and possibly bad for others

- price discrimination certainly results in increased revenue for the seller. whether this is seen as fair ot unfair depends on what happens to that extra revenue

- the use of price discrimination means that some or all of the consumer surplus is converted into revenue for the seller- i.e. the seller increases revenue at the expense of the consumer. however, the extra revenue could be used to improve products, or invested in more efficient production methods which might lead to lower prices

- in all cases, the average revenue is greater than MC- so price discrimination does not lead to allocative efficiency, because allocative efficiency occurs when P=MC

- consumers are not treated equally, but often the people who end up paying more have higher incoms, so are more able to afford those higher prices. some people see this as fair, especially if the greater profits made from some customers are used to subsidise lower prices paid by others

concentration ratios show how dominant the big firms in a market are

- some industries are dominated by just a few companies. these are called concentrated markets

- the level of domination is measured by a concentration ratio: - suppose 3 firms control 90% of the market, while another 40 firms control the other 10%. - the 3-firm concentration ratio would be 90%. - its easy to calculate the n-firm concentration ratio of a market. for example, suppose a market is worth $45m and you wanted to find the 3-firm concentration ratio. if the biggest 3 firms have revenues of $15m, $9m and $7m respectively, the 3-firm concentration ratio is: ((5+9+7)/45) x100= 68.9%

there are 2 ways to define an oligopoly

- you can define an oligopoly in terms of market structure: - an oligopoly is a market: >thats dominated by just a few firms. >that has high barriers to entry. >in which firms offer differentiated products

- or you can dfine an oligopoly in terms of the conduct of firms: - an oligopoly is a market: >in which the firms are interdependent- i.e. the actions of each firm will have some kind of effect on the others. >in which firms use competitive or collusive strategies to make this interdependance work to their advantage

firms in an oligopoly can either compete or collude

- unlike with perfectly competitve markets and monopolies, theres no single strategy that firms in an oligigopolistic market should adopt in order to maximise profits

- firms in an oligopoly face a choice about what kind of long-term strategy they want to employ, and each companys decision will be affected by how the other interdependant firms in the market act

- this means that there are differnt possible scenarios in an oligopolistic market

- competitive behaviour: - this is when the various firms dont cooperate, but compete with each other

- collusive behaviour: - this is when the various firms cooperate with each other, especially over what prices are charged. - formal collusion involves an agreement between the firms- i.e. they form a cartel. this is usually illegal. - informal collusion in tacit- i.e. it happens without any kind of agreement. this happens when each firm knows its in their best interests not to compete.. as long as all the other firms do the same. - some firms in a collusive oligopoly might still be able to act as price leaders, setting the pattern for others to follow

- the behaviour that occurs depends on the characteristics of a particular market

- competitive behaviour is more likely when: - one firm has lower costs than others. - theres a relatively large number of big firms in the market. - the firms produce products that are very similar. - barriers to entry are relatively low

- collusive behaviour is more likely when: - the firms all have similar costs. - there are relatively few firms in the market. - 'brand loyalty' means customers are less likely to buy from a different firm, even when their prices are lower. - barriers to entry are relatively high

collusion can bring about similar outcomes to a monopoly

- collusive oligopolies can produce esults quite similar to those in a monopoly

- collusive oilgopolies generally lead to there being higher prices and restricted output, as well as allocative and productive inefficiency. firms in collusive oligopolies often have the resources to invest in more efficient production methods and achieve dynamic efficiency, but theres not always an incentive for them to do so. so collusive oligopolies can lead to market failure

- because the firms in a collusive oligopoly dont lower prices even though they could, they make supernormal profits at the expense of consumers

- in the case where colluding firms have an agreement to restrict otuput to maintain high prices, the firms will set a price and a level of output that will maximise profits for the industry. they then agree output quotas- the level of output each of the firms will produce. then resulting in supernormal profits

- firms that collude on price might still compete in other ways though, so the firms marketing policies are very important: - for example, colluding firms may try to differentiate their products from their competitiors- either by improving them in some way or by trying to create a strong brand to attract and retain customers. - they could use sales promotions. - they may even try to find new export markets

- other firms that try to break into the market may face predatory pricing tactics. even so, if potential profts are large enough, they may preserve until they eventually establish themselves. however, they may then see that its not in their interests to compete further- if so, collusions can re-emerge

oligopolies might not be as bad as they sound

- some economists argue that collusive oligopolies are either: - not as bad at theyre sometimes made to sound. - unstable- i.e. theyre unlikely to last for long. - both of the above

- they argue that formal collusion is quite unlikely to occue because its usually illegal, and any informal collusion is likely to be temporary, because 1 firm will soon decide to 'cheat', and lower its prices to gain an advantage. this kind of behaviour is likely to trigger a price war

- even in a collusive oligopoly: - if firms arent competing on price, then non-price competition might even be stronger, leading to some dynamic efficiency. this would be good for consumers if it led to productive innovations and improvements. - firms are unlikely to raise prices to very high levels. this is because high prices may provide a strong incentive for new entrants to join the market, even if the barriers to entry are high

- compeitive oligopolies can achieve high levels of efficiency- these markets often work well in practice

game theory can be used to understand the results of interdependance

- in oligopolistic markets, each firm is affected by the behaviour of the others- the firms are interdependant

- this means that the behaviour of firms in oligopolistic markets can be looked at as a kind of 'mathematical game': - game theory is a branch of maths. - its all to do with analysing situations where 2 or more 'players' are each trying to work out what to do to further their own interests. - the fate of each of the players depends on their own decisions, and the decisions of everyone else. so all the players are interdependant. this is why its often used to analyse situations in economics

the kinked demand curve model is used to explain price stability

- you can understand some outcomes from oligopolistic markets by 'playing the game' from each firms perspective

- for example, the model of the kinked demand curve illustrates why prices are often quite stable, even in some competitive oligopolies

- in the kinked demand curve model, there are 2 assumptions: - if 1 firm raises its prices, then the other firms will not raise theirs. - if 1 firm lowers its prices, then the other firms will also lower theirs

- the 1st assumption means that a firm wich raises its prices will see quite a large drop in demand. this is because customers are likely to switch to buying their goods from other firms. in other words: when price is increased, demand is price elastic. this means any firm that raises its prices will loose out- the fall in demand will more than cancel out the gains from charging a higher price

- the 2nd assumption means that a firm which lowers its prices will not gain any market share. in other words: when price is decreased, demand is price inelastic. this means any firm that reduces its prices will loose out- they wont gain market share but the average pice for their products will have fallen

- the result of the above assumptions is a kinked demand curve

- the outcome is that firms have no incentive to change prices. if they either raise or lower prices, they will loose out as a result

- the result is price stability for prolonged periods of time

the kinked demand curve model describes just 1 possible outcome

- the kinked demand curve model shows 1 type of interdependance

- this means that it doesnt explain the behaviour of firms in every oligopoly

- the assumptions in the kinked demand curve model may not be appropriate for every oligopoly- and if theyre not, the model wont predict firms behaviour at all well. other oligopolistic markets will be better described using different models

the prisoners dilemma model can show a first-mover advantage

- the prisoners dilemma model can be used to understand how interdependant firms might act in an oligopolistic market. in the version below there are actuallly 2 firms: - suppose these are just 2 firms in a market, firm a and firm b. - each firm has to decide what level of output to produce in their oligopolistic market situation. - for simplicity, assume that each firm has 2 options: >produce a high level of output. >produce a low level of output. - both firms know the other firm is also trying to decide what level of output to produce. - and both firms know that theyre interdependant- i.e. both firms will be affected by each others decision

- the results of the firms different choices can be summarised using a payoff matrix

- if the firms cooperate and agree to restrict output levels, then the outcome for both firms is better than if they both output at a high level. this could work well for both firms, if they can both be trusted

- however, its in the interests of each firm to stop cooperating and raise output- as long as they do this before the other firm decides to

- this is because if one firm decides to 'cheat' and increase output, then its actually in the interests of the other firms to keep producing at a low level and take the reduced profit of 100. this is an illustration of first-mover advantage

- the theoru of first-mover advantage shows why cartels can be unstable- every firm knows they can get an advantage if they break the agreement before anyone else does

being the first mover isnt always an advantage

- being the first mover can give a firm an advantage, but it can also be a disadvantage

- different decisions will make sense in different situations- it all depends on the numbers in the payoff matrix

- for example, suppose several firms are all deciding whether to launch a new type of product into a market: - the 'first mover' could make a huge profit by winning a large market share very early. - however, if theyve overestimated the demand for the product, they may make huge losses. - also, competitiors may be able to use a lot of technology that the first firm has developed, reducing their costs, and allowing them to charge a lower price than the first mover

monopolistic competition resembles a lot of real-life industries

- monopolistic competition lies part-way along the range of market structures- between perfect competition and monopolies

- in monopolistic competition, the conditions of perfect competition are 'relaxed' slightly and instead become: - some product differentiation- either due to advertising or because of real differences between products: >this means the seller has some degree of price-making power. >so each sellers demand curve slopes downwards. >but the smaller the product differences, the more price elatic the demand for each product will be. - there are either no barriers to entry or only very low barriers to entry: >this means that if very high supernormal profits are earned, new entrants can join the industry fairly easily

- these 'relaxed' conditions are actually more typical of firms in real life. this means that the behaviour predicted in this model may also be more realistic

the short run condition is like a monopoly

- in monopolistic competition, the barriers to entry and/or the product differentiation mean that supernormal profits can be made, but only in the short run: - the profit-maximising level of output occurs where MR=MC. - this means that firms earn supernormal profit

but the long run position is more like perfect competition

- but unlike in a monopoly, the situation doesnt last in the long run

- in monopolistic competition, the barriers to entry are fairly low, so new entrants will join the industry. these new entrants will cause the established firms demand curve to shift to the left

- new entrants will continue to join until: - only normal profit can be earned- this is where P=AR=AC. at this point the slopes of the AC curve and the demand curve touch tangentially. - at this quanity, MR=MC

- since the firm is not producing at the lowest point on the AC curve, this outcome is not productively efficient

- and since the equilibrium is greater than MC, this is not allocatively efficient

- but despite this, a monopolistically competitive market will generally achieve much greater efficiency levels than a monopoly market

prices in monopolistic competition are higher than in perfect competition

- the short run position of monopolistic competition is basically the same as in a monopoly. however, unlike in a monopoly, new entrants to the market will drive prices down until only normal profit is earned in the long run

- exactly how long this process takes is important: - if it takes a very long time, the market will resemble a monopoly. - but if it all happens relatively quickly, then the market will be more like a perfectly competitive market. - this is why firms are often willing to spend large amounts of money to try to differentiate their product. the longer a firm can retain its price-making power, the longer it can make supernormal profit

- but unlike in perfect competition, in monopolistic competition the firm is not producing at the lowest point on the AC curve

- these different positions on the AC curve mean that prices in monopolistic competition tend to be higher than in perfect competition

- this is because firms in monopolistic competition need to spend money on differentiating their product and creating brand loyalty

- firms in monopolistic competition have also chosen to restrict output in order to maximise profits. this means they dont benefit from all the economies of scale that they could

- prices in monopolistic competition tend to be lower than those charged by a monopoly seller

- generally, monopolistic competition is felt to work reasonably well in practice

monopolistic competition doesnt usually lead to dynamic efficiency

- the length of time it takes for new entrants to force all firms in monopolistic competition to only make normal profit is the length of time an incumbent firm can make supernormal profits

- these supernormal profits are reward for risky production investment or product innovation

- however, the lack of barriers to entry mean that firms are unlikely to invest huge amounts of money on new innovations- so theres likely to be less dynamic efficiency in a monopolistically competitive market

- in the long run, the absence of supernormal profit will mean that there wont be much money available for investment

a contestable market is open to new competitors

- contestablility refers to how open a market is to new competitiors, even if currently theres little actual competition

- in a contestable market: - the barriers to entry and exit are low. so if excess profits are made by incumbent firms, new firms will enter. - supernormal profits can potentially be made by new firms

- these factors mean the incumbent firms always face the threat of increased competiton. increased competition is more likely if the incumbent firms make large supernormal profits, as new entrants will want some of those profits

- this means incumbent firms have an incentive to set prices at a level that wont generate vast supernormal profits

anything that makes barriers higher makes a market less contestable:

- there are patents on key products or production methods: - patents give a firm legal protection against other firms copying its products or production methods

- advertising by incumbent firms has already created strong brand loyalty

- theres a threat of limit pricing tactics by the incumbent firms: - if new entrants fear a 'price war', then they may decide not to enter the market. - this would be particularly difficult for new entrants if the incumbent firms had lower costs as a result of having been in the market for longer

- trade restrictions are present- these dont allow new foreign entrants to compete in domestic markets on equal terms with the incumbent firms

- incumbent firms are vertically integrated: - this could mean that access to supplies of raw materials or distribution networks is difficult for new firms

- sunk costs are high: - costs are 'sunk' if they cannot be recovered when a firm leaves an industry. - if these sunk costs are high then the cost of failure is high, entrants may be deterred

hit-and-run tactics can be used in contestable markets

- the low barriers to entry and exit in a contestable market mean that new entrants will 'hit and run'

- hit-and-run tactics: - this means entering a market while supernormal profits can be made. - and then leaving the market once prices have been driven down to normal-profit levels

- as long as the profit made while in the market is greater than the entry and exit costs, its worthwhile for a firm to compete, even for a short time

the contestability of a market affects the behaviour of incumbent firms

- in a contestable market, its the threat of increased competition that affects how incumbent firms behave. for example, incumbent firms will know that high supernormal profits are likely to attract new entrants, and that these new entrants are likely to drive down prices

- so, it might make more sense for the incumbent firms to sacrifice short-term profits, and set lower prices to avoid attracting new entrants. this may be the best way to maximise profit in the long run

- incumbent firms have an interest in creating high barriers to entry if they can

- this could involve heavy spending on advertising or making it clear they would be prepared to engage in predatory pricing if new firms entered the market

- but in the long run, firms in constestable markets will move towards productive and allocative efficiency, because supernormal profit is competed way and firms must settle for normal profit

- a market fails when the price mechanism fails to allocate scarce resources efficiently and society suffers as a result

- market failure is a common problem and governments often intervene to try to prevent it

externalities affect 3rd parties

- externalities are the effects of producing or consuming a good/service has on people who arent involved in the making, buying/selling and consumption of the good/service. 

- externalities can be either positive or negative. positive externalities are the external benefits to a 3rd party and negative externalities are the external costs to a 3rd party

- externalities can occur in production or consumption, for example: - a negative externality of producing steel could be pollution that harms the local environment. - a positive externality of producing military equipment could be an improvement in technology that benefits society. - a negative externality of consuming a chocolate bar could be litter thats dropped on the street. - a positive externality of someone training to be a doctor could be the benefit to society that this brings

Market failure occurs because externalities are ignored

- a private cost is the cost of doing something to either a consumer or a firm. For example, the cost a firm pays to make a good is its private cost and the price a consumer pays to buy the good is their private cost

- external costs are caused by externalities, e.g. if you dropped an empty crisp packet then that creates an external cost to the council who have to employ someone to sweep it up

- adding the private cost to the external cost gives the social cost. The social cost is the full cost borne by society of a good or service

- a private benefit is the benefit gained by a consumer or firm by doing something. For example, the private benefit a consumer might get from purchasing a skiing holiday is their enjoyment of the experience

- external benefits are also caused by externalities, e.g. a factory that invests in new equipment may create the external benefit of needing less electricity, which reduces its impact on the climate

- adding the private benefit to the external benefit gives the social benefit. The social benefit is the full benefit received by society from a good or service

- market failure occurs because in a free market the price mechanism will only take into account the private costs and benefits, but not the external costs and benefits

Externalities can be shown using diagrams

- the marginal private cost is the cost of producing the last unit of a good

- the marginal social cost= the marginal private cost+the external cost

- so, the difference between the MPC and the MSC curves is the external cost of production- the negative externalities

- if the MPC and MSC curves are parallel then external costs per unit are constant. If the curves diverge then external costs per unit increase with output

- an example of why the curves might diverge is pollution- the external costs per unit created by pollution can increase as output increases

- the marginal private benefit is the benefit to someone consuming the last unit of a good

- the marginal social benefit= the marginal private benefit+the external benefit

- the difference between the MPB and the MSB curves are the external benefits- the positive externalities

- again, if the MPB and MSB curves are parallel then external benefits per unit are constant. If they diverge then external benefits per unit increase with output

- an example of when the curves might diverge is vaccination- the more people that are vaccinated, the greater the protection for unvaccinated people

The equilibrium point may be different to the socially optimum point

- when supply and demand are equal theres equilibrium in the free market

- in a free market consumers and producers only consider their private costs and private benefits- they ignore any social costs or benefits. As a result, the MPC curve can be see as the supply curve of a good or service and the MPB curve can be seen as the demand curve

- so, equilibrium occurs when MPC=MPB

- however, the socially optimum level of output is where MSC=MSB, because this includes the external costs and benefits to society

- this means that this the socially optimum level. This level of output and price will give society the maximum benefit of any positive externality and still cover the cost of any negative externality

ignoring negative productio externalities leads to overproduction

- at the optimal output level and optimal price, as there are no positive externalities, MPB=MSB

- however, in the free market only private costs are considered

- this would cause overproduction and underpricing of this good- more is produced and sold at a lower price than is desirable for society. for each unit of this good produced the marginal social cost is greater than the marginal social benefit

- the area between the marginal social cost and marginal social benefit is the area of welfare loss- the loss to society caused by ignoring externalities

- example: a chemical factory may ignore the externalities it produces, such as the release of harmful waste gases into the atmosphere. if this happens then output from the factory will be higher than the socially optimum level and that will lead to a welfare loss to society

ignoring negative productio externalities leads to overproduction

- at the optimal output level and optimal price, as there are no positive externalities, MPB=MSB

- however, in the free market only private costs are considered

- this would cause overproduction and underpricing of this good- more is produced and sold at a lower price than is desirable for society. for each unit of this good produced the marginal social cost is greater than the marginal social benefit

- the area between the marginal social cost and marginal social benefit is the area of welfare loss- the loss to society caused by ignoring externalities

- example: a chemical factory may ignore the externalities it produces, such as the release of harmful waste gases into the atmosphere. if this happens then output from the factory will be higher than the socially optimum level and that will lead to a welfare loss to society

ignoring positive consumption externalities leads to underconsumption

- at the optimal level of output and optimal price, as there are no negative externalities, MPC=MSC

- in the free market only private benefits are considered

- this would cause underconsumption and underpricing of this good- less is consumed and sold at a lower price than is desirable for society. for each unit of this good consumed the marginal social benefit is greater than the marginal social cost

- the area between the marginal social benefit and marginal social cost is the area of potential welfare gain- the gain to society lost by ignoring externalities

- education: - in a free market the positive externalities of education will be ignored by suppliers of education. their choices are based on profit maximisation. - the positive externalities will also be ignored by students/parents, who will only consider the benefits to themselves/their children- e.g. that a good education will help someone get a better/higher-paid job. - there are many positive externalities of education- for example, the better educated the workforce the more productive they are, which in turn increases a countrys output. furthermore, increasing education levels has other social benefits such as reduced crime levels and a happier population

- health care: - in a free market, providers and consumers of health care will only consider the private costs and benefits. the decisions they make will ignore any positive externalities. - there are many positive externalities of health care- for example, a healthier workforce will be more productive and take less time of work, which will in turn increase a country's economic output. there are social benefits to recieving health care- for example, society as whole will benefit if people have an improved sense of personal well-being and increased life expectancy

ignoring negative consumption externalities leads to overconsumption

- at the optimal level of output and the optimal price, the marginal private benefit is larger than the marginal social benefit

- in the free market only private benefits are considered

- this would cause overconsumption and overpricing of this good- more is consumed and sold at a higher price than is desirable for society. for each unit of this good consumed the marginal social cost is greater than the marginal social benefit

- the area between the marginal social cost and marginal social benefit is the area of welfare loss- the loss to society caused by ignoring externalities

- example: drivers will ignore the negative consumption externalities associated with driving their cars, such as pollution and congestion. this will result in the usage of cars being higher than the socially optimal level, causing a welfare loss to society

ignoring positive externalities leads to underproduction

- at the optimal level of output and the optimal price, the marginal private cost is larger than the marginal social cost

- in the free market only private costs are considered

- this would cause underproduction and overpricing of this good- less is produced and sold at a higher price than is desirable for society. for each unit of this good consumed the marginal social cost is lower than the marginal social benefit

- the area between the marginal social cost and marginal social benefit is the area of potential welfare gain- the gain to society lost by ignoring externalities

- example: employers will ignore positive production externalities associated with paying to train their employees, such as the benefits to society of having a more highly skilled workforce. this means resources wont be allocated to training employees to the socially optimal level, causing a potential welfare gain to society to be lost

merit goods have greater social benefits than private benefits

- merit goods are goods whose consumption is regarded as being beneficial to society. they provide benefits to both individuals and society as a whole, but people are usually unaware of the full benefits than merit goods provide

- examples of merit goods include health care and education

- merit goods tend to be underconsumed for 2 main reasons: - in the free market the positive externalities that merit goods provide are ignored, and production and consumption will be below the socially optimal level. for example, producers and consumers wont consider the wider benefits to society of a good education, such as having a more productive workforce. - due to imperfect competition, consumers dont always realise the full benefits that merit goods provide. for example, people might not have enough information on how serious their health problems might be, so their demand for health care isnt as high as it should be and health care is underprovided

- not all merit goods will be welcomed by all potential consumers, and they can be rejected- for example, the offer of free vaccinations may be refused

demerit goods have greater social costs than private costs

- demerit goods are goods whose consumption is regarded as being harmful to the people that consume them, but people are usually unaware about the harm than the demerit goods can cause. demerit goods also have a harmful effect of society due to the negative externalities that result from their consumption

- examples of demerit goods are cigarretes and heroin

- demerit goods tend to be overconsumed for 2 main reasons: - in the free market the negative externalities than demerit goods caused are ignored, and production and consumption will be above the socially optimal level. for example, producers and consumers wont consider the wider disadvantages to society of cigarettes such as smoking-related health issues putting a strain on health care services. - due to imperfect information, consumers dont always realise the harm that demerit goods can cause. for example, people might not have enough information on how a harmful drug might affect their health, so their demand for the drug is higher than is should be and the drug is overprovided

demerit goods have greater social costs than private costs

- demerit goods are goods whose consumption is regarded as being harmful to the people that consume them, but people are usually unaware about the harm than the demerit goods can cause. demerit goods also have a harmful effect of society due to the negative externalities that result from their consumption

- examples of demerit goods are cigarretes and heroin

- demerit goods tend to be overconsumed for 2 main reasons: - in the free market the negative externalities than demerit goods caused are ignored, and production and consumption will be above the socially optimal level. for example, producers and consumers wont consider the wider disadvantages to society of cigarettes such as smoking-related health issues putting a strain on health care services. - due to imperfect information, consumers dont always realise the harm that demerit goods can cause. for example, people might not have enough information on how a harmful drug might affect their health, so their demand for the drug is higher than is should be and the drug is overprovided

- sometimes its hard to say which goods should be classified as merit or demerit goods. whether a good fits into one of these classificatons is usually a value judgement- based on peoples opinions and not on economic theory or facts

- for example, some people consider contraception to be a merit good, but others dont

- not all goods with postive externalities are merit goods, e.g. planting flowers in a garder may have positive externalities, such as providing pollen for bees or an attractive sight for passers-by, but flower seeds are unlikely to be seen as merit goods whose consumption should be encouraged for the benefit of society

- not all goods with negative externalities are demerit goods, e.g. driving in a car can cause negative externalities, but driving a car isnt seen as being harmful to an individual in the way that taking a drug might be

merit goods generate positive externalities

- if its left to the free market the price and quantity demanded of a merit goods will be where the MPB curve crosses the MPC/MSC curve. the market equilibrium is below the socially optimal level of consumption- where MSC=MSB

- to increase consumption to the socially optimal level the government could introduce a subsidy to bring the price down

demerit goods generate negative externalities

- if its left to the free market then the price and quanity demanded of a demerit good will be where the MPC/MSC and the MPB curves cross. the market equilibrium is above the socially optimal level of consumption- where MSC=MSB

- to decrease consumption to the socially optimal level the government could introduce a tax to bring the price up

short-term decision-making can affect the consumption of goods

- when individuals take a short-trm approach to decision-making, it can lead to the underconsumption of merit goods and the overconsumption of demerit goods

- people often only consider the short-term benefits or costs. individuals can fail to see the need to make provision for the future and for potential changes in their circumstances. a good example of this is paying into an old-age pension

- the long-term private benefits of merit goods are greater than their short-term private benefits and the long-term private costs of demerit goods are greater than their short-term private costs

- the short-term benefits of paying towards a pension are less than the benefits of recieving that pension when you retire

- the short-term costs of buying cigarettes are much less than the long-term costs- e.g. serious smoking-related illness

governments can intervene in markets for merit and demerit goods

- the failure of the free market to supply the socially optimal levels of merit and demerit goods is the main reason why governments intervene to affect their supply. governments can directly provide certain goods or services or they can use taxes and subsidies to decrease or increase consumption of certain goods or services to the socially optimal level

- governments have a lot of information regarding the costs and benefits of goods/services to both individuals and society as whole, and can use this information to make decisions that benefit the whole of society

public goods are goods that are consumed collectively

- an example of a public good could be a flood defence scheme or street lighting

- public goods have 2 main characteristics: - non-excludabilty- people cannot be stopped from consuming the good even if they havent paid for it, e.g. you couldnt stop an individual benefiting from the services of the armed forces. - non-rivalry/non-diminishibility- one person benefiting from the good doesnt stop others also benefiting, e.g. more people benefiting from flood defences doesnt reduce the benefit to the first person to benefit. this means that public goods have 0 marginal cost- theres no additional cost to extending the good to one more person

- some other examples of public goods include firework displays and lighthouses

private goods are the opposite of public goods

- private goods are excludable and they exhibit rivalry

- for example, biscuits are a private good- if you eat a biscuit you stop anyone else from eating it

- unlike public goods, people have a choice as to whether to consume private goods- biscuits can be rejected

- most goods are private goods- anything from bread to university education

some public goods can take on the characteristics of public goods

- some goods are pure public goods, e.g. lighthouses. others can exhibit the characteristics of a public good- but not fully. these are known as non-pure public goods

- for example, roads appear to have the characteristics of a public good- often theyre free for everyone to use and one person using a road doesnt prevent another person from using it too. however, tolls make a road excludable by excluding those who dont pay to use the road, and congestion will make a road exhibit rivalry as theres a limit to the number of people who can benefit from the road at any one time

- new technology can change a good that once had the characteristics of a public good into a private good

- for example, 'analogue' television broadcasting has some characteristics of a public good- if you own a TV and an ariel than TV broadcasts are non-rivalrous and non-excludable. however, the invention of digital technology has meant that channels can be encrypted to ensure that if people want a certain channel, they have to pay for it

public goods are under-provided by the free market

- the non-excludability of public goods leads to whats called the free rider problem

- the free rider problem means that once a public good is provided its impossible to stop someone from benefiting from it, even if they havent paid towaards it. for example, a firm providing street cleaning cannot stop a free rider, who has refused to pay for street cleaning, benefiting from a clean street

- the price mechanism cannot work if there are free riders. consumers wont choose to pay for a public good that they can get for free because other consumers have paid for it

- if everyone decides to wait and see who will provide and pay for a public good, then it wont be provided

- its also difficult to set a price for public goods because its difficult to work out their value to consumers

- producers will tend to overvalue the benefits of a public good in order to increase the price that they charge. consumers will undervalue their benefits to try to get a lower price

- these problems mean that firms are reluctant to supply public goods, and the problems will cause market failure. as a result, governments will usually have to intervene to provide the public good

- positive externalities are a form of a public good. theyre consumed by those who dont pay for them, so theyre an example of the free rider problem

- parts of the environment are often considered to have the characterstics of public goods. for example, the air is a public good which isnt bought or sold on a market- its non-excludable and non-rivalrous

- both clean air and dirty, polluted air cost the same- so if clean air becomes scarce its price wont rise and deter people from 'using it up'

- the non-excludability of clean air leads to the free rider problem. the benefits of not polluting the air, or cleaning the air afterwards, arent restricted to those who have 'paid' for the clean air by choosing not to pollute, or choosing to clean the air. therefore, in the free market, its unlikely that anyone will either choose not to pollute, or to clean up the pollution they make

- this is an example of the economic theory known as the tragedy of the commons- the idea that people acting in their own best interests will overuse a common resource without considering that this will lead to the depletion or degredation of that resource

- the tragedy of the commons can explain a lot of the causes of environmental market failure. again, governments will usually have to prevent the destruction and degredation of common resources

symmetric information means everyone has equal and perfect knowledge

- in a competitive market its assumed that theres perfect information. this means that buyers and sellers are assumed to have full knowledge regarding prices, costs, benefits and availability of products

- perfect information which is equally available to all participants in a market is known as symmetric information

- assuming that buyers and sellers are rational in their behaviour, this symmetric information will allow the efficient allocation of resources in and between markets. however, symmetric information rarely exists, e.g. buyers often dont have the time or resources to obtain full information on prices before buying a product

- usually sellers have more information on a product than buyers. for example, a used car salesman will have more information about the history of a car theyre selling than a prospective buyer

- sometimes buyers may have more information than sellers. for example, an antiques collector may know more about the value of an antique than the person selling it

- when buyers or sellers have more information this is known as asymmetric information, and information is imperfect

- providers of some services have a lack of information because the thing they provide a service for is unpredictable, e.g. health service providers dont know when someone will become ill and with what health problem

- moral hazard is another possible result of asymmetric information. this happens when people take risks because they wont suffer the consequences themselves if things go wrong. for example, an individual could buy home insurance, but then behave recklessly, safe in the knowledge that theyre covered. this can happen because the insurance provider lacks information about how the individual is acting

- imperfect information means that merit goods are underconsumed and demerit goods are overconsumed. there are many reasons why imperfect information affects the consumption of merit and demerit goods, for example: >consumers may not know the full personal benefit of a merit good. they may not realise that a good education could lead to improved future earnings, or that a regular medical check-up might improve their lifespan. >consumers may lack the information to decide which good or service is right for them. >consumers may not have the information on how harmful a demerit good, such as alcohol, can be. >advertising for a demerit good may withhold or 'gloss over' any health dangers

- due to information failure, merit goods tend to be underprovided and demerit goods are overprovided, causing a misallocation of resources and market failure. there are many reasons why imperfect information affects the provision of merit and demerit goods, for example: >pension providers have a greater knowledge of the pension shemes available than their clients- this can lead to them selling unnecessary schemes or more expensive schemes than may be needed. >doctors have a greater knowledge of medicine- they may persuade their clients to purchase more expensive care than is required. >information on a good/service may be too complex to understand, e.g. the technical differences between computers may be confusing to a consumer, so they might struggle to work out which is best for their needs

consumption by an individual depends on wealth and income

- income is the amount of money recieved over a set period of time, e.g. per week or per year

- income can come from many sources- e.g. wages, interest on bank accounts, dividends from shares and rents from properties

- wealth is the value in money of assets held- assets can include property, land, money and shares

- the greater an individuals income and wealth, the more goods and services theyre able to purchase

income and wealth are not distributed equally in a market economy

- many people view differences in income and wealth as unfair, if theyre significant

- in economies with high levels of inequality of income and wealth distribution, there can be people who are starving whilst others have very high levels of income and wealth

- inequality is caused by several things, such as wage differentials, discrimination, and regressive taxes. generally speaking, people who are born into a poor family will remain poor because they wont have the income and wealth needed to improve their situation

- this is because inequality can lead to differences in access to resources. for example, people with very low income or wealth may not be able to afford vital resouces and services, such as education. as a result, a lack of education may well mean these people will continue to have low income or wealth as they will struggle to get a good job. people with higher income and wealth will be able to afford the best education, and improve their prospects of high income in future

- some economists argue that the unequal distribution of income and wealth is a consequence of market failure, because the free market has led to this inequitable distribution of income and wealth. as a result, they say that redistribution of income and wealth would lead to allocation of resources that would increase the benefit to society, and societys overall 'happiness'

- the argument for this is that the benefit to a poor person from an additional £1 of income would be greater than the loss to a rich person who paid £1 extra in tax

- inequality is also a cause of market failure. if, for example, some people dont have the income and wealth to be able to pay for things that they need, then resources wont be allocated efficiently

governments might try to distribute income and wealth more equally

- correcting this market failure requires government intervention

- the level of redistribution undertaken by governments is a political decision based on value judgements- its up to them how much they redistribute income and wealth

- some people argue that redistributing income reduces the incentive for individuals and firms to work hard. these incentives are needed to encourage efficiency within the market, and not having them may cause greater market failure

the environment has 3 main functions

- the three main functions of the environment are:
> provider of resources- the environment provides resources to allow goods and services to be produced. for example, the environment provides oil to make plastics and wood to make furniture
> provider of amenities- the environment provides amenities- features of the environment that people can directly enjoy. for example, beautiful views, or mountains to climb
> absorber of waste- the environment is used to absorb waste produced by humans, such as pollution and rubbish dumped at landfill sites

production and consumption can have an impact on the environment

- the production and consumption of goods and services can have a major impact on the environment. this impact can be caused by using the environment to provide resources, as an amenity, to absorb waste, or a combination of the 3 functions

- using the environment for these 3 functions can lead to negative externalities. for example, deforestation means there fewer trees to absord carbon dioxide from the atmosphere, and dumping of industrial waste in rivers can damage wildlife and the health of people using the rivers

- ignoring negative production externalities, such as pollution from a factory, or negative consumption externalities, such as pollution from driving, will lead to environmental market failure

- much of the resulting welfare loss will be in the form of damage caused to the environment by the externalities

resource depletion is the reduction of available natural resources

- the reduction of available natural resources is a negative externality of using some natural resources- the 3rd part thats affected is the people who cant use these resources in the future

- the depletion of resources occurs with non-renewable resources, e.g. coal and gas, at once theyre used they cannot be replaced

- renewable resources, e.g. trees, can also be deplted if theyre used up more quickly than theyre replaced

resource depletion is the reduction of available natural resources

- the reduction of available natural resources is a negative externality of using some natural resources- the 3rd part thats affected is the people who cant use these resources in the future

- the depletion of resources occurs with non-renewable resources, e.g. coal and gas, at once theyre used they cannot be replaced

- renewable resources, e.g. trees, can also be deplted if theyre used up more quickly than theyre replaced

resource depletion is the reduction of available natural resources

- the reduction of available natural resources is a negative externality of using some natural resources- the 3rd part thats affected is the people who cant use these resources in the future

- the depletion of resources occurs with non-renewable resources, e.g. coal and gas, at once theyre used they cannot be replaced

- renewable resources, e.g. trees, can also be deplted if theyre used up more quickly than theyre replaced

resource degredation is when a natural resource becomes less productive

- resource degredation is when a natural resource becomes less productive over time. for example, if a river thats used for fishing is affected by water pollution, that river will become less productive. the fish may not grow as well, they may reproduce less and some fish may die

- resource degredation can also be caused by other types of pollution, or very intensive use of land, e.g. for farming

- this resource degredation is a negative externality- the 3rd party thats affected is the people who will use the less productive resource in the future

- the depletion and degredation of resources will limit sustainable development. if resources are depleted or degraded, then economic development will be much harder in future, but if resources are used sustainably then economic development can continue

an economys wealth can affect its environmental impact

- the structure of a countrys economy is based around 3 sectors: primary, secondary and tertiary

- less developed economies often have a large primary sector. if these economies are relatively unmechanised then the impact that these industries will have on the environment is fairly limited

- as an economy becomes more developed and wealthier, production and consumption increase and the secondary sector will grow. a rise in industry, such as construction and manufacturing, will lead to an increased use of natural resources, and an increase in negative externalities, such as pollution

- the growth of the secondary sector will also likely lead to the mechanising of the primary sector, so more machinery will be used for things like agriculture and mining to provide more resources for the secondary sector. this will mean that the primary sector will have a greater negative impact on the environment

- the continuation of a counteys development will eventually result in its economy becoming dominated by the tertiary sector. industries in the tertiary sector will often have a smaller impact on the environment as they require fewer natural resouces, and they may produce less pollution- although this country will begin importing the goods it no longer produces, so the pollution is likely to have moved to the countries its importing from

- furthermore, as a country develops and its inhabitants become wealthier, the population may want an improvement in their environment, and have the means to achieve this. this could lead to firms producing more environmentally friendly goods, or production methods may become more environmentally friendly due to 'green' legislation passed by the government

- the environmental Kuznets curve shows the relationship between environmental damage and the level of wealth in a country. as per capita income increases the environmental damage also increases until a 'turning point' is reached. after the turning point, as per capita income increases, environmental damage decreases

- for example, pollution of the air and rivers has reduced dramatically in the UK in last few decades, mainly due to legislation aimed at tackling these problems. however, continued economic growth may still cause other types of environmental deterioration- for example, land use may continue to rise, as might emissions of greenhouse gases

- there are several ways that governments can reduce the rate of resource degredation and resource depletion, e.g:
>indirect taxation and subsidies
>legislation and regulation
>the provision of information
>state provision/government spending
>public and private partnerships

- make sure you learn how these methods of intervention work, and their advantages and disadvantages

governments use indirect taxes to affect the supply of some goods/services

- indirect taxes can be imposed on the purchase of goods or services. there are 2 types of indirect tax: specific and ad valorem:
>specific taxes- these are a fixed amount thats charged per unit of a particular good, no matter what the price of that good is. for example, a set amount of tax could be put on bottles of wine regardless of their price
> ad valorem taxes- these are charged as proportion of the price of a good. for example, a 20% tax on the price of a good would mean that for a £10 product its £2 and for a £100 product its £20

- indirect taxes increase costs for producers to they cause the supply curve to shift to the left. the 2 types of indirect taxes affect supply curves in different ways:
> a specific tax causes a parallel shift of the supply curve. the tax is the same fixed amount at a low price and a high price
> an ad valorem tax causes a non-parallel shift of the supply curve, with the biggest impact being on the higher price goods. the tax is a smaller amount as a lower price compared to a high price

governments tax goods with negative externalities

- governments often put extra indirect taxes on goods that have negative externalities, such as petrol, alcohol and tobacco

- governments may use multiplr indirect taxes on 1 item, e.g. in the UK cigarettes have a specific tax and an ad valorem tax on their retail price

- the aim of this taxation is to internalise the externality that the good produces, i.e. make the producer and/or consumer of the product cover the cost of its externalities. the taxes make revenue for the government which can be used to offset the effects of the externalities- e.g. the revenue generated from a tax on alcohol could be used to pay for the additional police time needed to deal with alcohol-related crime

- another example of a specific tax used in the UK is landfill tax. the tax aims to reduce the impacts of environmental market failure linked to landfill:
> local authorities or firms that dispose of waste at landfill sites are charged an environmental tax. the tax is set at an amount which attempts to reflect the full social costs of using landfill- i.e. the external cost linked to the burying of waste in landfill, such as pollution released from landfill sites
> the tax should encourage recycling, which in turn will reduce the negative externalties caused by landfill that harm the environment
> however, the tax has led to an increase in fly-tipping by firms to avoid having to pay the tax

the total amount of tax paid can be shown on a diagram

- the diagram shows the effect of an ad valorem tax- the supply curve moves up from S to S1

- in the diagram, the total tax paid is made up of the total tax paid by the consumer plus the total tax paid by the producer. the part of the tax paid by the consumer is equal to the rise in price from P to P1. the part of the tax paid by the producer is equal to the difference between P2 and P

- the amount of tax passed on the consumer will depend on the price elasticity of demand- if demand for a good is price inelastic, most or all of the extra cost is likely to be passed on to the consumer. if demand for a good is price elastic, then the producer is much more likely to take on most of the extra cost

there are advantages and disadvantages to this kind of tax

advantages:

- the cost of the negative externalities is internalised in the price of the good- this may reduce demand for the good and the level of its production, reducing the effects of the negative externalities

- if demand isnt reduced, theres still the benefit that the revenue gained from tax can be used by the government to offset the externalities- e.g. tax on cigarettes could be used for funding government services to help people stop smoking

disadvantages:

- it can be difficult to put a monetary value on the 'cost' of negative externalities

- for goods where demand is price inelastic, the demand isnt reduced by the extra cost of the tax

- indirect taxes usually increase the cost of production, which reduces a products international competitiveness

- firms may choose to relocate and sell their goods abroad to avoid the indirect taxation. this would remove their contributions to the economy, such as they payment of tax and the provision of employment

- the money raised by taxes on demerit goods might not be spent on reducing the effectsof their externalities

- the government may pay subsidies with the aim of encouraging production and consumption of goods and services with positive externalities- e.g. merit goods. a subsidy increases the supply of a good/service, so the supply curve shifts to the right

- subsidies can be used to encourage the purchase and use of goods/services which reduce negative externalities, e.g. public transport, or as support for firms to help them become more internationally competitive

- both consumers and producers can gain from a subsidy

- in the diagram, the total cost of the subisdy is made up of the total consumer gain plus the producer gain. the consumer gain is equal to the fall in price from P to P1. the producer gain is equal to the difference between P and P2. the subsidy results in the price of the good/service falling from P to P1, and the quantity demanded increasing from Q to Q1

- the proportion of the subsidy producers and consumers benefit from depends on the elasticity of the supply and demand curves

- sometimes subsidies might be given directly to consumers instead

advantages:

- the benefit of goods with positive externalities is internalise, i.e. the cost of these externalities is covered by the government subsidy, so the price og the goods is reduced from what it would be in the absence of the subsidy

- subsidies can change preferences- producers will supply goods with positive externalities and consumers will consume them and recieve the benefits from them. also, making a merit good cheaper by the presence of a subsidy makes it more affordable and increases demand for it

- the positive externalities are still present. for example, if a subsidy is paid for wind farms, the wind farms will still reduce pollution levels

- subsidies can support a domestic industry until it grows to the point that it can exploit economies of scale and become internationally competitive

disadvantages:

- it can be difficult to put a monetary value on the 'benefit' of the positive externalities

- any subsidy has an oppurtunity cost- the money spent on it might be better spent on something else

- subsidies make producers inefficient and reliant on subsidies. the subsidy means that producers have less incentive to reduce costs or innovate

- the effectiveness of a subsidy depends on the elasticity of demand- subsidies wouldnt significantly increase demand for inelastic goods

- the subsidised goods and services may not be as good as those theyre aiming to replace. for example, imported goods may be of better quality than domestically produced alternatives a subsidy is promoting

governments can set a maximum price for a good or service

- a maximum price may be set to increase competition of a merit good or to make a necessity more affordable. for example, a government may set a maximum price to keep the cost of renting a property affordable

- if a maximum price is set above the market equilibrium price, it will have no impact

- if its set below the market equilibrium, it will lead to excess demand and a shortage of supply of Q1 to Q2. the excess demand cannot be cleared by market forces, so to prevent shortages the product needs to be rationed out, e.g. by a ballot

- a goods price elasticity of supply and price elasticity of demand will have a big effect on the amount of excess demand

governments can set a minimum price for a good or service

- minimum prices are often set to make sure that suppliers get a fair price. the european unions common agricultural policy involves the use of a guaranteed minimum price for many agricultural products

- if a minimum price is set below the market equilibrium pice, it will have no impact. if its set above the market equilibrium price, it will reduce demand Q1 and increase supply to Q2, leading to an excess supply of Q1 to Q2

- to make a minimum price for a good work the government must purchase the excess supply at the guaranteed minimum price. the goods bought by the government will either be stockpiled or destroyed

- a goods price elasticity of supply and price elasticity of demand will have a big effect on the amount of excess supply

- minimum prices are a good way to restrict monopoly power as they will provide a guaranteed price for suppliers and ensure that a firm thats a monopsony buyer cant keep negotiating lower and lower prices

maximum prices

advantages:

- maximum prices can help to increase fairness, by allowing more people the ability to purchase certain goods and services

- they can also be used to prevent monopolies from exploiting consumers

disadvantages:

- since demand will be higher than supply, some people who want to buy the product arent able to

- governments may need to introduce a rationing scheme to allocate the good, e.g. through a ballot

- excess demand can lead to the creating of a black market for a good

minimum prices

advantages:

- producers have a guaranteed minimum income which will encourage investment

- stockpiles can be used when supply is reduced or as overseas aid

disadvantages:

- consumers will be paying a higher price than the market equilibrium

- resources used to produce the excess supply could be used elsewhere- theres an inefficient allocation of resources

- government spending on a minimum price scheme could be used in other areas- schemes may have a high oppurtunity cost

- destroying excess supply is a waste of resources

buffer stocks are used to try to stabilise commodity prices

- prices in commodity markets, especially for agricultural products, can be very unstable

- buffer stock schemes aim to stabilise prices and prevent shortages in supply. they can only work for storable commodities- e.g. wheat

- a maximum price and minimum price for a commodity are set by a government

- when the market price for a product goes below the price floor, the government buys it and stores it in stockpiles. demand is increased and the price is brought up to an acceptable level

- when the market price goes above the price ceiling, the government sells the product from its stockpiles. supply is increased and the price is brought down to an acceptable level

>for example, the quantity supplied in a good year is shown by the supply curve S1, so its market price would be P1
>this price is below the minimum price, so to prevent this price fall, the government would purchase a quantity of Q3 to Q1 of the good at the set minimum price. supply would be reduced and the market price would rise to the set minimum price
>the goods bought by the government would be added to its stockpile
>the quantity supplied in a poor year is shown by the supply curve S2. the market price would be P2
>the government would sell Q2 to Q4 from its stockpile, at the set maximum price. supply is increased and the market price would fall to the set maximum price
>if the market price is between the set minimum and maximum, no action is taken

buffer stocks often arent successful

- in theory, the income from selling the product at the set maximum price should pay for purchases at the set minimum price and the running of the scheme. however, buffer schemes often dont work for a number of reasons:
>if the minimum price is set at too high a level, the scheme will soend excessively purchasing stocks to maintain this minimum price
>if theres a run of good or bad harvests, then the scheme may buy excessively or run out of stock
>storage and security of the stockpiles can be expensive
>some commodities will deteriorate and go to waste over time, causing losses for the scheme
>producers may overproduce because they will get a guaranteed minimum price. this can lead to massive stockpiles and a waste of resources

governments directly provide some goods and services

- governments use tax revenue to pay for certain goods and services so that theyre free, or largely free, when consumed. examples in the UK include the NHS, state education, waste disposal and the fire and police services

- public goods, such as defence and street lighting, are also provided by the state

- state provision can come directly from the government, e.g. state schools and the army, or alternatively, governments can purchase the good or service from the private sector and provide it to the public for free, e.g. in some cases community health services are purchasd from private companies and then provided free to NHS patients

state provision is a way to overcome market failure

- governments might provide certain things to increase the consumption of merit goods, such as education and health

- free provision of services can help to reduce inequalities in access, e.g. due to differences in wealth

- it can also redistribute income- most of the money to pay for the services comes from taxing wealthier citizens

- the level of state provision is a value judgement made by the government- its up to the government to decide the amount of a good/service that they provide. this decision is likely to be based on how important for society they think it is that they provide the good/service

state provision has several disadvantages

- state provision may mean theres less incentive to operate efficiecntly due to the absence of the price mechanism

- state provision may fail to respond to consumer demands, as it lacks the motive of profit to determine whats supplied

- the oppurtunity cost of state provision of a good or service is that other goods or services cant be supplied

- state provision can reduce individuals self-reliance- they know the good or service is there for them if they need it

health care is a merit good thats sometimes provided by governments

- the government funds the NHS so that society benefits from the positive externalities of health care. for example, the consumption of health care can contribute to a healthier, happier population and reduce the number of days people take off work due to sickness

- however, there are drawbacks to the state provision of health care by the NHS. these include:
>demand for health care in the UK has increased dramatically since the NHS was introduced. because the NHS is free at the point of delivery, this has led to excess demand and problems like long waiting lists
>hospitals and clinics can be wasteful of resources, such as money wasted on unused prescriptions
>the NHS may not always respond to the wants and needs of patients- e.g. local NHS officials might relocate medical services against the wishes of the population in their area for cost-saving reasons
>the NHS can reduce patients self-reliance. for example, it can remove the incentive for patients to deal with medical issues themselves- patients might visit their doctor or hospital with problems which could be treated at home with medicines they could buy in a shop

privatisation can improve efficiency

- a publicly owned firm/industry is owned by the government. the firm/industry will usually act in the best interests of consumers- so prices tend to be low and output tends to be high. this is possible as they dont have to make profits

- however, publicly owned firms/industries tend to be inefficient because they lack competition and that can lead to market failure. governments may decide to increase competition through privatisation

- privatisation is the transfer of the ownership of a firm/industry from the public sector to the private sector

- some economists believe this will lead to a more efficient firm/industry, because itll be open to free market competition. private firms have shareholders, so theyll usually need to maximise their profits to keep the shareholders happy

- privatisation covers a number of different things, for example:
>the sale of public firms- e.g. the royal mail was privatised through the sale of shares
>contracting out services- a government pays a private firm to carry out work on its behalf, e.g. cleaning government-owned buildings, such as hospitals or schools
>competitive tendering- private firms bid to gain a contract to provide a service for the government. firms will compete on price and the quality of service offered
>public private partnerships- a private firm works with a government to build something or provide a service for the public. an example of a PPP is a private finance initiative- a private firm is contracted by the government to run a project. for example, in the UK, some hospitals or schools are built by a private firm, then the government leases the buildings from the firm

- for example:
>in 2010, marks and spencer agree a 5-year partnership with somerset county council waste partnership for marks and spencer to provide funding for the council to collect waste from roadsides in the county. this funding has enabled the county council to improve its recycling services, and marks and spencer has benefitted from the collection of recylable plastic that can be used for its products

advantages of privatisation:

- increased competition improves efficiency and reduces x-inefficiency

- improves resource allocation- privatised firms have to react to market signals of supply and demand

- PFIs enable the building of important facilities that the government might not be able to afford to build

- PFIs mean lower taxes in the short run because the government wont pay for the new facility immediately

- the government gains revenue from selling firms

disadvantages of privatisation:

- a privatised public monoply is likely to become a private monopoly- so extra measures, e.g. deregulation, need to be taken to avoid this

- privatised firms have less focus on safety and quality because they have more focus on reducing costs and increasing profits

- the new private firm might need regulation to prevent it from being a private monopoly- this adds cost for taxpayers

- a PFI will cost more in the long run than its worth- so it adds to government debt and may not represent value for money

- PFIs mean higher taxes for future generations to pay for the cost of the government leasing the facility

- regulations are rules that are enforced by an authority and theyre usually backed up with legislation- which means that legal actions can be taken against those who break the rules. they can be used to control the activities of producers and consumers and try to change their undersirable behaviour

- regulations are used to try to reduce market failure and its impacts. they can help in a number of areas:
>reducing the use of demerit goods and services- e.g. by banning or limiting the sale of such products
>reducing the power of monopolies- e.g. using a regulating body to set rules such as price caps
>providing some protection for consumers and producers from problems arising from asymmetric information- e.g. the Sale of Goods Act protects consumers against firms supplying substandard goods

- with appopriate legislation, firms or individuals who dont follow the regulations can be punished, e.g. with fines. for example, laws, like the Clean Air Act and the Environmental Protection Act, have been created to limit the damage caused by economic activity and to enforce minimum environmental standards in major industries

regulations can be difficult to set

- it can be difficult for government to work out what is 'correct'. for example, a government might set the level of acceptable pollution by firms too low or too high

- theres a need for regulation in some areas to be worldwide rather than just in 1 country. for example, regulations to control greenhouse gas emissions might be more effective if they were enforced worldwide- regulations in 1 country may reduce its emissions, but this could be offset by an increase in emissions elsewhere in the world

- following excessive regulations can be expensive and may force firms to close or to move to a different country

- monitoring compliance with regulations can be expensive for a government, and if the punishment for breaking regulations isnt harsh enough, then they may not be a deterrent and change behaviours

some regulations are set to encourage the use of renewable energy

- the UK government has introduced Renewables Obligation Cerificates to encourage the use of power generated from renewable energy sources

- electricity suppliers are given a set minimum percentage of power that must come from renewable resources

- companies who generate the renewable energy are issued with ROCs which link to the amount of renewable enery theyve generated. then they sell these certificates on to suppliers

- suppliers that fall short of the target percentage of power from renewable sources have to pay a financial penalty. the money raised from these penalities is distribyed between the suppliers who did reach the target

deregulation is basically the opposite of regulation

- deregulation means removing or reducing regulations. it removes some barriers to entry, so it can be used to increase competition in markets, particularly monopolistic markets, and tackle market failure

- deregulation is often used alongside/as part of privatisation- privatising an industry effectively removes the legal barriers to entry that prevent other firms entering the market. additional deregulation to reduce barriers to entry further can be used to help prevent the privatised public monopoly from becoming a private monopoly

- examples of deregulation in the UK include the deregulation of directory enquiries. BT, which was a private firm at the time, provided the directory enquiries service- it was deregulated to allow other firms to enter the market

advantages of deregulation:
>improves resource allocation- removing regulations means the market becomes more contestable, so new firms are more likely to enter the market. the threat of competition from new firms, or the actual entry of new firms into the market, means prices fall closer to marginal cost and output increases
>it can be used alongside privatisation of a public monopoly to prevent the privatised firm from becoming a private monopoly
>improves efficiency by reducing the amount of 'red tape' and bureaucracy

disadvantages of deregulation:
>its difficult to deregulate some natural monopolies, e.g. utilities. these require large infrastructures, e.g. the water industry needs a pipe network. these infrastructures are expensive to build and maintain, and theres only a need for one of them
>deregulation cant fix other market failures such as negative externalities, consumer inertia or immobile factors of production
>deregulation might mean theres less safety and protection for consumers

competition policy aims to increase competition in a market

- governments often choose to intervene in concentrated markets where monopoly power is causing market failure. for example, if a monopoly exists and prices are above the market equilibrium price, theres a misallocation of resources and a deadweight welfare loss- i.e. theres market failure

- the intention of the government is to protect the interests of consumers by promoting competition and encouraging the market to function more efficiently. the government can do this through the use of competition policy

- the European Commisson and the UKs competition and Markets Authority both monitor competition to look for unfair monopolistic behaviour. things they look out for include:
>mergers- they monitor mergers and takeovers so they can prevent those that arent beneficial to the efficiency of the market or to consumers. they may choose to stop a merger that would give a firm too high a market share and make it a monopoly, or would give a firm too much monopoly power
>agreements between frims- often, agreements involving price fixing, splitting markets or limiting production are anti-competitive, cause market inefficiency and are unfair to consumers
>the opening of markets to competition- this is when markets that were controlled by a government are opened up to competition. for example, if a government-owned transport service is privatised, the government might want to ensure the existing firm is open to free market competition and doesnt dominate the market as a private monopoly
>financial support from governments- if a government in one EU country gives financial support to firms in a market, this may give them an unfair advantage over firms in other EU countries in that same market

- the European Comission and the CMA can block mergers and impose fines on firms guilty of anti-competitive behaviour

some markets have their own regulating bodies

- regulatory bodies are particularly common in monopolistic or oligopolistic markets. here are some UK examples:
>OFWAT regulates the water industry
>OFCOM regulates the communication industries
>OFGEM regulates the gas and electricity markets

- these bodies have varying responsibilities- these might include regulating prices, monitoring safety and product standards, and encouraging competition

- regulating bodies can be at risk of regulatory capture

competition policy is generally seen to be useful and effective

- the effectiveness of competition policy is greatly affected by the information available to the European Comission or the CMA- theyll need to decide whether behaviour in different markets is anti-competitive or unfiar to the consumer based on the information they have

- if the information available to the government is reliable, then it should be able to intervene in the market in a way that will improve efficiency, allocate resources more effectively and improve fairness to the consumer. if the information is imperfect then this could lead to government failure

- competition policy and its implementation have costs- but in general, these costs as seen to be outweighed by the benefits. if the costs outweigh the benefits, this is an example of government failure

governments can intervene in various ways

- there are many ways a government can intervene in a market to try to increase competition

privatisation can introduce competition into a market where theres a public monopoly

- a publicly owned monopoly can be privatised to open it up to competition and force it to respond to market signals

- however, privatisation alone wont increase competition, as the public monopoly may just become a private monopoly. there could also be an increase in prices and a reduction in output, as a private monopoly is less likely to act in the best interests of consumers. so, other steps need to be taken alongside privatisation, such as deregulation, to increase competition and protect consumers

regulation can be used to control or prevent monopoly power

- governments might use regulation to prevent a firm from gaining monopoly power, or to increase competition by reducing the monopoly power a firm already has

- for example, a government or regulating body might introduce price caps to stop firms from charging prices that are considered to be too high. price caps put a maximum on the price increase that firms can charge their customers. here are 2 types of price cap:
>RPI-X means firms must make real price cuts. RPI is inflation and X is the efficiency improvements the government or regulating body expects firms to be able to make. so for example, if the RPI was 3% and X was 1%, firms could only increase their prices by up to 2%
>RPI-X+K is commonly used in the water industry. K is the amount of investment firms will need to make in order to achieve efficiency improvements. in this case, the firm can charge higher prices to offset the cost of efficiency improvements
- price caps limit price rises, making a market fairer to consumers. they also provide an incentive for firms to increase efficiency, and consumers benefit from improved services

- alternatively, the government or regulator could monitor prices to ensure they stay reasonable and fair to consumers

- governments may introduce regulations to ensure quality standards, such as in food production or construction

- governments can regulate profits by imposing windfall taxes on what it decides are excessive profits- this means the government will tax those profits at a higher rate. windfall taxes can help to prevent firms from gaining too much monopoly power, but it reduces their incentive to improve efficiency

- setting performance targets can also help to maintain competition, but they need to be combined with some sort of penalty, e.g. a fine, if a firm doesnt reach its target. examples of performance targets include:
>firms might be given certain standards of customer service they need to achieve
>NHS departments might be given targets for the number of patients they should treat
- there are disadvantages to performance targets. health and safety, quality of service and any other areas of a business which arent included in targets might be overlooked in order to reach performance targets

- Payment Protectioon Insurance:
>PPI is insurance thats used to repay debt should the borrower be unable to do so, e.g. due to illness. in the UK there was little competition in the PPI market, a high level of rejected claims and a lot of cases of selling unncessary cover
>the market was investigated by the Competition Comission who produced a list of requirements for firms selling PPI, such as providing information about the right to cancel and costs. the aims were to prevent future mis-selling, help consumers make informed decisions, and increase competition in the market
>these requirements have increase competition, and successful reclaims of mis-sold insurance have risen since the investigation

-Mobile Phone Roaming Charges:
>roaming charges are charges for data usage, calls or texts, made or recieved, when abroad. the European Comission has monitored these charges since 2007 and found that a lack of competition led to excessively high charges
>the European Comission has used price caps to significantly reduce data roaming charges, and charges for calls and text messages
>all telecommunication providers in member states must comply with these price caps. firms can offer lower prices than the caps to compete with each other

deregulation can also be used to increase competition

- deregulation can make a market more contestable, so its easier for new firms to enter the market

- this increases competition, causing the price to fall closer to marginal cost, and output to increase

governments use cost benefit analysis to evaluate big investment projects

- cost benefit analysis involves considering the total costs and benefits of a major project such as building a new motorway, a new hospital, new schools or new wind turbines, over a fixed period of time

- when politicians analyse the costs and benefits of a project, they have to look at the impact on everyone whos affected. for example, for a major sporting event, along with the private costs and benefits, the external gains to the host nation, such as improved facilities or increased tourism, need to be evaluated, as do the external losses, such as the diversion of public funding from other projects to pay for the event

- all of the private and external costs and benefits are given monetary values- then these values are used to calculate the net social cost or benefit

- CBA can also be a useful tool for governments when deciding whether or not to provide a public good to correct a case of market failure. for example, if its left to the free market then a country is unlikely to have flood defences because of the free rider problem, so the government could use CBA to help them to decide whether or not to intervene to correct this market failure

there are various stages in CBA

- firstly, the private and external costs and benefits are identified as accurately as possible

- monetary values are then given to the costs and benefits. where these are assigned to something without a value, this is called shadow pricing. a shadow price can also be assigned to something that has a value, when that value isnt truly reflective of its real cost

- at the end, the net social cost or benefit is calculated:
>net social benefit=social benefit-social cost

- there might be uncertainty about whether some of the costs and benefits in the CBA will actually happen- the likelihood of these findings will be considered and factored into the final calculation

- in general, if theres a net social cost, then the project wont go ahead, but if theres a net social benefit, then it will

- externalities need to be incuded in a CBA, but theyre often difficult to put a monetary value on because they dont have a price decided by the market. for example:
>tourism- for example, a big sporting event is likely to increase tourism, which will benefit hotels, shops, restaurants, etc. its very difficult to predict the amount of money this will bring to the economy
>multiplier effect- an injection of money into the circular flow of income is likely to have a bigger effect on GDP than the intial injection, as it keeps moving round the economy. however, its very difficult to predict how much money will leak from the circular flow of income, and therefore what the size of the multiplier will be
>loss of human life- this is one of the most difficult things to include. people may argue that human life is priceless, but for the purpose of a CBA it needs to be given a value. for example, a human life may be given a value in terms of estimated earnings for a persons remaining working life. however, this doesnt take into account the effect that person has on their family and friends, or anything else they might have enjoyed or achieved in their life
>pollution- air and noise pollution can have many negative effects. for example, air pollution can affect peoples health. it can also damage the environment, contributing to global warming. noise pollution might affect peoples quality of life, and bring down the value of their houses
>congestion- congestion not only increases pollution, but it also wastes peoples time. some economists may calculate the value of each hour of wasted time

money will be worth less in the future than it is now

- £10 of benefit from a project in 10 years time is likely to be worth less than £10 today- i.e. due to inflation, £10 will buy fewer goods and services in the future than itll buy today

- this means that for a CBA, future costs and benefits need to be discounted to find their present values

- the difficult part is trying to decide what discount to apply to future costs and benefits. some people prefer to use low discount rates- for example, this might encourage investment now, and they see this as a good thing for economic growth. others prefer to use higher discount rates, as this might reduce the amount of investment now, e.g. to help to slow down economic growth and protect the environment

- most CBAs will only look at the costs and benefits over a set period of time, e.g. 25 years. this can have a big impact on the result of the CBA- if there are any big costs or benefits to come in the future, e.g. the cost of decomissioning a nuclear power plant, it can be argued that these should always be included in the CBA

- there are advantages to using a CBA to decide if a project should go ahead:

- a CBA is a good way of throughly assessing the various consequences of a project before work begins, and of assessing and considering the effects of any externalities. the CBA will provide governments with the information they need to make a decision

- in general, using a CBA means that projects will only go ahead if the benefits to society outweigh the costs

- there are advantages to using a CBA to decide if a project should go ahead:

- a CBA is a good way of throughly assessing the various consequences of a project before work begins, and of assessing and considering the effects of any externalities. the CBA will provide governments with the information they need to make a decision

- in general, using a CBA means that projects will only go ahead if the benefits to society outweigh the costs

- however, a CBA has certain limitations too:

- usually, some costs and benefits will be missed. often these wont be big enough to change the overall outcome of a CBA, but sometimes they might have a more significant impact- e.g. they might make a project have a net social cost instead of a net social benefit

- it can be difficult to put monetary values on the costs and benefits. this difficulty can also lead to disagreements between those who are in favour of a project and those who are against it, and big variations in the estimated value of any costs and benefits

- in the future, money will probably be worth less than it is now due to inflation. this needs to be factored into the CBA, but its difficult to accurately predict how money will change in value

- theres often a significant cost as a result of carrying out a CBA- this can cause government failure- especially if the CBA doesnt provide useful information

- CBAs often dont take equity into account- the costs and benefits might affect different people, so 1 group of people may benefit from a project, while another group has to 'pay' for it

- a CBA needs to be unbiased to be effective, but political factors can affect a decision, causing market failure. for example, if a project is considered to be a vote-winner then the government might fund it, even if the costs outweigh the benefits. this is called rent-seeking behaviour

- carrying out a CBA might mean decision-makers have too much information- it can cause a decision to be more confusing and take longer to make

tradable pollution permits are use to try to control pollution levels

- governments may try to control pollution by putting a cap on it. the government will set an optimal level of pollution and allocate permits that allow firms to emit a certain amount of pollution over a period of time

- firms may trade their permits with other firms, so if a firm can keep its emissions low, it can sell its permits to other firms who want to buy permits to allow them to pollute more

- tradable pollution permits use the market mechanism- pollution is given a value and firms can buy and sell permits

- the EU emissions trading system is a tradable pollution permit scheme, with permits called emissions allowances. these allowances are distributed between the EUs member governments, who in turn allocate these allowances to firms

- firms will be fined if they exceed their allowances, but they can trade allowances between themselves, so firms can buy extra allowances to cover any extra emissions

- each year the number of allowances available is reduced. this gives firms an incentive to lower their emissions- if they dont then they might have to buy more allowances

- firms in the ETS are allowed to invest in emission-saving schemes outside of the EU to offset their own emissions. for example, a UK firm could invest in low-carbon power production in India to offset some of its emissions in the UK

advantages of tradable pollution permits:

- these schemes are a good way of trying to reduce pollution to an acceptable level, as they encourage firms to become more efficient and pollute less

- firms causing low levels of pollution will benefit from these schemes- theyll be able to sell permits, allowing them to invest more and expand

- governments can use any revenue, e.g. from fines, to invest in other pollution reducing schemes

- these schemes internalise the externality of pollution

disadvantages of tradable pollution permits:

- the optimal pollution level can be difficult to set. if the level is set too high, firms have no incentive to lower their emissions. if the level is set too low, new firms might not be able to start up at all, or existing firms might choose to relocate somewhere theyre less restricted. so, setting the optimal pollution level at the wrong level can lead to government failure

- the pollution permit scheme creates a new market- there might be market failure within this new market

- high levels of pollution in specific areas may still exist, and this would still be harmfult to the environment

- there are administrative costs involved in such schemes, to both governments and firms

governments intervene to help consumers make well-informed decisions

- governments try to provide information on the full costs and benefits of goods and services. this information is given to try to help consumers make rational choices and prevent market failure caused by consumers and producers having asymmetric information. examples of government-provided information include:
>school and hospital performance league tables
>compulsory food labelling for most foods
>advertising campaigns encouraging healthy eating
>health warnings on cigarette packets

- the provision of information will impact on the demand for the goods. governements will try to increase demand for goods/services that they think will be beneficial to people and society and reduce demand for goods/services that they think will be harmful to people and society

- the effectiveness of government provision is often questioned. for example, the growing obesity problem in the UK suggests that government healthy eating campaigns arent having a signficant impact on the public

promoting small businesses can increase competition

- governments may choose to increase competition by promoting small businesses. this is likely to involve providing tax breaks or subsidies for small firms, or helping enterprises get the investment they need to start a new business

- reducing regulation and 'red tape' is also a good way to encourage new, small businesses to start up

- increasing competition in this way should lead to greater choice and lower prices for consumers

government intervention can cause the misallocation of resources

- government intervention can lead to resources being misallocated and a net welfare loss- this is government failure

- government failure is often an unintended consequence of an intervention to correct a market failure

- when looking at government failure in a market you should consider it in relation to the market failure it was attempting to correct. for example:
>local authorities can charge for some forms of non-household waste disposal, e.g. some county councils charge for the disposal of DIY waste. this is an attempt to force waste producers to internalise the externalities of waste disposal
>however, theres evidence that this has led to an increase in fly-tipping. this fly-tipping produces negative externalities for local residents and requires resources to be allocated to clear up the fly-tipping
>in this instance the intervention that aimed to recue the negative externalities linked to waste disposal has resulted in the production of other unintended negative externalities

government intervention may cause market distortions

- government interventions can cause market distortions rather than removing them. there are several examples of this:
>income taxes can act as a disincetive to working hard- if you increase your earnings by working hard then youll have to pay more income tax
>governmental price fixing, such as maximum or minimum prices, can lead to the disortion of price signals. for example, producers will overproduce a product if theyll recieve a guaranteed minimum price for it and flood the market with surplus goods. without the minimum price, the price signals given by the price mechanism would stop large surpluses from occurring
>subsidies may encourage firms to be inefficient by removing the incentive to be efficient

government bureaucracy can interfere with the way markets work

- governments have lots of rules and regulations- often referred to as 'red tape'. these usually exist in order to prevent market failure

- the enforcement of these rules and regulations by government officials is known as bureaucracy. excessive bureaucracy is seen as a form of government failure

- red tape can interfere with the forces of supply and demand- it can prevent markets from working efficiently. for example, planning controls can lead to long delays in construction projects. if these delays affect housing developments then this could restrict supply for the housing market

- in general, lots of red tape could mean that there are time lags so governments cant respond quickly to the needs of producers and/or consumers. this might result in a country having a competitive disadvantage to countries that are able to respond more quickly

- bureaucracy can lead to a lack of investment and prevent an economy from operating at full capacity

conflicting policy objectives are a source of government failure

- a governments effort to achieve a certain policy objective may have a negative impact on another. for example, if a government introduces stricter emission controls for industry this would contribute towards its environmental objectives. however, this could increase costs for firms and reduce their output- causing unemployment and a fall in economic growth

- politicians are also constrained by what is politically acceptable. for example, its unlikely the UK government would ban the use of private cars to reduce greenhouse gases because of the ideas political unpopularity

- governments often favour short-term solutions because theyre under pressure to solve issues quickly. for example, increasing the capacity of the UK road network will help with short-term congestion, but may increase road usage in the long term

government failure can be caused by inadequate information

- imperfect or asymmetric information can mean its difficult to assess the extent of a market failure, and that makes it hard to put a value on the government intervention thats needed to correct the failure. for example, an incorrect valuation of a market failure might lead to taxes or subsidies being set at an inefficient level

- governments may not know how the population want resources to be allocated. some economists would argue that the price mechanism is a better way of allocating resources that government intervention

- governments dont always know how consumers will react. for example, campaigns to discourage under-18s drinking alcohol may lead to alcohol being viewed as desirable and increase drinking by this age group

administrative costs can also be a cause of government failure

- government measures to correct market failure, such as policies and regulations, can use a large amount of resources- this can result in high costs. for example, the maintenance costs of a scheme to offer farmers a minimum price for a product can be substantial

- some government interventions require policing, which can also be expensive. for example, for pollution permit schemes the emissions of the firms included in the scheme must be monitored to check they arent exceeding their allowances

there are some other causes of government failure

- some other reasons for government failure are:
>regulatory capture- firms covered by regulatory bodies, such as utility companies, can sometimes influence the decisions of the regulator to ensure that the outcomes favour the companies and not the consumers. for example, a regulated industry might pressurise their regulatory body into making decisions that benefit them
>it takes time for governments to work out where theres market failure, and then devise and implement a polict to correct it- meanwhile, the problem may have changed
>government policies can be affected by issues outside of its control known as 'external shocks'- e.g. a major oil leak would impact on the effectiveness of anti-pollution policies

the Common Agricultural Policy was set up to help farmers

- the main aim of the CAP is to correct market failure caused by fluctuating prices for agricultural products. by correcting these fluctuations it aims to provide a reasonable, stable income for farmers

- to achieve its aim the CAP uses measures such as subisides and buffer stocks. another measure is import restrictions on goods from outsid the EU- for example, tariffs are placed on imported goods to allow the guaranteed minimum price level to be maintained

- the CAP has resulted in distortions in agricultral markets- it has encouraged oversupply, leading to a misallocation of resources. this misallocation of resources causes a net welfare loss to society, as does the high oppurtunity cost of running the policy

- in recent years prices have moved closer to the market price as part of the EUs reform of the CAP, but there are still problems with the policy

- the CAP has had some success, but it has also caused several problems:
>the CAP encourages increased output as farmers are guaranteed a minimum price for all that they produce. increased output can lead to environmental damage from a greater use of intensive farming methods and chemical fertilsers
>the minimum prices have also led to an oversupply of agricultural products, which have to be bought and stored by government agencies at great expense. governments have sold these stocks at a low price outside of the EU- negatively effecting farmers outside the EU who cannot compete with such low prices
>there are large amounts of wasted food products when perishable goods have to be destroyed
>the increased food prices caused by the CAP are particularly unfair on poorer households, who spend a large proportion of their income on good. it can be argued that the welfare gains to farmers brought about by the CAP are smaller than the size of the welfare loss to consumers
>theres a cost to the taxpayer of getting rid of excess agricultural products. this is because the produce disposed of in this way achieves a lower price that was paid to the producer for it by the EU
>the CAP can cause conflicts with other countries as it can make exports from non-EU countries less competitive, e.g. as products from non-EU countries can be subject to import tariffs. also, theres conflict between countries within the EU about how much of the CAP budget they should each recieve

- the CAP has had some success, but it has also caused several problems:
>the CAP encourages increased output as farmers are guaranteed a minimum price for all that they produce. increased output can lead to environmental damage from a greater use of intensive farming methods and chemical fertilsers
>the minimum prices have also led to an oversupply of agricultural products, which have to be bought and stored by government agencies at great expense. governments have sold these stocks at a low price outside of the EU- negatively effecting farmers outside the EU who cannot compete with such low prices
>there are large amounts of wasted food products when perishable goods have to be destroyed
>the increased food prices caused by the CAP are particularly unfair on poorer households, who spend a large proportion of their income on good. it can be argued that the welfare gains to farmers brought about by the CAP are smaller than the size of the welfare loss to consumers
>theres a cost to the taxpayer of getting rid of excess agricultural products. this is because the produce disposed of in this way achieves a lower price that was paid to the producer for it by the EU
>the CAP can cause conflicts with other countries as it can make exports from non-EU countries less competitive, e.g. as products from non-EU countries can be subject to import tariffs. also, theres conflict between countries within the EU about how much of the CAP budget they should each recieve

- price controls, such as maximum rents, are used by governments to protect tenants from excessive rental chargers

- the downside of the control of rent prices is that it can cause shortages of rental properties. this can be shown using a diagram:
>introducing a maximum rent would decrease the rent price from Pe to MR. this would cause the demand for rental properties to increase from Qs to Qd and supply to fall from Qe to Qs
>this could cause a shortage of rental properties of Qs to Qd because theres an excess demand for them- only some individuals demanding a rental property will get one

- the problems caused by maximum rents are an example of government failure:
>the excess demand for rental properties could lead to a shortage of available properties and cause a black market to develop. in a black market people are likely to end up paying more than the maximum rent level, so they wont gain any benefit from the governments maximum rent level. also, landlords operating illegally on the black market may not offer a good service to their tenants
>a shortage of rental properties can also impact the supply of workers. people might not be able to find somewhere to rent near to where they work- this could affect the ability of firms to attract new staff in areas where shortages are particularly bad

governments may provide subsidies to public transport

- bus and train journeys may be subsidised to reduce car usage and pollution levels

- subsidies dont always lead to increases in passenger numbers- bus transport is often viewed as an inferior good so even if its chaper, demand might not increase. individuals may also find travelling by car preferable for reasons of privacy or convenience

- the allocation of resources to public transport services that dont increase their usage and dont cause a reduction in pollution can be seen as a misallocation of resources and will lead to a net welfare loss. underused public transport services may actually contribute to higher overall emissions as people arent using their cars less

road congestion schemes aim to reduce externalities linked with traffic

- road congestion schemes are a method of reducing the external costs linked to road congestion and the pollution that it creates. these schemes are also called road pricing

- the schemes work by charging users to travel on roads in areas where congestion is a problem

- ideally the charge needs to be set at a level that will result in the socially optimal level of traffic. however, working out what this charge is could be very difficult

- getting the charge wrong has impacts on the effectiveness of road congestion schemes:
>if the price is set too low then it will have a limited impact on traffic levels
>if the price is set too high then too few cars will use the area covered by the charge. this will result in reduced trade for businesses within the congestion charge area, an under-utilisation of the road space in the congestion charge area, and may also cause congestion in other areas

- road congestion charges may unfairly impact on poorer motorists in an area and put them off using their cars

fishing quotas were introduced to help make fishing more sustainable

- fishing quotas were introduced by the EU in an attempt to make sure fish stocks remain stable in European waters. they aim to prevent overfishing, which can have severe negative impacts on fish populations, by setting limits on the amount of fish that can be caught

- the system of fishing quotas has been heavily criticised and has a few key problems:
>fish stocks are depleting even with quotas in place. this could indicate that the quota has been set too high and overfishing is still taking place
>fishing boats that exceed their quotas often throw large amounts of dead fish back into the sea- these dumped fish are known as discards. as well as damaging fish stocks, these discards are also wasteful
>there has been poor monitoring of fish catches. this could mean that fishing boats have been overfishing and it hasnt been detected

- problems with EU fishing quotas have led to a need for a reform. one proposed change is called a landing obligation. this means that everything fishermen catch must be kept on board and be counted against their quotas- they arent allowed to discard any fish. this landing obligation is likely to be difficult to police- it would be a huge task to check that every fishing boat hasnt discarded any fish at sea

the demand for labour is a derived demand

- the demand for labour comes from firms and the supply of labour comes from the economically active population

- when firms demand workers its because they need them to make the goods that are being demanded by their customers. so the demand for labour is driven by the demand for the goods that this labour would produce- this is derived demand

- when demand for these goods increases, so does the demand for labour. when demand for goods decreases, the derived demand for labour also decreases, resulting in unemployment

firms will only demand workers if they will make money by employing them

- firms demand labour in order to make revenue from selling the goods/services that the labour produces

- the marginal productivity theory says that the demand for any factor of production depends on its marginal revenue product

- the marginal revenue product of labour is the extra revenue gained by the firm from employing one more worker

- MRPl is calculated by multiplying the marginal physical product of labour by the marginal revenue

- firms will only hire workers if they add more to a firms revenue than they add to its cost. heres an example:
>if an extra worker produced 10 units per hour that were sold for £12 each, the MRPl would equal £120. as long as the worker costs less that this to employ, its profitable to employ the extra worker

- the cost of hiring 1 additional worker is called the marginal cost of labour. in a perfectly competitive labour market the MC is equal to the wage paid to the additional worker

- in a perfectly competitive market the firm cannot influence the wage- the wage on the diagram is the market equilibrium wage. if you compare the wage to the MRPl, this indicates the quantity of labour a firm needs to use to be most cost-effective:
>when MRPl is equal to the market equilibrium wage, the firm has the optimum number of workers to maximise profits
>when MRPl is greater than the wage, a firm could increase its profits by employing more workers- the firm is employing too few workers
>when MRPl is less than the wage, workers are adding more to costs than they are to revenue, so the firm is employing too many workers

the MRPl curve is the same shape as the MPPl curve

- remember, MRPl=MPPl x MR. this means that the values that make up the MRPl curve are the same as the ones that make up the MPPl curve multiplied by the MR

- as the values of the MPPl curve are multiplied by the MR to form the MRPl curve, the curves are the same shape

- the MPPl curve is downward sloping because of the law of diminishing returns. in other words, as each new worker is employed the amount of additional output thats produced falls:
>the diagrams show the MPPl and MRPl curve of the same firm
>by looking at these 2 diagrams its possible to work out the MR. to get a revenue of £50 at Q1 on diagram 2, output at Q1 on diagram 1 must have been multiplied by 5- so the MR is £5

a firms demand for labour is affected by productivity

- generally, a firms demand for labour will decrease if wages rise. however, this depends on the whether the wage increase in accompanied by an increase in productivity

- higher levels of productivity will reduce unit labour costs. unit labour costs are the labour costs per unit of output

- so, if wages increase but are accompanied by an equivalent increase in worker productivity, this means that the unit labour cost stays the same and demand for labour is unaffected. for example:
>if a workers wage was £10 per hour and they iced 10 cakes per hour, the wage cost per cake would be £1. if they get a 10% wage rise and had a 10% rise in productivity, the wage cost per cake would still be £1

- high unit labour costs suggest theres low productivity and this would reduce a countrys international competitiveness

- if a firms unit labour costs are reduced as a result of the increase in labour productivity, itll become more competitive- unless the increase is due to something which will improve the productivity of competing firms too, such as new technology, in which case its relative competitiveness wont change

- international competitiveness may mean the unit labour cost in a particular industry is too high in some countries for them to be competitive and production in that industry will stop

the MRPl curve is also the demand curve for labour

- anything that affects the MRP will shift the demand curve for labour. examples include:
>a change to the price of goods sold- if demand falls for a firms product and its price falls, this would decrease the firms demand for labour and the MRPl curve would shift to the left
>factors that affect labour productivity- e.g. if new technology or training increases the productivity of workers, this would increase the demand for labour and cause the MRPl curve to shift to the right
>increases to the costs of labour- the cost of labour doesnt only include wages. it also includes costs such as training, uniforms, safety equipment, and National Insurance contributions. if any of these labour costs increased, this would decrease the demand for labour and the MRPl curve would shift to the left

- elasticity of demand for labour measures the change in demand for labour when the wage level  changes. its calculated by dividing the percentage change in quantity of labour demanded by the percentage change in the wage rate

- when demand for labour is elastic, small wage changes can cause large changes in the quantity of labour demanded. when its inelastic even large wage changes only cause small changes to the quantity of labour demanded

- there are several factors that can influence the elasticity of demand for labour:
>the demand for labour is always more elastic in the long run as firms can make plans for the future to replace labour. in the short run, changes are more difficult to make, so demand for labour is more inelastic
>if labour can be substituted easily by capital, then the demand for labour will be elastic
>if wages are a small proportion of a firms total costs then the demand for labour will be more inelastic- this is because a wage increase will have little impact on total costs. if wages are a large proportion of a firms total costs then demand for labour will be more elastic- even small wage increases will have a large impact on total cost
>its important to consider the price elasticity of demand of the product being made. the more price elastic the demand for the product is, the more elastic the demand for labour will be. in this situation, when wages rise firms arent able to pass the increase in costs to consumers

labour supply can refer to an individual or an occupation

- an individuals labour supply is the total number of hours that that person is willing to work at a given wage rate. in the short run the supply of labour depends on an individuals decision to choose between work or leisure at a given wage rate

- for an occupation, the labour supply is the number of workers willing to work in that occupation at a given wage rate

- as the wage rate for an occupation rises, the quantity of labour supplied increases:
>usually, individuals are prepared to work more hours as the wage rate increases. however, therell be a limit to how many hours an individual will be prepared to work, even if wages continue to rise
>although individual workers have a limit to the amount of labour theyre willing to supply, high wages will attract more workers to an occupation and increase the labour supply
>this means that the supply curve for labour in an occupation slopes upwards

- generally, when wages rise from a low level an individuals supply of laboour increases because individuals are more willing to work for a higher wage to increase their standard of living. on the diagram, when the wage rate rises from W to W1, the quantity of labour supplied increases from Q to Q1

- leisure time is spent not working. people expect to be compensated to give up their leisure time for work. as wages rise the oppurtunity cost of leisure time becomes greater, which means that workes have an incentive to subsitute more leisure time with work. this is called the substitution effect

- the substitution effect becomes stronger as the curve slopes upwards. however, there comes a point where this is no longer the case and people begin to choose to work less even though their wage rate continues to increase- this is called the income effect

- the backward bending supply curve shows that at higher wage rates workers generally choose to work fewer hours- when the wage rate rises from W1 to W2, the quantity of labour supplied decreases from Q1 to Q2. this is because theyve reached a level of income that theyre happy with. as their income rises they can afford to have more leisure time while maintaining their target income- the income effect is now stronger

the supply of labour can be influenced by job satisfaction

- the supply of labour in the long run is determined by pecuniary and non-pecuniary factors. these factors determine the welfare gained by working, which is known as the net advantage

- the net advantage of a job can be divided into 2 types of benefit:
>pecuniary benefits: this is the welfare a worker gains from the wage they recieve
>non-pecuniary benefits: this is the welfare a worker can gain from non-wage benefits of their job. examples of these benefits include: >flexible working hours >employee discount >a generous holiday allowance >convenience of job location >training available >oppurtunites for promotion >job security >perks of the job. firms offering non-pecuniary benefits can encourage workers to supply more labour at a given wage rate. so they can effectively cause the position of the labour supply curve to shift

- when a worker enjoys their job theyre more willing to accept a lower wage because they gain high non-pecuniary benefits from their job

- people are likely to gain low non-pecuniary benefits from unpleasant or boring jobs with low job satisfaction. everything else being equal, workers doing these jobs will want a higher wage to compensate for the low non-pecuniary benefits they recieve

other factors can affect the supply of labour to a particular job or industry

- factors that affect the supply of labour include:
>the size of the working population in an area or the country as a whole. for example, if theres an ageing population with a large proportion of people in retirement then there may be insufficient workers to meet demand for labour
>the competitiveness of wages- workers may pick the job that will pay them the highest wage. firms/industries that pay poor wages may struggle to attract enough labour
>the publicising of job opportunities- it may be difficult to attract sufficient workers to a particular job/industry if jobs are not advertised effectively

the quantity of labour supplied depends of the elasticity of the labour supply

- the main determinant of the elasticity of labour supply is the level of skills and qualifications needed for a job

- low-skilled jobs:
>in low-skilled jobs the supply of labour tends to be elastic. this means that a small rise in the wage rate causes a proportionately larger rise in the quantity of labour supplied. this is because theres a large pool of low-skilled workers and many may be unemployed and looking for work
>its also important to remember that most low-skilled jobs tend to have similar wage rates. if one low-skilled job increases its wage rate, even by a small amount, low-skilled workers from other occupations will be attracted quickly

- skilled jobs:
>the supply curves for skilled jobs, such as doctors, pilots and lawyers tend to be inelastic, particularly in the short run. this can be explained by looking at the following example
>if there was a shortage of doctors in the UK, a rise in the wage rate would not be enough to increase the supply in the short run as it takes several years to train to become a doctor. increasing wage rates would have the effect of persuading more people to choose medicine at university, but this would only have an effect in the long run

- the mobility of labour is also another important factor that affects the elasticity of labour supply:
>if workers are occupationally mobile, then wage rises will cause greater increases in the supply of labour- labour supply will be more elastic
>if workers are geographically mobile, then wage rises will cause greater increases in the supply of labour- labout supply wil also be more elastic

net migration of labour can increase the supply of labour

- the UK is part of the EU, which supports the free movement of labour between its member states

- net migration of workers to the UK can increase the supply of labour and help alleviate shortages of skilled workers

- it can also help with the increase demand for seasonal workers, for example in agriculture and construction

market forces can determine wages in a labour market

- wage differentials are the differences in wages between different groups of workers, or between workers in the same occupation. there are many reasons why these differentials exist, for example:
>workers that are highly skilled tend to be paid more, e.g. if theyre highly trained or high have high-level qualifications
>wages vary in different regions and between industries- in some locations/industries workers will earn more
>a trade union can influence the wage rate paid to a group of workers

- generally, when people talk about wages they mean nominal wages- i.e. the amount of money that people are paid. economists also talk about real wages, which take inflation into account and represent the actual purchasing power of peoples wages

market forces can determine wages in a labour market

- wage differentials are the differences in wages between different groups of workers, or between workers in the same occupation. there are many reasons why these differentials exist, for example:
>workers that are highly skilled tend to be paid more, e.g. if theyre highly trained or high have high-level qualifications
>wages vary in different regions and between industries- in some locations/industries workers will earn more
>a trade union can influence the wage rate paid to a group of workers

- generally, when people talk about wages they mean nominal wages- i.e. the amount of money that people are paid. economists also talk about real wages, which take inflation into account and represent the actual purchasing power of peoples wages

- wages will probably be higher if demand is high and inelastic, and supply is low and inelastic. wages tend to be low when demand is low and elastic, and supply is high and elastic. this can be seen in the examples below:
- lawyers:
>lawyers are paid high wages
>demand for lawyers is high because they have a high MRP- in other words theyre able to make lots of revenue for their firm
>demand is also inelastic because lawyers are not easily replaced- few people have the right skills and experience
>supply will be low, especially in the short run, as it takes a long time to train to become a lawyer, and not everyone has the abilities to become one
- office cleaners:
>office cleaners are paid fairly low wages
>demand for cleaners is relatively low compared to the supply. the MRP for cleaners is low- this means demand for them is low as cleaners dont contribute greatly to the revenue of their employer
>supply will also be high and elastic as there are no long training periods involved. many people can do the job as no specific skills or qualifications are needed

wages are made up of transfer earnings and economic rent

- in a labour market, transer earnings can be seen as the minimum payment thats required to keep labour at its current occupation- i.e. the minimum pay that will stop a worker from switching to their next best paid job. the size of the transfer payment differs between workers

- workers are often paid in excess of their transfer earnings- the excess above transfer earnings is called economic rent

- this means that a workers wages can be divided into 2 parts: transfer earnings and economic rent. for example, a worker earns £400 per week. in his next best job hed earn £350 per week. so his weekly wage is made up of £350 transfer earnings and £50 economic rent

- transfer earnings and economic rent can be show using a diagram:
>in this market the equilibrium wage rate is W. a worker whos paid this wage supplies their labour at the margin because if the wage was reduced, the worker would look for alternative employment and leave this labour market. for the marginal worker the wage rate is equal to their transfer earnings
>the area under the supply curve below the equilbirium point is equal to the transfer earnings of workers in this market
>the economic rent of all the workers in the market is equal to the area above the supply curve up to the wage rate

- the elasticity of the labour supply curve has a significant impact on the proportion of the total earnings that makes up transfer earnings and economic rent:
>as the supply curve becomes more elastic, the proportion of the total earnings thats economic rent decreases and the proportion thats transfer earnings increases
>the opposite occurs if the supply curve becomes more inelastic

- for occupations where the supply of labour is elastic, the earnings of each worker will be mainly transfer earnings. the opposite is true for occupations that have an inelastic supply of workers

in a perfectly competitive labour market firms are price takers

- the diagrams show the equilibrium wage rate and level of employment for a perfectly competitive labour market and an individual firm within in:
>in diagram 1 the ruling market wage is determined by the forces of demand and supply
>individual firms have no power to influence the wage level so theyre forced to accept the ruling market wage, i.e. firms are price takers- see diagram 2
>the ruling market wage is also the individuald firms labour upply curve. this curve is perfectly elastic because the wage rate is set by the market and the firm can hire as many workers as it wants at this wage rate. notice that the supply curve is also the average cost of labour curve and the marginal cost of labour curve
>in diagram 2, the firm decides to use the quantity of labour Q1 because at Q1 its maximises profits
>remember, this is only a theoretical model as perfectly competitive labour markets dont exist in the real world. however, its still useful to compare this model with real markets, which are imperfectly competitive to some extent

a monopsony labour market is an example of an imperfect market

- this example shows the difference that imperfections can make to a labour market

- a monopsony means theres only 1 buyer in a market. in a monopsony labour market theres a single employer, so workers have only 1 choice of employer to work for

- a monopsonist employer can pay a wage thats less that a workers MRP and less than what wouldve been paid in a perfectly competitive labour market. monopsonist employers can also drive down the level of employment below the level that would exist in a perfectly competitive labour market

- the wages and employment levels in a monopsony labour market can be show using a diagram:
>the marginal cost of labour curve is above the average cost of labour curve, so the cost of employing 1 more worker is more than the average cost. MCl is above ACl because each time an extra worker is hired, not only does the firm have to pay that worker a higher wage to attract them, but the firm also has to increase existing workers wages to the same level
>the average cost of labour curve shows the number of workers that are prepared to work for the monopsonist at different wage levels- so the ACl curve is also the supply curve
>firms will hire the number of workers that maximise their profits. this is at T, and the number of workers hired is Q1. the wage paid is W1- the supply curve clearly shows that Q1 workers will accept W1 wage
>unlike in a perfectly competitve market, this wage is lower than the MRP of labour. the monopsonist could pay a higher wage than W1, but it doesnt need to as Q1 workers will work for W1. this means that monopsonists are price makers

- a trade union is an organisation formed to represent the interests of a group of workers. examples include the National Union of Teachers and the Professional Footballers Association. 1 of the main purposes of a trade union is to bargain with employers and get the best outcome for its members. for example, they can bargain for improved pay, better working conditions and job security. members of a trade unions have increased bargaining power compared to individual workers

- when a trade union negotiates with an employer this is called collective bargaining. collective bargaining can be done on a national level or at plant level

- productivity bargains can be made, which is where unions agree to specific changes thatll increase productivity in return for higher wages or other benefits for its members. for example, performance-related pay agreements may be negotiated. this is when workers get pay increases that are linked to the quality of their work and their productivity

- trade unions can also have a role in making sure workers are safe at work by making sure any laws about working conditions are adhered to. for example, they will make sure workers have sufficient breaks and their place of work meets health and safety requirements

-trade unions can also help to protect their members for discrimination

- trade unions are most powerful when they have huge membership- the more members a union has, the more influence it can have. at their peak in 1979, the trade unions in the UK were very powerful and had around 13 million members

- during the 1980s, when Margaret Thatcher was the Prime Minister, the Conservative government acted to reduce the power of trade unions- e.g. by making it more difficult for trade unions to go on strike. the government at the time saw weakening the trade unions as a supply-side policy that would help make UK industry more flexible and competitive

- in addition, there was a big decline in the large manufacturing industries in the 1980s and 90s, which had huge trade union membership. this de-industrialisation meant that there was a shift in employment towards jobs in the service sectors where unions tend not to exist- so union membership fell sharply

- modern trends in the economy have also reduced union membership further. workers on flexible contracts and part-time workers are less likely to join a union

- since the mid 1990s trade union membership has remained fairly stable at around 7 million members

trade union wage negotiations may result in unemployment

- trade unions cause labour market failure by forcing wages up to a level higher than the market equilibrium wage- causing a surplus of labour. some of a firms income is redistributed to the workers and its costs of production increase

- the effect of trade union wage negotiations in a perfectly competitve labour market can be seen on a diagram:
>without trade union action firms would pay the equilibrium wage rate and the level of employment would be Le
>when the trade union forces the wage rate up to Wt this means firms cant employ workers for less than this wage. this results in a kinked supply curve. at Wt the quantity of labour falls to L1
>at this higher wage rate theres an oversupply of workers- theres insufficient demand for the number of workers willing to work, so theres unemployment, and this is labour market failure
>the level of unemployment caused by the wage increase depends on the elasticity of the labour demand curve

pay rises negotiated by trade unions may not lead to unemployment

- trade unions can help to increase the wages of their members without causing unemployment. to do this the productivity of trade union members must increase- this would increase demand for workers from firms and help prevent the situation of an excess supply of labour

- trade unions can help persuade their members to agree to more efficient working practies which increase worker productivity. this is good for firms as a more productive workforce may increase their profits. workers will benefit from higher wages and trade union membership wont be reduced by unemployment

- when workers become more productive a firms MRP curve shifts to the right. firms can afford to pay wages that are equal to a workers MRP, so if a trade union can help raise the MRP of workers, then an increased wage can be justified

- a monopsonistic employer pays workers a wage thats lower than their MRP. if a trade union was involved it could increase the wage rate whilst maintaining the same level of employment, or even increasing it

- when a trade union enters a monopsonistic labour market this is an example of a bilateral monopoly. this is when theres a single buyer and a single seller- so in this case theres a single buyer of labour and a single seller:
>W1 is the wage that the monopsonist would have paid to workers without a union
>the presence of a union may increase wages to W2. in doing this it will change the shape of the supply/average cost of labour curve, and thatll then change the shape of the marginal cost of labour curve
>the profit maximising level of workers is still where the MC curve crosses the marginal revenue product curve. this is now at point U, giving a new increased level of employment of L2
>the union has managed to increase wages from W1 to W2, and increase employment from L1 to L2

- the presence of the trade union in the market means that the wage rate and level of employment have been brought closer to the levels that theyd be at in a free market. the trade union has had a positive impact on the labour market

trade unions are less likely to cause market failure today

- government legislation has reduced the power of trade unions. theyre less likely to cause market failure because they have less influence

- trade unions have made big changes in the workplace though. in return for higher pay and better working conditions firms have benefited from a more productive and flexible workforce. dont forget that the increase productivity of workers may drive an increased demand for workers and lead to a reduction in unemployment

wage discrimination can result in lower wage costs for firms

- wage discrimination is similar to price discrimination

- wage discrimination takes place when employers with monopsony power pay different wage rates based on different workers willingness to supply labour. this can be shown in a diagram:
>without wage discrimination all workers in a competitive market are paid We- the market equilibrium price
>the total wage cost for firms is the area below this wage
>when employers start to pay the minimum each worker is prepared to work for, the total wage cost is reduced to the area below the supply curve
>employers gain while workers lose out

- wage discrimination shouldnt be confused with labour market discrimination. this is a different concept based on workers being discriminated against depending on differences between them, such as gender and race

- wage discrimination is common in professions where employees negotiate their own pay and conditions- some people will be able to negotiate a higher wage than others for the same job

- in general, there are some categories of workers who are more likely to be prepared to work for lower wages. e.g:
>young workers may be more interested in gaining experience than earning a high wage
>part-time workers may be willing to work for lower wages if theyre not the main wage earner in their household
>some immigrants will accept lower wages if theyre higher than the wages they could earn in their country of origin

wage discrimination has advantages and disadvantages

- workers:
>advantage: as employers wage costs will be reduced, it can increase demand for labour, providing more jobs
>disadvantage: can lead to the exploitation of vulnerable workers who could be forced to accept low wages. could force wages down for all workers in a market

- employers:
>advantage: reduces the cost of wages, which can lead to higher profits
>disadvantage: can require additional administration. can lead to industrial unrest if workers know about the differences in wages

economy:
>advantage: could increase employment levels through increased demand for labour
>disadvantage: could lead to increases in inequality, so benefits may be required to 'top up' low wages

labour market discrimination is a cause of labour market failure

- labour market discrimination is when a specific group of workers is treated differently to other workers in the same job

- workers can be discriminated against because of their race, gender, sexuality, religion, disability, age, etc. here are 2 examples of labour market discrimination:
>racial discrimination can occur when employers only want to work with and employ people from a particular ethnic background. theyre prepared to pay a price for this- the loss in productivity from not employing a worker thats perhaps the most suited for the job
>the gender pay gap is where average pay rates are lower for women than for men. part of this pay gap is thought to be due to discrimination by employers that are prepared to pay male employees more than female employees for doing the same job

- in the UK this sort of discrimination is against the law. the Equality Act of 2010 replaced all previous anti-discrimination laws and made discrimination illegal in the UK

- discrimination can be one cause of the unequal distribution of wealth and income and can lead to a misallocation of resources, reduced efficiency and increased costs

workers suffering from discrimination tend to earn less

- workers who suffer from discrimination are generally forced to accept lower wages

- discrimination can also mean that some workers find it more difficult to find a job. they may resort to accepting a lower-paid job that theyre overqualified for. this is unfair to them and is also a misallocation of resources

- in addition, workers who are the victims of discrimination may be put off from going for promotions, which can leave them in low-paying jobs with limited career prospects

- employers who are influenced by their own prejudices believe that the marginal revenue product of the discriminated group of workers is lower than it really is. this means that they demand fewer of these workers

- when demand falls the MRP/demand curve shifts left, which means that wages go down for the discriminated job

- by discriminating like this, firms have fewer workers to choose from. by ignoring workers who may have been more suited to a job and more efficient, they increase their costs of production. increased costs may lead to increased prices

- this discrimination can be shown by the diagrams:
>for discriminated workers, MRP is lower than the level in the free market and this results in a lower wage rate
>for favoured workers employers believe their MRP to be greater than it actually is. this shifts the MRP curve to the right, increasing the wage rate for these workers 

- employers that dont discriminate have access to a greater supply of labour:
>as the demand for discriminated workers is reduced in firms that discriminate, there are more workers available to suppy their labour to firms who dont discriminate
>the supply curve for these firms shifts right and the wage rate decreases. this means discriminated workers could lose out again

discrimination leads to increased costs for the government and economy

- the government may need to increase welfare payments to support discriminated workers

- discriminated workers working for unfairly low wages will also reduce the governments tax revenues, which would be higher if these workers were paid fairly

- if discriminated workers arent in a job thats well suited to them, their levels of productivity can fall. when output and efficiency fall, a country may lose international competitiveness. this could negatively effect the countrys balance of payments, reducing the sale of exports, and this in turn may cause unemployment

not all economic inactivity is labour market failure

- people are classed as economically inactive if theyre not working and also not looking for work

- econonomically inactive people are considered by economists as a waste of scarce resources

- people are economically inactive for several reasons:
>they care for sick, elderly or young people
>theyre in full time education
>they have a long-term illness or disability
>theyre choosing not to find a job or have given up

- it can be good for some people to be economically inactive. for example:
>people that are looking after family members may actually save the government money. for example, the benefits paid to people caring for an elderly relative may be less expensive than the cost of providing a professional carer
>those in full-time education are also going to add value to the economy in the future when they will increase the quality of the labour force

- however, people who are inactive due to long-term illness or disability, but are still able to work, represent market failure. labour is a scarce resource and these people could still add up to an economys output if work can be found for them

- discouraged workers who have triend to find work but have given up are also a waste of scarce labour in exactly the same way. discouraged workers are also more likely to suffer from depression, which can add to health care costs

all labour markets suffer from imperfect information

- imperfect information is another source of labour market failure

- perfect information would exist if workers knew everything about every job and employers knew everything about every potential worker. using this information workers and employers would find their ideal job and employees

- imperfect information increase frictional unemployment. when people are between jobs they need to spend time researching to find the right job. if they had the benefit of perfect information their task would be similar

skill shortages increase the costs of production for firms

- a shortage of anything drives up price. therefore shortages of skilled labour drive up the wage costs for firms, which in turn increases their costs of production

- a shortage also means that firms may be forced to employ workers who dont have the desired level of qualification/experience for the job, and this will reduce productivity and quality levels

- training can increase employee skills and make them more productive, but employers can be reluctant to provide it as they often worry about other firms poaching their newly-trained employees without incurring the costs of this training

- encouraging the immingration of workers with certain skills is one way of tackling skills shortages

unemployment exists when labour supply is greater than labour demand

- unemployed workers are a waste of scarce resoruces- unemployment means an economy isnt making use of all its resources effectively. however, in an economy theres always some level of unemployment, and unemployment actually helps to keep wages down

- for example, if everyone in an economy had a job and an employer wanted to hire a worker, they would have to offer them a higher wage than their current job. a firm could offer better non-pecuniary benefits instead, but this would still increase the firms costs

- unemployment only becomes a serious market failure if its at a high level and persists for a long period of time

- the replacement ration is the ratio of how much a person would earn if they were unemployed to how much theyd earn if they were employed

- if the level of unemployment benefit is too high, i.e. the replacement ratio is too high, this can cause unemployment. this means that people can be better off by choosing not to work and claiming unemployment benefit rather than working for a low wage- this is called the unemployment trap

some people are more geographically mobile than others

- geographical immobility of labour is when workers arent able to move to different locations to find the best jobs for themselves. when this happens they end up either unemployed or at jobs that arent suited to them- so theres a misallocation of resources and market failure occurs

- there are a number of reasons behind geographical immobility. they include:
>people make friends and have family that they dont want to move away from
>its expensive to move house. not only does it cost to buy a house, but it costs to sell your house too

- geographical immobility can lead to labour shortages in one area and labour surpluses in another. this can then be followed by regional wage differences- high wages in the areas with shortages and low wages in the areas with surpluses

barriers that stop people from changing jobs create segmented labour markets

- in theory, if there were no barriers to entry and exit, workers would move from low wage jobs to high wage jobs until everyone had the same wage. however, in reality there would still be some wage differentials because not everyone has the motivation and talent to do a high-paying job

- in fact some people in vocational jobs, like nursing, arent motivated by money, so they wouldnt get a job in a different professions to earn higher wages. they might, however, move to a different nursing job with higher pay

- in reality barriers to entry and exit do exist and they prevent the free movement of workers between all of the different jobs that are available- this is what causes segmented labour markets to exist. rather than one labour market there are many distinct labour markets, which are sub-markets of the labour market

- the main barrier to entry in segmented labour markets is qualifications/skill levels- this limits supply and increases wages of particular groups of workers. the existence of these barriers might lead to market failure because the forces of demand and supply cant act to equalise wages- i.e. the market equilibrium wage cant be the same across a segmented labour market

- barriers arent all bad though. making sure workers in highly-skilled occupations have the necessary skills is crucial to keeping people safe- no one wants an unqualified dentist. so, minimum qualifications make sure the right people are doing the right job- making the market more efficient

demographic changes can be a major concern for governments

- demographic changes in the composition of a population. this might be changes in the proportion of people who are of working age or in the gender split of the population

- the UK has an ageing population, which means that a large proportion of the population is over 60. this is also the case for many other developed countries

- this demographic change is causing several big problems:
>the UK government pays a state pension to workers once they reach the state pension age and have made a minimum number of years of National Insurance contributions- so an ageing population means state pensions are a growing cost for the government
>the NHS is used more by older people, so an ageing population puts a strain on many of its services and increases the cost to the government
>theres a reduction in the working age population, a reduction in labour supply and an increase in the dependancy ratio. as a greater proportion of the population is not working, there are fewer people paying taxes to help the government to fund pensions and the NHS

- these problems are unlikely to resolve themselves soon, as life expectancy is increasing. the government needs to take action to tackle the problems caused by an ageing population

- the impacts of an ageing population on the labour market can include:
>wage increases, particularly for younger workers who will be more scarce
>a greater proportion of the working population being older, e.g. over 50
>increased participation in labour markets by those over 65
>changes in employment patterns- e.g. more jobs caring for the elderly population
>the need for more immigration, particularly of young, skilled workers
>tax increases to cover the costs of the increasing number of elderly people, e.g. to pay for health care and pensions

- other demographic changes have different impacts on the labour market. for example, increased female participation in a labour market can increase the supply of labour and lead to a fall in wages

incentives can be given to either workers or firms

- incentives are given to people to encourage them to work, which will increase the participation rate and the labour supply. for example, working tax credits are available for people who are in work but earning low incomes. those who are eligible are paid a certain amount depending on their earnings

- incentives can also be given to firms with the aim of increasing the number of available jobs. for example, employment allowance means that firms who should pay up to £2000 in national insurance contributions for their employees dont actually have to pay anything at all. these benefits smaller firms by reducing their costs and it also leads to job creation, but many of these jobs are low-paid

- a NMW can be an incentive for migrants to move to a country if its higher than wages they would be paid in their country of origin

the informal market is a significant proportion of many economies

- the informal market or sector is economic activity that occurs without taxation and government regulation, e.g. a worker in the informal market wont pay income tax for that job, and firms wont pay corporation tax

- the estimated size of the UK informal labour market is approximately 10% of GDP- this is below the EU average

- developing countries tend to proportionally have a much larger informal market- this is usually because they dont have the resources to prevent the development of informal market activity

- the informal market can have a number of benefits for an economy- it can create jobs and reduce unemployment. some workers may have 2 jobs- i.e. theyre employed both legally and in the black market, which increases the supply of labour

- employers benefit from cheap, flexible labour as workers wont have contracts or employment rights

- also, employees/the self-employed will likely benefit from a higher net income

- however, there are disadvantages of informal markets too- although the informal market increases GDP and exports, it reduces tax revenue. it can also introduce unfair competition into an economy- for example, firms in the informal market dont pay taxes, so they can sell products at cheaper prices than firms who are acting legally

- employees may also be disadvantaged, e.g. they can be exploited more easily due to their lack of employment rights

governments intervene in the labour market to correct market failure

- governments intervene to corect labour market failure because it causes several problems, such as unemployment or very low wages

- there are many ways governments can intervene in the labour market. one of the main ways the government can intervene is by influencing wages

the national minimum wage aims to make wages fairer

- the NMW sets a legal minimum hourly rate of pay for different age groups. a NMW was 1st introduced by the UK government in 1999 to stop firms setting wages so low that their employees couldnt afford a decent standard of living. it aims to prevent the exploitation of workers due to the payment of unfairly low wages

- by increasing the pay of the poorest workers a NMW leads to a more equitable distribution of income

- a NMW helps to encourage people to work. for example, having a minimum wage might encourage workers to get a job instead of claiming benefits, as it improves the replacement ratio

- in addition, increasing the number of people in work increases the partipation rate, which is good for the economy and increases labour supply

it can be argued that introducing a NMW leads to unemployment

- using supply and demand diagrams it could be argued that incresing the wage rate would lead to a contraction in demand for labour. this can be seen in a diagram:
>introducing a minimum wage thats higher than an industrys equilibrium wage would raise the wage rate for We to NMW. this would cause the supply of labour to increase from Qe to Q2 and demand to fall from Qe to Q1
>this could cause unemployment of Q1 to Q3 because theres an excess supply of labour
>introducing a minimum wage when the demand and supply of labour is fairly elastic results in greater unemployment than when the demand and supply of labour is more inelastic- the difference between Q1 and Q2 is larger when they are elastic

- unemployment caused by the introduction of a NMW would be an example of government failure. however, theres evidence to suggest that having a NMW hasnt caused a significant negative impact on the level of employment in the UK

- a NMW can be used to tackle inequality and poverty- there are other ways of doing this too

- advantages:
>introducing a NMW may help those on very low incomes and reduce the level of poverty in a country
>a NMW may also boost the morale of workers as theyll recieve better wages. happier workers tend to be more productive so output may increase as a result
>a NMW mwans theres greater reward for doing a job that pays the NMW. it gives people more incentive to get a job rather than be unemployed
>the governments tax revenue is likely to be greater if a NMW is introduced

- disadvantages:
>a NMW can increase wage costs for firms. this might mean they have to cut jobs, resulting in increased unemployment
>a NMW could decrease the competitiveness of UK firms compared to firms in other countries that have lower wage costs
>UK firms may have to pass on increases wage costs to consumers by increasing their prices, and this could contribute to inflation
>there are doubts about whether introducing a NMW really decreases poverty. this is because many of the poorest members of soceity, such as the elderly and disabled, are not in work

the living wage covers the basic cost of living

- the 'living wage' is an hourly wage independatly worked out by the living wage foundation. its a wage thatll cover an individuals basic cost of living in the UK and its higher than the current NMW. there are 2 different rates- one for london and one for the rest of the UK

- its not compulsory for employers to pay the living wage, but the government encourages it. over 1000 UK employers such as barclays and google, have voluntarily committed to pay their employees at, or above, the 'living wage'

- most of the advantages and disadvantaged of a NMW apply to the 'living wage' too- and the NMW diavram shows what effect a 'living wage' may have on employment levels

a government can set a maximum wage

- a maximum wage limits a workers wage rate. to be effective it must be set below the market equilbrium wage rate, which will reduce wages in that market and increase demand for labour

- the possible benefits of a maximum wage include:
>rises in wages aboce increases in productivity can cause inflation, so setting a maximum wage can limit how much prices can rise and help to prevent the wage-price spiral
>a maximum wage could limit the level of inequality in a country 
>a maximum wage could reduce a firms labour cost and increase their willingness to hire more workers

- there are arguments against a maximum wage too:
>some believe its unfair to not reward greater effort or ability with higher income
>the possibility of higher pay and pay increases provides motivation to work harder
>if only some countries had a maximum wage, people who could earn higher wages in other countries might move abroad. similarly, if 1 industry had a maximum wage and another didnt, then people would train to work in the industry without a maximum wage

- government intervention to improve the flexibility of the labour force will help to reduce labour market immobility

- a flexible labour force is one where workers can transfer between activities quickly in response to changes in the economy. for example, a worker in a flexible labour force would be able to retrain or transfer their skills to another job easily if something bad affected the industry they were employed in

- governments can act to increase the flexibility of the workforce:
>to increase the flexibility of workers, governments can promote or subsidise training and education schemes that help workers gain skills and knowledge that are attractive to employers. they can also provide training directly, e.g. skills training to the unemployed
>recently, there have been changes to the UK education system, such as an increase in apprenticeships and vocational education, and restructuring of the exam system. these schemes should improve labour market flexibility by helping young people to develop skills they need to get a job. it takes times for the effects of these changes to be seen, so itll be a while before anyone can assess whether theyve been successful or not
>the UK government has also increased flexibility by reducing the power of trade unions, which can cause inflexibility in the labour market

- government intervention to improve the flexibility of the labour force will help to reduce labour market immobility

- a flexible labour force is one where workers can transfer between activities quickly in response to changes in the economy. for example, a worker in a flexible labour force would be able to retrain or transfer their skills to another job easily if something bad affected the industry they were employed in

- governments can act to increase the flexibility of the workforce:
>to increase the flexibility of workers, governments can promote or subsidise training and education schemes that help workers gain skills and knowledge that are attractive to employers. they can also provide training directly, e.g. skills training to the unemployed
>recently, there have been changes to the UK education system, such as an increase in apprenticeships and vocational education, and restructuring of the exam system. these schemes should improve labour market flexibility by helping young people to develop skills they need to get a job. it takes times for the effects of these changes to be seen, so itll be a while before anyone can assess whether theyve been successful or not
>the UK government has also increased flexibility by reducing the power of trade unions, which can cause inflexibility in the labour market

- for employers, a flexible workforce is one that can be hired and fired easily. laws that make it easy to hire and fire workers encourage employers to take on more workers. this is because firms know they can chage the size of their workforce quickly in response to changes in the market

- different types of contract can also make workers more flexible for employers:
>short-term contracts allow firms to hire a wokrer for a certain length of time- if the firm still needs the worker torwards the end of the contract they can extend the contract for a longer period to suit their needs. zero-hour contracts are where firms can hire workers without guaranteeing them a definite number of hours of work per week- the employer can offer these employers a number of hours that suits the firms needs
>the cost of employing staff on short-term and zero-hour contracts is less that full-time contracts
>an increasing number of part-time workers and increasingly flexible working times in the UK also increases the temporal flexibility of labour

- zero-hour contracts are popular with governments because they reduce unemployment figures, but they can cause problems- workers on these contracts dont have a guaranteed income, so its hard for them to manage their finances

- for employers, a flexible workforce is one that can be hired and fired easily. laws that make it easy to hire and fire workers encourage employers to take on more workers. this is because firms know they can chage the size of their workforce quickly in response to changes in the market

- different types of contract can also make workers more flexible for employers:
>short-term contracts allow firms to hire a wokrer for a certain length of time- if the firm still needs the worker torwards the end of the contract they can extend the contract for a longer period to suit their needs. zero-hour contracts are where firms can hire workers without guaranteeing them a definite number of hours of work per week- the employer can offer these employers a number of hours that suits the firms needs
>the cost of employing staff on short-term and zero-hour contracts is less that full-time contracts
>an increasing number of part-time workers and increasingly flexible working times in the UK also increases the temporal flexibility of labour

- zero-hour contracts are popular with governments because they reduce unemployment figures, but they can cause problems- workers on these contracts dont have a guaranteed income, so its hard for them to manage their finances

- for employers, a flexible workforce is one that can be hired and fired easily. laws that make it easy to hire and fire workers encourage employers to take on more workers. this is because firms know they can chage the size of their workforce quickly in response to changes in the market

- different types of contract can also make workers more flexible for employers:
>short-term contracts allow firms to hire a wokrer for a certain length of time- if the firm still needs the worker torwards the end of the contract they can extend the contract for a longer period to suit their needs. zero-hour contracts are where firms can hire workers without guaranteeing them a definite number of hours of work per week- the employer can offer these employers a number of hours that suits the firms needs
>the cost of employing staff on short-term and zero-hour contracts is less that full-time contracts
>an increasing number of part-time workers and increasingly flexible working times in the UK also increases the temporal flexibility of labour

- zero-hour contracts are popular with governments because they reduce unemployment figures, but they can cause problems- workers on these contracts dont have a guaranteed income, so its hard for them to manage their finances

wage flexibility is an important characteristic of a flexible labour market

- wage flexibility refers to the abilty of real wages to change in response to changes in demand for and supply of labour

- performance-related pay and regional pay awards are examples of uses of flexible wages

- wage flexibility can be an important feature during a recession- wage cuts and pay freezes can be accepted by workers as an alternative to losing jobs

- governments can improve wage flexibility by scrapping the NMW and limiting trade union power

- as more people are living longer, governments may need to change the way that state pensions work to ensure that they can continue to afford to pay pensions to an increasing number of people for an increasingly long time

- there are a number of methods governments can use, which include:
>raising the state pension age- this will mean that on average pensioners will have fewer years claiming the state pension. the justification behind this is that it is because people are living longer, they should work longer before starting to claim a pension. in the UK the state pension age for men and women will increase to 66 by 2020, and its predicted to rise further in future years
>increasing the contributions necessary to qualify for a state pension. in the UK to qualify to recieve the state pension you need to have paid national insurance contributions for a certain number of years- this is paid by workers when they earn a certain amount. pension reforms may see the number of years of necessary contributions increase
>decreasing the amount paid out. this means people would need to do more planning and saving for retirement while theyre working, so they have enough money to live on when they retire. this is why the UK government made it compulsory for employers to enrol workers on a workplace pension, so that retirees have extra income in addition to the amount theyll recieve from their state pension

- in april 2015 there was a big change in pension legislation:
>approximately 18 million people aged 55 or over were given more flexibility in how they can use and withdraw their private pension savings
>changes were made to pension tax rules and certain parts of pension legislation
>for example, people now have the option to withdraw their entire pension fund and use or invest it as they choose, instead of having to accept a regular payment
>the change in legislation aims to increase choice. however, its likely to also lead to an increase in spending- e.g. by people withdrawing money from their pension savings to spend straight away. this could boost the economy because more spending may increase demand in an economy, creating economic growth and leading to more employment and higher wages. on the other hand, this growth might only be short term, and less spending later on could restrict future growth. it may also mean theres a risk that pensioners run out of money later in retirement, so rely more on the state, e.g. to provide care

changes to some laws will affect the workforce size and participation rates

- the pension age is currently planned to increase to 68 by 2046- this will increase the size of the workforce, and may raise the participation rate

- from 2015, people must remain in some form of training or education until theyre 18. this will cause a reduction in the size of the workforce, but the long-term benefits of a better educated, better paid, more productive and more flexible workforce are likely to outweight this drawback

- childcare can be expensive and its cost can contribute to situations where working means people are worse off than if they dont work- e.g. the income someone would recieve from their working wages, minus the cost of child care, may be less than the income theyd recieve if they stayed at home with their children and claimed benefits. so, increasing state provision of childcare is likely to increase participation rates

- incentives to workers and firms can help to increase participation rates

taxes and benefits can affect the level of employment and wage rates

- governments can increase the incentive to work to address the market failure thats caused by economic inactivity in the labour force. they can do that by lowering income taxes and benefit payments

- income tax:
>lowering marginal tax rates means workers get to keep more of their earnings. this acts as an incentive to work more and can increase the labour supply in the economy
>at the moment, workers in the UK have a tax-free allowance- this means they pay no tax on the 1st part of their earnings. recent government policy has seen the size of the tax-free allowance increase. this increases peoples incentive to work and increases equity

- benefits:
>lowering benefits increases the gap between income earned in work and income without work- i.e. it reduces the replacement ratio. this gives people a greater incentive to work, increasing the participation rate and labour supply
>lowering benefits will reduce the effect of the unemployment trap and cut voluntary unemployment
>recent changes to benefit legislation include: > a benefits cap for working-age people claiming certain benefits- the aim is to prevent people from being better off not working than working > the introduction of universal credit from 2013- a number of benefits, such as income-based jobseekers allowance, are combined into 1 benefit. its paid to people looking for work and those on low income. the aims of universal credit include making it easier for people to move into work and reducing the number of working people in poverty

the UK and EU legislate and regulate in labour markets

- the UK and EU implement legislation and regulation in labour markets for a number of reasons, for example to stop unsafe practices and to prevent employees from being exploited

- legislation involves putting specific laws in place, e.g. the UK has legislation on flexible working hours- everyone now has the right to request flexible working hours

- regulations are rules, which are often put in place so that UK or EU legislation is met

- many businesses complain that current levels of UK and EU legislation and regulation, including those in the labour market, are too high and impact on jobs and growth- e.g. rules on maternity and paternity leave. however, the european commission works to reduce the burden of regulations for small businesses

- EU directives are different to legislation- theyre set of instructions issued to EU member states. they describe particular objectives that need to be achieved within these states. a directive could affect all member states, or it could affect a single member

- authorities within member states covered by the directive must act to deliver the objectives by a certain date

- how each member state accomplishes this is up to them. this gives member states some flexibility over this process

the working time directive sets rules for working hours in the EU

- the working time directive is an example of an EU directive. it sets out rights for workers such as:
>a limit to average weekly working hours of 48 hours
>employers must give a minimum of 4 weeks paid leave per year
>a minimum daily rest period of 11 consecutive hours in every 24 hours
>average working hours for night workers shouldnt exceed 8 hours per 24-hour period

- the UK was allowed an opt-out clause fpr the limit to weekly working hours. this means that employees could formally agree to work more than 48 hours per week. employers can ask this of their employees but not force them to do this

- this directive has advantages and disadvantages for employyes and firms:
>advantages for employees include that theyre entitled to a minimum amount of paid leave which is standard across all jobs, and that workers arent overworkers
>however, a disadvantage for employers is that implementing the directive can increase their costs

migrant workers increase the labour supply of a country

- migrant workers that are young, skilled and flexible will generally have a positive effect on the economy- these workers will earn and spend money, which increases aggregate demand and grows the economy

- migrant workers can fill skill gaps in the economy. for example, the NHS has many nurses and doctors from foreign countries who have helped to do this

- this means sometimes governments will implement policies which encourage immigration- e.g. canadas federal skilled worker programme allows foreign workers from 347 different occupations to apply for permanent residency if they meet certain criteria

- free movement of workers between the EU member states has allowed workers to migrate to different EU countries. for example, there was in influx of workers into the UK from eastern european countries that became members of the EU- part of the reason for this was the higher wages in the UK

- in the UK, there has been a net inward migration of working-age people in recent years, from EU and non-EU countries. this helps the UK to cope with the problem of an ageing population

- as migrant workers increase the supply of labour availbale, its possible that migrant workers entering a labour market could depress the market wage rate. this is thought to be especially true of low-skilled workers, such as farm labourers:
>before immigration the wage rate of farm workers was W1
>when migrant workers expand the labour supply it shifts the supply curve to the right
>at this level of supply, there is an excess supply of farm labourers at W1. the wage rate falls until it clears the market, which is does at W2
>the increased supply of farm labourers has resulted in the wage rate falling from W1 to W2

governments might try to reduce immigration

- in recent years UK governments have tried to reduce immigration, particularly of low-skilled workers. this is because the high level of migration to the UK is believed to be unsustainable. the government is more supportive of skilled migrants coming to the country, as they can contribute more to the UK economy

- the effectiveness of government policies to reduce immigration is limited by a number of factors. as a member of the EU, the UK is restricted on the rules it can implement on immigration. the main reason for this is that the freedom of movement of EU citizens to any EU member nation is an important principle of the EU and is written into EU treaties

- however, the UK has made some changes to its policies to limit immigration:
>its placed a cap on the number of skilled-worker visas available to non-EU workers
>restrictions on certain welfare benefits have been brought in to make the UK less attractive to migrants- e.g. EU migrants cant claim benefits, such as jobseekers allowance, during their 1st 3 months in the UK