THEME 1 - ECONOMICS

  • Created by: iampriyal
  • Created on: 26-04-19 21:54

Economics as a Social Science

  • Economists need to make assumptions. A key assumption that is made is assuming that events occur with ceteris paribus. This assumption is that other things are being held equal or constant, so nothing else changes.
  • Economists cannot conduct scientific experiments, like in the natural sciences, so models are devised. Economists then use real-life scenarios to build these models upon, and assumptions are made with the models.
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Positive and Normative Statements

  • Positive statements are objective. They can be tested with factual evidence, and can consequently be rejected or accepted.
  • Look for words such as ‘will’, ‘is’. The key thing here is that these statements can be tested, the results can be examined and the statement can then be rejected or accepted.
  • Normative statements are based on value judgements. These are subjective and based on opinion rather than factual evidence.
  • Look for words such as ‘should’, and if the statement is suggesting one action is more credible than another.
  • Value judgements can influence economic decision making and policy. Different economists may make different judgements from the same statistic. For example, the rate of inflation can give rise to different conclusions
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The Economic Problem

  • The basic economic problem is scarcity. Wants are unlimited and resources are finite, so choices have to be made. Resources have to be used and distributed optimally.
  • The scarcity of the resource (the money) means a choice has to be made between two options. This gives rise to opportunity cost. The opportunity cost of a choice is the value of the next best alternative forgone. 
  • Opportunity cost is important to economic agents, such as consumers, producers and governments. For example, producers might have to choose between hiring extra staff and investing in a new machine. They cannot do both because of finite resources, so a choice has to be made for where resources are best spent. 
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The factors of production

Capital

Physical: goods which can be used in the production process

Fixed: Machines; buildings

Working: finished or semi-finished consumer goods

Entrepreneurship

Managerial ability: The entrepreneur is someone who takes risks, innovates, and uses the factors of production. Resources are drawn together into the production process.

Land

Natural resources such as oil, coal, wheat, water. It can also be the physical space for fixed capital. 

Labour

Human capital, which is the workforce of the economy.

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Renewable and non-renewable resources

  • Renewable resources can be replenished, so the stock level of the resources can be maintained over a period of time. If the resource is consumed faster than it is renewed, the stock of the resource will decline over time. This is important in environmental economics and can be managed by preventing or limiting deforestation, or imposing fishing quotas. 
  • Renewable resources are sustainable. However, currently, resources are being consumed faster than the planet can replace them. The Worldwide Fund for Nature claims that two planets will be required to meet global demand by 2050 if this continues. 
  • Non-renewable resources cannot be renewed. For example, things produced from fossil fuels such as coal, oil and natural gas are non-renewable. The stock level decreases over time as it is consumed. Methods such as recycling and finding substitutes, such as wind farms, can reduce the rate of decline of the resource.
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Production Possibility Frontiers

  • Production possibility frontiers (PPFs) depict the maximum productive potential of an economy, using a combination of two goods or services, when resources are fully and efficiently employed.
  • PPF curves can show the opportunity cost of using scarce resources. For example, if the scare resource is milk, there is a trade-off between producing more cheese or more yoghurt from the milk. 
  • The law of diminishing returns states that the opportunity cost of producing more yoghurt increases, in terms of the lost units of cheese that could have been produced.
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PPF - Economic growth and decline

  • The PPF can also depict economic growth or decline. Only production under and on the PPF is attainable. Production outside of the PPF is not obtainable.
  • Economicgrowth can be shown by an outward shift in the PPF whereas a decline in the economy would be depicted by an inward shift. 
  • An increase in the quantity or quality of resources shifts the PPF curve outwards, so the productive potential of the economy increases, and there is economic growth. This can be achieved with the use of supply-side policies. 
  • A PPF curve may shift inwards as a result of a decrease in the quality or quantity of resources in an economy. A country may see their PPF curve shift inwards if they are affected by natural disasters, such as flooding, or if there is a brain drain. 
  • Moving along the PPF is different from shifting the PPF. Moving along the PPF uses the same number and state of resources, and shifts production from fewer consumer goods to more capital goods, for instance. This incurs an opportunity cost. 
  •  Capital goods are goods which can be used to produce other goods, such as machinery. 
  • Consumer goods are goods which cannot be used to produce other goods, such as clothing
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Specialisation and the Division of Labour

Specialisation, a concept created by Adam Smith, occurs when each worker is completing a specific task in the production process. through the division of labour, worker productivity can increase which increases efficiency and lower average costs of production. 

Advantages:

  • Higher output and potentially higher quality, since production focusses on what people and businesses are best at.
  • There are more opportunities for economies of scale, so the size of the market increases.
  • There is more competition and this gives an incentive for firms to lower their costs, which helps to keep prices down.

Disadvantages: 

  • Work becomes repetitive, which could lower the motivation of workers, potentially affecting quality and productivity.
  • There could be more structural unemployment since skills might not be transferable, especially because workers have focussed on one task for so long.
  • There could be higher worker turnover for firms, which means employees become dissatisfied with their jobs and leave regularly. 
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The functions of money

A medium of exchange: without money, transactions were conducted through bartering. Goods and services were traded with other goods and services, but people did not always get exactly what they wanted or needed. The goods and services exchanged were not always of the same value, which also posed a problem. An exchange could only take place if there was a double coincidence of wants.

A measure of value (unit of account): Money provides a means to measure the relative values of different goods and services. For example, a piece of jewellery might be considered more valuable than a table because of the relative price, measured by money. Money also puts a value on labour. 

A store of value: Money has to hold its value to be used for payment. It can be kept for a long time without expiring. However, the quantity of goods and services that can be bought with money fluctuates slightly with the forces of supply and demand. 

A method of deferred payment: Money can allow for debts to be created. People can, therefore, pay for things without having money in the present, and can pay for it later. This relies on money storing its value. 

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Free market economies

  • Back by Adam Smith and Friedrich Hayek, free-market economies are where governments leave markets to their own devices, so the market forces of supply and demand allocate scarce resources.
  • Economic decisions are taken by private individuals and firms, and private individuals own everything. There is no government intervention.

Advantages

  • Firms are likely to be efficient because they have to provide goods and services demanded by consumers. They are also likely to lower their average costs and make better use of scarce resources. Therefore, the overall output of the economy increases.
  • The bureaucracy from government intervention is avoided

Disadvantages

  • The free market ignores inequality and tends to benefit those who hold most of the wealth. There are no social security payments for those on low incomes. 
  • Public goods are not provided in a free market, such as national defence. Merit goods, such as education, are underprovided.
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Command economy

Backed by Karl Marx, a command economy is where the government allocates all of the scarce resources in an economy to where they think there is a greater need. It is also referred to as central planning. 

Advantages 

  • It might be easier to coordinate resources in times of crises, such as wars.
  • Inequality in society could be reduced, and society might maximise welfare rather than profit.
  • The government can compensate for market failure, by reallocating resources. They might ensure everyone can access basic necessities.

Disadvantages 

  • Governments fail, as do markets, and they may not be fully informed about what to produce.
  • They may not necessarily meet consumer preferences.
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Mixed economy

This has features of both command and free economies and is the most common economic system today. There are different balances between command and free economies in reality, though.

The UK is generally considered quite central, whilst the US is slightly freer (although the government spends around 35% of GDP) and Cuba is more centrally planned.

The market is controlled by both the government and the forces of supply and demand.

Governments often provide public goods such as street lights, roads and the police, and merit goods, such as healthcare and education.

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Rational Decision Making

This is an area of behavioural economics.

When making economic decisions, consumers aim to maximise their utility and firms aim to maximise profits. A consumer’s utility is the total satisfaction received from consuming a good or service

A firm or an individual can make decisions using intuition or rationally. Intuition uses the feelings or instincts of the consumer and does not use facts. Businesses use this when they do not have access to facts or when making the decision is difficult. A rational decision is made using several steps, and it involves analysis and facts

However, this is not always the best or most realistic way for firms to make decisions. Although it might be fairer than making an intuitive decision, it takes significantly longer to decide, which is not practical in a firm with strict time constraints. 

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Demand

Demand is the quantity of a good or service that consumers are able and willing to buy at a given price during a given period of time.

Demand varies with price. Generally, the lower the price, the more affordable the good and so consumer demand increases. This can be illustrated with the demand curve.

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Types of demand

Derived demand: This is when the demand for one good is linked to the demand for a related good. For example, the demand for bricks is derived from the demand for the building of new houses. The demand for labour is derived from the goods the labour produces. For example, if the demand for cars increases, the demand for labour to produce those cars will increase.

Composite demand: This is when the good demanded has more than one use. An example could be milk. Assuming there is a fixed supply of milk, an increase in the demand for cheese will mean that more cheese is supplied, and therefore less butter can be supplied.

Joint demand: This is when goods are bought together, such as a camera and a memory card.

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Diminishing marginal utility

The demand curve is downward sloping, showing the inverse relationship between price and quantity.

The law of diminishing marginal utility states that as an extra unit of the good is consumed, the marginal utility, i.e. the benefit derived from consuming the good, falls. Therefore, consumers are willing to pay less for the good

This can be explained using the example of chocolate. The first chocolate bar will benefit the consumer more, because it satisfies more of their needs, and so the consumer is willing to pay more for it. The second bar will satisfy the consumer less, because they have less need for it, and the consumer will be willing to pay less for it. Eventually, the utility derived will become zero.

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Price elasticity of demand

The price elasticity of demand is the responsiveness of a change in demand to a change in price.

The formula for this is: % change in QD                                                                                                                                    % change in P

  • A price elastic good is very responsive to a change in price. In other words, the change in price leads to an even bigger change in demand. The numerical value for PED is >1.
  • A price inelastic good has a demand that is relatively unresponsive to a change in price. PED is <1.
  • A unitary elastic good has a change in demand which is equal to the change in price. PED = 1. 
  • A perfectly inelastic good has a demand which does not change when price changes. PED = 0.
  • A perfectly elastic good has a demand which falls to zero when price changes. PED = infinity.
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Factors influencing PED

Necessity: A necessary good, such as bread or electricity, will have a relatively inelastic demand. 

Substitutes: If the good has several substitutes, such as Android phones instead of iPhones, then the demand is more price elastic.

Elasticity also changes in the long and short run. In the long run, consumers have time to respond and find a substitute, so demand becomes more price elastic. In the short run, consumers do not have this time, so demand is more inelastic. 

Addictiveness or habitual consumption: The demand for goods such as cigarettes is not sensitive to a change in price

The proportion of income spent on the good: If the good only takes up a small proportion of income, demand is likely to relatively price inelastic. If the good takes up a significant proportion of income, the demand is likely to be more price elastic.

The durability of the good: A good which lasts a long time has a more elastic demand because consumers wait to buy another one.

Peak and off-peak demand: During peak times the demand for tickets is more price inelastic. 

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Income elasticity of demand

Income elasticity of demand is the responsiveness of a change in demand to a change in income.

The formula for this is: % change in QD                                                                                                                                   % change in income

Inferior, normal and luxury goods: I

  • Inferior goods are those which see a fall in demand as income increases. For example, the ‘value’ options at supermarkets could be seen as inferior. As income increases, consumers switch to branded goods. YED < 0.
  • With normal goods, demand increases as income increases. YED >0.
  • With luxury goods, an increase in income causes an even bigger increase in demand. YED > 1. For example, a holiday is a luxury good. Luxury goods are also normal goods, and they have an elastic income.
  • During periods of prosperity, such as economic growth when real incomes are rising, firms might switch to producing more luxury goods and fewer inferior goods, because demand for luxury goods will be increasing.
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Cross elasticity of demand

Cross elasticity of demand is the responsiveness of a change in demand of one good, X, to a change in price of another good, Y. The formula for this is: % change in QD of X                                                                                                                           % change in P of Y     

  • Close complements: a small fall in the price of good X leads to a large increase in QD of Y.
  • Weak complements: a large fall in the price of good X leads to only a small increase in QD of Y.   
  • Close substitutes: a small increase in the price of good X leads to a large increase in QD of Y.
  • Weak substitutes: a large increase in the price of good X leads to a smaller increase in QD of Y.
  • Unrelated goods have a XED equal to zero. For example, the price of a bus journey has no effect on the demand for tables.
  • Firms are interested in XED because it allows them to see how many competitors they have. Therefore, they are less likely to be affected by price changes by other firms, if they are selling complementary goods or substitutes.                      
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Supply

Supply is the quantity of a good or service that a producer is able and willing to supply at a given price during a given period of time.

Supply curves are upward sloping because: 

  • If the price increases, it is more profitable for firms to supply the good, so supply increases.
  • High prices encourage new firms to enter the market because it seems profitable, so supply increases.
  • With larger outputs, a firm’s costs increase, so they need to charge a higher price to cover the costs.

Price changes do not shift the supply curve. 

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Elasticity of Supply

The price elasticity of supply is the responsiveness of a change in supply to a change in price. The formula for this is: % change in QS                                                                                                          % change in P

  • If supply is elastic, firms can increase supply quickly at little cost. The numerical value for PES is >1
  • If supply is elastic, firms can increase supply quickly at little cost. The numerical value for PES is >1
  • A perfectly inelastic supply has PES = 0. Supply is fixed, so if there is a change in demand, it cannot be met easily.
  • Supply is perfectly elastic when PES = infinity. Any quantity demanded can be met without changing price.
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Factors influencing PES

Time scale: In the short run, supply is more price inelastic, because producers cannot quickly increase supply. In the long run, supply becomes more price elastic. The short run is the period of time in which at least one factor of production is fixed. The long run is the period of time in which all factors of production are variable.

Spare capacity: If the firm is operating at full capacity, there is no space left to increase supply. If there are spare resources supply can be increased quickly.

Level of stocks: If goods can be stored firms can stock them and increase market supply easily. If the goods are perishable firms cannot stock them for long so supply is more inelastic.

How substitutable factors are: If labour and capital are mobile, supply is more price elastic because resources can be allocated to where extra supply is needed. For example, if workers have transferable skills, they can be reallocated to produce a different good and increase the supply of it.

Barriers to entry to the market: Higher barriers to entry means supply is more price inelastic because it is difficult for new firms to enter and supply the market.

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Price Mechanism

The price mechanism determines the market price. Adam Smith called this ‘the invisible hand of the market’.

Resources are allocated through the price mechanism in a free market economy. The economic problem of scarce resources is solved through this mechanism. 

Rationing: When there are scarce resources, price increases due to the excess of demand. The increase in price discourages demand and consequently rations resources. For example, plane tickets might rise as seats are sold, because spaces are running out. This is a disincentive to some consumers to purchase the tickets, which rations the tickets.

Incentive: This encourages a change in the behaviour of a consumer or producer. For example, a high price would encourage firms to supply more to the market, because it is more profitable to do so.

Signalling: The price acts as a signal to consumers and new firms entering the market. The price changes show where resources are needed in the market. High prices signals firms to enter the market because it is profitable. However, this encourages consumers to reduce demand and therefore leave the market. This shifts the demand and supply curves. 

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Consumer Surplus

This is the difference between the price the consumer is willing and able to pay and the price they actually pay.

This is based on what the consumer perceives their private benefit will be from consuming the good.

It is always the area above the market price and below the demand curve.

Due to the law of diminishing marginal utility, consumer surplus generally declines with extra units consumed. This is because the extra unit generates less utility than the one already consumed. Therefore, consumers are willing to pay less for extra units.

Inelastic demand curves give a larger consumer surplus. This is because consumers are willing to pay a much higher price to consume the good.

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Producer Surplus

This is the difference between the price the producer is willing to charge and the price they actually charge. In other words, it is the private benefit gained by the producer that covers their costs and is measured by profit.

Producer Surplus is always the area below the market price and above the supply curve.

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Economic Welfare 

  • This is the total benefit society receives from an economic transaction.
  • It is calculated by the area of producer surplus and consumer surplus added together. 
  • The sum of the consumer surplus and producer surplus is the community surplus.
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Indirect Taxes

Indirect Taxes Indirect taxes are imposed by the government and they increase production costs for producers. Therefore, producers supply less. This increases the market price and demand contracts.

There are two types of indirect taxes:

  • Ad valorem taxes are percentages, such as VAT, which adds 20% of the unit price. This is the main indirect tax in the UK.
  • Specific taxes are a set tax per unit, such as the 58p per litre fuel duty on unleaded petrol.

If demand is more elastic (PED>1), the incidence of the tax will fall mainly on the supplier.

If demand is more elastic (PED>1), the incidence of the tax will fall mainly on the supplier.

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Ad Valorem Taxes

Since the tax is a percentage of the cost of the good, the absolute value of the tax increases as the price of the good increases. For example, with VAT at 20%, a good costing £10 will have £2 of tax. This causes the supply curve to pivot. 

  • If demand is inelastic, government revenue from the tax is higher than if demand is elastic. This is because demand will only fall slightly with the tax. 
  • If the tax is implemented with the intention of internalising the externality, it is hard to put a monetary value on the externality.
  • Internalising the externality means the individual or firm which causes the negative externality, for example, pollution, pays for the damage.
  • Taxes could be expensive for the government to collect.
  • Some taxes could be regressive, so they impact those on low and fixed incomes the most.
  • Taxes could be inflationary.
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Subsidies

A subsidy is a payment from the government to a producer to lower their costs of production and encourage them to produce more.

For example, the government might provide apprenticeship schemes or help farmers by contributing to their production costs.

  • Subsidies shift the supply curve to the right, which lowers the market price.
  • The vertical distance between the supply curves shows the value of the subsidy per unit. 
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Effects of subsidies

  • Subsidies increase output and lower prices for consumers, which could help families on low and fixed incomes. 
  • They increase the employment rate, by making workers more skilled through apprenticeship schemes and lowering the cost of employing workers. 
  • Subsidies could help control inflation, by keeping costs of production low. 
  • They could help boost demand during periods of economic decline. 
  • Long run aggregate supply could increase if the subsidy is aimed towards a capital project. 
  • There could be government failure, if the government provides an inefficient subsidy or if the subsidy distorts the market price. 
  • Government revenue could be better spent elsewhere. The opportunity cost of the subsidy should be considered. 
  • It is usually the taxpayer who pays for the subsidy, and they might not receive any direct benefit from the subsidy. 
  • If demand is price inelastic, the subsidy will have a large effect on equilibrium price. 
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Alternative Views of Consumer Behaviour

Consumers do not always act rationally. Acting rationally means making a decision that results in the most optimal level of utility or benefit for the consumer.

The reasons for this are: 

  • The influence of other people’s behaviour: Other people’s behaviour creates a bias within the consumer. Consumers become unwilling to change, even if it is of benefit to them if it goes against the norms of their society.
  • The importance of habitual behaviour: Habits reduce the amount of time it takes to do something because consumers no longer have to consciously think about their actions. Breaking a habit causes withdrawal symptoms in the consumer so they continue to commit irrational actions. 
  • Consumer weakness at computation: Consumers are unable to exercise self-control with some decisions leading to consumers making irrational decisions.
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Market Failure

Market failure occurs when the free market fails to allocate resources to the best interests of society, so there is an inefficient allocation of scarce resources.

Economic and social welfare is not maximised where there is market failure. 

Types of market failure:

  • Externalities: An externality is the costs or benefits a third party receives from an economic transaction outside of the market mechanism. In other words, it is the spillover effect of the production or consumption of a good or service.
  • The under-provision of public goods: Public goods are non-excludable and non-rival, and they are underprovided in a free market because of the free-rider problem.
  • Information gaps: It is assumed that consumers and producers have perfect information when making economic decisions. However, this is rarely the case, and this imperfect information leads to a misallocation of resources. 
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Externalities

An externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism. In other words, it is the spillover effect of the production or consumption of a good or service.

Externalities can be positive (external benefits) or negative (external costs).

The extent to which the market fails involves a value judgement, so it is hard to determine what the monetary value of an externality is. 

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Externalities cont..

Private costs

  • Private costs are the costs to economic agents involved directly in an economic transaction.
  • Producers are concerned with private costs of production. For example, the rent, the cost of machinery and labour, insurance, transport and paying for raw materials are private costs.
  • This determines how much the producer will supply.
  • It could refer to the market price which the consumer pays for the good. 

Social costs

  • This is calculated by private costs plus external costs.
  • It is the cost to society as a whole.
  • On a diagram, external costs are shown by the vertical distance between the two curves.
  • In other words, external costs are the difference between private costs and social costs.
  • It can be seen that marginal social costs (MSC) and marginal private costs (MPC) diverge from each other. 
  • External costs increase disproportionately with increased output. 
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Externalities cont..

Private benefit

  • Consumers are concerned with the private benefit derived from the consumption of a good. The price the consumer is prepared to pay determines this.
  • Private benefits could also be a firm’s revenue from selling a good.

Social benefit

  • Social benefits are private benefits plus external benefits.
  • On a diagram, external benefits are the difference between private and social benefits.
  • Similarly to external costs, external benefits increase disproportionately as output increases.

Social optimum position

  • This is where MSC = MSB and it is the point of maximum welfare.
  • The social costs made from producing the last unit of output is equal to the social benefit derived from consuming the unit of output. 
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External costs of production

External costs occur when a good is being produced or consumed, such as pollution. They are shown by the vertical distance between MSC and MPC.

The market equilibrium, where supply = demand at a certain price, ignores these negative externalities. This leads to over-provision and under-pricing.

With negative externalities, MSC>MPC of supply. At the free market equilibrium, therefore, there are an excess of social costs over benefits at the output between Q1 and Qe.

The output where social costs > private benefits are known as the area of deadweight welfare loss, shown by the triangle in the diagram.

The market fails to account for the negative externalities that occur from the consumption of this good, which would reduce welfare in society if it was left to the free market. 

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External benefits of consumption

An example of an external benefit of consumption of a good or service could be the decline of diseases and the healthier lives of consumers through vaccination programmes.

Since consumers do not account for them, they are under consumed in the free market, where MSB>MPB. This leads to market failure.

The triangle in the diagram shows the excess of social benefits over costs. It is the area of welfare gain.

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Government policies for negative externalities

Indirect taxes: To reduce the number of demerit goods consumed. This increases the price of the good. If the tax is equal to the external cost of each unit, then the supply curve becomes MSC rather than MPC, so the free market equilibrium becomes the socially optimum equilibrium. This internalises the externality. In other words, the polluter pays for the damage.

Subsidies: Encourage the consumption of merit goods. This includes the full social benefit in the market price of the good.

Regulation: To enforce less consumption of a good. However, it would be difficult to police and there could be high administrative costs. Bans could be enforced for harmful goods, although they can still be consumed on the black market. Bans are only useful where MSC > MPB (the MSC curve is above MPB).

Provide the good directly: The government could provide public goods which are underprovided in the free market, such as with education.

Personal carbon allowances: They could be tradeable, so firms and consumers can pollute up to a certain amount, and trade what they do not use. 

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Public Goods

Public goods are missing from the free market, but they offer benefits to society. For example, street lights and flood control systems are public goods.

They are non-excludable so by consuming the good, someone else is not prevented from consuming the good as well, and they are non-rival, so the benefit other people get from the good does not diminish if more people consume the good.

The non-excludable nature of public goods gives rise to the free-rider problem. Therefore, people who do not pay for the good still receive benefits from it, in the same way people who pay for the good do. This is why public goods are underprovided by the private sector: they do not make a profit from providing the good since consumers do not see a reason to pay for the good, if they still receive the benefit without paying.

Public goods are also underprovided because it is difficult to measure the value consumers get from public goods, so it is hard to put a price on the good. Consumers will undervalue the benefit, so they can pay less, whilst producers will overvalue, so they can charge more.

Governments provide public goods, and they have to estimate what the social benefit of the public good is when deciding what output of the good to provide. They are funded using tax revenue, but the quantity provided will be less than the socially optimum quantity. 

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Private goods

Private goods are rival and excludable. For example, a chocolate bar can only be consumed by one consumer. Moreover, private property rights can be used to prevent others from consuming the good.

Quasi (non-pure) public goods have characteristics of both public and private goods. They are partially provided by the free market. For example, roads are semi-excludable, through tolls and they are semi-non-rival because consumers can benefit from the road whilst other consumers are using it (unless it is rush hour). 

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Information Gaps

Symmetric information means that consumers and producers have perfect market information to make their decision. This leads to an efficient allocation of resources.

Asymmetric information leads to market failure. This is when there is unequal knowledge between consumers and producers. It can also be linked with the principal-agent problem. This is when the agent makes decisions for the principal, but the agent is inclined to act in their own interests, rather than those of the principal. Also, it can lead to the problem of moral hazard. 

There could also be imperfect information, where information is missing, so an informed decision cannot be made. This leads to a misallocation of resources. Consumers might pay too much or too little, and firms might produce an incorrect amount. 

Information could be made more widely available through advertising or government intervention. 

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Maximum price

The government might set a maximum price where the consumption or production of a good is to be encouraged. This is so the good does not become too expensive to produce or consume.

  • Maximum prices have to be set below the free market price, otherwise, they would be ineffective. 
  • They prevent monopolies from exploiting consumers. 
  • Maximum prices control the market price, but this could lead to government failure if they misjudge where the optimum market price should be.
  • Maximum prices could lead to welfare gains for consumers by keeping prices low, and they could increase efficiency in firms since they have an incentive to keep their costs low to maintain their profit level.
  • However, it could reduce a firm’s profits, which could lead to less investment in the long run. Moreover, firms might raise the prices of other goods, so consumers might have no net gain.
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Minimum price

The government might set a minimum price where the consumption or production of a good is to be discouraged. This ensures the good never falls below a certain price.

For example, the government might impose a minimum price on alcohol, so it is less affordable to buy it. The National Minimum Wage is an example of a minimum price.

Minimum prices would reduce the negative externalities from consuming a demerit good, such as alcohol.

Minimum prices have to be set above the free market price, otherwise, they would be ineffective.

This minimum price will yield the positive externalities of a decent wage, which will increase the standard of living of the poorest, and provide an incentive for people to work. 

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Tradeable pollution permits

These could limit the number of negative externalities, in the form of pollution, created in industries. For example, there could be a limit on the quantity of carbon dioxide emissions released from the steel industry. 

Firms will be allowed to pollute up to a certain amount, and any surplus on their permit can be traded. This means firms can buy and sell allowances between themselves.

Advantages

  • The government could raise revenue from the permits because they can sell them to firms. 
  • If firms exceed their permit, they will have to purchase more permits from firms which did not use their whole permit. This raises revenue for greener firms, who might then invest in green production methods. 

Disadvantages

  • However, it could lead to some firms relocating to where they can pollute without limits, which will reduce their production costs.
  • Firms might pass the higher costs of production onto the consumer.
  • It could be expensive for governments to monitor emissions. 
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State provision of public goods

  • The government could provide public goods which are underprovided in the free market, such as education and healthcare. These have external benefits.
  • This makes merit goods more accessible, which might increase their consumption and yield positive externalities.
  • It could be expensive for governments to provide education, and the government will incur an opportunity cost of spending their revenue. 

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Provision of information

  • By providing information, governments can ensure there is no information failure, so consumers and firms can make informed economic decisions.
  • For example, governments might make it illegal for second-hand car dealers not to reveal the entire history of a car, so consumers know exactly what they are buying.
  • This could be expensive to police. 
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Regulation

The government could use laws to ban consumers from consuming a good. They could also make it illegal not to do something. For example, the minimum school leaving age means young people have to be in school until the age of 16, and education or training until they turn 18.

This has positive externalities in the form of a higher skilled workforce.

If there was a compulsory recycling scheme, it would be difficult to police and there could be high administrative costs. Bans could be enforced for harmful goods, although they can still be consumed on the black market.

Firms which fail to follow regulations could face heavy fines, which acts as a disincentive to break the rule.

It could raise costs for firms, who might pass on the higher costs to consumers.

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Causes of government failure

Distortion of price signals

Government subsidies could distort price signals by distorting the free market mechanism. A free market economist would argue that this could lead to government failure. There could be an inefficient allocation of resources because the market mechanism is not able to act freely.

For example, the government might end up subsidising an industry which is failing or has few prospects.

Unintended consequences

This is when the actions of producers and consumers have unexpected, or unintended, consequences.

With government policies, consumers react in unexpected ways. A policy could be undermined, which could make government policies expensive to implement since it is harder to achieve their original goals. 

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Causes of government failure cont...

Excessive administrative costs

The social benefits of a policy might not be worth the financial cost of administering the policy. It might cost more than the government anticipated.

The government has to consider whether the policy is a good value for money.

Information Gaps

Some policies might be decided without perfect information. This might require a full cost-benefit analysis, and it could be time-consuming and expensive.

For example, government housing policies are long term and have failed several times in the past.

However, it is impractical for governments to gain every bit of information they need, so assumptions are made. 

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