Flashcards · 7135 · Topic 3.1

The operation of markets and market failure flashcards

52 cards on Topic 3.1, subtopics 3.1.1 to 3.1.5. Pick a subtopic or study them all.

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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.
Needs vs wants, and the three basic economic questions: Needs: what is required to survive. Wants: what is desired beyond that. What to produce, how to produce it, and for whom.
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.
Why is the environment treated as a scarce resource?: Clean air, water, forests and the capacity to absorb waste are limited. When the environment is treated as free it is over-used, and use now has an opportunity cost for future generations.
Scarcity and opportunity cost: Scarcity: limited resources against unlimited wants; it forces choices. Opportunity cost: the benefit of the next 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: movement along, moving from inside to the boundary, and an outward shift: Along: reallocation of resources (a trade-off). Inside to boundary: using idle resources (actual growth, at no opportunity cost). Outward shift: potential growth from more or better resources or technology.

3.1.2 Price determination in a competitive market

Demand, and movement along vs shift of the demand curve: 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).
PED, YED and XED formulae: PED = % change in quantity ÷ % change in own price (normally negative). YED = % change in quantity ÷ % change in income. XED = % change in quantity of A ÷ % change in price of B.
Price rises 10% and quantity demanded falls 5%. PED, and what happens to total revenue?: PED = −5 ÷ 10 = −0.5, inelastic. Total revenue (price × quantity) rises, because quantity falls proportionately less than price rises.
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. A negative XED would mean complements.
Elasticity vs slope on a straight-line demand curve: The slope is constant, but PED changes along the line: elastic at high prices, unitary at the midpoint, inelastic at low prices.
What shifts the supply curve?: Left: higher costs (wages, materials, energy), an indirect tax, exit of firms, a better price for an alternative product, bad weather. Right: new technology and lower costs, a subsidy, entry of firms.
Determinants of price elasticity of supply: Time period, spare capacity, level of stocks, and how easily factors can be switched between uses.
What happens when price is above equilibrium?: Excess supply. Price is pushed down; quantity demanded extends and quantity supplied contracts until the market clears.
Joint, competitive, composite and derived demand: Joint: complements bought together. Competitive: substitutes. Composite: a good with several uses. Derived: demand for an input that comes from demand for the final good.
Diagram: demand rises in a market with inelastic supply: Demand shifts right. With steep (inelastic) supply, price rises a lot and quantity only a little. With elastic supply, quantity rises more and price less.

3.1.3 Production, costs and revenue

Production and productivity: Production: converting inputs (the services of factors such as labour and capital) into output. Productivity: output per unit of input; labour productivity is output per worker or per worker-hour.
Specialisation, division of labour and the role of money: Specialisation: concentrating on what you do best. Division of labour: splitting production into separate tasks. Specialisation requires exchange, and money as a medium of exchange makes exchange easier.
Short run vs long run: Short run: some factor of production cannot be changed (there are fixed costs). Long run: every factor can be changed, so there are no fixed costs.
The cost formulae: TC = FC + VC. AFC = FC ÷ Q, AVC = VC ÷ Q, AC = TC ÷ Q = AFC + AVC. MC = ΔTC ÷ ΔQ.
Fixed vs variable costs: Fixed: do not vary with output in the short run (rent, insurance). Variable: vary with output (materials, piece-rate labour).
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 long-run average cost.
TR, AR and profit: TR = P × Q. AR = TR ÷ Q, which is the price. Profit = TR − TC.
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.
Invention, innovation and creative destruction: Invention: a new idea, product or process. Innovation: its first commercial use. Creative destruction: new products, methods and firms replacing old ones; technological change can lower costs and change market structure.

3.1.4 Competitive and concentrated markets

The spectrum of market structures: From perfect competition (many firms, identical products, free entry) through monopolistic competition and oligopoly to monopoly (a single seller with high barriers to entry).
Concentration ratio: The combined market share of the n largest firms. Top three sell 45, 30 and 15 in a market of 150: CR3 = 90 ÷ 150 × 100 = 60%.
Objectives of firms: Profit maximisation is the usual assumption, but firms may pursue sales or revenue growth, market share, survival, or satisficing (aiming for a satisfactory rather than maximum outcome).
Principal-agent problem: Shareholders (principals) own the firm but managers (agents) run it and may act in their own interest, for example pursuing growth or pay rather than profit.
Price taker: A firm too small to influence the market price, so it accepts it. In a competitive market it can sell all it wants at that price and nothing above it.
How do competitive markets benefit consumers?: Rivalry pushes firms to cut costs, keep prices low and improve quality; supernormal profit attracts entry, which drives price down towards cost.
Barriers to entry: examples: Economies of scale, patents and licences, high sunk costs, brand loyalty and advertising, control of supplies or outlets, and the incumbent's pricing.
Monopoly power and what influences it: The ability to hold price above cost. It is greater with higher barriers to entry, fewer firms, more advertising and product differentiation.
Possible costs and benefits of monopoly: Costs: higher prices, lower output, less choice, little pressure to cut costs. Benefits: economies of scale, and supernormal profit to fund research and innovation.
Monopolistic competition: Many sellers of differentiated products with easy entry and exit; firms compete through branding, quality, service and location as well as price.

3.1.5 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. 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 private firms cannot make a profit and the good may not be provided at all.
Diagram: negative production externality: MSC lies above MPC (supply). The market produces where MPC = MPB; the social optimum, where MSC = MSB, is lower. The welfare loss is the triangle between MSC and MSB over the extra output. It is over-produced.
Merit good vs demerit good: Merit good: judged good for people; under-consumed in a free market (education). Demerit good: judged bad for people; over-consumed (cigarettes). Both rest on a value judgement and often on imperfect information.
Market imperfections: Imperfect and asymmetric information, monopoly power (raising price above marginal cost by cutting output), and immobility of factors of production (occupational and geographical).
Why might an unequal distribution of income and wealth be a market failure?: Markets reward those with valuable skills and assets; the outcome may be judged inequitable (unfair), which is a value judgement. Equality means equal shares; equity means a fair distribution.
Indirect tax vs subsidy on a supply and demand diagram: Tax shifts supply up (left) by the tax per unit; a subsidy shifts it down (right). Neither shifts demand. The price paid by buyers and the price received by sellers differ by the tax or subsidy.
Maximum price vs minimum price: Maximum price (set below equilibrium): shortage, possibly black markets. Minimum price (set above equilibrium): surplus.
Government failure: Intervention that leads to a misallocation of resources, for example from poor information, unintended consequences, administrative costs, conflicting objectives or regulatory capture.