Flashcards · 9640 · AS Topic 1

The operation of markets, market failure and the role of government (AS Level) flashcards

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3.1.1 The economic problem and methodology

Scarcity (the fundamental economic problem): Resources are limited but wants are unlimited, so choices must be made between competing uses. It affects rich and poor countries alike.
Opportunity cost: The benefit of the best option rejected: the next best alternative forgone, not the total of everything given up and not "money".
Opportunity cost from time data: a chair takes 4 hours and a table 10 hours. What is the opportunity cost of one table?: 10 ÷ 4 = 2.5 chairs. Always express the answer in units of the good forgone.
The four factors of production, and the classic confusion for capital: Land (all natural resources), labour (human effort), capital (man-made goods used to make other goods), enterprise (organising and risk-taking). Capital is machines, tools and buildings, not money or a bank loan, which is finance.
Production possibility diagram: what does a point on, inside and outside the boundary show?: On: full, efficient use of resources (productively efficient). Inside: unemployed or inefficiently used resources (possible but wasteful). Outside: unattainable with current resources and technology.
Why is a production possibility boundary usually bowed outwards (concave to the origin)?: Some resources suit one good better than the other, so producing more of one good draws in resources less suited to it. Opportunity cost rises. A straight line means constant opportunity cost.
Movement along versus shift of the production possibility boundary: A movement along it changes the mix of goods produced. An outward shift is economic growth (more productive capacity); an inward shift is a loss of capacity.
Positive versus normative statements: Positive: about what is, was or will be; testable by evidence, and can be false and still be positive ("inflation rose to 6%"). Normative: about what ought to be; a value judgement ("inflation is too high", "the government should cut tax").
Ceteris paribus, and why economics is a social science: Ceteris paribus: other things held equal, so one relationship can be isolated in a model. Economics uses models, hypotheses and data like a natural science, but has few controlled experiments, many variables change at once, and values shape the questions.

3.1.2 How markets work

Movement along a demand curve versus a shift of the curve: Movement (extension or contraction): caused only by a change in the good's own price. Shift (increase or decrease in demand): caused by any other influence, such as income, prices of substitutes or complements, tastes.
PED: formula and a check. Price falls from 50 to 45; quantity rises from 800 to 920.: PED = % change in quantity demanded ÷ % change in price. Price −10%, quantity +15%, so PED = 15 ÷ −10 = −1.5: elastic. Revenue rises from 40,000 to 41,400.
PED and total revenue: what happens to revenue when price rises, for elastic, inelastic and unit elastic demand?: Elastic (size above 1): revenue falls. Inelastic (size below 1): revenue rises. Unit elastic: revenue unchanged. (The reverse for a price cut.)
YED: formula, signs and an example. Income rises 5% and demand rises 1%.: YED = % change in quantity demanded ÷ % change in income. Positive: normal good (above 1 is income elastic). Negative: inferior good. 1 ÷ 5 = +0.2: normal and income inelastic.
XED: formula and what the sign shows. A 12% rise in the price of Y cuts demand for X by 6%.: XED = % change in quantity demanded of X ÷ % change in price of Y. Positive: substitutes. Negative: complements. −6 ÷ 12 = −0.5: weak complements.
Determinants of price elasticity of demand: More elastic with: many close substitutes, a luxury, a large share of income, a long time period, a narrowly defined good. Less elastic with: few substitutes, a necessity, a small share of income, a short period, a broadly defined good, habit.
PES: formula and example. Price rises 8% and quantity supplied rises 2.4%.: PES = % change in quantity supplied ÷ % change in price. 2.4 ÷ 8 = 0.3: inelastic. Supply is more elastic with spare capacity, stocks, a long time period, mobile factors and low barriers to entry.
Which way does the supply curve shift for an indirect tax per unit and for a subsidy?: Tax per unit: supply shifts left (up) by the tax. Subsidy per unit: supply shifts right (down) by the subsidy. A change in demand does not shift supply; it causes a movement along it.
Find the equilibrium: Qd = 360 − 20P and Qs = −40 + 20P: Set Qd = Qs: 360 − 20P = −40 + 20P, so 400 = 40P and P = 10. Q = 360 − 200 = 160 (check: −40 + 200 = 160).
Why can a bumper harvest make farmers worse off?: Supply shifts right. Demand for the crop is price inelastic, so price falls by a larger percentage than quantity rises, and farmers' total revenue falls.
Joint demand, competitive demand, composite demand, derived demand and joint supply: Joint: complements bought together. Competitive: substitutes. Composite: one good with several uses (grain for food and feed). Derived: wanted for what it helps make (steel for cars, labour). Joint supply: several goods from one process (planks and sawdust).
The three functions of the price mechanism: Rationing: allocates scarce goods to those willing and able to pay. Incentive: higher prices and profit encourage more production. Signalling: price changes carry information about scarcity and tastes to producers and consumers.

3.1.3 An introduction to production, costs, revenue and profit

Production versus productivity: Production: converting inputs into final output (total output). Productivity: output per unit of input. Labour productivity is output per worker or per worker-hour. Output can rise with no rise in productivity if inputs rise in proportion.
Labour productivity example: 9 workers, 40 hours each, make 7,200 items: Total hours = 9 × 40 = 360. Output per worker = 7,200 ÷ 9 = 800. Output per hour = 7,200 ÷ 360 = 20.
Division of labour: benefits and costs: Benefits: practice makes workers quicker, less time switching tasks, tools in constant use, so output per worker rises and unit cost can fall. Costs: monotony and lower motivation, interdependence (one weak stage holds up the rest), narrow skills that raise the risk of unemployment.
Why does specialisation need money?: Specialists must exchange their surplus for other goods. Barter needs a double coincidence of wants and many exchange ratios, so money as a medium of exchange saves time and lets specialisation spread.
Fixed cost, variable cost, total cost and average cost: Fixed cost: does not change with output in the short run, owed even at zero output (rent, insurance). Variable cost: changes with output (materials). TC = FC + VC. AC = TC ÷ Q = AFC + AVC.
Short run versus long run: Short run: at least one input is fixed. Long run: all inputs can be varied, so the scale of production can change.
Internal versus external economies of scale: Internal: from the firm's own growth (technical, purchasing, managerial, financial, marketing); a movement down the LRAC curve. External: from the growth of the industry or area (skilled labour pool, specialist suppliers, infrastructure); a downward shift of the LRAC curve.
Diseconomies of scale and minimum efficient scale (MES): Diseconomies: LRAC rises as the firm grows, from co-ordination and communication problems, loss of control, lower motivation and duplication. MES: the smallest output at which LRAC reaches its minimum.
Revenue and profit formulae, with an example: price 18, 250 units sold, total cost 3,900: TR = P × Q; AR = TR ÷ Q (= price); profit = TR − TC. TR = 18 × 250 = 4,500. Profit = 4,500 − 3,900 = 600. Check: AC = 15.60, profit per unit 2.40 × 250 = 600.
Why is the average revenue curve the firm's demand curve?: At each price buyers choose how many units to take, and AR equals price when all units sell at one price. So AR plotted against quantity traces demand. A price change moves along it; a non-price factor shifts it.

3.1.4 Competitive and concentrated markets

The three features that distinguish market structures: How many firms compete, how different (differentiated) their products are, and how easily new firms can enter (barriers to entry).
Objectives of firms other than profit: Survival, growth and increasing market share. Objectives shape behaviour: for example a firm chasing market share may cut prices and accept lower profit now.
Main characteristics of perfect competition: Many buyers and sellers, none able to influence price (price takers); identical products; no barriers to entry or exit; good information about prices.
Why are profits likely to be lower in a competitive market than where a few large firms dominate?: No barriers, so supernormal profit attracts entry. Supply increases and price falls until only normal profit is left. With high barriers, entry cannot compete the profit away.
Concentration ratio: definition and example. Five firms sell 120, 90, 60, 30, 20; all others 80. Find CR3.: CRn = combined sales of the n largest firms ÷ total market sales × 100. Total = 400. CR3 = (120 + 90 + 60) ÷ 400 = 67.5%.
Pure monopoly versus monopoly power: Pure monopoly: a single firm is the whole market, with no close substitutes (few real examples). Monopoly power: the ability to influence price or earn higher profit because competition is limited; many firms have some.
Factors that increase a firm's monopoly power: High barriers to entry, few competitors, advertising and brand loyalty, product differentiation. Each makes demand less price elastic, so a price rise loses fewer customers.
Compared with a competitive market, what does monopoly tend to give? Possible benefits?: Higher price, lower output, higher profit, lower consumer surplus and a misallocation of resources. Possible benefits: economies of scale and profit to fund invention and innovation. It depends on whether cost savings are passed on to consumers.

3.1.5 Market failure and government intervention in markets

Market failure: When the market outcome leads to a misallocation of resources. Causes include public goods, externalities, merit and demerit goods, monopoly and other market imperfections, and inequality of income and wealth.
Public good: the two characteristics, and the free-rider problem: Non-rival (one person's use leaves others' unchanged) and non-excludable (non-payers cannot be stopped). Because non-payers cannot be excluded, people wait for others to pay, firms earn no revenue, and the good is not provided by the market.
Tragedy of the commons: An open-access resource that is rival but non-excludable is overused, because each user keeps the full gain from extra use but shares the cost with everyone else.
Externality, and private versus social cost: Externality: a cost or benefit to a third party, with no payment made. Social cost = private cost + external cost (likewise for benefit). Markets take account of private values only.
Diagram in words: negative production externality: Axes: price and quantity. The supply curve showing the full cost to society lies above private supply. Its crossing with demand gives lower output and a higher price than the market. The gap between the outputs is overproduction; the triangle between the curves is the welfare loss.
Merit and demerit goods: Merit good: society judges that people consume too little (underconsumed). Demerit good: society judges people consume too much (overconsumed). Causes: externalities in consumption and imperfect information. Classification rests on a value judgement.
Market imperfections that cause market failure: Imperfect and asymmetric information, monopoly power, factor immobility (occupational and geographical), and price instability (inelastic demand and supply plus supply shocks).
Tax incidence: Qd = 100 − 4P, Qs = 16P − 20, tax of 5 per unit. Who pays?: Before: P = 6, Q = 76. After: supply 16P − 100, so P = 10, Q = 60. Consumers pay 4 of the 5 (80%), because demand is inelastic. Tax revenue = 5 × 60 = 300.
Maximum price versus minimum price: Maximum price: a legal ceiling, binding when set below equilibrium; causes a shortage, queues, black markets. Minimum price: a legal floor, binding when set above equilibrium; causes a surplus.
How do tradable pollution permits work?: A cap fixes total pollution. Firms that can cut pollution cheaply cut more and sell permits; firms with high abatement costs buy. Total pollution is certain and cuts are made at least cost. Risks: the cap may be wrong, and monitoring is needed.
Government failure, and its sources: Intervention that leads to a worse allocation of resources and a fall in economic welfare. Sources: inadequate information, inappropriate or conflicting objectives, administrative costs, corruption, unintended consequences (such as black markets).