Flashcards · 4EC1 · Topic 1.1

The market system flashcards

35 cards on Topic 1.1, subtopics 1.1.1 to 1.1.6. Pick a subtopic or study them all.

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1.1.1 The economic problem

Scarcity: Wants are unlimited but resources are finite, so choices must be made. It affects rich and poor countries alike.
Opportunity cost: The value of the best alternative sacrificed by making a choice. It is one item: the next best option, not all the options given up, and not the price paid.
A farm can spend 12,000 on a tractor (adds 1,800 a year) or irrigation (adds 1,200 a year). It buys the tractor. What is the opportunity cost?: The 1,200 a year the irrigation would have earned, the next best project. (Returns: tractor 1,800 ÷ 12,000 = 15%; irrigation 1,200 ÷ 12,000 = 10%.)
Production possibility frontier (PPF): A curve showing the most of one good an economy can make for each level of the other good, with all resources in use.
What does a point on, inside and outside a PPF show?: On: maximum productive potential, resources fully employed. Inside: possible, but resources unemployed or underused. Outside: unobtainable with present resources.
Why does a PPF bow outwards, and what shifts it?: Bows out: the opportunity cost of each extra unit of one good rises (a straight line means constant opportunity cost). Outward shift (growth): more or better land, labour or capital, investment, better technology. Inward shift: war, natural disaster, depleted resources, loss of skills.

1.1.2 Economic assumptions

The two economic assumptions about consumers and producers: Consumers aim to maximise their benefit (the greatest satisfaction from spending). Businesses aim to maximise their profit (the greatest gap between revenue and cost).
Why might consumers not maximise their benefit?: Poor calculation of benefits and costs (such as ignoring unit prices); habits that are hard to give up; copying others, such as friends or influencers.
Why might producers not maximise profit?: Managers may maximise revenue or sales instead; the firm may care for customers (fair prices, free support); it may do charitable work.
Output 6: revenue 180, cost 120. Output 8: revenue 200, cost 190. Which output maximises profit and which maximises revenue?: Profit at 6 = 180 − 120 = 60; at 8 = 200 − 190 = 10. Profit is maximised at 6; revenue is maximised at 8. A sales-maximising manager choosing 8 gives up 50 of profit.

1.1.3 Demand, supply and market equilibrium

Demand and supply: Demand: how much buyers will purchase, being willing and able to pay, at each possible price over a stated period. Supply: how much firms will offer for sale at each possible price over a stated period.
Movement along vs shift of a demand or supply curve: Movement along: caused by a change in the price of the good itself ("quantity demanded" or "quantity supplied" changes). Shift: caused by any other factor; right is an increase, left a decrease.
Factors that shift the demand curve: Advertising; income (normal goods rise with income, inferior goods fall); fashion and tastes; price of substitutes (dearer substitute → demand rises); price of complements (dearer complement → demand falls); demographic changes.
Factors that shift the supply curve: Costs of production; technology; indirect taxes (supply shifts up and left); subsidies (supply shifts down and right); natural factors such as weather, harvests, disease.
Excess demand and excess supply: Excess demand: buyers want more than sellers offer; the price is below equilibrium. Excess supply: sellers offer more than buyers want; the price is above equilibrium.
How do market forces remove excess supply?: Stock is left unsold, so sellers lower prices. Quantity demanded extends and quantity supplied contracts until the two are equal and the price stops falling at equilibrium.
Demand increases and supply decreases at the same time. What happens to price and quantity?: Price certainly rises. The effect on quantity is unclear: it depends on which shift is bigger.

1.1.4 Elasticity

PED, PES and YED formulas: PED = % change in quantity demanded ÷ % change in price (usually negative). PES = % change in quantity supplied ÷ % change in price (usually positive). YED = % change in quantity demanded ÷ % change in income (positive or negative).
A price falls from 25.00 to 22.50 and sales rise from 600 to 720. Find PED and the effect on revenue: Price: −2.50 ÷ 25 = −10%. Quantity: +120 ÷ 600 = +20%. PED = 20 ÷ −10 = −2.0: elastic. Revenue rises from 25 × 600 = 15,000 to 22.50 × 720 = 16,200.
Factors affecting PED: More elastic with many close substitutes, a luxury, a large share of income, and a longer time period. Less elastic with few substitutes, a necessity, a tiny share of income, and a short period.
Factors affecting PES, and why primary products tend to have less elastic supply: More elastic when factors of production are easy to find and move, stocks are held, there is spare capacity, and in the long run. Primary products: growing seasons, weather and mine development times limit the short-run response.
Interpret YED values: Above 1: luxury good. Between 0 and 1: normal good, a necessity (demand rises less than proportionately with income). Below 0: inferior good (demand falls as income rises). Strictly, every good with positive YED is a normal good.
Income falls 10% and quantity demanded falls 25%. Find YED and classify the good: YED = −25 ÷ −10 = +2.5. Above 1, so a luxury good.
Why does PED matter to a government setting an indirect tax?: If demand is inelastic, quantity falls little, so tax revenue is high and firms can pass more of the tax on. If demand is elastic, quantity falls a lot, so revenue is lower and firms lose more sales.

1.1.5 The mixed economy

Mixed economy: Resources are allocated by both the market (private sector) and the government (public sector).
Private sector vs public sector: Private sector: owned and run by individuals and firms; usual aim profit or growth. Public sector: owned and controlled by the government; usual aim welfare, access and meeting needs.
Public good, and the free rider problem: A public good is both non-excludable (nobody can be stopped from using it) and non-rival (use by one leaves the same for everyone else). People use it without paying, so private firms cannot cover costs and do not provide it. Examples: street lighting, flood defences, national defence.
Market failure: Resources are used inefficiently in a free market. Two causes in this unit: no provision (public goods) and the wrong amount (externalities).
Privatisation: one possible gain and one possible loss for consumers and for the government: Consumers: possibly better quality and lower prices if competition grows, but possibly higher prices and cuts to unprofitable services. Government: sale proceeds and a lower subsidy bill, but it loses future profits and direct control.
Which of these is a public good: a toll bridge, street lighting, a restaurant meal?: Street lighting (non-excludable and non-rival). A toll bridge is excludable; a restaurant meal is rival and excludable.

1.1.6 Externalities

External cost and external benefit: External cost: a cost of production that falls on a third party (pollution, congestion). External benefit: a benefit of consumption that goes to a third party (education, vaccination).
Social cost and social benefit formulas: Social cost = private cost + external cost. Social benefit = private benefit + external benefit.
A quarry has a private cost of 40 per tonne and an external cost of 12 per tonne. Find the social cost per tonne and the total external cost of 500 tonnes: Social cost = 40 + 12 = 52 per tonne. Total external cost = 12 × 500 = 6,000.
What is the market result of an external cost and of an external benefit?: External cost: the firm ignores the harm, so its cost looks low and too much is produced. External benefit: buyers count only their own gain, so too little is consumed.
How could a tax deal with an external cost of 12 per tonne?: A tax of 12 per tonne makes the firm pay the external cost, so its costs rise, supply falls, and output moves towards the level society would choose.