Flashcards · 7136 · Topic 1

Individuals, firms, markets and market failure flashcards

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3.1.1 Economic methodology and the economic problem

How is economics like a natural science, and how is it different?: Like: it uses models, assumptions, testable hypotheses and ceteris paribus. Unlike: people react to incentives and to theories, controlled experiments are rare, data are messy, and results are tendencies rather than laws.
Positive vs normative statement: Positive: can be tested against evidence; it may turn out to be false. Normative: contains a value judgement about what ought to be; evidence alone cannot settle it.
Why do economists disagree about the best policy?: They predict different consequences (different models or evidence), and they hold different value judgements (fairness, freedom, the role of the state), so they weigh the same outcomes differently.
The three basic economic questions: What to produce (and how much), how to produce it (methods; the mix of labour and capital), and for whom (how output is shared).
The four factors of production and their rewards: Land: rent. Labour: wages. Capital (man-made goods used to make other goods): interest. Enterprise (organising factors and bearing risk): profit.
Scarcity and opportunity cost: Scarcity: limited resources against unlimited wants; it forces choices. Opportunity cost: the benefit of the next best (second-best) option given up, not the sum of everything rejected.
A hectare earns 900 from wheat, 700 from barley or 650 from sheep. Wheat is chosen. Opportunity cost?: 700 per hectare: the barley, the next best option only.
Production possibility diagram: points on, inside and outside the boundary: On: attainable with resources fully used (productively efficient). Inside: attainable but resources unemployed or used inefficiently. Outside: unattainable with current resources and technology.
A move along a PPD goes from (20 K, 90 C) to (50 K, 60 C). Opportunity cost of each extra unit of K?: Gain 30 K, lose 30 C, so each extra unit of K costs 30 ÷ 30 = 1 unit of C.
PPD: what does an outward shift show, and what does a bowed-out shape show?: Outward shift: potential growth, from more or better resources or technology. Bowed out: increasing opportunity cost, because resources are not equally suited to both uses. A straight line means constant opportunity cost.
Productive vs allocative efficiency on a PPD: Productive efficiency: every point on the boundary. Allocative efficiency: only one boundary point (what society values most), and the diagram cannot show which one.

3.1.2 Individual economic decision making

Rational economic agent: Someone who weighs costs and benefits, uses the information available and aims to maximise utility (consumers) or profit (firms).
TU for 1 to 6 cups of tea is 60, 110, 150, 180, 200, 210. MU, and how many cups at a price of 35?: MU: 60, 50, 40, 30, 20, 10 (diminishing). At 35 she buys 3 cups: the third has MU 40, the fourth only 30. A lower price means more bought, so demand slopes down.
Decisions at the margin, and why sunk costs are ignored: Do more while marginal benefit exceeds marginal cost; stop where MB = MC. Sunk costs cannot be recovered whatever is chosen, so they should not affect the decision.
How can asymmetric information lead to market failure?: Sellers know quality better; buyers offer only an average price; owners of good items withdraw; average quality and price fall further; beneficial trades are lost.
Bounded rationality vs bounded self-control: Bounded rationality: limited information, time and thinking ability, so people choose "good enough". Bounded self-control: failing to act in line with long-run interests (overvaluing the present).
Anchoring, availability bias and rules of thumb: Anchoring: the first figure seen sets the reference point. Availability: easy-to-recall events seem more likely. Rule of thumb: a simple shortcut, such as always buying the middle-priced item.
Social norms, altruism and perceptions of fairness: Social norms: copying what others do or approve of. Altruism: caring about others' welfare. Fairness: rejecting outcomes seen as unjust, even at a cost to yourself.
Choice architecture and nudges: Choice architecture: how options are presented and ordered. Nudge: steering choices without banning options or changing incentives much, such as placing healthy food first.
Default, restricted and mandated choice: Default: applies unless the person opts out (automatic pension enrolment). Restricted: limits the options available. Mandated: requires an active decision.

3.1.3 Price determination in a competitive market

Demand (AQA sense) and movement along vs shift: The quantity consumers will actually buy, with desire and ability to pay, at each price over a period. Movement along: only the good's own price changes. Shift: any other influence (income, tastes, prices of related goods).
Inelastic vs inferior: Inelastic is about the size of a response (PED between 0 and −1). Inferior is about the sign of YED (negative: demand falls as income rises). A good can be one without the other.
Income rises by 4% and quantity demanded falls by 2%. YED and type of good?: YED = −2 ÷ 4 = −0.5. Negative, so an inferior good.
Price of B rises by 10%; demand for A rises by 15%. XED, and how are A and B related?: XED = 15 ÷ 10 = +1.5. Positive, so substitutes (fairly close ones).
Why does demand usually become more price elastic over time?: Given time, buyers find and switch to alternatives and change habits.
Why does a firm's supply curve slope upwards (price-taking firm)?: A price taker produces where price = marginal cost, so its supply curve is its MC curve. A higher price makes extra units profitable (profit incentive) and attracts entrants.
Determinants of price elasticity of supply: Time period, spare capacity, level of stocks, ease of switching factors between uses, and how quickly output can be raised.
What happens when price is below equilibrium?: Excess demand (a shortage). Price is bid up; quantity supplied extends and quantity demanded contracts until the market clears.
Joint demand, competitive demand, composite demand and derived demand: Joint: complements bought together. Competitive: substitutes. Composite: a good with several uses (milk for drinking and cheese). Derived: demand for an input that comes from demand for the final good.
Joint supply: Producing one good also produces another (by-products), such as beef and leather. More output of one raises supply of the other.
Diagram: what happens to price and quantity when demand rises in a market with inelastic supply?: Demand shifts right. With steep (inelastic) supply, price rises a lot and quantity rises only a little. With elastic supply, quantity rises more and price less.

3.1.4 Production, costs and revenue

Specialisation and division of labour: Specialisation: concentrating on the tasks or goods you do best. Division of labour: breaking production into separate tasks, one worker per task (specialisation inside a firm). Money as a medium of exchange makes specialisation possible.
Law of diminishing returns: With another factor held fixed, each extra unit of a variable factor eventually adds less to output than the last. A short-run idea; marginal cost rises as marginal product falls.
Diminishing returns vs returns to scale: Diminishing returns: short run, one input variable, others fixed. Returns to scale: long run, all inputs change in the same proportion.
The cost formulae: TC = FC + VC. AFC = FC ÷ Q, AVC = VC ÷ Q, AC = TC ÷ Q = AFC + AVC. MC = ΔTC ÷ ΔQ (also ΔVC ÷ ΔQ).
Internal vs external economies of scale: Internal: lower unit cost from the firm's own growth (technical, purchasing, managerial, financial, marketing, risk-bearing). External: lower unit cost from growth of the industry or area.
Diseconomies of scale and minimum efficient scale: Diseconomies: unit cost rises as scale rises, often from communication, coordination and motivation problems. MES: the smallest output that reaches the lowest LRAC.
Why is the short-run AC curve U-shaped but LRAC often shaped differently?: Short run: falling AFC then diminishing returns. Long run: economies then diseconomies of scale. LRAC may fall and then stay flat over a range.
TR, AR and MR: TR = P × Q. AR = TR ÷ Q, which is the price. MR = ΔTR ÷ ΔQ, the extra revenue from one more unit sold.
Normal profit vs supernormal (abnormal) profit: Normal profit: the least reward that keeps the entrepreneur in the activity; counted as a cost. Supernormal profit: profit above normal profit (TR above TC including normal profit).
Invention vs innovation: Invention: discovering or creating a new idea, product or process. Innovation: the first commercial use of an invention.
Creative destruction: New products, methods and firms replacing old ones, destroying existing markets and profits while creating new ones. Technological change can also lower costs and change market structure.

3.1.5 Perfect competition, imperfectly competitive markets and monopoly

Profit maximisation rule, and the divorce of ownership from control: Produce where MC = MR, with MC crossing MR from below. Divorce of ownership from control: shareholders own the firm but managers run it, creating a principal-agent problem; managers may satisfice or pursue growth.
Perfect competition: assumptions: Many producers, identical products, free entry and exit, perfect knowledge. Each firm is a price taker: its demand curve is horizontal at the market price (P = AR = MR).
Perfect competition: short run to long run: Supernormal profit attracts entry; market supply shifts right; price falls until only normal profit is made (P = minimum AC). Losses cause exit until normal profit returns.
Monopolistic competition: Many sellers of differentiated goods; easy entry and exit. Long run: normal profit only, demand tangent to AC, with excess capacity (output below the lowest-cost output) and P above MC.
Oligopoly: structure vs conduct: Structure: a few dominant firms, high concentration, barriers to entry. Conduct: firms behave interdependently, watching, matching, leading or colluding. A market can fit one description and not the other.
Kinked demand curve: Rivals match a price cut but not a price rise, so demand is elastic above the current price and inelastic below it. MR has a gap at the kink, so price is sticky even if MC changes. It illustrates interdependence; it is not the only model.
Collusion: overt vs tacit, and why cartels break down: Overt: an explicit agreement (a cartel). Tacit: an understanding, often through price leadership. Cartels break down because each member gains by cheating, there are many firms or entrants, and collusion is illegal.
Monopoly: output, price and efficiency: Output where MR = MC, price from the demand curve. Usually P above MC (allocatively inefficient) and possible supernormal profit. With large economies of scale, average cost may still be lower than under competition.
Price discrimination: definition and conditions: Charging different prices for the same product where the difference is not due to cost. Needs market power, groups with different PED, and markets that can be kept separate (no resale).
Static vs dynamic efficiency: Static: efficiency at a point in time, with technology and capital fixed (productive and allocative). Dynamic: efficiency over time through R&D, investment and technological change.
Sources of dynamic efficiency: R&D (new products and cheaper processes), investment in human capital (training and skills), investment in non-human capital (machines, software, premises) and technological change, which shifts the ATC curve down over time.
Contestable market and the role of sunk costs: A market in which possible entrants restrain incumbents' prices and profits. It needs low sunk costs (money that cannot be got back on exit), which make hit-and-run entry possible.

3.1.6 The labour market

Marginal revenue product (MRP): The money value of the extra output of one more worker: MRP = MPP × MR. The MRP curve is the firm's demand curve for labour.
What shifts the demand curve for labour?: Demand for the product (labour is a derived demand), labour productivity, and the price of capital that can substitute for labour. A change in the wage is a movement along.
What shifts the supply of labour to an occupation?: Pay in other occupations, training and qualification requirements, migration, and non-monetary factors such as conditions, hours and job satisfaction.
Monopsony: employment and wage: A single (or dominant) buyer of labour. Employment is set where MCL = MRP; the wage is read from the supply (AC of labour) curve at that employment, so wage and employment are below competitive levels.
Trade union in a competitive labour market vs in monopsony: Competitive: a wage above equilibrium raises the wage but cuts employment. Monopsony: a union can raise both the wage and employment, up to a point.
National minimum wage: effect in a competitive labour market: A price floor above equilibrium: labour supplied rises, labour demanded falls; unemployment = labour supplied minus labour demanded. Effect depends on elasticities and how far above equilibrium it is.
Wage discrimination and occupational segregation: Wage discrimination: different pay for workers of equal productivity in the same job because of group membership. Occupational segregation: a group concentrated in particular, often lower-paid, occupations. A pay gap is not by itself proof of discrimination.
Wage taker: A firm that must pay the market wage and cannot change it by hiring more or fewer workers, as in a perfectly competitive labour market.
Bilateral monopoly: A single seller of labour (a union) facing a single buyer (a monopsony employer). The wage is decided by bargaining between the two limits.

3.1.7 The distribution of income and wealth: poverty and inequality

Income vs wealth: Income: receipts over a period (a flow): pay, profit, rent, interest, dividends, benefits. Wealth: net assets at one moment (a stock): property, savings, shares, pension rights, minus debts.
Equality vs equity: Equality: everyone has the same share. Equity: a distribution judged fair and just; it involves a value judgement.
Lorenz curve and Gini coefficient: Lorenz curve: cumulative share of income held by households lined up poorest first, against the 45° line of perfect equality. Gini: the gap between the curve and the diagonal divided by the whole triangle; 0 to 1. AQA requires interpreting it, not calculating it.
Absolute vs relative poverty: Absolute: income below the level needed for basic necessities, fixed in real terms. Relative: income below a set share (often 60%) of the median income in that society.
Causes of poverty and inequality: Unemployment and low pay, low skills and education, inheritance of wealth, age and family circumstances, regressive taxes, and changes in the labour market such as technology and globalisation.
Tax-free up to 1,200, 30% above that. Is it progressive? Check with incomes of 3,000 and 6,000.: Income 3,000: tax 540, average rate 18%. Income 6,000: tax 1,440, average rate 24%. The average rate rises with income, so it is progressive.
Means-tested vs universal benefits: Means-tested: paid only below an income or asset threshold; better targeted but with lower take-up and a poverty trap. Universal: paid to a whole category regardless of income; simple, high take-up, but costly.
Poverty trap and the effective marginal tax rate: Higher earnings bring little gain because benefits are withdrawn and tax is paid. Tax 25% plus benefit withdrawal 55% gives an effective marginal rate of 80%: the household keeps 20p of each extra pound.
Benefits and costs of inequality: Some inequality gives incentives to work, train and take risks. Excessive inequality can reduce opportunity, social mobility and cohesion, and lower demand if the poor spend a higher share of income.

3.1.8 The market mechanism, market failure and government intervention in markets

Functions of the price mechanism: Rationing: price limits demand to the available supply. Incentive: price and profit changes reward a change in behaviour. Signalling: price changes carry information to buyers and sellers.
Market failure: complete vs partial: Market failure: a market leads to a misallocation of resources. Complete: a missing market (it does not exist). Partial: the market exists but misallocates.
Classifying goods by rivalry and excludability: Rival and excludable: private good. Rival, non-excludable: common resource. Non-rival, excludable: quasi-public (club) good. Non-rival and non-excludable: pure public good.
Free-rider problem: People can use a non-excludable good without paying, so few will pay and private firms cannot make a profit: the good may not be provided at all (a missing market).
Diagram: positive consumption externality: MSB lies above MPB (demand). The market consumes Q1 where MPB = MPC; the social optimum Q*, where MSB = MSC, is higher. The welfare loss is the triangle between MSB and MSC from Q1 to Q*. It is under-consumed.
Merit good vs demerit good: Merit good: judged to be good for people; under-consumed in a free market (education, vaccination). Demerit good: judged to be bad for people; over-consumed (cigarettes). Both rest on a value judgement and often on imperfect information.
Legal vs economic incidence of an indirect tax: Legal incidence: who must pay the tax to government (sellers). Economic incidence: who actually bears the burden. The less elastic side of the market bears more.
Regulation vs tradable pollution permits: Regulation fixes what each firm may do. Permits fix the total quantity of pollution and let trading find the cheapest cuts.
Competition policy: what does it target?: Keeping markets competitive and stopping abuse of market power: cartels, abuse of dominance (such as predatory pricing) and mergers that would reduce competition.
Privatisation vs deregulation, and regulatory capture: Privatisation: transfer of a state-owned firm to private owners. Deregulation: removal or reduction of rules, often to ease entry. Regulatory capture: the regulator ends up serving the regulated industry, not the public.
Government failure: Intervention that leads to a misallocation of resources (a net welfare loss), for example from poor information, unintended consequences, administrative costs, conflicting objectives or regulatory capture.
Imperfect information as a market failure: Consumers who overestimate benefits over-consume; those who underestimate benefits (training, pensions) under-consume. Where perceived MB differs from true MB, welfare is lost.