Flashcards · 2281 · Topic 2

The allocation of resources flashcards

61 cards on Topic 2, subtopics 2.1 to 2.11. Pick a subtopic or study them all.

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2.1 Microeconomics and macroeconomics

Microeconomics: The study of the choices of individual households, workers and firms, and of single markets.
Macroeconomics: The study of the economy as a whole, including the choices of government that affect the whole economy.
Micro or macro? (a) a bakery sets its price (b) a country's unemployment rate (c) a farm chooses between two crops (d) the general price level: (a) Micro. (b) Macro. (c) Micro. (d) Macro.
Name the decision makers at the micro and macro levels: Micro: households (consumers), workers and firms. Macro: government and the central bank. Government acts at both levels: taxing one product is micro; changing taxes to influence national output is macro.

2.2 The role of markets in allocating resources

Market: Any arrangement that brings buyers and sellers together.
Price mechanism: The way prices change to answer the three allocation questions: prices signal, give incentives and ration.
The three basic allocation questions: What to produce, how to produce, and for whom to produce. Each answer has an opportunity cost.
How does the price mechanism answer what, how and for whom?: What: goods with high prices and profits are produced more; loss-making goods are cut back. How: firms choose the lowest-cost method given input prices. For whom: output goes to those willing and able to pay.
The three jobs of price in a market: Signalling: tells producers what buyers want. Incentive: higher profit encourages more supply; a higher price discourages buying. Rationing: price rises until only those willing and able to pay can buy.
One strength and one limitation of the price mechanism: Strength: responds quickly to changes in wants, with no central planner, and rewards low-cost production. Limitation: output goes to those with money, not always those in need; adjustment takes time, so shortages and surpluses can last.

2.3 Demand

Demand: The quantity buyers are willing and able to buy at each price in a given period. Demand needs the ability to pay as well as the willingness.
Why does a demand curve slope down from left to right?: A higher price makes the good dearer than alternatives and cuts what buyers can afford, so they buy less. (Axes: price on the vertical axis, quantity on the horizontal.)
Extension and contraction of demand vs increase and decrease in demand: Extension or contraction: a movement along the curve caused by a change in the good's own price (price falls → extension; price rises → contraction). Increase or decrease: a shift of the whole curve (right or left) caused by any other condition.
Give five changes that increase demand (shift the curve right): Higher income (normal good); a rise in the price of a substitute; a fall in the price of a complement; tastes or advertising in favour; more buyers (population); expected future price rise; suitable season or weather.
The price of cars rises. What happens to the demand for petrol, and what is the term?: Cars and petrol are complements, so fewer cars are bought and demand for petrol decreases: the demand curve for petrol shifts left.
Normal good vs inferior good: When income rises, demand for a normal good increases, but demand for an inferior good decreases (buyers switch to better alternatives).

2.4 Supply

Supply: The amount of a good or service that producers are prepared and able to offer at each possible price during a stated period.
Why does a supply curve slope up from left to right?: A higher price brings more revenue per unit, so selling more becomes more profitable and new sellers are drawn in.
The price of tea rises from 4 to 6 and quantity supplied rises from 40 to 80. Name the change and find the percentage change in quantity: An extension of supply (a movement along the supply curve). (80 − 40) ÷ 40 × 100 = +100%.
Give four causes of an increase in supply (shift right): Lower costs of production; better technology; more firms; a subsidy; a good harvest. The opposite (higher costs, indirect tax, poor harvest, other goods more profitable) decreases supply.
Effect of an indirect tax and of a subsidy on the supply curve: Indirect tax: raises costs, so supply decreases; the curve shifts up (left) by the tax per unit. Subsidy: lowers costs, so supply increases; the curve shifts down (right) by the subsidy.
How is market supply found from the supply of individual firms?: By aggregation: add the quantities each firm supplies at each price (a horizontal sum). Never add the prices. Example: 8 farms × 50 kg = 400 kg; with 10 farms, 500 kg.

2.5 Price determination

Market equilibrium: Quantity demanded equals quantity supplied; there is no pressure for the price to change.
Shortage (excess demand): Demand exceeds supply at the going price; the price is below equilibrium. (Scarcity always exists; a shortage exists only when price is below equilibrium.)
Surplus (excess supply): Supply exceeds demand at the going price; the price is above equilibrium.
At a price of 5, quantity demanded is 600 and quantity supplied is 400. What is the disequilibrium, and how many are traded?: A shortage (excess demand) of 600 − 400 = 200. Only 400 are traded: at a disequilibrium price the smaller of the two quantities is bought and sold.
Explain how a surplus is removed in a free market: Unsold stock builds up, so sellers cut the price. Quantity demanded extends and quantity supplied contracts until they are equal at the equilibrium price. The curves do not move.
Describe an equilibrium diagram in words: Price on the vertical axis, quantity on the horizontal. A downward-sloping demand curve D and upward-sloping supply curve S cross at the equilibrium; dotted lines show equilibrium price and quantity on the axes.

2.6 Price changes

Effect on equilibrium price and quantity of: an increase in demand; a decrease in supply: Increase in demand (D shifts right): price rises, quantity rises. Decrease in supply (S shifts left): price rises, quantity falls.
Effect on equilibrium price and quantity of: a decrease in demand; an increase in supply: Decrease in demand (D shifts left): price falls, quantity falls. Increase in supply (S shifts right): price falls, quantity rises.
A poor harvest hits a market. Explain the change in price in steps: Supply shifts left. At the old price there is a shortage. Buyers compete, so price rises. Quantity demanded contracts and quantity supplied extends until a new equilibrium at a higher price and lower quantity.
Demand and supply both increase. What happens to price and quantity?: Quantity rises for certain. Price could rise, fall or stay the same: it depends on which shift is larger.
After a supply decrease, price rises from 6 to 7.20 and sales fall from 520 to 424. What happens to sellers' revenue?: Revenue = price × quantity. Before: 6 × 520 = 3,120. After: 7.20 × 424 = 3,052.80. Revenue falls: the higher price did not make up for the fall in sales.
Evaluation: why may a real price change differ from the simple one-shift prediction?: It depends on the size of the shift, on time (supply is often slower to respond, so short-run price changes are larger), and on other changes happening at once ("other things equal" rarely holds).

2.7 Price elasticity of demand (PED)

Price elasticity of demand (PED): A measure of how far the amount buyers want to purchase reacts when the good's price changes.
PED formula. Price rises from 20 to 21 and quantity demanded falls from 400 to 340: find PED: PED = % change in quantity demanded ÷ % change in price. % change in price = 1 ÷ 20 × 100 = +5%. % change in quantity = −60 ÷ 400 × 100 = −15%. PED = −15 ÷ 5 = −3.0: elastic.
Name the PED for values of 0, between 0 and 1, exactly 1, over 1, and infinity (ignore the sign): 0: perfectly inelastic (vertical demand curve). 0 to 1: inelastic. 1: unitary. Over 1: elastic. Infinity: perfectly elastic (horizontal demand curve).
What makes demand more price elastic?: Many close substitutes; the good is a luxury; it takes a large share of income; a longer time period; the good is defined narrowly (one brand rather than the whole product).
PED and total revenue: what happens to revenue when price rises, if demand is elastic, unitary or inelastic?: Elastic: revenue falls. Unitary: no change. Inelastic: revenue rises. (A price cut does the reverse.)
Why does PED matter for a government taxing a good?: An indirect tax raises more revenue on a good with inelastic demand, because sales fall little, but it cuts consumption only a little. To discourage a harmful good, demand must be more elastic. It depends on whether the aim is revenue or less use.

2.8 Price elasticity of supply (PES)

Price elasticity of supply (PES): A measure of how responsive quantity supplied is when price changes.
PES formula. Price rises from 12 to 15 and quantity supplied rises from 160 to 176: find PES: PES = % change in quantity supplied ÷ % change in price. Price: +3 ÷ 12 = +25%. Quantity: +16 ÷ 160 = +10%. PES = 10 ÷ 25 = 0.4: inelastic. PES is positive.
What makes supply more price elastic?: Spare capacity; stocks of finished goods; factors of production easy to switch; inputs easy to obtain and quick production; a longer time period.
Describe supply curves with PES = 0, PES = infinity and PES = 1: PES = 0: vertical line (perfectly inelastic). PES = infinity: horizontal line (perfectly elastic). PES = 1: any straight line through the origin.
Why do food prices spike after a poor harvest?: Supply shifts left. Demand for a staple food is inelastic, so price must rise a lot to clear the market. Supply of the crop is inelastic within the season, so the high price cannot bring extra output quickly.

2.9 Market economic system

Market economic system: Resources are allocated mainly by demand and supply through the price mechanism, with private ownership and a small government role.
Three advantages of a market economic system: Wide consumer choice; competition lowers costs and prices; prices signal what consumers want; profit rewards effort and risk; quick adjustment without a planner.
Three disadvantages of a market economic system: Public goods not provided; external costs ignored; inequality in who can buy; monopoly power can develop; merit goods under-consumed and demerit goods over-consumed.
Evaluation: when does a market system work well and when badly?: Well for goods people can be charged for and can judge for themselves, in competitive markets. Badly for goods with large external effects, public goods, and where incomes are very unequal. No real economy is purely market-based.

2.10 Market failure

Market failure: The price mechanism allocates resources in a way that is not best for society.
Social cost and social benefit: Social cost = private cost + external cost. Social benefit = private benefit + external benefit. External costs and benefits fall on outsiders who are not compensated or did not pay.
A dye works has a private cost of 28 per unit and an external cost of 9 per unit. Find the social cost per unit and the total external cost at 2,500 units: Social cost = 28 + 9 = 37 per unit. Total external cost = 9 × 2,500 = 22,500.
Public good: its two features, and why the market fails to provide it: Non-excludable (people who do not pay cannot be stopped from benefiting) and non-rival (one person's use does not reduce another's). Free riders will not pay, so firms cannot raise enough revenue. Examples: street lighting, flood defences.
Merit good vs demerit good: Merit good: society judges it beneficial; under-consumed in a free market because benefits are undervalued (education, vaccination). Demerit good: harmful; over-consumed because harm is underestimated (cigarettes).
How do monopoly power and factor immobility cause market failure?: Monopoly: barriers to entry let a firm restrict output and raise price, so consumers lose. Factor immobility: geographical or occupational barriers leave unemployed workers and unfilled vacancies side by side.

2.11 Mixed economic system

Mixed economic system: Resources are allocated by both the private sector (through the price mechanism) and the government (the public sector).
Maximum price vs minimum price: where set, and the result: Maximum price: a legal cap set below equilibrium, causing a shortage (aim: affordability). Minimum price: a legal floor set above equilibrium, causing a surplus (aim: support producers). A control on the wrong side of equilibrium has no effect.
Qd = 100 − 4P and Qs = −20 + 8P. Equilibrium is P = 10, Q = 60. A maximum price of 7 is set: find the shortage: At P = 7: Qd = 100 − 28 = 72; Qs = −20 + 56 = 36. Shortage = 72 − 36 = 36. Only 36 are traded.
Effect of an indirect tax and a subsidy on a market: Tax: supply shifts up (left) by the tax; price rises (usually by less than the tax) and quantity falls. Subsidy: supply shifts down (right); price falls and quantity rises. The demand curve does not move.
Privatisation vs nationalisation: Privatisation: moving ownership from the public sector to the private sector. Nationalisation: moving ownership from the private sector to the public sector.
Evaluation: give one drawback of a minimum wage and of a tax on a demerit good: Minimum wage above equilibrium raises pay for those in work but may cut jobs; the loss depends on how responsive labour demand is. Tax on a demerit good with inelastic demand raises revenue but changes behaviour little. Intervention can itself cause government failure.